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Can banks individually create money out of nothing? — The theories and
the empirical evidence
☆
Richard A. Werner
Centre for Banking, Finance and Sustainable Development, University of Southampton, United Kingdom
abstractarticle info
Available online 16 September 2014
JEL classification:
E30
E40
E50
E60
Keywords:
Bank credit
Credit creation
Financial intermediation
Fractional reserve banking
Money creation
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 no n-bank financial institutions, collecting deposits that ar e 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 the-
ory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it ex-
tends 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, where-
by 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
accoun ts 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 create d as ‘fairy
dust’ produced by the banks individually, "out of thin air".
© 2014 Published by Elsevier Inc.
“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 socie ty 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 pro-
vide an adequate description of crucial features of our economies and
financial systems, and, most notably, fai led to include banks.
2
These
bank-less dominant theories are likely to have influenced bank regula-
tors and may thus have contributed to sub-optimal bank regula tion:
Systemic issues emanating from the banking sector are impossible to de-
tect in economic models that do not include banks, or in finance models
that are based on individual, representative financial institutions with-
out embedding these appropriately into macroeconomic models.
3
International Review of Financial Analysis 36 (2014) 1–19
☆
The author wishes to acknowledge excellent research support from Dr. Kostas
Voutsinas and Shamsher Dhanda. Moreover, the author is grateful to the many bank
staff at numerous banks involved in this study, who have given their time for meetings
and interviews. Most of all, the author would like to thank Mr. Marco Rebl, Director of
Raiffeisenbank Wildenberg e.G., for his cooperation and arranging the cooperation of his
colleagues in conducting the empirical examination of bank credit creation and making
the facilities, accounts and staff of his bank accessible to the researcher. Finally, should
grains of wisdom be found in this article, the author wishes to attribute them to the source
of all wisdom (Jeremiah 33:3).
1
Translated into English by the author. See also Wicksell (1935).
2
Federal Reserve Vice-Chairman Kohn (2009) bemoaned this issue. Examples of lead-
ing macroeconomic and monetary models without any banks include Walsh (2003) and
Woodford (2003), but this problem applies to all the conventional macromodels proposed
by the major conventional schools of thought, such as the classical, Keynesian, monetarist
and neo-classical theories, including real business cycle and DSGE models.
3
The ‘Basel’ approach to ba nk regulation focuses on regulation of capital adequacy.
Werner (2010a) has argued that this is based on economic theories that do not feature a
special role for banks. For an overview and critique, see Werner (2012).
http://dx.doi.org/10.1016/j.irfa.2014.07.015
1057-5219/© 2014 Published by Elsevier Inc.
Contents lists available at ScienceDirect
International Review of Financial Analysis
Consequently, many researchers have since been directing their
efforts at incorporating banks or banking sectors in economic
models.
4
This is a p ositive development, and the European Confer-
ences 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 Southa mpton Centre for Banking, Finance and
Sustainable Development. As the work in this area remains highly di-
verse, this article aims to contribute to a better understanding of crucial
features of banks, which would facilitate their suitable incorporation in
economic models. Researchers nee d 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 re-
view of the literature identifies three different, mutually exclusive views
on the matter, each holding sway for about a third of the twentieth cen-
tury. The present conventional view is that banks are mere financial in-
termediaries that gather resources and re-allocate them, just like other
non-bank financial institutions, and without any special powers. Any
differenc es between banks and non-bank financial institutions are
seen as being due to regula tion 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 direct-
ly. 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 domi-
nant view was that t he banking system is ‘unique’,sincebanks,un-
like other financial intermediaries, can collectively create money,
based on the fractional reserve o r ‘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 de posits an d lending these out, without the ability to
create money. This view shall be called t he fractional reserve theory
of banking.
Thereisathirdtheoryaboutthefunctioningofthebankingsec-
tor, with an ascendancy in the firs t two de cades 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 res pec ts. 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 inste ad 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: T oday 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 re-
cord 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 un-
derstanding and modelling the role of banks correctly within the
economy, but also for the d esign of appropriate bank regulation
that aims at sust ainable economic growth without crises. The
modern approach to bank regulation, as implemented at least since
Basel I (198 8), is predicated on the understa ndin g that the financial
intermediation theory is co rrect.
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 cor-
rect.
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 inter-
mediation theory is not an accurate description of reality, it would
throw doubt on the suitability of Base l III and similar national
approaches to bank regul ation, 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 evi-
dence 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 monitor-
ing of its internal records and operations, allowing access to its docu-
mentation 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 exp licitly 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 matt er 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 exp anded 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
4
One older attempt that has stood up to the test of time is Werner (1997).
5
See, for instance, the first BCBS Working Paper (BCBS, 1999), looking back on the first
decade of experience with Basel I for insights into the thinking of the Basel bank regula-
tors. Ina section headlined‘Do fixed minimumcapital requirements create credit crunches
affecting the real economy?’, the authors argue: “It would in fact be strange if fixed mini-
mum capital requirements did not bite in some periods, thereby constraining the banks,
given that the purpose of bank [capital] requirements is to limit the amount of risk that
can be taken relative to capital. However, for this to have an effect on output, it would have
to be true that any shortfall in bank lending was not fully made up through lending by
other intermediaries or by access to securities markets.” This statement presupposes that
the financial intermediation theory holds. If banks are the creators of the money supply, and
in this role unique and different from non-bank financial intermediaries, as the other two
hypotheses maintain, then a reduction in bank credit (creation) must have effects that
non-bank financial intermediaries cannot compensate for.
6
See, for instance, Werner (2005, 2010a).
7
As seen in the work of the Independent Commission on Banking, ICB, 201 1, also
known as the Vickers Commission. For contributions to the consultation of the ICB, see,
for instance, Werner (2010b). The recommendations therein, especially the recommenda-
tion to discard the financial intermediation theory, were not heeded.
2 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
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 not hing. As a result,
earlier authors, writing mainly about paper money issua nce, are
only mentioned in passing here, even if it could be said that their argu-
ments might also apply to banks that do not issue bank notes. These in-
clude John Law (1705), James Steuart (1767), Adam Smith (1776),
Henry Thornton (1802), Thomas Tooke (1838),andAdam Müller
(1816), among others, who either directly or indirectly state tha t
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, 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 editio ns well in to 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 c reated 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 suppo sing that bankers
only make advances out of bona fide capital. This is so fully set
forth in the chap ter on the Theory of Banking, that we need only
to remind our readers that all banking advances are made, in
the first instan ce, 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 li mited
by their own capi tal; they are no t, at le ast not immediately,
limited by any capital whatever; by conce ntrating in their
hands almost all payments, they themselves create the money
required….”
“In a pure system of credit, where all payments were made by trans-
ference 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 tremen-
dous 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)]
8
The practice of issuance of promissory notes by commercial banks has continued for
far longer in Scotland and Northern Ireland — namely until today. This did not seem, how-
ever, to result in a sizeable literature on bank money creation in the UK throughout the
20th century.
9
Referring to the issuance of bank notes that circulate as paper money, Smith com-
ments “The banks, when their customers apply to them for money, generally advance it
to them in their own promissory notes” (p. 242). …“It is chiefly by discounting bills of ex-
change, that is, by advancing money upon them before they are due, that the greater part
of banks and bankers issue their promissory notes. … The banker, who advances to the
merchant whose bill he discounts, not gold and silver, but his own promisso ry notes,
has the advantage of being able to discount to a greater amount by the whole value of
his promissory notes, which he finds, by experience, are commonly in circulation. He is
thereby enabled to make his clear gain of interest on so much a larger sum ” (Smith,
1776, p. 241). “Jeder Provinzialbanquier strebt dahin, sein Privatgeld zum Nationalgelde
zu erheben: er strebt nach der größtmöglichen und möglichst allgemeinen Umsetzbarkeit
seines Privatgeldes. Es ist in England nicht bloß die Regierung, welche Geld macht,
sondern die Bank von England, jede Pri vatbank, ja jede einzelne Haushaltung (ohne
gerade bestimmte Noten auszugeben, aber, in wie fern sie sich an eine bestimmte Bank
thätig anschließt) helfen das Geld machen” (Müller, 1816, p. 240). “Sobald die Regierung
also die Geldzeichen mechanisch vermehrt, ohne in demselben Maaße jene andern
Organe, denen die Vortheile der Geldvermehrung nur indirekt zu gute kommen, zu
stärken, ohne um so kräftiger und gerechter das Ganze zu umfassen, so überträgt sie im
Grunde nur das Privilegium der Gelderzeugung, das sie im Nahmen des Ganzen ausübt,
auf ein einzelnes Organ. … soll te sie [die Regierung] also ihr Privilegium der
Gelderzeugung nicht bloß aufheben, sondern das bisher erzeugte Geld zurück nehmen,
so gibt sie damit nur dem Privatc redit, das heißt, dem verwöhnten verderbten
Privatcredit, oder dem Wucher die förmliche Befugniß in die Hände, die Lücken zu
ergänzen, selbst Geldmarken zu machen, und somit seinen verderblichen und
vernichtenden Einfluß auf das Ganze nun erst recht zu äußern” (Müller, 1816, p. 305).
10
There is also another group of writers who to some extent agree with this description,
but one way or another downplay its role or importance in practice. In terms of the history
of economic thought it can be said that the latter group laid the groundwork and were the
founding fathers of the fractional reserve theory. To the extent that they recognise the cre-
ation of credit by banks out of nothing under certain circumstances one might argue that
they could be classified as supporter of either the credit creation theory or the fractional re-
serve theory, but to minimise confusion, here the impact their work has had in its common
interpretation was chosen, as well as their emphasis on reserves as a key mechanism, so
that they were included in the latter theory.
11
An Inn of Court with the status of a local authority, inside the territory of the City of
London Corporation.
12
This paper was read by Wicksell in London in the Economic Section of the British As-
sociation in 1906 and it is recorded in the Economic Journal that Palgrave and Edgeworth
commented on it. There is no mentioning of any objections to the claims about the ability
of banks to create money out of nothing.
3R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
“… 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 func-
tion the ban ks 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 curren-
cy, 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 been privatise d and granted to
the commercial banks:
“By this interesti ng 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 caug ht on in Germany with the publication of Sch umpeter's
(1912, English 1934) influential book The Theory of Economic Develop-
ment, in which he was unequivocal in his view that each individual
bank has the power to create money out of nothing.
“So mething like a cert ificate of f uture 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 ap-
proaches the banker. … (The banker) would not be an intermedi-
ary, but manufacturer of cred it, i.e. he would create himself the
purchasing power that he lends to the entrepren eur …. 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 pur-
pose of transferring it to the entrepreneur, but not simply the trans-
fer 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 writ-
ings of Davenport (1913) or Robert H. Howe (1915) indicate. Hawtrey
(1919), another leading British economist who like Keynes, had a Trea-
sury 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 de-
scribe 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 pay-
ment, 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 individ ually
through the process of lending.
16
Highly influentialinbothacademic
discou rse 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
Eff ecten- und Wechsel-Bank, Frankfurt. Like Macleod a trained law-
yer, he became an honorary professor at Goet he-University
13
“Since, then, variations in the quantity of currency have thesewidespread effects, it is a
matter which bankers have to consider seriously, how far it is possible from them to apply
some scientific regulation to the volume of currency, and whether it is possible to modify
the evils that follow from wide fluctuations in prices by some such regulation” (p. 55). For
a more recent application and more precise formulation of this principle, see Werner's
Quantity Theory of Credit (Werner, 1992, 1997, 2005, 2012). “… the most important of
the modern forms of currency, namely the cheque, is, in effect, manufactured for the use
of its customers by banks; and, further, that since the volume of currency has an important
effect upon raising prices, the extent to which currency is thus created is a responsibility
which has to be seriously considered by those who work the financial machine. This man-
ufacture of currency is worked through the granting of credit, and credit may thus be de-
fined, for the purposes of this inquiry, as the process by which finance makes currency for
its customers. As we saw in the last chapter, deposits, which are potential currency as they
carry with them the right to draw a cheque, are produced largely through the loans, dis-
counts and investments made by bankers” (p. 63). “The creation of credit is thus seen
clearly to result in the manufacture of currency whenever the banks buy bills of exchange
… or make an advance …. In either case the banks give somebody the right to draw
cheques. … When a bank makes an advance to a stock broker the result is exactlythe same
…. The same result, in rather a different form, happens when a bank makes investments
on its own account. … There has thus been, in each case, an increase in deposits through
the operation of the bank in lending, discounting, or investing. If we can imagine all the
banks suddenly selling all their investments and bills of exchange and calling in all their
advances, the process could only be brought about by the cancelling of deposits, their
own and one another's” (p. 72).
14
“Etwas Ähnliches wie eine Bescheinigung künftiger Produkte oder wie die Verleihung
von Zahlkraft an die Versprechungen des Unternehmers gibt es nun wirklich. Das ist der
Dienst, den der Bankier dem Unternehmer erweist und um den sich der Unternehmer
an den Bankier wendet. … so wäre er nicht Zwischenhändler, sondern Produze nt von
Kredit, d.h. er würde die Kaufkraft, die er dem Unternehmer leiht, selbst schaffen ….
Man könnte ohne große Sünde sagen, daß der Bankier Geld schaffe” (S. 197). Translated
by author.
15
“Die fiktive Bescheinigung von Produkten, die die Kreditzahlungsmittel sozusagen
ursprünglich darstellten, ist zur Wahrheit geworden” (Schumpeter, 1912, S. 223). Trans-
lated by author.
16
For instance, Moeller (1925) states that “In the modern monetary system the creation
of new paper or bank accounting currency (‘Buchungsgeld’,or‘bank book money’)ispri-
marily in the hands of the banks. … For the deposit money the same largely applies as for
paper money …” (pp. 177 ff.).
4 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
Frankfurt in 1928. C learly not only awa re of the works of Macleod,
whom he cites, but also likely aware of act ual banking practice
from his family business, Hahn argued that b anks 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 de-
scribed 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 busi-
ness, 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 s pawni ng much contr oversy and new res earch among econo-
mists in Germany. It also gr eatly heightened awareness a mong jour-
nalists 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 ent renched 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 j ust a popular explanation without
academic c redibility. Schumpeter cited it positively in th e se cond
(German) edition of his Theory of Economic Development (Sch umpeter,
1926), praising it as a further development in line with, but be-
yond, his own book. The English translation of Schumpete r's in-
flue ntial book Schumpeter (1912 [1934]) also favourably ci tes
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 ‘cur-
rent 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 dom-
inant view. In his Tract on Monetary Reform (Keynes, 1924), he asserts,
apparently without feeling the need to establish this furt her, 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, chieflytheBigFive…” (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 ex-
penditure. 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 spend-
ing 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 avail-
able by the banking system in other directions will, through a variety
of channels, affect the ease of embarking on new investment propo-
sitions. This, in turn, will affect the volume and profitablenes s of
business, and hence react in due course on the amount of accommo-
dation 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
17
“Jeder Kredit der gegeben wird, erzeugt seinerseits ein Deposit und damit die Mittel zu
seiner Unterbringung. … Die Folgerung aus dem skizzierten Vorgang kann man auch
umgekehrt ausrücken, indem man sagt – und dieser Schluß ist ebenso zwingend – ,daß
jedes irgendwie u nd irgendwo in der Volkswirtschaft vorhandene Scheck- oder
Ueberwei sungsguthaben sein Entstehen einer vorau sgegangenen Kreditge währung,
einem zuvor eingeräumten Kredit zu verdanken hat” (S. 28). Translated by author.
18
“Wir behaupten also im Gegensatz zu der gesamten, in dieser Beziehung so gut wie
einigen Bank- und Kreditliteratur, daß nicht das Passivgeschäft der Banken, insbesondere
das Depositengeschäft das Primäre ist, sondern daß allgemein und in jedem einzelnen
Falle ein Aktivgeschäft einer Bank vorangegangen sein muß, um erst das Passivgeschäft
einer Bank möglich zu machen und es hervorzurufen: Das Passivgeschäft der Banken ist
nichts anderes als ein Reflex vorangegangener Kreditgewährung. Die entgegengesetzte
Ansicht beruht auf einer Art optischer Täuschung …” (S. 29). Translated by author.
19
See, for instance, Phillips (1920, p. 72, p. 119).
20
This is in line with the credit supply determination view proposed by Werner (1997,
2005) and his Quantity Theory of Credit, as opposed to the endogenous credit supply view
of many post-Keynesians.
5R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
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 ma-
nipulated by the Bank of England, and thus was also considered exoge-
nous 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, 1997, 2005, 2012), which argues that credit for (a) pro-
ductive use in the form of investments for the production of goods and
services is sustainable and non-inflationary, as well as less likely to be-
come a non-performing loan, (b) unproductive use in the form of con-
sumption 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 frac-
tional 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.
2.2. The fractional reserve theory
An early prop onent of the fractional reserve theory was Alfred
Marsh all (1888).Hetestified 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 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 loan-
ing power got by the banks would amount to three times what it
otherwise would be.”
[Marshall (1888), as quoted by Yohe (1995, p. 530)]
With this, he contradicted Macleod's arguments. H owev er,
Marshall's view was still a minority view at the time. After the end of
the First World War, a number of influential economists argued that
the ‘Old Theory’ (Phillips, 1920:72) of bank credit creation by individual
banks was mistaken. Their vi ew gradually became more influential.
“The theory of deposit expansion reached its zenith with the publication
of C.A. Phillips' Bank Credit …” (Goodfriend, 1991, as quoted by Yohe,
1995, p. 532).
Phillips (1920) 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 ‘Old Theory’ (the credit creation theory)was
“predicated upon the contention that 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” (p. 72).
21
According to Phillips (1920), individual banks cannot create credit or
money, but collectively the banking system does so, as 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” (p. 40). Each bank is considered
mainly a financial intermediary: “… the banker … handles chiefly the
funds of others” (pp. 4–5). P hillips arg ued that sinc e banks target
particular cash to deposit and reserve to deposit ratios (as cited in
the money multiplier), which they wish to maintain, each bank ef-
fectively works as an intermediary, len ding out as much as it is
able to gather in new cash. Through the process of dispersion and
re-iteration, the financial int ermediation function of individual
banks, without the power to create credit, adds up to an expansion
in th e money supply in aggregate.
22
Crick (1927) shared this conclusion (with some minor caveats).
Thus he argued:
“The important point, which is responsible for much of the contro-
versy and most of the misunderstanding, is that while one bank re-
ceiving an addition to its cash cannot forthwith undertake a full
multiple addition to its own deposits, yet the cumulative effect of
the additional cash is to produce a full multiple addition to the de-
posits of all the banks as a whole” (p. 196).
“Summing up, then, it is clear … that the banks, so long as they main-
tain 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 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, invest-
ments and other assets. But this is not to say that the banks cannot
and do not effect multiple additions to or subtractions from deposits
as a whole on the basis of an expansion of or contraction in bank cash”
(p. 201).
The role of banks remained disputed during the 1920s and 1930s,
as several writers criticised the credit creation theory. Views not only
diverged, but were also in a flux, as several experts apparently
shifted their position gradually — ove rall an increasing number
moving away from the credit creation th eory and towards the frac-
tional reserve theory.
Sir Josiah C. Stamp, a former director of the Bank of England,
summarised the state of debate in his review of an article by Pigou
(1927):
“The general public economic mind is in a fair state of muddlement
at the present moment on the apparently simple question: “Can
the bank s c reate credit, and if so, how, and how much?” and be-
tween the teachings of Dr. Leaf and Mr. McKenna, Messrs. Keynes,
Hawtrey, Cassel and Cannan and Gregory, people have not yet found
their way.”
[Stamp (1927, p. 424)]
21
His analysis was based on the “overlooked … pivotal fact that an addition to the usual
volume of a bank's loans tends to result in a loss of reserve for that bankonly somewhat less
on average than the amount of the additional loans. … Manifold loans are not extended by
an individual bank on the basis of a given amount of reserve” (Phillips, 1920, p. 73).
22
It should be noted here that Phillips' (1920) work can be interpreted in a more differ-
entiated manner. For instance, Phillips did also point out that if all banks increased their
lending at roughly the same pace, each bank would, after all, be able to create credit with-
out losing reserves or cash, on balance (pp. 78 ff.). However, subsequent writers citing
Phillips usually do not mention this. While a more detailed discussion of Phillips is, how-
ever, beyond the scope of this paper, it is here merely claimed that Phillips' argument was
an important stepping stone towards the formulation of the fractional reserve theory of
banking, which is unequivocal in treating individual banks as mere financial intermedi-
aries without the power to create credit or money individually under any and all circum-
stances, even though it could possibly be argued that Phillips himself may not have agreed
with the latter in all respects.
6 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
Contributions to this debate were also made by Dennis Robertson
(1926), who was influenced by Keynes.
23
Keynes (1930) explains the
role of reserve holdings and the mechanics of determining a bank's be-
haviour based on its preference to hold cash and reserves, together with
the amount of reserves provided by the centra l bank — the fairly
predetermined mechanics postulated by the money multiplier in a frac-
tional reserve model:
“Thus in countries where the percentage of reserves to deposits is by
law or custom somewhat rigid, we are thrown back for the final de-
termination of M, the Volume of Bank-money on the factors which
determine the amount of these reserves” (p. 77).
Keynes (1930) 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 re-
serves a t th e central bank in order to lend th ese out to the non-
banking sector of the economy:
“When 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 addi-
tional deposit (to the credit of the borrower or to the credit of those
to whom he may c hoose to transfer it) on the other side of the
balance sheet of this or some other bank.”
[Keynes (1930, vol. 2, p. 218)]
Keynes here argues that new deposits, based on new loans, are de-
pendent upon and connected to banks' reserve balances held at the cen-
tral bank. This view is sometimes also supported by present-day central
bankers, such as in Paul Tucker's or the ECB's proposal to introduce neg-
ative interest rates on banks' reserve holdings at the central bank, as an
incentive for them to ‘move’ their money from the central bank and in-
crease lending.
24
Nevertheless, part of Keynes (1930), and much of his
most influential work, his General Theory (1936), appears more in line
with the financial intermediation theory, as will be discussed in the fol-
lowing section.
A representative example of the fractional reserve theory that at the
same time was begin ning to point in the direction of the financial
intermediation theory is the work by Lutz (1939), who published in
Economica, a forum for 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 ad-
ditional cash in use, simply because the same cash 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 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 Crick variety). That
theory explains the creation of deposits by the fact that the same
cash (in decreasing amounts) is succes sively paid into different
banks. It does, however, look upon this cash movemen t rather in
the nature of a technical affair between bank s … 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
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 a new, but to a very old theory of the func-
tion of banks: the function of a mere intermediary … (pp. 166 ff.).
“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: the provision of con-
fidenc e which induces the econ omic subjects to extend credit to
each other by using the bank as an intermediary” (p. 169).
Phillips' influence has indeed been significant. Even in 1995
Goodfriend still argued that
“… Phillips showed that the summation of the loan- and deposit-
creation series across all individual banks yields the multiple expan-
sion formulas for the system as a whole. Phillips' definitive exposition
essentiall y established the theory once and for all in the form found in
economics textbooks today.”
[as reprinted in Yohe (1995, p. 535)]
Statements like this became the mainstream view in the 1950s and
1960s.
25
The view of the fractional reserve theory in time also came to
dominate textbook descrip tions of the functioning of the monetary
and banking system. There is no post-war textbook more representative
and influential than that of Samuelson (1948). The original first edition
is clear in its description of the fractional reserve theory:Underthehead-
ing “Can banks really create money?”,Samuelsonfirst dismisses “false
explanations still in wide circulation” (p. 324):
“According to these false explanations, the managers of an ordinary
bank are able, by some use of their fountain pens, to lend several dol-
lars for each dollar left on deposit with them. No wonder practical
bankers see red 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; and any money that he does invest in
buying a security or making a loan will soon leave his bank” (p. 324).
Samuelson thus argues that a bank needs to gather the funds first, be-
fore it can extend bank loans. This is not consistent with the credit
creation theory. However, Samuelson argues that, in aggregate, the bank-
ing system creates money. He illustrates his argument with the example
of a ‘small bank’ that faces a 20% reserve requirement, and considering
the accounts of the bank (B/S). If this bank receives a new cash deposit
of $1000, “What can the bank now do?”, Samuelson asks (p. 325).
“Can it expand its loans and investments by $4000 …?”
“The answer is definitely ‘no’. Why not? Total assets equal total
liabilities. Cash reserves meet the legal requirement of being 20
23
In the Introduction, Robertson says: “I have had so many discussions with Mr. J. M.
Keynes on the subject matter of chapters V and VI, and have rewritten them so drastically
at his suggestion, that I think neither of us now knows how much of the ideas therein
contained is his, and how much is mine (p. 5).” (As cited in Keynes, 1930.)
24
On Paul Tucker's proposal, see BBC (2013), and also the critique by Werner (2013a).
Negative rates on bank reserves at the central bank were actually imposed by the Swedish
central bank in 2009, the Danish central bank in 2012 and for the first time by the Swiss
central bank in 1978 on deposits by foreign banks.
25
Even though a closer reading of Alhadeff (1954) shows that the author agreed that,
under certain circumstances,banks can create credit and money: “In certain cases, thepro-
portion between the legal reserve ratio and residual deposits is such that even a single
bank can expand its deposits to a somewhat greater amount than its primary deposits.
… Again, it might be possible for a very large bank, or a bank in an isolated community
with few business connections with outside banks, literally to create money because of
flow back deposits. [Footnote: ‘Flow-back deposit s refer to the circulation of deposits
among the depositors of the same bank.’] In either case, this amounts to a partial reduction
in the averagecost of producing credit (making loans), at least in terms of the raw material
costs …” (Alhadeff, 1954, p. 7). Although Alhadeff, if studied closely, could be said to have
agreed that an individual bank can create credit out of nothing, he clearly thought this to
be a special case without practical relevance, while it is normally only the banking system
in aggregate that creates credit.
7R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
per cent 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 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 and have it too. Table 4b gives, therefore a completely false pic-
ture of what an individual bank can do” (pp. 325 ff.).
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 re-
serves are just enough to match its deposits. There is nothing more
it can do until the public decides to bring in some more money on
deposit” (p. 326).
On the other hand, Samuelson emphasises that
“The banking system as a whole can do what each small bank cannot
do!” (p. 324),
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. He shows “this chain of deposit creation” in a ta-
ble, amounting to total deposits in the banking system of $5000 (out of
the $1000), due to the reserve requirement of 20% implying a ‘money
multiplier’ of 5 times (assuming no cash ‘leakage’).
What Samuelson calls the “multiple deposit expansion” is described
in the same way and with remarkable similarity in the fifteenth edition
of his book (Samuelson & Nordhaus, 1995) half a century later, only that
the reserve requirement cited as example has been lowered to 10%: “All
banks can do what one can't do alone” (p. 493). There are subtle though
important differences. The overall space devoted to this topic is much
smaller in 1995 compared to 1948. The modern textbook says that the
central bank-created reserves are used by the banks “as an input” and
then “transformed”“into a much la rger amount of bank money”
(p. 490). There is far less of an attempt to deal with the credit creation
theory. Instead, each bank is unambiguously represented as a pure fi-
nancial intermediary, collecting deposits and lending out this money
(minus the reserve requirement).
26
The fractional reserve theory had be-
come mainstream:
“Each small bank is limited in its ability to expand its loans and in-
vestments. It cannot lend or invest more than it has received from
depositors” (p. 496).
Meanwhile, bank deposit money is “supplied” by “the financial sys-
tem” in an abstract process that each individual bank has little control
over (p. 494). The unambiguous fractional reserve theory thus appears
to have come about in the years after the 1950s. It can be described in
Fig. 1.
In this scheme, funds move between the public, the banks and the
central bank without any barriers. Each bank is a financial intermediary,
but in aggregate, due to fractional reserve banking, money is created
(multiplied) in th e bankin g system. Specifically, ea ch bank can only
grant a loan if it has previously received new reserves, of which a frac-
tion will always be 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 (1997):
“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 the role they play in the process of multiple-deposit cre-
ation. All they see is that their deposits have increased and therefore
they are able to make more loans” (p. 737).
In another textbook on money and banking:
“In this example, a p erson we nt into ban k 1 and deposited a
$100,000 check drawn on another bank. That $100,000 became part
of the reserves of bank 1. Because that deposit immediately created
excess reserves, further loans were possible for bank 1. Bank 1 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.”
[Miller and VanHoose (1993, p. 331)]
The depos it of a cheque from another bank does not however
increase the “total amounts of deposits and money”:
“R emember, though, that the deposit was a check written on
another bank. Therefore, the other bank suffered a decline in its
transactions deposits and its re serves. While total assets and
liabilities i n bank 1 have increased by $100,000, they have de-
creased in the othe r bank by $ 100,000. Thus the total amount of
money and credit in the economy is unaffected by the transfer of
funds f rom one depository institution to another.Eachdepository
institution can create loans (and deposits) only to the extent that
it has excess reserves. The thing to remember is that new reser ves
are not created when che cks written on one bank are deposited in
another bank. The Federal Reserve System, however, can create
new reserves” (p. 331).
The textbook by Heffernan (1996) says:
“To summarise, all moder n banks act as intermediar ies between
borrowers and lenders, but they may do so in a variety of differ-
ent ways , from the trad itional function of taking deposits and
lending a percentage of these deposit s, to fee-based financial
services” (p. 18).
“For the bank, which pools these surplus funds, there is an opportu-
nity for profit through fractional reserve lending, that is, lending out
26
Moreover, the original Samuelson (1948: 331) offered an important (even though not
prominently displayed) section headed ‘ Simultaneous expansion or contraction by all
banks’, which provided the caveat that each individual bank could, after all, create de-
posits, if only all banks did the same at the same rate (thus outflows being on balance can-
celled by inflows, as Alhadeff, 1954, also mentioned). There is no such reference in the
modern, ‘up-to-date’ textbook.
Fig. 1. The fractional reserve theory as represented in many textbooks.
8 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
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” (p. 20).
While 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 on banking theory.”
[Mints (1945, p. 39)]
Several attempts were made to resolve this wi thin the fracti onal
reserve theory of banking, such as that by Saving (1977), who rendered
the supply of bank deposits a function of the behaviour of the savers —
arguing that the money supply is endogenous. This effectively pushed
out the inte rmediary function from the individual bank level to the
economy level, and helped ushering in the formulation of the financial
intermediation theory to which we now turn.
2.3. The financial intermediation theory
While the fractional reserve theory of banking was influential from
the 1930s to the 1960s, Keynes may have sown important seeds of
doubt. Already in his ‘Treatise’, Keynes (1930) makes use 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 disap-
proval, as well as mocke ry of the concept that banks could crea te
money out of nothing. The device was copied by many other writers
after Keynes who also emphasised the role of banks as ‘financial
intermediaries’. In Keynes' words:
“A banker is in possession of resources which he can lend or invest
equal to a large proportion (nearly 90%) of the deposits standing to
the credit of his depositors. In so far as his de posits are Savings-
deposits, he is acting merely as an intermediary 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 re-
sources for his borrowing-customers. Thus the modern banker per-
forms two distinct sets of services. He supplies a su bstitute for
State Money by acting as a clearing-house and 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
actin g 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 and trade mainly to meet
demands for working capital. 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.”
[
Keynes (1930, vol. 2, p. 213)]
The Keynes of the Treatise se ems 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 out. There seems
no money creation at all involved, certainly not on the individual bank
level. Keynes' most influential opus, General Theory (Keynes, 1936)
quickly eclipsed his earlier Treatise on Money in terms of its influence
on public debate. In the General Theory, Keynes did not place any em-
phasis on banks, 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 in-
creased bank-credit to the exclusion of the others. … 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 he deliberately prefers
to hold more money rather than some other form of wealth. … Thus
the old-fashioned view th at saving always involves investment,
though incomplet e and misle ading, is formally sounder than the
newfangled view that there can be saving without investment or in-
vestment without ‘genuine’ saving.”
[Keynes (1936, pp. 82 ff.)]
Schumpeter (1954) commented on this shift in Keynes' view:
The “deposit-creating bank loan and its role in the financing of in-
vestment 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
Keynesianism has in fact reverted to the old view …. Whether this
spells progress or retrogression, every economist must decide for
himself” (p. 1115, italics in original).
The early post-war period saw unprecedented influence of Keynes'
General Theory, and a Keynesian school of thought that managed to
ignore Keynes' earlier writings on bank credit creation, became
dominant in academia. Given that a former major proponent of both
the credit creation and the fractional reserve theories of banking had
shifted his stance to the new financial intermediation theor y,itisnot
surprising that others would follow.
A highly influential challenge to the fracti onal reserve theory
of
banking was staged by Gurley and Shaw (1955, 1960). 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 brokerage function of transmitting loanable funds that are
somehow generated elsewhere” (1955, p. 521). Beyond the usual rhe-
torical devices to denigrate the alternative theories, Gurley and Shaw's
actual argument was that banks should not be singled out as being ‘spe-
cial’, since the banks' financial intermediation function is identical to
that of other financial intermediaries:
“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 institutions create finan-
cial claims; and both may engage in multiple creation of their partic-
ular liabilities in relation to any one class of asset that they hold.”
[Gurley and Shaw (1960, p. 202)]
Banks and the banking system, we are told, like other financial inter-
mediaries, 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 challenges by proponents of the fractional reserve theory
of banking (see Gutt entag & Lindsay, 1968)weresweptaway
during the 1960s, when James Tobin, a new rising star in economics,
took a clear stand to proclaim another ‘new view’ of banking, formulat-
ing the modern version of the financial intermediation theory of banking.
“Tobin (1963), standing atop the wreckage in 1963 to set forth the
‘new view’ of commercial banking, stands squarel y with Gurley
and Shaw against the traditional view.”
[Guttentag and Lindsay (1968, p. 993)]
9R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
Like Keynes, Alhadreff 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
money and credit. Tobin (1963) argued:
“Neither individually nor collectively do commercial banks possess a
widow's cruse” (p. 412).
“The distinction between commercial banks and other financial inter-
mediaries has been too sharply drawn. The differences are of degree,
not of kind …. In particular, the differences which do exist have little
intrinsicall y to do with the monetary nature of bank liabilities … The
differences are more importantly related to the special reserve re-
quirements and interest rate ceilings to which banks are subject.
Any other financial industry subject to the same kind of regulations
wouldbehaveinmuchthesameway” (p. 418).
Banks only seem to be different from other s, because regulators
erroneously chose to single them out for special regulation. In Tobin's
view, “commercial banks are different, because they are controlled,
and not the other way around” (Gutt entag & Lindsay, 1968, p. 993).
Tobin and Brainard's (1963) portfolio model made no distinction be-
tween banks and non-bank financial intermediaries, indeed, ignored
the role of banks altogether and contributed much towards the modern
mainstream view of economics models without banks. Branson (1968)
further developed Tobin's new approach, which was popular in the
leading journals.
Guttentag and Lindsay (1968) wrote in the Journal of Political Economy
that despite the challenge by Gurley and Shaw (1955) “The uniqueness
issue, on the other hand, remains unsettled” (p.992).Banks,theyargued,
are different in their role and impact from non-bank financial intermedi-
aries, since “commercial banks have a greater capacity for varying the ag-
gregate volume of credit than other financial intermediaries” (p. 991).
“These points provide a rationale for special controls on commercial
banks that goes beyond the need to prevent financial panic. It is the ratio-
nale that has been sought by defenders of the traditional view that com-
mercial banks are ‘unique’ ever since the Gurley–Shaw challenge to this
view” (p. 991).
Undaunted, Tobin (1969) re-states his view in an article estab-
lishing his portfolio balance approach to financial markets, which ar-
gues that financial markets are compl ex webs of asset s and p rices,
leaving banks as one of many types of intermediaries, without any
special role.
27
This was the first article in the first e dition of a new
journal, the Journal of Money, Credit and Banking. While its name
may suggest open ness towards t he various the ories of bankin g, 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 is also true for most other journals classified as ‘leading
journals’ in economics (for instance, using the 4-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 financial
intermediation theory become the dominant creed among economists
world-wide.
Modern proponents of the ubiquitous financial intermediation theory
include, among others, Klein (1971), Monti (1972), Sealey and Lindley
(1977), Diamond and Dybvig (1983), Diamond (1984, 1991, 2007),
Eatwell, Milgate, and Newman (1989), Gorton and Pennacchi (1990),
Bencivenga and Smith (1991), Bernanke and Ge rtler (1995), Rajan
(1998), Myers and Rajan (1998), Allen and Gale (2000, 2004a,b), Allen
and Santomero (2001), Diamond and Rajan ( 2001), Kashyap, Rajan,
and Stein (2002), Hoshi and Kashyap (2004) , Matthews and
Thompson (2005), Casu and Girardone (2006), Dewatripont, Rochet
and Tirole (2010), Gertler and Kiyotaki (2011) and Stein (2014).There
are many more: It is impossible to draw up a conclusive list, since the
vast majority of articles published in leading economics and finance
journals in the last thirty to forty years is based on the financial interme-
diation theory as premise.
28
Quoting only a few examples, Klein (1971), Monti (1972) (later to
become EU commissioner and prime minister of Italy), and others
model banks as financial intermediaries, gathering deposits and 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 is-
suance of various types of deposits ….”
[Klein (1971, p. 208)]
“… 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 bank confronts, determine
the scale and composition of the bank's deposit liabilities the bank
will assume.”
[Klein (1971, p. 210)]
Diamond and Dybvig (1983) are cited as the seminal work on bank-
ing, and they argue that “Illiquidity of assets provides the rationale both
for the existence of banks and for their vulnerability to runs” (p. 403).
But in actual fa ct their theory makes no distinction between banks
and non-banks. T hey therefore are unable to explain why we have
heard of bank runs, but not of ‘insurance runs’ or ‘finance company
runs’, altho ugh the latter also hold illiquid assets and give out loans.
Diamond and Dybvig fail to identify what could render banks special
since they assume that they are not.
Other theories of banks as financial intermediaries are presented by
Mayer (1988) and Hellwig (1977, 1991, 2000), who also believe that
banks are merely financial intermediaries:
“The analysis uses the original model of Diamond (1984) of financial
contracting with intermediation as delegated monitoring. … Monitor-
ing is assumed to be too expensive to be used by the many house-
holds required to finance a firm or an intermediary. However
direct finance of firms based on nonpecuniary penalties may be
dominated by intermediated finance with monitoring of firms by
an intermediary who in turn obtains funds from households through
contracts involving nonpecuniary penalties.”
[Hellwig (2000, pp. 721 ff.)]
Banking expert Heffernan (1996)
states:
“The existence of the “traditional” bank, which intermediates be-
tween borrower and lender, and which offers a payments service
to its customers, fits in well with the Coase theory” (p. 21).
27
The conclusion of Tobin's paper: “According to this approach, the principal way in
which financial policies and events affect aggregate demand is by changing the valuations
of physical assets relative to their replacement costs. Monetary policies can accomplish
such changes, but other exogenous events can too. In addition to the exogenous variables
explicitly listed in the illustrative models, changes can occur, and undoubtedly do, in the
portfolio preferences – asset demand functions – of the public, the banks, and other sec-
tors. These preferences are based on expectations, estimates of risk, attitudes towards risk,
and a host of other factors. In this complex situation, it is not to be expected that the essen-
tial impact of monetary policies and other financial events will be easy to measure in the
absence of direct observation of therelevant variables(q in the models). There is no reason
to think that the impact will be captured in any single exogenous or intermediate variable,
whether it is a monetary stock or a market interest rate” (Tobin, 1969, p. 29).
28
This also means that the innumerable PhD theses and Masters dissertations produced
in this area in the last thirty years or so are mainly based on the financial intermediation
theory. For instance, Wolfe (1997) states: “Banks possess the power of intermediation,
which is the ability to transform deposits into loans. Deposits with one set of characteris-
tics are transformed into assets with other or different characteristics” (p. 12).
10 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
… or a leading textbook on international economics an d finance, by
Krugman and Obstfeld (2000):
“Banks use depositors' funds to make loans and to purchase other
assets …” (p. 659).
A widely used reference work on banking and money – the New
Palgrave Money (Eatwell et al., 1989) – contains a number of contribu-
tions by leading monetary economists and banking experts. In it,
Baltensperger (1989) clearly supports the financial intermediation theory:
“The role of credit as such must be clearly separated from the eco-
nomic role of credit institutions, such as banks, playing the role of
specialised intermediaries in the credit market by buying and simul-
taneously selling credit instruments (of a different type and quality).
Since th e ultimate borrowers and lender s can, in principle, do
business with each other directly, without the help of such an inter-
mediary, the function of these middlemen must be viewed as sepa-
rate from that of credit as such. Two main functions of institutions of
this kind can be distinguished. The first is the function of risk consol-
idation and transformation. … The second major function of these
institutions is that of a broker in the credit markets. As such, they
specialise in 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 transac-
tions themselves” (pp. 100 ff.).
Indeed, almost all authors in this reference book refer to banks as
mere financial intermediaries, even Goodhart (1989):
“‘Intermediation’ generally refers to the interposition of a financial
institution in the proc ess 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 in-
termediaries, lessens their advantages in the provision of financial
services, and drives financial transfers and 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 profit-
ability, so much that the more credit-worthy borrowers are induced
to raise short-term funds directly from savers, for example, in the
commercial paper market” (p. 144).
Myers and Rajan (1998) 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 in-
dividual investors” (p. 755).
Allen and Santomero (2001), in their paper entitled ‘What do finan-
cial intermediaries do?’ state:
“In this paper we use these observations as a starting point for
considering what it is that financial intermediaries do. At center, of
course, financial systems perform the function of reallocating the re-
sources of economic units with surplus funds (savers) to economic
units with funding needs (borrowers)” (p. 272).
Kashyap (2002) also believes that banks are pure financial interme-
diaries, not materially distinguishable from other non-bank financial
institutions.
29
Stein (2014) states, albeit with some hesitation:
“… at least in some cases, it seems that 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” (p. 5).
“Overall, our synthesis of these stylised facts is that banks are in the
busines s of taking deposits and investing these deposits in fixed-
income assets that have certain well-defined risk and liquidity attri-
butes but which can be either loans or securities” (p. 7).
The financial intermediation theory includes the ‘credit view’ in mac-
roeconomics, proposing a ‘bank lending channel’ of monetary transmis-
sion (Bernanke & Blinder, 1989; Bernanke & Gertler, 1995), as well as
the neo-classical and new classical macroecono mic models (if they
consider banks at all). To these and most contemporary authors in eco-
nomics 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/size), or which focus on ‘monitoring’
others (Sheard, 1989, another adherent of the financial intermediation
theory of banking), but do not create credit individually or collectively.
This is true for many ‘Post-Keynesians’ who argue that the money sup-
ply is determined by the demand for money. It is also true for popular
descriptions, such as th at by Koo and Fujita (1997) who argue that
banks are merely financial intermediaries:
“But those financial institutions that are counterparties of the Bank
of Japan obtain their funding primarily from the money that depos-
itors 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, these financial institutions must lend it to firms and indi-
viduals. Those borrowers must then use it to buy assets such as
machinery or housing or services” (p. 31).
A recent paper by Allen, Carletti, and Gale (2014) introduces money —
albeit only cash created by the central bank, while banks are mere
financial intermediaries that cannot create money or credit.
As a result, the leading forecasting models used by po licy makers
also do not include banks (
Bank of England, 2014a). Even the original
meaning of credit creation seems forgotten by the modern literature:
Bernanke (1993) uses the expression ‘credit creation’ much in his arti-
cle, 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 policymakers. The purpose of this paper is to re-
view 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 exchang e for paper claims, the savings of specific individuals
or firms are made available for the use of other individuals or firms
(for example 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 channeled to alterna tive uses,
and the act of saving itself …. In my broad conception of the credit cre-
ation process I include most of the value-added of the financial indus-
try, including the information-gathering, screening, and monitoring
activities required to make sound loans or investments, as well as
much of the risk-sharing, maturity transformation, and liquidity pro-
vision 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 bor-
rowers to transmit information about themselves to lenders: for ex-
ample, for firms, these activities include provision of data to the
29
See Werner (2003b) for a detailed critique of Kashyap (2002).
11R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
public, internal or external auditing, capital structure decisions, and
some aspects of corporate governance. The efficiency of the credit cre-
ation process is reflected both in its ability to minimise the direct costs
of extending credit (for example, the aggregate wage bill of the finan-
cial industry) and in the degree to which it is able to channel an
economy's savings into the most productive potential uses. The pre-
sumption of traditional macroeconomic analysis is that this credit cre-
ation process, through which funds are transferred from ultimate
savers to borrowers, works reasonably smoothly and therefore can
usually be ignored.”
[Bernanke (1993, pp. 50 ff.)]
As Bernanke points out, those works that assume such a financial in-
termediation 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 mon-
etary aggregates in Kiyotaki & Moore, 1997; Woodford, 2003). The most
widely used textbook in advanced Master-level economics at leading
British universities in 2010 was Romer (2006).Onpage3,Romertellsus:
“Incorporating money in models of [economic] growth would only
obscure the analysis” (p. 3).
2.4. Conclusion of the literature review
Since the 1960s it has become the conventional view not to consider
banks as 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 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 in termediation theory. The develop-
ment has not been entirely smooth; several influential writers have
either changed their views (on occasion several times) or have shifted
between the theories. Keynes, as 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.
30
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 of
banking have been well represented in the course of the 20th century,
by leading figures of the day. However, the conclusion by Sir Josiah
Stamp (1927), a director at the Bank of England, still se ems to hold
today, namely that there is “a fair state of muddlement … on the appar-
ently simple question: ‘Can the banks create credit, and if so, how, and
how much?’” Despite a century or so of theorising on the matter,
there has been little progress in establishing facts unambiguously.
Thus today the conclusion of 1968 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 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 20th century economics, namely the hypothetico-
deductive method. Unproven ‘axioms’ are ‘posed’ and unrealistic assump-
tions 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 con-
sider empirical reality as the arbiter of truth, in line with the inductive
methodology. In other words, it is to empirical evidence we must turn
to settle the issue.
3. 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 nec-
essary bank credit procedures have been undertaken (starting from
‘know-yo ur-custome r’ and anti-money laundering regulations to credit
analysis, risk rating to 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 principal into their bank account the bank actually with-
draws this amount from another account, resulting in a reduction of equal
value in the balance of another entity — either drawing down reserves (as
the fractional reserve theory maintains) or other funds (as the financial in-
termediation theory maintain s). Should it be found that the bank is able to
credit the borrower's account with the loan principal without having
withdrawn money from any other internal or external account, or with-
out transferring the money from any other source internally or externally,
this would constitute prima facie evidence that the bank was able to cre-
ate the loan principal out of nothing. In that case, the credit creation the-
ory would be supported and the theory that the individual bank 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 fi
nancial intermediation theory), would be rejected.
3.1. Expected results
With a bank loan of €200,000, drawn by the researcher from a bank,
the fo llowing 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.
According to this theory, banks behave very differently from finan-
cial intermediaries, such as stock brokers, since they do not sepa-
rate customer funds from own funds. Money ‘deposited’ with a
bank becomes the legal property of the bank and the ‘depositor’
is actually a lender to the bank, ranking among the general credi-
tors. When extending bank credit, banks create an imaginary de-
posit, by 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 re-
serve and capital requirements only need to be met at particular
measurement intervals. The account changes are shown in Table 1.
(b) Bank credit accounting according to the fractional reserve theory.
The distinguishing feature of this theory is that each individual
bank cannot create credit out of nothing. The bank is a
financial intermediary indistinguishable from other financial inter-
mediaries, such as stock brokers and securities firms. However,
banks are said to be different in one respect, namely the regulatory
treatment: regulators have placed onerous rules concerning re-
serves that have to be held with the central bank only on banks,
not other financial intermediaries. A bank can only lend money,
30
Though with the caveat that several of his statements, made at the same time, seem to
support different theories of banking.
Table 1
Account changes due to bank loan (credit creation theory).
12 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
when it has previously received the same amount in excess re-
serves from another bank, whose own reserve balances will have
declined, or from the central bank (Table 2).
“A bank will not lend more than its excess reserves because, by law,
it must hold a certain amount of required reserves. … Each deposito-
ry institution can create loans (and deposits) only to the extent that
ithasexcessreserves.”
[Miller and VanHoose (1993, p. 331)]
Following the exposition in Miller and VanHoose (1993, pp.
330–331), the balance sheet evolution in case of a €200,000 loan is as
shown in Table 2.
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 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 re-
serves, and it will have to draw down the reserve balance to lend. (Thus,
as noted, another distinguishing feature is that the balance sheet expan-
sion is driven by the prior increase in a deposit that boosted excess re-
serves, not by the granting of a loan).
It needs to be verified when the empirical test of bank lending is im-
plemented, 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 to have drawn down its reserve
balances then this constitutes a rejection of the fractional reserve theory.
(c) Bank credit accounting according to the financial intermediation
theory.
According to this theory, banks are, as far as payments and ac-
counts are concerned, not different from non-bank financial insti-
tutions. The reserve requirement 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 intermedi-
aries are required by FSA/FCA-administered Client Money rules to
hold deposits in custody for customers (a form of warehousing,
the deposits legally being bailments). Client funds of fina ncial in-
termediaries, such as securities firms, stock brokers and the like
are therefore still owned by the depositors and thus kept separate-
ly from the financial institutions' own funds, so that customer de-
posits are not shown on the balance sheet as liabilities. If banks are
merely financial intermediaries, indistinguishable from other in-
termediaries, 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 3.
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.
3.2. A live empirical test
The design of the empirical test takes the form of a researcher enter-
ing into a live loan contract with the bank, and the bank extending a
loan, 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 accounting data and proce-
dures 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 banks' internal risk
management rules. In that case, any single transaction would not be
easy 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 sys-
tems and 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 a re approximately 1700 local, mostly
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 €3 billion was approached, as well as a bank
with a balance sheet of about €700 million. Both declined 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 em-
pirical information value would not diminish with bank size, since all
banks in the EU conform to identical European bank regulations.
Thus an introduction to Raiffeisenbank Wildenberg e.G., located in a
small town in the district of Lower Bavaria was made. The bank is a co-
operative bank wi thin the Raiffeisen and cooperative banking
association of banks, with eight full-time staff. The two joint directors,
Mr. Michael Betzenbichler and Mr. Marco Rebl both agreed to the em-
pirical examination and also to share all available internal accounting
records and documentation on their procedures. A written agreement
was signed that c onfirmed that the planned transac tions 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 material 1 in online Appendix 3). One limitation
on the accounting records which is common t o most banks is that
they are outsourcing the IT to a specialised bank IT company, which
maintains its own rules concerning data protection and confidentiality.
The IT firm serves the majority of the 1,100 cooperative banks in
Germany, using the same software and internal systems and accounting
rules, ensuring that the test is representative of more than 15% of bank
deposits in Germany.
It was agreed that the researcher would personally borrow €200,000
from the bank. The transaction was undertaken on 7 August 2013 in the
offices of the bank in Wildenberg in Bavaria. Apart from the two (sole)
directors, also the head (and sole staff) of the credit department,
Mr. Ludwig Keil was present. The directors were bystanders not engag-
ing in any action. Mr. Keil was the only bank representative involved in
processing the loan from the start of the customer documentation, to
Table 2
Account changes due to bank loan (fractional reserve theory).
Step 1. Precondition for the bank loan
Step 2. The bank loan
Table 3
Account changes due to bank loan (fin. intermediation theory).
13R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
the signing of the loan contract and finally paying out the loan into the
borrower's account. The entire transaction, including the manual entries
made by Mr. Keil, was filmed. The screens of the bank's internal IT ter-
minal were also photographed . Moreover, a team fr om the BBC was
present and filmed the central part of the empirical bank credit
experiment (Reporter Alistair Fee and a cameraman).
The bank disclosed their standard internal credit procedure. The se-
quence of the key steps is shown in Appendix 1. As can be seen, the last
two steps are the signing of the ‘credit document s’ by the borrower
(the researcher) and, finally, the payment of the loan at the value date.
31
The loan conditions were agreed: the researcher would borrow EUR
200,000 from the bank at the prime rate (the interest rate for the best
customer). In the event the bank waived 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 7 August 2013, the loan amount was immediately credited
to the borrower's account with the bank, as agreed in the loan contract.
Supplementary material 2 in online App endix 2 shows the original
borrower's accounts and balances with Raiffeisenbank Wildenberg.
The key information from the account summary table is repeated
here, in English, in Table 4.
The bank also issued the following accounts overview, which is a
standard T-account of the transaction from the borrower's perspective
(Table 5).
The borrower confirmed that his new current account with the bank
now showed a balance of EUR 200,000 that was available for spending
(An extension of the experiment, to be reported on separately, used
the balance the following day for a particular transaction outside the
banking institution, transferring the funds to another account of the re-
searcher, 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 Raiffeisenbank Wildenberg
e.G. obtain 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 Rebl ex-
plained that the bank maintained its reserves with the central organisa-
tion of cooperative banks, which in turn maintained an account with the
central bank. These reserves amounted to a fixed amount of €350,000
that did not change during the observation 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 in-
volved in this test and bank transaction were present throughout, where-
by two (the directors) only watched and neither accessed any computer
terminal nor transmitted any instructions whatsoever. The accounts
manager (head of the credit department, Mr. Keil) was the only operator
involved in implementing, booking and paying out the loan. His actions
were filmed. It was noted and confirmed that none of the bank staff pres-
ent 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 reserves from the central bank, the central cooper-
ative bank or indeed any other bank or entity. In other words, it was ap-
parent 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 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
35min(andwasclearlysloweddownbythefilming and frequent ques-
tions by the researcher).
Secondly, the researcher asked the 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 de-
posit balances, or made any bookings or transfers of any kind, in connec-
tion to this loan contract. They all confirmed that they 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 bank is small, it was hoped that it would be possible to identify
the impact of the €200,000 loan transaction, and distinguish the account-
ing pattern corresponding to one of the three banking hypotheses.
4. Results
Supplementary material 3 in online Appendix 3 shows the scan of
the bank's balance sheet at the end of 6 August 2013, the day before
the transaction of the empirical test was undertaken. Supplementary
material 4 in online Appendix 3 shows the daily balance of the following
day. In Table 6 the key asset positions are summarised and account
names translated, for the end of the day prior to the loan experiment,
and for the end of the day on which the researcher had borrowed the
money. Table 7 shows the key liability positions for the same periods:
Starting by analysing the liability side information (Table 7), 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 not special and are virtually indistinguishable
from non-bank financial institutions that have to keep customer de-
posits off balance sheet. In actual fact, a bank considers a customers' de-
posits 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
under rubric ‘ claims by customers’, who in turn receive as record of
their loans to the bank (called ‘deposits ’) what is known as their
31
It is of interest that the last step expressly requires the bank staff implementing this
credit procedure to only pay out the loan for the agreed purpose, as evidence for which
a receipt for any purchases undertaken with the loan funds are demanded by the bank.
This demonstrates that the implementation of policies of credit guidance by purpose of
the loan is practically possible, since such data is available and the use of the loan is mon-
itored and enforced by each bank.
Table 4
The empirical researcher's new bank account.
Bank: Raiffeisenbank Wildenberg e.G.
Customer: Richard Werner.
Date: 7 August 2013.
Account no. Type of product Currency A/C balance
Current account
44636 Current account w/o fees EUR 200,000.00
Total in EUR: 200,000.00
Loan
20044636 Other private financing EUR − 200,000.00
Total in EUR: − 200,000.00
Table 5
The empirical researcher's new bank account balances.
Accounts' overview
EUR Credit Liabilities Balance No. contracts
Current account 200,000.00 200,000.00 1
Loan 200,000.00 − 200,000.00 1
Bank sum total 200,000.00 200,000.00 0.00 2
14 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
‘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
€190,000) has been deposited with 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 confirmed that in his own bank account the
loan balance of € 200,000 was shown on the same day. This means
that the increase in liabilities was driven by the increase by €200,000
in daily liabilities (item 2B BA in Table 7). Thus the total increase in lia-
bilities could not have been due to a coincidental increase in customer
deposits on the day of 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 4, claims on customers — fortunately
the only one that day with a maturity below 4 years and hence clearly
identifiable on the bank balance sheet. Apparently, customers also took
out short-term loans (most likely overdrafts) amounting to €35,071.88,
producing a total new loan balance of €2 35,071. 88. 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 (€235,071.88). So the bal-
ance sheet item of interest on the asset side is ΔA4, the increase in loans
(claims on customers) amounting to €235,071.88.
We now would like to analyse the balance sheet in order to see
whether this new loan of €235,071.88 was withdrawn from other ac-
counts 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 summarise the balance sheet changes during th e
observation period, within the balance sheet constraints as follows:
ΔAssets ¼ ΔA1 cashðÞþΔA3 claims on other FIðÞ
þ ΔA4 claims on customersðÞþΔA14 other assetsðÞ:
ð1Þ
Numerically, these are, rounded in thousand euro:
178 ¼ 158−219 þ
235 þ 4: ð2Þ
The fractional reserve theory says that the 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 ba nk's central
bank reserve balances) declined signifi cantly, by €2 19,000. At the
same time cash reserves increased significantly. What may have hap-
pened is that the bank withdrew legal te nder from its account with
the cooperative central bank, explaining both the rise in cash and de-
cline in balances with other financial institutions. Since the theories do
not distinguish between these categories, we can aggregate A1 and
A3, the cash balances and reserves. Also, to simplify, we aggregate A14
(other assets) with A4 (claims on customers), to obtain:
178
ΔAssetsðÞ
¼ −61
ΔreservesðÞ
þ239
Δclaims on customers; othersðÞ
: ð3Þ
We observe that reserves fell, while claims on customers rose signif-
icantly. Moreover, total assets also rose, by an amount not dissimilar to
our loan balance. Can this information be reconciled with the thre e
theories of banking?
Considering the financial intermediation hypothesis,wewouldexpecta
decline in reserves (accounts with other financial institutions and cash) of
the same amount as customer loans increased. Reserves however de-
clined by far less. At the same time, the balance sheet expanded, driven
by a significant increase in claims on customers. If the bank borrowed
money from other banks in order to fund the loan (thus reducing its bal-
ance of net claims on other banks), in line with the financial intermediation
theory of banking, vault 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 balan ce sheet (total assets and total liabiliti es),
which rose by €178,000. This cannot be reconciled with the financial inter-
mediation theory, which we therefore must consider as rejected.
Considering the fractional reserve theory,weconfirmed by asking the
credit department's Mr. Keil, as well as the directors, that none of them
checked their reserve balance or balance of deposits with other banks be-
fore signing the loan contract and making the funds available to the bor-
rower (see the translated letter in Appendix 2, and the original letter in
the online Appendix 3. Furthermore, there seems no evidence that re-
serves (cash and claims on other financial institutions) declined in an
amount commensurate with the loan taken out. Finally, the observed in-
crease in the balance sheet can also not be reconciled with the standard
description of the
fractional reserve theory. We must therefore consider
it as rejected, too.
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 to each other via the accounting identities
of the balance sheet (Eqs. (1), (2) and (3)). We can therefore ask the ques-
tion what would have happened to total assets, if we assumed for the
Table 6
Raiffeisenbank Wildenberg e.G.: daily accounts' assets.
6 August 2013, 22.46 h. vs. 7 August 2013, 22.56 h.
EUR.
Assets Balance 6 Aug.
2013
Balance 7 Aug.
2013
Difference
1. Cash 181,703.03 340,032.89 158,329.86
2. Bills of exchange
3. Claims on financial. inst. 5,298,713.76 5,079,709.21 − 219,004.55
4. Claims on customers 23,712,558.13 23,947,729.92 235,171.79
–Maturing daily 932,695.44 967,767.32 35,071.88
–Maturity under 4 years 1,689,619.97 1,889,619.97 200,000.00
–Maturity 4 years or longer 21,090,242.72 21,090,342.72 100.00
5. Bonds, bills, debt instr. 19,178,065.00 19,178,065.00
6. Stocks and shares
7. Stake holdings 397,768.68 397,768.68
8. Stakes in related firms
9. Trust assets 5262.69 5262.69
10. Compensation claims on the
public sector
11. Immaterial assets 102.00 102.00
12. Fixed assets 221,549.46 221,549.46
13. Called but not deployed capital
14. Other assets 707,569.26 711,288.64 3719.38
15. Balancing item 2844.32 2844.32
16. Sum of assets 49,706,136.33 49,884,352.81 178,216.48
Table 7
Raiffeisenbank Wildenberg e.G.: daily accounts' liabilities.
6 August 2013, 22.46 h. vs. 7 August 2013, 22.56 h.
EUR.
Liabilities Balance 6 Aug.
2013
Balance 7 Aug.
2013
Difference
1. Claims by financial inst. 5,621,456.60 5,621,879.66 423.06
2. Claims by customers 39,589,177.09 39,759,156.42 169,979.33
2A. Savings accounts 10,234,806.01 10,237,118.24 2312.23
2B. Other liabilities 29,354,371.08 29,522,038.18 167,667.10
–BA daily 13,773,925.93 13,963,899.89 189,973.96
–BB maturity less 4 years 13,296,042.92 13,273,736.06 − 22,306.86
–BC maturity 4 years or longer 2,284,402.23 2,284,402.23
4. Trust liabilities 5262.70 5262.70
5. Other liabilities 12,378.81 12,599.44 220.63
6. Balancing item 16,996.04 16,996.04
7. Reserves 1,138,497.64 1,138,497.64
11. Fund for bank risk 250,000.00 250,000.00
12. Own capital 3,057,248.57 3,057,248.57
13. Sum liabilities 49,706,136.33 49,884,352.81 178,216.48
15R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
moment that no other transaction had taken place, apart from the loan
(235). We can set the change in each asset item (except for ΔA4, our
loan) to zero, if we subtract the same amount from the change in total as-
sets. The new total asset balance in this hypothetical scenario would be:
178−158 þ 219−4 ¼ 235 ð4Þ
or, in general,
ΔA4 claims on customersðÞ¼ΔAssets−ΔA1 cashðÞ−ΔA3 claims on other FIðÞ
−ΔA14 other assetsðÞ:
ð5Þ
In other words, if the other transactions had not happened, the
bank's balance sheet would have expanded by th e same amount
as the loans taken out. This finding is consistent only with the credit
creation theory of bank lending.
The evidence 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 init iated by bank customers (who are now-
adays able to imple ment transactions via interne t banking even on
holidays). But the available accounting data cannot be reco nciled
with the fractio nal reserve and the financial intermediation hypothe-
ses of banking.
5. 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 existing and continuing controversies and find out which
of the three theories of banking is consistent with the empirical
observations.
5.1. Three theories but no empirical test
Concerning the first issue, in this paper we identified three dis-
tinct hypotheses concerning the r ole of banks, namely the credit cre-
ation theory,thefractional reserve theory and the financial
intermediation theory.Itwasfoundthatthefirst theory was domi-
nan t until about the mid- to late 1920s, featuring leading proponents
such as Macleod and Schumpeter. Then the second theory became
dominant, under the in flue nce of such e cono mists as Keynes, Crick,
Phillips and Samuelson, until about the e arly 1960s. From the early
1960s, first u nder the influence o f Keynes and Tobin and the Journal
of Money, Credit and Banking,thefinancial intermediation theory be-
came dominant.
Yet, d espite these identifiable eras of predominance, doubts h ave
remained concerning each theory. Most recently, the credit creation
theory has experience d a revival, having been championed again in
theaftermathoftheJapanesebankingcrisisintheearly1990s
(Werner, 1992, 1997) and in the run-up to and aftermath of
the E uropean and US financial crises since 2007 (see Bank o f
England, 2014b; Benes & Kumhof, 2 012; Ryan-Collins, Greenham,
Werner, & Jackson, 2011, 2012; Werner, 2003a, 2005, 2012). Howev-
er, such works have not ye t become influentialinthemajorityof
models and theories of the macro-economy or banking. Thus it had
to be concluded that the controversy continues, withou t any scientif-
ic attempt having been made at settling it through e mpirical
evidence.
5.2. 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 suc-
cessfully tested in a real world setting of borrowing from a bank and
examining the actual internal bank accounting in an uncontrolled real
world environment.
It was examined whether in the process of making money available
to the borrower the bank trans fers these funds from other accounts
(within or outside the bank). In the process of making loaned money
available in the borrower's bank account, it was found that the bank
did not transfer th e money away from other internal or external ac-
counts, resulting in a rejection of both the 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 the 5000 years' history of banking - that it has been empirically dem-
onstrated 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 supply is created as ‘fairy dust’ produced by the banks out of
thin air.
32
The implications are far-reaching.
5.3. What is special about banks
Henceforth, economists need not rely on assertions concerning
banks. We now know, based on empirical evidence, why banks are dif-
ferent, indeed unique — solving the longstanding puzzle posed by Fama
(1985) and others — and different from both non-bank financial institu-
tions and corporations: it is because they can individually create money
out of nothing.
5.4. Implications
5.4.1. Implications for economic theory
The empirical evidence shows that of the three theories of banking,
it is the one that today has the least influence and that is being belittled
in the literature that is supported by the empirical evidence. Further-
more, it is the theory which was widely held at the end of the 19th cen-
tury and in the first th ree dec ades of th e twentieth. I t is sobering to
realise that since the 1930s, economists have moved further and further
away from the truth, instead 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 intermedi ation theory that
today is so dominant. Thu s this paper has found evidence that there
has been no progress in scienti fic knowledge in economics, finance
and banking in the 20th century concerning one of the most important
and fundamental facts for these disciplines. Instead, there has been a re-
gressive development. The known facts were unlearned and have be-
come 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 the leading economists of
the day having played a significant role in it. The most influential and fa-
mous of all 20th century economists, as we saw, was a sequential adher-
ent of all three theories, which is a surprising phenomenon. Moreover,
Keynes used his considerable clout to sl ow scientificanalysisofthe
question whether banks could create money, as he instead engaged in
ad hominem attacks on followers of the credit creation theory. Despite
his enthus iast ic early support for the credit creation theory (Keynes,
1924), only six years later he was condescending, if not dismissive, of
this theory, referring to credit creation only in inverted commas. He
was perhaps 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
32
Thanks to Charlie Haswell for the ‘fairy dust’ allegory.
16 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
seem to believe in “magic” and some kind of “Utopia” (Keynes, 1930,
vol. 2, p. 215).
33
Needless to mention, such rhetoric is not conducive to scientificar-
gument. But this technique was followed by other economists engaged
in advancing the fractional reserve and later finan cial intermediation
theories. US Federal Reserve staffer Alhadeff (1954) argued similarly
during the era when economists worked on getting the fractional re-
serve theory established:
“One complication worth discussing concerns the alleged “creation”
of money by bankers. It used to 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 un-
der a fractional reserve system, only the totality of banks can expand
deposits to the full reciprocal of the reserve ratio. [Original footnote:
‘Chester A. Phillips, Bank Credit (New York: Macmillan, 1921),
chapter 3, for the classical refutation of this claim.’] The individual
bank can normally expand to an amount about equal to its primary
deposits” (p. 7).
The creation of credit by banks had become, in the style of Keynes
(1930),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 abductio ad absurdum to den-
igrate the credit creation theory by incorrectly suggesting it postulated
a ‘widow's cruse’, a miraculous vessel producing unlimited amounts of
valuable physical goods, and thus its followers were believers in mira-
cles or utopias.
This same type of rhetor ical denigration of and disengagem ent with
the credit creation theory is also visible in the most recent era. For in-
stance, the New Palgrave Money (Eatwell et al., 1989), is an influential
340-page reference work that claims to present a ‘balanced perspective
on each topic’ (Eatwell et al., 1989, p. viii). Yet the financial intermediation
theory is dominant, with a minor representation of the fractional reserve
theory.Thecredit creation theory is not presented at all, even as a possibil-
ity. But the book does include a chapter entitled “Monetary cranks”.In
this brief chapter, Keynes' (1930) derogatory treatment of supporters
of the credit creation theory is updated for use in the 1990s, with sharp-
ened claws: Ridicule and insult is heaped on several fateful authors
that have produced thoughtful analyses of the economy, the monetary
system and the role of banks, such as Nobel laureate Sir Frederick
Soddy (1934) and C.H. Douglas (1924)
. Even the seminal and influential
work by Georg Friedrich Knapp (1905), still favourably cited by Keynes
(1936),isidentified 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, 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 analyses centre 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 Eatwell et al.
(1989) tome was purposely designed to ignore and distract from the
rich literature supporting the credit creation theory. Nothing lost, accord-
ing 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 dis-
appeared from public debate …” (p. 214).
And so has the credit creation theory. Since the tenets of this theory
are never stated in Eatwell et al. (1989), the chapter on ‘Cranks’ ends
up being a litany of ad hominem denigration, defamation and character
assassination, liberally distributing labels such as ‘cranks’, ‘phrase-mon-
gers’, ‘agitators’, ‘populists’,andeven‘conspiracy theorists’ that believe
in ‘miracles’ and engage in wishful thinking, ultimately deceiving their
readers by trying to “impress their peers with their apparent under-
standing of economics, even though they had no formal training in the
discipline” (p. 214). Al l that we learn about their a ctual theories is
that, somehow, these ill-fated authors are “opposed to private banks
and the ‘Money Power’ without their opposition leading to more sophis-
ticated political analysis” (p. 215). Any reading of the highly sophisticat-
ed Soddy (1934) quickly reveals such labels as unfounded defamation.
To the contrary, the empirical evidence presented in this paper has re-
vealed that the many supporte rs of the
financial intermediation theory and
also the adherents of the fractional reserve theory are flat-earthers that be-
lieve in what is empirically proven to be wrong and which should have
been recognisable as being impossible upon deeper consideration of the
accounting requirements. Whether the authors in Eatwell et al. (1989)
didinfactknowbetterisanopenquestionthatdeservesattentioninfu-
ture research. Certainly the unscientific treatment of the credit creation
theory and its supporters by such authors as Keynes, who strongly en-
dorsed the theory only a few years before authoring tirades against its
supporters, or by the authors in Eatwell et al. (1989), raises this
possibility.
5.4.2. 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
‘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 recognised. They call for
a whole new paradigm in monetary economics, macroeconomics,
finance and banking (for details, see for instance Werner, 1997, 2005,
2012, 2013a,b) that is based on the reality of banks as creators of the
money supply. It has potentially important implications for other disci-
plines, such as accounting, economic and business history, economic
geography, politics, sociology and law.
5.4.3. Implications for bank regulation
The implications are far-reaching for bank regulation and the design
of official policies. 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 banks
are able to create money out of nothing, imposing higher capit al re-
quirements on banks will not necessarily enable the pr evention of
boom–bust cycles and banking crises, since even with higher capital re-
quirements , ban ks could still continue to expand the money supply,
thereby fuelling asset prices, whereby some of this newly created
money can be used to increase bank capital. Based on the recognition
of this, some economists have argued for more direct intervention by
33
“There is a common element in the theories of nearly all monetary heretics. Their the-
ories of Money and Credit are alike in supposing that in some way the banks can furnish all
the real resources which manufacture and trade can reasonably require without real cost
to anyone …. For they argue thus. Money (meaning loans) is the life-blood of industry. If
money (in this sense) is available in sufficient quantity and on easy terms, we shall have
no difficulty in employing to the full the entire available supply of the factors of produc-
tion. For the individual trader or manufacturer “bank credit” means “working capital”;a
loan from his bank furnishes him with the means to pay wages, to buy materials and to
carry stocks. If, therefore, sufficient bank credit was freely available, there need never be
unemployment. Why then, he asks, if the banks can create credit, should they refuse any
reasonable request for it? And why should they charge a fee for what costs them little or
nothing? … There can only be one answer: the bankers, having a monopoly of magic, ex-
ercise their powers sparingly in order to raise the price. … Where magic is at work, the
public do not get the full benefit unless it is nationalised. Our heretic admits, indeed, that
we must take care to avoid “inflation”; but that only occurs when credit is created which
does not correspond to any productive process. To create credit to meet a genuine demand
for working capital can never be inflationary; for such a credit is “self-liquidating” and is
automaticallypaidoff when the process of production is finished. … If the creation of cred-
it is strictly confined within these limits, there can never be inflation. Further, there is no
reason for making any charge for such credit beyond what is required to meet bad debts
and the expense of administration. Not a week, perhaps not a day or an hour, goes by in
which some well-wisher of mankind does not suddenly see the light — that here is the
key to Utopia” (vol. 2, pp. 217 ff.).
17R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19
the central bank in the credit market, for instance via quantitative credit
guidance (Werner, 2002, 2003a, 2005).
5.4.4. Monetary reform
The Bank of England's (2014b) recent intervention has triggered a
public debate about whether the privilege of banks to create money
should in fact be revoked (Wolf, 2014). 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 differ-
ent monetary system designs tried over the past 5000 years, very few
have met the requirement for a fair, effective, accountable, stable, sustain-
able and democratic creation and allocation of money. The view of the au-
thor, based on more than twenty-three yearsofresearchonthistopic,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 ensured by the introduction of a network of
small, not-for-profit local banks across the nation. Most countries do not
currently possess such a system. However, it is at the heart of the success-
ful German economic performance in the past 200 years. It is the very
Raiffeisen, Volksbank or Sparkasse banks – the smaller the better – that
were helpful in the implementation of this empirical study that should
serve as the role model for future policies concerning our monetary sys-
tem. 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 creation together would create a
decentralised and more accountable monetary system that should per-
form 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,
2013a,b).
Appendix 1. Sequence of steps for the extension of a loan
Raiffeisenbank Wildenberg e.G.
1. Negotiations concerning the details of the loan.
2. R eceip t of K YC information and opening of a new customer file
(new customer).
3. Opening of a current account (new customer).
4. Calculation of the loan and repayment schedule, model calculation,
European required customer notification information, recor d of
customer advisory.
5. Entry of loan application into the bank IT system.
6. Check of ability to service and repay the loan/conducting liquidity
calculation in loan application.
7. Credit rating of customer, entry into customer file.
8. Search of customer data on central bank data base for singular eco-
nomic dependencies and entry of results into bank IT.
9. Bank board recommendation on loan application with justification
(2 directors).
10. Print out of loan contract, general loan conditions, with handover
receipted by customer.
11. Print out of the protocol of the loan process.
12. Approval of credit by bank directors by signing the protocol and the
loan contract.
13. Creation of loan account in the IT system.
14. Establishment of credit limit and availability of credit.
15. Appointment with customer.
16. Customer signs credit documents.
17. 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 2. Letter of confirmation of facts by Raiffeisenbank
Wildenberg e.G. (Translation; original in online Appendix 3).
10 June 2014
Dear Prof. Dr. Werner,
Confirmation of Facts
In connection with the extension of credit to you in August 2014 I am
pleased to confirm that neither I as director of Raiffeisenbank Wildenberg
eG, nor our staff checked either before or during the granting of the loan
to you, whether we keep sufficient funds with our central bank, DZ Bank
AG, or the Bundesbank. We also did not engage in any such related trans-
action, nor did we undertake any transfers 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. Rebl,
Director, Raiffeisenbank Wildenberg e.G.
Appendix 3. Supplementary data
Supplementary data to this article can be found online at http://dx.doi.
org/10.1016/j.irfa.2014 .07.015.
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