[This post replaces an earlier one, which does not properly reflect modern banking practice.]

For most people the question of where money comes from is probably a bit mysterious, that is if the question ever even occurs to them. They might recall that notes and coins are produced at a mint, owned by the government. However notes and coins comprise only a small percentage of the money circulating in a modern economy. The rest exists only as accounting entries in banks and other places. In other words it exists only as numbers in computers. How does all this money come into existence?

You would think economists would know the answer to this question, but if anything they are even more confused than lay people. They have three main theories about how banks work. Most economists believe an incorrect version, that banks only loan what other people have already deposited. However many economics textbooks still describe a second incorrect version, that banks can loan new money up to about 90% of what they hold in deposits. A few people have been arguing that banks create money out of nothing with a few strokes on a computer keyboard.

The evidence has favoured the latter version, but very few were convinced. Now a new paper by Richard Werner presents evidence that is decisive, at least for Germany. It also gives a surprising historical perspective.

You might wonder how there could be so much confusion. Surely bankers know what they do, and surely it can’t be so hard for economists to find out what bankers do? Yet Werner notes that all three versions have been espoused by different employees of the Bank of England within the past few years. The source of the confusion seems to come ultimately from the shady practices of mediaeval moneychangers.

The three theories

1. Loanable funds

Householders deposit their savings in a bank. The bank loans those savings deposits to other people. Banks do not create money, they are only intermediaries.

2. Fractional reserve

The bank must hold deposits amounting to about 10% of its loans outstanding. I described this version in an earlier post in 2010. This system would create new money up to 10 times existing deposits, although many economists don’t seem to realise it.

3. Unlimited creation

The bank can create money at will, and loan it out with interest due, as if it were loaning other people’s deposits. It must then ensure it holds a small fraction of that amount as a deposit with the central bank, but only so it can clear any debts with other banks. The central bank will loan that small amount if the commercial bank does not already have it.

Most modern mainstream economists seem to believe the loanable funds theory. A few decades ago most of them seem to have believed fractional reserve theory, which is still commonly described in text books. Consistency is not one of the strengths of economics. The denial by modern economists that banks create money out of nothing is the central reason they did not anticipate the global financial crisis of 2008. The curious thing is that the unlimited creation theory had been described in 1856 and was widely known into the early 20th century.

The verdict

In 1990 Kydland and Prescott of the Minneapolis Federal Reserve bank, part of the US central bank system, showed that deposits of reserves at central banks rise only after loans are made by commercial banks¹. This favoured the unlimited creation theory. In 2014, McLeay and others, of the Bank of England, also claimed the unlimited creation theory is correct². Now Werner reports an explicit test using the standard secure software of a German regional bank. It shows quite clearly that the granting of a new loan involves the creation of the loaned money out of nothing.

This transaction was fully in accord with German banking regulations, which are similar to banking regulations in most other countries, so we can presume with great confidence that commercial banks in most countries can create unlimited amounts of money at will.

This means banks are not really loaning money, they are issuing money and charging interest on it as though it were a loan. At the very least, this practice is economical with the truth. However the consequences go well beyond banks profiting unreasonably. The practice distorts markets and destabilises whole economies.

Problem 1: too much debt

Banks’ main source of profit is from the loans they make. Because it is so easy to create more money, their incentive is to maximise the loans they make. They push loans onto people who may not be good risks. During the sub-prime loan scandal in the US, whose collapse triggered the global financial crisis, loans were made to unemployed people, people with drug habits and, so the joke went, anyone with a pulse. Banks load people and the economy with debt, and debt is a burden and a risk.

Problem 2: interest is a private tax

Because most of our money has been issued as so-called loans, it carries a burden of interest due. In effect this is a private tax on the entire economy. It is true the supply of the medium of exchange is a service for which we can pay an appropriate fee, but the fee could be much less, because the amount of money we need is actually much lower than the amount we have. This may not be obvious here, it is clarified in my book The Nature of the Beast. The burden of interest is large and is one of the main mechanisms transferring wealth to the very wealthy from the rest of us³.

Problem 3: land price inflation

Mortgage loans are one of the biggest categories of debt. In Australia they are much the biggest category. Because it is easy to get a mortgage loan, people bid up to the price of housing. As the price of housing rises, thanks treat the higher market price as collateral for yet bigger loans. In this way an upward spiral of prices is driven. Although people refer to the price of housing, it is really the price of the land that is spiralling upwards, as the cost of building a house does not increase much.

Most people understand that if too much money is issued inflation is likely to be triggered: there is too much money chasing too few goods, as they say. Yet curiously, land price inflation is not counted in the general measure of inflation you hear about in the news. I don’t know why this is so, but it does conveniently disguise a serious dysfunction of modern banks and economies. Economists do sometimes refer to “asset price inflation”, without being clear which of many possible assets they might be referring to. The phenomenon is also described as a bubble, since the Japanese example in the 1990s.

There is another deficiency of mainstream economic thinking lurking here. It is that land is not just another commodity. If there is a shortage of TVs you can produce more TVs. However the amount of land is fixed, although land can be converted from one use to another, or perhaps used more intensively. However mainstream economists’ habit of treating all assets as equivalent, combined with bank’s ability to create money at will leads to an unnecessary price spiral that is putting housing out of reach of many people. Land can be leased instead of sold, or land prices can be taxed, to avoid this dysfunction, but that is another big subject.

Problem 4: boom and crash

As a land price bubble inflates, money floods into the economy. People spend up and the economy booms. If this continues, eventually some people will be unable to repay their loans. This can trigger a cascade of defaults, and the whole debt house of cards collapses. Defaulted loans are written off, and the money they represent vanishes. As the money supply shrinks, the economy slows and may go into recession. As hard times spread people spend less and concentrate on paying down their debt. So businesses sell less and the economy slows further. As debt is paid off the money supply shrinks further. If the downward spiral is not arrested full-scale depression may ensue.

Thus the combination of banks creating money at will and unrestricted land prices can generate a destructive boom and bust. This was the basic mechanism behind the global financial crisis, although it was made worse by the creation of vast amounts of debt within the financial markets themselves.

Problem 5: Wall Street brings down Main Street

Here is a question that seems not to be asked very often. If I build a widget factory but nobody buys my widgets then I will go broke. If I borrowed money from my father-in-law to build the factory then he will also lose money. Employees and suppliers directly connected with the factory will lose employment and business. However the rest of the economy should continue as usual, should it not? The failure of an investment should not endanger the rest of the economy.

The business of Wall Street is supposed to be investment. A series of investment failures on Wall Street might slow the economy marginally, but only in the proportion of the investments to the whole economy. Instead a Wall Street crash slows the economy disproportionately. Wall Street brings down Main Street. Why should that be?

The answer is that our money is created and issued through loans by banks. If money was supplied separately to facilitate the exchanges of normal business, then normal business could continue as usual. However in our present system investment failures reduce the supply of money and thus constrain the whole economy.

The remedy is to loan only existing money, not to create new money for a loan. In this way an investment failure would not reduce the money supply, though it would shift to money from one person to another. Money can be created and issued in much the same way as happens when you use your credit card, although the fees and regulations ought to be rather different so as to avoid excessive issuing of money⁴. I have explained in more detail how money supply and investment could work in my books The Nature of the Beast and Sack the Economists.

Non-problem: government deficit

If the government borrows money to build a train line or a university then that money is being usefully invested and will stimulate the economy and return taxes to the government. Sensible government spending is a good thing. National governments outside the Eurozone can actually create money if they need, so there is no danger they will default. Because of the lower risk they are also charged lower interest rates on their borrowings. Government deficits are not a serious problem. The sum of private debts is usually far greater, and it does burden and destabilise the economy.

If governments were a bit smarter, they would create their own money and not have to pay any interest to private banks. Abraham Lincoln and some governments during World War I understood this, but that understanding has been suppressed or forgotten. Generally governments have been conned ever since the King of England was conned in 1698 by the founders of the Bank of England into borrowing their paper money instead of printing his own⁵.

So all the hysterical howling about government deficits it is really part of the campaign to keep governments small and ineffectual, and out of the way of those who want to make a lot of money for themselves.

Dark history

In the Middle Ages moneychangers would hold people’s valuables for safekeeping and give the people a receipt. Sometimes the receipt would be used as money, as a way for the holder to pay a debt a third person. Eventually the money changers realised they could issue more receipts than the worth of the valuables they were holding, so long as no one knew what was in their safe. So they took to making fraudulent loans of paper notes, on which they charged interest. They could make handsome profits, but if people suspected the paper money was not fully backed by gold or other valuables there could be a run on the bank, and the money changer might have to flee and guard his neck⁵.

Modern banks evolved out of these practices. This can explain their penchant for secrecy, complications and obscurities, which of course still benefit bankers by hiding from politicians, economists and the population the fact that we could have far cheaper, simpler and more stable systems of money and investment.

Bibliography

¹ Kydland, F.E. and C.P. Edward, Business Cycles: Real Facts and a Monetary Myth. Federal Reserve Bank of Minneapolis Quarterly Review 1421, 1990(Spring).

² McLeay, M., A. Radia, and R. Thomas, Money in the modern economy: an introduction. 2014, Bank of England; McLeay, M., A. Radia, and R. Thomas, Money in the modern economy. 2014, Bank of England, http://www.bankofengland.co.uk/publications/Pages/quarterlybulletin/2014/qb14q1.aspx.

³ Kennedy, M., Interest and Inflation Free Money. 1988, Steyerberg: Permakulture Institut e.V., Ginsterweg 5, D-3074 Steyerberg, Germany.

⁴ Greco, T.H., Jr., The End of Money and the Future of Civilization. 2009, White River Junction, VT: Chelsea Green.

⁵ Rowbotham, M., The Grip of Death. 1998, Charlbury, Oxfordshire: Jon Carpenter Publishing.