Download the Foreword and Overview for Free

Where Does Money Come From?, co-authored by Positive Money’s resident expert Andrew Jackson, explains exactly how money is created in the UK, based on over 500 original documents from the Bank of England and other banking authorities. With a foreword by one of the leading authorities in banking, Prof Charles Goodhart, this is the most comprehensive and authoritative guide to how money is created ever published, and reveals that most of the textbooks are very much out of date.

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Two of the authors, Josh Ryan-Collins and Tony Greenham from the New Economics Foundation, discuss the book and its findings below:

There is widespread misunderstanding of how new money is created. This
book examines the workings of the UK monetary system and concludes that
the most useful description is that new money is created by commercial banks
when they extend or create credit, either through making loans or buying
existing assets. In creating credit, banks simultaneously create deposits in our
bank accounts, which, to all intents and purposes, is money.

Many people would be surprised to learn that even among bankers,
economists, and policymakers, there is no common understanding of how
new money is created. This is a problem for two main reasons. First, in the
absence of this understanding, attempts at banking reform are more likely
to fail. Second, the creation of new money and the allocation of purchasing
power are a vital economic function and highly profitable. This is therefore a
matter of significant public interest and not an obscure technocratic debate.
Greater clarity and transparency about this could improve both the democratic
legitimacy of the banking system and our economic prospects.

£14.99 plus £2.50 postage within the UK, or £4.50 with international shipping

Defining money is surprisingly difficult. We cut through the tangled historical
and theoretical debate to identify that anything widely accepted as payment,
particularly by the government as payment of tax, is, to all intents and purpose,
money. This includes bank credit because although an IOU from a friend is
not acceptable at the tax office or in the local shop, an IOU from a bank most
definitely is.

We identify that the UK’s national currency exists in three main forms, the
second two of which exist in electronic form:

Cash – banknotes and coins.
Central bank reserves – reserves held by commercial banks at the Bank of
Commercial bank money – bank deposits created either when commercial
banks lend money, thereby crediting credit borrowers’ deposit accounts,
make payments on behalf of customers using their overdraft facilities, or
when they purchase assets from the private sector and make payments on
their own account (such as salary or bonus payments).
Only the Bank of England or the government can create the first two forms of
money, which is referred to in this book as ‘central bank money’. Since central
bank reserves do not actually circulate in the economy, we can further narrow
down the money supply that is actually circulating as consisting of cash and
commercial bank money.

Physical cash accounts for less than 3 per cent of the total stock of money in
the economy. Commercial bank money – credit and coexistent deposits –
makes up the remaining 97 per cent of the money supply.

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There are several conflicting ways of describing what banks do. The simplest
version is that banks take in money from savers, and lend this money out to
borrowers. This is not at all how the process works. Banks do not need to wait
for a customer to deposit money before they can make a new loan to someone
else. In fact, it is exactly the opposite; the making of a loan creates a new
deposit in the customer’s account.

More sophisticated versions bring in the concept of ‘fractional reserve banking’.
This description recognises that banks can lend out many times more than the
amount of cash and reserves they hold at the Bank of England. This is a more
accurate picture, but is still incomplete and misleading. It implies a strong link
between the amount of money that banks create and the amount that they
hold at the central bank. It is also commonly assumed by this approach that
the central bank has significant control over the amount of reserves banks hold
with it.

We find that the most accurate description is that banks create new money
whenever they extend credit, buy existing assets or make payments on their
own account, which mostly involves expanding their assets, and that their
ability to do this is only very weakly linked to the amount of reserves they hold
at the central bank. At the time of the financial crisis, for example, banks held
just £1.25 in reserves for every £100 issued as credit. Banks operate within an
electronic clearing system that nets out multilateral payments at the end of each
day, requiring them to hold only a tiny proportion of central bank money to
meet their payment requirements.

The power of commercial banks to create new money has many important
implications for economic prosperity and financial stability. We highlight four
that are relevant to the reforms of the banking system under discussion at the
time of writing:

Although useful in other ways, capital adequacy requirements have not and
do not constrain money creation, and therefore do not necessarily serve to restrict the expansion of banks’ balance sheets in aggregate. In other words, they
are mainly ineffective in preventing credit booms and their associated asset price
Credit is rationed by banks, and the primary determinant of how much they lend
is not interest rates, but confidence that the loan will be repaid and confidence in
the liquidity and solvency of other banks and the system as a whole.
Banks decide where to allocate credit in the economy. The incentives that they face
often lead them to favour lending against collateral, or assets, rather than lending
for investment in production. As a result, new money is often more likely to be
channelled into property and financial speculation than to small businesses and
manufacturing, with profound economic consequences for society.
Fiscal policy does not in itself result in an expansion of the money supply. Indeed,
the government has in practice no direct involvement in the money creation
and allocation process. This is little known, but has an important impact on the
effectiveness of fiscal policy and the role of the government in the economy.
The basic analysis of this book is neither radical nor new. In fact, central banks
around the world support the same description of where new money comes from.
And yet many naturally resist the notion that private banks can really create money
by simply making an entry in a ledger. Economist J. K. Galbraith suggested why this
might be:

The process by which banks create money is so simple that the mind is repelled. When
something so important is involved, a deeper mystery seems only decent.

This book aims to firmly establish a common understanding that commercial banks
create new money. There is no deeper mystery, and we must not allow our mind to
be repelled. Only then can we properly address the much more significant question:
Of all the possible alternative ways in which we could create new money and allocate
purchasing power, is this really the best?

£14.99 plus £2.50 postage within the UK, or £4.50 with international shipping

Download the Foreword and Overview for free

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