How Money Is Created

To understand where money comes from, we first need to picture the banking system.

All banks have an account with the Central Bank (for example the Bank of England in the UK).  These are sometimes known as reserve accounts.  This is a closed system – only banks can have an account with the Bank of England.

Whenever a debit card, cheque or electronic payment is made from one person to another, there is a corresponding transfer between the reserve accounts of the respective banks.  So if a Lloyds customer pays a TSB customer by debit card, Lloyds has to transfer the same amount from its reserve account to TSB’s reserve account.

The money in reserve accounts is sometimes called base money or narrow money, and sometimes Central Bank money or Central Bank Reserve (CBR).  The money that we all use is known as broad money.

So of the billions of pounds of transactions in Britain everyday, corresponding transactions are going on between the reserve accounts of the banks.  But think back to the example of cheques and clearing in Bankmoneyland:  by the end of the day, the net transfer between any two banks is going to be only a small proportion of the total number of transactions.  Now we’ve got that clear, we’ll be able to quickly add this piece of the jigsaw when we need it.

So how is money created?  When a bank makes a loan, it types the numbers into a computer, and they appear in your account.  They create the money out of thin air.

To be precise, when they credit the money into your account that’s a “liability” for the bank, because when you spend that money your bank will have to transfer reserves to the bank of whoever you are paying – it will be liable for that payment.  But the fact that you now owe the bank money is an “asset” for the bank – they own that loan and anticipate that you will repay them.  All businesses and banks record their accounts on what are called balance sheets – two columns, one of assets and one of liabilities.  Balance sheets always have to balance (the clue is in the name).  When a bank makes a loan, they add the liability of the money they’ve just created, and balance it against the asset that you now owe them money.  It’s called “expanding the balance sheet”.

I could go into much more detail about this, but many other people already have, so I’m going to keep it that brief.  The Bank of England describe this process in this paper from their March 2014 Quarterly Bulletin – it’s only 14 pages long and very clearly written.  This is pretty much the most authoritative reference you could ask for on this subject, so if anyone wants to challenge what I’ve said please refer to this paper first and either point out how what I describe is different to this, or give a reasonable explanation of why you are rejecting what the paper says.

There’s also an excellent book called “Where does money come from?”  If you go to the Positive Money website there are lots of short articles and videos on this subject.  And many others have written about this on-line and in books.  Nonetheless, the economic textbooks still get this wrong (a point made 6 times in the Bank of England paper).  Textbooks present money creation through fractional reserve banking (as described in this post).  We will come back and look at this error of the textbooks and why it matters in a couple of weeks.

So if banks can create money out of thin air, how come they can still go bust and why can’t they write themselves cheques for a gazillion dollars?  I will explain next week.