There’s a lot of confusion about how banks work, most university economics courses still teach a model of banking that hasn’t applied to the real world for decades. While banking may seem like a complicated subject, anyone can learn the basics.
Do you really want to understand how banks create money, and what limits their ability to do so? Then our new 6-part video course ‘Banking 101’ is for you! Now you can watch the first two parts of this course below (a total of about 15 minutes). The final four parts will be released over the next few weeks.
Misconceptions around Banking
Banking 101 (Part 1)
Over the next hour we’ll discover how banks really work, and how money is created. But first, to clear up any confusion, we need to see what’s wrong about the way that most people think banks work.
Public Perception of Banking Number 1: The ‘Safe Deposit Box’
Most of us had a piggy bank when we were kids. The idea is really simple: keep putting small amounts of money into your piggy bank, and when a rainy day comes along, the money will still be sat there waiting for you. For a lot of people, this idea of keeping your money safe sticks with them into adult life. A poll done by ICM on behalf the Cobden Centre found that a third of the UK public still believe that this is how banks work. When they were told that actually the bank doesn’t just keep your money safe waiting for you to return and collect it, they answered “This is wrong – I haven’t given them my permission to do so.” So this idea that the banks keep our money safe is a bit of an illusion. Your bank account isn’t a safe deposit box. The bank doesn’t take your money, carry it down to the vault and put it in a box with your name written on the front. And it doesn’t store it in any digital equivalent of a safe deposit box either. What actually happens is that, when you put money into a bank, that money becomes the property of the bank. That’s right. The money that you put into the bank isn’t even your money. When your salary gets paid into your account, that money actually becomes the legal property of the bank. Because it becomes their property, the bank can use it for effectively anything it likes. But what are those numbers that appear in your account? Is that not money? In a legal sense, no. Those numbers in your account are just a record that the bank needs to repay you some money at some point in the future. In the accounting of the bank, this is recorded as a liability of the bank to the customer. It’s a liability because the money has to be repaid at some point in the future. This concept of a liability is actually very simple – and very important if you want to understand banking. Just think of it like this: if you borrowed £50 from a friend, you might make a note in your diary to remind you to repay the £50 in the near future. In the language of accounting, this is a liability from you, to your friend. So the balance of your bank account doesn’t actually represent the money that the bank is holding on your behalf. It just shows that they have a legal obligation – or liability – to repay you the money at some point in the future. Whether they will actually have that money when you ask for it is a different issue, but we’ll talk about that later.
Public Perception of Banking Number 2: The Middle-Man
Now the other two thirds of the UK public have a slightly better understanding of how banks really work. These people think that banks take money from savers and lend it to borrowers. The Cobden Centre poll that we mentioned earlier asked people if they were worried about this process: around 61% of people said they didn’t mind so long as they get some interest and the bank isn’t too reckless. This idea of banks as middle-men between people with spare money and people who need to borrow money is very common. In this idea, banks borrow money from people who want to save it, such as pensioners and wealthy individuals, and they then use that money to lend it to people who need to borrow, such as young families that want to buy houses or small businesses that want to invest and grow. The banks in this model make their money by charging the borrowers slightly more than they pay to the savers. The difference between the interest rates makes up their profit. In this model, banks just provide a service by getting money from people who don’t need it at the time, to people who do. This implies that if there’s no-one who wants to save, then no-one will be able to borrow. After all, if nobody came to the bank with savings, then the bank wouldn’t be able to make any loans. It also implies that if the banks lend far too much far too quickly, then they’ll eventually run out of money to lend. If that was the case, then reckless lending would only last for a short time, and then the banks would have to stop once they ran out of people’s savings to invest. That means it’s good for the country if we save, because it will provide more money for businesses to grow, which will lead to more jobs and a healthier economy. This is the way that a lot of economists think as well. In fact, a lot of economics courses at universites still teach that the amount of investment in the economy depends on how much we have in savings. But this is completely wrong, as we’ll see shortly. Let me point out that, so far, we haven’t talked at all about where the money really comes from. Most people just assume that money comes from the government or the Bank of England – after all, that’s what’s written on every £5, £10 or £20 note.
If you’d like to translate these videos into other languages, please email us first. (Someone else might already be working on a translation.) We’ll send you the transcript with timecodes. (Do not translate the transcript above!) Email: mira[at]positivemoney.org
What’s wrong with the money multiplier?
Banking 101 (Part 2)
We’ve seen the two main ideas that the general public have about the way banks work. Both of them are wrong. That’s not too surprising, after all, unlike the Positive Money team most people don’t spend their time obsessing about how banks work. And banking is complex, which means that most people give up trying to understand it. But what about economics or finance students? Most of these students and graduates have a slightly better understanding of banking. They get taught about something called the ‘money multiplier’.
The money multiplier story says that banks actually create much of the money in the economy. Here’s how the story goes: A man walks into a bank and deposits his salary of £1000 in cash. Now the bank knows that, on average, the customer won’t need the whole of his £1000 returned all at once. He’s probably going to spend a little bit of his salary each day over the course of the month. So the bank assumes that much of the money deposited is ‘idle’ or spare and won’t be needed on any particular day. It keeps back a small ‘reserve’ of say 10% of the money deposited with it (in this case £100), and lends out the other £900 to somebody who needs a loan. So the borrower takes this £900 and spends it at a local car dealer. The car dealer doesn’t want to keep that much cash in its office, so it takes the money back to another bank. Now the bank again realises that it can use the bulk of the money to make another loan. It keeps back 10% – £90 – and lend out the other £810 to make another loan. Whoever borrows the £810 spends it, and it comes back to one of the banks again. Whichever bank receives it then keeps back 10% i.e. £81, and makes a new loan of £729. This process of relending continues, with the same money being lent over and over again, but with 10% of the money being put in the reserve every time. Note that every one of the customers who paid money into the bank still thinks that their money is there, in the bank. The numbers on their bank statement confirm that the money is still there. Even though there is still only £1000 in cash flowing around, the sum total of everyone’s bank account balances has been increasing, and so has the total amount of debt. Supposedly this process continues, until after around 200 cycles, almost all of the original money is now in reserves, and only a fraction of a penny is being relent. By now, the sum total of all bank accounts adds up to about £10,000.
So the multiplier model that is still taught in many universities implies that this repeated process of a bank taking money from a customer, putting a little bit into a reserve, and then lending out the rest can create money out of nothing, because the same money is double-counted every time is it relent. The model says that if the reserve ratio – that’s the percentage of customers’ money that the banks have to keep in a reserve – is 10%, then the total amount of money will grow to roughly 10 times the amount of cash in the economy. You can imagine this model as a pyramid. The cash is the base of the pyramid ,and then, depending on the reserve ratio, the banks multiply up the total amount of money by relending it over and over again.
The fact is that what we’ve just shown you is completely wrong. It’s an inaccurate and outdated way of describing how the banking system works. In fact, banks in the UK haven’t worked like this for years. But despite that, this model is still used most of the time whenever people talk about how money is created, whether in universities or on videos on the internet. Before we spent 5 months researching exactly how the system worked, we used to think it worked like this too.
The fact that this pyramid model is still used is a problem for three reasons:
Firstly, this model implies that banks have to wait until someone puts money into a bank before they can start making loans. This implies that banks just react passively to what customers do, and that they wait for people with savings to come along before they start lending. This is not how it really works, as we’ll see later.
Secondly, it implies that the central bank has ultimate control over the total amount of money in the economy. They can control the amount of money by changing either the reserve ratio – that’s the percentage of customers’ money that banks have to keep in reserve – or the amount of ‘base money’ – cash – at the bottom of the pyramid. For example, if the Bank of England sets a legal reserve ratio –– and this reserve ratio is 10%, then the total money supply can grow to 10 times the amount of cash in the economy. If the Bank of England then increases the reserve ratio to 20%, then the money supply can only grow to 5 times the amount of cash in the economy. If the reserve ratio was dropped to 5%, then the money supply would grow to 20 times the amount of cash in the economy. Alternatively, the Bank of England could change how much cash there was in the economy in the first place. If it printed another £1000 and put that into the economy, and the reserve ratio is still 10%, then the theory says that the money supply will increase by a total of £10,000, after the banks have gone through the process of repeatedly re-lending that money. This process is described as altering the amount of ‘base money’ in the economy.
But the most significant implication of this model is that the Bank of England, or the Federal Reserve or European Central Bank, has complete control over how much money there really is in the economy. If they change the size of the base – by pumping more ‘base money’ into the system – then the total amount of money should increase. If they change the reserve ratio, then the steepness of the sides of the pyramid will change. But eventually, the reserve ratio stops the money supply growing any further. At some point we reach the top of the pyramid and the money supply stops growing. So there’s absolutely no possibility that the money supply can get out of control. There’s just one small problem. Almost everything about this description of banking is wrong.
In fact, Professor Charles Goodhart, of the London School of Economics and an advisor to the Bank of England for over 30 years, described this model as “such an incomplete way of describing the process of the determination of the stock of money that it amounts to mis-instruction.”
It might be forgivable for textbooks to be out of date if the rules had changed in the last couple of years – after all, a lot of rules and regulations changed during the financial crisis. But Professor Goodhart actually said this in 1984. 27 years, later university students are still learning a description of banking that is completely inaccurate. This is a big problem. If these students then go on to become economists and advisors to the government, and they don’t even really understand how money works, then our economy could end up in a real mess. Oh wait…it already is!
Now, I have to point out that these videos do apply to the UK, and we haven’t had time to confirm exactly how things work in the USA and Europe. But for those of you in the US, a paper published in 1992 refers to a textbook still used in universities today – and states that “the multiplier model…is at best a misleading and incomplete model, and at worst a completely mis-specified model’.
[Lombra, http://www.jstor.org/pss/40325454 ]
Here’s the bottom line when it comes to the ‘money multiplier’:
1) There’s no reserve ratio in the UK anymore, and there hasn’t been for a long time.
2) The Bank of England doesn’t have any real control over the amount of cash, or even electronic ‘base money’ (which we’ll talk about later).
3) And the Bank of England certainly doesn’t have control over how much money there is in the economy in total.
It’s not just economics graduates who have the wrong information. Even people working in the Treasury still believe it works according to the textbook. We’ve had letters from the Treasury saying things like this: “In this system, the Bank of England alone has control over the monetary base, which consists of currency (banknote and coins) and reserves held by commercial banks at the Bank of England. Commercial banks keep only a fraction of their deposits in reserve, lending out the remainder, while maintaining the simultaneous obligation to redeem all deposits upon demand.” Allowing people with an incomplete understanding of how money works to manage our economy is very dangerous. It’s like allowing engineering students who don’t understand gravity to build skyscrapers. People will suffer.
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