The Loan

Where does money come from? The question seems to have an obvious answer — the government makes it, at the mint or the printing press — and the obvious answer is mostly wrong. Most of the money in a modern economy is made not by the state but by banks, and not by printing or minting but by lending; it is conjured into existence by the stroke of a pen when a loan is made, and it vanishes again when the loan is repaid. This is the most counterintuitive fact about money, and once seen it changes everything: money is debt, created by the act of borrowing.

The common picture of banking is of an intermediary: depositors place their money in the bank, and the bank lends that money out to borrowers, passing existing money from savers to spenders. On this picture the bank lends what it has taken in, and creates nothing. But this is not how a bank lends. When a bank makes a loan, it does not reach into a vault of depositors' coins and hand them over; it simply writes a number into the borrower's account — credits the account with the loan amount — and that new deposit, which existed nowhere a moment before, is new money, spendable at once. The bank has not moved existing money from a saver to a borrower; it has created new money by the act of lending, expanding the total quantity of money in the economy. The loan and the deposit are made in the same stroke: the bank's loan to the borrower, an asset on the bank's books, and the borrower's new deposit, the bank's liability and the borrower's money, appear together, conjured from nothing but the bank's willingness to lend and the borrower's promise to repay. Money, it turns out, is mostly created this way — privately, by banks, through lending — and the state's printed cash is only a small part of the whole.¹

If money is created when banks lend and destroyed when loans are repaid, then money and debt are not opposites but the same thing seen from two sides. Every deposit — every unit of bank-money — is matched by a loan somewhere, a debt owed to the bank; the money in your account exists because someone, somewhere, borrowed it into being. When the borrower repays, the deposit is extinguished, and that money ceases to exist: repaying a loan destroys money as surely as making one creates it. So the stock of money in an economy is the mirror of the stock of debt: they rise together in a boom, as banks lend freely and new money floods in; they fall together in a bust, as lending dries up and repayment drains money away. This is why money is, at bottom, credit — why the deposit is the bank's IOU and the loan the borrower's, two promises created in a single act — and why the volume's flagship will argue that money is, in its deepest nature, a circulating debt. The money in your account and the debt on someone's books are the same phenomenon: the promise to repay, made into the means of payment.²

Knut Wicksell saw, before most, what follows when money is created by bank lending: that the quantity of money, and so the price level, hangs on the rate of interest the banks charge. Imagine two rates. The first is what Wicksell called the natural rate — the return that real capital earns in the economy, the rate at which the demand to borrow for investment just matches the supply of real savings. The second is the money rate — the rate the banks actually charge on loans. When the banks set their money rate below the natural rate, borrowing for investment becomes profitable beyond what savings would fund, and businesses borrow eagerly; the banks, creating money as they lend, supply the credit; new money floods in, demand outruns the economy's capacity, and prices rise. And — this is Wicksell's key insight — the process does not stop, but feeds on itself: so long as the money rate stays below the natural rate, lending continues, money keeps expanding, and prices keep rising, in a cumulative process that runs as long as the gap between the rates persists. The price level, on this view, is governed not by the quantity of money directly but by the relation between the two rates — and the central bank's lever is the money rate, which it raises to choke the cumulative rise and lowers to spur a stagnant economy.³

If banks create money by lending, what stops them from creating it without limit? For a single bank in a system of many, the binding constraint is that its borrowers spend their new deposits, and the payments flow to other banks, draining the lending bank's reserves — the central-bank money it needs to settle with its rivals; lend too freely, and it runs short of reserves and must borrow them, at a cost. For the banking system as a whole, the constraints are several: the central bank, which sets the rate at which it supplies reserves, and so the cost of lending; the regulators, who require banks to hold capital against their loans, limiting how much they may lend; and the borrowers themselves, for money is created only when someone is willing to borrow and a bank willing to lend, so that in a slump, when no one wishes to borrow, no amount of willingness by the banks can force money into being. This last is crucial: because money is created by lending, its quantity depends on the demand for credit, not on the central bank's wish alone — which is why, in a deep slump, the central bank may push the cost of money to nothing and still find that money will not expand, for the borrowers it takes to create money are not there. Money is made by the meeting of a willing lender and a willing borrower, and when borrowers vanish, so does the power to make it.⁴

The loan reveals money to be a strange and unstable thing: created privately, by banks, in the act of lending; expanding and contracting with credit; its quantity governed not by a dial the state turns but by the willingness of banks to lend and borrowers to borrow. This explains much that the simpler picture cannot — why money and debt move together, why credit booms and busts drive the cycle, why the central bank works through the interest rate rather than by printing. But it also exposes money's deepest vulnerability, which the next plate confronts. If the bank's deposit is the bank's promise to pay, and the bank has created far more such promises than it holds in cash — lending many times over the reserves it keeps — then the bank's promise is good only so long as not everyone demands payment at once. The whole edifice of bank-money rests on the confidence of depositors that they can have their cash whenever they wish, a confidence that holds only because they do not all test it together. What happens when they do — when confidence fails and all demand at once — is the subject of the next plate. The next plate is the run.⁵

The loan, then, is where money truly comes from — not the mint but the bank, not printing but lending. When a bank makes a loan it creates a new deposit, new money conjured from the borrower's promise to repay; and when the loan is repaid the money vanishes again, so that money and debt are one thing seen from two sides, rising and falling together with credit. Wicksell saw that the price level then hangs on the interest rate — on the gap between the natural rate and the rate the banks charge — and that the cumulative process of rising prices runs as long as money is lent too cheaply. And the quantity of money, made by the meeting of willing lender and willing borrower, cannot be set by the state's wish alone, but vanishes when borrowers do. Yet the whole structure of bank-money rests on a promise the bank cannot keep to everyone at once: the promise to pay cash on demand, good only while not all demand together. The next plate turns to the moment that promise is tested, and the panic that proves it empty: the run.