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
They don’t create new *dollars*. They create new *value*.
I as a homeowner see a bunch of dirt that could be a home. The home will have more value than the dirt and materials that go into it, because labor has value. But I can’t afford to build a home.
The bank has dollars that some other person, a person with savings, doesn’t know how to put to work. The person has entrusted that money to the bank to find work for it to do. So it gives those dollars to me to do work – to build that home. I need $200,000 to build a home that I will value at more than $200,000. I agree to pay the bank some of that excess value in the form of interest which it then shares back to the person who provided their savings.
Those extra dollars come from the federal reserve. They see that the aggregate value of the economy has gotten bigger (because my dirt is now a home) and backfill new dollars to match that new value, so that the new value can be exchanged. If I sell my now $300,000 home, we need an extra $100,000 sloshing around somewhere above the original $200,000 (dollars that the federal reserve created ages ago).
How does that extra $100,000 make it into the economy? The feds lend it to the banks. That’s what the federal reserve rate is, upon which almost all other interest rates are based. It’s the cost of acquiring new dollars, and the banks pay it because the 3.5% they pay the Fed are lower than the amount of work they can do with those dollars.
So the bank doesn’t create dollars, but they create the need for dollars by funding new value to the economy, generally in the form of labor. They’re just a matchmaker and a mechanism for doing this efficiently. But all of us do this. We pay for college because it has value to us. We ask professors to teach us, which is labor and new value being created. Knowledge or skills in this case, but it’s still a thing of value to a future employer. That value can be a house, a factory, some intellectual property – a patent, a design – or some goods. I assess the iPhone I bought as having more value to me than the components and labor that Apple needed to make the phone. I just don’t have the means to make it myself. So that’s both a transfer of dollars from me to Apple, but those profits are also a form of demand for new dollars to be created. I am willing to turn the compensation for my labor into new value through the purchase of the phone. In a sequence of value transferral, that works its way back to some bank who will pay the fed to print more dollars.
Banks are allowed to loan out more money than they have. It’s called a “fractional reserve”; and means that, for every $100 they have in deposits, they only need to keep some fraction of that as a reserve against deposits.
Let’s assume that’s 50%. So you deposit $100 in a bank. They have to keep $50, but they loan out the other $50 to someone, who then deposits that money in their account; so the bank has $100 in cash and $150 in deposits – which means they’re safe to loan out $25. They loan that $25 to another person, who deposits it into their account. They keep doing this until the $100 they have represents $200 in bank accounts (and $100 owed to them).
When that’s done, that bank has turned your $100 in cash into $200 in money – effectively creating $100. The smaller the fractional reserve is, the more money gets made per $100 of deposits.
And it’s *technically* not the banks doing it. Because the fractional reserve is set by the Federal Reserve in the US, that’s who is technically creating the money. But that’s just a technicality.
Usually the only entity that can print new money are central banks. The take into account a lot of things to estimate how much physical money should move in the country. Money in banks, jobs,imports, exports, etc etc.
The more money is printed value decreases and less money in circulation raises value.
It is simpler than that even – Money is in fact debt, they are one and the same. The dollar is [Endogenous money](https://en.wikipedia.org/wiki/Endogenous_money).
A guy at the federal reserve types some numbers on a screen and presses “enter”, and that adds more money to the “M1” money supply.
Banks borrow money from the fed at roughly 4% right now, and loan it out for people to buy houses at roughly 6% (or car loans at 8%-16%, whatever they can get away with). That 2% is part of their profit.
In order to borrow twenty million dollars from the fed (as an example), they have to have maybe two million in their bank. That’s why they want to provide checking accounts and savings accounts. You don’t have to ask why they want credit card accounts, many of the interest rates are 16%-19%…
Its a game for the patient. If you borrow $200K to buy a house, you will end up paying back around $600K over 30 years. The 6% interest doesn’t sound like much, but…it adds up…
The money exists because banks say it does. At the moment you draw against the money the bank says you have, if you can use that money to satisfy a (any) debt, then the bank retains its reputation.
A loan is simply an agreement to repay money the bank ‘made available’ to you. Where that money comes from, or even whether it exists or not, is the bank’s business, (ideally) subject to law. In the meatime, the bank holds title to whatever collateral is specified in the loan agreement.
Yeah. Banks make bank.
The fractional reserve banking system! Very simple example – you’re the only bank in town and you have $100 in cash ($100 in equity funding $100 in cash assets i.e. “money today”). You lend that cash to a small business. You still have $100 in equity now funding $100 in loans (“money tomorrow”). The small business then takes that cash and deposits it back to you. You now have $200 in assets – $100 in cash and a $100 loan – offset by $100 in liabilities and $100 in equity. But now TWO people in town have $100 – you and the person you loaned to. So you’ve just created $100!
The illusion that enables this is pretending that the $100 in deposits are both your money and the small business’s money. To the small business, it’s as good as cash, but practically speaking that’s not true. It’s only cash once the small business withdraws it. It’s like saying you and your cousin both have a car so there’s two cars – but in reality you just borrow the car when your cousin isn’t using it. This illusion is called “maturity transformation” – the bank transforming “money today” into “money tomorrow” but pretending its all the same.
This cycle could in theory continue infinitely. You could lend out the cash, they deposit it, you lend it back out, etc. etc. until there’s infinite money – everyone in town has a $100 loan from the bank that they then deposited back. HOWEVER, this is very precarious. Going back to the car metaphor, it’s fine to pretend as long as only two people want to use the car and one uses it to commute on weekdays and the other uses it to travel on the weekend. But if there’s 10 people trying to use the car, it becomes very difficult to pretend there’s 10 cars. Inevitably two people are going to want to use it at once, and then the “illusion” comes crashing down. Back in bank-land, this constitutes a “run on the bank” (a la ‘It’s a Wonderful Life’). As soon as people try to withdraw their deposits and can’t, the music stops. People have to reckon with the fact that their only ever was $100. To pay back a depositor, the bank has to “call” a loan – to pay back the loan the borrower needs to withdraw their deposit – etc. etc. until the whole thing unwinds.
Regulatory capital requirements are intended to put a cap on how many times you can do this. Set as they are around 10%, it means banks can effectively do this cycle 10 times (i.e. turn $100 in new cash into $1000 in loans). The assumption there is no more than 10% of people are going to want to be really actively doing something with their cash at any point in time. But in extraordinary circumstances, obviously that can change.
Now this is a very simplified example that doesn’t take into account the concept of credit risk and considers a world with only two of the most basic banking products. But hopefully gives an idea of how the money wheel goes round.
Wait til someone points out that, to the bank, a loan is an asset (the commercial paper) while cash deposits are a liability (owed to the account owner)…
After your brain wraps around that, then I’m sure someone else has pointed out that “dollars” aren’t a “thing” like a gold coin, or an asset like commercial paper, but a “sovereign” promissory note.
TL,DR: a system designed to keep you turning that crank, in exchange for green pieces of paper, needs more paper because, more people. Therefore – quick, look over there, not here – hey, whaddya know, more paper here.
I’m going to make it way simpler than others here.
Banks create new money by double-counting the existing money. It’s basically a cheap magic trick.
You deposit money to a bank, and they loan it out, but they don’t reduce your balance when they create a loan. So the bank reports your money as separate money from what they loaned out, double-counting the same money. It’s just like a magician who gives the illusion of having two cards, when he’s really just passing one card back and forth between his hands when you aren’t looking.
But the economy falls victim to the illusion and reports that the money supply has increased.
This is really very simple. When a bank lends you money, it literally takes your bank account balance and increases it. You had $1,000 in the bank, and then the bank lent you $50,000? Now you have $51,000 in your bank account.
Where did that money come from? No where. The bank didn’t haul out currency, count out $50,000 of it, and then put in in a drawer with your name on it or something. The bank literally just increased your bank balance by 50 grand and now there’s 50 thousand more dollars in the world than there was before.
They do this, and count your loan as an asset on their end, because you’re going to pay them back with interest.
This is all explained in the further reading in the link OP posted: [https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-in-the-modern-economy-an-introduction.pdf?la=en&hash=E43CDFDBB5A23D672F4D09B13DF135E6715EEDAC](https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-in-the-modern-economy-an-introduction.pdf?la=en&hash=E43CDFDBB5A23D672F4D09B13DF135E6715EEDAC)
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