The Credit Creation Theory of Banking

An introduction to a centennially old credit creation theory of banking

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The theory of credit creation comprehends banking as acts of (double-entry) book-keeping and accounting in the way that when banks grant loans to credit-worthy counterparties they do so (at least initially) irrespective of their deposit base by extending their balance sheets (or their loan book in this respect). [1]

The figures above and below illustrate the reversal of the sequence (compared to the intermediation model) that is usually omitted in modern textbooks showing individual banks in the act of lending being at the same time creators of (new) deposits — in the so-called ‘financing through money creation’ (FMC) model of banking. [2]

As new loans are made, bank balance sheets expand and when the debt is repaid, the money ceases to circulate in the economy: ‘all new money entering the economy is issued as debt bearing interest’. [3]

Main assumptions:

• individual banks initially lend irrespectively of their deposit or reserve base

• private banks create money, i.e. bank deposits, in the act of lending, making them rather “manufacturers” than “intermediaries”

• money and debt are intertwined (one’s money = asset, is another’s debt = liability)

Historical formation & development:

Early on did Henry Dunning Macleod in his The Theory of Credit (1893) highlight:

“the very essence and nature of a Bank and a Banker […] to create and issue Credit payable on demand: and this credit is intended to Circulate and perform all the functions of Money. A Bank is, therefore, not an office for ‘borrowing’ and ‘lending’ Money: but it is a Manufactory of Credit: as Mr. Cazenove well said, it is the Banking Credits which are the Loanable Capital: and as Bishop Berkeley said ‘a Bank is a goldmine’.” [4] (own emphasis)

An elementary description of deposit creation through the activity of lending is also given by Simon Newcomb (1885):

“Men of business continually want to borrow money, provided the rate of interest is not too high; they therefore go to the banks for loans. But instead of taking the loans out as cash, they commonly leave them on deposit, and make their payment by cheques. In such cases there is a simple exchange of indebtedness, the bank acknowledging the indebtedness to the customer on demand, while the latter gives his note for the same sum payable with interest at a future time. When business is brisk and merchants see good opportunities for profit by enlarging their operations, they naturally go to their banks for discounts, thus creating a demand for money, or, to speak more accurately, for bank credits. In order to avoid too great an extension of this credit, the bank: raises its rate of interest, thus discouraging the applications of those borrowers who do not expect to make a profit to justify the increased rate. When business is dull the opposite effects take place: the merchants pay off their notes instead of letting them continue at interest, and the bank must lower its rate of interest in order to attract borrowers.” [5] (own emphasis)

Irving Fisher (1911) develops a theoretical understanding of the shifting of rights and liabilities in the course of lending activity (though counting at that time as an ancestor of the intermediation theory of banking):

“The total value of rights to draw, in whichever way arising, is termed "deposits." Banks more often lend rights to draw (or deposit rights) than actual cash, partly because of the greater convenience to borrowers, and partly because the banks wish to keep their cash reserves large, in order to meet large or unexpected demands. It is true that if a bank loans money, part of the money so loaned will be redeposited by the persons to whom the borrowers pay it in the course of business; but it will not necessarily be redeposited in the same bank. Hence the average banker prefers that the borrower should not withdraw actual cash.” [6] (own emphasis)

Fisher also established the insight on the need for elasticity:

“business convenience dictates that the available currency shall be apportioned between deposits and money in a certain more or less definite, even though elastic, ratio.” [7] (own emphasis)

Lucien Albert Hahn (1920) can be credited with the first thorough exposition of the theory of credit creation as:

“each credit granted in an economy generates a deposit and therefore the means of its own accommodation. Because the granting of credit creates a short-term deposit for another economic agent which, at least initially, does not disappear.” [8] (own emphasis)

John Maynard Keynes (1930) signifies the fact that banks as being involved in delivering accounting services when awarding new credits:

“[A] bank creates claims against itself for the delivery of money, i.e. what, hereafter, we shall call Deposits. […] It may itself purchase assets, i.e. add to its investments, and pay for them, in the first instance at least, by establishing a claim against itself. Or the bank may create a claim against itself in favour of a borrower, in return for his promise of subsequent reimbursement; i.e. it may make loans or advances.” [9]

Fisher (1935) eventually summarises his studious endeavours as follows:

“Under our present system, the banks create and destroy check-book money by granting, or calling, loans. When a bank grants me a $1,000 loan, and adds $1,000 to my checking deposit, that $1,000 of "money I have in the bank" is new. It was freshly manufactured by the bank out of my loan and written by pen and ink on the stub of my check book and on the books of the bank. As already noted, except for these pen and ink records, this "money" has no real physical existence. When later I repay the bank that $1,000, I take it out of my checking deposit, and that much circulating medium is destroyed on the stub of my check book and on the books of the bank. That is, it disappears altogether.” [10] (own emphasis)

Joseph A. Schumpeter (1954) further construes banks with the supposedly more realistic role of actual suppliers of credit and creators of deposits:

“[It is] highly inadvisable to construe bank credit on the model of existing funds' being withdrawn from previous uses by an entirely imaginary act of saving and then lent out by their owners. It is much more realistic to say that the banks 'create credit', that is, that they create deposits in their act of lending, than to say that they lend the deposits that have been entrusted to them. […] [B]ank loans and bank investments do create deposits.” [11]

Finally, Richard Werner (et al., 2011) counts as one of the few modern proponents of the credit creation theory:

“When banks are confident, they will create new money by creating credit and new bank deposits for borrowers. When they are fearful, they rein in lending, limiting the creation of new commercial bank money. If more loans are repaid than issued, the money supply will shrink. The size of the commercial bank credit balloon, and therefore the money supply of the nation, depends mainly on the confidence and incentives of the banks.” [12]

Purpose & ramifications:

• stimulation of economic activity

• elastic monetary framework concurring to monetary demand

• designation of different degrees of importance to certain economic roles pertained to activities such as saving, investing, and consuming

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Sources:

[1] McLeay, M., Radia, A. and Thomas, R. (2014) ‘Money creation in the modern economy’, in Quarterly Bulletin 2014 Q1, pp. 14-27, [online] available at: <https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-
   creation-in-the-modern-economy> [Last accessed 15th January 2023].

[2] Kumhof, M. and Jakab, M. (2016) ‘The Truth about Banks’, in IMF Finance & Development, Vol. 53 No. 1, March 2016, pp. 50-53, [online] available at: <https://www.imf.org/external/pubs/ft/fandd/2016/03/pdf/kumhof.pdf> [Last accessed 15th January 2023].

[3] Di Muzio, T. and Noble, L. (2017) ‘The Coming Revolution in Political Economy: Money, Mankiw and Misguided Macroeconomics’, in Real-world Economics Review, Vol. 80, pp. 85-108, [online] available at:<http://www.paecon.net/PAEReview/issue80/DiMuzioNoble80.pdf> [Last accessed 15th January 2023].

[4] Macleod, H. D. (1893) The Theory of Credit, London: Longmans & Green, p. 594.

[5] Newcomb, S. (1885) Principles of Political Economy, New York, NY: Harper & Brothers, pp. 170f.

[6] Fisher, I. (1911) The Purchasing Power of Money, New York, NY: The MacMillan Company, p. 38.

[7] Ibid., p. 53f.

[8] Hahn, A. L. (2015/1920) Economic theory of bank credit, Oxford: Oxford University Press, p. 25.

[9] Keynes, J. M. (2011/1930) ‘Chapter 2: Bank Money’, in Treatise on Money, Mansfield Centre, CT: Martino, pp. 23-33 (p. 23f).

[10] Fisher, I. (1935) 100% Money, New York, NY: Adelphi Company, p. 7.

[11] Schumpeter, J. A. (1963/1954) 'Chapter 8: Money, Credit, and Cycles', in History of Economic Analysis, New York, NY: Oxford University Press, pp. 1074-1136 (p. 1114).

[12] Werner, R., Ryan-Collins, J., Greenham, T. and Jackson, A. W. (2011) Where does money come from? A Guide to the UK monetary and banking system, London: New Economics Foundation, p. 23.