Cooking the Books: Loose Talk About Thin Air

The pre-WW2 currency crank, Major Douglas, used to talk about banks being able to create credit by a mere “stroke of the pen”. Currency cranks have been comforted in this belief by some modern writers on money and banking saying that banks can create money out of nothing. What the cranks don’t realise is that these writers mean something quite different.

One quote they have trumpetted all over the internet is from leading Financial Times journalist Martin Wolf who wrote in 2010:

“The essence of the contemporary monetary system is creation of money, out of nothing, by private banks’ often foolish lending.” (10 November)

US economist, Paul Krugman objects to such talk:

“As I read various stuff on banking … I often see the view that banks can create credit out of thin air … it should be obvious that it’s all wrong. First of all, any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand.” (http://krugman.blogs.nytimes.com/2012/03/30/banking-mysticism-continued/)

Wolf will not believe that an individual bank on its own can create money out of nothing to lend. The theory he was expressing somewhat sloppily is that the whole banking system (including central banks, such as in Britain the Bank of England, in the US the Fed) can.

Today all banks (which includes building societies) have to hold reserves at the central bank which are used to settle payments between them at the end of the working day. The argument is that this means that a bank can make a loan without first having the money. But not for long: they have to find it by the end of the day (literally). In a polemic against Krugman, another US economist, Scott Fullweiler, explains:

“But, let’s also assume that Bank A had no reserve balances on hand when it made the loan. How does it transfer reserve balances to Bank B? As it turns out, the Fed provides an overdraft for any payment sent in which a bank’s account goes below zero – that is, the payment is never rejected when it occurs on the Fed’s books. The Fed does this as part of its legal obligation to promote stability in the payments system. The rub is that the Fed requires Bank A to clear this overdraft by the end of the day, which Bank A will most likely do in the money markets (such as the federal funds market, often via pre-established lines of credit). So, on the liability/equity side for Bank A, we end with ‘+borrowings’ in the money market to clear the overdraft.” (http://neweconomicperspectives.org/2012/04/krugmans-flashing-neon-sign.html)

This invalidates neither the view that all loans have to be covered by deposits nor that banks are financial intermediaries, borrowing money and then lending it at a higher rate of interest (as Fullweiler puts it, banks aim “to earn more on assets than is paid on liabilities“). What this theory is aimed at refuting is the view that the central bank can, under existing arrangements, control bank lending, as indeed it can’t (for other reasons too). But to express this by saying that banks have the power to create money to lend “out of nothing” is highly misleading and a gift to the currency cranks.

What it does not support is the view that an individual bank can make a loan with no funding by a mere computer entry and then charge interest on it, a common currency crank fallacy.