It is often said that Governments have to operate just like any household budget. Governments can only spend what they can earn; where Government earnings are typically derived from “taxation”. If Governments want to spend they must first tax, or borrow from someone willing to deposit their money with them through a bond or gilt-edged security. In the current political convention the preferred route for Government is tax and spend; or rather, tax then spend. Households are just like Governments; that is what is often said, by people who should know better.

Notice it is not said that households are like banks. Households are not like banks, but nor are they like Governments (with access to their Central Banks). What is the difference? Banks create money. Households cannot create money. It would be much more accurate to say that households are nothing like Governments. But ‘households are nothing like Governments’ doesn’t work for the political ‘movers and shakers’ whose ideology depends on the opposite, and whose power and influence depends on the public believing in a fiction. The creation of money and the power of credit changes everything, for both banks and government.

I am not writing this to provide a polemic against the ideology of neoliberalism or its acolytes, for that would be a waste of your time and mine. I simply wish to point the interested general reader, who may be perplexed by the proposition that Governments are not just like households, in a different and more enlightening direction. My purpose is that the reader finds out for him/herself something about the underlying issues: the real issues.

I do not doubt that faith in the simple but potent vision that ‘households are just like Governments’ possesses a wholesome, if not homespun, common sense logic and reassurance that everyone can understand and embrace a common sensibility; a vision buttressed by the prospect of furthering virtue – a world in which prudence, careful spending and honest budgeting must work everywhere, and for everybody; and must triumph. Virtue, family and economics; it has a certain public potency. There is much sense in these aspirations, but none of them depend on the analogy of households and Governments. If the analogy did work, and we all have faith in the virtuous spiral created by the “truth” that ‘households are just like Governments’, we may wonder why we never, ever actually reach the goals to which we aspire; deficits extinguished, growth assured, debts controlled, managed and reduced. In the real world meanwhile the acolytes of household management in Government fail to achieve any objective, and always end with the same non-solution; they kick the can down the road: economic growth and debt reduction are never quite synchronous, or sustainable; deficits are never eliminated – the zero-deficit horizon is never reached, but disappears, over that same relentless, ever-receding horizon; and the national debt increases.

Where we are is always far, far from where we want to be; we want to be on the opposite shore; anywhere but here. Yet we are always here; under the cosh. Why does that keep happening; above all to the acolytes of ‘household management’, voted in to power to fix the household shortfall and prove that Governments are just like households? Oh well; one more long, long shove, to be attained perhaps; but not by us – rather by the next generation; or two? The nil deficit will finally recompense your children or grandchildren for the vast store of personal debt they will have accumulated by then; surpluses will abound, if you believe in ‘Nevereverland’. Nevereverland is much like us; there the debt always rises and expectations always disappear over the horizon. This is the long term and in spite of all that we are fine, because by then we will be safely dead: the household management fallacy may be a dud, but it “will see me oot” – if I may reveal the limits of ambition of our present household management government and its admirers. Could it be that instead, something isn’t working? We perhaps need a small refinement to the execution of the theory? Find better politicians to do it – next time? Find better political parties to do it – next time? Find better households to do it – next time? Or should we just plan for the time after that? I wish you luck with these ideas. Could there be something else? ‘

Something else’ is what I wish to discuss. I am not promoting myself as an expert on the areas I wish to present. The underlying ideas on money creation and the critical banking issues (the supposedly esoteric ideas of the multiplier, intermediaries, fractional reserve banking) are better found in the work of modern economists, who are at last breaking down the shibboleths and orthodoxies that have dominated thinking, and much worse – policy – for too long; old ideas that are overdue being consigned exclusively to the past, in our unsurprisingly error-strewn intellectual history. For those who wish to embrace the challenge fully, they can do no better than google such names as – among others – I am not attempting to be encyclopaedic – Ann Pettifor, Professor Steve Keen, Professor Richard Werner, or ‘Positive Money’. This will provide no single, simple answer; you will find important disagreements among them. Welcome to the real world.

For those less adventurous, or with less time, as the starting point I have taken a long excerpt from Richard Werner, which swiftly and trenchantly establishes the basic principles of money creation, and summarises the key theories that have influenced our understanding of money and credit:

“Over the past century and a half, three competing theories of banking have been influential — the financial intermediation, the fractional reserve and the credit creation theories of banking. Most current models, theories and textbooks in finance and economics assert the validity of the financial intermediation theory. According to it, banks do not have the ability to create money, neither individually (as the credit creation theory argues) nor collectively (as the fractional reserve theory maintains). Recently, two events have upset the status quo in this debate. The Bank of England has come forward clearly in support of the credit creation theory (Bank of England, 2014a, 2014b). Secondly, the first empirical tests of the three theories have been conducted (Werner, 2014a, 2014c). These tests showed that the financial intermediation and fractional reserve theories are not supported by the evidence: Banks do not gather deposits and then lend these out, as the financial intermediation theory assumes. Nor do they draw down their deposits at the central bank in order to lend, as the fractional reserve theory of banking maintains. The empirical facts are only consistent with the credit creation theory of banking. According to this theory, banks can individually create credit and money out of nothing, and they do this when they extend credit. When a loan is granted by a bank, it purchases the loan contract (legally considered a promissory note issued by the borrower), which is reflected by an increase in its assets by the amount of the loan. The borrower ‘receives’ the ‘money’ when the bank credits the borrower’s account at the bank with the amount of the loan. The balance sheet lengthens. Through the process of credit creation 97% of the money supply is created in the UK today (Werner, 2005), and similar proportions apply to most industrialised economies. Not surprisingly, the use to which bank credit is put to determines its effect, namely whether bank credit is extended for productive, consumptive, or speculative purposes (the Quantity Theory of Credit, see Werner, 1997, 2005, 2012a).”

(R.A. Werner, ‘How do banks create money, and why can other firms not do the same? An explanation for the coexistence of lending and deposit-taking’: International Review of Financial Analysis, 36, (2014); pp.71–77; for the date references to sources given above, go to the full article here).

The most important feature of the world for any scientific theory (economics claims to be a ‘science’), is evidence. As Werner indicates the evidence does not support either the fractional reserve or intermediation theories. Indeed we can go much further back than Werner, to the outset of World War I in 1914 to see that even then, people understood something else. Notice also that this evidence will show that to accomplish this extraordinary outcome, the British Government then did not rely on taxation or third-party borrowing to raise the funds to pay for WWI; the funds were initially created out of nothing. Of all the things that fell apart in WWI (just about everything), uncannily the Government’s creation of War Loan in 1914 was not one of them. What was until very recently deemed false by orthodox expert economic opinion, was almost the only part of the financial system that worked for a Government in search of money, over a century ago. Fortunately there were no ‘ household budget’ ideologues close to the decision to ensure it couldn’t happen; the ideologists were too busy in 1914, intent on destroying Europe: they kept their further destruction of the financial system until 1929.

Michael Anson, Norma Cohen, Alastair Owens and Daniel Todman have written an account of what was executed (but scarcely planned) by the Bank of England in 1914, in the Bank of England staff Blog, ‘Bank Underground’, from which I provide the excerpts below:

“Financing World War I required the UK government to borrow the equivalent of a full year’s GDP. But its first effort to raise capital in the bond market was a spectacular failure. The 1914 War Loan raised less than a third of its £350m target and attracted only a very narrow set of investors. This failure and its subsequent cover-up has only recently come to light following research analysing the Bank’s ledgers. It reveals the shortfall was secretly plugged by the Bank, with funds registered individually under the names of the Chief Cashier and his deputy to hide their true origin.


The general public could be forgiven for believing that the first War Loan was an unbridled success, given the overwhelmingly positive coverage. The Financial Times, for example, reported on 23 November 1914, that the Loan had been over-subscribed by £250,000,000. “And still the applications are pouring in,” it gushed.


Disclosure of the failed fund raising would have been “disastrous” in the words of John Osborne, a part-time secretary to Governor Montagu Norman, in a history of the war years written in 1926. Copies of this account were only given to the Bank’s top three officials and it was decades before the full version emerged. Revealing the truth would doubtless have led to the collapse of all outstanding War Loan prices, endangering any future capital raising. Apart from the need to plug the funding shortfall, any failure would have been a propaganda coup for Germany.

So to cover its tracks, the Bank made advances to its chief cashier, Gordon Nairn, and his deputy, Ernest Harvey, who then purchased the securities in their own names with the bonds then held by the Bank of England on its balance sheet. To hide the fact that the Bank was forced to step in, the bonds were classified as holdings of ‘Other Securities’ in the Bank of England’s balance sheet rather than as holdings of Government Securities (Wormell, 2000)”. ( “Your country need funds”, ‘Bank Underground’, 8th August, 2017 )”

At the time the Bank of England was a private institution, but in carrying out this transaction the BofE was effectively conducting an exercise that appears in broad principle very similar to what is now termed Quantitative Easing (QE), but in a very different world. The Bank of England created the funds out of nothing. We knew little about this because there was an elaborate and typically effective high-level cover-up of the 1914 War Loan issue failure. The failure also usefully reveals the nature of the banking system, if it had been based exclusively on attracting deposits: it shows that in times of real need they do not come. It is also important to note that the target market of the Bank for this issue was the large professional, institutional investor or high-net-worth individual, not the ‘man in the street’, who could not have met the particular investment criteria the bank set. The target market, the big investors (British or otherwise), did not invest in Britain.

Returning to the nature of banking, I would recommend two key technical papers; both published under the auspices of the Bank of England on the theory of the ‘money multiplier’ in a fractional reserve system, and on banks as intermediaries. The conclusions of both may be summarised in a bullet-point in the first paper, “Money creation in practice differs from some popular misconceptions—banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits”.

The first paper is, “Money creation in the modern economy” by Michael McLeay, Amar Radia and Ryland Thomas of the Bank of England’s Monetary Analysis Directorate. In the paper’s Overview McLeay, Radia and Thomas argue as follows:

“In the modern economy, most money takes the form of bank deposits. But how those bank deposits are created is often misunderstood: the principal way is through commercial banks making loans. Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.

The reality of how money is created today differs from the description found in some economics textbooks:

Rather than banks receiving deposits when households save and then lending them out, bank lending creates deposits.

In normal times, the central bank does not fix the amount of money in circulation, nor is central bank money ‘multiplied up’ into more loans and deposits.

Although commercial banks create money through lending, they cannot do so freely without limit. Banks are limited in how much they can lend if they are to remain profitable in a competitive banking system. Prudential regulation also acts as a constraint on banks’ activities in order to maintain the resilience of the financial system. And the households and companies who receive the money created by new lending may take actions that affect the stock of money — they could quickly ‘destroy’ money by using it to repay their existing debt, for instance.”

(McLeay, Radia and Thomas, “Money creation in the modern economy”, Bank of England Quarterly Bulletin, Q1, 2014)

Second, on banks as intermediaries (in effect that banks are dependent on deposits to make loans), see Bank of England Working Paper No. 529: Zoltan Jakab and Michael Kumhof, “Banks are not intermediaries of loanable funds — and why this matters” (2015). Jakab and Kumhof propose that banks are not intermediaries:

“….in the real world, the key function of banks is the provision of financing, or the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor. The bank therefore creates its own funding, deposits, in the act of lending, in a transaction that involves no intermediation whatsoever. Third parties are only involved in that the borrower/depositor needs to be sure that others will accept his new deposit in payment for goods, services or assets. This is never in question, because bank deposits are any modern economy’s dominant medium of exchange. Furthermore, if the loan is for physical investment purposes, this new lending and money is what triggers investment and therefore, by the national accounts identity of saving and investment (for closed economies), saving. Saving is therefore a consequence, not a cause, of such lending. Saving does not finance investment, financing does. To argue otherwise confuses the respective macroeconomic roles of resources (saving) and debt-based money (financing).”

[quote from p.ii].

Economic models that integrate banking with macroeconomics are clearly of the greatest practical relevance at the present time. The currently dominant intermediation of loanable funds (ILF) model views banks as barter institutions that intermediate deposits of pre-existing real loanable funds between depositors and borrowers. The problem with this view is that, in the real world, there are no pre-existing loanable funds, and ILF-type institutions do not exist. Instead, banks create new funds in the act of lending, through matching loan and deposit entries, both in the name of the same customer, on their balance sheets. The financing through money creation (FMC) model reflects this, and therefore views banks as fundamentally monetary institutions.” [quote from p.38, Conclusions, Bank of England Working Paper No. 529: Jakab and Kumhof, “Banks are not intermediaries of loanable funds — and why this matters” (2015)].

Think about it.

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