by elmads

Introduction

Have you ever wondered how money is created? Who makes the money, how does that new supply of money go to the economy and hopefully into our hands. There’s a lot of question, and a lot of complexities with it as well.

We have a lot of wants and needs, with limited resources. This is what I learned late into my life, this is the reason why I’ve been trying and learning how to prioritize. That being said, I saving money for the purpose to spend it later on the things that I really wanted was not new to me. That being said, saving money was not new to me because when I have been doing it since I was young. I saved money for the purpose of buying toys that I really wanted. I was a straightforward minded kid, I saved money to buy toys during my pre-school years then my purpose changed into saving money for me to be able to play computer games with my friends from grade-school to college. Even up to now, I save money for a specific endeavour or item that really makes me happy, while making sure that I do not sacrifice my basic necessities of life.

On the other hand, finding this passion and purpose of mine relating to finance and investing have shown me that money, in LITERAL TERMS is not limited anymore. Everyone of us can have a fair share of the said unlimited amount of physical money, unfortunately the distribution of money and its value is skewed to a few number of people in the world, this is why money seems scarce.

Despite this, in terms of its physical aspect, money can literally be unlimited now a days. Coming into this area opened my eyes into the world of finance, economics and accounting, where I did realized that money and its value are absolutely two different concepts.

Money as a physical representation of perceived value (today it’s paper and coins) that people trust to hold a universal utility that can be used as an exchange for any products and services in the market. Remove the word trust in the equation, then the value of money literally also goes away. What people trust in money is the government who makes the money itself, that they trust the government to uphold the value of the money as a means of exchange. Each currency in the world is owned by their respective governments, like the Great Britain Pounds (GBP) from the UK Government, the United States Dollars (USD) from the US Government and others more.

So, does the government have the sole responsibility for protecting the monetary value of their currency? or is there another institution who works hand in hand with the government?

The Central Bank and The Government

I’ve discussed already what is a central bank and what it does in my blog titled “The Financial System – The Central Bank”. To give you a short introduction, central banks are responsible for the monetary policy of an economy, they can create and destroy the money circulating in an economy, and increase and decrease the interest rates in order to influence spending in the economy. Their primary purpose is to stabilize market prices in an economy, which in turn mitigates the risk of any possible disastrous economic downturns, or cushion the fall if one does happen.

The government, as most of us know, consists of people that represents their citizens as a whole. They are the governing entity of a country that makes policies to support their citizens, ensure peace and justice, and govern people based on everyone’s utmost best interest.

Both Central Banks and The Government work hand in hand with the creation of money. The Central Bank can print more money, as they are the only legal entity to do so via their monetary policy, while the government receives that newly printed money and distributes it into the economy via new jobs, constructions, buildings, projects, investments and aids through their fiscal policies.

Basically, it’s the central banks who physically creates the money. The government on the other hand gets actual revenues as well from that money printing. In the US, printing a single note costs $3 in materials (the ink, machine maintenance and the paper). So when they print a $10 note, that means that they get around $7 in profit out of thin air, this is called a “seigniorage” revenue of the US government.

Maybe you’re thinking, so why not just print tons of money so that they would not need to get taxes from the people? Unfortunately it doesn’t work like that, because the money printed by a central bank is still considered debt that needs to be paid back by the government. Also, printing a lot of money can cause inflation, and when it goes out of hand it could turn into a dreadful hyperinflation.

Hyperinflation is a monetary phenomenon in which the value of money reduces rapidly, meaning the value it used to hold can no longer be the same as it was before. For instance, if you could buy $3 for a cup of coffee today, in a hyperinflationary environment, that same cup of coffee could cost around $1 million after a few years or possibly months.

I know it’s hard to believe that such things can happen, but it actually does. Look into at what happened to Argentina in 1989, Zimbabwe in 2007 and Venezuela in 2016. Their currency was obliterated, to the extent that people just used their monetary currency as a toilet paper, some made it into a hand bag, while others used it as a piece of drawing paper. Check my micro blog down below where I tackled about the Zimbabwe Hyperinflation in the 2000 decade.

“IT IS CHEAPER TO PRINT THIS ON MONEY THAN PAPER” -The Zimbabweans

Massive money printing cannot be and will never always be the answer. Some currency could sustain a lot more of money printing before runaway inflation can take place, depending if that currency has a high demand in the world exchange, like the USD. As it is the world currency, printing more of it will not immediately lead to an uncontrolled inflation, or so it seems. In today’s macro economic environment, we just need to wait and see for things to unravel by itself.

Fractional Reserve Banking

Money, both its physical and digital forms can only be minted and printed by the central banks, but there’s an exception. The creation of digital money can also be done by the commercial banks. Shocking isn’t it?

Most of us thought that the Central Bank, or as what I like to call them the “Godfather Bank”, are the only one who can make money out of thin air, but that isn’t the case.

Commercial Banks are the keeper money and intermediary of financial transactions. They finance endeavours through lending, manage wealth, act as a custodial of people’s wealth and keep safe a person’s hard earned money. These are one of the few purposes of banks in the grand scheme of things, but as the world moves forward and its economies improve, so as the need of the banks to innovate in order to increase their profits.

If you want to know the basics about what is banking and what do banks do to make money, see my blog titled “The Banking Industry – The 4 Common Types of Banks”.

Banks have different income streams, but interest income has always been their core business dating back in 13^th century Italy. Interest income is the amount of money they get from the spread difference of their Deposit Rates from their Loan Rates. For instance, if they charge 5% for Loans, while they pay 1% for deposits, that gives them a spread difference of 4% which is their interest income. A straightforward business model if you ask me. It just shows that a bank’s core purpose is to act as a third party intermediary between the lender and the borrower.

This interest income core business model of banks have two variations, the fractional reserve and the full reserve banking. Let’s talk first about the latter, as it is the easiest one to understand.

Full Reserve Banking – It is also called 100% reserve banking. When you hear or read the word “Reserve” in any banks, it just means the amount of physical money the banks have in their safety vaults. I’ll start this with a scenario for us to fully grasp what it means and does.

Scenario: Louise goes to a bank to open a deposit account with 100% reserve banking operations. He has $1,000 worth of money to deposit. Upon entering the bank, one of the employees explained to him the two different deposit accounts and how it works.

• Demand Deposit/Savings Accounts – In this account the bank will be the custodian of Louise’s money. The good side about this is that he’ll be able to withdraw or use the money on demand. Nonetheless, he won’t receive any deposit interest payment from it and he’ll need to pay the bank a fee. (The fee will vary depending on the bank, some will have an annual fee, while others will charge a fee for every withdrawal a person makes.)

• Time Deposit Accounts – In this account, Louise will be receiving an interest for his deposited capital, but it’ll be locked within a certain period of time, e.g. 1 year or 2 years. His capital will be locked because he’ll be agreeing to the contract terms. Once he agrees, the bank will then use that deposited capital to lend it to others, but don’t worry the bank will pay Louise back the whole amount he lent once the term expires.

So in full reserve banking, there’s no hocus pocus in their operations, meaning there’s no additional money created in the system. Banks who utilize this gets money through custodial fees from their demand deposits. While, they get interest income by lending the money from their time deposit account customers.

Below are the conclusions of a Full Reserve Banking, taken from EconClips.

• The demand deposit was not free. It had a fee because the bank was providing a service for the depositor: safekeeping of the money.
• There is no new money created, therefore the money dose not lose its purchasing power as a result of bank lending in full reserve system.
• As long as the banks maintain full reserves, it will always be able to redeem their customer’s demands for withdrawing their deposits. There’s no risk of insolvency in this regard. All of the customers can come in and claim their deposits with no problem.

Fractional Reserve Banking – now we move forward to the accepted dark side of banking. Why did I say accepted? well because both the government and central banks allow this. It is a complex way of banking, this method gave them the needed boost for their capital since they embraced it.

Most accounts in a fractional reserve system do not require custodian fees to hold your money into their savings accounts. They even have flexible savings accounts in which you’ll still be receiving interest in your deposit and still can withdraw the money on demand. It’s a great deal isn’t it? Absolutely! unlike the deposit accounts in a 100% full reserve banking, that we don’t get any interest in their accounts. Not to mention that we still need to pay for custodial fees. Tssk! Unfortunately, there’s no free lunch in this world.

Back to our scenario of Louise, who wants to open a deposit account into a bank, but this time around he went into a bank utilizing a fractional reserve banking.

Once the bank receives Louise’ deposit of $1,000. They can now lend 90%($900) of that deposited money to others (as approved by law), then the remaining 10%($100) will be stored into their bank reserves. That’s why its called fractional reserve, because only a portion of your deposited money will be placed into their vault as a physical reserve, while the remaining will be lent to other people.

NOTE: The one who sets the required reserve of a commercial bank in a fractional reserve banking method is the Central Bank.

The next is how the magic of money and credit creation happens; below is an oversimplified chain infographic example.

As you have seen from the slides above, there was a lot of money through credit that have been created with just the initial $1,000. When in fact the real amount of money is just worth $1,000. The rest are mostly driven by credit purchases, what’s surprising is the initial credit can also be used as a deposit by another person. This is just one example, imagine the vast majority of transactions happening every second, each day, worldwide. This is the creation of money through credit.

Take note, most banks around the world practice this banking method. That’s why monetary inflation doesn’t just happen due to the Central Bank’s money printing, but also because of the day to day fractional reserve banking method of banks through the creation of credit.

For us to grasp how much money or shall I say credit, does the fractional reserve banking makes out of thin air, we need to use a formula called the Money Multiplier, where;

Money Multiplier = 1 / Reserve Ratio

NOTE: The reserve ratio is the percentage of money that the bank is required to put in their vault. This ratio can only be changed by the Central Bank, it is one of their methods to keep in check the commercial banks. We’ll use the reserve ratio example with Louise’s scenario, which is 10%

Money Multiplier = 1/ 10%

Money Multiplier = 10

Then compute for the Money Created;

Money Created = (The initial deposit – (Initial Deposit * Reserve Ratio)) * Money Multiplier

Money Created = ($1,000 – ($1,000 * 10%)) * 10

  = ($1,000 – $100) * 10

  = $900 * 10

Money Created out of thin air= $9,000

You might be thinking why not just use the Initial Deposit instead, to directly multiply it with the Money Multiplier? the answer is because the new monies created are not due to the initial capital deposited, but through the 90% of that initial capital the bank used to lend to others. In this example it is via the initial lent $900. Hence the formula; (The initial deposit – (Initial Deposit * Reserve Ratio).

Below are the conclusions of a Fractional Reserve Banking, taken from EconClips.

• The account was free because the bank makes money off of lending deposits to other people. However, if everybody came to withdraw their deposits at the same time, the bank would be in big trouble.
• The bank earns interest on the total newly created $9,000 but the real deposit was $1,000 only. That’s crazy.
• Money itself is not real wealth, except that it allows us to purchase the goods and services we actually want. By creating a larger money supply and not a larger supply of goods and services, prices of goods and services increase and the purchasing power of all money decreases, including the “old” money that originally existed before the fractional reserve lending process.
• The lower the banking Reserve Ratio, the more the bank can lend to others. If the reserve ratio is 5% in our scenario, then $18,000 could have been created out of thin air.

The most lucrative way where banks make money and maximizes fractional reserve banking is through A lucrative way where banks make money and maximize fractional reserve banking is through Mortgage loans. Why? well we are talking about multiple thousands to millions of money being created out of thin air through credit, not to mention that banks charge interest payments on top of that imaginary credit created without even having a physical representation of money to back this up.

To put it simply, they’re saying that “I can lend you $1,000,000 of money even though I don’t have that real amount of money. Don’t worry, that imaginary amount of money is accepted worldwide because I am a trusted institution who handles money in this world. By the way! don’t forget to pay interest on that imaginary digital amount of money I gave you, okay?”

It only becomes real floating money in the economy when the person who owes them money through a mortgage loan has fully paid it already. I guess it’s really nice to make real money from imaginary money.(Sarcasm)

To sum it up

Money is created by Central Banks using their money printer with the approval of the government. Alternately, commercial banks can also procure digital money with a click of a button via their fractional reserve banking.

This is just the 1^st part of a two part series of money creation. There are a few more ways how the central banks with the commercial banks create and use money. Here’s the link for the “Money Creation Part 2”.

For some people, understanding this just sheds the light that the financial system is unfair to the uninformed. But, we also have to realize that complaining will not take us anywhere, we need to take actions based on this knowledge, and that’s through learning on how to expand and increase our sources of income, by investing and protecting our accumulated wealth over time.

Leveraging knowledge and information to our own advantage.

Knowledge is my Sword and Patience is my Shield,

elmads

This blog is for informational purposes only and not a Financial Recommendation. Not all information will be accurate. Consult an independent financial professional before making any major financial decisions.