Monday, December 22, 2014

Who Knew!? Banks Create Money out of Nothing

This recent paper by Richard A. Werner should be of interest to Post Keynesians:
Richard A. Werner, “Can Banks individually create Money out of Nothing? — The Theories and the Empirical Evidence,” International Review of Financial Analysis 36 (2014): 1–19.
From the abstract:
“This paper presents the first empirical evidence in the history of banking on the question of whether banks can create money out of nothing. The banking crisis has revived interest in this issue, but it had remained unsettled. Three hypotheses are recognised in the literature. According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it extends credit (the credit creation theory of banking). … This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, ‘out of thin air.’”
I do not mean to be snide or devalue this paper, which I suppose must be seen as a sign of progress in mainstream economics, but surely many economists and historians who have paid attention to the nature and history of modern banking already know that the empirical evidence demonstrates that banks create money out of nothing.

I also feel that plenty of economists with a “fractional reserve theory of banking” also recognise that banks create money from nothing too and are therefore also advocates of the “credit creation theory” of banking.

Despite that, this is an excellent paper, especially its comments on the need for better financial regulation and the inadequacy of the Basel regulations (Werner 2014: 2, 17–18). Werner provides a really useful literature review of the supporters of the “credit creation theory” of banking and their writings (Werner 2014: 2–6).

He lists Knut Wicksell, Henry Dunning Macleod, Hartley Withers, Schumpeter, Robert H. Howe, Ralph Hawtrey, Albert L. Hahn, and Keynes (at least in the Tract on Monetary Reform [1923]) as leading advocates of the “credit creation”/endogenous money theory of banking, and how this view even seemed to be widespread by the 1920s (Werner 2014: 6).

Werner also notes how the correct “credit creation theory” was displaced from the 1930s–1960s by advocates of a “fractional reserve theory of banking” that denied that individual banks can create money, even if the banking system in the aggregate does (Werner 2014: 7).

Paradoxically, Keynes by the time of the Treatise on Money seems to have endorsed the “fractional reserve theory” and, worse still, in the General Theory the financial intermediation theory (Werner 2014: 7, 9), a point which was noted with dismay by Schumpeter (Werner 2014: 9). One of the most interesting aspects of Werner’ paper is how Keynes’ regression to the “financial intermediation” theory of banking in the General Theory had a terribly bad influence on neoclassical synthesis Keynesianism and modern mainstream neoclassical economics, which owing in part to Keynes and the work of James Tobin and others has reverted to the “financial intermediation” theory (Werner 2014: 9–10).

This has been a stark and embarrassing regression in knowledge by mainstream economics, and Werner is absolutely right to complain that “since the 1930s, economists have moved further and further away from the truth, instead of coming closer to it” (Werner 2014: 16).

But, strangely, on p. 11 of the article Werner seems to be saying that “Post-Keynesians” also endorse the “financial intermediation” theory of banking (Werner 2014: 11), which is a most bizarre error.

The important empirical evidence that Werner provides was his personal borrowing of €200,000 from the Raiffeisenbank Wildenberg e.G. bank (in a town of Lower Bavaria) in August 2013, and the bank’s disclosure of how this occurred in accordance with its standard internal credit procedure, accounting practices, balance sheet and IT procedure (Werner 2014: 13–14). The bank did not borrow extra reserves or obtain new “deposits” before it made the loan, and its reserves remained fixed at €350,000 both immediately before and after the loan transaction (Werner 2014: 14). The daily account statements of the bank, obtained by Werner, demonstrate that its accounting activities and balance sheet contradict both the “fractional reserve theory of banking” and “financial intermediation” theory (Werner 2014: 14–15).

This is Werner’s (somewhat rhetorical?) conclusion:
“Thus it can now be said with confidence for the first time – possibly in the 5000 years’ history of banking – that it has been empirically demonstrated that each individual bank creates credit and money out of nothing, when it extends what is called a ‘bank loan’. The bank does not loan any existing money, but instead creates new money. The money supply is created as ‘fairy dust’ produced by the banks out of thin air.” (Werner 2014: 16).
I suppose Post Keynesians should be very pleased indeed with this conclusion, but will be dismayed by the (as far as I can see) total lack in Werner’s article of any reference to their work on banking and endogenous money which already reached this conclusion decades ago.

One final point can be made about Keynes: most probably Werner is right that Keynes’ exogenous money approach in the General Theory of Employment, Interest, and Money (1936) has had a pernicious effect on the modern theory of banking, but, as far as I know, Keynes reverted to the endogenous money theory in his article “Alternative Theories of the Rate of Interest” (1937), where he stressed the finance motive as a basis of endogenous money. Perhaps the trouble is also that many economists have not bothered to read what Keynes wrote after the General Theory.

Keynes, J. M. 1937. “Alternative Theories of the Rate of Interest,” The Economic Journal 47.186: 241–252

Werner, Richard A. 2014. “Can Banks individually create Money out of Nothing? — The Theories and the Empirical Evidence,” International Review of Financial Analysis 36: 1–19.

Sunday, December 21, 2014

Are all Facts Theory-Laden?

If we define “fact” as a synthetic a posteriori proposition, then it would appear that nearly all facts are to some extent “theory-laden,”* but that does not vindicate apriorism or Kant’s synthetic a priori knowledge, nor does it discredit the moderate form of empiricism that is rightly at the heart of modern methodology and epistemology in the natural and social sciences.

When we interpret some data or fact in the natural and social sciences ordinarily we will clearly pre-suppose a number of theories when we make interpretations of the facts.

But the standard theories we presuppose in either the natural sciences and social sciences have already been justified empirically, by experience, inductive argument and inference to the best explanation (which is just another non-deductive, or inductive form of reasoning) by long debates and arguments in philosophy or in the natural and social sciences too.

At the most basic level, there are all sorts of theories we do have about the world in which we exist and we make when we do natural and social sciences (including economics), such as the following:
(1) the real existence of other human minds;

(2) the real existence of an external world of matter and energy that is the causal origin of our sensory data (= an indirect realist ontology);

(3) that the past had real existence (and is not some figment of our imagination);

(4) the existence of a set of physical and chemical laws that have been discovered by the natural sciences that account for the order and nature of the universe;

(5) the view that our earth is about 4.54 billion years old;

(6) the view that all livings things on our earth are the product of a Darwinian process of evolution by natural selection (and, if one wants to be technical, also by (i) sexual selection and (ii) artificial selection by humans);

(7) the human mind is the product of the physical activity of the brain, and so on.
And of course we can keep listing such theories too as we move from natural science to the social sciences. (And note I use the word “theory” in the sense of a hypothesis that has been confirmed or justified by evidence.)

Theories (1) to (3) belong to the philosophical sub-disciplines we call ontology and epistemology. The theory that other human minds really exist and that an external world exists can only be justified empirically by inductive argument by analogy and inference to the best explanation. There are no a priori or deductive arguments that can establish the necessary truth of these ideas. In fact, you cannot prove they are necessarily true at all: they are synthetic a posteriori propositions whose truth is extremely probable at best, and we know this only by experience, induction or inference to the best explanation.

Exactly the same thing can be said of propositions (4) to (7): these are empirical propositions of the natural sciences that are synthetic a posteriori: their truth is extremely probable at best and is confirmed by experience, induction or inference to the best explanation.

We could continue listing “prior” theories that a social scientist like an economist assumes when interpreting some data or facts, but we would also find that these too are nothing but empirical propositions whose truth can be believed because we have good empirical evidence to do so. We will also encounter useful concepts that are formulated to categorise and classify objects and phenomena in the world which are analytic a priori (or true by definition because we define them in such-and-such a way). While this does presuppose a further type of “theory” when looking at data or facts, the ultimate test of whether a system of analytic classifications and definitions is useful and appropriate is how well it can classify and describe the world, so the actual justification for its use is not divorced from empiricism.

At some point of course we will start to encounter bad and false empirical theories or assumptions in some disciplines, such as in neoclassical economics. But even here the only way to know if a theory about the real world is true or false is by experience, induction or inference to the best explanation. You are not going to do it by armchair apriorism.

So what is the substantive point here?

Mises claimed that the German Historical School and the logical positivist empiricists of his time thought that they could take facts without recourse to any theory. Perhaps they did. They were wrong, and modern empiricism has since moved on.

And clearly heterodox economists of the non-neoclassical Institutionalist and Post Keynesian schools seem to accept that facts are theory-laden too (e.g., see Hodgson 1999: 146; Lawson 1997: 295).

But the lazy comment that all facts are “theory-laden” is still used by apriorists like Austrian economists to attack modern empiricism in their attempts to vindicate the intellectually bankrupt method called Mises’ praxeology.

It is an absurd exercise in vain, for the admission that “all facts are theory-laden” does not vindicate epistemological apriorism in either the natural or social sciences and not in economics either, and does not refute a more moderate version of empiricism that accepts that we do indeed have many prior theories but that they are also justified empirically.

The “all facts are theory-laden” mantra does not discredit the modern empirical method. Nor does it refute the observation that we have no good reason to think that all of our knowledge of the real world is anything but empirical and justified empirically: we have no good reason to think epistemological apriorism is a viable or necessary method in our study of the world in all of its complexity, from the natural world to the complex world of human societies.

Any given datum or fact may indeed presuppose a long list of prior theories or propositions. But we will find that these theories or propositions are themselves also empirical and have been justified too by some other social or natural scientist or philosopher who asked the question “how do we know such-and-such is true” and justified its truth convincingly a posteriori by experience, induction or inference to the best explanation.

* The only possible exception I can think of is Descartes’s cogito ergo sum (or cogito) argument, but on closer inspection probably many would argue that it is not free from a prior theory/assumption that there is an “I” that must be understood as a discrete conscious entity and perceiving subject that perceives objects of perception.

On a related point if the cogito argument is reformulated to conclude that some perceptions, sensations or thinking exist or are occurring, then it might possibly be considered an ontologically and epistemologically necessary a posteriori truth (but there are also arguments against this), and even if it were it takes you nowhere epistemologically: it is a dead end and cannot be used as a secure foundation for apriorism, nor to deduce any necessary truth in the natural and social sciences.

Hodgson, Geoffrey M. 1999. Economics and Utopia: Why the Learning Economy is not the End of History. Routledge, London and New York.

Lawson, Tony. 1997. Economics and Reality. Routledge, London and New York.