The Mysterious Creation Of Money

As politicians consider changes to Dodd-Frank, do they understand the most basic functions of a bank in the economy – the creation of money?



This is the second in a series on how banking works. You can read the first on capital adequacy as the basis for bank stability here.

In 2008, we saw that banks in all major countries had the potential to fail, bring down our entire economic system, and eliminate confidence in the nation’s currencies. The U.S. was no exception. Back to barter was a little extreme—but not beyond possibility. The Government felt extorted into helping banks. Regulators began the search for the Goldilocks rule that would stop banks from being too big to bully us into bailouts.

In 1988 the central bankers, of mainly the G-20 countries, had anticipated the need for a global standard for bank stability resulting in the first of the Basel Accords. I explained Basel I in my first article in this series. The bankers founded their prescription for better bank health on a concept called “capital adequacy”. Geeks who want a more in-depth exposition can read this by economist Stephen Matteo Miller on the Fin Reg Rag.

To simplify, capital adequacy meant the bank had to have sufficient reserves of capital to meet all of its obligations as they came due—if loans to customers were not repaid as expected. But here’s the kicker, banks have the usual operational expenses of an ordinary business: employee wages, taxes and such. However, they also have a unique obligation because they are the frontline creators of money in any economy. So let’s first look at the role commercial banks play in this near alchemical process of bringing money into being.

Money Out Of Nothing

In 1975 in his insightful book, Money Whence it Came — Where it Went, John Kenneth Galbraith warned:

The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it.

Thirty-eight years later (2013), the former head of the British financial regulator, Lord Adair Turner observed that the general understanding of money creation was still based on the myth that banks make their profit by paying a low rate of interest on deposits and lending that money out at a higher rate. Not so, he said, but rather:

“Banks do not, as too many textbooks still suggest, take deposits of existing money from savers and lend it out to borrowers: they create credit and money ex nihilo — extending a loan to the borrower and simultaneously crediting the borrower’s money account.”

Let’s take a look at the origins of this unique business of banking.

There are several versions of how banking was discovered. Some mainstream financial historians credit it to jewelers, then-called goldsmiths. They downplay the role of the alternative possibility, the more curious and colorful Knights Templar, the mysterious group so popular in B movies and video games.

No historian telling their account today was there, so I will tell the version that uses the Knights to demonstrate how modern money may have been invented.

It is undisputed that the Knights made loans by issuing paper notes instead of gold, conceived of early forms of letters of credit and travelers’ checks, and were the first international bankers, establishing 800 castles that served as bank branches.

Our valiant warriors recognized that peace was more profitable than war. They quickly made a treaty with the legendary Saladin, opening the way for branches throughout Europe and the Middle East.

The Knights had discovered something about money. It was not using paper to represent money. That was far from the genius of banking. The Knights had devised a way to make money out of nothing (only a slight exaggeration).

In those far-off days, there were no police. There were lots of wars, lots of desperate wandering mercenaries and wealthy people with lots of/piles of gold in their homes. Home invasions were inevitable. A vault was no security against a knife at the owner’s throat, but no mercenary would dare attack the elite fighting force of the era. The 1% of the day asked the Templars to store their gold and got a receipt.

The local Knight commander’s receipt might say something like this:

“Received from Guy Duchenne, Merchant, of Paris, one (1) bar of gold. Dated at Paris this 13th day of October in the year of our Lord 1307.

Jacques DeMolay, Grand Master, Paris Encampment”

An observant Templar noticed something peculiar — the wealthy rarely wanted their gold. They preferred to exchange the paper receipts signed by a Templar grand master with each other. Even better, a Paris merchant could travel to Damascus. If in need of a new camel costing one bar of gold, he could go to the Templar encampment in Damascus, present the receipt, and get a bar of gold to give to Sayid the camel seller.

However, Sayid also preferred the paper note. So the merchant wrote, “Pay to Sayid of Damascus” on the back and got his camel.

Nobody wanted the real thing.

Our medieval financial genius may have reasoned: If nobody wants to lug the heavy bars around, how does anyone know there is enough gold in our vault to honor the demands? They trust the paper.

Thus, our intrepid Templar watched. Depositors only ever asked to withdraw 10% of the vault contents. In the greatest “aha” moment in financial history, he understood that the Knights could issue receipts as loans for 10 times more gold than they had and get paid back in real gold — or goods and services.

The Templars transformed from warriors and warehousemen to bankers, creating money out of nothing.

The medieval mastermind saw that it was a confidence game. The key was to always have enough metal on hand, go into the vault and instantly hand over whatever was required.

There is a side lesson in politics here: Be careful who you deal with. The Knights Templar became too successful. They lent large sums to powerful people. Kings and popes felt threatened by the Knights’ success in finance and the mega debt owed to them. Finally, Philip of France and Pope Clement V conspired, trapped its grandmaster, and had him burned at the stake — a few piles of wood being cheaper than loan repayments. With his last words, Jacques DeMolay summoned Philip and the Pope to a higher court before the year was out. Both died within the year. The day Jacques was burned: Friday the 13th — still considered an inauspicious day to do a deal.

The Gold Standard Goes

The once necessary look for a bank

The once necessary look for a bank

Why gold backing our money? In a famine, you can’t eat it; in a war, you can’t make weapons out of it. You can’t even make a warm blanket of it. However, in the most desperate times, when currency devalues to useless, someone will give you something for it.

Why? You can make jewelry out of it. The value of gold is founded on vanity. What is the more durable basis for money: a human virtue or a human weakness? Obviously, our currency was founded on a reliable human quality.

For hundreds of years, bank notes (an old term) stated, “Will pay to the bearer on demand one dollar in gold.” Bank buildings looked like a meld of fortress and mansion, leaving no doubt as to their strength.

Convertible to gold on demand

Many economic disasters, including the Great Depression, were blamed wholly or in part on restricting a country’s money supply to how many pieces of gold it happened to have. By the 1930s, most countries had abandoned the promise of converting paper currency to gold. People adjusted. They had gotten one bubble gum for one penny during the gold standard days, and they still got one-for-one afterward.

As consumer confidence grew, and customers began to trust banks over their mattresses, bank buildings changed to look like retail stores in shopping plazas. Currency deleted any mention of gold, changing to “legal tender.” There is no promise of anything; it baldly recites an amount. There is no longer a need for more: In banks we trust.

It’s a different story today

Experience confirmed that all our money system needed was a way to maintain confidence. Gold backing was not necessary. Economists introduced a new name for our money under the archaic Latin for “a decree from above ” — a “fiat” currency. As long as customers got a physical dollar when they asked for one, the system survived.

By the way, in the Middle Ages, the financier elite understood that “belief” (from the Latin creditum, hence “credit”) was the essence of a new idea for a better medium of exchange.

Modern Money-Making

Old Mac Donald, who, as we all know, had a farm, decides he wants to expand it. The bank approves his business plan and lends him $100,000 by entering that amount on a ledger. As the good farmer sells his pigs, purchasers pay with checks that he deposits against his loan until it is paid off — a perfect banking transaction involving only notional money: no hard currency.
In more contemporary terms, it could all be done by e-transactions, mere blips on a computer screen.

From our barnyard lesson, we learn that modern money may sometimes be nothing but notations on bank records. Its acceptance is an act of true faith. We can deduce a few further principles:

  • Money is not the cash in our wallets.
  • Money is created by loans.
  • There never was gold backing most of our currency.
  • Private sector retail banks, not governments, generate most of our money supply at first instance.

In the beginning, banks continued this process of creating money by making loans. They followed the Templar practice of keeping a reserve, then of the depositors’ money in cash. If any depositor walked into the bank and demanded money on deposit back, the teller had a stash of depositor cash to hand over. In today’s terms, ATMs must spit out $20 bills without fail. Because banks only had to keep a fraction of hard money on hand, it was called “the fractional reserve system.” No one knows why this 10% quantity works, but it is as close to a natural law in banking as we have.

U.S. banks with more than $122.3 million in transactions are required to keep a 10% reserve against deposits.

So what’s backing the dollar today as you read this? Fragile confidence.

Zombie Banks

Sounds great, this business of banking, doesn’t it? Need money yourself, just create it. The hitch is that money is created by making loans which necessitates lowering lending standards. Recall that the government does not impose lending standards on banks, but trusts them to do their own risk management. So bankers can lend to whoever they want. There is no regulation preventing that.

That brings us back to the idea that there has to be some control on banks creating money. The Basel Committee decided that ‘capital adequacy’ would do the trick. The banks could not make more loans than they had an adequate amount of a certain type of reliable capital to back up that loan if it was not repaid.

But, when the 2008 Crisis hit, the banks were declared, “zombie banks” that could not make loans. Then Treasury Secretary, Hank Paulson, said banks were solvent, and that they could pay their debts as they became due. However, they had to dip into their capital to do so. Thus, they did not have enough left to make loans. Paulson justified giving the bailout money to the banks (capitalizing the banks) so they could continue to make loans and keep the economy going.

Of course, the Fed has a role in controlling the money supply. However, its role is well explained on many sites online. I recommend Investopedia’s blurb. I discuss/mention only the role of capital adequacy here as it is far less understood.

The Fearsome Derivative

We aren’t finished yet. We need to understand the instrument bankers used (and are using) to fool policymakers, regulators, and most economists into believing the banking system was AAA safe until it wasn’t: the derivative — Credit Default Swaps, Structured Instruments, CDOs and the like. Michael Moore did an excellent job in showing how even experts in the financial system, including prominent Harvard economist Kenneth Rogoff, could not explain what they are. A must see clip is available on YouTube.

They aren’t that hard to understand and I’ll explain them in my next article.

For more on the little-understood laws that continue to allow the transfer of wealth and power follow me on:

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