How is MONEY CREATED?

The way money creation works and how the banking system works is broadly misunderstood.

In the early days of banking, money creation was “physical”. aper notes and metallic coins would be crafted, imprinted with anti-fraud devices, and released to the public through favored government agencies or politically-connected business.

Central banks have become a lot more technologically creative, the Fed understood that money doesn’t have to be physically present to work as a unit of exchange. Businesses and consumers could use checks, debit and credit cards, balance transfers, and online transactions. Money creation doesn’t have to be physical, either, the bank can just imagine new dollar balances and credit them to other accounts.

A modern Federal Reserve drafts readily liquefiable accounts, such as U.S. treasuries, and adds them to existing bank reserves. Normally, banks sell other assets that can be of any kind, in order to receive these funds.

This has the same effects as printing up new bills and transporting them to the bank vaults but it’s cheaper. It is just as inflationary, and the credited money balances count just as much as the physical bills in the economy.

97% of the money in the economy exists as bank deposits, just 3% is physical cash.

Money is more than banknotes and coins, if you have a bank account, you can use what you have to buy things, typically with a debit card. Because you can buy things with your bank account, we think of this as money even though it’s not actual cash.

Let’s say you borrow £100 from the bank, and it credits your account with the amount,technically, ‘new money’ has been created, it did not exist until it was credited to your account.

This also means as you pay off the loan, the electronic money your bank created is permanently ‘deleted’, so it no longer exists. You haven’t got wealthier or poorer, you might have less money in your bank account but your debts have gone down too, so we could summarize it this way: “banks create money, not wealth.”

Banks create 80% of money in the economy as electronic deposits this way, banknotes and coins only make up 3%.

Let’s look a little deeper into

Money As Debt

When you put money into your bank account it’s called a “deposit”. This money can be used for any purpose.

When a person or business wants to take a loan from the bank to buy something, the bank uses the deposits from all of its clients in order to make that loan. Long-term savers are paid interest in exchange for letting the bank use their deposits to make these loans, but money in checking accounts can also be used (which is why some accounts charge no fees if you have a certain minimum balance).

Once the loan is taken out, the person can either take the money as cash, or as it usually happens, deposit it back into their savings or checking account. This means the money can be used to make another loan, so banks can re-lend the money again and again.

This means that virtually every dollar a bank lends out was, at some point in the chain, borrowed by someone else. The total amount of money in the economy is directly dependent on how many people and businesses have taken out loans. Even deposits made by people as income were almost certainly borrowed at some point. For example, consider this chain:

1. May 5: Local Banks and Loans issues a loan to Joe for $10,000 to start a restaurant
2. April 30: John deposits his paycheck for $5,000 at his bank (Local Banks and Loans)
3. April 29: Lucy Corporation (a software firm) gives John a paycheck for $5,000
4. April 10: Karl’s Construction pays Lucy Corporation $15,000 for software it developed to plan construction projects
5. April 1: Peggy writes a check to Karl’s Construction to buy a new house for $200,000
6. March 15: Peggy takes a loan out from Local Banks and Loans for $200,000

In this example, the same $200,000 was used in all of these transactions. In the end, Local Banks and Loans has only received $5,000 of the original $200,000 back in the form of deposits, yet it was still able to issue a new loan worth double that amount to Joe. It would seem that the bank created that extra $5000 out of thin air.

You might then ask can banks create as much money as they like?

No, they can’t.

Regulation limits how much money banks can create. For example, they have to hold a certain amount of capital in reserve, in case people default on their loans and so that people can continue to draw from their accounts. These limits have become stricter since the financial crisis.

Banks also risk going bust if they lend out money left, right and centre. For instance, people borrowing money will probably spend it. If they make payments to people who have accounts at other banks, their bank will need to transfer the money to that other bank by sending it some of its electronic central bank money. So if one bank lends out too much money, at some point it will not have enough electronic money in its account to pay the other banks.

The Credit Market Funnel

Suppose the U.S. Treasury prints $10 billion in new bills, and the Federal Reserve credits $90 billion in liquefiable accounts. At first, it could look like the economy just received a monetary influx of $100 billion, but that is only a very small part of the money creation.

This is because of the role played by banks and other lending institutions that receive new money. Nearly all of that $100 billion enters banking reserves. Banks don’t just sit on all of their money, even though the Fed pays them 0.25% interest to simply park the money with the Fed Bank. Most of that money is loaned out to governments, businesses, or private individuals.

The credit markets have become a funnel for distributing money. However, in a fractional reserve banking system, new loans create even more new money. With a legally required reserve ratio of 10%, the new $100 billion in bank reserves can even result in a monetary increase of $1 trillion.

Fractional Reserve Banking and the Money Multiplier

In today’s banking system, the central bank creates monetary reserves and sends those to commercial banks. Banks can then lend most of that money, up to a certain limit, which is the reserve requirement, which is 10% in the U.S.

So, if the Fed issues $1 billion in reserves to a bank, it can lend exactly $900 million to borrowers. These borrowers will then deposit those funds back to the banking systems (they can do it directly or indirectly), which can be loaned out at 90%, so if $900 million is deposited, an additional $810 million may be loaned out. Ultimately, through this money multiplier effect, the $1 billion in reserves will turn into $10 billion in new credit money in the economy.

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