creation

Li Yang, Zhou Liping*1

With the development of financial markets and the rise of modern shadow banking system, new agents and new means of credit creation are constantly emerging, and their effects on the financial system and macro-economic system are also obscure. Following historical clues, this paper conducts a review and analysis of the literature on credit creation from the perspective of so as to render some help for the understanding of credit creation in modern financial system.

Keywords: credit creation, , financial innovation

The word “credit” has roughly two meanings in Chinese. One meaning is to trust and assign to important tasks. The other is to keep one’s promise so as to obtain the trust of others. In the Western world, the word “credit” originated from “credo” in Latin, whose original meaning was also “to trust”. It is apparent that both domestically and abroad, the core meaning of credit is to trust and to keep one’s promise; the former means the recognition of one’s integrity by others, and the latter refers to one’s self-cultivation. To trust and to keep one’s promises are the core and foundation of understanding credit and its derivative terms. As a term in economics and finance, credit’s meaning extends from the original meaning of “to trust and to keep one’s promise”. Generally speaking, credit refers to a value movement under which, in the economic process of the exchange of goods and services and conditional transfer of monetary funds, a credit grantor, based on full confidence in a borrower’s ability to fulfill his commitment, grants loans (in kind or in monetary form) to the borrower in accordance with an agreement made between, which assures that principal and additional value flow back to the lender. Here the lending vehicle can be either in kind or monetary, so there are different categories of physical credit, credit sales, or monetary credit. The lending agent can be any institution or individual, so we have distinctions of state credit, enterprise credit, bank credit, and the personal credit of consumers. In the context of pure monetary finance, credit is further abstracted to a trading equivalent and/ or a claim. The issuers of this equivalent and/or claim enjoy wide confidence among the public and the cost of this monetary claim is the lowest as it is an abstraction of material money and is

* Li Yang, Vice President and Academician, Chinese Academy of Social Sciences, P. R. China; Zhou Liping (Corresponding Author, email: [email protected]), Assistant Research Fellow, Institute of Finance and Banking, Chinese Academy of Social Sciences, P. R. China. 4 China Finance and Economic Review hence generally held by the public as a . The “credit” discussed in this paper is based on these definitions.

1. Early-stage theory on credit intermediation and credit creation

Credit and credit creation originated from temple lending 5,000 years ago in Western Europe. But these concepts were not discussed as formal academic concepts until the nineteenth century. The historical context is that, with the development of commerce, the system was evolving to a credit money system, and people needed to discard the old system and to establish a new one and required certain new ideas and theories to prove that creating such a system was reasonable. In the process of the credit money system’s establishment, consolidation, and development, two fundamental practical movements boosted the construction of credit monetary theory. Firstly, the outbreak and conclusion of World War I, banking businesses turned from the era of formulating rules to establishing systems. The banking system that had previously operated on the foundation of a few rigid and simple rules came to a conclusion with the advent of the age of credit money. The new banking system needed to answer some basic questions concerning operations of money and to propose new theories. Among the questions, credit creation, its restraints, and its possible effects were the most urgent to be answered. Secondly, while the gradual establishment, consolidation, and improvement of central banking systems around the world legally unified and monopolized the authority to issue money, a most fundamental theoretical explanation was still needed for the monetary and credit connections among central banks and financial institutions including commercial banks. Credit is the core concept to explain the internal mechanism connecting banks, money, and the real economy. Before the appearance of modern central banks, the theoretical analysis centering on the money supply and demand that we are familiar with at present did not exist. Consequently, the academic discussion about money and its relation to the real economy was centered on the credit creation mechanism. In this sense, the theory of credit creation is the predecessor of the modern theory of monetary supply. As modern market economy was still struggling to emerge from its slumber, these discussions could be nothing but unsystematic and informal, often merely a few random thoughts or words. At the early stage of the capitalist economy, commercial banks were the center of credit for all of society. Hence, almost all classical theories about credit creation centered on the functions of commercial banks and the credit instruments they issued. Most classical economists limited their research to the field of material commodities. In their opinion, savings were no more than the surplus of consumption, so the function of banks was no more than to transfer this surplus to entrepreneurs in need of investment. In the whole process of capital transfer, banks, by virtue of their credit, on the one hand, acted as representatives of the borrowers to attract savings from savers; and on the other hand, acted as representatives of contributors to allocate savings among borrowers. In this process, banks functioned only as intermediaries between saving and investment, an instrument of capital reallocation, which is the main message of the theory of Li Yang, Zhou Liping 5 credit intermediation. Other economists held a different view that, as long as banks maintained their credit and business, they were capable of shaking off the restraints of savings that they absorbed to issue loans. In this sense, the basic function of banks was to create credit for society and provide new capital sources for the real economy, which is the main message of the theory of credit creation. Certainly as economists in the classical period, the supporters of the theory of credit creation agreed that loans, and the investments sustained by the loans, were ultimately constrained by the scale of savings. But they believed that in a real economy, this restrictive relationship of equilibrium only existed in long-term dynamics.

1.1. Theory of credit intermediation

The standard was the monetary system from the eighteenth to the nineteenth century, which is the key context to bear in mind in order to understand the theory of credit intermediation. This theory began in the eighteenth century and prevailed in the nineteenth century. Its main advocates included , D. Ricardo, J. Mill, and contemporary scholars such as W. Leaf, A. Lampe and H. Mannstaedt. Smith (1776) holds that banking credit can save circulation costs (e.g. the reserves held by capitalists), and reduce financial and circulation capital, thus having the function of enlarging production and increasing production capital. But the scale of bank credit cannot exceed the quantity of hard currency necessary for social circulation, or inflation will follow. The way to ensure this is to issue loans by way of the discounting of bills, and bills have to have real economic transactions as their foundation. This is the well-known real bill doctrine. Ricardo was Smith’s successor in credit theory. Ricardo (1817) holds that the nature of credit is to facilitate capital transfer and increase efficiency. On the one hand, bank notes and paper currency replaced and reduced circulation costs so as to increase national wealth and material comforts; on the other hand, credit promoted the reallocation of capital and the equalization of profit rates. Mill (1848) also maintains that credit cannot create material wealth from nothing. In particular it cannot increase means of production. The basic function of credit is to transfer present frozen capital, lend it with interest for use in production, facilitate capital reallocation, increase disposable capital, and increase total social production accordingly. Meanwhile, Mill holds that credit has the same purchasing power as cash and its growth can also have an effect on prices. The classical theory of credit intermediation is also represented among modern scholars, for instance, Walsh (2003), Mishkin and Eakins (2006) insist that financial intermediaries like commercial banks are only a medium whose function is to connect society’s savings with investments in order to distribute financial resources and guide resource allocation.

1.2. Theory of credit creation

The majority of researchers believe the pioneer of credit creation theory to be the Frenchman John Law, who was also known as a fraud and fortuneteller. Other scholars such as Henry Dunning 6 China Finance and Economic Review

MacLeod, Albert Hahn, M. Keynes, F. Hayek, J. Schumpeter, etc. also share this viewpoint. John Law was a well-known mercantilist at the beginning of the eighteenth century. Blood circulation was discovered in Law’s time. With this discovery, Law, together with some others, pointed out that credit was the blood of society. In his book Money and Trade: Considered with a Proposal for Supplying the Nation with Money, Law points out, “The body loses its vigor when blood no longer circulates. The same thing happens when money stops circulating.” He holds that the nature of money is notes to purchase commodities and its basic function is to purchase goods regardless of its form. Hence, money does not necessarily have to be gold or silver and the society can issue paper money on the basis of certain assets with stable value, land, for example. Credit is necessary and useful for economic activities, as it can have an initial impact on the real economy, thus promoting production and investment, and then increase wealth and allow business to prosper. In short, credit expansion can create money, wealth, and capital. MacLeod was not only an economist but also a prestigious lawyer, known for his proficiency in Roman law. Consequently his understanding of money and credit had two perspectives of both economics and law, and he proposed some very thoughtful assertions. He holds that money, credit, and wealth are of the same nature, all of them being an order, commitment, or trading privilege that can be satisfied, with the common characteristics of the of purchasing power. Money is the most advanced and most abstract form of credit, and while all money is credit, not all credit is money. He maintains that credit creation comes endogenously from the exchange process and is closely connected to the appearance and disappearance of credit and contracts. The complete credit system comprises three processes: the creation of credit obligation, the transfer of credit or debt, and the termination of the obligation. In this process, credit creates both the claim and the obligation of payment. The bank is in no sense the intermediary of the creditor and borrower but the credit creator. By issuing money the bank is creating credit, and the scale is not limited by that of deposits but by the reserve ratio; the over-issuing of money will result in commercial crisis. Hahn was a German scholar who sincerely believed in the theory of credit creation and further developed his predecessors’ theories. In Economic Theory of Bank Credit, Hahn (1920) conveys an idea different from the traditional: not all credit has to be obtained by means of saving or produced on the basis of saving. Commercial banks serve as credit creators, whose function of credit creation is not limited by the quantity of savings. Capital formation does not result from savings but from credit creation; credit creation is the foremost element for capital formation. Credit is not the same as capital; credit can boost capital formation. With the technological progress and labor reserves in modern society, its production enjoys great elasticity, thus production can be promoted through credit expansion. With the introduction of credit intermediation, he further maintains that there exist two types of banks in reality: one type, called banks of credit creation (mainly engaged in credit creation business not limited by deposits), can promote credit expansion; the other type, called banks of credit performance (not regarding supplying credit as main business) acts only as credit intermediaries. Banks of credit creation can create unlimited credit. Because the obligation of converting money to gold only occurs under the , the can announce the termination of conversion of its own accord. Li Yang, Zhou Liping 7

2. Various theories of credit creation

In academic research, scholars supportive of the theory of credit creation such as MacLeod and Wicksell generally view a pure credit economy as the foundation for credit creation. A pure credit economy and a pure commodity money system are two polar cases of the monetary finance system. A pure credit economy means that all payments are conducted by means of non-cash forms such as account transfers, and a pure commodity money system is exactly the opposite.

2.1. The Swedish school

Wicksell and Hayek both hold that the nature of banking activities is to create credit, which is a very insightful judgment. But unfortunately neither of them described the complete process of credit creation. In his famous work Interest and Prices, Wicksell points out that all money (including coins, bank notes, and paper money) after commodity money is a kind of claim and are credit and an advanced credit monetary system corresponds with a pure credit economy. In his viewpoint, money has two dimensions: the dimension of cash currency and the dimension of velocity. Credit can fulfill the second dimension of currency, i.e., to accelerate circulation. In an economy with a highly advanced banking system, the change of credit availability will result in a change of currency quantity, causing interest rates to deviate from the natural equilibrium rate of interest, thus disturbing the equilibrium of capital supply and demand and eventually affecting the operations of the real economy.

2.2.The

The Austrian school (Hayek, 1931, 1966; Mises, 1912, 1923) holds that financial intermediaries are credit-creating agents under a limited deposit reserve system, which can connect savers to investors. The basic view of Mises (1923) is that banks create money through the creation of credit. The newly created credit breaks through the limits of savings and finances investments, thus breaking the original production structure and forming different stages of the boom-bust cycle. Banks play a central role in credit creation. Compared with prior scholars, Mises’ remarkable contribution is that he not only proposes the view that banking activities are credit creation but he also makes detailed distinctions among the categories of credit creation. He maintains that the loans issued using deposits and their own funds are commodity credit, while credit mediums such as bills and deposits of all kinds that are beyond the monetary scope and newly created, are circulating credit. In his viewpoint, circulating credit is credit creation, and banks surpass the constraints of their own funds by creating circulating credit and thereby create credit “from nothing”. Other scholars including Machlup and Selgin from the Austrian school supported and developed Mises’ viewpoints. The Austrian school holds that under a fractional-reserve system is credit creation, and the two are unified. As for the effects of credit 8 China Finance and Economic Review creation, Hayek refers to the savings produced from bank credit as forced savings, and points out on the basis of detailed analysis that forced savings will not lead to , but will instead always induce economic crisis.

2.3. Keynesianism

Keynes stresses the function of money as a , and regards money as a future good. At the time, scholars called Keynes thinking a “new view” after Mises. Keynes points out that in the process of credit creation, commercial banks issue liability certificates and media of exchange and act as financial intermediaries and brokers through the cycle of absorbing deposits and issuing loans. Under a fractional-reserve system, no real savings are involved when commercial banks issue loans with derivative deposits. At this time, money creation is credit creation, not simply financial intermediation.

2.4. Free banking school

Selgin (1988, 1996) proposes “a qualified defensive new view”, which lies between those of Mises and Keynes. The core message is: even if banks implementing a fractional-reserve system are intermediaries, they can still create credit. But what they create is credit only when credit is “independent of any voluntary money-holder’s spending abstinence”. Credit creation in a broad sense requires not only the existence of a banking system with a fractional-reserve system, but also of a central bank system. Under this system, the portion where the creation of credit intermediaries matches the wills of intermediaries holding credit is not credit creation but financial intermediation, whose function is nothing but to convert savings into investments. If credit intermediaries and credit issued by the bank exceed the real demand of the real economy, credit creation occurs. Selgin also maintains that a free banking system with a fractional-reserve system can prevent inherent risks in credit creation and avoid economic crisis and depression.

2.5. Post Keynesianism

Post Keynesians hold a rather uniform idea about the nature and function of money. For example, they oppose money neutrality and the traditional theoretical framework of “dichotomy”, and they believe the nature of money to be credit and identify the two as one concept in constructing models. Credit creation is the starting point of post-Keynesian money supply endogeneity. Taking the horizontalist or accommodative view as an example, Moore (1989), following Hicks’ (1956) basic view about the relationship between money and time, analyses the relationship between credit creation and money supply in a single period, and he argues that, (1) money is credit-driven, and the amount of credit is determined by internal demands of developments in the real economy; (2) the process of credit creation is manifested in banks grante loans. Businesses cope with production costs with loans from banks; hence, the loan quantity is Li Yang, Zhou Liping 9 determined by businesses or individuals with credit, and the interest rate of a loan is dependent on the benchmark interest rate determined by the central bank and a certain markup; (3) bank loans create bank deposits, and commercial banks search for reserves via deposits, mainly on the basis of liquidity provided by a lender of last resort. As a result, the central bank is the money price setter and quantity taker. In summary, the credit creation curve, loanable funds curve, and money supply curve are all horizontal, and businesses’ financing demands can be satisfied by commercial banks and the central bank, so money supply is endogenous. With the element of financial innovations, Moore proves the uncontrollability of a high- powered base and money multiplier in the monetarist model, and further highlights the endogeneity of money supply. He holds that with the innovation of financial instruments, commercial banks no longer follow the traditional pattern, i.e., waiting for deposits, but are ready to issue credit certificates to grant loans on domestic or other financial markets based on economic goals and liquidity demand. And with the development of transferable certificates of deposit and a large number of other financing instruments, commercial banks have in fact transformed into brokers connecting the two parties of money supply and demand. Furthermore, a vast majority of tradable financial instruments are not under the direct control of the central bank, which further reduces the commercial banks’ dependence on the central bank. The gradual weakening of the central bank’s control over commercial banks decreases money exogeneity and strengthens its endogeneity (Moore, 1989). Post-Keynesian structuralism criticizes and corrects the horizontalist theory of money supply and argues that the liquidity preferences of households, enterprises, commercial banks and the central bank must be taken into account, as these elements will eventually determine the elasticity of the money supply. Thus, the money supply curve is not horizontal but upward sloping (Pollin, 1991; Arestis and Howells, 1996). In demonstrating endogeneity of money supply, horizontalists’ default assumptions include a single period and that money is a means of payment, etc, while the default assumptions of structuralism include multiple periods and that money is a store of value. Considering these distinctions, it is not surprising that the two expressions are different. However, whether horizontalism or structuralism, they both agree on the endogenous consistency between credit creation and money supply and regard credit creation as the starting point of demonstrating the endogeneity of money supply, which is the fundamental contribution made by post-Keynesians to credit creation.

2.6. Other scholars

Werner is deeply influenced by Schumpeter’s view about credit creation. Werner holds that the nature of money is credit. Based on different purposes, he divides credit creation into credit creation with real purposes (consumptive credit creation and productive credit creation) and speculative credit creation. Consumptive credit creation will lead to inflation without growth, productive credit creation will lead to growth without inflation, and credit creation in financial trade will lead to asset bubbles. Hence, the macroeconomic impacts of credit creation depend 10 China Finance and Economic Review on its use and purpose. In modern market economies, it is clear that the theory of credit creation is closer to the operating reality of the financial system than the theory of credit intermediation. Nowadays, ignoring that asset management already dominates commercial banks’ operating and management strategies, liability management has long since broken away from the restraints of forced savings. Apart from commercial banks, non-bank financial institutions not only function as credit intermediaries in various forms, but also initiate credit creation by issuing initial credit instruments.

3. Credit creation mechanism: traditional and modern

Throughout history credit creation process and the changes in the medium of payment are two interactive processes mutually independent but closely linked. The credit creation process in theory is the process in which financial institutions provide financing support to the real economy. In this sense, credit creation is one of the sufficient conditions for economic development. Since the appearance of the central bank, credit has also become the object of regulation and control by monetary policies. The emergence of the commodity economy brought about commercial credit. Bank credit was a natural result when the commodity economy developed to a certain stage, and it is an extension of commercial credit in a historical and logical sense. However, since bank credit came into being, it has displayed multiple characteristics superior to commercial credit, causing almost all credit activities to focus on commercial banks and to take the form of bank credit, which has made credit creation the basic function and feature of commercial banks. As financial institutions became increasingly diversified and financial markets developed profoundly, further problems once more arose: are those financial institutions other than commercial banks, and even the financial market, capable of participating in the process of credit creation? We note that Hayek (1966) acutely raised similar questions in the 1960s, but because of the level of financial development at the time, this extremely important question was not taken seriously. Given that credit preceded money in history we can logically believe that credit creation is the precursor of the modern theory of money supply and demand. However, just as money has elbowed all other forms of credit into a corner of the social economy on account of its low cost and widespread bank outlets, so Internet finance and the shadow banking system, which are Internet-based and use market transactions as basic channels, have now formed a credit-creation mechanism wandering outside the traditional central bank/commercial bank money-supply mechanism, and are increasingly eroding their traditional territory. All these developments once again prove Hayek’s assertion about the pluralism of the credit creation mechanism as early as half a century ago. To gain a deep insight into the comprehensive implications of these changes and the future development directions they indicate, we must return to the nature of things once more, and reexamine the original state of credit creation. Li Yang, Zhou Liping 11

3.1. Traditional credit creation mechanism: credit creation mechanism based on financial intermediaries

The traditional credit creation mechanism is exogenously driven: the central bank issues money and creates credit carriers, while commercial banks take deposits and at the same time evaluate borrowers’ credit ratings, price and allocate loans, and create new credit. The whole credit creation process ends with businesses or individuals repaying loans, and money is written off. The credit creation activities of commercial banks are a great application of the time value of capital born from the mismatch between the lengths of the deposit period and loan period. Only when the functions of depositing and lending are combined and the cycle of deposits— lending—derivative deposits comes into being, can the functions of credit creation be given full play. Besides this, Marx (1894) holds that banks have three ways to create capital: firstly, to issue bank notes; secondly, to issue a bill to be honored in London in 21 days but obtain the cash on issuing the bill; thirdly, to pay discounted bills, which have credit at least in relevant territory, first and mainly because the bills are endorsed by the bank. So instruments such as bills are also credit creation carriers, which played a leading role in the transition from metallic money to credit money and transforming to credit instruments and means of credit creation for commercial banks after the credit money system was improved. Mises (1971) holds that in a general sense commercial banks play two roles in the traditional credit creation mechanism: one being financial intermediaries, i.e., creating commercial credit with depositors’ savings to satisfy transactions in the real economy; the other being the channel, i.e., providing payment services. Here, the credit money supply and credit creation of commercial banks are two parallel and self-cycling processes, and once credit creation ceases the cycle ends. Credit creation of commercial banks is closely related to money supply. In modern societies, the primary channel of increasing money supply is credit creation by commercial banks. According to incomplete statistics, in most countries, credit creation by commercial banks accounted for 97% of the aggregate money supply, with the remaining 3% coming from central banks (Werner, 2011). In the traditional credit creation mechanism, modern central banks and financial market regulators have designed effective monetary policies and financial regulation instruments, including the legal deposit reserve ratio, liquidity ratio, advance ratio, deposit-loan ratio, capital adequacy ratio, etc. to restrict excessive credit creation in the banking system. The basic procedure of credit creation can be roughly described as follows: (commercial banks) taking debt-based funds such as deposits—limited deposit reserve system, credit evaluation, loan pricing and allocation—granting loans—loans transforming to deposits—re- granting loans…

3.2. Modern credit creation mechanism: shadow banking centered in the financial market

With the constant development of finance, credit creation agents have not been limited to 12 China Finance and Economic Review commercial banks. First various non-bank financial institutions gradually joined the ranks of credit creators, then the financial market itself, by constantly developing new transactions and increasing the liquidity of the financial market, gradually obtained the function of credit creation. These developments converged to form a new concept——shadow banking. Although shadow banking did not come to our attention until after the global financial crisis in 2007, it has been developing for over three decades. Up to now there is still no uniform definition of shadow banking in the academic world. In practice, many institutions (e.g. Financial Stability Board, FSB; Federal Reserve Board, FRB) tend to estimate the shadow banking system’s credit scale via the data of “other financial intermediaries” on flows-of-funds tables. This method implies a definition for shadow banks, i.e., they are credit intermediary entities or credit creation activities beyond regular banking system. To put it in a simple way, shadow banks are non-bank credit intermediaries. Non-bank credit intermediaries are still a very vague concept, as they can take a variety of forms in reality, it is still necessary for us to make a deep analysis. Considering the fact that the shadow banking system in the U.S. is relatively developed, we might as well use it as a model to make further divisions. In the U.S., the shadow banking system mainly consists of five parts. First are asset securitization arrangements that involve various institutions. Among them, mortgage- backed securitization institutions established by the federal government such as Freddie Mac and Fannie Mae play the most important role; meanwhile, among the securitization arrangements initiated by private institutions, investment banks play an important intermediary role. Second are market-oriented financial firms, such as money market funds, hedge funds, private equity funds, independent financial firms, and various private credit lending institutions. Third are structured investment entities, real estate investment trusts, asset-backed commercial paper channels, etc., which are mostly initiated by commercial banks or financial holding companies and constitute an indispensible part of those institutions. Fourth are financing and margin short-trading activities by brokers and market-makers, e.g., overnight repo. Fifth are all kinds of convenience payments, clearing, and liquidation, e.g., third-party payments. According to FSB’s statistics of “other financial intermediaries” on flows-of-funds tables of 25 jurisdictions globally and the Euro zone, the scale of shadow banking reached $27 trillion in 2002, rose to $60 trillion in 2007, and shrunk a little when the crisis broke out in 2008 but still amounted to as much as $56 trillion. When the crisis just subsided in 2011, the shadow banking system regained momentum and leaped to $67 trillion, by 2012 it had recovered to $71.2 trillion in 2012. In the year of 2012 the credit scale of shadow banking was equal to 117% of those 25 jurisdictions’ GDP that year. Within the financial system, credit created by shadow banking system accounted for 25% to 45% of the aggregate scale of the financial system. As far as functions and impacts are concerned, the shadow banking system differs greatly from traditional finance. As for the most fundamental function of finance, to create credit, traditional banking mainly depends on deposits, the granting of loans, and the creation of money. The shadow banking system, on the other hand, increases the velocity of circulation of traditional financial products by developing transaction activities and promoting liquidity of Li Yang, Zhou Liping 13 financial markets, or provides the economy with a steady flow of credit by “reframing” traditional financial products and services. In short, that the shadow banking system creates credit does not have a remarkable impact on the money stock, which is tightly pegged by monetary authorities. It is because of this that the development of the shadow banking system has not only eroded the traditional territory of commercial banks and even the whole traditional capital market, but also has fundamentally undermined the control of monetary authorities. It is apparent that the shadow banking system denies the theory of the money multiplier in traditional credit creation mechanism. The basic premise for the money multiplier to be effective is to assume that commercial banks are the only credit creating agents, but the existence of shadow banking system implies the existence of a new credit creation mechanism. This weakens and distorts traditional credit channels and prevents monetary authorities from smoothly conveying their policy intentions to real economy variables by regulating the deposit reserve ratio of commercial banks. In this way, the traditional money multiplier loses its practical significance, and fundamentally speaking, the regulatory foundation of monetary authorities is thus undermined. However, the independent credit creation mechanism of shadow banks can have a direct impact on capital supply and demand and its price on capital market and bridge the potential gap between monetary demand and supply. In contrast to commercial banks, the credit creation process of the shadow banking system is closely related to the development of the money market. The shadow bank credit creation process focuses on the money market. They depend on transactions of major, wholesale financial instruments to conduct capital circulation. It should be pointed out that there are no essential differences between this credit creation and the credit creation by commercial banks. But except for the period of the subprime mortgage crisis in 2007, in the past over 30 years, shadow banking institutions have never been qualified to obtain liquidity support from lenders of last resort, and they could not conduct transactions directly with the central bank. In turn, the scale of the under the rigorous control of the central bank cannot reflect the shadow banking system’s demand for high-powered base. So people cannot directly observe the effects of the shadow banking system’s credit creation on the money supply. But in the subprime crisis in 2007, FRB bought large quantities of the wholesale bond assets of shadow banks directly on the monetary market and thus increased the monetary base and expanded FRB’s balance sheet, providing a platform for shadow banking institutions to openly release and demonstrate their credit creation potential. This indicates that the effects of credit creation on the monetary market and monetary policies via the shadow banking system have reached an extent that cannot be ignored.

3.3. Further exploration into the credit creation mechanism

Traditional commercial banks and emerging shadow banking system are alike in that they both function as credit. Further analysis reveals that the reason the credit creation mechanism can accelerate money circulation and increase the flow of money is that it contains two basic features—maturity transformation and liquidity transformation. 14 China Finance and Economic Review

3.3.1. Maturity transformation

Maturity transformation is the core function of credit intermediaries, which means that commercial banks borrow short and lend long to carry out debt management, transform short- term into long-term assets and reach a balance between contract maturity of depositors’ deposits and loan contract maturity. Institutions with the function of maturity transformation are not limited to commercial banks; there are other non-bank financial institutions. Of course, not all non-bank financial institutions have this function. Such institutions can be called maturity transformation financial intermediaries. Early commercial bank franchise law monopolized the short-term debt of commercial banks—deposit taking. But with the development of the modern money market, the disadvantages of this passive debt of deposits emerged, depositing was replaced by various money market transactions, and commercial banks gradually depended on the money market to realize active debt. The maturity transformation pattern of traditional commercial banks is mainly “short-term debt + long-term claim”, including taking short-term deposits + granting long-term loans, short-term money market debt + granting long-term loans. Short-term money market debts include a variety of commercial papers with maturity less than a year, asset-backed commercial paper (ABCP), etc. The most fundamental function of maturity transformation is to create money and credit.1 Commercial banks create dual monetary claims via maturity transformation, i.e., depositors’ claims to commercial banks and commercial banks’ claims to borrowers. Dual claims solve the problem of information asymmetry and reduce transaction costs such as searching costs, which precisely demonstrates the most fundamental cause of the generation of money. Maturity transformation and maturity mismatch. Unsuccessful maturity transformation is maturity mismatch. Maturity mismatches may occur in commercial banks, thus leading to liquidity risks and interest rate risks, and may cause credit risks. But in most countries there is lender of last resort’s explicit guarantee against overall risks of the banking system, and maturity mismatch risks are not as large as they seem at first sight. Relatively speaking, non-bank financial institutions face bigger maturity mismatch risks, one reason being that their investments tend to be non-standard credit assets which are not effectively regulated or not regulated at all, the other reason being that these institutions are generally beyond the protection of the central bank’s financial network. More generally speaking, the security of maturity transformation is dependent on the agent’s credit, while the agent’s credit is dependent on the presence or absence and strength or weakness of its guarantee, the value of its long-term asset investment, or the value of its collateral.

1 From the perspective of credit creation, commercial banks’ investing in long-term bonds differs from granting long-term loans. Loans represent commercial banks’ credit; loans continuously create deposits, thus money derives from this, which is also the means by which commercial banks create credit. What bonds represent is not the credit of commercial banks but that of loan-granting agents, e.g., state credit, enterprise credit, etc. In this process commercial banks’ investments in bonds do not act as intermediaries of fund flow, so they have not created credit. Li Yang, Zhou Liping 15

Maturity transformation of shadow banks in the U.S. takes place on the money market, so it has a typical credit creation function. Shadow banking institutions conduct ultra-short and short-term financing from institutions like money market funds via instruments like the ABS channel mechanism, the asset-backed commercial paper market, and repurchases, and after a dazzling chain of derivatives eventually invest in credit assets with maturities longer than that of their debts. The shadow banking system’s maturity transformation also creates multiple money claims—various money market instruments such as ABCP and monetary market funds. As far as the function of credit creation that they possess is concerned, they are typically quasi-money. As the fastest-developing emerging economy, China’s shadow banking system has made great strides in a short period. Shadow banks in China also lie between direct financing and indirect financing and the banks’ operating functions include: issuing money claims to investors (trusts, funds, and finance products), granting loans, i.e., short-term claims, and mid-term and long-term loans. The financing means of shadow banks tend not to be debt contracts, but a kind of financial market instrument containing monetary claims (mainly trusts, funds, and finance products) and bonds, and the assets are non-standard credit assets like indirect financing market credit. But in terms of their financing and investment maturity and their profit patterns, shadow banks create credit, and long-term credit on the side of assets requires that shadow banks be equipped with the function of maturity transformation. Consequently, in essence, shadow banks in China with “short-term monetary claims + mid-term and long-term loans” function as maturity transformers.

3.3.2. Liquidity transformation

Liquidity transformation is the second core function of credit intermediaries. It is of the same process as maturity transformation. Commercial banks transform depositors’ non-liquid funds into liquid current deposits that can be drawn at any time, and meanwhile transform these liquid short-term liabilities once again into long-term assets which have relatively low liquidity but high yields, thus changing the liquidity state of assets twice. The history of developed countries indicates that more and more commercial banks have stopped passively depending on deposits to obtain funds and turned to the money market for financing as soon as “disintermediation” began. Although the liquidity transformation carriers of commercial banks changed to deposit substitutes such as finance products and monetary market funds, the process of liquidity transformation is not essentially different. In China, many non-bank financial institutions are also realizing liquidity transformation in the same pattern. Liquidity transformation is a process of creating credit and creating liquidity. Meanwhile, liquidity transformation is also a process of taking liquidity risks. Hence, this transformation process is accompanied by certain liquidity risks and premium income. The main forms of liquidity risks are that depositors may withdraw their deposits at any time, thus exposing commercial banks to risks of failing to provide cash in a timely manner. The premium income of liquidity risks is generally known as the “interest spread”, which constitutes one of the 16 China Finance and Economic Review basic reasons for the existence of financial intermediaries and also the original profit source of commercial banks. With the development of modern e-commerce and the Internet economy, credit creation of non-bank financial intermediaries began to remove itself from dependence on commercial banks and came to an independent existence. The dazzling independent quasi savings accounts and quasi currency media of payment developed have replaced the traditional savings accounts and currency of commercial banks. It is worth pointing out that the scale of this credit creation is not indicated in money aggregate by central bank statistics, but it is in practice affecting the development of the real economy. It is obvious that credit creation activities by non-bank financial intermediaries have posed severe challenges to the macro-control efforts and financial stability of all nations.

4. Macro-effects of credit creation

Analyzing the macro effects of credit creation requires first clarifying the relationship between credit and money.

4.1. The basic relationship between money and credit

Under a credit money system, credit creation is closely related to the money supply. The main reflection of this relationship is that credit and money are both mutually substitutive and supplementary in practical economic transactions. Concerning the relationship between money and credit, between money supply and credit creation, Schumpeter (1954) was the first to sort out two classic analyses with different logic— the monetary theory of credit and credit theory of money. Monetary theory of credit holds that the premise by which to analyze credit is to define money. Based on studies of the evolution of the trading and payment system, the monetary theory of credit concludes that money precedes credit. Built on historical facts, the monetary theory of credit decides on the following analytical logic: first giving a proper definition of money and investigating the relationship between commodity flows and monetary flows in economic transactions, then abstracting the definitions of money, quasi money, and credit and clarifying their differences and relationships. As a money analysis framework, the monetary theory of credit attempts to explain the roles that various monetary instruments (money and quasi money) play in the two separate processes of transaction and intermediation and their interrelations. The credit theory of money is the opposite, which holds that defining credit should come before defining money, so credit should be used to explain and analyze money. For example, Schumpeter (1954) maintains that whether from the perspective of practice or economic analysis, the credit theory of money is superior to the monetary theory of credit. Classical economists such as Walras, MacLeod, and Wicksell, and new Keynesians including Stiglitz, Greenwald, and Bernanke tend to view money problems from the perspective of credit. Hence, the credit Li Yang, Zhou Liping 17 theory of money has become one of the foundations on which many scholars have built their macroeconomic analysis frameworks. Among the proponents of the credit theory of money, Wicksell is undoubtedly the most creative. He proposes a pure credit system, i.e., a pure accounting system of exchange, and describes this system’s operating process. He suggests proceeding from a study of money from payment instruments other than money, such as credit and quasi credit, and thus asserts that the nature of money is credit. This assertion is undoubtedly innovative, but unfortunately Wicksell did not go further to give a more complete credit theory of money. It is necessary to point out that neither the monetary theory of credit nor the credit theory of money has proposed a uniform and complete theoretical system; they are merely logical thoughts or concepts at most. However, the more the modern financial system develops, the closer we get to the “pure credit system” established by Wicksell. We can distinguish two situations concerning the relationship between credit and money. One situation is that credit creation directly causes the simultaneous increase in money flow and amount. In this situation, credit creates money. The other situation is that credit creation does not change the amount of money, but accelerates money circulation thus increasing money flow. Under this situation, the generation of credit does not correspondingly create money. It is precisely because of the above two situations that the credit theory of money is superior to the monetary theory of credit.

4.2. The effects of credit creation on the real economy

Has credit creation had any effect on the real economy? On this issue nearly all supporters of the credit theory of money, such as Schumpeter, Wicksell, Hahn, Mises, and Hayek, give a positive answer. But as to the mechanism by which credit creation affects the real economy, there are certain differences among the various parties. Innovation and credit are key factors in Schumpeter’s theory of economic growth. In the view of Schumpeter (1934), bank credit sustains the periodic developments of the real economy, and bank credit follows the course of creation and writing-off in turn, corresponding to the stages of boom and bust in economic development. Then, are the ups and downs of bank credit the key factors disturbing real economy equilibrium? As to this question, Schumpeter and Wicksell share the same view. They both believe that commercial investment choices that disturb the equilibrium of the real economy come from technological progress. To take it further, does credit creation necessarily promote the development of production in the real economy? Schumpeter believes that the key to the question depends on where the newly-created credit expands: if it expands to innovative fields with unsaturated markets, it will promote the development of the real economy; if not, excess will follow and the consequence of credit creation are inflation and reallocation of social wealth. Mises and Hayek believe that commercial investment choices that truly disturb the equilibrium of the real economy stem from changes in interest rates, while the latter is determined by bank credit. German economist Hahn (1920) maintains that “capital formation is the outcome of credit, not 18 China Finance and Economic Review of savings, and to deduce from this, every expansion of credit at the same time means changes in credit allocation, and will eventually lead to the expansion of commodity production. Without credit expansion, these commodities cannot be produced, so credit expansion’s role in production is similar to ‘creating something out of nothing’. ” But Hahn points out at the same time that this assertion’s validity is not unconditional. Only when there are economies of scale and in a large quantity of potential labor reserve, i.e., production maintains adequate elasticity, can credit expansion lead to production expansion.

4.3. Effects of credit creation on aggregate price level

Does credit expansion necessarily lead to inflation? As an advocate of theory of credit intermediation, John Mill holds that bills like and checks do not affect prices by themselves; it is credit that affects prices. Credit has an identical purchasing power to money, and changes in its quantity and velocity of circulation can have an effect on prices. Proponents of theory of credit creation hold an opposite view. On this issue, Hahn, inheriting and developing Schumpeter’s view, discriminates between normal credit (credit with the support of savings) and abnormal credit (credit without the support of savings). Normal credit is also called non- inflationary credit while abnormal credit is called inflationary credit. MacLeod (1893) holds that an increase in bank credit has the same effects as an increase in the quantity of (money), and expansion of money credit will cause an infinite fall of the interest rate. If newly-added money is all used to purchase goods, then prices will inevitably rise; if newly-added money is all used to purchase bonds, prices of bonds will inevitably rise and at the same time interest rates will fall; if some of the newly-added money is used to purchase goods and another portion is used to purchase bonds, then there will be both a rise in prices and a fall in interest rates. Hahn (1928) holds that credit creation means an increase in money. First, both the central bank issuing banknotes and commercial banks creating deposit currency increase the money supply, and an increase in the money supply means an increase in purchasing power, which is eventually shown as an increase in demand. With supply assumed constant, increasing demand will drive up prices. Second, with credit expansion, the interest rates of loans will inevitably fall, and entrepreneurs’ financial costs will fall, enabling them to obtain excess profits, expand, and thus create additional employment. Next, with credit expansion, investments increase, thus prolonging roundabout production. In summary, Hahn believes that credit expansion is the basic cause of economic booms.

4.4. The relationship between credit creation and financial crisis

The Austrian school, with Mises and Hayek as representatives, proposes the theory of “forced saving—boom—bust” and based on this theory expounds upon the close relationship between bank credit creation and economic crisis. Li Yang, Zhou Liping 19

Mises analyzes the mechanism by which credit creation impacts the macro-economy in detail. An increase in credit money directly causes money depreciation and a rise in prices. Ensuing forced saving effects increase capital accumulation, reduce interest rates (Mises, 1923), and lead the economy into an upswing. With market demand increasing, commercial banks will keep raising interest rates of money and continually supply credit. The natural rate of interest rises at the same period, but its rate of increase is lower than that of the money rate of interest. There appear situations of prices rising, interest rates rising, wages rising, profits rising, and stocks reducing in the economic boom. However, when banks begin to alter the velocity of credit creation and stop reducing natural rates of interest, and to such an extent that is sufficient for market investors to change their expectations, the velocity of credit creation gradually weakens and the boom in the real economy will end and head for economic crisis. To summarize, in their opinion, the economic cycle of boom and bust originates from bank credit creation and its changes. In short, if banks do not expand credit or hold the money rate of interest below the natural rate of interest, equilibrium will not be disturbed. Naturally, economic development and subsequent economic bust will not appear either. Hayek (1958) holds that credit creation groundlessly increases money in circulation, which inevitably leads to a rise in prices. With the same amount of money consumers can only get less consumption; a decrease in the means of consumption causes a relative increase in the means of production, and production scale expansion and changes to the production structure become possible. When production scale expands, consumer incomes increase, their consumption recovering to the original level, and a sudden reduction in production will inevitably lead to economic crisis. Keynes (1936) is disapproving of this, and he denies Hayek’s analytical framework, arguing that whether the savings coming from bank credit are forced savings should be judged under the standard of savings under full employment. Savings can be called forced savings when actual savings exceed this standard, otherwise they are not forced. The global financial crisis beginning in 2007 once again opened discussions in the academic world about credit creation and its relationship with crisis. Among the researchers, Werner’s research is representative. Werner (2009) classifies credit creation into consumptive, productive, and speculative. He maintains that subprime mortgage market in the U.S. since 2004 has been dominated by speculative credit creation. The basic relationship between credit creation and financial crisis is: credit is created— asset prices rise—corporate balance sheets improve— collateral values rise—positive macroeconomic outlook—banks increase loan-to-valuation ratios and are more willing to lend—credit is created. Hereby, credit creation forms a complete positive feedback loop, propelling the appearance of asset price bubbles. However, at the Minsky moment this feedback loop begins to reverse: credit creation falls—a credit crunch and bankruptcies appear—the unemployment rate rises— aggregate demand and economic growth rate fall and there is deflation— bad debts increase—banks become more risk averse and shrink risk assets— credit creation falls. These two distinct processes of credit creation swelling and shrinking correspond to the boom and bust of the economic cycle as well as the generation and burst of asset price bubbles and, thus inherently form financial crises. 20 China Finance and Economic Review

According to the above theory, in a sense, economic crisis originates from credit creation. The question that needs further analysis is: what is the limit to credit creation (or expansion) and why will it end? Hayek’s (1931) explanation is that in a closed economic system, credit expansion will cause a progressive rise of prices. The progressively rising prices and ensuing risks of complete collapse of the monetary system are obstacles that cannot be overcome, so credit expansion cannot continue without bounds. The above theory of the Austrian school contains certain rationality. It provides the perspective by which to understand the relationship between bank credit creation and economic crisis. But obviously, whether under the commodity money system, the gold standard, or modern credit money system, bank credit expansion is one of the causes of economic crisis. Of course, it is not the only one.

5. Summary

The theory of credit creation concerning commercial banks including the credit creation process of commercial banks, scale and control, macroeconomic effects, its relation with financial stability, etc., has been elaborated upon in the economic and financial theories of the twentieth century. But with financial markets flourishing and the modern shadow banking system developing, the credit creation mechanism has undergone substantial changes; new agents and new means of credit creation have appeared, and at present it is still difficult for us to say that we are quite clear about their effects on the financial system and macroeconomic system. The review and analysis of literature on credit creation in this paper is basically conducted from the perspective of money. This is just one angle by which to understand credit creation. In theory there are other angles, e.g., capital, by which to analyze credit creation. At present whether in developed economies or in emerging economies, the credit creation mechanism is continuously making innovations based on internal market demands, which makes the liquidity supply of financial systems quite elastic. This does not mean that financial systems can create credit as they like; a number of other factors, mainly capital requirements and the reality that financial institutions are generally short of funds, effectively restrain the ability of financial institutions to create credit. In this way, from perspectives other than pure money, to deeply explore the basic relationship between credit creation and capital creation, financial stability and macroeconomic development may turn a new chapter in the research on credit creation.

References

Arestis, P. & P. Howells (1996). Theoretical reflections on : the problem with ‘convenience lending. Cambridge Journal of Economics, 20, 539-551. Ci Hai Editorial Board. (1980). Ci hai (An unabridged, comprehensive dictionary). Shanghai Li Yang, Zhou Liping 21

Lexicographical Publishing House.(In Chinese) Cochran, J., S. Call & F. Glahe. (1999). Credit creation or financial intermediation? fractional reserve banking in a growing economy. Quarterly Journal of Austrian Economics, 2, 53-64. Gorton, G. & P. He. (2008). Bank credit cycles. Review of Economic Studies, 75(4), 1181-1214. Haberler, G. (1937). Prosperity and depression: a theoretical analysis of cyclical movements. Central Compilation & Translation Press, the 2011 edition.(In Chinese) Hagemann, H. (2010). L. Albert Hahn’s economic theory of bank credit. Vienna University of Economics and Business Working Paper, 134. Hagerty, J. (1913). Mercantile credit, New York: Henry Holt and Company. Hahn, L. (1949). The economics of illusion. A critical analysis of contemporary economic theory and policy, New York: Squier Publishing. Hahn, L. (1920). Volkswirtschaftliche theorie des bankkredits, Tübingen 1920: J.C.B. Mohr (Paul Siebeck); 2nd ed. 1924; 3rd rev. ed. 1930; Italian translation as Teoria Economica del credito, edited and introduced by Lapo Berti, Naples 1990: Edizioni Scientifiche Italiane. Hayek, F. (1931). Prices and production. London: Routledge & Kegan Paul. Hayek, F. (1958). Prices and production. Shanghai: Shanghai People’s Publishing House.(In Chinese) Hayek, F. (1966). Monetary theory and the trade cycle. Clifton, N.J.: Augustus M. Kelley. Original German 1929. Hicks, J. (1956). Methods of dynamic analysis in Money, Interest and Wages: Collected Essays on Economic Theory, Vol. II, Oxford: Basil Blackwell, 217-235. Kemmer, E. (1903). Money and credit instruments in their relation to general prices, New York Henry Holt &Co. Kindleberger, C. P. (1984). A financial history of Western Europe. China Finance Publishing House, the 2007 edition.(In Chinese) Kynes, J. (1936). The general theory of employment, interest, and money. Atlantic Publishers & Distributors (P) Limited. Liu, X. (2010). Foreign monetary and financial theories. China Finance Publishing House.(In Chinese) Machlup, F. (1940). The stock market, credit and capital formation. Vera C. Smith, trans. London: William Hodge. Macleod, H. (1889). The theory of credit, Longmans, Green and Co., London. Marx, K. (1867). Das kapital, Band I, Engl. trans. by Ben Fowkes of the fourth edn (1984) Capital, Vol.1. Harmondsworth, Penguin. Marx, K. (1885). Das kapital, Band II, Capital II. Harmondsworth, Penguin. Marx, K. (1894). Das kapital, Band III, Capital III. Harmondsworth, Penguin. Melrose, C. (1980). Money and credit, London: Pall Mall, W. Collins Sons& Co, Ltd. Mises, L. (1912). The theory of money and credit, trans. H.E. Batson (Indianapolis: Liberty Fund, 1981). Mises, L. (1923). On the manipulation of money and credit. Bettina Bien Greaves, trans. Percy L. 22 China Finance and Economic Review

Greaves, Jr., ed. Dobbs Ferry, N.Y.: Books, 1978 edition. Mishkin, F. & Eakins, S. (2006). Financial markets and institutions. New York, Pearson. Moore, B. (1988). Horizontalists and verticalists: the macroeconomics of credit money, New York: Cambridge University Press. Moore, B. (1989). On the endogeneity of money once more. Journal of Post Keynesian Economics, 11, 474-478. Pollin, R. (1991). Two theories of money supply endogeneity: some empirical evidence. Journal of Post Keynesian Economics, 3, 366-396. Rivoire, J. (1992). Banking history. Commercial Press.(In Chinese) Schneider, E. (1952). Hahn contra Keynes. Schweizerische Zeitschrift Für Volkswirtschaft und Statistik, 88, 395-404. Schumpeter, J. (1931). The theory of the business cycle. Keizaigaku-Ronshu Journal of Economics, 4, 1-32. Schumpeter, J. (1934). The theory of economic development: an inquiry into profits, capital, credit, interest, and the business cycle, Cambridge, Mass.: Harvard University Press, Reprint Oxford University Press 1980. Schumpeter, J. (1939). Business cycles: a theoretical, historical and statistical analysis of the capitalist process. New York: McGraw-Hill. Schumpeter, J. (1954). History of economic analysis. Great Britain: Allen & Unwin (Publishers) Ltd. Selgin, G. (1988). The theory of free banking: money supply under competitive note issue. Totowa, N.J.: Rowman and Littlefield. Selgin, G. (1996). Bank deregulation and the monetary order. London: Routledge. Selgin, G. & L. White. (1996). In defense of fiduciary media—or, we are not devo(lutionists), we are misesians. Review of Austrian Economics, 9, 83-87. Sprague, O. & W. Burgess. (1929). Money and credit and their effect on business. Recent Economic Changes in the United States, Volumes1 and 2, NBER. Taylor, W. (1922). The credit system, New York: The Macmillan Company. Thornton, H. (1939). An enquiry into the nature and effects of the paper credit of Great Britain. London: George Allen and Unwin. Walsh, C. (2003). Monetary theory and policy. Cambridge, MA, MIT Press. Werner, R. (2009). Central banking and the governance of credit creation, In Where Next for International Financial Regulation? Copenhagen, DK, Danish Institute for International Studies. Werner, R. (2011). Economics as if banks mattered: a contribution based on the introductive methodology. Future of Macroeconomics, 25-38. Wilbur, A. (1903). Money and credit. New York: The Grafton Press. Zhou, L. P. (2011). Does the money multiplier still exist? Studies of International Finance(Guoji Jinrong Yanjiu), 1, 16-25.