Money and Banking

Understanding money starts with 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

1. There is no free lunch.

The “free lunch” has to do with the fact that banks create the money they lend. This simple fact lies at the core of banking and is the root cause of the current money and banking system’s problems.

2. Money is a creature of the nation state.

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

3. Money is uniform.

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. When the money and banking system is working properly it seems as if “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 is often revealed during banking crises. 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 must use central bank deposits created by the Federal Reserve.

4. Money is a positive number.

Money is actually a creature of accounting; it can be a positive or a negative number depending on whose balance sheet it sits on. The paper currency it issues is a liability (negative number) for the Federal Reserve. But for the banking and private sectors, paper currency is an asset (positive number). Bank deposits are a liability of the banking sector and an asset of the private sector.

KEY ISSUES

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

All money is created as debt.

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 with accounting entries when loans are issued by the private banking sector.

The private banking sector gets to determine the quantity and first use of the money it creates by lending it into specific sectors. This decision is driven by a profit motive, not by the priorities of society nor by the needs of the economy as a whole. For example, in the last decade banks in the US and other developed countries have created a vast amount of money simply by lending it into the real estate sector and 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 sustainable scenario 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.
• This design flaw virtually 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 onto a path of perpetual growth, since next year we need to borrow more money into existence in order to pay the interest on last year’s debt. Thus, the economy as a whole must continue to grow.
• As the expanding level of debt always exceeds the amount of money available to repay it, the trend to transform nature into commodities and relationships into services continues to accelerate. Consider that just a century ago, nearly all childcare, elder care and food preparation 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 are forced to borrow from the very entities they ceded their money creation power to.
• We are all effectively borrowing our money supply and paying interest on it every year.
• Such interest payments act as a tax on the productive economy, rewarding only the wealthy and the private banking sector.
• The mathematical consequence of this process is a continued increase in wealth inequality.

The private sector reaps the money-creation benefits while the public bears the risk.

When  private banks make loans, they get to create electronic money. 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 very banks that hold the power to create money.

HOW CAN WE REFORM THE MONEY AND BANKING SYSTEM?

The Chicago Plan

One proposed solution requires curtailing or eliminating money creation by private banks, recognizing it 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 managing the money and banking system in the interest of the public.

Eliminating the ability of banks to create money means turning them into what most of the public believes (and most textbooks claim) them to be – financial intermediaries lending out the excess savings of their customers.

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

NEED Act and Limited Purpose Banking

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

All of these proposals would eliminate a key feature of banking – maturity, liquidity and credit transformation (see my video above for an explanation). One could argue 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.

My analysis

I am now leaning towards a proposal that still allows private banks to create credit and therefore money, but strictly limits this power, both in terms of total amount of credit created and in terms of allocation of credit to sectors that are beneficial to society. In modern economies, most of the banking sector’s credit creation (and accordingly its money creation) goes towards real estate lending and financial speculation, creating asset bubbles and financial instability. Banks would also be constrained by much higher liquidity and capital requirements.

The main proponent of this reform is Lord Adair Turner, previous chairman of the Financial Stability Authority in the UK and current 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 money and banking system’s current design and how 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 have the authority to create money by lending it into existence, but the process would be transparent and accountable to the people in the jurisdiction. Loans would support projects deemed of significant social benefit, such as 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 banks reduce the amount of credit in the economy.