How money is created

Ask ten people where the money in a mortgage comes from and nine will say some version of the same thing: the bank gathers deposits from savers and lends them to borrowers. It is a clean story, it is what most of us were taught, and it is wrong in a way that matters for reading almost any macro argument you will meet.

Watch the balance sheet, not the story

A bank has two sides. On the left, what it owns or is owed: reserves at the central bank, loans it has made, securities it holds. On the right, what it owes: deposits, and the shareholders' capital that absorbs losses. The two sides are equal because that is what a balance sheet is.

Approve a $250,000 mortgage and two entries land at the same instant. The loan appears on the asset side, because the borrower now owes the bank $250,000. And a deposit of $250,000 appears in the borrower's account on the liability side, because the bank now owes the borrower that money. Nothing moved from anywhere. The bank typed both entries.

Push the buttons below and watch which rows move. The thing to notice on a loan is the row that does not: reserves sit exactly where they were. If banks lent out deposits, that is the row you would see fall.

The arithmetic behind that tool lives in a tested library rather than in the page. Among the tests is one that runs two thousand random sequences of operations and asserts, after every single one, that the sheet still balances and that the money supply moved by exactly what the operation reported creating and by nothing else.

What the deposit actually is

Money in a modern economy is mostly not notes. It is a promise from a bank to pay you on demand, which is to say it is a bank's liability. Roughly 95% of the money in circulation in an advanced economy is of this kind. The notes in your pocket are the minority case.

So when the bank credits the borrower's account, it has created a new promise, and a new promise from a bank is new money by the ordinary definition. The Bank of England put this in writing in 2014, in a bulletin whose title does most of the work: money creation in the modern economy. Their summary is that the textbook multiplier story runs the causation backwards.

McLeay, Radia and Thomas, "Money creation in the modern economy", Bank of England Quarterly Bulletin, 2014 Q1. Free at bankofengland.co.uk. The Bundesbank published a similar note in April 2017.

Repayment is the half nobody pictures

The creation story is now reasonably well known. The destruction story is not, and it is the same fact read backwards. Every pound of bank money in existence corresponds to somebody's outstanding debt. Pay down the debt and the money goes.

This is why a recession in which everyone sensibly repays debt at once is so hard to escape. Each household doing the prudent thing destroys deposits, the money supply contracts, and somebody else's income falls. Richard Koo named the pattern a balance sheet recession after studying Japan in the 1990s, and it is the mechanism behind the observation that an economy cannot save its way out of a slump the way a household can.

Three things that look like money creation and are not

• Paying cash into your account. Both sides of the bank grow, so it looks identical to a loan on the chart. No money is created. Currency that was already counted as money became a deposit that is also counted as money. The form changed and the total did not. Run it in the tool and watch the money supply readout stay still.
• Transferring money to another bank. One bank shrinks, another grows, and the system is unchanged.
• The central bank creating reserves. Reserves are money between banks. Households cannot hold them and cannot spend them. Creating reserves changes what banks settle with, not what the public has.

And one thing that does create money and surprises people: when a bank buys a bond from a pension fund, it pays by crediting the fund's account. That credit is a new deposit, created the same way a loan creates one. It is the channel through which quantitative easing reached the public at all.

What to do with this

When you next read that a central bank "printed money", ask which liability grew. If the answer is reserves, the public did not receive anything and the inflation argument has a step missing. If the answer is deposits, ask who was on the other side of the purchase.

And when you read that the money supply is growing or shrinking, remember what that sentence is really reporting. It is a statement about how much the private sector is borrowing, which is a statement about confidence. The money supply is not a dial somebody turns. It is the shadow that lending casts.