I have argued that now is the time for the government to create all the money that might be needed to keep our economy going in the face of the coronavirus crisis. My argument is that the government should, quite literally, run any deficit that is necessary to achieve this goal, given how important it is to our long-term economic survival, subject (of course) to the spending making sense for that same purpose i.e. it is consistent with the logic of building a future sustainable economy.
This does, though, give rise to the question of how this money can be found. The purpose of this post is to answer that question. The answer is that it can simply be created.
I stress, that this is an electronic process. It amazes me that most people think that money is printed. It isn't. Only 3% of all money in the UK is physical. The rest is created by banks, but that includes the Bank of England, of course.
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. To make it easier to understand presume that you have asked a bank you have not dealt with before for this loan. When they agree to the loan they open two accounts for you. One is a current account. 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, literally, be nothing left. Which is why I mean they add up to nothing. There was no money before the loan was agreed. There is none when it is repaid. In the meantime the loan created money. And repaying it destroyed it.
Note there's no cash involved in this process at all. It's just an accounting trick. Nothing more.
And no one else's money is involved in the process.
Or any existing money, at all.
This loan creates entirely new money, from nowhere.
Now, of course banks can't repeat this lending trick forever because if they did people would realise there was no substance behind the promise the bank makes to you when making the loan that the money they put in your current account is good to spend.
And that's the confidence part of the trick. 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 once suffered.
But there is one bank that can never run out of money. And that is a central bank of a government that has its own sovereign currency, such as the Bank of England in the UK. The Bank of England can always pay. It can never fail. Because as the creator of all money, it can simply mark up its account with the government, and issue some more currency at will whenever it wants.
The relationship between the Bank of England and the government is crucial here. The Bank can always lend what the government wants. So there need never be a shortage of money, most especially in situations of the type that now exist.
But, of course, this still involves a confidence trick. People have to believe that this government created money is worth using. They do for three reasons.
First, for many there is no practical alternative, and that is not just a matter of choice. Because we have to pay a significant part of our earnings in tax and the only currency we can actually pay in is sterling, as a matter of fact, then we must have access to that sterling and so we use it for our day-to-day exchanges.
Second, we trust the currency precisely because we know that the country will tax, which means that the currency will have value in the future. A strong and significantly sized tax system that is properly enforced is, then, key to the stable valuation of a currency. That tax also, and crucially, is the means to cancel this government created money. Tax pays the same role as loan repayment in cancelling money creation in the example previously given. And cancelling government created money is important: this means government spending need not create inflation when full employment is reached, which would otherwise be the case. So tax does not actually fund government spending: it cancels their inflationary impact of it if (and that's a crucial if) that inflationary impact arises, which only arises domestically when full employment arises.
And third, we usually trust our government and economy to broadly prosper in a fashion compatible with other economies, so our currency can usually be exchanged with others of similar type on a fairly consistent basis, meaning that those from outside the country are happy to use it too. So, again, the currency has value. And it's not money creation that ever changes this: it's poor tax and economic policy that does, because they are what prevent the control of inflation.
But it's still all down to confidence, because that is all there is to money creation.
Well, that, and a trick of double entry bookkeeping.
Who would have thought it? Not many, actually. When explaining this phenomenon 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 it. But it's time we got used to it, because government created money is an essential part of our new economic paradigm, as I will explain in blogs to come.
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The creation of money through loans has been highlighted many times but I don’t recall much attention being given to cancelling new money/loans. Since you mention exams, I’d like to see this an exam question – a bank creates new money by providing a mortgage to someone who then owes the bank the value of the mortgage and gets to live in a house that they bought using the mortgage loan. The bank created the money to buy the house from thin air using a few keystrokes on a computer (within the bank/public trust limits). The original house owner receives the new money as payment for their house sale. The new house owner then pays off the loan monthly over 25 years. But the new home owner loses their job and after a period of being unable to pay the monthly mortgage debt, they have to leave the house and the bank now repossesses the house. The bank then sells the now empty house in order to get the money that they created for someone to buy it in the first place. A new owner buys the foreclosed house by a mortgage loan, so more new money has been created.
So money is easy to create but not so easy to destroy. Discuss.
Ian. If the repossessed house is purchased with another mortgage from the original lender (or any other lender actually), the new mortgage will effectively cancel the old one.
Example. Man A buys house for £200,000 with mortgage from Bank. After 2 years he can no longer afford repayments and house is repossessed by Bank. Bank sells house for £200,000 to man B who buys it with mortgage from the same Bank. The NEW £200,000 is given to Man B who then gives it back to Bank for the house, and the Bank uses that £200,000 to cancel the mortgage for man A.
There are plenty of variations to this example, but the general idea stands.
At least that’s how I understand what happens to loans and mortgages.
No that is a new loan and new money creation to different person which goes on the books of the bank as separate commodity. No way would a new loan to different person cancel out the old loan/debt of another person. it does not matter if is the same house.
You missed out the original person who took the loan out they are still liable for the loan and the loan will have to be repaid either at reduced rate or via the courts. Any way the point is the loan is destroyed as the person will HAVE TO PAY IT BACK, over the periods of time. So the bank gets a double whammy, it gets the house back and the loan still has to be paid in lieu of the value of the house. So for example the mortgage is 200k but bank takes the house back at 50k, that 50k is destroyed but not the outstanding balance. Banks never take houses back a the mortgage they gave, most repossessed houses are taken back at a pittance and is a massive
This needs repeating, again an again, because mark my words, when this is over austerity-fetish brigade will all come out of their fetid holes claiming that we must give it all back. And so begins are struggle against forgetting………………….
What you have set out needs to be repeated again and again. Governments have to spend and to spend without limit. Ironically, central banks are literally begging them to do so and making it clear they’ll purchase any bonds issued in excess of market demand. The ECB has launched its Coronavirous Emergency Purchase Programme (PEPP).
And central banks and regulators will have to blow the hedgies and disaster capitalists who attempt to indulge in their usual sociopathic antics out of the water. Unfortunately, it looks like the new Governor of the BoE isn’t up to the job. Nils Pratley despairs of his incompetence in the second item here:
https://www.theguardian.com/business/nils-pratley-on-finance/2020/mar/18/coronavirus-bonanza-investors-business-rates-shareholders
Not on subject, but how are feeling today?
Whacked
But no chest infection
I am hoping I am ofver the worst
Trying to rest and failing so far today – strongly suspect I will be in bed this afternoon…
Hope you’re over the worst of it
The other point is that taking the balance sheet process in aggregate for the private sector the government money creating process supplies the interest on private bank loans. If the latter did so it would be a self-imploding Ponzi arrangement. The public and private banks need each other contrary to the Libertarian Market Fundamentalist view of the world.
They can create spending power by cancelling local government debt held by the PWLB. Last year councils paid £4.5 billion servicing their debt (£77 billion held by PWLB). This would provide them with £4.5 billion a year (or whatever they could manage to spend of it), potentially enabling them to take on more staff.
Sorry, PWLB?
Public Works Loan Board
Still a bit confused on the mechanics.
The BoE creates central bank reserves.
The Treasury creates the bonds.
1. Does the BoE buy the bonds direct from the treasury?
or
2. The BoE exchange the CBRs for “broad” money that the private banks create out of thin air? The private banks then purchase the bonds from the treasury using the CBRs?
The government can then spend the “broad” money in the economy.
Or
3. Something completely different?
Can anyone ease my confusion?
Can you search papers by Stephanie Kelpton here
I simply don’t have the time or energy to answer these questions now
https://www.google.com/search?q=stephanie+kelton+central+government+reserve+accoutning&oq=stephanie+kelton+central+government+reserve+accoutning&aqs=chrome..69i57j69i64.11647j0j7&sourceid=chrome&ie=UTF-8
Thanks Richard.
Will do.
Vinnie try these. Relatively straightforward. The Americans copied the UK’s reserves system:-
http://neweconomicperspectives.org/2019/10/the-peoples-money-part-1.html#more-11600
http://neweconomicperspectives.org/2019/10/the-peoples-money-part-2.html
Thanks Helen.
I’ll check them out.
I’ve just gone through Modernising Money again. (A. Jackson & B. Dyson).
I think I’ve got the gist.
1. Pension fund instructs Bank to buy Gov Bond.
2. Bank debits pension fund account and deposits equivalent in CBRs in Gov account at BoE. Purchasing bonds.
3. Gov can then spend CRBs by transfering CRBs to BoE account of Bank X to pay NHS hospital which has account at Bank X. Bank X then credits NHS Hospital account with equivalent amount in broad money.
I think this is how it works???
Does Bank X create the “broad” money that it deposits in NHS hospital account or is it just balancing out the liabilities against the newly gained CBRs assets?
The whole process seems so convoluted. Why can’t the BoE just create the CBRs and transfer them straight into the Gov CBR account at the BoE and cut out the middle man and not even have to create the bonds????
I’m sure there is a good reason but I just can’t figure it out?
I will try to do some stuff on QE today
Why do it when we could simply lend direct?
Because EU law and international convention does not allow direct lending: that’s the only reason why
That needs to change
Thanks Helen.
WOW!!!!!
Read the links you suggested, last night. Explains lots of the process and importantly WHY. It has created as many questions as it has answered though!!!!
A big piece of the jigsaw solved is that the Treasury only uses CBRs. I’ve been trying to figure out how government gets its hands on the broad money created by private banks and then spends it. Now I know it doesn’t. When we pay tax, I assumed the government was getting that broad money paid directly to it and then spending it directly back into the economy. It does not.
The WHY of the whole set-up was also an eye opener.
If there is a project/idea that is deemed of benefit to society. Has the resources, man power, technical know-how etc to be achived but can’t go ahead because of lack of money, then that is plain crazy. The system was designed to “create” that money. Which makes a mockery of the idea that there is no magic money tree.
It seems that the original goals have been forgotten by the private banks. They are more interested in making profit for themselves than enabling innovation. (Loans going into property/assets rather than realising ideas)
CBRs were/are a way of government having some control over the private banks. This seems to have failed and the tail wags the dog.
What effect would nationalising the banks have? Would the same convoluted process still exist but the government would control the banks and so take control of where the broad money is spent?
Why not just have everyones accounts held in CRBs at the BoE? The need to clear between banks would disappear. The BoE could just create credit in the treasury account with no need for bonds.
(I understand the pension funds would not be happy). A banks role would be to just manage the money, make the transactions, ATMs etc. Tax would just become a way of taking money out of circulation if inflation was going up.
In a zero growth economy, (which is the direction of travel if we are going to avoid climate change) commercial banks could no longer make a profit anyway.
I’m sure there are some perfectly reasonable reasons why this would be a problem, but I don’t know what they are???? (I like my world to be as simple as possible!)
Richard
If you could explain QE sometime, I for one would appreciate it.
I need it explaining in terms of following £1m of CRBs from the BoE to the treasury and all the stops in between. The various accounts it goes through. The bonds purchased (are they existing bonds already out there or does the treasury need to create more?) and when broad money comes into play. The collateral that banks use to buy CBRs?
To understand all of the above is to understand the core of everything else that is discussed in the blogs. The nature of money is at the heart of society. (For better or for worse)
I’m going to have to let my frazzled brain have a couple of days of processing before I even go near MMT !!!!!!!!!
I hoped to today, but to be candid know I have to listen to advice and rest for a day or so
I am whacked
Thank you for this. I’ve just sent an email to Johnson via 38 Degrees calling for deficit spending and quoting your piece. It’s probably like inserting a needle in a haystack but the message needs to be pushed and pushed.
Indeed it’s a bit like expecting the current Libertarian blunderers in office to burn an effigy of the monetary system illiterate Margaret Thatcher who famously said at the 1983 Conservative Party conference:
“The state has no source of money other than money which people earn themselves. If the state wishes to spend more, it can only do so by borrowing your savings, or by taxing you more. It is no good thinking that someone else will pay. That ‘someone else’ is you. There is no such thing as public money. There is only taxpayers’ money.”
But burn her they’re going to have to do!
You’re right
Good quote – I’m struck by the small proportion of supposedly educated people who understand where money comes from – I often slip the question in..
Mind you not many understand what ‘exponential’ means, which is even more important right now
Richard, I still really struggle with the parctical nature of government debt. When I talk to people about this, they always say “but the debt must be repaid” and I don’t have an answer. At a conceptual level it feels strange that a government has a debt even though it can create money.
So, since you are blogging about “the basics” I wonder if you (or one of the many experts who comment here) could please elaborate on the way the relationship between the govenment and the BoE works in practice. In particular, what is the nature of the agreement between the 2 parties? At what interest rate is the loan made? What is the payment schedule? What where does the money to service the debt come from (tax and gilts, I think)? What provisions are made for cases when the government can’t meet the schedule?
Also, as side points, why do we even bother tracking the deficit and where do government bonds fit into it all?
I realise this is a broad question, but I hope you understand where I am coming from.
Sorry – can you check MMT primers like the Gower Initiative for Modern Money
I have no time to do more….
I’d second Richard’s suggestion. Check out some MMT primers. You don’t have to buy the whole MMT package but the basic principles are explained
I agree
Some people don’t buy job guarantees for example
You can take it or leave it
Adrian.
Check out the links Helen Schofield suggested to me at 5.58 on the above comments.
Good explanation but it has created as many questions as it has answered!!!!!
Good luck!!!!!!
Thanks Vinnie and Richard
I’m working through them at the moment. I have time on my hands after all 🙂
Get well soon Richard
Richard.
Your detractors seem to have gone quiet. Are you editing their comments out of the blogs or have they gone to ground?
They are very quiet….
Had one or two rather nasty phone calls from landlords though….
I wonder if those same Landlords are going to give Boris a call and give him a piece of their minds, when Boris eventually announces a rent amnesty?
Government has effectively given the green light for tenants to miss rent days by saying no-one can be evicted for 3 months.
Some of them have been none too polite to me…
No rush this end Richard with a QE explanation.
I’m still digesting what Helen Schofield posted!!!!!
Conserve your energy and get well soon.
Bigger fish to fry than feeding my curiosity.
Yep i have known about this for years . Randal Wray is a good source, so is mike hudson and Mark Byth as well. Great guy as well
https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-the-modern-economy
https://www.youtube.com/watch?v=i35uBVeNp6c
https://www.youtube.com/watch?v=0zEbo8PIPSc
https://www.youtube.com/watch?v=JQuHSQXxsjM
Out of interest, have the government explained how they are going to fund all this spending?
Are they still saying that it can all be raised from borrowing (bonds)? Would there be enough interest in purchasing the vast amounts of bonds to do this? I’m guessing the financial markets will be looking for bailouts not spending on bonds?
I’m guessing that they aren’t saying taxes!!??
Is it inevitable that Government will just create the money at their end with reserves?
The money will be ‘borrowed’
But £200bn of new QE will help no end
Expect to to be £500bn by the year end