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 Money and money creation in Focus 

Katalin Botos

Money Creation
in the Modern Economy
Summary: An age-old debate has recently resurfaced in the columns of a daily newspaper Money creation in practice. Misconceptions
and reality. Is the issue still topical; indeed, is it one of journalism? Especially since the crisis, the public is still highly preoccupied
with how banks have come to have so much money. Experts in professional circles believe they know how money is created. The
textbooks used in economics education to this date teach the theory of traditional money multiplication. But nobody seems to be
interested in what the essence of money is – which in fact is not independent of its creation. As the saying goes, it is not important
what money is, only the effect it has.

Keywords: money creation, financial crisis, securities market

JEL codes: E4, E44, E5, E52, E58, E6, F3

Even though there have been numerous Obviously, today’s reality is very different
articles on the financial crisis itself and crisis from the reality of fifty years ago. Today there
management in recent years, it is a fact that are commercial banks in private ownership in
Hungarian finance has not really addressed Hungary as well. In the socialist era, the cen-
the changes that have occurred from a money tral bank was also the financier of companies
theory perspective. and as such, the issue was merely theoretical.
Finances played an absolutely passive role.
The decision on what must be produced was
A bit of history made by the planned economy, and financial
institutions merely arranged for financing. Fi-
It was some fifty years ago that university nancing for production, the extension of pro-
professors István Hagelmayer and Miklós Riesz, duction, or investments, was granted only to
experts of “socialist finance”, debated money entities that were authorised to carry out such
creation. István Hagelmayer was of the view that operations, i.e. those featured in the plan. The
the MNB (which at the time also functioned as MNB balance sheet included cash holdings as
the only commercial bank in the country) created well as OTP deposits. On that basis, it was
money simultaneously with credit rather than easy for planning to shift financing ratios to
lending against liabilities. Miklós Riesz insisted favour heavy industry.
on traditional tenets of finance. In principle, Even after the 1968 reform, financial gov-
a commercial bank must have liabilities so that ernment (using indirect methods) procured
it can engage in lending. A commercial bank that the economy produced what it needed to
buys and sells money, it trades in money. export to the other planned economies. (The
country was bound by transnational agree-
E-mail address: ments, which specified the numbers and tons

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 Money and money creation in Focus 

to be produced.) They also provided numer- legal regulations on promissory notes were
ous state incentives in an effort to influence rather strict at the time. Even then it hap-
capitalist exports. (In order to have enough as pened that the obligor of the promissory note
foreign currency was in very high demand.) If was unable to pay on time. But everybody was
unsecured money happened to flow out into trying really hard to avoid the consequences:
the consumption market as a result, it was not debtors’ prison. Many chose to commit sui-
considered a problem. The money ended up cide rather than live with the shame.
in the straw mattresses or in the OTP anyway. In Europe, the German economy also oper-
If there is nothing to spend our incomes on, ated through the mechanism of created money
what else can we do but to save it... A sort of as early as before World War II. After World
household deposit generation could therefore War II, West Germany clearly got back on its
be established ex post facto. (Note that foreign feet with the help of money created by central
currency management was fixed, and neither bank refinancing.
were products allowed into the country from
abroad without a permit. As a result, HUF
incomes could not involve imports.) That is Money creation
to say, subsequently the funds for forced in- in the market economy
dustrialisation were raised in the form of these
forced savings. The money creation process Also in the modern market economy, the primary
can thus also be conceived in a way that forced question is whether financial institutions, and
savings provided the funds for forced industri- in particular commercial banks actually create
alisation. money or simply mediate money. For a long
After the regime change, in an economy that time, we used to talk about the banking system
already operated on market terms, Hungarian as a set of institutions engaged in the mediation
financial literature argued explicitly that loans of money.
were not created from deposits, but rather de- Nonetheless, money creation by means of
posits from loans. (Tarafás, 2002). Note that promissory notes, as in our historical example,
well before that, the book Invisible Money has taken a backseat today. Why? Because the
by Gubcsi and Tarafás (1977) described very situation is very different today. There is an
clearly how, in general, created money came abundance of liquidity in the financial system.
to appear in the banking system, by means Loans are virtually forced down the throats of
of promissory notes. Promissory notes, being potential debtors. (We refer to liquidity be-
debt securities which banks considered wor- cause when we are looking for the relation-
thy of discounting were counter-discounted ship between the real economy and finances,
by the central banks. As a result, money was we are not looking at quantities of money but
created by the central bank. According to this rather quantities of liquidity – which is the
model, the funding underlying the (created) sum of money plus assets that can be turned
money was the loan itself, which was secured quickly into money –, which also include, in
not by the deposits, but rather by the port- addition to liquid money, securities that can
folio of promissory notes. A promissory note be quickly converted into money).
embodies a payment commitment by debtors. Commercial banks today are able not only
However, this is only a promise. Nevertheless, to acquire funds from their central banks but
being valuable securities, promissory notes also from one another in the form of inter-
were considered to be secure collateral, as the bank loans. They can also gain access to money

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through capital markets. But is this the money can be used for all transactions, in all settle-
they are passing on? Or do they create money ment arrangements and payments. The mon-
when they want to? ey created by commercial banks on the other
We should not believe that this question hand has limited use (Gubcsi ‒ Tarafás, 1977;
has lost its relevance. Even the Bank of Eng- Huszti, 1996; Issing, 2011). It is suitable for
land, in one of the studies published in its conducting a wide range of payment transac-
Quarterly Bulletin in 2014, felt it necessary tions, although only in the case of companies
to debunk the misconception related to lend- that belong to the same bank group. (This is
ing against deposits. The authors of the study usually a given for European banks with large
clearly stated that commercial banks created branch networks.) In the case of mutual off-
money (McLeay, Radia and Thomas, 2014). setting, commercial bank money can also be
True, but only bank deposit money. used in transactions conducted with other
Only the central bank can create cash. This banks.
fact is well established in the Hungarian lit- At the same time, there are numerous cases
erature (Bánfi et al., 1997). Non-bank insti- when commercial banks still need effective
tutions, however, do not create money but central bank money. If, for example, a com-
merely provide money-redistributing credit mercial bank’s customer wants to withdraw
(loans). (These non-bank institutions – shad- cash or the bank has to settle its interbank
ow banks – are often confused with commer- balance – for example, if we look at today’s
cial banks. Nonetheless, today the number of Europe: the TARGET settlements conducted
universal banks is on the rise in the Anglo- within the euro system – the bank will need
sphere as well. In Europe, this particular insti- central bank money. (Importantly, central
tutional type has always been predominant.) bank money will only be needed to settle the
In the case of commercial banks, the mon- balance. But definitely needed in that case...)
ey creation technique is a given, as described In addition, central bank money is also
above (back when the central bank also per- needed to fulfil the central bank’s mandatory
formed commercial banking functions in the reserve requirement. Therefore, there is a re-
planned economy). In the books of the banks, lationship between money creation by central
loans appear as assets while at the same time banks and commercial banks.
the money created is booked as own liabilities We have just answered the second ques-
on the borrower’s account. It is a liability since tion. Namely, it is clear that money creation
it is a debt, as the bank is required to provide by commercial banks cannot be unlimited. It
money, if necessary in cash, in the amount is intimately linked to how much central bank
in question to the requester of the loan. We money the commercial bank can gain access
have, however seen that – if necessary – they to and how it can do so.
are typically able to resolve this matter. The banking sector is primarily limited
But how much money can a bank create? in terms of money created through lending
This is the second question that arises. Do by whether there is demand for loans in the
commercial banks have an unlimited capacity economy at all. Obviously, banks’ profitabil-
to create money? ity targets and competition between banks
Commercial bank money – as we have seen also have significant roles to play. However,
– cannot take the form of cash only through the amount of loan money that can be cre-
the involvement of central bank money. Cen- ated primarily depends on the economy and
tral bank money is high-powered money. It the market expectations of enterprises. What

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counts is not just the interest rates of the loans of at least 8 per cent of risk-weighted assets.
on offer by the bank or the repayment terms The most current information on the website
applied. Demand for loans depends mostly on of the Bundesbank, for instance, indicates a 9
whether the entrepreneur expects to be able to per cent requirement. If a bank’s loan produc-
place its products or services on the market. In tion cannot be higher than that ratio then that
this sense, loan demand in the real economy is is also an indirect limit on money creation.)
the number one limitation of money creation However, central banks also indirectly reg-
by commercial banks. (Note that when loans ulate money creation through the instruments
are taken out to buy securities, this assertion of their monetary policies.
is only very indirectly true. That is because All of this is preceded by the question con-
oftentimes loans are taken out in the hopes cerning the purpose for which a central bank
that the price of the procured securities will limits money creation. (Above we have stated
increase, thereby allowing the borrower not that demand for loans already serves as a lim-
to only repay the loan but also generate some iting factor of money creation... Is another
profit. This is speculative demand for money, control needed?)
which is only indirectly linked to the real This is where we have to refer back to the
economy.) macroeconomic tasks of central banks. And
Regulation can also be a limiting factor. For those are to protect the value of money, to en-
example, banking supervision requirements sure liquidity and to guarantee financial and
also have a limiting effect on money crea- economic stability. In other words, macro-
tion. The Basel regulations have set certain prudential operations.
limitations on the growth of balance sheet to- At the macroeconomic level, the primary
tals of banks resulting from money creation. guardian of the value of money is the central
(The banking supervision tasks are generally bank. Demand that is monetised through
performed by the national banks. There are money creation (in other words, if the market
countries where there are separate institutions player looking to make purchases gains access
dedicated to this task; however, they are al- to money too easily through loans) could lead
ways closely linked to the central bank.) to an increase in the price of goods, i.e. in-
The banking supervision requirements flation. When the demand enabled through
are not primarily aimed at limiting money a sudden increase in the quantity of money
creation, rather they are there to ensure safe is greater than supply, adaptation by the real
banking operations. Experts usually say that economy may fall short of the increase in
banking supervision is there to regulate mi- money supply. This results in price increases
cro-prudential conditions. Safe banking op- (inflation), and economic stability is upset.
erations in essence mean ensuring that the Avoiding this is one of the main tasks of cen-
risks taken by individual banks do not exceed tral banks. This is the reason why they strive to
the risks that those banks can cover with their ensure that the money created is in harmony
own equity. Although this is a micro-level ap- with the volume of commodity supply.
proach, it serves the purpose of macroeconom- The question is, however, whether it is pos-
ic stability. That is because such requirements sible to measure the amount of money cre-
also curtail money creation. Setting manda- ated, or to be created. In the age of financial
tory capital adequacy ratios creates limits on innovation, money aggregates are difficult to
money creation. (Based on the Basel regula- quantify. Finance, however, is built on the
tions, the EU applies an equity requirement premise that “money matters”. There is a defi-

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 Money and money creation in Focus 

nite relationship between growth and changes multiplication theory on that premise. (That
in the quantity of money. is no coincidence as the reserve requirement
Our next question, therefore, relates to on transaction balances in the United States
what means a central bank has in general to is currently 10 per cent). A 20 per cent rate
influence quantities of money? was used in the examples given in the Saldo
Central bank regulations have various textbook. Today, however, in the euro system
means to influence the quantities of money the ratio has dropped to 1 per cent. (Actually
created by commercial banks or available to amounts to 1 per cent. To be kept as reserves
be created by central banks. Previously, they at the national banks on which the national
have even applied frameworks, direct quantity banks pay market rate interest.) What this
limitations. In the market economy, however, means is that the European banking system is
generally the central bank strives to influence able to create 100 times the value of one euro
commercial banks through market compliant, supplied by the Central Bank. The central
normative solutions. bank reserves, if no interest is paid on them, as
we have seen according to the arguments, will
raise the interest rates payable by loan debtors.
Instruments of monetary policy That is because banks want to earn the inter-
est payable to their depositors even on the
Textbooks usually refer to three main non-interest-bearing parts (reserves), which is
instruments: reserve rate, interest policy and usually aligned with inflation. (No one would
open market operations. put their money in a bank if it doesn’t at least
The reserve rate is one, but no longer the retain its purchasing power... Although even
most important instrument of monetary reg- negative interest exists today.) Interest must be
ulation. The commercial bank is required to payable on all deposits, otherwise people will
allocate a reserve with the central bank based take their money to another bank if the other
on the balances and the deposits of the bank’s bank offers higher interest. Therefore, the in-
account holders. This remains the property of terest paid on the reserves – according to the
the commercial bank in question, on which official argument – is a type of subsidy aimed
traditionally no interest was paid by the cen- at mitigating loan interest. (In other words,
tral bank. (This was also the case at the MNB interest paid on reserves translates into an in-
for a long time.) In the EU, central banks usu- crease in the profit generated by the banks.)
ally pay market rate interest to depositors. (So The reserve ratio requirement is an instru-
does the MNB.) The ideology behind this is ment that can be used better for restrictions
that if the bank does not receive interest on than for increasing quantities of money. It is,
the reserves, then it will ask for higher inter- however, a blunt instrument, as the effects of
est on the loans it provides from its remaining increasing its value are doubtful when there is
deposits (!) in order to be able to pay the in- significant available liquidity in the banking
terest it promised to pay its depositors (mean- system – in the form of central bank money
ing that this argument applies the principle of or equivalent securities (Tarafás, 2002). It is
“lending against deposits”). doubtful that reducing the value of the ratio
Reserve ratio rates have otherwise been would result in an increase in the quantity of
reduced progressively. Samuelson’s Econom- money as the ratio is already very low. If it
ics in the 1970s used 10 per cent in its sche- drops to 0 then its significance is lost altogeth-
matic textbook examples and based his money er, as it will not limit money creation.

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Nowadays increasing prominence is being of daily loan granted to the buyer’s bank (to the
given to ideas that banks should be required to bank that created a buying opportunity to its
apply higher reserve ratios, even up to 100 per client by way of the loan. In cases like this, the
cent, in order to limit the seemingly limitless banks share in the profits of money creation, as
ability of banks to create money (see the arti- the partner bank charges daily interest on day
cle published in the Staff Paper of the IMF on loans.) As referenced earlier, however, concrete
the rethinking of the so-called Chicago Plan; central bank money is needed to cover the daily
Benes ‒ Kumhof, 2012). Such ideas are based balances. The bank gains access to central bank
on the rationale that today’s financial system money – in its various forms – in exchange for
is prone to causing crises. Oftentimes, banks interest, which is another source of cost for the
finance speculative activities with the created bank. Although it can be obtained from the
money. This recommendation would, in fact, interbank market, the liquidity of that market
put a radical constraint on the activities of depends on market circumstances. Therefore,
banks. Probably including speculative actions leaving it up to the interbank market would
as well. Unfortunately, however, it would also definitely carry some sort of risk. (This was
put a constraint on GDP growth. Therefore, crystal-clear during the 2008 crisis.) Therefore,
the probability of its implementation is rather banks usually try to reduce their dependence
small. As a matter of fact, the so-called “Chi- on interbank liquidity risk. This is the purpose
cago Plan”, that is money creation (lending) that their deposit policy serves. They encour-
secured by a reserve of 100 per cent, would age their current account holders to turn their
be a sort of return to the socialist monopoly demand accounts into longer-term deposit ac-
banking experiment. It would be a centrally counts. With fixed deposits, they have fewer
controlled money creation system. We have, reasons to be afraid that another bank would
however, seen that this has already failed with not grant them central bank loans or would
the downfall of the planned economy. But, only do so at a higher risk premium. (In other
apparently, it would be impossible anyway words, they exert an effort to reduce liquidity
for a regulatory change of this proportion to risk). Naturally, when collecting deposits banks
pass through legislatures in today’s world. The also share the profits of money creation: how-
spheres of interest that run counter to it are ever, in this case not with another bank rather
too great. “Partially secured money creation” with the depositor who earns interest after its
– as described in the Chicago Plan – like our fixed deposit. But the bank does not lend out
current system, is a source of great profit for the depositor’s deposit money in this case ei-
the players of the banking system.) ther. The depositor’s deposit is a form of col-
Then what is the most generally used in- lateral ensuring that it can gain access to central
strument that can influence money creation? bank money if such money becomes necessary
Nowadays, this would be the base interest rate for the purposes of its transactions.
policies of central banks. Ultimately, the cost of money creation – in-
The money credited to clients’ accounts does cluding the bank’s profit – is paid for by the
not stay there for long. The borrowers obvious- borrower; the same borrower that uses the cre-
ly use the received money to purchase items, ated money in the form of a loan and pays the
after which the money is credited to the sup- interest on it. The size of that interest impacts
plier’s bank through the settlement system of demand for loans.
the clearing house. The bank’s partner could The money created in the banking system is
provide a credit for the transaction in the form undoubtedly a huge business for banks. Due

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to the fact that it bears interest, and as such is the money on the market in this case would
quite expensive for the borrower. The loan in- clearly drop, thereby being unable to monetise
terest includes the profits of the bank, coverage demand resulting in a anti-inflationary effect.
of its risks and any parts of the interest that is Through these operations, the central bank,
shared with other eventual participants of the in fact, “determines” the profitability of banks,
financing arrangement. That is why assump- as the interest it pays on banks’ deposits (or on
tions have resurfaced time and time again on the securities created) adds to the profits of
how much cheaper it would be if the state the bank. So, what sources are available to a
would create its own, self printed interest-free central bank to pay these interests? It does so
currency in accordance with the theory of state to the detriment of its profits, a bill that is ul-
money. (As it is done when change money is timately footed by the shareholder (in our case
minted, which is a monopoly held by the treas- the central budget). The central bank must
ury in many places.) (Huber, 2014) settle its accounts with the central budget at
But let’s get back to the third element of the end of every year. The changes in central
the “textbook” instruments that a central bank bank reserves must also be taken into consid-
can use to influence the quantity of money: eration in this case, as well as what the central
namely, open market operations. This gener- banking laws of the country in question allow
ally encompasses the buying and selling of the central bank to use its “profits” towards.
government securities by the central bank. Nonetheless, the central bank pays any posi-
The portfolios of commercial banks natu- tive balance to the state, as shareholder, and
rally contain government securities, as gov- if it runs into the red, the deficit is covered
ernment security auctions usually have com- by the central budget. In the spirit of ensur-
mercial bank partners, due to the prohibition ing the independence of central banks, the
of direct central budget financing applicable government has no say in the costs related to
to central banks. If a bank needs liquidity, it the instruments applied by the central bank in
can turn to the central bank and may receive order to implement its monetary policy. Not
central bank money, provided by central bank even if the interests eat into the profits of the
availability, against a pledge of the government central bank. If the central bank is owned by
securities in its portfolio. If, however, the com- the state, taxpayer money is what will be af-
mercial bank has too many liquid assets and fected if too much revenue is trickled down
is unable to appropriately place them into the into the banking sector.
economy, it can deposit its money at the cen-
tral bank in exchange for a modest interest.
(Naturally, these deposits cannot be directly Pronounced changes after 2008
loaned out to the corporate sector, as corpo-
rations do not have accounts with the central The situation has radically changed in the
bank). The central bank is the bank of banks... international world of finance, not only after
Under certain circumstances, a commer- the 2008 financial crisis but even prior to that.
cial bank may even buy central bank securi- Initially nobody was against the abundance of
ties. Naturally, the central bank does not need money and the cheap loans which were the
money created by these artificial means, this direct result of the Fed’s policy for decades,
is an instrument specifically created for the which it continued to use after 2008 with the
purpose of curtailing liquidity. (The MNB purpose of crisis management. (Not the least
has also applied this practice.) The quantity of the general economy of the US, since the

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country’s securities were in demand, enabling The rate of interest chargeable on loans is
it to finance its deficit and easily and cheaply primarily determined by the central bank base
refinance its sovereign debt). Inflation – rate1. The central bank base rate was kept very
measured in terms of consumer baskets – was low by the Fed for three decades in order to
negligible, making the abundance of money boost lending. In other words, interest policy
less of a concern. The huge demand on the continuously provided ways to abundantly
real estate market, however, as it is generally create money2. As in the previous period, they
known, led to higher prices, the formation are again looking for a way to boost the econ-
of a bubble and eventually to a crisis. (That omy. But how is it possible to boost the econ-
is because asset prices were not included in omy further with interest rate policies nearing
inflation measurements). Interbank liquidity 0 per cent? There is no room for additional
dried up on the private market. Confidence base rate cuts when the central bank base rate
was lost. Nobody knew what situation the is barely above zero. The fact that deposit in-
other bank was in, whether or not they were terest rates are also low due to low inflation
going to file for bankruptcy... Then it was does not provide an incentive for savings. It
not inflation resulting from the abundance of cannot be in the interest of society for citizens
money that became the main problem rather to forgo saving for the future due to spending
the shortage of liquidity. Money was available in the now. In order for monetary policy to
(as it is today) in banks but due to the lack of start out on a path to normalisation, central
confidence, it became stagnant during the crisis bank base rates should be slowly increased.
and did not flow as before. There was a shortage Interest policy, as an instrument, has become
of liquidity, which brought with it a threat of a limited in the monetary policies of central
severe economic crisis. As a result, in the Uni- banks.
ted States the Fed was doing everything in its But it is not only interest policies that are
power to pump liquidity into the institutions of problematic.
the market because private counterparties had Open market operations restricted to gov-
suddenly withdrawn from interbank lending. ernment securities did not seem sufficient
A large part of the bad portfolios were during the crisis. More targeted action was
cleared out by the government-instituted required. This has led to direct securities pur-
bailout packages and confidence was slowly chases from banks and non-bank financial
restored in the banking system. Problems, institutions, even overstepping the previous
however, still remain in the world economy. textbook rules to buy corporate bonds (!).
The economic cycle is slow to return to pros- These steps were truly unusual, unorthodox
perity. The threat of deflation still looms over measures. That is because financial textbooks
the international economy, and that is just as have written for decades that in a market
undesirable in a market economy as inflation. economy the central bank is the bank of the
Due to considerable joblessness, governments banks and that it does not directly come into
are still preoccupied by with how economies contact with corporations (this would only
can be incentivised. Is monetary policy a good occur in the socialist planned economy...);
way to do it and to what extent can it be used? and it happened all the same. The Fed bought
The primary task of central banks is, in ad- the bonds of General Motors, General Elec-
dition to their main function of protecting the tric and other companies in order to prevent
value of money, to support the economic poli- the collapse of market of commercial papers,
cies of governments. corporate bonds (securities). Meaning that

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the central bank got into the business of the a half times as many American government
direct financing of companies... (Anderson ‒ securities as the Fed. That is, the Fed was not
Gascon, 2009) acting on the basis of full sovereignty when
New times, new means... creating American monetary policy (Reinhart,
But there are other issues as well. And that 2016). The second and the third quantitative
is the cross-border effects of monetary poli- easing programmes of the Fed, QE2 and QE3,
cies, specifically Quantitative Easing (QE). therefore, were less successful than the first one,
as established by analysts.
Why? Because contrary to the first package,
QEE – Quantitative External Easing international developments at that time no
longer favoured the FED’s abundant liquidity
It makes one wonder whether the so-called creating policies. Whereas previously foreign-
quantitative easing, money quantities increased ers also contributed to expanding liquidity
by government security buying and the effects by buying American government securities
thereof, were truly the result of the Fed’s en masse, that was no longer the case after
monetary policies. That is because in the past 2013. That is because developing countries,
decade and a half other high-stakes players due to the varying slowdown of oil and raw
have also entered the US market. Foreign materials markets, have begun to sell their
(central) banks had already been purchasing US government securities instead of buying
US government securities en masse even before them (these decisions were also influenced by
the introduction of QE. As a result, they had the statements made by the Fed on its inten-
a significant influence on the quantities of tions to normalise its monetary policy and to
money (liquidity) in the American economy. slowly raise the base rate) (Reinhart, 2016).
The dollars that were previously created by (It is uncertain as to whether the volume of
the American system and used (for example foreign ownership will drop; the question is
by American importers) to make international whether it will be private or state ownership.
payments, were “repatriated”. In 2003, The US government bond is still a safe haven
government bonds held by foreign central for private equity in times of turmoil but the
banks already represented a significant portion movement of privately held papers introduces
of the government securities portfolio. By higher uncertainty into the processes than the
2006, American government securities held by more predictable behaviour of central banks.)
foreigners represented one third of the overall The lesson here is that in a globalised world,
portfolio, twice the volume held by the Fed. there is not one single all-powerful central
One could say that this was phase 0 of QE, bank, not even the Fed, that can influence
independently of the easing implemented by money creation.
the Fed... When in 2008 the Fed started its But let us now look at the issue of how
first quantitative easing programme (“QE1”), the central banks of these foreign countries
foreign institutional shareholders – mainly the came to amass reserves, which then they were
Central Bank of China – already held nearly able to invest in such enormous quantities in
40% (!) of government securities. This means American government securities.
that the quantity of money denominated in Parallel to the cheap money policies of the
dollars was not only dependent on the policies United States, Asian countries such as China
of the Fed but also those of other central banks. were able to generate significant dollar revenue
In 2015, foreign central banks held one and through rapidly increasing exports. (This pro-

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 Money and money creation in Focus 

cess was largely the result of American capital also to protect its extrinsic value. If demand for
investments, but other developed countries conversion back to the US dollar presents en
also took on the opportunity offered by China masse, the exchange rate would drop. A drop
which has lifted capital import restrictions.) in the exchange rate would mean a reduction
The resulting export surplus increased de- in extrinsic value, which would detract from
mand for the renminbi (yuan)3, which would the purchasing power of the domestic currency
have led to the appreciation of the Chinese on account of domestically generated inflation,
currency. All long-term export surpluses can meaning that the intrinsic value of the currency
have effects like this. Considering that cur- would also drop sooner or later. In such cases,
rency appreciation would have slowed exports central banks would be compelled to act due to
down in China, the central bank intervened their commitment to the protection of the in-
on the foreign currency market and bought trinsic and extrinsic value of money. If there is
up the excess dollars supply in exchange for an oversupply of a country’s own currency, the
the created domestic currency. As a result, the central bank must intervene if it is to maintain
central bank was able to maintain the under- exchange rates. In essence, it will begin to buy
valued status of the renminbi together with its its own currency in order to avoid depreciation
exports incentivising effect. Over the past 15 that would lead to inflation. This is what for-
years, nearly 4,000 billion dollars have been eign currency reserves are for.
amassed by the Central Bank of China. The In China, however, central bank interven-
primary means of money creation of all cen- tion was underpinned by the opposite eco-
tral banks is lending but they can also create nomic policy goal. The central bank did not
their own currency through foreign currency want demand for its currency to increase the
purchases. And that is what happened here. exchange rate, as that would have made the
As a result, the Chinese central bank accumu- country’s economy uncompetitive in interna-
lated a large foreign currency reserve. tional trade. In this case, it sold its own cur-
In the modern banking system, by creating rency – which is an easier task – as it is able to
central bank money a central bank essentially create it. (The other source of money creation
commits to ensuring that the given (national) – as is known – is foreign currency purchases)
currency can be converted to another currency As a result, Chinese economic policy was
at anytime. That is because currencies are con- heavily criticised by American think tanks.
vertible and central banks have the ultimate re- The experts of PIIE (Peterson Institute for In-
sponsibility of guaranteeing that convertibility. ternational Economics) have been writing for
This guarantee is secured by the central decades that the reduction of international im-
bank’s foreign currency reserve. In this day and balances would be beneficially affected if China
age, when there is no fixed conversion rate ap- allowed its currency to appreciate. That would
plicable to currencies, anybody, anywhere may curtail the country’s growth and the current ex-
attempt to convert a national currency to an- cessive international imbalances would correct
other currency on the money markets. The only themselves. Market operation would swing to-
question that remains is at what rate that person wards equilibrium. (There was a marked politi-
manages to convert the currency. If someone cal pressure from the United States to this end.
takes the currency out of the country, wants China resisted for quite a while, only making
to convert it, then they put it up for sale. The modest concessions.)
task of the central bank, however, is not only to Such central bank intervention undoubt-
protect the intrinsic value of the currency but edly distorts the markets. International or-

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 Money and money creation in Focus 

ganisations, however, cannot really criticise cy of developed countries primarily the US, as
these types of policies – even though obvious the deficit to Asian countries is already great.
state intervention into market operations run Yet this is exactly what their money creation
contrary to their principles – as they were practice is leading to.
unable to ensure that central banks with sig- If it could be achieved that central banks
nificant influence (FED) be considerate of consider the external consequences and the
the effects of their monetary policies on ex- potential impact on their own economies,
ternal countries. Practically, during its regular then perhaps we could see somewhat more
consultations, the IMF has no influence over reasonable conduct around the world by the
the financial policies of the US. (All findings setters of monetary policy. (When the Fed an-
relating to the reduction of the deficits were nounced that it would be willing to take slow
in essence dead letters.) One could say that steps towards normalisation and move away
the relationship was, in effect, the opposite for from unorthodox policies, capital movement
decades. The US was driving the mechanism again swiftly changed by the periphery – and
of the IMF. Internal economic, employment not necessarily in the manner and in the direc-
concerns always figure higher in the forma- tion envisaged by developed countries.)
tion of monetary policies than cross-border
spill over effects.
And the monetary policies of a large coun- Money creation and globalisation
try have a spill-over effect on other countries.
In today’s international currency ‘non-system’ Let’s take a look at the underlying causes of
(as described by Rajan in one of his speeches), these phenomena. Why does money creation
the medicines applied to the ailments of the in- have such a substantial impact on the monetary
ternational economy create more damage than policy of other countries? Why is the volume
the profit they generated home. The reactions of hectic, sudden and exchange rate-shattering
to the QEs of developed countries were astutely capital flows in the globalised world so high?
described by Raghuram Rajan as Quantitative Essentially, there are two reasons. One is
External Easing (QEE) (Rajan, 2014). that (developed) countries have an immense
Thus, there is a money dilution race of sorts amount of surplus capital, and the other is
in the international market. Countries are us- that this flows in the world economy much
ing every instrument at their disposal to gain too freely (Lámfalussy, 2008).
a share in international demand. The situation Immense free capital has been accumulated
is slightly similar to the devaluation race of in the world economy which is unable to find
the 1930s, when countries were devaluating good opportunities in the real economy. As
their currencies en masse to gain a momentary Raghuram Rajan put it, there is no abundance
advantage in foreign trade. Due to the recent of savings, but rather a scarcity of investment.
miserable experiences gained in the 1990s – This surplus capital has been freely flowing
represented by the drastic devaluating effect globally in recent decades among the various
of hectically exiting and crisis-causing boiling economies, in essence driven by short-term
capital –, emerging countries strive to gener- profit incentives.
ate export surplus above everything else, to ac- If there is so much free capital, then it is
cumulate sufficient reserves to repel interna- absolutely understandable that the traditional
tional economic shocks. This contest certainly money creating mechanism, creating “a new
cannot be the objective of the monetary poli- world out of nothing”, such as we have seen

452 Public Finance Quarterly  2016/4

 Money and money creation in Focus 

after World War II, has become wholly unnec- provide fresh loans as the loan portfolio sold
essary. There is money, in various financial as- pumped fresh funds into the banking system.
sets (albeit in derived form). Someone has it. As a consequence of the relationship estab-
The only thing left to do is find it and change lished with the capital market, the lending
it back into liquid assets. opportunities of banks have expanded. This is
In order to better understand the situation, why the modern theory of money ‒ as referred
we must also clarify why there is so much sur- to earlier ‒ states that it is not the quantity
plus “crystallised” money in the shape of fi- of money created, but rather so-called liquid-
nancial assets. The older generation may recall ity that has interrelation with the changing of
Marxist teachings if I say that this is the result real economy (O. Issing, 2007; Ács A. 2014;
of exploitation. But we could also word this Botos, 2015). (In this case, we are examin-
in the terms of civic economics. In the past ing liquidity in the meaning of an amount
quarter of a decade, the sharing ratios between of money.) The concept of liquidity – as we
wage and profit have clearly shifted in favour have seen, beyond traditional money supplies
of profit (Stiglitz, 2013). If purchasing power – also comprises the volume of financial as-
is not expanded at the strata consuming con- sets that can be easily and swiftly liquidated
sumption goods, sooner or later the money (Issing, 2007; Botos, 2015). If a real economy
supply seeking investment will pile up as there business opportunity arises, “frozen” money
is nothing to invest in. These monies (incomes) swiftly comes to life, takes on the function
are looking for financial investments. This is needed and becomes a means of payment. The
why it is becoming an increasingly profitable same is true for loans secured by collateral.
business to manage and reinvest saved funds Collateral may be things other than goods
and the securities generated from these. It is or real estate. It may also be a financial in-
a fact that in periods when income and asset vestment or property receivables. Value is
differences are becoming increasingly great, represented by bonds, treasury bills, and
realised profits and savings are unable to find other tradable securities. People have derived
direct investment or spending opportunities funds in the above which, if needed, may be
in the real economy. As such, they await po- reconverted into money, means of payment,
tential real investment opportunities in the through the banking loan mechanism. In the
form of financial assets. And until then they case of mortgage collateral, long-term use val-
keep circulating. ue or asset represents a specific value, which is
In respect of money creation, what we are reactivated into circulation, into goods once
most interested in is how the close relationship the collateral is liquidated. As, however, this
of the two sectors, money market and capital has already been converted from money to
market institutions, became so close and insti- product, it is impossible to know what it is
tutionalised, and how this gave a boost to the worth. This is only revealed upon sale. This is
increase in money supply (liquidity). why the nominal mortgage collateral request-
What actually has been happening recently ed by banks is higher than the actual worth
on the securities market? of the loan. For the potential sale to securely
By offering favourable yields and thus cover the debt.
drawing money out of traditional forms of Banks granted the real estate and housing
savings, the new forms of investments have loans, then went on to securitise and sell them.
re-channelled money to bank institutions There was no need to wait a long-time for the
and made it liquid. Banks were again able to return on long-term loans, they could recruit

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 Money and money creation in Focus 

new customers immediately as the given bank illustrated the increased concentration of as-
had sufficient liquid assets. The economy grew sets (Piketty, 2015).
swiftly on account of the driving force of the We should not soothe ourselves with the
construction industry. As we have seen, the fact that large capitals on a global scale are
policy of cheap money launched a lending far from unnecessary, as many regions of the
“boom” that drove up real estate prices. (This, world economy (would) require capital for
however, was not viewed as inflation and as development. We should also consider the
such, fiscal policy did not react either, because segmentation of the world’s financial system.
real estate prices and asset prices are not in- In other words, the fact that a loan taken out
cluded in the consumer basket.) As it is well in a given currency must be repaid in the
known, as a result of complex financial inno- same currency. Also, that the volume of loan
vations, securitisation techniques and the ir- demand, as a result of which the foreign cur-
responsible conduct by credit rating agencies, rency needed for repayment is created, is not
a massive real estate bubble was formed by without its limits. Even if the loan – in do-
2007. This artificially “inflated” economy col- mestic currency – generates a return. (As János
lapsed suddenly when it turned out that many Száz put it, money has a temporal dimension.
borrowers are unable to repay their debts. The We might add that on account of the differ-
US government also developed bailout pack- ences in currency issuers, currencies also have
ages. The Fed intervened with asset purchases a spatial dimension.)
and the provision of funds. All this for finan- There has been a considerable body of litera-
cial firms that do not necessarily have a spill- ture after the crisis on the notion that it is not
over effect on the economy. (If investment expedient to finance growth in certain econo-
institutions do not deal with conducting pay- mies from external loan funds – i.e. currencies
ment transactions, the domino effect does not issued by others (Rajan, for instance, is of this
spill over. The real danger is in the destabi- opinion. Eichengreen went as far as calling the
lisation of institutions that conduct payment use of foreign currency loans to finance eco-
transactions, namely commercial banks. These nomic growth an “original sin”; Eichengreen
actually should be protected.)4 It is a fact that ‒ Hausmann ‒ Panizza, 2005) If foreign funds
during the most recent crisis, the Fed moved are primarily used to finance investments that
mountains in order to save not just banks, but produce for domestic needs, the question aris-
investment institutions and the entire finan- es: at what price (exchange rate) will there be
cial sector in general. Wall Street is perhaps money for repayment in the given economy?
even more important than Main Street... In the case of utilisation with a consumption
As a result of these processes, the financial purpose, repayment is especially doubtful, as in
sector boasts an increasingly large share of this case there is no connection between value
GDP. An increasing number of people are deal- creation and the loan. The currency crises of
ing with managing and trading financial instru- recent decades primarily involved such loan ar-
ments, and these institutions take increasingly rangements (see real estate investments).
substantial revenues from the value generated.
This phenomenon is called financialisation.
The domination of the economy by the fi- Closing Thoughts
nancial sector is a process examined by many
(Orhangazi, 2008; Belyácz, 2014; Botos, Let us recap, as a summary of sorts, the train
2014). Numerous authors have also recently of thought of the study.

454 Public Finance Quarterly  2016/4

 Money and money creation in Focus 

We established that money creation is not they also monetised other financial instru-
carried out using funds, but is rather based on ments. In fact, they also purchased corporate
the money creation privilege afforded to banks. securities. This debunked the thesis that, in
According to the rules established, loans are not theory, the central bank have a relationship
created against deposits; rather the contrary, with the real sector.
the deposits are created from loans. As well reflected by its activity, the Fed did
In the modern banking system, commercial everything in its power to save the securities
banks create money using the mechanism of market segment. It subordinated its quanti-
loans. However, only central banks can cre- tative easing policy to this. The doctoring of
ate cash. When customers wish to withdraw internal problems, however, has international
banknotes or if balances need to be settled impact. The spill-over effect of this increased
in interbank clearings, banks require central money supply resulted in a quantitative ex-
bank money. (They also need this when they ternal easing of sorts, in other words, a di-
need to meet their reserve requirements. With lution of money in other countries, in order
the dropping of the base rate, however, this re- to preserve the rate (undervaluation) of their
quirement is less and less significant.) There is currency. As a result, they stockpiled dol-
a relationship between the money creation of lars, the backflow of which could neutralise
banks and that of central banks, but the first money supply-regulating efforts in the issuing
step is taken by commercial banks and not the country (especially the US). For this reason, it
other way around; in other words, it is not the would be expedient for key currency issuers to
central bank that determines the quantity of take the international impacts of their actions
money to be created. With a view to econom- into consideration. For the sake of others, and
ic stability, central bank regulation attempts ultimately their own as well.
to limit money creation, by means of bank- This makes it absolutely clear that the theo-
ing supervision regulations, the base rate and retical clarification of the issue of money crea-
measures related to securities. (The role of the tion is a mammoth task we are facing. The
reserve rate has been suppressed.) The enor- solution requires the in-depth analysis of real
mous quantity of financial assets, however, economy, and a rethinking of income genera-
could become part of liquidity, transforming tion and distribution conditions and the so-
back into means of payment through money cio-economic order.
creation by banks. The reason why there are The current financial crisis obviously can-
so many financial instruments is the increas- not be resolved with purely monetary in-
ing concentration of incomes in the hands of struments. The review of fiscal policy is also
capital owners. This leads to increasing finan- needed. It is clear that without appropriate
cialisation, and the dominant weight of the solvent demand, capital cannot find buyers
financial sector within the economy. for its products, therefore, the mechanisms
After 2008, the financial crisis rewrote a of income sharing must also be reconsidered.
number of earlier rules. Drastic base rate cuts Lending, as an incentive made possible by
were also part of the “helicopter money” the- mere money creation, is not enough to help
ory. As this was insufficient to increase lend- the economy grow. Money is an essential, but
ing, and as such money supply as well, central in itself insufficient prerequisite of the pro-
banks turned to other unorthodox instru- cess. As the saying goes, you can lead a horse
ments. In addition to government securities, to water, but you can’t make it drink.

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 Money and money creation in Focus 

1 2
The US is driving processes in the increasingly This was the so-called “Greenspan put”, “the big
integrated world economy. That is why I keep invention” during his three decades of presidency. In
referring often to the American example. Considering order for dollar interest rates, which have been kept
that in the European contacts the ECB has a similar low, to ensure uniform, 2 per cent economic growth.
function, I also make occasional references to the
European system. Renmibi is the American specialist term for the
Chinese yuan.


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