In the comments to one of the gold standard threads, a controversy is brewing that I think it might be helpful to bring to the fore in a post. Namely, I think I am blowing some commenters’ minds by noting that commercial banks create money when they make loans. Indeed, it’s the main way that money is created!
The Bank of England put out a couple of papers that describes the mechanism involved. Here is one (.pdf), and here are a couple of key passages supporting my contention that commercial banks create money when they lend money and create deposits:
In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.
. . . .
The vast majority of money held by the public takes the form of bank deposits. But where the stock of bank deposits comes from is often misunderstood. One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.
In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.
Watch these videos for some elaboration. First a short video from two bankers telling you, very clearly, that bankers do not simply lend out the deposits they have. They create money when they make the loan and create the deposit:
Here is a slightly longer, but still short, video featuring one of the authors of the Bank of England paper. One of his main points is that, while people think deposits enable loans, the truth is actually the reverse: loans enable (create) deposits.
When banks lend money, they create deposits, which are IOUs. Typically, no currency changes hands; a credit is simply posted to a bank account. As long as the bank stays within regulatory requirements, it need not have 100% of the cash on hand to fund these IOUs. It just creates the deposit.
The difference between these IOUs and IOUs from any other institution is that bank IOUs function as a medium of exchange and can be easily converted into currency.
Now, when banks lend this money, they have the loan, which is an asset, and they create a deposit, which is a liability. This balances out — but there is still new money in the system . . . until the loan is repaid, at which point the money is destroyed.
But the key point to recognize is that the bank does not need to have the cash on hand to make the loan. They simply create a deposit, by pushing a button on a computer keyboard, and voila! new money is created.
Commenters in the other thread note that banks cannot simply create this money “willy-nilly.” Well, of course. Banks are constrained by the need to have the loan repaid, and that means they need a supply of creditworthy borrowers. The bank’s ability to make a profit is affected by the interest rates set by the central bank.
So, if bankers can affect the money supply, thank God for the Fed, right? After all, bankers don’t have society’s interests in mind., so we need to rely on the steady hand and immense wisdom of our central bankers to prevent runaway inflation . . . right?
Yeah, not so much. Under the gold standard, there was a natural brake on bankers’ natural tendency to overinflate the supply of money . . .
. . . but that’s another post.
CAVEAT: As always, this comes with the caveat that I am not an economics expert, and I assure you that several commenters here could talk rings around me when it comes to balance sheets and the like. However, I have done enough reading on the topic to feel comfortable with my position, and am happy to have it challenged with facts, logical arguments, and links. As always, please keep dismissiveness and ad hominems out of the discussion. We’re all learning here.