Credit Creation Theory

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As discussed in my previous post, this week I will be focusing on specifically on the credit creation theory of banking. Dr. Werner ultimately makes the case that this is the most compelling theory of banking because it most accurately depicts how the current financial system functions at the transactional level. I tend to agree with his assessment and find the credit creation theory to be a helpful lens through which to view the current financial system. Moreover, if you accept the tenets of this theory, deficits in monetary policy and banking regulations start to appear. This post will focus on the concept of money, how it is circulated and the logic of credit creation.

The Concept of Money & How it is Circulated

Money within an economy can take several forms. The most common forms are notes, coins, and credit. Precious metals such as gold and silver are also prominent forms of money. However, only about 3% of the money in circulation is derived from cash or coins. The overwhelming majority of the money in circulation, ~97%, is comprised of credit originated by banks. This credit is derived from bank deposits and circulated through the economy in the form of loans. A bank effectively creates credit money when generating a bank deposit that is a consequence of fulfilling a loan agreement with a borrower. When the debt instrument is executed, the bank deposits the agreed upon sum into the borrower’s account.

Credit money represents the total amount of money that is owed to banks by borrowers and it only remains valid so long as the bank is solvent. Though it is intuitive to assume that as a loan is paid back to a bank the money supply would expand, the opposite is actually true. Bank deposits basically represent an IOU between a commercial bank and their clients (represented by both individuals and organizations). Again, when a commercial bank lends money, they are technically creating a deposit in another account. Moreover, when individuals deposit their money in a bank they are technically serving as a creditor to the bank, which in turn reserves the right to deploy the depositors’ capital as they see fit. This dynamic is important to understand in order to grasp the credit creation theory of banking at a high level.

The Logic of Credit Creation

As mentioned previously, the dominant theories of banking have been the intermediation theory and fractional reserve theory. These are the theories that are most often taught in college level business, economics, and finance courses. Credit creation theory is seldom considered in academia, however the Bank of England recently published a paper which recognizes the credit creation theory as useful and practical. The theory proposes that individual banks create money and do not solely have to draw upon existing deposits. Instead, the banks create deposits with each loan they originate. As a result, banks are not actually constrained by their deposit activities. By virtue of the bank’s lending, new purchasing power is created which did not previously exist.

The argument for credit creation theory works like this – banks act as the ‘accountant of record’ within the financial system, which enables them to create the fiction that the debtor has deposited money at the bank. The general public is unable to distinguish between money that a bank has created through debt instruments and money deposited at the bank by individuals. Moreover, banks’ ability to create credit money has had significant impacts in the economy – as stated previously, ~97% of all transactions taking place in the economy are considered non-cash or credit transactions. These transactions are settled with non-cash transfers within the banking system as a whole. Ultimately, this theory makes the case that banks are capable of creating an endless supply of money through their lending activities. When viewed from this perspective, current and past financial crises, as well as interventions from the Fed begin to make sense.

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