I don’t get it. I don’t get it. I don’t get it. I don’t get it.
When a bank makes a $1,000 loan, that creates $1,000 in the recipient’s account, but I don’t get how the loan, the absence of money, is an asset on the lending bank’s books. If it’s because the money will be paid back, then isn’t it’s value based on a corresponding debit of the recipients account thus nullifying the created money?
Edit: I am not asking how banks make a profit. I get that. I am asking how NEW DOLLARS are created. There are more dollars in existence now than there were say 100 years ago. I want to understand how they came to be. The answer I’ve found so far is that NEW DOLLARS are created when a commercial bank makes a loan.
Second Edit: For those saying commercial loans don’t create new dollars, apparently they do, but I don’t get it. For reference:
https://positivemoney.org/how-money-works/proof-that-banks-create-money/
In: 23
Ever heard the phrase, “my word is as good as gold?” Well it applies to commercial money. Deposits are just money banks owe to the public—for any host of reasons, whether that be because someone actually deposited money with the bank or the bank extended a loan. This debt that banks owe to the public is considered so safe and risk-free that it becomes fiduciary media money, people trust it so much that they transact with it, bank deposits, just as much as they transact with the thing it represents, cash. A bank can choose to owe anyone as much as they want and so long as their word is still considered as good as cash, they can thereby extend the money supply.
Think about it this way: back when merchants traded with gold, they could deposit that gold with banks and those banks would give them back receipts promising to pay the merchant back his gold whenever demanded. Merchants quickly adopted these receipts as a new medium of currency—why lug around the gold when you can just carry a receipt that represents it? Well, soon banks realized that they could virtually create new money by issuing new receipts that represented no original deposit—after all, it’s unlikely all merchants go and redeem their gold all at once, so the bank can over extend its receipts.
tldr; anyone can increase the money supply so long as their debt is so safe and widely-accepted that it becomes a form of money.
A big part of your confusion is that there are two definitions of dollars that are created by different mechanisms:
– Definition 1: Dollars are green pieces of paper [1].
– Definition 2: Dollars are green pieces of paper, and notes from a bank that say things like “IOU $ – Bank of Bob.”
*New dollars (Definition 2) can come into existence through fractional reserve banking*. It works like this:
Meet Alice. Alice has $30,000. Her large purse is stuffed to bursting with small green pieces of paper. No matter which definition you use, Alice has $30,000 in the form of her purse full of bills.
Now suppose Alice opens an account at the Bank of Bob and deposits $29,000 of those green pieces of paper. Then Bob loans $20,000 to Cindy Commuter, who uses it to buy a car from Dan’s Dealership.
When the dust settles, let’s see where the money (Definition 1) ends up:
– There’s $1,000 green pieces of paper in Alice’s purse.
– There’s $9,000 green pieces of paper in the vault at Bank of Bob.
– There’s $20,000 green pieces of paper in the cash register at Dan’s Dealership.
No new money (Definition 1) was created.
Now if we count money (Definition 2) a funny thing happens: We get a different answer! That’s because Alice now has a piece of paper in her purse, or on a screen in her mobile banking app, that says “Bank of Bob — Statement of Account — Balance: $29,000.” Translation: “IOU $29,000 – Bank of Bob.”
So the count of money (Definition 2) is like this:
– There’s $1,000 green pieces of paper in Alice’s purse.
– Alice has $29,000 in her bank account.
– There’s $9,000 green pieces of paper in the vault at Bank of Bob.
– There’s $20,000 green pieces of paper in the cash register at Dan’s Dealership.
There’s now $29,000 extra money that didn’t exist before. But most economists exclude the green pieces of paper in Bob’s vault from the count, since it’s not in circulation, so normally this would be counted as $20,000 extra money.
*New dollars (Definition 1) aren’t created by fractional reserve banking. They’re created by a different process*:
When the economics experts, data doctors and math mavens at The Fed decide there’s not enough money in the economy, The Fed prints new green pieces of paper and uses them to buy IOU’s — usually from a different government department (The Treasury) but sometimes from other parts of the financial system (in response to 2008 and 2020, they bought mortgage backed securities and even a few commercial bonds).
[1] And technically also a database at The Fed, but we won’t get into that.
They double count the money that they lend out.
Suppose you deposit $1,000 in a bank. They then decide they want to loan $100 of that money to someone else.
Now that person has $100 of cash (and $100 of debt..) but your bank account still shows $1,000 despite the fact that $100 of your money money is somewhere else.
This only works because you don’t really withdraw all of your money very frequently.
It’s the magic of accounting, wich operates differently from regular money maths.
But it’s important not to confuse magic accounting with the reality of the situation. So technically they did create money, but in reality they didnt.
If you loan your car to a friend, it’s still your car. If your friend starts paying you in installments for your car, it’s still partially your car until he’s paid all the agreed payments. So, you maintain ownership of that asset and slowly replace the vehicle with cash. But essentially, you retain the same level of assets the entire time.
Let’s look at a country with only a single small bank to make it easier to see what’s happening. They have one depositor who deposited $100,000. The total deposits of the nation are $100,000 in deposits. If the next day the bank gets a loan application, they might be ready to make a $90,000 loan to the borrower.
Now the loan is made. What’s the borrower going to do with the money? It’s going to be deposited back in the bank (either by the borrower or when the borrower spends the money buy the guy who owns the business where the borrower spent the money). Now there are deposits of $190,000 in the only bank. No more currency exists, so the bank created the extra $90,000 with their loan.
Now because they have additional deposits. They can make another loan creating more money (the cycle is the same).
Obviously, in a nation with many banks, this pattern will be much harder to follow (the people paid by the borrower might bank in many different banks) but from the perspective of the system it’s almost exactly the same.
I’ll try and eli5 level explanation.
Imagine i have a vault with 100$ in it.
I can lend Jack 50$ for a year. But because ingots and coins are heavy, and can be lost, and stolen, etc. I can just give Jack a piece of paper saying: i (the bank) will give 50$ in coins to Jack, or whoever he paid those 50$.
Chances are, those people will accept the paper and not get the coins within the year. Jack will pay back after a year, and all is fine.
But i can also write 10 such papers, lend 500$ and be fine. (Profit increases tenfold this way) If the people pay me back, I’m good. My only problem occurs if too many cannot pay me back and suddenly i, the bank, owe more than i have.
Last time i checked, banks in Europe needed about 11% of the capital they lend, which means for every 11$ they actually owned, they could lend out 100$. And that’s after-banking-crisis rules…
As for your edit:
Now more money exists because money is bound to some value let’s take gold ingots (which is no longer true, but for eli5..). You did up some gold, smelt ingots, put them in a bank vault, print an according number of paper dollars.
Now you have more money than a year ago, in this world.
Honestly i alway knew that bank was capable of making money like a money tree. Its why we got such inflation to where it gotten as bad as it gets.
There no standard on min or maximum its all relative to population and fools to control. Obviously with current trend higher the population = more money for the elite
Another way to think of it is that dollars are created when you put the dollars in the bank, and it’s our fault.
Say I have a $100 bill. There is $100 total. End of story. Simple.
Now I go to the bank and I put it in my account. Now I have a bank account that says $100 on the screen, and the bank has $100. I don’t have $100 any more, just a bank account that says I do. The bank has all the money, which is $100.
But if I start counting my bank account as actual money, then I’m double-counting. I count the $100 account as $100 and I also count the bank’s $100 bill as $100, which adds up to $200 in total.
Duncan deposits $1000 in his savings account. The bank now has $1000 they can lend to Malcolm. Duncan’s account still says it has $1000 in it. Now there are $2000.
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