When you go to a bank to borrow money, you might think that the bank gives you money that other people deposited. That’s what a lot of people believe, but it’s not quite how it works. In this article, I will explain how banks are in the unique position to create money by issuing (giving out) loans, and reflect a little on its implications.
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This article is also available in Dutch. You can find it here.
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To understand a bank’s money-creating superpower, I will illustrate some examples using a simple balance sheet.
A balance sheet shows what you own (assets), what you owe (liabilities), and the difference between them, which is your equity or net worth. Assets include things like cash, investments, and property, while liabilities are debts like loans and credit card balances. Your equity is what’s left over after you subtract what you owe from what you own—essentially, it’s the value that’s truly yours. As the name suggests, the amount of assets is always balanced by the amount of liabilities.
Let’s say I own $1000 in cash and owe nothing to anyone else. My balance sheet would look like this:
| assets (me) | liabilities |
|---|---|
| $1000 cash | $1000 equity |
| total: $1000 | total: $1000 |
My net worth is $1000, which I happen to own in cash.
Let’s now say I borrow $1000 to a friend. This basically entails giving my friend $1000 in cash in exchange for a promise (worth $1000) to repay me. In my balance sheet, we see the following change:
| assets (me) | liabilities |
|---|---|
| $1000 loan | $1000 equity |
| total: $1000 | total: $1000 |
As you can see, my total assets and liabilities remain unchanged: my net worth is still $1000, but now I own it in the form of a loan.
For my friend, the balance sheet will look a little different. He now owns $1000 cash (asset), but is also $1000 in debt with me (liability):
| assets (friend) | liabilities |
|---|---|
| $1000 cash | $1000 loan |
| total: $1000 | total: $1000 |
While assets and liabilities are still in balance, my friend’s balance sheet has lengthened from taking the loan. Together, however, we still posses only $1000 cash.
Let’s now assume that I am unable to lend my friend $1000, and he decides to take a 0-interest loan at a bank instead.
The bank now gets the $1000-dollar loan that I owned previously, but instead of handing my friend $1000 in cash, the bank provides him with a $1000 deposit (a liability for the bank, an asset for my friend).