Can Banks Create Money?

You may have heard that banks create money out of thin air every time they make a loan and that 97% of all money was created in this way. If so, parts of what you've heard are true and parts of it aren't.

In this article, I'm only going to answer the question about whether or not banks can create money. Rather than giving full explanations in a single post, I'll break it up into multiple posts over time, so you can take that glazed look off your face!

Lending

There's an enormous amount of false information online about how this works. You may have heard someone talking about something called fractional reserve banking or the money multiplier, but this method of money creation is a myth. What banks actually use is something called credit creation.

Accountants will immediately understand how this works (and most economists don't because they haven't learned accounting). If you want to get money from a bank so that you can buy yourself a trendy new gadget, like a smartphone that mines cryptocurrency every time you make a call, the bank gets you to sign something called a promissory note.

A promissory note is just a promise to pay. It says how much you'll pay, when and at what interest. As soon as you sign it, you've just issued what's called a security (a financial product) and the bank then buys that security by making the following three entries on their ledger:

1. Debit the personal loan account
2. Credit the personal loan interest account
3. Credit the borrower's account

And that's one way they create a lot of money. They enter assets on one side of the balance sheet and liabilities on the other side. Accounting 101.

Notice that the bank didn't lend money. Contrary to what almost everyone believes, banks aren't in the business of lending money - they buy and sell securities.

When it comes to deciding on whether or not to give you money, all banks care about is whether or not the people asking for 'loans' are credit-worthy. If they're not credit-worthy, they drop them like a hot snot.

Spending

If a bank buys goods or services from someone who has an account at the bank, then they can create money to buy those goods and services. All they need to do is enter some numbers into a computer to increase the balance of the vendors account.

As governments make most of their important decisions by playing rock, paper, scissors, it's important that they don't make any mistakes. When they spend money on purchasing the instruction manuals for the game, the central bank will create money in the account of a commercial bank, who then increases the balance of the printing company's account. The same thing happens when they buy other stuff, too.

The claims that 97% of the money supply was created through lending are incorrect because they haven't factored in this method of creating money. And as you already know, because you were paying attention farther above, banks don't lend money - they buy securities.

Is It The Same As Government-Created Money?

Central banks create money in a similar way to commercial banks. They simply enter numbers into a computer. However, the government will only accept money that has been created by the central bank for the payment of taxes.

"What about coins? In Australia, they're created by the Royal Mint and not the central bank."

True, but if you call the Australian tax office, they'll tell you that they never accept notes or coins for the payment of taxes - only electronic transfers. If you go to their office and try to hand over cash, they might just direct you to the nearest post office so that you can give the cash to them and they'll make the electronic transfer for you.

The government doesn't accept bank-created money for taxes. It's just a liability on the banks balance sheet, so it makes no sense for them to take it.

If you pay your taxes by bank transfer, what's going on under the hood is that your bank is reducing the credit in your account and then transferring the government-created money that they have in their account at the central bank to the tax office.

Is the money that banks create really money? Well, it's bank credit. They try to make it look the same as government-created money by giving it the same name (dollars, pounds, yen, etc.) and will exchange their credit one-for-one with government-created money. It's just marketing, but that doesn't mean that it isn't money. I'd argue that anything that gets used as money is money. Oh, and the central bank also keeps a record of it and says that it's money, so there!

There's More

I'm not going to go into things like capital adequacy requirements here because they're pretty boring, even when I talk about them. I'll probably give them their own post because they explain why banks can't just create infinite amounts of money and buy themselves out of trouble.

Banks create vast amounts of money for people who want to buy real estate, but they don't lend so much to businesses. This means that the price of real estate can increase rapidly while incomes stagnate, thus creating an economic bubble. That's definitely getting several posts (inflation, unaffordable housing, intergenerational fairness, inequality growth, etc.) of its own.

Should banks be allowed to create money? Well, money has to get into the economy one way or another and banks are supposed to do this. They don't do a great job at it, though. That'll be another post, someday.

Conclusion

At the end of the day, banks are a bit like a version of Santa Claus who lends out toys for up to 35 years. So, if you hate banks, you hate children!