for ordinary people to understand the financial system. Finance is not complicated. And managing a little bit of money, making it go far, requires far more skill and intelligence than managing huge sums of money. We all need money to be economically active. The poor, in particular, need money. We are intellectually mesmerised by this thing we call money, partly as a result of our dependence on it, even though many have difficulty understanding it. The ones that have the most difficulty are economists. Very few economists understand or study the nature of money – in particular, bank money. Having said that, some of the greatest economists and political leaders, from Abraham Lincoln to John Maynard Keynes, understood the nature of money – and acted accordingly.
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One of the reasons we have difficulty understanding the nature of bank money, is that, for most of us, our first experience of money is when we leave school; we are penniless, work for a week or a month, and then find money deposited in our bank. That leads us to think that the money arrives as a result of our economic activity. In reality, exactly the opposite is the case: money or credit stimulates economic activity. These are key concepts. Credit creates economic activity. Credit creates deposits. Expenditure creates income. The money deposited in the young worker’s bank account existed prior to her economic activity, and made it possible for her to get paid work. It did not come into existence as a result of her activity. People find it hard to get their heads
around this concept, but we must, or else we will fail to understand the financial system. Before western societies invented bank money and institutionalised banking systems – there were often shortages of money in the economy as a whole. This was because money was linked to a commodity – like gold – which was limited, and, indeed, was used as an anchor, precisely to limit the availability of money.
Then some geniuses (including the Scottish economist John Law) discovered that it was inhibiting economic activity to have the same amount of ‘money’ or ‘credit’ in circulation, as there was gold in the bowels of the earth. One just needed to create enough money equal to the amount of economic activity in the economy. If one created less money than the amount of economic activity, this led to depression and deflation. If one created more money than the amount of possible economic activity, the result was inflation. Central bank governors were given the task of carefully measuring economic activity and then supplying enough money (credit) to enable
s an economist, I’ve long been convinced that key economic concepts ought to be more widely understood. I believe that it is vital
that activity to take place. The important thing to remember is this: money is not the thing for which we exchange goods and services. It’s the thing by which we exchange goods and services. And bank money is not tangible. You cannot touch it or smell it. You cannot even see it – except perhaps as a statement on your monthly bank account. What you do touch and smell is cash – and these days only a tiny proportion of the money we use is issued as cash. The rest takes the form of cheques (declining in number now, and soon to be abolished in some stores in Britain); bank transfers; credit card and debit card payments.
Bank money Now, intangible bank money is one of the most wonderful things humanity has ever invented. It enables us to engage in economic activity. That’s all. It’s effectively incidental to that activity – because without economic activity that money would be useless. And, without money, we could still make things, grow food, cook dinners, care for our families, the sick and the elderly. However, money can help to make all this activity happen, at the right time and in the right place.
But money is potentially also one of the most dangerous of our inventions – which is why credit creation must be so carefully regulated.
Bank money comes into existence in the form of credit, issued by the central bank, and then distributed by the commercial banking system. Credit creates deposits, and in England it has done so since 1694 and the foundation of the Bank of England. This is the very opposite of what most people think – that only once you have deposits can you obtain credit. No, credit creates deposits in the bank. So when you are a youngster, fresh out of school, your employer has invariably obtained credit from the bank to finance her investment, and she uses part of that to pay you, and you promptly pay that into the bank as a deposit – using some of it as cash. That credit has stimulated or generated the first month of your productive economic activity. The deposits that the young person places in her bank account are then exchanged and transferred as ‘bank money’, invisible and intangible – but very useful when she is shopping on Ebay, using her credit card, or paying by cheque. Until recently, most people could not bring themselves to believe in something intangible and invisible called bank money. But now we have a new phenomenon to discuss over our dinner tables: quantitative easing, or ‘queasing’ as we joke in English. Last year, the Chairman of the US Federal
Reserve, Ben Bernanke, gave an interview to CBS, in which he was asked: ‘Where did you find $160 billion to bail out the insurance
company AIG? Was that taxpayers’ money that the Fed was spending?’ ‘That was not tax money,’ replied Bernanke. ‘The banks have accounts with the Fed, much the same way that you have an account with a commercial bank. So to lend to a bank we simply use the computer to mark up the size of the account that they have with the Fed’. The Fed did what a commercial bank does when it provides you with a loan: they entered a number into a computer and charged it to AIG’s account.
And that is what the bank does when you apply for a mortgage. All the bank needs is your application for a loan, the collateral of your property and your promise to repay at a certain rate of interest. Hey presto! The money is transferred – digitally – to your bank account and appears there as a deposit. You may spend 10 per cent of that money on small purchases with cash, but most of that will be paid by cheque or bank transfer. Now the point of explaining this is as follows: the creation of credit is in fact an almost effortless activity. Different, for example, from growing tomatoes. To grow tomatoes one has to depend on the weather, on the land and its fertility, and on labour, yours or that of another. To create credit there is no need for our banking system to depend on the weather, on land, or even on labour. ‘Why then,’ as John Maynard Keynes argued in his 1930 Treatise on Money, ‘if banks can create credit, should they refuse any reasonable request for it? And why should they charge a fee for what costs them little or nothing?’
Price of money The ‘fee’ that Keynes refers to here, is the rate of interest – the ‘price’ of a loan. And the point he is making is correct: the price of money should remain low – to enable people like entrepreneurs to borrow to invest; to enable governments to borrow to invest, for example, in de-carbonising the economy – something that requires major investment. However, he also argued that while the rate of interest should be low – the creation of credit should be carefully regulated. In other words, bank money should be regulated so that it is lent to stimulate productive economic activity rather than speculative, inflationary activity. We have just lived through three decades of financial de-regulation where economic policymakers have encouraged reckless, privatised credit creation. This, in turn, led to crazy speculation and gambling – in derivatives, collateralised debt obligations, and a range of other parcelled up, sliced-and- diced securities.
At the same time, central bank governors and finance ministers succeeded in repress- ing the inflation of wages and prices – while allowing the prices of assets (property, race- horses, works of art, stocks and shares etc) to rocket upward in an inflationary bubble.
APRIL 2010 ADULTS LEARNING 27
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