Saturday, November 29, 2014

How Money is Made

BERLIN/SOUTHAMPTON – Last month, the BRICS countries (Brazil, Russia, India, China, and South Africa) announced the establishment of their own development bank, which would reduce their dependence on the Western-dominated, dollar-focused World Bank and International Monetary Fund. These economies will benefit from increased monetary-policy agency and flexibility. But they should not discount the valuable lessons offered by advanced-country central banks’ recent monetary-policy innovation.

In June, the European Central Bank, following the example set by the Bank of England in 2012, identified “bank credit for the real economy” as a new policy goal. A couple of weeks later, the Bank of England announced the introduction of a form of credit guidance to limit the amount of credit being used for property-asset transactions.

Before the financial crisis hit in 2008, all of these policies would have been disparaged as unwarranted interventions in financial markets. Indeed, in 2005, when one of us (Werner) recommended such policies to prevent “recurring banking crises,” he faced vehement criticism.

This March, however, the Bank of England acknowledged the observation that he and others had made – that, by extending credit, banks actually create 97% of the money supply. Given that a dollar in new bank loans increases the money supply by a dollar, banks are not financial intermediaries; they are money creators.

The growing recognition of banks’ true function will be a game-changer in areas like monetary policy and financial regulation, enabling officials to tackle effectively problems like recurring banking crises, unemployment, and underdevelopment. But it will take time to be fully accepted – not least because it challenges a fundamental tenet of traditional economics. Indeed, according to this new paradigm, savings, while useful, are not an essential prerequisite to investment and thus to economic growth. The United States, which experienced a prolonged period of growth without savings, is a case in point.

In general, economic growth depends on an increasing number of transactions and an increasing amount of money to finance them. Banks provide that finance by extending more credit, the impact of which depends on who receives it. Bank credit for GDP transactions affects nominal GDP, while bank credit for investment in the production of goods and services delivers non-inflationary growth.

The problem lies in bank credit-for-asset transactions, which often generate boom-bust cycles. By extending too much of this type of credit, banks pump up asset prices to unsustainable levels. When credit inevitably slows, prices collapse. As the late-coming speculators go bankrupt, the share of non-performing loans on banks’ balance sheets rises, forcing banks to reduce credit further. It takes only a 10% decline in banks’ asset values to bankrupt the banking system.

With an understanding of this process, policymakers can take steps to avert future banking crises and resolve post-crisis recessions more effectively. For starters, they should restrict bank credit for transactions that do not contribute to GDP.

Moreover, in the event of a crisis, central banks should purchase non-performing assets from banks at face value, completely restoring banks’ balance sheets, in exchange for an obligation to submit to credit monitoring. Given that no new money would be injected into the rest of the economy, this process – which the US Federal Reserve undertook in 2008 – would not generate inflation.

In order to stimulate productive bank credit – and boost the effectiveness of fiscal policy – governments should stop issuing bonds, and instead borrow from banks through loan contracts, often available at lower rates than bond yields. This would bolster bank credit and stimulate demand, employment, GDP, and tax revenues.

Finally, a network of small not-for-profit local banks should be established to provide universal banking services, and loans to small and medium-size firms, like the scheme that has underpinned Germany’s economic strength and resilience over the last 200 years. Beyond making the banking sector more robust, such an initiative would boost job creation per dollar in bank credit.

Of course, large multinational banks, which have long benefited from the perception that economies need savings, are likely to resist such reforms. For decades, these banks have been selling “foreign savings” to developing countries by lending at high interest rates and in a foreign currency, fueling the accumulation of massive amounts of foreign debt, which would often be converted into equity. In other words, they issued credit that contributed little to the local economy, and then drained local resources through interest and exploding foreign currency-denominated debt.

Just as the BRICS have rejected Western-led economic institutions, developing economies would do well to expel foreign banks and allow local financial institutions to create money for productive purposes. After all, successful economic development – in countries like the US, Germany, Japan, and China – has depended on domestic credit creation for productive investment.

During the Great Depression of the 1930s, Michael Unterguggenberger, the mayor of the Tyrolean town of Wörgl, performed an experiment. In order to reduce unemployment and complete much-needed public-works projects, he hired workers and paid them with “work receipts” that could be used to pay local taxes. With the local authority effectively issuing money for work performed, the local economy boomed.

The central bank, however, was not pleased, and decided to assert its monopoly over currency issuance, forcing Unterguggenberger to scrap the local public money and causing Wörgl to fall back into depression. Some 80 years later, the English city of Hull has begun to implement a similar scheme, using a digital crypto-currency that is, so far, not prohibited by law.

The unfettered creation of money by large private banks has generated overwhelming instability, undermining the fundamental principle that money creation should serve the public good. This does not have to be the case. By implementing safeguards that ensure that credit serves productive and public purposes, policymakers can achieve debt-free, stable, and sustainable economic growth.

  • Contact us to secure rights


  • Hide Comments Hide Comments Read Comments (14)

    Please login or register to post a comment

    1. CommentedHartmut Rißmann

      For german readers:

      "Die zügellose Geldschöpfung durch private Großbanken hat eine enorme Instabilität erzeugt und das Grundprinzip untergraben, dass Geldschöpfung dem Wohl der Allgemeinheit dienen soll. Das muss nicht so sein. Durch die Einführung von Sicherungsmaßnahmen, die gewährleisten, dass Kredite produktiven und gemeinnützigen Zwecken dienen, können politische Entscheidungsträger schuldenfreies, stabiles und nachhaltiges Wirtschaftswachstum erzielen. "

      Die "Sicherheitsmaßnahmen" für die Kreditvergabe in z.Bsp. Deutschland, genannt "Basel" sind mit das größte Problem bei der Kreditvergabe an Unternehmen. Gerade in schwierigen wirtschaftlichen Zeiten, wie sie sich z.Zt. darstellen, muss man feststellen, das Investitionsbereitschaft durch strenge Kreditvergabebedingungen abgewürgt wird, trotz Sonderprogrammen der EU für die Banken. Diese horten lieber dieses Geld , statt es an die Wirtschaft weiterzugeben.

      Allerdings erschwert ein wirtschaftlich schwieriges Umfeld auch die Nachfrage nach Krediten.
      Kleinere und mittlere Unternehmen neigen doch eher zu Vorsicht, als sich in "finanzielle Abenteuer" zu begeben.

      Der Artikel von Karl-Theodor zu Guttenberg und Richard A. Werner zeigt das Bankenproblem nochmal sehr schön auf und erläutert an einigen Beispielen, wie man Banken dazu bringen könnte, mehr Kredite der Wirtschaft zur Verfügung zu stellen.
      Doch sind alle Maßnahmen wirkungslos, wenn das politische Umfeld nicht stimmt. Sanktionen z.Bsp. sind alles andere als der Wirtschaft förderlich , politisch aber gelegentlich notwendig. So kommt es in der aktuellen Situation darauf an, die Konflikte in der Welt und in Europa schnellstens zu beenden. Durch die Vernetzung der Welt wirken sich regionale Konflikte längst auch auf den Rest der Welt aus. So könnte dies ein Hoffnungsschimmer sein, das sich diese Erkenntnis bei den "Wirtschaftsmächten" durchsetzt und das Risiko von größeren, militärischen Konflikten dadurch verringert wird. Denn es wird am Ende nur Verlierer geben !

      " I have a dream" sagte einst Martin Luther King.

      The Dream of peace in the world and justice for all mankind we should never surrender !

      Möge dieser Traum in Erfüllung gehen !

    2. CommentedJohn Rogers

      It is good to see such knowledge finally getting to a wider audience. Organisers of 'complementary currencies', like the Wörgl experiment mentioned, have known for decades that groups of businesses or citizens can 'create money' just like a bank does.

      It is a larger field than highlighted in this article. For instance, this year the Swiss WIR Bank celebrates 80 years of continuous operation of its unique WIR Credits that are issued alongside loans in Swiss francs, serving 60,000 SMEs. The Brazilian Banco Palmas has created a successful model for local currencies created by people in poverty that is replicated all over the country. The business to business exchange industry is worth billions of dollars. And now local authorities in Brixton and Bristol in England and in 2015 Nantes, France are backing the creation of regional currencies.

      In September I wil be running workshops for the City of Hull (mentioned in the article) and for Welsh Assembly Government about the creation of regional currencies. This is a rapidly emerging field that is a direct response to the financial crisis and the 'bankruptcy' of conventional approaches to provide a stable medium of exchange.

      Read my Guardian article from June 2013 on how local authorities are using local currencies:

      For an overview of the field of local currencies, watch the Prezi I created:

      Then read "People Money - the Promise of Regional Currencies", which I co-authored with Margrit Kennedy and Bernard Lietaer:

      and "Local Money - What Difference Does It Make?":

    3. CommentedProcyon Mukherjee

      Stopping the deluge of money that gets created with the single minded purpose of fueling speculation whether in stocks or in bonds or in real estate must be a step that should be preceded by measuring this flow; the quality of credit never gets measured by its end use and there is absolutely no visibility on this. Central banks would have done better to measure this as this flow does precious little to improve GDP.

    4. CommentedRalph Musgrave

      “banks are not financial intermediaries; they are money creators.”??? That claim by Werner and Guttenberg is very questionable and for reasons I in sections 1.12 and 3.1 here:

    5. Commentedroberto martorana

      I had write about this on "Riodialogues":I suppose a new rule for Central Bank: when CB, respectively of each country or through international agreements ,have a new emission of money whith the same CB print corresponding quantity of money of rate out balance ,and give this quantity, (to compense the monetary mass to solve the lack natural compensation previously provided by 'gold mining) , at a pubblic commission that use for pubblic necessity etc etc...we resolve three problem :pubblic necessity,pubblic balance,and market crisis,;for example : the B.C. have a emission of hundred billion unit and fix a rate of 3% and give this money to privat bank or pubblic... at the same moment print 3 billion extra and give these to "pubblic commission" that spend for pubblic problem ...i hope to be clear bat if not you can also have a look to :

    6. CommentedAbhishek Shekhar

      Nice article brilliantly explains the role of banks in creating money.
      But how does a currency becomes international why all World trade are done in dollars, and since there are practically no commodity based currencies how does the value of money fluctuates.

    7. CommentedPaul Daley

      The BOE's decision to use lending directives was a measure born of desperation; so is this whole scheme. It's just very difficult to channel investment towards new capital expenditures rather than current assets when real interest rates are so low. Some sort of fiscal measure -- probably wealth taxes -- are necessary to discourage excess saving, raise real interest rates and channel investment towards higher yielding assets. It is interesting, however, that Piketty's recommended solution for wealth inequality might also be useful in controlling bubbles and treating the macro doldrums that have settled on industrial economies.

    8. CommentedAndrew Zimin


        CommentedJonathan Lam

        gamesmith94134: How money is made
        It was what Cuban did? but they prefer dollars to shop in Miami.
        "By implementing safeguards that ensure that credit serves productive and public purposes, policymakers can achieve debt-free, stable, and sustainable economic growth." then Ms. Yellen can sweep foreign or domestic debt under the rug, and she might not have to ponder when or how appropriate is raise the interest rate. Perhaps, we can eliminate exchange rate too; and a dollar for a rupee shouldn't be a problem if we can print them. Every American will made million and the Indian too.
        Kindergarten? $100,000 for his or her birth right and we beat Saudis; and American government will give them jobs they enjoy too. It is not euphoria; and everyone is scare of the DJ is coming to a correction. Who cares if it is how money is made? they like dollar, don't they?

        May the Buddha bless you?