We published this short video on YouTube last night:
Where does money come from? Most people think banks move it around. But the truth is: they create it. In this video, I explain how bank lending literally generates new money and why the system works purely on trust.
This is the transcript:
People keep on asking me, "How do banks create money?" And the answer is really very simple.
If you walk into a bank and ask for a loan - let's suppose you ask for £10,000 that you want to borrow to buy a car - they look up your credit record and decide whether you are worth it or not.
If they think you are worth the risk of lending £10,000 to, they don't go into their vaults and see if there's £10,000 of spare cash sitting there, because that's not how banks operate. Banks only really deal in electronic money these days.
So all they do is open two bank accounts for you. I'm assuming you've walked into a new bank to make this easier. One of those accounts is a current account, and they say there's £10,000 on it. The other is a loan account, and they say there's £10,000 on it.
One of those is an asset; one is a liability. It doesn't matter which way you're looking at it, that's always going to be true.
One is a plus, in other words, and one is a minus, whoever's books you're looking at.
And the result is that, actually, if you add up £10,000 plus and £10,000 minus, they come to nothing. So, the bank literally created the money it's going to lend to you out of thin air by simply putting a plus £10,000 in one account and a minus £10,000 in the other account.
And that's it. That's how banks create money.
And you believe that the money in your bank account is good to spend, and what is more, the person you buy the car from believes that the payment you make from your bank is worth £10,000. And on the basis of that trust, the whole of the banking system works.
But money is still just made up entirely out of thin air.
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Also worth noting another feature that contributed to the credit crunch – the debt side of that can be (and often is) sold to another company, and may be packaged up in other financial instruments like CDOs so losses aren’t just based on the one loan, they’re based on how a whole group of debts behave.
That’s part of why the markets froze so badly – nobody knew who actually held the debt for the mortgages that were going bad, suddenly many more companies had problems borrowing while things were worked out.
That many banks were borrowing short term and rolling this over constantly to cover long term loans meant when transactions paused they had borrowing to repay before the corresponding debts were repaid, creating the full on liquidity crisis.
AKA banks trying to be too clever with their creations while ignoring the risks of a wider market downturn.
Richard, well explained
I find the stumbling block for others to understand money creation is their next question
“But where do banks get it from?
and it comes down to whether they believe you or not, because politicians and the media tell it differently
Yes, money is complicated
Moeny is very complicated
Will the created money be deleted when it has been repaid?
What about interest payments, is this money that has been created?
All money is cancelled when repaid.
Interest paymnnts are appropriations, or redistributions out of income otherwise created. New money is not created: moeny already created is transferred from those owing it to the bank as their income.
I have, since coming across Tax Research, pondered long and hard on this for some while. (Apologies for the convolution).
Using your example; I get the loan and buy the car, I repay the loan with money that my employer pays me who has in turn taken a loan to extend his business and so on ad infinitum, with commercial banks creating, I believe, 97% of all money in circulation.
Now if we hypothesise that all bank loans were called for settlement today and everyone paid each other the principal that they were owed where do the funds come from to pay the interest on the loans? That can only be from the government surely?
Your employer paid you out of money transfers to them as a result of their sales.
That is how they get their income.
Then they pay some of their income to you.
And some they pay to the bank, either as loan repayment (which destroys money) or as interest, which is a transfer of their income to the bamk and does not destroy money.
No money is made or destroyed by money transfers.
Interest is a transfer payment, as are your wages.
And if you pay interest on a loan all it means is you have less to spend on other things and the bank now has part of your incoem to treat as its own.
The money that repays the credit advance/loan and interest to a bank is fiat money (money that the government had spent into existence and remains in circulation with currency users as it has not been taxed away) which circulates amongst users as long as and until it is returned/deleted by the issuer (taxation).
Interest payments could be viewed as equivalent to a “private tax” into the hands of a bank to form a part of its income from the circulation of fiat money.
How would you acknowledge the role of collateral (physical or reputational) in the bank money creation process?
It has none in the money creation process.
It has in providing security to a bank. That is something quite different.
And just to rub it in, the banks charge us anything up to 40% interest p/a on credit card debt.
Agreed
Hello Richard.
Firstly, I like these short explainer videos.
Secondly, (and I hope I have this correct) I’m sure you’ve said before that all money is debt. I found this difficult to understand at first but then thinking that all money is created, and the only way you can create money from nothing is through double entry bookkeeping.
Thirdly, does this mean that the entirety of money in any country could theoretically be repaid, (including all money the government owes itself at its central bank) so all debts are zero and all bookkeeping balances, and there would exist zero money in the system?
Theory suggests that possible.
I deal in reality, and there that is not going to happen.
Richard, regarding your being a bit tetchy because of stress – it’s just an ordinary reaction.. Everyone gets it. I’d have a total meltdown trying to do a fraction of what you do. Hey-ho, another day. No big deal.
I do not dispute, disagree with or otherwise pretend that what you said here isn’t true – “I deal in reality, and there that is not going to happen.”
What I said helps me (if no one else) better understand money creation, and from this think that there is a sameness to all money because it’s all created in the same way. Therefore the focus turns to the power struggles within society as to who controls this power to create and destroy/distribute and redistribute the money. I think this is what you yourself call political economics, and is basically what your whole blog is about. The ability to create/destroy money in a fiat economy is not in question and once that is understood then an ordinary, non-economist member of the public, like myself, can stop focusing on this and instead ask what is actually stopping us having a better quality of life as a society?
Thanks
I like to use money as an example of magical thinking…blows people’s minds! Most people still seem to think there’s some vast hoard of gold somewhere (probably guarded by a dragon).
I like the dragon….
That fills another gap in my understanding – relating to commercial bank money creation.
Thanks.
KUTGW!
Thanks
This, unfortunately, is one of the drawbacks of a cashless society. I know you are a fan of it, as am I, however, if you don’t have cash, you have nothing. I know cash is just a promise, but it is tangible. If I was undesirable to those with power, any “money” I had in a bank could be frozen or reduced to zero; cash would need to be physically removed. I don’t know how you get around this
But cash is also just a promise to pay – and it can cease to be legal tender overnight.
I agree that cash is still nothing more than a promise, but my bank account can be targeted individually. To decide that cash was no longer legal tender, would affect everyone, and is not practical.
Shorts are great! ‘Simple-to-get short explanations to cut thru the deliberate fog created perennially by politicians of all colours.
Amal Rajan has written to me, in response to my email to him, saying he will “see if they(Today editors) can get you on the programme.
Here’s hoping!
Can’t wait for your upcoming visit to KWAKU!!!
Shorts are great! ‘Simple-to-get short explanations to cut thru the deliberate fog created perennially by politicians of all colours.
Amal Rajan has written to me, in response to my email to him, saying he will “see if they(Today editors) can get you on the programme.
Here’s hoping!
Thank you.