Do Banks Create Money?

The Debate

Before I get into the subject, I must say that this is a controversial subject and I'll try to be as specific as possible. Part of the controversy lies in the definition of money itself. Depending on how you define money you get into different answers whether money can be created by private banks or not.

That central banks can create money is highly uncontroversial. After all, that has been the role of central banks for centuries in terms of producing physical bank notes and coins. The recent years private banks have been criticized for their role of money creation as well, usually in terms of issuing loans. In this vivid debate, group A loudly declares group B's incompetence for not understanding money and/or vice versa. Let's clarify this debate and remove some of the misunderstandings.

Red and Green money

Group A's reasoning goes like this: Only central banks have access to true money (of the nation's currency) and only the central bank is allowed to control the nation's money supply. Private banks have (electronic) accounts at the central bank allowing them to trade with other private banks (of the same country.) Only these accounts at the central bank consist of true money (of the nation's currency.) The bank deposit accounts for ordinary customers (like my checking account) are not accounts in the nation's currency, but in a new type of currency, normally called "bank debt" or what the bank owes you. According to group A this is not real money.

To simplify the following discussion we'll color the two types of currencies; money in your checking account (for bank's ordinary customers) is "red money" and banks' money at the central bank is "green money." The only way a private citizen can get hold of green money is by withdrawing that money from an ATM machine and get the physical notes.

How Transferring Money Works in Practice

In practice, only banks use green money, as only 3% of the nation's money supply (Sweden) is available in the form of physical bank notes and coins. That ratio is similar in other countries. Let's make a concrete example on how this works:

We have citizen A at Bank A who wants to transfer money to citizen B at Bank B. This is what happens:

  1. Bank A reduces its debt to citizen A by X (decreasing the number at the checking account for citizen A.)
  2. Bank A logins at the central bank servers for which both Bank A and Bank B have accounts.
  3. Bank A makes a wire transfer of X amount to Bank B with a message to Bank B that it should increase its debt to citizen B.
  4. Bank B receives the amount and adjusts its debt to citizen B.

When banks trade each day using the accounts at the central bank it could happen that their liquidity requirements are below the required amount. In this case, the bank borrows money from the central bank directly or via a bank cartel for a specific interest rate (determined each day by the cartel itself.) You may have heard of this term before; this interest rate is the inter-banking lending rate which is called STIBOR in Stockholm/Sweden, and LIBOR in U.K/London, etc.

The Counter Arguments

Using the above view, with the constraint that only green money is true money, then yes, private banks don't create money. This view however is highly misleading and extremely narrow when it comes to the definition of money itself. As a proponent for group B, here comes my counter arguments:

  1. People (including private companies) are color blind; they don't care if the money is green or red. Both will be accepted as debt settlements.
  2. Red money can always become green money by withdrawing the amount in physical notes.
  3. If banks get into trouble, governments will bail them out so red money always become green money.
  4. The government (together with the banks) always want to keep the illusion that red and green money are the same.

To sum it all up: yes, private banks DO create money; they create RED money which is considered by ordinary people to have the same purchasing power as GREEN money. When a bank issues a loan, they do not act as intermediaries; instead they conjure up a number in the computer and add that number to your checking account. They also add you to their balance sheet to become a bank asset (you're promising to pay back the same amount with interest.) Only if a large enough group of people is trying to convert their RED money into GREEN, the bank may get into trouble. If that theoretical scenario happens, government will just bail out the banks.

What are the Alternatives?

The current system of transferring debt between accounts seems incredibly complicated. Wouldn't it be much easier if the central bank had all the accounts for all citizens? Then the different central banks would only be involved in clearing for international money transfers.

The obvious follow-up question is then: Wouldn't it be easier if ALL citizens' accounts of the entire planet could transfer money to each other without going through the central banks as well? Once the domino bricks start falling in your head, you'll realize that the answers to all your questions, the singularity of fundamental monetary truth, is bitcoin.