The basics: how is money made?

How is money made? Who creates it? Where does it come from? This post looks at the basics of how money is made in the UK and what that means for financial independence.

What’s “money” in the UK?

I have a really catchy definition for “money” that I’ve lovingly stolen from Wikipedia.

This bit is important: “or verifiable record”. I’m quite open in embracing cryptocurrency stablecoins, which are basically just a verifiable record, but it’s important to realise that money as we know it isn’t just a physical banknote.

In fact, actual banknotes are only worth £80billion in the UK, according to the Bank of England. In fact, the Bank reckons that only 4% of money in the UK is held in physical notes and coins, as a rough working figure.

In the UK, we think of “money” as being pound sterling. The pound is kept in power as a money because the government demands that all taxes are paid in it. It’s called “fiat currency” because you can’t actually exchange your pounds for anything: they’re worth whatever the collective belief in them is worth. I mean, sure, you can buy stuff at the shop with them, but you can’t go to a bank vault and demand that your tenner is swapped for silver.

The Gold Standard

If you’ve read my post on investing in gold, you’ll know that back in 1914 money in the UK was on the “gold standard”. That’s right: your coins were silver and gold, they had intrinsic melt value. Intriguingly, UK gold and silver coins still have a value listed in pounds on them (except gold sovereigns, which are the last £1 coin issued under the gold standard but don’t have it written on them). Seriously, you can buy a silver Britannia with a value of £2 on it.

Gold and silver were rare enough that the only ways to create more money were to a) take it from other countries, through trade or war, or b) debase the currency.

“Debasing the currency” literally means adding more base metals (e.g. lead) to the melting pot and diluting the gold/silver content of the final coins. That’s how easy that was! Of course, if your coins contained less gold than, say, a French coin, they would be worth less than other countries’ coins.

The whole world has pretty much moved to “fiat” currencies now. As far as I’m aware, there’s no gold standard in normal cash money. Interestingly, crypto stablecoins sometimes do use the gold standard, such as the Perth Mint token, Pax Gold and Tether Gold. See my post on investing in gold if you want to learn more.

So, the Bank of England makes the money, right?

Well, yes. Sort of. It technically does.

The Bank of England makes the “narrow money”. It also makes banknotes. It outsources the making of coins to the Royal Mint. What it doesn’t do it make the “broad money”. That right: the Bank of England doesn’t make all of the money in the UK.

Narrow money

Narrow money is basically all the money that’s created by the central bank – the Bank of England. It’s a mix of the actual banknotes in circulation and the government bonds (gilts) that the Bank agrees to buy from the UK government and/or pension funds. Here’s an interview below that’s sponsored by the Bank of England itself, which explains a bit about how this works. Sadly, it’s a little dry, but it’s only 5-and-a-bit minutes long.

The bit of the Bank of England that decides how much to buy/ make is the Monetary Policy Committee (the MPC). Their job is to work out what’s needed for both interest rates and purchases to hit the UK government’s target of 2% inflation.

The Chancellor of the Exchequer (at the time of writing, that’s Rishi Sunak) sets the inflation target. It’s usually a 2% target, based on the Consumer Price Index (CPI).

You’ll note that this means that “money printer go brrr!” isn’t really what’s happening when narrow money is made. Basically, “money being made” is the UK government agreeing to owe the Bank of England money. That’s right: money in the UK is just debt and deposits on a balance sheet. A ledger, if you will.

Hold on to that thought: we’re going to look at broad money next.

Broad money

If money in the UK is just debt, it stands to reason that the Bank of England isn’t the only place where money is made. Who else controls debt?

That’s right: regular banks. This means that regular banks create money. This isn’t tinfoil-hat-conspiracy theory, the Bank of England is quite open about it.

When overdrafts and credit are extended by banks, this creates new money. That money is destroyed when the debts are paid off. This is known as “M4” or “broad money” and the Bank of England/ UK government don’t directly control it.

That said, there are regulations that prevent the banks from going rogue and creating limitless money. These are things like the prudential regulations, which another Bank of England department (the Prudential Regulation Authority) monitors. Basically, there are limits to how much capital can be loaned out and how much needs to be credited to a bank’s balance sheet. Banks won’t be able to lend out or create more than a certain amount of it.

Why is this important?

So far, I’ve told you about two things:

1. Money in the UK = debt.
2. The Bank of England creates some of it, the regular banks create some of it.

With so many opportunities to make money, there’s a deliberate oversupply to meet the demand/ repayment of debts. This is what creates inflation. This is the bit that’s super important for financial independence and is something that a lot of people don’t consider.

Inflation

Inflation is what happens when something that’s measured against something else becomes worth more than that something else. It’s an expression of supply and demand of one thing against supply and demand of the other. this might need an example.

An example using potatoes and peas

Let’s say that one potato on your allotment is worth 5 pods of peas normally. If you took a potato that you grew, you could swap it with someone who grew peas and get 5 pods of peas.

If there’s an abundance of peas one year but the same amount of potatoes, you might all agree that one potato is worth 10 pods of peas. That’s inflation of the potato in terms of peas: someone has created more peas than anyone wants to eat, now potatoes can be swapped for a lot more.

Alternatively, potato blight might kill off half of the potatoes. They are now rare, so you need to exchange more peas if you want one of these few potatoes. That’s also inflation of the potato against the pea. Bad news if you’ve based your allotment prices in terms of peas.

Well done, you’ve just understood the basics of inflation!

Inflation of money

The peas and potatoes example is pretty much how fiat money works. When more fiat money is created, you can demand more of it in exchange for your goods and services. When debts are paid and money decreases, i.e. people want to buy less, you have to lower prices if you want to sell anything. Similarly, if you have something that doesn’t increase in supply, like gold or fine wines or something, you can expect to demand more for it. It’s rarer that the fiat money you’re swapping it for.

It’s pretty reasonable to assume that sellers will raise prices as high as people are willing to pay for. Well, generally. Obviously there are discount sellers and stuff, but in general terms we can all agree that £5 for a regular loaf of bread would be too much at today’s prices. However, my dad remembers a time when 50p could buy you a Mars bar and a can of Coca-Cola. It’s clear that inflation has happened.

Below is a calculator that I stole from the Bank of England. Have a bit of fun working out how much inflation has happened for different years!

Cool eh? The formatting on the Bank’s website is a lot better, but it’s an interesting tool nonetheless!

CPI and RPI inflation

Back in the day, inflation was aimed at something called the Retail Price Index. Nowadays, we use the Consumer Price Index.

Both of them are based on a basket of goods and services, based on what policymakers agree is a list of common things that UK consumers would buy. Interestingly, RPI includes mortgages and rent, whereas CPI doesn’t. Take from that what you will! The chart below shows how RPI inflation has changed since 1987. You can see that goods in the RPI basket have trebled in price, from 100% in 1987 (i.e. their “base” cost) to 300% now.

Let’s compare that to the CPI basket. This one came into use around 2015, so the data from before that date has been worked backwards, which is why it starts at 50 instead of 100. However, we can see that prices of goods and services in the CPI basket have a little more than doubled since 1988, when CPI first became possible to measure.

What these charts tell us is that:
a) RPI inflation is going up faster than CPI inflation – it’s a higher rate
b) As RPI includes mortgages (i.e. a measure of house prices) then people who want to buy their own homes will need to keep up with RPI instead of CPI
c) Stuff is definitely getting more expensive over time!

Your personal experience of inflation might not be the same as CPI or RPI. That’s because you might not buy the average list of items. These indices are an average of a big list of what people might buy. You might end up buying lots of the things that increase in price by 5% each year and nothing that’s getting cheaper. That’s the problem with averages: you might not be average!

Key bit of information: the Chancellor of the Exchequer and the Bank of England will aim for 2% CPI inflation. They want to create more money each year so that 2% CPI growth happens. They don’t track RPI any more, that can do whatever it likes. That means that you can expect goods and services to keep getting more expensive. It also means that property values have until today increased faster than planned inflation.

What this all means for financial independence

This means a few things that you need to be aware of.

• Money does not equal wealth, as more money is created each year by creating debt
• If everything is increasing in price by inflation, storing money under your mattress means that it’s less useful as time passes
• If you want to grow your wealth, you need to own assets that increase in value or make money faster than inflation.

This is the basic case for investing your money. The whole point of investing is to own assets that either grow in value faster than inflation can shrink the value of your money, or so that the asset can generate more money through rent or dividends or whatever so that your income grows faster than inflation.

How I use this information in my financial independence campaign

Now that you know how money is created, you’re probably wondering what to do about it. I can’t advise you, I’m not qualified. However, I can tell you in general terms how I use this information to create my financial independence campaign plan.

Cash savings

We need to have an emergency fund in cash. That’s just sound financial management, everyone should do that. Otherwise, a slight inconvenience would end up wiping out your money and put you in debt!

That said, we’ve seen how cash is losing value over time due to more money being created. This means that I want to keep as little in actual cash as possible, because it’s money that could be spent on an asset instead.

My partner and I are both working full time and we have no kids. We’re pretty confident in our ability to find work and our costs are low: it wouldn’t take much work (or even a few side hustles) to keep us fed and happy. As a result, we keep only 3 months’ expenses in cash savings.

Our money is in a cash savings account, but that’s earning 0.4% interest. If inflation is 2% based on CPI, that’s -1.6% growth each year (i.e. 0.4% – 2%, because inflation works against you). Depressing, but I can’t pay for a boiler repair or an emergency dentist in gold coins.

Conventional financial wisdom is to have 6 months’ savings for emergencies, but I’m quite comfortable that my assets are well diversified. This means that there’s always something that I can sell without losing money if things get really bad.

Invest in myself

It stands to reason that if I want to grow my income, I need to make sure I can offer rare services in exchange for money. Remember the peas and potatoes? If you’re offering something that’s hard to come by, you can charge more for it. I’m currently working in law as a trainee, which was a considerable investment in changing careers. I’m also studying for my diploma in financial advice. In the background, I’m learning about basic web development through the Odin Project, because the internet is pretty much everywhere now (this also helps me with this blog!). I read a lot of personal finance books to give me ideas. Ultimately, I want to make sure that no matter how the world changes, I have something rare to offer or some way to make sure that I own more potatoes, both figuratively and literally!

Invest in assets

I try to spend more of my money on assets. I like shares, ETFs, REITs, gold, even using more stable cryptocurrencies for earning high interest. I even overpay my mortgage. Basically, if it’s going to beat inflation and actually make me wealthier so that I can achieve financial independence, I consider it. I don’t want to be a billionaire, I just want freedom: and that means having an income that sustains my lifestyle while keeping up with inflation.

Debt

If inflation is working against me, I don’t see why I should have debts that are also working against me. I’ve got enough problems of my own! At the time of writing, I have mortgage debt and a little bit of student loan debt left over.

I would consider taking on debt if there was an opportunity to earn more than the interest payments on a debt. This might mean starting up a business of something like that. I haven’t gotten any big ideas at the time of writing, so I’m expecting my debt to shrink over time, not grow. We’ll see!