How is money created? Most people think that it is created exclusively by the central bank. This is not the case. The central bank only creates base money, which consists of the electronic money in the reserve accounts at the central bank held by commercial banks and all physical cash (notes and coins). When commercial banks order cash from the central bank their reserve accounts are debited, and vica versa.
How is the amount of base money controlled? In principle any govertment with its own currency it can simply create it by adding numbers to reserve accounts. However in most modern economies there are self-imposed rules in place to prevent governments from creating money. The reasoning behind this seems to be that politicians (and voters) cannot be trusted to do this responsibly. Instead this power is given to a central bank. Of course central banks are created and ultimately controlled by governments (and thus the people) so this is a somewhat artificial excercise. Nevertheless in normal times only central banks can create base money.
Although the amount of base money is tightly controlled it represents only a small fraction of the money circulating in the economy - currently under 5% of the broad money supply in the UK. So who creates the rest of the money? Commercial, privately owned banks.
Yes that is correct. Most of the spendable money that we absolutely depend on is created by private banks. When private banks make a loan to a customer they usually just add numbers to that customers bank account, creating 'bank money'. At the same time they get the customer to sign a debt or mortgage contract which compels them to repay the loan by a certain date and also pay interest. The money is created out of nothing together with a matching debt contract. This does not mean that all money that is lent by banks is newly created. But it does mean that banks do not need to wait for customers to deposit money with them before they make loans. Most people are surprised and disbelieving when they are told that banks are able to create money out of nothing. Ask any central bankers and they will acknowledge this as a simple fact. The best evidence for this is that there is vastly more money in private bank accounts (bank money) than the amount of base money created by central banks. It must have come from somewhere!
There is a notion that private banks are limited as to how much money they can lend by having to keep a certain fraction of money in their reserve accounts, and this is termed fractional reserve banking. In fact this is not a real limit as there is no longer any reserve requirement in many countries (such as the UK), and in countries with reserve requirements (eg USA) banks can always borrow additional reserves from the central banks. Banks lend first and then obtain the reserves later. The central banks will always provide the reserves because failure to do so would undermine the financial system.
Bank lending is legally limited by a requirement to meet a 'capital adequacy ratio', but this is nothing to do with reserves so is not limited by base money. All it means is that banks need to have assets that exceed their liabilities by a certain amount. Incredibly, this amount, also called equity, is only around 3-4% of assets. Any businessman will tell you that having equity of 4% is incredibly risky because if your assets decrease by 4% (through defaults or decreases in asset prices) you will be insolvent. Equity buffers of 20-30% are more typical of businesses. Bizarrely, given their importance, banks are allowed to operate with dangerously low equity buffers. Banks can expand total lending by simply retaining profits. With current rules retaining profits of £1 billion enables them to create a £25 billion of new money through lending. Their only real constraint on lending is being able to find customers wiling to borrow and their judgment as to whether they will be paid back.
The fact that most spendable money in the economy is created by private banks when they make loans had important consequences. All such loans are matched by an equivalent debt, so no NET new money is created. When loan are repaid the money is 'destroyed'. When the private sector reduces its debt levels by paying back its existing loans and taking out fewer new ones the overall money supply shrinks, which depresses the economy. That is why governments and central banks are desperately trying to encourage more credit creation by banks.
To counter the contraction in the money supply that economies are experiencing because of the reduction in bank credit creation, central banks are increasing the dramatically amount of base money by quantitative easing or QE. This involves central banks purchasing various assets from the private sector, typically government bonds.
Some people are concerned that this increase in base money will result in inflation. This always seemed unlikely given that the level of total bank money was and still is actually shrinking, despite QE. What is odd is that the same people that are worried about this increase in base money were unperturbed by the far greater increase in the broad money supply in the 20 years before 2008. Indeed the money supply tripled in the UK and USA in the 10 years leading up to 2008, with almost all of this increase being accounted for by commercial bank created money. This did not result in consumer price inflation, but it was responsible for asset price inflation, especially property prices.
To conclude, the rules that are in place to prevent governments from creating money have had the curious and underappreciated effect of placing most of the responsibility for money creation in the hands of private banks. In effect we rent our money from banks. In my view this was a mistake and one of the underlying cause of the global financial crisis (GFC). This crisis was a result of excessive credit creation by private banks which governments had enabled by loosening regulations governing banking. Many of these regulations had been introduced after the financial crash that precipitated in the Great Depression, which was also ultimately caused by a bank-created credit bubble. The reason why the GFC did not result in another depression is almost certainly because this time central banks flooded the financial system with enough base money to prevent banks collapsing. Unfortunately, however, this extra base money may not be enough, on its own, to restore growth. The reason for this will be discussed in the next post.
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