Money Creation – Where Does the Money Come From?

How Banks Create Money continued

One of our popular posts located here talks about 'how banks create money'. You should read that link before this one as it is the necessary part 1 of this series on money creation. A lot of people think it's a huge conspiracy that banks would create money out of thin air. Fact is they don't, and our entire financial system is based upon the responsibility of banks to lend correctly. Furthermore, in the capitalist system, in the simplest form, the troubled banks would be permitted to fail and close its doors, however, because most nations aren't true capitalists economies (free market) because of the intervention of the central bank, you'll note that the government through the central bank is doing more to ensure consumer confidence is settled by the guarantee of loans in banks and the banks themselves.

Here are some notable comments from the previous article on How Banks Create Money that are worthy to be posted in article form (from Keir in the UK.) we've had folks from all around the world respond to this post so please feel free to comment.

Keir notes:

Hi. I'm new to this site, and have been reading and thinking about money supply for the last few years. I read the above comments with interest.

Here is some pretty hard evidence that banks do create money out of nothing:

1. I used the Bank of England database to create a graph of the total money in UK bank accounts (M4) from 1988 to 2008. It shows an exponential growth from 0.3 to 1.8 trillion GBP (£) over those 20 years. This raises the question where did all of this money come from? How was it created?

2. I then found the data for the total UK cash stock (M0, i.e. note and coinage) over the same period. It was almost flat rising from onlly 0.016 trillion in 1988 to 0.046 trillion in 1996 (when they stopped recording it !) i.e. nowhere near enough to explain the growth in M4. So that rules out the idea that the money is printed by government.

3. I then downloaded the total outstanding loans (UK). This produces a graph that rises exponentially and almost exactly matches the M4 graph!

The conclusion from this data is that the money supply (M4) is created out of debt.
So is money created out of nothing? Yes and No:

Yes - Money is created by banks 'out of nothing', becuase they do not transfer a deposit to create it.

No - because they only create it against a real assets (houses, businesses etc). You could argue that banks create money out of our assets. They seem to have created the recent credit mess principly by overvaluing property, so the security on their outstanding loans has gone.

Now as I understand it, the example that started this thread is correct. Across the banking system as a whole the money created as debt (credit) becomes a new deposit. As there are millions of such transactions per month between banks the effect is that this deposit ends up in the same bank as issued the credit.

The financial regulations insist that banks maintain a debt to credit ratio of 95% (or whatever the figure is), which produces the appearence that they 'only lend what they have' (as DebtBasedEconomics said above). To Jo Public this statement confirms the false notion that his deposit is being loaned out, but if that were true there would be no new money created. What the statement fails to acknowledge is that by making a loan the banks create new deposits which enables them to make more loans... So they can increase the money supply virtually indefinitely, as long as we keep taking out more loans this year than last year, as long as property prices keep rising, and as long as we keep repaying. Sub prime and housing slump has messed this up.

Christopher Dean responded with:

If money is created from the issuance of government debt and through lending in our Fractional Reserve System where does the money to pay the interest come from? The interest due on the original and additional monetary infusions was never created in any of the “M” components. The amount owed to ANY bank, private or government = principle + interest. What component in our monetary system creates the money needed to pay the interest?

Wouldn’t it be safe to assume we can always expect retractions in the credit markets - not as a results of houses - but when the interest due on our expanding currency becomes to burdensome? I guess we could print more money! But then my question still remains.
Too which Keir responds again:

Reading Christopher Dean's point again, I think there is another issue lurking in your question. Which is that all of the loans in the economy that reach maturity each year (and therefore need paying off) are essentially financed by even more new debt-money released in that same year.

Governement borrowing seems to work that way. They raise money by issuing bonds and Gilts. These raise money for the Government now, but promise to pay back principle + interest in (say) 5 years time. When those Gilts mature, the government has to find more money (=principle + interest) so simply issues even more gilts, meaning they have to pay back even more in another 5 years time etc etc. So National debt grows...

Where does the money to pay the interest come from? What do you mean? That's just part of the normal money flow.

Once banks have created money it circulates in the economy (M4 accounts + M0 cash). It passes in and out of accounts as wages, receipts and payments i.e. cash-flow. Bank interest is just part of that flow. Banks don't simply hord that interest. Some has to be used to pay interest on deposits. Part of the rest they use to finance their operations (running the business, rent, wages etc), the rest is their primary income 'profit' (my term).

This 'profit' from their normal banking operations (deposits and loans) is then invested in stocks, shares and bonds. Some is speculated on the money markets. The end result of this is their real profit that you hear announced on the News ('This week Natwest announced profits of...').

That 'real' profit goes to shareholders, bonuses and expansion - just like any limited company.

The moral repugnance that we should feel for the banking system is that they are able to extract interest simply for lending us money that they have done nothing to earn. They have not really produced any goods or services commensurate with the vast amounts of interest they charge.

To illustrate the privaleged position banks are in consider this: If you or I wanted to lend money to a friends we could lend them money in exchange for an IOU secured against an item of their property. This is what banks do. We could even charge them interest - although most of the people I know would consider that immoral, miserly or at the very least bad-taste. The difference between this and what the banks do, is that we would actually have had to earn the money in the first place. Banks can just create it out of nothing!

It is worth considering too that as the total money stock increases (which it does) we (the public) are more and more indebted and they (the banks) hold more and more of our homes and businesses as security. As a country we can never reverse this. If you manage to pay off your loan, it reduces the available monay in available for Joe Blogs to pay off his.

It is an extraordinary position that we have got ourselves into where we are all beholden to the banks to create the tokens (money) that allow us to play 'living in the modern world'. Even our Governments play this game - allowing the banks to control the means of economic activity AND MAKE A PROFIT FROM IT!
The fact is that governments could take on this role if they wanted, reduce the powers of the banks, and set about creating all the money they need to finance public work out of nothing and, crucially, without creating an equal amount of national debt to burden you & me with.

In the UK parliament there have been a number of early-0day-motions calling for this. It was also suggested in the early days of New Labour by Brian Gould MP. The main arguments against this that I hear are spurious:

1) that 'printing money' would cause inflation:

I don't think this is correct. Most of the horror stories we know about from the past I presume are in fact the reverse of this - namely that when you get runnaway inflation that you have to print lots of money because it is devaluing so quickly. Inflation happens when there is too much money for the goods and services on offer. Carefully reducing the debt in society by releasing non-debt backed money would not create inflation all the time that people wanted to provide more goods and services, or pay off their existing debts. If inflation started to rise because there was more money than services, government could release less 'free' money to reduce inflationary pressures.

Any way, look at the incredible exponential growth of money in the economy over the last twenty years - they don't say that has caused inflation. They say that has caused economic growth! Why would non-debt backed money be any different?

2) that governments can't be trusted to run the economy:

That may be true, but it is not necessarily true. When you look at it it is a miracle that the banking system works even as well as it does. Surely it is not beyond the powers of good people and good government to design a system of good money creation? What we need are people who are good and clever. Good first, clever second mind you. Good means puting the public-good first not their own self-interest. Unfortunately we seem to have a lot of people in power who are clever enough to appear good - the very definition of cunning I believe.

The problem of monetary reform is the huge ignorance of how money is created among the general public, politicians and economists. The whole money jargon is so complex and obfuscating that people can't see the emperor has no clothes. It is amazing if you listen to the news, or people discussing it in the pub: "Yeah, the Banks have stopped lending to each other... It's a problem of liquidity... They have been lending more than they have got..." Not one of them knows what any of it means - it is incredible! They all nod sagely, even the interviewers on the TV, as if anything comprehensible has been said! Sometimes you hear the interviewer get rather to close to the truth - on the BBC4 radio news recently one presenter asked a government financial expert "But where is this £500 billion coming from?" and the expert expertly avoided the question with a load of waffle. The interviewer pressed - "But you havn't answered my question..." to which the expert said "I'm coming to that" and proceeded to give an expertly wordy answer that didn't even attempt to get close to an answer! The interviewer gave up - I assume through feeling that he must be too stupid to understand how beautiful the emperors new clothes are, and who wants to appear stupid?

It is a weird hypnosis - people are not asking simple questions for fear of appearing ignorant. So we all say "Yep there's a credit crisis. Bloody banks!" - without one sensible piece of information being communicated about how money is created and what is going on.

Well put... comments?

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