Saturday, June 9, 2012

Do banks create money out of thin air?

How do banks create money

When I go to a bank to take a loan, where does the bank have the money from?

Do they lend me someone else’s money? Do they create it? Do they get it from the Fed/Bank of England?

No. Many people, thinking of money as of something with inherent value, have problems with thinking that banks simply create money “out of thin air”. However, with our definition of money as contracts for labour (, then it is very easy to see what is happening.

The magic happens here

When I walk into a bank, I take a loan and I sign a piece of paper pledging part of my labour to the bank. I am creating contracts for labour with the bank’s help – and the bank can give me money/bearer contracts now in exchange, because they know that I will work for them to cover those contracts.

So it is I, the guy who will do the labour, that creates the money out of thin air, by declaring that I exist and that I can back the labour contract that I sign with my labour. What the bank creates from thin air is the printouts of the contracts for labour, once as the loan agreement, which then promptly exchanges for bearer contracts emitted by the government (the dollar bills).

The accounting mechanics of it are explained very well here:

So what do we carry in our pocket? or on our credit card?

The money that everyone thinks as money are just the contracts printed on something. Now it is paper, albeit quite expensive paper.

They used to be printed on silver, on gold, on cowrie shells, on knots in pieces of string. In closer times, the futures contracts are printed on expensive paper, with expensive inks. And lately they exist on the encrypted computers sitting behind our credit cards.

The fact that silver and gold are good metals which make nice jewelry, somehow we came to think that the printing support has some value in itself. Well, it does not - as the Spanish have discovered when returning with too many galleons loaded with gold from the New World. Inflation still bit them!

All this was also analysed in a very good way and with better words than mine by A. Mitchell Innes here:

A. Mitchell Innes is a genius, way above the other money philosophers. Albeit he did not make the mental jump from money to contracts in the above paper, he remains one of the best.

Does it matter what the contract is printed on? Well, as with any contract, not really...

Did money exist before they were printed on something? Well, yes - verbal contracts are still contracts - but they were valid in small communities only. And if you were owed some future work by a few of your neighbours, and the tribe over the mountain came and killed your neighbours, your (verbal) money was gone...

Most people think that barter preceded money.  Lately, a few started to see that the so-called "gift economies" preceded money. Barter was just a way to trade, was not money - maybe through a roundabout way. And the "gift economy" is just the "verbal" stage of contract printing.

People equate the birth of money with the birth of solid support for the contracts.

The metals were indeed good as a device of contract recording, for their durability and relative resistance to forgery.

So commodity money? no, commodity money never existed - just money printed on commodity - gold etc.

What is money

What is money? 

Money is a bearer contract for labour, contract that can be enforced only within the same jurisdiction that governs that pool of labour.

The story so far:

We have been using money for a good few millennia, and we have so far failed to find a good definition of it. Most of us think of money as something with inherent value, and this is a great trap.

I have read somewhere that the greatest failure of humanity is the failure to really understand the exponential curve. Surely the failure to understand money and the way it works must be number two. :)

Yes, I have read Adam Smith, and the Money Illusion, and Benjamin Franklin and Karl Marx.

A. Mitchell Innes is the one that gets closest to it.  ( Although he has not made the jump to the final conclusion and definition, his analysis is spot on. Respect!

Closer to our times, Modern Monetary Theory (MMT) and its similar splinter groups have explained how the money flows around the system very well (
- and they are about the only ones who got it correctly. They understand what money is, in their bones, but without a formal definition.  As a result, MMT has a Public Relations (PR) problem: it talks about money in its own terms, and people at large think about money in their terms.

So here it goes again:

Definition of money:

Money is a bearer contract on a fraction of the pool of human labour available within a jurisdiction, contract that can be enforced only within the same jurisdiction that governs that pool of labour. .

Points to note:

  1. It is a contract, and therefore subject to all contract problems - enforcement, breach etc
  2. The human labour it contracts is not fixed. It diminishes with time - it is called inflation. Nominal value vs Real value. In normal times it is tractable on a weekly/monthly timescale. Longer than that... you just never know... :) 
  3. Its value is governed by two variables: number of contracts/money in circulation and the value of the pool of labour. They both vary simultaneously, so it is difficult to track it down. Also there is a great inertia to a system as big as a whole country economy, so changes take time to propagate. 
  4. Human labour is the source of all value (thank you, Marx and Ben Franklin) - whenever we buy something we essentially buy the human labour that has gone into making it. This applies to 
  5. natural resources (labour to extract it), water (water to pump it and make it potable), land (labour to set up the system of registration and ownership and (military) labour to protect it from invasion) etc.
  6. The jurisdiction limits to its validity and enforceability, as for all contracts. There is of course forex to go outside the jurisdiction, but that is just a mechanism to trade between jurisdictions. 
In short and in conclusion, money is a token representing a futures contract to be drawn on a certain division of the pool of labour and means of production.

Comments welcome.


If we have more future contracts ("money" for the rest of us) being drawn on the same pool of labour, with the same capital tools enabling them to produce an amount of goods - then it stands to reason that the value of each individual contract (unit of currency) will be smaller.

If we reach full employment, and if government spends on things that do not increase the productivity of the labour pool in 1-2 years (the time it takes for information to propagate through the system) then we have inflation - too many contracts chasing too little labour.

As a corollary of the same line of thinking - are banks richer when they accumulate a lot of money? well, no... bear in mind that the pool of labour is the same, and the productivity is less, because credit is less available... so in 2012 the banks have more money (contracts) in their vaults and on the computers, but they cannot exercise them - as the real things that they could exercise them on (the pool of labour) have stayed the same. They have created an imbalance in the system.

This is one of the functions of money: to indicate when the system is working well, and when the system is out of balance.

Back to the banks - in effect they are like someone at poker who is rich in poker chips, but he cannot find anyone to play with. In the meantime, the real economy does not have enough "tokens" to function properly - in order to go back to good functioning the government will print more "contracts" and get the gears moving again. As a consequence of the dead money in the banks, we will have inflation, the mechanism to regulate imbalances.