Can banks individually create money out of nothing? — The theories and the empirical evidence

Richard A. Werner

Open Access
Abstract

This paper presents the first empirical evidence in the history 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 recognised 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. 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 ‘out of nothing’ and does so when it extends credit (the credit creation theory of banking). The question which of the theories is correct has far-reaching implications for research and policy. Surprisingly, despite the longstanding 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 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 as ‘fairy dust’ produced by the banks 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 demonstrate and test their economic wisdom — or folly. History shows that the latter has often prevailed.”1

Wicksell (1922, p. 3)

1. Introduction

Since the American and European banking crisis of 2007–8, the role of banks in the economy has increasingly attracted interest within and outside the 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.2 These bank-less dominant theories are likely to have influenced bank regulators and may thus have contributed to sub-optimal 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.3

Consequently, many researchers have since been directing their efforts at incorporating banks or banking sectors in economic models.4 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 2013, held on 6 March 2013 in Winchester Guildhall and organised by the University of Southampton Centre 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 need to know which aspects of bank activity are essential — including 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 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 re-allocate them, just like other non-bank financial institutions, and without any special powers. Any differences between banks and non-bank financial institutions are seen as being due to regulation and effectively so minimal that they are immaterial for modelling or for policy-makers. 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 1960s.

Between approximately the 1930s and the late 1960s, 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 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 20th century. Unlike 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 individual bank is not a financial intermediary that passes on deposits, or reserves from the central bank in its lending, 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 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 modelling the role of banks correctly within the economy, but also for the design of appropriate bank regulation that aims at sustainable economic growth without crises. The modern approach to bank regulation, as implemented at least since Basel I (1988), is predicated on the understanding that the financial intermediation theory is correct. 5 Capital adequacy-based bank regulation, even of the counter-cyclical type, is less likely to deliver financial stability, if one of the other two banking hypotheses is correct. 6 The capital-adequacy based approach to bank regulation adopted by the BCBS, as seen in Basel I and II, has so far not been successful in preventing major banking crises. If the financial intermediation theory is not an accurate description of reality, it would throw doubt on the suitability of Basel III and similar national approaches to bank regulation, such as in the UK. 7

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 so far been performed. This is the contribution of the present paper.

The remainder of the paper is structured as follows. Section 2 provides an overview of relevant literature, differentiating authors by their adherence 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. In Section 3, I then present an empirical test that is able to settle the question of whether banks are unique and 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 and some implications are discussed in Section 4. 

2. The literature on whether 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 whether banks can create money, as they often simply assume their preferred theory to be 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 whether banks can create credit and money. During time periods when in the authors' countries banks issued promissory notes (bank notes) that circulated as paper money, writers would often, as a matter of course, mention, even if only in passing, that banks create or issue money. In England and Wales, the Bank Charter Act of 1844 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 the (until 1946 officially privately owned) Bank of England with a monopoly on bank note issuance. Meanwhile, the practice continued in the United States until the 20th century (and was in fact expanded with the similarly timed New York Free Banking Act of 1838), so that US authors would refer to bank note issuance as evidence of the money creation function of banks until much later.8 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 and 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 includeJohn Law (1705), James Steuart (1767), Adam Smith (1776), Henry Thornton (1802), Thomas Tooke (1838), and Adam Müller (1816), among others, who either directly or indirectly state that banks can individually create credit (in line with the credit creation theory). 9

2.1. The credit creation theory of banking

Influential early writers that argue that non-issuing banks have the power to individually create money and credit out of nothing wrote mainly in English or German, namely Wicksell, 1898 and Wicksell, 1907, Withers (1909), Schumpeter (1912), Moeller (1925) and Hahn (1920).10 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. 11 Macleod produced an influential opus on banking, entitled The Theory and Practice of Banking, in two volumes. It was published in numerous editions well into the 20th century ( Macleod, 1855–6; the quotes here are from the 6th edition of 1905). Concerning credit creation by individual banks, Macleod unequivocally argued that individual banks create credit and money out of nothing, whenever they do what is called ‘lending’:

“In modern times private bankers discontinued issuing notes, and merely created Credits in their customers' favour to be drawn against by Cheques. These Credits are in banking language termed Deposits. Now many persons seeing a material Bank Note, which is only a Right recorded on paper, are willing to admit that a Bank Note is cash. 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 an “Issue”, and “Currency,” but they fail to see that a Bank Credit is exactly in the same sense equally an “Issue,” “Currency,” and “Circulation”.”

Macleod (1905, vol. 2, p. 310)

“… Sir 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” (p. 370, emphasis in original).

In his Theory of Credit Macleod (1891) put it this way:

“A bank is therefore not an office for “borrowing” and “lending” money, but it is a Manufactory of Credit.” 

Macleod (1891: II/2, 594)

According to the credit creation theory then, banks create credit in the form of what bankers call ‘deposits’, and this credit is money. But how much credit can they create? Wicksell (1907) 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 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 interest.” 12

Wicksell (1907, 214)

Withers (1909), from 1916 to 1921 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 900 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, 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 book-keeping credits lent to it by its bankers.”

Withers (1909, pp. 57 ff.)

“… The greater part of the banks' deposits is thus seen to consist, not of cash paid in, but of credits borrowed. For every loan makes a deposit ….”

Withers (1909, p. 63)

“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 itself. Now, a bank makes an advance or discounts a bill, and makes a liability for itself in the corresponding credit in its books.”

Withers (1909, p. 66)

“… It comes to this that, whenever a bank makes an advance or buys a security, it gives some one the right to draw a cheque upon it, which cheque 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.”

Withers (1916, p. 45)

“When once this fact is recognised, that the banks are still, among other things, manufacturers of currency, just as much as they were in the days when they issued notes, we see how important a function the banks 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 ….”

Withers (1916, p. 47)

“If, then, the quantity theory is, as I believe, broadly true, we see how great is the responsibility of the bankers as manufacturers of currency, seeing that by their action they affect, 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 ….”13

Withers (1916, pp. 54 ff.)

“And so it becomes evident, as before stated, that the deposits of the banks which give the commercial community the right to draw cheques are chiefly created by the action of the banks themselves in lending, discounting, and investing” (pp. 71 ff.).

“… then, it thus appears that credit is the machinery by which a very important part of modern currency is created …” (p. 72).

Withers argues that the sovereign prerogative to manufacture the currency of the nation has effectively beenprivatised 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.”

Withers (1916, p. 40)

While Withers was a financial journalist, his writings had a high circulation and likely contributed to the dissemination of the credit creation theory in the form proposed by Macleod (1855–6). This view also caught on in Germany with the publication of Schumpeter's (1912, English 1934) influential book The Theory of Economic Development, in which he was unequivocal in his view that each 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, 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.” 14

Schumpeter (1912, p. 197, emphasis in original)

“[C]redit is essentially the creation of purchasing power for the purpose of transferring it to the entrepreneur, but not simply the transfer of existing purchasing power. … By credit, 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.”

Schumpeter (1954, p. 107)

“The fictitious certification of products, which, as it were, the credit means of payment originally represented, has become truth.”15
Schumpeter (1912, p. 223)

This view was also well represented across the Atlantic, as the writings of Davenport (1913) or Robert H. Howe (1915) indicate. Hawtrey (1919), another leading British economist who like Keynes, had a Treasury background and moved into academia, took a clear stance in favour of the credit creation theory:

“… for the manufacturers and others who have to pay money out, credits are still created by the exchange of obligations, the banker's immediate obligation being given to his customer in exchange for the customer'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 bag of money from his customer, one means of payment, a bank credit, is merely substituted for another, an equal amount of cash” (p. 20).

Apart from Schumpeter, a number of other German-language authors also argued that banks create money and credit individually through the process of lending.16 Highly influential in both academic discourse and public debate was Dr. Albert L. Hahn (1920), scion of a Frankfurt banking dynasty (similarly to Thornton who had been a banker) and since 1919 director of the major family-owned Effecten- und Wechsel-Bank, Frankfurt. Like Macleod a trained lawyer, he became an honorary professor at Goethe-University Frankfurt in 1928. 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 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.”17

Hahn (1920, p. 28)

“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 and every case an asset transaction of a bank must 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 ….”18

Hahn (1920, p. 29)

Overall, Hahn probably did more than anyone to popularise the credit creation theory in Germany, his book becoming a bestseller, 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 or the US, namely well into the post-war 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 ( Schumpeter, 1926), praising it as a further development in line with, but beyond, his own book. The English translation of Schumpeter's influential book Schumpeter (1912 [1934]) also favourably cites Hahn.

It can be said that support for the credit creation theory appears to have been fairly widespread in the late 19th and early 20th century in English and German language academic publications. By 1920, 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. 19

The early Keynes seemed to also have been a supporter of this dominant view. In his Tract on Monetary Reform ( Keynes, 1924), he asserts, apparently without feeling the need 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 …” (p. 178).

“The amount of credit, so created, is in its turn roughly measured by the volume of the banks' deposits — since variations in this total must correspond to the variations in the total of their investments, bill-holdings, and advances” (p. 178).

We know from Keynes' contribution to the Macmillan Committee (1931) that Keynes meant with this that each individual bank was able to create credit:

“It is not unnatural 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 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” (p. 34).

Concerning the banking system as a whole, this bank credit and deposit creation was thought to influence aggregate demand and the formation of prices, as Schumpeter (1912) 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 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” (Macmillan Committee, 1931, pp. 12 ff.).

“… 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” (p. 13).

Concerning the question whether credit demand or credit supply is more important, the report argued that the root cause is the movement of 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 by industry from the banking system. … Thus what started as an alteration in the supply of credit ends up in the guise of an alteration in the demand for credit” (p. 99). 20

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 exogenous as far as loan applicants are concerned:

“There can be no doubt as to the power of the banking system … to increase or decrease the volume of bank money” (p. 102).

“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 money in enterprise and investment is indisputable” (p. 102).

The Macmillan 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 financial variables were later formalised in the Quantity Theory of Credit (Werner, 1992,Werner, 1997, Werner, 2005 and Werner, 2012), which argues that credit for (a) 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 (c) unproductive use in the form of asset transactions results in asset inflation and, if large enough, banking crises. However, since the 1920s 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 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. more