The Creation of Money

In the 1660s, London merchants who needed somewhere safe to store their gold and silver began using the vaults of goldsmiths, who already had the locks and the reputation. The goldsmith would issue a paper receipt; merchants quickly discovered that it was easier to pay each other with receipts than to cart metal through the streets. The receipts circulated as currency.

The goldsmiths making these transactions noticed that at any given time, only a fraction of depositors came to claim their metal. The rest left it in the vault, trusting the paper. A goldsmith willing to issue more receipts than he actually had gold in the vault could lend out the extras and collect interest, as long as depositors never all came at once. This is the origin of fractional reserve banking, a name that makes it sound more principled than it is.

This matters for understanding the modern financial system because the same basic mechanism is still operating, at much larger scale, with slightly more oversight, in digital form. The story is also the origin of the periodic bank run: when depositors suspect the receipts exceed the gold, everyone tries to claim their metal at once, which confirms the suspicion, which guarantees the collapse. In September 2007, people queued outside branches of Northern Rock, a British mortgage lender, for three days—the first run on a British bank in 150 years. The queues were orderly and very British, but the mechanism was identical to panics that had destroyed banks in Amsterdam in 1763, in the United States repeatedly between 1873 and 1907, and in Argentina in 2001.

In 2014, the Bank of England published a paper with the dry title “Money Creation in the Modern Economy.” Its core claim was not subtle: when a commercial bank makes a loan, it does not lend out money that was previously deposited. It creates the deposit simultaneously with the loan. The loan and the deposit appear on the bank’s books at the same moment. Money that did not previously exist comes into existence through the act of lending.

This is just as ridiculous as it sounds, but very useful. When you repay a loan, the deposit disappears from your account and the corresponding debt disappears from the bank’s books. Money is destroyed. The money supply—the total amount of deposits in the economy—expands when banks are lending and contracts when loans are being repaid or written off.

The 2008 financial crisis makes more sense through this lens. When house prices fell, mortgage-backed securities lost value. Banks had to recognize losses on assets they held. To maintain their required capital ratios, they had to stop making new loans and call in existing ones. This made the money supply contract, which meant less money available for businesses to borrow, workers to spend, and consumers to use to repay their debts. The financial crisis became an economic crisis not through some mysterious contagion but through the straightforward mechanism of money destruction. Governments and central banks responded with quantitative easing: central banks created new money by purchasing assets from banks, replacing the money that bad loans were destroying. This is why central banks can “create money” without necessarily causing inflation when the money supply is contracting—they are filling a hole.

The anthropologist David Graeber spent years studying debt across cultures and centuries. In Debt: The First 5,000 Years, he showed that the story economists tell about money—that barter came first, that money was invented to make barter easier, and that credit developed on top of money—has almost no support in the historical or anthropological record. The fish-for-axes economy that appears in introductory economics textbooks has never actually existed anywhere. What appears in the record instead are systems of mutual obligation and accounting: I owe you, you owe me, the village keeps track. Credit relationships, Graeber argued, are older than markets and older than money. Money emerged not to simplify barter but to settle and record debts.

Graeber’s insight matters here because it reframes what a bank actually is. A bank is not a warehouse that stores your money and lends it out. It is an institution with the power to create new obligations—to say “I owe you this” in a form that the recipient can treat as equivalent to goods or labor. That power is not derived from having gold in a vault. It is derived from legal recognition, regulatory framework, and the collective social agreement that a bank’s promises are worth treating as money.

Who gets to issue these promises, and under what constraints, are political questions. Andrew Jackson ran his 1832 presidential campaign substantially on the question of whether a private institution (the Second Bank of the United States) should have the power to create the country’s money. He won, and the financial panics that followed eventually produced the Federal Reserve Act of 1913, which as passed in the aftermath of the 1907 panic to give the money-creation system a lender of last resort.

Contemporary fintech companies are participating in this long argument without usually acknowledging it. Klarna, Afterpay, and Affirm extend credit to consumers at the point of purchase. In doing this they are creating money, but they are doing it without the deposit insurance, capital requirements, or regulatory oversight that apply to licensed banks. PayPal holds tens of billions of dollars in customer balances that do not carry deposit insurance, and Stripe extends credit to merchants. These companies are, in each case, capturing the profit of money creation while avoiding the obligations that historically came with it—the same maneuver that London goldsmiths discovered in the 1660s.

Cryptocurrency takes this further. Bitcoin and its successors are explicit attempts to create parallel monetary systems outside state control, with the money-creation mechanism determined by algorithm rather than central bank policy. The technical design is genuinely novel. The social question it raises is not: who gets to create money and who bears the losses when it goes wrong. If the past is any guide, the answer to the latter question is, “Not the bankers.”

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Chang2012

Ha-Joon Chang: 23 Things They Don’t Tell You About Capitalism. Bloomsbury, 2012, 9781608193387.

Graeber2011

David Graeber: Debt: The First 5,000 Years. Melville House, 2011, 9781933633862.

Kindleberger2005

Charles P. Kindleberger and Robert Aliber: Manias, Panics, and Crashes: A History of Financial Crises (5th ed.). Wiley, 2005, 9780471467144.

McLeay2014

Michael McLeay, Amar Radia, and Ryland Thomas: “Money Creation in the Modern Economy.” Bank of England Quarterly Bulletin, 2014 Q1, https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy.