Daily Archives: November 24, 2013

Can commercial banks create money out of thin air?

If the title of this posting is Googled there will be many hits suggesting that banks are able to do just this.

For instance according to Michael Kumhof Deputy Division Chief, Modeling Unit, Research Department, International Monetary Fund “The key function of banks is money creation, not intermediation.”

Some banks are also able to issue their own banknotes (or bills in the US). For instance Scottish banknotes, designated in £ sterling,  can be issued by several of their commercial banks and are readily accepted there.  But, maybe less so in England!  Normally UK banknotes are issued by the Bank of England. The Bank of England is the reserve bank of the UK,  part of the UK government and the issuer of the £ sterling currency.

When commercial banks issue loans they credit the bank accounts of the borrower and but they don’t debit their own reserves. The bank has the asset to the amount of the loan, and the borrower assumes the liability of repayment.

Of course, there are rules, which vary from country to country, which govern the lending practices, and ability to print banknotes, of the commercial banks. There is often, but not always, a requirement for the commercial bank to maintain a certain level of reserves. However, subject to these rules, the commercial banks can borrow as they need to provide commercial loans. They borrow at a low rate of interest, either from the reserve bank or their depositors, and lend out at a higher rate. The difference between the two rates provides the banks with their profit margin and also acts as an insurance against a default on the loan.

But if they feel they don’t need to borrow anything they don’t. They just write out an IOU which we all tend to think of as if it were the same as a government IOU.

Government, or their reserve banks, set interest rates as a matter of policy to regulate lending. The conventional, but erroneous, wisdom,  is that money can be created by the Reserve bank,  in printed  form or by keystroke,  and lent out via  the commercial banks  to regulate the level of activity in an economy.   It is is not considered that this should be done to directly fund additional government spending though. That needs to be done via the process of printing or creating treasury bonds. Somehow, for reasons which don’t appear to be quite logical, the economic mainstream don’t consider printing bonds to be the same as printing money.

Swapping money for bonds, or vice versa, doesn’t really change anything much at all , as has been recently seen through the so-called process of Quantitative Easing so maybe something of a rethink is called for on this point.

However, regardless of any inconsistency, the process works reasonably well in normal times but less well when interest rates are deliberately reduced to ultra low levels. The control knob can’t be turned any further.

Does this mean the commercial banks,  too,  are also acting as currency issuers rather than users? Are the Scottish banks assuming the role of a currency issuer when they print banknotes?

No, they aren’t.  Apart from being able to borrow directly from the reserve bank, individuals can do the same thing. They can issue IOUs as they please which in principle can be traded by a third party. Casinos can issue £5 chips, which are their IOUs, for use on , say, a roulette table. They, too, in principle could be traded on an open market. Of course, if the casino were considered a credit risk the chips would lose their value. Scottish banknotes could lose their value too if the issuing bank was considered to be in risk of default. Similarly, any bank customer with a bank account full of newly created credits would need to have all payments cleared using those credits. It is possible that they would be refused, by another bank, if the issuing bank were considered to be at risk of default.

It’s the financial viability of the issuing institution which guarantees any written IOU. Conventional theories involving banking multipliers are bunk! That’s not how it works.

So, in conclusion,  the “thin air” expression is somewhat misleading. Commercial banks aren’t doing anything special at all. The only issuer of a currency is the government, or governments in the case of the Euro,  via their Reserve bank. Everyone else is a user, and cannot , unless they are in the counterfeiting business, create their own extra units of that currency.

Further reading:


PS This posting has generated more heat than any other with 23 comments so far. I think I now understand the  problem better than I first did, so I’d like to thank everyone for their contributions. It seems to me that there needs to be a recognition that what we see in our bank accounts, at the commercial banks, isn’t quite the same thing as money. The figures actually do refer to bank IOUs which can of course be always swapped for government printed banknotes, which are certainly money,  providing the bank is solvent.
Similarly what the bank creates isn’t quite money. They generate their own IOUs or asset/liability pairs in the same way as anyone else can.  Should they be prevented from doing this? I’d have to say no. Anyone has the right to issue an IOU.  But, that of course is a political and not an economic question.