It's the banks, not their customers, who actually wind up owing each other money...

Observers of Fractional Reserve Banking have noticed that your deposit into a bank can cause the bank to offer new loans well above and beyond the size of your deposit.

Those watchers often object on the grounds that this is new money which shouldn't have been created.

But every one of us can easily create spending power in the same way. Do a favour for a friend today and your work created an unreturned favour. So I'm going to call a unit of credit an 'Uf', and wherever possible I'll use the word Uf instead of credit. Somehow it makes it much easier to understand what the hell is going on.

Even if you didn't write it down you made a mental note of a social debt, and if your friend returns the favour tomorrow you then mentally release the favour he owed you. A sort of payment occurred.

If your friend were to pay you through the bank for the original favour you did then you could spend your Uf anywhere. Banking is useful, like Uf tokens are, because an Uf you earn from your friend, then record at your bank, becomes available for you to pay anyone who's got a bank account.

Let's suppose Godfrey has opened a bank account and deposited a few Uf tokens. He can do payment transactions both ways through his account with other people in his city who are account holders at his bank. He could go and do a favour for Fred next door - maybe build him a garden shed. Fred can tell the bank to pay Godfrey, and the bank puts some negative Ufs into Fred's account and some positive Ufs in Godfrey's. If Fred started with a zero (or negative) balance of Ufs then with the bank's help they have created money, because Godfrey now has general purpose spending power where none previously existed.

Is that necessarily a problem? Maybe not, so long as the bank looks warily at Fred. Can he be trusted to return an Uf? The bank wouldn't have let his account go negative without good reason.

They probably only allowed it because either:-

a) They are holding collateral, i.e. control over some of Fred's non-monetary wealth (property) like the deeds to his house, or his share portfolio; or

b) They have information - maybe that Fred's wealthy mother is not long for this world, or that he has just got a job at Goldman Sachs.

Scenarios like these give Fred access to Ufs in the future, and credibility at the bank, which responds - occasionally - by letting him run a negative balance of Ufs now. Meanwhile it is the bank's own reserve of Uf tokens which can be given to Godfrey, if he asks to withdraw.

Something unrelated has happened in the meantime to expand this proto-banking system to make it much more useful. Godfrey's bank and the next door city's bank have opened bank accounts with each other. This is a simple response to an economic fact: the citizens of the two cities have started doing transactions between each other, and there is a demand for payment services between them.

Brad lives in the neighbouring city. Having built a first-class shed Godfrey starts advertising in yellow pages, and soon enough he finds himself building Brad's shed. When the job is finished Brad gives Godfrey a cheque (or nowadays some sort of modern electronic equivalent, but it's easier to understand the process if you analyse it with cheques).

The cheque is an authorised instruction from Brad to Brad's bank to post negative Ufs to Brad's account, and to post positive Ufs to whoever presented the cheque. The positive side could be to Godfrey's own account (if he banks at the same bank) or to the bank account of Godfrey's bank.

The cheque starts its journey at Godfrey's bank, by being paid in. When Godfrey deposits his cheque, his bank only accepts it because it sees that it's drawn on a bank (Brad's) which they now regularly deal with and which has an account with them. So the bank now adds positive Ufs to Godfrey's individual account, and takes them away from Brad's bank's account. It uses the routing information (Bank Address) printed on the cheque to send it to Brad's bank as an explanation. So it is Godfrey's bank, not Godfrey himself, which deposits the cheque which Brad signed at Brad's bank.

Brad's bank therefore adds positive Ufs to the bank account it holds for Godfrey's bank, and takes them away from Brad's personal account (which he authorised by his signature on the cheque). Brad's bank now owes Godfrey's bank some Ufs. They agree (reconcile) on this point. One bank has a positive, and the other a negative; one bank is owed an Uf, and the other owes it; one bank has an asset on its books, and the other has a liability. It is a balance of Ufs to be set off in future against some Ufs flowing the other way when Brad finally gets up off his ass to do something useful.

Godfrey's bank has become a depositor at Brad's bank (or a lender to it, which is the same thing). It is a sort of aggregate depositor for all the people in Godfrey's city who don't have an account in Brad's bank, but who have done things for people who do. What everyone hopes and expects will happen is that Brad will do some work for someone in Godfrey's city, then the process will reverse, and the Ufs will switch back. That's what will happen if trade between the cities is broadly in balance.

But what happens if Brad's city is lazy? Then slowly, Godfrey's bank's books will build a large positive Uf balance on their account for Brad's bank. Godfrey's bank is owed Ufs because there are no favours being returned. Brad's bank's books will show large negative Ufs; that is Ufs owed to Godfrey's bank. That means Godfrey's bank manager could amble into Brad's bank and draw its balance down in cash, or write a cheque to move it somewhere else.

Bank managers don't often turn up to each other's main branch demanding a few tens of millions in cash to balance out a long period of one-way traffic. They could, but they don't need to, because in a modern banking system they are both account holders at the Central Bank, which is basically another bank, but one with a monopoly power to create Uf tokens, and the right to make up new rules for bankers to obey.

Nowadays when Godfrey's bank gets edgy about the amount it is owed by Brad's bank, it simply draws a cheque on its account at Brad's bank, and deposits the cheque in its own account at the Central Bank, thereby converting all its accumulated Ufs held at Brad's bank to Ufs held at the Central Bank.

This takes Godfrey's bank off-risk with regard to the failure of Brad's bank. Central is acting as - well - a centralised clearer of risk. Indeed any bank which accepts a deposit drawn on another bank and credits the depositor's account is clearing the risk. Once Godfrey's account at his own bank is credited he doesn't have to worry if Brad's bank goes bust. Godfrey is now exposed to his own bank's failure, because it cleared his risk. When his bank deposits its balance at Brad's bank to Central, then it clears away its risk of Brad's bank's failure. It is Central which will now be exposed to the failure of Brad's bank.

I expect you are now saying to yourself "Is this what the cheque clearing system is all about?" Alright, maybe you're not, but I'm going to explain it anyway, in one paragraph.

You could set up a cheque clearing system simply by starting a bank called 'The Cheque Clearing Bank'. You would then open accounts with all the real banks on the high street. Then tell all the members of the system that they can accept deposits to their private account holders with any cheque drawn on one of the members of your cheque clearing system. On the high street bank's books the negative Uf goes to the depositor's private account, the positive Uf gets posted to the Cheque Clearing Bank's account, and the cheque is sent to your new 'Cheque Clearing Bank' in explanation, to be routed to the drawing bank, and thence the individual who wrote the cheque.

At each stage of the journey there's a negative Uf and a positive Uf put on the books of the bank which receives the cheque, and the boundary between each bank is composed of one bank's negative balance matching another bank's positive balance, which they validate by reconciling each other's bank statement. Banks have entire reconciliations departments doing this all the time.

Okay, I lied - it was two paragraphs. But I have illustrated that however many layers of banks, clearers and transfers you set up, and whichever way you look at it, the net failure of Brad and his neighbours to do anything valuable for anyone else will ultimately lead to a big balance of Ufs at an account somewhere. It's the accounting inevitability which follows from Brad going shopping with the money created by his bank. It also explains that the last bank in the chain is accepting the risk that Brad's bank can't return the Ufs, and because banks can get off that risk by drawing a cheque on Brad's bank and depositing it into Central, the Ufs created by Brad's bank usually end up owed by Brad's bank directly to the central bank.

These days Central is feeble, and frightened of the political consequences of any bank failure, so it lets Brad's bank run up an ever growing balance on ever weaker collateral. Other banks can deposit any of Brad's bank's junk at Central. Central's bluff (that it might close down a dodgy bank like Brad's) has been well and truly called. If you are a sound bank you can now do stupid business with a bad bank which you know can never pay you properly, and it won't hurt you. Because Central's Governor has made it known he won't let banks fail he's set himself up as the patsy. Just deposit the large Uf balance which Brad's bank owes you onto Central. The Governor can't stop you doing this while he is determined to turn a blind eye to Brad's bank's insolvency. After all you could - instead - go down to Brad's bank and demand your balance in cash, which comes from Central anyway. It comes to the same thing, which is to force the Ufs issued by Brad onto Central, until such time as Central recognises that enough is enough.

You can now see - I hope - that when the economic imperative of shutting a bad bank gets corrupted by politics it positively invites reckless bankers to create money (and to pay themselves absurdly well) and it encourages the good banks to do silly deals with the bad ones, quickly passing the risk of failure to Central, which becomes a sort of magnet for banking rottenness. This has been happening all around us in a big way.

The resulting huge Uf balances at Central can be made grand and confusing by saying "The Bank of England's Balance Sheet is expanding" which I'm sure makes everyone think it's doing a remarkably important job. What it really means is that the Governor won't demand that a busted bank pays up or shuts down, so Central just runs up an ever bigger deposit balance at an ever weaker bank. While Central permits this Brad's bank really is being allowed to 'create money out of thin air'.

So, to go back to our original question about Fractional Reserve Banking, Brad's bank can create money and spending power by allowing Brad a negative balance of Ufs. But the intuitive idea that electronic money is easily created simply by adding positive numbers to accounts is wrong. It cannot be done without being found out by other banks, as Brad's spending transmits the negative Ufs through the relationships between banks, and ends up leaving Brad's bank owing Central all the money it created.

It is only Central's wimpish ambivalence about its giant Uf balance with Brad's bank which allows this to happen.

This excerpt is taken from Paul Tustain's new report, Money Printing for Beginners (and Experts). To read the full PDF for free today, simply register your email address at BullionVault now.