Money Creation – Where Does the Money Come From?


How Banks Create Money continued

One of our popular posts located here talks about ‘how banks create money’. You should read that link before this one as it is the necessary part 1 of this series on money creation. A lot of people think it’s a huge conspiracy that banks would create money out of thin air. Fact is they don’t, and our entire financial system is based upon the responsibility of banks to lend correctly. Furthermore, in the capitalist system, in the simplest form, the troubled banks would be permitted to fail and close its doors, however, because most nations aren’t true capitalists economies (free market) because of the intervention of the central bank, you’ll note that the government through the central bank is doing more to ensure consumer confidence is settled by the guarantee of loans in banks and the banks themselves.

Here are some notable comments from the previous article on How Banks Create Money that are worthy to be posted in article form (from Keir in the UK.) we’ve had folks from all around the world respond to this post so please feel free to comment.

Keir notes:

Hi. I’m new to this site, and have been reading and thinking about money supply for the last few years. I read the above comments with interest.

Here is some pretty hard evidence that banks do create money out of nothing:

1. I used the Bank of England database to create a graph of the total money in UK bank accounts (M4) from 1988 to 2008. It shows an exponential growth from 0.3 to 1.8 trillion GBP (£) over those 20 years. This raises the question where did all of this money come from? How was it created?

2. I then found the data for the total UK cash stock (M0, i.e. note and coinage) over the same period. It was almost flat rising from onlly 0.016 trillion in 1988 to 0.046 trillion in 1996 (when they stopped recording it !) i.e. nowhere near enough to explain the growth in M4. So that rules out the idea that the money is printed by government.

3. I then downloaded the total outstanding loans (UK). This produces a graph that rises exponentially and almost exactly matches the M4 graph!

The conclusion from this data is that the money supply (M4) is created out of debt.
So is money created out of nothing? Yes and No:

Yes – Money is created by banks ‘out of nothing’, becuase they do not transfer a deposit to create it.

No – because they only create it against a real assets (houses, businesses etc). You could argue that banks create money out of our assets. They seem to have created the recent credit mess principly by overvaluing property, so the security on their outstanding loans has gone.

Now as I understand it, the example that started this thread is correct. Across the banking system as a whole the money created as debt (credit) becomes a new deposit. As there are millions of such transactions per month between banks the effect is that this deposit ends up in the same bank as issued the credit.

The financial regulations insist that banks maintain a debt to credit ratio of 95% (or whatever the figure is), which produces the appearence that they ‘only lend what they have’ (as DebtBasedEconomics said above). To Jo Public this statement confirms the false notion that his deposit is being loaned out, but if that were true there would be no new money created. What the statement fails to acknowledge is that by making a loan the banks create new deposits which enables them to make more loans… So they can increase the money supply virtually indefinitely, as long as we keep taking out more loans this year than last year, as long as property prices keep rising, and as long as we keep repaying. Sub prime and housing slump has messed this up.

Christopher Dean responded with:

If money is created from the issuance of government debt and through lending in our Fractional Reserve System where does the money to pay the interest come from? The interest due on the original and additional monetary infusions was never created in any of the “M” components. The amount owed to ANY bank, private or government = principle + interest. What component in our monetary system creates the money needed to pay the interest?

Wouldn’t it be safe to assume we can always expect retractions in the credit markets – not as a results of houses – but when the interest due on our expanding currency becomes to burdensome? I guess we could print more money! But then my question still remains.
Too which Keir responds again:

Reading Christopher Dean’s point again, I think there is another issue lurking in your question. Which is that all of the loans in the economy that reach maturity each year (and therefore need paying off) are essentially financed by even more new debt-money released in that same year.

Governement borrowing seems to work that way. They raise money by issuing bonds and Gilts. These raise money for the Government now, but promise to pay back principle + interest in (say) 5 years time. When those Gilts mature, the government has to find more money (=principle + interest) so simply issues even more gilts, meaning they have to pay back even more in another 5 years time etc etc. So National debt grows…

Where does the money to pay the interest come from? What do you mean? That’s just part of the normal money flow.

Once banks have created money it circulates in the economy (M4 accounts + M0 cash). It passes in and out of accounts as wages, receipts and payments i.e. cash-flow. Bank interest is just part of that flow. Banks don’t simply hord that interest. Some has to be used to pay interest on deposits. Part of the rest they use to finance their operations (running the business, rent, wages etc), the rest is their primary income ‘profit’ (my term).

This ‘profit’ from their normal banking operations (deposits and loans) is then invested in stocks, shares and bonds. Some is speculated on the money markets. The end result of this is their real profit that you hear announced on the News (‘This week Natwest announced profits of…’).

That ‘real’ profit goes to shareholders, bonuses and expansion – just like any limited company.

The moral repugnance that we should feel for the banking system is that they are able to extract interest simply for lending us money that they have done nothing to earn. They have not really produced any goods or services commensurate with the vast amounts of interest they charge.

To illustrate the privaleged position banks are in consider this: If you or I wanted to lend money to a friends we could lend them money in exchange for an IOU secured against an item of their property. This is what banks do. We could even charge them interest – although most of the people I know would consider that immoral, miserly or at the very least bad-taste. The difference between this and what the banks do, is that we would actually have had to earn the money in the first place. Banks can just create it out of nothing!

It is worth considering too that as the total money stock increases (which it does) we (the public) are more and more indebted and they (the banks) hold more and more of our homes and businesses as security. As a country we can never reverse this. If you manage to pay off your loan, it reduces the available monay in available for Joe Blogs to pay off his.

It is an extraordinary position that we have got ourselves into where we are all beholden to the banks to create the tokens (money) that allow us to play ‘living in the modern world’. Even our Governments play this game – allowing the banks to control the means of economic activity AND MAKE A PROFIT FROM IT!
The fact is that governments could take on this role if they wanted, reduce the powers of the banks, and set about creating all the money they need to finance public work out of nothing and, crucially, without creating an equal amount of national debt to burden you & me with.

In the UK parliament there have been a number of early-0day-motions calling for this. It was also suggested in the early days of New Labour by Brian Gould MP. The main arguments against this that I hear are spurious:

1) that ‘printing money’ would cause inflation:

I don’t think this is correct. Most of the horror stories we know about from the past I presume are in fact the reverse of this – namely that when you get runnaway inflation that you have to print lots of money because it is devaluing so quickly. Inflation happens when there is too much money for the goods and services on offer. Carefully reducing the debt in society by releasing non-debt backed money would not create inflation all the time that people wanted to provide more goods and services, or pay off their existing debts. If inflation started to rise because there was more money than services, government could release less ‘free’ money to reduce inflationary pressures.

Any way, look at the incredible exponential growth of money in the economy over the last twenty years – they don’t say that has caused inflation. They say that has caused economic growth! Why would non-debt backed money be any different?

2) that governments can’t be trusted to run the economy:

That may be true, but it is not necessarily true. When you look at it it is a miracle that the banking system works even as well as it does. Surely it is not beyond the powers of good people and good government to design a system of good money creation? What we need are people who are good and clever. Good first, clever second mind you. Good means puting the public-good first not their own self-interest. Unfortunately we seem to have a lot of people in power who are clever enough to appear good – the very definition of cunning I believe.

The problem of monetary reform is the huge ignorance of how money is created among the general public, politicians and economists. The whole money jargon is so complex and obfuscating that people can’t see the emperor has no clothes. It is amazing if you listen to the news, or people discussing it in the pub: “Yeah, the Banks have stopped lending to each other… It’s a problem of liquidity… They have been lending more than they have got…” Not one of them knows what any of it means – it is incredible! They all nod sagely, even the interviewers on the TV, as if anything comprehensible has been said! Sometimes you hear the interviewer get rather to close to the truth – on the BBC4 radio news recently one presenter asked a government financial expert “But where is this £500 billion coming from?” and the expert expertly avoided the question with a load of waffle. The interviewer pressed – “But you havn’t answered my question…” to which the expert said “I’m coming to that” and proceeded to give an expertly wordy answer that didn’t even attempt to get close to an answer! The interviewer gave up – I assume through feeling that he must be too stupid to understand how beautiful the emperors new clothes are, and who wants to appear stupid?

It is a weird hypnosis – people are not asking simple questions for fear of appearing ignorant. So we all say “Yep there’s a credit crisis. Bloody banks!” – without one sensible piece of information being communicated about how money is created and what is going on.

Well put… comments?

14 responses to “Money Creation – Where Does the Money Come From?”

  1. I’m going crazy over all of this… what can be done… is the solution to get rid of the monetary system or to regulate the bank of england or federal reserve??

    History just seems to be ridiculously repeating itself…

    1. Its not quite repeating itself, because we have never had a such global integration between central banks.

      I think the solution needs many parts:

      1. Change the extreme bonus culture of banks
      2. Regulate the banking exchange methods better.
      3. Change the intense profiteering culture which has proliferated for the last 50 years and get focused on other more useful key indicators and values.
      4. learn to manage risk better as a society, which included understanding the system (this is already happening everytime some one discusses this issue).
      5. teach basic financial skills to kids in schools
      6. Stop focusing on currency as the only means of exchange.

  2. UK economy documentary?
    It seems to me that reading about this is not what the average UK citizen has time for with all the jargon/bs to cut through. Is there a documentary type guide available? If not has anyone got video/audio clips, or skills that may be useful in piecing something together?

  3. Mark, watch ‘Money as debt’ on youtube.

  4. An interesting place to start reading about all of this is in the history books of how the system started in the first place. I highly recommend reading about John Law.

  5. The solution to the money problem is to have the U.S. Government SPEND the currency into circulation through legitimate government projects or services. If that would happen, there would be NO NATIONAL DEBT which exists to make bankers rich.

    And since debt and usury wouldn’t be crushing us, banks wouldn’t be needed as such primary sources of “money.” Armored cars wouldn’t have to round up all the currency from the masses and businesses just to be LOANED AT INTEREST back to the next victim in order for the currency to circulate again.

    1. Like I said in my other comment, I think there is a fallacy here. I do not believe there is a plan, but merely a complex system of monetary lending which most people dont understand and therefore they fall foul of it. If everyone understood the role that banks actually play, perhaps things would be a lot better.

  6. The government can only ‘spend’ currency if they have money to ‘spend’. They don’t ‘own’ all the money in circulation. So if the govt wants to build they need to first get their hands on cash. One way is through gov’t bonds (taking money out of circulation) and then turning around and spending. That’s a really simplistic example, but it shows that there are steps before you can ‘spend’.

  7. barry econ – We need to remove the power to create money from bankers.

    And your fears of inflation are overblown. The money in circulation would be backed by the goods and services of the American people. The problem most people have in discussing economics is that they are conditioned into thinking everything has be borrowed.

    Bankers and their controlled media and schools have done a good job in hiding the evil and greediness of their debt-as-money system.

  8. Money is printed ‘with’ interest attached. To me that’s making it from nothing. ie: a dollar gets printed @ the reserve rate of say 5%. (I’m an Aussie) So that dollar now costs $1.05 to repay. Repay who btw? Once Joe Average deposits it into his bank account Mr. Bank Robber can now legally loan $9 against every dollar they hold. Again profiting from ‘nothing’ This means that the 2% the bank pay’s you in interest on your $4000 savings account creates a loan value to create bank profits. A pinch for you & truck loads for them. Again from doing nothing. They have loaned $36,000 against your 4k @ 12-15% over 4-5 yrs. Do the math it’s shitloads. In the late 90’s world wide. Banks and insurance companies no longer needed to hold 35% in cash as security. It came down to under 10%. Look where that got us. It freed up the market to pursue their newly acquired addiction for derivatives. The so called GFC bailed out these bank derivatives yet the insurance side is ballooning 4-5 times greater than that. Which of course will be GFC round 2. If you owe money. Get ready to be a slave for REAL! This shit doesn’t just happen. It’s planed that way. If I’m wrong at all here please set me straight, but I doubt it.

    1. You are repaying the central issuing bank (of australia in this case). Central banks usually use this money to cover their operating costs and then literally destroy the rest. The only reason they put the interest on the loan is to encourage people to trade so that they can create value to repay the interest and catch up. Its a stimulus method for society.

      Like I said in my other comment, you could lend $9 against every $1 in your own account, its just you are not as established with the same size and trust record as the bank (I know that sounds ironic in this situation), this means that your borrowers are more like to cash in quicker and do the equivalent to your finances of a run on a bank.

      I agree with you on the stupidity of deregulation and bullshit risk spreading. A debt is a debt, and you need to manage the risk. Complicating the issue doesn’t help, and although I am no expert I am pretty confident that you should never leverage more than about 40% of your asset base.

  9. While intriguing, I think the real problem with the argument that we should just nationalize the role of banks (by having government print and lend the money), is that it’s the identical argument for nationalizing everything and having government run the entire economy. Interest by banks is equivalent to markup by stores; it’s just their way of taking a profit on what they do. People think that banking is “too easy” a way to make money, and therefore immoral. But if it’s so easy, then we should all just invest in bank stocks! However, on that measure, it’s not so easy. In arguing that the banks are just parasites that suck all the wealth out of the society, people perhaps forget: 1) that banks are in competition and can’t just dictate their interest rate and spread with what they give depositors; 2) the effect of defaults in flowing money out of banks which effectively reduces the sucking effect of the interest they charge; 3) the fact that increased money supply via debt reduces the value of that debt via inflation, so the banks’ share of the economy is not necessarily always increasing; 4) governments do print money sometimes, especially during deflation. Those factors may help to account for where money for interest comes from.

    1. The problem (among many) happens when bank cease to be in competition and collude. For example CDOs that contributed to the financial collapse. Many financial institutions were in bed. Doesn’t mean nationalizing is the answer, but perhaps well placed regulations.

  10. I must say that Christopher Dean’s response is one of the most comprehensible on the entire internet. The main point about the gap between money and currency is very elegant: 1. recorded money is increasing 2. physical currency (notes and coins) has only increased a little.

    I think I have identified two fallacies which leads to this confusion:

    1. Money/value = Currency … NOT TRUE (Although your notes and coins are money it doesn’t mean money always has to come in the form of notes and coins, it could be bonds, numbers on a balance sheet, stock, or even goods)
    2. The Central Bank is the only one who can create money/value … NOT TRUE (because of the first point people often make this second mistake. While the central bank can print currency, any organisation or individual who holds a ledger with accounts on it can create money/value, that includes you)

    Here is what I believe to be true

    1. Money = Value (in physical form) and can therefore be any form of exchangeable currency, this could be a bag of grain, some stocks in a company, a debt you have on your balance sheet, gold bars, an IOU, or even ancient african shells. The only requirement is that it can be used as an agreed unit of measuring value.

    person 1: I’ll give you 10 shells for that bag of grain
    Person 2: No way man that’s easily worth a bar of gold.

    2. To try and compare all of these exchanges people use a recognisable unit of measure (such as a currency).

    person 1: well if I happened to have £10 in my pocket I would give that to you for that bag of grain
    person 2: well if I happened to have £5 in my pocket thats all I would give you for those shells
    person 1: well I’ll give you twice the number of shells and we will call it quits.

    3. Because of these two points, money (remember it means any community value system not just currency) can literally be created out of thin air based purely on the subjective viewpoint of the people to which you are trading with. Case in point is the man who made repeated trades starting with a paperclip and ending up with a house.

    I want to give two stories which illustrate this:

    Story 1 – All value is subjective
    You would not pay £20 for a hamburger at mcdonalds. But if you are sitting on a flight to Australia with nothing but 12 hours of boredom and inflight food and you have £20 (a currency you might no longer need) you might just consider giving that to the bloke next to you who has opened up a fresh big mac. (This all relies on you being carnivorous and not adverse to fast food).

    Story 2 – Notes and coins are not important
    Say for example a company sells itself for £2 billion. THIS DOES NOT MEAN THAT THE CENTRAL BANK PRINTS A LOAD MORE MONEY EVERY TIME SOMEONE SAYS THEY JUST EXCHANGED THE EQUIVALENT OF £2 BILLION. What actually happens is that some numbers are deducted on one ledger and added on another ledger, the bank does not even move notes around in a vault, they just move the numbers.

    So when the reporter on telly asks the politician ‘but where did this money come from?’ all that happened is that some numbers where added to some balance sheets, starting at the top in the bank of England, and this means that the bank of england have more numbers to give to the countries and banks which hold accounts with the bank of england, which means that suddenly those countries or national banks have more numbers to give to their customers and so on (although it will mean amongst other things that people don’t value the currency as much because it seems like there is more of it around)

    Here is what actually happened throughout history to create money…
    1. The central bank printed a bit of currency in notes and coins, just enough to circulate on the street in everyday transactions but not enough to cover every transaction in the country, they print a bit more every so often as the notes and coins get old etc.
    2. This becomes the standard unit of value when completing most normal exchanges, even if you don’t actually exchange the cash, you assume that if you and your customer both had coins that is the amount you would be exchanging.
    3. Organisations write IOU’s (say for instance lloyds makes a loan for £5000), but they dont give out the cash, or if they do, it is only for a short time. What they really do is add some numbers to their balance sheet, and give someone a bit of paper which says they now have £5000. That person then goes and uses that bit of paper (or electronic reading on the internet banking) and tells other people that they can have some of it in return for giving him something of equal monetary value.

    The interesting thing is that I could do the exactly the same as a private individual. Here’s how:

    I have £10, I write 10 unaddressed cheques each for £10. I have therefore temporarily created the effect of £100. If all of those people decided to cash those cheques straight away I would have a problem. The same as if every person in the country with a loan decided to withdraw the value of their loan in cash. But what if instead of cashing them the people used the cheques to exchange for goods which they then sold and then returned me the money plus a charge of £1 for borrowing that money off of me. I would then end up with £20 in my account without ever doing anything but writing some cheques. It would be a gamble, but in the case of the Banks they are all using systems which never fully clear and are always hanging in the balance of larger and larger exchanges which are usually impossible to be called in all at the same time.

    If you where to take a snapshot of this situation just after me writing the cheques, you would see 10 people all believing they have £10 of money in their possession which is £100 more than ever existed in the whole world only a few minutes before hand. So in effect I just printed money, but the money has a much larger chance of becoming worthless than normal currency because its a small group of people who could quickly lose faith, where as it usually takes a lot more to shake a whole countries faith in a currency.

    The last point I want to make is about central banks, which will perhaps explain the problems with the eurozone…

    A central bank is like any other bank, the ONLY difference is that if everyone decided to ask for hard currency at the same time (this being the usual standard value system to measure all other transactions in the given society) it is the ONLY institution which can legally print money and give it to those people who want their money. They can literally print the currency to give to people that are calling in their debts. For the rest of the time the central bank just has a sheet of paper like any other individual/business/bank where it records the balances of its account holders whom usually include the following:

    1. the national government
    2. major national banks
    3. clearing houses and credit interbank credit agencies
    4. Other countries banks and governments

    I wonder if there is an economic boundary which means that when you get such an incredibly large amount of money/value recorded in accounts compared to the actually circulating cash it causes a tension and fear in the society, something for another discussion perhaps.

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