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Have you ever thought about the question: How is money made?

Actually, that question, though it is often stated this way, is incorrect. Most people already know that there are presses that print and stamp currency. The real question is “how is currency brought into circulation?”. How do we get money in our hands? While we must work for money, where does this start? who gets to “distribute” the money after it has been printed?

Before we answer that question, some memorable quotes of famous people:

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” - Henry Ford

“The process by which money is created is so simple the mind is repelled.” - John Kenneth Galbraith

So then, how is it created? or brought into circulation?

Answer: By a book entry.

Yup, that is it. Of course there are rules and regulations, overseers, rapports and what not. But in the end it is simply someone that writes in a book: I hereby create so and so much money.

Who would not like to be that person!

Example: John walks into a bank and asks for a $1000 loan. The bank manager trusts John to pay back the loan and thus decides to give him the loan. He gives John the $1000 and writes two things in his book: 1) created $1000, and 2) John owns me $1000.

That is it. There is no more to it. Well, maybe… once John pays back the loan, the bank manager writes in his books: John owns me nothing, and: destroyed $1000.

But that is all there is to bringing money into circulation. All the money we see around us is the result of people taking out a loan.

In a figure:

money-creation

The figure may look complex, but if we simply follow the flow from left ro right, we get: “no money”, “loan given”, “money” and “debt”, “loan repaid” and from there on: “no money”.

I must emphasise that money is not only created, but als destroyed! Once a loan is paid back, the money ceases to exist. It simply disappears into nothingness. This is in fact a crucial step in the entire process that (from observation) not many people seem to grok. Most articles you will find on the internet seem to concentrate on the creation, and forget that there is also the destruction. The destruction is important though, because without it modern money cannot exist. It is the destruction that gives money its value.

All money must be destroyed after the time of the loan expires. If somebody is unable to pay back his loan, the money is still destroyed. Only this time the money that is destroyed comes out of the reserves/earnings of the bank! This is called “writing down” the value of a loan. If the bank manager misjudged the capacity of John to pay back his loan, and John defaults, then the bankmanager must destroy the loan value from the banks own money. And if that is not enough, it will ultimately need to write down the loan value from the money the depositors have with the bank. I.e. our savings will be used to cover the loan from John. This ensures that the manager cannot give a loan to everybody. He must be a good judge of people. Giving loans to everybody who asks would ensure that the bank would go bankrupt itself! This is the principal method by which the amount of money in circulation, and thereby its value, is regulated.

You may have noticed the possibility for a “loophole” here: the destruction of money is “enforced” by rule. But rules can be flexible, in fact they will be as flexible as the people in power want them to be. This is what happened after the crisis that started in 2008: banks were given leeway to revalue loans and thus avoid bankruptcy. If the rules that were in place would have been enforced, there would have been a global meltdown of nearly all financial institutions. This was deemed unacceptable and the banks were allowed to value loans at “make believe” numbers. This did solve the problem at hand, but remember: it is the destruction of money that gives money its value. Failing to destroy money will have the ultimate consequence of making money worthless. Don’t panik though… while this will eventually happen there is sufficient production power to keep the wolves at bay… for now and probably quite some time to come… however that is an entirely different subject.

While the above is true for all money, not all money is loaned into existence at the same time. Loans overlap, thus giving us the illusion of a constant supply of money. In reality though, there is a constant creation and destruction of money going on.

It is often said that the total money supply always increases. And that is (mostly) true. But this simply means that in aggregate we keep loaning more money into existence than is destroyed by paying off loans. There are several explanations for this: the most obvious is the growing population. But there are others. Most notably a certain group of people who (almost) never pay off their debt: the government. Almost every government in the world has an ever expanding deficit. This deficit is nothing but loans which means that this deficit is directly responsible for a growing money supply. Note: While governments may seem to pay of their debt, in reality they are “rolling over” their loans. They pay back money of the first loan by taking out a second loan! go figure…

Having said the above, it is important to keep in mind that not all loans create money. If I were to loan you $1000, this would not create new money. It would be a transfer of my money to you. Money is only created when banks loan money.

The Central Banks usually regulate how much money the banks may loan into existence, but this process is rather complex. Despite the seemingly simple rules. If interested, please google for that info.

A last word: because the banks take risks in giving loans, they would rather have somebody else to carry the risk. If we think back to the crisis that started in 2008, banks had sold their (bad)loans to investors. Unfortunately for the banks though, they are the only ones who can create and destroy money. No matter how many people they line up between the loan and the money they created. Hence when confidence caters, its always the banks who get into trouble. It cannot be any other way.


Originally posted at: 2016-12-27
Last modified on: 2016-12-27