Frequently Asked Questions

Here you can read lots of quotes from the Bank of England confirming that banks do indeed create money. They are not describing the popular economic textbook myth of the money multiplier either (see next question for more on the money multiplier).

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. The confusion comes because the reality of modern banking is complex and partially hidden. In researching for the guide to the UK monetary and banking system “Where does money come from?”, the authors had to piece together information that was spread across more than 500 documents, guides, manuals and papers from central banks, regulators and other authorities. Few economists have time to do this research first-hand and most individuals in the financial sector only have expertise in a small area of the system, meaning that there is a shortage of people who have a truly accurate and comprehensive understanding of the modern banking and monetary system as a whole. Regarding the Vickers report, unfortunately their analysis is still based on a textbook model of banking that believes that banks simply take money from savers and lend this money to borrowers. Our response to the Vickers report can be found here.

For a full discussion of the problems with the money multiplier see here.

The money multiplier should be ignored as it is confusingly wrong. It has been disproven time and time again, both empirically and through descriptions given by central bankers. For example, Charles Goodhart said over 20 years ago that the Money Multiplier is: ‘…such an incomplete way of describing the process of the determination of the stock of money that it amounts to misinstruction’. For empirical evidence see this paper by the Fed, or this one for the UK.

The money multiplier assumes various things. Firstly, a bank needs deposits before it can make loans. This is demonstrably false: banks create deposits by making loans. This also confuses reserves with deposits not lent.

Secondly, the Government can control the amount of money created by the banking sector by altering the reserve ratio and amount of ‘base money’ in circulation. Again, this is untrue – there is no reserve ratio in the UK. Even if there was the Bank of England cannot use it to control the total money supply created by banks. Furthermore the central bank cannot even control the amount of base money in circulation – by not lending to commercial banks when they wish to borrow the central bank can create a liquidity and possible a solvency crisis, which goes against its mandate to protect financial stability.

Thirdly, the money multiplier assumes that the amount of money created by banks is mathematically limited.

The money multiplier view lead economists to see banks as mere intermediaries, without real importance. Because of this they could make models which did not include banks, money or debt. This was a primary reason why most economists didn’t see the financial crisis coming.

One might object that the commercial banks are not really creating ‘money’ – they are extending credit and this is not the same thing. The book ‘Where does money come from?’ examines the nature and history of money in greater depth and concludes that in fact money is always best thought of as credit. But in short, is it really meaningful to describe the balance in your bank account as anything other than money? You can use it to pay for things, including your tax bill, and the government even guarantees that you will not lose it if the bank gets into trouble.

Furthermore, the Government guarantees to repay the money in your bank account if your bank goes bust, making whatever is in your bank account money rather than credit.

While the idea that most new money is created by the likes of Barclays, HSBC, Lloyds and RBS rather than the Bank of England will be a surprise for most members of the public (although not as much of a shock as if you tried to convince them that their bank deposits were not really money at all), it is well-known to those working in central banks. For some quotes from central bankers on money creation by private banks see here.

See here for a full explanation of the process.

Part of the confusion around this issue may be due to talking at cross purposes, and confusion as to the difference between reserves and deposits. In short, when loans are repaid the customer’s deposit is extinguished, as is the bank’s loan asset, decreasing the total amount of bank-created money in the hands of the public. However, the reserves or cash which are used to pay off the loan are not extinguished, and become assets of the bank.

This is explained in far more detail here.

Going bust

In brief, banks create money by making loans, and go bust when they owe more than they are owed and own (when their liabilities are worth more than their assets). When a bank makes a loan it opens an account for the borrower (which it counts as a liability) who in return agrees to repay the principle (which it counts as an asset) plus any interest. The money a bank creates is a debt which it owes to the borrower – it is not the same as printing ten pound notes and using them to pay off your debts.

If a bank is insolvent then making lots of loans increase the bank’s assets and its liabilities in step with each other. Consequently this will not improve the banks solvency position in the short run. While making loans will increase the bank’s assets in the long run (and thus bring it out of insolvency) a bank run is likely to occur before then.

Running out of money

When you transfer money from your bank account your bank settles this transaction by using something called central bank reserves. Only the central bank can create this type of money, and therefore it is entirely possible for private banks to run out of it.

When depositors spend their money central bank reserves flow from their bank to the bank of the business they are buying from. If all banks expand their lending at the same rate, the outflows of reserves will broadly match the inflows from other banks. However, if one bank is increasing its lending faster than the others, then it will have a constant outflow of reserves to the other banks. Banks may borrow reserves from other banks; however in times of financial stress other banks may be unwilling to lend their reserves in case the bank they are lending to goes bust. This is essentially what happened to Northern Rock.

Banks can only create the type of money that we as members of the public use (known as bank deposits). When businesses borrow from banks more often than not they spend this newly created money with customers of other banks. Banks use a special type of money to make payments between themselves – central bank reserves (see this page for a full description). Only the central bank has the power to create central bank reserves. Because commercial banks use central bank reserves as money and can’t create it is valuable to them. When bank loans are used to buy things off customers of other banks central bank reserves are transferred to those customers banks. As the loan is repaid these reserves are transferred back.

Banks therefore don’t like lending money unless they are sure they are going to be repiad. This is one of the reasons why banks prefer to lend for asset purchases, such as housing. The house serves as collateral on the loan, which the bank can reposses and sell if the borrower is unable to repay. This is also the reason banks prefer to lend to large rather than small businesses – they have real assets which can be seized if the firm defaults on the loan.

They didn’t, they bought it from the holders of the debt, such as the pension funds. However, this involved the reserves being transferred to banks, as the holders of the bonds had accounts at these banks, which were credited when the bank bought the bonds.

There’s nothing at all wrong with banks making a profit in a free market where bad banks are allowed to fail. But when they are given a monopoly over the supply of money to the nation’s economy, and given an implicit (but permanent) guarantee from government using taxpayer’s money, it’s hardly a profit won in the sense of true capitalism. In reality much of the banks’ profits are just wealth extraction, unlike say, Apple or Google, which actually produces something of significant value to people who aren’t forced to buy their products.

The reforms do not advocate an additional method for money to enter the economy, rather an alternative. Between 1983 and 2009 banks increase the money supply by an average of 12.5% a year. Because almost all of this newly-created money was lent into the economy and was matched by the same amount of debt, it laid the foundation for the recent financial crisis. This chart shows just how much new money – and new debt – the banks added to the economy in the run up to the crisis. The reforms that we are proposing would make it impossible for high-street banks to create new money when they make loans. As a result, they won’t be able to increase the money supply of the nation every single year.

However, people have learned from history that allowing governments to create new money is a recipe for inflation. So a conventional knee-jerk response to the proposed monetary reform is that it will be inflationary. It is true that money creation by feudal and monarchical governments in the past and by elected governments more recently has led to inflation. But that does not mean inflation will result from giving an operationally independent central bank responsibility for creating new money directly, as we propose. The Monetary Policy Committee will be instructed to consider the needs of the economy as a whole in deciding how much new money should be injected into the economy. The needs or desires of the elected government do not factor in this decision at all. In fact, the members of the MPC should be expressly forbidden from considering political matters or the intentions of the current government in making the decision. Monetary reform in those new circumstances will enable the Bank to control inflation more effectively, not less effectively, than at present.

We may still need to increase the amount of money in the economy in line with rises in population, productivity or other fundamental changes in the economy. There are also issues as we make the transition from a debt-fuelled economy that requires new money to avoid collapsing under the weight of the debt, to the stable, low-debt economy that this reform would create. Like a junkie coming off heroin, our economy might need to be weaned off continual injections of new money over a period of time. There’re some good arguments for (and against) fixing the money supply and letting prices adjust naturally according to economic fundamentals. However, the current consensus amongst central bankers and economists is that a small amount of inflation is necessary for a stable and growing economy, and as such the idea of a fixed money supply would be a political non-starter.

Unlike the current system, the process of making loans after the reform is very mechanical. The process would move money from A to B, rather than creating new money (unlike the current system). In the post-reform banking system, a bank will only be able to make loans using money from one of the following sources:

1. The money that bank customers have given to the bank for the purposes of investment (specifically, the money that bank customers have used to open Investment Accounts.
2. The bank’s own funds, for example from shareholders or retained profits.
3. Any borrowings from the Bank of England (when permitted).

In contrast with the current system, all money in Transaction Accounts (which would currently be held in ‘current’ accounts) is ‘off limits’ to the bank’s loan-making side of the business.

A secondary role for the Monetary Policy Committee during the period of the transition will be to ensure there is enough money in the economy during the Transition Process. The Transitionary Lending Scheme is to ensure a sufficiency of loan finance during this Process. This finance will be on-lent by the commercial banks and will work to smooth out any changes in the availability of credit from the banks during the period of the transition. More details here.

If not much investment is needed, then people won’t borrow, and if a lot is needed, interest rates will go up and that will encourage people to save more and provide more money for investment.

If someone is able to borrow money and pay it back, why shouldn’t there be savers and banks that are willing to lend to them? People who are ‘good for the money’ will still be able to borrow – we don’t need to allow banks to create money out of nothing (whilst being underwritten by the government) just to ensure that people can borrow. Besides, don’t forget that the current dependency on credit is because almost all money has to be borrowed from the banks – we have to go into debt to get money into the economy. If we have a new source of money, which isn’t created as debt, then there will actually be less need for people to go into debt.

No, what will probably happen is that house prices would stay flat until people’s salaries had time to catch up. House prices originally got so far out of reach because banks were able to create vast quantities of new money and pump it into mortgages. That wouldn’t happen again if our proposals were implemented, so it’s unlikely that house prices will increase further. But they’re unlikely to fall much either, as people simply don’t like to sell houses for a loss, so most people tend to sit and ‘wait for the market to recover’. So with average house prices being pretty much fixed, our only option is to wait for salaries to catch up. But don’t forget that home ownership is already out of reach for anyone who doesn’t own a home right now. That situation is unlikely to change under the existing system.

In short no. The investment accounts will not be money – they cannot be drawn down until the allocated date (when the loan is repaid to keep things very simple) they are simply a record of the customers loan to the bank. As soon as the bank has this money it will lend it to a borrower – no new money is created, it is simply transferred. When the time comes for the loan to be repaid the bank would merely transfer money from the borrowers transaction account back to the lenders investment account and from there the money would be transferred back to the lenders transaction account. All the time the amount of demand deposits would never increase.

If you contrast this with fractional reserve banking, when a bank makes a loan they do not reduce the value of anyone’s account, they simply open a new account for the borrower. Thus new purchasing power is created when loans are made, and new money is created – deposits increase. Full-reserve banking does not allow the quantity of deposits to increase when loans are made, and therefore doesn’t allow total purchasing power to increase. Of course, you can still have a chain of debts through Investment Accounts, but the total level of lending will be dependent on the number of people who are willing to tie up their funds in an Investment Account.

In the existing monetary system, the total amount of money (defined as ‘bank deposits’ – the numbers in your bank account) is increased whenever a bank makes a loan. Consequently, the money supply increases as a result of the individual decisions of thousands of loan officers and mortgage advisors, and the lending priorities of bank directors. Because banks profit from making loans, there underlying tendency is to create too much of it. As revealed in the financial crisis that started in 2007, this tends to lead to disaster. Post-reform, the health of the whole economy will be considered before a decision is made to increase or decrease the money supply. While there are always issues when decisions are made by small committees of ‘wise men’, we believe that it would be hard for the Monetary Policy Committee to do a worse job of managing the money supply than the banks have done to date. With a holistic view of the economy, and an incentive to support the economy rather than to maximise their own bonuses, this should lead to better outcomes overall.

When the Monetary Policy Committee authorises the creation of a certain amount of new money, the Bank of England’s Issue Department will add that money to the government’s Central Government Account. The government is free to use this money however it chooses in order to achieve its democratically-mandated policy objectives. Therefore the government may choose to:

1. reduce the overall tax burden
2. increase government spending
3. make direct payments to citizens (sometimes referred to as a ‘citizen’s dividend’)
4. pay down the national debt

The exact mix of the above will depend on the priorities and ideology of the government of the day. Since the newly created money will simply be added to tax revenue, there is no need for a special process to decide how to spend it. If the public have elected a government that promises to increase public spending, then the government can justifiably use the money for this purpose. Likewise, if the public elected a government that promised to reduce the overall tax take, then the government can use the money to this end (by using this money to cover existing spending and reducing the overall tax take). Read in more detail about each option here. We don’t aim to make proscriptive recommendations – How the money should be spent is a political decision and not for us to decide.

There are some major sources of instability in the current system that can be removed with a few simple changes to the way that banks do business.
The stability in the new system arises from the fact that the funds a bank uses to make loans are now ‘locked in’ – customers can no longer demand them back whenever they choose. As a result, the bank knows: a) What it will need to repay to customers who have made investments, and when. b) What it will receive from borrowers making repayments on their loans, and when. The risk of any bank or all banks suffering a ‘cashflow crisis’ is significantly lower post-reform than under the existing banking system, for the following reasons:

1. Unlike the present day banking system, the post-reform banking system is not pro-cyclical. This means that the banking system will not create debt-fuelled booms that soon turn into economic crashes, causing a wave of defaults. Consequently, each bank’s loan portfolio is likely to be far safer than under the current system.
2. The economy will be generally more benign. Without regular banking-fuelled boom and bust cycles, recessions will be less frequent and less severe. If a million people are no longer thrown out of employment every few years, then fewer people will run into financial difficulties, and therefore fewer borrowers will be forced to default.
3. Because the bank has limited funds for making loans (and because each loan does not create new deposits), the incentive for loan-making departments shifts from lending as much as possible, to finding good quality borrowers to lend to. As a result, the banks are less likely to lend to bad-risk borrowers, and consequently the overall quality of a bank’s loan portfolio should be higher, making defaults less likely.
4. There will be no bail-outs of bad banks after the reform. If a bank is judged to be badly managed or have made bad investments across the board, meaning that all holders of Investment Accounts are likely to lose money, then the bank in question should be wound down, broken up and sold off to either healthier banks or debt collection firms. In the post-reform system, winding down a bank would be far easier and cheaper than under the existing system, for the following reasons:

The funds placed in Transaction Accounts are 100% safe, held separately from the bank’s investments in the bank’s Customer Funds Account at the Bank of England.
The taxpayer and government has no exposure or responsibility whatsoever for the funds owed to holders of Investment Accounts. The Investment Account holders would become creditors of the liquidated bank, and insolvency law would govern whether and by how much they are repaid their original investment.
Read in more detail about this here.

No. What we’re proposing is that money which customers want to hold risk-free isn’t invested. Instead of sitting on the balance sheet, it’s held in custody for the customer. Therefore it’s not exposed to any risk (because it’s not lent or invested). Customers who want some kind of return will need to accept some risk and take the risk of losing all or part of their investment if the bank goes belly up. Read our response to the Vicker’s proposals.

Interest rates on current accounts are close to zero now, and traditionally current accounts paid no interest.

Currently the only reason your current account is ‘risk free’ is because all the risk is passed on to the government, and therefore back onto the taxpayer (via the £85k guarantee on your account). We’re arguing that the risk should be aligned so that the people who stand to benefit from the upside also stand to benefit from the downside. But if you want instant access to the money, it can’t be invested at the same time, so you’d have to give up your return for instant access.

Yes the BoE already has the ability to create money but this is presently limited to cash and central bank reserves. By not providing the government with interest-free money the BoE is serving the interests of private banks and bankers. The whole point is that under the reforms no private institution will be able to create new money and the BoE will serve the nation, not private banks. Banks will have to operate like any other business.

It’s impossible to guarantee that it’ll be independent, but it’ll still be subject to much less of a conflict of interest than we have now with banks creating money. We’ve also done a massive amount of work in the proposed draft legislation to clarify that separation of powers.

The MPC already manipulate interest rates, which is intended to influence bank’s lending decisions and therefore the money supply indirectly. Having the power to alter money supply directly, within the constraints of the inflation target, has a far more focused and less harmful impact that pushing interest rates up and down economy-wide. Think about the wisdom of the current system: in order to encourage a few extra people to go into debt (so as to increase the money supply), the Bank of England has to lower interest rates that affect nearly every single member of society. It’s incredibly ineffective. So they would actually have less power to screw things up than in the current system. Regarding corruption, the reality is if inflation rates start rising, they would need to stop creating money. Banks do not have that constraint, and all their incentives push them to increase the money supply (by increasing their lending) which is why money supply has been able to grow at over 10% a year for the past 30 years. We genuinely struggle to see how the MPC could do a worse job.

The Bank of England is wholly owned by the UK government. It isn’t private, unless your key source of information is unreferenced conspiracy theories. The Bank of England Nominees is owned in whole by the Bank of England and one nominee shareholder, who is also an employee of the Bank of England. As this Hansard record states, it holds shares on behalf of ‘Heads of State’ and the government. It has less that £1million in assets that it owns itself, as the Bank of England annual report states, which means the company itself doesn’t hold very much at all – it just holds securities in custody for other groups. In short, it appears to be a company structure set up to hold shares confidentially on behalf of the Queen (as if she or the royal estate was to buy them through normal means, they’d be visible to staff at share-dealing companies and would be leaked). It’s a bit of an odd thing to set up for the sake of a monarch, but then so is prancing around on horseback dressed in bearskin hats. We don’t see anything overly concerning with the set-up. A bit unaccountable of course, but not evidence of some major conspiracy. Focusing on BoE is a complete distraction from the real issues. 

At first glance it might look like this would centralise power, but take a look at where we are now: the amount of money in the economy depends on the lending policies of a few people at the head offices of the 5 main banks in the UK. There is no democratic oversight or accountability over these people, and the vast majority of the public and MPs have no idea that these senior bankers even have this power or ability to affect the money supply. Our proposal would separate the decision over how much money is created, and how that money is spent, so it eliminates a huge conflict of interest. The Bank of England would only be deciding how much money the economy needs to run, but not decide how that money can be spent, in the same way that a mechanic will decide how much oil to put into a car, but doesn’t tell you where you should drive. If it is unacceptably centralising to treat new national money as a public resource, to collect its value as public revenue, and to distribute it via public spending programmes, the same principle should presumably apply to the state’s monopoly of national taxation and public spending. Imagine for a moment that the history of taxation and public spending had led to them being managed now on a profit-making basis by the Big Four banks. Would decentralists be responding to proposals for reform with the objection that it isn’t “possible or desirable to give the state a monopoly of national taxation and public spending”? Actually there is no contradiction between mainstream monetary reform and decentralised monetary innovation. Both embody the principle that money should serve the needs of people (not vice versa). If you accept that plural currencies are likely to serve people’s needs better than a single one-size-fits-all currency for all purposes, both are desirable. The practical fact is that in a democratic society, unlike other forms of society, additions to the money supply put into circulation as public revenue will tend to be distributed just as wisely and fairly, if not more so, via increases in public spending and reductions in taxes and public debt than the new money now created by the commercial banks as loans to their customers.

Do you realise how little power the ‘market’ has in the current system? Banks are fully-underwritten by the government (implicitly or explicitly) and allowed to operate a business model that will inevitably lead to bank failures. If we had a true free market then any bank that tried to operate this way would go out of business, people would lose their money and then people would choose to avoid the banks that operate like this. It is only because the government uses taxpayers’ money to rescue these banks that they are allowed to continue in business. In a real free market, banks would operate the way that we’re proposing. Our proposals are actually closer to a free market. Interest rates for example would be set by supply and demand, rather than being set centrally by the Monetary Policy Committee. With regards to whether this is ‘extreme’, we’re simply suggesting that banks operate the way people think they operate. The way how the system really works is unbelievably far from being a free-market.

This is another spurious conventional reaction. But of course the proposed reform need not result in allocating resources only to the public sector. Governments could equally well use the new source of revenue to cut taxes and the national debt and so stimulate private investment and consumer spending. Even if new money does circulate via public spending, it will soon reach businesses and citizens who can use it for private sector investment or consumption as they themselves decide.

In fact, this will not necessarily be true. Nor will it be the whole story. The banking industry will become more competitive when it is no longer subsidised, and the oligopoly of lending to small businesses now enjoyed by the “Big Four” will be more easily challenged by other banks. That will tend to reduce the costs of borrowing. Furthermore, when money is put into circulation debt-free, the costs of servicing and repaying debt that the use of debt-created money now imposes on every economic transaction will be eliminated, with the result that less borrowing will be needed than now because that element in the present cost of all economic activity will no longer have to be met. As regards the costs and efficiency of payments services, it is true that if banks are no longer subsidised by the profit they now get from creating money but have to borrow money at interest to lend to their customers, they will no longer be able to cross-subsidise their payments services as much as at present. Initially, costs to bank customers may rise as they have to meet the full costs of the payments services they use. But, although withdrawing subsidies from any industry initially makes the cost of its products higher, it is generally recognised that this kind of cross-subsidisation between different services is an impediment to competitiveness and economic efficiency. It is also true that withdrawing the present subsidy will encourage banks to cut costs, perhaps involving further closure of branches and loss of banking jobs. Withdrawing subsidies from any subsidised industry, including coal, steel, ship-building and many others, has had effects of that kind. But subsidies have been withdrawn in the knowledge that subsidies to an industry reduce its competitiveness, by making it more difficult for smaller firms to compete with bigger ones and more difficult for new innovative entrants into the industry to establish themselves. So far as the economy as a whole is concerned, subsidies to particular industries tend to hold back innovation and reduce the growth of efficiency and productivity by distorting the allocation of resources. Are there any special reasons why the banking and financial services industry should be sheltered from these facts of economic life, except the mystique and power it now exercises over political decision makers?

It applies to a single currency bloc. Practically there’s no problem with plugging this model of banking into all the forex systems. Obviously there will be some (over)reaction from the markets but once that’s settled down there’s no long term issue.

This brings to mind the joke about the economist who tells his grandson not to bother picking up a £5 note from the pavement, because if it were real somebody else would have picked it up already! There will probably be no harm, and much gain, in being first to introduce monetary reform, if it will make the economy as a whole more efficient and productive, and society more just and inclusive.

Depriving banks of the hidden subsidy This view is a favourite with opponents of reform. Whether depriving commercial banks of that privilege would lead to the migration from the City of London of the largest collection of banks in the world, and whether – even if that happened – it would be a disaster for the British economy and society as a whole, are moot points. In fact, it is likely that, after a short period of adaptation by the banking and financial sector, the outcome would prove beneficial to British society as a whole, including the economy’s international competitiveness.weaken their ability to compete internationally with other countries’ banks.

Why don’t we just nationalise our money supply, not our banks, and the government can create money debt-free? We propose to nationalise rather the “creation of money”. If we did not rely on banks to create our money supply then they would be ordinary businesses. And it would not be of interest to us how responsible their lending is and who they lend to. They would be allowed to fail and go bankrupt just as any other ordinary business and we wouldn’t have to worry.

Reserve requirements, while useful for other reasons, do not actually constrain banks from lending. In the real world banks make loans first, and then go looking for the reserves later. Furthermore, the central bank is committed to providing however many reserves the private banking system needs on a day to day basis in order to maintain the interest rate. If it chooses not to, it can create a liquidity and potentially even a solvency crisis.

In the early days of steam power, engines were liable to run amok and blow up. Mechanical regulators were developed to control speed and pressure, but if these jammed engines were liable to run amok and blow up. Regulations were introduced to require the inspection and testing of vehicles before they were allowed into service, but if the inspectors missed something, engines were liable to run amok and blow up. You don’t see many steam engines these days. If a system is inherently liable to run amok and blow up, regulation can at best buy you time until a system designed to eliminate this liability can be developed and introduced to replace it. We don’t believe in regulating the banks (as far as what they’re allowed to invest in goes). We don’t believe in bailing them out or nationalising them either. We believe in making them liable for their actions like any other business or entity is. They would not have been giving away cash for sub-prime mortgages if they felt that they would ultimately be held liable for the debt. They should not be in a situation where they are given special treatment by our government. And, we shouldn’t be giving our government any more power than it already has. There must be a free market way for our banks to function productively like any other business.