Chapter 2: How the banks create new money.

How the banks create new money. 

The crucial role of the central clearing system and the enormous amounts created.  Why money, once it has been created, takes on a life of its own and refuses to fade away.

Money is a means of exchange and a store of value, or it should be, and in the form of gold and silver it was.  Now it is a better means of exchange than ever but it has lost much, if not all, of being a long term store of value.   It is created by banks that are members of the bank clearing system, either in the form of loans or by simply allowing cash flows to increase as prices and wages increase.  This money exists almost entirely in the form of bank deposits while cash is a small and decreasing proportion of money in circulation. We have reached the point where cash accounts for only £3 out of every £100 we use; £97 has been created by the private banking system.

Money in the form of bank deposits is effectively legal tender because it can be converted into cash by the use of a credit card in a cash machine and as the deposits were originally created by banks acting independently of government they are effectively forged money, counterfeit money, legally forged money.

It is beyond belief that we allow our money to be created in this way.  When the Government runs short of money it actually borrows some of the forged money and pays interest on it!!!
It seems that it is somehow immoral for the Nation to create its own money so we have to get private banks to do it for us.  Are we afraid that the Government will run riot with the electronic printing presses?  They could but would they, or indeed could they be worse than the private banking system?  We could see exactly how much new money the Government was creating; we would know what they were doing with it.  The private banks, however, are experts at concealing their money in places like the Cayman Islands.  We may well disagree with the Government over what it spends our money on but we know where it is going.  We only find out where the private banks are spending their money (really our money) when they go bust and we are forced to support them in order to avoid losing every penny apart from the cash in our wallets.
The fact that banks are able to create money in a form that is universally accepted as legal tender raises the question of how the amount they can create is controlled and who benefits from the introduction of new money – “The Seigniorage”.  The next question is how to measure the rate of growth of new money and the final question is how to control the rate of growth in order to avoid excessive rates of price inflation and to prevent existing holders of money losing as its value is diluted.

In the UK the power to create new money is reserved to members of the central clearing system known as APACS.  The power to create new money depends on being a member of the clearing system because a loan made by a member returns when it is spent, either to the member making it or to other members of the clearing system.  If all members of the clearing system make new loans at the same rate and in proportion to the number of their current account customers, an amount approximately equal to the loans made will return to each bank.  The term “new loan” is used for loans made by a bank of money not received by them in the form of deposits before making the loan:  this is new money which raises the monetary aggregates as measured by the statistic M4.

Why bank created money becomes permanent.

All bank created money now exists only in the form of electronic records in computers as paper ledgers are no longer in use.  Almost all transfers and payments other than cash are now done electronically and although paper cheques are still used to a diminishing extent for payments they become electronic entries when they are paid into a clearing bank.  To distinguish this money from cash it will be referred to as bank created electronic money, or simply as “bank money”.

The acceptability of bank money as the equivalent of legal tender depends on the reputation of the clearing bank making the transfer.  There were 26 banks who were members of the Central Clearing System (APACS) in the UK at the end of 2006 and several of these were foreign.  All of these banks had a very high reputation and prior to 2007 were believed extremely unlikely to fail to complete a transfer.  Smaller banks who are not members of APACS depend on member banks to complete transfers on behalf of their customers.  A payment by bank money is the transfer from one bank account to another.

At first sight you might think that the new money created in the form of a loan would be extinguished when either the loan is repaid to the bank making it or the debtor is unable to repay.  However, before a loan is repaid or failed to be repaid the money has already been spread far and wide into other bank accounts where the resulting deposits are just like any others. When it is repaid, probably over a period of time and from a multitude of possible sources, there is no way of distinguishing the repayments from other deposits and no reason for writing it off and not using it to make further loans.

In the case of failure to repay, the money has already been spent and is in someone else’s deposit account.  Once new money has been created and spent it belongs to someone else and has been changed from being a loan from a bank to being private property either held as cash or on deposit.

It is a characteristic of bank money that it cannot rest or remain stationary in the way notes or coins can be kept physically under the bed.  It can only be used as money to make payments via a clearing bank.  Bank money can only exist in the form of bank deposits but it is as good as treasury notes for making payments, it is effectively legal tender because it can be converted into cash at the stroke of a plastic card for as long as the bank remains solvent.

Deposits belong to the depositors not to the banks.  It follows that a bank cannot destroy a deposit without paying the depositor back and in this case it will either be transferred to another bank as a deposit or be drawn out in cash.  If a bank becomes insolvent its deposits are destroyed and this is the reason for the panic among the depositors at Northern Rock until the depositors were rescued by nationalization of the bank.  The shareholders were not so lucky.


A borrower who receives a loan from a bank, whether the loan is made from newly created money or from money received by the bank in the form of a deposit, will be charged interest, and this interest will add to the total to be repaid by a borrower if he does not default on the loan.  Interest adds to the burden of debt and if the original loan was made with new (forged) money it is an added and completely unearned benefit to the bank making the loan.

When a borrower of new money uses it to buy something it is transformed into old money which is free of interest payments by its new owner.  If the new owner deposits this money in a bank it will increase the total level of deposits in the banking system. Although interest payments add to the profits earned by a bank and to the burden on the borrower they do not add to the quantity of new money because the payer has to find money to pay interest from the existing stock of money.

For hard evidence of the permanent nature of bank money once it has been created you need only look at the growth of bank deposits as measured by M4 (see chart No.1).  If the enormous losses recently made by banks affected their deposits it would show up in a fall in M4.  The growth in deposits marched relentlessly on until well into 2010 and is only recently following the fall in lending.
Banks must make a profit and cover their running expenses.  They cannot leave deposits lying idle and more and more deposits keep rolling in as new money is created.  It is the need to make money on all deposits which forces banks to seek out a continuously growing number of new borrowers and in the process take on ever more risky loans, which in turn drives up asset prices and the search for new, ever more exotic assets. This is the fundamental cause of the credit crisis in the summer of 2007.  It was not simply greed and recklessness; it was the opportunity for unlimited legal forgery.  The whole monetary system would have tempted a saint and bankers are only human.

The ability of members of APACS to forge new money explains why building societies like to become banks and why banks take every possible measure to increase the number of customers holding current accounts, either by giving incentives to open new accounts or by amalgamating to form larger banks.  For it is through customers holding current accounts; accounts into which pay cheques and all other forms of receipts flow, that banks can increase their share of money in circulation without the need to pay high rates of interest for new deposits.

Chart No 1 above gives the history of M4 since 1963 

Although it has suffered from changes in definition over the past thirty years, the broad measure of money M4 is a reasonable first approximation to measuring the quantity of money available for use by the community. 

A paper by Mervyn King in the BoE Journal in the summer of 2002, entitled “No money, no inflation – the role of money in the economy”, gives a very convincing case for the relationship between broad money and inflation worldwide and throughout history.  In our case inflation showed up in asset prices, particularly property prices, and did not show up in our inflation indexes.  The reason why the Retail and Consumer Price Indexes failed to follow growth in money supply is given in chapter 5.  Another destination of forged money was the World Wide Casino of pure gambling, which is well described in "The Big Short" by Michael Lewis, who also wrote "Liars.Poker", a very entertaining account of his time as a bond trader with Salomon Brothers in the 1980's..

M4 does not include sterling deposits held in banks overseas branches or “off balance sheet” in subsidiary companies, the magnitude of this is not known but is probably very large indeed.  It is these overseas balances which are used to move our exchange rates in ways quite outside our control and with little relationship to our balance of payments.  The overseas sterling balances may well be increasing even faster than M4.

The value of M4 at the end of 1963 was £15 Billion and had reached £1,674 Billion at the end of 2007, with an increase of £177 Billion in the last year alone.  The amount of money available in this form is one hundred and eleven times what it was forty four years ago.  It should be noted that in spite of the bank panic in August 2007 the growth of M4 over the year slowed very little until the last quarter but was still growing at an annual rate of 7%.
The chart shows the rate of increase was still accelerating and it shows that 1971 when the USA came off the gold standard and bank de-regulation started was a turning point.  In 1963 cash made up 21% of M4.  In 2007 cash made up only 3% of M4 and it is only this tiny proportion which is provided by the Government and which can be used as the substitute for taxation known as “seigniorage”.  All the rest was created by the private banking system. Surely this is a privatisation too far. 

A reduction in bank money only happens if a bank becomes insolvent.  In this case its deposits disappear and its depositors lose their money.  Northern Rock would have caused a major disaster if it had not been nationalized.

For a good account of how the USA money supply was reduced in 1929 read “The Great Crash” by J K Galbraith 1954.  Back in the 1930’s hundreds of banks failed in the USA and the resultant fall in the money supply caused the great depression.  The problems at Northern Rock stemmed from a classic panic by depositors, all trying to withdraw their money at once.  Northern Rock probably had more assets in the form of mortgages on property than liabilities in the form of depositors but they were victims of “borrowing short and lending long”.

Halifax Bank of Scotland (HBOS) and Royal Bank of Scotland were effectively insolvent but were “saved” by enormous amounts of government money, but not before Lloyds TSB, a previously solvent bank, was dragged in to amalgamate with HBOS and caused an even bigger mess to clear up.

Alternative and far less costly ways of rescuing banks were available and had been demonstrated to be workable in Sweden in the early 1990’s. See Chapter 7.

We can sum up the process of creating new money, as far as the UK is concerned, as follows:

The supply of loans by members of the clearing bank system was limited only by the demand for loans by suitable borrowers, as the amount available could be increased by the creation of new bank money.  Suitable borrowers are those who have the ability to pay the interest and can, preferably, offer tangible security in the form of property, shares or other assets.  The demand for loans is constrained by interest rates and driven by the expectations of borrowers that the price of the assets they intend to buy with loans will increase and/or yield more interest than they pay on the loans.  These expectations tend to be self fulfilling by the ever increasing volume of new bank money chasing a finite amount of real assets.
Many people still believe that the textbook reserve base system places a limit on monetary expansion by the banks but in fact the UK authorities have never used such a system. Chapter 6 is based on a paper written in April 2008 by Nigel Jenkinson, Executive Director for financial stability at the Bank of England. .  Today there is no credit multiplier apart from statutory liquidity ratios and a bank can easily purchase eligible liquid assets out of profits, the statutory liquidity ratio was 32% when the Bank of England was nationalised in 1947.  It was then steadily reduced until it was finally replaced by a cash ratio deposit regime in 1981, which in 1996 was calibrated to ensure that a bank had enough highly liquid assets to meet its outflows for the first week of a liquidity crisis without recourse to the inter-bank market, in order to allow the authorities time to explore options for an orderly resolution.  As a restraint on lending this was virtually non existent.