SOVEREIGN GOVERNMENTS CREATE CURRENCY AS THEY “SPEND”. BANKS CREATE BANK DEPOSITS AS THEY “LEND”

Banks don’t actually “lend” money; they create new bank account deposits by accepting the credit risk of each customer that is willing to repay them over time. Most of the money in our economy is actually created by banks – we will call this bank credit to distinguish it from the government’s currency.

HOW DO BANKS CREATE MONEY?

The government creates new currency as it makes payments by crediting bank accounts, but banks also create new bank deposits each time they extend bank credit to a customer. In modern economies, almost all money is created via the banking system in the form of bank deposits. Banks play a large role in the economy, both in extending bank credit and as an agent for the flows of government currency in and out of the economy.

Each time a business gets a loan for new equipment, or a household signs a mortgage for a house, the bank uses a computer to increase the deposit balance in the customer’s account. In other words, banks accept our I.O.U.s (our promises to repay) and issue their own I.O.U.s (bank deposits). They don’t “lend” other people’s money to “borrowers”.

Similarly, when we use a credit card to buy goods from a store, the store’s bank account is credited with the amount of the purchase. But credit card companies don’t “have” money to “lend”. They simply accept our I.O.U. (our promise to repay the balance each month) and they issue their own I.O.U.s to the store in the form of bank deposits. Each payment creates a new deposit – new money in the economy. Repaying your credit card removes bank deposits from the banking system, redeeming (or extinguishing) the IOU.

We can simplify this by saying that banks “create money” when they expand bank credit and they “delete money” when that bank credit is repaid – which may occur over many years.

Many of us were taught that banks collect money from savers and then lend out that money to borrowers, but this isn’t actually how banking works. Rather, banks have a license from the government to create dollar deposits whenever they accept a creditworthy “borrower.”

WHY ARE BANK I.O.U.’S SO WIDELY ACCEPTED?

Bank deposits have broad acceptance in part because our government insures bank deposits and supports a streamlined inter-bank transaction clearing system. Banks have a special relationship with the government that can be viewed as a kind of public-private franchise of the government’s currency. This perspective provides insight into how and why banking should be regulated to serve the public’s need for credit and a payments system. Some countries even use a public banking system such as Postal Banking to provide these services to every local community.

CREDIT VERSUS CURRENCY

So the government makes payments by creating new bank deposits and banks also create deposits each time they extend credit. All money in our economy comes from either bank credit (someone’s debt), or is facilitated by government payments.

There is a big distinction worth noting at this stage.

For every new dollar of bank credit the private sector debt burden grew – perhaps your house mortgage or your company’s new equipment financing.

However, when the government spends its currency into the economy, no household or business became further indebted. Instead, the recipient received an increased bank balance free of any offsetting obligation to repay.

This is a vital distinction to grasp: when the government pays for some public service or infrastructure, the private sector doesn’t have to go higher into debt to pay for it. And remember that the government doesn’t have to tax more every time it initiates new investments, but rather only if the economy requires some tax adjustment to manage inflation or other public concerns.

The banking system is integral to how our modern monetary system works and there is much to say about how it can be improved to better serve the public. That topic is beyond the scope of this current project, but you can look up the works of MMT economists such as Bill Mitchell, Stephanie Kelton, Warren Mosler, Randall Wray, and Eric Tymoigne on the topic if you are interested.