How do banks create money?
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Introduction
Once again we are in the eminency to enter an economic period of recession due to several economic problems, for example, the recent bank crises. But calm down. This article is not intended to be alarming, but to pass a fundamental knowledge that is not taught to us in schools. And, the reason for that, I will leave it for you to wonder.
Certainly, at some point, you have heard how capitalism is the one to blame for everything, that the villains of this story are the capitalists (people who make money with private capital), and that all of this is orchestrated by the huge United States of America. If that is true, it is also not the merit of this text to talk about conspiracy theories. However, once all here have a high probability of having heard that in our lives, have you ever questioned why we are not encouraged to research what is capitalism all about? How does it work? After all, we live under this system!
Recently, already passed on my mid-thirties, I caught myself with those questions. A lot of that was caused by the fact that I want to work in the financial field. Therefore, I wanted to study the system's fundamentals and go deeper into the precepts that rule it. I know that not all have this spirit. However, certain concepts are part of our daily lives and interfere in our pockets so, it would be wise to at least know a thing or two about them.
I started with the most basic question I could do: "Where does the money started?", and, first, I wish to know the origin of this little paper that has value. This simple question led me to a universe of a bunch of others. Some of which I was not even aware that I wanted to know but, happily I found them on the way. This is to show you that questioning is good and makes us elevate our awareness of the things that surround us but, often pass by unnoticed.
With those doubts, I searched for books and begin with "The Ascent of Money" by Niall Ferguson, which has its own special article (click here to read it). And, with that reading, I understood how banks create money.
Historic
Riksbank, a Swedish loan bank, was founded in 1656. And, what they eventually realized changed the direction of the economy. As they received a great number of guarantees to provide loans (that could be in cash, precious metals, etc.) they saw an opportunity to profit even more with those amounts that remained “idlers” in their vaults.
Those values that should stay in the vaults are known as reserves, since it is the bank's guarantee, in case of some customers default, of not having a bigger loss. However, as soon they started to use the reserve to profit, this term changed to fractional reserve. This means that now, only a percentage of the total is going to be reserved indeed, without any possible use. On the other hand, the remaining could be used as capital for new loans and, then, increasing the profits.
That was possible due to the very low probability to occur a massive withdrawal by the clients who own deposits in the bank. And, in part, that is what happened in the Subprime crisis, for example. Roughly speaking, a bank run is when a high amount of people withdraw their money from the bank. When this happened, in 2008, some banks didn't have how to return people's money back because... They have loaned it to other people that did not pay them!
After all, how do banks create money?
Time to put the pieces together and see a practical, and fictional example. The characters of our story are Ana, Bob, and Carol. Besides the banks: Alpha and Beta.
For starting, Ana received 100 dollars as payment for selling her camera. Then, she deposited the money in Alpha Bank.
Alpha Bank separates the money into 2 amounts:
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Bob deposits the borrowed money in an investment at Beta Bank. Now, Beta Bank is the one to receive an amount of money, in this case, US$ 90. This bank can proceed the same way as Alpha Bank, which means: separating part of the money into its reserve and another to offer as loans to their customers.
To make it more educational, let's assume that Beta Bank also operates with an operational coefficient of 10%. Then, 10% of US$90 is equal to US$9, which goes to the bank's reserve. On the other hand, the other 90% of US$90 results in US$81 went to Carol, a client bank that took the money as a loan.
It is easy to realize that we could keep this going indefinitely, until thousandths of cents (if it would be worthful for the banks it is another story). But, let's stop here because it is necessary that, at this point, you answer these two questions:
Take a second. See if the summary of the story in the image below helps, and try, by yourself, to get the results. The answer is just below.
Both of these questions explain two major concepts of monetary theory. But first, let's answer them:
The story begins with Ana receiving US$ 100 due to selling her camera.
This is where things start to get cloudy, and most of us do not even realize it. The correct answer is US$ 271. Yes, more than 2x of what we had at the beginning of our story, and we only passed the money through two banks.
Let's check it closely the money movement:
Sum all these values together and you get the unbelievable amount of 271 dollars!
With that, it is easier to comprehend what happened in several moments of history with bank runs. Thats because, if Ana, who deposited her US$ 100 to leave it there in her bank account, suddenly, wanted to withdraw her money, Alpha Bank would have to, first, take the 10% that they put in the bank's reserve, and two, ask for?Bob to pay for its loan. In his turn, Bob runs to Beta Bank to withdraw his invested money. Now, it is Beta Banks who has to recover 10% of what they had reserved, besides they have to ask Carol to pay for her loan, and there it goes.
Despite the fact that this is a simplified example, increasing it to thousands of customers, in the more than 460 banks that are spread over the world, clearly that the created amount of money is obscene. As well, with a low operational coefficient a bank run, as tiny as it might be, could lead to several unprevented banks collapsing.
Going further
We can now, in a simple way, conceptualize M0 and M1. The first, M0, is also known as the monetary base, and it is the sum of all the physical money circulating (coins, bank reserves held at the central bank, etc.). The M1 is the sum of all the money, which means M0, and goes beyond, also considering the deposited money on banks (the value that we can withdraw, for example).
In 2022, the M0 or, the total sum of physical money (circulating printed currency) in the world was US$ 8 trillion. Meanwhile, in the same year, the M1 was US$ 48.9 trillion, that is, all the physical money (M0), plus those values in bank deposits, banknotes, and checking deposits (source: Visual Capitalist). Observe the math: if in these 48.9 trillion dollars we already consider the 8 trillion dollars from M0, then we have more than 40 trillion created out of nowhere!
Closing
Many people declare themselves anti-capitalists, and many others say that this system is doomed to fail. This is very likely. After all, what still exists in humankind that has been lasting since our beginnings? We are constantly evolving, and, because of that, it is only natural that as we test things, we see problems, then try to make them better. That is why, fortunately, or unfortunately, we are still going to see this financial system for a few decades. Also, this financial system, like everything in life, has its strengths and weaknesses. Learn them and use them in your favor!