How Money Creation Works – Part I – Intro

 

This is a multi-part series I began a long time ago examining the mechanics of money creation, a very elusive and deceptive process misunderstood by almost everybody. Since it is such a central process to the economy, I have decided to cover it in great detail. It is not only central; it is the greatest power in the whole world. Far superior than standing armies and military might. Those who control money, control the world. It is that simple. Even the military is at the mercy of the banks.

Unfortunately these days, hardly any bankers go to jail for misconduct let alone for this inherently fraudulent process that goes on unquestioned and assumed as “business as usual”. It seems that people around the time of the founding fathers in America had a much better awareness of the issue, compared to today’s age of blithe ignorance, mass manufactured consent and dangerous manipulation. Hordes of people get ripped off on mortgages and loans by institutions that have the power to create money out of nothing at the stroke of a keyboard, at no opportunity cost, while charging exorbitant interest for it, and enriching themselves grossly with this fraud. If people discovered how this system of banking worked, remarked Henry Ford, there would revolution tomorrow morning. Hardly anybody fully understands the deceptive nature of money creation. It’s too bad that universities don’t really cover this process deeply, only claiming that banks lend their deposits. Inquiring minds however, would follow up with:  “for if they did that, no money would be created!”. It’s strange how no academic paper explores and questions money creation itself. By understanding the money creation process, you will be able to understand how the economy works at a fundamental level, probably much better than most economists. Once you learn it, you will be shocked as to how central it is to the economy and yet how centralised it is in the hands of the very few. Part I will introduce definitions and a high level overview. Part II will go into the technical details. Part III will look into the implications, why this is fraudulent, and what I think should change.

Background on money creation

As the story goes, it all began with Goldsmiths in Europe from the middle ages. Goldsmiths were essentially the first bankers. Of course this is coming from the European perspective; we know paper money existed in China long before. Money back then was in the form of gold coins. When people deposited their sums of gold coins with the Goldsmiths and paid a safekeeping fee for the service, they got a receipt back. This receipt was the genesis of paper money today. Over time, people realized that carrying receipts was more practical than carrying heavy coins around, and safer too (less muggings). Meanwhile, the Goldsmiths also realized that at any given time, people would only withdraw a small fraction of their total gold holdings for everyday usage, leaving the rest in the vaults. The Goldsmiths now conjured up a clever scheme whereby they would issue much more receipts, or claims on real gold, than actual gold holdings in the vaults. Since people hardly withdrew their total gold holdings, nobody was the wiser. The Goldsmiths were insidiously printing more receipts and inflating away the value of gold, loaning out this extra money to collect more and more interest profit on it. This process is very similar to today’s fractional reserve banking system. As you can see, cheating the system was easy as long as you had the power to do so. Only when bank runs occurred did people discover the scheme and the game was up. This was because when everybody at once wanted to withdraw his or her gold, there obviously wasn’t enough real gold backing every single paper claim on it. The Goldsmiths were insidiously inflating away people’s wealth to make money out of it. A fury of revolt would ensue, and the Goldsmiths would be hung.

Definitions

Before we go deep, we need to learn the basic definitions first, so you can understand the rest of the article. Please note however, that this is a very detailed, long article that may get a little technical, but I have tried to make it simple as possible for the layman to understand, having studied this process rigorously myself. I provide official references and statistics at the end, where the reader can do further research. Phew, OK here we go.

Money: Today, money is not commodity money (it is not intrinsically valuable like gold coins), rather it is known as fiat money. Fiat money is made of paper and is intrinsically worthless. It is called fiat because the government simply said so, or issued a legal fiat, mandating that their paper money should be the only acceptable tender for all transactions in the economy. The choice to use paper was arbitrary, – it could have chosen seashells or rocks if it wanted to, but clearly paper as a medium of exchange is more convenient. Over time, money has developed some defining characteristics to pass for a good medium of exchange – it must be divisible, fungible, portable, a store of value, relatively scarce and durable.

Money itself should be thought of as a claim on real assets in the economy. Assets could be financial, such as stocks, bonds and foreign currency, or physical, such as goods, services, factories, housing and land. Money is a claim on those assets, because it is used to buy them. Liabilities on the other hand, or debt, is never real; it is always financial in nature. You never owe someone a house, a car or haircut (unless you are in a barter system), rather, you always owe someone a financial asset such as, for example, cash (the most liquid form of money).

We must understand that money is also debt. Every single paper note you hold as an asset to you, is somebody else’s liability, or debt. Think about it this way. If you have a $10 note, to you that’s an asset – you can purchase things with it. But to the person you got it from, it is their liability – they cannot use it to purchase things any more. As a matter of fact, the notes you have in your possession are your asset, but the central bank’s liability, because theoretically they are legally bound to meet your demand (just no guarantees during bank runs and financial crises). This is because every single transaction in the world is double sided; on one side it is an asset, and on the other side it is a liability. When Person A pays money to Person B, Person A loses that money while Person B gains it. In game theory speak we would call that a zero-sum game. Every transaction is zero-sum. Your gain is always somebody else’s loss and vice versa.

Here are some important definitions to keep in mind that you may refer back to later:

Base money: Aka ‘monetary base’ or ‘high powered money’ – the sum of currency in circulation (physical coins minted and notes printed) plus reserves.

Reserves: Aka ‘bank reserves’. This is very important. Made up of commercial bank reserve accounts at the Fed (usually electronic cash) + vault cash (real coins and notes in bank branches to cover your daily withdrawals). The reserve account is composed of required reserves and excess reserves. From now on, when I say ‘reserves’, I refer to bank reserve accounts with the Fed rather than vault cash. This is because money creation is driven by these important reserve accounts which commercial banks have at their respective central bank. They are usually known as reserve accounts in the US and Europe. In Australia, the RBA calls them exchange settlement accounts.

Deposits: These make up most of the money supply in the economy – the numbers you see in your transaction and savings accounts. Essentially deposit money is created by the commercial banks (while reserves are created by the Fed), sitting in the accounts of the public such as companies and individuals. Money supply is mainly made up of deposit money. I will explain this later.

The Fed: This is the central bank of the United States and I will frequently refer to the Fed in my article.

OMO: Open market operations – the chief mechanism of monetary policy in modern banking systems. It relies on influencing a small supply of bank reserves to drive a much larger pool of deposit money supply in the economy. As a result of the changes in reserves, the interest rate changes. Technically this interest rate is called the ‘Fed Funds rate’ and it is the rate governing the market for bank reserves with the Fed, which all commercial banks buy and sell to each other in order to bridge overnight funding gaps.

The process of money creation

The market for these obscure and not very well known bank reserves basically drives money creation in the economy. The inter-bank market affects the supply and demand for reserves. This market is between the commercial banks and the central bank, but is connected indirectly to almost every single person in the economy because most people and institutions have a deposit account at any given commercial bank. It is important to remember that deposit money is included in money supply but reserves are not. The supply of deposit money changes every time the supply of reserves changes. Think of a puppeteer at a show moving his fingers, and this motion carrying through along the strings to the puppet. Deposit money could be thought of as the puppet, hanging by the strings (which represents the payments system) and by the jerk of the puppeteer’s hand, it expands or contracts every time his hand (which represents reserves) pushes or pulls in proportion. The banking system could be thought of as a pyramid structure, with the central bank right at the top initiating money creation to influence a small but vital market of reserves kept internally between commercial banks and the Fed, and this in turn influences the commercial banks to (hopefully) create additional money in the much larger market of deposits in proportion to those reserves, hence increasing money supply. The market for deposits is kept externally between commercial banks and all their deposit-holders, which includes almost everybody in the entire economy. This critical process initiated by the Fed and continued by commercial banks, pumps and drains money throughout the economy as the Fed sees fit.

My funny attempt to draw the pyramid of money

In contrast, when there is too little money in the economy and commercial bank lending is weak (hence deposits are low), the central bank steps in and floods the market for reserves. Since the market for reserves pays little to no interest, commercial banks would rather make money by lending or investing reserve cash rather than keeping cash idle in their reserve accounts. So the theory goes, the banks expand money supply with new deposits, and increase inflation. How exactly this happens will be explained in more detail soon. The Fed basically kick-starts the process through OMO by initially buying government bonds from primary dealers in the non-bank sector. The primary dealer’s bank deposit is credited with freshly created money out of nothing. This didn’t come from any money already existing in the system, for if it did, money supply would not increase. It came from the Fed which has the power to create money out of nothing, by a few electronic keystrokes and accounting tricks. Money supply thus increases as the primary dealer spends that brand new money. The primary dealer’s bank now has extra deposit money, and extra reserves too, since more deposits means more vault cash on hand and bigger reserve settlements with the Fed by end of day clearance. This triggers a chain of additional money creation by commercial bank lending/investing, expanding money supply much more than the initial amount created by the Fed. Deposits don’t always increase with reserves on a 1-to-1 basis, but we will assume that they do for simplicity. If you still don’t exactly understand how this works, don’t worry. We will get into more detail soon. It is a very counter-intuitive process to understand, but one of the greatest sleights of hand in the world!

Now, as the economy rolls along, loans are made, debts are repaid and goods and services are traded many times over. Nobody can control this, – this is the natural procession of the economy. But bank reserves can be controlled, and this is how money is created and destroyed with the intention to influence the procession of the economy by affecting the quantity of deposit money and currency in circulation. The Fed and the commercial banks together control the quantity of money in the economy, and they are the only institutions that are armed with the power of money creation. Anybody else who tries will go to jail for counterfeiting. They are also the only institutions that are ultimately responsible for inflation and the purchasing power of your money. The banking cartel is the most powerful mafia in the world. And you thought the mob was big.

Lets go into more detail on what exactly ‘money supply’ means.

More definitions

Now let us introduce how money supply is measured. There are a few important measures of money supply. These are referred to as money supply aggregates. In the US, there are two main money supply aggregates: M1 and M2. There used to be M3, which was the broadest measure of money supply, but the Fed stopped measuring it in 2006. M0 and MB also exist, but are very narrow measures of money supply.

M0: Measures only physical currency including coins and notes. These can include currency abroad and in the US. Most M0 is overseas, as US currency finds use as the world’s reserve currency held by many central banks (and other crime syndicates).

MB: Monetary base. This measure counts all notes and coins in circulation plus reserves, both required and excess.

M1: Includes the most liquid forms of money (M0) – currency in circulation (notes and coins) plus transaction deposits at commercial banks (travellers checks, demand deposits and other deposits against which checks can be written). M1 captures deposit money, – transaction deposits are generally money of the non-bank public, such as your bank account and those of corporations, also held at commercial banks.

M2: A broader measure of money supply than M1, including – M1, savings accounts, time deposits (or term deposits of less than $100K) and the accounts of retail money market mutual funds.

Note that M1 does not include bank reserves. We know that money creation is started by the central bank (the Fed), but whether Fed expansionary OMO results in new M1 money depends on who sells securities to the Fed. If a commercial bank sells securities to the Fed, no new transaction deposits are created and money supply does not increase. But if a non-bank entity such as a primary dealer sells securities to the Fed, a new transaction deposit is created for the dealer whose bank receives equal deposits at the Fed. Brand new money is created and money supply increases. That’s why the counter-parties of OMO are always non-bank primary dealers and not banks – so monetary policy is actually effective and changes money supply or M1. Generally, payments by banks to the non-bank sector increases M1. And vice versa, payments by the non-bank sector to banks reduce M1. Remember this, because it is important, and there will be more on this later.

Bank reserves

It’s important to understand that bank reserves are non-interest bearing, that is, they do not bear much interest that banks normally love to earn. Banks usually invest spare cash in interest bearing instruments such as bonds, stocks or loans. Reserves don’t earn them much money. Each time commercial banks make loans to non-banks (when you want a mortgage loan for example), the commercial bank creates a deposit out of nothing for the borrower at the bank to cover the cheque. A bank loan involves payment by the bank to cover the borrower’s cheque, thus increasing M1. Think of the bank’s reserve account as your every day transaction account – when you want to spend money, say, from your savings account which is busy bearing interest, you must first transfer it into your transaction account and only then can you spend it. For banks, it is the same principle. Their transaction account that covers day-to-day operations in the over-night market is their reserve account at the Fed, as well as corresponding accounts with the inter-bank market (other commercial banks). The interest bearing stuff that makes them money is tied up with loans and investments, – i.e. money not in the reserve account and instead part of the money supply.

Banks don’t like hoarding cash unless they really have to, like this cartel boss. They prefer to make money on money.

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9 Comments on "How Money Creation Works – Part I – Intro"

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JSwift
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I have found it useful to be careful to differentiate “money” and “currency,” because even though colloquially everyone uses the term “money,” they are almost always referring to currency. Money is a uniform, easily tradable thing of actual value–e.g., gold and silver coins. Even paper can be money if it is actually fully backed by precious metals or some other real commodity of relatively stable value. What you refer to as “fiat money” I would refer to as currency, because, as you state, it has no real value other than what we are told it has by the issuer, and… Read more »
Pacificnorthwest
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Very nice & information rich article… will continue reading the other two in this series. Thought I’d mention how the class of opaque derivatives instruments sloshing around the global markets (which is huge) also functions as a kind of money. Especially after several degrees of separation from being based on any tangible asset… such as packaged instruments like shorts or longs on some future value such as an underlying asset as a short long on say a commodity price point. These are opaquely packaged bets, placed on some future value of other bets, on what… often no one really knows,… Read more »
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[…] was essentially an application of the very same underpinnings behind modern banking, as I explained here, here and here. The only difference was that gold in this system served as bank ‘reserves’, and […]

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[…] you missed it, I already covered how modern banking and money creation works in a 3-part series here, here and here. Read up on that first to better understand what we are dealing with. But I will try […]