Most people believe that the bulk of money in the economy consists of notes and coins, that the government creates most if not all of the new money in the economy and that private banks only lend out money that has been deposited with the bank by the government or other depositors. But none of this is true.
Only 3-7% of the money in our economy is notes or coins. The rest consists of electronic computer entries in accounts. And banks are not restricted to lending out money that has been deposited with them. They are at liberty to create new money out of “thin air” by simply crediting money, in the form of a loan, to their customers’ accounts. This new money is created as a debt owed to the bank by the customer who must repay it with interest. Most of the new money in the economy is created in this way.
Only the state, through the Central Bank, can lawfully print money. If a private individual did so, he or she would commit the crime of counterfeit.
If private banks were permitted to print notes there would likely be public outrage. Yet private banks can lawfully create new money electronically. Not only this, unlike the counterfeiter, banks get to charge interest on the new money they create and lend out.
This is not to say that the banks have a completely free rein. Some countries require them to hold a fraction of the amount they lend in reserves, usually around 10%. This is called the fractional reserve banking system and operates in the USA and UK. Other countries, such as Australia, impose capital adequacy requirements. This involves a more complicated, two tiered. formula. But neither of these two systems prevent the banks from creating new money out of thin air.
But do banks really create new money out of thin air?
Robert Vivian, Professor of Finance and Insurance, University of the Witwatersrand, says banks do not create money out of thin air.
He provides an example of the purchase of a house by B from S, where B offers to pay the purchase price of $1 million back to S over 20 years. Vivian says “This transaction would take place whether banks existed or not, because a need exists for the managed exchange of property.”
The social utility of the bank acting as an intermediary, by lending B the money, is that S does not have to wait 20 years to receive payment and is protected against the risk of insolvency of B.
Vivian acknowledges that the loan by the bank to B does increase the money in the economy. But he argues that this increase is “created as a result of an underlying transaction, which had taken place externally from the bank and has been recorded by the bank.”
Further the intervention by the bank changes the nature of the asset. It is no longer a claim for payment by S against B. Vivian says “S’s ceded claim against B is the bank’s matching asset.”
The intervention of the bank to facilitate the sale of the house certainly provides the social advantages Vivian mentions. And it is true that the parties may have wished to enter into this transaction irrespective of the bank. But none of these factors negate the fact that the bank has indeed created new money out of thin air.
If the parties entered into the transaction themselves without he bank and B did not have all the money to pay S straight away, B might have promised to pay S the money in future instalments. But the mere promise to pay is not the same as the bank crediting the money to B’s account which creates new legal tender.
Further, exactly the same result could have been attained if a counterfeiter had printed the money and given it to B to buy the house. S would have then been paid immediately and would have been protected from insolvency of B and B would owe $1 million to the counterfeiter. Of course the transaction, if it involved counterfeit, would be unlawful. But the issue of unlawfulness is irrelevant to the question of how the money is created. Whether created by the bank or the counterfeiter, the new money is created out of thin air. The fact that there were parties who wanted to buy and sell a house independent of the existence of the bank or the counterfeiter is irrelevant to the question of how the money is created.
What is money?
The historian Yuval Harari says money is a universal medium of exchange which enables people to store wealth and to convert it into almost anything else. It is the most universal and efficient system of mutual trust ever devised.
In some ways, says Harari, money represents a high point in tolerance. There is undoubtedly great discrimination in the way money is initially allocated. But once allocated, money does not discriminate on the basis of religion, gender, race or sexual orientation. Christians and Muslims might not be able to agree on religious dogmas. But they can agree to trust each other on the value of money. That the value of money is based upon trust explains why our financial system is so tightly bound up with our political, social and ideological systems.
The exchange value of money, of promises to pay money (IOU’s, bonds, cheques and other financial instruments) and even gold, are all ultimately matters of trust and confidence. But this does not mean they are identical. You can buy or sell promises to pay money or gold. You can also trade currencies against other currencies. But money still has a quality that promises to pay money and gold do not have. Only money is immediate legal tender.
What is the organization ‘Positive Money’?
Positive Money is a UK based organization that campaigns against the way the current banking system is organized. It says new money should only be able to be created by the state. The Positive Money webpage contains this documentary on the monetary system.
Positive Money argues that both the fractional reserve banking system and the capital adequacy system should be reformed and that only the state should be able to create new money, whether it be printed money, or electronic.
It argues that fractional reserve banking only limits the speed at which private banks can increase the money supply. It puts no limit on the total size the money supply can grow to. It argues capital adequacy rules are about preventing private banks from going bust when loans go bad. But it does not limit dangerous lending by private banks or limit how much new money they create through lending. And although the capital adequacy requirements can restrain lending after a banking crisis, it does not do anything to restrain lending in a boom.
Positive Money argues that the current banking system is responsible for:
- increased inequality- the bottom 90% pay more interest to banks than they ever receive from them, which results in a redistribution of income from the bottom 90% to the top 10%;
- money being sucked out of the real economy and into the financial sector. Only a small percentage of the new money created by banks goes to the real economy including loans to small business- the overwhelming majority goes into speculative investment- derivatives, the share market and property;
- share price and asset inflation including inflation of house prices- When house prices are pushed up by banks creating new money, those on low incomes suffer the most – they won’t be able to get a mortgage big enough to buy a house, so they won’t benefit from the higher prices;
- financial instability (boom-bust cycle).
Positive Money has called for three basic reforms to be implemented to the monetary system:
- A new committee accountable to Parliament responsible for determining how much new money should be created in the economy- not enough to cause bubbles, but not so little that it causes a recession.
- Create money free of debt. Currently banks create new money by creating the debts that are owed to them by the people they lend money to. Nearly all new money is created through debt upon which interest must be paid. If people try to pay down their debts this reduces the supply on money in the economy making it harder for others to pay down their debts. Instead the state should create money free of debt. Instead of lending money into the economy, like banks do through mortgages and loans, government can spend money stimulating the real economy, creating jobs and making it possible for ordinary people to pay down their debts without reducing the overall supply of money.
- Money should go into the real economy before it reaches the financial sector. If newly created money funds public spending or tax cuts, it would start its life in the real economy instead of getting trapped in the financial sector.
Positive Money describes the system under which only the state can create new money in the economy as a sovereign money system. They respond to criticism that such a system would lack “flexibility” by stating that the flexibility in the current system has fuelled inequality and “has translated not into greater economic growth, but into speculative bubbles in property and financial assets.”
But they also argue that a sovereign money system need not be inflexible. Flexibility depends not upon who creates new money in the economy but upon the trigger for its creation.
Support from Martin Wolf
Positive Money’s proposals are supported by the chief economist at the Financial Times, Martin Wolf. He sets out his reasons in this video.
Wolf points out that ending the fractional reserve banking system by requiring banks to only lend out their deposits is supported by some on the political Right. This is because it removes the need to regulate the banks through the central bank or other state interventions.
Examples of right wing support include the Chicago and Austrian School economists and US economic libertarian and Congressman, Ron Paul. in 1975, Milton Friedman from the Chicago school, told a US House sub-committee:
“I have long believed that the most effective way to reduce regulation is to separate the monetary functions of the commercial banks from their credit conscience. The way to do this would be to require all institutions offering demand deposits to keep 100-percent reserves”.
Wolf also points out that parts of the Left like the proposal for the state to monopolise the creation of new money because it allows government to funnel money into the real economy in preferred areas of spending rather than the new money getting caught the financial system where it is mostly used for less productive investment- property and share market speculation.
Quantitative Easing v Direct Spending
Governments have created new money in the economy through policies known as “quantitative easing”.
The term “quantitative easing” typically refers to central bank actions in recent years – namely in Japan during the early 2000s and in the US, England and Eurozone since 2007 – to inject liquidity into the financial system as a means of providing a monetary stimulus to the economy in the face of flagging demand and lack of willingness of private banks to lend.
But ‘Positive Money’ has been very critical of the way that quantitative easing policy has been applied by the Central Bank in the UK- the Bank of England.
“In 2010 the government cancelled a program to rebuild 715 schools, because they’d run out of money. But at the same time the Bank of England had created £445 billion of new money through a program called Quantitative Easing. Instead of this money being spent on something useful, it was pumped into the financial markets, benefitting the richest 5% but doing almost nothing to create jobs and stable economic recovery.
So why does the government cancel essential projects because “there’s no money”, while at the same time the Bank of England was able to create more new money than the entire government spends in 6 months? Why is it that the power to create money is used to blow up property bubbles and boost financial markets, but not to do the things that we actually need? Our latest video explains how things could have been done differently, and why it’s so important to campaign for a better monetary system…”
The approach in the UK contrasts with the approach of the Rudd Government to the global financial crisis. The approach of the Rudd Government was to spend over $50 billion directly into the real economy through cash grants and infrastructure programs.
“In the September and December quarters of 2008, the cash payouts to pensioners and low-income families saw government consumption contribute strongly to GDP growth at a time when household spending was falling. Throughout 2009, the $12.7bn given to all families (the cash splash) saw household consumption contribute very strongly to growth.
And while private investment fell in 2009, the public investment through stimulus measures, such as the building the education revolution did the heavy lifting. And once private investment began to improve again – through both the mining sector and also housing (via the increase in the first-home buyer grant for new properties), government investment tapered off.
Add in the performance of exports, and the ability of the RBA to cut rates by 4.25 percentage points in seven months, and you had Australia’s economy continuing to grow while the rest of the world was on the on the floor wondering if anyone got the number of the truck that had just hit it.”
Of course the Rudd government also took the step of guaranteeing the $600-$700 billion deposits in Australian financial institutions. These moves were unprecedented in Australian banking history and were a response to moves by government’s in other countries to prop up their failing financial systems.
According to a submission by Industry Super Australia to the Financial System Inquiry, the guarantees resulted in a windfall of up to $3.7 billion to the larger banks. Since implementation of the guarantee, the Big Four’s dominance of home lending has grew from 63 per cent to 85 per cent of the $1.7 trillion mortgage market, delivering hem bumper profits.
One of its proposals is for banks to be required to offer secure accounts at low or zero interest rates that would be completely quarantined in that they would be required to be transferred out of the bank in the event of failure. These accounts might only be invested in very secure investments such as government bonds. Other accounts would offer higher interest rates but on the understanding that they would not be guaranteed, or fully guaranteed.
Critics of Positive Money and Martin Wolf
This is not to say that the proposals of Positive Money and Martin Wolf are without credible critics.
Professor of Economics and New York Times columnist Paul Krugman defends the role of banks in creating new money:
“Normally only some depositors want to withdraw funds in any given period, so it’s normally possible to meet those demands without actually having liquid assets backing every deposit. And this solution makes the economy more productive, providing more liquidity even as it allows more productive investment.”
Krugman says there are two problems associated with changing the current system:
“First of all, you would be trying to ban a genuinely productive activity…Second, you would run smack into the problem of defining what constitutes a bank…If we impose 100% reserve requirements on depository institutions, but stop there, we’ll just drive even more finance into shadow banking, and make the system even riskier.”
Positive Money has responded to Krugman’s criticisms here. They say the problem of shadow banks is a valid concern and is a “job for the regulator”. But are things this simple?
Labor and the Banks
Labor has promised to establish a Royal Commission into the financial services industry to examine issues such as:
- how widespread instances of illegal and unethical behaviour are within Australia’s financial services industry;
- how Australia’s financial services institutions treat their duty of care to their customers;
- how the culture, ethical standards and business structures of Australian financial services institutions affect the behaviour of these institutions;
- whether Australia’s regulators are really equipped to identify and prevent illegal and unethical behaviour;
- comparable international experience with similar financial services industry misconduct and best practice responses to those incidents; and
- other events as may come to light in the course of investigating the above.
These are important issues. But Positive Money raises more fundamental issues that go to the heart of “normal” private bank practices. Is it in the public interest for private banks to be able to create new money in our economy, or should this reside exclusively with government?
It is unlikely that Labor’s Royal Commission can or will go these broader more fundamental issues. If you think the mining industries’ campaign against Labor’s mining tax was vicious, wait and see what sort of a campaign the private banks would wage against any party that questions their right to create new money.
But it would be good to see an equivalent organisation to Positive Money develop in Australia to educate the public on how banking and money actually works and to advocate for fundamental reform to the financial system.