Discussion of the way money is created is endlessly confused and confusing, partly because of the terminology used, and partly because what is happening is so surreal. This page attempts to address the problem graphically with reference to the above diagram, in the hope that visualisation will aid comprehension. I am not an economist, thank god, but an average intelligent person who has made huge efforts recently to get my head around the problem.

Start at the top. There are 2 players, the borrower and the bank (or other lending institution). The borrower asks for a loan, the bank officer decides the borrower is a safe bet, and provides the loan.

The key thing here is that the bank's loan is not drawn from the banks reserves as such. The relation of the loan to reserves is via a multiplier, called the Fractional Reserve (FR). With a 10% FR the bank can lend out 90% of what it holds, and must hold 10% in reserve for reasons of bank security. In fact in the UK this reserve has been abandoned, leaving prudence (which in the case of Northern Rock was in short supply) as the only limit to lending.

The loan creates a credit that appears in the borrower's account, and an equal and opposite debit that appears in the banks accounts. These values have a dual nature: to the borrower his loan is both an asset that he can use and also a liability to be paid off; to the bank it is an asset (in the expectation that it will be paid off with interest) and also a liability, in that the borrower might default.

The borrower can now spend her money into general circulation, perhaps buying machinery to increase the productivity of her business. All the time she works she is paying off her loan, first the interest, and finally the principal - that is, the sum she borrowed in the first place. When that happens, the loan (debt on the bank side) is written off the banks books, so the bank loses the both the liability (no more risk of default) and the asset (no more interest payments). The banks loan books have reverted to where they were before, except that the bank's assets have increased from the interest payments.

Meanwhile, the man who sold the machinery to the borrower has made a profit, and he may be able to put some of this in the bank as savings. So from interest repayments and savings, the bank's assets and reserves increase, leaving the bank in a position to lend out even more money.

Note that the bank makes more money from lending than providing a safe deposit for savings. It has to pay interest out to the saver (although it uses the increased reserves from the savings to boost its lending), whereas a borrower pays a higher rate of interest.

This analysis predicts that (a) the money supply and (b) the debt in the world economy will be increasing. The facts confirm this: the world's money supply is increasing by between 4% for established economies and 16% for emerging economies.

Debt is also increasing. All but five of the world's nations have significant foreign (external) debt. The UK has debts equivalent to 4 years' worth of GDP. The economist Margit Kennedy quotes a German study showing that interest on borrowed money represented around 30-50 percent of the prices of all goods and services, depending on whether you owned your own house without a mortgage or not, as housing is such a big factor.

This system is unsustainable and is one of the drivers for economic growth. It has evolved from a system where the government used to create the money supply (see this video to explain the evolution of banking).

The creation of money by interest bearing loans is one of the factors behind the economic divergence between rich and poor. The rich have surplus money, so they can lend it to banks or stock markets, becoming richer (unless the stock markets crash). The poor have no money, and so have to borrow - if they can - and become poorer since they have to pay the interest.

There are alternatives available, in which the Government itself issues money into the economy by funding beneficial projects (for example, renewable energy generators). This solution always raises the fear of hyperinflation, but this does not have to be the case if the government is careful not to inject too much money.