17.5 – How Banks Create Money
Learning Objectives
By the end of this section, you will be able to:
- Explain, using T-account balance sheets, how banks create money
- Evaluate the difference between the orthodox and heterodox approaches to money and banking
In the orthodox approach to banking in the previous section, you learned that banks can expand on a given amount of deposits to create more money than initially existed. From this perspective, money is still a scarce thing–fixed in initial quantity, in the form of deposits at the bank. Heterodox economists conceptualize money as something completely different. From a heterodox perspective, money is in essence an IOU, a relationship between two parties: the creditor (the one owed) and a debtor (the one owing). This alternative way of looking at the what money fundamentally is has far-reaching implications, some of which will be explored in a later chapter. For now, we’ll see that, if money is at its heart an IOU, then banks don’t just expand on an initial sum of money they’ve collected as deposits; they actually create money ‘from thin air’.
Money Creation by a Single Bank
To see how a bank can create money ‘from thin air’ (or ex nihilo), we’ll start over with a hypothetical bank called Singleton Bank and three businesses.
The Bank and the Businesses:
For this example, let’s assume Singleton bank has all the tools a bank needs: a piece of paper and a pen (no deposits are necessary here, nor a pickaxe to mine for gold). Also, the Singleton bank is run for free—that is, it’s not looking to make a profit, just break even—, but it does charge interest to cover the risk of default (that is, borrowers not repaying their loans).
Now suppose three businesspeople, Hank, Rosalita, and Cassandra, each running their own auto parts stores, come to the bank, asking to borrow money so that they can invest in their businesses and pay other expenses. Each businessperson is asking for a loan of $1,000.
The Loans:
After looking into the credit histories of the potential borrowers, the bank determines that the three Hank, Rosalita, and Cassandra are all creditworthy, but estimates that there is a risk of one of these businesses failing. For the bank, this is important because it means one these borrowers won’t be able to repay their loan. Since the bank doesn’t know which one will fail, it will have to charge an interest rate to all three of them that covers the likelihood of one of them defaulting. This works out to an interest rate of 50%, which means each business will borrow $1,000 and agree to repay $1,500.
Calculating Interest for Risk
Here’s how the bank came up with this interest rate:
The number of successfully repaid loans times the dollar amount of each individual loan gives the total amount the bank will actual recoup. But since some loans won’t be repaid, this number will be less than the total amount loaned out. So we simply take this amount and multiply it by 1 plus the necessary interest rate (r) and set that equal to the total loans made. In this case, that means 2 loans repaid × $1,000 for each loan × (1 + r) = $3,000 in original loans made. Then a little bit of algebraic magic will show that
[latex]r = (3,000/2,000) - 1 = 0.5[/latex]
Which is a 50% interest rate.
Once the loans are made, the balance sheets look like this: the loans are assets to the bank, totaling $4,500 from the principal and interest that the three businesses agreed to pay. In the processes of making the loans, though, the bank creates deposits in the businesses’ checking accounts of $3,000 total. These are liabilities to the bank, since the businesses can withdraw the money, or otherwise use it to pay someone else when they need to.
The businesses’ balances sheets are the reverse of the bank’s. Each of the three businesses has a liability in the form of the loan of $1,000 plus $500 dollars interest—so the total liabilities in the form of loans for the three businesses come to $4,500. But each business has an asset in the form of the $1,000 in its checking account— again, created by the bank’s loan. To fill out the businesses’ balance sheets, let’s say they each has a existing capital and inventories worth $4,000. Shareholder equity represents money the business owes to its shareholders, and hence is a liability to the business, balancing out the accounts such that each business’ assets equal its liabilities. (Since, for the sake of simplicity, we’re assuming the bank isn’t trying to make a profit, we’ll leave shareholder equity off of its balance sheet.)
Singleton Bank
| Assets | Liabilities |
| Loans: $4,500 | Deposits: $3,000 |
Hank’s Auto Supply
| Assets | Liabilities |
| Checking: $1,000 | Loan: $1,500 |
| Capital & inventories: $4,000 | Shareholder equity: $3,500 |
Rosalita’s Car Parts
| Assets | Liabilities |
| Checking: $1,000 | Loan: $1,500 |
| Capital & inventories: $4,000 | Shareholder equity: $3,500 |
Auto Parts by Cassandra
| Assets | Liabilities |
| Checking: $1,000 | Loan: $1,500 |
| Capital & inventories: $4,000 | Shareholder equity: $3,500 |
Investment, Production, and Sales:
Having borrowed $1,000, each business cuts a check for $200 for new capital equipment and the remaining $800 to its workers and other suppliers to keep the business running. This zeroes out the businesses’ checking accounts, but increases the checking accounts of the suppliers and workers by the same amount—a total of $3,000 from the three businesses to their suppliers and workers.
Hank’s Auto Supply
| Assets | Liabilities |
| Checking: $0 | Loan: $1,500 |
| Capital & inventories: $4,200 | Shareholder equity: $2,700 |
Rosalita’s Car Parts
| Assets | Liabilities |
| Checking: $0 | Loan: $1,500 |
| Capital & inventories: $4,200 | Shareholder equity: $2,700 |
Auto Parts by Cassandra
| Assets | Liabilities |
| Checking: $0 | Loan: $1,500 |
| Capital & inventories: $4,200 | Shareholder equity: $2,700 |
Suppliers and Workers (Total)
| Assets | Liabilities |
| Checking: $3,000 |
For the sake of argument, let’s assume that the suppliers and workers spend all their money on auto parts. This means that, while the businesses’ checking accounts had initially fallen to zero when they paid these groups, the money returned to their accounts in the form of sales.
But let’s also assume that, as the bank had predicted, one of the businesses failed. Realistically, this would probably be because it was unpopular, but to make the story cut-and-dry, let’s say Autoparts by Cassandra was destroyed by a tornado. Don’t worry, no one was hurt, but the business and all its capital and inventories were destroyed, and all of the sales Cassandra was hoping to make went to the other two businesses.
This means that $3,000 in sales come out of the accounts of the suppliers and workers, and go into the accounts of the remaining businesses–let’s say evenly.
Hank’s Auto Supply
| Assets | Liabilities |
| Checking: $1,500 | Loan: $1,500 |
| Capital & inventories: $4,200 | Shareholder equity: $4,200 |
Rosalita’s Car Parts
| Assets | Liabilities |
| Checking: $1,500 | Loan: $1,500 |
| Capital & inventories: $4,200 | Shareholder equity: $4,200 |
Suppliers and Workers (Total)
| Assets | Liabilities |
| Checking: $0 |
The Repayment:
One of the businesses was destroyed, driving the business owner into bankruptcy and causing her to default on the loan—not good for the business, but not good for the bank either. The other two businesses, however, were able to pay their workers and to make sales of $1,500 each. Since their loans were for $1,000 plus 50% interest, each of the successful business is able to repay its loan in full.
Repayment means a transfer of each business’ money out of its checking account, returning the accounts of the businesses to zero. Since checkable deposits are a liability to the bank, this means the bank’s liabilities also go to zero. Repayment of the loans, $3,000 in total (since the unsuccessful business’ loan was not repaid and therefore ‘written off’) retires the debts of the two successful businesses—that is, their loans, which are liabilities to the businesses, go away. Since those loans were assets to the bank, the bank’s assets go to zero as well.
Singleton Bank
| Assets | Liabilities |
| Loans: $0 | Deposits: $0 |
Hank’s Auto Supply
| Assets | Liabilities |
| Checking: $0 | Loan: $0 |
| Capital & inventories: $4,200 | Shareholder equity: $4,200 |
Rosalita’s Car Parts
| Assets | Liabilities |
| Checking: $0 | Loan: $0 |
| Capital & inventories: $4,200 | Shareholder equity: $4,200 |
Loans Create Deposits; Deposits Retire Loans
Notice that in the example above the bank had initially created $3,000 of new money ‘out of thin air,’ so to speak, by making the loans. But, because it anticipated the possibility of default, the bank charged interest on those loans totaling another $1,500. The loans themselves allowed for all three businesses to distribute bank-created money to their suppliers and workers, which would be returned to the businesses in the form of sales, and ultimately to the bank in the form of loan repayments. Repaying the debt, in turn, meant destroying the money initially created in the process of making the loans. The interest, then, ensured that the average money coming back to the bank—taking into account the probably that a business would not be able to repay—would be sufficient to retire the debt. The bank breaks even, which, in this example, is all it was looking to do.
Again, the tools the bank required to make these loans, create the money, and so on, did not include a pickaxe or any other implements for mining precious metals. In fact, no commodity, gold, seashells, or otherwise, to create and circulate the money necessary to make investments, to hire and pay workers, to buy things, or to pay the debt. In fact, no deposits at all were necessary. The bank didn’t even need a vault. A piece of paper and a pen—along with some basic math skills and a good understanding of business conditions—are all that were needed to facilitate (that is, ‘finance’) capitalist investment and production. This is because, in the heterodox view money isn’t a physical thing with ‘intrinsic value,’ but a system of credit-debt relationships—a collection of IOUs being exchanged to accommodate an economic system in which production, income, and sales are all done for money.
Further Complexity
In the above example, we made a number simplifying assumptions to make it easier to understand (1) how banks create money by making loans, and (2) how charging interest on those loans can allow banks to cover the risk of some borrowers not repaying. In reality, of course, banks and businesses earn profits, assets depreciate, transactions occur through multiple, overlapping time periods, and households save money (in the form of deposits or otherwise), all of which were ignored in our example. Heterodox economists have, of course, developed more complex theories to deal with these additional aspects of real-world economies. But for now, it is worth keeping difficult concepts a simple as possible.