17 4.2 Who creates money?

In our discussion so far, we’ve established that money is fundamentally defined by its function – anything that serves as a medium of exchange, a store of value, and a unit of account can be considered money. The example of farmer money illustrates this idea in a simple and relatable way, showing that money doesn’t have to take a specific form as long as it fulfills these roles. However, in the modern economy, the nature of money is far more complex, shaped by financial systems, institutions, and policies.

Now, we take our understanding of money a step further by exploring how it actually comes into existence in today’s world. This leads us to an essential question: Where does money originate? The simple answer is that money comes into being as a result of economic activity or a production process.

Imagine you’re a brilliant entrepreneur with an innovative idea that could revolutionise the tech world. Your invention is a ring that functions as a smartphone. From the diamond on the ring, a screen can project, allowing you to watch videos, make calls by reading your thoughts, send texts as you dictate them, organise your daily tasks, and even monitor your health by checking your blood pressure and other vital signs.

To turn this idea into reality, you need to negotiate with various key players in the production process, such as engineers and designers. After those negotiations, you calculate the costs and determine how much money you’ll need to bring this project to life. To fund this venture, you approach a bank to request a loan.

In this way, money is created to fuel economic activity. It begins as an idea, turns into a plan, and eventually requires capital to bring that idea into the market. Money is introduced into the economy through such productive ventures, financing new technologies, businesses, and industries that drive growth and progress.

Let’s say you need £1 billion for a project, and you walk into a bank. In the traditional view of banking, the bank would need to have that same amount of money available to lend to you. This could come from deposits made by other customers or from newly printed money supplied by the government to the banking system. In this scenario, the bank can only lend money if it physically has the funds.

However, according to the modern concept of endogenous money theory, banks don’t need to have the money on hand to grant you a loan. Instead, they evaluate your project, your business plan, and your creditworthiness. If everything checks out, they approve the loan and create the money digitally. This process happens instantly – within a nanosecond. The money, often referred to as “credit money” in economic literature, is simply added to your account electronically. You can open your banking app and see that the £1 billion has been deposited and is ready for you to use. It’s that quick and seamless. This is known as “loans create deposits”, which differs from traditional orthodox theories that suggest deposits must exist before loans can be made. In reality, it’s the act of lending that creates deposits, not the other way around.

What if you ask the bank to provide you with your money in physical cash, specifically in banknotes? First, the bank will likely offer to help by suggesting alternatives, such as transferring the funds electronically, especially if you need to make payments, for example, to the employees working on your project, rather than giving you large sums of cash.

Take the UK as an example: even if you have billions of pounds in your account, a typical bank branch will only provide you with up to £1,000 in cash per day. If you visit a main branch in town, they might increase this limit to £2,000 in banknotes. For anything beyond that, you would need to schedule an appointment in advance.

While it’s highly unlikely, let’s imagine you request £1 billion in cash. The physical money, or banknotes, is referred to as central bank money, and in the UK, the Bank of England is responsible for printing it. If this were the case, your bank wouldn’t have such a large amount on hand. They would need to contact the Bank of England, which, as the lender of last resort, is responsible for providing liquidity to banks when necessary.

The Bank of England would then supply the £1 billion to your bank to prevent a financial crisis. If they didn’t, and you couldn’t access your money in cash, you might take to social media, warning others that your bank doesn’t have the funds. This could spark a panic among other customers who would rush to withdraw their money, fearing their savings are at risk. As more people try to withdraw cash, the bank could face a liquidity crisis, potentially leading to its collapse if the Bank of England doesn’t step in. Events like this have occurred in financial history, leading to significant consequences.

In reality, no one typically asks for £1 billion in cash. Most of us only keep a small amount of physical money on hand. Think about your own bank account – how much of it do you actually hold in cash? Thanks to modern payment methods, we rely less and less on physical money. For instance, just 10 years ago in the UK, you’d need cash to pay for a bus ride, but now you can simply tap your bank card. Banknotes and central bank money are slowly disappearing from our daily lives.

There are only a few situations where we still need physical money, and it’s becoming rarer for places to ask for cash payments. Personally, I keep a small amount of cash for specific situations, like when volunteering at a local event where payment options are limited, and we contribute a small sum in cash. But these instances are becoming less common as digital payments continue to dominate our lives.

When a bank provides a loan of £1 billion, that loan creates a deposit, which appears in your account. If you then request the same amount in cash, the central bank will provide it in the form of banknotes, and an equivalent amount of reserves will be created by the central bank.

Whenever a bank requests liquidity or cash from the central bank, the central bank sets a price for that request, known as the interest rate. This rate is determined and announced in advance, so any financial institution needing central bank money knows the cost they will have to pay. Essentially, the interest rate is the price of borrowing money from the central bank. Banks and other financial institutions operate by taking the central bank’s interest rate and adding a markup. For example, if the Bank of England sets its interest rate at 3%, a bank might add a 1% markup. This means they would offer loans or mortgages at an interest rate of 4%, which covers both the central bank’s rate and the bank’s own margin.

When the bank creates a loan for you, £1 billion appears in your account. You then use this money to pay your employees and cover other production expenses, transferring the funds into their accounts. Once the production process is complete, some of those employees may want to buy one of the rings they helped produce, and the money returns to your account through their purchases.

Eventually, when you’ve received enough money, you pay back the loan to the bank, and the money essentially disappears. In this way, money is created when the bank issues the loan and disappears once the loan is repaid.