The monetary system has been drawn into sharp focus after the 2007-8 global financial crisis. The vast majority of money today is not created by the state, as most would assume, but by the private, commercial (or high-street) banking sector. In modern economies, this money exists in the form of bank deposits (the accounting liabilities of banks), which are created when banks make loans or buy assets. The economic, social and environmental consequences of such a system are explored here.
Around 97%1 of the money used by people and businesses in the UK exists in the form of bank deposits at commercial – i.e. ‘high-street’ – banks. Only 3% exists as physical cash that is created by the state, via the central bank (in this case, by the Bank of England). A similar situation exists in most countries around the world. Banks create new money in the form of the electronic numbers (bank deposits) that appear in bank accounts, through the accounting process used when they make loans. In the words of the Bank of England:
“When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.” (McLeay et al., 2014)
Conversely, when people use those deposits to repay loans, the process is reversed and money effectively disappears from the economy. As the Bank of England describes:
“Just as taking out a loan creates new money, the repayment of bank loans destroys money. … Banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy.” (McLeay et al., 2014)
This power to create money, in the hands of commercial banks, has been highlighted as one of the root causes of both the Great Depression of the 1930s and the financial crisis of 2007-2009. The former chairman of the UK’s Financial Services Authority, Adair Turner, has argued that:
“The financial crisis of 2007/08 occurred because we failed to constrain the private financial system’s creation of private credit and money” (Turner, 2012).
With most money being created by banks making loans, the level of bank lending determines the money supply. What then determines how much banks can lend? The demand for credit (lending) will always tend to be high due to: insufficient wealth, the desire to speculate (including on house prices), and various legal incentives. Meanwhile the supply of credit depends on the extent to which banks are incentivised to lend. During benign economic conditions banks are incentivised to lend as much as possible – creating money in the process – by the drive to maximise profit, and this process is exacerbated through the existence of securitisation, deposit insurance, externalities and competition. For a variety of reasons, regulations that are meant to limit the creation of money, such as capital requirements, reserve ratios and the setting of interest rates by the Monetary Policy Committee, are ineffective. Yet despite the high demand for credit, the strong incentives for banks to create money through lending, and the limited constraints on their ability to do so, banks do not simply lend to everyone who wants to borrow. Instead, they ration their lending. For this reason, the level of bank lending, and therefore the money supply, is determined mainly by banks’ willingness to lend, which in turn depends upon the confidence they have in the health of the economy.
1 This figure excludes central bank reserves as the general public does not have access to them.
Demand for Money & Credit
Credit is demanded in order to make investments in businesses, smooth consumption over a period of time (such as housing or consumer finance), or to speculate. Legal constructs for corporations and tax incentives can increase the level of demand for credit from businesses. As such there will usually be substantial demand for borrowing from banks. However, because the banking sector (i.e. licenced deposit-taking institutions) is the only source of both cash and bank deposits, there is also a structural demand for borrowing from the economy itself, determined by the demand for money (although this will not directly result in an increase in the demand for credit). Individuals operating within an economy require money, but because bank deposits are created when banks make loans, for an individual to obtain money – whether to make transactions or to store against future contingencies – someone else must have previously gone into debt. This means that, in the current monetary system, for there to be money, there must also be debt.
What’s more, if people en masse try to repay their debts to banks whilst also reducing their borrowing from banks, the net rate of money creation by banks will fall. To the extent that this money creation would have financed the purchase of goods and services, GDP will also fall, the lower spending this leads to can cause a debt deflation, bankruptcies, increased unemployment and lower growth.
In conclusion, in addition to the demand for credit that occurs as a result of people wanting to borrow, there is also a need for credit to ensure the economy has the money it needs to function. It is crucial that the right amount of credit is provided as there is a tendency for the supply and demand of credit to be very high during economic booms, and to the extent this credit is not used to finance GDP related transactions leads to asset price inflation and bubbles. While on the other hand the supply of credit by banks and demand for it by the public tends to be insufficient during busts, leading to recessions. In other words, the demand and supply of credit is pro-cyclical.
Economic consequences of the current system
The economic effects of money creation depend on how much and where lending is allocated. If newly created money is used to increase the productive capacity of the economy, the effect is unlikely to be inflationary. However, banks currently direct the vast majority of their lending towards non-productive investment, such as mortgage lending and speculation in financial markets. This does not increase the productive capacity of the economy, and instead simply causes prices in these markets to rise, drawing in speculators and leading to more lending, higher prices, and so on in a self-reinforcing process. These dynamics foster asset price bubbles.
While the increases in asset prices may create the impression of a healthy, growing economy, this ‘boom’ is usually fuelled by an increasing build-up of debt. The current monetary system therefore sows the seeds of its own destruction: households and businesses cannot take on ever-increasing levels of debt, and when either start to default on loans, it can cause a chain reaction that leads to a banking crisis, a wider financial crisis, and an economy-wide recession. Financial crises therefore come about as a result of banks’ lending practices and the activities funded by newly created money.
The boom-bust cycle is also caused by banks’ creation of excessive amounts of money as explained by Schularick & Taylor (2012). Some measures implemented to dampen these effects have the perverse effect of actually making a crisis more likely. Deposit insurance, for example, is intended to make the banking system safer but in reality enables banks to take higher risks without facing the costs of that risk in terms of scrutiny and caution on the part of their customers. Economists call this ‘moral hazard’. The Basel Capital Accords, again designed to make the system safer by requiring that banks hold capital to cover their assets proportional to the risk that those assets will generate a loss, give banks incentives to choose lending secured by collateral, such as mortgages, over unsecured lending to businesses, making house price bubbles and the resulting crises more rather than less likely.
Social and environmental impacts of current system
Much of the money created by the banking system is directed into housing, causing house prices to rise faster than incomes as seen below for the UK, US and EA 17:
House price affordability has been worsening since the 1990s
nominal house prices / rent price, 2015=100, 2018, UK, USA & EA17. Source: OECD
As well as making housing unaffordable for those who were not on the housing ladder before prices started to rise, it also leads to a large number of people using property as an alternative to other forms of wealth, such as pension or retirement savings, without them realising the rising prices are artificially fuelled by the rise in mortgage lending and money supply.
The interest that must be paid on this debt results in a transfer of wealth from the bottom 90% of the population (by income) to the top 10%, exacerbating inequality. This is because bank profits are paid out to shareholders, who are typically people in high-income households. In addition, any attempt by the public to pay down its debts will result in a shrinking of the money supply, usually leading to recession and making it difficult to continue reducing debt. The state currently earns a profit, known as seigniorage, from the creation of bank notes. However, because it has left the creation of electronic money in the hands of the banking sector, it is the banks that earn a form of seigniorage on 97% of the money supply. That seigniorage is in the form of the ‘spread’ between interest the bank pays out to savers, and the interest it receives from loans. Due to the implicit state protection against liquidity crises afforded by deposit protection insurance, access to lender of last resort facilities at the central bank and the perceived willingness of the state to intervene at any sign of instability, savers and investors are prepared to lend to banks at a lower rate of interest than other lending institutions can enjoy.This is a significant and hidden subsidy to the banking sector, and the loss of this seigniorage by the state requires that higher taxes are levied on the population. A report by the New Economics Foundation and Copenhagen Business School have calculated that the subsidy amounts to an annual average of £23 billion in the UK.
Some have argued instability caused by the monetary system harms the environment (Macquarie, 2018). The burden of servicing an inflated level of debt creates a drive for constant growth, even when that growth is harmful to the environment and has limited social benefit. When the inevitable recessions occur, regulations protecting the environment are often discarded, as is longer-term thinking with regards to the changes that need to be made. In addition, there is little control over what banks invest in, meaning that they often opt for environmentally harmful projects over longer-term beneficial investments.
Monetary reform is a philosophy of change dedicated to transforming existing monetary arrangements either at a regional, national or international level. Reform movements, usually attacked by the economics mainstream as being based on loose theory and casual empirical observation of the persistence of ‘poverty amidst plenty’, become more prominent in times of economic distress such as during the 1870s Long Depression, the 1930s Great Depression, and since the 2008 financial crisis.
There are a number of monetary system reform groups arguing for a different system. The differing theories and history of monetary reform are covered in the ‘Economic Perspectives’ page.
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