The Bank of England's dose of honesty throws the theoretical basis for austerity out the window

The truth is out: money is just an IOU, and the banks are rolling in it
The Bank of England's dose of honesty throws the theoretical basis for austerity out the window



Back in the 1930s, Henry Ford is supposed to have remarked that it was a good thing that most Americans didn't know how banking really works, because if they did, "there'd be a revolution before tomorrow morning".

Last week, something remarkable happened. The Bank of England let the cat out of the bag. In a paper called "Money Creation in the Modern Economy", co-authored by three economists from the Bank's Monetary Analysis Directorate, they stated outright that most common assumptions of how banking works are simply wrong, and that the kind of populist, heterodox positions more ordinarily associated with groups such as Occupy Wall Street are correct. In doing so, they have effectively thrown the entire theoretical basis for austerity out of the window.

To get a sense of how radical the Bank's new position is, consider the conventional view, which continues to be the basis of all respectable debate on public policy. People put their money in banks. Banks then lend that money out at interest – either to consumers, or to entrepreneurs willing to invest it in some profitable enterprise. True, the fractional reserve system does allow banks to lend out considerably more than they hold in reserve, and true, if savings don't suffice, private banks can seek to borrow more from the central bank.

The central bank can print as much money as it wishes. But it is also careful not to print too much. In fact, we are often told this is why independent central banks exist in the first place. If governments could print money themselves, they would surely put out too much of it, and the resulting inflation would throw the economy into chaos. Institutions such as the Bank of England of US Federal Reserve were created to carefully regulate the money supply to prevent inflation. This is why they are forbidden to directly fund the government, say, by buying treasury bonds, but instead fund private economic activity that the government merely taxes.

It's this understanding that allows us to continue to talk about money as if it were a limited resource like bauxite or petroleum, to say "there's just not enough money" to fund social programmes, to speak of the immorality of government debt or of public spending "crowding out" the private sector. What the Bank of England admitted this week is that none of this is really true. To quote from its own initial summary: "Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits" … "In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money 'multiplied up' into more loans and deposits."

In other words, everything we know is not just wrong – it's backwards. When banks make loans, they create money. This is because money is really just an IOU. The role of the central bank is to preside over a legal order that effectively grants banks the exclusive right to create IOUs of a certain kind, ones that the government will recognise as legal tender by its willingness to accept them in payment of taxes. There's really no limit on how much banks could create, provided they can find someone willing to borrow it. They will never get caught short, for the simple reason that borrowers do not, generally speaking, take the cash and put it under their mattresses; ultimately, any money a bank loans out will just end up back in some bank again. So for the banking system as a whole, every loan just becomes another deposit. What's more, insofar as banks do need to acquire funds from the central bank, they can borrow as much as they like; all the latter really does is set the rate of interest, the cost of money, not its quantity. Since the beginning of the recession, the US and British central banks have reduced that cost to almost nothing. In fact, with "quantitative easing" they've been effectively pumping as much money as they can into the banks, without producing any inflationary effects.

What this means is that the real limit on the amount of money in circulation is not how much the central bank is willing to lend, but how much government, firms, and ordinary citizens, are willing to borrow. Government spending is the main driver in all this (and the paper does admit, if you read it carefully, that the central bank does fund the government after all). So there's no question of public spending "crowding out" private investment. It's exactly the opposite.

Why did the Bank of England suddenly admit all this? Well, one reason is because it's obviously true. The Bank's job is to actually run the system, and of late, the system has not been running especially well. It's possible that it decided that maintaining the fantasy-land version of economics that has proved so convenient to the rich is simply a luxury it can no longer afford.

But politically, this is taking an enormous risk. Just consider what might happen if mortgage holders realised the money the bank lent them is not, really, the life savings of some thrifty pensioner, but something the bank just whisked into existence through its possession of a magic wand which we, the public, handed over to it.

Historically, the Bank of England has tended to be a bellwether, staking out seeming radical positions that ultimately become new orthodoxies. If that's what's happening here, we might soon be in a position to learn if Henry Ford was right.

http://www.theguardian.com/commentisfree/2014/mar/18/truth-money-iou-bank-of-england-austerity


Well, that turned everything on it's head!

at one time the banks could only loan a percentage of the money they actually had, eventually that percentage they could loan grew and grew and now it's worthless so hardly surprising...

Nope, that's how it was in the beginning, even in the 1930s, as Henry Ford said, that's only what the public's perception of it was and the line they were fed.

Godisgoodallthetime wrote:at one time the banks could only loan a percentage of the money they actually had, eventually that percentage they could loan grew and grew and now it's worthless so hardly surprising...

I remember Gordon Brown making some rules like that for the government when he was chancellor - he changed the rules too - ended rather badly (for us, the taxpayer).

BigAndy9 wrote:

Godisgoodallthetime wrote:at one time the banks could only loan a percentage of the money they actually had, eventually that percentage they could loan grew and grew and now it's worthless so hardly surprising...

I remember Gordon Brown making some rules like that for the government when he was chancellor - he changed the rules too - ended rather badly (for us, the taxpayer).

yeah it gave them literally a licence to print money, money that never actually had...

The problem is that even banks are loosing contact with reality when stating how banking really works.

I do not deny that at the moment it is working exactly how they say and that the "old ideas" are wrong. The thing is the "old ideas" grew up when money was tied to gold standard and gold most definitely was and is a finite resource.

The point where the banks have lost touch with reality is their clear belief that because the gold standard was lost so long ago few people can remember why we think banking works the way we do they think that money is indeed totally free of any finite link. However they are wrong. At the bottom of money is the human animal and at the bottom of the human animal are 2 finite resources - food and land.

it could end up like germany after ww1, your bank tells you your account is 1 million pounds and the stamp on the envelope is 3 million pounds...

BigAndy9 wrote:

Godisgoodallthetime wrote:at one time the banks could only loan a percentage of the money they actually had, eventually that percentage they could loan grew and grew and now it's worthless so hardly surprising...

I remember Gordon Brown making some rules like that for the government when he was chancellor - he changed the rules too - ended rather badly (for us, the taxpayer).

Absolute bollocks:

Essentially, the narrative being put forward is this: the historical effect of all previous events and governments, up to and including Margaret Thatcher's and John Major's, is erased, even when it is direct. The universe in which we live begins at the 13-year Labour administration. The clearest example of this is the idea that the energy oligopoly, which is causing so many problems in that market, is a result of Labour's policies and specifically those of Ed Miliband as energy secretary in the year and a half between October 2008 and May 2010. The direct contribution of previous Conservative governments, for example, in privatising energy and setting up the regulatory framework is nil.

The global financial crisis in 2007-08 was the result of Labour's spending record. It was having too many nurses and teachers that caused the sub-prime lending bubble, the US housing bubble, and the collapse of Fannie Mae, Freddie Mac, Northern Rock and Lehman Brothers. In Nick Clegg's words, "Labour was the party that crashed the British economy." This is despite all parties acknowledging, at the time, that they were in the midst of an international maelstrom and broadly endorsing, applauding even, Gordon Brown's reaction to events.

Anything negative that has occurred since May 2010 is down to external factors – namely, EU regulation, immigration, profligate southern European economies, the euro crisis, aggressive Chinese expansion, the weather being too hot, too cold, too wet or too dry, the "mess we inherited", the extra bank holiday, the dog eating our homework. Conversely, every plaudit for anything positive is due exclusively to the "difficult decisions" this government is making.



And I don't think that any of you are understanding what the Bank of England is saying, essentially that this is the way banking has always worked.

And now Gorgy Porgy is pretending he is doing such a good job, when he is actually borrowing £190 billion more than he forecast in 2010!!!!!!! And people where stupid enough to applaud.

and this is news???

the economy GROWS on credit....its what drives growth

you go to your bank....the second you sign the agreement the bank "magics" into existance the 10,000 pounds which DID NOT EXIST, before you borrowed it. at the beginning of the loan of course this is a "theoretical amount" it still has to aquire "real existance"...but then you spend it ..say you buy a car....immediately YOU have put 10,000 quid into the economy, you then make that money "real" by paying off the loan plus the interest
at the end of the loan period you ahve grown the economy by 10,000 PLUS the extra costs and interest...

The money is made "real" becasue, presumably you are employed and thus directly ot indirectly "producing something" for which you are paid only a meagre part of its value...

madness...sheer madness....