Debunking Economic Myths: How Modern Banking and Debt Creation Work

Many people are confused about the mechanisms behind money creation and how debt operates in our modern financial systems. This article aims to clarify these concepts by exploring how banks and governments create money and the nature of debt. Additionally, we will demystify a popular Kenyan story that illustrates the intricacies of modern supply chain and debt dynamics.

Money Creation by Banks: A Closer Look

When it comes to money creation, let's start with a fundamental truth: mortgage and other types of money are created by banks, albeit with permission from the government. This money is deemed "horizontal money", as it is created as a liability of the bank and does not rely on the bank's own resources. Instead, creditworthy customers are needed to generate this money.

The process begins when a bank grants a loan to a customer. This loan is created on the bank's balance sheet as a newly issued amount. For example, if a bank grants a $1 million loan, $1 million is created out of thin air and credited to the borrower's account. This newly created money is not generated by the bank's reserves but rather by the decision to grant a loan.

The Role of the Government

While banks create money, the government plays a significant role by providing the permission and framework for this creation. In many countries, central banks have the authority to issue currency and control the money supply, while commercial banks issue banknotes and conduct most of the daily moneymaking activities.

This setup creates a complex ecosystem where the government ensures the stability and value of the currency, while banks take on the risk of lending and managing credit. The entire system operates on the trust that these entities will adhere to established financial regulations and standards.

A Pyramidal Structure with Significant Risk

The pyramidical structure of modern banking and lending is often criticized for its inherent risks. The top tier of the pyramid includes the global financial elite, who benefit the most from this system. When the pyramid crashes, it is typically the bottom tiers, or the general public, who bear the brunt of the consequences.

This structure raises questions about financial stability and equity. While most people believe the system is stable, the lack of financial literacy among the general populace can lead to mismanagement and, ultimately, economic crises.

The Debunking of the Kenyan Debt Story

Let's delve into a popular story that has circulated about a town in Kenya and see how it sheds light on modern supply chains and debt dynamics. The story goes as follows: a tourist placed a $100 note at the hotel reception, and when he returned, the note had traveled through the local supply chain, allegedly clearing all debts in the town. This scenario seems magical, but it can be demystified.

The Circulation of Debt

In the actual story, the debt did not involve any real transfer of currency but rather the circulation of a debt agreement. Let's break this down step-by-step:

Hotel owner rarr; Butcher Butcher rarr; Pig Farmer Pig Farmer rarr; Feed Supplier Feed Supplier rarr; Prostitute Prostitute rarr; Hotel Owner

Each transfer of the $100 note was actually a cancellation of a previous debt, resulting in a closed loop. The note itself did not leave the hotel reception counter.

Barter Economics vs. Currency

Without the tourist and the $100 note, the scenario illustrates a barter economy. In such a system, transactions are settled directly with goods or services without the need for money. The introduction of currency makes these transactions easier and more flexible, but fundamentally, the same debt dynamics occur.

In the Kenyan scenario, even though currency was involved, the debts were settled in a circular manner, resembling a barter economy. This method, though effective in clearing debts, can lead to privacy issues, especially when it involves sensitive economic relationships.

Conclusion

Understanding the mechanisms of money creation and debt in modern banking is crucial for navigating the complexities of the global financial system. While these systems are designed to serve the economy as a whole, they also include risks that can impact various stakeholders differently.

The Kenyan story, while intriguing, highlights the cyclical nature of debt and the potential for misinterpretation. Circulating debts in a circular fashion is an effective way to resolve them but does not necessarily reflect the reality of economic transactions. This exploration should help demystify the workings of modern economic systems and encourage greater financial literacy.