“Great and mighty things which thou knowest not” [?]

In his recent paper, “A Lost Century in Economics:  Three Theories of banking and the conclusive evidence”, Richard Werner argues that the old “credit creation theory” of money is true (empirically “accurate”), while both the newer “fractional reserve theory” and the presently dominant “debt intermediation theory” are false.  For him, this matters mainly because the false theories are guiding current bank regulation and development policy, leading down a blind alley.

But it matters also simply because we need correct understanding of how the economy actually works, “we” meaning not just economists but also the general public.  “Today, the vast majority of the public is not aware that the money supply is created by banks, that banks do not lend money, and that each bank creates new money.”

Why is the public ignorant of the truth?  Much of Werner’s paper is devoted to an account of how the correct theory was pushed out of the conversation, first in the 1930s by the fractional reserve theory, and then after WWII by the debt intermediation theory.  One culprit was a shift toward deductive and away from inductive methods.  Another culprit, he suggests, was the self-interested “information management” by central banks, i.e. direct suppression of truth in their own publications.  And in this suppression, he further suggests, Keynesian academics were at the very least complicit:  “attempts were made to obfuscate, as if authors were at times wilfully trying to confuse their audience and lead them away from the important insight that each individual bank creates new money when it extends credit.”

In this history, Werner gives special attention to Keynes himself since Keynes seems to have held each of the three theories in succession throughout his life.  Keynes’ own intellectual trajectory thus foreshadows the subsequent evolution of monetary thought, and so probably is partly responsible for leading successive generations astray.   Just so, one apparent legacy of Keynes is that the Bank of England is currently holding all three theories at the same time!  “Since each theory implies very different approaches to banking policy, monetary policy and bank regulation, the Bank of England’s credibility is at stake.”  BoE credibility is thus a third reason that all of this matters.

But is it really true, as Werner claims, that these three theories are “mutually exclusive”?

He is at considerable pains to show that they are mutually exclusive, by using a succession of stylized balance sheet examples.  The credit creation theory says that banks make loans by creating deposits, essentially expanding their balance sheets on both sides by the same amount.  (The borrower of course also expands his own balance sheet, the loan being his liability and the deposits being his asset.  In my own “money view”, I call this a swap of IOUs.)  In this way, money (bank deposits) is created that was not there before.

By contrast, the debt intermediation view says that banks make loans by lending reserves that they are already holding, essentially swapping one asset for another, these reserves having previously been obtained by someone’s deposit.  The balance sheet expands when the deposit is made, not when the loan is made.  Banks merely intermediate between savers and borrowers, and do not create money.

In between these two views, the fractional reserve view says that individual banks make loans by lending reserves, but that the banking system as a whole can and does create money, up to a multiple of reserve holdings.  The banking system does create money, but only after and as a consequence of the central bank increasing reserves–this is the famous “money multiplier”.

So the difference between the theories seems clear, and it also seems like that difference should be testable empirically simply by watching actual bank balance sheets and seeing what happens when a loan is made.  Does the balance sheet expand or does it not?  With the cooperation of an actual bank, Werner books a dummy loan and finds that the balance sheet of the bank does in fact expand.  This he takes to be scientific proof that the credit creation theory is correct and the others are false.

Not so fast.  Let’s look a bit closer.

Let me begin by admitting my sympathy for Werner (as I have already hinted by mentioning my own “money view” as a version of the credit creation view).  In fact, Werner’s heroes–H.D. McLeod and Joseph Schumpeter–are my own heroes as well, and I suspect that graduate school exposure to these authors sent him off on his own intellectual journey just as it did me.  Even more, thirty years after that initial exposure, I find Werner’s (co-authored) money and banking textbook “Where Does Money Come From?” one of the best introductions to the subject.  Last fall I assigned Chapters 2 and 4 in the first two weeks of “Economics of Money and Banking” which I teach at Barnard College, Columbia University.  I’m sympathetic.

But I don’t think these three theories are quite as mutually exclusive as he makes them out to be.

For me, the central analytical issue is the distinction between “payment” and “funding”.

Let us suppose, with Werner, that Citibank makes a mortgage loan to me of $200,000, simply by swapping IOUs.  I then transfer my new asset (the new Citibank deposit) to you, and you transfer your house to me.  As my payment clears, you have a new deposit in your own bank (let’s say Chase, to make it interesting), Citibank has a “due to” at the clearinghouse, and Chase has a “due from”.  Again, to make it interesting, let’s suppose that Citibank has no reserves, so it enters the interbank market to borrow some, from Chase.  At the end of the day, what we see is that the Citibank balance sheet is still expanded, so is Chase’s, and so is mine.  Only your balance sheet stays the same size, since you have swapped one asset (your house) for another (money).  That’s the payments perspective.

What about the funding perspective?  If we follow the balance sheets through, it is clear that your money holding is the ultimate source of funds for my borrowing. (You lend to Chase, which lends to Citi, which lends to me.)  In this sense, we can think of both Chase and Citibank as intermediaries, channeling funds from one place in the economy to another.  But, in this example, there is no saving and there is no investment.  The sale of the house adds nothing to GDP, it is just a transfer of ownership.  The expansion of the banking system has facilitated that transfer of ownership by creating a liability (the deposit) that you apparently prefer to your house, at the same time acquiring an equivalent asset of its own (the loan).  Citibank collects the spread between the mortgage rate and the interbank rate; Chase collects the spread between the interbank rate and the deposit rate.

But all of that is only what happens right at the moment of payment.  What happens afterwards depends on the further adjustment of all of these balance sheets.  One way this could all work out is that Citibank packages my mortgage with others to create a mortgage backed security, and that you spend your Chase deposit to acquire a mortgage backed security (perhaps indirectly through a mutual fund that stands in the middle).  In this scenario, the newly created money is newly destroyed, the balance sheets of both Citi and Chase contract back to their original size, and the end result is that you are funding my loan directly.  But again, no saving and no investment, just a change in your asset allocation, away from money toward fixed income investment.

Obviously this final scenario is a limiting case on one side.  The limiting case on the other side is that you (or whoever you transfer your money to) are willing to hold the newly created money balances as an asset, so you continue to fund my loan indirectly.  Now when Citibank securitizes and sells, it is able to repay its interbank liability to Chase, and for simplicity let’s say that Chase uses that payment to acquire a different money market asset.   One way this could all work out is that a shadow bank–money market funding of capital market lending–acquires the security and uses it as collateral for wholesale money market borrowing from Chase.  Again, no saving and no investment, but the new money stays in circulation and is not destroyed.

These are the limiting cases, and obviously anything in between is also possible, depending on the portfolio decisions of Citibank, Chase, and you.  But in all the cases, the debt intermediation view of banking is perfectly consistent with the credit creation view of banking.  One focuses on the ultimate funding, while the other focuses on the initial payment.

That said, I have to agree with Werner that the credit creation process is all too commonly left out of the story–most modern courses never even mention the payments system–and it is a real (and important) question how this came to be so.  It is a further real (and important) question why the intellectual memory of how the process actually works was left to marginalized sections of academia–Werner mentions specifically the Austrians and post-Keynesians.  I’m not so sure that it was a central bank plot, though I do think that the shift in academic fashion toward studying equilibrium of a system of simultaneous equations played a role in obscuring the kind of dynamic balance sheet interactions that are the essence of the story.

What I would emphasize however is not the negative but the positive.  The fact of the matter is that today the credit creation view is out of the shadows, and no longer the exclusive property of the marginalized.  In evidence of this, I would direct your attention to the two Bank of England papers that Werner himself cites:  here and here.  But I would add to that also the most recent report coming out of the Group of 30 “Fundamentals of Central Banking, Lessons from the Crisis”.  On page 3 you will find the following:

“In a barter economy, there can rarely be investment without prior saving.  However, in a world where a private bank’s liabilities are widely accepted as a medium of exchange, banks can and do create both credit and money.  They do this by making loans, or purchasing some other asset, and simply writing up both sides of their balance sheet.”

That’s the truth that Werner wants central banks to admit, and now it appears that they have admitted it.  The next question is what difference it makes, and that’s a question for next time.  Already it should be clear that progress toward answering that question will require us to be more careful about issues of payment versus funding.

P.S.  BTW, the title of this post is taken from Jeremiah 33:3 which Werner references in a footnote to his title: “should grains of wisdom be found in this article, the author wishes to attribute them to the source of all wisdom.”  Werner is apparently listening to powers higher than just McLeod and Schumpeter!


24 comments on ““Great and mighty things which thou knowest not” [?]

  1. WanderingMind on said:

    A couple of entries into the literature on the money creation power of banks are two books by Bray Hammond, financial historian and assistant secretary to the Board of Governors of the Federal Reserve System in 1944-1950. He won the 1958 Pulitzer Prize for History for Banks and Politics in America from the Revolution to the Civil War (1957).

    He covers the topic of bank balance sheet expansion as the source of the means of exchange in that book and one other:

    – Sovereignty and an Empty Purse: Banks and Politics in the Civil War (Princeton, 1970)

    While this topic is not the exclusive focus of either book, what he does show is that a person intimately involved with the Federal Reserve was well aware of this essential aspect of banking.

    It also seems to me that, while the deposits created by banks circulate as money, presently the Federal Reserve and other central banks are the ultimate source of the assets which are used as cash, whether they are bank deposits or physical notes.

    The demand for those cash assets by private banks ultimately land at the doorstep of the central bank, which expands or contracts its balance sheet accordingly. In this larger sense, then, there is no intermediation system-wide.

    I would appreciate Prof. Mehrling’s comments whether he thinks that view of the system is accurate.

    • Perry Mehrling on said:

      I think of “cash” as also a liability, of the central bank, matched with an offsetting asset, nowadays likely a mortgage backed security.

      • WanderingMind on said:

        Right. So, no intermediation, then? Only expanding balance sheets?

        • Perry Mehrling on said:

          Expanding balance sheets always involve intermediation, borrowing on one side and lending on the other. That is as true of central bank balance sheet as well as any ordinary bank.

          • WanderingMind on said:

            I think I understand your use of “intermediation” here to mean the bank facilitating a transaction between a buyer and seller.

            However, I understand the conventional economics view of intermediation to require that the loan cannot start without a deposit of savings from a “patient” actor in the economy, a priori. I can see how the conversion of a real asset, such as a house, into a financial asset such as a deposit, appears to be the same, but I don’t think that is how it is taught in traditional economics courses.

            Your explanation exposes money as something which arises from within the economy and is an integral part of it; the traditional story fixes money as something which affects the system from the outside, like a hurricane or a flood.

            It appears to me, then, that although your use of the term “intermediation is accurate, it is in fact different from the way in which it is traditionally used; so much so that your use of the term and a mainstream economist’s use of the term describes two different concepts.

          • I was about to post the same thing but it seems WanderingMind has done it.
            Firstly thank you for pointing out the mechanics of the banking system here.

            From what I understand of the term ‘intermediation’ when used in explaining bank lending has meant that before the loan is made, the bank has to have that amount of money in the first place. I would personally not call the end result of your ‘Citibank-HSBC-Chase’ example intermediation. The end result of the deposit at Chase being equal to the mortgage loan amount at Citibank is simply the end result of how the payments system works. The causality flows from Citibank to Chase and not the other way and because of that the intermediation theory and credit creation theory are mutually exclusive.

            I think that if economics is to make serious progress on this front, it has to settle down on what the basic terms mean and this post is a good step towards that.

          • Perry Mehrling on said:

            It is definitely correct that I use the term intermediation in a more general way. Banks create money and credit by expanding their balance sheet on both sides, which means borrowing as well as lending. In this sense they are intermediating, simple as that. I used an example where no one is saving or investing precisely to show that much of current discussion of intermediation is too narrow, and misses a lot of what goes on in the financial system.

            As a matter of history of thought, I think the focus on growth economics caused people to focus attention on capital accumulation, and to abstract from payments, which is one reason the credit creation view fell out of sight. But I would insist that Gurley and Shaw were doing something different from Tobin–see my first book Money Interest and Credit Interest–and Tobin’s “translation” of their book into the language of general equilibrium theory meant that some important things were lost. Since the next generation read Tobin rather than Gurley and Shaw, these things did not get reproduced.

  2. Hi Perry,

    I think what you have to say would be even clearer if you distinguished between gross and net savings and investment. That is, when I read this: “But, in this example, there is no saving and there is no investment.” I did a double take, because it’s only true if you net the changes. In gross terms there have been significant changes in position. In particular, your balance sheet has gone from gross balances of zero to gross positive balances (dissavings offset by housing investment).

    The sense in which the “payments” function of banking affects the “funding” function is that the banks are the arbiters who decide who has access to the offsetting gross balances. When the banking system works well it expands the money/credit system to a broad set of individuals and when it is failing it does not do so. For this reason, the gross margin is extremely important and I think it’s confusing to focus on net savings/investment.


    • Perry Mehrling on said:

      It is confusing to focus on net savings, we agree. But economics is entirely organized around the NIPA accounts, which records only net savings. My example was intended exactly to show an important, and typical, transaction that would not show up at all in NIPA, so we can see why finance matters. Once you establish intuition correctly, you can shift to NIPA for other purposes, but not before.

  3. Sunil Nair on said:


    It is always better late than never; so here it goes. Thanks for the Money & Banking course you posted on-line. It was a fantastic revelation and an experience.

    On money creation by banks, it is (now) pretty obvious once you think through the flows. The residual of economic transaction in any period creates “balances” that need to be transferred across time and banks are the entities that facilitate that. Or there is no “surplus” without somebody willingly taking on a “deficit” and in our modern world this is increasingly done more through banks than through private IOUs. Money is the reflection of “balances” resulting from economic transactions; which are in most cases (other than equity not bought back probably) settled eventually.

    Transactions in the investment (asset) world are transfers of balances already created; so in that sense they do not create any new “balances” that need to be denoted with fresh money. They create gross balances in a number of intermediaries (motivated by risk sharing or transfer needs), but the final balances are what is created by buying and selling goods/services.

    And you do mention above that Central bank balances are just balances at another bank- just that the bank balances have higher status and can be used for clearing by banks with lower status than it. All wonderful.

    But I do have a question? What about short selling of financial securities? They are not like “investment” transactions because in the process of selling short- you create supply of a “balance” without it being a residual of an economic transaction. Or short selling seems to create money just like providing credit to back an economic deficit/surplus pair does. Or is it really no different from a “forward” transaction with uncertain maturity date where the entire value of the asset is transferred and not just price differences at maturity. I am seeing a Forward/Futures transactions where you are buying/selling an asset and “financing” each other without the help of an intermediary.

    Have I completely misunderstood what is going on when we move away from industrial/service & investment credit to what happens in a system of side bets? Is short selling just a Forward transaction without directed “virtual credit”- or the lender now has cash collateral to buy a completely different asset rather than just provide it as credit to the “counterparty” which will in the end clear like in your favorite two party “house buying” example.


    • Sunil Nair on said:

      On second thoughts please ignore the last two paragraphs of my comments. They have not been thought through and should not be here.


  4. Professor Mehrling,

    In your example, why does the bank need to go to the dealer(HSBC) to fund its requirements for reserves? Why cant it simply get it from the central bank(Fed) itself? Wouldn’t that be cheaper and less complicated?

    • Perry Mehrling on said:

      Typically discount window borrowing is at a spread above the effective Fed Funds rate, so banks prefer the interbank market.

  5. John Merryman on said:

    I think an extended aspect of this situation is how and why government debt is used to store excess money.

    For instance, Paul Volcker is credited with curing inflation by raising interest rates, but that also slowed economic activity, reducing the ned for money and inflation didn’t really come under control until 1982, by which time Reaganomics had increased the deficit to 200 billion.

    As one way the Fed has to raise rates is to sell bonds it bought to create the money in the first place, what is the difference between the Fed selling debt it is holding and the Treasury issuing fresh debt, other than the money the Fed collects is eliminated and the Treasury spend theirs in ways which serve to prime the economic pump?

    So logically it would seem that if there is an excess of money, causing inflation, the effective way to remove it is from those with an excess. Yet if the public is to borrow it, unless the ways it is spent generate significant return, eventually the public will go bankrupt.

    Most people save for specific reasons, from raising children, to housing, healthcare, retirement, etc. If the government/public were to threaten to tax excess money, rather than borrow it, out of the system, people would have to find ways to invest directly into these needs. Since specific expenditures won’t be known ahead of time, this would require investing in more public and community needs and commons, rather than save individually.

    While this may seem onerous, we do live in a highly atomized society and this would force people to come out of their personal spaces more and build stronger social networks, as well as healthier environments for these communities.

    Now money really is a glorified voucher system and an excess of vouchers is destructive, but those with the most also have the most influence over the system and so it seems logical that might be why public debt is used to store excesses of money.

    The government spends by putting together enormous bills, adding enough to get sufficient votes and the president can only pass or veto them. Which gives congress incentive to override a veto.

    This is not budgeting. To budget is to list priorities and spend according to ability. If they wanted to actually budget, instead of the old line item veto proposal, which would eviscerate the power of congress to write the budget, instead they could break the bills into all their various items, have each legislator assign a percentage value to each item, re-assemble them in order of preference and then have the president draw the line. This would balance the power and remove the inclination to override the president’s decision.

    Of course, it would drastically change the financial mechanisms of the country, but they seem to be headed for disaster anyway. So if there were to develop a more public financial system, it would keep wealth generated in the community within it.

    There was a time when government was largely a private affair, otherwise known as monarchy and the monarchists claimed “mob rule” would never work, but when the costs of the system outgrew its benefits, societies had no choice, but to develop public forms of governance. It would seem the financial circulation system is now reaching that point as well.

    One way democracy works is to push power down to the level it is most responsive. If banking were to function similarly, there would be local community banks, serving as foundation for regional and state banks, which then served as foundation to a national system and each focused on the sectors they served most efficiently.

  6. There are also two sides with their corresponding balance sheets in the case of defaults , as well. Nevertheless , in the case of widespread defaults there is always economic disruption , even though the net worth of the debtors increases by the same amount as the decreases in net worth of the creditors.

    The debate about intermediation vs “thin air” credit creation needs to cut to the chase , rather than get bogged down in endless discussions of transaction mechanisms and dynamics. In other words , does the economy respond to credit “as if” it’s created from thin air ? Do creditors behave “as if” their essential financial condition is unchanged , even though they may have recently exchanged large quantities of cash in their investment accounts for AAA loan securities , like , say , MBSs ?

    I say the answer to both of those “as if” questions is yes. I don’t think it’s a coincidence that U.S. nonfinancial debt/gdp ratios have gone up by about 1 x gdp over the last few decades and that we saw a corresponding increase in net worth / gdp of about the same 1 x gdp ( accruing mainly to the already-wealthy , natch ).

    Others , like Adair Turner , Steve Keen , Werner , etc. , also think the answer is yes , and have set out to develop models and suggest policies to deal with the unfortunate fact that we seem to have blundered our way into living in an unsustainable , debt-dependent economy. Their efforts make more sense to me than prolonging the damage caused by textbook economics by engaging in these futile debates , most of which appear to be simply efforts by the mainstream to close ranks , and save face.

  7. Professor Mehrling, do you know of any good read that describes in detail how this whole banking system came about to be? The thinking and the development of it from the start?

  8. Dear Professor,

    What about the “fractional reserve theory”… I suppose that a bank’s ability to create money depends on whether its reserve requirement is binding or not. If it binds, they are unable (at least without acquiring reserves in the FF market, or elsewhere). Looking at the past century, on the banking system in general, are there periods when the requirement binds more and the theory holds better than in other periods?

    In your example, suppose that Citibank (your bank) has a binding reserve requirement. Then they would have to borrow more reserves in the FF market, to keep a fraction at the Fed. Down the road, that creates a mismatch for HSBC, as they are lending more than they are borrowing. If Chase also has a binding requirement, then they will lend fewer reserves to HSBC, which creates an even greater mismatch for HSBC.

    If my understanding is correct, the “fractional reserve theory” definitely has something to offer. But of course, if the requirements are not binding, the theory becomes useless… or?

    Thanks for all the inspiration!

    • Hi Ralph,

      I have had your question before and will take a shot at an answer in case the professor does not come back to this post for a while.

      Were the reserve constraint to bind, there would be upward pressure on the interbank rate as banks compete for scarce reserves. Given that CBs target that rate, they would be forced to intervene and supply the desired reserves to bring the interest rate back to target. After all, the CB can target a price or a quantity, but not both. In the U.S. the reserve constraint is not for every moment in time, but instead an average reserve ratio over 2 weeks I think, so there is plenty of time for CB accommodation.

      Hope that helps (and that I am not wrong!)

  9. Sunil Nair on said:

    Prof Perry

    A comment Professor Werner makes is very interesting. This is about cross border credit being ill-thought through and mostly unnecessary. The reason we see cross border credit flows is because it is a form of the carry trade (as BIS recognized). When I worked out the flows it seemed that carry trade spread income is largely borne by the host country central banks. The Dollar inflows from borrowers/speculators are exchanged for local currency reserves (autonomous flow) which is then deposited in international money markets as Dollar deposits (and paradoxically funding the original loan). The central bank has the exact opposite negative carry exposure of the speculator – a Dollar deposit (asset) and a local currency reserve liability. As long as the central bank tries to maintain the currency exchange rate as the marginal (buyer), the speculator just collects the spread without the risk of a currency depreciation. Carry trades are structurally profitable trade built of the central bank objective function. The only time they fail is when host central banks are unable to maintain the currency values.
    What do you think? Thanks.

  10. Lee Bertman on said:

    Would it not be possible to evaluate the three theories by analyzing the cost of funds for individual banks and for the banking system as a whole? To the extent that banks create money which they lend, then that portion of the cost of funds to the bank(s) should be zero.