9 Benefits of Switching to a Sovereign Money system

The power to create money, in the hands of commercial banks, has been highlighted as one of the root causes of both the Great Depression of the 1930s and the financial crisis of 2007-2009. Lord (Adair) Turner, the former chairman of the UK’s Financial Services Authority, has argued that: “The financial crisis of 2007/08 occurred because we failed to constrain the private financial system’s creation of private credit and money” (2012).

The current monetary system can be re-designed. A reform that would remove the ability of banks to create money, and return this power to public body working in the interests of the economy and society as a whole would bring significant advantages.

We refer to this specific reform as a ‘sovereign money system’, describing a system in which all money is created by the state.

Briefly, the power to create all money, both cash and electronic, would be restricted to the state via the central bank (such as the Bank of England or European Central Bank). Changes to the rules governing how banks operate would still permit them to make loans, but would make it impossible for them to create new money in the process.

This paper outlines the proposal, including the transition process and responses to common critiques.

A switch to a sovereign money system addresses a large number of problems that would be difficult to address through individual policies:

1. Creating a better and safer banking system

2. Increasing economic stability

3. Reducing the dependence on debt

4. Supporting the real economy

5. More effective monetary policy

6. Better government finances

7. Tackling unaffordable housing

8. Slowing the rise in inequality

9. Improving democracy

Economic Benefits

1. Creating a better and safer banking system

Problem: In the current system, 97% of money consists of bank deposits. These deposits are liabilities of commercial banks, which means that they depend on the health of the bank’s balance sheet. In the event of a bank failure (due to, for example, bad investment decisions), these deposits would become ‘frozen’ and unable to be spent. In the case of the failure of Royal Bank of Scotland, if the bank had not been rescued by taxpayers, millions of customers would have been unable to make payments. This would have had a devastating effect on the real economy, as well as causing panic that could have resulted in a wave of bank failures. In an extreme case this could have resulted in a reversion to a cash-only economy. So the health of our payments system, which underpins the real economy, depends on banks not taking excessive risks, even though risk taking is inherent to banking. Ultimately, it depends on the readiness of the government to intervene when banks fail.

To prevent banks failing and threatening the payments system and real economy, governments resort to high levels of regulation and supervision. However, the complexity of this regulation (such as the 400+ page Basel III or the 8,000+ page Dodd-Franks bill) means that it is certain to be full of loopholes and therefore largely ineffective.

In addition, to prevent runs on banks (which could bring down banks and the payments system), government provides deposit insurance – an £85,000 guarantee on the balance of each individual’s account. But this amounts to the state underwriting the liabilities of private banking corporations. It means that the liabilities of banks are also the contingent liabilities of the state. When a bank fails, the government is faced with liquidating the bank and becoming liable to reimburse all depositors, or injecting capital to restore the bank’s balance sheet (a bail out). It will almost always be cheaper and quicker to bail out the bank than to liquidate it, meaning that no bank beyond a certain size will be allowed to fail. Thus deposit insurance, rather than making the system safer, actually protects banks from the consequences of their own actions, encourages greater risk taking, and therefore makes the system riskier.

Sovereign money as a solution: In a sovereign money system, the payments system (made up mainly of Transaction Accounts) would be technologically and financially separated from the risky investing and lending of banks. The money that is used by the real economy to make payments would exist at the central bank, rather than being liabilities of a commercial bank. This means that even if a commercial bank were to fail due to bad investments, the payment accounts that it administered could easily be transferred to a functioning bank with no loss to the taxpayer or account holders.

This knowledge that banks could be allowed to fail without affecting the payments system means that moral hazard would be reduced. Banks would have an incentive to take lower levels of risk (because there would be no option of a bailout or rescue from the taxpayer). The fact that bank failure would not pose such a threat to the real economy means there would be less need to use complex regulation to protect banks from themselves. Simpler regulation is likely to be more effective in safeguarding economic stability. (Of course the regulator still needs to ensure that there is no fraud or mis-selling of financial products).

2. Increasing economic stability

Problem: Money creation by banks tends to be pro-cyclical. When the economy is improving, banks become more willing to lend. This creates further demand (or house price inflation) which leads to greater confidence about the future health of the economy, and an even greater willingness to lend. But ultimately the ever-higher levels of private debt result in a financial crisis. Postcrisis, banks are unwilling to lend (because they are not sure whether borrowers will be able to repay), and the real economy suffers through a shortage of credit and spending.

In a post-crisis environment, there is a real risk of a ‘debt deflation’ scenario outlined by Irving Fisher, or the ‘balance sheet’ recession outlined by Richard Koo. The higher the levels of private debt following a crisis, the harder it is to recover from the recession.

Sovereign money as a solution: Money creation by the central bank would be countercyclical. In times when the economy is booming, rates of money creation would be reduced, to avoid fuelling inflation. But when the economy is in recession, rates of money creation will be increased to prevent prices from falling, leading to additional spending and boosting the economy. This is likely to lead to a much more stable economy.

In times of recession, households and businesses will be withdrawing demand from the economy by attempting to pay down their own debts. The creation of money by a central bank can offset this shrinking demand.

3. Reducing the dependence on debt

Problem: In the current system new money is created by banks as they make loans. This means that in order to get more new money into the economy (to accommodate economic growth), it is necessary for a household or business to go further into debt. The last few decades suggest that we need the level of bank lending, and therefore the money stock and private debt, to grow faster than GDP in order to produce positive growth in GDP (see for example, Turner, 2014). But other research has shown that rising levels of bank credit (and therefore private debt) tend to lead to financial crisis (see for example Shularick and Taylor, 2009). We therefore have a catch-22 situation:

• To grow our economy, we must encourage further bank lending and further private debt

• But this inevitably leads to financial crisis.

In addition, loan repayments lead to the destruction of money and a fall in the money stock (because they are the reverse process of loan issuance). It is therefore impossible to significantly reduce the level of private debt without simultaneously contracting the money stock, withdrawing spending power from the economy, and potentially causing a recession.

Sovereign money as a solution: In a sovereign money system, the central bank is able to create money that is transferred to the government to be spent into the real economy. No household or business has to borrow in order for this process to take place. This means that the central bank can provide additional spending and demand without relying on households or businesses going further into debt. Consequently, it becomes possible to have economic growth without simultaneously increasing the level of private debt and the risk of a financial crisis.

In addition, the changes made in the transition to a sovereign money system (see part 5) make it possible for debt repayments to be gradually recycled back into the economy in a way that could lead to a significant reduction in private debt levels.

4. Supporting the real economy

Problem: Because most of our money is created as a result of bank lending, the lending preferences of banks determine where new money starts its life in the economy. In practice, this has resulted in the bulk of money going into property markets and to the financial sector. According to Bank of England figures, between 1997-2007, of the additional money created by bank lending, 31% went towards mortgage lending, 20% towards commercial property, 32% to the financial sector (including mergers and acquisitions, trading and financial markets). Just 8% went to businesses outside the financial sector, whilst a further 8% financed credit cards and personal loans. Yet it is only ultimately the last two – lending to businesses and consumer credit – that have a real impact on GDP and economic growth. In short, we have a system where very little of the money created by banks is used in a way that leads to economic growth or value creation. Instead, the majority of the money created has the effect of inflating property prices and therefore pushing up the cost of living.

Sovereign money as a solution: In a sovereign money system, new money is created by the central bank and then spent into the real economy through government spending. Depending on how the money is spent, this will have a much higher impact on GDP and economic activity than the money created by banks. This is primarily because a) it will all be spent directly on activities that contribute to GDP, whereas most bank lending is not, and b) it does not come with the cost of servicing additional private debt, which could act as a brake on spending. This means that the real economy is better supported in a sovereign money system.

5. More effective monetary policy

The Problem: In the current monetary system, the central bank must use interest rates in an attempt to influence the lending behavior of banks and the demand for borrowing from businesses and the public. Lower interest rates are supposed to encourage more borrowing (and so more money creation), and higher rates are supposed to discourage borrowing (so slowing down the rate of money creation). However, this is a blunt and ineffective tool. When money creation fuels house price rises in excess of 10% a year, a small change in interest rates is not going to significantly discourage borrowers, and so will not restrain money creation. In the opposite scenario, when private debt is at historically high levels, dropping interest rates to 0.5% will still not encourage people to borrow more, and so will not lead to more money creation.

In addition, the use of interest rates has negative side effects across the wider economy. Those who borrowed responsibly at a certain interest rate can find themselves in financial difficult when interest rates are raised particularly high in an attempt to dissuade new borrowers. Particularly low interest rates can cause serious complications for the management of pension funds and the savings income of pensioners.

Sovereign money as a solution: In a sovereign money system the central bank has direct control over money creation, so there is no need to exert indirect influence through the setting of interest rates. Interest rates are therefore likely to be more stable than under the current system, and are less likely to reach the extremes seen in recent years. Neither savers nor borrowers have their income arbitrarily increased or reduced as a result of the decisions of the central bank. The direct creation of money, for spending into the real economy, has a direct benefit on those who receive the money but no negative costs on the rest of society (unless excessive money is created and fuels inflation). The direct creation of money is a more targeted tool that will be more effective than the use of interest rates.

6. Better government finances

The Problem: When the central bank or government issue physical cash (banknotes or coins), the proceeds from creating that money are added to the government budget. However, this only applies to the 3% of money that exists in physical form. The remaining 97%, being electronic bank deposits issued by the banks, generate no seigniorage for the government. In practice, the seigniorage from creating bank deposits goes to the banking sector, and acts as a hidden subsidy, whilst being a significant loss of potential revenue for the government.

In addition, the instability caused by credit bubbles is a significant factor in soaring levels of public (national) debt. The UK national debt has more than doubled since the start of the financial crisis, predominantly due to the fall in tax receipts and the rise in unemployment benefits that followed the crisis. The costs of crises caused by money creation by banks are passed back onto the taxpayer.

Sovereign money as a solution: Because all money – physical and electronic – would be issued by the central bank in a Sovereign Money system, the proceeds on creating electronic money would go to the Treasury. This could be a significant addition to government budgets.

In addition, the greater economic stability of a sovereign money system means that there is much lower risk of recessions leading to high deficits, and therefore the national debt would be lower and more stable.

Social & Environmental Benefits

7. Tackling unaffordable housing

Problem: Around a third of the money created by banks goes towards mortgage lending (and a further significant proportion goes towards commercial property). This creation of money to buy pre-existing assets (i.e. houses in limited supply, and the underlying land which is in fixed supply) leads to prices rising. Rising house prices make banks even more confident about lending further amounts for mortgages (since rising prices mean that they are unlikely to lose money even in the event of a default and repossession). This becomes a highly pro-cyclical process, leading to house price bubbles.

Sovereign money as a solution: There is a need for a number of policy and tax reforms to address the problem of unaffordable housing (particularly in the UK). However, removing the ability of banks to create money will remove much of the fuel for house price inflation. House prices that rise at a lower rate than growth in wages will mean that housing becomes more affordable over time.

8. Slowing the rise in inequality

Problem: House price bubbles have the effect of transferring wealth from the young to the old, and from those who can get on the property ‘ladder’ and those who cannot. This is a significant channel through which wealth inequality is further increased.

Furthermore, the fact that the nation’s money supply must be borrowed from banks means that we are having to pay interest on the entire money supply. Household income data surveys show that this has the effect of transferring income from the bottom 90% of the population to the top 10%. (See Chapter 5 of Modernising Money for further details).

Sovereign money as a solution: As discussed above, removing the ability of banks to create money should have a dampening effect on house price rises, which in turn will reduce the rate of growth in wealth inequality. The creation, by the central bank, of money that has no corresponding interest-bearing debt, means that there is a stock of money that is effectively ‘debt free’, and no need for members of the public to borrow simply to ensure that there is money available in the economy. The resulting lower levels of private debt will mean that less interest is paid overall, and therefore less income is transferred to the top 10% of the population. Again, this will slow the rate of growth in inequality.

9. ENHANCING democracy

Problem: When banks decide how quickly they want to grow and what areas of the economy they want to invest in, they effectively also decide how quickly the money stock will grow and how newly created money will be spent. This control rests ultimately with those who set each bank’s strategy i.e. the board directors and senior leadership. Consequently a very small number of people (around 80 board members across the 5 largest UK banks) make decisions that shape the entire UK economy, even though these individuals have no obligation or mandate to consider the needs of society or the economy as a whole, and are not accountable in any way to the public. This appears to be a major democratic deficit.

In addition, because banks are currently the only source of new money into the economy, this puts government into a position of dependency on the banks. Any attempt to impose regulations or reforms to the banking system are met with the threat from the banks that this will limit their ability to provide credit and therefore harm the economy recovery.

Sovereign money as a solution: By removing the power to create money from the banks, and returning it to the state, democratic control is restored over money creation. The Money Creation Committee, which makes decisions on how much money to create, would be highly transparent and accountable to parliament. The decision on how to spend the money created will be taken by government (just as they take decisions on how to spend all tax revenue).

In addition, because the central bank can directly supply additional money to the economy, we are no longer dependent on bank lending to fuel economic growth. This significantly reduces the political power of the banking sector.

This was an extract from the paper Creating a Sovereign Monetary System