Money makes the world go around

Money makes the world go around, or so the song says.

The world as we know it would not function without money. Money is an essential human creation and everyone uses it. Money has a powerful influence on our lives and we have an emotional connection to it. Money keeps us awake at night and motivates us to work hard during the day.

We can’t live without money, yet few people can precisely tell you what it is and how it works. Defining money is surprisingly difficult as it does not just comprise paper currency. In Australia, physical cash accounts for less than four per cent of “broad money” (i.e., the amount of money held by households and companies in bank deposits and currency).

Nowadays, very few of us are paid in cash. Our salaries and wages are credited to our bank accounts. Which is one of the reasons why 96 per cent of broad money exists in bank deposits. This form of electronic money can’t be physically held as it is intangible numbers in a ledger.

These numbers are accounting entries and banks produce a large percentage of them when they create new money by lending money. As counterintuitive as it sounds, most money is lent into existence. Banks and other financial institutions create new money whenever they extend credit.

Banks are in the business of selling credit. Money is created as evidence of debt. Credit and debt are the same thing, seen from different points of view. Money is a debt instrument, not a debt itself. Thus, the amount of money in our economy is a function of debt.

This debt is created when a government borrows from its central bank. It is also created when individual citizens of a sovereign nation go into debt by taking out loans from banks and other financial institutions through the mechanism of Fractional Reserve Banking.

When a bank makes a loan to a customer, the proceeds are deposited to an account in the name of the borrower or in the name of the person/s from whom goods or services (e.g., car, holiday) are being purchased. Regardless, new credit money is created and this increases the money supply.

However, only a fraction of the new credit money which is deposited is kept in reserve to meet withdrawals. The rest is invested by banks in loans to other customers (borrowers). This is known as Fractional Reserve Banking and it is the current form of banking worldwide.

The amount of money a bank can lend is affected by the cash reserve or liquidity requirement set by the local banking authority. Liquidity refers to the amount of cash a bank holds to meet its financial obligations (like customer withdrawals) as they come due.

Let’s say the cash reserve (liquidity) requirement is 10 per cent of a bank’s total deposits. This means the bank can lend $90 when it receives a $100 deposit. That $90 is used by the borrower to buy goods and the shopkeeper deposits the funds with his bank.

The second bank takes the $90, keeps 10 per cent and lends $81 to another person. That $81 goes back into the economy and eventually finds its way into the other person’s account at a third bank. The third bank, in turn, holds back $8.10 and lends out $72.90.

This goes on until there is nothing left to deposit and lend out. If you do the math, you will find that the original $100 eventually amounts to $1,000 in credit money. This is an example of the money multiplier effect resulting from banks creating money through their lending activities.

It can be seen that how money is actually created today (a) differs from the description found in some economics textbooks and (b) dispels the myth that financial institutions can only lend out pre-existing money. Banks create “cashless money” from making loans which means that money is really just an IOU.

When the average Joe learns that banks make money seemingly “out of thin air” they are either surprised or sceptical. So, for the Doubting Thomas’ out there, I‘ll leave the final comment on money creation to none other than the Bank of England. In a 2015 report the bank stated:

“In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.”

So, now you know how money is created in reality and in my view it’s a great way of doing it that benefits all the economy and therefore us as individuals!

Sincerely
John (JT)Thomas

This opinion piece is provided by John (JT) Thomas, a 48- year veteran of the financial services industry and since 1987 a specialist in commercial mortgage funds. Considered by many to be the father of the modern commercial mortgage fund sector, JT helped establish and then managed – for 17 years – what became the largest and most successful commercial mortgage fund in Australia – The Howard Mortgage Trust – with assets exceeding $3 billion. Under JT’s stewardship, investors never lost one cent of their investments and indeed, investors always received competitive monthly returns. JT was also Chair of the $40 billion mortgage trust industry sector working group.

JT has been proudly involved with Princeton for nine years and sits on both the Princeton Credit Committee and the Princeton Compliance Committee as well as being an advisor to the Princeton Board.