Why not read our earlier article What was QE (1) and what happened in 2008? which sets the scene nicely for this post.

An equally relevant and related question is this:

Is money illusory?

We all use money every day in some form or other – coin, paper or simply “putting it on the card”. And it strikes me that few of us really know where money comes from or fully understand what it is.

So, I thought it time to do a bit of research and then attempt to distil the huge volume of stuff on the internet into some key points.

This article aims to tell it how it is and get you thinking a little bit about the stuff that we call money.

Before diving into more detail you need to be aware of three things:

Something called “Central Bank Reserves”;
How UK banks operate and interact with other banks; and,
Why banks are so reliant on those other banks.

1. Central Bank Reserves

Authorised banks (and only authorised banks) in the UK have accounts with the Bank of England.

This is where they keep their Central Bank Reserves – these reserves are not really money (as in hard cash) but bits of computer code – “0”s and “1”s.

In 2008, Central Bank Reserves in the UK totalled between £150Bn and £200Bn.

You should also appreciate that “money” in circulation is made up of 2 sorts of money:

Base money – money created by the government/Bank of England and which consists of actual cash and those notional Central Bank Reserves (see above)
Bank Created money – money created by (privatised/private) banks

In 2007 and just before the collapse of the western banking system, Bank Created money was 80 times that of Base money!

2. Interacting with other banks

UK banks use these Central Bank Reserves to settle up with each other on a daily basis through what is called Inter-Bank Settlement.

3, Why banks are so reliant on those other banks (and the Bank of England)

Rather than settling up monies by individual transaction, the inter-bank settlement settles on a net basis at the end of each day. So, the amount due from bank A to bank B at the end of the day will be set off against the amount that bank B owes to bank A. And this is done for all banks to generate net settlement figures.

And the Bank of England is there as lender of last resort to bail the banks out if they get into trouble:

If one bank is unable to pay the money back or if they are insolvent then no other bank would be prepared to lend to them.
So, when there is a problem, (for example, Northern Rock due to the run by its depositors baying for their money in 2008) the Bank of England pumps a huge amount of new money into Central Bank Reserves so every bank has far more Central Bank Reserves than they need – this is what happened in 2008 and was called Quantitative Easing – now referred to as QE1. (Why not read our earlier article What was QE (1) and what happened in 2008?)
But do remember that if a bank is bust (liabilities exceed assets), the Bank of England can delay the inevitable by pumping in this cheap money – but eventually reality hits – again Northern Rock and HBOS refers.
QE1 was ‘new money’ funded by the Bank of England buying huge amounts of government bonds from the private sector – private individuals, pension funds and insurance companies.
The consequence of this huge slug of cash (approximately £375Bn) was that the individual banks did not need to lend to each other thereby averting total collapse of the UK banking system.

As the well-respected economist, Roger Martin-Fagg says:

“The Industrial Revolution was enabled by the (then) emerging banking system. In essence, banks discovered that customers would accept a bit of paper (a cheque) as money and would only require a proportion of their money held by the bank in cash. So, arithmetically, the following happens: Customer A deposits £100 physical cash but only requires, say, £20 cash on demand, so £80 is idle. Customer B wants a loan of £400, but only needs £80 on demand in cash; the rest he will spend using a cheque. So the bank creates £300 of credit. The cash reserve ratio in this example is 20% (being £80 divided by £400).

Issuing a cheque allowed credit to be created out of thin air. And this is how the Industrial Revolution was financed; it was built on debt.”

To answer the original question – Is Money illusory? – let’s explore how banks create money:

When you borrow £10,000 from your bank no real money changes hands – your bank simply plays with some numbers on their computer systems and they give you a loan account showing you owe the bank £10,000 (plus interest) and they set up a deposit account for you.
So your bank has effectively created £10,000 – out of thin air!
When you want to spend some of that money with say a car dealership, your bank and the car dealership’s bank again simply play with some numbers to reflect the fact that your bank owes the car dealership bank some money.
Then they settle up between themselves through Inter-Bank Settlement.
The really clever bit is that banks do not need to depend on their own reserves to create money as they can (and do) loan first then, if need be, borrow from other banks through the Inter-Bank Lending Market.

So, it is pretty clear that UK banks can create money simply by creating loans to businesses and individuals.

What does this mean for us?

It means we have, and each of us are part of, a system where privatised bodies – i.e. the banks – are the main ones creating money for our society. And it is all illusory.

It is the banks – and not democratically elected bodies – that create the vast majority of money. The money that elected bodies do create is less than 5% of the overall money.

Conclusion

So this seems to suggest that the premise that money is largely an illusion is probably true.

And that the UK banks and the Bank of England can create money broadly whenever they want.

That is our take on the premise that Banks can create money when they want and provides a backdrop for when you read our related articles in which we look at:

And in our next article we look at what Checks and Balances are in place to prevent things going awry.

Note: A large chunk of the inspiration for this synopsis is drawn from the excellent Economic Updates produced by Roger Martin-Fagg