Into the Heart of Darkness—of Money: Upstream to Its Source, by Agent d’Amore

There is a great flow that many people find they are a part of, perhaps never wondering where it comes from or ultimately goes. Like those living on a great river, they only have a vague idea of its source but do know when it gets too high or too low. The great river overflowing its banks is a worry, but its causes may be far upstream. Similarly, a drop in the level of the river can be just as disastrous for those depending upon it for life.

I don’t speak here of the mighty Congo, the Mekong, the Mississippi, or other flows of water but of the great stream of money that flows through our economic lives. What is the source of this stream? Where does it ultimately flow? Let’s explore this analogy to see if we can gain better insight. After all, it is hard to speak with a fish about water, as they have no reference outside of the medium in which they live their lives. Similarly, we who are swimming in the economic waters consisting of payments, borrowings, and savings, probably take money as a given fact of life, never stopping to understand its true nature or asking for an understanding beyond “how do I get enough?”.

When talking about money, we’re going to focus on the USA for now; we need to be clear about what we mean by money. There are of course physical cash (think of a dollar bill and a dollar coin), U.S. Treasury securities (also known as T-Bills or bonds), and various forms of bank credit or electronic money (you can just as easily buy dinner with a credit card as with cash or a debit card in most places).

Banks are the ultimate end point to the modern payment system, as all non-cash transactions depend on banks. The government and the banking system have encouraged the growth of electronic payments for efficiency and for the ability to track transactions (under the guise of preventing financial and other crimes). We refer to electronic payments as a type of bank credit, due to the role of banks and bank-like institutions in this payment system. It is important to remember that all payments using credit or debit cards have a bank ultimately talking to another bank to “settle” the accounts between the customer and the merchant. For perspective, only about 3% of money is in the form of cash (bank notes and coins), which leaves 97% of money merely in an electronic form in the computers of the banking system. [

*1] In fact, U.S. Treasury securities are exclusively sold in book entry form; that is, they only exist in the computer systems of the Treasury (TreasuryDirect), and payment is done electronically.

There are reasons for electronic money transfers that include convenience and safety, but one of the costs is that the authorities know your business. I recently witnessed two young women at a Bank of China branch withdraw stack after stack of 100-Yuan notes. There were so many bills that it took them about 30 minutes to count them all using a bank-provided high-speed bill counter. When they had finished counting, they left the bank with four bags of cash in bags marked with the bank’s name. Based on the number of stacks, I estimate they walked down the street with in excess of US$20,000. While they may have felt safe on a Chinese street, the same can’t be said for New York or other major cities around the world. Carrying bags or suitcases of cash to pay for high-priced purchases can be cumbersome and risky, and remember, any cash purchase over $10,000 requires special paperwork to answer, “where did that money come from?”.

Doesn’t money just exist like water and we just move it around? In fact, water exists in abundance, good old H₂O, but it can be destroyed (run an electric current through it to break apart the hydrogen and oxygen) or created (burn hydrogen, and water results).

Similarly, with money, a lot of it already exists and moves around, but it can also be created and destroyed. The creation of coins and bills is literally “printing money” and is done by the U.S. Mint, which is understood by most people. However when the Federal Reserve (the central bank) or other banks can “print money”, it is done in bank credit/electronic form, and that is not as obvious, since it takes place only on the bank’s network of computers.

Money is created when a bank buys a debt security, adds it to the asset side of their balance sheet, and balances that with a corresponding entry in the liability side of the balance sheet (known as giving a loan). That money is destroyed when the security is removed from the balance sheet after sufficient sums to meet the debt security conditions have been paid to the holder of the note (when the debt is paid off) or when the debt is erased without payment (when the bank takes a loss).

I work at a large bank and ask employees there occasionally “how does a bank work?” or “when you deposit money in a bank, who’s money is it?” I get pretty consistent answers, which fall into two categories: the way a bank actually works or the way many people think it works. Both types of responses are seen as self-evident and obvious to those I ask. There are also those who honestly answer, “I don’t know.” For those of you in the last category, please let me explain.

The primary difference between a bank and other businesses is that banks are allowed to “take deposits”. To be more technically precise, when someone “deposits” money into a bank, what they are in reality doing is providing an unsecured loan to the bank. The bank then accounts for this loan from the “depositor“ as a liability on its balance sheet. In this system, any bank liability will appear to an outsider as if it were a deposit. Also, these so-called “deposits”, which in legal reality are instead actually loans to the bank, therefore belong to the bank, who may do with them as they please.

Again, technically speaking, banks don’t take deposits, as this would legally imply some sort of trust relationship. But rather the banks are allowed to borrow from the public with an “on-demand”, instead of a fixed-term, payback. Even brokerage firms hold funds in a trust account for the benefit of the customer, and they are not allowed to co-mingle these funds; they must segregate them and use them only for the customer’s benefit.

Loans are promises to pay back to the bank by a specific date, a specific amount, and on a specific schedule. A properly formatted IOU by someone to the bank is called a promissory note. All the paperwork you sign and fill out when getting a loan is actually involved in creating a legally enforceable promissory note that the bank can use to “secure” its rights to collect the money. Promissory notes are considered “debt securities”.

As noted, a bank takes “deposits” and puts them on its books on the liability side of its balance sheet. And “deposits” into bank accounts are actually loans given to the bank, and the money is then owed by the bank to the “depositors”.

This same bookkeeping methodology allows a bank to buy a promissory note (commonly called “giving a loan”) from a seller (the “borrower”) and to put it on the asset side of its balance sheet. The bank at this point makes a corresponding entry on the liabilities side of the balance sheet, because it must “balance” after all, in the account of the promissory note seller (showing that the bank now has the liability of needing to “pay” that money to the “borrower”). This entry represents funding of the loan to the seller (the “borrower”), and this is the point at which new money is created.

This is how “money” (in the form of bank credit) is created. The bank balance sheet has been expanded (and the number of dollars that exist in the money supply has been increased) by the value of the loan given to its customer (by the value of the promissory note). The liability the bank has to the seller of the promissory note (the “borrower”) is a form of bank credit, which can be used as money within the payment system or withdrawn as cash from the bank. [

*2]

It appears to the customer (the “borrower”), when the customer gets the “loan” from the bank, that the customer is being given money by the bank from existing money—as the bookkeeping entry by the bank appears to have been a deposit of already existing money. This is because the customer sees the money in their account, just as they would if they had made a “deposit”. But it was not already existing money; it is in fact the creation of new money.

As mentioned above, a deposit in a bank account is an unsecured loan to the bank, and the money belongs to the bank, who can use it any way they want. By depositing your money, you have loaned the bank your money in an unsecured manner. They owe you, but it is their money; you are their creditor.

When a bank customer asks for a loan (asks to sell a promissory note to the bank), the banker, wanting to ensure that the note will be valuable over time as a bank asset, must be diligent in assessing the ability of the note seller (the borrower) to meet the conditions of the note. The banker will determine the worthiness of granting trust to the seller (the borrower). If the seller is deemed trustworthy or if there is collateral (something of value pledged by the seller to reduce the bank’s risk of default), then the banker will allow the seller to fully execute a promissory note in exchange for bank credit.

Depending on the size of the bank and how big they want to grow their asset base (remember that bank assets earn interest income, so a bigger asset base means more income for the bank), bankers can either buy many small assets or relatively few large ones. From the banker perspective, there is an ideal mixture of large-to-small and risky-to-safe assets (riskier borrowers pay higher interest rates) that will maximize the bank’s income at the lowest cost.

Credit card debt is a relatively risky asset for a bank, but it can earn rates as high as 30%. Through computer automation and things like AI models, many of these assets can be acquired and managed at a relatively low cost. A million credit cards, each with a $1,000 credit limit, may yield more profit than a $1 billion loan to a large company.

Compared to the U.S. Treasury’s issuance of promissory notes (T-Bills and T-Notes), the amount of lending for credit cards or commercial loans is relatively small. The outstanding USA national debt (which is in the form of interest-bearing government securities) now stands in excess of $22 Trillion. This torrent of promissory notes, while extremely safe (U.S. Treasury securities are considered “risk free” assets), also produces relatively low returns for the banks. These assets are very handy to balance out overall risk of a balance sheet.

So what we’ve seen above is that while money creation is happening often and in a variety of ways, it is the USA government that is the main creator of outstanding debt (which is what causes new money to come into existence). It is both creating money by issuing debt and destroying money by retiring debt. It also manages the amount of money by collecting taxes, taking money out of the hands of those hoarding it as savings (just as concert tickets are issued prior to being collected at the door, so too, are dollars created prior to being collected in taxes).

What does “the full faith and credit” of the USA really mean? Bankers search for good-credit-risk customers to buy securities from. This allows them to charge market interest rates for “loans” without losing too much sleep worrying about default by borrowers (worrying about credit risk). The ultimate good-credit customer is the USA. Remember, if the US government needs dollars (to pay off a loan, for example), it is the one who is the sovereign money authority who controls the money creation process. It also controls tax collections, so if it doesn’t want to create new money, it can use existing money from tax receipts to pay debts.

It is this capability to create new or collect existing money to pay debts that is generally referred to as the “full faith and credit” of the United States. The USA has the ability to pay any dollar-denominated debt in dollars. If a country borrows money in a foreign currency, it does not control the currency and would need to acquire the foreign currency on the open market. The US dollar also has a special status as a legacy of WWII and the Bretton Woods agreement. The US dollar is considered a world “reserve currency”, thus almost anything for sale in the world can be bought with dollars.

This unique status of the dollar gives the USA tremendous financial power. The world looked to the US central bank for dollar loans during the 2008 crisis. For as we have seen, it is possible for it to create money as needed. The Federal Reserve Bank was happy to give dollar-denominated loans to central banks of other countries to help those countries deal with the problem of insolvent banks. Since the United States is the only country that can create US dollars, the Fed helped foreign borrowers (mostly foreign banks) with dollar-denominated loans the same way it helped US banks, by buying securities and creating dollars by typing bookeeping entries into its computers. As all this new money stayed within the banking system (globally), there was not a flood of new dollars causing inflation, merely healthier balance sheets for banks with dollar-denominated loan portfolios.

With such financial power comes great responsibility. Some would say this responsibility is to the owners of capital, to protect against inflation. And others would argue the responsibility is to all the people of the planet to use this power for the benefit of the many. Clearly this power was recognized by the Federal Reserve during the 2008 global banking crisis, as it helped banks all around the world. This power can be harnessed to help solve important real problems, not just to resolve banking crises.

Money creation in our current system is not magic; it is in essence bookkeeping carried out by institutions that are authorized by the government to create money. This system is based on using profit-making banks as a component of the money-creation mechanism, and it was designed to support the current system of industry and wealth. If there is a political desire, the same power can be deployed to support alternative systems that do not address just the status quo of wealth and power but can move the world in a better direction.