German economics students gently rocking the boat

One may ask what took them so long? Anyhoo, here they are:

Open Letter: Rethinking the Role of Banks in Economics Education

Dear Economics Professors and Teaching Staff,

Banks and their role in the creation of money are integral to our modern, financialised economies. Yet, the teaching economics students receive doesn’t give them the full picture. As those with the power to influence the next generation of economists, it is essential that you review the teaching of the role of banks in economics courses and bring it in line with up-to-date research. Our economics graduates need to understand how banks function in the real-world, in order to avoid past crises and to create better economies in future. 

What is currently taught?

Economics textbooks across the world, some of them first published in the 1960s, continue to teach students a model of the monetary system in which commercial banks act as intermediaries, that only move existing money around the system, like lubricant in a machine. Many economics courses rely on the models in these textbooks, without recognising the empirical evidence that undermines them. This gives an unbalanced view of the way the monetary system functions and of the role of banks in the economy.

How is money created?

As research from the Bank of England, Bundesbank and numerous academics has shown, banks are not intermediaries channelling pre-existing funds from savers to borrowers. Commercial banks create the vast majority of money in circulation. Unlike other financial institutions, they create money when they extend loans to borrowers. In the process of extending a loan, banks do not move pre-existing funds from any other account but newly ‘invent’ the money by crediting the borrower’s account. Therefore, banks’ lending is constrained by borrowers’ demand, profitability considerations and financial regulations, not by pre-existing funds (i.e people’s savings) nor by central bank reserves. This reality is in line with the credit creation or endogenous money theory, which is absent from most current economics textbooks and teaching.

Commercial banks also determine where money is directed in the economy. Around 80% of new money created in countries like the US and UK currently goes towards existing property and financial markets, rather than the ‘real’ or productive economy, leading to soaring house and land prices, and housing crises. In the Global South, 33 major global banks poured $1.9 trillion into fossil fuels since the 2015 Paris Climate Agreement, directly influencing the trajectory of economies that will be hit first and hardest by climate change. The power of banks to create money therefore has enormous implications for the shape and stability of our economy. Yet, in an overwhelming number of cases, economics textbooks and courses do not teach this to the economists of tomorrow.

What are the consequences of this teaching?

These models, taught without balance or regard for existing evidence on the financial sector, lead economics graduates – who often gain influential positions in society – to draw flawed conclusions. One example is the misconception that in order to increase investment in the economy we need to encourage people to save money first. Other misconceptions that arise are that money is a scarce resource and that public investment always ‘crowds out’ the private sector.

Furthermore, a main driver of the 2008 global financial crisis was the build-up of debt and credit by the private sector, as banks lent unprecedented amounts to property and financial markets. The crash was unanticipated by the majority of academic economists. This was in no small way influenced by blind spots regarding the power of banks to create money and influence the wider economy.

The same theories that led to these blind spots are still being uncritically presented to economics students 11 years on. When real-world evidence demonstrates that banks function a certain way, why is this not taught to students? Any decisions these students take in their future careers – from financial regulation, to approaching issues like asset price bubbles or unproductive lending – will be influenced by their education at university.

Full letter here.

There is also an extended version. Conspicuously, German rock star economists Fratzscher and Fuest (cough) are not among the signees.