7 common myths about modern money

Money is important but widely misunderstood. Here are seven hard-to-bust misconceptions about modern money that might surprise you.  

by | 4 Feb, 2025

Gold coins fall onto a piggy bank

Myth 1: ‘Fiat money’ and government control of the money supply

‘Fiat money’ means money that is created and given value through the decisions of government. Official bank notes and coins are highly visible examples of fiat money.

Today, in modern capitalist economies, the most dominant form of money by far is not fiat money. Instead, commercial banks create the vast majority of money, and they do so without the day-to-day involvement of governments. Physical currencies like coins and notes are playing a small and shrinking role in the money supply.

The creation of commercial bank money is surprisingly simple and quite counter-intuitive. Canadian-American economist John Kenneth Galbraith wrote that “the process by which banks create money is so simple that the mind is repelled. Where something so important is involved, a deeper mystery seems only decent.”

So what is this repellently simple process?

The overwhelming majority of money is created through private-sector bank lending. When a bank writes a loan, the borrowed amount and the obligation to pay the debt are created simultaneously.

The borrower’s obligation is an asset for the bank; and the loan amount, deposited for the benefit of the borrower, is a corresponding liability for the bank.

In this way, bank money is created anew – in the form of ledger entries – with every loan a bank writes, not from or in relation to deposits or other existing money.

Myth 2: The role of ‘fractional reserve banking’

Fractional reserve banking describes a system where most but not all of the money deposited in banks is loaned out.

According to this popular concept, private banks gather pre-existing money from depositors, then lend that money to borrowers, retaining a fraction as a ‘safety net’ or financial buffer.

This concept is ubiquitous, as are the related ideas of banks intermediating between depositors and borrowers, and banks creating new money at the system-level (as opposed to the individual bank level) by converting deposits into loans.

But none of these concepts is an accurate or useful description of money creation or the role of banks. In creating money through lending, banks don’t transform deposits into loans, and they do not intermediate between depositors and borrowers. The risks and complexities facing commercial banks are much smaller than is widely believed.

Myth 3: Money circulates persistently through the economy in a durable, unitised form

Even authors and commentators who correctly describe private bank money creation can fall afoul of this misconception.

Money, whether created by governments or banks, is almost universally understood as consisting – once it is created – of some form of official or semi-official currency unit, such as the ‘US dollar’ or the ‘Australian dollar’.

Money, in its commonsense form, is unitised, token-like, and durable. It moves between banks and around the economy while retaining its essential money-like form.

In reality, as described in myth #1, the dominant form of money is contractual and ledger-based – very unlike our commonsense idea of durable money.

On the contrary, bank money does not move unchanged between banks, nor does it survive ‘collection’ through taxation (see below).

Myth 4: Taxes are collected and go into government ‘coffers’ at the national level

Contractual, ledger-based money – which, to reiterate, is by far the dominant form of money in modern finance and commerce – is not ‘collected’ through taxation at the national level.

Instead, bank money used to pay taxes is wiped or vaporised the moment taxes are paid. Then, at a later date, when the national government needs to spend, new ledger-based bank money is spent into existence via the banking system.

There is no structural requirement for the amount of bank ledger money ‘collected’ (i.e. destroyed) through taxation and government borrowing to equal or exceed the amount of bank ledger money created through national government spending.

Myth 5: Bank reserves as ordinary bank deposits

The nature of bank reserves is almost universally misunderstood. One commonly held belief is that banks collect and retain a quantity of ordinary deposits and hold them as reserves, which provide some form of prudential buffer.

In reality, modern bank reserves are inter-bank clearing and settlement units (‘exchange settlement account’ funds, or ESAs). These are held on the balance sheet of the relevant central bank.

ESAs are essentially IOUs from the central bank that creates them. In the post-Bretton Woods world, they perform the role previously played by gold as a medium for inter-bank settlement of payments.

It’s important to note that ESAs are not money because, among other things, non-banks like you and I cannot directly hold or spend them.

Myth 6: The ‘money market’

Contractual, ledger-based bank money is not and cannot be traded on the ‘money market’, and nor can it be traded between countries on the foreign exchange market. (The actual forex – or foreign exchange – trade is conducted bank-to-bank in ESAs).

Though bank money is not tradable, there are experiments underway to create tradable tokens that are claims on bank account balances.

Myth 7: Digital bank money

The durable, official, unitised money described in myth #3 is often conceived of as existing in digital form.

Indeed it was those official, digital units that the maverick creators of cryptocurrencies sought to replace with their unofficial, tokenised, digital currencies.

In almost all cases, however, bank account money is only digital in a very limited sense: the ledgers that record bank account balances are computerised.

In large part, therefore, the crypto-mavericks emulated a widespread idea of money that in fact is only a myth. In other words, they were chasing a phantom.

At the same time, governments and central banks around the world have experimented with new forms of digital currencies.

But, as with crypto, those official experiments are novel and quite different to the overwhelming majority of ordinary, ledger-based bank money.

So to summarise, the dominant form of modern money is not directly controlled by governments. It does not circulate throughout the economy in a durable form.

Banks do not gather it up as the basis for loans, and governments do not gather it up as the basis for public spending.

The dominant form of money is not tradeable, nor can it be held outside the relevant country’s banking system.

Bank reserves are not the same as ordinary bank money and only in a limited sense is bank account money digital.

Misunderstandings about money are central to muddled policy debates in fields as diverse as taxation, monetary policy, inflation, fiscal ‘austerity’, bank failures, money laundering, phishing scams, cryptocurrencies, ‘dollarisation’ and loans for countries in financial distress.

To formulate useful public policy in these fields, we first need to bust these myths.

This article was first published on Pursuit. Read the original article here.


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