Attempts within Economics to develop a more complete theory of the banking system are broadly categorised under ”exogenous” theories where deposits create loans, and ”endogenous” or post-Keynesian theories where lending creates deposits. Interestingly many endogenous money authors continue the tradition set by Keynes of omitting loan repayment and default, and there seems to be a general aversion to presenting the historical context of a system whose rules vary considerably between time and place. The focus on credit also frequently overlooks the role of money in establishing the price level, and thereby providing a critical economic signal, and the unfortunate reality that credit and money are directly linked within the banking system is rarely addressed simultaneously. Although Minsky’s financial instability hypothesis does consider the role of financial debt relationships relative to financial activity, it does not consider the operational mechanics of the banking system in sufficient detail to uncover the intrinsic mechanisms for this instability.
Both theories of money contain accurate observations of some aspects of the banking systems’ behaviour, but neither offers a complete system analysis, and in a recursively defined system to debate whether loans create deposits or deposits create loans is quintessentially tautologous. Further problems are created by their inclusion within economic theories of supply and demand for money and credit, and definitions of money as debt that can be traced to the origins of money as bills of account. This is particularly noticeable with the proponents of monetary circuit theory and the idea that there is a demand for money and credit which determines the system’s behaviour. Certainly historically there have been periods where physical shortages of money caused significant problems. However one of the considerable advantages of the banking system was that it alleviated these issues, and discussion in particular of the demand for money tends to overlook the interaction with the price level that occurs when the money supply itself increases. Debates over the demand for credit also fail to consider that the system itself provides a very clear signal when insufficient demand occurs (it contracts), absent which behaviour it can be safely assumed that limits on loan supply are dominating.
Even a simple simulation of the textbook model with loan repayments suggests that this is a system whose behaviour is sensitive to many conditions, and it is probably this failure to consider the multiple and separate causes of gross macro-economic features such as price deflation and credit expansion originating from seemingly minor differences between banking systems that have created significant problems for any purely empirically based analysis. Determining how any given currency’s banking system will behave over time is challenging, complete and testable descriptions of their regulatory frameworks are not currently provided by any central bank. There is also considerable confusion in the monetary statistics themselves, with no consistency in either the measures being used, or the components used within them. The definition of M2 used for the Euro for example, is significantly different from that provided by the Federal Reserve Banks for the US dollar, and differs again from that used in other countries.
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