Money creation: household sector

Let us embark on some surmising on how money was created in these early years. Assume that the public in a year borrowed from the banks 11 million pounds; this was granted by the banks in two forms (see Figure 5, which assumes that the money was all borrowed at one time):

• One million pounds in bank notes (some borrowers still wanted this form of money).

• Ten million pounds in loans (credits to the borrowers' current accounts).

Messrs A, B & C did the bor rowingto purchase good s from Messrs X, Y & Z tothe -value of 11 000 000 pounds over the year.

money creation: bank notes & deposits

Figure 5: money creation: bank notes & deposits

Messrs A, B & C pay to Messrs X, Y & Z £1 000 000 in bank notes by handing them over and instruct their bankers by cheque (this is what a cheque accomplishes) to transfer £10 000 000 to their current accounts at their bankers. The balance sheets changes are shown in Figure 6.

On a net basis Messrs A, B & C's balance sheet changes as indicated in Balance Sheet 1. The banks' collective balance sheet is unchanged from that shown in Figure 5: because the outstanding bank notes just changed hands and the deposit created was transferred from Messrs A, B & C to Messrs X, Y & Z. It will be evident that the amount of money in circulation (the money stock) increased by £11 000 000 and the balance sheet cause of change (BSCoC) was the increase in bank loans. As shown in detail later, when changes in the money stock and its BSCoC are calculated, only the banking sector's balance sheet is analyzed.

payment for goods

Figure 6: payment for goods

BALANCE SHEET 1: MESSRS A, B & C (POUNDS)

Goods

+ 11 000 000

Loans from bank

+11 000 000

Total

+11 000 000

The actual cause was the demand for loans from Messrs A, B & C, and underlying this was the demand for goods (AC = AGDE) which was supplied Messrs X, Y & Z (AGDP = AGDE) who receive the money. This was made possible by the creation of new money by the banks to the extent of £11 00 000 in the form of new bank notes and new bank deposits, that is, the generally accepted means of payment. It will be evident that in the case of new bank notes issued an accounting entry was made and the physical notes were printed, whereas in the case of the bank deposits only the former was effected.

The creation of money by the goldsmith-bankers as described above is not fiction. It happened in this manner. However, up to now we have probably created the impression that money is created mainly by the banks' lending to the household sector. This is not the case at all. In high inflation times in the distant past the culprit on most occasions was government. We saw earlier how governments debased coin money, based on the fact that coin money was generally accepted by count. Later, governments were not slow to learn that money was to be relatively easily acquired by borrowing from the banks. In fact the creation of the Bank of England was founded on this experience, as we shall see.

Money creation: government sector

In the seventeenth century the banks were substantially engaged in deposit money creation resulting from loans to government in the form of the purchase of the first government bonds (all short-term). They were then called "Exchequer Orders" and essentially were "orders" by government for the Exchequer (= the government tax authority) to pay to the holder of the Exchequer Order an amount (i.e. the amount borrowed) on maturity plus interest on the amount borrowed at stipulated intervals or on maturity. Two points of interest here are the fact that these Exchequer Orders (now called government bonds) were issued against the proceeds of specific taxes at one stage and later against revenue in general, and that they were "assignable", meaning that could be "signed" over to a third party, that is, they were negotiable.

It is also recorded that the goldsmith-bankers were the largest holders of government debt at that time and even "made a market" (that is, quoted buying and selling prices) in these securities.94 This was a significant step in the history of the bond market.

BALANCE SHEET 2: BANKS (POUNDS)

Liabilities

Loans (bonds)

+1 000 000

Bank deposits

+ 1 000 000

+1 000 000

Total

The activity of market making on bonds by the goldsmith-bankers cannot be associated with money creation if their dealing took place in already-issued bonds. To the extent that they bought bonds at issue they would have created money, but it is not recorded how they paid government for the new issues. Thus, we can only surmise how this took place. If this was effected by credits to government's accounts by the banks (assuming the banks bought the bonds) (as opposed to the issue of bank notes - although the result is the same) then the creation of money would have been manifested as indicated in Balance Sheet 2 (assuming a new issue of bonds to the extent of £1 000 000). Government's balance sheet would have changed as indicated in Balance Sheet 3.

BALANCE SHEET 3: GOVERNMENT (POUNDS)

Liabilities

Bank deposits

+1 000 000

Bonds in issue

+ 1 000 000

+1 000 000

Total

Assuming government spent the funds on goods locally the relevant balance sheets would have changed as indicated in Figure 7 (a reminder: the non-bank private sector is indicated as NBPS).

government spending

Figure 7: government spending

The amount of money in circulation (read from the balance sheets of the banks) increased by £1 000 000 million. The BSCoC of the change in money is an increase in bank loans to government, and actual cause is the demand for loans by government (for the purchase of goods).

Money creation: corporate sector

It is also recorded that the goldsmith-bankers' were engaged in the business of buying bills of exchange. The bill of exchange, then also called a "bill on London", was an instrument of lending to merchants. Tied to specific transactions it was a "self-liquidating" loan and also the forerunner of the trade bill and the bank acceptance of later years (which were at the heart of the early money market). A loan to a merchant in the form of buying a bill of exchange with a face value of £1 000 000 would also have resulted in the creation of money as indicated in Balance Sheet 4.

BALANCE SHEET 4: BANKS (POUNDS)

Liabilities

Loans (bill of exchange)

+1 000 000

Deposits (or notes)

+ 1 000 000

+1 000 000

Total

We now have two sources of money creation: the demand for loans / credit by the household and corporate sectors (the non-bank private sector - NBPS95), and government, which together can be termed domestic loan extension (or DLE). We will later show that there is a third: the activities of banks in the foreign exchange market.

As we have stated a few times in this text, the "discovery" of deposit money creation was probably the most significant event in the history of banking, money and money creation. It liberated economies; Davies96 puts it as follows: "The new forms of bank money brought a liberating, timely and essential extension to overcome the debilitating constraints of the metallic money supply, and.. .the bankers offered a range of new financial services beyond the ken of the Royal Mint."

An essential question now arises: was there an intrinsic brake on the monetary system to curb the excessive creation of money and thereby inflation? The answer, which is to be expected from an economist, is yes and no. The "yes" stems from the convertibility of bank notes into gold and the rise of central banking, and the "no" from certain bankers' avaricious disposition and the slow rise of central banking.

 
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