According to a poll conducted by City AM on behalf of the “sovereign money” advocates Positive Money, 84% of British lawmakers don’t know that banks create money when they lend. This is despite the fact that in 2014, the Bank of England produced a definitive statement to that effect.
Shocked by politicians’ ignorance, The Guardian’s Zoe Williams took it upon herself to explain how bank lending works:
How is money created? Some is created by the state, but usually in a financial emergency. For instance, the crash gave rise to quantitative easing – money pumped directly into the economy by the government. The vast majority of money (97%) comes into being when a commercial bank extends a loan. Meanwhile, 27% of bank lending goes to other financial corporations; 50% to mortgages (mainly on existing residential property); 8% to high-cost credit (including overdrafts and credit cards); and just 15% to non-financial corporates, that is, the productive economy.
The link in this paragraph is to the Bank of England’s aforementioned definitive statement. Sadly, Zoe did not understand it. If she had, she would not have gone on to say this:
Is there a magic money tree? All money comes from a magic tree, in the sense that money is spirited from thin air. There is no gold standard. Banks do not work to a money-multiplier model, where they extend loans as a multiple of the deposits they already hold. Money is created on faith alone, whether that is faith in ever-increasing housing prices or any other given investment. This does not mean that creation is risk-free: any government could create too much and spawn hyper-inflation. Any commercial bank could create too much and generate over-indebtedness in the private economy, which is what has happened. But it does mean that money has no innate value, it is simply a marker of trust between a lender and a borrower. So it is the ultimate democratic resource. The argument marshalled against social investment such as education, welfare and public services, that it is unaffordable because there is no magic money tree, is nonsensical. It all comes from the tree; the real question is, who is in charge of the tree?
This is one of the most muddled paragraphs I have ever read.
Firstly, it is entirely incorrect to say that money is “spirited from thin air.” It is not. Indeed, Zoe herself said it is not, in the previous paragraph. Money is created when banks lend. The rules of double entry accounting dictate that when banks create a new loan asset, they must also create an equal and opposite liability, in the form of a new demand deposit. This demand deposit, like all other customer deposits, is included in central banks’ measures of broad money. In this sense, therefore, when banks lend they create money. But this money has in no sense been “spirited from thin air”. It is fully backed by a new asset – a loan. Zoe completely ignores the loan asset backing the new money.
Nor does the creation of money by commercial banks through lending require any faith other than in the borrower’s ability to repay the loan with interest when it is due. Mortgage lending does not require ever-rising house prices: stable house prices alone are sufficient to protect the bank from loan defaults.
Commercial banks’ ability to create money is constrained by capital. When a bank creates a new loan, with an associated new deposit, the bank’s balance sheet size increases, and the proportion of the balance sheet that is made up of equity (shareholders’ funds, as opposed to customer deposits, which are debt, not equity) decreases. If the bank lends so much that its equity slice approaches zero – as happened in some banks prior to the financial crisis – even a very small fall in asset prices is enough to render it insolvent. Regulatory capital requirements are intended to ensure that banks never reach such a fragile position. We can argue about whether those requirements are fit for purpose, but to imply – as Williams does – that banks can lend without restraint is simply wrong. There is no “magic money tree” in commercial banking.
It is of course possible for banks to lend more than the population can realistically afford. But we should remember that prior to the financial crisis, political authorities actively encouraged and supported excessive bank lending, particularly real estate lending, in the mistaken belief that vibrant economic growth would continue indefinitely, enabling the population to cope with its enormous debts. “We will never return to the old boom and bust,” said the U.K.’s finance minister Gordon Brown in 2007. Such is the folly of politicians.
In contrast, central banks’ ability to create money is constrained by the willingness of their government to back them, and the ability of that government to tax the population. In practice, most central bank money these days is asset-backed, since central banks create new money when they buy assets in open market operations or QE, and when they lend to banks. However, in theory a central bank could literally “spirit money from thin air” without asset purchases or lending to banks. This is Milton Friedman’s famous “helicopter drop.” The central bank would become technically insolvent as a result, but provided the government is able to tax the population, that wouldn’t matter. Some central banks run for years on end in a state of technical insolvency (the central bank of Chile springs to mind).
The ability of the government to tax the population depends on the credibility of the government and the productive capacity of the economy. Hyperinflation can occur when the supply side of the economy collapses, rendering the population unable and/or unwilling to pay taxes. It can also occur when people distrust a government and its central bank so much that they refuse to use the currency that the central bank creates. Distrust can come about because people think the government is corrupt and/or irresponsible, as in Zimbabwe, or because they think that the government is going to fall and the money it creates will become worthless (this is why hyperinflation is common in countries that have lost a war). But nowhere in the genesis of hyperinflation does central bank insolvency feature.
So the equivalence that Williams draws between hyperinflation and commercial bank lending is completely wrong. A central bank can create money without limit, though doing so risks inflation. Commercial banks simply can’t do this….
Control the money, control the world. This is a great rundown on how money is added to the economy. A very important topic.
More info Here