Principles of the Modern Monetary System
Money Makes the World Go Round
By Eden Ding.
Money as an Economic Real
In classical economics, money is treated as ‘non-real’. That is to say that it is not a fundamental driver of the economy. This is in contrast with ‘real’ drivers of the economy, such as workforce education, unemployment or natural resources. The implication is that changing money cannot change the economy.
There is a classic thought experiment that is meant to illustrate this. Imagine that the quantity of money was doubled overnight. Then people would simply double prices, and things would continue as they were previously. It follows that changing the quantity of money cannot have real economic consequences. In this sense, it is ‘non-real’.
This could not be further from the truth. The economy is a psychological creature, the product of millions of psychological calculations. At the foremost of many of these psychological calculations is money. It does not matter, if objectively, it is only valuable because the government says it is valuable. It does not matter, if objectively, it should not matter. What matters, ultimately, is that people believe it matters.
In normal economic conditions, outside of hyperinflation, people treat money as an end in itself. The business owner, when planning investment, looks at sales to see if he should expand his production. It does not matter to him if money is being created by loans from a perilously outstretched banking system. It does not matter to him if money is circulating only because the government has dangerously spent itself into debt. In the immediate instance, all he sees is money, even if the ‘real’ foundations of the economy have become rotten.
All of this is to say that money is what drives the economy. Therefore, its manipulation can produce real economic consequences, even if money itself is, at the end of the day, ‘non-real’. Human psychology allows for a number of non-rational phenomena to exist. The economy, driven by money, is only one of these examples.
Economic Growth Requires Money Growth
The modern economy, in contrast to previous eras, is characterised by an extraordinary pace of technical innovation. Under capitalism, competition forces firms to introduce new methods that cut costs, lest they themselves go extinct. The result is that the modern economy has a permanent bias towards deflation.
Deflation is ruinous to most economies. When prices fall, people are encouraged to hoard more money, in hopes it can buy even more goods later. This reduces consumption, furthering the vicious cycle as prices fall even more. Therefore, we arrive at the first intuition for why money growth is necessary for economic growth. It is needed to prevent the fatal deflation that is endemic to capitalism.
There is a second intuition for why economic growth under capitalism requires money growth. Consider how money circulates around the economy. It begins in the hands of those with capital, i.e. capitalists, who send it out to consumers in return for labour. Consumers then spend money on goods sold by capitalists, returning money back to the capitalists. We have a closed loop circuit of sorts.
For capitalists to remain incentivised, they must accumulate more money over time. Otherwise, they stop behaving like capitalists, and the innovation and investment that drives economic growth ceases. Yet on the macroeconomic level, the entire system appears to be a closed loop – money returning to the capitalist from consumption ultimately comes from the capitalist themselves, when they pay out wages. Therefore, for the capitalist to be able to accumulate money over time, there must be exogenous money entering the circuit. This is our second intuition.
Earlier we emphasised that money should be regarded as ‘real’. We now make a formal claim that real things, such as development of new technology under capitalism, are driven by the growth of money, which economics has traditionally regarded as ‘non-real’.
Our claim is much stronger than a banal observation that money growth accompanies economic growth. What we suggest is that increasing money growth itself can lead to economic growth, as long as it is psychologically sound.
For instance, if we increase money supply by 5%, then businesses will see a convincing increase in revenue. Believing that there is increased demand for their products, they will invest in expanding production, such that real output increases by 3%, with a benign inflation of 2%. This effect is all the more convincing if the increase in money growth is carefully hidden or dispersed across private actors, such as through the banking system.
On the other hand, if the government suddenly prints money and provides it to citizens, then the fictitious nature of money is exposed. Even though revenues increase, capitalists do not feel richer because the extra money has no psychological value. As a result, they raise prices, businesses refuse to plan, production collapses, hyperinflation ensues. For this reason, we emphasised that the growth in money must be psychologically sound.
How Banks Create Money Supply
Most money exists in the form of bank deposits. Many people confuse these deposits with money sitting in a box, waiting to be claimed. However, a deposit is nothing but a legal promise of the bank to pay cash. The bank does need to have the money to honour all its promises. Indeed the ratio of cash to deposits (the reserve ratio) in most banks is about 10%. That is to say if more than 10% of a bank’s customers demanded their cash in a single day, then that bank would collapse immediately.
Just as anyone can make a promise, banks can create more deposits through their own volition. Those deposits are then free to function as money in the broader economy. In this sense banks can create money ‘out of thin air’. Of course, this is not for free – each deposit created is liability to the bank – and no business would increase its liabilities without something in return.
The process by which banks create deposits is through loan creation. When a bank creates a loan for someone, they simply create new deposits in the person’s name. This is as simple as changing numbers on a computer. They do not actually need to find the cash to back up that deposit immediately. And since banks generally deliver on their promises, those deposits are as good as money in the economy.
The only thing constraining the bank from creating excessive deposits, beyond legal regulations, is their ability to honour those deposits. Should a bank make too many deposits without enough cash to back them up, then people will lose faith in the bank and demand their money back immediately. Hence traditionally the ratio of reserves to deposits is around 10% – go too low and that faith is disturbed.
Something over ninety percent of the money in the economy exists in the form of deposit money. If all the banks were to go bankrupt, all of that money and associated wealth and spending power would disappear overnight. This is why warnings of an economic return to the ‘Stone Age’ during the Global Financial Crisis were not exaggerated.
Just as loans create money, loan creation destroys money. The bank reduces the size of its promises until no money is owed at all. Therefore, something like ninety percent of the money in the economy is temporary. If no new loans were made, all of it would be recovered and destroyed through loan repayment, and the money supply would suffer a fatal contraction.
In this sense, money circulation is far more fragile than many people understand. Not only must money supply constantly expand, but it is constantly threatened with shrinkage from loan repayment. Moreover, much of that money exists in the form of legal promises – they become worthless if the promisor goes bankrupt. This is why a bankruptcy of a bank is no ordinary business bankruptcy.
Productive Loans and Unproductive Loans
Not all loans have the same effect on the economy. We introduce a distinction between productive and unproductive loans. A productive loan is one that finances increased production, such as through the purchase of machinery and labour. An unproductive loan is one that finances increased consumption of already produced products.
Both productive and unproductive loans increase money supply. However, only unproductive loans increase capitalist profits on a macroeconomic level. This is because they provide consumers with more money to buy capitalist products. Such money is exogenous to the circulation; it is entirely new money for the capitalist to accumulate. On the other hand, productive loans are made to capitalists – if consumption and profit increases, that is only because capitalists spend more on wages as a result of their loans. This does not register as profit to the capitalist, because any extra money they have is money they borrowed, rather than money coming from someone else.
Put differently, the difference between productive and unproductive loans is where they enter the loop of money circulation between capitalist and consumer/wage-earner. The productive loan makes a ‘full lap’ and begins from the capitalist. As a result, it increases both production and consumption. However, it does not make the capitalist feel richer, as all increase in money coming back from the circuit is money they borrowed. The unproductive loan makes a ‘half lap’ and begins from the consumer. As a result, it only increases consumption. This makes the capitalist feel richer, because the new money does not come from their own pocket, but from that of others who have taken out the loan.
When unproductive and productive loans are in balance, the boon to capitalist growth is immense. Productive loans enable new economic activity, whilst unproductive loans ensure that profits on that new economic activity are actually realised. Where there are only productive loans, then there is excessive production, leading to deflation and unprofitability. Where there are only unproductive loans, there may be excessive inflation. However, as we have noted previously, capitalism is inherently deflationary, such that this risk is greatly reduced.
Mortgages are the Engine of Modern Money Supply
The main source of unproductive loans in the modern economy is the mortgage. This is because most mortgages are for purchases of existing property. They merely facilitate a transfer of existing assets – no new economic activity occurs. More often than not, that seller is a retiree, who then spends the deposits on consumption. In this sense, a mortgage is really an unproductive loan that boosts consumption without any change to production.
The role of mortgages in the modern economy is underestimated. If capitalist growth requires profits, and profits require growth in consumption, for which mortgages are the main source, then mortgages are the hidden engine of the modern capitalist economy.
Simultaneously, for more money to be created from mortgages, housing prices must increase. We might add our own adage: ‘Housing inflation is everywhere and always and everywhere a monetary phenomenon’. Without housing inflation, mortgages cannot create as much money as the previous year, leading to negative effects on growth.
The role of mortgages in money creation is a relatively recent phenomenon. For the 300 or so years before the abandonment of the gold standard, the root base of money growth was simply the mining of new precious metals. This formed a foundation from which new cash could be issued, from which in turn new deposits could be created.
For example, $10 million in newly mined gold could be exchanged for $10 million in newly created cash, which could then back $100 million in newly created deposits via loans. Of course, money growth could, and often did, outrun this growth in the base of precious metals, but the base provided a hard limit onto which money supply could shrink in a crisis.
The modern economy is different. As money is no longer backed by anything, all new money is simply created through loans, such that it is all of a temporary character. This gives the modern economy a degree of instability not previously seen in capitalism, as there is no stable base that sets a hard limit to the degree of monetary contraction. There is simply a balloon which can shrink all the way to zero should no new loans be made, or if the banks were to suddenly collapse.
Determinants of Loan Creation
There are two key determinants of loan creation, and in turn the growth of money supply. They are interest rates and economic confidence.
Lower interest rates stimulate loan creation because more businesses become viable when repayments are viable. Simultaneously, lower interest rates also reduce the rate of money destruction from loan repayment. For this reason, interest rates are a key lever of control in the modern economy.
Economic confidence is the second determinant of loan creation, and in many respects the more fundamental one. This is because confidence determines whether anyone wishes to borrow or lend at all. A business will only take on a loan if it expects future revenues to justify the repayment. A household will only take on a mortgage if it expects its income to remain stable and property values to hold. And conversely, a bank will only lend in an economic environment where it feels confident that the debtor will be able to repay.
The importance of economic confidence cannot be understated. Central banks can lower interest rates to stimulate borrowing, but they cannot compel anyone to borrow if people remain irredeemably pessimistic about the economic situation.
Money Creation is Cyclical
Let us retrace our core claims thus far. Economic growth depends on money supply growth. Money supply growth depends on confidence. Confidence depends on economic growth. This forms a perfect loop – already we can envisage a self-reinforcing quality to both money creation and economic growth.
In the expansionary phase, prevailing economic confidence encourages more lending, leading to increased consumption and rising asset prices. This increases economic growth and feeds into confidence, which justifies further lending. Productive and unproductive loans multiply in tandem. Businesses borrow to expand, households borrow against rising property values, and capitalist profits grow accordingly. The balloon inflates.
The very process of expansion contains the seeds of its reversal. As asset prices and debt levels rise, borrowers become increasingly stretched, and the margin for error narrows. Any shock — a rise in interest rates, a fall in employment, a decline in export demand — can tip heavily indebted households and businesses into default.
Eventually, a tipping point is reached, where even though economic confidence remains high, some actors have simply borrowed too much because of reckless optimism. They default on their loans, causing banks to suffer losses. As a result, banks become more defensive by tightening lending standards, slowing money creation. This then slows consumption and causes a fall in asset values, which makes it even more difficult for people to repay their loans. The balloon deflates.
An economic crash creates opportunities for new growth. Inefficient firms are liquidated whilst stronger firms can buy up their assets at bargain prices. Eventually, some businesses find opportunities to make a reliable profit and secure loans from banks. This restarts the credit cycle.
Financial Crisis
A financial crisis is the ultimate expression of the cyclical instability described above. It occurs when the self-reinforcing contraction of credit creation crosses a threshold which threatens the faith in money itself — specifically the faith in deposit-money.
Recall that over ninety percent of the money supply exists as bank deposits. That is, they exist as promises of the bank to pay cash. Under ordinary conditions, the gap between promise and cash is invisible, because not everyone demands their cash simultaneously. As a result, people often treat deposits as if they are cash. A financial crisis is precisely the moment when that gap between promise and cash becomes exposed.
During a financial crisis, as asset prices decline, banks suffer losses to their balance sheets. When these losses are sufficiently severe, people doubt whether the bank can honour its promises to pay cash by selling off those assets. To pre-empt this scenario and secure their cash, depositors and creditors attempt to convert promises into cash at the same time.
Normally, banks only hold a small amount of cash relative to their deposits. If too many people suddenly cash their deposits, the bank is forced to raise cash by calling in loans, selling assets, and restricting new lending. This further worsens the position of the bank as asset prices collapse even more from forced selling, causing even more people to demand their money from the bank, leading to even more selling.
Eventually, the bank has no cash to meet its promises even after selling all its assets, and must declare bankruptcy. All remaining deposits become worthless, such that money is literally destroyed.
What makes a bank collapse so threatening is the interlinked nature of the financial system. Money by itself does not make more money unless it is lent out. Therefore, banks often have complex relationships where they lend to each other to minimise the amount of idle cash – those which have excess cash lend to those which are short of it. But should a single bank go bankrupt, then it cannot honour its debts to others, such that the health of other banks is threatened as well. This is not to mention hits to their health from the prevailing negative economic climate, as well as forced selling of assets. For this reason, a single bank failure is never an isolated event.
Governments’ Role in the Money Supply
The government, including the central bank, can manage the money supply through fiscal spending and monetary policy.
Fiscal policy operates primarily on the velocity of money. Government spending is typically financed through taxation or bond issuance. In both cases, money is taken from the wealthy, who have the highest marginal propensity to save, and is transferred to the poor, who have the highest marginal propensity to consume. This increases the circulation of money – what in economics is called its ‘velocity’ – such that consumption increases even though quantity of money remains unchanged.
An increase in the velocity of money can have similar effects to an increase in the quantity of money, in terms of stimulating economic activity. Consider, for example, money sitting in the savings account of a billionaire. It has a velocity approaching zero, as the richest have only so many ways to spend their money. When the government borrows such savings and uses it for wages for public workers, they immediately spend it on food, rent and entertainment, allowing it to recirculate to generate new economic activity.
Monetary policy, by contrast, operates primarily on the quantity of money. Firstly, by setting interest rates, the central bank can influence the rate of money creation via loans, as previously discussed above. Secondly, by adjusting reserve requirements, central banks can alter how much cash banks must hold against their deposits. Thirdly, banks can also create new reserves directly through asset purchases. When done in large quantities this is called quantitative easing.
The most important lever of central bank policy, in ordinary times, is interest rates, as they help to determine loan creation. However, as previously discussed, it is an inferior determinant of money creation when compared to economic confidence.
Reserves and the Money Supply
Reserves are essentially promises of the central bank to pay cash. They do not affect the economy directly because only banks and the government can have an account at the central bank. Should a bank redeem its reserves and obtain cash, this does not enter the economy until the bank uses that cash to pay out deposits. Therefore, the main effect of reserves on money supply is indirect – in situations where banks are cash-strapped, increasing reserves can allow them to make more loans.
Banks can be cash-strapped at opposite ends of the credit cycle.
In a contraction, banks can be cash-strapped because too many deposits have been redeemed by nervous depositors. If the central bank buys their assets for reserves, they suddenly have enough cash to honour their deposits easily, reassuring depositors and halting the bank run.
In an expansion, banks can be cash-strapped because they have too many opportunities to grant loans, and not enough money to safely honour those deposits. If they have more reserves, then they can be confident to make all the loans they want, without being short of cash.
There is one exception where reserve creation does directly impact the effective money supply. This is when a central bank purchases bonds directly from the government, such that the reserves flow immediately into government expenditure and enter the real economy without passing through the lending decisions of banks. Under this scenario, reserves result in an immediate expansion of economic activity.
Of course, banks could also achieve the same effect if they decided to use their reserves to fund cash handouts to the general public. But banks do not hand out free money, unlike the government. Therefore, if banks get reserves, the impact on the real economy is entirely contingent on what they do with the reserves.
Case Studies
The 2008 Financial Crisis
In the 2000s, the rise of Chinese manufacturing exacerbated the deflationary tendencies of capitalism. Due to its inflation mandate, the Federal Reserve kept interest rates artificially low, propelling a mild boom in the American economy. However, as with any credit cycle, excessive risk piled up until it could no longer be sustained by optimism, resulting in a crash of the housing bubble in 2007.
Thus in 2007 the cycle went into reverse – it was not until 2008 that bank failures were threatened. At that moment the US government intervened handsomely to avert absolute crisis, addressing most of the important determinants of the money supply we have identified above.
Firstly, it prevented the banking system from collapsing, which would have wiped out deposit money entirely. To do this, it provided direct capital injections, that is cash, to help shore up the health of banks. The most important of these was a bailout of AIG, which was an indirect bailout of the banking system by bailing out their key insurer. On the side of the Federal Reserve, quantitative easing allowed banks to sell their assets at reasonable prices, directly addressing any risk of a fire sale of assets.
Secondly, as the banking system took a while to recover and regain its confidence, the government substituted for its role in the circulation of money through fiscal spending. That is to say, it increased the velocity of money through budget deficits, making up for a decrease in money supply growth from an anaemic banking system.
Thirdly, the Federal Reserve lowered interest rates to help support the recovery of the banking system in making loans. Indeed, it had to do this to historically unprecedented levels, that is close to 0% in many countries.
Nevertheless, the global economy remained unusually stagnant until the 2020s – leading some to coin the term, ‘secular stagnation’. Three key reasons can be offered.
Firstly, although governments continued using budget deficits and low interest rates to encourage the economy, ultimately the most important factor, economic confidence, had not recovered, in the absence of a compelling narrative. After all, the global economy had nearly suffered a catastrophic crash.
Secondly, no true crash had occurred due to the bailouts. There were reduced opportunities for businesses to pick up cheap assets. Of course, had a crash been allowed to occur, even if growth would be far stronger, the economy would have been starting from a much lower baseline, such that the overall picture would still be worse.
Thirdly, global growth was average by historical standards – the situation of stagnation only prevailed in Western economics. This was because China was still growing at the expense of the West – money growth in the West made up for deficient demand in China rather than stimulating their own Western markets.
The Japanese Economic Bubble
In the late 1980s, Japan saw extraordinary economic growth associated with an asset bubble. The mechanism is now clear from our approach to understanding the economy – asset bubbles allow for more money creation, particularly from mortgages, leading to more consumption, more revenues, more investment and greater economic confidence.
Yet when the Japanese bubble collapsed, the government failed to intervene decisively as it had occurred in the US in response to the Global Financial Crisis. They failed to bail out the banks immediately, fearing it to be politically toxic, instead settling for legal manoeuvring that could keep the banks technically solvent even though they were in critical failure. The result was that the money-creating ability of the banking system was suppressed for too long, and pessimism was allowed to build up. As a result, even though the government alter resorted to quantitative easing, large deficits and bailouts, lack of economic confidence had already started its own vicious circle.
Quantitative Easing
The first round of quantitative easing was essential to restoring the heath of the banking system. It allowed banks to raise reserves without resorting to fire sale prices, shoring up their health and protecting them from a loss of confidence. But further QE could not induce banks to actually create more money through loans, even if it became very safe to do so with plenty of reserves. Hence even though QE technically added trillions to the money supply, inflation remained extremely modest in the 2010s.
The 2025 AI Boom
The current 2025 AI boom is simply another repeat of the virtuous cycle that characterises the economy and money growth. Notably, the presence of a new innovation galvanises economic confidence to generate a slurry of loan creation. Whether if AI will actually be profitable, even if it is genuinely productive, is entirely beyond the point. All that matters is that the virtuous cycle of money creation and increasing consumption is sustained – the production side will take care of itself, thanks to the innovative nature of capitalism.
What is peculiar to this boom is that ‘reserves’, in both a literal and non-literal sense, have been built up by the prior decade of failed economic stimulus. Notably, the banking system at the start of the boom was already unusually flush with reserves from QE. As a result, they had all the safety in the world to make as many loans as they liked. Moreover, as governments had worked themselves into a habit of deficit spending, with social programmes difficult to unwind once implemented. This only added to the velocity of money, which would have been already high from the boom. As a result the term ‘secular stagnation’ has already faded into distant memory.
Like all booms, the current one will result in an excess of risky loans and bad decisions. Eventually a tipping point will be reached where the excess cannot sustain itself, and the cycle will go into reverse. Governments already responded well to the Global Financial Crisis (and in turn to the SARS-CoV-2) and will no doubt respond even more decisively this time. The problem, however, is that the ‘ammunition’ is running out. Government debts and central bank balance sheets are both at historic highs. And the amount of bad debt which will have to bailed out does not only include that from the current AI boom, but all the bad debt that was bailed out from SARS-CoV-2 and the Global Financial Crisis. The only mild saving grace is that interest rates finally have some room to run lower, compared to when they were close to 0% in the 2010s.
*Disclaimer: This information is for general informational purposes only and does not constitute financial, investment, or professional advice. The author may hold positions in the assets or companies discussed.
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