How banks create money from scratch
October 1, 2023: What do you think is the role of banks in our lives? What we are told is that banks take deposits and lend out loans, and they make money out of that – it’s their business model. Well, this narrative is true if seen in isolation, but it’s not the full story.
In fact, banks play a much bigger role in our lives than just handling deposits and loans. The shocking truth that is hardly discussed in banking and economy circles is that the primary job of banks in society is to create money out of thin air.
It sounds absolutely incredible and outlandish that banks manufacture money out of nothing. But that is precisely what an old banking theory categorically tells us – a theory that has been brushed under the carpet for almost 100 years now. Let us dig deep into this mysterious role of banks that no one talks about.
We need to first get a clear picture of where all our money comes from. Most people think that the money that we have in our possession is produced entirely by central governments and central banks. But that’s not entirely true. Only about 3-5% of the money supply in all the countries comes from governments and central banks, no more than that. That money comes in the form of currency notes and coins.
So, that leaves us with the remaining 95-97% of the money supply in society. Where does that come from? Who produces all that money? The answer is: high-street banks. Private or commercial banks and government-owned banks in your locality, in your country, and all over the world create 95-97% of the money – from scratch. It is produced in the form of electronic money. And what is electronic money? It’s the money that we all have in our bank accounts. This form of money exists in the computer systems of banks.
The incredible process explained
Now, let’s try to understand how banks create money with a real-world example. What happens when you take a loan from a bank? The bank makes it look like it is transferring to you existing money from its own accounts or balance. But technically speaking, that simply does not happen. The bank doesn’t lend you any existing money. Instead, it creates new money. After that, it opens an account in your name, and tells you that your approved loan can be accessed from your newly opened account with the bank – you’re free to use it.
So, the bank isn’t actually transferring to you any existing money. Instead, your decision to take a loan resulted in the creation of new money, which the bank handed over to you – eventually for you to release it into the economy either by spending it, or transferring it, etc.
Of course, the bank hasn’t given you the newly created money for free. In return for giving you newly manufactured money, it has purchased a ‘security’ from you. In strictly legal terms, banks are in the business of purchasing securities, that’s it.
Let’s go deeper into the process because it is vitally important to understand that banks are actually extremely special and privileged institutions, since they have full permission to quietly manufacture 95-97% of the money that society needs. So, coming back to the example, while the bank approves your loan, you issue a ‘promissory note’ or a security in writing, which the bank purchases from you. In return for what? For giving you access to the new money it has instantly created for you.
That’s the whole transaction. And how does the bank create this new money? A designated bank official creates it in electronic form simply by clicking a few buttons on a computer keyword, that’s it.
Credit creation theory
This almost unheard-of but sensible observation about how banks create money is made by a school of economic thought, called the credit creation theory. This theory about how banks create money out of nowhere 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 economy circles across western Europe.
But during the 1930s, the credit creation theory was drastically sidelined, and a different banking theory was floated to take its place. It is called the fractional reserve theory. Then in the 1960s, after about 30 years, 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.
Let’s quickly look at these two recent theories that replaced the older credit creation theory – which explains how banks create money out of nothing. The fractional reserve theory says banks don’t create new money. Instead, banks individually act as only financial intermediaries. That is, they make a living by taking deposits and lending out loans; but all the banks collectively play the role of creating new money in society through what is called the ‘money multiplier process’ (more on this process in our next report on banking and economy).
Friedrich Hayek and Joseph Stiglitz are two influential economists who supported the fractional reserve theory.
The latest school of thought, called the financial intermediation theory, further plays down the role of banks as the economy’s money creators. This theory says banks are just financial intermediaries, nothing more than that. They only deal with deposits and loans. Neither individually nor collectively do they add to the money supply in society, let alone creating money out of thin air.
Top economists who supported the financial intermediation theory are Raghuram Rajan, Anil Kashyap, John Maynard Keynes, Ben Bernanke, and Paul Krugman.
Now, coming back to the old credit creation theory, well-known economists who echoed the belief of how banks create money in society include Irving Fisher, Henry McLeod, Joseph Schumpeter, and most recently, Richard Werner.
Werner’s breakthrough paper
German economist Richard Werner famously invented the monetary policy that is now called Quantitative Easing or QE back in 1994. Today, Werner is a firm believer that banks produce money out of thin air, and his support for the 100-year-old credit creation theory is based on a successful, game-changing experiment that he carried out a few years ago.
Werner presented his case in a detailed report following an investigative empirical study of a real-world loan transaction he carried out at a functional bank. His landmark paper concluded that whenever registered banks issue loans, they invariably manufacture new money out of nothing.
His thought-provoking paper that gives a detailed lowdown of how banks create money from thin air was published in 2015 in the popular finance journal, International Review of Financial Analysis. Werner’s 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 (more on this in our next report on banking and economy) 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?
How banks create money: Uneasy silence
Now, the question is, why does it happen in hush-hush tones? Why is the credit creation theory, which wonderfully explains this role of banks, downplayed in mainstream discussions and coverage? In other words, if banks create 95-97% of the money supply, why is there an attempt to hide it?
We are openly told that central governments mint coins and central banks print paper currency. But that’s just 3-5% of the money supply, as discussed earlier. We are never openly told that normal banks manufacture the main chunk of the money supply – and they do it just like that.
Why do most influential economists avoid bringing it up? Why is the credit creation theory downplayed in textbooks? We will return with the answers to these haunting questions in our next report on the topic.
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