Report25 May 2018Updated 4 days ago

The money creation paradox

To understand the significance of the Swiss referendum on monetary reform, it helps to understand how the global banking system actually works. In the report below, first published in 2014, we challenge the misconception that commercial banks can create "free" money without restraint and explain how central banks already have ultimate control

Executive summary

Banks create money out of nothing, but an individual bank doesn’t. This is the money creation paradox, and it helps to explain many common misunderstandings about money and monetary policy.

While it is true that bank deposits, which these days dominate the money supply, are created in the process of banks making loans, it is not true that they can be created without restraint.

The key is to recognise that an individual bank, when it makes a loan, doesn’t usually retain the associated bank deposit. The borrower typically uses the loan to buy something from someone else, who will deposit the proceeds in their bank, which typically will be another bank. The lending bank, therefore, has to ensure that it can fund the loan.

So while banks as a whole create money ‘out of nothing’ by making loans which result in the corresponding deposits which contribute to the supply of money, every individual bank still has to compete to secure the deposits that are backing their loans, or else borrow the money, raise capital or sell other assets. At the same time, they also have to reconcile their profit goals with prudent levels of risk, capital and liquidity.

Lending Banks