The Credit Theory of Banking

Executive Summary

• This is the hypothesis that money is created as a form of social credit.

Introduction

This theory is far less known than the evidence for it would indicate.

Academic Research into Whether the Credit Theory of Banking is True or False

It is curious that there is academic research into this question, as it is already determinable by simply reading the documentation of central banks. However, an article titled “Can banks individually create money out of nothing? — The theories and the empirical evidence” was published in 2014. Important quotes from this article include the following.

“According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it ex- tends credit (the credit creation theory of banking). The question which of the theories is correct has far-reaching implications for research and policy. Surprisingly, despite the longstanding controversy, until now no empirical study has tested the theories.“

The article admits that there no empirical study to prove which of these theories are correct.

The Confusion Even Within Banks Regarding the Competing Theories

“The three theories are based on a different description of how money and banking work and they differ in their policy implications. Intriguingly, the controversy about which theory is correct has never been settled. As a result, confusion reigns: Today we find central banks – sometimes the very same central bank – supporting different theories; in the case of the Bank of England, central bank staff are on record supporting each one of the three mutually exclusive theories at the same time, as will be seen below.”

One might presume that while laymen are confused, that those that work in banks, and in fact within one bank (The Bank of England) with staff more knowledgeable on average than the staff of a typical bank would have a consistent understanding of which of the three theories is correct.

Credit Theory of Banking

The following quote explains the credit theory.

“According to the credit creation theory then, banks create credit in the form of what bankers call ‘deposits’, and this credit is money. But how much credit can they create? Wicksell (1907) described a credit-based economy in the Economic Journal, arguing that..

“The banks in their lending business are not only not limited by their own capital; they are not, at least not immediately, limited by any capital whatever; by concentrating in their hands almost all payments, they themselves create the money required….”

“In a pure system of credit, where all payments were made by transference in the bank-books, the banks would be able to grant at any moment any amount of loans at any, however diminutive, rate of interest.” 12 [Wicksell (1907, 214)]”

Withers (1909), from 1916 to 1921 the editor of the Economist, also saw few restraints on the amount of money banks could create out of nothing:

“… it is a common popular mistake, when one is told that the banks of the United Kingdom hold over 900 millions of deposits, to open one’s eyes in astonishment at the thought of this huge amount of cash that has been saved by the community as a whole, and stored by them in the hands of their bankers, and to regard it as a tremendous evidence of wealth. But this is not quite the true view of the case. Most of the money that is stored by the community in the banks consists of book-keeping credits lent to it by its bankers.” [Withers (1909, pp. 57 ff.)]

Apart from Schumpeter, a number of other German-language authors also argued that banks create money and credit individually through the process of lending. 16 Highly influential in both academic discourse and public debate was Dr. Albert L. Hahn (1920), scion of a Frankfurt banking dynasty (similarly to Thornton who had been a banker) and since 1919 director of the major family-owned Effecten- und Wechsel-Bank, Frankfurt. Like Macleod a trained lawyer, he became an honorary professor at Goethe-University”

When and Where the Credit Theory of Banking Was Dominant

It is curious to find that at one time, in a few countries at least, the credit theory of banking was the dominant view of how banks operated as the following quotation explains.

“Overall, Hahn probably did more than anyone to popularise the credit creation theory in Germany, his book becoming a bestseller, and spawning much controversy and new research among economists in Germany. It also greatly heightened awareness among journalists and the general public of the topic in the following decades. The broad impact of his book was likely one of the reasons why this theory remained entrenched in Germany, when it had long been discarded in the UK or the US, namely well into the post-war period. Hahn’s book was however not just a popular explanation without
academic credibility. Schumpeter cited it positively in the second (German) edition of his Theory of Economic Development (Schumpeter, 1926), praising it as a further development in line with, but beyond, his own book. The English translation of Schumpeter’s influential book Schumpeter (1912 [1934]) also favourably cites Hahn. It can be said that support for the credit creation theory appears to have been fairly widespread in the late 19th and early 20th century in English and German language academic publications. By 1920, the credit creation theory had become so widespread that it was dubbed the ‘current view’, the ‘traditional theory’ or the ‘time-worn theory of bank credit’ by later critics.

What Theory Keynes Subscribed To

“The early Keynes seemed to also have been a supporter of this dominant view. In his Tract on Monetary Reform (Keynes, 1924), he asserts, apparently without feeling the need to establish this further, that banks create credit and money, at least in aggregate: “The internal price level is mainly determined by the amount of credit created by the banks, chiefly the Big Five …” (p. 178).”

We know from Keynes’ contribution to the Macmillan Committee (1931) that Keynes meant with this that each individual bank was able to create credit:

“It is not unnatural to think of the deposits of a bank as being created by the public through the deposit of cash representing either savings or amounts which are not for the time being required to meet expenditure. But the bulk of the deposits arise out of the action of the banks themselves, for by granting loans, allowing money to be drawn on an overdraft or purchasing securities a bank creates a credit in its books, which is the equivalent of a deposit” (p. 34).

When Did the Credit Theory of Banking Fall Out of Favor?

“The credit creation theory remained influential until the early post war years. The links of credit creation to macroeconomic and financial variables were later formalised in the Quantity Theory of Credit (Werner, 1992, 1997, 2005, 2012), which argues that credit for (a) productive use in the form of investments for the production of goods and services is sustainable and non-inflationary, as well as less likely to become a non-performing loan, (b) unproductive use in the form of consumption results in consumer price inflation and (c) unproductive use in the form of asset transactions results in asset inflation and, if large enough, banking crises.”

“However, since the 1920s serious doubts had spread about the veracity of the credit creation theory of banking. These doubts were initially uttered by economists who in principle supported the theory, but downplayed its significance. It is this group of writers that served as a stepping stone to the formulation of the modern fractional reserve theory, which in its most widespread (and later) version however argues that individual banks cannot create credit, but only the banking system in aggregate.”

This is curious and telling. This theory means that banks create money. However, why is this being “downplayed” by economists at this point in time?

Why Downplay the Importance of Money Creation?

It is hugely significant and means that banks have the power of the federal government and receive a perpetual financial benefit from charging interest on what is the government’s money-creation function. This brings up the question is these economists, were pressed to fighting against the Credit Theory of Money by private banking interests that wanted the significance of the immense subsidy given to banks downplayed. Secondly, the statement by these economists that “only the banking system in aggregate” can create money is false and nonsensical. When a bank approves a loan, that money did not exist before. So each specific bank creates money.

Source: Science Direct

https://www.sciencedirect.com/science/article/pii/S1057521914001070