Bank of England: Money creation in the modern economy

I sometimes encounter incredulity when I point out that banks create money by making loans, or that this is the source of most modern money. This easy to read paper may be of some interest to those who don’t believe it, but may also be of general interest.

A taste:

“Commercial 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. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.”

As an aside, it is the very process which makes it feasible to repudiate bank debt. Such repudiations cause harm and damage, but they needn’t be existentially perilous. I bring it up because I think this is knowledge we will need in the near future.

18 thoughts on “Bank of England: Money creation in the modern economy

  1. I think that you may be referring to me with this statement about encountering incredulity that banks create money through their fractional reserve lending activities. I have understood their role since I took Economics 101 in the first year of college.

    What I have disputed with you is that banks create “wealth.” They do not.

    Let’s say you have $10,000 of legal tinder. You deposit it in the bank. You have money (and wealth) in the form of a bank balance. Banks currently have a reserve requirement of around 10%. So the bank can loan $9,000 to you neighbor who deposits it in HIS bank. So there is now $19,000 of money in circulation but there is still just $10,000 of “wealth” because your neighbor has a liability of $9,000 offsetting his money in the bank.

    Liked by 1 person

    1. RE: “I think that you may be referring to me with this statement about encountering incredulity that banks create money through their fractional reserve lending activities.”

      I was not referring to you, at it happens, but since you bring it up: Banks do not, in fact, create money through “fractional reserve lending activities.” As the Bank of England paper makes clear, even in the short quotation I shared, “Commercial banks create money, in the form of bank deposits, by making new loans.” The fractional reserve requirements are merely part of the regulatory apparatus and, one might argue, a relic of the days when banks held physical reserves in the form of gold and silver.

      Also, your dispute with my observation that banks create wealth is unfounded. They most certainly do in the sense that they finance (monetize) the transformation of raw materials into finished goods and simple goods into more complex ones. One might argue that banks don’t create the goods themselves, specifically, but one cannot really argue that the goods are not wealth or that they don’t come into existence because of the service banks offer.

      You should read the paper. It was written to dispel a number of myths about money and banking.

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      1. @Roberts

        Sorry if my mention of the reserve requirement confused you. We are saying the same thing.

        As for “creating wealth” by making a loan . . .

        Sure by lending money to someone who will use it in a business the loan makes wealth creation possible by the labor of the entrepreneur and his employees but that is not creating wealth in and of itself.

        This goes back to your taking exception to the fact that labor is involved in the creation of all wealth. By taking that position you thought you were taking a stand against Marxism. You were not.

        Liked by 1 person

      2. RE: “We are saying the same thing.”

        No, we are not, and the difference is the reason I posted the paper. Reserve requirements literally have nothing to do with money creation.

        RE: “This goes back to your taking exception to the fact that labor is involved in the creation of all wealth.”

        I do take exception because it is not a fact. There are many ways wealth is created without any connection to labor, unless we wish to assume — irrelevantly — that labor includes such things as breathing or walking or thinking. One such example is process improvement, which typically subtracts labor from production.

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        1. All wealth is created by labor in any economic system that involves a medium of exchange for services, products or even land and all it’s various rights.

          Picture yourself alone on a desert island that has a rich gold mine. Unless you labor to harvest coconuts, fish, cook and grow edibles you perish.

          Liked by 1 person

        2. RE: “Unless you labor to harvest coconuts, fish, cook and grow edibles you perish.”

          That’s certainly true in a way, but is about as useful to understanding economics as observing, “Unless you breathe you will die.”

          Think of it this way. There is no material connection between labor and wealth, because there are many ways to produce, even increase, wealth by subtracting labor. If labor created wealth, there would be no benefit in process improvement. In fact, process improvement that reduces labor to create the same or more goods would be physically impossible.

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          1. Process improvement is laudable. But then comes the issue you missed in my example.

            Who buys your product and with what to exchange?

            Economics can be complicated, abstruse and confusing. Yet, it is simply a study of the exchange of goods and services among people. Take out the people and wealth means nothing.

            Now it may be that if a process reduces or eliminates labor, that labor cost in that product is minimized or eliminated. Unless there is a market for this product or service, it is useless. Like the gold on the island.

            And the market is driven by the value of other labor that allows enough income, or value for the labor, to permit the purchase.

            The market will determine the value of your product in part by the wealth the buyers created for themselves by making other products or services.

            So if you are the only car dealer in a vast slum in Chittagong, you might consider used Fiats instead of Maseratis. Your wealth is directly dependent upon meeting the market and the wealth created individually by labor in that market. Even there, if not enough wealth is created by the labor of your buyers, none will transfer to you for your efforts, or labor.

            All this is a problem as robotics takes over. A company could eliminate all labor with the opportunity to create massive wealth, but only if there were buyers.

            Why are we borrowing trillions in taxpayer dollars for this crisis? It is to substitute for the loss of individual and corporate wealth which cannot be created since labor has stopped. If labor doesn’t create wealth, why are we giving money to people who are not working?

            I’m not an economist, nor do I play one on TV. I am sure math and theories can drum me off the podium. But to rehash a racist joke about Chinese laundries: “No tickee , no washee”. That is the source of wealth: labor and it’s ability to allow the transfer of wealth for goods and services.

            IMHO

            Liked by 1 person

          2. @Roberts

            Your “logic” is bizarre.

            Process improvements to create more wealth with less labor does not mean that wealth is created with no labor. Even in a factory that is 100% automated, someone labored to create the robots. And to feed them electricity. And grease their bearings.

            Your frankly bizarre attempts to minimize the importance of labor in the economy makes me have to ask – why do you hate people who work?

            Liked by 1 person

          3. @Rothman

            Your time would be better spent reading the paper instead of disputing it. You don’t have to be economist to understand it.

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          4. @Murphy

            RE: “Process improvements to create more wealth with less labor does not mean that wealth is created with no labor.”

            I didn’t say it does. I said there is no material connection between labor and wealth, an important point in basic economics.

            RE: “why do you hate people who work?”

            Non sequitur much?

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          5. “ Your time would be better spent reading the paper instead of disputing it.”

            I am not disputing the article, just your statement:

            “There is no material connection between labor and wealth, because there are many ways to produce, even increase, wealth by subtracting labor. If labor created wealth, there would be no benefit in process improvement. In fact, process improvement that reduces labor to create the same or more goods would be physically impossible.”

            If all labor were eliminated except for John’s robots making widgets and Len’s company robots making widget boxes, we could each trade one to the other perhaps, and that it.

            Labor is the only source of wealth. If not directly in your company, but certainly as a source of income, then wealth, and leftover money to buy your widget.

            Liked by 2 people

          6. RE: “Labor is the only source of wealth.”

            I might as well say that air is the only source, since we all have to breathe it produce anything. Without air, there can be no wealth!

            Read the paper: Banks create money by making loans.

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          7. “ Banks create money by making loans.”

            Therein lies the problem. Creating money doesn’t necessarily create wealth. An investment may tank. Then the borrower defaults, the bank loses money and vendors don’t get paid, etc.

            Wealth is created when a resource is changed to a higher purpose but only if it sells. And it can only sell to people with money. People don’t get money except through some form of labor. That labor then adds value to the market by exchanging money, really just goods and services with some form of credit generally accepted like dollars, euros, pounds, etc.

            It all comes down to labor without which there is no free market, no capitalism, and no wealth is created.

            Unless, and this is a big “unless”, we redesign an economic system that is not built on the exchange of goods and services. A Garden of Eden. Everything magically appears as you need it. (Kind of like the Republican policy of borrow and spend.)

            Liked by 1 person

          1. RE: “The reserve requirement determines how much money a bank can legally create with YOUR money.”

            Banks don’t use my money to create more money. That’s one of the myths the paper debunks.

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          2. @Roberts

            YOUR money deposited is the money that the bank can lend. A myth? Good grief.

            Of course they can lend from their capital but that is a tiny proportion of most bank lending. In that case it was YOUR money as an investor that they lend out, not YOUR money as a depositor.

            The reserve requirement tells the bank how much of YOUR money they can lend out.

            Put your stable genius to this question. You start a bank with $0 capital and $0 Deposits. How much can you lend?

            Liked by 1 person

          3. RE: “YOUR money deposited is the money that the bank can lend. A myth?”

            Yes, that’s what the Bank of England says. Why don’t you read the paper instead of pretending to know better?

            Like

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