Magnus Langton
On Sunday August 15th, 1971, United States of America President, Richard Nixon addressed the nation and announced,
“I have directed Secretary Connally to suspend, temporarily, the convertibility of the dollar into gold . . .”.
With that, the Bretton Woods Agreement of 1944 came to an end. This settlement had defined the post World War II international monetary system with fixed exchange rates, pegging other currencies to the U.S. dollar, which was convertible to gold at $35/ounce and making the dollar the world’s reserve currency. As the dollar became fiat, so did the rest of the world’s currencies. The word fiat is Latin, meaning ‘it shall be’. The intrinsic value of money was now derived from a government’s decree that it is legal tender and by faith of others that the economy behind that currency will perform in order to maintain the value of the money.
The perennial fear is that under a fiat system, a government, lacking the controlling hand of a gold standard, will over produce money, to meet its own priorities and this will therefore lead to spiralling inflation and deflation of the currency.
In a world ruled by the economic assumptions of the neo-classical school, the implications of the fiat world do not always seem to be understood by the political élite and if they do, they have done little to communicate this to the population.
In answer to Jeremy Corbyn at PMQs, on June 7th 2017, Theresa May had said, “. . .there is no magic money tree . . .” However, the government had previously raised £45.8 billion to bail out various banks with a further £375 billion raised by the (BoE) Bank of England in 2008/9 and the BoE ‘created’ £450 billion in digital money during Covid with the government chipping in a further £310 billion – which looked rather a lot like a magic money tree to many. So how was this achieved, and did it have a anything to do with the money system being fiat?
Money is at the very heart of every modern society but what it is, where it comes from and why; this is all such a closely guarded secret. What is even more incredible is that journalism in general does not seem that interested in finding out the answers and neither does the academic profession of economics.
On a daily basis, the Treasury Debt Management Office is aware of the spending demands upon all UK government departments. The government (Treasury) directs the Bank of England to make payment from the government’s ’Exchequer Account’ in the Bank of England. This is the main UK bank account held in the BoE. It is the physical action arm of the statutory accounting entity -The Consolidation Fund, which was created in 1688 under the Bill of Rights and amended in the Exchequer and Audit Departments Act 1866, which authorises state expenditure. The Bank of England then pays this money to the bank accounts of government departments, that then allocate the money to innumerable private bank accounts, for the benefit of recipients: pensioners, local governments, arms manufacturers etc. The Exchequer account is topped up by the Treasury. The funds for this come from a) tax revenue and b) the proceeds of Gilt (bond) sales by the government. Note, the spending comes first. The government creates the ‘spending’ and the tax revenue comes into the account afterwards. The government does not need tax revenue (or gilt sale proceeds) to spend, it creates money first. The effect of the tax revenue being returned to the Treasury is that the money is destroyed. New money is created daily, but the money supply does not rise inexorably because it is being destroyed daily as tax and gilt revenues return to the Treasury. The tax and gilt revenues are primarily there to control inflation from oversupply of money – not to initiate spending power.
A country with a sovereign currency (not any country in the European Union, any African country still using the Franc or any country that uses the dollar as its currency) cannot go bankrupt because it can always create enough money to meet any debt, held in that currency. If the UK has a debt denominated in pounds, the government can pay that debt. A sovereign government with its own currency controls the ‘means of production’ of the money.
Government expenditure is not the only source of money in society. Banks also create money.
There are three theories about bank money creation. ‘Loanable funds’, ‘fractional reserve banking’ and ‘credit creation’ theories. In the ‘loanable funds’ model, banks loan savers’ money to other customers in search of funds and the ‘fractional reserve’ model of banking is where through some accounting jiggery-pokery, more money comes out of the banking system than was put in. The credit creation model is where banks just create new money when they issue a loan.
The Bank of England released its Quarterly Bulletin 2014 Q1 entitled ‘Money Creation in the Modern Economy’ authored by Michael McLeay, Amar Radia and Ryland Thomas of the Bank’s Monetary Analysis Directorate on 14 March.
The opening line is,
” This article explains how the majority of money in the modern economy is created by commercial banks making loans.”
Bombshell number 1!
It goes on, “Money creation in practice differs from some popular misconceptions -banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits.” Boom . . . Boom!
In short, the Bank of England declared the ‘loanable funds’ model and the ‘fractional reserve’ model of banking, were both dead wrong.
The BoE article describes how private commercial banks, through the mechanism of a banking licence, create money, essentially from nothing. The banks have a (literal) licence to print money, and a lot of it.
It is perhaps no accident that the Bank of England chose 2014 to come clean about how money is created.
On 7th August 2013, at the German Raiffeisenbank Wildenberg, Professor Richard Werner conducted the world’s first public, empirical test regarding how money was created in a bank. The experiment allowed for total transparency within the bank’s systems. Professor Werner took out a 200,000 Euro loan and the internal accounts of the bank were monitored in real time. There was no deduction from any other customer’s accounts and there was no fluctuation in the banks’ reserves, so, the loanable funds and the fractional reserve models did not apply. The money was just created and appeared in Professor Werner’s account. The reality was the bank had ‘purchased’ a financial instrument, a promise by Professor Werner to repay the money, with interest, in an agreed time frame. The bank had done nothing but wave a magic wand, a wand issued with the banking licence.
This whole experiment was filmed by the BBC. To this day the BBC has chosen not to release this footage.
The German central bank, the Deutsche Bundesbank, published a monthly report in April 2017 entitled ‘The Role of Banks, Non-Banks and the Central Bank in the Money Creation Process’. It states, “Money creation is a bookkeeping Transaction . . .in principle, the central bank and banks can create money’ and ‘the bulk of the money circulating in the euro area is created by commercial banks”. It further states “This does not involve any savings that were previously placed with the bank being lent out. Rather the bank creates the deposit money when it grants the loan.”
The European Central Bank similarly added an article to their website on or around March 2015 entitled ‘Money Creation in the Modern Economy’ which endorses the credit creation model.
How much money do the banks create every year and where does it go?
Lending M4 is the metric by which new loan created money in the economy is generally measured. This figure was approximately £57.7 billion in 2023/4. It is estimated 95% of this is bank derived credit creation money. http://.bankofengland.co.uk/statistics/money-and-credit
Bank of England (2024) Money and Credit – Bankstats (Tables A21, A2 2) Statistical Interactive database, series LPMB7AI and LPMMAUAI.
These loans can be divided into three types: Consumer, Productive and Asset Speculation.
- Consumer: (creating demand but not boosting productivity) approximately 10%
- Productive: business investment approximately 10% and
- Speculative: used to boost the price of pre-existing assets (mostly house buying) approximately 80%.
Post war credit control was a central part of the Keynesian economic platform that guided the gradual growth in the economy and living standards in Britain. The Bank of England Act 1946 gave power to the Treasury to issue directives to the Bank of England and to issue ‘guidance’ to commercial banks. The Exchange Control Act 1947 created capital controls. The government received powers to restrict all transactions involving foreign currencies, gold and securities between residents and non-residents. This controlled capital flight and managed the balance of payments, directly influencing bank’s abilities to lend abroad. These legislations were unwound, first in 1970 under the Competition and Credit Controls scheme, the Bank of England sought to liberalise the system. This resulted in a huge spike in lending and the state re-imposed direct control. It was under Maragaret Thatcher that the Supplementary Special Deposit Scheme (SSD) which had reimposed central control of lending was repealed and the immediate removal of all credit controls. With the City of London’s ‘Big Bang’ in 1986, the City became the centre of the world’s capital markets, facilitating the rapid re-deployment of capital for those with it, around the world, 24-7. The longstanding influence by governments on commercial banks to prioritise ‘productive’ loans into ‘priority’ areas of the economy in favour of market led (speculative) loans, was eroding during the late 1970s and was dispelled completely with the repeal of the SSD IN 1980.
Credit money is created, (effectively for free) by the banks, the return of this money in re-payments is paid directly to the lending bank. The profits are subject to taxation, but the result is, the money created by the banks is paid off by the borrower and the interest (profits) – go to the bank. Many loans are made with the subject of the loan held as collateral for the loan. The Courts have repeatedly held that the interests of the creditors are prime. *Should repayments fail to be made, the bank receives the asset. Heads I win, tails you lose.
As each round of loans is made, so the assets rise in value, so the loans increase, so the value of the interest payments increase, again and again and again. Fine work if you can get it. The profits increase each time for the banks.
The exorbitant privilege of issuing loans is possible because the bank holds a banking licence. These are issued by the government and by the central bank. The Bank of England was wholly nationalised on 1st March 1946 by the Attlee Labour government under the Bank of England Act. This means any ‘loan’ by the Bank of England to the government is, in reality, one hand taking money from the right trouser pocket and handing it to the other hand that places the money in the left trouser pocket.
The legislation underpinning this is the Financial Services and Markets act 2000. This enables the Bank of England through the Bank’s (PRA) Prudential Regulation Authority to work with the (FCA) Financial Conduct Authority. The FCA is an ‘arm’s length body’. Funded by contributions from the institutions and companies it is meant to regulate whilst being accountable to the Treasury, the Treasury Select Committee in Parliament and the Courts and they have their own independent complaints commissioner.
The banks are limited as to how much they can loan, at any one time. The regulations are in line with the International Basel III/IV (banking) Accords. A bank can lend as much money as its capital can support, after accounting for the ‘risk’ of the loan, the bank must meet liquidity rules and cannot overexpose itself to one borrower. The rules for these calculations are held in the Prudential Regulation Framework. The capital requirements for a bank when lending are contained in the Capital Requirements Directive (UK). The stated aim of these regulations is to provide a stable environment in which both lenders and borrowers can have faith in the banking sectors’ stability.
Ironically, perhaps the loudest criticism of these regulations is that this structure amplifies the markets’ instability in both boom and bust. A bank will hold assets to provide capital, which makes their balance sheet look strong, but these valuations can collapse when markets fall, just when the bank is required to sell them. When the markets suffer yet another bubble burst, the banks are now required to build the value of their capital before they can start to lend again. No bad thing you might think, but productive loans are classed the same as the speculative loans that caused the bubble in the first place and these are at least as likely not to be approved as their wrecking ball speculative sibling.
The lending models are intricate and the ratios are based upon the particulars of an individual bank. Each loan is assessed in-house by the issuing bank, which can result in very different lending conditions for the same loan between banks.
The costs of compliance are high. The regulations are applied the same for small banks and large banks. The costs of scale mean the larger the bank, the more efficient this process becomes. The European Central Bank has been making many statements regarding amalgamating banks to ‘streamline’ the banking sector. The effect of this would be larger, less personal banks, that would be more profitable.
The banks are businesses, driven not by their public function of ordering the movement and storage of money but by shareholder profits. The more loans they make and the higher the asset bubbles they can fuel, the greater their profits. This is only part of the banks’ business.
We have a system where the money in society is created by the government, directly through the Bank of England and indirectly through the banks it licences. The results of this money creation are political choices.
As Tony Benn said, “If we can find the money to kill people, we can find the money to help people.” Our society increasingly finds money, seemingly, for the priorities of the richest.
Labour Affairs 