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  • Before we start looking at how money is really created, we need to have a quick look at what

  • types of money we actually use in the economy. There's actually three types of money that

  • we use in the economy. As a member of the public, you will only have ever used two of

  • them.

  • The simplest form is cash -- the £5, £10, £20 and £50 bank notes and the metal coins

  • that most of us will have in our wallets at any point in time. As you probably know, only

  • the government, via the Royal Mint and the Bank of England, is allowed to create these.

  • If you try to make your own at home, pretty soon you'll get the police kicking down

  • your door at 2 in the morning.

  • Now imagine that you need to pay your rent, and your landlord has an account with a different

  • bank to you. When you log into your internet banking and make the payment to your landlord,

  • your bank has to send some money to your landlord's bank to 'settle' and complete the transaction.

  • Of course, the banks don't want to make these payments to each other in physical cash

  • because carrying all this money around is dangerous, even if they use protected security

  • vans and guards with bullet vests and helmets.

  • So instead, they use a type of electronic money, which is called 'central bank reserves'.

  • Remember that name because we'll be using it a lot in this video.

  • Central bank reserves are effectively an electronic version of cash, and banks use these electronic

  • central bank reserves to make payments to each other. The central bank reserves are

  • created by the Bank of England -- we'll cover how later on -- and they can only be

  • 'stored' in accounts that the big banks have with the Bank of England.

  • To get one of these bank accounts at the Bank of England, you have to be a bank. So as members

  • of the public, we can't get our hands on any central bank reserves. We just have to

  • use the physical cash.

  • So the first two types of money are 1) Cash and 2) Central Bank Reserves. Remember that

  • central bank reserves are like an electronic version of cash that only the banks can use

  • to make payments between themselves.

  • The third type of money is a type of money that isn't created by the Bank of England,

  • the Royal Mint or any other part of government. This third type of money is the type of money

  • that's in your bank account right now.

  • This money is just numbers in a computer system.

  • Bankers and economists refer to this type of money with jargon such as 'bank deposits'

  • 'demand deposits', 'sight deposits' or 'bank credit'. These terms all mean

  • pretty much the same thing and are used interchangeably. They might also be referred to as bank liabilities

  • -- this is the accounting term, because this money is a liability of the bank to you i.e.

  • it's what the bank needs to repay you at some point in the future.

  • Now in a legal sense, the numbers in your account aren't really money at all. But

  • despite that, they serve exactly the same purpose as the £10 and £20 notes that you

  • might hold in your wallet.

  • It's this type of electronic, bank-deposit money that now makes up over 97% of all the

  • money used in the UK economy. Less than 3% of the money supply is cash created by the

  • government.

  • And all this electronic bank-money is created by the banks, as we'll explain now.

  • The Balloon Model

  • Let's revisit the multiplier model that we saw in the last video. Remember that it

  • describes the money system as having a base of 'base money'. In the simplified version,

  • the 'base' is made up of cash. In reality, it's not just cash in this base -- it's

  • also the electronic central bank reserves that banks keep in their accounts at the Bank

  • of England. But it's true that this base is made up of money -- either cash or electronic

  • -- that was created by either the Bank of England or the Royal Mint.

  • Now let's look at the top of the pyramid. The rest of the pyramid is made up of the

  • third type of money -- the electronic bank-created money. So the pyramid is split up into a base

  • of government-created money, and a tower of bank-created money at the top.

  • Remember that we said this pyramid, in theory, is limited by the reserve ratio? Well, there

  • is no reserve ratio, and there hasn't been for years.

  • This means that the total amount of money in the economy isn't really limited. It

  • can keep expanding without coming to a point at the top.

  • So the pyramid is actually the wrong shape to describe the money system.

  • In reality its closer to a balloon of bank-created money, wrapped around a smaller balloon of

  • base money. In this case, the base money is the electronic central bank reserves and cash.

  • As we'll see in this video, the Bank of England has relatively little control over

  • the total size of the balloon of bank-created money.

  • They can't really control how much money is in the economy, even if they claim to be

  • able to.

  • The outer balloon of bank created money could expand out of control and the Bank of England

  • wouldn't be able to stop it -- at least not within the current monetary system.

  • We saw this happen before the crisis. In 2006, the outer balloon of bank-created money was

  • 80 times bigger than the inner balloon of base money. The multiplier wasn't 10 times,

  • like the textbook models suggest: it was actually 80 times!

  • And then when banks panicked during the crisis and refused to lend, the Bank of England pumped

  • a load of extra base money into the inner balloon, through the scheme known as Quantitative

  • Easing. But this didn't lead to a massive increase in the size of the outer balloon.

  • Right now the outer balloon -- the amount of bank-created money -- is only 14 times

  • bigger than the inner balloon. This shows that there is no real connection between the

  • amount of central bank reserves -- or base money -- and how much money that the banks

  • are able to create.

  • WHAT DETERMINES THE AMOUNT OF MONEY IN THE ECONOMY?

  • So what actually affects the ratio between bank-created money in the outer balloon and

  • government-created cash and central bank reserves in the inner balloon? What determines how

  • much money is created for the economy?

  • The research that we have done suggests that the amount of money that banks can create

  • is not determined by reserve ratios, or by regulation, or by the control of the Bank

  • of England.

  • The reality is that the total amount of money depends on the confidence of banks. If they're

  • feeling confident, banks will create new money by lending more. And when they're scared,

  • they limit their lending, which limits the creation of money.

  • So the size of the outer balloon really depends on the confidence and incentives of the banks.

  • Or to put it another way, the amount of money in the economy depends on the mood swings

  • of bankers.

  • Given that the amount of money in the economy can determine the health of the economy, does

  • it sound like a good idea to have such an important thing decided by the mood swings

  • of bankers? Probably not!

  • EXACTLY HOW BANKS CREATE MONEY OUT OF NOTHING

  • OK, back to the numbers in your bank account. These numbers are all created by banks. The

  • vast majority of these numbers were created when somebody took out a loan from a bank.

  • Let's see how this happens.

  • A customer, who we'll call Robert, walks into a Barclays Bank and asks to borrow £10,000

  • for home improvements. Barclays runs a quick automated credit check and decides that the

  • customer can be relied on to keep up repayments on the loan.

  • The customer signs a loan contract promising to repay the £10,000, plus the interest,

  • over the next 4 years, according to an agreed monthly schedule.

  • This loan contract is a legal contract that binds the customer to make repayments to the

  • bank. This means that it is a legal contract that is considered to be worth £10,000 (plus

  • the interest).

  • Because it's an asset, Barclays can record the loan on its balance sheet.

  • Now if you haven't come across a balance sheet before, don't worry -- it's pretty

  • simple.

  • There's two parts to a balance sheet. One half records all the things that the bank

  • owns -- this could be money, other financial products like bonds and derivatives, bank

  • buildings, computers, and most importantly, the loans it has made.

  • How can you own a loan? Well, if someone signs a contract promising to pay you money, then

  • that contract is worth something. It's considered an asset of the bank.

  • In the case of Robert, the contract that he signs promising to pay the bank £10,000,

  • plus interest, over the next few years, is worth at least £10,000 to the bank, and therefore

  • it's an asset to the bank.

  • So the bank puts an extra £10,000 on its balance sheet, like this:

  • BARCLAYS BANK BALANCE SHEET (Step 1)

  • (Left side) Assets (What the borrowers owe to bank + bank's

  • money) Loan to Robert: +£10,000

  • Now what about the other half of the balance sheet?

  • The other half of the balance is what's called the Liabilities. This is a record of

  • everything the bank owes to other people. On this side, you'll find a record of money

  • that the bank has borrowed from other banks or large pension funds. You'll also find

  • all the customers accounts, because -- if you remember -- the balance of your account

  • is just a number showing what the bank promises to pay you when you ask for your money back.

  • When Robert signed the contract promising to pay the bank £10,000, plus interest, over

  • the next 10 years, he did it because he wanted some money from the bank. So the bank creates

  • a new account for Robert, which is linked to his debit card, and just types £10,000

  • into their computer records. This £10,000 is a liability from the bank to Robert, and

  • it shows up on the other half of the balance sheet.

  • (Right side) Liabilities (What the bank owes to the depositors + bank's

  • net worth) Robert's new account: £10,000

  • Now when Robert goes to the cash machine to check his balance, he'll see £10,000 which

  • he didn't have before.

  • All the bank has done to create this new money is type some numbers into an account. It hasn't

  • reduced the balance of anyone else's account, and it hasn't taken any money from some

  • pensioners and moved it into Robert's account.

  • So the process of creating commercial bank money -- that's the money that the general

  • public use -- is as simple as:

  • 1. a customer signing a loan contract and 2. the bank typing numbers into a new account

  • set up for that customer

  • This new bank-created money represents new spending power -- or money - in the economy.

  • Robert can now go and spend his money anywhere in the economy, using his debit card, cheque

  • book, internet banking transfers, or even by taking the cash out of the ATM.

  • INTER-BANK SETTLEMENT: ONE PAYMENT

  • But there's a small complication. What happens if Robert goes and spends the new bank-created

  • money with a shop that has a bank account with a different bank, say Lloyds?

  • If this happens, then Lloyds will want to see £10,000 of real money from Barclays.

  • Barclays would then need to transfer £10,000 of central bank reserves to Lloyds to settle

  • the transaction. Note that from the point of view of Lloyds, receiving a transfer of

  • £10,000 in central bank reserves into its account at the Bank of England is just as

  • good as Barclays pulling up in a truck and dropping off £10,000 in cash, although it's

  • much more convenient for the banks to have the electronic central bank reserves than

  • to have to carry around all that cash.

  • This process of banks making payments between themselves is called inter-bank settlement,

  • and it's really important to understand it, because it's crucial to the way that

  • banks have been able to gain control of the entire money supply.

  • First, let's look at the simplest example of inter-bank settlement, with just two banks

  • and two customers.

  • Robert, when he receives his loan, goes straight to a DIY store and spends £10,000 on everything

  • he needs. He gets to the checkout and pays using his visa debit card. Here's a simplified

  • version of what happens behind the scenes:

  • First, the DIY Store's debit card machine automatically contacts Visa and say "Please

  • charge £10,000 to this card number: xxxxxx".

  • Visa's computer systems then dial up Barclay's computer systems and say "Robert's trying

  • to spend £10,000 on his debit card. Is that ok?" Barclays' computer system checks

  • the balance of the account and says "Yes". Barclays computer system then reduces the

  • balance of Robert's account by £10,000.

  • Now, Visa's computer system contacts the Lloyds, and says "I'm sending you £10,000

  • for the DIY Store's account". Lloyds then updates the balance of the DIY Store by £10,000.

  • However, importantly, when the owners of the DIY store log into their internet banking,

  • they see two figures. One says "Account balance", and the other says "Available

  • now". For the next couple of days after Robert has come into the shop, the Account

  • balance will be £10,000 higher than the Available Now balance. The £10,000 that Robert spend

  • isn't available to the DIY Store for them to spend just yet. Why?

  • Well, behind the scenes, Barclays needs to settle with Lloyds. When Lloyds gets the message

  • that someone has spent £10,000 in the DIY store, it updates their account balance, and

  • then calls Barclays to say "Send me the money...".

  • Barclays could settle with Lloyds by delivering the £10,000 in cash, but in reality this

  • is just a hassle for both banks. They'd have to find somewhere to store all the cash,

  • and a van with security to transport it. So instead, Barclays will settle by making a

  • £10,000 transfer from its reserve account at the Bank of England, to Lloyds reserve

  • account at the Bank of England.

  • Once Lloyds gets the £10,000 in its account at the Bank of England, then it will update

  • the Available Balance in the DIY Store's account.

  • INTER-BANK SETTLEMENT: MULTIPLE PAYMENTS

  • Now, this was a simple example that involved just one payment between two bank customers

  • (Robert and the DIY store). Only two banks are involved.

  • But in the UK right now there's around 50 million people with bank accounts. Some of

  • these people make more than one electronic payment a day. And they bank with over 50

  • different banks.

  • In fact, every day over 60 million transactions are made between bank accounts in the UK,

  • through a number of different payments systems including Visa, Mastercard, direct debit and

  • online bank transfers.

  • If banks had to go through the whole hassle in the example with Robert every time someone

  • bought a sandwich from a supermarket using their debit card, it would get very messy

  • very quickly.

  • But there's a clever way of simplifying the whole thing massively. It's called multi-lateral

  • net settlement.

  • When you have a lot of individuals and businesses all making payments to each other, that's

  • a lot of money flowing between the different banks.

  • So what the banks do, especially with systems like BACS (which manages direct debits and

  • the type of bank transfers that you make via internet banking), is this: First, they put

  • all the payments into a big computer database first without actually moving any real money

  • -- cash or central bank reserve -- about.

  • Then, at the end of the day, or every few hours, they run a process to cancel out all

  • as many of the payment flows as possible.

  • For example, imagine a customer at Lloyds sends his rent - £350 -- to his landlord's

  • account at Barclays. But on the same day, a customer at Barclays sends his own rent

  • - £400 -- to his landlord, who happens to be at Lloyds. The two payments almost cancel

  • each other out, so after cancelling out -- or 'netting' in the official jargon -- the

  • only money that really needs to be moved is £50 from Barclays to Lloyds.

  • Because there are millions of payments being cancelled out by this system, the amounts

  • that actually need to be transferred between the banks at the end of the day are usually

  • just a tiny fraction of the total value of the payments made.

  • This is why, even though in 2007 RBS customers had nearly £700 billion in its customers

  • accounts, RBS itself only had £17bn that it could actually use to make payments on

  • behalf of those customers. This £17bn was more than enough for the total netted payments

  • that it would need to make at the end of each day.

  • FRACTIONAL RESERVE BANKING

  • This netting out effect means that a bank only needs to have a very small amount of

  • available money compared to the total amount that they owe to customers at any particular

  • time. They know that any payments they make to other banks are likely to be cancelled

  • out by payments coming back to it.

  • On some days, the banks customers will spend more than they receive, and at the end of

  • the day the bank must pay some of its money across to other banks to settle these payments.

  • But on other days, customers will receive more -- in salaries and other income -- that

Before we start looking at how money is really created, we need to have a quick look at what

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