Economy #1: How Money is Created

Posted: September 9, 2009 by livingmyrichlife in Money and economics, World-Changing Wednesday

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Photo by: cayusa

This is the first post in my World-Changing Wednesday series. Tune is each Wednesday to read my thoughts on an issue which I think will have a huge impact on how we live our lives in the years to come.

This week, I’m going to talk about how money is created. If you are anything like me, you’ve probably never even given this topic a second thought. In hindsight, this attitude might have been a little crazy given that most of us live our lives in pursuit of money. In our culture we’ve been taught that money buys us happiness. Without consciously choosing to do so, we’ll seek riches as a means of fulfillment and in the process we’ll put the earning of money above all other pursuits.  However once you understand the nature of money, you may think twice about its relative value.

The process by which banks create money is so simple that the mind is repelled ~ John Kenneth Galbraith, Economist

Where does money come from?

printing-money

Most people imagine that the government makes money. Indeed the coins and paper we usually consider to be money are produced by a government agency known as the mint, but the vast majority is created by private corporations known as banks.

Most of us probably think that banks lend out money that they have on deposit from peoples’ savings, but this is not the case. The banks simply create money out of thin air, based on the borrower’s promise to pay. The borrower agrees to pay back the money loaned to them, plus interest and if they don’t they will forfeit their collateral (i.e. car or home).

So, for that big commitment made by the borrower, you’d think there would have to be some sort of large commitment on the banks behalf, wouldn’t you? In fact, all the bank needs to do in this exchange is to conjure out of thin air, the amount of the loan and write it into the borrowers account. So you’re now thinking, ‘Surely this can’t be true?’ But it is.

Money is loaned into existence.

Let me try to explain. If it takes you a couple of reads to get this, don’t worry. I’ve been there. It’s actually a pretty simple process, but it is difficult to accept. The following explanation applies to the process in the USA, but the system is similar in all industrialised nations.

Firstly, let’s imagine that a brand new bank has just opened up in town and it has no depositors yet. To get things started, the bank’s investors have made a reserve deposit of $1111.12 of existing cash money at the Central Bank.

new-bank

Screen capture from Money as Debt

Step 1. The bank welcomes their first loan customer who needs $10,000 to buy a car. At the 9:1 reserve ratio required in the USA, the bank’s reserve legally allows it to conjur into existence nine times that amount (9 x $1111.12 = $10,000). This $10,000 is not taken from anywhere. It’s brand new money simply typed into the borrowers account as bank credit. The borrower then writes a cheque (check) against that credit to buy a used car.

Step 2. The seller of the used car then deposits this newly created $10,000 at her bank. Money deposited into commercial banks can then be loaned out on a 9:1 ratio.  So for the $10,000 deposited, $9,000 could be loaned out and the bank would keep $1,000 in reserve.

Step 3. If that $9,000 is then deposited in a bank, that deposit can again be used for a third issue of bank credit, this time for the amount of $8,100. Each new deposit contains the potential for a slightly smaller loan. In all likelihood, this process will repeat over and over until nearly $100,000 of brand new money has been created within the banking system.

All of this new money has been created entirely from debt and the whole process has been legally authorised by the initial reserve deposit of just $1111.12 which is sitting at the Central Bank. So ultimately, the banks initial Central Bank reserve deposit of $1111.12 allows it to collect interest on up to $100,000 that the bank never had.

Banks loan money they DO NOT HAVE!

What’s even more interesting is that the required reserve ratio in Australia, Canada and the UK is 0%. There is no statutory limitation to the amount of artificial money that can be created by the banks.

Now while there are some complex rules I won’t go into, the reality is quite simple. Banks can create as much money as we can borrow.

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Photo by: Martin Kingsley

Despite, the fact that we usually think of money as the physical cash and coins we have in our wallets, Government created money typically accounts for less than 5% of the money in circulation. More than 95% of all money in the world today was loaned into existence. Is this all real money? Sure it is….. especially if it’s in your bank account.

Ok….How’s your brain doing?

I’m afraid that the ordinary citizen will not like to be told that banks can and do create money …. And they who control the credit of the nation direct the policy of Governments and hold in the hollow of their hands the destiny of the people. ~ Reginald McKenna, past Chairman of the Board, Midlands Bank of England.

Now that you know all this, give some thought to what might happen if everyone who had money in the bank walked in and tried to take all their money out at once. Remember, depending on your country, the banks have been holding somewhere between 0-10% of your deposit in reserve. How many people will receive their deposits back before the bank has to close it’s doors because it’s run out of money?

Also give some thought to what happens when people default on their loans. This system works great while people are able to keep making their payments, but what happens to the money when loans don’t get repaid?

You may also have noticed that we haven’t really touched on an important aspect of this whole system……. Interest. Where does the money come from to pay the interest on all the loans? If all the loans are paid back without interest, we can undo the entire string of transactions, but when we factor in interest, there suddenly isn’t enough money to pay back all the loans.

This issue is addressed in a follow-up article: The Debt Trap (Our Economic System is Not Sustainable)

Ok, I think I’ve written enough for today, so I’m going to leave the next part of this discussion to another day. It’s a lot to digest all at once, so as long as you come away from today understanding that all money is loaned into existence you’ll have a good basis for understanding why this might create problems within our society.

Please note that I am not an economics expert. I’m simply an ordinary gal trying to make sense of a complex world. I urge you to do your own reading on this subject. Here’s some good places to get started:

The Story of Money – Comic book from the Federal Reserve

Money Creation – Crash Course Chapter 7

Wikipedia.org – Explanation of Money

Read more from me:

Economy#2: Is a housing bubble looming in Australia?

Economy#3: How the Credit Crisis Happened

Economy#4: The Debt Trap (Our Economic System is Not Sustainable)

Energy#1: What is Peak Oil?

Energy#2: The Economy and Oil (The Long Decline)

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Comments
  1. Umaima says:

    Excellent Article

  2. Hickchick says:

    This is really interesting stuff. It’s all just a house of cards, isn’t it.
    I’m going to read more now.
    Kris

  3. LS says:

    Nice post. My partner Sam wrote a similar thing recently on her blog. It takes a while to get to grips with the shear stupidity of this system, but once you do the consequences are logical and unavoidable. It’s a shame that so few people take the time to do so.

    A local journalist (who specialises in economic matters) recently said that “the main purpose of growth is to improve our standard of living”. Umm. No. The main purpose of growth is to allow us to pay service existing debt. These people live is a make-believe fantasy world.

  4. Gary says:

    Sorry pal, but this sort of thing just does not help at all. It is a bit like school level economics, and just discovering FR banking.

    I personally think a FR system is an excellent thing as it allows liquidity at the point of requirement. The main problem is managing the FR ratios, and bad management in anything leads to the excrement hitting the fan.

    Still if you ever have a eureka moment and come up with a good alternative I am all ears.

  5. kk says:

    Good insight, that old saying paper money isn’t worth the value written on it

  6. Agelita says:

    Love your blog. Glad i found it lot’s of information. Please keep writing!

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