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Bank Lending is Primarily a Demand Side Issue

The real problem with concepts like the money multiplier and bank lending is that it boils bank lending down to a supply side issue.  In essence, it implies that banks can only make loans if they have some supply of loans.  It’s the mythical loanable funds or reserve constraint idea.  As if banks have to go bid on some loanable funds market or find reserves that they can go out and multiply BEFORE they make loans.

Of course, as the Bank of England nicely explained (and I’ve been explaining for years) this is wrong.  Yes, a bank has to be willing to supply loans (in other words, borrowers must be deemed “creditworthy”), but that doesn’t mean the bank is necessarily supply constrained.  After all, banks are in the business of creating debt contracts from thin air.  Unless the world runs out of air their supply of loans should be in safe supply.

I was reminded of this point as I was reading this excellent post from Frances Coppola.  She’s responding to a UK economist who is responding to the recent piece from the Bank of England on endogenous money (you can read his response here).  And as I was reading his response it occurred to me that one of the major hurdles to understanding endogenous money appears to be this concept of supply side monetary thinking.  As if banks are constrained by their ability to create loans from thin air because of reserve requirements or “savings” or something else.  But this is the wrong way to think about endogenous money.

It’s better to start from the demand side.  Remember, banks are in the business of making loans.  If creditworthy customers are walking in their doors they don’t turn them down.  And if the bank has adequate capital levels and deems the customer to be creditworthy then they write up a loan contract, expand their balance sheet endogenously (which creates a loan asset for the bank, a deposit liability for the bank, a deposit asset for the borrower and a loan liability for the customer) and, if they must, the bank will find reserves to meet reserve requirements AFTER the fact (in the interbank market or via the Central Bank).

So, when we think of banking it’s really better to think of it as being a demand side issue. If you start from the supply side you’ll likely get confused.  Yes, banks have real constraints (like capital and their own lending standards), but in a healthy functioning economic environment a well capitalized bank will service as many creditworthy customers as it can.  After all, that’s their line of business.

Some related work:


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