Money out of thin air?



Money creation does exist. And money creation does happen when a bank lends someone money.

However, the bank doesn’t create that money out of thin air. The money it hands over to the borrower, is actually money somebody else has put in the bank. It’s real money.

So how can both statements be true? I’ll explain later. It is a paradox. It looks like a contradiction but it isn’t.

This is difficult to understand. So many people misunderstand, and that results in:

That is a pity, because all of this is based on misunderstandings, not on fact and insight.

Granting a credit

Initial situation

A simple example. Suppose we have a village with only two inhabitants. One owns a hundred dollars in cash. The other one has nothing.

There is also a bank in that village. The bank has just started its operations. It has no initial capital yet and no money at all. Its balance sheet is empty.

The village also has a supermarket. It’s empty right now.

OK, so far the situation is rather weird and unrealistic. But that’s just to keep things simple, so we can closely monitor what will happen.

Step 1

What happens?

Villager A has enough food and everything he needs in store for some time. So he doesn’t need to go the supermarket to buy anything.

Because Villager A doesn’t need his 100 dollars for a while, he decides to put them in the bank.

Balance sheet

Now after the bank has entered this transaction in its books, what does the bank’s balance sheet look like?

Description Debit (assets) Credit (liabilities)
Cash 100
Checking account (demand deposit) of Villager A 100

Money supply

To find out if any money creation has already taken place, we need to look at the money supply. That is the total amount of money in this small economy, which consists of just one village.

Before step 1, the money supply was simply $100, namely the cash amount that Villager A had in his purse or wallet. Nobody else had any money.

Strange though it may seem, after Villager A has deposited those 100 dollars in the bank, they no longer count as money! Well, it depends on how you define ‘money’. There are several kinds of money, and several slightly different definitions. I use type M1, which basically consists of cash not in banks, and demand deposits.

Villager A’s $100 used to belong to M1 while he had them in his pocket, but now no longer does because that money is in the bank.

But: to account for the fact that the bank doesn’t own this money, that the owner is still Villager A, the bank acknowledges in a account that they owe Villager A those $100. They recognise a debt.

For the bank this is a liability, so it appears on the credit side of the balance sheet.

This bank account is a demand deposit, meaning Villager A can ask part or all of his money back at any time. Because of this, it is considered as ‘money’ under the definition of money type M1.

Summing it all up, the total money supply is still $100: the cash in the bank isn’t M1 money, though the balance of the checking account is.

Step 2

What happens?

Villager B does need some money. The bank decides to loan 90 dollars, of the 100 dollars it got from A, to Villager B. 10 dollar remains as a cash reserve.

Balance sheet

After the bank has entered also this transaction in its books, what does the bank’s balance sheet look like?

Description Debit (assets) Credit (liabilities)
Cash 10
Checking account (demand deposit) of Villager A 100
Loan facility of Villager B 90

Money supply

The 90 dollars, now outside of the bank’s tills or vaults, but in the hands of villager B, count as money (again: type M1). The $100, as before in Villager A’s checking account, also count for the total money supply of our isolated and very simple village.

That makes a total of $190. Before we had $100. The total has risen by $90. That means money creation must have taken place. And it happened when the bank granted a credit and gave 90 dollars to Villager B.

That’s what credit is all about!

Is this kind of money creation, that happens as a result of credit granting, a bad thing?

No. It’s the very essence of the concept of credit: money that someone doesn’t need for a while, can meanwhile be used by somebody else, in such a way that the original owner doesn’t lose it!

That’s smart, useful, beneficial and convenient. But use with care, of course.

The borrower has part of the money and can spend that part, so that is money. But the original depositor still has the right to claim the full amount back at some point in time. That claim is also a type of money.

Credit granting by the bank effectively duplicates a large proportion of the originally deposited amount. However, what the bank passes to the borrower actually came from the original depositor. The bank does not cheat in any way. No money suddenly appears out of the blue.

That is the paradox. I hope it’s clearer now.

Is that money creation limitless? No. More on that later.

Copyright © 2012 R. Harmsen. All rights reserved.