Bank of England backs NEF on money creation

Photo credit:   George Rex

March 14, 2014 // By: Josh Ryan-Collins

The Bank of England has just published probably the most accurate and clear accounts of how the modern monetary system works ever written by a major central bank. The two articles are published in the Bank’s prestigious 54 year-old Quarterly Bulletin series – the main channel it uses to communicate its thinking to the public.

The good news is that the Bank agrees with the key aspects of NEF’s book Where Does Money Come From? (first published 2011), which set out to dispel many of the myths surrounding the process of money creation.  Most importantly, their first article, on the nature of modern money, states that:

“Most money in the modern economy is in the form of bank deposits, which are created by commercial banks themselves…  When a bank makes a loan to one of its customers it simply credits the customer’s account with a higher deposit balance. At that instant, new money is created…”

In the second article, on money creation and its limits, the Bank lays to rest two of the great ‘money myths’. First, it dismisses the commonly held view that when a bank makes a loan it is simply recycling someone else’s savings. In fact, it is the other way round: “rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.”

The Bank also dismisses the ‘money multiplier’ theory, whereby the central bank determines the quantity of loans and deposits in the economy by controlling the quantity of central bank money:

“…the relationship between reserves and loans typically operates in the reverse way to that described in some economics textbooks. Banks first decide how much to lend depending on the profitable lending opportunities available to them…It is these lending decisions that determine how many bank deposits are created by the banking system. The amount of bank deposits in turn influences how much central bank money banks want to hold in reserve (to meet withdrawals by the public, make payments to other banks, or meet regulatory liquidity requirements), which is then, in normal times, supplied on demand by the Bank of England.”

The first article explains that “commercial banks can create new money because bank deposits are just IOUs of the bank; banks’ ability to create IOUs is no different to anyone else in the economy…” (page 8). But what makes bank IOUs different is that they are widely accepted as a medium of exchange. Why? Because the State guarantees every person holding a bank account the first £80,000 of these Bank IOUs. This “ensures that bank deposits are trusted to be easily convertible into currency and can act as a medium of exchange in its place.”

The Bank does not explain why private bank IOUs get this special treatment, however. To understand this you’ll need to delve in to the 19th Century and the Banking Act of 1844. At the time private banks were free to issue their own currency notes, a fact that was leading to repeated ‘bank runs’ and resulting instability. The Bank legislated to outlaw the issuance of private banknotes and took up its monopoly position as the only agent able to issue legal tender. It did not, however, prevent banks from creating deposits in checking accounts, as described above. Since then, such IOUs have outgrown currency issuance and currently account for 97% of the money in circulation. 

Modern money creation can thus be seen as something of an accident of history. As we point out in Where Does Money Come From?, there are serious questions as to whether a relatively unregulated system dominated by private money creation in the form of interest bearing debt is best suited to the challenges facing modern humanity. In a speech in 2010, Mervyn King suggested that “Of all the many ways of organising banking, the worst is the one we have today.” 

Of course, money creation is not completely without constraints, as the Bank goes on to illustrate in the 2nd article. But the weakness of monetary policy focussed on short- or long-term interest rates has become clear in the last 5 years with lending to businesses remaining sluggish despite historically low interest rates and £375bn worth of QE. Perhaps it is time for a return to the quantitative  controls on private money creation that were standard in the 1950s and 1960s; or perhaps it is time to consider whether the power to create money really should reside with private companies at all - the UK banks’ record since 2008 begs the question.

Whatever the future though, the Bank of England should be congratulated for setting the record straight on how the modern monetary system works. These articles will stand the test of time as a reference for anyone interested in both understanding and reforming our financial system. They can be seen as a victory for those – like NEF, Positive Money, Michael Kumhof, Adair Turner, Richard Werner and many others – who have been working to educate policy makers and the general public about the realities of our monetary system. And let’s hope they lead to a few textbooks being ripped up.

Issues

Banking & Finance

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