How Money is Created
Money is created every time someone incurs a bank debt.
When you borrow money from a bank to buy a house, e.g. $350,000, you sign a ‘mortgage contract’ with the bank, promising to repay that money over a defined time horizon, e.g. 30 years, and to pay interest on the loan during that time horizon. Many people think that the bank then takes $350,000 worth of savings of depositors, and on-lends them to the borrower; but that’s not really what happens at all. A bank does have to collect some money from investors (people who buy equity shares in the bank) in order to meet certain financial criteria before it can open up for business and start making loans, but it doesn’t have to collect savings from depositors before it can make loans to borrowers.
What happens when you borrow money from a bank is that the bank simultaneously records and debt and a credit, in equal amount, on its balance sheet, by means of double-entry bookkeeping. In this case, the $350,000 mortgage contract you sign is the bank’s “asset”, which it enters into its spreadsheet along with the mortgage term and interest rate information, and the $350,000 it enters into your deposit account so you can buy a house is the bank’s “liability” incurred as a result of the mortgage lending transaction.
In point of fact, when a bank makes a loan to a borrower, the bank creates both credit and debt in equal amounts. As the Bank of England (the British central bank) explained in a paper entitled ‘Money Creation in the Modern Economy’ published in 2014, what we ordinary citizens call ‘money’ is in fact nothing other than bank credit entered as numbers in bank deposit accounts during acts of borrowing.
Most payments are made by transferring electronic digits between bank customers’ accounts. A small fraction, perhaps 3%, of that money is ‘paid out’ as cash printed by the government’s mint; this results in a corresponding decrement to our deposit account (or an increase in our debt to the bank, if we have a credit line or a credit card). But paying out cash doesn’t change the amount of credit in the banking system; it merely transforms it from an electronic digital form to a paper or metal form. This doesn’t change the fact that all of the ‘money’ that people own is ultimately always offset by an equal amount of debt that someone, somewhere, owes to a bank. If you have $6,234 in cash and bank deposits, and no bank debt, that means some other people (or companies) in the country’s banking system owe $6,234 to banks within the system. If all bank debts were repaid in full tomorrow, then at the end of the banking day, there would be no bank debts in the system, but also no money. Bank debt and money (bank deposits plus cash) exist in a 1:1 ratio. (Note that it isn’t possible to repay all the bank debts in the system tomorrow, because the debtors don’t have the money to repay their debts in their possession — other people own that money, namely those who are in the happy position of being net creditors in the banking system.)
Money, in short, is created in the banking system through acts of ‘bank lending,’ and ultimately, banks are simply administrators of vast spreadsheets that keep score of who owes them points in the scorekeeping game we call ‘the monetary system’ and to whom they owe points. The whole thing nets out to zero. It’s a zero-sum game, which results in positive-sum economic value creation because the creation and circulation of credit creates a system of trust in an institution, rather than in individual people; the banking system allows people to buy and sell inputs from perfect strangers without having to trust those strangers’ debt instruments. That’s why the double entry bookkeeping based banking system is perhaps the most important invention in human history — more important, arguably, than the wheel.
Within any given currency system (e.g. the Euro system or the British Pound system), individual banks’ spreadsheets are interlinked, in part through the fact that banks themselves all have accounts at the same bank: namely the ‘central bank’ (in the UK, the central bank is the Bank of England; in Canada, it’s the Bank of Canada; in the Eurozone, it’s the European Central Bank; in the USA, it’s the several regional member banks of the Federal Reserve System). The several dozen central banks of the world, in turn, also have a global ‘central bank’ at which they all maintain accounts to ease transactions between themselves; it’s called the Bank of International Settlements (BIS), and it’s headquartered in Switzerland.
Now you know.
