Where does money come from?

Listening to one of the RSA's excellent 15 minute 'Four Thought' talks on Radio 4 the other day I was struck how naive I was about how money was created. And I think I'm not alone. When I say how money is created, I don't mean companies earning it, I mean extra money added to the supply. My naive reaction would have been 'The Bank of England does it - quantitative easing, that sort of thing.' But actually the BoE is a small player in this.

The reason I missed the point is that I hadn't really thought about what ordinary high street banks do with money. Don't get me wrong. I wasn't like a young friend of ours many years ago who thought that the bank had a series of shoe boxes (or equivalent), and when she paid money in, they put it in her shoe box in the safe. I knew the money you pay in just enters the system and can go anywhere. But I hadn't thought about another aspect of dealing with banks.

Let's imagine you go to your bank and get a loan. You can do it online in about 2 minutes - it's frighteningly easy. At the end of the process, the bank waves that magic wand and the amount you borrow - £1,000, say - is in your account. Nothing has actually moved anywhere. All they have done is increased the number on the computer file that says 'Brian's balance' (my electronic shoe box). And here's the totally amazing thing. They just created that money. They didn't need anything to back up that number. They just changed the value and hey presto there was more money in the system. Simples.

And scary. That is, on the whole, how money is made without any need for any reserves to back it up. Which it's hard not to see as a contributory factor in the financial mess we got into. You can hear the original talk here and I recommend it.