The Truth About Money

The Money Tree

Have you ever wondered how money is created? Most people believe the government creates money, the Royal Mint manufacturing it and the Bank of England (BoE) putting it into circulation. But there is more to creating money than the BoE creating physical money or adding to their reserves electronically. Most people know very little of the process for creating money, what part tax plays and even how the money is destroyed. There is nothing "magic" about the money tree and it certainly isn't watered by the collection of tax. It is just a system of soveriegn currency that on a day to day basis has very little to do with tax collection and spend. This section looks to explain how money works, explode the myths around money and show how the government is so badly mismanaging the monetary processes that ensure a fair and prosperous society.

Types of Money

As can be seen from Figure 1 money can be categorised into three types. Cash is fairly obvious being the physical notes and coins that are used to make purchases. This is the physical money created by the Royal Mint. Only the Bank of England can issue this type of money. Less than 3% of the money in circulation is made up of cash.

The BoE reserve is the money held full the purpose of interbank transfers. Only banks can hold and utilise money in the BoE reserve. The reserve works as a pool of money held by each bank to faciliate money going between banks. So for example if somebody wants to pay somebody who banks with the NatWest and they bank with Barclays, they will either go to a branch or online and make a payment to the applicable NatWest account. Rather than transfer the money directly to the NatWest, Barclays will pull down money from their reserve at the BoE and this will be paid into the appropriate NatWest account. This saves banks having to move physical cash between different banks.

The third type of money is bank liabilities. This goes by a number of names, but the it is essense a liability that the bank holds electronically. If somebody pays £100 into their bank, it will be recorded on a computer as a liability to the person who pays in the money. This is not legally money as such, but acts in the same way as the two other types and makes up 97% of money in circulation (existence). This money can be created out of thin air by a bank for example providing a loan (see how money is created section)

Figure 2 shows the different types of money. Bank liabilities are referred to with several names in the industry, such as Bank Deposits, Demand Deposits, Sight Deposits or Bank Credit. But they are as such a liability that the bank has on its books. The Bank of England state that Bank Liabilities are not actual money... “Bank of England notes are a form of ‘central bank money’, which the public holds without incurring credit risk. This is because the central bank is backed by the government.” But Bank Liabilities are also backed by a government guarantee. As happened in 2008/9 when the banks ran out of money, the government used tax payers money to bail the banks out and by doing so guaranteed the bank liabilities were paid off. In reality Bank Liabilities have exactly the same guarantees as BoE created money. The BoE doesn't like this to be known, because this would reveal that the money in the economy is managed by private companies whose first priority is to create profit for the shareholders.

The BoE keeps central reserves which serve the purpose of ensuring that there is always enough money to loan to a bank should it for any reason not be able to meet its commitments.

The money you put into a bank is not the money that is loaned out
Banks loan each other money if they do not have enough reserves to pay their liabilites (inter bank loans)
The BoE will loan banks money if they cannot meet their commitments

How Money is Created

In the section Types of Money it is shown that there are three types (or sources) of money. The money that is created by commercial banks forms the majority of the money in the system. Electronic money or Bank Liabilities, as shown in Figure 3 is 97% of the money in the system.

Money is created when somebody takes out a loan with a bank. It is not created from money that people deposit in a bank. While historically it was people depositing money into a bank that provided the supply of money for loan money to build British industry, this is no longer how it works. Today if somebody goes to a bank to borrow say £1000 then the bank will literally create the money on a computer system. It will be no more than an electronic transaction.

As can be seen in Figure 4 what happens in reality is that when an individual borrows money from a bank, the bank creates the money out of thin air by adding a liability into their system. They then credit the borrowers account with the borrowed money. If you look at the bank's accounts it will show a liability of say £1000, which hopefully the borrower will pay back and a credit amount in the borrowers account for the £1000.

Once the borrower has the money in their account they will then withdraw it for the purpose it was borrowed. This places the money into circulation. If as in figure 4 the borrower goes out and buys a car, then most probably the seller of the car will place the money into their account. Historically what would have happened that the car sellers bank would have put 10% of the money into a reserve account and then lent out the money to somebody else. Nowadays because the bank is at liberty to create electronic money at will, it is not so relevant that the car seller has then deposited the money in an account at their bank, as banks don't need to receive money to lend money.

The present economy needs borrowers. This is the main way that money is created. If people or businesses stop borrowing then the amount of money in the economy shrinks and the economy begins to contract. The major problem in the UK economy is where the money is targeted. Because so little money is loaned out to productive activities this means that the productive economy does not grow and itself create money through higher wages. If banks loan money to enterprise then they create product that consimers buy and the economy stays more balanced. If a higher percentage of money is loaned in personal debt it creates the money, but in times of recession the economy shrinks and there is no foundation to ensure that people retain a reasonable standard of living. Typically as industry and the public sector have been constrained, this leads to high personal debt and no means to pay the debt during difficult periods.

There is an old economic theory that the government and BoE control the amount of money that is in the system. Figure 5 shows that the BoE holds what is known as base money. Historically it was the case that the size of the base money (real money)in the system controlled how much money the banks could create. This is in fact not the case. Banks can create as much money as they wish. There are no legal or structural controls to limit the supply of money. There are only two bank controls that decide how much money is avaailable:

How confident are banks to loan money. If banks are confident that they can get the money re-paid then they are confident to loan out money and the economy will grow
How confident are people to borrow money. If the public is nervous that they can meet their loan repayments they are less likely to loan

If the money supply gets too large then the BoE can increase interest rates to disinsentise borrowing, but this runs the risk of damaging businesses and causing a slump. The government can raise taxes to reduce the money supply, but over recent years this has become a political no, no. To increase the money supply in times of recession the BoE can use Quantitative Easing (QE) providing additional base money to banks with the hope that this will encourage them to make loans. With QE the risk is removed from the bank as the money is central reserve money and isn't their liability, while they can gain the benefits of the interest through making loans. However expanding the reserve has not lead to productive loans (loans used for investment in productive growth), but rather allowed the banks a free hand to speculate at no risk to themselves.

What destroys money?

If money keeps being created by banks the supply would just grow and grow, which in the end would lead to inflation and a devaluing of the currency. In some respects money does grow unhindered in the present system as vast quantities are invested in the financial markets, where the money mutliples and is often moved offshore into tax havens.

This leaves the economy with a situation where the it is being bled of the money for productive investment while a minority sit on a wealth that they will never be able to do anything constructive with. However money that is in the UK economy will continue to grow if the banks make personal are business loans and the money is not paid back. So a banks just gave away money then in theory the money supply would just grow and grow. That is not the full story with other controls being possible, but as a general rule, created money must also be destroyed, at some point.

In Figure 6 the Borrower that needed £1000 to have had his car repaired has had the work done and now wants to pay off his loan to the bank. He gives the bank the £1000 and this wipes out the asset held in the bank. This has destroyed the money.

The problem with money being created using this method is that when a recession happens as in 2008 this happens:

The public stops borrowing so less money is created
Borrowers try to pay back their loans and this destorys money
Banks stop giving out loans as they lack confidence they will be paid back
Banks don't lend for mortgages so house prices shrink
When house prices shrink then banks have further debts that do not have an asset to offset
Banks don't loan to business

This causes the money supply to shrink shrink. This is where during the 2008 crash the BoE stepped in with QE to increase the money supply. For more detail you can watch this video course that further explains money