Tuesday, October 14, 2008

Where does money come from?

Credits Cards same as Cash, originally uploaded by Dave Gorman.
I'm sure I'm going to look very simple... but it's a genuine question.

Where does it come from? It's all symbolic anyway. If there were a hundred people living on an island without any contact with the outside world and they all had a pound each... and one of them opened a bank and offered the others 1% interest per annum... then how would they pay that interest? If someone invested their whole pound, then at the end of the year they'd be owed a penny and that would mean the banker had only 99p of their own pound left... which would make banking an inherently unprofitable business. Which (despite the recent evidence) it can't be... or there wouldn't be bankers.

If those hundred people continued to live with their pounds, swapping them here and there, the baker buying an apple from the greengrocer for a penny here and the greengrocer buying a loaf of bread from the baker for tuppence there, then I can see how some people would do better than others. Some people are going to get richer than others because more people spend more with them... but the sum total of their money would still be £100 and the only way of changing that would be to create more money out of thin air.

If some of them had kids that would just spread the wealth a little thinner. There are more people in the world now than there were 300 years ago and there's more money too. So where did it come from?

Someone has to have decided to just make more of it. Someone somewhere must be deciding to increase the amount of money in the world year on year. But who decides how much and where does it go to? Say you're one of the 100 people who all started with a pound each. And say you've decided that for your society's economy to function you need to have another £10 added in to the mix? So what do you do next? You mint another ten coins... and then where do you put them? Who do they belong to? Are they yours? The governments? How do they get into the system?

If governments are just creating more symbolic money each year, how do they decide how much to create? How do they balance that out with each other?

Let's say there was another group of a hundred people who lived on another island and they all started with two dollars each. Then one day, some brave mariner from Island A discovers Island B and the two islands start trading with each other. As it goes, what costs about a penny on Island A costs a couple of cents on Island B so everyone's happy trading two dollars for a pound.

So now what happens when the first island decides to add another £10 into their economy. They've just created something - out of nothing - that makes them wealthier than their neighbours. So what's to stop Island B deciding to just create even more money to make them even wealthier?

Countries borrow money from each other. For that to work there has to be some agreement between nations about where money comes from. You can't decide that a pound is worth two dollars if they're allowed to just make more dollars whenever they want.

Somebody somewhere has to be increasing the sum total of money in the world bit by bit... because there's more of it now than there was then... and there has to be some kind of international agreement between governments about how that works... or there would be no way of trading with each other.

So... on the off-chance that the World's Money Increaser (I think that must be his/her title) is reading this (and come on, I think there's every chance they google themselves) can I offer them this suggestion: make more.

You know how tax-payers are meant to be bailing out the banks with 500 squillion pounds? Why not just create a new 500 squillion pounds and use that instead? You won't even have to print the paper or mint the coins... because it's the kind of money that only really exists on computer screens and bank statements. Just tell everyone it's there... and then it is there... because surely that's how all money works anyway. Then the problem is solved and it won't have cost tax payers anything in real terms because we'll only be spending money that didn't exist before.

You know that National Debt that people are always going on about? However much it is... that's how much I'd create on Day 2 if I was in charge. Just make enough money to pay it off.

I don't know why no one seems to have thought of it sooner.


Unknown said...

My god man! You've gone and solved the financial crisis... I fully expect a black helicopter to land on your house and three ninjas to bag you up and take you away to some secret island for interrogation.

How did you come to this conclusion Dave? Personally, I think you must have touched a monolith.

Anonymous said...


You ask where money comes from, and say that if everyone on an island was guaranteed 1% growth then the bank which guaranteed this would lose money. This is true.

But. In reality you never have only savers. You have savers, and borrowers. The banks charge borrowers a bit of money - say 10% a year; and pay savers a little bit less, say 5% a year. The difference is their profit.

Of course, the problem with this is that if all the savers take their money out at once the bank can go bust. Also, banks oftyen lend out more than they actually have. Personally, I have £20,000 in an icesave account, and because of the turmoil tried to withdraw it. I'll now have to wit 3 months before I have any access to it. I think one of the causes is not just turmoil in the markets but the notion that it is ok for retail banks to lend more money than they really have.

I always have this fairly old fashioned notion that you should ionly spend what you have, and that applies to consumers , banks and everyone. One of the reasons why the credit crunch is a probelm is that we're addicted to cheap creidt. If people had learned to live within their means it wouldn't be such an issue. Furthermore, banks shouldn't be allowed to lend out to people 10 times what they really have. Its situations like that that mean that when if everyone tries to withdraw their money the whole house of cards collapses.

Dave Gorman said...

@Mike: yes... but there's still more money in the world now than there was a few hundred years ago and it had to come from somewhere. Where?

Anonymous said...

You might find this video informative.

It's ages since I watched it, but IIRC new money is created whenever someone goes into debt - it all seems a bit of a con-trick really...

Unknown said...

I think it's literally like you said Dave, organisations like the Federal Reserve (US) and the Bank of England etc have the ability to 'elasticate' the currency in the respective country... they are allowed to add and remove money from the system to keep it stable. So, yeah... they just print some more.

Seems incredible but true.

Abigail Brady said...

When you print new money, the purchasing power of existing money goes down a little bit, because of supply and demand. This would be called inflation, and while a little bit of inflation is probably not a bad thing (and certainly better than the alternative), too much is Very Bad.

If the island currencies have a floating exchange rate, then Island A's currency will just go down in value relative to Island B's currency, so that nothing changed, except that Island A's government got a bit richer and its people poorer.

Maire said...

I have arguments with economists every so often about how economics is not that different from, say, voodoo, or some other occult system. About 10% of the money in the world exists note/coin form - which doesn't even represent value anyway, and are more about promises than anything else. The long and short of it is that money is about belief. We believe a piece of paper is worth a bag of potatoes. We believe if we put money into the bank it's there even though there isn't a part of the vault with a pile of notes marked as ours. The bank believes that someday I'll earn more money and so they lend me it now. We believe we can get credit so we spend more, so people make more money, profits go up and we lend more. As soon as we stop believing the system comes crashing down, and we have recession. And we have recession because people believe now is not the time to spend, mainly because someone told them there's a recession on. So you've got to ask: if no one told us about recession or the credit crunch, would it be better for the economy?

Anyway the 'world's money increaser' would have to be doing things on the sly (and mostly have been) because if there's more money, it's valued less and then we might all start thinking we should have two bits of paper for a bag of potatoes instead of one - hence inflation.

So the bottom line is money doesn't really exist. Marshaling something like the national debt is more about marshaling promises and thoughts.

I've got another question... if every country has a massive national debt at the moment, is there some country somewhere that I haven't heard of rolling around in a fat pile of cash? metaphorically of course.

Abigail Brady said...

@Aunty Helpful Dictator

Well, yes, China, which has been buying US treasury bonds by the bucketful.

But a lot of the US national debt will be owed to US private investors, for example - it's not really a "national" debt so much as a government one.

Anonymous said...

I think you should look up 'deposit money' if my GCSE economics serves me right.

Basically, you put a pound in the bank at 5% interest, and I borrow that pound at 10%, then the bank makes a profit, but has effectively *created* a pound because both you and I believe we have it.

EdTech Rambler said...

There is a summary of the video that Adrian linked to at http://www.populistamerica.com/money_as_debt

My head was hurting before I read it, but I think I now understand more about 'where money comes from'.

Next question is how do we change away from this debt spiral to a system that can work...?

Anonymous said...

I don't really understand money either. What I do know is that 'creating more money' never works - it just decreases the value of the currency. This is what happened in the Weimar Republic, where people ended up paying for cups of coffee with wheelbarrows of cash.

Money measures value. So, if we have 100 units at the start of our island adventure, those 100 units must measure the value of the resources on the island.

If I then take some of those resources (some bits of wood) and create a chair, then I have created something people want, and therefore have created value. Life is better with chairs. So, I make more. With every chair I create more value. This is what it means for an economy to grow. Now, either we increase the amount of units in the system to take account of this additional value, or each unit becomes worth more. (because we have 100 units measuring more than it was before)

There is both more money in the system today (I don't know where that comes from) but, more importantly, we are better off in REAL terms (i.e., discounting inflation).

Anonymous said...

My head hurts.

Maire said...

I forgot the golden rule: never forget about China!

Anonymous said...

I think it's easier to understand, if you think back to when an economy's wealth was measured by the quantity of gold held by a country. You could increase the 'wealth' of the economy by increasing the quantity of gold in that economy, i.e. by mining more or through being a pirate.

We no longer measure economies by the quantity of gold held. Instead it's relative to the output of the economy. If you are manufacturing goods, you are converting the inputs (raw materials) to outputs (finished goods), but as we (the UK) are a service based economy, primarily, it is difficult to see where the inputs are coming from and hence, where the new 'wealth' is created.

This is why we use measures like GDP, because we are dealing with intangible quantities, rather than an actual count of the gold that is held.

"Somebody somewhere has to be increasing the sum total of money in the world bit by bit" -- The amount of money in the world isn't really increasing, as money is only a symbolic measure of the wealth that exists.

Instead, we are all creating more wealth. You, Dave, do it, by writing and performing. A farmer does it, by growing food every year using the same piece of land. A miner does it, by extracting ores from the ground. Previously, these products existed in another form (thoughts, seeds + nutrients, stone), but someone took the time to convert them to something someone else holds a value to.

As we've seen recently, Governments have very little to do with the growth or control of an economy. Really, they just react to changes.

As money represents the wealth of an economy, one pound (or dollar or euro) represents a percentage of that economy. Therefore, Governments cannot (or more accurately should not) simply 'create' more money, as this devalues the pound (or dollar or euro). For example, if one pound represented 1% of an economy, there would be 100 pounds in that economy. If 100 new pounds were minted (? I'm sure that's not the correct term), there would be 200 in the economy and each would represent 0.5%.

I apologise if my rambling does not make sense. It did when it was in my head. If you have any more questions, please e-mail me at oliver@oliverwhite.com.

Nick Taylor said...

So the 'new' money is really just representing the value of our newly created wealth?

Anonymous said...

I make it.

Anonymous said...

Governments can just print money to pay bills. That's what Zimbabwe's doing at the moment. Of course this does mean they have an inflation rate of 231000000% per annum.

As for the people on the island: Lets say there's one on the edge who spends an hour fishing and catches a dozen fish, because he's good at it. But he couldn't weave cloth if he spent all day at it.
Inland there's someone who's a good weaver who can make a loin cloth in a hour, but doesn't know how to catch fish.
So there's an incentive for these two to to trade. As by spending two hours working they both have fish and clothes. By working together they have "created" more time.

Dave Gorman said...

@Oliver: Yes... I follow your argument that we're not creating more money, merely more wealth... and I understand the bit about how a farmer , a miner and a writer do this... but in order for us all to sell our food/minerals/thoughts there have to be other people out there who are prepared - and able - to buy them. Which means there need to people out there with enough tokens of wealth - coins/notes/pixels on a screen/whatever - to purchase our goods. And for the economy to grow, for everyone to profit from their output there needs to be more money each year.

What I think I've understood from the earlier comments (and the video in particular) is the relationship between debt and new-money. If you want to borrow ten pounds from me, I am only able to lend it to you if I have ten pounds to spare. The money passes from me to you. I'm temporarily ten pounds poorer, you're temporarily ten pounds richer. The sum total of money in the world is the same as a result of this transaction.

But a bank is allowed - encouraged even - to lend money it doesn't have. The amount it can lend is proportionally related to the amount of actual money that it has in the vault... for ease, let's say 10 to 1. So, if you want to borrow 10 grand to buy a car, a bank with only 1 grand in the vault is allowed to lend it to you. It doesn't actually exist... but because you promise to pay it back plus interest they're prepared to lend it to you... even though they haven't got it. That money is created there and then... and it becomes real - even though it's really just your promise to pay it back that is being traded. If the car dealer takes your ten grand and puts it back in the bank, they now have 11 grand in the vault... and that means they can now lend someone 110,000 pounds... which involves creating 99,000 pounds that didn't exist until someone else promised to pay it back. And so it goes on. It's a pyramid selling scheme that sees new money created so long as new debt is created... and so long as the whole thing keeps turning over it'll work. Of course the world's resources aren't infinite so the economy can't grow for ever and it has to end at some point...

It all goes wrong when people decide they don't want the iou and would really rather have their cash. Because there's more fictional money in debts than there is real money to pay it off. Scary.

Anonymous said...


Just one related point - you are correct about banks / governments "creating" money in the manner that you have described.

But a government cannot just print more money to pay off all of its debts. If it does so, then the currency devalues, and so purveyors of goods and services are forced to increase the cost of their goods to reflect the new rela cost. This would be hyper inflation if the government printed off enough money to pay off all of its debts. this is what happened in Zimbabwe recently or Germany in the early 20th century. Clearly hyper inflation is bad, and hence a government cannot just print off enough money to pay off its debts.

* * *

Picking up on a point someone else made: yes our financial system is built on trust. There's a whole number of emotional responses onw hich a banking system is built:

- Trust: banks have to trust each other to lend them money, otherwise they'll set interbank lending rates too high and banks can't afford to borrow from other banks.

- Promises: Money doesn't really exist. Even a phsyical paper £10 note in your hand isn't really money. It is a promise. "A promise to pay the bearer on demand". The idea originally being you would hand in the bank note for money which used to be metal.

- Greed and Fear: The two emotions that drive a marketplace or stock market. Stock markets are highly irrational and people often buy on rumor. There's a famous saying : "buy on rumor, sell on confirmation". To stay ahead of the competition you want to be doing what the rest of the market are not. If something comes up on the news saying a company is doing well, then its stock price will go up. But this is unlikely to be good for an individual trader who wants to make a short term gain, as everyone elses stock will go up too. The best thing for a trader is a rumor ahead of a major announcement, so they'll buy low and then sell high when the news is made public.

So there are a lot of human emotions that guide modern economics. Trust, Promises, Greed, and Fear. Personally I think the first two are positive and the last two are not so positive.

Anonymous said...

I forgot to point out that there isn't always new money, what appears to be new money is really just money that has circulated. For example, a builder builds a home and an insurance broker purchases that home. The house builder now goes out and spends that money buying insurance for his business, giving some money back to the broker.

Our (UK) economy grows by typically 2-4% every year, which is good in economic terms, but not an exceptionally high percentage, so it's easy to forget that in fact, there isn't a great deal of growth. Most of the economic activity is simply recirculation.

Anonymous said...

Hey! Your site ate my comment. Hmph!

Anyway, what I wrote was, that Banks aren't lending fictional money, they are lending against their assets (typically mortgages - in the cases of the collapsed building societies). This is the same situation that consumers put themselves in when taking out mortgages -- they don't have the money to repay the price of the house, but the lender will repossess the house if payments are upkept. The house is in effect, an insurance policy.

The problems of late occur, when savers withdraw their money en masse and the lenders can't readily convert their assets into liquid/cash (by respossessing houses and selling them), causing a cash flow problem (unable to pay wages, etc.) and have to go into administration.

Murk said...

If one Island A dollar was worth one Island B dollar, and then Island A made more dollars, the exchange rate would change to reflect the different 'worth'.

In practice there will be discrepancies. If you notice that Island A dollars are now worth less, but the exchange rate hasn't changed, you buy island B dollars, wait for everyone else to notice, then re-buy island A dollars when the rate adjusts.

This is called arbitrage. The effect of your buying island B dollars means that island B dollars are seen as worth more, and island A as worth less. This prompts the price adjustment you want. (When you re-buy island A, everyone else is buying B... so the price stabilises at the new level).

In practice this happens very fast, and the exact rate fluctuates with supply and demand, and with all these other factors.

Governments do make more money - when they do so, it leads to inflation. If they don't do it at all, then it can lead to recession as people avoid buying things because it'll be cheaper tomorrow as we get better at making things (you see this effect in consumer electronics - though this is offset by the 'want it now' and 'early adopter' brigades.)

The trick is to print new money at the 'right' rate. What is 'right' depends upon what you want to achieve.

If a government printed lots and lots of new cash, the currency would de-value and the debt would increase (as a large chunk of the debt will be in OTHER currencies).

Hope that helps with your question... I'm afraid your idea is not genius....

Murk said...

"even though it's really just your promise to pay it back that is being traded"

"It's a pyramid selling scheme that sees new money created so long as new debt is created"

You're exactly right here.

Get some paper money out of your wallet. Look at it. I'll wait.

'I promise to pay the bearer on demand...'

Simon said...

As people have already said (sort of) the problem is that there's no "standard" attached to the currency. It used to be a pound meant something in terms of a physical quantity and, short of being a pirate or a miner, you weren't going to get more of that without trading goods and services.

What about defining a new standard, and choosing something that would be beneficial to the world. A friend suggested a "tree standard", so a currency would be proportional to the number of healthy trees per square mile (say). This would give a real (arbitrary, but real) grounding to the currency as well as encouraging states to grow more trees (or what ever beneficial standard you chose...). Would that work?

Unknown said...

Actually a lot of importance attaches not to how much money there is, but how fast and in what direction it travels. People need goods and services, and as everyone here more or less agrees, money is a convenient fluid to allow them to be exchanged without inconvenient quantization (imagine if television factory workers were paid in televisions and wanted to buy a tomato).

I realized a few years ago that money is rather like the concept of a hole in semiconductor electronics: it's where value *could* be, as a hole is where an electron could be. As such money might be thought to have negative value!

So the problem here seems to be that people spent money on things that actually weren't worth the money they spent, and everyone is now suddenly realizing this. The obvious things were the dodgy securities banks have been buying from each other but actually property is probably at the root—houses just aren't worth that much compared to televisions and tomatoes.

So a lot of money is effectively glued to houses which aren't worth what we thought they were. The money in the system then changes value to reflect the actual worth of things in the system. Either we will inflate, or there will be a housing crash, or something, and the job of government is to try and make it all happen as non-catastrophically as possible ... money somehow has to flow from the places it's been dammed in to the places where there's a drought, and since the flow of money is actually what we all rely on to live, massive sudden flows are bad.

I think when it comes down to it the idea that you can make value simply by moving value around is limited. Sure, people do benefit from this movement, so as such it has a real value that people will pay for, but I don't think people are aware they are paying for it, and ultimately the value still derives from the things, like televisions and tomatoes and houses and my ARP Odyssey (which has a voltage drift, poor thing) we want or need. So trading probably isn't quite as exciting as traders thought it was and quite soon the world will probably adjust to reflect that.

Anonymous said...

The Terry Pratchett Discworld Novel, Making Money, has some interesting ideas on a monetary "standard".

It's mostly in the ending, and I'm not going to post spoilers here..

Anonymous said...

You do realise the government will announce this next week and Gordon Brown will claim he thought of it.

Anonymous said...

After reading all the complex and interesting posts above, I still have one question which appears to be unanswered...

Where chocolate coins come in to play?

Anonymous said...

Where *do* chocolate coins come in to play?

Darn my typo.

Anonymous said...

if you simply put 500 squillio pounds into someones bank account then thats an extra 500 squillion inserted into the whole economic system,
everyone's money would simply be worthless.
completely understand where you're coming from,
but that can happen.
national debt comes from the fact every note thats printed the government have to pay more than the note's value in order for it to go into circulation,
thats where our taxes come into play and so on. but our taxes also have to pay for everything else the country needs to.
therefore a constantly unstable economy!
they do this so no-one can take over the governments power with there wealth.
really crazy, watch
its on google video, make sure you watch the remastered one, starts on religion, politics then moves onto economy.

Unknown said...

What i dont understand is how the FED can be privately owned?


Anonymous said...

The original "island" situation is onewhich I use to teach absolute beginners the nature of economics.
Markets are a way of allowing decisions to be made about what should be made and how much of it. Prices are simply a feature of markets.
Markets will (as has been pointed out) respond to any creation of new money in a state; most obviously inflation increases (because now there is an increased "demand" for the stuff because more purchasing power exists.)
If ten pounds is created in an economy of 100 pounds your pound will not buy you as much. In effect you get poorer.
Everybody does.
Except the ones who are creating that ten pounds. They get richer.
They get richer because of their lovely little scam.
I am poor so off I go; off to work. Off to work to produce things of value and to be paid a symbol of a store of the total value in the society for that work.
Others can use thair accumulated wealth to generate yet more wealth through "investment" which is still arguably justifiable for reasons some left-wingers might debate.
But I know that there is no justification for a private individual or group to have a special printing press. I know it and it makes me angry.

Jonnycab said...

We (or rather our government on our behalf) are just about to totally screw the UK public sector and those in receipt of benefits in order to pay back debt when at the same time the Bank of England can and does create billions through quantitative easing. Why as Dave suggests can't the money created by the Bank of England be used to ease this debt burden. I understand if too much money is created we will get hyperinflation but how much is too much?
M4 the broad measure of money in the UK economy seems to be roughly £1.5 thousand billion (http://www.bankofengland.co.uk/statistics/fm4/2010/jun/fm4.pdf). In 2009 the deficit was about £160 billion, out of a total government debt of about £900 billion (http://www.statistics.gov.uk/cci/nugget.asp?id=277). The Bank of England has created £200 billion through quantitative easing almost all of which has been used to purchase gilts (i.e. government debt) (http://www.bankofengland.co.uk/markets/apf/results.htm). Why should our government have to pay out on government debt owned by the Bank of England? Why don't we just have the Bank of England give these guilts back to the treasury? If this was done over five years than that would either be a reduction in the total government debt of £40 billion each year or, if the government wanted to spend instead, a 25% reduction in the money needed to finance the deficit. Would this be too inflationary - an extra £40 billion per year out of 1.5 thousand billion? Unless someone can persuade me otherwise I'm with Dave's original proposal - print the money.

Anonymous said...

Money is created thanks to 'fractional reserve banking.'

A retail bank encourages people to save money with them and then lends that money to borrowers at a higher interest rate. But, they have to keep so much of the origianl deposit in reserve (say 20% of the original amount).

1. Saver puts in £100 in Bank 1.
That Bank lends out £80 and then puts £20 in reserve.
2. The money lent out is then used to buy goods/services and reenters the banking system via whatever payment method.
3. Bank 2 receives a deposit of £80, lends out £64 and reserves £16.
4. Repeat this process...

The reserves will eventually reach the ORIGINAL deposit amount but new money will have been created as debt.

In this example, (thanks wikipedia)
after 11 transactions, the original deposit of £100, has turned into £457.05 of deposits.
The money lent out has went from the original £80 to £357.05 but the reserves equal the £100 when added with the last loan amount.

New money is created as debt, which when repaid, will provide a profit for the bank.
When the borrower does not repay, the bank seizes assets.

The 'new money' has no actual value.

If all the depositors request the money from their deposits, the bank doesn't actual have it all. This causes a 'run on the bank' and creates liquidity problems as banks need their 'investment' to return in order to pay savers back.

In regards to printing money, this is known as 'quantative easing' and does nothing but drive the value of the currency down. The BofE could print off £500 BILLION but it would devalue the £ so much, we'd be buying bread for £4000 a loaf!

In America, the Federal Reserve prints their dollars and lends it to the US government as debt. A private company owns America.

Jason Matthews said...

The last post explaining Fractional-reserve banking makes sense but the big problems I have with it are these:

1. The greedy commercial banks are making too much money from this system and the inflated profits could have been made by us the people via a country owned bank.

2. The mega staff bonuses paid out wouldn't have to wasted on greedy bankers who leech the working man and that cost reduction would make borrowing cheaper.

3. Greedy banks have created too much debit and countries are finding it impossible to pay back - see http://www.debt-clock.org/

4. The system is not sustainable and will come crashing down as growth cannot keep up in a world of dwindling resources. ie peak oil

Watch how the price of gold keeps going up, I wonder why.......were all doomed.

Anonymous said...

What utter garbage Gorman writes. No account of the basic principle of economics - that you need an economy to start with - you know, goods and services being produced!

I am amazed that so many of Gorman's followers have swallowed his argument hook, line and sinker - well I for one wouldn't be loaning Dave Gorman any money as with his financial sense I would never see it again.

Jason Matthews said...

You really are a useless bell end. Watch this and you might learn something:


Steve said...

The simple answer to the question can be found here - and by watching a couple of 4 minute videos


As for the answers explaining the fractional reserve system - they are close - but since banking de-regulation Banks - in effect - create money out of nothing - by making loans, (extending credit), and simply typing a new set of numbers into an account.

In the UK only 3% of money is in the form of notes and coins - the rest is debt created money.

Thats why, in the words of David Cameron, the balance sheet of RBS is bigger than the UK economy.

And thats only one bank.

Angie Greenham said...

The definitive article and the definitive explanation - now in to it's 2nd Edition, Where Does Money Come From: A Guide to the UK Monetary & Banking System provides, according to LSE Prof Charles Goodhart, "A clear path through the complex thickets of misunderstanding on this important issue".


I know Tony and Josh at The New Economics Foundation are always interested in new ways to explore getting the message out about money, you can get in touch with them by email