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Introduction

Money, Credit, Banks, and Central Banks

Austrian School of Economics Fundamentals

Money, Credit, Banks, and Central Banks

  • How Money is Created
  • Instability of Fractional Reserve Banking and Lender of Last Resort
  • The Cantillon Effect
  • Consequences of Zero Interest Rate Policies
  • Conclusion
“The root problem with conventional currency is all the trust that’s required to make it work. The central bank must be trusted not to debase the currency, but the history of fiat currencies is full of breaches of that trust. Banks must be trusted to hold our money and transfer it electronically, but they lend it out in waves of credit bubbles with barely a fraction in reserve. We have to trust them with our privacy, trust them not to let identity thieves drain our accounts.” Satoshi Nakamoto, pseudonymous inventor of Bitcoin

How Money is Created

In our present-day monetary system, money is primarily created through a banking practice known as "fractional reserve banking." This term essentially means that banks are not required to hold as many reserves as they receive in deposits. Consequently, they can create new purchasing power when granting loans and, conversely, reduce purchasing power when customers repay their loans.
For example, if you were to approach your local bank to secure a mortgage for a house purchase, the money lent to you by the bank would come into existence as a bookkeeping entry. In accounting, we typically represent an individual's net wealth with a balance sheet, which has two sides: the asset side, including any property, financial contracts, inventory, or other forms of wealth owned, and the liability side, showing the source of funds used to create the capital listed on the asset side. The difference between assets and liabilities is referred to as "equity" and can be thought of as the net wealth of the entity.
When a financial institution holds a banking license, it essentially means that the liabilities recorded as "customer deposits" are considered official money within a specific country or monetary zone. Therefore, when you seek a loan to purchase a house from the bank, the banker doesn't lend funds deposited by another customer. Instead, the bank credits the borrowed amount to your account and simultaneously records your loan contract as an asset of the bank. As you repay your loan, money is effectively extinguished, and the value of the corresponding loan contract decreases, with the bank retaining only the interest on the loan.
Upon purchasing the house, you instruct your banker to transfer money to the seller's account. If the seller's account is with a different bank, your banker notifies the corresponding banker at the other institution to ensure the seller's account is credited accordingly, while debiting your account by the corresponding amount.
Figure 1: Money Creation as Bookkeeping Entries
“It is well enough that people of our nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning” Henry Ford
This process allows banks to record all transactions, including wire transfers, credit card purchases, and checks, over a specified period (usually a week or a month). They then settle these transactions with each other using bank reserves, which are another form of fiat currency never used by the public. Bank reserves are held at the central bank in a special account accessible only to licensed banks and financial institutions.

Instability of Fractional Reserve Banking and Lender of Last Resort

The main issue with this fractional reserve system is that significant withdrawals from a particular bank can potentially lead to its bankruptcy. Since banks must meet customer demands for cash while holding only a limited buffer of bank reserves, a simultaneous rush by many customers to withdraw funds can render the bank unable to satisfy these demands, resulting in bankruptcy. Given that many individuals, firms, and institutions have their funds deposited in banks, allowing a bank to fail could have severe economic consequences, such as a recession or even a depression.
This conundrum gave rise to the modern central banks. In the 19th century in England, repeated bank runs threatened financial stability, leading to the establishment of the Bank of England as the “lender of last resort.” The Bank of England was tasked with lending funds to distressed banks during crises to prevent a domino effect that could paralyze the entire financial system. This concept of central banks as lenders of last resort has since spread worldwide and become commonplace.
In addition to maintaining financial stability, central banks are responsible for setting key policy rates. These rates determine the cost at which licensed banks can borrow funds from the central bank, essentially defining the cost of liquidity for the financial institutions that play a crucial role in lending in our economies. Therefore, these rates serve as a benchmark for the entire financial system. As an individual, the interest rates you pay on your mortgage can be broken down into the policy rate and the bank’s margin.
Figure2: Lehman Brothers’ Bankruptcy (15/09/2008)
During the major financial crisis of 2008, Lehman Brothers, a large investment bank, declared bankruptcy after suffering significant losses on its mortgage securities holdings and experiencing massive withdrawals from concerned clients. In response to this unprecedented financial turmoil, central bankers around the world injected large amounts of liquidity into financial markets, merged struggling investment banks with commercial banks, and lowered policy rates to near zero in an effort to prevent a systemic collapse.
While these measures prevented a cascading wave of bankruptcies, they did little to alleviate the subsequent economic slowdown. Millions lost their jobs and homes, consumer spending plummeted, businesses went under, and banks incurred substantial losses. Despite historically low interest rates, few were willing to borrow, resulting in a vicious cycle where the initial decrease in spending and investment reinforced itself. Consequently, central bankers took further steps by implementing Quantitative Easing (QE) programs. These programs involved central banks purchasing government bonds and mortgage-backed securities from commercial banks with central bank reserves.
Figure3 : Interest Rates Across Major Economies / Source: ECB
Contrary to many expectations, QE programs did not significantly revive economic growth but did inflate financial assets to historic levels. This primarily benefited the wealthy and financial institutions, as they already held substantial quantities of such assets, thereby widening wealth disparities. Given the structure of the banking system explained earlier, this outcome should not come as a surprise. Since bank reserves cannot easily flow into the real economy, QE programs mainly boosted asset prices without effectively improving the financial situations of average individuals.

The Cantillon Effect

Nonetheless, an essential economic principle can be drawn from this episode: when new money is created, it initially benefits those closest to the source of the money, at the expense of those further away. This economic insight dates back to the 18th century when Richard Cantillon outlined it in his "Essay on the Nature of Commerce in General." It is now colloquially referred as the “Cantillon Effect”.
Figure4: Cantillon Effect in a Nutshell / Source: River Financial
In this instance, bankers, bank executives, stock and bond owners, real estate developers, real estate lenders, and anyone holding financial assets or real estate received a financial windfall, while the burden fell on everyone else. This situation persisted for years and largely explains the growing wealth inequality, the sense of disenfranchisement among hardworking individuals, and the seemingly unstoppable rise in asset prices despite sluggish GDP growth.
In essence, the system is skewed. Banks are inherently unstable, yet their failure can jeopardize the entire economy. This moral hazard incentivizes bank executives to take excessive risks to maximize their bank's revenue, knowing that the central bank will ultimately bail them out, shifting the cost to taxpayers. In such scenarios, central bankers create conditions for a massive transfer of purchasing power from hardworking individuals and savers to asset owners and those connected to the financial system, thereby disconnecting the process of wealth creation from wealth accumulation.
Figure5: Wealth Distribution in China + Europe + the US / Source: OECD

Consequences of Zero Interest Rate Policies

During extended periods of Zero Interest Rate Policies (ZIRP), banks have limited opportunities to rebuild their equity because their margins are eroded. Banks typically earn money by borrowing at short-term rates and lending at longer-term rates. However, when central banks purchase large quantities of bonds and set rates at zero, banks have little incentive to lend, especially to entrepreneurs and other risk-takers. Instead, they allocate their resources to securitize existing capital or provide loans against collateral to meet the demand of those benefiting from the Cantillon effect.
Another unintended consequence of ZIRP is that it encourages governments to engage in extensive spending. Since governments face no borrowing costs and can rely on central banks to purchase their bonds through QE programs, they have a natural incentive to spend as much as possible, particularly in democratic contexts where spending can garner votes. This tendency often disregards the long-term consequences of such fiscal profligacy, leading to a significant increase in public debt levels across developed economies since the Global Financial Crisis (GFC).
Figure 6: Public & Private Debt as % of GDP (World, weighted by GDP per country) / Source IMF
With inflation on the rise due to substantial money creation in response to COVID-related lockdowns, central bankers are now raising policy rates in an attempt to curb inflation. However, this poses a significant challenge for the entire system. Banks are more leveraged than ever, governments carry historically high levels of debt, economic growth is sluggish, deficits are mounting, and consumers, grappling with rising prices for essential goods, are struggling to make ends meet. Controlling inflation would require raising rates to a level that could bankrupt governments, while banks risk losing depositors as individuals spend their savings on increasingly expensive essentials or seek refuge in hard assets and money market funds to hedge against inflation.

Conclusion

“By this means (fractional reserve banking), governments may secretly and unobserved, confiscate the wealth of the people, and not man in a million would detect the theft” John Maynard Keynes
In essence, our system is facing substantial challenges, and Bitcoin emerges as the only credible alternative. However, Bitcoin alone cannot address the issues within our monetary system. Above all, we need individuals who understand basic economic principles among Bitcoin enthusiasts, enabling a broader awareness and economic common sense to guide us away from constructing another fragile financial foundation for our civilization. The primary objective of this course is to educate new Bitcoin enthusiasts in sound economic principles.
To achieve this goal, we will explain the fundamental principles of "Austrian Economics," an economic school of thought with a methodological tradition dating back to the 16th century, providing insights into human action under economic constraints. With this introduction, you now grasp the essentials of money creation and the current state of our financial and monetary system.
In the upcoming chapter, we will delve into the foundational cornerstone of any economic school of thought: the theory of value. Subsequent chapters will explore money as a social institution, the theory of capital and the business cycle, the challenge of economic calculation, and a brief overview of the history and methodology of the Austrian School of Economics.
Quiz
Quiz1/5
What are the consequences of Zero Interest Rate Policies (ZIRP)?