Still unconvinced that banks create money? Ask the Governor of the Bank of England…

Every now and again, Mervyn King, the Governor (or chief) at the Bank of England speaks with a clarity about the current system that is rare amongst economists and central bankers. His speech yesterday evening in Cardiff was a perfect example. He started by explaining, more clearly than the Bank of England has in the past, how money is created:

[sws_blockquote_endquote align=”left” cite=”Sir Mervyn King” link=”http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech613.pdf” quotestyle=”style02″]When banks extend loans to their customers, they create money by crediting their customers’ accounts. The usual role of a central bank is to limit this rate of money  creation, so that an excessive expansion of money spending does not lead to inflation.[/sws_blockquote_endquote]

How well they do that job of limiting the rate of money creation can probably be answered best by the following chart, which shows the total amount of money created by banks over the last 40 years (the green line):

Money supply 1960 – 2010

Of course, Sir Mervyn recognises that the Bank of England hasn’t been that effective in stopping banks creating too much money, as he explained in an earlier speech in 2010:

[sws_blockquote_endquote align=”left” cite=”Sir Mervyn King” link=”http://www.bankofengland.co.uk/publications/Documents/speeches/2010/speech454.pdf” quotestyle=”style02″]The Bank of England’s key role has always been to ensure that the economy is supplied with the right quantity of money – neither too much nor too little. For fifty years, my predecessors struggled to prevent there being too much, so leading to inflation. I find myself in the opposite situation having to explain that there is too little money in the economy. But, in the wake of the financial crisis, and the sharp downturn that followed, the amount of money in the economy as a whole – broad money – is now barely growing at all.[/sws_blockquote_endquote]

For the last few decades our economy has been fuelled by money created by the banking sector when they made loans. But in the crisis, banks panicked and refused to lend. This meant that they stopped creating money. Skip forward two years and today we still have the same problem:

[sws_blockquote_endquote align=”left” cite=”Sir Mervyn King” link=”http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech613.pdf” quotestyle=”style02″]But a damaged banking system means that today banks aren’t creating enough money. We have to do it for them.[/sws_blockquote_endquote]

By “We have to do it for them”, the Governor is referring to Quantitative Easing. If you’ve been following the news you’ll probably have heard something to the effect that Quantitative Easing amounts to ‘printing money’ in the tradition of Zimbabwe and 1930s Germany, with the risk of hyperinflation (where prices in shops double every couple of months or less).

The reality, as King suggests above, is that for the last 10 years, banks were creating tens (and often hundreds) of billions of brand new money every year. Once the crisis hit, they stopped, and the Bank of England stepped in to fill the gap. Money creation isn’t some extreme and dangerous measure only to be used in the depth of a financial crisis; it’s something that happens every time someone takes out a mortgage, personal loan or credit card. Strangely, it’s only when it’s done by the Bank of England that everyone is up in arms about the process.

Positive Money argues that banks simply can’t be trusted with the power to create money in this way. Watch this 20 minute talk or see any of the consequences here to see why.

But what’s the alternative? We’d like to see the power to create money removed from banks as a priority, and for the Bank of England to take over the role of directly creating money (paper and electronic). Of course, we don’t want politicians to have the keys to the (electronic) printing press, as they’ve just as much reason to abuse this power as profit-seeking banks. But transferring the power to create money away from the banks to an independent, transparent and accountable committee (probably at the Bank of England, but it could be entirely separate), would allow them to create money in the interests of the economy as a whole. They would need to create money only while inflation was low; if the money creation pushed up inflation, then they’d have to stop creating money. As King says in his speech, not all money creation is a path to disaster:

[sws_blockquote_endquote align=”left” cite=”Sir Mervyn King” link=”http://www.bankofengland.co.uk/publications/Documents/speeches/2012/speech613.pdf” quotestyle=”style02″]Some people talk about the dangers of  money creation. I want to explain why it is important to distinguish between “good” and “bad” money creation. In essence, the argument is very simple. “Good” money creation is where an independent central bank creates enough money in the economy to achieve price stability. “Bad” money creation is where the government chooses the amount of money that is created in order to finance its expenditure. Insufficient money creation can lead to a contraction of the money supply and a depression. We saw that in the United States during the Great Depression and we see it today in Greece. Excessive money creation leads to accelerating inflation and ultimately the collapse of the currency.[/sws_blockquote_endquote]

Positive Money advocates the ‘good’ money creation that Mervyn King alludes to – creating just enough money to keep the economy ticking over with no inflation (rising prices) or deflation (falling prices because of a collapsing economy). We’re also very clear that giving Gordon Brown or George Osborne the power to create money to fund their own ‘vote-winning’ schemes would be a disaster and should be avoided.

But we’d add one more form of ‘bad’ money creation to Sir Mervyn’s list: the creation of money, by private-sector banks, in order to maximise profits, meet targets and boost bonuses. Especially when only a tenth of all money created by banks actually goes to businesses (Source: Where Does Money Come From?). But 97% of all money that exists is created in this way, by banks, when they make loans.

My fingers are crossed that the Governor will use his next speech to question the wisdom of leaving the power to create money in the hands of the same banks that caused the crisis.

MORE INFO: Positive Money’s proposals for reform of the monetary system