Limitations On Money Creation

If banks create money simply by typing numbers into a computer, why can’t they create limitless money for themselves, and how can they go bust?

This question is often asked, but it just shows you aren’t paying attention.  There are two parts to the answer.  The first is that banks can only create new money when they make a loan.  The bank has to have a customer to whom they are making that loan. Banks can’t just create money and go out and spend it, or deposit the money in the bank accounts of their owners.  There must be a customer taking out a loan for the bank to be able to create new money.

So the first limitation could be said to be the demand for loans, which is itself linked to the performance of the economy.  But it’s not that simple (when is it ever).  Banks will, of course, sometimes turn down applications for loans.  There are types of loans that they like, and types of loans they don’t – they will use lower interest rates to attract the former, and higher rates to offset the risks they perceive associated with the latter.  We will say more about this in a couple of weeks.

Having found a customer for a loan, the second limitation comes in – the customer is going to want to spend that loan, and the bank has to make that payment.  As described last week, when the customer makes a payment, the bank will be liable to transfer central bank reserves to the bank of the recipient of that payment.  Remember, if I pay you £100 on-line, then my bank has to pay your bank £100 in reserves.  This is really important – don’t just gloss over it – read that again and make sure you understand it.

Now think of the millions of pounds in loans that banks make everyday.  And all the recipients of these loans go out and spend that newly created money.  There’s thousands of transactions flying across the banking system, and the equivalent amount of reserves being transferred between the banks in their central bank accounts.

But these transfers between the banks will offset each other to a great extent.  If in a single day Lloyds bank customers make £100m in payments to customers of other banks, and meanwhile Lloyds customers receive £99m from the customers of other banks, at the end of that day Lloyds has made a net payment in reserves of only £1m.  But if their customers had made £200m in payments, Lloyds would be down by £100m in a single day.  Clearly, they could go bankrupt if this continues indefinitely.

What this means, is that banks can only create new money at a similar pace to which its own customers are receiving payments – which itself is determined by the rate at which new money is being created, which of course is the rate at which the banking system as a whole is making loans.  Again, banks will use interest rates, both on loans and deposits, to balance these flows and ensure not just solvency but profitability.  To look at this in more detail would take too long, but the Bank of England paper referenced last week does cover these points.

The Nobel prize winner James Tobin wrote an article on this issue in 1963 (back in the days when economists had a better understanding of the monetary system – something I will explain in a couple of weeks).  It’s somewhat dated, but gives a flavour of the kind of detail there is to explore for those who are interested.  In writing a 500-word post for a general audience it’s necessary to summarise and simplify each topic considerably.  I am really meticulous about trying to ensure that what I write is as accurate a representation of the system as these limitations allow, but you must understand that this subject is far more nuanced than I present.  This blog post on Tobin’s paper is a really good exploration of the kind of debates that this paper has stirred up in the econoblogosphere, and here is one taking a slightly different point of view.  For me, it’s not a question of which I agree with, they are all making valid points that overall enable a balanced point of view.

Anyway, coming back to this issue of the banks needing to attract deposits to cover their customers’ payments – the transactions between banks in a single day are never going to balance out exactly.  How do the banks manage this day to day?  The answer to this leads us to a technical detail about banking that is arguably the single most important element to understand if you want to grasp how our monetary system, including central bank monetary policy, works.

2 Replies to “Limitations On Money Creation”

  1. Every time I read your blog I think to myself I really must go out and buy some gold. A big lump. To keep under my bed.

    1. In general, I would suggest that the belief in gold as a long-term store of value is irrational – except that because so many people have had this irrational belief for so many centuries, you know that at the first hint of trouble people buy gold and its price goes up – so it becomes a rational investment because we’re banking on others’ irrationality! (Note, the purpose of this blog is not to give investment advice – investments can go up as well as down.)

      At the heart of so many poor decisions (e.g. by governments) is a lack of understanding of the international monetary system as a whole, which is what we are slowly moving towards on the blog. In fact, just this morning I was reading an exciting IMF paper on the resilience of this system, and steps the IMF could take to further protect from shocks and crises – no doubt I will be referring to this in future posts!

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