Endogenous Money and "Out of Thin Air" Money

I often hear comments confusing the endogeneity of money with the idea that banks create money "out of thin air".  Although these two ideas are connected, that are not the same and one does not imply the other.

In particular, there seems to be a belief that an essential feature of money being endogenous is that banks can make loans without needing deposits first.  This is not correct.  Even if loans were only made out of previously deposited funds, monetary growth would still be determined in substantially the same way.

We can illustrate this with a little thought experiment.

Imagine that a law is passed under which banks are strictly prohibited from making loans by crediting deposits.  Any new credit must involve the bank handing over physical cash to the borrower.   People could still make payments by bank transfers from their current accounts, but not if it involved going overdrawn.  Instead, such people would have to borrow physical cash from the bank, then deposit it into their current account, before drawing on it.

In such an arrangement, it would be impossible for a bank to make a loan without having first taken a deposit (or received cash through some other means like stock issuance).  Does this mean that the loans are now constrained by deposits?  No, at least no more than it did before.

In the example above, the bank pays out cash in place of allowing an overdraft (using cash from a previous deposit).  The cash is then deposited back with the bank, so the borrower can make transfers from it.  This leaves everyone in exactly the same position as if the bank had simply credited the borrower's account.  The bank now has the cash again to make another loan, and then another, ad infinitum.

It makes no difference to this argument if the borrower deposits the cash with another bank.  The only way that cash will not flow back to the banks is if the non-bank public decides to start hoarding it and there's no reason to suppose that they will automatically do so in response to an increase in lending activity. 

This latter point is no different to the way things work in the real world, where banks make loans by crediting accounts.  The ability to do so without limit depends on the public retaining their new money in the form of bank deposits.  If the public suddenly decided to start hoarding cash, withdrawing the balance of their newly created deposits, banks would cease to be able to make new loans.

In our thought experiment, as well as in the real world, it is the interaction between banks and borrowers that is driving money creation.  Regardless of the actual mechanics of making loans, it does not require a spontaneous decision by depositors to increase savings for an expansion in the money supply to occur.  The endogenous nature of money does not depend on the fact that banks can make loans without having taken deposits first.

The reasons for the growth or otherwise of private money lie in the budget decisions of economic agents, not in payment mechanics.  Money growth is a result of the pressure created by when the equilibrium between non-banks wanting more debt and banks prepared to take on more risk implies a higher level of loans.  Even if deposits must proceed loans, that pressure is still there and balances will move towards the equilibrium position.

I have glossed over practical issues, because I don't think they affect the argument, but I should say something on these.  Obviously, having to make all loans in cash would raise some practical considerations.  It would also mean that the amount of cash holdings of banks and non-banks would probably need to be significantly larger than is currently the case.  If the monetary authorities attempted to constrain lending by restricting the supply of cash, this could potentially slow up the pace of money creation, even if it did not change the final equilibrium.  However, this is not very different from using monetary base control methods in the real world.

The way banks create money "out of thin air" is certainly a useful thing to understand, but in terms of considering the endogeneity of money, it is nothing more than a red herring.