There's a lot of confusion about how banks work and where money comes from.
Very few members of the public really understand it.
Economics graduates have a slightly better idea, but many university economics courses
still teach a model of banking that hasn't applied to the real world for decades.
The worrying thing is that many policy makers and economist still work on this outdated
model.
Over the next hour we'll discover how banks really work, and how money is created.
But first, to clear up any confusion, we need to see what's wrong about the way that most
people think banks work.
Public Perception of Banking Number 1: The 'Safe Deposit Box'
Most of us had a piggy bank when we were kids. The idea is really simple: keep putting small
amounts of money into your piggy bank, and when a rainy day comes along, the money will
still be sat there waiting for you.
For a lot of people, this idea of keeping your money safe sticks with them into adult life.
A poll done by ICM on behalf the Cobden Centre found that a third of the UK public
still believe that this is how banks work. When they were told that actually the bank
doesn't just keep your money safe waiting for you to return and collect it, they answered
"This is wrong -- I haven't given them my permission to do so."
So this idea that the banks keep our money safe is a bit of an illusion.
Your bank account isn't a safe deposit box. The bank doesn't take your money, carry
it down to the vault and put it in a box with your name written on the front. And it doesn't
store it in any digital equivalent of a safe deposit box either.
What actually happens is that, when you put money into a bank, that money becomes the
property of the bank.
That's right. The money that you put into the bank isn't even your money.
When your salary gets paid into your account, that money actually becomes the legal property
of the bank. Because it becomes their property, the bank can use it for effectively anything
it likes.
But what are those numbers that appear in your account? Is that not money?
In a legal sense, no. Those numbers in your account are just a record that the bank needs
to repay you some money at some point in the future.
In the accounting of the bank, this is recorded as a liability of the bank to the customer.
It's a liability because the money has to be repaid at some point in the future.
This concept of a liability is actually very simple -- and very important if you want
to understand banking. Just think of it like this: if you borrowed £50 from a friend,
you might make a note in your diary to remind you to repay the £50 in the near future.
In the language of accounting, this is a liability from you, to your friend.
So the balance of your bank account doesn't actually represent the money that the bank
is holding on your behalf. It just shows that they have a legal obligation -- or liability
-- to repay you the money at some point in the future.
Whether they will actually have that money when you ask for it is a different issue,
but we'll talk about that later.
Public Perception of Banking Number 2: The Middle-Man
Now the other two thirds of the UK public have a slightly better understanding of how
banks really work.
These people think that banks take money from savers and lend it to borrowers. The Cobden
Centre poll that we mentioned earlier asked people if they were worried about this process:
around 61% of people said they didn't mind so long as they get some interest and the
bank isn't too reckless.
This idea of banks as middle-men between people with spare money and people who need to borrow
money is very common. In this idea, banks borrow money from people who want to save
it, such as pensioners and wealthy individuals, and they then use that money to lend it to
people who need to borrow, such as young families that want to buy houses or small businesses
that want to invest and grow.
The banks in this model make their money by charging the borrowers slightly more than
they pay to the savers. The difference between the interest rates makes up their profit.
In this model, banks just provide a service by getting money from people who don't need
it at the time, to people who do. This implies that if there's no-one who wants to save,
then no-one will be able to borrow. After all, if nobody came to the bank with savings,
then the bank wouldn't be able to make any loans.
It also implies that if the banks lend far too much far too quickly, then they'll eventually
run out of money to lend. If that was the case, then reckless lending would only last
for a short time, and then the banks would have to stop once they ran out of people's
savings to invest.
That means it's good for the country if we save, because it will provide more money
for businesses to grow, which will lead to more jobs and a healthier economy.
This is the way that a lot of economists think as well. In fact, a lot of economics courses
at universities still teach that the amount of investment in the economy depends on how
much we have in savings. But this is completely wrong, as we'll see shortly.
Let me point out that, so far, we haven't talked at all about where the money really
comes from. Most people just assume that money comes from the government or the Bank of England
-- after all, that's what's written on every £5, £10 or £20 note.