Education

How banks create money out of nothing

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In most economics and finance texts, there is the notion that banking is a simple intermediary between depositors and borrowers. This notion is so ingrained in financial and economic DNA that money is considered to be completely neutral in the economy. However, the reality is very different and in this post we will try a first approximation to a subject that is little known but that has great consequences in the development of the financial markets.

The title “How banks create money out of nothing” is a bit misleading to be fair. It should be noted that banks create money from something. The question is, what is that something, and what is wrong with it?

The answer is that banks create money based on the promises of their borrowers to pay. In many economic and financial texts it is believed that banks simply take the money from the savers and lend it to the borrowers. This is a rather misleading view. Even the Federal Reserve, in its own publications ( Modern Money Mechanics , explains the process of money creation:

The actual process of creating money is carried out mainly by private banks … The liabilities of the banks are acceptable as money. These liabilities are the accounts of the clients, which increase when the bank grants loans that are credited to the accounts of the borrowers…This exclusive attribute of the banking business was discovered many centuries ago.

It began with the goldsmiths…They were the first bankers who initially rendered the custody service, and obtained profits by storing in their vaults the gold and the currencies of the savers. Whenever people needed gold or coins to buy something, they exchanged a “deposit receipt.” 

Over time, they found that it was much easier to directly use deposit receipts as a means of payment. These receipts were accepted as money because whoever had them could go to the bank and exchange them for money … Then the bankers discovered that they could make loans simply by giving their promises of payment, or bank notes, to the borrowers. In this way, banks began to create money .

Operative of the creation of money

Banks have two main functions. They act as repositories in the reallocation of funds from savers to borrowers and in the issuance of loans that monetize the promises of their borrowers. At this point, the bank can create money in good faith, when lending on the basis of existing deposits, and in bad faith, when it does on non-existent deposits.

I wont go into detail but you can learn here about how Banks engage in what is called Monetary Expansion, which had a major role in the incubation of the crisis that broke out in 2008. Since most banks do not have reserve requirements, banks can manage at their own discretion. It is reported that Citibank and Goldman Sachs held reserves less than 1 percent of deposits. A deposit of 1 million dollars became, through the monetary multiplier, 100 million dollars.

One of the most used mechanisms in the creation of money is real estate investments. The real estate boom is due to the artificial creation of money by the bank. Each loan of 100 thousand dollaras by the bank, promotes the expansion of the economic cycle and when it becomes a pandemic, unleashes a bubble that accelerates until it explodes by its own unsustainability.

When this happens it is because banks have not lent in good faith and because they have exceeded their lending powers. On the other hand, in periods of boom, there arises the insane competition of lending money to people who have no possibility of repaying it. This is what happened to Fannie Mae and Freddie Mac.

The creation of money on the basis of interest-bearing loans has been one of the imperatives of growth in the current debt-based economic model. But as the loans exceeded the good faith and the basic principles of the sustainability of capitalism, we witnessed the epic collapse of the financial markets in 2008. If we want to achieve a sustainable society and ensure the survival of civilization, we must reformulate the importance of money and reinvent a financial system without excesses and abuses.

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