Repeat After Me: Banks Cannot And Do Not “Lend Out” Reserves

About two weeks ago Standard&Poor’s published an economic research paper with the remarkable title Repeat After Me: Banks Cannot And Do Not “Lend Out” Reserves. It is a must read for economists, bankers, policymakers, politicians and even the general public. Two quotes to give you an impression:

“John Maynard Keynes famously wrote that: “Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” (1) A modern example of that dictum, relevant to the economy, policy, and markets, is the widespread view that banks can “lend out” their reserves (deposits) at the central bank, as if bank reserves represented a pool of money that is just waiting to “flow into” bank lending. Because such a thing cannot occur and therefore has not occurred, the point is usually made in reverse: banks currently are not “lending out” their reserves–rather they are “parking” their reserves at the central bank or leaving them “idle.” But that they might lend them out in the future is a lurking risk and a reason to be cautious about the central bank engaging in aggressive quantitative easing (QE) (2).” (p2)

And:

“Banks lend by simultaneously creating a loan asset and a deposit liability on their balance sheet. That is why it is called credit “creation”– credit is created literally out of thin air (or with the stroke of a keyboard). The loan is not created out of reserves. And the loan is not created out of deposits: Loans create deposits, not the other way around. Then the deposits need a certain amount of reserves to be held against them, and the central bank supplies them.” (p6)

Without understanding the basics of money creation, money destruction and banking, it is impossible to solve the current crisis. Unfortunately a lot of text books (and a lot of people) give a wrong explanation of the current monetary system. Fortunately there are more and more economists queueing up to dismiss these wrong explanations. Positive Money made a nice overview.  Slowly but surely our knowledge of the system is increasing….