Friday, January 11, 2008

How Banks Create Money Out Of Thin Air

By Kalinda Rose Stevenson, PhD

Banks manufacture money. They exist to make money. Bankers know how to create money out of thin air. It's true that banks provide essential financial services, such as bank accounts and loans. However, the reason that the banks provide such services is that banks need money to use as raw material to create more money, using customer deposits.

Notice very carefully, banks "create" money. It's not simply that banks "earn" profits when they provide bank services and loans. Banks actually "create" new money that did not exist before.

For example: You deposit $100,000 into a one-year Certificate of Deposit at 5% interest. Your money now becomes raw material for bank loans.

Banks must operate under Federal Reserve rules. One rule concerns reserve rates. Banks cannot loan out all of their customers' deposits. They must keep a percentage "on reserve." The reserve rates vary between 3 and 10 percent. With a 3 percent reserve, the bank must keep only 3% of your $100,000 on reserve. It can loan out the remaining 97 percent. With a 10 percent reserve, the bank must keep 10% of your $100,000 on reserve. This means the bank can loan out only 90 percent, or $90,000. To keep the numbers simple, let's assume that the reserve rate is 10 percent.

So, the bank makes Loan #1 of $90,000 and keeps $10,000 on reserve. This is the critical point where the bank creates money. According to the bank's balance sheet, the $90,000 loan to the borrower is also a $90,000 asset for the bank. By its own brand of money magic, the bank has created $90,000 out of thin air.

It gets even more interesting. The bank does not have to stop with one loan. Since it now has an asset of $90,000, it can make another loan. Again, it must follow the Federal Reserve rules and keep 10% on reserve. This means that bank can make another loan, which is 90% of $90,000. The second loan is $81,000. And once again, the bank has created a new asset. It has created $81,000 in new money.

And since the bank now has an additional $81,000 asset, it can make another loan. Once again, the bank must keep 10% of this asset on reserve. This means it can loan only 90% of the $81,000 asset. Loan #3 is $72,900.

Federal Reserve rules allow the bank to make five to six loans based on the original $100,000 deposit. Each loan creates an additional asset. We'll stop at three loans, review the process, and add up how much money the bank has created.

You deposit $100,000 into a CD. The bank creates three loans based on the original $100,000 deposit. Loan /Asset #1 = $90,000 Loan/Asset #2 = $81,000. Loan/Asset #3 = $72,900. The total = $243,900 in assets for the bank. This is $243,900 in new money.

When you cash out your CD, you get your $100,000 deposit back, in addition to the $5,000 interest. Meanwhile, the bank has created $243,900 of new money. After it pays you 5% interest, the bank has made a tidy profit of $238,900. ($243,900 - $5,000 = $238,900.) If the numbers are confusing, go over them again until you see how magical this process is. This is how banks create money.

This example is oversimplified, but the principle behind the example demonstrates how banks create money out of thin air. When you deposit your money into the bank, it goes into a pool of money available for the bank to make loans. When the bank creates a loan, it creates an asset. This asset is new money.

Since you and I cannot do what banks do, what is the point of knowing how banks create money with customer deposits? The advantage is to take the mystery out of money.

The process a bank uses to create money demonstrates that money is not a commodity in limited supply, where there is only so much to go around. Money is not equivalent to currency. Money is created in money-making transactions, which means there is no potential limit to money.

The crucial idea behind all of this is: The greatest limit to money is the belief that money is limited. If you want more money, adopt the money-making mindset of a banker. Ask how you can use money to create more money. If you really think the way bankers think, you will use someone else's money to create more money.

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