Do you know where money really comes from? The 'textbook' explanation is wrong

But here’s the thing, none of them could. It’s not that they were stupid. They knew the facts and could crunch the numbers required to get their degrees and do their jobs, but clearly that knowledge didn’t include an answer to my question.

Of course, even I knew where physical money, i.e. cash, comes from. The notes are printed and the coins minted by the state. However, in a modern economy, cash is the loose change of the money supply – most of which only exists electronically in the form of bank deposits and the like.

So where does that sort of money come from? None of the people I asked knew. It’s strange because while we talk endlessly about how money is earned, spent, taxed and redistributed, how it comes into being barely gets a mention.

It is, however, the topic of an eye-opening article by Pierre Ortlieb for the Economic Questions website.

Ortlieb tells us the truth, which is that most money is created by banks in the process of making loans. I mean that quite literally – the money that a bank lends to a borrower is simply brought into being at the stroke of a pen (or the click of a keyboard). Yes, really – they are allowed to do this. It’s all perfectly legal. In fact, it’s fundamentally what banks are for.

When the loan is repaid, there’s another click of the keyboard and the money is destroyed, returning to the notional space from whence it came. (However, the interest paid on the loan is not destroyed and is instead trousered by the bank – a little thank you for their trouble.)

There are complications of course, but basically that’s where money comes from.

Ortlieb is not revealing some deep dark secret here – prominent financial institutions have made it quite clear how it all works:

“For instance, in 2014, the Bank of England published a short, plainly-written paper that described in detail how commercial banks create money essentially out of nothing, by issuing loans to their customers. The Bank author’s noted that ‘the reality of how money is created today differs from the description found in some economics textbooks,’ and sought to correct what they perceived as a popular misinterpretation of the credit creation process…”

A lot of people, however, still believe in the ‘textbook explanation’ i.e. that banks expand the money supply by lending out their savers’ deposits. As the Bank of England explains, the mere act of saving money doesn’t create anymore of it – because if it wasn’t being saved it would be spent. In fact, spending the stuff may well be more of a stimulus to the economy than sticking it in a savings account.

The idea that commercial banks are creating money out of thin air is counterintuitive, indeed downright disturbing. We assume that only the state can ‘print money’ and we hope that the printing press stays in the hands of sober and sensible central bankers. But no, it turns out that commercial bankers have money creating powers too!

That said, the central bank sets interest rates, putting a limit on what people can sensibly borrow and therefore what the commercial banks can sensibly lend. This constrains their money creating powers.

With interest rates currently so low, central banks have been resorting to the alternative mechanism of quantitative easing to jumpstart the economy. Ortlieb argues that the weirdness of QE has prompted the authorities to be much more open about how money works:

“As quantitative easing has stoked public fears of price instability, monetary authorities including the Bank of England have sought to clarify who really produces money. In this sense, taking steps to inform the public on the real source of money – bank loans – is a worthwhile step, as it provides constraints on what a central bank can be reasonably expected to do, and reduces informational asymmetries between technical experts and lay citizens.”

Perhaps the best way to assuage concerns that QE is ‘funny money’ is to be clear that it’s all funny money. QE or no QE, the modern economy runs on a medium of exchange that is created out of nothing and is only worth something because everyone believes that it is.

This is the nature of a fiat currency, and in these troubled times Ortlieb urges those in charge not to hide the truth:

“Central banks would be better off engaging in a clear, concise, and careful communications program to inform the public of how credit actually works, even if they might not really want to know how the sausage gets made.”

I’m sure that’s right, but all the same, it’s probably best that people aren’t thinking too hard about what’s in the sausage when they’re eating it.

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Peter Franklin is Associate Editor of UnHerd. He was previously a policy advisor and speechwriter on environmental and social issues.

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