Where Does Money Come from ? banking, credit, finance, money creation

banking, credit, finance, money creation – updates

Bernard Lietaer used to start his presentations with this multiple choice:

1) governments 2) central banks 3) private banks

He stopped maybe because his typical audience now points to (3). But beyond the marginalized fringe of money reformers we still live in a world where 80% of the UK population, and 84% (!) of MP’s  do not know this. Nor are they likely to believe it when told.

These days you can google “money creation” and find mountains of evidence. Arguably that’s only because following the 2008 crisis the Bank of England thought it prudent to confirm that yes, private banks do “create” money. Not exactly “ex nihilo” but on account of  valuing something like an asset or future earnings.


“ Refreshing and clear . The way monetary economics and banking is taught in many — maybe most — universities is very misleading and what this book does is help people explain how the mechanics of the system work . ” David Miles , Monetary Policy Committee , Bank of England

“ It is amazing that more than a century after Hartley Withers’s ‘ The Meaning of Money ’ and 80 years after Keynes’s ‘ Treatise on Money ’ , the fundamentals of how banks create money still need to be explained . Yet there plainly is such a need , and this book meets that need , with clear exposition and expert marshalling of the relevant facts . Warmly recommended to the simply curious , the socially concerned , students and those who believe themselves experts , alike . Everyone can learn from it . ” Victoria Chick , Emeritus Professor of Economics , University College London

“ I used ‘ Where Does Money Come From ? ’ as the core text on my second year undergraduate module in Money and Banking . The students loved it . Not only does it present a clear alternative to the standard textbook view of money , but argues it clearly and simply with detailed attention to the actual behaviour and functioning of the banking system . Highly recommended for teaching the subject . ” Dr Andy Denis , Director of Undergraduate Studies , Economics Department , City University , London

“ By far the largest role in creating broad money is played by the banking sector . . . when banks make loans they create additional deposits for those that have borrowed . ” Bank of England ( 2007 )

Many people would be surprised to learn that even among bankers, economists, and policymakers, there is no common understanding of how new money is created.

This is a problem for two main reasons. First, in the absence of this understanding, attempts at banking reform are more likely to fail. Second, 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. Greater clarity and transparency about this could improve both the democratic legitimacy of the banking system and our economic prospects.

Defining money is surprisingly difficult. We cut through the tangled historical and theoretical debate to identify that anything widely accepted as payment, particularly by the government as payment of tax, is, to all intents and purpose, money. This includes bank credit because although an IOU from a friend is not acceptable at the tax office or in the local shop, an IOU from a bank most definitely is.

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

  1. Cash – banknotes and coins.
  2. Central bank reserves – reserves held by commercial banks at the Bank of England.
  3. Commercial bank money – bank deposits created either when commercial banks lend money, thereby crediting credit borrowers’ deposit accounts, make payments on behalf of customers using their overdraft facilities, or when they purchase assets from the private sector and make payments on their own account (such as salary or bonus payments).

Only the Bank of England or the government can create the first two forms of money, which is referred to in this book as ​‘central bank 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 money in the economy. Commercial bank money – credit and coexistent deposits – makes up the remaining 97 per cent of the money supply.

There are several conflicting ways of describing what banks do. The simplest version is that banks take in money from savers, and lend this money out to borrowers. This is not at all how the process works. Banks do not need to wait for a customer to deposit money before they can make a new loan to someone else. In fact, it is exactly the opposite; the making of a loan creates a new deposit in the customer’s account.

More sophisticated versions bring in the concept of ​‘fractional reserve banking’. This description recognises that banks can lend out many times more than the amount of cash and reserves they hold at the Bank of England. This is a more accurate picture, but is still incomplete and misleading. It implies a strong link between the amount of money that banks create and the amount that they hold at the central bank. It is also commonly assumed by this approach that the central bank has significant control over the amount of reserves banks hold with it.

We find that the most accurate description is that banks create new money whenever they extend credit, buy existing assets or make payments on their own account, which mostly involves expanding their assets, and that their ability to do this is only very weakly linked to the amount of reserves they hold at the central bank. At the time of the financial crisis, for example, banks held just £1.25 in reserves for every £100 issued as credit. Banks operate within an electronic clearing system that nets out multilateral payments at the end of each day, requiring them to hold only a tiny proportion of central bank money to meet their payment requirements.

The power of commercial banks to create new money has many important implications for economic prosperity and financial stability. We highlight four that are relevant to the reforms of the banking system under discussion at the time of writing:

  1. Although useful in other ways, capital adequacy requirements have not and do not constrain money creation, and therefore do not necessarily serve to restrict the expansion of banks’ balance sheets in aggregate. In other words, they are mainly ineffective in preventing credit booms and their associated asset price bubbles.
  2. Credit is rationed by banks, and the primary determinant of how much they lend is not interest rates, but confidence that the loan will be repaid and confidence in the liquidity and solvency of other banks and the system as a whole.
  3. Banks decide where to allocate credit in the economy. The incentives that they face often lead them to favour lending against collateral, or assets, rather than lending for investment in production. As a result, new money is often more likely to be channelled into property and financial speculation than to small businesses and manufacturing, with profound economic consequences for society.
  4. Fiscal policy does not in itself result in an expansion of the money supply. Indeed, the government has in practice 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.

The basic analysis of Where Does Money Come From? is neither radical nor new. In fact, central banks around the world support the same description of where new money comes from. And yet many naturally resist the notion that private banks can really create money by simply making an entry in a ledger. Economist J. K. Galbraith suggested why this might be:

“The process by which banks create money is so simple that the mind is repelled. When something so important is involved, a deeper mystery seems only decent.”

This book aims to firmly establish a common understanding that commercial banks create new money. There is no deeper mystery, and we must not allow our mind to be repelled. Only then can we properly address the much more significant question: Of all the possible alternative ways in which we could create new money and allocate purchasing power, is this really the best?


My highlight excerpts

Page 31 3. The Nature and History of Money And Banking

Hence , in orthodox economic theory , the demand for money can be understood almost entirely through its marginal utility . 17 And this was presumed to be relatively constant , in the long run at least , since money was simply representative of the value of other ‘ real ’ commodities . * Hence money was built in to models of general equilibrium with the concept of its neutrality effectively maintained . Mainstream macro – economic models today treat money this way , by including a ‘ money – in – utility ’ function that attempts to show why people desire money , whilst preserving its neutrality . 18

Page 32 3.2. Commodity theory of money: money as natural and neutral

Think about any of the successful entrepreneurs you know . You will probably find that most of them started out with very little money and had to get loans from the bank , friends , or family before they could begin selling their services or products on the market . As Marx pointed out , in the capitalist system , money ( or capital / financing ) is required prior to production , 26 rather than naturally arising after production as a way of making exchange more convenient . This is why it is called ‘ capital – ism ’ . So building a model that starts with market clearing and allocation and then tries to fit in money as a veil on top of this makes little sense .

Page 33 3.3. Credit theory of money: money as a social relationship

The orthodox economics narrative rests upon deductive * assumptions about reality that enable the construction of abstract models . 30 In contrast , researchers who have chosen a more inductive approach , investigating empirically how money and banking actually works , have been more likely to favour the view that money is fundamentally a social relation of credit and debt . These researchers of money come from various academic disciplines . They include : heterodox economists ( including some early twentieth – century economists ) , anthropologists , monetary and financial historians , economic sociologists and geographers and political economists . 31 , 32 , 33 , 34 , 35 , 36 In fact , the only thing they have in common in terms of their academic discipline is that they are not neo – classical economists .

Page 34

The historical record suggests that banking preceded coined money by thousands of years . Indeed , historical evidence points to the written word having its origins in the keeping of accounts . The earliest Sumerian numerical accounts consisted of a stroke for units and simple circular depression for tens . 39

Page 35

Money originated then , not as a cost – minimising medium of exchange as in the orthodox story , but as the unit of account in which debts to the palace , specifically tax liabilities , were measured . 46 , 47

Page 40 3.4. Key historical developments: promissory notes, fractional reserves and bonds

The state’s informal and eventually legal acceptance of goldsmiths ’ fictitious deposit receipts increased the state’s spending power and allowed the creation of modern commercial bank money . Commercial bank money was already in use in seventeenth – century Holland and Sweden and it was now developed in England . These countries were engaged in wars at the time and were short of money . As a result , they took to issuing bonds ( Box 3 ) to the rich merchants and goldsmiths of their respective countries . The practice of bond issuance had begun much earlier in the city states of northern Italy and was another transformative financial innovation – a way for the state and later companies to fund expansionary trade through long – term borrowing without the need for additional metal coinage . 75

Page 41

Parliament and creditors of the state ( namely the merchants and goldsmiths of the Corporation of London ) lobbied for the creation of a privately owned Bank with public privileges – the Bank of England – and the secession of one square mile of central London as a quasi – sovereign state within the state . * The merchants loaned £ 1.2 million to the state at 8 per cent interest , which was funded by hypothecated customs and excise revenues . 77 The English state had begun to issue bonds and borrow at interest and for the first time , the state committed a proportion of its tax revenues towards the interest payments on long term debts . 78 This system of private credit creation superseded the former system of public money issuance in the form of tallies issued by the Treasury .

Page 42 3.5. Early monetary policy: the Bullionist debates and 1844 Act

The new integration of the state and its creditor class proved to be successful for England and is often held up as one of the key reasons for its defeat of France in the war that followed and for the expansion of English commercial , trade and military power . 80 , 81 It was a model that was eventually imitated over much of the rest of the Western world .

Page 43

However , importantly , the Act exempted demand deposits – the accounting entries that banks made either when people deposited money with them or , more likely , were created as a result of borrowing – from the legal requirement of the 100 per cent gold reserve backing . We have seen how fractional reserve banking allowed banks to lend multiples of the amount of gold in their vaults . Similarly , they could create new bank deposits through lending or purchasing assets , which were multiples of the amount of now restricted banknotes . Because these account balances were technically a promise by the bank to pay the depositor , they were not restricted by the Act in the same way that banknotes were . This meant that the country banks were able to create them without breaking counterfeiting laws .

Page 44

No doubt the failure to include demand deposits in the 1844 Act was also related to the strength of the commodity theory of money.

Transaction deposits are the modern counterpart of banknotes . It was a small step from printing notes to making book – entries crediting deposits of borrowers , which the borrowers in turn could ‘ spend ’ by writing checks , thereby ‘ printing ’ their own money . 92 The result was that the 1844 Act failed to stop fractional reserve banking – the creation of new money by private banks . It merely led to a financial innovation in the medium of exchange . At the same time it made the ability of banks to create money out of nothing far less visible : while it is more obvious in Scotland and Northern Ireland , where banks continue to issue paper money carrying their own branding , the general public in England and Wales has no daily reminder of the banks ’ role as the creators of the money supply . This has served to perpetuate the myth – widespread even today – that only the central bank or possibly the Government can create money .

Page 51 3.6. Twentieth century: the decline of gold, deregulation and the rise of digital money

A review of the arguments at the time makes clear that the theoretical support for such deregulation was based on the unrealistic assumptions of neoclassical theoretical economics , in which banks also perform no unique function and are classified as mere financial intermediaries just like stockbrokers . This does not recognise their pivotal role in the economy as the creators of the money supply .

Page 61 4. Money and Banking Today

4.1. Liquidity, Goodhart’s law, and the problem of defining money

Economist Charles Goodhart argued that defining money was inherently problematic because whenever a particular instrument or asset was publicly defined as money by an authority in order to better control it , substitutes were produced for the purposes of evasion5

Page 80 4.7. Managing money: repos, open market operations, and quantitative easing (QE)

Werner has argued that after banking crises one can reduce interest rates to zero or below and this will not produce an economic recovery , since interest rates are not the determining factor of bank credit creation .

Page 83

All three channels are indirect , and all attempt to stimulate the real economy by acting through the financial sector . So , bond purchase operations and QE do not involve creating ( or ‘ printing ’ ) money if by ‘ money ’ , we mean more money in the real economy that is being used in GDP – related transactions . Although it may well have pushed down medium to long term interest rates and made it easier for the Government to borrow by creating significant additional demand for gilts , since at least 2010 the main criticism of QE has been that it has failed to stimulate bank lending in the real economy . Bank credit creation shrank in 2011 and the UK economy moved into a double – dip recession in 2012 . †

Page 103 5. Regulating Money Creation and Allocation

5.5. Endogenous versus exogenous money

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

Page 104

Thus , there are inconsistencies when attempting to describe the money creation process as purely endogenous . Whether the central bank is able to influence money creation depends very much on how it chooses to intervene .

Page 106

As US economists Jaffee and Russel showed in 1976 and as Stiglitz and Weiss showed in 1981 , banks prefer to ration and allocate credit – even in the best of times . 37 Paul Tucker , Deputy Governor of the Bank of England , appears to agree : . . . [ households and companies ] . . . are rationed in their access to credit , given that borrowers know a great deal more about their conditions and prospects than do risk – averse lenders , and that lenders face obstacles in ensuring that borrowers honour their contracts . 38

5.6. Credit rationing, allocation and the Quantity Theory of Credit

An interesting example of how credit rationing affects the macro – economy arises when comparing banks ’ incentives for mortgage lending vis à vis lending to small business .

Page 109

12 : The Quantity Theory of Credit The link between money and the economy is a central pillar of economic theories and models . The ‘ equation of exchange ’ offers such a fundamental link , as it says that The amount of money changing hands to pay for transactions is equal to the value of these transactions . The most common application in most major economic theories is as follows : MV = PY which says that money ( M ) times the speed of its circulation ( velocity – V ) is equal to prices ( P ) times nominal GDP ( Y ) *

Page 109

When combined with further assumptions , this equation has become known as the ‘ Quantity Theory of Money ’ . 48 An important assumption is that velocity is constant or at least stable . However , empirically velocity has been unstable and since the 1980s has frequently and significantly declined in many economies . The net result is a lack of reliable or predictable links between measures of money and nominal GDP . Consequently , economic theories that do not include money or banks increased in popularity and came to dominate mainstream economics ( as explored further in section 2.2.2 ) . However , such theories and models have been much criticised since the financial crisis of 2008. 49 , 50

Page 110

Based on empirical observation and institutional analysis Werner argues that banks ration credit and hence the credit supply is the driving variable .

Page 112 5.7. Regulating bank credit directly: international examples

Detailed research on the efficacy of window guidance by the Bank of Japan has shown that this monetary policy tool has always worked extremely effectively , even when the goals set by the central bank were the wrong ones , such as the expansion of financial and speculative credit in the 1980s . In other words , credit guidance is an effective tool , although this is no guarantee that the policy goals selected will be the right ones . 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 .

6. Government Finance and Foreign Exchange

Page 119 6.1. The European Union and restrictions on government money creation

While the issuance of government money to fund fiscal expenditure is often thought to be inflationary , this need not be the case , especially if limited by the amount of money – supply expansion needed to reach the growth potential of the economy .

Page 122 6.2. Government taxes, borrowing and spending (fiscal policy)

If the Government is running a deficit , then spending outflows exceed tax inflows . To make the account balance , the difference can be made up by the issuance of government money – a practice not adopted since before 1945 ( see section 7.6.3 ) – or else must be made up through government borrowing . The government borrows primarily by issuing government bonds , or ‘ gilts ’ ( see section 3.4.3 , box 3 ) . Because the Government is perceived to be the safest borrower available as it need never default on debt denominated in its own currency ( for reasons explained above ) , government bonds are usually sold with ease to investors .

Page 137 7. Conclusions

It is the ability of banks to create new money , independently of the state , which gave rise to modern capitalism and makes it distinctive . As political economist Geoffrey Ingham describes it , following Joseph Schumpeter : The financing of production with money – capital in the form of newly created bank money uniquely specifies capitalism as a form of economic system . 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 system . 1

Page 138 7.1. The history of money: credit or commodity?

However , 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 tax – payer .

Page 139 7.2. What counts as money: drawing the line

A further difficulty in defining money arises from the tension between its role as a means of exchange – where the more liquid the better – and its role as a store of value , where generally assets which are less liquid , such as homes , tend to hold their value more effectively against inflation . 6 It may be that different conceptions of money are partly driven by the relative importance that people place on the different functions of money at different times – whether they consider its usefulness as a store of value to be the most important aspect , or its usefulness and availability as a means of exchange . This tension merits further research , because it points to the possibility that no single form of money will perform all the functions of money equally well .

Page 139 7.3. Money is a social relationship backed by the state

Money is a social relationship backed by the state 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 , the 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 .

Page 141 7.4. Implications for banking regulation and reforming the current system

As the Quantity Theory of Credit shows , fiscal policy does not in itself result in an expansion of the money supply . Indeed the Government has in practice 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 .

Page 143 7.6. Are there alternatives to the current system?

the type of QE policies adopted do not appear to have been effective in boosting GDP growth and employment , as the additional purchasing power remains within the financial sector when bank and investor confidence is low ( see section 4.7.3 on QE ) .

Page 144

Historically , there are many examples of states directly creating money and putting it in to circulation free of interest . * Indeed , prior to the invention of modern banking at the end of the seventeenth century , most states used simple accounting techniques such as tally sticks in the UK ( see section 3.3.1 ) , minted coins or printed paper money to fund their activities and ensured their widespread adoption through taxation . 27 , 28 , 29 There are also numerous historical examples of governments funding fiscal shortfalls through the issuance of government money .

Page 145

A range of leading economists , including Irving Fisher33 , Milton Friedman34 , Henry Simons35 , James Tobin36 and Herman Daly37 have argued that a banking system where only the Government is permitted to expand the money supply would be more stable and could be implemented by instituting a 100 % reserve requirement on bank accounts , with banks then playing a true intermediary role of matching savers and borrowers in the way that peer – to – peer lenders now do .

Page 146

Many naturally resist the notion that private banks can really create money by simply making an entry in a ledger . Economist J . K . Galbraith suggested why this might be The process by which banks create money is so simple that the mind is repelled . When something so important is involved , a deeper mystery seems only decent. Where Does Money Come From ? categorically establishes that there is no deeper mystery . We therefore must not permit our minds to be repelled , because 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 .

banking, credit, finance, money creation – updates

see also

Ann Pettifor’s “The Production of Money” review

Richard Werner “Three theories of banking”

youtube   2015 Banks don’t lend money, they create it: Demystifying monetary and banking terminology by Ib Ravn

paecon.net/RWER97pdf 2021 How financial bubbles are fueled by money creation a.k.a. bank lending: An explanation for public education – by Ib Ravn

JoEEg/pdf 5-2022 Examining modern money creation: An institution centered explanation and visualization of the “credit theory” of money and some reflections on its significance – by Andrew Hook

ABSTRACT – Despite recent clarifications by central banks that it is indeed commercial banks that are the main creators of the money supply, money creation processes remain as confusing and opaque as ever to many. This article develops a simplified macro-visual diagram of today’s money system based on the increasingly accepted “credit theory” of money creation. It aims to explain not only how money is created and which institutions have the authority to create it; it also aims to discuss the implications of this understanding of money creation for wider issues, such as political sovereignty, inequality, and socio-economic development. Ultimately, it aims to provide a pedagogical resource upon which both technical and normative discussions about our current money system among academics, activists, and students can be based

springer.com 2021 On the money creation approach to banking – Salomon Faure & Hans Gersbach

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