A lost century in economics: Three theories of banking and the conclusive evidence

This article examines three competing theories of how banks work and whether they create money. The currently prevalent financial intermediation theory holds that banks collect deposits and lend them out, just like other nonbank financial intermediaries. The older fractional reserve theory holds that each individual bank is a financial intermediary without the power to create money, but the banking system as a whole is capable of creating money through the process of "multiple deposit expansion." The credit creation theory, dominant a century ago, does not view banks as financial intermediaries that collect deposits to lend them out, but instead holds that each individual bank creates credit and money from scratch when it makes a bank loan. The article presents a new empirical test of the three theories, controlling for all transactions, and yields clear results. The fractional reserve and financial intermediation theories are rejected, while the credit creation theory is supported by evidence. This has important implications for banking regulation and economic policy.