After posting yesterday's infographic on how banks create money by lending, there were questions and challenges, both here and on Substack, about how this suggestion is altered by the requirement to pay interest on this new money that has been created by a couple of entries in a double-entry bookkeeping ledger. This is my explanation:
I am not quite happy with the sketch in box 3, but I have not come up with anything better yet. I think the rest work, and this one is good enough.
This infographic was corrected after the first publication to provide consistent bullet points.
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I really like this one.
Interest IS a transfer from poor to rich and the rate of transfer is decided by… errr…. the rich.
Thank you
I know one infographic cannot cover eveything, but is it worth addressing somewhere the question of who controls the interst rate on bank loans? It’s my understanding that the minimum interest rate that can be charged is set by the central bank via its base rate (given that interest is paid on central bank reserves) and not by the bank that makes the loan. So the bank making the loan is not fully responsible for the interest rate and its social consequences. A big part of that responsibility rests with the central government.
I have done one on central banks
Okay. In that case, I wonder if there is some way to link between the infographics? If each infographic could be linked to the one or two others that relate most to it, then perhaps that could be helpful for new people trying to learn about these topics to rapidly build up a conceptual network? Maybe for now it could be as simple as just mentioning at the bottom of the blog post which other existing infographics are most relevant to explore next? Another idea (for later) would be creating some kind of a mind map, with each box being the title of one of the infographics, to give some indication of the links between the different topcs covered. A meta infographic, if you will. This might help with developing system level thinking?
Iwill bring this to our team meeting tomorrow. We need to work this out.
Okay, great. Thank you for everything you and your team does, by the way.
You are correct – banks will always charge a rate above the Base Rate. Lending to non-government borrowers always carries risk of default and has to be administered… and this is reflected in the “spread” over the base rate (or gilts).
In practice, small businesses can’t issue bonds and are captive clients for their bank. So, no surprise that they are gouged on rates and required to offer all sorts of security/guarantees. This a problem that needs addressing and is not simple.
On the other hand, the Central Bank is a servant of the people and should be easier to fix. My suggestion (at least for a start) is having a broader range of people on the policy making committee but other solutions are available. Here, all that is lacking is political will.
Agreed
Nice one Richard. So: interest is purely extractive – it’s a kind of rent?
I wonder if you could do one on profit? I am still unclear as to whether profit is extractive or not. I suspect that it can be, but also that profit based upon real production of goods and services can actually “make” money…
Interest is, indeed, rent, and nothing else. I will be doing a dedicated infographic on it and another on profit. Both are on my ever-growing list.
That works well for me, thank-you. Redistribution (from lower to higher income) and trickle-up and lots of other political stuff in that infographic. Much appreciated .
I was reminded of the Giro Bank set up by Labour in the late 60s. It was not like other banks. I never used it but many seemed happy with it.
It was taken over by the Alliance and Leicester who then were taken into Santander.
I read that the Post Office Money brand continues some of the services but is now run by the Bank of Ireland and I gather the American Capital One is also involved.
My suspicion is that once again neo-liberal doctrine has handed some of our national financial structure to other nations.
Correct.
Reading all the topics in this series has been very helpful, but I’m still confused about something:
I understand that a country’s government (and banks) create and put money into its economy, and taxes (or repayment of loans) destroys it/removes it from the economy.
It all makes sense to me if each country were a closed system, but what about foreign debt from the government borrowing money from other countries and the interest owed to them, or possibly other transactions between countries like international trade? Do inter-country lending or trade change the equation on any of this, or does it all still work out the same somehow? I suppose part of the answer may have to do with which country’s currency is used in the transactions.
Currency does matter. Take the UK. The UK government issues pounds, and almost all UK government debt is denominated in pounds. If somebody in Japan buys a UK government bond, the UK does not borrow Japanese yen. The Japanese investor acquires a sterling asset. When the bond matures, the UK government pays pounds. It can do that because it is the issuer of the pound.
The situation is different if a government borrows in a currency it does not issue. If the UK government borrowed in dollars, it would need dollars to repay that debt. It cannot create them. That can create a financial constraint, which is one reason why foreign-currency debt is never advisable. The UK does not do that.
International trade adds another dimension. If the UK imports from Germany and pays in pounds, those pounds do not disappear from the sterling system. Somebody in Germany then holds a sterling asset, unless they exchange it with somebody else who wants pounds.
That is why sectoral balances matter. The overseas sector is another sector alongside government and the domestic private sector. If the UK runs a current-account deficit, the rest of the world is accumulating claims on the UK. The accounting balances.
But that does not mean international trade does not matter. It matters in real resource terms. Britain cannot create resources elsewhere. Foreign suppliers have to be willing to provide them and, ultimately, to accept sterling on terms that work for them.
So the monetary logic does not cease to apply when we introduce other countries. But another constraint is more obvious: a government can create its own currency, but it cannot create the resources produced by the rest of the world.
And that is why trade relationships, productive capacity and exchange rates matter so much.
Thank you. So if I understand correctly, borrowing doesn’t affect the equations no matter where it’s borrowed from, as long as it’s in your own currency.
But thinking about your example, trade does have an effect. Those pounds spent in Germany are still in the sterling system, but are now out of reach–they can’t be removed by taxation, for example. So the amount of money held in other countries this way needs to be accounted for and brought back in or the amount going out limited, to avoid negatively impacting the the government’s control over its economy. I think I may have learned a little about trade deficits today.
You have the first point right. What matters with government debt is principally the currency in which the debt is denominated, not the nationality of the person holding it. If the UK government owes pounds, it can always make the sterling payment.
On trade, though, I would make one correction to what you say. Pounds held by someone in Germany have not really left the sterling system, nor do we need to get them back.
Sterling ultimately exists as claims within the UK banking system. A German exporter who receives pounds can hold them, buy UK goods or assets with them, or exchange them for euros. If they exchange them, somebody else acquires the pounds. They do not disappear.
Nor does the government need to tax those particular pounds. Taxation does not have to cancel the same pounds that government previously created. What matters is the overall amount of spending power within the economy relative to the resources available.
A trade deficit therefore does matter, but not primarily because Britain is “losing money”. In one sense, Britain has received real goods and services from overseas in exchange for financial claims denominated in pounds. The more important question is what persistent trade deficits tell us about our productive capacity and our dependence on imports.
If we allow domestic industry to decline and become increasingly dependent upon other countries for essentials, that creates real vulnerabilities. It can weaken sterling, increase import prices and leave us exposed to disruptions in international trade.
So I think you have reached the important insight, but I would phrase it slightly differently: the danger in a trade deficit is not that the pounds have escaped. It is that the productive capacity that could have produced what we imported may have escaped instead.
That’s very helpful, thank you!
Box 3. Find, rather than ‘earn’ the money? The graphic works for me.
Saw this infographic earlier on LinkedIn. Infographic work there. The series is addressing questions so many people don’t know that they don’t know (though they may think they must know). I’m liking the simple language you are striving to use. Sends the subliminal message that the ideas can’t be complicated if they can be simply explained.
Thanks. I am happy with box 3, but have updated the infographic to provide consistent bullet points.
Richard, the infographic says that banks create money when they make a loan. But what about the banks’ need to fund themselves (indeed to adequately match the volumes and duration of the loan and deposit sides of their balance sheets)? Some of this funding* comes from depositors’ money (both current and deposit money), some comes from wholesale funding (e.g. pension funds, insurers, fund managers etc) via a bank’s Treasury operations, and some from shareholders’ funds. When those funds are gathered by the banks, are they not equally destroying money through deposit-gathering, if they create it through lending?
Also, Clive Parry, you make the fair point that small business customers don’t have market access to issue bonds and instead become captive customers for banks. But it’s a bit suspect to make a leap that they are “gouged” on rates – the last time I looked closely at this, the main UK domestic clearers generally lost money (or made a poor return) on small business customers, viewed across the economic cycle. The reason is that rates, which are certainly high, still aren’t sufficient to allow for the risk inherent in lending to such businesses. The problem is that banks have never figured out how to provide other kinds of finance to small businesses, and the UK economy generally is not good at providing it either – equity finance is seldom available to small businesses, for example. I agree there is a problem here; however I think the diagnosis that might help lead to a solution is pretty complex.
* I say “some of” because another part of it can come from central bank funding, and I agree part that is money creation.
There is an infographic coming on this
Very clear and helpful. Thanks.