Money, Credit and Spending: Drawing Causal Inferences

It is widely accepted that loans cause deposits. Hitherto, though, the empirical evidence has come from bivariate causality tests which we know can give rise to invalid inference if the two variables are causally influenced by some third, omitted, variable. This is a real danger where loans and deposits are concerned since there is a substantial body of evidence that both are linked to GDP, or some similar variable. In this paper we have used tests developed by Toda and Yamamoto to investigate the possibility that earlier inferences were incorrect because of the presence of a third variable, total transactions in this particular case. Including the third variable does require us to revise some of our earlier inferences notably the reverse causality running from deposits to loans which Howells and Hussein (1998) found for most of the G7 countries. The most striking result, however, is that while deposits appear to be caused by total transactions (which could have invalidated the fundamental inference that loans cause deposits) our tests show that even in the presence of a third variable, the core of the endogeneity thesis prevails. Loans do cause deposits.