Money Creation in the Modern Economy – the Schism Widens

March 23rd, 2014
in Op Ed

by Dirk Ehnts, Econoblog101

The schism between academia and central banks, banks and policy makers has just been increased by this publication of the Bank of England. It has been written by Michael McLeay, Amar Radia and Ryland Thomas of the Bank’s Monetary Analysis Directorate.

Follow up:

This article explains how the majority of money in the modern economy is created by commercial banks making loans.

There is an accompanying video that summarizes the creation of money in five minutes.

In a nutshell, it confirms the views of Wicksell (1898) and everybody that followed him in describing money as basically connected to credit: loans make deposits. So, Post-Keynesians and Modern Monetary Theory (MMT) get it right when they stress the importance of endogenous money. Those arguing that the monetary supply plays a role in this will not find their view represented in the documentation of the Bank of England. Of course, central banks are not academic institutions and their findings should not be believed without critical examination. The Bank of England is not the first to describe money creation by banks in these terms either. However, some central banks are still reluctant to discard the use of the money supply concept and instead use monetary aggregate. The Federal Reserve Bank writes:

Over some periods, measures of the money supply have exhibited fairly close relationships with important economic variables such as nominal gross domestic product (GDP) and the price level. Based partly on these relationships, some economists–Milton Friedman being the most famous example–have argued that the money supply provides important information about the near-term course for the economy and determines the level of prices and inflation in the long run. Central banks, including the Federal Reserve, have at times used measures of the money supply as an important guide in the conduct of monetary policy.

Anyway, I think the silence of mainstream economists when it comes to crisis resolution has something to do with their realization that the central bank cannot increase the money supply at will and hence they will not be able to stop deflation when it has started. The world is more complex, money and credit are intertwined and so are central bank and treasury, as Eric Tymoigne illustrates using historical episodes in recent US central banking in this new working paper.

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