Endogenous Money Theory

Most people’s lives are, in some way controlled or influenced by a bank. But do you know the processes behind the issuing of loans that occurs every day?

The accepted thought surrounding the operation of banks stems from Neo-classical economic ideas. The advocates of the standard theory argue the existence of a money multiplier and that deposits create loans in the banking sector. The money multiplier idea is best described using an example. Say a person deposits $100 into a bank, the bank then saves 10% of this as a reserve and lends out the rest (90%) to the public. The $90 is then deposited once again by whoever receives the initial loan, where again, the bank keeps 10% as reserves. This cycle continues until the original $100 has become $1000 or larger and is referred to as the money multiplier effect. This basically means that banks hold much less in reserves compared with what they loan out to customers.

While this idea can be argued to operate in theory, in a real-world bank operating in a fiat currency based economy, banks are not constrained by the amount of reserves they currently hold. This is because fiat currency is not backed by a particular commodity and can be created artificially by the central bank. Banks issue loans based on customer demand and credit worthiness, rather than their supply or bank reserves (what they have in their vault). If the situation arises where banks loan out more than their current reserve requirement, they borrow the difference from other commercial banks at the end of the day. This is a hugely common occurrence and banks lend to each other on a short-term basis, and at a lower rate of interest than what the market interest rate customers pay is. Commercial banks can also borrow from the central bank as a last resort at a higher interest rate than what is offered between the commercial banks.

This theory is argued by Post-Keynesian economists and Modern Monetary Theorists, such as Robert Nielson and key members of the world banking sector have validated the theory. Victor Constancio, the Vice President of the European Central Bank stated that “In reality, the sequence works more in the opposite direction with banks taking first their credit decisions and then looking for the necessary funding and reserves of central bank money.”

In terms of understanding how banks operate, the endogenous theory of money best describes the everyday actions and requirements commercial banks in fiat-based economies undertake. The unconstrained nature of fiat currency gives light to the theory that loans create deposits, through banks issuing loans based on credit worthiness, not their reserve requirements. The interbank lending market, that allows banks to lend out more than they currently hold in reserves, also facilitates this process, as does the central bank, acting as the lender of last resort.

What happens if this process is not heavily regulated you may be thinking? The over-confidence in the banking sector, in the form of granting loans to customers with high default risk, was one of the major causes of the Global Financial Crisis in 2008.

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