Guardian: The truth is out: money is just an IOU

Tony Gosling tony at
Wed Mar 19 19:53:27 GMT 2014

The truth is out: money is just an IOU, and the banks are rolling in it
The Bank of England's dose of honesty throws the 
theoretical basis for austerity out the window
Tuesday 18 March 2014 10.47 GMT
ack in the 1930s, Henry Ford is supposed to have 
remarked that it was a good thing that most 
Americans didn't know how banking really works, 
because if they did, "there'd be a revolution before tomorrow morning".

Last week, something remarkable happened. The 
Bank of England let the cat out of the bag. In a 
paper called 
Creation in the Modern Economy", co-authored by 
three economists from the Bank's Monetary 
Analysis Directorate, they stated outright that 
most common assumptions of how banking works are 
simply wrong, and that the kind of populist, 
heterodox positions more ordinarily associated 
with groups such as 
Wall Street are correct. In doing so, they have 
effectively thrown the entire theoretical basis 
for austerity out of the window.

To get a sense of how radical the Bank's new 
position is, consider the conventional view, 
which continues to be the basis of all 
respectable debate on public policy. People put 
their money in banks. Banks then lend that money 
out at interest – either to consumers, or to 
entrepreneurs willing to invest it in some 
profitable enterprise. True, the fractional 
reserve system does allow banks to lend out 
considerably more than they hold in reserve, and 
true, if savings don't suffice, private banks can 
seek to borrow more from the central bank.

The central bank can print as much money as it 
wishes. But it is also careful not to print too 
much. In fact, we are often told this is why 
independent central banks exist in the first 
place. If governments could print money 
themselves, they would surely put out too much of 
it, and the resulting inflation would throw the 
economy into chaos. Institutions such as the Bank 
of England or US Federal Reserve were created to 
carefully regulate the money supply to prevent 
inflation. This is why they are forbidden to 
directly fund the government, say, by buying 
treasury bonds, but instead fund private economic 
activity that the government merely taxes.

It's this understanding that allows us to 
continue to talk about money as if it were a 
limited resource like bauxite or petroleum, to 
say "there's just not enough money" to fund 
social programmes, to speak of the immorality of 
government debt or of public spending "crowding 
out" the private sector. What the Bank of England 
admitted this week is that none of this is really 
true. To quote from its own initial summary: 
"Rather than banks receiving deposits when 
households save and then lending them out, bank 
lending creates deposits" 
 "In normal times, the 
central bank does not fix the amount of money in 
circulation, nor is central bank money 
'multiplied up' into more loans and deposits."

In other words, everything we know is not just 
wrong – it's backwards. When banks make loans, 
they create money. This is because money is 
really just an IOU. The role of the central bank 
is to preside over a legal order that effectively 
grants banks the exclusive right to create IOUs 
of a certain kind, ones that the government will 
recognise as legal tender by its willingness to 
accept them in payment of taxes. There's really 
no limit on how much banks could create, provided 
they can find someone willing to borrow it. They 
will never get caught short, for the simple 
reason that borrowers do not, generally speaking, 
take the cash and put it under their mattresses; 
ultimately, any money a bank loans out will just 
end up back in some bank again. So for the 
banking system as a whole, every loan just 
becomes another deposit. What's more, insofar as 
banks do need to acquire funds from the central 
bank, they can borrow as much as they like; all 
the latter really does is set the rate of 
interest, the cost of money, not its quantity. 
Since the beginning of the recession, the US and 
British central banks have reduced that cost to 
almost nothing. In fact, with "quantitative 
easing" they've been effectively pumping as much 
money as they can into the banks, without producing any inflationary effects.

What this means is that the real limit on the 
amount of money in circulation is not how much 
the central bank is willing to lend, but how much 
government, firms, and ordinary citizens, are 
willing to borrow. Government spending is the 
main driver in all this (and the paper does 
admit, if you read it carefully, that the central 
bank does fund the government after all). So 
there's no question of public spending "crowding 
out" private investment. It's exactly the opposite.

Why did the Bank of England suddenly admit all 
this? Well, one reason is because it's obviously 
true. The Bank's job is to actually run the 
system, and of late, the system has not been 
running especially well. It's possible that it 
decided that maintaining the fantasy-land version 
of economics that has proved so convenient to the 
rich is simply a luxury it can no longer afford.

But politically, this is taking an enormous risk. 
Just consider what might happen if mortgage 
holders realised the money the bank lent them is 
not, really, the life savings of some thrifty 
pensioner, but something the bank just whisked 
into existence through its possession of a magic 
wand which we, the public, handed over to it.

Historically, the Bank of England has tended to 
be a bellwether, staking out seeming radical 
positions that ultimately become new orthodoxies. 
If that's what's happening here, we might soon be 
in a position to learn if Henry Ford was right. 

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