How do banks create invisible money? Let’s take a simple look at the process of money creation through the nature of money, credit, and the role of the reserve requirement ratio.
Money is credit!
Why must the money supply increase? And “how” can the money supply actually grow? To unravel this mystery, we must examine the concept of “deposits and loans,” something everyone has experienced at least once. We often assume that when we make a deposit, the bank is simply “holding” our money. And when we take out a loan, we think the bank is “lending” us money that was sitting in a vault—that is, money someone else deposited with the bank. And the truth is, this idea is taken for granted as if it were perfectly natural. However, this is nothing more than a misconception stemming from our lack of understanding about banks.
We often say that “money is printed by the mint,” but the physical cash we actually handle is only a tiny fraction of the total money supply. The rest is money we cannot touch—virtual money that exists solely as numbers. Let’s hear what the experts have to say.
Niall Ferguson, Professor of History at Harvard University
“When people talk about money, most think of something like a $5 bill. They imagine only things like paper bills or coins. Of course, those are part of money. But the truth is, most money is invisible.”
Ellen Brown, Director of the Institute for Public Banking and Attorney
“People look at the government’s printing presses and think the government creates money. But that’s not how money is created.”
This Is How Money Is Created
So how exactly is money created? The secret lies in the process by which banks accept deposits and make loans.
For example, let’s say you put $100 in a safe at home. No matter how much time passes, that $100 will simply remain $100. But suppose you deposit that money in a bank. The bank doesn’t just leave that money sitting there. When the bank receives $100, it keeps only $10 and lends the remaining $90 to a person named A. As a result, not only is $100 already credited to my account, but $90 is also credited to A’s loan account. Now that Person A can also spend $90, the total amount of money that Person A and I can spend simultaneously suddenly becomes $190. As a result, through the process of lending, the original $100 deposit has created $90 in new money. This $90 that appeared out of nowhere is referred to as “credit money.”
When I deposit the $100 I had in my safe into the bank, the bank keeps $10 and lends the rest to Person A. Now, Person A and I together can withdraw and spend a total of $190.
How is this possible? It is all because of a promise. This is possible because the government has permitted banks to keep only 10% of a $100 deposit and lend out the remaining $90. This permission and promise are also outlined in ‘Modern Money Mechanics: A Workbook on Bank Reserves and Deposit Expansion’, an operational manual created by the Federal Reserve Bank (FRB) in 1963. According to this regulation, banks must keep 10% of the money on hand as a “fractional reserve ratio.” This refers to the “proportion of money a bank must set aside in case a depositor withdraws their funds.” This is simply called the “reserve ratio.” The fact that there is more money in circulation than the actual amount of money exists is due to this “reserve ratio.” This is an explanation by Professor Jeffrey Myron of the Department of Economics at Harvard University.
“Most of the money in deposits does not exist in the bank. It has all been lent out. The reserve ratio kept at the bank is typically around 10%. If you deposit $1,000 into an account, $100 is kept at the bank, and $900 is lent out as mortgages, car loans, business loans, and so on.”
The money we deposit in banks is never actually ‘held’ by the bank. It’s merely a number reflecting that amount on my account statement, while the remaining 90% is lent out to others. Conversely, the same applies if I take out a loan. The point is that banks do not lend me a portion of the money they’ve received from others; rather, they “create” money by entering 90% of the deposited amount into my account via their computer systems. Ultimately, the bank’s role is not simply to hold money and lend it out as-is to earn a profit. The essence of what banks do can be described as “creating money out of thin air.”
The money supply expands according to the reserve requirement ratio
So, just how much can the money supply grow? Let’s assume $10 billion has been deposited. If the government sets the reserve requirement ratio at 10%, the bank keeps 10% of that $10 billion—$1 billion—and lends the remaining $9 billion to another bank, Bank B. Bank B can then set aside 10%—$900 million—and lend the remaining $8.1 billion to Bank C. Bank C can then set aside 10% and lend to Bank D, Bank D to Bank E, and Bank E to Bank F, and so on. As a result, when added to the original $10 billion, the total becomes $10 billion + $9 billion + $8.1 billion + $7.2 billion + $6.5 billion + $5.9 billion + …, resulting in a staggering $100 billion in new money being “created.” Ultimately, money is not something we exchange with one another, but rather a product created by banks. We refer to this process of creating and intentionally increasing money that does not actually exist as “credit creation” or “credit expansion.”
In fact, when you think about it, the process of creating new money is actually quite simple. The bank simply needs to retain an amount equal to the reserve requirement ratio of the incoming funds and then manually “type” numbers into the borrower’s deposit collateral account. Professor Niall Ferguson of the Department of History at Harvard University puts it this way.
“We think money is in the bank because we can withdraw it immediately from an ATM. But in reality, it is only there in theory. Money is almost invisible; it appears only as numbers entered on a computer screen.”
Let’s hear from Professor Geoffrey Ingham of the Department of Sociology at the University of Cambridge in the UK.
“It’s a promise to pay. It’s credit. All money is credit.”
The graphs showing the increase in the money supply and the rise in prices are almost identical. This clearly demonstrates the correlation between the money supply and prices. We refer to this economic phenomenon—where an increase in the money supply causes the value of money to fall and prices to rise—as monetary expansion, or inflation.
Ultimately, it would be more accurate to describe the capitalist economic system not as a “society driven by money” but as a “society that creates money.” And at the very heart of building such a society lies the institution known as the “bank.” Because banks exist, the amount of money increases, and consequently, prices rise.
We often say that rising prices are due to difficulties in economic activity. Furthermore, many companies actually raise their prices while claiming, “We have no choice but to raise prices because raw material costs have gone up.” However, this is merely a superficial explanation. The rise in raw material prices is also caused by the increase in the money supply. The fundamental cause of rising prices is neither increased consumption nor companies seeking to maximize profits. It is, in fact, the banks themselves—and the capitalist system that revolves around them.
