Watch “Richard Werner: Banking & The Economy” on YouTube
Uploaded on Mar 30, 2011
Banks have a pivotal function in the economy, they are the main creators of the money supply. In granting or issuing so called ‘loans’ to their customers they create the money that is essential to make the modern economy work. In fact says Prof Werner: ‘there is no such thing as a bank loan’ he says what happens is credit creation, when banks make the money (credit ) needed out of nothing.
He explains how the system works, whereby, from a miniscule deposit of funds a huge amount of money is created.
The Empirical Evidence
Volume 36, December 2014, Pages 1–19
This paper presents the first empirical evidence in the history of banking on the question of whether banks can create money out of nothing. The banking crisis has revived interest in this issue, but it had remained unsettled. Three hypotheses are recognised in the literature. According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it extends credit (the credit creation theory of banking). The question which of the theories is correct has far-reaching implications for research and policy. Surprisingly, despite the longstanding controversy, until now no empirical study has tested the theories. This is the contribution of the present paper. An empirical test is conducted, whereby money is borrowed from a cooperating bank, while its internal records are being monitored, to establish whether in the process of making the loan available to the borrower, the bank transfers these funds from other accounts within or outside the bank, or whether they are newly created. This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, “out of thin air”
Available online 8 September 2015
How do banks operate and where does the money supply come from? The financial crisis has heightened awareness that these questions have been unduly neglected by many researchers. During the past century, three different theories of banking were dominant at different times: (1) The currently prevalent financial intermediation theory of banking says that banks collect deposits and then lend these out, just like other non-bank financial intermediaries. (2) The older fractional reserve theory of banking says that each individual bank is a financial intermediary without the power to create money, but the banking system collectively is able to create money through the process of ‘multiple deposit expansion’ (the ‘money multiplier’). (3) The credit creation theory of banking, predominant a century ago, does not consider banks as financial intermediaries that gather deposits to lend out, but instead argues that each individual bank creates credit and money newly when granting a bank loan. The theories differ in their accounting treatment of bank lending as well as in their policy implications. Since according to the dominant financial intermediation theory banks are virtually identical with other non-bank financial intermediaries, they are not usually included in the economic models used in economics or by central bankers. Moreover, the theory of banks as intermediaries provides the rationale for capital adequacy-based bank regulation. Should this theory not be correct, currently prevailing economics modelling and policy-making would be without empirical foundation. Despite the importance of this question, so far only one empirical test of the three theories has been reported in learned journals. This paper presents a second empirical test, using an alternative methodology, which allows control for all other factors. The financial intermediation and the fractional reserve theories of banking are rejected by the evidence. This finding throws doubt on the rationale for regulating bank capital adequacy to avoid banking crises, as the case study of Credit Suisse during the crisis illustrates. The finding indicates that advice to encourage developing countries to borrow from abroad is misguided. The question is considered why the economics profession has failed over most of the past century to make any progress concerning knowledge of the monetary system, and why it instead moved ever further away from the truth as already recognised by the credit creation theory well over a century ago. The role of conflicts of interest and interested parties in shaping the current bank-free academic consensus is discussed. A number of avenues for needed further research are indicated.
Joshua Jacob Ryan-Collins
Thesis for the degree of Doctor of Philosophy
UNIVERSITY OF SOUTHAMPTON ABSTRACT
.FACULTY OF BUSINESS AND LAW
School of Business
This thesis is composed of three empirical studies examining the relationship between credit creation, monetary policy and macroeconomic activity. It is motivated by the neglect of credit in mainstream macroeconomic theory and empirical work prior to the financial crisis of 2007-08.
The first study investigates the relationship between monetary policy and nominal GDP in the United Kingdom over 50 years using a new quarterly dataset. Different theories of the monetary transmission mechanism are tested using the ‘General-to-Specific’ (GETS) method. A long-run cointegrating relationship is found between a real economy credit growth variable and nominal output growth. Changes to short-term interest-rates and broad money growth fall out of the parsimonious model. Vector error correction and vector auto-regression (VAR) analysis finds one- way Granger causality from credit growth to nominal-GDP growth.
The second study examines evidence of a ‘credit cycle’ by analyzing the dynamic interlinkages between credit, house prices, monetary policy, and economic activity in nine advanced economies. Credit is decomposed in to ‘productive credit’ (bank lending to non- financial firms and for consumption) and ‘asset market credit’ (lending for domestic mortgages or financial assets). Country-level and panel VAR analysis finds: 1) a secular growth in asset market credit relative to productive credit; 2) productive credit growth has a stronger impact on real-GDP growth than asset-market credit although there is cross-country heterogeneity; (3) property prices strongly influence both credit growth aggregates and the macroeconomy; and (4) interest rates are more weakly linked to the other variables.
The third study considers the monetary financing of government expenditure by central- banks as a monetary policy tool. This is pertinent today given historically high private and public debt-to-GDP levels. A literature review finds little support for the standard claim that such activity leads to damaging inflation. A counter-example is presented via an institutional case study of the central bank of Canada during the period 1935-1975 when it monetised on average 25% of government debt to support fiscal expansion and economic growth. Econometric analysis also finds no evidence for a relationship between monetary financing and inflation.
The policy implications of the thesis are that: 1) credit growth plays a central role in the monetary policy transmission mechanism; 2) there is evidence of a credit cycle strongly related to house prices in advanced economies which may be strengthening over time; and 3) monetary financing of government deficits should be considered as a policy tool given high private debt levels and private banks’ turn towards asset market credit creation.