Money Creation and Society: The beginning of the debate on how money is created

12^th December 2014

The Chancellor’s autumn statement shows how much scrutiny parliament places on how money is spent, with relatively small changes to budgets generating either applause or outrage. But parliament has a habit of completely overlooking more fundamental questions about money, questions such as: who should be allowed to create it in the first place? How much new money should be created? And how should that newly-created money be used? 

Parliament has ignored the issue of money creation for around 170 years, but on Thursday 20th November, backbenchers held a debate on “Money creation and society”. The issues MPs raised touched on many of the big social and economic challenges we’re facing today: unaffordable housing, growing inequality, rising personal debt, financial instability and the state of government finances.

But this debate around money creation is not a debate about the benefits of switching from paper to plastic banknotes. Paper money these days is a trivial part of the UK’s monetary system, with coins and banknotes making up just 3% of all the money we use. Far more significant is the other 97% of money, which exists as bank deposits – the numbers that you see when you check your bank balance, and which you spend every time you make an electronic payment.

Unlike coins and paper money, bank deposits are not created by the government. Instead, they’re created by banks, through some simple accounting, whenever anybody takes out a loan. As the Bank of England explains:

“In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood. The principal way in which they are created is through commercial banks making loans: whenever a bank makes a loan, it creates a deposit in the borrower’s bank account, thereby creating new money.”

Once this process of money creation is understood, it becomes clear just why banks are so important. Banks are not just lenders of money; they actually create the money that we use. If they create and lend too much money, it gives the illusion of an economic boom. If they panic and refuse to lend (as they did after the financial crisis) then money effectively disappears from the economy and we head into recession.

With money creation having such an important effect on the health (or otherwise) of our economy, it’s crucial that MPs understand it. But a recent poll commissioned by Positive Money found that 71% of MPs still believe that only the government has the power to create money. Just over 1 in 10 MPs accurately understood that banks create new money every time they make a loan, or that money is destroyed whenever individuals or businesses repay loans.

This lack of understanding of money creation is dangerous, as Conservative MP Zac Goldsmith highlighted at the parliamentary debate:

“If Members of Parliament do not really understand how money is created — and I really believe that that is the majority position, based on discussions that I have been having — how on earth can we be confident that the reforms that we have brought in over the past few years are going to work in preventing repeated collapses of the sort that we saw before the last election? In my view, we cannot be confident of that.”

Without understanding that banks create new money when they make loans, MPs are ill equipped to appreciate that:

1. Theboom running up to 2007 was fuelled by the creation of new money by high street banks. Over £1 trillion of new money was created as the banks went on a lending spree.
2. Thehousing bubble is driven largely by money creation by banks, rather than the scarcity of housing. For instance, the £22 billion of new mortgage lending provided in 2013 resulted in £22 billion of new money being creating by the banks and pumped into the housing market.
3. Governments can create short-term economic growth by encouraging households togo further into debt, because every new loan from a bank creates money. But as Lord Turner (former chairman of the Financial Services) has warned, this will ultimately increase the risk of another financial crisis.
4. If households try to pay down their debts, money disappears from the economy. This could potentially lead to a recession.

More fundamentally, since money is power, whoever has the power to create money has the power to shape society. The backbench debate on money creation was a step towards a wider public debate about where we want that power to lie. Do banks have the right incentives to use the power to create money responsibly? Can we counter their tendency to put most of the money they create into property bubbles and financial markets?

Or should we just strip banks of their power to create money altogether? This is something that the campaign group Positive Money has been arguing for since the crisis. It’s an idea that’s gaining traction, with even the chief economics commentator of the Financial Times, Martin Wolf, arguing that it would bring ‘huge advantages’. The government currently sees the idea of stopping banks from creating money as too radical to contemplate, but it’s clear that this is a debate that is only just beginning.

For more about money creation and its effect on the economy, visit www.positivemoney.org