Credit creation

The credit creation theory of banking is one of three theories concerning the role of banks in the economy. It maintains that each individual bank is able to provide credit and to issue money out of nothing, without having to have received new reserves first (as by contrast the fractional reserve theory of banking maintains), or without having to have received new deposits first (as the financial intermediation theory of banking maintains). Credit creation is recognized by, among others, Schumpeter (1912), Austrian school authors such as von Mises (1934 [1953]), post-Keynesian authors such as Moore (1988) and Rochon and Rossi (2003), and empirical economists such as Werner (1992, 1997, 2005).

The question about which of the three theories of banking is correct has been disputed for at least 150 years, without ever having been put to a decisive empirical test. This has recently been provided by Werner (2014a; 2014b), whose tests involved borrowing from a bank that offered access to its internal processes and accounting. It was found that both the fractional reserve and the financial intermediation theories of banking are contra- dicted by the empirical facts.

The credit creation theory of banking was consistent with the observed operations and internal accounts. This empirical research established for the first time in the long history of banking that a bank that engages in what is usually called "bank lending" in actual fact purchases the signed loan contract (which it considers a promissory note), adding it to the assets side of its balance sheet, and simultaneously records its debt to the borrower in its accounts as a liability, but classifying it as a "customer deposit", although nobody deposited this money: it was not transferred to the borrower's account from anywhere inside or outside the bank. Instead, the bank created a fictitious customer deposit entry as a representation of its liability to the borrower to pay out the borrowed money. Since the public is not able to distinguish such fictitious customer deposits from real depos- its, they are treated like the latter. Deposits at banks are money, constituting the vast majority of the "money supply", as measured by M1, M2, M3 or M4.

Thus banks do not lend money. Instead, they purchase assets, and they owe the seller the payment. This debt by banks to the public is called a "deposit", causing much confu- sion. It is therefore better to use the expression "credit creation" instead of misleading expressions such as "lending money".

Through the process of credit creation about 97 per cent of the money supply is issued in the United Kingdom by commercial banks (Werner, 2005; Ryan-Collins et al., 2011). In other words, the money supply is privately created, although the central bank has the ability to influence such private money creation.

While banks create credit and money simultaneously through credit creation, credit is a superior measure of banks' money creation activity compared to deposits. The latter measure money that is at the moment of measurement not used for transactions (that is, potential money, a measure of savings, which includes prior savings and newly created savings), while bank credit measures money creation that is being used for transactions.

Bank credit data also give an indication about the use money is put to, which has different macroeconomic implications, as the quantity theory of credit (Werner, 1997) indicates: bank credit creation for GDP transactions determines nominal GDP growth, while bank credit creation for transactions that are not part of GDP determine asset transaction values, and usually account for the bulk of asset price changes.

Bank credit creation is not directly influenced by central bank interest rates, because the credit market is characterized by pervasive rationing (as the equilibrium conditions of perfect information, complete markets, flexible prices and so on are not met). Rationed markets function according to the short-side principle, so that whichever quantity of supply or demand is smaller determines the outcome. Since the demand for monetary units is virtually unlimited, it is their supply that is the determining factor. In rationed markets the short side exerts allocation power, and is able to pick and choose who to trade with, often extracting additional non-price benefits.

Credit creation is in most countries undertaken by the banking sector, as governments have mostly given up creating and allocating the money supply. Banks are encouraged to maximize their short-term profits, without regulators insisting that they also create the right amount of credit and money, and without insisting that this newly created money is used to fund transactions that are sustainable and beneficial to the community. As a result, much of the banking sector activity in countries such as the United Kingdom is unsustainable and not beneficial for society.

Many central banks have therefore in the past decided to intervene in the bank credit market in order to guide bank credit - both its quantity and its allocation for particular types of economic activity. Such credit guidance was pioneered by the German central bank (Reichsbank), but has at times been adopted by most central banks. Most notably, it has been deployed by the successful East Asian economic developers (Japan, Korea, Taiwan, and China) in the post-war era. Through this policy, harmful, unsustainable or undesirable transactions were not forbidden, but could not receive newly created credit money to fund them (for instance, bank credit for financial speculation was not allowed during the heyday of credit guidance). Instead, bank credit was guided towards invest- ment in the production of goods and services or implementation of new technologies, which contributes to nominal GDP and, since productive, does not drive up consumer prices, thus also boosting real GDP.

An alternative to credit guidance is to end the conflict of interest inherent in for-profit banks operated for the benefit of shareholders by shaping the structure of the banking sector so that it is dominated by small, local, not-for-profit banks operating for the benefit of the community. This has been the case in post-war Germany.

A policy of credit easing has been suggested in the aftermath of banking crises in order to ease the pressure on the banking system and produce an economic recovery through an expansion in credit creation.

See also:

Credit easing; Credit guidance; Money and credit; Money creation; Money creation and economic growth; Quantity theory of credit; Reichsbank.