Where Money Comes From: A Reply to the New Economics Foundation.
In a 140-page booklet entitled Where Does Money Come From? the New Economics Foundation (NEF), a greenish think-tank, set out to refute one theory of the nature of money and banking and replace it by another which they consider more accurate.
“What is Money?” is not just a question of fact but of definition. “We disagree with the view of money as a commodity,” says the NEF, “and show instead that money is a relationship of credit and debt” (p. 9). More boldly, they declare “money has never been a commodity” (p. 51).
In Classical Political Economy (Adam Smith, David Ricardo, John Stuart Mill), and in Marx too, a commodity is an article of wealth produced to be exchanged. Wherever commodity-production has been widespread one commodity has emerged that can be exchanged for any other commodity. To be able to be such a “universal equivalent” this commodity must have its own intrinsic value, i.e. must also be the outcome of a certain amount of labour; otherwise nobody would exchange the product of their labour for it.
Other commodities have functioned as the universal equivalent, but in the end it was the precious metals, gold and silver, that proved the most convenient (because of their divisibility and their concentration of value in a relatively small bulk). To make things even more convenient states eventually stamped pieces of gold and silver as a guarantee of their weight and value. Hence coinage, which is still the popular idea of what money is.
To deny that the commodities that have functioned as a universal equivalent were “money” is to give a quite new definition of what money is. The NEF don’t deny that to be called “money” something has to be, as in the traditional definition, a medium of exchange, a store of value and a unit of account.
If they had just claimed that, today, money is not a commodity, they would have had a point. But to claim that no commodity has ever served as a medium of exchange, store of value and that accounts have not been kept in units of it, is clearly at variance with the historical facts. But, to sustain their definition that money is essentially a “social relationship of credit and debt”, they had to make this extravagant and historically incorrect claim. They are right, however, to see money as a social relationship but it’s one between buyers and sellers rather than creditors and debtors.
It is true that it does seem strange to still describe money today as a “commodity”, even though modern money does have a commodity ancestry. Modern money consists of paper notes and metallic coins that are accepted in payment (of taxes and debts as well as to buy things). These notes and coins have virtually no intrinsic value; they are like all-purpose, re-usable vouchers that can be used for any payment, just as the old commodity-money (such as gold) could be. We know where they come from: the state, which issues them via its central bank or finance ministry, and makes their circulation and acceptance compulsory. Because such money is entirely a state’s creation it is sometimes called “fiat” (“let there be”) money.
“Money” and “purchasing power” are not the same. If they were, the total face value of the currency would have to be equal to the value of all the newly produced wealth. One feature of money (in the classical sense) is that it circulates: one coin or note can be used for many transactions. Hence the concept of the “velocity of circulation” of money. The amount of money needed by the economy to make payments is thus not the total value of these payments but this divided by the velocity of circulation of money.
One thing banks do is to reduce the need for cash. They have done this ever since, in the 17th century, they became an important feature of the capitalist economy. In addition, through clearing houses, they settle payments without the actual transfer of cash. Nowadays the vast majority of transactions are made through banks using cards, cheques and bank transfers, with cash (notes and coins) reduced to being the small change of the economy.
What this means is that today most purchasing power is exercised via the banks. But can banks create extra purchasing power that did not exist before? The NEF are in the tradition of economic thinkers (and monetary cranks) who have said “yes”. In the past the argument used to be that banks could create extra purchasing power in the form of “credit”. Nowadays, as the distinction between deposits in banks made by savers and deposits created by banks for borrowers has become blurred, the same idea has come to be expressed by saying that banks can create new “money”.
Though this looser definition of money is popular today, even those who favour it feel obliged to distinguish between traditional money (today, notes and coins issued by the state) which they call “base money” and “bank money” (bank loans).
Calling bank loans “money” instead of “credit” doesn’t alter the facts. When banks make a loan, or extend credit, they do enable idle purchasing power to become effective; they do allow spending to take place – which is something that modern governments do strive to control. But the basic question remains: when banks make a loan do they create new purchasing power?
Purchasing power is generated in production as added value and is distributed in the first instance as the wages and salaries of productive workers and as the profits of capitalist firms. A large proportion is later redistributed by the state as “transfer payments” to others, via taxes and public service salaries, pensions and other state payments. But National Income (total new purchasing power) and National Product (total new value added) are always equal (there is no built-in or chronic shortage of purchasing power compared to new production, as economic theorists known as ‘underconsumptionists’ claim).
Some of the purchasing power is saved (not spent) by the recipient on consumption. When income is saved it is not simply hoarded. It is typically deposited in a bank or a building society. The bank doesn’t hoard it either. It lends it to someone else to spend: to capitalist firms to expand production; to the government; or to workers (to buy a house or a car or a holiday). It should be clear, then, that such bank loans come out of income (purchasing power) that others have saved (refrained from spending themselves).
Banking a fraud?
This, however, is not clear to the NEF. In fact, they vehemently deny that this is the case. They attack the view that banks are financial intermediaries whose core activity consists of “taking money from savers and lending it to borrowers” and even criticise the recent Independent Commission on Banking for accepting this view. They declare:
“private banks can really create money by simply making an entry in a ledger” (p. 5).
“when a bank makes a loan it does not require anyone else’s money to do so” (p. 21).
“Banks create brand new money whenever they want by extending credit or buying assets” (p. 100).
“Those with the power to create new money have enormous power – they can create wealth simply by typing figures into a computer” (p. 51).
That banks can lend something they haven’t got is an extravagant and extraordinary claim. The NEF attempt to trace this back to goldsmiths in seventeenth-century London who, they claim, as custodians of other people’s money, adopted the practice “of issuing deposit receipts to a value greater than the value of the deposits the custodians actually possessed – a practice that would later be described as fractional reserve banking” (p. 35).
If goldsmiths did do this, it would have been fraud. In theory they could have done but there is no historical evidence that this was the normal and widespread practice that the NEF and others allege it was.
Because they think that banks today behave like they imagine the London goldsmiths did, the NEF describes modern banking as an “innocent fraud”. They have also misunderstood the nature of “fractional reserve banking”. It merely means that anyone taking in someone else’s money can safely lend only a proportion of it, a “fraction” having to be retained as a “reserve” against likely withdrawals.
The NEF claims that, “commercial banks can be seen to generate ‘special profits’ from their power to issue money in the form of credit through the interest charged upon loans and used overdraft facilities” (p. 68) and that “bank loans are rather special since they do not cost the bank anything to create, but the bank can charge very profitable rates of interest on them”. (p. 97)
But there is nothing special about bank profits compared to those of other businesses. Banks do not make their profits by charging interest on loans they conjure up out of thin air. Their income comes from the difference between the rate of interest they charge borrowers and the lower the rate of interest (if any) they pay savers. Their profit is what remains after they have paid the expenses of the business (buildings, computers, staff salaries).
Incredible credit unions
Any organisation that lends other people’s money has to keep a part of what is deposited with it as cash but can lend the rest, and so practises “fractional reserve banking”. The NEF does not shrink from this logical deduction from their position and asserts that banks are not the only organisation that can create money (new purchasing power) out of nothing:
“Building societies and credit unions also have the right to create money through issuing credit” (p. 18).
A credit union, as a mutual society in which members save and lend to each other, is a good example to judge whether or not a lending organisation can lend more than has been saved with it. Merely to pose the question is to answer it – with a ‘No’. The only source of what a credit union has to lend is what its members have paid in; the loans it makes come entirely out of this.
Suppose that a credit union tried to lend more than had been saved with it. If its loans were payable in cash, clearly it would be impossible to hand out more cash than it had. If the loan were paid out by a cheque or some other kind of money order, if more of these were issued than the union had in savings then not all of them would be able to be honoured. The union would go bankrupt. The same would apply in the case of electronic transfers.
Building societies were originally like credit unions – members saved to be able to later get a loan to buy a house, their money in the meantime being loaned to other members to buy one – but these days they accept savings from anyone. But what they can lend is still limited by what has been saved with them. Building societies are in competition with each other and with banks to attract savings. If they could simply give a loan by typing figures into a computer then they wouldn’t be under such competitive pressure.
Banks are no different in principle from building societies and credit unions, although the link between savings with them and the amount of loans they can give is perhaps not so obvious. They can lend more than has been saved with them, but only by borrowing from elsewhere (“wholesale” from the money market, as their jargon puts it).
Banks cannot create extra purchasing power; they can only redistribute it from those who don’t want to use for the moment (“savers”) to those who need money to spend immediately, whether for consumption or investment (which is really spending on production). Contrary to what the NEF asserts, banks essentially are financial intermediaries.
The NEF seems to have been carried away by its own arguments when it claims that commercial banks (and, by inference, credit unions) create new money not only when they make a loan but even whenever they spend any money, as on buildings, computers and the wages and salaries of their staff:
“the bank creates new money when it buys assets, goods or services on its own account, or pays its staff salaries or bonuses” (p. 57).
This is an own goal as it would mean that to set up a bank you wouldn’t need any capital. You could go to an internet café, conjure up some money by typing some figures in a ledger and then spend it to buy a building and hire staff, which is ridiculous.
There is, however, one type of bank that can and does do this – a state’s central bank. A central bank can create purchasing power out of thin air and use it to acquire assets, as recently with so-called “quantitative easing”. However, this action does not create any new wealth (that can only be done by people actually working, not by any bank operation). It is popularly called “printing more money” but this does not necessarily involve in the first instance actually printing more bank notes. The new purchasing power is created in the way the NEF mistakenly thinks commercial banks can do it, electronically as digital money, though with quantitative easing it is a temporary phenomenon.
Banking is neither a form of magic nor a fraud. Those who believe that it is (and the NEF is far from being alone in this) are led to waste their time campaigning to reform something which doesn’t exist. In fact, the situation most of them want to achieve – control of the creation of nominal purchasing power by the government instead of by private bodies that profit from it – is what already exists but they can’t see it.