types of money we actually use in the economy. There's actually three types of money that

we use in the economy. As a member of the public, you will only have ever used two of

them.

The simplest form is cash -- the £5, £10, £20 and £50 bank notes and the metal coins

that most of us will have in our wallets at any point in time. As you probably know, only

the government, via the Royal Mint and the Bank of England, is allowed to create these.

If you try to make your own at home, pretty soon you'll get the police kicking down

your door at 2 in the morning.

Now imagine that you need to pay your rent, and your landlord has an account with a different

bank to you. When you log into your internet banking and make the payment to your landlord,

your bank has to send some money to your landlord's bank to 'settle' and complete the transaction.

Of course, the banks don't want to make these payments to each other in physical cash

because carrying all this money around is dangerous, even if they use protected security

vans and guards with bullet vests and helmets.

So instead, they use a type of electronic money, which is called 'central bank reserves'.

Remember that name because we'll be using it a lot in this video.

Central bank reserves are effectively an electronic version of cash, and banks use these electronic

central bank reserves to make payments to each other. The central bank reserves are

created by the Bank of England -- we'll cover how later on -- and they can only be

'stored' in accounts that the big banks have with the Bank of England.

To get one of these bank accounts at the Bank of England, you have to be a bank. So as members

of the public, we can't get our hands on any central bank reserves. We just have to

use the physical cash.

So the first two types of money are 1) Cash and 2) Central Bank Reserves. Remember that

central bank reserves are like an electronic version of cash that only the banks can use

to make payments between themselves.

The third type of money is a type of money that isn't created by the Bank of England,

the Royal Mint or any other part of government. This third type of money is the type of money

that's in your bank account right now.

This money is just numbers in a computer system.

Bankers and economists refer to this type of money with jargon such as 'bank deposits'

'demand deposits', 'sight deposits' or 'bank credit'. These terms all mean

pretty much the same thing and are used interchangeably. They might also be referred to as bank liabilities

-- this is the accounting term, because this money is a liability of the bank to you i.e.

it's what the bank needs to repay you at some point in the future.

Now in a legal sense, the numbers in your account aren't really money at all. But

despite that, they serve exactly the same purpose as the £10 and £20 notes that you

might hold in your wallet.

It's this type of electronic, bank-deposit money that now makes up over 97% of all the

money used in the UK economy. Less than 3% of the money supply is cash created by the

government.

And all this electronic bank-money is created by the banks, as we'll explain now.

The Balloon Model

Let's revisit the multiplier model that we saw in the last video. Remember that it

describes the money system as having a base of 'base money'. In the simplified version,

the 'base' is made up of cash. In reality, it's not just cash in this base -- it's

also the electronic central bank reserves that banks keep in their accounts at the Bank

of England. But it's true that this base is made up of money -- either cash or electronic

-- that was created by either the Bank of England or the Royal Mint.

Now let's look at the top of the pyramid. The rest of the pyramid is made up of the

third type of money -- the electronic bank-created money. So the pyramid is split up into a base

of government-created money, and a tower of bank-created money at the top.

Remember that we said this pyramid, in theory, is limited by the reserve ratio? Well, there

is no reserve ratio, and there hasn't been for years.

This means that the total amount of money in the economy isn't really limited. It

can keep expanding without coming to a point at the top.

So the pyramid is actually the wrong shape to describe the money system.

In reality its closer to a balloon of bank-created money, wrapped around a smaller balloon of

base money. In this case, the base money is the electronic central bank reserves and cash.

As we'll see in this video, the Bank of England has relatively little control over

the total size of the balloon of bank-created money.

They can't really control how much money is in the economy, even if they claim to be

able to.

The outer balloon of bank created money could expand out of control and the Bank of England

wouldn't be able to stop it -- at least not within the current monetary system.

We saw this happen before the crisis. In 2006, the outer balloon of bank-created money was

80 times bigger than the inner balloon of base money. The multiplier wasn't 10 times,

like the textbook models suggest: it was actually 80 times!

And then when banks panicked during the crisis and refused to lend, the Bank of England pumped

a load of extra base money into the inner balloon, through the scheme known as Quantitative

Easing. But this didn't lead to a massive increase in the size of the outer balloon.

Right now the outer balloon -- the amount of bank-created money -- is only 14 times

bigger than the inner balloon. This shows that there is no real connection between the

amount of central bank reserves -- or base money -- and how much money that the banks

are able to create.

WHAT DETERMINES THE AMOUNT OF MONEY IN THE ECONOMY?

So what actually affects the ratio between bank-created money in the outer balloon and

government-created cash and central bank reserves in the inner balloon? What determines how

much money is created for the economy?

The research that we have done suggests that the amount of money that banks can create

is not determined by reserve ratios, or by regulation, or by the control of the Bank

of England.

The reality is that the total amount of money depends on the confidence of banks. If they're

feeling confident, banks will create new money by lending more. And when they're scared,

they limit their lending, which limits the creation of money.

So the size of the outer balloon really depends on the confidence and incentives of the banks.

Or to put it another way, the amount of money in the economy depends on the mood swings

of bankers.

Given that the amount of money in the economy can determine the health of the economy, does

it sound like a good idea to have such an important thing decided by the mood swings

of bankers? Probably not!

EXACTLY HOW BANKS CREATE MONEY OUT OF NOTHING

OK, back to the numbers in your bank account. These numbers are all created by banks. The

vast majority of these numbers were created when somebody took out a loan from a bank.

Let's see how this happens.

A customer, who we'll call Robert, walks into a Barclays Bank and asks to borrow £10,000

for home improvements. Barclays runs a quick automated credit check and decides that the

customer can be relied on to keep up repayments on the loan.

The customer signs a loan contract promising to repay the £10,000, plus the interest,

over the next 4 years, according to an agreed monthly schedule.

This loan contract is a legal contract that binds the customer to make repayments to the

bank. This means that it is a legal contract that is considered to be worth £10,000 (plus

the interest).

Because it's an asset, Barclays can record the loan on its balance sheet.

Now if you haven't come across a balance sheet before, don't worry -- it's pretty

simple.

There's two parts to a balance sheet. One half records all the things that the bank

owns -- this could be money, other financial products like bonds and derivatives, bank

buildings, computers, and most importantly, the loans it has made.

How can you own a loan? Well, if someone signs a contract promising to pay you money, then

that contract is worth something. It's considered an asset of the bank.

In the case of Robert, the contract that he signs promising to pay the bank £10,000,

plus interest, over the next few years, is worth at least £10,000 to the bank, and therefore

it's an asset to the bank.

So the bank puts an extra £10,000 on its balance sheet, like this:

BARCLAYS BANK BALANCE SHEET (Step 1)

(Left side) Assets (What the borrowers owe to bank + bank's

money) Loan to Robert: +£10,000

Now what about the other half of the balance sheet?

The other half of the balance is what's called the Liabilities. This is a record of

everything the bank owes to other people. On this side, you'll find a record of money

that the bank has borrowed from other banks or large pension funds. You'll also find

all the customers accounts, because -- if you remember -- the balance of your account

is just a number showing what the bank promises to pay you when you ask for your money back.

When Robert signed the contract promising to pay the bank £10,000, plus interest, over

the next 10 years, he did it because he wanted some money from the bank. So the bank creates

a new account for Robert, which is linked to his debit card, and just types £10,000

into their computer records. This £10,000 is a liability from the bank to Robert, and

it shows up on the other half of the balance sheet.

(Right side) Liabilities (What the bank owes to the depositors + bank's

net worth) Robert's new account: £10,000

Now when Robert goes to the cash machine to check his balance, he'll see £10,000 which

he didn't have before.

All the bank has done to create this new money is type some numbers into an account. It hasn't

reduced the balance of anyone else's account, and it hasn't taken any money from some

pensioners and moved it into Robert's account.

So the process of creating commercial bank money -- that's the money that the general

public use -- is as simple as:

1. a customer signing a loan contract and 2. the bank typing numbers into a new account

set up for that customer

This new bank-created money represents new spending power -- or money - in the economy.

Robert can now go and spend his money anywhere in the economy, using his debit card, cheque

book, internet banking transfers, or even by taking the cash out of the ATM.

INTER-BANK SETTLEMENT: ONE PAYMENT

But there's a small complication. What happens if Robert goes and spends the new bank-created

money with a shop that has a bank account with a different bank, say Lloyds?

If this happens, then Lloyds will want to see £10,000 of real money from Barclays.

Barclays would then need to transfer £10,000 of central bank reserves to Lloyds to settle

the transaction. Note that from the point of view of Lloyds, receiving a transfer of

£10,000 in central bank reserves into its account at the Bank of England is just as

good as Barclays pulling up in a truck and dropping off £10,000 in cash, although it's

much more convenient for the banks to have the electronic central bank reserves than

to have to carry around all that cash.

This process of banks making payments between themselves is called inter-bank settlement,

and it's really important to understand it, because it's crucial to the way that

banks have been able to gain control of the entire money supply.

First, let's look at the simplest example of inter-bank settlement, with just two banks

and two customers.

Robert, when he receives his loan, goes straight to a DIY store and spends £10,000 on everything

he needs. He gets to the checkout and pays using his visa debit card. Here's a simplified

version of what happens behind the scenes:

First, the DIY Store's debit card machine automatically contacts Visa and say "Please

charge £10,000 to this card number: xxxxxx".

Visa's computer systems then dial up Barclay's computer systems and say "Robert's trying

to spend £10,000 on his debit card. Is that ok?" Barclays' computer system checks

the balance of the account and says "Yes". Barclays computer system then reduces the

balance of Robert's account by £10,000.

Now, Visa's computer system contacts the Lloyds, and says "I'm sending you £10,000

for the DIY Store's account". Lloyds then updates the balance of the DIY Store by £10,000.

However, importantly, when the owners of the DIY store log into their internet banking,

they see two figures. One says "Account balance", and the other says "Available

now". For the next couple of days after Robert has come into the shop, the Account

balance will be £10,000 higher than the Available Now balance. The £10,000 that Robert spend

isn't available to the DIY Store for them to spend just yet. Why?

Well, behind the scenes, Barclays needs to settle with Lloyds. When Lloyds gets the message

that someone has spent £10,000 in the DIY store, it updates their account balance, and

then calls Barclays to say "Send me the money...".

Barclays could settle with Lloyds by delivering the £10,000 in cash, but in reality this

is just a hassle for both banks. They'd have to find somewhere to store all the cash,

and a van with security to transport it. So instead, Barclays will settle by making a

£10,000 transfer from its reserve account at the Bank of England, to Lloyds reserve

account at the Bank of England.

Once Lloyds gets the £10,000 in its account at the Bank of England, then it will update

the Available Balance in the DIY Store's account.