Banks Are Creators of Money — A Serious Oversight in Economic Theory

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Mainstream economics still largely ignores the role of money in an economy. It is treated as a non-essential frill and added on in a way that does disturb the model of an equilibrium barter economy on which neoclassical economics relies.

As Keynes and others discovered, accounting for money in proper fashion upsets the myth of an economy that is supposed to be self-regulating and keeping itself in a benign state of equilibrium.

Schumpeter acknowledged as much in 1954, when he suggested that it has proven extraordinarily difficult for economists to realise that loans and investments by banks create deposits and hence money:

Es hat sich für Ökonomen als außerordentlich schwierig herausgestellt, zu erkennen, dass Bankkredite und Investitionen der Banken Einlagen [und damit Geld] schaffen.

As a consequence economists are blind to the disruptions that money can create in the economy. Little wonder they were caught unawares by the Great Financial Crisis of 2007.

Borio urges

to capture more deeply the monetary nature of our economies. [... M]odels should deal with true monetary economies, not with real economies treated as monetary ones, as is sometimes the case (eg, Borio and Disyatat (2011)).17 Financial contracts are set in nominal, not in real, terms. More importantly, the banking system does not simply transfer real resources, more or less efficiently, from one sector to another; it generates (nominal) purchasing power. Deposits are not endowments that precede loan formation; it is loans that create deposits. Money is not a “friction” but a necessary ingredient that improves over barter. And while the generation of purchasing power acts as oil for the economic machine, it can, in the process, open the door to instability, when combined with some of the previous elements. Working with better representations of monetary economies should help cast further light on the aggregate and sectoral distortions that arise in the real economy when credit creation becomes unanchored, poorly pinned down by loose perceptions of value and risks. [...] Only then will it be possible to fully understand the role that monetary policy plays in the macroeconomy. And in all probability, this will require us to move away from the heavy focus on equilibrium concepts and methods to analyse business fluctuations and to rediscover the merits of disequilibrium analysis, such as that stressed by Wicksell (1898)(Borio and Disyatat (2011)).

The source. My emphasis.