An overview of the UK monetary system

By Ellis Winningham

Oftentimes, we advise people to limit the use of the word “money” when discussing MMT concepts. Although the word is incredibly common, the term is actually quite vague and will inevitably cause immense confusion among the public.

It is best that you define what you’re talking about. In most cases, when we are talking MMT, we are talking exclusively about the act of government spending “government money”. Occasionally, you will see us refer to it as High Powered Money (HPM), “government money”, “government IOUs”, reserves, “Pound Sterling”, or simply “pounds”. So, when we say that “the pounds used to pay taxes are destroyed”, we are talking about the “money thing” issued by the BoE, and when we are talking about consumer spending as it relates to fiscal policy, again, we are talking about the “money thing” issued by the BoE.

But, when we begin discussing bank lending, here we sort of break down the monetary system and talk about bank-created IOUs rather than “pounds”. Doing so provides the public and those who are learning with a means to understand the differences between private debt and public debt, to understand how bank lending works, and to understand how the monetary system itself works on a basic level. In fact, let’s break down the monetary system for a deeper look.

At the top is the central bank, the Bank of England (BoE). The BoE issues central bank liabilities (the Pound Sterling) because it is the financial arm of the UK government. It also houses and controls all reserve accounts, and these accounts contain central bank liabilities. The BoE is the central clearinghouse for all payments.

Commercial banks are licensed by government and are connected to the BoE through reserve accounts which allows them to facilitate transactions (payments).

People and businesses interact financially with the UK government (The BoE and the Pound Sterling) through commercial banks.

Central bank liabilities are the “money thing” that settles all payments because they are issued by the BoE, and the government is the supreme authority. Since the monopoly issuer emits central bank liabilities, these “money things” are government-issued, and because of that, they can be saved by the non-government sector.

Commercial banks, on the other hand, are licensed by government and they issue an IOU which must be denominated in Pound Sterling, and which can facilitate transactions, but cannot settle transactions. For that, you need central bank liabilities. The process is pretty straightforward.

The BoE issues its own liability which all bank IOUs are dependent on. The existence of “government money” ensures that 1 bank IOU will clear on par with £1. Thus, when you spend £20, “bank money” is debited from your current account, and is credited to the merchant’s account, and exactly £20 in central bank liabilities moves from one reserve account to another guaranteeing that the payment clears.

In other words, there is no market-determined exchange rate between two different UK banks that issue IOUs, as there is between two different currencies like the Pound Sterling and the US dollar. All bank IOUs are compelled to be equal to £1 of central bank liabilities.

With that information, we can now understand bank lending much better.

Though commercial banks are licensed by government, they aren’t funded by government and must make a profit in order to remain in business. There is a public side and a private side to banks. On the public side is the payments system that we just discussed. Banks facilitate payments. On the private side, they need profit to continue to operate as a bank. So, how do they earn a profit? The most common way is to leverage their licensed status and engage in lending activity.

Because banks are licensed by government, they can issue spendable funds by creating their own IOUs which they obviously denominate in Pound Sterling. They determine their own credit conditions for lending, and when a qualified customer pops in, they do the same thing that the UK government does when it spends: They create a deposit.

Unlike the mainstream would want you to believe, the UK government doesn’t “spend out” taxpayer money, and banks do not “lend out” customer deposits. Banks simply type some numbers into an account, and in doing so, a deposit is created.

In other words, because they are licensed agents of the UK government, banks create money to lend in the same way that the UK government creates pounds to spend.

For example, if the loan amount is £100,000, the bank types 100,000 into a new account, and suddenly there is £100,000 waiting to be spent. The key word here is “waiting”. It doesn’t become “money” until it’s spent.

Since the customer is borrowing the bank’s product – the bank’s IOU – the customer is charged a fee called “interest”. When the customer does spend the loan, reserves (Pound Sterling) at the BoE will shift from the lending bank to another bank if the recipient of the spending banks at another bank. If the recipient banks at the same bank, the reserves do not shift.

Later, when the borrower makes a payment, he or she pays the principal plus interest charged. The principal amount is deleted from existence by the bank. However, the interest is transferred to the bank, and the bank divides it up between an account for paying taxes and an equity account. The latter account, after whatever expenses the bank must pay to do business, represents the bank’s profit.

Now, when we put the big picture back together, one central fact becomes obvious: when you spend bank money; that is, when your current account is debited for a purchase at Tesco, you are spending government money. And who controls the monetary system?  I’ll answer this question in two ways. First, in the proper way for those who are learning, and second, in a way that will annoy James Meadway.

Who controls the monetary system?

The currency-issuer: The UK government.

Who controls the monetary system?

The Magic Money Tree does.