February 26, 2020
Stephen A. Marglin, Harvard University
This is a curious debate on which much seems to turn on “the stroke of a pen.”
Do banks create money or are they intermediaries between depositors and borrowers? Marc Lavoie is spot on. Banks create money, and, yes, they do it with the stroke of a pen. This is true even if banks are constrained by reserve requirements and can only “lend out what they have already received in deposits.” Even if the money is out the door before the ink is dry on the loan documents by which it was created. Banks are uniquely able to create money because the loans they make create a means of payment acceptable for discharging “all debts public and private,” just like every piece of paper money issued by the Federal Reserve. And they have privileged access to a pool of funds provided by the banking system.
Banks as Financial Intermediaries?
James Tobin (1963), the apparent fons et origo of the modern financial-intermediation view, took exception to the idea of banks as creators of money on the grounds that once a deposit created by a loan is out the door, it may not end up in another bank. In 1963 It might have instead gone to a Savings & Loan institution, which paid interest on deposits, unlike banks, then barred from doing so by government regulations. (In 2020, the money may end up in a mutual fund.) In the 1963 setting the depositor had a trade-off between the interest paid by S & L’s on the one hand and, on the other, the inconvenience of not being able to write checks against an S & L deposit and the (small) chance that the S & L would insist on notice before withdrawing any deposit. These depositors, good economic men and women, would make optimal decisions on the basis of their utility functions. The money multiplication process, subject to the choices made by optimizing agents, is not an institutional given.
Tobin concluded that there was nothing special about banks: every financial activity had a potential multiplier, S & L mortgage lending could stimulate economic activity and hence deposits into S & L’s and hence more mortgage lending. Banks were just one category of players in financial markets.
Tobin was right that money created by one bank would likely fly out the door, and right that some of it may end up leaking out of the banking system—leakages into currency are another way of reducing the monetary base, one that was important during the Great Depression. In short the value of the money multiplier is not etched in stone by reserve requirements: the monetary base to which the multiplier applies is not fixed once and for all by some given amount of reserves, reserves are themselves subject to change as a result of agents’ preferences. Or central bank policy in the service of maintaining a target interest rate.
The problem for the financial-intermediation view is that none of this constitutes an argument against money creation, nor an argument against the role of banks in the process. Nothing in Tobin’s argument militates against the special character of banks lying in their unique ability to create money as means of payment and their privileged access to funding.
Orthodox and Heterodox Views of Money Creation
The textbooks are right in likening money creation to alchemy.[1] The real argument is not about whether banks are merely intermediaries or creators of money, but between orthodox and heterodox versions of money creation. The difference between the two schools is not about the mechanism of money creation but about the autonomy of the banking system in the process. To appreciate the common core of heterodoxy and orthodoxy, consider a hypothetical series of transactions under both lenses.
The heterodox story imagines a banking system with no reserve requirements, literally able to create money ex nihilo. BankOne incorporates on Sunday, no capital, no assets, no liabilities. On Monday Christine Builders comes to the bank asking for a loan of $1 million to build two houses. BankOne agrees and creates a deposit in that amount, which CB uses to pay construction workers, subcontractors, suppliers, etc. By check. On Tuesday the houses are up and the $1 million disbursed in wages and payments are deposited to accounts in BankTwo. BankTwo presents the checks to BankOne for collection. BankOne has no asset but CB’s note and has to borrow the funds to cover the checks. That’s what the Fed and the Fed Funds market are for, but no Fed is necessary for the story, just the funds, that is, just the willingness of banks to lend to each other to cover shortfalls of liquidity. Suppose that BankTwo, the only other game in town, lends BankOne the funds to cover the checks drawn on CB’s account. (If BankTwo does not accommodate BankOne and no other lender comes forward, BankOne is out of business, and so, most likely, is Christine Builders.)
On Monday and Tuesday, the money supply is $1 million in the form of bank deposits, created ex nihilo by the stroke of a pen. The owners of the deposits are different on the two days, Monday it’s CB and Tuesday it’s CB’s employees, subs, and suppliers. But the total remains the same.
We are not done. On Wednesday CB puts the two houses on the market for $1 million each, and the houses are under contract at the asking price by midday. Appraisals and other paper work are completed in the afternoon and the sales are finalized by the end of the day.
Where do the buyers get the money? Where else but BankOne, which writes two mortgages for $1 million each. The proceeds are deposited into CB’s account. So at the end of Wednesday, the money supply stands at $3 million, consisting of CB’s deposit at BankOne ($2 million) and the multiple deposits at BankTwo ($1 million). Observe that though it is still true that BankOne is creating money via the deposit accompanying its new loans, the deposit is not to the account of the borrower. In this case CB gets the deposit, while the new homeowners incur the debt.
On Thursday CB withdraws half of its funds to pay off its loan, the other half, $1 million, becoming part of Christine’s wealth portfolio. This reduces the money supply to $2 million, divided between Christine’s $1 million in BankOne and the $1 million on deposit in BankTwo, likely no longer in the accounts of the people who actually built the two houses—we can assume this $1 million is churning around among various bank customers, with none of it ever leaving BankTwo. Total bank liabilities are $3 million, which includes the $1 million owed by BankOne to BankTwo along with the $2 million of deposit liabilities of the two banks. The offsetting assets are the $2 million mortgages on the two houses held by BankOne and BankOne’s note for $1 million held by BankTwo.
This could be the end of the heterodox story, but it need not be. Christine may decide on Friday that Greater Shutesbury S & L, down the street from BankOne, or a money-market mutual fund, is offering a better deal for her $1 million, the interest premium compensating for the possible inconvenience in accessing her money. What happens to the money supply and the various balance sheets depends on how we define money and what action the S & L takes upon receiving the deposit. With a narrow M1 definition of money, the transfer from BankOne to Greater Shutesbury S & L (or a mutual fund) reduces the money supply by $1 million. With a broad M2 definition the money supply is unchanged.
As for balance sheets, if GS S & L does nothing with its new deposit, BankOne will have to borrow another $1 million to cover the new outflow of funds. I assume instead that the S & L, remembering its purpose in life, buys one of the two mortgages that BankOne is holding, paying $1 million to BankOne.[2]
Tables 1-6 summarize the state of play from Sunday to Friday.
How is the orthodox story different? Only in the beginning. The orthodox view of money creation accepts the bankers’ lament that they can only lend what they have previously received in deposits. The orthodox tohu v’vohu is a world with only currency, so we begin with Marc deciding on Sunday to entrust BankOne with $2.5 million in currency stored under his mattress. From here on the orthodox story parallels the heterodox one. It’s pretty much cutting and pasting the previous eight paragraphs.
Some details differ. First we have to assume a minimum ratio of reserves to deposits. In the present example, any reserve ratio up to 1/3 will do. Second, when CB pays the workers, subs, and suppliers, currency moves from BankOne to BankTwo. Or, if BankOne has deposited the currency into its account at the Fed, reserves rather than currency will move. So there need be no interbank lending and borrowing in the orthodox story, though nothing prevents this form of accommodation. And on Friday, when Christine moves her funds out of BankOne, reserves will also move along with her deposit, at least temporarily.
The changes in the money supply are the same in the two stories because the mechanism is the same. There is $1 million of additional money on Monday and Tuesday, $3 million on Wednesday, $2 milliion again on Thursday, and only $1 million on Friday. See Tables 7-12.
Essentially, banks are unique in both stories in their ability to create money. BankTwo, as well as Bank One, can create money by lending in either story, assuming the existence of a mechanism (like the Fed funds market) for mutual accommodation, but Shutesbury S & L cannot without an accommodation from the banking system. Telling the story as we do in Ec 10, with each bank hewing to the limits of money creation imposed by reserve requirements, allows us to elide the crucial role of access to interbank or central-bank lending in distinguishing banks from non-bank financial institutions. Once the ilk of Shutesbury S & L has the same privileged access to mutual or central bank funding, and checks drawn on the S & L are legal tender, the wall between banks and non-bank financial institutions is truly breached. For now non-bank financial institutions can also create money.
In both stories BankOne assesses the credit-worthiness of its borrowers, in the first instance CB and in the second installment prospective home buyers. In both stories the business of banks is based on knowing their customers. (See George Bailey.) Only when banks become originators rather than holders of loans can the appearance of credit worthiness be an acceptable substitute for the real thing.
If reserves are absent in the heterodox story, this is to emphasize a larger truth (that reserves don’t matter) rather than a description of reality. In the orthodox case the central role of reserves is also in the service of a larger truth (that the banking system is limited in its ability to create money).
But, as practical bankers know, once interbank borrowing (or borrowing from a central bank) is part of the picture, the reserve position cannot be dispositive. Though not dispositive, in neither story are reserves irrelevant. The first step after presenting the bare-bones orthodox model is for the Ec 10 teacher to note that regulators and (prudent) boards of directors don’t like hot money. Neither would a heterodox theorist deny the practical relevance of reserves.
What Is At Stake?
The difference between heterodoxy and orthodoxy is the larger truth each is trying to impress upon the world. Heterodoxy insists on an active role of the banking system in the economy, orthodoxy on its passivity.
What difference does it make? You can see the difference in how orthodox and heterodox economists interpret the quantity equation, MV = PY, in which M is the money supply, V is the (income) velocity of money, P is the price level, and Y is real output or income. The quantity-of-money theory of prices, the quantity theory, is that at least in the long run causality runs from an exogenously given money supply to the price level, from left to right in the quantity equation. Output is assumed to be determined by “real” forces, by the preferences and production possibilities open to the community. So the classical dichotomy holds.[3] Heterodoxy, at least my own heterodoxy, is wedded to the opposite interpretation, namely, that causality runs from the price level and output to the quantity of money, from right to left. For heterodox economists there is a quantity equation but no quantity theory. And no classical dichotomy.
The quantity theory implicitly assumes the orthodox view of money creation: reserves and the money multiplier are exogenously given. The heterodox interpretation of the quantity equation implicitly assumes that in a world in which reserve requirements constrain overall money creation, reserves and the money multiplier are endogenously determined. A key difference is whether banks can be assumed to be fully loaned up, a necessary if not sufficient condition for the orthodox position to hold.
Interestingly, the key role of the assumption that banks are always fully loaned up surfaced more than one hundred years ago. At its annual meeting in 1911, the American Economics Association held a symposium on the causes of the changes in the price level experienced in the previous decade and a half.[4] Differences of opinion hinged on assumptions about bank behavior with respect to reserves.
Irving Fisher (1911, p 38) emphasized the standard interpretation of the quantity theory, in which causality runs from the quantity of money, exogenously given, to the price level. J Laurence Laughlin, a critic of the quantity theory, argued that causality actually ran in the opposite direction:
When the price is fixed, the credit medium by which the commodity is passed from seller to buyer comes easily and naturally into existence… That is, the quantity of the actual media of exchange thus brought into use is a result and not a cause of the price-making process (Laughlin 1911, pp 29-30).
Laughlin was making the case for endogenous money, by assuming that banks would vary reserve ratios according to the transactions demand for money rather than maintaining constant (fully loaned-up) ratios by moving in and out of other assets.
Edwin Kemmerer, a third contributor, explicitly recognized the complication that fractional-reserve banking introduced into the quantity theory—only to dismiss it. Gold formed the basis of bank reserves and reserves were, he argued, exogenous. Profit maximization could be counted upon to insure that reserves were always fully utilized:
Banks do not make interest on money held in reserves, and accordingly take measures to invest such surplus money, keeping these reserves as low as is consistent with law and their ideas of safety; (Kemmerer, 1911, p 56).
Consequently, though banks theoretically can vary reserve ratios, self interest would prevent them from doing so.
The Great Depression settled the question empirically. In mid-1933 Jacob Viner saw excess reserves as the result of a self-interested prudence on the part of bankers:
In the past three years the test of a successful banker has been the rate of speed with which he could go out of the banking business and into the safety-deposit business. Those bankers have survived who have succeeded in the largest degree and at the most rapid rate in converting loans into cash. That has been good banking from the point of view of the individual banker, or of his individual depositors; but from the social point of view it has been disastrous. Which is preferable during a depression—a bank that continues to finance business and thus endangers its solvency, or a bank that acts on the principle that during an acute depression good banking means no banking? The latter have survived the crisis and now have the confidence of the public. They should now be able to serve effectively in taking care of the present needs of business if they are willing to return to the banking business. (1933, p 130)
The assumption that banks are fully loaned up, that excess reserves are nonexistent, is especially salient in the post-2008 world, a world in which the Federal Reserve and other central banks no longer operate regimes of reserve scarcity. Excess reserves at the Fed are currently $1.5 trillion (with a t), of a total of $1.6 trillion of reserves. Both numbers are down from their peak levels in August, 2014, of $2.7 trillion and $2.8 trillion.
Financial Mediation as Ideology
This leaves us with the question of why the interpretation of banks as intermediaries survives. I think Morgan Ricks nails the answer: it is a useful ideological tool in the fight for deregulation, a fight which started under the Carter Administration and continued under Democrats and Republicans alike until the financial crash of 2008.
I suspect that Ricks gives more credit (or blame) to Tobin than he is due. If Tobin hadn’t existed, he would have been invented. Tobin’s point was to emphasize the general-equilibrium nature of financial markets. Point well taken, but there was no need to deny the distinctive features of banks to make this point. In any case, Tobin went out of his way to stress that his analysis had no implications for regulation:
I draw no policy morals from these observations. That is quite another story, to which analysis of the type presented here is only the preface. The reader will misunderstand my purpose if he jumps to attribute to me the conclusion that existing differences in the regulatory treatment of banks and competing intermediaries should be diminished, either by relaxing constraints on the one or by tightening controls on the other (1963, pp 16-17).
Would that his warning had been heeded.
—
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I consulted three, Baumol, Blinder and Solow (2020); Mankiw (2018), and Krugman and Wells (2018). All three explain how banks create money. Krugman and Wells are outliers, not in adopting a different approach, but in describing banks as financial intermediaries and stressing, à la Tobin (Krugman was Tobin’s student), leakages, in their case leakages into currency. Their estimates of the size of the money multiplier confuse the marginal with the average multiplier.
The consensus doesn’t make the theory right. It is, as Charles Goodhart has recently emphasized, only partially true as a theory of the money supply (Goodhart, 2017). But the kernel of the argument, that banks create money when they make loans, is on the money. ↑
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Likely GS S & L will have to pay more than $1 million since BankOne is presumably in business to make a profit, but that will affect the respective balance sheets only by creating a debt obligation from GS S & L to BankOne for the difference. In due course the interest and principal payments from the mortgagor will cover this debt, with some margin to spare if all goes according to plan: (Greater Shutesbury S & L is not in business for fun either.) In this case, the balance sheet of BankOne shrinks by the reduction in its liabilities and assets, but it finally has some capital to show for its efforts. To keep the argument as simple as possible, I ignore this complication and assume that the mortgage is sold for $1 million. ↑
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The perceptive reader will have noticed that my orthodox story, like my heterodox story, doesn’t jibe with the classical dichotomy: the creation of money in both stories is linked to building houses and financing their construction and sale. To make the creation story dovetail with the classical dichotomy, imagine that Christine wakes up, smells the flowers, and realizes that she doesn’t have to build houses, she can just flip them. No construction workers, no subs, no suppliers. No construction. Just rising home prices. Like the first years of this century. The money creation story doesn’t change. ↑
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The symposium was prompted by the transition from cash money to bank-deposit money, a transition that was still under way in the United States despite the huge steps taken in this direction during the 19th century. ↑
Money Creation Without Reserves |
|||||||||
| Table 1. Sunday | |||||||||
| Assets, $ millions | Liabilities, $ millions | Money Supply | |||||||
| Loans To Public | Loans To Banks | Reserves | Deposits | Owed to Banks | M1 | M2 | |||
| BankOne | 0 | 0 | 0 | 0 | 0 | 0 | 0 | ||
|---|---|---|---|---|---|---|---|---|---|
| BankTwo | 0 | 0 | 0 | 0 | 0 | 0 | 0 | ||
| Money Supply (M1) = Demand Deposits + Currency | 0 | ||||||||
| Money Supply (M2) = M1 + Time Deposits + Money-Market Funds | 0 | ||||||||
| Table 2. Monday | |||||||||
| Assets, $ millions | Liabilities, $ millions | Money Supply | |||||||
| Loans To Public | Loans To Banks | Reserves | Deposits | Owed to Banks | M1 | M2 | |||
| BankOne | 1 | 0 | 0 | 1 | 0 | 1 | 1 | ||
| BankTwo | 0 | 0 | 0 | 0 | 0 | 0 | 0 | ||
| Money Supply (M1) = Demand Deposits + Currency | 1 | ||||||||
| Money Supply (M2) = M1 + Time Deposits + Money-Market Funds | 1 | ||||||||
| Table 3. Tuesday | |||||||||
| Assets, $ millions | Liabilities, $ millions | Money Supply | |||||||
| Loans To Public | Loans To Banks | Reserves | Deposits | Owed to Banks | M1 | M2 | |||
| BankOne | 1 | 0 | 0 | 0 | 1 | 0 | 0 | ||
| BankTwo | 0 | 1 | 0 | 1 | 0 | 1 | 1 | ||
| Money Supply (M1) = Demand Deposits + Currency | 1 | ||||||||
| Money Supply (M2) = M1 + Time Deposits + Money-Market Funds | 1 | ||||||||
| Table 4. Wednesday | |||||||||
| Assets, $ millions | Liabilities, $ millions | Money Supply | |||||||
| Loans To Public | Loans To Banks | Reserves | Deposits | Owed to Banks | M1 | M2 | |||
| BankOne | 3 | 0 | 0 | 2 | 1 | 2 | 2 | ||
| BankTwo | 0 | 1 | 0 | 1 | 0 | 1 | 1 | ||
| Money Supply (M1) = Demand Deposits + Currency | 3 | ||||||||
| Money Supply (M2) = M1 + Time Deposits + Money-Market Funds | 3 | ||||||||
| Table 5. Thursday | |||||||||
| Assets, $ millions | Liabilities, $ millions | Money Supply | |||||||
| Loans To Public | Loans To Banks | Reserves | Deposits | Owed to Banks | M1 | M2 | |||
| BankOne | 2 | 0 | 0 | 1 | 1 | 1 | 1 | ||
| BankTwo | 0 | 1 | 0 | 1 | 0 | 1 | 1 | ||
| Money Supply (M1) = Demand Deposits + Currency | 2 | ||||||||
| Money Supply (M2) = M1 + Time Deposits + Money-Market Funds | 2 | ||||||||
| Table 6. Friday | |||||||||
| Assets, $ millions | Liabilities, $ millions | Money Supply | |||||||
| Loans To Public | Loans To Banks | Reserves | Deposits | Owed to Banks | M1 | M2 | |||
| BankOne | 1 | 0 | 0 | 0 | 1 | 0 | 0 | ||
| BankTwo | 0 | 1 | 0 | 1 | 0 | 1 | 1 | ||
| GS S & L | 1 | 1 | 0 | 1 | |||||
| Money Supply (M1) = Demand Deposits + Currency | 1 | ||||||||
| Money Supply (M2) = M1 + Time Deposits + Money-Market Funds | 2 | ||||||||
| Note: bank deposits are demand deposits. S & L deposits are time deposits | |||||||||
Money Creation With Reserves |
|||||||||
| Table 7. Sunday | |||||||||
| Assets, $ millions | Liabilities, $ millions | Money Supply | |||||||
| Loans To Public | Loans To Banks | Reserves | Deposits | Owed to Banks | M1 | M2 | |||
| BankOne | 0 | 0 | 2.5 | 2.5 | 0 | 2.5 | 2.5 | ||
|---|---|---|---|---|---|---|---|---|---|
| BankTwo | 0 | 0 | 0 | 0 | 0 | 0 | 0 | ||
| Money Supply (M1) = Demand Deposits + Currency | 2.5 | ||||||||
| Money Supply (M2) = M1 + Time Deposits + Money-Market Funds | 2.5 | ||||||||
| Table 8. Monday | |||||||||
| Assets, $ millions | Liabilities, $ millions | Money Supply | |||||||
| Loans To Public | Loans To Banks | Reserves | Deposits | Owed to Banks | M1 | M2 | |||
| BankOne | 1 | 0 | 2.5 | 3.5 | 0 | 3.5 | 3.5 | ||
| BankTwo | 0 | 0 | 0 | 0 | 0 | 0 | 0 | ||
| Money Supply (M1) = Demand Deposits + Currency | 3.5 | ||||||||
| Money Supply (M2) = M1 + Time Deposits + Money-Market Funds | 3.5 | ||||||||
| Table 9. Tuesday | |||||||||
| Assets, $ millions | Liabilities, $ millions | Money Supply | |||||||
| Loans To Public | Loans To Banks | Reserves | Deposits | Owed to Banks | M1 | M2 | |||
| BankOne | 1 | 0 | 1.5 | 2.5 | 0 | 2.5 | 2.5 | ||
| BankTwo | 0 | 0 | 1 | 1 | 0 | 1 | 1 | ||
| Money Supply (M1) = Demand Deposits + Currency | 3.5 | ||||||||
| Money Supply (M2) = M1 + Time Deposits + Money-Market Funds | 3.5 | ||||||||
| Table 10. Wednesday | |||||||||
| Assets, $ millions | Liabilities, $ millions | Money Supply | |||||||
| Loans To Public | Loans To Banks | Reserves | Deposits | Owed to Banks | M1 | M2 | |||
| BankOne | 3 | 0 | 1.5 | 4.5 | 0 | 4.5 | 4.5 | ||
| BankTwo | 0 | 0 | 1 | 1 | 0 | 1 | 1 | ||
| Money Supply (M1) = Demand Deposits + Currency | 5.5 | ||||||||
| Money Supply (M2) = M1 + Time Deposits + Money-Market Funds | 5.5 | ||||||||
| Table 11. Thursday | |||||||||
| Assets, $ millions | Liabilities, $ millions | Money Supply | |||||||
| Loans To Public | Loans To Banks | Reserves | Deposits | Owed to Banks | M1 | M2 | |||
| BankOne | 2 | 0 | 1.5 | 3.5 | 0 | 3.5 | 3.5 | ||
| BankTwo | 0 | 0 | 1 | 1 | 0 | 1 | 1 | ||
| Money Supply (M1) = Demand Deposits + Currency | 4.5 | ||||||||
| Money Supply (M2) = M1 + Time Deposits + Money-Market Funds | 4.5 | ||||||||
| Table 12. Friday | |||||||||
| Assets, $ millions | Liabilities, $ millions | Money Supply | |||||||
| Loans To Public | Loans To Banks | Reserves | Deposits | Owed to Banks | M1 | M2 | |||
| BankOne | 1 | 0 | 1.5 | 2.5 | 0 | 2.5 | 2.5 | ||
| BankTwo | 0 | 0 | 1 | 1 | 0 | 1 | 1 | ||
| GS S & L | 1 | 1 | 0 | 1 | |||||
| Money Supply (M1) = Demand Deposits + Currency | 3.5 | ||||||||
| Money Supply (M2) = M1 + Time Deposits + Money-Market Funds | 4.5 | ||||||||
| Note: bank deposits are demand deposits. S & L deposits are time deposits | |||||||||
References
Baumol, William, Alan Blinder, and John Solow. 2020. Economics: Principles & Policy, 14th Edition. Boston: Cengage.
Fisher, Irving. 1911. “Recent Changes in Price Levels and Their Causes,” American Economic Review, 1:37-45.
Goodhart, Charles. 2017. “The Determination of the Money Supply: Flexibility Versus Control,” Manchester School, Special Issue: Proceeding of the Money, Macroeconomics and Finance Research Group, 2016, 85:33-56.
Kemmerer, Edwin. 1911. “Money and Prices: Discussion, American Economic Review, 1:52-58.
Krugman, Paul, and Robin Wells. 2018. Economics, 5th Edition. New York: Worth.
Laughlin, J. Laurence. 1911. “Causes of the Changes in Prices Since 1896,” American Economic Review, 1:26-36.
Mankiw, N Gregory. 2018. Macroeconomics, 8th Edition, Boston: Cengage.
Tobin, James. 1963. “Commercial Banks as Creators of ‘Money’,” Cowles Foundation Discussion Paper 159, New Haven: Cowles Foundation at Yale University. (Subsequently published in in Deane Carson, editor, Banking and Monetary Studies, Homeward, Illinois:. Irwin, 1963, pp 408-419.)
Viner, Jacob. 1933. “Inflation as a Possible Remedy for the Depression,” Proceedings of the Institute of Public Affairs, University of Georgia, 7th Annual Meeting , May 8-16, 1933, Athens GA.