How banks create money

Did you know that by keeping your money in the bank, you are contributing to your own inflation?

It doesn’t matter if we are not in the U.S. Our currency is pegged to the dollar and for that reason alone, we are affected by the monetary policies of the United States of America. Moreover the way money is created in the U.S.A., is pretty much the same in other countries worldwide and the U.A.E. as well.

“I am afraid that the ordinary citizen will not like to be told that banks can and do create money …
And they who control the credit of the nation, direct the policy of Governments, and hold in the hollow of their hands the destiny of the people”.

(MCKENNA, Reginald) Past Chairman of the Board, Midlands Bank of England

Let’s imagine that a new bank has just started up and has no depositors yet. Investors have paid for the bank’s infrastructure and have supplied it with sufficient cash to meet the demand for cash withdrawals. Typically, cash in the vault will amount to no more than one dollar for every 20 or 30 dollars that could be demanded from the bank. The bank has joined the central bank system, which permits the new bank to borrow cash from the central bank if it’s needed.

The doors open and the new bank welcomes its first loan customer. The customer needs $10,000 to buy a car. On approval, the bank creates an account for the borrower and types in that the borrower owes the bank $10,000. This $10,000 is not taken from anywhere.

It is created on the spot. The borrower does not take this money out in cash. Instead he writes a check on his account to buy the car. The seller then deposits this newly created $10,000 check at her bank. At a ratio of 9:1, this new $10,000 deposit allows the seller’s bank to create a new loan of $9,000. If a third party then deposits that $9,000 in another bank, it becomes the legal basis for a third issue of bank credit, this time for the amount of $8,100.

Like one of those Russian dolls, each layer of which contains a smaller doll inside, each new deposit contains the potential for a slightly smaller loan in a decreasing series.

Now, at any stage, if the money created is taken in cash and not deposited at a bank, the process stops. That’s the unpredictable part of the money creation mechanism.

But more likely, at every step, the new bank credit money will be deposited at a bank, and the reserve ratio process can repeat itself over and over until almost $100,000 of brand new bank credit money has been created within the banking system.

All of this new money has been created entirely from debt, and all transactions have been carried out with bank credit. None of the banks involved have needed to use any of the cash in their vaults.

“Thus, our national circulating medium is now at the mercy of loan transactions of banks, which lend, not money, but promises to supply money they do not possess.”

(FISHER, Irving, 1922), Economist and Author.

What’s more, under this ingenious system, the books of each bank in the chain must show that the bank has 10% more on deposit than it has out on loan. This gives banks a very real incentive to seek deposits to be able to make loans, supporting the general but misleading impression that loans come out of deposits.

Now, it can’t be said that any one bank got to multiply the initial $10,000 of bank credit into $100,000 of bank credit. However, the banking system is a closed loop. Bank credit created at one bank becomes a deposit in another, and so on and so on.

In a theoretical world of perfectly equal exchanges, the banks would owe each other nothing at the end of the day, and the $10,000 created out of thin air as a loan by the first bank could indeed become almost $100,000 of new loan money in the banking system.

If that sounds ridiculous, try this. Actual reserve ratios can be much higher than 9:1. For some types of accounts, twenty to one and thirty-three to one ratios are common. There are also many exceptions where NO reserve requirements apply at all! So…while the rules are complex the common sense reality is actually quite simple.

Banks can create as much money as we can borrow.

Despite the endlessly presented mint footage, government-created money typically accounts for less than 5% of the money in circulation. Someone signing a pledge of indebtedness to a bank today created more than 95% of all money in existence.
(GRIGNON, Paul, 2002)

What’s more, this bank credit money is being created and destroyed in huge amounts every day, as new loans are made and old ones repaid. Banks can only practice this money system with the active cooperation of government.

  1. First, governments pass legal tender laws to make the use of national fiat currency mandatory.
  2. Secondly, governments allow private bank credit to be paid out in this government currency.
  3. Thirdly, government courts enforce debts as payable in this currency.
  4. And lastly, governments pass regulations to protect the money system’s functionality and credibility with the public while doing nothing to inform the public about where money really comes from.

The Simple Truth

The simple truth is that, when we sign on the dotted line for a so-called loan or mortgage, our signed pledge of payment, backed by the assets we pledge to forfeit should we fail to pay, is the only thing of real value involved in the transaction.

To anyone who believes that the banks will honor their pledge, and that their loan agreement or mortgage is now a portable, exchangeable and saleable piece of paper, needs to think again. It’s an IOU. It represents value and it is therefore a form of money. This money the borrower exchanges for the bank’s so-called loan.

Now a loan in the real world means that the lender must have something to lend. If you need a hammer, my loaning you a promise to provide a hammer I don’t have, won’t be of much help. But in the artificial world of money, a bank is allowed to pass off its promise to pay money it doesn’t have, as money and we accept it as such.

Once the borrower signs the pledge of debt, the bank then balances the transaction by creating, with a few keystrokes on a computer, a matching debt of the bank to the borrower. From the borrower’s point of view this becomes “loan money” in his or her account, and because the government allows this debt of the bank to the borrower to be converted to government fiat currency, everyone has to accept it as money.

Again the basic truth is very simple. Without the document the borrower signed, the banker would have nothing to lend!

Have you ever wondered how everyone…governments, corporations, small businesses, families can all be in debt at the same time and for such astronomical amounts? Have you ever questioned how there can be that much money out there to lend? Now you know. There isn’t.

Banks do not lend money. They simply create it from debt.
Since debt is potentially unlimited, so is the supply of money.

“If all the bank loans were paid, no one could have a bank deposit, and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash, or credit. If the banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless situation is almost incredible — but there it is.”

(HEMPHILL, Robert, 1935), Credit Manager, Federal Reserve Bank, Atlanta.

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About the Author Amit

Amit is an Independent Financial Advisor, based in Dubai since 1997. He is part of the prestigious ‘Million Dollar Round Table’ (MDRT), which is an elite club of the best financial advisors worldwide. He has authored the ‘6-Step Financial Success Guide’, and the book ‘Creating, Preserving, Distributing Wealth’. He helps business owners and professionals ‘Create A Second Income’ through investments.

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