The Secrets of Liquidity Creation: Money Printing by the Banking System, at the Expense of the People
Banks have increased the “speed of money creation” by offering loans at rates lower than the inflation rate, and the people ultimately bear the inflation incurred by the banking system.
Milton Friedman, the Nobel Prize-winning economist, encountered a question during a Q&A session regarding the validity of a statement made by the U.S. Treasury Secretary, who claimed that the roots of inflation stem from the actions of labor unions and business groups. Friedman’s response was historic; after a bitter smile, he remarked: “The Secretary knows exactly where the roots of inflation lie, just as you and I do. Those unions cannot cause inflation because they do not have the big printing presses that print those green pieces of paper (dollars)… Inflation is created in Washington…” He aptly noted that monetary policies and behaviors are the true causes of inflation. Inflation is nothing more than the government, central banks, and the entire banking system spending money directly from the people’s pockets without them even realizing it. Every morning, cash and unregulated liquidity are created from the pockets of the people, which will never be destroyed, and without a single rial being deducted from anyone’s pocket, their assets effectively diminish in value. In this article, we will discuss the liquidity creation by the banking system and its repercussions.
Inflation is Nothing but the Spending of the Government, Central Banks, and the Entire Banking System from the Pockets of the People
Money and Liquidity
Before delving into this topic, it’s essential to clarify what we mean by money and liquidity. We do not intend to dissect the concept or history of these terms but rather to understand what is practically referred to as money in people’s hands and how it is created.
First, let’s explore the concept of money. After many years, human societies benefited from various experiences, evolving from barter systems and metal coins to using paper money. Initially, these paper currencies served as receipts, for which banks could provide gold or silver in exchange. This meant that these receipts could only be issued to the extent of a country’s actual wealth; this paper money was genuinely valuable and served as a rational basis for assessing the value of goods and services. Consequently, the supply and demand of any commodity, or the overall market, would only become unbalanced when there was a rational need for a more valuable asset to acquire goods and services. Thus, “inflation” or “increased value” might occur, but this situation was not technically inflation.
In the mid-twentieth century, due to World War II, the United States and then the rest of the world decided to abandon the gold or silver standard, meaning that paper currency no longer represented a valuable asset held by banks. In fact, the backing of money, or more accurately, fiat currencies worldwide, is the size of the economy, gross production capacity, and the political hegemony of each country. This situation poses a significant risk because banks and governments have committed to ensuring that what they offer as money is equivalent to that which arises from wealth creation and production, thereby enabling the cycle of value generation. For now, let’s leave this topic and turn to the concept of liquidity.
In the mid-twentieth century, countries worldwide abandoned the gold or silver standard.
Liquidity refers to the asset or money that individuals can use to acquire goods or services; in other words, it is the ability to be converted into cash and assessed for value. In reality, individuals need liquidity to engage in any economic activity. Paper money, receipts for precious metals, and fiat currencies are all tools representing liquidity. The more these tools can be transferred and traded without issues and conditions, the greater their liquidity and, inherently, their value. With this explanation, we all require liquidity to meet our needs or to generate wealth. Economic growth requires liquidity growth; if liquidity remains stagnant, no one can strive for a larger share, and consequently, the incentives for creating value disappear. Now, let’s move on to money and liquidity creation.
The Concept of Money and Liquidity Creation
Let’s explain the concept of money and liquidity creation through a completely abstract story. Imagine a union of farmers and gardeners who engage in specific exchanges and fulfill their needs through each other. For instance, a gardener receives pistachios, grapes, or similar products from other members in exchange for each box of apples they have. Since products do not grow simultaneously, an elder is appointed as a trustee to issue receipts to each farmer based on the volume of their produce, allowing them to spend these receipts immediately. Then, during the harvest season, each farmer and others can visit and present these receipts to receive their products. Additionally, the union has stipulated that a free supply and demand market should be established, enabling each gardener to strive for greater profit, expand their operations, and adjust their supply to match the number of receipts they hold. On the other hand, if a farmer has a low yield at any given time, they will automatically receive fewer receipts or may be allowed to raise their prices slightly. In the event of any cheating or concealment, the elder will reclaim any excess receipts from the farmer based on the actual volume of their produce or penalize them. With this imagined equilibrium set, let’s have our fictional union experience two scenarios.
Experience One
In the pomegranate harvest season, that is, in autumn, an early frost drastically reduces the pomegranate yield. Naturally, the owners of the pomegranates are worried because they do not have enough produce to supply the market and will not receive sufficient receipts to meet their needs in the coming months. Here, either more receipts must be issued for the available pomegranates or the elder must be assigned new responsibilities for management. Raising its price will not solve the problem if the pomegranate yield is too low, as the other farmers and gardeners will protest, ultimately leading to insufficient receipts for meeting the pomegranate growers’ future needs. Therefore, two missions are defined for the elderly: preventing the emergence of a black market for pomegranates and finding a way to assist the pomegranate holders. In the first instance, the elder must take specific action, which is not the subject of our discussion, but there are many ways to assist the gardeners. There is a sensible approach and a poor one! The rational approach is to slightly relax the previous traditions of the gardeners. These receipts are essentially bonds that represent the debt of money and liquidity given to individuals, and as each farmer’s harvest season arrives, that individual’s debt is cleared; in other words, the created money is extinguished. Here, one could generate debt beyond the total market value and provide it to the pomegranate holders to solve their problems. In return, they commit to repaying their debt over several periods and a reward. The elder prints these bonds as debt and takes a firm commitment (seizing the pomegranate orchards and transferring them to other farmers in the event of non-repayment of the debt) from the pomegranate holders that they must be able to fulfill. Other farmers buy these bonds and leave their excess receipts with the pomegranate holders. But what is the poor approach?
The poor approach is for our elders to assume the debt and issue new receipts instead of the lost pomegranates. In other words, the elder takes on the debt without having a share in production, and the receipts in the market are no longer equivalent to the market’s output! Suppose the pomegranate holders do not fulfill their commitments. In that case, the receipts will become completely worthless in subsequent years because money and liquidity exist in the market without anything to buy in exchange. In other words, those holding these excess receipts will be forced to sell their products at higher prices to create appropriate economic circulation and regain their previous economic power by selling their products at inflated prices. This natural behavior leads to the collection of excess receipts from the market, and if it happens once, it may not be a significant problem, but what if the number of debtors increases? What if the elderly, influenced by the desire for wealth and capital, begin printing receipts for themselves and investing in the market with them? Let’s shorten this experience: if these trends occur, after a few years, some debtors will go completely bankrupt, some products will no longer have any economic viability for production, and this union will face a pile of worthless receipts! In our fictional union, the elder is essentially the central bank and the government, which should provide receipts or money equivalent to the actual value of the market to individuals. This union represents the parts of the government that need capital and the industries that continuously receive unregulated assistance and support. Is the first experience of our fictional union anything other than the inflation and accumulation of liquidity we see today?
Experience Two
One day, a gardener creates a savings fund for his colleagues. He tells them that if they have extra receipts or do not intend to spend them, they can deposit their receipts at the fund for safekeeping. This fund can provide secure savings for them, lend to gardeners in need, and increase their receipts through investment without requiring them to labor for “more production.” This fund could be a perfectly reasonable and beneficial initiative, but it has several essential conditions. First, a threshold must be established for spending and investing the deposited receipts. Second, the elder must supervise the fund and control this threshold. Third, the fund itself must also have a stake in the game, meaning it should not solely rely on the receipts of other gardeners. Furthermore, strong guarantees must be obtained from the fund’s founder in case of emergency or failure. The elder could retain part of the receipts at the fund and the deed to the fund owner’s garden as collateral. With these conditions, this fund becomes the best place for collecting liquidity held by individuals who have no way to spend it. It also helps the elder of the union maintain a balance between the assistance provided to other gardeners (the poor approach from Experience One) and the debts created and sold among other gardeners (the sensible approach from Experience One). Additionally, it is an appropriate base for gardeners to meet their liquidity needs for business expansion or problem-solving. Unfortunately, here, too, the fund can go down the wrong path. (Footnote: An economist might remind us that such money in the fund should be termed “quasi-money.” By definition, quasi-money refers to assets that are not directly convertible into cash or exchangeable but can be used as a source for money and check writing.)
The fund owner discovers that if they lend more to others and charge them fees, they can provide greater profits to other gardeners and fill their own pockets, all while this money is not being used for more production and requires little effort. This strong incentive leads the fund to lend the pooled resources to the depletion threshold. This course undermines the original objectives of establishing the fund as new liquidity enters the hands of individuals. At the same time, the accounts still reflect an equivalent amount of money, and a new debt is also created that will require liquidity generation over time for repayment. In other words, new liquidity has been created through indiscriminate lending from the liquidity accumulated and stagnant in the fund.
In the previous experience, we saw the consequences of excess liquidity. Consider that if borrowing is possible for everyone and paid without oversight, a competitive black market for loans will emerge, forcing the fund to curb it with higher fees or seek “help.” If all loans are repaid, everything is fine, but remember, if the excess liquidity of the receipts exceeds the value of the hypothetical agricultural union, it will lead to the depreciation of the receipts, triggering an unpleasant domino effect. On the other hand, if even part of the loans does not result in increased productive value, the loan fees will compel the owners of the gardens to raise the prices of their available products, which will pressure others to take similar actions to maintain their purchasing power. In reality, the amount of liquidity created through loans must be strictly limited and necessary, and the result should either address a real problem (like frost damage) or enhance production efficiency. As we mentioned, the elder must have a significant intervention here; unfortunately, the desire for more income and profit or well-intentioned motives, such as helping some gardeners, can worsen the situation. All it takes is for the elder to allow the fund manager to spend all the existing money in the fund “for help” and issue guarantees based on nonexistent money, claiming that the deposited assets are secure. In reality, both the appointed agent of our imaginary union and the fund hope that all debts and liquidity created from lending will be repaid and thus extinguished, avoiding the need to print new receipts (make money) instead of relying on this unrealistic guarantee. Unfortunately, this is not the end of our story. The loans taken will be spent, and individuals will benefit from them in this union, creating a desire to deposit their receipts in the fund and take out loans when needed. this cycle continues, ultimately leading to the depreciation of the receipts at the expense of the depositors’ pockets in the fund.
Regrettably, if the elder does not supervise the fund according to proper regulations, even worse scenarios may unfold. For example, the elder or one of their friends could take large loans from the gardeners’ fund, then open substantial deposits in the fund with those same loans, eventually reaching a point where, apparently, with this virtual and unsupported liquidity created, they possess such a significant share in the fund that they can claim a large portion of the deposits belong to them and should take control of the fund (it seems that in our fictional story, the concept of conflict of interest is still misunderstood and related laws are not enforced). Here, the fund exists only on paper. In practice, all the money has vanished. This created liquidity, which cannot be extinguished, has altered the fund’s ownership without any specific economic activity being undertaken. If our fictional story reaches such a bitter point, and if there is not another entirely imaginary union on the other side of the world to offer visas, residency, and green cards to these elders and fund managers, some improvements could be made by reclaiming liquidity, dissolving the fund, and punishing the wrongdoers. However, the effects of this abstract liquidity have created real debts among the gardeners and raised expected inflation, so for a long time, a fund that no longer exists will continue to deplete the pockets of the gardeners. I hope you do not recall any institution’s name or specific deposit and loan scheme.
Let’s conclude this imaginary story. Now that we have understood how ordinary and central banks create money and liquidity, it is best to peek into the real world and see what the statistics and figures say about the country.
Liquidity in the Country: A Silent Theft from All of Us
In economic terms, and according to the quantity theory of money, when money is more abundant in society, the speed of transactions and financial dealings will increase rapidly. A desire forms within society to quickly fulfill needs and acquire more valuable assets in the presence of liquidity. On the other hand, the quantity of goods and services in society has a threshold; it cannot exceed a specific limit and must logically correspond to the amount of money available. Therefore, with an increase in liquidity, this balance is disrupted, and the velocity of money rises excessively, forcing owners of goods and services to demand more money to maintain their share of liquidity and its speed. Under these conditions, the demand for purchases also increases from individuals. If industries and service providers cannot meet these needs adequately, or if prices are suppressed through arbitrary means or faulty leverage, the field becomes ripe for the entry of foreign goods, as they are cheaper than domestically produced items. This phase results in the breakdown of production and value, the shutdown of economic enterprises, and an increase in unemployment. In this way, liquidity fulfills its role of causing people to lose their assets.
Where does this liquidity enter our story, and how does it increase in our country? First and foremost, it is the result of the central bank’s policies. In our country, the government cashes all its checks through the central bank and fulfills its obligations. The government neither collects taxes properly nor obtains the money it needs through borrowing and creating debt. Governments in Iran have been securing the assets and liquidity they need for over 50 years by selling crude oil and gas. To this end, the central bank is responsible for selling the country’s foreign exchange revenues (selling oil rent) in the market and collecting rials for the government. Thus, there must be enough rials available to be collected, or, in other words, the government needs the speed of money creation to match its own needs rather than being proportional to the size of the economy and the essential liquidity in the economic system! Consequently, with the help of the parliament, the government adjusts the budget so that borrowing from the central bank becomes the only solution, forcing the central bank to increase the volume of liquid money. This definition may sound familiar to many; we are essentially discussing expanding the monetary base. We only need to look at liquidity growth in 1401 (2022) to prove our point. For instance, from Farvardin 1401 to Aban of the same year, liquidity rose from about 4,802 trillion rials to 5,800 trillion rials, and by the end of the year, it exceeded 6,200 trillion rials; that is, an average of more than 120 trillion rials of liquidity was created each month, while the government budget for that year was slightly over 3,600 trillion rials. It should be noted that the central bank’s balance sheet is always negatively tilted towards debts, which means the central bank needs to create money and distribute a large amount of “strong money” in society. The earlier section and the first experience of our imaginary union were of this nature, with the only result being inflation and emptying people’s pockets. Here, a point that clarifies the role of the banking system is worth mentioning. About 23% of the liquidity share comes from money creation, while the remainder stems from quasi-money derived from the deposits of people in the monetary and banking system of the country. Now, we must ask what led us to this point.
Over 70% of the liquidity in the country comes from quasi-money.
The Mushrooming Growth of Financial Institutions and Credit Organizations
At the beginning of the 1380s (2000s), about 44% of the liquidity share was composed of created money. Aware that vital money and liquidity growth are destructive, the government began treating the symptoms instead of addressing the root causes of the problem. As a result, believing that the created money and liquidity needed to be collected to improve the situation, banks were granted permission to offer short-term and long-term deposits with interest rates exceeding 20% for the public. Meanwhile, numerous financial and credit institutions’ entirely illogical and mushroom-like growth occurred, offering much higher interest rates, sometimes up to 30% or more. Additionally, banks organized large lotteries where depositors could win a point for every 5,000 tomans deposited in “Qarz al-Hasane” (interest-free loans). The television was inundated with advertisements from all state, semi-private, and private banks, making daily colorful promises to the public. Banks were supposed to deposit a significant portion of the collected funds with the central bank to prevent the issuance of strong money, but this never happened. This trend intensified from 1385 (2006) to 1390 (2011), during which the share of quasi-money rose to 76%, while the share of created money fell to 24%.
This era, marked by the peak of oil sales in the country’s history and record prices for oil barrels in international energy markets, not only did not reduce liquidity but instead saw liquidity increase from about 45 trillion tomans to over 339 trillion tomans and by the mid-1390s (2010s), it exceeded 1,000 trillion tomans. In the 1390s, many of these institutions, such as Samen-al-Hojaj, Ferdowsi, and Noor, ceased operations, causing the public to bear the losses. The central bank repeatedly compensated for these institutions’ failures using the public’s assets, repaying the debts, and then claiming they had returned the people’s money. Meanwhile, the central bank bore all the blame, as it was both the supervisory body and had the necessary enforcement tools. The interest rates on deposits also fell below 20%, and there were no longer any promises of thousands of cars or round-the-world trips in 80 days as lottery prizes; nevertheless, the share of bank deposits in liquidity remained around 76% to 77%.
During the peak oil sales in the 2000s (Iranian calendar, corresponding to the 1980s in the Gregorian calendar), liquidity did not decrease; in fact, the volume of liquidity increased from around 450 trillion IRR to over 3,390 trillion IRR.
Excess Liquidity and Long Queues for Loans
Here, banks began to manage the public’s deposits by offering loans with interest rates ranging from 20% to 40% (excluding loans like marriage and dowry). Initially, the interest rates on these loans were close to the country’s inflation rate; however, these rates were subsequently lowered by decree, leading to long loan queues. These loans ranged from several hundred thousand tomans to several billion tomans. This is where excess liquidity began to be created, and banks started withdrawing from their reserves at the central bank. During this period, many individuals and companies provided loans through contracts and deposits to banks, expecting returns greater than their loan installments. This situation caused the money multiplier to grow, with each money turnover between loans and deposits adding to liquidity. Thus, these deposits never assisted the central bank in managing its balance sheet. In its latest report for 1401 (2022), the central bank attributed the monthly growth of 120 trillion tomans in liquidity to the excess withdrawals by banks and financial institutions—a trend that began in the mid-1380s and has continued to this day.
Bank deposits were never able to assist the central bank in managing its balance sheet.
Our second experience with a fictional union is similar to the strange situation the banking system has now imposed on the people and their assets. Banks and financial institutions have dramatically increased the pace of money creation by offering loans at rates significantly lower than inflation and drawing from resources that should be under the central bank’s control. This has led to a rush by people to purchase goods and services. Meanwhile, the price suppression of the dollar and energy, along with high customs tariffs, has crippled the production sector of the economy. Rather than contributing to production, people’s liquidity has been directed toward purchasing goods that can serve as appropriate investments or has been funneled into the stock market, gold, and dollars due to psychological and promotional pressures, with disastrous effects on the economy and household livelihoods in recent years. Apartments, cars, flagship smartphones, and SIM cards have transformed consumer goods into investment assets, with prices increasingly out of reach for a large part of society. This is happening while many banks are entangled in widespread systemic corruption. Individuals, through obtaining illegal loans worth trillions of tomans without sufficient collateral, have caused massive financial damages, driving banks and financial institutions to the brink of bankruptcy. One of the most notable examples in recent years is the case of Sarmayeh Bank.
Banks and financial institutions, by offering loans at rates far below inflation, have accelerated the “money creation process,” which has led to a rush by people to purchase goods and services.
Summary
This bitter story has numerous aspects, and this article only aims to highlight some of them. Statistics up to the end of 1401 (2022) do not reflect any change in behavior or approach despite all the claims and speeches by government officials. Indeed, the public is increasingly harmed by the banking system’s behaviors every day, and unfortunately, this bitterness shows no signs of diminishing.
