Most people, businesses and governments want more money, but where does it come from? This question is addressed in a 2012 book published by the new Economics Foundation called simply “Where Does Money Come From?” In this treatise, the authors Richard Werner and his co-authors Josh Ryan-Collins, Tony Greenham and Andrew Jackson piece together information spread across more than 500 documents, guides and manuals as well as papers from central banks, regulators and other authorities. The foreword is written by Charles A. E. Goodhart, Professor Emeritus of Banking and Finance, London School of Economics.

In practice the central bank has always sought to control the level of interest rates, rather than the monetary base. Hence, the supply of money is actually determined primarily by the demand of borrowers to take out bank loans. Moreover, when such demand is low, i.e. because the economy is weak and hence interest rates are also driven down to zero, the relationship between available bank reserves (deposits at the central bank) and commercial bank lending/deposits can break down entirely. Flooding banks with additional liquidity, as central banks have done recently via Quantitative Easing (QE), has not led to much of a commensurate increase in bank lending nor broad money (notes and coins in circulation plus bank accounts).

Many small businesses seeking bank finance will testify to this.

New money is principally created by banks when they extend or create credit, either through making loans, including overdrafts, or by buying existing assets. In creating credit, banks simultaneously create brand new deposits in our bank accounts, which, to all intents and purposes, is money.

Our money is not central bank money, nor is it backed pound for pound by central bank money. Our money is a ‘promise to pay’ by a bank, and even central bank money is only a promise to pay that is enforced by the Government. The difference between the credibility of central bank money (including cash) and commercial bank money is further blurred by the insurance of commercial bank money by the state. In fact all an account with a bank provides, is the right to request a transfer to another bank (currently only guaranteed up to £85,000).

As Reginald McKenna, ex-Chancellor of the Exchequer, said back in 1928 “ I’m afraid that the ordinary citizen will not like to be told that the banks or the Bank of England can create and destroy money.”

So, banking has a number of popular misconceptions:

1. Banks take in money from savers and lend this money out to borrowers.

This is not actually how the process works. Banks do not need to wait for a customer to deposit money before they can make a new loan to someone else. In fact, it is exactly the opposite; the making of a loan creates a new deposit in the borrower’s account. More sophisticated explanations bring in the concept of ‘fractional reserve banking’. This description recognises that the banking system can lend out amounts that are many times greater than the cash and reserves held at the Bank of England.

2.  Banks have a strong link between the amount of money that they create and the amount held at the central bank. The central bank has significant control over the amount of reserves that banks hold with it.

In fact, the ability of banks to create new money is only very weakly linked to the amount of reserves they hold at the central bank. On average, prior to the financial crisis of 2008 onwards, the banks had just £1.25 in central bank money for every £100 of customers’ money. In the more cautious, post-crisis environment, the banks in 2012 still had on average only £7.14 for every £100 of customers’ money. To the ordinary citizen, it is hard to believe or understand that banks could lend 14 to 80 times the cash they actually have..!

Banks operate within an electronic clearing system that nets out multilateral payments at the end of each day, requiring them to hold only a tiny proportion of central bank money to meet their payment requirements. Furthermore, Werner et al argue that rather than the central bank controlling the amount of credit that commercial banks can issue, it is the commercial banks that determine the quantity of central bank reserves that the Bank of England must lend to them to be sure of keeping the system functioning.

3.  The bank rate of interest controls the amount of credit that is granted to businesses and individuals

In a world of imperfect information, credit is rationed by banks and the primary determinant of how much they lend is actually not interest rates, but confidence that the loan will be repaid and confidence in the liquidity and solvency of other banks and the system as a whole. Banks decide where to allocate credit in the economy. The incentives that they face often lead them to favour lending against collateral, or existing assets, rather than lending for investment in production. As a result, new money is often more likely to be channelled into property and financial speculation than to small businesses and manufacturing, with associated profound economic consequences for society.

Fiscal policy does not in itself result in an expansion of the money supply. Indeed, in practice the Government has no direct involvement in the money creation and allocation process. This is little known but has an important impact on the effectiveness of fiscal policy and the role of the Government in the economy.

As Paul Tucker, Deputy Governor at the Bank of England and member of the Monetary Policy Committee, said in 2007; subject only (but crucially) to confidence in their soundness, banks extend credit by simply increasing the borrowing customer’s current account, which can be paid away to wherever the borrower wants. So, a bank extends credit simply by ‘writing a cheque on itself’ creating money.

The research by Werner et al found that the amount of money created by commercial banks is currently not actively determined by regulation, reserve ratios, the Government or the Bank of England, but largely by the confidence of the banks at any particular period in time.

4.  Increased bank lending supports investment and higher returns on capital. Bank credit aids production.

Unproductive credit creation for non-gross domestic product transactions (GDP) simply results in asset price inflation, bursting bubbles and banking crises as well as resource misallocation and dislocation. However, in contrast, credit used for the production of new goods and services, or to enhance productivity, is productive credit creation that will deliver non-inflationary growth. This ‘Quantity Theory of Credit’ has been developed by Werner. Historical evidence suggests that left unregulated, banks will prefer to create credit for non-productive financial or speculative credit, which often maximises short-term profits. This may explain why the Bank of England, like most central banks, used to impose credit growth quotas on banks. Such credit controls were abolished in the early 1970s.

While money is really nothing more than a promise to pay, what distinguishes money from, say, an IOU note, is its general acceptability. Promises to pay that are accepted as tax will tend to be the most widely accepted for private debts and exchanges as almost everyone needs to make regular tax payments. The nature of the credit-debt relationship is abstract rather than specific. As American economist Hyman Minsky has pointed out, “anyone can create money, the problem is getting it accepted”. Since banks are the accountants of the economy, through whose computers the vast majority of all transactions are booked, they are uniquely placed to get their money – created though granting credit – accepted. Part of the widespread acceptance of bank deposits as payment may be due to the fact that the general public is simply not aware that banks do indeed create the money supply.

 Window Guidance

During the post war decades, credit controls, in some countries called “window guidance”, were managed by the central banks who determined the desired nominal GDP growth, calculated the necessary amount of credit creation to achieve this and allocated the credit creation across various types of banks and industrial sectors. Unproductive credit creation, was suppressed because financial credit creation such as today’s large scale lending to hedge funds, simply produces asset inflation and the risk of subsequent banking crises. Thus it was difficult or impossible to obtain bank credit for large-scale, purely speculative transactions.

Most bank credit was allocated to productive use, which meant either investment in plant and equipment to produce more goods, or investment to offer more services or other forms of investment that enhanced productivity (such as the implementation of new technologies, processes, and know-how) – and often a combination of these. Such productive credit creation turned out to be the least inflationary, since not only was more money created, but also more goods and services with more value added and stimulated

Deng Xiao Ping had recognised this earlier and made Japanese-style window guidance the core of the Chinese economic reforms that led to decades of extremely high economic growth in China.

Equally, this suggests that by severely limiting or entirely banning bank credit for transactions that do not contribute to GDP, asset bubbles and banking crises could be avoided in future. To be sure, such a measure would not stop speculation; instead, it would not allow speculators to use the public privilege of money creation for their speculative transactions, which may be sufficient to avoid banking crises.

EU rules prevent central banks buying bonds directly from governments. However, these rules do not apply to buying bonds from ‘publicly owned credit institutions’, for example, in the UK the Green Investment Bank (GIB), the recently announced Business Investment Bank or another nationalised bank could issue large quantities of bonds which could be purchased by the Bank of England in the same way it purchases Government bonds. Again this would create new purchasing power which could be directed into productive sectors. If the central bank resisted taking these kinds of assets onto its balance sheet, they could be underwritten by the Treasury, as with the Government’s ‘credit easing’ policy and the existing Asset Purchase Facility.

 Should the UK government re-introduce credit control options?

Under its QE programme, the Bank of England did not, and under Article 101 EC is not permitted to, purchase newly issued gilts directly from the UK government, but bought them on the open market.

Such an action would, of course, provide the Government with newly created money which could be spent directly in to the economy via government departments or used to reduce the national debt. These EU rules, in theory at least, ensure that when government spending exceeds taxes, governments are forced to borrow funds from the market and run up a deficit, rather than finance the deficit or increase public spending through new central bank money creation.

Political economist Geoffrey Ingham argues that the Maastricht Treaty effectively removed the power of money creation from individual states and subjected them to ‘market discipline’. However, the Maastricht rules do not prevent governments borrowing directly from commercial banks in the form of loan contracts, which also creates new money, to fund public sector borrowing, and hence remains a viable avenue to monetise government expenditure. Thus there are ways for governments to continue to exercise their powers of money creation, even under the restrictive Maastricht rules.

While the issuance of government money to fund fiscal expenditure is often thought to be inflationary, this need not be the case, especially if limited by the amount of money-supply expansion needed to reach the growth potential of the economy. As has been argued by Huber and Robertson and others, government-created money may represent an efficient use of the monetary system to minimise the tax burden and maximise value for tax-payers. No servicing costs in the form of interest, and interest on interest (compound interest), are incurred. This could be of substantial benefit at a time when many a government spends as much or even more on compounded interest on their debts than on their core government expenditure programmes

The power of commercial banks to create new money has many important implications for economic prosperity and financial stability. Four are highlighted by Werner et al:

1. Although useful in other ways, capital adequacy requirements do not constrain money creation and therefore do not constrain the expansion of banks’ balance sheets in aggregate. In other words, they are ineffective in preventing credit booms and their associated asset price bubble

2. In a world of imperfect information and disequilibrium, credit is rationed by banks and the primary determinant of how much they lend is not interest rates, but confidence that the loan will be repaid and confidence in the liquidity and solvency of other banks and the system as a whole

3. Banks in effect decide where to allocate new credit in the economy. The incentives that they currently face lead them to favour credit creation for the purchase of existing assets or other financial speculation, rather than lending for investment in the creation of new assets. New money is more likely to be channelled into property and financial speculation than to small businesses and manufacturing, with profound economic consequences.

4. Fiscal policy does not in itself result in an expansion of the money supply. Indeed the Government has in practice no direct involvement in the money creation and allocation process. This is little known but has an important impact on the effectiveness of fiscal policy and the role of the government in the economy.

Werner and his co-authors reveal a paradox at the heart of our monetary system: it is the state that essentially determines what money is and underwrites its value and yet it is predominately commercial banks that create it. In deciding who receives credit, commercial banks determine broadly how it is spent within the economy; whether on consumption, buying existing assets or productive investment, their decisions play a vital macro-economic role.

This leads to some questions to be considered about banking reform and credit management:

1. Should credit guidance, including the suppression of credit creation for speculative purposes, be reintroduced into the UK monetary policy toolset?

2. Should the UK Government set up national banks able to create credit at zero or very low rates of interest for specific infrastructure projects?

3. Should the restrictions imposed upon direct government credit creation by the Maastricht Treaty be reviewed?

Credit management action by even conservative states is not new. It has been termed simply ‘suasion’ and in one form has been used to persuade banks and other financial institutions to keep to official guidelines. Governments have a duty to operate in a way that is consistent with furthering the good of the economy. In Australia, the Reserve Bank has shown preference for this type of credit policy control. In Japan, it is known as ‘window guidance’ and in the U.S., it is known as ‘jawboning’ – exercising the persuasive power of talk rather than legislation.

The election of Jeremy Corbyn to lead the labour party may stimulate further discussion on these topics. Martin Wolf, reporting in the FT has written of Corbyn’s economic proposals  that “… higher public investment at a time of low interest rates makes sense….letting the Bank of England inject the money it creates directly into the economy, makes sense in quite restricted circumstances…”

Surely time for the UK to re-consider a new banking and credit policy linked to economic growth…?