PIG IRON 1: How Money Works

Essay One — How Money Actually Works

The Debt Question and Where It Ends

In 2014 the Bank of England published a paper that should have been front page news. It wasn’t. The paper explained, with institutional precision and remarkable candour, as overweening central banks are wont to do, that almost everything taught in economics textbooks about how money is created is wrong.

The textbook version goes like this. Banks take in deposits from savers. They lend out most of those deposits to borrowers, keeping a fraction in reserve. The money supply is therefore a multiple of the deposits that exist — the famous money multiplier. Central banks control the money supply by adjusting the reserve requirement and the base rate.

This is not how it works.

What actually happens is this. When a bank makes you a loan — for a mortgage, a car, a business — it does not lend out someone else’s savings. It creates a new deposit in your account at the moment of lending. New money. At the stroke of a key. Created from nothing except the bank’s willingness to lend and your willingness to borrow. When you repay the loan, that money is destroyed. The money supply is therefore not a multiple of existing deposits. It is essentially the aggregate of all outstanding private debt. Boot, other, foot.

No new debt. Means no new money. Which means no functioning economy as currently constituted.

Read that again. It matters more than almost anything else in these essays. And it still does my head in. Even now. Having worked with it, studied it and now written about it. No wonder most people get confused by it.

The implications are vertiginous once you let them in.

It means that the money in your bank account is not a store of value sitting in a vault somewhere. It is a claim — on the bank, on other claims, on the future productive capacity of the economy, on the coercive taxing power of the state. Money is not a thing. It is a relationship. A social institution, created by political choice, maintained by collective belief, and currently organised primarily to serve the interests of those who already have most of it. Economists know this. Academics know this. Bankers know this. Well maybe some of them do. But most people, when pushed, probably do not.

It means that private banks — not central banks, not governments, not some neutral market mechanism — are the primary creators of the money supply. They create it when they lend and they decide who they lend to. This is a form of power so fundamental that its invisibility is itself a political fact. If most people understood that a relatively small number of private institutions controlled the creation of the medium of exchange on which all economic life depends, the political conversation about financial regulation would be very different.

It means that the relationship between saving and lending that most people imagine — you save, the bank lends your savings to someone else, everyone benefits — is a fiction. A useful fiction in some ways, but a fiction nonetheless. Banks do not intermediate between savers and borrowers. They create the money that both savers and borrowers hold.

And it means that debt is not a problem to be solved or a pathology to be corrected. It is the structural mechanism by which money exists. You cannot have the money supply without the debt that creates it. This is not a bug. It is, in the most literal sense, a feature.

Central banks sit above this system, setting the price of money — the interest rate — rather than its quantity, despite what the rhetoric of the last fifteen years might suggest.

The era of Quantitative Easing — the “money printing” that generated such political heat from 2008 onward — was largely misunderstood by almost everyone including many of its practitioners. QE did not, in any straightforward sense, print money and inject it into the economy. What it did was swap one type of financial asset — government bonds — for another — bank reserves held at the central bank. This expanded the balance sheet of the central bank dramatically. It did relatively little to expand the money supply in the economy where ordinary people and businesses operate.

What it did do was inflate asset prices. Bonds, equities, property — all rose substantially as QE pushed investors toward riskier assets in search of return. The people who owned these assets — already the wealthiest — became significantly wealthier. The people who didn’t — the majority — experienced the cost of housing rising while their wages stagnated.

This is why you got the paradox that confused so many commentators. Unprecedented monetary expansion. Persistently low inflation. Stagnant wages. Apparently contradictory until you understand that QE was not demand stimulus in any meaningful sense. It was, functionally, a bailout mechanism for asset holders dressed in the language of economic rescue.

The Kool Aid — to use an indelicate but accurate phrase — was the belief that this was both safe and effective. Safe because asset price inflation seemed contained within financial markets rather than spilling into goods and services. Effective because it prevented a deeper financial collapse in 2008 and 2009. Both beliefs had enough truth in them to be superficially persuasive. Neither was the whole story.

Now consider the numbers.

Global debt — public and private, sovereign and corporate and household — currently sits at somewhere above three hundred percent of global GDP. Three hundred percent. The economy would have to run for three years producing nothing but debt repayment to clear it. It will not do this. It cannot.

This is not a crisis waiting to happen in the way that a bubble is a crisis waiting to happen. It is more structural, more chronic and in some ways more dangerous than that. An economy carrying this debt load requires growth simply to stand still on debt servicing. When growth falters — as it periodically does and as structural forces increasingly cause it to — the mathematics become genuinely vicious. Higher debt service costs crowd out investment. Lower investment produces lower growth. Lower growth makes the debt harder to service. The cycle feeds itself.

Hyman Minsky — an American economist largely ignored during his lifetime and urgently relevant after his death — called this the financial instability hypothesis. Stability breeds instability. During periods of economic calm, lenders and borrowers both become more confident, extend more credit, take on more risk. The system becomes progressively more fragile even as it appears progressively more robust. Until the moment — the Minsky moment — when confidence cracks and the fragility is suddenly, brutally visible. A fundamental contradiction for the Marxist thinker.

2008 was a Minsky moment. The resolution of 2008 — the socialisation of private debt onto public balance sheets, the QE programmes, the near-zero interest rates held for over a decade — prevented the immediate collapse but did not resolve the underlying fragility. It extended the music and raised the stakes for when it eventually stops.

The usual correction mechanisms have a long and imperfect history.

Inflation erodes the real value of debt. Creditors lose, debtors gain, the debt burden falls in real terms over time. This worked — imperfectly and unevenly — in the postwar decades when the enormous debt loads of the 1940s were gradually reduced by a combination of growth and inflation. It requires political will to maintain, because it is a transfer of wealth from creditors to debtors, and creditors vote, organise and fund political parties in ways that debtors, being more numerous and more diffuse, do not.

Currency depreciation reduces the real burden of debt denominated in the depreciating currency and stimulates exports. It tends to import inflation and reduce living standards for those who consume imported goods, which is most people. When multiple countries attempt it simultaneously — as they do, in the competitive devaluations euphemistically called currency wars — the effects largely cancel out.

Recession destroys debt through default and bankruptcy. Businesses and households who cannot service their debts stop doing so. The debt is written off, the creditors take losses, the system resets at a lower level of both debt and economic activity. This is brutal in its immediate effects — unemployment, bankruptcy, hardship — but it is also how market economies have historically cleared accumulated imbalance.

What is striking about the post-2008 period is that none of these mechanisms has operated cleanly or fully. Inflation remained stubbornly below target in most advanced economies through the 2010s despite extraordinary monetary expansion — until supply-side shocks in 2021 did what demand stimulus couldn’t, and then tightening crushed it back down again. Currency depreciation has been neutralised by simultaneous competitive devaluation across major economies. And recession — genuine debt-clearing recession — has been prevented at each turn by policy intervention precisely because the debt levels are now so large that a genuine clearing event would be systemically catastrophic.

The result is an economy that is neither sick enough to force resolution nor healthy enough to grow its way out of the problem. Zombie companies kept alive by cheap credit. Zombie banks carrying impaired assets at fictional valuations. Zombie sovereign balance sheets carrying debt that nominal growth rates cannot service. A kind of managed stagnation that feels stable until it doesn’t.

There are powerful deflationary forces at work that make this situation more intractable than historical comparisons suggest.

Ageing demographics in all major advanced economies suppress demand structurally. Older populations save more and spend less. The baby boom generation moving through retirement age is a deflationary force of considerable power that will persist for decades regardless of monetary policy.

Technological displacement of labour — automation of routine cognitive and physical tasks — suppresses wages in the affected sectors and creates downward pressure on labour’s share of income more broadly. This is not a new phenomenon but it has accelerated and broadened in scope. The productivity gains from technological change are real. Their distribution is not.

The offshoring of goods production to lower wage economies has suppressed the price of tradeable goods for decades. This has been presented as a benefit to consumers — cheaper televisions, cheaper clothes, cheaper everything. It has also suppressed the wages of workers in advanced economies whose labour competed with lower-wage alternatives elsewhere. The consumer benefit and the wage suppression are two sides of the same coin.

Monopoly platform capitalism — the five or six technology companies that now dominate the information economy — extracts rent without generating proportionate employment or wage growth. The marginal cost of serving an additional user approaches zero. The profits are extraordinary. The employment generated relative to market capitalisation is historically tiny. This is not capitalism in its productive sense. It is capitalism in its extractive sense — rent rather than profit, tollbooth rather than factory.

These forces are structural and persistent. They mean that the normal relationship between monetary expansion and inflation has broken down in important ways. You can create enormous quantities of money — as the post-2008 period demonstrated — without generating the wage and price inflation that would normally signal overheating and trigger the correction mechanisms. The money flows into asset markets, inflating the wealth of those who own assets, without reaching the real economy in ways that would restore the demand that productive investment requires.

This brings us to what may be the most important and least discussed risk in the current configuration.

The standard catastrophe scenario for sovereign debt is inflationary. The confidence crisis. The bond market revolt. Investors losing faith in a currency and demanding higher yields to hold it. The central bank forced to monetise debt. Inflation accelerating. The currency collapsing. Weimar. Zimbabwe. Argentina. This scenario is real and has historical precedent.

But there is an equally plausible and in some ways more likely scenario that runs in precisely the opposite direction. A deflationary debt spiral driven by demand collapse.

The logic runs as follows. Inequality concentrates income at the top of the distribution where the marginal propensity to consume is low. Wealthy households save a larger fraction of their income than middle or working class households — not because they are more virtuous but because above a certain level of consumption, additional income has nowhere to go except into savings and asset accumulation. Meanwhile debt-servicing costs hollow out disposable income for the majority. Austerity politics — which speak to intuitions about household budgeting that are comprehensible even when they are wrong about sovereign finance — further suppress public demand. The engine of consumption sputters. Corporate investment follows consumption expectations downward. The demand deficit becomes self-reinforcing.

Japan has been living this dynamic for thirty years. Enormous public debt, near-zero interest rates, persistent deflationary pressure, stagnant wages, asset price inflation disconnected from underlying economic performance. Japan is not the exception. It may be the template.

The catastrophic default scenario in this version is not a sudden hyperinflationary collapse but a cascading series of sovereign and corporate defaults as it becomes clear that the growth sufficient to service the debt is not coming. Not a Weimar moment. A slow grinding recognition that the music has stopped — not with a bang but with a long, dreary diminuendo during which the people least able to bear the costs bear most of them.

History is instructive but may be genuinely less informative than we would like.

The numbers are qualitatively different from any previous episode. The interconnection of global financial systems means that contagion is instantaneous in ways that have no historical precedent. Derivative chains mean that notional exposures dwarf underlying assets — the nominal value of outstanding derivatives dwarfs global GDP by multiples that would have been considered fantastical a generation ago.

And crucially the political economy of response has changed. In 1930 you could let banks fail. Lehman Brothers in 2008 demonstrated that this was no longer politically or practically possible — the interconnection of modern finance meant that letting one institution fail threatened to bring down the system. The implicit guarantee has grown so large that moral hazard is now structurally embedded. Each crisis is resolved in a way that makes the next one larger.

The honest position is this. We are in genuinely novel territory. Not because the laws of political economy have been suspended. Not because debt has stopped mattering. But because the scale, complexity and interconnection of the current system means that historical analogies are instructive but not predictive.

What history does suggest — clearly and consistently — is that debt crises resolve through some combination of inflation, growth, default and institutional restructuring. The postwar reduction of the enormous debt loads of the 1940s is the most relevant precedent for a managed resolution — combining growth, mild financial repression and a degree of inflation to gradually erode the real burden over two to three decades. It required political will, institutional capacity and a favourable growth environment that may be harder to replicate.

The alternatives are less managed and less pleasant. But they too have historical precedent. And that precedent is not encouraging about what happens to democratic institutions and to the people least able to protect themselves when the resolution is imposed rather than chosen.

What to do about it is where the subsequent essays go. This essay’s task is simpler and harder simultaneously. To make visible what is usually hidden. To explain the mechanics of a system that affects every person on earth and that most people — including many who operate within it professionally — do not fully understand.

Knowledge asymmetry is power. The people who understand how money is created, how debt works, how the deflationary dynamics operate and where they lead — these people are not neutral technicians. They are participants in a political economy that distributes its costs and benefits very unequally. Understanding the mechanics is not sufficient for changing them. But it is the necessary beginning.

The Bank of England told the truth in 2014. Almost nobody noticed. These essays are, among other things, an attempt to make sure more people notice.

Because the alternative — continuing to discuss the symptoms while remaining ignorant of the system that produces them — is how you get to the point where the music stops and nobody quite understands why or what to do next.

And we are closer to that point than the current political conversation, in almost any country you care to examine, is willing to honestly acknowledge. None of this is a secret. It is well known by practitioners, commentators, policy makers. But confronted. With you. It seems not.

Next: Essay Two — The Winning Idea and Its Exhaustion. Why neoliberalism won the battle of political economy, what it got right, why it generated the conditions for populism, and where that leaves us.

The manifesto these essays argue toward — Listen to Me — is on this blog. The gaps in these arguments are real and acknowledged. If you see them, say so. The conversation is the point.