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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.
THE ANSWER
It was never there in the first place
Houses and shares are not money, but assets whose values vary with market
forces
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only a small fraction of money deposited in them will be withdrawn in cash.
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:
their customers
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, 37bn of new shares in banks have been
purchased by the government - 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.
Disappearing wealth
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..
WHO, WHAT, WHY?
A regular feature in the BBC News Magazine - aiming to answer some of the
questions behind the headlines
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.
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.