The Money Paradox

Since starting to look into the nature of our monetary system, there its one particular argument I have heard played out time and time again:

On one side we have: “Banks can create money out of nothing. They do not need to have somebody’s savings in hand in order to make a loan”.

On the other side we have: “Banking regulations dictate that banks are only allowed to lend out a fraction of their depositors money”.

These arguments appear irreconcilable. So who is right? And how could there have been any doubt?

The reason the argument rages so often is that they are both right. The reason for this is quite subtle and not discussed at all in standard economics textbooks.

People will point out that banks can only lend out a fraction (albeit a large fraction) of money they are looking after from their depositors. And they may have to pay interest to those depositors whose money they are lending. This way banks are seen as making money from the difference between the interest they pay to whoever they got the money from and the interest they charge to whoever they lend the money to.

They point out that banks are not allowed to lend out money they don’t have.

This is where we have to examine things a bit more carefully. We need to consider how this is enforced: Let us consider those people at the bank who’s job it is to make loans. Do you imagine that they have a hotline to some other person in bank that monitors how much money the bank has on deposit on a second by second basis? Can you imagine a situation where you go into a bank, discuss a loan and then the banker says “hang on, I have just heard that we used up all our funds twenty seconds ago, can you come back tomorrow?” Of course not, the system is managed on a much more approximate basis where the loans made and the deposits taken (or money borrowed from other banks) are monitored over some period of weeks. The regulations are only concerned with these long-term averages, not what goes on, on a second by second basis.

But this attention to averages opens up an opportunity for a leak in the system: what can now happen is that banks can lend out money they don’t currently have and then in order to comply with regulations they can borrow the money from other banks at a later time. You may note however that the (created out of nothing) money lent out will end up being in another bank somewhere. Thus money can then be borrowed back by the bank that made the loan in the first place. This means that no previously existing money was required. The bank has created money out of nothing and borrowed it from a depositor!

To summarise: It is true that banks make money from the difference between what they have to pay in interest from wherever they get their money from and what they receive in interest from whoever they land money to – but because the order of events (borrow-then-lend vs. lend-then-borrow) can occur either way round, it is also true that banks can create money out of nothing.

The number of economists that are aware of this subtle phenomenon is tiny.
 

Michael Reiss is the author of What Went Wrong with Economics.

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