Crash Course Chapter 7: Money Creation

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Here we will explore the process by which money is created.

Let me introduce you to John Kenneth Galbraith. He taught at Harvard University for many years and was active in politics, serving in the administrations of Franklin D. Roosevelt, Harry S. Truman, John F. Kennedy, and Lyndon B. Johnson; and among other roles served as United States Ambassador to India under Kennedy.

He was one of a few two-time recipients of the Presidential Medal of Freedom.

Clearly a pretty accomplished and stand-up kind of guy. About money, he famously said: “The process by which money is created is so simple that the mind is repelled.” We’re about to discuss that very thing.

If you don’t get this segment on the first pass, don’t worry, because money creation is truly a bizarre thing to ponder, let alone accept. It’s actually a very simple process, but really difficult to accept.

First, let’s look at how money is created by banks.

Leaving aside for now where this money comes from, suppose a person walks into town with $1000, and, luckily, a brand new bank with no deposits has just opened up. The $1000 is deposited in the bank, and now the person has a $1000 asset (their bank account) and the bank has a $1000 liability (the very same bank account).

Now, there’s a rule on the books, a federal rule, that allows banks to loan out a proportion, a fraction, of the money they have on deposit to others. In theory, banks are allowed to loan out up to 90% of what people have on deposit with them, although, as we’ll see later, the actual proportion is much closer to 100% than 90%. Nonetheless, because banks retain only a fraction of their deposits in reserve, the term for this process is “fractional reserve banking.”

Back to our example. We now have a bank with $1000 on deposit, and banks do not make money by holding on to it – rather, they make their living by borrowing at one rate and loaning at a higher rate.

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.

And so another loan, this time for $810, is made, which gets spent and redeposited in the bank, meaning that a brand new, fresh deposit of $810 is available to loan against. So the bank loans out out 90% of $810, or $729, and so it goes, until we finally discover that the original $1000 deposit has mushroomed into a total of $10,000.

Is this all real money? You bet it is, especially if it’s in your bank account. But if you were paying close attention, you’d realize that what we’ve actually got here are three things. First, we’ve got $1000 held in reserve by the bank, $10,000 in total in various bank accounts, and $9000 dollars of new debt. The original $1000 is now entirely held in reserve by the bank, but every new dollar, all $9,000 of them, was loaned into existence and is “backed” by an equivalent amount of debt. How’s your mind doing? Is it repelled yet?

You might also notice here that if everybody who had money at the bank, all $10,000 dollars of them, tried to take their money out at once, that the bank would not be able to pay it out, because, well, they wouldn’t have it. The bank would only have $1000 hanging around in reserve. Period. You might also notice that this mechanism of creating new money out of new deposits works great…as long as nobody defaults on their loan. If and when that happens, things get tricky. But that’s another story for later.

For now, I want you to understand that money is loaned into existence. Conversely, when loans are paid back, money ‘disappears.’

This is how money is created, and I invite you to verify this for yourself. One place is the Federal Reserve itself, which has published a handy comic book from which I drew this fine example. You can find a link to that on the website under Essential Articles.

You may have noticed that I left out something very important here, and that is interest. Where does the money come from to pay the interest on all the loans? If all the loans are paid back without interest, we can undo the entire string of transactions, but when we factor in interest, there suddenly isn’t enough money to pay back all the loans.

Clearly that is a big hole in this story, and so we’ll need to find out where that comes from. In doing so, we’ll also clear up the mystery of where the original $1000 came from.

So what was the purpose of all this? Why did we spend these past few minutes studying the mechanism of money creation? Because in order to appreciate the implications of our massive levels of debt, you have to understand how the debt came into being. That’s one reason. And the more important one is tied to all those exponential graphs we viewed earlier in Section 3. But we’re not quite there yet. Let’s go.

Comments

dickharmon's picture
dickharmon
Status: Member (Offline)
Joined: Apr 19 2012
Posts: 1
connection between compound interest and compound growth

What's the exact connection between compound interest and compound economic growth? What is the specific mechanism (s), and how is that mechanism established?

Thank you.

  Dick Harmon

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