Credit creates
money.
The Bank of England said it explicitly in 2014: "Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money." The mechanism matters. Here is the 5-step flow and what it means for the money supply.
Commercial banks do not lend out deposits. When a bank makes a loan, it creates a matching deposit by keystroke. New money enters the economy on the spot. Approximately 97 percent of all U.S. dollars in circulation were created this way, not by the government and not by the Fed. When the loan is repaid, the money is destroyed. That is why recessions feel like the money supply is shrinking, because it is.
The loan-creates-deposit flow
This is the most important mechanism most people never learn. Textbooks still describe banks as intermediaries that take your deposits and lend them out to someone else. That is not how a modern commercial bank works. It has not been for decades.
"Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower's bank account, thereby creating new money."
McLeay, Radia, Thomas. "Money creation in the modern economy." Bank of England Quarterly Bulletin 2014 Q1, p.14Implications: most money is debt
Three consequences fall out of the mechanism above. Each one is worth sitting with.
Note that this is the banking-system view. For the higher-level take on how new money drives inflation and wages, see Money Creation.
The Bank of England paper
For decades, mainstream economics textbooks described a "money multiplier" model in which central-bank reserves were the first-order constraint on bank lending. Banks, the story went, took deposits, held a fraction in reserve, and lent the rest. In March 2014 the Bank of England's Quarterly Bulletin published a paper that dismantled that story in plain language.
The paper is "Money creation in the modern economy" by Michael McLeay, Amar Radia, and Ryland Thomas, published in the Bank of England Quarterly Bulletin, 2014 Q1. It describes exactly the five-step flow above, and it states, in the central bank's own words, that commercial banks create most money when they lend.
This is not a heterodox or fringe claim. The Bank of England, the Bundesbank, and multiple Federal Reserve Bank research departments have published the same mechanism in the decade since. The textbook money-multiplier story has been officially retired by its former publishers. It still appears in undergraduate textbooks.
Post-2020: reserve requirements eliminated
On March 15, 2020, the Federal Reserve Board announced that, effective March 26, 2020, reserve requirement ratios for all depository institutions would be reduced to zero percent. The announcement was framed as a pandemic-response liquidity measure. The change has not been reversed.
In practice, reserve requirements had not been the binding constraint on U.S. bank lending for years before 2020. Banks were already operating in an "ample reserves" regime where the Fed steered rates via interest on reserve balances rather than reserve scarcity. The March 2020 change simply made that reality explicit.
The binding constraint on modern U.S. bank lending is regulatory capital, not reserves. Banks must hold a minimum ratio of equity and loss-absorbing capital against their risk-weighted assets. That is what limits loan growth. The undergraduate story about 10 percent reserves and a 10x money multiplier is not how anything works.
"There is no country at present, and there never was any country before, in which the ratio of the cash reserve to the bank deposits was so small as it is now in England. So far from our being able to rely on the proportional magnitude of our cash in hand, the amount of that cash is so exceedingly small that a bystander almost trembles when he compares its minuteness with the immensity of the credit which rests upon it."
Walter Bagehot, Lombard Street, Ch. I (1873) — England's reserve ratio was 11.2% then. The US ratio is now 0%.Credit destruction equals recession
Because the money supply is made almost entirely of bank credit, any large-scale contraction of bank credit is, mechanically, a contraction of the money supply. This is why severe recessions feel like money has disappeared. It has.
Three things can cause credit to contract: banks voluntarily pulling back in a risk-off environment, borrowers defaulting in large numbers, and regulators forcing banks to tighten capital. All three happened in 2008. The result was the first year-over-year M2 contraction the United States had seen in generations.
When credit contracts, the Fed's response is to cut rates and make new borrowing cheap enough that the flow of new loans resumes. The goal is to restart the credit-creation machine. QE is a stronger version of the same impulse. Every tool the Fed deploys in a crisis is aimed at restoring private credit growth.
Related pages
- McLeay, M., Radia, A., Thomas, R. "Money creation in the modern economy." Bank of England Quarterly Bulletin 2014 Q1 - bankofengland.co.uk
- Federal Reserve Board. "Reserve Requirements" - action of March 15, 2020 effective March 26, 2020 - federalreserve.gov/monetarypolicy/reservereq.htm
- Federal Reserve Bank of St. Louis FRED. M2SL series - fred.stlouisfed.org/series/M2SL
- Deutsche Bundesbank Monthly Report, April 2017. "The role of banks, non-banks and the central bank in the money creation process" - bundesbank.de
- Federal Reserve Bank of St. Louis. Carlson, M. "A Brief History of the 1987 Stock Market Crash" - context on Fed crisis lending - federalreserve.gov
- Bagehot, Walter. Lombard Street: A Description of the Money Market. 1873. Ch. I on the fragility of fractional-reserve credit. Full text at Project Gutenberg. The 11.2% reserve ratio is from Appendix Note A.
Last updated 2026-06-02. Not financial advice. Do your own research.
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