McConnell 1975: How Banks Create Money

Excerpts from and commentary on Chapter 15: How banks Create Money, from Economics by Campbell McConnell, sixth edition, 1975:

In Chapter 14 we saw that the Federal Reserve Banks are the primary source of the economy's paper money. However, we shall find in the present chapter that commercial banks are the fountainhead of the major component of the money system -- demand deposits.

More specifically, in this chapter we want to explain and compare the money-creating abilities of:
1. A single commercial bank which is part of a multibank system
2. A monopoly bank
3. The commercial banking system as a whole

It will be convenient for us to seek these objectives through the commercial bank's balance sheet.

Next, a bit about balance sheets (for my benefit):

The Balance Sheet of a Commercial Bank

What is a balance sheet? It is merely a statement of assets and claims which portrays or summarizes the financial position of a firm -- in this case a commercial bank -- at some specific point in time. Every balance sheet has one overriding virtue: By definition, it must balance. Why? Because each and every known asset, being something of economic value, will be claimed by someone.

A balance sheet balances because assets equal claims. The claims shown on a balance sheet are divided into two groups: the claims of the owners of a firm against the firm's assets, called net worth, and the claims of nonowners, called liabilities.

Assets = liabilities + net worth

Off-topic, but I will point it out now anyway: If there is a weakness in thinking in terms of balance sheets, it is that a balance sheet is a picture "at some specific point in time." A balance sheet is a snapshot. A static image. It cannot show growth. It cannot show change. It cannot show the development of imbalances in the economy.

A Single Commercial Bank in a Banking System

Let us start from scratch. Suppose some farsighted citizens of the metropolis of Wahoo, Nebraska, decide that their town is in need of a new commercial bank... Assuming these enterprising individuals are able to secure a state charter for their bank, they then turn to the task of selling, say, $250,000 worth of capital stock...

The cash held by a bank is sometimes dubbed vault cash...

Now remember, these excerpts are from the 1975 edition of McConnell's book. The excerpt below says state banks "have the option of joining or not joining the Federal Reserve System." I'm not sure that's still an option.

Being a state bank, the Merchants and Farmers Bank of Wahoo will have the option of joining or not joining the Federal Reserve System. Suppose the directors of the bank decide in favor of joining. To accomplish this, the bank must meet a very specific requirement: It must keep a legal reserve deposit in the Federal Reserve Bank of its particular district.

This legal reserve deposit is an amount of cash equal to a specified percentage of its own deposit liabilities which a member bank must keep on deposit with the Federal Reserve Bank in its district. Since 1960, banks have been permitted to count vault cash as a part of reserves. As a matter of banking practice, however, the vast bulk of bank reserves are in the form of deposits in the Federal Reserve Banks.

Vault cash as part of reserves. Related post: Bank Error in Your Favor??? See also Footnote 1 on Robert Schenk's The Federal Reserve and Monetary Policy page.

McConnell says that to simplify the presentation he will assume that all reserves are kept as deposits at the Fed. He continues:

The "specified percentage" of its deposit liabilities which the commercial bank must deposit in the central bank is known as the reserve ratio... Hence, if the reserve ratio were 10 percent, our bank, having accepted $100,000 in deposits from the public, would be obligated to keep $10,000 as a deposit, or reserve, in the Federal Reserve Bank in Kansas City...

How is the exact size of the reserve ratio determined? Congress has the responsibility for setting the upper and lower limits within which the ratio may vary... The Board of Governors can vary the ratio at its discretion within these limits.

To avoid a lot of tedious computations, we shall suppose that the reserve ratio for all banks is 20 percent. This is a nice round figure and is reasonably close to reality. It is to be emphasized that reserve requirements are fractional, that is, less than 100 percent.

McConnell's 20% as "reasonably close to reality" is again a reminder that these excerpts are from the 1975 edition of his book.

The fact that Congress establishes the limits within which the Federal Reserve can vary the ratio is one reason I say it is Congress, not the Fed, that is ultimately to blame for our economy going bad.

One might think that the basic purpose of reserves is to enhance the liquidity of a bank and thereby protect commercial bank depositors from losses... But this reasoning does not hold up... In practice, legal reserves are not an available pool of liquid funds upon which commercial banks can rely in times of emergency. As a matter of fact, even if legal reserves were accessible to commercial banks, they would not be sufficient to meet a serious "run" on a bank. Why? Because, as we shall soon discover, demand deposits may be three, four, or five times as large as a bank's required reserves.

McConnell points out that most deposits are FDIC-insured "up to a maximum of $20,000". 1975, remember.

If the purpose of reserves is not to provide for commercial bank liquidity, what is their function? Control is the basic answer. Legal reserves are a means by which the Board of Governors can influence the lending ability of commercial banks.

"Control is the basic answer. Legal reserves are a means by which the Board of Governors can influence the lending ability of commercial banks."

The object is to prevent banks from overextending or underextending bank credit. To the degree that these policies are successful in influencing the volume of commercial bank credit, the Board of Governors can help the economy avoid the business fluctuations which give rise to bank runs, bank failures, and collapse of the monetary system. It is in this indirect way -- as a means of controlling commercial bank credit -- that reserves protect depositors...

The economy is a kite in the sky. Bank credit is the string. The Federal Reserve is the little boy holding the kite string.

The wind blows. The kite wants to go up. The boy decides whether or not to let out more string. The boy has control.

The wind stops. The kite wants to fall. It does not matter how much string the boy lets out, now. You can't push on a string.

Isn't it simple?

In The Ratio of Debt to Money I looked at Steve Keen's The Roving Cavaliers of Credit from January '09. Keen looked at the "conventional model" of the money multiplier:

Every macroeconomics textbook has an explanation of how credit money is created by the system of fractional banking that goes something like this:

   •  Banks are required to retain a certain percentage of any deposit as a reserve, known as the “reserve requirement”; for simplicity, let’s say this fraction is 10%.

   •  When customer Sue deposits say 100 newly printed government $10 notes at her bank, it is then obliged to hang on to ten of them—or $100—but it is allowed to lend out the rest.

   •  The bank then lends $900 to its customer Fred, who then deposits it in his bank—which is now required to hang on to 9 of the bills—or $90—and can lend out the rest. It then lends $810 to its customer Kim.

   •  Kim then deposits this $810 in her bank. It keeps $81 of the deposit, and lends the remaining $729 to its customer Kevin.

   •  And on this iterative process goes.

There is nothing wrong with that description. As Keen points out, after a new deposit is made, the bank is allowed to lend out most of it. After that loan is deposited, the bank can lend out most of the new deposit. And after that loan is deposited, the bank can lend out most of it as well -- but now Keen omits the word "can" and instead says the bank "lends" it out.

Keen does not mean to suggest that after the second relending (or, ever), that the bank is "forced" to lend out the money. He continues to mean that the bank is "allowed" to do so. Keen simply dropped a word to make the reading easier. That's what I would have done, anyhow.

The bank is never forced to lend money that is not tucked away as required reserves. Ordinarily, the bank wants to lend that money out.

Keen by the way, says simply that the conventional model is "completely inadequate as an explanation of the actual data on money and debt."

In other words it remains true that one dollar, newly deposited, is partially re-lent over and over (or, for those who object to that sentence structure, that the one dollar will serve as reserves for several dollars of money created "from nothing" by new lending) but Keen has numbers that show something else is going on as well.

If the conventional model told the whole story, Keen says, "changes in M0 should precede changes in M2." But the "empirical conclusion was just the opposite: rather than fiat money being created first and credit money following with a lag, the sequence was reversed: credit money was created first, and fiat money was then created about a year later".

Okay. I can live with that. If banks have reserves to use, they will use them. As long as they want to lend more. But if they want to lend more and they do not have the reserves, they do what comes natural: They lend anyway, then get the reserves they need to meet the reserve requirement.

This is not at all what most people say, who object to the conventional money multiplier model. But it answers a question I have asked:

So, what do banks DO with deposits? Are you saying they refuse to lend them out? It seems to me a piece of the story is missing.

I don't mind if you want to add to the story and say that reserves, as a control on lending, don't work very well. I have to object if you say banks don't base loans on existing reserves, because then existing reserves would go into limbo and new reserves would have to be obtained before (or soon after) new loans are made. And the limbo thing doesn't make any sense.

But I don't mind if you want to take the conventional model and build on it. I think Keen shows that we have to do that. As McConnell said,

The object [of reserves] is to prevent banks from overextending or underextending bank credit.

If it doesn't work, if it has worked less and less well since, oh, the time of Reagan, well, remember that Robert Schenk describes the late 1970s and early 1980s as "a period of rapid financial change".

And if things have only gotten worse since that time, then perhaps all of the financial innovation has something to do with it.


At the conclusion of his Chapter 15, McConnell writes

Willingness Versus Ability to Lend

It is only fair to emphasize that our illustration of the banking system's ability to create money rests upon the supposition that commercial banks are willing to exercise their abilities to create money by lending and that households and businesses are willing to borrow. In practice, this need not be the case.

Obviously, if the amount actually loaned by each commercial bank falls short of its excess reserves, the resulting multiple expansion of credit will be curtailed.