You earn it, spend it, invest it.
Many of us spend quite a bit of time worrying about it. But do you know where money actually comes from?
Here’s a rough guide to how it all works.
Most money is created by retail banks
If you’ve ever heard people talking about home loans being “fake” money you might have wondered what was going on.
While it sounds a bit like a conspiracy theory, there is a little truth to this idea.
Retail banks create money through lending.
In a recent paper, the Reserve Bank explained how, with an example of someone who wanted to buy a house for $1 million and needed to borrow $800,000 to do so.
The $800,000 loan becomes an asset on the bank’s balance sheet, because it’s counting on the money being repaid.
As part of the transaction, the bank gives an $800,000 deposit to the seller of the house, which becomes a liability on its balance sheet. This money has been transferred from the bank to the buyer, then on to the seller.
But with the deposit on its books, it can lend against it more than once.
Banks don’t have to have to hold deposits equal to all the lending they do.
The $800,000 of new money created by the initial transaction then slowly disappears over time as the loan is repaid. But at the same time, other loans can be taken out.
“The amount of money created through bank lending is ultimately determined by the supply of and demand for bank loans,” the Reserve Bank said.
As the number of deposits held on the banks’ liabilities sheets increases, so too does the potential for people to want to withdraw money.
That meant banks have to ensure they have access to base money stores (more on that in a minute), or hold other assets that could easily be traded for cash, such as government bonds.
The Reserve Bank’s capital requirements detailed how much capital they needed to hold for any amount of lending they do.
Economist Shamubeel Eaqub said a loan was basically a promise to pay.
“Everything about money is about confidence, a belief system. It’s a way for us to pool our confidence in each other and money is the medium of that exchange.
“That’s what mortgages are, too. The bank is taking a risk — ‘I think you’re going to be able to pay off the debt’ – so it creates a deposit on the other side on the strength of that debt, and assuming the deposits are not going to be called all at one time, it can keep lending the deposit many times.”
Dennis Wesselbaum, associate professor at the University of Otago, said money created by banks was temporary. “It could be your credit card that you pay back next week or your mortgage you pay back in 20 years.”
Brad Olsen, chief executive at Infometrics, said retail banks could not go on creating money completely unchecked.
“There are some speed limits that exist naturally. Capital requirements mean that banks need to hold enough money-worthy instruments to meet those capital requirements. That means that retail bank lending rises, they also need enough assets to meet the capital requirements as their loan levels rise.
“There’s also a natural level of risk taking within banks — they don’t want to lend out so much that they can’t service the amount of money people demand from them. Taking out a loan is essentially paying but from the future, and that means banks have to think long term about having rising loan levels and if people will be able to repay them — giving out too many loans, to a level that people couldn’t actually repay, would see the banks without the money they loaned out, so the banks want to get the balance right.”
A bit is created by the Reserve Bank
When ‘the government’ creates money, it happens through the filter of the Reserve Bank.
Money created by the Reserve Bank is known as “monetary base” or “base money”.
This includes physical currency (about 20% of the base) and the settlement cash balances that retail banks hold in their accounts with the Reserve Bank.
Banks can use their settlement cash with the bank to buy physical money for their customers.
Banks can move their settlement cash between each other, without changing the total level of settlement money.
But transactions involving government and the Reserve Bank can change the settlement cash level – primarily through the government issuing bonds that are sold to investors.
What’s this about money printing?
Remember the government “money printing” during the pandemic — when there were efforts made to keep the economy turning over despite lockdowns?
We had the funding for lending programme (FLP), which gave the banks cheaper access to money, which they could then lend at lower interest rates; and the large-scale asset purchase programme (LSAP), when settlement cash was created to purchase government bonds from the market.
“The Reserve Bank has infinite power to create money,” Eaqub said. “On occasion, especially during Covid, they did try to essentially print more money… with LSAP and those kinds of things, they were designed to increase money supply.
“But it was a very unusual circumstance and a very short-term thing. And, even though the Reserve Bank created the money to buy the existing bonds from investors, the government still has to pay it back, which is what we are seeing at the moment.
“The way we have set up the system, we can print money if we want to do but we understand that printing an unlimited sum of money would destroy confidence in the monetary system which can then lead to the kind of Banana Republic issues we’ve seen in other places like Zimbabwe. That’s why the link between the government and the Reserve Bank is via the commercial banking system.”
He said the Reserve Bank paying a dividend to the government was the extent to which printed money would turn up in government accounts.
“It’s not true the Reserve Bank is funding government borrowing. It could, but it would lose trust in the value of the New Zealand dollar, then we would have inflation and our money would be devalued.”
Eaqub said the system was much more technical than political.
“It’s faith, an exchange of promises. None of it works when we don’t agree.”
And what’s the deal with cash anyway?
Although we’re increasingly moving to contactless and cashless payment methods, New Zealanders were still fond of cash.
There was about $8.6 billion in notes in the hands of the public, up from less than $5b 10 years ago, and there was about $9b total currency in circulation.
rnz.co.nz
