Yes Mr. Neoclassical Economist, Banks Really do Create Money

There seems to be some confusion in certain circles as to what banks actually create.  Do they just create debt or do they create “money”.  Money is a tricky term, but let’s go back to basics on the design of the US monetary system.

The monetary system in the USA is designed around private competitive banking (see here for a full explanation of our monetary system’s design).  That is, most of the “money” in our system exists in the form of bank deposits.   When a bank makes a new loan this results in a new deposit in the banking system.  All those digits in your bank account are numbers that some bank entered into the system.  And no, they didn’t need to call the central bank first, check their reserve balances or calculate some silly mythical money multiplier before they issued these deposits.  Banks are never reserve constrained.  So they issue loans almost entirely independent of the government (with the obvious exception of some regulations which obviously don’t work to constrain them that well).   The key to understanding the design of the US monetary system is understanding how banks “rule the roost”.  Banks issue most of the money through a competitive market based (demand) process and the institutional design around this system is in place primarily to support the health of this process.  What do I mean by that?

It helps to quickly understand the two primary forms of money in our monetary system – inside money and outside money.  Inside money is money created inside the banking system.  This is bank deposits (loans create deposits).  Outside money is money issued outside the banking system by the government or the Fed.  This includes notes, coins and reserves.  

First off, our entire monetary system caters to banks.  In fact, the entire Federal Reserve system is designed to cater to banks.  The Fed system brings payment settlement into one place.  So, instead of having 1,000 different banks running around issuing their own notes and trying to settle payments among themselves, we have a Fed system which creates an interbank market where payments can all settle.  This is a lot like having one national bank (but not really because the banks remain privately owned for-profit entities).   The interbank market is where the central bank maintains reserve accounts primarily for the purposes of enacting monetary policy (which is designed to influence the price/demand/supply of bank money) and to ensure proper payment settlement.  So the Fed system is really designed around stabilizing the banking system in various ways even though it’s far from perfect.

Further, the primary purpose of notes and coins is to facilitate inside money.  Most of the transactions in a modern monetary system occur in electronic deposit transfers which settle through the interbank market in reserves.  But you can also draw on your electronic account for notes or coins.  This is a convenient, but quickly becoming extinct form of transaction.  But it’s important to understand that notes and coins exist primarily to facilitate the primary form of money – inside money.

Again, you have to get the order of importance here.  Banks “rule the roost” so to say in the monetary system because they issue the primary form of money which greases the economic engine.  Monetary economists have gotten this all wrong for ages with their money multipliers and arcane beliefs that the government controls the money supply through its various mechanisms that are merely designed to facilitate the existence of inside bank money.  The US system is specifically designed around the private competitive market based banking system.  Yes, the government could, in theory, control the money issuance business.  But it essentially outsources it to private banks.

Make no mistake.  This is a banking centric monetary system where the money supply has been almost entirely privatized.  So the question is – do banks issue money?  They don’t only issue money.  They issue the most important form of money because without inside money, there are no transactions, no payments, and no economy to begin with.