Banks create money by typing it into your account when they approve a loan, which is why around 90% of all money does not exist as physical cash and the whole system runs on trust. The entire global economy runs on credit, because building cities, funding companies and running governments using only money people already have would be literally impossible.
This article explains how credit works, why most money is not real in the physical sense, and how the rich use cheap money while everyone else pays for expensive money.
Watch the full video here, or skip to the breakdown below.
How credit works at a glance
1. The illusion of money
The world is around $300 trillion in debt, and people sometimes ask who it is owed to. A simple example shows how it works. If I lend you $100, you lend the same $100 to Jimmy, and Jimmy lends it back to me, our friend group still holds only $100 in cash but has created $300 in debt. No new money entered the system, just three promises stacked on top of each other. Scale that to the whole world and you get $300 trillion of debt with only a fraction of it in actual cash.
The difference is that we all get to spend money we do not actually have. Most of what we call money is a number on a screen, and there is technically no limit to how much digital money can be created, as long as the system trusts it will be paid back. As long as we collectively believe debts will be repaid, debt can keep growing and so can the economy.
That is why a banker does not tell you the bank is out of money because someone else borrowed today. If the bank believes you are good for it, it approves the loan and new money appears in your account out of thin air. It only becomes physical cash if you withdraw it, and then the bank has to open the vault.
Banks have decades of data showing that only about 10% of money is ever withdrawn as physical cash at any time, so they do not keep 100% in reserve. In the US there is about $21 trillion in broad money supply but only around $5.5 trillion as physical cash. If everyone withdrew at once, the banks would run out of cash within hours and the system would collapse. Everyone has agreed not to do that, an economic pinky promise.
When you swipe a card or send a wire, you are moving promises, and the illusion holds as long as the chain does.
2. How credit is created
Banks do not lend out money they already have. They create new money based on the promise to repay it. Every loan is a digital entry typed into your account, which becomes spendable because the bank says so and the economy agrees to treat it that way.
Say you take out $200,000 for a house. The bank checks your credit score, income and debt load to judge how risky you are, and that determines whether you get cheap money or expensive money, which is your interest rate. You sign, the bank hits approve, and $200,000 appears in the seller’s account. The bank took your future income, converted it into a digital promise and injected it into the present as spendable currency.
This is how banks expand the money supply: they convert debt into money and the economy treats it as if it was always there. The expansion happens in what economists call the M1 and M2 money supply, which includes checking accounts, savings and other liquid assets. It is made possible by fractional reserve banking, where banks need to keep only a fraction of deposits as cash or central bank reserves. Deposit $1,000 and the bank might keep $100 and lend $900, which becomes another deposit, creating a ripple of new money.
In many modern economies that fraction is now 0%. The Federal Reserve eliminated all reserve requirements in March 2020 to handle the Covid pandemic, so US banks no longer have to hold any cash in reserve to issue loans. They can lend as much as they want if the borrower is creditworthy and the bank meets its capital ratio obligations. So when you hear about printing money, what is really happening is typing it digitally.
3. Cheap money versus expensive money
The real sign someone is wealthy is not how much money they have but how cheaply they can borrow lots of it. The better your credit score, income, assets and perceived risk, the lower your interest rate, and that rate is the cost of money. Good credit might get you 3%. Bad credit leaves you at 15% to 25%, or not approved at all.
Cheap money is lucrative because it opens up credit arbitrage: borrow at one rate, invest at a higher one and pocket the difference. Even someone who knows nothing about finance could buy the S&P 500, an index of the 500 largest US companies. It has returned an average of 10.3% a year over the past 10 years, so borrowing at 3% to invest in it is, in the video’s words, free money. This is part of why the buy, borrow, die strategy is so profitable, and the rich have done it for decades.
Entire nations have done it too, and sometimes paid the price. In the 1980s Japan’s economy was booming, interest rates were very low and the yen was stable. Investors borrowed at home and invested abroad, especially in higher-return US assets, in what became known as the carry trade: borrow cheap yen, convert to dollars, buy higher-yield foreign securities. By the early 1990s Japan had a wildly overvalued real estate market, a bloated stock market and a debt-fueled economy. When asset prices crashed the system collapsed, and Japan entered the Lost Decade, a stagnation of 10 years or more it has still not fully escaped.
The lesson drawn is that cheap money is not inherently bad, but when it fuels speculation instead of productivity it becomes a ticking time bomb.
Access to cheap borrowing is the real dividing line, not the size of a bank balance.
A system of promises that still works
As long as people do not all demand cash at once and loans get repaid, everything runs smoothly. It may look like a shaky system running on pinky promises, but it is what makes development possible. If a country had to save up before building new infrastructure, it would take decades and everything would halt.
It is not a perfect system, but it is the most efficient way found so far to scale human productivity using money we do not have yet. Until someone finds something better, this is what we have, and it works for the most part.
FAQ
How do banks create money?
When a bank approves a loan, it types the amount into the borrower’s account as a new digital deposit. That new money exists because the bank and the economy trust it will be repaid.
Is most money physical cash?
No. In the US there is about $21 trillion in broad money supply but only around $5.5 trillion as physical cash. Everything else is numbers on a screen.
What is fractional reserve banking?
It is a system where banks only keep a fraction of deposits as cash or central bank reserves and lend the rest. In the US the Federal Reserve eliminated reserve requirements in March 2020.
What is credit arbitrage?
It means borrowing at a low interest rate and investing at a higher return, keeping the difference. For example, borrowing at 3% to invest in an index that has returned an average of 10.3% a year.
What happens if everyone withdraws their money from banks at once?
Banks would run out of cash within hours and the system would collapse, because they only keep a fraction of deposits in cash. The video calls the agreement not to do this an economic pinky promise.
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