Until the economic crash of 2008 I, like many other people, had done my level best to avoid the subject of money and money creation all together. It was a topic for economists, government ministers, financiers and other people with an unhealthy relationship to Microsoft Excel. It wasn’t for me and I wasn’t for it, a mutual understanding that served both sides well. So after the crash, like many others, I was left in a position of knowing something catastrophic had happened, but not really knowing what, why or how…and I wasn’t alone.
It was in the void left by this lack of public knowledge that Ben Dyson decided to start a blog in an attempt to try to answer peoples questions. In particular he sought to redress what he saw as a distinct lack of understanding about the actual mechanism by which money in a modern economy is created.
The blog gained some popularity and eventually Ben founded Positive Money, a not for profit organisation campaigning for a fair, democratic and sustainable money system.
To understand what Positive Money are trying to achieve you need to understand some widely unknown basic information about our current financial system. These basics are covered brilliantly and in more depth on their website (here and here) but the gist is as follows:
As Positive Money describe it there are three dominant ideas about how banking works in the UK which break down as follows…
Piggy bank
You put your money in and it sits there waiting for you and when you want to spend it you go and get it out again.
Middle man
The bank takes the money you deposit with them and lends it to people who need to borrow money, charging the borrower interest on the loan and paying some of that interest to the saver. This implies that the bank is reliant on the deposits of it’s savers to make loans. If the bank doesn’t have any deposits it can’t make any loans.
The Money Multiplier
The previous two models form the basis of the majority of people’s beliefs about how banking works, but a more sophisticated understanding, taught to most economics students, centers around the money multiplier model.
This is the idea that, rather than only being able to lend a pound out for every pound that is deposited, instead a bank can make as many loans as it wants as long as it has a specified fraction of the amount on loan in its cash reserves. For example, if the law states that a bank must have 10% of a loan amount in its reserves and that bank made a loan of £1000, then it must have £100 (10%) of cash (base money) in its coffers.
This model means that the money supply can grow without the central bank printing more money. Imagine that a loan of £1000 is then used by the person who borrowed it to buy a car from a dealership. That dealership might then deposit that £1000 in their own bank account. This allows the dealership’s bank to make another loan of £900 (because they have to keep 10% of the money in their reserves) even though there is no new base money in the economy. Essentially money has been created out of nothing. The process continues with the amount of money available to lend by the banks getting smaller and smaller each time. When the process is complete, for that original £1000 of base money that was added to the economy the money supply has increased to nearly £10,000.

The Money Multiplier Model
In this model the Bank of England (the state) have two mechanisms by which they can control the money supply and the amount banks (privately run entities) can lend.
Option one is to print more base money and add it into the economy, which would mean banks could make more loans.

Increasing base money leads to more total money in the economy.
Option two is to change the percentage of base money the bank is required to have in reserves for every loan it makes. For example, if a bank was required to hold 20% in reserves then the money supply would only increase to £5,000 for every £1000 of base money as opposed to £10,000 for a 10% requirement.

Decreasing the reserve ratio increases the total money in the economy.
As stated above, this is the model still taught to most graduate level economics students…which is fine but for one small thing…
According to Positive Money, this model represents a complete misunderstanding of how modern money creation works.
Why is it wrong? Well, there is no reserve ratio in the UK anymore and there hasn’t been since it was abolished in 1981. This means that if a bank is under no obligation to have a certain amount of money in its reserves then there is no upper limit on the number of loans they might make. With no reserve ratio, adding or removing base money from the economy by The Bank of England no longer has a direct relationship to the size of the overall money supply.
In light of this it’s Positive Money’s assertion that, the power to control the money supply and thus the economy of the UK has been taken from the the Bank of England (representatives of the people) and ceded to the banks, meaning that control of our economy is now in the hands of commercial entities motivated by short term profits and not necessarily the needs of society in general.
We sat down with Rachel Oliver, Lead Organiser at Positive Money to discuss these ideas in more detail and learn why we should all be paying attention.