How money works

How banks create money


Most of the money in our economy is created by banks, in the form of bank deposits – the numbers that appear in your account. Banks create new money whenever they make loans. 97% of the money in the economy today is created by banks, whilst just 3% is created by the government. This short video explains.

The money that banks create isn’t the paper money that bears the logo of the government-owned Bank of England. It’s the electronic deposit money that flashes up on the screen when you check your balance at an ATM. Right now, this money (bank deposits) makes up over 97% of all the money in the economy. Only 3% of money is still in that old-fashioned form of cash that you can touch.

Banks can create money through the accounting they use when they make loans. The numbers that you see when you check your account balance are just accounting entries in the banks’ computers. These numbers are a ‘liability’ or IOU from your bank to you. But by using your debit card or internet banking, you can spend these IOUs as though they were the same as £10 notes. By creating these electronic IOUs, banks can effectively create a substitute for money.

In the video below Professor Dirk Bezemer at the University of Groningen and Michael Kumhof, an IMF Economist explain where money comes from in less than 2 minutes:

Every new loan that a bank makes creates new money. While this is often hard to believe at first, it’s common knowledge to the people that manage the banking system. In March 2014, the Bank of England release a report called “Money Creation in the Modern Economy”, where they stated that:

“Commercial [i.e. high-street] banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.(Original paper here)

Martin Wolf, who was a member of the Independent Commission on Banking, put it bluntly, saying in the Financial Times that: “the essence of the contemporary monetary system is the creation of money, out of nothing, by private banks’ often foolish lending” (Article).

By creating money in this way, banks have increased the amount of money in the economy by an average of 11.5% a year over the last 40 years. This has pushed up the prices of houses and priced out an entire generation.

Of course, the flip-side to this creation of money is that with every new loan comes a new debt. This is the source of our mountain of personal debt: not borrowing from someone else’s life savings, but money that was created out of nothing by banks. Eventually the debt burden became too high, resulting in the wave of defaults that triggered the financial crisis.

The proof that banks create money


More than 97% of all the money in the economy exists as bank deposits – and banks create these deposits simply by making loans. Every time someone takes out a loan, new money is created. The Bank of England recently released a report explaining how this process works:

Where does money come from? In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood. The principal way in which they are created is through commercial banks making loans: whenever a bank makes a loan, it creates a deposit in the borrower’s bank account, thereby creating new money. This description of how money is created differs from the story found in some economics textbooks.”(Bank of England)

Money creation in the modern economy: Watch video

What the Bank of England says about Money Creation:

What Is Money?

In the words of the Bank of England:

“Economic commentators and academics often pay close attention to the amount of ‘broad money’ circulating in the economy. This can be thought of as the money that consumers have available for transactions, and comprises: currency (banknotes and coin) — an IOU from the central bank, mostly to consumers in the economy; and bank deposits — an IOU from commercial banks to consumers.

“Currency [bank notes and coins] only accounts for a very small amount of the money held by people and firms in the economy. The rest consists of deposits with banks.

“97% of the money held by the public is in the form of deposits with banks, rather than currency.” (Bank of England – Money in the modern economy: an introduction)

So most of the money in our economy is made up of bank deposits – the numbers that you see when you check your balance. And bank deposits are a IOU – a promise to pay, or in accounting terms, a liability – from the bank to you. But it would be wrong to think of these deposits as simply a representation of the cash that the bank owes you; in fact, these deposits function as money:

“In the modern economy, bank deposits are often the default type of money. Most people now receive payment of their salary in bank deposits rather than currency. And rather than swapping those deposits back into currency, many consumers use them as a store of value and, increasingly, as the medium of exchange.

“For example, when a consumer pays a shop by debit card, the banking sector reduces the amount it owes to that consumer — the consumer’s deposits are reduced — while increasing the amount it owes to the shop — the shop’s deposits are increased. The consumer has used the deposits directly as the medium of exchange without having to convert them into currency [notes and coins].” (Bank of England: Money in the modern economy: an introduction)

How is Money Created?

“In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

“Commercial [i.e. high-street] banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.(1)” ­[our addition in brackets] (Bank of England, Money Creation in the Modern Economy)

In short, money exists as bank deposits – IOUs of commercial banks – and is created through some simple accounting whenever a bank makes a loan.

Banks aren’t Middlemen between Savers and Borrowers:

There is a common idea – even taught in many economics textbooks and academic papers – that banks are simply middlemen (‘intermediaries’) between savers and borrowers. But this is inaccurate. As the Bank of England describes:

“One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

“In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.(3)” (Bank of England, Money Creation in the Modern Economy)

How much money have banks created


Banks have two key powers in today’s economy – they get to decide:
1.how much money to create
2.And how this money can be spent.

How much money have banks created?
From the time when the Bank of England was formed in 1694, it took over 300 years for banks to create the first trillion pounds. It took only 8 years for banks to create the second trillion. Today cash accounts for just 3% of the total money in the economy. Money created by banks accounts for the other 97%.

How have they used this new money?

Over the last 15 years the banks have used their power to create money to pump hundreds of billions of pounds into the property market (shown in red below). This has pushed the price of housing out of reach of ordinary people. Lending to the finance sector has also increased greatly over the past 15 years; this sector includes the companies that were involved in much of the speculation which contributed to the crisis.

Meanwhile, lending to businesses has stagnated, harming the real (non-financial economy) economy and lowering employment and growth.

How we got here


How did banks get the power to create money? Watch video here

Laws that make it illegal for you to print your own £5 or £10 notes have been in place since 1844. But when these laws were passed, they  overlooked the fact that money can also exist in the form of bank deposits (the numbers in people’s bank accounts). Because of this oversight, banks now have the power to create money through a simple accounting entry. As a result, today almost all money exists as electronic bank deposits, and is created when banks make loans.

A Short History of Money in the UK

Two centuries ago, only the government was legally allowed to create metal coins. But trying to keep metal coins safe or carrying them around was inconvenient, so people would typically deposit their coins with the local jeweller or goldsmith, who would have a safe. Eventually these goldsmiths started to focus more on holding money and valuables for customers than on actually making jewellery. They became the first bankers.

Laws that make it illegal for you to print your own £5 or £10 notes have been in place since 1844. But when these laws were passed, they  overlooked the fact that money can also exist in the form of bank deposits (the numbers in people’s bank accounts). Because of this oversight, banks now have the power to create money through a simple accounting entry. As a result, today almost all money exists as electronic bank deposits, and is created when banks make loans.

A customer putting coins into the new ‘bank’ would be given a piece of paper stating the value of coins deposited, a little like the one on the left. If the customer wanted to spend his money, he could take the piece of paper to the bank, get the coins back, and then spend them in the local shops.

However, the shopkeeper who received the coins would usually take them straight back to the bank for safety. To save a trip to the bank, shopkeepers would simply accept the paper receipts as payment instead. As long as people trusted the bank that issued the receipts, businesses and individuals would be happy to accept the receipts, safe in the knowledge that they would be able to get the coins out of the bank whenever they needed to.

Over time, the paper receipts became accepted as being as good as metal money. People forgot that they were just a substitute for money and saw them as being equivalent to the coins.

The goldsmiths soon noticed that the bulk of the coins placed in their vaults were never taken out. Only a small percentage of deposits were ever asked for at any particular time. This opened up a profit opportunity – if the bank had £1,000 of coins in the vault, but customers only withdrew a maximum of £100 on any one day, then the other £900 in the vault was spare. The goldsmith could lend out that extra £900 to borrowers, and make a profit by charging interest on the loan.

However, rather than lend the coins, the goldsmiths would write out new paper receipts for borrowers. This meant that the bank could issue paper receipts to other borrowers without needing many – or even any – coins in the vault. With only £1,000 of coins in the vault the bank could lend out £2,000, £4,000 or as much paper money as it dared too. (Of course, the banks still faced some restrictions – if too many people came to get their money back at the same time then it would be obvious that the bank didn’t have enough money to repay everyone.)

The banks had acquired the power to create a substitute for the metal money created by the government. In effect, they had acquired the power to create money.

1844 Bank Charter Act

The hunt for profit drove banks to issue and lend too much paper money. This increased the amount of money in the economy, pushing up prices and de-stabilising financial markets. (One crisis was particularly embarrassing for the Bank of England – in 1839 it had to borrow £2 million of gold from France to rescue failing banks).

In 1844, the government of the day, led by Sir Robert Peel, realised that they had allowed the power to create money to slip into the hands of banks. They passed a law to take back control over the creation of bank notes. This law, the Bank Charter Act, prohibited the private sector from (literally) printing money, transferring this power to the Bank of England.

The Flaws in the Law

However, the 1844 Bank Charter Act only stopped the creation of paper bank notes – it didn’t refer to other substitutes for money, such as bank deposits. Because of this oversight, banks could still create ‘bank deposits’ by making loans – and so they could still create money simply by opening accounts for people or companies and adding numbers to them. With growth in the use of cheques these deposits could be transferred to make payments, and therefore used as money. When a cheque is used to make a payment, no cash is withdrawn from the bank. Instead, the paying bank talks to the receiving bank to settle any differences between them once all customers’ payments in both directions have been cancelled out against each other. This means that payments can be made even if the bank has only a fraction of the money that depositors believe they have in their accounts. However, despite the rise of cheques, cash was still used for a large proportion of transactions, and so banks were limited in the amount of money they could create in case they ran out of physical cash.

And then there were computers…

Following on in the spirit of financial innovation, after cheques came credit and debit cards, electronic fund transfers and internet banking. Cheques are now irrelevant as a means of payment: today over 99% of payments (by value) are made electronically. With the rise of computers and financial deregulation beginning in the 1970s, banks could really let loose.

Even those who know that banks are able to create money often assume that banks are obliged to possess a sum corresponding to a significant fraction of their liabilities (their customers’ deposits) in liquid assets (i.e. in cash, or a form that can be rapidly converted into cash). In fact, such laws were weakened in the 1980s in response to lobbying from the industry (although some effort is now being made to re-impose such rules in the aftermath of the crisis).

The situation today

The electronic numbers in your bank account do not represent a specific pile of cash with your name on it. They simply give you a right to demand that the bank gives you physical cash or makes an electronic payment on your behalf. In fact, if you and a lot of other customers demanded your money back at the same time (a bank run) it would soon become apparent that the bank does not actually have your money. For example, on the 31st of January 2007 banks held just £12.50 of reserve money (in the form of electronic money held at the Bank of England) for every £1,000 of deposits in their customers’ accounts.

Deposit money now makes up over 97% of all the money in the economy – around £2.1 trillion, compared to only £60 billion of cash.1 By value of payments, bank deposits are used for 99.91% of transactions and transfers, with cash being used for just 0.09% of transfers2. Consequently, the physical currency issued by the state has been almost entirely replaced by a digital currency issued by private companies. The UK’s money supply has been effectively privatised.

 

Source: Positive Money