Where Credit Comes From (Not Your Mattress)

Tuesday, September 22, 2009 , , , , 0 Comments


If Credit is Not Created Out of Excess Reserves, What Does That Mean? (Washington's Blog):

We've all been taught that banks first build up deposits, and then extend credit and loan out their excess reserves.

But critics of the current banking system claim that this is not true, and that the order is actually reversed.

Sounds crazy, right?


But as PhD economist Steve Keen pointed out last week, 2 Nobel-prize winning economists have shown that the assumption that reserves are created from excess deposits is not true:
The model of money creation that Obama’s economic advisers have sold him was shown to be empirically false over three decades ago.

The first economist to establish this was the American Post Keynesian economist Basil Moore, but similar results were found by two of the staunchest neoclassical economists, Nobel Prize winners Kydland and Prescott in a 1990 paper Real Facts and a Monetary Myth.

Looking at the timing of economic variables, they found that credit money was created about 4 periods before government money. However, the “money multiplier” model argues that government money is created first to bolster bank reserves, and then credit money is created afterwards by the process of banks lending out their increased reserves.

Kydland and Prescott observed at the end of their paper that:

Introducing money and credit into growth theory in a way that accounts for the cyclical behavior of monetary as well as real aggregates is an important open problem in economics.

In other words, if the conventional view that excess reserves (stemming either from customer deposits or government infusions of money) lead to increased lending were correct, then Kydland and Prescott would have found that credit is extended by the banks (i.e. loaned out to customers) after the banks received infusions of money from the government. Instead, they found that the extension of credit preceded the receipt of government monies.

See also yesterday's The Fed as Banking's Mattress.


Jr Deputy Accountant

Some say he’s half man half fish, others say he’s more of a seventy/thirty split. Either way he’s a fishy bastard.