Where is money created

Something that seems to be an extremely common misconception is that all money is created by the government. Given that most people don't actually study how it works they come to their understandings of how money and finance works based on personal experiences and what other people tell them. Unfortunately most financial advice is bullshit (at best) but even then in most financial discussions the nature of money itself and the systems around it are not so commonly discussed. So I feel many people's intuitions are mostly based on their personal interactions with the monetary system. One bias I think comes from the handling of government created coinage and banknotes, however physical currency is a very small fraction of the money in the modern monetary system, but yet in your daily interactions if you use cash you are very much using something the government has made. Lately though I hear more and more stories about the ever increasing bubble in Australian real estate, when someone purchases a house with a mortgage this is likely going to be one of the major interactions someone has with the financial system as is it the largest purchase many individuals make in their lives (if they can afford to buy into real estate that is, which an increasingly large number of people now cannot afford to do). In this case the mortgage represents a large sum of money and most of the money is actually created by the bank offering the mortgage.

In reality the majority of money is actually created by the commercial banking system, with some created in the private sector and some in the public sector. This along with the assumption that debt can be treated as a form of money forms the cornerstone of the operations of the modern monetary system. Among people who know this I've seen another common misconception which is that many people significantly overestimate how much of the money in the system is created by the government. In the recent decades in the western world¹ in practice the vast majority of money was created by the private banking sector.

The historical breakdown of ratios of where money is created typically surprises people. There was a report made by the Bank of England on this in 2014² that investigated what the sources of money creation were. In this report the central bank claimed that 97% of money was created by the private banking sector. The report is worth reading for a few reasons, particularly how it explains the specifics of how quantitative easing allows the central bank to more directly create money in the system. Of course there's the usual bias from central banks in this article that they are completely in control of monetary policy³, even when admitting 97% of money is not created by them, but the discussions on the mechanics of the bank operations are detailed and are worth reading. With the rise of cryptocurrencies and other various monetary alternatives we have even more currency that's not being created by the government. Also keep in mind with cryptocurrencies that none of this money is included in banking aggregates like M2 that are often used as a stat to indicate changes in the monetary supply.

Also of interest in that report is the comment that "Central banks do not typically choose a quantity of reserves to bring about the desired short-term interest rate.". Since 2014 it seems central banks have become much more active in creating money and in their operations in the markets, this is especially so in the wake of the pandemic with especially heavy handed financial interventions being increasingly normalized. We have seen in practice in recent times very explicit targets being mentioned like the Reserve Bank of Australia having set an explicit target amount for their Yield Curve Control program. The purpose of this sort of policy is to directly intervene in the markets via open market operations to force yields down on bonds. A large change since 2014 is that interest rates have dropped across the world and we are now very close to the zero-lower-bound for interest rates in nominal terms which has meant that dropping interest rates is no longer an easy thing to do as compared with times in the past. This bizarre situation might be coming to an end soon though as yields are starting to rise in much of the world as a response to extremely harsh inflation.

In the future it would appear that there's a number of scenarios in which the central banks will become more of a driver of direct monetary creation than they are today. With high government debts worldwide compared to GDP there will be inevitable pressures and political temptations to monetize that debt, and because there's so much debt vs GDP monetizing the debt would be something that the central banks would have to be involved in. The reason a central bank digital currency would be such a major change is because this would put the central bank in a much more direct position to control monetary creation all the way down to the individual bank account level. I think many misconceptions get in the way of people understanding the true impact of Central Bank Digital Currencies, firstly most people have no understanding of the fact that the vast majority of money in the modern system is already entirely digital, though with the pandemic of mindless cashless payments as each year goes on people use their plastic cards for more and more purchases. We also have seen a massive proliferation of buy-now-pay-later schemes. Thinking about this reveals an important aspect of the nature of modern money, it is mostly digital ledger entries, or more literally just numbers in various banking databases. Who controls those databases has a lot of very real power over people. If the only way to interact with the economy is via one singular database then whoever controls that database controls immense power, Central Bank Digital Currencies represent a potentially huge centralization of power. Then we also have the misconceptions like the government/central bank creating all the money at play as well, if you think for example that the central bank is already creating all the money then a program to allow the central bank to create all the money doesn't sound anywhere near as radical as it does if you understand that the central bank doesn't create all the money let alone the real situation where the central bank creates only a portion of the money. Even with an increasingly digital financial system this is why CBDCs are a radical change to the financial system, it would be a huge change in who creates the money.

The other thing about central bank digital currencies is the ability this provides for the direct meddling at the level of individual bank accounts for the stated aim of pursuing various monetary policy aims. For example if the inflation is too low it would be very easy to bump up inflation via instantly creating extra money in people's accounts. Real logistical impediments to implementing helicopter money get avoided. For example in Venezuela they couldn't even afford to charter the international freight to deliver the freshly printed new higher denomination banknotes at one point in the crisis. With a CBDC adding extra zeros is a lot easier because it's just a matter of changing some digits in a centralized database. Say inflation starts getting out of control you could use a system like this to remove money from people's accounts. Putting aside politics for a moment, the current system doesn't make it so easy to destroy money in individual accounts, but with a CBDC since it's all just digits in a database that becomes possible. If such a system were to be put into place the questions around how and where money is created would have a very different answer.

I think a very good example of the power of a centralized digital currency and all the problems associated with such is the current situation unfolding with Tether. Tether is supposed to be a stable coin, a digital currency where each token is directly convertible to US dollars at a stable fixed 1-1 ratio. Because of a number of issues with having enough collateral to actually maintain that exchange peg there's a lot of incentives for them to just print as much as they need in the centralized Tether Treasury and have those newly created tokens available for people to exchange. And people do exchange these, and as long as the withdrawals to USD can be covered the whole system can keep going along. But the issue here is that not only is it easy for that centralized source to mess with the supply there's extremely strong incentives for them to do so. As a result a huge number of Tether tokens could be created without backing and if those were to trade on an open market with no informational asymmetry issues at play ⁴ that those tokens would start to trade at less than par. For example if Tether just decided to just double the size of the token pool without getting more collateral then you'd expect to see the tokens start to trade closer towards half their current value. But what if there is a situation like the number of tokens doubling without the collateral doubling but people don't initially know this to be the case? There's a lot of different things that could happen in a situation like this, if nobody ever realized that there's not enough collateral for example if not enough people actually try to redeem the tokens for USD to stress the reserves then the token could trade at a 1-1 value for a long time. This situation however threatens a complete collapse of confidence if there were to be a situation whereby informational asymmetry ended and people started to know that there was not enough collateral to back the tokens that continued to trade at 1-1 since this would imply many people will be stuck with something worth zero if they take too long to cash it out. Confidence in the ability to use the system to redeem your tokens, or fiat currency, at a later date for goods and services is absolutely critical to the system working. Without this confidence you end up in the situation where the psychology of hyperinflation kicks in as this is a psychological state where there's significant anxiety and doubt about the future ability to redeem the value. For most currencies the feasibility entirely rests on the stability of being able to redeem the currency for things of value in the future.

I think many of the same dynamics seen with Tether are possible with CBDCs since most contemporary calls for CBDCs are not really proposing having that money backed by some sort of solid reserves. In fact many of the people championing CBDCs are explicitly seeing this lack of backing as a feature and not a bug. Without this backing many of the dynamics seen with Tether, which allow for arbitrary instantaneous monetary creation and destruction by a central power, are possible. Trusting an unaccountable central agency to keep the purchasing power of a currency stable when they are likely exposed to strong incentives to do otherwise seems like a dangerous place to be.