If you Google: Can banks individually create money out of nothing? you’ll get access to one of the most downloaded academic papers across almost all disciplines.
The main question of this study was, when you borrow money, where does it come from?
Three hypotheses are recognized in the literature.
One is that banks are merely intermediaries like other non-bank financial institutions. The second is that banks are mere financial intermediaries that cannot create money, but collectively, they create money through systemic interaction. The third says each bank has the power to create money ‘out of nothing’ and does so when it extends credit (the credit creation theory of banking).
Scientists had to get access to the IT from the banks, which was a huge hurdle, to find out if the money comes from customers’ deposits, as the financial intermediation theory claims, or is it from extra reserves from central banks, as the fractional reserve theory says.
Or third, if money is created just out of nothing.
The conclusion was that the money was invented, created out of thin air.
The deposits didn’t change, neither did the extra reserves from central banks. It was simply created new credit for the customer.
When someone signs a loan, it’s like issuing a security, like when the government issues treasuries. Banks put it on their balance sheet as an asset.
Although most bank customers think that the bank will transfer money to your account, that doesn’t happen. There is no transferring because the money doesn’t come from another place.
It is created out of nothing.
Banks have the legal power to put on their balance sheets that they owe money to the customer, meaning they assume the liability in their balance sheet and create money to give to the customer.
Banks are, therefore, the ones that increase the money supply.
If banks were mere intermediaries, they would have little impact on the economy. Instead, however, they are the ones that decide who gets the money and how much.
It means commercial banks have the power to reshape the economic landscape in a brief period.
However, in the Covid-19 pandemic crisis, things changed radically.
Simultaneously, a tech boom appears as a necessity from the need for people to stay at home. Instead, people needed their mobile devices to work. Applications like Zoom, Teams, or Skype were mainly the only way people could keep working and keeping the economy going.
At the same time, the stock market quickly returned to pre-pandemic levels. Still, due to the amount of money printed and placed on the market, accumulated with all the gamblers who were at home unable to access casinos, and with young people quickly accessing online brokerages, an investment bubble in highly leveraged stocks has taken the digital world by storm.
Central bankers started to see DeFi as a threat to the financial system, so they needed to shift their analog mindset and run into a digital form of doing things, with the threat of DeFi and decentralized financial solutions.
Central Bank Digital Currency
In a recent conference at the Hitchins Center on Fiscal & Monetary Policy at Brookings, Eswar Prasad, Senior Fellow in the Global Economy at Brookings and professor at Cornell University, did a fascinating presentation on the role of central banks in a highly digitized economy. They are concerned about the emergence of decentralized and deregulated structures, which could jeopardize the “balance” that central banks promote in the global economy.
The inconvenience of the decentralization of financial services was shared by all those present on the panel of speakers. In that panel was Agustín Carstens, ex-Governor of Banco do Mexico, and the General Manager of the BIS (Bank of International Settlements), Stefan Ingves, governor of Sveriges Riksbank, and Urjit R. Patel, Former Bookings Expert Governor from the Reserve Bank of India.
Of course, each one of these politicians has its agenda, but it was exciting to notice the concern about technological advances in finance.
It is not easy, and still, no one knows if it will be a better option than the one we currently have, to believe that a system governed by cryptography, code, and protocols could be the ideal solution for a world that is structured in two distinct realities: the countries where banking systems work vs. countries where there is no banking (the unbanked).
This model is radically different from the existing one, but it already works in the digital world, as additional tokens (coins) are beeing traded for service payments without any intermediation, only consensus through protocols and smart contracts.
These two worlds will one day collide; let’s not wait for anything else.
The men of power, the men of law, will do their utmost to destroy any threat to the installed power.
On the other hand, no one can annihilate the decentralized system unless the internet is turned off. But it can be highly constrained if decentralized financial processes were deemed illegal.
In this future war of powers, central banks are preparing to create their digital solution. CBDCs will virtually eliminate the role of commercial banks as we know them. Instead, digital wallets may be made directly from central banks to citizens, where all payments will be centrally managed and controlled.
How far centralized and decentralized forces will coexist, no one knows.
But it will be a fascinating virtual war to watch.
Final Thoughts
Money is the perfect incentive so that technological solutions are created in the financial ecosystem.
It means we, the customers, will be the first to benefit from it.
Yet, there are two strands of macro-economic thinking that collide.
One that believes the role of central banks should be minimal, letting markets work freely, even if it means recessions.
Another one believes that central banks allow no significant recessions and depressions, which enables the world to develop more quickly, creating wealth and technological development.
Money is power, and it’s about power that we’re talking about here.
Will central banks be able to avoid the next burst? Will central banks provide a better digital solution with the CBDCs compared to the decentralized finances?
Can Bitcoin, Ethereum, and all blockchains thrive in a digitized world? Can DeFi provide better solutions worldwide? Is DeFi only going to solve the unbanked problems, or will it give better solutions to the western world too?
Many questions, but few answers for now.
One thing is for sure- it’s going to be a hell of a ride.
This article was written by Nuno Fabiao and is for informational purposes only, it should not be considered Financial or Legal Advice.
Find Nuno at @nuno_fabiao or nunofabiao.medium.com
