Do banks create money or just credit? (new video)

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You might hear some people say that “Banks don’t create money – they just create credit”. This response often comes from civil servants and people trying to deny that banks now create the nation’s entire money supply. So let us show you why the numbers that banks create are money, and not just ‘credit’.

Watch the 5th part of our Banking 101 Video Course now:

TRANSCRIPT

You might hear some people say that “Banks don’t create money – they just create credit”. This response often comes from civil servants and people trying to deny that banks now create the nation’s entire money supply. So let me show you why the numbers that banks create are money, and not just ‘credit’. The key thing about ‘credit’ is that it has something called credit risk. Credit risk is the risk that a person, or company, that owes you money won’t pay you back. If you lend £50 to an unreliable friend who still owes you money from the last time you lent to him, then there’s a lot of credit risk attached to that loan, because it’s fairly likely that he won’t repay you on time. So if the numbers that banks add to your bank account are not money, but just credit, then there must be some credit risk attached to that money. In other words, there must be a risk that the bank won’t be able to repay you. And of course, as we saw with Northern Rock, Wachovia and the Icelandic banks, there is a pretty good chance that your bank won’t be able to repay you. In fact, in a legal sense, the numbers in your bank account aren’t money. They’re just a promise to pay from the bank. The promise is that the bank will either give you cash when you ask for it, or will electronically make payments to other banks when you ask them to. So that would suggest that there is credit risk attached to the numbers in your bank account, because the bank may not be able to repay you. And that would suggest that the numbers banks create of not money, but just credit are credit. In fact, the Bank of England actually follows this argument and points out a distinction between cash and bank-created money. In their 2010 Q3 Quarterly Bulletin, they say that “Bank of England notes [i.e the cash in your pocket] are a form of ‘central bank money’, which the public holds without incurring credit risk. This is because the central bank is backed by the government.” (p302). Interesting. So cash has no credit risk because it is backed by the central bank, which is backed by the government. But the commercial banks aren’t backed by the government. So that implies that the numbers they type into people’s accounts must be credit, and not money. But hang on a minute. The government has a scheme called the Financial Services Compensation Scheme – or FSCS. This scheme promises to repay you up to £85,000 if your bank goes bust and loses all your money. In fact, you might have seen them advertising this scheme on the tube or buses. This guarantee is supposed to be funded by contributions pooled across the banks. But if the contributions from the banks aren’t enough – as happened during the financial crisis – then taxpayers have to make up the rest of the money. Just think about what this means for a second. This guarantee scheme amounts to the government saying, you give your money to a bank, let them do whatever they like with it, and if they lose it all, we’ll just use other people’s money to reimburse you and make sure you don’t lose a penny”. In what way does this not count as the banks being backed by the government? Here’s the bottom line. The numbers that banks type into customers’ accounts would be ‘credit’ and not money IF – and only if – there was a credible risk that you might not get all that money back. If that was the case, then bank deposits – the numbers in your account – would actually be a risky investment, and anyone putting their money into the bank would have to accept that they might lose some or all of the money. IF this was the case, then banks would just be extending credit, even though their payment systems would allow you to use that credit to make payments. But because the government steps in and guarantees all this bank ‘credit’, it completely removes all the risk. In effect, the numbers that banks create are fully backed by the government guarantee, and therefore they don’t have any credit risk. There is absolutely no difference in the riskiness of a banknote created by the Bank of England, and a number typed into a bank account by one of the high-street banks. So, to sum up, the numbers in your account are just as good and just as safe as the cash created by the Bank of England, because the numbers in your bank account are guaranteed by the government. In other words, what banks create when they type numbers into bank accounts is money, not credit. When the government steps in to guarantee that you won’t lose a penny even if your bank does something stupid and is unable to repay you, then it effectively converts the risky credit of the bank into a risk-free form of money, backed up with taxpayers funds, but which the government permits private companies to create out of nothing. By the way, probably the main reason why civil servants in the Treasury and the Banking Commission try to argue that banks can’t create money is that, if they acknowledged that banks had acquired the power to create money, then they’d have to deal with the serious implications of giving one of the greatest powers that government has to a private short-term profit-seeking collection of corporations.

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  • m96gran

    Isn’t it more correct to call this money “I owe you real money”-money?.. (“real” money could be central bank money, note ,coins). Isn’t this the real reason to why banks are allowed to create this?.. because it’s NOT counted as money. It is a “I owe you real money”-money. And it’s not illegal to say that I owe you some money.. and you.. and you.. and you.. Me and my friend can agree that I owe him just as much money as we want.. for whatever reason. We have not created any new “real money” by doing this. Our agreement on a piece of paper could be some sort of money of course, because if it’s trusted by our friends, it could be used to pay for within our circle. But we would never get caught for counterfeiting.. because it’s not “real money”. The contract will be some form of money.. but not the money that the government or central bank is giving out..

    I still think there is a definition problem. People mean different things when they use the word “money”. You use a broad definition of the word “money”.. as meaning generally any form of means of payment? Maybe this is correct.. it’s correct in any practical point of view regarding payment itself. But is this the real wordbook definition of money? The legal dictionary? If it is correct to use the word money for means of payment.. what is then the definition of counterfeiting? Is it specified as to printing your own CENTRAL BANK money? If it’s only specified to as printing your own money.. then money can not be the private money that banks create.. or you and I could create some form of, by telling a friend that we owe him money.. because you will never get caught for doing that.

    • Simon

      The “credit” money becomes real money when it ends up as a deposit in someone’s account. A bank does not have to have deposits to lend out before it creates a loan to you or me. “Bank of Dave” in Burnley has to have savers’ deposits before he can lend out. Most people think all banks work like “Bank of Dave”, but they do not, and they do indeed create money from nothing by the act of lending. However the act of lending does ultimately reduce the bank’s reserve account at the Bank of England if the new deposit created ends up with a different bank. These reserve accounts are what the banks uses to settle up between themselves. This process is described in detail in some of the earlier Banking 101 videos. If all the banks increase their lending at roughly the same rate, they can expect new deposits to return to them, thus increasing the money supply, house prices, and associated debt. The economy is relatively short of money at the moment, because banks are lending much less compared with a few years ago, and people are trying to pay down debts. The government is still borrowing fairly strongly, and along with quantitive easing, is going some way to counteract the relative reduction in the money supply compared to a few years ago. However the days of a bank like Northern Rock lending 8 times salary for a mortgage are long gone and unlikely to return, which is a good thing.

      The reason Northern Rock went bust is quite interesting, and is described in detail elsewhere on this site. They lent too much, did not get enough deposits and repayment of debt back, so depleting their reserve account at the Bank of England. Other banks then felt they would not be paid by Northern Rock, so lost trust in it. It is important to distinguish between the accounts banks have to settle between themselves at the Bank of England, and loans and deposit accounts which most of us have with the banks. The new loans generally come first, before new deposits are created elsewhere in the banking system. Interest rates and the “reserve requirement” are usually very weak regulators of bank lending or new money creation. The main driver is the appetite for people to borrow, and the banks willingness to lend. Interest rates are at an all time low, and yet net lending (new loans less debt repayement) is very much less than in the boom years of the early 2000s when interest rates were higher. Too much was lent on private and commercial property in the boom years, so pushing up rents and house prices, which the real, productive economy has to pay for. Even now, the banks are lending very little for productive enterprise as they prefer to gamble on property and shares. Positive Money would reduce the level of debt in society by gradually replacing credit / debt money with debt free money, and taking the power to createnew money awayfrom the private banking system.

      • reg32

        The fact that lending by “Bank of Dave” does not create money is down to the fact that it is not defined as a bank rather than operating procedure.

        “Bank of Dave” is not classed as a monetary financial institution for the purposes of producing M4 data. If it was, then the act of making a loan
        would increase the balance of M4 money, regardless of how it manages its
        balance sheet.

        It’s the same point as noting that bank creation of money doesn’t depend on banks being able to credit the borrower’s account – new lending would still create money, even if they could only lend by handing over cash.

        • Simon

          Bank of Dave lends existing deposits, whereas a conventional bank creates the loan and new deposit/money from nothing.

        • Simon

          Bank of Dave lends existing deposits, whereas a conventional bank creates the loan and new deposit/money from nothing.

          • reg32

            I’m not sure I understand your point, Simon.

            Do you think that when a bank lends you money by giving you cash that it doesn’t create money? Say, for example, I have a zero balance on my current account but I take £100 from an ATM, making me overdrawn. The bank has provided me funds from its existing holding of notes; no new deposit has been created. This still creates money (even under a narrower money measure, like M1).

            I’m not saying the organisations don’t have different operating procedures, nor that the distinction is unimportant. I’m only pointing out that whether or not it creates money (as conventionally understood) depends only on how the organisations are classified, not how they operate.

          • Simon

            I give money to Dave’s bank, my bank balance reduces, his increases, he lends it on, no increase in money supply. It is like lending money between friends, just using his “bank” as a middleman. It does matter that Dave’s bank does not create money, and conventional banks do, because 90% of the populace think all banks are like Dave’s, when they are not.

            In the case of a bank giving you £100 in cash and you going overdrawn, the bank’s reserve account which includes it’s holdings of physical cash at the Bank of England is reduced so the overall stock of money is the same. You have £100 more, the bank has £100 less. However, if they had electronically credited your account with £100 which is the most likely scenario, £100 of new money would be created. When you go to the cash machine and draw it out, then the bank’s reserve account at the B of E is reduced, so again the stock of overall money is the same. The situation is very different when electronic money is used. The bank credits your account with say £10,000, you spend it at the car dealers and a new deposit of £10,000 is created at his bank. The main thing is if all the banks create new loans in step, they can expect new deposits to return to them, which is what they did in the early 2000s increasing the money supply, house prices and debt. Northern Rock got into trouble because it was lending faster than other banks, and borrowing off other banks so it’s reserve account at the Bank of England was depleted and it was no longer trusted by the other banks. The banking 101 videos on this site, and the book “Where does money come from ?” explain how individuals accounts work with the banks, and how banks settle up amongst themselves using their reserve accounts at the Bank of England. It becomes laborious defining money as M1, M2, M4 or whatever, especially when cash M1 only forms 3% of money, although M4 is used as a broad measure of debt and money supply.

          • reg32

            I’m afraid you are just not correct to say that the stock of money is unchanged in the cash example.

            As you mentioned “where does money come from?”, maybe I can refer you to section 4.1 of that book which gives simplified definitions of the main monetary aggregates. You will note that as far as notes and coin go, this only includes that part that is the hands of the UK resident non-bank public sector. Cash held by MFIs is not included (as this would involve double counting). If a bank pays you cash, either in advancing a loan or as compensation for mis-selling, it adds to the amount of cash held by non-banks and therefore adds to the money stock. This is well understood.

            This does not apply if we are talking about what’s called high-powered money, as this includes notes and coin held by private MFIs. However, that’s by-the-by, as private banks definitely cannot create high-powered money.

            The rest of what you say, I think I agree with, although I would note again, that the fact that lending by “Bank of Dave” does not create money as conventionally measured, is only because the BoE does not
            class them as an MFI.

          • Simon

            Physical cash can only be created by the Bank of England, whether it is visible to the public or not. Electronic money can be created by the private banking system through the act of lending.
            Bank of Dave does not create money, whichever way the Bank of England would like to measure or call it, until Dave gets the powers of a conventional bank.

          • reg32

            Let me a try a different way. “Where does money come from?” is an excellent book, so I’ll refer to it again.

            Section 2.6 of the book describes the money multiplier model. As highlighted in the book, there are a number of problems with this model as a description of modern banking. However, it does provide a reasonable description of how organisations like “Bank of Dave” operate. Money is deposited by the public; then, and only then, is it lent out. However, this still involves the creation of money. The description in the book makes it very clear that money is being created and even provides a neat chart which illustrates it.

            Of course, this all relates only to money as conventionally measured. You may feel that money is really something different and nobody can say you’re wrong. In normal life, we use the term “money” very loosely, so it means different things to different people at different times. This is why it is so hard for PM to explain to people how money really works and why it is so important that they do.

          • Simon

            We will have to agree to differ, although I accept the reasons for your conclusions. Conventional banks do the lending first, which
            creates the new deposits, whereas as you rightly say Dave’s bank takes existing deposits and lends them on. I fail to see how Dave creates money, in the same way as my friend recently lent me money to buy a car. Her bank balance went down by £5000, mine increased by same, and the reverse applied when I repaid her 3 months later. Neither of us could do “legal forgery” in this instance, unlike the conventional banks who are members of APACS, the financial clearing system.
            The money multiplier model does not really apply in the UK, and you seem to think the deposit comes before the loan, but it is the other way round. I accept that money coming from Dave’s bank will end up in a conventional bank which will increase their deposits / reserves, which they can then use as a basis for further lending, although my bank balance will have reduced when I lent the money to Dave . What really happens is what is described below from http://www.legalforgery.com , and “Where does money come from” says the same, 5.2.1 page 98. In effect the banks make new loans in concert, and then seek the deposits and reserves later to back them up, rather than the “multiplier model” applying.
            I am a strong supporter of Positive Money and their proposals,and my father has done a lot of related work on his website http://www.legalforgery.com
            This is from my Dad’s web site. This does not include notes and coins created by the bank of England. Dave’s bank is not a member of APACS which is the privilege of conventional banks and building societies.
            “In the UK the power to create new money is reserved to members of the central clearing system known as APACS. The power to create new money depends on being a member of the clearing system because a loan made by a member returns when it is spent, either to the member making it or to other members of the clearing system. If all members of the clearing system make new loans at the same rate and in proportion to the number of their current account customers, an amount approximately equal to the loans made will return to each bank. The term “new loan” is used for loans made by a bank of money not received by them in the form of deposits before making the loan: this is new money which raises the monetary aggregates as measured by the statistic M4″

    • Peterv

      I think it’s “money” if I can spend it – it is purchasing power that really matters in the economy.
      I can spend the money in my current account at Tescos or I can pay my taxes with it, so that’s money. You can’t spend your friend’s IOU so it’s not. You can’t spend Bank of England reserves either (because you can’t have an account with the BoE).
      Bank of Dave can’t create money (ie spending power), commercial banks can.
      The grey area is what I’ve got in my deposit account. True, I think of it as “money” but I can’t spend it, or at least not immediately. It’s more like deferred money. It doesn’t make any difference how many times money is lent and borrowed, it only creates spending power when it’s in a current account. M4 is a rather useless measure, as pointed out in Modernising Money

      • reg32

        I’d agree that M4 is a poor measure of the medium of exchange. Its advantage as a measure of money supply is that it has a much stronger correlation with the level of debt in the economy than more narrow measures.
        The problem with narrow measures (like M1 say) is that, although new money would fall within that definition at the point of creation, it’s highly uncertain whether the asset created will remain as M1 money rather than being converted to non-M1 bank debt. With M4, once it’s created it’s much harder to get rid off without debts being repaid, so the relationship is stronger.

        It depends what you are concerned with. If you want to look at the current payment power in the economy, M4 is probably not very helpful. If you are concerned with debt build-up, M4 is at least better than narrower alternatives.

        Incidentally, I had assumed that PM’s analysis (including the 97% figure) was based on an M4 like measure.

        As a further note, the BoE reviews the definition of M4 from time to time to ensure that it reflects the latest market developments. If the aggregate balance sheet of lenders like “Bank of Dave” was to become significant, I would expect them to reclassify them as money creators for the purposes of M4 measurement.

      • reg32

        I’d agree that M4 is a poor measure of the medium of exchange. Its advantage as a measure of money supply is that it has a much stronger correlation with the level of debt in the economy than more narrow measures.
        The problem with narrow measures (like M1 say) is that, although new money would fall within that definition at the point of creation, it’s highly uncertain whether the asset created will remain as M1 money rather than being converted to non-M1 bank debt. With M4, once it’s created it’s much harder to get rid off without debts being repaid, so the relationship is stronger.

        It depends what you are concerned with. If you want to look at the current payment power in the economy, M4 is probably not very helpful. If you are concerned with debt build-up, M4 is at least better than narrower alternatives.

        Incidentally, I had assumed that PM’s analysis (including the 97% figure) was based on an M4 like measure.

        As a further note, the BoE reviews the definition of M4 from time to time to ensure that it reflects the latest market developments. If the aggregate balance sheet of lenders like “Bank of Dave” was to become significant, I would expect them to reclassify them as money creators for the purposes of M4 measurement.

  • Bob Welham

    Superb, crystal clear video.

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  • RJ

    Credit is money. Notes and coins are no more than a token to represent credit. Money is a financial asset always backed by debt (it is impossible to have debt free money). Most have got there thinking back the front on this point. People just will not accept that money is no more than credit created by a journal entry. And as such it must be backed by debt

  • JB

    One minor interesting fact that has been ommitted is the fact we have free banking in this country as a direct result of the profit that banks make on lending etc. Banks overseas levy charges on personal and current accounts for customers cheques deposits etc

  • Bob Welham

    With apologies to Clark Kent:
    Is it money?

    Is it credit?

    No, it’s Superscam!

  • Mike O’Keefe

    OK for retail customers : the £85 k is pertinent. BUT this is nothing compared to the money created for corporate lending. If a bank lends £ 10 million by way of an overdraft facility or a term loan, is it not creating credit with associated credit risk ?

    I would like to see what the proportion of the 97 per cent is corporate rather than to private individuals covered by the Government guarantee. From the Modernising Money book ( p 113/4) we see 45 per cent is to individuals, but this is secured lending and not at all clear what this means for retail deposits

    Cheers.

  • mitaky

    Banking terms are full of false speech and not right speech. This is how people are misled to view credit and money the same way. First of all why something that is actually a debt (as in mortgage loan) would be called a credit for the bank and you. Bank has devised double entry bookkeeping where all credit and debit balances in two columns; not like our personal checkbooks.

    Money (cash and coins) created by Treasury in the US like credit orginates as debt but once put into circulation carry no interest, so it is interest free IOU. Many developing and post-colonial countries like India and China has large part of money supply in cash, coin in resilient informal sector (not yet touched by banking so much) unlike US (3% of total money Supply is in cash).

    Credit or loans carry interest for a term that is compounded for 3, 5, 7 upto 30 years. Banking can be seen as a legalized scam that originated during colonial period to meet the needs of imperialism, industrial capitalism and colonial trade, due to misunderstanding or very limited understanding of the nature of money.

    This is where a mass awakening is needed and very much possible.
    http://conscious-capitalism.blogspot.com

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