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WHERE DOES

MONEY

COME FROM?

A GUIDE TO THE UK MONETARY AND BANKING SYSTEM

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OF MISUMPEftSTANOINCSOF THIS IMPOfiTANTIttlJe 1

Refreshing and clear. The way monetary economics and banking is

taught in many maybe most universities is very misleading and what this book does is help people explain how the mechanics of the system work.”

David Miles, Monetary Policy Committee, Bank of England

“It is amazing that more than a century after Hartley Withers's The Meaning of Money’ and So years after Keynes’s Treatise on Money’, the

fundamentals of how banks create money still need to be explained. Yet

there plainly is such a need, and this book meets that need, with clear

exposition and expert marshalling of the relevant facts.

recommended to the simply curious, the socially concerned, students and those who believe themselves experts, alike. Everyone can learn from it.”

Victoria Chick, Emeritus Professor of Economics, University College London

Warmly

T used Where Does Money Come From7 as the core text on my second year undergraduate module in Money and Banking. The students loved it. Not only doesit present a clear alternative to the standard textbook view of

money, but argues it clearly and simply with detailed attention to the

Highly

recommended for teaching the subject.

Dr Andy Denis, Director of Undergraduate Studies, Economics Department,

City University, London

actual behaviour

and functioning

of

the

banking

system.

“By far the largest role in creating broad money is played by the banking

when banks make loans they create additional deposits for those

that have borrowed.”

sector

Bank of England (2007)

WHERE DOES MONEY COME FROM? A GUIDE TO THE UK MONETARY AND BANKING SYSTEM

JOSH RYAN-COLLINS TONY GREENHAM RICHARD WERNER

ANDREW JACKSON

FOREWORD BY CHARLES A, E. GOODHART

NS TONY GREENHAM RICHARD W E R N E R A N D R E W

Acknowledgeme11ts

The authors would like to thank Ben Dyson for his valuable contributions to the wilting of this book.

We are also most grateful to Professor Victoria Chick, Jon Relleen, James

Meadway, Professor Charles Goodhait, Mark Burton and Sue Charman for

their helpful insights and comments.

Our thanks go to Angie Greenham for invaluable assistance with editing,

proofing and production control and to Peter Greenwood at The Departure

Lounge for design and layout.

Finally, we would like to express our gratitude to James Biuges and Marion

Wells, without whom the book would not have been written.

James B i u g e s and Marion Wells, without whom the book would n

FOREWORD

CONTENTS

l.

INTRODUCTION

1.1.

Key questions

1.3.

Overview of key findings

l.

2.l.

The money supply and how it is created

l.

2. 2.

Popular misconceptions of banking

l.ft.

How the book is structured

2.

WHAT DO BANKS DO?

2.1.

The confusion around banking

2.2.

Popular perceptions of banking 1: the safe-deposit box

2.2.1.

We do not own die money we have put in die bank

2.3. Popular perceptions of banking 2; taking money from

savers andlending it to borrowers

2.4. Three forms of money

2. ~.

How banks create money by extending credit

2.6. Textbook descriptions; the multiplier model

2.7. Problems with the textbook model

2.8. How money is actually created

ft.

ft.i.

ft. 2.

THE NATURE AND HISTORY OF MONEY AND BANKING

The functions of money

Commodity theory of money: money as natural and neutral Classical economics and

money

ft. 2.l.

3-2.2.

3.2.3.

3.3.

3.3.1.

3.3.2.

3.4.

Neo-classical economics and money

Problems with die orthodox story

Credit theory ofmoney: money as a social relationship

Money as credit: historical evidence

The role of die state in defining money

Key historical developments: promissory notes, fractional

reserves and bonds

3.4. l.

Promissory notes

3.4.2. Fractional reserve banking

3.4.3.

3.5.

Bond issuance and die creation of the Bank of England

Early mo 11etary policy: the Bullionist debates 11 Art

3.6. Twentieth century: the decline of gold, deregulation and the rise of digitalmoney

3.6.1. A brief history of exchange rate regimes

3.6.2. WWI die abandonment of the gold standard and the regulation of

credit

3.6.3. Deregulation of die banking sector in die 1070s and 1080s

3.6.4. The emergence of digital money

a.

4.1.

MONEY AND BANKING TODAY

Liquidity. Goodhart’s law, and the problem of defining

money

4.2.

4.3.

Banks as the creators ofmoney as credit

Payment: using central bank reserves for interbank

payment

4.3.1. Interbank clearing: reducing die need for central bank reserves

4.3. 2.

Effects on die money supply

44

Cash and seignorage

4.4.1. Is cash a source of 'debt-free' money?

4.5. How do banks decide how much central bank money they

need?

4.6. Is commercial bank money as good as central bank

money?

4.6.1. Deposit insurance

4.7*

Managing money: repos, open market operations, and quantitative easing (QE)

4. 7.1.

Repos and open market operations

4.7.2. Standing facilities

4.7.3. Quantitative Easing

4.7.4. Discount Window Facility

4.8.

4.8.1.

Managing money: solvency and capital

Bank profits, payments to staff and shareholders and die money

supply Summary; liquidity and capital constraints 011money

4,0.

creation

REGULATING MONEY CREATION AND ALLOCATION

ft.i.

5. 1.1.

5- 1. 2.

,".2.

Protecting against insolvency: capital adequacy rules

Why capital adequacy requirements do not limit credit creation

Leverage Ratios: a variant of capital adequacy rules Regulating liquidity

5.2.1. Compulsory reserve ratios Sterling stock liquidity regime (SLFO

Securitisation, shadow banking and the financial crisis

fl.4

g.g.

The financial crisis as a solvency and liquidity crisis

Endogenous versus exogenous money

5.6. Credit rationing, allocation and the Quantity Theory of

Credit

5.7. Regulating bank credit directly: international examples

6.

GOVERNMENT FINANCE AND FOREIGN EXCHANGE

6.1.

The European Union and restrictions oil government money creation

6.1.1. The Eurozone crisis and the politics of monetary policy

6.a.

Government taxes, borrowing and spending (fiscal policy)

6.2.1.

Taxation

6.2.2.

Borrowing

6.2. 3 .

Government spending and idle balances

6.3. The effect of government borrowing 011 the money supply:

‘crowding out*

6.3.1. Linking fiscal policy to increased credit creation

6.4. Foreign exchange, international capital flows and the

effects 011money

6.4.1. Foreign exchange payments

6. 4. 2.

6. 4.3.

Different exchange rate regimes

Government intervention to manage exchange rates and die

‘impossible trinity'

6.5.

Summary

7.

7,1,

CONCLUSIONS

The history of money: credit or commodity?

7.2. What counts as money: drawing the line

7.fl.

7.4.

7.5.

7.6.

Money is a social relationship backed by the state

Implications for banking regulation and reforming the

current system

Towards effective reform: Questions to consider

Are there alternatives to the current system?

7.6.l.

Government borrowing directly from commercial banks

7.6.2.

Central bank credit creation for public spending

7.6.%

Money-financed fiscal expenditure

7.6. 4.

Regional or local money systems

7.7. Understandingmoney and banking

APPENDIX 1:

THE CENTRAL BANICS INTEREST RATE REGIME

A1.1. Setting interest rates demand-driven central bank

money

Ai.a. Setting interest rates supply-driven central bank money

APPENDIX 2:

GOVERNMENT BANK ACCOUNTS Aa.i. The Consolidated Fund

Aa.a. The National Loans Fund

Aa.ft. The Debt Management Account

As, 4. The Exchange Equalisation Account (EEAI

APPENDIX 3:

FOREIGN EXCHANGE PAYMENT. TRADE AND

SPECULATION

Aft.i. Trade and speculation

A*ya. The foreign exchange payment system

A3,s.i. Traditional correspondent banking

A3.2.2. Bilateral netting

A3.2.3. Payment versus payment systems: the case of CLS Bank

A3.3.4. On Us. with and without risk A3.3. 5. Other payment versus payment settlement methods

Index

LIST OF EXPLANATORY BOXES

Box 11 Retail, commercial, wholesale and investment bank

Box a: Building societies, credit unions and money creation Box 3: Bonds, securities and gilts

Box 4: Wholesale money markets

Box g: Double-entry bookkeeping and T-accounts

Box 6: Money as information - electronic money in die Bank of England Box 7: Wliat is LIBOR and how does it relate to die Bank of England policy

rate?

Box 8: Seigniorage, cash and bank's special profits'

Box o: Real time gross settlement (RTGSl

Box 101

If banks can create money, how do they go bust? Explaining

insolvency and illiquidity

Box 11: The shadow banking4 system

Box ia: The Quantity Theory of Credit Box lfl: Could die Government directly create money itself?

Appendices

BoxAl: Market-makers

Box As: Foreign Exchange instruments

LIST OF FIGURES, CHARTS AND GRAPHS

Figure 1; Banks as financial intermediaries

Figure a: The money multiplier model Figure 3: The money multiplier pyramid

Figure

4: Balloon' of commercial bank money

Figure g: Growth rate of commercial bank lending excluding

securitisations 2000-12

Figure 6: Change in stock of central bank reserves. 2000-12

Figure 7: UK money supply. 1063-5011: Broad money (Mÿand Base money

Figure 8; Decline in UK liquidity reserve ratios Figure o: Indices of broad money (M4)and GDP, 1070-2011

Figure 10: Liquidity scale

Figure 11: Commercial banks and central bank reserve account with an

example payment

Figure 12: Payment of £500 from Richard to Landlord

Figure lft: Simplified diagram of intra-day clearing and overnight trading

of central bank reserves between six commercial banks Figure 14; Open market operations by the Bank of England

Figure ig: Balance sheet for commercial bank including capital Figure 16: Bank of England balance sheet as a percentage of GPP Figure 17: Net lending by UK banks by sector. 1007-2010 sterling millions Figure 18: Change in lending to small and medium-sized enterprises.

2004-12

Figure 19: Government taxation and spending

Figure so: Government borrowing and spending (no net impact on die money supply)

Figure

Figure aa: The impossible trinity

si: A foreign exchange transfer of $1. 5m

Appendix

Figure Al; Conidor system of reserves Figure Aa: The floor system of reserves

Figure Afl: The exchequer pyramid - key bodies and relationships involved

in government accounts Figure A4: The UK debt management account. 2011-12

Figure Ag: Assets and liabilities of die exchange equalisation account 2011-

12

Figure A6: Amount of foreign currency settled per day by settlement method (2006ÿ

Figure A7; Foreign exchange using correspondent banking

Figure A8: CLS fin fulO Bank operational timeline

LIST OFT-CHARTS

T-chart 1; Loan by Barclays Bank

T-chart a: Bank simultaneously creates a loan (assets and a deposit (liabilityÿ

T-chart 3: Balance sheet of private banks and central bank showing

reserves

T-chart 4: Private banks' balance sheets T-chart ft; Private and central bank reserves

T-chart 6: withdrawal of£10

T-chart 7: QE on central bank balance sheet T-cliart 8: QE on pension fund balance sheet

T-chart 9: QE on asset purchase facility (APF) balance sheet T-cliart 10: QE on commercial bank balance sheet

s e f a c i l i t y (APF) balance sheet T-cliart 1 0

Foreword

Far from money being 'the root of all evil', our economic system cannot cope

without it. Hence the shock-horror when the Lehman failure raised the spectie of an implosion of our banking system. It is far nearer the tinth to

claim that 'Evil is the root of all money, a witty phrase coined by Nobu

Kiyotaki and John Moore.

If we all always paid our bills in full with absolute certainty, then everyone

could buy anything on his/her own credit, by issuing an IOU on him/

herself. Since that happy state of affaire is impossible, (though assumed to their detriment in most standard macro-models), we use - as money - the short-term (sight) claim on the most reliable (powerful) debtor. Initially, of course, this powerful debtor was the Government; note how the value of State money collapses when tire sovereign power- is overthrown. Coins are

rarely full-bodied and even then need guaranteeing by die stamp of die ruler

seigniorage. However-, diere were severe disadvantages in relying solely on die Government to provide sufficient money for everyone to use; perhaps

most importandy, people could not generally borrow from die Government.

So, over time, we turned to a set of financial intermediaries: die banks, to provide us bodi with an essential source of credit and a reliable, generally

safe and acceptable monetary asset.

Such deposit money was reliable and safe because all depositors reckoned

tiiat tiiey could always exchange tiieir sight deposits with banks on demand

into legal tender. This depended on die banks themselves having full access

to legal tender, and again, over time, central banks came to have monopoly

control over such base money. So, the early analysis of the supply of money

focused on die relationship between die supply of base money created by die

central bank and die provision by commercial banks of bodi bank credit and

bank deposits: die bank multiplier analysis.

In practice however, die central bank has always sought to control die level

of interest rates, rather dian die monetary base. Hence, as Richard Werner and his co-authors Josh Ryan-Collins, Tony Greenham and Andrew Jackson document so clearly in diis book, die supply of money is actually determined

primarily by die demand of borrowers to take out bank loans. Moreover, when such demand is low, because die economy is weak and hence interest rotes are also driven down to zero, die relationship between available bank resenres (deposits at die central bank) and commercial bank lending/deposits can break down entirely. Flooding banks witii additional liquidity, as central banks have done recentiy via Quantitative Easing (QE), has not led to much commensurate increase in bank lending or broad

money.

All diis is set out in nice detail in tiiis book, which will provide die reader

widi a clear padi through die complex diickets of misunderstandings of diis

important issue. In addition die audiors provide many further insights into

current practices of money and banking. At a time when we face up to

massive challenges in financial reform and regulation, it is essential to have a propel-, good understanding of how die monetary system works, in order to

reach better alternatives. This book is an excellent guide and will be suitable for a wide range of audiences, including not only tiiose new to die field, but

also to policy-makeis and academics.

Charles A. E. Goodliart,

Professor Emeritus of Banking andFinance,

LondonSchool of Economics

19 September 2011

E . Goodliart, Professor Emeritus of Banking and Finance, London School o f Economics 1 9

1

INTRODUCTION

Tm afraid that the ordinary citizen will not like to be told that the banks or

theBank of England can create and destroy money.

Reginald McKenna, ex-Chancellor of the Exchequer, 1928-

I feel like someone who has been forcing his way through a confused

jungle

But although my fieldof study is one which is being lectured upon

in every University in the world, there exists, extraordinarily enough, no printed Treatise in any language - so far asI am aware - which deals systematically and thoroughly with the theory and facts of representative

money as it exists in the modern world.

John Maynard Keynes, 1930=

The importance of money and banking to die modem economy lias

increasingly come under die global spodight since die North Adantic financial crisis of 2008, Yet there remains widespread misunderstanding of

how new money is created, both amongst the general public and many economists, bankers, financial journalists and policymakers.

This is a problem for two main leasons. First, in die absence of a sliaied and

accurate understanding, attempts at banking reform aro more likely to fail.

Secondly, die creation of new money and die allocation of purchasing power are a vital economic function and highly profitable. This is therefore a matter of significant public interest and not an obscure technocratic debate.

Greater- clarity and transparency about tiiis key issue could improve botii die

democratic legitimacy of die banking system, our economic prospects and,

perhaps even more importandy, improve die chances of preventing future

crises.

By keeping explanations simple, using non-technical language and clear diagrams, Where Does Money Come From? reveals how it is possible to

describe die role of money and banking in simpler tenns dian has generally

been die case. The focus of our efforts is a factual, objective review of how

die system works in die United Kingdom, but it would be brave indeed of us

to claim diis as die complete and definitive account. Reaching a good

understanding inquires us to interpret die nature and history of money and banking, as set out in Chapter ft. bodi of which contain subjective elements

by dieir very nature.

Drawing on research and consultation witii experts, including staff from die

Bank of England and ex-commercial bank staff, we forge a comprehensive

and accurate conception of money and banking through careful and precise

analysis. We demonstrate throughout Where DoesMoney Come from? how

our account represents the best fit with the empirical obseivations of the

workings of the system as it operates in the UK today,

1.1.

Key questions

The financial ciisis of 2008 raised many more questions about our national system of banking and money than it answered. Along with questions around

die ciisis itself - Why did it happen? How can we prevent it happening

again? - tiiere has been broad basic questioning of die nature of banks and money including:

Where did all diat money come from? - in reference to die credit bubble' diat led up to die ciisis.

* Where did all diat money go? - in reference to die credit crunch’.

* How can die Bank of England create £375 billion of new money through quantitative easing ? And why has die injection of such a

significant sum of money not helped die economy recover more

quickly?

+ Surely diere are cheaper and more efficient ways to manage a banking crisis dian to burden taxpayers and precipitate cutbacks in public

expenditure?

These questions are very important. They allude to a bigger question which

is die main subject of diis book: How is money created and allocated in die UK?' This seems like a question diat should have a simple answer, but clear

and easily accessible answers are hard to find in die public domain.

1.2.

Overview of key findings

1.2.1.

The money supply and liow it is created

Defining money is surprisingly difficult. In Where Does Money Come From? we cut through the tangled historical and theoretical debate to identify that

anything widely accepted as payment, particularly by the Government as

payment of tax, is money. This includes bank credit because although an

IOU from a friend is not acceptable at the tax office or in the local shop, an

IOU from a bank most definitely is.

New money is principally created by commercial banks when they extend or

create credit, either through making loans, including overdrafts, or buying

existing assets. In creating credit, banks simultaneously create brand new

deposits in our bank accounts, which, to all intents and puiposes, is money.

This basic analysis is neither radical nor new. In fact, central banks around

die world support die same description of where new money conies from - albeit usually in dieir less prominent publications.

We identify diat die UK's national currency exists in tiiree main forms, of

which die second two exist in electronic form:

l.

Cash - banknotes and coins.

2.

Central bank reserves - resenres held by commercial banks at die Bank

of England.

3. Commercial bank money - bank deposits created mainly eidier when

commercial banks create credit as loans, oveidrafts or for purchasing

assets,

Only the Bank of England or the Government can create die first two foims of money, which is referred to in tiiis book as central bank money' or base money. Since central bank reseiÿves do not actually circulate in die economy,

we can further naiTow down die money supply diat is actually circulating as

consisting of cash and commercial bank money.

Physical cash accounts for less tiian 3 per cent of die total stock of circulating

money in the economy. Commercial bank money - credit and coexistent

deposits - makes up die remaining 97 per cent.

1*2*2.

Popular misconceptions of banking

There are several conflicting ways to describe what banks do. The simplest version is diat banks take in money from saveis and lend diis money out to borrowers. However, diis is not actually how die process works. Banks do not

J

1

-S 1 s', sine:

need to wait for a customer to deposit money before they can make a new

loan to someone else. In fact, it is exactiy the opposite: the making of a loan

creates a new deposit in the borrower’s account.

More sophisticated versions bring in die concept of ‘fractional reserve

banking. This description recognises diat die banking system can lend out

amounts diat are many times greater tiian die cash and reserves held at die Bank of England. This is a more accurate picture, but it is still incomplete

financial

and misleading, since each bank is still considered a mere

intermediary' passing on deposits as loans. It also implies a strong link

between die amount of money tiiat banks create and die amount held at die

central bank. In diis version it is also commonly assumed diat die central bank lias significant control over die amount of reseives diat banks hold widi it.

In fact, die ability of banks to create new money is only veiy weakly linked to

die amount of reseives diey hold at die central bank. At die time of die

financial crisis, for example, banks held just £1.25 in reserves for eveiy £100 issued as credit. Banks operate widiin an electreiiic clearing system diat nets out multilateral payments at die end of each day, requiring diem