The bank credit creation process

Banks simply lend credit into existence. Ideas that they are simply financial intermediaries, or that they lend deposits are incorrect. This article explains why.

Introduction

Economists of all disciplines are seemingly unaware of the credit creation process. In their theoretical discourses of money and credit they assume that banks are intermediaries, taking in deposits and lending them out. Consequently, they are seen to have little consequence in economic analysis.

The exception, perhaps, is the Austrian school which posits that bank credit is destabilising. But even there, Ludwig von Mises in his The Theory of Money and Credit appears confused on this issue, writing,

“The activity of banks as negotiators of credit is characterized by the lending of other people's, i.e. of borrowed money. Banks borrow money in order to lend it; the difference between the rate of interest that is paid to them and the rate that they pay less their working expenses constitutes their profit on this kind of transaction”[i]

In a youtube interview of Richard Werner by Tucker Calson, Werner correctly identified the process of bank credit creation. It was subsequently followed by a commentary on this topic by two senior economists of the Austrian School, Bob Murphy and Jonathan Newman to whom the concept appeared to be new to them, having been schooled in von Mises’s analysis.

In this article I shall explain why the fractional reserve theory is incorrect, and Werner’s explanation of credit creation is what actually happens. For the avoidance of doubt and to clarify the position, we must make two important definitions at the outset:

· Gold is money, and everything else is credit. Gold has no counterparty risk and is final settlement, extinguishing credit. Credit is always on the other side of a balance sheet to a debt obligation.

· Banks are dealers in credit.

Defining credit