A man walks into a bank and deposits his salary of a thousand pounds in cash. Now the bank knows that on average the customer won’t need the whole of his thousand pounds returned all at once. He’s probably going to spend a little bit of his salary each day over the month. So the bank assumes that much of the money deposited is idle or spare and won’t be needed on any particular day.
So, It keeps back a small reserve of let’s just say, 10 percent of the money deposited with it, in this case, it would be £100, and lends out the other nine hundred pounds to somebody who needs a loan. So the borrower takes this 900 pounds and spends it at a local car dealer. The local car dealer doesn’t want to keep that much cash in its office, so it returns the money to another bank.
Now the bank again realizes it can use the bulk of the money to make another loan. It keeps back 10 percent, 90 pounds, and lends out the other 810 pounds to make another loan. Whoever borrows the 810 pounds spends it, and it comes back to one of the banks again.
Whichever bank receives it then keeps back 10 percent, i.e. 81 pounds, and makes a new loan of seven hundred twenty-nine pounds.
This process of re-lending continues with the same money being lent over and over again. But with 10 percent of the money being put in the reserve every time. Note that every one of the customers who paid money into the bank still thinks that their money is there, in the bank. The numbers on their bank statement confirm that the money is still there, even though there is still only a thousand pounds in cash flowing around.
The total of everyone’s bank account balances has been increasing, and so has the total amount of debt.
Supposedly, this process continues until after around 200 cycles. Almost all of the original money is now in reserves, and only a fraction of it is being re-lend. By now, the total of all bank accounts adds up to about 10000 pounds.
So the multiplier model that is still taught in many universities implies that this repeated process of a bank taking money from a customer, putting a little bit in reserve, and then lending out the rest can create money out of nothing because the same money is double counted every time it relents. The model says that if the reserve ratio, that’s the percentage of customers’ money that the banks have to keep in a reserve is 10 percent, then the total amount of money will grow to roughly 10 times the amount of cash in the economy.
You can imagine this model as a pyramid, the cash is the base of the pyramid, and then depending on the reserve ratio, the banks multiply the total amount of money by lending it over and over again.
There are three types of money that we use in the economy as a member of the public, you will only ever have used two of them. The simplest form is cash, the five-pound, ten-pound, 20-pound, and 50-pound banknotes, 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 it in your own home, pretty soon you’ll get the police kicking down your door at 2:00 in the morning. So now imagine that you need to pay your rent and your landlord has an account with a different bank than 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 bulletproof 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 article. 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 which we’ll cover later on, and they can only be stored in accounts that the big banks have with the Bank of England. But, to get one of these bank accounts to 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 one cash and two 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 the 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, site deposits, or bank credit, these terms will pretty much mean 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 the same purpose as the 10-pound and 20-pound notes you might hold in your wallet because this type of electronic bank deposit money now makes up over 97 percent of all the money used in the UK economy. Less than three percent of the money supply is cash created by the government. And all this electronic bank money is created by banks, as I’ll explain now.
The balloon model.
Let’s revisit the multiplier model that we talked about earlier. 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 this base is indeed 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.
Electronic banks such as Revolut created money, so the pyramid is split up into a base of government-created money and a tower of bank-created money on top. Remember that we said this pyramid in theory is limited by the reserve ratio?
Well, there is no reserve ratio. 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 Basically, the pyramid is actually the wrong shape to describe the money system. In reality, it’s 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 I’ll explain in my next article, how 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 situation we’re facing 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 Alta balloon of bank-created money was 80 times bigger than the 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 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 out of balloon, the amount of bank-created money is only 14 times bigger than the balloon. This shows that there is no real connection between the amount of central bank reserves or base money and how much money the banks can create.
