Wednesday, 14 November 2012

Where does money come from?

Listening to one of the RSA's excellent 15 minute 'Four Thought' talks on Radio 4 the other day I was struck how naive I was about how money was created. And I think I'm not alone. When I say how money is created, I don't mean companies earning it, I mean extra money added to the supply. My naive reaction would have been 'The Bank of England does it - quantitative easing, that sort of thing.' But actually the BoE is a small player in this.

The reason I missed the point is that I hadn't really thought about what ordinary high street banks do with money. Don't get me wrong. I wasn't like a young friend of ours many years ago who thought that the bank had a series of shoe boxes (or equivalent), and when she paid money in, they put it in her shoe box in the safe. I knew the money you pay in just enters the system and can go anywhere. But I hadn't thought about another aspect of dealing with banks.

Let's imagine you go to your bank and get a loan. You can do it online in about 2 minutes - it's frighteningly easy. At the end of the process, the bank waves that magic wand and the amount you borrow - £1,000, say - is in your account. Nothing has actually moved anywhere. All they have done is increased the number on the computer file that says 'Brian's balance' (my electronic shoe box). And here's the totally amazing thing. They just created that money. They didn't need anything to back up that number. They just changed the value and hey presto there was more money in the system. Simples.

And scary. That is, on the whole, how money is made without any need for any reserves to back it up. Which it's hard not to see as a contributory factor in the financial mess we got into. You can hear the original talk here and I recommend it.

3 comments:

  1. "All they have done is increased the number on the computer file .."

    And don't I wish that I could hack that database field with what I would consider a more useful figure!

    I must admit that this doesn't sound right. Say I'm a bank, and I lend you £1,000,000 at 0%. Haven't I just magically made you a millionaire? Whilst I can see it's digitally just 1s and 0s, it seems to me that if someone wanted it in Gold say that there'd be a bit of a problem if those 1s and 0s weren't backed-up with something (like Gold)?

    So, say the interest rate is 100% per day; and you pay back £2000 the next day; does this mean that the bank has made £1000 for nothing? That doesn't seem right

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  2. I think that's the whole point, Peet. And, no it isn't backed up by gold.

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  3. Brian

    Accountant here.....what a lot of piffle, mirrors and left wing propaganda!

    It is true that banks "create" money by making loans, however they can only lend money if they have sufficient assets with which they can support the loan; they can't just continue to lend in the absence of new deposits.

    What does all that mean for the banking system as a whole? And why is it now so difficult to borrow money?

    In 2008 banks were hit by toxic loans from US mortgages (based on poor lending and probable incompetence by some banks) which meant that they had to reduce the value of their assets against which they could lend and in the process had to rebuild their reserves. Some banks did this by requiring additional equity from their shareholders, and some by going to the government for assistance. It is taking time to rebuild these reserves. Mean while the real economy is stuttering because of the declining money supply.

    Into this mix must also be fed the new stricter Basel lll Global Regulations for financial institutions which have effectively tripled the reserves that banks must now hold against losses; these regulations are being introduced between now and 2019 and it is argued by some that the global economy will take until then at least to recover from the strains imposed by the recession.

    You always knew I could be boring if required……

    Ian

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