How Banks Create Money?

The money that banks create isn’t the paper money that bears the logo of the Reserve Bank of India. It’s the electronic deposit money that flashes up on the screen when you check your balance at an ATM.

Right now, this money (bank deposits) makes  up over 97% of all the money in the economy. Only 3% of money is still in that old-fashioned form of cash that you can touch.

Banks can create money through the accounting they use when they make loans. The numbers that you see when you check your account balance are just accounting entries in the banks’ computers. These numbers are a ‘liability’ or IOU from your bank to you. But by using your debit card or internet banking, you can spend these IOUs as though they were the same as 10 rupee notes. By creating these electronic IOUs, banks can effectively create a substitute for money.

Martin Wolf, who was a member of the Independent Commission on Banking, put it bluntly, saying in the Financial Times that: “the essence of the contemporary monetary system is the creation of money, out of nothing, by private banks’ often foolish lending”.

By creating money in this way, banks have increased the amount of money in the economy by an average of 11.5% a year over the last 40 years. This has pushed up the prices of houses and priced out an entire generation.

Of course, the flip-side to this creation of money is that with every new loan comes a new debt. This is the source of our mountain of personal debt: not borrowing from someone else’s life savings, but money that was created out of nothing by banks. Eventually the debt burden became too high, resulting in the wave of defaults that triggered the financial crisis.


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