Where Does Money Come From?  A guide to the UK monetary and banking system. Second Edition. by Josh Ryan-Collins, Tony Greenham, Richard Werner and Andrew Jackson.

Reviewed for SSM by Justin Hellings

One of the things that always bothered me about money was where it came from. Over time we buy more and more stuff at steadily increasing prices. We read about the super-rich whose wealth apparently grows at a rate far greater than our own. Assuming that the global South didn’t have enough money to plunder in order to make all this wealth, where did it come from?

The answer, as explained by Messrs Ryan-Collins, Greenham, Werner and Jackson in “Where does money come from?” is outrageously simple: Your bank makes it.

Here’s the textbook example:

Barry’s pay of £1000 lands in his bank account. His bank knows that (on average) Barry is not a pokemon-playing, crack-addicted fashion-victim so he is unlikely to spend all this money right away. Great! They can make this money work, so they reserve a bit to keep Barry in socks and sandwiches and lend out £900 to their customer Janine by increasing the balance in her bank account by that amount. Note that Barry’s bank statement still shows that he has the original £1000. Janine desperately needs to fix her 4×4 so she can drive her kids the 500 yards to school in order to stop them from being ritually humiliated. She duly uses her debit card to transfer £900 to Bodgit and Son Motors. When the money lands in Bodgit’s account, their bank sees the same opportunity to make that money work so they keep back £90 and lend out the remaining £810 thereby increasing the balance in another customer account. You can see where this is going, right?

So, if 10% is kept back each time the money is lent then the relending will, after about 200 repetitions, leave a total of £10,000 across different bank accounts. But that’s the textbook model.

The truth is that banks will lend to you regardless of whether they have received customer deposits to cover that amount. Their primary criterion is that they believe you will pay them back. Well, as long as you’re going to pay them back why not create some more money by increasing your bank balance? It’s only numbers in a computer.

There’s more. According to the Bank of England, about 3% or 4% of money in the UK is “base” money, i.e. notes and coins, and reserves electronically created by the Bank of England. The other ninety-something-percent is credit created by commercial banks. How would we know the difference? We treat this bank-created money exactly as if it was notes and coins, except that debit cards and internet banking make it much more convenient to transfer than physical money.

If, like me, you’ve only now understood money creation, recent events feel quite different. When a lot of debts turn bad in quick succession, the banks that have been burned are suddenly far less keen to lend out money. They need to repair their balance sheets (the tally of all that money they created) in order to comply with a formal definition of solvency. In order to do this, they turn off the money tap. Without that credit helping businesses to manage their cash flow, some of those businesses grind to a halt leaving people unemployed.

This seems particularly cruel when you consider it in terms of money creation. Lot’s of money was created for consumers (who bought houses). Lots of money was created for speculators (who traded the consumers’ mortgages). When that market spun out of control and burnt the banks that had created all that money in the first place, everyone else got the cold shoulder.

It’s not just business that has suffered financially. We taxpayers spent a lot of money to bail out the banks. Given the nature of money creation, it’s hard not to wonder why the Bank of England didn’t just create money in order to bail out the banks rather than making us pay for it. They do create money for other purposes and our country’s finances would now be in a much better state.

Here comes the summary: Banks create money. Banks decide who to create that money for. Businesses need that money in order to start, to expand, and to manage cash flow. When banks are running scared they can stop creating money for businesses, even though they may still create money for profitable financial speculation that they feel they understand better (and that does not help the majority of citizens). The result is recession. Logically, something needs to happen in order to convince the banks to restart credit creation for businesses. Why not legislation?

And here’s the review of “Where does money come from?”: Smart, clear, relatively short and just repetitive enough to make sure I understood the relevant concepts. As you would expect, it touches on many more things, e.g. the legitimisation of money through tax, the pathology of interbank lending and its effect on banks’ willingness to lend, and so on.

You can get this book from nef here.