Money creation: A primer

Michael Hatcher, University of Southampton. Posted on August 28th 2021.

The U.S. sub-prime crisis of 2007-8 threw the issue of private money creation firmly into the public spotlight. Greedy bankers, or so the story goes, extended mortgage loans to all those wanting to climb the ‘housing ladder', confident that house prices would go on rising. According to this popular narrative, central banks and regulators could be criticised for ‘falling asleep at the wheel’, but it was the money creation of banks that was ultimately responsible for steering us off the road.

To understand such claims, we need to understand how money is created, where it goes, and the limits (if any) to money creation. Comprehensive guides that go beyond the basics covered here include Bank of England (2014) and Bundesbank (2017).

How money creation works

Let us begin with the basics: a single loan. When a commercial bank makes a new loan, it simultaneously creates both a new liability (loan to customer) and a new asset (contractual promise of repayment). The new liability is in the form of deposits: the customer’s current account is credited by the amount of the loan, say £50m (Figure 1, top panel). Since deposits function as money, the bank loan is an act of money creation and will increase measures of broad money, such as M4 in the UK, ceteris paribus.

Figure 1 – Money creation by making loans (stylized bank balance sheet, £m)

Figure 1 shows that money is ‘created’ out of assets. Or as Freund and Rendahl (2019) put it, “commercial banks create private money by transforming an illiquid asset (the borrower’s future ability to repay) into a liquid one (bank deposits)”. Hence, money creation by banks solves the intertemporal problem that future ability to pay is not generally accepted as payment for goods and services today. Money creation does not, as some argue, violate the common-sense maxim ex nihilo nihil fit (nothing comes from nothing).[1]

Money creation backed by assets is not the same as stipulating that all loans should be repaid. Banks recognize that loans are a risky business and that some borrowers will not repay, for example, because they may lose their job or go bankrupt. What is necessary, for money creation to be backed, is that lenders carry out due diligence on borrowers, allowing them to make a good estimate of repayment probabilities. The likelihood of repayment depends, amongst other things, on a borrower’s future income and wealth prospects. The problem of estimating the likelihood of repayment is particularly acute for long-term loans like mortgages, which are repaid over several decades, as Knightian uncertainty poses significant difficulties for valuing the underlying assets.[2]

Since forecasting is itself a risky business, banks typically require that borrowers pledge collateral, often physical assets, against their loans. This way, if the borrower defaults on the loan repayments, the bank has a legal right to seize the collateral and resell it. For example, in the case of mortgage loans, the house itself is usually pledged as collateral. In the event of default, the lender can trigger foreclosure proceedings, thereby seizing the house from the borrower and putting it up for sale.[3]

The importance of reserves

Having discussed how money is created by granting new loans, we now turn to financing. Note that a bank which creates money must transfer reserves to another bank when the loan is spent. For instance, if the loan is a mortgage, the deposits of the borrower would soon be used to buy a house. At this point, there is a transfer of deposits from the bank account of the borrower to that of the house seller, which is settled by transferring reserves from the borrower’s bank to the seller’s bank (Figure 1, lower panel).[4]

One sees here that ‘money creation’ is a potentially misleading term, since when the loan is spent (withdrawal), this is financed by a transfer of reserves to another bank. If the bank that originated the loan did not have sufficient reserves to ‘pay’ the other bank, it would face a bank run and find itself illiquid. Hence, the latter is a ‘hard constraint’ on bank lending, albeit that reserves may be borrowed from the central bank or from other banks. Since the total amount of reserves in the banking system is ultimately central bank determined, money creation relies on liquidity (past or present) provided by the Bank of England.[5]

A useful way to think about money creation, then, is as follows. When a bank approves a loan to a customer it creates money (increase in deposits) – and this does not require the approval of the Bank of England. However, for the loan to be used as purchasing power by the borrower, the bank must be able to settle the corresponding withdrawal using its reserves. If it has too few reserves, it may borrow reserves from the Bank of England or from other banks, provided they are willing to lend them. Since banks keep a ‘reserve buffer’ as protection against bank runs, their reserves are often sufficient to finance new loans (as in Fig. 1).[6]

In language of the mathematician, banks are locally unconstrained, but not globally unconstrained. That is, if a typical bank would like to create money by making new loans, it can do so day-to-day, for some time, without hitting any constraint. But banks cannot 'create as much money as they like' because at some point banks will have too few reserves to meet outflows triggered by spending of new loans, and there is no guarantee the Bank of England will expand reserves, via open market operations, to accommodate their wishes. Moreover, while banks can typically borrow reserves from other banks in the interbank market, the market would ‘dry up’ if all banks tried to make new loans upon new loans, because they would all want the reserves for themselves.

In summary, total reserves made available by the central bank limit potential money creation by the banking sector. However, individual banks may create money for some time before hitting the limit, and what matters is not just how much money is created, but where it goes. The expansion of the U.S. sub-prime mortgage market stored up problems because loans were given to people with little or no prospect of repaying unless house prices went on rising. It is this dangerous lending, not big lending, that kills banks.

Michael Hatcher, University of Southampton

References

Bank of England (2014), “Money creation in the modern economy”, Quarterly Bulletin, 2014 Q1.

Bundesbank (2017), “The role of banks, non-banks and the central bank in the money creation process”, Monthly Report 2017.

Graeber, D (2019), “Against economics”, The New York Review of Books, 5 December.

Freund, LB and P Rendahl (2019), “Banks do not create money out of thin air”, VoxEU.org, Dec 14.

Williams, Z (2017), “How the actual magic money tree works”, The Guardian, Oct 29.

[1] One popular, but mistaken, notion is that of banks as ‘magic money trees’ (see Williams, 2017; Graeber, 2019). One can only (correctly) argue that the money comes from ‘thin air’ if the assets out of which the loan is created do not in fact exist (e.g. fraudulent loan applications that go unchecked). Even then, reserves are still needed to meet withdrawals (see Figure 1, lower panel).
[2] Knightian uncertainty refers to situations where the underlying distribution of payoffs is unknown. Keynes, in Ch. 12 of the General Theory (The problem of long-term expectation), states “Our knowledge of the factors which will govern the yield of an investment some years hence is usually very slight and often negligible…[O]ur existing knowledge does not provide a sufficient basis for a calculated mathematical expectation.”
[3] The film 99 Homes provides vivid examples of home foreclosures and the problems that can arise both for those evicted and the lenders who seize the properties and then resell them.
[4] In some cases a transfer of reserves is not necessary; e.g. the house buyer and the house seller may have the same bank. However, the bank still faces the problem that the deposits may be withdrawn (spent) on demand.
[5] Banks may also obtain reserves by attracting additional deposits. However, such deposits can be withdrawn at short notice and the propensity to save in deposit accounts is limited at any given point in time. The demand for saving in deposit accounts will depend, amongst other things, on the (private sector) savings rate and the popularity of alternative investment opportunities, including online trading platforms and new asset classes such as cryptocurrencies.
[6] Banks can borrow reserves from one another in the interbank market. In some countries, regulation stipulates that reserves should not fall below a certain fraction of deposits (or liquid liabilities), known as the minimum reserve ratio. Examples are China and Switzerland (8.9% and 2.5%, respectively, as of writing).