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Unlimited money creation?

5–6 July 2012

Limited by reserve requirement

In the first section I showed that money creation does exist, and that it happens when a bank grants a credit, using money that is in a demand deposit. However, that money is not created in the sense that it comes from nowhere, just like that, as if it were money out of thin air. Instead, the money that the borrower borrows from the bank, was always first deposited there by some other bank client.

In the second section I made detailed calculations about how money creation can happen repeatedly, and eventually results in a much greater money supply than the amount of cash originally available.

But – and this is important – this blow-up effect is not without bounds! It is limited by the reserve requirement that central banks impose upon commercial banks. That means banks have to keep a percentage of all the demand deposits as a reserve, in the form of cash physically in a bank vault, or as deposits in the central bank.

If the reserve requirement is 10 percent, the money supply can, in theory, grow to 10 times the original cash in circulation. If it is 2 percent (that was the situation in the eurozone until recently), that’s 50 times. With only 1 percent it can grow 100-fold.

Limited by cash in pocket

Also in my second section, I showed that the amount of cash money (coins and banknotes), as held by non-banks (people, companies, shops, etc.), also severely limits the amount of money creation that can take place as a result of bank credits.

This means that the theoretical, calculated limit, based on the reserve requirement alone, is never reached in practice. The German Wikipedia gives a realistic example (quote) of this:

In November 2011, the European Central Bank required commercial bank to hold 2% in cash reserves (in German: Mindestreserve). But the actual money supply wasn’t 50 times the amount of cash, but just under 11 times.

That’s still a lot of money, but the important point is that money creation does not get out of bounds, isn’t without limits. Even with a very low reserve requirement like 2% or 1%, the amount of created extra money isn’t excessive. It is restricted by several factors.

Money has been created already

So money creation by credit granting is limited. How much of such created money there is at any given moment, is variable.

Because the system of fractional reserve banking has been in use for many, many years, most of the extra money that can be created (given the amount of cash the central bank brought into circulation), has already been created in the past!

So the idea that some people have, that banks constantly keep creating more and more money out of nothing, to grant ever more loans, is mistaken. They can only use what little excess reserves they happen to have.

Just like money can be created when the bank grants a loan, money is destroyed again when the borrower pays off (part of, or all of) the loan. This increases the bank’s excess reserves, so there is more room for other loans. It’s the same as step 2, but in reverse.

Banks can to some extent control how close they come to the minimum reserve requirement imposed by the central bank. But they cannot control the total amount of money, original and created.

That’s a privilege only the central bank has. However, central banks don't want too much extra money in circulation, because that might cause inflation.

Conclusions

Money creation does happen and it is also done by commercial banks. Yet, banks can only lend money that somebody first deposited. That is a paradox.

Money creation, and total money supply, do not get out of hand. Money supply is relatively stable over long periods.

Money creation is useful and beneficial because it ‘lubricates’ the economy.

Money creation is not a big problem, and not a vile trick invented by banks to squeeze more money out of people and businesses.

The next chapter is about interest.


Note to this remark: This is what the German Wikipedia (version 18 July / 28 August 2012) says about that (translated below):

Bei der EZB beträgt der Mindestreservesatz derzeit 1%. [3] Es kann also theoretisch maximal die 100-fache Menge an Giralgeld im gesamten Bankensystem geschöpft werden. Im November 2011 (bei dem damaligen Mindestreservesatz von noch 2%) waren in der Eurozone 893 Milliarden Euro Bargeld im Umlauf, während die Geldmenge M3 9.775 Milliarden Euro betrug. [4]

My English translation:

The minimum reserve percentage that the ECB now imposed is 1%. [3] That means that in theory the total banking system can create the 100-fold in deposits money. In November 2011 (when the minimum percentage was still 2%), currency in circulation in the Eurozone was 893 billion euros, while the M3 money aggregate amounted to 9,775 billion euros. [4]


Copyright © 2012 R. Harmsen. All rights reserved.

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