Yesterday I explored what money is.
I said it was a promise to pay that is backed up by the government, which is in turn backed up by its ability to tax.
That explanation did not, however, explain how electronic money is created, because it has to be. This recording does that.
Next I will explain how this process of money creation and the government's promise to pay are intimately connected. But that's for another day.
The transcript of what I said (near enough, because a few words always seem to change during a recording) is as follows:
Almost all the money that we use is electronic.
It is not notes and coins.
There is no gold, or anything else, sitting in banks to back it up.
And when 97p in every pound spent in the UK, overall, is spent electronically, there aren't notes and coins sitting in bank vaults to back all that electronic money up either.
Our money is nothing more than an entry in a computer.
But those entries do have value. They get that from the fact that all electronic money is a promise to pay.
That promise is written on banknotes. But it's not written on our bank accounts.
And although it's easy to see how a banknote is created - by simply turning on a printing press - how is electronic money made? After all, it has to come from somewhere.
And it does. It is made. It has to be. And the process by which it is made is deceptively simple.
Money is made whenever a bank lends money. An example helps.
Suppose a person wants a loan. Suppose they want £10,000 to buy a car and haven't got that money. So, they ask a bank to borrow it.
The bank asks them for information - almost certainly online. And then the bank checks it out. That's called a credit check. If the person passes that check the bank agrees to lend the money.
It does that because it has decided that the person who has asked for the loan is likely to fulfil their promise to repay it. They trust them. So they create a bank loan account with £10,000 owed by the customer in it.
In return the bank makes a promise. Its promise is to put £10,000 in the borrower's bank current account which they can then use to buy the car.
And that process - of the borrower promising to repay the loan and the bank promising to pay whoever the borrower wants to make payment to, is all that it takes to create all the electronic money that there is in the world.
Importantly, note that the bank does not give the borrower another customer's money. In fact, no one else is involved in any way in creating the loan and the money it creates.
All that money creation requires is two equal and opposite entries in the bank's books that in return reflect the two promises made.
The bank's promise is reflected by their being £10,000 in the customer's current bank account.
And the customer's promise is reflected in the fact that there is £10,000 in their loan account at the bank, which is what they now owe it.
These entries are all it takes to make the new money that is needed to pay for the car.
But that means something quite important as well. That is that when the loan is repaid the money it created is destroyed.
What that in turn means is that money is being made and destroyed by lending and loan repayment all the time.
And some of that lending is from you to the bank, which is what you do if you're in what is called credit, and some of it is lending by the bank to you. But all it takes is that process of lending and borrowing to make all our money.
Money does then come down to just one thing - which is the promise to pay.
And bank lending is now the only way we now have to create all the money that we need to make the economy work.
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What are the limitations on the amount of electronic money an individual bank is able to create?
I will get to this – it’s not possible to deal with everything in 4 minutes
There will be more to come…maybe tomorrow
No limitations really,banks can and do create as much as they wish when conditions are right, i.e as long as there is demand and they think you are a good credit risk. This is due to the peculiar way banks operate, they can quite easily do this in a boom when they make good profits, of course the opposite happens in a crash, then banks don’t want to lend,as their profits drop and people don’t want to borrow. So it all depends on the general confidence in the future.
There is one indirect real limit on an individual bank,and that it cannot increase its lending faster than the other banks,if it does it runs the risk of becoming insolvent. This is because the new money it created for loans will inevitably be transferred to other banks as the loans are used to pay borrowers debts to people with accounts at other banks. If an individual bank is out of kilter with the rest of the banking sector on the rate of its new lending it will find it cannot settle its end of day settlements ,which is a serious problem for any bank. So as long as all the banks increase their lending in step there should be no real problem in any individual bank making its end of day settlements ,if a bank is short of reserves in any one day it just borrows the money from another bank on the interbank market and everthing carries on . Problems happen when you can’t pay your end of day settlements and can’t get a loan on the interbank market. As happened in 2008 to Northern Rock.
That’s super. Very easy to understand.
I think people will struggle to internalise the idea that money is just numbers in a computer. Money is emotionally connected in culture to the idea of virtue and work, to “earning”. That’s why people hate the idea of the feckless scroungers who get money apparently without “earning” without the effort and sacrifice that they make to get it. And, I guess, that’s why the rich need to propagandise about the vast sums of money they hold are the product of unimaginably hard work and intelligence and not just the ability to manipulate a game of numbers. People cleaning hotel rooms work far harder and have nothing to show for it.
Helping people to understand what money is and breaking the mythology around it must be one of the most revolutionary things possible at the moment. Many thanks.
Thanks
My problem is this. When I get the £10,000 to buy a car, I go out & pass the money to the garage, which then asks my bank for payment. It is in trouble if it can’t find the cash to pay this claim, surely.
That is why we have bank regulation
I will get to that….soon….it’s not possible to deal with everything in 4 minutes
A few months ago, I was lucky enough to get a post in Progressive Pulse.
http://www.progressivepulse.org/economics/a-perfectly-regressive-tax-a-guest-post-by-michael-green/comment-page-1
It argued that this process is the formal equivalent of a perfectly regressive tax system. Those with the least money pay the highest rate of tax.
Moreover, failed bank loans take the excess money that governments are supposed not to print and turn it back into thin air. If you do the sums, governments MUST print more money than they collect as tax, in order to offset the losses of the private lending sector.
The problem with the banks providing loans is that they demand interest. This means that all the debt can not be paid off so the government must running a surplus to cover this interest or the GDP will go down. The ancient civilisations who invented loans and interest understood this and to stop every one going bankrupt (literally being enslaved) was to periodically declare a debt jubilee.
I liked this. If anything it was better than yesterday’s.
A possible question people might have after hearing this is, ‘if banks make money electronically by providing loans, does this mean government only creates paper money?’ or similar.
I’d like to see one of your upcoming recordings cover the topic of government creating electronic money.
Thank you.
That’s the next one…maybe tomorrow
Having thought about this further I wish to suggest the following.
Money is the thing that is issued by the state that allows the citizens to transact for goods and services produced within the economy. The state can affect the amount of money in three ways.
1) Print it either directly or through the banking system
2) Via interest rates which affects the flow of savings and credit into and out of the system
3) Taxation with which it can directly affect the money in the system
The money system is analogous to a gas in a balloon. The Government has a money pump with which it can pump the gas in the form of money into the balloon. As the pressure in the balloon increases the gas heats up and the money circulates around the balloon transacting in a similar way to gas particles, putting pressure on the balloon envelope and increasing the size of the balloon. The volume of the balloon represents the size of the economy. If the pressure of the gas becomes too great some of the gas escapes back into the atmosphere in the form of inflation and the government will need to take action to reduce the flow of money into the system as further inputs have no effect on increasing the size of the economy. If on the other hand the pressure falls due say as in the current case a fall in demand caused by a government induced reduction in transactions the ballon starts to deflate and the government needs to pump more money into the system in order to keep the balloon inflated. It can do this without any risk of inflation until such time as the balloon is reflated.
There is no limit to the amount of money available to the government which it can pump into the system. It is like the atmosphere outside. If London sees an increase in population we do not concern ourselves that London will need to borrow air from Wales in order to allow the increased population to breath and that at some time in the future Wales will need to be repaid the air. Likewise we do not worry about repaying the air we use to pump up our tyres. Money is the same. There is an infinite supply. Only the flow into the balloon needs controlling and in this the government should use the price mechanism as feedback regarding the pressure in the system.
Never again should e be forced to hear the question from journalists “How are you going to pay for it?” The government can pump as much money into the system as it needs in order to expand the economy subject to any overheating which might happen.
That works
how about
car = collateral = credit = cash
I like both of your ‘explanations’. I think they are the right length with the right amount of content. The fact that most of the comments are “why don’t you say xxxxx?”… with your response “tomorrow, maybe” is very positive.
Looking ahead the questions are:
How do you get them listened to more widely?
How will they be received by a more sceptical audience (after all, the blog is read mainly by those that agree with you)?
Good questions….
I will have to think about that
Facebook?
Well I just looked up “money” in five dictionaries of economics, and none of them said anything about “promises to pay”.
Money certainly CAN TAKE the form of a promise to pay. Money issued by commercial banks is a promise to pay in base money (central bank issued money): witness the fact that if you are the lucky holder of some commercial bank issued money, i.e. your account is in credit at your local high street bank, you can demand some of it be turned into central bank money by going to an ATM and getting physical cash.
But central bank money is not a promise to pay you anything: you certainly won’t get gold from the Bank of England (in the way people could over a hundred years ago). Nor will the BoE pay you anything else.
In short “promise to pay” is not a definition of money: it is only a definition of a particular form of money.
No it’s the only definition of money
As the Bank of England said very pointedly in 2014, the reference books have all got money wrong
You should believe them
Of course that’s not actually what the Bank of England said, but you must know that?
What did the Bank of England not say?
Just to expand on this, as it adds clarity. There is a distinction between real money (central bank credit; ie the bank of England) and bank credit (money created within the banking system). When a bank creates new money as a loan, they create bank credit, and so long as that money remains in accounts within that particular bank (one reason banks like to get as big as possible and operate under many different brands), it does not need to call on its account with the central bank to move real money to cover the transaction.
So you take a loan of £10k with Barclays, and use it to buy goods or services from someone who also happens to bank with Barclays (or another bank within their group). That transaction stays within the bank, and so only requires their own internal bank credit to support it. Only when, or indeed if, the recipient moves the money to a bank outside of the Barclays group, would the bank then need to transfer real money (central bank credit) to cover the transaction.
Another things to be known. On any given day, the criss-cross of transactions between banks that require central bank funds is relatively stable, with many transactions cancelling each other out, so that the net outflow of central bank credit from one bank to another can be a tiny fraction of the actual capital outflow. So whilst many millions may flow from Barclays to Santander in any given day, the reverse is also true, and the net position, and consequently the need of the banks to access central bank credit, is much smaller. This is why bank runs are so disastrous, because it involves massive outflows of electronic and paper (or plastic) central bank credit from a bank, without capital inflows from other institutions to balance it out.
You can’t tell bank-created money from government-created money
They are the same as they cannot be told apart
And they all happen under government licence – which is how banks operate and why they have CBRs
I will address this soon
They are entirely fungible as far the general public is concerned, but the distinction matters greatly for banks.
As to banks operating under ‘licence’. I’ll simply observe that by definition a licence is something which is granted, and crucially can be withdrawn if you fail to abide by the terms of it (be it rules or payment of associated dues). Given that no large bank has ever seen the withdrawal of its ‘licence’, no matter how colossal and systemic the malfeasance, the nomenclature serves only to provide a veneer of public accountability.
But they have to comply with the demands made of them
Those demands are not always sufficient, but they do comply
An aside which I find interesting is that the process of money creation you describe is in full operation every time a human being pays for goods etc. with a credit card. Pay off in full at the month’s end and the created money vanishes.
In reality, we are all money creators and destroyers. Snag is, if we don’t pay it off regularly we end up paying interest on this thing we ourselves brought into being.
True
I’m a bit perplexed by this explanation.
In MMT-speak, this is purely about ‘horizontal’ money creation by the private sector. Yet, important though it is to explain how that process works, there is no mention that this only part of the story. Namely that there is another distinct form of money creation by the government sector – aka ‘vertical’ money.
Following on from that, the closing sentence is even more puzzling…
“And bank lending is now the only way we now have to create all the money that we need to make the economy work.”
As this implies the government spending plays no part in the economy! But surely it does? And patently so e.g. the billions of £s spent into existence by the UK government to tide workers and companies through the Covid-19 crisis.
I am told these things have to be 4 minutes
That is the next one!
Of course I think the government has a vital role
But if you can script it all in 4 minutes might you share it?
I’s love to see it
Richard.
I think you have the length and content spot on.
It’s not too long so that there isn’t too much information to digest in one go.
Obviously, the podcasts have to be listened to in the correct sequence and they will need to be numbered to reflect this, but I guess you know this already!!
Someone can’t just listen to one in isolation and get an understanding of what it all means.
It just goes to show just how many layers there are that need explaining, to fully understand how the economy works. There are no short cuts.
That’s why those who use the “Household budget” analogy have the upper hand!
Are these the final drafts or are you planning to re-record them after making tweeks? Not sure if you are looking for constructive criticisms or not?
I will be using the Wiki and link to it to cover this issue as it develops
I may well re=record these – it is clear the first needs re-recording already and I am open to comments – and am taking them on board
I have one quibble and one suggested change. Firstly my quibble…
“And when 97p in every pound spent in the UK, overall, is spent electronically”
The 97% figure applies to private bank money creation (the other 3% being BoE notes & coins). However this is a very limited view of the overall picture as it ignores the £600-odd billion that government creates electronically each year. Note that the reason this gets overlooked, is that government £s are almost all destroyed in the same financial year (via taxation or via bond purchases).
Ok, now my suggested tweak to the following line, which needs expanding to include the manufacture of ‘vertical’ money (something tells me it might burst the 4 minute limit!)…
“Money is made whenever a bank lends money. An example helps.”
Change to…
“Money is made whenever the government spends or whenever a bank lends money.
The most important of these is government money.
Government spends by instructing its bank, the Bank of England, to keystroke money into existence in a recipient private bank’s account at the BoE. This newly created government money (collectively known as reserves) enables the private bank to then keystroke money into existence an equivalent amount in the recipient customer’s account.
The private bank thus has two equal and opposite entries in it’s books – its promise to pay its customer, and a promise to pay the private bank. The private bank is more than happy with this, as the promise made to it comes from the most acceptable possible source there is: the currency issuer itself.
Moreover, since reserves are so acceptable to private banks, this facilitates the payments system whereby customers can transfer funds between private banks.
One final, but quite subtle, consequence of this process is that reserves provide the private sector with the possibility of saving. This is important as this is something which is not possible to achieve with the second method of money creation in the economy – that is whenever a private bank lends money.
“
Stephen
I have already said I will get to this and do a post on the role of government in this
And I will
I will build in those points
I have noted your text
But a) these things have to be short and b) I am horribly time constrained by other work and lif3 and, occasionally, sleep 🙂
Richard
Absolutely Richard. On both points.
Thanks.
🙂
I will get there….just too much zoom right now
I’d say it is best to think of money as a scoring system, a rugby match being a good analogy. The teams can only get their hands on points by scoring tries; in contrast the ref can issue points without limit by adding numbers to the scoreboard. This makes it clear the difference between users (the teams) and the issuer (the ref).
The score is backed by the state (I promise to pay the bearer …). A scoring system gets away from the insidious framing of money being stuff, and avoids talk of creating or even printing money. Money as stuff is behind all the nonsense of a sovereign state being unable to pay for things; the confusion over the fiscal deficit; and over non-government sector savings (aka the National Debt). This all harks back to an era 90 years ago now when the state was obliged to convert some moneys to gold.
If we don’t get this fallacious framing sorted out, the neo-liberal ideology will continue and Scotland will get fooled into taking on debt when it leaves the UK.
The scoring system idea is very strongly embedded in MMT thinking
And the bank keeps the interest that is paid as their profit, correct? I think that should be in there if so.
I am not sure what you are saying – sorry
The interest isn’t really relevant.
Its just the bank’s fee for giving people access to more liquid IOUs than we as individuals can create. Also is worth pointing out that the common ‘treadmill of debt’ misconception – that private bank interest payments act like a black hole leaving us all in ever-increasing debt servitude – is completely false.
Bank profits still stay in the economy e.g. they end up paying wages, dividends etc.
They also pay massive dividends…
I have only just found found this blog and find it absolutely fascinating.
I am not an economist, just a primary school teacher, but am intrigued by all of this and wish I’d learnt more about economics before.
Could I just ask, where is the best place or book to gain an understanding of Modern Monetary Theory?
Thanks in advance.
Stephanie Kelton has a book about to come out
https://www.amazon.co.uk/Deficit-Myth-Monetary-Peoples-Economy/dp/1541736184
It is worth waiting for
Your description is quite outdated for how banks operate today for a number of reasons.
Banks carry significant liquid reserves i.e. they lend out significantly less than they have raised already in funding. Lloyds has 440bn in loans but 540bn in funding. So everything they lend has already been borrowed from someone else.
The old loan into current account is not how modern banking operates with people using multiple banks. I have a mortgage, personal loan and business fiance loan (in my personal capacity) all from banks other than where my current account is held. They was no current account at the bank when the loans were created as the money left the bank immediately. Those loans had to be prefunded, with the creation of loan in the accounts requiring an offsetting entry to reserves rather than deposits.
The old idea of end of day settlement is no longer true with the vast majority of payment value settled in real time.
Regulations have tightened significantly restricting how banks can operate. They can’t even make a commitment to lend to someone in the future without it impacting their capital and liquidity requirement.
True, in detail
But absolutely none of which changes the substance of the argument one iota