How our debt-based money system works

The Reserve Bank creates our notes and coins that form less than 3% of our money supply. The rest is electronic money for EFTPOS transactions and internet banking which is created by private banks when people take out loans. This electronic money is created out of thin air and the banks then lend it to you and me and charge us interest on money they never had.

The vast majority of money in circulation is created by commercial banks, through the process of bank lending.
— Money creation in New Zealand, Reserve Bank Bulletin, January 2023

Banks have an incentive to create as much money as they can. The more they create, the more profit they make. The main limit placed on them is the expectation that the loans will be repaid.

While this is good for the banks, it is not always good for the economy or our wellbeing, especially when most of that credit goes into property, inflating the prices of houses, farms and commercial real estate.

It’s not surprising our money system is flawed when even the textbooks got it wrong.  As the Bank of England puts it:

‘The reality of how money is created today differs from the description found in some economics textbooks: Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.’

Watch this video explaining how it works in New Zealand

Nearly every dollar in the economy today was created when somebody went into debt

So where do banks put this created money? They pump most of it into the housing market, pushing up prices year in and year out.

It is probably not surprising that the period when house prices escalated coincides with the period when banks were deregulated. It is very profitable for banks to lend money on housing. If you cannot make the payments on the loan for the house or farm, then you will be thrown out. Remember that banks created the money out of thin air, yet you and I have to pay interest on that created money.

This is only half of the problem.

As they create the money themselves, the main constraint on how much new money is created is people’s ability to take on higher and higher levels of debt. This created money distorts the property market and allows house prices to increase year in and year out.

Banks make enormous profits from money creation — more than 5,000 million dollars (that’s $5 billion) each year — $10 million dollars a day and most of that profit disappears overseas. It is a huge drain on our economy.

“Of all the many ways of organising banking, the worst is the one we have today.”

Sir Mervyn King

Former governor, Bank of England

There is however another problem. When people repay their loans, that money disappears from the economy.

Loan money that is repaid to the banks cannot then be lent out again because as the original loan money was created from nothing it must return to nothing.

In banking terms money is “destroyed” when people repay loans.  This is ridiculous and is probably what the former governor of the Bank of England Sir Mervyn King was alluding to when he said, “Of all the many ways of organising banking, the worst is the one we have today”.

For our economy to work, more people must get into debt than get out of debt. This is unsustainable and is at the heart of inequality, rising debt levels and growing child poverty.

In times of recession, people take out fewer loans as confidence declines, and more people repay their loans reducing our money supply. The banks also get nervous as their confidence in people’s ability to repay loans diminishes and they lend out less money.

Governments make matters worse by introducing austerity measures or requiring surpluses, cutting back on their spending. This further reduces the amount of money in the economy, prolonging any recession.

When confidence picks up, people take on new loans faster than the old ones are repaid, banks become bolder and lend more and the government spends more, creating a boom. This is the boom and bust cycle which is an artificial construct based on a flawed monetary system. 


What can we do to fix this problem?

One approach is to use bank regulation. With this approach, banks continue to issue most of our money, but we use stronger regulations to limit how much new bank money is created and for what purposes. Advocates of this approach argue that banks are more responsive to the economy’s monetary needs and all that’s required is better regulation. Critics point to regular boom-bust cycles, credit going to the wrong places, and a history of banks loosening regulations over time. Positive Money believes solving the problem with better bank regulation requires systemic change, not just tinkering at the edges.

A second approach is to do what most people assume has been happening all along – have the Government issue all of our money. Banks would then lend existing money rather than create new money. Positive Money has developed one such proposal called Sovereign Money. This has the Reserve Bank issue our electronic money as well as our notes and coins. The newly-issued money would enter the economy through spending on public infrastructure projects such as hospitals, roads, or new schools, rather than being pumped into an overheated property market as most commercial bank money is today.

A third approach is a hybrid of these two. It would retain some bank money, i.e. banks could still create new money, but the proportion of our money supply that is public money issued directly by the Government would rise from its current very low level. One of the main drivers of this approach is technology, in particular developments in Central Bank Digital Currency (CBDC).

Positive Money believes the current system’s problems will only be fixed when there is real systemic change, not just tinkering. It’s too important to leave this to experts and lobbyists. Citizens and civil society groups must lead the debate so we get the system that works for people and planet.

Want to learn more?

Here are some resources that will help you to further your knowledge of this important subject.



Check out the Positive Money website, where you can find out more about how money works and what we can do to reform the money system to benefit everyone, not just a few.

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