How Banks Create Money When They Lend

The prevailing theory of banking for the past century holds that banks function as intermediaries, collecting deposits from depositors and lending them out for interest. This view is maintained, with minor differences, by all neo-classical schools of economic thought regardless of ideological bent. Austrians, Monetarists, and New Keynesian economists alike operate under the assumption that commercial banks merely lend out money which they have first obtained from depositors or the central bank. Paul Krugman, Nobel-prize winning New Keynesian economist writes:

“As I (and I think many other economists) see it, banks are a clever but somewhat dangerous form of financial intermediary… For in the end, banks don’t change the basic notion of interest rates as determined by liquidity preference and loanable funds… Banks don’t create demand out of thin air any more than anyone does by choosing to spend more; and banks are just one channel linking lenders to borrowers.” (March 27, 2012, Banking Mysticism, New York Times)

Many core neo-classical models, such as the “Loanable Funds Theory”, which posits that banks extend credit based on a limited supply of loanable funds and therefore private investment may be “crowded out” by government deficits, depend on the intermediary theory of banking. This view is so pervasive that the reader likely has difficulty imagining how banking could operate any other way. If banks do not obtain money first, how can they lend it out?

A closer analysis of banking operations reveals the intermediary theory of banking to be false. Rather than lending out existing deposits, commercial banks create new deposits when they extend credit. This view, known as the credit creation theory of banking, has long been held by so-called heterodox economic disciplines such as Modern Monetary Theory (MMT) and many post-Keynesian economists. Despite fierce opposition from economists like Krugman, this credit creation model is rapidly displacing the intermediary theory as overwhelming evidence mounts in favor of the formerly heterodox position. In recent years, a steady flow of academic papers and reviews by central banks, including this paper from the Bank of England, have contributed to the paradigm shift in economics. Even many mainstream resources outside of academia, such as Investopedia, have now…