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

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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.)




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Frank Van Lerven

Frank is our Research and Policy Analyst, and is responsible for our research on current events. Frank also leads our research in Public Money Creation and Quantitative Easing. Prior to working on the availability of credit under a Sovereign Money system, Frank also researched issues related to the 1844 Bank Charter Act and its implications for contemporary monetary policy. With a Research Master’s in Advanced Political Economy (cum laude) and a BA in African Development Studies, Frank is especially interested in how Western financial systems (and models) influence developing economies.
  • Kiril Mihaylov

    1 point to make – money is created by central banks and coommercial banks ..both is created as debt ! not only commercial banks …. central banks are also private and loan money to governments at interest …. you have to look how Federal Reserve works !!!

    • jamesmurraylaw

      Fair point Kiril.

      Not a PM expert but there is a difference between a debt a State owes to the private bank system and its own central bank.

      With the first the loan has to be paid back at the end of the term of the bond and interest paid during that term.

      With the second, PM holds that the bond is created by the Treasury as non-interest bearing and with no redemtion date.

      It is then ‘bought’ by the Bank of England by it creating the fixed loan amount as a credit entry in the Treasury’s B of E account for the Treasury then to spend as it wishes.

      The ‘debt’ entry is then held against the Treasury by the Bank but as it is wholly owned by the Government, the Treasury never has to pay back the capital on the Debt as it is merely a note in the accommodation units with nothing more than notional importance.

      Thus, the ‘loan’ does not increase the National Debt, and has no other effects other than the money amount is then able to be spent into the economy as the politicians decide.

      So, completely different from the government bonds sitting in the asset columns of the balance sheets of the private banks….

      • RJ

        “by the Bank of England by entering the amount of the bond as a credit entry”

        No a DEBIT entry. The bond held by the BoE is an asset = a debit. The credit is to a bank

        Example when a bond is bought back from Lloyds or a Lloyds customer
        DEBIT Bonds asset account
        CREDIT Lloyds reserves held account

        This BoE credit is a Lloyds reserve debit asset and a treasury credit DEBT liability

        1 A financial ASSET held by one party always without exception equals a DEBT LIABILITY held by another party.
        2 The options are for debt to be held by the BoE or the market. Held by the BoE makes the non Govt sector poorer as they miss out on interest income.
        3 But are classified as Govt debt.

    • RJ

      Reserves (the banks and treasuries money) is created by the BoE.

      Bank credit (our money) is not created by the BoE. But the BoE can create reserves to buy bank credit. And does whenever a Govt pays someone.

      And all money is created as debt. Notes and coins are only a token to represent bank credit. We could get by without them today due to massive technology improvements but could not have in the past. Hence why they were used.

      • Kiril Mihaylov

        actually you are wrong ! money in its physical form is created from BOE ….. it also sets the requirements for minimal bank reserves at BOE ….. so the bankks keep Minmum reserves at BOE …. usually 10 % but may be less …at least in USA is 10 % … in Europe is 2 % ….. I don’t know how much in UK ….Central banks also lends money to goverments at interest ! also sets benchmark interest rate which the commercial bank use to charge interest on their clients ….so basicallyy tho whole financial system is run by BOE …the commercial banks as well …. people need to wake up how central banks work !!! only a small lnubmer of people understand the whole system …….

        • Barney Rubble

          As much as I like you disagreeing with RJ, you are partially wrong (in my opinion central bank money is equity, so does the head of research at the BOE – but I’ve seen RJ’s trolling abilities, so lets agree to disagree)…

          I would really suggest, in the kindest way possible, that you dont go around saying that people need to wake up to how central banks work, when you aren’t sure about reserve requirements in the UK – THERE ARENT ANY…Also if the benchmark interest rate had any influence over the real economy they wouldn’t currently be at zero…also the rates central banks set are used to control what rate commercial banks lend settlement assets to each other…finally, the BOE is a public institution and so are the majority of other central banks – so the BOE cannot lend money to the treasury at interest, as the interest payments just go right back to the treasury…

          We clearly all have a lot to learn…

          • RJ

            “central bank money is equity”

            NB. Equity is a credit side of a journal entry except when a company makes a loss. Then the loss is debited to the Equity / SHF’s account.

            So equity to whom.
            1 The UK Banks like Lloyds etc. It most definitely isn’t. It’s the banks asset

            2 The BoE. No. Its treated as a liability.

            3 The treasury. No

            Central bank money is treated as bank credit money is. (I assume your HoR thought Bank Equity = Assets – Liabilities. It does of course but calling reserves Equity is very misleading. Everything in a banks balance sheet could be called Equity)

          • Barney Rubble

            Our current HoR at the BOE was actually making reference to the United States. He wrote the paper whilst working at the IMF:

            “In this context it is critical to realize that the stock of reserves, or money, newly issued by
            the government is not a debt of the government. The reason is that fiat money is not
            redeemable, in that holders of money cannot claim repayment in something other than
            money. Money is therefore properly treated as government equity rather than
            government debt, which is exactly how treasury coin is currently treated under U.S.
            accounting conventions (Federal Accounting Standards Advisory Board (2012)).

          • RJ

            The HoR should know better.

            Coins are treated as equity today only because the credit entry is treated as revenue / equity due to an estimate for the $ value of LOST MONEY. This was accepted by the accounting profession.

            But quite rightly notes are not treated as revenue / equity as there is no reason why they should be and good reason why they are not
            – Note holders record or treat notes as a financial asset. A rule of standard accounting practice today is that financial assets held by one party must equal a financial liability held by another one
            -The Govt does have a debt for these notes as they can be exchanged for a tax write off. In others words an otherwise worthless piece of paper can be exchange for a Govt asset (tax owing). So this is not correct.
            “holders of money cannot claim repayment in something other than
            Holders can also exchange money (notes and coins) for a tax write off. That is only reason notes and coins have value.

          • solutrean

            RJ, you say “Holders can also exchange money (notes and coins) for a tax write off. That is only reason notes and coins have value.”

            Payment of taxation is only one reason why notes and coin have value. Possibly even more important is that notes and coin, and also bank money can be exchanged for goods and services in the real economy. In my opinion this is what gives money its value.

          • Adrian

            But if there was no tax value, who would want to accept bank money as payment for goods and services? This is why Bitcoin is hard to value, and it presumably has no value at all if it stops circulating.

          • solutrean

            I said that payment for taxation was not the ONLY reason why money has value Adrian. Anything widely accepted as payment IS money.

            In wartime prison camps, cigarettes were often used as a medium of exchange, therefore they were a form of money that could be used to purchase the limited amounts of goods and services that were available in the camp. Apparently the cigarette economy functioned very well even though they were not used for the payment of taxes.

          • Kiril Mihaylov

            all of you is wrong !!! even Postive money is wrong ! but that’s somthing normal … 98 % of the world population does not understand how the banking and fiancial system operates !

            money is debt – it is vreated out debt through governement bonds issues by the governments to the central banks which buy them !!! so basically money is created from central banks not goverments ! you need to leran this – it is very important !!! commercial create only credit money – debt money in 90 % ot world money suppluy the other 10 % is created by CENTRAL BANKS !!! as debt to goverments !!! Also CBs manipuate curerencies and interest rates !!! check how banking system work … all of you are wrong …. what you say it has nothing to do with reality !!!!!!

          • RJ

            ??? Strange post. And you are confused about this subject. Money is not debt but it is backed by debt. For example when banks loan money
            DEBIT Bank loan (bank asset our debt)
            CREDIT Bank credit (our money / bank liability
            So our money is backed by someone else holding a debt liability but money is not debt.

            And you haven’t a clue what the central banks do and how they relate to a Governments or the banks.

          • Kiril Mihaylov

            you don’t understand central banking !!!

          • Kiril Mihaylov

            nope ….central banks are private entites !!! even Federal Rserve i US which the most powerful financial instituition is private ….. BOE is also private although they are trying to make it look state-onwed ….it is not !!!

  • bajupebillano786

    Suppose with Corbyn’s victory, Positive Money could get heard within the Labour party regarding getting a monetary commission set up. Both Corbyn and John McDonell the new shadow chancellor would be sympathetic to the idea.

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