The Debt Creation of Money and its Consequences

 The Debt Creation of Money and its Consequences

A brief Note for Non-Economists by a Non-Economist

Nasim Beg – March 2026

Many of us will recognise that the amount of money in circulation, the aggregate of currency notes and digital numbers that appear on our bank statements, should ideally grow in line with the growth in the supply of goods and services.

Central Banks constantly attempt to maintain that balance, so as not to allow inflation to set in, with too much money chasing a limited supply of goods and services and at the same time, not to stifle economic activity, from the lack of liquidity, i.e., enough money to go around to support the growth in supply of goods and services. (Note 1)

The mechanism through which the central banks facilitate the creation of money is primarily the amount of new debt that the government and the private sector put together can raise. This debt can be in the domestic currency or in foreign currencies.

In the case of foreign exchange borrowings, the central bank keeps the foreign exchange and creates the equivalent in the domestic currency and gives that amount to the borrower.

The money equivalent to foreign exchange flows on trade account (imports and exports) are added (created) to the money supply to the extent of exports and withdrawn from circulation (destroyed) to the extent of imports. A similar process applies to the FDI flows.

To clarify, export proceeds (and FDI proceeds) in foreign exchange are kept by the central bank and an equivalent amount of domestic currency is created and given to the exporter. The reverse happens for imports (as well as repatriation against FDI), i.e., the importer hands over domestic currency, which is taken out of circulation (destroyed) by the central bank, and it pays the foreign exchange out of its reserves.  

Similarly, domestic currency is created equivalent to the remittances received in foreign exchange by the central bank and the equivalent domestic currency is given to the beneficiaries.    

On the domestic front, commercial banks are the institutions that lend money to the private sector and the government (by buying its bonds), and central bank creates money to the extent of the net increase in loans for the commercial banks to have liquidity, without blocking their depositors’ money.

In case of a net reduction in debt in the system (foreign or domestic), the central bank removes (destroys) the equivalent currency from circulation.

As will be seen from the above, other than a net trade surplus, FDI and remittances, against which the central bank would create money without debt coming into play, all other money is created through debt.

Money in circulation and economic growth: On the assumption that the economy will continue to grow, both on account of increasing consumption patterns (standards of living), as well as on account of the growth in the number of consumers, money supply will have to grow continuously.

In addition, since interest must be paid on debt, paying of it to the banks will remove that amount from circulation; thus, the banks must create more debt to maintain the quantum of money supply in the system.

Since the trigger for money creation is predominantly debt, it appears that debt would have to grow into perpetuity. Any repayments would trigger stifling of the economy, as the central bank would do the reverse of creating money for new loan, i.e., not enough money will remain in circulation to support the increased supply of goods and services.

The data below shows the fact that the aggregate world debt has grown at a pace significantly higher than the growth of the world economies over the past fifty years (more or less since the time the USD went off the gold standard):

The Consequences

The global nominal GDP (size of the world economies) grew from $11.45 trillion to $117.2 trillion, i.e., by 10.2 times over the fifty years, while global debt grew from $12.5 trillion to $348 trillion over that period, i.e., 27.8 times in size.

Alongwith this, the financial services extracted twice as much out of the productive side of the economies as compared to its extraction fifty years ago.

Most people assume that banks and financial institutions play the role of recirculating savings into productive investments. However, the question is that if the entire world economy grew by 10.2 times, how have loans grown by 27.8 times.

The role of Fractional Reserve Banking

Behind this puzzle lies fractional reserve banking, whereby the central banks create money out of the thin air, allowing commercial banks to lend anything between 90% to 95% of the deposits they hold. Thus, while the banks do not block deposits of their depositors to use the funds to give out loans, the central banks create new money to allow the banks to use the newly created money to enable the lending.

Extraction by financial sector from the productive sectors

The money that did not exist but was created out of the thin air allowed businesses to grow their businesses to obtain money beyond their own capital and multiply their profits; not only that, the interest they paid for the use of this manufactured capital, is allowed to be set off as an expense for tax purposes, thus, the business pays reduced tax.

In the meanwhile, the money creation is inflationary and affects the average working person, who at times must resort to borrowing money to get by; this person of course does not get a tax set off and pays full tax on his or her income. Thus, no tax break, tax in form of inflation and cost of borrowing money for necessities.

The beneficiaries are the wealthier members of society, who earn interest on the money that is growing at a higher pace than the economic growth. This creates more surpluses for them to “invest”.  They “earn” returns on staggering amounts of mythical savings.

And where did that return come from? It is what the financial sector extracts from the productive side of the economy (the input of the average citizen of the world).

The growth in inequality:

Fifty years ago, this extraction amounted to 4% of the GDP, it is now twice that. With the extraction at 8% of the GDP of $117.2 trillion, the extraction for the year was $ 9.4 trillion.

Based on the world population of 8.28 billion this extraction per person, works out to $ 1,146 per year, while annual per capita income of the bottom 25% of the population is merely $1,135 (versus the world average of $14,200),

In other words, in absence of this extraction through the primarily unsaved mythical capital, manufactured by fractional reserve banking, the per capita income of the bottom 25% of the world, could be significantly higher, which would go a longer way in absence of the manufactured inflation.  

Likely collapse of the economic system: But inequality is not the only consequence; with the growth of debt into perpetuity and the accelerating growth rate of the extraction by the financial investors out of the productive sectors, at some point it will overwhelm productivity and the world economic system is destined to collapse.      

 

Note1:

The central banks use two primary tools to regulate the amount of money in circulation in the economy; the Cash Reserve Ratio, i.e., a small part of the money deposited with the commercial banks. This ranges between 5% and 10% in most countries. With the rate at 5%, banks can make loans of upto 95% of their deposits, for which the central bank creates new money; by increasing the rate to say 10% the quantum on new money creation will be restricted to 90% of the deposits

The other, more commonly used tool is the interest rate. The central bank sets the interest rate at which commercial banks can get temporary financing from the central bank, to balance their day-to-day cash requirements. The commercial banks in turn set the interest rate above the policy rate set by the central bank. The higher rates make it unattractive for borrowers, not only to take new loans for which the central banks create new money, but many borrowers try and repay the loans, which has the opposite result of money creation; thus, money in circulation comes down.

The low interest rates tend to encourage borrowing and the addition of money in circulation, which can be inflationary, while the increase in interest rates can lead to reduction in the money in circulation, which acts to stifle the economy and can cause a recession.

Recessions caused by asset price bubbles: Apart from the interest rates, there is another, lesser recognised, factor that when individuals and businesses buy speculative assets with borrowed money; the borrowing leads to new money creation, which in turn is used to buy more speculative assets, which can turn into a cycle of buying and the creation of a price bubble. At some stage, the speculative prices reach a level when the buyers stop buying and a selling spree starts, which triggers banks calling back loans owing to the rapidly falling prices, this now turns into a vicious cycle; as the banks call back the loans, that amount of money is removed from circulation, which is recessionary. This is what happened during the 2008 recession. So much so that the central banks the world over, bought off the loans turning irrecoverable and pumped new money into the commercial banks to fight off the recession.

Had the central banks given the money directly to the people who had taken out mortgage loans on their homes, the people could have used the money to pay down the mortgages and not be on the street losing their homes to repossession by the mortgage lending banks.