The system that a bank makes loan with deposit, increases apparent total bank deposit, and makes loan again is called “Credit Creation.” This system is based on the premise that banks have credit and the loan will be repaid properly.
Mechanism of Credit Creation
Where do our deposits go?
Many of us deposit a lot of money in a bank, and the bank uses the deposited money to make loan. For example, suppose that Mr. A deposited 10 million yen with a bank, then the bank keeps 10%, which means 1 million yen as cash reserve, and the remaining amount 9 million yen will be loan to someone.
Next, suppose that Mr. B asked the bank to loan him 9 million yen. Then the bank credits the amount to his account. Same as the case of Mr. A, the bank keeps 10%, which means 900,000 yen as cash reserve, and the remaining amount 8.1 million yen will be loan to someone.
Furthermore, suppose that Mr. C asked the bank to loan him 8.1 million yen. Then, same as the case of Mr. B, the bank credits the amount to Mr. C’s account and keeps 10%, which means 810,000 yen as cash reserve, using the remaining amount of 7.29 million yen as loan.
The table below is summary of the above.
As shown in the table above, the total loan of 24.39 million yen is created.
If you have credit, you can increase the amount of deposit, and you can make more loan. And the interest charged on a loan will become profit of the bank.
In other words, somebody’s loan creates money. This is a simple mechanism of Credit Creation.
Q＆A about Credit Creation
Q．Suppose that the cash reserve ratio was 10%, same as the example above, and Mr. A wanted to withdraw all the deposited amount of 10 million yen, what will happen?
A．Since a lot of people deposit their funds with a bank, they can handle withdrawal of one person’s whole balance. However, if the credit of the bank becomes seriously impaired, and a large number of people want to withdraw their funds, the bank will be unable to handle it and go bankrupt.
Q．If money continues to be created by Credit Creation, the amount of money increases unlimitedly, and will it cause inflation?
A．Certainly, money is created when someone borrows money, but on the other hand, if the loan is repaid, the fictional money decreases. Therefore, it is not true that the amount of money increases unlimitedly.
Q．How can they make loan with non-existent money?
A．Actually, they don’t give real cash for loan, they just put the loan amount to the credit of the borrower’s account. If the bank placed 10 million yen to the credit of the borrower’s account, then the bank is deemed to have made loan of 10 million yen, and there is a deemed deposit of 10 million yen.
Q．Is the actual cash that really exists only a small part of money?
A．Among the money circulating in the world, cash is about 85 trillion yen, while deposits are said to be 530 trillion yen. You can see so many people deposit their money in banks.
The Problem of Credit Creation; it’s Based on Growing Market
The system of Credit Creation is based on a premise that it will be repaid properly if you finance enterprises and individuals. Therefore, if the society tumbles into recession and the risk of bad debt increases, banks will be reluctant to lend money. When credit crunch occurs, naturally the money supply decreases and the recession will become worse. It may further raise the risk of bad debt.
As we have seen in above, the system of Credit Creation is greatly affected by economic fluctuations. In countries which have reached maturity stage, economic growth is hard to be expected. So it seems unreasonable to use the Credit Creation system for currency supply.
I’m sure you could understand how the money in the world is supplied by Credit Creation. I hope that each person gains knowledge about money and become able to use money in better way, not to be used by money.