Banks can create money through the accounting they use when they make loans. The numbers that you see when you check your account balance are just accounting entries in the banks’ computers. These numbers are a ‘liability’ or IOU from your bank to you. But by using your debit card or internet banking, you can spend these IOUs as though they were the same as £10 notes. By creating these electronic IOUs, banks can effectively create a substitute for money.
The following video from the Bank of England explains how money is created by commercial banks:
Every new loan that a bank makes in this way creates new money. While this is often hard to believe the first time you hear it, it’s common knowledge to the people that manage the banking system. In March 2014, the Bank of England release a report called “Money Creation in the Modern Economy”, where they stated that:
“Commercial [i.e. high-street] banks create money, in the form of bank deposits, by making new loans. 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.” (Original paper here)
Sir Mervyn King, the Governor of the Bank of England from 2003-2013, recently explained this point to a conference of businesspeople:
Sir Mervyn King, Governor of the Bank of England 2003-2013 (Speech)
And Martin Wolf, who was a member of the Independent Commission on Banking, put it bluntly, saying in the Financial Times that: “the essence of the contemporary monetary system is the creation of money, out of nothing, by private banks’ often foolish lending” (Article).
By creating money in this way, banks have increased the amount of money in the economy by 11.5% a year over the last 40 years. This has pushed up the prices of houses and priced out an entire generation.
Of course, the flip-side to this creation of money is that with every new loan comes a new debt. This is the source of our mountain of personal debt: not money that had been prudently saved up by pensioners, but money that was created out of nothing by banks and lent to people who could not repay. Eventually the debt burden became too high, resulting in the wave of defaults that triggered the start of the financial crisis.