Do banks create money?
Matt Yglesias has a new Substack on money and banking, with the following title and subtitle:
How banks create money out of nothing
The Fed’s two missions are intimately linked
Given that most colleges have a course on “Money and Banking”, the claim in his subtitle is not particularly controversial (although I don’t entirely agree.) But first let’s consider the concept of banks “creating money”.
If you define money to include bank deposits (as most people do), then obviously banks do have some role in the process of money creation. Because arguments about “banks creating money out of thin air” involve a great deal of confusion, let’s start there first. I’ll begin with an analogy using the restaurant industry. What determines growth in the nominal size of the restaurant industry?
1. Growth in nominal GDP.
2. Growth in the share of NGDP comprised by the profit-maximizing restaurant industry.
3. Non-profit maximizing growth in the restaurant industry.
Suppose that in 2000, restaurant comprised 5% of GDP. If GDP were $10 trillion, then the restaurant industry would be $500 billion. Now assume that NGDP doubles to $20 trillion in 2020. Other things equal, the restaurant industry will double to $1 trillion.
Other factors (both supply and demand side) may impact restaurants as a share of GDP. Immigration might add to the supply of restaurants with tasty new menus. More women working and rising real incomes might lead to people eating out more often. Suppose these factors push the restaurant industry up to 6% of GDP. In that case, the industry would increase to $1.2 trillion in 2020.
And finally, a restaurant might decide to grow larger even though it reduced profits. They could offer larger portions to induce more customers, selling meals at a loss. I don’t think this factor is all that important in the aggregate, but it’s a theoretical possibility.
Banking is similar, with three factors determining the nominal size of bank deposits (i.e. bank “money”):
1. Growth in nominal GDP.
2. Growth in the ratio of deposits to NGDP in the profit-maximizing banking industry.
3. Non-profit maximizing growth in bank deposits.
The first factor is easy to explain. In the US, the Fed determines NGDP. If NGDP doubles over time, that will tend to double the equilibrium quantity of bank money. This is related to the concept of “velocity”.
We all know that velocity is not a constant, as the ratio of deposits to NGDP changes over time. Lots of factors cause that ratio to change, but the only ones worth spending much time thinking about are the factors that influence the profit-maximizing ratio of bank deposits to NGDP. Yglesias provides a typical thought experiment:
Alternatively, you can ask a bank for a loan that’s secured by the equity in your home. The way that works is the bank will put down in a spreadsheet “John owes us $X, with the loan secured by his home.” Then in another spreadsheet, they’ll put X additional dollars in John’s bank account.
When you get a loan like that from the bank, they don’t tell you “hang on for a couple of hours, we need to scrounge up some extra deposits before we can lend you the money.” In part because just like the deposits “in” the bank are, for the most part, not physically located anywhere, the expectation is that you’re not going to be getting your loan in the form of physical cash. These are all just spreadsheet entries. The bank goes from having no entries about you on their spreadsheets to having one entry about the money in your bank account and another entry about the money you owe them. The act of lending you the money created the bank deposits. And by taking out the loan, you transform yourself from being someone who has a lot of home equity but no money into someone who has a bunch of money but less home equity. You and the bank worked together to create money.
I don’t find that sort of thought experiment to be particularly helpful, as it isn’t clear whether this transaction is assumed to be profitable. When I think about factors that affect the ratio of deposits to NGDP, I focus on those that impact the equilibrium size of the banking industry. Consider the following example:
An economic boom leads banks to spot more opportunities for making profitable loans. When the loans are made, the borrowers are given a bank deposit in the fashion discussed by Yglesias. But then the borrowers withdraw the money to pursue their goals. Here there are several possibilities. One possibility is that the same shock that caused more equilibrium lending also causes people to wish to hold proportionately more bank deposits in aggregate, even at the same interest rate. If that is not the case, it’s possible that interest rates rise during the boom. Increasingly profitable firms are willing to pay higher borrowing rates, and banks can then offer depositors higher rates to induce them to keep the money in banks rather than moving to alternatives such as mutual funds.
In that case, you can think of new loans leading to new deposits. But one can also envision a shock where people become more inclined to deposit money in the bank (perhaps due to more generous deposit insurance.) That inflow of funds into banks depresses interest rates, which increases the number of profitable lending opportunities. As Paul Krugman once said when exasperated tedious MMT arguments, “it’s a simultaneous system”.
If there is no economic “shock” that affects the equilibrium size of the banking industry as a share of GDP, is it still possible for a banker to create money out of thin air? Yes, if they are willing to lose money. A banker could suddenly decide to make a loan to someone with a bad credit risk, thereby “creating money”. But why would they do this?
To summarize, when thinking about banks creating money, I’d focus on two primary factors. First, the Fed determines NGDP, and money neutrality implies that a monetary policy that causes NGDP to rise will have a proportional effect on all other nominal aggregates in the economy, including the nominal size of the restaurant industry and the nominal size of bank deposits. In addition, specific economic shocks can cause the profit-maximizing ratio of bank deposits to NGDP to change over time, and this is probably what most people mean when they speak of banks “creating money”. In general, booms tend to lead to positive money creation, and vice versa. Deregulation can also lead to money creation, whereas a financial crisis can reduce the money supply.
So far, there’s nothing strange or different about banking. The same sorts of factors that determine the nominal size of the restaurant industry also determine the nominal size of the banking industry. So why does Yglesias think banking is special and that the Fed should control both monetary policy and banking regulation?
Under the gold standard, banking shocks often had a big impact on NGDP, whereas restaurant industry shocks have relatively little impact on NGDP. The central bank might want to regulate banking to prevent a banking crisis from reducing the money supply and NGDP. Yglesias worries that this issue might even arise under a fiat money regime:
A lot of people made a lot of ignorant criticisms of the 2007-2008 bailouts. As bailout defenders have always argued, if we’d let more banks fail, we would have had a stronger pullback of lending activity and an even larger contraction in aggregate demand — more unemployment, a deeper recession, and so forth. Dean Baker always offered the non-ignorant counter that whatever contraction arose from bank failures, you could have just done more stimulus to compensate. I think the counter-counter is that sure you “could have,” but nobody was in fact going to. We had some bank bailouts and some interest rate cuts and some fiscal stimulus and it was all pulling in the same direction, and the problem was that it wasn’t enough.
I’m not convinced the Fed would not have offset a more severe banking crisis, but it’s a defensible argument. I’m also not convinced that the Fed needed to be involved in the bailout, but I suppose there are also arguments that the Treasury could not or would not have done as effective a job without Fed assistance.
As I said at the top, I don’t think acknowledging the reality of endogenous money necessarily leads to any radical policy conclusions.
“People put deposits into the bank, and then the bank lends the deposits out” is a decent approximation of how things work for most purposes, even if the reality is more complicated.
One thing that does follow, though, is that central banks’ roles as bank regulators and as macroeconomic stability agencies necessarily get muddled together.
I’m not sure it’s necessary, but perhaps it’s inevitable.
In any case, Yglesias gets to the core issue in his Substack post, without all the nonsense you often see in “endogenous money” debates. From a certain perspective, everything is endogenous. But waving around the term “endogenous” like a magic wand doesn’t resolve any interesting monetary questions.
Here’s a Buffalo bank from the golden age of bank architecture:
Mar 26 2023 at 1:34am
I’m assuming that the above quote is from one of Scott’s previous articles:
Note that Krugman is doing loanable funds fallacy here because there are no loanable funds. They do not and cannot exist. This was one of Keynes’ key insights.
The reason that this stuff matters is that starting with a fallacy leads to other fallacies, like the crowding out effect where the government competes with the private sector for these mythical loanable funds instead of focusing on the competition for real resources and the amount of slack in the economy which is what matters.
Mar 26 2023 at 1:42pm
Sorry, but I don’t think you understand what Krugman is saying. There are multiple factors that impact the equilibrium interest rate.
Mar 26 2023 at 12:12pm
Economics is about the rates-of-change in the flow-of-funds. Take: Eric Basmajian
In the week ending March 15th, other deposits at all domestically chartered banks declined by $60 billion.
Other deposit liabilities “ODL” strips out large-time deposits and money market funds.
Other deposits at large banks increased by $65 billion, while other deposits at small banks declined by $125 billion.
Over the last 12 weeks, other deposits at small banks contracted at an unprecedented 16.4% annualized pace.
As deposits flow out of smaller and regional banks, the funds are absorbed by larger banks or money market funds, which drive much less credit creation in the post-2008 period.
Mar 26 2023 at 12:18pm
The pundits couldn’t fool everybody:
WSJ: “In a letter of March 15, 1981, Willis Alexander of the American Bankers Association claims that: ‘Depository Institutions have lost an estimated $100b in potential consumer deposits alone to the unregulated money market mutual funds.’
As any unbiased banker should know, all the money taken in by the money funds goes right back into the banks, in the form of CDs or bankers acceptances or other money market instruments; there is no net loss of deposits to the banking system. Complete deregulation of interest rates would simply allow a further escalation of rates by the banks, all of which compete against each other for the same total of deposits.”
Written by Louis Stone whom the movie “Wall Street” was dedicated to – Vice President Shearson/American Express
Never are the commercial banks intermediaries between pooled savings and borrowers. From the standpoint of the entire system and the economy (macro-economics), commercial banks never loan out, & can’t loan out, existing funds in any deposit classification (saved or otherwise), or the owner’s equity, or any liability item.
Every time a DFI makes a loan to, or buys securities from, the non-bank public, it creates new money – demand deposits, somewhere in the system. I.e., deposits are the result of lending and not the other way around.
This can be demonstrated by examining the differences in the consolidated condition statements for commercial banks, plus the monetary system, for any two points in time. For the commercial banking system, this requires constructing a balance sheet for the system, an income & expense statement for the system, & a simultaneous analysis of the flow of funds in the entire economy.
Mar 26 2023 at 12:22pm
re: “Saving at the prior date cannot be greater than the investment at that date.”
Loan funds = credit. Credit includes new commercial bank created money.
Mar 26 2023 at 12:29pm
What if the borrower, and many others like him, believe that restaurant stocks are undervalued? The price of restaurant stocks go up. A spiral begins …
Mar 26 2023 at 5:15pm
The following is a quote from a previous article of Scott’s about banking titled: “Three MMT fallacies”:
This sounds to me like a combination of the fallacy of banks as financial intermediaries and the fallacy of fractional reserve banking, as opposed to the credit creation theory of banking which is the correct one. On the contrary, an increase in deposit inflows decreases a bank’s ability to make loans. This quote is from Frances Coppola who worked in banking for many years:
Mar 27 2023 at 8:19pm
I don’t believe you understood the post. Read it again.
Mar 27 2023 at 11:43am
Just ask a banker how much of its deposits is new money. Ask him how money is created.
Jeremy BlumBlum: “cash is created by profits”I rest my case.
Mar 27 2023 at 1:48pm
Change economic boom to stock market boom or even real estate boom. Is this what you mean by non-profit-maximizing growth in deposits?
I’m not sure what you mean by profitable loans. To a bank, a profitable loan is any loan with a spread that doesn’t default.
Mar 28 2023 at 9:36am
I think this is the whole point of the matter. The banker makes the ex-post money losing loan for a variety of quite obvious reasons. The first that ex-ante they think its going to make money. They don’t have a crystal ball to know if a loan will or won’t make money.
They make a risk assessment and are willing to make a loan at a certain level of risk premium. There’s no strong reason to think that this risk premium is a perfectly static level. We see risk premiums shifting every day in liquid markets and the same is true of bank loans.
New CEO comes in wanting to increase loan growth as that what the market is rewarding vis-a-vis the banks stock price and instructs its bankers to accept a lower risk premium and boom money creation.
Mar 28 2023 at 12:10pm
You missed the point. When I talk about “profit-maximizing loans”, I am speaking of ex ante perceptions.
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