How is money created?
Most people, including many economists, think that central banks and thus government creates our money. The central bank then lends the money to ordinary banks, which bring it into the economy by lending to consumers, businesses and governments. People also believe that, apart from central bank money, the deposits in the (savings) accounts held by bank customers are an important source of the money lent by banks.
The idea that banks work only with money created by central banks and with the money depositors put in their care is wrong. In reality only about three percent of the total money supply, the part consisting of coins and banknotes, is created by the central bank. The remaining 97 percent of money is produced by private banks when they give loans. This is done through a simple accounting practice which results in the amount of the loan – and the money thus created – being added to both sides of the bank’s balance sheet (for accountants among us: to the assets as a loan; to the liabilities as a deposit in the account of the borrower). As the British Central Bank, the Bank of England, put it in 2014:
“Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.”
In theory the money created by lending is destroyed when the loan is repaid. In practice that does happen, but at the same time the amount of newly given credit is almost always much higher than the amount of credit repaid. Thus the money supply continues to increase.
Banking: good business
For private banks money creation is a lucrative business. Think about it: without having to produce anything tangible a product is created that can be marketed for a return – the interest on the loan – of between 5% (mortgage) and as high as 15% (consumer credit). Of course some time and brainpower is spent on the assessment and administration of credit applications. But overall there is no trade in which it is so easy to make money – both literally and figuratively speaking.
Why money creation by private banks?
A legacy of history
Money creation by private banks is a legacy of history. Banking started around the 15th, 16th century when goldsmiths started storing gold for their clients. To prove ownership customers received certificates which came to be used as a means of payment. Initially the goldsmiths gave out as many certificates as they had gold in stock, but they soon realized it was very unlikely that all customers would demand their gold at the same time. So they issued more certificates than they had gold in their vaults: money creation through private banking was born. For banks today the same applies as for goldsmiths at the time: if all customers demand their deposits at the same time – a so-called “bank run” – the bank will not be able to pay and will fail. And worse, depositors will loose their money.
An effective lobby
Over the past two centuries, in countries where money creation took place by central banks and thus by government, bankers have used all their influence to push for privatizing money creation. In some countries, especially the United States, that’s been a tough but ultimately successful battle. To such an extent that the current US central bank, the Federal Reserve, is partly owned by private banks. In practice, therefore, the Fed functions as a kind of public-private partnership which represents the interests of the general public as well as the banks.
Whereas in the US the battle for control over the money supply was an arduous one, in some cases pitting presidents or presidential candidates against the most prominent bankers, in other countries the privatization of money creation has gone virtually unnoticed. Either way the outcome has been the same: today in all developed and almost all developing countries money is created by private banks. Perhaps the most remarkable feature of this situation is that the question of whether money creation should be a public or private function is asked no longer.
A matter of trust
As is the case with money the whole concept of banking is based on trust: the belief that the bank will be able to pay out whenever the client demands it. If that trust wanes and large numbers of depositors all demand their money at the same time, the bank will fail. In the past, before the 1930s, this happened frequently, with serious consequences for the economy if major banks were involved. To avoid bank runs and thereby bank failures the US government created deposit guarantees, with which the state guarantees the deposits of private individuals and companies up to a specified amount. Deposit insurance has been an effective instrument in maintaining confidence in the ability of private banks to pay out the deposits of their customers, thus avoiding the bank runs that would lead to the guarantee having to be honoured.
 Bank of England (2014), Money creation in the modern economy
This were the chapters 4 and 5 of the booklet “Our Money” by Frans Doorman, author of the books Crisis, Economics and the Emperor’s Clothes, Global Development: Problems, Solutions, Strategy – A Proposal for Socially Just, Ecologically Sustainable Growth and The Common Sense Manifesto.