Definition of money creation

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What is money creation?

Money creation is the process leading to an increase in the money supply. This money supply can be divided into 2 main categories:

- currency: This is notes and coins in circulation within a country or geographical area. It represents about 5% of the world's money supply.

- book money: This is money in the form of accounting entries. It represents 95% of the world's money supply. This money does not physically exist, it is simply lines that appear on the debit or credit side of bank accounts.

That is why banks were only afraid of one thing during the crisis, that individuals would decide to empty their accounts for fear of the bank's collapse. Panic movements alone have led to the closure of some banks, physically incapable of issuing banknotes and coins. Effectively, this money does not really exist, it is a simple accounting entry.

Money creation is permanent and is theoretically regulated by central banks. They are the ones who decide on the level of money creation they want.

The general public often has a distorted image of money creation that they associate with a "printing press". Only counterfeiters operate printing presses like in films, but despite everything, central banks and those counterfeiters do have something in common. They create money ex nihilo (out of nothing). The Nobel Prize winner in Economic Sciences, Maurice Allais, also believes that there is no difference between the money created by central banks and counterfeiters (punished by law). It is made out of nothing and leads to the same results. The only difference is that those who benefit from it are different. Something to consider!

Let us now look at the different mechanisms leading to money creation.

Money creation through the credit multiplier

A large part of money creation is carried out by commercial banks that provide credit to their customers (individuals or companies).

If a loan application is accepted by the bank, it will credit the applicant's account with the loan amount. For example, if you need €200,000 to buy your house, the bank credits your account with this amount and this amount appears as a debit on the bank's account. It advances you €200,000.

To finance your loan, the bank can use all of its collected deposits (short and long-term savings for its customers). So it uses your money, your savings to make a profit. Effectively, when a bank lends money to a client, the client has to pay an interest rate (this is quite normal). In reality, it lends money that does not belong to it (its customers’ money), that it does not own. It is just a right granted to it by the central bank. By a simple accounting entry (linked to the creation of a new loan), there is therefore money creation from a simple bank deposit.

Banks transform savings into new loans. But money creation does not end there. Effectively, the loan amount also generates new loans. This is called the deposit or credit multiplier.

Let’s look at our example again. So you receive €200,000 from your bank to buy your house. You pay either the former owner or the builder for this house. They deposit the €200,000 that you give them into their bank account at their bank. That bank then receives fresh savings that it can, in turn, lend by granting new loans. It is an endless circle of money creation.

However, there is a limit to this type of money creation due to the Basel III rules. You know, these regulations on bank solvency imposed by the authorities. These rules stipulate that a bank must have a solvency ratio of 8% (mandatory reserve rate), plus 2.5% security, i.e. 10.5%. This ratio prevents the bank from lending all the available savings from its customers.

In other words, when the bank receives €1,000 of savings from a customer, it must keep €105 (1,000 * 10.5/100) in reserve. It can therefore only lend €895. The next bank receiving the money from the credit can only lend €801. This limits the credit multiplier and therefore the creation of money.
With an initial deposit of €1,000 in a bank, money creation is theoretically around €4,500 (895 + 801, etc.), or a credit multiplier of 4.5 (4500 /1000).

The other limitation of money creation by the credit multiplier is demand. To grant new loans, there must be a need for money from the various economic actors. In times of economic crisis, these needs are reduced, due to low investor confidence in the future. For its part, the bank must also be able to find customers it considers solvent. The credit multiplier is never used at its theoretical maximum level.

Monetary creation through debt

To grant new credit (and thus generate money creation), a bank must have resources. If its customers' deposits do not allow it to grant new loans, it can turn to the central bank and borrow money from it.

In this case, the money created is truly ex nihilo. The bank credits its customer's account with the loan amount and the same amount is debited to the commercial bank's account. In parallel with this, the same bank is credited with the amount of the loan by the central bank, which debits the loan to its account.

But who finances the central bank? No one! The central bank can create as much money as it wants by a simple accounting entry and it owes nothing to anyone. This is the magic of our monetary system. This is the origin of money creation. Thereafter, it can either lend this money to commercial banks or buy treasury bills. Its objective is to inject money into the real economy to finance its development. The problem is that commercial banks do not necessarily reinvest this money into the real economy. For several years, we have seen a tightening of the rules for banks to obtain credit, yet they have excess liquidity from the central bank.

This is the perversity of the monetary system. The central bank lends to commercial banks without even knowing what they are going to do with the money. As a result, this money ends up on the financial markets. And not in the real economy!

However, the amount lent to banks is not unlimited. Every week, the central bank sets an amount that it is prepared to grant to banks (allowing it to maintain theoretical control over money creation). This amount varies according to the central bank's objectives (fighting deflation, boosting growth, etc.). The banks offering the highest interest rates to the central bank are allocated the money. With the current low rates, money is given to banks almost free of charge.

With this free money (or at a very low cost), these banks can provide loans if they wish. If new loans are granted, the money created is doubled. There is money created by the central bank and money created by commercial banks with the effect of the credit multiplier I mentioned above.

For these banks, life is good! They lend money that comes either from its customers or from the central bank. This money does not belong to them, but banks can make a significant profit from it (the interest rate on the loan). The only risk is that the loan will not be repaid. But if this is the case, the bank may seize the assets related to the loan. For example, if you can't repay the credit on your home, it seizes your home and sells it to pay off its loan. It's a great job, being a banker. They win every time.

Tools available to the central bank to regulate money creation


The reserve requirement rate

: This is the rate used for Basel III solvency ratios applied to commercial banks. It is currently 8%. It corresponds to the money that the bank must put in reserve and cannot lend when it receives funds (from the savings of its customers or the central bank). The central bank sets this rate.

To reduce the number of loans and thus money creation, it only needs to increase this rate. The effect of the credit multiplier is therefore reduced. Conversely, by lowering the rate, the central bank favours money creation.


Refinancing rate

: This is the rate at which commercial banks can refinance themselves with the central bank. The lower this rate, the more commercial banks try to borrow (money being cheaper), which increases money creation. Conversely, an increase in the refinancing rate reduces money creation. It corresponds to the key interest rate that you know.


Open market operations

: This is an operation carried out by the central bank to buy or sell government securities (treasury bills) on the interbank market. If the central bank sells securities, it recovers liquidity from commercial banks. This liquidity cannot then be used to grant new loans, which has the effect of reducing money creation. Conversely, by buying public securities (a QE operation), the central bank provides liquidity to commercial banks, thus promoting money creation through the credit multiplier effect.

All this is theory, because in the end banks do what they want, they are free to lend or not (and therefore to inject this liquidity into the real economy). Whatever they do, no one says anything. It is these banks that rule the world, that have control over money creation, inflation, growth, investment, etc. Excess liquidity only benefits financial institutions, the population (i.e. you) has only crumbs, which we are willing to give them.

I suggest a very simple idea to have greater control over money creation. It would be enough for the central bank to ask and verify for what purpose the money borrowed by the banks will be used. Why doesn't the central bank do it? The banking sector is all-powerful, it leads the world.

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