The Importance of Credit Creation: How Banks Create Money

Money is one of those objects caught up in an existential duality. We create money, we give value to money, and money only has value because humans believe it to have value. If tomorrow everyone forgot what money was, then money would no longer have any value.

On the other hand, money seems to have a real existence apart from our thoughts and beliefs. After all, the stock market keeps ticking and the economy changes regardless of what people believe on the matter. Traditional orthodox economics teaches that money is created in the form of credit and debt held by banks.

In some sense, the phrase “banks create money” is inaccurate.

It implies that banks literally conjure money out of thin air. In fact, this misunderstanding of the role that banks play in money creation is responsible for many political movements that seek to end the process of money creation by banks.

To understand exactly what role banks play in the money creation process, we first need to talk about the fundamental question: What is money?

What is Money?

Money is often defined in virtue of its functional role. The term “money” can refer to a measure of value, medium of exchange, payment standard, or a store of value.

Money exists in different forms depending on what role it is supposed to play. In the UK economy, the three major sources of money are fiat money, central bank reserves, and bank liabilities.

The first is often associated with the notes and coins manufactured and regulated by the government. The second refers to reserves held by commercial banks at the Bank of England. Only the Bank of England or the government can create the first two kinds of money.

For much of history, people believed in the “metallist” theory of money; the idea that money gained its value in virtue of the purchasing power of the commodity on which it is based.

According to this theory, money gained its value in virtue of it “standing for” some other good, most often precious metals like gold and silver. Nowadays, most economists take a “fiat” view of money; the idea that money has no intrinsic value other than that agreed upon by participants in the economy.

Perhaps surprisingly, there really isn’t any universal consensus among economists on how money is actually created in a fiat economy. The two most popular theories that attempt to answer this question are the fractional reserve theory and the credit theory of money creation.

How Money is Created: Fractional Reserve Theory

Obviously, most money is not created by the government treasury printing notes and coins. Doing so would just increase inflation and lower the value of each piece of currency. In fact, only about 3% of the total value in the economy is in the form of physical notes and coins. In the modern economy, most money is created in the form of bank deposits.

According to the dominant economic orthodoxy, banks create money in the form of bank deposits by making new loans. When banks extend loans to customers, they create money in the form of credit allocated to customers’ accounts.

Creating Money Through Loans

1. When a person puts money in their account, it is called a “deposit.” Banks issue out loans using the funds from their customer’s bank accounts.
2. When banks issue out loans, they credit the borrower’s account with the amount and create new money in doing so.
3. When the loan is taken out, the borrower can take the loan in cash or (more commonly) deposit it back into a bank account.
4. This redeposited money can then be used to give out more loans, which creates more money in the economy.

In other words, according to the orthodox theory, money can be seen as a form of customer deposits that are held by the bank and extended to borrowers as credit on their account.

The trick is that banks are allowed to loan out much more money than what they hold as deposited reserves.

For example, under Basel III, banks in the UK must hold at least 8% of loaned money in the form of deposits in accounts. These capital adequacy requirements keep the bank from loaning out the same dollar an infinite amount of times.

Read More: Do Multiple Credit Cards Damage Your Credit Score?

Credit Creation: In Practice

Let’s put some numbers to this story to flesh out the idea a little more. Say that Bank A has £10 million in deposits.

1. At this point, this money is solely deposited; it is not being used to make loans so no interest is paid on these deposits either.
2. Next, assume that the bank loans out £9 million to Bob.
3. The bank records this loan as an entry on their balance sheets and it is called an asset as it will generate interest income.
4. The bank then issues Bob a cashiers check for £9 million, which he then deposits that check into an account at Bank B.

The deposits at Bank B increase by £9 million along with its reserves. Since Bank B only has to have 10% in reserve of what they loan out, they keep £90,000 and loan out the other £8.1 million. So in these two transactions, the total amount of money has gone from £10 million to £19 million.

The ratio of the total money added to the money supply to the total money originally added is called the money multiplier.

The money multiplier can be thought of as the constant m in the expressions M1= MB ✕ m, where M1 is the new monetary supply and MB is the monetary base.

In our hypothetical example, MB stands for the original amount of money in the system (£10 million) and M1 stands for the total amount gained (£19 million) so our money multiplier values would be m = 1.9; nearly double the initial amount.  

Fractional Reserve Banking

This money creation theory is sometimes referred to as “fractional-reserve banking” and is the dominant theory among economists regarding money creation in a fiat economy.

Fractional-reserve theory holds that money is created when banks issue loans to borrowers. Of integral importance to this system is the role that central banks play in the creation of money.

The Bank of England plays the crucial role of providing credit to its customers.  

Fractional reserve systems let banks act as financial intermediaries between borrowers and savers, which gives them a lot of control over the money system.

This system of fractional reserve banking is only made possible because there are multiple banks in the financial system. Since banks are only required by law to hold a small fraction of their total reserves, loans end up as deposits in other banks which increases the total money supply.

So no individual bank can create money, only a network of them can. The idea is that the central bank can control the money supply dependant on whether the money multiplier is limited by the required reserve ratio.

How Money Is Created: Credit Theory

The fractional reserve theory has come under increased scrutiny after the 2007-2008 financial crisis as many economists observed that bank reserves were not actually a limiting factor in how many loans the bank issues out.

In fact, many economists argue that the amount of money in circulation is limited only by loan demand, not reserve requirements.

The credit-theory of money creation holds that money is created whenever a bank issues a loan to borrowers.

When a customer borrows £5,000, they debit the loan account with £5,000 and credit the deposit account with £5,000 that can be used immediately.

When the bank credits the customer’s deposit account with £5,000, that money is then created. The new £5,000 in circulation did not exist prior to that transaction.

In this sense, the bank is not lending out deposits provided to them but creating deposits as a result of lending.

As a consequence, the amount of money that banks can lend out is not limited by the number of monetary reserves they hold. As another consequence, the credit theory of money creation implies that when you pay off debts, you are actually destroying money as a side-effect of reducing bank loans.

So, contrary to the fractional reserve theory, which holds that systems of banks can only create money through a process of borrowing and lending, the credit theory holds that individual banks literally create money when they issue out loans.

This money is held primarily in the form of debt. Another consequence of this theory is that a bank’s confidence that a loan will be repaid is an important factor determining the creation of credit money.

In other words, banks’ perception of credit default risk directly influences the amount of bank lending, which directly affects the amount of money in the economy.

Credit theory differs from fractional reserve theory in the importance it places on the role that individual banks play in the money creation process. Banks do not act as a financial intermediary between savers and borrowers, they literally create money from nothing when they issue loans.

That is one reason that credit theory advocates tend to press the importance of including bank activity in macroeconomic models.

Why is Money Creation Important?

Readers may be wondering why money creation is important. Money is money, so why does it matter how it is created if it behaves all the same?

In short, appropriate policy needs to be crafted around a theory of money creation that matches up with the reality of our economic institutions.

One of the major criticisms of fractional reserve theory is that it does not account for the role that banks play in the creation of money.

Advocates of the credit creation theory tend to believe that failing to recognize how individual banks create money ultimately blinds us and prevent us from passing legislation that is conducive to a healthy economy.

They also argue that capital adequacy requirements do not do much to control the amount of money in circulation.

Although the fractional-reserve theory has long been the dominant theory in the economic orthodoxy, the credit theory of money creation is gaining wider acceptance, driven largely in part by the inadequacies of the fractional reserve theory to explain the behaviour of the economy during the 2007-2008 recession.

For many, the credit creation theory sounds strange as it seems to imply that banks can create money out of nothing by simply making a mark on their ledgers.

Economist J.K. Galbraith once suggested that the reason people are hesitant to accept the credit theory of money creation is that:

“the process by which banks create money is so simple that the mind is repelled when something so important is involved, a deeper mystery seems only decent.”

Credit Creation: Final Thoughts

In summary, money creation theories are important because they tell us where we need to focus our efforts to make smart monetary policy.

If money is created according to the fractional reserve system, then laws meant to stabilize the economy need to be focused on that crucial juncture of the money creation process.

Likewise, if the credit theory is true, then it means that whenever money is created, an accompanying amount of debt is created as well.

That means financial policy should be set up to step in a fix things when the debt burden becomes too high.

Of course, it is entirely possible that both theories are true, or at least true in different domains and scope.

Fractional reserve theory may be the correct theory to explain how money is created in a system of banks borrowing and lending, and the credit theory may be true in cases of individual banks creating money.

Even a banking system such as the UK’s that is largely based upon the fractional reserve theory of money creation recognizes the validity of the credit theory in some instances.