Most of us spend our lives earning, saving and investing it, yet surprisingly few people understand how money is created or how the system behind it works.
We often imagine that the Bank of England prints money, people deposit it into banks, and those banks then lend the same money to somebody else.
That sounds logical.
But it is not how most modern money is created.
Money is more than notes and coins
When we think of money, we picture banknotes, coins or the numbers displayed in our banking apps.
Physical currency represents only a small part of the money used in the UK economy. Most money exists electronically as deposits held in commercial bank accounts.
The balance in your current account is not a pile of Bank of England notes stored somewhere with your name on it. It is a promise from your bank to pay you.
Money is therefore a widely accepted system of financial claims and IOUs.
Banks create money when they make loans
Banks do not wait for one customer to deposit £300,000 before passing that same money to somebody applying for a mortgage. When a bank approves a mortgage, it usually creates a new loan and a new bank deposit at the same time.
Imagine borrowing £300,000 to buy a house.
The bank records the mortgage as an asset because you owe it money. At the same time, it creates a matching £300,000 deposit that can be transferred to the seller. That deposit did not exist before the loan was approved.
New money has been created.
Banks cannot do this without limits. They must hold sufficient capital and liquidity, comply with regulation and manage the risk of default. But the central principle is simple: Bank lending creates deposits.
Money can also be destroyed
Bank lending creates money, but repaying a loan removes it.
When the borrower repays the principal, the matching deposit money is extinguished. Interest is different: it becomes income for the bank and may return to the economy through wages, costs, taxes or dividends.
New loans create money. Loan repayments destroy it.
This is one reason credit conditions matter. When lending expands, spending and investment can rise. When lending slows, economic activity can weaken.
What about the Bank of England?
The Bank of England sits at the centre of the financial system, but it does not directly control every pound created by commercial banks.
It issues banknotes, provides central-bank reserves, supports financial stability and sets Bank Rate.
Central-bank reserves are electronic money used by banks to settle payments between themselves. They are different from ordinary customer deposits.
The Bank can also create reserves through quantitative easing, which may increase commercial bank deposits when assets are bought from investors.
When rates rise, mortgages, business loans and other credit usually become more expensive. Borrowing and spending may slow, helping to reduce inflationary pressure.
When rates fall, borrowing usually becomes cheaper, encouraging lending, investment and spending.
The Bank does not precisely control the amount of money in circulation. It influences the conditions under which banks, households and businesses make decisions.
Why this matters to investors
Money creation affects almost every asset we invest in.
When borrowing is cheap and credit is widely available, more money can flow into property, businesses and financial markets. When rates rise and lending slows, those assets can come under pressure.
Government borrowing is not the only influence on gilt yields. Expectations for inflation, growth and future interest rates all play a part.
Gilt yields feed into mortgage rates, business borrowing costs and the returns investors demand from shares. Interest rates also affect company valuations. When rates are low, investors may pay more today for profits expected many years into the future.
When rates rise, those distant profits become less valuable today. This is why highly valued growth companies, such as the MAG 7, can be sensitive to interest-rate changes.
Understanding money will not predict every decision made by the Bank of England.
But it can help explain why markets react, why borrowing costs change and why some assets perform better in certain conditions.
The system ultimately depends on trust
Most of the money we use is created through bank lending and removed when loans are repaid.
But the whole system depends on trust, supported by regulation, institutions and the central bank.
We trust that pounds will remain widely accepted and retain their value. Banks trust borrowers to repay. Savers trust banks to honour their deposits. Investors trust the Government to meet its obligations.
While that confidence remains, money can circulate, banks can lend and governments can refinance their debts.
Money may now exist mainly as numbers on screens.
But those numbers are valuable because, we trust the system behind them.
The Compounder
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