This article is part of the Money series in this blog.
The preliminary considerations I exposed last time were just an explanation of the methodology the I follow when I study economics. This led me to demolish some common misconceptions I had..
NOTE: an excellent book that explains how money is created nowadays is "Where does money come from?", by Positive Money think tank. It is not a super-easy book, nevertheless it is a mandatory read for everybody interested in the topic. The theories it carries on are very well documented.
First misconception: the money that you deposit in a bank is yours.
We have already covered this misconception in a previous post, extensively.
Second misconception: A bank lends you money when you apply for a mortgage or a loan.
The act of lending implies that you renounce to the possession of something for some time. For example, you may lend 20000 € to a friend of yours, who will give it back to you the next year.
In this case, for one year, you have 20000 € LESS at you disposal.
In the case of a bank, this is not true. Simply, the bank creates money from thin air when you ask for a mortgage. The bank does not take any money from anybody when it puts 20000 in your bank account. When a bank gives you money, it expands the money in circulation, by the same amount of your loan. That is why currently 97% of money in circulation, called M2 money, that is the money that everybody uses, is made of money created by commercial banks. Only 3% of the money in circulation is made by coins and notes, that are printed by the Treasury.
NOTE: this is extremely difficult for an average person to accept. I have done technical studies, and to me the first law of Thermodynamics, that is , broadly speaking, nothing can be created or destroyed but only transformed, is a kind of basement in my brain. In finance, under current monetary system, it is not like that: Money is created and destroyed by banks.
So, a bank does not lend you any money, it creates money from nothing and gives it to you in exchange for the original principal plus the payment of interests. You and the bank are binded by a contract, for example the mortgage contract, that is an asset for the bank. More on this in a future post.
Remember, in today's world, there is no difference between money and credit, as I explained here.
You may wonder where the money for paying interests is coming from. Of course, on average, if we consider million people and transactions with the pertaining interest rates, it is money created in the future by other banks.
Third misconception: money is created by means of fractional reserve mechanism.
For an explanation of how fractional reserve works, please visit this page.
This assumption is not completely wrong, but it is strongly misleading.
First, it does not explain who creates money first. If you go to a bank and deposit, say, 10000 euros in your account, and this 10000 euros are turned into 100000 euros in the system thanks to a reserve ratio of 10%, you are missing one piece of the puzzle: who gave you originally the first 10000 euros?
Second, banks nowadays have many many ways to bypass the reserve ratio control, so actually it is up to the bank to decide how much money through loans and mortgages they want to inject into economy, and according to this figure the bank sets apart amount of reserves it needs to keep in liquidity to obey the law. It is not the way around, that is it is not the basic reserve that determines how much credit a bank can produce. Theoretically, there is no limit, no ceiling, to the amount of credit that a bank can create.
Third, this model assumes that Central Banks can control the amount of money in the economy, by changing the monetary base. More on this in future posts. This implies that there is no possibility that money supply can get out of control. Of course this is false, as the crisis of 2007 reminds us.
Fourth misconception: banks takes money from savers (families) and lend it to borrowers, like firms (that can invest this money).
This is the story that everybody is told since their childhood. It is false. As we have already seen, banks create money from nothing. They do not take money from one party to give it to another party. Of course, banks make money by charging borrowers more for a loan than it is paid to depositors. But that is a complete different matter. Banks make money when they create money, by applying a delta between the cost of money for the borrower and the cost of money for the bank.
Since credit is the bridge between the present and the future for the population, you can imagine that if you leave the control of the credit erogation to a private company (a bank IS a private company), then it is only up to the mood of bankers if we are in excess of credit or in shortage of credit. If the banker feels insecure about giving me credit, then it does not issue mortgages. If he feels we are in a boom, he will give me the money. It is not that he does not give me the money because there are not enough deposits from savers in his bank to take the money from, for my needs!
So, after this introduction, two question may arise:
1. If banks can create money "ad libitum", at least theoretically, why can they go bust? Why cannot they create all the money they need to avoid bankrupcy?
2. If banks can crete money "ad libitum", at least theoretically, why are they so scared of a bank run, ie when a large number of depositors decide to withdraw their money?
I will answer these two questions in another post.
To conclude this post, I invite you to watch this excellent, yet professional, short video, by Positive Money, that shows the misconceptions I have written about so far. Subtitles are available in many languages.