HOW BANKS CREATE MONEY
OUT OF NOTHING
You Must Learn How Banks Create Money or Your Freedom is Threatened
The following is from mainstream economics textbook Success in Economics by Derek Lobley B.A. (London: John Murray Publishers Ltd, 1978 edition), which was part of the "Success Studybooks" series. It was intended to be "appropriate to the Economics syllabuses of many of the professional bodies such as ... the Institute of Bankers". It is published verbatim (but with emphases added) from ch.17, pp. 205-206.
Let us imagine an economy in which there is only one bank. Soon after beginning business it finds that individuals and firms have placed $10,000 with it for safe-keeping. Its balance sheet (ignoring the shareholders' capital or property owned by the institution) would appear as follows:
The balance sheet is in effect a photograph of the institution's position at a particular point in time. The liabilities show the amounts that may be called upon to provide to customers and the assets show the cash and other resources available to meet liabilities.
At this stage it is quite clear that the bank has sufficient cash in its till to meet any demands made by its customers.
In practice customers prefer to settle their debts with each other by cheque, ordering the transfering of money from one account to another. Thus if Adam and Brown have each deposited $500, and Adam owes Brown $100, he can settle his debt by making instructions to reduce his account by $100 and to increase Brown's by the same amount. No cash changes hands; the bank still has obligations to its customers of $10,000; there has simply been a slight readjustment to those obligations.
If all the depositors were always prepared to settle their debts in this way the bank could forget all about its holdings of cash. Customers will, however, need to draw out a certain amount of cash each week to make small payments (it is not usual to write cheques for very small amounts) and to pay those people who prefer not to use the banking system.
If the bank discovers that, at the most, the weekly withdrawal of cash amounts to 10 per cent of total deposits, and that this is quickly re-deposited by traders accepting cash payments from customers, then the most cash needed to meet demands from customers with deposits of $10,000 is actually only $1000.
Alternatively we may take the view that with cash in hand of $10,000 the bank can afford liabilities of $100,000.
In this case let us imagine a customer, Mr Clark, who asks for a loan of $1000. The manager is agreeable and opens an account for him with a credit balance of $1000. Mr Clark can now write cheques to the value of $1000 although he has not deposited any money; he simply promises to repay the $1000 plus interest, having probably offered up some security. The bank's balance sheet (2) now shows a different picture:
There is now insufficient cash to supply all the customers if they wished to withdraw their deposits, but the manager knows that the most that is likely to be withdrawn is $1100.
He will, therefore, be prepared to go on making loans (or creating credit, which is the same thing) until the cash that is held is equivalent to only 10 per cent of deposits (as per Balance Sheet 3):
So far as customers are concerned the standing of their account is the same whether they have actually deposited cash to open the account or whether it has been created by a loan. When they spend their money the recipient has no means of knowing whether or not they originally deposited cash.
Thus in creating credit, the money supply has been increased.
image - http://www.usmint.gov/kids/coinNews/images/bankNotesCoins.gif
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