Chester A. Phillips and the forgotten history of bank credit

Abstract

This thesis studies the main contributions to monetary theory by Chester A. Phillips in the 1920s and 1930s which deal with the expansion of the money supply when commercial banks use the creation of bank credit to purchase a loan or asset. Chapter one deals with his doctoral thesis from 1919, A Study in Bank Credit, done at Yale under the supervision of Irving Fisher, which was then published as a book in 1920 and quickly won general acceptance as the definitive exposition on the multiple expansion of bank credit. This pioneering work dealt with the multiple expansion of deposits that results in the banking system when commercial banks originate loans and overturned nearly a century of muddled thinking regarding the interaction of bank credit and the money supply. Economists of this time were still struggling to formulate a complete theory when Phillips devised an innovative mathematical theorem to calculate the lending potential of any individual bank based on the required reserve ratio and the ability of that individual bank to retain this newly created money. Chapter two explores the rise and fall of Phillips’s original equation. By tracking the evolution of bank credit theory as presented by introductory textbooks from 1877 to 2017, the data clearly shows how the consensus view of bank credit creation has changed over time. The findings reveal that the predominant view for over a century - that banks create money in the act of purchasing a loan or an asset - was only recently replaced in the 1980s by the new view that banks are mere intermediaries of preexisting deposits. Chapter three deals with Phillips’s other major contribution, Banking and the Business Cycle, written in 1937, which expanded on his previous work to show that the purchase of either government or corporate securities by the commercial banks had the same effect on the expansion of money supply. Here, Phillips explains that the effort to finance the First World War through the commercial banking system led to a multiple expansion of deposits which then required an unorthodox operational policy in the 1920s to avoid credit deflation. Phillips contends that the Federal Reserve’s open-market operations in the 1920s were intended to stabilize the economy and the price level, but also inadvertently allowed bank credit to flow into long-term assets instead of short-term revolving loans as was originally intended under the Federal Reserve Act. Phillips’s conclusion is that that the decision to target price stability alone is not a sufficient central bank policy, and this critique is still relevant today.