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Why can private banks create money?

Author: 17/07/2012

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.