All money is nothing but debt – or how money is created

The process by which banks create money is so simple that the mind is repelled.
John K Galbraith , “Money: Whence It Came, Where It Went“, p. 29

“Money As Debt”: a very fine animated documentary on how money is created, what money is, its history and the function of banks and Federal Reserve. Very entertaining. Created by Paul Grignon, and here’s his comments on the movie. This video can also be downloaded as AVI from here (direct link).

People rarely stop to think how money is created in modern economies. Most people think that money is created by governments. Even after watching this and a couple of similar videos I had a weak grasp on the issue. Only after giving it some thought I finally got it.

Most money is created by banks when they loan it. In essence, whenever a bank gives you a mortgage, it creates money which is added to the overall money supply and gives it to you, thus collecting interest on the money that it (nor any one else) never had, since it simply never existed before.

Here’s a line of thinking that helped me cope with it – imagine person A deposits $1000 cash into his bank account. The bank now lends this $1000 to person B. Person B deposits it in the same bank (it really doesn’t matter but it’s easier to follow this way). Now the bank yet again has $1000 on its hands, which can be lent to person C. Now we have 3 people each with a $1000 bank account which can be used to buy stuff. Granted, all this debt will have to be paid off some day, but for the moment, we’ve created additional $2000 of “money” that has purchasing power, effectively diluting the existing money and decreasing its purchasing power by 66%.

The source of the trouble is that these bank accounts are nothing but bank obligations not backed by real cash. Whenever you’re writing a check to somebody, you’re paying this person with your bank’s obligation to pay you. Obligations with purchasing power can infinitely dilute money supply and render all money worthless. To understand that, imagine you and I will loan each other a thousand dollars which we don’t have. So, you have an IOU for $1k and I have another. This is a transaction which have zero effect, until we actually start using these IOU to buy apples in a grocery store. If it’s accepted (as bank checks are), we have just created money that never existed before.

As described, the process can go on forever. In actuality, fractional reserve banking system puts some limits in place. Banks can only lend every 9 dollars out of 10 dollars of there assets which means that depositing $1 cash in the bank can create only $10 worth of money in the economy. Although additionally, when Federal Reserve “prints” and deposits $1 onto bank’s assets, it can become $9 of new loans. So, it total, every $1 printed by Federal reserve can expand into $90 dollars with actual purchasing power in form of bank loans.

This is how it works, and gold-standard money would not change that. In order to change that we should make it impossible for obligations not backed by cash to have any purchasing power. Which would mean that the money your checking accounts would not be lent to anybody and keep sitting in the bank (so you would probably pay for this privelege), and your saving accounts would not be so easily withdrawable (how can you withdraw money that has been given to somebody else?).

Everyone sub-consciously knows banks do not lend money. When you draw on your savings account, the bank doesn’t tell you you can’t do this because it has lent the money to somebody else.
Mark Mansfield 

According to my limited understanding, Austrian School of Economics argues for this approach which would result in constant monetary supply and a slow rate of deflation, instead of permanent inflation. Which would be totally fine since they argue that only monetary deflation hurts economies, while deflation caused by increased productivity does not.


One Response to “All money is nothing but debt – or how money is created”

  1. I.O.U.S.A. (2008) - documentary « Artem Boytsov’s Mind Says:

    […] The movie concentrates on national debt, and also discusses money creation process on which I posted earlier. It paints a picture of 4 […]

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