Money is passed from person to person and place to place as people buy and sell products and services. Most people don’t give much thought to how the money came into being in the first place, but it actually does have to be created. It has to start somewhere. Someone has to feed it into the economy before it can start being passed around as we make exchanges.
Many people think the U.S. government creates money for the U.S. economy, and it’s true that the U.S. Treasury creates the supply of coin money. The US Treasury also prints our dollar bills (though it does not turn them from pieces of paper into currency1). But the cash notes and coins account for only a small portion (around 10%) of the money we use in the U.S. today. Most of the money is bank account money—numbers in bank accounts for which there is no corresponding cash.
Bank account money is created by private banks and based on their own lending decisions. This fact is not well publicized, and many people may find it shocking to learn this, but when a bank makes a loan, they create money that didn’t exist before. The key to this process is that numbers in bank accounts are accepted as money. This is what allows banks to use a bookkeeping procedure that no other entity can. The banks’ role as money creator often goes unnoticed—even by many bankers.
To create money for a loan, the bank creates an asset by drawing up a loan agreement and getting the borrower to sign it. And they create a liability by entering numbers in a bank account for the corresponding amount of money. The asset represents value that they own—someone else’s promise to pay money in the future. The liability represents value that they owe—they’re promising to provide the account holder with cash or a transfer of funds to another account whenever requested. If you’re familiar with accounting principles, you can see that this would balance on a Balance Sheet.
Incredible as it may seem, this is the legal accepted way for banks to make loans; they create the money they lend. Another important factor in this process is that when the borrower pays down the loan principal, the created money is extinguished from the money supply.
As you might imagine, much of the economic woes we face today can be traced to this process of money creation.
If you thought banks were lending out the money that their customers have on deposit, you’re not alone. While we believe it should be that way, and in the Just Money system we advocate, it will be that way, that is not currently the case. For more clarification of the current process, you may find these references helpful:
- For a basic explanation of how people create money – a two step process that involves how it is created and how it is entered into an economy, see USMoney.US: How do people create money?
- For a step by step explanation with examples and diagrams showing the relationship between how people think banks work and how they actually do work in the U.S. today, see Workable Economics: Where does money come from?
- Also, Positive Money in the UK has produced a number of short animated introductory videos illustrating how banking really works. See Introductory Videos or for a more in-depth explanation try their Banking 101 video course. (Positive Money is UK based so their figures reflect UK statistics, but the basic principles are the same as in the U.S.)
1U.S. Federal Reserve Notes are essentially issued as IOUs from the Federal Reserve (see https://en.wikipedia.org/wiki/Federal_Reserve_Note for more information). The only money issued without corresponding debt is coins.
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