How do banks create money?

This is one of those questions that make me squirm when I have to answer it on the spot, for a lot of reasons. First, money is an intimate topic to people’s lives. They owe people and institutions money, their savings are in money; money is just an integral part of everyday experience. Explaining the nature of money to someone can be a difficult experience, especially when they understand the answer.

Second, there’s the fact that multiple explanations of how banks create money exist. Not only that but neoclassical economics proposes one view that dominates the academic and political discourse (neoclassical economics is broadly the economic point of view that has dominated economics for the last 140 years, with perhaps a brief interlude during the “Keynesian” revolution). In the neoclassical view banks are only able to lend money after depositors have put their cash into a bank. Since governments sometimes require banks to hold a certain amount of money aside (in the U.S it’s 10%), the idea is that the rest of their “excess” reserves are available for lending. This theory plus the US’s 10% reserve requirement has led to one of neoclassical economics’s most appealing teaching example. I think it is valuable to quote N. Gregory Mankiw's principles of economics textbook at length here because he's a very clear writer and his book dominates the textbook market (not to mention it gives me a chance to remind people that his students walked out of his class in protest of it's content last semester here: www.thecrimson.harvard.edu/article/2011/11/2/mankiw-walkout-economics-10 )

"Let's suppose that First National has a reserve ratio of 1/10, or 10 percent. This just means that it keeps 10 percent of its deposits in reserve and loans out the rest... First National still has $100 in liabilities because making the loans did not alter the bank's obligation to it's depositors. But now the bank has two kinds of assets: It has $10 of reserves in its vault, and it has loans of $90. (These loans are liabilities of the people taking out the loans, but they are assets of the bank making the loans because the borrowers will later repay the bank.)

...Once again consider the supply of money in the economy. Before First National makes any loans, the money supply is the $100 of deposits in the bank. Yet when the First National makes these loans, the money supply increases. The depositors still have demand deposits totaling $100, but now the borrowers hold $90 in currency. The money supply (which equals currency plus demand deposits) equals $190. Thus, when banks hold only a fraction of deposits in reserve, banks create money.

The amount of money the banking system generates with each dollar of reserves is called the money multiplier. In this imaginary economy, where the $100 of reserves generates $1000 of money, the money multiplier is 10. What determines the size of the money multiplier? It turns out that the answer is simple: The money multiplier is the reciprocal of the reserve ratio. If R is the reserve ratio for all banks in the economy, then each dollar of reserves generates 1/r dollars of money. In our example, R=1/10 so the money multiplier is 10."

sector	Government		Banks		Debtors (to the bank)		Creditors (to the bank)
Parts of balance sheet	assets	liabilities	assets	liabilities	assets	liabilities	assets	liabilities
Balance sheet	0	$10 (currently held as bank reserves)	$10 reserves. $90 loans	$100 in bank checking account	0	$90 loans	$100 in bank checking account	0

I should add that although this is what Mainstream economics puts in their undergraduate textbooks their is a lot academic literature written and published by Neoclassical economists that qualify or even contradict this story. Indeed the most common defense of neoclassical economics is that the critics either don't understand it or are criticizing a "caricature" (aka what appears in the textbooks). The table above is a much more detailed (with the implicit sectors made explicit) exposition of the model Mankiw is presenting. If you learn accounting, you find out very quickly that any financial asset is someone/something else's liability so that they should all sum to zero (The real world contains physical objects that don't have corresponding liabilities so real world balance sheets should sum to positive values).

Notice that in this conception of money creation by banks, the government directly controls the money creation process. If it lowers reserve requirements, excess reserves will appear in the banking system that, according to these theorists, will be lent out, redeposited and lent out again in the “money multiplier” process Mankiw described. If it raises reserve requirements, banks will have to attract more deposits or reduce the amount of loans they are making.

This is a very orthodox theory but it is used in more unorthodox circles to defend various policies. Many liberal critics of big banks have criticized them on the grounds of “not lending” even after the bailouts (this being based on the idea that their holdings of excess reserves are and should be available for “funding investment”). The “move your money” campaign is largely predicated on the idea that moving your deposit limits the ability of big banks to lend money and increases the ability of small banks to. The NEED act (HR 2990) introduced by Dennis Kucinich is largely based on the American Monetary Institute's ideas.

They subscribe to the Neoclassical view of money creation, with the crucial difference that they don't see the “loanable funds” (the deposit and loan concept described by Mankiw) market as an equilibrating system that balances savings and investment in a way beneficial to all. They see it as a system that allows a privileged few to function as a usurious middle man between government, industry and the public (see: monetary.org). For them returning money creation back to the government simply involves raising reserve requirements to 100% .Recall what Mankiw said above:“If R is the reserve ratio for all banks in the economy, then each dollar of reserves generates 1/r dollars of money.” In this case R=1 so each dollar of reserves is just 1 dollar. To AMI, this means that money is only created when governments spend it into existence.

Another view is presented (usually) by the Post-Keynesian school . They look at the correlation between reserves and broader money creation but think that Neoclassical economics has the causation reversed. Rather then banks needing deposits (and thus reserves) to make loans, they see banks making loans which create deposits and then seeking out reserves later. In Neoclassical economics (as alluded to above) savings and investment is balanced through the loanable funds market. The variable that adjusts to balance these two things is the interest rate. If there are more (less) savings being offered as loans then borrowers willing to borrow them, the interest rate is supposed to fall (rise) until equilibrium is reached. Post-Keynesians in contrast envision a central bank with a target interest rate that will intervene to inject reserves when demand for reserves rises to prevent (unplanned) rises in interest rates and withdraw reserves to prevent (unplanned) falls in interest rates. For them the money supply expands and contracts to accommodate the (profitable) financing needs (and desires) of (credit worthy) economic actors including corporations, other financial institutions and households.

I personally subscribe to the Post-Keynesian view. For some Theoretical and empirical defenses of the Post-Keynesian position see Schumpeter's book, Basil Moore's empirical work and definitive book, and a sampling of federal reserve publications cited below. This is enormously relevant to social inequalities. If one accepts the neoclassical view, banks don't have very much agency. they are simply the (well paid) intermediary between savers and borrowers. It is ultimately their actions and reactions that make major changes in the global economy. Rather then the housing bubble being led by madly inventive, criminal bankers, it is supposedly let by investors in search for higher returns and borrowers desire for more and bigger houses. The neoclassical view also leads to the idea that the level of debt doesn't really matter. It also leads to the idea that less radical forms of activism, like moving your money, will bring banking under control, rather then protest, confrontations or even revolution. Social inequality created by finance is ultimately our own fault. If we just became more active and conscious, these ills would shrink enormously. It's not a class conflict, it's a conflict with ourselves.

Works Cited

Delreal, Jose A. "Students Walk Out of Ec 10 in Solidarity with 'Occupy'" The Harvard Crimson. Harvard University. Web. 23 Mar. 2012.

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Kydland, Finn E.; Prescott, Edward C., "Business Cycles: Real Facts and a Monetary Myth", Federal Reserve Bank of Minneapolis Quarterly Review 14 (2): 3–18

Holmes, A. R. Operational Constraints on the Stabilization of Money Supply Growth. Controlling Monetary Aggregates. F. E. Morris. Nantucket Island, The Federal Reserve Bank of Boston: (1969) 65-77 .

Mankiw, Nicholas Gregory. Principles of Economics. Mason, OH: Thomson South-Western, 2011. Print.

Moore, Basil J. Horizontalists and Verticalists: The Macroeconomics of Credit Money. Cambridge [England: Cambridge UP, 1988. Print.

Moore, Basil J. "The Endogenous Money Stock." Journal of Post Keynesian Economics 2.1 (1979): 49- 70. Print.

Schumpeter, J. A. The theory of economic development : an inquiry into profits, capital, credit, interest and the business cycle. Cambridge, Massachusetts, Harvard University Press. 1934. Print