Commercial Banks Create Money Out of Nothing

Abstract

There are three main competing theories of banking: (McLeay et al., Money Creation in the Modern Economy, Bank of England Quarterly Bulletin 2014 Q1, 27 Mar. 2014 at https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2416234, 2014) financial intermediation, (New Economics Foundation at https://neweconomics.org/, n.d.) fractional reserve, and (Tobin, Commercial Banks as Creators of ‘Money’ (Cowles Foundation Yale University, 1963)) credit creation. The vast literature on this subject asserts the validity of the financial intermediation theory. This chapter sets forth each model and then demonstrates that, drawing upon empirical evidence, the only model to survive empirical scrutiny is the “credit creation” model: commercial banks create money by reclassifying entries in its balance sheet, unavailable to non-financial corporation and to non-bank financial institutions. Clarifying the “defining characteristics of commercial banks” has far reaching consequences. First, commercial bank credit creation accounts for 97% of the money supply. Second, banks, when making loans, do not draw down their “reserves” held at the Central Bank; “reserves” are used to settle interbank payments through the Central Bank. Third, if as asserted the Basel Accords are based upon the financial intermediation assumption, the Basel Accords are impotent to stabilise the global banking system. The “credit creation” model also calls into question a second unverified claim found throughout the literature: credit creation leads to economic growth as measured by gross domestic product.

Questions

• 1. What is a central bank and why is it deemed essential to modern economies?

• 2. Summarise the findings in the publication: New Economics Foundation, “Making Money from Making Money: Seigniorage in the Modern Economy”, Copenhagen Business School 2017.

• 3. Using the example provided to show marketplace constraints upon commercial credit creation, create a stylised balance sheet showing the effects of the transactions upon Bank “ABC” and the seller’s bank.