The Uneconomics guide to money creation

In it's latest book, "Where does money come from?", the New Economics Foundation provides one of the sharpest accounts of money creation in recent times. Can your high street bank really create money?
Oliver Huitson
17 February 2012

In it's latest book, "Where does money come from?" by Josh Ryan-Collins, Tony Greenham and Richard WernerNEF provides one of the sharpest accounts of money creation in recent times. Can your high street bank really create money?

Banking was conceived in iniquity and was born in sin. The bankers own the earth. Take it away from them, but leave them the power to create money, and with the flick of the pen they will create enough deposits to buy it back again. (Josiah Stamp, former Director of the Bank of England)

It is one of the great mysteries of the world. Ask ten different economists, bankers and politicians and you’ll get ten different answers. No metaphysical dilemma about bankers on pinheads, the question and answer should be relatively straightforward; it’s a physical process that happens thousands of times a day. Can banks really create money?

Within certain bounds, definitions and constraints - yes. The latest book from the New Economics Foundation, Where does money come from?, is one of the clearest accounts you’ll find of both our monetary system and the unique role our banks play. Studiously researched, accessible, measured, it is recommended reading for anyone with an interest in how our economy operates and it’s worth setting out their argument in some detail. How, then, does your bank create money?



First off, it needs to be understood what money is. To a great degree, money is as money does. Overcoming the time constraints of the barter system, it must act as a store of value, the function Locke would condemn as the root of greed, the enabler of limitless appropriation. Additionally, negating the “coincidence of wants” problem of barter, money must be an accepted medium of exchange and a divisible and reliable unit of account. Anything which meets certain basic requirements can function as money, from inmates’ cigarettes to cowry shells. One commodity is merely expressed in terms of another.

The problem with the simple commodity theory of money, as NEF explore, is that money itself is effectively removed the model, a mere “veil” under which the true economy operates. On the wider theoretical problems the model throws up, that “the assumptions are so far fetched that they fatally undermine the model” is hardly surprising; this is, after all, economics. More critically, no account is made of how money comes into being. Finally, we no longer even use commodity money. Our modern banknotes and digital account balances are fiat currency (from the Latin, ‘let it be done’), their value is given not by any inherent utility but by the sovereign’s decree; ultimately, the value of £10 rests only on social agreement rather than a claim to any underlying commodity. As NEF argue, money must be understood as a social relation: the credit theory of money. In the creation of money, credit is everything.

on a £10 note it states that ‘I promise to pay the bearer on demand the sum of ten pounds’. It appears this money is a future claim upon others – a social relationship of credit and debt between two agents. (NEF)

As a means of payment, the £10 note then is merely the transfer of a debt, a claim on the Bank of England, from buyer to seller. Where does your bank come into it, and where does the magic happen?

Banking models

NEF cite a survey showing a full 33 percent of the public believe banks make no use of the money in their customers’ current accounts, the “safe-deposit box” model. The same poll found 61 percent of the public supporting the more realistic “intermediary” model of banking: banks take deposits and lend them to borrowers, making their profit on the ‘spread’ - the difference between the interest charged to borrowers and the interest paid to savers. Intermediating across both time and space, savings in Glasgow can fund loans in Bournemouth and long term savings can fund short term borrowing needs. To see where this model breaks down, and how our modern system functions, you first need to travel back a few hundred years: the goldsmiths.

Custodians of precious bullion and stones, the goldsmiths’ vaults became a popular choice for depositing valuables. The ‘deposit receipts’ issued were simply acknowledgements of a deposit. Over time, it became “a lot easier to simply use the deposit receipts directly as a means of payment. The banker’s deposit receipts effectively became a medium of exchange…” (ibid, p36). Looking at the deposits they had amassed, the goldsmiths soon realised that at any given time only a small portion of the deposits they held – their ‘liabilities’ to customers – would be called in. So they began to loan it out, with interest.

Because the deposit receipts themselves were being used as means of payment, rather than the gold in the vault, the goldsmiths learnt that they could simply issue deposit receipts as loans rather than actual gold. Critically, receipts were issued not just to those depositing money but also those borrowing money. By this process the total value of a goldsmith’s loans could greatly outweigh the deposits in the vault. What they retained was merely a fraction of their loans to cover those few customers who physically withdrew their holdings. “Fractional reserve” banking had arrived. As NEF point out, this is ultimately a deceit, legal fraud, yet it is the foundation of modern banking. The deposit receipts’ claim that Mr Smith held an ounce of gold was untrue:

No deposit had been made and the gold was not there. The receipts were fictitious – they were pure credit and had nothing to do with gold. But no one could tell the difference between a real deposit receipt and a fictitious one. (ibid, p.37)

It is by this process that money is created, a £1000 loan is simply written on a piece of paper with the flick of the pen or, in the modern context, keyed into someone’s bank account. That’s it.

In Galbraith’s famous words, the mind is indeed “repelled” at its simplicity. Banking works as long as everyone believes it does; we accept a payment – a debt – because we know others in turn will accept it as payment. The dept itself never need be called in as long as everyone remains confident that it could be. When that confidence goes, as happened to Northern Rock in 2007, the system collapses because it is based on a fiction – the £1000 isn’t there, and it never was.

But commercial bank credit isn’t really money, critics argue, credit is something entirely different. So we must have in our economy a sizable amount of ‘real money’. As the book explains, we ultimately have three kinds of money in our economy. Firstly, and most simply, cash – notes and coins. Secondly, we have money that no one ever sees or spends: central bank reserves, held by the Bank of England on behalf of the commercial banks (more of which later). Thirdly, we have bank deposits created by those commercial banks and included by the Bank of England as part of the money supply (M1 to M4). This final type, commercial bank money, doesn’t make up just a fraction of our money supply but a full 97.4 percent of it (ibid, p.16). Credit creation as money creation is even endorsed by central bankers themselves:

Given the near identity of deposits and bank lending, Money and Credit are often used almost inseparably, even interchangeably… (Bank of England, 2008, ibid, p18)

Each and every time a bank makes a loan, new bank credit is created – new deposits – brand new money. (Graham Towers, 1939, former Governor of the Central Bank of Canada, ibid, p18)

Between the central bank and the government the system must surely be under close supervision, but in recent times, however, both have played an increasingly distant “light touch” role.


The central bank

Established in 1694, the Bank of England would both act as banker to the government and solidify the fragmented banking system operating at the time. Critically, the promissory notes (deposit receipts) of private institutions could then be redeemed at the Bank of England for state-backed money (at a discounted rate). In practice, promissory notes had become only marginally different to money itself. Today, private banks retain state support in two important ways. Firstly, the Bank of England’s role as “lender of last resort” sees it stand behind banks when all other avenues fail. In addition, the Financial Services Compensation Scheme means that:

Not only are [banks] allowed to create money and allocate purchasing power, but someone else guarantees to pay their liabilities for them if they are unable to. That someone else is you, the taxpayer, via the government. (ibid, p.69)

The taxpayer effectively guarantees the first £85,000 of deposits held at any UK bank. Private, profit-geared institutions have the ability to create state-backed deposits from thin air. In terms of keeping the banking system stable and functioning the central bank has a number of tools for regulating the money supply, primarily the reserve requirement: the proportion of a deposit that must be retained (the rest may in turn be loaned out, as below). The central bank then, presumably, retains close control over money creation.

The multiplier model

To go from 2.6 percent cash up to a full blown money supply some serious multiplication is going on somewhere. As NEF sets out, the standard model does a lot of the explanatory work here but is undone primarily by changes in banking systems over the last four decades. For example:

Mr Smith deposits £1,000 into his Barclays account. Knowing the usual tendencies of their customers, the bank holds back only a fraction of this deposit as ‘reserves’ (the reserve ratio functions as a brake on the scale of money creation – the higher the reserve level the less new money can be created from a given deposit). With a reserve ratio of 10%, £100 of Mr Smith’s deposit is retained and the other £900 is “leant out”. Or rather, since it still appears under Mr Smith’s assets as a full £1,000, the £900 is created and leant to Mr Jones who now has £900 in his account. £1,000 just became £1,900. Upon purchasing a new television, Mr Jones’ £900 loan is now deposited into the sellers HSBC account. HSBC in turn will hold back only a fraction of the £900 deposited, 10%, and loan out the remaining £810. The initial £1,000 deposit is now £2,710. And so on. After 204 cycles, £1,000 becomes £10,000 of bank deposits - money.

The problem, NEF continues, is that the textbook model above suggests some important constraints and functions which are not necessarily applicable in the modern setting. Chronologically, the process of taking in deposits and using them to create loans leaves an impression far closer to the “intermediary model” of banking than is accurate; the bank doesn’t need a deposit to create a loan. Furthermore, the emphasis on the role of the reserve ratio suggests a much greater deal of control on the part of the central bank or government than they exercise in practice. Finally, the model is a closed system; a given deposit can only be multiplied so far under diminishing returns. By controlling the monetary base (cash plus central bank reserves) and the reserve ratio - the amount of deposits that can be created from that base - the money supply can be strictly controlled. It is in highlighting the problems with this idea that NEF’s book comes to the fore. Rather, they argue, the creation of commercial bank deposits (loans) rests only on the bank’s confidence in the borrowers’ ability to repay.

Central bank control on money creation

Going back to the three forms of money, the first two represent base money: cash (notes and coins) and central bank reserves. These reserves, like commercial bank money, are simply numbers, held on account at the central bank. The purpose of the system is firstly to settle inter-bank payments: if our Mr Smith pays £100 from his HSBC account to Mr Jones’ Barclays account, £100 of HSBC’s central bank reserves may simply be transferred electronically to the Barclay’s reserve account. Each day, then, banks must retain enough reserves to facilitate their interbank payments.

In addition to maintaining the interbank clearing process, central bank reserves function to control the money supply by altering the portion of any deposit which must be retained (with a zero reserve requirement, banks could create as many deposits as they chose without constraint). In theory, by setting the level of reserves that must be held with the central bank the overall money supply can to a great degree be controlled.

Problems with the model

Firstly, the UK does not currently have a formal reserve ratio requirement; it was abolished in 1981 by Conservative Chancellor, Geoffrey Howe, because it “complicated monetary control”. Instead, we enjoy a voluntary scheme which has led to reserves being held at around just 3 percent. Rather than a means by which the central bank limits credit creation, banks need only enough reserves to meet their daily clearing requirements. Reserve requirements do not overly inhibit their lending decisions:

Subject only but crucially to confidence in their soundness, banks extend credit by simply increasing the borrowing customer’s current account, which can be paid away to wherever the borrower wants by the bank “writing a cheque on itself”. That is, banks extend credit by creating money. [my bolds] (Paul Tucker, Deputy Governor at the Bank of England and member of MPC, 2007, ibid, p.22).

On a given day, substantial levels of inter-bank lending will simply cancel each other out, requiring no change in the central bank reserves they hold. Due to the uncompetitive nature of British banking (effectively a cartel, as became clear during the overdraft charges furore), considerable lending takes place within banks: one Lloyds customer paying another. Again, the reserves may sit untouched. Prior to 2008, ‘the banks had £1.25 in central bank money for every £100 of customers’ money’ (ibid, p.69).

…rather than the Bank of England determining how much credit banks can issue, we could argue that it is the banks which determine how much central bank reserves and cash the Bank of England must lend to them. (ibid, p.22)

Various forms of securitisation have only blown the bubble bigger: by packaging up loans and selling them for cash the scale of bank lending, and consequently their reserve requirements, is distorted. Securitisation and the wider “shadow banking system” were pivotal in the financial crisis, having ballooned to over $10 trillion in size: the description of 2007/2008 as “a ‘run’ on the shadow banking system” carries a lot of truth (ibid, p.95).


Like so much of our current problems, they can to a great degree be traced back to deregulation and liberalisation, the fascinating idea that allowing private firms - able to effectively issue state backed money – to regulate themselves and their monetary requirements would be a prudent way to manage the money supply. “Wealth creation” in the City must be defended at all costs, even Britain’s effective sidelining at the EU. But it’s a phrase rich in irony. Not only are significant portions of bank profits built on their unique privileges – hardly industrious “wealth creation” as the orator intends – but instead they are built on a rather more literal form of “wealth creation”: the ability to issue state-backed money. Understanding what money is has rarely been so important, and Geoffrey Ingham’s definition is as good as they come:

A social relation of abstract value defined by a sovereign unit of account. (ibid, 116).

Is it right for the means of money creation, the process by which over 97% of our money is created, to reside with private, profit-seeking firms – firms with worrying levels of influence on global policy making? To what ends should money creation be directed: casino operations running out the Cayman Islands or projects of more tangible social utility? Can inflation be adequately managed without direct control on the supply of credit?

NEF’s conclusions are more questions than answers, but that is not the purpose of the book, and the questions are at least pertinent. Where does money come from? is such a timely and well-constructed book it seems churlish to criticise, but there was certainly room for a more thorough account of monetary history lest the reader come away thinking our contemporary problems are in any way unique. The history of banking, from start to finish, is fraud followed by catastrophe ad infinitum. The role of both commercial and central banks surrounding the Great Depression – rampant credit creation in the 20s followed by rigid monetary policy in the 30s - merits little mention at all. In its discussion of ‘credit rationing’, supply and demand for credit seem to be treated as largely independent of one another, painting a picture of today’s problems as largely a shortfall of supply. Demand for credit is possibly less durable than suggested; the same macroeconomic outlook dampening credit supply simultaneously dampens demand – people are reluctant to borrow when they fear their ability to repay.

The book is also strangely, and perhaps intentionally, apolitical. Power and its manifestations are absent from the analysis, and money creation as a historic tool of subordination and resistance – both American and French revolutions - is mentioned only fleetingly. But NEF have left power for the polemicists. What they have provided is a highly readable and contemporary account of our monetary institutions and their central role in the modern economy. Banking is a system that runs on make-believe and survives on ignorance. Public education of the sort NEF provide is surely the best remedy.

In the 1960s, Mr George W Ball, an eminently successful lawyer, politician and diplomat, left public office to become a partner of the great Wall Street house of Lehman Brothers. “Why,” he was heard to ask a little later, “didn’t someone tell me about banking before?” (Galbraith, Money, 1975)

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