Money

How can we create money from scratch?

It seems that to advance funds it is necessary to dispose of it in advance. This would be true if all the money was in gold, if there were no bank notes, or deposits on bank accounts. But the banking system creates money out of nothing, just ink and paper, or computerized accounting. It allows to advance funds that did not exist before, which are created at the very moment they are loaned. It looks like counterfeit money, but it's very different, because money is created in exchange for promises of repayment.

Bank notes first appeared as deposit securities. We deposited our gold in the bank and we received in return a deposit security that could be used instead of gold for payments. Simply writing a deposit security is not enough to create money. The amount of money in circulation does not increase. The gold that was in circulation is immobilized in deposit and is replaced by a security that is the only one to circulate. But these deposit securities played the role of bearer repayment promises and the banks could put into circulation more promises of repayment than they had gold in their coffers, because the promises of repayment were not all required at the same time. They could be used as gold and they were easy to circulate. During normal periods, they remained in circulation and their repayment was not required. But if there was a loss of confidence in the bank's ability to repay its notes, all the holders could come forward at the same time to demand gold, and the bank could not meet its obligations.

The privilege of issuing notes could be very profitable and not very risky, because the banks lent with interest created money which did not cost them anything. If the borrowers were reliable, a bank feared little for not being able to repay the notes it had issued. But it still faced a risk of illiquidity, meaning that it could be asked to repay its notes before the loans it had granted were repaid.

Another way to create money from scratch is to print counterfeit notes. If their quality is sufficient so that they are not distinguished from others, the amount of money in circulation has been increased.

Imagine two friends who are mutually signing IOUs of equal value. An IOU can work as currency, provided the debtor's reputation is good. If no one is aware of the deception, and the two friends have a good reputation each, each can pay with the other's debt recognition. They thus circulate their papers as money. So they created money from scratch - almost, only a little ink and paper.

If the debts are repaid, the IOUs are destroyed and disappear from circulation. Generally, money can be created with IOUs and destroyed when debts are repaid.

Individuals generally can not circulate IOUs as currency. On the other hand, bankers can if their IOUs are considered very reliable. When a bank issued a loan with notes that it had created, it exchanged a debt acknowledgment, the notes, against another, that of his client.

Central banks

Banks that had acquired the right to print banknotes have gradually lost this privilege, except for central banks. Originally a central bank was the bank of the prince, or the ruler. Rich individuals who lent their gold to the sovereigns in exchange for privileges together formed banks to strengthen their position (which was sometimes tricky: a way for the princes to free themselves of a debt was simply to cut the head of the creditor). Thus they gradually acquired the monopoly of issuing banknotes.

Bank notes have gradually ceased to be convertible into gold, or silver metal. Such convertibility is dangerous and costly for banks, because they have to keep gold reserves that may not be enough if there are too many holders of notes who ask to be reimbursed. Even central banks, which held large gold reserves, were constrained in their monetary creation by the gold convertibility requirement. In fact during a crisis, they did not hesitate to suspend this convertibility as soon as they feared for their reserves.

With the abandonment of gold convertibility, central banks have ceased to be constrained by the need to keep gold reserves, they can create all the money they decide. Gold as a currency has become useless. Now economies no longer need gold for currency trading.

How does the money created by the central banks flow into the economy? In principle, they can buy anything they want, including gold stocks, and even all wealth available for sale. But of course grabbing all the riches is not their role.

A central bank puts money into circulation by a technique that looks like an exchange of IOUs, because in general it lends the money it creates, either directly, by lending to banks, it is then a bank of banks, or indirectly, by purchasing IOUs on the financial markets. When the central bank grants a loan, or when it buys a bond, it puts money into circulation. When the loan or bond is repaid, the money is withdrawn from circulation. But it is not really an exchange of IOUs, because a central bank owes nothing. Its notes are not rights to real wealth but only rights to be exchanged for real wealth at a price that is a priori indeterminate. Since gold convertibility has been completely abandoned, central banks do not have to pay off debts any more because they no longer have debt. It all happened as if they had refused to repay their debts, since originally the notes were IOUs.

A central bank can also give the money it creates, either to the state, which allows it to reduce taxes or repay its debts, either directly to the citizens, giving them all an equal amount, for example, as an egalitarian Christmas gift. In this case, it is sometimes referred to as helicopter money, as if the central bank was distributing its notes by helicopter. The term helicopter money is obviously a joke, but not the reality. Creating money and giving it to all citizens can be useful.

Imagine someone finding a huge treasure, gigantic gold reserves. He has no interest in selling such wealth too quickly, because if he floods everyone with his gold, he raises prices and it diminishes the value of his treasure. Central banks have the same problem. They have an unlimited supply of money, a sort of huge treasure, but if they sell it too quickly, they drive up prices. For example, a state that relies on money creation by the central bank to pay civil servants without levying taxes necessarily causes hyperinflation that destroys the economy.

The creation and destruction of money by banks

Let C be the amount of cash (coins and notes) in the pockets or cash boxes of individuals and firms (except commercial banks). Let R be the reserves of commercial banks, it is the cash in their coffers and their accounts at the central bank. Let B be the sum of all bank accounts of individuals and firms in commercial banks.

The central bank is the bank of commercial banks. The reserves of all commercial banks are counted by the central bank.

A bank account is a claim of the customer on his bank. It is counted in the client's assets and in the bank's liabilities. A bank has the obligation to repay these claims on demand, at any time. This is the obligation to withdraw at sight.

M1=B+C is the monetary mass circulating between individuals. M0=C+R is the central money supply, or base money. The total money supply is the sum of all the contents of all the pockets of individuals and all the coffers of firms, including commercial banks. The money possessed by an individual is for him a reserve. A firm's cash is also a reserve. Commercial bank reserves are not different. There is no reason to exclude them from the money supply. They circulate in the economy, like the contents of the cash boxes of all firms. The total quantity of money in the economy at a given moment is therefore M=R+B+C.

As if it were a counterfeiter, the central bank creates the money with which it lends to commercial banks and buys other assets (a loan can be considered as the purchase of a claim, therefore of an asset). M0 is all the money created by the central bank in return for its assets. Base money is created by the bank when it buys assets, and it is destroyed when it sells them, or when loans are repaid. It is counted as a liability of the central bank, as if all holders of central money had a claim on the central bank, but it is a fictitious claim, because the central bank is never obliged to repay it. Individuals cannot open an account with the central bank, but when they hold cash, it is the same, because the notes are like a claim on the central bank. When an individual pays for a purchase with banknotes, he is only ceding a claim on the central bank to the seller, and this claim is never repaid.

When depositing or withdrawing cash from a commercial bank, neither M0 nor M1 is modified, but M is increased by the amount deposited, or reduced by the amount withdrawn. If it is a deposit, B is reduced by the amount deposited, R is increased by exactly the same amount, as is C. The increase in the total quantity of money M=R+B+C is monetary creation. When we deposit money in the bank, we create bank money. The money that has been deposited is multiplied by two, it is once in the bank's reserves and a second time in the depositor's account. This does not change the bank's balance sheet, because depositors' accounts are liabilities, while its reserves are assets. If we withdraw the deposited money, we destroy the money that we first created.

To grant a credit, a banker only has to click on his computer and the credit is automatically displayed on the customer's account. That's all. If the individual deposits the loan in another bank, the reserves of the lending bank decrease by the amount of the loan, but the reserves of the bank of the borrowing customer increase by exactly the same amount. If the individual deposits the amount of the loan in his account at the lending bank, the reserves of the bank are not modified. In both cases, R is not changed, but M1 and M increase by the amount of the loan. The money lent when a credit is granted is therefore created at the very moment it is lent. If the loan is in cash, the bank's reserves decrease, so R decreases but B increases by the same amount, so M does not change and M1 is increased by the amount of the loan. M does not change because the money that was created to be lent is destroyed if it is withdrawn in cash. This is normal monetary destruction, which is caused by all cash withdrawals, whether the money was created by a loan or not.

When a bank grants credit to one of its customers, it is an exchange of claims. The bank gives the customer a claim on itself, when it credits his account, in exchange for a claim on the customer, the obligation to repay the money lent. It is the exchange of a debt on demand against a term debt. Banks transform term debts into debts on demand and vice versa. By transforming term debts, which are not money, into debts on demand, which are, banks create money. 

Bankers sometimes claim that they don't create money. When they credit a depositor, they have not created money, only a claim on the bank. When they grant a credit, they do not create the money lent, they only dip into their reserves. But they forget to say that claims on banks are money, because they are used as such, and that the total reserves of the banks are not modified when one of them grants credit, unless credit is received in cash.

Money creation by banks is not final. Consider an individual repaying a bank loan from his account at the lending bank. C decreases by the amount of the loan, but the bank's reserve is not changed. If the individual repays from another bank, he decreases the reserves of this bank and increases the reserves of the bank he is repaying. In both cases, R does not change. Each time a loan is repaid, the money that was created to grant it is destroyed. The money created can therefore always be ultimately destroyed. If the banks decide to lend less than the loans that are repaid to them, they destroy more money than they create and they thus reduce the money supply. If agents refused to go into debt, if they repaid all their debts, would money disappear from the economy? Almost all the money in circulation today would be destroyed by the repayment of debts. The central bank and commercial banks would then have to find other ways to put money into circulation.

The central bank creates money when it buys assets and destroys it when it sells them. Commercial banks create money when they accept deposits to credit bank accounts, and when they grant credit. They destroy the money thus created, when deposits are withdrawn and when credits are repaid.

Credits make deposits and deposits make credits

Credits make deposits, because the money lent is generally deposited in a bank. If it is spent, it goes to the sellers' bank accounts. Deposits make credits, because commercial banks do not have the right to lend more than their reserves, and because they do not want to let the deposited money lie dormant in their coffers. The business of a banker is to lend the money entrusted to him.

Each credit makes a new deposit that can make a new credit, and so on. Is it then to be feared that banks can create money without limit and drown the economy in a monetary deluge?

Since some of the money created by banks is kept in the form of notes and is not redeposited, the sequence of credits and deposits can not lead to unlimited creation, because each new deposit is only a fraction of the credit that created it. In addition, central banks generally impose mandatory reserves on banks. For each deposit, they must keep a fraction in reserve and therefore do not use it to grant a new credit. As a result of these two effects, the money created by the banks can only be a multiple of money put into circulation by the central bank. This monetary multiplier depends on the reserves of the banks, mandatory or surplus, and the mass of cash in circulation.

If we removed cash money and if there were no reserve requirements, would the money supply increase to infinity? No, because banks only lend if they find reliable borrowers, and because the number of borrowers is necessarily limited. Lenders do not readily agree to lend. Borrowers do not easily take on debt. The sum of the loans is limited by the capacity of the agents to get into debt. Even if the banks were not obliged to keep reserves, they would keep some anyway, for lack of borrowers to lend them to. Monetary creation by banks cannot therefore lead to an infinite inflation of the money supply.

Should banks be prohibited from creating money?

From the point of view of a depositor, his money in the bank is kept, since he can withdraw it at any moment, but from the point of view of the bank, everything happens as if it were lent, since it can lend almost as much money as the one deposited. Monetary creation by banks is a way of turning sleeping money into circulating money. By depositing our money in a bank, we keep it without letting it sleep, since it makes more money circulating into the economy.

From an accounting point of view, the money deposited in the bank is lent to borrowers. A depositor may rebel against this practice. If the bank goes bankrupt, it could lose its deposit. We can therefore think of 100% reserve deposits (Fisher), that is to say that the bank would promise not to lend them, it would refrain from using it to create bank money. Today's banks could offer such a 100% reserve bank money service, but depositors would have to pay more bank fees for the management of their accounts, because the banks could not pay themselves by lending the money entrusted to them. Such an increase in fees would be a deterrent. In addition, depositors would have nothing to gain, because demand deposits are already guaranteed. Even if his bank goes bankrupt, the depositor does not lose his money. Why then want a 100% reserve account?

Centralized or decentralized money?

Money is decentralized when there is no central bank to regulate monetary creation. When money is tangible wealth (gold, silver...) it is decentralized. Some believed that cryptos could play the role of decentralized money, but that was believing in illusions and lies.

When money is centralized, the central bank adjusts the money supply to the needs of the economy and tries to stabilize the financial system. Centralized money is therefore anchored indirectly on the real wealth of the economies that it enables to operate. Cryptos are generally not anchored to anything. They are delivered to the madness of speculators.

In relation to financial markets, central banks are in the position of a schoolteacher facing unruly children. The Fed (Federal Reserve, the central bank of the United States) was created precisely to stabilize the financial system. Before the existence of the Fed, the economy suffered from repeated financial crises. To suppress the schoolteacher is to deliver the whole economy to the madness of speculators.

In general, speculators do not like the power of central banks, because they have to align their decisions with those of central bankers: don't play against the Fed. But they are making a very big mistake if they want to get rid of it with decentralized money. The masses of gold and silver are a very bad way to manage the money supply, cryptos are a scam, free money (Hayek, each bank is free to issue its own banknotes in its own currency) and any decentralized money deliver the economy to hazard or madness.

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