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
  • The Federal Reserve is an entity of the US government that controls the overall amount of money in circulation for the optimal functioning of the economy
  • Banks are financial intermediaries that loan out the money they receive as deposits

None of the above statements is accurate.

Everything you need to know about money and banking in three minutes:

(read more below …)


While the complexity of the money and banking system can be overwhelming, the key design features of the system can be easily understood and 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 participates in reshaping the system.

To explain the system to a lay audience, I will present an earlier version of the money and banking system. This will allow us to understand its functioning and its effects without getting lost in the complexity brought about by the globalization of wholesale money markets and the financialization of the money and banking system in the last 30 years.

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.

The bottom line is that the money and banking system is a hybrid and hierarchical system. It is hybrid because money is in part a creature of the state and in part a creature of the private sector. It is hierarchical because what we call money is made up of various forms of money (currency, reserves, bank credit) with a clear ranking among them. 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. The complexification of the system in the last 30 years has exacerbated this trend, rendering effective regulation of the system arduous and increasing economic risk globally.

The Positive Money Institute in the UK has done an excellent job at understanding and explaining how this early version of the money and banking system works. They provided an in depth analysis and proposed a way of reforming the money and banking system so that it works for society at large in the book Modernizing Money.

Here are three short introductory videos they created:

The first 28’ of the documentary The Money Fix provides a good introduction to the money and banking system. In a nutshell, here are the key design features of our money and banking system and the problems associated with them.

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 causing a global housing bubble.

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.

  • 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 exceed the amount of money available to repay it forces us to transform nature into commodities and to transform 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 the 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 documentary The Secret of Oz and the book The Web of Debt by Ellen Brown tell the long history of the battle between governments and private banks for the power to create money and control the money supply.

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 time 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 idea is to take the money-creation privilege away from the private for-profit banking sector and to put it in the hands of an entity accountable to the people and acting in the interest of the people and the economy as a whole.

This can be achieved by a top-down or a bottom-up approach.

The top-down approach is reflected in the proposal by the Positive Money Institute outlined in Modernizing Money and in the NEED Act legislation (H.R. 2990) introduced by Congressman Dennis Kucinich in the US House of Representatives in 2011.

It would include the following steps:

  • Any increase in the money supply would come from the US Treasury in the form of debt-free US money with Federal Reserve Notes phased out of circulation.
  • The Federal Reserve would be nationalized and incorporated in the US Treasury.
  • A Money Creation Authority would be created under the US Treasury to regulate the money supply based on the need of the economy to be neither inflationary nor deflationary.
  • Bank demand deposits would be converted into transaction accounts held at the US Treasury, but managed by the private banks for a service fee, and therefore removed from the risk of bank assets.
  • Private banks would be turned into financial intermediaries taking at-risk time deposits in order to issue loans (effectively this would turn the private banking system into a 100% reserve requirement system).

The bottom-up approach is the creation of a 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. The interests generated by those loans would come back to the jurisdiction and fund its programs and services in lieu of taxes.

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

Webinar on the money and banking system organized by Transition US – March 19th, 2014