Love the blog. A few things I'm curious about. Credit Creation theory makes sense at a single point of time - the origination of the loan. The bank creates the loan with the spread it needs to make a profit and then immediately marks up the account with the corresponding deposit.
Almost all deposits from loans never sit on the banks balance sheet as the loanee is sending that money to a recipient at another bank. Therefore banks must have a reserve position in order to accommodate outflows. While they may net settle at the end of the day or a longer time period, they cannot afford to be short on reserves when the time comes. Therefore, wouldn't it be reasonable to say that banks don't really create money out of thin out since most take in deposits so that they have requisite reserves to fund their outflows during the loan making process?
Thanks Jason! As I understand your point, you are asking whether banks face a settlement constraint in terms of credit creation and not merely just a profit constraint. It's an excellent question.
A caveat that the full answer depends on the specific banking system we're talking about. But at least in the US, the answer is no - banks do not face a settlement constraint in creating money (aka making loans).
The very brief reason why is that if a bank ever faced a reserve shortfall in terms of settling outflows, then they can always borrow the necessary reserves via the federal funds market by paying interest at the federal funds rate. Thus, what appears to be a settlement constraint is actually just another profit constraint.
I began typing out a full, more detailed answer but I realized I'll need an article to explore the nuances, so please keep an eye out for that issue in the coming weeks. There's a lot of detail to treat including scarce reserves vs. ample reserves regime, reserve requirements, and the Fed's ability to keep the FF rate in target via reserve creation. Thanks again.
I think you're correct that at the point of loan origination a settlement constraint doesn't exist. However, at some point they do need to have those corresponding reserves to settle payments with other financial institutions. Again, almost all loan created deposits will sit on a balance sheet outside of the original bank balance sheet that originated it.
Also, while banks aren't reserved constraints to make loans they are capital restrained as per Tier 1 requirements. As a regular HS teacher who is interested interested in this, I've had to do a lot of digging and still do because the credit creation theory is sometimes written with a lot of over simplification that leads the layperson to say "why don't banks just created unlimited money" and I can see why.
I look forward to future writings! Also curious if you've developed an MMT or MMT adjacent lens as I've found much of their writing to be very helpful in understanding these topics.
I definitely have run into the same things with reading up on credit creation theory. That has been one of my motivations for writing these pieces as I think there are still a lot of gaps in the research on this topic (and certainly gaps in my own knowledge).
For what it's worth, I've been asked that question a lot and I've always answered it the same way: "Because banks don't have infinite opportunities to lend to qualified borrowers at profitable spreads."
MMT is very compelling to me and it's precisely because, just as in credit creation theory, money is viewed as endogenous rather than exogenous - which does appear to reflect how money actually works in the real world. There's a lot I could and will critique MMT on, but I still think the MMT lens offers a more useful framework for understanding real-world economics than any other approach I've found.
Brian,
Love the blog. A few things I'm curious about. Credit Creation theory makes sense at a single point of time - the origination of the loan. The bank creates the loan with the spread it needs to make a profit and then immediately marks up the account with the corresponding deposit.
Almost all deposits from loans never sit on the banks balance sheet as the loanee is sending that money to a recipient at another bank. Therefore banks must have a reserve position in order to accommodate outflows. While they may net settle at the end of the day or a longer time period, they cannot afford to be short on reserves when the time comes. Therefore, wouldn't it be reasonable to say that banks don't really create money out of thin out since most take in deposits so that they have requisite reserves to fund their outflows during the loan making process?
Thanks Jason! As I understand your point, you are asking whether banks face a settlement constraint in terms of credit creation and not merely just a profit constraint. It's an excellent question.
A caveat that the full answer depends on the specific banking system we're talking about. But at least in the US, the answer is no - banks do not face a settlement constraint in creating money (aka making loans).
The very brief reason why is that if a bank ever faced a reserve shortfall in terms of settling outflows, then they can always borrow the necessary reserves via the federal funds market by paying interest at the federal funds rate. Thus, what appears to be a settlement constraint is actually just another profit constraint.
I began typing out a full, more detailed answer but I realized I'll need an article to explore the nuances, so please keep an eye out for that issue in the coming weeks. There's a lot of detail to treat including scarce reserves vs. ample reserves regime, reserve requirements, and the Fed's ability to keep the FF rate in target via reserve creation. Thanks again.
Thanks Brian,
I think you're correct that at the point of loan origination a settlement constraint doesn't exist. However, at some point they do need to have those corresponding reserves to settle payments with other financial institutions. Again, almost all loan created deposits will sit on a balance sheet outside of the original bank balance sheet that originated it.
Also, while banks aren't reserved constraints to make loans they are capital restrained as per Tier 1 requirements. As a regular HS teacher who is interested interested in this, I've had to do a lot of digging and still do because the credit creation theory is sometimes written with a lot of over simplification that leads the layperson to say "why don't banks just created unlimited money" and I can see why.
I look forward to future writings! Also curious if you've developed an MMT or MMT adjacent lens as I've found much of their writing to be very helpful in understanding these topics.
I definitely have run into the same things with reading up on credit creation theory. That has been one of my motivations for writing these pieces as I think there are still a lot of gaps in the research on this topic (and certainly gaps in my own knowledge).
For what it's worth, I've been asked that question a lot and I've always answered it the same way: "Because banks don't have infinite opportunities to lend to qualified borrowers at profitable spreads."
MMT is very compelling to me and it's precisely because, just as in credit creation theory, money is viewed as endogenous rather than exogenous - which does appear to reflect how money actually works in the real world. There's a lot I could and will critique MMT on, but I still think the MMT lens offers a more useful framework for understanding real-world economics than any other approach I've found.