Money creation: how banks conjure the world's money supply

Ask the people around you a simple question: where does the money in your bank account actually come from? The most common answer, "the bank lends out the savings other people deposited," is wrong. In a modern economy, most money is not moved from one pocket to another. It is manufactured out of thin air. And it is commercial banks, not the central bank, that do the manufacturing.

This is not a fringe theory. The Bank of England spelled it out in 2014: in the United Kingdom, 97% of the broad money held by the public existed as bank deposits. Those deposits are created when banks make loans. The share is unchanged in Britain today, and it tops 90% in both the euro area and the United States. Grasping this mechanism changes how you read almost every economic headline: interest rates, inflation, bank failures, and even the Basel rules argued over in Washington, Frankfurt and London.

Where money really comes from

Start with a distinction people routinely blur. The first kind of money is central bank money: the notes and coins in your hand, plus the reserves banks hold in their accounts at the central bank. The second is commercial bank money: deposits, meaning the balances shown on your accounts. A deposit is nothing more than a promise by the bank to hand you cash on demand.

In a developed economy, the first kind is tiny and the second is overwhelming. Notes and coins make up only a small slice of the money used day to day. Almost everything we call "money" has no physical existence at all: it is lines in banks' databases.