The Creation of Money
Edited by David Soori and John Courtneidge, from an article by Richard Greaves

The money loaned by banks is created by them out of nothing – the idea that all a bank does is to lend out money deposited by other people is very misleading.

MONEY IS CREATED AS A DEBT

At the moment we don’t distinguish between the £25 billion in circulation as notes and coins (issued by the government) and £680 billion in the form of loan accounts, overdrafts etc. (created by the banks).  The failure to distinguish is a big mistake.  The notes and coins are debt-free money, i.e. when it is printed/coined, the government does  not go into debt. But the loan accounts and overdrafts are interest-bearing [credit]money i.e., you have to repay it and pay interest on top as well.  Even money earned, which does not have to be repaid, is mostly available only because someone has borrowed it into existence.

The relationship between debt-free money and interest-bearing [credit]money has radically changed over time.  In 1948 we had £1.1 billion of notes and coins (i.e. debt-free money) and £1.2 billion of loans etc. (i.e., interest-bearing money) created by banks.  By 1963 the figures were £3 billion and £14 billion respectively.

Today, well over 95% of the new money supply comes from the banks as interest-bearing [credit]money – around £680 billion.  Even allowing for inflation, that’s an enormous relative and absolute increase.

How has this vast amount of bank-created money come into existence?

“The process by which banks create money is so simple that the mind is repelled.”

Professor. J. K. Galbraith

And here’s how it’s done!  (This is a simplified example).

Think of a small bank with ten depositors/savers who have just deposited £500 each.  The bank therefore owes them £5,000 and it has £5,000 with which to pay out what it owes.  (It will keep that £5,000 in an account at the Bank of England –the contents of this account are called the bank’s liquid assets).

Along comes Sid, an entrepreneur.  He asks the bank for a £5,000 loan to set up a business.  The bank agrees the loan - repayment in 12 months time @ 10% interest.  A new bank account is opened in Sid’s name and, although Sid has put in no money, he is nevertheless being allowed to withdraw and spend a £5,000 overdraft. 

It should be noted that the original depositors have not been consulted about the loan to Sid and the reason is that their money has not been lent to Sid. 

But, you will say, in granting Sid his loan, the bank has increased its obligations to £10,000 - Sid is entitled to £5,000, and the depositors can still claim their £5,000.  If the bank now has obligations of £10,000, then isn’t it insolvent because it only had £5,000 of deposits in the first place?

The answer is - not exactly!  The bank treats the loan to Sid as an asset, not a liability, on the basis that Sid now owes the bank £5,000.  The bank’s balance sheet will show that it owes its depositors £5,000, and it is now owed £5,000 by Sid.  Thus the bank has created for itself a new asset of £5,000 in the form of a debt owed by Sid where nothing existed before - and this is on top of any of the original deposits still in its account at the Bank of England.  Therefore -at least for accounting purposes- the bank is solvent! 

NB.  At this stage the bank is gambling that as Sid spends his loan, the depositors won’t all want to withdraw their deposits!  One thing, however, is very clear - the bank has created the [credit]money for the £5,000 loan out of nothing.  It is new (interest-bearing, repayable) money where none existed before.  The creation was done by the pressing of a computer key.

And isn’t that extraordinary?  The banks create money out of nothing (and then charge interest on it).  Yet if you or I created money out of nothing (let alone charged interest on it) we would be guilty of fraud, or counterfeiting or both!

New “money” into the economy...

Sid’s loan effectively becomes new “money” as it is spent by him to pay for equipment, rent and wages etc. in connection with his new business.  This new “money” is thus distributed to other people, who will in turn use it to pay for goods and services.  Very soon, the new money is circulating throughout the economy and, as it circulates, it inevitably ends up in other people’s bank accounts.

And now note something - when the new money is paid into someone’s account which is not overdrawn, it is a further deposit.  So when Sid pays his secretary £100 and she pays it into her account at our small bank, the bank now has £5,100 of deposits.  Moreover, if we assume for a moment that the remaining £4,900 ends up in the accounts of the original depositors of our hypothetical small bank, it now has another £4,900 in deposits - £10,000 in total if the depositors have not touched their original deposits.  Of course, in practice much of the new £5,000 will end up in depositors accounts at other banks, but, either way, there is now £5,000 of new “money” in circulation.

Thus in reality, all deposits with banks and elsewhere actually come from “money” originally created out of nothing as loans – (except where the deposits are made in cash – more on cash very shortly).

So you have £500 in your bank account, the fact is someone else like Sid went into debt to provide it!

The key to the whole thing is the fact that: -

1.      Cash withdrawals account for only a tiny percentage of a bank’s business.

2.      Bank customers today make almost all payments between themselves by cheque, switchcard, direct debit or electronic transfer etc.  Their individual accounts are adjusted accordingly by changing a few figures in computer databases – just book-keeping entries.  No actual money/cash changes hands.  The whole thing is basically an accounting process that takes place within the banking system.

THE ROLE OF CASH

The state is responsible for the production of cash in the form of notes and coins.  These are then issued by the Bank of England to the high street banks - the banks buy them at face value from the government to meet their customers’ demands for cash.   The banks must pay for this cash and they do so out of what they have in the accounts which they hold at the Bank of England – their liquid assets.  Their accounts are debited accordingly.

The state (through the Treasury) also keeps an account at the Bank of England which is credited with the face value of the notes and coins as they are paid for by the banks.  (This is now money in the public purse available for spending on public services etc.)

This is how all banks acquire their stocks of notes and coins, but the cash a bank can buy is limited to the amount it holds in its account at the Bank of England – its liquid assets.

As this cash is withdrawn by banks’ customers, it enters circulation in the economy.  Unlike bank created loans etc, cash is interest-free and debt-free and can circulate indefinitely.

NON CASH PAYMENTS - Book keeping entries

With so little cash being withdrawn, and from experience knowing that large amounts of deposits remain untouched by depositors for reasonable periods of time, banks just hope that their liquid assets will be sufficient to enable them to buy up the cash necessary to meet the relatively very small amounts of cash that are normally withdrawn.

A bank has serious problems if demands for cash withdrawals by depositors (and, indeed, borrowers who want to draw some of their loans in cash) exceed what the bank holds in its account at the Bank of England.

In practice it would probably try to get a loan itself from the Bank of England or another bank, to tide itself over.  Failing that, it would have to call in some loans and seize the property of borrowers unable to pay.

DEPOSITORS’ CLAIMS AGAINST BANKS …

Once you have made a deposit at the bank (in cash or by cheque), all you then have is a claim against the bank for the amount in your account.  You are simply an unsecured creditor.  Your bank statement is a record of how much the bank owes you.  (If you are overdrawn, it is a record of what you owe the bank).  The bank will pay you what it owes you by allowing you to withdraw cash, provided it has sufficient cash to do so.

If customers are trying to withdraw too much cash, there is a run on the bank, which will soon refuse further withdrawals.  So it’s a case of First Come, First Served!

Should you want to make a payment by cheque, this is less likely to be a problem – you are simply transferring part of your claim against the bank to someone else – the person to whom your cheque is payable - just a book-keeping entry.

If the person to whom your cheque is payable has an account at the same bank as you do, the deposit stays with that bank – overall the bank is in exactly the same position as it was before.

If I give you a cheque for £50 – and we both have accounts in credit at Barclays – what Barclays owes me is reduced by £50, and what Barclays owes you increases by £50.  But nothing has left Barclays – the total deposits or claims against Barclays remain the same…

BANKS’ CLAIMS AGAINST EACH OTHER

.BUT if you keep your account at Lloyds, deposits at Barclays are reduced by £50, whilst deposits at Lloyds increase by £50.

Millions of transactions like this take place every day between customers of the various banks, using switch cards, direct debits, electronic transfers as well as cheques – deposits are therefore constantly moving between the banks.

All these cheques and electronic transfers pass through a central clearing house (which is why we refer to a cheque being “cleared”).  The transactions are set off against one another, but at the end of each day, a relatively small balance will always be owed by one bank to another.

A bank must always be ready to settle such debts.  To do this, it makes a payment from its account at the Bank of England to the creditor bank’s account at the Bank of England.

Thus a bank faces claims from two sources (which it meets out of its liquid assets) – its customers wanting cash, and other banks when it has a clearing house debt to settle.

Unless all the banks are faced with big demands for cash at the same time, the banking system as a whole is safe, although an individual bank is vulnerable, should a large number of depositors for some reason withdraw their deposits in cash or transfer their deposits to other banks.

We now see how today the whole system is basically a book-keeping exercise where millions of claims pass between the banks and their borrowers and depositors every day with relatively very little real money or cash changing hands – backed by tiny reserves of liquid assets.

The system is known as FRACTIONAL RESERVE BANKING and banks are sometimes accurately referred to as dealers in debts.

Barclays Bank’s 1999 accounts illustrate the whole thing very well - it had loans of £217 billion owing to it; and it owed £191 billion to its depositors – backed by just £2.2 billion in liquid assets!

A bank’s level of lending is geared to the amount of cash it has or can buy up – its liquid assets - rather than the amount of its customers’ deposits.

But if a bank can attract customers deposits from other banks, it will add to its liquid assets, as other banks settle the resulting clearing house debts in its favour – hence there is tremendous competition between banks to attract deposits.  

Interest ….  =   Big Profits for the bank...

Let’s now return to Sid who has to pay our small bank 10% interest on his loan i.e., 10% of £5,000 = £500.  These interest payments are money coming into the bank, they are profits and they end up in its account at the Bank of England - additional liquid assets for the bank.

He bank now has an extra £500 to meet its depositors’ withdrawals.  If Sid manages to repay the original loan as well, it will have an extra £5,500!

So our bank created for itself out of nothing an asset of £5,000 in the form of a loan to Sid. It is no longer owed anything by Sid, but in repaying his loan with interest, Sid turned a mere debt into £5,500 of liquid assets for the bank – a tidy profit for the bank…. and the basis on which more loans can be made!

You will therefore not be surprised to learn that banks today create loans 100 times or more in excess of their liquid assets –  see above Barclays Bank’s 1999 accounts

Thus our bank will soon be making many more loans. In this way, the deposits it receives back will increase and so will interest payments and therefore profits.  With more loans and more deposits, there will be a greater demand to withdraw cash  – but increasing profits means more cash can bought by the bank.  (This is how the amount of cash in circulation has been   increasing to reach £25 billion by 1997.)

Therefore, it is a myth to think that when you borrow money  from a bank, you are borrowing money that other people have deposited.  You are not – you are borrowing the bank’s money which it created out of nothing and made available to you in the form of a loan.

More debt for the rest of us...

However, Sid’s interest payments and any repayment of the loan itself to the bank means that this “money” is no longer circulating in the economy.  Indeed, any payment into an overdrawn account reduces that overdraft but it also operates as a repayment to the bank and the repaid  “money” is lost to the economy.

Consequently, more money must be lent out to keep the economy going!  If people don’t borrow or banks don’t lend, there will be a fall in the amount of money circulating, resulting in a reduction in buying and selling – a recession, slump or total collapse will follow depending on how severe the shortage is.

The increase in bank created loans over the years is additional conclusive proof that banks do create “money” out of nothing – £1.2 billion in 1948; up to £14 billion by 1963; and up to £680 billion by 1997.

Today’s supply of notes and coins, after taking inflation into account, has similar buying power to the supply in 1948 (£1.1 billion) but since then, there has been a ten fold plus increase in real terms in money supply made up of credit created by banks.

This may have enabled the economy to expand enormously, and as a result living standards for many people may have improved substantially...– but it has all been done on borrowed money!  What is credit to the bank, is debt to the rest of us.

Thus the banks are acquiring an ever increasing stake in our land, housing and other assets through the indebtedness of individuals, industry, agriculture, services and government – to the extent that Britain and the world are today effectively owned by them.