The Supply of Money and the Great Banking Confidence Trick.

In this discusssion we are talking about 'money' in all its forms; not just 'cash', ie notes and coins, which make up only a small fraction of 'money'. Money is what we use to buy things and its commonest form is as bank accounts, particularly current accounts, in the commercial banks. These are alternatively known as demand deposits or sight deposits, and are referred to as being chequebook (or checkbook) money or credit money. Cash and credit money together are often given the name M1.

Banks create money.
Commercial banks and some other institutions may, by law, create money from nothing. This is done by setting up a current account deposit for an individual or business which is balanced by a loan, or overdraft, owed by that customer. The bank's books balance and the customer can set about spending the new money from his or her current account. It is important to realise that this means that a bank can lend money which has not been previously deposited. The banks may even use this new money to pay bills; for a building, for example. As payment the builder is given a current account deposit in the bank's books. This is the bank's liability. It is balanced by an asset, the value of the building.
Unfortunately the subject of the creation of money is not always clearly explained in textbooks.

The Central Bank of a State acts as the banker for the commercial banks and for the Government, and in this position oversees the commercial banks. It also issues cash as needed to the commercial banks.

There are two other sorts of money which are regarded as being equal to, and convertable into, cash. These are the deposits which commercial banks have in the Central Bank. The other is the short term securities, or liquid assets, such as those securities issued by the government in return for loans from the commercial banks. These may be called Treasury Bills.
Cash, liquid assets (eg Treasury Bills) and Central Bank deposits make up what is called the commercial bank's "cash base". They may be converted one to the other.

Below is shown the outline of a balance sheet for a commercial bank (representing all commercial banks) with some hypothetical values in millions of pounds.

Items marked * make up the bank's cash base.

Another reason why the commercial banks must not create too much new money is the need for them all to "keep in step" with each other. If one bank creates new money and the others do not, then the new money will be spent and finish up as deposits distributed between all the banks. Money will have to be transferred from the issuing bank to all the other banks in the holdings in the Central Bank. This means the cash base of the issuing bank will decrease and it will come under pressure to stay within its cash base ratio. To do this it will have to call in loans to reduce total deposits.

If the government spends more than it raises in taxes then its 'public deposits' in the Central Bank fall. Correspondingly the holdings of the commercial banks in the Central Bank rise by the same amount. These holdings are a large part of the 'cash base' of the commercial banks. With an increased 'cash base' the commercial banks can then lend more, if they want to, and if there is demand for money.

When the banks increase the money supply like this the surprising thing is that they are able to charge interest on this newly created money! They do not pay interest on the current accounts which they reciprocally create.
The other aspect of this creation is that if the banks create more money than is matched by the increase in the value of national production then there is more money in circulation than goods and services to satisfy the demand. There is price inflation. Thus inflation is not directly in the hands of the state.

Virtually all the money in use at the present time has been created in the past by the commercial banks; and they have charged interest on the money ever since, from the time of its creation, even though the debt has changed hands several times! Also all the inflation which has occurred has been caused by the commercial banks.

As we said, if the Government spends more than it raises in taxes then its public deposits in the Central Bank fall (or go negative) and the deposits of the commercial banks in the Central Bank rise. The government can do two things.
a) It can issue long term securities to the people. The government's public deposits in the Central Bank rise and the deposits of the commercial banks fall.
b) It can issue short term securities, ie Treasury bills, to the commercial banks. This gives relief in that the government's public deposits rise and the commercial banks deposits fall, but the commercial banks have given up some of their cash base only to have it replaced by some cash base of a different kind; ie the Treasury Bills.
The Government has more money to spend. The purchasing power of the system has increased. New money has been created. So this is a second way in which the commercial banks can create money from nothing at no cost to themselves.

Unfortunately many radical writers are not clear about the nature of the creation of money. For example Will Hutton, in his best selling book "The State We're In", talks of the Government 'creating money'. He writes:
"In today's capital markets the equivalent to printing money is to issue Treasury Bills, short term IOU's which are bought by the banking system. The banks part with cash which the government can spend, and now hold an asset - a Treasury Bill - which counts as cash as far as banks are concerned. They can use the bills to settle accounts with each other, and they are always realisable for a predictable amount of cash in the London money markets. In effect the government has printed money."
That is one way of looking at it. The mechanics are right, but really the government has allowed the banks to create the money! It has then borrowed that money from the banks; and acquired also a liability for the interest. If the government was really 'printing money' it would not need to pay interest to the commercial banks for that money.
Even worse, from the point of view of the money supply, the banks can treat the Treasury Bills as part of their cash base, and can then lend some multiple of this to the public. That is they can create yet more new money on which they can charge interest.

The United Kingdom has a unique system using "discount houses" to manage the short term loans. However the principles are as described here.

Yet the money system we have is an historical accident. It could easily be replaced by a system in which the government really did create new money. The government would then lend to the commercial banks any new money which they required, and charge them interest on the money. The profits from the creation of the new money would fall to all the people and not just to the banks.
The government would also create, for itself, any new money it needed, up to the amount which growth in the economy could maintain. It would only need to borrow any amount greater than this.
In addition, in this new system, the government would have full control over the important matter of the magnitude of the money supply.

THE END