4. Law of Economics: Money is created through credit

By Jan Frederik Moos

They say you shouldn’t talk about money – but we do. We tend to think of money as something solid and independent: coins in our pocket, notes in our wallet, or figures in our bank account. Yet the surprising truth is that money never exists on its own. It always comes into being alongside debt. Every dollar is simultaneously an asset and a liability. Take your bank deposit. For you, it is money you can spend — an asset. For the bank, however, that very same deposit is a liability, because it owes the money to you.

The same logic applies if you lend $1,000 to a friend. For you, the loan is an asset — a promise to be repaid. For your friend, it is a liability — the obligation to repay you. In that moment, the world’s financial assets and financial liabilities both rise by $1,000. In this way, money and debt always move together, like reflections in a mirror.

That is why economists say: whenever black ink (an asset) is written in the books, red ink (a liability) must be written as well. The two are inseparable. Money and debt are like a couple that never quarrels, because our economy runs on the principle of double-entry bookkeeping: every liability must always come with a matching asset.

At first sight this may seem puzzling, because as an individual you can plainly hold money without being in debt yourself. If you have $50 in your wallet, you do not owe anyone that $50. But for society as a whole, the picture is different. For every $50 note in circulation, the central bank records a $50 liability. For every bank deposit, there is a corresponding liability on the commercial banks balance sheet. What is wealth for one person is always debt for another.

Seen clearly, money is not a pile of coins or a stack of notes. It is a web of promises, recorded in ledgers and upheld by law. For the individual, money appears as wealth. For society, money and debt are always a balance: every financial asset is mirrored by a financial debt. Money in short, is always born of debt — and it never exists without it. Now that we are prepared, we can get started.

“Money is not like other goods because it is costless to produce, so that as people switch from goods to holding money less factors of production are employed.” (Thirlwall, A. P.: 1993).

This essay develops the fourth of five economic laws. Its premise is simple but decisive: money is fundamentally unlike any other good. One of its most important characteristics we have already encountered in the second chapter: it can be saved indefinitely. Through this unique feature, it creates a gap between potential supply and demand if the state does not intervene. Let us take a closer look at how money differs from other goods.

The uniqueness of money rests on three properties. First, money has no production elasticity (production elasticity means how responsive production is when demand changes). Entrepreneurs can increase the output of cars or wheat, but they cannot produce money in response to a higher demand for it — that is, when people wish to hold a larger portion of their income as bank deposits (Davidson, 1994, pp. 94–95). Second, money has virtually no substitution elasticity. Taxes must be paid in state currency, not in cars or gold; there is no alternative. Third, money can be hoarded. Unlike perishable goods, it can be withdrawn from circulation indefinitely.

When money is withheld, demand — that is, total spending — contracts. As a result, output declines and unemployment emerges. Saving, in this sense, withdraws money from the monetary circuit, reducing overall expenditure and creating a gap between supply and demand. Money is therefore unique: it is the only “good” that cannot be produced on demand, cannot be substituted, and can be stored indefinitely. In short, no one will increase production or hire additional workers in response to a rising saving rate. By contrast, entrepreneurs who now sell less as a result of higher saving will reduce production and lay off workers.

Money does not arise from production or labour; it comes into being through the creation of debt. To see this more clearly, post-Keynesians (capable economists) turn to the language of accounting. Stephanie Kelton has captured the essence of double-entry bookkeeping in a memorable phrase: “red ink always faces black ink”. Every liability is paired with an equivalent asset. Nobody can hold “money in the abstract”; it always takes the form of a claim—such as a bank deposit, a government bond, or a promise to repay. At this point the argument may still appear somewhat abstract, which is why it helps to illustrate this dual structure more concretely.

Money is not a free-standing object but a relationship: it exists only as a matched entry in the accounts of different agents. To clarify once again: your bank deposits are, in the accounting sense, a claim on the bank; the bank is the counterparty and, correspondingly, records a liability to you. For our discussion, we will focus on bank deposits, since that is probably what you most immediately associate with the word "money". Economists tend to use the term more broadly: they may also count government bonds or other financial claims as money, or at least as money-like. But here, to keep things clear, we will stick to the simple case. The money we are talking about in the following example therefore corresponds to the sum of all bank deposits held by economic agents at commercial banks.

Following the didactical approach of Marc Lavoie (a fine Canadian economist)—and in line with the method already employed by John Maynard Keynes—we begin with a simplified, closed economy that contains only a single commercial bank. Within this framework, the mechanics of money creation can be clearly illustrated with a stylised bank balance sheet. Let’s take a first look at it.

Figure 1: Bank Balance Sheet – Initial Position

On the left are the bank’s assets: loans and government bonds. On the right side are its liabilities: deposits held by households and entrepreneurs. For the bank, deposits are liabilities, since they belong to the depositors. For depositors, they are assets — claims against the bank. Or, simply put: this is the money of the economy. This dual structure lies at the heart of monetary economies. Using Richard Koo's (an outstanding Taiwanese economist) terminology, we can say that the left side shows the origination side of the money and the right side shows who the money currently belongs to. Now suppose the bank grants a loan of $50 to an entrepreneur. The loan is recorded as a debit under assets (“loans to entrepreneurs”), and the entrepreneur’s deposit is credited under liabilities ("deposits of entrepreneurs"). Let's take a look at the new bank balance sheet.

Figure 2: Bank Balance Sheet – After Entrepreneurial Loan

Both sides of the balance sheet expand. The bank has a new claim on the entrepreneur, and the entrepreneur has a new claim on the bank. Crucially, no pre-existing money was transferred; the deposit was newly created. As the entrepreneur spends it, ownership of the deposit changes hands, but the total remains. This illustrates two principles: money creation is endogenous (endogenous means that something originates within the economic system itself), driven by credit demand, and every unit of money appears as both an asset and a liability. Through Koo’s lens, we not only see that there are 50 dollars more in the economy (on the right-hand side of the bank’s balance sheet), but also how they came into existence (on the left-hand side of the balance sheet).

Money comes into existence when the state, entrepreneurs, or households take on debt. The money circulating today is the result of borrowing, and its current holders reflect past decisions to spend or to save. You, too, can create money by taking out a loan—for instance, to buy a house. From the perspective of the economy as a whole, apart from you as an individual, this amounts to an injection of money. You can provide the economy with a net financial injection, and this brings us to an important topic — namely, what happens in the case of government debt. What is interesting here is that the state does not hold its own account at the bank; rather, it finances its deficit spending by issuing government bonds. This is what we will now examine more closely.

Government spending follows the same logic, but with an important difference. Suppose the government decides to finance $25 of social transfers by issuing government bonds. In this case, the bank’s asset account for "government bonds" increases by $25, while on the liability side household deposits rise by the same amount. The corresponding journal entry reads: government bonds $25 to household deposits $25. The bank records the bond as an asset and the household deposit as a liability.

Figure 3: Bank Balance Sheet – After Government Deficit Spending

In this case, the private sector’s net financial assets increase. Unlike private credit creation, which balances an asset with a liability inside the economy, government deficit spending provides deposits without imposing new private liabilities. Only the state can do this.  As we have seen, you and I can in principle inject money into the economy. Yet since we are part of the private economy ourselves, our debts are, naturally, part of it as well. Public debt thus provides the safest financial assets in the economy and uniquely makes net private saving possible.

This explains why money cannot be treated as any other commodity. It is created through debt, it has no production elasticity, and it always appears as a claim and a liability. When the private sector seeks to increase saving, it cannot generate additional money on its own. The private sector cannot net save without a matching deficit elsewhere. If the government refuses to provide the matching deficit, the economy’s attempt to save becomes self-defeating. Money is withdrawn from circulation without creating any additional savings, aggregate expenditure falls, and the economy contracts. Seen again through our lens: the left-hand side is trying hard to increase bank deposits — to save as much as possible — but since no one is borrowing (on the right-hand side), the balance sheet does not expand, and the economy as a whole fails to save.

In our scenario, total spending in the economy would fall rapidly, while account balances would not increase. If the government did not spend money to maintain overall demand and to accommodate the desire to save, the economy would fall into a severe depression. What is often presented as prudent austerity is, in fact, economic self-destruction. Here lies the core problem of why Keynesianism is so hard to accept, as analysed by Joan Robinson, who exposes the alleged virtue of saving as an actual vice:

“What made the general theory so hard to accept was not its intellectual content, which in a calm mood can easily be mastered, but its shocking implications. Worse than private vices being public benefits, it seemed that the new doctrine was the still more discerning proposition that private virtues of thriftiness and careful husbandry were public vices.” (Robinson, J. 1962).

The difficulty does not lie in the Keynesian logic, which is undoubtedly correct, but in the fact that it exposes the comforting tale of the diligent filling of the piggy bank as a myth. The theory outlined here is known as the endogenous theory of money, developed systematically by Basil Moore within the Post-Keynesian tradition. It describes how money is actually created by banks and how government debt operates in practice, and it provides the foundation for all further analysis.

Yet money is more than a set of balance sheet entries; it should not be conceived merely as a static stock. Money flows through the economy in wages, expenditures, and payments. When it is saved, it is withdrawn from circulation, and it must re-enter through borrowing; otherwise, spending falls. To capture this dynamic, Steve Keen developed the Minsky model, which sets money in motion and incorporates the dimension of time into monetary analysis. The blog Relearning Economics also deals competently with this topic.

In the next chapter, we will also take a closer look at the scientific methodology behind this approach, which views the economy either as an open system (models with time) or as a closed system (equilibrium models). For empirical work and for embedding monetary processes into historical processes, the most recent sectoral balances—which map income and expenditure flows across sectors—are of central importance.

For finance nerds, I’d like to give a few reading recommendations. In a real monetary system, the government first overdrafts its account with central bank money, which then enters the banking system, and later pulls it back via government bonds. Of course, in reality there are many banks rather than the single-bank model we use here for didactic clarity. For a closer look at the European system, I recommend Modern Money Theory: A Simple Guide to the Monetary System by Dirk Ehnts. For the American context, try Understanding Modern Money by Randall Wray.

If you are interested in working with me as an editor, interview guest or guest lecturer, or if you have any questions, please feel free to get in touch: mmtmitjan@gmx.de

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