Where does Money come from, aka Money creation?

My true story: When I was at university in Qld credit cards were first introduced. This was my first year at university so I was somewhat naïve. However, I did think through the implications of many people having a credit card and thought it would be a boost to spending and therefore GDP.

I was in Macro-economics 101 being lectured to by none other than the author (Samuelson) of the very large text book on an introduction to economics that was used in universities all over Australia. So I thought he would be an excellent person to ask about credit cards and GDP.

So in one lecture on GDP I got up and asked about the effect on GDP on the issuing of these credit cards to a large part of the population. He replied that it would have no effect because spending on credit cards was just lending of deposits by banks that would have been lent and spent anyway just in another form.

I replied, with some trepidation, that the answer made no sense. The banks had already lent out existing deposits so using the credit card must create money and therefore increase spending and GDP. “Rubbish” or something like that was the reply. It was a disappointing response but I soon realised that economics is about not letting the facts get in the way of a good model.

I passed Macro-economics 101 but poorly as I did not answer many questions the way a student was supposed to. That subject though informed me a lot about economic dogma and models that have stuck with me my whole life.

Banks

Money is created by the government and private banks exclusively and is created and destroyed every day. It’s very important to get your head around how Money is created as it’s counterintuitive to conventional wisdom and generally misrepresented.

Let’s think of the Australian money system and its four major banks, with many smaller banks and the Central Bank, as being one big bank that we’ll call, ‘Megabank’. Megabank holds all the Money (deposits) and all the loan assets in Australia. Now imagine a single point in time and take a look at Megabank’s balance sheet. Megabank holds all the Money in Australia at that point in time, and the Assets (loans) must equal the Liabilities (deposits) plus capital or equity. How then does Megabank fund the next day’s loans?

Every time Megabank lends Money (an asset), it creates an equal deposit of Money (a liability). It is not the other way around, i.e., Megabank does not receive a Money deposit and then lend out that Money.  Megabank holds all the Money and loans in the country, and it cannot just receive a new deposit because the Money quite simply doesn’t exist. All Money deposits are matched by loans so there is no Money just lying around.  But Megabank can certainly lend Money (loan), which is then immediately deposited in Megabank to balance the books but also to increase the amount of Money in the system. The reciprocal also applies. When loans are repaid to Megabank, deposits decrease and Money is destroyed, so the books of Megabank always balance.

Let’s go over Money creation one more time very simply. Megabank at any point in time holds all the Money in Australia (almost). Megabank does not print Money to increase the Money supply but it creates Money when it lends. So if a citizen goes to a Megabank to borrow Money to buy a house, Megabank does not have reserves to lend Money. However, it digitally credits the borrower’s account who then transfers that to the seller of the house who deposits digitally the Money into their account in Megabank. This all occurs within a day so Money is created by Megabank but at the end of the day the books still balance. This Money creation is a stimulus to the economy.

When a country has rising house prices and rising mortgage loan balances, Money is being created and the Money supply increases. This increasing of the Money supply allows many citizens to have extra Money and enjoy extra benefits. The simple point in this process is that the Money created to enjoy the good times is backed by a borrower’s housing debt, and that debt must be repaid either by a borrower’s Money earnings or by a version of pass the parcel. When a country uses this Money creation model we should ask the question, is the Money creation productive or sustainable, and which citizens are paying? Experience tells us that pass the debt parcel to create Money can be played for a very long time, but not forever.

In a democracy, a government can’t increasingly marginalise a large segment of citizens. Citizens must use more and more Money to pay for housing by sponsoring increased asset prices. At some future point, the cost will land in the hands of citizens with not enough future Money earnings to pay the required price. Sheer voter pressure forces either a revaluation of prices or a redistribution of wealth, imposed upon the government of the day. This asset-value-increase-Money-creation economy cannot be productive today, or equitable across generations for the future, but that’s where we are.

As each bank is governed by the same regulations and is indirectly supported by the government and Central Bank, it matters not in Money creation whether we have Megabank or hundreds of banks. The same process applies. Every bank creates Money when it lends Money and the Money created from loans borrowed must balance on the collective Megabank’s balance sheet.

Individual banks can have Money liquidity issues within Megabank. The basic bank business model is to borrow deposits short term at low interest rates and lend on longer terms at higher rates, resulting in profits or net interest margin. The basic bank business model allows depositors to suddenly either discover, or imagine, risks in a bank and withdraw their Money. When that Money is not replaced by other deposits, other bank lending or Central Bank lending, that bank has a mismatched balance sheet, and therefore a liquidity problem. The balance in the Money system has not changed and unless there are real credit losses that exceed a bank’s capital, a liquidity crisis does not add or subtract from the Money balance.

So where does the Money that was taken out by frightened depositors go?

In the past when there was no digital Money, only fiat money or cash, depositors could have a run on a bank and withdraw cash that they horde and do not deposit in another bank. In those past circumstances, a run on a bank is fatal because fiat money is extracted from the total banking system. The situation today is different.

Today, Depositors must put the digital Money into other banks which creates, for those banks, an excess of Money but not in Megabank or the system where the total amount of Money remains the same. The excess Money could be lent to the bank with liquidity problems within Megabank, but that is unlikely to occur and therefore the Money ends up at the Central Bank. So the Central Bank has the Money, and unless it lends that money to the individual liquidity-challenged bank to give it back liquidity, that bank has a liquidity crisis, or a lack of money, that will cause it to cease to exist. Banking is a finely balanced, bitchy business where size does count.

As we’ve seen in the aftermath of the 2008 financial crisis as well as more recently, in a crisis large banks do not help smaller banks with liquidity problems. An example in Australia was CBA’s takeover of Bankwest at a minimal price.  The large banks just devour the smaller banks. It would not be difficult or uncommercial for large banks to assist smaller banks in remaining solvent even in the face of credit losses. But the alternative of devouring the assets of a bank with liquidity problems enhances the larger banks’ ‘too big to fail’ status by adding to their balance sheet for very little cost. A big win for little effort.

Why don’t other non-bank institutions create Money when they lend? A non-bank cannot take deposits that would treated as Money, is not in the banking system and is not supported by the Central Bank. A non-bank can borrow Money from out of the banking system and lend that Money, which immediately finds its way back into the banking system. A non-bank acts as an intermediary but does not itself create Money. Rather it facilitates the banking system to create more Money.

Rule 2: In the banking system, loans come before deposits (not the reverse) to create Money. The private bank lending and borrowing process creates Money in the form of digital deposits in a bank. This is true for any loan from any bank whether loan purposes are productive or not. Liquidity crisis in banking always enhance large bank too big to fail status.

Governments and Central Banks

Government Money creation is often referred to as printing money, a reference back to the days when government printing presses churned out fiat money. Devices for backing fiat currency were used to reduce printing, such as the gold standard, where gold was used to back fiat money. The value of a country’s money was backed by the value of gold owned by that country.

When a government runs a deficit caused by excessive expenditure, that deficit is funded by the issuance of debt, usually in the form of bonds. If a bank (including the Central Bank) buys these bonds, the Money creation process continues as the funds to buy the bonds ends up in the banking system through government expenditure into the economy.

As a point of contrast if a superannuation fund buys bonds directly from the government, Money is not created. The superfund withdraws money from the banking system and provides it to the government, which puts the money back into the banking system through expenditure. Is it surprising that in the guise of needing high quality liquid assets, banks are required to buy government bonds so that the money supply is increased?

Central Banks can also create Money by digitally printing and calling it things like ‘Quantitative Easing’, or in Australia’s case, a ‘Term Funding Facility’. How this works is no mystery. The Central Bank simply loans funds to Megabank by digitally bringing Money into existence and crediting it to the bank’s account at the Central Bank. The Central Bank’s books balance, as it created an asset (loan to Megabank) and a liability (digital Money). Megabank’s books balance as well, and it now has Money it can lend.  Megabank does not create additional Money as the lending only creates Money that replaces the Money from the Central Bank that has been lent. At this point, it must be noted that the Central Bank may want their loans repaid, which reverses the Money creation process unless it is replaced by another Money creation mechanism. The ultimate question is who pays when loans are repaid, and Money is destroyed?

A government in a democracy is simply the representation of its citizens, and by extension Central Banks are owned by those citizens. Governments (citizens) have powers to create Money by running budget deficits and borrowing. This, at least, is publicly reported, and governments can be held accountable to their citizens for mismanagement of Money creation. On the other hand, so called independent Central Banks have substantial Money creating powers but are rarely held to account, rarely report in detail, and rarely explain their actions to the citizens. Central Banks can and do create too little or too much Money and certainly misdirect where it should be spent [JW3] with little accountability. Money creation powers of the Central Bank are at least as powerful as the interest rate setting power, a fact that citizens should be cognisant of in 2023.

Rule 3: Governments have substantial Money creation powers and use that power to stimulate the economy but are at least held accountable by citizen voters. Central Banks also have money creation powers but are rarely held accountable and are publicly opaque on why and what actions are taken. This gives Central Banks significant Money creation power.

---