Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Banks Create Money From Thin Air
Transcript
- Lucas: We tend to think of money as something physical, or at least something that starts with the central bank and trickles down. But if you look at where most of the money actually lives today, it's sitting in commercial bank ledgers, created out of thin air every time a loan is approved. Luna: Right, so it's not really about printing presses. It's about accounting entries. Lucas: Exactly. Let's take a concrete example from a big player like JPMorgan Chase. Say you walk into a branch and deposit one hundred dollars in cash. That hits their balance sheet as a liability, but it also gives them reserves. Now, under modern rules, they don't need those reserves to lend out the money. They lend first, then manage the reserves later. Luna: So the act of lending creates the deposit, rather than the other way around? Lucas: Precisely. When JPMorgan approves a fifty-thousand-dollar car loan for a customer, they don't transfer fifty thousand dollars from another account. They type 'fifty thousand' into the borrower's account. New money has been created. The total money supply goes up by fifty thousand dollars instantly. Luna: That feels almost too simple. Why doesn't every bank just do that until the economy collapses? Lucas: Because there are guardrails. First, capital requirements. Banks must hold a certain percentage of their own equity against risk-weighted assets. If JPMorgan lends too much without enough capital backing, regulators step in. Second, and maybe more importantly, there's loan demand. You can create all the money you want, but if no one wants to borrow because they're scared of recession, the money stays stuck. Luna: So the constraint isn't really reserves. It's confidence and regulation. Lucas: Confidence and capital. And let's be clear about the Federal Reserve's role here. The Fed controls the price of money—interest rates—and the quantity of base money, which is mostly just reserves and currency in circulation. But they don't directly control broad money, which includes all those commercial bank deposits we just talked about. Luna: That explains why sometimes the Fed cuts rates and inflation still runs hot. The private sector is driving the volume. Lucas: Spot on. In September 2026, we see this dynamic playing out right now. Even if the Fed holds rates steady, if banks are eager to lend and businesses are eager to borrow for AI infrastructure or green energy transitions, credit expands. That expansion fuels demand, which pushes prices up. Luna: It’s a reminder that monetary policy is a two-player game. The Fed sets the tempo, but banks play the music. Lucas: I love that framing. But before we dive deeper into how that tension plays out in today's market, I want to mention something small but important. A handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making these episodes possible. No ads, just us talking through the stuff that matters. Luna: Yeah, it keeps the lights on and lets us dig into the details without chasing clicks. Lucas: If that resonates with you, check it out. Otherwise, let's get back to the mechanics. So, if loan demand is the primary brake on money creation, what drives demand right now? Luna: Well, corporate investment cycles seem strong, especially in tech and manufacturing. But consumer debt is already pretty high. Lucas: That's the key tension. Corporate borrowers have low cost of capital relative to expected returns in some sectors, so they keep borrowing. Consumers, however, are feeling the pinch from higher mortgage rates and credit card balances. So we see a divergence: business loans growing, consumer loans stagnating or shrinking. Luna: Does that mean the overall money supply growth is slowing, even if it doesn't feel like it in the news? Lucas: It does. Look at the M2 metric, which tracks broad money. Its growth has decelerated compared to the pandemic boom years. But deceleration doesn't mean contraction. As long as M2 is growing, even slowly, it adds fuel to the economy. Luna: So the risk isn't necessarily deflation. It's persistent, moderate inflation driven by stubborn credit growth in specific sectors. Lucas: Exactly. And this brings us to the liquidity buffer. Banks aren't just lending blindly. They hold high-quality liquid assets—like government bonds—to meet stress scenarios. This limits how much they can lend in a panic, but it also means their lending capacity is somewhat predictable. Luna: Predictable enough for investors to price in? Or does the unpredictability of individual bank decisions still cause shocks? Lucas: Individual decisions add up. Remember the regional bank stresses a few years ago? It wasn't about lack of capital per se, but about maturity mismatch and sudden withdrawals. Today, the system is more resilient, but the underlying mechanism—lending creating deposits—remains fragile if trust evaporates. Luna: Trust is the real collateral. Lucas: In many ways, yes. Which leads to a fascinating question for our current moment in late 2026. With digital currencies and fintech apps disrupting traditional banking channels, are we seeing a shift in who creates money? Luna: Some argue that stablecoins are becoming a parallel money-creation engine. If people hold USDC instead of checking accounts, does that bypass the traditional bank multiplier? Lucas: It does, partially. Stablecoin issuers hold reserves in short-term Treasuries and cash. They aren't creating new money via lending in the same way; they're intermediating existing money. But if they start lending those reserves out, they could become shadow banks. Regulators are watching that closely. Luna: Shadow banks creating money. That sounds like a recipe for a new kind of financial instability. Lucas: Or a new kind of efficiency. If fintechs can lend faster and cheaper than traditional branches, they might win market share. But they operate under different rules, or lack thereof, depending on jurisdiction. Luna: So the next crisis might not come from Wall Street, but from a crypto exchange or a neo-bank app. Lucas: Possible. But for now, the vast majority of money still flows through the regulated banking system. JPMorgan, Bank of America, Citigroup—they are the primary creators of purchasing power in this country. Luna: Which makes their internal risk management culture incredibly important. One bad decision by a chief credit officer can ripple out globally. Lucas: Agreed. And that's why monitoring bank lending standards—the Senior Loan Officer Opinion Survey—is such a vital leading indicator. It tells us not just how much money is being created, but how cautiously it's being deployed. Luna: Loose standards mean easy money, tight standards mean contraction. Simple as that. Lucas: Simple in theory, messy in practice. Because standards change based on fear, greed, and regulatory pressure. We saw standards tighten after 2008, loosen during the pandemic, and now they're stabilizing. But stabilization isn't static. Luna: Nothing ever is in finance. Lucas: Never. So, as we wrap up, think about your own bank account. Every time you pay with a card, you're spending money created by someone else's loan approval. The economy is a web of IOUs, and central banks just set the interest rate on the web. Luna: A beautiful, terrifying web. Thanks for pulling back the curtain, Lucas. Lucas: Anytime. Next week, we'll look at how this lending cycle impacts housing markets specifically. Luna: Can't wait. See you then.