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Category Archives: Mainstream Myths

According to mainstream economics, customer deposits allow banks to on-lend those deposits and make loans. Banks then hold a portion of those deposits in “reserve” for customer withdrawals. You may have heard of this referred to as the “money multiplier.”

The reality is, of course, exactly the opposite: banks don’t need deposits to make loans because the loan itself creates the deposit.(1)

Banks make their loan determinations based on the credit-worthiness of the customer, their capital requirements (2) and the cost of obtaining any reserves it would need ( if any) after creating the loan.

This is called endogenous money, because the money supply is determined by the preferences of actors in the real economy. For example, your need to spend on credit expands the money supply and didn’t come from anyone else’s pre-existing deposit. So the appropriate causation says: Loans Create Deposits. Banks create loans ex nihilo (out of nothing).

(1) Marc Lavoie, Credit And Money: Overdraft Economies, And Post-Keynesian Economics, pp 67-69, Money And Macro Policy, ed. Marc Jarsulic, 1985.

(2) SEC rule changes in 2004 make even capital requirements a suspect drag on bank lending, particularly for investment banks.

In a previous post, we defined “sound money” as the practice of Governments to balance their budget over the business cycle.

Understanding why sound money principles lead to recession and depression requires an understanding of “sector balances.”

In a nutshell, the budget balances of the Government, domestic private sector and foreign sector will net to zero.  If we assume a balanced trade account (imports=exports) then the government surplus will exactly equal the private sector deficit.  Conversely, a government deficit will exactly equal the private sector surplus  (I had demonstrated this in the post linked to above, so you can go there and see it for yourself).

Once we have this, we can understand that when the Government runs consistent surpluses, the private sector will be in jeopardy.

Let’s say, for example, the Government runs a surplus of $200 billion for 3 straight years, and that the trade balance is neutral (imports=exports).  If this is the case, the private sector will have spent $600 billion more than they earned over the same period.  In order to keep up their spending, the private sector will be forced to either spend down existing savings or increase their borrowings by the same amount.

For reference, the last time the US ran consistent surpluses prior to the late 1990′s was the late 1920′s, just before the Great Depression.

This is why Governments very rarely run surpluses, why they never pay off the National Debt –the one time the US did this, in 1835, a particularly nasty depression resulted–and why attempting to run down deficits during a downturn in private credit creation, such as now, is a recipe for disaster.