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by Michael Newland

A British economist once described how he became a leading adviser on economic affairs to the newly installed government of Harold Wilson in 1964. His office overlooked the House of Commons, and, as estate agents would say, enjoyed the benefit of a balcony. From this balcony, he ruefully admitted, he had fantasised about greeting the waving crowds, who would congratulate him and his colleagues on a massive burst of economic growth and prosperity, brought about by their skilful management. All the economic ills of the past years would give way in the face of new economic insights which would be applied to Britain.

In that heady time of the 'white heat of the revolution', which Harold Wilson promised, it seemed that magic solutions to the management of economies were available. 'Magic bullets' had proliferated in medicine during the post-war period - why not in economics too?

Reality soon bore in. During the following years, unemployment and inflation climbed steadily. There were, after all, no easy answers to problems which seem miniscule by today's standards, or at least none which were politically practical at the time. The period was, in fact, a near golden age compared to our present condition!

If professional economists can be mistaken into believing in magic solutions, there is every excuse for those untrained in economics to hold inflated expectations. Nothing has caused greater difficulty among nationalists in discussing the economy - and indeed many others of a radical viewpoint - than mistaken beliefs about the creation of money. This is not to say that there are no answers to economic problems - merely that they are complex, and involve a balance of advantage and disadvantage.

There is still a widely held view that bankers create money out of nothing, by a process of near forgery, and then enjoy fat salaries by charging interest on it! If this conspiracy against the laity could only be stopped, it is said, the entire burden of interest payments upon business, and upon government borrowings, could be removed at a stroke - with only the proverbial fat bankers being the losers. Like our now rueful economist believed in 1964, a 'magic bullet' revivifying the economy needs only to be employed, and much of our difficulties would disappear.

What has created a misperception about the creation of money is what economists call a 'fallacy of composition' - the belief that what applies to a whole economy must apply to an individual person or agency. The banking system does indeed create money out of nothing - as a whole - but individual private banks do not. The exception is, of course, the Bank of England, which can indeed simply print cash.

The perplexing result occurs in this way:-

When the Bank of England issues new banknotes - let us say by way of example £100 - and injects it into circulation, the following happens. Let us suppose that Denis, a turnspit by trade, finds the 100 quid in folding fall into his blackened palm, and decides to pay it into his bank.

Now bankers know that most people do not want much of the money they hold in bank accounts in actual cash at any one time. Maybe 20%. When Denis pays in his £100 at his local branch, it unlikely he will ask for more than £20 back again in coins and notes - the 'fractional reserve'. Most of his spending will by cheque. A cheque is a promise to pay in cash to another bank. But, since there are innumerable cheques flying every which way between the banks, they will on average net off to a very small figure which does not need much cash available to any individual bank to enable it to settle up with the others.

So the banks are generally safe in lending out most of the money deposited to someone other than the depositor - and charging them interest. They are not lending out money they have invented. If they lend £80 of Denis's cash, it is real money he could have spent, but decided to place with them for safe-keeping and convenience. A bank cannot borrow a tenner from you and lend out 100 on the strength of it! This is the point on which so many go wrong in their judgement about how the banking system works.

If the bank finds that it is in trouble, with customers rushing in demanding everything in cash - a 'run' as it is called - they can always borrow from the Bank of England, which does not generally wish to see banks going under, because of its dreadful effects on confidence generally. Every banker knows the dreadful story of the Austrian Creditanstalt Bank, which went bust in 1931, and set off a chain of other banking failures. Ten thousand banks in the US alone followed it into the oblivion of the Great Depression.

Now we reach the clever bit. Suppose Larry, a personage of good repute - or so Denis's bank hopes - borrows the latter's £80 and spends it on double glazing. There are a lot of banks, and it is likely that whoever next finds the £80 come into his hands will deposit it at a different bank. That bank in turn will lend 80% of Larry's money out again - £64. And so on around a chain of lending banks and borrowers.

The end result is an amount of money in circulation of (mathematically) five times the original £100 which Denis paid in over the counter - £500. No single bank, however, has done more than lend out more than a part of the actual cash deposited.

Now you may well object that the banks are growing fat by charging interest on the loans to Larry, and other borrowers, and it is true that are enjoying an income in this way. However, much of the money paid in to them is placed in deposit accounts on which they have to pay interest themselves, at a slightly lower rate than they charge to borrowers. The difference pays for running the branches. Bank clerks have to eat!

Many people, of course, receive no interest on cash in their current accounts, but they often get the services for nothing in return these days, with a crisp statement through the letter box from time to time. The banks also have to deal with paying out lenders like Denis, if the loans they themselves make turn out to be to men of straw. Denis does not expect the bank to tell him it has lost the money in his current account!

The banks then have created money - as a whole - and why should we let them do it? The Bank of England could create all the money themselves, and insist that banks don't lend at all. Who then would lend?

One hopes that readers appreciate that there is a genuine need to allow people to borrow. Businesses, house purchasers, and so on would be in difficulty if only those with inherited money could buy a home, or exploit a good idea in the market place. The Bank of England could set up a chain of local branches, and lend money, but would a state monopoly do the job better than commercial banks?

A National Investment Bank, with branches everywhere, might be very desirable. However, all would depend on how it was run, and whether the dead hand of civil servants would force it in the same direction as the big commercial banks - or worse.

Is there then nothing wrong with the commercial banks?

Yes, plenty! Short-sighted, often lending massively to fuel speculative bubbles, and sending small firms to the wall after pressing loans on them they could not afford, there is plenty of room for change. It may also be argued that they make too much profit. The 'big four' alone made about £ profits during 1995.

One accusation is not, however, borne out. The banks do not forge money and then charge interest on it. The banking system as a whole does indeed expand the money supply if the economy demands it in the form of people taking out loans. If this were not the case, central government would need to do the same to avoid a strangulation of the economy by a lack of cash to oil the wheels of trade.

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