I published this glossary entry on money creation on Sunday. Does it work? Are there suggestions for improvements? Comments are welcome:
In a fiat currency system , which system is now used by almost all money-creating jurisdictions in the world (including the UK, USA and eurozone) all that money represents is a promise to pay, which is otherwise called debt. All money creation must, as a result, recognise the creation of new debt between the parties who give rise to that new money creation.
This process is not as complicated as it sounds. Only two types of organisation can be involved in transactions that create money.
One is the government of a jurisdiction that creates a fiat currency. A government can create new money at will by demanding that its central bank make a loan to it to finance its expenditure. This is the source of all new government-created money, otherwise known as base money, which is used to enable the banking system of a jurisdiction to function by providing the liquidity required so that the jurisdiction's commercial banks can settle their liabilities to each other.
Government-created money is injected into the economy via the central bank reserve accounts that commercial banks maintain with a jurisdiction's central bank.
Government-created money is destroyed through the payment of tax. This is important. It explains why tax does not fund government spending. Money creation by the government funds government spending. Taxation takes the money the government creates to fund its spending out of circulation as a mechanism to control inflation. That money is then destroyed. Tax as a result never funds government spending: it cancels money creation.
Government-created money can also be effectively neutered by the issue of government bonds: these effectively lock away government-created money from use in the economy for significant periods of time. They do not have the same impact of destroying money as taxation does, but the impact is not far short of that: the money, or debt, is locked out of use.
Commercial banks also take part in the money-creation process. They do so by lending, The money that they create is destroyed by loan repayment. This was acknowledged as a fact by the Bank of England in 2014.
There is no fixed stock of money. The amount of money in circulation depends on the amount of money created by both the government and the commercial banks of a jurisdiction, and the amount of money destroyed by taxation and loan repayment. In that case, the control of inflation necessarily requires the integration of tax policy and monetary policy. The fact that this rarely happens is a major weakness within modern macroeconomics.
Money creation by banks is pro-cyclical. That means when the economy is booming the banks lend more and so create more money. When an economy is sluggish borrowing is reduced and loan repayments tend to increase. The result is that if money supply is to be maintained across an economic cycle a government has to spend more money into existence during economic downturns. This is a major reason why austerity economics has been so counter-productive because it reinforces the pro-cyclical swings created by commercial bank lending policies and exaggerates the economic cycle as a result.
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Fascinating article, thank you. I have never properly understood economics (I’m an engineer by inclination and profession so all the abstract intangibles are a bit of a mystery to me).
Could we please have a further explanation of where crypto money (or value) comes from too. That really does make my head hurt!
It is on my list
I will push it higher
That’s the nub of the [problem, the majority of economists and media commentators think that taxes pay for government expenditure and not that money creation is done via government spending and taxes destroy money,. My local Labour councilor thinks that MMT is wrong so what hope is there?
We just need to keep on banging on
Hi Richard – one aspect that confuses me and many I speak to is the bit about gov’t created money being injected into banks’ reserve accounts, mainly because reserve accounts are a mystery, what are they?
Examples would really help illustrate this, so how does say £5bn spent on the NHS or new nuclear warheads flow through to bank reserve accounts? I use these two as one is public and the other private sector spending.
Thanks
Does this help? https://www.taxresearch.org.uk/Blog/glossary-items/central-bank-reserve-account/
If not, let me know.
Perfect!
Trying to get this and related stuff across to people, most of whom switch off, would be so much easier with pictures & diagrams!
Thanks Richard
Sovereignty – it has to be mentioned in my view – Ms Kelton was big on this because it deepens the idea of ‘authority’ and unlocks the state’s potential to pay for the courageous society as well as bailing out the banks.
I agree with PSR (please, PSR, excuse my familiarity).
If Brexit has any use whatsoever, surely it must be the notion of sovereignty. As a sovereign State (no chance to quibble given to the politicos who accept Brexit) we have the authority over our money.
“We” the people, the citizenry, the voters, who give our collective authority to our government at the ballot box, we are not beholden to the price of gold, or silver, or seashells – or the dollar, the euro or the rembibi, or the bankers or the hedge-fund managers or the bond-buyers.
It is the government authority invoked in the Exchequer and Audits Act that requires the government bank to issue credits to settle the government’s bills, and to redeem those credits when tax revenue is received into the Consolitated Fund. And the government’s authority is held because we are a sovereign State.
To deny that is to deny the very principle from which the Leavers took their arguments. Sovereignty.
I can understand how income tax and inheritance tax etc take money out of the economy. But please explain the point therefore of calls for windfall taxes.
There are six reasons to tax:
1) To ratify the value of the currency: this means that by demanding payment of tax in the currency it has to be used for transactions in a jurisdiction;
2) To reclaim the money the government has spent into the economy in fulfilment of its democratic mandate;
3) To redistribute income and wealth;
4) To reprice goods and services;
5) To raise democratic representation – people who pay tax vote;
6) To reorganise the economy i.e. fiscal policy.
Thanks Richard…and did I read the other day that one dollar out of every five ever ‘printed’ (accounts vary – as to the percentage and how recently) has been at Biden’s ‘fiat’. The guy next door is ‘creating’/borrowing like Billy-Oh. What effect does this have on the UK (and others) who choose not to go down that same route? Could you say something about Japan’s debt-to-GDP and why it hasn’t turned into Venezuela (closer to home I think France borrows and spends more than us…under Euro rules??)
Give me time….
Really great article, thank you. Though I think it might be better to leave out the reference to the Eurozone as a jurisdiction, because the definition given for a jurisdiction includes ‘it has a national government’. Whilst the Euro is a fiat currency, it is more complicated than the others you mention. Thanks again Richard for your blog’s and videos.
I agree. The Eurozone should have been left out. Canada, Japan, or Iceland could have been used instead.
We will have to disagree
It is staying
Thank you for this, Richard.
My limited perspective of this is that Governments of a right-wing variety are essentially….lazy.
It’s an easy excuse to say that ‘We don’t have the money’ or ‘It’s taxpayers money’ instead of doing the hard yards of judicious application of the resources (eg money) on the economy – applying it well, at the right place, to the right group of people. So, they pretend they are not sovereign in monetary terms.
The market is seen as the final arbiter. Despite the sovereign means at our disposal, a government should just stand back and let it take its course. So, government spending is cut and the responsibility that goes with that spending and ‘let the private sector pick up the slack’ as the Cameron/Osborne duo opined. And here we are…..
We need a government that is active in the economy , not a bystander with a pretence of concern.
A Courageous State, as I once called it
I would add that commercial banks are also involved in government money creation. They effectively lend (i.e. create deposits) just as the central bank does, when their reserve accounts are credited by government spending. It would be interesting to know what proportion of deposits are created this way, as opposed to by commercial lending.
I think you are getting confused.
The central bank is the creator of base money and central bank reserve accounts https://www.taxresearch.org.uk/Blog/glossary-items/central-bank-reserve-account/
Thanks – what I meant is covered by:
“…they provide the mechanism by which payments from commercial banks and their customers are made to and from the government.”
Which is just to say that commercial deposit accounts are credited whenever government spends (as well as when commercial banks make loans).
You get it
I understand the recent bank failures caused a problem with several so-called “stablecoins” because the liquid assets backing the coins were held with one of the banks. They were forced to “depeg” – removing their parity with US dollars. Oops. Not so safe or stable at all.
There is no crypto stablecoin
The claim is oxymoronic in my opinion
If you wat stablecoin hold the dollar
Great article. Thinking about this in the context of your post about GDP, it’s interesting to see (if I understand it) that government spending underpins the rest of GDP, that without government spending (money creation) everything else might just grind to a halt?
Spot on
You are right
Hi Richard,
Thank you for this post, clear as always. One thing about bank created money that puzzles me. Is their any constraint on how much a bank can create in loans? Or is a matter of if there is the demand, a bank will satisfy it provided they were confident of repayment?
There is banking regulation that requires reserves to be maintained as a ratio of loans. The reserve depends upon the type of lending. This acts as a constraint on lending, supposedly.
I agree with the description, and I can find lots of well-qualified economists that do too.
What I can’t find is whether the establishment agrees. For example, the BBC quote this page from the Institute of Fiscal Studies as saying that taxes fund revenue: https://ifs.org.uk/taxlab/taxlab-key-questions/where-does-government-get-its-money
I’ve emailed them about it, but no response.
Thanks