You may have heard that banks create money out of thin air every time they make a loan and that 97% of all money was created in this way. If so, parts of what you've heard are true and parts of it aren't.
In this article, I'm only going to answer the question about whether or not banks can create money. Rather than giving full explanations in a single post, I'll break it up into multiple posts over time, so you can take that glazed look off your face!
There's an enormous amount of false information online about how this works. If you've heard anyone talking about something called fractional reserve banking or the money multiplier, but this method of money creation is a myth. What banks actually use is something called credit creation.
Accountants will immediately understand how this works (and most economists don't because they haven't learned accounting). If you want to borrow money to buy yourself a trendy new gadget, like a smartphone that mines cryptocurrency every time you make a call, the bank makes the following three entries on their ledger:
And that's one way they create a lot of money. They enter assets on one side of the balance sheet and liabilities on the other side. Accounting 101.
If a bank buys goods or services from someone who has an account at the bank, then they can create money to buy those goods and services. All they need to do is enter some numbers into a computer to increase the balance of the vendors account.
As governments make most of their important decisions by playing rock, paper, scissors, it's important that they don't make any mistakes. When they spend money on purchasing the instruction manuals for the game, the central bank will create money in the account of a commercial bank, who then increases the balance of the printing company's account. The same thing happens when they buy other stuff, too.
The claims that 97% of the money supply was created through lending are incorrect because they haven't factored in this method of creating money.
Central banks create money in a similar way to commercial banks. They simply enter numbers into a computer. However, the government will only accept money that has been created by the central bank for the payment of taxes.
"What about coins? In Australia, they're created by the Royal Mint and not the central bank."
True, but if you call the Australian tax office, they'll tell you that they never accept notes or coins for the payment of taxes - only electronic transfers. If you go to their office and try to hand over cash, they might just direct you to the nearest post office so that you can give the cash to them and they'll make the electronic transfer for you.
The government doesn't accept bank-created money for taxes. It's just a liability on the banks balance sheet, so it makes no sense for them to take it.
Is the money that banks create really money? Well, it's bank credit. They try to make it look the same as government-created money by giving it the same name (dollars, pounds, yen, etc.) and will exchange their credit one-for-one with government-created money. It's just marketing, but that doesn't mean that it isn't money. I'd argue that anything that gets used as money is money.
I'm not going to go into things like capital adequacy requirements here because they're pretty boring, even when I talk about them. I'll probably give them their own post because they explain why banks can't just create infinite amounts of money and buy themselves out of trouble.
Banks create vast amounts of money for people who want to buy real estate, but they don't lend so much to businesses. This means that the price of real estate can increase rapidly while incomes stagnate, thus creating an economic bubble. That's definitely getting several posts (inflation, unaffordable housing, intergenerational fairness, inequality growth, etc.) of its own.
Should banks be allowed to create money? Well, money has to get into the economy one way or another and banks are supposed to do this. They don't do a great job at it, though. That'll be another post, someday.
At the end of the day, banks are a bit like a version of Santa Claus who lends out toys for up to 35 years. So, if you hate banks, you hate children!
