However, there were severe disadvantages in relying solely on the Government to provide sufficient money for everyone to use; perhaps most importantly, people could not generally borrow from the Government. So, over time, we turned to a set of financial intermediaries: the banks, to provide us both with an essential source of credit and a reliable, generally safe and acceptable monetary asset.

The supply of money is actually determined primarily by the demand of borrowers to take out bank loans. Moreover, when such demand is low, because the economy is weak and hence interest rates are also driven down to zero, the relationship between available bank reserves (deposits at the central bank) and commercial bank lending / deposits can break down entirely. Flooding banks with additional liquidity, as central banks have done recently via QE, has not led to much commensurate increase in bank lending or broad money.

  • Where did all that money come from? — in reference to the “credit bubble” that led up to the crisis.
  • Where did all that money go? — in reference to the “credit crunch”.
  • How can the BoE create $375B of new money through QE? And why has the injection of such a significant sum of money not helped the economy recover more quickly?

Defining money is surprisingly difficult. We identify that anything widely accepted as payment, particularly by the Government as payment of tax, is money. This includes bank credit because although an IOU from a friend is not acceptable at the tax office or in the local shop, an IOU from a bank most definitely is.

New money is principally created by commercial banks when they extend or create credit, either through making loans, including overdrafts, or buy existing assets. In creating credit, banks simultaneously create brand new deposits in our bank accounts, which, to all intents and purposes, is money.

The UK’s national currency exists in 3 main forms, of which the second two exist in electronic form:

  1. Cash — banknotes and coins.
  2. Central bank reserves — reserves held by commercial banks at the BoE.
  3. Commercial bank money — bank deposits created mainly either when commercial banks create credit as loans, overdrafts or for purchasing assets.

There are several conflicting ways to describe what banks do. The simplest version is that banks take in money from savers and lend this money out to borrowers. However, this is not actually how the process works. Banks do not need to wait for a customer to deposit money before they can make a new loan to someone else. In fact, it is exactly the opposite: the making of a loan creates a new deposit in the borrower’s account.

More sophisticated versions bring in the concept of “fractional reserve banking.” This description recognizes that the banking system can lend out amounts that are many times greater than the cash and reserves held at the BoE. This is a more accurate picture, but it is still incomplete and misleading, since each bank is still considered a mere “financial intermediary” passing on deposits as loans. It also implies a strong link between the amount of money that banks create and the amount held at the central bank. In this version it is also commonly assumed that the central bank has significant control over the amount of reserves that banks hold with it.

In fact, the ability of banks to create new money is only very weakly linked to the amount of reserves they hold at the central bank. At the time of the financial crisis, for example, banks held just $1.25 in reserves for every $100 issued as credit. Banks operate within an electronic clearing system that nets out multilateral payments at the end of each day, requiring them to hold only a tiny proportion of central bank money to meet their payment requirements.

Furthermore, we argue that rather than the central bank controlling the amount of credit that commercial banks can issue, it is the commercial banks that determine the quantity of central bank reserves that the BoE must lend to them to be sure of keeping the system functioning.

  1. Although possibly useful in other ways, capital adequacy requirements have not and do not constrain money creation and therefore do not necessarily serve to restrict the expansion of banks’ balance sheets in aggregate. In other words, they are mainly ineffective in preventing credit booms and their associated asset price bubbles.
  2. In a world of imperfect information, credit is rationed by banks and the primary determinant of how much they lend is not interest rates, but confidence that the loan will be repaid and confidence in the liquidity and solvency of other banks and the system as a whole.
  3. Banks decide where to allocate credit in the economy. The incentives that they face often lead them to favor lending against collateral, or existing assets, rather than lending to investment in production. As a result, new money is often more likely to be channelled into property and financial speculation than to small businesses and manufacturing, with associated profound economic consequences for society.
  4. Fiscal policy does not in itself result in an expansion of the money supply. Indeed, in practice the Government has no direct involvement in the money creation and allocation process. This is little known but has an important impact on the effectiveness of fiscal policy and the role of the Government in the economy.

We criticize the view, often presented in mainstream economics, that money is a commodity and show instead that money is a social relationship of credit and debt.

We do not own the money we have put in the bank. The custodial role that one third of the public assume banks play is something of an illusion. 77% of people believed that the money they deposited in banks legally belonged to them. In fact, the money that they deposited legally belongs to the bank. Instead, the bank takes legal ownership of the cash deposited and records that they owe the customer the money. In the bank’s accounting, this is recorded as a liability of the bank to the customer. It is a liability because at some point in the future, it may have to be repaid.

The balance of your bank account, and indeed the bank account of all members of the public and all businesses, is the bank’s IOU, and shows that they have a legal obligation (i.e. liability) to pay the money at some point in the future. Whether they will actually have that money at the time you need it is a different issue.

It also leads to assumptions about the economy that do not hold true in reality, such as the idea that high levels of savings by the public will lead to high investment in productive businesses, and conversely, that a lack of savings by the public will choke off investment in productive businesses.

Money is implicitly assumed to come from the BoE (after all, that’s what it says on every note); the Royal Mint or some other part of the state. The reality is quite different.

Most payments for larger sums are made electronically. This raises the question of who creates and allocates electronic or computer money. Not surprisingly, the BoE can create electronic money. It may do so when granting a loan to its customers, allowing them to use a kind of “overdraft” facility or when making payments to purchase assets or pay the salaries of its staff. The most important customers are the Government and the commercial banks.

The third type of money is what is in your bank account. In banking terminology, it’s referred to as bank deposits or demand deposits. In technical terms, it is simply a number in a computer system; in accounting terms, it is a liability of the bank to you. The terminology is somewhat misleading. A bank deposit is not a deposit in the sense that you might store a valuable item in a safety deposit box. Instead, it is merely a record of what the bank owes you.

In fact, not all deposits with the banks were actually deposited by the public. When banks do what is commonly, and somewhat incorrectly, called “lend money” or “extend loans,” they simply credit the borrower’s deposit account, thus creating the illusion that the borrower have made deposits. This focus on bank deposit, including deposits with the central bank, distract from the money creation process. We can learn more about credit creation — when banks lend or make payments — from other parts of their balance sheet.

The term “money supply” usually refers to cash and bank deposits taken together, with the latter being by far the most significant. On the BoE’s standard definition of the money supply, known as M4, this type of money now make up 97.4% of all the money used in the economy. In this book we refer to the money created by banks as commercial bank money.

The vast majority of money in our economy was created by commercial bank. In effect what the UK and most other countries currently use as their primary form of money is not physical cash created by the state, but the liabilities of banks. These liabilities were created through the accounting process that banks use when they make loans. An efficient electronic payments system then ensures that these liabilities can function as money: most payments can be settled electronically, without any physical transfer of cash, reducing the balance of one account and increasing the balance of another. This form of “clearing” has been a function of banks as far back as historical records go. The vast majority of payments, by value, are made in this way.

We might object that the commercial banks are not really creating money — they are extending credit — and this is not the same thing. The next chapter examines the nature and history of money in greater depth and concludes that in fact money is always best thought of as credit.

Money-creating organizations issue liabilities that are treated as media of exchange by others. The rest of the economy can be referred to as money holders.

Given the near identity of deposits and bank lending, Money and Credit are often used almost inseparably, even interchangeably.

Each and every time a bank makes a loan, new bank credit is created — new deposits — brand new money.

Changes in the money stock primarily reflect development in bank lending as new deposits are created.

This model implies 3 important things. First, it implies that banks cannot start lending without first having money deposited with them. In an economy with just a single bank, it would have to wait until someone deposited money, before it could lend anything, whatever the reserve ratio. So this model supports the concept of banks being primarily intermediaries of money. The banks in this example can be thought of as intermediating in succession, the outcome being “credit creation” — the creation of new purchasing power in the bank accounts of the public.

Secondly, this money multiplier model suggests that by altering the reserve ratio of the monetary base (cash plus central bank reserves), the central bank or the Government can closely control bank reserves and, through this, the amount of credit issued into the economy. If the money at the base of the pyramid is doubled, then the total amount of money in the economy will also double.

Thirdly, it implies that the growth in the money supply within the economy is mathematically limited. With a 10% reserve ratio, there is an increase in the money supply for the first approximately 200 cycles, but after this point there is no discernible increase, because the amounts being effectively re-lent are infinitesimal.

The textbook model of banking implies that banks need depositors to start the money creation process. The reality, however, is that when a bank makes a loan it does not require anyone else’s money to do so. Banks do not wait for deposits in order to make loans. Bank deposits are created by banks purely on the basis of their own confidence in the capacity of the borrower to repay the loan.

In the UK, there are currently no direct compulsory cash-reserve requirements placed on banks or building societies to restrict their lending. The main constraint on UK commercial banks and building societies is the need to hold enough liquidity reserves and cash to meet their everyday demand for payments.

Conversely, during the crisis, the BoE’s QE scheme pumped hundreds of billions of new base money into the system, yet this had not noticeable impact on lending, which continued to contract in 2010, 2011, and 2012. The only significant impact was a decrease in the ratio between commercial bank money and base money. This illustrates that banks’ reserves with the central bank are not a very meaningful measure of money supply: they may indicate that the amount of money could potentially rise, but at any moment in time they do not measure money that is used for transactions or necessarily affecting the economy in any positive way. If the central bank creates more reserve money, then everything else being equal this does not in any way stimulate the economy. However, an increase in bank credit creation will have a positive impact on the value of economic transactions.

When banks are confident, they will create new money by creating credit and new bank deposits for borrowers. When they are fearful, they rein in lending, limiting the creation of new commercial bank money. If more loans are repaid than issued, the money supply will shrink. The size of the commercial bank credit balloon, and therefore the money supply of the nation, depends mainly on the confidence and incentives of the banks.

One reason that banks’s confidence may be volatile is the fact that, despite their ability to create money, they can nevertheless go bust. Banks can create deposits for their customers, but they cannot create capital directly for themselves. Banks must ensure at all times that the value of their assets are greater than or at least match their liabilities. If the value of their assets falls, and they do not have enough of their own capital to absorb the losses, they will become insolvent. Once a bank is insolvent, it is illegal for them to continue trading. Equally, while banks can create deposits for their customers, they cannot create central bank reserves. Therefore, they can still suffer a liquidity crisis if they run out of central bank reserves and other banks are unwilling to lend to them.

Historical evidence suggests that the most important external factor in determining the quantity of money created by banks is the central bank’s attitude to the regulation of credit itself. When a central bank chooses to adopt a laissez-faire policy concerning bank credit, as now in the UK, boom-bust credit cycles are likely to result, with all their implications for economic analysis and policy. This is obvious if we think about the link between credit creation and economic activity. When banks create credit, and hence expand the money supply, whether the money is used for GDP or non-GDP transactions is crucial for determining the impact on the economy. Unproductive credit creation (for non-GDP transactions) will result in asset price inflation, bursting bubbles and banking crises as well as resource misallocation and dislocation. In contrast credit used for the production of new goods and services, or to enhance productivity, is productive credit creation that will deliver non-inflationary growth.

Historical evidence suggests that left unregulated, banks will prefer to create credit for non-productive financial or speculative credit, which often maximizes short-term profits. This may explain why the BoE, like most central banks, used to impose credit growth quotas on banks. However, such credit controls were abolished in the early 1970s.

Money is not metal. It is trust inscribed. And it does not seem to matter much where it is inscribed: on sliver, on clay, on paper, or on a LCD.

Think about any of the successful entrepreneurs you know. You will probably find that most of them started out with very little money and has to get loans from the bank, friends, or family before they could begin selling their services or products on the market. As Marx pointed out, in the capitalist system, money (or capital / financing) is required prior to production, rather than naturally arising after production as a way of making exchange more convenient. This is why it is called “capital-ism”. So building a model that starts with market clearing and allocation and then tries to fit in money as a veil on top of this makes little sense.

We cannot understand how our economy works by first solving the allocation problems and then adding financing relations; in a capitalist economy resource allocation and price determination are integrated with the financing of outputs, positions in capital assets, and the validating of liabilities. This means that that nominal values (money prices) matter: money is not neutral.

“I promise to pay the bearer on demand the sum often pounds.” It appears this money is a future claim upon others — a social relationship of credit and debt between 2 agents. This relationship is between the issuer of the note, in this case the state, and the individual. It does not appear to have anything to do with relations of production, between an agent and an object, or with the exchange of commodities.

If enough people recorded their debts with a single bank, that bank would be in a position to cancel out different debts through making adjustments to different accounts without requiring the individuals to be present.

The story begins with parents creating coupons they then use to pay their children for doing various household chores. Additionally, the parents requires the children to pay them a tax of 10 coupons a week to avoid punishment. The coupon are now the new household currency. Think of the parent as “spending” these coupons to purchase “services” (chores) from their children. The parents, like the federal government, are now the issuer of their own currency.

When coins did come into common usage, rarely was the nominal value of coins the same as the value of the metal of which they were made. Instead, the state determined the value of the coin and was free to change it whenever it felt like it.

Soon goldsmiths further realized that as the real deposit receipts were being used as a means of exchange as opposed to the metal itself, they could equally issue deposit receipts instead of actual metal for their loans. And this meant they could issue more gold deposit receipts than they had actual gold deposited with them. Goldsmiths chose to keep just a fraction of their total loan value in the form of gold in their vaults. Thus they created new money and fractional reserve banking was born.

From a legal perspective, the goldsmiths were committing fraud. The receipts were fictitious — they were pure credit and had nothing to do with gold. But no-one could tell the difference between a real deposit receipt and a fictitious one.

Given the previous repeated defaults by indebted kings and a raid on the national mint; Parliament and creditors of the state (namely the merchants and goldsmiths of the Corporation of London) lobbied for the creation of a privately owned Bank with public privileges — the Bank of England — and the secession of one square mile of central London as a quasi-sovereign state within the state.

We have seen how fractional reserve banking allowed banks to lend multiples of the amount of gold in their vaults. Similarly, they could create new bank deposits through lending or purchasing assets, which were multiples of the amount of now restricted banknotes. Because these account balances were technically a promise by the bank to pay the depositor, they were not restricted by the Act in the same way that banknotes were. This meant that the country banks were able to create them without breaking counterfeiting laws.

As banks work as the accountants of record — while the rest of the economy assumes they are honest accountants — it is possible for the banks to increase the money in the account of some of us (those who receive a loan), by simply altering the figures. Nobody else will notice, because agents cannot distinguish between money that had actually been saved and deposited and money that has been created “out of nothing” by the bank.

Transaction deposits are the modern counterpart of banknotes. It was a small step from printing notes to make book-entries crediting deposits of borrowers, which the borrowers in turn could “spend” by writing checks, thereby “printing” their own money.

Historically, during the long phase of “commodity-money”, the exchange rate would depend upon the amount of gold, silver, or copper contained in the coins of each country.

Similarly, after the advent of paper money and the gold standard, the exchange rate depended upon the amount of gold a government promised to pay the holder of bank notes.

The system lasted into the 1970s until, just like Britain in the 1931, the USA found itself unable to live up to the promise to convert dollars into gold. European commentators accused the USA of abusing the system by simply creating too many dollars, with which US firms then bought European companies and assets. The French government responded by demanding the conversion of its dollar balances into gold. As with the British gold standard, it turned out that the promise to convert into gold worked only as long as it was not acted on. In response to the French “raid on on Fort Knox,” US President Nixon cancelled the dollar convertibility into gold. By 1976 all the world’s major currencies were allowed to float freely against each other.

Much of the theoretical support for such deregulation was based on an analysis that thought of banks as mere financial intermediaries, and which neglected their crucial function as creators of the money supply.

The Bank abandoned its age-old Bank Rate and replaced it with a Minimum Lending Rate (MLR), now described as the Policy Rate or short-term interest rate, which determined the rate at which banks and other financial institutions could access cash and BoE reserves. These organizations could then lend reserves to other banks at whatever rate they wanted. Hence monetary regulation became more subject to market forces and the goal of the bank turned to attempting to ensure the market rate of interest was reasonably close to the policy rate.

We have discussed how all money is credit. Nowadays, we can say that, with the exception of a tiny fraction of cash, money is basically information. Huge volumes of money are moved around our economies simply by people typing data into computers.

Indeed bank deposits are sometimes more acceptable since it is actually easier and more convenient to use electronic payment for many routine obligations, including utility bills and taxes, than it is to use cash.

Central bank money (also known as M0, high-powered money, monetary base, or narrow money):

  1. Notes and coins in circulation (sometimes referred to as cash).
  2. Reserve balances at the BoE.

Broad money: M1: M0 plus sterling current accounts. M2: M1 plus sterling time deposits with up to 3 months’ notice, or up to 2 years’ fixed maturity. M3: M2 plus repurchase agreements, money market fund units, and debt securities up to 2 years. M4: M3 plus other deposits at UK banks or building societies.

The process of defining money becomes easier when we focus on the question of when and how new money is created. Then the definitional problems become irrelevant. When a bank makes a loan it invariably credits the borrower’s current account and from there the money is spent. When a bank grants an overdraft facility, it promises that it will make payments on my behalf even though I have no deposits. In this case, new deposits are created for the person to whom I have made a payment. Thus new commercial bank money enter circulation when people spend the credit that has been granted to them by banks.

Others also sometimes point out that commercial bank money is credit and then proceed to distinguish this from “money,” and measures of the money supply. Such an agreement is mere smoke and mirrors. It is impossible for anyone else to distinguish between a balance on my current account that got there because I paid $1K in cash over the counter, and the same balance that got there because the bank advanced me a $1K loan.

Note that the bank has expanded its balance sheet and all it has done is added some numbers to a record in a computer database, recording that it has a liability to Robert and also an asset in the form of Robert’s agreement to repay his loan. This is the process of extending credit or, more accurately, of creating credit. The process of creating commercial bank money — the money that the general public use — is as simple as a customer signing a loan contract, and the bank typing numbers into a new account set up for that customer.

A double-entry bookkeeping system is a set of rules for recording financial information where every transaction changes at least 2 different ledger accounts.

The name derives from the fact that financial information used to be recorded in books — hence “bookkeeping”. These books were called ledgers and each transaction was recorded twice as a “debit” and a “credit”.

The accounting equation serves as an error detection system: if at any point the sum of debits does not equal the corresponding sum of credits, an error has occurred. It follows that the sum of debits and credits must be equal. Double-entry bookkeeping is not a guarantee that no errors have been made, for example, the wrong nominal ledger account may have been debited or credited, or the entries completely reversed.

These banks can keep a tally on their computer systems and usually many of the movements cancel each other out at the end of each day — this is called intra-day clearing. Hence the actual amount of central bank reserves that needs to be tranferred between banks at the end of the day or overnight is a small proportion of the total value of the transactions that have taken place between their customers.

If central bank reserves are withdraw from one account, they must go up in some other account. What this mean is that the 46 banks within the clearing system know that there should always be enough money in aggregate to meet all the necessary payments. There may not be enough reserves to meet liquidity requirements, if the central bank imposes such a rule. This means that if a bank finds itself with too few reserves to make a payment, it can borrow central bank reserves from another bank within the loop, which, by definition, will have excess reserves. The one vital caveat is that banks have enough confidence in one another to be happy to lend to each other. These transfers are made on the interbank money market at the interbank market rate of interest, known as LIBOR.

In theory, if the BoE is operating a corridor system, then the LIBOR rate should not exceed the boundaries set out by the corridor. We would expect that no bank would deal in the market on worse terms than it could receive from the BoE. However, in practice this need not be the case. The banks worry that turning to the BoE would make them appear as though they are in trouble, which could spark a run on their deposits or make other banks less willing to lend to them. Essentially, the BoE lending facilities has a sigma attached to their use.

Commercial bank money does not have to be obtained from the central bank, however, and can be created at will by banks themselves. If all the banks “move in step” and all create new loans, which is quite typical during times of economic confidence, the aggregate amount of money will increase in the economy and the central bank may be forced to increase the aggregate amount of reserves in the system to ensure that payment system does not collapse.

Just as banks create new money when they make loans, this money is extinguished when customers repay their loans as the process is reserved. Consequently, banks must continually create new credit in the economy to counteract the repayment of existing credit. However, when banks are burdened by bad debts and are more risk averse, more people will repay their loans than banks are willing to create new ones and the money supply will contract, creating a downturn.

Given that bank notes are still created by the BoE, some monetary analysts have concluded that there are 2 “money supplies.” Firstly a supply of cash, created by the BoE and injected into the economy by being lent to commercial banks, and secondly a much larger supply of bank-created money.

However, the reality now is slightly different. While it is true that cash a different status from bank deposits — people have more confidence in banknotes — it is only possible for members of the public to get hold of cash via their bank deposits. In this sense one could describe cash as a physical representation of commercial bank money, over which the BoE retains the branding rights. The reason for this is as follows: when the BoE creates bank notes, it does not give them to the Government for spending directly into the economy. Instead it sells them to commercial banks in exchange for either gilts (government bonds) or central bank reserves. Bank notes therefore do not represent deb-free money for the Government, although the BoE does make a profit on the sales of banknotes, parts of which accrue, eventually, to the Treasury.

Commercial banks effectively “sell” the cash to the public; when you take money out of a cash machine you are not literally withdrawing the cash from your account. Instead, you are swapping banknotes for bank deposits. From the bank’s perspective, they initially had an asset (the $10 note) and a liability to you, recorded as your bank balance. When you withdraw cash from the ATM, the bank’s assets and liabilities both fall by $10 as they hand the cash over to you and reduce the balance of your account by $10.

The BoE sells bank notes to commercial banks. They sell these notes at face value (a $10 note sells for $10), yet the cost of printing a $10 note is just a few pennies. The difference between the face value and cost of production gives the BoE a substantial profit. This profit from the creation of money is known as “seigniorage,” and is paid over to the Treasury, where it can be used to fund government spending or to reduce taxation.

So Barclays could sell some of its liquid assets (government securities) on the money markets, replenishing its stocks of central bank reserves when it receives payment, from other banks, for the assets it sold. But how much should it increase its cash and central bank reserves in order to remain sufficient “liquid” to service this new loan? Given that the ratio of physical cash to customer demand deposits in 2010 was 1:37, the bank decides it only needs an additional $270 ($10K / 37) in cash. In addition, since the ratio of central bank reserves to deposits in 2010 was 1:15, it decides to increase it reserve account by $667 ($10K / 15), which requires borrowing the additional reserves on the interbank market. So out of the total loan of $10K, the bank accesses just $937 of additional central bank money, equivalent to less than 10% of the total loan.

On average, prior to the financial crisis of 2008 onwards, the banks had $1.25 in central bank money for every $100 of customer’s money. In the more cautious, post-crisis environment, the banks still have on average only $7.14 for every $100 or customers’ money.

Your money is not central bank money, and nor is it backed pound for pound by central bank money. Your money is a “promise to pay” by a commercial bank, but even central bank money is only a promise to pay that is enforced by the Government. The difference between the credibility of central bank money and commercial bank money is further blurred by the insurance of commercial bank money by the state.

Commercial banks are in a rather privileged position compared with ordinary businesses. Not only are they allowed to create money and allocate purchasing power, but someone else guarantees to pay their liabilities for them if they are unable to. That someone else is you, the taxpayer, via the Government. The Financial Services Compensation Scheme guarantees that the first $85K of any money deposited in UK licensed banks will be repaid in the event the banks are unable to make the payment. This $85K is risk-free. It has been transformed by the state from an IOU issued by a bank to an IOU issued by the Government. For any deposit above $85K, if the bank went into liquidation you would join the queue of general, unsecured creditors (behind the secured and senior creditors) hoping to get some of their money back.

As new kinds of financial institutions — secondary banks — began lending aggressively, the Bank decided that rather than try to regulate the quantity of credit provided by the banking system as a whole, it would attempt to influence the price of credit. The price or cost of credit is the interest rate charged on it when it is lent out. This makes sense in a world of perfect information, complete and competitive markets, flexible prices, zero transaction costs, and utility-maximizing agents, which are the conditions required for markets to clear, or reach equilibrium. In such a world, higher interest rates should lead to a reduction in the demand for credit and vice versa, as the credit market, like all markets, would be in equilibrium.

Open market operations by the BoE:

A. Withdrawing liquidity:

  1. BoE sells government bonds to the interbank money market.
  2. It receives central bank reserves / cash in return, withdrawing reserves from commercial banks’ account at the central bank reducing liquidity in the system.

B. Increasing liquidity:

  1. BoE buys government bonds to the interbank money market.
  2. It provides central bank reserves / cash in return, increasing reserves at the commercial banks’ and increasing liquidity in the system.

Central banks tell us that monetary policy is conducted mainly through interest rates. The official description is along the following lines: when the BoE believes that the economy is heating up it will raise interest rates to dampen economic activity. Conversely, if too little economic activity is taking place the Bank will lower the policy rate on the basis that, since interest rates are the driving force of economic activity, this will stimulate growth.

This official narrative has been criticized, as there is very little empirical evidence to support it; interest rates tend to follow economic growth and are positively correlate with it. The problem with this official narrative become especially obvious when interest rates have been lowered so many times — and without the desired effect — that they approach zero. The same economic theory would then suggest that interest rates would need to fall below zero, becoming negative — in effect punishing banks for holding reserves with the central bank by requiring them to pay a fee.

Interest rates are not the determining factor of bank credit creation.

When it had reduced short-term interest rates from 7% at the beginning of the 1990s to 0.001% at the end of it, the results were not impressive: Japan remained mired in deflation. Thus in March 2001 the Bank of Japan adopted the monetarist policy of expanding bank reserves, a policy common among central banks in the early 1980s, but abandoned due to its ineffectiveness. This policy was also ineffective, but thanks to using a label originally defined as expanding credit creation — “quantitive easing” — it caught the imagination of investors and commentators. Thus today often monetarist reserve or base money expansion is referred as “quantitive easing,” or QE.

How is QE supposed to affect the economy? QE may have an impact on the economy via multiple channels. Firs, as commercial banks hold significantly higher levels of central bank reserves, it is hoped the additional liquidity will enable them to increase their lending to the real economy, creating credit for new GDP transactions (the “liquidity effect”). This is however the weakest part of the argument, as in the past, as evidenced by Japan’s experience, this has not been possible due to banks’ higher risk aversion, triggered by large amounts of non-performing assets.

Secondly, due to central bank purchases of such large quantities of government bonds, their availability in the market decreases. It is then hoped investors will turn to other forms of investment which would support the businesses (the “portfolio rebalancing” effect), however, only the purchase of newly issued corporate bonds and equity in the primary market will increase purchasing power of businesses and the primary market is only a fraction of the overall turnover of capital markets.

Thirdly, by purchasing gilts on such a large scale, the BoE hopes to push up their price and thereby push down the interest rate received by investors. Again, it is anticipated this will make other types of financial assets more attractive and stimulate growth: the “wealth effect.”

All 3 channels are indirect, and all attempt to stimulate the real economy by acting through the financial sector. Thus bond purchase operations by central banks, including what is styled as QE, do not create new credit or deposits (purchasing power) directly in the hands of households, businesses or the Government. The investment sector may choose to invest this new purchasing power in newly issued corporate bonds or equity that may allow companies to increase their spending. However, it may also choose to buy government or corporate bonds from outside the UK, or it may invest in existing financial assets such as previously issued bonds or equities, or derivatives based on commodities such as oil or food, which will have the effect of inflating the prices of these assets. Or it may simply sit on these deposits because of concerns about the future of the economy.

Meanwhile, companies that are able to raise additional funds through bond or equity issuance may choose to use the money to simply pay off existing bank debt rather than invest in productive activity. If so, this will have the paradoxical effect of reducing credit creation, and the money supply, by exactly the same amount as QE increased it.

The banking sector, flooded with new central bank reserves, also has multiple options. It can choose to expand its lending to the real economy. However, it can also simply sit on the reserves. Banks are paid 0.5% interest on reserves by the central bank and they are the most liquid form of asset they can hold. Furthermore, if banks do not use this additional liquidity to create credit, it might be for transactions that are profitable but do not contribute to GDP, e.g. mortgage lending or foreign currency or commodity speculation.

Banks and central bank try to ensure there is sufficient liquidity in the banking system, and how the central bank tries to manage the quantity of credit creation through influencing interest rates and, when these are close to zero, undertaking QE.

Capital can be in the form of equity, or “own funds,” which constitutes the initial investment by shareholders plus retained profits. It also includes additional equity issued to investors over time. Because it can use retained profits as capital, every time a bank makes a profit, it can set some aside to increase its capital. Capital also contains a substantial third component: provisions. These principally cover depreciation and amortization, which are typically reported as negative entires on the asset side, and bad loans.

The equity capital proportion of capital is a liability of the bank to itself or its shareholders. In contrast to deposits it cannot be drawn down by its owners. Instead, the own funds are reduced when a borrower defaults on a loan. In that case, an amount equal to the default would be reduced from loans on the asset-side and from the “own capital” on the liability side. When bad loans become too large as a proportion of total assets, own capital — that is, the net worth of the bank — can become negative. In this case, the bank has become insolvent. This is quite feasible, since capital is commonly less than 10% of bank assets. This means that a mere 10% fall in values of assets held by banks will wipe out most banks.

Solvency is determined by whether you have sufficient capital to cover losses on your assets.

Liquidity is determined by whether you have sufficient liquid assets to meet your liabilities.

This said, a lack of liquidity can cause a bank to become technically insolvent. In an attempt to convert its assets into cash, the bank might have to sell them at such a discount that its losses exceeds its capital.

To stay in business, banks must ensure their assets (loans) are greater than or at least match their liabilities (deposits). If the value of assets falls below their liabilities, they will become insolvent. This means that even if the bank sold all its assets, it would still be unable to repay all its depositors and thus meet its liabilities. Once a bank is insolvent in a balance sheet sense, it is illegal for them to continue trading.

The bank can try to quickly sell off its loans in order to bing in the central bank reserves it needs to pay other banks, but if investors have concerns about the quality of the loans they are likely to force down the price of the loans and pay below the “book” value of those loans. The bank may then be forced in to a “fire-sale” of all of its assets in order to meet depositors’ demands for withdrawals. If the price of its assets keeps falling, this will eventually lead to the type 1 insolvency, whereby the total value of a bank’s assets is less than its liabilities.

In a liquidity crisis, the ability of banks to create money by making loans is of no help. In fact, it would make the situation worse, because every loan create new liabilities (the new bank deposits), which the borrower could then pay away to customers of another bank. This would mean that the bank would need to find even more central bank reserves to settle the transaction with other banks.

There are 2 main liquidity constraints on the creation of new commercial bank money that may affect individual banks:

  1. Having enough central bank reserves to ensure cheque, debit card or online payments can be made to other banks in the BoE closed-loop clearing system at any one time.
  2. Keeping enough of their demand deposits in the form of cash so that solvent customers can get access to cash whenever they wish.

According to the rules, banks must set aside a certain amount of capital every time they make a loan.

Since capital usually less than a tenth of assets, which include bank loans, sovereign debt, and derivatives such as ETF and Collaterized Debt Obligations, a 10% default of loans would wipe out all capital and render the bank insolvent. A small loss would leave it in breach of capital adequacy rules, requiring it to shrink its lending or raise more capital. When the proportion of bad assets becomes too large, own capital — that is, the net worth of the bank — can become negative.

Being able to use retained earnings as capital means that every time a bank makes a profit, it can set some aside as capital, which enables further lending, which leads to further profits, which further increases capital. therefore, under a stable capital ratio, a bank’s balance sheet can expand at the same rate of increase as its retained profits.

From this it follows that unless a business loan makes 3 times as much profit as a mortgage, the bank will prefer to extend mortgages.

It should be clear by now that increasing capital adequacy ratios will not necessarily prevent an increase in bank credit creation when times are good. There are 3 main reasons for this:

  1. An economic boom, and particularly rising asset / collateral values, will encourage each individual bank to lower its estimates of risk, and hence of the level of capital it requires.
  2. A more favorable view of economic prospects will also encourage the bank to make more loans, generating additional profits which increase its capital and allow it to make more loans.
  3. If regulators in the future impose higher capital adequacy requirements as a counter-cyclical “macro-prudential” policy, banks will find it easier to raise more capital, as the money to purchase newly issued preferred shares, for instance, is ultimately created by the banking system, and an increasing amount is created during boom times (hence the boom in the first place).

Furthermore, different dynamics come into play when we distinguish between an individual bank and the banking system as a whole. If the banks expand their balance sheets in step, there is little to restrain them. If only one bank continues to lend, it will find that it bumps up against its capital adequacy and liquidity limits, but if all banks are lending and creating new deposits, provided they remain willing to lend to one another, the banking system in aggregate will generate enough additional capital and liquidity.

So the trouble is that the design of capital adequacy rules usually neglects the crucial fact that banks are the creators of the money supply. Requiring banks to raise more capital in the boom times won’t stop the boom. The boom is caused by increased bank credit, and some of the expansion in the money supply can be tapped by banks to fund higher capital ratios.

Leverage ratios are therefore also an indirect and inadequate means of trying to control bank credit. Historically the only effective method of controlling bank credit has been via direct credit controls. These work as follows: the central bank tells commercial banks that they can extend credit for transactions that are not part of GDP, such as financial asset transactions including lending to hedge funds, only by a certain absolute amount, expressed as a fraction of GDP; say 5%. At times they may even entirely forbid credit for such purposes. Banks then have to focus more on creating credit for transactions that are part of GDP. Under such a system there would be either no credit ceiling, or very high credit growth quotas, for investment in the production of goods and services and productivity enhancements, as these are non-inflationary and growth-enhancing.

Unlike direct control of credit, the leverage ratio or capital adequacy may not achieve the goal of avoiding asset bubbles or may not enable the authorities to achieve the desired amount of credit creation. Indeed, leverage can give a misleading picture of both the state of the banking system and that of the economy.

Prior to the financial crisis, banks discovered a means to circumvent the Basel regulations on capital adequacy. This new method allowed them to preserve their capital adequacy and maintain liquidity while continuing to expand credit creation and is known as “securitization.” Securitization is the process of selling on a loan, or a package of loans, and passing the risk and reward onto someone else in exchange for cash. By taking loans off the bank’s balance sheet, it can create capacity for new lending while staying within the required capital ratios.

Depending on the quality, quantities, and streams of interest accruing to them, the bank can make a judgment as to whether it will be profitable to hold a loan or a set of loans or to sell them. Because banks “originate” the loans in the first place — and larger investment banks in particular have huge teams of analysts spread across the world looking at the latest developments in financial markets — they are quite often in a better position to judge the quality of a loan or a set of loans than the buyer of the securitized loans.

This is another example of the problem that arises when banks are given the privilege of creating new money without any guidance as to how this should be done in the public interest in order to contribute to general prosperity and stability. Each individual bank might pursue an “optimal” strategy, but the collective result for the economy as a whole is far from optimal.

This was close to the peak of the market; the crash of 2007-08 has been described as a “run” on the shadow banking system: and confidence in the complex structures of unregulated credit creation evaporated, leaving the US banking system “effectively insolvent for the first time since the Great Depression” as the crisis spread into conventional banking. Colossal injections of government funds in those countries worst affected by the crash have stabilized and restored confidence to the system, promoting a further boom in its activities. Meanwhile, banking bailouts have increased government borrowing and national debt, whereas bailouts funded by the central bank would not have created any liabilities for taxpayers. Despite, or perhaps because of the success of internationally co-ordinated government action to avoid widespread banking collapses, the underlying weaknesses of an unregulated, off-balance-sheet credit system have not been addressed.

When queues formed outside Northern Rock, the BoE was forced to step in, lending billions to Northern Rock directly and buying increasing amounts of assets from the banks in exchange for BoE reserves and cash that would enable them to make payments and rebuild their capital. Only by flooding banks and the interbank market with central bank reserves on a massive scale was the Bank able to avert financial collapse.

In reality, the tail wags the dog: rather than the BoE determine how much credit banks can issue, one could argue that it is the banks that determine how much central bank reserves and cash the BoE must lend to them. This follows on from the Bank’s acceptance of its position as lender of last resort, even though it has not fully played this role in the recent bank rescues, such as Northern Rock and RBS, since it passed on the cost of initial central bank money injections to the Government and hence to taxpayers. When a commercial bank requests additional central bank reserves or cash, the BoE is not in a position to refuse. If it did, the payment system described above would rapidly collapse.

In academic terminology, this process is often described as endogenous money creation.

The Bank of Japan could have injected more money into the economy than required by the reserve needs of banks. There is nothing to prevent it simply purchasing assets from the non-bank sector and thus bringing new money into circulation. For instance, it was proposed as early as 1995 that the BoJ should simultaneously boost the economy, rescue the property market (where values had fallen by about 80%) and strengthen the banking sector, while increasing the quality of life in the large cities. Tokyo, for instance, is a major city with one of the lowest ratios of park acreage per capita. It could do this by purchasing, at attractive prices, unused or empty real estate and creating new public parks. This would inject new purchasing power, support the property market and thus, by boosting collateral values, also help the banking system. In fact, the Japanese central bank has purchased properties in the past, albeit exclusively for the use of its own staff, such as beach resorts, golf courses, restaurants and clubs in central Tokyo. The central bank has drawn on the endogenous money argument to maintain its policy stance even as Japan’s recession has entered its third decade.

Without perfect information, there is nothing to ensure that demand will equal supply and that transaction prices are equilibrium prices. In a world such as ours, with imperfect information, markets do not automatically clear — so we are in a state of disequilibrium. This means that markets are rationed and outcomes are determined by quantities, not prices.

The outcome of these markets follow the short-side principle: whichever of demand or supply is smaller, that quantity will be transacted. Whoever in on the “short side” has a major advantage, namely market power.

The risk to the business owner of taking the loan is much smaller than for the bank. In practice, banks often attempt to circumvent limited liability by seeking collateral from the directors or shareholders of the business, usually taking a charge on their house. Thus, business loans may not even be granted to applicants who cannot provide such personal guarantees.

So, we can perhaps conclude the endogenous versus exogenous money debate as follows: in modern economies, where new money is created by the banking system, the supply of money is driven by credit creation, but credit creation is not driven by the demand for credit. Instead, the credit market is determined by the supply of credit and credit is rationed. It is the quantity of credit supplied, rather than the price of credit, which will determine macro-economic outcomes and without even perhaps being aware of it, banks are thus in a very powerful position. The total increase, or decrease, in the nation’s money supply is the collective result of their individual lending and asset purchase decisions. In other words, because commercial banks ration and allocate credit, and they create new money in the process, they have a decisive influence over the allocation of new money in our economy. Macro-economic policy and analysis should be guided by an understanding and monitoring of these processes.

The appropriate regulation of the total quantity of credit creation and the quality of its sue (i.e. the allocation of credit for different types of use) are key variables that economic policymakers should monitor and, indeed, seek to control. The quantity and allocation of credit across different uses will shape the economic landscape.

Indeed, during their history, almost all central banks have employed forms of direct credit regulation variously called: credit controls, the direction of credit, the guidance of credit, the framing of credit, window guidance or moral suasion.

Unproductive credit creation was suppressed because financial credit creation, such as today’s large-scale bank lending to hedge funds, simply produces asset inflation and subsequent banking crises. Thus it was difficult or impossible to obtain bank credit for large-scale, purely speculative transactions. Likewise, it was difficult to obtain consumer loans on a significant scale as these would increase the demand for consumer goods but not necessarily result in a direct increase in goods and services available, hence triggering consumer price inflation instead. Most bank credit was allocated to productive use, which meant either investment in plant and equipment to produce more goods, or investment to offer more services or other form of investment that enhanced productivity (such as the implementation of new technologies, processes, and know-how) — and often a combination of these. Such productive credit creation turned out to be the least inflationary, since not only was more money created, but also more goods and services with more value added.

The banks were quite willing to participate in such a system of credit guidance, as by way of return they also achieved unrivaled stability and a much greater degree of certainty concerning their market shares or even profits. Banks were recognized to be public utilities, and thus bonuses were also far more modest than, for instance, in the UK at the same time.

The Chinese central bank officially states that window guidance is one of its key monetary tools and empirical research has revealed this to be the case. Window guidance could also be cited as a key reason why the Chinese economy has not fallen victim to the Asian economic crisis or to the international banking crisis of 2008.

This prohibits the direct financing of government spending by the nation’s central bank. Article 101 EC does however allow the central bank to purchase debt instruments directly on the secondary market, after they have previously been issued to private investors and started to be traded in the money markets. It is for the independent central bank, not the Government, to decide whether and when to do this.

These EU rules, in theory at least, ensure that when government spending exceeds taxes, governments are forced to borrow funds from the market and run up a deficit, rather than financing the deficit or increase public spending through new central bank money creation. This is why the interest rates on government debt of different European countries, particularly since the financial crisis, are the focus of so much media attention. If the interest rates on government debt reach a certain level, the markets may lose confidence in the Government’s capacity to service its existing loans by keeping up interest payments, or roll over its debt, pushing interest rates even higher until eventually the country faces the prospect of default. Maastricht Treaty effectively removed the power of money creation from individual states and subject them to market discipline.

The UK, through its $375B QE program, can be seen to have, at least temporarily, monetized the Government debt “by the backdoor.” The BoE maintains in official communications that the reserves will eventually be sold back into the market, but with such a vast figure it is not easy to see this happening in the near future. The reality is that the UK can only default on its debt if the central bank decides to stop buying government bonds and since there is no actual limit to the amount of reserves the Bank can create to buy bonds, there would appear little reason for this to happen. The fact that there are no restrictions on the BoE’s ability to buy up government debt is one of the reasons that interest rates on UK government bonds have remained low.

If the Government cannot borrow from the central bank or create its own money, how then does it “spend”? Generally this spending is either funded from revenue, proceeds from profitable government-operated enterprises or services, national insurance contributions and taxes, or through borrowing.

Firstly, there are a number of reasons private investors might allocate money in less productive ways than the Government. Private investors, particularly institutional investors, will normally put their money where they receive the highest returns, including investing money in projects outside the UK. While this may result in a higher private return than if they had invested locally, the entire social benefit of the investment will fall abroad. A further example is when private investors fund private equity vehicles that take over productive manufacturers, fire local staff and outsource production to foreign low-wage countries. This reduces the number of low-skilled jobs available in the UK and contributes to unemployment.

In contrast, government investment is bound to contribute to GDP transactions — there is little reason for the Government to invest in existing financial assets. Particular types of investment, such as in transport infrastructure, housing construction or low-carbon conversion and energy efficiency-enhancing investments, appear to have a positive long term growth impact but are often under-funded by the private sector because the initial costs of investment are high and the returns on investment are low or take many years to arrive. In addition, spending by the Government tends to also be redistributive; channeling funds towards lower income groups who may spend a larger proportion of any additional income than higher income socio-economic groups.

When it cannot be sure of the long-term cooperation of the central bank, the Government can easily implement an alternative by ceasing the issuance of government bonds and borrowing instead directly from commercial banks in the form of long-term loan contracts. This has the advantage of increasing bank credit creation, as well as strengthening the banking system by improving the quality of its loan book. Such a policy is a potential solution to many of the problems faced by countries such as Spain and Ireland presently: the prime rate, i.e. the interest rate banks charge borrowers with the best credit risk, is often far lower in Spain, Ireland, Portugal and Greece, than the sovereign bond yield of similar maturity. The reason is that bank credit is not tradable and hence not susceptible to speculative attacks, or downgrades by rating agencies — while being eligible as collateral with the ECB, not required to be marked to market and not requiring new capital from banks, according to the Basel rules.

By 2010 the foreign exchange market had grown to be the largest and most liquid market in the world, with an average of more than $4T of currency being exchanged (settled) every day.

Of the currencies that are traded, the US dollar is the most prominent, accounting for 85% of all transactions.

Other types of pegged regimes include crawling pegs and currency bands. Under a crawling peg, the exchange rate is allowed to appreciate or depreciate slowly to allow for differing rates of inflation between the 2 countries. This stops goods in one country becoming relatively more expensive than in the other country, preserving the so-called real exchange rate (the exchange rate in terms of goods or PPP). Conversely, currency bands allow the exchange rate to float freely, although only within a narrow range.

It is widely acknowledged that it is not possible to simultaneously maintain free capital flows, a fixed exchange rate and a sovereign monetary policy, i.e. to use monetary policy as a policy tool to fulfill particular national requirements. This is known as the Impossible Trinity.

To see why this is so, consider a country with a fixed exchange rate regime. If the central bank of this country tried to lower its interest rate in order to stimulate the domestic economy, then residents of the country may look to transfer their savings into foreign assets, to take advantage of the relatively higher interest rate abroad. In order to so, they would sell the domestic currency, likely leading to the price falling due to the sudden extra supply. However, the central bank is committed to maintaining the exchange rate. In order to stop the currency depreciating, it has to sell its foreign exchange for domestic currency. However, people may continue to shift into foreign assets for as long as there is a difference between the interest rates. So unless the central bank increases the interest rate, the selling of the domestic currency may continue until the Bank’s foreign exchange reserves are exhausted. At this point the central bank will no longer be able to support the currency — leading to its devaluation. Of course, this will break the central bank’s commitment to the fixed exchange rate.

Could a country restrict capital flows? Yes, it can if it has an independent currency and central bank. This strategy was successfully implemented by the Malaysia government after the outbreak of the Asian crisis and although this policy was initially opposed by the IMF, it has since reversed its opposition to capital controls. China, India and Brazil have also all made routine use of such policies. However, the implementation of capital controls faces challenges, such as large firms attempting to disguise capital flows as current account transactions.

EU legislation prevents member governments from expanding credit creation directly by borrowing from the central bank, or “monetizing government debt.” QE is sometimes seen as a means by which central banks get round these strictures, since the effect of buying up large quantities of government bonds with the creation of new reserves can be viewed as the monetization of debt “via the backdoor.” However, the effectiveness of QE has been widely contested, and in particular regarding its effectiveness in stimulating credit creation and GDP. Furthermore, with independent central banks governments have no direct control over such policies.

Governments have intervened on a massive scale to bail-out the banking system, causing a strain on their fiscal position. Central banks have in turn used monetary policy to intervene on a significant scale in bond markets to support governments. This has contributed to lower interest rates and boosted demand for sovereign debt, thereby easing the strain on fiscal policy. The ECB’s policies of 2012, in particular the OMT mechanism which places conditions on a government’s fiscal policy before the ECB will embark on purchasing its bonds, challenge the idea that central banks can be truly “apolitical.” Fiscal policy, monetary policy and the banking system, as the engine of credit creation, are inextricably intertwined.

The privately owned BoE transformed the sovereign’s personal debt into a public debt and then, eventually, into a public currency. The private money of the bill of exchange was lifted out from the private mercantile network and given a wider and more abstract monetary space based on impersonal trust and legitimacy.

Thus modern capitalism gave birth to a hierarchical form of regulatory control, with the central bank at the apex of the hierarchy, ensuring the continued link between the nominal value of commercial bank money and the real value of central bank money. The hope was that the central bank could control the quantity of commercial bank money through its power of discounting and, as lender of last resort, rescue any bank which faced a run when depositors lost confidence, by emergency issuance of central bank money (“printing money”). For short periods of time, the system appeared to be stable, most obviously during the 1950s and 1960s, with a fixed exchange rate and strict national and international credit controls in place.

Identify what counts as money is not easy. Financial innovation means that when an instrument is defined and controlled as “money,” Goodhart’s Law suggests that substitutes will be found to enable evasion of tax and regulation. Such instruments include derivatives based on loans that are secured on highly illiquid assets such as houses. Although never really considered as money, such instruments have been increasingly traded in a moneylike fashion: moved around the world at great speed and frequency by investment banks, hedge funds and other global financial actors, but as the financial crisis has revealed, their acceptability among financial institutions ultimately depends upon the strength of the credit-debtor relationship.

A further difficulty in defining money arises from the tension between its role as a means of exchange — where the more liquid the better — and its role as a store of value, where generally assets which are less liquid, such as homes, tend to hold their value more effectively against inflation. It may be that different conceptions of money are partly driven by the relative importance that people place on the different functions of money at different times — whether they consider its usefulness as a store of value to be the most important aspect, or its usefulness and availability as a means of exchange. This tensions points to the possibility that no single form of money will perform all the functions of money equally well.

The implications of the credit model of money are profound. Rather than being neutral or a veil over the “real” activities of the economy (trade, exchange, the use of land and labor), it becomes clear that money — as an abstract, impersonal claim on future resources — is a social and political construct. As such, its impact is determined by whoever decides what it is (the unit of account), who issues it, how much of it is issued to whom and for what purpose.

While money is really nothing more than a promise to pay, what distinguishes money from, say, an IOU note, is its general acceptability.

Anyone can create money, the problem is getting it accepted. Since banks are the accountants of the economy, through whose computers the vast majority of all transactions are booked, they are uniquely placed to get their money — created through granting credit — accepted.

People accept and hold money not because of its intrinsic value as a commodity but because of guarantees regarding its future re-exchangeability; the “satisfaction of the holder does not depend on possession per se, but on possession with a view to future use for payment.”

In a world of imperfect information and disequilibrium, credit is rationed by banks and the primary determinant of how much they lend is not interest rates, but confidence that the loan will be repaid and confidence in the liquidity and solvency of other banks and the system as a whole.

Central banks have the power to create money in the same way as commercial banks, via the expansion of their balance sheets. The QE policies of the BoE, the Fed, the ECB and the BoJ show that, in times of crisis, there is nothing to stop central banks creating vast quantities of credit to support the existing financial system. However, the type of QE policies adopted do not appear to have been effective in boosting GDP growth and employment, as the additional purchasing power remains within the financial sector when bank and investor confidence is low.

The authors reveal a paradox at the heart of our monetary system: it is the state that essentially determines what money is and underwrites its value and yet it is predominately commercial banks that create it. In deciding who receives credit, commercial banks determine broadly who it is spent within the economy; whether on consumption, buying existing assets or productive investment, their decisions play a vital macro-economic role.