Money Creation

Keiran Taylor

Keiran Taylor

Corporate Finance and Banking Specialist

Money Creation

Let me start by posing an interesting question. As a business owner, what would you do if you had a machine that could make widgets without the need for any raw materials? Consider this scenario: You come into work in the morning, crank the handle and out pops a widget that you can take to the market and sell, and it cost you nothing to make. My guess is you’d probably start cranking the handle as much as you could. A year later, however, there seems to be a problem. You’ve created so many widgets that everyone who needs one has one, no one is buying them anymore, but you still own a machine that makes them for free. What do you do now? You either go about creating a new market for them and encouraging everyone who has one that really, they need 2 or 3; or you convince the people who don’t need them that they do really.

On the face of it this seems like a highly farfetched business model, an imaginative thought experiment. However, what would you think if I said the machine you own is actually called “a computer”, the widgets it makes for free are “money”, and the business you own is called a bank? Still seems a little over imaginative right? Well according to a bulletin produced by the Bank of England entitled “Money Creation in the Modern Economy” this is what commercial banks do.


Banking Myths

It is a popular misconception, often taught in economic text books, that commercial banks work as follows. Firstly, they obtain some deposits from you and I, local authorities large corporations, pension funds, central government and other sources; and then look for ways to lend this money to those who want to borrow it for consumer spending, property purchases, business expansion etc. The banks’ profits are then derived from the difference between, the income they make in interest and fees from lending out money and the expense of paying depositors interest on their savings.

The bulletin published by the Bank of England confirms that this banking model is a myth in the real world. The truth is that a commercial bank creates NEW MONEY out of nothing the moment it makes a loan. When you ask your local branch loan clerk for a loan to buy a car and they create a new loan account depositing say £15,000 in your account, this deposit is created out of thin air. The funds are not transferred from another account in which the bank holds them ready for lending. The moment before the loan is drawn down that £15,000 does not exist and the moment after the loan monies are deposited into your account the number of pounds in existence just increased by 15,000. Just think about that, the banks’ raw material, money, does not have to be earned or bought or borrowed, it is created on a computer out of nothing and then lent into existence.

This theory of how money is created was, in the past, often thought of as being from the minds of “Conspiracy Theorists” and “Social Anarchists”; even Keynes himself described proponents of the “Credit Creation Theory” as being an “Army of Heretics and Cranks”. However, the very notion has been confirmed by the Bank of England in 2014, and in various academic papers such as that written by Prof. Richard Werner of Southampton University, also in 2014. This is not new and has been the practice of the banking system generally for hundreds of years.

This information is now becoming more widely disseminated among everyday working people in the wake of the financial crisis, although still largely misunderstood, and is now more widely accepted as the very cause of the financial crisis. Like our widget machine in the earlier scenario, the banks, with the power to create money out of thin air and profit from interest paid on it, set about creating as much of it as they could. Their problem was, however, much like our widget maker, that they made more than the market needed, so they had to think of new ways to get people to borrow more of it.

The issue here, unlike with our widget maker, is that almost all new money created must be lent into existence. For every new pound that has been created, a new pound of debt has also been created.

What Happens when too much money is created?

Well, the increased supply of money feeds its way into different assets. The value of assets is affected by the ability and willingness of buyers to pay an increased price for the asset. As such, the availability of money and credit to the buyers, by the method of supply and demand economics, causes prices to increase. An upward spiral ensues, and we have ourselves an asset bubble, whereby asset prices are artificially inflated, not by normal demand but by the oversupply of money.

This phenomenon became most apparent before the crisis of 2007/2008 in property, not just in the US but in the UK, Japan, Australia and many other countries. As has been proven to be inevitable with bubbles, they will eventually burst, and the size of the burst is often relative to the size of the bubble.

In the bulletin written by the Bank of England, the author goes on to explain that there are limits on how much new money is created by the commercial banks. These restraints are not, however, concrete, instead they rely on influencing the demand for borrowing by consumers, by controlling the price of debt through setting the interest rates. As can be seen since the financial crisis, when interest rates have been at record low levels across the world, total world debt has increased to $178 trillion. This is a 50% rise in the 10 years since June 2008 to June 2018 (S&P Global Ratings 12 Mar 2019). In other words, in the few hundred years prior to June 2008 the world had amassed debts of around $118 trillion and then in the 10 years since a further $60 trillion was added.

What is interesting is that the reverse of the Money Creation process is also true, so repaying a debt will remove money from existence. For example, if you were to decide to use your savings to repay the £15,000 car loan you took out in the earlier example, then the bank would reduce your deposit balance by £15,000 and cancel the loan. In summary, all types of bank borrowing create new money and repaying borrowing destroys money and thus the link between debt and money is fixed. Almost all money in existence has corresponding debt, one cannot grow the money supply without growing debt.

What does this mean for our current banking system?

In our current banking system then, it is the commercial banks, with a duty to earn profits for their shareholders, who decide where new money is utilised in our economy and it commonly argued now that this awesome responsibility should not sit with commercial banks. There is a growing voice, arguing for a fundamental reform to this money creation system, to allow for a more democratic way of deciding where and how new money is created and distributed across the economy. Should money be lent into existence or should democratically elected bodies create the funds required by an economy and spend them into existence on goods, services and infrastructure?

With the growing body of experts now publicly discussing the real world facts about our current money creation system, the question of what money is, or perhaps, what is should be, can now be discussed more knowledgably. Should it be a tool for social equalisation, to distribute economic effort and work more evenly or should it represent a reward for risk taking as the current system promotes? Should money itself allow for the further creation of wealth, the old adage that “money makes money” (through investment) suggests that the current system creates an imbalance of opportunities for the wealthy to become wealthier simply because they are wealthy.

What is difficult to avoid, is the conclusion that the current system of money creation has also created economic instability, over hundreds of years. The consequent cycling through boom and bust and the intrinsic link between debt and money, seems like a system destined to eventually fail.

Keiran Taylor

Corporate Finance and Banking Specialist