In the classic 1946 film It’s a Wonderful Life, depositors demand their money from a small town building society. Its manager, George Bailey (in an unforgettable performance by James Stewart), explains that the money is not in the building society’s vault; it has been lent to other people in the town. “The money’s not there,” Bailey pleads. “Your money’s in Joe’s house … and in the Kennedy house, and Mrs Macklin’s house, and a hundred others.”
Bailey’s explanation reflects a widespread idea of how banks work.
According to this idea, banks gather funds, such as through retail deposits and wholesale borrowing, then lend out those funds – or a proportion of them. This picture of banking permeates popular culture and popular notions of finance.
In 2008, during the crisis that rocked the foundations of western capitalism, the author and Harvard professor Niall Ferguson published The Ascent of Money. His goal was to explain the underpinnings of the global financial crisis and put it in its historical context.
Ferguson’s book repeated uncritically the It’s a Wonderful Life explanation of how banking works. Seventeenth-century banks, he explained, had pioneered what would become the foundation of modern finance: “fractional reserve banking”. That mode of banking exploited the fact that “money left on deposit could profitably be lent out to borrowers. Since depositors were highly unlikely to ask en masse for their money, only a fraction of their money needed to be kept in the [bank’s] reserve at any given time.”
The George Bailey-Niall Ferguson explanation of banking is widely held, and, long ago, it was a valid explanation of how banks worked.
But as a descriptor of banking today, it is incorrect. Banks don’t lend out money from reserves or deposits or other sources of pre-existing funds. Counterintuitively, the loans come first.
When you borrow money and your bank credits your loan account, the account balance is created anew, “from thin air”, not from or in relation to existing deposits or other existing money. And as you repay the loan principal, the money created at the time of the loan gradually disappears, reverting to its previous form of airy nothingness.
The Bailey-Ferguson picture of bank lending is back to front, and the nature of bank deposits is also widely misunderstood. The unnerving reality: a positive balance in your bank account does not correspond to a stock of “money” held somewhere for you, over and above the account balance. The account balance is all there is. It is the record of a promise from the bank, effectively an IOU.
Your deposit account is a liability for your bank and, as a depositor, you are no more than one among many of the bank’s unsecured creditors.
In normal times a promise from a private bank is nearly as good as a promise from a government or a central bank. But in a crisis the promise is worth much less, and can be worth as little as nothing at all.
These differences in understanding are the tip of an iceberg of confusion that also extends to public finance and fiscal policy.
According to the standard picture of public expenditure and revenue raising, governments can only spend if they first gather money through taxes or asset sales or borrowing. The reality, however, is again the reverse. Just as banks lend money into existence in the form of IOUs, governments spend it into existence.
(From time to time, governments and central banks also make loans, such as for monetary policy and economic development purposes. In those instances, governments and central banks lend money into existence just as private banks do.)
As with money created through bank lending, money created through government spending does not persist and circulate indefinitely through the economy. The slightly shocking and dispiriting reality is that, when you pay your taxes, the money doesn’t go into an account or a vault. It is vaporised. The tax payments cancel out the money that was created at the time of the original government spending.
These differences in understanding are not peripheral or inconsequential. Their implications extend far beyond the practical administration of banks and governments.
The standard view dominates the politics of taxation and fiscal responsibility. It also prevails in sections of the academy, where some economists are wedded to the idea of money continually circulating through the economy as a persistent element in a closed system. In reality, money is regularly being created and destroyed, and economic models that don’t reflect that fact are not even slightly useful.
(The New Zealand economist Alban William Housego “Bill” Phillips became famous for the Phillips curve, postulating a relationship between rising inflation and unemployment. In 1949 he invented the monetary national income analogue computer, or Moniac. Also known as the financephalograph, this heroically clunky contraption used real liquid, hydraulics and pipes to illustrate how Phillips thought a sealed, circular, money-fuelled economy worked.)
Misunderstandings about money and banking affect the incentives and tactics of the largest private banks, and how well citizens and taxpayers hold governments and financial regulators to account. They prevent us all from having an adult, evidence-based conversation about debt, taxes and monetary policy. Without such a conversation (knowledgeably adjudicated by finance writers and journalists) citizens will forever be bit-part players in capitalism – the irresistible targets of participants with better information.
Protecting customers, taxpayers and the community as a whole from the excesses of modern banking requires a new understanding of the roles of banks and governments in finance; a new understanding of loans, deposits and derivatives as one family of financial contracts; and a new awareness of the privileged position of private corporations in the global financial system.
Crucially, society as a whole needs to think differently about the nature of money –possibly by first discarding the term itself. “Money” encompasses a range of phenomena that have intrinsically different purposes and risks. Commercial bank deposits are materially different to banknotes, for example, which are different to reserve funds. Money as a concept is increasingly outdated and misleading.
A better understanding of money would open up the possibility of important innovations such as lending-only and deposit-only institutions; new mechanisms of financial prudence and oversight; and an integrated monetary and fiscal policy that uses monetary and fiscal levers in concert.
A new financial conversation would make the causes of inter-generational inequities more explicit, and it would allow the community to rethink allowing “too big to fail” banks to earn, year in year out, enormous risk-free profits.
This is an edited extract from Alice TM: The biggest untold story in the history of money by Stuart Kells, published by MUP on 3 April
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