Policy Research in Macroeconomics

Today’s revival of monetary theory should lead us towards, not away from Keynes

A review essay of R. A. Werner (2015) ‘‘Do banks really create money out of nothing? Another empirical test of the three theories of banking”, International Review of Financial Analysis.[1]

In my own particular field, a new book or article by Keynes was a target on which all converged if one could make a valid criticism of Keynes, one’s stock automatically rose. There was nothing to be gained by praising an idea of Keynes.

Memoirs of New Deal economist Lauchlin Currie, referring to his time from 1925 to 1934 in Harvard (Sandilands, 2004, p. 198)

*     *     *     *   

Since the economic crisis there has been a revival of interest in the nature and creation of money. The work restores a literature that developed significantly from the start of the twentieth century, though that extends back at least three centuries through various occasional and often individual contributions (not least around the time the Bank of England was founded in 1694). Correspondingly there is recognition that the dominant or mainstream school of economic thought has been based on erroneous theories of money for at least half a century.  

In contrast, a rich and deep understanding of money was the foundation to all of Keynes’s economics, from his earliest lectures (‘Money, Credit and Prices’ in 1908/09).[2] through to his plan for an International Clearing Union in the 1940s (amounting to a global central bank). But Keynes’s work was obliterated through the imposition of the IS-LM scheme, which in practical terms confined his initiative only to fiscal policy, and in theoretical terms had no material role for money (amongst many other things). The revival of interest in monetary theory should provide the opportunity to address again Keynes’s theoretical scheme and policies, but this is very far from the case.

While authors enjoy citing Keynes’s remarks and occasionally refer to specific processes he outlined, none even remotely do justice to the scale of his contribution. Indeed many are profoundly misleading, but Richard Werner’s latest (2015) paper in the International Review of Financial Analysis plumbs new depths. In his version Keynes is blamed for the failures of understanding on the part of the profession today, and the profession implicitly steered away from Keynes’s contributions.

This is achieved through a highly superficial and selective interpretation of Keynes’s analysis, as well as ignoring any subsequent literature. Keynes is charged effectively with equivocating between Werner’s classification of the three opposing views of banking:  ‘financial intermediary’, ‘fractional reserve’ and ‘credit creation theory of banking’.

The situation has not been helped by the fact that some influential authors, such as Keynes or the Bank of England, have been supporting all three mutually exclusive theories at one point or another. (p. 18).  

Werner selects quotes that might at a stretch be construed as supporting his argument, but avoids any considered view of what Keynes was actually trying to argue.

That said, few have come to Keynes’s defence. In particular post-Keynesian economists have fought hardest in Keynes’s corner (not least over uncertainty and equilibrium), but they have fought less hard over his understanding of money. IS-LM may have been taken to task on its failure to incorporate credit, but the theory of money is often seemingly regarded as a new development in post-Keynesian economics, rather than Keynes’s own. However, some recompense is now being made.

But even given the grave shortcomings in the literature in this area, Werner’s account amounts to a grave misrepresentation of the facts and should not be taken seriously.   

Werner’s account

Werner begins with the ‘financial intermediary’ theory; a list of ‘proponents’ begins with a reference to the General Theory. He argues:

Keynes’ (1936) General Theory argues that for investments to take place, savings first need to be gathered. (p. 6)

Yet surely everybody knows that Keynes changed the worldview of a ‘saving’ dog wagging an ‘investment’ tail to an investment dog wagging a saving tail:

Saving, in fact, is a mere residual. The decisions to consume and the decisions to invest between them determine incomes. Assuming that the decisions to invest become effective, they must in doing so either curtail consumption or expand income. Thus, the act of investment in itself cannot help causing the residual or margin, which we call saving, to increase by a corresponding account. (Keynes, 1936, p. 64)

Moreover, the investment decision can be effective through money creation.

Next Werner goes for A Treatise on Money: “Keynes (1930) is not a beacon of clarity on this important topic”. Keynes is associated with the fractional reserve (i.e. money multiplier) view, first because he cites two authors who allegedly take this approach:

“… he supports the fractional reserve theory, citing both Phillips (1920) and Crick (1927) approvingly (p. 25)” (p. 9).

The charge follows from Phillips and Crick taking a system-wide view of the credit creation process, with Werner seeing this as synonymous with fractional reserve. But this is wrong. He does not even cite how Keynes incorporated the same processes into his own account:

…[T]here is no limit to the amount of bank-money which the banks can create safely provided that they move forward in step. The words italicised are the clue to the behaviour of the system. Every movement forward by an individual bank weakens it, but every such movement by one of its neighbours banks strengths it; so that if all move forward together, no one is weakened on balance. (Keynes, 1930, p. 26)

This is a fundamental step in explaining the nature of credit creation, as Werner once recognised himself (Ryan-Collins et al, p. 65). But now he claims that inherent to such a process is a denial that a single bank can create credit, which simply does not follow. (In the above passage, Keynes says “create safely” – he does not just say “create”!) And of course, in reality, the system does move forward together; that is why booms last so long.

Keynes is then taken to task for discussing “the concept of money ‘creation’ by referring to any increase in bank deposits as the ‘creation’ of deposits” (p. 9).

Werner seeks to claim that Keynes has in mind the kind of deposit-led process that underpins the fractional reserve account (where the money multiplier process is triggered by an initial deposit of unknown origin). But Keynes was perfectly clear about the two circumstances under which an increase in deposits might come around:

In the first place it creates them in favour of individual depositors against value received in the shape either of cash or of an order (i.e. a cheque) authorising the transfer of a deposit in some bank … But there is a second way in which a bank may create a claim against itself. It may itself purchase assets … Or the bank may create a claim against itself in favour of a borrower, in return for his promise of subsequent reimbursement; i.e. it may make loans or advances. (Keynes, 1930, p. 24)

It is quite bizarre to suggest that his using the idea of deposit creation or even simply the word ‘deposit’ is analogous to adhering to a money multiplier process. Moreover it would seem a moot point whether deposit or credit creation is a better description of what is going on.

The historical literature

The commentary on Keynes’s (1930) Treatise on Money is unambiguous. The work was two-sided: first a restatement of the theory of money, and second a (ultimately unsuccessful) theory of the economy.

On the former, his account was the fullest and most sophisticated account that had been set out to date. Sir Josiah Stamp, statesman and administrator par excellence, gave the highest praise in a review for the Economic Journal. This extract captures Keynes’s contribution to the theory of the creation of money:

In a complete treatise, Mr. Keynes necessarily has to deal with aspects ancillary to his main thesis, and there are, therefore, various chapters which do not contain the same note of originality as others. But, even in these, his touch and treatment are fresh and distinctive, nowhere is he merely summarising or recording existing material, for he brightens, retests, criticises and adorns. … Book I opens with a classification of money and bank money, where appears a discussion of the controversy, partly verbal, as to how and by whom bank deposits are “created,” … (Stamp, 1931, p. 243)

Some years later Joseph Schumpeter summed up Keynes’s contribution to the theory of credit creation in his highly-regarded History of Economic Analysis:

Nevertheless, it proved extraordinarily difficult for economists to recognize that bank loans and bank investments do create deposits … And even in 1930, when the large majority had been converted and accepted that doctrine as a matter of course, Keynes rightly felt it necessary to re-expound and to defend the doctrine at some length, and some of its most important aspects cannot be said to be fully understood even now …

For the facts of credit creation – at least of credit creation in the form of banknotes – must all along have been familiar to every economist. (Schumpeter, 1954, pp. 1114–15)

Even those scholars who take Keynes less seriously tend to concede the sophistication of the analysis in the Treatise; I have never before come across Werner’s complaint. Perhaps Keynes’s analysis is less than perfect, but anybody who has written about credit creation must know how damn difficult it is.

The General Theory is a different matter, being commonly regarded as a retrograde step in terms of monetary analysis. The rot may have begun with Schumpeter:

The deposit-creating bank loan and its role in the financing of investment without any previous saving up of the sums thus lent have practically disappeared in the analytic schema of the General Theory, where it is again the saving public that holds the scene” (ibid., n. 5).

Post-Keynesians have played a peculiar role here. Beyond the wider position on IS-LM, some of their number, notably Nicholas Kaldor and later Basil Moore explicitly pursued this critique.[3] Here is a typical example: “In the heat of the debate Keynes appears to have completely forgotten his endogenous credit money model of the Treatise” (Moore, 2012, n. 45, p. 504). For post-Keynesians the debate was between endogenous money (corresponding broadly to Werner’s credit creation) and the mainstream exogenous money position (corresponding either to financial intermediary or fractional reserve).

It has always struck me as ridiculous to suggest that an economist could forget the nature of money, and even more ridiculous coming from an economist who claims to understand money himself or herself : for to understand money is surely a revelation not to be forgotten. Werner even cites a (1924) passage that makes this obvious:

Yet the almost revolutionary improvement in our understanding of the mechanism of money and credit and of the analysis of the trade cycle, recently effected by the united efforts of many thinkers, may prove to be one of the most important advances in economic thought ever made. (Keynes, 1924, p. 68)

And sees “Keynes giving the impression of recent convert whose eyes had been opened” (p. 16), though as on page 1 above they were opened by at least 1909/10. He spent the next 20 years fighting with mainstream figures who resisted these ideas, most notably Edwin Cannan, professor of economics at the LSE (at whom the above extract was aimed; the preceding sentence: “Professor Cannan is unsympathetic with nearly everything worth reading – as it seems to me – which has been written on monetary theory in the last ten years”). The idea that Keynes reverted to a non-monetary economy is akin to suggesting that Newton set his theory of gravitation in a system where the sun revolved around the earth. Or that Darwin later reverted to Adam and Eve.

Moreover Keynes is very clear in the Preface:  “… whilst it is found that money enters into the economic scheme in an essential and peculiar manner, technical monetary detail falls into the background” (Keynes, 1936, p. xxii). With the General Theory, the central preoccupation had become the theory of money as a store of value (liquidity preference), but this was still in the context of a credit economy. He was writing for an audience that was completely comfortable in that context, and I for one cannot see how the General Theory can be properly understood apart from that context. The index includes an entry: “Banking system –”, the first sub-heading “and the creation of credit, 81-5”; contrast the following extract with Schumpeter’s claim above:

The notion that the creation of credit by the banking system allows investment to take place to which ‘no genuine saving’ corresponds can only be the result of isolating one of the consequences of the increased bank-credit to the exclusion of the others. If the grant of a bank credit to an entrepreneur additional to the credits already existing allows him to make an addition to current investment which would not have occurred otherwise, incomes will necessarily be increased and at a rate which will normally exceed the rate of increased investment. (Keynes, 1936, p. 82)

Werner and other contemporary literature

Now Werner knows this: his citation of 1924 quote is via a paper I wrote for the Bank for International Settlements (Tily, 2012).[4] Here I make exactly this point, as well as covering the above ground as backdrop to a fuller account of Keynes’s theory of interest. 

Obviously it is Werner’s prerogative to disagree, but he simply ignores the existence of my argument. He ignores also the whole of the post-Keynesian literature, within which the nature of money has been debated for at least 60 years.  He ignores also corresponding contributions from sociologists, notably today Geoffrey Ingham and before him Georg Simmel and Mitchell Innes. He champions only contemporary contributions on credit creation from the Bank of England (even though they are – justly – also charged with equivocating between theories both in the present and past), the IMF and the new economics foundation (of which Werner is one of four co-authors – Ryan Collins et al, 2009).

It is obviously a good thing that economists are waking up to the nature of money, but some are not doing so with an open mind and respect for wider scholarship past and present.  The recent, important, contributions from the Bank of England (e.g. McLeay et al, 2014) also fall short in not recognising Keynes’s contribution, though they at least avoid slinging any mud.  Interestingly there is no sense of Keynes equivocating in the NEF book, which opens with a quotation from Keynes’s Treatise on Money, presumably regarded as aptly setting the scene for the reader’s coming journey:

I feel like someone who has been forcing his way through a confused jungle … But although my field of study is one which is being lectured upon in every University in the world, there exists, extraordinarily enough, no printed Treatise in any language – so far as I am aware – which deals systematically and thoroughly with the theory and facts of Representative Money as it exists in the modern world. (Keynes, 1930, pp. vi-vii)

My BIS article goes on to argue about the manner in which Keynes’s theory and policy has been dismissed and what has been lost. And this of course is the fundamental concern. Old truths are being relearned, but right at the start Keynes is ruled out as irrelevant to the new version of the science.

The reality is that for the duration of the inter-war period, the economics profession had a sophisticated understanding of the nature of money. Keynes’s contributions were at the cutting edge. The whole of the science was lost thanks to the post-war consensus in academic economics, and in particular the imposition and dominance of the IS-LM model which had no material role for money.

With the move from IS-LM to monetarism, the profession’s understanding of money remained primitive and so it has remained through to the present. It beggars belief that someone would want to blame Keynes for this state of affairs. Though, as discussed, even post-Keynesians have hardly done Keynes justice in this fundamental area, with the notable exceptions of Professors Sheila Dow and Victoria Chick (e.g. Dow, 1997 & Chick, 2001). Only in 2006 did Geoff Harcourt (p. 67) finally concede that “Kaldor was wrong” to charge Keynes with exogenous money (i.e. with the financial intermediary or fractional reserve theory). 

Keynes’s understanding of money led finally to a fundamentally new theory of macroeconomics. The theory prescribed a radical different monetary system, not least a rejection of financial liberalisation and instead involving a far more significant role for public authority in the management of money. Ultimately Werner’s account is detrimental to any revival of monetary theory and policies that in my view remain of the most profound importance. 


[1] Page references are to the on-line version.

[2] Extracts from notes for his early lectures are included in Chapter 5, Volume XII of Keynes’s Collected Writings.

[3] I gave a fuller history of the post-Keynesian approach at the 2007 conference of the Association for Heterodox Economics: Keynes, the Post-Keynesians and the Curious Case of Endogenous Money  

[4] Keynes, Moggridge, 1983, p. 419, as quoted by Tily, 2012.


Chick, Victoria. 2001. ‘Varieties of Post Keynesian Monetary Theory: Conflicts and (Some) Resolutions’, paper for the Annual Conference of the Association for Heterodox Economics, July 2001.

Dow, S. C. 1997. Endogenous Money, in G. C. Harcourt and P. A. Riach (Eds.), A ‘Second Edition’ of The General Theory, London: Routledge.

Harcourt, Geoff (2006) The Nature of Post-Keynesian Economics, Cambridge University Press.

Keynes, J. M. (1924) ‘A Comment on Professor Cannan’s Article’, Economic Journal, Vol. 34, No. 133, March, pp. 65-68.

Keynes, J. M. (1930) A Treatise on Money, Volume 1, Basingstoke: Macmillan.

Keynes, J. M. (1936) The General Theory of Employment, Interest and Money, Basingstoke: Macmillan.

McLeay, Michael, Amar Radia and Ryland Thomas (2014) ‘Money creation in the modern economy’, Bank of England Quarterly Bulletin, 2014 Q1, 14-27.  

Moore, Basil John (2006) Shaking the Invisible Hand: Complexity, Endogenous Money and Exogenous Interest Rates, Basingstoke: Palgrave Macmillan.

Ryan-Collins, Josh, Tony Greenham, Richard Werner and Andrew Jackson (2011) Where does money come from?, New Economics Foundation. 

Sandilands, Roger J. (Ed.) (2004), ‘New light on Lauchlin Currie’s monetary economics in the New Deal and beyond, Journal of Economic Studies, 31, Number 3.

Schumpeter, Joseph A. (1954) History of Economic Analysis, Routledge: London.

Stamp, Josiah (1931) ‘Mr. Keynes’ Treatise on Money’, Economic Journal, XLI, 162, Jun., 241-49.

Tily, Geoff (2012) ‘Keynes’s monetary theory of interest’, Bank for International Settlements Papers No 65, Threat of Fiscal Dominance? BIS/OECD workshop on policy interactions between fiscal policy, monetary policy and government debt management after the financial crisis, May.

Werner, R. A. (2015) ‘Do banks really create money out of nothing? Another empirical test of the three theories of banking’, International Review of Financial Analysis (2015), doi: 10.1016/j.irfa.2015.08.014http://dx.doi.org/10.1016/j.irfa.2015.08.014

One Response

  1. "But Keynes’s work was obliterated through the imposition of the IS-LM scheme, which in practical terms confined his initiative only to fiscal policy, and in theoretical terms had no material role for money (amongst many other things)."

    Keyne’s work may have been obliterated through the imposition of the IS-LM scheme, however, in his letter of 31 March 1937, commenting on a draft of Hicks’ 1937 paper, Keynes wrote: “I found it very interesting and really have next to nothing to say by way of criticism.”

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