Most Money Is Created By Banks, Not Governments
If you think money is created by governments or their central banks then think again, because most money is created by commercial banks when they make loans.
Some two decades and change ago, I was outside the Clontarf Castle Hotel in Dublin, where I was attending the Gaelcon gaming convention. I was chatting with a guy called Padraig, we’d got onto economics, and the content of the conversation had got way beyond my understanding. Then Padraig took a drawl on his cigarette before declaring:
“Most money is created by commercial banks when they make bank loans.”
At this point I concluded that the conversation had clearly gone beyond my comprehension. I’d clearly misunderstood what he’d said, because he couldn’t have said what he appeared to have just said, because what he appeared to have said was clearly insane.
Several years later, in the banking crisis of 2008 I read some more and realised that I had heard him correctly.
When a commercial bank lends you money, they’re not moving existing money to you, they’re creating new money.
Don’t believe me? Well let’s explain it in the form of a historical story.
Disclaimer: What follows is my layman’s understanding, and is likely highly simplified, and possibly slightly wrong. But I do think it gets over the general gist.
Imagine a D&Desque town somewhere in a pseudo-medieval society. In this town are a hundred people, twenty horses, and a thousand gold crowns (they mint their own money).
Every year, the town council sends people out to go door to door making a census, asking how many people live in each house, how many horses they own, and how much money they have. Now the number of people and horses might fluctuate, but the amount of money reported always adds up to a thousand gold crowns, because they aren’t producing any more coins.
One day, a man goes away on a long business trip. He doesn’t want his wife to have to look after his horse, so he asks a guy who owns a stable down the road to look after it. While he is away, unbeknownst to him, the guy illegally sells the horse to someone else in town.
A few nights later, the census takers go round doing the annual census. When they knock on the wife’s door, she replies that they do own a horse, it’s in the stable down the road. And when they knock on the door of the person who unwittingly bought they horse, they also reply that they own a horse.
When they add the figures up they will find that there are twenty-one horses in the village. Except that there aren’t, there are only twenty, but one horse has been double-counted. (And when the horse’s true owner returns, the situation will be resolved, albeit likely with some strife involved).
Now imagine that one day, a bloke in the village learns around this new thing the Dutch have invented called “fractional reserve banking”. He goes to the town council, explains what a bank is, and asks them to rewrite the town’s laws in order to allow him to open a bank. They agree to do so.
Soon he opens, and has his first customer, a woman who puts ten crowns into the bank. He updates her deposit book to show he has ten crowns. He is allowed to loan up to 80% of deposits back out, and he immediately does so, loaning 8 crowns to a man who wants to open a café.
That night, the census takers go round. The rules / laws now state that money in the bank counts as money for the purposes of the census. So when they ask the woman how much money she has, she reports that she has ten crowns, showing her bank deposit book as evidence. And when they ask the guy who wants to open a café how much money he has, he reports that he has eight crowns sitting on his bedside cabinet.
When they add up all the money in the village they will get a total of 1008 crowns. This is not a mistake. I’ll say that again. It isn’t a mistake. Unlike with the case of the mis-sold horse, they haven’t double-counted stolen money. When the banker loaned eight of the woman’s ten crowns out, he wasn’t illegally* giving her money to someone else.
He was perfectly legally creating eight new crowns.
There are now 1008 crowns in this village’s money supply, 1000 of them physical, and eight of them virtual.
Padraig was right. It was just that this is a principle so counter-intuitive that we as a society simply fail to believe it.
Sorry Padraig. I wasn’t being rude. I just was unable to comprehend what you were saying.
*Background note: banking started when goldsmiths started offering to let people store their physical money in their safes for safe-keeping, then started illegally letting other people use that money for a fee, figuring that if the original owners ever asked for it back, they could just give them the equivalent amount in someone else’s money. It was then realised that this is actually a really good way of making your economy grow – so laws were written to make what was previously illegal, legal.
The Nexus Files is free to read. But if you subscribe you'll get new posts emailed to your inbox automatically, and I won't feel like I'm pointlessly screaming into the void.