How Do Banks Create Money?

Yves here. Richard Murphy has been making short videos that introduce various aspects of MMT. This discussion of how banks create money will be old hat for most readers, but it could help introduce MMT ideas to people in your circle who are not hopelessly resistant. It also introduces double entry bookkeeping as the way to show that MMT holds together. Murphy is on the Mr. Rogers end of the spectrum of economics presenters, which helps.

By Richard Murphy, a chartered accountant and a political economist. He has been described by the Guardian newspaper as an “anti-poverty campaigner and tax expert”. He is Professor of Practice in International Political Economy at City University, London and Director of Tax Research UK. He is a non-executive director of Cambridge Econometrics. He is a member of the Progressive Economy Forum. Originally published at Tax Research UK

Modern monetary theory highlights the important role of the government in creating money when it spends. That process makes sure our money has value. But it’s not alone in creating money: banks can do it too. This video explores the implications of that.

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  1. LowellHighlander

    Following Ellen Brown, J.D.’s lead, I’d like to ask whether Mr. Murphy’s lesson here can be used to argue for establishing publicly owned (not through joint stock, though) State Banks along the lines of North Dakota’s?

    1. Adam Eran

      Already happening, e.g. in California.

      JFYI, Gavin Newsom authorized localities to start their own public banks, and the legislature is exploring turning the existing California Infrastructure Bank into a state bank. Jerry Brown (pocket) vetoed even funding a study of this kind of banking.

    1. bill

      Both link to the same wikipedia page. And author Larry Randall Wray of modern money theory is part of modern monetary theory. So yes i would say they are the same thing. The interesting thing with Larry he is also a student of Minsky and therefore also post-Keynesian.

    2. Grebo

      Wray tends to call it Modern Money Theory because he has a particular interest in the history of money, and he wants to point up the fact that we no longer use commodity money. He also notes that the name is ironic since fiat money long predates the use of commodity money.

      But no, there is no difference beyond this emphasis.

  2. Darius

    If Congress or Parliament creates money by appropriating it, what is the role of the central bank? Does the central bank actually issue the currency? Does the Treasury draw from the Fed? Can’t the Treasury just issue notes to cover what Congress appropriates? Why do we even need the Fed?

    1. Young

      The Fed has dual mandate:

      1. It provides cover for the politicians who failed to make policies to benefit the nation as a whole.

      2. It makes sure that the real power (i.e., the rich) to maintain the power at all costs.

      My condolences for the retired people who depends on fixed income which will die poor because of the Fed’s policy announced today.

      1. Anonymous

        My condolences for the retired people who depends on fixed income which will die poor because of the Fed’s policy announced today.

        So welfare proportional to account balance* is the only possible form of welfare for pensioners? What about increasing Social Security instead? And/or adding an equal Citizen’s Dividend?

        Let’s please not hide injustice behind concerns for pensioners?

        *I.e. positive yields/interest on inherently risk-free sovereign debt constitutes welfare proportional to account balance in said debt.

  3. Adam1

    When Congress / Parliament is sovereign in its currency it creates it by spending it, not by appropriating it. Appropriating it / Taxing it is to remove it or destroy the currency, not creating it. The central bank is basically a subsidiary of the Treasury.

    “Does the central bank actually issue the currency?” – that depends on the legal framework of your country. In the US the FED distributes paper currency and coin but the US Bureau of Engraving & Printing creates paper currency and the US Mint creates coins which get acquired but the FED which is sold/exchanged to banks payable in bank balances held at the FED.

    “Does the Treasury draw from the Fed?” – the Treasury operationally has a checking account at the FED.

    “Can’t the Treasury just issue notes to cover what Congress appropriates?” – Yes and no. There are technically legal barriers to this, however because of the mechanics and accounting they are irrelevant. If Congress spends more than it taxes net new financial assets (money) is created. A US dollar bill or coin is as much a legal liability to the US government as a US Treasury Bond/Bill – all of which are financial assets held by the non-government portions of the US citizenry. For most people it’s smoke and mirrors, but the actual process becomes net new money when deficit spending is done.

    “Why do we even need the Fed?” – the FED is just a government institution which was created to ensure the banking / payment system could remain functional should the private banking system go into a panic. That’s appropriate, but that’s also its limit despite what others wish it could do. As Warren Mosler says, it could be reduced to a department of a few people within the Treasury and be adequate for what it really is for and capable of doing.

    1. Anonymous

      “Why do we even need the Fed?” – the FED is just a government institution which was created to ensure the banking / payment system could remain functional should the private banking system go into a panic. Adam1

      And who says we should have only a SINGLE payment system that MUST work through private banks or not at all? Hmm? Why can’t everyone or at least all citizens have accounts at the Central Bank (or Treasury) itself? So that we’d have an additional but risk-free payment system?

      As Warren Mosler says, it could be reduced to a department of a few people within the Treasury and be adequate for what it really is for and capable of doing. ibid

      Disingenuous since Mosler would require the Central Bank to provide unlimited, unsecured loans at ZERO percent interest to banks and also provide unlimited deposit guarantees for banks FOR FREE.

      So Warren Mosler thinks the Central Bank is qualified to be a lap-dog for private banks? How fascist is that?

  4. Chauncey Gardiner

    Think I understand MMT in the context of M1 and M2 definitions of “money”. But can corporate equities also be considered money in the sense that corporations can issue and use their stock as a medium of exchange to purchase other corporations?

    I’m also trying to understand the systemic role of the Primary Dealers who purchase US Treasury debt, and their role in the gigantic offshore eurodollar market where I believe they lend US dollars into existence. Considering their leverage through foreign exchange markets and derivatives.

    1. OpenThePodBayDoorsHAL

      I’d argue that the “NASDAQ” rocket can no longer be described as “stock market” related. We’re witnessing the FAANG stocks attaining the status of the sovereign currencies of the new kingdom of Cyberlandia.

      And I’d love to see discussion of China versus the US. Seems to me China functionally has a sovereign currency whereas the US does not. In the case of China the sovereign (functionally the PBOC) decrees how much money will be created for the next period. This is handed down in the form of quotas to the regional and then local banks: you WILL lend this much into existence.

      Contrast the US: where private entities are coerced and enabled into creating the nation’s money but at the end of the day if they do not there is nothing the sovereign (or its proxies) can do.

      I’d also add a point Prof Richard Werner makes: that probably the most successful CB in the modern era post-WWII was The Bundesbank. Emphatically *not independent*! Answerable to Parliament and with the long term interests of Labor firmly grasped and included.

    2. eg

      In response to the first question in paragraph one, though corporations issue stocks, they are purchased with money created by banks chartered through and backed by the central bank, so they (the corporations) are not involved directly in the issuance of sovereign currency.

      I don’t know enough about the questions raised in the second paragraph to answer those, and leave them to members of the NC commenteriat who may.

  5. Adam Eran

    FYI, Warren Mosler is not a fan of public banking. … and in fairness, apparently India’s public banks are corrupt.

    1. Anonymous

      Public banks and government-privileged banks are INHERENTLY corrupt since they extend the public’s credit but for private gain.

      But not to despair since inexpensive fiat makes the honest lending of existing fiat ethical and feasible and without high interest rates.

  6. Greg S

    I understand his point that banks can get into trouble when they make bad loans but what happens to society when banks don’t make loans because they fear a significant number have a high potential of going bad? Do the bank’s reserves simply sit at the fed earning them a small but safe amount of interest and never get circulated into the economy as newly made money?

    1. Anonymous

      and never get circulated into the economy as newly made money? Greg S

      Fiat, except for coins and paper Central Bank Notes (physical fiat), CANNOT circulate in the non-bank economy because the non-bank economy may not have fiat accounts at the Central Bank.

      Interestingly, if physical fiat is ever totally abolished, we’ll have the situation where citizens may not even use their Nation’s fiat at all but instead be totally reliant on private bank deposits.

      Then, at least, it’ll be undeniable that we are slaves to a usury cartel.

  7. Jeff W

    “Every single pound you have is, of course, government-created because nobody but the government can create pounds, literally no one.” [0:22]

    “So all our money is made out of thin air. And some of it is made by the government when it spends and puts money into literally its spending…and some is created by banks when they make loans. And that’s the only way which, literally, money enters circulation in this country.” [5:40]

    [emphasis added]

    I think this video would have been much stronger if Murphy had reconciled—or somehow addressed—these two sets of statements. (Is he talking about the actual physical bank note in the first instance? I hadn’t thought that was how he was distinguishing the two.)

    1. Mel

      In the first case he’s talking about reserves, which are the pounds that British private banks keep in their ‘current accounts’ at the Bank of England. These are the ‘real pounds’ that British banks exchange when they settle transactions with each other. The way to get these real pounds in the first place is to borrow them from the Bank of England, or to sell some asset to the Bank of England.
      Of course, once they exist in the banks’ current accounts, they can be transferred from bank to bank via loans or via settlement payments. They’re the financial bedrock, so to speak, that supports all the other business in the national economy.

      You might say that each private bank can create its own pounds, but that no private bank will trust another bank’s pounds. They insist on settling in Bank of England pounds.

    2. Creigh Gordon

      You’re right, this should be clarified.

      As Murphy rightly notes, money is a promise, or perhaps more formally, a promissory note issued by a widely trusted agent, typically a government or a bank.

      Where these two things differ is that the Government promises to accept its money as payment of tax liability. Bank money is a promise to pay in Government funds.

      1. Creigh Gordon

        Murphy alludes to the difference when he observes that the Gov can always keep its promise but banks can’t always keep theirs.

  8. Sound of the Suburbs

    Banks can create money and this is the fundamental flaw in the free market theory of neoclassical economics.

    The University of Chicago worked out the flaw in the free market theory of neoclassical economics in the 1930s.
    Banks can inflate asset prices with the money they create from bank loans.
    Henry Simons and Irving Fisher supported the Chicago Plan to take away the bankers ability to create money.
    “Simons envisioned banks that would have a choice of two types of holdings: long-term bonds and cash. Simultaneously, they would hold increased reserves, up to 100%. Simons saw this as beneficial in that its ultimate consequences would be the prevention of “bank-financed inflation of securities and real estate” through the leveraged creation of secondary forms of money.”

    1. Sound of the Suburbs

      The 1920s roared with debt based consumption and speculation until it all tipped over into the debt deflation of the Great Depression.
      No one realised the problems that were building up in the economy as they used an economics that doesn’t look at private debt, neoclassical economics.

      What’s going on here?
      Policymakers don’t realise it’s the money creation of bank loans that is making the economy boom as they head towards a financial crisis.
      The bank loans are not going into areas that grow the productive capacity of the economy, so debt rises faster than GDP until you get a financial crisis.

      At the end of the 1920s, the US was a ponzi scheme of over-inflated asset prices.
      The use of neoclassical economics and the belief in free markets, made them think that over-inflated asset prices represented real wealth accumulation.
      1929 – Wakey, wakey time

      Why did it cause the US financial system to collapse in 1929?
      Bankers get to create money out of nothing, through bank loans, and get to charge interest on it.
      What could possibly go wrong?
      Bankers do need to ensure the vast majority of that money gets paid back, and this is where they get into serious trouble.
      Banking requires prudent lending.
      If someone can’t repay a loan, they need to repossess that asset and sell it to recoup that money. If they use bank loans to inflate asset prices they get into a world of trouble when those asset prices collapse.
      As the real estate and stock market collapsed the banks became insolvent as their assets didn’t cover their liabilities.
      They could no longer repossess and sell those assets to cover the outstanding loans and they do need to get most of the money they lend out back again to balance their books.
      The banks become insolvent and collapsed, along with the US economy.

      When banks have been lending to inflate asset prices the financial system is in a precarious state and can easily collapse.
      If you don’t want a Great Depression, you had better save those bust banks.

      What was the ponzi scheme of inflated asset prices that collapsed in Japan in 1991?
      Japanese real estate.
      They avoided a Great Depression by saving the banks.
      They killed growth for the next 30 years by leaving the debt in place.
      Debt repayments to banks destroy money, this is the problem.

      What was the ponzi scheme of inflated asset prices that collapsed in 2008?
      “It’s nearly $14 trillion pyramid of super leveraged toxic assets was built on the back of $1.4 trillion of US sub-prime loans, and dispersed throughout the world” All the Presidents Bankers, Nomi Prins.
      They avoided a Great Depression by saving the banks.
      They left Western economies struggling by leaving the debt in place, just like Japan.
      It’s not as bad as Japan as we didn’t let asset prices crash in the West, but it is this problem has made our economies so sluggish since 2008.

      1. Anonymous

        The bank loans are not going into areas that grow the productive capacity of the economy, so debt rises faster than GDP until you get a financial crisis. SoS

        Does automation to dis-employ the population WITHOUT COMPENSATION count as growing “the productive capacity of the economy” or is it a subtle form of looting since currently, due to government privilege, the banks extend the PUBLIC’S CREDIT but for private gain?

        You’re enamored of so-called “prudent banking” as if “prudent” theft is ever justified.

  9. Steven Greenberg

    I would argue that we stop saying private banks create money and just say that private banks create promises of money. The difference between what private banks create and what the central bank creates is that the central bank only promises to give you what they create in exchange for what they create. Private banks promise to give you what the central banks create in exchange for what the private banks create.

    Let’s stop creating confusion by using the same word for what private banks create and what the central bank creates.

    I have checked this with Warren Mosler, and he hates my idea. I hope he sees this video.

    1. Anonymous

      What you are saying is true; banks only create liabilities for fiat, not fiat itself.

      What Mosler would do is make those liabilities for fiat as good as fiat itself via unlimited deposit guarantees for banks – thus allowing banks to essentially create fiat themselves.

      We could have an ethical banking model instead but what Mosler proposes to do is make the current system more stable by making it more unethical.

    2. larry

      I like your idea, though I would put it differently. I agree different terms should be used for what are actually slightly different operations. Mosler is not necessarily the best expositor of his own ideas.

  10. Scott1

    Well then I do need to buy Stephanie Kelton’s book, “The Deficit Myth” in the expectation that she will be the better “expositor” of Warren Mosler’s ideas.
    What is corrupt is when a bank loans money without the expectation of ever being repaid. For one political reason or another someone will receive a great deal of money that the bank giving to them knows that they can’t or won’t ever repay. This is corrupt because it violates the rules that apply to the majority who cannot get loans, as gifts. When a bank gives money to a character like Trump they expect him to spend it to enable them to launder money. Their aim is to turn their rubles into dollars held by them under shell company names and rules as it is all meant to remove from the reach of the nation they are a citizen or far enough and oblique enough it cannot be claimed for taxes or any other purpose by the nation where their wealth originated.
    There are two Financial Engineers whose methods for acquiring and banking money are followed since the 20th Century. One is the mobster Meyer Lansky whose financial engineering used every trick in the book to launder and hide money. Mobster Money Theory. Let’s call it. Eric Schlosser details this as it was made legal under Bill Clinton’s regime.
    The other is David Cay Johnston who has become a supporter of Warren Mosler and Stephanie Kelton we might call Civil Money Theory. By Civil I mean Ethical. If you borrow from a bank you repay that loan. There was a written purpose for the loan. That purpose was legitimate and legal. If you go bankrupt it will not break the bank.
    The point of creating a system dependent on sovereign wealth and infinite numbers of units of dollars and pounds is to give the nation the power to wage wars and wage peace. The Fiat Dollar is a work of conceptual art. The ways of waging peace are for the government to spend the money it can create with clicks for education, UBI, and FJG and healthcare have obvious good purposes that make the nation strong and worth defending.
    The US has traditionally come to have obligations payable in US Dollars, and has always paid its bills in dollars, excepting possibly when it created Fronts to buy Titanium and Chromium. I am not fully aware of what currency the USSR got for the Titanium and Chromium it sold to the Front created to get what the USSR would otherwise not sell to the US on the basis of it being a strategic material.
    There is no reason for the US to subsidize its fossil fuel industry any more. Subsidization by the government of an industry that threatens the food & water supply becomes corrupt since it is counter to principles of Defense of the nation.
    The concept, the idea of what real things are done with the work of conceptual art that is fiat currency is more important than the money itself.
    Thanks, Scott One

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