How banks create money: The big role
October 1, 2023: Most people think the money we have is produced by governments and central banks. That’s not entirely true. Only about 3-5% of the money supply in most countries comes from governments and central banks. It comes in the form of currency notes and coins. That leaves us with the remaining 95-97% of the money supply. Where does that come from? Who produces all that money?
The answer is: high-street banks. Private banks and government-owned banks in your locality and all over society create 95-97% of the money from scratch. It is produced in the form of electronic money. What is electronic money? It’s the money in our bank accounts. It exists in the computer systems of banks.
This absolutely insane but sensible observation about how banks create money out of nowhere is made by a school of economic thought, called the credit creation theory. The theory has been floating around informally throughout 5,000 years of banking history. But it came into the limelight only in the late 19th century. By then, it was openly discussed and accepted in banking and economic circles in western Europe.
But during the 1930s, the credit creation theory was sidelined, and a different banking theory was floated. It is called the fractional reserve theory. Then in the 1960s, this theory was phased out and replaced by yet another one, called the financial intermediation theory. Right now, the financial intermediation theory is the most widely accepted banking theory.
Werner reconfirms how banks create money
Coming back to the old credit creation theory, which explains how banks create money, well-known economists who supported it include Irving Fisher, Henry McLeod, Joseph Schumpeter, and most recently, Richard Werner. German economist Richard Werner famously invented the monetary policy called Quantitative Easing back in 1994.
Today, Werner is a firm believer that banks produce money out of thin air. His support for the 100-year-old credit creation theory is based on a successful experiment he carried out a few years ago. He presented his case in a detailed report following an investigative empirical study of a loan transaction he carried out at a real bank.
His landmark paper concluded that whenever banks issue loans, they manufacture new money out of nothing. His paper on how banks create money out of thin air was published in 2015 in the popular finance journal, International Review of Financial Analysis. The paper is titled ‘A lost century in economics: Three theories of banking and the conclusive evidence’.
So, we can say that all high-street banks are tasked by some higher authority to create money out of thin air and release it in the economy as loans to individuals and organisations. It’s an enormously powerful role, isn’t it – that your next-door bank can decide how much money it will create and release into the economy? Watch this special report on how banks create money, and share it.
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