The Money View

Banks as creators of money

In conversation recently, I was called upon to defend the claim that banks are in the business of creating and destroying private money. This has been for me a working hypothesis for so long that I was unable to respond effectively or cogently to the argument. My interlocutor followed up in e-mail with a Cowles Foundation paper by Tobin in support of her case. Here is my response to Tobin, hopefully better articulated than I managed on the fly. In this post, I'll stick to the theoretical claim (the practical context was bank capital requirements).

I agree wholeheartedly with Tobin's dismissal of the

mystique of "money"—the tradition of distinguishing sharply between those assets which are and those which are not "money," and accordingly between those institutions which emit "money" and those whose liabilities are not "money,"

but rather than enclosing the difficult word in quotes, I prefer to try to understand it. By all means let us not draw an abritrary line between money and non-money. But Tobin is wrong to conclude that there is nothing special about money at all.

There is indeed something special about money. All of the traditional functions of money come down to the certainty that one will be able to get rid of it, at a reasonably certian price, for a reasonably long distance into the future. That certainty amounts to money's liquidity, and the institutional setup of the payment system—including commercial banks, the central bank, and deposit insurance—all exist to support it. It is costly to do so; liquidity is not a free good.

This moneyness is not something that is inherent in the thing; it is present when institutions and individuals provide and maintain it. Participation in the payment system is an expression of a bank's willingness to trade at par deposit claims on itself with those on other banks. To do this is to guarantee the liquidity of the bank's deposit liabilities—if a depositor wishes to enter or exit a position in some bank's deposits, it can do so, in size, without moving the price from par (i.e., from one). The central bank supports this guarantee by ensuring banks' access to clearing balances for the processing of interbank payments; deposit insurance supports it by protecting banks from runs.

Moneyness should, moreover, be viewed as a property which can be possessed in degrees. No arbitrary line should be drawn, but some things are more like money than others: federal funds are very money-like, T-bills less so, equity shares not so much at all. The degree depends on how deeply the liquidity of each type of claim is supported by the banking system.

Asking whether the fact that their liabilities are monetary means that banks have priveleged access to funds, Tobin finds that

[t]his advantage of checking accounts does not give banks absolute immunity from the competition of savings banks; it is a limited advantage that can be, at least in some part for many depositors, overcome by differences in yield.

Tobin imagines banks raising funds by issuing various kinds of securities—checking deposits, savings deposits, bonds, shares—and competing on yield with other issuers to raise funds. But the differences among those liabilities are not to be found only in yields. They possess moneyness to varying degrees, and when the need is for liquidity, no yield is high enough to entice lenders. Yield and liquidity are not commensurate, especially in a crisis.

Asking whether, in aggregate, an expansion of bank lending necessarily entails an expansion of deposits, he says that

[i]t depends on whether somewhere in the chain of transactions initiated by the borrower's outlays are found depositors who wish to hold new deposits equal in amount to the new loan.

That is, Tobin says, the deposit that a bank creates for its borrower is soon spent, and so this deposit cannot be said to fund the loan for that bank. Moreover, it can neither be said to fund the loan for the banking system as a whole, because deposits will be held only if someone wishes to hold them.

On this point Tobin is simply wrong. He neglects to consider who has the initiative in deposit creation and destruction. A bank's role in the payment system, and the very reason that its deposit liabilities serve as money, is that they guarantee conversion of bank deposits at par, conversion into cash or conversion into deposits elsewhere in the system, at the initiative of the depositor.

A borrower can exit a position in bank deposits in two ways—by selling them to a non-bank, for example by buying real goods, or by selling them to a bank, for example by buying bank bonds. The former does not destroy aggregate bank deposits, it just moves them from one bank's balance sheet to another's. The latter does destroy aggregate bank deposits, but only if some bank is willing to sell bonds. Thus deposit destruction can happen only at a bank's initiative.

All this is to say that what is important about the fact that banks issue monetary liabilities is that those liabilities are liquid—that you can be sure that you can get rid of them at par—and that that liquidity is provided and guaranteed by the banks, supported (for commercial banks, anyway) by the Fed's guarantee of the payment system. Banks guarantee the liquidity of their deposit liabilities, not that of their other liabilities, so someone who wishes to hold them faces a market price, not guaranteed by anyone.



A private bank cannot destroy demand deposits.

This is because private banks create 'look-alikes' of central bank money and THEN spend them (creating demand deposits) or lend them (creation, sale and repurchase of demand deposits)

Only the Central Bank can create and destroy fiat currency, which it does as the fiscal agent of the Treasury.

The Central Bank does not have - as is the prevalent myth - a banking counter-party (ie debtor/creditor)relationship with the Treasury in respect of demand deposits: the proof is that US Treasury Notes and Federal Reserve Notes are fungible and spend exactly the same.


Why be so mean-spirited? Tobin was a great economist. You insult him by insinuating he does nothing more than "enclose the difficult word in quotes."


Chris, a private bank can certainly destroy bank deposits, as when a depositor draws down their deposit to pay off a loan they have taken out from the same bank.

When you hold a deposit, that is an obligation of your bank, not an obligation of the central bank. Yet you can certainly spend it as money.


Nowhere did I say Tobin was not a great economist. Even great economists are wrong sometimes, and Tobin certainly is in this piece, as I argued in the post.

Tobin repeatedly encloses the word money in quotes, as though it is something that is not real or worthy of consideration. And indeed he does not seem to have considered a great deal of monetary theory that disagrees with him. I think money is real, and that it is worthy of consideration, and that is what I have tried to do here. I do not think it is mean-spirited to call someone out for making an error.

And do read the Tobin piece, especially the first section (link is in the post). I think you will agree that Tobin himself is quite dismissive.


Aren't bank deposits destroyed at the discretion of the depositor when they 'purchase' currency by withdrawing cash?

Or do they become CB deposits when the bank purchases cash from the Fed?


I think an interesting way to confirm the 'moneyness' of all this created credit/money - is to have a look at the securities or paper the central bank is willing to take as security for providing liquidity (effectively freshly printed legal tender) to a bank.

The Bank of England has a list of eight things (on page 8 here: but of coruse extended that in the credit crunch. So at some level there is a very real way of seeing what can be directly made into 'money' but then you have the whole issue of what people are willing to take as money...


Very good post. I have been trying to argue this on blog posts, for some time. The key insight of people like Yeager and Laidler is that the medium of exchange is different. A willingness to *accept* the medium of exchange does not necessarily imply a willingness to *hold* a bigger stock of the medium of exchange. We plan to pass it on to someone else.

My own attempt:

"The latter [buying bank bonds] does destroy aggregate bank deposits, but only if some bank is willing to sell bonds. Thus deposit destruction can happen only at a bank's initiative."

I think it would be good if you expanded on that point a little. What other examples are there (other than buying bank bonds)? Can all of them only happen at the bank's initiative? What if I have the right to repay a bank loan any time I like?


@thehumaneconomist: that's a good point, which I was not careful about in my post, so thank you.

Yes, part of the guarantee that banks provide is convertibility into cash, which is to say obligations of the Federal Reserve.

It doesn't weaken the point I was making though. Less fundamentally, cash transactions are small enough that in practice, convertibility into cash is neither supplied nor demanded in significant size--you use deposits for any big transaction. More fundamentally, Tobin's point was about people holding less money-like securities, such as bonds, where I would say that cash is more money-like.

But again, thank you for noting my error.


Nick, thanks for reading and glad to hear you appreciated the effort.

I read your post now for the first time, and I think we're basically in agreement on the mechanics, and on where the initiative lies. I tend not to frame the discussion in terms of the money stock, which you do in that post, precisely because of the point where I do agree with Tobin, namely that the line between money and not-money is either very fuzzy or moves around all the time.

To your request for examples, what is fundamental is that the bank will accept deposits (one kind of liability that it issues) in exchange for a different kind of liability, or in exchange for some asset that it is holding. In the first case, which is the one I used in the post, the bank sells its customer one of its own bonds and deducts the deposits as payment. This changes the bank's liability structure, and its customers' asset structure, but not the size of either party's balance sheet.

In the second case, the bank could sell something else (anything other than its own liabilities) to its client. In this case the composition of the client's balance sheet changes, and the size of the bank's balance sheet changes (it shrinks on both sides).

Now I'm being slightly loose with the term "bank" here, as we might be thinking of the securities-dealer arm of a bank. What's critical is that the bank guarantees the liquidity of its deposit liabilities. If it's also a dealer, it may support the liquidity of other things, too, but that support is not the same as the guarantees that support the payment system.

Again, thanks for comment and for helping me clarify my argument.


Daniel: thanks.

The mark of a good economist is that, even when he's wrong, he forces you to think deeply about why he is wrong. Tobin is doing that here.


@Ben: absolutely right. By guaranteeing that a set of assets can be used to obtain cash, the central bank is effectively supporting those assets' liquidity. Knowing that the assets can be discounted with the central bank, dealers elsewhere in the system are happier to accept them from their clients.

In this post I have focused on what it means to be money-like, but your comment suggests another angle, which is to consider the range of moneyness of different types of claim.


Great post! And interesting discussion thread. I would like to ask:

When the borrower pays back the loan to the bank, is that then destruction of deposit or money?

Assuming the borrower having earned the cash to pay back the loan, and collected it as deposits, the repayment transaction is then just a transfer between banks balance sheets. While reducing the balance sheet of the borrower, and keeping the total balance sheet of the banking system unchanged, will this deleveraging then "by rules of accounting and arithmetics" result in the increase on the balance sheet of the central bank (where the commercial bank transfers its assets from the paid back loan), theoretically, or am I misunderstanding?


Nice post!

I however disagree with

"That is, Tobin says, the deposit that a bank creates for its borrower is soon spent, and so this deposit cannot be said to fund the loan for that bank. Moreover, it can neither be said to fund the loan for the banking system as a whole, because deposits will be held only if someone wishes to hold them.

On this point Tobin is simply wrong."

Tobin just made a statement about deposits - he doesn't say "deposits don't fund"

Also, I do not know what you exactly mean by "deposit destruction can happen only at a bank's initiative"

Btw, such issues (using Tobin's approach) has been studied very carefully by Marc Lavoie:

“Circuit and coherent stock-flow accounting”


It appears from the flow of funds account (FOFA) data that Fed actively services the currency drain using open market operations to offset the impact on reserve balances and transaction accounts. This is confirmed by FOFA data in the Monetary Authority levels table L.109 where prior to the crisis Fed holdings of Treasury securities are roughly equal to Fed liabilities for currency in circulation, the debit and credit mechanics for a purchase of Treasury securities reverse the impact of the currency drain on the aggregate balance sheet of banks.


I do like money "look alikes"! As a mathematician and system analyst, I find it extraordinary that economists tend to omit what "money" is. For Credit relies on "interest" and nobody seems to think about where the interest is coming from, when Credit is created.

The distinction between interest-free Cash and interest-bearing Credit is fundamental to the 'money supply'. But I have long feared that economics is the pseudo-science set up to camouflage what central banks and other financial institutions are really doing: turning a 'medium of exchange' into a 'tool for control'.

With sighs!


This whole discussion is about whether commercial banks can "create" money or not, right? Or, in other words, whether "fractional reserve banking" is the bad guy of "all the current mess" in finance, correct?
INET heavy weights like Adair Turner or Dirk Bezemer still uphold the opinion (which exists for many many years...) that commercial banks can create money.
New economic thinking has not started until people shut up spreading such non-sense.
You better consult Helmut Creutz who explained about that money creation hoax and why it is wrong (you can find that explanation on the web for free). His research is facts based, not theory imaginated somewhere in the clouds of academia.
Only central banks can create money. Anything else is rubbish, no matter who tells it.


The Socialist Myth of the Greedy Banker & the Gold Standard

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