How money is created

[SXGuy]

Thought id write a short story about how money is actually created, and how its given value. Some of you may already know, others may not.

Some brief history about how british money came about. (applies to other countries but maybe not all)

At first, people used to trade in coins, they were made from gold, copper etc.

But rather than carrying around tons of coins, they needed somewhere to store them. What came then, was what we refer today as banks. But it wasnt the same as it is now, they were merely holders of coins.

You would deposit your coins, and the holder would issue you with a receipt for the amount they were holding.

Some time passed, and these holders thought, if we are holding all this wealth, we could lend some of it out, so long as we kept enough to cover anything that would be returned should the customer wish.

So they lent out other peoples coins, and repyament included interest.

That formed the basis of the first type of banking system in our country.

Some of you, may recall that our paper money, was backed by gold. At some point in our past, £1 may have been equal to 1lb of gold or such like, but since then, money has changed to what we now call "promisary notes"

Promisary notes, are peices of paper, endorsed by goverment and the bank of england, and accepted by us has having value. However they do not.

The only value they hold is the assurance that at some point in time, those notes can be replaced by the value to which they state.

If you check any notes, you will see it says "i promise to pay the barer the sum of £x"

This means, that when you hand over a £5 note to the bank, you are not actually givening them real money, what you are doing, is stating that should they wish to redeem that £5 note in the future, you promise to pay it.

And thats how our monetary system works today, everything is based on what we consider to hold value, backed by the promise to give the person your paying the sum of that value in the future.

Now this starts to get more techincal when you consider what banks do to issue credit.

Credit, is simply debt, it can not be anything else, because credit is not based on any promisary note. But is expected to be repaid using it, while adding interest to it.

For every £1 you deposit to a bank, they are able to lend up to 10 times the amount they hold.

So that means £1 in circulation, becomes another £9 not in circulation, but "lent" to the borrower.

The borrower then has to repay £9 plus interest.

You can see from this example that the £9 was generated out of thin air, so the only way to repay it, would be to use money that was in circulation.

If everyone borrowed money, then for every £10, £9 would be money borrowed that never existed in the first place.

What happens when you gain to much credit and not enough money to repay? a Crash in the market, or "resession"

The only way to combat this, is to use quantitive easing. Theres no real evidence that it works however, and i will explain why.

For every note you issue in to the market, the value as a whole decreases.

So you need more to repay debts.

But thats providing the banks actually lend the money out to you, if they hold on to the extra money, it doesnt solve the problem, and its something we are seing today, bank of england has issued more notes in to circulation, but banks are holding on to it, by not lending it out.

If everything was manufactured locally, and every day items was produced in your own country, then it wouldnt matter how much the value decreased because everything else would decrease with it, but with the ever increasing need to import goods, and the ever decreasing value of money due to quantitive easing, you would find yourself needing more to buy the same items.

There are tons more variables to money that i wont go in to now, but the simple fact remains.

If banks continue to lend more than they actually hold, then you will forever have a ressession, or "depression" because there will never be enough real money to repay credit.

Goverments will use the excuse that it was under regulated credit, and the sub prime market that caused the crash, this is only true to a certain point. Crashes are always going to happen in a fiat currency country, you cant repay more than is there to begin with. All the sub prime market and the deregulation did, was speed up the process by giving out more credit quicker.

So how do we solve this issue? well its not easy, if we remember that currency only holds the value to which we give it, and nothing else, then we could trade in rabbits feet for all it matters.

But getting out of the credit bubble is something we should all strive to, we can not continue to repay debt with money that simply isnt there to begin with.

We need to start trading goods, bakers exchanging bread for wine, etc.

Its happening slowely but surely in some countries, and some are actually accepting other forms of payment in exchange for goods, how? because they attribute that form of payment to hold worth.

In the end its no different to currency, except, goverments and banks, have no hold over it. Thus removing the need for credit, and removing any chance of economic crashes.

Feel free to pick at holes in my story, ive prob missed something out, but generally this is how it works.

[Scarlet x]

Re: How money is created

You call that short?!!

[AnonymousA]

Re: How money is created

Also I think there are some mistakes, purely based on my A-level Economics and the part of my degree that was Economics.

For example, for every £10 that is deposited, I think it's much more than £9 they can lend. The reason for this is that they need to keep a very small proportion of the money that is deposited. I think it's 1% (though I might be wrong here). So the banks can lend £9.90. Of course, that £9.90 is then deposited somewhere (after being spent usually) and they can lend £9.801p of that £9.90, which is then deposited somewhere.... and on it goes.

So that £1 has actually led to the lending of a lot more than £9 when that circle is complete. I can't remember exactly what it's called but it's something multiplier and is the reason it actually doesn't take much to get a 'run on the bank' - like with Northern Rock - because they are only holding 1% (or whatever it is) of what is deposited.

Also, manufacturing more money does just lead to inflation; the thing that the government is hoping with Quantitative Easing, is the effect short term can be to stimulate growth and hence negate some of the inflationary effect (which itself takes some time).

Money is a system of exchange that is based on trust - ie if we don't believe money is worth anything, then it isn't. We've seen this in countries that have succumbed to hyper-inflation. However, I don't accept that is happening here, and I don't accept that we are going back to some kind of barter system, as you hint at at the end of your post. For a start, we're a largely service economy now and are not self sufficient for food, let alone anything else, so are dependent on the world economy (and hence that very system of exchange that requires money) to feed ourselves.

Having said all of that, I hold a Marxist view of value (that ironically comes from Adam Smith) - and that means that the value of anything is directly proportional to the labour that has gone into producing it, so I don't interchange "value" and "money" as terms.

[AnonymousA]

Re: How money is created

That's called fractional reserve banking ---> Fractional reserve banking - Wikipedia, the free encyclopedia

The % that can be lent is determined by Central Banks (although banks probably manage to get around this in their own unique way)

Thanks. I think I recall that, but never would have come up with it on my own.

I actually meant the name for the multiplier that means that £10 creates £1000 (I think) at 1% fractional reserve.

edit: if I click on your link, it's called the money multiplier. And I was right. 1% is 0.01 which makes 100 times the original amount (because 1/0.01 = 100)

edit2: I didn't realise, but at the moment, in theory, the banks have a 0 reserve requirement (not 1%) though they hold on average 3.1% (source is wikipedia, so may be wrong: Reserve requirement - Wikipedia, the free encyclopedia)

[SXGuy]

Re: How money is created

Also I think there are some mistakes, purely based on my A-level Economics and the part of my degree that was Economics.

For example, for every £10 that is deposited, I think it's much more than £9 they can lend. The reason for this is that they need to keep a very small proportion of the money that is deposited. I think it's 1% (though I might be wrong here). So the banks can lend £9.90. Of course, that £9.90 is then deposited somewhere (after being spent usually) and they can lend £9.801p of that £9.90, which is then deposited somewhere.... and on it goes.

So that £1 has actually led to the lending of a lot more than £9 when that circle is complete. I can't remember exactly what it's called but it's something multiplier and is the reason it actually doesn't take much to get a 'run on the bank' - like with Northern Rock - because they are only holding 1% (or whatever it is) of what is deposited.

Also, manufacturing more money does just lead to inflation; the thing that the government is hoping with Quantitative Easing, is the effect short term can be to stimulate growth and hence negate some of the inflationary effect (which itself takes some time).

Money is a system of exchange that is based on trust - ie if we don't believe money is worth anything, then it isn't. We've seen this in countries that have succumbed to hyper-inflation. However, I don't accept that is happening here, and I don't accept that we are going back to some kind of barter system, as you hint at at the end of your post. For a start, we're a largely service economy now and are not self sufficient for food, let alone anything else, so are dependent on the world economy (and hence that very system of exchange that requires money) to feed ourselves.

Having said all of that, I hold a Marxist view of value (that ironically comes from Adam Smith) - and that means that the value of anything is directly proportional to the labour that has gone into producing it, so I don't interchange "value" and "money" as terms.

I agree with you about the amount they lend, i was way out with what i wrote obviously. But the point on how its done remains.

I understand that we are now a service country and its one reason why a barter system wouldnt work generally, but that doesnt mean things cant change.

While this country remains one of largest financial sectors of the world, things will never change.

But what can change, is the relationship between the people and the banks. People need to understand fractional reserve banking in order to see why things like the economic crisis happen. Only then will it change.

[BBoo]

Re: How money is created

What can also change surely, with bugger all knowledge of any of the above (which I found really interesting thank you!) is peoples' over reliance on and use of credit.

It's funny how the people least likely to use credit are those who have previously been seriously in debt.

[SXGuy]

Re: How money is created

What can also change surely, with bugger all knowledge of any of the above (which I found really interesting thank you!) is peoples' over reliance on and use of credit.

It's funny how the people least likely to use credit are those who have previously been seriously in debt.

Funny, but true, because it is those who understand the nature of it. The hard way.

Nothing wrong with credit providing it has reasonable repayments, which you can afford. But credit cards are the killer, infact id say any credit with no real fixed interest repayment is unfair and should be made illegal.

Compound interest should also be banned and outlawed, whoever thought of it was a genius, but should have been shot on the spot lol