In ancient times, gold was the currency that was being traded for items depending on the value of the gold. This was because gold have a proven history of holding up it’s value over long periods of time. Even today, gold is still a very valuable item that can be exchanged or pawned for cash.
But something changed in history that was the conceptualization of the monetary world we live in today. People started to deposit their gold in stores and carried around receipts representing the amount of gold they have. Carrying around certificates was definitely more convenient than carrying around heavy gold coins and bars. As the trend caught on, it led to the currency notes we have in our wallets today.
That is not the only thing that has changed. The dollar notes and coins we have are no longer backed by a similar valued gold reserve kept in a high security mega vault. In fact the truth of where that money comes from can be surprising to many people.
The way the average person understands banking is this. He would deposit his savings into his bank in return for an interest. The bank will in turn loan out those deposits to a borrower for a higher interest. This interest will make a profit for the bank after repaying the interest to the initial depositor. If this is the scenario, the amount of money in the economy is finite and limited. There can only be a specific amount of money belong loaned out as there is a specific amount of deposits available.
But as we all know, banks seem to have an infinite amount of money to lend as long as they are willing to. Why is this so? Because money is essentially created by debt.
Banks have the freedom to lend out money as debt in many multiples of the amount of deposits they have collected. This multiple is controlled by the central bank called fractional reserve banking. For example, a bank could be allowed to lend out $10 to a borrower for every $1 of deposit they collect. No wonder banking is known as a business that has an almost certainty in success.
If this is the first time that you are hearing about this, you must be thinking “how can this be? If a lenders gives out $10 for a loan, what happens when the depositor comes to withdraw his money?”. The answer is that there are millions of depositors and that it is very unlikely that all of them will withdraw their money at the same time. Even if such an event take place, the bank entertaining all those withdrawals may get support by the central bank. So to truly understand money in the economy in the big picture, you have to see your bank as just an arm of an even bigger bank, which is the central bank.
Money constantly flows through this interconnected network that keeps the financial industry in business. This is why there is often very little (if any) real money being used even when you get a loan from one bank to pay off another. Because they are all interconnected, it is just a digital amendment of figures and numbers in different accounts. This is indisputable if the deposit account is from the same bank as the withdrawal account. As for different bank transactions, other unrelated transactions more or less even out the debits and credits to each other.
As in the case where a loan is taken and deposited into the same bank, there is no actual use of cash. The bank simply debits and credits the accounts of the borrower and depositor. In the process of this transaction, A loan account is created for the borrower while the depositor cashing in the payment will increase the digits in his bank account. Meaning the borrower becomes liable to a loan with interest and the bank increases it’s deposits. The increase in deposit also affects the fractional reserve banking ratio. The bank will then be allowed to lend out even more money. All these happen without needing the bank to issue any cash. It is like creating money out of thin air.
As you can see, since no real money is needed and deposits are often just a number being generated, a bank can create as much money as it wants as long as it keeps within the lending ceiling set by the central bank. The only way this system that has served us well over the years will crumble is if all depositors draw down all their savings from all banks at the same time. An event that is very unlikely to happen. Should this really occur the central bank can still get money from another central bank in another country. See the self-sustaining system that will probably never collapse?
If you are a regular borrower of personal loans, credit lines, mortgages, etc, how does it feel to know that you are actually borrowing money that isn’t there? And if you are a saver who has all your money kept in the bank, how does it feel to know you are not just contributing a specific amount of principle equal to your savings?
Even though this financial system has benefited us well, it is also important to note that it is sustained by increasing debt. And what we were taught in classes about debt is that they are bad things that we should stay away from. As long as debt growth is sustainable, very few catastrophic problems will arise. I irony is that should debtors start to redeem all their borrowings, the economy could come to a standstill and be brought to it’s knees. It’s a good thing that that is probably never going to happen.