Another fine explanatory video from Positive Money, who are making good headway in explaining how banks create money. Slowly, one person at a time, the myth that banks lend out savings is dissolving.
They’ve also posted one recently on banks and democracy.
The Earthbound Report 
I’m trying to understand this … if banks just create money “out of nothing” (0:30), then why do banks need to borrow money?
Anthony, I see no-one ‘in the know’ has attempted to answer you. My interests do not need to cover this area so I can only suggest that by placing more of their own imaginary figures into the banks own books just to counter their own debt, they would not profit from an internal transaction, and, it could not be circulating outside in customers accounts and the economy in general. So, it would have no beneficial effect. It might remove their own debt on the computer account, but would show as more gone out that cannot be returned by them, returning them to the status quo. I expect this must be a very simple answer but may have some sort of relevance. Accounting skills will be relevant, I suspect. What a shame no-one better informed wanted to help. I’d like to have seen a better reply too. Disappointing!
Thanks for that – helpful ideas, but I’m still puzzled! Will keep looking online…
Anthony, There was one clue that I meant to add, but accidentally left out of my shortened version. The whole idea is based on ‘the money goes round and round’ (whether real or just ficticious money on computers), whilst the banks and many of us, profit (short-term), through the process (which encouraged the use of more and more ficticious money). I believe the big BUT, was that it was not coming back as much as went out, until finally the hole in the gaping difference between in and out was devastingly evident in various financial realms. (In the balloon analogy, so much can be made out of thin air, but eventually the bubble bursts). Listening to one radio money programme some time ago, Michael Portillo was the only person I’ve heard say ‘But where did it go?’ His question went unacknowledged by all, just as your question! (It’s no doubt all part of the mighty tangle we weave when fist we practice to decieve, and no-one wants to discuss this!). Of course many benefit, but some MUCH more than others and some were pulling the strings. As if often the case, it seems that those pulling the strings gained most and lost least. No doubt, humanity itself suffers the greatest loss, but a conscience and long term thinking is needed to address that, and we’ve always lacked there haven’t we (overall, I mean). If you find more specific answers perhaps you’ll help me, as no-one else is giving anything away.
Reblogged this on gfmurphy101.
Jeremy, I was hoping someone would help Anthony Smith with his question (above). Perhaps you were too. I was going to provide my very basic short thoughts, but thought better of it as I’m not versed in economics – I don’t want to point in the wrong direction. Can you have a go at making a simple explanation to help?
I’ve been away for a few days, so I’m catching up with comments to some pre-scheduled posts. Apologies for the delay.
There are a few different answers here. The first is that banks can generate the money as they lend it, and that goes out in the form of loans and mortgages. It always has an end recipient. They can’t generate money for their own use, so if they need to find funds to expand or build branches or whatever, they’d borrow that.
The biggest area where banks need money for their own use is for playing the markets. All those mortgages that have been lent out are assets on the bank’s balance sheet, so they can borrow against those and use that money to speculate on the markets. Creating loans and mortgages is only a small part of the business for many banks – the real money is made in speculating on stocks, currencies, commodities etc.
Other businesses are incorporated in different ways and don’t have the full rights of banks, so they borrow money cheaply and lend it out at a profit. Not every company that lends money has the right to create money.
Thanks Jeremy, but what we really need to understand is how did these ‘short-term profits’ cause the problem in the banks (as the video states), and what will a public institution do differently? I realise it could be difficult for you to appreciate how little understanding some may have. Can you offer more?
Sure, it was things like irresponsible lending that were done for short term profit. For example, you might give a mortgage to someone who doesn’t have a stable job. They might not be able to repay, but you don’t mind because you can sell on their mortgage and get your bonus for meeting mortgage sales targets. That’s profit today, and disaster for everybody tomorrow.
A public institution wouldn’t have shareholders clamouring for their cut all the time, so they’d be able to lend with lower returns, on a longer time frame. There isn’t the urgent need for growth and profits. You don’t have any competitors who will put you out of business if you act more responsibly.
Thanks. That’s some of the things I’ve heard. The video went from how banks make money out of nothing just by entering numbers on keyboards, to the problem being that debts get paid back(!), to us needing a public institution to stop chasing short term profits. But it made no logical connections anywhere for the genuine enquirer. It badly lacked clarity. This caused Anthony’s question to arise. I hope he has followed us to have more light shed.
I’ve been trying to follow – afraid I’m still getting a bit lost! What I’m hearing is that banks don’t need to borrow money to balance their loans – they can just create that money out of nothing. However, they need to borrow money for their own purposes, and to play the markets.
But I don’t follow that, for three reasons.
First, the banks get plenty of income from interest payments on loans, so I don’t see why they need to resort to borrowing in order to supplement that.
Second, with all the income from repayments of loans, I don’t see why banks need to play the markets at all. Why not set up a separate company to play the markets, then that company can borrow without limit from the banks, and play the market with that “created” money.
Third, it leaves unexplained why banks would ever refuse a loan application. Suppose you give a mortgage to someone who doesn’t have a stable job – or even any job at all. What is the worst that can happen? The money you’ve “created” out of nothing is never repaid. But if banks can create money out of nothing with no limit, then nothing has been lost.
Or have I got it wrong – are there actually limits to how much money banks can “create”?
Hi Anthony – One more try from me.
On your first two points – Businesses seek to make profits, and most are not satisfied to make ‘plenty’ as you put it. They want their plenty of money to make plenty more, ad infinitum. That’s why they will borrow and speculate. On your point about separating speculation from basic banking, I believe this is already being looked into by the government. It remains to be seen.
On your third point. You’ve asked if the banks made a loss (whatever the cause), what stops them making more money ‘out of nothing’, as it was suggested they do. The Positive Money video said that this imaginary money DOES IN REALITY create our debts. This means it is not in reality a NEUTRAL commodity. It could be said that, in effect, the banks BORROWED money to loan, from thin air. (Many did not appreciate this fact). This is the connection which has not been made crystal clear and keeps your question unanswered. Positive Money said, ‘It sounds crazy, but this isn’t the crime of the century, it’s just the way banks work.’ They explained that we can borrow as much as we like, but it will only in effect, pay back the debt which was real, and created from the ‘imaginary’ money (because, as they already stated, the imaginary money is not as innocuous as it sounds – it does put us into REAL debt because it can’t come from nothing). And of course it can’t, because ‘there is no such thing as a free dinner’ and that includes imaginary money. They might have made a profit from it but much is only paying for the money they did not really have, except as a debt. We wanted to keep borrowing more, but we did not repay it as fast as we borrowed it, yet the bankers kept paying themselves bonuses on the loans, which did not produce the expected profits, because they weren’t properly repaid. This makes the debt ever growing on their books until we have to face up to it, because, embarrassingly for those ‘in the know’, (and a hard shock for those who don’t), some-one, ultimately, has to pay for it, because it is real debt. The video chose not to touch on that but, simply, to basically say that we need bankers who don’t do that.
So, this fact of the imaginary money being real debt which grew, was not expressed as well as it could have been, after the misleading expression about creating money ‘out of nothing’. This is my understanding of it. I really hope this does help.
You’re correct to be confused, Anthony. The video maker strikes me as one of those guys who understands like 90% of a concept, and then goes off to the races with suppositions. Let’s start with what’s true.
What separates income (and commerce) from wealth (and currencies) is something called “money velocity”. Suppose that a town only had a single £1 coin in existence. There’s no bank and no loans, but everyone played by the rule that as soon as you get the coin you have to spend it within 1 second to someone else in town. At the end of the year that town would have a collective income of £31,536,000 (number of seconds), even though only £1 ever existed.
Far away there’s another town with a collective savings of £100 million. But they’re all misers who insist on making everything themselves. They never loan, invest, or purchase anything. At the end of the year, the income of everyone in that town is £0, even though they have all this money.
So the amount of currency that exists and the amount of commerce that an economy is doing aren’t strictly correlated. The reason they go together is because of convenience. (The second town is living like subsistence farmers despite lots of wealth, and the first will run into trouble as soon as someone gets the pound and can’t spend it.)
So what we want is for the money supply to grow and shrink according to the ability of people to spend it. And the easiest way to do that is via banks which are already involved in transactions.
Let’s return to that first town. This time I’m the bank, and whoever starts with the coin deposits it with me for easier transfers. When Ralph spends his £1 to Julia, instead of handing off currency between them they just contact me, and I move a 1 to Julia’s column and take it off of Ralphs. From the view of the townspeople, it’s the same but more convenient. But how’s it look to me, the bank? Well I’m holding £1 year round and that never changes.
Now suppose Vikram comes to me and says “I’m on the east side and it seems like we never get access to the coin. The west side keeps trading it back and forth. There’s all this stuff we want to buy and sell, but we can’t because we never get the coin!” So I (the bank) say “I’m going to set you up with a loan. I’m going to put a 1 in your savings account, but instead of taking it from someone else I’m going to put a -1 in your loan account. And just remember that one of these days, when the coin comes back to you, you have to pay back the loan.”
So now what’s happening in town? Now there are £2 running around town (separately), which means if everyone keeps up spending once per second, the town will double it’s income for the year. And we’ve actually solved a problem. Without loans, if the person who got the coin chose to save it, the whole economy shuts down. But now, thanks to that loan, people can keep spending (even if more slowly). So this has been so beneficial I might do it a few times, and get multiples (let’s say 5) of our virtual coin running around town.
But in so doing we’ve created another problem. Now if any one of those 5 people with a coin in their account comes to me and says they want to withdraw it, I’m insolvent. (And that’s true whether they want the coin, or just a deposit to another bank – say they’re leaving town. Either way I have no actual assets.) If two people do that, we have a bank run and then a failure. (Even though nothing actually went wrong!) This reason, and ONLY this reason, is why banks cannot “create infinite money through loans”.
Every banking system has something called a “reserve requirement”, which says banks cannot loan out “more than”, or even “all of” the money that they take in. They must have some portion (usually like 10%) of the money available. If depositors come to take their money out so the bank falls below 10% reserve, that bank MUST get more cash from another bank. And that’s why we have things like LIBOR and the Federal Funds rate, a very liquid and well-known rate that banks offer each other to meet this requirement.
(And if you want to think further on that, the higher this rate is the more reluctant banks are to use it. Which means they will lend out less – or at higher rates – to ensure bonus reserves. This is why central banks “lower rates”, meaning that inter-bank rate, to encourage easier lending and thereby boost the economy.)
So yes, making loans means there’s more money moving around, and repaying loans means there’s less. But it’s at least as much a RESULT of the economy as a CAUSE of it. This is why central bank activity is often referred to as “pushing on a rope”: just because money is available to loan, invest, or spend, doesn’t mean people actually will.
And none of that has anything to do with people defaulting, which is a much bigger problem than simple withdrawals. Consider my little bank again, and lets ignore reserve requirements for a moment. My assets are £1 in that original coin, and £4 in loans. And my liabilities are £5 in various people’s accounts. So those balance out at a net 0. If someone pays back a loan, we go to 1 coin + 3 loans = 4 accounts. If someone withdraws the coin it’s 4 loans = 4 accounts. (With no cash on hand, but we’re still balanced.)
But what if Vikram comes to me and says he can never pay back his £1? Now it’s £1 coin + £3 loans in assets, and £5 in accounts as liabilities. This is not just a temporary problem of cash on hand. It’s a serious problem where things don’t add up. I don’t just need another £1 short-term to meet people’s needs. I need another £1 permanently to re-balance things. And that was the problem with the bank collapses. It’s not that depositors money was busy in good loans, it’s that it was gone from bad ones.
Fortunately, there’s a simple fix for this too. It’s called the “capital requirement”. See, the problem with my bank was that I never had any of my own money involved. All I did was take deposits and hand out loans. And my one and only concern was keeping things flowing. So I had no built-in incentive to verify Vikram’s ability to repay. And thus I was perfectly happy to make any loans, good or bad, until they blew up.
But a capital requirement means that I (the bank owner) need to be the first one to put money in and the last one to take it out. Sure, if things go well and there’s a profit, I get it. But if things go wrong I should be the first one to lose and (ideally) the only one to lose. And with enough of my money in capital there, I have a very VERY strong incentive to ensure solid loans because everything that goes wrong comes out of my share. But with a tiny requirement my own risk is dwarfed by the profits I could potentially make, and so I stop paying attention where I should. (Call this short-term thinking if you like.)
So (fair warning – now leaving facts and entering my opinion) this was really where governments failed to properly regulate banks. We cannot predict what everyone else will think of, and we certainly cannot predict what everyone else will think of and how it will turn out. But what we CAN AND SHOULD do is make sure that the ones who benefit from risk are the ones who are responsible for it. Once we do that, banks will be smarter with our money not because they suddenly care, but because it’s in their own best interest.
To wrap up, here’s where I disagree with the video and some comments here:
A) Banks create money but it’s not infinite. It might, however, be too loose. And if it is, fixing that is as easy as raising the reserve requirement or capital requirement. (The latter being a position I strongly support.)
B) Profit-driven instutions are not inherently short-term and public institutions not inherently long term. I would probably argue the opposite: stock prices are based on earnings predictions well into the future, and policitians are interested in votes from the next election. But neither is inherently good or bad. The problems arise from a mismatch of control, risk, and benefit in either sector.
C) “Playing the markets” is not not, in this context, functionally different from making a loan to a homeowner. It’s taking cash and turning it into an asset that generates returns. Either can be bad or good, either is taking risk. In fact, sometimes they’re incredibly identical. Instead of loaning money directly to homebuyers, banks gave money to other banks to give to borrowers and called this second-line transfer a “Collateralized Debt Obligation” or “CDO”. One transfer happens on a market and the other when papers are signed at closing, but either fails if the house goes underwater. Same cause, same effect.
D) Repaying debt does reduce the amount of money outstanding that can flow around. But that doesn’t necessarily mean the economy is worse, especially if the money used for the repayment would just have been sitting around anyway. The important thing is to ensure loans are available where they will be repaid, and only where they will be repaid. If a bad loan is made, or a good borrower is denied, those are both negatives for money flow and thus the economy. Since we’re only human, we WILL make mistakes on both sides. But the best way to minimize those errors is to ensure that lenders have both reward AND risk for making loans.
Well, thanks Amarsir, there’s a lesson and a half in economics for us novices! I don’t know about Anthony, but if I want to get my head around the ‘ins and outs’ of it that you offer, I’ll have to be determined enough to read it quite a few times, I think! But fundamentally, I’m sure that without the specific details of banking, we all appreiate that it boils down to your final sentence, which we can all readily understand. Let’s hope the government bolts the door before the horse bolts again.
Hi Amarsir,
I have now had time to properly read your explanations. You have helpfully given us the’ in and outs’ of the system, but fundamentally, I find that it has confirmed the simple truth that, whatever way you look at it, it goes wrong when banks are asked to give back more than they have.
However, I also find that, a few of your own descriptions are at least, questionable. I’ll give the most important one. You say that it goes wrong (a ‘problem’ arises), ‘Even though nothing actually went wrong!’ To be fair, something did indeed go wrong. It was the fact that the banks’ first loan to people wanting to use money they had not got, was given by banks that also did not have any money, so, figures, IN DISGUISE AS MONEY, went from the bank to get circulated to everyone (like a cold). We have to recognise this to stand a chance of knowing whether this act of disguise, which claims to be ‘beneficial’ for society, truly is. It does not matter how else you explain matters, this phrase of yours (‘Even though nothing actually went wrong’), serves to make the truth less obvious and then, we have even less hope of getting out of the culture of blame and making less ‘problems’ in the world for one and all to suffer by. (There were many ways to say this, so I’ve chosen the briefest, and hope it does not lead to further confusion!).
Please don’t take this as a personal attack. I can assume it is not your intention to disguise some truth, but I’m sure it does, and that it ought to be raised.
Amarsir, thanks for taking the time to write up that long comment – an elegant answer.
I think the problem here is that we’re discussing the fundamentals of banking on the back of a viral video! They’ve sacrificed detail to make their point, but as we’ve all just demonstrated, it raises some massive questions that it can’t deal with.
They have done their homework elsewhere though, in particular the book ‘Where does money come from?’. http://www.positivemoney.org.uk/publications/
Not related to Positive Money, but I also recommend David Boyle’s little book ‘Money Matters’ which is a very readable introduction to what money is:
http://makewealthhistory.org/2009/10/01/money-matters-putting-the-eco-into-economics-by-david-boyle/
Thanks for the detailed comment, Amarsir. That makes a lot of sense. I’ll need to follow up the references Jeremy gave, but it does seem clear now that there are limits to the extent to which banks are able to increase the amount of money in circulation (“create money”).