Column #3 Where Does Our Money Come From?

(Week 1 - Wednesday July 30)

As I travel around the country talking about money, I often ask people - "Where does our money come from?" I don't mean where do the paper notes that are used to represent dollars come from. Those are obviously printed. No, I am talking about money itself; the credits that paper dollars represent, which convey the power to buy something.

For greater specificity, the question might be broken down into three parts:

(1) What is the procedure by which dollars are created?
(2) How do they enter into circulation?
(3) Who controls the process?

Over the years I have only rarely found a person who can offer a clear and accurate answer to the where-money-comes-from question. Surprisingly, politicians, financiers, and even economists, fare only marginally better than the man on the street. This is astonishing in a nation that prides itself on its financial sophistication and has built up a vast financial network that now reaches around the world. What is more ironic still is that virtually every citizen of the country has had a direct personal experience of the process by which our money comes into being. Indeed, many of us participate in one or more of its various forms almost daily, and yet remain completely unconscious of what we are actually doing. The process I am talking about is the deceptively simple act of borrowing money from a bank.

For purposes of illustration, I will choose a straightforward example. When a person goes to a bank to apply for a loan, he or she fills out an application, submits it to the banker, and, if all goes well, the "loan" is approved. This banker will then place in front of the applicant a contract, the signing of which obligates the borrower to "pay back" the money "lent," plus an additional charge that is designated as "interest." After the paper is signed, the banker hands over the money, and the borrower goes out and spends it for whatever purpose he had in mind when he asked for the loan. Over time the borrower will, by the terms of the contract, be obliged to "pay back" the "loan," plus the "interest." Supposedly, when the terms of the loan are satisfied, the contract is stamped "paid," and life goes on (or so it would seem; more on this later).

To all appearances, this transaction is very up-front, honest and understandable, but there are several questions about it that need to be asked. The first is –"Where did the banker get the money to loan?" My experience has shown that by far the majority of people assume that he had the money on-deposit in his vaults or accounts, and is now handing some of it over to the borrower for a period of time, until he or she "pays it back." This is a fundamental misunderstanding of this process (which, as will be shown, has great consequences).

The truth is that the banker did not go back into his vault to get the money. Rather he created it with the "stroke of a pen" when he wrote the check. This strikes many people that I talk to as a startling assertion. Not a few will declare that this simply cannot be true, but, as stated by Robert Hemphill, former credit manager of the Federal Reserve Bank of Atlanta, "If all bank loans were paid, no one would have a bank deposit, and there would not be a dollar of currency or coin in circulation. . . We are completely dependent on the commercial banks. Someone has to borrow every dollar we have in circulation, cash or credit . . ."

In modern banking practice, there may or may not be a physical writing of a check (the funds could have been credited electronically to an account, or there may even have been cash passed across the desk), but the actual mode of transference is a technical detail that concerns mainly the convenience of the parties to the transaction. The crux of the matter is that before the banker "signed the check" (or credited the borrowers account with new funds), the monetary credits (the "dollars" of whatever form) the banker is "lending" (in reality issuing) did not exist.

The borrower accepts the check, and then, after cashing or depositing it, spends the proceeds for whatever purpose he took out the loan to accomplish. This newly-created money now enters into circulation and becomes blended into the public money supply which we all use to conduct our business.

The mistaken notion that we actually borrow money from banks, in the common sense use of the term "borrow" (i.e. that the banker lends us something of substance that he has in his possession, and will have to do without it until he is "paid back"), constitutes a fundamental misunderstanding of what is actually happening in this process. At the point of the "loan" transaction the banker is actually creating and issuing money. What is more, virtually all the monetary woes of the modern world arise from the nature of this "private-bank-loan" transaction by which our money comes into being.

In the next edition of this column we will begin to examine why this is so.

Richard Kotlarz
richkotlarz@gmail.com