I wrote the blog reproduced below in September 2007: Northern Rock was falling over at the time and needed bailing out. I issued it again in 2011, and now it looks like it needs a third outing given the comments on the blog over the last few days.
The point is a simple one, and is that banks create money not out of deposits but out of lending. Without it the economy does not function. Money supply is, despite QE, 12% down since the start of the recession in the UK as measured by the standard measure called M4. And that's down to saving, which repays loans, reduced lending and a lack of consumer confidence. But unless we understand money we can't address these things and get out of recession and the reality is that money is literally a confidence trick as it literally comes out of thin air, and the trouble is that right now we don't have that confidence:
“It amazes me that most people think that money is printed. It isn't. Only 3% of all money in the UK is created by the government. The rest is created by banks.
How does a bank create money? The honest answer is out of thin air. It happens whenever they create a loan.
Most people think when they ask a bank for a loan money paid in by one person is paid on to them. That's not true. Not true at all, in fact.
Instead what the bank does is a conjuring trick. They agree to give you a loan. They do it by opening two accounts for you. One is a current account (for ease, let's assume you haven't already got one). The other is a loan account. If you borrow £10,000 they mark your current account as having £10,000 in it. You're now free to spend that however you like.
They also mark your loan account as having £10,000 in it. You now owe that to the bank.
Add the two together and they add up to nothing. One you apparently own (the current account) and one you apparently owe (the loan account). But if you decided to cancel the deal you could straight away repay the loan using the current account and there would be nothing left. Which is why I mean they add up to nothing.
Note there's no cash involved in this process at all. It's just an accounting trick. Nothing more.
And now the bank charge you interest for the benefit of having created that money. Even though there is no money as such, even though you think there is, because you can spend what's in the current account as if it were money. Which is what I mean about the banks creating that money. You can see why they make so much profit, can't you? They make money out of nothing and then charge you to use it.
Of course they need some cash. That's necessary to ensure that if anyone does want their money back in straightforward cash they can pay it to them. That's why they need part of that 3% of money created by the government.
And of course they can't repeat this lending trick forever because if they did people would realise there was no substance behind the promise they made to you when you agreed to pay them back a loan. That promise is that the money in your current account can be used to pay other people — a promise that is only as good as the bank on which the cheque is written on.
But that's the confidence part of the rick. So long as people believe the banks will pay they don't need money. They can just pretend they have it. When people don't have that confidence they do need money. Trouble is, they always lend far more money than they actually have. That's the risk in a ‘run on the bank' of the sort Northern Rock has suffered.
But now that risk has been taken away. The government has said it will cover it. So the banks can lend more money at limited risk to themselves. And so make more interest on something they have created out of thin air. Are you surprised that banks are the biggest companies in the world? After all, their basic product really does not cost them anything to make. Amazing, isn't it?
You don't believe me? Actually, you wouldn't be alone. When explaining this the second greatest economist of the last century (J. K Galbraith) said:
The process by which banks create money is so simple that the mind is repelled
(John K. Galbraith, in “Money: Whence it came, where it went”, p. 29.)
He was right, because it's true: the process is so simple that we're repelled by the idea that we pay for it.”
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When banks abuse this privilege to blow up a housing economic bubble which is drowning young people in debt, and often negative equity, you can see that they are extracting wealth from the economy in the form of interest from the most vulnerable. Added to this the Seigniorage forgone and the fact that they avoid tax, they are the most heavily subsidised industry in the world. That does not even include the government safety net.
Socialism works very well for them, yet they and their backers are the first to argue against socialism for the poor.
Government should be creating money.
“Instead what the bank does is a conjuring trick. They agree to give you a loan. They do it by opening two accounts for you. One is a current account (for ease, let’s assume you haven’t already got one). The other is a loan account. If you borrow £10,000 they mark your current account as having £10,000 in it. You’re now free to spend that however you like.”
Have you ever got a mortgage? If you have, you will realise that the description above does not apply in any way (because the loans gets paid straight to your solictor), not in credit cards where spending goes onto a loan account or overdraft (when a bank gives you an overdraft it doesn’t simply put the money in your current account). Given that these three account for around 95% of UK retail lending, it is only in a tiny minority of cases that bank lending would result in a deposit being created in the way you describe. Instead, the actual money creation occurs after the fact when your loan is paid to someone else and they deposit it.
Money is created by a banking system, not an individual bank.
“Most people think when they ask a bank for a loan money paid in by one person is paid on to them”
Every single bank in the world has more money paid in by other people, than lent out. Look at any bank balance sheet.
“You can see why they make so much profit, can’t you? They make money out of nothing and then charge you to use it.”
If banks are so profitable and make money out of nothing, why aren’t there hundreds of people lining up to buy the branches being flogged off by Lloyds and RBS. The simple fact is that banks are not particularly profitable, when measured against the capital they consume.
This is crass!
The payment goes via a solicitor to your vendor
You fail at stage 1
If this is the best you can do expect to be deleted in future
Richard
“The payment goes via a solicitor to your vendor”
Well, that is exactly what Tom said. So you have just admitted it never goes anywhere near a deposit account in the way you describe.
If that is the best you can do Richard I suggest maybe you spend some time educating yourself about how a banking system works. There is a big difference between thinking you know something and actually knowing it.
You remind me of the type of tyrannical dictators around the world who answer to any criticism of them in the media is to shut the paper down.
Oh for heavens above
Who said deposit account?
Your inability to think serially is staggering
Tom, if you want to improve your knowledge of how the banking system really works, then I recommend “Modernising Money” by Andrew Jackson and Ben Dyson.