Debunking the Myth of Neoclassical Money Creation

“Banks are financial intermediaries who transfer money from the savers to the borrowers” has become a very common explanation of the role of banks in our society. Well, this is precisely what many neoclassical economists, such as Robert Solow, believe is the role of the banks. It’s time to debunk this notion entirely.

For years, people blindly accepted the fact that banks are deposit-taking, money-lending institutions. In other words, banks are financial intermediaries acting as a channel to direct money from savers to borrowers. Legally, this simply isn’t true. Banks don’t take deposits and they don’t lend money.

Firstly, at law, the word deposit is meaningless. The legal reality is that banks don’t take deposits. The money you are giving to the bank is the equivalent of a loan. In short, banks borrow from the public.

Now comes the part of lending. It is a widely held belief that banks lend money, but this simply isn’t the case. The law clearly states that they are in the business of purchasing securities, namely your promissory notes. That’s all. For example, let’s say you have visited a bank to get a loan of $100,000 to purchase a house. You sign the loan document and the bank purchases your promissory notes.

Now what about the actual loan?

Well, the bank will say you will find the loaned money in your account. But that does not mean that they have “transferred” money to your account. All they have done is created a debt of $100,000 to your account and the equivalent sum of $100,000 as secured credit for the bank. In reality, no money has been created and no money has been transferred. The money which you think you are getting as a loan is simply the bank’s record of what it owes to you. That’s it.

In this process, banks make themselves creators of money and not just “financial intermediaries,” like the neoclassical economists believe they are.

After you secure the loan, one of two things happens:

1) You start making payments every month, amounting to $150,000 total with interest over the course of 5 years.

2) You fail to repay the loan and the bank repossesses the asset where you invested that loan.

All for the money that was never created in the first place.

In this way, private banks create “fictitious demand deposits,” where nobody has deposited anything and they create more loans for investors. This mechanism accounts for 97 percent of the money supply in our economy, and only 3 percent accounts for actual exchanges of notes and coins.

So the first myth that banks are financial intermediaries is utterly false. Banks are merely creators of money supply.

Secondly, due to this pervading misconception about money creation, we do not add the change in debt component while calculating gross domestic product (GDP).

As the neoclassicals put it: when banks transfer reserves, the saver’s purchasing power decreases and the borrower’s purchasing power increases by the same amount and so the net debt is zero in the end. This is the simplicity of economics at its finest. Since banks do not transfer reserves, there is no point in giving the borrower a part of the saver’s reserve.

What actually happens is banks create fictitious demand deposits and create money out of thin air, meaning they do not create anything in the first place but just register the loan as a corresponding debt to the borrower.

In this way, they shell out thousands of loans everyday by creating nothing, thus increasing the borrowers’ spending power way above the money that is deposited by the saver.

So there is a significant debt change in our economy which never gets added while computing GDP. Why is this?

Because of the oversimplification of economics by the neoclassicals.

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