A noble reward for a “popular misconception” – Peter Bofinger

Peter Bofinger questions last week’s awarding of prestigious award economy award to an Orthodox school that could not anticipate the crash of 2008.

If only they knew: US President George W Bush passing the baton to the Federal Reserve from Alan Greenspan to Ben Bernanke (right) in 2005 (White House)

This year, the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel honors Ben Bernanke, Douglas Diamond and Philip Dybvig. According to the Royal Swedish Academy of Sciences, the winners “have significantly improved our understanding of the role of banks in the economy”.

But what is the role of banks in the economy? The academy describes it this way: “To understand why a banking crisis can have such enormous consequences for society, we need to know what banks actually do: they take money from people who make deposits and channel it to borrowers. According to this view, banks are therefore pure intermediaries or merchants of savings between saving households and investing companies. This is a widely held view in economics today, but there has long been a completely different theory of the function of banks.

This was formulated, among others, by Joseph Schumpeter. In his Economic development theory (published in German in 1911), Schumpeter wrote: “The banker is therefore not so much above all an intermediary in the commodity “purchasing power” as a producer of this commodity.

In this vein, in 2014, the Bank of England asserted: “Money creation differs in practice from some popular misconceptions: banks do not simply act as intermediaries, lending the deposits that savers place with they. Three years later, the Deutsche Bundesbank likewise spoke of “the common misconception that banks merely act as intermediaries at the time of lending, i.e. banks can only grant loans using funds placed with of them previously in the form of deposits by other customers”.

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Surprisingly, the academy did not address this alternative point of view in its explanatory document. Instead, he even presents Schumpeter as a representative of the theory of intermediation.

Underlying models

To understand both theories, it is necessary to examine the design of the underlying models. The theory of intermediation (or loanable funds) presents itself as a pure market theory or a “real analysis”, as Schumpeter put it in his History of economic analysis. In this model, there is only one general-purpose asset, which can be used indifferently as a consumption good, an investment good or “capital”. At the center are household consumption decisions, whether to consume or save the asset. Households channel unconsumed or saved assets (“capital”) directly, or through banks, to investors, who then invest them. As a result of the investment, a larger quantity of the unit good becomes available.

It follows from the assumptions of the model that the banks are not able to produce this good themselves. Their role is therefore limited to facilitating its transfer between savers and investors. Because of the dual nature of assets, as real assets and as “capital” or savings, the real economic sphere is thus identical to the financial sphere. There is no place for money as an independent asset or for financial decisions separate from the decision of consumption and investment. Given these assumptions, it seems ambitious to derive insight into the functioning of banks and the financial system from a model that has no independent role for money or other financial assets.

Monetary approaches, or what Schumpeter called “monetary analysis”, recognize real assets (consumer and investment goods) as different from monetary assets (bank deposits and bonds), as in the “IS/LM” model. , for example. In addition to consumption and investment decisions, there are independent financial decisions: lending by central banks and commercial banks and bond purchases by non-banks.

The crucial element of these models is that banks do not need “savings” or deposits to lend. It is rather the opposite: when a bank grants a loan, deposits are created. Banks are therefore, exactly as Schumpeter describes it, “producers of purchasing power”.


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Of course, lending to an individual bank means that the deposits it creates are used for transfers to other banks. For the banking system as a whole, however, deposits remain unchanged. The lending bank’s deposit loss is offset by interbank loans or central bank refinancing loans.

The fact that this process can be disrupted in the event of a crisis, as described by Anat Admati and Martin Hellwig, does not fundamentally call it into question and does not justify the validity of the theory of intermediation. This also applies to their argument that cash withdrawals could limit bank credit expansion. Since central banks control commercial bank credit expansion with their policy rates, they are willing to passively provide the amount of central bank money (including liquidity) that the banking system needs.

Banking crises

For the analysis of banking crises, the distinction between the two model approaches is essential. The main cause of banking crises is usually excessive bank credit, which leads to overheating, especially in the real estate sector. The subsequent collapse of this market leads to loan defaults and bank insolvencies. The intermediation model cannot, however, explain such an inflation in the volume of credit. Household savings, the only source of credit in this model, is a very inert variable.

This is different in a monetary model, where banks are able to generate excessive credit expansion over an extended period. When property prices increase, loan security increases. Income from loans brings profits to banks and increases their capital. The dynamics of these processes can be seen in Spain, Greece and Ireland before the financial crises, where bank lending increased by 450-500% (see chart).

It is a feature of the literature on intermediation that, as in the work of Bernanke – former chairman of the US Federal Reserve – it can explain the phases of crisis but not the processes that led to them. This also applies to the work of Diamond and Dybvig, who represent banks as a kind of insurance company. They identify the risks of this insurance contract but are unable to deal with the dangers of excess credit.

Here one can learn more about Schumpeter. In business cycles (published in 1939), he clearly identifies these problems with the power of banks to create credit:

Once prosperity is set in motion, households will borrow for consumption purposes, in the hope that effective incomes will be permanently what they are or will increase further; businesses will only borrow to expand on old lines, in the hope that this demand will persist or increase further; farms will be bought at prices that they could only pay if the prices of agricultural products remained at their level or increased.

It is difficult to understand how the Swedish academy could decide to honor a theory which – due to its “actual analysis” – is unsuitable for representing monetary processes in reality. In terms of economic policy, it makes a fundamental difference whether banks are mere intermediaries for savings or insurance companies or whether they are producers of purchasing power. “Real analysis” was an important factor in the economic profession’s inability to anticipate the Great Financial Crisis in time.

After this painful experience, praising the approach of banking intermediation with the Nobel Prize in economics is equivalent to posthumously offering Ptolemy the prize in physics – because he discovered that the sun revolves around the earth.

This is a joint publication of Social Europe and IPS-Journal

Peter Bofinger is professor of economics at the University of Würzburg and former member of the German Council of Economic Experts.

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