The Alchemy of Banking
Transmuting Promises into Money
Depositing money in a bank creates new money. This is because the deposit claim—a promise for cash—is itself a form of money.
“You cannot ride on a claim to a horse, but you can pay with a claim to money.”
(Schumpeter 1954, 305)
Perry Mehrling calls this "the alchemy of banking" (2017, 2017a, 2023).
Clip Length: 3:11 (2017 Lec 1, 17:21–20:32)
You and I can't create money, but through the interaction with banks, money is created. This is the nature of the system, and we need to understand that this is how it works.
(2017 Lec 1, 20:11)
When a bank lends, it accepts the borrower's promise (the loan) in exchange for its own promise (deposits).
The essence of banking is a swap of IOUs.
(Mehrling 2017a, 7)
The above balance sheets show the creation of a loan.
The loan is the liability of the borrower and an asset to the bank.
The deposit is the liability of the bank and an asset to the borrower.
The bank and the borrower each promise future payment to the other. They are "paying" each other by issuance.1 It is a mutual obligation.2
Nothing could be simpler, and yet the mind rebels, especially the well-trained economist’s mind, because this simple operation increases my purchasing power without decreasing anyone else’s. It seems like alchemy, or anyway a violation of some deep conservation law. Real productive resources are the same as they were before, and the swap doesn’t change that, does it?
(Mehrling 2023, 103)
It might be easier to imagine a scenario where someone borrows money from a lender (1) and deposits it in his bank (2).
But what if the lender and the bank are the same entity? The borrower gets cash and immediately deposits it back in the bank. Why not skip the cash step? No cash needs to exist to make this loan possible. We're back to our swap of IOUs.
Now imagine a bank lending out (2) some deposited money (1).
If the borrower and depositor are the same person, we're again back to our IOU swap.
These scenarios are two different perspectives on the same transaction. The borrower deposited the money he borrowed. Meanwhile, the bank lent the deposited money.3
There is expansion, from [the bank's] point of view, on each side of its balance-sheet. But from the point of view of the rest of the economy, the bank has 'created' money.
(Hicks 1989, 58)
Borrowing from a bank means paying the bank—in the form of interest—to convert your promise of future payment into money you can spend today. Banks are in the business of "monetizing" debt.
Hyman Minsky famously wrote:
Everyone can create money; the problem is to get it accepted.
(Minsky 1986, 255)
What he meant was that everyone can write an IOU. Not everyone's IOUs are money. And not everyone's IOUs are exchangeable for money.
Bank IOUs are money. Banks turn other people's IOUs into money by replacing them with their own IOUs. That's the alchemy of banking.
References
Hicks, John. 1989. A Market Theory of Money. Oxford: Clarendon Press.
Howlett, Alex. 2025a. "Four Ways to Pay: Representing Payment Types." The Survival Constraint (blog). February 23. https://survivalconstraint.substack.com/p/four-ways-to-pay.
Howlett, Alex. 2025a. "Transactions: It Takes Two." The Survival Constraint (blog). February 24. https://survivalconstraint.substack.com/p/transactions.
Mehrling, Perry. 2017. "Lecture 1: Why Is Money Difficult?" Warsaw School of Economics, recorded October 11, 2017. Video of lecture, 1:33:46. https://youtu.be/9DozcacGdYI
Mehrling, Perry. 2017a. "Financialization and Its Discontents." Finance and Society 3 (1): 1–10. https://doi.org/10.2218/finsoc.v3i1.1935.
Mehrling, Perry. 2023. "Payment vs. Funding: The Law of Reflux for Today." In Monetary Economics, Banking and Policy: Expanding Economic Thought to Meet Contemporary Challenges, edited by Penelope Hawkins and Ioana Negru, 103–118. London: Routledge. https://doi.org/10.4324/9781003142317-8.
Minsky, Hyman P. 1986. Stabilizing an Unstable Economy. New Haven, CT: Yale University Press.
Schumpeter, Joseph A. 1954. History of Economic Analysis. Edited by Elizabeth Boody Schumpeter. New York: Oxford University Press.
Notes
(Howlett 2025a)
(Howlett 2025b)
In the world of banking and finance, you normally don't have to wait to have money before you can spend money. The chronological order of operations can be flexible.
"Depositing money in a bank creates new money."
It certainly creates a new deposit, which is a type of money, but I've made the mistake before of thinking that this is an increase in the total money stock ("money supply"). It turns out it isn't.
If you look at the definition of M1 (see https://en.wikipedia.org/wiki/Money_supply#M0 and scroll up to the table), you'll see it doesn't include cash and reserves held by banks. So M1 is actually unchanged by someone depositing cash at the bank. Deposits go up, but cash in circulation outside the banking system goes down.
Another way to understand banking is that they borrow interest free credit and use it to buy assets like bonds and loan contracts. This credit creation amount is leverage based on their investor bank capital, not customer deposits. So when they find an asset to purchase they merely record the credit creation as a loan they must pay back and this is why the majority of their purchases are as secure as possible, usually backed by an asset itself, like a house, the car, biz assets, or the faith of the government. They are limited to these secure assets otherwise they would take too many risks and suffer insolvency more often due to leverage of up to 30x (BIS 3% capital adequacy ratios)