There has been a quiet Tobin revival which mirrors the unsuitability with which monetarism has found itself in a serial bubble world. I am referring to James Tobin, who did some great monetary theory back in the 1960’s when IS-LM and the “exploitable” Phillip’s Curve were groping for monetary relief. Specifically, money was believed to be a constraint in the way it may have been under a true gold standard where banks could only fraction claims upon real money. To those economists heading toward “general equilibrium” theory and producible models about economic function, the idea that banks might actually create “money” was abhorrent since it prevented applicable limits in the math.

The potential about general equilibrium was that it was expected to offer a realistic assessment of economic combinations, and thus offer a compelling means of control – change X and Y results. To even contemplate such a massive and complex undertaking such as controlling something incomprehensively complex and often misleading because of that should have produced more appreciation for the task. Instead, equations have ruled not out of tested validity but mathematical expedience. “Rational expectations” is but one of those factors.

Another is money itself. Economists that seek to control and manage massive economic systems have been curiously uninterested in the subject. There has been great contention on the subject but no debates since dominant economic theory just accepts what it wants no matter how much it fails. Whether or not banks actually create “money” is not some trivial squabble about math. The traditional, Keynesian and DSGE view is that banks are the same money-multiplier as they have always been. In other words, they do create deposits but are strictly bound by the limitations of the generalized money supply (thus, much easier in theoretical terms to translate to top-down views and equations).

In 1963, James Tobin was already lamenting the laziness by which this view came to dominate, writing:

Perhaps the greatest moment of triumph for the elementary economics teacher is his exposition of the multiple creation of bank credit and deposits. Before the admiring eyes of freshmen he puts to rout the practical banker who is so sure that he “lends only the money depositors entrust to him.” The banker is shown to have a worm’s-eye view, and his error stands as an introductory object lesson in the fallacy of composition. From the Olympian vantage of the teacher and the textbook it appears that the banker’s dictum must be reversed: depositors entrust to bankers whatever amounts the bankers lend. To be sure, this is not true of a single bank; one bank’s loan may wind up as another bank’s deposit. But it is, as the arithmetic of successive rounds of deposit creation makes clear, true of the banking system as a whole. Whatever their other errors, a long line of financial heretics have been right in speaking of “fountain pen money” – money created by the stroke of the bank president’s pen when he approves a loan and credits the proceeds to the borrower’s checking account.

Writing in 1969, Tobin warned relatedly:

If the interest rate on money, as well as the rates on all other financial assets, were flexible and endogenous, then ….there would be no room for monetary policy to affect aggregate demand.

So that was simply ignored into DSGE models that could hold instead a monetary simplification that worked even when reality most definitely did not agree. Ever since that time, “money supply” has been given a generic treatment and bubbles some deficiency of capitalism. Mainline economists, such as Paul Krugman, continue to hold to the idea of deposit creation in the same sense, that banks do not create “money” ex nihilo.

This position was made, quite stirringly, uncomfortable just last year when the Bank of England noisily published a quarterly view validating Tobin’s view.

Where does money come from? In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood. The principal way in which they are created is through commercial banks making loans: whenever a bank makes a loan, it creates a deposit in the borrower’s bank account, thereby creating new money.

As you would expect, Krugman didn’t take it very well.

OK, color me puzzled. I’ve seen a number of people touting this Bank of England paper (pdf) on how banks create money as offering some kind of radical new way of looking at the economy. And it is a good piece. But it doesn’t seem, in any important way, to be at odds with what Tobin wrote 50 years ago (pdf) — indeed, the BoE paper cites Tobin extensively. And I have always thought of money in Tobinesque terms, even if I sometimes use shorthand descriptions that can be misread if you take them out of context; the same is true of many economists.


Furthermore, the key Tobin insight — which is fully consistent with the BoE analysis — is that while banks are indeed more complicated creatures than the mechanical lenders of deposits we like to portray in Econ 101, this doesn’t mean either that they have unlimited ability to create money or that they are somehow outside the usual rules of economics.

That’s disingenuous to a fault, given a very clear and contradictory stance from just a few years earlier (to which he even published a paper, co-authored by Gauti Eggertson) in which he claimed to have created a model of Minsky, but somehow not including actual bank-driven money supply.

As I read various stuff on banking — comments here, but also various writings here and there — I often see the view that banks can create credit out of thin air. There are vehement denials of the proposition that banks’ lending is limited by their deposits, or that the monetary base plays any important role; banks, we’re told, hold hardly any reserves (which is true), so the Fed’s creation or destruction of reserves has no effect.


This is all wrong, and if you think about how the people in your story are assumed to behave — as opposed to getting bogged down in abstract algebra — it should be obvious that it’s all wrong.


First of all, any individual bank does, in fact, have to lend out the money it receives in deposits. Bank loan officers can’t just issue checks out of thin air; like employees of any financial intermediary, they must buy assets with funds they have on hand. I hope this isn’t controversial, although given what usually happens when we discuss banks, I assume that even this proposition will spur outrage…


Yes, a loan normally gets deposited in another bank — but the recipient of the loan can and sometimes does quickly withdraw the funds, not as a check, but in currency. And currency is in limited supply — with the limit set by Fed decisions. So there is in fact no automatic process by which an increase in bank loans produces a sufficient rise in deposits to back those loans, and a key limiting factor in the size of bank balance sheets is the amount of monetary base the Fed creates — even if banks hold no reserves.

Again, this is how economists model the economy, where the Fed or any central bank predominates upon the generic “money supply.” And it also one reason why none of these models predicted anything close to the Great Recession (or even a recession) and its financial panic. The very people that claim to be grand experts on the economy don’t even accept the manner in which the economy’s greatest tool operates. Krugman writes that “Bank loan officers can’t just issue checks out of thin air” which is entirely untrue and betrays a childish lack of understanding on the subject matter. You would expect someone that claims such power as to be able to manage the economy would at least bother about minimal investigation as to what a modern, wholesale bank actually does, how it does it and why.

To that end, the Bank of England seems to have unlocked, almost as if “official” permission, a steady flow of academic research on the subject – all of which concludes that, yes, banks do create money ex nihilo, and all those DSGE models (and even their Bayesian cousins) are way, way over-simplifying monetary characteristics, pace Tobin, reaching very dubious conclusions about what monetary commandments can achieve.

The latest is another modeled attempt at updating DSGE, but with the introduction of actual money characteristics. The differences in back-tested, at least, monetary behavior upon the economy is drastic.

Problems in the banking sector played a critical role in triggering and prolonging the Great Recession. Unfortunately, macroeconomic models were initially not ready to provide much support in thinking about the interaction of banks with the macro economy. This has now changed.


In our new work, we argue that many of these unresolved issues can be traced back to the fact that virtually all of the newly developed models are based on the highly misleading ‘intermediation of loanable funds’ theory of banking (Jakab and Kumhof 2015). We argue instead that the correct framework is ‘money creation’ theory.

The updated models the authors (one from the IMF, the other from the Bank of England) present show much, much larger disruptions in everything from GDP to consumption to bank net worth to inflation due to endogenous “money.” Even though they claim that such a view has been a staple of central bank literature for quite some time, their own conclusions demonstrate that such knowledge amounted to nothing more than a hobby (Greenspan/Bernanke’s “global savings glut” falls in line here as the Fed, in particular, was certainly in the Krugman camp no matter how much the academic side may or may not have explored ledger money; central bankers may have been aware, an arguable proposition given any plain reading of all the FOMC transcripts published to date, but they surely did nothing about incorporating it into actual policy).

That is the central point in all of this, taking the forest from the trees. In other words, it is 2015 and economists are just now orientating themselves from a 19th century view of banking and money. In reality, they are only catching up to the 1960’s where even these “latest” academic offerings finally recognizing ledger money are decades behind wholesale evolution. Given the trajectory implied here, that would suggest that central bank economic policy will begin to offer some early 21st century wholesale conditions and traits in their attempts at economic management sometime in the latter half of this century.

It is truly damning that the “best and brightest” that claim overriding exertion upon the economic landscape, for “our own good”, don’t even have a working or workable understanding of the most basic of economic concepts. Again, it is 2015 and economists are just now reaching the outer contours of what wholesale money was decades ago. When they get to the more complicated, post-1995 stuff they will be quite shocked and maybe even dismayed. I guess that raises plausible deniability surrounding their socialist intentions, as they quite intentionally tried to control the global economy but instead proved yet again they have no idea what they are doing. Capitalism requires actual expertise in at least something; socialism only deniability, especially if there are equations.