Banks: The Magic Money Trees

Honouring our pain

The word bank makes reference to the Italian ‘banco’, meaning the benches in which goldsmiths would facilitate monetary transactions between merchants from different parts of the continent in the 13th-century. Goldsmiths were generally trustworthy businessmen who charged a fee for keeping coins safe in strongboxes, issuing a receipt for future withdrawals. At one point, realising that most gold coins stayed stored for long periods of time and that they were unlikely to be retrieved simultaneously by all depositors, the goldsmiths started issuing more receipts than the gold they were keeping, thus creating the concept of credit and the first paper currencies.

Fast forward to the 17th-century when European governments granted the banking system “the right to create money as a ‘legal tender’ in exchange for a commitment always to provide whatever funds the government needed” (Lietaer, 2001:304). Although this is still the current practice to date, what most people do not know is that central banks actually create a very small portion of the money circulating in the economy. The largest portion is created by commercial banks. In fact, in the UK, 97% of all the money used is created by commercial banks in the form of bank credit.

In a nut-shell, there are three types of money in our economy: notes and coins; central bank reserves, and bank deposits — also referred to as ‘bank credit’ or ‘bank liabilities’. Common citizens do not deal with central bank reserves as this is the way banks make payments between themselves. While notes and coins can only be printed by central banks, the third type of money, bank deposits, is created by commercial banks through the magic of a click:

“Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created.” McLeay, Radia and Thomas, 2014:16

This reality debunks myths that have been sustained even by economics textbooks throughout the years. Going back to the Circular Flow diagram, for instance, where banks are illustrated as mere intermediaries, in case there were no more savings, banks would run out of money to lend to businesses. However, this is not the case. Banks are in fact money creators, and they do not depend on how much money they have in depositors’ savings accounts. Ryland Thomas, senior economist at the Bank of England summarizes in an interview: “In fact, loans create deposits, not the other way around”.

In this dynamic, the limit to how much money can be created by banks is, in the first instance, established and monitored by the banks themselves, considering their profitability, risk-assessments around lending, and households’ and companies’ demand for loans or repayment of debts. The ultimate limit, though, is set by central banks when they define interest rates, which will influence both the loan rates faced by borrowers and the amount of interest that banks pay out to depositors.

The growth of the speculative economy got traction in the 1990s when money started flowing predominantly in the realm of the virtual and fictitious instead of corresponding to real wealth generation. One significant enabler of the speculation increase was deregulation. The abolishment of the Glass-Steagall Act by president Bill Clinton in 1999, for example, gave back to commercial banks the permission to offer investment banking services, such as trading and distributing securities. As a result, a number of merges followed, forming global financial conglomerates. One of the main critiques around banks these days is that they have abandoned their primary role as providers of long-term financial products to pursue short-term returns. The way they do this is by taking low-risk assets, like deposits, and investing them in higher-risk assets, like stocks. In actual figures, from all the money created by banks in the UK from 1997 to 2007 — just before the crash in 2008–40% was invested in real estate and 37% in the stock market. On the other hand, only 13% of the sum was invested in businesses outside the financial sector.

Driven by the ‘profit-maximisation and accelerated growth’ motto of our modern economy, this intense gambling resulted in two big phenomena. First, a massive wealth concentration in the hands of a small and extremely powerful financial elite, whose fortunes “were unconnected to any material production”. And second, the collapse of the housing market in the United States and parts of Europe, which led to the financial crisis of 2008. As we know, although banks paid billions in fines, causing some to go bankrupt, the real shock was felt by the millions of people who lost their houses, their jobs and their money.

What we have today then is a powerful yet invisible finance sector that makes the rules of the money-game in a way that benefits them, using us depositors-investors as their poker chips. Furthermore, busy trying to work out numbers to make more profits, the banking system has for a long time been blind to social and ecological needs. Not by mere chance, the great majority of the population is entirely unaware of what happens in the back-stage of our economy. Nevertheless, we are still in the game, and every time we open an account in a commercial or investment bank we are holding responsibility for part of this dynamic. In this sense, it is legitimate and important to understand what our money is being used for. [See in the next article]

References used for this article:

LIETAER, B. (2001) The Future of Money: A new way to create wealth, work, and a wiser world. London: Century.

MELÉ, J. A. (2017a) Dinheiro e Consciência: A quem meu dinheiro serve? São Paulo: João de Barro.

RAWORTH, K. (2017) Doughnut Economics: Seven Ways to Think Like a 21st-Century Economist. London: Random House Business Books.

EISENSTEIN, C. (2011) Sacred Economics: money, gift, and society in the age of transition. Berkeley, CA: North Atlantic Books.

MCLEAY, M., RADIA, A. and THOMAS, R. (2014) Money creation in the modern Economy. Bank of England Quarterly Bulletin 2014 Q1. [Online] Available from: https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy [Accessed 14/08/19].

POSITIVE MONEY (2012) Banking 101 (Video Course). [Online] Available from: https://positivemoney.org/how-money-works/banking-101-video-course/ [Accessed 14/08/19].

THOMAS, R. (2014) Money creation in the modern economy — Quarterly Bulletin article. Bank of England Quarterly Bulletin 2014 Q1. [Online] Available from: https://www.bankofengland.co.uk/quarterly-bulletin/2014/q1/money-creation-in-the-modern-economy [Accessed 14/08/19].

GREENHAM, T. (2013) ‘Money is a social relationship’ at TEDx Leiden. [Online] Available from: https://www.youtube.com/watch?v=f1pS1emZP6A [Accessed 14/08/19].