People create money ‘out of thin air’. Not banks!

Historically, commercial banks have been thought of as institutions that take money from savers and lend it to borrowers. That is, as financial intermediaries.

In recent times, this idea has been turned on its head.

Academics and central banks now acknowledge that, because new money is created by commercial banks when they make new loans1banks are not simply financial intermediaries, but creators of money.

This modern (and more accurate) view of banking is often encapsulated in statements like “banks create money out of nothing”, or “banks create money – as ‘fairy dust’ – out of thin air” – all of which are somewhat true.

There is a problem however.

According to Professor Robert Vivian and Nicholas Spearman, the notion of “banks creating money out of thin air” is very misleading2.

In fact, Vivian & Spearman argue that banks don’t create money out of nothing. Rather, banks record and enable (intertemporal) value-for-value exchange transactions between buyers and sellers, and it just so happens that money is created – as a by-product – in the process.

So do commercial banks create money out of thin air? Or is there more to the story?

To answer this question I want to elaborate on two scenarios that are discussed in detail by Vivian & Spearman.

Scenario one – selling a house without a bank

Imagine a scenario were Ms S wants to sell her house and Mr B wants to buy a house (Figure 1).

Ms S asks for $1 million and Mr B agrees. They form an agreement at a price of $1 million, with the balance vendor financed and payable by monthly installments over the next 30 years3.

Essentially, the exchange consists of a $1 million house to Mr B and an IOU of $1 million to Ms S.

Figure 1. Selling a house without a bank

In Australia (my home country), this type of property transaction is quite possible using installment sales, where the seller finances the buyer directly, instead of a bank (source: Cordato Partners). 

Although possible, this type of direct vendor financing comes with some significant disadvantages.

Lets consider these disadvantages for Ms S (i.e. the seller) in the context of our example.

Disadvantages for Ms S

Firstly, Ms S would have to wait 30 years to receive the full $1 million. But, what if she wanted the money immediately to fund another property or a holiday? Vivian & Spearman refer to this as a liquidity disadvantage for Ms S.

Secondly, to make the transaction feasible, Ms S would be strongly advised to carry out her due diligence on Mr B. For example, how can Ms S be sure the accuracy of Mr B’s current finances? Should Ms S organise insurance? Should she insist on a mortgage bond?

Thirdly, even after performing her due diligence, Ms S is still exposed to the risk of Mr B becoming unable to repay the loan. In other words, she is exposed to default risk.

Finally, how is Ms S going to collect and record the payments from Mr B? Although not impossible, collecting payments and keeping accurate (and secure) records for 30 years places a considerable administrative burden on Ms S.

In summary, by financing Mr B directly, Ms S is exposed to a number of disadvantages including liquidity problems, default risk, and significant administrative burdens.

As Vivian & Spearman argue, it would seem that there is an opportunity for an institution (like a Bank) to step in and reduce Ms S’ disadvantages.

Lets consider the same scenario with a bank stepping in to facilitate.

Scenario two – selling a house with a bank

In this scenario, Ms S agrees to sell to Mr B with a condition that Mr B seeks finance from a bank – to act as intermediary to the transaction (Figure 2).

Figure 2. Selling a house with a bank

Having made an offer to purchase, Mr B approaches the bank and applies for a loan. The bank now undertakes its due diligence and is satisfied Mr B can repay the loan in installments over a 30 year period4.

The bank then guarantees to make a currency facility available on demand to Ms S for an amount of $1 million, and the transfer of the property begins.

Once official transfer of the property has occurred, the guarantee is provided to Ms S in the form of a right to make withdrawals up to $1 million on demand from the bank. This obligation is recorded on the bank’s balance sheet as a liability (i.e. ‘deposit’ of $1 million in her account).

In the process, the Bank also acquires5 Mr B’s IOU of $1 million (i.e. claim for periodic payments) which is recorded as an asset on the bank’s balance sheet.

In this scenario the bank has acted as an intermediary between the buyer (Mr B) and the seller (Ms S), and in the process, two important things have happened.

Firstly, by recording the $1 million dollars on its balance sheet as a ‘bank deposit’, the total amount of bank deposits (i.e. money supply) has increased in the economy, even though nothing has been deposited with the bank.

However, counter to the notion that the bank has ‘created the money out of thin air’, the money – with a face value of $1 million – was created only as a result of the underlying value-for-value exchange (i.e. the house)6.

Secondly, Ms S receives her money immediately and she no longer needs to perform her due diligence on Mr B. Ms S also no longer has to worry herself with the administrative burden of recording and collecting payments. These risks and burdens have been transferred to the bank7.

In summary, the bank has provided Ms S with liquidity and with a significant reduction of the risk/costs that are associated with the sale of her house to Mr B8.

For providing this transfer of risk/cost mitigation from Ms S, the bank will be compensated from an interest cost (or fees charged) that are built into the repayments made by Mr B9.

This service provided by the bank is not trivial. In fact, Vivian & Spearman argue that the reduction of the various risks and costs associated with the transaction between buyer and seller is the rationale for the existence of the bank.

Final thoughts

Do banks create money out of thin air?

According to Vivian & Spearman (and others), the answer is no.

Rather, it is only as a result of a value-for-value exchange transaction between a buyer and a seller, that money is created10.

Is it not the case therefore, that the genesis of money creation is ultimately due to the intent and agreement of people (i.e. companies/individuals/households) to make an exchange?

And if so, rather than saying “banks create money out of thin air”, is it not more accurate to say that “people create money out of thin air”?


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  1. see Bank of England, Reserve Bank of Australia, Bundesbank, Werner.
  2. see Kervick and Rendahl & Freund who also argue the notion that “bank create money out of nothing” is misleading.
  3. In this example, the installment amount consists of only the principal, but a principle and interest scenario is also possible.
  4. In a recent speech, the RBA Head of Financial Stability said that “One of four characteristics that gives Banks their special role in the economy is their expertise in credit and liquidity risk management, having a long history and ongoing relationships that generate private information about customers.”
  5. Professor Richard Werner argues that a bank purchases securities in the form of the borrowers IOU (promissory note) when the loan contract is signed by a borrower.
  6. If only seen from the view of the bank’s balance sheet, it may superficially appear as though the bank has created the money in the form of a bank deposit guaranteed to Ms S. However, as pointed out by Vivian & Spearman – this accounting entry has only been possible due to the underlying exchange and the value of which has been determined by the price of the goods provided in the exchange.
  7. Yes it is true that Ms S is now exposed to the liquidity and solvency risk of the bank, however, this is arguably a much less risky proposition than the scenario without a bank.
  8. If you are thinking that using the exchange of a house as the only example may be limited due to a lack of generalisation. Consider that the majority of all loans (~60%) that are created by banking institutions in Australia are for property exchanges (source RBA). In addition, Vivian & Spearman discuss both business (i.e. overdrafts) and personal loans and suggest that the money created in these loan arrangements is still the surface phenomenon of an underlying value-for-value exchange transaction.
  9. The buyer may also benefit from the banks involvement. How? By acting as the intermediary, the bank has facilitated the buyer to bring a purchase ‘backward in time’. The buyer also receives the benefit of a lower interest rate that they may be faced with without the bank acting as intermediary. Note that vendor finance agreements typically involve a much higher interest rate than the standard variable rate offered at a bank (source onproperty).
  10. Put another way, banks transform an illiquid asset (the buyers’s IOU) into a liquid one (the seller’s bank deposit) and money is created in the process (Rendahl & Freund).

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