I've been reading on money creation. Bank loans are often cited as a mechanism of money creation: working based on fractional reserves, banks issue loans to the public based on deposits, thereby "creating" money.

However, those loans must be paid back eventually. Further, the bank demands interest on the loan, and must pay the depositors interest, too. Therefore, once fully settled, the interested paid means that more money has been removed from the system than added. In a sense, all of these operations are "conservative": if the banks stopped issuing loans, eventually loaned dollars would need to return to the bank and be obliterated.

Barring the banks making loans monotonically-increasing size over time, I don't see how this durably increases the amount of money available to the economy. I can see how someone conspiracy-minded might conclude "it's all a ponzi!" but I'm sure there's more to the story than that.

Can anyone help me understand what causes durable money creation? Stuff that won't eventually be settled out of existence?


1 Answer 1


First let me correct your misconception.

Paying interest does not remove money from economy. Money does not cease to exist when it returns to bank as interest only when principal is repayed. The reason why repaying loans destroy money is as follows:

When \$1000 loan is issued two (accounting) accounts are created, bank records \$1000 (asset - the loan), and \$1000 deposit (and deposits are considered by economists to be part of M2 money supply e.g. see Blanchard Macroeconomics).

When loan is repaid, a person transfers money from their deposit to bank. That destroys the \$1000 deposit and the \$1000 asset hence destroying money.

When interest on that loan is payed to bank, that interest goes on bank's own deposit account, or becomes recorded as cash (against profit temporary account) so the interest always counts as a money. It is just transfer from your consumer deposit to bank's business deposit but both deposits are part of M2 money supply.

It does not even remove money from a circulation, since banks don't just charge interest because they wan't to collect money in some vault for 'shits and giggles', the money they earn from interest is first used to pay all wages and other expenses and then leftover profit is used to expand business or paid as dividend to owners who then spend it in one way or another.

Hence this isn't some conspiracy or Ponzi scheme anything like that. Repaying debt destroys exactly the same amount of money issuing debt creates.

Can anyone help me understand what causes durable money creation? Stuff that won't eventually be settled out of existence?

This can be done only when:

  • Debt is forgiven, then the loan on bank/central bank balance sheet is shredded but the deposit of whoever took the loan stays.

  • base money is created. Either money is printed (in most countries by central bank in US, its technically by treasury but on orders from Fed). Theoretically it could also be created by central bank creating electronically new reserves and just depositing them on accounts of governments or individuals but this is not done by any major central bank.

In these cases money simply won't be settled out of existence. Technically, the money created above could be destroyed if either government taxes it and then deletes it or if individual destroys the cash, but the former is unlikely as governments usually spend more than they raise through taxes, and the latter is crime in most countries.


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