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Why can private banks create money?

July 17, 2012
Why can private banks create money?

We at the CTF are often emailed questions about the private banks; how they are allowed to create money and inflate the money supply, why they're not required any more to hold larger reserves, and why the Bank of Canada isn't the ones controlling the entire money supply (including why the Bank of Canada doesn't just print money to pay off the National Debt from the private banks)?

So, we asked an expert to help answer a couple of questions.

 

Why can private banks create money?

Dr. Ron Kneebone, Professor of Economics at the University of Calgary answers:

 

“Money” is anything generally accepted in exchange for goods and services.  My IOU is not money because you don’t know me from Adam and so you are not willing to give me your car in exchange for a piece of paper on which I have scrawled “Ron owes Scott $12,000.”  However, Scott will give me his car in exchange for Canadian currency.  He will do so because he has faith that other people will in turn give him goods and services for the currency I give him.  Canadian currency, then, is money.

Scott will also give me his car in exchange for a cheque.  That cheque is an order that tells my bank to give Canadian currency to Scott.  My cheques, then, are also money.  Indeed, the sum of the value of everyone’s chequing accounts is the biggest part of the total money supply. Currency is actually a small part of what we know as the supply of money.

This is true for individuals too.  If I asked you the amount of money you have, you would not just count the change in your pocket and the paper currency in your wallet.  You would include the amount you have in your bank account.  You quite correctly count that as part of your personal money supply because you know that a cheque written on that account will be accepted in exchange for goods and services.

My bank knows from experience that at any point in time I will hold only a small fraction of my share of the money supply in the form of currency to make day-to-day purchases.  I will keep the great majority of it in my bank account.  Knowing this is how my bank turns a profit.

My bank carefully calculates how much of my money it needs to keep in its vault to keep me happy should I come and ask for currency.  It then offers the difference – the difference between the amount of money in my account and the amount it knows it must keep handy in case I drop by looking for currency – to other people in the form of a bank loan.  Those people must pay interest on the money they borrow and that is how the banker makes a living.  The people who borrow my money also want to leave most of it in their bank account and hold only a fraction of it as currency.  So, the bank again calculates how much currency it must keep in the vault to keep me and the next guy happy should we come looking for currency.  The rest is offered as loans to other people.

And so it goes.  In this way, the banking system puts our savings to work.  Rather than just letting our money sit in bank vaults, the banking system lends it to those who are building new houses or new factories and so are creating new jobs.

If you have been following the story, you realize that my initial deposit of currency into my bank has resulted in money being “created.”  That is, most of my initial deposit of currency was put to work as a loan to someone else who will now report they have just received money they did not have before.  I still have my money and now she has money too.  When the bank makes a second loan the third person also reports having just received money they did not have before.  Of course the second guy and I still have our money and so new money is appearing.  This is not magic.  The trick to understanding what is happening is to remember that most money is in the form of chequing accounts, not currency.  The loans being made by the banking system are creating new line entries in bank accounts, not currency.  But it is all money.

By the same process, you and I and the banking system also “destroy” money.  If I withdraw more of my money from my bank than the bank expects, it will need to find some currency to keep me happy.  It finds it by recalling loans provided to others and so frees up the amount the bank was holding in case they came looking for currency.  In this way, chequing accounts shrink and money is “destroyed.”

It is important to stress two things about this process.  First, while money is being created and destroyed by this process, no wealth is being created or destroyed.  That is, the person who takes a loan receives money but also incurs a debt of an equal amount so their net wealth is unchanged.  Second, the amount of money created depends on how much of our money we choose to hold as currency.  The more that the banker must keep in her vault to satisfy me should I come along and ask for currency, the less she has available to make loans.  The banker tries to minimize the amount of currency kept in her vault because doing so maximizes the amount she can make in loans.  Keep too little, however, and she runs the risk of not being able to satisfy my request for currency.  This causes panic amongst depositors and can cause a “run on the bank.”

The Bank of Canada lets private banks decide on the amount of currency they keep available but it also guarantees the value of bank deposits (up to $100,000 per account) to protect depositors should the banker get it wrong.  This arrangement ensures the maximum amount of our savings is put to work as loans to others.

There is no magic in any of this.  It is how the banking system puts our savings to work to create jobs.  It is one of the foundations of a successful economy.

 

Ron Kneebone is a Professor of Economics and Director of Economic & Social Policy in The School of Public Policy, both at the University of Calgary.  His research interests are mainly in the areas of the macroeconomic aspects of public finances and fiscal federalism.  His published research has dealt with issues pertaining to government budget financing in a federal state, the political economy of government deficit and debt reduction, the history of government fiscal and monetary relations in Canada and the characteristics of Canadian federal, provincial and municipal fiscal policy choices.  Professor Kneebone is a co-author of two undergraduate textbooks in economics; a best-selling economics principles text with co-authors Gregory Mankiw and Ken McKenzie and an intermediate level text with co-authors Andrew Abel, Ben Bernanke, and Dean Croushore.  For joint work with Ken McKenzie he was awarded the Doug Purvis Memorial Prize for the best published work in Canadian public policy in 1999.  From 2002-2006, Professor Kneebone was an associate editor of Canadian Public Policy, Canada's foremost journal examining economic and social policy.  An eight-time winner of a Superior Teaching Award in the Department of Economics he was also awarded the Faculty of Social Sciences Distinguished Teacher Award in 1997 and again in 2003.

By
on July 18, 2012
"The Bank of Canada lets private banks decide on the amount of currency they keep available but it also guarantees the value of bank deposits (up to $100,000 per account) to protect depositors should the banker get it wrong. This arrangement ensures the maximum amount of our savings is put to work as loans to others." Why should it matter if someone has 2 bank accounts with $100,000 each or 1 bank account with $200,000? The full amount should be guaranteed. At least 50% of the money should be available to the depositer at all times. I think that it was the Mulroney government who took away the cash reserve requirements; jerks. I seem to recall that Milton Friedman once said that there was no difference between a bank having a 0% cash reserve requirement or a 100% cash reserve requirement. How could someone who is so smart be so dumb at the same time?

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By
on July 22, 2012
While it is true that the money you receive from private banks via loans has value because we accept it as having value and have faith that it will be generally accepted for value by most canadians, we must also understand that we must work hard to repay these loan, while the bank just created them out of thin air. They did not create anything of real value, and if you default on your loan in any way, they may then seize your property and voila, they have now gained(stolen) real assets through simple accounting and book-keeping entries. But there is more....you must also pay interest on your loans, which is what the banks state is their way of making a profit from these loans. The fact is that the interest is not created. In other words, our combined loans are impossible to re-pay, which is why we must constantly create new money in order to keep up with the interest, until we inflate the dollar into oblivion. The banking system is a complete fraud and it is insane that we accept private banks to create our money when we, as a country, can create our own money interest free. It is not, as Ron states, the foundation of a successful economy, it is the foundation of the complete destruction of our economy and a method used by private banks to steal the wealth of entire nations. They have done this repeatedly throughout history to countless nations and are in the process of doing it to us. Do not be fooled by the institutionalized, feel good, everything is ok dribble of clueless "professors" who can only spoon feed you the same lies and propaganda that he learned in his banker controlled schools and universities. We must, as a nation, stand together, create a new money system, and stop using their substitute for money before our dollar becomes worthless and we lose everything. Ninz

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By
on July 23, 2012
This white washed version of reality is surprising to read on a site that is supposed to be working for Canadian taxpayers. Fractional reserve banking is just a state sanctioned crime (fraud and counterfeiting), instituted by elite financial families, with the deadly flaws and unfairness that Ninz outlines. It has to stop, either by self destruction or from the people's outrage, sadly it looks like self destruction is the most likely option at this point in time.

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By
on August 06, 2012
Dr. Ron Kneebone, Your article is not even worth debating. I wonder how you are able to look at your children in the eyes and tell them that we must be honest and always tell the truth. One would imagine with your education and experience, you can clearly understand the fraud that fractional banking represents. Simply not saying anything that may upset your masters, would allow you to keep your job. Instead you write bogus arguments trying to defend the indefensible. Your words aim to bamboozle the average person into believing it is fine to be scammed throughout history. Yes, society is much dumber than it used to be and with iphones and facebook, there is very little chance than most people would even be able to digest your meaningless diatribe. Fortunately, there are still some awaken minds that will call BS like this, just for what it is. Just for your information, if we addressed this fundamental issue, all of the other stupidities would go away. Instead we debate left, right, democrat, republican and many other meaningless circumstances that would not exist without banks creating money out of thin air, enslaving nations and us having to service a national debt. I would not want your job nor your values, no matter how much it pays, for I would have to look at myself in the mirror every morning and ask: "How I could be possible be content doing such disservice to my country and mankind?"

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By
on September 02, 2012
Wow, I am now starting to feel some real hope for the future! Judging from the comments posted here, it looks like the average Canadian Joe is starting to wake up to the fraud, eh Ron? Maybe you should work towards removing your name from lists shared with the likes of Dr. Bernanke. I doubt he will end up with many career options in the near future. If you think the banksters will care about a little Canadian professor like you (are you actually Canadian?) when they go down in flames and take the world with them, I suggest you think again. They don't care about you. All they care about is their gold and about removing the middle class now that it's served its purpose. I really love your solutions: Raise taxes and cancel program spending! Sounds an awful lot like forced austerity in Greece, Spain, and soon to be most of Europe, the USA, and then likely here as well! Gotta keep the fantasy alive for as long as possible eh? You must be fishing buddies with Mark Carney too. If only you banksters and their corporate and "educational" schills can just hold on for a few more months, so that nobody realizes that all our banks are bankrupt and our currency is worthless unless we peg it to the soon-to-be-announced new gold-backed Chinese reserve currency. Just gotta make it to October, right? Oops did I say that out loud? Oh hey, by the way, maybe in your next paper, you can explain the Banksters' reasons for not including real estate, food or oil in the basket of goods which comprises the CPI? Oh, right--it's so you can pretend the inflation rate is between 1% and 3% in Canada...so that people believe that the BoC really knows how to keep things steady, right? Good o'l Mark--a steady hand on the tiller. Is he from the Reformed Canadian Alliance Church also? Well, that probably won't be working for too much longer, even if you keep cooking the books, since people will realize that when merchants or precious metals traders no longer accept currency, it is likely because that currency has become worthless. You must be scrambling to make arrangements for yourself. Why not share some of the preparations you are making to safeguard yourself over the next couple of years? | hope you've been busy "stacking". Remember, "gold is for security, and silver is for profit!" When exactly did they turn you? Does the rest of your organization realize you're a double agent, working on behalf of the criminal banking cartel? Go back to school and get a reality education. Or maybe grow a new soul and start to tell people the truth before our country is destroyed from within by the likes of you and your evil masters. There is still time for you to do the right thing. Renounce, denounce and then re-educate. And please, leave out your "macroeconomics" textbook drivel and give people the real, simple facts. You "economists" think you're so smart. I'll never forget my econ101 professor telling me how describing economics is simply the ability to "tell a story". If only my classmates had understood what she really meant--that you can just make it up as you go, if you're a bankster holding all the information back from average joe Canadian. Knowledge is power, and you have abused yours. Shame on you. Citizen Tim

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By
on September 23, 2012
I am surprised to read the above article trying to answer the question, "Why can private banks create money?" It seams as though someone had mentioned to Dr. Ron Kneebone that the question had come from a 3rd grader. His response is insulting and apparently full of miss truths and evasive. I would like to request that he, or someone, actually answer the question truthfully. It is becoming common knowledge that if a bank creates $100 based on a reserve of $10, and requires the borrower to repay the $100 + interest, that the required interest doesn't exist. I believe that the bank has no mathematical right to charge interest for lending money.

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By
on October 12, 2012
You say; "It is important to stress two things about this process. First, while money is being created and destroyed by this process, no wealth is being created or destroyed." Really? So how do banks earn billions in profits per quarter? That's after they have bought every possible asset they can get their greedy little hands on! Still, they find the means to get government bailouts (yes, even in Canada, sheeples). Or how about the wealth of hard working people who have their life's wealth stolen by the banks when they cannot afford the minimum payment a few times? Then you say; "Second, the amount of money created depends on how much of our money we choose to hold as currency." Seriously? WTF does that mean? So the Central Bank does a sort of head count of the amount of "hard" currency out there, and does some magic bean counting to figure out how much more to print? Who's "we"? You don't consider creating bonds to support MASSIVE government debt might also have something to do with the amount of money created? I don't know if I am more disgusted with you or the CTF for calling you an expert! I know I feel sorry (and afraid) for the brain washed students that are paying top dollar to get a so-called "education" from the likes of you! I guess your co-authoring buddy Ben Bernanke has your back though, eh? Have fun laughing all the way to the bank (you have to pass by there anyways, on your way to HELL!)

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By
on November 14, 2012
SO WHY DOESNT BANK OF CANADA PAY OFF DEBT ? WHAT STOPS THIS FROM HAPPENING?

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By
on December 21, 2012
You know the country is in trouble if this guy is a Professor. As others have said here, he didn't answer the question, wrote in a tone suitable for grade school students, and generally churned out the standard twaddle intended to pacify the masses. The question was "Why can private banks create money?" The answer is: private banks can create money because the Government of Canada allows them to. The Bank of Canada, a crown corporation, could create money, but that would put money creation in the hands of the public. And successive governments prefer that money creation be in the hands of the private sector - specifically, the banks. Why would our governments prefer this? Ideology, ignorance, cowardice, and corruption, come to mind. The Canadian Taxpayers Federation should be exploring the answers to the above as well as determining how many of our tax dollars go to pay government debt service to Canada's private banks.

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By
on December 21, 2012
You really aren't advancing the conversation with your guesses and misinformed opinions. In fact, you're making things worse.

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By
on December 29, 2012
The ignorance of money creation and destruction and its effect on the macro economy by the economics profession never ceases to amaze me. As Hartly Withers, one time editor of the Economist said, "every loan creates a deposit". To suggest that deposits have anything to do with "savings" is the height of ignorance. When I purchase a good or service using a debit card, my deposit is debited by the price of the good, and the company's bank account is credited by the same amount. Goods were purchased, but total deposits remained the same. People do not have to exchange their bank deposits for cash in order to purchase a good or service. Very few transactions actually involve cash or coin. The amount of deposits has NOTHING to do with "savings". This belief is based on the old erroneous belief of previous economists who believed that banks "loan deposits" as if they take someone’s "savings" and loan it to someone else. That's not how banking works. Banks create deposits/money. When Dr. Kneebone says, "And so it goes. In this way, the banking system puts our savings to work.", he only demonstrates his ignorance on the subject. The amount of money that banks create via the process of loans to individuals or businesses is dependent on the demand for money. It has absolutely nothing to do with "savings". The amount of deposits in existence has to do with individuals or businesses demand for money. Even reserves do not directly influence a bank’s decision to create deposits as the following research from the US Federal Reserve indicates: http://www.federalreserve.gov/pubs/feds/2010/201041/201041pap.pdf The theory of “deposit expansion” taught in university courses is bunk. Money is endogenous, and the vast majority of money is credit, the majority of which is created by private commercial banks through loans. Given the fact that money is the lifeblood of the economy, and economists are completely oblivious to its creation and destruction in the real world, we should be demanding that these people be removed from government, the banks and education institutions.

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By MikeWisniewski
on April 28, 2015
I'll keep the vitriol to a minimum, but, I would like to say two things about this article. I don't believe the role of interest was as prevalent as it should have been it the article. Also, Dr. Kneebone says that a deposit "creates" money. I have to ask where the deposit's funds came from? Would it not have already been "created" prior to it being given to the depositer. My 2 cents.

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