What’s Going On… With The Monetary System?

The common assumption of money is that it’s created directly by the Government. This is a misconception. It is true only to a certain extent. The vast majority is created by private corporations, specifically banks. It’s convenient for people not to have competent understanding of the banking system. The common illusion is that depositors pay money to a bank, which is then lent out to other people at interest. This is not how modern banking, else know as the Fractional Reserve System, works. Money lent is simply created, which people then have to pay back with interest attached. On first glance accepting this as fact may leave you skeptical, but it really a basic fact of the banking industry and is how it works. But how does such a system come in to fruition?

Throughout history many items have been used as currency: barley, beads, precious metals and even cows. But it became convenient to use coins as a means of trade, due to ease of transport, standardisation and that they hold a recognised value. Early bankers (around the 16th century) were simply those who rented out vault space for their gold coins, giving their customer’s credit cheques so that their gold is redeemable at any point. It became even more convenient to simply trade with these credit cheques and this was the basis for paper money – as large sums of gold were quite obviously hard to transport.

Loans have long become an established part of banking, originally the banker would loan out his own gold and at a rate of interest to repayments. However, as credit cheques themselves were being traded it became feasible that bankers should lend out depositors gold as it is unlikely that all the depositors would withdraw all withdraw their gold at once. This is known as a “run on the bank”.

But how exactly does this process create new money? Consider that a person deposits some gold in the bank and receives a credit cheque in exchange. However, along comes a second person to apply for a loan, they are given a credit cheque against the gold in the first persons bank. So there are now two credit cheques in circulation against the one piece of gold. Whilst we accept the credit cheques as legal tender the amount of money is increasing, but the amount of gold remains the same. New money is created out of thin air.

However, this is not the true extent to which the banking system, as it is so unlikely that people would claim the gold at once that they can repeat this process around 10 times for every deposit. Creating ten times the original amount of ‘money’ and then if this new money is almost inevitably deposited in a bank then this process can repeat over and over. This means that the proportion of gold backing the credit cheques tends towards almost nothing and so money effectively becomes equal to debt. But if it is these concepts that have permeated in to the modern Fractional Reserve System. But how do these ideas work in our economy today?

If I asked you to picture what money is in your mind, you’d be forgiven for imagining a pile of bank notes, perhaps some coins. You’re only correct to a very limited extent. In fact less than 3% of money exists as coins or bank notes. So where is the other 97% you may ask? Well the answer is simple, today the vast majority of money is in the form of digital money. The money that is simply written in to an account. The numbers on your bank’s computer screen, or the ones on your bank statement. In 2007 £50 billion was in circulation in the form of bank notes or coins, where as £2,151 billion was in the form of digital money.

Once more, we have to step back in time to find how this became so. The fractional reserve system completely destabilised the economy as the banks themselves were issuing (or arguably ‘inventing’) credit notes against diminishing proportions of gold. This creation of bank notes (as we now call them) caused massive inflation, meaning the money itself lost value against good and services for it was relatively worth less as it was backed by a smaller amount of gold. This destabilisation led to the creation of the Bank Charter Act in 1844, which prohibited banks other than the Bank of England from creating bank notes. However, with the advent of digital banking, the act was not updated and so this destabilisation has become inevitable once more and as  such the money supply was doubled between 2000 and 2008 by means of excessive lending. This is why digital money has grown to such a significant proportion of our economy from nothing.

Digital banking takes the forefront in out economy today, in fact 99.91% of daily monetary transfers are made digitally, where as cash accounts for just 0.09%. It is how the banks manage these digital transfers, using these aged principles, that divulges the true nature of how modern banks create money. The digital money that you deposit in to your bank account inevitably comes from another, or in fact, the same bank. There are currently 46 banks operating that have an account with the bank of England. These banks keep all of their depositors money in these collective accounts (known as ‘reserve accounts’) at the Bank of England. It is the responsibility of the individual banks to keep tabs on the amounts in individual’s accounts. Digital transfers solely take place between these for it never has a reason to leave this loop as numbers are simply altered in the individual’s accounts by the respective banks.  Collectively, within there reserve accounts only around 7% is active, the amount that is used in day-to-day transactions. The other 93% can be used to forge loans. Hence if a person deposited X amount of money, 93% of the deposited money could be used to create another loan to a secondary person. However this is created as new money because as we established before, money is created with equivalence to debt. In two loan cycles the initial money can more that double. (For a deeper explanation of the digital creation of money please see this page)

It is clear that this system cannot provide endless financial stability, is it wise to try to perpetuate a system that is seemingly fundamentally flawed? Private corporations have a power over the money supply and moreover charge interest on loans. This means that there must be more debt than the money created.and so the banking system is a self perpetuating cycle. More loans must be taken to create the money to pay for the debt, to which even more debt is attached. Whilst the banks reap significant profits.  In March 2011 the Independent reported that the major banks had doubled their profits. To give some perspective, the amount that bankers have effectively cost the tax payer by their foolish lending in bailing them out is £863.9 billion, where as the recent August 2011 UK riots cost the tax payer £200 billion. That’s over 4,300 riots worth of damages that have effectively been looted from the public in bailing them out. Numerous future generations will pay for the bail out. Furthermore consider the increases in tuition fees as of 2012, this increases the loans issued will likely result in loans for greater amounts being issued, hence blowing up the money supply even more than at present. The credit crunch alone should be evidence for the monopoly banks have over the economy, where the motor was removed from the economy because the banks simply stopped lending.  We are without a stable monetary supply, it is at the hand of bankers working for private corporations and we have become dependant on what I perceive as a corrupt, greedy and broken system. But what’s your opinion?

Further Reading & Sources

Positive Money: http://www.positivemoney.org.uk

“Money as Debt” Transcript: http://paulgrignon.netfirms.com/MoneyasDebt/MoneyasDebt_revised2009TRANSCRIPT.pdf

Bank Charter Act (1844): http://www.bankofengland.co.uk/about/legislation/1844act.pdf

Perfect Storm: England Riots Documentary http://youtu.be/IMvuoGji3yU