The Economy: 5. Banks

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Welcome to Understand the Economy, the podcast that takes you back to basics and explains the way economics affects our everyday lives.

We've already explained inflation, interest rates, growth and bonds in our previous episodes, which are available now on BBC Sounds.

In this episode, we're looking at banks.

Not those buccaneering investment banks like JP Morgan Chase or Goldman Sachs.

No.

Quiet, solid, trustworthy retail banks like Northern Rock.

The very name Northern Rock was designed to create a sense of foundational stability, and retail banks do that with their long-standing brands and big posh buildings with all the pillars outside.

But of course, Northern Rock's pillars fell down.

It had to be bailed out, and we'll talk about why later.

So what are banks, really?

And what do they do?

Are they just great big storehouses of cash that you can swim around in like Scrooge McDuck?

It can't be that.

It's all spreadsheets these days anyway.

So are they great big storehouses of spreadsheets?

I'm joined by Wendy Carlin, Professor of Economics at University College London and the leader of the Core Econ project, which is reforming the undergraduate economics curriculum.

Wendy, when I strip away all the fancy stuff like galloping black horses and touchless debit cards, the fundamental thing that banks do is take deposits and give out loans, right?

That's right.

They're profit-making companies, and that's exactly what they do.

They borrow cheap, and they make loans for which they charge a higher interest rate, and the difference between the two is what generates their profits.

So let's say that Phoebe, the producer of this program, gives me my presenter's fee.

And let's say it's 50 quid in cash in a plain brown envelope, which of course is absurd because Radio 4 would never give me 50 pounds for anything.

Let's say I get 50 pounds cash and I toddle over to my bank, old school, and I deposit the money.

So what then?

Did I just lend 50 to the bank?

You did, Tim.

You lent £50 to the bank, and that will join all the other

small savings that have been deposited in the bank.

You probably won't get any interest on your deposit.

And the bank will be looking out there, making its decisions about who it should be making loans to.

And it will then fund those loans.

And part of the funding will come from the deposits that it's accumulated in the bank.

Right.

So it's not that they've got lots and lots of safety deposit boxes full of, you know, my £50 and someone else's £50 and mine's, you know, it's got my name on.

That money just goes into a big pool and then

might be lent to you because of a mortgage, for example.

Absolutely.

Talk me through the idea, which

people who study banks keep telling me this, and it keeps blowing my mind, that banks create money.

Because it seems very straightforward, what we've described.

You know, the banks are lending money for mortgages and they get that money from the depositors and there you go.

They just sit in the middle.

But bank experts say, no, no, there's something else going on.

Yeah, so when they make the loan, they are creating money because that turns up in the borrower's bank account.

So that's the sense in which they're creating money.

Right.

So

you decide you want to borrow money from a bank to...

You're going to buy a new motorbike.

Your old motorbike is getting a bit rusty.

You want a brand new motorbike.

So it's going to cost you £8,000.

You go to the bank, you say,

lend me £8,000

because I want to buy a motorbike.

And the bank just says, sure, here you are.

And in your current account is an extra £8,000,

which you then take out, you spend on the motorbike, but then that money is...

in the motorbike manufacturer's account and they then spend it on salaries or whatever.

So money's appear.

So where did that money appear from?

Because the bank is not like the Bank of England.

It can't just magically decide to create money, but it's put £8,000 in your bank account.

Yes, so this is what's called bank money.

So

the banks create it.

But the idea that that's the same as sort of creating profits or money that they can spend is absolutely the wrong way to think about it.

It's much better to think about it as just the outcome of their decision to make a loan.

So you can think of it as a rather technical thing, that when they make a loan, what does that mean?

It means that money appears in the bank account of the borrower.

Wendy, if I may, I want to ask you what happens when banks go on strike.

And there is a particular historical incident that's quite famous among banking nerds, which is the Irish banking strike of the 1970s.

What happened and what does it teach us?

What happened is that the Irish banks were afflicted by an industrial relations dispute and it lasted for six months.

So all of the Irish banks had their doors closed for six months.

Which is a long time and given what we know about banking, that should lay waste to the Irish economy.

But it didn't.

So how did they cope?

Well, the answer to that comes in a three-letter word.

And the three-letter word is pub.

So what happened...

One of my favourite words.

Well, that's what I thought you'd like the story.

So what happened is that essentially the publicans, so it's important to remember at the time that there was something like one pub for every 180 people in Ireland.

So there are a lot of pubs.

A lot of pubs.

They knew their communities very well.

So they knew, more or less, whether you, when you wrote a check, whether there was money in your bank account.

And so the publicans, they couldn't actually check whether you had the money in the bank account, but they could make a reasonable guess about whether there was money, funds in your bank account and therefore whether that transaction would be honoured.

Right.

So the publican knows me, I drink at his pub, knows where I live, knows a lot about me, and so has a good idea whether I am in fact good for the £100.

That's right.

So I can understand how that solves the problem of paying for a pint of Guinness.

I go in and I write a cheque for a pint of Guinness, but how does that keep the whole system working?

So those pieces of paper, the cheques

that the publican was accumulating, were then able to be used by people for other transactions.

So they could then get the publican to endorse the back of the cheque so they knew that you had the money in your bank account to pay for the pint.

The publican could put that cheque back into circulation and that could be used for someone else to purchase their groceries.

So it kind of turns into a £100 note, sort of.

It turns into a £100 note.

So it was circulating as money, newly created money, during the banking strike.

Is it money or is it not money?

It is money.

A piece of paper that allows you to exchange the piece of paper for a bag of groceries.

So, when you say it's money, what you mean is it's a piece of paper that can pass around that everybody agrees has value.

So, if everyone agrees it's money, it's money.

That's right.

So, it really points to the crucial role of trust in underlying the whole concept of money.

Well,

the Latin for trust is credo, hence credit, credit cards, all of this.

Well,

somewhere between Roman times and the Irish bank strike of 1970, a very remarkable and now almost forgotten economist set up one of the UK's first savings banks.

Let's hear from economic historian Victoria Bateman with that story.

So in 1798, a woman by the name of Priscilla Wakefield noticed that there was a problem.

Normal people from domestic servants to factory women had nowhere safe to put their spare money.

They were literally having to put it in a pot under their bed.

And so, Priscilla Wakefield, noticing this need for safety for people's money, offered a service in the sense that people could put their money in safety in her savings bank and, in return, would receive a reward-a reward in the form of interest, a 5%

interest rate on any money that they deposited in her bank.

So, Wakefield actually didn't have a physical bank building.

She instead used a local school and so would set up a bench once a month where people would come if they wanted to put their savings with her or if they wanted to retrieve the savings.

And of course, interestingly, the word bank comes from the Italian word bench.

And so, many of the earliest banks in history were literally benches benches that were set up in local squares.

And so your money lender or your banker would sit behind a bench in the public square, and people knew that that was the place to go if they wanted to do any financial dealings.

But of course, in Britain, because the weather is so poor, they look for buildings that are familiar.

And so schools were the type of places where these early banks could do their dealings.

So Wakefield would in turn take people's savings and of course she wants to put them in a safe place and so people's savings were essentially put into these government bonds.

If people want to take back their money from the savings bank

then that's okay because all the time you have some people coming into the bank in order to deposit their money and that enables the bank to match that with people who are coming into the bank in order to retrieve their money.

So, inspired by Wakefield's Bank, other savings banks started to spring up across the country, and some of these were trustworthy, but others were, quite frankly, scammers.

They wanted to take people's savings and effectively to run off with them.

And so, Parliament felt that it needed to act.

It needed to act in the interests of people's savings.

And so, in 1817, it introduced the Savings Bank Act, which forced all savings banks to make sure that when they took people's money, they placed that money in something secure and solid, and that something was a government bond.

Over the years, more and more acts and regulations followed in the hope of keeping people's money safe.

And eventually, we arrive at today's modern-day big banks.

Dr.

Victoria Bateman.

Wendy Carlin, why is it that governments seem quite happy to let an energy company go bankrupt, or even a supermarket could go bankrupt, but they won't let a bank go bankrupt.

The bailouts always seem to come.

So why is that?

Is it just a case that the banks have better lobbyists, or is there something else?

There is something else, because the banks operate the payment system in the economy that allows us to seamlessly transact with all of our purchases as households and firms throughout the economy.

So there's a crucial piece of infrastructure that's provided by the banking system.

But even more importantly is the interconnectedness of banks.

So that if one energy company fails or if one automobile company fails, that doesn't have repercussions throughout the economy.

That's not the case with the banking system.

So if one bank fails, that creates problems for other banks and...

But why do I care about problems for the banks?

I mean that's...

they've got money.

Who cares if they all go bankrupt?

It affects you because you need the banks in order to engage in your everyday life.

So you need to

make payments on your mortgage, you need to pay for your groceries, you have a whole series of interactions every day that require a functioning banking system.

So now you can just think of how many times you flash your phone to conduct a financial transaction, to buy something, to buy a service, a ticket to the cinema.

All of these things rely on a functioning banking system.

Right, so no move is no food.

Correct.

Okay, you convinced me it would be bad.

And the experience with the crisis in 2008, 2009, where a crucial bank was allowed to go bankrupt, Lehman Brothers, it was not bailed out.

And we lived to experience the consequences from the interconnectedness of banks, not just within a country, but all around the world.

And pubs did not, in fact, step in.

They did not.

So banks can't live with them, can't live without them.

We lend them money, they lend us money, they even create money.

They're fundamental to the way any economy works, and they're often at the heart of economic trouble, too.

Please remember to subscribe to our podcast, Understand the Economy, available now on BBC Sounds.

Understand the Economy was presented by me, Tim Harford, and produced by Phoebe Keene.

The researchers were Drew Hindman and Mariana Brain.

The editor was Claire Fordham, and it was mixed by Gareth Jones and Nigel Appleton.

Hello, this is Marianne Keys.

And this is Tara Flynn.

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