From the horses mouth: How money is created

The Bank of England published quite a nice briefing today entitled “Money creation in the modern economy“. It won’t surprise you if I tell you that a lot of central bank publications are quite heavy going for the lay person, but this one is actually quite an easy read. It sets out to bash a couple of common myths in how bank lending words, some of which is quite quotable, which is what I’m going to do now.

It’s a very common belief that banks take money from savers and lend it out to borrowers, and in doing so play an intermediary role. I think this belief is sometimes used to bolster the view that savers are virtuous and more saving would be a very good thing. While saving is a very good thing for an individual or household, if everyone saved as much as the could, we get into a paradox of thrift type situation – not good. So do banks take savers money and lend it to borrowers? Here’s what the Bank of England say:

“One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them. In this view deposits are typically ‘created’ by the saving decisions of households, and banks then ‘lend out’ those existing deposits to borrowers, for example to companies looking to finance investment or individuals wanting to purchase houses.

In fact, when households choose to save more money in bank accounts, those deposits come simply at the expense of deposits that would have otherwise gone to companies in payment for goods and services. Saving does not by itself increase the deposits or ‘funds available’ for banks to lend. Indeed, viewing banks simply as intermediaries ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. This article explains how, rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.”

So rather than lending out savers deposits, what banks actually do when they make a loan is to create new money, which then becomes a deposit. The Bank of England paper explains it like this:

“Commercial banks create money, in the form of bank deposits, by making new loans. When a bank makes a loan, for example to someone taking out a mortgage to buy a house, it does not typically do so by giving them thousands of pounds worth of banknotes. Instead, it credits their bank account with a bank deposit of the size of the mortgage. At that moment, new money is created. For this reason, some economists have referred to bank deposits as ‘fountain pen money’, created at the stroke of bankers’ pens when they approve loans.”

These things are not well understood by the general public, and it’s quite rare to find an honest attempt to explain them from an official source, so this paper is very welcome. Helpfully, the BoE produced this short video to accompany the paper. Have a watch!

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