Where does money come from?

Introduction

In my previous article I discussed what money is in Australia and highlighted that most of the ‘money’ is in the form of bank deposits.

It only takes a quick look at the Reserve Bank of Australia’s (RBA) money aggregates to see that the amount of bank deposits in Australia have been growing at a very healthy rate since the 1980’s (see Chart 1).

Chart 1 – Australian Bank Deposits. Calculated by subtracting currency from the M3 series.

So where does this extra money (i.e. bank deposits) come from? Who creates it? And is there a limit to how much can be created?

The Bank of England published a 2014 bulletin explaining where money comes from in detail. It is simple really. Money is created every time a commercial bank creates a new loan.

In 2018, the RBA confirmed the BOE’s assertion about money creation by stating that in Australia “Money creation primarily occurs via the extension of loans by financial intermediaries” (source RBA).

So there we have it. Most of the money in Australia is created through the extension of loans by commercial banking institutions.

But how does this money creation through loans process actually work? To answer this question, I’m going to take a closer look at the BOE’s bulletin.

The BOE starts their article by dispelling a common misconception about money creation. The common ‘myth’ about money is that banks simply act as intermediaries, taking money from savers and lending this money out to borrowers. In this view ‘savings’ of households or companies create deposits.

The reality of the situation, according to the BOE, is almost the exact opposite. Rather than banks lending out deposits that are placed with them, it is the act of lending that creates deposits.

Lets explore this idea further by using an example1. Imagine you walk into your bank and ask to take out a mortgage of $1 million.

The bank asks you a few questions, you complete and sign a lot of paperwork, the bank approves the loan, and they tell you that you will find the $1 million in your account at the bank.

At this stage what do you think has happened? You may assume that the bank has somehow transferred the $1 million from someone else’s account, either inside or perhaps outside of the bank, into your account. This is wrong!

What has actually happened is that the bank has simply credited your bank account – likely by typing numbers into a sophisticated spreadsheet – with an amount of $1 million.

At that moment, new money is created in the form of a ‘bank deposit’2. This process takes advantage of a wonderful ‘technology’ called double entry bookkeeping.

Figure 1 illustrates the process by showing a hypothetical balance sheet of a bank. For simplicity, the bank in this example is a newly formed bank which begins with $100 million raised as capital from investors.

The initial balance sheet of the bank (Figure 1 left) shows the initial cash raised as an asset (what the bank owns) and the shareholder equity as a liability (what the bank owes).

Now let’s consider this same bank provides you the $1 million loan. The bank simply records the $1 million loan as an asset (an IOU from you to the bank), and then credits your ‘deposit account’ with the funds, while simultaneously recording it on the balance sheet as a liability (an IOU from the bank to you). This can be seen in Figure 1 right.

Figure 1 – Hypothetical Bank Balance Sheet

The most important idea to take from this example is that the loan created the deposit. Moreover, because this newly created bank deposit can be used as money in the economy to pay for good and services, the act of making the new loan has created new ‘money’.

Just as money is created through new loans, the BOE and RBA point out that the process can also work in reverse. That is, the repayment of loans will typically extinguish deposits.

For example, if an individual or company use newly created ‘deposits’ to repay an existing loan, the total system wide level of deposits will remain as it was before the initial money was created.

So the money supply of an economy is like a balloon that can expand and contract. When loans are created the money supply expands. When loans are paid back the money supply contracts.

Curiously, the Australian money supply data (Chart 1) suggests that the money supply ‘balloon’ is more often expanding than contracting at a system wide level.

But who decides how much money should be created?

It would seem logical to think that if most of the money is created through the extension of loans by commercial financial institutions (source RBA), then it is these very institutions that dictate how much money is created!

Some argue that commercial financial institutions do indeed dictate how much money is created and sometimes create money too freely and for the wrong purposes.

However, the BOE argues that commercial banks cannot create money without limits.

In fact, the BOE suggests there are three primary factors that influence/restrain how much money banks can create. Let us touch on each briefly.

Banks have internal limits on how much they can lend

The BOE argues that banks need not only to stay profitable in a competitive market but also need to be aware of internal risks associated with making additional loans.

Banks also have to comply with regulatory policies which are put in place to mitigate risks that could cause instability of the financial system as a whole. These competitive factors and regulatory policies typically constrain the lending activities of banks.

In Australia for example, the RBA suggest that limits on bank lending are reinforced by minimum liquidity and capital adequacy requirements set by The Australian Prudential Regulation Authority (APRA).

Money creation is constrained by behaviours of borrowers

The BOE refers to a 1963 paper by James Tobin who argues that because households and companies who take out loans do so because they want to spend more, they will quickly pass that money on to others.

How these households and companies respond will determine the level of money creation in the economy. The two main possibilities of what could happen to newly created deposits are:

  1. The money may quickly be destroyed if the households or companies receiving the money after the loan is spent wish to use it to repay existing outstanding bank loans.
  2. The extra money creation by banks can lead to more spending in the economy, if the households or companies use the money to spend on goods and services.

These two scenarios have very different effects on the total supply of money. If money is quickly destroyed there may be minimal impacts to the total money supply.

If it is passed on via spending, the money may continue to be passed between different households and companies and thus increase the total supply of money in the economy.

Monetary policy

The BOE suggests that the central bank can strongly influence the amount companies and households will want to borrow and therefore will influence how much new money is created. Central banks do this by influencing the level of interest rates in the economy (i.e the ‘price of loans’) through their monetary policy.

In Australia the RBA implements monetary policy by creating a target for the interbank overnight cash rate – or in other words – the interest rate on unsecured overnight loans between banks.

This ‘target’ is determined at the RBA monetary policy meetings and is specifically implemented through what it calls its domestic open market operations.

But how do changes in the overnight cash rate affect wider interest rates and economic activity?

Unfortunately, this question doesn’t have an easy answer and has likely been the topic of many PhD’s. If the reader is interested, the RBA has published articles and videos which highlight a number of different ‘channels’ of monetary policy transmission.

Conclusion

Recent articles from the BOE and RBA argue that money is created in the economy when commercial financial institutions make loans.
Luckily, we don’t have to take their word for it. There are several other people and institutions who agree.

For example, the German central bank – the Bundesbank – has published an article on their website which states that “banks can create book money just by making an accounting entry: according to the Bundesbank’s economists, “this refutes a popular misconception that banks act simply as intermediaries at the time of lending”

Moreover, two academics in the economics field have been attempting to highlight the reality of banks and money creation and the impact it has on the economy for many years.

Professor Richard Werner has published a number of articles that corroborate the BOE’s view about money creation, not only in terms of theory (see Werner, 2014), but also empirically (see Werner, 2016).

Australian Professor Steve Keen has also been trying to help his economic colleagues understand the reality of money creation in the modern economy (see Keen, 2015).


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  1. This example was inspired by a similar example in the RBA’s 2018 bulletin.
  2. Remember that a bank deposit is one of the three types of money in Australia and the primary type of money used for transaction by households and companies. Therefore, a creation of a bank deposit is the creation of ‘money’.

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