The Ecology of Money

Richard Douthwaite

• Publisher: Green Books
• Year: 2015
• ISBN:
  9780857843708
• Topic: Economics
• Subtopic: Environmental Economics
• Index: Economics

In this Schumacher Briefing, Richard Douthwaite argues that just as different insects and animals have different effects on human society and the natural world, money has different effects according to its origins and purposes. Was it created to make profits for a commercial bank, or issued by a government as a form of taxation? Or was it created by its users themselves purely to facilitate their trade? And was it made in the place where it is used, or did local people have to provide goods and services to outsiders to get enough of it to trade among themselves? The Briefing shows that it will be impossible to build a just and sustainable world unless and until money creation is democratized.

Chapter 1

Commercially-produced Money

Let’s start by asking the first of the questions identified in the Introduction about the type of money we know best: a typical national currency. Many people will be surprised that the answer to the first question ‘Who creates it?’, is not ‘the government’, nor ‘the country’s central bank’, but ‘the commercial banks’. Yet there is no conspiracy to hide this fact. In his well-known economics textbook, David Begg states: “Modern banks create money by granting overdraft facilities in excess of the[ir] cash reserves”.⁷ He adds: “Bank-created deposit money [the money that people can draw from their bank accounts] forms by far the most important component of the money supply in modern economies.”

Dishonest goldsmiths

So how did money creation come to be privatized? This query takes us back to the late middle ages, when gold and silver coins were the main form of money. During this period, if anyone obtained a large amount of coins (more than they felt safe with) then they would deposit them with the local goldsmith, the only person in the area with a reliable strongroom or safe. The goldsmith would give a receipt in exchange. The oldest surviving British record of money being deposited with a goldsmith is dated 1633.⁸ Initially, depositors called at the goldsmith to reclaim their coins whenever they wanted to make a payment, but as time went on some of them found it more convenient to transfer the goldsmiths’ receipts instead. Thus, by 1670, receipts frequently had the words ‘or bearer’ on them as well as the depositor’s name. As coins were heavy and risky to carry around, the new receipts quickly became the preferred method of settling bills.

Shortly afterwards, the goldsmiths would have noticed that they had many coins in their vaults which were never taken out. History doesn’t record the name of the first goldsmith who was both smart and dishonest enough to realize that, as it was unlikely that all his customers would present receipts and demand their coins at once, he could make money by lending out a proportion of the coins entrusted to him and charging the borrowers interest on them. Indeed he might not actually have to part with any of the coins at all, because if he gave borrowers receipts with which to make their payments (instead of cash), it would be rare for those who had received the false receipts to bring them in and ask for real money. The only problem was to decide how many such receipts he could issue without being found out if receipt-bearers did actually want to collect coins in exchange. If several receipt-bearers came in a short period, and there wasn’t enough gold and silver money in his safe to pay them, he’d be disgraced and forced out of business.

This piece of sharp practice by a long-dead goldsmith laid the foundations of modern fractional reserve banking—the system under which banks maintain reserves of coins and notes in their vaults worth only a fraction of the cash they would have to provide if all their customers came simultaneously to demand the money they were entitled to withdraw. The goldsmith had created purchasing power (in other words, money) by issuing receipts that, in total, involved him in promising to pay out more gold and silver money than he had in his safe. Modern banks create money in the same way, by promising to pay out more paper notes and coins than they possess.

How banks create money

Begg explains how modern banks create money in the following way. He assumes that there are ten banks, each trying to maintain its lending at the point at which the amount of cash held in reserve in its vaults, or with the central bank, is equal to 10% of the amount that its customers could draw out from their accounts. The total amount that account-holders could withdraw (in other words, the bank’s liability to its customers) not only consists of their deposits, but also any loan and overdraft facilities that they may have been granted but which they have not yet drawn upon.

If one of the ten banks receives a lodgement of £100 in cash, both the amount of notes and coins it holds in its safe, and the total of its liabilities to its customers, rise by that amount. However, the bank’s liability-to-cash-reserve ratio is no longer the 10:1 it wants to maintain. It has £90 too much cash and if it increased its liabilities by lending £900 to its customers, its desired ratio would be restored. But should it make the £900 loan? What would happen if the person granted the new overdraft drew all £900 out as cash and spent the money in businesses that deposited their takings in rival banks? In this case, the bank’s liability-to-cash-reserve ratio would be greater than 10:1, and there would be a risk that the bank might be unable to cash its customers’ cheques if an unusual number of them came at the same time—perhaps just before Christmas, when a lot of cash enters circulation.

The only safe course for the bank to take is to lend out £90 rather than £900. Then, if the entire amount gets withdrawn as cash and ends up in other banks, its cash reserve ratio will still remain within the desired limit. In his explanation Begg assumes that the £90 is withdrawn and spent in such a way that all ten banks have an equal amount (£9) deposited with them. He could have equally, and more plausibly, assumed that it ended up with the banks in proportion to their size. No matter, the outcome would have been the same. If each bank now lends out 90% of whatever deposit it has received, that will create further deposits throughout the banking system. And if 90% of that money is lent out too, through an infinite number of lending rounds, then the banking system as a whole (rather than the bank which received the initial deposit) will have generated £900 in loans. This occurs just on the basis of the original reserve surplus of £90 in cash. In other words, the original £100 cash deposit allows the ten banks to increase their loans to the public (and hence the money supply), by £1,000.

Box 1: How the Bank of England controls the money supply

The explanation of the way banks create money makes it appear that the amount of notes and coins in circulation, coupled with the reserve ratio the banks set themselves, determine the extent of a country’s money supply. Actually, this is not quite the case. In most countries, the central bank does not attempt to control the total value of the notes and coins in circulation. In Britain, for example, the Bank of England (BoE) will sell as many notes and coins to the commercial banks as they wish. It simply debits the accounts these banks operate with it by the appropriate amount. So the cash base of the British monetary system is not just the notes and coins that the banks have in their branches, but whatever money they have in their accounts with the BoE as well.

Another minor difference is that it is not the commercial banks themselves that decide the reserve ratio they want to follow, but the central bank to which they report. For example, in Britain until 1981, the BoE specified the total amount of notes and coins a bank must have available at its branches, plus the amount on deposit with it, in relation to the amount of money the bank had created by granting its customers overdrafts and other loans. This meant that if at any time the BoE felt that the amount of money in circulation was too high and was causing inflation, it could force banks to reduce their lending by requiring them to deposit more funds in their accounts. A reduction in the reserve ratio from 20:1 to 10:1 would have halved the total of the amount of money that banks could create.

That system still applies but in a less rigid form. Responding to pressure from the commercial banks (who argued that they would otherwise lose overseas business to foreign banks), the BoE abolished its minimum reserve ratio in 1981. It now agrees a reserve requirement individually with each bank. This reflects both the level of competition the bank is experiencing from its foreign rivals, and the lending and other risks that it is perceived to be running. This change has weakened the BoE’s ability to control the money supply by varying the reserve ratio.

The second way that the BoE can control the money supply is by ‘open market operations’. These involve the BoE in buying, or selling, interest-bearing bonds. If it sells bonds, the purchasers (financial institutions or members of the public), pay for them by writing out cheques drawn on their commercial bank accounts in favour of the BoE. Subsequently, the BoE debits the accounts that the commercial banks operate with it by the relevant amounts. Unless the commercial banks make up these debits in some way, the volume of lending they are able to make (and thus the amount of money in circulation), has to be reduced by a figure set by whatever the reserve ratio they had agreed with the central bank. If the ratio were 20:1, their lending would have to be reduced by twenty times the amount of bonds that the BoE had sold.

If the reserve requirement is increased, or the amount in its account with the BoE falls, a bank could maintain its lending by raising more capital and depositing this with the central bank. The new capital could come from selling more shares, or from making a trading profit and paying that to the BoE rather than distributing it to shareholders as a dividend. For many years the Irish commercial banks attempted to justify their huge profits with the argument that they were necessary to enable the banks to lend enough money to finance a rapid expansion of business activity. Profits made by the UK’s twelve banks and former building societies quoted on the Stock Exchange are high too. In 1998/9 they totalled £22bn, around £400 for every man, woman and child in the country. If the BoE wants to increase the amount of money in circulation, it can do so by buying up bonds that it, or perhaps a local council, had issued previously.

The third way in which the BoE can control the national money supply is to alter the interest rate at which it lends funds to banks that fail to keep positive balances in their accounts with it. According to an official BoE statement,⁹ this is the main way that the money supply is controlled at present. The technique involves keeping the banking system short of money and then lending the banks the money they need at an interest rate that the BoE decides. The BoE statement explains, “If, on a particular day, more funds move from the private sector [i.e. non-government accounts held in the commercial banks], to the Government’s accounts than vice versa, for example because banks’ customers are paying their taxes, then the banking system will be short of the funds needed [by the commercial] banks to maintain positive balances on their accounts at the Bank.” Alternatively, if the government is spending more than it is collecting, the BoE can create a shortage by selling bonds itself. The Bank then lends the banks the funds they need to keep their accounts with it in credit at a rate of interest that sets the rates at which the banks lend to each other, and to their customers. And that rate of interest, of course, determines how much the banks’ customers borrow, and hence the national money supply.

So the answer to question one, ‘Who creates money?’, is that almost all of it is created by commercial banks, although, as Box 1 explains, central banks limit the extent to which they are able to do so. Most people find this answer quite staggering. Even bankers do. Lord Stamp, a director of the Bank of England at the time, commented in 1937: “The modern banking system manufactures money out of nothing. The process is perhaps the most astounding piece of sleight of hand that was ever invented.” As the economist J. K. Galbraith remarked: “The process by which banks create money is so simple the mind is repelled. Where something so important is involved, a deeper mystery seems only decent.” ¹⁰

Let’s move on to our other questions:

Question 2: Why do commercial banks create money? To make profits.

Question 3: How do they create money? By granting loans on which interest is paid. This means that almost all the money in a country exists because someone, somewhere, has gone into debt and is paying interest on it.

Question 4: When do they create money? Whenever there is a demand for loans at interest rates above that at which they can borrow from the central bank.

Question 5: What gives the money its value? This hasn’t been mentioned yet, but the answer is purely its acceptability to other people. The value is not guaranteed. No one is standing by prepared to supply a fixed amount of something tangible in exchange, as they were in the days when paper currency could be exchanged on demand for a definite weight of gold. The value of modern money is constantly eroded by inflation. It is backed by nothing at all.

Question 6: Where is the money created? In the banks’ head offices, wherever those may be. For although decisions on individual loans are made in hundreds of bank branches around the country (and the book-keeping side of money creation is done there too), each branch works within limits and to policies set by its head office. The profits generated by the lending also flow to the head office. Places using bank-created money for trading locally can only obtain money if they are prepared to borrow it on the same terms as other bank customers, or if they can sell goods and services to the outside world to earn money that people in other communities have borrowed. The fact that there is a branch bank in the community means nothing.

A little more discussion is needed to answer the intriguing problems posed by Question 7, namely ‘How well does this sort of money fulfil the three functions of money?’ and ‘What are the consequences of allowing commercial companies to create it in this peculiar way?’ The first thing to note is that as bank-created money only exists because people have borrowed it, it will cease to exist if they pay their loans off. This is because when borrowers assemble the funds they need to repay their loans and lodge them with their banks, those funds cease to be available to other people to use for trading unless the bank lends them out again. The money supply therefore contracts. Consequently, people need to take out new loans to maintain the amount of money in circulation.

Circumstances could easily arise in which they would not be prepared to borrow more, and the economy could plunge into a depression. For example, suppose a crisis overseas caused exports to fall sharply. As redundancies at home increased and people lost their confidence about their future prospects, they might be unwilling to take out new loans. However, if they continued to meet the interest and capital payments due on their existing debts, thereby reducing the total sum they owed, then the amount of money in circulation in the country would fall. Unless ‘the velocity of circulation’ of money increased (in other words, money moved from account to account fast enough to compensate for the fact that there was less of it about), then the volume of buying and selling going on in the country would also fall. Indeed, this would be bound to happen at some point when the rise in the velocity of circulation of the money became unable to counteract the diminishing supply. There is nothing remotely contentious about this. After all, it is the reason why central banks put up the interest...