Since watching the movie, the big short, I have begun to be fascinated by how the economic system works and how it can be so wrong. After years of thinking, I plan to use a series of blog posts to share my insights of what are the issues, where we are heading to, and the potential solutions with our current monetary system.
This first post introduces how money is “printed” in our modern economy. I never work in a commercial or central bank. So, my understanding is solely based on reading papers whose authors researched it12. Surprisingly, how money is issued in the modern world is not clear to the public, and even many economic textbooks do not reflex the correct view. Thus, if you are an econ or finance student, you might also find something new in this post. As usual, I try to use simplistic language to illustrate it.
To understand how money is “printed” in the modern economy, one needs to understand the balance sheet, which summarizes the financial balance of an entity. A balance sheet has two sides: Assets and liabilities. The assets side records money or any valuable things belonging to the entity, while the liabilities side represents obligations of the entity. Furthermore, we add equity to represent the value owned by the entity to the liabilities side when there is an unbalanced mismatch between assets and liabilities.
Assume that someone has some paper money in his pocket and some deposits in his bank, and he does not have any loan; thus, his balance sheet would look like Figure 1 on the left. The items on his assets are currency and deposits, while his liabilities are solely his equity as he has no debt.
Imagine that he is now taking a loan from his bank for his future house. This action would change both sides of his balance sheet. On the assets side, he has an additional deposit in his bank when the bank grants his loan, whereas, on the liabilities side, he has a loan from his bank, which is an obligation that he needs to repay in the future. His new balance sheet would look like Figure 1 on the right.
How a commercial bank creates money from the thin air
The majority of the money is created by commercial banks when making loans1. By using the balance sheet, we can see this process. Whenever someone makes a loan from his commercial bank, he will see that his bank account is credited with a new deposit from his commercial bank and know that he has a new obligation that, in the future, he will have to settle this loan by paying the money back to his commercial bank (Figure 1 from left to right).
From the bank’s point of view, its balance sheet also changes. When the commercial bank grants the loan, the loan becomes the bank’s asset, as the bank expects the borrower to repay the loan in the future, while the borrower’s new deposit is the bank’s liability, as he can demand to withdraw his deposit, demonstrated in Figure 2 from left to right.
In this process, the money is created from thin air digitally. The borrower can consider his deposit in his banking account as his money. He can withdraw this deposit from an ATM, spend this deposit to purchase goods and services, or transfer this deposit to others.
Similarly, when the borrower repays his loan, the process is reverted, and the money disappears. Whenever the borrower uses his deposit to repay his loan, the deposit and loan disappear from the bank’s balance sheet and the individual’s, presented in Figure 2 from right to left. In practice, this process may not be symmetrical because commercial banks usually can profit from creating new money as a loan is not free: the borrower needs to repay not only the principal but also the interest.
Usually, commercial banks cannot create too much money, as there is a risk associated with it. All clients of the bank can demand to withdraw money or transfer their deposits to other banks, and if a bank creates too much money (higher leverage ratio), the client’s demands may not be satisfied. If this happens, the bank is in trouble and may need to declare bankruptcy.
How a central bank creates money from thin air (Season 1)
When a commercial bank faces a liquidity issue that it cannot satisfy demands from its client, it can borrow money from other commercial banks or directly from the central bank. Whenever a commercial bank borrows money from the central bank, the money is created from thin air, but this time, it is the central bank that “prints” them digitally.
Similar to individual borrowing, when a commercial bank borrows money from the central bank, the bank’s account in the central bank is credited with newly created money called reserve, which can be exchanged for currency in banknotes or coins. Figure 3 from left to right presents the balance sheet before and after commercial bank borrows money from the central bank.
From the central bank’s point of view, the commercial bank loan is the central bank’s asset, while the newly created reserve is the central bank’s liability. Figure 4 from left to right illustrates the changes in the central bank’s balance sheet. However, unlike the commercial bank, which needs to worry about its liabilities, the central bank does not need to worry about them, as the central bank can simply “print” money as much as it wishes in theory.
Although a central bank can create infinite money, it has consequences on the market. If a central bank creates too much money relative to the goods and services produced on the market, leading to too much money chasing too few goods and services, this will result in inflation (prices of goods and services go up). A functional central bank usually wants to control the inflation rate to an acceptable range, but history is full of failures examples.
The central bank does not set the money supply target directly but by controlling interest rates indirectly. The central bank would set up an interest rate target and control the money supply to achieve the interest rate target. If the central bank wants to decrease the interest rate, the central bank can then offer loans to commercial banks lower than the current market interest rate. By injecting more money into the market, more money supply is chasing fewer loan demands; thus, the market interest rate decreases. If the central bank wants to increase the interest rate, it can sell its loans on the market in exchange for the money the central bank created before. By withdrawing money from the market, more loan demands are chasing less money supply; thus, the market interest rate goes up.
The money created by the commercial bank and the central bank is different. While an individual can spend money created by the commercial bank (It is digital money in the form of a deposit in its commercial bank), a commercial bank can only use money created by the central bank to settle the transactions with other commercial banks or the central bank (as the money created by the commercial bank is just a digital number in its database). The money created by the central bank is called base money, whereas the money created by the commercial bank is named broad money.
How a central bank creates money from thin air (Season 2)
After the financial crisis of 2007-2008, the above method is not powerful enough to provide enough base money for the market. The central bank began using a more radical method to inject base money into the system by directly purchasing assets from the market, a process called Quantitative Easing (QE).
The central bank can purchase assets, such as government debts, company stocks, mortgages, etc., by creating new reserves. Figure 5 from left to right demonstrates this process. The money would eventually end up in commercial banks’ assets, reducing the risk of the commercial bank (reducing the leverage ratio), as it now has more base money for its settlement with other commercial banks and the central bank.
By QE, the central bank can reduce the interest rate to 0% or even negative (commercial banks need to pay for keeping their reserve in the central bank accounts) by injecting an incredible amount of base money into the market. This radical policy helped to save our economy after the financial crisis.
However, if the central bank abuses the QE by injecting too much money into the market, the prices of goods and services will increase (inflation). If the central banks want to reduce inflation, it needs to intervene by decreasing the amount of money. The central bank can then sell its purchased assets to the market in exchange for the base money it created before, thus reducing the bank’s balance sheet and withdrawing money from the market, a process called Quantitative Tightening (QT). Figure 5, from right to left, demonstrates this process.
What is wrong with our monetary system? Debt-based money
The above process is how money is created in the modern economy. What’s wrong with this system? Let’s look at the trend of the dollar’s base money supply. We can observe that the FED (Central Bank of the USA) needs to inject more base money into the market constantly, and if there are financial crises, the injections are even more tremendous. Why?
One of the reasons is due to money creation. Whenever money is created, the system also creates its by-product, liability, in the form of debt. Any entity has an obligation to repay the debt with interest. However, whenever a debt is settled, the money and the principal of the debt are canceled out in the balance sheet (money is essentially an IOU, and it disappears when the debt is repaid), but not its interest. Since fiat money is only legal tender to settle the debt, the interest payment needs future money to repay, and the process of creating the future money induces more interest needed to repay, which requires even more money to settle the debt in the future, resulting in even more interests needed to repay. This process goes forever and must go forever.
Money is not wealth
From an individual point of view, money is wealth you can directly spend. However, from an entire system point of view, money is not wealth. When we sum up the balance sheets of all the entities in the system, the money we created is canceled with the principal of debt, but not the interests; thus, the money we have today, in fact, creates the negative net value of wealth for our society.
But then, how is overall wealth created? In this series’s next blog post, we will explore it.