We all know what money is and, more importantly, how to spend it. But how often do we stop and think about how that money is created? Whether it be physical or digital, is the process of money creation the same? How can we tell where our money came from and who it was that created it? Contrary to popular opinion, not all money is created by the government. In fact, only a tiny proportion of the money in the economy is manufactured by the Bank of England.
It is often stated that the early 20th Century industrialist, Henry Ford, once proclaimed: “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” Fast-forward to present day, and we see that more and more “revolutionary” groups such as the Occupy movement are calling for exactly that. However, when we consider the opinion of the general public, we do not observe the same radical calls for revolution. Was Henry Ford right? Are the majority of the general public unaware of how monetary and banking systems work? Or are they just not particularly bothered about it?
It would be hard to believe that, were the majority of the public aware of the reality of the monetary and banking systems, they would not care. With ever increasing non-conformity to social and economic norms among younger generations, we are inclined to conclude that Mr Ford was, in fact, correct. So how does money get created? Surely by the government of a country or the member states of a monetary region (such as the Eurozone)? Is it possible that groups such as Occupy have been right all along and that the rest of us have been too caught up stressing over how to save (or spend) our money to realise how it actually comes into existence in the first place? Well, actually yes. Back in March of 2014, the Bank of England did, in fact, release a paper called “Money Creation in the Modern Economy” in which it proves right the claims of Occupy and other such groups.
After its summary and introduction, “Money Creation in the Modern Economy” dives straight into addressing the common misconception of how money is created. It states: “One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them.” This, it would seem, is indeed how the majority of people believe banks work, however, this is not correct.
Digital or Physical?
The reality of how money is created very much depends on what kind of money you’re talking about. The majority of the money in the economy is digital money, created by commercial banks in the form of bank deposits. It is estimated that around 97% of the money in the economy is digital money. The remaining 3% is the physical cash and coins created under the authority of the Bank of England. Coins are manufactured and pressed at the Royal Mint and notes are printed by specialist printer De La Rue, who are the largest commercial printer of bank notes in the world.
So, what are bank deposits? Essentially, they are the numbers that appear on your bank account when you check your balance. In banking terms, these numbers are what’s known as a ‘liability’, roughly translating as an IOU between you and your bank. But how is this creating new money, I hear you ask? Well, this new money is created when a bank makes a loan. For example, If you were to go into a bank and ask for a loan of £15,000, instead of lending you that amount from someone else’s deposits, the bank would credit your account with that amount and you would agree to a repayment plan for the original amount plus interest (More on interest later.) This money is created out of nothing and credited into your account due to the accounting the bank uses when it agrees to a loan.
The idea that banks work as intermediaries has perpetuated throughout a large part of society and continues to misinform those looking to understand the monetary system. When asked how banks make their money, a large percentage of people would assume through the interest it adds to its loans. However, we can now see that, if a bank makes a loan of £15,000 with interest totalling an extra £3,000 on top of that, the bank doesn’t just make £3,000 once the loan is repaid, it actually stands to make £18,000 after the final repayment, due to the original loan amount being created out of nothing. So what reasoning is there for banks and lenders to slap interest onto their loans? If interest isn’t the way banks make their money, what is it for?
So what is interest? Typically, interest is the money you pay on top of a loan. There are various reasons put forward as to why interest exists; from it being how the banks make their money to the cost of borrowing from, and subsequently inconveniencing, the original owner of the money being loaned out. The argument that interest is a necessary evil when it comes to loans and financing agreements begins to fall apart once you consider the fact that the money for loans is created out of nothing. No one is being inconvenienced and the bank is due to gain the whole of the original loan amount back once it is repaid, so why should it exist? Another common argument for the existence of interest is that it can be justified due to the inherent risk of lending the money out in the first place. Surely then, if there is a perceived risk involved in lending to certain individual or organisation, then adding more money on top of that only increases that risk, as well as the amount that could be lost if a loan cannot or is not repaid?
Now that we know what interest is, how is it decided how much interest is paid?
The amount of interest payable on any loan is dictated via the current interest rates set by the Bank of England’s Monetary Policy Committee (MPC). The MPC is made up of nine people: the Governor of the Bank of England, two Deputy Governors, the Bank of England’s Chief Economist, the Executive Director for markets and four other members that are directly appointed by the Chancellor of the Exchequer. The MPC meet every month to set interest rates and do so via a voting system whereby each member has a single vote to decide what interest rate should be set. The main aim of the MPC’s setting of interest rates is, according to the Bank of England: “to hit the Government’s 2% inflation target.” However, due to the fact it takes around two years for interest rates to actually take effect on inflation, the majority of decisions are based upon “inflation forecasts” or, in other words, guesswork.
The problem with banks creating money out of nothing to loan out with interest on top of the original loan amount comes when we consider the concept of debt. If 97% of the money in the economy is this digital money, then what about that debt that must surely be created along with it? For example, let’s say you having £0.00 in your bank account and you want to take out the previously mentioned loan of £15,000. You are also aware that the total amount of interest you will have to pay on this loan is £3,000. This becomes a problem when, once you’ve paid off your £15,000 loan, you end up back at £0.00 again. So how are you then able to pay back the £3,000 interest you’ve accrued without having to take out another loan?
As we can see, the problem can only increase as, once you’ve taken out another loan of £1,500, you will again have interest added on top of that loan and thus, the cycle will repeat.
Isn’t there a better way?
We’ve now seen that, by creating money out of nothing via loans and subsequently adding interest to those loans, commercial banks are actually perpetuating a cycle of debt. This model of money creation is the main factor in creating the ever-deepening hole of personal debt we find ourselves in. Back in 2007/08, the growing weight of this debt eventually broke the camel’s back and caused the huge swathes of loan defaults that would eventually turn into the financial crisis. This crisis was the main reasoning behind many countries enacting austerity measures and turning to schemes such as “quantitive easing” in order to try and regain some measure of economic stability. So far, however, austerity measures in the UK have failed to reach the proposed position of economic stability.
According to an Oxfam case study of the UK titled “The True Cost of Austerity and Inequality”, during the time in which austerity measures have been in place, “public debt has risen from 56.6% of GDP in July 200911 to 90% of GDP (£1.39trillion) in 2013”. With these figures in mind, austerity measures do not appear to be the ideal (or even a half-decent!) solution to combat a situation that was caused by mass loan defaults due to unsustainable amounts of public debt. During David Cameron’s time as PM, the phrase “We’re all in this together” was bounded about like no tomorrow. This quickly became the buzz phrase of the disenfranchised as it would soon become clearer and clearer that the wealthiest percentage of the population, along with those in power, had no intention of taking the brunt of the hit that came from the financial crisis.
Between 2009 and 2012, the Bank of England created £375 billion in new money through its quantitive easing programme. This measure was taken as an attempt to stimulate the economy in the wake of the financial crisis. It was hoped that, by buying financial bonds from financial institutions and introducing this new money into the economy, interest rates would fall and in turn would lead to higher public borrowing and spending. This, however, does not seem to have been the case. The Bank of England would later calculate that the value of bonds and shares had indeed reason by roughly £600 billion, although 40% of these gains had gone to the richest 5% of households. In layman’s terms, the people who needed the least financial assistance during this period actually received the most.
So what else could be done in order to combat the ever increasing public debt that is caused by our current methods of money creation? The website positivemoney.org has been working on exactly this problem and has come up with three simple measures that could be enacted in order to create a fairer system. They propose the following:
1) Take the power to create money away from the banks, and return it to a democratic transparent and accountable process.
If the power to create money remains with the banks, it is highly unlikely we will ever see a significant deviation from our current modus operandi. Regulators have failed in keeping these banks on a leash and thus, should no longer be trusted either. By removing this power and making it a democratic, transparent and accountable process, we may then begin to see an improvement to our current situation.
2) Create money free of debt
As we’ve seen, the system we’re currently using not only creates new money through loans, it also creates new debt with each of those loans. This only serves those who create the loans to the detriment of everyone else. If for example, the state were to create this new digital money free of interest and debt, it could then be used to stimulate the economy through investment in public infrastructure which could then create jobs and make it vastly easier for everyday people to begin to reduce the size of their own personal debt.
3) Put new money into the real economy rather than financial markets and property bubbles
According to the positivemoney.org website: “Most of the money that banks create goes straight into the property and financial markets, pushing up house prices and increasing inequality. This money doesn’t create jobs – it simply makes life more expensive and unstable for people. Instead, any newly created money should be used to fund public spending, reduce taxes, or be distributed directly to citizens to spend as they choose. This means that the money will start its life in the real (non-financial) economy instead of getting trapped in financial and property markets.”
So, what do you think? Are these ideas feasible? And, if so, how should we go about ensuring their introduction? Only by uniting and making our voices be heard as one can we ensure that we the people are not bullied out of our say on monetary policy by banking institutions and financial lobbyists.
To learn more about the positive changes we can make to our monetary system visit www.positivemoney.org and become part of the growing call for change.