If you open any economic textbook you will find a standard explanation of how banks operate. The basic story is that a person deposits some money (say €100) into a bank which then saves a percent of this (say 10%) as a reserve and then lends out the rest. This €90 is then deposited by whoever receives the loan, 10% of which is saved and the rest is lent out. This goes on and on until the original €100 has become €1,000. It is easy to see why students are told this story; it is simple, intuitive and gives them a basic idea of banking. Unfortunately, it is wrong.
There is strong evidence that contrary to the above story (known as the loanable funds theory) the banking system works the other way around. Deposits don’t create loans; loans create deposits (this is known as endogenous money). This is a more complicated story but a more realistic one that can better guide our view of the economy.
In reality banks do not check their reserves when deciding whether to make a loan. In a modern electronic economy with a fiat currency, money does not have to be physical cash but can be created from thin air. If you think about the loan process, all the emphasis is on the demand (customer) side rather than the supply (bank) side. Banks decide to make loans based on the credit worthiness of the customer, in order words if they will get paid back. This loan will be spent and the next person will save some and spend the rest and so on until the original loan ends up back in a bank. If the original bank does not have enough reserves at the end of the day, it then borrows the money from other banks. (To be clear I am describing how banks actually work, not how they should work).
But why would other banks lend to them? The reason is that other banks are in the same position and will sooner or later need to borrow to meet the reserve requirement. The traditional theory doesn’t explain the large amount of lending between banks, most of which is of a very short term basis (a few days or less). However endogenous money theory can explain this as temporary actions of banks to meet regulatory requirements. If a bank cannot raise its money from other banks then it can borrow it from the central bank. The central bank has top lend it the money or else the bank would be insolvent and could fail and spark a panic (which the central bank would naturally do everything to avoid).
In this way banks are able to create money from nothing just by typing a few lines into a computer. This does not mean that everyone who asks for a loan gets one; banks still have to make a profit and ensure that the loan is repaid. The credit worthiness of the customer is still the main determinant of a loan. There are also the administration costs in making a loan such as interest rates, taxes, debt collection etc. Many countries also have laws regarding how much reserves a bank must keep. So even though banks can make loans out of thin air, there are loans that they cannot or should not make. The idea that banks are houses of smoke and mirror where nothing is real and everything is based on illusions and bluffs should not be that surprising considering the Financial Crisis.
Now I don’t blame you if you find this a bit much. I’ll admit it took me a while to get my head around this and I’m not fully there yet myself. But that’s the crazy world of finance for you. I think one important thing we got from the Financial Crisis was that a lot of what was going on didn’t make any sense. A lot of it was just playing around with numbers that didn’t exist and promptly vanished in a puff of smoke. If banks based their loans on their reserve levels there is no way Ireland would have experienced a massive credit boom during the Celtic Tiger. Banks are able to create loans out of nothing and can therefore easily lose the run of themselves like Anglo Irish Bank.
It is not just Post Keynesians who advocate this theory. Even prominent bankers and economists are starting to realise that deposits do not lead to loans, but the other way around. Alan Holmes of the Federal Bank of New York said in 1969
“In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.”
Distavet and Bori write that:
“This paper contends that the emphasis on policy-induced changes in deposits is misplaced. If anything, the process actually works in reverse, with loans driving deposits. In particular, it is argued that the concept of the money multiplier is ﬂawed and uninformative in terms of analyzing the dynamics of bank lending.”
Victor Constancio, Vice President of the ECB said that:
“In reality the sequence works more in the opposite direction with banks taking first their credit decisions and then looking for the necessary funding and reserves of central bank money.”
According to Paul Sheard, Chief Global Economist at Standard & Poor:
“Banks do need to hold reserves (as a liquidity buffer) against their deposits, and banks create deposits when they lend.”
Even some of the best known Neo-Classical economists Kydland and Prescott agree that:
‘There is no evidence that either the monetary base or M1 leads the [credit cycle], although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the [credit cycle] slightly”.
There are three important consequences of endogenous money. Firstly, it means the financial system is far more unstable than under the loanable funds theory. Banks are not conservative and constrained as in the traditional model, but are prone to wild fluctuations. They could hugely increase the supply of credit far beyond their reserves (as they did in the run up to the Financial Crisis) or shrink it to far less than what their reserve ratio allows (as they did after 2008). Credit therefore becomes far more volatile, unpredictable and uncontrollable by the central bank. Credit booms and crises are not caused by shocks from outside the system, but are inherent within the economic system itself.
Secondly, if loans create deposits then Say’s Law and the fear of “crowding out” doesn’t exist. There is no longer any pool of potential credit that if the government borrows from, leaves less for the private sector. Instead both government and private sector borrowing could grow together. Government borrowing could even spur the private sector to increase its investment if it created private sector revenue.
Thirdly, monetary policy is far less effective. This can be seen from the monetarist failure to control inflation and the money supply during the 80s despite explicit central bank targeting. The simple fact is that private sector banks add more to the money supply than the central bank printing presses. If credit is not constrained by bank reserves, then increasing the required reserve ratio will have little effect. This means central banks will lose one of their main weapons to curb excess credit lending. The policy of Quantitative Easing is based on increasing bank reserves in the hope that this will lead to more lending. The failure of this to occur is another piece of evidence in favour of endogenous money. Interest rates will still be an option, but they are of only limited use in reducing lending (interest repayments are only a minor proportion of a business’s costs).
Endogenous money is a seemingly counter-intuitive theory that turns the world of banking on its head. However, it provides a more accurate and realistic view than the simplistic traditional story. It provides a warning that finance is far more unstable and crisis prone than previously thought. Crises are not shock occurrences but rather an inbuilt part of the system. Without reserves to constrain them, banks can greatly lending and cause credit bubbles unless kept in firm check. Endogenous money calls for a fundamental rethinking of how we view the world of banking.