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Is money really created out of thin air through fractional reserve banking system?
This is for people who know about the fractional reserve banking system. People who heard of the Jerome Daly case are an additional asset. Thank you.
Yes, in a sense it is. But it gets worse. The normal banking system has some reserve requirements. The shadow banking system is unregulated and so has no reserve requirements at all:
http://en.wikipedia.org/wiki/Shadow_banking_system
Furthermore, more loans come out of the shadow banking system than come out of the regulated system:
http://www.npr.org/blogs/money/2010/07/14/128511585/shadow-banking-is-still-bigger-than-traditional-banking
And yes, there are many who consider this to be a great Ponzi scheme and others, such as the justice of the peace in the Jerome Daly case who consider all this “repugnant to the Constitution of the United States and the Bill of Rights in the Minnesota Constitution". But the fact is that on a daily basis, we all really do consider credit with a bank to be of real value.
If you want some analogies, consider physics where our normal instincts is to treat matter and energy separately, even though the physicists tell us it is all one and that what we think of as solid is mostly empty space.
Or consider the classic story about stone soup. What counts is not the money itself but what it gets others to do for you and for themselves.
Money is not a thing, it is a relationship. As Krugman notes about Midas and gold:
http://www.pkarchive.org/cranks/goldbug.html
There are differences between gold-backed money and fiat money, but both have their value because of faith - whether faith that people are going to want gold or faith that people will accept fiat money in exchange for gold.
http://en.wikipedia.org/wiki/Tinkerbell_effect
(BTW, for centuries, Chinese money was based on silver, not on gold. Gold was just a pretty metal used for jewelry. So when the Europeans bought all those silks, teas, and porcelains from China, a stream of silver went the other way. Soon Europe was running out of silver even though it still had plenty of gold.
http://en.wikipedia.org/wiki/Opium_Wars#European_trade_with_Asia
And even in Europe, silver was the primary money for many years. The silver "thaler" was where the word dollar came from:
http://en.wikipedia.org/wiki/Thaler
So the whole idea of gold being the only "real" money is just a joke.)
And just to make the stew even harder to handle, think about Krugman's babysitting club story:
http://www.slate.com/id/1937/
It all makes perfectly good sense on a piece-meal basis. But just as the lawyers in the story didn't really understand the solution and the implications for monetary policy in general, neither do most other people, and (guessing from the comments of various economists I've read) not even all economists.
In any case, just because money is created out of thin air, doesn't mean you can create as much as you want without consequences. Create too much and you do get inflation, the value of your money goes down, etc.
(Related to this is the Chartalist idea that the real reason fiat money has value is that the state will accept it for payment of taxes. Since everyone has to pay taxes, everyone needs at least some money.
http://en.wikipedia.org/wiki/Chartalism
Also check out the colonial scrip used because the early colonies didn't have enough gold.
http://en.wikipedia.org/wiki/Early_American_currency
BTW, none of these ideas and none of this confusion is new. Mark Twain wrote about the nature of money and the surrounding confusion back in 1889 in his "A Connecticut Yankee in King Arthur's Court"
http://en.wikipedia.org/wiki/A_Connecticut_Yankee_in_King_Arthur's_Court