Credit Creation


The most important feature of banks: credit creation
(Extracted from: New Paradigm in Macroeconomics, Richard Werner*, Palgrave Macmillan,2005; pp. 174-180)

Many economics textbooks that mention banks still acknowledge that they can ‘create credit’. However, it appears that the original meaning of this expression has been lost.Those textbooks and authors that mention the words credit creation now give it quite adifferent meaning. Proponents of the present-day ‘credit view’ define credit creation as ‘theprocess by which saving is channeled to alternative uses’ (Bernanke, 1993, p.50).

To Bernanke, ‘credit creation’ is therefore the ‘diversion’ or transfer of already existingpurchasing power. This is also the understanding of the concept by economists from other persuasions, including monetarists like Meltzer (1995). They all therefore agree in classifying banks as mere financial intermediaries, providing services similar to and in parallel with non-banks and capital markets. [21]

Clearly, thus defined, credit creation would not be a unique feature of banking. proponents of the credit view consequently also argue that credit aggregates are not to be considered an ‘independent casual factor affecting the economy’; rather,credit conditions – best measured, by the way, by the external finance premium and not the aggregate quantity of credit – are an endogenous factor that help shape the dynamic response of the economy to shifts in monetary policy.

Thus the theory has no particular implications about the relative forecasting power of credit aggregates. (Bernanke andGertler, 1995, pp. 43ff.)

The representation of banks as mere intermediaries is perpetuated by the explanation of credit creation in textbooks, which depict it as a process of successive lending of already existing purchasing power by intermediating banks. Figure 12.1 reproduces the textbook representation of credit creation: Bank A receives a new deposit of US$100. If the reserve requirement is 1%, textbooks say that the bank will lend out US$99, and deposit US$1 withthe central bank as reserve.

The US$99 will, however, be deposited with another bank,Bank B, which will also be able to lend out 99% of that amount (US$98.01) . and keep 1% as reserve. This process continues until in the end a total of US$9900 has been lent out.

Textbooks represent credit creation as successive financial intermediation. According to this description, a single bank is unable to create credit…


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