If Credit is Not Created Out of Excess Reserves, What Does That Mean?

We’ve all been taught that banks first build up deposits, and then extend credit and loan out their excess reserves.

But critics of the current banking system claim that this is not true, and that the order is actually reversed.

Sounds crazy, right?


But as PhD economist Steve Keen pointed out last week, 2 Nobel-prize winning economists have shown that the assumption that reserves are created from excess deposits is not true:

The model of money creation that Obama’s economic advisers have sold him was shown to be empirically false over three decades ago.

The first economist to establish this was the American Post Keynesian economist Basil Moore, but similar results were found by two of the staunchest neoclassical economists, Nobel Prize winners Kydland and Prescott in a 1990 paper Real Facts and a Monetary Myth.

Looking at the timing of economic variables, they found that credit money was created about 4 periods before government money. However, the “money multiplier” model argues that government money is created first to bolster bank reserves, and then credit money is created afterwards by the process of banks lending out their increased reserves.

Kydland and Prescott observed at the end of their paper that:

Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.

In other words, if the conventional view that excess reserves (stemming either from customer deposits or government infusions of money) lead to increased lending were correct, then Kydland and Prescott would have found that credit is extended by the banks (i.e. loaned out to customers) after the banks received infusions of money from the government. Instead, they found that the extension of credit preceded the receipt of government monies.

Keen explained in an interview Friday that 25 years of research shows that creation of debt by banks precedes creation of government money, and that debt money is created first and precedes creation of credit money.

As Mish has previously noted:

Conventional wisdom regarding the money multiplier is wrong. Australian economist Steve Keen notes that in a debt based society, expansion of credit comes first and reserves come later.

And as Edward Harrison writes:

Central to [Keen's] ideas is the concept that demand for credit creates loans which create reserves, which is the opposite causality of what one sees in neoclassical economics.

This angle of the banking system has actually been discussed for many years by leading experts:

“[Banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers’ transaction accounts.”
- 1960s Chicago Federal Reserve Bank booklet entitled “Modern Money Mechanics”

“The process by which banks create money is so simple that the mind is repelled.”
- Economist John Kenneth Galbraith

[W]hen a bank makes a loan, it simply adds to the borrower’s deposit account in the bank by the amount of the loan. The money is not taken from anyone else’s deposit; it was not previously paid in to the bank by anyone. It’s new money, created by the bank for the use of the borrower.
- Robert B. Anderson, Secretary of the Treasury under Eisenhower, in an interview reported in the August 31, 1959 issue of U.S. News and World Report

“Do private banks issue money today? Yes. Although banks no longer have the right to issue bank notes, they can create money in the form of bank deposits when they lend money to businesses, or buy securities. . . . The important thing to remember is that when banks lend money they don’t necessarily take it from anyone else to lend. Thus they ‘create’ it.”
-Congressman Wright Patman, Money Facts (House Committee on Banking and Currency, 1964)

The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented.
- Sir Josiah Stamp, president of the Bank of England and the second richest man in Britain in the 1920s.

Banks create money. That is what they are for. . . . The manufacturing process to make money consists of making an entry in a book. That is all. . . . Each and every time a Bank makes a loan . . . new Bank credit is created — brand new money.
- Graham Towers, Governor of the Bank of Canada from 1935 to 1955

Indeed, some critics of the current banking system – like Ellen Brown – claim that the entire credit-creation system is an accounting sleight-of-hand, and that banks simply enter into loan agreements, and then obtain the reserves later from the Fed or in the open market. In other words, they claim that banks extend money first, and then increase their reserves on their books later to cover the loans.

So What Does It Mean?

So what does it mean that loans and debt are created first, and then reserves and credit come later?

There are several results.

First, it makes it less likely than most people think that the giant banks will increase the amount of money they’re loaning out to individuals and small businesses. Specifically, since loans are made before new infusions of government cash (Kydland and Prescott), there is not a simple cause-and-effect relationship. So the bailouts to the banks will not necessarily encourage them to make more loans. Indeed, the heads of the big banks have themselves said that they won’t really increase such loans until the economy fundamentally stabilizes (no matter how much money the government gives them).

As Mish writes today:

A funny thing happened to the inflation theory: Banks aren’t lending and proof can be found in excess reserves at member banks.

Excess Reserves

In practice, banks lend money and reserves come later. When defaults pile up, the Fed prints reserves to cover bank losses. Thus, those “excess reserves” aren’t going anywhere. They are needed to cover losses. It’s best to think of those reserves as a mirage. They don’t really exist.

Second, if banks won’t increase their lending in response to government funds, then that argues against inflation and for continuing stagnation in the economy.

Is This Method of Credit-Creation Unsustainable?

Going beyond what most economists believe or will publicly discuss (and going beyond what I have any background or inside information to confirm) – monetary reformers like Ellen Brown argue that the entire banking system is based upon a fraud. Specifically, she and other monetary reformers argue that the banks have intentionally spread the false reserves-and-credit first, loans-and-debt later story to confuse people into thinking that the banks are better capitalized than they really are and that the Federal Reserve is keeping better oversight than it really is.

Moreover, many monetary reformers argue that the truth of loans-before-reserves is hidden in order to obscure the alleged fact that the entire financial system is built on nothing but air. Specifically, Brown argues that unless more and more debt is continually created, since money creation follows debt creation, what we think of as the money supply will shrink, and the economy will crash. In other words, they say that we a massive, ever-expanding debt bubble has been blown for many decades, and that the myth that banks make loans out of their excess reserves helps to fuel the bubble.

Some evidence for that argument comes from a September 30, 1941 hearing in the House Committee on Banking and Currency, where the then-Chairman of the Federal Reserve (Mariner S. Eccles) said:

That is what our money system is. If there were no debts in our money system, there wouldn’t be any money.

Monetary reformers argue that the government should take the power of money creation back from the private banks and the Federal Reserve system.

Do the monetary reformers go too far? If so, what should the reality of the way credit is created mean for us and the stability of the economy?

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  • http://www.blogger.com/profile/10327081755103408682 Stk

    I don't think this is a big deal…

  • http://bibocurrency.org marc

    The definitive analysis is at bibocurrency.org. The solution is trivial and only needs that the average person understand:Money creation, destruction, relationship to wealth, debt growth that leads to inflation or commensurate exponential growth of economic output which being impossible incites the powerful economies to ramsack the more vulnerable ones. Most importantly, money is an auxiliary LOGICAL system design that affects our behaviour but that our behaviour cannot affect unless directed to changing the system that is:"System design affects user behaviour but user behaviour does not affect system design unless it acts to alter of replace it."Changing the system requires three things:1) A certifiable alternative design that is workable2) Standardising the of design for interoperability3) The will to implement and defend the standardAll of the above is within the grasp of most anyone, but first you have to read a bit go to:bibocurrency.org – passive bibo currency rationale

  • http://www.blogger.com/profile/14374913605730692218 King of the Paupers

    Jct: Yes, the banking system issues new chips. See How banks create money to explain financial flows with plumbing: http://www.youtube.com/watch?v=WefdeNLup3M So, banks work like casino banks issuing new chips, not like piggy banks lending out old ones.

  • http://www.blogger.com/profile/13972303952456203618 sunbringer

    It´s good to see the money as debt meme getting the attention it deserves. Bank lending has decreased along with the velocity of circulation of money, as conceptualized. Why should the banks lend if they expect the economy to sputter along or descend back into the maelstorm? It would be irrational for them to risk making loans that they expect to go bad because of low consumption due to rising unemployment, credit defaults, and a general, newly-found thrift on the part of consumers. So if the banks are not lending then where has all that money gone? Ah, that´s right; our wonderful stock market rally. And why, pray tell, did Greenspan say that he expected the market rally to lead to an improved economy? How does neo-classical economics explain that little tidbit? Rewind to 1936:"Unfortunately a serious fall in the marginal efficiency of capital also tends to affect adversely the propensity to consume. For it involves a severe decline in the market value of Stock Exchange equities. Now, on the class who take an active interest in their Stock Exchange investments, especially if they are employing, borrowed funds, this naturally exerts a very depressing influence. These people are, perhaps, even more influenced in their readiness to spend by rises and falls in the value of their investments than by the state of their income. With a “stock-minded” public, as in the United States to-day, a rising stock-market may be an almost essential condition of a satisfactory propensity to consume; and this circumstance, generally overlooked until lately, obviously serves to aggravate still further the depressing effect of a decline in the marginal efficiency of capital.When once the recovery has been started, the manner in which it feeds on itself and cumulates is obvious. But during the downward phase, when both fixed capital and stocks of materials are for the time being redundant and working-capital is being reduced, the schedule of the marginal efficiency of capital may fall so low that it can scarcely be corrected, so as to secure a satisfactory rate of new investment, by any practicable reduction in the rate of interest. Thus with markets organised and influenced as they are at present, the market estimation of the marginal efficiency of capital may suffer such enormously wide fluctuations that it cannot be sufficiently offset by corresponding fluctuations in the rate of interest. Moreover, the corresponding movements in the stock-market may, as we have seen above, depress the propensity to consume just when it is most needed. In conditions of laissez-faire the avoidance of wide fluctuations in employment may, therefore, prove impossible without a far-reaching change in the psychology of investment markets such as there is no reason to expect. I conclude that the duty of ordering the current volume of investment cannot safely be left in private hands."J. M. Keynes The General Theory Ch 22Now, were one to be of the conspiratorial minded sort, one would have to start giving credence to the plunge protection team theory and with tin foil hat on start to disabuse oneself of the illusion that such a thing as a free and fair market exists. But what do I know. I am not an economist.

  • http://www.blogger.com/profile/04013856749944723226 OrpheoTreschulla

    This both hits and misses the point. Yes reserves follow credit, but credit does follow reserves too, as we all know. The point missed is that the relationship is not linear but cyclic. I mean, goddamn, of course its cyclic, this is money we're talking about!