Making Money: Leverage and Private Sector Money Creation

39 Pages Posted: 31 Mar 2013

See all articles by Margaret M. Blair

Margaret M. Blair

Vanderbilt University - Law School

Date Written: March 2013

Abstract

In the wake of the financial crisis of 2008-2009, practitioners and theorists in law, finance, and economics are rethinking our theories about how the financial sector influences the real economy. In particular, they are reexamining the linkages among financial innovation, supply of credit and money, monetary policy, bubbles, financial stability, and economic growth. One of the key issues that is being reconsidered is the dynamics of how banks and other financial institutions drive credit creation and credit allocation, and how these factors, in turn affect the performance of the macroeconomy. In this article, I argue that, by providing an alternative to “money” (as traditionally defined), credit acts like money in stimulating the economy. When financial institutions that provide credit to the real economy borrow too much and become over-leveraged, the effect is like an uncontrolled expansion of the money supply, increasing the risk of dangerous asset bubbles and making financial markets unstable. Excessive leverage in the financial sector can set the stage for sudden and catastrophic contractions when multiple financial institutions all try to deleverage quickly and at the same time. This is because when financial institutions collectively withdraw credit from the market, this depresses aggregate economic growth, I further argue that the tendency of financial institutions to use too much leverage will not be self-correcting because leverage has helped to drive up profits and incomes over time in the financial sector. Thus, because of the substantial negative social externalities of excessive leverage, financial market regulations must be deployed to prevent financial institutions from using too much leverage.

Suggested Citation

Blair, Margaret M., Making Money: Leverage and Private Sector Money Creation (March 2013). Seattle University Law Review, Vol. 36, 2013; Vanderbilt Public Law Research Paper No. 13-18; Vanderbilt Law and Economics Research Paper No. 13-12. Available at SSRN: https://ssrn.com/abstract=2241697 or http://dx.doi.org/10.2139/ssrn.2241697

Margaret M. Blair (Contact Author)

Vanderbilt University - Law School ( email )

131 21st Avenue South
Nashville, TN 37203-1181
United States
615-322-6087 (Phone)

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