Reform 101: Why do we want to redefine money? (Post 1)

There are a number of problems with our current monetary system, in which the vast majority of money is created by banks, when they make loans. At Positive Money we try to unravel the issues related to money creation and raise awareness about them. In doing so we hope to arm everyday people with the necessary means to campaign for change. So today I thought it would be worth highlighting one of the major benefits to the Sovereign Money system, and explain one of the primary reasons as to why we want to redefine money.

In proposing a Sovereign Money system, we are effectively seeking to withdraw the power to create money from private banks and return it to a public body (i.e. the central bank). We ultimately want to redefine money, so that it is no longer created as debt by private banks. This is primarily because under the current system, money exists as both private debt and a means of payment. At Positive Money we want to decouple money as a means of payment from the credit system.

Different Types of Money

In the current system, 97% of money consists of bank deposits while the other 3% is made of coins and bank notes issued by the Royal Mint and the Central Bank. There are also central bank reserves, which are a type of electronic money, created by the Bank of England. Central bank reserves, notes and coins are considered the safest forms of money.

Central bank reserves are what commercial banks use to make payments amongst themselves – they are considered the final means for settling payments. Only banks have access to central bank reserves, which hold an account at the Bank of England. Since everyday people do not have access to central bank reserves, the final means of settling payments, they are not considered part of the money stock.

Bank deposits are liabilities of commercial banks. They are effectively promises by the bank to make payments on behalf of the customer in cash or central bank reserves. These promises to pay can take two forms:

1) A promise to pay their customers the value of their deposit in cash upon demand. For example, your bank promises to provide you with cash when you want to withdraw it from a machine.

2) A promise to settle a payment, due to some form of transaction (generally electronic), on behalf of the customer. For instance, when you buy a coffee using your debit card, your bank will settle this payment for you using central bank reserves – and deduct the corresponding amount from your balance. Deposits are the promises by banks to continue settling these payments on behalf of the customer until the value of deposit is reached.

Some Important and Interesting Points

Accordingly, the deposits created by private banks do not represent money that the depositor actually owns. Deposits only represent a legal obligation on the part of the private bank to pay you cash when you wish to withdraw it, or to make a payment on your behalf using central bank reserves when you want to make a transaction. Thus, legally speaking you don’t actually own the money paid into your bank, you have a legal claim to it and the bank has a legal obligation to provide you with cash and settle payments on your behalf.

This means that those of us with bank deposits are actually banks’ creditors. More interestingly, in this country if you want a legal job you generally have to have a bank account. This legally means that if you want a job, you have to become a bank’s creditor.

It also means that the general public does not have direct access to central bank reserves, the safest form of electronic money. Instead, we are required to use a form of electronic money that is not 100% safe: we are required to use money created by banks (which is effectively a promise to pay central bank reserves on our behalf).

Accordingly, as Keynes had recognized, banks are able to create as many deposits as they please so long as they did so in step. This is due to the fact that reserves are used as a final means of settling payments amongst banks themselves. Only banks and building societies have access to Central Bank accounts, meaning reserves cannot leave the system. If banks create large amounts of broad money in step, then the payments between them will cancel out, the net settlements between them will remain the same, and no additional reserves will need to be injected into the system. In this system, it is a mathematical certainty that if one bank is experiencing a shortage of reserves, another bank will have a surplus. As long as the banks with the surplus are willing to lend to those experiencing a shortage, new deposits can be continuously created.

The Dangers to the Payment System

Because 97% of our money stock consists of private banks’ promises to pay, our current monetary and payments system depend on the health of the bank’s balance sheet. If a bank were to fail (i.e. due to poor investment decisions), these deposits would become ‘frozen’ and could not be spent or used to settle payments. Thus, if taxpayers had not rescued the Royal Bank of Scotland, millions of customers would have been unable to make payments. If RBS customers could not make payments, this would eventually prevent customers of other banks (dependent on the payments from RBS customers) from also making payments. Not only would this have a profound impact on the real economy, but also it could have caused panic and potentially prompted a cascade of bank failures.

The point here is that the health of our payments system, which underpins the real economy, depends on the lending decisions and risk taking of private banks, (even though the more banks lend and the more risks they take the more potential profits they can make). Accordingly, the success of the current monetary system is ultimately dependent on whether the government intervenes when banks fail.

Moral Hazard, Deposit insurance, and Too Big to Fail

In the meantime, to stop banks from failing and threatening to wreck the payments system and devastate the real economy, the government tries to regulate the banking system. Yet, the complexity of this regulation (for instance, the 400+ page Basel III or 8,000+ page Dodd-Frank bill) means that there is space for loopholes and regulation is often extremely ineffective (for more on the ineffectiveness of regulation click here).

On the other hand, the government offers deposit insurance – an £85,000 guarantee on the balance of every individual’s bank account – to stop runs on banks (which could trigger a collapse of the payments system). This however means that the state is effectively underwriting the liabilities (promises to pay) of private banks – implying that the private banks liabilities are also the contingent liabilities of the state.

The government does not have many options when a bank fails. It can either liquidate the bank, a long and tedious process that could prompt a number of problems, not to mention the government would in effect become liable to reimburse all depositors. Or it can inject capital to restore the bank’s balance sheet (bailing it out). It will be cheaper, faster and less problematic to bail out the bank then to liquidate it and reimburse deposits (effectively passing the losses onto taxpayers). In essence, banks beyond a certain size become too big to fail.

Deposit insurance and too big to fail give banks a layer of protection from their respective actions. This system allows for profits to be privatised but losses to be socialised. It thus engenders a certain level of moral hazard, where banks take on more risk knowing that someone else will bear the burden of those risks.

Redefining Money to Protect the Payment System

The Sovereign Money system proposed by Positive Money seeks to change the nature of money, so that it no longer takes the form of bank liabilities created when banks issue loans. This would separate the business of lending and providing credit from the business of providing a payment system.

We would do this by separating investment (savings) accounts from transaction (current) accounts. Instead of having current accounts with money that is composed of uncertain promises to pay issued by banks, such accounts would hold risk-free central bank money. This means a Sovereign Money system would give people the option of directly holding the safest form of electronic central bank money (currently unavailable to the public). If the customer’s bank were to fail, the money in the current account would still be safe and the customer could still access it and spend it.

Customers that made their money available for lending in an investment account, would need to wait while the bank was liquidated in order to get their investment back. Payments could only be made via a current account and not an investment account.  Accordingly, it would not be necessary to bail out an irresponsible bank in order to protect the payment system, thus the payments system would not be jeopardized when a bank fails.

Letting banks fail will allow regulation to be simplified and deposit insurance to be removed. This results in a removal of the subsidy to banks and the moral hazard that is associated with it. The knowledge of potential failure and insolvency should encourage banks to take less risk, hopefully leading to more cautious lending activity and less potential for asset price bubbles (although the recent crisis has shown that we shouldn’t expect banks to pay too much attention to what’s good for them in the long-term.)