The Power of Money

Commercial banks create new money when they advance loans.

In a modern economy, all money begins life in one of three ways: via commercial bank lending, government deficits and central bank open-market purchases. In normal times, most of the annual growth in money, which a growing economy requires, comes from commercial banks creating loans. The old-fashioned textbook model is that commercial banks attract people’s savings and then lend these funds to borrowers.

The reality is that banks don’t need deposits on their balance sheets before they can make a loan. Specific capital adequacy or reserve requirement regulations might constrain their lending, as will the judgment of their management as to their loans’ profitability and risks. Banks make loans based on these and other factors, and then the funds from those loans to individuals and businesses inevitably find their way back into the national banking system. This is because whatever the borrower spends the borrowed money on, someone else gets a payment to put in their bank account. In this way new loans create their own deposits for bank balance sheets. This ability...