Who should have the power to create money?

Who should have the power to create money? In Modernising Money we argue that the power to create money should be removed from the banks and transferred to a democratic, transparent, and accountable body. Martin Wolf recently backed these proposals, but Ann Pettifor describes them as ‘deeply flawed’ and ‘outlandish’.

One of Ann’s main concerns is whether a committee can correctly make decisions over how much money should be added to (or removed from) the economy.

Let’s approach this by considering the different options for who could be given the power and authority to create money:

• Banks – as per the status-quo

• Banks – heavily reformed (as Ann would suggest)

• Elected politicians

• The Monetary Policy Committee at the Bank of England (as proposed in Modernising Money)

When it comes to deciding who should have the power to create money, incentives are crucial. If those that create money also stand to benefit from doing so, then it’s likely they will want to create more than is socially optimal. So let’s consider the incentives of each of the groups above.

Option 1: Banks as per the status quo

In the current monetary system, the more successful loans a bank makes, the greater will be its profits. And if a bank manages to make successful loans at a faster rate than its competitors, it will grow its market share. Consequently, in the years before the financial crisis the senior leadership teams of banks designed incentive schemes that turned old-fashioned loan officers into salespeople. The loan officers were motivated to increase their lending by a range of bonuses, commissions and opportunities for promotion.

This interview with Paul Moore makes very clear the kind of culture affecting the banks in the run up to the crisis. He tells the story of one branch where the highest performing loan officer (i.e. the one who had lent the most money) got a cash prize, while the worst performer was publicly humiliated by being given a cabbage. While this is an extreme example, it shows that when an institution profits from creating money, its incentives can become completely unbalanced.

But why do banks incentivise their staff to act in such an irresponsible manner, when it’s evidently not in their interest to fail? One of the main reasons is because, in the current system, most of “our” money exists in the form of bank deposits. Furthermore, the payments system is inherently tied up with the banking sector. For these reasons (as well as several others) the major banks in the UK are “too big/too systemically important to fail.” If a large bank failed and the Government did not step in, the result would be a destruction of a huge amount of “money” and a cascade of bankruptcies throughout the banking and finance sector. This would almost certainly lead to a credit crunch and a financial crisis, and possibly a debt deflation and depression. Of course, the banks know this (larger banks can borrow at cheaper rates than smaller ones as a result of this implicit guarantee). Consequently, bank will tend to lend excessively, safe in the knowledge that for them, it’s “head we win, tails the taxpayer bails us out”.

So, in the current system, it is ultimately a small group of board members at the largest banks that decide how much money is lent and what this money is lent for. They choose the bank’s strategy, area of focus, and how aggressively they want to expand the bank.

Option 2: Banks with significant reform

Ann Pettifor suggests that the power to create money should remain with banks, but with significant reforms:

“[T]he reason that it’s better to have thousands of different bank clerks deciding on the allocation of millions of new loans (to fund e.g. the purchase of a washing machine, or investment in solar panels, or the expansion of a successful small business) is that it is better that these decisions are devolved and diverse. However, I am very clear that these clerks should – like dentists and electricians – be very carefully regulated so that they do not lend recklessly; and do not cause systemic failure…”

Before we start, it’s important to note that under the Positive Money reform proposals bank clerks will still decide “on the allocation of millions of new loans”, so that these decisions will be “devolved and diverse”. It’s just that this lending won’t create new money. We are not proposing that the Bank of England decides who gets a loan and who doesn’t; simply that they, rather than banks, control how quickly the amount of money in the economy increases year on year.

The crucial point in Ann’s quote is that clerks should be “very carefully regulated so that they do not lend recklessly; and do not cause systemic failure”.

It is clear that in the current system banks have a systemic biases towards lending too much (in economic expansions), and favour lending into speculative bubbles in property and financial markets rather than lend to productive businesses. Ann is effectively proposing that regulation can lean against these biases.

The key question is who will decide on this regulation, and how will this regulation work? Also, who will adjust the regulation if it turns out to be ineffective? Clearly there will need to be a group of people to make these decisions/regulations, and adjust them given economic conditions. And of course, to prevent ‘systemic failure’, both the quantity and the direction of new lending would need to be regulated, to prevent excessive speculative lending. So, seemingly, Ann’s plan would require a group of people (or a “committee”) to decide not only on the amount of new lending by banks, but also what this lending is for too. But this is exactly what she criticises the Positive Money proposals for:

“First, the idea that society can set up a single “independent” committee of men to make far-reaching decisions about the quantity of money needed by a nation of sixty four million people, all engaged in varied and complex activities – is bordering on authoritarian.”

Ann goes on to claim that there would be “no chance” of such a committee being independent. Firstly, this criticism would apply whether the committee is setting regulation (as required in Ann’s plan) or deciding directly on the amount of money creation. If Ann is right, and a committee is unable to maintain independence, then the regulation committee would presumably be pushed – by both politicians and bankers – to allow more lending during periods of economic growth. In this case we would be back to the pro-cyclical system we have today, in which the banks decide how much and to whom to lend. So again, we would have a system in which the boards of banks decide the amount and direction of new money creation.

There are other related problems in relying on regulation:

1. Banks can usually afford to spend more on circumventing regulation than the regulator can afford to spend on stopping them. And if banks are to be regulated by limiting the size of their loan books, or through capital adequacy requirements, then banks can simply securitize their loans to move them off their books. Indeed, one of the major reasons banks became more concerned with the quantity of lending rather than the quality was because they could sell off loans they had made.

2. Regulations tend to be chipped away over time. One of the main reasons the regulations that worked relatively well during the 50 and 60s were done away with is because they were successful, which meant bank lobbyists could argue that such ‘restrictive’ regulation was not required. Regulators were happy to go along with this sentiment.

3. No one is immune to bouts of irrational exuberance, not even the world’s top bank regulator. In the run up to the crisis, Ben Bernanke, then Fed Governor, argued, along with large proportions of the world’s economics profession, that the business cycle had been tamed and that recessions and financial crises were a thing of the past. This is why Ann’s analogy, that banks should be regulated very strictly, “like dentists or electricians” is not correct. Being an electrician requires considerable training but not much judgement – there are hard and fast rules about what kind of wire to use for what kind of circuit. The same applies to building houses: it is clear what kind of structure will be safe for human habitation. But banking is fundamentally different and requires significant human judgement. And judgments are susceptible to sentiment and waves of irrational exuberance and optimism. Banks therefore cannot be regulated in anything like the same way as electricians can.

As Minsky argued, stability is destablising.

Option 3: Elected politicians (e.g. the chancellor/finance minister)

What if we gave the power to create money to the finance minister? In theory this is democratic (they are elected), transparent and accountable to the public. But the conflicts of interest here are huge: the decision over how much money the economy as a whole needs would be conflated with the decision over how the government funds election-winning spending programmes. We would expect to see more money created in the run up to an election. This would be a repeat of the political business cycle that was a problem when Chancellors and finance ministers set interest rates.

Option 4: The Monetary Policy Committee at the Bank of England (as proposed in Modernising Money)

The following section is copied from Modernising Money:

The decision over how much new money to create/remove from circulation would be given to an independent body, to be known as the Money Creation Committee (MCC). As is the case today, the target of monetary policy will be the rate of inflation. However, in line with democratic principles, Parliament will have the ability to change the MCC’s mandate if it considers other targets, such as economic growth or employment to be more relevant.

The MCC would aim to keep inflation at around the 2% a year target by either adding or removing money from circulation. Creation of new money by the MCC will increase the amount of spending in the economy (as it will add to government spending). Depending on the state of the economy at the time, this may push up the inflation rate (discussed in detail in Chapter 9).

If inflation is above the target rate, then the MCC will likely slow or stop the rate of new money creation. Note that the MCC’s decision will be based on the amount of additional money they consider necessary to meet the inflation target. Under no circumstances would they be aiming to create however much money the government needs to fulfil its election manifesto promises.

With the MCC having direct control over the amount of money in the economy, the Monetary Policy Committee (MPC) at the Bank of England would no longer be needed and could be disbanded. Currently the MPC attempts to control bank lending – and therefore the quantity of broad money in the economy – by influencing the interest rate at which banks lend to each other on the interbank market. Post-reform, central banks would have direct control over the money creation process and so there would be no need for them to set interest rates. Instead, interest rates would be determined in the markets.

The Money Creation Committee will have no control over how the newly created money is used. Whilst the way the money is used will determine to some degree its effect on inflation, giving the MCC any influence over how the money is spent would introduce a conflict of interest, whereby its members might find that their judgement is swayed by their opinion on the merit of various spending programmes. In order to prevent this conflict of interest from arising, and to ensure that the MCC does not become politicised, the decision over how much money is created and what that money is used for must be taken by separate bodies.

How the Money Creation Committee would work

Each month, the Money Creation Committee would meet and decide whether to increase, decrease, or hold constant the level of money in the economy. During their monthly meetings the MCC would decide upon two figures:

1. The amount of new money needed in order to maintain aggregate demand in line with the inflation target (similar to the setting of interest rates today), and;

2. The amount of new lending needed in order to avoid a credit crunch in the real economy and therefore a fall in output and employment (discussed in section 7.6).

Both figures would be determined, as is the case now when setting interest rates, by reference to appropriate macroeconomic data, including the Bank of England’s Credit Conditions Survey (a survey of business borrowing conditions, outlined in Box 7.C). Once a conclusion had been made on the two figures mentioned above, the Money Creation Committee would authorise the creation of a specific amount of new money. This newly created money could then enter the economy in two ways:

The first (and most common) of these would be to grant the money to the government (by increasing the balance of the Central Government Account), which would then spend this money into circulation, as discussed in the next section. This process increases the amount of money in circulation without increasing the level of debt in the economy and can therefore be thought of as ‘debt-free’ money creation.

The second method would be for the central bank to create new money via the MCC and lend it to banks, which would then lend this money to businesses and the productive economy (but not for mortgages or financial speculation). This increases the quantity of money in circulation but simultaneously increases the level of debt, and so does not constitute debt-free money creation. This option provides a tool to ensure that businesses and the real economy do not suffer from a lack of access to credit.

Is it possible for the Money Creation Committee to determine the ‘correct’ money supply?

To begin with, it is important to note that the MCC would not determine how much money the economy needs from scratch. Instead, it would decide whether to increase or decrease the stock of existing money from its existing level (which has been determined by historical events), given current levels of inflation and economic activity. This requires that the MCC take a view on the likely future path of the economy in addition to reacting to economic events. Essentially the MCC will be guided by both theory and the results of their previous decisions.

There is of course no way for the MCC to predict perfectly how much money to create. However, this is true of all monetary and political decisions – including the Monetary Policy Committee’s decision to increase or decrease interest rates in the present system. The question therefore becomes one of who is most likely to supply the economy with the ‘correct’ amount of money: commercial banks in the current system, or an independent committee in the reformed system?

As was outlined in Chapter 2, commercial banks create money when they make loans. Bank officials therefore are not deliberately and consciously making a decision about how much money they think should be in the economy; they are instead making a decision about whether a particular loan will be profitable. This means that the stock of money is currently determined as a by-product of bank lending decisions, made in the pursuit of profit. Because the majority of banks’ profits come from the interest they charge on loans, in relatively benign periods banks are incentivised to lend as much as possible, creating money in the process.

However, although the money supply is determined by the actions of companies in the private sector, it would be a mistake to believe that the stock of money is determined by market forces, for several reasons. First, the top five banks in the UK dominate almost the entire market, making it an oligopolistic market. Second, the creation of new money is not determined by the demand for money, but by the demand for credit. Third, even the market for credit is not determined by market forces – as section 3.5 showed, banks ration credit. Of course, the overall strategies of banks, and therefore their lending priorities, are determined at board level. Consequently, it is a small group of senior board members at the largest banks who determine the growth rate of lending and consequently the amount of money in the economy. As the “cash vs bank issued money” chart in the introduction showed, these incentives, combined with a lack of any meaningful constraint on bank lending, led to a doubling of the M4 money supply from 2002-2008.

Banks therefore create too much money in good times, leading to economic booms, asset bubbles and occasional financial crises. Because this money is created with an accompanying debt, eventually the economy becomes overindebted, with a bust occurring when individuals cut back spending to repay their debts. During the bust, banks’ pessimistic views as to the future state of the economy (which are magnified by disaster myopia – see Box 4.C) lead them to create too little money and as a result the economy suffers more than it needs to. The story of this type of business cycle is therefore one of banks creating too much credit, which causes a boom and eventually a bust when debt gets too high. Then, during the bust banks lend too little, worsening the downturn. In short, there is no reason to think that the level of money creation that maximises banks’ profits will be the level of money creation that is best for the economy as a whole.

In contrast, under the reformed system the decision to create or destroy money will be determined by the MCC, a committee charged with creating the right amount of money for the economy as a whole. While it is unlikely that this committee will be able to get the level exactly right, history has shown that the current system rarely provides the ‘right’ amount of money, and more often than not gets it disastrously wrong. The choice is not therefore between a ‘perfect’ market-determined system on one hand and one determined by a committee on the other, but rather between leaving the nation’s money at the mercy of the interests of banks or organising it squarely in the interests of the national economy. Given the above, it is difficult to imagine that the MCC could manage the creation of money more destructively than the banks have done to date.

Conclusion

Who should have the power to create money?

In the current system, in which a committee, the MPC, sets interest rates, it is the boards of (predominantly 5) banks that ultimately decide how much and to whom they lend. Thus new money is created not for the benefit of society at large, but rather to increase bank profits. It’s not democratic, transparent, or publically accountable, although the public does underwrite this system when things go wrong. Profits are privatised and losses are socialised.

Second, in Ann’s “highly regulated” system, both the quantity and direction of new credit is determined by committee. But over time these regulations are likely to be undermined, and gradually the power to create money will return to the boardrooms of banks. As above, this won’t be democratic, transparent, or publically accountable.

Third, the power to create money could be handed to politicians at Westminster. While this would on paper appear to be democratic, transparent, and publically accountable, politicians are likely to abuse this power in the run up to elections for party gain (just as they did when the chancellor controlled interest rates). This is likely to lead to a political business cycle, and may not be much better than the status quo.

Forth, the power could be handed to an independent, transparent body that is accountable to parliament, such as we suggest in Modernising Money. It won’t be perfect, and they won’t get the decision right all the time, but unlike in all the other systems this gives those with the power to create money the incentives to create money in line with best interests of the country as a whole. In this system the targets of monetary policy are transparent and democratically mandated, and the committee is accountable to parliament.

The primary problem is therefore quite simple: some group of people, somewhere, is going end up deciding the quantity and direction of lending in the economy. The only question is who should have this power?

The advantage of our proposal is that it eliminates the conflicts of interest over the decision to create money. When bankers or politicians are able to create money, these conflicts of interest lead to them abusing that power. And regulations will be eroded over time, returning us to the dysfunctional system we have today.