Although the modern banking sector grew out of the fraudulent activities of goldsmiths, it is subject to greater rigour and oversight than was possible historically. Nevertheless the same principles and processes apply, in that money in the form of credit is created in response to people taking on debt, and destroyed when debts are repaid. For completeness it should be added that money created by banks in return for loan agreements[160] can only be in the form of bank money, they cannot create coins or banknotes for this purpose.[161]
Before exploring how banks create money in a modern economy it is worth discussing the two other theories of banking that have been predominant for most of the history of banking: (i) the intermediation theory; and (ii) the fractional reserve theory. Banks themselves have encouraged belief in these theories, especially the first, because it nicely conceals what they are really up to. Also it hasn't just been the public that have believed these theories, politicians and economists have also believed them and largely still do, indeed many economic textbooks still set out one or other of these theories as fact (Ryan-Collins et al. 2012 p11 and Werner 2005 Chapter 11). In truth neither theory is tenable.
i. The intermediation theory of banking - the simplest and most believed theory.
In this theory savers deposit money in banks and banks lend out that money to borrowers. Banks make money by charging borrowers more interest than they give to savers. In effect banks intermediate - i.e. they act as middlemen between savers and borrowers. In this theory there is no question of banks creating money, the money supply is fixed outside the banking system and all banks do is redistribute it. The theory is easy to understand and easy to believe, but it soon falls down because it fails to consider the next step which is what happens to the money that the borrower receives. Borrowers of course spend the money which is then owned by someone else, who is likely to save it in a bank - indeed with bank money they have no option as bank money never leaves the banking system - this feature is discussed later. At this stage the money has already been lent once and then re-deposited, so if the bank lends it again the same money has been lent to two different people, then three, then four and so on. Banks are bound to do this because they don't ask a depositor whether the money has already been lent once, and indeed even if they did the depositor can't know, because when someone buys a product the seller doesn't know and doesn't care how the buyer got the money to buy it. Therefore the intermediation theory has to give way to the fractional reserve theory, which is more complex but nevertheless just as false as the intermediation theory.
ii. The fractional reserve theory of banking - the more sophisticated theory (Ryan-Collins et al. 2012 p38).
Here banks do indeed re-lend the same money over and over again, but not indefinitely because a single bank can never lend out more than its savers have deposited, and it has to retain a portion of deposits in order to pay out people who want their money back or want it transferred to someone else when they buy something. Say someone deposits £1,000 in cash and all banks retain 10% of deposits to meet their reserve requirements, so the bank that took the £1,000 cash lends out £900 as bank money. That £900 comes back to the same or another bank as a new deposit (as bank money this time, not as cash), and 90% of that is re-lent, which is £810. As this process continues the amount lent at each stage gradually lessens and the total amount grows ever more slowly. Eventually when the initial £1000 is all retained as the reserve, not necessarily in the same bank but somewhere in the banking system, then that £1000 represents 10% of the total amount of money deposited and lent, which is therefore £10,000, consisting of £1,000 in cash and £9,000 in bank money. In other words the original £1,000 cash is now believed to be owned by no less than ten different people or organisations, only one of which is the original depositor of the money. This works because all ten believe (most of the time) that their money is safe, so they don't all want their money in cash at the same time. If they did then the system would collapse - this is known as a run on the bank.
In the fractional reserve theory banks do create money, but they can only do it collectively by working together, no individual bank can lend out more than it has on deposit.
Belief in this system is reinforced in countries that set a minimum reserve requirement - i.e. fixing by law the lowest ratio of central bank reserves to bank money. This sets a limit on the amount that a bank can lend as a multiple of its reserve, and the lower the reserve requirement the more likely it is that banks will be unable to pay depositors who want to take their money out.
Banks don't operate in either of the above ways, they operate by credit creation - i.e. banks create new money both individually and collectively and are not restricted in the amount they lend by what has already been deposited. It is known as the endogenous money theory - 'endogenous' means 'coming from within', in this case from within the economy itself as opposed to being supplied from outside, which would be referred to as 'exogenous'. Most of the money is created when a person or organisation takes on a debt - it is the debt obligation to the bank that is the trigger for new money to come into existence. In countries where there are reserve requirements banks are free to create money first, and obtain the reserves afterwards, by borrowing from the central bank, from other banks or from the money markets. [162] As with the fractional reserve system many people in effect have claims on the same money - they all think they have access to the same cash reserve, so again if they all want their money in cash at the same time then the system collapses.
In fact there are two forms of 'cash', cash itself as we all know it and 'reserves', which are a form of electronic cash, issued in the UK by the BoE. BoE reserves are freely exchangeable by banks for cash and vice versa. Reserves are only used by banks, the BoE, the government and a few other organisations that need access to them. They are not available to the general public because the public has no need for them. The story of how reserves came into being is discussed in more detail in chapter 41. Both cash and reserves are the most secure forms of money because they are guaranteed by the state.
In this system there is no need for any concern about whether bank money is owned outright or has already been lent, because almost all bank money has been lent - most of it only comes into existence by being lent - although the term 'lent' isn't appropriate for newly created money as will be seen later. Occasions when bank money is created other than in return for debt obligations are as follows:
i. when banks buy things for themselves; pay their employees, managers, and directors; and pay dividends to shareholders. All they do is credit the relevant bank accounts, either by a keyboard entry if their accounts are with the bank in question or by sending reserves to another bank if not, and the other bank then creates bank money and credits their accounts. However this gives the impression that banks can create as much money as they want and spend it for their own purposes, but this isn't the case. Bank money created by a bank for its own purposes merely offsets some of the other bank money that is destroyed when interest payments are received from borrowers, so it doesn't increase the overall supply of bank money, and the interest it receives is bank money that was created in return for another loan agreement to a bank, though not necessarily the bank that receives the interest. In effect a bank's own purchases are funded by interest, or if there isn't enough interest then the shareholders have to fund it, so there is no net creation of bank money in these cases. These transactions are explained more fully in chapter 44.
ii. when the BoE creates reserves and uses them to buy things in the economy in open market operations[163] or quantitative easing. When the reserves are sent to bondholders' banks in return for bonds, the banks credit the bondholder's accounts with new bank money.
The only way that banks, on their own, create money is by simultaneously creating debt.
Credit creation is the true basis of bank operation and all debate on the subject should have ended when the BoE published its paper and videos[164] describing exactly how the system works. Old beliefs die hard however so the earlier discredited theories are still in widespread circulation.
An easier way to understand bank money - at least I find it so - is to regard it as IOUs. If I have £100 in a current account then what I have is an IOU from the bank for £100 (the bank owes me £100). What's more this is an especially good form of IOU because I can spend it. Everyone has heard of Barclays or NatWest or whatever bank I use, and they know that an IOU from them is a lot better than an IOU from me which might circulate as money amongst my friends but wouldn't circulate any more widely than that. Therefore whoever gets the bank IOU will be confident that they can use it to purchase goods from anyone else so it meets all the requirements of money. When I take on a debt with a bank I give the bank a personal IOU, which they will accept subject to a string of conditions, and in return the bank gives me a bank IOU in the form of bank money which is credited to my account.
When I take on a bank debt the bank swaps my IOU to them for an IOU from them, which can be used as money.
When I spend this money it is transferred to someone else's bank account, and when they spend it is transferred again, probably being split up as well as dispersed, until fractions of it are held by probably hundreds or even thousands of different people who have never heard of me or my debt, but at all times that precise amount of bank money remains firmly tied to my loan agreement to the bank, and it exists only as long as that agreement exists. A very clear and highly recommended fifteen minute TedX talk on this subject by Mick Taylor is available at
http://www.youtube.com/watch?v=KveTVWCY4xQ.
It should be noted that banks create money, not wealth. What the banks have done is to create spending power - the ability to spend - by converting a non-spendable IOU or asset into a spendable IOU.
The fact that banks create the bulk of the money supply by simultaneously creating debt means that the economy can only have money if it has debt. This is a vitally important point - money only exists as long as debt exists.
If we want more money then we have to have more debt, if we want less debt then we have to have less money. In the current system the two are inextricably linked together.
The person paying the debt is very rarely the same person who is holding the money, but nevertheless for almost every pound that exists in a person's bank account, someone, somewhere, is paying interest on it to a bank.
Perhaps unexpectedly it is the destruction of money when debts are repaid that is normally more harmful to the economy than its creation, because money being taken out of circulation, when done in significant amounts, is what causes recessions and depressions. When people become fearful for the future for whatever reason they repay their debts, cut back on spending and avoid taking on new debts. Money destroyed in debt repayment reduces the overall money supply, so there is less money available for anyone to spend, and spending cutbacks represent other people's income that is not paid, leading to lay-offs and even more spending cuts by those laid off in a damaging downward spiral - see chapters 13 and 15. In contrast when banks are creating money it is because people are happy to take on debt, which means that they are generally optimistic about the future, and as more money enters circulation more jobs are created and everyone prospers - for a while at least until the next recession.
A common misleading statement perpetuated by banks is that they lend money. In fact they don't lend anything. In lending someone is deprived of whatever is lent for the duration of the loan. Most bank money comes into existence as a result of someone taking on a debt, and would not exist without the debt, so no-one is deprived of anything when the borrower's account is credited with bank money. The misconception is very helpful to banks however, because no-one questions whether they are entitled to interest, but interest entitlement only follows from giving up something of value for a period, whereas banks give up nothing. They are entitled to something for their service, but interest due for deprivation isn't one of them - see chapter 49. In fact something real is indeed lent when a person takes out a bank loan, but it isn't the bank that lends it - see chapter 48. Because the terms lending and borrowing are in such common usage with regard to bank money I shall continue to use them for consistency, but strictly speaking their use is inappropriate.
In considering how bank money is used it will be helpful to consider a particular bank - e.g. Barclays. All Barclays' bank money is held in bank accounts, all maintained in Barclays' computers and all positive balances owned by people other than Barclays. The money in those accounts represents money owed by Barclays to the account holders; unless the account is overdrawn in which case it is in effect negative bank money - money owed by the account holder to Barclays. In fact that is all that the account is - an electronic record of the amount owed by Barclays to a particular person or organisation, or owed by them to Barclays if overdrawn. As members of the public with bank accounts we are so accustomed to think of the money in our accounts (when not overdrawn) as something that is both useful and tangible (we can exchange it for cash which we can see and touch), which indeed to us it is, that it is hard to see it in any other way. But to Barclays it is neither useful nor tangible - Barclays can't exchange it for cash or anything else - so it can't and doesn't ever use it for itself. To Barclays it is simply a record of something owed. All Barclays does with that money is to respond to our instructions - to transfer it, add to it, or exchange it for cash.
When we and others talk about banks lending, investing or gambling with our money, we imagine that it is our bank money - the money in our bank accounts - that is being used for these purposes, but it isn't. Banks can't use a record of a debt owed by them for anything that is of benefit to them.
Banks don't use the money in our bank accounts for anything that benefits them because to the bank that money is merely a record of what the bank owes to us, and a record of what is owed can't be used for anything useful by the bank.
This point is worth emphasising because it is so widely misunderstood:
It is commonly assumed that when we have money in a bank account, that money is used productively by the bank in lending on to businesses and individuals. We think therefore that we can keep money in the bank, perhaps idle for long periods, without any concern about it being taken out of economic circulation. Yet that is precisely what is happening. Money that lies idle in bank accounts has exactly the same effect on the economy as cash hoarded in a mattress!
The misunderstanding comes from the belief that bank money is something that is being held by the banks on our behalf for safe keeping, just as goldsmiths held customers' gold for safe keeping. However nothing is held for safe keeping except the loan agreement that the original borrower signed and gave to the bank in return for a newly created record of liability, which is transferable from person to person as money.
The BoE confirmed this in their quarterly bulletin for Quarter 1 2014[165]:
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, retail 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.
What banks do is to create new money for new debts and call it lending. Although our money isn't used by banks it is nevertheless put at risk because as more money is created the amount owed by banks increases, but the amount of state-guaranteed money that they use to pay customers doesn't increase, so their ability to discharge their debts is reduced. What happens is that the ratio of bank money (bank debts to customers) to reserves (state money) rises, making individual banks and the banking system as a whole more fragile and therefore less able to withstand financial shocks, as was seen only too clearly in 2008.
Money is anything that is immediately available for spending - cash or bank money in bank current accounts. Credit cards appear to be money because they allow money to be created (if issued by a bank) or transferred (if issued by a non-bank) when it is demanded, but the credit card isn't itself money, it is a facility that permits rapid money creation or transfer. Time deposits - bank savings accounts that don't pay out for a fixed period of time - also aren't money because such deposits aren't immediately spendable. Spendable money used to buy such savings products is taken out of circulation (destroyed by the bank in return for the time deposit - reducing the bank's liability) for the duration of the saving period. Some savings accounts allow immediate withdrawal on penalty of some of the interest that would have been paid. This still isn't money, but it is immediately convertible to money on demand. Although savings accounts don't contain money the money that was used to buy them is still in effect idle, in that it is taken out of circulation and only brought back when the account pays out. Therefore money 'in' savings accounts can also be considered idle money.
At this point is will be helpful to examine just what bank money really is. Let's start from something we recognise as money - cash. Cash is created by the BoE, which is an agent of the state. The BoE also creates reserves - electronic cash - which is as good as cash but much more convenient in transactions between banks, the BoE and government. Cash and reserves have their value guaranteed by the state, which is as good a guarantee as we can get now that precious metals aren't used any more.
From our point of view as account holders we know that banks respond to our instructions to exchange our bank money for cash, transfer it to another account and so on, but what do banks do when they receive these instructions? In a transfer we probably imagine that it is bank money itself that is transferred. For example Barclays might say to HSBC 'we have received an instruction to transfer £100 from John Smith's account with us to Fred Bloggs' account with you, so please credit Fred's account and we'll debit John's.' But why should HSBC take on a debt to Fred Bloggs when Barclays discharges a debt to John Smith? It would be of great help to Barclays but quite the reverse for HSBC so it doesn't happen. Instead Barclays transfers £100 in reserves to HSBC, so Barclays loses £100 in reserves but balances that by losing an equivalent debt to John Smith, and HSBC accepts a debt to Fred Bloggs but balances it by accepting £100 in reserves from Barclays. After the transaction both banks have neither gained nor lost. Similarly if we withdraw £100 in cash from our account, then our bank loses £100 in cash but balances that by reducing its bank money debt to us by £100, so again everything balances. There is a very significant point here, and it is this:
The only money that banks recognise as having real value is state-guaranteed money. Therefore we should agree with them on this - cash and reserves represent real money.
It was noted in chapter 11 that bank money never leaves the banking system. In fact it goes further than that.
Each bank has its own particular form of bank money which never leaves that bank.
Bank money from different banks never mixes; it always stays as positive or negative numbers in each bank's computers in named accounts. Transfers between banks are made with state-guaranteed money, normally reserves, not with bank money.[166] Although this basic point is worth keeping in mind and is of great importance to banks, it is not normally significant in practice to bank users because it is hidden by the payments system - the mechanism by which one person pays another using bank money, which operates as though all bank money is the same. It does become significant however when a bank is in danger of being unable to pay its debts.
Now consider how bank money comes into existence. I take out a mortgage for £100,000 which I owe to my bank, Barclays for example, and in return my bank acknowledges a debt of £100,000 to me, which they do by recording that debt as an entry in my account at the bank. That is bank money. Note that no more cash has come into existence as a result of my new mortgage, and Barclays hasn't paid me anything, they just acknowledge that they owe me £100,000 and that acknowledgement is bank money. When I buy a house with it £100,000 in reserves is transferred from Barclays to the house seller's bank, which for example might be HSBC. At the same time a customer of HSBC also takes out a £100,000 mortgage, and £100,000 in reserves is transferred from HSBC to the house seller's bank which happens to be Barclays. At the end of these transactions no reserves have moved - they went from Barclays to HSBC but promptly came back again - but £200,000 in bank money has been created - out of thin air! Banks are granting loans to lots of people all the time, for mortgages, cars, furniture, holidays, investments and so on, and cash is being withdrawn from accounts and paid into accounts all the time, so the only reserves that are transferred between banks or lost or gained by them from withdrawals and deposits is the small residual amount needed after all balancing transfers have cancelled out at the end of each settlement period. In our simple example above nothing at all was transferred. In practice it has been found that about thirty times as much bank money can be created as is required in reserves, because the residual transfers are so small.
So what do we now know? Four things:
i. bank money is no more than a record of what banks owe to account holders;
ii. banks promise to pay all owed money in cash (real money) on demand;
iii. banks owe account holders vastly more than they have available as cash or reserves; and therefore
iv. banks can't possibly pay what they owe.
So now we know what bank money is - an illusion! And like all illusions it doesn't exist. But here's the trick: as long as we believe that bank money exists, it behaves as though it does exist! More than that, even though you and I know that it isn't real we shall still go on using it, because in order to live a normal life we and everyone else must pretend that it is real. Indeed the economy can only function provided that we and everyone else maintain the pretence that it is real!
Cash is real money, bank money is pretend money.
The banking system as a whole does its best to maintain the pretence by lending reserves on a short-term basis between member banks, the BoE does its best too by acting as lender of last resort, and the government does its best by guaranteeing the value of the first £75,000 of each depositor's money in a single banking institution. Only the government guarantee carries any weight in a crisis however because banks soon stop lending to other banks if they think they may be in trouble, and the BoE stops lending if it thinks the bank's assets aren't worth what the bank hopes they are. Also the government's guarantee doesn't mean that £75,000 of every depositor's bank money is real money, it merely means that if a particular bank fails the government will pay £75,000 to a sound bank which will credit the depositor's new account with that amount. This gives security to the depositor, but it gives even more security to the bank, because in reality it is always less expensive for the government to save a failing bank than to pay out depositors. In effect therefore the government guarantees all bank money (Jackson and Dyson 2012 pp91-94).
Every so often banks' inability to pay becomes so evident that we can't go on pretending any more, and then the government (i.e. the taxpayer) must step in to save not only the bank but the banking and financial system as a whole.
It is a mystery how the authorities can possibly believe that this is a good basis on which to finance the economy. A banking licence legalises activities that if anyone else carried them out would be fraud. If you or I did what banks do we would go to jail, and rightly so.[167] But fraud is deception whether legalised or not, and deception on this scale is bound to be found out, and is, at regular intervals, leaving a trail of damage in its wake that is very real.
As well as current accounts banks also offer savings accounts (time deposits as discussed above), where an attractive rate of interest is payable, usually for a fixed period of time, to induce people to save in this way. It is tempting to assume that the money banks receive in return for setting up these accounts is lent to borrowers, but it isn't, instead it is a bank debt that is bought with money when it is taken out, but isn't money while it lasts, because it isn't immediately spendable. Banks like people to invest in savings accounts because they improve bank security - they exchange short-term liabilities for longer-term liabilities - so they help banks in matching incoming reserves with outgoing reserves, which is the cash flow balancing act that all banks have to undertake on a day-to-day basis. Often there are interest penalties if these investments are cashed in early, the aim being to discourage early cashing in or transfer. The bank also hopes the customer will keep the account after the good rate has expired as this costs the bank much less, and it is largely successful in this because people tend not to cash them in if they don't immediately need the money.
An irony is that as we have seen (chapter 23) the quantity of money required in an economy is that which supports the totality of transactions that the economy wishes to undertake within a given period of time, taking account of the rate of spend (MV = PT). However the amount of money that the economy gets (by far the most money in the economy is bank money) is determined by the totality of banks' lending policies, which may be more (during the expansionary phase of the business cycle) or less (during the contractionary phase) than is really required, but seldom and only by chance is it ever exactly equal to what it