Endogenous money creation is back with a vengeance

About a year ago, some BoE staff produced a paper on money creation that made some noise by (apparently) embracing an endogenous (outside) money view. A number of people, and I, pointed out the internal inconsistencies of the theory outlined, which in fact seemed to misunderstand what the traditional money multiplier was about.

A year later, here we go again.

A couple of weeks ago, other BoE staff published a working paper explicitly titled Banks are not intermediaries of loanable funds – and why this matters. Surprisingly, not many people seemed to have picked up on it so far. Unfortunately, the same sort of ‘ivory tower’ flaws and contradictions are present in this paper.

The very first page of the report declares that:

The bank therefore creates its own funding, deposits, in the act of lending, in a transaction that involves no intermediation whatsoever.

I just can’t believe that this is a serious assertion. This is repeated throughout the paper. Later they declare that a bank cannot lend more by attracting deposits from competitors (page 10). Given what I keep reading in academic economic research documents, I’d seriously advise all economists to speak to bankers, bank CFOs, bank treasurers, bank analysts and other market participants before writing such things. They would find out that when a bank lends it indeed creates new deposits, although those do not represent funding but extra pressure on the bank’s existing funding structure (and liquidity)!

They would also find out that banks actively compete for deposits, by raising the rate they pay. According to the authors’ theory, bankers are really really confused and should not bother attempting to attract deposits in the first place… This would mean the suppression of the market for deposits, which a quick reality check rapidly dispels. I have spoken to many bankers whose lending and external funding plans were carefully linked (and no, they never considered raising funds from the central bank, as the theory suggests, unless exceptional circumstances).

In fact, the whole purpose of funding is to get hold of extra reserves. Raising deposits (retail, corporate, interbank…) or raising wholesale funding (senior, sub, secured debt, repos) brings about a reserve (high-powered money) transfer from one bank to another. The one that suffers from the deposit outflow sees increased pressure on its funding structure as its liquidity declines. The one that benefits from the deposit inflow, on the other hand, is now awash with new liquidity it is willing to use.

Despite being a BoE paper, it seems like the UK experience has been quickly forgotten: Northern Rock failed exactly because it had funded its growth by raising mostly volatile wholesale funding that vanished all of a sudden when the crisis struck, leaving the bank illiquid and in a downward spiral. This would have never happened if it had been able to ‘create its own funding’.

As I have explained time and time again, it is naïve to believe that banks can simply continuously extend credit then borrow the reserves from the central bank, and get away with it. The central bank lending stigma is strong, and it is confirmed by the literature (see here or here). This fact is well-known by market participants but clearly not by endogenous money theorists, unfortunately. As the paper says:

The [deposit multiplier] model however does not recognise that modern central banks target interest rates, and are committed to supplying as many reserves (and cash) as banks demand at that rate. The quantity of reserves is therefore a consequence, not a cause, of lending and money creation.

It’s not that central banks don’t provide the reserves. It is that commercial banks are not willing to borrow them!

Ironically, the paper contradicts itself when it says (page 5, my emphasis):

They add that, from the (microeconomic) point of view of an individual bank that considers whether to deviate significantly from the behaviour of its competitors, other important limits exist, especially increased credit risk when lending too fast to marginal borrowers, and increased liquidity risk when creating deposits so fast that too many of them are lost to competitors.

Another problem of this paper is that it wrongly depicts the traditional money multiplier model. Banks can lend before they secure extra-reserves, as long as they have enough reserves to face adverse clearing during the interbank settlement process, or when the new loan is withdrawn as cash. See the following extracts as evidence they do not understand that the money multiplier model does allow for endogenous money creation through deposit creation (page 6):

The fact that banks create their own funds through lending is acknowledged in descriptions of the money creation process by leading central banks and policymaking authorities. The oldest goes back to Graham Towers (1939), the then governor of the central bank of Canada: “Each and every time a bank makes a loan, new bank credit is created — new deposits — brand new money”.

And (page 7):

The fact that banks create their own funds through lending is also repeatedly emphasised in the older economics literature. One of the earliest statements is due to Wicksell (1906): “The lending operations of the bank will consist rather in its entering in its books a fictitious deposit equal to the amount of the loan…”. Rogers (1929): “… a large proportion of … [deposits] under certain circumstances may be manufactured out of whole cloth by the banking institutions themselves.”

And (page 13):

The fact that the creation of broad monetary aggregates by banks comes prior to and in fact may (if commercial banks need more reserves) cause the creation of narrow monetary aggregates by the central bank is acknowledged in many descriptions of the money creation process by central banks and other policymaking authorities. The oldest and clearest comes from Alan Holmes (1969), who at the time was vice president of the New York Federal Reserve: “In the real world, banks extend credit, creating deposits in the process, and look for the reserves later.” This is exactly the view put forward in this paper.

The authors are mixing up ‘funding creation’ and what Chester Arthur Philipps, in his 1920 book Bank Credit, called ‘derivative deposits’, or temporary deposits created by the bank by the action of lending:

CAP_Derivative Deposits

In fact, nobody has ever denied the endogenous money creation inherent to the money multiplier model. But this endogenous creation of deposit liabilities (inside money) is constrained by the exogenous variable of the availability of reserves (outside money), as I explained in this post. Is there a fixed limit in the absence of reserve requirements? No. But in this case banks estimate the amount of precautionary reserves and secondary reserves (i.e. mostly highly-rated/high-quality liquid securities they invest in for margin and liquidity management) they need. Apart from asset quality considerations (and other exogenously-defined factors like banking regulations), nothing prevents a bank from expanding its loan book, and hence its liabilities, ad infinitum. Except the threat of illiquidity.

During the Scottish free banking period, it was reported that banks maintained minimal reserve ratios of around 2% once clearinghouse were established, but sometimes as high as 60%+ before that (see Selgin’s The Theory of Free Banking). Things aren’t that different today: markets are more liquid, securities types more varied, volumes higher, facilitating day to day liquidity management, but the central bank funding stigma prevents banks from having a liquidity free lunch.

So in short, in the absence of reserve requirements, what we end up with is a banking system whose endogenous expansion is bound by the (also inherently endogenous) market actors’ perception of the need for an exogenous variable (reserves/high-powered money). (Not easy to formulate…)

The authors also don’t address the fact that many central banks (China, Turkey…) actively, and rather successfully, use reserve requirements as a monetary policy tool (the latest one being Moldova, but also see examples here).

Funnily, this new BoE staff paper on endogenous money theory disagrees with… last year BoE staff paper on the same topic. While last year’s paper considered that James Tobin’s famous publication Commercial Banks as Creators of Money fitted into their theoretical framework (by describing the limits to bank expansion), this year’s paper mostly views it as in contradiction with their own framework. This makes the whole endogenous outside money theory even more confusing.

Even more problems appear when they devise their model (page 12). Their banking system consists of a single bank that can extend credit without limitations. They fall in the trap that I explained in my detailed critique of the MMT version of the endogenous money theory (see also here). With no competitor expanding or contracting at different paces (as in the real world), this single bank is indeed freed from adverse clearing constraints on liquidity (with only cash withdrawal risk remaining, although cash is very rarely mentions in this article). And worse, they use Werner’s rather weird research paper (in which he ‘discovered’, for ‘the first time in 5000 years’, that customer deposits are part of the bank’s balance sheet… Yep, really…) as ‘evidence’ empirically validating their view (see my more comprehensive review of Werner’s piece here).

Let just finish with the fact that this latest BoE staff working paper never ever mentions any critique of endogenous outside money-type theories, and believe that DSGE models are appropriate for macro-economic modelling despite more and more people now turning against them.

In the end, this paper is a ‘rougher’ version of the theory than the piece published a year ago: fewer internal inconsistencies but also less realistic. Seems like the endogenous theory needs refinement.

PS: The authors say that S&P, the rating agency, endorsed their view. This is wrong. The paper they are referring to is a personal report published by the member of one of S&P’s economics department. S&P explicitly says that this report reflects the view of this economist only. He probably should have consulted his bank analysts before publication.


12 responses to “Endogenous money creation is back with a vengeance”

  1. tkojejohngalt says :

    Excellent post. It seems like guys at BoE are some weird MMT kind of folk?

    • Julien Noizet says :

      I don’t think they believe in MMT, which involves a lot more than money creation theory. I think some of them believe in an endogenous outside money story, though not necessarily the one described by MMT proponents.

      We are also talking about A FEW people at the BoE. It’s far from sure that exec committees believe in those stories given some of the policies they put in place since the crisis.

  2. Swithun says :

    I don’t know if you’ve seen this piece from Q1 2014 but it’s another crankish Bank of England piece that we were suggested to read by the exam board- I teach A-level Economics.


  3. Swithun says :

    Thanks for the link.

  4. Egon says :

    This post is old but better late than never..
    Your paragraph on the ultimate constraint of bank lending reminds me of Perry Mehrling’s thinking to whom I haven’t found any references in your blog so far.

    “So in short, in the absence of reserve requirements, what we end up with is a banking system whose endogenous expansion is bound by the (also inherently endogenous) market actors’ perception of the need for an exogenous variable (reserves/high-powered money). (Not easy to formulate…)”

    He has a very useful course full of positive theory of money and banking on coursera but what I think of in this particular case is his take on the hierarchy of money. The ultimate money, some outside money (whatever it is today, SDRs or gold maybe), exerts some discipline on the banks which provide elasticity through their lending.
    Not that these are news or anything but he has a very clear way of writing which I can only rudimentarily paraphrase.
    So in case you or your readers are interest, here’s the link:

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