Jump to content
House Price Crash Forum

Where Did All The Uk Debt/credit Come From?

Recommended Posts

Hey, I'm studying Economics and did a few modules on finance and basically from what I understand is that the banks 'create' money out of nowhere is the short answer... although that is not totally true because they do create money out of somewhere.

Ok here goes, basically any commercial bank has a reserve ratio requirement set by the Bank of England. Let's take this to be 25%. That means for every deposit it gets it must keep 25% of the deposit (that is the money we stick into our account either by putting in cash, cheque, or via electronic debit such as a direct debit). The other 75% it can use to do whatever it wants, and banks lend it out to other people and businesses and they earn interest on these loans and so that's how banks earn profits.

Now to monetary creation. Say for example a bank has deposits (from its customers) of £400. It's reserve ratio states it needs to keep 25% of this as reserves, in case of a bank run, and so it keeps £100 that it cannot touch. Now the £300 can be used as loans to earn profits. Now if someone puts in £1 the bank will have reserves of £101. It has excess reserves, reserve ratio of greater than 25% which is unnecessary. That extra reserve could be better used as loans to earn profits. So, it now has £101 of reserves, £300 on loan, and £401 in total deposits. 101/401 = 25.18...% and if reserve ratio requirement is 25% then 101 x 4 = £404. This is the amount that the bank can viably have. So the discrepancy between £404 and £401 is £3. Thus £3 is 'created out of nowhere' and can be used for making loans.

I hope that's clear and if I got anything wrong or if I didn't explain something well then please feel free to comment! :D

Nice to hear from you Econ1. I see this is your first post. welcome!!

...but I have a slight complaint with the description that you give. It does not (I think) take account of the fact that the money the bank takes in on deposit is not all "high powered money". Most of it will be Fractional Reserve money.

We need to consider the banking system as a whole. If we only think about a single bank lending fractional money which is then deposited in another bank we forget that the original bank may also be taking in deposits which are the fractional money of the second bank (which, in turn, is using as deposits fractional money from the first bank).

Let's consider the following scenario: We have a bank which has £20 in "high powered money" on deposit at the central bank. Because the reserve ratio is 10% this bank is able to lend out up to £180. Let's imagine that the only other money in the entire economy is £20 held evenly by four individuals. Let's consider a simple round of loans where they each borrow £10 at 10% interest for one year. The Reserve Ratio (for the bank) is now 33% (£20/£60).

For the entire economy the reserve ratio is 50%

At the end of the year the 4 people pay the money back plus the interest. The bank pays the money it has borrowed back to the central bank. It now has £24 (£20 on deposit plus £4 held as assets). The 4 individuals have £16 between them.

Now for the interesting bit. Let's imagine that three of the individuals were not able to pay the money back. Instead of being prudent they end up giving the money to the fourth individual and they are incapable of earning the money to pay their debts. At the end of the year the bank would receive £11 from the prudent individual and nothing from the other three (let's say for argument that they have spent absolutely all of their money including the original £5 and used it to pay the 4th person for some purpose). The prudent individual now has the original £5 minus £1 interest to the bank plus the original £15 from the rest of the economy plus their three loans, so in total the prudent individual now has £49.

The bank, as well as not receiving the £3 interest from the profligate debtors, also does not receive the principal of three of the loans. It had expected to receive £44 but only receives £11. It owes £40 to the central bank but it has only £20 plus the £11. The bank now switches to Fractional Reserve Banking.

It pays back nothing to the central bank and works on a (semi) permanent reserve ratio of 33%.

Link to post
Share on other sites

Hi Austrian!

Thanks for replying to my message. I tried to follow your message and I think I got most of it! Haha... The model I was using was overly simplified and was upon the basis of the workings of one bank for simplicity. I was merely using it as an example to answer the original question which was, 'Where has this money magically come from for the banks to lend'?

I'm sure in reality (which we economists never work in!!!) that the process will be far more complex what with interbank lending, Central Bank lending, desired reserve ratios on top of required reserve ratios and so on, however monetary creation doesn't change. However you message made for an interesting read nonetheless! Thank you

Link to post
Share on other sites
  • 2 months later...

No - the money supply is not dependant in any way on the amount people save.

Sure, Your savings are lent out - yes - but your savings are irrelevant to the system - (not to individual banks though who compete for them).

Credit and loans are created against new people wanting money at such and such an interest rate - and that money is printed out of thin air, with no reliance on savings, but reliance on central bank reserve rules.

That is why it is called debt-money, not value-money. It is created against debt, and not based on commodity value or fixed resources.

The only limit to this process is the fractional limit based on central banks reserves.

To the system - all this newly created money comes right back to the banks, as transactional deposits before being spent or reinvested again, which creates new loans...

The banks are limited by a fractional reserve system. If UK people used to save £1000 in a bank and the bank were allowed ,by the fractional reserve limit, to loan out 75% of that £1000 then that would be £750 (which I realise has a cascade effect).

So, if UK people are saving £10 now instead of £1000, then the banks only have £7.50 to lend out.

I realise this is an incredibley oversimplified way of putting it, as this money will have a multiplier associated with it as it passes throught the economy, but I felt my question wasn't being understood, and I don't really know how much simpler I can put it.

Where is all this money the banks suddenly have to loan out coming from?

Link to post
Share on other sites
  • 4 weeks later...

just stumbled across this thread and this is unreal.i did an economic geography degree :wacko: and ive learnt more here than i did in the 3 years!!!

the system is so stupidly simple yet so complicated.

in short is this a fair summary?

1. banks start with a little/nothing of something

2. lend that nothing to someone who will pay the bank something back plus more something, ie interest.

3. the banks then use the more something from 2 to lend more something out to more people? and the prosess multiplies like a PYRAMID scheme? gets exponentially bigger right?

also when the person(s) spend that money and it gets deposited in another bank they do the same and it grows even faster?

but the whole system needs to be fueled at an exponential rate in order for money to be made and not to collapse. ie it more debt needs to be created and more money lent. i presume when this stops slows then money is "lost"?

is this what explains boom and bust?

i studied multiplier effects in a geographical area at uni and thought it was bonkers when my professor said the more times money changes hands in the local economy the more it is worth. is this true and applies the same here/theory?

this is an awesome concept and this thread has got me totally thinking...... it is 12.30 am and i am drunk so i do apologise my understanding above is totally wrong. i need to see the rest of the videos.

Link to post
Share on other sites

Join the conversation

You can post now and register later. If you have an account, sign in now to post with your account.

Reply to this topic...

×   Pasted as rich text.   Paste as plain text instead

  Only 75 emoji are allowed.

×   Your link has been automatically embedded.   Display as a link instead

×   Your previous content has been restored.   Clear editor

×   You cannot paste images directly. Upload or insert images from URL.

  • Recently Browsing   0 members

    No registered users viewing this page.

  • Create New...

Important Information

We have placed cookies on your device to help make this website better. You can adjust your cookie settings, otherwise we'll assume you're okay to continue.