How to Manhandle Money


In my last column, I explained how governments and banks create money. The basics are incredibly simple – so simple, in fact, that the great non-traditional economist John Kenneth Galbraith once commented that:

“The process by which banks create money is so simple that the spirit is repelled. Where something so important is involved, a deeper mystery only seems decent.[1]

Figure 1 shows the almost offensively simple actions that create money. Banks place dollars, per year, in the deposit accounts of their customers, matching dollar for dollar by recording in dollars, per year, the additional debt owed by their customers. Governments pour dollars into the bank accounts of their citizens every year, and the same funds, dollar for dollar, into the reserve accounts of banks.

Figure 1: The absolute bases of money creation by banks and governments. (Steve Keen)

There are more steps involved, as I explained in my last column, but there is no “deeper mystery”: Banks and governments can both create money simply because ‘they can both enter numbers into bank deposit accounts. That’s it.

However, if you read an economics textbook, you are likely to come across much more obscure topics, such as fractional reserve banking, reserve lending, money multiplier, loanable funds. These esoteric concepts have one thing in common: they are all wrong! They mutilate the money, rather than explain it.

It wouldn’t matter if it was just stupid stories that unimportant people would believe. But, unfortunately, these are stories believed by economists who often have substantial power over economic policy. These stories can therefore have incredibly harmful effects on the real economy.

For example, guess what Charles Plosser, former President of the Federal Reserve Bank of Philadelphia, was most worried about during the depths of the Great Recession in December 2009, when unemployment in the United States hit 10%?


His argument was that the cost banks faced for “holding vast excess reserves…could lead to a rapid increase in the money multiplier and a conversion of excess reserves into loans or borrowed money… Thus, I see greater upside risk over the medium term – the two to five year term – to inflation than the greenback. (“Federal Open Market Committee Minutes, December 15-16, 2009,” p. 55.) (The “Green Book” sets standards for an effective internal control system for federal agencies.)

Excess reserves are reserves in excess of the requirement, called required reserve rate, which banks must hold, equivalent to 10% of their deposits. Excess reserves were indeed high – they had grown from virtually zero to over $1 trillion in just 15 months (see Figure 2), thanks to the Federal Reserve’s deliberate policy of quantitative easing (QE). Plosser feared that these excess reserves would trigger a huge increase in the money supply (or M2) and thus trigger inflation.

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Figure 2: St. Louis FRED data on excess reserves (beyond those set by the reserve requirement ratio)

But instead, the rate of money creation remained low, comparable to the rate that applied when there were no excess reserves. However, the COVID-19 pandemic has also caused a huge increase in excess reserves, and this did lead to a rapid increase in the money supply (see Chart 3).

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Figure 3: Percent growth rate of M2. (Data: Federal Reserve Economic Data [FRED]St. Louis Fed)

So why did one increase in excess reserves have very little impact on the money supply, while another had a huge impact? This question is easily answered using the simple monetary system shown in Figure 1. Just add another asset to Figure 1—bonds held by banks—and another liability—the deposit accounts of banks. non-bank financial institutions (NBIFs) to banks, since QE bought bonds from both banks and NBIFs, such as pension funds, hedge funds, insurance companies, etc. Figure 4 adds four additional operations to Figure 1: the common practice of the Treasury selling bonds to banks at the same value as the deficit; QE for banks and NBFIs; and support payments during COVID-19.

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Figure 4: Quantitative easing and COVID-19 stimulus payments added to the basic model in Figure 1. (Steve Keen)

Presented this way, it’s easy to see why QE has done very little to increase the money supply, while COVID-19 payments have dramatically increased it.

Quantitative easing with the banks does not create money: it simply reduces the value of the bonds held by the banking sector and increases the value of their reserves by the same amount. In this way, it reverses the standard process of the Treasury issuing bonds equal to the deficit. The only way to create money would be for banks to lend out those excess reserves, which neoclassical economists like Plosser and former Fed Chairman Ben Bernanke thought would happen. As Bernanke said:

“Sharp increases in bank reserves brought about by central bank lending or securities purchases are a feature of the unconventional policy approach known as quantitative easing. The idea behind quantitative easing is to provide banks with substantial excess liquidity in the hope that they will choose to use some of that liquidity to lend. or buy other assets.[2] (Emphasis added.)

It was false hope, born out of a bad money-making model, as I will explain shortly.

Quantitative easing with NBFIs creates money, but NBFIs are not free to spend that money on physical economy goods and services. Instead, their first use of the funds should be to buy what they are authorized to buy when they receive the money: stocks, properties, etc., i.e. assets financial. This increase in silver significantly affected asset prices, but there was only a small ripple effect on the real economy, such as increased salaries for NBFI staff, profits from NBFI, purchases of goods from the physical economy (computers, data services, etc.). So this aspect of QE directly increased the amount of money in the financial system and indirectly increased the amount of money in the physical economy by a much smaller amount.

COVID-19 payments, on the other hand, created money that went directly to households and businesses in the physical economy, as opposed to the FIRE sector (finance, insurance and real estate). They were free to spend that money however they wanted – and we had a sudden boom, with the growth rate of money supply jumping sharply from 7% per year in February 2020 to 23% per year in June 2020, and reach a maximum growth rate of 27% per year in March 2021.

Quantitative easing has not boosted lending and money supply as Plosser and Bernanke thought, because the money creation models they believe in are simply wrong. The two models are fractional reserve banking and money multiplier (there is another false theory, loanable funds, but it is not relevant here). In both cases, banks can easily lend from their reserves. But economists have never checked the accounting involved, and that is simply wrong.

There are two ways to show banks that lend from reserves, neither works:

  • By showing declining reserves and rising deposits, which violates the fundamental law of accounting (see the first line of Figure 5); and
  • By showing declining reserves and rising loans (see the second row of Figure 5).

This is correct in accounting terms, but there is a problem: Where is the money the borrower is supposed to receive?

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Figure 5: The idea that banks can lend from their reserves violates essential accounting principles. (Steve Keen)

The only way this second line can show that the borrower is receiving money from the loan is if the loan is in cash. So for fractional reserve banking and the money multiplier to work, all loans must be cash. Figure 6 shows this: the public’s cash holdings increase by the same amount as their debt to banks has increased.

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Figure 6: On-reserve loans only work if the loans are in cash. (Steve Keen)

Cash loans may have been commonplace in the 19th century, but we are in the 21st century. Banks lend, very simply (as shown in Figure 1), by increasing their loans and deposits by the same amount. Reservations are irrelevant or, rather, they are an afterthought.

Think about the consequences of this flawed model. The substantial excess liquidity that Bernanke’s Fed was pumping into the banks was powerless – and yet it was this, not fiscal policy, that bore the brunt of the government’s efforts to pull the economy out of the Great Recession. On the other hand, because COVID-19 payments had to go directly to households and businesses, fiscal policy was used – and it had the necessary hit to get the job done not only to prevent an economic collapse, but also to make the COVID-19 recession the shortest in American history.

If policymakers had simply understood the accounting of money in 2008, rather than believing mainstream economic theory, then fiscal policy could have been used heavily to stimulate the economy out of its slump. But because they believed in these false traditional economic models, America struggled through the slowest recovery in its economic history.

There are serious consequences to being wrong about how money is created.

(As a footnote, the “required reserve ratio” was abolished in March 2020.)


1. John Kenneth Galbraith, “Money: Where It Came From, Where It Went” (Houghton Mifflin: Boston, 1975, p. 22).

2. Ben Bernanke, “The Federal Reserve’s Balance Sheet: An Update”, in “Federal Reserve Board Conference on Key Developments in Monetary Policy” (Washington, DC: Board of Governors of the Federal Reserve System, 2009, p.5).

The opinions expressed in this article are the opinions of the author and do not necessarily reflect the opinions of The Epoch Times.

Steve Keen


Professor Keen is a Distinguished Researcher at University College London, author and recipient of the Revere Prize from the Real World Economics Review. His main research interests are in the development of the complex systems approach to macroeconomics and the economics of climate change. He entered politics as the lead candidate in New South Wales for Australia’s new political party The New Liberals. His main research interests are in the development of the complex systems approach in macroeconomics and in the economics of climate change. In an unusual step for a retired academic, he entered politics as the lead candidate in New South Wales for Australia’s new political party The New Liberals.

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