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EDN Europe's Editor Graham Prophet posts a selection of comments and insights prompted by the many items of industry news and rumour that cross the editorial desk or are gathered on his frequent travels to interviews, press conferences and events around Europe - and further afield - and somehow never find their way to the magazine or the web site, recovering some of the information otherwise lost in the noise level...

Friday, March 05, 2010

Money for [from] nothing - comment

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Response to the Editorial column "Brightest and Best" in the March edition of EDN Europe - follow the adjacent link... John Carver comments;

Good article, but one thing you got completely wrong.

"However clever bankers are, they cannot create money out of thin air - that's a job for governments."

You couldn't be more wrong. This is a popular misconception. In fact, governments DO NOT create money. Money IS created by banks, and only banks. Let me say that again. Money is created by banks, NOT by governments.

"How can they possibly do this?" you may ask. It's easy.

As engineers, to show how it's done, we'll create a simplified model. Imagine an island with 3 men on it. Call them Mr Smith, Mr Jones, and Mr Higgins the banker. Call it "3 Man Island".

The start point is 9am Monday morning. The initial conditions are that Mr Higgins is about to open his bank for the first time. He has £1000 as reserves in his safe. Mr Smith and Mr Jones have zero. So the total amount of money on the island is £1000.

Mr Higgins opens his bank. His first customer, Mr Smith, walks in and asks to open an account. He asks to borrow £10000 to buy Mr Jones's car. What does Mr Higgins say? He only has £1000 so how can he lend £10000? Quite easily. He says yes. He gives Mr Smith a cheque book, and tells him he has agreed an overdraft of £10000.

Mr Smith then goes to see Mr Jones. "Good news" he says. "That nice Mr Higgins has agreed to lend me £10000. Here's a cheque for your car." He writes the cheque, and drives away. Mr Jones is confident that the £10000 cheque is real money. We know that it's imaginary money. So will Mr Higgins be exposed as a charlatan? By no means.

Mr Jones then goes to the bank, opens an account, and drops the cheque on the counter. The cheque is of course is a promise by Mr Higgins to pay Mr Jones the sum of £10000 on demand. So if Mr Jones were to say "Please can I have this in 20s and 50s" Mr Higgins will be in real trouble. But nobody carries that kind of cash around in the modern world. Mr Jones drops the cheque on the counter, and says "Please pay this into my account". So Mr Higgins pays the imaginary money into Mr Jones's account.

So what's the situation now on 3 Man Island. Mr Higgins taps a few keys on his computer, and the money in the accounts is as follows:
1. Mr Smith. £10000 in the red.
2. Mr Jones. £10000 in the black.
3. Mr Higgins still has £1000 in reserves, in his safe.

The £10000 is negotiable currency. Mr Jones can spend it any time he likes, provided of course that everybody else on 3 Man Island believes that the money is real. He could, for example, go to Mr Robinson and offer him £10000 for his boat.

Points to note:

1. The total amount of money in circulation in the island's economy is £10000. It has been created by Mr Higgins by the simple expedient of pretending he had the money, and lending the money he pretended to have.

2. The total amount of money on the island, however, is only £1000. That is a very important point. In a real economy the sum total of money is only a tiny fraction of the amount in circulation. For practical purposes you can say that the total amount of money is zero, even though the amount in circulation is large.

3. The total amount of credit on the island is equal to the total amount of debt. That is because, quite simply, all money is created as debt by private banks. So when you next hear on the news that we're all in debt, you can say "Of course we're all in debt, stupid. That's the amount of money necessary for the economy to function." To have enough money in circulation for the economy to function, it all has to be borrowed. If everybody paid back their debts tomorrow, there would be zero money and the economy would collapse.

4. If your account is in credit, you are forcing somebody else to be in debt by that amount. This is the opposite of what we are told. We are told that we must save so that the banks can have money to lend out. Nonsense. The more we save, the more we cause other people to go into debt. This is an unavoidable consequence of the maths of how the system works.

Note that this is exactly the opposite of the way it is supposed to happen. We are told that money is deposited in the bank, and then the bank lends it out. If that were the case, Mr Higgins would have to wait for Mr Jones to deposit £10000 in his account before he could lend it to Mr Smith. Where would Mr Jones get the £10000 from? The inference is that the government creates it in the first place. Nothing could be further from the truth. The government are responsible for creating notes and coins. That is about 3% of the money in circulation. The rest is created by the banks, by fractional reserve accounting. That means they pretend to have it, and as long as everybody believes the money is real, it becomes real for practical purposes. That is probably why we are never told about this. There is no attempt to hide what goes on. It is common knowledge among those who take the trouble to find out, but it is almost unknown amongst the general public, even those with PhDs in engineering.

Like most engineering models, you need to make it a bit more complicated to mimic the real world. In reality there is not one bank but many banks competing. But this does not affect the basic principle of how money comes into existence.

Well as long as the system works, why worry? The system has been running for about 300 years, and it has created the money necessary to bring the industrial revolution into existence. True, it does have some advantages. If we had had to rely on metal coins to fund the industrial revolution it might not have happened. But it also has serious disadvantages. The chief of these is that the system can only function by people going into debt. As I said earlier, for the economy to function the people of this nation have to borrow enough money into existence to allow it to function. It also means that if your bank account is in the black, you are forcing somebody else to be in the red by the same amount, since the total money in the system is equal to zero plus notes and coins (v. small). A little bit of further thought shows that the system has inherent instability. When people lose confidence they tend to pay back their debts, shrinking the amount of money in the economy and causing further loss of confidence. The "stop/go" economy is inherent in the system.

So should we go on using this system to run the world's economy? Economists will tell it's the only system that could possibly work, and any other system would bring chaos. Maybe. On the other hand, it's also the only system in which the banks get a cut of every transaction. Most economists salaries are paid directly or indirectly by bankers, so they would say that, wouldn't they? All we really need for the economy to function is a monetary system in which people have confidence, such that the correct amount of money is always in circulation for the economy to function without overheating or recession. There are much better ways of doing this than leaving the bankers to do it. We don't need a system in which everyone has to be in debt for it to work. Many people have given thought to this, but (surprise surprise) their voices are never heard.

regards
John Carver

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