Saturday, 30 November 2013

The Current Monetary System

The second of our economic reading group meetings happened least Wednesday (20 November). In this gathering, we looked at the current monetary system with an emphasis on how the banking system works with emphasis on the way that it creates money. As well as Jackson and Dyson's (2012) book, we used the videos from the Positive Money website ( The six videos in the sequence cover most of what is in the second chapter of the book.

So what makes something money? Money can be defined as what is accepted for payment of the exchange of goods and what the government accepts as taxes. Jackson and Dyson describe three types of money. These are cash, central bank reserves, and commercial bank money. Cash is manufactured by the Royal Mint and sold to banks. The profits go to the government. Central bank reserves is electronic money held in central bank accounts for each commercial bank. It is created by the central bank and used by the commercial banks to make payments between themselves. These are not counted as part of the money supply since they are not available to the public for transactions. The third type of money is commercial bank money. This makes up 97% of the money supply and is created by the process of making loans or buying assets. How did we get to 97% of the money supply having come into existence through commercial bank money?

Part of it has to do with the way that banks operate. When a person deposits money in a bank, that deposit belongs to the bank. The bank does create an account for the depositor but in its own accounts, it accepts a liability to the depositor agreeing that it will give the depositor that amount when asked. Since the bank takes ownership of the deposit, it also becomes an asset to the bank. This process doesn't cause any change in the money supply. When the depositor withdraws their money, the bank reverses the process reducing the liability and their assets.

However, when a bank makes a loan, it creates a deposit for the borrower and in the process creates an asset and a liability on the banks accounts. In other words the bank has increased its own value by creating what it calls a loan and because the lender can use the loan to purchase goods or services, the money supply has been increased. Can it really be called a loan if the bank isn't actually lending money that it already possesses? It is only a loan in the sense that the borrower is expected to repay the bank at some later date. When the loan is repaid, the bank reduces its assets and liabilities thus reducing the money supply.

There are other implications since the bank has the loan on its accounts as an asset, it is able to sell them on to some other organisation and thus remove the risk from their own accounts. That is they can turn the asset that represents a loan into what appears to be real cash.

In the UK, there is no restriction on how the quantity of loans that a bank can create. The limit is based on the amount of risk that the bank is prepared to accept. If a bank exceeds its ability to settle with other banks using its central bank reserves then it needs to borrow from other banks. If this continues for too long a period then other banks may be unprepared to accept the risk thus causing a bank to default in the settlement process.

There are a number of consequences. Two key issues are that banks can create as much as the wish and they also decide where to invest. This leads to investment bubbles such as the housing bubble. As long as the banks believe their clients can repay the mortgage, they will keep lending. Since this also increases the pressure on prices (increasing asset value) and therefore reduces the risk of lose but the bank, the banks will tend to pump more money into mortgages. The banks interests are in improving their profits while minimising the risk and not the interests of society.

In contrast investing in production has no guarantee of improved income for the business the bank invests in or for the bank. Even if the bank invests more in production or consumption, it investment doesn't ensure improvement in the market. Investment in property therefore appears to be lower risk that investing in production.


Andrew Jackson and Ben Dyson (2012) Modernising Money: Why our monetary system is broken and how it can be fixed. London: Positive Money.