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> So let’s look at a dollar traveling through the system. The Fed decides that $1, yes one more dollar, needs to be added to the economy and then everything will be dandy. The Fed purchases a Treasury bill from Bank X for $1, putting $1 on the deposit side of X’s ledger (remember, no physical currency is involved here). Bank X, subject to a 10% reserve requirement, is then free to lend out, that is create deposits, representing up to $10. The Fed “created” $1 but the commercial bank, X, “created” $9.

I'm confused. This seems to imply that commercial banks can magically credit their customers with $10 just because they happen to have $1.

I'm not able to do that. If I want someone else to have $10, I have to hand or wire them $10 in currency.

Do commercial banks really get to do this?

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Yes! As an example, if you borrow money from a bank to buy a house: - the bank literally creates that money out of thin air to pay for the house. - that is new money, and therefore the total money supply (of your entire currency) is increased. - when you you make a mortgage payment, you are decreasing the total money supply.

All modern economies are built of this system.

To make things weirder, you need to repay to the bank more money than they lent you. If everybody wanted to repay their mortgages at once, there would not be enough money available to do this, without more money being created. (At least, I think that's how it works -- it's super confusing!)

If a bank wants 'someone else' to have $10, such as a customer at an ATM or a different bank, they indeed must hand them literal cash or 'wire' them $10 of reserves.

Banks, through 'loans', don't create cash or reserves, they create local bank deposits. One flows freely around, the other is confined to a particular institution.

You are able to do almost exactly what a bank does: My holding a $50 IOU issued by you is like having a $50 balance in a chequing account. The only way I can 'transfer' that to someone else is either (1) having you give me literal cash that I can give them, or (2) forfeiting my IOU and having you generate one for someone else.

(1) Works because cash is universally accepted. (2) Only works when the other party is part of your IOU club. Translated to the world of banking: they are a member of the same bank!

I think I get it now. The bank is able to "create" money because it is, in some sense, the sovereign issuer of its own internal "IOU" currency. It makes IOUs (deposit records) to track who has the right to draw currency from it, and it can create as many of these IOUs as it wants for any reason. And if you classify bank deposits as money, these IOUs count as money.

You've got it. They certainly don't create these IOUs for -any- reason (I'd wager there's legislation that strictly governs this.) In practice deposits (customer assets/bank liabilities) are created simultaneous to the customer handing over an asset of equal value: their promise to pay down the debt, such that the books balance.

A side note to think about: Although the memes might have you believe that 'money' is being 'printed' by the bank, in actuality the true creation is happening on the side of the customer whom, from nothing, manifests an asset into the world: their promise to pay. Intentional or otherwise the system obfuscates this fact.

Thank you, this is great. I am still a bit mystified for murky reasons I may be able to articulate better later... but feel much closer to understanding this than before :)

The point is not that the bank magically credits someone with $10. The $10 figure is arrived at after a series of infinitely recursive loans and deposits.

If you deposit $10, you still have $10, it's just in a bank account. If the bank then lends out $9 of that and hands it to them, that person now has $9, and you still have $10 (in your account). Presto, now there's $19 of money available. Of course if you both want to spend your money at the same time, then the bank will have to go back to the fed and say oops! we're illiquid and need to borrow $9. And the fed will say, ugh, you should manage your capital better but here's a loan for $9.

The same process that's occurred here can be done recursively, i.e. the person who borrowed $9 can deposit it in another bank, who then loans out $8.10, and so on...

This works out such that for every real dollar d, the total money supply is (d / r), where r is the reserve requirement, in this case, 10%.

No the $10 is indeed 'magically' credited in one step. There is no recursion required.

It is a byproduct of how money works you can check a sample here:

https://www.investopedia.com/terms/m/multipliereffect.asp

Basically, up to 0.9 dollar is lent to customer 1 with 0.10 in reserve who deposits in bank 2 .. who lends up to 0.81 to customer 2.. who deposits in bank….

So you end up with the “same” dollar being reused across the whole monetary system multiple times…

That makes sense and is what I'm familiar with.

I'm wondering if the author's explanation is just bad and I should stop trying to make sense of it.

They both are saying the same thing.

Makes sense but is completely wrong. A bank can credit customers with any size deposits at any time, though in reality they will only do so with an equal sized debit, and within the confines of regulation.

I get all of this at some level, but the piece I don’t understand is - where does the Treasury bill come from? Does the bank use its customers’ cash to purchase government securities, and then the Fed buys the government securities from the bank? It doesn’t seem like that step would be necessary (why can’t the bank just create money based on deposited assets and applicable reserve requirements?), so I assume I’m not thinking about this the right way.

I deposit $100K in my account. The bank keeps $10K of it in its vault, and loans out $90K to you. You deposit the $90K in your account, and the bank keeps $9K and loans out $81K. Keep doing this over and over again, and ultimately the bank has close to $100K in its vault but all of us put together have $1M in spending money (numbers all inaccurate, but gets the point across).

So every dollar the fed creates out of thin air turns into $10 circulating through the economy because of fractional reserve banking.

That’s not how it works, if you are the first ever client in the bank and deposit $100k the bank can go ahead an lend out $1m.

The bank only has 100k though. They can’t loan out 1m because they don’t have 1m to give out.

That's the whole point, they just create $1m and give it out

What happens when the person withdraws the million dollars? The bank only has 100k.

Are you talking about physical paper currency? That’s totally a different issue. What happens if the original depositor deposited via a bank wire and you want to loan out $100 dollars in paper money? You just get some paper money from the FED. Same thing here.

> I'm not able to do that. If I want someone else to have $10, I have to hand or wire them $10 in currency.

Sure you can, just write a post dated cheque, or any other sort of IOU. Whoever you give the cheque to can use it like money by endorsing it to somebody else. As long as you're trustworthy that cheque or IOU can circulate as money.

> As long as you're trustworthy

As long as I'm trustworthy and always have an actual $10 to back the IOU. Which the bank does not have to have, according to this article.

It's a post dated cheque. Usually those are written because you explicitly don't have $10 today, but expect to in the future.

In other words, exactly like the bank. They don't have $10 today, but expect to be able to produce it on demand because of the staggered nature of withdrawals.

Yeah, I think I get it now, thank you.

I just wish the article would point out that bank deposits aren't the same as currency and are more like IOUs or post-dated checks.

I understand how it can be useful to call both currency and bank deposits money, but they're still different in some very important ways. If I give my friend a trillion dollar IOU, that's very different from (1) the government printing a trillion dollars in currency and writing people checks with it, (2) the central bank crediting a commercial bank with a trillion dollar deposit.

Actually I'm a little unsure what to think about the second one. Illuminating that one could help us get to the heart of the matter.

Because they have deposits from 10 other customers from which they where allowed to lend only $9/10. The new dolar they get, allows them to lend the 10th dollar from each and still comply with the 10% reserve.

Yes. This is how banking has always worked, even before central banks. Being part of a central banking system basically just means that the liabilities (i.e. deposits) created by all the member banks are fungible.

But this can't be done with physical currency. If I have to make loans in physical currency, I can't magically loan out $10 the moment I receive $1. I literally do not have the money to do this.

Wasn't there ever a time when banking was done with physical currency? How did it work before electronic banking?

The bank would issue IOUs (bank notes/promisory notes etc) that were redeemable 1-to-1 to the physical currency.

IOUs i.e. paper money. Transacting in hard currency is tedious and dangerous. A trustworthy bank is an absolutely essential component of anything beyond village-scale commerce.

"Fractional reserve banking" is the thing to look up but, yes.

But you can have fractional reserves without the ability to magically credit to customers more real dollars than you have.

If I take my customers' deposits and loan out 90% of the currency they gave me to other people, that's fractional reserve banking too.

At the beginning the author explicitly tells us that this "Wonderful Life" depiction of banking is NOT what actually happens. And then he seems to imply that, actually, banks just get to magically credit borrowers with 10x the deposits their customers give them.

The author is right, commercial banks create money out of thin air https://www.bankofengland.co.uk/knowledgebank/how-is-money-c...

Banks requirement is that they have 10% of assets on hand at any moment. So if you, or the federal reserve gives them a dollar, that means they can create a record of 9 dollars owed to other parties without being over levered. Remember that's what is being done here, numbers in ledgers are increased but nobody has to send a brinks truck to move pieces of paper or bullion.

You have to use 2nd order thinking.

I give you $10. You lend $9 to Joe. Joe takes that money and deposits it in your bank. So, now you have $19 in your bank. You lend Sally $8.1 of the $9 that Joe gave you. Sally deposits the $8.1 in your bank. Your bank now has $27 in deposits. Continue until you've basically got 10x what you originally had in deposits.

This is not how it works in reality. $10 of new deposits can be created in a single fell swoop.

Economics textbooks used to explain it that way, with a "money multiplier". That is, in the limit, if you keep lending 90% of each deposit then you'll 10x the money supply.

The reality is that banks don't "shuffle around" dollars like this, they just make accounting entries in ledgers. The vast majority of transactions are between member banks, and they just use FedWire or whatever to securely move the numbers from one bank's ledger to another. If the bank needs "cash" (i.e. the numbers in the ledger are too low) because there happens to be more outflows than inflows on a particular day they just lend assets overnight or whatever.

I think much confusion comes from association with the word 'loan'. In reality, a bank 'loan' is actually an extension of credit.

You are indeed 'magically' credited, in an instant, with say $100 of new deposits which is a liability to the bank. Simultaneously the bank gains an asset: your signed promise to pay that $100 or otherwise forfeit equivalent collateral.

A key point here is that this new 'magical' deposit is not the same stuff as cash or reserves. It is confined to that particular institution. Nothing that is being 'magically' created can escape the bank. Only cash and reserves can do that.

Ok, but if the credit is say a mortgage for a property being bought, the seller still receives the money in full, no? I guess the idea that they fully cash it out is unlikely and so that scenario would indeed come from the reserve - and otherwise if they just deposit it, even if at another bank, then it's just updating some ledgers around (i.e. the ledgers of the two banks with each other)?

The only ledger that two different banks share is the ledger of reserves at the central bank. The bank deposit that is created through the mortgage process has no means of escaping the buyer's bank and into the seller's account -- it's an artifact of the contract between the buyer and their bank. The seller's account grows only in response to a bank-to-bank transfer of reserves or a huge cash withdrawal and deposit (which are essentially similar.)

> "Fractional reserve banking" is the thing to look up but, yes.

No, it is not. Relending customers' money hasn't been a thing for decades. Tobin called this the "Old View" in 1963:

* https://cowles.yale.edu/sites/default/files/files/pub/d01/d0...

> Business schools teach that banks obtain deposits and then leverage those deposits ten times or so. This is why we call the modern banking system a fractional reserve banking system. Banks supposedly lend a portion of their reserves. There’s just one problem here: banks are never reserve constrained. Banks are always capital constrained. This can best be seen in countries such as Canada, which has no reserve requirements. Reserves are used for two purposes—to settle payments in the interbank market and to meet the Fed’s reserve requirements. Aside from this, reserves have little impact on the day-to-day lending operations of banks in the United States.

* https://www.pragcap.com/the-basics-of-banking/

> The role of reserves and money in macroeconomics has a long history. Simple textbook treatments of the money multiplier give the quantity of bank reserves a causal role in determining the quantity of money and bank lending and thus the transmission mechanism of monetary policy. This role results from the assumptions that reserve requirements generate a direct and tight linkage between money and reserves and that the central bank controls the money supply by adjusting the quantity of reserves through open market operations. Using data from recent decades, we have demonstrated that this simple textbook link is implausible in the United States for a number of reasons.

* https://www.federalreserve.gov/pubs/feds/2010/201041/201041p...

This is a very good point, and it really points to the changing role of banks over the ~500 year history of modern global-industrial society. Economics textbooks have not done a good job of staying current.

Yes, and in other countries, such as Australia, the fractional part of this has been abolished - eg, banks in Australia don't have to keep 10% in their vaults.

>> Bank X, subject to a 10% reserve requirement, is then free to lend out, that is create deposits, representing up to $10. The Fed “created” $1 but the commercial bank, X, “created” $9.

> I'm confused. This seems to imply that commercial banks can magically credit their customers with $10 just because they happen to have $1.

Nope, it's actually incorrect: commercial banks can magically credit their customers with $10 even if they have $0 dollars. Canada (amongst many others) does not have reserve requirements:

* https://en.wikipedia.org/wiki/Reserve_requirement#Canada

* https://www.pragcap.com/the-basics-of-banking/

* https://www.federalreserve.gov/pubs/feds/2010/201041/201041p...

See Cullen Roche's 2011 paper "Understanding the Modern Monetary System":

* https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1905625

Interview:

* https://rationalreminder.ca/podcast/132

See also the Bank of England's 2014 paper, "Money creation in the modern economy":

* https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/m...

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