How Money is Created
Origins of money in the modern world
Where does money originate from? Where does the cycle of money begin? How is money created? This is a simplified explanation of how money is created.
First, there are a few terms you must understand:
1. Global Reserve Currency. It is the currency used to settle all international transactions. This is the US dollar. All global trade takes place using the US dollar.
2. Central Bank. This is a bank created to be the bank for commercial banks within a country or economic zone. For example, we have the Bank of Japan (BOJ), People's Bank of China (PBOC), Central Bank of Nigeria (CBN), Bank of England (BOE), European Central Bank (ECB), etc. Each central bank controls the issuance of currency in the region they operate in.
3. The Federal Reserve Bank of America (also known as The Fed). This is the central bank of the USA.
4. Treasury or Finance Ministry. This is the arm of a national government that deals with government spending and government revenue.
5. Bonds. These are legally binding notes issued by a government or corporate entity to raise money. The note entitles the recipient to repayment with interest. In other words, bonds are debt obligations (of the issuer).
To really understand how money is created, you need to understand how "normal" banking works.
How Banking Works
Most people think that when they keep money in banks, the banks take their money and lend it out to someone else at an interest. So, let's say you keep 10,000 in the bank. The bank lends 5,000 out to a businessman at 10% interest and then pays you (the depositor) 5%. So the 5% margin is the gain of the bank.
This is still how most people think banks operate. But that is very far from the reality today. I am still learning some of the details of this and it is a serious reality check.
The way banks operate is much closer to this illustration...
If you deposit 10,000 in a bank, the banks can lend out 100,000 based on your deposit. Let's say they lend it out at 5%. And the 5% is compound interest, not simple interest monthly. Meanwhile, you get the same 5% on your 10,000 (not 100,000) compound interest yearly.
After a whole year, you have a total of 10,500. Meanwhile, banks (on your money) have made a total of 105,116.194. They made 5,116 extra and you got 500 extra. So, that is a profit of 4,616 for the bank. All that on your 10,000.
This is where it gets trickier. They declare all 105,116.194 as revenue. Meanwhile, you can recall that the actual money they got was 10,000. This means that 90,000 was created from thin air.
This is how money is created.
Meanwhile, if they lose big and there are massive defaults, the central bank gets to bail them out by giving them customer deposits back (getting them to start all over to do the same things again).
Of course, this is generalized for easy understanding, but this is pretty much the system. And oh, as of 2020, banks (in America) do not need a reserve to lend money. This means that a bank can lend as far as they wish without being constrained by how much in deposits they have.
The Ripple Effect
From our previous example, remember that the bank gave out a 100,000 loan. Well, that loan will go into another bank account. And the bank can then issue out a 1 million loan based on the 100,000 sitting in their account.
Yes, people withdraw and deposit. But it evens out in the sense that the amount of money that sits in a bank doesn't change much. People need banks to transact. And with credit cards and cashless transactions, withdrawals are being discouraged.
So, if you never have to withdraw, the banks can just keep the entire money supply in their system and keep making more based on what they already have. This is how money gets created.
If the banks mess up and can't balance the books anymore, the central bank comes in to clean the mess. And they do it at the expense of taxpayers.
Where Treasury Comes In
A country spends money on government programs, aid packages and other government-run institutions. The country makes money from taxes, tariffs, and government-run businesses.
In 2008, when the US government bailed out Wall Street, the US Congress only approved a huge amount to "stabilize" the economy. The US government didn't have savings anywhere they can rely on.
What happened was that when Congress approved the money, the Fed (which is the central bank of America) took all those loan losses out of the balance sheet of the banks into their balance sheet. And gave the banks new money.
Also, it is not like the Fed has savings. Instead, the central bank has the authority to issue money. In the past, you still need paper and ink. So, to create a $100 note, you would need to spend 15 cents. Nowadays, it is just digital. No cost - just numbers on a computer screen.
The Fed gave the banks money and took their debts. The same thing happened in 2020. The US Congress just has to approve, then the Treasury will create bonds (which is basically a legally binding note that the US will pay back the amount stated on the bond with interest).
This bond by the Treasury will be auctioned. But most of them are bought by the Fed, Wealth funds, pension funds, other countries, etc. Most of these buyers of bonds are the ultra-wealthy who have amassed wealth one way or another and want to keep their money intact while still earning interest on it.
The interesting fact to note here is that the government of every country has to borrow money. Governments do not create money, banks do. And banks operate for profit, not in the interest of anybody. Let that sink in.
How is money created? Three basic ways;
1. Money is created when banks lend out money
2. Money is created when central banks bailout banks
3. Money is created when governments borrow money by creating bonds
Share this knowledge with someone today. The government of your country does not create your country's money. Even the government has to borrow.
Stay wise. Stay rich.