How Banks Create Money

The means by which the banking system creates money by extending credit is a pretty complex phenomenon, to the extent that experts in monetary theory claim that economics textbooks oversimplify the matter in their explanations so to not even give students an adequate picture of what really goes on.

So in spite of the brief amount of space we have and the fact that our goal is to explain things in a way that a lay person can understand, we can set forth some of the basic principles here so that you at least come away with a pretty good understanding of how this all works, which will put you ahead of just about everyone.

The first thing we want to deal with is what money really consists of, and it isn’t just currency. The last time money was defined as currency was in the pre banking days, and we’re talking a very long time ago here.

This was back in a time where money was simply stored, in temples mostly, you would have some gold coins or other currency and keep it in a vault somewhere, much like a safety deposit box works today. There are a lot of people who think that is how banking works, but instead of this, the money you put into a bank is put into play so to speak, by the bank lending it out.

The key to understanding what money really is is grasping the notion that it is mostly credit, and only about 1/10 of the money supply is actual currency, with 9/10 of it being credit. So when we tell you that banks create money by extending credit, and money is destroyed by people paying back loans, it we see money as mostly credit, this rather bizarre sounding notion can at least start to make sense to you.

Banks creating money does tend to bother some people though, and has spawned all sorts of notions of the banking system having way too much power and manipulating us, making us all slaves to the Illuminati or whomever, the people in control, but the truth is that this is all healthy for the economy and is extremely tightly monitored by the government, who do know what they are doing here.

How Money Mostly Consists of Credit

The government actually actively participates in all of this money creation, and through various means such as manipulating interest rates that they charge banks, changing the required percentage of reserves a bank must hold, or having the central bank create money themselves by buying and selling securities with the proceeds entering or exiting the banking system to either expand or contract the money supply.

The reason why the money supply is dependent upon the total amount of credit extended is due to what’s called the multiplier effect. Here’s a simple example of this. Let’s say you deposit $1000 at a bank, You have loaned the bank the $1000, so the bank can now lend this money out to others.

If this were all the money in the world, for the sake of simplicity, the money supply at the time of your deposit would be $1000,  The bank then lends the money to your neighbor, although they only lend out $900, because of their 10% reserve requirement, which is typical.

Should you show up at the bank to get your money out, they could borrow money from the central bank to repay you over and above what they have in reserves, and they do have assets to counterbalance the liabilities they have to you, so this reserve ratio mostly exists to place constraints on how much the bank can lend out.

If the reserve ratio was zero, banks could lend out an infinite amount of money from just this $1000, to this ratio serves to keep that under control.

So in this case we now have $1900 in the money supply, as your neighbor spends this $900 loaned to him, which ultimately gets deposited in the bank,  It may not be your bank but we’re talking the banking system here when we look at the money supply so that doesn’t matter.

So there’s an actual $1000 of deposits, let’s say that’s hard cash, plus $900 worth of credit. Out of this $900 that gets deposited from the proceeds of the loan, the banks keep 10% of this back and loan out the rest, $810 more in loans in this case, and now the money supply has grown to $2710 from the original $1000.

This process continues in theory, and this is why extending credit is called the money multiplier, and if you work this out you will see that it comes to around the 90% credit and only about 10% currency that we see in the economy.

How Money is “Destroyed”

So banks create money from extending credit, and banks always are in the process of extending credit, so if this were the only factor here then this would simply explode the money supply and be super inflationary. Now the money supply does get expanded anyway over time but this is not a matter of all the loans ever made being added together, its instead how much money is out on loan at any given time.

So the money supply increases or decreases by way of the net amount of credit extended, and when this goes up, the money supply increases, and when this goes down, by way of more credit being paid back than extended, the money supply decreases.

This is because, as credit creates money, repaying credit destroys money. Destroying it in this way is a good thing though because otherwise the economy would go haywire,

Let’s go back to our simple example. If the first person who borrowed simply repaid the $900 loaned out immediately, this would reduce the money supply, by exactly the $900. This is counterintuitive because we would think that the bank would have this $900 added as new money which they could lend to someone else, but that’s not the case.

The key to understanding this is to realize that this money was already in the system, the repayment amount, and the total money on deposit at banks has not been increased by this amount, it has been reduced by this amount.

In our case, at the time of the loan of the $900, there was $1900 in the system, your $1000 plus your neighbor’s $900, both on deposit. Your neighbor pays back the $900. Now there is only $1000 on deposit. The total money supply has therefore shrank by $900. This takes us to the same place prior to the loan, the bank can re-lend this $900, but the money created by this original loan of $900 has been destroyed by the repayment.

Credit Really Does Drive The Economy

So the amount of credit in the economy directly determines the money supply in this fashion, how much money is loaned out in other words, by banks and by governments as well. The notion of all this does bother some people who may call for reform, but these reforms always involve attempts to contract the money supply by placing limitations on credit, which is not a real good idea actually.

During recessionary periods, this is exactly what happens, so calls to reduce the creation of money through methods that contract the money supply, such as excessively high reserve amounts, would just serve to beckon a recession, and the more contraction you desire, the bigger the recession will be.

The extreme example of this would be if credit were somehow outlawed, with no one being allowed to borrow legally. The banks would immediately all go under, people’s deposits with them would mostly go with it, and the government who normally insures deposits to a certain amount can only do so much anyway, but now they can’t borrow either because it’s outlawed, and this plus all the other ripple effects would cause the economy to completely collapse.

So this would be the equivalent of nuclear war to the economy, and therefore is something we’d never see, but whatever artificial constraints on the money supply over and above what’s needed to control excessive inflation is going to damage it to some degree.

We owe our prosperity to the credit economy actually, not just in part but in whole, and some may claim that we are addicted to credit, and that’s true, but it’s a necessary economic addiction if we want to maintain our present level of economic prosperity. Since we do, the extent of credit as we know it is here to stay, this bank created money, and governments will go to great lengths to preserve this, even spending hundreds of billions of dollars to prop it up if needed.

So banks creating money is not part of some diabolical scheme for banks to take over the world, or maintain their present ownership of it, this is simply a way that we can live more prosperously, in the aggregate, much like we can do so from personal borrowing.

If we’re investing though or are even curious as to how the economy works, having at least a basic understanding of how our money supply works, how banks and governments create money, and even how it is destroyed, certainly doesn’t hurt and can even have practical value in our decision making in our own lives.