It amazes me that most people think that money is printed. It isn't. Only 3% of all money in the UK is created by the government. The rest is created by banks.
How does a bank create money? The honest answer is out of thin air. It happens whenever they create a loan.
Most people think when they ask a bank for a loan money paid in by one person is paid on to them. That's not true. Not true at all, in fact.
Instead what the bank does is a conjuring trick. They agree to give you a loan. They do it by opening two accounts for you. One is a current account (for ease, let's assume you haven't already got one). The other is a loan account. If you borrow £10,000 they mark your current account as having £10,000 in it. You're now free to spend that however you like.
They also mark your loan account as having £10,000 in it. You now owe that to the bank.
Add the two together and they add up to nothing. One you apparently own (the current account) and one you apparently owe (the loan account). But if you decided to cancel the deal you could straight away repay the loan using the current account and there would be nothing left. Which is why I mean they add up to nothing.
Note there's no cash involved in this process at all. It's just an accounting trick. Nothing more.
And now the bank charge you interest for the benefit of having created that money. Even though there is no money as such, even though you think there is, because you can spend what's in the current account as if it were money. Which is what I mean about the banks creating that money. You can see why they make so much profit, can't you? They make money out of nothing and then charge you to use it.
Of course they need some cash. That's necessary to ensure that if anyone does want their money back in straightforward cash they can pay it to them. That's why they need part of that 3% of money created by the government.
And of course they can't repeat this lending trick forever because if they did people would realise there was no substance behind the promise they made to you when you agreed to pay them back a loan. That promise is that the money in your current account can be used to pay other people - a promise that is only as good as the bank on which the cheque is written on.
But that's the confidence part of the rick. So long as people believe the banks will pay they don't need money. They can just pretend they have it. When people don't have that confidence they do need money. Trouble is, they always lend far more money than they actually have. That's the risk in a 'run on the bank' of the sort Northern Rock has suffered.
But now that risk has been taken away. The government has said it will cover it. So the banks can lend more money at limited risk to themselves. And so make more interest on something they have created out of thin air. Are you surprised that banks are the biggest companies in the world? After all, their basic product really does not cost them anything to make. Amazing, isn't it?
You don't believe me? Actually, you wouldn't be alone. When explaining this the second greatest economist of the last century (J. K Galbraith) said:
The process by which banks create money is so simple that the mind is repelled
(John K. Galbraith, in "Money: Whence it came, where it went", p. 29.)
He was right, because it's true: the process is so simple that we're repelled by the idea that we pay for it.
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very good – I think you are almost worthy of a C grade in GCSE Economics!
This is not taught on any economics course to undergraduate level
Why is that, I wonder?
Richard
The economist would be a good source of information on this and other basic economic terms – try http://www.economist.com/research/Economics/
It was a long time ago but I first learnt this at A-level (my tutor was very good – in spite of being a Scottish Socialist!). Although I learnt a lot from my economics degree (statistical method, marxist ecomonics, the role of the banks in supporting a student drinking habit, etc) I don’t recall learning anything more about economics than I already learned from A-level!
And I note the Economist makes no reference to the point I make
Why is that?
There is an excellent book on this subject by former FT journalist James Buchan (I’ve never met him; this isn’t a plug) called Frozen Desire: the Meaning of Money, although it’s historical in scope.
I urge anyone with an interest in history and money to give it at least a look over. Very interesting passages on the silver mines at Potosi and also the Scottish economist John Law, amongst other things.
On another note, I’m sure that Galbraith was parapharasing an investment banker there.
Oh well, so much for the invisible hand of the free market.
Rob
I agree – a good book
Richard
Hi Richard. I think there is a small mistake in your analysis. You state “Note there’s no cash involved in this process at all. It’s just an accounting trick. Nothing more.” In fact it is most likely that there will be a transfer of funds from the lending institution, and they actually have to have funds to be able to make that transfer. I would agree that funds is not the same as cash. I think you mean physical bank notes? But presumably you are aware that no currency is underwritten by gold or precious metals of similar value. As it happens I believe that it is only governments that are able to issue money backed up only by a promise.
When I were a lad the Economist published a series of articles for students, including as a call a particularly good one on the banking system. I don’t know if these are still in print.
[…] All money is a confidence trick […]
Alistair
The funds movement is subsequent to the creation of the ‘money, not a part of it.
What it does show though is that all money is in fact debt.
Richard
actually, what it shows is that debt is one way of measuring the money supply. Of course there are other measures. Perhaps it would help if you start by considering money as a means of exchange, rather than as an absolute with an intrinsic worth?
Meaningless
As the people who queued outside Northern Rock showed – money is not a means of exchange when there is no intrinsic worth
When worth was restored they went away. So your causality makes no sense
I understand that they are still queueing! And who said it had to make sense?
[…] novembre 6th, 2007 Ich habe diesen spannenden Blog bei Richard Murphy gelesen. Ich wollte ihn mit euch teilen, zumindest mit denjenigen, die Englisch lesen. Quelle: http://www.taxresearch.org.uk/Blog/2007/09/18/all-money-is-a-confidence-trick/ […]
Here is a good video that explains this concept, called “Money As Debt”:
http://video.google.com.au/videoplay?docid=-9050474362583451279
How many people realize that banks create money out of thin air? Or how many people know that they create their own loans?
When you apply for a loan and you fill out the application form the banks use this information to create a promissory note which they give to themselves and create the loan given that you have promissed to pay back this loan. They now have your repayments + interest and they also have the Promissory note to invest with.
How much a fool are we as it is illegal to create money out of thin air, this also goes for credit cards, as it is illegal to create credit. At law you must have a loss to claim that you are owed funds/credit debt. From which account did the bank loan you your credit funds? What loss did they sustain? Ask them to show you where is their loss? From which bank account did they lend you the funds from? eg:- Account no 111 balance before loan 1,111,111 dollars after loan of 111,111 dollars = 1,000,000.00 . At law they must be able to prove their loss and if their was no loss shown then you owe no debt to them.