Sunday, 30 March 2014

Deposits create loans or the other way round?

The “loans create money” brigade have got all excited over the last two weeks or so as a result of this Bank of England publication which says that loans create deposits / money.
Actually the cause effect relationship runs both ways. That is, the commercial bank system cannot lend an extra £X unless someone or a collection of people are prepared to deposit approximately £X in the commercial bank system. That is, the relationship between depositors and borrowers is a bit like the relationship between apple growers and apple consumers: the market price for apples is not determined exclusively by buyers or sellers.
Or as Nick Rowe put it, “And commercial banks, neither individually nor collectively, can create loans, unless they can persuade people to hold their deposits and not hold central bank money instead.”
At least the latter point by Nick is right if the economy is at capacity. That is, in the latter scenario, if commercial banks did simply credit the accounts of borrowers without bothering to see if they had enough depositor money, the result would be increased aggregate demand. That is, the fact of failing to “persuade people to hold their deposits” would mean that those depositors would try to spend away their increased stock of money, thus demand would rise, which would be inflationary, which the central bank / government would counter, e.g. by raising interest rates or increased taxes. Result: no extra borrowing.
In contrast, if the economy is BELOW capacity, lending money into existence with the resulting depositors trying to spend away their new stock of money would increase demand. But that wouldn’t matter to the extent that extra demand was called for.


  1. I am thinking that you and I interpreted Nick's comment "Or as Nick Rowe put it, “And commercial banks, neither individually nor collectively, can create loans, unless they can persuade people to hold their deposits and not hold central bank money instead.” " in a different way.

    I thought that Nick's central-bank-money was "currency". If depositors decided to forgo deposits and held only currency, the bank would have no money to lend with the result that no further loans would occur.

    You go on in this post to relate bank lending to economic full capacity or less than full capacity, saying that it does matter at full capacity but doesn't matter at less than full capacity. If we used my interpretation (that potential customers all have begun using currency), it does not seem to me like a relationship between currency and full capacity would exist.

    1. I agree with Nick’s claim that no bank lending would take place if everyone was determined to hold base money. But that’s a trifle unrealistic: i.e. it’s far fetched to suggest everyone would ever want to keep all their money in the form of cash under the mattress.

      But I don’t see why Nick’s very hypothetical point is incompatible with my point. Nick said that the bank system cannot lend an extra £X unless there are depositors willing to hold an extra £X of deposits, which I think is basically correct. However, that point is partially or wholly invalid if the economy is below capacity. That is, if banks lend an extra £X, and depositors refuse point blank to deposit it – choosing instead to spend the money as fast as they can – the resulting increase in demand might not matter in that increased demand is exactly what the relevant economy would need.

  2. I roughly agree with Ralph on this.

    If there is an excess supply of money, then either Y and/or P will increase, until that money is willingly held. But in order to figure out whether it is P or Y or a bit of both, we need to say something about the Phillips Curve, and where the economy is on it.

    1. Nick, Can't the velocity can also fall. A slower velocity is an increase in average holding time for each deposit holder caused by more money in the average deposit..

      I agree that the ultimate Y or P will increase as the result of money supply increases but the time period in which this happens may be far in the future. It seems to me that we are seeing this delay in effect with the current QE programs.

      Ralph. It seems to me that depositors-spending--their-money-more-quickly does not reduce the amount of deposits present at the bank. Only repayment of loans or holding more currency would reduce the amount of deposits present.

    2. Correct. But that doesn’t invalidate my above basic point, which is that if the economy is not at capacity, and banks lend out more money which the resulting depositors don’t want to keep, then those depositors will try to spend away their surplus stock of money. Ergo in as far as that just brings the economy up to capacity, where banks lend more, without there being depositors willing to hold that money, there is no problem.


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