Where Money Comes From

(Originally from previous post—broken apart because of length)

By now, hopefully you should know that new money is created when people and businesses take out loans.

That is, money is injected into the economy by governments through banks as intermediaries.

This is something that is quite controversial in economic circles. For a long time–and still often today–many economists do not accept this explanation, despite overwhelming evidence for it.

For a long time, in fact, economists did not really think about money at all. This may seem odd, in that most of us think that economics is the study of money! But they portrayed money as simply a means of exchange–the intermediate good that allowed one thing to be exchanged for another thing in the real economy. It was not worthy of note in and of itself, they thought. Sure, how much of it there was floating around might be important, but beyond that you didn’t really need to think about it too much.

To explain how money was created, economists developed three alternative theories of banking. Let’s look at each one in turn.

1.) The loanable funds theory. This is the idea that banks are simply intermediaries between savers and borrowers.

So you save $100 dollars a week out of your paycheck, let’s say. Multiply that by thousands of workers and businesses throughout the entire economy and you’ve got increasing piles of cash piling up in bank’s vaults (or, rather, balance sheets) over time.

At the same time, you’ve also got people who need money. They want to do some sort of profitable enterprise, but they don’t have the money to do it right now. Or they want to buy something that they can’t pay for on the spot, but can pay back over a period of time, like a house or car for instance. Where do they go? To the bank, of course!

If you’re a bank, you pay savers a particular interest rate to get the money into your vaults, and then you loan out that money at a higher interest rate to those who want to borrow. That’s how you make your money.

So the banks are the intermediaries between savers and borrowers—those who want to save and those who want to borrow. Those are never perfectly in sync in any particular bank, so banks borrow from and loan to each other as a routine matter. But the banking system as a whole functions as an effective intermediary between savers and borrowers. The rest of the money is circulating, presumably.

In this scenario, only when the desire to borrow is greater than the desire to save, is new money injected into the system by governments through various means. Banks borrow new money from the government’s central bank to loan out.

2.) The fractional reserve theory. This idea is similar to above, but allows for money to be created not by individual banks, but through the banking system as whole through the process of “multiple deposit expansion.” That is, while the banks themselves are still intermediaries just as above, but when the central bank injects money into the banking system, that money is multiplied through the actions of banks making loans–the multiplier effect.

With a reserve of 10 percent, a bank would lend out 90 percent of a deposit, which would increase the deposits at other banks in the system, who would subsequently lend out 10 percent of those deposits, resulting in an expansion of money throughout the banking system due to the process of loaning money. Any individual bank still has to get deposits in order to lend, according to the theory. But that act of lending does create new money elsewhere in the system. George Goodman (a.k.a. “Adam Smith”) explains how it works. He imagines an oil company depositing $100.00 in a U.S. bank:

Now the bank has a deposit, let’s say…of $100. The Federal Reserve says that bank has to keep 10 percent of the deposit as a reserve. You walk in and borrow $90. You put that money in a checking account; now it’s a deposit there, and your cousin Charley can walk in and borrow $81, because that fractional reserve is set each time. Your cousin Charley deposits his loan in his checking account, and the bank lends $72.90 to the next borrower. That’s the way the multiplier works, and it keeps on going. If the Federal Reserve wants more money in the banks, it lowers the fractional reserve, so that you can borrow $95 instead of $90, and your cousin Charley can borrow $85.50 instead of $81. if the Federal Reserve wants there to be less money, it raises that fractional reserve.

PAPER MONEY, p. 245.

This system allegedly originated in the goldsmith’s discovery that he could make more loans than there was actual gold in his vaults, so long as too many people didn’t show up to claim their gold all at once.

Paper money, it is said, originated with the goldsmiths of Europe who held the private gold hoards deposited by wealthy citizens for safekeeping. The goldsmith issued a receipt for the gold deposit, and over time, it became clear that the receipt itself could be used in commerce since whoever owned that piece of paper could go to the goldsmith and claim the gold.

Modern banking originated in the goldsmith’s discovery that they could safely write more receipts and lend them to people, exceeding the total gold that was on hand, so long as they always kept a reasonable minimum in reserve to honor withdrawals. This was the origin of fractional reserve banking and the bank lending that created money.

This private money system endured for centuries and was inherited by the American Republic: privately owned banks created money by issuing paper bank notes, paper backed by a promise that at any time it could be redeemed in gold.

In nineteenth-century America, the money in use consisted mainly of these privately issued bank notes, backed by gold oor silver guarantees. The money’s value was really dependent, therefore, on the soundness and probity of each bank that issued notes. Banking scandals were recurrent, particularly on the frontier, where ambitious bankers, eager to make new loans for enterprises, sometimes printed paper money that had no gold behind it. Governments imposed regulations to keep banks honest, but the bankers still were free to create their own varieties of money. When banks failed, their money failed with them.

SECRETS OF THE TEMPLE; William Grieder pp. 227-228

3.) The credit creation theory. In this view, new money is created when loans are extended. That is, the bank does not have to make sure it has enough deposits to make the loan; it simply creates a deposit for the amount of the loan that the lender can draw against.

The third theory of banking is at odds with the other two theories by representing banks not [simply] as financial intermediaries — neither in aggregate nor individually. Instead, each bank is said to create credit and money out of nothing whenever it executes bank loan contracts or purchases assets.

So banks do not need to first gather deposits or reserves to lend. Since bank lending is said to create new credit and deposit money, an increase in total balances takes place without a commensurate decrease elsewhere. Therefore according to this theory, over time bank balance sheets and measures of the money supply tend to show a rising trend in time periods when outstanding bank credit grows — unlike with the financial intermediation theory, where only existing purchasing power can be re-allocated and the money supply does not rise.

A lost century in economics: Three theories of banking and the conclusive evidence; Richard A. Werner

William Grieder summarized this process in his mammoth book, Secrets of the Temple. First, he describes the transition from bank notes hypothetically backed by gold, to demand deposits delineated in bank ledgers:

The money illusion was transferred to a new object with the rise of demand deposits, better known as checking accounts. Instead of currency, the paper money created by banks, people hesitantly came to accept that money also existed simply as an account in the bank’s ledger, redeemable by personal drafts or checks. In the United States, the transition was inadvertently stimulated by government regulation. The National Bank Act, enacted during the Civil War, placed a heavy tax on new bank notes issued by state banks, and in order to avoid the tax, banks encouraged customers to use demand deposits–writing personal checks instead of drawing out their money in cash.

It took generations for the public to overcome its natural distrust of checks, but by 1900 most people were persuaded. Personal checks, written by the buyers themselves, were accepted as just as valuable as dollar bills. Currency remained in use, but demand deposits were by now the bulk of the money supply. The nationalization of currency issuance, completed with the creation of the Federal Reserve in 1913, simply continued this arrangement. A new dimension of trust had added to the illusion. pp. 227-228

He then goes on to describe just how money is created using these demand deposit accounts via the banking system:

New money was created not only by the Federal Reserve but also by private commercial banks. They did it by new lending, by expanding the outstanding loans on their books. Routinely, a bank borrowed money from some group, the depositors, and lent it to someone else, the borrowers, a straightforward function as intermediary. But, if that was all that occurred, then credit would be frozen in size, unable to expand with new economic growth. On the margins, therefore, bankers expanded their lending on their own and the overall pool of credit drew–and the banks credit turned it into money.

A bank officer authorizes a $100,000 loan to a small-business man–a judgement that the businessman’s future earnings will be sufficient to repay the loan, that his enterprise would create real value in the future, which would justify the risk and the creation of the additional money. Ordinarily the banker would not hand over $100,000 in dollar bills. He would simply write a check or, more likely, enter a credit in the businessman’s bank account for $100,000. Either way, money has been created by the simple entry in a ledger.

Implausible as that might seem, it was a reality that everyone would accept, even if they were unaware of its audacity. The businessman would go out and spend the money, writing checks on his new account, and everyone would honor their value. The creation of new money, thus, was really based on bank-created debt.

This concept is what baffled and outraged so many critics of the money system. Money ought to be “real,” they insisted. It should be based on something tangible from the past, accumulated wealth like gold, not on a banker’s hunch about the future.

How could such a system possibly work? Why didn’t it collapse and produce social disaster? The short, simple explanation was: trust. People trusted the banks…They believed, perhaps not even knowing the actual mechanics, that bankers would use this magic prudently. Banks would make sound loans that would be repaid, and they would always keep enough money on hand so that any individual depositor could always withdraw his when he needed it. pp. 59-60

Clearly, the trust in banks described by Grieder above has been undermined due to the financialization of the economy, not to mention the bailouts. David Graeber sums up the three school of banking in the New York Review of Books:

Economists, for obvious reasons, can’t be completely oblivious to the role of banks, but they have spent much of the twentieth century arguing about what actually happens when someone applies for a loan.

One school insists that banks transfer existing funds from their reserves, another that they produce new money, but only on the basis of a multiplier effect (so that your car loan can still be seen as ultimately rooted in some retired grandmother’s pension fund). Only a minority—mostly heterodox economists, post-Keynesians, and modern money theorists—uphold what is called the “credit creation theory of banking”: that bankers simply wave a magic wand and make the money appear, secure in the confidence that even if they hand a client a credit for $1 million, ultimately the recipient will put it back in the bank again, so that, across the system as a whole, credits and debts will cancel out. Rather than loans being based in deposits, in this view, deposits themselves were the result of loans.

The one thing it never seemed to occur to anyone to do was to get a job at a bank, and find out what actually happens when someone asks to borrow money. In 2014 a German economist named Richard Werner did exactly that, and discovered that, in fact, loan officers do not check their existing funds, reserves, or anything else. They simply create money out of thin air, or, as he preferred to put it, “fairy dust.”

…Before long, the Bank of England (the British equivalent of the Federal Reserve, whose economists are most free to speak their minds since they are not formally part of the government) rolled out an elaborate official report called “Money Creation in the Modern Economy,” replete with videos and animations, making the same point: existing economics textbooks, and particularly the reigning monetarist orthodoxy, are wrong. The heterodox economists are right. Private banks create money.

Central banks like the Bank of England create money as well, but monetarists are entirely wrong to insist that their proper function is to control the money supply. In fact, central banks do not in any sense control the money supply; their main function is to set the interest rate—to determine how much private banks can charge for the money they create. Almost all public debate on these subjects is therefore based on false premises. For example, if what the Bank of England was saying were true, government borrowing didn’t divert funds from the private sector; it created entirely new money that had not existed before.

Why is this important? It’s important because it shows that if private borrowing creates new money, then it is excessive levels of private borrowing that will expand the money supply. Consequently, debt defaults will contract the money supply. So there’s more to macroeconomic stability than merely “government money printing.”

All this is a prelude to two very important points:

1.) Private debt and public debt are two very different things. It is private, not public debt which is a cause for alarm.

And

2.) A crucial distinction must be made between the “real” economy of providing goods and services, and the banking/financial sector of the economy which makes money from debt and interest.

A lot of the mistakes in understanding the modern economy have come from just those two misunderstandings. But without understanding these facts, you cannot understand what is really going on in the economy, and you’ll be making the same mistakes as all those armchair commentators worrying about “excessive government debt,” or hyperinflation “any day now.”

2 thoughts on “Where Money Comes From

  1. ch, been trying to comment for a while, hasn’t been working. For now I’ll just say thanks, and note that Ray Dalio is publishing a money book that is, well, wrong about all this (principles.com, ch.2). Sigh, as they say.

    1. I’ve set the comment policy to be as open as possible in WordPress, so I don’t know what the trouble is. You shouldn’t have to sign in to comment.

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