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
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.
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.
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.
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.
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