How do banks create money?

Cross-posted from Science Direct: (h/t to Delusional Economics for bringing this important work to our attention)

1. Introduction

Thanks to the recent banking crises interest has grown in the details of how banks operate. In recent decades, the empirical and institutional micro-structure of how banks operate had not been a primary focus of attention by investigators. This lack of interest may partly be due to the predominance of the hypothetico-deductive research methodology in economics, which begins by posing axioms and assumptions. Such a theoretical and hypothetical framework has also been the basis for bank regulations. As is well known to historians, reality may be less logical and rational than the designers of theoretical constructs may envisage. This is known in other areas of finance, where market and investor behaviour often does not conform to the precepts of theoretically posed ‘rational agents’. By contrast, an inductive approach begins by establishing the empirical facts.

Over the past century and a half, three competing theories of banking have been influential — the financial intermediation, the fractional reserve and the credit creation theories of banking. Most current models, theories and textbooks in finance and economics assert the validity of the financial intermediation theory. According to it, banks do not have the ability to create money, neither individually (as the credit creation theory argues) nor collectively (as the fractional reserve theory maintains). Recently, two events have upset the status quo in this debate. The Bank of England has come forward clearly in support of the credit creation theory (Bank of England, 2014a and Bank of England, 2014b). Secondly, the first empirical tests of the three theories have been conducted (Werner, 2014a and Werner, 2014c). These tests showed that the financial intermediation and fractional reserve theories are not supported by the evidence: Banks do not gather deposits and then lend these out, as the financial intermediation theory assumes. Nor do they draw down their deposits at the central bank in order to lend, as the fractional reserve theory of banking maintains. The empirical facts are only consistent with the credit creation theory of banking. According to this theory, banks can individually create credit and money out of nothing, and they do this when they extend credit. When a loan is granted by a bank, it purchases the loan contract (legally considered a promissory note issued by the borrower), which is reflected by an increase in its assets by the amount of the loan. The borrower ‘receives’ the ‘money’ when the bank credits the borrower’s account at the bank with the amount of the loan. The balance sheet lengthens. Through the process of credit creation 97% of the money supply is created in the UK today (Werner, 2005), and similar proportions apply to most industrialised economies. Not surprisingly, the use to which bank credit is put to determines its effect, namely whether bank credit is extended for productive, consumptive, or speculative purposes (the Quantity Theory of Credit, see Werner, 1997, Werner, 2005 and Werner, 2012a).

One reason for the neglect of the institutional and operational details of banks in the research literature in the past decades is likely the fact that no law, statute or bank regulation explicitly grants banks the right (usually considered a sovereign prerogative) to create and allocate the money supply. As a result, many economists, finance researchers, lawyers, accountants, even bankers, let alone the general public, have not been aware of the role of banks as creators and allocators of the money supply.

The establishment of these facts motivates a number of new research questions, many of which did not arise within the two alternative theories of banking. In this paper the question is considered of what exactly it is that enables banks to individually create credit and money out of nothing, and why or whether other financial firms and intermediaries, or ordinary corporations not active in the financial sector, cannot do likewise. Is what enables banks to create money a feature unique to banks, or is Minsky’s (1986) claim more relevant that “everyone can issue money”? Being able to create money is a desirable ability, and if it was possible for other agents to do so, they would likely also engage in this activity. Are non-bank financial institutions, including so-called ‘shadow banks’, engaged in money creation? With financial deregulation and the development of hybrid financial instruments, the demarcation between banks and non-banks often is said to be elusive. Is it possible to pinpoint the difference?

Furthermore, there are a number of fundamental questions concerning banks that remain unanswered in the literature. “What are the defining characteristics of a bank?” ask Kashyap, Rajan, and Stein (2002). Specifically, it remains a conundrum to economists why banks combine what are effectively very different operations, namely deposit-taking and granting of loans, and why securities or capital markets cannot substitute these functions, despite in theory being capable of doing so separately:

“…commercial banks are institutions that engage in two distinct types of activities, one on each side of the balance sheet—deposit-taking and lending. …A great deal of theoretical and empirical analysis has been devoted to understanding the circumstances under which each of these two activities might require the services of an intermediary, as opposed to being implemented in arm’s-length securities markets. While much has been learned from this work, with few exceptions it has not addressed a fundamental question: why is it important that one institution carry out both functions under the same roof?” ( Kashyap et al., 2002, p. 33f).

They also argue that it is of utmost importance to answer this question:

“The question of whether or not there is a real synergy between deposit-taking and lending has far-reaching implications” (op. cit., p. 34).

They cite the question of monetary reform as one of the reasons why the question needs to be answered. Their own answer is based on the provision of loan commitments by banks — a particular institutional feature that does not apply to all banks and does not usually dominate bank lending. It is hence difficult to argue that the question they raise has been answered fully. This is especially true, since the authors are adherents of the financial intermediation theory of banking which claims, erroneously, that banks gather deposits and then lend these deposits out.

It is the purpose of this article to offer new answers to these questions, which are in line with the empirical record. Joseph Schumpeter (1917/18) argued that banking is primarily accounting, and that banks are the ‘bookkeeping centre’ of the economy and act as its ‘social accountants’ (1934, p. 124). Stiglitz and Weiss (1989) also consider banks as operating ‘society’s accounting system’. Werner, 2014a and Werner, 2014c shows that the three theories of banking are distinguished by their differing bank accounting and that the crucial difference of banks and firms without a banking licence revolves around the issue of lending. Werner (2005) had argued:

“Bank credit creation does not channel existing money to new uses. It newly creates money that did not exist beforehand and channels it to some use…. What makes this ‘creative accounting’ possible is the other function of banks as the settlement system of all non-cash transactions in the economy. … Since banks work as the accountants of record – while the rest of the economy assumes they are honest accountants – it is possible for the banks to increase the money in the accounts of some of us (those who receive a loan), by simply altering the figures. Nobody else will notice, because agents cannot distinguish between money that had actually been saved and deposited and money that has been created ‘out of nothing’ by the bank” (p. 179).

However, surprisingly little has been written about the actual accounting details of bank operations, especially concerning their lending, and how precisely it differs from the accounting of non-bank firms. It is thus corporate accounting that we must turn to in order to analyse the questions at hand in a comparative analysis of the treatment of lending by different types of corporate lenders.

2. Comparative accounting of lending

Although the implementation of banking services relies heavily on accounting, hardly any scholarly literature exists that explains in detail the accounting mechanics of bank credit creation and precisely how bank accounting differs from corporate accounting of non-bank firms. There is also virtually no scholarly literature on the question of which regulations precisely enable banks to create money. These issues are however of great interest, especially since the function of banks as the creators and allocators of the money supply is not explicitly stated in any law, statute, regulation, ordinance, directive or court judgement.

From the absence of explicit statutory powers to create money it can be deduced that this ability of banks is likely derived from the operational, that is, accounting conventions and regulations of banking. These either differ from those of non-banks, so that only banks are able to create money, or else non-banks have missed out on the significant opportunities money creation may afford.

In order to identify the difference in accounting treatment of the lending operation by banks, we adopt a comparative accounting analysis perspective. For this purpose, we compare the accounting of a loan extended by (a) a non-financial corporation (NFC, such as a manufacturer extending a financial loan to a supplier), (b) a non-bank financial institution (NBFI, such as a stock broker extending a margin loan to a client) and (c) a bank. Table 1 shows the changes in balance sheets of a new loan of $100 m, after its issuance and remittance.

Table 1.Comparative accounting: taking out a loan and disbursing it.

This table shows how accounting conventions handle the granting and disbursing of a loan by different types of firms: a non-financial corporation (NFC), a non-bank financial institution (NBFI, e.g. a stock broker), and a bank. In this and the following tables, only the change in balance sheet items is shown. As can be seen, something is different in the case of the bank.

When the non-financial corporation, such as a manufacturer, grants a loan to another firm, the loan contract is shown as an increase in assets: the firm now has an additional claim on debtors — this is the borrower’s promise to repay the loan. The lender purchases the loan contract, treated as a promissory note. Meanwhile, when the firm disburses the loan (and hence discharges its obligation to make the money available to the borrower), it is drawing down its cash reserves or monetary deposits with its banks. As a result, one gross asset increase is matched by an equally-sized gross asset decrease, leaving net total assets unchanged.

In the second case, of a non-bank financial institution, such as a stock broker engaging in margin lending, the loan contract is the claim on the borrower that is added as an asset to the balance sheet, while the disbursement of the loan – for instance by transferring it to the client or the stock exchange to settle the margin trade conducted by its client – reduces the firm’s monetary balances (likely held with a bank). As a result, total assets and total liabilities remain unchanged.

While the balance sheet total is not affected by the granting and disbursement of the loan in the case of firms other than banks, the picture looks very different in the case of a bank. While the loan contract shows up as an increase in assets with all types of corporations, in the case of a bank the disbursement of the loan takes a different form from that of the other firms: it appears as a positive entry on the liability side of the balance sheet, as opposed to being a negative entry on the asset side, as in the case of non-banks. As a result, it does not counter-balance the increased gross assets. Instead, both assets and liabilities expand. The bank’s balance sheet lengthens on both sides by the amount of the loan (see the empirical evidence in Werner, 2014a and Werner, 2014c). Thus it is clear that banks conduct their accounting operations differently from others, even differently from their near-relatives, the non-bank financial institutions.

What precisely, however, causes this very different treatment of lending on bank balance sheets as opposed to its treatment by all other types of firms? In order to answer this question, the comparison of the above accounting information is insufficient. It is necessary to gain further, more detailed insight into the accounting operations shown inTable 1. Specifically, what is it that enables banks to discharge their loan without drawing down any assets (as both the financial intermediation and fractional reserve theories of banking had indeed maintained, erroneously)?

In order to answer this question, the device is chosen to break down what currently is one set of double-entry operations, into smaller steps in order to be able to analyse them in greater detail. Specifically, the lending process is broken down into two steps, whose accounting representations are shown separately and in sequence. Assume, for instance, that the borrower asked out of convenience to proceed with signing the loan contract, but for the disbursement of the loan to be delayed by a week, while all other paper work and accounting are completed. In other words, the act of signing a loan contract and both borrower and lender contractually agreeing to their respective obligations is analytically and practically separated from the act of disbursing the loan and thereby the lender discharging the lender’s obligation to pay out the funds.

Step 1 shows the loan upon signing, committing both parties to their respective obligations (the bank to pay soon, the borrower to repay with interest much later). At this stage the loan funds are not yet made available by the lender. So the lender has an open liability, namely the disbursement of the loan to the borrower. In corporate accounting this is identified as a liability of the category ‘accounts payable’. (Step 2 will then describe the situation when the lender has in fact made the loan money available to the borrower and thus discharged the liability arising from its accounts payable item to the borrower.)Table 2 shows Step 1 of this disaggregated lending operation, by recording the changes in balance sheet items.

Table 2.Disaggregating lending: Step 1 — lender and borrower agree.

This table shows Step 1 of the loan operation, now disaggregated into two steps. All parties have signed the loan contract, but the borrower has asked, out of convenience, to delay the disbursement of the loan, which happens in Step 2. Interestingly, at Step 1 it is seen that the accounting treatment is the same for all lenders, including the bank. Banks are not different in any way concerning Step 1.

The same operation is shown for the non-financial corporation, the non-bank financial institution and for the bank (Table 2). In all cases, in Step 1 the loan contract creates an asset for the lender, as the money will be repaid in the future, and a liability in the form of the ‘accounts payable’, as the loaned money will have to be made available to the borrower at some stage. Therefore, for all types of firms, including banks, the balance sheet lengthens, as both an asset and a liability is added to the balance sheet. What emerges is, therefore that, surprisingly, in Step 1, the accounting is identical for all types of firms, including the bank. In other words, whatever makes banks different and special from non-banks is not visible in the act of agreeing to and implementing a loan contract without disbursing it. Moreover, we see what lengthens the balance sheet of firms – any firm, not just banks – namely agreeing to lend money, while not (yet) paying out the funds to the borrower.

That banks and non-banks are identical in their operations at this stage is an interesting finding. Upon reflection, it is not surprising, as it makes legal and regulatory sense: The act of granting a loan by one legal person to another is not a regulated activity. Business lending in the UK does not require authorisation of any supervisory or regulatory authority. Thus any firm can specialise in lending to other companies at interest, without requiring any authorisation from the financial regulators (Financial Conduct Authority or Prudential Regulatory Authority) or a banking licence in general. Hence it would indeed be surprising to see accounting differences in the operations conducted so far.

It is thus time to proceed to Step 2, the disbursement of the money from the lender to the borrower. We now already know that whatever it is that enables banks to create money out of nothing, it must take place in the act of making loan funds available to the borrower.

Considering the comparative accounting in Step 2, we observe that for the firm (NFC) and the broker (NBFI) to make the funds available to the borrower, so that the borrower can use them for transactions, involves drawing down the lender’s monetary funds (cash at hand, or the lender’s deposit balances held with a bank): firms need to give something up, when they pay out the loan (Table 3). Hence, as the money is made available, the cash or deposit balance (an asset) is drawn down and simultaneously the accounts payable item disappears from the firm’s liabilities: the firm has paid its account payable and thus discharged its obligation. For firms without a bank licence, the disbursement of the loan is from funds elsewhere within the firm. Thus there is an equal reduction in balance of another account from which the lent funds came from. Therefore, the balance sheet shrinks again. There is no overall change in the total size of the balance sheet as a result of Steps 1 and 2 together.

Table 3.Disaggregating lending: Step 2 — loan funds paid out.

This table shows Step 2 of the loan operation, disaggregated into two steps. All lenders now disburse the loan and thus discharge their liability. For firms without a banking licence, the balance sheet contracts and thus reverts back to the original position. For banks only the balance sheet remains unchanged in its expanded position — banks remain stuck in Step 1. In other words: banks do not discharge their liability.

However, as can be seen in Table 3, the story is quite different for the bank. Surprisingly, we find that unlike the other firms whose balance sheets shrank back in Step 2, the bank’s accounts seem in standstill, unchanged from Step 1. The total balance sheet remains lengthened. No balance is drawn down to make a payment to the borrower.

So how is it that the borrower feels that the bank’s obligation to make funds available are being met? (If indeed they are being met). This is done through the one, small but crucial accounting change that does take place on the liability side of the bank balance sheet in Step 2: the bank reduces its ‘account payable’ item by the loan amount, acting as if the money had been disbursed to the customer, and at the same time it presents the customer with a statement that identifies this same obligation of the bank to the borrower, but now simply re-classified as a ‘customer deposit’ of the borrower with the bank.

The bank, having ‘disbursed’ the loan, remains in a position where it still owes the money. In other words, the bank does not actually make any money available to the borrower: No transfer of funds from anywhere to the customer or indeed the customer’s account takes place. There is no equal reduction in the balance of another account to defray the borrower. Instead, the bank simply re-classified its liabilities, changing the ‘accounts payable’ obligation arising from the bank loan contract to another liability category called ‘customer deposits’.

While the borrower is given the impression that the bank had transferred money from its capital, reserves or other accounts to the borrower’s account (as indeed major theories of banking, the financial intermediation and fractional reserve theories, erroneously claim), in reality this is not the case. Neither the bank nor the customer deposited any money, nor were any funds from anywhere outside the bank utilised to make the deposit in the borrower’s account. Indeed, there was no depositing of any funds.

In Step 1 the bank had a liability — an obligation to pay someone. How can it discharge this liability? A law dictionary states:

“The most common way to be discharged from liability … is through payment.” 1

And yet, no payment takes place in Step 2 (and hence in the entire ‘lending’ process), which is why the bank’s balance sheet in total remains stuck in Step 1, when all lenders still owe the money to their respective borrowers. The bank’s liability is simply re-named a ‘bank deposit’. However, bank deposits are defined by central banks as being part of the official money supply (as measured in such official ‘money supply’ aggregates as M1, M2, M3 or M4). This confirms that banks create money when they grant a loan: they invent a fictitious customer deposit, which the central bank and all users of our monetary system, consider to be ‘money’, indistinguishable from ‘real’ deposits not newly invented by the banks. Thus banks do not just grant credit, they create credit, and simultaneously they create money.

While other non-bank firms can also grant credit, in their case it would be misleading to speak of ‘credit creation’, since their granting of a loan results in a gross increase in credit (and temporary lengthening of their balance sheet; Step 1), but the discharging of their accounts payable liability arising from the loan contract results in an equal reduction in another credit balance, resulting in a reduction of the overall balance sheet and thus no change in total net credit or money in the economy (Step 2). There is no money creation in the case of firms that are not banks.

The bank, on the other hand, creates gross credit, just like non-banks, but this is not counter-balanced by an equal reduction in credit balances elsewhere, leaving a net positive addition to credit and deposit — hence money — balances: net credit creation. This credit creation is visible in the permanent expansion in the bank’s balance sheet, and is executed through the operation that makes banks unique, namely that instead of discharging their liability to pay out loans, the banks merely reclassify their liabilities originating from loan contracts from what should be an ‘accounts payable’ item to ‘customer deposit’ (in practise of course skipping Step 1 entirely and thus neglecting to record the accounts payable item). The bank issues a statement of its liability to the borrower, which records its liability as a ‘deposit’ of the borrower at the bank.

We have gained important insights, which raise new questions: Why are non-banks not able to do the same, and what precisely is it that allows banks to act differently in Step 2? Could non-banks also create credit in this way? A necessary condition for being able to create an imaginary deposit in the name of the borrower is that the lender ordinarily maintains customer deposits and thus is solely in charge of the record-keeping of customers’ deposits. In this case, this controlling power over customers’ deposit account records can be used to invent make-belief customer deposits that did not in fact originate from any new deposits (and hence cannot honestly be called ‘deposits’).

Maintaining customer deposits is not part of the regular business operations of non-financial institutions, so we cannot expect them to be able to engage in credit and money creation. However, there are a number of non-bank financial institutions that in the course of ordinary business do maintain deposit accounts for their customers — for instance, stock broking firms. Why, then, are stock brokers which receive client funds and deposits, not able to create credit and money out of nothing, just like banks?

3. Regulation: the little-known ‘client money rules’

It is necessary to move beyond corporate accounting rules to the wider field of regulations of business conduct. Tobin (1963) argued about banks that

“Any other financial industry subject to the same kind of regulations would behave in much the same way” (p. 418).

This is likely true, but the question remains precisely which regulations are crucial to allow banks to engage in the activity that makes them unique, and likewise, whichregulations, if applying equally to non-banks, would allow non-banks to behave in the same way as banks. As noted, lending to other firms is unregulated. It is necessary to examine the regulations of the business of taking customer deposits. An examination of the regulations concerning this reveals that, unlike the lending business, it is a highly restricted type of activity. Regulations differ starkly between banks and non-banks.

In the UK, the cradle of modern banking, financial regulations, specifically, the so-called ‘Client Money Rules’ (FCA, 2013), require all firms that hold client money to segregate such money in accounts that keep them separate from the assets or liabilities of the firm itself:

“Depositing Client Money

7.4.1. R

A firm, on receiving any client money, must promptly place this money into one or more accounts opened with any of the following:

(1)a central bank;
(2)a CRD credit institution 2;
(3)a bank authorised in a third country;
(4)a qualifying money market fund” FCA (2013).

For firms that do not have a banking authorisation, client deposits must be held in segregated accounts with banks or money market funds. This means the client assets remain off-balance sheet for the firm, including non-bank financial intermediaries, and the depositor remains the legal owner. This is why the extension of a bank loan by a stock broker cannot result in any addition to the balance sheet: the stock broker will owe the borrower the money (an increase in accounts payable), but since any account of the borrower is not held directly with the stock broker, it is not possible for the stock broker (or other non-bank entities) to mix the clients’ deposit accounts with the other liabilities that the broker has towards the clients (such as an accounts payable item arising from loan contracts). So it would be impossible for the stock broker to engage in the re-classification exercise of referring to accounts payable items as (imaginary) customer deposits.

However, things are different, if one has a banking licence:


1.4.6 R The client money chapter does not apply to a depositary when acting as such” …

“Chapter 7 Client Money Rules

Credit Institutions and Approved Banks

7.1.8 R The client money rules do not apply to a CRD credit institution in relation to deposits within the meaning of the CRD held by that institution. …

7.1.9. G If a credit institution that holds money as a deposit with itself is subject to the requirement to disclose information before providing services, it should, in compliance with that obligation, notify the client that:(1) money held for that client in an account with the credit institution will be held by the firm as banker and not as trustee (or in Scotland as agent);and (2) as a result, the money will not be held in accordance with the client money rules” ( FCA, 2013).

It follows then that what enables banks to create credit and hence money is their exemption from the Client Money Rules. Thanks to this exemption they are allowed to keep customer deposits on their own balance sheet. This means that depositors who deposit their money with a bank are no longer the legal owners of this money. Instead, they are just one of the general creditors of the bank whom it owes money to. It also means that the bank is able to access the records of the customer deposits held with it and invent a new ‘customer deposit’ that had not actually been paid in, but instead is a re-classified accounts payable liability of the bank arising from a loan contract.

Whether the Client Money Rules were designed for this purpose, and whether it is indeed lawful for banks to reclassify general ‘accounts payable’ items as specific liabilities defined as ‘customer deposits’, without the act of depositing having been undertaken by anyone, is a matter that requires further legal scrutiny, beyond the scope of this paper.

We conclude that by disaggregating bank lending into two steps we have identified precisely how banks create credit, and we have solved a long-standing conundrum in the literature, namely why banks combine what at first appear to be two very different businesses: lending on the one hand, and deposit-taking on the other. The answer is that banks are not financial intermediaries, but creators of the money supply, whereby the act of creating money is contingent on banks maintaining customer deposit accounts, because the money is invented in the form of fictitious customer deposits that are actually re-classified ‘accounts payable’ liabilities emanating from loan contracts. Banks could not do this if they did not combine lending and deposit taking activities. But, as we saw, combining these activities is a necessary yet insufficient condition for being able to create credit and money. The necessary and sufficient condition for being able to create credit and money is being exempt from the Client Money Rules.

Kashyap et al. (2002) argued that what makes banks unique and the reason why they engage in the two tasks of lending and deposit-taking simultaneously was the granting of loan commitments and the resulting need for liquidity provision. However, loan commitments are a subset of lending activity, and we have found that what makes banks unique and requires them to combine lending with deposit-taking does not derive from the lending function per se — since business lending is not even regulated, so that anyone can engage in it without a licence, and, as we saw, the impact of signing a loan contract is common to all firms (Step 1 in the disaggregated accounting of lending).

What makes banks unique and explains the combination of lending and deposit-taking under one roof is the more fundamental fact that they do not have to segregate client accounts, and thus are able to engage in an exercise of ‘re-labelling’ and mixing different liabilities, specifically by re-assigning their accounts payable liabilities incurred when entering into loan agreements, to another category of liability called ‘customer deposits’.

What distinguishes banks from non-banks is their ability to create credit and money through lending, which is accomplished by booking what actually are accounts payable liabilities as imaginary customer deposits, and this is in turn made possible by a particular regulation that renders banks unique: their exemption from the Client Money Rules.

4. Some implications

The argument that it is bank regulation that makes banks special has been used to justify deregulation of interest rates and reserve requirements. The logic was that it was the regulation of interest rates and reserve requirements that made banks different and hindered a level playing field. However, this argument has not focused on what really makes banks different from other firms. It is in the business of taking deposits that the regulations make a crucial difference for banks and non-banks. It would appear that those who argue that bank regulations should be liberalised in order to create a level playing field with non-banks have neglected to demand that the banks’ unique exemption from the Client Money Rules – a regulation benefitting only banks – needs to be deregulated as well, so that banks must also conform to the Client Money Rules. Indeed, it would appear that monetary reformers (see, for instance, Benes and Kumhof, 2012) could very simply achieve their goal of revoking the banks’ ability to create money through credit creation, by simply scrapping banks’ exemption from the Client Money Rules. In the case of UK regulation, deleting CASS 7, 1.4.6 and 7.1.8. should be sufficient.3 A reasonable justification for cancelling the banks’ exemption would be the fact that (a) no reasonable grounds for their exemption have been made, and (b) banks have routinely abused this exemption in order to misrepresent other liabilities as ‘customer deposits’. While the latter would not have been possible if the Client Money Rules had applied to banks, it is not obvious that the Client Money Rules were designed for this purpose.

Alternatively, one could argue that it would level the playing field, if the banks’ current exemption from the Client Money Rules was also granted to all other firms — in other words, if the Client Money Rules themselves were abolished. This would allow all firms to also engage in the kind of creative accounting that has become an established practise among banks. It would certainly ensure that competition between banks and non-bank financial institutions would become more meaningful, since the exemption from the Client Money Rules, together with the banks’ deployment of this exemption for the purpose of re-labelling their liabilities, has given significant competitive advantages to banks over all other types of firms: banks have been able to create and allocate money – virtually the entire money supply in the economy – while no other firm is able to do the same. However, apart from the new risks for the public arising from such deregulation, even in this case banks would maintain their advantage and their monopoly on money creation, if the state maintained the rule that taxes need to be paid in privately created bank money only: Today, tax payments cannot be made in legal tender (Bank of England notes), but only in bank credit money, which is private company credit, created by banks’ re-classification of their accounts payable liabilities as imaginary customer deposits. By forcing all tax payers to acquire bank money in this way, the state effectively transfers sovereignty over money creation to the banks. The importance of the denomination of taxes has long been recognised. Adam Smith commented on it as follows:

A prince, who should enact that a certain proportion of his taxes should be paid in a paper money of a certain kind, might thereby give a certain value to this paper money” ( 1776, p. 328).

The findings are important also for other types of reforms, including the reform of bank regulation. So far, bank regulation has emphasised capital adequacy requirements in order to manage bank activity. This has failed spectacularly, as Basel I could not prevent, and likely contributed to the propagation of the Japanese and Asian crises in the 1990s, and Basel II is similarly implicated in the 2008 financial crisis. As Werner, 2005, Werner, 2010, Werner, 2014a and Werner, 2014c argues, Basel rules were doomed to failure, since they consider banks as financial intermediaries, when in actual fact they are the creators of the money supply. Since banks invent money as fictitious deposits, it can be readily shown that capital adequacy based bank regulation does not have to restrict bank activity: banks can create money and hence can arrange for money to be made available to purchase newly issued shares that increase their bank capital. In other words, banks could simply invent the money that is then used to increase their capital. This is what Barclays Bank did in 2008, in order to avoid the use of tax money to shore up the bank’s capital: Barclays ‘raised’ £5.8 bn in new equity from Gulf sovereign wealth investors — by, it has transpired, lending them the money! As is explained in Werner (2014a), Barclays implemented a standard loan operation, thus inventing the £5.8 bn deposit ‘lent’ to the investor. This deposit was then used to ‘purchase’ the newly issued Barclays shares. Thus in this case the bank liability originating from the bank loan to the Gulf investor transmuted from (1) an accounts payable liability to (2) a customer deposit liability, to finally end up as (3) equity — another category on the liability side of the bank’s balance sheet. Effectively, Barclays invented its own capital. This certainly was cheaper for the UK tax payer than using tax money. As publicly listed companies in general are not allowed to lend money to firms for the purpose of buying their stocks, it was not in conformity with the Companies Act 2006 (Section 678, Prohibition of assistance for acquisition of shares in public company). But regulators were willing to overlook this. AsWerner (2014b) argues, using central bank or bank credit creation is in principle the most cost-effective way to clean up the banking system and ensure that bank credit growth recovers quickly. The Barclays case is however evidence that stricter capital requirements do not necessary prevent banks from expanding credit and money creation, since their creation of deposits generates more purchasing power with which increased bank capital can also be funded. To manage bank credit creation more effectively, the differing consequences of different types of lending need to be recognised (bank credit creation for financial transactions affects asset prices and is in aggregate unsustainable, bank credit for consumption affects consumer prices, and bank credit for productive investment purposes is sustainable and non-inflationary, as the Quantity Theory of Credit, Werner, 1997, maintains). Given the reality of market imperfections and rationing, more direct interventions in the credit market, in the form of ‘guidance’ of bank credit (for instance by curtailing costly and dangerous financial credit creation) need to be re-considered (Werner, 2005). They have a good track record for preventing credit and hence asset boom-bust cycle. Alternatively, the structure of the banking system needs to be designed such that it is dominated by banks that mainly lend for productive investments in the ordinary course of their business, such as local banks lending to SMEs (Werner, 2013).

5. Conclusion

In this paper a number of fundamental questions concerning banks have been answered. This includes the old questions of why banks combine what are effectively very different operations, namely deposit-taking and granting of loans under one roof, what are the “defining characteristics of a bank”, and “why securities markets and non-bank firms cannot do the same” (Kashyap et al., 2002). It also includes new questions predicated on the recognition that banks create credit and money, namely what exactly it is that enables banks to create credit and money out of nothing, and whether or why other financial firms and intermediaries, or ordinary corporations cannot do the same. This includes the question of whether non-bank financial institutions, including so-called ‘shadow banks’, can engage in money creation as well, the question whether “everyone can issue money” (Minsky, 1986), and the questions of how bank regulation should and how monetary reform could be structured.

To answer these questions, the accounting details of banks’ credit and money creation were examined in a comparison of corporate accounting for lending. Breaking the act of lending into two steps, it was possible to isolate just what makes bank accounting different from the accounting of non-financial firms and non-bank financial institutions, and precisely how banks manage to create money newly. The act of signing the loan contract and purchasing it as a promissory note of the borrower without yet making the borrowed funds available to the borrower (Step 1) has the same accounting implications for banks, non-banks and non-financial corporations alike. In all cases, the balance sheets lengthen, as an asset (the loan contract) is acquired and a liability to make money available to the borrower is incurred (accounts payable). In Step 2, the lender makes the funds available to the borrower. The fact that in Step 2 the bank is alone among firms in showing the same total impact on assets and liabilities as everyone else at Step 1, when the money had not yet been made available to the borrower, demonstrates that the bank did not actually make any money available to the borrower. This means that the bank still has an open ‘accounts payable’ liability, as it has not in fact discharged its original liability. What banks do is to simply reclassify their accounts payable items arising from the act of lending as ‘customer deposits’, and the general public, when receiving payment in the form of a transfer of bank deposits, believes that a form of money had been paid into the bank. As a result, the public readily accepts such ‘bank deposits’ and their ‘transfers’ to defray payments. They are also the main component of the official ‘money supply’ as announced by central banks (M1, M2, M3, M4), which is created almost entirely through this act of re-classifying banks’ accounts payable as fictitious ‘customer deposits’. No wonder an expert in bank accounting has warned me, upon presentation of my analysis, that I must never use the concept of ‘accounts payable’ in the context of bank accounting! In my view, the only reason why one would not wish to use it as presented in this paper is because through this device the truth is revealed for all to see.

The ‘lending’ bank records a new ‘customer deposit’ and informs the ‘borrower’ that funds have been ‘deposited’ in the borrower’s account. Since neither the borrower nor the bank actually made a deposit at the bank — nor, in connection with this transaction, anyone else for that matter, it remains necessary to analyse the legal aspects of bank operations. In particular, the legality of the act of reclassifying bank liabilities (accounts payable) as fictitious customer deposits requires further, separate analysis. This is all the more so, since no law, statute or bank regulation actually grants banks the right (usually considered a sovereign prerogative) to create and allocate the money supply. Further, the regulation that allows only banks to conduct such creative accounting (namely the exemption from the Client Money Rules) is potentially being abused through the act of ‘renaming’ the bank’s own accounts payable liabilities as ‘customer deposits’ when no deposits had been made, since this is also not explicitly referred to in the banks’ exemption from the Client Money Rules, or in any other statutes, laws or regulations, for that matter.

This raises the broader problem that much of the terminology in banking appears to mislead the public. An innocent bank customer could be forgiven for believing that money ‘deposited’ with a bank was still the property of the depositor and hence safe in the case of a bankruptcy of the institution, while money deposited with a stock broker with the intention to speculate in the markets was at risk of being lost should the stock broker go bust. That the legal reality is precisely the opposite – money deposited with stock brokers is unencumbered by the broker’s bankruptcy since it remains the property of the depositor, held in safe custody as segregated Client Money, while money deposited with a bank, exempt from the Client Money Rules, is no longer the property of the depositor and thus in principle goes under together with the bank – is testament to the misleading character of banking terminology.

In this paper it was found that banks combine what are effectively very different operations, namely deposit-taking and granting of loans under one roof, because in this way they can invent new money in the form of fictitious ‘customer deposits’ when purporting to engage in the act of ‘lending’. It was found that the defining characteristic of banks is that they are exempt from the Client Money Rules, which prevent other firms from creating money in the same way. It was found that, in practise, only banks can issue money in this way. It was also found that bank regulation needs to be reconsidered, as focusing on capital adequacy, already proven ineffective by the many banking crises since its introduction in the 1980s, is likely to remain unable to prevent credit booms and subsequent banking crises. Finally, a simple way was found to implement monetary reform, should the sovereign – the people – decide to introduce a more transparent way of creating and allocating the money supply: one only needs to revoke the one-sided exemption from the Client Money Rules granted to banks (and combine this with Client Money custody services offered to all banks by HM Treasury). Having said this, since the privilege to create mney is a public prerogative, it can be justified if it is used for the benefit of the public. How can this be achieved? I have come to be convinced that probably the best method to implement monetary reform realistically – since possible without waiting for grand top-down reforms and since in this way breaking power up into small, manageable units – is to establish many small, local, not-for-profit community banks, as the success of the German economy has demonstrated over the past 170 years.

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  1. Macro Enthusiast

    Interesting, and unsurprising that central banks don’t tell us about how the government sector creates money. Endogenous money for banks is fine, but government spending on overdraft with central banks is not apparently.

    Also interesting to see that the blogs don’t talk much about shadow banking, and its connection with MMT. The gurus of shadow banking, reckon that shadow banks can do the loans create deposits thing, even though they don’t technically have reserve accounts with the central bank. I suspect they mean one of two things:

    1. Shadow banks create shadow money, backed up by reverse repos, but not necessarily publicly usable money.

    2. Shadow banks can create publicly usable money, but only because somewhere in the transaction chain, they are interacting with an actual bank.

    Another issue is accounting for currency-pegged economies. In China, the central bank targets the quantity of money, and not the price. So reserves actually are a “funding” constraint on lending.

    • MMT was around before the wheels were coming off… so the agency which perverted it is not inherent.

      Skippy… the human tool user problem is not going to go away by trying to imbue objects with morals or ethics…. only humans have that capacity… so next question…. eh.

      • MMT describes quite well the operations of a monetary system with private bank Public Money money creation at its core.

        Once you start to question whether private bank creation of Public Money is a good idea MMT has less to offer.

        So if you do believe that government and the public service can run health, education, job guarantees, defence, justice infrastructure etc BUT do not believe it could be trusted to manage Public Money better than a bunch of bankers who are incentivised to create (write loans) as much money as possible (boom) and periodically run assets collection and concentration programs (busts) then MMT is probably the best approach on offer.

        It really boils down to whether you think power over Public Money creation works well in the hands of the FIRE sector – with RBA and APRA keeping it in line.

      • MMT pre dates the FIRE sector and the advent of “free market” ideological dominance, so your inferences are not based on facts.

        Do you really think that making government just one big bank magically makes all the problems with our currant dramas go away or does it just make government behave just like the them [see psychology].

        Hate to say it 007 but your myopic focus on banks is obviously quite biased and not indicative of the broader historical account, which imo is not a very sound footing for granular analysis. All human societies function on some sort of foundation mythos, it is at this wellspring that all other events stem from, so the next question is, whom is concocting the narrative and what is the agenda.

        Skippy…. I like the way Toynbee splains* it here wrt to the employment of the creative class…

        PS. You can have the best of both worlds – public and private, you just have to keep the private from taking over the public and from blowing itself up endlessly…

      • Skippy

        “…Do you really think that making government just one big bank..”

        As per usual your imagination runs away with you. Nothing I have said suggests or implies anything less than a primary role for private banks as financial intermediaries.

        The problem is that you don’t really understand the difference between the three theories Werner discusses in the paper. Which is why you don’t understand the difference between lending by non-financial institutions (shadow banking) and lending by banks.

      • Lets take another purview…

        “Quantitative easing has been a controversial policy even among the financiers who benefitted from it. The Fed has brushed those critics off, its confidence based on the fact that the economy didn’t go into a Great Depression-style black hole, which Fed officials believe was the result of its ministrations. One suspects the central bank regards its critics as an uninformed lot: goldbugs and hyperinflationists, right-wingers who don’t like government intervention in markets, pinkos who don’t like banks.

        But there’s a world of difference between saying that the alphabet soup of special programs, which did shore up all sorts of players who didn’t have direct access to the Fed’s coffers, benefitted, and to say that QE, which didn’t begin until March 2009, was a plus to the economy. (And the cheery view of the Fed’s “success” during the crisis brushes by the fact that the Fed was fixated on rescuing only the financial system, and never even considered ways to do that, like restructuring debts, that would also have helped households and real economy businesses).

        In addition, QE and its fellow traveller, ZIRP, has imposed a huge tax on retirees and savers, who can’t find high yielding, safe assets. The central bank believe they’d of course do the rational thing of either spending more of their principal or going into riskier assets (Gazprom, anyone? It has a nice 5.3% yield, although you would have done even better buying it six weeks ago). Instead, most are hunkering down and trying to make do on lower income.

        In in a CNBC opinion piecePaul Gambles, the managing partner of MBMG Group, provided an elegant kneecapping of QE based on central bank research. Many of the arguments will be familiar to NC readers.

        Gambles starts out by stressing that central banks are working from the wrong model of how lending works and the role it plays in economic expansion. He doesn’t use the term “loanable fund model” but he points out that banks don’t lend out of savings, that banks create credit based on demand for loans. The shorthand is “loans create deposits”. And what is devastating is that the Bank of England has gone on record calling out the “earth is flat” orthodoxy. Here’s Gambles’ layperson-friendly summary:

        The findings in question are contained in the BoE’s Quarterly Bulletin. The paper’s introduction states that a “common misconception is that the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money — the so-called ‘money multiplier’ approach.”

        This “misconception” is obviously shared by the world’s policymakers, including the U.S. Federal Reserve, the Bank of Japan and the People’s Bank of China, not to mention the Bank of England itself, who have persisted with a policy of quantitative easing (QE).

        QE is seen by its adherents, such as former U.S. Federal Reserve Chairman Ben Bernanke, as both the panacea to heal the post-global financial crisis world and also the factor whose absence was the main cause of the Great Depression. This is in line with their view that central banks create currency for commercial banks to then lend on to borrowers and that this stimulates both asset values and also consumption, which then underpin and fuel the various stages of the expected recovery, encouraging banks to create even more money by lending to both businesses and individuals as a virtuous cycle of expansion unfolds.

        The theory sounds great.

        However it has one tiny flaw. It’s nonsense….

        The credit which underpins economic activity isn’t created by a supply of large deposits which then enables banks to lend; instead it is the demand for credit by borrowers that creates loans from banks which are then paid to recipients who then deposit them into banks. Loans create deposits, not the other way round.

        Gambles points out that the Bank of England tries to salvage its reputation by claiming that QE nevertheless did some good by lowering interest rates which might have generated some additional (stimulative) borrowing. Gambles will have none of that:

        …. the elasticity or price sensitivity of demand for credit has long been understood to vary at different points in the economic cycle or, as Minsky recognized, people and businesses are not inclined to borrow money during a downturn purely because it is made cheaper to do so. Consumers also need a feeling of job security and confidence in the economy before taking on additional borrowing commitments…

        Ben Bernanke positioned himself as a student of history who had learned from the mistakes of the past. Dr. [Andrea] Terzi [Professor of Economics at Franklin University Switzerland] questions this, “This view that interest rates trigger an effective ‘transmission mechanism’ is one of the Great Faults in monetary management committed during the Great Recession.”

        “The reality is that the level of interest rates affects the economy mildly and in an ambiguous way. To state that monetary policy is powerful is an unsubstantiated claim.”

        This echoes a echoes a longstanding NC theme, that putting money on sale won’t induce businesses to borrow…unless the cost of money is a major factor in the cost of goods or services. What might those businesses be? Financial services companies, natch.

        But here’s the part that is the real killer:

        It may even be that QE has actually had a negative effect on employment, recovery and economic activity.

        This is because the only notable effect QE is having is to raise asset prices. If the so-called wealth effect — of higher stock indices and property markets combined with lower interest rates — has failed to generate a sustained rebound in demand for private borrowing, then the higher asset values can start to depress economic activity. Just think of a property market where unclear job or income prospects make consumers nervous about borrowing but house prices keep going up. The higher prices may act as either a deterrent or a bar to market entry, such as when first time buyers are unable to afford to step onto the property ladder.

        This is the exact opposite of the Fed’s beliefs, that the wealth effect encourages people to spend more. But what we saw in the cycle just past was that the spending consisted to a significant degree of tapping into accumulated paper wealth through borrowing. This wasn’t spending more out of discretionary income out of confidence; this was to a significant degree monetizing housing assets. And the value of those assets proved to be a hell of a lot more volatile than the Fed dreamed.

        In the post-crisis era, with wealth even more concentrated, we’ve seen bifurcation: the wealthy indeed are spending again, as to some degree are upper income households. But they don’t have as high a propensity to spend as lower income earners. So an asset-price-driven recovery is almost bound to be flaccid. And that’s before you get to the huge negative that Gambles flags, that the Fed’s success in goosing asset prices, particularly housing, is actually undermining housing serving as a driver for a broader recovery (as it has in every past post World War II recovery).”

        Skippy…. so the guy that forwarded QE [not a Keynesian anything] and sees everything through optics which implicate banks as being the cornerstone to – all – our problems – is – some how a go to source on fixing anything…. seriously?

      • Skippy,

        Nice long article that is irrelevant. You should read what you link before posting it as a response. Unless it was your intention to derail the thread.

      • 007….

        If you don’t have the acumen to actually disseminate your pro or cons wrt the article please desist with the pettifoggery.

        “Nice long article that is irrelevant.” – sayeth the lord 007

        “You should read what you link before posting it as a response.” – demands which are not supported by an evidenced based argument.

        “Unless it was your intention to derail the thread.” – rhetorical device which assumes intent yet never elaborates on how one arrives at it, compounded by projections of intent, and more than not a whinge about not staying within the preferred narrative as framed by you.

        I screw around a lot 007, but don’t take that as an indicator of my experience or knowlage base.

        Skippy…. again what issues do you have with the above article and how does that square with your opinions – assertions…

  2. Great article – although I’m not too sure I agree with its conclusion. Nevertheless, there are few pieces that properly explain how deposits/lending are linked.

  3. The problem with economists trying to inform public about money creation is that they have complete lack of understanding of ordinary people. They live in a world of academia or “high finance” industry and are completely disconnected from real world – something like high priests in Rome during early Christian period …

    When I usually unwillingly get into that discussion I use the following story while trying to explain it to someone:
    You have $10000 and you just went to newly opened bank and deposit the money into a saving account (in which I have just opened debit account) and I have $0 on that account (or otherwise). How much money two of us have to spend?
    -it’s easy and everyone says $10k

    Now I need to buy something (let’s say new clothes for my kids). So later that day I go to bank to get a cash credit and after approval the bank (as all the banks do) takes part ($2000) of your savings and deposits it onto my account.
    – At this point none ever had any objections on the story because they start with the premises that credit comes from savings and they are usually not aware how I can use this to prove my point.

    Than I ask only one question:
    How much money two us have in the bank to spend now?
    it ends with:
    But ….. followed by awkward and enjoyable silence … and question where $2000 came from?
    I usually say “from the future”

    • And do you ever ask the next question?
      “And now you spend your $10k. What does the bank do, now that it’s $2k short?”
      That might explain – what’s coming!

      (“Borrow more money!” is likely to be the general answer, to which the response is “But what if there isn’t any?”)

    • How is fractional reserve lending from the future?? I think that’s how you’re confusing people. Draw it on a set of T accounts and you will get a better response.

      • Because what happens when he repays the $2,000 that he borrowed? The money that was ‘created’ is now destroyed.

        All debt is ‘from the future’. It’s an intertemporal reallocation of resources, assuming you pay it back.

      • If currency/money was backed by real assets, it would potentially work – post Bretton woods and decoupling from gold, essentially we are just printing out, inflating incomes – and consuming more fossil carbon than at any other time in history – these energy stores don’t belong to one or two generations who seem to argue that technology will provide energy to future gens – what is happening is that the fiat system is stealing these non-renewable stores from future generation – if the amounts had to be backed by something real, incomes would stay lower and people would not be able to consume so much and waste so much, as well as kill the nest we live in.

    • I have another analogy, good Doctor, from the ordinary people.
      We actually don’t care to understand how banks “reproduce”. Rather, we want peace of mind that, should we have a “relationship” with one:
      (a) We won’t be afflicted by a life-threatening disease (i.e. properly regulated for clean health)
      (b) No whips or handcuffs (i.e. transparent and reasonable behaviours and protections)
      (c) Their balls are personally in a vice should their boudoir crumble (i.e. full director responsibility)

      • b and c around about as likely as me finally getting my head around how money is created. That said, I’ll read that article, maybe i’ll finally get it..

      • Yes, with an effective ‘ Glass–Steagall’ like Act in place. No Joes really need to care about how money is created. Damn corruption of leadership forcing us all to learn this crap! Try these guys. Important objective, unlikely to achieve their educational aim I reckon:

    • Which is all well and good so long as the purchase leads to some kind of productivity that grows the wider economy enough to eventually cover the expanded money supply when the payments fall due right? This is why economists ignore debt in their models right? Because who in their right mind would make a bunch of loans that they think are likely to never be paid back?! LOL

  4. I like the idea about small not for profit banks.
    What the author fails to point out though is that the application of interest to the supply of new money is entirely unnecessary. When interest is applied to the creation of money it means that the real economy must grow exponentially to keep up, which it can’t, and hence we have economic crises.

    • Its simple… if the economy starts to overheat [upper bound inflation] you just tax it away….

      That is the key to how the whole schemozzle got started, antiquarian ideological wankery supported by ex nihilo axioms proclaiming that tax was theft and only Markets could, without agency, distribute goods and services to their ultimate utility.

      Skippy… seems the breathers put the cart before the horse e.g. the market before humanity i.e. we serve it and not it us… well I guess its back to the majority scrabbling around the priest class gain silo to make a living…

  5. Here is a doco based on a book by the author of that article.

    It is not an accident that even most of the participants of the FIRE industry seem confused about how the process works. On the bright side that paper by the Bank of England and the new book by Lord Adair Turner (former head of the UK’s APRA) are making it harder for the issue to be ignored.

    ““Princes of the Yen: Central Banks and the Transformation of the Economy” reveals how Japanese society was transformed to suit the agenda and desire of powerful interest groups, and how citizens were kept entirely in the dark about this.

    Based on a book by Professor Richard Werner, a visiting researcher at the Bank of Japan during the 90s crash, during which the stock market dropped by 80% and house prices by up to 84%. The film uncovers the real cause of this extraordinary period in recent Japanese history.

    Making extensive use of archival footage and TV appearances of Richard Werner from the time, the viewer is guided to a new understanding of what makes the world tick. And discovers that what happened in Japan almost 25 years ago is again repeating itself in Europe. To understand how, why and by whom, watch this film.

    “Princes of the Yen” is an unprecedented challenge to today’s dominant ideological belief system, and the control levers that underpin it. Piece by piece, reality is deconstructed to reveal the world as it is, not as those in power would like us to believe that it is.

    “Because only power that is hidden is power that endures.”

    A film by Michael Oswald”

    • One has to take into consideration the geopolitical aspects of stuff like the Plaza Accord and the larger – long term ramifications like the the unleashing of the shadow sector to compete with traditional retail and commercial banking. Under the auspices that it was good “competition (UFC sort)” – more efficient allocation of capital. I did link to that IMF paper a wee bit back imo.

      Which in hindsight was the impetus for the traditional banking sector to seek yield and market share in C/RE – MBS via increasing leverage and computational multipliers after traditional markets were over taken by unregulated activity, only to have the two actually met in the twain down the road, and presto, less than a decade and orgasmic implosion. Yet all at the helm claim no intent was involved, stuff happens, boom – bust…. its only natural(tm).

      But hay lets not forget that the cold war was going on and only by unleashing the full narcissistic potential [greed is good] of a small percentage of the entire population could the ev’bal empire be defeated. Seems like that meme got out of hand and overshot the objective and is currently eviscerating its own because it knows nothing else, all the economic metrics demand it, who can argue with that.

      Skippy…. Just to say it again… Central Banks did not, where not, ground zero to the machinations… it started else where and infected the entire system architecture, seek it mate and stop with the convenient or bias conformation seeking easy – simple scapegoats.

      PS. I would remind that Japan has been a protectorate of you know who since the end of WWII.

      • If your memory serves I linked to him on a post Keynesian site not that long ago, so I am up to speed on him. FYI your attribution to him is curious due to proposed the term quantitative easing being of his authorship.

        “Werner proposed a policy he called “quantitative easing” in Japan in 1994 and 1995. At the time working as chief economist of Jardine Fleming Securities (Asia) Ltd. in Tokyo, he used this expression during presentations to institutional investors in Tokyo. It is also, among others, in the title of an article he published on September 2, 1995, in the Nihon Keizai Shinbun (Nikkei).[6] According to Werner, he used this phrase in order to propose a new form of monetary stimulation policy by the central bank that relied neither on interest rate reductions (which Werner claimed in his Nikkei article would be ineffective) nor on the conventional monetarist policy prescription of expanding the money supply (e.g. through “printing money”, expanding high powered money, expanding bank reserves or boosting deposit aggregates such as M2 –all of which Werner also claimed would be ineffective).[7] Instead, Werner argued, it was necessary and sufficient for an economic recovery to boost “credit creation”, through a number of measures.[6] He also suggested direct purchases of non-performing assets from the banks by the central bank; direct lending to companies and the government by the central bank; purchases of commercial paper, other debt, and equity instruments from companies by the central bank; and stopping the issuance of government bonds to fund the public sector borrowing requirement, instead having the government borrow directly from banks through a standard loan contract.[8][9]”

        Skippy… mate your all over the shop….

      • And…

        Richard Werner says government should borrow from private banks – I’m baffled.

        “At the end of a letter in the Financial Times, an economics Prof. for whom I have a lot of respect, Richard Werner, says government should borrow from private banks. I’m puzzled.
        Given that the government / central bank machine can create money ex nihilo at no cost and in limitless quantities whenever it wants, why does need to go begging to private banks? Private banks will obviously take their cut, and to what benefit for the country as a whole?

        Werner’s exact words:
        …it is high time for lenders to realise that they need to kick-start the bank credit money supply, and can do so immediately by stopping the issuance of government bonds and instead funding the public sector borrowing requirement by having the Treasury enter into loan contracts with the money creators – the banks. That would constitute true quantitative easing of the kind I called for in Japan in the 1990s and it would create a full-blown recovery within six months.”

        In response…

        “Looks like you have many libertarians over there too same as over here in the US… these folks just cant see govt possessing the fiscal authority you point out… so to them, “govt has to borrow”… “govt has no authority”, etc..

        It’s a classic libertarian/authoritarian dichotomy… libertarians have been winning for quite a while (looks like going on 2,000 years to me) but our current economic malaise may finally lead to their overthrow if they don’t come up with something soon to get our economies at higher output/employment….”

        That’s off Ralph’s place and hes a 100% reserve sort…

        Just to put it all in perspective without the sophistry…

        Carlin’s model is not quite loanable funds — at least, not in the sense that Mankiw’s is. They have replaced the LM-curve with a central bank reaction curve. This was suggested some time ago by David Romer. Thus they recognise that the central bank sets the interest rate.

        So, we are back to the Wicksellian version of loanable funds where money is endogenous but there is a ‘natural rate of interest’ that will ensure full employment equilibrium. In order to criticise this construction you must start talking about Keynes’ liquidity preference theory of interest rates and the animal spirits theory of investment behavior.

        Given that the profession seems to be moving back to Wicksell it might be worthwhile discussing these issues.

        Skippy…. the whole edifice built on shifting sands and mobile goal posts, just to obfuscate the fundamental agenda, does get a bit overdone if not deceptive and why, why, why, just because of some antiquarian notion about the self born out of the dark past. How intelligent…. sigh..

        PS. say hi to mig- i for me… eh

      • “..FYI your attribution to him is curious..”

        Not really – I don’t need or seek an all encompassing grand narrative, single bullet theory or ‘guru’ of choice unlike some people I know.

        If your only tool is a hammer everything looks like a nail.

      • Well thanks for the non reply and fiend confusion, you are the one that said watch the doco and “all will be revealed”… Now that I have shown a more comprehensive aspect to this persons views and how that contradicts quite a bit of your assertions – opinions, I’m left wondering about your honesty and ethical standards 007.

        Skippy…. its the flexian way

      • Skippy,

        “…I’m left wondering about your honesty and ethical standards 007….”

        LOL – meow.

      • I see your channeling mig-i now, once all the pettifoggery is blown away its childish antics… [meow].

        On the other hand I’m being quite honest about my opinion, about you, those that you associate with, ideological agendas and crafting a narrative to support those endeavors by hook or crook.

        Its the faux civility that I detest the most, especially once someone that adamantly refuses to join the cult and the true nature is apparent…. must be a False consciousness thingy… i.e. is, within Marxist theory, an attempt to explain why all workers do not do what Marxist theory says they are supposed to do, viz., support a communist revolution.

        Flip the coin and you have –

        Some hard-right activists and libertarians of a conspiracy theorist bent have developed their own version of false consciousness, in which they claim that people only vote left-wing because they’ve been duped by the liberal media, public education system, and other institutions. Deep down these “left-wing” (which just means anything left of firmly right-wing) voters supposedly believe in right-wing values, they just don’t know it. When taken to an even greater extreme they may say liberals are just right-wingers in denial, or are vying for attention. A more mainstream version of this was pushed by Fox News and the GOP after the 2012 U.S. Presidential Election, where they tried to say that people didn’t vote for Mitt Romney because of “messaging problems” as opposed to their platform itself being too extreme for the public.[2]

        Another right-wing version of this pops up every now and then to explain why minorities don’t vote Republican. The answer is that they’ve been fooled by the Democratic Party, who repress them through food stamps and welfare into not taking personal responsibility, never mind that the suggestion that minorities are too stupid to know what’s good for them is an argument that will help turn off minority voters.

        The libertarian version of this is to refer to people who didn’t vote for Ron Paul as “sheeple” on YouTube.

        It is the Marxist version of the Christian idea that “people only reject Christianity because they want to sin.”

        The fact that both the far right and far left like the theory goes to show it may just appeal to ideologues who need to explain away why most people don’t support their perfect ideology.

        Skippy…. it gets to be like the movie Cell… people trapped inside someone else delusion as delightful play things, tho when they want to leave… get all petty and large about it…

      • Skippy ( the crypto Libertarian)


        And no I am not going to waste my time “unpacking” your shtick and wild eyed bar room sprays.

        “..Its the faux civility that I detest the most..”

        Faux? You have problems with all varieties.


      • Yes yes you refuse to delve into the basics of your ideology or what shapes your world view and what actual outcomes you want for – everyone – that would be just to exceedingly forthright. Much better to paint convenient boogieman and rally the unwashed to your stripes flag with “common sense” messages of goodwill too all.

        What you think I made up the bit about Libertarian Marxism out of whole cloth, when its your own words “Libertarian Marxist with tongue firmly in cheek”, sans the inference of crypto, on your part, to obfuscate or worse broad brush me as some wild eyed meth addict at the pub, wildly swing at threats. It was the same with mig-i 007, same basic template, which then extraneous bits could be re-ordered or re-branded in seemingly endless configurations yet still be the very same template a the end of the day.

        This whole exercise about making out the shadow sector is some how meaningfully different than banks is just naval gazing, what cooking the books or managing public perception to increase valuations, which in turn increase equity’s and reduce risk profiles is not conjuring wealth form thin air or paying oneself from the either. Just the fact that most of the OCC derivatives action is conducted in the shadow system make it a ludicrous proposition. Paying someone to hold the bag of risk in order to hive it off, therefor reducing credit terms, without having any meaningful guarantee that should the day come, that they can fulfill those terms times 10s of trillions. Which is made even more crazy by couching everything in the first person dialect, when what were really talking about corporations as “natural humans” in the eyes of the law and the ramifications of it.

        Look we have this thing called compounds for such people, where they can live out life according to their beliefs and without expecting [demanding] everyone else to follow suit. Where the whole lot can devolve back to the most purist form of its ideology all whilst seeking perfection and the ultimate truth hidden by time, way back in antiquity. I have no bloody problem with that, get sum, enjoy it, just don’t go pointing all that gibberish at everyone else like you have a right too.

        Skippy…. its as bad as mig-i’s man love for Freud and dislike of Jung, even tho Freud outed himself as a mythologist in one of is latter works… so much for veneer of intellectualism or is a love for poetry…

      • Skippy,

        Still going Skip? Still smarting because I have, along with many, questioned the wisdom of putting so much control over the creation of Public Money in the hands of private banks.

        For all your foaming and rage you have not addressed that point beyond a bald assertion (and plenty of bad history) that placing more control over Public Money creation in the hands of the public would be a step towards totalitarianism.

        Or did you mean serfdom?

      • You just can’t seem to grok that public money is already in the hands of the state, it never left, tho your equivocation that private moeny creation is somehow on par is legally inaccurate. Fiscal is always in the hands of congress, that Free Market dominance has, over some decades, ideologically captured both private and public institutions, to the point of TINA is another story.

        PS. btw still await your response to the above comment on QE and how that squares with your stripes account.

        Yet you endlessly piffle on about your pet theory’s and quasi religious optics about how things work i.e. proto – early Judaic mysticism…. oh man… must be why you have a pyramid on your blog page… channeling the energy or something…

        As noted before the state writes laws… everything is a subset of it e.g. if you have problems its the result of those that influence the writing of said laws and not bricks and mortar becoming possessed… that would reflect the dominate neoliberal narrative of the last 40 years… and not the Fed, CBs, banks, or state.

        Skippy… the whole anti authoritarian thing is based on nothing more than some wonky spiritualism and concerns about coercion to the point of absurdity. Go play hunter gather and send a post card…

      • Skippy,

        “..You just can’t seem to grok that public money is already in the hands of the state, it never left, tho your equivocation that private moeny creation is somehow on par is legally inaccurate. ..”

        Well there is the problem.. you are just flat out wrong. Not a matter of opinion.

      • If – you – say so 007, inaction on laws all ready on the books or the capacity to change or create new laws is a factor of ideological capture and not fact[s.

        Changing the structure of the system won’t help when the entire system gets captured. In fact money does not even play the primary roll in all this, as the money does not influence the human mind by special powers, societies are shaped by environmental conditions both physical and mythological. To date the dominate mythology is “homo economicus, or economic man, is the concept in many economic theories portraying humans as consistently rational and narrowly self-interested agents who usually pursue their subjectively-defined ends optimally.” This status is awarded to our species as a prescriptive and not as a descriptive, in a quasi religious manner and with its foundations in the dominate esoteric philosophy as extenuated from thousands of years ago.

        The abuse of the term – rational – is instructive here, it is defined by what its authors – say – is rational and magnified by Bernays style social propaganda, which is a bit of Orwellian double speak because as aforementioned its actually its based on the use of irrational fears in the human psyche, left over from our dim past, than it is actually based on any sort of scientific introspection. Probability of die hard followers, strangely having a propensity to arbitrarily discount or flat out refuse to acknowledge AGW – is – quite a tell here, cognitive dissonance as it were.

        Skippy…. keep that faith mate…

        PS. I find the doco Century of the Self to be much more relevant than yours imo, do have a look and then expand seeking…

      • Skippy,

        What? Now it is a competition between docos?

        They are BOTH good docos – buy enough popcorn and enjoy them both. Your endless one upmanship and aggression is tedious but worth keeping in mind when watching the Century of the Self.

      • 007…

        The only thing I can discern in your comment is the projection that you think we’re competing, about your doco and the one I proffered, you could be not further from my intent. My argument is based on the proposition that the dramas started long before your offerings examination, you are orders of magnitude removed from the origins of our dilemmas e.g. some perceived notion that the shadow sector and traditional sector have some intrinsic separation which avails one of ethical introspection whilst he other is not.

        I vehemently disagree based on the evidence that both are subject to introspection and the acknowledgement that both are intertwined and not to mention both have considerable political pull – clout.

        Skippy…. sorry 007 but you seem to have a predisposition and are quite ridged about it, almost sacred cow territory.

  6. So the Chinese banking system creates trillions from thin air, injects into the Chinese economy, where businesses ‘corner’ or borrow from commerce or a lender, can then buy AUD and then swaps that AUD for the house down the road and makes the local working family pay 1/3 of gross income (for ever) to use that shelter.

    That is why we MUST have macro-prudential now ! Better late than never

    • Exactly right. And Australians are supposed to compete with that. lol Revolution is nearly assured.

    • That needs to be plastered all over the nation.

      How will MP stop that process? Seems it will only clear whatever is left of the locals and pave the way for more foreign buying. Hello Auckland.

      The only solution is to put a stop to foreign buying. Enforce the law!

      • Jimbo Its not an either or situation its an AND we need everything including as you suggest the enforcement of the laws, but I see MP in this context as akin to anti-dumping and MP would control the entry of the anti competitive (vis a vie local money savings) at the point of entry. What do you think?

  7. An fascinating article. I’ve never seen such an explanation provided in such forensic detail before. Quite Brilliant. Well found CB.

    It makes you wonder then doesn’t it why Banks are allowed to have shareholders. If they are granted the special privilege by the sovereign – the people – of being able to create money out of thin air, then firstly why do they need shareholders, since they can simply conjure up their own capital by lending out money, and secondly why do we allow the shareholders and management of banks the latitude to reward themselves so highly, when they they have such an incredible legal advantage over all other types of business in the economy.

    • Incredible advantage? Lack of accountability? Don’t they know it.

      ‘Mr Alexiou was paid around $3.7 million to join the bank in 2011 as compensation for forgone bonus and share incentives from his previous employer, Barclays. He received bonuses of $11.3 million from 2012 to 2014 in cash and deferred shares. He is claiming $8.5 million in withheld payments and $21 million in past and future income losses. Mr Alexiou’s $7.2 million Point Piper mansion was put up for sale in November 2015.’

      All you aspiring specialist medical practitioners out there, slaving your guts out for 100 hours a week for 20 years, in advance of perhaps leading your first of hopefully many organ transplants, performing miracle feats………you need your heads read earning less than 10% of these leeches.

    • Beesem…

      Banks are not the only ones that can create money ex nihilo as all business can, anyone can, you just have to find someone to take it. This is why its cogent to understand the shadow sectors involvement or Gunna pointing out equities are a form of money.

      Whilst were at it you might consider if wage derived income rather than dividend (rentier) derived income is something which has a huge part to play – in – the great schemes of things, especially wrt taxation.

      • Seriously Skip – read the article. It explains the difference between banks and non-bank financial institutions. That is not to say non-banking lending is not an issue but they are different issues. The critical problem with non-banking lending is the involvement of exposure of banks to it.

      • Mate you either don’t understand the last 200 years, but more importantly the last 100, which was all built on the previous 2000 thousand.

        You really seem to be compelled more so by ideological reasons than more empirical methodology.

        Skippy…. read the article… moan… like I going to to make – one articles opinion – my baseline or singular optic by which to view all human history – ????? – its as bad as the Marxists… most can’t delineate between Marx and Engels… gravitational belief reduces everything to a singularity… next stop Stalin…

      • Skip, claiming a superior knowledge of history is not the same as having one. When it comes to cherry picking to suit your purpose you are quite the orchardist.

      • Yet your advocating policy just on the basis of one component of the entire monetary – financial system, like it radiates ev’bal which possesses the good traders like pigs. Good grief the Doco you linked to your blog takes its starting point long after the barn door was left wide open, that is blatant cherry picking.

        Mig-i comment and your agreement with it, on your blog is not confusing, yet both of you are blinded by your nascent fears and blinkered views [based on homily’s from the ignorant past], its just so Bernays. Yet in the same breath advocate folding in the banks into the government in toto, like the issue will just cease and desist be cause it changed buildings. Which becomes even more absurd when you and mig-i were cranking a fat about social engineering seeking deterministic out comes as a form of totalitarianism. That’s the really weird bit about libertarian fundamentalism, its quite happy when social institutions are pushing its agenda, but howl about anything contrary to its thought collectives dicta e.g. one big halo effect.

      • The whole libertarian Marxist thingy is just so reminiscent of the 40K denominations of monotheistic spiritualism, just bolt on libertarianism to – anything – and presto… its brand new and the old smell is gone…

        What makes it worse is the subterfuge, every policy recommendation should have the header “Libertarian Marxist” strategy e.g. Libertarian Marxism refers to a broad scope of economic and political philosophies that emphasize the anti-authoritarian aspects of Marxism. Early currents of libertarian Marxism, known as left communism, emerged in opposition to Marxism–Leninism and its derivatives, such as Stalinism, Maoism, and Trotskyism.

        Get that, hate the state [anti-authoritarian] but loves atomatistic market communism [bear pit survival of the fittest – thank you Spencer!] i.e. like at church, so adolescently stunted and incoherent and ad hoc.

        Skippy…. mean while we have 40K years of hard forensic anthropology on our species, DNA, interbreeding, massive increase in knowlage over the last 50 years, yet we are closer to screwing the pooch since the great depression… sigh… its all the banks fault…

      • Skippy,

        Love it when you get a head of steam up.

        The bottom line is that you believe that private bank creation of Public Money is productive and can be regulated effectively by the government. The fact that the last 100-300 years (at a minimum) provides abundant proof that it cannot escapes you.

        That is where we must agree to differ. No need to rev up your random word soup insult generator (though often it hard to tell what is intended as a compliment and what is intended as an insult).

      • So droll mate…


        mektronik Retweeted Peter van Onselen

        Wooohooo @pfh007 @DerorCurrency @3d1kZen @notgunnamatta

        mektronik added,
        Peter van Onselen @vanOnselenP
        Polemicists are destroying the ideological left right spectrum…

        Colin McKay

        9:31 PM – 4 Sep 2015
        Melbourne, Victoria

        PFH007 ‏@pfh007 4 Sep 2015

        @mektronik @DerorCurrency @3d1kZen @notgunnamatta – nice article – at ‘The Authoritarian’ he passes for left wing
        1 retweet 2 likes

        mektronik ‏@mektronik 4 Sep 2015 Melbourne, Victoria

        @pfh007 @DerorCurrency @3d1kZen @notgunnamatta sort of like skippy at MacroBusiness 😉
        0 retweets 0 likes
        PFH007 ‏@pfh007 4 Sep 2015

        @mektronik @DerorCurrency @3d1kZen @notgunnamatta – red-state democrat?
        0 retweets 0 likes
        mektronik ‏@mektronik 4 Sep 2015 Melbourne, Victoria

        @pfh007 @DerorCurrency blue state libertarian bw9

        Skippy… lulz at the sovereign man thingy colin mckay on the alchemy of banking everyone is a central bank and Practical Kabbalah and Usury stuff…. pure loon pond mysticism allusions to dark magic, you can’t make this stuff up mate… art life thingy… David Koresh and Jim Jones all rolled into one…. no thank you~

        PS. best part is you guys pigeonhole yourselves and then try to do the same to others, arbitrarily, yet yack on about freedom stuff… how absurdly delirious…

      • Skippy,

        Excellent – nice to see you are getting the hang of twitter!

        I appreciate that the 140 character limit will cramp your style but there are ways around that too. There is a wide world of people out there – some of them might even point you to something that you did not already know. Hard to believe – with so much locked in and beyond review – but anything is possible.

      • Twitter is just more conditioning through OCD like addictions.

        “I have a foreboding of an America in my children’s or grandchildren’s time — when the United States is a service and information economy; when nearly all the manufacturing industries have slipped away to other countries; when awesome technological powers are in the hands of a very few, and no one representing the public interest can even grasp the issues; when the people have lost the ability to set their own agendas or knowledgeably question those in authority; when, clutching our crystals and nervously consulting our horoscopes, our critical faculties in decline, unable to distinguish between what feels good and what’s true, we slide, almost without noticing, back into superstition and darkness…

        The dumbing down of American is most evident in the slow decay of substantive content in the enormously influential media, the 30 second sound bites (now down to 10 seconds or less), lowest common denominator programming, credulous presentations on pseudoscience and superstition, but especially a kind of celebration of ignorance”

        ― Carl Sagan, The Demon-Haunted World : Science as a Candle in the Dark

        Skippy… Devolution… doing your part with help… attaboy…

      • Skip,

        You do understand that most people use twitter to link to longer articles and sources ? You can arrange your follows so it works like a link collector by topic.

        No different to what you do here.

        Except you insist on pasting the full content into your comment – presumably to force people (evangelising style – though I have no problems with that of course) to read them rather than to save them the expense of the energy of a single click.

    • Keep in mind, when the debt is repaid the entire process goes in reverse – ‘money’ is destroyed.

    • Agree… or put alternatively, all citizens should have equal shareholding, by right of that citizenship!

  8. BTW Kudos for the much needed post CB…

    Tho I fear the mental mastication and gastrointestinal processes will not be without its culinary hiccups and episodes of another bucket for monsieur….

    Skippy…. good on you mate….

    PS. I stand in awe of your epic cut and paste… I am an amateur and bow before my better…. snicker…

    • Pro tip… the term – believe – is not applicable here as we are not talking about religion nor spiritual matters, what does matter is if the – historical evidence – is compelling or not and if it squares with reality sans the ex nilhilo folksy narratives.

      This article was first published in the January, 1946, issue of a periodical named American Affairs.


      by Beardsley Ruml,
      Chairman of the Federal Reserve Bank of New York.

      Mr. Ruml read this paper before the American Bar Association during the last year of the war [World War II]. It attracted then less attention than it deserved and is even more timely now, with the tax structure undergoing change for peacetime. His thesis is that given (1) control of a central banking system and (2) an inconvertible currency, a sovereign national government is finally free of money worries and need no longer levy taxes for the purpose of providing itself with revenue. All taxation, therefore, should be regarded from the point of view of social and economic consequences. The paragraph that embodies this idea will be found italicized in the text. Mr. Ruml does not say precisely how in that case the government would pay its own bills. One may assume that it would either shave its expenses out of the proceeds of taxes levied for social and economic ends or print the money it needs. The point may be academic. The latter end of his paper is devoted to an argument against taxing corporation profits. — Editor.

      Skippy…. caveat… a lot has changed since that time, water under the bridge thingy, tho the fundamental aspect is still operative.

      • To reword the question then, does he believe the assertions are accurate, or well informed?

        But Chris has answered below that he lacks the expertise to judge. This may be the most honest and accurate statement in the thread, if not somewhat disingenuous, given he thought sufficient of it to paste it into a post. Perhaps it was just sufficiently interesting, in a clickbait kind of way.

      • As CB notes it is a very twisted road and unfortunately obscured by vested interests advocating ideological agency before more empirical methodology. Some of the arguments I’ve been privy too and engaged in are more religious in context than not, seriously, a never ending cavalcade of truisms [freedom and liberty, self evident, et al] by where everything can be simplistically reduced to conform to their optics e.g. own all the good but, blame all the bad – failures on everything-one else.

        Worse of all…. its couched in anything but their template is automatically ascribed to Bernays style irrational fear manipulation.

        I was just kidding with CB wrt the Cut and Paste due to others umbrage at such devices, only individual opinion is acceptable, you know axiomatic individualism grooming.

        Skippy…. the point is history is a better method of insight than conjecture, sadly most of the dominate economics of the last decades+ is beholden to the latter and without a functional model of finance of any sort too boot…

      • “…But Chris has answered below that he lacks the expertise to judge. This may be the most honest and accurate statement in the thread,….”

        Pure gold – As if you would know .

    • way above my paygrade – I’m just a simple trader.

      I’ll let Delusional Economics explain it betterer.

      All I know is that historically, banks have had too much power. They should just be utilities, nothing more. A lot of their “business” could be nationalised and done by the State for no loss in effectiveness(e.g mortgage lending).

  9. If banks could self finance loans with deposits at least 2 things would happen:
    1) bank credit and bank deposits would grow at roughly the same rate
    2) bank credit and CB liabilities would grow at roughly the same rate.
    Neither of these things happen. Credit and bank deposits grow and contract at wildly different rates. In the US post 08, when credit was contracting broad money grew rapidly (banks were buying Tbills and accepting deposits). Likewise growth in CB liabilities does not follow bank credit – the reverse is the case).
    Bank credit and bank deposits are pretty much unrelated. bank deposits are somewhere to store wealth (demand is mainly driven by return on other assets) – so its demand for a stock. Credit demand is demand for a flow of resources which the lender makes available.
    If the public are holding all the deposits they want to hold, given returns available on other assets, and a bank credits a zero interest paying deposit to make a loan, only 2 things can happen (after the borrower has spent the money):
    1. The last bank (not necessarily the lending bank) will have to offer a high interest rate to the last depositor for them to willingly hold the deposit in the banking system (this is a disincentive for the lending bank to write up deposits since the money doesn’t necessarily return to them, and for the banking system as a whole because they have to pay interest).
    2. Somewhere along the chain, one of the recipients of the bank money will use the money to repay bank debt. Nobody is going to hold a zero interest deposit when they could save money paying interest. So the deposit returns to the banking system.
    this is what the accounting entries miss – ie. what happens after the borrower actually spends the money?
    Also, the Bank of England also made the point that the ultimate constraint on bank money creation was the CB. Which is true, since there has to be some relationship between base and broad money.

    • Macro Enthusiast

      Sweeper – deposits are bigger than bank loans in most systems because the government creates deposits (net financial assets) as well. FX intervention can also add to deposits, because the central bank prints the currency desired by foreigners. QQE can add to deposits, by helicopter dropping money into public hands – but at the cost of removing a yield-bearing asset from the system.

      In Australia, part of the issue is the classification of deposits held in superannuation.

      I see no issue with the equality (or inequality) as it were between loans and deposits.

      • It’s actually the opposite. Credit always far exceeds deposits (you can check the numbers).
        The reason is anybody can create credit, whereas only deposit taking banks can create deposits – and they can only create deposits because the CB provides bank reserves so that their liabilities are accepted as means of payment with a 1 to 1 exchange rate with base money.
        And there is no relationship (possible even a reverse relationship) between credit and bank money creation. When risk assets are faring badly, credit growth slows and bank money growth always increases. Reason? Banks by safe assets and accept deposits. When risk assets are performing well (say during a bubble), credit grows strongly, bank money growth slows. Reason? 1) The public doesn’t want to hold their wealth in deposits when there are higher perceived returns available & 2) more credit creation moves to non-banks (see securitisation pre-GFC).

  10. Amazing article. Really puts the Bank of England report in more clear terms. Also means all the current mechanism reserve ratios and capital adequacy ratios are useles

  11. “deposit-taking and granting of loans under one roof, because in this way they can invent new money in the form of fictitious ‘customer deposits’ when purporting to engage in the act of ‘lending’.”

    This article is definitely not for the lay person. However did it miss or confuse a few steps?

    It fails to explain what happens when the lent deposit is actually spent… It may hit another bank account… Making it the same scenario as a non-bank loan – that is having to be deposited elsewhere.

    In which case the lending bank must seek funds from the RBA overnight. And later seek deposits from the public to ensure its reserve requirement is met (whatever that is these days).

    Complex yes….

    But isn’t it the low reserve requirement that explains money creation.

    If I personally give you credit for future services, and you’re good for those services then I can sell those future services and others can do the same on the back of your promised rock solid services.

    Didn’t that create money?…. without reserve capital.

    • I agree with your closing comments. The only difference between this scenario and the banking scenario is that ‘bank deposits’ are included in the official definition of various measures of cash, but ordinary business accounts payable are not.

    • “It fails to explain what happens when the lent deposit is actually spent… “.

      Exactly, that’s the problem with trying to explain banking with accounting entries.

      • Sweeper – pretty much right on! In fact the whole problem here is trying to explain a complex dynamic with a couple of simplistic accounting equations. Escobar gets it in a nutshell when he asks what happens when the money is spent.
        Sorry I don’t have time for this right now and it does require a bit of a lengthy argument. There seems to be a problem of definition of ”Money Supply’ We count it before it is actually there!

        Again we have another classic saying the Banks can create money at will without any reference to taxation, interest rates or the external account. Does the article explain the minutae of the banks accounting,,,sure! Can banks create credit to infinity just because they feel like it – Nah! Has it got anything really to do with the macro-economic reality – Nah!
        It IS relevant to pfh’s earlier effort to get a discussion going about the form of Banking we ought have.

      • Agree Flawse,
        It does require a lengthy argument. But trying to draw it out through accounting entries is a really bad way to do it – unless you want to do page after page of entries from the depositors book, borrower, multiple banks. All for a single transaction.
        And the accounting entries simply show the book-keeping effect if something does happen. They don’t identify if something is likely to happen.
        For example:
        Why is a bank going to credit a new deposit, when they don’t know where it will end up in the banking system, whether it will return as a term/demand deposit, what the ultimate cost to the bank will be? So how would they judge their required return?
        Why is the last depositor going to be willing to hold a 0% deposit, when they were happy with the quantity previously held at rates of return available on other assets?
        Why is another borrower somewhere in the chain of transactions not going to use the deposit to repay debt rather than earning a negative carry?

      • @ Sweeper
        “Why is a bank going to credit a new deposit, when they don’t know where it will end up in the banking system, whether it will return as a term/demand deposit, what the ultimate cost to the bank will be? So how would they judge their required return?

        Because they’re a bank ! They don’t grow revenue and earnings unless they are generating new loans. That is their ultimate incentive. Even at a lower interest margin (to ensure they are capturing the deposits or rolling over debt), given the inherent leverage they can get away with, it is still a fundamentally attractive proposition. The question really at this point is why will bond holders continue to tip in funding. To wit your second question …

        “Why is the last depositor going to be willing to hold a 0% deposit, when they were happy with the quantity previously held at rates of return available on other assets?

        Because at that point in time, given the structural distortions in the system, holding any other higher yielding asset is going to be correspondingly more risky, i.e. the effective ‘yield to maturity’ or ROI on those other assets is more likely to be less than 0% over anything other than a short time frame.

        There are effective limits as flawse implies; real growth in demand and physical resources (i.e. the sustainability of assumptions around repayment/security). Which is why maintaining the delusion at a cultural and social level is central to propping up the entire system, and why each vested generation passes on that delusion to the next.

      • Green, that doesn’t answer the question.
        By assumption, the last depositor was happy with their portfolio before the deposit was created.

      • Also, required return is a real consideration:
        A bank is always weighing up whether the marginal return on a risky loan (say a mortgage) exceeds the marginal return on holding a safe asset.
        If it doesn’t, they then have to weigh up whether their marginal cost of capital (incl. bank deposits) plus intermediation is less than the marginal return on safe assets. If it isn’t, they won’t take new deposits. Simple as that.
        That’s exactly what happened to BNY Mellon post GFC. They stopped accepting deposits, because marginal cost started to exceed the return on safe assets. So yes the cost of a new deposit is a real constraint on lending and buying assets.

    • Escobar,

      “…In which case the lending bank must seek funds from the RBA overnight…”

      The RBA does not lend to banks overnight. It doesn’t really like lending to banks at all.

      The ES accounts at the RBA net out at the end of each day as they are simply a tally of the interbank. transactions.

      Those banks with ES accounts that are in the red are required to borrow from those that are in the black. The RBA simply manages the process so the rate at which that happens is the target rate.

      In ‘theory’ the banks could borrow from the RBA at the end of the day if they could not borrow to cover their ES shorfalls but in practice that doesn’t happen. Why because the RBA doesn’t want to explicitly lend taxpayer money to banks.

      If the RBA finds the banks and not keen to lend to each other – as they were not immediately after the GFC – it will increase the level of encouragement but again this does not involve ‘lending’. The RBA will buy approved securities (bonds etc) from banks (who agree to sell) and then deposit the proceeds into the banks ES account. As a consequence of the rules relating to ES balances – those OMO – provide a greater incentive for lending to take place at the target rate rather than a higher rate which a nervous banks (i.e post GFC) might want.

      Graph 1 shows this for the period around the GFC

      Note: repurchase agreements are a grey zone in the sense they are an agreement to re-purchase but in effect they smell like a loan – so in that sense one might describe OMO’s involve repos as lending by the RBA.

      • Thanks Pfh

        So essentially the banks borrow from each other when lent amounts are spent (and deposited to another bank).

        If the lent amounts are spend and deposited to the same bank – then no real overnight balancing is required (unless for reserve requirement? )

      • Effectively pfh the RBA does lend to Banks as per your last statement. They manage that overnight funds rate to teh target rate, My question always is how long can that go on for. if it has a corresponding Swap with the US Fed the answer is quite a while. If it doesn’t then it is quickly screwed. (Hence my arguments re the RBA not being able to continuously lower rates in the face of increased cost of overseas funding for banks.)

      • Escobar,

        “…If the lent amounts are spend and deposited to the same bank – then no real overnight balancing is required (unless for reserve requirement? )..”

        Correct – (though there is no reserve requirement).

        One of the reasons that having fewer banks makes life so much easier for the banks.

        If a large chunk of the ‘deposits’ after creation are simply being transferred to other customers of the bank (by cheque or transfer) then the ES accounts is not affected at all. It is just an internal accounting exercise – but the interest on the loan keeps accruing. Money for Jam! Create a deposit that accrues interest and when spent it still goes nowhere.

        While there are no reserve requirements there are APRA’s capital adequacy requirements but as Deep T (check out his articles under bloggers above ) makes clear that is a bit of an exercise in smoke and mirrors as well.

      • Flawse,

        How long can it go on?

        I believe it has been some decades 🙂

        As we know the process is not cost free – we will pay in one of two ways.

        1. Watch the value of the currency fall

        2. Maintain (for a while) the value of the currency with the ongoing transfer of title to our land, industry, assets and promises to pay (bonds and debt) to foreign ownership.

        Understanding how banks work is important to understanding the mechanics of the problem but at core the problem is simply remains the delusion that we can support a lifestyle with assets sales and debt.

      • “If a large chunk of the ‘deposits’ after creation are simply being transferred to other customers of the bank (by cheque or transfer) then the ES accounts is not affected at all”.

        Ignore the accounting for a second, and focus on behaviours:
        1) Assuming interest rates on safe assets are > 0%, once the deposit is spent why is the recipient going to be happy to hold a zero interest paying deposit, when they can either 1) earn the safe interest rate or if they have debt 2) repay bank debt?
        2) Given that as per above the banking system can only write up deposits if they are willing to offer higher interest rates to depositors, or accept an equal an offsetting deposit contraction somewhere else (through debt repayments), why are banks going to be more pre-disposed to writing up deposits v sourcing deposits?

  12. Thank you. It’s articles like these (no matter how sourced) that deliver 50% of the value of my MB subscription.

  13. Thanks for publishing this. I’ve been linking the Bank Of England paper on how banks create money from nothing here from time to time almost since it was published.

    Now if you will just publish a similar analysis on QE including the liabilities side, which almost everyone who writes on QE totally ignores. That would include whether QE provides any money to the real economy, or for speculation, or stocks etc as opposed to banks creating new money for that purpose separate to the increased reserves they have with the US Fed.

    After that can we deal with hot money flows and whether there really is a flow of money into and out of a country or whehter there is a change in the ownership of assets including money and a change in who has liabilities and how much.

    Then we can get to whether Australian banks borrow from abroad or whether holders of AUD abroad (eg those who receive AUD from some investment in Australian shares (private or public) or debt (private or government) who are abroad have to deposit, directly or indirectly, their AUD in Australian banks or buy Australian assets or repay Australian liabilites, because what else can you do with AUD and earn a yield/save some expense. That might include mention of interbank accounts (nostro and vostro).

      • @tonydd I agree with skippy that it is a portfolio swap of securities (from bank to Fed) (ie Fed increases its assets) and deposits at the Fed (banks receive a credit into their account with the Fed) (ie Fed increases its liabilities to banks) (Banks decrease securities assets and increase “deposits at Fed” assets. There is probably an interst rate effect but this was also muddied/helped by the decision by the Fed to pay interest on reserves. The really big question in my mind was the extent to which the Fed did a bank shareholder bailout by buying crap securities at way above market prices then and even with the passing of the GFC. This is what the ECB has done for the German and French banks that held so much Greek government and bank debt. The Greeks are getting big assistance over time from low interest rates compared to the counterfactual of a default but then no ability to borrow except on a secured basis eg through sale and leaseback of public transport, water, electricity and other essential infrastructure and at ver high (relative to todays’s) interst rates.

      • Explorer don’t forget the munis and pensions which would have been exposed to all kinds of IR swaps et al and gone critical mass…

  14. I feel like I’m caught up in a time warp. This report is so agonising to read it’s like a fresher essay. How anyone can turn such a straightforward process into a convoluted narrative leaves me feeling like taking a hit of speed.

    When the first humans walked the planet they had the power to create credit. Anyone can do it. The banks are a species protected by sovereign powers for the delivery of monetary policy. To achieve this the sovereign gave banks “special” powers in exchange for regulation and created a central bank to manage the currency making them the regulator to the banks. All designed to create order out of chaos. This worked ok for a time until vested interests wanted to capture parts of the process for their own purpose. The central banks became players in the market, banks ceased to operate as intended and chaos was created from order under the guise of “market reform”. The market became the assumed determining factor and the sovereign retired to the bleachers to watch the show. Fast forward to the present and we have complete capture of the process – or what we now call the financialised economy which is tearing the guts out of the real economy.

    Surely we’ve moved beyond postulating credit creation and associated market operations. This report was due forty years ago and for the authors to assume everyone is wandering around in the monetary wilderness is trite. The only ones who appear in the dark are the authors.

    Let’s ignore this shite and talk about how we get ourselves out of this current cluster fark..

    • “Let’s ignore this shite and talk about how we get ourselves out of this current cluster fark..”

      • “sovereign retired to the bleachers to watch the show”

        Sort of! But the whole shebang fundamnetally requires the CB’s of the Reserve currency nations,especially the US Fed, to keep printing.So if CB’s are Sovereign 9which i hold from a macro viewpoint) the sovereign is not quite out of it although that is its intention.

    • Malcolm…

      You have to deal with the dominate philosophy which informs the formation of laws and who controls that process, any thing else is just chasing what the tail wags. Everything is a subset of law, society, markets, money, you name it. Hence going all monetarist [everything is a monetary event] on palliatives is many steps away – from the wellspring.

      Skippy…. even Milton in his latter years recanted much of his previous opinions…

      • I was just ranting tongue in cheek guys. I’m just fed up with these experts authoring regurgitated work as though they are earth shattering revelations. FFS the world is heading for the rest room so can’t they come up with some original or new research? No sarc to CB or anyone, I’ve probably just been on the planet too long.

      • Yeah I feel you Malcolm, albeit it seems the friction is over scarcity ie some want it that way because it assuages their irrational fears, where others note that is not the case and never has been, except as self inflicted.

        Skippy…. Its almost like saying were to broke to save ourselves or those yet to come… what an epitaph.

    • Agree that theoretically anyone can create money out of nothing by making a loan, the problem is that when the money is withdrawn to spend it has to be replaced and given that it is likely to go into someones account at a real bank (banks are a huge proportion of the market for deposits) then unless the banks will lend to the original lender they can’t reliquefy and would have to call the loan. It may even be the bank cannot actually fund the withdrawal because it is not part of the clearing system and has no lender of last resort. Banks exist as specialists because only they have the legal infrastructure around them including of course the implicit governemtn guarantee of the sovereign and through the RBA lender of last resort. It’s not creating the credit in the borrowers account that is the problem it is being able to fund the withdrawal by close of business or through RBA exchange settlement account that matters.
      Look what happened to depsoit takers like Spedley securities once banks stopped providing the 11am/24 hour and other facitilies that allowed them to reliquefy.

      • The article explains the difference between bank lending and ‘lending’ by non-banks

        “It follows then that what enables banks to create credit and hence money is their exemption from the Client Money Rules. Thanks to this exemption they are allowed to keep customer deposits on their own balance sheet. ”

        This is fundamental.

        In the Australian context the Banking Act 1959 described “banks” as Authorized Deposit Taking Institutions and the definition illustrates the importance of deposit taking to what it means to be a bank.

        The key is the definition of banking business

        banking business means:
        (a) a business that consists of banking within the meaning of paragraph 51(xiii) of the Constitution; or
        (b) a business that is carried on by a corporation to which paragraph 51(xx) of the Constitution applies and that consists, to any extent, of:
        (i) both taking money on deposit (otherwise than as part‑payment for identified goods or services) and making advances of money; or
        (ii) other financial activities prescribed by the regulations for the purposes of this definition.

      • And how about Barclay’s Bank bailing itself out with the same money creation method. hahaahah

        You couldn’t make this stuff up its great. I want to be a banker!

      • yes, which begs the question – how hard would it be to get a banking license? if you have 50 mill in tier 1 capital you’re ready to go apparently – are there any other hurdles? ACCC or other?

      • Young OK,

        I suspect the hardest bit is ticking all the regulation boxes. Credit unions and building societies all carry on the business of banking within the meaning of the banking Act and that means that they do what Werner describes. Some credit unions are quite small so probably best to cut your teeth starting one of those!

      • @ Young OK.
        There was also a requirement at one stage for a broad based shareholding to be involved. That meant that 3 big non bank corporates corporates could not start a bank in Australia no matter how much banking capital they might have. But maybe a big corporate could do some sort of stapled security spinoff so long as it became unstapled at some future point in time, but I would expect that there would be a huge raft of restrictions on related party transactions imposed by the regulators in relation to the founding corporate shareholder(s). So then why bother with the distraction?

  15. Grrrrrrrrrrrrrrrrr damned laptop keyboards……..Just lost a whole lot of typing that is, for me, quite a laborious process

  16. Whilst were at it…

    Results from trade deficits. China, for example, collects more dollars than we take back in trade. The surplus, in turn, are converted into bonds

    How would someone think this could hurt our economy?

    They worry about say… China dumping a shit ton of Treasuries on the market. They think it will drive up interest rates. China did this last summer. Nothing happened. People, both foriegn and domestic snapped up the excess securities PDQ. It’s like the irrational inflation monster.

    Skippy…. its almost like the dude in Gondor running around like a chicken with his head cut off yelling were doomed all doomed becuse of IR fears and money crankery…

      • I’ll just refer to Explorers response to your throwaway comment…. above…

        I really don’t understand the relevance of your drive by slur – “I’m sure you’d make a good modern economist skippy – totally myopic.” – as I’ve repeatedly mentioned my disdain for mainstream economics and especially the ones that craft their optics first, then look at everything, and then proclaim truth is relieved. That’s not even getting into a more accurate term for economics is sociopolitical theory, accent on theory, before the ideologues went on their little secret crusade.

        Skippy… do take Explorers advice, just breathing it does not cut it imo…

  17. arthritic kneeMEMBER

    Bank profits always confused me. How did they make so much when the differential between the interest paid on deposits and the interest charged on a loan was so small? Easy when you create the loaned amount and therefore receive the headline 5% rate and not the 1ish% difference.

    • No, they still have to pay interest on their liabilities (deposits), so the interest margin may only be 1.5% – 2% or so. The profit for banks comes from the sheer amount of leverage.

      • which is part of the sad story – when default kicks in across the system the dominoes fall pretty quick and they only make money by taking yours whether thru bail in or bail out

  18. Is it possible for the Aus money supply to increase off books, as in cheap o/s loan coming into our financial sector in $US.

    • Don’t know if that will increase the money stock – probably would lift the exchange rate though – unless the money was used as ‘equity’ and a further loan taken at an aussie bank which is known to happen from time to time

    • there are some slight yet important changes in Australia – Jesse Hermans at Fair Money the best guy to talk you thru it

  19. Couple of points – great that we are getting discussion on money creation into Parliaments around the world – and some even voting on it.

    I’m building a website for Fair Money Australia at the moment – there are some young kids with some passion and deeper understanding of the need to get the maths ‘right’ – so beyond MMT, MPE, Positive Money etc – there is an awareness thru Occupy that the system is a ponzi that is broken.

    It would be nice if our elected reps actually understood the accounting and modelling implications.

    Peter Costello, showing he has no idea how banking works in the above letter to a constitutent.

    My view on money creation is that we need to go back to data school – and start modelling out what type of consumption, production etc is best – ie start pricing externalities in the way that credit is allocated and in a way that smoothes our consumption of energy and stopgaps or limits unfettered destruction of the ecosystem due to the way that money is created (and allocated) -ie without data or without any though to principles of ‘triple bottom line’ accounting or due diligence that involves securing the natural resources and oceanlife and biosphere of future generations.
    The way in which Money is created and allocated and the health of the environment and of our species- resource extraction, preservation, rates of regrowth of env assets go hand in hand – yet to this point nobody has managed to show this graph. All you have to do is graph income against non-renewable consumption, and you’ll see the spike post 1971 after moving to non-backed fiat.

      • Keen has a model for understanding the economy- in fact anyone can have a copy on their computer and plug in what is going around them and cancel their subscription to macrobusiness. The link is as follows

        Maths party have developed a source code that pretty much replicates Minsky and added an extra panel which they will be releasing for review soon that draws on information theory and non-linear systems theory to plot extra vectors based on survival points – ie tipping points at which change accelerates along a collapse trajectory – keen doesn’t go near any of this in his modelling.

        The tools we have used really fall into the following

        Geometry: Fractals and the measure of fractal dimensions can be used to study the nature of attractors.
        Dynamics: Lyaponov exponents can be used to understand the dynamics of attractors
        Topology: Topological tools have been found to provide powerful means to classifying strange attractors.

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