How is money created in the UK?

Most people will never have given this a moment’s thought, and would have no idea how to answer. If pushed though, I’d bet a common answer would be “by the Bank of England”.

That seems a sensible answer – but it’s mostly wrong. The Bank of England does create some money, but the vast majority is brought into existence by your average high street bank.

You may even have seen it happen in front of you, but not realised. In this article, I’ll explain how they do it.

Spoiler: It’s nothing to do with savers

You might have the idea that banks take in deposits from one group of people, then lend them out to another group of people. They pay you interest at 1%, lend it out at 4%, and keep a 3% spread for themselves as profit. This was the case once, but it’s not any more.

If you’ve studied some economics, you might believe that banks engage in “fractional reserve” lending – meaning that for every £1 deposited by savers, they can lend out (say) £9. This was also once true, but isn’t now.

In reality, the lending done by banks has very little to do with money deposited by savers. They don’t need your savings in order to make a loan – because money is created purely by the act of making a loan itself.

This sounds crazy, and doesn’t accord with our intuitive understanding of how lending works. If I borrow £100 from you, you have £100 less and I have £100 more. Money has moved, not been created. But banks are special: they almost literally have a license to print money. Let’s see how it works.

Money-creation in action

Adam walks into the bank wanting a £200,000 loan to start a business. The bank makes some checks to assess his ability to pay the loan back as promised. It does not check to make sure that it has £200,000 deposited by savers to pass on to Adam. It doesn’t matter if they do or don’t.

If the bank decides Adam is a good risk for the loan, a bank employee will open an account for him and type the number “2” followed by five zeroes.

That. Is. It.

The £200,000 has literally been typed into existence, and Adam can go buy the equipment he needs to start his business. As a result of this loan, there’s £200,000 more money in circulation in the UK.

In accounting terms, where everything needs to balance, the bank now has a new liability (the £200,000 they gave Adam) and also a new asset (his promise to repay £200,000). These entries were both created by the act of making the loan itself: the money wasn’t brought over from anywhere else.

(This is why accounting seems weird to non-accountants: if someone owed you money, you probably wouldn’t consider that to be an asset of yours. You’d be more likely to worry about them not paying it to you, and only consider it an asset once it’s safely in your possession. But that’s not how accounting works.)

When Adam repays the loan, the opposite happens: the money ceases to exist. The loan account that had £200,000 typed into it is replaced by £0, and the bank’s asset and liability go away. Sure, Adam’s business must have earned money from other people to generate that £200,000, so money has been changing hands – but the overall quantity of money shrinks when the loan is repaid.

Too simple to understand

At first it takes a bit of getting your head around the fact that creating money is as simple as typing it in. It doesn’t feel “right”: surely some people borrowing requires others to be saving? Nope.

It might take you a few read-throughs of the previous section, and scribbling some numbers on a piece of paper to follow along, before it makes sense. That might be because my explanation isn’t very good, but it’s certainly not because there’s anything wrong with you: it just “feels wrong”, and your intuition and past education both lead you astray.

In fact, GK Galbraith rather neatly put it like this:

“The process by which banks create money is so simple that the mind is repelled. When something so important is involved, a deeper mystery seems only decent.”

GK Galbraith

So is money creation limitless?

As we’ve seen, the money was magicked into existence by making the loan, so the bank doesn’t need to have a certain “stock” of money to lend out. Given that the bank earns fees and interest every time they make a loan, the temptation must be to give loans to anyone who comes through the door.

What prevents them from doing this?

There are a few reasons:

  1. Banks are required to have a certain amount of “regulatory capital” relative to the loans they make, which can limit their lending. (Deposits from savers are one potential source of this capital, so savers do play some role in banks’ lending).
  2. There are only so many creditworthy borrowers. Lending to anyone with a pulse is a great short-term move because it generates interest and fees, but if lots of loans default then lots of money is destroyed – meaning the bank’s balance sheet shrinks.

    (Interesting side-point #1: This means that “government backed” loans, like the “Bounce Back” and various other Covid-related loans introduced in 2020, increase money creation: banks will make more loans to more dubious customers than they otherwise would have done, because their losses will be made good by the government.)
  3. There’s only so much borrowing that customers demand, given a certain rate of interest. Can’t banks set whatever rate of interest they like? Yes, but in practice the rates they can lend at are determined by the base rate set by the Bank of England. This mechanism is a whole article in itself, so for now just take my word that the Bank of England influences the price of borrowing which in turn affects the demand for borrowing.

    (Interesting side-point #2: This means that even though the vast majority of money-creation in the UK is performed by private banks, the Bank of England still indirectly controls how much money is created.)

So even though banks create money by just doing the banking equivalent of waving a magic wand, there are still practical limits on how much money they can create. And even though banks are in the driving seat when it comes to money creation, our side-points show that both the government and the Bank of England can sit in the passenger seat shouting at them to ignore the sat-nav and go their preferred way instead.

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