Sunday, October 30, 2011

Where Does Money Come From? (Revisited)

I just came back from the excellent Positive Money conference today and can highly recommend that everyone take a serious look at their site, their analysis and their suggestions.

Here's the basic outline of the Positive Money analysis (which they've undertaken with the help of some economics professors and one guy from the Bank of England).

Q: Where does money come from?

Largely money is created by banks making loans. That is, you ask the bank if you can borrow some money; the bank says yes, and credits your account with the money and their balance-sheet with the asset of your debt to them.

That's it. That's how money is made in the economy. The money the bank lends to you DID NOT have to come from a deposit that someone else made with the bank.

Most people (including economists, bankers and politicians) find this incredibly hard to believe and assume it must be wrong. But no-one can give any other explanation for where money actually comes from. (Well, some is made by, say Quantitative Easing, but that's just small proportion of the total money in the economy.)

Q2 : What restrictions are there on banks creating money this way?

There *used to be* restrictions that said banks could only create some multiplier of the deposits they held.

And you can still read this story on some websites and even economics textbooks. Positive Money's assertion is that various deregulations since the 1970s have effectively removed these constraints. (There are still some, but they're mainly around the "clearing" of different banks' debts to each other. And, as long as all banks are not getting into serious debt with each other, it seems there's no real constraint on how much new money they can create.)

Furthermore, nowadays banks have adopted a sales culture where everyone is incentivated to sell as many loans as possible and, until the crash, this is what banks tried to do.

That's why your bank was always trying to get you to take out a second mortgage to go on holiday or buy a new sofa.

Q3 : So what's the problem?

Well, the first problem is that every pound created this way is "debt money" ie. when the pound is created, the person who receives it receives a debt. Mostly the debt is a pound + interest.

In other words, when money is created by loans, it means debts are also created. And because the debt includes extra interest, the size of debt created is *bigger* than the quantity of money.

So there is always MORE debt in the economy than there is money to repay it.

And that's why most people in the country have such a debt problem. It's not even economically *possible* to pay off all the debt. The money for it doesn't exist. And you can't create more money without creating more debt.

Q4 : Is that the only problem?


The banks like to make loans because they make their income from the interest on loan repayments. But they prefer some kinds of loans to others.

In particular, they prefer *secured* loans. That is, loans which, if you don't repay, they have something to repossess.

So, they don't like lending to businesses with limited liability because if the business goes bust most of money was probably spent on wages and materials anyway, and the capital equipment is probably not worth that much when sold second-hand.

On the other hand, they LOVE lending to individuals to buy houses ie. giving mortgages, because if the individual can't repay, the bank repossesses the house which, normally, has held / increased its value.)

Positive Money estimate that of all the billions of pounds that banks create, only about 8% is lent to businesses that create jobs and produce goods and services in the economy, and the other 92% goes into the mortgage market or other financial products with "known" risk profiles.

And that's why :

a) house prices have increased much faster than wages in recent years (ie. lots of newly created money went into bigger mortgages for more expensive houses) and you can't get on the housing ladder.

b) it's been so hard to finance your usefully productive company (unless you have something to repossess like land or intellectual property)

c) banks bought so many packages of collateralized debt.

In conclusion :

Banks have been given the monopoly on creating money.

There is no oversight.

They have incentives to create as much money (sell as much debt) as they can.

There is always more debt in society than money to repay it.

Because money is created by and in private banks, they choose how it is allocated in the economy.

Because the banks prefer secured loans, the new money goes mainly to places we don't want it to go (ie. to  inflating house prices and speculating on financial products) and doesn't go where we do want it to go (ie. to financing expansion by businesses that create jobs, goods and services.)

Economists, politicians, most bankers themselves, and certainly the general public have no fucking idea that this is how the system works, and most of them can't believe it when you tell them.

Q5 : So what can we do?

Positive Money's recommendation is as follows :

1) Take the power to create money (ie. to loan money that you don't have) away from private banks, and give it to the Bank of England.

2) Because you don't want the Bank of England to print money whenever it suits politicians, give the power to decide **when** to create the money to an independent committee. Probably with some fairly stringent criteria for when they should. Positive Money's own suggestion is that every month when inflation is around 2%, they should authorize the creation of new money. If inflation creeps above 2%, they shouldn't create more that month.

3) Rather than the new money being given to government or banks to allocate it should be given directly to the public in a slightly *progressive* form :

a) as VAT cuts. (Everyone benefits and you stimulate more economic activity)

b) by raising the threshold at which people start to pay income tax. (So the lowest wage earners benefit.)

I have to say, I think this is an absolutely brilliant blend of radicalism and realism. They've spent a lot of time thinking about this. (The analysis / book has taken their team about 18 months to put together, based on about 500 different documents. Apparently they asked the Bank of England for its own training manuals / documentation on how money is created and were told that there is none.)


chad said...

like george carlin said, its a big club and you ain't in it!

Ben said...

See this for an explanation of why fractional reserve banking isn't quite the 'original sin' that explains all financial woes (a popular but I suspect misguided perspective):