The Truth about Banks

• Author: Michael Kumhof and Zoltán Jakab

The Truth about Banks Finance & Development, March 2016, Vol. 53, No. 1

Michael Kumhof and Zoltán Jakab

Banks create new money when they lend, which can trigger and amplify financial cycles

Problems in the banking sector played a critical role in triggering and prolonging the two greatest economic crises of the past 100 years: the Great Depression of 1929 and the Great Recession of 2008. In each case, insufficient regulation of the banking system was held to have contributed to the crisis. Economists therefore faced the challenge of providing policy prescriptions that could prevent a repeat of these traumatic experiences.

The response of macroeconomists—those who study the workings of national economies—in the 1930s was strikingly different from attitudes today. Then, there were two leading contenders for radical banking reform in the United States: the proposals that would eventually become the Glass-Steagall Act—which separated commercial and investment banks, created the deposit insurance program, and allowed greater branching by national banks—and proposals for 100 percent reserve banking, under which each dollar deposited by a bank customer must be backed by a dollar of cash in bank vaults or of bank reserves in the central bank.

Most leading U.S. macroeconomists at the time supported 100 percent reserve banking. This includes Irving Fisher of Yale and the founders of the so-called Chicago School of Economics. One of the main reasons they supported 100 percent reserve banking was that macroeconomists had, just before the Great Depression, come around to accepting some fundamental truths about the nature of banking that had previously eluded the profession, specifically the fact that banks fund new loans by creating new deposit money (Schumpeter, 1954). In other words, whenever a new loan is made to a customer, the loan is disbursed by creating a new deposit of the same amount as the loan, and in the name of the same customer. This was a critical vulnerability of financial systems, it was thought, for two reasons.

First, if banks are free to create new money when they make loans, this can—if banks misjudge the ability of their borrowers to repay—magnify the ability of banks to create financial boom-bust cycles. And second, it permanently ties the creation of money to debt creation, which can become problematic because excessive debt levels can trigger financial crises, a fact that has since been corroborated using modern statistical techniques (Schularick and Taylor, 2012).

The proposals for 100 percent reserve banking were therefore aimed at taking away the ability of banks to fund loans through money creation, while allowing separate depository and credit institutions to continue to fulfill all other traditional roles of banks. Depository institutions would compete to give customers access to an electronic payment system restricted to transactions in central-bank-issued currency (some of which could bear interest); credit institutions would compete to attract such currency and lend it out once they had accumulated enough.

In Benes and Kumhof (2012) we found support for the claimed advantages of the 100 percent reserve proposal, using modern quantitative tools. To be clear, this article does not advocate 100 percent reserve banking; we mention its history here only as critical to the debate over the nature of banks.

In the 1930s the less radical Glass-Steagall reforms won the day, and eventually the U.S. financial system stabilized. But a by-product of this victory was that critical pre-war lessons about the nature of banking had, by the 1960s, been largely forgotten. In fact, around that time banks began to completely disappear from most macroeconomic models of how the economy works.

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