Money… how it works

A short, clear video explanation by Positive Money Brighton Group member Michael Reiss (@Mickanomics) on how money works. Highly recommended.

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up the down escalator

up the down escalatorOpinions on the causes of poverty and social inequality in our society seem to vary enormously depending on who you talk to. Just the other day I overheard someone attributing poverty, in a moralistic fashion, to the sheer passivity, indolence and lack of drive of the poor – the suggestion being that if only the poor had the ‘real moral fibre’ to overcome these negative characteristics, they could save themselves from hardship, destitution and (presumably) regular visits to either payday loan shops charging interest at 4214% APR or the local branch of Cash Converters to pawn their possessions.

The reality of course is that poverty is a problem born of a number of complex social drivers. It brings misery to the lives of millions of people, and the presumed absence of “real moral fibre” has nothing at all to do with it. It is estimated for instance, that globally a hundred million people were driven into poverty as a direct result of the 2008 financial crash.

As the saying goes; “There, but for the grace of God, go I.”

I am however also struck by the observation that, even amongst those who are most enlightened on the causes of poverty, there is – not so much a misunderstanding – as an ‘under-understanding’ of other, more insidious mechanisms that drive this corrosive social blight.

The first thing to understand, and as mentioned in my previous blogpost, is that virtually all money (97% of it) is created as debt by the banking system. In essence; the banking sector is collecting interest from us at an average rate of around 5% per annum on nearly every pound in existence. It is worth re-emphasising at this point an aspect of this that most people will probably find rather unpalatable; Under the current banking system, debt is not a choice – if we are to have money, there has to be debt – it really is as simple as that.

So, for the non-banking economy (i.e. 98% of the UK’s population) to have a money supply with which it can trade, it has to pay around 5% of all the money in existence to the banking sector each year.

As the Positive Money campaign points out, this state of affairs results in an inexorable and relentless transfer of wealth from the non-banking sector to the banking sector, and shifts the baseline of poverty down to zero or negative, rather than a low-but-positive bank balance. Since it is those on below average incomes that end up with much of the debt, and furthermore, that as ‘poor credit risks’ they suffer the highest average interest rates on that debt, it is the poor who in effect, subsidise the rich. As a recent article in The Guardian convincingly argued; under the current banking system, inequality becomes a “mathematical certainty”.

Now, going hand-in-hand with this is the often overlooked question of money destruction.

That is, if nationally the amount of debt being repaid to the banks exceeds the amount of new money (debt) being issued by them, the money supply shrinks. and there is currently no way out of this impasse. The banks are presently furiously deleveraging in order to reduce their exposure to risk in an uncertain economic climate, and the Bank of England’s “Quantatitive easing” program, ostensibly created to pump new money into the economy, has arguably had precisely NIL effect in terms of increasing the money supply.

Simply put; if the banks aren’t confident of the state of the economy they simply will not lend money, there is consequently a decreasing amount of money in the economy with an ever increasing number of people trying to access what remains.

When you set this alongside the finding of the Institute of Fiscal Studies in 2012 that “pre-tax earnings in the UK fell by 7.1% in real terms in 2010–11, mostly due to falls in the real earnings of those employed as opposed to a fall in the numbers employed”, it becomes clear that what this means for the poor is that they are perpetually engaged in climbing “up the down escalator” where any attempt at upward financial and social progress is utterly nullified by the downward effect of ever increasing debt and the shrinking money supply.

Poverty and social inequality is a direct attack on people’s fundamental rights. It grieviously limits the opportunities they have to achieve their full potential, and exacts a high cost to society – both in negative social effects and in the financial cost of welfare – and it hampers sustainable economic growth. Poverty reflects fundamental failures in the system for redistributing resources and opportunities in a fair and equitable manner. These lead to deep-seated inequalities and thus to the stark contrast of excessive wealth concentrated in the hands of a few, while others are forced to live restricted and marginalised lives, even though they are living in a (relatively) rich economic area.

Finally, it is worth considering that it is very probable that the upwards redistribution of income caused by the current system cancels out any downwards redistribution of income through the welfare state. In fact, it is entirely possible that the welfare state in it’s current form may only be necessary because of the current design of the banking system, and could be significantly scaled back if the method of creating money was reformed.

It is high time that we changed this deleterious state of affairs.

It’s time to switch off the escalator.

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the magic money tree

moneytreemediumIn a pre-Budget speech recently, David Cameron argued that there was no “magic money tree”. He was, in this instance of course, referring to the apparently fraught question of government spending and borrowing, but interestingly enough, for the private banks at least, there does indeed appear to be a “Magic Money Tree”.

It is a relatively little known fact that 97% of the UK money supply is created by private banks as debt – with cash issued by the Bank of England making up the remaining 3%. Furthermore, and contrary to popular opinion, the banks do not lend out the money of their depositors. When they make a loan they literally create money out of… nothing.

To clarify, when you buy something with your credit card, or take out a mortgage or a personal loan, the bank does not lend you money that they actually possess; they simply type some numbers into a computer and create a deposit in a new loan account for you. This deposit, upon which you as the borrower shall draw, is a ‘liability’ of the bank to you. It is thus recorded on the bank’s balance sheet as thus.

Simultaneously, and having at first secured from you a signed contract of a promise to pay them back the loan sum [the principle] plus interest, the bank records your ‘promise to pay’ as an asset on their balance sheet. This asset has intrinsic value, and can be traded as any other asset can be, as was the case with the bundling and trading of sub-prime mortgages in the USA that preceded the 2008 crash.

It is by this mechanism, that the banking sector is effectively collecting interest from all of us at an average rate of around 5% per annum on nearly every pound in existence. And those pounds were never money in any real sense; they were simply figures entered into a computer at the point of creation of a new loan.

Now, an obvious result of this state of affairs is that the banks always have less real money in their reserves than the total of that which their customers have in their accounts. The banks simply presume (most of the time correctly) that not all of their customers are going to want to withdraw their cash at the same time. However, as in the famous case of Northern Rock, if enough people go simultaneously to the bank to withdraw their money, the bank can, in the worst case scenario, simply not have enough money to cover those withdrawals. This is known as a ‘run on the banks’, and can render banks insolvent overnight. It is their living nightmare.

To illustrate this sometimes precarious state of affairs, consider this;

On the 31st of January 2007 banks held just £12.50 of real money (in the form of electronic money held at the Bank of England) for every £1000 shown in their customers’ accounts.

Whichever way you slice it; THAT is living dangerously.

The amount of money that the banks create in this way is not determined by regulation, reserve ratios, the government OR the Bank of England, but by-and-large by the confidence of the banks at any given time: When banks are confident, they create new money loans and bank deposits for borrowers – when they are fearful, they reduce lending and hence limit the creation of new commercial bank money. In these circumstances, when perhaps more loans are being repaid than are being issued, the money supply shrinks, and you have what we have in the UK now – recession.

This effectively means that private companies (i.e. banks) are controlling the UK money supply, and it is they, in being the ones who decide who gets a loan and for what purpose, who broadly get to decide what the overall spending priorities of our nation’s economy are.

Since the mass deregulation of the banking and financial sectors in the late 70’s, the banks favourite loans have proven to be those that fund asset speculation;  the housing market (secured lending to individuals & real estate lending), and financial speculation in particular. This is a result of their overwhelming preference for lending against collateral.


Take a look at this other chart; and note when bank-created money really took off.


As you will see; the chart above only goes back to 1870, and not back to the formation of the Bank of England (1694), so here’s one final little idea to turn over in your mind;

From the time of the formation of the Bank of England in 1694, it took banks a little over 300 years – up to 2001 – to create the first trillion pounds of the UK money supply.

It took them just another EIGHT YEARS to create the second trillion…

Coming soon: Impacts

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