The Bank of England explains money creation

This is from “Money creation in the modern economy“, an article published in the Bank of England Quarterly Bulletin 2014. The bold text is in the original.

In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans.

Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money. The reality of how money is created today differs from the description found in some economics textbooks:

  • Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.
  • In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.

Although commercial banks create money through lending, they cannot do so freely without limit. Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system. Prudential regulation also acts as a constraint on banks’ activities in order to maintain the resilience of the financial system. And the households and companies who receive the money created by new lending may take actions that affect the stock of money — they could quickly ‘destroy’ money by using it to repay their existing debt, for instance.

Monetary policy acts as the ultimate limit on money creation.

The Bank of England aims to make sure the amount of money creation in the economy is consistent with low and stable inflation. In normal times, the Bank of England implements monetary policy by setting the interest rate on central bank reserves. This then influences a range of interest rates in the economy, including those on bank loans.

In exceptional circumstances, when interest rates are at their effective lower bound, money creation and spending in the economy may still be too low to be consistent with the central bank’s monetary policy objectives. One possible response is to undertake a series of asset purchases, or ‘quantitative easing’ (QE).

QE is intended to boost the amount of money in the economy directly by purchasing assets, mainly from non-bank financial companies. QE initially increases the amount of bank deposits those companies hold (in place of the assets they sell). Those companies will then wish to rebalance their portfolios of assets by buying higher-yielding assets, raising the price of those assets and stimulating spending in the economy.

This proves that Paul Krugman and the Neo-Keynesians clinging to their textbook Samuelsonian  Econ 101 have it wrong. It also shows very clearly why credit is the vital issue and why the paper-printing of the past is not going to lead to hyperinflation, but the eventual collapse of total credit market debt is going to lead to deflation.

The BoE even spells it out; “money” can be destroyed by using it to repay existing debt… or defaulting on it. By money, of course, they mean “credit money”, which is the only sort of money that matters in terms of the current global financial system.

Concerning which, Zerohedge quotes Robert H. Hemphill, Credit Manager of the Federal Reserve Bank of Atlanta:

If all the bank loans were paid, no one could have a bank deposit, and there would not be a dollar of coin or currency in circulation. This is a staggering thought. We are completely dependent on the commercial Banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the Banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is. It is the most important subject intelligent persons can investigate and reflect upon. It is so important that our present civilization may collapse unless it becomes widely understood and the defects remedied very soon.

And, as I have repeatedly stated over the last six years, the Fed cannot print borrowers. There is no “permanent money” in this particular monetary system, which is another way to say that this is a “credit money-substitute” system. This little fact explains why Congress and the Executive Branch agencies inexplicably permit the bankers to openly flout the law; they are collectively deemed too structurally important to fail or even be held legally accountable.