HOW BANKS INDIVIDUALLY CREATE MONEY OUT OF NOTHING: Secrets of Money Creation Revealed - Richard A. Werner (2014) - SECRETS OF SUCCESS: Masters’ Greatest Wisdom

Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Speaker 1 (00:00):
Can banks individually create money out of nothing? The Theories
and the Empirical Evidence, Richard A. Werner Center for Banking,
Finance and Sustainable Development, University of Southampton, United Kingdom, Abstract.
This paper presents the first empirical evidence in the history

(00:20):
of banking on the question of whether banks can create
money out of nothing. The banking crisis has revived interest
in this issue, but it had remained unsettled. Three hypotheses
are recognized in the literature. According to the financial intermediation
theory of banking, banks are merely intermediaries like other non
bank financial institutions, collecting deposits that are then lent out.

(00:44):
According to the fractional reserve theory of banking, individual banks
are mere financial intermediaries that cannot create money, but collectively
they end up creating money through systemic interaction. A third
theory maintains that each individual bank has the power to
create money one out of nothing, and does so when
it extends credit, the credit creation theory of banking. The

(01:06):
question which of the theories is correct has far reaching
implications for research and policy. Surprisingly, despite the long standing controversy,
until now, no empirical study has tested the theories. This is
the contribution of the present paper. An empirical test is
conducted whereby money is borrowed from a cooperating bank while

(01:27):
its internal records are being monitored to establish whether, in
the process of making the loan available to the borrower,
the bank transfers these funds from other accounts within or
outside the bank, or whether they are newly created. This
study establishes for the first time empirically that banks individually
create money out of nothing. The money supply is created

(01:47):
as ferry dust produced by the bank's individually out of
thin air. The choice of a measure of value, of
a monetary system, of currency, and credit legislation all are
in the hands of society, and natural conditions are relatively unimportant. Here, then,
the decision makers in society have the opportunity to directly

(02:08):
demonstrate and test their economic wisdom or folly. History shows
that the latter has often prevailed Wisel, nineteen twenty two
one introduction. Since the American and European banking crisis of
two thousand seven to eight, the role of banks in
the economy has increasingly attracted interest within and outside the

(02:30):
disciplines of banking, finance, and economics. This interest is well justified.
Thanks to the crisis, awareness has risen that the most
widely used macroeconomic models and finance theories did not provide
an adequate description of crucial features of our economies and
financial systems, and most notably failed to include banks. These

(02:51):
bank less dominant theories are likely to have influenced bank
regulators and may thus have contributed to suboptimal bank regulation.
Systemic issues emanating from the banking sector are impossible to
detect in economic models that do not include banks, or
in finance models that are based on individual representative financial
institutions without embedding these appropriately into macroeconomic models. Consequently, many

(03:15):
researchers have since been directing their efforts at incorporating banks
or banking sectors in economic models. This is a positive development,
and the European Conferences on Banking and the Economy ECOBATE
are contributing to this task, showcased in this second special
issue on ECOBATE twenty thirteen, held on March sixth, twenty

(03:35):
thirteen in Winchester Guildhall and organized by the University of
Southampton Center for Banking, Finance and Sustainable Development. As the
work in this area remains highly diverse. This article aims
to contribute to a better understanding of crucial features of banks,
which would facilitate their suitable incorporation in economic models. Researchers

(03:56):
need to know which aspects of bank activity are essential,
including in important characteristics that may distinguish banks from non
bank financial institutions. In other words, researchers need to know
whether banks are unique in crucial aspects, and if so why.
In this paper, the question of their potential ability to
create money is examined, which is a candidate for a

(04:17):
central distinguishing feature. A review of the literature identifies three
different mutually exclusive views on the matter, each holding sway
for about a third of the twentieth century. The present
conventional view is that banks are mere financial intermediaries that
gather resources and reallocate them, just like other non bank
financial institutions, and without any special powers. Any differences between

(04:41):
banks and non bank financial institutions are seen as being
due to regulation and effectively so minimal that they are
immaterial for modeling or for policymakers. Thus, it is thought
to be permissible to model the economy without featuring banks directly.
This view shall be called the financial intermediation theory of banking.
It has been the dominant view since about the late

(05:03):
nineteen sixties. Between approximately the nineteen thirties and the late
nineteen sixties, the dominant view was that the banking system
is unique since banks, unlike other financial intermediaries, can collectively
create money based on the fractional reserve or money multiplier
model of banking. Despite their collective power, however, each individual

(05:25):
bank is in this view considered to be a mere
financial intermediary, gathering deposits and lending these out without the
ability to create money. This view shall be called the
fractional reserve theory of banking. There is a third theory
about the functioning of the banking sector, with an ascendancy
in the first two decades of the twentieth century. Unlike

(05:46):
the financial intermediation theory and in line with the fractional
reserve theory, it maintains that the banking system creates new money. However,
it goes further than the latter and differs from it
in a number of respects. It argues that each which
individual bank is not a financial intermediary that passes on
deposits or reserves from the central bank. In its lending,

(06:06):
but instead creates the entire loan amount out of nothing.
This view shall be called the credit creation theory of banking.
The three theories are based on a different description of
how money and banking work, and they differ in their
policy implications. Intriguingly, the controversy about which theory is correct
has never been settled. As a result, confusion reigns. Today

(06:29):
we find central banks, sometimes the very same central bank,
supporting different theories. In the case of the Bank of England,
central bank staff are on record supporting each one of
the three mutually exclusive theories at the same time. As
will be seen below, it matters which of the three
theories is right not only for understanding and modeling the
role of banks correctly within the economy, but also for

(06:52):
the design of appropriate bank regulation that aims at sustainable
economic growth without crises. The modern approach to bank rene regulation,
as implemented at least since Basili nineteen eighty eight, is
predicated on the understanding that the financial intermediation theory is correct.
Capital adequacy based bank regulation, even of the countercyclical type,

(07:14):
is less likely to deliver financial stability if one of
the other two banking hypotheses is correct. The capital adequacy
based approach to bank regulation adopted by the BCBS, as
seen in Basil one in two, has so far not
been successful in preventing major banking crises. If the financial
intermediation theory is not an accurate description of reality, it

(07:36):
would throw doubt on the suitability of Basil three in
similar national approaches to bank regulation, such as in the UK.
It is thus of importance for research and policy to
determine which of the three theories is an accurate description
of reality. Empirical evidence can be used to test the
relative merits of the theories. Surprisingly, no such test has

(07:57):
so far been performed. This is the contribution of the
present paper. The remainder of the paper is structured as follows.
Section two provides an overview of relevant literature, differentiating authors
by their adherents to one of the three banking theories.
It will be seen that leading economists have gone on
the record in support of each one of the theories.

(08:20):
In section three, I then present an empirical test that
is able to settle the question of whether banks are
unique in whether they can individually create money out of nothing.
It involves the actual processing of a live bank loan
taken out by the researcher from a representative bank that
cooperates in the monitoring of its internal records and operations,
allowing access to its documentation and accounting systems. The results

(08:44):
and some implications are discussed in section four two. The
literature on weather banks can create money. Much has been
written on the role of banks in the economy in
the past century and beyond. Often authors have not been
concerned with the question of weather banks can create money,
as they often simply assume their preferred theory to be

(09:04):
true without discussing it directly, let alone in a comparative fashion.
This literature review is restricted to authors that have contributed
directly and explicitly to the question of weather banks can
create credit and money during time periods when in the
author's country's banks issued promissory notes bank notes that circulated
as paper money, writers would often, as a matter of course, mention,

(09:28):
even if only in passing, that banks create or issue money.
In England and Wales, the Bank Charter Act of eighteen
forty four forbade banks to make any engagement for the
payment of money payable to bearer on demand. This ended
bank note issuance for most banks in England and Wales,
leaving them until nineteen forty six officially privately owned Bank

(09:49):
of England with a monopoly on bank note issuance. Meanwhile,
the practice continued in the United States until the twentieth century,
and was in fact expanded with the similarly time New
York Work Free Banking Act of eighteen thirty eight, so
that US authors would refer to bank note issuance as
evidence of the money creation function of banks until much later.

(10:09):
For sake of clarity, our main interest in this paper
is the question whether banks that do not issue bank
notes are able to create money in credit out of nothing.
As a result, Earlier authors writing mainly about paper money
issuance are only mentioned in passing here, even if it
could be said that their arguments might also apply to
banks that do not issue bank notes. These include John

(10:31):
Law seventeen oh five, James Stewart seventeen sixty seven, Adam
Smith seventeen seventy six, Henry Thornton eighteen oh two, Thomas
Took eighteen thirty eight, and Adam Muller eighteen sixteen, among others,
who either directly or indirectly state that banks can individually
create credit in line with the credit creation theory two

(10:54):
point one. The credit creation theory of banking influential early
writers that are gu u that non issuing banks have
the power to individually create money and credit out of nothing,
wrote mainly in English or German, namely Wicksel eighteen ninety eight,
Wicksel nineteen oh seven, Withers nineteen oh nine, Schumpad nineteen twelve,

(11:15):
Moeler nineteen twenty five, and Hahn nineteen twenty. The review
of proponents of the credit creation theory must start with
Henry Dunning MacLeod of Trinity College, Cambridge and barrister at
law at the Inner Temple. McLeod produced an influential opus
on banking entitled The Theory and Practice of Banking in

(11:35):
two volumes. It was published in numerous editions well into
the twentieth century McLeod eighteen fifty five to six. The
quotes here are from the sixth edition of nineteen oh five.
Concerning credit creation by individual banks, MacLeod unequivocally argued that
individual banks create credit and money out of nothing whenever

(11:55):
they do what is called lending. In modern times, private
bankers discontinuea issuing notes and merely created credits in their
customer's favor, to be drawn against by checks. These credits are,
in banking language termed deposits. Now, many persons seeing a
material bank note, which is only a write recorded on paper,
are willing to admit that a bank note is cash,

(12:18):
but from the want of a little reflection, they feel
a difficulty with regard to what they see as deposits.
They admit that a bank note is in issue and currency,
but they fail to see that a bank credit is
exactly in the same sense, equally in issue, currency and
circulation dot Macloud, nineteen o five, page three ten. Sir

(12:40):
Robert Peel was quite mistaken in supposing that bankers only
make advances out of bona fide capital. This is so
fully set forth in the Chapter on the Theory of Banking,
that we need only to remind our readers that all
banking advances are made in the first instance by creating
credit page three seventy, emphasis in original. In his Theory

(13:01):
of Credit, McLoud eighteen ninety one put it this way.
A bank is therefore not an office for borrowing and
lending money, but it is a manufactory of credit. McLoud
eighteen ninety one, five hundred and ninety four. According to
the credit creation theory, then banks create credit in the

(13:21):
form of what bankers call deposits, and this credit is money.
But how much credit can they create? Wisel nineteen o
seven described a credit based economy in the Economic Journal,
arguing that the banks, in their lending business are not
only not limited by their own capital, they are not,
at least not immediately limited by any capital whatever. By

(13:44):
concentrating in their hands almost all payments, they themselves create
the money required. In a pure system of credit, where
all payments were made by transference in the bank books,
the banks would be able to grant at any moment
any amount of loans at any However, diminutive rate of
intros Withers nineteen o nine. From nineteen sixteen to nineteen

(14:05):
twenty one, the editor of The Economist, also saw few
restraints on the amount of money banks could create out
of nothing. It is a common popular mistake when one
is told that the banks of the United Kingdom hold
over nine hundred millions of deposits, to open one's eyes
in astonishment at the thought of this huge amount of
cash that has been saved by the community as a
whole and stored by them in the hands of their bankers,

(14:27):
and to regard it as a tremendous evidence of wealth.
But this is not quite the true view of the case.
Most of the money that is stored by the community
in the banks consists of bookkeeping credits lent to it
by its bankers. The greater part of the bank's deposits
is thus seen to consist not of cash paid in,
but of credits borrowed. For every loan makes a deposit.

(14:50):
When notes were the currency of commerce, a bank which
made an advance or discounted a bill gave its customer
its own notes as the proceeds of the operation, and
created a liability for its Now a bank makes an
advance or discounts a bill and makes a liability for
itself in the corresponding credit in its books. It comes
to this that whenever a bank makes an advance or

(15:12):
buys a security, it gives someone the right to draw
a check upon it, which check will be paid in
either to it or to some other banks. And so
the volume of banking deposits as a whole will be increased,
and the cash resources of the banks as a whole
will be unaltered. When once this fact is recognized that
the banks are, still, among other things, manufacturers of currency,

(15:33):
just as much as they were in the days when
they issued notes, we see how important a function the
bank's exercise in the economic world, because it is now
generally admitted that the volume of currency created has a
direct and important effect upon prices. This arises from what
is called the quantity theory of money. If then the
quantity theory is, as I believe, broadly true, we see

(15:56):
how great is the responsibility of the bankers as manufacturers
are currency, seeing that by their action they effect not
only the convenience of their customers and the profits of
their shareholders, but the general level of prices. If banks
create currency faster than the rate at which goods are
being produced, their action will cause a rise in prices,
which will have a perhaps disastrous effect. And so it

(16:19):
becomes evident, as before stated, that the deposits of the banks,
which give the commercial community the right to draw checks,
are chiefly created by the action of the banks themselves
in lending, discounting, and investing. Then it thus appears that
credit is the machinery by which a very important part
of modern currency is created. Withers argues that the sovereign

(16:40):
prerogative to manufacture the currency of the nation has effectively
been privatized and granted to the commercial banks. By this
interesting development, the manufacture of currency, which for centuries has
been in the hands of government, has now passed, in
regard to a very important part of it, into the
hands of companies working for the convenience of their customers
and the profits of their shareholders. While Withers was a

(17:03):
financial journalist, his writings had a high circulation and likely
contributed to the dissemination of the credit creation theory in
the form proposed by McLeod eighteen fifty five to six.
This view also caught on in Germany with the publication
of Schumpaters nineteen twelve influential book The Theory of Economic Development,
in which he was unequivocal in his view that each

(17:25):
individual bank has the power to create money out of nothing.
Something like a certificate of future output or the award
of purchasing power on the basis of promises of the
entrepreneur actually exists. That is, the service that the banker
performs for the entrepreneur and to obtain which the entrepreneur
approaches the banker, the banker would not be an intermediary

(17:46):
but manufacturer of credit, i e. He would create himself
the purchasing power that he lends to the entrepreneur. One
could say, without committing a major sin, that the banker
creates money. Credit is essentially the creepedation of purchasing power
for the purpose of transferring it to the entrepreneur, but
not simply the transfer of existing purchasing power. By credit,

(18:08):
entrepreneurs are given access to the social stream of goods
before they have acquired the normal claim to it, and
this function constitutes the keystone of the modern credit structure.
The fictitious certification of products, which, as it were, the
credit means of payment originally represented, has become truth. This
view was also well represented across the Atlantic, as the

(18:31):
writings of Davenport nineteen thirteen or Robert H. Howe nineteen
fifteen indicate. Hawtree nineteen nineteen, another leading British economists, who
like Canes, had a treasury background and moved into academia,
took a clear stance in favor of the credit creation theory.
For the manufacturers and others who have to pay money

(18:52):
out credits are still created by the exchange of obligations,
the banker's immediate obligation being given to his customer in
exchange for the custustomer's obligation to repay at a future date.
We shall still describe this dual operation as the creation
of credit. By its means, the banker creates the means
of payment out of nothing, whereas when he receives a

(19:12):
bag of money from his customer, one means of payment,
a bank credit is merely substituted for another, an equal
amount of cash, page twenty. Apart from Schumpeter, a number
of other German language authors also argued that banks create
money and credit individually through the process of lending. Highly
influential in both academic discourse and public debate was doctor

(19:34):
Albert L. Hahn nineteen twenty, scion of a Frankfort banking dynasty,
similarly to Thornton, who had been a banker and since
nineteen nineteen, director of the major family owned effect in
und Wexelbank Frankfort. Like MacLeod, a trained lawyer, he became
an honorary professor at Goody University Frankfort in nineteen twenty eight,

(19:55):
clearly not only aware of the works of MacLeod, whom
he cites, but also likely aware of actual banking practice
from his family business. Hahn argued that banks do indeed
create money out of nothing. Every credit that is extended
in the economy creates a deposit and thus the means
to fund it. The conclusion from the process described can

(20:15):
be expressed in reverse by saying that every deposit that
exists somewhere and somehow in the economy has come about
by a prior extension of credit. We thus maintain, contrary
to the entire literature on banking and credit, that the
primary business of banks is not the liability business, especially
the deposit business, but that, in general and in each
in every case, an asset transaction of a bank must

(20:38):
have previously taken place in order to allow the possibility
of a liability business and to cause it. The liability
business of banks is nothing but a reflex of prior
credit extension. The opposite view is based on a kind
of optical illusion. Overall, Han probably did more than anyone
to popularize the credit creation theory in Germany, his book

(20:59):
becoming a bestat and spawning much controversy and new research
among economists. In Germany. It also greatly heightened awareness among
journalists and the general public of the topic in the
following decades. The broad impact of his book was likely
one of the reasons why this theory remained entrenched in
Germany when it had long been discarded in the UK

(21:19):
or the US, namely well into the postwar period. Hahn's
book was, however, not just a popular explanation without academic credibility.
Schumpeter cited it positively in the second German edition of
his Theory of Economic Development Schumpater nineteen twenty six, praising
it as a further development in line with but beyond

(21:41):
his own book. The English translation of Schumpeter's influential book,
Schumpater nineteen twelve, also favourablest sites Hahn. It can be
said that support for the credit creation theory appears to
have been fairly widespread in the late nineteenth and early
twentieth century in English and German language academic publications. By

(22:01):
nineteen twenty, the credit creation theory had become so widespread
that it was dubbed the current view, the traditional theory,
or the time worn theory of bank credit by later critics.
The early Caines seem to also have been a supporter
of this dominant view. In his tract on Monetary Reformkines
nineteen twenty four, he asserts, apparently without feeling the need

(22:23):
to establish this further, that banks create credit and money,
at least in aggregate. The internal price level is mainly
determined by the amount of credit created by the banks,
chiefly the Big Five. The amount of credit so created is,
in its turn, roughly measured by the volume of the
bank's deposits, Since variations in this total must correspond to

(22:44):
the variations in the total of their investments, bill holdings,
and advances. We know from Kaine's contribution to the Macmillan
Committee nineteen thirty one that Kaines meant with this that
each individual bank was able to create credit. It is
not unnapped to think of the deposits of a bank
as being created by the public through the deposit of
cash representing either savings or amounts which are not, for

(23:07):
the time being required to meet expenditure. But the bulk
of the deposits arise out of the action of the
banks themselves, for by granting loans, allowing money to be
drawn on an overdraft, or purchasing securities. A bank creates
a credit in its books, which is the equivalent of
a deposit. Concerning the banking system as a whole, this
bank credit and deposit creation was thought to influence aggregate

(23:29):
demand and the formation of prices. As Shumpater nineteen twelve
had argued, the volume of bankers loans is elastic, and
so therefore is the mass of purchasing power. The banking
system thus forms the vital link between the two aspects
of the complex structure with which we have to deal,
For it relates the problems of the price level with

(23:50):
the problems of finance, since the price level is undoubtedly
influenced by the mass of purchasing power which the banking
system creates and controls, and by the structure of credit
which it builds. Thus, questions relating to the volume of
purchasing power and questions relating to the distribution of purchasing
power find a common focus in the banking system McMillan Committee,

(24:11):
nineteen thirty one. If finally the banks pursue an easier
credit policy and lend more freely to the business community,
forces are set in motion, increasing profits and wages, and
therefore the possibility of additional spending arises. Concerning the question
whether credit demand or credit supply is more important, the
report argued that the root cause is the movement of

(24:34):
the supply of credit. The expansion or contraction of the
amount of credit made available by the banking system in
other directions, will, through a variety of channels, affect the
ease of embarking on new investment propositions. This, in turn
will affect the volume and profitableness of business, and hence
react in due course on the amount of accommodation required

(24:55):
by industry from the banking system. Thus, what started as
an alteration in the supp apply of credit ends up
in the guise of an alteration in the demand for credit.
While money is thus seen as endogenous to credit. When
what is called a bank loan is extended, the committee
argued that bank credit was exogynous as far as loan
applicants are concerned. There can be no doubt as to

(25:17):
the power of the banking system to increase or decrease
the volume of bank money in normal conditions. We see
no reason to doubt the capacity of the banking system
to influence the volume of active investment by increasing the
volume and reducing the cost of bank credit. Thus, we
consider that in any ordinary times, the power of the
banking system to increase or diminish the active employment of

(25:39):
money in enterprise and investment is indisputable. The McMillan Committee
also argued that bank credit could be manipulated by the
Bank of England and thus was also considered exogenous. In
this sense, the credit creation theory remained influential until the
early post war years. The links of credit creation to
macroeconomic and financeantial variables were later formalized in the quantity

(26:02):
theory of credit Werner two thousand twelve, which argues that
credit for productive use in the form of investments for
the production of goods and services is sustainable and non inflationary,
as well as less likely to become a non performing loan.
B Unproductive use in the form of consumption results in
consumer price inflation and see Unproductive use in the form

(26:23):
of asset transactions results in asset inflation and if large enough,
banking crises. However, since the nineteen twenty serious doubts had
spread about the veracity of the credit creation theory of banking.
These doubts were initially uttered by economists who in principle
supported the theory but downplayed its significance. It is this

(26:46):
group of writers that served as a stepping stone to
the formulation of the modern fractional reserve theory, which, in
its most widespread and later version, however, argues that individual
banks cannot create credit, but only the banking system in aggregate.
It is this theory about banks that we now turn
to two point two, the fractional reserve theory. An early

(27:08):
proponent of the fractional reserve theory was Alfred Marshall. Eighteen
eighty eight, he testified to a government committee about the
role of banks as follows. I should consider what part
of its deposits a bank could lend, and then I
should consider what part of its loans would be redeposited
with it and with other banks, and vice versa. What
part of the loans made by other banks would be

(27:29):
received by it as deposits. Thus I should get a
geometrical progression, the effect being that if each bank could
lend two thirds of its deposits, the total amount of
loaning power got by the banks would amount to three
times what it otherwise would be. With this, he contradicted
MacLeod's arguments However, Marshal's view was still a minority view

(27:50):
at the time. After the end of the First World War,
a number of influential economists argued that the bold theory
of bank credit creation by individual banks was mistake. Their
view gradually became more influential. The theory of deposit expansion
reached its zenith with the publication of C. A. Phillips
Bank Credit Good Friend nineteen ninety one. Phillips nineteen twenty

(28:14):
argued that it was important to distinguish between the theoretical
possibility of an individual bank manufacturing money by lending in
excess to cash and reserves, on the one hand, and
on the other the banking system as a whole being
able to do this. He argued that the bold theory
the credit creation theory, was predicated upon the contention that

(28:35):
a bank would be able to make loans to the
extent of several times the amount of additional cash newly
acquired and held at the time the loans were made,
whereas a representative bank in a system is actually able
ordinarily to lend an amount only roughly equal to such cash.
According to Phillips nineteen twenty, individual banks cannot create credit
or money, but collectively the banking system does so as

(28:57):
a new reserve is split into small fragments becomes dispersed
among the banks of the system. Through the process of dispersion,
it comes to constitute the basis of a manifold loan expansion.
Each bank is considered mainly a financial intermediary. The banker
handles chiefly the funds of others. Phillips argued that since

(29:18):
banks target particular cash to deposit and reserve to deposit
ratios as cited in the money multiplier which they wish
to maintain, each bank effectively works as an intermediary lending
out as much as it is able to gather in
new cash through the process of dispersion and reiteration. The
financial intermediation function of individual banks without the power to

(29:39):
create credit adds up to an expansion in the money
supply in aggregate. Krick nineteen twenty seven shared this conclusion
with some minor caveats. Thus, he argued, the important point
which is responsible for much of the controversy and most
of the misunderstanding, is that while one bank receiving an
addition to its cash cant not forthwith undertake a full

(30:01):
multiple addition to its own deposits. Yet the cumulative effect
of the additional cash is to produce a full multiple
addition to the deposits of all the banks as a whole.
Summing up, then it is clear that the banks, so
long as they maintain steady ratios of cash to deposits,
are merely passive agents of the Bank of England policy.
As far as the volume of money in the form

(30:22):
of credit is concerned. The banks have very little scope
for policy in the matter of expansion or contraction of deposits,
though they have in the matter of disposition of resources
between loans, investments and other assets. But this is not
to say that the banks cannot and do not affect
multiple additions to or subtractions from deposits as a whole

(30:43):
on the basis of an expansion of or contraction in
bank cash. The role of banks remained disputed during the
nineteen twenties and nineteen thirties as several writers criticize the
credit creation theory. Views not only diverged but were also
in a flux as several exps berts apparently shifted their
position gradually overall, an increasing number moving away from the

(31:04):
credit creation theory and towards the fractional reserve theory. Sir
Josiah C. Stamp, a former director of the Bank of England,
summarized the state of debate in his review of an
article by Piegu nineteen twenty seven. The general public economic
mind is in a fair state of muddlement at the
present moment on the apparently simple question can the banks

(31:25):
create credit? And if so, how and how much? And
between the teachings of doctor Leif and mister McKenna, Messrs
canes Hawtrey, Castle, and Cannon and Gregory, people have not
yet found their way. Contributions to this debate were also
made by Dennis Robertson nineteen twenty six, who was influenced
by Canes. Canes nineteen thirty explains the role of reserve

(31:49):
holdings and the mechanics of determining a bank's behavior based
on its preference to hold cash and reserves together with
the amount of reserves provided by the central bank. The
fairly predetermined micare canos postulated by the money multiplier in
a fractional reserve model. Thus, in countries where the percentage
of reserves to deposits is by law or customs, somewhat
rigid we are thrown back for the final determination of

(32:12):
m the volume of bank money on the factors which
determine the amount of these reserves. Kines nineteen thirty also
backed a key component of the fractional reserve theory, namely
that banks gather deposits and place parts of them with
the central bank, or alternatively, may withdraw funds from their
reserves at the central bank in order to lend these
out to the non banking sector of the economy. When

(32:35):
a bank has a balance at the Bank of England
in excess of its usual requirements, it can make an
additional loan to the trading and manufacturing world, and this
additional loan creates an additional deposit to the credit of
the borrower or to the credit of those to whom
he may choose to transfer it on the other side
of the balance sheet of this or some other bank.
Kaines here argues that new deposits based on new loans

(32:57):
are dependent upon and connected to banks recus deserve balances
held at the central bank. This view is sometimes also
supported by present day central bankers, such as in Paul
Tucker's or the Ecbeast's proposal to introduce negative interest rates
on bank's reserve holdings at the central bank as an
incentive for them to move their money from the central
bank and increase lending. Nevertheless, part of Kin's nineteen thirty

(33:22):
and much of his most influential work, his General Theory
nineteen thirty six, appears more in line with the financial
intermediation theory, as will be discussed in the following section.
A representative example of the fractional reserve theory that at
the same time was beginning to point in the direction
of the financial intermediation theory is the work by Lutz
nineteen thirty nine, who published in Economica, a forum for

(33:46):
some of these debates at the time. The expansion of
the economic system leads to an increase in the volume
of deposits to a figure far in excess of the
amount of the additional cache in use, simply because the
same cache is deposited with the banking system over and
over again. The fact that banking statistics show an aggregate
of deposits far above the amount of cash in the

(34:06):
banking system is therefore not of itself a sign that
the banks must have created the whole of the difference.
This conclusion is also of course, somehow implicit in the
multiple expansion theory of the creation of bank deposits of
the Phillips or Quick variety. That theory explains the creation
of deposits by the fact that the same cash, in

(34:27):
decreasing amounts is successively paid into different banks. It does, however,
look upon this cash movement rather in the nature of
a technical affair between banks, which would disappear if the
separate banks were merged into one. In that case, the
deposits would be regarded as coming into existence by outright creation.
In our example, we assume throughout only one bank, and

(34:50):
still the deposits grow out of the return again and
again of the same cash by the public. The force
which really creates expansion is the trade credit given by
producers to one another. The bank plays the role of
a mere intermediary. This seems to lead not to anew
but to a very old theory of the function of banks,

(35:10):
the function of a mere intermediary. The modern idea of
banks being able to create deposits seemed to be a
startling departure from the view held by most economists in
the nineteenth century. If, however, we approach this modern idea
along the lines followed above, we find that it resolves
itself into much the same elements as those which many
of the older writers regarded as the essence of banking operations,

(35:33):
the provision of confidence, which induces the economic subjects to
extend credit to each other by using the bank as
an intermediary. Philip's influence has indeed been significant. Even in
nineteen ninety five, good Friends still argued that Phillips showed
that the summation of the loan and deposit creation series
across all individual banks yields the multiple expansion formulas for

(35:56):
the system as a whole, Philip's definitive exposition and essentially
establish the theory once and for all in the form
found in economics textbooks today. Statements like this became the
mainstream view in the nineteen fifties and nineteen sixty s
point twenty five. The view of the fractional reserve theory
in time also came to dominate textbook descriptions of the
functioning of the monetary and banking system. There is no

(36:20):
post war textbook more representative and influential than that of
Samuelson nineteen forty eight. The original first edition is clear
in its description of the fractional reserve theory under the
heading can banks really create money? Samuelson first dismisses false
explanations still in wide circulation. According to these false explanations,

(36:41):
the managers of an ordinary bank are able, by some
use of their fountain pens, to lend several dollars for
each dollar left on deposit with them. No wonder practical
bankers see read when such behavior is attributed to them,
They only wish they could do so, as every banker
well knows he cannot invest money that he does not have,

(37:01):
and any money that he does invest in buying a
security or making a loan will soon leave his bank.
Samuelson thus argues that a bank needs to gather the
funds first before it can extend bank loans. This is
not consistent with the credit creation theory. However, Samuelson argues
that in aggregate, the banking system creates money. He illustrates

(37:24):
his argument with the example of a small bank that
faces a twenty percent reserve requirement and considering the accounts
of the bank be slash s. If this bank receives
a new cash deposit of one thousand dollars, what can
the bank now do Samuelson asks, can it expand its
loans and investments by four thousand dollars? The answer is

(37:46):
definitely no. Why not total assets equal total liabilities? Cash
reserves meet the legal requirement of being twenty percent of
total deposits. True enough, but how does the bank pay
for the investments or earning assets that it buys? Like
everyone else, it writes out a check to the man

(38:07):
who sells the bond or signs the promissory note. The
borrower spends the money on labor, on materials, or perhaps
on an automobile. The money will very soon therefore have
to be paid out of the bank. A bank cannot
eat its cake, can have it too. Table four begives
therefore a completely false picture of what an individual bank

(38:29):
can do. Instead, Samuelson explains, since all the money lent
out will leave the bank, an individual bank cannot create
credit out of nothing. As far as this first bank
is concerned, we are through. Its legal reserves are just
enough to match its deposits. There is nothing more it
can do until the public decides to bring in some

(38:51):
more money on deposit. On the other hand, Samuelson emphasizes
that the banking system as a whole can do what
each small bank cannot do, namely, create money. This, Samuelson
explains via the iterative process of one bank's loans based
on prior deposits, becoming another bank's deposits, and so forth.

(39:12):
He shows this chain of deposit creation in a table
amounting to total deposits in the banking system of five
thousand dollars out of the one thousand dollars due to
the reserve requirement of twenty per cent, implying a money
multiplier of five times assuming no cash leakage. What Samuelson
calls the multiple deposit expansion is described in the same

(39:34):
way and with remarkable similarity in the fifteenth edition of
his book nineteen ninety five, half a century later, only
that the reserve requirement cited as example has been lowered
to ten per cent. All banks can do what one
can't do alone. There are subtle, though important differences. The
overall space devoted to this topic is much smaller in

(39:54):
nineteen ninety five compared to nineteen forty eight. The modern
textbook says that the central bank created reserves are used
by the banks as an input and then transformed into
a much larger amount of bank money. There is far
less of an attempt to deal with the credit creation theory. Instead,
each bank is unambiguously represented as a pure financial intermediary,

(40:17):
collecting deposits and lending out this money minus the reserve requirement.
The fractional reserve theory had become mainstream. Each small bank
is limited in its ability to expand its loans and investments.
It cannot land or invest more than it has received
from depositors. Meanwhile, bank deposit money is supplied by the

(40:38):
financial system in an abstract process that each individual bank
has little control over. The unambiguous fractional reserve theory thus
appears to have come about in the years after the
nineteen fifties. It can be described in figure one the
fractional reserve theory as represented in many textbooks. The graphic
illustrates that money multiplication process in a fractional reserve banking

(41:02):
system with a one per cent reserve requirement. It starts
with bank A receiving a one hundred dollars deposit. Bank
A keeps one dollar as a reserve one percent of
one hundred dollars and lends out the remaining ninety nine
dollars as loanable funds. This ninety nine dollars is deposited
into bank by bank, by then keeps ninety nine cents

(41:24):
one percent of ninety nine dollars as a reserve and
lends out ninety eight dollars in one cent. This process continues,
with bank C and subsequent banks each holding one percent
as a reserve and lending out the rest. The diagram
shows this step by step progression, with deposits, reserves, and
loanable funds decreasing slightly at each stage. Ultimately, the total

(41:47):
deposits across all banks some to ten thousand dollars, the
total reserve some to one hundred dollars, and the total
loanable funds some to nine thousand, nine hundred dollars. This
demonstrates how an initial deposit can lead to a much
larger total amount of money in the economy through the
multiplier effect, as described by Werner two thousand five. In

(42:08):
this scheme, funds move between the public, the banks, and
the central bank without any barriers. Each bank is a
financial intermediary, but an aggregate. Due to fractional reserve banking,
money is created multiplied in the banking system. Specifically, each
bank can only grant a loan if it has previously
received new reserves, of which a fraction will always be

(42:31):
deposited with the central bank. It will then only be
able to lend out as much as these excess reserves.
As is made clear in major textbooks. In the words
of Stiglitz nineteen ninety seven, it should be clear that
when there are many banks, no individual bank can create
multiple deposits. Individual banks may not even be aware of

(42:52):
the role they play in the process of multiple deposit creation.
All they see is that their deposits have increased and
therefore their area able to make more loans. In another
textbook on money and banking, in this example, a person
went into Bank one and deposited a one hundred thousand
dollars check drawn on another bank. That one hundred thousand

(43:13):
dollars became part of the reserves of Bank one. Because
that deposit immediately created excess reserves, further loans were possible
for Bank one. Bank one lent the excess reserves to
earn interest. A bank will not lend more than its
excess reserves because by law, it must hold a certain
amount of required reserves. The deposit of a check from

(43:36):
another bank does not, however, increase the total amounts of
deposits and money. Remember, though, that the deposit was a
check written on another bank. Therefore, the other bank suffered
a decline in its transactions, deposits, and its reserves. While
total assets and liabilities in Bank one have increased by
one hundred thousand dollars, they have decreased in the other

(43:58):
bank by one hundred thousand dollars. Thus, the total amount
of money and credit in the economy is unaffected by
the transfer of funds from one depository institution to another.
Each depository institution can create loans and deposits only to
the extent that it has excess reserves. The thing to
remember is that new reserves are not created when checks

(44:20):
written on one bank are deposited in another bank. The
federal reserve system, however, can create new reserves. The textbook
by Heffernan nineteen ninety six says, to summarize, all modern
banks act as intermediaries between borrowers and lenders, but they
may do so in a variety of different ways, from

(44:40):
the traditional function of taking deposits and lending a percentage
of these deposits to fee based financial services for the
bank which pools these surplus funds, there is an opportunity
for profit through fractional reserve lending, that is, lending out
money at an interest rate which is higher than what
the bank pays on the deposit, after allowing for the
riskiness of the loan and the cost of intermediation. While

(45:04):
the fractional reserve theory succeeded in attracting many followers, rendering
it an important and influential theory until this day, it
is not famous for its clarity. The problem of the
manner in which the banking system increases the total volume
of the circulating medium while at the same time the
lending power of the individual banks is severely limited has
proved to be one of the most baffling for writers

(45:25):
on banking theory. Several attempts were made to resolve this
within the fractional reserve theory of banking, such as that
by Saving nineteen seventy seven, who rendered the supply of
bank deposits a function of the behavior of the savers,
arguing that the money supply is endogenous. This effectively pushed
out the intermediary function from the individual bank level to

(45:47):
the economy level and helped ushering in the formulation of
the financial intermediation theory to which we now TURNE two
point three the financial intermediation theory. While the fractional reserve
theory of banking was influential from the nineteen thirties to
the nineteen sixties, Caines may have sown important seeds of
doubt already. In his treatise. Canes nineteen thirty makes use

(46:10):
of inverted commas in order to refer suggestively to the
creation of bank money a section title. This rhetorical device,
employed by the expert already hailed as the leading economist
in the world, implied disapproval as well as mockery of
the concept that banks could create money out of nothing.
The device was copied by many other writers after Caines,

(46:32):
who also emphasized the role of banks as financial intermediaries.
In Kaine's words, a banker is in possession of resources
which he can lend or invest equal to a large
proportion nearly ninety percent of the deposits standing to the
credit of his depositors. In so far as his deposits
are savings deposits, he is acting merely as an intermediary

(46:55):
for the transfer of loan capital. In so far as
they are cash deposits, he is acting both as a
provider of money for his depositors and also as a
provider of resources for his borrowing customers. Thus, the modern
banker performs two distinct sets of services. He supplies a
substitute for state money by acting as a clearinghouse and

(47:15):
transferring current payments backwards and forwards between his different customers
by means of book entries on the credit and debit sides.
But he is also acting as a middleman in respect
of a particular type of lending, receiving deposits from the public,
which he employs in purchasing securities or in making loans
to industry in trade, mainly to meet demands for working capital.

(47:36):
This duality of function is the clue to many difficulties
in the modern theory of money and credit, and the
source of some serious confusions of thought. The canes of
the treatise seems to say that the two functions of
banks are to either act as financial intermediary, fulfilling the
utility banking function of settling trades, or to act as
financial intermediary, gathering deposits and lending. The majority of these

(47:58):
out no money creation at all involved, certainly not on
the individual bank level. Kain's most influential opus General Theory
Kines nineteen thirty six, quickly eclipsed his earlier treatise on
Money in terms of its influence on public debate. In
the General Theory, Kaines did not place any emphasis on banks,

(48:20):
which he now argued were financial intermediaries that needed to
acquire deposits before they could lend. The notion that the
creation of credit by the banking system allows investment to
take place to which no genuine saving corresponds can only
be the result of isolating one of the consequences of
the increased bank credit to the exclusion of the others.

(48:40):
It is impossible that the intention of the entrepreneur who
has borrowed in order to increase investment can become effective,
except in substitution for investment by other entrepreneurs, which would
have occurred otherwise at a faster rate than the public
decide to increase their savings. No one can be compelled
to own the additional money corresponding to the new bank credit,
unless as he deliberately prefers to hold more money rather

(49:02):
than some other form of wealth. Thus, the old fashioned
view that saving always involves investment, though incomplete and misleading,
is formally sounder than the new fangled view that there
can be saving without investment or investment without genuine saving.
Schumpeter nineteen fifty four commented on this shift in Kaine's
view that deposit creating bank loan and its role in

(49:25):
the financing of investment without any previous saving up of
the sums, thus lent have practically disappeared in the analytic
schema of the general theory, where it is again the
saving public that holds the scene. Orthodox Kinesianism has in
fact reverted to the old view. Whether this spell's progress
or retrogression, every economist must decide for himself. The early

(49:47):
postwar period saw unprecedented influence of Kaine's General Theory, and
a Kinesian school of thought that managed to ignore Kaine's
earlier writings on bank credit creation became dominant in academia.
Given that a fo former major proponent of both the
credit creation and the fractional reserve theories of banking had
shifted his stance to the new financial intermediation theory, it

(50:08):
is not surprising that others would follow A highly influential
challenge to the fractional reserve theory of banking was staged
by Gurley and Shaw nineteen fifty five. Gurley and Shaw
nineteen sixty. They rejected the view that banks stand apart
in their ability to create loanable funds out of hand,
while other intermediaries, in contrast, are busy with the modest

(50:29):
brokerage function of transmitting loanable funds that are somehow generated elsewhere.
Beyond the usual rhetorical devices to denigrate the alternative theories,
Gurley and Shaw's actual argument was that banks should not
be singled out as being special, since the bank's financial
intermediation function is identical to that of other financial intermediaries.

(50:49):
There are many similarities between the monetary system and non
monetary intermediaries, and the similarities are more important than the differences.
Both types of financial institution create financial claims, and both
may engage in multiple creation of their particular liabilities in
relation to any one class of asset that they hold.
Banks and the banking system we are told, like other

(51:12):
financial intermediaries, need to first gather deposits and then are
able to lend these out. In this view, any remaining
special role of banks is due to outmoded regulations which
treat banks differently. Therefore, they argue the Federal Reserve should
extend its banking supervision to the growing set of non
bank financial intermediaries, thus treating them equally to banks. Initial

(51:36):
challenges by proponents of the fractional reserve theory of banking
see gutten Tag and Lindsay nineteen sixty eight were swept
away during the nineteen sixties when James Tobin, a new
rising star in economics, took a clear stand to proclaim
another new view of banking, formulating the modern version of
the financial intermediation theory of banking Tobin nineteen sixty three

(51:59):
stay ending atop the wreckage in nineteen sixty three to
set forth the new view of commercial banking, stand squarely
with Girly and Shaw against the traditional view. Like kanes
alhadref and others before him, Tobin only referred to bank
credit creation in inverted commas and used rhetorical devices to
ridicule the idea that banks individually or collectively could create

(52:21):
money and credit. Tobin nineteen sixty three argued, neither individually
nor collectively do commercial banks possess a widow's cruise. The
distinction between commercial banks and other financial intermediaries has been
too sharply drawn. The differences are of degree, not of kind.
In particular, the differences which do exist have little intrinsically

(52:45):
to do with the monetary nature of bank liabilities. The
differences are more importantly related to the special reserve requirements
and interest rate ceilings to which banks are subject. Any
other financial industry subject to the same kind of regulations
would behave in much the same way. Banks only seem
to be different from others because regulators erroneously chose to

(53:07):
single them out for special regulation. In Tobin's view, commercial
banks are different because they are controlled, and not the
other way around. Gutten Tag and Lindsay, nineteen sixty eight.
Tobin and Brainerd's nineteen sixty three portfolio model made no
distinction between banks and non bank financial intermediaries, indeed ignored

(53:28):
the role of banks altogether, and contributed much towards the
modern mainstream view of economics models without banks. Branson nineteen
sixty eight further developed Tobin's new approach, which was popular
in the leading journals gutten Tag and Lindsay nineteen sixty eight,
wrote in the Journal of Political Economy that despite the
challenge by Gurley and Shaw nineteen fifty five, the uniqueness issue,

(53:53):
on the other hand, remains unsettled. Banks, they argued, are
different in their role and impact from them non bank
financial intermediaries. Since commercial banks have a greater capacity for
varying the aggregate volume of credit than other financial intermediaries.
These points provide a rationale for special controls on commercial
banks that goes beyond the need to prevent financial panic.

(54:16):
It is the rationale that has been sought by defenders
of the traditional view that commercial banks are unique ever
since the Girly Shaw challenge to this view undaunted. Tobin
nineteen sixty nine restates his view in an article establishing
his portfolio balance approach to financial markets, which argues that
financial markets are complex webs of assets and prices, leaving

(54:38):
banks as one of many types of intermediaries without any
special role. This was the first article in the first
edition of a new journal, the Journal of Money, Credit
and Banking. While its name may suggest openness towards the
various theories of banking, in practice, it has only published
articles that did not support the credit creation theory and
were mainly in line with the financial intermediation theory. This

(55:02):
is also true for most other journals classified as leading
journals in economics, for instance, using the four rated journals
from the UK Association of Business Schools list in Economics. Henceforth,
the portfolio balance approach, which treated all financial institutions as
mere portfolio managers, was to hold sway. It helped the

(55:23):
financial intermediation theory become the dominant creed among economists worldwide.
Modern proponents of the ubiquitous financial intermediation theory include, among others,
Klein nineteen seventy one, Monty nineteen seventy two, Sealy and
Lindley nineteen seventy seven, Diamond and Divveg nineteen eighty three,

(55:44):
Diamond nineteen eighty four, Diamond nineteen ninety one, Diamond two
thousand seven, spring Eatwell, Millgate and Newman nineteen eighty nine,
Gordon and Panacci nineteen ninety Bensyvanga and Smith nineteen ninety one,
Rannank and Girdler nineteen ninety five, Rajan nineteen ninety eight,

(56:04):
Myers and Rajan nineteen ninety eight, Allan and Gale two thousand,
Allan and Gayale two thousand four, A. Allen and Gaale
two thousand four, b Allen in Santa Mario two thousand one,
Diamond and Rajan two thousand one, Cuship at All two
thousand two, Hoshi and Cuship two thousand four, Matthews and

(56:26):
Thompson two thousand five, Cassu and Gerard one two thousand six,
De watrupont at All two thousand ten, Girdler and Kiyotaki
twenty eleven, and Stein two thousand fourteen. There are many more.
It is impossible to draw up a conclusive list since
the vast majority of articles published in leading economics and

(56:47):
finance journals in the last thirty to forty years is
based on the financial intermediation theory as premise. Quoting only
a few examples. Klein nineteen seventy one, Monty nineteen seventy two,
later to become EU Commissioner and Prime Minister of Italy
and others model banks as financial intermediaries, gathering deposits and

(57:07):
lending these funds out. The bank has two primary sources
of funds, the equity originally invested in the firm and
borrowed funds secured through the issuance of various types of deposits.
It will be shown how the bank determines the prices
it will pay for various types of deposits, and how
these prices, in conjunction with the deposit supply functions the

(57:27):
bank confronts, determine the scale and composition of the bank's
deposit liabilities the bank will assume. Diamond and Divviig nineteen
eighty three are cited as the seminal work on banking,
and they argue that illiquidity of assets provides the rationale
both for the existence of banks and for their vulnerability
to runs, but in actual fact, their theory makes no

(57:49):
distinction between banks and non banks. They therefore are unable
to explain why we have heard of bank runs but
not of insurance runs or finance company runs, although the
latter also hold a liquid assets and give out loans.
Diamond and Divvig fail to identify what could render banks special,
since they assume that they are not. Other theories of

(58:10):
banks as financial intermediaries are presented by Mayor nineteen eighty
eight and Helwig nineteen seventy seven, Helwig nineteen ninety one
Helwig two thousand, who also believe that banks are merely
financial intermediaries. The analysis uses the original model of Diamond
nineteen eighty four of financial contracting with intermediation as delegated monitoring.

(58:34):
Monitoring is assumed to be too expensive to be used
by the many households required to finance a firm or
an intermediary. However, direct finance of firms based on non
pecuniary penalties may be dominated by intermediated finance, with monitoring
of firms by an intermediary, who in turn obtains funds
from households through contracts involving non pecuniary penalties. Banking expert

(58:56):
Hefernin nineteen ninety six states the existence of the traditional bank,
which intermediates between borrower and lender and which offers a
payment service to its customers, fits in well with the
coast theory or a leading textbook on international economics and
finance by Krugman and Obstfeld two thousand, banks use depositors'

(59:18):
funds to make loans and to purchase other assets. A
widely used reference work on banking and money, the new
Palgrave Money, contains a number of contributions by leading monetary
economists and banking experts in it. Boltensberger nineteen eighty nine
clearly supports the financial intermediation theory. The role of credit

(59:39):
as such must be clearly separated from the economic role
of credit institutions such as banks playing the role of
specialized intermediaries in the credit market by buying and simultaneously
selling credit instruments of a different type and quality. Since
the ultimate borrowers and lenders can in principle do business
with each other directly without the help of se such

(01:00:00):
in intermediary the function of these middlemen must be viewed
as separate from that of credit as such. Two main
functions of institutions of this kind can be distinguished. The
first is the function of risk consolidation and transformation. The
second major function of these institutions is that of a
broker in the credit markets. As such, they specialize in

(01:00:21):
producing intertemporal exchange transactions and owe their existence to their
ability to bring together creditors and debtors at lower costs
than the latter can achieve in direct transactions themselves. Indeed,
almost all authors in this reference book refer to banks
as mere financial intermediaries. Even good Heart nineteen eighty nine.
Intermediation generally refers to the interposition of a financial institution

(01:00:46):
in the process of transferring funds between ultimate savers and
ultimate borrowers. Disintermediation is then said to occur when some intervention,
usually by government agencies for the purpose of controlling or
regulating the growth of financial intermediaries, lessens their advantages in
the provision of financial services and drives financial transfers and

(01:01:06):
business into other channels. An example of this is to
be found when onerous reserve requirements on banks lead them
to raise the margin, the spread between deposit and lending
rates in order to maintain their profitability, so much that
the more credit worthy borrowers are induced to raise short
term funds directly from savers. For example, in the commercial

(01:01:26):
paper market, Myers and Rajan nineteen ninety eight state we
model the intermediary as a bank that borrows from a
number of individual investors for its own core business and
to lend on to a project. Even though the bank
can extract more from the ultimate borrower, the bank has
to finance these loans by borrowing from individual investors. Allen

(01:01:48):
and Santa Mario two thousand one, in their paper entitled
what do Financial Intermediaries Do? State in this paper we
use these observations as a starting point for considering what
it is is that financial intermediaries do. At center, of course,
financial systems perform the function of reallocating the resources of
economic units with surplus funds savers to economic units with

(01:02:12):
funding needs borrowers. Cushship two thousand two also believes that
banks are pure financial intermediaries, not materially distinguishable from other
non bank financial institutions. Stein twenty fourteen states, albeit with
some hesitation, at least in some cases. It seems that

(01:02:33):
a bank's size is determined by its deposit franchise, and
that taking these deposits as given its problem then becomes
one of how best to invest them. Overall. Our synthesis
of these stylized facts is that banks are in the
business of taking deposits and investing these deposits in fixed
income assets that have certain well defined risk and liquidity attributes,

(01:02:53):
but which can be either loans or securities. The financial
intermediation theory includes the credit view in ds macroeconomics, proposing
a bank lending channel of monetary transmission Burnank and Blinder
nineteen eighty nine, Burnanc and Girdler, nineteen ninety five, as
well as the neoclassical and new classical macroeconomic models if

(01:03:14):
they consider banks at all. To these and most contemporary
authors in economics and finance, banks are financial intermediaries like
other firms in the financial sector, which focus on the
transformation of liabilities with particular features into assets with other
features e g. With respect to maturity, liquidity, and quantity
slash size, or which focus on monitoring others shared nineteen

(01:03:38):
eighty nine, another adherent of the financial intermediation theory of banking,
but do not create credit individually or collectively. This is
true for many post Kynesians, who argue that the money
supply is determined by the demand for money. It is
also true for popular descriptions, such as that by Coup
and Fujida nineteen ninety seven, who argue that banks are

(01:04:00):
merely financial intermediaries. But those financial institutions that are counterparties
of the Bank of Japan obtain their funding primarily from
the money that depositors have deposited with them. This money
they cannot pass on for consumption and capital investment because
they have to lend it at interest to earn money,
in other words, for this money to support the economy.

(01:04:22):
These financial institutions must lend it to firms and individuals.
Those borrowers must then use it to buy assets such
as machinery or housing or services. A recent paper by Allen,
Karletti and Gale twenty fourteen introduces money, albeit only cash
created by the central bank, while banks are mere financial

(01:04:42):
intermediaries that cannot create money or credit. As a result,
the leading forecasting models used by policy makers also do
not include banks. Bank of England twenty fourteen. A. Even
the original meaning of credit creation seems forgotten by the
modern literature. Burnank nineteen ninety three uses the expression credit

(01:05:03):
creation much in his article, but explains that this concept
is defined as the process by which saving is channeled
to alternative uses i e. Financial intermediation of savers deposits
into loans. This fortuitous conjunction of events and ideas has
contributed to an enhanced appreciation of the role of credit
in the macroeconomy by most economists and policy makers. The

(01:05:26):
purpose of this paper is to review and interpret some
recent developments in our understanding of the macroeconomic role of credit, or,
more accurately, of the credit creation process. By credit creation process,
I mean the process by which in exchange for paper claims.
The savings of specific individuals or firms are made available
for the use of other individuals or firms, for example,

(01:05:48):
to make capital investments or simply to consume. Note that
I am drawing a strong distinction between credit creation, which
is the process by which saving is channel to alternative uses,
and the act of saving it. In my broad conception
of the credit creation process, I include most of the
value added of the financial industry, including the information gathering, screening,

(01:06:10):
and monitoring activities required to make sound loans or investments,
as well as much of the risk sharing, maturity transformation,
and liquidity provision services that attract savers and thus support
the basic lending and investment functions. I also want to
include in my definition of the credit creation process activities
undertaken by potential borrowers to transmit information about themselves to lenders.

(01:06:32):
For example, for firms, these activities include provision of data
to the public, internal or external auditing, capital structure decisions,
and some aspects of corporate governance. The efficiency of the
credit creation process is reflected both in its ability to
minimize the direct costs of extending credit. For example, the
aggregate wage bill of the financial industry, and in the

(01:06:55):
degree to which it is able to channel in economy
savings into the most productive potential uses. The presumption of
traditional macroeconomic analysis is that this credit creation process through
which funds are transferred from ultimate savers to borrowers, works
reasonably smoothly, and therefore can usually be ignored. As Bernank
points out, those works that assume such a financial intermediation

(01:07:18):
role for banks will therefore often ignore banks entirely. They
cannot be particularly important or relevant in the economy. Many
went as far as to leave out any kind of money.
There are no monetary aggregates in Kyotaki and More nineteen
ninety seven, Woodford, two thousand three. The most widely used
textbook in advanced master level economics at leading British universities

(01:07:40):
in twenty ten was Romer two thousand six. On page three,
Romer tells us incorporating money in models of economic growth
would only obscure the analysis sec. Two point four conclusion
of the literature review. Since the nineteen sixties, it has
become the conventional view not to cant consitter banks as

(01:08:01):
unique and able to create money, but instead as mere
financial intermediaries like other financial firms in line with the
financial intermediation theory of banking. Banks have thus been dropped
from economics models, and finance models have not suggested that
bank action has significant macroeconomic effects. The questions of where
money comes from and how the money supply is created

(01:08:23):
and allocated have remained unaddressed. The literature review has identified
a gradual progression of views from the credit creation theory
to the fractional reserve theory to the present day ubiquitous
financial intermediation theory. The development has not been entirely smooth.
Several influential writers have either changed their views on occasion
several times or have shifted between the theories. Kines, as

(01:08:47):
an influential economist, did little to enhance clarity in this debate,
as it is possible to cite him in support of
each of the three hypotheses through which he seems to
have moved sequentially. Some institutions, such as the Bank of England,
manage to issue statements in support of all three theories.
We conclude from the literature survey that all three theories

(01:09:08):
of banking have been well represented in the course of
the twentieth century by leading figures of the day. However,
the conclusion by Sir Josiah Stamp nineteen twenty seven, a
director at the Bank of England, still seems to hold
to day, namely that there is a fair state of
muddlement on the apparently simple question can the banks create credit?
And if so, how and how much? Despite a century

(01:09:32):
or so of theorizing on the matter, there has been
little progress in establishing facts unambiguously. Thus today the conclusion
of nineteen sixty eight applies, namely that the issue cannot
be considered as settled. It is possible that the pendulum
is about to swing away from the financial intermediation theory
to one of the other two. But how can we

(01:09:53):
avoid that history will merely repeat itself and the profession
will spend another century locked into a debate without firm conclusion.
How can the issue be settled and the muddlement cleared up.
One reason for this state of muddlement is likely to
be the methodology dominant in twentieth century economics, namely the
hypothetico deductive method. Unproven axioms are posed and unrealistic assumptions

(01:10:17):
added to build a theoretical model. This can be done
for all three theories, and we would be none the
wiser about which of them actually applied. How can the
issue be settled? The only way the facts can be
established is to leave the world of deductive theoretical models
and consider empirical reality as the arbiter of truth in
line with the inductive methodology. In other words, it is

(01:10:41):
to empirical evidence we must turn to settle the issue
free the empirical test. The simplest possible test design is
to examine a bank's internal accounting during the process of
granting a bank loan. When all the necessary bank credit
procedures have been undertaken, starting from know your Customer and
anti money laundering regulations to credit analysis risk raating to

(01:11:05):
the negotiation of the details of the loan contract and
signatures are exchanged. On the bank loan, the borrower's current
account will be credited with the amount of the loan.
The key question is whether, as a prerequisite of this
accounting operation of booking the borrower's loan principle into their
bank account, the bank actually withdraws this amount from another account,
resulting in a reduction of equal value in the balance

(01:11:26):
of another entity, either drawing down reserves as the fractional
reserve theory maintains, or other funds as the financial intermediation
theory maintains. Should it be found that the bank is
able to credit the borrower's account with the loan principle
without having withdrawn money from any other internal or external account,
or without transferring the money from any other source internally

(01:11:47):
or externally, this would constitute prima facie evidence that the
bank was able to create the loan principle out of nothing.
In that case, the credit creation theory would be supported,
and the theory that the individual bank ac acts as
an intermediary that needs to obtain savings or funds first
before being able to extend credit, whether in conformity with
the fractional reserve theory or the financial intermediation theory, would

(01:12:10):
be rejected. Three point one expected results with a bank
loan of two hundred thousand euros drawn by the researcher
from a bank, The following changes in the lending bank's
accounting entries are expected a priori according to each theory,
a bank credit accounting according to the credit creation theory.

(01:12:31):
According to this theory, banks behave very differently from financial
intermediaries such as stockbrokers, since they do not separate customer
funds from owned funds. Money deposited with a bank becomes
the legal property of the bank, and a depositor is
actually a lender to the bank, ranking among the general creditors.
When extending bank credit, banks create an imaginary deposit by

(01:12:54):
recording the loan amount in the borrower's account, although no
new deposit has taken place. Credit creation out of nothing
the balance sheet lengthens cash. Central bank reserves or balances
with other banks are not immediately needed, as reserve and
capital requirements only need to be met at particular measurement intervals.
The account changes are shown in Table I account changes.

(01:13:17):
Due to bank loan credit creation theory, the table presents
a simplified balance sheet with two main columns, assets and liabilities.
Under assets, it lists loans and investments with a value
of plus pound two hundred and a total of plus
pound two hundred. Under liabilities, it lists deposits borrowers a

(01:13:39):
C with a value of plus pound two hundred and
a total of plus pound two hundred. This indicates that
the total value of loans and investments matches the total
value of deposits, balancing the sheet at two hundred pounds
b Bank credit accounting according to the fractional reserve theory.
The distinguishing feeature of this theory is that each individual

(01:14:02):
bank cannot create credit out of nothing. The bank is
a financial intermediary, indistinguishable from other financial intermediaries such as
stockbrokers and securities firms. However, banks are said to be
different in one respect, namely the regulatory treatment. Regulators have
placed onerous rules concerning reserves that have to be held
with the central bank only on banks, not other financial intermediaries.

(01:14:26):
A bank can only lend money when it has previously
received the same amount in excess reserves from another bank
whose own reserve balances will have declined, or from the
central bank Table two. A bank will not lend more
than its excess reserves because by law, it must hold
a certain amount of required reserves. Each depository institution can

(01:14:47):
create loans and deposits only to the extent that it
has excess reserves. Table two. Account change is due to
bank loan fractional reserve theory. ZO two illustrates a bank's
balance sheet in two steps related to a bank loan process.
In step one, precondition for the bank loan, the assets

(01:15:09):
column lists excess reserves at plus pound two hundred and
total reserves at plus pound two hundred. The liabilities column
lists deposits at plus pound two hundred total at plus
pound two hundred, showing that the excess reserves are matched
by deposits. In step two bank loan, the assets column

(01:15:30):
shows excess reserves decreasing by minus two hundred pounds, while
loans and investments increase by plus pound two hundred, resulting
in a total of zero pounds. The liability's column has
no changes, with total remaining at zero pounds. This reflects
the process where the bank converts excess reserves into a loan,

(01:15:51):
balancing the assets without altering liabilities. Following the exposition in
Miller and van Houss nineteen ninety three, Ellan's sheet evolution
in case of a two hundred thousand euro loan is
as shown in Table two. In other words, for the
bank to be able to make a loan, it first
has to check its excess reserves. As this is, according

(01:16:12):
to this theory, a strictly binding requirement and limitation, as
well as its distinguishing feature. The bank cannot at any
moment lend more money than its excess reserves, and it
will have to draw down the reserve balance to lend. Thus,
as noted, another distinguishing feature is that the balance sheet
expansion is driven by the prior increase in a deposit

(01:16:33):
that boosted excess reserves, not by the granting of a loan.
It needs to be verified when the empirical test of
bank lending is implemented, whether the bank first confirmed the
precise amount of its available excess reserves before entering into
the loan contract or paying out the loan funds to
the customer so as not to exceed that figure. If
the bank is found not to have checked or not

(01:16:54):
to have drawn down its reserve balances, then this constitutes
a rejection of the fractional reserve theory see bank credit
accounting according to the financial intermediation theory. According to this theory,
banks are, as far as payments and accounts are concerned,
not different from non bank financial institutions. The reserve requirement

(01:17:15):
is not an issue, a claim supported by the empirical
observation that reserve requirements have been abolished in a number
of major economies such as the UK and Sweden many
years ago. However, UK financial intermediaries are required by FSA
SLA FAA Administered Client Money rules to hold deposits in
custody for customers, a form of warehousing. The deposits legally

(01:17:37):
being bailments. Client funds of financial intermediaries such as securities firms, stockbrokers,
and the like, are therefore still owned by the depositors
and thus kept separately from the financial institution's own funds,
so that customer deposits are not shown on the balance
sheet as liabilities. If banks are merely financial intermediaries indistinguishable

(01:17:58):
from other intermediaries, then all bank funds are central bank
money that can be held in reserve at the central
bank or deposited with other banks. The balance sheet implications
are shown below in Table three account changes due to
bank loan fin intermediation theory. Table three shows a bank's
balance sheet with changes in assets. The assets column lists

(01:18:22):
excess reserves decreasing by minus two hundred pounds, and loans
and investments increasing by plus pound two hundred, resulting in
a total of zero pounds. The liability's column has no changes,
with total remaining at zero pounds. This indicates that the
reduction in excess reserves is offset by an equal increase

(01:18:43):
in loans and investments, maintaining a balanced sheet. According to
this theory, the bank balance sheet does not lengthen as
a result of the bank loan. The funds for the
loan are drawn from the bank's reserve account at the
Central Bank three point two A live empirical ten. The
design of the empirical test takes the form of a

(01:19:04):
researcher entering into a live loan contract with the bank
and the bank extending alone while its relevant internal accounting
is disclosed. Several banks in the UK and Germany were
approached and asked to cooperate in an academic study of
bank loan operations. The large banks declined to cooperate. The
reason given was usually twofold, the required disclosure of internal

(01:19:27):
accounting data and procedures would breach their confidentiality or IT
security rules. Secondly, the transactions volumes of the banks were
so large that the planned test would be very difficult
to conduct when borrowing sensibly sized amounts of money that
would not clash with the bank's internal risk management rules.
In that case, any single transaction would not be easy

(01:19:48):
to isolate within the bank's IT systems. Despite various discussions
with a number of banks. In the end, the banks
declined on the basis of the above reasons and additionally
that the costs of operating their systems and can controlling
for any potential other transactions would be prohibitive. It was
therefore decided to approach smaller banks, of which there are
many in Germany. There are approximately seventeen hundred local, mostly

(01:20:11):
small banks in Germany. Each owns a full banking license
and engages in universal banking, offering all major banking services,
including stock trading and currencies to the general public. A
local bank with a balance sheet of approximately three billion
euros was approached, as well as a bank with a
balance sheet of about seven hundred million euros. Both declined

(01:20:34):
on the same grounds as the larger banks, but one
suggested that a much smaller bank might be able to oblige,
pointing out the advantage that there would be fewer transactions
booked during the day, allowing a clearer identification of the
empirical test transaction. At the same time, the empirical information
value would not diminish with bank size, since all banks
in the EU conformed to identical European bank regulations. Thus

(01:20:59):
an introduction to Raphizenbank Wildenburg EG, located in a small
town in the district of Lower Bavaria, was made. The
bank is a cooperative bank within the Raephisen and Cooperative
Banking Association of banks, with eight full time staff. The
two joint directors, mister Michael Betsen Bickler and mister Marco Rebel,
both agreed to the empirical examination and also to share

(01:21:22):
all available internal accounting records and documentation on their procedures.
A written agreement was signed that confirmed that the plan
transactions would be part of a scientific empirical test and
the researcher would not abscond with the funds when they
would be transferred to his personal account and undertakes to
immediately repay the loan upon completion of the test. Supplementary

(01:21:42):
material one in online Appendix three. One limitation on the
accounting records, which is common to most banks is that
they are outsourcing the IT to a specialized bank IT
company which maintains its own rules concerning data protection and confidentiality.
The IT firm serves the majority of the one thousand,
one hundred cooperative banks in Germany using the same software

(01:22:04):
and internal systems in accounting rules, ensuring that the test
is representative of more than fifteen per cent of bank
deposits in Germany. It was agreed that the researcher would
personally borrow two hundred thousand euros from the bank. The
transaction was undertaken on August seventh, twenty thirteen, in the
offices of the bank in Wildenburg in Bavaria. Apart from

(01:22:26):
the two sole directors, also the head and sole staff
of the credit department, mister Ludwig Keel, was present. The
directors were bystanders, not engaging in any action. Mister Keel
was the only bank representative involved in processing the loan,
from the start of the customer documentation to the signing
of the loan contract and finally paying out the loan

(01:22:48):
into the borrower's account. The entire transaction, including the manual
entries made by mister Keel, was filmed. The screens of
the bank's internal IT terminal were also photographed. Moreover, a
team from the BBC was present and filmed the central
part of the empirical bank credit experiment reporter Alistair Fi

(01:23:08):
and a cameraman. The bank disclosed their standard internal credit
procedure The sequence of the key steps is shown in
Appendix one. As can be seen, the last two steps
are the signing of the credit documents by the borrower
the researcher and finally the payment of the loan at
the value date the loan conditions were agreed, the researcher

(01:23:31):
would borrow two hundred thousand euros from the bank at
the prime rate, the interest rate for the best customer
in the event the bank waighed the actual interest proceeds
in support of the scientific research project. When the bank
loan contract was signed by both the bank and the
borrower on August seventh, twenty thirteen, the loan amount was
immediately credited to the borrower's account with the bank, as

(01:23:54):
agreed in the loan contract. Supplementary Material two in online
Appendix two shows the original borrowers accounts and balances with
Raephaisenbank Wildenberg. The key information from the account's summary table
is repeated here in English in Table four. The empirical
Researcher's new bank account. Table four details the bank account

(01:24:15):
of Richard Werner at Raephaisenbank Wildenburg EG, dated August seventh,
two thousand thirteen. It includes two sections A current account
and a loan account. The current account with account number
four four six three six is a fee free account
in Euro, holding a balance of two hundred thousand euros
with a total of two hundred thousand euros. The loan

(01:24:38):
account with account number two zero zero four four six
three six is categorized as other private financing in Euro,
showing a balance of minus two hundred thousand point zero
zero euros with a total of minus two hundred thousand
point zero zero euros. This reflects a net balance of
zero between the account and loan. The bank all al

(01:25:00):
So issued the following account's overview, which is a standard
T account of the transaction from the borrower's perspective. Table five.
Table five The empirical researcher's new bank account Balances. Table
five provides an overview of the bank account balances for
Richard Werner at Rapheisenbank Wildeenburg EG. It includes two accounts,

(01:25:22):
a current account and a loan account, both in Euro.
The current account has a credit of two hundred thousand euros,
no liabilities, a balance of two hundred thousand euros and
one contract. The loan account has a credit of zero
euros liabilities of two hundred thousand euros, a balance of
minus two hundred thousand point zero zero euros, and one contract.

(01:25:46):
The bank some total shows a credit of two hundred
thousand euros, liabilities of two hundred thousand euros, a net
balance of zero euros, and a total of two contracts.
The borrower confirmed that his new current account with the
bank now showed a balance of two hundred thousand euros
that was available for spending. An extension of the experiment
to be reported on separately used the balance the following

(01:26:08):
day for a particular transaction outside the banking institution, transferring
the funds to another account of the researcher held with
another bank. This transfer was duly completed, demonstrating that the
funds could be used for actual transactions. We are now
moving to the empirical test of the three banking theories.
The critical question is where did Rapheizenbank wildeenburg Eg obtain

(01:26:31):
the funds from that the borrower researcher was credited with
and duly used and transferred out of the bank The
following day, when the researcher inquired about the bank's reserve
holdings in line with the fractional reserve theory of banking.
Director Marco Rebel explained that the bank maintained its reserves
with the Central Organization of Cooperative Banks, which in turn
maintained an account with the Central Bank. These reserves amounted

(01:26:55):
to a fixed amount of three hundred and fifty thousand
euros that did not change during the OBSOT period. Concerning
the bank credit procedure, the researcher attempted to verify the
source of the funds that were about to be lent. Firstly,
the researcher confirmed that the only three bank officers involved
in this test and bank transaction were present throughout whereby

(01:27:16):
two the directors only watched and neither accessed any computer
terminal nor transmitted any instructions whatsoever. The account's manager, head
of the credit department, mister Keel, was the only operator
involved in implementing, booking and paying out the loan. His
actions were filmed. It was noted and confirmed that none

(01:27:37):
of the bank's staff present engaged in any additional activity
such as ascertaining the available deposits or funds within the
bank or giving instructions to transfer funds from various sources
to the borrower's account, for instance, by contacting the bank
internal treasury desk and contacting bank external interbank funding sources.
Neither were instructions given to increase, draw down or borrow

(01:27:58):
reserves from the Central Bank, the Central Cooperative Bank, or
indeed any other bank or entity. In other words, it
was apparent that upon the signing of the loan contract
by both parties, the funds were credited to the borrower's
account immediately, without any other activity of checking or giving
instructions to transfer funds. There were no delays or deliberations

(01:28:19):
or other bookings. The moment the loan was implemented, the
borrower saw his current account balance increase by the loan amount.
The overall credit transaction from start to finish until funds
were available in the borrower's account took about thirty five
minutes and was clearly slowed down by the filming and
frequent questions by the researcher. Secondly, the researcher asked the

(01:28:42):
three bank staff present whether they had, either before or
after signing the loan contract and before crediting the borrower's
account with the full loan amount, inquired of any other
parties internally or externally checked the bank's available deposit balances,
or made any bookings or transfers of any kind in
connection to this loan contract. They all confirmed that they

(01:29:02):
did not engage in any such activity. They confirmed that
upon signing the loan contract, the borrower's account was credited
immediately without any such steps. Thirdly, the researcher obtained the
internal daily account statements from the bank. These are produced
only once a day after close of business. Since the

(01:29:23):
bank is small, it was hoped that it would be
possible to identify the impact of the two hundred thousand
euro loan transaction and distinguish the accounting pattern corresponding to
one of the three banking hypotheses. Four results. Supplementary material
three in online Appendix three shows the scan of the
bank's balance sheet at the end of August sixth, twenty thirteen,

(01:29:45):
the day before the transaction of the empirical test was undertaken.
Supplementary Material four in online Appendix three shows the daily
balance of the following day. In Table six, the key
asset positions are summarized in account names true translated for
the end of the day prior to the lone experiment
and for the end of the day on which the
researcher had borrowed the money. Table six presents the daily

(01:30:08):
accounts assets of Rapheisenbank Wildenburg EG, comparing balances at twenty
two forty six h on August sixth two thousand thirteen
and twenty two fifty six h on August seventh, two
thousand thirteen in euro The table lists various asset categories
with their balances and differences. One cash increased from one

(01:30:30):
hundred eighty one thousand, seven hundred and three euros and
three cents to three hundred forty thousand, thirty two euros
and eighty nine cents, a difference of one hundred and
fifty eight thousand, three hundred and twenty nine euros and
eighty six cents. Two Bills of exchange had no balance
or change not applicable. Three Claims on financial institutions decreased

(01:30:51):
from five million, two hundred ninety eight thousand, seven hundred
thirteen euros and seventy six cents to five million, seventy
nine thousand, seven hundred and nine euros and twenty one cents,
a difference of minus two hundred nineteen thousand and four
euros and fifty five cents. Four claims on customers rose
from twenty three million, seven hundred and twelve thousand, five

(01:31:12):
hundred and fifty eight euros and thirteen cents to twenty
three million, nine hundred and forty seven thousand, seven hundred
and twenty nine euros and ninety two cents, a difference
of two hundred and thirty five thousand, one hundred and
seventy one euros and seventy nine cents with subcategories. Maturing
daily increased from nine hundred and thirty two thousand, six
hundred and ninety five euros and forty four cents to

(01:31:34):
nine hundred and sixty seven thousand, seven hundred and sixty
seven euros and thirty two cents, a difference of thirty
five thousand and seventy one euros and eighty eight cents.
Maturity under four years increased from one million, six hundred
and eighty nine thousand, six hundred nineteen euros and ninety
seven cents to one million, eight hundred and eighty nine thousand,
six hundred and nineteen euros and ninety seven cents. A

(01:31:56):
difference of two hundred thousand euros four years or longer
increased from twenty one million ninety thousand, two hundred and
forty two euros and seventy two cents to twenty one million,
ninety thousand, three hundred and forty two euros and seventy
two cents, a difference of one hundred euros. Five bonds,
bills and debt instruments remained steady at nineteen million, one

(01:32:19):
hundred and seventy eight thousand, sixty five euros. Six stocks
and shares had no balance or change not applicable. Seven
stakeholdings stayed at three hundred ninety seven thousand, seven hundred
and sixty eight euros and sixty eight cents. Eight stakes
and related firms had no balance or change not applicable.

(01:32:41):
Nine trust assets remained at five thousand, two hundred and
sixty two euros and sixty nine cents. Ten compensation claims
on the public sector had no balance or change not applicable.
Eleven immaterial assets stayed at one hundred and two euros.
Twelve fixed assets remained at two hundred and twenty one thousand,

(01:33:03):
five hundred and forty nine euros and forty six cents.
Thirteen called but not deployed capital had no balance or
change not applicable. Fourteen Other assets increased from seven hundred
and seven thousand, five hundred and sixty nine euros and
twenty six cents to seven hundred eleven thousand, two hundred
eighty eight euros and sixty four cents, a difference of

(01:33:25):
three thousand, seven hundred nineteen euros and thirty eight cents. Fifteen.
Balancing items stayed at two thousand, eight hundred and forty
four euros and thirty two cents. Sixteen. The sum of
assets rose from forty nine million, seven hundred and six thousand,
one hundred thirty six euros and thirty three cents to
forty nine million, eight hundred eighty four thousand, three hundred

(01:33:47):
fifty two euros and eighty one cents, a total difference
of one hundred seventy eight thousand, two hundred and sixteen
euros and forty eight cents. Table seven shows the key
liability positions for the same periods. Table seven presents the
daily accounts liabilities of Rapheizenbank Wildenburg e G, comparing balances
at twenty two forty six h on August sixth two

(01:34:09):
thousand thirteen and twenty two fifty six h on August seventh,
two thousand thirteen in euro The table lists various liability
categories with their balances and differences. One, Claims by financial
institutions increased from five million, six hundred twenty one thousand,
four hundred fifty six euros and sixty cents to five million,

(01:34:31):
six hundred and twenty one thousand, eight hundred seventy nine
euros and sixty six cents, a difference of four hundred
and twenty three euros and six cents. Two Claims by
customers rose from thirty nine million, five hundred eighty nine thousand,
one hundred seventy seven euros and nine cents to thirty
nine million, seven hundred fifty nine thousand, one hundred fifty

(01:34:51):
six euros and forty two cents, a difference of one
hundred sixty nine thousand, nine hundred seventy nine euros and
thirty three cents. With subcategories two A, savings accounts increased
from ten million, two hundred thirty four thousand, eight hundred
and six euros and one cent to ten million, two
hundred and thirty seven thousand, one hundred and eighteen euros

(01:35:12):
and twenty four cents, a difference of two thousand, three
hundred and twelve euros and twenty three cents. Two B
Other liabilities increased from twenty nine million, three hundred and
fifty four thousand, three hundred and seventy one euros and
eight cents to twenty nine million, five hundred and twenty
two thousand, thirty eight euros and eighteen cents, a difference
of one hundred and sixty seven thousand, six hundred and

(01:35:34):
sixty seven euros and ten cents, with further breakdowns. BA
daily increased from thirteen million, seven hundred and seventy three thousand,
nine hundred and twenty five euros and ninety three cents
to thirteen million, nine hundred and sixty three thousand, eight
hundred and ninety nine euros and eighty nine cents, a
difference of one hundred and eighty nine thousand, nine hundred
and seventy three euros and ninety six cents. B B

(01:35:58):
maturity less four years decreased from thirteen million, two hundred
ninety six thousand, forty two euros and ninety two cents
to thirteen million, two hundred and seventy three thousand, seven
hundred and thirty six euros and six cents, a difference
of minus twenty two thousand, three hundred and six euros
and eighty six cents. B C maturity four years or
longer remained at two million, two hundred eighty four thousand,

(01:36:20):
four hundred and two euros and twenty three cents. Four
Trust liabilities stayed at five thousand, two hundred and sixty
two euros and seventy cents. Five. Other liabilities increased from
twelve thousand, three hundred and seventy eight euros and eighty
one cents to twelve thousand, five hundred and ninety nine
euros and forty four cents, a difference of two hundred

(01:36:41):
and twenty euros and sixty three cents. Six. Balancing item
remained at sixteen thousand, nine hundred and ninety six euros
and four cents. Seven Reserves stayed at one million, one
hundred and thirty eight thousand, four hundred and ninety seven
euros and sixty four cents. Eleven. Fund for bank risk
remained at two hundred and fifty thousand euros. Twelve. Owned

(01:37:05):
capital stayed at three million, fifty seven thousand, two hundred
forty eight euros and fifty seven cents. Thirteen. The sum
of liabilities increased from forty nine million, seven hundred and
six thousand, one hundred thirty six euros and thirty three
cents to forty nine million, eight hundred eighty four thousand,
three hundred fifty two euros and eighty one cents, a

(01:37:26):
total difference of one hundred seventy eight thousand, two hundred
sixteen euros and forty eight cents. Starting by analyzing the
liability side information Table seven, we find that customer deposits
are considered part of the financial institution's balance sheet. This
contradicts the financial intermediation theory, which assumes that banks are

(01:37:46):
not special and are virtually indistinguishable from non bank financial
institutions that have to keep customer deposits off balance sheet.
In actual fact, a bank considers a customer's deposit starkly
differently from non bank financial institutions who record customer deposits
off their balance sheet. Instead, we find that the bank
treats customer deposits as a loan to the bank recorded

(01:38:08):
under rubric claims by customers, who in turn receive as
record of their loans to the bank called deposits, what
is known as their account statement. This can only be
reconciled with the credit creation or fractional reserve theories of banking.
We observe that an amount not far below the loan balance,
about one hundred ninety thousand euros, has been deposited with

(01:38:30):
the bank. This is itself not far from the increase
in total liabilities and assets. Since the fractional reserve hypothesis
requires such an increase in deposits as a precondition for
being able to grant the bank loan, i e. It
must precede the bank loan, it is difficult to reconcile
this observation with the fractional reserve theory. Moreover, the researcher

(01:38:53):
confirmed that in his own bank account, the loan balance
of two hundred thousand euros was shown on the same day.
This means means that the increase in liabilities was driven
by the increase by two hundred thousand euros in daily
liabilities item two b BA in Table seven. Thus, the
total increase in liabilities could not have been due to
a coincidental increase in customer deposits on the day of

(01:39:15):
the loan. The liability side account information seems only fully
in line with the credit creation theory. Turning to an
analysis of the asset side, we note that the category
where we find our loan is item four claims on customers,
fortunately the only one that day with a maturity below
four years and hence clearly identifiable on the bank balance sheet. Apparently,

(01:39:38):
customers also took out short term loans, most likely overdrafts,
amounting to thirty five thousand and seventy one euros and
eighty eight cents, producing a total new loan balance of
two hundred and thirty five thousand, seventy one euros and
eighty eight cents. In order to keep the analysis as
simple as possible, let us proceed from here assuming that
our test loan amounted to this total loan figure two

(01:40:00):
hundred thirty five thousand, seventy one euros and eighty eight cents.
So the balance sheet item of interest on the asset
side is delta A four, the increase in loans claims
on customers amounting to two hundred thirty five thousand, seventy
one euros and eighty eight cents. We now would like
to analyze the balance sheet in order to see whether
this new loan of two hundred thirty five thousand, seventy

(01:40:23):
one euros and eighty eight cents was withdrawn from other
accounts at the bank, or how else it was funded.
We first proceed with considering activity on the asset side,
denoting balances in thousands below. We can summarize the balance
sheet changes during the observation period within the balance sheet
constraints as follows. The fractional reserve theory says that the

(01:40:45):
loan balance must be paid from reserves. These can be
either cash balances or reserves with other banks, including the
central bank. The deposits claims with other financial institutions, which
effectively includes the bank's central Bank reserve balances decline significantly
by two hundred and nineteen thousand euros at the same

(01:41:06):
time cash reserves increased significantly. What may have happened is
that the bank withdrew legal tender from its account with
the Cooperative Central Bank, explaining both the rise in cash
and decline in balances with other financial institutions. Since the
theories do not distinguish between these categories, we can aggregate
A one and A three the cash balances and reserves. Also,

(01:41:30):
to simplify, we aggregate A fourteen other assets with A
four claims on customers to obtain. We observe that reserves
fell while claims on customers rose significantly. Moreover, total assets
also rose by an amount not dissimilar to our loan balance.
Can this information be reconciled with the three theories of banking?

(01:41:53):
Considering the financial intermediation hypothesis, we would expect a decline
in reserves, accounts with other financial institutions and cash of
the same amount as customer loans increased. Reserves, however, declined
by far less. At the same time, the balance sheet expanded,
driven by a significant increase in claims on customers. If

(01:42:15):
the bank borrowed money from other banks in order to
fund the loan, thus reducing its balance of net claims
on other banks. In line with the financial intermediation theory
of banking, balt cash should not increase, and neither should
the balance sheet. We observe both a significant rise in
cash holdings and an expansion in the total balance sheet
total assets and total liabilities, which rose by one hundred

(01:42:38):
and seventy eight thousand euros. This cannot be reconciled with
the financial intermediation theory, which we therefore must consider as rejected.
Considering the fractional reserve theory. We confirmed by asking the
credit departments mister Keel as well as the directors that
none of them checked their reserve balance or balance of
deposits with other banks before signing the loan come contract

(01:43:00):
in making the funds available to the borrower. See the
translated letter in Appendix two and the original letter in
the online Appendix three. Furthermore, there seems no evidence that reserves,
cash and claims on other financial institutions declined in an
amount commensurate with the loan taken out. Finally, the observed
increase in the balance sheet can also not be reconciled

(01:43:22):
with the standard description of the fractional reserve theory. We
must therefore consider it as rejected. Two. This leaves us
with the credit creation theory. Can we reconcile the observed
accounting asset side information with it? And what do we
learn from the liability side information? The transactions are linked

(01:43:42):
to each other via the accounting identities of the balance
sheet X one two three. We can therefore ask the
question what would have happened to total assets if we
assumed for the moment that no other transaction had taken
place apart from the loan two hundred thirty five. We
can set the change in each asset item except for

(01:44:03):
delta A four our loan to zero if we subtract
the same amount from the change in total assets. In
other words, if the other transactions had not happened, the
bank's balance sheet would have expanded by the same amount
as the loans taken out. This finding is consistent only
with the credit creation theory of bank lending. The evidence

(01:44:24):
is not as easily interpreted as may have been desired,
since in practice it is not possible to stop all
other bank transactions that may be initiated by bank customers
who are nowadays able to implement transactions via internet banking,
even on holidays. But the available accounting data cannot be
reconciled with the fractional reserve and the financial intermediation hypotheses

(01:44:45):
of banking. Five conclusion, This paper was intended to serve
two functions. First, the history of economic thought was examined
concerning the question of how banks function. It was found
that a long standing controversy exists that has not been
settled empirically. Secondly, empirical tests were conducted to settle the

(01:45:07):
existing in continuing controversies and find out which of the
three theories of banking is consistent with the empirical observations
sec five point one three theories, but no empirical tests
concerning the first issue. In this paper, we identified three
distinct hypotheses concerning the role of banks, namely the credit
creation theory, the fractional reserve theory, and the financial intermediation theory.

(01:45:32):
It was found that the first theory was dominant until
about the mid to late nineteen twenties, featuring leading proponents
such as McLeod and Schumpeter. Then the second theory became
dominant under the influence of such economists as Kines, Krick, Phillips,
and Samuelson until about the early nineteen sixties. From the
early nineteen sixties, first under the influence of Caines and

(01:45:55):
Tobin and the Journal of Money, Credit and Banking, the
financial intermediation theory became dominant. Yet despite these identifiable eras
of predominance, doubts have remained concerning each theory. Most recently,
the credit creation theory has experienced a revival, having been
championed again in the aftermath of the Japanese banking crisis

(01:46:16):
in the early nineteen nineties. And in the run up
to and aftermath of the European and US financial crises
Since two thousand seven. However, such works have not yet
become influential in the majority of models and theories of
the macroeconomy or banking. Thus, it had to be concluded
that the controversy continues without any scientific attempt having been

(01:46:36):
made at settling it through empirical evidence. Five point two
the empirical evidence credit creation theory supported. The second contribution
of this paper has been to report on the first
empirical study testing the three main hypotheses. They have been
successfully tested in a real world setting of borrowing from
a bank and examining the actual internal bank accounting in

(01:46:59):
an unconnrolled real world environment. It was examined whether in
the process of making money available to the borrower, the
bank transfers these funds from other accounts within or outside
the bank. In the process of making loan money available
in the borrower's bank account, it was found that the
bank did not transfer the money away from other internal
or external accounts, resulting in a rejection of both the

(01:47:22):
fractional reserve theory and the financial intermediation theory. Instead, it
was found that the bank newly invented the funds by
crediting the borrower's account with a deposit, although no such
deposit had taken place. This is in line with the
claims of the credit creation theory. Thus, it can now
be said with confidence for the first time, possibly in

(01:47:43):
the five thousand years history of banking, that it has
been empirically demonstrated that each individual bank creates credit and
money out of nothing. When it extends what is called
a bank loan. The bank does not loan any existing money,
but instead creates new money. The money, nay supply is
created as ferry dust produced by the banks out of

(01:48:03):
thin air. Point thirty two. The implications are far reaching
five point three What is special about banks? Henceforth, economists
need not rely on assertions concerning banks. We now know,
based on empirical evidence, why banks are different, indeed unique,
solving the long standing puzzle posed by Fauma nineteen eighty

(01:48:25):
five and others, and different from both non bank financial
institutions and corporations. It is because they can individually create
money out of nothing. Five point four implications five point
four point one implications for economic theory. The empirical evidence
shows that of the three theories of banking, it is

(01:48:46):
the one that today has the least influence and that
is being belittled in the literature, that is supported by
the empirical evidence. Furthermore, it is the theory which was
widely held at the end of the nineteenth century and
in the first three decades of the twenty aeth It
is sobering to realize that since the nineteen thirties economists
have moved further and further away from the truth instead

(01:49:07):
of coming closer to it. This happened first via the
half truth of the fractional reserve theory and then reached
the completely false and misleading financial intermediation theory that today
is so dominant. Thus, this paper has found evidence that
there has been no progress in scientific knowledge in economics, finance,
and banking in the twentieth century concerning one of the

(01:49:28):
most important and fundamental facts for these disciplines. Instead, there
has been a regressive development. The known facts were unlearned
and have become unknown. This phenomenon deserves further research for now.
It can be mentioned that this process of unlearning the
facts of banking could not possibly have taken place without

(01:49:48):
the leading economists of the day, having played a significant
role in it. The most influential and famous of all
twentieth century economists, as we saw, was a sequential adherent
of all three theories, which is a surprising phenomenon. Moreover,
Kines used his considerable clout to slow scientific analysis of
the question whether banks could create money, as he instead

(01:50:10):
engaged in ad hominem attacks on followers of the credit
creation theory. Despite his enthusiastic early support for the credit
creation theory Canes, nineteen twenty four, only six years later
he was condescending, if not dismissive, of this theory, referring
to credit creation only in inverted commas. He was perhaps

(01:50:30):
even more dismissive of supporters of the credit creation theory,
who he referred to as being part of the army
of heretics and cranks, whose numbers and enthusiasm are extraordinary,
and who seem to believe in magic and some kind
of utopia. Needless to mention, such rhetoric is not conducive
to scientific argument. But this technique was followed by other

(01:50:51):
economists engaged in advancing the fractional reserve and later financial
intermediation theories. US Federal Reserve Staffer. Alhadef nineteen fifty four
argued similarly. During the era when economists worked on getting
the fractional reserve theory established, one complication worth discussing concerns
the alleged creation of money by bankers. It used to

(01:51:14):
be claimed that bankers could create money by the simple
device of opening deposit accounts for their business borrowers. It
has since been amply demonstrated that under a fractional reserve system,
only the totality of banks can expand deposits to the
full reciprocal of the reserve ratio. The individual bank can
normally expand to an amount about equal to its primary deposits.

(01:51:36):
The creation of credit by banks had become, in the
style of Canes nineteen thirty, an alleged creation, whereby rhetorically
it was suggested that such thinking was simplistic and hence
could not possibly be true. Tobin used the rhetorical device
of abduccio at absurdum to denigrate the credit creation theory
by incorrectly suggesting it postulated a widow's cruise, a miraculous

(01:51:59):
vessel producer unlimited amounts of valuable physical goods, and thus
its followers were believers in miracles or utopias. This same
type of rhetorical denigration of and disengagement with the credit
creation theory is also visible in the most recent era.
For instance, the new Palgrave Money eat Well nineteen eighty
nine is an influential three hundred and forty page reference

(01:52:21):
work that claims to present a balanced perspective on each topic,
Yet the financial intermediation theory is dominant, with a minor
representation of the fractional reserve theory. The credit creation theory
is not presented at all, even as a possibility, but
the book does include a chapter entitled Monetary Cranks. In

(01:52:42):
this brief chapter, Cain's nineteen thirty derogatory treatment of supporters
of the credit creation theory is updated for use in
the nineteen nineties with sharpened clause. Ridicule and insult is
heaped on several fateful authors that have produced thoughtful analyzes
of the economy, the monetary system, and the role of banks,
such as Nobel Laureate Sir Frederic Soddi nineteen thirty four

(01:53:04):
and C. H. Douglas nineteen twenty four. Even the seminal
and influential work by George Friedrich Knapp nineteen o five,
still favorably cited by Knes nineteen thirty six, is identified
as being created by a crank. What these apparently wretched
authors have in common, and what seems to be their
main fault punishable by being listed in this inauspicious chapter,

(01:53:28):
is that they are adherents of the credit creation theory,
but revealingly, their contributions are belittled without it anywhere being
stated what their key tenets are, and that their analyzes
center on the credit creation theory, which itself remains unnamed
and is never spelled out. This is not a small
feat and leaves one pondering the possibility that the eat
Well at All nineteen eighty nine tome was purposely designed

(01:53:51):
to ignore and distract from the rich literature supporting the
credit creation theory. Nothing lost, according to the authors, who
applaud the development that due to the increased emphasis given
to monetary theory by academic economists in recent decades, the
monetary cranks have largely disappeared from public debate, and so
has the credit creation theory, since the tenets of this

(01:54:14):
theory are never stated and eat Well at All nineteen
eighty nine, the chapter on cranks ends up being a
litany of ad hominin denigration, defamation, and character assassination. Liberally
distributing labels such as cranks, phrasemongers, agitators, populists, and even
conspiracy theorists that believe in miracles and engage in wishful thinking,

(01:54:35):
ultimately deceiving their readers by trying to impress their peers
with their apparent understanding of economics, even though they had
no formal training in the discipline. All that we learn
about their actual theories is that somehow these ill fated
authors are opposed to private banks and the money power,
without their opposition leading to more sophisticated political analysis. Any

(01:54:59):
reading of the high highly sophisticated Saudi nineteen thirty four
quickly reveals such labels as unfounded defamation. To the contrary,
the empirical evidence presented in this paper has revealed that
the many supporters of the financial intermediation theory, and also
the adherents of the fractional reserve theory, are flatter thirsts
that believe in what is empirically proven to be wrong

(01:55:20):
and which should have been recognizable as being impossible upon
deeper consideration of the accounting requirements. Whether the authors in
eat Well at al. Nineteen eighty nine did, in fact
no better is an open question that deserves attention in
future research. Certainly, the unscientific treatment of the credit creation
theory and its supporters by such authors as Kanes, who

(01:55:41):
strongly endorse the theory only a few years before aufering
tirades against its supporters, or by the authors in eat
Well at al. Nineteen eighty nine, raises this possibility five
point four point two implications for government policy. There are
other far reaching ramifications of the finding that banks individually
create credit and money when they do what is called

(01:56:03):
lending money. It is readily seen that this fact is
important not only for monetary policy, but also for fiscal policy,
and needs to be reflected in economic theories. Policies concerning
the avoidance of banking crises or dealing with the aftermath
of crises require a different shape once the reality of
the credit creation theory is recognized. They call for a

(01:56:26):
whole new paradigm in monetary economics, macroeconomics, finance, and banking.
For details see for instance, Werner twenty thirteen that is
based on the reality of banks as creators of the
money supply. It has potentially important implications for other disciplines
such as accounting, economic and business history, economic geography, politics, sociology,

(01:56:49):
and law five point four point three implications for bank regulation.
The implications are far reaching for bank regulation and the
design of official policy. As mentioned in the introduction, modern
national and international banking regulation is predicated on the assumption
that the financial intermediation theory is correct. Since in fact

(01:57:11):
banks are able to create money out of nothing, Imposing
higher capital requirements on banks will not necessarily enable the
prevention of boom bust cycles and banking crises, since even
with higher capital requirements, banks could still continue to expand
the money supply, thereby fueling asset prices, whereby some of
this newly created money can be used to increase bank capital.

(01:57:33):
Based on the recognition of this, some economists have argued
for more direct intervention by the central bank in the
credit market, for instance via quantitative credit guidance Onerner two
thousand five five point four point four monetary reform the
Bank of England two thousand fourteen. Recent intervention has triggered
a public debate about whether the privilege of banks to

(01:57:55):
create money should in fact be revoked Wolf two thousand fourteen.
The reality of banks as creators of the money supply
does raise the question of the ideal type of monetary system.
Much research is needed on this account. Among the many
different monetary system designs tried over the past five thousand years,
very few have met the requirement for a fair, effective, accountable, stable,

(01:58:20):
sustainable and democratic creation and allocation of money. The view
of the author, based on more than twenty three years
of research on this topic, is that it is the
safest bet to ensure that the awesome power to create
money is returned directly to those to whom it belongs,
ordinary people, not technocrats. This can be insured by the
introduction of a network of small, not for profit local

(01:58:42):
banks across the nation. Most countries do not currently possess
such a system. However, it is at the heart of
the successful German economic performance in the past two hundred years.
It is the very rapeisen folks bank or sparks banks,
the smaller the better, that are helpful in the implementation
of this empirical study that should serve as the role

(01:59:03):
model for future policies concerning our monetary system. In addition,
one can complement such local public bank money with money
issued by local authorities that is accepted to pay local taxes, namely,
a local public money that has not come about by
creating debt, but that is created for services rendered to
local authorities or the community. Both forms of local money

(01:59:25):
creation together would create a decentral eased, and more accountable
monetary system that should perform better, based on the empirical
evidence from Germany than the unholy alliance of central banks
and big banks, which have done much to create unsustainable
asset bubbles and banking crises. Werner, twenty thirteen, Appendix one.

(01:59:45):
Sequence of steps for the extension of a loan Rapheisenbank
Wildenburg Eg. One Negotiations concerning the details of the loan.
Two receipt of KYC information and opening of a new
customer file customer. Three opening of a current account new customer.

(02:00:05):
Four Calculation of the loan and repayment schedule model calculation
European required customer notification information, record of customer advisory. Five
entry of loan application into the bank it system. Six
check of ability to service and repay the loan slash
conducting liquidity calculation in loan application. Seven credit rating of

(02:00:29):
customer entry into customer file. Eight search of customer data
on Central Bank database for singular economic dependencies and entry
of results into bank IT nine Ink Board recommendation on
loan application with justification two directors. Ten print out of
loan contract general loan conditions with handover receded by customer.

(02:00:54):
Eleven print out of the protocol of the loan process.
Twelve Approval of credit by bank directors by signing the
protocol and the loan contract. Thirteen creation of loan account
in the IT system. Fourteen establishment of credit limit and
availability of credit fifteen appointment with customer sixteen customer signs

(02:01:18):
credit documents. Seventeen payment of loan at the value date
in exchange for evidence of use of the loan in
line with the declared use in the loan application. Appendix two.
Letter of confirmation of facts by Raphisenbank Wildenburg EG June tenth,
twenty fourteen. Dear Professor Doctor Werner, confirmation of facts in

(02:01:44):
connection with the extension of credit to you in August
twenty fourteen. I am pleased to confirm that neither I,
as director of Raphisenbank Wildenburg EG, nor are staff checked
either before or during the granting of the loan to you,
whether we keep sufficient funds with our central bank, dz
Bank or the Bundesbank. We also did not engage in
any such related transaction, nor did we undertake any transfers

(02:02:07):
or account bookings in order to finance the credit balance
in your account. Therefore, we did not engage in any
checks or transactions in order to provide liquidity. Yours, sincerely, M. Rebel,
Director Rapheizenbank Wildenburg EG

All Episodes

HOW BANKS INDIVIDUALLY CREATE MONEY OUT OF NOTHING: Secrets of Money Creation Revealed - Richard A. Werner (2014)

Episode Transcript

Popular Podcasts

Stuff You Should Know

Dateline NBC

On Purpose with Jay Shetty

.css-15opob5{left:0;position:absolute;top:0.8rem;} All Episodes

.css-14f5ked{margin:0;word-break:break-word;display:-webkit-box;-webkit-box-orient:vertical;box-orient:vertical;-webkit-line-clamp:2;overflow:hidden;}HOW BANKS INDIVIDUALLY CREATE MONEY OUT OF NOTHING: Secrets of Money Creation Revealed - Richard A. Werner (2014)