Last month we looked at how the Government creates new money to provision itself.

The magic money tree, or the printing press as some people like to think of it, is not only alive and well, it is how all central government funding is created.

This week we look at the role of private, commercial banks in creating new money. Surely they don’t create money out of thin air as well?

Buckle up.

Deposits don’t create loans

The widely held view is that banks either loan the funds they have or loan out multiples of those deposits, leaving enough cash "in hand" to manage daily withdrawals. This is the Loanable Funds model, where deposits create loans.

In reality, as confirmed by this very helpful article from the Bank of England, this credit creation process happens independently of the amount of funds held in deposits by the bank.

Deposits don’t make loans; the opposite is true: Loans make deposits, and around 80% of the money created in the UK is created by banks as debt.

A private bank creates money on one condition: If it considers the borrower to be creditworthy. Therefore private money, often called vertical money, like public money, referred to as horizontal money, is not scarce.

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But of course, bank money is not free. At some point, a loan must be repaid. For many, money appearing out of thin air is an unsettling back-to-front view of where new money comes from.

The government creates new money every day. And so do banks.

To understand why the simple mechanics of the financial system seem, for many people, fanciful and unsettling, we must view our idea of money creation as writer George Monbiot calls a “root metaphor”.

So deeply rooted is the idea that money is scarce that it frames our understanding and choices without us even being aware. When root metaphors are untrue, there is the possibility that those roots can cause real damage.

Money is an IOU

Money flows through the financial system in digital and physical form, but it is something much more than data and paper; it is, in fact, as last night’s SCOTONOMICS guest Bob Hockett, along with his Cornell Law School colleague Saule Omarova stated in their 2017 article ‘The Finance Franchise’, said, “the flow of public full faith and credit throughout the financial system”. It is this faith that gives it value.

Banks could not issue any vertical money if it were not backed by trust in the UK Government. Private banks are literally nothing without public money.

Realising that money is a display of trust in public institutions leads to a fascinating puzzle: Is it right for private banks to lend something they don’t own? Hockett & Omarova squint their eyes at the financial system and ponder, aren’t banks really a type of franchise?

They view the relationship between the principal issuers of new money, private banks, along the lines of a franchise model where: “The state cedes management of the flow of its key resource to private rent-earning financial institutions that supply the macroeconomy with sufficient credit to support productive enterprise."

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Banks are not legal franchises in the Starbucks or McDonald’s sense, but they act significantly like a public-private franchise in many ways.

Banks dispense the public trust via data and paper. The new money only has value because it is underpinned and ultimately underwritten by trusted public institutions.

Private companies fulfil the administrative role of placing money into the economy via credit creation and earning a profit by ensuring the amount returned is more than the amount lent.

What if we decided to place that right not in the hands of bubble-hunting profit-seekers, but in public institutions?

Without the profit motive playing the central role, we would likely be better positioned to advance the long-term public good.

To many readers, this is perhaps a fantasy far-off land. However, public development banks are at the heart of the finance system in Europe, playing a role alongside private banks. Government-owned banks are already creating credit on behalf of the public instead of chasing destabilising risky returns. The potential is already here.

In Scotland, that potential is placed within the Scottish National Investment Bank (SNIB). Its core aims are to invest in; industries that support a more resilient and productive population, reduce inequalities and rebalance the economy towards sustainable technology.

Unfortunately, it is, so far, a story of potential unfulfilled.

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Digging up those root metaphors of money creation allows us to picture a better world. Today's world is not what it seems. With an understanding that money is not scarce, government priorities can be observed in a different light.

Austerity policies are decloaked as deliberate choices. We can also question why the current macroeconomic framework places so much importance on savers ahead of borrowers. And finally, it emphasises the importance of an independent country being able to issue its own currency.

With a better understanding of how horizontal and vertical money is created, we see the potential for a seismic shift in how we manage our economy.

On Monday, we asked Bob Hockett to reimagine an independent Scotland’s financial services industry, and you can see the 30 min interview here. Join us on June 28 at 2.30pm to discuss this month's topics Adam Smith and privately created money.