The Truth About Money Creation: A Guide to Understanding the Role of Banks and Government in the Economy

Ayn Rand Fan Argument

Memorial Day is around the corner. And along with flags, barbecues, parades, and baseball might come a discussion of how the U.S. is going to hell in a hand-basket.

One family member who is an Ayn Rand fan and watches Fox News faithfully might start squawking about how the government is printing all this money and sinking us into a big hole. He might argue with another family member, who happens to be a fan of the New York Times columnist and Nobel Prize laureate in economics, Paul Krugman.

Overview of Krugman‘s Philosophy

Krugman has been adamant since the 2008 financial crisis that the government should be spending more money. This view stems, in part, from a belief that the government, not commercial banks, can boost the amount of cash in the economy.

Money and Banking

He is not alone. Many people see money and banking as similar to the way the field is idyllically portrayed in the movie, It’s a Wonderful Life. In the film, Jimmy Stewart’s S&L takes in deposits and lends them out to individuals in the community.

In the real world, the opposite happens. Banks create money when they make loans. That is why lending is called “credit creation.” In fact, what separates capitalism from other economic systems is that private debts created by banks circulate as new money.

For example, say a person takes out a $50,000 home equity loan. Here a bank is creating a deposit of $50,000 and crediting that person with a loan for the same amount. The customer then spends the money, and a private agreement between the bank and the customer results in new money entering the economy.

The Bank of England, the U.K.’s version of the Federal Reserve, estimates that bank deposits produce 97% of the U.K.’s money. Moreover, the loan-generating function of the private financial institutions described above provides most of those deposits.

So, I should tell my Paul Krugman-loving cousin, aunt or sister-in-law that banks make money out of thin air? Yes, and most money in the economy was created by the banks’ magic wands, not the government.

Quantitative Easing

And what if your Fox News-loving cousin, uncle or brother-in-law argues that quantitative easing (QE) is government money printing? The Federal Reserve is the government’s bank, so it can create money. It has gotten into the money creation business with quantitative easing or QE.

In capitalism before QE, the government’s role in creating new money was limited. It mostly moved around cash, funded itself by collecting taxes or selling government bonds, and then spent that money back into the economy.

Our government’s primary role was backstopping bank-produced money. That is what happened during the financial crisis in 2008. After a five-year bank money-printing binge that doubled total mortgage debt from $4 to 8 trillion, the banking system froze. Healthier banks were unwilling to honor the payments made by customers of weaker banks. The government had to decide whether to allow the more vulnerable banks to fail, which could have brought down the entire financial system, or to guarantee the bank money.

Overview of Government Role in Money Creation

So what does this mean for this made-up barbecue beef? Both combatants are right. Government spending is increasing the money supply because the Federal Reserve is printing money to buy back that debt using commercial banks’ deposit-making functions.

When the Federal Reserve buys a bond from a nonbank, the seller’s bank credits them with a deposit. The Federal Reserve then offsets that deposit by providing that bank with equal reserves. That deposit is new money, since no one’s bank account gets reduced by the amount.

These are the opinions of Financial Advisor Tim Hayes and not necessarily those of Cambridge Investment Research. They are for informational purposes only and should not be construed or acted upon as individualized investment advice.