Currency Debasement (Part 2) – Money Creation

INTRODUCTION

The first of these three articles on currency debasement demonstrated that currencies have lost value and spending power over time – £1 today can buy far less than it used to. The first car that I purchased in 1986, a second hand orange maxi, cost me £50, a sum that today wouldn’t be enough to fill my current car’s petrol tank.

The article defined “currency” as any asset that can be used to make a purchase. Currency includes physical banknotes and coins in circulation, money held in bank current accounts and saving deposit accounts, as well as short-term liquid investments. For the purpose of these articles, “Currency”, “Money” and “Money Supply” are all the same thing. Two charts, repeated below, highlighted the gargantuan increase in Currency, or Money Supply over the last 50 years.

Inflation was properly defined as the change in money required to buy the same item over a period of time. Importantly, two different types of inflation were discussed:

• Consumer Price Inflation (CPI) is the change in money required by a consumer to buy the same typical basket of goods and services over time

• Asset Price Inflation (API), a broader term, measures the difference in money required to buy a more expensive asset over a period of time. These assets are typically purchased infrequently and are not included in the CPI basket (e.g. a house, stocks and bonds, artwork etc.).

Using the housing market as an example, it was shown that over the last 5 decades, Asset Price Inflation of a house has increased multiple times more than the cost of servicing a mortgage or the cost of renting the house, which are included in the CPI basket.

This article will focus on the increase in currency, explaining how money is actually created. The examples used might seem over simplistic, but the process is not complex at all. To put flesh on the bones, official data is presented to demonstrate the size and sources of money creation. Let’s dive in….

WHAT IS “MONEY” AND HOW HAS IT DEVELOPED OVER TIME?

A very simple history of money (not completely precise, but close enough) until 1971:

• People initially exchanged goods by bartering (two of my sheep for 10 bales of your wheat)

• Metal coins came into existence and became i) a store of value and ii) a means for exchanging goods (I have 20 groats, and I will exchange 1 of my groats for 5 bales of your wheat)

• Banks were formed where you could “deposit” your metal coins (predominantly gold but also silver) for safekeeping.

• Banks started lending money and issuing paper money (bank notes) backed by those deposited coins

As long as the paper money issued by banks (or the loans extended by banks to their customers) HAD TO BE backed by gold or silver, then money could not grow. The only way to increase the money in circulation was to dig more gold out of the ground or import Gold from abroad, for example when the Spanish brought Latin American gold and silver back to Europe, or when Elisabeth I confiscated a significant amount of Spanish Gold (on its way to Antwerp) and minted it into English money.

The key point is that directly or indirectly, money in the form of cheques, acceptance bills, discount bills or banknotes were for the most part backed by gold, and as long as this remained the case, currency or the money supply could not grow (*).

Roll forward to World War 2 and subsequent years. Under the Bretton Woods accord struck between nations in 1944, currencies fixed their exchange rates against the US Dollar (US$), which itself was fixed against a set amount of Gold (35US$ = 1 troy ounce). This was called the “Gold Standard”.

All currencies in the Accord were indirectly backed by Gold because they were themselves fixed to the US$, which was itself fixed to Gold. An international account who owned US$s, or who sold its currency to buy US$s, could go to the US government and exchange their US$s to receive gold at the rate of US$ 35 per ounce.

Clearly, because their own currency HAD to be backed by gold, the US government could not create huge amounts of new US$s, as they would run the risk of not having enough Gold if foreigners (or domestics) took fright and demanded Gold in exchange for any US$s they owned.

In my view, for what it’s worth, 15 August 1971 is perhaps the most important date in post war finance. Due to domestic economic stresses, President Nixon abandoned the “Gold Standard”, and suddenly US$ were no longer backed by gold. The US government could now inject more US$s to boost its economy, indeed the US$ currency in circulation increased by 13% in the next 12 months and the growth trend has only gone in one direction ever since. The chart below, from the Federal Reserve (the US Central Bank) shows the growth in the amount of currency, or money, in the US since 1960.   

Because all major currencies were fixed to the US$, they too were suddenly no longer backed by Gold when the US abandoned the Gold Standard. The US$ and all major currencies became what is termed "Fiat Money", i.e. backed by promises and purely a stable means of exchange, but nothing else. No longer shackled by having to be backed by Gold, they too started to expand significantly:

The remainder of this article will focus on how money is created and how it grew after 2000. Like the first article, this one will focus purely on accounting principles and official financial data.

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(*) In reality, history is littered with many cases when governments and banks issued paper notes that were not backed by gold. These often resulted in bank crises and bank runs, when confidence in the paper money vanished and depositors lost their savings when they went to their banks and were unable to convert their deposits back into gold.

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MONEY CREATION

Who is responsible for the creation of ~$17 trillion ($17,000,000,000,000) of new US money since 2000, and how has this been carried out? The simple answer is that initially banks created a truly astonishing amount of money, and when that then caused the Great Financial Crisis of 2008, Central Banks stepped in and started creating money…….in spades.

So how does a bank create money? Here is a very simple example that demonstrates the money creation process.  

A)      COMMERCIAL BANK CREATES MONEY

Imagine an island with one occupant called Chris, who owns a house and has £20,000 deposited at the only bank. Chris thinks his house is worth £10,000, so he also thinks his total net worth is £30,000.

Say two new people, Albert and Bella, arrive on the island and camp. Each brings £10,000 in savings which they deposit in the bank. The net situation of the three individuals and the bank is depicted below. The total currency (Money Supply) on the island is £40,000 (i.e. the three deposits at the bank).

If Albert and Bella want to buy Chris’s house and have no access to any other funds (savings or mortgages), then either of them can only buy the house for a maximum of £10,000. And as long as this situation persists, Chris’s house can only be worth £10,000.

Say Chris wants to sell his house and travel and camp around the island, and let’s say he agrees to sell his house to Albert for £10,000. After the transaction, the net financial situation of all 4 parties would be as below:

The amount of currency on the island stays the same at £40,000. Note also that all 3 parties have the same net worth as before and also that the bank’s position has not changed. The difference is just that Albert’s net worth is now all tied up in his new house, whilst Chris’s net worth is now all deposited at the Bank. The bank now owes nothing to Albert but more to Chris.

But what if Chris wants £12,000 to sell his house? If the bank extends a £2,000 mortgage loan to Albert, then the house sale can proceed. This would result in the following net financial situation for the 4 parties:

Chris’s net worth has now increased by an extra £2,000. The assets and liabilities of the bank have both increased by £2,000. Crucially, the deposits, i.e. the total currency on the island, have increased by £2,000 to £42,000.

This money creation was made possible by the bank being able to create a mortgage loan for Albert and offset it against the extra £2,000 deposit that it will receive from Chris (£12,000 instead of £10,000). Assets and Liabilities both increased by the same £2,000 amount, and the money supply (i.e. Deposits) increased by £2,000 to match the increase in the house price. In other words, the creation of a loan for £2,000 for Albert has increased Chris’s deposits by £2,000, and so the currency in circulation has increased by £2,000.

This process of banks expanding their balance sheets, creating loans that lead to corresponding increases in deposits, is called Fractional Banking. This is the principal mechanism behind the huge increase in money supply since 1970. The above example is overly simplistic, as bank capital and leverage considerations need to be taken into account, but fractional banking by commercial banks was the primary driver of monetary expansion since 1970, as they extended loans (or “credit”) to households and businesses and received large deposits in return.  

Before looking at the size of this credit creation over the last 55 years, it’s worth pausing to consider the consequence of the £2,000 increase in the money supply which stemmed from the mortgage loan extended to Albert. Because of this loan creation, Albert was now able to buy the house for £12,000, instead of £10,000, which led to a 20% increase in the house price (API). Going back to our discussion on currency debasement, more £s were used to buy exactly the same house. Credit creation therefore led directly to API and a debasement of the £ on the island.

The chart below shows the growth of outstanding US Mortgages (left) and Business debt (right) since the end of WW2, and the annual percentage changes, (Source: Federal Reserve):

 Some observations:

• Today’s $13.3trillion of outstanding Mortgage debt is 46 times what it was in 1970 ($286billion), which goes a long way to explain why US house prices have risen so much (remember the simple case above of Albert getting a mortgage to buy Chris’s house, which caused a rise in the house price). This illustrates why so many more US$s are required to buy a house today compared to 55 years ago.

• Business debt has also grown tremendously in this period, from $566billionb in 1971 to $21.6trillion today.

• Until the Great Financial Crisis (GFC) struck in 2008, annual Mortgage and Business ALWAYS increased by at least 5% every year - even during recessions (red lines in charts above).

• Mortgage and business loan growth has been very poor since the GDC – green boxes - the only exception was briefly during the pandemic. Remarkably, people and businesses did not borrow much from 2008 onwards, despite interest rates being close to zero!

After blooming decades of new money creation, Money Supply creation from expanding bank credits reduced significantly after the 2008 financial crisis.  Householders and Businesses just reduced their pace of borrowing. THIS WAS AN IMPORTANT WATERSHED MOMENT, WHICH I WILL COME BACK TO IN THE THIRD ARTICLE.

In conclusion:

• banks extended huge amounts of new loans over the last 50 years to Households and Businesses, which has increased the money supply and therefore asset prices.

• this led to currency debasement – more US Dollars are now required to buy the same asset (e.g. residential house) compared to 10, 20 or 50 years ago.

• however, something changed after the GFC, as the pace of borrowing decreased.

B)      CENTRAL BANK CREATES MONEY

In my view, again, for what it’s worth, 25 November 2008 is perhaps the second most important date in post war finance – the US Federal Reserve (the US Central Bank, or simply the Fed) announced a $600bn “Quantitative Easing” program, known now as “QE1”. What is this QE and how does it impact the money supply?

Again, let’s keep things nice and simple to demonstrate the process. Imagine a government that has £ 3 million (mm) in outstanding debt (in the form of bonds). These are currently owned by

1. a Commercial Bank, that holds £2mm of the bonds. These are termed as “Assets”, as when the bonds expire, the bank will receive £2mm back from the Government. The Commercial Bank also has “Liabilities”, which is a term to indicate monies that it owes. These include current account deposits of £1mm which are money deposits given to the bank for safekeeping (like from Albert, Bella and Chris). The difference between the £ 2mm bonds in which the Bank has invested and the £1mm that it owes to depositors is what the bank is worth, i.e. £1mm. This is the “Equity” of the bank, which in effect is what it owes its shareholders if the bank is wound up and dissolved (and why it is also classed as a Liability). So £2mm Assets (Government Bonds) = £2mm Liabilities (£1mm Deposits + £1mm Equity). 

   
   

2. an Independent Central Bank, that holds £1mm of the Government’s bonds. Similar to the Commercial Bank, the Government Bonds are held as Assets, and match the Notes and Coins (Liabilities) that it has printed/minted and issued in circulation.

Say the economy goes into recession, and the government has to spend £1mm on unemployment benefits. Where would this extra £1mm money come from? Well, it could raise taxes or borrow from abroad.

Unfortunately raising taxes during a recession would cause further economic hardship, and borrowing from abroad might cause a devaluation of the currency, making foreign imports more expensive and thus risk stoking inflation from more expensive imports.

An alternative is to create new money……so step forward the Central Bank!

Yes, a Central Bank can create money, even though as students who have studied the Weimar Republic in Germany will testify, this is generally considered a “dangerous” option. In the process of money creation, a Central Bank can promise its actions are not “dangerous” by giving the process a complicated sounding name, assuring that it is only a “temporary” operation (*) and the Bank can also find ways to get around existing laws and regulations that were put in place to prevent money creation by a Central Bank.  

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(*) Some market participants were shocked when Ben Bernanke, the then Fed Chairman, announced money creation (QE) in 2008. People who really understood the consequences of his announcements were in disbelief that a Central Bank of an Advanced Economy would create huge amounts of money, and did not believe that the operation would be “Temporary” as promised. As will be seen in the final article, this money creation has been vast, and 17 years on, everything but “Temporary” in nature, leading to cause many of today’s significant financial and societal imbalances.

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In the process called Quantitative Easing (QE), QE STEP 1 goes as follows:

• the Central Bank simply creates “New Money”, in this case £1mm,

• it uses that newly generated money to buy £1mm of bonds from the Commercial Bank’s £2mm stock of existing bonds.

• the Commercial Bank now has a spare £1mm of money and it buys a new bond issued by the government.

• the government has now raised its required £1mm for unemployment benefits

• the Assets and Liabilities of the Central Bank’s balance sheet has increased by £1mm

• the Commercial Bank’s position has remained unchanged,

• the Money Supply has increased by £1mm to £3mm.

To understand the power of this money creation, you have to consider what happens to the £1mm raised by the government. In QE STEP 2:

• the government distributes £1mm to unemployed people, who deposit their payments at the Commercial Bank before spending it. These are “excess deposits” for the bank.

• until that money is spent, the Commercial Bank will deposit these “excess deposits” with the Central Bank (termed Central Bank Deposits) and gain interest on it.

  
  

Et voila’, £1mm of new money has been created by the Central Bank, that has indirectly funded the government and increased the money supply.

As shown at the end of the previous section on Commercial Bank money creation, the Great Financial Crisis in 2008 saw a reduction in money creation by banks, as mortgage and business credit growth decelerated substantially. But from 2008, Central Banks Quantitative Easing programs ensured that they now stepped in and created money, and they did this on an industrial scale.

As can be seen in the above simple example, the size of the £ 1mm Central Bank money creation can be determined by the change in the Central Bank’s holding of Government Bonds (from £ 1mm to £2mm) or from the amount it owes Commercial Banks (£1mm).

To demonstrate how much money has been created since the GFC by Central Bank QT programs, the charts below depict the Bond holdings of the Federal Reserve in the US, the Bank of England in the UK, the European Central Bank in the Eurozone and the Bank of Japan. The charts are similar for the Central Banks in Australia, Sweden, Canada etc.

A few observations

1. The amounts are truly staggering. For example, consider that it took 50 years for US mortgage debt to grow by  $13trn – it only took the Federal Reserve 13 years to “create” $ 7 trillion of new dollars since 2011.

2. There has not been a uniform increase in money growth since 2008. It has been in fits and starts – the reason for this will be covered in the final article.

3. Central Banks are now doing the opposite of QE, called Quantitative Tightening (QT). They are undertaking the reverse operation, selling bonds back to Commercial Banks, and thus reducing the money supply. This will also be covered in the next article, as it will have a huge consequence on financial markets and economic growth.

CONCLUSION

The first article showed that currencies have been debased, and how the purchasing power of £1 or $1 has declined over time. Much more money is required to buy a good or service compared to 10, 20 or 50 years ago.

The reason for this currency debasement is the never-ending increase in money creation since the abandonment of the Gold Standard. First banks increased the money in circulation by extending loans to businesses and households, receiving deposits in return. Then after the financial crash in 2008, when credit growth declined, Central Banks expanded their balance sheets. This ensured that the money supply would continue to grow rapidly.

Now that the basics have been explained and the facts established, an interesting discussion can be had. The next and final article will highlight how money growth has impacted global economies. It will show how it has influenced Asset Price Inflation, creating significant social disparities in today’s societies, and also how it has allowed governments to borrow incredible amounts of money, leaving many of them in a dangerous fiscal situation. It will hopefully dispel many economic and political myths and also demonstrate how day-to-day issues are being impacted by money growth.  

The article will raise some important and difficult questions about Central Banks. It will also highlight the large financial imbalances that exist today and will conclude with some thoughts about where economies might go from here.

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APPENDIX

The Compound Annual Growth Rate (CAGR) represents the average annualised growth rate for compounding values over a given time period. CAGR smooths a series of different values, and it is particularly useful as it allows a comparison of growth rates of various data values, in this case the yearly growth of money in different countries.

The table below lists the outstanding currency in US at the end of each particular year over the last 17 years. It also shows the yearly increases from one year to the next.

The average yearly growth for that 17 year period, that took the money supply from $7.08trn in 2006 to $21.5trn in 2024, is 6.4% – this is the CAGR