1. Misconceptions
Money generation remains central to economic activity. The process of how money is generated / created and destroyed is not, in fact, readily understood and is subject to numerous misconceptions. If anything, main conceptions about money creation and destroy assumes a linear conceptualization mode. Typically, money is widely – but mistakenly – believed to be created and destroyed by a direct relationship by which an owner places money deposits in a financial institution which, sooner or later, lends money to borrowers and hence creates more money. In modern era, particularly in a global financial system in which financial transactions are performed via complex banking systems, depositing, lending and borrowing money are much more complex processes which are hardly understood, if at all. Two main conceptions stand out, primarily, as far as money creation is concerned: (1) banks are intermediaries whose primary job is to lend deposits placed by savers, and (2) central banks control loans and deposits by controlling quantity of central bank money (McLeay, Radia and Thomas). If anything, money is neither created nor controlled. In practice, money is created and controlled, as shown in next section, in a radically different manner which is far from a linear process.
2. Actual Practice
In practice, money – "broad money," in particular, which refers to money deposits of households and banks – is created by commercial banks lending individuals and/or corporations (McLeay, Radia and Thomas). By borrowing money from a financial institution, primarily a commercial bank, a customer is said to increase his liability and increase a bank's assets which are not, in fact, in a banknote form but are credited to a bank's account in a value commensurate with a customer's requested loan. True, money is created by bank loans, as is just shown. However, lending / borrowing process is not a linear process by which money is created by mere money deposits into a bank's coffers. Instead, banks increase assets by lending money at specific interest rates (regulated by central banks, as show later) and hence create more asset value. Indeed, bank deposits are liabilities, assets, which show how much money a bank owes customers. If anything, banks do not lend "pre-existing money" but lend money which is guaranteed by bank assets.
For central bank reserves, money reserves circulated in a given economy are not simply controlled by central banks by managing money quantity. Instead, central bank reserves are decided based on lending / borrowing decisions made by lenders (primarily commercial banks) and borrows (i.e. individual and corporate customers). More specifically, commercial banks consider, first of all, whether to lend a customer or not based on profitability opportunities which are decided on light of interest rates decided by central banks. Thus, banking deposits, including a central bank's reserves, are decided by lending decisions made by lending institutions, primarily commercial banks.
3. More Ways for Money Creation
In addition to conventional money creation and destroying by lending and borrowing practices, respectively, money can be created and destroyed by numerous different ways. In all money creation and destroying ways, one critical principle should be noted: in creating money, leading institutions increase assets (not money) and by borrowing, customers destroy money by increasing liability on balance sheets. Thus, money creation and destroying ways can include, for example, government bonds and long-term debt and equity instruments, both of which are different asset / liability increase ways for lenders and borrowers.
4. Constraints on Money Creation
Broadly speaking, interest rates set by central banks regulate lending and borrowing activities in a given economic system. Put differently, commercial banks are not given free rein to just lend money to borrowers without constraints. Instead, interest rates govern lending and borrowing activities. In addition to interest rates, no less important constraints exist to self-regulate lending and borrowing beyond monetary policies set by central banks. If anything, market forces play a major role in a commercial bank's decision to lend or not (McLeay, Radia and Thomas). Specifically, by weighing different opportunities and risks in making a lending decision, commercial banks are, in fact, responding to supply and demand requirements defined, not as per fixed rules and regulations, but in response to dynamic and complex processes between different economic actors in a given economic system. Moreover, households and businesses remain central in restraining lending activities of commercial banks. For instance, by borrowing money to repay loans, lending banks may refrain from making a lending decision since money in such case is destroyed and is not invested in a money creation cycle.
5. Managing Risks
Important as is, banks need to ensure lending decisions involve minimum risk. There are, in fact, numerous ways by which banks mitigate or minimize risks resulting from lending activities, particularly during active economic periods when interest rates are lowest and incentives to lend in large amounts are highest. (The 2008 Financial Crisis, later renamed Great Recession, was largely cause by "irresponsible" lending behaviors by big banks using questionable securities and financial instruments.)
One most conventional way to mitigate risks by commercial banks is to attract comparatively stable deposits which are not readily accessible by customers over one or close periods and hence might lead to a liquidity crisis (McLeay, Radia and Thomas).
A second way to mitigate risks is via regulatory bodies. Indeed, 2008 Financial Crisis has proven, above anything else, that market forces and a laissez-faire monetary policy is apt to lead to enormous effects over short, medium and long ranges. The credit crunch numerous economies now face and careful reviews of interest rates, particularly in more developed economies, can be attributed largely to irresponsible lending / borrowing practices by major lending institutions, particularly mortgage ones prior to 2008 Financial Crisis. Two major patterns stand out as to how broad money can be managed in order to mitigate risks of excessive lending. First, central banks can adopt a loose monetary policy and hence increase broad money deposits and, ultimately, increase loans (McLeay, Radia and Thomas). Or, by adopting an stricter monetary policy, broad money is increased which, accompanied by increased consumer spending, could lead to more demand on reserves by banks and customers alike and hence boost economic activity and, ultimately, create money. Thus, central banks remain critical in not only governing how money is created and destroyed in a given economic system but also, more importantly, in creating wealth (or not) for nations.
Works Cited
McLeay, Michael, Amar Radia, and Ryland Thomas. Money Creation in the Modern Economy. Bank of England, 2014, http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf.
