Friday, 6 May 2011

Creation of money

It's time to look at how money is created.

Money from debt

Money in a modern monetary system is created by the central bank.

Once upon a time, there was no official currency of Somewhereia. Even so, barter had become too inconvenient — when Mr Courgette, who had two cows, wanted to buy a bag of flour, he didn't want to buy enough flour to be worth one cow, and besides it would have halved his cheese production. And he couldn't just sell one leg of a cow, because it would be unethical and make it harder to milk. What he really wanted was to get some flour, combine it with some of his cheese to make two cheese pies, then sell one cheese pie to pay for the flour, and eat the other cheese pie.

People had taken to using spoons of various sizes as money. After all, spoons are quite useful, and people were happy to exchange their flour and/or cheese for spoons. A small teaspoon was worth one bag of flour. Mr Courgette could pay for the flour with a teaspoon, make his two cheese pies, sell one for a teaspoon, and eat the other.

But one day, the dictator of Somewhereia decided (for reasons which we may examine another time) to create a fiat currency – the Somewhereia shilling. A fiat currency is one which the government simply declares to be the official currency. It would enforce this by only accepting taxes using shillings, and would enforce the collection of taxes by having harsh penalties for people who refuse to pay taxes using shillings. This created a demand for shillings because people needed them in order not to be put in prison (or worse). The government also created a law saying that any private debt can be paid in shillings — if Mrs Lemon owes Mr Aubergine some money, Mr Aubergine can ask the law courts to force her (using the resources of the state) to pay, but if Mrs Lemon agrees to pay the debt using shillings, Mr Aubergine cannot force her via the courts to pay with spoons or cheese pies instead.

The dictator of Somewhereia decided to use a central bank model with a debt-based currency for his shillings. There were other possible approaches, but he decided to use that one. He set up the Bank of Somewhereia, with no assets and no liabilities. The BoS created an account for the government, but with a zero balance – there were still no shillings.

Now the dictator wanted some shillings, so he asked the BoS for a loan of one million shillings for ten years. The BoS agreed to make the loan in return for a promise to repay the money plus 4% interest annually. So the dictator asked his government treasurer to print ten pieces of paper (unrelated to the ten years), each with a flattering picture of the dictator and the words 'Treasury of Somewhereia – One hundred thousand shilling bond.' Near the bottom of the piece of paper was a horizontal perforation, and from there to the bottom of the bond were nine vertical perforations making ten detachable coupons. Each coupon had the words 'Treasury of Somewhereia – Four thousand shillings' printed on. The treasurer sent these pieces of paper to the BoS, which wrote in a book that the government account now contained one million shillings. (The effect of having these coupons is interesting, and will be investigated later — when the government borrows money, it has to pay back more than it borrowed, just like other borrowers in the economy).

The government now had some money to spend, and it started to spend it — mostly on gold statues of the dictator to put up on plinths in the market square, and people to guard them. Since the people of Somewhereia didn't have accounts with the BoS, the government paid them with cash which it withdrew from its BoS account.

This then is how new money is first created. It is essentially identical to the creation of bank credit when a normal person or business takes out a loan, as was discussed earlier. A bond is equivalent to a promissory note — it is a promise to repay money in future, so it represents a debt, and money is created in exchange for the promise. When the bonds mature (i.e. have to be repaid) at the end of the ten years, the government must have sufficient money in its account (100,000 shillings for each bond) at the BoS to pay back the million shillings. At that point, the money is destroyed, again just as bank credit is destroyed when a loan is repaid.

More money?

We looked above at the loan of money to the government directly by the central bank. While this is essential for starting the monetary system going, in practice money is rarely lent directly to governments by central banks once a certain amount of money has been created. In fact, it may not be allowed at all (at least in principle, although quantitative easing is suspiciously similar to this). Let's look at what actually happens, and that will eventually lead on to seeing the other way in which money is commonly created.

After the government has borrowed enough shillings, and started spending them, people throughout Somewhereia now have money. Some of them may eventually accumulate enough money to be able to set up a bank.

Let's assume that six months later, the government has spent all of its million shillings, and that October Bank of Somewhereia (OBoS) has accumulated 100,000 shillings. Unfortunately, the government hasn't got any money left to pay the guards to look after the gold statues in the market square — it desperately needs 20,000 shillings or they will desert their posts. But the government has an empty bank account at the BoS. How can it pay the guards?

There are three main options:

  1. It could tax the people of Somewhereia.
  2. It could borrow more money from the BoS.
  3. It could borrow money from someone who has some of the million shillings originally created.

If a government has ongoing costs, it should pay for these through taxation. However, if it has unexpectedly high costs or an unexpected shortfall in taxation income, and is in danger of running out of money, raising taxes will probably not bring the money in quickly enough. For example, raising income taxes will probably not produce extra income until the end of the month. So borrowing money as a short-term measure makes sense as long as measures are taken to reduce spending or increase income (taxes) to bring the income and expenditure back in balance.

Typically, governments do not borrow from the central bank, but instead auction bonds to whoever decides to buy them (often commercial banks). This is criticised by the Money as Debt film, but that is a discussion for later. Let's assume that the government decides to borrow 20,000 shillings for 2 years at 4% interest, and the only interested buyer is OBoS.

Here is the location of all the money in the economy before the new bonds are issued:

Table 1 - All money in Somewhereia before new bonds issued
Agricultural Bank of Somewhereia (ABoS)50,000
Industrial Bank of Somewhereia (IBoS)80,000
October Bank of Somewhereia (OBoS)100,000
Government of Somewhereia0
Cash in circulation770,000

The government treasury prints another couple of bonds, each with a value of 10,000 shillings, with their respective coupons. OBoS buys the bonds, and here is the new situation:

Table 2 - All money in Somewhereia after new bonds issued
Agricultural Bank of Somewhereia (ABoS)50,000
Industrial Bank of Somewhereia (IBoS)80,000
October Bank of Somewhereia (OBoS)80,000
Government of Somewhereia20,000
Cash in circulation770,000

Now the government can spend its newly-acquired money, and have the statues guarded for a few more months. Of course, it will have to pay interest on the debt to OBoS, and repay the 20,000 shillings at the end of the two years. Both of these will presumably come from taxation.

Note that there are still 1,000,000 shillings in total. The government just borrowed some of the existing money. Let's look at where some new money could come from.

Imagine that OBoS has agreed to lend 85,000 shillings to Mr Lentil, who wants it to buy a sports car. But the sports car dealer banks with IBoS. When Mr Lentil pays the dealer with a cheque, the 85,000 shillings will eventually move from OBoS's bank account to IBoS's bank account at the Bank of Somewhereia. Unfortunately, OBoS doesn't actually have 85,000 shillings in its BoS account. What can it do? Here are three possibilities:

  1. It could borrow some money from another bank – perhaps IBoS itself. The assumption is that in the not-too-distant future, there will be a day when the net transfer between OBoS and IBoS will be in the other direction, and the loan can be repaid. In this case, existing money is transferred.
  2. It could sell an asset, such as its government bonds, to raise the money. Again, it is existing money which is transferred.
  3. Or it could borrow from the BoS (the lender of last resort) itself.

Borrowing from the BoS is very simple. OBoS calls BoS, and the conversation goes something like this:

OBoS: I'd like to borrow 20,000 shillings for one day please.
BoS: Certainly, as long as you pay a reasonable rate of interest and give us a good security. We really hate making a loss on our loans, don't you know.
OBoS: I've got these government bonds with a face value of 20,000 shillings.
BoS: That'll do nicely, sir.

So the BoS takes temporary ownership of the bonds, and deposits a further 20,000 shillings in OBoS's account, making a total of 100,000 shillings, and allowing it to transfer the 85,000 shillings to IBoS. But note what has happened now:

Table 3 - All money in Somewhereia after OBoS borrows from BoS
Agricultural Bank of Somewhereia (ABoS)50,000
Industrial Bank of Somewhereia (IBoS)80,000
October Bank of Somewhereia (OBoS)100,000
Government of Somewhereia20,000
Cash in circulation770,000

There is now more money in total. It has increased from 1,000,000 shillings to 1,020,000 shillings. That extra money exists until OBoS repays the loan later.


We saw before that when retail banks lend, bank credit is created. Now we have seen that something very similar happens with a central bank: when it lends, money is created. The basic difference between the two is that the money's value is derived from the promise of the Bank of Somewhereia, but bank credit's value is derived from the promise of the retail bank.

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