The money that banks create isn’t the paper money that bears the logo of the government-owned Bank of England. It’s the electronic deposit money that flashes up on the screen when you check your balance at an ATM. Right now, this money (bank deposits) makes up over 97% of all the money in the economy. Only 3% of money is still in that old-fashioned form of real cash that you can touch.
Banks can create money through the accounting they use when they make loans. The numbers that you see when you check your account balance are just accounting entries in the banks’ computers. These numbers are a ‘liability’ or IOU from your bank to you. But by using your debit card or internet banking, you can spend these IOUs as though they were the same as £10 notes. By creating these electronic IOUs, banks can effectively create a substitute for money.
The following video from the Bank of England explains how money is created by commercial banks:
In the video below Professor Dirk Bezemer at the University of Groningen and Michael Kumhof, an IMF Economist explain where money comes from in less than 2 minutes:
Every new loan that a bank makes in this way creates new money. While this is often hard to believe the first time you hear it, it’s common knowledge to the people that manage the banking system. In March 2014, the Bank of England release a report called “Money Creation in the Modern Economy”, where they stated that:
Sir Mervyn King, the Governor of the Bank of England from 2003-2013, recently explained this point to a conference of businesspeople:
And Martin Wolf, who was a member of the Independent Commission on Banking, put it bluntly, saying in the Financial Times that: ”the essence of the contemporary monetary system is the creation of money, out of nothing, by private banks’ often foolish lending” (Article).
By creating money in this way, banks have increased the amount of money in the economy by 11.5% a year over the last 40 years. This has pushed up the prices of houses and priced out an entire generation.
Of course, the flip-side to this creation of money is that with every new loan comes a new debt. This is the source of our mountain of personal debt: not money that had been prudently saved up by pensioners, but money that was created out of nothing by banks and lent to people who could not repay. Eventually the debt burden became too high, resulting in the wave of defaults that triggered the start of the financial crisis.