How Debt Creates New Money
As we will soon see, banks “create” the bank deposit money that they use to pay for their purchases of government bonds. So banks create money to get bonds, then put up the bonds as collateral to get banknotes. It is not a “problem” for banks to get banknotes, so banks will never run out of “money” if their customers decide to convert their bank deposit money into cash money. Commercial banks can no longer “directly” print up their own banknotes, but they can create the money they use to buy the collateral assets against which security they can borrow banknotes from their central bank.
Sovereignty of Bankers
You will note that only bank workers are allowed to change the numbers in bank accounts. You cannot change the numbers in your own accounts. You can make a deposit and your bank will add that number to your deposit balance. Or you can write a check or make a debit card payment or withdraw cash and your bank will deduct that number from your deposit balance. Banking systems are legislated into existence by governments, but once they are licensed to create and manage a nation’s money the bankers are sovereigns within the realm of their banking and money system. Only “bankers” can change the numbers in bank accounts.
In some nations like China the government owns the national banking and money system so the government retains its monetary sovereignty because it has retained the power to tell its bankers what to do and not do. In many nations such as Germany and Japan there are government owned banks operating alongside privately owned banks. In the US only the Bank of North Dakota is a government owned bank. The rest of the US banking system, including the Federal Reserve Bank that issues the cash money, is privately owned.
There are some who will say that the Fed is part of the government. I maintain that the Fed is a licensed and privately owned government contractor.
Deficit Spending into the Economy
When the US government needs to borrow money to cover its deficit spending, the government does what you and I do: it goes to the private banks and gets a loan. Instead of signing an Uf as a promissory note, the Treasury Secretary signs a “bond”. A bank buys the government’s bond by creating a deposit in the government’s account at that bank. The government then transfers the new deposit to its checking account at the Fed.
Then the government writes checks and authorizes direct debits against its Fed bank account balance, and thereby “spends” its new credit money into the economy. Whoever gets the checks deposits them in their bank accounts, where the new ‘money’ becomes a new “bank deposit”. Direct debits from the government’s Fed account are directly credited to the recipient’s bank account, all managed via the banking system’s payments system, which is quite simply a very large accounting system of credits and debits to bank accounts.
Private Sector Borrowers
Private sector borrowers do the same thing as government borrowers. Brad goes to his bank and gets a loan, which his bank creates by adding a new deposit into his bank account, then Brad writes a check to Godfrey. Godfrey deposits the check in his bank account, the payments system debits Brad’s account and credits Godfrey’s account, and now the new “money” exists as a new deposit balance in Godfrey’s bank account.
New bank loan money first exists as a deposit in the borrower’s account, but borrowers borrow in order to spend, and they also owe the borrowed money as debt. When they spend the money, somebody else earns it, and the money becomes the “property of” the earner. So the earner deposits the money in his bank account as a positive credit that he does not owe to anybody.
The banking “system” remains in balance. One bank created the new money and that bank holds the borrower’s (Brad’s) debt as an asset on its balance sheet. And the other bank that accepted Godfrey’s deposit of Brad’s check now holds that money as a liability on its balance sheet. So the bank loan created a new bank asset and a new bank liability in the same amount, and the banking system’s balance sheet remains in balance.
Where Does Money Come From?
Where do banks get the money they lend? I just laid out the simple process by which banks “create” the money that they lend, by adding credits to borrowers’ bank accounts. The money only exists as numbers in these bank accounts. That’s all there is to it. Banks create money. Banks create virtually ALL the money, simply by adding positive numbers into bank account balances, and simultaneously adding negative numbers into loan account balances.
The positive numbers are money, the negative numbers are debt. Each bank loan or bond purchase is made by the creation of brand new money that never existed before, as a new addition to the economy’s money supply. And all the money is owed to banks as debts, owed by the people and firms and governments who borrowed and spent newly created bank deposit money.
Banks create our money by “monetizing debts”. We sign debt notes promising to pay interest and repay the principal, and a bank “purchases” our debt note by creating a bank deposit in our account. The borrower spends the new deposit, the recipient of the spending deposits the money in his bank account. Bank loans “create” bank deposits. That’s where the deposits come from in the first place.
Lending of Deposits is a Myth
Tustain and Ash and pretty much all the schools of economics will tell you banks get money when people deposit money in banks, then they lend this money out to borrowers. A simple logical consequence of this mistaken belief is that all the money that banks currently have out on loan must have already existed before they loaned it, or else from whence did the depositors get the money that they deposited and the banks loaned out? The US banking system currently has about 56 trillion dollars out on loan. So did Adam and Eve start off with the $56 trillion, and eventually their descendants deposited it all in banks so banks could lend it out? If not Adam and Eve, then where did 56 trillion US dollars of money come from in the first place?
Again: Bank loans create bank deposits. That’s where our money comes from in the first place. Banks do not lend out their depositors’ savings. That belief is just wrong.
Misunderstood Fractional Reserve Banking
Some people believe that banks only hold a “fraction” of the deposits, and lend out the rest. So each time the money gets deposited in a different bank, the new deposit becomes the basis for the new bank to create even more new money based on its fractional reserves. So at a 10% reserve ratio a $1000 deposit is the basis for $900 of new lending, then the $900 deposit is the basis for an additional $810 of new lending, and so on. All in all, the original $1000 deposit becomes the basis for somewhere south of $10000 of newly created fractional reserve bank money. But this is just not the way “fractional reserve” banking has ever worked.
Even assuming fractional reserve banking worked like this, which it doesn’t, it could only multiply an original total of “real money” deposits by less than 10X. So did God only give Adam and Eve $5.6 trillion instead of $56 trillion? Was there $5.6 trillion of money in the US when the Federal Reserve Bank money system began operating in 1913? Not even close. There were a few billions of dollars then, not trillions. Fractional reserve banking cannot multiply billions into tens of trillions, even if that’s how the money system worked, which it doesn’t.
Fractional reserves refers to the “base money”, the “cash money”, the “real” final form of money. It used to be gold and silver, now it’s printed banknotes and central bank reserve balances in the accounts that the commercial banks have at the Fed (or other central bank, in the case of other nations’ currency systems).
In the pre-Fed gold standard days banks started with a “capital stock” of actual gold specie. They then went into the banking business, but they never loaned out their actual gold. Their gold was their “monetary base”. They loaned out money in the form of banknotes that banks printed, which were the bank’s Ufs, the bank’s promise to pay gold in the future, to the holder of their Uf who presented the banknote at the bank for “redemption” into final payment money, gold. And they loaned out money in the form of checkable bank account balances that were also supposedly “convertible” into gold when a check was presented at the bank.
Gold was believed to be the ‘real’ money, and the banknotes and checkbook money were thought to be “money substitutes” or “near money”. Bank loans of banknotes and bank deposits were “claims” on the bank’s stock of gold. The claims were ‘good as gold’, but they were not actually the gold. But the claims were not good as gold because banks have ALWAYS loaned out way more claims than they had gold to honor those claims. They issued “claims on gold money” based on “fractional reserves” of actual gold.