What is Leaf-Cannon Criticism of the Theory of Credit Creation?

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Dr. Walter Leaf and Dr. Edwin Cannon, however, raised a firm objection to the above analysis and contended that banks do not create credit or money at all.

According to them, it is incorrect to say that the initiative in the creation of credit lies with the banks; on the contrary, the initiative lies with the depositors whose money is loaned out by the bank.

Bankers cannot lend anything more than what is entrusted to them by the depositors. Walter Leaf being practical banker argued that when bankers create a deposit, the deposit amount is likely to be withdrawn sooner or later; hence it cannot grant loans beyond the cash deposited by the customer with it.

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Thus, in real terms, a bank cannot expand credits. Dr. Cannon in his book An Economist’s Protest has depicted the banking system in the form of a cloak room. Suppose 100 members attend a night club regularly and bring one umbrella each which they deposit at the counter of the club.

The man at the counter, by experience, knows that only 10 members demand umbrella during an hour, and may rent out the other 90 umbrellas for the duration of the night and make some money.

In such a case, can it be said that the counter-man created 90 umbrellas. Obviously no. Similarly, a banker, when he knows that all the depositors do not withdraw their money at the same time, may lend a part of the deposits.

But this does not mean that the bank has created money. “The most abandoned cloak room attendant cannot lend out more umbrellas than have been entrusted to him, and the most reckless banker cannot lend out more money than he has of his own plus what he has of other people’s,” says Cannon.

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“Creation” is, thus, hardly an exact description of the method by which bank deposits come into existence.

The practical banker says that his power has been exaggerated; but, in fact, if he has Rs. 10 extra cash, he can lend Rs. 10 extra, neither more nor less. Thus, banks, bankers say, do not create money; they only lend the money their depositors entrust to them.

To this, Crowther gives two answers, one theoretical and the other practical. The theoretical answer is that the practical banker has not carried his analysis far enough.

From the point of view of an individual banker, the argument may seem to be valid. But it loses ground when the banking system as a whole is taken.

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When a bank creates credit, such credit money may go to another bank, which enables the bank to start creating money further by making loans. In the process, some of the “created” money will come back to the first bank, which will, thus, get some of its cash back.

But if its original excess fund had come from somewhere outside the banking system, it must be swelling the cash reserves of some bank, and until a multiple of new deposits has been created somewhere in the banking system, the cash reserve ratios of these banks on the average will be in excess of their usual figure.

The expansion of deposits and the handling of cash back and forth must continue until the extra multiple amounts has been “created”.

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