Banks, Money Creation, and What the Crypto Community Refuses to Learn from Them

TL;DR: Contrary to the prevailing “fractional reserve” narrative of money creation in the crypto community, Central Banks today admit to money creation in the economy by individual banks as being more nefarious than previously propagated in mainstream economic and financial disquisition. Money is in fact empirically created ex nihilo, where loans create deposits (and bank lending is not reserve constrained). Owing to its superior monetary attributes as a store-of-value (SoV), the implication of this empirical finding further justifies Bitcoin’s role as the best alternative for the average citizen, in the 21st century, to hedge against the frequent financial and economic crises we experience worldwide triggered by our debt/credit-based economic system.

"The study of money, above all other fields … is one in which complexity is used to disguise truth or to evade truth, not to reveal it … The process by which banks create money is so simple that the mind is repelled."

― John Kenneth Galbraith

("Money: Whence It Came, Where It Went," c1975)

Acursory look at the crypto community’s understanding of how money is created by banks reveals an unfortunate yet undifferentiated narrative about the “fractional reserve theory” of money creation, chanted ad nauseam with little to no objection on how empirically flawed this monolithic assertion is.

Amidst the cacophony of rival interpretations of economic theory exchanged between extreme Keynesian no-coiners and Libertarian bitcoin maximalists lies an overlooked, vile, and empirical truth about the way money is created in our society today by individual banks.

Given the Austrian school of economics’ role in forming the foundational economic principles that led to the creation of Bitcoin, the obvious distaste for the Keynesian schools of thought and its accompanying variations (e.g. post-Keynesians, new Keynesians, neo Keynesians, etc.) in the cryptosphere cannot be overstated.

It’s however shortsighted of us as a community to ignore various useful empirical insights from those we tend to label “fiat and inflation apologists” provided it helps us in exposing the conceptual flaws on which the fragile edifice of our global financial system is built on.

Militant armchair psychology, philosophizing, and highly abstract theorization without empiricism forms the crux of what is mainly wrong with the field of economics today.

The mission the crypto community has embarked on to build a parallel open, secure, decentralized, and permissionless global financial system requires us to fully grasp the legacy system it is trying to replace, and as such, empirical economic realities devoid of frivolous underlying economic assumptions trumps any irrational ideological aversion for other schools of thought, within economics or any other field, and should remain the guiding principle towards deciphering the complex economic realities we live in.

Understanding the limitations of the varying schools of thought is the beginning of wisdom for anyone trying to understand economics and even more so, for those trying to build a more efficient financial system in the 21st century.

We proceed.

Competing Theories of Money Creation

We shall explore, albeit briefly, the 3 competing banking theories over the last century, along with the implication of the empirical findings for the average citizen looking for the best asset class to store value going forward:

• - Financial Intermediation Theory
• - Fractional Reserve Theory
• - Credit Creation Theory

Banks as Financial Intermediaries Theory

"The activity of the 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; … Banking is negotiation between granters of credit and grantees of credit. Only those who lend the money of others are bankers; those who merely lend their own capital are capitalists, but not bankers"

- Ludwig Von Mises (The Theory of Money and Credit, pg. 262)

The financial intermediation theory is a core tenet of mainstream neoclassical economics and posits that banks are mere financial intermediaries that collect deposits from “patient savers,” where the bank effectively borrows money from these savers at low-interest rates with short maturities.

The banks then lend out these deposits to “impatient borrowers” at a higher interest rate with longer maturities.

Banks are thus considered identical to other financial intermediaries such as credit unions, building societies, pension and mutual funds, etc. in their operations and are incapable of creating money on their own or collectively as the banking sector.

This eventually leads to the erroneous exclusion of banks from neoclassical macroeconomic models, as they are considered to have no effect whatsoever on the wider financial system.

Fractional Reserve Theory of Banking

The crypto community is replete with endless narratives of how banks lend out more money than they have in reserves as a result of the crooked history and nature of the banking system which has, over time, managed to perpetuate this fraud with zero accountability (or something to that effect).

The name “fractional reserve” is derived from a system where an individual bank gathers customer deposits in cash (gold was used in the past), and then turns around and lends out a portion of the cash it has in customer deposits and keeps a fraction of it left as a reserve.

This theory restates that banks individually act as financial intermediaries (as explained above) but asserts that as a whole, the entire banking system can collectively create money via “multiple deposit expansion” to the maximum reciprocal of the “required-reserve ratio.”

A simple example is as follows: We assume a monetary base of $100,000 in the economy and a 10% required-reserve ratio, which means the banks have to hold reserves equal to 10% of their customer deposits. Reserves are usually in the form of money the bank has in their reserve account with the central bank.

1. Hal deposits $100,000 into Bank A where total bank deposits in the economy now equal $100,000. Given the required-reserve ratio of 10%, Bank A holds $10,000 in reserves (10% of $100,000) and then goes on to loan Nick $90,000.

2. Nick then transacts with Adam who proceeds to deposit the $90,000 into Bank B. Total bank deposits in the economy have now increased to $190,000 from the initial $100,000 Hal deposited into Bank A.

3. Bank B also keeps 10% of the $90,000 Adam deposited as reserves and lends out the remaining $81,000 to Gavin who enters into a transaction with Satoshi.

4. Satoshi then deposits the $81,000 into Bank C and total bank deposits in the economy eventually add up to $271,000.

This money multiplier process continues until we reach the full reciprocal of the reserve ratio of 10% amounting to total commercial deposits of $1,000,000 in the economy from an initial deposit of $100,000.

It is worth noting that as the total deposits grew by $900,000 in the economy, so did the total debt (i.e. outstanding loans). The more debt in the system the bigger the economy and paying off the debt would have the opposite effect.

The Credit Creation Theory of Banking

"Thus causation in money creation runs in the opposite direction to that of the money multiplier model: the credit money dog wags the fiat money tail. Both the actual level of money in the system, and the component of it that is created by the government, are controlled by the commercial system itself, and not by the Federal Reserve."

- Steve Keen (2009)

The credit creation theory of banking however empirically refutes the previously stated theories and argues that whenever a bank extends a new loan — by virtue of its accounting operations — it simultaneously creates a deposit (new money) for the borrower with the same amount.

E.g. If Charlie borrows $1,000 from Bank A, the bank creates a new loan on its books and simultaneously creates a new deposit in Charlie’s name (and credits it with the borrowed amount of $1,000).

In the double-entry bookkeeping process of creating credit, the asset side of the balance sheet increases by the loan amount of $1,000 and on the liabilities side of the balance sheet the bank simultaneously creates a matching deposit in Charlie’s name of $1,000 without an equal corresponding reduction in the balance of anyone else’s account in the bank (as would have been the case in the financial intermediation theory).

This increases Bank A’s balance sheet whereby new money was created and hence loans create deposits, not vice versa.

It further states that each bank can extend new loans (credit) without the need to accumulate prior deposits, cash, central bank reserves or funds from other banks before it extends a new loan, and issues of capital and reserve requirements are complied with afterwards and don’t necessarily form a precondition for the process of extending a loan.

It concludes that loans create deposits where new loans create new money, and as people spend new money into the economy, new demand is also created and without strict regulation of this vast superstructure of credit, the economy usually ends up being wholly dependent on this credit-based demand.

Unlike the financial intermediation theory, where the existing stock of money in an economy cannot grow and can only be reallocated, the credit creation theory contends that over time, as the process of bank lending creates new bank loans (credit) and new deposit money on each bank’s balance sheet, the periods of growth in monetary aggregates in the economy usually tends to correlate with outstanding bank loans (credit) in the economy.

The credit creation theory has existed for over a century and was further argued in the 20th century by the likes of Basil Moore in 1979 and fiercely publicized by the likes of Steve Keen in the past few decades.

However, It wasn’t until 2014 that Richard Werner conducted the first empirical test in the history of banking on all 3 theories to ascertain whether, in the loan process, banks merely deducted funds from existing deposits, external sources, or whether these funds were originated from newly created deposits.

His study (found here and here) concluded for the first time, empirically, that banks individually (via the process of extending new loans) create new money ex nihilo. Thus the debate regarding money creation in the modern economy and its operational realities have finally been laid to rest and corroborated by the Central Banks themselves:

“Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.”

“… the majority of money in the modern economy is created by commercial banks making loans. Money creation in practice differs from some popular misconceptions — banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.”

- Bank of England (2014)

"Sight deposits are an example of book money: sight deposits are created when a bank settles transactions with a customer, i.e. it grants a credit, say, or purchases an asset and credits the corresponding amount to the customer's bank account in return. This means that banks can create book money just by making an accounting entry: according to the Bundesbank's economists, 'this refutes a popular misconception that banks act simply as intermediaries at the time of lending - i.e. that banks can only grant credit using funds placed with them previously as deposits by other customers'. By the same token, excess central bank reserves are not a necessary precondition for a bank to grant credit (and thus create money)."

- Bundesbank (2017)

"When you borrow from a bank, the bank credits your bank account. The deposit - the money - is created by the bank the moment it issues the loan. The bank does not transfer the money from someone else's bank account or from a vault full of money. The money lent to you by the bank has been created by the bank itself - out of nothing: fiat - let it become."

- Norges Bank (2017)

We should note however that the phrase ex nihilo, which translates to “out of nothing,” should not be misconstrued. While the process of individual bank lending is not reserve constrained, banks can’t just go about creating money indefinitely without any limit or constraint whatsoever, they still need capital and creditworthy debtors to lend to. They also need to comply with policies and procedures laid out by their respective Central Banks and are also affected by banking regulations.

Implication and Impact

The broader implication of the findings above is demonstrated in deregulated and irresponsible bank lending regimes during times of relative economic stability characterized by:

• - Favourable macroeconomic environment (strong economic growth, stable inflation, unemployment and interest rates)
• - Lax lending regulation and oversight
• - Increased leverage and borrowing in the economy

The above contributes to increased risk-taking through leveraged debt financing from banks for speculative investments by hedge funds, investors, and other traders, which then fuels asset and debt bubbles in a booming economy.

Prices eventually begin to stop rising and over-indebted borrowers eventually realize they can’t meet up with their debt repayments and begin to panic by selling off their assets, triggering a sudden collapse in asset prices and eventual economic downturn popularly known as a “Minsky moment”.

The aforementioned coupled with unchecked subprime lending is touted as one of the many causes of the global financial crisis of 2007- 2008, which culminated into a full-blown global economic downturn widely termed as the Great Recession, with all its attendant spillover effects on developing countries worldwide:

• - The poorest 390 million people of Africa saw their per capita income drop by 20% as a result of the Great Recession.
• - The World Bank estimated that the crisis added approximately 89 million people to the number of people living on less than $1.25 a day.
• - The International Labour Organisation (ILO) estimated the number of unemployed in developing countries as a result of the crisis to be near 50 million at the end of 2009.
• - In the course of the first half of 2009, export income decreased by 43.8% amongst the 49 poorest developing countries.

As the wealthy continue to profit off artificially inflated financial assets and sometimes even global crises, and given the debt-based economic system we live in, the foregoing begs the fundamental question: how can the average person protect themselves against our inflationary fiat system, that erodes the value of our money amidst our never-ending cycles of:

• Financial crises:
• - Balance of Payments (BoP) crisis
• - Sovereign debt crisis
• - Banking /Credit crisis
• - Corporate debt crisis
• - Household debt crisis
• - Exchange rate/currency crisis
• - Fiscal crises
• Hyperinflation (and the silent debasing/dilution of the currency)
• Stagflation (supply shocks)
• Debt-deflation

Adjusting to the economic vicissitudes of our changing times necessitates the urgent need for a non-sovereign, inflation-proof and uncorrelated digital savings technology devoid of any ties to our farcical credit system and the clutches of Government manipulation, control and outright theft. 

Luckily, in response to the Great Recession in 2008, this revolutionary monetary network was proposed to humanity…

Bitcoin as a Store of Value

“Just as the technology of printing altered and reduced the power of medieval guilds and the social power structure, so too will cryptologic methods fundamentally alter the nature of corporations and government interference in economic transactions.”

- Timothy C May (Crypto Anarchist Manifesto)

“I think that Bitcoin is a novel institutional technology — high-assurance wealth storage and transfer without reliance on the State or a financial system — which will unlock new modes of human organization and will enable productive commerce in places where property rights are poorly enforced.”

- Nic Carter

A full exposition of the Bitcoin network is beyond the scope of this article, A full exposition of the Bitcoin network is beyond the scope of this article, but suffice it to say that Bitcoin largely represents an inflation-proof, censorship-resistant, and largely unseizable asset with no intermediation needed by Governments or banks.

This makes it a compelling alternative to conventional financial instruments used for storing intergenerational wealth and hedging against inflation, economic crises, and risks of government seizure.

Unlike other currencies and commodities, Bitcoin’s supply schedule is permanently capped at 21 million bitcoins. This important property is a major value proposition of bitcoin over time — based on our inherent notion of ascribing value to scarcity — coupled with the amount of computing power invested to secure the network by miners, and its appreciating price makes bitcoin even more valuable than Gold — by having a predefined (absolute) finite supply.

An overview of Bitcoin’s superior monetary attributes are further highlighted below vis-a-vis traditional SoVs:

In addition, Bitcoin has surpassed all conventional asset classes in the last decade of its existence, returning a whopping 9,000,000%+ since July 2010. As the Bitcoin network matures and its price stabilizes over time, the average citizen can rest assured that her savings will not be exposed to the violent shocks of our credit induced boom and bust cycles.

It is therefore paramount that one seeks out an asset capable of long term wealth preservation, one that is censorship resistant (devoid of Government interference) and is globally transmittable with no intermediaries.

The road to financial liberation in the 21st century may be paved with volatile bitcoin prices, but bitcoin adoption largely remains a natural and logical progression in our monetary evolution.

In light of the above, we conclude with my favourite closing from last year by Nic Carter:

You may deride Bitcoin, no matter. Bitcoin will be there for you when you need it. You may not need it now; you may not need it ever. But as we plunge into a more despotic, authoritarian, and chaotic world, you may one day feel comfort knowing that the world’s highest assurance wealth protection system in history is waiting patiently for you.

Until then, it will keep ticking along.

Special thanks to Abubakar N K for the feedback and review.