I wrote the blog reproduced below in September 2007: Northern Rock was falling over at the time and needed bailing out.
It seems as relevant today: Greece is falling over and needs bailing out. It won't be alone.
The point is a simple one: this is about money required until confidence is restored, and it is confidence that is key. Because the reality is that confidence is all there is to money because it literally comes out of thin air:
"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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Editor: this post was deleted for being gratuitously patronising
On the subject of confidence in general and specifically of the government guaranteeing deposits, you know they actually haven’t? One of the guys on the Positive Money forums did a FOI request and there’s no law, no statute compelling anyone to do anything. http://forum.positivemoney.org.uk/viewtopic.php?f=4&t=15
BB
Yes Bill, you are right, thanks for pointing this out. I have sent background information to the Positive Money team to help them in their research. It would appear that BoE is still in private hands, although technically “nationalised” in 1946. This was probably a concession made by those who financed and profited from WW2 as some sort of compensation to us. BoE might be viewed as mortgaged to the original owners with annual interest being paid.
Someone has already mentioned Tragedy and Hope by Carroll Quigley but much more detail is available in Secrets of the Federal Reserve by Eustace Mullins. There is a section headed The London Connection. All is explained here. Incidentally, this is available freely on the internet and may be accessed through Google, if your Service Provider allows it.
That argument is wrong: there is no evidence to support it
I do not believe the BoE is privately owned
I am pleased someone has pointed out the fact that, when a bank makes a loan, money is actually being created.
Banks keep a fraction of existing money back (usually regarded as 10% but probably much lower) and banks against the deposits it has at that time. If you lend £1000, it is simply written into your account. no actual existing money has changed hands. When that loan moey is spent and circulates in the economy, all of it is likely to end up back into the banking system, swelling their balances with money they never actually had in the first place. These deposits coming back to a bank are then used as the basis for new loans.
In short, banks loan you “number money” or “checkbook money” on which you have to pay principal and interest on money they never actually has in the first place. They do NOT lend you existing depositors money. They create new number money every time they make a loan. However, they also create a debt.
And that is ultimately how our money supply works. No debt = no money!
Thanks, that’s one of the books I’ve not got around to yet. I have a pile by the bath which is where I do all my reading. It’s difficult to get the computer near it so I’ll probably wait till I get a paperback copy 🙂 The book I’m most keen to read is The Magic of Money by Jamjald Schacht, sometimes known as Hitler’s Banker. The only copy I can find in the country is in the British Library and I can’t get that anywhere near my bath either so reading it remains an ambition.
Both of you, I don’t know how we got onto the BofE but I’ve heard that it’s run by private nominees who remain anonymous. It’s something I’ve yet to look into (I’ve been taking an historical approach to all this, trying to find out how it all started) – Richard, you say it’s genuinely nationalised, can you refer me to something to support that please?
BB
http://www.bankofengland.co.uk/about/legislation/1946act.pdf
Read the preamble
It says:
An Act to bring the capital stock of the Bank of England into public ownership and bring the
Bank under public control, to make provision with respect to the relations between the
Treasury, the Bank of England and other banks and for purposes connected with the matters
aforesaid.
And that’s what it actually did
Richard – Ownership is probably the wrong word. Control is perhaps more appropriate. In 1946 we were not in a position to raise the capital to purchase BoE. Because of the Royal Charter status, an audit trail of funds cannot be identified.
In 1948 the railway companies were nationalised and again, the original shareholders were not fully compensated and dividends in £millions continued to be paid by the BRB. This matter has been investigated by the railway unions. This perhaps offers a parallel view.
I do understand that this is sensitive ground and interpretations differ.
I think you are confused
Of course we didn’t have the money to nationalise – but we didn’t pay any money. We issued new debt to nationalise – which given that money is debt could be said to amount to the same thing, but certainly did not require the payment of cash
It did require the payment of interest though, which is true
But that is nothing like an ownership claim, or control
I think you’re seriously confusing issues
The best book that explains how our financial system works is “The Grip of Death” by Mike Rowbotham. It rips apart any conceived notions of conventional economists.
Well worth buying!
I haven;t seen that referred to for a while
I’d recommend The Skeptical Economist by Jonathan Aldred and Debunking Economics by Steve Keen
I’m rereading GOD as I want to find references to earlier times when money was scarce and people developed their own currencies here in England/Scotland etc. in a Worgl kind of way. My thoughts are that we’ll have to be doing that again soon if the money supply is choked off enough. I’m trying to work out an actionable blueprint. Also Richard I have TSE on my bathside table already 🙂
BB
I would recommend watching the new documentary film which has just come out on DVD called Inside Job. It shows how deregulation allows banks to keep passing on toxic debt so that some banks get left holding the “hot potato” of toxic debt and then need bailing out by the tax payer.
It explains how the deregulation gives a bank the confidence to give loans with no capital backing, they do not care because they just sell it onto another organisation. I could not pretend to understand every detail, not being an economist, but it made it crystal clear to me how a bank can become loaded with toxic debt, and how a country can create massive deficits by bailing them out. Obviously nothing to do with public social spending!
Richard – One last thought – If BoE were truly free, we could issue new capital, interest free or rebate the interest at a later date. To whom did the government have to pay the interest and what control did the lender exert?
In WW2 my father was a financial intelligence officer and he investigated these issues and even attended BIS meetings in Basel as an observer. Before he died, he told me many stories which I have kept to myself over the years but Eustace Mullins has covered the whole issue now and it is freely available for all to see.
I fear we can’t do those things – the EU does not let us
It’s why we have to use quantitative easing instead
Quite so.
John
Yes, I have read that we cannot DIRECTLY fund the treasury with debt-free money created by the central bank via the government.
However, is there really a great deal the EU could do if, given an extremely unlikely scenario, we were to do that?
I could be very wrong, but I fail to see what the EU could really do.
This last should perhaps be considered in the light of the looming probability that there won’t be an EU much longer.
BB
[…] Davis lives in a terribly simple world. He seems to genuinely believe that if people do not put money in banks than banks cannot lend. It seems he’s never heard of fractional reserve banking or the fact that banks can literally make money out of thin air. […]