15 January 2007

Where does money come from?

If you ask people where money comes from they will probably tell you from a bank. Dig deeper and you will find that people believe that the money they take out of the bank has been deposited there by somebody: by the person herself, in which case it is simply a withdrawal, or by somebody else, in which case it is a loan. This is the first big myth of money, because the truth is that all or nearly all (depending on your theorist of choice) the money you take from the bank has been created out of thin air by the bank itself.

When you begin teaching students about the economics of banking you teach a fiction known as ‘fractional reserve banking’ and many who have never taken economics as an academic discipline or worked in a bank have a hazy notion about this system. It is understood, because of Hollywood movies about ‘runs on the bank’,that the bank does not actually hold, or need to hold, as much money as it lends to people. Because it is highly unlikely that everybody will come and ask for all their money, all at the same time, the banks can consider themselves to be acting with probity if they retain only a proportion as ‘reserves’, this proportion being understood to be around 10 per cent. Let us for the time being take this story as a reasonable account of how banks create money; it is the one that is reproduced in most economics textbooks. The first stage is the deposit of some money by a punter, let us say £100. Because banks have learned from historical experience that only one in ten of such punters will want her or his money back at any given time, they feel quite secure in lending £900 on the basis of this deposit, effectively inflating its nominal value, and thus reducing its real value, tenfold.

The second myth about money that is universally believed is that it is, and needs to be, backed by something of real value. Governments create money and this money has credibility because the government has a sufficient store of gold in its vaults to support its value. Like the reserve banking story, according to this fiction governments can create more money than the gold they have, but only up to a certain limit. This story was true for some time, but it was found that the uncontrollable growth of the capitalist economy rapidly outstripped the gold available to support it and maintaining a ‘gold standard’ stifled economic growth.

Eagle-eyed and sharp-minded readers will have noticed that there is an inconsistency between the two stories told so far, in that they disagree about who is responsible for creating the money. They have in common the idea that, while there should be something of real value backing up a currency at least in part, who owns this collateral and who therefore creates the money could be either the bank or the government. This was how things were, both banks and government were entitled to create money: governments created money as fiat issues, whereas banks created it in return for a debt.

So there are several different types of money, distinguishable by the nature of their back-up and by who controls them. Banks can create money on the basis of deposits, as credit. Governments can create money by selling bonds, or just by making a decision to create currency. It may be efficient to leave the job of generating credit for economic activity to banks, so long as they operate within political controls, but it will also be necessary to have money created by government both as credit, to fund public works, and as currency, to facilitate economic activity without the creation of parallel debts. The graph shows how the political attitude to money since the Second World has effectively been the privatization of money creation. It shows the relative proportions of money created by banks and governments over that period. This has had the inevitable consequence of increasing the proportion of money paid to bank shareholders and producing a squeeze on the money available for public investment.

. . . to be continued (when you can bear it!)
If you can bear any more just now you might like to follow this link to a short presentation about money.


  1. yes ... fractional reserve banking is a real promblem and/or threat ... any run on the banks will create the physical greenbacks being scarce and gold & silver will be discounted as industrial waste {then is the time ti buy silver} ... i suspect an islamic superstate will emerge using as base golden dinar/silver dirham and expand commoditiy based wharehousing to include copper/silver/gold coffee/tea/wheat/corn and back an islamic state currency i think the paper form of this new world currency will be the iraqi dinar ... ... ... "It would be difficult to exaggerate the psychological and social impact of the anticipated replacement of the jumble of existing monetary systems--for many, the ultimate fortress of nationalist pride--by a single world currency operating largely through electronic impulses."

  2. Anonymous; What did you mean by the New Iraqi Dinar being the new paper form of the new world currency?

  3. Love this blog - where have you been hiding???!

  4. there is talk of money needing to be backed by something more than just gross domestic product ... something like a physical basket of commodities .. at one point we had the gold standard in America {and we also tried a bimettalic system here} ... ... something like that i suspect will happen with the new iraqi dinar, but bigger,better, and on a global scale ... already iraq has the second biggest deposit of oil, so, in kinda of a superficial way the iraqi dinar is backed with oil ... ... ... given the immenient collapse of the usd/world currency/economy i suspect the islamic nations will band togethere and issue/mint golden dinars/silver dirhams and these bullion banks that issue/mint these coins will trade paper iraqi dinar for coins {or at least this is what i am thinking}, thus iraqi dinar becomes backed with gold/silver/oil and this is just beginning of it all ... other big wharehouse will soon form for such things as copper/wheat/tea/coffee/corn and iraqi dinar will have a set price for such things ... .... but basically the usd is trash and iraqi dinar will revalue itself against other commoditites starting off with silver/gold first ... btw i think silver/gold is overpriced in terms of usd, suspect a 40% drop in prices, then i plan to buy more ... ... currency and real estate have a lot in common ... ... location location location ... ... thus i plan to use local currency {usd/new usd} until the islamic superstate emerges and i suspect that i will then use the iraqi dinar to move about freely ... ... a little far fetched i know ... but plausable .... the strongest nations on earth went to war for some reason even printed up 16 billion paper notes with some of the strongest security measures availablle for paper curreny ... yes ... for some reasons the iraqi dinar was printed ... sugested reading "golden dinar" ... suggested internet chat/forum "investors iraq forum"

  5. The golden dinar post was made on January 17 - it's been 6 months now June 18th - iraq hasn't even revalued the new currency to let alone go a golden dinar.

    Does anybody know when the iraq dinar will revalue?

    thanks for the blog - I like it

  6. Confidence in the value of metal coins was such that some people were even able to give up farming, boatbuilding, mining and pottery to become full time travellers and traders.

  7. There is ONLY one currency that has been, is, and will in the future be of value ... my promise to pay.

  8. I wonder with the present economic situation with governments having pumped billions into a closed and global banking system whether this actually benefits those particular countries. The banks having no particular loyalty to their country of origin I would imagine their cash would be directed to countries where they would make the most profit and have the strongest growth. The expectation that they would use our given dosh to support their native economies, supporting and investing in business and infrastructure is I suspect naive? Are we just allowing the banks to boost there profits by pumping billions of our money into a system we have no control over nor any true awareness of what they do with it and without any real returns for ordinary people except years of debt?

  9. Thank you for the article- I like it, very crearly written. But there is a problem opening your powerPoint "presentation". Is there somewhere else you have the rest of the article (or the full article) that I can go to?

  10. Very well explained.

    For anyone who would like more detail, or have the above explained a different way, you may be interested in our website, www.sensiblemoney.ie

    I hope it helps,
    Paul Ferguson
    Sensible Money