Banks make money by creating it. By making money, I don’t mean that they earn it through fees and interest. And I don’t mean that they print it either –that’s the job of the Canadian Bank Note Company.
No, I mean they literally create money: all 97% of it now in circulation. Author Peter Stalker exposes the trick: “Nowadays almost all money is created out of thin air when they make loans,” he explains in the New Internationalist magazine. It’s not how I thought it worked.
I thought that banks loaned out money that others deposited. It turns out that cash is only about one-tenth of the supply. In 1992, the Bank Act was amended to allow banks to keep only as much cash on hand as they deemed necessary.
This sleight of hand is best explained by an example. If I go to my bank and make a loan of $5,000, I don’t usually walk out with a wad cash. If I did, no money would have been created. Instead, an entry is made to my bank account; no cash is deposited to my account, simply an entry.
Suddenly, and with a stroke of a key, money that didn’t exist is there in my account. I can now write a cheque for $5,000 to buy a car from Fred. Fred can take my cheque and deposit it.
Now I owe the bank $5,000 (plus interest) and the bank owes Fred the same amount. All seems fair except for two things. The bank must keep $5,000 in reserve to pay Fred. Unless Fred withdraws the deposit as cash, the bank can do with it what it wants. If Fred uses the money for on-line bill payments, the newly created currency is passed around. And the bank collects $5,000 from me.
Pierre Parisien doesn’t think that’s fair because the $5,000 collected from me represents untaxed capital gains. He calls this bank reflux. A fairer system would be for the Bank of Canada to create all currency regardless of whether it’s banknotes or book entries.
“I suggest that the federal government be granted the exclusive right to create new money, whether in the form of currency, book entry, or even computer data. The Bank of Canada would be mandated to accommodate the chartered banks in the granting of credit, create the necessary funds, and loan them at zero interest to the banks. The banks, however, would have to repay this capital, thus giving the government the full benefit of the reflux.”
Another problem with banks creating money is that they encourage debt. When they can create money, why not persuade people to borrow in order to collect interest? However, as we found out in the Great Recession of 2008, too much easy money can drive borrowers into bankruptcy and the whole facade comes crashing down like a house of cards.
The profit motive is not the best way to create money. Switzerland recently considered a proposal to have the Swiss National Bank become the sole creator of money. Leonid Bershidsky suggests in Bloomberg that such a plan would reduce the money supply but that might be a good thing.
Great explanation! Thanks David.
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