Good qustion

Money, unlike energy, is created and destroyed. There are, however, some erroneous beliefs regarding the process of creating money, and in particular the ability of central banks to "print money".

In the modern economy most of the money takes the form of bank deposits. Of the total money in circulation in Spain, 97% are bank deposits and only 3% are banknotes and coins. But where do these deposits come from?

A misperception is that banks are mere intermediaries that lend the money that savers deposit in them. According to this perception, the deposits would be created with the savings of the people, and the banks would limit themselves to lend that money to the investors. Actually, saving in itself does not create deposits. If a person decides to open a deposit with money that he has received from his company or from another person, he is simply transferring that money from one deposit to another. That operation does not increase the money in circulation available to be borrowed.

 The reality is that it is the banks themselves that create the deposits when giving credits. That is to say, most of the money in the modern economy is created by commercial banks. When a bank gives a credit to a person, it makes an accounting note in which it simultaneously recognizes a deposit to the client in which it pays the credit money. Out of nowhere, a new deposit has arisen whose counterpart in the balance sheet of the bank is the credit granted to the client.

In the same way, money in circulation is also destroyed with the opposite operation. If a person cancels a credit by paying the outstanding debt, an accounting note is produced that simultaneously implies the disappearance of the debt and a bank deposit.

In short, money in the broad sense is created and destroyed continuously by commercial banks through the process of granting and canceling credits. Given that the granting of a credit implies the joining of the will of two parties, it would be more correct to say that money is created and destroyed as a consequence of the investment and credit decisions that banks, on the one hand, and banks and businesses make freely. families for another.

 This process is free in a market economy, albeit within limits. On the one hand, the limits imposed by the parties in terms of their capacity to assume debt, profitability of the loans for the bank, etc. And on the other hand, the regulatory limits on issues of capital requirements, reserves and others for banks.

Money, therefore, is not created by central banks, but by companies, families and banks in their freely agreed economic decisions. The role of central banks through their monetary policy tools is rather to try to adapt this process to an environment of sustainable growth of prices, compatible in turn with a sustainable growth of the economy. If there is an excessive growth of money capable of creating inflation, the central bank raises interest rates. If, on the other hand, credit and the creation of money slow down too much because of the fall in economic activity, the central bank lowers interest rates.

Monetary policy decisions, however, do not ensure a direct and concrete response from economic agents. As we have been able to verify in the past, the behavior of economic agents is not so easy to model by central banks. In particular, economic cycles occur periodically in a natural way without the central banks being able to do much more than soften their consequences.

 In the case of the recent credit bubble and subsequent crisis in our country, there have been exceptional circumstances that have contributed to magnify the credit expansion or creation of money in the period 2004-2007 and the opposite process as of 2008. These circumstances have been the existence of the euro and the capital flows from the center to the periphery. The following graphs show the two sides of the money creation process in Spain and the euro zone: the year-on-year change in credit and money in circulation since 1998.

The huge growth of money in circulation in the 2004-2007 period does not come from the ECB's printing press, but from credit to the private sector for the most part. It was the investment decisions of companies and families, and the granting of credit from banks, that explain this growth. On the other hand, the natural limits to the growth of credit were surpassed thanks, to a large extent, to the financing received from European banks in search of higher profitability. Obviously, low interest rates, a consequence of a monetary policy for the euro area as a whole, also helped boost the bubble.

Now, however, we are in the opposite situation. The cancellation of loans from companies and families, although individually necessary, is causing a drop in the money in circulation which in turn translates into a fall in prices. In principle, the central bank's response to this situation is to lower interest rates. Once these are almost zero, we would enter into quantitative measures, the famous QEs that seek to increase the money in circulation to compensate for the contraction that results from the deleveraging of the private sector. The QE involves the purchase of bonds by the central bank to banks, Investment Funds and Pension Plans. The objective is that with the liquidity received, the Funds invest in other assets and thus contribute to support the reactivation of the economy.

It should be understood that such measures do not directly imply greater economic activity. As with interest rates, they are measures that try to incentivize the decisions of economic agents, but it is ultimately those decisions that determine economic activity.

And at this point we are in Europe. With the credit to the private sector still falling and a weak creation of money, insufficient for the inflation target of 2%, the conditions for a quantitative monetary policy would be given. The ECB, however, believes that the situation will be improving little by little, so no QE plans are necessary. It is difficult to understand this from a country with a 25% unemployment as is Spain, but the truth is that Europe is not yet a country and that makes such measures impossible for now. Of course, the economy can be reactivated by itself. All that is needed is for companies and families to start increasing their level of consumption and investment. The problem is that in an environment of pessimistic expectations it is difficult to start this change of attitude. Surely a more expansive monetary policy would help.