The interesting relationship between money and debt creation

Well, the biggest business issue at the moment for any business or economic opinion piece (in the UK most definitely) is our imminent EU ‘in-out’ referendum. Exciting as and energising as this topic is, for several reasons we aren’t going to discuss it in this (or any other) blog.

 

So, instead I’m going to look once more at the issues raised in the BofE’s 2014 discussion note (or bombshell, perhaps, to some readers) – Money Creation in the Modern Economy.  Historically, money was intrinsically tied to the quantum of precious metals held by a country (often a king, queen or equivalent).  Or, to be more precise, the money was itself, to a greater or lesser degree, made of the precious metal.

 

Understanding this is important because it is no longer the case that the £10 in your pocket can actually be exchanged for glittering gold (powder as opposed to chunks given the price of the stuff; £10 won’t buy you very much of it).  Look carefully on a note of money and you will find the phrase “..promise to pay the bearer on demand the sum of..”.  Despite such a seemingly clear and irrevocable promise, you will struggle to exchange the note for gold if you present it to the BofE.

 

Radical as it sounds our money has, and has done so for several decades, had a value largely because we believe in it; it’s value is symbolic if you will.  Everything may not be quite what it seems when it comes to the pounds in your pocket.

 

Money in the modern economy (of which we are one) mostly takes the form of bank deposits; but as the BofE spells out, how those deposits are created is often misunderstood.
Actually, what happens is this –  whenever a bank makes a loan it simultaneously creates a matching deposit in the borrowers bank account for them to draw upon; thereby creating new money.  It can feel like money is pretty much being created out of thin air –  which, to a large degree, it is.

 

Notwithstanding this, it is true (as the paper makes clear in, occasionally, somewhat technical language) that there are regulatory rules and conventions which effect to prevent banks creating money freely without limit.  In recent times (say the last 15 years or so) some people would say that such regulatory checks and balances have been characterised by a failure to check and being woefully out of balance

 

Now, let’s just pause and think about this; the BofE makes clear that banks do not receive deposits and then lend them out; or, they do, but what they take in as deposits is only a small proportion of what the lend out.

 

The taking of deposits and then lending them out is how ‘the man on the Clapham omnibus’ tends to think our banking system works; he is incorrect.

 

Have a deeper look at this whole issue of money creation and you will come across alternative views which state that the central bank fixes the amount of money in circulation or it is somehow ‘multiplied up’ into more loans and deposits –  the BofE makes clear that this is not correct either.

Everyone would agree that the central bank has a key role to play in the creation of money (and debt) –  but it is just not in that manner. Economics –  it has all got a bit confusing of late hasn’t it?

 

Unfortunately, it can be a rather dry and arcane subject this matter of the linkages between money and debt creation in our modern economy –  but we have to understand it in order that we can adequately grasp what is happening with our private and public debt levels, why it is happening and what we can do about it.

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