#77: Markets and The Madness of Crowds — Robert Shiller




Robert J. Shiller

Yale University

An indexed unit of account, such as the Unidad de Fomento (UF)

in Chile, is a money analogue that can be used to price items for sale

or to specify amounts to be repaid in the future. While it is in a sense

a sort of money, it is not true money since it is not a medium of

exchange and it has no physical embodiment like coins, notes, or

reserve balances. An exchange rate between the unit and the true

money or legal tender (in Chile, the peso) is defined using an index

number (such as the consumer price index), and payments are executed

in money. Indexed units of account thus facilitate payments

that are tied to the index number, without being a means of payment.

How can the indexed unit of account be called an analogue of

money when it does not have any physical embodiment? Money,

the textbooks have long said, has three attributes: it is a medium of

exchange, a store of value, and a unit of account. As a medium of

exchange, it is a physical object or account balance that passes from

person to person when items are bought and sold. This role is very

important because it eliminates the need for ordinary barter, which

is an inefficient means of effecting trade as it requires discovering a

double coincidence of wants. The store of value function of money

allows people to store purchasing power between transactions, which

allows them to transact more efficiently, even though money is not

the primary medium for long-term storage of value. This function is

central to the cash-in-advance theoretical literature in monetary

I am indebted to Michael Bordo, Robert Hall, Michael Krause, Gil Mehrez, Felipe

Morandé, Andrew Powell, James Tobin, and Salvador Valdés-Prieto for helpful comments

and discussions. Jinku Lee provided research assistance. Research support

was provided by the Central Bank of Chile.

Indexation, Inflation, and Monetary Policy, edited by Fernando Lefort and Klaus

Schmidt-Hebbel, Santiago, Chile. C 2002 Central Bank of Chile.


106 Robert J. Shiller

economics. The third function, the unit of account, is that prices are

quoted in money units.

The use of an indexed unit of account, such as the UF in Chile,

separates the first two functions from the third. A distinction can

then be made between the unit of account and the currency or legal

tender or between the money of account and the money (see Keynes,

1930, p. 3). In Chile, the peso serves as the medium of exchange and

the store of value (and also partly fills the unit of account function),

while another unit of account, the UF, is fixed in real terms. Prices

are often quoted in UFs.

This paper reviews the history of and reasons for the use of an

indexed unit of account and then asks why there might be an advantage

to separating the three functions of money, allowing a unit of

account that is not the same as the currency. I argue not only that the

Chilean UF is an excellent idea that should be imitated around the

world, but also that another indexed unit of account, defined in

terms of nominal incomes rather than the consumer price index,

should also be created. Moreover, I consider whether the indexed

units of account should be “monetized” by creating institutions to

allow transactions to be carried out in reference to the units of

account. With automated debit card, credit card, and electronic

funds transfer systems, it may be possible to specify all prices in

terms of indexed units of account, thus effectively indexing all prices.


The Unidad de Fomento (UF) was introduced in Chile in January

1967 by the Superintendencia de Bancos e Instituciones Financieras,

a government regulatory agency. As far as I have been able to determine,

the UF is the world’s first successful indexed unit of account.

That is, it is the first case of indexation being achieved by quoting

prices in a money-like unit, rather than relying on an indexation


Chile had issued an earlier unit of account in 1960, namely, the

Unidad Reajustable or UR, which was based both on price and

wage indexes, but it was not very successful. The UF is an amount

of currency related to the Índice de Precios al Consumidor (IPC),

the Chilean consumer price index. The UF was originally calculated

three times a year, and it was calculated monthly between

1975 and 1977, but daily adjustments in the UF have been made

Indexed Units of Account: Theory and Assessment 107

since 1977. The UF is now a lagged daily interpolation of the monthly

consumer price index. The formula for computing the UF on day t is

UF t

UF t 1

1 F

1 d


where F is either the inflation rate for the calendar month preceding

the calendar month in which t falls if t is between day ten and the last

day of the month (and d is the number of days in the calendar month

in which t falls) or the inflation rate for the second calendar month

before the calendar month in which t falls if t is between day one and

day nine of the month (and d is the number of days in the calendar

month before the calendar month in which t falls). Since the inflation

rate for a calendar month is computed using the consumer price index

for that month and for the preceding month, the UFs within a given

calendar month will depend on the consumer price index for each of

the three preceding months. In April, for example, the UFs for April 1

through 9 depend on the consumer price index for January and February

and for April 10 through 30 on the consumer price index for February

and March.

UFs were not generally used by the public until the early 1980s,

about fifteen years after their introduction, though only a few years

after the values were produced on a daily basis (Levin, 1995). The UF

is now widely used in Chile.

Most bank deposits in Chile are thirty-day nonindexed deposits or

ninety-day indexed deposits whose rates are expressed in terms of

the UF. Interest rates on the indexed deposits are expressed as a

premium over the UF. On maturity, the deposits are converted back

to pesos at the current UF rate. Because indexed and unindexed bank

deposits coexist, one might say that the Chilean banking system is

partially indexed using the UF. Deposits denominated in U.S. dollars

are also permitted for maturities over thirty days. The UF is used in

Chile for nearly all mortgages, car loans, and long-term government

securities. All taxes are expressed in UFs. Pension payments are automatically

tied to the UF. Executive stock options sometimes have

strike prices denominated in UFs. The UF is widely used for rent

payments. Alimony and child support payments are often denominated

in UFs. Office properties for sale are usually quoted in UFs.

Houses for sale are often quoted in UFs, though pesos are also used. The

UF is not so commonly used for listing the selling prices of automobiles,

however, nor is it used directly for setting salaries. Wages and salaries

108 Robert J. Shiller

are denominated in pesos and only indirectly influenced by the UF,

in that the change in the peso value of the UF is taken into account

in wage and salary deliberations.



While the UF is apparently the first successful unit of account

indexed to a true price index, units of account separate from money

have been used for millennia. Historically, units of account precede

money altogether. Trade in terms of precious metals, rather than any

money, preceded the invention of coinage in the seventh century B.C.

Units of weight, such as the talent or the shekel, evolved into units of

money when coins were minted with specified relations to the weight.

Because governments could not be trusted to maintain the weight of

the coinage, however, a tradition developed of writing contracts in

units that did not correspond to any current coins. Einaudi (1953, pp.

234–35) describes the situation as follows:

Today each country has only one monetary unit: the lira, the franc,

mark, pound sterling, or dollar. This is the system established by the

French assemblies at the end of the eighteenth century.... Prior to the

French Revolution, the monetary system of most European countries

was based on altogether different principles. Contemporary authors

could take these principles for granted and did not have to explain

them to others. Their strange terminology causes us, who live in

another world, to wander for a while in a dark forest. By and by, we

finally understand the tacit assumptions of their discourses. The

key, needed to interpret the apparent confusion of the monetary

treatises written prior to the eighteenth century, is the disjunction

between a monetary unit and a standard of value and of deferred

payment and another monetary unit used as a medium of exchange.

In medieval and Renaissance times, even contracts that were explicitly

written in terms of units of currency that were circulating as

coins sometimes were understood to be executed in terms of some

other measure. For example, in Milan in 1445, a debt of one florin

would not be paid with one of the gold florin coins, but rather in an

amount computed under the assumption that the florin was still worth

384 silver deniers—and not the 768 deniers that the florin coin was

then worth (see Cipolla, 1956).

Indexed Units of Account: Theory and Assessment 109

Since there were often no coins in circulation that corresponded

to these units, the actual units of account were sometimes called

imaginary money or, alternatively, moneta numeraria, money of account,

ideal money, political money, or ghost money. From the time

of Charlemagne, trade and contracts in Europe were substantially

based on the moneta numeraria called the pound, (or, equivalently,

the livre or lira), which was always worth 20 sous (shillings) and each

sou worth 12 deniers (pence) (see Einaudi, 1953). Ultimately, the standard

of value represented by this system was the silver denarius issued

by Charlemagne in the late eighth and early ninth centuries—

coins that were no longer circulating, or even seen, later in the middle

ages and in the Renaissance. Charlemagne’s denarius weighed one-

240th of a troy pound; the earlier Roman denarius had gone through

repeated debasements and was not a unit of account in medieval or

Renaissance times. Because they are even fractions, the sou (at twelve

deniers) and pound were natural units of account, but Charlemagne

never issued coins representing these values. Actual exchange was

executed in terms of current coinage, which had many names from

the realms that issued them, including angels, blanks, crowns, crazies,

doblons, dollars, douzains, ducats, ducatoons, écus, farthings, florins,

guilders, louis, moutons, nobles, obols, phillipi, reals, sovereigns,

stivers, and testoons. Many of these would circulate simultaneously

in each country, a situation that would have created tremendous confusion

if there had not been a standard unit of account.

Aspects of this ancient system did, of course, continue into the

nineteenth century as a result of governments’ efforts to maintain

bimetallic standards with fixed exchange rates between the coins of

different metals. This practice sometimes caused the coin of lower

value to disappear from circulation, a tendency that is predicted in

Gresham’s Law. In other cases, people began to adopt the convention

that only one of the coins would be the money of account, while the

other’s price was allowed to float against it despite government proclamations

to the contrary (see Rolnick and Weber, 1986).

The only aspect of the UF that was really new when it was introduced

in 1967, therefore, is that it was based not on a single commodity

but on a representative consumer basket. This innovation was

indeed significant, since the management of risks is much better

handled in terms of such an index rather than in terms of a single

good. It is not surprising that the innovation represented by the UF

was not adopted in ancient or medieval times, despite the apparent

110 Robert J. Shiller

simplicity of the idea of index numbers. There was no published theory

of index numbers, and there was no governmental authority that

could plausibly have attempted to start a new social convention of

denominating contracts in terms of such indexed units. The advantage

of defining contracts in terms of the single commodity, the precious

metal, rather than the currency, was obvious enough to ensure

that the practice would continue over the centuries, but the next

step, the indexed unit of account, was not at all obvious or easy.


The European Currency Unit (called the ecu) might be regarded

as a UF analogue, in that it is based on an index of currencies. The

ecu, which was created in 1979, was defined as a basket of European

currencies. It was regarded as less vulnerable to runaway inflation

than were the individual currencies, since it was essentially

a diversified portfolio of currencies. Partly for this reason, a substantial

amount of European private long-term debt was ultimately

denominated in ecus (see Bordo and Schwartz, 1989). (A more important

reason for the private use of the ecu may have been circumventing

exchange and capital controls.) Since the ecu is not based

on a broad index of prices, wages, or incomes, however, I would not

call it a true indexed unit of account.

A number of examples of true indexed units of account can be

found outside of Chile. While these are not yet as ingrained in

their countries’ economies as the UF is in Chile, they do represent

important beginnings. In 1993 Ecuador created a unit of account

modeled after the UF. It is called the Unidad de Valor Constante

(UVC) (see Polit, 1994). Mexico similarly copied the Chilean UF in

1995 by creating a unit of value called the Unidad de Inversión

(UDI). The UDIs began at a par of one to one with the peso on

April 4, 1995, and the peso value of the UDI increases one to one

with consumer inflation. The Bank of Mexico publishes the value

of the UDI on the 10th and 26th of every month based on the

national consumer price index. Mexican banks offer UDI-denominated

instruments and use the interpolated published values of

the UDI to make daily advances.

Colombia has also copied the UF, with its Unidad de Poder

Adquisitivo Constante (UPAC), or unit of constant purchasing power.

Indexed Units of Account: Theory and Assessment 111

The UPAC is used for mortgage loans and for financing construction

by savings and housing corporations (see Bernardez, 1996).

Uruguay has a unit of account called the Unidad Reajustable

(UR), which is used to index government pension payments and,

since 1996, to index government bonds. The UR is based on a wage

index, rather than a consumer price index; I discuss the possible

advantages of such a variation on the UF below.

In the Ukraine, a unit of account called the uslovnaya edinitsa

(conventional unit) or y.e. has been used since 1995. Prices in stores, as

well as houses, cars, and other items advertised for sale in newspapers,

are often denominated in these units. The units came into use after the

government prohibited pricing in foreign currencies during a period of

high inflation in 1995. Despite their superficial similarity to the indexed

units of Latin America, however, these units are not true indexed units

of account. In fact, the government does not even decree the definition of

the units. When the unit is used in ordinary advertisements, such as

in an advertisement for a home for sale, it is understood to be a

disguised price in the U.S. dollar. Other definitions of the unit are

also used. Stores post their conversion rate from y.e. to the currency,

which often deviates substantially from the dollar exchange rate.


While the Unidad de Fomento is being copied by several countries,

other Latin American countries are currently moving to deindex

the economy, to reduce or even eliminate the reliance on indexation

schemes. Now that the inflation rate is down throughout most of Latin

America, many feel that it is time to return to economic institutions

that are more akin to those in the rest of the world.

Deindexation proposals are not new in Chile. In 1986, the Pinochet

government reacted to complaints from debtors such as farmers with

a proposal to freeze the UF and at the same time to extend the repayment

of debts. Fortunately, the UF was not frozen, as such a move

would have damaged confidence in any future effort to revive the UF.

In the fall of 1996 Nicolás Eyzaguirre, the research director of the

Central Bank of Chile, gave a speech in which he questioned whether

the widespread use of the UF indexation system should be reconsidered,

as it represented a possible obstacle to low inflation in the

future. According to Eyzaguirre, “It is a unique paradox, unlike any

112 Robert J. Shiller

other in the world: an extremely low inflation rate with all business

and financial contracts protected against inflation.” 1 An editorial in

the Chilean newspaper La Nación concurred:

Indexation emerged in Chile at a time when high inflation rates

compelled the government to adopt precautions in order to strengthen

the financial market. The situation has changed, as all the indicators

prove, but the indexation mechanism persists and has now become

an obstacle to current anti-inflationary aims rather than a palliative.

At any rate, putting an end to indexation is not easy because it

has become indispensable to the way our economy functions. The

economy’s different actors have already made contracts based on the

system of indexation, contracts which cannot be modified from one day

to the next. We need to discover ways of gradually removing the system

from our economy.... If we really want to reach inflation rates of two or

three percent—an aim set by the Central Bank as ideal—we are going

to have to do away with indexation. 2

Bankers Trust issued a report in 1993 asserting a similar position:

BT concludes that tight monetary policies won’t be enough to cut

inflation significantly. The government could instead abolish the

Unidad de Fomento (UF), the unit of measure that sets worker salary

expectations and also is applied as a variable index to virtually all

mortgages, car loans, and government debt securities.

On 14 August 1997, Carlos Massad, president of the Central

Bank of Chile, gave a speech at the Latin American meeting of the

Econometric Society in Santiago, in which he expressed the opinion

that the UF should be phased out in a matter of some years.

In Mexico, spokesmen for the Mexican Businessmen’s Council

(Coparmex) and the newsletter El Inversionista Mexicano (EIM) have

already criticized the UDI as being inflationary (see Levin, 1995).

Fortunately, deindexation does not seem likely to involve scrapping

the indexed units of account any time soon. In Chile, for example,

deindexation in the short run may mean little more than

lengthening the maturities of nonindexed debt from the very short

maturities that currently predominate to something intermediate.

1. “The Counterweight of an Indexed Economy,” La Nación, 1 November 1996.

2. “The Counterweight of an Indexed Economy,” La Nación, 1 November 1996.

Indexed Units of Account: Theory and Assessment 113



Figure 1 plots the inflation rate in Chile since 1960. Point A marks

the date 1967, when the Unidad de Fomento was first introduced.

Point B on the figure marks 1982, when the Unidad de Fomento first

became commonplace (roughly speaking). The figure gives no evidence

that the introduction of the UF was inflationary.

Still, the concern is legitimate that any indexation scheme for

wages and salaries may contain an inflationary bias. When one indexes

wages and salaries, one immediately sets expectations. In contrast,

when wages or salaries are set in currency units, inflation naturally

erodes real buying power. The natural base of comparison for wage

and salary changes is thus one of declining real value. If indexation

causes wages and salaries to be defined in such terms that the base of

comparison is constant or growing in real terms, then worker

expectations will tend to rise. This may trigger a vicious cycle, in which

inflation expectations yield higher prices and then even higher

expectations. This vicious cycle is part of the neostructuralist model

of inflation in Latin America.

Figure 1. Annual Inflation Rate in Chile, Based on Consumer

Price Index, Annual Data, 1960-96, in Percent







1960 1965 1970 1975 1980 1985 1990 1995 2000

a. Date when UF was created

b. Approximate date when UF became widely used. Log scale is used on vertical axis.

114 Robert J. Shiller

Morandé and Schmidt-Hebbel (1997) find “significant evidence

for explicit indexation mechanisms in the behavior of exchange rate

depreciation and wage growth, contributing to large observed inflation

inertia.” Jadresic (in this volume) holds that “unless policymakers

are firmly committed to maintaining low inflation, wage indexation

to lagged inflation is relatively more likely to increase average inflation.”

The inflationary impact of wage indexation cannot be summarized

so simply, however, since one must consider the alternative to

indexation of wages. Jadresic concludes that “wage indexation to

lagged inflation can reduce the cost of disinflation if the alternative

to indexed wage contracts are contracts that specify preset timevarying


A basic fact of human behavior that is relevant for understanding

the impact of indexation is that people are very reluctant to

accept a nominal wage cut (see Akerlof, Dickens, and Perry, 1996;

Card and Hyslop, 1996). People don’t want to have to admit to their

families that their wage or salary has been cut. However, economic

conditions may sometimes necessitate wage or salary cuts. People

seem much more willing to accept real wage cuts caused by consumer

price inflation that is greater than their wage increase. Indexed

units of account for wage and salary contracts need some

kind of humane face-saving mechanism to allow people to deal better

with the truth about their incomes.

The face-saving mechanism that I propose is an indexed unit of

account that has a slight downward bias, so that over long intervals,

wages or salaries that are constant in terms of this unit will decline

gradually in real terms; this will be made more concrete below. In

countries like Chile, where deindexation is being discussed, a proposal

that is more constructive than the proposal to abolish the UF

might be to introduce the option of a second UF with a downward

bias relative to inflation.



The difference between a government’s promoting indexation (such

as by setting an example with indexed government debt) and a

government’s establishing an indexed unit of account might appear to

be a very subtle one, little more than a difference in presentation.

Indeed, most of the world has not paid much attention to the indexed

units of account in Chile and elsewhere, to the extent that some

Indexed Units of Account: Theory and Assessment 115

major surveys on indexation published in Chile hardly address the

UF (see Sáez, 1982; Morandé, 1996; Landerretche and Valdés, 1997).

However, the difference between an indexed unit of account

and a simple indexation scheme is fundamental. It relates to the

way people use money or, one might say, to the “moneyness” of the

indexed units of account.

Simon Newcomb, an astronomer renowned for establishing a

worldwide unified system of astronomical constants, long ago criticized

economists who argued that rational people ought to be able

to make proper allowances for inflation in their contracts without

any special institutions. He argued that money occupies a special

niche in people’s thinking:

So far as the investigations of Walker and other economists extend,

their reasoning appears to be perfectly sound. We consider, however,

that their results are to a certain extent ill founded from the

circumstance of their leaving out of sight one of the most important

factors of the problem, namely the effect of changes of the standard of

living producing a universal deception among the community in respect

to the increase or diminution of wealth. This factor is so important

as to need very close consideration (Newcomb, 1879, p. 230).

Because of this universal deception, Newcomb argued, people will

always be deceived if their contracts are made in terms of currencies:

All men in this and other countries are accustomed from youth

to measure the increase or diminution of wealth by dollars or other

denominations supposed to be units of value.... Even when the facts

are understood, the idea that the change is in the value of the commodities

measured, and not in that of the dollar itself, is so natural

that a long and severe course of mental discipline is necessary to get

rid of it. Indeed, we question whether the most profound economist

can be entirely successful in this respect (Newcomb, 1879, p. 230).

Newcomb proposed what he called the dollar of uniform value, as

measured by the average of commodities. He called his proposal a

multiple standard of value since it is based on a weighted average

price of multiple commodities. He argued, therefore, that the conventional

unit of account must be replaced by a unit that is tied to an

average of prices of commodities.

Irving Fisher, the most prominent advocate of indexation in the

United States, wrote a book entitled The Money Illusion about just

116 Robert J. Shiller

this inability of people to appreciate the subtleties of price level

movements (Fisher, 1928). The term money illusion has been part of

economists’ vocabulary ever since. Like Newcomb, Fisher advocated

a compensated dollar, whose purchasing power would be absolutely

constant, so that people would not be hampered by money illusion

(Fisher, [1911] 1997, 1913a).

The experimental research of Shafir, Diamond, and Tversky (1997)

carefully documents the idea that people do indeed have powerful tendencies

to make errors in dealing with inflation and that they tend to

want to anchor their decisions in terms of currency units. These authors

find not only that people make simple mistakes by failing to

take inflation into account in their decisionmaking, but also that people

behave as if they really have their preferences in terms of currency

units rather than money. They find, for example, that people report

feeling better off when their wages are increased (in terms of currency)

even if they fully understand that prices have increased just as much.

People have serious problems in learning to adopt indexation

schemes. Efforts to start indexed government debt in countries with

moderate inflation (including Australia, Canada, Sweden, the United

Kingdom, and the United States) have met with a very lukewarm

public response (see Campbell and Shiller, 1996). Even in some high

inflation countries there is little public use of indexation. In Turkey,

where inflation rates have been running in the vicinity of 100 percent

a year for years and where inflation has not been below 20 percent a

year since the late 1970s, there is still very little indexation. The

Turkish government did not successfully introduce indexed debt until

1996, and even then the amounts were very small. Private debt is

unindexed, except for some indexed savings accounts created by banks

at the urging of the government. Remarkably, alimony and child

support payments are usually denominated in the Turkish lira, even

though the payments are part of schedules that may last a lifetime.

The real value of these payments will clearly be reduced to nearly

zero in only a few years. (Recipients of these payments regularly apply

to the courts for a modification of the payments, which is a costly and

difficult procedure that raises many painful issues.) Why don’t they

just index the payment scheme?

I recently conducted a study (1999), involving interviews and questionnaires

to learn why people in both the United States and Turkey

are so little interested in indexation. The results are complex and

hard to describe in a short space, in part because it is not easy to

characterize people’s misunderstanding of economic principles. Money

Indexed Units of Account: Theory and Assessment 117

illusion appears to be an important factor in reducing interest in

indexation. On rejecting indexation, many people say, “I just want to

know how much money I will be getting,” as if they regarded money as

an end in itself. This appears to be pure money illusion à la Newcomb

and Fisher. As mentioned above, many people will openly admit, if

asked, that they feel better about a pay increase in money terms even

if they fully understand that prices have risen just as much.

More is at work in inhibiting public interest in indexation, however,

than just pure money illusion. One factor identified in my study

of the United States and Turkey is that people have incorrect theories

about the correlation of inflation with real incomes. There is a widespread

belief that inflation coincides with stunning reversals in real

incomes of ordinary people. The wage-lag hypothesis, long discredited

by economists (see Alchian and Kessel, 1960), is alive and well in the

public imagination. This is one reason why alimony and child support

payments are usually not indexed in the United States and Turkey:

people think that if inflation is high, then an indexed alimony and

child support payer would not be able to keep up with the increased

payments. People also largely believe that inflation hurts firms’

profits as well. The idea that the effects of unforecastable inflation

are primarily a redistribution between debtors and creditors is not

well understood. Inflation is viewed as hurting everybody (see also

Shiller, 1997).

Another important reason why people resist indexation is that

people do not appreciate the uncertainty that inflation generates in

price levels at distant dates (Shiller, 1999). Even in Turkey, where the

price level has drifted over orders of magnitude, people seem not to

appreciate the uncertainty about future price levels. When I asked

Turkish respondents, on the questionnaire, to give a range in which

the Turkish price level would probably fall in ten years, the median

ratio between the high and low limits of the range was 1.5 to 1. This

must be a grotesque understatement of the uncertainty about future

price levels. In part, the judgment error probably arises because the

media do not give much attention to the true uncertainty that price

levels have over long periods. Another factor is the difficulty that the

public apparently has in understanding the power of compounding.

Even in countries with low inflation, people just haven’t thought about

how much difference it makes over long time spans if, for example, the

inflation rate is 2 percent every year versus 6 percent every year. These

differences do not sound like very much, but in fact the difference in

118 Robert J. Shiller

real values of fixed cash payments between these two inflation rates

is in the ratio of 1.47 to 1 in ten years and 2.16 to 1 in twenty years.

Indexed units of account, such as the UF in Chile, solve deep and

ingrained problems that people have in taking account of the effects of

inflation. These units help promote indexation where it would not otherwise

occur, or where it would occur only haphazardly or incompletely.



The creation by some authority like the government of an indexed

unit of account may also solve a sort of coordination problem

that otherwise would inhibit indexation. A coordination problem

appears when there is an advantage to everyone taking some action

together (like adopting some form of indexation) but the

actions are not as beneficial when taken individually. If no steps

are taken to help people coordinate, then the actions may never be

taken. Coordination problems are central to monetary theory. Indeed,

the medium of exchange function of money itself may be regarded

as helping deal with the coordination problems that would

arise when, in a barter economy, people have difficulty locating a

double coincidence of wants.

Coordination problems can be solved by social conventions. We

all drive on the right-hand side of the road, for example. It wouldn’t

matter if we all drove on the left-hand side of the road, but it would

be a disaster if half of us chose one side and half the other. Once a

social convention is established, the coordination problem is solved

and people have little or no incentive to change it.

Why don’t people in the United States quote prices in CPIs in the

absence of any government initiative to create indexed units of account?

People could name the price of a product as, say, ten CPIs,

meaning that they will charge in dollars ten times the latest CPI. The

reason people do not may have to do, in part, with a coordination

problem of deciding together that we will do this. Until such a decision

is made, individuals will not find it in their individual interest to

try to convince people to take the other side of indexed contracts.

Until there is a social convention on how and when to index, people

will find it costly to try to come to an agreement on indexation. There

are many questions. On what date does the price change? Which CPI

should be used? (There are many definitions available.) What do the

economists who compute the CPI think about which unit should be

Indexed Units of Account: Theory and Assessment 119

used? At present, in countries where no indexed unit of account exists,

each person must answer these questions alone. It is thus not

surprising that there is no tendency to quote prices in CPIs.

Another coordination problem involves smoothing the CPI.

Prices should not be defined only in terms of the latest CPI because

the CPI is vulnerable to sudden jumps from month to month.

This is particularly true in the case of indexing financial contracts

to the CPI. A unit of account like the UF would smooth out the CPI

movements. Otherwise, there would be important jumps in deposit

balances on the dates of new announcements of the CPI. Smoothing

the CPI has thus been another fundamental aspect of the functioning

of the UF as an analogue of money.



What is the point of separating the medium of exchange and

store of value functions, which are carried out by currency, from

the unit of account function, which is effected through the Unidad

de Fomento and other examples? Many argue that the reliance on

indexed units of account like the UF is nothing more than a sign of

failure to maintain the currency unit in constant buying power, and

that what the authority really should do is just stop inflation dead.

Irving Fisher (1913a) thought that keeping an indexed unit of

account separate from the medium of exchange would not be sensible

partly because of “laborious calculations in translations from

the medium of exchange into the standard of deferred payments

and back again.” This argument is reminiscent of the arguments

made today for the common currency in Europe, by people who are

tired of the currency exchanges that they must make whenever

they cross a border. Making these exchanges, and also making calculations

between the indexed unit of account and the currency,

may seem unnecessarily complicated. It is perhaps for this reason

that the UF is not used to quote everyday prices in Chile.

The inconveniences generated by keeping a separate unit of account

are not really large. In this age of computers, the complications

created by the need to calculate how many pesos corresponds to a

UF, or the calculations necessary for currency exchanges, can hardly

matter. Indeed, the distinction between the currency and the separate

unit of account will inevitably become blurred once credit card

120 Robert J. Shiller

companies allow charges to be made directly in the units of account

and banks allow checks to be written in terms of the units of account.

(This has not happened yet, as far as I have been able to determine.)

Still, keeping the indexed unit of account separate from the currency

does involve some slight inconveniences, and so one naturally asks, why

not merge the two? Why not just keep the price level steady? The problem

with this solution is that the history of inflation around the world

does not create any optimism that it is possible to stop inflation dead, at

least without some kind of fundamental structural institutional change.

In the course of history inflation has often been temporarily stopped, but

producing lasting price stability, over many decades, has proved illusive.

While economists have proposed other schemes for achieving automatic

price stability (notably Hall, 1983, 1997), there is no guarantee

that such schemes will fully succeed in their objective. If these alternative

schemes are not sure to succeed, it may be better for all longer-term

contracts to be defined in terms of a unit of account, which is itself a

proxy for a price index, so that the indexation cannot fail.

Simon Newcomb (1879) and Irving Fisher ([1911] 1997) thought

they had a mechanism whereby an indexed unit of account could also

be a medium of exchange and store of value. They believed they could

achieve just this by defining the currency itself as an indexed unit of

account. In effect, they wanted to print pieces of paper called UF and

use these as money. Newcomb and Fisher were writing at the time of

the international gold standard. Any government could merely promise,

they argued, to regularly adjust the quantity of gold in its currency

so that the real buying power of the gold represented by the

currency was kept constant. This proposal became known as the compensated

dollar plan after it was published by Irving Fisher (1913a).

There is a potential difficulty, however, in the government’s efforts

to maintain a compensated dollar. In order to guarantee that the

real buying power of the compensated dollar is constant, the government

must promise to make the currency freely convertible into gold

and back at all times. The problem then, as recognized by Irving Fisher,

is that speculators might be able to make large trading profits at the

government’s expense. As Fisher (1913a) pointed out, if the mint price

were $18 per ounce and if it were known that the mint price would

shortly be $18.50 per ounce, then speculators could redeem their dollars

into gold and buy back their dollars at $18.50. If the buying power

of the currency is indeed to be kept steady, then the price index on

which it is based must include the prices of many things that are not

traded on speculative markets. Notably, it must include the price

Indexed Units of Account: Theory and Assessment 121

of services. Any price index that includes these will almost surely

be serially correlated, forecastable into the future. If the buying

power of gold falls far enough, the government could find itself

obligated to pay out more gold than it has. Given this possibility,

public fears that the compensated dollar plan may have to be abandoned

could force abandonment of the plan.

Fisher’s proposed solution to this problem is that the government

would impose a 1 percent bid-asked spread when exchanging

gold for compensated dollars, and that the maximum movement of

the gold content of the dollar would be 4 percent per annum. This

would help prevent speculation, he said. It would also make the

buying power of the dollar unresponsive to large changes in the

price of gold. Fisher wrote an article (1913b) in which he presented

simulations with actual historical data for the period 1896-1911,

indicating that speculation and the limit on the change in the gold

content would not have been an important problem. He points out

that as long as the bid-asked spread, or brassage charge, exceeds

the maximum allowed monthly change in the gold content of the

dollar, there is no riskless arbitrage profit to be obtained by buying

and redeeming dollars over a zero time interval (actually overnight)

at month end. Any attempt to profit from the predictable changes

in the gold content would then involve some risk, and so presumably

such attempts would be limited in importance. Despite the

success of his simulations for that period, however, the potential

fluctuations in the buying power of gold could be large enough to

cause the formula value of the dollar to fluctuate beyond 4 percent

in a year, and this possibility suggests serious problems with the

compensated dollar plan. Note, for example, that the buying power

of gold doubled between 1979 and 1980 and then fell back nearly to

its 1979 level by 1982. Fisher’s simulations do not address the full

complexity of the problem of speculation with the compensated

dollar, a problem that involves such issues as the simultaneous

determination of the real price of gold and the money supply with

public expectations both of future changes in the gold content of

the dollar and of the probability of the event that the compensated

dollar plan will be suspended.

Fisher’s proposals generated much discussion, among both academics

and the general public. Fisher reports a list of 344 articles about his

idea, many of them critical (Fisher, [1914] 1997). The story of the campaign

for the compensated dollar, or the Fisher plan, is recounted in

Fisher (1934, appendix I, pp. 374-89). He found much opposition to his

proposal, apparently mostly misinformed, but nonetheless effective in

122 Robert J. Shiller

preventing its serious consideration. He later abandoned the proposal

without disavowing it: “I had never believed that the compensated dollar

plan was the only possible plan, nor even ideally the best.... I am therefore

still in favor of it for America, as part of a general plan, although, for

simplicity, the method recently adopted in Sweden (a managed currency

independent of gold) seems better.” (Fisher, 1934, p. 382). He seems to

have grown tired of his campaign for a compensated dollar, given the

difficulty of convincing the public of its merits, and his attention was distracted

by other plans. The significant risks of inflation with the new

managed currency independent of gold were not so apparent at the time

as they are now, and so the relative attractiveness of the compensated

dollar plan was not so prominent.

Fisher’s original plan for a compensated dollar defined in terms of

gold might possibly be workable today, but it seems to involve more

uncertainties as to its ultimate success than are associated with the

use of indexed units of account. At this stage in history, of course,

there is no reason to return to a monetary system that creates any

special function for gold. The potential problems of speculation in the

currency-gold ratio, to which Fisher alluded, are shortcomings of the

compensated dollar plan. In the age of computers, keeping the unit of

account separate from the medium of exchange is not such a problem

as it was in Fisher’s day. Given the apparent difficulty of guaranteeing

the real value of currency, contracts can instead be written in terms

of price indexes themselves, that is, in terms of units of account, leaving

the medium of exchange function for conventional money.




While the Chilean example illustrates the use of a single indexed

unit of account in a country, there may be reasons to adopt multiple

units of account. I have in mind here creating an additional unit of

account, beyond the CPI-based unit of account, that is related to a

measure of national economic prosperity, such as personal income.

Indexed units of account were first developed in Chile to solve a

pressing problem of high inflation. At that time, it would not have

mattered very much, compared to the magnitude of the problem of

existing nominal contracts, whether the units were denominated in

terms of a consumer price index or in terms of nominal income. It was

probably natural to create them in the simplest, most direct way

Indexed Units of Account: Theory and Assessment 123

possible, so as to facilitate public acceptance. Public acceptance of

the UFs was not assured, and it did not come immediately. The

concept of the UFs could be explained more easily in terms of a price

index than in terms of nominal income indexes.

The problems caused by tying the UF to the consumer price index

in Chile have not gone unnoticed, however. Critics of the UF in

Chile have said, for example, that the UF causes problems for mortgage

lenders in periods of high inflation, since the UF-denominated

mortgages are adjusted daily, whereas salaries are denominated in

pesos and are adjusted annually (see Bernardez, 1996).

While some appear to think that this problem should be solved

by deindexing, this is not at all a reason to eliminate the indexed

units of account. It is, rather, a reason to define additional units

that are related to income measures. A number of policymakers

have recognized this point. In fact, in 1960 the Chilean government

created an indexed unit of account, called the Unidad Reajustable

(UR), that depended on both wage and price indexes. Although the

effort apparently was not very successful, when the UF was created

in 1967 there were two indexed units of account simultaneously in

use in Chile, namely, the CPI-based UF and the wage-CPI-based

UR. Moreover, the Chilean government drafted a bill in 1991 “that

would establish a new, optional mechanism for adjusting mortgages

by linking them to wages rather than the inflation rate.” 3 While a

wage-indexed unit of account never got far in Chile, Uruguay did

establish a wage-based indexed unit of account, also called the Unidad

Reajustable (UR), which is in use there today.

When indexed units of account are established in times and places

characterized by moderate inflation, then the relative importance of

getting the index right becomes central. By moderate inflation I mean

the 1 to 5 percent inflation that is common in many countries of the

world today, which is small on a year-to-year basis, but large and

variable enough to create substantial uncertainty over longer periods.

In an extreme case in which the problem of inflation is utterly

solved, such that no inflation ever occurred at all, there would be

no need of indexed units of account tied to inflation itself. In this

extreme case, however, there may still be a role for indexed units

of account tied to income measures.

The importance of creating an optional mechanism for indexing

to some income measure such as wages goes far beyond the issue of

3. “Bill Seeks Mortgage Link to Wages, Not Inflation,” Lagniappe Letter, May 3,

1991 (via Latin American Information Services).

124 Robert J. Shiller

mortgage loans. In fact, creating units of account tied to some such

measure is central to the fundamental problem of individuals’ optimal

risk management.


The overlapping generations model is a useful construct for considering

what kind of intertemporal contracts ought to be made and

how these should be indexed. This analysis is inspired by Fischer (1983),

Merton (1983), and others.

First, consider some rudimentary examples. To simplify exposition,

suppose that there is no population growth, such that all generations

have the same number of individuals. The population is represented

as belonging to either of only two generations, and only the young

earn income. Suppose also that the utility is additively separable and

that future income is uncertain. Then, utility is


U u


@ u

c 0


where c y is real consumption while young and c 0 is real consumption

while old, u(.) is an instantaneous utility (or felicity) function, and @ is a

discount factor representing the subjective time preference that people

have. Suppose also that there is no storage or investment, and that

there is a social planner who wishes to reallocate the income in each

time period between the two generations that are alive at the time.

Since the two generations have the same number of individuals,

and since the utility function is additively separable, the social planner

at time t, who has just learned the level of per capita income y t


time t, must merely allocate the total income to maximize the utility

function where, however, the consumption is the consumption of different

people alive at the same time. The social planner needs only

solve the problem,




@ uT

Max u






where T t

is the transfer from young to old at time t. The issue is how this

transfer depends on Y t

. Consider the constant relative risk aversion



utility function u ( c)

c that has been widely used in empirical

Indexed Units of Account: Theory and Assessment 125

literature as a sensible representation of people’s utility. Then the

optimal transfer is







1 @

The transfer is thus directly proportional to income. This means

that the optimal redistribution would be indexed to income (namely,

nominal income measured in currency) and not to the consumer price

index. The same redistribution could be achieved in terms of a social

contract based on an indexed unit of account that is tied not to the

consumer price index but to total income. This transfer could be effected

if young people buy government bonds that pay out in units of

account indexed to income (for example, to save for their retirement),

and at the same time they are taxed (credited) by the government for

any shortfall (surplus) in making the transfer to the then-old people.

For the above model, table 1 shows the welfare loss, as a fraction

of income, that is effected by indexing the units of account to the

consumer price index rather than to income, where feasible. Note the

words, where feasible. In considering any scheme of indexing payments

to the elderly, it must be recognized that in some states of the

world it will not be easy—and perhaps not even possible—to make the

fixed real payment to the elderly, if national income is not large enough

to make the payments. Indexed social security plans do not actually

provide fixed real payments in all states of the world, even if that is

what is promised. Analyzing such social security plans is a bit like

analyzing so-called fixed exchange rates: everyone knows that the

Table 1. Simulated Optimal Fixed Real Transfers from Young

to Old a

Standard deviation Optimal transfer Welfare loss

0.100 0.477 0.008

0.200 0.436 0.025

0.300 0.400 0.039

0.400 0.373 0.042

Source: Author’s calcuations.

a. Based on a Monte Carlo simulation as described in text, assuming a coefficient of relative risk aversion of 3.00,

with zero subjective discount rate, and an iid lognormal distribution for generational incomes, with zero mean and

standard deviation shown. Transfers are capped at 70 percent of income and represent the fraction of expected

income and welfare loss from maintaining capped fixed real transfers instead of income-related transfers in an

overlapping generations model.

126 Robert J. Shiller

exchange rates will in fact be changed if extreme conditions prevail.

For the purpose of constructing table 1, I assumed that if the

fixed real transfer to the old generation were more than 70 percent

of total income available, then the transfer would be capped

at 70 percent of total income.

It is assumed for this table that the income of each generation

has the same lognormal distribution with zero mean of log income;

values are shown for various assumptions about the standard deviation

of log income. The table assumes that the transfer made in

the consumer price indexed case (so that the real transfer is constant

unless it is greater than 70 percent of total income) is the

optimal one that maximizes expected utility. A Monte Carlo experiment

with 100,000 iterations was used to derive the table, since

analytical expressions for the values are not obtainable.

The table shows, for example, that the welfare loss from fixing the

amount transferred subject to feasibility is about 4 percent of total

income in the case in which the standard deviation is 0.3 or 30 percent.

(A standard deviation of 30 percent for real national income in

30 years is not an unreasonable estimate of the uncertainty, given

evidence on the variability of national incomes. See Shiller, 1993.) A

welfare loss of around 4 percent indicates a very substantial advantage

to tying payments to income, given the virtually zero cost of

creating indexed units of account.

The above analysis assumes a constant relative risk aversion utility

function. One might, as an alternative, suppose that the utility

function is not of the constant relative risk aversion variety, but rather

is constant absolute risk aversion, that is, exponential utility

u( c ) exp ( λc

) . In the context of the above model, the optimal transfer

from young to old is then


Now, the optimal transfer has both a component indexed to nominal

income (whose real value Y t

appears in the first term) and a component

indexed to the consumer price index (whose real value is

represented by the second term). For reasonable values of the parameters

@ and , the first term is likely to dominate. In fact, it is not clear

that there are any reasonable’ parameters for the exponential utility;

this utility function has the odd property that negative consumption

while young is not only possible, but also no disaster.

Indexed Units of Account: Theory and Assessment 127

A utility function that implies that the transfer between generations

should be defined in fixed real terms would have the

younger generation infinitely less concerned with income fluctuations

than is the older generation:


c cy




where u(c 0

) is concave, while U depends linearly on c y . With this utility

function, young people again are not particularly concerned with

the possibility of negative consumption. It is hard to imagine why

there should be such a sharp distinction between the attitudes of the

young and old toward poverty.

This simple overlapping generations model deals only with transfers

between generations, but the basic principles that it illustrates

can obviously be extended to other models. Just as there is an advantage

to defining a social security system to tie payments to incomes,

there will be an advantage to defining all sorts of payments specified

in long-term contracts to income-indexed units of account.


As indexed units of account become increasingly accepted, there

may come a day when institutions are developed that allow all prices

or incomes to be denominated in terms of indexed units of account and

all exchanges made in terms of the units. I will call the units in such

an arrangement monetized indexed units of account, because although

they are not really money, they have the appearance of money in that

all transactions are made in terms of the units. 4

In contrast to Newcomb’s or Fisher’s day, the use of indexed units

of account could now be made so easy, through the use of debit card,

credit card, or electronic transfer systems, that the presence of the

medium of exchange itself might become virtually invisible to most

people. Money might be seen only in the account balances representing

the individual’s cash budget constraint, although even these balances

could be translated daily into indexed units of account. Money may

4. My use of the term monetized is different from the usual sense in economics,

since the units will still have to be translated into money by the clearing house for


128 Robert J. Shiller

then have importance only for account balances and at the clearing

house for transactions.

The question arises: how can the price or income index that defines

the indexed unit of account then be computed? One may be concerned

whether it would be possible to define a price or income index

to serve as the basis of an indexed unit of account if all prices are

quoted in terms of the same unit. This concern appears to be misplaced.

There is no problem in defining a consumer price index or an

income index in terms of money, the ultimate medium of exchange,

even if all prices or incomes are specified in terms of an indexed unit

of account. Because the money equivalent of the indexed unit of account

at time t is known at time t, based as it is on lagged information,

the prices or incomes quoted in terms of the indexed units of account

can always be converted into money terms. Therefore, the consumer

price index or income index can always be computed.

One may then wonder how changes in the supply of or demand for

money, the medium of exchange, will find their way into the price

level, if all prices are specified in terms of indexed units of account.

Here again, there appears to be no cause for concern. Whenever there

is an excess supply of the medium of exchange, for example, the immediate

effect should be an increase in some prices expressed in terms

of the indexed units of account. Those prices that are relatively less

sticky should be affected first. Their price rise should then cause an

increase in the price or income index, which would then effectively

communicate the price increases to the currency value of the indexed

unit of account itself. Ultimately, as the consumer price index or income

index moves toward its new equilibrium value, these less sticky

indexed unit of account prices can return to their original values, all

the adjustment being incorporated by the exchange rate between the

indexed unit of account and the currency. An example of such an

adjustment process is given in Shiller (1999).



A table that defines two indexed units of account for the United

States, units which I call units of price (UP) and units of income (UI),

and gives their conversion into U.S. dollars is now available on a daily

basis on my web site, Both

are based on government statistics, so the underlying data are likely

Indexed Units of Account: Theory and Assessment 129

to be available for the foreseeable future. Since the formulas defining

the units (formulas used to construct the tables) are also provided

on my web site, these would appear to be usable indexed units

of account at the present time. It is, of course, unlikely that many

people will use my units. I present them here by way of illustration

and example, with the hope that the U.S. government will someday

define such units.

The unit of price is based on the U.S. consumer price index, and it

is closely analogous to the Chilean UF. This unit might be used to

price houses, rents, catalog items, and other items that sell slowly.

Pricing in terms of the unit of price means that the price would stay

roughly constant relative to a broad market basket of consumer items.

The unit of income is based on growth-corrected per capita personal

income. The growth correction divides the per capita personal

income by a growth trend line. The growth correction is included here

to deal both with possible upward biases in the index as a measure of

individual income growth and with the psychological resistance to

nominal wage cuts (see Shiller, 1999). This unit might be used, for

example, to specify annuity or mortgage payments or for labor contracts.

Specifying payments in terms of the unit of income ensures

that the payments will be roughly a constant fraction of per capita

personal income.

Of these two indexed units of account, the unit of price, rather

than the unit of income, might be most readily accepted by the public,

since it is tied to a consumer price index as in the Chile case. There is

widespread public appreciation of the importance of inflation, and so

the public needs much less convincing when the index is tied to the

usual measure of inflation, namely, the consumer price index. That

an income index may also be used for much the same purpose may

not be so obvious to many people. There appears to be less public

appreciation of real national income variations than of inflation variations

through time. Still, it seems likely that if the two units of account

are introduced together, and if people see these two as parallel

alternatives, then substantial numbers of people will find ample reason

to use the unit of income in appropriate circumstances.


Governments of all nations of the world should create indexed units

of account for their citizens. It is virtually costless for them to do so.

130 Robert J. Shiller

All the governments need to do is decide on a price and income index,

decide on a smoothing method, begin publishing daily values for the

unit of account in terms of currency, and make some commitment

that the index will continue to be calculated on a consistent basis and

without future freezes or other interference. It is also possible that

the indexed unit of account could be created by some other agency

that can commit to continuing to produce the index in the indefinite

future (as in Brazil, where production of the consumer price index

was privatized after concerns were expressed about government mishandling

of the statistics). Still, some government involvement in

establishing the index is probably important for its success. The introduction

of the units of account might also be accompanied by policies

encouraging the creation of institutions, such as debit cards, credit

cards, and checking accounts, that are designed to facilitate quoting

everyday prices in terms of the units of account.

To summarize briefly the arguments given above for indexed units

of account, the creation of indexed units of account might be considered

similar, in a sense, to the creation of daylight savings time (although

the units of account are likely to be much more important in

economic significance). Technically speaking, if everyone were perfectly

rational, there would be no need to set our clocks forward one

hour in the summer; we could all just decide to get up an hour earlier.

But everyone knows that will never happen. One reason is that

there is a coordination problem in getting people to start their business

an hour earlier. Coordination problems appear if people in some

workplaces arrive at work earlier while their clients and suppliers do

not. By analogy, people could just decide to raise all deferred payments

in keeping with inflation, just as they could all decide to get

out of bed an hour earlier, but if some do this and some do not, or if

some use one price index formula and some use another, then a coordination

problem will arise here, too. Another advantage of daylight

savings time goes beyond the coordination problem. There is the problem

of human habit, of looking at the clock and unthinkingly deciding

that it is time to do this or that. The advantage to daylight savings

time, as opposed to making a collective decision to do everything an

hour earlier in the summer, very plainly has something to do with

the persistence of such habits. The same advantage is created by

indexed units of account. Just as there was apparently no collective

decision to change the times of most daily activities seasonally in the

years before daylight savings time, the alternative to the indexed

Indexed Units of Account: Theory and Assessment 131

units of account is really a lack of consistent indexation or, more

probably, no indexation at all. And with no indexation, the ability

to make long-term contracts itself will suffer.

The alternative to the indexed units of account is essentially the

same system of fiat money and nominal pricing and contracts that

most of the world has experienced since the 1930s. While it has not

been a disaster, this system has an absurd quality to it. People make

contracts in terms of pieces of paper whose value is ultimately decided

by political bodies with vague instructions to promote the general welfare,

who have succumbed to political pressures in the past by abandoning

their concern for the real value of those pieces of paper. People

who are owed money normally have no legal recourse if the real value

of the amounts owed is wiped out. Such a system would appear to have

been invented by a prankster, who wanted to keep surprising people

and stirring up discontent. In viewing the deindexation proposals, one

wonders, why would anyone want to return to such a system?

The current move toward deindexation in many countries that

had formerly experienced hyperinflation is perhaps motivated in

part by the feeling that the indexation was a palliative introduced

to deal with an extreme crisis. Now that the crisis is past, it may

be reassuring to many to see the indexation ended. I think that

the history of the development of indexation, and of the indexed

units of account in particular, should have another interpretation.

The indexation and the indexed units of account were indeed begun

in times of great stress, but the same is true of many other

great innovations. Daylight savings time, for example, was introduced

during World War I, as an effort to deal with a wartime

energy shortage. Such innovations should be viewed as a blessing

stemming from an otherwise stressful time, and the system of

indexation should not be dismantled in times of lower inflation.

The United States does not have much indexation, and has never

experienced the indexed units of account, for example, because it

has never, in modern times, had the experience with high inflation

that might have shaken it from its complacency about nominal

contracting. 5

5. That is, the Unites States has not had really high inflation since the Revolutionary

War in the late eighteenth century. It is interesting to note that the very first

indexed bond issue in world history occurred in the United States in 1780; see W.

Fisher (1913).

132 Robert J. Shiller


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. 1997. “Irving Fisher’s Self-Stabilizing Money.” American

Economic Review 87: 436–38.

Jadresic, E. 2002. “The Macroeconomic Consequences of Wage Indexation

Revisited.” This volume.

Keynes, J. M. 1930. A Treatise on Money, vol. 1. New York: Macmillan.

Landerretche, O., and R. Valdés. 1997. “Indización: historia chilena

y experiencia internacional.” Working Paper 21. Santiago: Banco

Central de Chile.

Levin, B. F. 1995. “Working through the Web with UDIs.” Business

Mexico (June). Mexico City: American Chamber of Commerce

of Mexico.

Merton, R. C. 1983. “On Consumption Indexed Public Pension Plans.”

In Financial Aspects of the United States Pension System, edited

by Zvi Bodie and John Shoven, 259–89. University of Chicago

Press for the National Bureau of Economic Research.

Morandé, F. G. 1996. “Indización financiera, ahorro privado e inercia

inflacionaria: el caso de Chile.” Ilades/Georgetown University.

Morandé, F. G., and K. Schmidt–Hebbel. 1997. “Inflation Targets

and Indexation in Chile.” Paper presented at the International

Conference on Indexation, Inflation, and Monetary Policy,

Santiago. Banco Central de Chile.

Newcomb, S. 1879. “The Standard of Value.” North American Review

(September): 223–37.

Polit, L. 1994. “Ecuador: Ecuador’s Stock Market; Latin Equities

Directory.” Latin Finance (April).

Rolnick, A. J., and W. E. Weber. 1986. “Gresham’s Law or Gresham’s

Fallacy?” Journal of Political Economy 94(1): 185–99.

Sáez, R. E. 1982. “Evolución de la indexación en Chile.” Notas Técnicas

49. Santiago: La Corporación de Investigaciones Económicas para

Latinoamérica (March).

134 Robert J. Shiller

Shafir, E., P. Diamond, and A. Tversky. 1997. “Money Illusion.”

Quarterly Journal of Economics 112(2): 341–74.

Shiller, R. J. 1993. Macro Markets: Creating Institutions for Managing

Society’s Largest Economic Risks. Oxford University


. 1997. “Public Resistance to Indexation: A Puzzle.” Brookings

Papers on Economic Activity 1: 159–211.

. 1999. “Designing Indexed Units of Account.” NBER Working

Paper 7160. Cambridge, Mass.: National Bureau of Economic


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Indexed unit of account

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When a daily indexed unit of account or Daily Consumer Price Index (Daily CPI) or monetized daily

indexed unit of account is used in contracts or in the Capital Maintenance in Units of Constant Purchasing

Power accounting model, deferred payments and constant real value non-monetary items are indexed to the

general price level in terms of a Daily Index such that changes in the inflation rate—in the case of monetary

items—and the stable measuring unit assumption—in the case of constant real value non-monetary items—

have no effect on the real value of these items. Non-indexed units, such as contracts written in nominal

currency units and nominal monetary items, incur inflation or deflation risk in the case of monetary items.

During all periods of inflation (low, high or hyperinflation), the debtor pays less in real terms than what both

the debtor and creditor agreed at the original time of the contract/sale. On the other hand, in periods of

deflation, the debtor pays more in real terms than the original agreed value. The opposite is true for

creditors. Contracts and constant real value non-monetary items accounted in daily indexed units of

account, Daily CPI or monetized daily indexed units of account incur no inflation or deflation risk, as the real

value of payments and outstanding capital amounts remain constant over time while the nominal values are

inflation- or deflation-indexed daily.

Indexation is typically achieved by adjusting payments and outstanding capital as well as interest values

using a Daily consumer price index or a monetized daily indexed unit of account. A monetized daily indexed


unit of account, called the Unidad de Fomento was introduced in Chile in 1967, but it was only in the early

1980s that it was widely adopted by both the Chilean people and the Chilean government. Its original base

value has never been changed. By 1983, over 60 percent of total bank loans in Chile were written in the

UF. [1] which eliminated the effect of inflation during inflation. The value of the UF in pesos is published daily

in all major Chilean newspapers and on government websites. Initial doubts about the Chilean governments

ability to adopt inflation targeting under such an indexed financial system proved unfounded as the Bank of

Chile has successfully maintained low inflation rates since 1998.

In 1848, John Stuart Mill discussed the inflation risk of non-indexed units of accounts. He stated that "All

variations in the value of the circulating medium are mischievous: they disturb existing contracts and

expectations, and the liability to such changes renders every pecuniary engagement of long date entirely

precarious." [2] In 1887 William Stanley Jevons referred to previous authors and discussed an indexed unit of

account which he calls a "tabular standard of value". [3] In 1887 Alfred Marshall, also referring to previous

authors, discussed a similar proposal. [4] In 1998 and onwards, Robert Shiller similarly argued for the

introduction of an indexed unit of account into the United States economy as a means of eliminating inflation

risk. [5][6][7]

See also [ edit ]

Constant Item Purchasing Power Accounting

WCU – World Currency Unit

Mexican Unidad de Inversion

Unidad de Fomento

Unidad de Valor Constante

Unidade Real de Valor

Notes [ edit ]

1. ^ Herrera, Luis Óscar; Valdés, Rodrigo O. (2005). "De‐dollarization, Indexation and Nominalization: the Chilean

Experience". Journal of Policy Reform. 8 (4): 281–312. CiteSeerX .

doi:10.1080/13841280500394493 .

2. ^ Mill, John Stuart (1848). Principles of Political Economy. West Strand: John W. Parker.

3. ^ Jevons, William Stanley (1876). "Chapter XXV". Money and the Mechanism of Exchange . D. Appleton and


4. ^ Marshall, Alfred (1925). "Remedies for Fluctuations of General Prices". In Pigou (ed.). Memorials of Alfred

Marshall. London: MacMillan and Co.

5. ^ Shiller, Robert (January 1998). "Indexed Units of Account: Theory and Assessment of Historical Experience".

NBER Working Paper No. 6356. doi:10.3386/w6356 .

6. ^ Shiller, Robert (June 1999). "Designing Indexed Units of Account". NBER Working Paper No. 7160.

doi:10.3386/w7160 .

7. ^ Shiller, Robert (2003). The New Financial Order. Princeton University Press.

Categories: Inflation

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House price index

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A house price index (HPI) measures the price changes of residential housing as a percentage change from some

specific start date (which has HPI of 100). Methodologies commonly used to calculate a HPI are the hedonic

regression (HR), simple moving average (SMA) and repeat-sales regression (RSR).

Contents [hide]

1 United States


1.2 S&P/Case-Shiller indexes

1.3 FNC Residential Price Index

1.4 HouseCanary Home Price Index

2 United Kingdom

2.1 Governmental house price indices

2.2 Private sector house price indices

2.3 Current UK indices

3 Ireland

4 India

5 Canada

6 See also

7 Resources

8 References

United States [ edit ]

FHFA/OFHEO [ edit ]


The US Federal Housing Finance Agency (formerly Office of Federal Housing Enterprise Oversight a.k.a. OFHEO)

publishes the HPI index, a quarterly broad measure of the movement of single-family house prices.

The HPI is a weighted, repeat-sales index, meaning that it measures average price changes in repeat sales or

refinancings on the same properties in 363 metropolises. This information is obtained by reviewing repeat mortgage

transactions on single-family properties whose mortgages have been purchased or securitized by Fannie Mae or

Freddie Mac since January 1975.

Since the HPI index only includes houses with mortgages within the conforming amount limits, the index has a natural

cap and does not account for jumbo mortgages.

The HPI was developed in conjunction with OFHEO's (now FHFA) responsibilities as a regulator of Fannie Mae and

Freddie Mac. It is used to measure the adequacy of their capital against the value of their assets, which are primarily

home mortgages.

On July 30, 2008 OFHEO became part of the new Federal Housing Finance Agency (FHFA). The index is now termed


S&P/Case-Shiller indexes [ edit ]

Main article: Case-Shiller index

The Case-Shiller index prices are measured monthly and track repeat sales of

houses using a modified version of the weighted-repeat sales methodology

proposed by Karl Case and Robert Shiller and Allan Weiss. This means that,

to a large extent, it is able to adjust for the quality of the homes sold, unlike

simple averages.

As a monthly tracking index, the Case-Shiller index has a long lag time.

Typically, it takes about 2 months for S&P to publish the results, as opposed

to 1 month for most other monthly indices and indicators. Specific indexes are

available for specific metropolitan areas, and composite indexes for the top 20

and top 10 metro areas, and nationwide.

The Case–Shiller Real Home Price


FNC Residential Price Index [ edit ]

FNC Inc. publishes the Residential Price Index, which is based on data collected from public records blended with

data from real-time appraisals of property and neighborhood attributes. The RPI is the mortgage industry's first

hedonic price index for residential properties. The RPI is constructed to gauge price movement among non-distressed

home sales, and excludes sales of foreclosed properties. [1]

As a monthly tracking index, the RPI has a lag time of about two months. Specific indices are available for specific

metropolitan areas, and composite indices are available for the top 10, 20, 30, and 100 [2] metro areas. The RPI is also

available at the zip code level and can be constructed to track price trends for specific characteristics (e.g., ranch-style

house, colonial-style house, etc.) since preferences can change over time.

HouseCanary Home Price Index [ edit ]

HouseCanary publishes monthly HPI data at block, block group, zipcode, metro division and metropolitan levels.

These indices include forecasts up to 3 years into the future. [3]

United Kingdom [ edit ]

House Price Indices (HPIs) have been produced in the UK since around 1973, initially by mortgage-providers, and

more recently by government bodies. More recently, they have come from property market websites.

Governmental house price indices [ edit ]

In June 2016 the UK House Price Index (UK HPI) [4] was launched as a collaboration between the Office for

National Statistics, HM Land Registry, Registers of Scotland and Land and Property Services Northern Ireland.

The index is calculated using land registration data (such as that held by HM Land Registry). The UK HPI release

provides comprehensive information on the change in house prices on a monthly and annual basis. It also includes

analysis by geography, type of buyer, type of dwelling, property status (whether the property is a new build or not)

and funding status (cash or mortgage). Several guidance documents [5] are published alongside the release

explaining its methodology and the difference between the different sources of official house price statistics.

From 2012 to 2016 the Office for National Statistics produced a monthly House Price Index (HPI) release which

was calculated using mortgage financed transactions collected via the Regulated Mortgage Survey by the Council


of Mortgage Lenders. These covered the majority of mortgage lenders in the UK. This release was replaced by the

UK House Price Index in June 2016. [6]

Historically, HM Land Registry also published a separate house price index calculated by Calnea Analytics. It used

the HM Land Registry’s own data, which consists of the transaction records of all residential property sales in

England and Wales. It uses Repeat Sales Regression. This release was replaced by the UK House Price Index in

June 2016.

DCLG House Price Index [7] by the Department of Communities and Local Government used the mix-adjusted

method, which is based on weighted averages. The data used in this HPI was mortgage completion data supplied

by a few large lenders. DCLG handed the production of this index to the Office for National Statistics in 2012

A House Price Index used to be produced by the Department for the Environment.

Private sector house price indices [ edit ]

The Nationwide House Price Index and Halifax House Price Index use Hedonic regression (also known as the

characteristics based method) using their own datasets compiled from their mortgage lending. These indices have

a longer time-series than the Governmental HPIs.

Current UK indices [ edit ]


Calculated by









Indices Frequency Price


UK House Price


Office for



HM Land


100k HR Yes Monthly

Actual price


HM Land Registry



HM Land


100k RSR Yes Monthly

Actual price


Knight Frank

Knight Frank



100k RSR Yes Monthly -















approvals 12k HR Regional



Price agreed

at time of loan





approvals 12k HR Regional



Price agreed

at time of loan











Rental prices











Asking price











Asking price

Financial Times




100k SMA Yes Monthly

Actual price


Ireland [ edit ]

In the Republic of Ireland, the Central Statistics Office publishes a monthly Residential Property Price Index . Up until

2011, Permanent TSB and the Economic and Social Research Institute published a similar monthly houseprice

index .

India [ edit ]

In India, National Housing Bank completely owned by Reserve Bank of India computes an index termed NHB

RESIDEX. The index was formulated based on a pilot study covering 5 cities, Delhi, Mumbai, Kolkata, Bangalore and

Bhopal representing the five regions of the country. Actual transactions prices are used to compute an Index reflecting


the market trends. 2007 is taken as the base year for the study to be comparable with the WPI and CPI. [8] It now

covers [9] Delhi with NCR, Bangalore, Mumbai, Kolkata, Bhopal, Hyderabad, Faridabad, Patna, Ahmedabad, Chennai,

Jaipur, Lucknow, Pune, Surat, Kochi, Bhubaneshwar, Guwahati, Ludhiana, Vijayawada, Indore, Chandigarh,

Coimbatore, Dehradun, Meerut, Nagpur and Raipur. The index shows that the prices have doubled in cities like

Mumbai, Delhi and Bhopal, but have declined in Hyderabad and Kochi.

Canada [ edit ]

In Canada, the New Housing Price Index is calculated monthly by Statistics Canada. Additionally, a resale house price

index is also maintained by the Canadian Real Estate Association, based on reported sale prices submitted by real

estate agents, and averaged by region. In December 2008, the private National Bank and the information technology

firm Teranet began a separate monthly house price index based on resale prices of individual single-family houses

in selected metropolitan areas, using a methodology similar to the Case-Shiller index [10] and based on actual sale

prices taken from government land registry databases. This allows Teranet and the National Bank to track prices

without allowing periods of high sales in one city to push up the national average. [11] The National Bank also operates

a forward market on Canadian housing prices.

See also [ edit ]

Real estate appraisal

Resources [ edit ]

Downie, M. L. & Robson G. (2007) Automated Valuation Models: an international perspective. Pp 11 Council of

Mortgage Lenders, London, ISBN 1-905257-12-0.

Lim, S. & Pavlou M. (2007) An improved national house price index using Land Registry data RICS research

paper series: Volume 7 Number 11. Pp 10–14. London, ISBN 978-1-84219-347-1. Accessed 21 November 2007.

How is the HPI calculated? (2014) Accessed 9 May 2014

References [ edit ]

1. ^

2. ^

3. ^ "Archived copy" . Archived from the original on 2017-12-07. Retrieved 2017-07-01.

4. ^

5. ^

6. ^


7. ^


8. ^ About Residex NHB Residex

9. ^ NHB Residex Base Year: 2007 = 100 Current values

10. ^ "S&P Corelogic Case-Shiller Home Price Indices" , "S&P Dow Jones Indices", 2016

11. ^ The shocking truth about the value of your home , Maclean's, 2009-02-23

Categories: United States Department of Housing and Urban Development

Real estate indices

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Unidade real de valor

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Find sources: "Unidade real de valor" – news · newspapers · books · scholar · JSTOR

(September 2010) (Learn how and when to remove this template message)

The Daily Unidade Real de Valor, or URV (Portuguese, Real Value Unit), was a non-monetary reference currency (i.e.,

non-fiat) created in March 1994, as part of the Plano Real in Brazil. It was the most theoretically sophisticated piece of

the Plano Real and was based on a previous academic work by Pérsio Arida and André Lara Resende, the "Larida

Plan", published in 1984.

Its main purpose was to establish a parallel currency to the cruzeiro real, free from the effects of inertial inflation on the

latter, which exceeded 1,200% per year prior to the implementation of the new currency, the real.

It was conceived as a temporary instrument to break up the "psychological inertia" that had ingrained in the Brazilian

mindset and which caused prices to keep rising as a consequence of subjective estimation of inflation or preemptive

adjustment without cost assessment. These phenomena are among the chief characteristics of hyperinflation, resulting

from the erosion of confidence on the legal tender. The idea was to let the old currency (the cruzeiro real) fully absorb

the effects of hyperinflation while having a new currency to be stable (in nominal terms) by adjusting its exchange rate

against the old one.

URVs were quoted in cruzeiros reais and its intrinsic value was pegged to three price indices and had a fixed parity of

1-to-1 to the daily U.S. dollar exchange rate. The exchange rate of URVs to cruzeiros reais was recalculated and

published daily by the government.

Prices were quoted both in URVs and cruzeiros reais but payments had to be made exclusively in cruzeiros reais, since

the URV would not become legal tender until July 1, 1994. For instance, banks were required to report balances on

accounts in both currencies and contracts had to be rewritten to express prices in URVs.


The URV was extinguished on July 1, 1994, when it was converted to a new currency, the real at a parity (i.e., 1 real = 1

URV = CR$ 2,750), effectively breaking the hyperinflationary cycle, bringing stability to the Brazilian currency.

The implementation of the new currency was one of the greatest currency changes in known history, with almost the

entirety of the country's legal tender replaced in about 45 days.

Daily value of the URV per week (cruzeiros reais)



Mon Tue Wed Thu Fri



Mon Tue Wed Thu Fri


























Mon Tue Wed Thu Fri



Mon Tue Wed Thu Fri



























Mon Tue Wed Thu Fri



Mon Tue Wed Thu Fri



























Mon Tue Wed Thu Fri



Mon Tue Wed Thu Fri



























Mon Tue Wed Thu Fri



Mon Tue Wed Thu Fri



























Mon Tue Wed Thu Fri



Mon Tue Wed Thu Fri



























Mon Tue Wed Thu Fri



Mon Tue Wed Thu Fri



























Mon Tue Wed Thu Fri



Mon Tue Wed Thu Fri



























Mon Tue Wed Thu Fri



Mon Tue Wed Thu Fri
























R$ 1.00

Mondays values were retroactive to Saturdays and Sundays. Subsequently, a formula was established for retroactive accounting for the previous

months and years.

Source: Banco Central [1]

See also [ edit ]

Constant Purchasing Power Accounting

Inflation accounting

International Financial Reporting Standards

Indexed unit of account

References [ edit ]

1. ^ Banco Central do Brasil. Disponível em BCB


External links [ edit ]

How Fake Money Saved Brazil

This article related or pertaining to the economy of Brazil is a stub. You can help Wikipedia by expanding it.

Categories: Currencies of Brazil

Brazil economy stubs

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Corrugated City

F r i d a y , 3 A u g u s t 2 0 0 7

Inflation and the mysterious UF


Everywhere you go in Chile you'll see 2 letters: UF. When i first arrived

in this country way back in December 2003 (i can't believe it was so long ago) i just

ignored it, thinking it was just some bizarre Chilean way of making things more

complicated than strictly necessary. I still think the same but now i actually

understand what the hell the UF is all about.

UF stands for Unidad de Fomento. It's an inflation index and once you get your

head around it it's quite a useful tool when calculating how much things cost.

Let's have an example:

You want to buy a house. You look on an agent's website and see the price is listed

at 1500 UF. Just what does that mean? Well, One UF is equivalent, today, to

18792.93 Chilean Pesos. So that means that the house is valued at 1500UF X

18792.93 which means 28,189,395 Pesos (or about us$54k).

The UF level is adjusted every day. Inflation in Chile runs to around 3-4% per year.

Tomorrow's UF is expected to be around 6 Pesos higher, at 18798.36 Pesos. That

means the same house tomorrow will cost: 18798.36 X 1500UF=28,197,540 or 8,145

pesos more than yesterday (about us$16).

If you're interested in property in Chile then please click Pacific Five, Real Estate

Consulting, Chile

Pretty much all large scale purchases in Chile, such as cars and real estate, are

valued in UF. Many services are also valued in this way. Retaining a lawyer on a

monthly basis, for example, would be valued in UF. You would pay a fee every

month of, let's say, 100UF. That fee in actual pesos would rise in line with inflation

but the amount in UF stays the same. Insurance (health, car, home etc) is also

valued in UF. In real terms, the cost doesn't increase, it only rises at the same rate

as the Consumer Price Index. In some cases, you can freeze the UF to the level it

was when you signed a contract. That means the cost of a service doesn't rise at all

in line with inflation.

Chile's Central Bank pursues a policy of keeping inflation below 4% per year. A

jump in consumer prices in July means that inflation is on course to come close to

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that 4% level by the end of the year. Last night there was a report on the news

with worried Chileans wondering where it was all going to end. Short answer, it'll

end with further increases in interest rates in Chile. Interest rates are currently at

their highest levels for years, at 5.25% and are expected to be raised again to 5.5%

in the near future. If the BC wants to keep inflation below 4% that's what needs to

be done. (For anyone that doesn't understand the correlation between inflation

and interest rates, a very basic explanation is that higher interest rates mean

people have to spend more money re-paying loans and mortgages which, in turn,

means they have less money to spend on consumer goods which reduces demand

for goods and services which means prices don't rise as fast which means you can

now breathe after a sentence involving lots of which).

Of course, raising interest rates has other effects. One of them is that the Peso will

rise in value against other currencies (another basic explanation-higher interest

rates mean that Chile is a nicer place to put your money for interest earnings so

more people want to buy Pesos making them more expensive). Back in 2004 i was

getting almost 1300 pesos to my Pound. Now i get 1050. The Dollar was around 750

Pesos, now it's 520. This has made Chileans goods more expensive. Chile is a major

exporter and the higher price of the Peso has hit exporters hard. Further rises

against foreign currencies won't help.

Anyway, whilst browsing Argentine daily, Clarin (a paper that somehow manages to

be both tabloid and high-brow broadsheet at the same time), i came across yet

another report about inflation in Argentinaa. Compared to their cousins across the

mountains, Chileans really have nothing to worry about. I wrote about inflation in

Argentina a while back, after my last visit there. It's really out of control. Again.

Official figures are a lie. Friends still living in BA say that things are getting really

expensive. Just read the articles linked-in some cases there have been 900% rises

in the prices of basic fruit and veg. 900%!! That's absurd.

From being far and away the best tourism bargain in the world just a couple of

years ago, Argentina is now, in many cases, more expensive than Chile.

Supermarkets in Chile are now cheaper than in Argentina (and food is of a higher

quality in Chile, with the exception of the unbeatable Argentine beef which can be

bought here anywhere), eating out at a really decent restaurant is cheaper, hell

even the price of a beer in a bar is less in Chile nowadays. And i'm not even

including the fact that electrical goods and cars are 50-75% more expensive in

Argentina due to ridiculously high import tariffs.

And it just has to get more expensive. Inflation will continue to gallop along at 12-

40% a year (depending on who you believe) until the government drops its policy of

maintaining the Argentine Peso below its true value (currently trading at around

3.12 to the Dollar). When this happen, prices in foreign currency will increase by

up to 35% overnight. It should be around 2.1-2.3 to the Dollar. And prices in Pesos

won't come down. So you'll have had 3-4 years of rampant inflation followed by a

monetary adjustment of 35%. That'll make for one hell of a pricey country.

A lot of foreigners moved to Argentina because of it's great value real estate and

extremely low cost of living. Both of those aspects of living have now been pretty

much eroded. Property is over valued and the market is a big bubble waiting to

burst. What's left is the cultural aspect of Argentina, something that far surpasses

what Chile can offer (in terms of theatres, cinemas, film, art, literature,

architecture). But i wonder how long all these foreigners who moved to Argentina

for the cheap life will last as prices continue to rise?

What i've always found funny is the claim by numerous people involved in both

tourism and real estate in Argentina (actually, both are very much linked as many

foreigners have bought property there as a rent-to-tourist investment) that

"Buenos Aires will be as expensive as Paris, New York and Madrid in a few years

time. Invest in Buenos Aires property!!" This is ridiculous. BA tries to model itself

as the Paris of the South. If the real Paris is no more expensive then i think i know

where most foreigners will end up...especially as the flight is half the price...

Anyway, Argentina is still a pretty damn cool place to visit and i'm looking forward

to my next trip back, probably sometime in the next couple of months. Nightlife is

much more fun over there than here and i love going to a packed restaurant on a

Tuesday night. In Chile restaurants aren't even packed on Saturday night. That

enjoy life to the full attitude is something sorely missing in Chile. I guess it's a

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trade off between a stable economy and culture to the roller-coaster fun of

Argentina. I love roller-coasters. But they make me feel sick after too many rides.

Posted by Matt at 10:52

Labels: BUYING PROPERTY IN CHILE, money, tourism


Anonymous said...

excellent commentary on the fate of the Argentine economy....

6 August 2007 at 18:32

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American Dream Downpayment Assistance Act

From Wikipedia, the free encyclopedia

On December 16, 2003, President George W. Bush signed into law the American Dream Downpayment

Initiative (Pub.L. 108–186 (text) (pdf) ), which was aimed at helping approximately "40,000 families a

year" with their down payment and closing costs, and further strengthen America’s housing market. This

legislation complemented the President's "aggressive housing agenda" announced in a speech he gave at

the Department of Housing and Urban Development on June 18, 2002. [1]

This loan assistance program was discontinued in 2008. [2] However, other similar programs are still

available. Down Payment Assistance programs are all different with certain requirements for each. State or

local housing authorities, a non-profit organization, or lender usually set the requirements and conditions for

the DPA program. Some programs require you or your loan officer to take a short course on Down Payment

Assistance for first time home buyers. [3]

References [ edit ]

1. ^ "HUD website President's remarks" . Archived from the original on 2009-12-15. Retrieved 2010-02-06.

2. ^ FHA: AmeriDream Loan Assistance Program Canceled in 2008

3. ^ "Down Payment Assistance"


External links [ edit ]

American Dream Downpayment Initiative

This United States federal legislation article is a stub. You can help Wikipedia by expanding it.

Categories: Acts of the 108th United States Congress

United States federal legislation stubs

United States federal housing legislation

This page was last edited on 29 August 2020, at 01:53 (UTC).

Text is available under the Creative Commons Attribution-ShareAlike License; additional terms may apply. By using this site,

you agree to the Terms of Use and Privacy Policy. Wikipedia® is a registered trademark of the Wikimedia Foundation, Inc., a

non-profit organization.

Privacy policy About Wikipedia Disclaimers Contact Wikipedia Mobile view Developers Statistics Cookie statement


212 captures

18 Mar 2004 - 15 Oct 2019 2009 2010 2012 ▾ About this capture


To be eligible for ADDI assistance, individuals

must be first-time homebuyers interested in

purchasing single family housing. A first-time

homebuyer is defined as an individual and his or

her spouse who have not owned a home during

the three-year period prior to the purchase of a

home with ADDI assistance. ADDI funds may be

used to purchase one- to four- family housing,

condominium unit, cooperative unit, or

manufactured housing. Additionally, individuals

who qualify for ADDI assistance must have

incomes not exceeding 80% of area median


First-Time Homebuyers

Press Release |Focus Message

Bush Signs American Dream

Downpayment Act

Press Release | Focus Message


PowerPoint Presentation


Captioned | Non Captioned

Eligible Activities

ADDI funds may be used for downpayment, closing costs and, if necessary,

rehabilitation in conjunction with home purchase. ADDI funds used for rehabilitation

may not exceed twenty percent of the participating jurisdiction's total ADDI

allocation. The rehabilitation assisted with ADDI funds must be completed within one

year of the home purchase.

Funding Status

In FY 2007, Congress appropriated $24,750,000 for ADDI. Previously, Congress

appropriated $74,513,000 in FY2003 and $86,984 in FY2004, $49,600,000 in

FY2005 and $24,750,000 in FY2006. HUD has issued formula allocations for FY

2007 to assist participating jurisdictions in preparing their consolidated plans.

Obtaining Assistance

First, check the formula allocation page to determine whether your local HOME

administering agency received ADDI funding. If they did not receive ADDI

funding, ADDI funds may be available through your state. Every state received ADDI

funds. The contacts for state are available in the HOME administering agency list.

For further information regarding the administration of ADDI, visit our Q&A; page

(PDF | Word).

Content current as of 4 May 2010 Back to top

FOIA Privacy Web Policies and Important Links Home

U.S. Department of Housing and Urban Development

451 7th Street S.W., Washington, DC 20410

Telephone: (202) 708-1112 TTY: (202) 708-1455

Find the address of a HUD office near you


100 captures

28 Jun 2002 - 19 Nov 2020 2001 2002 2003 ▾ About this capture


can go buy a home. They hate freedom; that's what they hate. They hate the fact

that we worship freely. They don't like the thought of Christian, Jew and Muslim

living side by side in peace. They don't like that at all. And therefore, they -- since

they resent our freedoms, they feel like they should take out their resentment by

destroying innocent lives. And this country will do everything we can possibly do to

protect America. (Applause.)

And that's going to mean making sure our homeland is secure, and I appreciate the

progress we're making on setting up a Department of Homeland Security. I know it's

going to be hard for some in Congress to give up a little power here and there, but I

think it's going to happen because people realize we're here to serve the American

people, not here to serve a political party or turf in the United States Congress.


But the best way to secure the homeland is to hunt them down one by one. And I

mean hunt them down one by one and bring them to justice, which is precisely what

America will do. (Applause.)

I want to thank the choir for coming, the youngsters for being here. I just want you

to know that, when we talk about war, we're really talking about peace. We want

there to be peace. We want people to live in peace all around the world. I mean, our

vision for peace extends beyond America. We believe in peace in South Asia. We

believe in peace in the Middle East. We're going to be steadfast toward a vision that

rejects terror and killing, and honors peace and hope.

I also want the young to know that this country, we don't conquer people, we

liberate people -- because we hold true to our values of life and liberty and the

pursuit of happiness. The security of our homeland, the need to make sure that

America is safe and secure while we chase peace is my number one priority for the


But I've got another priority, as well. I not only want America to be safer and

stronger, I want America to be better. (Applause.) I want America to be a better

place. I worry about our economy, because there are people who can't find work

who want to work. In this town, people look at numbers all the time -- you know,

such and such a number dropped, or this number increased. What I worry about are

hearts and souls. That's what I worry about. And if somebody is trying to find work

who can't find work, we need to continue to expand our job base. (Applause.)

We also have got to understand, in this land of plenty, there are pockets of

hopelessness and despair. You know, I mentioned the word American Dream in

Atlanta. I also recognize that some people aren't sure that dream extends to them.

Some people don't even know what the dream means. And our job -- our jobs, our

collective jobs, is to make sure that notion of the American Dream extends into

every single neighborhood around this country. (Applause.)

I know this isn't the right department when I talk about education, but education,

making sure every child is educated and no child is left behind, is part of making

sure the American Dream extends to every single neighborhood in America.

(Applause.) And we're making progress in a practical way when it comes to

educating children, because, you know what, for the first time the federal

government says, if you receive money, you need to let us know whether the

children are learning to read and write and add and subtract. And if they are, we'll

praise the teachers and praise the parents and praise the administrators. But if not,

if our children can't read and write and add and subtract, instead of just hoping

something changes, we're going to use the accountability system to insist upon

change, so every child has a chance to realize the dream in America. (Applause.)

But I believe owning something is a part of the American Dream, as well. I believe

when somebody owns their own home, they're realizing the American Dream. They

can say it's my home, it's nobody else's home. (Applause.) And we saw that

yesterday in Atlanta, when we went to the new homes of the new homeowners. And

I saw with pride firsthand, the man say, welcome to my home. He didn't say,

welcome to government's home; he didn't say, welcome to my neighbor's home; he

said, welcome to my home. I own the home, and you're welcome to come in the

home, and I appreciate it. (Applause.) He was a proud man. He was proud that he

owns the property. And I was proud for him. And I want that pride to extend all

throughout our country.

One of the things that we've got to do is to address problems straight on and deal

with them in a way that helps us meet goals. And so I want to talk about a couple of

goals and -- one goal and a problem.

The goal is, everybody who wants to own a home has got a shot at doing so. The

problem is we have what we call a homeownership gap in America. Three-quarters

of Anglos own their homes, and yet less than 50 percent of African Americans and


Hispanics own homes. That ownership gap signals that something might be wrong in

the land of plenty. And we need to do something about it.

We are here in Washington, D.C. to address problems. So I've set this goal for the

country. We want 5.5 million more homeowners by 2010 -- million more minority

homeowners by 2010. (Applause.) Five-and-a-half million families by 2010 will own

a home. That is our goal. It is a realistic goal. But it's going to mean we're going to

have to work hard to achieve the goal, all of us. And by all of us, I mean not only

the federal government, but the private sector, as well.

And so I want to, one, encourage you to do everything you can to work in a realistic,

smart way to get this done. I repeat, we're here for a reason. And part of the reason

is to make this dream extend everywhere.

I'm going to do my part by setting the goal, by reminding people of the goal, by

heralding the goal, and by calling people into action, both the federal level, state

level, local level, and in the private sector. (Applause.)

And so what are the barriers that we can deal with here in Washington? Well,

probably the single barrier to first-time homeownership is high down payments.

People take a look at the down payment, they say that's too high, I'm not buying.

They may have the desire to buy, but they don't have the wherewithal to handle the

down payment. We can deal with that. And so I've asked Congress to fully fund an

American Dream down payment fund which will help a low-income family to qualify

to buy, to buy. (Applause.)

We believe when this fund is fully funded and properly administered, which it will be

under the Bush administration, that over 40,000 families a year -- 40,000 families a

year -- will be able to realize the dream we want them to be able to realize, and

that's owning their own home. (Applause.)

The second barrier to ownership is the lack of affordable housing. There are

neighborhoods in America where you just can't find a house that's affordable to

purchase, and we need to deal with that problem. The best way to do so, I think, is

to set up a single family affordable housing tax credit to the tune of $2.4 billion over

the next five years to encourage affordable single family housing in inner-city

America. (Applause.)

The third problem is the fact that the rules are too complex. People get discouraged

by the fine print on the contracts. They take a look and say, well, I'm not so sure I

want to sign this. There's too many words. (Laughter.) There's too many pitfalls. So

one of the things that the Secretary is going to do is he's going to simplify the

closing documents and all the documents that have to deal with homeownership.

It is essential that we make it easier for people to buy a home, not harder. And in

order to do so, we've got to educate folks. Some of us take homeownership for

granted, but there are people -- obviously, the home purchase is a significant,

significant decision by our fellow Americans. We've got people who have newly

arrived to our country, don't know the customs. We've got people in certain

neighborhoods that just aren't really sure what it means to buy a home. And it

seems like to us that it makes sense to have a outreach program, an education

program that explains the whys and wherefores of buying a house, to make it easier

for people to not only understand the legal implications and ramifications, but to

make it easier to understand how to get a good loan.

There's some people out there that can fall prey to unscrupulous lenders, and we

have an obligation to educate and to use our resource base to help people

understand how to purchase a home and what -- where the good opportunities

might exist for home purchasing.

Finally, we want to make sure the Section 8 homeownership program is fully

implemented. This is a program that provides vouchers for first-time home buyers

which they can use for down payments and/or mortgage payments. (Applause.)

So this is an ambitious start here at the federal level. And, again, I repeat, you all

need to help us every way you can. But the private sector needs to help, too. They

need to help, too. Of course, it's in their interest. If you're a realtor, it's in your

interest that somebody be interested in buying a home. If you're a homebuilder, it's

in your interest that somebody be interested in buying a home.

And so, therefore, I've called -- yesterday, I called upon the private sector to help us

and help the home buyers. We need more capital in the private markets for firsttime,

low-income buyers. And I'm proud to report that Fannie Mae has heard the call

and, as I understand, it's about $440 billion over a period of time. They've used

their influence to create that much capital available for the type of home buyer we're

talking about here. It's in their charter; it now needs to be implemented. Freddie

Mac is interested in helping. I appreciate both of those agencies providing the

underpinnings of good capital.


There's a lot of faith-based programs that want to be involved with educating people

about how to buy a home. And we're going to have an active outreach from HUD.


And so this ambitious goal is going to be met. I believe it will be, just so long as we

keep focused, and remember that security at home is -- economic security at home

is just an important part of -- as homeland security. And owning a home is part of

that economic security. It's also a part of making sure that this country fulfills its

great hope and vision.

See, I tell people -- and I believe this -- that out of the evil done to America will

come some incredible good. (Applause.) You know, they thought they were

attacking a country so weak and so feeble that we might file a lawsuit or two, and

that's all we'd do. (Laughter.) That's what they thought. We're showing them the

different face of America. We're showing them that we're plenty tough. When it

comes to taking somebody trying to take away our freedoms, we're tough, and

we're going to remain tough and steadfast. (Applause.)

But I also want people to see the deep compassion of America, as well. I want the

world to see the other side of our character, which is the soft side, the decent side,

the loving side. I want people to know that when we talk about dreams, we mean

big dreams. And when we talk about a free society, we want a society in which every

citizen has the chance to advance, not just a few.

And part of the cornerstone of America is the ability for somebody, regardless of

where they're from, regardless of where they were born, to say, this is my home; I

own this home, it is my piece of property, it is my part of the American experience.

It is essential that we stay focused on the goal, and work hard to achieve that goal.

And when it's all said and done, we can look back and say, because of my work,

because of our collective work, America is a better place. Out of evil came incredible


Thank you all for coming by.


Content updated June 18, 2002 Back to Top

U.S. Department of Housing and Urban Development

451 7th Street S.W., Washington, DC 20410

Telephone: (202) 708-1112 TTY: (202) 708-1455

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Constant purchasing power accounting

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From Wikipedia, the free encyclopedia

Constant purchasing power accounting (CPPA) is an

accounting model approved by the International Accounting

Standards Board (IASB) and the US Financial Accounting

Standards Board (FASB) as an alternative to traditional

historical cost accounting under hyper-inflationary

environments [1] and all other economic environments. Under

this IFRS and US GAAP authorized system, financial capital

maintenance is always measured in units of constant

purchasing power (CPP) in terms of a Daily CPI (consumer

price index) during low inflation, high inflation, hyperinflation

and deflation; i.e., during all possible economic environments.

During all economic environments it can also be measured in

a monetized daily indexed unit of account (e.g. the Unidad de

Fomento in Chile) or in terms of a daily relatively stable foreign

currency parallel rate, particularly during hyperinflation when a

government refuses to publish CPI data.

Part of a series on


Historical cost ·

Constant purchasing power · Management

· Tax

Major types

Audit · Budget · Cost · Forensic · Financial ·

Fund · Governmental · Management · Social ·


Key concepts

Accounting period · Accrual ·

Constant purchasing power ·




Contents [hide]

1 Authorized by the IASB during low inflation

2 Net monetary gains and losses authorized during low

inflation and deflation in IFRS since 1989

3 Underlying assumptions

4 Difference between US GAAP and IFRS

5 Concepts of capital maintenance and the determination of


6 See also

7 References

8 External links

Authorized by the IASB during low

inflation [ edit ]

In the IASB's original Framework (1989), Par 104 (a), CPPA

was authorized as an alternative to the traditional HCA model

at all levels of inflation and deflation, including during

hyperinflation as required in IAS 29. Income statement

constant items like salaries, wages, rents, pensions, utilities,

transport fees, etc. are normally valued in units of CPP during

low inflation in most economies as an annual update.

Payments in money for these items are normally inflationadjusted

by means of the consumer price index (CPI) to

compensate for the erosion of the real value of money (the

monetary medium of exchange) by inflation only on an annual

not daily basis. "Inflation is always and everywhere a

monetary phenomenon" and can only erode the real value of

money (the functional currency inside an economy) and other

monetary items. Inflation can not and does not erode the real

value of non-monetary items. Inflation has no effect on the real

value of non-monetary items.

Economic entity · Fair value · Going concern ·

Historical cost · Matching principle · Materiality

· Revenue recognition · Unit of account

Selected accounts

Assets · Cash · Cost of goods sold ·

Depreciation / Amortization · Equity ·

Expenses · Goodwill · Liabilities · Profit ·


Accounting standards

Generally-accepted principles ·

Generally-accepted auditing standards ·

Convergence ·

International Financial Reporting Standards ·

International Standards on Auditing ·

Management Accounting Principles

Financial statements

Annual report · Balance sheet · Cash-flow ·

Equity · Income · Management discussion ·

Notes to the financial statements


Bank reconciliation · Debits and credits ·

Double-entry system · FIFO and LIFO ·

Journal · Ledger / General ledger · T accounts

· Trial balance


Financial · Internal · Firms · Report

People and organizations

Accountants · Accounting organizations ·

Luca Pacioli









History · Research · Positive accounting ·

Sarbanes–Oxley Act

V · T · E

Net monetary gains and losses authorized during low inflation and

deflation in IFRS since 1989 [ edit ]

Accountants have to calculate the net monetary loss or gain from holding monetary items when they choose

the CMUCPP model and measure financial CMUCPP in the same way as the IASB currently requires its

calculation and accounting during hyperinflation. The calculation and accounting of net monetary losses and

gains during low inflation and deflation have thus been authorized in IFRS since 1989. There are net

monetary losses and net monetary gains during low inflation too, but they are not required to be calculated

when accountants choose the traditional HCA model.

Net constant item gains and losses are also calculated and accounted under CMUCPP.

Underlying assumptions [ edit ]

IFRS authorize three basic accounting models:

1. Physical Capital Maintenance. [2]

2. Financial capital maintenance in nominal monetary units or Historical cost accounting (see the Framework

(1989), Par 104 (a)).

3. Constant Purchasing Power Accounting (see the Framework (1989), Par 104 (a)).

A. Under Historical cost accounting the underlying assumptions used in IFRS are:


Accrual basis: the effect of transactions and other events are recognized when they occur, not as cash

is gained or paid.

Going concern: an entity will continue for the foreseeable future.

Stable measuring unit assumption: financial capital maintenance in nominal monetary units or

traditional Historical cost accounting; i.e., accountants consider changes in the purchasing power of the

functional currency up to but excluding 26% per annum for three years in a row (which would be 100%

cumulative inflation over three years or hyperinflation as defined in IFRS) as immaterial or not sufficiently

important for them to choose financial capital maintenance in units of CPP during low inflation and

deflation as authorized in IFRS in the Framework (1989), Par 104 (a).

The stable measuring unit assumption (traditional Historical Cost Accounting) during annual inflation of 26%

for 3 years in a row would erode 100% of the real value of all constant real value non-monetary items not

maintained under the Historical Cost paradigm.

B. Under Constant Purchasing Power Accounting the underlying assumptions in IFRS are:

Accrual basis: the effect of transactions and other events are recognized when they occur, not as cash

is gained or paid.

Going concern: an entity will continue for the foreseeable future.

Measurement in units of CPP of all constant real value non-monetary items automatically remedies the

erosion caused by the stable measuring unit assumption (Historical Cost Accounting) of the real nonmonetary

values of all constant real value non-monetary items never maintained constant at all levels of

inflation and deflation. It is not low inflation, high inflation or hyperinflation doing the eroding. It is the

implementation of the stable measuring unit assumption during low inflation, high inflation and

hyperinflation. Constant real value non-monetary items are measured in units of CPP in terms of a daily

rate at all levels of inflation and deflation. Monetary items are inflation-adjusted daily. Net monetary

losses and gains are calculated when monetary items are not inflation-adjusted daily in terms of a daily

rate. Variable items are measured in terms of IFRS and then updated daily in terms of a daily rate. All

non-monetary items (variable real value non-monetary items and constant real value non-monetary

items) in Historical Cost or Current Cost period-end financial statements are restated in terms of the

period-end monthly published CPI during hyperinflation as required in IAS 29 Financial Reporting in

Hyperinflationary Economies.

Difference between US GAAP and IFRS [ edit ]

A major difference between US GAAP and IFRS is the fact that three fundamentally different concepts of

capital and capital maintenance are authorized in IFRS while US GAAP only authorize two capital and

capital maintenance concepts during low inflation and deflation: (1) physical capital maintenance and (2)

financial capital maintenance in nominal monetary units (traditional Historical Cost Accounting) as stated in

Par 45 to 48 in the FASB Conceptual Statement Nº 5. US GAAP does not recognize the third concept of

capital and capital maintenance during low inflation and deflation, namely, financial CMUCPP as authorized

in IFRS in the framework, Par 104 (a) in 1989.

Concepts of capital

Par 102 A financial concept of capital is adopted by most entities in preparing their financial statements.

Under a financial concept of capital, such as invested money or invested purchasing power, capital is

synonymous with the net assets or equity of the entity. Under a physical concept of capital, such as

operating capability, capital is regarded as the productive capacity of the entity based on, for example,

units of output per day. [3]

Par 103 The selection of the appropriate concept of capital by an entity should be based on the needs of

the users of its financial statements. Thus, a financial concept of capital should be adopted if the users of

financial statements are primarily concerned with the maintenance of nominal invested capital or the

purchasing power of invested capital. If, however, the main concern of users is with the operating

capability of the entity, a physical concept of capital should be used. The concept chosen indicates the

goal to be attained in determining profit, even though there may be some measurement difficulties in

making the concept operational. [4]


Concepts of capital maintenance and the determination of profit [ edit ]

Par 104 The concepts of capital give rise to the following concepts of capital maintenance:

(a) Financial capital maintenance. Under this concept a profit is earned only if the financial (or

money) amount of the net assets at the end of the period exceeds the financial (or money) amount of

net assets at the beginning of the period, after excluding any distributions to, and contributions from,

owners during the period. Financial capital maintenance can be measured in either nominal

monetary units or units of CPP.

(b) Physical capital maintenance. Under this concept a profit is earned only if the physical productive

capacity (or operating capability) of the entity (or the resources or funds needed to achieve that

capacity) at the end of the period exceeds the physical productive capacity at the beginning of the

period, after excluding any distributions to, and contributions from, owners during the period. [5]

The three concepts of capital defined in IFRS during low inflation and deflation are:

(A) Physical capital. See paragraph 102.

(B) Nominal financial capital. See paragraph 104 (a).

(C) Constant purchasing power financial capital. See paragraph 104 (a). [6]

The three concepts of capital maintenance authorized in IFRS during low inflation and deflation are:

(1) Physical capital maintenance: optional during low inflation and deflation. Current Cost Accounting

model prescribed by IFRS. See Par 106.

(2) Financial capital maintenance in nominal monetary units (Historical cost accounting): authorized

by IFRS but not prescribed—optional during low inflation and deflation. See Par 104 (a) Historical cost

accounting. Financial capital maintenance in nominal monetary units per se during inflation and deflation

is a fallacy: it is impossible to maintain the real value of financial capital constant with measurement in

nominal monetary units per se during inflation and deflation.

(3) Financial capital maintenance in units of CPP in terms of a Daily Consumer Price Index or daily

rate at all levels of inflation and deflation (see the original Framework (1989), Par 104 (a)) [now

Conceptual Framework (2010), Par. 4.59 (a)] under the Capital Maintenance in Units of Constant

Purchasing Power paradigm. [7][8]

See also [ edit ]


Inflation accounting

List of International Financial Reporting Standards

Negative interest on excess reserves

Purchasing power

Unit of account

References [ edit ]

1. ^ "IFRS Interpretations Committee Meeting : IAS 29 Financial Reporting in hyperinflationary Economies"

(PDF). Archived from the original (PDF) on 24 September 2015. Retrieved 24 February 2015.

2. ^

3. ^ IFRS, Framework for the Preparation and Presentation of Financial Statements, Par. 102

4. ^ IFRS, Framework for the Preparation and Presentation of Financial Statements, Par. 103

5. ^ IFRS, Framework for the Preparation and Presentation of Financial Statements, Par. 104

6. ^ Constant Purchasing Power Accounting

7. ^

8. ^ page 25 of 74

External links [ edit ]

Irving Fisher (1911) The Purchasing Power of Money

Categories: Accounting systems Inflation Accounting terminology


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本 語 ⽇


Edit links

For the German sculptor, see Richard Martin Werner.

Richard Andreas Werner (born 5 January 1967) is a German banking and development economist who is

a university professor at De Montfort University.

He has proposed the "Quantity Theory of Credit", or "Quantity Theory of Disaggregated Credit", which

disaggregates credit creation used for the real economy (GDP transactions) on the one hand, and financial

transactions on the other hand. [1] In 1995, he proposed a new monetary policy to swiftly deal with banking

crises, which he called 'Quantitative Easing', published in the Nikkei. [2] He also first used the expression

"QE2" in public, referring to the need to implement 'true quantitative easing' as an expansion in credit

creation. [3] His 2001 book 'Princes of the Yen' was a number one general bestseller in Japan. In 2014 he

published the first empirical evidence that each bank creates credit when it issues a new loan. [4]

Contents [hide]

1 Early life

2 Career

3 Selected works

4 Honors

5 References


6 External links

Early life [ edit ]

In 1989, Werner earned a BSc in economics at the London School of Economics (LSE). During his

postgraduate studies at Oxford University he spent over a year in Japan, studying at the University of Tokyo

and working at the Nomura Research Institute. [5] His DPhil in economics was conferred by Oxford. In 1991,

he became European Commission-sponsored Marie Curie Fellow at the Institute for Economics and

Statistics at Oxford. [5] His 1991 discussion paper at the institute warned about the imminent 'collapse' of the

Japanese banking system and the threat of the "greatest recession since the Great Depression". In Tokyo,

he also became the first Shimomura Fellow at the Research Institute for Capital Formation at the

Development Bank of Japan. He was a Visiting Researcher at the Institute for Monetary and Economic

Studies at the Bank of Japan; and he was a Visiting Scholar at the Institute for Monetary and Fiscal Studies

at the Ministry of Finance. [5]

Career [ edit ]

Werner was chief economist of Jardine Fleming from 1994 to 1998 and published several articles on the

Japanese credit cycle and monetary policy, many of which are in Japanese. In 1997, he joined the faculty of

Sophia University in Tokyo. [5] Werner was senior managing director and senior portfolio manager at Bear

Stearns Asset Management. He worked at the University of Southampton for 14 years, mainly as Chair and

Professor in International Banking. [5] He is the founding director of the university's Centre for Banking,

Finance and Sustainable Development and organiser of the European Conference on Banking and the

Economy (ECOBATE), first held on 29 September 2011 in Winchester Guildhall, with Lord Adair Turner, FSA

Chairman, as keynote speaker. From 2011 to 2019, he was a member of the ECB Shadow


[citation needed]

Werner has developed a theory of money creation called the Quantity Theory of Credit, which is in line with

Schumpeter's credit theory of money. [6] He has argued, since 1992, that the banking sector needs to be

reflected appropriately in macroeconomic models since it is the main creator and allocator of the money

supply, through the process of credit creation by individual banks. [7]

Werner's book Princes of the Yen, about the modern economic development of Japan, including the bubble

of the 1990s and subsequent bust, was a number one general bestseller in Japan in 2001. [8] The book

covers the monetary policy of the Bank of Japan specifically and central bank informal guidance of bank

credit in general. [9]

Werner proposed a policy he called "quantitative easing" in Japan in 1994 and 1995. At the time working as

chief economist of Jardine Fleming Securities (Asia) Ltd. in Tokyo, he used this expression during

presentations to institutional investors in Tokyo. It is also, among others, in the title of an article he published

on September 2, 1995, in the Nihon Keizai Shinbun (Nikkei). [10] According to Werner, he used this phrase in

order to propose a new form of monetary stimulation policy by the central bank that relied neither on interest

rate reductions (which Werner claimed in his Nikkei article would be ineffective) nor on the conventional

monetarist policy prescription of expanding the money supply (e.g. through "printing money", expanding

high-powered money, expanding bank reserves or boosting deposit aggregates such as M2 –all of which

Werner also claimed would be ineffective). [11] Instead, Werner argued, it was necessary and sufficient for an

economic recovery to boost "credit creation", through a number of measures. [10] He also suggested direct

purchases of non-performing assets from the banks by the central bank; direct lending to companies and the

government by the central bank; purchases of commercial paper, other debt, and equity instruments from

companies by the central bank; and stopping the issuance of government bonds to fund the public sector

borrowing requirement, instead having the government borrow directly from banks through a standard loan

contract. [12][13]

Werner is founding director and chairman of Local First Community Interest Company, which promotes the

establishment of not-for-profit local community banks, modelled on the successful German local cooperative,

Raiffeisen and Sparkasse savings banks that have enabled German small firms to become top

exporters and job creators in Germany. [14]


In 2019, Werner took out a discrimination case against his employer, Southampton University, claiming he

was discriminated against and ‘victimised’ in a ‘harassment and bullying’ campaign for being German and

Christian, during his 14 years career at the university. The £2.5m payout was one of the largest awards ever

made by a British tribunal and was so high because the university failed to defend itself although the

University are appealing the decision. [15]

Selected works [ edit ]


Ryan-Collins, Josh; Werner, Richard; Jackson, Andrew (2012). Where Does Money Come From?: A

Guide to the UK Monetary & Banking System (2nd ed.). London: New Economics Foundation. p. 178.

ISBN 978-1908506238. OCLC 816167522 .

Neue Wirtschaftspolitik, München: Vahlen Verlag (2007) - New Economic Policy, Munich: Vahlen

Publishing House (2007)

New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance (2005)


Princes of the Yen: Japan's central bankers and the transformation of the economy (2001) 2nd edition

2018 by Quantum Publishers [9]

虚 構 の 終 焉 』 = Towards a new macroeconomic paradigm. Tokyo: PHP. (2003)

謎 解 き! 平 成 ⼤ 不 況 : 誰 も 語 らなかった「 危 機 」の 本 質 』 = The enigma of the great recession (2003)

Three essays on Japanese macroeconomic policy in the 1980s and 1990s (2006)

福 井 ⽇ 銀 ・ 危 険 な 素 顔 』 = The Bank of Japan under Toshihiko Fukui, with M. Ishii. Tokyo: Appuru

Shuppan. (2003)

不 景 気 が 終 わらない 本 当 の 理 由 』 = Central Banking and Structural Changes in Japan and Europe.

Tokyo: Soshisha. (2003)

Dismantaling the Japanese Model, with M. Kikkawa. Tokyo: Kodansha. (2003)

Princes of the Yen, Japan's Central Bankers and the Transformation of the Economy. New York: M.E.


円 の⽀ 配 者 』. Tokyo: Soshisha (2001)


1998 – "Bank of Japan window guidance and the creation of the bubble," in: Rodao, F. and A. Lopez

Santos (eds.), El Japon Contemporaneo, Salamanca: University of Salamanca Press

2002 – "Macroeconomic Management in Thailand: The Policy-induced Crisis," in: Rhee, G.S. (eds.),

Rising to the Challenge in Aisa: A Study of Financial Markets, Vol. II, Thailand, Manila: Asian

Development Bank

2006 – "The relationship between interest rates and economic activity: How the conventional literature

has dealt with the Japanese experience," in: Batten, J.A., Fetherston, T.A. and Szilagyi, P.G. (eds.),

Japanese Fixed Income Markets: Money, Bond and Interest Rate Derivatives, Amsterdam: Elsevier

(pp. 135–170)

2007 – "Europe’s choice and lessons from Japan: supply vs. demand policy, fiscal vs. monetary policy,"

in: Terzi, A. and J. Bibow (eds.), Euroland and the World Economy: Global Player or Global Drag,

Basingstoke: Palgrave Macmillan

2007 – "The cause of Japan’s recession and the lessons for the world," in: Bailey, Coffey and Tomlinson

(eds), Crisis or Recovery: Industry and State in Japan. Cheltenham: Edward Elgar

2008 – "Was sind die Voraussetzungen fuer ein gesundes Wirtschaftswachstum ohne

Bankenprobleme?," in: Carl Spaengler KAG (ed.), 20 Fragen zur Geldanlage. Salzburg: Carl Spaengler

Kapitalanlagegesellschaft mbH.


1994 – Werner, Richard A. (1994). "Japanese Foreign Investment and the "Land Bubble" ". Review of

International Economics. 2 (2): 166–178. doi:10.1111/j.1467-9396.1994.tb00038.x .

1997 – Werner, R. A. (July 1997). "Towards a new monetary paradigm: a quantity theorem of

disaggregated credit, with evidence from Japan" . Kredit und Kapital. 30: 276–309.


2002 – Werner, Richard A. (2002). "Monetary Policy Implementation in Japan: What They Say versus

What They do". Asian Economic Journal. 16 (2): 111–151. doi:10.1111/1467-8381.00145 .

2003 – Werner, Richard A. (2002). "Post-Crisis Banking Sector Restructuring and Its Impact on

Economic Growth". Japanese Economy. 30 (6): 3–37. doi:10.2753/JES1097-203X30063 .

2003 – Werner, Richard A. (2002). "Aspects of Career Development and Information Management

Policies at the Bank of Japan" . Japanese Economy. 30 (6): 38–60. doi:10.2753/JES1097-

203X300638 .

2003 – Werner, Richard A. (2002). "A Reconsideration of the Rationale for Bank-Centered Economic

Systems and the Effectiveness of Directed Credit Policies in the Light of Japanese Evidence". Japanese

Economy. 30 (3): 3–45. doi:10.2753/JES1097-203X30033 .

2004 – Werner, Richard A. (2004). "No Recovery without Reform? An Evaluation of the Evidence in

Support of the Structural Reform Argument in Japan". Asian Business & Management. 3: 7–38.

doi:10.1057/palgrave.abm.9200077 .

2009 – Werner, Richard A. (6 June 2009). "Financial crises in Japan during the 20th century" .

Bankhistorisches Archiv. 47: 98–123.

2011 – Voutsinas, Konstantinos; Werner, Richard A. (2011). "Credit supply and corporate capital

structure: Evidence from Japan". International Review of Financial Analysis. 20 (5): 320–334.

doi:10.1016/j.irfa.2011.05.002 .

2011 – Chen, Yuanquan; Werner, Richard A. (2011). "The role of monetary aggregates in Chinese

monetary policy implementation". Journal of the Asia Pacific Economy. 16 (3): 464–488.

doi:10.1080/13547860.2011.589633 .

2011 – Werner, Richard (2011). "Economics as if Banks Mattered: A Contribution Based on the Inductive

Methodology". The Manchester School. 79: 25–35. doi:10.1111/j.1467-9957.2011.02265_5.x .

2012 - Lyonnet, Victor; Werner, Richard (2012). "Lessons from the Bank of England on 'quantitative

easing' and other 'unconventional' monetary policies". International Review of Financial Analysis. 25:

94–105. doi:10.1016/j.irfa.2012.08.001 .

2012 - Werner, Richard A. (2012). "Towards a new research programme on 'banking and the economy'

— Implications of the Quantity Theory of Credit for the prevention and resolution of banking and debt

crises" (PDF). International Review of Financial Analysis. 25: 1–17. doi:10.1016/j.irfa.2012.06.002 .

2013 - Werner, Richard A. (2013). "Towards a More Stable and Sustainable Financial Architecture – A

Discussion and Application of the Quantity Theory of Credit". Credit and Capital Markets – Kredit und

Kapital. 46 (3): 357–387. doi:10.3790/ccm.46.3.357 .

2013 - Werner, Richard A. (2013). "Commentary" . Environment and Planning A: Economy and Space.

45 (12): 2789–2796. doi:10.1068/a130106c .

2014 - 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.

doi:10.1016/j.irfa.2014.07.015 .

2014 - Werner, Richard A. (2014). "Enhanced Debt Management: Solving the eurozone crisis by linking

debt management with fiscal and monetary policy" . Journal of International Money and Finance. 49:

443–469. doi:10.1016/j.jimonfin.2014.06.007 .

2015 - Werner, Richard A. (2014). "How do banks create money, and why can other firms not do the

same? An explanation for the coexistence of lending and deposit-taking" . International Review of

Financial Analysis. 36: 71–77. doi:10.1016/j.irfa.2014.10.013 .

2016 - Werner, Richard A. (2016). "A lost century in economics: Three theories of banking and the

conclusive evidence" (PDF). International Review of Financial Analysis. 46: 361–379.

doi:10.1016/j.irfa.2015.08.014 .

2016 - Ryan-Collins, Josh; Werner, Richard A.; Castle, Jennifer (2016). "A half-century diversion of

monetary policy? An empirical horse-race to identify the UK variable most likely to deliver the desired

nominal GDP growth rate" . Journal of International Financial Markets, Institutions and Money. 43:

158–176. doi:10.1016/j.intfin.2016.03.009 .

2018 - Lee, Kang-Soek; Werner, Richard A. (2018). "Reconsidering Monetary Policy: An Empirical

Examination of the Relationship Between Interest Rates and Nominal GDP Growth in the U.S., U.K.,

Germany and Japan" . Ecological Economics. 146: 26–34. doi:10.1016/j.ecolecon.2017.08.013 .


2018 - Bermejo Carbonell, Jorge; Werner, Richard A. (2018). "Does Foreign Direct Investment Generate

Economic Growth? A New Empirical Approach Applied to Spain" . Economic Geography. 94 (4): 425–

456. doi:10.1080/00130095.2017.1393312 .


1991 – "The Great Yen Illusion: Japanese Capital Flows and the Role of Land," Oxford Applied

Economics Discussion Paper Series, Oxford: Institute of Economics and Statistics, University of Oxford,

No. 129, December

1993 – "Towards a quantity theorem of disaggregated credit and international capital flows," Paper

presented at the Royal Economic Society Annual Conference, York, April 1993

2010 – Comment on Range of Methodologies for Risk and Performance Alignment of Remuneration [in

the banking sector], official submission to public call for comments on ‘Range of Methodologies for Risk

and Performance Alignment of Remuneration, Consultative Document’ by the Basel Committee on

Banking Supervision, 14 October 2010, submitted 31 December 2010. [16]

2010 – Towards Stable and Competitive Banking in the UK - Evidence for the ICB, submitted to the

Independent Commission on Banking, UK (Chair: Professor Sir John Vickers), submitted 19 November

2010 [17]

2010 – Towards a Twenty-First Century Banking and Monetary System, Joint Submission to the

Independent Commission on Banking, UK (Chair: Professor Sir John Vickers), with Ben Dyson, Tony

Greenham, Josh Ryan-Collins, by the Centre for Banking, Finance and Sustainable Development, the

new economics foundation, and Positive Money, submitted 19 November 2010 PDF

2010 – Comment on Strengthening the Resilience of the Banking Sector, official submission to public

call for comments on ‘Strengthening the Resilience of the Banking Sector, Consultative Document’ by

the Basel Committee on Banking Supervision, September 2009. [18] Submitted 16 April 2010; published

by the Bank for International Settlements, Basel. [19]

Honors [ edit ]

2003 – World Economic Forum in Davos, "Global Leader for Tomorrow" [20]

References [ edit ]

1. ^ Werner, R. A. (July 1997). "Towards a new monetary paradigm: A quantity theorem of disaggregated credit,

with evidence from Japan" . Kredit und Kapital. 30: 276–309.

2. ^ Richard A. Werner (1995), Keiki kaifuku, ryōteki kinyū kanwa kara, (How to Create a Recovery through

‘Quantitative Monetary Easing’), The Nihon Keizai Shinbun (Nikkei), ‘Keizai Kyōshitsu’ (‘Economics Classroom’),

2 September 1995 (morning edition), p. 26; English translation by T. John Cooke (November 2011) [1]

3. ^ Richard Werner, "Keizai Kyoshitsu: Keiki kaifuku, ryoteiki kinyu kanwa kara," Nikkei, 2 September 1995. ‘QE2’

was first used publicly by Richard Werner live on CNBC on 22 September 2009. He argued that 'true

quantitative easing' was needed, namely an expansion in productive credit creation. This required a second

attempt by central banks, "a kind of QE2". Squawkbox, CNBC, live studio panel, 18:00-21:00 hrs London time, 22

September 2009. Meanwhile, the expression is today mainly used to refer to a second round of what Prof.

Werner would consider the 'wrong type' of QE.

4. ^ Werner, Richard A. (2014). How do banks create money, and why can other firms not do the same? An

explanation for the coexistence of lending and deposit-taking, International Review of Financial Analysis, 36, 71-

77, [2]

5. ^ a b c d e University of Southampton, Richard Werner ; retrieved 2011-08-20

6. ^ Richard A. Werner (1992), ‘Towards a quantity theory of disaggregated credit and international capital flows’,

Paper presented at the Royal Economic Society Annual Conference, York, April 1993 and at the 5th Annual

PACAP Conference on Pacific-Asian Capital Markets in Kuala Lumpur, June 1993

7. ^ Richard A. Werner (1992), ‘Towards a quantity theory of disaggregated credit and international capital flows’,

later published as Werner, Richard A. (1997). ‘Towards a New Monetary Paradigm: A Quantity Theorem of

Disaggregated Credit, with Evidence from Japan’, Kredit und Kapital, vol. 30, no. 2, July 1997, pp. 276-309. See

also Werner, Richard A. (2012). Towards a New Research Programme on ‘Banking and the Economy’ –

Implications of the Quantity Theory of Credit for the Prevention and Resolution of Banking and Debt Crises,

International Review of Financial Analysis, 25, 94-105, [3]

8. ^ Yamagawa, Hiroshi. "BOJ planned bubble, decade of misery," The Japan Times, 27 July 2001; retrieved



9. ^ "Book exposes BOJ 'rulers'," Asahi Shimbun. May 10, 2001; retrieved 2011-08-20

10. ^ a b Richard Werner, Keizai Kyoshitsu: Keiki kaifuku, ryoteiki kinyu kanwa kara, Nikkei, 2 September 1995.

11. ^ Nikkei 2 Sept. 1995, op. cit; see also Lyonnet and Werner (2012), Lessons from QE and other ‘unconventional’

monetary policies – Evidence from the Bank of England, Centre for Banking, Finance and Sustainable

Development Discussion Paper, University of Southampton

12. ^ Richard Werner, Keizai Kyoshitsu: Keiki kaifuku, ryoteiki kinyu kanwa kara, Nikkei, 2 September 1995. But also

other publications, e.g. Japanese Economist, 14 July 1998 [4] ; Financial Times, 9 February 2000 [5]

13. ^ Richard A. Werner, New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic

Performance, Basingstoke: Palgrave Macmillan

14. ^ [6]

15. ^ [7]

16. ^

17. ^ "Southampton Business School | University of Southampton" (PDF).

18. ^ "Strengthening the resilience of the banking sector" . 2009-12-17.

19. ^

20. ^ Press Release: "The World Economic Forum Designated 100 New Global Leaders for Tomorrow: Richard A

Werner Selected for Class of 2003" ; retrieved 2011-08-20

External links [ edit ]

Official site

Authority control

BNF: cb156033938 (data) · GND: 133225011 · ISNI: 0000 0001 1469 788X ·

LCCN: n2002107982 · NLK: KAC200411312 · NTA: 258457678 ·

SUDOC: 087584913 · VIAF: 28254193 · WorldCat Identities: lccn-n2002107982

Categories: Academics of the University of Southampton German economists Living people

Monetary reformers 1967 births Academics of De Montfort University

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you agree to the Terms of Use and Privacy Policy. Wikipedia® is a registered trademark of the Wikimedia Foundation, Inc., a

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Centre for Banking, Finance

& Sustainable Development

Business School

Scientific Macroeconomics &

The Quantity Theory of Credit

Prof. Richard A. Werner, D.Phil. (Oxon)

Centre for Banking, Finance and Sustainable Development

University of Southampton Business School

14 March 2018

Invited Contribution for the Workshop

Real analysis versus monetary analysis: Does it matter and what are its main

implications for macroeconomic theory and policy?

© Richard A. Werner 2018

Österreichische Nationalbank


Centre for Banking, Finance

& Sustainable Development

Business School

There had been many “anomalies” in finance, banking &


1. Why are banks are special?

2. Why do we witness recurring banking crises?

3. What is the link between money/finance/banking & the economy?

(velocity decline)

4. What is money and how can we measure it?

5. Why are interest rate policies often not effective?

6. Why is fiscal policy often not effective?

7. What determines asset prices?

8. Why have Germany, Japan, Korea, China grown so fast without free markets?

9. Why have many developing countries failed to develop?

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

3. What is the Link between Money and the Economy?

‣ Classical Economics

‣ Keynesian Economics

– IS-LM Synthesis

– Phillips Curve

‣ Monetarism

MV=PY; price of money (i)

MV=PY; price of money (i)

MV=PY; price of money (i)

‣ New Classical Economics

– Rational Expectations MV=PY

– Real Business Cycle/ Supply-side (no money), price of money (i)

‣ Fiscalism / Post-Keynesianism

‣ New Monetary Policy Consensus

(Woodford, 2003)

MV=PY, price of money (i)

M does not matter;

price of money (i) is key

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Anomaly No. 3:

The relationship between Money and the Economy ‘broke down’

Conventional theory assumed that all money is used for GDP transactions.

Effective Money = nominal GDP


with constant or stable V

“an identity, a truism” (M. Friedman, 1992)

“valid under any set of circumstances whatever” (Handa, 2000)


© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Anomaly No. 3:

The relationship between Money and the Economy ‘broke down’

















80 82 84 86 88 90 92 94 96 98 00 02


Source: Bank of Japan, Cabinet Office, Government of Japan











70 72 74 76 78 80 82 84 86 88 90 92 94 96 98 00 02

© Richard Source: Bank of Japan, A. Cabinet Werner Office, Government of 2018



But by the mid-1980s:

• Velocity V declined

MV = PY; M d = kPY

(V const.; k const.)

• ‘Breakdown of the money demand

function’ in Japan, US, UK, Scand., Asia

• ‘Mystery of the missing money’

• A world-wide “puzzling” anomaly

(Belongia & Chalfant, 1990).

• The quantity relationship “came apart at

the seams during the course of the 1980s”

(Goodhart, 1989).


Centre for Banking, Finance

& Sustainable Development

3. The “Anomaly” of the Velocity Decline

Business School

The textbook link between money & the economy:

MV = PY; M d = kPY

(V const.; k const)

‣ Standard deposit aggregates (M0, M1, M2, etc.) are not in a reliable

relationship with economic activity (‘velocity decline’)

‣ Once viewed as “a pillar of macroeconomic models”, the quantity equation “is

now … one of the weakest stones in the foundation” (Boughton, 1991).

‣ Attempted explanations only raise further puzzles: if the velocity decline is

due to financial deregulation and liberalisation, should this not increase,

instead of reducing the velocity?

‣ This means most of the mainstream macroeconomic theories that include

money do not work. As a result, the moneyless real business cycle and

DSGE models have become dominant.

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Five Steps to Explain Many ‘Anomalies‘ and Formulate

Successful Macro Policies

I. Common Feature: The deductive (hypothetico-axiomatic) research methodology

of equilibrium economics.

The alternative: The inductive research methodology (common in the sciences).

II. Empirical evidence on key issues: What makes banks special? Which of the 3

banking theories is correct? What is money and how can we measure it?

III. Macro-Finance: Incorporating Banking into Macroeconomics –

The Quantity Theory of (Disaggregated) Credit

IV. Policies to prevent banking crises and ensure high and sustainable economic growth

V. Post-banking crisis stimulation policies: The original Quantitative Easing and

Enhanced Debt Management

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

I. Research Methodology

There are two approaches to research methodology:

• the empiricist approach, aka the inductive methodology;

• the axiomatic approach, aka the deductive approach.

Business School



“characterized by the inference of general laws from particular instances.”

Source: Compact Oxford English Dictionary

deductive or axiomatic method:

“In logic, the procedure by which an entire science or system of

theorems is deduced in accordance with specified rules by logical

deduction from certain basic propositions (axioms), which in turn are

constructed from a few terms taken as primitive. These terms may be

either arbitrarily defined or conceived according to a model in which some

intuitive warrant for their truth is felt to exist.”

Source: Britannica Concise Encyclopaedia

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Which approach is most widely used in the sciences?

‣ This is an empirical question. Using the inductive approach, we can observing what

scientists actually do.

‣ Historically, many scientists have followed the steps below:

1. Careful observation of a set of natural phenomena

2. During observation, the material is organised in categories and classifications.

3. Observation of certain patterns and associations of the data.

4. Reflection leads to a characterisation of the observed phenomena. The

characterisations are explanatory theories.

5. The explanatory theories can be revised or rejected in the light of new facts that

emerge or are collected.

‣ This process is widely accepted in the sciences. It is called ‘inductive reasoning’.

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Methodology in Economics: The Deductive Method

I. Axiom: Individual ‘rational’ utility maximisation

People lack individual personality, are rational, and selfish-autistic, so do

not care about others at all, are never influenced by others, and mainly want

to maximise their own consumption and accumulate goods and wealth.

(Billions in advertising spending wasted!)

II. Assumptions:

3. Perfect, symmetrically distributed information

4. Complete markets

5. Perfectly flexible, instantly adjusting prices

6. Perfect competition (no oligopolies or monopolies, everyone a price-taker)

7. Zero transactions costs

8. Infinite lives, no time constraints; others

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

‣ A theoretical dream world is constructed, which is, by definition, ‘optimal’

‣ In such a world, markets are defined to be efficient and perfect.

‣ Any intervention must thus by definition be less than optimal.

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Methodology in Economics:

The Deductive Method

Business School

‣ The deductive approach is less concerned with empirical reality.

‣ Karl Popper recognised that a researcher may adopt an ‘immunizing stratagem’, “to

guard his theory against being falsified”.

‣ This is a problem especially in the deductive approach, which is prone to immunisation

and abuse by ‘reverse engineering’:

‣ Steps

1. Start with your preferred conclusion: what do we want to ‘prove’ or conclude?

E.g. gov’t intervention is bad; big business is good, should have unlimited control in society

2. Identify how a model would have to be formulated in order to conclude as in 1.

3. Identify the assumptions needed to justify the model in 2.

4. Identify the general axioms that might help justify the above.

5. Finally, the most important step: present the above in reverse order.

This is wholly unscientific

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

The Concept of Equilibrium: Where does it come from?

Theory: Markets always clear and they are efficient.

‣ Assume:

1. Perfect information; 2. Complete markets; 3. Perfect competition;

4. Instantaneous price adjustment; 5. Zero transaction costs;

6. No time constraints; 7. Profit maximisation of rational agents;

8. Nobody is influenced in any way by actions of the others.

‣ Then: It can be shown that markets clear, as prices adjust to deliver equilibrium.

‣ Hence prices

are key, incl.

the price of

money (interest)


© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development


Fact: We cannot expect markets to clear

Business School

‣ Assume:

1. Perfect information; 2. Complete markets; 3. Perfect competition;

4. Instantaneous price adjustment; 5. Zero transaction costs;

6. No time constraints; 7. Profit maximisation of rational agents;

8. Nobody is influenced in any way by actions of the others.

‣ If each assumption has a probability of 55% of being true, what is the probability of

all assumptions being jointly true?

‣ (55%) 8 = 0.8%

‣ But the individual probability is much lower.

‣ Result: Markets can never be expected to clear.

Market Equilibrium

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Rationing: Core of the New Paradigm

Business School

‣ If only one of the many assumptions does not hold, markets do not clear.

‣ Economics must recognise pervasive disequilibrium as the dominant state.

‣ What happens when markets do not clear (i.e. always)?

‣ Demand does not equal supply. Markets are rationed.

‣ Rationing in one market affects other markets.

‣ In our world, information, time and money are rationed.

‣ Thus practically all markets must be expected to be rationed.

‣ Rationed markets are determined by quantities, not prices.

‣ The outcome is determined by whichever quantity of demand or supply is

smaller (the ‘short-side principle’)

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Markets are rationed & determined by quantities

Implication: The short side has allocation power and

uses it to extract non-market benefits

‣ The ‘short-side principle’ also reveals: The short side has the power to pick

and choose who to do business with.

‣ This power is usually abused to extract non-market benefits. Think Hollywood


‣ What about money? What is the short side? What is larger: supply or demand?

‣ Who supplies most of our money?

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Five Steps to Explain Many ‘Anomalies‘ and Formulate

Successful Macro Policies

I. Common Feature: The deductive (hypothetico-axiomatic) research methodology

of equilibrium economics.

The alternative: The inductive research methodology (common in the sciences).

II. Empirical evidence on key issues: What makes banks special? Which of the 3

banking theories is correct? What is money and how can we measure it?

III. Macro-Finance: Incorporating Banking into Macroeconomics –

The Quantity Theory of (Disaggregated) Credit

IV. Policies to prevent banking crises and ensure high and sustainable economic growth

V. Post-banking crisis stimulation policies: The original Quantitative Easing and

Enhanced Debt Management

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

II. The Three Theories of Banking and the Evidence

Theories of Banking and the Economy

1. The Financial Intermediation Theory

2. The Fractional Reserve Theory

3. The Credit Creation Theory

Which one is correct?

‣ They differ in the question of where the money for a new bank

loan comes from.

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

‣ “Banks gather deposits (savings) first and then hand out this money to borrowers”

“Banks act as mere intermediary agents.” (Financial Intermediation Theory)

‣ “Banks put a reserve aside with the central bank. New loans are extended out of

new reserves.” (Fractional Reserve Theory)

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

The Three Theories of Banking:

Theory of


Read: The first empirical test:

Period of


Source of

loan money

Banks create


Banks create



approach to bank

Richard A. Werner (2014). Can Banks Individually Create Money Out of

individually collectively regulation

Nothing? – The Theories and the Empirical Evidence, International

Review of Financial Analysis, 36, 1-19

Financial since 1960s Deposits Capital adequacy

Intermediation (Basel I, II, III)

Fractional about 1920s Reserves


Reserve to 1960s


Credit Creation

until about the



(ex nihilo)

Credit growth

quotas (‘credit


© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Applying the inductive method: conducting an empirical test

‣ There had not been an empirical test of the 3 theories of banking

‣ First empirical tests: Werner (2014, 2016):

Theory of Banking

Claimed source of

loan funds

Financial Intermed. deposits rejected

Fractional Reserve reserves rejected

Empirical finding

Credit Creation created ex nihilo consistent with


‣ Concl.: Banks are quite special: they create 97% of our money supply.

‣ Theories and models not reflecting this can‘t be used to describe our


© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Economists: Banks are deposit-taking firms that lend money

Legal reality: Banks don‘t take deposits & don‘t lend money

Banks do not take deposits. They borrow: At law, ‘deposits’ are loans to the bank.

‣ When a ‘deposit’ is made with a bank, the money is not ‘on deposit’ (i.e. held in

custody by the bank). It is owned & controlled by the bank, not the ‘depositor’.

‣ This is because the ‘depositor’ lends money to the bank, and becomes a

general creditor of the bank. Hence the bank records a ‘credit’ on behalf of the

customer in its records of its debts.

Banks don’t ‘lend’ money (unlike firms, insurance companies, others).

‣ They purchase securities – the ‘loan contract’ is a promissory note (like BoE

notes, but without legal tender status) that the bank acquires.

‣ The bank does not pay out the money referred to in the loan contract. Instead,

just as with a ‘deposit’, it records a ‘credit’ on behalf of the customer in its records

of its own debts to the public. We use this as ‘money’ (Werner, 2014b).

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Trade Secret: What makes banks unique

The case of a £1,000 loan

Step 1

The bank ‘purchases’ the loan contract from the borrower and records

this as an asset.

Balance Sheet of Bank A


£ 1,000


Step 2

The bank now owes the borrower £ 1000, a liability. It records this

however as a fictitious customer deposit: the bank pretends the

borrower has deposited the money, and nobody can tell the difference.


£ 1,000


£ 1,000

NB: No money is

transferred from


So the creditor (the bank) does not give up anything when a loan is ‘paid out’

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Empirical evidence: Banks are not financial


‣ Scholars finally discover where money comes from:

‣ 97% is created by banks (not financial intermediaries) when they

extend credit (‘lend’)

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Banks are special. They create the money supply

‣ Unlike non-bank financial institutions, banks create money.

‣ They do this by what is called ‘bank lending’: credit creation.

‣ Bank credit and deposit money are created simultaneously.

‣ Credit creation is a unique measure of money as it is injected into the

economy, and that can be disaggregated by the use the new money is put to.

‣ Banks decide who gets newly created money and for what purpose.

‣ Banks reshape the economic landscape through their loan decisions.

‣ Now we know why central banks often conduct their true monetary policy by

‘guiding’ bank credit.

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Five Steps to Explain Many ‘Anomalies‘ and Formulate

Successful Macro Policies

I. Common Feature: The deductive (hypothetico-axiomatic) research methodology

of equilibrium economics.

The alternative: The inductive research methodology (common in the sciences).

II. Empirical evidence on key issues: What makes banks special? Which of the 3

banking theories is correct? What is money and how can we measure it?

III. Macro-Finance: Incorporating Banking into Macroeconomics –

The Quantity Theory of (Disaggregated) Credit

IV. Policies to prevent banking crises and ensure high and sustainable economic growth

V. Post-banking crisis stimulation policies: The original Quantitative Easing and

Enhanced Debt Management

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

III. Introducing the Reality of Bank Credit Creation in

Macro-Models (Macro Finance) is a Game Changer for…

‣ government policy (monetary policy, fiscal policy, regulatory policy)

‣ solving many of the world’s problems, including

– the problem of the recurring banking crises,

– unemployment,

– business cycles

– underdevelopment and the

– depletion of finite resources.

‣ achieving high, stable and sustainable economic development. How?

‣ solving the many puzzles and ‘anomalies’ in macroeconomics

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

The Quantity Theory of Credit (Werner, 1992, 1997)

This is how banks’ decisions reshape the economic landscape:

∆C F → ∆(P F x Q F ) C F V F = (P F x Q F ) Asset Markets

Total new credit money ∆C = +

∆C R → ∆nom. GDP C R V R = (P R x Y) Real economy

If banks create credit (money) and allocate it for

non-GDP transactions:

1. financial/asset transactions (C F ), this affects asset prices and is, in aggregate

and if large, never sustainable (banking crises, income and wealth inequality).

the ‘real economy’ (GDP transactions):

2. consumption purposes, this creates consumer price inflation (unsustainable).

3. productive purposes (productivity enhancement, technology-implementation, value

added generation), the result will be sustainable growth without inflation and with

a more equal income and wealth distribution: Money is allocated for productive,

sustainable work, producing income streams, not speculation (at best producing

capital gains).

© Richard A. Werner 2018

Centre for Banking, Finance

& Sustainable Development

Business School

Quantity Theory of Credit (Werner, 1992, 1997):

Rule: The allocation of bank credit creation determines what

will happen to the economy – good or bad...

non-GDP credit

= unproductive credit


Case 1: Financial credit

(= credit for transactions that do not

contribute to and are not part of GDP):

Result: Asset inflation, bubbles

and banking crises

GDP credit

Case 2: Consumption credit

Result: Inflation without growth

Case 3: Investment credit

(= credit for the creation of new

goods and services or productivity

gains that generate income)

Result: Growth without inflation,

even at full employment

= productive credit creation

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

The Quantity Theory of (Disaggregated) Credit (Werner, 1992, 1997)

C = C R

+ C F

∆(P R

Y) = V R

∆C R

∆(P F


) = V F

∆C F

nominal GDP ‘real economy credit creation’ asset markets financial credit creation

YoY %








83 85 87 89 91 93 95 97 99



nGDP (R)

CR (L)

YoY %

Latest: Q4 2000

Empirical result of GETS methodology:

‘Real economy credit’ determines nominal

GDP growth










YoY %










Real Estate

Credit (L)

Nationwide Residential

Land Price (R)

YoY %



71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01











Latest: H1 2001

Financial credit determines asset prices –

leads to asset cycles and banking crises

© Richard A. Werner 2018

Centre for Banking, Finance

& Sustainable Development

Business School

The solution to the breakdown of the quantity relationship:

1. Money had been defined wrongly: The money supply (deposits) is created

via credit creation, which defines effective purchasing power (Werner, 1992,


2. The assumption that the entire money supply is used for GDP transactions

(the ‘real economy‘) is wrong. In many countries the majority of credit

creation is for non-GDP transactions.

3. Thus defining money supply as credit creation (C) and disaggregating it into

the GDP and non-GDP transaction streams solves the velocity decline

puzzle and restores a stable relationship between a monetary aggregate

(credit for the real economy) and nominal GDP growth.

4. This underlines the importance of quantities in macroeconomics, which

dominate prices when markets are quantity-rationed.

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Explaining the ‘Velocity Decline’

Business School

‣ C = C R

+ C F

‣ If credit for financial transactions rises, cet. par. the traditional definition

of velocity (V= PY/M) will give the illusion of a velocity decline.

‣ The correctly defined velocity of real circulation remains constant/stable.

Old and New Velocities VM and VR


VR (L)







VM (R)




79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00


source: Cabinet Office, Government of Japan, Bank of Japan



© Richard A. Werner 2018

Centre for Banking, Finance

& Sustainable Development

Business School

Rule: Credit for financial transactions explains boom/bust

cycles and banking crises

‣ A significant rise in credit creation for non-GDP transactions (financial credit C F ) must lead to:

- asset bubbles and busts

- banking and economic crises

‣ USA in 1920s: margin loans rose

from 23.8% of all loans in 1919

to over 35%

‣ Case Study Japan in the 1980s:

C F /C rose from about 15% at the

beginning of the 1980s to almost

twice this share











79 81 83 85 87 89 91 93

Source: Bank of Japan

C F /C

C F /C = Share of loans to the real estate

industry, construction companies and non-bank

financial institutions

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School


Broad Bank Credit Growth > nGDP Growth = banking crisis

YoY %


Broad Bank Credit

This Created Japan's Bubble.



Excess Credit Creation


Nominal GDP




81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

Latest: Q3 2011

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School


Out-of-control C F causes bubbles & crises (e.g. Ireland, Spain)

Broad Bank Credit and GDP (Ireland)

Broad Bank Credit and GDP (Spain)






































© Richard A. Werner 2018














Broad Bank Credit Growth > nGDP Growth























Centre for Banking, Finance

& Sustainable Development

Business School

Five Steps to Explain Many ‘Anomalies‘ and Formulate

Successful Macro Policies

I. Common Feature: The deductive (hypothetico-axiomatic) research methodology

of equilibrium economics.

The alternative: The inductive research methodology (common in the sciences).

II. Empirical evidence on key issues: What makes banks special? Which of the 3

banking theories is correct? What is money and how can we measure it?

III. Macro-Finance: Incorporating Banking into Macroeconomics –

The Quantity Theory of (Disaggregated) Credit

IV. Policies to prevent banking crises and ensure high and sustainable economic growth

V. Post-banking crisis stimulation policies: The original Quantitative Easing and

Enhanced Debt Management

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Is there a monetary policy tool that has an empirical track record

of successful use to prevent asset bubbles and banking crises?

‣ Fractional reserve requirements failed to control the money supply,

because they were based on the rejected fractional reserve theory.

‣ Capital adequacy-based bank regulation (Basel I, II, III etc.) also failed,

because it is based on the rejected financial intermediation theory of

banking. (Why? Banks can create their own capital – see Barclays)

‣ The only successful form of bank regulation in preventing banking crises

is a policy based on the correct credit creation theory of banking: the

policy of ‘credit guidance’.

‣ In all countries where this was deployed to prevent banking crises – by

simply restricting C F (credit for non-GDP, i.e. asset transactions) – it

has been successful in preventing asset bubbles and the ensuing crises.

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

This is Why Central Banks Often Use Bank Credit to

Manage the Economy

‣ Case Study Japan 1980s:

How did the Bank of Japan actually implement monetary policy?

Empirical research using econometric evaluation of statistical data

and extensive interviews with central bankers and private sector

bank staff dealing with the central bank*

‣ Result:

Official policy tools:

1. Price Tool (interest rate: ODR, call rate): not relevant

2. Quantity Tool (operations, lending): not relevant

3. Regulatory Tool (reserve ratio): not relevant

* See: Richard Werner (2003), Princes of the Yen

Richard A. Werner (2002), Asian Economic Journal, vol. 16, no.

2, pp. 111-151, Blackwell, Oxford


© Richard A. Werner 2018

Centre for Banking, Finance

& Sustainable Development

Business School

Unofficial policy tool: Direct bank credit control (window guidance):

no. 1 policy tool

YoY %









Bank Lending and Window Guidance

Window Guidance

Bank Lending

74 76 78 80 82 84 86 88 90

* See: Richard Werner (2003), Princes of the Yen

Richard A. Werner (2002), Asian Economic Journal, vol. 16, no.

2, pp. 111-151, Blackwell, Oxford

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

‘Informal guidance’ of bank credit by central banks

‣ The Bank of Japan is not the only central bank to ‘informally’ control

bank credit.

‣ “Most industrialised countries outside of North America imposed direct

controls over the volume of bank lending for some, often most, of the

time from 1945 till the 1980s” (Goodhart, 1989b, p. 157).

‣ This practice is known world-wide, for instance, in

– the UK as ‘moral suasion’

– Germany as ‘Kreditplafondierung’

– the US as ‘credit controls’

– France as ‘encadrement du crédit’

– Thailand as ‘credit planning scheme’

– Korea, Taiwan, China as ‘window guidance’

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Credit guidance to suppress unproductive (harmful) credit

creation and encourage productive credit creation =

the East Asian Economic Miracle Model

‣ Top-down determination of total credit creation (and thus nominal GDP

growth) desired

‣ Allocated for productive investments via central bank and banking system.

‣ Implemented in Japan, Taiwan, Korea, China

‣ Partially implemented in Thailand, Malaysia, Singapore, Indonesia, India

‣ This is not a planned economy. It is simply a measure to restrict a

dangerous tool (credit creation) so as to make it beneficial to the economy,

and achieve high nominal and real GDP growth.

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

IV. The only alternative that has worked (with lower growth):


Broad Bank Credit and GDP Growth (Germany)





© Richard A. Werner 2018































Centre for Banking, Finance

& Sustainable Development

Business School

Rule: A banking sector dominated by local, not-for-profit

banks avoids asset bubbles and banking crises

German banking


Large, nationwide banks




other banks



Local cooperative

banks (credit unions)

Local gov’t-owned

Savings Banks 42.9%

70% of the banking sector is

accounted for by hundreds of


small not-for-profit banks,

lending mostly to productive



© Richard A. Werner 2018

Centre for Banking, Finance

& Sustainable Development

Business School

Rule: Concentrated banking systems are prone to recurring

crises and instability

‣ Banks and bankers maximise their benefits by growing quickly

‣ The easiest way to grow is to create credit for non-GDP (speculative

asset) transactions

‣ This is why we have had hundreds of banking crises since the 17th

century (when modern banking started)


© Richard A. Werner 2018

Centre for Banking, Finance

& Sustainable Development

Business School

Five Steps to Explain Many ‘Anomalies‘ and Formulate

Successful Macro Policies

I. Common Feature: The deductive (hypothetico-axiomatic) research methodology

of equilibrium economics, the artificial separation of financial from real factors, excessive

separation of research on finance/banking from macroeconomics, and from accounting

and law. The alternative: The inductive research methodology (common in the


II. Empirical evidence on key issues: What makes banks special? Which of the 3

banking theories is correct? What is money and how can we measure it?

III. Macro-Finance: Incorporating Banking into Macroeconomics –

The Quantity Theory of (Disaggregated) Credit

IV. Policies to prevent banking crises and ensure high and sustainable economic growth

V. Post-banking crisis stimulation policies: The original Quantitative Easing and

Enhanced Debt Management

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

V. Werner-proposal of 1995: A monetary policy called ‘Quantitative

Easing’ = Expansion of credit creation for the real economy

Richard A. Werner, ‘Create a Recovery Through Quantitative Easing’,

2 September 1995, Nihon Keizai Shinbun (Nikkei)

What I said

would not work:

• reducing interest

rates – even to


• fiscal stimulation

• expanding bank


powered money

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

V. How to Reflate after a Banking Crisis:

Re-ignite bank credit creation for GDP transactions

to avoid credit crunch & deflation

‣ 1. Central bank purchases all banks’ non-performing assets at face value,

cleaning up bank balance sheets and allowing bank credit creation to rise.

‣Catch: In return banks are required to submit to ‘window guidance’

(This has been shown to be able to raise credit growth: Werner, 2005)

‣ 2. Central bank purchases assets from non-banks as short-term liquidity

measure, ensuring stability of the financial system.

‣ If bank credit creation remains weak:

3. Government stops the issuance of government bonds, borrows from banks:

Enhanced Debt Management

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Enhanced Debt Management

‣ 97% of the money supply is created and allocated by private-sector

profit-oriented enterprises, the commercial banks.

‣ Government should raise the public sector borrowing requirement

from the commercial banks in their country.

‣ They can enter into 3-year loan contracts at the much lower prime rate,

while the central bank provides short-term liquidity.

‣ The prime rate in most eurozone countries is close to the banks’

refinancing costs of 1% e.g. 3.5%.

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Why fiscal spending programmes alone are ineffective

Fiscal stimulation funded by bond issuance

(e.g. : ¥20trn government spending package)

Non-bank private sector

(no credit creation)







Ministry of Finance

(no credit creation)



Net Effect = Zero

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

How to Make Fiscal Policy Effective

Business School

Fiscal stimulation funded by bank


(e.g. : ¥20trn government spending package)

Bank sector

(credit creation power)

Assets Liabilities

¥20 trn ¥20 trn


via bank




(No credit


Non-bank private


(no credit creation)

+¥ 20 trn



Net Effect = ¥ 20 trn

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

The solution that maintains the euro and avoids default

Government borrowing from banks

Advantages of Enhanced Debt Management (EDM) to stimulate growth:

‣ No increased spending or government debt needed.

‣ Increased credit creation for the real economy (C R ), more money used for

GDP-transactions, rise in corporate sales, employment and nominal GDP

‣ Increased tax revenues

‣ Falling deficit/GDP and debt/GDP ratios

‣ A decline in unemployment, a sustainable economic recovery

‣ Banking sector gets healthier, is able to grow out of its problems, rebuild

balance sheets

‣ Less need for central bank money injections into banking system

‣ Lower fund-raising costs (no underwriters’ fees)

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Prime Rate vs. Market Yield of Benchmark Bonds:



© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Prime Rate vs. Market Yield of Benchmark Bonds:


© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Advantages of this Proposal

‣ Eurozone governments remain zero risk borrowers according to the

Basel capital adequacy framework: banks can create the credit/money

out of nothing, without needing capital

‣ The ECB allowed banks to use their loan books as collateral

‣ Instead of governments injecting money into banks, banks give

money to governments.

‣ The measure is also necessary, because central banks have

refused to bail out banks and have asked governments to fund

bail-outs with tax payers’ money, boosting national debt and

bankrupting countries (Ireland, Portugal, Greece, Spain)

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Assessment of EDM by Prof. Charles Goodhart

‣ “Richard has proposed a new mechanism by which bank credit can be


‣ It is a very interesting idea and do take it seriously, as it is well worth

taking seriously.

‣ One could implement it, too, in the UK

‣ This approach undoubtedly would enable fuller monetary expansion, in

essence allowing monetary policy [in the eurozone] to be brought back

to the nation state…”

April 2013, International Conference on the Global Financial Crisis

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Central Banks Can Prolong Recessions & Crises

Or they can end them easily, cheaply and quickly

Compare 2 major 20 th century Japanese banking crises: post-1945 and post-1991

1991 1945

% of non-performing assets 25% 95%

Firm reliance on bank finance 45% 100%

Supply-situation in economy very good very bad

Length of post-crisis recession

20 years 1 year

The difference:

central bank policy

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

What were the successful Bank of Japan policies of 1945?

‣ Central bank purchase of non-performing assets from banks at face value

‣ Credit expansion by central bank (direct lending to companies)

‣ Window guidance credit quota system, expanding bank credit creation.

‣ UK 1914, Fed 2008

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Some nagging questions

1. Has this analysis been conducted based purely on hindsight?

2. Were the actual policy responses to the crisis predictable, and

wrong? (Fiscal bailouts and greater powers for central banks)

3. Is it too late to change things?

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Was the financial crisis really unpredictable?

Richard Werner (2001) in: Princes of the Yen (Japanese ed.)

‣ “Greenspan’s Fed has been fuelling the flames with an historic

expansion of its own credit creation and by encouraging commercial

banks to keep creating more money.“

‣ “Alan Greenspan knows that the economic dislocation that will follow

his bubble will let previous post-war economic crises pale by


‣ “Individual savers will lose their money. …Large losses will be incurred

by most Americans... As individual wealth collapses, demand shrinks

sharply. Bankruptcies will rise. Bad debts at banks will rise. Credit will

shrink. Deflation will expand.”

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

What policies should not have been adopted?

‣ Richard Werner (2005) in: New Paradigm in Macroeconomics

Fiscally-funded bank bailouts, creating massive fiscal deficits and government

debt – and in the process nearly bankrupting states (Ireland, Spain etc.).

Greater powers for the central bankers: Regulatory moral hazard

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Drawbacks of Central Bank Independence

‣ When I presented such policy proposals on how to create a recovery to

Bank of Japan staff in 1993, I was told that they were not interested in

creating a recovery. Instead, they wanted to use the recession to push

through structural reform.

‣ The Bank of Japan took until 2013 (20 years+) to do something about

weak bank credit growth

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

The Bank of Japan did not stimulate bank credit until 2013

YoY (%)


Total Loans






79 81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11 13 15

Latest: May 2015

‣ Since 1992, bank credit growth had never exceeded 3% for a year or longer.

‣ This however is necessary for a sustainable recovery.

‣ More precisely, bank credit for GDP transactions (ideally credit 4 investment)

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

But Ben Bernanke Listened

‣ In 2009, the former Fed chairman insisted he had not adopted BoJ-style

‘Quantitative Easing’ i.e. reserve expansion

‣ Instead, he was doing something else. He adopted parts of my true QE policy


1. The Fed purchased non-performing assets from banks, at high prices.

2. The Fed purchased assets in the markets, massively increasing liquidity.

‣ Ben Bernanke called this ‘credit easing’ – closer in name to my credit-creation

based original QE.

‣ As a result, US bank credit recovered sharply, and thus so did the economy.

‣ In Japan, and in the eurozone, an additional policy is needed:

Enhanced Debt Management

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

How should the system be reformed?

‣ Abolishing bank credit creation powers and only using the central bank to

create money and credit would further centralise already too centralised

decision-making structures

‣ Better: make bank behaviour transparent, accountable & sustainable, by

– Banning bank credit for transactions that don’t contribute to GDP (asset


– creating a network of many small community banks, lending for productive

purposes and returning all gains to the community – creating real choice in banking.

‣ Competition in banking is only ensured if commercial banks are forced to

compete against such community banks: see Germany

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Moving towards action:

Setting up Community Banks in the UK

Business School

‣ Goal: Introduction of public-benefit oriented, not-for-profit local community

banks creating credit for productive purposes, mainly to SMEs

‣ Modelled on the German local public savings banks and local co-operative

banks (Sparkasse, Volksbank)

‣ Hampshire Community Bank launch 2019.

‣ No bonus payments to staff, only ordinary, modest salaries

‣ Credit mainly to SMEs, and for housing construction (buy-to-build


‣ Owned by a charity for the benefit of the people in the county of Hampshire,

with half the votes in hands of investors (local authorities & universities)

‣ Next: establishment of such community banks in other cities across the UK

and in other countries

© Richard A. Werner 2018


Centre for Banking, Finance

& Sustainable Development

Business School

Basingstoke: Palgrave Macmillan, 2005 New Economics Foundation, 2012

© Richard A. Werner 2018

Centre for Banking, Finance

& Sustainable Development

Business School

Weitere Details:

München: Vahlen Verlag, 2007 M. E. Sharpe, 2003

© Richard A. Werner 2018

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Debt deflation

From Wikipedia, the free encyclopedia

Debt deflation is a theory that recessions and depressions are due to the overall level of debt rising in real

value because of deflation, causing people to default on their consumer loans and mortgages. Bank assets

fall because of the defaults and because the value of their collateral falls, leading to a surge in bank

insolvencies, a reduction in lending and by extension, a reduction in spending.

The theory was developed by Irving Fisher following the Wall Street Crash of 1929 and the ensuing Great

Depression. The debt deflation theory was familiar to John Maynard Keynes prior to Fisher's discussion of it,

but he found it lacking in comparison to what would become his theory of liquidity preference. [1] The theory,

however, has enjoyed a resurgence of interest since the 1980s, both in mainstream economics and in the

heterodox school of post-Keynesian economics, and has subsequently been developed by such post-

Keynesian economists as Hyman Minsky [2] and by the mainstream economist Ben Bernanke. [3]

Contents [hide]

1 Fisher's formulation (1933)

1.1 Rejection of previous assumptions

1.2 Initial mainstream interest

2 Ben Bernanke (1995)

3 Post-Keynesian interpretation


4 Solutions

5 Empirical support and modern mainstream interest

6 See also

7 References

8 External links

Fisher's formulation (1933) [ edit ]

In Fisher's formulation of debt deflation, when the debt bubble bursts the following sequence of events


Assuming, accordingly, that, at some point in time, a state of over-indebtedness exists, this will

tend to lead to liquidation, through the alarm either of debtors or creditors or both. Then we

may deduce the following chain of consequences in nine links:

1. Debt liquidation leads to distress selling and to

2. Contraction of deposit currency, as bank loans are paid off, and to a slowing down of

velocity of circulation. This contraction of deposits and of their velocity, precipitated by

distress selling, causes

3. A fall in the level of prices, in other words, a swelling of the dollar. Assuming, as above

stated, that this fall of prices is not interfered with by reflation or otherwise, there must


4. A still greater fall in the net worths of business, precipitating bankruptcies and

5. A like fall in profits, which in a "capitalistic," that is, a private-profit society, leads the

concerns which are running at a loss to make

6. A reduction in output, in trade and in employment of labor. These losses, bankruptcies

and unemployment, lead to

7. pessimism and loss of confidence, which in turn lead to

8. Hoarding and slowing down still more the velocity of circulation.

The above eight changes cause

9. Complicated disturbances in the rates of interest, in particular, a fall in the nominal, or

money, rates and a rise in the real, or commodity, rates of interest.

— (Fisher 1933)

Rejection of previous assumptions [ edit ]

Prior to his theory of debt deflation, Fisher had subscribed to the then-prevailing, and still mainstream,

theory of general equilibrium. In order to apply this to financial markets, which involve transactions across

time in the form of debt – receiving money now in exchange for something in future – he made two further

assumptions: [4]

(A) The market must be cleared—and cleared with respect to every interval of time.

(B) The debts must be paid. (Fisher 1930, p.495)

In view of the Depression, he rejected equilibrium, and noted that in fact debts might not be paid, but instead

defaulted on:

It is as absurd to assume that, for any long period of time, the variables in the economic

organization, or any part of them, will "stay put," in perfect equilibrium, as to assume that the

Atlantic Ocean can ever be without a wave.

— (Fisher 1933, p. 339)

He further rejected the notion that over-confidence alone, rather than the resulting debt, was a significant

factor in the Depression:

I fancy that over-confidence seldom does any great harm except when, as, and if, it beguiles its

victims into debt.


— (Fisher 1933, p. 339)

In the context of this quote and the development of his theory and the central role it places on debt, it is of

note that Fisher was personally ruined due to his having assumed debt due to his over-confidence prior to

the crash, by buying stocks on margin.

Other debt deflation theories do not assume that debts must be paid, noting the role that default, bankruptcy,

and foreclosure play in modern economies. [5]

Initial mainstream interest [ edit ]

Initially Fisher's work was largely ignored, in favor of the work of Keynes. [6]

The following decades saw occasional mention of deflationary spirals due to debt in the mainstream, notably

in The Great Crash, 1929 of John Kenneth Galbraith in 1954, and the credit cycle has occasionally been

cited as a leading cause of economic cycles in the post-WWII era, as in (Eckstein & Sinai 1990), but private

debt remained absent from mainstream macroeconomic models.

James Tobin cited Fisher as instrumental in his theory of economic instability.

Debt-deflation theory has been studied since the 1930s but was largely ignored by neoclassical economists,

and has only recently begun to gain popular interest, although it remains somewhat at the fringe in U.S.

media. [7][8][9][10]

Ben Bernanke (1995) [ edit ]

The lack of influence of Fisher's debt-deflation in academic economics is thus described by Ben Bernanke in

Bernanke (1995, p. 17):

Fisher's idea was less influential in academic circles, though, because of the counterargument that debtdeflation

represented no more than a redistribution from one group (debtors) to another (creditors).

Absent implausibly large differences in marginal spending propensities among the groups, it was

suggested, pure redistributions should have no significant macroeconomic effects.

Building on both the monetary hypothesis of Milton Friedman and Anna Schwartz as well as the debt

deflation hypothesis of Irving Fisher, Bernanke developed an alternative way in which the financial crisis

affected output. He builds on Fisher's argument that dramatic declines in the price level and nominal

incomes lead to increasing real debt burdens, which in turn leads to debtor insolvency, thus leading to

lowered aggregate demand and further decline in the price level, which develops into a debt deflation spiral.

According to Bernanke a small decline in the price level simply reallocates wealth from debtors to creditors

without doing damage to the economy. But when the deflation is severe, falling asset prices along with

debtor bankruptcies lead to a decline in the nominal value of assets on bank balance sheets. Banks will

react by tightening their credit conditions. That in turn leads to a credit crunch that does serious harm to the

economy. A credit crunch lowers investment and consumption, which leads to declining aggregate demand,

which additionally contributes to the deflationary spiral. [11]

Post-Keynesian interpretation [ edit ]

Debt deflation has been studied and developed largely in the post-Keynesian school.

The financial instability hypothesis of Hyman Minsky, developed in the 1980s, complements Fisher's theory

in providing an explanation of how credit bubbles form: the financial instability hypothesis explains how

bubbles form, while debt deflation explains how they burst and the resulting economic effects. Mathematical

models of debt deflation have recently been developed by post-Keynesian economist Steve Keen.

Solutions [ edit ]

Fisher viewed the solution to debt deflation as reflation – returning the price level to the level it was prior to

deflation – followed by price stability, which would break the "vicious spiral" of debt deflation. In the absence

of reflation, he predicted an end only after "needless and cruel bankruptcy, unemployment, and

starvation", [12] followed by "a new boom-depression sequence": [13]


Unless some counteracting cause comes along to prevent the fall in the price level, such a

depression as that of 1929-33 (namely when the more the debtors pay the more they owe)

tends to continue, going deeper, in a vicious spiral, for many years. There is then no tendency

of the boat to stop tipping until it has capsized. Ultimately, of course, but only after almost

universal bankruptcy, the indebtedness must cease to grow greater and begin to grow less.

Then comes recovery and a tendency for a new boom-depression sequence. This is the socalled

"natural" way out of a depression, via needless and cruel bankruptcy, unemployment,

and starvation. On the other hand, if the foregoing analysis is correct, it is always economically

possible to stop or prevent such a depression simply by reflating the price level up to the

average level at which outstanding debts were contracted by existing debtors and assumed by

existing creditors, and then maintaining that level unchanged.

Later commentators do not in general believe that reflation is sufficient, and primarily propose two solutions:

debt relief – particularly via inflation – and fiscal stimulus.

Following Hyman Minsky, some argue that the debts assumed at the height of the bubble simply cannot be

repaid – that they are based on the assumption of rising asset prices, rather than stable asset prices: the socalled

"Ponzi units". Such debts cannot be repaid in a stable price environment, much less a deflationary

environment, and instead must either be defaulted on, forgiven, or restructured.

Widespread debt relief either requires government action or individual negotiations between every debtor

and creditor, and is thus politically contentious or requires much labor. A categorical method of debt relief is

inflation, which reduces the real debt burden, as debts are generally nominally denominated: if wages and

prices double, but debts remain the same, the debt level drops in half. The effect of inflation is more

pronounced the higher the debt to GDP ratio is: at a 50% ratio, one year of 10% inflation reduces the ratio

by approximately

to 45%, while at a 300% ratio, one year of 10% inflation reduces

the ratio by approximately

to 270%. In terms of foreign exchange, particularly of

sovereign debt, inflation corresponds to currency devaluation. Inflation results in a wealth transfer from

creditors to debtors, since creditors are not repaid as much in real terms as was expected, and on this basis

this solution is criticized and politically contentious.

In the Keynesian tradition, some suggest that the fall in aggregate demand caused by falling private debt

can be compensated for, at least temporarily, by growth in public debt – "swap private debt for government

debt", or more evocatively, a government credit bubble replacing the private credit bubble. Indeed, some

argue that this is the mechanism by which Keynesian economics actually works in a depression – "fiscal

stimulus" simply meaning growth in government debt, hence boosting aggregate demand. Given the level of

government debt growth required, some proponents of debt deflation such as Steve Keen are pessimistic

about these Keynesian suggestions. [14]

Given the perceived political difficulties in debt relief and the suggested inefficacy of alternative courses of

action, proponents of debt deflation are either pessimistic about solutions, expecting extended, possibly

decades-long depressions, or believe that private debt relief (and related public debt relief – de facto

sovereign debt repudiation) will result from an extended period of inflation.

Empirical support and modern mainstream interest [ edit ]

Several studies prove that the empirical support for the validity of

the debt deflation hypothesis as laid down by Fisher and Bernanke

is substantial, especially against the background of the Great

Depression. Empirical support for the Bernanke transmission

mechanism in the post–World War II economic activity is weaker. [15]

There was a renewal of interest in debt deflation in academia in the

1980s and 1990s, [16] and a further renewal of interest in debt

deflation due to the financial crisis of 2007–2010 and the ensuing

Great Recession. [6]

In 2008, Deepak Lal wrote, "Bernanke has made sure that the

second leg of a Fisherian debt deflation will not occur. But, past and present U.S. authorities have failed to

adequately restore the balance sheets of over-leveraged banks, firms, and households." [17] After the


financial crisis of 2007-2008, Janet Yellen in her speech acknowledged Minsky's contribution to

understanding how credit bubbles emerge, burst and lead to deflationary asset sales. [18] She described how

a process of balance sheet deleveraging ensued while consumers cut back on their spending to be able to

service their debt. Similarly invoking Minsky, in 2011 Charles J. Whalen wrote, "the global economy has

recently experienced a classic Minsky crisis - one with intertwined cyclical and institutional (structural)

dimensions." [19]

Kenneth Rogoff and Carmen Reinhart's works published since 2009 [20] have addressed the causes of

financial collapses both in recent modern times and throughout history, with a particular focus on the idea of

debt overhangs.

See also [ edit ]

Causes of the Great Depression: Debt deflation

References [ edit ]

1. ^ Pilkington, Philip (February 24, 2014). "Keynes' Liquidity Preference Trumps Debt Deflation in 1931 and

2008 ".

2. ^ Minsky, Hyman (1992). "The Financial Instability Hypothesis".

3. ^ Steve Keen (1995). "Finance and economic breakdown: modelling Minsky’s Financial Instability Hypothesis",

Journal of Post Keynesian Economics, Vol. 17, No. 4, 607–635

4. ^ Debtwatch No. 42: The economic case against Bernanke , January 24th, 2010, Steve Keen

5. ^ "Archived copy" . Archived from the original on 2013-06-03. Retrieved 2012-12-13.

6. ^ a b Out of Keynes's shadow , The Economist, Feb 12th 2009

7. ^ Fisher, I. (1933) "The Debt-Deflation Theory of Great Depressions," Econometrica 1 (4): 337-57

8. ^ Grant, J. (2007) "Learn From the Fall of Rome, U.S. Warned," Financial Times (14 August)

9. ^ Robert Peston, "UK's debts 'biggest in the world'," BBC (21 November 2011).

10. ^ John T. Harvey (Jul 18, 2012). "Why You Should Love Government Deficits" . Forbes.

11. ^ Randall E. Parker, Reflections on the Great Depression, Edward Elgar Publishing, 2003,

ISBN 9781843765509, p. 14-15

12. ^ Compare: "Let us beware of this dangerous theory of equilibrium which is supposed to be automatically

established. A certain kind of equilibrium, it is true, is reestablished in the long run, but it is after a frightful amount

of suffering.", Simonde de Sismondi, New Principles of Political Economy, vol. 1 (1819), pp. 20–21.

13. ^ Irving Fisher on Debt, Deflation, and Depression , Brian Griffin, November 05, 2008, Seeking Alpha

14. ^ Can the USA debt-spend its way out? , November 29th, 2008, Steve Keen

15. ^ Randall E. Parker, Reflections on the Great Depression, Edward Elgar Publishing, 2003,

ISBN 9781843765509, p. 15

16. ^ (Bernanke 1995, p. 17)

17. ^ Deepak Lal, "The Great Crash of 2008: Causes and Consequences," Cato Journal, 30(2) (2010), p.271-72.

18. ^

19. ^ Charles J. Whalen, "Rethinking Economics for a New Era of Financial Regulation: The Political Economy of

Hyman Minsky," Chapman Law Review, 15(1) (2011), p. 163.

20. ^

Bernanke, Ben (1995), "The Macroeconomics of the Great Depression: A Comparative Approach" , Journal of

Money, Credit, and Banking, 27 (1): 1–28, doi:10.2307/2077848 , JSTOR 2077848

Fisher, Irving (1933), "The Debt-Deflation Theory of Great Depressions" , Econometrica, 1 (4): 337–357,

doi:10.2307/1907327 , JSTOR 1907327

Eckstein, Otto; Sinai, Allen (1990), "1. The Mechanisms of the Business Cycle in the Postwar Period" , in Robert J.

Gordon (ed.), The American Business Cycle: Continuity and Change , University of Chicago Press, ISBN 978-0-


Charles Roxburgh; Susan Lund; Tony Wimmer; Eric Amar; Charles Atkins; Ju-Hon Kwek; Richard Dobbs; James

Manyika (January 2010), Debt and deleveraging: The global credit bubble and its economic consequences ,

McKinsey Global Institute

External links [ edit ]


, by Steve Keen


Categories: Business cycle theories

Monetary economics

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International Review of Financial Analysis 36 (2014) 1–19

Contents lists available at ScienceDirect

International Review of Financial Analysis

Can banks individually create money out of nothing? — The theories and

the empirical evidence☆

Richard A. Werner

Centre for Banking, Finance and Sustainable Development, University of Southampton, United Kingdom




Available online 16 September 2014

JEL classification:






Bank credit

Credit creation

Financial intermediation

Fractional reserve banking

Money creation

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). The question which of the theories is correct has far-reaching

implications for research and policy. Surprisingly, despite the longstanding controversy, until now no empirical

study has tested the theories. This is the contribution of the present paper. An empirical test is conducted, whereby

money is borrowed from a cooperating bank, while its internal records are being monitored, to establish

whether in the process of making the loan available to the borrower, the bank transfers these funds from other

accounts within or outside the bank, or whether they are newly created. 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".

© 2014 Published by Elsevier Inc.

1. Introduction

“The choice of a measure of value, of a monetary system, of currency

and credit legislation — all are in the hands of society, and natural

conditions … are relatively unimportant. Here, then, the decisionmakers

in society have the opportunity to directly demonstrate

and test their economic wisdom — or folly. History shows that the

latter has often prevailed.” 1 [Wicksell (1922, p. 3)]

Since the American and European banking crisis of 2007–8, the role

of banks in the economy has increasingly attracted interest within and

outside the disciplines of banking, finance and economics. This interest

is well justified: Thanks to the crisis, awareness has risen that the most

widely used macroeconomic models and finance theories did not provide

an adequate description of crucial features of our economies and

financial systems, and, most notably, failed to include banks. 2 These

bank-less dominant theories are likely to have influenced bank regulators

and may thus have contributed to sub-optimal bank regulation:

Systemic issues emanating from the banking sector are impossible to detect

in economic models that do not include banks, or in finance models

that are based on individual, representative financial institutions without

embedding these appropriately into macroeconomic models. 3

☆ The author wishes to acknowledge excellent research support from Dr. Kostas

Voutsinas and Shamsher Dhanda. Moreover, the author is grateful to the many bank

staff at numerous banks involved in this study, who have given their time for meetings

and interviews. Most of all, the author would like to thank Mr. Marco Rebl, Director of

Raiffeisenbank Wildenberg e.G., for his cooperation and arranging the cooperation of his

colleagues in conducting the empirical examination of bank credit creation and making

the facilities, accounts and staff of his bank accessible to the researcher. Finally, should

grains of wisdom be found in this article, the author wishes to attribute them to the source

of all wisdom (Jeremiah 33:3).

1 Translated into English by the author. See also Wicksell (1935).

2 Federal Reserve Vice-Chairman Kohn (2009) bemoaned this issue. Examples of leading

macroeconomic and monetary models without any banks include Walsh (2003) and

Woodford (2003), but this problem applies to all the conventional macromodels proposed

by the major conventional schools of thought, such as the classical, Keynesian, monetarist

and neo-classical theories, including real business cycle and DSGE models.

3 The ‘Basel’ approach to bank regulation focuses on regulation of capital adequacy.

Werner (2010a) has argued that this is based on economic theories that do not feature a

special role for banks. For an overview and critique, see Werner (2012).

1057-5219/© 2014 Published by Elsevier Inc.

2 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19

Consequently, many researchers have since been directing their

efforts at incorporating banks or banking sectors in economic

models. 4 This is a positive development, and the European Conferences

on Banking and the Economy (ECOBATE) are contributing to

this task, showcased in this second special issue, on ECOBATE 2013,

held on 6 March 2013 in Winchester Guildhall and organised

by the University of Southampton Centre for Banking, Finance and

Sustainable Development. As the work in this area remains highly diverse,

this article aims to contribute to a better understanding of crucial

features of banks, which would facilitate their suitable incorporation in

economic models. Researchers need to know which aspects of bank

activity are essential — including important characteristics that may

distinguish banks from non-bank financial institutions. In other

words, researchers need to know whether banks are unique in crucial

aspects, and if so, why.

In this paper the question of their potential ability to create money is

examined, which is a candidate for a central distinguishing feature. A review

of the literature identifies three different, mutually exclusive views

on the matter, each holding sway for about a third of the twentieth century.

The present conventional view is that banks are mere financial intermediaries

that gather resources and re-allocate them, just like other

non-bank financial institutions, and without any special powers. Any

differences between banks and non-bank financial institutions are

seen as being due to regulation and effectively so minimal that they

are immaterial for modelling or for policy-makers. Thus it is thought

to be permissible to model the economy without featuring banks directly.

This view shall be called the financial intermediation theory of banking.

It has been the dominant view since about the late 1960s.

Between approximately the 1930s and the late 1960s, the dominant

view was that the banking system is ‘unique’, sincebanks,unlike

other financial intermediaries, can collectively create money,

based on the fractional reserve or ‘money multiplier’ model of

banking. Despite their collective power, however, each individual

bank is in this view considered to be a mere financial intermediary,

gathering deposits and lending these out, without the ability to

create money. This view shall be called the fractional reserve theory

of banking.


with an ascendancy in the first two decades of the 20th century.

Unlike the financial intermediation theory and in line with the

fractional reserve theory it maintains that the banking system creates

new money. However, it goes further than the latter and differs from

it in a number of respects. It argues that each individual bank is not a

financial intermediary that passes on deposits, or reserves from the

central bank in its lending, but instead creates the entire loan

amount out of nothing. This view shall be called the credit creation

theory of banking.

The three theories are based on a different description of how

money and banking work and they differ in their policy implications.

Intriguingly, the controversy about which theory is correct has never

been settled. As a result, confusion reigns: Today we find central

banks – sometimes the very same central bank – supporting different

theories; in the case of the Bank of England, central bank staff are on record

supporting each one of the three mutually exclusive theories at the

same time, as will be seen below.

It matters which of the three theories is right — not only for understanding

and modelling the role of banks correctly within the

economy, but also for the design of appropriate bank regulation

that aims at sustainable economic growth without crises. The

modern approach to bank regulation, as implemented at least since

Basel I (1988), is predicated on the understanding that the financial

4 One older attempt that has stood up to the test of time is Werner (1997).

intermediation theory is correct. 5 Capital adequacy-based bank

regulation, even of the counter-cyclical type, is less likely to deliver

financial stability, if one of the other two banking hypotheses is correct.

6 The capital-adequacy based approach to bank regulation

adopted by the BCBS, as seen in Basel I and II, has so far not been

successful in preventing major banking crises. If the financial intermediation

theory is not an accurate description of reality, it would

throw doubt on the suitability of Basel III and similar national

approaches to bank regulation, such as in the UK. 7

It is thus of importance for research and policy to determine which of

the three theories is an accurate description of reality. Empirical evidence

can be used to test the relative merits of the theories. Surprisingly,

no such test has so far been performed. This is the contribution of the

present paper.

The remainder of the paper is structured as follows. Section 2

provides an overview of relevant literature, differentiating authors

by their adherence to one of the three banking theories. It will be

seen that leading economists have gone on the record in support

of each one of the theories. In Section 3, I then present an empirical

test that is able to settle the question of whether banks are unique

and whether they can individually create money ‘out of nothing’. It

involves the actual processing of a ‘live’ bank loan, taken out by the

researcher from a representative bank that cooperates in the monitoring

of its internal records and operations, allowing access to its documentation

and accounting systems. The results and some implications

are discussed in Section 4.

2. The literature on whether banks can create money

Much has been written on the role of banks in the economy in

the past century and beyond. Often authors have not been concerned

with the question of whether banks can create money, as they often

simply assume their preferred theory to be true, without discussing it

directly, let alone in a comparative fashion. This literature review is

restricted to authors that have contributed directly and explicitly to

the question of whether banks can create credit and money. During

time periods when in the authors' countries banks issued promissory

notes (bank notes) that circulated as paper money, writers would

often, as a matter of course, mention, even if only in passing, that

banks create or issue money. In England and Wales, the Bank Charter

Act of 1844 forbade banks to “make any engagement for the payment

of money payable to bearer on demand.” This ended bank note issuance

for most banks in England and Wales, leaving the (until 1946 officially

privately owned) Bank of England with a monopoly on bank note

issuance. Meanwhile, the practice continued in the United States

until the 20th century (and was in fact expanded with the similarly

timed New York Free Banking Act of 1838), so that US authors

would refer to bank note issuance as evidence of the money creation

5 See, for instance, the first BCBS Working Paper (BCBS, 1999), looking back on the first

decade of experience with Basel I for insights into the thinking of the Basel bank regulators.

In a section headlined ‘Do fixed minimum capital requirements create credit crunches

affecting the real economy?’, the authors argue: “It would in fact be strange if fixed minimum

capital requirements did not bite in some periods, thereby constraining the banks,

given that the purpose of bank [capital] requirements is to limit the amount of risk that

can be taken relative to capital. However, for this to have an effect on output, it would have

to be true that any shortfall in bank lending was not fully made up through lending by

other intermediaries or by access to securities markets.” This statement presupposes that

the financial intermediation theory holds. If banks are the creators of the money supply, and

in this role unique and different from non-bank financial intermediaries, as the other two

hypotheses maintain, then a reduction in bank credit (creation) must have effects that

non-bank financial intermediaries cannot compensate for.

6 See, for instance, Werner (2005, 2010a).

7 As seen in the work of the Independent Commission on Banking, ICB, 2011, also

known as the Vickers Commission. For contributions to the consultation of the ICB, see,

for instance, Werner (2010b). The recommendations therein, especially the recommendation

to discard the financial intermediation theory, were not heeded.

R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19


function of banks until much later. 8 For sake of clarity, our main interest

in this paper is the question whether banks that do not issue bank

notes are able to create money and credit out of nothing. As a result,

earlier authors, writing mainly about paper money issuance, are

only mentioned in passing here, even if it could be said that their arguments

might also apply to banks that do not issue bank notes. These include

John Law (1705), James Steuart (1767), Adam Smith (1776),

Henry Thornton (1802), Thomas Tooke (1838), andAdam Müller

(1816), among others, who either directly or indirectly state that

banks can individually create credit (in line with the credit creation

theory). 9

2.1. The credit creation theory of banking

Influential early writers that argue that non-issuing banks have the

power to individually create money and credit out of nothing wrote

mainly in English or German, namely Wicksell (1898, 1907), Withers

(1909), Schumpeter (1912), Moeller (1925) and Hahn (1920). 10 The

review of proponents of the credit creation theory must start with

Henry Dunning Macleod, of Trinity College, Cambridge, and Barrister

at Law at the Inner Temple. 11 Macleod produced an influential opus

on banking, entitled The Theory and Practice of Banking, in two volumes.

It was published in numerous editions well into the 20th century

(Macleod, 1855–6; the quotes here are from the 6th edition of 1905).

Concerning credit creation by individual banks, Macleod unequivocally

argued that individual banks create credit and money out of nothing,

whenever they do what is called ‘lending’:

“In modern times private bankers discontinued issuing notes, and

merely created Credits in their customers' favour to be drawn

against by Cheques. These Credits are in banking language termed

Deposits. Now many persons seeing a material Bank Note, which is

8 The practice of issuance of promissory notes by commercial banks has continued for

far longer in Scotland and Northern Ireland — namely until today. This did not seem, however,

to result in a sizeable literature on bank money creation in the UK throughout the

20th century.

9 Referring to the issuance of bank notes that circulate as paper money, Smith comments

“The banks, when their customers apply to them for money, generally advance it

to them in their own promissory notes” (p. 242). …“It is chiefly by discounting bills of exchange,

that is, by advancing money upon them before they are due, that the greater part

of banks and bankers issue their promissory notes. … The banker, who advances to the

merchant whose bill he discounts, not gold and silver, but his own promissory notes,

has the advantage of being able to discount to a greater amount by the whole value of

his promissory notes, which he finds, by experience, are commonly in circulation. He is

thereby enabled to make his clear gain of interest on so much a larger sum” (Smith,

1776, p. 241). “Jeder Provinzialbanquier strebt dahin, sein Privatgeld zum Nationalgelde

zu erheben: er strebt nach der größtmöglichen und möglichst allgemeinen Umsetzbarkeit

seines Privatgeldes. Es ist in England nicht bloß die Regierung, welche Geld macht,

sondern die Bank von England, jede Privatbank, ja jede einzelne Haushaltung (ohne

gerade bestimmte Noten auszugeben, aber, in wie fern sie sich an eine bestimmte Bank

thätig anschließt) helfen das Geld machen” (Müller, 1816, p. 240). “Sobald die Regierung

also die Geldzeichen mechanisch vermehrt, ohne in demselben Maaße jene andern

Organe, denen die Vortheile der Geldvermehrung nur indirekt zu gute kommen, zu

stärken, ohne um so kräftiger und gerechter das Ganze zu umfassen, so überträgt sie im

Grunde nur das Privilegium der Gelderzeugung, das sie im Nahmen des Ganzen ausübt,

auf ein einzelnes Organ. … sollte sie [die Regierung] also ihr Privilegium der

Gelderzeugung nicht bloß aufheben, sondern das bisher erzeugte Geld zurück nehmen,

so gibt sie damit nur dem Privatcredit, das heißt, dem verwöhnten verderbten

Privatcredit, oder dem Wucher die förmliche Befugniß in die Hände, die Lücken zu

ergänzen, selbst Geldmarken zu machen, und somit seinen verderblichen und

vernichtenden Einfluß auf das Ganze nun erst recht zu äußern” (Müller, 1816, p. 305).

10 There is also another group of writers who to some extent agree with this description,

but one way or another downplay its role or importance in practice. In terms of the history

of economic thought it can be said that the latter group laid the groundwork and were the

founding fathers of the fractional reserve theory. To the extent that they recognise the creation

of credit by banks out of nothing under certain circumstances one might argue that

they could be classified as supporter of either the credit creation theory or the fractional reserve

theory, but to minimise confusion, here the impact their work has had in its common

interpretation was chosen, as well as their emphasis on reserves as a key mechanism, so

that they were included in the latter theory.

11 An Inn of Court with the status of a local authority, inside the territory of the City of

London Corporation.

only a Right recorded on paper, are willing to admit that a Bank Note

is cash. But, from the want of a little reflection, they feel a difficulty

with regard to what they see as Deposits. They admit that a Bank

Note is an “Issue”, and “Currency,” but they fail to see that a Bank

Credit is exactly in the same sense equally an “Issue,” “Currency,”

and “Circulation”.”

[Macleod (1905, vol. 2, p. 310)]

“… Sir Robert Peel was quite mistaken in supposing that bankers

only make advances out of bona fide capital. This is so fully set

forth in the chapter on the Theory of Banking, that we need only

to remind our readers that all banking advances are made, in

the first instance, by creating credit” (p. 370, emphasis in


In his Theory of Credit Macleod (1891) put it this way:

“A bank is therefore not an office for “borrowing” and “lending”

money, but it is a Manufactory of Credit.”

[Macleod (1891: II/2, 594)]

According to the credit creation theory then, banks create credit in

the form of what bankers call ‘deposits’, and this credit is money. But

how much credit can they create? Wicksell (1907) described a creditbased

economy in the Economic Journal, arguing that

“The banks in their lending business are not only not limited

by their own capital; they are not, at least not immediately,

limited by any capital whatever; by concentrating in their

hands almost all payments, they themselves create the money


“In a pure system of credit, where all payments were made by transference

in the bank-books, the banks would be able to grant at any

moment any amount of loans at any, however diminutive, rate of

interest.” 12 [Wicksell (1907, 214)]

Withers (1909), from 1916 to 1921 the editor of the Economist,also

saw few restraints on the amount of money banks could create out of


“… it is a common popular mistake, when one is told that the banks

of the United Kingdom hold over 900 millions of deposits, to open

one's eyes in astonishment at the thought of this huge amount of

cash that has been saved by the community as a whole, and stored

by them in the hands of their bankers, and to regard it as a tremendous

evidence of wealth. But this is not quite the true view of the

case. Most of the money that is stored by the community in the

banks consists of book-keeping credits lent to it by its bankers.”

[Withers (1909, pp. 57 ff.)]

“… The greater part of the banks' deposits is thus seen to consist, not

of cash paid in, but of credits borrowed. For every loan makes a

deposit ….”

[Withers (1909, p. 63)]

“When notes were the currency of commerce a bank which made an

advance or discounted a bill gave its customer its own notes as the

proceeds of the operation, and created a liability for itself. Now, a

bank makes an advance or discounts a bill, and makes a liability for

itself in the corresponding credit in its books.”

[Withers (1909, p. 66)]

12 This paper was read by Wicksell in London in the Economic Section of the British Association

in 1906 and it is recorded in the Economic Journal that Palgrave and Edgeworth

commented on it. There is no mentioning of any objections to the claims about the ability

of banks to create money out of nothing.

4 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19

“… It comes to this that, whenever a bank makes an advance or buys

a security, it gives some one the right to draw a cheque upon it,

which cheque will be paid in either to it or to some other banks,

and so the volume of banking deposits as a whole will be increased

and the cash resources of the banks as a whole will be unaltered.”

[Withers (1916, p. 45)]

“When once this fact is recognised, that the banks are still, among

other things, manufacturers of currency, just as much as they were

in the days when they issued notes, we see how important a function

the banks exercise in the economic world, because it is now

generally admitted that the volume of currency created has a direct

and important effect upon prices. This arises from what is called the

“quantity theory” of money ….”

[Withers (1916, p. 47)]

“If, then, the quantity theory is, as I believe, broadly true, we see how

great is the responsibility of the bankers as manufacturers of currency,

seeing that by their action they affect, not only the convenience of

their customers and the profits of their shareholders, but the general

level of prices. If banks create currency faster than the rate at which

goods are being produced, their action will cause a rise in prices

which will have a perhaps disastrous effect ….” 13

[Withers (1916, pp. 54 ff.)]

“And so it becomes evident, as before stated, that the deposits of the

banks which give the commercial community the right to draw

cheques are chiefly created by the action of the banks themselves

in lending, discounting, and investing” (pp. 71 ff.).

“… then, it thus appears that credit is the machinery by which a very

important part of modern currency is created …” (p. 72).

Withers argues that the sovereign prerogative to manufacture the

currency of the nation has effectively been privatised and granted to

the commercial banks:

“By this interesting development the manufacture of currency,

which for centuries has been in the hands of Government, has now

passed, in regard to a very important part of it, into the hands of

companies, working for the convenience of their customers and

the profits of their shareholders.”

[Withers (1916, p. 40)]

While Withers was a financial journalist, his writings had a high

circulation and likely contributed to the dissemination of the credit

creation theory in the form proposed by Macleod (1855–6). This view

13 “Since, then, variations in the quantity of currency have these widespread effects, it is a

matter which bankers have to consider seriously, how far it is possible from them to apply

some scientific regulation to the volume of currency, and whether it is possible to modify

the evils that follow from wide fluctuations in prices by some such regulation” (p. 55). For

a more recent application and more precise formulation of this principle, see Werner's

Quantity Theory of Credit (Werner, 1992, 1997, 2005, 2012). “… the most important of

the modern forms of currency, namely the cheque, is, in effect, manufactured for the use

of its customers by banks; and, further, that since the volume of currency has an important

effect upon raising prices, the extent to which currency is thus created is a responsibility

which has to be seriously considered by those who work the financial machine. This manufacture

of currency is worked through the granting of credit, and credit may thus be defined,

for the purposes of this inquiry, as the process by which finance makes currency for

its customers. As we saw in the last chapter, deposits, which are potential currency as they

carry with them the right to draw a cheque, are produced largely through the loans, discounts

and investments made by bankers” (p. 63). “The creation of credit is thus seen

clearly to result in the manufacture of currency whenever the banks buy bills of exchange

… or make an advance …. In either case the banks give somebody the right to draw

cheques. … When a bank makes an advance to a stock broker the result is exactly the same

…. The same result, in rather a different form, happens when a bank makes investments

on its own account. … There has thus been, in each case, an increase in deposits through

the operation of the bank in lending, discounting, or investing. If we can imagine all the

banks suddenly selling all their investments and bills of exchange and calling in all their

advances, the process could only be brought about by the cancelling of deposits, their

own and one another's” (p. 72).

also caught on in Germany with the publication of Schumpeter's

(1912, English 1934) influential book The Theory of Economic Development,

in which he was unequivocal in his view that each individual

bank has the power to create money out of nothing.

“Something like a certificate of future output or the award of

purchasing power on the basis of promises of the entrepreneur

actually exists. That is the service that the banker performs for

the entrepreneur and to obtain which the entrepreneur approaches

the banker. … (The banker) would not be an intermediary,

but manufacturer of credit, i.e. he would create himself the

purchasing power that he lends to the entrepreneur …. One could

say, without committing a major sin, that the banker creates

money.” 14

[Schumpeter (1912, p. 197, emphasis in original)]

“[C]redit is essentially the creation of purchasing power for the purpose

of transferring it to the entrepreneur, but not simply the transfer

of existing purchasing power. … By credit, entrepreneurs are

given access to the social stream of goods before they have acquired

the normal claim to it. And this function constitutes the keystone of

the modern credit structure.”

[Schumpeter (1954, p. 107)]

“The fictitious certification of products, which, as it were, the credit

means of payment originally represented, has become truth.” 15

[Schumpeter (1912, p. 223)]

This view was also well represented across the Atlantic, as the writings

of Davenport (1913) or Robert H. Howe (1915) indicate. Hawtrey

(1919), another leading British economist who like Keynes, had a Treasury

background and moved into academia, took a clear stance in favour

of the credit creation theory:

“… for the manufacturers and others who have to pay money out,

credits are still created by the exchange of obligations, the banker's

immediate obligation being given to his customer in exchange for

the customer's obligation to repay at a future date. We shall still describe

this dual operation as the creation of credit. By its means the

banker creates the means of payment out of nothing, whereas when

he receives a bag of money from his customer, one means of payment,

a bank credit, is merely substituted for another, an equal

amount of cash” (p. 20).

Apart from Schumpeter, a number of other German-language

authors also argued that banks create money and credit individually

through the process of lending. 16 Highly influentialinbothacademic

discourse and public debate was Dr. Albert L. Hahn (1920), scion of a

Frankfurt banking dynasty (similarly to Thornton who had been a

banker) and since 1919 director of the major family-owned

Effecten- und Wechsel-Bank, Frankfurt. Like Macleod a trained lawyer,

he became an honorary professor at Goethe-University

14 “Etwas Ähnliches wie eine Bescheinigung künftiger Produkte oder wie die Verleihung

von Zahlkraft an die Versprechungen des Unternehmers gibt es nun wirklich. Das ist der

Dienst, den der Bankier dem Unternehmer erweist und um den sich der Unternehmer

an den Bankier wendet. … so wäre er nicht Zwischenhändler, sondern Produzent von

Kredit, d.h. er würde die Kaufkraft, die er dem Unternehmer leiht, selbst schaffen ….

Man könnte ohne große Sünde sagen, daß der Bankier Geld schaffe” (S. 197). Translated

by author.

15 “Die fiktive Bescheinigung von Produkten, die die Kreditzahlungsmittel sozusagen

ursprünglich darstellten, ist zur Wahrheit geworden” (Schumpeter, 1912, S. 223). Translated

by author.

16 For instance, Moeller (1925) states that “In the modern monetary system the creation

of new paper or bank accounting currency (‘Buchungsgeld’,or‘bank book money’)isprimarily

in the hands of the banks. … For the deposit money the same largely applies as for

paper money …” (pp. 177 ff.).

R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19


Frankfurt in 1928. Clearly not only aware of the works of Macleod,

whom he cites, but also likely aware of actual banking practice

from his family business, Hahn argued that banks do indeed ‘create

money out of nothing’:

“Every credit that is extended in the economy creates a deposit and

thus the means to fund it. … The conclusion from the process described

can be expressed in reverse by saying … that every deposit

that exists somewhere and somehow in the economy has come

about by a prior extension of credit.” 17 [Hahn (1920, p. 28)]

“We thus maintain – contrary to the entire literature on banking and

credit – that the primary business of banks is not the liability business,

especially the deposit business, but that in general and in each

and every case an asset transaction of a bank must have previously

taken place, in order to allow the possibility of a liability business

and to cause it: The liability business of banks is nothing but a reflex

of prior credit extension. The opposite view is based on a kind of

optical illusion ….” 18 [Hahn (1920, p. 29)]

Overall, Hahn probably did more than anyone to popularise the

credit creation theory in Germany, his book becoming a bestseller,

and spawning much controversy and new research among economists

in Germany. It also greatly heightened awareness among journalists

and the general public of the topic in the following decades.

The broad impact of his book was likely one of the reasons why this

theory remained entrenched in Germany, when it had long been

discarded in the UK or the US, namely well into the post-war period.

Hahn's book was however not just a popular explanation without

academic credibility. Schumpeter cited it positively in the second

(German) edition of his Theory of Economic Development (Schumpeter,

1926), praising it as a further development in line with, but beyond,

his own book. The English translation of Schumpeter's influential

book Schumpeter (1912 [1934]) also favourably cites


It can be said that support for the credit creation theory appears to

have been fairly widespread in the late 19th and early 20th century in

English and German language academic publications. By 1920, the credit

creation theory had become so widespread that it was dubbed the ‘current

view’, the‘traditional theory’ or the ‘time-worn theory of bank

credit’ by later critics. 19

The early Keynes seemed to also have been a supporter of this dominant

view. In his Tract on Monetary Reform (Keynes, 1924), he asserts,

apparently without feeling the need to establish this further, that

banks create credit and money, at least in aggregate:

“The internal price level is mainly determined by the amount of

credit created by the banks, chiefly theBigFive…” (p. 178).

17 “Jeder Kredit der gegeben wird, erzeugt seinerseits ein Deposit und damit die Mittel zu

seiner Unterbringung. … Die Folgerung aus dem skizzierten Vorgang kann man auch

umgekehrt ausrücken, indem man sagt – und dieser Schluß ist ebenso zwingend – ,daß

jedes irgendwie und irgendwo in der Volkswirtschaft vorhandene Scheck- oder

Ueberweisungsguthaben sein Entstehen einer vorausgegangenen Kreditgewährung,

einem zuvor eingeräumten Kredit zu verdanken hat” (S. 28). Translated by author.

18 “Wir behaupten also im Gegensatz zu der gesamten, in dieser Beziehung so gut wie

einigen Bank- und Kreditliteratur, daß nicht das Passivgeschäft der Banken, insbesondere

das Depositengeschäft das Primäre ist, sondern daß allgemein und in jedem einzelnen

Falle ein Aktivgeschäft einer Bank vorangegangen sein muß, um erst das Passivgeschäft

einer Bank möglich zu machen und es hervorzurufen: Das Passivgeschäft der Banken ist

nichts anderes als ein Reflex vorangegangener Kreditgewährung. Die entgegengesetzte

Ansicht beruht auf einer Art optischer Täuschung …” (S. 29). Translated by author.

19 See, for instance, Phillips (1920, p. 72, p. 119).

“The amount of credit, so created, is in its turn roughly measured by

the volume of the banks' deposits — since variations in this total

must correspond to the variations in the total of their investments,

bill-holdings, and advances” (p. 178).

We know from Keynes' contribution to the Macmillan Committee

(1931) that Keynes meant with this that each individual bank was

able to create credit:

“It is not unnatural to think of the deposits of a bank as being created

by the public through the deposit of cash representing either savings

or amounts which are not for the time being required to meet expenditure.

But the bulk of the deposits arise out of the action of the

banks themselves, for by granting loans, allowing money to be

drawn on an overdraft or purchasing securities a bank creates a

credit in its books, which is the equivalent of a deposit” (p. 34).

Concerning the banking system as a whole, this bank credit and

deposit creation was thought to influence aggregate demand and the

formation of prices, as Schumpeter (1912) had argued:

“The volume of bankers' loans is elastic, and so therefore is the mass

of purchasing power …. The banking system thus forms the vital link

between the two aspects of the complex structure with which we

have to deal. For it relates the problems of the price level with the

problems of finance, since the price level is undoubtedly influenced

by the mass of purchasing power which the banking system creates

and controls, and by the structure of credit which it builds …. Thus,

questions relating to the volume of purchasing power and questions

relating to the distribution of purchasing power find a common focus

in the banking system” (Macmillan Committee, 1931, pp. 12 ff.).

“… if, finally, the banks pursue an easier credit policy and lend more

freely to the business community, forces are set in motion increasing

profits and wages, and therefore the possibility of additional spending

arises” (p. 13).

Concerning the question whether credit demand or credit supply is

more important, the report argued that the root cause is the movement

of the supply of credit:

“The expansion or contraction of the amount of credit made available

by the banking system in other directions will, through a variety

of channels, affect the ease of embarking on new investment propositions.

This, in turn, will affect the volume and profitableness of

business, and hence react in due course on the amount of accommodation

required by industry from the banking system. … Thus what

started as an alteration in the supply of credit ends up in the guise of

an alteration in the demand for credit” (p. 99). 20

While money is thus seen as endogenous to credit, when what is

called a ‘bank loan’ is extended, the Committee argued that bank credit

was exogenous as far as loan applicants are concerned:

“There can be no doubt as to the power of the banking system … to

increase or decrease the volume of bank money” (p. 102).

“In normal conditions we see no reason to doubt the capacity of the

banking system to influence the volume of active investment by

20 This is in line with the credit supply determination view proposed by Werner (1997,

2005) and his Quantity Theory of Credit, as opposed to the endogenous credit supply view

of many post-Keynesians.

6 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19

increasing the volume and reducing the cost of bank credit. … Thus

we consider that in any ordinary times the power of the banking

system … to increase or diminish the active employment of money

in enterprise and investment is indisputable” (p. 102).

The Macmillan Committee also argued that bank credit could be manipulated

by the Bank of England, and thus was also considered exogenous

in this sense.

The credit creation theory remained influential until the early postwar

years. The links of credit creation to macroeconomic and financial

variables were later formalised in the Quantity Theory of Credit

(Werner, 1992, 1997, 2005, 2012), which argues that credit for (a) productive

use in the form of investments for the production of goods and

services is sustainable and non-inflationary, as well as less likely to become

a non-performing loan, (b) unproductive use in the form of consumption

results in consumer price inflation and (c) unproductive use

in the form of asset transactions results in asset inflation and, if large

enough, banking crises. However, since the 1920s serious doubts had

spread about the veracity of the credit creation theory of banking. These

doubts were initially uttered by economists who in principle supported

the theory, but downplayed its significance. It is this group of writers

that served as a stepping stone to the formulation of the modern fractional

reserve theory, which in its most widespread (and later) version

however argues that individual banks cannot create credit, but only

the banking system in aggregate. It is this theory about banks that we

now turn to.

2.2. The fractional reserve theory

An early proponent of the fractional reserve theory was Alfred

Marshall (1888). Hetestified to a government committee about the

role of banks as follows:

“I should consider what part of its deposits a bank could lend and

then I should consider what part of its loans would be redeposited

with it and with other banks and, vice versa, what part of the loans

made by other banks would be received by it as deposits. Thus I

should get a geometrical progression; the effect being that if each

bank could lend two thirds of its deposits, the total amount of loaning

power got by the banks would amount to three times what it

otherwise would be.”

[Marshall (1888), as quoted by Yohe (1995, p. 530)]

With this, he contradicted Macleod's arguments. However,

Marshall's view was still a minority view at the time. After the end of

the First World War, a number of influential economists argued that

the ‘Old Theory’ (Phillips, 1920:72) of bank credit creation by individual

banks was mistaken. Their view gradually became more influential.

“The theory of deposit expansion reached its zenith with the publication

of C.A. Phillips' Bank Credit …” (Goodfriend, 1991, as quoted by Yohe,

1995, p. 532).

Phillips (1920) argued that it was important to distinguish between

the theoretical possibility of an individual bank ‘manufacturing money’

by lending in excess to cash and reserves on the one hand, and, on the

other, the banking system as a whole being able to do this. He argued

that the ‘Old Theory’ (the credit creation theory) was

“predicated upon the contention that a bank would be able to make

loans to the extent of several times the amount of additional cash

newly acquired and held at the time the loans were made, whereas

a representative bank in a system is actually able ordinarily to lend

an amount only roughly equal to such cash” (p. 72). 21

21 His analysis was based on the “overlooked … pivotal fact that an addition to the usual

volume of a bank's loans tends to result in a loss of reserve for that bank only somewhat less

on average than the amount of the additional loans. … Manifold loans are not extended by

an individual bank on the basis of a given amount of reserve” (Phillips, 1920, p. 73).

According to Phillips (1920), individual banks cannot create credit or

money, but collectively the banking system does so, as a new reserve is

“split into small fragments, becomes dispersed among the banks of the

system. Through the process of dispersion, it comes to constitute the

basis of a manifold loan expansion” (p. 40). Each bank is considered

mainly a financial intermediary: “… the banker … handles chiefly the

funds of others” (pp. 4–5). Phillips argued that since banks target

particular cash to deposit and reserve to deposit ratios (as cited in

the money multiplier), which they wish to maintain, each bank effectively

works as an intermediary, lending out as much as it is

able to gather in new cash. Through the process of dispersion and

re-iteration, the financial intermediation function of individual

banks, without the power to create credit, adds up to an expansion

in the money supply in aggregate. 22

Crick (1927) shared this conclusion (with some minor caveats).

Thus he argued:

“The important point, which is responsible for much of the controversy

and most of the misunderstanding, is that while one bank receiving

an addition to its cash cannot forthwith undertake a full

multiple addition to its own deposits, yet the cumulative effect of

the additional cash is to produce a full multiple addition to the deposits

of all the banks as a whole” (p. 196).

“Summing up, then, it is clear … that the banks, so long as they maintain

steady ratios of cash to deposits, are merely passive agents of the

Bank of England policy, as far as the volume of money in the form of

credit is concerned. … The banks … have very little scope for policy

in the matter of expansion or contraction of deposits, though they

have in the matter of disposition of resources between loans, investments

and other assets. But this is not to say that the banks cannot

and do not effect multiple additions to or subtractions from deposits

as a whole on the basis of an expansion of or contraction in bank cash”

(p. 201).

The role of banks remained disputed during the 1920s and 1930s,

as several writers criticised the credit creation theory. Views not only

diverged, but were also in a flux, as several experts apparently

shifted their position gradually — overall an increasing number

moving away from the credit creation theory and towards the fractional

reserve theory.

Sir Josiah C. Stamp, a former director of the Bank of England,

summarised the state of debate in his review of an article by Pigou


“The general public economic mind is in a fair state of muddlement

at the present moment on the apparently simple question: “Can

the banks create credit, and if so, how, and how much?” and between

the teachings of Dr. Leaf and Mr. McKenna, Messrs. Keynes,

Hawtrey, Cassel and Cannan and Gregory, people have not yet found

their way.”

[Stamp (1927, p. 424)]

22 It should be noted here that Phillips' (1920) work can be interpreted in a more differentiated

manner. For instance, Phillips did also point out that if all banks increased their

lending at roughly the same pace, each bank would, after all, be able to create credit without

losing reserves or cash, on balance (pp. 78 ff.). However, subsequent writers citing

Phillips usually do not mention this. While a more detailed discussion of Phillips is, however,

beyond the scope of this paper, it is here merely claimed that Phillips' argument was

an important stepping stone towards the formulation of the fractional reserve theory of

banking, which is unequivocal in treating individual banks as mere financial intermediaries

without the power to create credit or money individually under any and all circumstances,

even though it could possibly be argued that Phillips himself may not have agreed

with the latter in all respects.

R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19


Contributions to this debate were also made by Dennis Robertson

(1926), who was influenced by Keynes. 23 Keynes (1930) explains the

role of reserve holdings and the mechanics of determining a bank's behaviour

based on its preference to hold cash and reserves, together with

the amount of reserves provided by the central bank — the fairly

predetermined mechanics postulated by the money multiplier in a fractional

reserve model:

“Thus in countries where the percentage of reserves to deposits is by

law or custom somewhat rigid, we are thrown back for the final determination

of M, the Volume of Bank-money on the factors which

determine the amount of these reserves” (p. 77).

Keynes (1930) also backed a key component of the fractional reserve

theory, namely that banks gather deposits and place parts of them with

the central bank, or, alternatively, may withdraw funds from their reserves

at the central bank in order to lend these out to the nonbanking

sector of the economy:

“When a bank has a balance at the Bank of England in excess of its

usual requirements, it can make an additional loan to the trading

and manufacturing world, and this additional loan creates an additional

deposit (to the credit of the borrower or to the credit of those

to whom he may choose to transfer it) on the other side of the

balance sheet of this or some other bank.”

[Keynes (1930, vol. 2, p. 218)]

Keynes here argues that new deposits, based on new loans, are dependent

upon and connected to banks' reserve balances held at the central

bank. This view is sometimes also supported by present-day central

bankers, such as in Paul Tucker's or the ECB's proposal to introduce negative

interest rates on banks' reserve holdings at the central bank, as an

incentive for them to ‘move’ their money from the central bank and increase

lending. 24 Nevertheless, part of Keynes (1930), and much of his

most influential work, his General Theory (1936), appears more in line

with the financial intermediation theory, as will be discussed in the following


A representative example of the fractional reserve theory that at the

same time was beginning to point in the direction of the financial

intermediation theory is the work by Lutz (1939), who published in

Economica, a forum for some of these debates at the time:

“The expansion of the economic system leads to an increase in the

volume of deposits to a figure far in excess of the amount of the additional

cash in use, simply because the same cash is deposited with

the banking system over and over again. … The fact that banking

statistics show an aggregate of deposits far above the amount of cash

in the banking system, is therefore not of itself a sign that the banks

must have created the whole of the difference. This conclusion is

also, of course, somehow implicit in the “multiple expansion” theory

of the creation of bank deposits (of the Phillips or Crick variety). That

theory explains the creation of deposits by the fact that the same

cash (in decreasing amounts) is successively paid into different

banks. It does, however, look upon this cash movement rather in

the nature of a technical affair between banks … which would

disappear if the separate banks were merged into one. In that case

the deposits would be regarded as coming into existence by outright

creation. In our example we assume throughout only one bank, and

still the deposits grow out of the return, again and again, of the same

23 In the Introduction, Robertson says: “I have had so many discussions with Mr. J. M.

Keynes on the subject matter of chapters V and VI, and have rewritten them so drastically

at his suggestion, that I think neither of us now knows how much of the ideas therein

contained is his, and how much is mine (p. 5).” (As cited in Keynes, 1930.)

24 On Paul Tucker's proposal, see BBC (2013), and also the critique by Werner (2013a).

Negative rates on bank reserves at the central bank were actually imposed by the Swedish

central bank in 2009, the Danish central bank in 2012 and for the first time by the Swiss

central bank in 1978 on deposits by foreign banks.

cash by the public. … The force which really creates expansion is the

trade credit given by producers to one another. … The bank plays the

role of a mere intermediary.”

… This seems to lead not to a new, but to a very old theory of the function

of banks: the function of a mere intermediary … (pp. 166 ff.).

“The modern idea of banks being able to create deposits seemed to

be a startling departure from the view held by most economists in

the nineteenth century. If, however, we approach this modern idea

along the lines followed above, we find that it resolves itself into

much the same elements as those which many of the older writers

regarded as the essence of banking operations: the provision of confidence

which induces the economic subjects to extend credit to

each other by using the bank as an intermediary” (p. 169).

Phillips' influence has indeed been significant. Even in 1995

Goodfriend still argued that

“… Phillips showed that the summation of the loan- and depositcreation

series across all individual banks yields the multiple expansion

formulas for the system as a whole. Phillips' definitive exposition

essentially established the theory once and for all in the form found in

economics textbooks today.”

[as reprinted in Yohe (1995, p. 535)]

Statements like this became the mainstream view in the 1950s and

1960s. 25 The view of the fractional reserve theory in time also came to

dominate textbook descriptions of the functioning of the monetary

and banking system. There is no post-war textbook more representative

and influential than that of Samuelson (1948). The original first edition

is clear in its description of the fractional reserve theory:Undertheheading

“Can banks really create money?”, Samuelsonfirst dismisses “false

explanations still in wide circulation” (p. 324):

“According to these false explanations, the managers of an ordinary

bank are able, by some use of their fountain pens, to lend several dollars

for each dollar left on deposit with them. No wonder practical

bankers see red when such behavior is attributed to them. They only

wish they could do so. As every banker well knows, he cannot invest

money that he does not have; and any money that he does invest in

buying a security or making a loan will soon leave his bank” (p. 324).

Samuelson thus argues that a bank needs to gather the funds first, before

it can extend bank loans. This is not consistent with the credit

creation theory. However, Samuelson argues that, in aggregate, the banking

system creates money. He illustrates his argument with the example

of a ‘small bank’ that faces a 20% reserve requirement, and considering

the accounts of the bank (B/S). If this bank receives a new cash deposit

of $1000, “What can the bank now do?”, Samuelson asks (p. 325).

“Can it expand its loans and investments by $4000 …?”

“The answer is definitely ‘no’. Why not? Total assets equal total

liabilities. Cash reserves meet the legal requirement of being 20

25 Even though a closer reading of Alhadeff (1954) shows that the author agreed that,

under certain circumstances, banks can create credit and money: “In certain cases, the proportion

between the legal reserve ratio and residual deposits is such that even a single

bank can expand its deposits to a somewhat greater amount than its primary deposits.

… Again, it might be possible for a very large bank, or a bank in an isolated community

with few business connections with outside banks, literally to create money because of

flow back deposits. [Footnote: ‘Flow-back deposits refer to the circulation of deposits

among the depositors of the same bank.’] In either case, this amounts to a partial reduction

in the average cost of producing credit (making loans), at least in terms of the raw material

costs …” (Alhadeff, 1954, p. 7). Although Alhadeff, if studied closely, could be said to have

agreed that an individual bank can create credit out of nothing, he clearly thought this to

be a special case without practical relevance, while it is normally only the banking system

in aggregate that creates credit.

8 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19

per cent of total deposits. True enough. But how does the bank pay

for the investments or earning assets that it buys? Like everyone else

it writes out a check — to the man who sells the bond or signs the

promissory note. … The borrower spends the money on labor, on

materials, or perhaps on an automobile. The money will very soon,

therefore, have to be paid out of the bank. … A bank cannot eat its

cake and have it too. Table 4b gives, therefore a completely false picture

of what an individual bank can do” (pp. 325 ff.).

Instead, Samuelson explains, since all the money lent out will leave

the bank, an individual bank cannot create credit out of nothing:

“As far as this first bank is concerned, we are through. Its legal reserves

are just enough to match its deposits. There is nothing more

it can do until the public decides to bring in some more money on

deposit” (p. 326).

On the other hand, Samuelson emphasises that

“The banking system as a whole can do what each small bank cannot

do!” (p. 324),

namely create money. This, Samuelson explains via the iterative process

of one bank's loans (based on prior deposits) becoming another bank's

deposits, and so forth. He shows “this chain of deposit creation” in a table,

amounting to total deposits in the banking system of $5000 (out of

the $1000), due to the reserve requirement of 20% implying a ‘money

multiplier’ of 5 times (assuming no cash ‘leakage’).

What Samuelson calls the “multiple deposit expansion” is described

in the same way and with remarkable similarity in the fifteenth edition

of his book (Samuelson & Nordhaus, 1995) half a century later, only that

the reserve requirement cited as example has been lowered to 10%: “All

banks can do what one can't do alone” (p. 493). There are subtle though

important differences. The overall space devoted to this topic is much

smaller in 1995 compared to 1948. The modern textbook says that the

central bank-created reserves are used by the banks “as an input” and

then “transformed” “into a much larger amount of bank money”

(p. 490). There is far less of an attempt to deal with the credit creation

theory. Instead, each bank is unambiguously represented as a pure financial

intermediary, collecting deposits and lending out this money

(minus the reserve requirement). 26 The fractional reserve theory had become


“Each small bank is limited in its ability to expand its loans and investments.

It cannot lend or invest more than it has received from

depositors” (p. 496).

Meanwhile, bank deposit money is “supplied” by “the financial system”

in an abstract process that each individual bank has little control

over (p. 494). The unambiguous fractional reserve theory thus appears

to have come about in the years after the 1950s. It can be described in

Fig. 1.

In this scheme, funds move between the public, the banks and the

central bank without any barriers. Each bank is a financial intermediary,

but in aggregate, due to fractional reserve banking, money is created

(multiplied) in the banking system. Specifically, each bank can only

grant a loan if it has previously received new reserves, of which a fraction

will always be deposited with the central bank. It will then only

be able to lend out as much as these excess reserves, as is made clear

in major textbooks. In the words of Stiglitz (1997):

26 Moreover, the original Samuelson (1948: 331) offered an important (even though not

prominently displayed) section headed ‘Simultaneous expansion or contraction by all

banks’, which provided the caveat that each individual bank could, after all, create deposits,

if only all banks did the same at the same rate (thus outflows being on balance cancelled

by inflows, as Alhadeff, 1954, also mentioned). There is no such reference in the

modern, ‘up-to-date’ textbook.

Fig. 1. The fractional reserve theory as represented in many textbooks.

“It should be clear that when there are many banks, no individual

bank can create multiple deposits. Individual banks may not even

be aware of the role they play in the process of multiple-deposit creation.

All they see is that their deposits have increased and therefore

they are able to make more loans” (p. 737).

In another textbook on money and banking:

“In this example, a person went into bank 1 and deposited a

$100,000 check drawn on another bank. That $100,000 became part

of the reserves of bank 1. Because that deposit immediately created

excess reserves, further loans were possible for bank 1. Bank 1 lent

the excess reserves to earn interest. A bank will not lend more than

its excess reserves because, by law, it must hold a certain amount of

required reserves.”

[Miller and VanHoose (1993, p. 331)]

The deposit of a cheque from another bank does not however

increase the “total amounts of deposits and money”:

“Remember, though, that the deposit was a check written on

another bank. Therefore, the other bank suffered a decline in its

transactions deposits and its reserves. While total assets and

liabilities in bank 1 have increased by $100,000, they have decreased

in the other bank by $100,000. Thus the total amount of

money and credit in the economy is unaffected by the transfer of

funds from one depository institution to another. Eachdepository

institution can create loans (and deposits) only to the extent that

it has excess reserves. The thing to remember is that new reserves

are not created when checks written on one bank are deposited in

another bank. The Federal Reserve System, however, can create

new reserves” (p. 331).

The textbook by Heffernan (1996) says:

“To summarise, all modern banks act as intermediaries between

borrowers and lenders, but they may do so in a variety of different

ways, from the traditional function of taking deposits and

lending a percentage of these deposits, to fee-based financial

services” (p. 18).

“For the bank, which pools these surplus funds, there is an opportunity

for profit through fractional reserve lending, that is, lending out

R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19


money at an interest rate which is higher than what the bank pays

on the deposit, after allowing for the riskiness of the loan and the

cost of intermediation” (p. 20).

While the fractional reserve theory succeeded in attracting many

followers, rendering it an important and influential theory until this

day, it is not famous for its clarity:

“The problem of the manner in which the banking system increases

the total volume of the circulating medium, while at the same time

the lending power of the individual banks is severely limited, has

proved to be one of the most baffling for writers on banking theory.”

[Mints (1945, p. 39)]

Several attempts were made to resolve this within the fractional

reserve theory of banking, such as that by Saving (1977), who rendered

the supply of bank deposits a function of the behaviour of the savers —

arguing that the money supply is endogenous. This effectively pushed

out the intermediary function from the individual bank level to the

economy level, and helped ushering in the formulation of the financial

intermediation theory to which we now turn.

2.3. The financial intermediation theory

While the fractional reserve theory of banking was influential from

the 1930s to the 1960s, Keynes may have sown important seeds of

doubt. Already in his ‘Treatise’, Keynes (1930) makes use of inverted

commas in order to refer, suggestively, to ‘The “Creation” of Bank-

Money’ (a section title). This rhetorical device, employed by the expert

already hailed as the leading economist in the world, implied disapproval,

as well as mockery of the concept that banks could create

money out of nothing. The device was copied by many other writers

after Keynes who also emphasised the role of banks as ‘financial

intermediaries’. In Keynes' words:

“A banker is in possession of resources which he can lend or invest

equal to a large proportion (nearly 90%) of the deposits standing to

the credit of his depositors. In so far as his deposits are Savingsdeposits,

he is acting merely as an intermediary for the transfer of

loan-capital. In so far as they are Cash-deposits, he is acting both as

a provider of money for his depositors, and also as a provider of resources

for his borrowing-customers. Thus the modern banker performs

two distinct sets of services. He supplies a substitute for

State Money by acting as a clearing-house and transferring current

payments backwards and forwards between his different customers

by means of book-entries on the credit and debit sides. But he is also

acting as a middleman in respect of a particular type of lending,

receiving deposits from the public which he employs in purchasing

securities, or in making loans to industry and trade mainly to meet

demands for working capital. This duality of function is the clue to

many difficulties in the modern Theory of Money and Credit and

the source of some serious confusions of thought.”

[Keynes (1930, vol. 2, p. 213)]

The Keynes of the Treatise seems to say that the two functions of

banks are to either act as financial intermediary fulfilling the utility

banking function of settling trades, or to act as financial intermediary

gathering deposits and lending the majority of these out. There seems

no money creation at all involved, certainly not on the individual bank

level. Keynes' most influential opus, General Theory (Keynes, 1936)

quickly eclipsed his earlier Treatise on Money in terms of its influence

on public debate. In the General Theory, Keynes did not place any emphasis

on banks, which he now argued were financial intermediaries

that needed to acquire deposits before they could lend:

“The notion that the creation of credit by the banking system allows

investment to take place to which ‘no genuine saving’ corresponds

can only be the result of isolating one of the consequences of the increased

bank-credit to the exclusion of the others. … It is impossible

that the intention of the entrepreneur who has borrowed in order to

increase investment can become effective (except in substitution for

investment by other entrepreneurs which would have occurred

otherwise) at a faster rate than the public decide to increase their

savings. … No one can be compelled to own the additional money

corresponding to the new bank-credit, unless he deliberately prefers

to hold more money rather than some other form of wealth. … Thus

the old-fashioned view that saving always involves investment,

though incomplete and misleading, is formally sounder than the

newfangled view that there can be saving without investment or investment

without ‘genuine’ saving.”

[Keynes (1936, pp. 82 ff.)]

Schumpeter (1954) commented on this shift in Keynes' view:

The “deposit-creating bank loan and its role in the financing of investment

without any previous saving up of the sums thus lent have

practically disappeared in the analytic schema of the General Theory,

where it is again the saving public that holds the scene. Orthodox

Keynesianism has in fact reverted to the old view …. Whether this

spells progress or retrogression, every economist must decide for

himself” (p. 1115, italics in original).

The early post-war period saw unprecedented influence of Keynes'

General Theory, and a Keynesian school of thought that managed to

ignore Keynes' earlier writings on bank credit creation, became

dominant in academia. Given that a former major proponent of both

the credit creation and the fractional reserve theories of banking had

shifted his stance to the new financial intermediation theory, itisnot

surprising that others would follow.

A highly influential challenge to the fractional reserve theory of

banking was staged by Gurley and Shaw (1955, 1960). They rejected

the view that “banks stand apart in their ability to create loanable

funds out of hand while other intermediaries in contrast are busy with

the modest brokerage function of transmitting loanable funds that are

somehow generated elsewhere” (1955, p. 521). Beyond the usual rhetorical

devices to denigrate the alternative theories, Gurley and Shaw's

actual argument was that banks should not be singled out as being ‘special’,

since the banks' financial intermediation function is identical to

that of other financial intermediaries:

“There are many similarities between the monetary system and nonmonetary

intermediaries, and the similarities are more important

than the differences. Both types of financial institutions create financial

claims; and both may engage in multiple creation of their particular

liabilities in relation to any one class of asset that they hold.”

[Gurley and Shaw (1960, p. 202)]

Banks and the banking system, we are told, like other financial intermediaries,

need to first gather deposits, and then are able to lend these

out. In this view, any remaining special role of banks is due to outmoded

regulations, which treat banks differently. Therefore, they argue, the

Federal Reserve should extend its banking supervision to the growing

set of non-bank financial intermediaries, thus treating them equally to


Initial challenges by proponents of the fractional reserve theory

of banking (see Guttentag & Lindsay, 1968) were swept away

during the 1960s, when James Tobin, a new rising star in economics,

took a clear stand to proclaim another ‘new view’ of banking, formulating

the modern version of the financial intermediation theory of banking.

“Tobin (1963), standing atop the wreckage in 1963 to set forth the

‘new view’ of commercial banking, stands squarely with Gurley

and Shaw against the traditional view.”

[Guttentag and Lindsay (1968, p. 993)]

10 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19

Like Keynes, Alhadreff and others before him, Tobin only referred to

bank credit creation in inverted commas, and used rhetorical devices to

ridicule the idea that banks, individually or collectively, could create

money and credit. Tobin (1963) argued:

“Neither individually nor collectively do commercial banks possess a

widow's cruse” (p. 412).

“The distinction between commercial banks and other financial intermediaries

has been too sharply drawn. The differences are of degree,

not of kind …. In particular, the differences which do exist have little

intrinsically to do with the monetary nature of bank liabilities … The

differences are more importantly related to the special reserve requirements

and interest rate ceilings to which banks are subject.

Any other financial industry subject to the same kind of regulations

wouldbehaveinmuchthesameway” (p. 418).

Banks only seem to be different from others, because regulators

erroneously chose to single them out for special regulation. In Tobin's

view, “commercial banks are different, because they are controlled,

and not the other way around” (Guttentag & Lindsay, 1968, p. 993).

Tobin and Brainard's (1963) portfolio model made no distinction between

banks and non-bank financial intermediaries, indeed, ignored

the role of banks altogether and contributed much towards the modern

mainstream view of economics models without banks. Branson (1968)

further developed Tobin's new approach, which was popular in the

leading journals.

Guttentag and Lindsay (1968) wrote in the Journal of Political Economy

that despite the challenge by Gurley and Shaw (1955) “The uniqueness

issue, on the other hand, remains unsettled” (p.992).Banks,theyargued,

are different in their role and impact from non-bank financial intermediaries,

since “commercial banks have a greater capacity for varying the aggregate

volume of credit than other financial intermediaries” (p. 991).

“These points provide a rationale for special controls on commercial

banks that goes beyond the need to prevent financial panic. It is the rationale

that has been sought by defenders of the traditional view that commercial

banks are ‘unique’ ever since the Gurley–Shaw challenge to this

view” (p. 991).

Undaunted, Tobin (1969) re-states his view in an article establishing

his portfolio balance approach to financial markets, which argues

that financial markets are complex webs of assets and prices,

leaving banks as one of many types of intermediaries, without any

special role. 27 This was the first article in the first edition of a new

journal, the Journal of Money, Credit and Banking. While its name

may suggest openness towards the various theories of banking, in

practice it has only published articles that did not support the credit

creation theory and were mainly in line with the financial intermediation

theory. This is also true for most other journals classified as ‘leading

journals’ in economics (for instance, using the 4-rated journals from the

UK Association of Business Schools list in economics). Henceforth, the

portfolio balance approach, which treated all financial institutions as

mere portfolio managers, was to hold sway. It helped the financial

intermediation theory become the dominant creed among economists


Modern proponents of the ubiquitous financial intermediation theory

include, among others, Klein (1971), Monti (1972), Sealey and Lindley

(1977), Diamond and Dybvig (1983), Diamond (1984, 1991, 2007),

Eatwell, Milgate, and Newman (1989), Gorton and Pennacchi (1990),

Bencivenga and Smith (1991), Bernanke and Gertler (1995), Rajan

(1998), Myers and Rajan (1998), Allen and Gale (2000, 2004a,b), Allen

and Santomero (2001), Diamond and Rajan (2001), Kashyap, Rajan,

and Stein (2002), Hoshi and Kashyap (2004), Matthews and

Thompson (2005), Casu and Girardone (2006), Dewatripont, Rochet

and Tirole (2010), Gertler and Kiyotaki (2011) and Stein (2014). There

are many more: It is impossible to draw up a conclusive list, since the

vast majority of articles published in leading economics and finance

journals in the last thirty to forty years is based on the financial intermediation

theory as premise. 28

Quoting only a few examples, Klein (1971), Monti (1972) (later to

become EU commissioner and prime minister of Italy), and others

model banks as financial intermediaries, gathering deposits and lending

these funds out:

“The bank has two primary sources of funds; the equity originally

invested in the firm … and borrowed funds secured through the issuance

of various types of deposits ….”

[Klein (1971, p. 208)]

“… It will be shown how the bank determines the prices it will pay

for various types of deposits and how these prices, in conjunction

with the deposit supply functions the bank confronts, determine

the scale and composition of the bank's deposit liabilities the bank

will assume.”

[Klein (1971, p. 210)]

Diamond and Dybvig (1983) are cited as the seminal work on banking,

and they argue that “Illiquidity of assets provides the rationale both

for the existence of banks and for their vulnerability to runs” (p. 403).

But in actual fact their theory makes no distinction between banks

and non-banks. They therefore are unable to explain why we have

heard of bank runs, but not of ‘insurance runs’ or ‘finance company

runs’, although the latter also hold illiquid assets and give out loans.

Diamond and Dybvig fail to identify what could render banks special

since they assume that they are not.

Other theories of banks as financial intermediaries are presented by

Mayer (1988) and Hellwig (1977, 1991, 2000), who also believe that

banks are merely financial intermediaries:

“The analysis uses the original model of Diamond (1984) of financial

contracting with intermediation as delegated monitoring. … Monitoring

is assumed to be too expensive to be used by the many households

required to finance a firm or an intermediary. However

direct finance of firms based on nonpecuniary penalties may be

dominated by intermediated finance with monitoring of firms by

an intermediary who in turn obtains funds from households through

contracts involving nonpecuniary penalties.”

[Hellwig (2000, pp. 721 ff.)]

Banking expert Heffernan (1996) states:

27 The conclusion of Tobin's paper: “According to this approach, the principal way in

which financial policies and events affect aggregate demand is by changing the valuations

of physical assets relative to their replacement costs. Monetary policies can accomplish

such changes, but other exogenous events can too. In addition to the exogenous variables

explicitly listed in the illustrative models, changes can occur, and undoubtedly do, in the

portfolio preferences – asset demand functions – of the public, the banks, and other sectors.

These preferences are based on expectations, estimates of risk, attitudes towards risk,

and a host of other factors. In this complex situation, it is not to be expected that the essential

impact of monetary policies and other financial events will be easy to measure in the

absence of direct observation of the relevant variables (q in the models). There is no reason

to think that the impact will be captured in any single exogenous or intermediate variable,

whether it is a monetary stock or a market interest rate” (Tobin, 1969, p. 29).

“The existence of the “traditional” bank, which intermediates between

borrower and lender, and which offers a payments service

to its customers, fits in well with the Coase theory” (p. 21).

28 This also means that the innumerable PhD theses and Masters dissertations produced

in this area in the last thirty years or so are mainly based on the financial intermediation

theory. For instance, Wolfe (1997) states: “Banks possess the power of intermediation,

which is the ability to transform deposits into loans. Deposits with one set of characteristics

are transformed into assets with other or different characteristics” (p. 12).

R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19


… or a leading textbook on international economics and finance, by

Krugman and Obstfeld (2000):

“Banks use depositors' funds to make loans and to purchase other

assets …” (p. 659).

A widely used reference work on banking and money – the New

Palgrave Money (Eatwell et al., 1989) – contains a number of contributions

by leading monetary economists and banking experts. In it,

Baltensperger (1989) clearly supports the financial intermediation theory:

“The role of credit as such must be clearly separated from the economic

role of credit institutions, such as banks, playing the role of

specialised intermediaries in the credit market by buying and simultaneously

selling credit instruments (of a different type and quality).

Since the ultimate borrowers and lenders can, in principle, do

business with each other directly, without the help of such an intermediary,

the function of these middlemen must be viewed as separate

from that of credit as such. Two main functions of institutions of

this kind can be distinguished. The first is the function of risk consolidation

and transformation. … The second major function of these

institutions is that of a broker in the credit markets. As such, they

specialise in producing intertemporal exchange transactions and

owe their existence to their ability to bring together creditors and

debtors at lower costs than the latter can achieve in direct transactions

themselves” (pp. 100 ff.).

Indeed, almost all authors in this reference book refer to banks as

mere financial intermediaries, even Goodhart (1989):

“‘Intermediation’ generally refers to the interposition of a financial

institution in the process of transferring funds between ultimate

savers and ultimate borrowers. … Disintermediation is then said to

occur when some intervention, usually by government agencies for

the purpose of controlling, or regulating, the growth of financial intermediaries,

lessens their advantages in the provision of financial

services, and drives financial transfers and business into other

channels. … An example of this is to be found when onerous reserve

requirements on banks lead them to raise the margin (the spread)

between deposit and lending rates, in order to maintain their profitability,

so much that the more credit-worthy borrowers are induced

to raise short-term funds directly from savers, for example, in the

commercial paper market” (p. 144).

Myers and Rajan (1998) state:

“We model the intermediary as a bank that borrows from a number

of individual investors for its own core business and to lend on to a

project. … Even though the bank can extract more from the ultimate

borrower, the bank has to finance these loans by borrowing from individual

investors” (p. 755).

Allen and Santomero (2001), in their paper entitled ‘What do financial

intermediaries do?’ state:

“In this paper we use these observations as a starting point for

considering what it is that financial intermediaries do. At center, of

course, financial systems perform the function of reallocating the resources

of economic units with surplus funds (savers) to economic

units with funding needs (borrowers)” (p. 272).

Kashyap (2002) also believes that banks are pure financial intermediaries,

not materially distinguishable from other non-bank financial

institutions. 29

Stein (2014) states, albeit with some hesitation:

29 See Werner (2003b) for a detailed critique of Kashyap (2002).

“… at least in some cases, it seems that a bank's size is determined by

its deposit franchise, and that, taking these deposits as given, its

problem then becomes one of how best to invest them” (p. 5).

“Overall, our synthesis of these stylised facts is that banks are in the

business of taking deposits and investing these deposits in fixedincome

assets that have certain well-defined risk and liquidity attributes

but which can be either loans or securities” (p. 7).

The financial intermediation theory includes the ‘credit view’ in macroeconomics,

proposing a ‘bank lending channel’ of monetary transmission

(Bernanke & Blinder, 1989; Bernanke & Gertler, 1995), as well as

the neo-classical and new classical macroeconomic models (if they

consider banks at all). To these and most contemporary authors in economics

and finance, banks are financial intermediaries like other firms

in the financial sector, which focus on the ‘transformation’ of liabilities

with particular features into assets with other features (e.g. with respect

to maturity, liquidity and quantity/size), or which focus on ‘monitoring’

others (Sheard, 1989, another adherent of the financial intermediation

theory of banking), but do not create credit individually or collectively.

This is true for many ‘Post-Keynesians’ who argue that the money supply

is determined by the demand for money. It is also true for popular

descriptions, such as that by Koo and Fujita (1997) who argue that

banks are merely financial intermediaries:

“But those financial institutions that are counterparties of the Bank

of Japan obtain their funding primarily from the money that depositors

have deposited with them. This money they cannot pass on for

consumption and capital investment, because they have to lend it at

interest to earn money. In other words, for this money to support the

economy, these financial institutions must lend it to firms and individuals.

Those borrowers must then use it to buy assets such as

machinery or housing or services” (p. 31).

A recent paper by Allen, Carletti, and Gale (2014) introduces money —

albeit only cash created by the central bank, while banks are mere

financial intermediaries that cannot create money or credit.

As a result, the leading forecasting models used by policy makers

also do not include banks (Bank of England, 2014a). Even the original

meaning of credit creation seems forgotten by the modern literature:

Bernanke (1993) uses the expression ‘credit creation’ much in his article,

but explains that this concept is defined as “the process by which

saving is channeled to alternative uses”, i.e. financial intermediation of

savers' deposits into loans:

“This fortuitous conjunction of events and ideas has contributed to an

enhanced appreciation of the role of credit in the macroeconomy by

most economists and policymakers. The purpose of this paper is to review

and interpret some recent developments in our understanding

of the macroeconomic role of credit or, more accurately, of the credit

creation process. By credit creation process I mean the process by

which, in exchange for paper claims, the savings of specific individuals

or firms are made available for the use of other individuals or firms

(for example to make capital investments or simply to consume).

Note that I am drawing a strong distinction between credit creation,

which is the process by which saving is channeled to alternative uses,

and the act of saving itself …. In my broad conception of the credit creation

process I include most of the value-added of the financial industry,

including the information-gathering, screening, and monitoring

activities required to make sound loans or investments, as well as

much of the risk-sharing, maturity transformation, and liquidity provision

services that attract savers and thus support the basic lending

and investment functions. I also want to include in my definition of

the credit creation process activities undertaken by potential borrowers

to transmit information about themselves to lenders: for example,

for firms, these activities include provision of data to the

12 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19

public, internal or external auditing, capital structure decisions, and

some aspects of corporate governance. The efficiency of the credit creation

process is reflected both in its ability to minimise the direct costs

of extending credit (for example, the aggregate wage bill of the financial

industry) and in the degree to which it is able to channel an

economy's savings into the most productive potential uses. The presumption

of traditional macroeconomic analysis is that this credit creation

process, through which funds are transferred from ultimate

savers to borrowers, works reasonably smoothly and therefore can

usually be ignored.”

[Bernanke (1993, pp. 50 ff.)]

As Bernanke points out, those works that assume such a financial intermediation

role for banks will therefore often ignore banks entirely:

they cannot be particularly important or relevant in the economy.

Many went as far as to leave out any kind of money (there are no monetary

aggregates in Kiyotaki & Moore, 1997; Woodford, 2003). The most

widely used textbook in advanced Master-level economics at leading

British universities in 2010 was Romer (2006).Onpage3,Romertellsus:

“Incorporating money in models of [economic] growth would only

obscure the analysis” (p. 3).

2.4. Conclusion of the literature review

Since the 1960s it has become the conventional view not to consider

banks as unique and able to create money, but instead as mere financial

intermediaries like other financial firms, in line with the financial

intermediation theory of banking. Banks have thus been dropped from

economics models, and finance models have not suggested that bank

action has significant macroeconomic effects. The questions of where

money comes from and how the money supply is created and allocated

have remained unaddressed.

The literature review has identified a gradual progression of views

from the credit creation theory to the fractional reserve theory to the

present-day ubiquitous financial intermediation theory. The development

has not been entirely smooth; several influential writers have

either changed their views (on occasion several times) or have shifted

between the theories. Keynes, as an influential economist, did little to

enhance clarity in this debate, as it is possible to cite him in support of

each of the three hypotheses, through which he seems to have moved

sequentially. 30 Some institutions, such as the Bank of England, manage

to issue statements in support of all three theories.

We conclude from the literature survey that all three theories of

banking have been well represented in the course of the 20th century,

by leading figures of the day. However, the conclusion by Sir Josiah

Stamp (1927), a director at the Bank of England, still seems to hold

today, namely that there is “a fair state of muddlement … on the apparently

simple question: ‘Can the banks create credit, and if so, how, and

how much?’” Despite a century or so of theorising on the matter,

there has been little progress in establishing facts unambiguously.

Thus today the conclusion of 1968 applies, namely that the issue cannot

be considered as ‘settled’. It is possible that the pendulum is about to

swing away from the financial intermediation theory to one of the

other two. But how can we avoid that history will merely repeat itself

and the profession will spend another century locked into a debate

without firm conclusion?

How can the issue be settled and the ‘muddlement’ cleared up? One

reason for this “state of muddlement” is likely to be the methodology

dominant in 20th century economics, namely the hypotheticodeductive

method. Unproven ‘axioms’ are ‘posed’ and unrealistic assumptions

added, to build a theoretical model. This can be done for all three

theories, and we would be none the wiser about which of them actually

applied. How can the issue be settled? The only way the facts can be

established is to leave the world of deductive theoretical models and consider

empirical reality as the arbiter of truth, in line with the inductive

methodology. In other words, it is to empirical evidence we must turn

to settle the issue.

3. The empirical test

The simplest possible test design is to examine a bank's internal

accounting during the process of granting a bank loan. When all the necessary

bank credit procedures have been undertaken (starting from

‘know-your-customer’ and anti-money laundering regulations to credit

analysis, risk rating to the negotiation of the details of the loan contract)

and signatures are exchanged on the bank loan, the borrower's current

account will be credited with the amount of the loan. The key question

is whether as a prerequisite of this accounting operation of booking the

borrower's loan principal into their bank account the bank actually withdraws

this amount from another account, resulting in a reduction of equal

value in the balance of another entity — either drawing down reserves (as

the fractional reserve theory maintains) or other funds (as the financial intermediation

theory maintains). Should it be found that the bank is able to

credit the borrower's account with the loan principal without having

withdrawn money from any other internal or external account, or without

transferring the money from any other source internally or externally,

this would constitute prima facie evidence that the bank was able to create

the loan principal out of nothing. In that case, the credit creation theory

would be supported and the theory that the individual bank acts as an

intermediary that needs to obtain savings or funds first, before being able

to extend credit (whether in conformity with the fractional reserve theory

or the financial intermediation theory), would be rejected.

3.1. Expected results

With a bank loan of €200,000, drawn by the researcher from a bank,

the following changes in the lending bank's accounting entries are

expected a priori according to each theory:

(a) Bank credit accounting according to the credit creation theory.

According to this theory, banks behave very differently from financial

intermediaries, such as stock brokers, since they do not separate

customer funds from own funds. Money ‘deposited’ with a

bank becomes the legal property of the bank and the ‘depositor’

is actually a lender to the bank, ranking among the general creditors.

When extending bank credit, banks create an imaginary deposit,

by recording the loan amount in the borrower's account,

although no new deposit has taken place (credit creation out of

nothing). The balance sheet lengthens. Cash, central bank reserves

or balances with other banks are not immediately needed, as reserve

and capital requirements only need to be met at particular

measurement intervals. The account changes are shown in Table 1.

(b) Bank credit accounting according to the fractional reserve theory.

The distinguishing feature of this theory is that each individual

bank cannot create credit out of nothing. The bank is a

financial intermediary indistinguishable from other financial intermediaries,

such as stock brokers and securities firms. However,

banks are said to be different in one respect, namely the regulatory

treatment: regulators have placed onerous rules concerning reserves

that have to be held with the central bank only on banks,

not other financial intermediaries. A bank can only lend money,

Table 1

Account changes due to bank loan (credit creation theory).

30 Though with the caveat that several of his statements, made at the same time, seem to

support different theories of banking.

R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19


when it has previously received the same amount in excess reserves

from another bank, whose own reserve balances will have

declined, or from the central bank (Table 2).

Table 3

Account changes due to bank loan (fin. intermediation theory).

Table 2

Account changes due to bank loan (fractional reserve theory).

Step 1. Precondition for the bank loan

Step 2. The bank loan

“A bank will not lend more than its excess reserves because, by law,

it must hold a certain amount of required reserves. … Each depository

institution can create loans (and deposits) only to the extent that


[Miller and VanHoose (1993, p. 331)]

Following the exposition in Miller and VanHoose (1993, pp.

330–331), the balance sheet evolution in case of a €200,000 loan is as

shown in Table 2.

In other words, for the bank to be able to make a loan, it first has to

check its excess reserves, as this is, according to this theory, a strictly

binding requirement and limitation, as well as its distinguishing feature.

The bank cannot at any moment lend more money than its excess reserves,

and it will have to draw down the reserve balance to lend. (Thus,

as noted, another distinguishing feature is that the balance sheet expansion

is driven by the prior increase in a deposit that boosted excess reserves,

not by the granting of a loan).

It needs to be verified when the empirical test of bank lending is implemented,

whether the bank first confirmed the precise amount of its

available excess reserves before entering into the loan contract or paying

out the loan funds to the customer, so as not to exceed that figure. If the

bank is found not to have checked or not to have drawn down its reserve

balances then this constitutes a rejection of the fractional reserve theory.

(c) Bank credit accounting according to the financial intermediation


According to this theory, banks are, as far as payments and accounts

are concerned, not different from non-bank financial institutions.

The reserve requirement is not an issue — a claim

supported by the empirical observation that reserve requirements

have been abolished in a number of major economies, such as the

UK and Sweden many years ago. However, UK financial intermediaries

are required by FSA/FCA-administered Client Money rules to

hold deposits in custody for customers (a form of warehousing,

the deposits legally being bailments). Client funds of financial intermediaries,

such as securities firms, stock brokers and the like

are therefore still owned by the depositors and thus kept separately

from the financial institutions' own funds, so that customer deposits

are not shown on the balance sheet as liabilities. If banks are

merely financial intermediaries, indistinguishable from other intermediaries,

then all bank funds are central bank money that

can be held in reserve at the central bank or deposited with

other banks. The balance sheet implications are shown below

in Table 3.

According to this theory, the bank balance sheet does not lengthen

as a result of the bank loan: the funds for the loan are drawn from the

bank's reserve account at the central bank.

3.2. A live empirical test

The design of the empirical test takes the form of a researcher entering

into a live loan contract with the bank, and the bank extending a

loan, while its relevant internal accounting is disclosed. Several banks

in the UK and Germany were approached and asked to cooperate in

an academic study of bank loan operations.

The large banks declined to cooperate. The reason given was usually

twofold: the required disclosure of internal accounting data and procedures

would breach their confidentiality or IT security rules; secondly,

the transactions volumes of the banks were so large that the planned

test would be very difficult to conduct when borrowing sensibly sized

amounts of money that would not clash with the banks' internal risk

management rules. In that case, any single transaction would not be

easy to isolate within the bank's IT systems. Despite various discussions

with a number of banks, in the end the banks declined on the basis of

the above reasons and additionally that the costs of operating their systems

and controlling for any potential other transactions would be


It was therefore decided to approach smaller banks, of which there

are many in Germany (there are approximately 1700 local, mostly

small banks in Germany). Each owns a full banking license and engages

in universal banking, offering all major banking services, including stock

trading and currencies, to the general public. A local bank with a balance

sheet of approximately €3 billion was approached, as well as a bank

with a balance sheet of about €700 million. Both declined on the same

grounds as the larger banks, but one suggested that a much smaller

bank might be able to oblige, pointing out the advantage that there

would be fewer transactions booked during the day, allowing a clearer

identification of the empirical test transaction. At the same time the empirical

information value would not diminish with bank size, since all

banks in the EU conform to identical European bank regulations.

Thus an introduction to Raiffeisenbank Wildenberg e.G., located in a

small town in the district of Lower Bavaria was made. The bank is a cooperative

bank within the Raiffeisen and cooperative banking

association of banks, with eight full-time staff. The two joint directors,

Mr. Michael Betzenbichler and Mr. Marco Rebl both agreed to the empirical

examination and also to share all available internal accounting

records and documentation on their procedures. A written agreement

was signed that confirmed that the planned transactions would be

part of a scientific empirical test, and the researcher would not abscond

with the funds when they would be transferred to his personal account,

and undertakes to immediately repay the loan upon completion of the

test (Supplementary material 1 in online Appendix 3). One limitation

on the accounting records which is common to most banks is that

they are outsourcing the IT to a specialised bank IT company, which

maintains its own rules concerning data protection and confidentiality.

The IT firm serves the majority of the 1,100 cooperative banks in

Germany, using the same software and internal systems and accounting

rules, ensuring that the test is representative of more than 15% of bank

deposits in Germany.

It was agreed that the researcher would personally borrow €200,000

from the bank. The transaction was undertaken on 7 August 2013 in the

offices of the bank in Wildenberg in Bavaria. Apart from the two (sole)

directors, also the head (and sole staff) of the credit department,

Mr. Ludwig Keil was present. The directors were bystanders not engaging

in any action. Mr. Keil was the only bank representative involved in

processing the loan from the start of the customer documentation, to

14 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19

the signing of the loan contract and finally paying out the loan into the

borrower's account. The entire transaction, including the manual entries

made by Mr. Keil, was filmed. The screens of the bank's internal IT terminal

were also photographed. Moreover, a team from the BBC was

present and filmed the central part of the empirical bank credit

experiment (Reporter Alistair Fee and a cameraman).

The bank disclosed their standard internal credit procedure. The sequence

of the key steps is shown in Appendix 1. As can be seen, the last

two steps are the signing of the ‘credit documents’ by the borrower

(the researcher) and, finally, the payment of the loan at the value date. 31

The loan conditions were agreed: the researcher would borrow EUR

200,000 from the bank at the prime rate (the interest rate for the best

customer). In the event the bank waived the actual interest proceeds,

in support of the scientific research project.

When the bank loan contract was signed by both the bank and the

borrower on 7 August 2013, the loan amount was immediately credited

to the borrower's account with the bank, as agreed in the loan contract.

Supplementary material 2 in online Appendix 2 shows the original

borrower's accounts and balances with Raiffeisenbank Wildenberg.

The key information from the account summary table is repeated

here, in English, in Table 4.

The bank also issued the following accounts overview, which is a

standard T-account of the transaction from the borrower's perspective

(Table 5).

The borrower confirmed that his new current account with the bank

now showed a balance of EUR 200,000 that was available for spending

(An extension of the experiment, to be reported on separately, used

the balance the following day for a particular transaction outside the

banking institution, transferring the funds to another account of the researcher,

held with another bank; this transfer was duly completed,

demonstrating that the funds could be used for actual transactions).

We are now moving to the empirical test of the three banking

theories. The critical question is: where did Raiffeisenbank Wildenberg

e.G. obtain the funds from that the borrower (researcher) was credited

with (and duly used and transferred out of the bank the following day)?

When the researcher inquired about the bank's reserve holdings, in line

with the fractional reserve theory of banking, director Marco Rebl explained

that the bank maintained its reserves with the central organisation

of cooperative banks, which in turn maintained an account with the

central bank. These reserves amounted to a fixed amount of €350,000

that did not change during the observation period. Concerning the

bank credit procedure, the researcher attempted to verify the source

of the funds that were about to be lent.

Firstly, the researcher confirmed that the only three bank officers involved

in this test and bank transaction were present throughout, whereby

two (the directors) only watched and neither accessed any computer

terminal nor transmitted any instructions whatsoever. The accounts

manager (head of the credit department, Mr. Keil) was the only operator

involved in implementing, booking and paying out the loan. His actions

were filmed. It was noted and confirmed that none of the bank staff present

engaged in any additional activity, such as ascertaining the available

deposits or funds within the bank, or giving instructions to transfer

funds from various sources to the borrower's account (for instance by

contacting the bank internal treasury desk and contacting bank external

interbank funding sources). Neither were instructions given to increase,

draw down or borrow reserves from the central bank, the central cooperative

bank or indeed any other bank or entity. In other words, it was apparent

that upon the signing of the loan contract by both parties, the

funds were credited to the borrower's account immediately, without

31 It is of interest that the last step expressly requires the bank staff implementing this

credit procedure to only pay out the loan for the agreed purpose, as evidence for which

a receipt for any purchases undertaken with the loan funds are demanded by the bank.

This demonstrates that the implementation of policies of credit guidance by purpose of

the loan is practically possible, since such data is available and the use of the loan is monitored

and enforced by each bank.

Table 4

The empirical researcher's new bank account.

Bank: Raiffeisenbank Wildenberg e.G.

Customer: Richard Werner.

Date: 7 August 2013.

Account no. Type of product Currency A/C balance

Current account

44636 Current account w/o fees EUR 200,000.00

Total in EUR: 200,000.00


20044636 Other private financing EUR −200,000.00

Total in EUR:


any other activity of checking or giving instructions to transfer funds.

There were no delays or deliberations or other bookings. The moment

the loan was implemented, the borrower saw his current account balance

increase by the loan amount. The overall credit transaction, from start to

finish, until funds were available in the borrower's account, took about

35min(andwasclearlysloweddownbythefilming and frequent questions

by the researcher).

Secondly, the researcher asked the three bank staff present whether

they had, either before or after signing the loan contract and before

crediting the borrower's account with the full loan amount inquired of

any other parties internally or externally, checked the bank's available deposit

balances, or made any bookings or transfers of any kind, in connection

to this loan contract. They all confirmed that they did not engage in

any such activity. They confirmed that upon signing the loan contract the

borrower's account was credited immediately, without any such steps.

Thirdly, the researcher obtained the internal daily account statements

from the bank. These are produced only once a day, after close of business.

Since the bank is small, it was hoped that it would be possible to identify

the impact of the €200,000 loan transaction, and distinguish the accounting

pattern corresponding to one of the three banking hypotheses.

4. Results

Supplementary material 3 in online Appendix 3 shows the scan of

the bank's balance sheet at the end of 6 August 2013, the day before

the transaction of the empirical test was undertaken. Supplementary

material 4 in online Appendix 3 shows the daily balance of the following

day. In Table 6 the key asset positions are summarised and account

names translated, for the end of the day prior to the loan experiment,

and for the end of the day on which the researcher had borrowed the

money. Table 7 shows the key liability positions for the same periods:

Starting by analysing the liability side information (Table 7), we find

that customer deposits are considered part of the financial institution's

balance sheet. This contradicts the financial intermediation theory, which

assumes that banks are not special and are virtually indistinguishable

from non-bank financial institutions that have to keep customer deposits

off balance sheet. In actual fact, a bank considers a customers' deposits

starkly differently from non-bank financial institutions, who

record customer deposits off their balance sheet. Instead we find that

the bank treats customer deposits as a loan to the bank, recorded

under rubric ‘claims by customers’, who in turn receive as record of

their loans to the bank (called ‘deposits’) what is known as their

Table 5

The empirical researcher's new bank account balances.

Accounts' overview

EUR Credit Liabilities Balance No. contracts

Current account 200,000.00 200,000.00 1

Loan 200,000.00 −200,000.00 1

Bank sum total 200,000.00 200,000.00 0.00 2

R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19


Table 6

Raiffeisenbank Wildenberg e.G.: daily accounts' assets.

6 August 2013, 22.46 h. vs. 7 August 2013, 22.56 h.



Balance 6 Aug.


Balance 7 Aug.



1. Cash 181,703.03 340,032.89 158,329.86

2. Bills of exchange

3. Claims on financial. inst. 5,298,713.76 5,079,709.21 −219,004.55

4. Claims on customers 23,712,558.13 23,947,729.92 235,171.79

–Maturing daily 932,695.44 967,767.32 35,071.88

–Maturity under 4 years 1,689,619.97 1,889,619.97 200,000.00

–Maturity 4 years or longer 21,090,242.72 21,090,342.72 100.00

5. Bonds, bills, debt instr. 19,178,065.00 19,178,065.00

6. Stocks and shares

7. Stake holdings 397,768.68 397,768.68

8. Stakes in related firms

9. Trust assets 5262.69 5262.69

10. Compensation claims on the

public sector

11. Immaterial assets 102.00 102.00

12. Fixed assets 221,549.46 221,549.46

13. Called but not deployed capital

14. Other assets 707,569.26 711,288.64 3719.38

15. Balancing item 2844.32 2844.32

16. Sum of assets 49,706,136.33 49,884,352.81 178,216.48

‘account statement’. This can only be reconciled with the credit creation

or fractional reserve theories of banking.

We observe that an amount not far below the loan balance (about

€190,000) has been deposited with the bank. This is itself not far from

the increase in total liabilities (and assets). Since the fractional reserve

hypothesis requires such an increase in deposits as a precondition for

being able to grant the bank loan, i.e. it must precede the bank loan, it

is difficult to reconcile this observation with the fractional reserve theory.

Moreover, the researcher confirmed that in his own bank account the

loan balance of €200,000 was shown on the same day. This means

that the increase in liabilities was driven by the increase by €200,000

in daily liabilities (item 2B BA in Table 7). Thus the total increase in liabilities

could not have been due to a coincidental increase in customer

deposits on the day of the loan. The liability side account information

seems only fully in line with the credit creation theory.

Turning to an analysis of the asset side, we note that the category

where we find our loan is item 4, claims on customers — fortunately

the only one that day with a maturity below 4 years and hence clearly

identifiable on the bank balance sheet. Apparently, customers also took

out short-term loans (most likely overdrafts) amounting to €35,071.88,

producing a total new loan balance of €235,071.88. In order to keep the

analysis as simple as possible, let us proceed from here assuming that

Table 7

Raiffeisenbank Wildenberg e.G.: daily accounts' liabilities.

6 August 2013, 22.46 h. vs. 7 August 2013, 22.56 h.



Balance 6 Aug.


Balance 7 Aug.



1. Claims by financial inst. 5,621,456.60 5,621,879.66 423.06

2. Claims by customers 39,589,177.09 39,759,156.42 169,979.33

2A. Savings accounts 10,234,806.01 10,237,118.24 2312.23

2B. Other liabilities 29,354,371.08 29,522,038.18 167,667.10

–BA daily 13,773,925.93 13,963,899.89 189,973.96

–BB maturity less 4 years 13,296,042.92 13,273,736.06 −22,306.86

–BC maturity 4 years or longer 2,284,402.23 2,284,402.23

4. Trust liabilities 5262.70 5262.70

5. Other liabilities 12,378.81 12,599.44 220.63

6. Balancing item 16,996.04 16,996.04

7. Reserves 1,138,497.64 1,138,497.64

11. Fund for bank risk 250,000.00 250,000.00

12. Own capital 3,057,248.57 3,057,248.57

13. Sum liabilities 49,706,136.33 49,884,352.81 178,216.48

our test loan amounted to this total loan figure (€235,071.88). So the balance

sheet item of interest on the asset side is ΔA4, the increase in loans

(claims on customers) amounting to €235,071.88.

We now would like to analyse the balance sheet in order to see

whether this new loan of €235,071.88 was withdrawn from other accounts

at the bank, or how else it was funded. We first proceed with

considering activity on the asset side. Denoting balances in thousands

below, we can summarise the balance sheet changes during the

observation period, within the balance sheet constraints as follows:

ΔAssets ¼ ΔA1ðcashÞþΔA3ðclaims on other FIÞ

þ ΔA4ðclaims on customersÞþΔA14ðother assetsÞ:

Numerically, these are, rounded in thousand euro:

178 ¼ 158−219 þ 235 þ 4: ð2Þ

The fractional reserve theory says that the loan balance must be paid

from reserves. These can be either cash balances or reserves with other

banks (including the central bank). The deposits (claims) with other

financial institutions (which effectively includes the bank's central

bank reserve balances) declined significantly, by €219,000. At the

same time cash reserves increased significantly. What may have happened

is that the bank withdrew legal tender from its account with

the cooperative central bank, explaining both the rise in cash and decline

in balances with other financial institutions. Since the theories do

not distinguish between these categories, we can aggregate A1 and

A3, the cash balances and reserves. Also, to simplify, we aggregate A14

(other assets) with A4 (claims on customers), to obtain:

178 ¼ −61




ðΔclaims on customers; othersÞ : ð3Þ

We observe that reserves fell, while claims on customers rose significantly.

Moreover, total assets also rose, by an amount not dissimilar to

our loan balance. Can this information be reconciled with the three

theories of banking?

Considering the financial intermediation hypothesis,wewouldexpecta

decline in reserves (accounts with other financial institutions and cash) of

the same amount as customer loans increased. Reserves however declined

by far less. At the same time, the balance sheet expanded, driven

by a significant increase in claims on customers. If the bank borrowed

money from other banks in order to fund the loan (thus reducing its balance

of net claims on other banks), in line with the financial intermediation

theory of banking, vault cash should not increase and neither should the

balance sheet. We observe both a significant rise in cash holdings and

an expansion in the total balance sheet (total assets and total liabilities),

which rose by €178,000. This cannot be reconciled with the financial intermediation

theory, which we therefore must consider as rejected.

Considering the fractional reserve theory,weconfirmed by asking the

credit department's Mr. Keil, as well as the directors, that none of them

checked their reserve balance or balance of deposits with other banks before

signing the loan contract and making the funds available to the borrower

(see the translated letter in Appendix 2, and the original letter in

the online Appendix 3. Furthermore, there seems no evidence that reserves

(cash and claims on other financial institutions) declined in an

amount commensurate with the loan taken out. Finally, the observed increase

in the balance sheet can also not be reconciled with the standard

description of the fractional reserve theory. We must therefore consider

it as rejected, too.

This leaves us with the credit creation theory. Can we reconcile the

observed accounting asset side information with it? And what do we

learn from the liability side information?

The transactions are linked to each other via the accounting identities

of the balance sheet (Eqs. (1), (2) and (3)). We can therefore ask the question

what would have happened to total assets, if we assumed for the


16 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19

moment that no other transaction had taken place, apart from the loan

(235). We can set the change in each asset item (except for ΔA4, our

loan) to zero, if we subtract the same amount from the change in total assets.

The new total asset balance in this hypothetical scenario would be:

178−158 þ 219−4 ¼ 235

or, in general,

ΔA4ðclaims on customersÞ ¼ ΔAssets−ΔA1ðcashÞ−ΔA3 ðclaims on other FIÞ

−ΔA14ðother assetsÞ:


In other words, if the other transactions had not happened, the

bank's balance sheet would have expanded by the same amount

as the loans taken out. This finding is consistent only with the credit

creation theory of bank lending.

The evidence is not as easily interpreted as may have been

desired, since in practice it is not possible to stop all other bank

transactions that may be initiated by bank customers (who are nowadays

able to implement transactions via internet banking even on

holidays). But the available accounting data cannot be reconciled

with the fractional reserve and the financial intermediation hypotheses

of banking.

5. Conclusion

This paper was intended to serve two functions. First, the history of

economic thought was examined concerning the question of how banks

function. It was found that a long-standing controversy exists that has

not been settled empirically. Secondly, empirical tests were conducted

to settle the existing and continuing controversies and find out which

of the three theories of banking is consistent with the empirical


5.1. Three theories but no empirical test

Concerning the first issue, in this paper we identified three distinct

hypotheses concerning the role of banks, namely the credit creation

theory, the fractional reserve theory and the financial

intermediation theory. Itwasfoundthatthefirst theory was dominant

until about the mid- to late 1920s, featuring leading proponents

such as Macleod and Schumpeter. Then the second theory became

dominant, under the influence of such economists as Keynes, Crick,

Phillips and Samuelson, until about the early 1960s. From the early

1960s, first under the influence of Keynes and Tobin and the Journal

of Money, Credit and Banking, thefinancial intermediation theory became


Yet, despite these identifiable eras of predominance, doubts have

remained concerning each theory. Most recently, the credit creation

theory has experienced a revival, having been championed again in


(Werner, 1992, 1997) and in the run-up to and aftermath of

the European and US financial crises since 2007 (see Bank of

England, 2014b; Benes & Kumhof, 2012; Ryan-Collins, Greenham,

Werner, & Jackson, 2011, 2012; Werner, 2003a, 2005, 2012). However,

such works have not yet become influentialinthemajorityof

models and theories of the macro-economy or banking. Thus it had

to be concluded that the controversy continues, without any scientific

attempt having been made at settling it through empirical


5.2. The empirical evidence: credit creation theory supported

The second contribution of this paper has been to report on the first

empirical study testing the three main hypotheses. They have been successfully

tested in a real world setting of borrowing from a bank and


examining the actual internal bank accounting in an uncontrolled real

world environment.

It was examined whether in the process of making money available

to the borrower the bank transfers these funds from other accounts

(within or outside the bank). In the process of making loaned money

available in the borrower's bank account, it was found that the bank

did not transfer the money away from other internal or external accounts,

resulting in a rejection of both the fractional reserve theory and

the financial intermediation theory. Instead, it was found that the bank

newly ‘invented’ the funds by crediting the borrower's account with a

deposit, although no such deposit had taken place. This is in line with

the claims of the credit creation theory.

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. 32 The implications are far-reaching.

5.3. What is special about banks

Henceforth, economists need not rely on assertions concerning

banks. We now know, based on empirical evidence, why banks are different,

indeed unique — solving the longstanding puzzle posed by Fama

(1985) and others — and different from both non-bank financial institutions

and corporations: it is because they can individually create money

out of nothing.

5.4. Implications

5.4.1. Implications for economic theory

The empirical evidence shows that of the three theories of banking,

it is the one that today has the least influence and that is being belittled

in the literature that is supported by the empirical evidence. Furthermore,

it is the theory which was widely held at the end of the 19th century

and in the first three decades of the twentieth. It is sobering to

realise that since the 1930s, economists have moved further and further

away from the truth, instead of coming closer to it. This happened first

via the half-truth of the fractional reserve theory and then reached the

completely false and misleading financial intermediation theory that

today is so dominant. Thus this paper has found evidence that there

has been no progress in scientific knowledge in economics, finance

and banking in the 20th century concerning one of the most important

and fundamental facts for these disciplines. Instead, there has been a regressive

development. The known facts were unlearned and have become

unknown. This phenomenon deserves further research. For now

it can be mentioned that this process of unlearning the facts of banking

could not possibly have taken place without the leading economists of

the day having played a significant role in it. The most influential and famous

of all 20th century economists, as we saw, was a sequential adherent

of all three theories, which is a surprising phenomenon. Moreover,

Keynes used his considerable clout to slow scientific analysisofthe

question whether banks could create money, as he instead engaged in

ad hominem attacks on followers of the credit creation theory. Despite

his enthusiastic early support for the credit creation theory (Keynes,

1924), only six years later he was condescending, if not dismissive, of

this theory, referring to credit creation only in inverted commas. He

was perhaps even more dismissive of supporters of the credit creation

theory, who he referred to as being part of the “Army of Heretics and

Cranks, whose numbers and enthusiasm are extraordinary”, and who

32 Thanks to Charlie Haswell for the ‘fairy dust’ allegory.

R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19


seem to believe in “magic” and some kind of “Utopia” (Keynes, 1930,

vol. 2, p. 215). 33

Needless to mention, such rhetoric is not conducive to scientific argument.

But this technique was followed by other economists engaged

in advancing the fractional reserve and later financial intermediation

theories. US Federal Reserve staffer Alhadeff (1954) argued similarly

during the era when economists worked on getting the fractional reserve

theory established:

“One complication worth discussing concerns the alleged “creation”

of money by bankers. It used to be claimed that bankers could create

money by the simple device of opening deposit accounts for their

business borrowers. It has since been amply demonstrated that under

a fractional reserve system, only the totality of banks can expand

deposits to the full reciprocal of the reserve ratio. [Original footnote:

‘Chester A. Phillips, Bank Credit (New York: Macmillan, 1921),

chapter 3, for the classical refutation of this claim.’] The individual

bank can normally expand to an amount about equal to its primary

deposits” (p. 7).

The creation of credit by banks had become, in the style of Keynes

(1930), an“alleged ‘creation’”, whereby rhetorically it was suggested

that such thinking was simplistic and hence could not possibly be

true. Tobin used the rhetorical device of abductio ad absurdum to denigrate

the credit creation theory by incorrectly suggesting it postulated

a ‘widow's cruse’, a miraculous vessel producing unlimited amounts of

valuable physical goods, and thus its followers were believers in miracles

or utopias.

This same type of rhetorical denigration of and disengagement with

the credit creation theory is also visible in the most recent era. For instance,

the New Palgrave Money (Eatwell et al., 1989), is an influential

340-page reference work that claims to present a ‘balanced perspective

on each topic’ (Eatwell et al., 1989, p. viii). Yet the financial intermediation

theory is dominant, with a minor representation of the fractional reserve

theory.Thecredit creation theory is not presented at all, even as a possibility.

But the book does include a chapter entitled “Monetary cranks”. In

this brief chapter, Keynes' (1930) derogatory treatment of supporters

of the credit creation theory is updated for use in the 1990s, with sharpened

claws: Ridicule and insult is heaped on several fateful authors

that have produced thoughtful analyses of the economy, the monetary

system and the role of banks, such as Nobel laureate Sir Frederick

Soddy (1934) and C.H. Douglas (1924). Even the seminal and influential

work by Georg Friedrich Knapp (1905), still favourably cited by Keynes

(1936),isidentified as being created by a ‘crank’. What these apparently

wretched authors have in common, and what seems to be their main

fault, punishable by being listed in this inauspicious chapter, is that

33 “There is a common element in the theories of nearly all monetary heretics. Their theories

of Money and Credit are alike in supposing that in some way the banks can furnish all

the real resources which manufacture and trade can reasonably require without real cost

to anyone …. For they argue thus. Money (meaning loans) is the life-blood of industry. If

money (in this sense) is available in sufficient quantity and on easy terms, we shall have

no difficulty in employing to the full the entire available supply of the factors of production.

For the individual trader or manufacturer “bank credit” means “working capital”; a

loan from his bank furnishes him with the means to pay wages, to buy materials and to

carry stocks. If, therefore, sufficient bank credit was freely available, there need never be

unemployment. Why then, he asks, if the banks can create credit, should they refuse any

reasonable request for it? And why should they charge a fee for what costs them little or

nothing? … There can only be one answer: the bankers, having a monopoly of magic, exercise

their powers sparingly in order to raise the price. … Where magic is at work, the

public do not get the full benefit unless it is nationalised. Our heretic admits, indeed, that

we must take care to avoid “inflation”; but that only occurs when credit is created which

does not correspond to any productive process. To create credit to meet a genuine demand

for working capital can never be inflationary; for such a credit is “self-liquidating” and is

automatically paid off when the process of production is finished. … If the creation of credit

is strictly confined within these limits, there can never be inflation. Further, there is no

reason for making any charge for such credit beyond what is required to meet bad debts

and the expense of administration. Not a week, perhaps not a day or an hour, goes by in

which some well-wisher of mankind does not suddenly see the light — that here is the

key to Utopia” (vol. 2, pp. 217 ff.).

they are adherents of the credit creation theory. But, revealingly, their

contributions are belittled without it anywhere being stated what their

key tenets are and that their analyses centre on the credit creation theory,

which itself remains unnamed and is never spelled out. This is not a small

feat, and leaves one pondering the possibility that the Eatwell et al.

(1989) tome was purposely designed to ignore and distract from the

rich literature supporting the credit creation theory. Nothing lost, according

to the authors, who applaud the development that due to

“the increased emphasis given to monetary theory by academic

economists in recent decades, the monetary cranks have largely disappeared

from public debate …” (p. 214).

And so has the credit creation theory. Since the tenets of this theory

are never stated in Eatwell et al. (1989), the chapter on ‘Cranks’ ends

up being a litany of ad hominem denigration, defamation and character

assassination, liberally distributing labels such as ‘cranks’, ‘phrase-mongers’,

‘agitators’, ‘populists’, andeven‘conspiracy theorists’ that believe

in ‘miracles’ and engage in wishful thinking, ultimately deceiving their

readers by trying to “impress their peers with their apparent understanding

of economics, even though they had no formal training in the

discipline” (p. 214). All that we learn about their actual theories is

that, somehow, these ill-fated authors are “opposed to private banks

and the ‘Money Power’ without their opposition leading to more sophisticated

political analysis” (p. 215). Any reading of the highly sophisticated

Soddy (1934) quickly reveals such labels as unfounded defamation.

To the contrary, the empirical evidence presented in this paper has revealed

that the many supporters of the financial intermediation theory and

also the adherents of the fractional reserve theory are flat-earthers that believe

in what is empirically proven to be wrong and which should have

been recognisable as being impossible upon deeper consideration of the

accounting requirements. Whether the authors in Eatwell et al. (1989)


research. Certainly the unscientific treatment of the credit creation

theory and its supporters by such authors as Keynes, who strongly endorsed

the theory only a few years before authoring tirades against its

supporters, or by the authors in Eatwell et al. (1989), raises this


5.4.2. Implications for government policy

There are other, far-reaching ramifications of the finding that banks

individually create credit and money when they do what is called

‘lending money’. It is readily seen that this fact is important not only

for monetary policy, but also for fiscal policy, and needs to be reflected

in economic theories. Policies concerning the avoidance of banking

crises, or dealing with the aftermath of crises require a different shape

once the reality of the credit creation theory is recognised. They call for

a whole new paradigm in monetary economics, macroeconomics,

finance and banking (for details, see for instance Werner, 1997, 2005,

2012, 2013a,b) that is based on the reality of banks as creators of the

money supply. It has potentially important implications for other disciplines,

such as accounting, economic and business history, economic

geography, politics, sociology and law.

5.4.3. Implications for bank regulation

The implications are far-reaching for bank regulation and the design

of official policies. As mentioned in the Introduction, modern national

and international banking regulation is predicated on the assumption

that the financial intermediation theory is correct. Since in fact banks

are able to create money out of nothing, imposing higher capital requirements

on banks will not necessarily enable the prevention of

boom–bust cycles and banking crises, since even with higher capital requirements,

banks could still continue to expand the money supply,

thereby fuelling asset prices, whereby some of this newly created

money can be used to increase bank capital. Based on the recognition

of this, some economists have argued for more direct intervention by

18 R.A. Werner / International Review of Financial Analysis 36 (2014) 1–19

the central bank in the credit market, for instance via quantitative credit

guidance (Werner, 2002, 2003a, 2005).

5.4.4. Monetary reform

The Bank of England's (2014b) recent intervention has triggered a

public debate about whether the privilege of banks to create money

should in fact be revoked (Wolf, 2014). The reality of banks as creators

of the money supply does raise the question of the ideal type of monetary

system. Much research is needed on this account. Among the many different

monetary system designs tried over the past 5000 years, very few

have met the requirement for a fair, effective, accountable, stable, sustainable

and democratic creation and allocation of money. The view of the author,

based on more than twenty-three yearsofresearchonthistopic,is

that it is the safest bet to ensure that the awesome power to create

money is returned directly to those to whom it belongs: ordinary people,

not technocrats. This can be ensured by the introduction of a network of

small, not-for-profit local banks across the nation. Most countries do not

currently possess such a system. However, it is at the heart of the successful

German economic performance in the past 200 years. It is the very

Raiffeisen, Volksbank or Sparkasse banks – the smaller the better – that

were helpful in the implementation of this empirical study that should

serve as the role model for future policies concerning our monetary system.

In addition, one can complement such local public bank money

with money issued by local authorities that is accepted to pay local

taxes, namely a local public money that has not come about by creating

debt, but that is created for services rendered to local authorities or the

community. Both forms of local money creation together would create a

decentralised and more accountable monetary system that should perform

better (based on the empirical evidence from Germany) than the

unholy alliance of central banks and big banks, which have done much

to create unsustainable asset bubbles and banking crises (Werner,


Appendix 1. Sequence of steps for the extension of a loan

Raiffeisenbank Wildenberg e.G.

1. Negotiations concerning the details of the loan.

2. Receipt of KYC information and opening of a new customer file

(new customer).

3. Opening of a current account (new customer).

4. Calculation of the loan and repayment schedule, model calculation,

European required customer notification information, record of

customer advisory.

5. Entry of loan application into the bank IT system.

6. Check of ability to service and repay the loan/conducting liquidity

calculation in loan application.

7. Credit rating of customer, entry into customer file.

8. Search of customer data on central bank data base for singular economic

dependencies and entry of results into bank IT.

9. Bank board recommendation on loan application with justification

(2 directors).

10. Print out of loan contract, general loan conditions, with handover

receipted by customer.

11. Print out of the protocol of the loan process.

12. Approval of credit by bank directors by signing the protocol and the

loan contract.

13. Creation of loan account in the IT system.

14. Establishment of credit limit and availability of credit.

15. Appointment with customer.

16. Customer signs credit documents.

17. Payment of loan at the value date, in exchange for evidence

of use of the loan in line with the declared use in the loan


Appendix 2. Letter of confirmation of facts by Raiffeisenbank

Wildenberg e.G. (Translation; original in online Appendix 3).

10 June 2014

Dear Prof. Dr. Werner,

Confirmation of Facts

In connection with the extension of credit to you in August 2014 I am

pleased to confirm that neither I as director of Raiffeisenbank Wildenberg

eG, nor our staff checked either before or during the granting of the loan

to you, whether we keep sufficient funds with our central bank, DZ Bank

AG, or the Bundesbank. We also did not engage in any such related transaction,

nor did we undertake any transfers or account bookings in order

to finance the credit balance in your account. Therefore we did not engage

in any checks or transactions in order to provide liquidity.

Yours sincerely,

M. Rebl,

Director, Raiffeisenbank Wildenberg e.G.

Appendix 3. Supplementary data

Supplementary data to this article can be found online at http://dx.doi.



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Towards a New Research Programme on

‘Banking and the Economy’ –

Implications of the Quantity Theory of Credit for the

Prevention and Resolution of Banking and Debt Crises

Richard A. Werner *1

* Centre for Banking, Finance and Sustainable Development,

Southampton Management School, University of Southampton, Southampton SO17 1BJ

Abstract. The financial crisis has triggered a new consensus among

economists that it is necessary to include a banking sector in macroeconomic

models. It is also necessary for the finance and banking literature to consider

how best to incorporate systemic, macroeconomic feedbacks into its modeling

of financial intermediation. Thus a new research programme on the link

between banking and the economy is needed. This special issue is devoted to

this theme. In this paper an overview of the issues and problems in the

economics and finance literature is presented, and a concrete, simple approach

is identified of how to incorporate banks into a macroeconomic model that

solves many of these issues. The model distinguishes between the type of

credit that boosts GDP and credit that is associated with asset prices and

banking crises. The model is consistent with the empirical record. Some

applications are discussed, namely the prediction and prevention of banking

crises, implications for fiscal policy, and a solution to the European sovereign

debt crisis that stimulates growth while avoiding the corner solutions of euro

exit or fiscal union.

Keywords: bank credit, banking and the economy, credit creation,

disaggregation of credit, methodology, quantity equation, macroeconomics

JEL Classification: E41, E52, E58

1 Parts of this paper were presented at the European Conference on Banking and the Economy

(ECOBATE 2011), held on 29 September 2011 in Winchester Guildhall. The paper was presented at the

NCB Expert Meeting on Flow-of-Funds analysis at the European Central Bank on 28 November 2011 and

at the Expert Meeting on ‘The macroeconomic imbalances procedure (MIP): private sector balance sheet

sustainability’, European Commission, Directorate General Economic and Financial Affairs, LIME II, LAF,

Centre Borschette, Brussels, 26-27 January 2012. The author would like to thank the organisers, Dr.

Bernhard Winkler and Carlos Cuerpo-Caballero, for their kind invitations. None of the above are

implicated by any potential errors. Should any addition to knowledge be found in this paper the author

would like to acknowledge the source of all wisdom (Jeremiah, 33:3).

1 Introduction

Since the outbreak of the financial crisis emanating from the US and UK in 2007

and 2008, macroeconomics has been the target of severe criticism. 2 Thanks to the

banking crisis, a broader spectrum of the public became aware of the fact that leading

economic theories and models, as well as influential advanced textbooks in

macroeconomics and monetary economics, did not feature money (e.g. Woodford,

2003), or banks (Walsh, 2003; Woodford, 2003). In the UK in 2010, the most

commonly used textbook in macroeconomics on MSc Economics programmes was

that of Romer (2006), Advanced Macroeconomics. 3 On page 3, Romer explains that

he is not covering money in his book, because:

“Incorporating money in models of growth would only obscure the analysis” (p. 3).

Without money there is also no financial sector. Likewise, the hitherto popular

DSGE models had not included a financial sector, a deficiency not easily remedied

due to their particular methodology and assumptions. Economists have increasingly

conceded that this state of affairs is unsatisfactory. Alan Greenspan confessed in 2008

that he recognised a ‘flaw’ in mainstream models (Congress, 2010). Simon Johnson

(2009) of the Peterson Institute of International Economics concluded:

“Whether or not our economies manage to avoid a major global depression, economics is in

crisis. … [We need] to rethink a great deal about economics and how economies operate”

(Johnson, 2009).

Donald Kohn (2009), as Vice-Chairman of the Federal Reserve, reflected the sense

of embarrassment of the economics profession when having to admit to the public that

our economic models simply assumed that banks did not exist:

“It is fair to say …that the core macroeconomic modelling framework used at the Federal

Reserve and other central banks around the world has included, at best, only a limited role

for …credit provision, and financial intermediation. …asset price movements and the

feedback among those movements, credit supply, and economic activity were not well

captured by the models used at most central banks.“

These insights did not arrive a moment too early. Macroeconomics has experienced

a number of major empirical challenges over the past thirty years or so, which have

2 For instance, Nassim Taleb said: “People who were driving a school bus blindfolded (and crashed it)

should never be given a new bus. The economics establishment (universities, regulators, central bankers,

government officials, various organisations staffed with economists) lost its legitimacy with the failure

of the system. It is irresponsible and foolish to put our trust in the ability of such experts to get us out of

this mess. Instead, find the smart people whose hands are clean.” (Taleb, 2009).

3 Survey of top 40 MSc programmes conducted by author in September 2010.


largely remained unaddressed by the mainstream literature. The time may now be ripe

for a more fundamental rethink in order to address them.

While economists seem to have taken the brunt of the public critique triggered by

the crisis, researchers in the fields of banking and finance, often situated at business

schools and supposedly more keenly interested in real world applications of their

work, seem to have largely avoided criticism. However it could be argued that

banking and finance research also failed in delivering prescriptions, tools and

recommendations for appropriate regulation, supervision and risk management. While

economists had dropped banking from their work, entire disciplines exist that focus

almost exclusively on financial intermediaries. Why did they not warn about the

looming banking crisis? Alan Greenspan said in 2008 that “modern portfolio

management… the entire edifice… has collapsed” (Congress, 2010). Why did the

apparently sophisticated approaches in risk management, portfolio optimisation and

asset allocation seem of little help when the banking crisis struck?

A fundamental problem seems to be the very separation of disciplines into

economics on the one hand, with the potential to capture systemic and

macroeconomic aspects, and finance and banking on the other, with the potential to

model banks in detail. The separation allowed the systemic importance of banks to

remain unnoticed: The economists have tended not to model the financial

infrastructure and banking, and the finance and banking researchers have tended not

to be concerned with macroeconomic effects of the collective behaviour of financial

intermediaries. Focusing on microeconomic studies of representative financial

institutions, they neglected the systemic effects of collective bank behaviour that may

affect the entire economy and thus generate important feedback to financial

intermediaries. Both disciplines had developed in a way that blindsided them

concerning banking crises.

It could thus be said that economics needs more finance and banking, while finance

and banking need more economics. A new interdisciplinary research programme on

‘Banking and the Economy’ is required, based on the inductive, empirically-based

research methodology. This special issue is devoted to a first conference on this

theme, the European Conference on Banking and the Economy (ECOBATE), held on

29 September 2011 at Winchester Guildhall, and organised by the Centre for Banking,

Finance and Sustainable Development, University of Southampton Management

School. This paper is meant as a call for such a new interdisciplinary research

programme on banking and the economy. To illustrate the need and importance of

this topic, I survey the state of modern macroeconomics, combined with commentary

on relevant finance theory, and point out the many empirical challenges that need to

be overcome. But to take the discussion a step further, I present an introduction to a

concrete model linking banking and the economy via the reflection of a fundamental,

yet usually neglected fact about banks of which both finance and economics experts

are often unaware for the majority of their career: banks create the money supply

through the process of ‘credit creation’. This topic is also the focus of the keynote

address of the ECOBATE conference, by Lord Adair Turner (2011), FSA Chairman.

This special issue carries selected contributions to the conference. As there is also a

need for a forum to discuss policy-focused papers, a selection of such contributions,

including Lord Turner’s, can be found in a special policy section.


In this paper I first discuss seven major empirical puzzles in macroeconomics and

then a simple modification of the most basic macro model, the quantity equation. The

latter enables the introduction of the banking sector into macroeconomic models and

offers solutions to the puzzles. I next discuss the justification for this model and its

empirical record. This is followed by an application of the model to current questions

of how to prevent banking crises, how fiscal policy can be effective or ineffective

depending on the role and contribution of the banking sector, and how to solve the

European sovereign debt crisis.

2 Major ‘Anomalies’ in Macroeconomics

2.1 The Velocity Decline and the Inability to Define Money

The widespread criticism of recent macroeconomic approaches suggests that the

research agenda culminating in models that neither feature banks nor incorporate

monetary variables has not been successful. If macroeconomics has proceeded down

the wrong path, one needs to return to the crossroads at which the path to moneyless

real business cycle models, DSGE formulations or versions of Woodford’s (2003)

approach was taken.

It may not be possible to identify a single point in time, but the late 1980s cannot

be far off: Until about the mid-1980s, the hitherto prevailing approaches (classical,

many neo-classical, Keynesian, monetarist and post-Keynesian approaches, as well as

most eclectic models), despite their differences, had much in common. They still

included a monetary aggregate that was linked to nominal GDP through the quantity


(1) M V = P Y

whereby M stands for the money supply (measured and defined variously as M0,

M1, M2, M3 or M4), V denotes the (income) velocity of money (originally the

number of times gold was said to circulate during an observation period), P the GDP

deflator (the appropriate price level) and Y symbolises real GDP. PY hence represents

nominal GDP. Expressed in logarithms, this relationship can also be stated as:

(2) m + v = p + y

Friedman had famously claimed that this equation was characterized by a


“uniformity… of the same order as many of the uniformities that form the basis of the

physical sciences. And the uniformity is in more than direction. There is an extraordinary

empirical stability and regularity to such magnitudes as income velocity that cannot but

impress anyone who works extensively with monetary data” (Friedman, 1956, p. 21).

He still called it “an identity, a truism” decades later (Friedman, 1992, p. 39).

Handa (2000) still wrote, somewhat confidently, that equation (1)

“is valid under any set of circumstances whatever since it can be reduced to the statement:

in a given period by a given group of people, expenditures equal expenditures, with only a

difference in the computational method between them” (p. 25).

Until about the mid-1980s equations (1) or (2) were the widely accepted workhorse

that represented the link between the tangible (‘real’) economy and the

financial/monetary sectors. However, from the early 1980s onwards, faith in this link

had been increasingly shaken by the widespread and growing empirical observation

that velocity had become erratic, was declining significantly and the money demand

function was unstable (e.g. Hendry, 1985; Belongia and Chalfant, 1990; Boughton,

1991). The ‘quantity equation’ relationship, expressed as a stable income velocity,

“came apart at the seams during the course of the 1980s” (Goodhart, 1989). This

phenomenon is known as the ‘velocity decline’, ‘breakdown of the money demand

function’, or even the ‘mystery of the missing money’ (Goldfeld et al., 1976). It has

been described as a world-wide “puzzling” anomaly (Belongia and Chalfant, 1990).

Once “viewed as a pillar of macroeconomic models”, the quantity equation “is now

… one of the weakest stones in the foundation” (Boughton, 1991). As a result,

economists could not identify a reliable relationship between a monetary aggregate

and nominal GDP.

The implications of the observed velocity decline and breakdown in the money

demand function for macroeconomics were devastating. This empirical failure not

only discredited monetarism, but posed a major obstacle to all the other schools of

thought as well, most of which had previously relied on the quantity equation in one

way or another.

Attempts at explaining this phenomenon raised more questions than they answered:

usually attributed to financial deregulation and innovations (e.g. Judd and Scadding,

1981; Gordon, 1984; Hetzel, 1984; Roley, 1985; Miller, 1986), it was argued that this

lowered velocity (as money was used more efficiently). But the empirical record of

financial deregulation was to increase the volume of transactions, suggesting a higher

speed of transactions. After an initial burst of papers attempting to explain this puzzle,

the discipline turned away from it – not because the problem had been solved: the

apparent anomaly grew bigger over time, and no convincing explanations had been


As one monetary aggregate after another succumbed to an unstable relationship

with nominal GDP, the profession became ever less specific about the very definition


of money. Today, textbooks, as well as leading central bank publications, state that

they do not know just what money is. In the words of then Federal Reserve staff:

“…there is still no definitive answer in terms of all its final uses to the question: What is

money?” (Belongia and Chalfant, 1990, p. 32).

Miller and Van Hoose (1993) concluded their chapter on money:

“Although there is widespread agreement among economists that money is important, they

have never agreed on how to define and how to measure money” (p. 42).

The empirical failure to define money without much ambiguity has been one of the

weaknesses of the macroeconomics prevalent until about the mid-1980s, and it is one

that remains unresolved within the mainstream.

Motivated by the velocity decline and the inability to define money clearly, in the

1980s leading economists called for the adoption of “an alternative paradigm”

(Spindt, 1987; Judd and Scadding, 1982; Gordon, 1984; Roley, 1985). We know that

this was the time at which the paradigm of moneyless economic models, real business

cycle theories and supply-side economics became influential. Given that the

profession had a fundamental problem with handling money, such moneyless models

must have become more appealing to economists. If nothing else, they seemed to

offer an escape route from an apparently intractable problem. However, adopting nonmonetary

models because previous attempts at modeling money had not been

successful is not an acceptable scientific research methodology. The currently

prevailing paradigm therefore must face the criticism that it was potentially adopted

as a form of escapism. Instead of rising to the challenges posed by the velocity

decline and getting to the root of the problem, economists simply assumed away the

problem, by operating on the empirically unsupported premise that money (and

banks) did not matter.

This development also began to drive a wedge between the research agendas of

monetary and macroeconomists on the one hand, and banking and finance researchers

on the other. It turned out to be a costly separation, as especially the systemic

(macroeconomic) implications of collective bank actions seemed to fall between two


However, there were other challenges which indicated already many years ago that

not all was well. If adopting non-monetary models was meant to sidestep the

empirical failure of prior approaches, economists must have felt haunted when other

empirical challenges arose that have proven equally devastating for the non-monetary



2.2 Banks and Banking Crises

The role of banks has remained a persistent puzzle in conventional

macroeconomics – whether of the pre- or post-1980s type. Because of the belief that

they are mere financial intermediaries without any special features that would justify

a unique representation, they have not been explicitly modelled in a meaningful way

in major macroeconomic theories and models over the past thirty years. There is

however a small though important body of evidence to the effect that banks are

special in some way that standard theory cannot explain (e.g. Fama, 1985; Peek and

Rosengren, 2000; Ashcraft, 2005; Werner, 1992; Werner, 2005; Leary, 2009;

Voutsinas and Werner, 2011). Blanchard and Fischer (1989) pointed out already more

than twenty years ago:

“The notion that there is something about banks that makes them ‘special’ is a recurrent

theme.” (p. 478).

But since conventional approaches failed to identify the nature of this special

feature, economists did not feel compelled to include banks in their modelling efforts.

With banks unexplained, so has been the powerful phenomenon of the recurring

banking crises, which time and again provide a stark reminder that banks indeed have

an important role to play in the economy. Caprio and Klingebiehl (1999) have shown

that there have been well over a hundred banking crises in the past fifty years and

their number and magnitude seems to have increased during that time, not decreased.

See also the more recent work by Reinhart and Rogoff (2008). The ‘anomaly’ of

banking crises became the Achilles heel of the moneyless theories that had become

dominant since the mid-1980s.

2.3 The Empirical Puzzle of Interest Rates

There are other significant ‘anomalies’ that have challenged the old as well as the

new mainstream approaches. While theories place great store by the role of interest

rates as the pivotal variable that has significant causal force, empirically they seem far

less powerful in explaining business cycles or developments in the economy than

theory would have it. 4 In empirical work, interest rate variables often lack

explanatory power, significance or the ‘right’ sign. 5 When a correlation between

interest rates and economic growth is found, it is not more likely to be negative than

positive. 6 Interest rates have also not been able to explain major asset price


See Melvin (1983) and Leeper and Gordon (1983), who found little support for the so-called

liquidity effect of interest rates on the money supply.


King and Levine (1993) did not find evidence to support the hypothesized relationship

between real interest rate and economic growth in a cross-section of countries. Taylor (1999)

found that the link between real interest rates and macroeconomic aggregates such as

consumption and investment is tenuous.


Kuttner and Mosser (2002) pointed out the positive correlation between GDP growth and

interest rates in the US between 1950 and 2000. Dotsey, Lantz and Scholl (2003) examined the


movements (on Japanese land prices, see Asako, 1991; on Japanese stock prices, see

French and Poterba, 1991; on the US real estate market see Dokko et al., 1990), nor

capital flows (Ueda, 1990; Werner, 1994) – phenomena that in theory should be

explicable largely through the price of money (interest rates). Furthermore, in terms

of timing, interest rates appear as likely to follow economic activity as to lead it. 7

This became apparent when the Japanese central bank lowered interest rates over a

dozen times in the 1990s, while the economy continued to stagnate and the money

supply failed to expand. But Keynesian, post-Keynesian and even most monetarist

advice was based on a monetary transmission mechanism via interest rates.

Again, there were many attempts at explaining this phenomenon, producing the

voluminous ‘credit view’ literature (including the ‘bank lending view’ and the

‘balance sheet channel’ approach; see Bernanke and Gertler, 1995). These attempts

also failed: They could not resolve the empirical puzzle, because according to its

proponents the additional credit channel of monetary transmission should enhance the

role of interest rates. This was evidently not the case in Japan or a number of other

major economies. As a result, key proponents began to distance themselves from this

approach (Bernanke, 1993; Bernanke and Gertler, 1995).

An attempt was made to explain the apparent failure of falling interest rates to

stimulate the economy by reviving the ‘liquidity trap’ argument, originating in

Keynesian approaches, and subsequently adopted by rational expectations theories

(Krugman, 1998). While there is a widespread perception that the ‘liquidity trap’

explanation has been successful, in fact it failed to even ask the right question, let

alone offer an answer to it: The liquidity trap argument is about a situation where

interest rates have fallen to their lowest point, and it merely argues that, at this point,

interest rate-based monetary policy cannot be effective (since rates cannot be reduced

further). However, in Japan interest rates reached their lowest point only in March

2003, after over a decade of recession and over a dozen interest rate reductions. As to

the relevant question at hand, namely why repeated interest rate reductions over a

decade have failed to stimulate the economy, the liquidity trap argument has nothing

to say. 8 As it turns out, the liquidity trap argument is merely the restatement of the

tautology that rates cannot fall further when they have fallen to the lowest possible


behaviour of real interest rates. Their results disclosed the real interest rate series is

contemporaneously positively correlated with lagged cyclical output. Other studies finding a

positive correlation between interest rates and growth include Gelb (1989), Polak (1989),

Easterly (1990) and Roubini and Sala-i-Martin (1992). This positive relationship between

interest rates and growth is also acknowledged in a leading textbook in advanced

macroeconomics (Sorensen and Whitta-Jacobsen, 2010). For a comparative empirical study on

the US, UK, Germany and Japan, see Werner and Zhu (2011).


While Stock and Watson (1999) find that the nominal rate is a leading business-cycle

indicator, short-term interest rates, since influenced by central banks, tend to follow nominal

GDP growth. The same also seems to apply to long-term interest rates (Werner, 2005).

Gurkaynak, Sack, and Swanson (2005) showed that long term interest rates react to various

macroeconomic shocks that in the conventional macroeconomic models are only expected to

affect short-term interest rates.


For a survey of how the literature has dealt with the ineffectiveness of interest rate policy in

Japan, see Werner (2006).


For interest rates to play the role theory suggests, the money and credit markets

have to be in equilibrium. But Japan’s recession, about to enter its third decade,

makes sport even of the contention that in the medium to long run markets are in

equilibrium. Many economists have been trained to avoid contemplating the

possibility that markets may never be in equilibrium. Yet, this is a distinct possibility.

In such a world, it would not be prices (such as interest rates) that determine

outcomes, but quantities (such as the quantity of credit). Further, rationing implies

that an allocation decision is made that can be decided on the basis of non-price or

even non-market factors, such as the extraction of ‘rents’ or benefits (Werner, 2005).

Even Blanchard and Fischer (1989) noted, in a comment that echoes their sentiment

on the missing role of banks:

“A recurrent theme in the literature and among market participants is that the interest alone

does not adequately reflect the links between financial markets and the rest of the economy.

Rather, it is argued, the availability of credit and the quality of balance sheets are important

determinants of the rate of investment” (p. 478).

This has stirred interest in the credit rationing argument (Jaffee and Russell, 1976;

Stiglitz and Weiss, 1981). However, even this eminently sensible explanation raised

more questions than it answered: the credit rationing argument itself does not explain

why available alternatives to domestic bank credit (foreign bank credit, direct finance,

equity issuance) failed to compensate for credit supply constraints. In effect, credit

rationing is a microeconomic argument without any explicit macroeconomic

implications. However, it is macroeconomic issues that require explanation: why have

interest rate reductions failed to stimulate the economy, and why could non-bank

sources of funding not compensate for lack of bank credit?

2.4 The Failure of Supply-Side Explanations

Some economists consider ineffective demand management policies – such as in

Japan’s case – as evidence that supply-side economic reforms should be adopted

instead. However, the supply-side advice to increase productivity and factor input

mobilization through deregulation, liberalization and privatization, derived from new

classical theories, has hardly fared any better than the conventional demand side

economics: there is no evidence that the significant textbook supply-side structural

reforms that Japan undertook in the past 30 years has helped in the short-term or the

long-term, or that structural factors were actually the cause of the recession (see

Werner, 2004). This adds to the older empirical challenge that the phenomenal

economic performance of Japan, Taiwan, Korea and Germany (mid-1930s to early

1970s) and China (since 1982) has posed to mainstream approaches. The latter argued

that only economies with freer markets should be efficient and productive, while

economies using non-market mechanisms and government intervention should be less

so. As Chalmers Johnson (1999) argued:


“Japan’s ‘flagrantly flouting all received principles of capitalist rationality’, to use

Dore’s words (1986, p. 18), was turning it into one of the world’s richest big nations

and the model for all the other countries of East Asia, including China” (p. 33).

Proponents were reduced to arguing, somewhat improbably, that Japan, Taiwan,

Korea, and China, as well as Germany earlier on, were successful despite their nonmarket

mechanisms and government intervention in the form of incentive-compatible

institutional design and allocation of credit, not because of it. The implication of this

argument is that these countries would have been even more successful, had they not

engaged in such policies (see Johnson, 1988, for an eloquent rebuttal).

Thomas Kuhn (1962) argued in his account of the growth of scientific knowledge

that researchers operate within generally accepted ‘paradigms’. The process of

shifting to a new, more advanced paradigm is not necessarily smooth, as the old

paradigm is supported by those who have made a career out of its propagation.

Lakatos (1970) argued that defenders of the ‘old paradigm’ (defined by him as a

research programme) would adopt ‘immunisation’ strategies, such as the introduction

of ad hoc assumptions, to try to ‘protect’ their ‘core’ beliefs against contrary

empirical evidence – a practice already condemned by Karl Popper (1968) as

unscientific. As the number of inexplicable facts rises (‘anomalies’, in Kuhn’s

terminology), the call for a new paradigm should become louder. The new paradigm

must be able to explain at least as much as the previous approach and in addition also

account for the many ‘anomalies’ of the old paradigm, thereby encompassing it.

If the analysis of Kuhn and Lakatos applies to macroeconomics, then defenders of

the conventional approaches should have become increasingly embattled over the past

thirty years, and ever more reliant on inconsistent ad hoc assumptions, while criticism

of their approaches spread.

Proponents of real business cycle theories have indeed argued that

macroeconomics should respond to the challenges posed by the financial crisis by

incorporating a financial or banking sector into DSGE models. This is recognizable as

an ad hoc modification of an incompatible approach. Instead, a new paradigm is

needed. Already before the crisis a number of influential economists, including

Joseph Stiglitz and collaborators had renewed the call for a “new paradigm”. 9


slow but steady rise of non-mainstream theories over the past twenty years, including

institutional economics, experimental economics, psychological economics,

behavioural economics and economic history – all sub-disciplines with an empirical

orientation – suggests that momentum is building in favour of a shift towards a model

developed from an inductive research methodology.

I believe that a convincing new paradigm can only arise from an inductive

approach, avoiding the errors of the prevailing paradigm, which was built on the

hypothetico-deductive method that starts with so-called first principles by adding

unrealistic assumptions to erroneous axioms. A new paradigm must rise to the

challenge of explaining at least the seven central empirical puzzles in macro- and

monetary economics:

9 See Stiglitz (2001), Stiglitz and Greenwald (2003).


(1) The apparent velocity decline; (2) the identification problem of money, and (3)

of what makes banks special (while incorporating this feature appropriately into a

macroeconomic model); (4) why there are recurring banking crises; (5) the

ineffectiveness of over a decade of interest rate reductions in stimulating growth in

Japan (and a growing number of other countries), and, more generally, the link

between interest rates and growth; (6) the success of the German and East Asian

economic model, despite wide-spread government intervention and use of non-market

mechanisms; and (7) the ineffectiveness of supply-side reforms (deregulation,

liberalization, privatization) in enhancing economic performance in Japan and other


In the following section it will be argued that – following the inductive method –

empirical observation of key aspects of banking activity can be used to construct such

an alternative approach by modifying the last common macro model that included

money: the quantity equation. In response to the empirical failures of equations (1) or

(2) economists in the late 1980s could have persisted in identifying the reasons for its

failure and formulated an alternative framework, instead of abandoning it. In fact I

first proposed such a modification in its basic form in 1991 (Werner, 1992), but

economists had already embarked on their moneyless research paradigm, while

finance researchers showed little interest in systemic issues. The model has however

stood the test of time well. I would argue that the past twenty years have further

strengthened its appeal.

3 Two Flaws in the Quantity Equation and How to Address Them

3.1 The Role of Financial Transactions

There are two flaws in the use of the most widely accepted version of the quantity

equation (equations 1 or 2). As a result, it is neither “valid under any set of

circumstances whatever” (as Handa, 2000, still claimed), nor “an identiy, a truism”

(Friedman, 1990). To the contrary, it is a special case that applies only under

exceptional circumstances. More often than not it is incorrect, resulting in the

apparent ‘velocity decline’.

The first flaw emerges when reconsidering the original formulation by Irving

Fisher (1911), based on Newcomb (1885) and John Stuart Mill (1848), which can be

stated as follows:

(3) M V = P Q

Fisher said that the ‘effective’ money MV (assumed to circulate and be used for

transactions) is equal to the value of transactions (the sum of all pairs of prices times


quantities transacted). 10 We can rephrase this slightly and say that, in its original

form, the quantity equation stated:

The total value of transactions during any time period must be the same as the amount of

money used to pay for these transactions.

This is now an equation that indeed is “valid under any set of circumstances

whatever” and is of course the reason why the quantity equation is also known as the

‘equation of exchange’. 11 But there was an important drawback to Fisher’s equation.

When attempting to apply it in practice by using data, M and P could be readily

identified. V is hard to measure and thus had to be the residual. Thus data on

transactions Q were necessary. But they did not exist, at least not in official

publications (today central banks could easily publish such figures – available to them

in real time due to their function as clearing house of all bank transactions, which in

turn account for a likely 97% of all transaction values in the economy – but they have

chosen not to do so). As national income accounts were becoming increasingly

available, Pigou (1917) and several of his colleagues at Cambridge University argued

that the stock of money should be proportional to ‘total nominal expenditures’, which

could be represented by the expenditure-side of GNP. Many Cambridge economists

therefore replaced PQ with PY, yielding the most widely-known formulation of the

quantity equation in (1) above. 12

This change in the definition of the quantity equation is usually undertaken with

minimal justification. Milton Friedman, for instance, explains that

“Fisher, in his original version, used T to refer to all transactions – purchases of final

goods and services…, intermediate transactions…, and capital transactions (the purchase of

a house or a share of stock). In current usage, the item has come to be interpreted as

referring to purchases of final goods and services only, and the notation has been changed

accordingly, T being replaced by y, as corresponding to real income” (Friedman, 1990, p.


While it is undoubtedly true that it “has come to be interpreted as referring to

purchases of final goods and services only”, which can be represented by GDP,

Friedman fails to tell us why this is justified and what the implicit assumptions are.

From a comparison with Fisher’s earlier formulation we know that equation (1) is a

special case that is only accurate if:

10 Fisher originally used the notation MV=PT, whereby T stands for the quantity of transactions.

11 Since Fisher had the concept of species in mind as money M, and since he realized that the total volume

of transactions was much larger than the stock of gold or precious metals, he, like other economists at the

time, felt that banking or other financial innovations served to economise on this stock of gold. Thus

some kind of ‘multiplier’ was necessary – the number of times one unit of gold money M was used for

transactions during the period of observation. This is velocity V.

12 Only marginally different by solving for M, thus representing it as a money demand function, with 1/V

on the r.h.s. renamed ‘k’ – the ‘Marshallian k’, named in honour of another Cambridge economist.


(4) P Y = P Q

or, in other words, if nominal GDP is a robust proxy for the value of total

transactions in the economy for which money is changing hands. When considering

growth rates, the lesser requirement applies that transactions proxied by GDP are a

constant proportion of total transactions. However, it is neither clear that GDP

accurately reflects all transactions in the economy nor that GDP-based transactions

are a constant proportion of total transactions. Friedman (1990, p. 38), casually inserts

the formulation “if we restrict purchases to final goods and services…” in his

explanation of equation (1). But as Friedman acknowledges, Fisher originally

included asset transactions. These constitute an important potential use of money M.

They may be of substantial volume in modern economies – often a multiple of GDP –

yet are not included in the GDP statistics, as the latter reflect income, value added in

production and services or expenditure on goods and services only. Capital gains on

assets are not included in the income definition. Financial sector transactions affect

wealth, but are not part of income and hence GDP (for more details on national

income accounting, see UN 1993, 2003, or Lequiller, 2004). Likewise, the majority of

real estate transactions are not part of the GDP statistics.

John Stuart Mill (1848) suggested that one must consider the possibility that

money is used not for goods (and services), but instead for financial transactions, such

as the purchase of securities. 13 Jeremy Bentham did so as well, and in fact came to

different, probably more accurate, conclusions than Mill - but the publication of his

key contribution to this topic was delayed by well over a century and remains little

known (see Bentham, 1952-54). 14 Fisher, and after him Keynes, suggested to

distinguish between transactions arising from the sale or purchase of finished goods

and services (which can be measured by GDP) and financial transactions that are not

related to national income. 15 Theoretical and empirical work using a similar

distinction includes Selden (1956), Spindt (1985), Cramer (1986), Stone and Thornton

(1987), Niggle (1988) and Allen (1989). The UK’s Central Statistical Office (1986)

argued that the total value of transactions should be used in the quantity equation,

while GDP was merely a subset of transactions involving final output. 16

It can

therefore be said that the need to distinguish between GDP-based transactions and

non-GDP-based transactions has been pointed out clearly in the literature, although

this was not successfully linked to a corresponding separation of relevant monetary

aggregates. 17

Yet, the mainstream use of the quantity equation has remained confined

13 It frequently happens that money, to a considerable amount, is brought into the country, is there actually

invested as capital, and again flows out, without having ever once acted upon the markets of

commodities, but only upon the market of securities, or, as it is commonly though improperly called, the

money market” (Book III, chapter 8, para. 18).

14 Thanks to Gunnar Tomason for pointing this out.

15 Fisher (1926) distinguished between income and financial transactions, Keynes (1930) between

‘industrial’ and ‘financial’ transactions.

16 As quoted by Howells and Biefang-Frisancho Mariscal (1992).

17 See also Werner (1992, 1997d) for an overview and a counter-example presented below.


to nominal income, neglecting the possibility that money is used for non-GDP


Thus equation (1) will not be reliable when the value of non-GDP transactions,

such as asset transactions, rises. In those time periods we must expect the traditional

quantity equation, MV=PY, to give the appearance of a fall in the velocity V, as

money is increasingly used for transactions other than nominal GDP (PY). This

explains why in many countries with asset price booms economists puzzled over an

apparent ‘velocity decline’, ‘breakdown of the money demand function’ or a ‘mystery

of missing money’. 18

The solution is to disaggregate the general equation of exchange for all transactions

into two flows – those of money used for GDP (‘real’, hence subscript R) and those of

money used for non-GDP transactions (‘financial’, subscript F). As Friedman pointed

out about equation (3):

“Each side of this equation can be broken into subcategories: the right-hand side into

different categories of transactions and the left-hand side into payments in different form”

(Friedman, ‘Quantity Theory’, Encyclopedia Britannica, 15th edition, p. 435).

This was first successfully implemented by Werner (1992, 1997). Following this

framework, we choose to disaggregate both sides of (1), on the one hand into money

used for transactions that are part of GDP (called M R V R ) and those that are not (called

M F V F ), and on the other hand the value of transactions that are part of GDP (P R Q R )

which should be accurately proxied by nominal GDP (P R Y), and those that are not

(P F Q F ): 19 (5) MV = M R V R + M F V F

(6) PQ = P R Q R + P F Q F

At the same time, equations (7) and (8) must also hold:

(7) M R V R = P R Q R

(8) M F V F = P F Q F

Since we defined P R Q R as the value of all transactions contributing to GDP, the

value of transactions that are part of GDP should be equal to nominal GDP (P R Y):

(7’) M R V R = P R Y

with V R = (P R Y)/M R = const.

18 Spindt (1985), Howells and Biefang-Fisancho Mariscal (1992) and Werner (1992, 1997).

19 As has been suggested by Werner (1992, 1994b, 1994c, 1995a, 1995b, 1995c, 1996a, 1996b, 1996c,

1996d, 1996e, 1997a, 1997b, 1997c, 1997d, 1997e, 2002b, 2003c). See also Economics Focus, The

Economist, 19 June 1993, p. 74


With a stable ‘real’ velocity of money, V R , the effective amount of money used for

GDP transactions during any period of time (M R V R ) must be equal to nominal GDP.

Meanwhile, the amount of money effectively used for non-GDP transactions will be

equal to the value of these non-GDP transactions.

By definition, for economic growth to take place, the value of economic

transactions during one time period must exceed that of the previous period of

comparison. Considering therefore net changes in variables over the observed time

period, we obtain:

(9) ∆(M R V R ) = ∆(P R Y)

(10) ∆(M F V F ) = ∆(P F Q F )

We can say that the rise (fall) in the amount of money used for GDP-based

transactions is equal to the rise (fall) in nominal GDP. Similarly equation (10) states

that the rise (fall) in the amount of money used for non-GDP transactions is equal to

the change in the value of non-GDP transactions. In other words, an asset bubble can

be caused if more money is created and injected into asset markets.

3.2 How to Measure Money Used for Transactions

In order to put data into these equations we must now agree on how to measure

money (or, to be precise, MV, the net amount of nominal money effectively used for

all transactions). As we saw, the inability to define money has been a major anomaly.

Fisher, Keynes and most post-war researchers used deposit aggregates ranging from

M0 to M4 to represent M in the quantity equation. But there are a number of problems

with this approach.

Firstly, the original equation of exchange defines M as the purchasing power that is

actually exerted when transactions take place. The so-called ‘money supply’ ‘M’-

aggregates, as traditionally defined, mainly consist of money deposited with banks or

the central bank. They measure subsets of private-sector savings and hence money

that, at the moment of measurement, is not used for transactions. The original

equation of exchange however demands a measure of that money which is used for

transactions – money in circulation, not money out of circulation.

John Stuart Mill (1848) was clear on this point, but subsequent authors have tended

to neglect it. First he defines the quantity equation as a transactions equation, as

described later by Fisher and by us above. 20 He then points out that

20 “The whole of the goods sold (counting each resale of the same goods as so much added to the goods)

have been exchanged for the whole of the money, multiplied by the number of purchases made on the

average by each piece. Consequently, the amount of goods and of transactions being the same, the value

of money is inversely as its quantity multiplied by what is called the rapidity of circulation. And the

quantity of money in circulation is equal to the money value of all the goods sold, divided by the number

which expresses the rapidity of circulation” (Book III, Chapter 8, paragraph 13).


“Whatever may be the quantity of money in the country, only that part of it will affect prices

which goes into the market of commodities, and is there actually exchanged against goods.

Whatever increases the amount of this portion of the money in the country, tends to raise

prices. But money hoarded does not act on prices. Money kept in reserve by individuals to

meet contingencies which do not occur, does not act on prices. The money in the coffers of

the Bank, or retained as a reserve by private bankers, does not act on prices until drawn

out, nor even then unless drawn out to be expended in commodities” (Book III, Chapter 8,

par. 17, p. 20).

Secondly, defining money by certain private sector assets, such as deposits, creates

the identification problem recognized by Friedman (1956) that “there is no hard-andfast

line between ‘money’ and other assets” (p. 65).

Thirdly, using the traditional definition of money as cash or deposits, it remains

impossible to implement a disaggregation of the money by the use it is put to. As

Friedman (1956) noted, “dollars of money are not distinguished according as they are

said to be held for one or the other purpose” (p. 61).

The correct definition of money for purposes of these equations is one that

measures the money that actually circulates in the economy and is used for

transactions at any moment in time, as Mill would have argued. It is an empirical

question to find out what data conveys this information.

The issue can be reformulated: equation (9) defines nominal GDP growth (P R Y).

Growth this year means that more transactions (that are part of GDP) have taken place

this year than last year. We know that this is only possible if more money has also

exchanged hands to pay for these transactions. The next question therefore is: how

can the amount of money used for transactions increase in our modern financial

system? If we had a pure gold standard – which is what most classical and many

neoclassical theories were designed for – then the answer would be that either gold

retired from circulation (savings) is spent and put into circulation, or more gold is

discovered, extracted and injected into the economy. However, today no country is on

a gold standard. Instead, we have a system of fiat money. There are many different

ways of organising such a system and history is full of interesting case studies.

At this juncture it is necessary to remind ourselves of the most successful (since

efficient) research methodology, namely the one applied in the natural sciences: the

inductive (or empirical) method. The deductive approach postulates to start with

axioms and assumptions, on which theories are built which are then inevitably

challenged by empirical reality. The alternative is to start with empirical facts, which

are used to identify patterns and formulate theories, which then can be tested against

the facts again.

How is money created and injected in our present-day system? This is a simple

question that empirical research should quickly be able to answer. Intriguingly,

virtually no research is published on this question at all in the leading journals of

macroeconomics, monetary economics, or banking and finance. To be sure, they carry

many articles that make assumptions about how a theoretical monetary system may be


defined in the particular cases of their stylised models. This does not help us further

though, if we are interested in reality.

The particular type of fiat money system that is currently employed world-wide is

one in which about 97% of the money supply is created and allocated by private

profit-oriented enterprises, namely the banks. How do banks create money? As

Werner (1992, 1997, 2005) argued and as we show in Ryan-Collins et al. (2011),

banks simply invent 97% of the money supply when they credit borrowers’ bank

accounts with sums of money that nobody transferred into these accounts from other

parts of the economy. To use another phrase: banks create money out of nothing when

they extend bank credit (or purchase other assets, or pay their staff). This is why the

process of granting bank loans is better described by the expression credit creation.

It is a simple point. So much so that J. K. Galbraith (1975) said of it:

“The process by which banks create money is so simple that the mind is repelled. When

something so important is involved, a deeper mystery seems only decent” (p. 18f).

On the one hand the fact that banks create the money supply is well known to a

small group of experts. This is attested by many central bank publications, although

mostly in obscure locations that have not attracted attention. 21 It has also been

recognized by Pollexfen (1697), Law (1720), Thornton (1802), John Stuart Mill

(1848), Macleod (1855/56) and others (even though usually not formulated explicitly

or precisely). But it failed to become the mainstream view, probably due to the

fixation on legal tender or metallic money, and the subsequent focus on ‘M’-type

deposit aggregates. Schumpeter (1954) points out that these authors recognized that in

their economic effect money (traditionally measured) and bank credit could be


“As soon as we realize that there is no essential difference between those forms of ‘paper

credit’ that are used for paying and lending, and that demand, supported by ‘credit’, acts

upon prices in essentially the same manner as does demand supported by legal tender, we

are on the way toward a serviceable theory of the credit structure…”. 22

21 By far the largest role in creating broad money is played by the banking sector ... When banks make

loans they create additional deposits for those that have borrowed.” (Bank of England, 2007). “Moneycreating

organisations issue liabilities that are treated as media of exchange by others. The rest of the

economy can be referred to as money holders (Bank of England, 2007). “... changes in the money stock

primarily reflect developments in bank lending as new deposits are created” (Bank of England, 2007).

“Given the near identity of deposits and bank lending, Money and Credit are often used almost inseparably,

even interchangeably …” (Bank of England, 2008). “Each and every time a bank makes a loan, new bank

credit is created – new deposits – brand new money” (Graham Towers, 1939, former Governor of the

Central Bank of Canada). “Over time … Banknotes and commercial bank money became fully

interchangeable payment media that customers could use according to their needs” (European Central

Bank, 2000). “The actual process of money creation takes place primarily in banks” (Federal Reserve Bank

of Chicago, 1961). “In the Eurosystem, money is primarily created through the extension of bank credit ….

The commercial banks can create money themselves, the so-called giro money” (Bundesbank, 2009).

22 Schumpeter (1954), p. 718f.


The recognition that credit may have the same economic effect as money was a

major breakthrough, because legally money and credit are quite different constructs.

As Schumpeter pointed out:

“And this is why Thornton’s perception of the fact that the different means of payments

may, on a certain level of abstraction, be treated as essentially alike was a major analytic

performance, for the mere practitioner will in general be impressed by the technical

differences rather than by the fundamental sameness.” 23

The link between credit and the macroeconomy was recognized widely enough at

the beginning of the twentieth century to warrant the following entry in the

Enzyclopedia Britannica (1911 edition):

“The immense growth of credit and its embodiment in instruments that can be used as

substitutes for money has led to the promulgation of a view respecting the value of money

which may be called the Credit Theory. According to the upholders of this doctrine, the

actual amount of metallic money has but a trifling effect on the range of prices, and

therefore on the value of money. What is really important is the volume of credit instruments

in circulation. It is on their amount that price movements depend. Gold has become only the

small change of the wholesale markets, and its quantity is comparatively unimportant as

determinant of prices” (italics added). 24

An explicit link between bank credit creation and macroeconomic activity was also

made by Hahn (1920). But despite these early insights and occasional bursts of

research focusing on credit, its role has remained too small in mainstream theories,

especially in the post-war era. According to Schumpeter,

“it proved extraordinarily difficult for economists to recognize that bank loans and bank

investments do create deposits. In fact, throughout the period under survey they refused with

practical unanimity to do so” (p. 1114).

Thus this fact has not been properly reflected in macroeconomic or monetary

models, and neither has it found its way into the quantity equation. 25 Today, despite

its simplicity, it is not generally well known, even among experts in economics and

finance (as a questionnaire survey I conducted with students in Frankfurt in 2010

demonstrated). This testifies to the possibility of regressive development of

knowledge in economics and finance.

However, the fact that banks create the money supply can be utilized to answer our

research question at hand: In an economy with a banking system, the amount of

money actually used for transactions can only increase when banks create new credit

(Werner, 1992, 1997). This means that bank credit creation should have a direct

impact on transaction volumes, demand, and hence also prices, as Mill (1848) and

Bentham (1952-4) suggested. 26

23 Schumpeter (1954), p. 719, emphasis as in original.

24 Encyclopedia Britannica (1910-1911).

25 until Werner (1992, 1997) that is.


In Mill’s words, not dissimilar to the at the time unpublished Bentham: “This extension of

credit by entries in a banker’s books, has all that superior efficiency in acting on prices,


In order to avo