Monetary Realism

Understanding The Modern Monetary System…

‘Loans Create Deposits’ – in Context


Loans create deposits. We’ve heard it many times now. But how well is it understood? The phrase is typically invoked accurately, in conjunction with a rejection of the ‘money multiplier’ fable found in economic textbooks. From an operational perspective, banks do not “lend reserves” to their non-bank customers. “Loans create deposits’ is an operation in endogenous money. And where central banks impose a level of required reserves based on deposits, the timing of the demand for and supply of reserves in respect of such a requirement follows the creation of the deposit – it does not precede it. The money multiplier story is bunk. And ‘loans create deposits’ is correct as an observation.

Nevertheless, there is a larger context for deposits, which includes their fate after they have been created. Deposits are used to repay loans, resulting in the ‘death’ of both loan and deposit. But there is more. As part of the birth/death analogy, there is the lifetime of loans and deposits to consider. This sequence of birth, life, and death in total may be helpful in putting ‘loans create deposits’ into a broader context. There is potential for confusion if ‘loans create deposits’ is embraced too enthusiastically as the defining characteristic, without considering the full life cycle of loans and deposits. Indeed, we shall see further below that ‘deposits fund loans’ is as true as ‘loans create deposits’ and that there is no contradiction between these two things.

Monetary Systems

The monetary system and the financial system are constructions of double entry accounting. It has been this way for a long time. This did not start in 1971. The fact that there was gold serving as a fixed value backstop for certain monetary assets shouldn’t obscure the fact that a monetary system is a fiat construction at its foundation. Gold at one time was a hard constraint on the behavior of the monetary authorities. But the authorities will inevitably create paradigms of operational constraint and guidelines in any monetary system. These restrictions include central bank balance sheet constraints (e.g. gold backing; Treasury overdraft constraints; supply and pricing of bank reserves that are consistent with the monetary policy interest rate target) and other guidelines (such as the reaction function of the policy rate to various measures of inflation, output, or employment). The full category of potential constraints is broad and varied. But none of this alters the fact that a monetary system is basically a bookkeeping device for the intermediation of real economic activity. It is a construct that enables moving beyond a barter economic system that can only be imagined as a counterfactual.

The Choice for Banking

Starting from this monetary bookkeeping foundation, a fundamental choice exists. Will the system include a competitive banking sector? More broadly, will financial capitalism exist in substance and form? Will there be competition? Within this landscape, will there be more than one bank? While a banking singularity (a single, concentrated, nationalized institution) is usually considered to be non-pragmatic, it serves as a useful theoretical reference point for understanding how banks actually work. The competitive framework that is often taken for granted is in fact a choice for banking system design – including the presence of a reserve system that enables active management of individual bank balance sheets.

‘Loans Create Deposits’

When we say ‘loans create deposits’, we mean at least that the marginal impact of new lending will be to create a new asset and a new liability for the banking system – typically for the originating lending bank at first. A bank makes a loan to a borrowing customer. That is a debit under bank assets. Simultaneous, it credits the deposit account of the same customer. That is a new bank liability. Both of those accounting entries represent increases in their respective categories. This is operationally separate from any notion of reserves that may be required in association with the creation of bank deposits.

In another version of the same lending transaction, the lending bank presents the borrower with a cheque or bank draft. The lending bank debits the borrower’s loan account and credits a payment liability account. The bank’s balance sheet has grown. The borrower may then deposit that cheque with a second bank. At that moment, the balance sheet of the second bank – the deposit issuing bank – grows by the same amount, with a payment due asset and a deposit liability. This temporary duplication of balance sheet growth across two different banks is captured within the accounting classification of bank ‘float’. The duplication gets resolved and eliminated when the deposit issuing bank clears the cheque back to the lending bank and receives a reserve balance credit in exchange, at which point the lending bank sheds both reserve balances and its payment liability. The end result is that the system balance sheet has grown by the amount of the original loan and deposit. The loan has created the deposit, although loan and deposit are domiciled in different banks. The system has expanded in size. The growth is now reflected in the size of the deposit issuing bank’s balance sheet, with an increase in deposits and reserve balances. The lending bank’s balance sheet size is unchanged from the start (at least temporarily), with loan growth offset by a reserve balance decline.

Money Markets

In this latter example, it is possible and even likely, other things equal, that the lending bank additionally will seek to borrow new funding from wholesale money markets and that the deposit issuing bank will lend funds into this market. This is a natural response to the respective change in reserve distribution that has been created momentarily for the two banks. Without further action, the lending bank has lost reserves and the deposit bank has gained reserves. They may both seek to normalize these respective reserve positions, other things equal. Adjusting positions through money market operations is a basic function of commercial bank reserve management. Thus, this example features the core role of bank reserves in clearing a payment from one bank to another. The final resolution of positions in this case is that the balance sheets of both banks will have expanded, indirectly connected through money market transactions that follow on from the initial ‘loans create deposits’ transaction. However, this too may be a temporary situation, as the original transaction involving two different banks will inevitably be followed up by further transactions that shift bank reserves between various bank counterparties and in various directions across the system.

The Money Multiplier Fable

The money multiplier story – a fable really – claims that banks expand loans and deposits on the basis of a central bank function that gradually feeds reserves to banks, allowing them to expand their balance sheets with new loans and reservable deposits – according to reserve ratios that bind the pace of that expansion according to the reserves supplied. This is entirely wrong, of course. In fact, bank balance sheet expansion occurs largely through the endogenous process whereby loans create deposits. And central banks that impose reserve requirements provide the required reserve levels as a matter of automatic operational response – after the loan and deposit expansion that generates the requirement has occurred. The multiplier fable describes a central bank with direct exogenous control over bank expansion, based on a reserve supply function – which is a fiction. The facts of endogenous money creation have been demonstrated by empirical studies going back decades. Moreover, the facts are obvious to anybody who has actually been involved with or closely studied the actual reserve management operations of either a commercial bank or a central bank. In truth, no empirical ‘study’ is required – the banking world operates this way on a daily basis – and it is absurd that so many economics textbooks make up stories to the contrary. The truth of the ‘loans creates deposits’ meme is pretty well understood now – at least by those who take the time to learn the facts about it.

Central Bank Reserve Injections

A central bank that imposes a reserve requirement will follow up new deposit creation with a system reserve injection sufficient to accommodate the requirement of the individual bank that has issued the deposit. The new requirement becomes a targeted asset for the bank. It will fund this asset in the normal course of its asset-liability management process, just as it would any other asset. At the margin, the bank actually has to compete for funding that will draw new reserve balances into its position with the central bank. This action of course is commingled with numerous other such transactions that occur in the normal course of reserve management. The sequence includes a time lag between the creation of the deposit and the activation of the corresponding reserve requirement against that deposit. Thus, there is a lag between two system growth impulses – ‘loans create deposits’ as the endogenous feature and a subsequent central bank reserve injection as an exogenous follow up. The required reserve injection is typically small by comparison, according to the reserve ratio. The central bank can provide the reserves in different ways, such as by purchasing bonds or by conducting system repurchase operations with investment dealers. In the case of either bond purchases or system repurchase agreements, additional system deposits might be created when the end seller (or lender) of the bonds is a non-bank. And that second order creation of deposits may be reservable as well. But what might appear to be a potentially infinite series of reserve injections is in fact highly controlled in the real world – because the reserve ratio is relatively small. Some countries such as Canada have no such required reserve ratio. Indeed, the case of zero required reserves nicely emphasizes the nature of the money multiplier as an annoying analytical error and distraction from accurate comprehension of how banks actually work. But as a separate point, central bank injections of required reserves illustrate how not all deposits are necessarily created by commercial bank loans. ‘Loans create deposits’ is true, but not exclusive. This aspect is made clear also by the example of central bank ‘quantitative easing’, noted further below.

The Growth Dynamic

The ‘loans create deposits’ meme is best understood as a balance sheet growth dynamic, distinct from any reserve effect that might occur as part of an associated interbank clearing transaction at the time (e.g. the second example above) or as part of a deposit ratio requirement that might be activated at a later date. The banking system can be visualized in continuous time, punctuated by discrete banking transactions that are reflected as accounting entries. If one divides time into very small time intervals, individual banking transactions can be isolated as the only transactions that occur during a given interval of time. Thus, the growth dynamic of ‘loans create deposits’ can be conceived of as an instantaneous balance sheet expansion at the point of corresponding accounting entries. As noted in the examples above, this expansion may then migrate across individual banks when the lending and deposit issuing bank are different.

‘Deposits Fund Loans’

Some interpretations of the ‘loans create deposits’ meme overreach in their desired meaning. The contention arises occasionally that ‘loans create deposits’ means banks don’t need deposits to fund loans. This is entirely false. This is the point that requires emphasis in this essay.

There is no inconsistency between the idea that ‘loans create deposits’ and the idea that banks need deposits to fund loans. Bank balance sheet management must respond to both growth dynamics and steady state conditions in the dimension of nominal balance sheet size. A bank in theory can temporarily be at rest in terms of balance sheet growth, and still be experiencing continuous shifting in the mix of asset and liability types – including shifting of deposits. Part of this deposit shifting is inherent in a private sector banking system that fosters competition for deposit funding. The birth of a demand deposit in particular is separate from retaining it through competition. Moreover, the fork in the road that was taken in order to construct a private sector banking system implies that the central bank is not a mere slush fund that provides unlimited funding to the banking system. In fact, active liability management is important in private sector banking – in the system we actually have. Other systems have been proposed, in which central banks intervene in some way to adjust the landscape of competitive liability management (e.g. the Chicago Plan; full reserves) or to subsume this competition more comprehensively (e.g. the MMT Mosler plan). These are ideas for significant change that should not be confused with the characteristic of competitive banking as it now exists. Some analysts tend toward language that conflates factual and counterfactual cases in this regard. To repeat – bank liability management is very competitive in the system we have, by design. The ‘loans create deposits’ meme, while true, only touches on this competitive dynamic.

We note again that loans are not the sole source of deposit creation. A commercial bank’s purchase of securities from a non-bank will typically result in new deposit creation somewhere in the system. There are cases where deposit creation results from other liability or equity conversion – commercial bank debt redemption and stock buybacks are examples of this. Existing fixed term deposits can convert to demand deposits and vice versa. And central bank quantitative easing most often results in new deposit creation – because the bonds that the central bank purchases are typically sourced from non-bank portfolios, and exchanged for deposits. Nevertheless, ‘loans creates deposits’ is a reasonable reference point and standard for the process of deposit creation.

Bank Asset-Liability Management

The ‘loans create deposits’ dynamic comprises the production of much of the money that serves as a basic source of liquidity in a monetary economy. The originating accounting entries are simple – a loan asset and a deposit liability. But this is only the start of the story. Commercial bank ‘asset-liability management’ functions oversee the comprehensive flow of funds in and out of individual banks. They control exposure to the basic banking risks of liquidity and interest rate sensitivity. Somewhat separately, but still connected within an overarching risk management framework, banks manage credit risk by linking line lending functions directly to the process of internal risk assessment and capital allocation. Banks require capital – especially equity capital – to take risk – and to take credit risk in particular.

Interest rate risk and interest margin management are critical aspects of bank asset-liability management. The ALM function provides pricing guidance for deposit products and related funding costs for lending operations. This function helps coordinate the operations of the left and the right hand sides of the balance sheet. For example, a central bank interest rate change becomes a cost of funds signal that transmits to commercial bank balance sheets as a marginal pricing influence. The asset-liability management function is the commercial bank coordination function for this transmission process, as the pricing signal ripples out to various balance sheet categories. Loan and deposit pricing is directly affected because the cost of funds that anchors all pricing in finance (e.g. the fed funds rate) has been changed. In other cases, a change in the term structure of market interest rates requires similar coordination of commercial bank pricing implications. And this reset in pricing has implications for commercial bank approaches to strategies and targets for the compositional mix of assets and liabilities.

The life of deposits is more dynamic than their birth or death. Deposits move around the banking system as banks compete to retain or attract them. Deposits also change form. Demand deposits can convert to term deposits, as banks seek a supply of longer duration funding for asset-liability matching purposes. And they can convert to new debt or equity securities issued by a particular bank, as buyers of these instruments draw down their deposits to pay for them. All of these changes happen across different banks, which can lead to temporary imbalances in the nominal matching of assets and liabilities, which in turn requires active management of the reserve account level, with appropriate liquidity management responses through money market operations in the short term, or longer term strategic adjustment in approaches to loan and deposit market share. The key idea here is that banks compete for deposits that currently exist in the system, including deposits that can be withdrawn on demand, or at maturity in the case of term deposits. And this competition extends more comprehensively to other liability forms such as debt, as well as to the asset side of the balance sheet through market share strategies for various lending categories. All of this balance sheet flux occurs across different banks, and requires that individual banks actively manage their balance sheets to ensure that assets are appropriately and efficiently funded with liabilities and equity.

In examining all of these effects, it is helpful to consider the position of the banking system in its totality, in conjunction with the position of individual banks that constitute the whole. For example, the US commercial banking system is composed of thousands of individual banks. Between discrete ‘loans create deposits’ events, the banking system is in continuous balance sheet churn. Specifically, deposits are moving back and forth between individual banks, as a matter of normal payment system operations. They are also moving and inter-converting in the form of term deposits at both the retail and wholesale level. This overall liquidity churn feeds economic activity of all sorts, where households, businesses, and governments are making payments to each other for various goods and services and other types of transactions, and are making choices about the portfolio structure of their liquid assets. This is the core liquidity provided by the banks to their customers. And this is the stuff that involves a good deal of transferring of reserves back and forth between banks, in order to affect accounting completion of balance sheets that are in continuous flux in size and composition.

Bank Reserve Management

The ultimate purpose of reserve management is not reserve positioning per se. The end goal is balance sheets that are in balance, institution by institution – and where deposits fund loans, alongside various other asset-liability matching configurations. The reserve system records the effect of this balance sheet activity. The reserve account is the inverse exogenous money image of the nominal configuration of the rest of the balance sheet. The balance sheet requires asset liability management coordination in order to match up assets and liabilities both in nominal terms and in a way that is financially effective. And even if loan books remain temporarily unchanged, all manner of other banking system assets and liabilities may be in motion. This includes securities portfolios, deposits, debt liabilities, and the status of the common equity and retained earnings account. And of course, loan books don’t remain unchanged for very long, in which case the loan/deposit growth dynamic comes directly into play on a recurring basis.


In summary, the original connection by which deposits are created by loans typically disappears at some point following deposit creation – at the micro bank level and/or the macro system level. The original demand deposits associated with specific loan creation become commingled as they move back and forth between different banks. And they not only move between banks, but they can change in form within any bank. They can be converted into term deposits or other funding forms such as bank debt or common and preferred stock. The task of dealing with this compositional flux falls under the joint coordination of bank asset-liability management and reserve management. The overarching point of observation is that both system growth and system competition for existing balance sheet composition are in constant operation. ‘Loans create deposits’ only describes the marginal growth dynamic at the inception of deposit creation. ‘Deposits fund loans’ is the more apt description that applies to a good portion of what constitutes ongoing balance sheet management in competitive banking.


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345 Responses

  1. Fed Up says


    What Really Constrains Bank Lending

  2. Fed Up says


    Basics of Banking: Loans Create a Lot More Than Deposits

  3. Fed Up says

    Basically, yes.

  4. Greg says

    How do you conceive of real AD? Is it AD that would be there even without a moneynsystem?

  5. Fed Up says

    Will short-term treasury interest rates go into negative territory also?

  6. Fed Up says

    Greg, I’m not sure what to think about that other than it is not right. I think in terms of real AS, real AD, and MOA/MOE “added” to those two.

  7. Fed Up says

    “So the idea of required reserves is simply that of a tax. They serve no purpose in interbank clearing and settlement functionality – because there is no clearing and settlement with just one bank.”

    Couldn’t the central bank use the required central bank reserve percentage to limit debt production? Once this one bank/banking system hits this limit the overnight rate will rise to the point of stopping debt being produced?

  8. Fed Up says

    “The problem is that the bank has nowhere to go to bid for reserves – other than the central bank, which has to inject them anyway in order to allow banks in any system to meet their requirement.”

    If there is currency in circulation, couldn’t the bank bid for currency using the overnight rate (raise it so some entity saves and deposits the currency at the bank)?

  9. Fed Up says

    I’ll need to think about that one. Is a bank issuing new bonds or new stock different than another type of business issuing new bonds or new stock?

  10. Fed Up says

    “Have you seen Sumner or anybody else attempt this sort of analysis?” And, “I followed you until the last several sentences.”

    Not that I know of. I think most of the people that want negative IOR are saying MOA = currency plus central bank reserves, MOE = currency, and MOA = the M in MV = PY (nominal GDP). Getting the 2.2 trillion in central bank reserves converted to currency will increase velocity in the real economy and raise NGDP. They want to keep NGDP positive until “something” happens and the economy fixes itself.

    “However, there’s a further problem if the public can convert their deposits earning (2) per cent to currency earning 0 per cent (I assume that’s your assumption).”

    Yep, that is the assumption.

    “The question then is what form the $ 4 trillion Fed reserve injection takes. Suppose the Fed buys bonds to inject the reserves. Assuming the end sellers of bonds are non-banks, they will end up with new deposits at the banks.”

    What if the end sellers are banks? Is it possible for them to lose all of their assets in this “negative IOR bank run”?

  11. Ramanan says

    Neil Wilson refers to this post here:

  12. Ramanan says


    Yes I know!

    But generally people don’t realize the importance of it. A nation’s rich region is always making transfers to the poorer ones. So a rich region may pay more taxes than receive government expenditure and it is the opposite for the poorer one. However, this isn’t really due to higher rates themselves. It is more because of higher incomes in the rich region leading to higher taxes paid. The rich regions stay rich because of running a trade surplus with the other regions and this makes them rich. The Germans tend to think that they will pay higher taxes because of higher tax rates. There needn’t be any increase in the tax rate. They forget that higher prosperity of the region as a whole makes them receive payments from trade surpluses. So they forget what they receive and think of what they pay even though in a burden sense there isn’t an increase.

  13. stone says

    JKH, it is fantastic that you go to the trouble of writing these posts but have you ever also considered contributing to the wikipedia banking pages? They do seem to be gradually improving but are still predominantly money multiplier stories.

  14. JKH says

    that too!


  15. Jose Guilherme says

    “although there are transfers, it isn’t expensive in any sense to Germany”

    I’m afraid German taxpayers may show some reluctance to share your enthusiasm :)

  16. Ramanan says

    Yes there is a connection of ideas – supposedly because the government creates money that monetary economists seem to think that a nation cannot be considered indebted to foreigners in domestic currency or similar intuitions such as that!

  17. JKH says

    Just to repeat something – it occurred to me a few comments back that ‘loans create demand deposits’ may be one way of establishing the connection I’m attempting to make in the post between that and funding. The counterfactual where the entire liability structure of banking consists of demand deposits is a non-starter from an asset-liability management and risk management perspective.

    And there’s an interesting analogy and connection between that idea and the ‘no-bonds’ configuration for deficit financing – but that really is a story for later on.

  18. JKH says

    Roughly – as a blanket statement, that may overstate the intensity of the operational influence – it’s complex in total, involving different operational interfaces with various funding and asset units – some immediate, some remote. But the function has accountability at the most senior level in the sense of coherence of funding strategy across the organization. You know the story about the TBTF banks being too big to manage? This function is right in the middle of that (managing hopefully) as a challenge. It deals directly with the area of greatest complexity in banking. The London Whale fiasco could be considered to be a combined failure of over-delegation of trading authority, risk management, and asset-liability management. ALM would have had a heavy involvement in the internal routing of deposits in that case. One of the things the function does is change interest rates used in transfer pricing across the board –where necessary – whenever there’s a central bank target interest rate change, or a big bond market move for example. Transfer pricing rates are a very strong signal in banking, and are driven by market rates.

    I may do a post on this sometime, but not very soon – it is complicated indeed.

  19. Ramanan says

    “A fiscal union would be expensive and it would have to be paid with German net transfers.”

    That isn’t so. A fiscal union leads to a stronger Euro Area and more production and although there are transfers, it isn’t expensive in any sense to Germany.

    German leaders do want a union – although a muddled one. It is others who do not want it.

  20. Tom Hickey says

    I neglected to get back to that thread at Interfluidity after commenting and didn’t see your replies and beowulf’s comments drilling in. Good stuff. Thank for the link.

  21. Tom Hickey says

    So I assue then that this overall corporate strategy is then used tactically at desks to make specific operational moves under the coordination of the ALM dept. No need to respond if correct.

  22. Tom Hickey says

    “S was generated once – by the company’s profit when recorded.”


  23. Jose Guilherme says


    It’s clear that Germany does no want a fiscal union and I can understand their POV.

    A fiscal union would be expensive and it would have to be paid with German net transfers. Just like the fiscal union with the former East Germany had to be paid by western Germany.

    Such a union would mean a common budget to pay for European pensions, European health care, European unemplyment subsidies for all the labor force of the continent, etc. That is, federalism as it presently exists in the U.S.A. It simply is not on offer.

    What Germany and TPTB on the continent want is the continuation of present policies. Austerity for the south to correct the current account imbalances. And let the rest be damned.

    In fact, the recently amended (and signed by all euro members) fiscal compact will impose harsh austerity on the non core until 2035 at a minimum. The southern countries will have to reduce massively their public debts to get them to the Maastricht-prescribed maximum of 60% of GDP. For periphery countries with present debt levels at 120% of GDP that will require annual budget surpluses of 3% of GDP until the mid 30s. In all likelihood such policies will engender a permanent and massive southern recession for the next decades. Yes, those objectives are unrealistic and unattainable. But the countries will anyway be forced to attempt massive cuts in spending and tax increases that will have devastating impact on aggregate demand. Not a nice scenario for the future.

    In the end, one should perhaps not blame Germany for all this – at least not too much. She is pursuing her interests (or at least what she sees as being her interests) with a certain consistency. It’s the southern elites – who failed their own peoples by embarking on a European monetary adventure without properly considering the likely impact on their economies – the ones who should mainly carry the blame.

  24. JKH says

    ALM is not a single ‘funding operation’ itself. ALM is more of a corporate strategy function that provides overall direction and/or input to the entire mix of funding operations. It’s a ‘super portfolio’ management function, looking at the bank’s entire balance sheet.

  25. JKH says

    To paraphrase Friedman/Nixon:

    We’re all AL managers now.

  26. JKH says

    Selling your stock has no bearing on national income. It’s an asset swap.

    S was generated once – by the company’s profit when recorded.

    Forget capital gains – they’re not included in national income.

    I commented recently on this issue here:

  27. jt26 says

    Not sure if it is 100% Have a look at Ally (used to be GMAC) in US and Canada. They have a bank subsidiary in both. True also for independent credit card issuers; have a look at the annual report for Discover Financial, for e.g. Have a look at the list of FDIC-insured banks (US) or CDIC-insured banks (Canada), you’ll see them along with many retail stores’ finance arms.

  28. Ramanan says


    Although at an individual level, income is defined differently (for example in the tax returns form), at a national accounts level the definition is different.

    At the national accounts level, it is treated as holding gains or revaluations and so the identity which connects stocks and flows is:

    Change in Net Worth = Saving + Revaluations.

  29. Tom Hickey says

    Yes, thanks. I suspect that most non-bankers are not familiar with ALM operations and this is clearing up how banks “fund” assets that are at risk as lonas are.

    I would suppose that large industrial corps that self-finance, like auto companies that extend low-cost loans to customers through their own finance companies, also fund their exposure through ALM operations like this?

  30. Tom Hickey says

    “If the company buys back your stock at $ 17, it’s an asset swap – your stock for a deposit.
    And if you sell the stock to another bank at$ 17, it’s an asset swap – a deposit for your stock.”

    Yes, but if I hold the stock in my portfolio without selling, over the years my financial wealth increases but it does not affect my income so how does it contribute to S if income is saving plus consumption so that S = I – C?

    In other words, based on the definitions, I don’t see how an unrealized portfolio increase can add to “saving” =def residual of income after consumption. For tax purposes, the income is determined by the realized gain. Are unrealized paper gains to portfolios somehow included in saving? Absent a sale price, how is the unrealized gain figured, e.g., average over the period, close of the period minus beginning of period?

  31. JKH says

    That’s right.

    There is the ancilliary argument that RR can be a useful buffer against daylight overdrafts and collateral requirements for daylight overdrafts – when you have a normal interbank clearing function. So in that sense there may be some ‘value’ or utility for the system in imposing a moderate level of RR. But that argument doesn’t work in the weird case here of 1 bank with no interbank clearing function. The tax characteristic here is even ‘purer’ in that sense.

    But I think you’re basically right.

  32. JKH says

    Funding as defined falls within an overarching strategy of asset liability management and risk management.

    If a bank wants 5 year funding, it’s not because its balance sheet is necessarily ‘out of balance’ in the sense of having an offside reserve position.

    It’s because it wants 5 year funding as part of its asset-liability structure – instead of what it has now. And targeting that asset-liability structure reflects risk management for things like liquidity and interest rate risk.

    For example, it can pay off other short term funding when it raises 5 year funds.

    And as an example of that, it may pay off a demand deposit.

    This connects pretty nicely with ‘loans create deposits’.

    ‘Loans create deposits’ for the most part means ‘loans create demand deposits’.

    But banks have no intention of funding their entire balance sheet with demand deposits.

    So they do other types of funding. At the system level, this drains and replaces what would otherwise would be demand deposits.

    In a sense, MMT leaves off at the initial stage of ‘loans create deposits’. That isn’t surprising – since I doubt MMT is greatly interested in explaining how bank asset-liability and risk management works. But it may be why there’s been some difficulty with the idea that funding in this sense is not inconsistent with ‘loans create deposits’.

  33. JKH says

    Suppose you own stock with a book value of $ 10.

    The company makes a profit of $ 1 and retains it.

    The book value is $ 11.

    That $ 1 of profit becomes part of national income.

    Suppose the market value of your stock at the start is $ 15.

    And at the end the market value is $ 17.

    That just happens to be the way that the stock market values the book value of the company at a point in time – lots of volatility in that.

    Your own net worth (your own equity position) is $ 17.

    The company earned the income of $ 1.

    But the income, because it’s retained, is reflected – along with all other cumulative retained earnings of the company over multiple years – in your net worth – as a result of owning the stock and as a result of how the stock market values the company.

    So the $ 1 income effect of the most recent year is embedded and translated as part of the value of your stock.

    But that value is embedded in the value of all previous year’s income – according to how the market values the total.

    It’s the company’s income – but it’s your wealth.

    If the company buys back your stock at $ 17, it’s an asset swap – your stock for a deposit.

    And if you sell the stock to another bank at$ 17, it’s an asset swap – a deposit for your stock.

  34. stone says

    Just as a thought experiment, if all lending required a prior sale of a debt security of the same duration of the loan don’t you think loans would be much more limited? Wouldn’t houses only be bought with shorter term loans and land prices would be lower? If a typical household today spends $300k on housing of which $100k goes to interest would that not change to say $100k paid off in five years rather than thirty years and only $30k going to interest?

  35. Tom Hickey says

    Since RR are not required operationally, as the Canadian experience shows, this would suggest that any RR > O constitutes a tax? Seems so.

  36. Tom Hickey says

    But the value of shares does not become income until realized, and S is defined as the residual of household income after consumption in a period. I don’t see how that works if the shares are not sold and the gain is not realized as income in the period.

  37. Ramanan says


    It is true that something really needs to be done rather than doing nothing or worse fiscal contraction but the problems of the Euro Area are not really easy. They are extremely difficult to solve.

    A union requires a federal government at the central level but the Europeans are not game for such a plan even if Germany wants it. More importantly, it seems Germany and the European leaders and central bankers think their “fiscal union” is genuine – which it is not.

    But even if Germany comes with a non-fake fiscal union plan, the Europeans won’t accept it because of distrust.

    And Germany doesn’t want to reflate European demand because it will make the need for a union grow weaker. Other nations will grow a bit stronger and refuse to form a political union.

    But a plan to form a bank to buy government bond exclusively will meet with distrust. The right solution comes by winning everyone’s trust rather than doing the opposite.

  38. Tom Hickey says

    “The lending bank has now ‘funded’ its loan in the sense that I’ve used that word. Note that it took specific additional discretionary market action on its part in order to accomplish this – which is why I use the term ‘fund’ in the active sense – and this happens even though the endogenous money process created the ultimate source for the new funding from an overall system balance sheet perspective.”

    That makes “to fund” clear in the sense of ALM. So the operational meaning is risk hedging?

  39. Jose Guilherme says

    “Not a good plan” may be preferable to inactivity and passive acceptance of economic contractions that have already surpassed the peak to trough declines of the great depression.

    As for Mr. Silvio B. being able or not able to do something good – I’d say the proof of the pudding is always in the eating.

    Any leader – no matter his or her origin – that dares to react against the depression-loving eurocrats would deserve the adjective “great”.

    And using the treaty loopholes in self defense (by mandating banks to buy T bonds, for instance) seems to me a matter of common sense. At a minimum, it would take the ECB by surprise and force it to reassess its positions.

  40. Ramanan says


    The unlimited credit lines of NCBs with each other seem shocking in the first instance one hears but it is alright. Needed for the system. However, it comes with the price of giving up powers of the central bank providing credit to the government. You cannot have unlimited NCB credit to each other and NCB providing credit to the government simultaneously.

    This was already known in the 1960s! (The Europe plan had been in existence since ages before Maastricht).

    So the NCBs granting each other credit while good, can hardly be called a free line of credit on the rest of the world.

    The plan of using their own banks to finance the government is not a good plan. We don’t need plans which are so sensitive to what happens in the markets. If the price of government bonds fall, the banks which have a lot of government debt on their books will fail.

    One needs someone to prevent the price to fall below a level and the ECB does that. The ECB however cannot grant unconditional credit to governments.

    Berlusconi cannot do anything great.

    Anyway all this is a digression.

    The original point of Neil Wilson was that he assumes that banks (not NCBs) will automatically get funding everyday – the reason being that if one bank loses funds, others will have more. While this is not unreasonable in the first instance, it ignores the fact that the bank receiving funds may choose to not lend at all because of a crisis environment whatever price the borrower is willing to pay. (If the borrower is quoting a high price, there is more reason to be panicky).

    Also, his argument is not specific to the Euro Area.

    He also seems to suggest to write a post on this and suggests that it is possible for banks to fund all their liabilities on a daily basis! He ignores that even when banks don’t do it that way (nowhere close), they may still have funding pressures. Imagine what would happen if a bank needs to roll over all its liabilities on a single day!

  41. Jose Guilherme says

    In fact, all the euro ideologues (not only the southern ones) claimed that external imbalances would cease to be a concern once a single currency area was established.

    The periphery countries swallowed this delusion lock stock and barrel and instead of the promised paradise are now being forced to accept impoverishment and recession as a price to stay in the euro.

    And yet they are so weak that they refuse to consider the possibility of using their own state banks to refinance their public debts. Technically, this would not constitute a breach of the Treaties (the texts admit interventions by states in their own financial systems for unspecified “prudential reasons” – a catch all expression to legitimize exceptional governmental measures for guaranteeing the Stability and safety of the financial sector such as, e.g., bank nationalisations).

    But history has its surprises and maybe one day a more maverick, Berlusconi-type leader, will call the bluff on Europe by using the unlimited and uncollaterized mechanisms of the euro to undermine the present austerity craze.

  42. Ramanan says

    Yes investment creates saving. And investment is financed by both borrowing and saving. So investment is not limited by saving in existence. Nothing wrong there with PKE. For example you can find a lot on PKE papers on how retained earning finances quite a large fraction of investment for corporations.

    Also one has to be careful – although residential home loans are financed out of banks, banks finance only a small fraction of investment (as in “fixed capital formation”) for corporations. So banks do initial finance as opposed to final finance. You can find such discussions in Davidson or Circuit Theory.

  43. Jose Guilherme says

    The money multiplier textbook example always starts with the proverbial guy or girl who deposits $100 and in the end the banking system has created $1000 or $10,000 in deposits through a constrained process of credit extension.

    You can reinterpret all this as an instance of the “savings precede investments” syndrome.

    Whereas PK economists say that investments create savings. And show the loans create deposits mechanism as evidence of this.

    But if a fraction of all outstanding loans (call them “investments”) is matched on the banks’ books by deposits that originally resulted from savings; and if banks are condemned to compete for deposits (“funding”) some of which resulted from savings – then one might say that some investments are really “financed” by savings.

  44. Ramanan says

    “For instance, NCBs in the eurosystem provide unlimited and uncollateralized lines of credit to one another.”

    Yes I know.

    “That’s the reason there can never be an import crunch in the eurozone. Unbalanced current accounts can always get the necessary financing via the NCBs.”

    It amounts to saying that the TARGET2 claims between the NCBs is the accommodating item of the balance of payments.

    However it ignores the issue of what happens if a nation has large current account deficits. It ends up showing as sovereign debt crisis.

    “Too bad the periphery countries never noticed that this is a feature – not a bug – of the system.”

    Actually they thought that with a single currency, the balance of payments problems are removed. It came back with vengeance. Euro Area nations are forced to deflate demand to reduce their external imbalance.

  45. JKH says

    Good points.

    More generally, deposit creation and destruction can occur within the funding side of banking, quite apart from the asset channel.

    The funding side includes the equity account.

    And that includes dividends as ‘anti-funding’.

    Bank A could pay a cash dividend, which creates a deposit directly.

    Or it could pay a stock dividend, which creates a liquid asset that can be ‘monetized’ as in your example.

    Agree on QE – I’m amazed at how this seems to have been overlooked in general – that the banks are not the original source of QE bonds – and that there is a significant banking system liability effect as a result of the non-bank source of most of the bonds. The banks are acting as dealers/agents/brokers in the QE bond sales to the Fed – not as principals – but the payment for the bonds does affect the balance sheet size of the banking system through reserves and deposits.

    This can only be reconciled by running a plausible counterfactual – it can’t be done by simple time series analysis of the system balance sheet as its evolved – due to deleveraging otherwise – which I think is why the basic point has been missed.

    I’ve seen nobody focus on the banking system liability impact of QE (as opposed to the reserve impact) – as it might have affected depositor behavior more specifically from there. QE analysis seems floating in the clouds for the most part.