What is money?

Protests against the world's financial institutions are growing, but do most people even know where money comes from?

We spend a lot of time thinking about money, one way or another. We think about how to get our hands on it, how to keep it safe and how to spend it. When we aren't asleep, there's a good chance that we're paying attention to money. But while money is never far from our thoughts, there is something curious about our relationship with it. For all that we use it to get through the day, most of us don't know what it is.

I mean, we know what it can do. We know how much we have, more or less. We know what things cost and so we have some idea of what we can afford at any given moment. When we start thinking about the future, how long we might live and how much money we'll need, we tend to want to think about something else. But money itself escapes our calculations. For the most part we don't think to ask where it comes from or what it is, in itself. The advantages of having money and the consequences of having none loom so large that we seldom stop to wonder about money as such.

Today is as good a day as any to explain where money comes from and why it matters. On Thursday, the Bank of England announced another £75 billion of "quantitative easing". If you don't know what that means or vaguely think it has something to do with "printing money", it is probably because you don't know what money is. All will be revealed in what follows. OK. Are you ready to know where money comes from, to know the truth jealously guarded from the dawn of recorded time?

Money is lent into existence by banks

There's nothing complicated going on behind the scenes. The great secret is that there isn't really much of a secret. Yet the truth about money eludes us for most of the time.

The economist and ironist JK Galbraith once wrote that "the process by which banks create money is so simple that the mind is repelled. When something so important is involved, a deeper mystery seems only decent". Offered the unadorned truth, stripped of any technocratic flim-flam, we can scarcely believe it. It seems preposterous that money should have such humble origins, as though it is beneath money's dignity that it should begin life at a banker's keystroke.

The truth about money creation is a bit like the end of The Wonderful Wizard of Oz, when it turns out that there is no all-knowing wizard, only an old man behind a curtain, making things up as he goes along. It's a lot like The Wonderful Wizard of Oz, in fact. Frank Baum's book is a parable about currency reform, written at the height of the struggle in America between the architects of corporate finance and those who wanted the money supply to be controlled by the public. The 1939 film adaptation brought the story to a vast new audience, but somewhere along the line, the author's original point was somehow lost. I know, that such a thing could happen in Hollywood, of all places.

So, banks create money through the act of lending it. They don't have to limit themselves to lending out the money deposited with them. In fact, they can end up lending huge multiples of the money they hold in reserve. When they authorise a loan or extend credit in the form of an overdraft, the money is conjured out of nowhere. The banks then receive interest on the loan. The interest is how banks make their profits, so they want to lend out as much as possible for as long as possible, even if the lending is unsustainable in the long run. This is what Chuck Prince was getting at when he said in July 2007 that "when the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing".

As the authors of Where Does Money Come From?, a handy guide to money creation published by the New Economics Foundation, point out, banks prefer to lend money against existing collateral. As a result they have a really bad record when it comes to supporting start-ups and small and medium-sized enterprises that want to expand or innovate. But they are brilliant at inflating bubbles in commercial and residential property. Perhaps mindful that the money they lend out has an immaterial quality, bankers crave the solidity of bricks and mortar.

Intelligent conversations, not riots

I said earlier that the Bank of England has announced another round of quantitative easing. Quantitative easing (QE) occurs when central banks create new money and use it to buy interest-bearing assets. So far QE in Britain has been used to buy government and corporate bonds. This has supported asset prices and relieved the pressure on the other banks. The banks exchange assets of uncertain value for cash backed by the credit of the government.

If you think it's a little odd that one national institution, the Bank of England, is buying bonds issued by another, the Treasury, you're right, it is. The government doesn't want you to think too hard about it, in case we start thinking that they, like the wonderful wizard, are making things up as they go along and hoping for the best.

No one is claiming that finance and economics aren't complicated. But this shouldn't blind us to the fact that they both rest on a cardinal simplicity - the money-creating power of banking institutions. Those who profit from this underlying simplicity have had no great desire to enlighten the public. Their control of the money supply has never been subject to democratic debate. It is doubtful that this control would survive any such debate. As protesters gather in the world's financial districts, I hope they will be able to bring reform of the banking system out of the shadows.

The established order can cope with riots. It cannot cope with a reasonable conversation about the role of the banks in misallocating capital and creating crises.

Britain's Chancellor of the Exchequer, George Osborne, has already indicated that some of the money conjured up by the Bank of England should find its way to small and medium-sized businesses, in a tacit admission that the financial sector in its current form cannot adequately support productive industry. Private and unaccountable control of the money supply - the very archetype of unconstitutional privilege - has failed and this failure is bringing misery to millions around the world.

A discussion began in the spring of this year in North Africa, about the society and economy we want. Europe and North America are now joining in. The problems we face are complicated, it's true, but they are not as complicated as some would like to make out. We will begin to see how to solve them when we have a clear understanding of the fundamentals of social organisation, including the origins and nature of money.

It is an understanding that those who are currently powerful would rather we didn't have. After all, as another great American ironist, Walter Karp, put it, "usurped power is only secure as long as it remains unregarded". For too long, the banks have shaped the laws of economic exchange in private. Even in the midst of a debt crisis their privilege has so far evaded our understanding. It is time that it became the object of our steady and patient attention.

Continue reading - What is money?