Money Creation – A Historical Perspective

A recap on the last post. Over 95% of our money (all the electronic money) is created by private banks (for profit) through the creation of loans.

The Reserve Ratio was abandoned (per the Bank Of England website here – look under “Band 1 dealing rates”)  and replaced by the Cash Ratio (see here ) which hardly seems onerous requiring 0.11% of deposits (less than 2 years) to be held at the Bank Of England.

Ever hear the phrase “license to print money”.

Ever wondered why house prices went through the roof completely out of correlation with any change in population despite there being ongoing house building. Printing excessive money creates inflation. In this case creating excess electronic money and pumping it in to housing created the close to hyper inflation we’ve seen numerous times since the early 80s.

How on earth did we as a country allow the creation of money to be in the hands of private banks ? A little historic perspective may help.

There was a time when money was gold and silver coins. They were good for money since they were in limited supply. You couldn’t just go creating them and they were difficult to forge. Coins would be issued by the crown and if there was a need for increased money supply they could recall the coins and re-mint them with less gold or silver content. There were issues with using gold but thats not for this post.

Goldsmiths fell in to the role of securely storing peoples money and issuing notes as promises to redeem it on presentation of the notes. Soon people found that it was more convenient to carry the notes rather than the coins and they became a form of money. The Goldsmiths / banks started to notice that only a certain proportion of notes were ever presented at one time so they could issue more notes than they had gold. Just like in todays electronic world they could make a loan merely by making an entry in their accounts and printing the notes. Provided they kept sufficient reserves of gold for any notes that were redeemed they’d be OK.

There were problems. If they got their calculations wrong they could run out of gold. At which point they would call in the loans which would have to be paid in gold. Runs on banks were common, just a rumour that they would run out of gold could result in people demanding their gold for the notes and a self fulfilling prophecy would ensue. Just think now what such a bank run would mean. When you have an account with a bank you think of it as offering two things – one you can convert it to physical money and two you can make electronic payments with it. If you felt a bank was going bust you would either transfer you money to another bank or go get the cash. Given that about 4% of money is cash and 96% is electronic if all those 96% holders of electronic money try and convert it to cash we’ve got real problems !

It was in the interests of the banks / goldsmiths for the paper notes they were issuing to be more widely accepted. To be trusted as having value in and of themselves. As people became more comfortable that this piece of paper could be exchanged for goods at some future date fewer and fewer people ever found the need to redeem for gold. This meant that the reserve of gold they kept could be less thus allowing more loans to be made for profit.

Remind you of anything ? Wonder why banks make it so easy for electronic transactions to take place ? Free internet banking ? free debit cards. All this push for the cash-less society. The less we demand converting our electronic money to coins and notes the lower the reserve ratio the banks can employ and the more loans they can make. Remember there is no longer a legal reserve ratio the banks just decide what they need themselves.

Back to history.

Allowing private banks to issue their own notes meant they controlled the money supply. It’s effect was for periods of high inflation (when they issued lots) followed be deflationary periods. In 1844 the government of Robert Peel passed the Bank Charter Act – this stopped banks issuing new bank notes and left the issuing of new notes in the hands of the Bank Of England and all must be 100% backed by gold or up to £14 million of government debt.

Yes, back in 1844 the government had the guts to remove the ability of banks to print there own notes. I’m sure it could be argued that the spirit of the act was that private banks should not be able to create money BUT it  is all to do with notes. They could never have foresaw the electronic age, computers and the like. The idea of electronic money wouldn’t have had a basis to be even imagined.

So now we’re back in the equivalent position. The private banks create, effectively, our whole money supply. They increase or decrease it’s supply for their own benefit resulting in cycles of boom and bust. More or less all money is issued as debt plus interest which means for it to be paid off yet more debt must be taken out. Under such an axiom it is impossible for us to become debt free without us removing 96% of the money supply (in fact, given we’d have to pay back 96% + Interest it’s probably impossible to pay it back FULL STOP). Look at government debt, if they paid it off it would require removing half the money supply which would clearly result in a massive depression.

For me it is almost beyond belief that politicians have such a misunderstanding about all this. When they talk about the need for austerity to reduce the deficit and pay of the debt they clearly have no idea. Then in the next breath they say we need a return to growth. Off the back of this you wonder whether they should be allowed to make any decisions.

Luckily there are groups trying to get this sorted. Take a look at:

Positive Money

The Monetary Reform Part

Shortly I shall blog about the alternative.

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