Money creation, the monetary system, and inflation in plain language

Introduction

Finance and the financial world seem complicated to most people. Full of numbers, charts, goals, and accounting that only experts appear to understand. This creates the feeling that the smartest thing to do is to trust “those who know” — investors, bankers, ministers.

We are told about the economy through complex calculations and forecasts: interest rates, budgets, GDP, and other indicators. Yet all of it revolves around one central metric — the Consumer Price Index, i.e., official inflation. Based on this, we are told how healthy the economy is, targets are set, returns on different instruments are calculated, and policies are implemented.

But this is only the surface shimmer of the whole story. The Consumer Price Index says nothing about how money itself is created or why its value decreases over time. It is measuring symptoms, not describing the cause.

How money is actually created

To understand what matters most, you don’t need complex models — you need to look at how money comes into existence.

Central banks

• A central bank has the exclusive right to create base money (M0): cash and banks’ reserves at the central bank.
• This is done by buying government bonds or lending to banks.
• That money then flows onward through the commercial banking system.

Commercial banks

But it is in commercial, everyday banks that something happens which is not a secret, yet is an almost completely ignored truth. This is where most money is born through credit creation. When a bank issues a loan, it is not taken from existing deposits. On the contrary, the loan creates a new deposit. This is done through a single accounting entry.

• On the asset side: “Loan claim against the customer” (the bank’s receivable).
• On the liability side: “Deposit in the customer’s account” (the bank’s obligation to the customer).

The customer can use this new money, and it moves through the system as if it were “real.” Technically, we can describe such money as “book money” (English: “book money”, German: “Buchgeld”) compared to “base money” (English: “cash”, German: “Bargeld”). You can distinguish them, but in practice it is still money in circulation.

That is why loan and deposit volumes always move together. When loans grow, deposits grow. When loans are repaid, those deposits are destroyed. Money is created and disappears through credit creation.

The fractional reserve double shock

Fractional reserve banking means a bank must keep only a small part of customer deposits — for example 10% — as reserves. The rest can be lent out… That alone should raise serious questions about how the whole arrangement is built. If you deposit €100, the bank can lend out €90 of it. That is major leverage and risk. Should banks really be doing this with our money?

But reality is even more intriguing. The loan does not come from an existing deposit — the bank creates it as new money. So the same €100 deposit can serve as reserves on the basis of which €900 in new loan money can come into being. In total, the accounting shows €1,000 — €100 in reserves and €900 created as loans. The same fractional reserve rule, but at a completely different order of magnitude. And this is normal — the financial world is pumped up with money that does not actually exist, and the entire monetary system has been devalued through it.

Legal foundation

• The state grants banks operating licenses and sets the framework. Laws, supervision (in Estonia, the Financial Supervision Authority), and the deposit guarantee system provide a societal guarantee that a bank may operate with special rights that ordinary companies do not have.
• The central bank sets the rules of the game: how much equity and reserves a bank must hold, what the interest rates are, and how settlement works. In this way the system is kept “in balance” and guided according to the needs of the economy.
• Banks operate within these boundaries. They decide whom to lend to and how much, and earn interest on it. But interest means that even when loans are repaid, the money-creation cycle can never fully close — the system constantly needs new money and new debt so that interest can be paid.

In the central banks’ own words

Money creation through credit is not an “alternative theory,” but confirmed by central banks themselves:

• Bank of England (2014): Money creation in the modern economy “Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.”

• Deutsche Bundesbank (2017): How money is created Banks can create book money just by making an accounting entry: according to the Bundesbank’s economists, “this refutes a popular misconception that banks act simply as intermediaries at the time of lending — i.e., that banks can only grant credit using funds placed with them previously as deposits by other customers.”

• BIS ECONOMIC PAPERS N° 1 — November 1979: CREDIT AND LIQUIDITY CREATION IN THE INTERNATIONAL BANKING SECTOR The first document in its series in which the “central bank of central banks,” the Bank for International Settlements (BIS), clearly described how international banks create money and liquidity through credit, rather than merely intermediating deposits. This makes it one of the earlier and more influential official confirmations of the logic of the modern monetary system.

• Richard Werner — Princes of the Yen Werner was among the first to show, academically and empirically using Japan’s financial system as an example, how credit creation works, how banks create money “out of thin air,” and how the central bank steers this process. “Banks do not lend out deposits, they create deposits by granting credit. This credit creation is the source of most of the money supply.”

The money we use in everyday life is mostly loan money, created by commercial banks when they issue new loans. A smaller part is base money — cash and reserves created by the central bank. Together these form the overall money supply (M2), but their nature is completely different.

This may sound strange and unbelievable. Most people (including bank employees) still think that a bank lends out someone’s deposits. In reality it is the opposite: the loan creates the deposit. This makes it difficult to draw conclusions from a bank’s balance sheet. It can seem as if loans should come from deposits and therefore be balanced, but we do not realize that deposits are in fact mostly loans.

Apparent prices vs money supply

Officially, we are told that inflation means rising prices. The Consumer Price Index is the metric by which politicians and central banks make decisions. If prices rise by 2–3% per year, that is considered “normal” and a sign of a “healthy economy.”

But originally, inflation meant something else. The word “inflation” was used when the amount of money was inflated — when more currency was released into circulation than had previously been backed. Rising prices were not the definition, but the consequence.

This change is not accidental. If inflation means only rising prices, it can be measured with a limited basket and presented as seemingly controllable. But the expansion of the money supply is more politically uncomfortable to acknowledge. And so the focus of the concept shifted — from money to prices.

Real inflation is the growth of the money supply, i.e., the erosion of the money’s value itself. And it is on a completely different scale: in Estonia roughly 7–10% per year, sometimes even more. That means money burns faster than we are told.

Does this matter?

Of course. The difference is huge. The mismatch begins at the root level.

If you believe the official 2% inflation, then a 3% interest rate on a bank deposit or a 5% return in a pension fund seems good. But if the money supply is actually growing 7–10%, then we are system-wide in the negative. Money loses value faster than returns grow. This changes the entire understanding of saving, investing, and pensions. Over time it destroys generational wealth and increases inequality. The ones who suffer most are the “proper” ones — those who save and avoid loans.

This also affects state policy. If a government talks about a “responsible budget” while simultaneously expanding the money supply through the central bank and commercial banks, the real picture is distorted. Tax increases, the pension system, and public debt are all built on the assumption that inflation is what the CPI shows. If the foundation is wrong, the entire discussion is off.

The most important level is people’s consciousness — education. We have become used to thinking that rising prices are inevitable. In reality, they are not. This is a consequence of the system, not a law of nature. Money as the equivalent of our work and energy should not leak.

This is the apparent vs real inflation: not the price increase in the store, but how fast our money’s value actually disappears. When you become aware of it, the whole picture changes. And it is no longer an economic detail, but the foundation on which all politics, the tax system, and our shared future rest.

A lot is said about investing and financial freedom — financial gurus, conferences, and all kinds of courses create the impression that investing is exciting and necessary. Yet at the same time we must acknowledge that most investors lose money. Survival in markets is serious work, and it is sad that in addition to everyday life one must also do this just to preserve the value of hard-earned money. In addition to the fact that markets and the information space are extremely manipulated, there is another important challenge to become aware of. Let’s look at it through our local financial market.

The OMX Baltic 10 index brings together the 10 most actively traded and most liquid stocks on the Baltic exchange. The growth of its price index over the last ten years is nearly twofold. Including dividends that are reinvested immediately back into the stock, the return is almost threefold. Pretty good, right?

But the return of the larger and better Baltic stocks is no longer that impressive once you consider that over the last decade the money supply in Estonia has grown 2.5 times (on average 9.5% per year). Over 20 years, the money supply has grown 6.6 times (9.8% per year). This means that the returns of the best companies are more or less zero compared to the loss of money’s value. The following chart shows where all these loans come from.

In the current financial system and social norm, “economic growth = debt growth.” In that case, our current success is directly at the expense of the future. Do we really want to be among the fastest-growing countries in Europe?

The Keynesian framework

When you first understand that banks create money by issuing loans, and that economic growth actually means debt growth, it seems absurd. How can such a thing be legal and why is it considered normal? The answer lies in the story of economic theory.

Classical economic theory (18th–19th century, Adam Smith, David Ricardo) believed in market self-regulation. If a crisis occurred, the market was supposed to bring itself back into balance: prices fall, less efficient companies disappear, and eventually a new equilibrium returns. This logic also lives on in the Austrian school — faith in the market’s natural ordering

force and in limited money. Money is like a living organism with natural cycles that reflect humanity and the state of the moment.

John Maynard Keynes wrote his main ideas in a very different era — during the Great Depression of the 1930s, when unemployment was massive and the market did not recover. The classical “wait and the market will improve” did not work fast enough. Keynes concluded that the problem might not be supply but demand: if everyone starts saving and spending disappears, the economy stalls. His solution was that the state must intervene when necessary — spend more, borrow, create demand.

This was a convincing, even saving idea in its time. Politically it was not difficult to sell to the public. Keynes did not advocate endless printing, but crisis support. But when the link between money and gold was cut in 1971, his framework became an ideal justification for the new era of fiat money: now there were no constraints, and money could be expanded as needed. This became the “new normal” of the economy. Academia is still dominated by Keynesian thinking, where central bank printing, the growth of public debt, and bank credit creation are natural tools. So the expansion of the money supply seems not like a problem, but an inevitability — even a solution.

Fiat — money by state decree

The word fiat comes from Latin and means “let it be,” “so be it.” It expresses the force of a command or decision. That is exactly how fiat money works: its value comes from the state and the law declaring, “this is money.”

If gold gets its value from the metal itself and mining it — physical scarcity limited by nature; and for example Bitcoin gets its value from mathematics and energy-based distributed mining — digital scarcity limited by code; then fiat money gets its value from shared belief and the legal obligation to accept it. Today’s euro, dollar, and other major currencies are all fiat — money that exists and has any value because we agree that it exists.

How did we get here?

The history of money is long and colorful — ranging from barter, shells, polished stones, and metal money to the tax systems of various empires. All of this has played a role in shaping human society.

Here we begin with the last few centuries, because that is when the logic of modern banking and finance was born: money as a promise, fractional reserves, and finally a full fiat system.

The gold era

At first, money literally meant gold or silver. For safety and convenience, bankers and goldsmiths emerged who stored precious metal and issued deposit receipts (IOU — I owe you).

These receipts quickly became more popular than carrying gold — they could be used to buy goods and settle debts.

This is where the first logic of “money intermediation” was born: people did not come to reclaim their gold every day, but used paper as proof. It was simpler, and inevitable. Intermediaries noticed that most gold simply sits in vaults and that the vast majority prefers to use “paper gold” because it is practical; and so intermediaries began issuing more receipts than the gold they actually had in reserve. This was the first step toward credit creation: more promises were created than real backing.

An important clarification

Gold itself no longer moved; promises for gold moved. Money changed from the asset to access to the asset — and from there into belief in access.

The British pound and a gold-backed world

In the 18th–19th centuries, Great Britain became a global empire, and the British pound sterling became the world’s leading money. The pound was linked to gold, and London’s banking system became a center of international trade. Many other currencies were either directly linked to gold or indirectly linked through the pound.

This period is often presented as the “golden age of the gold standard.” In reality, even this system was intermediated and centralized: gold was concentrated in the hands of banks and state vaults, and the money circulating in daily economic life had long been paper and settlement. This means that even a “gold-backed world” did not function as direct gold money, but as a hierarchical access system where a few had real control and most had a promise.

The 20th century — fractional reserves and world wars

During the 19th–20th centuries, fractional reserve banking was established: banks had to keep only part of the gold as reserves. The rest could be lent out. This system held until crises and wars arrived. During the world wars, money was printed massively to finance the war machine, and the link to gold eroded.

This is an important side note: today’s massive wars are only possible because of money printing. That is also a reason to be passionate about monetary systems. This is not just a “finance topic,” but a theme of humanity with monumental consequences, and therefore important for a conscious person.

Here one thing also became finally clear: money tied to gold cannot be maintained in a crisis. When a state’s existence is at stake, the promise always breaks.

Bretton Woods and the dollar’s gold backing

In 1944, the Bretton Woods conference agreed on a new world order: the US dollar was pegged to gold (1 oz = 35 USD) and all other currencies were pegged to the dollar. The US became the keeper of the world’s reserve currency because it had the largest gold reserves.

In reality, this was already a second-tier gold standard: most countries no longer had a direct relationship with gold, but trusted the US promise. Gold was concentrated into one center, and the world used the certificates issued by that center.

The Nixon shock

In 1971, US President Richard Nixon ended the dollar’s convertibility into gold. The underlying reason was simple: the US had spent enormously due to the Vietnam War and social programs, and there was no longer enough gold to cover all foreign claims on dollars. Many countries, especially France, had begun converting dollars into real gold (tragicomically, in 1965 a warship was sent to New York to pick up gold), and gold reserves began to run out. As a side note, it is interesting to see similar behavior today, when Italy demands its gold back into its own hands.

Nixon told the public this was a “temporary measure to protect the dollar from speculators.” It was presented as a necessary defensive step to stabilize the situation. In reality, it meant the final separation of gold and the dollar and the global beginning of the full fiat era. And as with many “temporary measures,” it became permanent.

The central bank and the Federal Reserve

In the broader context of history, it is necessary to understand the special position of central banks. They are not ordinary market participants, nor are they directly run by governments. Their task is to manage monetary policy: regulate interest rates, manage the money supply, and ensure the functioning of the financial system.

Every system is a bit different: in Europe monetary policy is led by the supranational European Central Bank; in China the central bank is under party control; in the US the Federal Reserve operates as a formally independent body. At the international level, central bank activity is coordinated by the Bank for International Settlements in Switzerland.

The most powerful central bank is the US Federal Reserve (FED), because the US dollar is the world’s reserve currency. The FED was created in 1913 after a secret meeting on Jekyll Island, where a small circle of politicians and bankers set the rules of the new system. The FED is a special hybrid: its member banks are the largest commercial banks, its leadership is appointed through politics, but the people do not elect it. The FED is protected by law, US military power, and global agreements.

Critics, such as G. Edward Griffin in The Creature from Jekyll Island, have called the FED a system where collective money is created as debt, interest profit accumulates to a few, and risk is shared by all. It is an institution not elected by the public and without direct democratic control, even though its decisions affect the entire world economy. The question surrounding central banks is: how is it normal that the levers of the economy are in the hands of a small circle?

The final phase — the evaporation of fiat money

Today, cyclically, we are in the last phase of the system: money is not tied to gold, silver, or any physical constraint. It is based on belief, debt, and continuous expansion. If economic growth slows, more money must be created. If a crisis deepens, more money must be created. This is a system that can no longer stop, and it is in a bursting phase.

At the same time, the claim increasingly appears that “the solution is to go back to gold,” because gold has “worked for 5,000 years.” In reality, gold has never functioned systemically as global money without centralization and intermediation, which always leads to centralization, after which the relationship between money and gold is blurred until it is finally removed entirely. So “back to gold” is not progress, but a return to an already-walked, non-working cycle whose ending is known. Gold is not designed to be the money of a modern, global society. Gold is not sovereign/freedom money, but a precious metal.

Estonia’s story in this context

Estonia’s history reflects the broader movement, but in the context of a small country the steps were especially sharp:

• In the 1920s–30s we had our own gold-backed kroon. Inflation was low because money was tied to a physical asset.
• During the Soviet era, Estonia had no own money, but the ruble, which was a tool of political control. Monetary reforms (1947 and 1961) were currency reforms and also purges of people’s savings. This left Estonians with a deep experience that the value of money can change overnight.
• After the 1992 currency reform, we experienced hyperinflation. Prices rose by over 1,000% in 1992. This showed how fragile trust in money is without real backing.
• The currency board system (kroon pegged to the German mark) brought inflation down and created stability. By the mid-1990s inflation was already below 30% and later fell into single digits.
• From 2002, tied to the euro area and later with the adoption of the euro, we lost independent monetary policy. The inflation communicated to the public (CPI) has mostly stayed in the 2–4% range, but real money supply growth (M2) has been much faster — roughly 7–10% per year.

The flow of money, in summary

• At first, money = gold/silver.
• Then money = a promise of gold, which enables intermediaries to take a cut.
• Therefore money = a partially backed promise.
• After 1971 = pure fiat, only the promise of central banks and commercial banks.
• In Estonia = our own gold kroon → loss of independence → our own kroon again (hyperinflation and stabilization) → euro and a unified fiat system.
• Now money = debt, globally.

Future paths

The monetary system will not stand still. Already now, several possible new paths are forming. It would be useful to understand the different directions and at the same time recognize differences in design. Otherwise the existing sinking ship may take you down under new slogans.

1. Central bank digital currency (CBDC) In Europe a digital euro is being built; in China the digital yuan is already operating. The difference is control: in Europe an “independent” central bank; in China direct state control. In both cases it is fiat — centrally guided, inflationary base money. In total, 137 countries and currency unions are researching or building a central bank digital currency.

2. Stablecoins These are new digital monies linked, for example, to the US dollar. The innovation is that they can be transferred quickly, cheaply, and easily around the world, like cryptocurrency. But the substance remains the same: it is still FIAT. A stablecoin does not break the old system — it strengthens it. It creates new demand for the base currency (e.g., the dollar — USD stablecoins

are backed, i.e., they buy US government debt) and extends its lifespan — even in a situation where trust might otherwise be eroding.

Decentralized, sovereign, limited-supply base money — Bitcoin The first real technical alternative money. Distributed, limited supply (21 million; each bitcoin contains 100 million smaller units, satoshis), dependent on no state and no central bank. Bitcoin offers a completely new sovereign and global base money logic: money that is not based on debt, not centrally controlled, and cannot be created more — even if someone wanted to.

What does this all mean for us? The system works the way it works. There is no point denying it, dramatizing it, or attacking the participants — debt-based money collapses without all of this. But we can avoid increasingly painful consequences by preparing now for a shift to new foundations.

Individually, this means we should realize: official inflation does not reflect the real decrease in money’s value. When evaluating saving and investing, we must take money supply growth into account. For example, gold has reflected and neutralized the increase in Estonia’s money supply over the last 20 years quite well.

But gold is not designed as global base money — it is a useful, even magical element that we keep, by force and by habit, hidden in vaults.

Collectively, this means we face a choice: what monetary system do we create for ourselves? What is the money of the new world, considering our entire past and the developments of today?

Final word Money is a store and transmitter of human work/energy. If it functions fairly, it amplifies our cooperation and creativity. But if money is constantly leaking — if its value decreases and it serves only the interests of a few — it becomes a force that exhausts us all.

Independent and honest money would be a tool that serves everyone’s interests. Right now it does not. But this knowledge is not a reason for panic. On the contrary — it is a reason for clarity.

What you have read here is not a specialist textbook or an “experts’ secret.” It is basic education for everyone, not higher education for a few. Understanding money is not complexity, but simplicity. It is a step toward literacy and a clearer worldview.

What next?

How do we want to store and direct our energy? What money enables direct cooperation? How can we ensure that money is independent and honest? How do we create a system that does not leak energy into the pockets of a few, but supports all of us?

These are questions worth thinking about both individually and collectively. And perhaps it is exactly from this discussion that a path will emerge — one that leads us to a more honest and brighter money of the future.