Where does new money actually come from?

Where the mortgage money came from

A mortgage clears and a house changes hands, and somewhere in the background a natural picture forms of what the bank just did. It gathered the savings that thousands of depositors left with it, kept some aside, and handed the rest to the borrower. On this picture the bank is a cautious middleman, moving other people’s money from those who have it to those who need it, and its own vault is the reservoir the loan is drawn from. The picture is intuitive, it is a common one, and it is not how the transaction works.

The previous chapter left money as a record of debt kept in a ledger, a descendant of temple credit rather than of coin (Chapter 1). That reading is what makes the mechanics of a modern loan legible. If money is an entry in a ledger, then the question “where did the money come from” becomes “who wrote the entry,” and the answer is the bank itself, in the same keystroke that recorded the loan.

What the bank actually does

When a bank approves a mortgage, it does not debit a reservoir of savings. It writes two new lines into its books at once. On one side it records a loan, an asset, because the borrower now owes it the principal. On the other side it records a deposit in the borrower’s account, a liability, because the bank now owes the borrower that balance on demand. The deposit is the money. It did not exist a moment earlier, no saver’s balance fell to supply it, and it was conjured not from a vault but from an act of accounting. The Bank of England, describing its own monetary system, states the mechanism without hedging: whenever a bank makes a loan, “it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.”

Repaying the loan runs the process backward. When the borrower sends money back to the bank, the loan asset and the deposit liability cancel one another, and that quantity of money leaves existence as quietly as it entered. Money is created when banks lend and destroyed when loans are repaid, so the stock of it in the economy rises and falls with the willingness of banks to lend and of everyone else to borrow. This is the sense in which the deposit in an account is not a stored object but a live relationship, an outstanding debt that happens to be spendable.

Most money is bank-made

If this were a marginal quirk of accounting, it would not be worth a chapter. It is instead how nearly all money comes to exist. Set the notes and coin that a mint or central bank issues against the deposits that commercial banks create by lending, and the mint’s share is small. In the United Kingdom the Bank of England puts bank deposits at “the vast majority (97%) of the amount … currently in circulation,” leaving physical cash at roughly the remaining 3%. The United States sits at a different ratio for a specific reason, but tells the same story.

The two aggregates are not the same measure, and it is worth keeping them apart rather than blurring them into a single number. The Bank’s 97% refers to the broad money held by the British public, where deposits swamp cash. Figure 2.2 tracks a narrower United States measure, currency as a share of M2, which runs higher mainly because a large fraction of US banknotes lives abroad, in economies that treat the dollar as a refuge. What both measures agree on is the shape of the thing: the money that clears rent and wages is overwhelmingly deposits, and deposits are what banks make when they lend. The mint is a minority shareholder in the money supply.

What stops the banks, then

A power to create money by writing it down invites the obvious worry, that banks could then make money without limit. They cannot, and the constraints are worth naming even though their full treatment belongs to later chapters. A bank that lends recklessly acquires bad loans and fails; the need to stay solvent and profitable disciplines how much it writes. Capital rules require it to fund each loan with a cushion of its owners’ money, which is costly and caps how far it can stretch. When a borrower spends the new deposit, it usually lands at another bank, and the lending bank must find the reserves to settle, so competition for deposits and reserves prices its lending. Above all, loans require willing borrowers, and the demand for credit rises and falls with the economy. The work these banks do in matching savers to borrowers and bearing the risk in between is not nothing; it is the intermediation the middleman chapter treats as its subject (Frameworks, on why the middleman often captures more value than the maker). What the modern picture corrects is only the direction: the lending comes first, and the funding is arranged around it.

Standing over all of these is the central bank, which sets the price of the reserves banks settle in and so leans on the whole quantity of lending. The Bank of England is explicit that “the amount of money created in the economy ultimately depends on the monetary policy of the central bank.” Why that steering exists, why nearly every country hands it to an independent central bank, and why the target is a slow positive drift in prices rather than none, is the question the next chapter takes up. What happens when the discipline fails and a state pays its bills by creating money without limit is the collapse case in Volume V: Pathologies, in the chapter on what happens when money dies; how the same lending machinery drives the recurring boom and bust is Volume V’s chapter on why boom and bust keep happening. This chapter claims only the mechanism, not its pathologies.

Why the mechanism still surprises people

What makes this chapter’s subject unusual is that the finding is not new, contested, or hidden. It is stated plainly by the institution with the most authority to describe it, and it has been the working reality of banking for a long time. Yet the intermediary picture, of the bank as a vault lending out savings, is a common misconception; by the Bank of England’s own account the way money is created “differs from the story found in some economics textbooks.” The gap between how money is made and how it is commonly imagined is itself a fact about the system, and a durable one. It is worth stating without insinuation: there is no trick being concealed, and the account here is the central bank’s own. The surprise is simply that a mechanism this basic to daily life is so often misunderstood, which is reason enough to set it down carefully before building anything on top of it.

Reading a deposit as a debt the bank owes, created when it lends, also answers the question the previous chapter left open about the number in an account. It is not a coin, not a claim on a coin, and not a slice of someone else’s savings. It is the newest form of the oldest kind of money, credit written into a ledger, now written by banks at the moment they lend.

Where the argument goes next

Once money is understood as bank-created credit, the machinery that governs it comes into view, and with it the questions the rest of this volume takes up. If banks create money when they lend, someone has to stand behind the banks when lending seizes up and depositors want their balances at once, and someone has to keep the total from drifting into too much money chasing too few goods. Both jobs fell to central banks, which were built after financial panics and now aim deliberately at a little inflation rather than none. That is the next chapter’s subject: why every country ended up with a central bank, and why they steer toward 2% rather than zero.