When mainstream economists arrive at ideas 50 or so years late and pretend to be contributing to knowledge

I regularly encounter mainstream economists who are confounded by the dissonance that the body of theory they have been working in introduces and then seem to think they have come up with new ideas that restores their credibility. The more extreme version of this tendency is called plagiarism in academic circles. But the less extreme version is to produce some work in which you conveniently ignore the main contributors in history but hold out implicitly that the ideas are somehow your own. As mainstream economics fumbles through this period where the fictional world they operate in and push onto students is increasingly being revealed as a fraud, several economists are trying to distance themselves from the train wreck by resorting to restating ideas that in a period past they would have criticised a ‘pop science’. This syndrome is an accompaniment to the well established ‘we knew it all along’ or ‘there is nothing new here’ defenses that are often used when new ideas make the mainstream uncomfortable. I saw this again in a recent article from the British-based Centre for Economic Policy Research (CEPR) which discusses the way modern banks work – How monetary policy affects bank lending and financial stability: A ‘credit creation theory of banking’ explanation (March 20, 2023). The problem is that heterodox economists knew this from years ago including with the seminal work in the early 1970s of Canadian economist – Basil Moore. The other problem is that the CEPR authors choose not to credit the seminal authors in the reference list, which I think is poor form.

The CEPR article seeks to tie monetary policy positions of central banks with shifts in financial stability.

They introduce what they call a “credit theory of banking”, which anyone versed in Modern Monetary Theory (MMT) will immediately identify.

As a note, the treatment of endogenous money in MMT is derivative in the sense that it is part of the MMT body of knowledge that we accumulated from past Post Keynesian contributions and embedded in our broader framework.

That is the way paradigms progress – the expression – Standing on the shoulders of giants.

I consider that point in the three-part series:

1. Modern Monetary Theory – what is new about it? (August 22, 2016).

2. Modern Monetary Theory – what is new about it? – Part 2 (long) (August 23, 2016).

3. Modern Monetary Theory – what is new about it? – Part 3 (long) (August 26, 2016).

The CEPR article states that:

… ‘funds’ are liquid bank deposits created by the banking system independently of private saving(s) …

Which for laypersons means that the mainstream theory of banking is flawed.

Banks are not primarily intermediaries that channel savings that depositors have entrusted them with to borrowers (investors).

That concept spawns a range or related components:

1. Mainstream monetary theory considers that banks are reserve constrained in their lending, which means the central bank can control their lending via manipulation of the reserves in the accounts that the commercial banks have to maintain with the central banks..

I wrote a critique of that idea in this blog post (among others) – Lending is capital- not reserve-constrained (April 5, 2010).

2. The loanable funds theory of interest and saving – which argues that the interest rate serves to equalise saving and investment and is used as the basis for so-called ‘crowding out’ cases against fiscal policy – such that increasing fiscal deficits compete for savings with private investors and drive up the interest rate, which reduces private investment.

See blog posts (among others):

1. The IMF fall into a loanable funds black hole … again (September 22, 2009).

2. A response to Greg Mankiw – Part 1 (September 23, 2019).

3. Bank of England finally catches on – mainstream monetary theory is erroneous (June 1, 2015).

4. Building bank reserves will not expand credit (December 13, 2009).

So the statement that bank deposits are liquid deposits created at will by banks quite apart from the ‘funds’ they may have currently available to them via private savings counters those mainstream concepts as I will explain.

The CEPR authors note that there is a recent literature that links monetary policy decisions taken by central banks to financial system stability and that low interest rate eras increase “financial fragility” over time.

There is also a long dated literature in Post Keynesian economics that ‘discovered’ the same thing (years ago).

Minsky any one?

But the astounding part of the CEPR article is their next claim:

Why, though, do money and credit expand in the first place? By analyzing this question, we contribute to the strand of the literature that focuses on potential causes of credit booms. To the best of our knowledge, this strand is relatively thin.

The reality is that the literature is, in fact, very rich on this topic.

Knut Wicksell

Axel Leijonhufvud

Basil Moore

Marc Lavoie

Augusto Graziani

Wynn Godley

and others, have all provided the original contributions in this field over many decades.

It is just that mainstream economists have ignored their work for all these years because by acknowledging it one has to jettison all the main precepts in mainstream monetary theory, which then leads to the conclusion that the dominant paradigm has nothing interesting or valid to say about policy design.

But now, in 2023, these German economists based at the University of Würzburg are claiming a contribution.

The problem is the horse already bolted – years ago.

Their contribution is really no contribution but merely a useful summary of the state of knowledge in Post Keynesian economic thinking.

The only reference they provide to the ‘credit creation theory of banking’ is Werner (2014), who is also selective in who he credits with the ideas he pursues.

The CEPR authors compare:

… the standard loanable funds model with a model of the market for bank loans.

The modern approach, which negates the mainstream (loanable funds) view that banks are passive intermediaries between savers and investors, acknowledges that loans create deposits, not the other way around.

Accordingly, banks are not intermediaries between savers and investors, but active seekers of credit worthy customers who want to borrow.

The banks function to attract those borrowers and then at the stroke of a keyboard create a loan, which appears, initially and instantaneously as a deposit in favour of the borrower.

That deposit is liquid and is then used for the purposes the borrower sought the funds for.

The lending arm of the bank does not first consult other workers in the bank as to whether the bank has ‘enough funds’ to make those loans.

Covering the liability that the deposit creates is the function of the reserve management section of the banks and they operate quite separately from the loan department.

In some cases, there are no reserve implications of a loan.

For example, if I use Bank A and borrow to build a house and my builder uses Bank A, then when I pay the builder with my deposit, he/she deposits the payment in the same bank and there is just a mark down of my deposit and a mark up of the builder’s account.

When transactions span different banks then there are reserve implications and the reserve management section of the bank is tasked to ensure they can cover any daily calls on it from other banks.

That is what reserve accounts do – they rationalise all the daily cross bank transactions.

They can get any shortfall of funds from existing depositors or from other funding sources (for example, wholesale funding markets and interbank transactions).

See this blog post – The role of bank deposits in Modern Monetary Theory (May 26, 2011) – for more information on reserve management.

The point is that when banks make loans the liquidity in the system expands which is an endogenous process.

The central bank has little control on this process.

Banks loans are driven by the demand for loans by credit worthy borrowers and what constitutes credit worthiness fluctuates with the cycle as credit risk and debt levels rise.

Just before the GFC, almost anyone could access millions.

After the GFC, credit risk assessment became more intense and the number of eligible borrowers fell dramatically.

These ideas also counter the notion that if the central bank provides more reserves, the commercial banks will make more loans.

This was the mainstream idea that underpinned the belief that quantitative easing (swapping bank reserves for bonds) would stimulate the economy at the depth of recession.

Of course, it didn’t and the reason it didn’t was because bank lending is not reserve constrained.

Rather it is constrained by how many borrowers turn up that are assessed to be credit worthy.

The CEPR authors claim that accepting the idea that loans create deposits (credit money) means that the central bank can:

… directly influence the supply of credit by banks …


1. Manipulating the interest rate it supplies to banks who are short of reserves on any day.

2. Because “central bank’s policy rate is a key determinant of the cost of bank loans”.

There is some truth in that claim – but the capacity of the central bank in this regard is limited.

First, it has to supply reserves to banks that are short on any day and cannot access the funds from other sources (deposits, wholesale markets, interbank market).

But the central bank can not really hold banks to ransom in this way with prohibitive discount rates (the interest rate they charge for making short-term reserves available) because if there are major defaults within the interbank system – banks not being able to reconcile the transactions against them – then financial chaos would ensue.

Second, the idea that the interest rate is an effective way to manipulate lending is overstated.

For example, when interest rates fall to low levels, the presumption that borrowers will suddenly turn up to borrow is largely wrong.

These situations are usually associated with recessionary environments and even if rates are at rock bottom no one really wants to borrow.

Firms don’t want to borrow because they have excess productive capacity anyway and worry that the revenue they are likely to get will not pay back the loans.

Consumers are not wanting to borrow in recessions because they fear they will be next to lose their jobs and incomes.

Alternatively, in an rising interest rate environment, firms may still keep borrowing big because their expectations of sales are bouyant.

So there are reasons to suspect the effectiveness of the central bank’s capacity in restricting bank lending.

The CEPR authors seem to think the relationship is linear.

It is anything but as noted above.

The CEPR authors are correct though in noting that the mainstream money multiplier theory is flawed:

The model differs from the textbook multiplier … in that it assumes reverse causality. The textbook multiplier is rightly criticised for assuming that an increase in monetary base causes a higher amount of bank loans and money … In our model, the amount of bank loans is determined in the market for bank loans for a given central bank policy rate … this implies that the central bank must passively supply the required amount of monetary base.

This is the core proposition of the notion of endogenous money.

The broad money in the system is determined by the demand for credit and the central bank has to accommodate the reserves to match, not the other way around.

The money multiplier, which is a main idea taught in mainstream monetary theory, is that the central bank provides bank reserves, which then allow the bank to make loans, which then increases the money supply.

It was at the heart of Milton Friedman’s Monetarism.

It justified his belief that by monetary targetting the central bank could control the money supply and hence inflation (where the latter was characterised as ‘too much money chasing too few goods’).

As Monetarist swept into dominance in the early 1970s, central banks tried to set money supply targets and control reserves.

The Bank of England was the first to try formally and abandoned the approach soon after once they realised it was impossible to sustain.

At that point Monetarism was shown to be a flawed doctrine yet the profession has held onto it ever since in various morphed versions.

For references, these blog posts among others consider all of that:

1. Money multiplier – missing feared dead (July 16, 2010).

2. Money multiplier and other myths (April 21, 2009).

The CEPR article finishes with:

… it is not surprising that models that are essentially based on the loanable funds model, in which the role of banks is limited to the intermediation of funds created by savers, have difficulty in explaining the effects of the central bank’s policy rate on bank lending and financial stability.

They might have said, that such ‘models’ have difficulty explaining anything of interest about the real world.


I see a number of articles these days that reflect increased awareness of the shortcomings of mainstream economics.

But most fail to acknowledge the work that has been done previously and in many cases vilified that work.

At least there is some progress though.

That is enough for today!

(c) Copyright 2023 William Mitchell. All Rights Reserved.

This Post Has 7 Comments

  1. I have a page with a couple of quotes from the book “Post War Banking Policy” from 1928.

    It’s a book by The Right Honourable Reginald McKenna P.C. who was a former Chancellor of the Exchequer (1915-16) and ended up as Chairman of the Midland Bank in the 1920s.

    The pertinent one is:

    I am afraid the ordinary citizen will not like to be told that the banks or the Bank of England can create or destroy money. We are in the habit of thinking of money as wealth, as indeed it is in the hands of the individual who owns it, wealth in the most liquid form, and we do not like to hear that some private institution can create it at pleasure. It conjures up a picture of an autocratic and irresponsible body which by some black art of its own contriving can increase or diminish wealth, and presumably make a great deal of profit in the process

    Endogenous money is not new stuff. It was clearly common knowledge amongst London city types a century ago. Other works show it was common knowledge well before that.

    Mainstream economists invented a fantasy and sold it to the gullible.

  2. Micro economics disguised as macro should have been a warning sign to those who didn’t have a ideologic bias toward mainstream’s group think.
    Now, that we are on the brink of a total colapse of Milton Friedman’s fairy tales, it must be a worrying thought and a serious threat to the livelihood of anyone who built his reputation over a bunch of lies.
    Note: when I click the shortcut “How monetary policy affects bank lending and financial stability: A ‘credit creation theory of banking’ explanation”, I get a paper from the ECB (“The asymmetric effects of weather shocks on euro area inflation”).

  3. The CERP article came up for discussion on the Naked Capitalism blog last week (https://www.nakedcapitalism.com/2023/03/how-monetary-policy-affects-bank-lending-and-financial-stability-a-credit-creation-theory-of-banking-explanation.html). Its faux novelty immediately struck me. As I wrote in a comment, “Does this article say anything that post-Keynesians have not been saying for a long time … or is it merely the fact that these are orthodox economists making the point?”

  4. Well, they’re trying to sneakily own the ball. Over a period all these people will step up what they’ve been doing for some time: making, hopefully undetectable, micro-adjustments to their wrong views so that they come out the other end not peddling drivel, but never admitted they were wrong. It’s been all over the place.

    A robust grip on the history of economic theory (as above) will root it out. We’re in the midst of something I never thought I’d see, a real intellectual battlefield in economics rather than fakery on top of a dominant ideology. It’s all rather exciting.

  5. “We have always been at war with Eurasia”

    No less of a doublespeak and constant historical revisionism is occurring in mainstream economics than the one Orwell presented us with in Nineteen Eighty-Four. (“He who controls the past controls the future”)

  6. The frustration in this post reminds me of a piece from old times…

    “… You are educated, you are intelligent, you are proficient—
    But certainly not in order to steal—
    But look at yourself! You make yourself just like everyone else!
    Your deeds are perverse,
    And the example for all men is now the deceiver of the entire land.
    He who tends the garden of evil waters his field with corruption
    And cultivates his plot / with falsehood,
    So as to irrigate iniquity for ever. …”
    The Tale of The Eloquent Peasant, The literature of ancient Egypt, William Kelly Simpson

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