Where did our money go?
The actual process of money creation takes place primarily in banks. Federal Reserve Bank of Chicago13 The process by which banks create money is so simple that the mind is repelled. John Kenneth Galbraith14 The crucial point about the development of banking that is usually overlooked is that it permits the authorities control of the rate of interest. Through history the emergence of banking has been accompanied by great reductions in the rate of interest; reductions that, in turn, permit economic activity to flourish and societies to prosper.15 Therefore, it is important to emphasise that the system of fractional reserve banking has been a significant driver of economic development, but to be successful it requires at least three conditions to hold true: 1. Banks select economically useful enterprises, and financially sound individuals, to lend to, and do not create excessive credit for speculation and activities that do not add to GDP. 2. There is no sudden loss of confidence that leads to customers trying to withdraw all their money at once, which is of course impossible as only a fraction of their deposits actually exist in the form of cash. 3. The system operates so that control over the rate of interest is maintained Government and regulators have a large part to play in preventing the loss of confidence that results in a run on the banks and ultimately this requires banks being provided with a highly valuable deposit guarantee scheme funded at taxpayers’ expense. As we saw with Northern Rock, if this guarantee is called upon it can be expensive indeed for the taxpayer. The fairness of a scheme that sees taxpayers with little or no financial assets compensating individuals wealthy enough to hold up to £50,000 on deposit at a bank is an interesting question in itself, but not considered here. Have they delivered on the first condition – productive and sound lending?
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