Where does money come from? The answer is so simple that many people find it confusing. In this article, we’ll be talking about a specific source of money creation — that of fractional-reserve banking used by almost every saver and borrower in the West.
For the most part, money is created out of thin air by banks literally printing new money when they create new loans. When the bank gives out a loan for a house, it’s printing the money. When a bank gives out a loan for college, it’s printing the money. That’s where nearly all money originates — banks “loan” it into existence.
It works like this: the bank has lots of money on hand from depositors. As long as the bank keeps money from depositors on hand, the government allows banks to “print” a certain amount of new money for loans — up to a certain fraction of whatever money they have on hand from deposits.
For example, if the fractional-reserve requirement is 10%, then the banks can literally print $90 new dollars for every $100 they have in deposits. In the end, this ends up expanding because the money is deposited at other banks who are able to create new money from that money as well.
Don’t worry if this sounds muddled — it’s a tricky topic. We’ll explain it in simpler terms below.
How Lending Creates “New” Money
Here’s a simple description of what happens when a bank makes a loan by Lloyd G. Reynolds, an economist from Yale University:
“What happens when a bank makes a loan? A company applies for a loan of $1 million, and the bank agrees. The company gives the bank a piece of paper promising to repay the loan after, say, six months. The bank gives the company an addition of $1 million to its checking account. Money supply increases. When the time for payment comes round, unless the loan is renewed, repayment is made by deducting $1 million from the company’s checking account. The central principle is simple: Making a loan creates money, while repaying a loan extinguishes money.
This looks very easy and profitable — the bank just creates money by a stroke of the pen. So why not create as much money as possible? The difficulty with this idea is that when people and companies have checking accounts, they are likely to use them. In addition to writing checks, they may want to draw out part of their deposit in cash. So a bank must have some cash in the vault, and a place where it can go for more cash if necessary. In short, a bank must have reserves.
Where money comes from reveals a lot about who is really in power, what our economy is based on, and how we should react.
But What About the Deposits?
Some argue that the banks aren’t actually printing new money — they’re just lending money out that’s been deposited. This is, unfortunately, not true. The reason is that deposits are money that can be requested at any time by any specific individual. With the exception of a bank run, an individual can redeem his balances at any time he wishes from the bank.
Let’s pretend the system was a little different. Let’s assume there’s a man named John and a bank named Bank of Mainstreet. Now let’s assume that every dollar John deposits in the bank is actually a golden coin with a special serial number on it that he is able to withdraw whenever he’d like. The bank has to be able to give him ever actual dollar he deposits whenever he asks.
Now let’s say that someone decides they need a loan and they go to the bank. Is the bank able to give out those dollars in that loan? Of course not — John might ask for his money at any time. Giving out new loans isn’t possible in such a system because John has a right to “his” money in that bank’s vault.
Is this what’s going on in the current system? Not quite. Something extremely different is occurring. When you deposit money in the bank, you don’t have a specific claim to a specific dollar — you just have claims to a specific amount of dollars. That’s the point of money in the first place, after all.
So what is happening in the system? It’s a little different. John is depositing his “dollars” usually in the form of checks and other types of money, and simply has a guarantee that he’ll be able to get out an equal amount of currency whenever he chooses. The money is still “in” his account. If the bank makes out a loan with “his” money, that doesn’t mean his account goes down — his account is still “filled” with money and he can stop saving whenever he’d like. In a sense, it can be seen as a type of double counting. The bank can give out loans — without emptying his bank account.
His deposits aren’t the only source of the new money being lent out. His deposit is just the cap on the new money being lent out. Banks can only lend out money in smaller amounts than what they have in deposits, but that doesn’t mean the deposits themselves are actually shrinking at all — new money is just being created at a smaller ratio than 1-to-1 to deposits.
The Federal Reserve completely agrees with the notion that deposits are not the “source” of loans. That’s why the Federal Reserve Bank of New York wrote the following:
”Commercial banks create checkbook money whenever they grant a loan, simply by adding new deposit dollars in accounts on their books in exchange for a borrower’s IOU.”
This is the source of new money in the system. Deposits are important because they cap how much money can be “invented” — but banks don’t lend out deposited money. They lend out money that never existed before.
How Fractional-Reserve Banking is Similar to Double Counting
Money is a collective accounting trick. It’s when plenty of people decide to mess with their books in such a way that it makes bartering exponentially easier. It’s when cattle farmers and truck manufacturers agree to “barter” with something that allows them to quickly turn around and barter with other people and corporations. They’re not trading trucks for cows — they’re trading trucks for money, and that money was traded for with the cows. Money is the accounting “middle man”.
Of course, at some point in history, bankers and political leaders realized they could manipulate this. It’s an accounting trick, so why don’t they just add it whenever they’d like? Whey don’t they mess with the “supply” of money and create their own? And that’s the source of inflation.
It could be said that fractional reserve banking is double-counting, something that occurs a lot in the modern financial world — and something that makes financial risk explode. Ellen Brown, JD explains:
”In the shadow banking system, as in the old fractional reserve banking system, the collateral is being double-counted: it is owed to the borrowers and the depositors at the same time.”
This “double counting” works until there’s a bank run. Then the whole house of cards collapses. That’s why the federal government tries to back bank accounts through the FDIC. Of course, that just begs another question — where would the FDIC get the money during a bank run? But that’s another question for another time.
How Fractional Reserve Banking Creates Price Inflation
Some might be unimpressed by the above explanation, and believe that it doesn’t matter if the new loans are “technically” new money because they’re capped by deposits. After all, if you can still pay everything back, who cares? The answer is simple: what happens to the “new” money when it’s printed? The answer: it can be deposited in a new bank and the process begins to repeat itself.
Remember the above story about John and his coins with serial numbers? That’s not going on right now. Instead of there being a set amount of dollars, the banks can print money as long as they have enough deposits, and a lot of the money they print will end up being new deposits.
Remember, loans that banks give out aren’t just raw cash that disappears or something. It’s usually just another checking account that will switch to some other bank’s account. After they “print” the new money, that money is deposited somewhere else again — increasing more printing during healthy economic times. That makes the money supply go up.
“Since any bank can loan out up to 90%, the bank in our example manages to locate a single individual that wants to borrow $900. This borrower then spends that money by giving it to another person, perhaps his accountant, who, in turn, deposits it in a bank. Now it could be the same bank, or a different bank, but that really doesn’t change how this story gets told at all. With this new deposit, the bank has a fresh $900 to work with, and so it gets busy finding somebody who wants to borrow 90% of that amount, or $810.”
In other words, people are spending tons of money that didn’t exist before, meaning that there’s more money in the system but roughly the same amount of stuff. That causes price inflation.
Why This Really Does Matter
The entire system is bizarre and it often takes someone a while before they “get it”. I’ve heard literally dozens of people say, “That just can’t be right because that’s nuts.” They’re right about one thing: it is nuts.
But it’s also true. Such a system where money is only created through debt means that our economy is based on debt. And debt is based on interest. This means our entire economic system is based on society paying rent to the financial class. It’s no surprise that the financial class has grown exponentially over the last few decades.
Ludwig von Mises, a beloved Austrian economist, was right when he said:
“Inflation and credit expansion, the preferred methods of present day government openhandedness, do not add anything to the amount of resources available. They make some people more prosperous, but only to the extent that they make others poorer.”