Banks don't lend money, they create it: Deobfuscating monetary and banking terminology

AARHUS UNIVERSITET
Banks don’t lend money, they create it:
Deobfuscating monetary and banking terminology
7th Critical Finance
Studies Conference
CBS, Copenhagen,
August 20-21, 2015
Ib Ravn
Research Program
on Organization and Learning,
Department of Education,
Aarhus University, Denmark

Ib Ravn
ravn@dpu.dkAARHUS UNIVERSITY
Problems
• What does a bank do when it lends?
• Three theories of bank lending
(Werner, 2014). Which is true? Or when?
• Why does ‘lending’ and so much
other monetary and banking
terminology seem like obfuscation?
My argument
1. How banks create money (account money).
2. The three theories of bank lending fit three different monetary and banking systems.
3. Some money and banking terms that need to be deobfuscated
– and a few hypotheses as to why they haven’t been already.
1. The problems and my argument
To obfuscate: To deliberately make more confusing
in order to conceal the truth.

Ib Ravn
• Bank of England paper, Money Creation in the Modern Economy:
”Banks do not act simply as intermediaries, lending out deposits that savers place with
them” (McLeay et al., 2014, p. 14).
• Hugo Frey Jensen, (Deputy) Governor, Danmarks Nationalbank: "Banks create
deposits, and thus money when providing loans” (Jensen, 2013, p. 1).
• Example: I take a loan of 800,000 DKK. The loan officer enters this amount into
my current account (a bank liability) and opens a loan account in my name, entering
the 800,000 as my debt to the bank (a bank asset). The bank’s balance has been
extended. No transfer of funds. No intermediation.
• Michael Kumhof, Senior Research Advisor, Bank of England: “…whenever a bank
makes a new loan to a non-bank customer X, it creates a new loan entry in the
name of customer X on the asset side of its balance sheet, and it simultaneously
creates a new and equal-sized deposit entry, also in the name of customer X, on the
liability side of its balance sheet. The bank therefore creates its own funding,
deposits, in the act of lending.” (Jakab & Kumhof, 2015, p. 3).
2. Banks create money when they ‘lend’

Ib Ravn
• When loan has been made, the borrower spends it = payment, a transfer to another
account. Doesn’t that require the bank to cough up the money?
• No, because millions of payments -- the national payment system (in DK: Nets).
Clearing (Norman et al., 2011). Only small net amounts are transacted. A payment
system facilitates money creation.
• The money supply (M1) is mostly sum of bank deposits.
M1 increases as loans are created
and shrinks as loans are repaid.
Thus, bank lending is money creation.
• Consequence: In good times, banks
over-lend and feed bubbles in fixed assets,
driving boom-and-bust rollercoaster.
• Unchecked bank lending (money creation)
is the main cause of the business cycle
(Werner, 2005).
3. Lending + clearing => money creation

Ib Ravn
• Crazy terminology. What lawn mower
do you create in the act of lending it?
• And does it cease to exist
when you return it?
• Why has this and many other
misleading banking terms persisted?
• To justify the charging of interest?
(Savers must be compensated for the
unavailability of their funds, right?)
4. The term ‘lending’ obfuscates

Ib Ravn
1. The financial intermediation theory:
A bank gathers deposits and lends them.
2. The fractional reserve theory of banking:
A bank retains a fraction of any deposit and
lends the main part, again and again.
3. The credit creation theory: Bank creates
new (account) money by bookkeeping
(adding digits to customer accounts).
• Werner (2014) finds overwhelming
evidence for no. 3.
• I’ll argue they are suitable for three different banking systems (Weberian types)
5. Three theories of bank lending (Werner, 2014)
Money. Jens Overgaard Bjerre
Money. Jens Overgaard Bjerre

Ib Ravn
• Theory: A bank intermediates savers’ money by lending it to borrowers.
• This was true when and where banks accept gold and valuables (like a painting)
for safekeeping (de Soto, 2012).
• The gold coins were lent, with or
without depositor’s knowledge.
• This theory has survived later
developments in banking and
remains popular theory of banks.
• Theory 1 is true for that type of
bank (historically very rare).
6. (1) The intermediation theory fits a warehouse bank

Ib Ravn
• Theory: A fraction of every deposit is
kept as a ‘reserve’, before on-lending,
in case the depositor comes for it
(Mankiw, 2009, p. 549)
• Theory invented for a gold-type banking
system, where deposit slips circulate as
money (bank notes) and depositaries
write fake deposit slips, passing them
off as loans (Ravn, 2014). Reserves are
banks’ and nations’ safeguards against
bank runs.
• “Reserve” only makes sense here (not in warehouse bank: no new money, thus no
need for reserves).
• In the 1700-1900’s this theory was a fair fit (if we ignore account money)
7. (2) The fractional reserve theory fits a bank with reserves

Ib Ravn
1. Theory: A bank credits the borrower’s
account with the deposit and enters a
corresponding asset (the value of the loan)
on the other side of the ledger. No funds
transferred. Deposit is created from scratch.
2. Suitable for a banking and monetary system
where all money is account money
(no gold or cash) (Jakab & Kumhof, 2015)
3. Bookkeepers discovered they could ”lend”
by adding numbers to borrower’s account, without honestly subtracting same numbers
from some other account. Because, when amounts are transferred between accounts,
they tend to clear. In the clearing of matching loans lies money creation.
4. As loans are not given as cash/gold today, this theory fits current banking system.
8. (3) Credit creation theory fits pure account-money bank

Ib Ravn
• Suitable to historically different banking systems.
• Past economists confused about bank lending?
• “Keynes… did little to enhance clarity in this debate, as it is possible to cite him in
support of each of the three hypotheses, through which he seems to have moved
sequentially” (Werner, 2014, p. 12).
• British banks in 1925 were a combination of warehouse banks, gold-reserve banks,
and account-money banks.
• Theory 3 holds today (Werner, 2014; Benes & Kumhof, 2012). Our banking system is
evermore account-based. For the other banking systems: the other theories are fine.
• Using theory 1 concepts today is misleading and self-serving:
- It justifies interest (“Lender forgoes use of his money”. No)
- It hides banks’ enormous power to create money and control the money supply
- It portrays banks as humble servants of society’s needs when pursuing own profits
9. The three theories evaluated

Ib Ravn
Finansrådets hjemmeside:
”Banker skaber kontakt mellem de, der vil
låne penge, og de, der ønsker at spare op.
Bankernes unikke rolle som ‘pengeformidlere’
skaber blandt andet værdi ved at gøre det nemmere og billigere at låne og spare op.
…[B]ankerne leder pengene i samfundet derhen, hvor de gør størst gavn….
http://www.finansraadet.dk/Tal--Fakta/Pages/bankernes-betydning-i-samfundet/bankerne-og-vaekst/uddybning-om-ind--og-udlaan.aspx
Translation: The Danish Bankers Association website:
“Banks establish contact between those who want to borrow money and those who wish
to save. The banks’ unique role as ‘money intermediators’ creates value by making it
easier and cheaper to borrow and save. …[T]he banks channel the money in society to
where it does the most good….
10. Example: Theory 1 used for public communication

Ib Ravn
11. Theory 1 terms
that obfuscate
1. Lending, loan. Warehouse terms
conceal that banks create money
2. Loanable funds; funding. Suggest
lent money derives from ‘funds’
3. Make a deposit. Nothing is deposited.
It’s all numbers. No gold; rarely cash.
4. Repayment of a loan. No such thing.
You don’t ‘repay’ freshly created money.
5. Business cycle – as if the boom-bust
economy is normal, not preventable.
• Create money: ”I’d like you create
£200,000 for a new home for us.”
• Money creation. Unethical to pretend
otherwise. Truth in advertising? Illegal?
• Coordinate numbers. “Would you jiggle
some numbers in my accounts?”
• Destruction. “Let me destroy £500 a
month. Erase it from my account.”
• Money bubbles – to underscore the
money-created origins of boom-bust

Ib Ravn
1. Ignorance: When early trading houses allowed customers to go into debt and still
trade, they didn’t know they were creating money.
2. Gradual awareness of deception: E.g., goldsmiths writing fake deposit slips.
3. Deliberate silence for gain. Why call attention to a fraud by naming it so?
4. ‘Bankers’ responsibility’ to guard the public’s ‘trust’ (Nielsen, 1930, s. 59)
5. Scholars unaware. Money and banks virtually
absent form economics. Neutral veil; can be ignored.
Highly convenient for bankers. Shared interests?
Major failing:
• Bankers practical – use extant concepts
• But economists and finance scholars
should have updated theory (from no. 1 to 3)
and reconceptualized ages ago.
www.tinyurl.com/keen-krug
12. Possible reasons why no change in terminology

Ib Ravn
1. Lending and other terminology hidden behind a veil.
Not veil of neutrality, but a veil of deception (Häring, 2013)
2. Three banking systems overlap, as do three models of lending.
3. (1) The warehouse theory legitimizes the charging interest and glorifies bank’s role
(2) Banks seen as having gold reserves: fractional reserve banking
(3) Best fit today: banks add to the money supply when lending = money creation
4. Responsibility of academics in (critical) finance: This really matters. Business cycles
concentrate wealth at the top and deprive millions of their just share.
5. If we don’t understand this causal factor, bubbles will return. The nature of bank
lending needs to be clear: banks’ money creation feeds bubbles and crises.
6. Help design a more equitable monetary system – which controls bank credit creation
(Werner, 2005) or strips banks of their power to create money (Wolf, 2014; Jackson &
Dyson, 2012; Sigurjónsson, 2015)
13. Conclusions

Ib Ravn
Benes, J., & Kumhof, M. (2012). The Chicago Plan revisited. IMF Working Paper
WP/12/202.
De Soto, Jesús Huartes (2012). Money, bank credit, and economic cycles. 3rd edn.
Auburn, AL: Ludwig van Mises Institute.
Häring, Norbert (2013). The veil of deception over money: How central bankers and text-
books distort the nature of banking and central banking. Real-world economics re-
view, 62: 2-18 (25 March).
Jackson, Andrew, & Dyson, Ben (2012). Modernising money. London: Positive Money.
Jakab, Zoltan, & Kumhof, Michael (2015). Banks are not intermediaries of loanable funds –
and why this matters. Working paper No. 529, Bank of England, May.
Jensen, Hugo Frey (2014): Money at the bank is also good money. Danmarks
Nationalbank, Press Release, Sept. 23, www.tinyurl.com/hugo-money
Mankiw, N. Gregory (2009). Macroeconomics. 7th edn. New York, NY: Worth Publishers.
McLeay, Michael, Radia, Amar, & Thomas, Ryland (2014b). Money creation in the modern
economy. Bank of England Quarterly Bulletin, Q1, 14-27.
Nielsen, Axel (1930). Bankpolitik. Bd 2: Læren. København: Hagerups Forlag.
14. References (a)

Ib Ravn
Norman, B., Shaw, R., & Speight, G. (2011). The history of interbank settlement
arrangements: exploring central banks’ role in the payment system. Working Paper
No. 412, Bank of England, June.
Ravn, Ib (2014). Private bankers pengeskabelse – belyst ud fra en episode i 1600-tallet
med Londons guldsmede. Samfundsøkonomen, nr. 2, april, 4-10. [Money creation by
commercial banks, explained through an episode in the 1600’s with the goldsmiths of
London]
Sigurjónsson, Frosti (2015). Monetary reform: a better monetary system for Iceland. A
report commisioned by the prime minister of Iceland.
Werner, Richard A. (2005). New paradigm in macroeconomics: Solving the riddle of Jap-
nese macroeconomic performance. Houndmills, UK: Palgrave Macmillan.
Werner, Richard A. (2014). Can banks individually create money out of nothing? — The
theories and the empirical evidence. International Review of Financial Analysis, 36, 1-
19. A blogger’s fine summary here: www.kortlink.dk/frkv
Wolf, Martin (2014): Wolf, M. (2014). Strip private banks of their power to create money.
Financial Times, 24. April.
15. References (b)

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