Private Banks and Credit Creation

This article is a very condensed study of banking and credit creation.

The three kinds of money and their relationship to credit creation

To recap: credit creation is the practice of increasing the money supply by the simple process of adding credits to a borrower’s account without taking money from somewhere else. New money is created with a credit creation loan. It is also possible, where gold coins are currency, that credit creation can be practised by issuing more gold certificates than there are corresponding gold deposits.

Modern civilization has undergone a development in which three different kinds of money has evolved. The three forms of money are 1) coins of precious metals, which shall simply be called gold coins in this article; 2) paper money; 3) money existing as credits in bank (computerised) ledgers which shall be called ledger money.

In relationship to the subject of credit creation, it should be easy to note that it is not really possible to practise credit creation with gold coins. The supply of gold is relatively fixed. When people realised that gold certificates – issued by certain banks and other parties like goldsmiths – could be passed around as if they were gold coins, it was also realised that one could issue more certificates than one had in gold deposit, and then loan out these certificates (with interest). So long as not more than a small proportion of people holding these certificates wanted to cash them in for gold coins, the lenders were safe. Note that while it is physically possible to practise credit creation in this manner, there is a high level of fraudulence involved. This same fraudulence is being practised by modern banks.

Paper money has two essential forms. One is a gold certificate as just mentioned; the other is a fiat currency. A fiat currency is issued by a government solely on its legal authority and is not redeemable in gold. All currencies today are fiat currencies. A currency that is backed by gold is said to be on a gold standard. In principle a paper currency bill that is on a gold standard is actually a gold certificate because the government or central bank that issues it ‘promises’ to exchange it for gold at a certain exchange rate. Now such a currency cannot practise credit creation. Credit creation will expand the money supply and in principle the holdings of gold should expand in line with the money supply. Any institution that practises credit creation whilst on a gold standard is practising fraud.

With a fiat currency the money supply is infinitely expandable. Of course prudent governments do not just expand it at will because that would create inflation. For the most part, when loans are made in a modern economy, credit creation is practised using ledger money. In theory, it is possible to issue paper money when a new loan is made, but since most people will just want a bank deposit instead, the new money takes the form of ledger money.

Finally, it should be noted that even though credit creation expands the money supply, when a loan is being paid off, the money supply is contracting. If in any given period, loans are being paid off at the same rate as new loans are being made, the money supply stays stable and there is no inflation.

Later in this article we will examine other factors such as why a modern economy cannot do without credit creation; and why the issuing authority of the money should be the only body with the right to practise credit creation.

Milestones in the history of credit creation

Credit creation, creating money out of nothing in the form of bank credit, was discovered or invented by the medieval Italian bankers. Using a process we call double entry book keeping, money could magically appear on their books if they created an overdraft (a negative entry) in their books. Understandably, as these were private banks, this lead to abuses. However credit creation did give an enormous boost to the bourgeoning mercantile trade of Italy. We shall see later how a vibrant modern economy cannot do without credit creation.

The next major use and development of credit creation was in England. The Bank of England, a private bank granted monopoly power by the government to issue bank notes in 1697, used the power of credit creation,  as ‘one of the instruments of English world supremacy’ (Carroll Quigley in Tragedy and Hope 1966). The English used credit creation to expand production to a level that the ‘sound money’ French could not match. Quigley writes in Tragedy and Hope:

It early became clear that gold need be held on hand only to the amount needed to cover the fraction of certificates likely to be presented for payment; accordingly, the rest of the gold could be used for business purposes, or, what amounts to the same thing, a volume of certificates could be issued greater than the volume of gold reserved for payment of demands against them. Such an excess volume of paper claims against reserves we now call bank notes.

In effect, this creation of paper claims greater than the reserves available means that bankers were creating money out of nothing. The same thing could be done in another way, not by note-issuing banks but by deposit banks. Deposit bankers discovered that orders and checks drawn against deposits by depositors and given to third persons were often not cashed by the latter but were deposited to their own accounts. Thus there were no actual movements of funds, and payments were made simply by bookkeeping transactions on the accounts.

Accordingly, it was necessary for the banker to keep on hand in actual money (gold, certificates, and notes) no more than the fraction of deposits likely to be drawn upon and cashed; the rest could be used for loans, and if these loans were made by creating a deposit for the borrower, who in turn would draw checks upon it rather than withdraw it in money, such “created deposits” or loans could also be covered adequately by retaining reserves to only a fraction of their value.

Such created deposits also were a creation of money out of nothing, although bankers usually refused to express their actions, either note issuing or deposit lending, in these terms. William Paterson, however, on obtaining the chatter of the Bank of England in 1694, to use the moneys he had won in privateering, said, “The Bank hath benefit of interest on all moneys which it creates out of nothing.” This was repeated by Sir Edward Holden, founder of the Midland Bank, on December 18, 1907, and is, of course, generally admitted today.

The next major milestone in the history of credit creation may be considered the creation of the first fiat currency. A fiat currency is one that a government issues without any promise to redeem it in gold or silver. Abraham Lincoln’s government was the first to create such a currency, prompted by the need to finance the war against the south. A fiat currency means that the government – a democratic institution – could issue new money as it chose. This new money can take the form of paper money or credits in bank ledgers. Fiat money means that in principle, the government can be the sole issuer of new money and the sole institution to enjoy credit creation. Lincoln was assassinated (bringing joy to the private bankers) and the fiat currency he issued (the Greenback) was shortly thereafter rescinded and replaced by a gold backed currency. It should be understood that wealthy bankers did not liked fiat currencies because if the power of credit creation rested with the owners of the gold reserves (i.e. themselves), then they basically enjoyed a monopoly on credit creation and the interest on loans would accrue to them. Many powerful figures who opposed the power of credit creation by private banks have met with great misfortune, including assassination.

In 1913 the U.S. Federal Reserve was created. This is a privately owned bank which enjoys the right to issue a national currency – the currency of the most powerful country in the world. Money is not created out of nothing in the U.S. by the government and then issued into circulation – it is borrowed into existence by the government, and loaned by the Federal Reserve using a complicated system that involves bond issue (treasury bills). It is arguable that the Federal Reserve is not a huge money maker for the banking cartel that owns it; its primary function is to ensure that the few powerful banks that own the Fed Reserve do not have their banking rights curtailed by the government; and that they, the banks, can hold the government (i.e. U.S. citizens) in debt to them.

The Fed began its existence on the assertion that its currency was backed by gold. This was probably a lie since no public authority ever audited the amount of gold it held against the amount of currency it issued. It was also a lie because no gold-backed currency can practise credit creation without some fraudulence involved. If one has say $100 billion in circulation and the exchange rate is $100 per ounce of gold, then one should possess a billion ounces of gold. If one practises credit creation on such a gold standard, the ratio of gold to currency is no longer $100/ounce. If credit creation expands the money supply by a factor of ten, then the real exchange rate between gold and the dollar is $10/ounce. Needless to say the private banks that operated under the aegis of the Federal Reserve practised credit creation from day one.

The twentieth century saw successful efforts by the powerful international banking cartel to prevent all kinds of public banks from enjoying monopoly rights to credit creation. In Australia, the early government owned Commonwealth Bank could have functioned as the sole Australian bank, but private bankers saw to it that its monopoly powers were rescinded and then the bank placed into a position of competing against private banks in the market. Almost all central banks now are no longer managed by their government but instead come under the control of a supranational banking organisation called the Bank for International Settlements located in Switzerland. The few countries which central banks are not under the BIS scheme have come under military attacks and other forms of destabilisation from the west – countries like Libya, Iraq, Syria, Lebanon, Libya Somalia, Sudan, and Iran.

Credit creation is necessary for a modern economy

It will not be possible for a modern economy to function without credit creation. Without credit creation, all loans will have to be on the basis of an ‘out-of-pocket’ loan. When you borrow from your friend or from your aunt, the lender is out of pocket for the duration of the loan – they can’t spend the money they loaned to you. Imagine what that would do to a banking system if the same principle was practised: it means that when you get a loan from a bank, the bank has to inform its depositors that a certain percentage of the depositors’ funds are not accessible until the loans are repaid. This would completely stall the banking system. People would stop placing their money in banks because they need access to it when they want to – not when borrowers repay their loans. The only reason that both borrowers and depositors (who are lenders to the bank) can access their funds at the same time is because credit creation is practised. This point needs to be expressed because many people think that the iniquities of private banking can only be resolved by eliminating credit creation.

History has demonstrated the advantages to be gained from the practice of credit creation. The English speaking and Protestant societies adopted the practice of credit creation ahead of the Catholic countries (a fact which may be attributed to a lack of an all-powerful Church enforcing the prohibition against usury with the former). This gave them an enormous increase in productive capacity and therefore a great advantage in their trade and military wars.


Who owns the right to credit creation? – democracy and fiat money

Fiat money can only be issued by governments. If a private (for-profit) entity issued money that was not backed by gold, people would treat it rightly as a bit of rubbish. Since government is in principle a public authority, this means that fiat money can only be issued by the public via their government. It follows that the issuing of money in both a paper and ledger form is the sole right of the public/government.

If money existed as gold and silver coins, it is a different matter; then, private banks could practise credit creation on the basis of issuing ‘gold credits’ against their gold reserves. The banks can then claim – albeit questionably –  that depositors have placed gold with them and that they have the right to practise credit creation with these reserves (so long as depositors understood the risk involved with the bank’s practise of credit creation).


Why the money supply has to expand under private banks

The U.K has a money supply in which 97%of the currency exists as credits created by private banks out of nothing. The Australian equivalent appears to be 96.2%[1]. Let us imagine a hypothetical currency in which the total money supply is 100 billion units, of which 97 billion units (97%) is created by private banks as credit creation, and the other 3billion units is by a nominally publicly owned central bank in the form of paper money. Now let’s add one or two years’ interest of say 10% on to that 97 billion units of currency which has been created as debt. That would come to 106.7 billion units (97 + 9.7 billion). So existing loans paid back with just 10% interest would require more money than there is existing in the total money supply. The only way the current loans can be paid off with interest is if the banks expand the money supply – by credit creation of course. [2]

If the banks do not expand the money supply with more loans, the interest payments on existing loans would suck up money from the goods and services economy and the resulting lack of demand for goods and services would lead to many business and individuals going bankrupt; their creditors would go bankrupt; people would be laid off or have their sales dramatically curtailed;a domino effect of people and businesses going bankrupt causing other businesses and individuals to also do the same would result, and a major financial crisis would ensue that would bankrupt the banks themselves (because they have a lot of loans (considered assets by banks) that will never be repaid. Hence a continuous expansion of the money supply is necessarily a part of capitalist banking. Below is a graph from Wikipedia showing the Australian money supply. In this graph, the difference between the green data and the blue data gives you the amount of money that the private banking sector has created.


The banks’ profits – from interest on loans – originate as money they themselves created

When banks in aggregate issue loans, say for $100 billion and then further down the line make 50% in interest payments ($50 billion) before the loan is paid off, where does that extra $50 billion come from? The answer is that banks created that money earlier in the form of a loan. The banks’ profit originates as money they created out of thin air. So in issuing a loan, they are also creating the money that one day they will claim as profit. Consider you take out one of the absurdly huge mortgages that is necessary to buy property in most major cities today. You might pay say twice the principal (the original loan amount) by the time you pay off the loan with interest charges. You sweat and struggle, lose time with your family and friends, perhaps endure a job you find stressful or mind numbing in order to prevent foreclosure on your property – and then the bank, without raising a sweat, makes the same amount of money as what they loaned you (the principal) for the trouble of arranging a bit of paperwork.

The two mechanisms that enable and restrict credit creation by banks

Banks cannot create money at will. Two mechanisms exist in place that both enable and circumscribe their ability to practise credit creation. One mechanism is fractional reserve lending. This means that when money is deposited within a bank (whether via cash deposit at the teller or via a bank transfer) the bank has the right to create, at a 10% reserve ratio, 90% of the value of the deposit as new loan money. A $100 deposit entitles the bank to create $90 in new money, the other $10 has to be kept as reserve (against customers who might want to withdraw their money in cash). The newly created $90 loan money, when transferred to yet another bank account (or even within the same bank) enables yet another $81 of new money to be created (90% of $90). And so on. A 10% reserve requirement enables the banking system as whole to increase the money supply by a factor of ten. A 5% reserve requirement means that the banks can increase the money supply by 20. (The formula is 1/x where x is the reserve requirement.)

There is more to this picture. When banks make a loan, even without any ‘reserves’ behind it, the loan creates a deposit in the borrower’s account which they then can count as a deposit against which they can make a loan. So instead of the deposit preceding the loan, the loan precedes the deposit. The whole banking system is a scam.

The other mechanism circumscribing bank loans is called the Capital Adequacy Ratio (CAR). A short explanation of this rather complicated mechanism is that a bank’s ability to make loans is limited by its assets, i.e. how wealthy it is. The argument is that the assets are a sort of guarantee against bank deposits; but the reality is that it just gives the more powerful banks a greater capacity to practise credit creation than the other less wealthy banks, i.e. the ability to loan more money. Since credit creation (and the right to earn interest on loans) should be a right of the public/commons, this mechanism is just there to enable the wealthy to get even wealthier.

Whilst theoretically fractional reserve lending would limit the total amount of money that can be created through credit creation – to a multiple of the amount of money issued by the central bank – CAR regulations allows the money supply to expand indefinitely at the hands of private banks.

Why the laws regulating credit creation are stacked against community minded banks

With the understanding of the regulations that permit banks to practise credit creation as described above, consider how things fare for a community bank or credit union. If f the bank exists to serve its membership, it would not be gouging its borrowers with exorbitant fees or predatory loan conditions. It would probably choose to loan to the more financially impoverished members of society. However this action curtails its profit making, and hence its accumulation of assets. This in turn hampers its ability, according to CAR regulations, from making further loans. So the predatory banks surge ahead in profit and assets while the community-minded banks flounder as a result of caring for the community and its membership. The banking system is cleverly structured to make the wealthy even wealthier.


Private banks’ existence is dependent on socialist support from the public

It is not even necessary for the public or government to ban credit creation by private banks in order to deny them their existence. All one has to do is to not guarantee their deposits (meaning that deposits will not be guaranteed to be convertible to cash if there is a run on the bank). Imagine the following:

The public exercises its democratic rights and take control of its own central bank. This is quite compatible with capitalist free market ideology – the public does what it does and the private banks likewise, without interference from the public/government. The publicly controlled central bank now opens retail branches through which the public can deposit their money and get loans etcetera – still within the capitalist free market ideology. Further the new central bank declares that it will no longer accept bank transfers and cheques from the private banks. Any person wishing to say, pay their tax bill with money held in a private bank account, will have to withdraw the money in cash, deposit the cash with the new central/public bank, before paying their bill – still within the capitalist free market ideology. Now the new central/public bank also says that it will shortly no longer guarantee the deposits in the private bank sector. Again, this is still within the capitalist free market ideology in which the government does not intervene to support private enterprise. Because the banks have a lot more credits than cash in their system, the withdrawal of a public guarantee against deposits means that people will effectively have no cash to withdraw against their deposits. The banks will suffer a run. The banks will crash. The new central/public bank, to prevent a general financial crisis, takes over and buys out the private banks (for say $1) and reinstates the loans and outstanding debts of the banks. The banks are finished.

In short, the very existence of the private banks is dependent on guarantees provided by central banks; and if central banks really represented the public interest, it would withdraw its guarantee on deposits. The public/government does not even have to prohibit the private banks from practising credit creation – they would not survive in a free market without a publicly funded guarantee on their deposits. So we see that the foundation of capitalism is based on a free market lie. The banks thrive on the basis of socialist support from the state; they then inflict free market capitalism on the very members of the state that provide them with this socialist support. Lies are everywhere in the structure of the banking system.

Elsewhere on this website…

We discuss the role of banks in relationship to many other things – inflation, unemployment, all sources of unearned income, inequality, financial crisis, holding the public and the government to ransom by the use of debt, and so on. Please read the relevant article to follow up on these issues. Readers may be interested to read some quotations by famous people speaking out against the nefarious nature of private banks. Try here and here and here (note the views of the website’s authors are not necessarily endorsed).

[1]This link states that 97% of the money supply in the UK is created by private banks. The Australian data was sourced here. (The data used is from row 754 – May 2021 – in the spreadsheet, and the ratio was derived from dividing the currency supply, column B, by the broad money supply, column I.)

[2] There is another possibility (which will never happen in the real world) in which bank loans can be fully serviced out of the existing money supply, and that is if the banks and its shareholders takeall its profits and then use it to purchase goods and services. The money so used will recirculate back into the economy and will feed the income of those with outstanding loans, and then service their loans with the interest component. This does not happen of course. Banks, in line with the capitalist principle, minimise their spending (on goods and services) so as to roll over their income into the purchase of more assets, in order to generate more wealth. The banks roll over their profits as further loans – with the effect that the money supply grows, as does the level of societal debt. A commons bank in contrast, uses all its interest payments income to spend on the purchase of goods and services on behalf of the members of the commons.

Transaction Tax

In the national economy, a transaction tax would be a flat rate tax on every monetary transaction with only a few minor exceptions such as transfers within a family unit. No costs or expense s by businesses will be tax deductible. Purchases of things like shares and currencies will also incur this tax (which pretty much wipes out the speculative transfers of capitalism). In the FEC economy we apply this tax to transfers between members so that we as a collective can do very good and powerful things with it. For marketing reasons, we have renamed this tax to ‘community contribution’.


We at the FEC do not think that the government is the appropriate collective institution to manage things like banking, taxation and land rental. These can all be taken out of the hands of government. Government should be restricted to policy making in the political realm. What we call the commons is an economic collective. This economic collective does not have the argy bargy of the political life. Outside of the capitalist context, it is the principle of cooperation and mutual aid that pervades the economic life, and it will have a very different structure to government. Because the term ‘public’ is often associated with government, we prefer the term ‘commons’ in reference to this economic collective.

Community Contribution

‘Community contribution’ is in fact the same as a transaction tax as described elsewhere [see Article 2 in ‘Further reading’]. The reason we have renamed the tax is for marketing reasons as people recoil from the notion of paying an extra tax. Tax payments is in fact how we as individuals contribute to the community in order to fund things like public transport, welfare and a functional judicial system. So people should be proud in saying that they pay their taxes. The reason that we have an aversion to the word tax is brought about by corporations who have the ability to make their expenses cost deductible. They load up all costs of dubious things into their income-expenditure calculations that they can get away with not paying a lot of the taxes that are their due. The whole scam trickles down to the rest of the economy and tax avoidance/evasion becomes an acceptable sport. In a true transaction tax, no expenses are tax deductible.

What is a fractal?

A fractal is by one definition ‘An object whose parts, at infinitely many levels of magnification, appear geometrically similar to the whole’. Take the fern leaf as shown in this image:

The first image above is a graphic picture of a whole fern leaf. If we take one of the ‘branches’ of the leaf – as depicted in the boxed section – and examine its structure, we find that the ‘branch replicates in full the pattern of the original fern leaf. The boxed section of the first image, rotated and appropriately magnified as in image 2, show an identical pattern to the whole leaf. If we take yet another ‘sub-branch’ out of the fern in image 2 as depicted in the boxed section of Image 2, we find the same leaf pattern replicated again. And so on.

The Fractal Economy Cooperative takes its name from this feature of fractals – that the part replicates the whole. We believe that what needs to be done in the global economy is the same as what needs to be done in the national economies; and that it is what we intend to do in the fractal economy. This means that we policies in a number of places that should also be practised in the national economy in order to make it a socially just and environmentally sustainable economy: direct democracy in the realm of policy making, direct individual participation in the allocation of public/commons spending; all the practices that make up for what we call commons banking, a new taxation system (which we call ‘community contribution’ for marketing reasons); support for cooperatives over share ownership of companies; a return to common ownership of land effected through the banking system.