Banks create money out of thin air, but it's less impressive than it sounds

Most people are familiar with central banks’ ability to create money out of thin air. A central bank has access to physical printing presses which can produce physical banknotes, and it has the corresponding ability to create electronic money. However, central banks are not the only entities which create money. Money is also created by regular banks, such as retail banks and commercial banks, in the process of making loans.

Many people believe that regular banks’ ability to create money is similar to central banks’ ability to create money. It is not. This misconception has been perpetuated by a powerful cast of characters which includes mainstream news outlets and even some economists.

This article will demystify money creation by illustrating the following facts:

• A bank deposit is merely an IOU.
• A bank loan is merely an exchange of 2 IOUs.
• Anyone can create IOUs out of thin air.
• When a customer redeems an IOU at a bank, the bank needs to hand over another form of money, and the bank has no ability to create that money out of thin air. For example, when you make a bank transfer to another bank, the bank can not simply send over money created by itself.

The main argument presented here is that banks do not have central bank-like special powers in relation to money creation; the process in which banks create money is entirely pedestrian.

Bank deposits are merely IOUs

Suppose you have $100 in cash. You decide to deposit it at your local bank. Now you no longer have $100 in cash. Instead, you have a promise from the bank that you can withdraw $100 in cash at any time. The bank has $100 in cash and you have a promise. Let’s imagine this promise as a physical document acknowledging debt, an IOU (”I owe you”). The bank owes you $100 and promises that you can exchange this IOU to $100 cash at any time.

Is this IOU ”money”? We’ll get to that later, but the short answer is yes, that IOU is money. There are different types of money, and checking account deposits are usually considered to be a type of money.

Let’s illustrate this bank deposit as an exchange:

Now let’s look at the bank’s balance sheet. If you were the only customer at the bank, its balance sheet might look like this:

Assets are things the bank owns, liabilities are things the bank owes. In this simplified example, the only asset that the bank has is the $100 in cash that you deposited — now considered to be the bank’s asset — and the only liability is the $100 debt that the bank owes to you. These accounting entries were created at the same time: when the bank incremented your checking account by $100 (the deposit liability in bank’s accounting), there was a corresponding $100 cash deposit (the cash asset in bank’s accounting).

A bank loan is merely an exchange of 2 IOUs

Let’s continue with the example where you deposited $100 to a bank. Suppose I will go into that bank and ask for a $10 loan. Now that the bank owns $100, it can easily afford to loan me $10. I promise to pay back $11 at a later point in time, so the bank is eager to offer me a loan and make that dollar.

The bank deposits this $10 loan to my checking account. Remember, checking account deposits are IOUs, so the bank just gave me a $10 IOU. I promised to pay back $11, so I also created an IOU. In other words, this loan is an exchange of 2 IOUs: the bank promises to give me $10 in cash whenever I want, and I promise to give the bank $11 at a later point in time. Let’s imagine these IOUs as physical documents:

When I take out a bank loan, I am exchanging one IOU for another:

After this transaction, the bank’s balance sheet might look like this:

The bank still has that $100 cash in assets, and it still has that $100 liability to John. But now the bank also has a $10 liability to me: I could withdraw my $10 from the bank in cash at any time. Corresponding to this liability, the bank has recorded a new asset: my promise to pay back $11 later.

Notice how the bank now has $110 of deposits, but only $100 of cash in the vault. Welcome to fractional reserve banking! If I decided to withdraw my $10 from the bank today, and you decided to withdraw your $100 from the bank tomorrow, the bank would say ”oops, we no longer have your money”. In practice this rarely happens due to a myriad of reasons (banks can trade assets between each other when they have too little/too much cash, banks have internal risk controls which limit lending and other risky endeavours, lawmakers impose restrictions which are monitored by regulators, the existence of deposit insurance reduces likelihood of bank runs, etc.).

Anyway, let’s get to the interesting bit. Before taking out the loan there was $100 on checking account balances and afterwards there was $110 on checking account balances. Clearly, money was created in the process of taking out the loan. Where did this money come from? Was it created out of thin air? The short answer is yes, kind of, but let’s step back a little bit.

What is money, anyway?

Let’s go back to the cash deposit example. You deposit $100 into a bank and the bank records it as an asset. The bank records a corresponding liability: a $100 deposit to your checking account. Did the bank create money in this scenario?

Before the deposit there was $100 of cash money, but after the deposit there was $100 of cash money + $100 of electronic money = $200 worth of money in total. But of course we don’t want to ”double count” your money just because you deposited it in a bank, right? That’s why economists developed this convention that cash money in a bank’s vault is considered to be ”out of circulation”, and thus, is not typically counted when we count how much money exists.

The Eurozone M1 definition for money is basically equal to this notion of ”currency in circulation”. The concept of money is ambiguous, so there are many different definitions, varying by both economic area and by use case. Nevertheless, checking account balances are included in most commonly used definitions (though not in all, for instance the UK M0 definition for money does not include checking account balances).

In abstract terms we might think that the $100 cash you deposited into a bank was transformed into a $100 checking account balance. Except it wasn’t. That $100 of cash money still exists. It was not transformed into anything. The bank took $100 of cash and put it in a vault. Then the bank created an IOU out of thin air and gave it to you. (We can say that the IOU was created out of thin air, because the corresponding $100 cash in the vault is not earmarked to this IOU — the bank may run out of cash before you try to redeem that IOU.) Then economists decided that the IOU counts as money, and the cash in the vault does not count as money. Thus, the act of depositing cash in a bank does not result in (net) creation of money. $100 of electronic money is added to circulation while $100 of cash money is removed from circulation, for a net difference of $0.

When you deposit cash in a bank, the bank creates an IOU out of thin air. Similarly, when you take a loan out of a bank, the bank creates an IOU out of thin air. However, due to accounting conventions, the latter action results in net money creation, while the former action does not. (Although these conventions are weird, they make sense: currency in circulation is a good measure with real implications for economic activity, and currency in circulation is genuinely increased when banks loan money.)

Anyone can create IOUs out of thin air

If there’s only one thing you take away from this article, let it be this: there is nothing special about the IOUs created by banks. IOUs are promises. Anyone can make promises out of thin air. For example, I could be handing out IOUs like this, furbished with my signature for authenticity:

You might think these would be worthless, but that’s not exactly the case. People who know me would think ”Atte is good for $10”. These would not be worth exactly $10, because you would still rather take $10 in cash than a coupon that’s exchangeable for $10 in cash. And it’s unlikely that these IOUs would be used to facilitate real economic activity, so these IOUs should not be considered ”money”. Although there are clear differences in how these IOUs would be used, compared to the IOUs created by banks, is there any fundamental difference between the IOUs themselves?

Let’s take another example and get one step closer to creating money. This one is real, not hypothetical, example of IOUs created by a non-bank corporation.

We have to go all the way back to 2011. Poker is booming and Full Tilt Poker is one of 2 giants dominating the scene (the other being PokerStars). The way that poker sites work is you deposit money (like you would in a bank) and then as you play poker and you win and lose money from other players, the poker site keeps track of how much money everyone has (like a bank would keep track of transfers between customers of the same bank).

In other words, a poker site issues IOUs to players. These IOUs are supposedly redeemable at any time (like the IOUs created by a bank). The IOUs created by Full Tilt Poker were largely treated as money by players of the site, to the point where they were used to facilitate real economic activity. For example, it was typical for players to settle small debts (like $10 for a movie ticket) by sending a player-to-player transfer on Full Tilt Poker instead of sending a bank transfer (because transfers on poker sites were typically faster and easier to make than bank transfers).

For all intents and purposes, the IOUs created by Full Tilt Poker were money. They simply were not counted as money due to accounting conventions. Now, some of you might be thinking ”Wait a minute… Doesn’t the poker site have all player funds in the bank? If all player funds have corresponding bank deposits, then those bank deposits would already be counted as money, and we wouldn’t want to double count that money.” Yeah, I also thought that Full Tilt Poker had player funds in the bank (can you guess where this is going?).

On April 15, 2011, known in the poker world as Black Friday, the FBI raided offices of Full Tilt Poker and PokerStars as part of a larger crackdown on online gambling. This law enforcement action triggered an instant bank run by players: everyone wanted to withdraw their money at the same time. This should not be a problem, because all poker sites promise to segregate player funds from operational funds. And for PokerStars it wasn’t a problem, because they had done so. Full Tilt Poker hadn’t. Even worse, they had slowly siphoned off almost all player funds over the course of multiple years, leaving only a small fraction in reserve. In other words, Full Tilt Poker had been operating like a fractional reserve bank.

Now, going back to the IOUs created by Full Tilt Poker: since Full Tilt Poker is not a bank, its IOUs were not counted as money. And since it did not have sufficient bank deposits to cover its IOUs, these IOUs were not ”indirectly” counted as money, either. But players still considered these IOUs to be money, and these IOUs facilitated real world economic activity similarly as bank money does. If you have an argument why these IOUs should not be considered money, I would love to hear it. Otherwise, let’s conclude that non-bank corporations can sometimes create money out of thin air.

No permissions needed, either

One question that often comes up in discussions about money creation is why are banks allowed to create money out of thin air. Sometimes this is a legitimate question about the merits of full-reserve banking versus fractional reserve banking, but more often, this question implies some kind of misunderstanding about how money is created. This confusion is exacerbated by some economists pouring gasoline into the fire by using inflammatory language like this:

The money supply is created as ‘fairy dust’ produced by the banks out of thin air.

That’s Richard A. Werner in his influential 2014 paper. Werner continues in a subchapter titled ”What is special about banks”:

We now know, based on empirical evidence, why banks are different, indeed unique … and different from both non-bank financial institutions and corporations: it is because they can individually create money out of nothing.

There’s a lot to unpack here. First, Werner claims that banks are special due to their ability to create money out of thin air. Second, Werner claims that the first claim is proven conclusively with empirical evidence.

Werner’s second claim is patently false, because the ”evidence” he presents in his paper only describes banks’ ability to create money out of thin air — he presents no evidence for non-bank entities’ inability to create money out of thin air. Thus, he presents no evidence that banks possess an ability non-banks do not possess. And yet, he claims to have done the opposite.

Werner’s first claim is correct only on a technicality: due to accounting conventions, some IOUs are counted as money, while others are not. As we saw with the Full Tilt Poker example, some IOUs created by non-bank entities are indistinguishable from money. In other words, we have empirical evidence that non-bank entities are sometimes able to create money-like IOUs out of thin air — we simply do not count those IOUs as money due to accounting conventions.

Redeeming an IOU

Now, let’s move on to the final point I want to make: When a customer redeems an IOU at a bank, the bank needs to hand over another form of money, and the bank has no ability to create that money out of thin air.

Note that redemption of an IOU works the same way regardless of the origin of the IOU. Perhaps you had originally deposited cash into your checking account. Perhaps you took out a loan and the bank deposited money into your checking account. Regardless, redemption works the same way.

In typical cases a bank’s IOU is redeemed into money in one of these forms:

• Cash withdrawal
• Bank transfer

The cash case is simple. You can think of it like a reverse cash deposit (assuming the bank has cash available). Banks have no ability to create cash out of thin air, because they do not have access to money printing facilities (like a central bank does). The bank needs to actually have that cash, and once they give it to you, they no longer have it.

The bank transfer case is more complicated. You can think of it as exchanging an IOU from bank A to a similar IOU from bank B. But how does bank A actually transfer your money to bank B?

You might imagine bank A calling bank B and saying ”Hey there, fellow bank. Carol wants to transfer $5 from her account at our bank into her account at your bank. Can you please create $5 out of thin air and add it to Carol’s account balance? I promise to delete $5 from her account here, so we don’t accidentally create money.”

You can probably imagine all sorts of problems with that approach, but I’ll describe one anyway. Suppose it’s not Carol. It’s Bill Gates, and he wants to transfer a billion dollars. Now bank B is going to be like ”Uh, what if Bill wants to withdraw his billion dollars in cash later, wouldn’t we have an obligation to deliver him a billion dollars in cash?” In a world without laws and regulation, bank A might say ”Don’t worry! We’ll just create an IOU out of thin air. The IOU says that we’ll provide you with a billion dollars in cash any time you want. That doesn’t seem like a good proposition for bank B, does it? The obvious solution is that bank A needs to provide a billion dollars in cash to bank B before the transaction can be settled.

Now, imagine a world where transactions are settled at the end of each day. Banks A and B have many customers who make many transactions every day. In order to settle the day’s worth of transactions, we need to count the net amount for the day. On some days more money is moved from bank A towards bank B, and on some days the opposite is true. But how? Are these banks going to be driving truckloads of cash between each others’ offices every single night? That doesn’t sound good.

What if you had an entity that could just hold a bunch of cash in a vault and keep accounts of how much money bank A and bank B own at any given time? This way there would be no need to drive actual trucks of cash every night. Banks could simply ask this entity to move some IOUs from one deposit account to another. We could call it… a bank of banks. No, let’s call it a central bank.

Banks can deposit their reserves at the central bank. Reserves at the central bank appear as a line item on banks’ assets. When banks need to settle transactions of their clients, they can simply make transactions of their own at the central bank. The nice thing about a central bank is that it doesn’t actually need to have all that cash in the vault. It can simply create IOUs out of thin air, and when it runs out of cash money, it can actually print more cash to cover the IOUs it has issued.

Note that a regular bank is unable to create deposits in a central bank out of thin air. Just as in the cash withdrawal case, the bank transfer from bank A to bank B can succeed only if bank A actually has deposits at the central bank (or if the bank has cash, it can deposit cash at the central bank, and then it has deposits at the central bank).

In conclusion

This article has illustrated the following facts:

• A bank deposit is merely an IOU.
• A bank loan is merely an exchange of 2 IOUs.
• Anyone can create IOUs out of thin air.
• When a customer redeems an IOU at a bank, the bank needs to hand over another form of money, and the bank has no ability to create that money out of thin air.

These facts support the main argument of this article: that banks do not have any special powers in relation to money creation. Hopefully this article has demystified money creation and demonstrated that the process is entirely pedestrian.

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