Monday, September 26, 2016

Money series: how commercial banks create money (part 1) - preliminary considerations

This article is part of the "Money series" in this blog.

In our last post of the Money series, we learned that the money that you put in a bank is no longer yours. Legally, it belongs to the bank, which on its turn has a liability to you.
Nevertheless, after several posts about the origin of money, what money is, what it the deep meaning of an interest rate applied to credit, we still don't know who creates money.

This is one of the most important questions ever: where does the money come from?

It is odd that everybody uses money, yet they ignore who is in charge of creating it. I started questioning the origin of money in 2014, when I began studying investment strategies and macroeconomics. When the stock exchange collapses, and TV news claim that 3 billion euros were destroyed, where did they actually go? When there is a surge in New York Stock Exchange, where is this money coming from? When the FED claims they have printed 1 trillion dollars, how this money was created? where did it go?
And still: when you buy a house by means of a mortgage loan, and the bank gives you the money, how did get the money on the first instance? When you pay back the principal and the interests, on a monthly basis, to the bank, where is this money going?

Ok, let's get started.

There are two ways that money can be created:

1. By central banks
2. By commercial banks

In the following posts, we are going to cover the process of money creation by commercial banks. How money is created by central banks..well, I am still studying it. I have little time to dedicate to my studies in monetary economics, at work I am moving to other projects and I have to study also other engineering and product assurance documentation. In any case, maybe later than sooner, I will be able to explain also the exact way central banks create money.

Before moving on, it is important to get rid of some common misconception, which are unfortunately very popular by the people, also "supposed-to-be"economists and journalists. Bear in mind that economics is a very wide social science, therefore those who claim to be "experts" in economics are already lying: it is like asking a heart surgeon if he is also and expert in tumors only because he has studied medicine!
I consider economics as a social science because economy is a byproduct of human activity: to get and maintain a complex society, you need complex financial tools. Renaissance was born in Italy not because of the nice weather, but because the family of Medici invented extreme powerful financial tools to be able to survive for decades and fund artists and scholars. They turned from gangsters into banksters. One day I will cover this nice story in a dedicated post.
The financial tools are created by human beings so their behavior is not predictable like the motion of an electron in an electromagnetic field, which is easily described by Lorentz law.
As a consequence, those economists who claim they have found the perfect explanation of the law of economics make me laugh: how can you expect to have laws for humans in a world which is continuously changed by human beings? When demographic forces, technological innovation, information media, and many other factors altogether concur to change and influence each other?
That is why there are so many economic theories. Each theory has its flaws. You discover the flaws only after there is a change in history that cannot be explained by the former theories.

NOTE: The Nobel Prize for economy is a fake Nobel Prize. It is a marketing ploy.

I am not an academic. I do not embrace a particular theory like a Taliban. I only want to understand how things work "hic et nunc", here and now. And to understand how money is created and transferred across the population is mandatory if you hope just to scratch the surface of how the world works nowadays. From the crisis of pension funds, to how everlasting wars can occur, to the rising of inequality in the Western countries, to the importance of private debt over government debt, to the generation of the Japan and Chinese bubbles in the last thirty years, and so on.

This long introduction was just to make you aware that for me the key point for a good post is to find somebody destroying my theories. It makes no sense in looking for evidences to support my findings: I had already these evidences when I formulated and explanation to the events I had observed! If I read ZeroHedge (Austrian school, basically) and I am convinced that the Doomsday is coming, and the Doomsday has not arrived yet, it is mandatory for me to accept the idea that they have to be wrong somewhere. Or, if I read Krugman (Keynesian) and he is one of the promoters of the super Quantitative Easing by the Bank of Japan, and this policy is not producing the expected outcomes, it is important to understand, if I am a long-term investor or a simple saver, the reasons behind all this and the delta between the propaganda and the reality. I can end up making money or losing money.

It is not only for a pure research of the Truth, with the capital T. Nobody knows that, you can simply come closer to that. The Truth is like a mathematical asymptote. You get as close to it as you can (providing that your life is finite and your free time is even shorter!), but never touch it.

Since the way money is created is by far and foremost the most important topic in economics, we will cover this in detail, with an open minded approach, and will examine the social consequences of all this, that are of extreme importance.


  1. "how can you expect to have laws for humans in a world which is continuously changed by human beings? When demographic forces, technological innovation, information media, and many other factors altogether concur to change and influence each other?"...

    You are confusing economic theories (or laws if you prefer to say so) with the natural variables. This is the reason why there are different economic theories. They are/were made within a given social, cultural and political context and are true within that given mix of variables. By changing the variables of the context some of those theories could not make sense anymore. For example the principle of bid and demand to determine the price is no longer valid in a situation of monopoly but it does not mean that such a theory is not true and works perfectly in other contexts. So if you expect the perfection of the economic theories by means of being true regardless the context where they must be applied, you are clearly missing the point.

    Let me ask you a question: what is the sum of 25 + 54?

  2. I totally agree that in economics there are only theories that are very difficult to prove since persons are not free electrons living under a crystal cupola. But I am very surprised by the bullshit that economists dare to give the people as if there was scientific evidence of the solutions they propose. This is unacceptable to me. Economic theories are funny since they think that if they have 100 equations then they fix 99 variables and solve the last equation. Economics is to me a social science. Economists need humilty.

    To answer your question, in a decimal base the result is 79.

    1. That's a very good answer. More or less this is the way economists use to justify their theories: they specify the elements according to which the result is true. But unlike mathematicians and physicists, sometimes their elements are unstable or confined to a certain demographic situation. In this moment, for example, the result of the sum is 65...

    2. Just realizing the base of the system I was observing is octal. You have rightly specified a very important element in your answer because it is something engineers or mathematicians are used to take into account (the average layman would have simply answered 79). But there could be other elements to validate your answer that you did not think about or, better, that you have also taken for grant. For example we do not know if those numbers represent other dimensions of a cryptographic system (we took for grant values and operations belonged to the arithmetic system).
      For example think about the economic theories of the pension system: which one is right? Which one is perfect? All are perfect because all the theories make sense within a given set of conditions. Knowing in advance if the same set of conditions will keep on being true for decades, it is another story.

    3. Ah ok, you were cheating :-)

      All of this is very theoretical: in engineering, the conditions are called boundary or initial conditions, according to the kind of variables you take into account: space or time. It makes NO SENSE to solve a differential equation without specifying the boundary/initial conditions. The outcomes can be completely different.

      To me, a theory that do not rigorously specify the conditions by which is valid, is not very useful. And, since we cannot know a priori the conditions of the future manking, even in two years, all economic theories are inherently flawed. Flawed by the fact that mankind is not predictable, even if they are trying to create super-states "a la Orwell" to better control the peoples.

      Luckily enough, I am not an academic so I can study economics according to my experience without the classical bias.