A few weeks ago I shared the first paper in my series on the Theory of Money. It asked a simple question: why is money created at all? The answer is that money is a social and political institution first, and a commercial tool only later. That gives us a foundation. But a foundation is not a building.
The next question is a practical one: where does money actually come from?
Ask most people and they will say the government prints it and banks lend it out. Both halves are incomplete.
In 2014 the Bank of England said it plainly: banks do not lend out savings. When a bank makes a loan, it writes a new deposit into the borrower’s account, and that deposit is new money. Germany’s Bundesbank says the same. So most of the money we use every day is not printed by the state. Commercial banks create it, loan by loan.
That is one source. In the second paper I argue there are four:
Central bank money. This is base money created by the central bank. It should grow roughly in line with real output, and it is the economy’s lasting store of value.
Commercial bank money. Banks create it every time they lend and destroy it when the loan is repaid.
Foreign earnings. These are trade surpluses and remittances. This is earned money, and it carries no claim.
Foreign capital. This is FDI, FPI and external loans. It is borrowed money that arrives with a claim attached.
The last two become domestic money only if the central bank chooses to convert them. That makes them a policy choice, not an automatic fact.
Why does this matter? Because these four sources are not interchangeable. Several things become clear once you lay them side by side.
The aggregate interest paradox. A bank creates the principal of a loan but not the interest. Add up every loan, and the economy always owes more than the money in it. If bank money were the only money, someone would have to keep borrowing just so others could pay their interest. Central bank money fills that gap, but only if it reaches the people who carry the debt.
The leakage. In most countries the central bank may not lend directly to the government. New money passes through dealers and other intermediaries, and each one takes a cut. In the paper I follow a single $950 bond, step by step, to show where the cut is taken.
The aggregate return paradox. Foreign capital creates the same problem across a border. It brings money in, but not the returns it expects. Dividends and profits must be drawn out of the domestic money stock, and then they leave the country.
Investment swarming. FDI and FPI tend to rush in together and rush out together. This herd behaviour works much like a bank run, but there is no international lender of last resort to stop it.
The paper uses a simple analogy. A bank loan is a blood transfusion that revives an anaemic patient. But the lender takes back more blood than he gave. Whether the patient survives depends on whether his own bone marrow is making new blood, and that bone marrow is central bank money. Foreign capital is a transfusion from an outside donor who also wants more back, and that blood leaves the body for good. Foreign earnings are blood given outright.
This is how I begin to make sense of the questions I wrote down back in 2007:
Why does the bottom of the income distribution seem locked in debt while the top does well?
Why did quantitative easing not create the inflation everyone feared?
Why is the first response to weak growth still a rate cut?
This paper does not answer all of them. That is the job of the papers that follow. The next one looks at the limits of each source, and why those limits fail. But we cannot answer any of these questions, or value a currency properly, without first knowing where money comes from.
If you want to dig in, download the paper below. It is written in plain language, with a worked example and a short glossary. As always, please share your feedback, especially if you disagree.
