April 28, 2014 6:31 pm

Money creation is too vital to be left to the state

  • Share
  • Print
  • Clip
  • Gift Article
  • Comments
The great inflations of the past were caused by profligate or greedy governments, says Philip Booth
British fifty pound notes are arranged for a photograph in Cambridge, U.K., on Monday, Jan. 26, 2009. U.K. companies are getting their biggest bailout not from the government but the collapse in the pound puknews©Bloomberg

Modern governments claim a monopoly over the creation of cash, and this is often said to be the wellspring of their economic power. But the state’s grip on the money supply is weaker than it seems. In the UK, notes and coins adorned with images of the Queen’s head may be the most visible instruments of economic exchange, but they comprise less than a 20th of the money supply. Much of the rest consists of bank deposits – in effect, private debts that financial institutions owe their customers. These deposits function like money; they can be transferred from person to person with the flick of a pen, the wave of a card or even a mobile phone. Yet they are created by private contracts between citizens, not by government fiat.

Writing in these pages, Martin Wolf has argued for the abolition of such “private money”. Our economies would be more stable, he believes, if money creation were left entirely to the state. It is an alluring proposal; the monetary system is fiendishly complicated, and simple solutions to complex problems are often attractive. But it is misguided.

When an account holder gives a bank some cash in return for an increased deposit balance, the bank keeps only a tiny fraction of what it has received in the form of liquid reserves. The rest is lent out to borrowers, who in turn deposit the money, creating still more private money. Because borrowers pay interest, this process leads to the peculiar position that I both receive interest on my current account balance and pay no charges for the bank’s transaction services.

Abolishing private money would stop “fractional reserve” banking in its tracks. Banks would have to match deposits pound for pound with cash instead of loans. Account holders would have to pay charges and would receive no interest on their deposits. The gains from creating money that currently accrue to banks and their customers would instead be pocketed by the state. This could help fund public spending, reducing the government’s borrowing requirement or perhaps eliminating it altogether.

But this is no recipe for monetary stability. On the contrary: it is striking how many of the great inflations of the past were caused by profligate or greedy governments indulging in deficit financing – and destructive wars have been financed this way, too.

Since the 1970s economists have been persuaded that government borrowing should be funded transparently through bond issues and not stealthily through money creation. Allowing the state to pay for its activities by minting fresh cash would undo the progress that has been made.

There is another difficulty with the proposal to ban fractional reserve banking: it is manifestly unenforceable. It is all very well to say that, when money changes hands, it must be government money – notes, coins, or balances in non-interest-bearing accounts that are not used to finance any form of lending. But, how can the government realistically stop balances in investment accounts being reassigned? People cannot be prevented from giving away what is theirs, and the recipients of such largesse cannot be banned from offering goods or services in return.

Perhaps the government could criminalise the use of government-issued notes and coins in a fractional reserve system. But this would not stop the determined financier. In many countries, mobile phone credits are used as a medium of exchange. One day, a successor to Bitcoin might serve that purpose. Or Britons hankering after interest-bearing bank accounts might start using dollars or euros instead of pounds. What is to stop them from lending such things to a bank, or to stop the bank from lending to others in turn? Very little: unless there was a prohibition on any lending on of any good that could be construed as money.

There would be one big difference between this samizdat system of fractional reserve banking and what we have today: it could go broke, because there would be no central bank on hand to bail out the deposit-taking institutions in an emergency. This would encourage prudence. Perhaps we should abolish central banks rather than fractional reserve banking – but that is an argument for another day.

Private money is no menace. And that is for the best – since it could not be wished away.

The writer is programme director at the Institute of Economic Affairs

-------------------------------------------

Letters in response to this article:

Transparency – and anything but / From Dr Niccolo Caldararo

Now is the time for a debate about the creation of money / From Mr Gottfried Hoerich

Monetary system is not yet stable or transparent / From Mr Andrew Cichocki

Rose-tinted view of economic history / From Mr Rod Price

New low inflation environment requires fresh policy ideas / From Prof Stephany Griffith-Jones

Copyright The Financial Times Limited 2015. You may share using our article tools.
Please don't cut articles from FT.com and redistribute by email or post to the web.

  • Share
  • Print
  • Clip
  • Gift Article
  • Comments

VIDEO

NEWS BY EMAIL

Sign up for email briefings to stay up to date on topics you are interested in

SHARE THIS QUOTE