Credit theory of money

The fractional reserve theory where the money supply is limited by the money multiplier has come under increased criticism since the financial crisis of 2007–2008. It has been observed that the bank reserves are not a limiting factor because the central banks supply more reserves than necessary and because banks have been able to build up additional reserves when they were needed. Many economists and bankers now believe that the amount of money in circulation is limited only by the demand for loans, not by reserve requirements.

When a bank issues a loan of $1,000 to a customer, they debit the customer's loan account with $1,000 and at the same time they credit the customer's deposit account with $1,000, ready for using. The bank now has a new asset of $1,000 and a new liability of $1,000. The bank's accounts are still in balance because the assets and liabilities are increased by the same amount. The bank does not take the $1,000 out of its reserves. It takes it from the pool of client funds, deposited with it, that would be out of circulation, if the bank didn't re-lend it.

The claim that to this $1,000 is new circulating money that did not exist prior to the transaction is not entirely accurate, because it was originally sourced from the bank's depositing customer(s), and removed from circulation on deposit. It is this incompletely recognised concept that the "credit theory of money" is largely based.

A study of banking software demonstrates that the bank does nothing else than adding an amount to the two accounts when they issue a loan. The observation that there appears to be no limit to the amount of credit money that banks can bring into circulation in this way has given rise to the often-heard expression that "Banks are creating money out of thin air". The exact mechanism behind the creation of commercial bank money has been a controversial issue. In 2014, a study titled "Can banks individually create money out of nothing? — The theories and the empirical evidence" empirically tested the manner in which this type of money is created by monitoring a cooperating bank's internal records:

This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, "out of thin air".

The amount of money that is created in this way when a loan is issued is equal to the principal of the loan, but the money needed for paying the compound interest of the loan has not been created. As a consequence of this process, the amount of debt in the world exceeds the total money supply. Critics of the current banking system are calling for monetary reform for this reason.

The credit theory of money, initiated by Joseph Schumpeter, asserts the central role of banks as creators and allocators of the money supply, and distinguishes between "productive credit creation" (allowing non-inflationary economic growth even at full employment, in the presence of technological progress) and "unproductive credit creation" (resulting in inflation of either the consumer- or asset-price variety).

The model of bank lending stimulated through central-bank operations (such as "monetary easing") has been rejected by Neo-Keynesiannote and Post-Keynesian analysis as well as central banks.note The major argument offered by dissident analysis is that any bank balance-sheet expansion (e.g. through a new loan) that leaves the bank short of the required reserves may affect the return it can expect on the loan, because of the extra cost the bank will undertake to return within the ratios limits – but this does not and "will never impede the bank's capacity to give the loan in the first place." Banks first lend and then cover their reserve ratios: The decision whether or not to lend is generally independent of their reserves with the central bank or their deposits from customers; banks are not lending out deposits or reserves, anyway. Banks lend on the basis of lending criteria, such as the status of the customer's business, the loan's prospects, and/or the overall economic situation.