Future Forum | Bank of England

How is money created?

Future Forum
Future Forum | 3 months ago | in Money, Money, Money

Most of the money in the economy is created, not by printing presses at the central bank, but by banks when they provide loans.

How does it work?

Money is more than banknotes and coins. If you have a bank account, you can use what’s in it to buy things, typically with a debit card. Because you can buy things with your bank account, we think of this as money even though it’s not cash.

Therefore, if you borrow £100 from the bank, and it credits your account with the amount, ‘new money’ has been created. It didn’t exist until it was credited to your account.

This also means as you pay off the loan, the electronic money your bank created is “deleted” – it no longer exists. You haven’t got richer or poorer. You might have less money in your bank account but your debts have gone down too.  So essentially, banks create money, not wealth.

Banks create around 80% of money in the economy as electronic deposits in this way. In comparison, banknotes and coins only make up three percent. Finally, most banks have accounts with us at the Bank of England, allowing them to transfer money back and forth. This is called electronic central bank money, or reserves.

To find our more about money creation, read our full KnowledgeBank Guide: https://edu.bankofengland.co.uk/knowledgebank/how-is-money-created/

edited on Nov 1, 2018 by Future Forum

Robert Taggart 3 months ago

Speaking as a saver... There would be an awful lot more money in the economy if the BoE raised the interest base rate! ⬆️

Jack (BoE Moderator) 3 months ago

As a general rule, the link with Bank rate and money creation actually goes the other way. A higher base rate would tend to push up on the funding costs of banks and make it more expensive for them to create loans, and ultimately money. There's some really nice explanations by colleagues in this article if you fancy reading more.


Batigol 3 months ago

Hopefully, this will put an end to the myth banks are simply "financial intermediaries" between saving and loans and highlights instead their role as creator of new purchasing power, bankers, to quote Schumpeter, are the Ephors of capitalism. However, that such a vital function, i.e. money creation, is almost totally entrusted to private entities raise some issue in terms of how this power should be properly regulated (abolished?, playing devil's advocate here...) so as to be beneficial to society at large, as per Hyman ‪‎Minsky‬: “Today’s narrowly focused financiers do not conform to ‪‎Schumpeter‬’s vision of ‪‎bankers‬ as the ephors of ‪‎capitalism‬ who assure that ‪‎finance‬ serves progress.
Today’s financial structure is more akin to ‪‎Keynes‬’ characterisation of the financial arrangements of advanced capitalism as a casino".

Armen Papazian 3 months ago

Thank you for this post and the explanation. Indeed, this is a critically important exercise.
I share with you a few paragraphs from a report written in 2011, titled: 'A Tragic Farce:
Sovereign Debt Crises and Austerity Measures' where I discuss our debt and credit based money creation methodology. Naturally, some elements are out of date, but still relevant in its main arguments.

"There was a time when humans used to think and believe that the world was flat. This should be a good reminder of how wrong and inaccurate our perceptions and beliefs can be. We need this type of humility right now in every cabinet, every central bank, and every
bank in Europe and across the world.

Our current monetary architecture is deeply flawed, reflecting an error in approach as
limiting as 'thinking the Earth is flat' once was.

Money is backed by government debt. The Central Banks print the banknotes and balance the entry in their liabilities with assets that are mainly government bonds. Money is created by debt and then grows through credit. Credit, through the fractional banking system, creates new money. This is achieved by creating new deposits based on debt agreements and contracts that banks sign with their clients. Thus, at the creation level and at the expansion level, money is driven by debt and credit. Growth implies being bigger or larger or more active than previously. From a monetary perspective, in our current model, growth in money supply implies growth in debt or credit
somewhere in the system.

Our current debt-based monetary architecture does not do justice to the creative and expansive nature of the Universe we live in, and it is too limiting to survive no matter how many artificial ways we find to sustain it. The central banks and big banks of this world must realize that the transformation of the system will position them in a far better equation on the short, medium and long run, and thus it is in their interest to lead the unavoidable upcoming systemic change.

The current crisis is a great opportunity to slip through the debt-based monetary system we have built for ourselves, and open the gates of wealth-based prosperity.
All potential warnings that such a transformation cannot be achieved should be
assessed in light of the fact that the world turned out to be a sphere despite staunch
beliefs and warnings that it is flat.

“The fact that an opinion has been widely held is no evidence whatever that it is not utterly absurd...” Bertrand Russell

To resolve the crisis effectively and fundamentally, the debt-based monetary architecture must be complemented with a channel of money creation that does not add more debt to the system and creates income without depending on bank credit.

Governments must be able to inject fresh money without adding debt. Central Banks must be able to inject new money through instruments that are not debt-based instruments. I have proposed a new instrument called Public Capitalization Note (PCN), which is a profit sharing project-based real activity enhancing instrument. If such instruments were to be used for money injection, we could turn the page on this crisis in a relatively very short period of time.

PCNs, while channelling funding to where it is most needed, facilitate job creation, employment, income, deposits, and real activity. Public Capitalization Notes allow the existing system: 1) to survive through a bypass of its own mechanisms, and 2) to balance the inadequacies of a purely debt-based model. After all, the State is the creator of money and a 'sovereign debt crisis' is an absurdity of the highest order, a system chasing its own tale.

Instead of backing money with Public Debt, which is untenable without ever increasing debt levels, we could also back it with Public Investments, i.e., wealth.

When money is created via debt and wealth-based instruments, when government and central bank share the ownership of projects aimed at supporting the very fabric of the economy, taxes can be reduced over time to become fairer and more manageable. After all, government and central bank are inventing the banknotes (75% cotton and 25% linen). Why is it that they need to collect it back from the hard working public and businesses? High taxation is a side effect of the debt-based monetary architecture and can be dealt with through the implementation of PCNs.

Interestingly, the Bank of England Issue Department does actually implement a mechanism that allows it to back its banknotes with what it calls a "Deposit with Banking Department" on its asset side of the balance sheet. Indeed, in 2010, the Issue Department and the Banking Department of the Bank of England were inventing more than 50% of the British Pounds in circulation through an internal deposit. If money can be backed by a deposit in the other branch of the same bank, it sure can be backed with Public Capitalization Notes that have a direct impact on employment and real

To fix the system, central bankers, policy makers, lawmakers, and economists in general must conceive a change in the way we imagine and create money. Meanwhile, the current policy trends take us to an economic contraction....

The only true challenge that a transformed and healthier financial architecture faces is our ability and willingness to think and implement a better system.

Here is another article that may be of interest:
Our Financial Imagination and the Cosmos

Sabrina Rochemont 3 months ago

Food for thought: The Swiss voted against the end to fractional reserve banking in a referendum in June 2018.
All background and rationale, position statements from the Swiss National Bank: https://www.snb.ch/en/ifor/media/dossiers/id/...ssiers_vollgeld

Florence (BoE Moderator) 3 months ago

Dear Sabrina, thank you for sharing international perspectives - this helps enrich the debate!

Sabrina Rochemont 3 months ago

You're most welcome. Feel free to ask if you are looking for international perspectives for any of the topics. You can find most of the 2017 developments in the links from my profile. 2018 trends are documented in a monthly newsbrief. Recent copy attached (earlier ones available on request).

Armen Papazian 3 months ago

Hi Sabrina, many thanks for the link and the perspective.

Just to clarify that the idea of PCNs being used as parallel avenues of money creation is not the same as Sovereign Money as discussed and addressed by the SNB. Below I raise some points regarding SNB's position, may be of interest. My comments are preceded with a * after each position point.

"The SNB opposes the initiative, as does the Federal Council. Here, in brief, the SNB’s position at a glance:

- Switzerland’s financial system has a proven track record and relevant new regulation has made it more secure.
* True, a system with a proven track record, and immense institutional bias towards what has worked for decades... or seems to have worked for decades. Also, what does 'secure' mean here is unclear, and leaves out decades and countless instances of institutional failure. Especially given the 2008 and 2011 crises and the following QE and Austerity measures enacted in much of Europe and UK which have had very unsettling implications for economic and social stability (euphemism).

- There is no fundamental problem that needs fixing. A radical overhaul of Switzerland’s financial system is inadvisable and would entail major risks.
* How can you argue with that!?! Look around, a healthy planet, prosperity everywhere, equality and fairness well established, and we seem to be tackling all major evolutionary imperatives with ease and on time! This position point ignores the responsibility of monetary structures completely, which is conveniently thrown under the rug a few points later with central bank independence, and 'standing up to political ambitions'.

- Today’s decentralised system is both customer-focused and efficient. Competition between banks ensures favourable interest rates and high-quality, modern and low-cost services.
* I am all for the decentralised system, and a competitive landscape, and I do not think the current banking system as such needs to be replaced with a public money system. The issue is to create a channel of money creation, in parallel to the debt based channels we have now, that makes it possible to create new money without debt at the central bank level. This is critical for a healthier system and also, in order to invest according to evolutionary priorities, and not the risktime priorities of banks.

The role of banks is not eliminated in the PCN proposition. Furthermore, all new money eventually ends up in banks anyway, even if they are first created outside them, which is what PCNs will achieve.

- The SNB has the requisite instruments at its disposal to steer the interest rate level and hence the money supply, thereby fulfilling its mandate of ensuring price stability.
* Yes of course, as the provision and management of debt and credit is privately run in most parts of the architecture, a Central Bank that directs or intervenes via the cost of money is useful. But this does not really negate the necessity of a parallel money creation instrument that is non-debt based. In fact, it reinforces it.

Furthermore, a credit based money creation methodology has the track record of creating inflationary pressure and asset bubbles, far more than asset and real activity creating injections as conceived in PCNs.

- The proposed reform would politicise and complicate the implementation of monetary policy.
* The main point of the argument and the product (PCN) I propose is that monetary policy needs to change by adding new and parallel channels of money creation and injection that are not debt based. At least in the proposition described, the idea is to complement the system with non-debt instruments.

- Today, the SNB can steer demand for money and credit via interest rates. Interest rate targeting is practised by the major central banks and has proved its worth as a strategy. Abandoning the current system of interest rate targeting in favour of monetary targeting would be an unnecessary and regressive step.
* With the introduction of PCNs this is not negated or omitted. As PCNs are created and developed, over time, there will be parallel platforms developed that can have their own 'return rate' in the future. Furthermore, it is envisaged that as the non-debt instruments become used on the asset side of central banks, this diversification will eventually lead to a new parallel market for those instruments as well.

- The ‘debt-free’ issuance of central bank money envisaged by the initiative would expose the SNB to political ambitions. It would also result in a concentration of tasks at the central bank, which would jeopardise monetary policy independence and the fulfilment of the SNB’s mandate.
* While I agree in full that Central Banks should not be exposed to short term political manipulations, I believe they must be held fully responsible vis-à-vis evolutionary imperatives. Indeed, central bank independence needs to be kept in check when it comes to socioeconomic and environmental responsibility, and this independence from political intervention should not be used to absolve banks and central banks.

- The ‘debt-free’ issuance of central bank money would erode the SNB’s balance sheet and weaken confidence in the Swiss franc.
* Not true, because debt based assets are not the only type of assets around, and here, the role and significance of Public Capitalisation Notes is critical, as they will transform Central Bank balance sheets, but that does not mean they will weaken them; on the contrary. Again, my proposition of PCNs is not identical to what the Swiss voted on, or what the SNB is actually discussing.

Furthermore, the Bank of England has used 'deposits in the banking department' to back issuance of notes, I really do not see why other alternative instruments like PCNs would erode the balance sheet of the banking department.

As for confidence in the currency, I believe this is a short term fear based argument. In a value paradigm built on Risk and Time, however, this is understandable. Our Value paradigm needs to also change. Indeed, I believe and have argued elsewhere that unless we introduce the missing principle of value, i.e., Space Value of Money, our valuation frameworks as well as what is considered viable for monetisation will be directly dependent on our current mindset, which will prioritise the mortal risk averse investor, and will eventually lead to irreversible evolutionary challenges, as we seem to be faced with now.

- A sovereign money system could not prevent credit cycles and asset bubbles. Improved instruments are now available to ensure financial stability – these include capital requirements and the ‘too big to fail’ regulations.
* This may be true for what the SNB has considered, but it is not true for the step by step introduction of PCNs as a monetisation tool. Simply put, with non-debt based tools of money creation, central banks will have far better tools to more effectively address the negative effects of such cycles.
The issue of course is that with non-debt based money creation at the central bank level, when used and applied, the injected money will not enter the economy via the reserve accounts of banks, but via the accounts of specific agencies or public/private partnerships that will engage in investing it directly in the real economy.

Constraining and conditioning new money creation by central banks into banks, and only banks, has nothing to do with independence, and a lot more to do with keeping the monopoly of that power under the guise of safeguarding independence.

- A sovereign money system could not deliver on its promise to guarantee a secure financial system and ensure greater prosperity through directly issued central bank money.
* Again, here, there are a few key and fundamental differences between my proposition and the proposal discussed and addressed by the SNB.
But isn’t it ironic to notice that central banks already directly issue money, its just that based on the current architecture, this new issuance can only be directed into the accounts of banks, and can only translate into increased money supply via new debt transactions defined and chosen by banks.

It is just amazing how power and fear disguise themselves as rational decision making, scaring us from alternative creative solutions…. Just like explorers used to be warned that sailing their ships away into the horizon could result in… them falling off the surface of the earth.

Finance and economics have yet to cross their flat earth moment in their intellectual history, and all the sophisticated maths and econometrics cannot absolve us from treating the cosmos as something that exists in cosmology books alone, and building our entire monetary philsophy and architecture on scarcity, artifical scarcity.

Until we recognise where we are, and the role of our financial imagination in creating true sustainable prosperity, on country and world levels, many more referendums and votes will come and go, with the same outcome. Even this forum, will just be something interesting that happened, with the only real outcome of creating a surprised curiosity in a future AI sniffing around the digital garbage of our time....

View all replies (3)

Batigol 3 months ago

Interesting the Swiss voted on an issue that probably does not even really exist... You might want to have a look at the attached scholarly article for a deeper insight. Even Lord Keynes was not consistent in his analysis of how money is created by the banking sector and injected in the economic circle, no wonder the Austrian economists (who endorse the "fractional reserve banking" theory) talk about, somewhat tongue in check, about "the mystery of banking".

Shelley (BoE Moderator) 3 months ago

Thank you for sharing!

Stephen Bassett 3 months ago

Look at it another rhetorical way. When a bank licensed to do so gives you a loan, is it not just providing an advance against your hoped for future money and surely you do end up poorer, because there is a fee for this credit in the form of interest. Are they really creating money, or just a temporary time warp or acceleration, a blip which washes itself out, unless there is a default. What happens to that 'money' when it is not returned.

Shelley (BoE Moderator) 3 months ago

Thank you for your comment. Interesting questions you raise. I'd be interested in others views?

Amy Buckingham 2 months ago

This idea has been advanced to the next phase

Amy Buckingham 1 month ago

This idea has been advanced to the current phase