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A Theory of Banking Made Out of Thin Air

Instances of self-styled Austrian economists bungling their banking theory seem almost as common these days as instances of theologians bungling their cosmology were six centuries ago.  One such instance, by the Cobden Centre's Sean Corrigan, occurs in the course of a long and meandering series of posts inspired by a four-way debate he took part in, with yours truly attending, at Oxford's Divinity School this May:

[I]magine that I take your IOU to the bank and that [sic] peculiar institution registers my claim upon its (largely intangible) resources in the form of a demand liability of the kind which–by custom, if not by legal privilege–routinely passes in the marketplace as money. Your promissory note–a title to a batch of future goods [sic] not yet in being–has now undergone what we might facetiously call an 'extreme maturity transformation' which it [sic] has conferred upon me the ability to bid for any other batch of present goods of like value without further delay. It should, however, be obvious that no such goods exist since you have not had time to generate any replacements for the ones whose use I, their [sic] lender [sic], supposedly forswore until such a time as your substitutes are ready to used [sic] to fulfil [sic] your obligations, something we agreed would be the case only at some nominated [sic] point in the future.

More claims to present goods than goods themselves now exist…and thus the actions we may now simultaneously undertake have become dangerously incongruous [sic]. Our [plans] have become instead a cause of what is an inflationary conflict no less than would be the case if I had sold you my place at the head of the queue for the cinema only to try and barge straight past you in a scramble for the seat in question.

Even setting aside the typos and malapropisms, Corrigan's prose isn't likely to inspire anyone to twine a garland around him for his lucidity.*  But one thing that is clear is that the bank lending that he has in mind involves three parties only: the banker, the borrower, and a debtor whose IOU to the borrower serves as the borrower's collateral.   For the sake of concreteness, let's call them the banker, the miller, and the baker; and let's imagine further that the miller, having offered the baker a ton of flour in exchange for a $101 30-day promissory note, uses the note to secure a $100 loan from the banker.

According to Corrigan the loan thus secured is inflationary because it allows the miller to take part in the "scramble" for present goods, even though he got the loan in exchange for "a title to a batch of future goods not yet in being."  In fact a promissory note or IOU isn't a "title" to anything, much as Austrians may like calling things "titles" that aren't such.  It is, well, a promise to pay.  And it is a promise to pay, not goods, but money.  Let us grant, nevertheless, that the note in question stands for goods–loaves of bread, for instance–that have yet to be produced or put on the market, the presumption being that bread will only eventually be made from the flour that was exchanged for the promise, to be put on the market at some still later date.  Consequently the loan, and the extra demand for goods that it unleashes, instead of coinciding with an increase in the supply of goods, anticipates such an increase, and to that extent seems bound to raise prices.  Bank lending appears analogous to creating fake "tickets" to an already fully-booked performance, allowing the new credit recipients to secure present goods, despite a lack of voluntary savings, simply by bidding goods away from others, that is, by forcing others to consume less, just as holders of fake tickets might take up seats that ought to have gone to holders of legitimate ones.

But the appearance is deceiving, for it depends crucially on Corrigan's having failed to consider all of the parties that usually take part whenever a competitive bank makes a loan.  To see this, we need only consider our imaginary banker's fate if he makes the loan in question without anyone's cooperation save that of the miller, who is supposed to repay the loan, and the baker, whose IOU secures the loan in case the miller defaults.  The banker's fate hinges on the fact that bank borrowers borrow money, not to hold, but to spend.  So once our miller has $100 credited to his account, he uses it to purchase wheat or other supplies, or to pay his workers, or to settle accounts due–in short, to make whatever payments he cannot afford to put off making for another 30 days–payments that compelled him to borrow money in the first place.  So the miller writes checks, and writes them quickly, to the tune of $100.  And those checks are paid to persons who, if the banking system is competitive, are likely to deposit them in rival banks.  Those banks in turn return the checks for payment, directly or through a bank clearinghouse.  So by lending $100 to the miller, the banker generates $100-worth of claims for immediate payment against his institution.  Those claims, it goes without saying, cannot be settled directly using the baker's promissory note, which has yet to mature.  They must be settled in cash, which means that the bank must either have such cash on hand, or fail.

If the bank fails, it obviously hasn't been able to get away with creating credit "out of thin air," and presumably there will not be many banks rushing to replicate its irresponsible behavior.  If, on the other hand, the bank has the cash needed to avoid failing, the obvious question arises: where does the cash come from?   Two answers suggest themselves.  One is that it comes from the bank owners themselves, that is, from capitalists.  The other is that it comes from persons who deposited it with the bank, presumably in return for services or a share of its interest earnings or both.   In either case, it should be apparent that a competitive bank cannot lend, or rather that it cannot lend and profit by it, unless it has, or quickly gets hold of, cash reserves at least equal to the amount of the loan.  That means, in turn, that for a bank to lend someone has to have engaged in prior voluntarily saving, by refraining from spending or from otherwise cashing in their own claims against it.  Our banker cannot, in other words, simply create loans out of thin air, and thereby drive prices upward.  Instead, if his business is to survive he must act as a go-between or intermediary, lending to the miller only what he has induced others to lend to him.   These ultimate suppliers of bank credit, by refraining from consuming, place downward pressure on prices precisely equal to the upward pressure stemming from the banks' lending. By airbrushing them out of his account of the workings of a typical bank, Corrigan succeeds in painting a picture of the banking business that's as misleading as it is lurid.

All this, of course, refers only to ordinary commercial bankers–bankers who must do business the hard way, by competing head-on with dozens if not hundreds or even thousands of more-or-less equally privileged rivals.  It doesn't apply to central bankers who, by being able to print-up arbitrary amounts of their economies' ultimate cash reserve asset, are indeed capable of making loans "out of thin air," without having to struggle to first gather funding from others.  This distinction is what gives central bankers their extraordinary power to do either good (as their proponents imagine them doing) or harm (as they tend to do, more often than not, in fact).   By suggesting, in short, that there is no difference between the credit-creating capacity of ordinary commercial banks and that of central banks, accounts like Corrigan's do a great disservice, by making it harder for people to recognize the unique threat posed by today's monopoly suppliers of irredeemable paper currency.

Addendum (8/12/13): A correspondent has alerted me to this post, accusing me of having joined Paul Krugman and others in making a "sport" of bashing Austrian economics, and suggesting that I have failed in the post above and elsewhere to recognize the difference between demand and savings deposits, only the last of which (according to the Austrians I criticize) represent true savings. In fact, the distinction in question is absolutely irrelevant to my argument above, the point of which is that a competitive bank cannot get away with creating credit out of thin air. Instead it can afford to lend only to the extent that others save with it. Whether the savings come to a bank in the shape of "demand" or "time" deposits matters only to the extent that it influences the length of time for which the savings in question are likely to remain at the bank's disposal. The bank is responsible for limiting its credits to amounts consistent with the total extent of credit supplied to it by its liability holders, allowing also for the timing of withdrawals. A banker that misjudges the timing in question exposes his bank to the same risk of failure that confronts one who attempts to extend credit without having received any prior deposits. So whether a bank derives its funding from demand or from time deposits, the conclusion stands: if the bank is to survive, the bank's lending must be limited to the amount of real savings it has on hand.

As for my being just another anti-Austrian economist, that's a calumny: I am a fan of Austrian economics, as embodied in the works of such great Austrian pioneers as Menger, Mises, and Hayek, as well as in those of many living members of the school. What deserves to be ridiculed is the unending tide of junk written, mostly on the internet, by people who label themselves "Austrian economists" despite appearing to know only as much about economics as I know about string theory, which is to say, next to nothing.

*Some of Corrigan's more florid passages read as if concocted by tossing one copy each of Finnegans Wake, Sartor Resartus, and the Communist Manifesto into a blender and hitting "Pulse" once or twice.  Consider: "Among other enormities, the fact that production must necessarily precede consumption and that it is the first which comprises the creation of wealth and the second which encompasses its destruction, was far beyond the ken of the spoiled Bloomsbury elitist who exhibited a life-long contempt of the aspirations and mores of the bourgeoisie and who hence imagined that policy was at its finest when, like an over-indulgent aunt, it was pliantly accommodating the otherwise ‘ineffective’ demand being volubly expressed by the old dame’s petulant nephew as he stamped his foot in the tantrum he was throwing up against the sweet-shop window." When I encounter such prose I cannot quite decide whether to throw up a tantrum myself, or simply to throw up.