How Money is Made

The Bank of England, I found out recently, produces a quarterly bulletin. The Bank published a couple of fascinating – to me at least – articles on how money is created and destroyed in the modern economy in their quarterly bulletin for Q1 2014:

  1. Money in the modern economy: an introduction
  2. Money creation in the modern economy

While other articles in the bulletin look to be fairly specialised, I found these opening two quite accessible. Mostly anyway, some paragraphs required a little more thinking than I was willing to put in for now.

At the crux of the articles is the theory, which the Bank says is the currently correct one, of how money is created. Surprisingly, money is created by commercial banks when they lend to you, me, companies and so on. Out of thin air, a higher number appears in our deposit accounts. On the bank’s side, a corresponding lending account appears. As we pay back into that lending account, we are actively destroying money. So money is created from nothing and, mostly, returns to nothing.

This runs counter to the belief that banks lend out money that people have previously deposited; in fact, it runs exactly in reverse to that thought. Instead, lending comes first, banks creating money at the stoke of a pen and tap of a key.

My first thought was what, then, stops banks just creating more and more money, leading to runaway inflation? Competition and profit-motive, basically. Increasing a bank’s lending typically comes at the cost of their decreasing the interest they charge on loans, which decreases the likely profit. And there is a balance between the interest paid to depositors by a bank and the interest they charge on loans, which has to be positive for the bank to have enough money to pay its employees. I did ponder whether a bank could just conjure up money for their employees, but realised that, of course, employees don’t want to be paid in loans.

The interest rate set on reserves by the central bank – that is, the money that commercial banks hold with the central bank – also affects the price of loans on the street, to you and I. I get a bit lost at this part, so do email me if I’ve buggered this bit up. But so far as I can see we’re broadly saying that the reserves which the commercial bank borrows from the central bank have an interest rate attached, which, given banks settle between themselves in reserve bank currency, influences the rate at which the bank is willing to loan that money further down the chain. Competition between banks drives down that rate towards the central bank rate, and the desire not to lose money keeps rates above it. By increasing the rate, the central bank can make lending more expensive, decreasing demand and therefore money creation.

Paying for something, in this world, really is the action of decreasing the number in someone’s deposit account and increasing the number listed against someone else’s. If the parties are with the same bank, this can be instantaneous. If not, it needs to be accompanied with a transfer in central bank reserves (I think) from the buyer’s bank to the seller’s bank.

There is a classic computer science example of the need to have transactional protection around a purchase, to keep the addition and subtraction appearing instantaneous, and in that we tend to think about the numbers as only representing people’s balance. In reality, it seems to me that the bits on disk really are that balance – and if they accidentally change, the money really does change. If that happens, the bank has, most likely, accidentally created or destroyed money.

I haven’t quite figured out what this means. It’s a bit like quantum physics, where you learn that reality is far less solid than everyday experience suggests. Similarly, money appears to be a far more mailable, slippery concept than I thought. I get the feeling that if my mind comes to accept this new view of money, a bunch of my underlying feelings about how economies – and governments – work will come tumbling down to be replaced with quite different ones.

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