I've just read Money Creation in the Modern Economy, an article published by the Bank of England. I'm trying to wrap my head around this from multiple points of view, since it brings about a lot of questions in my mind. This article talks about money being created through commercial bank loans, and that central banks only have the authority to set interest rates or to employ quantitative easing in order to stimulate the economy. Loans being repaid should theoretically destroy the money that was created and balance the books, but inflation grows in that economy as banks earn interest (and in this case, the interest is actually the money that never existed, assuming that they destroy the rest of the money paid back).

So, my questions are:

  1. How is this fair for every other constituent in the economy who has earned money the hard way, by working and not by generating it so freely like interest returns on loans do for commercial banks? How is inflation fair, as populations increase and every time someone gets a bank loan, new money is added to the economy over time as they pay back that loan, and everyone else's currency is de-valuated? Consider country X which has one constituent named Roger who works at a commercial bank in X and, coincidentally is also the president of X. He gets a loan from his bank for 100 dollars (with an interest rate of 5%), however, in his economy, only 100 dollars of money exists as actual currency and he has 0 dollars in his bank account. He will never be able to pay off his interest rate of 5% without getting another loan. His bank or state will coincidentally not be able to pay him his wage over time without printing new money from a central bank or giving his bank a loan, or, perhaps a bail-out. All this interest will do is inflate the economy, and you can only fight interest with interest. Now apply this concept to our current economic system on a macro level, and you'll see that it will ultimately fail as a system, because inflation can only combat inflation for so long.

  2. How is this all regulated and who regulates the balancing of the books? Given how many commercial banks there are, how few central banks there are, and the lack of power of central banks to only be able to set interest rates or buy assets through quantitative easing, this must require a lot of regulation in order to be feasible. What's stopping a commercial bank from making a deposit into someone's bank account that isn't on the books or what's stopping them from not destroying the money they get paid back from loans?

  3. How does this make sense on a global scale? You have X number of countries employing the same mechanism, each one with Y number of commercial banks. These countries each compete on a commercial scale to increase the value of their currency, and yet each is inflating their own economy which in turn drives down their monetary value on a global scale. If your economy inflates very quickly, and constituents of your country don't spend their money locally for whatever political reasons (such as the state for example owning every property in the country, even if purchased by a constituent), people can leave your country quickly and the foreign state they go to will suffer further by more increased inflation when these people convert all of their money over to the new currency since they haven't spent it locally for it to have shifted its value on a global exchange rate scale.

  4. How does this make sense from the point of view of sustainability? Already, this article states that 97% of money exists as bank deposits and only 3% as actual cash. That's a staggering amount, and it makes me worried. Given my points above, we have not just one state to worry about, but all other states driving inflation on a global scale which can directly impact ours. Given the concept of currency as it works now, everything will soon be valued too high to be acquired without more, and more inflation, but the more inflation we have, the less sustainable the system is because we ultimately just end up needing more inflation to compensate for it to buy the things we need. Thus, the money we earn working is slowly worth less, things cost more, and even through quantitative easing, there are no guarantees that money will trickle down enough to stop the debt spiral.

  5. If you give someone a loan, they use it to buy something, and then repay their loan, the next person gets a loan to buy that thing from them, and eventually repays their loan. Its as if the things we buy keep exchanging hands as they become valued higher and higher because populations increase and more money is given out and in circulation. The real winners are the people who bought the thing first, who had the asset first. Does this not strike anyone else as crazy? This means that we are destroying the world for our kids who are growing up in completely unsustainable times as the value of everything will approach infinity.

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    $\begingroup$ I'm quite glad this question has been asked. Firstly that BoE report is very good, and secondly, I think it would be good to give a comprehensive, but simple answer to the fractional reserve skeptic crowd. $\endgroup$
    – dwjohnston
    Jun 2 '15 at 3:42
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    $\begingroup$ Meta here: meta.economics.stackexchange.com/questions/1354/… $\endgroup$
    – dwjohnston
    Jun 2 '15 at 4:02
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    $\begingroup$ I agree with @dismalscience: These are 5 (good) questions which can only be answered as different questions, so I suggest you split them up. $\endgroup$ Jun 2 '15 at 8:57
  • $\begingroup$ Agreed, the interest rate question on its own is worth asking - there's a lot of misunderstanding around this area. $\endgroup$
    – Lumi
    Jun 2 '15 at 15:46
  • $\begingroup$ I'm breaking them up now into separate questions. Thanks for the help, guys. You are right, there will be higher quality answers to all of these separately. Unfortunately, I can only post every 5 minutes. $\endgroup$
    – Alexandru
    Jun 2 '15 at 21:50

I'll answer the first question.

How is this fair for every other constituent in the economy who has earned money the hard way, by working and not by generating it so freely like interest returns on this free money do for commercial banks?

Remember that commercial banks don't create money from nothing at all. When they create a loan, they also create a liability for themselves.

So if Bank A creates a loan of $1000 to Bob, and Bob spends that money at Charlie's store, then absconds without paying the loan back, then Bank A is still required to give money to Charlie.

The bank's 'work' then, is assessing the risk of, and bearing the responsibility for making loans.

Now of course, as the Global Financial Crisis demonstrated, the banks haven't always really taken responsibility for their loans, and required a bail out.

  • $\begingroup$ I've modified my question a bit on point 1 because the wording didn't quite express what I wanted to say. The interest rate which is set by the central bank is incurred by commercial banks, and can only be re-paid by more loans, and this generates free money for them, plus financial inflation of the system as a whole. So, basically when financial crisis happens, the central bank sets the rate close to 0% to try and stop inflation as a whole in order to increase the value of their economy on a global scale. I'm very skeptical about how this can all be regulated. There's many commercial banks. $\endgroup$
    – Alexandru
    Jun 2 '15 at 13:13
  • $\begingroup$ Wait, if Bank A creates a loan of $1000, who do they have to pay back, if they just created it? $\endgroup$
    – PyRulez
    Feb 29 '16 at 0:54
  • $\begingroup$ @PyRulez They have to honor the payment that Bob made. ie. in this case they need to give the money to Charlie. $\endgroup$
    – dwjohnston
    Feb 29 '16 at 1:37
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    $\begingroup$ @Mustang - The work is evaluating the risk of each loan. The bank has to eat any bad debts. $\endgroup$
    – dwjohnston
    Feb 29 '16 at 1:45
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    $\begingroup$ @Mustang Yes the 'socialised risk, privatised profit' is a pretty legitimate criticism of our banking system IMO. But I hope my answer puts to rest the idea that 'Banks create risk free money from thin air', with that caveat about bailouts. $\endgroup$
    – dwjohnston
    Feb 29 '16 at 1:48

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