There is a farce at the centre of our money system. It’s the one alluded to in the above title: one that Prof Mary Mellor deals with in her two books, “The Future of Money” and “Debt or Democracy”.
Money, as the saying goes “is a creature of the state”. That is, there has to be general agreement in any country as to what the country’s basic form of money shall be: it would be highly inconvenient if some people used gold coins as money, while others used silver and others used cowrie shells (which have long been a popular form of money on desert islands and similar). And in practice, throughout history, money has normally been organized by some central authority: often a king or ruler who wants to make tax collection more efficient.
So, the basic form of money in the US is the Fed-issued US dollar. In Russia, it’s the Russian central bank-issued Ruble, etc.
As to the optimum amount of such money to create and spend into the economy, clearly, that needs to be whatever brings full employment without causing excess inflation. The more money people have, the more they will spend (not that the relationship there is particularly close or predictable). So, ideally an amount of money needs to be issued that (to repeat) brings full employment without too much inflation.
Having done that, however, commercial banks normally play a little trick which is profitable for them: it’s to issue their own dollars (in the case of the US) or pounds in the case of the UK. To be more exact, they create and lend out “promises to pay” central bank dollars, pounds, etc. In fact, commercial banks make good on that promise when you get physical cash from an ATM.
But when you get a loan for $X from a commercial/private bank, and $X is credited to your account, the bank invariably keeps quiet about the fact that you have not actually got $X there: to repeat, what you have is a promise by the bank to pay $X to whoever you want to pay $X to (possibly to yourself at an ATM).
Another important feature of privately created money is that it tends to displace state created money. That is, if the state creates and distributes an amount of money that brings full employment without too much inflation, and commercial banks then start creating and lending out their own home-made money, then households and businesses will find themselves with an excess supply of money. Demand and inflation will rise, so the state will have to raise taxes and withdraw some of the state-issued money.
An alternative scenario, set out by George Selgin in the first few paragraphs of his Capitalism Magazine article “Is Fractional Reserve Banking Inflationary” is that government lets inflation rip, which means the real value of the stock of state issued money is whittled away to near nothing. But either way, privately-issued money displaces state-issued money. (Incidentally I am not suggesting Selgin would agree with everything in this article or even most of it.)
But the big problem with commercial bank-created money is that it is not 100% reliable: the fact is that commercial banks, regular as clockwork, go bust and have to be rescued by the state. Now, what on Earth is the point of replacing state-issued money with privately-issued money which cannot function unless it is backed by the state?
Moreover, to add insult to injury, it is precisely the fact of trying to create a form of money/liquidity that makes banks vulnerable and prone to bank runs, as Douglas Diamond explains in the abstract of this paper.
Well, one apparent advantage of privately created money is that interest rates are presumably lower than under a “state money only” system. Reason is that if a commercial bank can simply print or “create from thin air” the money it lends out, that is clearly cheaper for it than obtaining the relevant money the same way households and non-bank corporations obtain money, namely earn it or borrow it. But in that case, lending is being subsidised by money printing, or by seigniorage of a sort, and there is no particular reason why money lenders (aka commercial banks) should reap the benefits of seigniorage rather than garages or restaurants.
When money is created, the money creator normally makes a profit from doing so. E.g. when the state prints money and spends it on new roads, the state profits in that it obtains more road at zero cost to itself. But we all benefit from improved roads, thus the profit does not matter there. In contrast, there is no good reason for commercial banks to be the ones who benefit from money creation.
Another glaring weakness in any alleged advantages in the relatively low interest rates that stem from private money creation is that private banks have not had to pay a suitable amount of insurance for the risks that such money creation entails.
First, banks were rescued by the Fed in the recent crisis with billions of dollars’ worth of loans, not at the “penalty rate” suggested by Walter Bagehot, but at a near zero rate of interest. Don’t you wish you could borrow at a zero rate of interest?
Second, it would be perfectly reasonable to charge the bank industry for a significant proportion of the trillions of dollars’ worth of lost GDP that most countries have experienced over the last ten years as a result of bank irresponsibility: car drivers have to be insured in most countries against the possibility that they cause a serious and life-long injuries which cost millions of dollars to deal with. If banks paid an insurance premium that took account of the latter trillions of dollars of lost GDP, the cost of running commercial banks would go through the roof: put another way, that sort of insurance would make a complete mockery of the idea that privately issued money results in lower interest rates.
But even if the latter insurance point can be ignored, it might seem tempting to favour the lower interest rates that private money creation brings, given that stimulus is often imparted by lowering interest rates.
The answer to that is that stimulus is easily imparted without adjusting interest rates: as Keynes pointed out in the early 1930s, stimulus can be imparted by having the state create new money and spend it (and/or cut taxes).
The line between money and non-money
Another possible objection to the above argument is that even in the absence of commercial banks, individuals and non-bank firms would engage in a significant amount of money creation or at least “liquidity creation”. Thus, so it might be argued, banks should be allowed to do the same. I’ll expand on that.
Assume an economy with state-issued money only. In such an economy, people and firms would lend to each other, and some people would grant relatively long-term loans to others, e.g. ten years for a mortgage. But in that scenario, lenders would not be absolutely committed to losing access to their money for ten years. Reason is that if someone who had made a ten-year loan wanted their money back after six months, there’d be a good chance they could sell the loan to someone else.
That process makes those loans more liquid. Indeed, if the latter “loan selling” were efficient enough, then loans would be almost of liquid as money itself. Thus, so it might be argued, why shouldn’t commercial banks engage in that process and try to make it even more efficient?
Well, there is no reason banks shouldn’t do that, but they’ll never be able to produce what is commonly understood to constitute money (i.e. something which is 100% guaranteed not to lose value (inflation apart)) without state backing. An exception to that doubtless comes where the state is very irresponsible (e.g. a Robert Mugabe style hyperinflation economy) and people regard commercial banks as more responsible than government. But that scenario is relatively uncommon.
Put another way, there’s nothing wrong with commercial banks funding loans via what are in effect bonds, even if those bonds take the form of small deposits at such banks. But there is no good reason for the state to give its backing to those “bonds” and turn them into genuine, 100% proof, pukka money. That just constitutes a subsidy by taxpayers of commercial banks.
In short, advocates of full reserve banking are right to claim that loans should be funded via equity or similar (e.g. bonds which can be bailed in).
Is deposit insurance OK?
Having said that depositors should be on the hook where a bank is sufficiently incompetent, another question arises, namely: is deposit insurance of those “bond/deposits” acceptable? Well, it’s a bit hard to see why not if the insurance system is run on strictly commercial lines, as is the FDIC.
But doesn’t that then mean that those deposits then become 100% proof, pukka money? Well, yes: it does. But there is a catch, as follows.
Milton Friedman and Warren Mosler (founder of MMT) argued for a permanent zero interest rate policy, and I argued the same here. But given that sort of low interest rate policy, how much interest will the above “bond/depositors” actually get after the costs of deposit insurance have been deducted? Well, I suggest the answer is “none”, and for the following reason. This reason is not desperately well thought out at the moment – I’ll hopefully improve on the thinking in the future. But here goes.
Interest is paid for two reasons: first, as a reward for accepting risk. But depositors whose deposits are insured by an insurer with an infinitely deep pocket, i.e. the state, are accepting no risk!
A second reason for paying interest is as a reward for the lender for losing access to a sum of money (or some other asset) for a period of time. But if the above depositors have instant access to their money, then they aren’t losing access (to make a statement of the obvious). Conclusion: there is no reason for those depositors to get any interest.
In contrast, if as suggested by some proponents of full reserve banking, depositors do lose access to their money for a significant period, then there is good reason to pay them interest. (E.g. Ben Dyson and Andrew Jackson in their book “Modernising Money”) suggest a minimum of two months.) But in that case, those deposits cannot really be classified as money: certainly, a deposit where the “term” is more than about two months is not counted as money in most countries, though obviously that two-month dividing line is a bit arbitrary. I.e. there is no sharp dividing line between money and non-money there. But then, there never has been a sharp dividing line between money and non-money.