What Everyone Should Know About Money

Excerpt: The article contains essential information about money to provide a proper context to references in the novel to money creation and banks' handling of money.

Introduction

In different parts of the book, there are references to money creation and issues relating to privileges of how banks may handle money, which is not surprising as the novel is about banking. I, therefore, thought that it may be of interest for some to read about money, especially since, surprising as this may sound, very few people really understand monetary cycles, even though the lives of all of us revolve around money, whether we like it or not.

False Assumptions About Money Creation

A UK documentary reported that they asked random pedestrians in London first the question: “Who creates the money supply?” to which an overwhelming majority responded “The government”. Then they asked: “Would you be in favor of a system where commercial banks create the money supply for private profit” (which is the system we have) to which the overwhelming majority responded “No!” (with some adding: “Are you crazy?!”) But more worrisome than that, a recent survey amongst MPs of the House of Commons revealed that only 15% of them are aware of how most money is created in the modern economy. A survey in the United States revealed that only 3% of the population knows that the majority of the money supply is created by commercial banks. Elsewhere, the numbers are even lower.

Governments do indeed create a small percentage of the money supply: by printing paper money or coins (physical currency), which accounts for less than 3% of the money supply in Western countries (the rest being electronic currency), and by issuing bonds (IOUs or long term interest bearing debt instruments) that they sell to their central banks, other countries’ central banks, commercial banks, and large investors. However, in normal times, meaning outside of crises when banks need to be bailed out (as in 2008) or when there are global financial emergencies (for example in 2020 due to the pandemic), this amount is not more than 10% to 12% of the total money supply. 85% or more of the money supply is made up of so-called demand deposits, which is another term for money created by commercial banks.

How Commercial Banks Create Money

Prof. Richard Werner of the University of Winchester conducted a study titled Can banks individually create money out of nothing? — The theories and the empirical evidence in 2014, the results of which were published in the peer-reviewed journal International Review of Financial Analysis. This study, which was based on monitoring a cooperating bank’s internal records, established for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, ‘out of thin air’.

Prof. Werner explained the money creation process as follows: “It is basically an accounting trick… Banks create money. They don’t lend it… When a bank gives out what is called a loan, it basically pretends that you have deposited the money… it has to invent the liability… This is how the money supply is created.” Indeed, when a bank makes a new loan, it creates a new asset on its balance sheet and credits the borrower’s account with new funds which creates a new deposit. Every time the bank makes a new loan it creates new money. This is an inherent aspect of what is known as fractional reserve banking.

Paul Tucker, a former Deputy Governor of the Bank of England explained the process as follows: “Subject only but crucially to confidence in their soundness, banks extend credit by simply increasing the borrowing customer’s current account. That is, banks extend credit by creating money.” The reason the term ‘fractional reserve banking’ is used is because when people deposit money in banks, the banks are required to keep only a fraction of that money (reserves) and can lend out the rest. The recipients of these loans can then deposit the borrowed money in their own bank accounts, and so on, creating a progression. This process of banks lending and re-lending money creates a multiplier effect, where the initial deposit results in a much larger increase in the money supply.

Banker opening credit as imagined by Midjourney AI

Banks’ total lending capacity is restricted by their capital adequacy ratios and, in nations where mandatory reserve ratios are in place, by these as well. Reserve requirements oblige commercial banks to keep a minimum, predetermined, percentage of their deposits at an account at the central bank. Many countries in the world, including the United States, Australia, Canada, and New Zealand, do not impose minimum reserve requirements on banks. Comparing the monetary expansion in those with European countries has led to the observation that bank reserves are not a limiting factor. A lot of bankers and economists now think that the demand for loans — rather than reserve requirements — are the sole factors limiting the amount of money in circulation.

Lombard Banking and the Fractional Reserve System

You might be wondering how this system came to be established. After all, as I wrote above, it comes as a shock to most people that “commercial banks create the money supply for private profit.” In the novel, the Grand Master explains the historical development of the fractional reserve banking system through the way pawn shops operated in Lombardy during the Middle Ages. This system was later implemented in England in the 17^th century, where goldsmiths provided secure storage for people’s gold and valuables. Individuals would receive a receipt for their deposits. These receipts became a form of early banknotes because they could be transferred to others as a claim to the deposited gold.

Over time, as had happened exactly the same way centuries earlier in Northern Italy, goldsmiths noticed that not all depositors came to withdraw their gold at the same time. This led to the realization that only a fraction of the total deposits needed to be kept in reserve to meet the normal demands for withdrawals. Building on this insight, goldsmiths started issuing more receipts (banknotes) than the actual amount of gold they held in reserve. The confidence in these banknotes was based on the assumption that not everyone would show up to withdraw their deposits simultaneously. In the 18^th century, the practice of issuing more notes than the actual reserves evolved into the system of fractional reserve banking which allowed banks to expand their lending capacity as banking became more sophisticated.

The establishment of central banks, like the Bank of England in 1694, played a crucial role in institutionalizing the fractional reserve system. Central banks were supposed to provide a backstop, helping to maintain confidence in the banking system to prevent widespread bank runs. Reserve requirements, interest rate policies, and other tools were to be used by central banks to manage the money supply and control inflation. However, the experience in almost all countries with central banks has been that their policies have led to cyclical booms and busts – which many economists are now realizing are programmed into the system. The recent high inflationary phase, following the monetary easing after the 2008 crisis, is the latest testament to this cyclical nature of monetary (mis)management.

Monetary and Price Inflation

Monetary inflation refers to an increase in the money supply within an economy. This can happen through various means as explained above, including the central bank printing more money or buying government securities, or commercial banks creating more money through lending. Price inflation, on the other hand, refers to the general increase in the prices of goods and services in an economy over time. Each unit of currency may purchase fewer products and services as prices rise.

Money tree as imagined by Midjourney AI An increase in the money supply can boost consumer spending and aggregate demand. If the supply of goods and services doesn’t keep pace with the increased demand, prices tend to rise. This is known as demand-pull inflation. In other words, more money chases the same amount of goods increasing prices. An expansion of the money supply can also affect production costs. For example, if the cost of raw materials or labor increases due to higher demand fueled by monetary inflation, producers may pass these higher costs on to consumers in the form of higher prices. This is cost-push inflation.

But price inflation also has a psycho-sociological basis. If people expect prices to rise in the future, they may be more willing to spend and less inclined to save. If interest rates are low, borrowing becomes cheaper, encouraging spending and investment, thus increasing the money supply and monetary inflation. A higher money supply can lead to a depreciation of the currency. If the value of the currency decreases, the prices of imported goods may rise, contributing further to price inflation. As a cumulative effect of these mechanisms, expansion of the money supply will increase price levels and thereby decrease the purchasing power of money.

Functions of Money

Money is, first of all, a medium of exchange that a large enough community, such as people in a country, accept as such. We can say that this is so today because it is legally sanctioned. You can sell goods or services, get money for it, and then use that money to buy whatever goods or services you want from others or make whatever payments you have to make. By working, we exchange our time for money; i.e. the intrinsic value behind money is our time and freedom.

Second, money makes it possible to put a price tag on goods and services, so the value of each is quantified. How the price is determined is another matter. Thus, money defines a unit of economic value, much like yards or meters define a unit of length. Only when there is a unit and a quantity is it possible to compare things with one another. However, we should not mix up this economic value, meaning the relative measure of the value of one good to another at some instant in the market with an intrinsic value, which is a subjective term.

These two functions actually apply to what we call currency, which is a medium of exchange and a measure of instantaneous value. But currency lacks the third function of money, namely that it must be useable as a store of purchasing power over a period of time and used to finance future payments. For example, eggs can be used as currency in a barter-based economic system: a baker might sell a loaf of bread for two eggs, thereby using eggs as a measure of value, and decide to buy a square yard of cloth that is worth six eggs after he has sold three loaves of bread, thereby using eggs as a medium of exchange. But not only do eggs spoil and rot after a few days but a chicken farmer might literally print money to enrich himself parasitically, thereby affecting the price of bread and cloth in terms of eggs. Therefore, eggs may be used as currency but are not money.

Gold coins and bullion as ideal money

Thus, to be regarded as money, a currency must preserve its purchasing power over a long period of time. That is why precious metals like gold have played such an important role as money in history: Because of its intrinsic properties, gold has always been freely accepted as a medium of exchange. Its purity and weight can be easily measured and checked. It is lightweight and takes little space. It is tough, strong, sturdy, and resistant to nearly all environmental influences. It is divisible and fungible. Pure gold is same in my pocket as it is in yours. But more than that, because of its limited availability and complicated mining, its value has remained nearly constant for thousands of years, thereby making it an ideal store of purchasing power.

Money Ethics

In contrast to gold, the US dollar has lost 97% of its purchasing power since the Federal Reserve was established in 1913. $1 in 1913 was equivalent in purchasing power to about $31.08 today, an increase of $30.08 over 110 years. Thus, the dollar had an average inflation rate of 3.17% per year between 1913 and today, producing a cumulative price increase of 3,007.79%. But why does that matter? Why is inflation detrimental?

It is because it continually transfers assets from the working class to those who control the capital. It is a wealth transfer mechanism that benefits the financial sector in the first place, those to whom they lend money in the second, and governments in the third. With the above explanations it should be trivial to understand this: Whoever can access the newly created money supply before it leads to price inflation gets a boost in purchasing power.

But the widening wealth gap and income inequality (indeed, as an example, in the United States, the top 1% now earn 50 times more than the average; for the top 0.1% that is 220 times more!) are only a few of the consequences of the current system of money being created by commercial banks. That role puts them in the position of being able to decide who gets the freshly printed – or should we say typed – money. In a truly democratic country, it should be the people who decide which direction the economy takes: Whether to support developments in green energy or boost prices of housing thus creating bubbles should not be up to commercial banks.

One final point should be made about the international implications of the inflationary nature of the US dollar – applicable to some extent also to other currencies like the Euro. Because the US dollar is the world’s number one reserve currency due to historical developments – for example, because oil is transacted in dollars only, thus the term petrodollar – nearly half of all assets denominated in US dollars are held by foreign entities, which amounts to roughly $40 trillion as of 2023. An annual inflation on the US dollar of 3.17% during the last 110 years means, due to the money being created in the United States, that there was an unrequited flow of wealth from the rest of the world to the US in the amount of 1.27 trillion (2023) dollars every year. Without this ‘tax’ on the rest of the world, the standard of living of US citizens would be substantially lower than it is today.