Moving on to you comments about banks, I can easily understand your statement that money deposited with a bank is credit as well. It is, as you say, the bank borrowing from us, and that money is re-lent by the bank in the way you describe. All very straightforward.

Long ago – in the nineteenth century, probably, banks discovered that if they lent every penny they borrowed, they would rapidly run into deep trouble. For this reason, they formulated two principles of lending (there may have been others, but these two will do for present purposes): Borrow long and lend short (so that money would be returned to the bank before you wanted to withdraw your deposit), and only lend a proportion of the total amount deposited. I have no idea what proportion was used, so let’s fall back on the famous 80:20 rule. If I deposit £100, the bank will lend £80 and will retain £20 in liquid funds. The borrower of the £80 will deposit the money into his account (or he will spend the money, and the seller will deposit it) and the bank will then relend £64 and retain £16. £51 of that £64 is relent, and then £41, and so on. After 20 or so cycles, the amount available to lend is less than £1, but the total of loans created by my £100 is almost £400.

Money for nothing. Let’s say the bank pays 3% for deposits and charges 7.5% for loans and overdrafts. Over the course of a year, my £100 and the subsequent deposits in the cycle described will produce about £12, while borrowers will collectively pay about £30 to the bank. £18 profit just for being there. However, the extra lending will hopefully have produced more profits for industry and more jobs for workers. Profits and jobs that might never have been created otherwise. So each cycle produces more real wealth (or the further means of producing it).

Most credit is supported by real wealth or assets in another form: only the government can create money without creating wealth.

If I wanted my hundred back, there would be a lot of disappointed borrowers, but the £20 the bank held back, and the 20% set aside with each subsequent loan, should provide enough to meet routine withdrawals. After 20 cycles, there will be just £100 set aside. Only if there was a run on the bank would this money be inadequate, and the bank would have to meet the extra demand by borrowing from other banks and lenders.

If just one bank experienced a run, and borrowed form others, then the amount of money available everywhere would reduce. That in turn would make things difficult for other banks, and so, in a worst case scenario, the run could spread.

“Banks only work because people have confidence in them, because people have confidence in their promises.” That’s perfectly true – “credit” is Latin for “he believes”, and the promise on Bank of England notes demonstrates this perfectly: I promise to pay the bearer on demand the sum of five pounds. That used to mean, five pounds in gold coin. If I tried to hold the Bank to that promise now, I’d be laughed all the way out of Threadneedle Street.

Money supply is more than just notes or coin. It can be measured in two ways: the “narrow” measure – basically, the value of notes and coin in the banking system – and the “broad” measure, which is the value of all notes and coin in issue plus the value of all bank deposits (which obviously includes deposits generated by lending). The need to be able to measure money supply is important because it is closely linked to inflation, and the control of inflation is one of the main priorities of governments/central banks.

In USA money supply is measured slightly differently: notes and coin (M0) plus the amount of money on deposit with banks and available on demand (M1), plus savings (M2) and large time deposits and other liquid assets (M3). There are also other ways of measuring it used in other economies.

When an economy is stagnating, or is in a deflationary cycle, central banks will try to control this by adjusting the amount of money in circulation. They will encourage lending through lower interest rates, and they will increase the amount of money in circulation which the banks should lend. The traditional way of doing this is by repurchasing government debt by issuing new money. Thus economic activity is hopefully stimulated - and inflation begins to rise …

The recent slow-down in the global economy is due to the fact that the banks themselves no longer believe in each other, and they have stopped lending. Thus when Washington Mutual and Northern Rock started to find that an important source of funds had dried up, they could no longer meet their obligations to their depositors. These banks had broken the rules about borrowing long and lending short, and they had reversed the rule about lending only a proportion of your deposits, by seeking short-term funding from the money market at commercial rates of interest and lending to housebuyers against that.

The trouble with leverage is that levers can break, and a weight heavier than you can lift yourself comes tumbling back down on top of you.

As a result, governments have had to step in and replace those missing funds with taxpayers’ money, creating massive public debt that will take ages to repay. In all probability, however, we will never repay it. It will just become permanent debt.