WHO, WHAT, WHY?
The Magazine answers...
Billions of pounds have been wiped off property values and share prices remain volatile, while the debt-laden banks are being bailed out. But where has all this money gone? Economist John Sloman explains.
Money consists of two main elements.
The first is cash (notes and coins). The total amount of cash in the UK is just over £50bn, with about £43bn circulating outside the banks and £7bn in banks' safes, tills and cash machines.
But cash is a relatively small proportion of the total amount of money. So what is the rest?
The bulk of money is in the form of bank deposits not backed by cash. This totals around £1,800bn. The point is that the main purpose of money is for buying things. And for most large purchases - and many small ones too - we don't use cash.
Instead, we access the money in our accounts by using debit cards, direct debits, standing orders and cheques. When you pay for something with your debit card in Tesco, your account is debited and Tesco is credited. Money is transferred between the two accounts - but no cash has been used.
It is similar with credit cards. When you buy something with a credit card, the shop's account is credited. You get a monthly bill and when you pay it, your account is debited. The bulk of money, then, is simply a record of deposits - entries on balance sheets.
But isn't all this very worrying? The answer is: not in normal times. Of course, times have not been "normal" recently. So let's look first at what banks do in normal times and then we'll look at the abnormal times of recent days and weeks.
Worst case scenario
Banks are not giant safes. When you pay in £100 in cash, the bank does not just hold on to it, waiting for you to withdraw it. Banks know that in normal times, only a small fraction of money deposited in them will be withdrawn in cash.
When people withdraw cash, other people are paying in cash
The vast bulk of people's balances in their accounts will stay there. Even when people do spend some, most of it involves plastic or electronic transfer, not cash. Even when people do withdraw cash, other people are paying in cash.
So what do banks do with their deposits? The answer is that they lend to individuals and firms, and to each other. When people spend these loans - say in shops - the shops then deposit the money back into the banks.
These deposits are used as the basis of further loans to other people. These, in turn, generate more deposits and yet more loans.
And so the process goes on and on. More and more deposits get generated. And these deposits count as money. Thus money grows. But there is no more cash. Feeling worried? You shouldn't be for two reasons:
- 1. Banks are normally careful to keep enough cash to meet the demands of their customers
- 2. If they do start running short of cash, they can always borrow money from the Bank of England
But what about abnormal times? What happens if people start getting worried that their bank will not have enough cash, or worse still, if it could go out of business? What happens if banks stop lending to each other, fearing they might not get their money back?
Central banks are backed by governments and can always print enough cash to meet all demands
The worst-case scenario is a "run on the bank". This is what happened with Northern Rock. People queued to take their money out. In the end, it's up to the government and central banks (the Bank of England in the case of the UK). They have to guarantee that deposits are safe.
And this is what's been happening these past few days.
Central banks have been lending vast sums of money to the banking system. Central banks are backed by governments and can always print enough cash to meet all demands.
Governments themselves have been pumping mind-boggling sums of money into banks by buying shares in them. In the UK, the government has promised to purchase £37bn of new shares in banks if it cannot be raised from private investors - £20bn in the Royal Bank of Scotland alone.
In addition, the government has guaranteed everyone's personal deposits in banks up to £50,000. In practice, as with Northern Rock and Bradford & Bingley, the government would almost certainly guarantee all deposits if a bank ran into difficulties. Even private deposits in the failed Icelandic banks have been guaranteed by the UK government.
So where has all the money gone? Your money is still there. So don't worry about that.
Nevertheless, money is being eroded in value by inflation. £100 today can buy only about 95% of what it could last year and only about half as much as it could 20 years ago. This is one reason why we need to be paid interest to save money..
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But what about so-called "sub-prime debt"? This was money lent to people unlikely to be able to pay it back. The problem is that the loans were mainly to buy houses and houses have fallen in value. Thus if people sold their house, they would not get their money back.
It's the same with stocks and shares. If you had bought £1,000 worth of shares a year ago, they would be worth only around £670 today.
But houses and shares are not money. They are assets whose value varies with market forces. If demand rises and/or supply falls, their price will rise. If demand falls and/or supply rises, their price will fall. Don't forget that warning in small print: "prices can go down as well as up".
Thus your money as bank deposits may not have disappeared. But some of your wealth may well have.
But declining wealth feeds back into money creation. If banks are worried about bad debts, they may not lend so much. With a deepening credit crunch, there would be less spending and less money would be deposited by shops and businesses. There would be even less lending and the economy could fall into recession.
After all, less spending leads to less production and less employment. No wonder governments feel they have act. No wonder vast sums are being pumped into the banking system.
John Sloman is director, Economics Network, the Economics subject centre of the Higher Education Academy, based at the University of Bristol. He is author of Economics, Essentials of Economics and various other textbooks.