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Where Does Money Come From?

By Josh Ryan-Collins, Richard Werner, Tony Greenham, Andrew Jackson

Far from money being ‘the root of all evil’, our economic system cannot cope without it. It is far nearer the truth to claim that ‘Evil is the root of all money’.

At a time when we face up to massive challenges in financial reform and regulation, it is essential to have a proper, good understanding of how the monetary system works, in order to reach better alternatives.

But although my field of study is one which is being lectured upon in every University in the world, there exists, extraordinarily enough, no printed Treatise in any language – so far as I am aware – which deals systematically and thoroughly with the theory and facts of representative money as it exists in the modern world. (John Maynard Keynes).

There remains widespread misunderstanding of how new money is created, both amongst the general public and many economists, bankers, financial journalists and policymakers. This is a problem for two main reasons. First, in the absence of a shared and accurate understanding, attempts at banking reform are more likely to fail. Secondly, the creation of new money and the allocation of purchasing power are a vital economic function and highly profitable. This is therefore a matter of significant public interest and not an obscure technocratic debate.

The financial crisis of 2008 raised many more questions about our national system of banking and money than it answered…including:

Where did all that money come from? – in reference to the ‘credit bubble’ that led up to the crisis.

Where did all that money go? – in reference to the ‘credit crunch’.

How can the Bank of England create £375 billion of new money through ‘quantitative easing’?

And why has the injection of such a significant sum of money not helped the economy recover more quickly? Surely there are cheaper and more efficient ways to manage a banking crisis than to burden taxpayers and precipitate cutbacks in public expenditure?

These questions are very important. They allude to a bigger question: ‘How is money created and allocated in the UK?’

The UK’s national currency exists in three main forms, of which the second two exist in electronic form:

Cash – banknotes and coins

Central bank reserves – reserves held by commercial banks at the Bank of England. Commercial bank money – bank deposits created mainly either when commercial banks create credit as loans, overdrafts or for purchasing assets.

Only the Bank of England or the Government can create the first two forms of money; ‘central bank money’ or ‘base money’. Since central bank reserves do not actually circulate in the economy, we can further narrow down the money supply that is actually circulating as consisting of cash and commercial bank money.

Physical cash accounts for less than 3 per cent of the total stock of circulating money in the economy. Commercial bank money – credit and coexistent deposits – makes up the remaining 97 per cent.

The power of commercial banks to create new money has many important implications for economic prosperity and financial stability.

Banks decide where to allocate credit in the economy. As a result, new money is often more likely to be channelled into property and financial speculation than to small businesses and manufacturing, with associated profound economic consequences for society.

Fiscal policy does not in itself result in an expansion of the money supply. Indeed, in practice the Government has no direct involvement in the money creation and allocation process. This is little known but has an important impact on the effectiveness of fiscal policy and the role of the Government in the economy.

Without a proper understanding of money, we cannot attempt to understand banking

Our intention in publishing Where Does Money Come From? is to facilitate improved understanding of how money and banking works in today’s economy, stimulating further analysis and debate around how policy and decision makers can create a monetary system which supports a more stable and productive economy.

There is significant confusion about banks. Much of the public is unclear about what banks actually do with their money.

While many assume that only the Bank of England has the right to create computer money, in actual fact this accounts for only a tiny fraction of the money supply. The majority of the money supply is electronic money created by commercial banks. How these mostly private sector banks create and allocate the money supply remains little known to both the public and many trained economists, as it is not covered in most textbooks.

The vast majority of money in our economy was created by commercial banks. In effect what the UK and most other countries currently use as their primary form of money is not physical cash created by the state, but the liabilities of banks. These liabilities were created through the accounting process that banks use when they make loans.

You can use it to pay for things, including your tax bill, and the Government even guarantees that you will not lose it if the bank gets into trouble.

The amount of money created by commercial banks is currently not actively determined by regulation, reserve ratios, the Government or the Bank of England, but largely by the confidence of the banks at any particular period in time.

The Bank of England or the Government could intervene in order to influence or control money created by commercial banks, as they did in the past. In other words, the authorities are not free of responsibility for results produced by the largely unchecked behaviour of the banking sector.

The money supply of the nation depends mainly on the confidence and incentives of the banks.

When a central bank chooses to adopt a laissez-faire policy concerning bank credit, as now in the UK, boom-bust credit cycles are likely to result, with all their implications for economic analysis and policy.

Unproductive credit creation will result in asset price inflation, bursting bubbles and banking crises.

This may explain why the Bank of England, like most central banks, used to impose credit growth quotas on banks. However, such credit controls were abolished in the early 1970s.

Just as important to our understanding of the modern monetary and banking system, however, have been developments in information and communication technology. These have changed not just the medium of exchange: from cash to cheques to debit and credit cards to internet banking, but the relative power of different actors in relation to the issuance of new money.

Today virtually all (most estimates are between 97 to 98 per cent) money in circulation is commercial bank money.

Digital money – in the form of transferring demand deposits (commercial bank money) from one account to another – is used almost exclusively for larger transactions and hence accounts for the majority of transaction volumes.

Those with the power to create new money have enormous power – they can create wealth simply by typing figures into a computer and they decide who can use it and for which purpose.

Few phrases have ever been endowed with such mystery as open-market operations, the Bank Rate, the rediscount rate. This is because economists and bankers have been proud of their access to knowledge that even the most percipient of other citizens believe beyond their intelligence. J.K. Galbraith (1975)

We have seen that today the bulk of the UK’s money supply is created not by the state, the Bank of England, the Treasury, or the Royal Mint, but by a small collection of private, profit-oriented companies that are commonly known as banks. These are the fundamentals.

There is a relationship between a bank’s reserves with the Bank of England and the amount banks can lend. However, this is not a relationship that is compatible with widespread public perception of ‘banks as intermediaries’ or the ‘money multiplier’ model in economics and finance textbooks. Banks do not intermediate the deposits they receive. Banks create brand new money at will by extending credit or buying assets.

The first agreement on liquidity between the Bank of England and commercial banks occurred in 1947, when the privately owned Bank of England was nationalised. It involved a requirement to hold a minimum ratio of highly liquid assets, such as central bank reserves, cash or Treasury bills, to deposits of 32 per cent. This was lowered to 27 per cent 16 years later. The regime prevailed until 1971, when the Competition and Credit Control policy regime (CCC) introduced a minimum reserve ratio of 12.5 per cent.

After twice lowering the minimum requirement, the Bank of England finally abolished the compulsory reserve ratio regime with the cash ratio deposit regime in 1981, which did not directly require a minimum level of liquid assets.

Securitisation is the process of selling on a loan, or a package of loans, and passing the risk and reward onto someone else in exchange for cash.

Banks which merely originate loans which they intend to sell on to others have less of an incentive to be careful in their analysis of credit risk and the sustainability of these loans.

This is another example of the problem that arises when banks are given the privilege of creating new money without any guidance as to how this should be done in the public interest in order to contribute to general prosperity and stability.

What all these have in common, aside from their extraordinary expansion over the last decade, is the creation of forms of credit that have no relationship to traditional banking. As discussed previously, it is quite possible for banks to create money and credit out of nothing. In a myriad of ways, the shadow banking system hugely extends that principle.

The crash of 2007-08 has been described as a ‘run’ on the shadow banking system: and confidence in the complex structures of unregulated credit creation evaporated, leaving the US banking system ‘effectively insolvent for the first time since the Great Depression’ as the crisis spread into conventional banking.

The underlying weaknesses of an unregulated, off-balance-sheet credit system have not been addressed.

When queues formed outside Northern Rock, the Bank of England was forced to step in, lending billions to Northern Rock directly and buying increasing amounts of assets from the banks in exchange for Bank of England reserves and cash that would enable them to make payments and rebuild their capital. Only by flooding banks and the interbank market with central bank reserves on a massive scale was the Bank able to avert financial collapse.

We have seen then that the central bank cannot control bank money creation through adjusting the amount of central bank reserves which banks must hold.

In reality, the tail wags the dog: rather than the Bank of England determining how much credit banks can issue, one could argue that it is the banks that determine how much central bank reserves and cash the Bank of England must lend to them.

This follows on from the Bank’s acceptance of its position as lender of last resort, even though it has not fully played this role in the recent bank rescues, such as Northern Rock and RBS, since it passed on the cost of initial central bank money injections to the Government and hence to tax-payers.

Because cash and central bank reserves must be created on demand by the central bank whenever commercial banks request it, there is no obvious limit to the amount of this ‘high-powered’ money that the central bank must create.

This follows on from the Bank’s acceptance of its position as lender of last resort, even though it has not fully played this role in the recent bank rescues, such as Northern Rock and RBS, since it passed on the cost of initial central bank money injections to the Government and hence to tax-payers.

Because cash and central bank reserves must be created on demand by the central bank whenever commercial banks request it, there is no obvious limit to the amount of this ‘high-powered’ money that the central bank must create.

In modern economies, where new money is created by the banking system, the supply of money is driven by credit creation, but credit creation is not driven by the demand for credit. Instead, the credit market is determined by the supply of credit and credit is rationed.

In other words, because commercial banks ration and allocate credit, and they create new money in the process, they have a decisive influence over the allocation of new money in our economy.

The appropriate regulation of the total quantity of credit creation and the quality of its use (i.e. the allocation of credit for different types of use) are key variables that economic policymakers should monitor and, indeed, seek to control. The quantity and allocation of credit across different uses will shape the economic landscape.

First implemented by the German Reichsbank in 1912, credit controls were copied by the Federal Reserve in the 1920s (and had the greatest impact in economic history when adopted by the Japanese, Korean and Taiwanese central banks in the early 1940s during WWII) and then continued for many decades in the post-war era.60 Called ‘window guidance’ in these countries, the central bank determined desired nominal GDP growth, then calculated the necessary amount of credit creation to achieve this and then allocated this credit creation both across the various types of banks and across industrial sectors.

Window guidance could also be cited as a key reason why the Chinese economy has not fallen victim to the Asian economic crisis or to the international banking crisis of 2008.

Economic history thus provides evidence that a simple regime of credit guidance, combined with adequate incentives (both carrots and sticks) for the banking system is an attractive avenue for delivering stable and high economic growth that is sustainable and, crucially, without recurring banking crises.

Private investors, particularly institutional investors, will normally put their money where they receive the highest returns, including investing money in projects outside the UK.

In addition, the private investment sector can and does borrow money for non-productivity-enhancing purposes, such as commodity speculation and commercial property finance. This does not increase GDP transactions and will instead inflate asset prices.

A further example is when private investors fund private equity vehicles that take over productive manufacturers, fire local staff and outsource production to foreign low-wage countries.

When private sector economic confidence is low, as during recessions, investors will tend to be risk averse and seek existing financial assets, including property, in which to store wealth in preference to providing funding for new commercial ventures.

In contrast, government investment is bound to contribute to GDP transactions – there is little reason for the Government to invest in existing financial assets.

In addition, spending by the Government tends to also be redistributive; channelling funds towards lower income groups (e.g. via benefits) who may spend a larger proportion of any additional income than higher income socio-economic groups.

In summary, it is possible that the Government could invest in a socially more beneficial way than the private sector, and that the nature of its spending would lead to money circulating faster and boosting economic activity. There is, however, no guarantee that governments will have the right information to invest productively, or even try to do so.

Banks create new deposits when extending credit, buying existing assets or by providing overdraft facilities which customers themselves turn in to deposits when they draw on them. These deposits are accepted by everyone, including the state, in payment for taxes. This is the process of credit creation, which enables banks to create money.

It is the ability of banks to create new money, independently of the state, which gave rise to modern capitalism and makes it distinctive.

Enterprises, wage labour and market exchange existed to some small degree, at least, in many previous economic systems, but... their expansion into the dominant mode of production was made possible by the entirely novel institution of a money-producing banking.

Deregulation and developments in technology have brought us to a situation where commercial banks now completely dominate the creation of credit and, hence, the money supply. This is the case even though the acceptability of money is guaranteed by the state and the security of bank deposits backed ultimately by the taxpayer.

The implications of the credit model of money are profound. Rather than being neutral or a veil over the ‘real’ activities of the economy (trade, exchange, use of land and labour), it becomes clear that money – as an abstract, impersonal claim on future resources – is a social and political construct. As such, its impact is determined by whoever decides what it is (the unit of account), who issues it, how much of it is issued to whom and for what purpose.

The unit of account function continues to be determined primarily by the state, as it has been for at least four thousand years.

The medium of exchange may change – credit cards, cheques, online or mobile phone payments – but the unit of account remains the same, otherwise money loses its power of acceptability.

Part of the widespread acceptance of bank deposits as payment may be due to the fact that the general public is simply not aware that banks do indeed create the money supply.

Future exchangeability of money is guaranteed by the Government in three key respects:

Through its acceptability to pay taxes

By tax-payer-backed insurance of bank deposits

By implicit tax-payer-funded guarantees that banks themselves will be bailed out if they get into trouble

New money is more likely to be channelled into property and financial speculation than to small businesses and manufacturing, with profound economic consequences.

This is little known but has an important impact on the effectiveness of fiscal policy and the role of the government in the economy.

The misunderstanding of money as a commodity rather than a creditor/debtor relationship has so dominated the imagination of our leaders and economists that they have allowed the development of a monetary policy regime that, despite repeated crises, remains steadfast.

The main purpose of Where Does Money Come From? is to illustrate how the current system works * .

The authors reveal a paradox at the heart of our monetary system: it is the state that essentially determines what money is and underwrites its value and yet it is predominately commercial banks that create it. In deciding who receives credit, commercial banks determine broadly how it is spent within the economy; whether on consumption, buying existing assets or productive investment, their decisions play a vital macro-economic role.

It is only through the application of proper analysis and further public and policy debate, that we can collectively address the much more significant and pressing question of whether our current monetary and banking system best serves the public interest and, if not, how it should be reformed.