Why an understanding of money creation is essential to financial reform

At the heart of our dysfunctional financial system is a remarkably poorly understood fact. Private banks create the vast majority of the money supply - 97% according to most estimates.  Not the Bank of England, nor the Government, nor any institution which could be viewed as democratically accountable or representing the public interest, but private banks.

Banks create money when they ‘extend credit’, to use the technical jargon.  What this really means is making a loan or honouring an overdraft. When a bank makes a loan it simultaneously creates a deposit in the borrowers’ bank account. The bank does not take the deposit out of anyone else’s account. The balance that appears in your account is new money. 

This is no more than simple double-entry bookkeeping. The bank has increased its assets because I now owe it money. It has also increased its liabilities by the same amount because my bank deposit is simply the money that the bank owes to me – a bank IOU if you like.

But unlike an IOU between me and you, scribbled on a piece of paper, this electronic Bank IOU is impersonalized. It is accepted by everyone else in the UK in payment for goods and services. This is because it also accepted by the government for taxes. This means everyone wants it because everyone can use it to make their most regular payments. 

If you are finding it difficult to believe that banks create money so easily, by just typing numbers in to a computer, you are not alone. Policy makers and economists, including civil servants at the Independent Commission on Banking, have found it very difficult to accept. Banks are usually described as ‘financial intermediaries’, ‘recycling’ the deposits that we’ve put in them for safekeeping as loans. In fact, it's the other way round. Bank loans create deposits. Banks are better described as ‘credit creators’ than intermediaries. 

In an effort to banish these misunderstandings and create a shared reference point upon which to build arguments for alternatives, nef has decided to write a book on the topic. Where does money come from? lays out the facts in clear jargon-free language suitable for all audiences. 

We’ve written the book in conjunction with Professor Richard Werner at the University of Southampton, a globally recognized expert on the relationship between banks and the economy, with two bestselling books on the topic and experience in the sector, including during the Japanese 1990s recession. There is also a forward written by Professor Charles Goodhart, one of the world’s leading monetary economists and a founding member of the Bank of England’s Monetary Policy Committee.

In researching the Where does money come from? we read literally hundreds of documents published by the Bank of England and other academic sources and consulted with experts from the Bank, academia and former bankers themselves. The book reviews theoretical and historical debates on the nature of money and explains how we arrived today with a system controlled by banks. It includes in-depth explanations of the role of the central bank, regulators, the government and the European Union in influencing the creation and allocation of money. Controversial topics are covered in depth, including the emergence of bond issuance, fractional reserve banking, the ‘money multiplier’ theory, fiscal policy and crowding out and quantitative easing. This is a quote on the back of the book from another leading monetary economist, Professor Victoria Chick:

‘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.”

The book concludes that the current monetary system is inherently unstable, depending as it does primarily on the confidence of private banks themselves. Interest rate adjustments have proven to be a week tool in influencing on bank’s lending decisions, as we can see at the present time. The central bank and the government have chosen, through successive rounds of deregulation, to exert less and less control over either the quantity of new money created or whether it is used for productive or speculative purposes. This has lead to increasingly severe credit booms and busts, culminating in the financial crisis of 2008-09. 

Ultimately, the book concludes, it is private bank’s decisions on how much credit to create and to whom it is allocated that determines the shape of our economy. Please buy the book, read it and pass it on.  Without a shared understanding of this vitally important dimension of our financial system, reforms will not be effective and our economy will remain at the mercy of a dysfunctional banking system.