How do governments create money

Fractional reserve banking

How do governments print/create money? Who do they give it to the newly created money?

you can never get rich if you don’t understand how money is created. When you are an employee, you don’t make money. you collect money from your employer and give it to your landlord. so, if you want to get rich, then you must need to understand how money is created.

If you want to understand how money is created, then this is an article for you. In our current monetary system more than 90% of money in circulation created via fractional reserve banking. (Note that many governments are not very transparent in how much money they create)

What is fractional reserve banking

Fractional reserve is a banking system that allows commercial banks to profit by loaning part of their customers’ deposits, while just a small fraction of these deposits are stored as real cash and available for withdrawal. Practically speaking, this banking system creates money out of nothing using a percentage of their customers’ bank deposits. 

In other words, these banks are required to hold a minimum percentage (a fraction) of the money that is deposited in their financial accounts, meaning that they can loan out the rest of the money. When a bank makes a loan, both the bank and the person who borrows the money count the funds as assets, doubling the original amount in an economic sense. This currency is then re-used, re-invested and re-loaned multiple times, which in turn leads to the multiplier effect, and this is how fractional reserve banking “creates new money”.

How does it work?

When a customer deposits money in their bank account, that money is no longer the depositor's property, at least not directly. The bank now owns it, and in return, they give their customer a deposit account that they can draw on. This means their bank customer should have access to their full deposit amount upon demand, with established bank rules and procedures.

However, when the bank takes possession of the deposited money, it doesn't hold on to the full amount. Instead, a small percentage of the deposit is reserved (a fractional reserve). This reserve amount typically ranges from 3% to 10% and the rest of the money is used to issue loans to other customers.

Consider how these loans create new money with this simplified example:

• Customer A deposits 50,000 in Bank 1. Bank 1 loans Customer B 45,000

• Customer B deposits 45,000 in Bank 2. Bank 2 loans Customer C 40,500

• Customer C deposits 40,500 in Bank 3. Bank 3 loans Customer D 36,450

• Customer D deposits 36,450 in Bank 4. Bank 4 loans Customer E 32,805

• Customer E deposits 32,805 in Bank 5. Bank 5 loans Customer F 29,525

With a fractional reserve requirement of 10%, that original 50,000 deposit has grown to 234,280 in total available currency, which is the sum of all customers’ deposits plus 29,525. While this is a very simplified example of the way fractional reserve banking generates money via the multiplier effect, it demonstrates the basic idea. 

Note that the process is based on the principal of debt. Deposit accounts represent money that banks owe their customers (liability) and interest-earning loans make the most money for banks and they are a bank’s asset. Simply put, banks make money by generating more loan account assets than deposit account liabilities.

What About Bank Runs?

What if everyone who hold deposits in a certain bank decides to show up and withdraw all their money? This is known as a bank run and since the bank is only required to hold up a small fraction of their customers’ deposits, it would likely cause the bank to fail due to an inability to meet their financial obligations. This is what banks have rules and regulations to say that you cannot withdraw more than a certain limit per day. Also, there is a certain limit to withdraw actual cash from ATM, and different limit for withdrawing digitally. On top of it, when billionaires like Vijay mallya, Nirav modi, ran out of countries after committing billions in fraud in India, central government steps in and print extra money and give to the bank to prevent the bank run.

How does it affect you and me ?

While banks enjoy most of the advantages of this highly lucrative system, a tiny bit of this trickles down to bank customers when they earn interest on their deposit accounts. Governmental are also part of the scheme and often defend that fractional reserve banking systems encourage spending and provide economic stability and growth.

On the other hand, every newly created penny dilute the value of existing currency. People who have investing experiences understand this better. For example, if a company has a 2-for-1 stock split, this means that for every one share of stock that a shareholder owned before the split, they will now own two shares of stock. The value of each individual share of stock will be halved, but the total value of the shareholder's holdings will remain the same. When money supply in circulation is increased, people and businesses have more money to spend, at the same time the available goods and services is not increased as much as money had increased. Therefore, each unit of currency buys a little lesser than it used to. In other words, purchasing power of money goes down. For example, a poor farmer, who do not understand anything about fractional reserve banking and inflation, work hard for all his life and save every penny in a bank. He saves 100,000 per year. He receives 3% interest on his saving, while he loses 10% of his purchasing power to inflation. On the other hand, billionaire who understands how the monetary system operates, take debt for  $1 billion and buy the assets which prices goes up as government creates more and more money. Thereby, the billionaires get 60 to 70 million free money thanks to fractional reserve banking. Adding compound interest to that free money every year, their net worth will be increased by extra a few billion just because he took some debt. At the same time if the poor farmer saves 100,000 per year, every year he loses the purchasing power of that money. Adding negative interest to his savings, the affordability of the farmer would go down significantly just because he doesn’t understand the monetary system and saved money in the bank. It increases the gap between the haves and the have nots. The wider the gap, the rich get more influence over the poor. Money is not a tool to buy luxury items but it’s a tool to buy freedom. Freedom comes with responsibility.  The more you understand the finance, the more freedom you get in your life.

Bitcoin vs fractional reserve banking

Governments which supposed to be servants of public becomes fear of public just because they got monopoly in money printing. Often many argue that bitcoin will replace all fiat currencies because the current monetary system has several flaws in it including fractional reserve banking. Since bitcoin supply is limited, and governments around the world continue to print money to stimulate their economies, the value of fiat currencies (like the US dollar and Indian rupees) decrease, which could drive people to seek out alternative forms of currency like bitcoin that are not controlled by any government or central authority. This could lead to increased demand for bitcoin, and therefore an increase in its price. The more price bitcoin reaches,  the more people will go for it. The more people adopt to it, the lesser the government will have control over money.

In order to prevent that from happening, governments have two tools. One is banning bitcoin. However, the problem with banning is, since bitcoin is a decentralised currency, people will always find a way to invest in it as long as they believe it values goes up in the long run. Second option is, making the fiat currency better than bitcoin by limiting it supply. However, it is highly unlikely to happen because governments all over the world, enjoyed the absolute power of creating more money out of thin air. Nevertheless, when they understand the fact that they do not have monopoly control in money printing anymore, at least they try to act more responsible. The responsible behaviour would help millions of people to preserve their wealth without worrying about loosing their purchasing power to inflation.

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