It is a myth that only banks create money out of thin air. We all do. However, let me begin by admitting that I don’t know precisely the mechanics of money creation. This post is, therefore, a place for me to organise some thoughts on the subject. There is a great video that touches on the subject in relation to the economy as a whole.

To discuss such a delicate subject it is worth defining what do we mean by money. Wikipedia gives a pretty good definition: money is any item or verifiable record that is generally accepted as payment for goods and services and repayment of debts in a particular country or socio-economic context.

There are a few subtle points on this definition:

  • It can be any item. Early types of money were cattle and sheep. The use of metal for financial transaction came much later.
  • It can be a verifiable record. Today banks mostly use computerised form of record as money.
  • It must be generally accepted as payment to settle any debts in a particular socio-economic area. In most countries, this is legally recognised as legal tender. This means that any debtor must consider the debt settled if the debtee repays using a particular legal tender. So, when you want to pay for goods, a shopkeeper in England may refuse your Scottish pound (it is not a legal tender in England). He may also choose to refuse your British pound, but that means you can walk away with that goods, as the debt is considered settled.

Most of money that we know is what some refer as credit. 

Credit is a form of verifiable record. Like in the video, it is a bit like setting up a bar tab. In creating a bar tab, you are now holding liability in form of debt that must be repaid in the near future, and the bartender now has an asset in form of expected future cash. This is how credit (money) is created.

…credit is created when any two parties are willing to accept each other’s liabilities.

Similarly, when I seek a loan from a bank, I am essentially creating a financial liability that the bank may or may not want to hold. If it believes that I can repay on the loan, then it will accept my liabilities. In creating a loan, the bank now holds an asset (loan) and I, on the other hand, now hold a liability (loan). Essentially credit is created when any two parties are willing to swap one’s assets for the other’s liabilities.

Credit requires both parties making and honouring the transaction. In a recession, there is less willingness to enter an agreement on loan, because banks would find majority of people “uncreditworthy” (more likely to default on their loans at particular interest rate). This means the money supply during a recession usually goes down, and normally the central bank would lower interest rate to ensure that more loans (credit) are created enough so that the money supply can increase at a steady rate (read —  within inflation target).

The central bank has another tool at disposal when interest rate is at zero. It can physically print banknotes. This generally doesn’t add much into the money supply, since cash makes up a tiny percent of money supply. The central bank can also create credit in form of bank reserves. It is like a bank account, each private bank have at the central bank. There are some rules and regulations regarding bank reserve holding. And that is one of many ways, the central bank control the money supply.

The trick is to create at the right rate. Otherwise, we can get a hyperinflation that German experienced in the 1920s.