# The science of finance/How can we create money from scratch?

It seems that to advance funds it is necessary to dispose of it in advance. This would be true if all the money was in gold, if there were no bank notes, or deposits on bank accounts. But the banking system creates money out of nothing, just ink and paper, or computerized accounting. It allows to advance funds that did not exist before, which are created at the very moment they are loaned. It looks like counterfeit money, but it's very different, because money is created in exchange for promises of repayment.
One of the oldest ways to create money from scratch was seigniorage. The lord of the kingdom demanded that he be put in deposit the existing coins, he then made them coined at a different, higher value, and he returned the deposits to their face value, by cashing the difference, which allowed him to repay his debts or increase his treasure.

### Bank notes and exchanges of debt recognitions

Bank notes first appeared as deposit securities. We deposited our gold in the bank and we received in return a deposit security that could be used instead of gold for payments. Simply writing a deposit security is not enough to create money. The amount of money in circulation does not increase. The gold that was in circulation is immobilized in deposit and is replaced by a security that is the only one to circulate. But these deposit securities played the role of bearer repayment promises and the banks could put into circulation more promises of repayment than they had gold in their coffers, because the promises of repayment were not all required at the same time. They could be used as gold and they were easy to circulate. During normal periods, they remained in circulation and their repayment was not required. But if there was a loss of confidence in the bank's ability to repay its notes, all the holders could come forward at the same time to demand gold, and the bank could not meet its obligations.
The privilege of issuing notes could be very profitable and not very risky, because the banks lent with interest created money which did not cost them anything. If the borrowers were reliable, a bank feared little for not being able to repay the notes it had issued. But it still faced a risk of illiquidity, meaning that it could be asked to repay its notes before the loans it had granted were repaid.
Another way to create money from scratch is to print counterfeit notes. If their quality is sufficient so that they are not distinguished from others, the amount of money in circulation has been increased.
Imagine two friends who are mutually signing IOUs of equal value. An IOU can work as currency, provided the debtor's reputation is good. If no one is aware of the deception, and the two friends have a good reputation each, each can pay with the other's debt recognition. They thus circulate their papers as money. So they created money from scratch - almost, only a little ink and paper.
If the debts are repaid, the IOUs are destroyed and disappear from circulation. Generally, money can be created with IOUs and destroyed when debts are repaid.
Individuals generally can not circulate IOUs as currency. On the other hand, bankers always can, because their IOUs are considered very reliable. When a bank issued a loan with notes that it had created, it exchanged a debt acknowledgment, the notes, against another, that of his client.

### Central banks

Banks that had acquired the right to print banknotes have gradually lost this privilege, except for central banks. Originally a central bank was the bank of the prince, or the ruler. Rich individuals who lent their gold to the sovereigns in exchange for privileges together formed banks to strengthen their position (which was sometimes tricky: a way for the princes to free themselves of a debt was simply to cut the head of the creditor). Thus they gradually acquired the monopoly of issuing banknotes.
Bank notes have gradually ceased to be convertible into gold, or silver metal. Such convertibility is dangerous and costly for banks, because they have to keep gold reserves that may not be enough if there are too many holders of notes who ask to be reimbursed. Even central banks, which held large gold reserves, were constrained in their monetary creation by the gold convertibility requirement. In fact during a crisis, they did not hesitate to suspend this convertibility as soon as they feared for their reserves.
With the abandonment of gold convertibility, central banks have ceased to be constrained by the need to keep gold reserves, they can create all the money they decide. Gold as a currency has become useless. Now economies no longer need gold for currency trading.
Imagine someone finding a huge treasure, gigantic gold reserves. He has no interest in selling such wealth too quickly, because if he floods everyone with his gold, he raises prices and it diminishes the value of his treasure. Central banks have the same problem. They have an unlimited supply of money, a sort of huge treasure, but if they sell it too quickly, they drive up prices.
How does the money created by the central banks flow into the economy? In principle, they can buy anything they want, including gold stocks, and even all wealth available for sale. But of course grabbing all the riches is not their role.
A central bank puts money into circulation by a technique that looks like an exchange of IOUs, because in general it lends the money it creates, either directly, by lending to banks, it is then a bank of banks, or indirectly, by purchasing IOUs on the financial markets. When the central bank grants a loan, or when it buys a bond, it puts money into circulation. When the loan or bond is repaid, the money is withdrawn from circulation. But it is not really an exchange of IOUs, because a central bank owes nothing. Its notes are not rights to real wealth but only rights to be exchanged for real wealth at a price that is a priori indeterminate. Since gold convertibility has been completely abandoned, central banks do not have to pay off debts any more because they no longer have debt. It all happened as if they had refused to repay their debts, since originally the notes were IOUs.
A central bank can also give the money it creates, either to the state, which allows it to reduce taxes or repay its debts, either directly to the citizens, giving them all an equal amount, for example, as an egalitarian Christmas gift. In this case, it is sometimes referred to as helicopter money, as if the central bank was distributing its notes by helicopter. The term helicopter money is obviously a joke, but not the reality. Creating money and giving it to all citizens can be a very effective way of fighting deflation (see next chapter).
The economies of today are generally debt economies. The amounts of all debts are important in relation to the wealth produced. This allows central banks, and other banks, to easily circulate the money they create, lending it to those who want to borrow it. If the agents refused to go into debt, if they paid off all their debts, would the money disappear from the economy? All the money today in circulation would be destroyed by the repayment of debts. To replace the destroyed money, the central bank would be led to give the money it can create.

### Bank accounts

Losing the privilege of bank notes emission has not deprived banks of the money-creation privilege, because bank accounts are a form of money. A creditor bank account is an acknowledgment of the bank's debt to its client. To grant a credit a banker does not need to have the money beforehand, he just has to click on his computer and the credit is automatically displayed on the customer's account. That's all. When a banker gives credit, it is simply an exchange of IOUs. The client signs an acknowledgment of the debt vis-à-vis the bank. In exchange, the bank increases the customer's current account.
One would think that banks do not create money because they would only lend the money they are loaned, but this is not true. A bank does not have the right to lend more than its depositors have entrusted to it, but that does not prevent it from creating money. When it grants a credit, it does not debit the account of its depositors. Since the money supply includes all current accounts, it increases each time a bank grants a credit: the current account of the borrower is increased without any other current account being debited.
Of course, if the bankers were completely free to grant credit, we would live in complete monetary anarchy, because accomplice bankers could lend each other money and create as much as they wish, to the point of buy all the wealth of humanity! What prevents them from becoming crooks? Only the rule that forbids them to grant more credits than the money that was given to them by the depositors, because if they spent the money they created, the deposits would not be enough to cover the granted credits. This rule does not prevent them from creating money, but it prevents them from creating as much as they could wish.
Only a central bank can create money without limit. When it lends money, it is limited only by its own rules of operation. It can create billions with one click. It just has to decide it. Of course it does not have the right to abuse this privilege, otherwise it would sink the economy.

### Deposits make credits and credits make deposits

Banks have the right to grant new credits as soon as they receive new deposits. So deposits make the credits.
When a bank gives credit, the money created is usually left in the same bank, or in another if the credit has been spent. Only a portion of the credit granted is in the form of notes in circulation. Most of it is usually somewhere in bank accounts. So the credits make the deposits.
Each credit makes a new deposit that can make a new credit, and so on. Is it then to be feared that banks can create money without limit and drown the economy in a monetary deluge?
Since some of the money created by banks is kept in the form of notes and is not redeposited, the sequence of credits and deposits can not lead to unlimited creation, because each new deposit is only a fraction of the credit that created it. In addition, central banks generally impose mandatory reserves on banks. For each deposit, they must keep a fraction in reserve and therefore do not use it to grant a new credit. As a result of these two effects, the money created by the banks can only be a multiple of money put into circulation by the central bank. This monetary multiplier depends on the reserves of the banks, mandatory or surplus, and the mass of cash in circulation.
If we removed cash money and if there were no reserve requirements, would the money supply increase to infinity? Presumably no, because banks lend only if they find reliable borrowers, and it is not always easy to find. Even if they were not obliged to keep reserves, they would still retain them because of the lack of borrowers to lend them to.

### Should banks be prohibited from creating money?

From the point of view of a depositor, his money in the bank is kept, since he can withdraw it at any moment, but from the point of view of the bank, everything happens as if it were lent, since it can lend almost as much money as the one deposited. Monetary creation by banks is a way of turning sleeping money into circulating money. By depositing our money in a bank, we keep it without letting it sleep, since it makes more money circulating into the economy.
From an accounting point of view, the money deposited in the bank is lent to borrowers. A depositor may rebel against this practice. If the bank goes bankrupt, it could lose its deposit. We can therefore think of 100% reserve deposits (Fisher), that is to say that the bank would promise not to lend them, it would refrain from using it to create bank money. Today's banks could offer such a 100% reserve bank money service, but depositors would have to pay more bank fees for the management of their accounts, because the banks could not pay themselves by lending the money entrusted to them. Such an increase in fees would be a deterrent. In addition, depositors would have nothing to gain, because demand deposits are already guaranteed. Even if his bank goes bankrupt, the depositor does not lose his money. Why then want a 100% reserve account?

### Are the interests of a bank loan a theft?

We may find that there is something dishonest in collecting interest by lending money that was not had beforehand. Should we accuse the banks of organized fraud and ask them to repay all interest improperly received?
Legally banks, except central banks, do not create money, they only lend the money that is lent to them by depositors. We count, however, a monetary creation by summing all deposit accounts. Where is the truth ? Is the money created by the banks, or only lent? This ambiguity about money creation by banks comes from the ambiguity of demand deposits: is it money kept by banks, or money they put back into circulation in the economy by lending? Both answers are legitimate. From the depositor's point of view, a bank account works like a cash register, and the money he deposits there is kept, since he can withdraw it whenever he wants. But from the point of view of the bank, the money deposited is put back into circulation as soon as it is lent.
Banks do a useful and important job of evaluating borrowers' projects. They must be paid for it. In addition, they are necessary for the economy, if only to manage our means of payment. That they are paid is therefore legitimate. Only if the interest they ask for is too high, or for other forms of dishonest loans, can one really speak of theft.
If banks were not allowed to charge interest on their loans, they would not be able to lend because they could no longer cover their costs. This would deprive the economy of a major source of funding and prevent bankers from doing their job, while it is useful and important for everyone.
Deposit banks do not own the funds they lend. The interest they receive is therefore not income from property, it is only income from work.
Individuals could complain about unfair competition from banks. To collect interest, they must first earn the money they lend. Banks compete with them by lending money that they have not earned. The wealthy owners are thus competing with workers, the bankers, who lend money they have not even acquired.

### Should we return to the convertibility of bank notes into gold?

Since the convertibility of their notes to gold has been abandoned, central banks can create unlimited money. This allows them, in particular, to intervene in the market for lendable funds to lower interest rates, if this seems desirable to them. They only have to lend the money they create at a rate as low as they decide. Other lenders must then lower their own rates if they want to remain competitive. The market for loans is therefore not an ordinary market where individuals meet on an equal footing. Central banks are clearly favored. They lead the dance. This is why they are regularly accused of dangerously disturbing the economy. Their decisions do not always benefit everyone.
The return to gold convertibility of their notes would be a way of limiting the power of central banks. If we are opposed to state intervention in the economy, this may seem desirable, but then we ignore that such convertibility can not be a lasting solution. Gold reserves can not generally grow at the same rate as the rest of the economy. But to meet the needs, a central bank must increase the money supply in a growing economy. Gold reserves increase little while the mass of notes in circulation increases more. It can not last forever. Sooner or later agents will understand that the gold reserves are not enough and they will ask to convert their notes. From this point of view it is surprising that gold convertibility has been abandoned so late. It could only be a temporary system, which prompted agents to accept paper money and bank money, but which could not last.

### Why money creation is not necessarily bad

When central banks and other banks create money, they do not do it in the manner of a fraudulent crook who would squander an ill-gotten fortune, they do it in the manner of a serious banker who assesses the quality of the borrower and who asks for guarantees. Money is created only in exchange for reliable repayment promises, not for playing poker. This helps to meet the financing needs of the economy without being limited by the amount of gold available. Money can be created to meet the real investment needs, and the ability of the economy to engage in profitable projects. A good project is a sufficient guarantee to legitimize the creation of the money that finances it.
It must be remembered that monetary creation by banks is not final. It is enough that they decide to lend less than the loans that are repaid to them to destroy some of the money they have created. The money lent can always be eventually destroyed if necessary. Only helicopter money, given by the central bank, can not be taken out of circulation.
The higher the interest rates, the more owners take a significant share of the domestic income, to the detriment of non-owners. With money creation, central banks generally have the power to impose low interest rates permanently. If inflation is already under control, a slight rise in interest rates is usually sufficient to contain possible inflationary trends. Even in times of full employment, rates can remain quite low without excessive inflation. With money creation, central banks therefore have redistribution power. As in the legend of Robin Hood, they can take to the rich, the owners, to give to the poor, non-owner workers. They do it daily by charging interest rates as low as possible.