Let's Not Pussyfoot Around with the Banks

There is a simple fact about the UK banking system that is both profound and mundane. It is also little known, and yet the source of much hyperbole, according to Tony Greenham, Head of Finance and Business at nef (New Economics Foundation)

What is this simple fact?

Commercial banks create new money.

This statement often seems to have a strange effect on people, either sending them down to St Paul’s with a Guy Fawkes mask and a tent, or backing away from you in horror as if you had just blasphemed in front of the Pope.

I really don’t know why, because it is merely a description of how fractional reserve banking allows banks to expand “broad money”, or bank deposits, when they create new credit. This is really the whole point of fractional reserve banking. Indeed, the ability to create new money in this way to finance investment and growth in consumption was arguably a major factor behind the successful industrialisation of nations, the UK being first and foremost among them.

So if you are not happy with the statement “banks create money” I hope you will read our new book Where does money come from? which has been endorsed by Professors Charles Goodhart and David Miles, former and current members of the Bank of England Monetary Policy Committee respectively.

The real questions should be: “Is this a problem? And if so, is there any sensible alternative?”

I think it has become a problem. The proportion of the money supply created in this way has shifted considerably over the past decades to reach 97 per cent, while the Bank of England’s control over this process is in reality minimal, or at least ineffective.

The result is asset-price inflation and a highly unstable financial system. The system reinforces booms, leading inevitably to credit bubbles, and reinforces the subsequent bust, leading to a credit crunch in particular for SMEs.

Another nasty consequence is that the creation of new money is privatised, but its exchangeability is guaranteed by the state – that’s you, the taxpayer of course – leading to the calamitous moral hazard spoken of by Mervyn King, and the inevitability of publicly funded bail-outs of private losses.

So what can be done to improve matters?

One approach is to go the whole hog and properly privatise money – broadly speaking the approach of the Austrian school of economic thought represented by Hayek.

There would be no state backing of bank deposits or banks, who would compete on their creditworthiness and reputation to ensure that their bank deposits were accepted by other banks.

Theoretically this should get taxpayers off the hook and, one would hope, restore market discipline to bankers. However, it is not clear that it would stop the boom and bust cycle.

Everyone seems creditworthy in a boom.

And as the credit crunch demonstrated, everyone looks like an unacceptable risk in a banking crisis. In this event, would it be credible to imagine that the central bank could sit by and watch large swathes of banks close their doors imposing potentially huge losses on their customers?

Another approach is to properly nationalise the control of Sterling.

Give the central bank not just control over interest rates, but closer control over the quantity of new credit created by banks and its sector allocation – a sort of Project Merlin with teeth. This should improve the Bank of England’s control over inflation and stability. Credit control, or sometimes less formal guidance, is a feature of many country’s monetary systems including the UK up to the 1960s.

A more radical variation is to remove credit creation powers from banks entirely.

Banks would then offer two sorts of account:

First, a payment and safety deposit account (think paypal, but backed by the Bank of England).

Second, an investment account where funds are actually transferred to borrowers (think Zopa or stockbroker). This is sometimes referred to as “full-reserve banking”.

Key to this would be an acceptance by customers that if the bank’s lending was poor, that they could actually lose money on their investment account. Radical perhaps, but surely the alignment of risk with reward is at the heart of a free market system, so why should we expect risk free returns on our savings if they are being lent to businesses or individuals who might never repay?

Finally, we could have a multi-currency world where Sterling is used alongside local currencies issued and controlled by local banking institutions. Local currencies increase the local money multiplier effect that can support jobs and business is less wealthy areas. National and international currencies would remain the payment medium of choice for national and international transactions.

Pie in the sky? Not really, because each of these four suggestions have more or less operated successfully around the world in the past, including in the UK. As we watch the continuing debacle of chronic financial crises unfold, isn’t it time to ask some more fundamental questions about our money system?