2 Nobel Economists Confirm that Credit is NOT Created Out of Excess Reserves → Washingtons Blog
2 Nobel Economists Confirm that Credit is NOT Created Out of Excess Reserves - Washingtons Blog

Sunday, September 20, 2009

2 Nobel Economists Confirm that Credit is NOT Created Out of Excess Reserves

We've all been taught that banks first build up deposits, and then extend credit and loan out their excess reserves.

But critics of the current banking system claim that this is not true, and that the order is actually reversed.

Sounds crazy, right?


But take a look at the following quotes:

“[Banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts."
- 1960s Chicago Federal Reserve Bank booklet entitled “Modern Money Mechanics”

"The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented. Banking was conceived in inequity and born in sin . . . . Bankers own the earth. Take it away from them but leave them the power to create money, and, with a flick of a pen, they will create enough money to buy it back again. . . . Take this great power away from them and all great fortunes like mine will disappear, for then this would be a better and happier world to live in. . . . But, if you want to continue to be the slaves of bankers and pay the cost of your own slavery, then let bankers continue to create money and control credit."
- Sir Josiah Stamp, president of the Bank of England and the second richest man in Britain in the 1920s.

Banks create money. That is what they are for. . . . The manufacturing process to make money consists of making an entry in a book. That is all. . . . Each and every time a Bank makes a loan . . . new Bank credit is created -- brand new money.
- Graham Towers, Governor of the Bank of Canada from 1935 to 1955

[W]hen a bank makes a loan, it simply adds to the borrower's deposit account in the bank by the amount of the loan. The money is not taken from anyone else's deposit; it was not previously paid in to the bank by anyone. It's new money, created by the bank for the use of the borrower.
- Robert B. Anderson, Secretary of the Treasury under Eisenhower, in an interview reported in the August 31, 1959 issue of U.S. News and World Report
This is a bizarre concept, and you might not be convinced by these claims.

But as Steve Keen writes today, 2 Nobel-prize winning economists have shown that the assumption that reserves are created from excess deposits is not true:

The model of money creation that Obama’s economic advisers have sold him was shown to be empirically false over three decades ago.

The first economist to establish this was the American Post Keynesian economist Basil Moore, but similar results were found by two of the staunchest neoclassical economists, Nobel Prize winners Kydland and Prescott in a 1990 paper Real Facts and a Monetary Myth.

Looking at the timing of economic variables, they found that credit money was created about 4 periods before government money. However, the “money multiplier” model argues that government money is created first to bolster bank reserves, and then credit money is created afterwards by the process of banks lending out their increased reserves.

Kydland and Prescott observed at the end of their paper that:

Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.

In other words, if the conventional view that excess reserves (stemming either from customer deposits or government infusions of money) lead to increased lending were correct, then Kydland and Prescott would have found that credit is extended by the banks (i.e. loaned out to customers) after the banks received infusions of money from the government. Instead, they found that the extension of credit preceded the receipt of government monies.

Indeed, as Mish has previously noted:

Conventional wisdom regarding the money multiplier is wrong. Australian economist Steve Keen notes that in a debt based society, expansion of credit comes first and reserves come later.
Indeed, some critics of the current banking system - like Ellen Brown - claim that the entire credit-creation system is an accounting sleight-of-hand, and that banks simply enter into loan agreements, and then obtain the reserves later from the Fed or in the open market. In other words, they claim that banks extend money first, and then increase their reserves on their books later to cover the loans.

If true, this would certainly turn our entire understanding of the banking and credit-creation system on its head.


  1. This 47 minute animated video is the best explainer I can find...


  2. Yes, this is true. It clearly is true. But, consider what it means...

    Economists have been inept at fathoming the depth of the incorrect side of all their own basic assumptions which go very deep -indeed.

    There is nothing inherently fatal about this particular assumption however, -that isn't already inherently fatal about the entire credit economy.

    To understand the problem, we must force ourselves to trace the fault as we discover it.

    Consider: every time you or I write a check, or use a debit card, -something we all perceive of as a transfer of real wealth-, WE are not transferring real wealth either.

    We also are creating money out of thin air.

    In the case of writing a personal check, some of that money we've created is -often enough- proved to be vaporous stuff -when a check is returned, marked "INSUFFICIENT FUNDS" funds.

    The society-sized pitfall arises less from the notion of there being insufficient funds in an account, than there is -this inherent danger in the notion that we extend credit at all.

    This is because it opens up many possibilities for expansive problems that grow out of this otherwise seemingly innocuous fix meant to address our desire for expediency.

    Consider: right now- we have government backing up trillions upon trillions of dollars of credit extended by private banks, -when in fact-, the checks of all those insolvent banks -need to be marked, "INSUFFICIENT FUNDS" to protect the efficacy of the entire inter-dependent system that assumes no one is cheating -by creating money out of thin air -as we all have seen is entirely possible, and, apparently subject to great and increasing abuse.

    This is the insidious, abhorrent and heinous side of the credit economy and Ben Bernanke's doomed bailout solution to the current state of our societal woe, -in a worldwide sense.

    Ben Bernanke is actually encouraging, or trying to encourage, completely insolvent banks -to continue kiting checks to keep the economy rolling onward through the treacherous and rising waters of this increasing fraud -arising outside the function of what was thought to be a proper extension of credit.

    And -that is what a Princeton education buys today.

    The entire social order has fallen into the reality trap of an obsessive-compulsive and essentially criminal behavior, -most can only just barely comprehend as a problem in the economic scheme -underlying just one facet of all our affairs.

    No. It is the entire scheme of everything being taught to everyone that has been pressed into such an essentially illegitimate, confabulated contortion.

    Virtually every aspect of societal life has ceased to operate smoothly because all the cogs have been pushed too far. They are under far too heavy a load, -for any efficacy to remain in what has been built upon the false assumptions underpinning what has been built up over time.

    Yes, the fed is corrupt. The treasury is corrupt. The FDIC is corrupt. The government is corrupt. But -our educational systems too are corrupt.

    We all see that an all-pervasive ethic of greed and avarice has been corrupting every individual of any social responsibility, from the lawyer and the judge -right on down to the meat-cutter and the mechanic.

    Even the clergy has been exposed for the corruption it too has let fester within its own midst.

    Our entire scientific ethos has failed catastrophically. It is not just economics.

    Science is dead. Humanity has proved itself wildly incapable of resisting the temptation to corrupt all that vagaries of all the basic assumptions of science.

  3. Here is how a bank is created--All you need is someone to loan you $51 million and make agreement to the loaner--he receives 20% interest and once FDIC approves the bank ,the loaner gets agreement/requires a loan (3times) $153 Mils and at a interest he pays Prime rate.
    Capital of $51m,bank loans out $510 million,FDIC approved such a bank transaction in N.C.
    Nice guys these money moochers changers :^/

  4. discuss:
    Stimulus Explained

    Imagine this scenario:

    It is the month of August, on the shores of the Black Sea. It is raining, and the little town looks totally deserted. It is tough times, everybody is in debt, and everybody lives on credit.

    Suddenly, a rich tourist comes to town. He enters the only hotel, lays a 100 Euro note on the reception counter, and goes to inspect the rooms upstairs in order to pick one.

    The hotel proprietor takes the 100 Euro note and runs to pay his debt to the butcher.

    The Butcher takes the 100 Euro note, and runs to pay his debt to the pig grower.

    The pig grower takes the 100 Euro note, and runs to pay his debt to the supplier of his feed and fuel.

    The supplier of feed and fuel takes the 100 Euro note and runs to pay his debt to the town's prostitute that in these hard times, gave her "services" on credit.

    The hooker runs to the hotel, and pays off her debt with the 100 Euro note to the hotel proprietor to pay for the rooms that she rented when she brought her clients there.

    The hotel proprietor then lays the 100 Euro note back on the counter so that the rich tourist will not suspect anything.

    At that moment, the rich tourist comes down after inspecting the rooms, and takes his 100 Euro note, after saying that he did not like any of the rooms, and leaves town.

    No one earned anything. However, the whole town is now without debt, and looks to the future with a lot of optimism ...

    And that, ladies and gentlemen, is how governments are doing business today.

  5. The most complete and concise explanation of money is at bibocurrency.org. This site has a formal engineering stability analysis of the debt money creation process as well as a proposal for an alternative technical spec for a currency accessible to all for all and any transactions while maintaining a constant ratio between wealth, debt and money in circulation. If you want to know exactly what you need to know read:

  6. The example given of how the rich tourist solves the problems of the town by bringing money from abroad is NOT how governments operate today. The difference lies in that the government actually owes the money at interest. To understand the whole thing completely go to bibocurrency.org and read: http://bibocurrency.org/stability%20video%20v%204.2.8.pdf. It is relevant to all entities governments, companies and individulas the model is simple and deadly only if you remain ignorant of the complete cylce. You must study it all not just parts, otherwise you may think you know but you won't. It ain't hard but it must be understood in full rigour nontheless.

  7. Of course banks operate this way. We have a fractional reserve system. This is/should be common knowledge. Daro's link is pretty much the definitive explanation for us commoners.


  8. All theorists are merely the best Texas liars to show up in town -lately- with their long tales.

    The history of every scientific theory amply describes the nature of all scientific theories, -where each theorist in succession, disproves something of the theories of his predecessors, proving all theories are just lies when they are somehow asserted to be ultimately meaningful, or even, reliable.

    Reality is infinitely complex -and entirely inter-related. The compartmentalized view of economics is a fabrication of academics.

    We could computerize the movement of everything financial, and it would still leave the story massively untold.

    If there is nothing categorically true one can say about the study of economic policy, then -there is -nothing- that can really be said with any truth-substance to back it up, -statistics maybe, as statistics -are far more pliable than reality.

    One of my sons told me the other day -about a friend of his that had just graduated from a criminal justice academy, and had gotten a job as a border patrol officer. He would be making over $100k a year.

    What is this world coming to? And why?

  9. Jct: So it works like my blueprint of the banking system from the tap to the drain with pipes at

    I've said for years that new money comes out of the tap and is loans paid are extinguished down the drain as a function of the savings in the reservoir.

  10. this is a superb article - it has opened my eyes quite a bit even after listening to G. Edward Griffin describe money creation and the fed's role in it....i supose it is just now sinking in....

    regarding the comments about systemic corruption in the educational system i have to heartily concur since it is simply a repition of ideas i have expressed.

    but there are specific anecdotes told by folks with inside access to the elite corriders of financial power....these insiders tell of rabid contempt for morals (and we are not talking sex for those who are short of perspicacity) and probity in financial matters....these people absolutely do not care if they sell crap to pension funds; they don't care if the economy grows or shrinks because they will win under all circumstances in part because they know that they will be bailed out....

    american life is irretrievably corrupt because the pathologies of moral life are inculcated from the earliest years...economics is about teaching morality but we do not practice economics....instead we are engaged in a macabre voodoo dance which pretends to be economics but is nothing more than death by a 1000 cuts...

    i close my comments by saying that the only safeguard to economic morality is gold. without honest money there are no honest men. i am entirely aware of all of the sophistry defending money creation ex nihilo or based upon debt but i am as equally unpersuaded and adamantly opposed such corrupting schemes....god help us all.

  11. Thanks for posting this info. Other websites besides Paul Grignon's moneyasdebt.net and Ellen Brown's webofdebt.com with useful info on monetary reform are Stephen Zarlenga's monetary.org , Richard Kotlarz's concordresolution.org/column.htm , Claire Foss's cfoss.com , Fred Lundgren's economy101.net , Randy Cook's normeconomics.org , Jere Hough's wealthmoney.wordpress.com and Mike Montagne's perfecteconomy.com . Time to throw the moneychangers out of the temple once again.

  12. Great post, G!
    I was unaware of the analysis from these two Nobel laureates. This is a big deal to help understand the truth of how credit is created for the profit of banks. With monetary reform, the benefits shift to the public.

  13. Re: Morality in Business.

    I attended one of the "higher end" MBA programs in the country. Not an Ivy but a well known program (top 10). We were required to take a Business Ethics class...I approached it a bit cynically because I don't think you can teach it at the grad school level. Either you have them at that point or you don't.

    That said it was clear the school was checking a box by having a Business Ethics class.

    Looking for a suitable framework for ethics, in my mind something layered on top of the concept of "legal", I was stunned to have the professor basically admit to me offline that ethics from his perspective amounted to "whatever was best for you at a particular point in time".

    Clearly one can immediately see the problems with this approach. Forgetting for a second that ethics are in theory something that should be similar across different individuals (eg. the meaning behind the statement "he/she is an ethical individual"), what this professor advocated what a method of analysis that ignored whether what was good for you NOW might not be good in the FUTURE.

    That's when I realized that a diploma from TOP MBA schools is about getting a license to milk the cow.....

    And if you don't/can't your a fool....at least from their perspective.....

  14. It is not a hidden fact that we have a fractional reserve system where most of the money is created by the private banking system.

    Money creation should be done only by the government but money distribution (loan making) should be done by the private banking system.

    Here is my proposal for addressing the issue:

    Here is my idea:
    1) We essentially need an orderly bankruptcy and liquidation of the United States' financial system.
    2) I suggest we create a government owned bank and transfer all deposits of the private commercial banking system to the new government owned bank. This "transfer" is really just new money creation. This new money will be digital cash (electronic version of physical paper cash). Very much like reserves at the FED.
    3) Note that the plan will not create net new money since we will be destroying all deposits of the commercial banking system in the process.
    4) All assets of the commercial banking system will be transferred to the government and auctioned off in an orderly manner over the next 10 years. The proceeds from the sale would go the United States treasury and not the commercial banks. The assumption here is that commercial banks deserve nothing since the entire industry would have been most likely destroyed any way. Even good banks would have been destroyed due to bank runs and defaults if the government had allowed the dominoes to fall. Of course bank shareholders, bank bond holders and counter parties of bank derivatives would not receive anything.
    5) After the transfer FDIC protection will be removed for any private bank which wishes to remain in business or any new private depository institution or bank. From that point on the government should make it absolutely clear that there will be no more bailouts and no more conversions. This will discourage (but not completely eliminate) fractional reserve deposit banking and private money creation that results from pyramiding of government created money. This will also limit debasement of the currency that results from fractional reserve deposit banking. In fact, we can have "free banking" from that point on and not even have reserve requirements or capital requirements. All depositors who use private banks will be fully at-risk. The industry will have to set the interest rate high enough to attract depositors.
    6) The new government bank will act as an electronic "piggy bank" only. All deposits will be 100% reserve and it will not make any loans. Loan making will be left to the private banking system (with no deposit insurance or a possibility of a future bailout). The new government owned bank exists only as a "safe" money storage and a payment clearing system so the public does not have to carry around physical paper cash to make purchases and pay bills.
    7) Of course this plan is not without pain or cost. Cost of funds for banks and borrowers will probably rise as bank deposits are a source of very low cost money for the banks. Nothing is free. We are just exchanging higher cost of funds for removal of systemic failure risk. Economically we are recognizing that when money is loaned there is always credit risk.
    8) We are just separating the payment and clearing transaction system which is absolutely necessary for day-to-day commerce (no credit risk) from the loan banking and investment system (has credit risk).

    Mansoor H. Khan

  15. Actually this is an elementary principle you get in any Money and Banking course.

  16. Only legal tender notes and coins are money. All else are CONTRACTS.

    When a banker credits an account of a holder who has taken out a loan, the banker does not increase the amount of money in circulation (legal tender notes and coins). No money accretion happens.

    The banker increases the potential for increased transaction rate. In short, the banker increases the turnover of EXISTING MONEY (existing notes and coins).

    Everyone else has it wrong, especially Academic Economists.


    Economists and others don't get money and credit. They confuse credit with money.

    Credit and debt mean the same thing. Neither credit or debt are money.

    Only legal tender notes and coins constitute money.

    Everything else is a product.

    A checking account is a product that arises from contract. A checking account is not money.

    -- Smack MacDougal

  17. Arent you happy that the private offshore federal reserve bankers was given 23 trillion dollars of the USA taxpayers money in the last 10 months to give each other bonuses that translates into your children and grand children being the new slave class of the money lenders?

  18. A very nice explanation of the US banking system and how banks don't really have the money but still loan it to the public is explained in the second Zeitgeist movie. Anyone who is interested in understanding how this system works (or should I say doesn't work) should see that movie. It's clear that banks only promise people that they have the money but physically they loan the public money created out of thin air. That's just one of the negatives of this banking system that desperately needs to be changed.

    Take care, Ella

  19. I'm amazed that people thought it could be any other way, but maybe that's because I come late to t he dance and so have a fresh perspective. The banks lend any amount in the sure knowledge that they can get their buddy banks to lend them the necessary reserves at teeny interest after the event. This all stopped completely for a while in London at least - for UK readers, remember all that fuss in the papers about the LIBOR being huge? London Interbank Lending Rate. The banks stopped lending to each other at the customary small interest rates and started charging so much it made any lending to any party impractical.


  20. God this is so sophomoric. If somebody runs up a gambling debt and then their friend comes up with a scheme to counterfeit money after the fact to pay off that debt you idiots think the money was generated by the bet, and not the printing press?

    Simple experiment. Don't let the government print fiat dollars to bail out the banks and lets see if we get inflation. Wait, the experiment was run before 1915 and there WAS NO LONG TERM INFLATION. Dopes.

  21. And there we have it. Commenters proving again that a little knowledge is a dangerous thing. Yes, many banking and finance courses discuss these issues and yes there are many text books, but who reads them when the internet tells all (snark). And somehow science and academics and economists are all (a) the same thing (b) evil (c) illiterate and uneducated (d) engaged in a conspiracy to hide the truthy truth.

  22. Are the millions of innocent dead Iraqi people being educated by the USA/England facist empire or are they dead?

  23. There are still many misconceptions!

    Money is debt/credit, legal tender (bills and notes) in today's world is created AGAINST debt money. Mints DO NOT such print money on the order the Government. Banks order legal tender against the reserves in credit money. So logically first the bank credit is created a reserve in that bank credit is generated and then only then can any physical cash be issued.

    I would like to also calrify that savings has no effect on the destruction of money but rather on the rate at which debt grows i.e. savings park money out of the reach of those that need to earn to pay off debt.


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