Where money comes from

Almost all money is created by commercial banks when they make loans — not by governments printing it, and not by lending out existing deposits. The central bank's own explanation says so plainly.

Part one of how money actually flows.

Most people carry one of two mental models of where money comes from. Either a government prints it, or banks take in deposits from savers and lend those deposits out to borrowers.

Both are wrong, and the second one is wrong in a way that matters enormously, because it is what most of us were taught in school.

Banks do not lend out deposits

When a bank makes you a loan, it does not go and find someone else’s savings to hand over. It writes two numbers: a loan on its asset side, and a new deposit in your account on its liability side. That deposit did not exist a moment earlier. Nobody’s balance went down to make it.

That newly created deposit is money in every sense that matters — you can spend it, and the shop that receives it treats it identically to any other money.

This is not a fringe reading. It is the Bank of England’s own description, published in its Quarterly Bulletin in 2014 under the title Money creation in the modern economy, which states directly that the common textbook model has the process backwards: loans create deposits, not the other way round. The paper is short and worth reading in the original rather than in anyone’s summary of it, including this one.

The mirror image is also true. When you repay a loan, that money is destroyed — the deposit and the loan cancel each other. Money is not a fixed pool being passed around. It is continuously created by lending and destroyed by repayment.

So what does the central bank do?

Not print the money you use. Central banks do three things that matter here:

They set the price of money. By setting the base interest rate, they make lending cheaper or more expensive, which changes how much of it commercial banks do. This is indirect: they influence the rate of money creation without doing the creating.

They issue reserves. Reserves are a separate kind of money that banks hold at the central bank and use to settle with each other. Households and businesses never touch reserves. This distinction is the single most common source of confusion in public argument about money creation — a bank cannot “lend out its reserves” to you, because you have no account at the central bank to receive them.

They buy assets. Quantitative easing means the central bank creates reserves and uses them to buy financial assets, mostly government bonds, from whoever holds them. This raises the price of those assets and lowers their yield.

Note what QE does and does not do. It does not deposit money in household accounts. It swaps one asset for another at the top of the system, and the effect reaches households indirectly — through asset prices first, and through lending conditions second. Hold that thought; it becomes the whole argument in part three.

The third source: government spending

Governments also put money into the economy by spending it, and take it out by taxing. A government that spends more than it taxes is, net, adding money to the private sector — someone’s deficit is someone else’s surplus, as a matter of accounting rather than opinion.

How this interacts with the central bank varies by country and is genuinely contested territory. What is not contested is the direction: deficit spending adds financial assets to the private sector, and taxation removes them.

What this means for the shape of the flow

Three consequences follow, and everything else in this series rests on them.

Money enters at specific points, not evenly. It enters where lending happens and where the central bank buys. It does not descend uniformly on the population. If most new money is created as loans, then most new money enters in the hands of people creditworthy enough to borrow, secured against assets valuable enough to lend against.

The quantity of money is not controlled by anyone directly. It emerges from millions of lending decisions. Central banks influence it; nobody sets it.

Most money is bank deposits, not cash. Physical notes and coins are a small fraction of the money in circulation in developed economies — a few percent. When you picture “the money supply,” picture entries in bank databases, not printing presses.

The uncomfortable part

If money is created mostly through lending, and lending is mostly secured against assets, then the system creates new money most readily for people who already own things.

That is not a scandal. It is a rational risk-management practice: lending against collateral is safer than lending without it, and a bank that ignored this would fail. But the aggregate effect of a great many individually sensible decisions is that new money flows toward existing ownership.

You cannot understand why asset prices behave the way they do without this. And you cannot understand why a wage feels like it is falling behind, in an economy that is not obviously failing, without it either.

Next: how money reaches people →

Sources

• Bank of England, Money creation in the modern economy, Quarterly Bulletin 2014 Q1 (McLeay, Radia and Thomas). The primary source for loans-create-deposits, from the institution that would know.
• Bank of England, Quantitative easing explainer, for the reserve-swap mechanism.

Figures on cash-versus-deposit shares vary by country and year; check your own central bank’s monetary aggregates rather than relying on the round number above.