The design of the banking and money system is implicated in the largest challenges we face as a society:

  • Increasing levels of debt (public and private)
  • Economic instability
  • Concentration of wealth
  • Loss of democracy
  • Environmental and climate disruption

Yet, there is very little understanding of how money and banking work and misconceptions abound.

Here are three popular misconceptions:

  • Money is created by the government
  • Banks are financial intermediaries that loan out the money they receive as deposits
  • Returning to a gold standard will fix our economic problems

None of the above statements is accurate.

Everything you need to know about money and banking:

(read more below …)

In a nutshell, money is a sort of public-private partnership where the risks have gravitated towards the public sector while the benefits have gravitated towards the private sector. Money and credit creation need to be recognized as a common and be managed for the benefit of society as a whole and not just for the benefit of the private banking sector.

The money and banking system has become very complex in the last thirty years with the financialization of banking, the emergence of shadow banking and the globalization of the wholesale money market. Getting a grasp of it can feel overwhelming. Yet, the key design features of the system can be easily understood. They reveal the role the system plays in the problems we face and ways to redesign it so that money works for the collective benefit and within the limits imposed by finite ecosystems. It is essential for our democracy that the general public understands these matters and feels empowered to challenge and reshape the money and banking system.

Understanding money requires overcoming four patterns of thought:

  1. There is no free lunch
  2. Money is a creature of the nation state
  3. Money is uniform
  4. Money is a positive number

The “free lunch” has to do with the fact that banks create the money they lend. This simple fact is at the core of banking and also at the core of the problems caused by the money and banking system as currently designed.

The money and banking system is a hybrid system because money is in part a creature of the state and in part a creature of the private sector. In fact the vast majority of the money we use is private money created by the banking sector when it makes loans.

Money is not uniform, it is hierarchical. There are very distinct forms of money (currency, central bank deposits, bank deposits) and they are qualitatively different. The money and banking systems when it is working properly makes it seem like “a dollar is a dollar” whether it is in the form of a banknote or a checking account balance. Yet, bank deposits and the national currency sit on two very different levels of the money hierarchy as it is often revealed during banking crisis. It is important to understand that, while banks create the money we use in the form of checking account deposits, they do not create the money they use to settle their inter-bank transactions. For that they need to use central bank deposits created by the Federal Reserve.

Money is really a creature of accounting and can be a positive or a negative number depending on whose balance sheet it sits on. The paper currency issued by the Federal Reserve is a liability of, and therefore a negative number for, the Federal Reserve. But paper currency is an asset of, therefore a positive number for, the banking sector and of the private sector. Bank deposits are a liability of the banking sector and an asset of the private sector.

The Positive Money Institute in the UK has done an excellent job explaining how the money and banking system works. They provided an in depth analysis and proposed a radical way of reforming the money and banking system so that it works for society at large in the book Modernizing Money. They are calling for eliminating banks’ the ability to create money by establishing a 100% reserve requirement similar to what was proposed in the aftermath of the financial collapse of 1929 by economists like Irwin Fisher, Henry C Simon and Milton Friedman. In other words, they are suggesting to turn banks strictly into financial intermediaries.

Here are three short introductory videos they created:

Here are the key issues with the money and banking system as currently designed.

With the exception of the coins in our pockets, all money is created as debt. The paper currency issued by the Federal Reserve is backed by US Government debt. Most of the money we use, in fact more than 95% of the money supply in the US is electronic money created by the private banking sector with accounting entries when loans are issued.

One important consequence of this fact is that the private banking sector decides the quantity and first use of the money they create by lending it into specific sectors. This decision is driven by their profit motive not by the priorities of society nor by the needs of the economy as a whole. In the last decade, for example, banks in the US and other developed countries have created vast amount of money by lending it into the real estate sector and for financial speculation causing a global housing bubble and inflated financial markets.

No money is ever created to repay the interest on that debt. This is arguably the biggest design flaw of our money system. This is what keeps money scarce.

  • If all money is created as debt when loaned into existence at interest, the only scenario that is sustainable is one where all interests circulate in the economy and where no one saves a single penny. As soon as someone builds some savings, it creates a corresponding amount of unrepayable debt in the economy.
  • The inevitable consequence of this design flaw is that it guarantees that many people will default on their loans and lose whatever collateral they might have pledged.
  • This forces the amount of money in circulation and therefore the overall level of debt on a continued growth path since next year we need to borrow more money into existence in order to pay the interest on last year’s debt. The economy is therefore also forced on a path of continued growth.
  • An expanding level of debt which always exceeds the amount of money available to repay it accelerates the trend to transform nature into commodities and relationships into services. To understand this last point notice that just about all childcare, elder care and food preparation about a century ago required no exchange of money.

The private banking sector has now effectively a monopoly on money creation. Over the last couple of centuries the US government, and many governments around the world, have ceded a key government function – money creation – to the private banking sector.

  • When their tax revenues are insufficient to cover their expenses those governments need to borrow from those they ceded the power to create money and from those that have accumulated financial resources into their hands.
  • We are all effectively borrowing our money supply and have to pay interest on it every year.
  • Such interest payments are a tax on the productive economy that rewards the wealthy and the private banking sector that has the power to create money.
  • The mathematical consequence of this process is continued increase in wealth inequality.

The private sector reaps the money-creation benefits while the public bears the risk. The private banking sector gets to create electronic money when it makes loans. That money, which is our primary means of exchange and part of our payment system, participates in the credit and default risk of those loans which are assets of the banking sector. The profit motive leads the banking sector to lend as much as possible during good times therefore creating assets of progressively deteriorating quality. When the asset quality deteriorates to the point of threatening the system of payments the Government is called in to bear the risk either through the FDIC program or by bailing out the too-big-to-fail banks. The irony is that the Government, backed by us – the taxpayers, has to borrow the money necessary to bail out the banks which have the power to create money.

What are the necessary reforms to the money and banking system?

One of the proposed solution requires curtailing or eliminating money creation by private banks, recognizing money creation as a quintessential government function. We would also need to nationalize the Federal Reserve, as the UK did in 1947 with the Bank of England. The Federal Reserve is currently a network of 12 private “super” banks owned by the nationally chartered private banks in the US. Its private ownership has prevented the Fed from being an effective regulator of the banking sector and to manage the money and banking system in the interest of the public at large.

Eliminating the ability of banks to create money means turning them into what people believe, and most textbooks claim, they are – financial intermediaries lending out the excess savings of their customers.

This idea is not new and it was proposed by a group of economists including Irwin Fisher and Henry C. Simon, to President Roosevelt to resolve the mess created by the collapse of the banking system in 1929. It was called at the time The Chicago Plan. Modern proponents of a similar plan are, among others, the Positive Money Institute in the UK and the American Monetary Institute in the US.

Positive Money Institute outlined their clear analysis of the money and banking system and their proposal in their recent book Modernizing Money. Inspired by the ideas of the American Monetary Institute Congressman Dennis Kucinich introduced in the US House of Representatives in 2011 a legislative proposal called the NEED Act (H.R. 2990). On a similar vein, Professor Lawrence Kotlikoff at the University of Boston proposed limited purpose banking, a version of 100% reserve banking of The Chicago Plan. Similarly, Jaromir Benes and Michael Kumhof has proposed The Chicago Plan Revisited in a 2009 IMF working paper.

All the above proposals would eliminate a key feature of banking – maturity, liquidity and credit transformation (see my video above for an explanation of this transformation). An argument could be made that, while such transformation is at the core of the repeated financial crises in the last couple of centuries, it has a potential positive function in society.

I am now leaning towards a proposal that still allows private banks to create credit and therefore money but where such power is strictly constrained both in terms of total amount of credit created and in terms of allocation of credit to sectors that are beneficial to society. Most of the credit creation (and therefore of the money creation) by the banking sector in modern economies goes towards real estate lending and lending for financial speculation causing asset bubbles and financial instability. The banks would also be constrained by much higher liquidity and capital requirements.

The main proponent of this reform is Lord Adair Turner, the previous chairman of the Financial Stability Authority in the UK and currently the chairman of the board of the Institute for New Economic Thinking. His recent book Between the debt and the devil is a brilliant and crystal clear analysis of the problem with the current design of the money and banking system and what we need to fix it. See also his recent talk on this topic.

If private banks are still allowed to create money, we should also develop a competing network of public banks at various levels of jurisdiction – city-owned banks, county banks and state banks. Public banks would be allowed to create money by lending it into existence but the process will be transparent and accountable to the people in the jurisdiction. The loans would be made to support projects deemed of social benefit like infrastructure projects, building or upgrading schools and other public buildings, low-interest student loans or loans to small local businesses. Public banks could also act counter-cyclically reducing the amount of credit available when private banks extend plenty of it during economic expansions, and providing additional credit during recessions when private back reduce the amount of credit in the economy.

Check out the Public Banking Institute to learn more about public banking.

Sophisticated readers with substantial knowledge of banking and of monetary theory might enjoy reading the recent book by Prof. Perry Mehrling “The New Lombard Street – How the Fed Became the Dealer of Last Resort” to gain an understanding of the current money and banking system and the challenges brought about by financial globalization, a topic I do not delve into in my talk for didactic reasons.