How The Monetary Creation Works
It is a payment instrument recognized by governments, households and businesses. For millennia, we have been content to use precious materials to pay for purchases (gold and silver coins, salt and even shells). But from the middle of the 17th century, the London goldsmiths, to whom the wealthy merchants entrusted their gold, began issuing certificates of deposit.
And their owners realized that it was much easier to pay and get paid with these pieces of paper (which everyone trusted) than with metal parts. Fiduciary money was born.Today things have changed: 90% of the exchanges are done by simple writing games (check) or by electronic movements (credit card, transfers). But the principle – trust – is always the same.
Who Creates The Currency?
Contrary to what is often believed, the issuing institutions (ECB, US Federal Reserve and all other central banks), the only ones authorized to print banknotes and to coin coins, are at the origin only of about 10% of cash in circulation. Essentially, it is the commercial banks, like the BNP or CIC, that create the currency.
How Are They Doing?
They give credits to their customers, that’s all! Admittedly, to be able to do this, they must have in reserve the sums they lend – and even a little more, in order to cope with withdrawals. For 100 euros deposited in their funds, they can thus offer a credit of about 80 euros to an individual, a company, or the State. But in doing so, they do create money.
The proof ? The 100 euros deposit still exist, since their owner can enjoy it as he pleases. And the other 80 exist too, their borrower may have already spent the time we write these lines. The bank has therefore manufactured them from scratch. Just back things, when refunded, they will be automatically destroyed.
As we can see, money is not a stable mass, a large pile of money distributed among economic agents, as we imagine intuitively. It is a moving amount of cash, which swells and shrinks permanently, depending on the credits offered. Things are going faster than we think. Imagine again that a customer A deposits 100 euros on his account and that the establishment uses it to grant a loan of 80 euros to a customer B.
Whatever the way it will be spent, this money will land him also on a bank account. It can therefore be used in turn to reserve a new credit, about 60 euros this time, and so on. In total, from a deposit of 100 euros, the banks as a whole can manufacture more than 200 euros new cash. Specialists call this the credit multiplier.
But then, Why Do Not We Create More Money To Get Rich?
In Santa’s country, it would surely work. But not in reality. Because it is not the means of payment that make the wealth, but the volume of products and services available on the market. What is the use of having the pockets full of gold if the stalls are empty! This is why the quantity of money in circulation must always be correlated to production. If it increases more quickly, it’s … the prices that are racing.
The Germans can testify. In the 1920s, their central bank had printed such a mass of marks (to pay France war damage) that labels doubled daily in stores. He needed a wheelbarrow filled with tickets to buy his bread! A century later, our neighbors are still traumatized by the memory of this hyperinflation, and this explains their obsession with rigor.
We are certainly not here today. But economists say the world is still suffering from excess liquidity, and that’s not good news. Placed on the financial markets, this huge amount of money causes the appearance of speculative bubbles whose explosion can be devastating, like the subprime. It is to avoid this kind of drift that states and central banks try to regulate monetary creation.
On this subject, the interview of Frédéric Alexis, director of the specialized Masters in Risk Management Control at Audencia Nantes: Why does the ECB not create more euros to facilitate the revival of growth?
How Are They Doing It?
They put in place mechanisms to limit the lending capacity of banks. In Europe, for example, companies are required to comply with several regulatory ratios: they must invest the equivalent of 1% of their deposits with the ECB. These are the reserve requirements. They must also comply with the Basel III ratio, which prohibits them from lending more than 8% of their own funds – that is, their capital.
Central banks can also vary their key rate, which determines the interest rates at which banks lend money. The more it increases, the more expensive the loans, the less households and businesses will ask, and the less they will be granted. Thus, the credit multiplier, at the origin of monetary creation, will be slowed down.