What’s Wrong with Banking Today?

How Do Banks Create Money?

Banks create new money (the numbers in your bank account) when they make loans. As the Bank of England says, “When banks make loans they create additional [bank] deposits for those that have borrowed the money.” (Bank of England Quarterly Bulletin 2007 Q3, p377) This means that nearly every pound in the economy today was created when somebody went into debt. All the money that we need to trade, to buy food, and to run businesses, must be borrowed from the profit-seeking banking sector, at a huge cost to us, and a massive benefit to them.

How Did This Happen?

Laws that make it illegal for you to print your own £5 or £10 notes have been in place since 1844. But those laws haven’t been updated to account for the fact that almost all money now is electronic. Because of this loophole, banks worldwide now have the power to create money, effectively out of nothing.

How can We Fix this?

A few simple changes to the banking system could remove this power to create money from the banks. We just need to move away from the current banking system – known as ‘fractional reserve banking’ – to what we call full-reserve banking.  And some heavy-weight people are in favour of change as well, including Herman Daly, a former senior economist at the World Bank (watch the video here).

How Did We Get into this Mess?

1844 Bank Charter Act

A couple of centuries ago, commercial banks were allowed to print their own bank notes (fivers and tenners), while coins could only be created by the state. Over time the banks started to issue (print) and lend out so many bank notes that they caused significant inflation and destabilised the entire economy. (This should sound familiar).

In response, the government of Robert Peel passed the 1844 Bank Charter Act, which made it illegal for anyone other than the Bank of England to print pound sterling bank notes.

Digital Money

However, this law did not make it illegal for banks to create ‘bank deposits’ or ‘number money’ – the numbers in your bank account, and in the bank accounts of any citizen or company in the country.

Originally this number money was simply written into huge ledger books in the bank, but is now stored in huge computer databases maintained by the banks.

97% of All Money is Digital Money…

With the rise in debit and credit cards, internet bank, direct debit and so on, this digital number money makes up 97% of all the money in the economy – around £2,151 billion compared to £50 billion of cash [1].

…So the ‘Money’ in Your Bank Account was Created By Private Companies

The numbers in your own bank account were all created, essentially out of nothing, not by the Bank of England or the Royal Mint, but by commercial banks.

The banks are able to create this ‘number money’ through the accounting process that they use to make loans, using a business model known as ‘fractional reserve banking‘. Rather than taking money from a saver and lending it to a borrower (as per the common understanding of banking), they simply write new numbers into the bank account of a borrower – effectively creating new money.

Without seeing the process in action, it can be a little hard to believe, so below are a few quotes ‘straight from the horse’s mouth’ which confirm this amazing fact:

“…by far the largest role in creating broad money is played by the banking sector… when banks make loans they create additional deposits for those that have borrowed the money.” – Bank of England Quarterly Bulletin, 2007 Q3

“Subject only but crucially to confidence in their soundness, banks extend credit by simply increasing the borrowing customer’s current account, which can be paid away to wherever the borrower wants by the bank ‘writing a cheque on itself’. That is, banks extend credit by creating money.” – Paul Tucker, Deputy Governer of the Bank of England & member of the Monetary Policy Committee

“… changes in the money stock primarily reflect developments in bank lending as new deposits are created.” – Bank of England Quarterly Bulletin 2007 Q3, p378

“…the banking sector plays such an important role in the creation of money. Changes in the terms for deposits will affect the demand for money, while changes in the terms for loans will affect the amount of bank lending and hence money supply.” – Bank of England Quarterly Bulletin 2007 Q3, p383

“The money-creating sector in the United Kingdom consists of resident banks (including the Bank of England) and building societies” – Quarterly Bulletin 2007 Q3, p405

Bank deposits (the numbers in your bank account) now make up 97.4% of the total quantity of money in the economy¹. By volume of payments, bank deposits are used for 99.91% of transactions and transfers, with cash being used for just 0.09% of transfers². Consequently, the physical currency issued by the state has been almost entirely replaced by a digital currency issued by private companies. The UK’s money has been privatised.

The ‘Rules of Money’

Under a fractional reserve banking system, there are two ‘rules of money’:

1. When a bank makes a loan, it increases the amount of money in the hands of the public (by increasing the total quantity of digital bank deposits)
2. When a member of the public repays a loan, it reduces the amount of money in the hands of the public (by decreasing the total quantity of digital bank deposits)

Consequently, through excessive lending between 2000 and 2008, banks were able to double the money supply in just 7 years – an increase in the total money supply from £884 billion to £1,674 billion³. The chart below shows the increase in the Bank of England’s M4 measure of money supply,  and therefore the total quantity of bank deposits, in each year. Each red bar represents new money created by the commercial banks (click the image to enlarge):

All the ‘Money’ in Your Bank Account Represents Someone Else’s Debt

Since all the number money in your account was created by banks making loans, this means that for every pound in your bank account, someone else is in debt by an equal amount.

In fact, due to compound interest, the public’s debts are now greater than all the money that exists in the economy. According to Bank of England figures, if the UK public collectively took all the money in our bank accounts and used it to pay down our debts, we would end up with no money at all and still owe £306billion (plus interest) to the banks!⁴

In other words, we now have a debt-based money supply issued entirely by private, profit-seeking companies. Our money supply has been effectively privatised.

The damaging effects of this system to the economy and society are numerous and severe, and are covered in more detail in the pages on the left.

Implications of Fractional-Reserve Banking

There are two important implications of fractional reserve banking that affect everything that happens in our economy and society:

1. Banks have the power to shape Britain’s economy through their monopoly on the supply of money to the public and to businesses. If they invest wisely in productive businesses, they can help the economy to grow, but if they choose to pump the money (bank deposits)  that they create into housing and commercial real estate, we get destabilising asset price bubbles and a severe financial crisis. Judging by their track record, should we entrust this huge power and responsibility to an industry concerned solely with short term profit, rather than the health of the wider economy?
2. As the sole suppliers of money to the public, if banks lend, the economy functions. If they don’t, it grinds to a halt (as in the credit crunch). Our economy is completely without a stable, permanent money supply, and entirely dependent on the mood of the banking sector.

Who Should We Blame?

Many people are angry at the banks, or individual bankers. But the truth is that it is the government who sets that ‘rules of play’, and successive governments have failed to reform the banking system at the right time.

Instead, after every crisis, the government and authorities focus on getting back to business as usual. They focus on ‘getting banks lending again’ without questioning why we are all so dependent on bank debt to keep the economy functioning.

So we should blame all those successive governments who have repeatedly failed to fix the banking system, but the pressing concern is to do something about it.

But we also need to make sure that they don’t make the same mistake again. We need to make sure everyone understands how the banking system really works, how money is created, and how we can fix the system.