If you ask a person in the street ‘how is money created?’ they will probably look at you blankly. A couple might hazard a guess and say the Bank of England.
There’s a Chinese proverb that says: ‘The fish is the last to know water.’ Money is all around us, playing a role in almost everything we do, yet it can be difficult to understand. We are swimming in a society that depends on money—that’s become obsessed with money—but few of us know where it comes from or how it actually works.
A landmark paper released by the Bank of England in March 2014 explains how private banks create the vast majority of money we use when they make loans. When you go into a commercial bank and take out a loan, the money is created out of thin air: ‘Ping!’ Money is created and at the same time, so is debt. 97 per cent is created in this way, the remaining three per cent of the money in circulation is in the form of cash; the coins and notes in your pocket.
The paper goes onto show how money exists in the form of accounting entries in a computer system—a kind of electronic money that’s created when banks make loans, and destroyed when those loans are repaid. So most of the money we use is a kind of temporary money—bank IOUs that are being continuously created and destroyed.
The significance of this paper from the Bank of England shouldn’t be underestimated. It dismisses the money creation theory taught in almost all economics courses (the so-called money multiplier model). The fact that this Bank of England paper was newsworthy shows that the topic is subject to such widespread ignorance. Positive Money polled MPs on their understanding of money creation, and only 1 in 10 were able to correctly identify that money is created when banks make loans, and that when loans are repaid, the money disappears. Even some economists have fallen victim to this confusion, Nobel Laureates Joseph Stiglitz and Paul Krugman have both made comments suggesting they don’t understand that banks create money when they make loans. With such a widespread misunderstanding about a fundamental tenet of economics—how money is created—it’s not surprising that economists failed to see the economic crisis coming, and that politicians are failing to build a sustainable recovery.
Over the last 40 years, banks—which are profit seeking corporations—have had the freedom to make as many loans as they want and lend based on their own profits and confidence. Banks therefore tend to allocate money to property and financial markets, skewing economies towards housing bubbles and the financial sector. As a result, people and households all end up under mountains of debt.
Since the 2008 financial crash, the biggest crash in living history, banks haven’t been creating as much money, so central banks have had to step in. Central banks have been undertaking a programme, known as unconventional monetary policy, called quantitative easing (QE). QE is when central banks create new money and use it to buy mostly government bonds from financial institutions including pension funds, insurance companies, and banks. Essentially, new money is used to flood the financial markets, inflating share and bond prices. The transmission mechanisms through which QE work are weak and uncertain,. But a major outcome of QE is that it makes the rich richer and does little to help ordinary people and businesses. In fact a study from the Bank of England showed that QE in the UK has actually increased inequality.
QE for People
Economists including former chief economist at the IMF, Olivier Blanchard, and many leading civil society organisations are now calling for a new approach which is being called: ‘QE for People’. The idea behind QE for People is for central banks to create new money, but rather than flood financial markets, they instead lend the new money directly into the real, productive economy. This could work in two ways: either by distributing it via government spending or through direct payments to citizens. The result would be that QE for People bypasses the financial markets and gets money straight into the real economy, either through increased government spending or by transferring it to the pockets of the people who will spend it.
This idea hit the headlines in the UK last summer due to the now Labour leader, Jeremy Corbyn floating a similar proposal. But, I suggest that this is not only a left-wing policy. QE for people, or some version of it, has been advocated by a range of economists, including the famously free market advocate Milton Friedman.
Positive Money, where I am executive director, is an organisation set up in response to the fact that no one after the financial crisis was talking about money creation by banks. It has been campaigning on a similar policy to QE for People for the last two years.
Positive Money makes the case that QE for People (we call it Sovereign Money Creation) would be much more effective than giving money to financial institutions. The analysis suggests that this policy would increase spending and incomes in the economy—without increasing the level of household debt. Directing money in this way would actually allow highly indebted households to pay down their debts and improve their economic situation.
Some economists also argue that lower household debt could also reduce financial fragility and worsen the risk of another crisis. QE for People would stimulate the real economy—create jobs, support business, and increase tax revenue. It would do this without making housing even more unaffordable or blowing up dangerous and unsustainable asset bubbles.
Unlike conventional QE, QE for People would not increase inequality. Instead, it improves democracy. Right now it is the private banks that decide where money is lent in our economy. QE for People would ensure at least some new money would be spent through the government and used in the public interest.
What’s stopping us?
There is a deeply entrenched taboo around money creation. Economists and politicians alike feel uncomfortable talking about money being created out of thin air, even though it happens every day when private banks create loans.
“It will lead to Zimbabwe-style inflation!” is another common refrain. Many people assume that money creation by central banks will inevitably result in inflation and yet banks create money every day when they make loans and the QE program in the UK has already created £375bn. Martin Wolf, the chief economic commentator of the Financial Times, wrote an article on this idea in entitled ‘Only the ignorant fear hyperinflation’.
We are arguing for just enough direct QE for People to boost demand and create jobs. As Lord Adair Turner (Former Chair of the FSA) said at a recent Positive Money event (referring to a form of QE for People called Overt Monetary Financing):
“There are indeed, I now strongly believe, no technical reasons whatsoever why OMF cannot be used to stimulate aggregate demand, and no technical reason why the extent of that stimulus should not be calibrated to an appropriate level.”
It is perfectly possible to carry out QE for People without it leading to inflation. Runaway inflation is no more likely to result from QE for People than it is from giving banks a license to create money or from flooding financial markets with new money created via traditional quantitative easing. In fact, if you look at the impact of recent UK monetary policy on the housing market, it clearly has been inflationary. Leaving money creation solely in the hands of private, profit-seeking banks creates housing and asset bubbles, which increases inequality. The fear around uncontrollable inflation and the taboo discussing money creation is a direct result of the lack of understanding outlined earlier. There is a great responsibility on the part of economists and politicians to challenge the conventional wisdom that led to the 2007 crisis. If we don’t understand the money system we have created, we’ll be destined to repeat our mistakes.
Fran Boait is the Executive Director of Positive Money. In this article, he presents arguments in support of money creation by cooperation between central banks and governments that bypasses private banks and instead is directed straight into the economy – a process that has been term ‘quantitative easing for the people’.
This blog series aims to inform public and policy debate on the role of public assets in our political economy. The series and related seminars were supported by the University of Oxford’s ESRC Impact Acceleration Account.
 Friedman, M. (1948). A monetary and fiscal framework for economic stability. The American Economic Review, 38(3), 245-264.