Myths of Money Creation

What students are almost universally taught about Money Creation, is almost the opposite of the truth. The standard Monetary Theory course teaches that the government creates High Powered Money, or the Monetary Base. This is called M0 or M1, or narrow money. Loans made by private banks in a fractional reserve banking system multiply this monetary base to create broad money or M2. This discussion implies that the government is in control of the process of money creation. Furthermore, no distinction is made between narrow money, which is created by the government, and broad money, which is created by the private banks. As we will show, these two types of money are very different from each other, and have different effects on the economic system. Furthermore, the private sector can create any amount of money, and the government has no control over this process. Sigurjonsson (2105) provides a detailed discussion and explanation of this issue.

In financially advanced economies, the monetary base is often less than 5% of broad money. Thus more than 95% of the money in existence is created by private banks. The controversy between endogenous and exogenous theories of money lies in how much control private banks have in this process. According to the dominant exogenous theories, the process of money creation by banks is mechanical and automatic, which means that if the governments sets the monetary base to be MB, then the amount of broad money which comes into existence is M2 = k x MB, where k is the deposit multiplier. The endogenous money theories say, quite sensibly, that banks and borrowers exercise a lot of discretion, so that k is very much dependent on what they choose to do. This means that 95% of the stock is created at the discretion of the private sector. Thus, the amount of money in circulation is not determined by the government, but rather depends on choices made by banks and borrowers.

There is strong evidence that the endogenous money view is correct. Mcleay et. al. (2014) of the Bank of England explain in detail the private creation of money by banks. Benes and Kumhof (2012) of IMF write that “The deposit multiplier is simply, in the words of Kydland and Prescott (1990), a myth. And because of this, private banks are almost fully in control of the money creation process.” Mian and Sufi (2014) provide evidence that the Quantitative Easing regime adopted in the recent past, in which Central Banks created huge amounts of High Powered money, had NO effect on the stock of broad money. In effect the Central Bank was powerless to change the money supply, contrary to the conventional theory of exogenous money. Similarly, the Iceland plan for monetary reform (Sigurjonsson, March 2015) is based on the experience of the central bank, that it was unable to control money supply in the post-crisis era. This same problem was noted by the creators of the Chicago Plan, in the aftermath of the Great Depression of 1929; see Benes and Kumhof (2012).