‘’Money, Money, Money, its funny…’’– so said ABBA..
Let me ask you, do you ever wonder how money is created?
We carry it around in our pockets. We use it everyday. We are always trying to get more of it. We worry we wont have enough of it in the future. But do we ever really spend much time understanding how money is created?
Well ladies and gentlemen tonight I am going to talk to you about how money is created so that when you go home you will be able to explain to your family and friends exactly how money is created.
[What is Money] But before I do that let me first let me clarify what I mean by money.
When I say money I mean paper money, more correctly called a Fiat Currency, which derives its value from government regulation or law – such a USD, euros etc. Paper money has no practical value, it is merely a medium of exchange – you get paid paper money for your work, which enables you to buy food, clothes etc. It differs from commodity money, which is based on a good, often a precious metal such as gold or silver, which has uses other than as a medium of exchange. Interestingly only about 10% of paper money actually exists as notes and coins, the rest exists in digital form in financial institutions records.
[How money is created]
So now let me tell you how paper money is created – this is the saucy part. Imagine you want to buy the car of your dreams.
You go your friendly bank manager and ask for 100,000D. Because you earn a good salary, the bank manager decides to approve the loan. 100,000D is transferred into your bank account allowing you to buy your dream car. But where did the bank get the 100K to give you?
Now most people assume that the bank lends to you from the deposits it holds from other customers. But that is incorrect. Banks do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. The answer is they created it out of thin air. The money never existed until you signed the loan agreement. The money is created because you agreed to take on the debt. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers’ transaction accounts. The money doesn’t come out of their existing assets, the bank is simply inventing it, putting up nothing of it’s own, except for a theoretical liability on paper. This raises an interesting contradiction. Money is created from debt. In order to create new money, new debt needs to be created. When I found this out I was shocked. Other companies have to design, build and sell a real physical product, or find and extract resources out of the ground to create money, commercial banks simply credit it in the loan books. AND they charge you interest on the money they never owned!! Wouldn’t it be great if we could all just get commercial bank licenses and charge interest for money we created out of thin air.
[First National Bank of Montgomery v. Jerome Daly- 1968, Minnesota]
Let me tell you and interesting story.
The bank had foreclosed on Daly’s property for non-payment of the mortgage, and was seeking to evict him from the property. Daly based his defense on the argument that the bank had not actually loaned him any money but had simply created credit on its books. Consideration is the legal term to describe real ,legitimate property that is supposed to be put up as collateral by “both” parties in a Mortgage contract. Daly argued that the bank had thus not given him anything of value and was not entitled to the property that secured the loan. The jury and the judge agreed with this argument. The judge sdeclared that the mortgage was “null and void” and that the bank was not entitled to possession of the property.[ The immediate effect of the decision was that Daly did not have to repay the mortgage or relinquish the property
[Another interesting aspect of Money creation process]
Let me inform you about another very interesting aspect of the money creation process. Commercial banks are licensed by the government regulators to lend, to create money and to increase the money supply in the economy. Most banks operate under the fractional reserve system. Under this system they can lend out up to 90% of the value of the customer deposits they hold (their reserves), keeping the remaining 10%. So when you get 100,000d loan advanced into your bank account from your bank, your bank is able to lend out up to 90% of that 100,000d. That 90,000 is loaned to your friend, who receives 90,000 in his bank account, allowing the bank to lend out 81,000d and on it goes. An initial loan of 100,000, results in cumulative new money creation of up to 9 times the original amount, a total of 900,000.
Abba were right, money is funny and the ways it created is even funnier. Incredibly money can just magic’d into existence at the stroke of a bankers pen. So when you go home tonight, you can explain to your family how money is created. I wonder if they will believe you.