Friday, 27 November 2015

Loans create deposits?

This article entitled “Money Creation in the Modern Economy” (by sundry Bank of England authors) claims that loans are the source of commercial bank created money. Plenty of other literature makes that claim. As the opening sentence of the BoE article puts it, “This article explains how the majority of money in the modern economy is created by commercial banks making loans.” There is actually a glitch in that claim, as follows. (The BoE authors do say that there are reservations to be made to the “loans create money” idea, but not everyone pushing that idea makes the appropriate reservations.)

Obviously when a commercial bank grants a loan to some individual / borrower, and the relevant money is spent, that money ends up in the bank account of some other individual or individuals.

However, let’s assume, to keep things simple that the economy is at or near capacity / full employment. In that case, the inflationary effect of spending the new money must be matched by an equal amount of “spending abstinence”, i.e. saving by others, else excess inflation ensues. And if those others do not intend to use their new stock of money for a significant period, chances are they’ll put it into a term or savings account. At least if they’ve got any sense, that’s what they’ll do (with a view to earning more interest).

But the longer money is locked up for, the less money like it is. In fact when it comes to measuring the money supply, many countries draw the line between money and non-money at somewhere around the two month point. That is, if money in an account can be accessed within two months it is counted as money; if not, it isn’t.

Even if recipients of the new money DON’T put it into a term / savings account, i.e. assuming they put it into a current / checking account, that new money, again, cannot be spent, else inflation rears its ugly head. Thus that new money is effectively not money: it’s more in the nature of a long term loan to the relevant bank (which in turn makes possible a long term loan to the borrower we started with above).

Indeed banks recognise that a proportion of the money in current / checking accounts is in effect a form of long term saving: that’s one reason why banks know they’re safe lending that money on.

As to how recipients of new money are induced not to spend their new stock of money, the central bank might raise interest rates so as to induce more saving and forestall the inflation that would otherwise occur. But it’s possible those recipients increase their saving VOLUNTARILY.

In the above sort of scenario, commercial banks are simply engaged in their traditional activity, namely intermediating between borrowers and lenders.

Unemployment is above NAIRU.

In contrast to the above assumption that unemployment is above the level at which inflation gets serious (NAIRU), if unemployment is at NAIRU, i.e. the economy is not at capacity, then loans would indeed create money, i.e. the central bank would allow that to happen.

“Borrowers” owe banks, or vice-versa?

Another glitch in the “loans create money” idea is that when commercial banks create money, it is arguably not loans that do the creating, and for the following reason.

In an economy where people wanted a form of money (created by commercial banks), but didn’t want long term loans, people would simply deposit collateral at banks, have banks open accounts for them, and have banks credit money (created out of nothing) to those accounts.

But that process does not create any sort of long term debt. In fact banks, if anything, are indebted to bank customers, rather than the other way round. Reasons are thus.

Bank X would owe customer Y the collateral deposited (i.e. the bank must return the collateral at some stage).  Second, there’s the artificial debt owed by the bank to the customer, that debt commonly being known as “money” (if you have $Z in your bank, the bank owes you $Z). And third, customer Y owes a debt to the bank in that Y undertakes to repay the newly created money to the bank at some state (maybe not till Y dies). So that’s two debts owed by the bank to the customer, and one debt owed by the customer to the bank!

Of course if a bank customer spends a significant amount of their new stock of money and simply leaves their account with a smaller balance than the initial balance, that constitutes a loan by the bank (and other depositors) to the customer in question. But on the above assumption, namely that people are simply after a form of money, not long term loans, than no customer would do that: the balance on each customer’s account would bob up and down around the original balance. E.g. the balance would tend to be ABOVE the original balance when the monthly pay cheque arrives, and BELOW the original balance three or four weeks later.


Assuming an economy is at or near capacity, then loans do not result in money creation. Second, where money creation takes place, it’s not long term loans which create that money


  1. Hi Ralph,
    You have repeated this unfortunate heresy several times on this blog.
    You agree that initially a bank loan to customer Y creates money in the form of deposits.
    But you don't explain what causes a reduction in money/deposits, or the likely scale of any such effects.

    You right that if the economy is at full capacity, real GDP cannot increase. Yes, any extra real spending by borrowers must be matched by reduced real consumption or investment by other consumers or firms (or by higher imports, lower exports or lower government expenditures).
    Some of these processes may be associated with the repayment of old loans. But the the scale of any such effects will be small relative to the initial bank loan to Y. On the other hand, some of these processes (and any extra inflation) may also be associated with increased demand for new loans.
    The net effect is likely to be close to zero.

    Using simple algebra:
    Change in bank deposits = the initial new loan to Y + a . change in money GDP.
    The parameter "a"is the extra demand for loans per unit change in GDP, which is likely to be positive.
    Your assumption is that the change in money GDP is zero, so this has no effect on deposits.

    1. Hi KK,

      Fair point. I did rather make it look like I was ASSUMING extra loans would not be inflationary. Thought I did say “As to how recipients of new money are induced not to spend their new stock of money, the central bank might raise interest rates so as to induce more saving and forestall the inflation that would otherwise occur. But it’s possible those recipients increase their saving VOLUNTARILY.” I.e. the most reasonable assumption – certainly the best “all else equal assumption” – as you say, is that demand does rise, and the central bank has to deal with that.

      Though it’s possible that just by coincidence, as I tried to say in the article, that some extra saving takes place at the same time as the extra loans are made, in which case there could be no need for the central bank to do anything.


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