Introduction

In 2014, an economics professor visited a small bank in Germany. The bank allowed him to observe a loan approval from inside the room, with its books open and its systems running. He recorded the bankers as they created money step by step. He became the first person to document this process on paper. The professor was Richard Werner, a professor of banking and finance in Germany. Shortly after his study was published, the Bank of England stated the same conclusion in its own official publication.

The process is simple, yet it conflicts with common intuition. The following sections explain how money is created, how it is destroyed, where new lending flows, and what changes could alter that flow.

Three Types of Money

The monetary system contains three types of money:

Commercial bank money is the largest component of the economy's money supply.

The Common Explanation Is Incorrect

The conventional account holds that banks receive deposits, keep 10% as reserves, and lend the remaining 90%. Each loan then returns as a new deposit, and the cycle repeats.

This account does not match how banks operate. If banks needed deposits to fund loans, they would compete for deposits by offering high interest rates of 10% or 15%. In practice, banks offer very low deposit rates. Banks do not depend on customer deposits to make loans.

How a Bank Creates a Loan

Banks record transactions using double-entry bookkeeping. Every transaction appears on two sides of the balance sheet: assets on the left and liabilities on the right.

When a bank grants a $10,000 loan, two entries occur at the same time:

Both sides increase by $10,000. The bank creates the money by recording the loan on both sides of its books.

No Reserve Requirement

In most Western countries, the legal reserve requirement is zero. A bank does not need to hold any money in reserve before it issues a loan. Under this framework, the only practical limit on money creation is the bank's choice of borrowers.

Official Confirmation

The Bank of England published the following statement in 2014: commercial banks create money in the form of bank deposits by making new loans. When a bank lends to a mortgage borrower, it credits the borrower's account with the mortgage amount instead of issuing banknotes. At that moment, money is created.

How Money Is Destroyed

A loan has two components:

• Principal: the amount the bank credits to the borrower, such as $10,000.
• Interest: the additional payment for borrowing, such as $2,000 over five years.

When the borrower repays the principal, the money is not transferred to another customer or stored in a vault. It is removed from the system. The repayment deletes the money that the loan created. Banks therefore both create and destroy money.

Illustrative Analogy

The following analogy illustrates the mechanism. It is not a precise legal model.

A bank rents a car to a customer. The car exists only on paper, but it becomes available when the customer signs the rental agreement. The customer uses the car for five years and pays rent every month. At the end of the term, the car disappears from the record.

In this analogy, the car corresponds to the loan money. It is created at signing and deleted at repayment. The rent corresponds to interest. The rent is the only real payment, and the bank keeps it as profit.

Where New Lending Goes

If the only practical limit on bank lending is the choice of borrower, the choice of borrower determines the economic effects.

Lending to Businesses Versus Mortgages

• A $50,000 loan to start a small business is difficult to obtain. The bank typically requires weeks of review, charges a high rate, and may still refuse.
• A $400,000 mortgage to buy a house is substantially easier to obtain.

According to the source, lending to a business is almost three times riskier for a bank than lending against a house. If a business fails, the bank loses the money. If a homeowner stops paying a mortgage, the bank can take the house as collateral.

UK Lending Data, 1997 to 2011

Between 1997 and 2011, UK mortgage lending increased sharply. Lending to small businesses remained almost unchanged over the same period.

Effect on House Prices

Banks add new money to the property market. The number of houses stays the same while the amount of money competing for them increases. The source attributes rising house prices primarily to this expansion of easy bank credit. Each new mortgage creates new money that flows into property purchases and raises prices. The source acknowledges that supply shortages, demand from buyers, immigration, and foreign investment also affect prices, but it presents these as secondary factors.

The source links this dynamic to a generational gap. It states that a person who bought a house at 24 in an earlier generation may find a person of 30 still renting, despite working as hard or harder.

A Proposed Solution

Richard Werner, co-author of the book Where Does Money Come From?, argues that the system does not need to be dismantled. In his view, the problem is not that money is created. The problem is the direction in which money flows.

Two Scenarios

Scenario 1: Lending for an existing house. A bank lends $1 million to a buyer of an existing house. The money goes to the seller. No new factory, job, or output results. The same house changes hands, and more cash in the market makes housing more expensive for everyone.

Scenario 2: Lending to a small business. A bank lends $1 million to a small business owner. The owner hires 10 workers, buys equipment, and develops a product. The economy gains output, jobs, and wealth.

Both scenarios use the same banking system. The results differ because of the direction of lending.

Why Banks Favor Large Loans

Processing a $50,000 loan for a small business requires nearly the same effort and time as processing a$50 million corporate loan. The paperwork is similar, and the difference lies in the contract amount. Large banks focus on large corporate transactions because the return is about 1,000 times greater.

Structural Proposal

According to the source, a banking system that funds productive activity requires many small banks rather than a few large ones. Small local banks, where managers know the business owners in their communities, can lend to small businesses.

The source states that two out of every three jobs in advanced economies come from small businesses. When a few large banks dominate the system, small businesses cannot obtain the credit they need. The source argues that this limits job creation and economic growth while house prices continue to rise.

Case Study: China

In 1978, Deng Xiaoping came to power. According to the source, he traveled to Japan to study the sources of its economic growth. He then founded thousands of small, local, and village banks across China.

His reasoning was that one central bank cannot manage lending for an entire country from a single location, but many local bankers can. The source states that China subsequently sustained four decades of rapid economic growth and lifted more people out of poverty than any country in history. The source states that China achieved this by directing money creation toward productive uses instead of eliminating it.

Why the System Is Not Widely Understood

The source states that most people do not know how the system works. It notes that the author studied economics at a university and did not learn this material, and suggests that most people have not learned it either.

Implications for Earnings

The source frames money as a store of human labor time. People exchange hours of their lives for money. According to this view, when new money raises prices, the purchasing power of earned income falls. Work performed in earlier periods becomes worth less. The source argues that this effect harms most people.