A Review of “Where does Money com from?”

Introduction

Banking and the financial sector in general are surrounded by a cloud of mysticism, as very few – if anyone – knows how banks actually work. However, proper understanding of the financial sector is essential to sensible banking and monetary reform.

The book “Where does Money come from? A guide to the UK monetary and banking system” is an attempt the shed light on one of the most important and least understood sectors of the modern economy.

I will attempt to give a review of this remarkable and interesting book. Due to the complexity of the subject matter, I have decided to split up this review into three installments. In the first installment I will discuss chapters 1, 2 and 3, in the second one chapters 4 and 5, and in the final part chapters 6 and 7.

On the authors

“Where does Money come from?” is written by Richard Werner, Josh Ryan-Collins, Tony Greenham and Andrew Jackson. Richard Werner is an economist and professor at the University of Southampton. Ryan-Collins is a senior researcher at the new economics foundation. Greenham is head finance and business at that same institute. Jackson is a PhD-student at the University of Southampton.

Chapter 1

The authors start this book by remarking that though the 2008 crisis has demonstrated the importance of the banking sector, there is wide-spread misunderstanding about the financial system. This is not only limited to the general public, but also economists, bankers financial journalists and policymakers.

This lack of understanding will, according to the authors, likely result in failure of proposed reforms. Further they believe that accurate understanding of the banking and monetary system is essential for the democratic legitimacy of the financial system.

Their first finding is that defining money is not as easy as one would think. To shortcut to all historical and theoretical debates, the authors define money as anything which is generally accept as payment. They then identify three types of money:

  • cash: banknotes and coins;
  • central bank reserves: held by commercial banks at the central bank (in casu the Bank of England);
  • Commercial bank money: deposits of the public held at banks, mainly created when banks provide credit to the public.

In the UK cash accounts only for 3% of the money supply and commercial bank money for 97%. Since central bank reserves do not circulate in the economy, this is excluded from the “stock of money in circulation”.

As we will see later, commercial banks can essentially create an unlimited amount of money by providing credit. This has the following consequences, according to the authors.

  • capital requirements do not constrain money creation by banks;
  • not interest rates but confidence that loans will be repaid determines how much banks will lend;
  • banks decide how to allocate credit;
  • under the current system fiscal policy has virtually no effect on the creation and allocation of the money supply.

These issues are discussed in more detail in the remainder of the book and we will come to it in due time.

Chapter 2

This chapter starts by pointing out that not only the general public suffers from confusion about the banking system, but they also argue that economic textbooks are outdated by a few decades. Consequently much policy is based on outdated information.

For their book the authors have analysed pieces of information from more than 500 sources. Since many economists do not have the time to do this type of research and people working in the financial sector have only limited expertise, there is no up-to-date textbook on how the current banking system works.

Subsequently the authors turn to a discussion of two popular misconceptions of banking: the safe-deposit box model and the financial intermediary model. According to an opinion poll 33%  of the UK population believes in the former model and 61% in the latter.

According to the same poll 77% of the people believes that money put on the bank is property of the customers. However, this is not the case. Once you put money on the bank, the title is transferred to bank and in return you got a claim against the bank.

So if you have £100 on the bank, it means the banks has to pay you £100 if requested by you. Meanwhile the cash stored in the bank’s vaults is property of the bank.

The intermediary model holds that people deposit their savings on the banks and they then lend it back to the public. But as we will see this model is also incorrect.

In reality banks create money when the extend credit. And unlike what many believe this newly created money does not have to be backed by central bank reserves or cash. This is possible due to a process known as fractional reserve banking.

According to the textbook model, it works as follows. If I put £1,000 on the bank and if there’s a 10% reserve requirement, than the banks has to hold £100 and could lend £900 to someone else. The total amount of money is now £1,900. Once this £900 is put on a second bank, they could lend up to £810, which further increases the money supply to £2,710. This process could be repeated several times, until the additional loans the banks can make decreases to zero.

This model has a few implications. It holds that the money creation by commercial banks is limited by the reserve requirement and that central banks could control the money creation by manipulating the reserve requirements.

However, the authors argue that the textbook model is flawed. They notice that there is no minimum reserve requirement in the UK. And banks do not wait for people to deposit money, but provide loans anyway if the believe the borrower is credible enough. As a point of interest the authors note that in 2006 there was only £1 in reserves for every £80 of money created by commercial banks [1].

Chapter 3

This chapter deals with the nature and history of money and banking. It starts with a discussion of what the functions of money are: store of value, medium of exchange, unit of account and a mean of final settlements.

The authors then discuss two different theories about the origin of money: the commodity theory of money and the credit theory of money.

The first theory is derived from classical economics (Adam Smith and Karl Marx among others). Essentially this theory is the well-known story of money being evolved from barter. Money is believed to be more efficient than traditional barter and to be neutral, i.e. does not influence economic preferences.

However, the authors point out that this theory suffers from internal inconsistencies. For instance barter is only possible if both sides have something to exchange at the same moment, but in a capitalist economy one need to obtain capital before one can even start to produce anything.

The main competitor of the commodity theory of money is the credit theory. Unlike the former theory, which is based on  assumption, the credit theory is founded upon archaeological evidence such as Sumerian and Babylonian clay tablets. And curiously banking existed much earlier than physical coins.

Instead of relying on barter, people recorded debts on clay tablets and bankers simply kept the records. A similar system existed in Europe in the form of wooden sticks, known as “tally sticks” [2].

The origin of physical money, as opposed to the Sumerian credit records, is believed to lay in the imposition of tax liabilities on citizens. First the palace or temple required its subjects to pay certain amount of money (with the threat of punishment in case of failure) and then issue money to purchase services from the public.

Modern day banking is the result of complex, step-wise process which started with people depositing silver and gold by goldsmiths for safe-keeping. In return people received promissory notes, which could be returned for gold. However, people started to pay with this notes rather than to exchange the notes back for gold.

Given that most depositor did not reclaim their gold and silver, the smiths realized they could lend out the “gold” by issuing more notes than was covered by physical reserves.

The next step, which resulted in the establishment of central banks – and of the Bank of England in particular – derived from the issuance of bonds. In the 1600s England was in a permanent state of war and the state was unable to raise enough revenue through taxation, so they turned to borrowing the money to fund all wars.

In order to ensure confidence in the government, the Bank of England was created. The bonds issued by the state were bought by the BoE, which in turned borrowed from wealthy individuals. And quite importantly the government used tax revenue as collateral of this bonds.

Similar developments occurred in other European countries such as the Netherlands and Sweden. Since then government bonds and promissory notes as medium of exchange are a essential part of the modern financial system.

I will now skip a bit of history (you could read this ifor yourself, if you are interested) and go to the 20th century. Due to WWI the UK left the gold standard in an effort to fund the war and after the war the gold standard was reestablished, until the crisis of the 1930s forced again to give up the gold standard.

After the collapse of the Bretton Woods system in 1971, the banking sector was gradually deregulated., in particular in regard of credit creation.  The authors show a few graphs of the results of this deregulation, but the most interesting ones are figures 7 and 9.

In figure 7 we see the growth of the broad money supply (M4) and the amount of cash and central bank reserves. Whereas the latter remained roughly the same between 1964 and 2011, M4 grew from about 1 billion to more than 2,000 billion.

Figure 9 shows that up to 1982 the growth of M4 was proportional to the growth of the real economy (GDP).  Thereafter the money supply increased significantly faster than the GDP.

The authors conclude this chapter with a few observations. First of all, the theoretical arguments for banking deregulation is based on flawed economic theories (i.e. neoclassical economics). Neoclassical theory assumes that bank are just intermediaries and have no unique position. However, the evidence suggest that banks play a pivotal role in the economy.

Also because of this regulators have not monitored how much credit has been created by banks, let alone they have registered how bank credit was allocated among different sectors. In particular there is no regulation or monitoring whether credit was allocated to GDP or non-GDP (read: financial markets) sectors. By allowing banks to provide virtually unlimited credit to financial markets, the authors argue, asset bubbles have been created.

The authors conclude this chapter with a few remarks on digital money. Today money is more than ever before nothing but information. Hence money even less tangible than ever before.

Next time we will discuss chapter 4 and 5.

Notes

[1] It is interesting to note that the authors do not mention that banks could circumvent the “money multiplier” easily, by interpreting the reserve requirements in a creative fashion, despite that one of the authors, Richard Werner, has explained that here.

Suppose there is a 10% reserve requirement and I put £1000 on the bank. Rather than holding £100 in reserve and lending £900, the bank will held £1000 in reserve and lend £9000.

If this is repeated over and over, the additional money created by new loans will not go to zero but rather to infinity.

[2] A modern version of recoding credit on clay tablet or tally ticks, is the mutual credit system.

References

Ryan-Collins, Josh, Tony Greenham, Richard Werner and Andrew Jackson, Where does Money come from? A guide to the UK banking system, New Economics Foundation, London 2015.

Advertisements

2 thoughts on “A Review of “Where does Money com from?””

First comment? Please read our comment policy first

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s