Money from nothing: How banks create money out of thin air

The power of the pen.

Banks are subject to myriad laws and regulations, a fact that any harried bank compliance officer will attest to. Yet when it comes to the law of the conservation of energy, banks appear curiously unaccountable. The creation of millions of dollars in value takes most people significant time and effort to achieve. For a banker, it takes just a couple clicks on a computer keyboard.

The ability to create vasts sums of money out of thin air is the result of a bank’s position as a lender. When a bank approves a loan, the loaned amount is simply added to the amount of the borrower’s deposits in the bank’s computer system. No transfer takes place, and no cash changes hands. In an important sense, the money does not ‘come’ from anywhere. It is created the moment the loan is approved.

The fact that a private company has the right to create money on a whim seems strikingly at odds with the values of an inclusive society. Take a closer look, however, and the picture is more complicated. These newly created deposits are liabilities of the bank, not assets. If the borrower wants to withdraw their deposits in cash, or transfer them to another bank, the lending bank must be able to satisfy that request. It is the loan itself, and the corresponding expectation of future repayment, that is the asset of the bank.

Banks create money, but only because it is a social fact that bank deposits are defined as money. Primarily as a result of government insurance, an IOU from a bank is money, while an IOU from a construction company is not. Money is an overloaded term, which can refer to cash, central bank reserves, or bank deposits, all depending on the context. While banks can create bank deposits out of thin air, they cannot print currency, nor can they add to their reserves without selling assets.

The spontaneous creation of money through the expansion of credit is more common that one might think. Suppose a customer buys a loaf of bread from a local bakery, and charges the purchase to their credit card. If the bakery uses the same bank as the customer, the bank will simply mark up the value of the bakery’s account. Simultaneously, the bank will add the value of the purchase to the customer’s outstanding card balance. The bank matches their newly created liability (the bank deposit), with their newly created asset (the card loan). In that moment, new money has been created.

At the end of the month, when the customer pays off their card balance, money will be destroyed. The bank will decrease the value of both the credit card balance and the value of the customer’s bank account. Just as the expansion of bank credit creates money, the contraction of bank credit destroys it. It is this feature of the banking system that causes central banks to believe that by raising interest rates, and therefore lowering the demand for credit, they can lower inflation.

Note that banks creating money out of thin air contravenes most commonly accepted models of the banking system. The traditional textbook model of banking, which has banks taking deposits from customers, keeping a portion as reserves, and lending the rest out, is wrong. Modern banking does not require deposits for loans to be created. Rather, it is the act of lending which creates customer deposits. Consider that a newly formed bank with investor capital can start lending immediately, and rely on the capital to meet withdrawal or transfer requests for the newly created deposits.

Despite appearances, banks are ultimately bound by the same physical laws as us all. The creation of money by banks is no more than the extension of credit, with the new liability being balanced by a corresponding asset. That this extension of credit can be understood as the creation of money says more about the definition of money than it does about the power of commercial banks. Whether in banking or in physics, the books always have to balance.