Detlev Schlichter on Positive Money: A Response

Detlev Schlichter has written a thought-provoking and critical piece on Positive Money’s analysis here. Schlichter is very clear on the workings of the current monetary system and the process by which money is created, which is rare amongst many economic commentators in the press:

Most of what we use as ‘money’ today is deposit-money and thus an item on a balance sheet of a bank. This form of money has come into existence through the banking system’s lending activities, i.e. through fractional-reserve banking.

Banks, for as long as they have been around, have never only just channeled saved funds into investments, such as fund management companies do today. Banks have always also been in the business of creating money derivatives (or fiduciary media), that is, financial instruments that are treated as money proper by the public (usually because they were issued with a promise of instant redemption in money proper), and thus circulate in the economy next to money proper. This process allows banks to fund a portion (and potentially a large one) of their lending through their own issuance of money derivatives, although today hardly anybody even distinguishes any longer between money proper and bank-created money derivatives. In a way, it can be said that the banks extend loans by drawing cheques on themselves and having these cheques circulate in the economy as money (and in the hope that they won’t be cashed!). These ‘cheques’ used to be the banknotes of the olden days, when banks were still allowed to print them, today there are deposit money, items on a bank balance sheet, like your current account balance.

And points to some of the problems with the current monetary system:

Let it suffice to say that the extra money created by banks lowers interest rates on credit markets and expands the supply of investible funds beyond the volume of available true savings. Thus, investment and saving get out of line, misallocations of capital ensue, and what appears like a solid economic expansion for a while is ultimately revealed as an artificial and unsustainable credit boom that will end in a recession. Sustainable growth requires investment funded by proper saving, i.e. by the voluntary reallocation of real resources from present consumption to future consumption (that is saving). Bank credit expansion creates a dangerous and fleeting illusion of the availability of more savings, which means more resources for investment projects that are in fact not there.

Schlichter highlights 4 ideas that he describes as fallacies. For clarity, the first two do not actually represent Positive Money’s position:

• The idea that the charging of interest, or in particular the charging of interest on money, is a fundamental problem in our financial system.

There are monetary reform groups that object to the charging of interest, and the charging of interest is prohibited in Sharia (Islamic) finance. But we don’t see the charging of interest as a problem per se. However, when almost the entire money supply is issued as liabilities of banks when they make loans, there is a stock of debt equivalent to the stock of money, and analysis that Graham Hodgson (a researcher for Positive Money) has done using household income and expenditure surveys from the ONS and other official sources has shown that the payment of interest on debts to banks leads to a net redistribution of income from the bottom 90% of the population to the very top 10%. This redistribution would be less severe in a monetary system where the money supply is not issued as debt, simply because there would be a lower stock of debt to pay interest on.

• The notion that there must be a systematic shortage of money in the economy because banks, through fractional-reserve banking, bring into circulation only amounts of money equivalent to the principal of the loans they create but not the necessary amount to pay the interest on these loans.

This idea is common in American monetary reform videos and intuitively easy to grasp, but almost certainly wrong. The story usually starts with a banker with a chest of gold coins on a desert island, lending 10 gold coins to the people of the island and demanding 10% interest. At the end of the year, the people owe 11 gold coins, but only have 10, so must borrow the 11th from the banker. This simplistic story is then extended to suggest that every year, the money to pay the interest on debt must also be borrowed from the banks. But the story ignores the reality of banking; that the interest paid to banks is spent back into the economy through salaries for staff, rent for branches and offices, corporation tax etc, and can be used to pay further interest. The reality is much more complex than the story on the desert island, although we don’t have space to go into it here.

• The notion that it is a problem that money-creation is tied to debt-creation (again, as a consequence of fractional-reserve banking) and that it would be possible and advantageous to have the state issue money directly (debt-free) rather than have the banks do it.

This is certainly our position, for all the reasons discussed on this website and in Modernising Money.

• The idea that schemes are feasible that allow the painless shrinkage or even disappearance of the national debt.

We write in Modernising Money and this free plain English guide to the reforms why paying off the national debt through money creation is not a good idea and should be avoided. Unlike some commentators, we’re certainly not arguing for measures that would allow governments to continue wasting money without restraint. Governments need to start making hard choices, and in particular it would be a delight to see the US Federal Government faced with a hard spending constraint that would mean they either provide for their own citizens or continue spending 7 times more on the military than they spend on education (and face the political consequences of choosing the second option).

Schlichter disagrees with our approach of removing the ability of banks to create money:

Fallacy 1: As fractional-reserve banking is a source of economic instability, it would be better to force the banks to become fully-reserved banks with no ability to create money, and have the state create all money directly and inject it – wisely – into the economy. This would allow us to enjoy the benefits of more money without suffering the disadvantage of more debt. We may even use this process to reduce or eliminate existing debt.

This is an accurate description of our position. However, I would question the use of the word ‘wisely’. We’re not naive enough to believe that government will invariably spend newly created money wisely; newly created money would be wasted in the same way that much tax revenue is currently wasted, but the important thing is that the money ends up in the hands of the public, in the real economy, where it can be used to allow trade to take place, rather than being injected into property bubbles and financial markets, as currently happens with bank-issued money.

Schlichter describes these proposals as “resolutely anti-banking”, yet in reality we see a valuable role for banks as intermediaries (middle men) between savers and borrowers. We simply don’t think they should also have the privilege of being able to issue the money (bank deposits) that is used by the rest of the economy to trade. This is a huge subsidy to the banking sector, and a privilege which does not extend to the rest of the investment industry (who have to raise every pound they want to invest, and cannot acquire interest bearing assets simply by creating new liabilities (bank deposits) on their balance sheet. We’re simply asking that banks operate in the same way as the rest of the (rather successful and profitable) investment industry.

“Neither Benes/Kumhof [authors of the IMF working paper, the Chicago Plan Revisited] nor Positive Money provide a single economic argument to support the claim that the state is a superior guardian of the privilege of money creation.

This is quite simple. Banks have completely one-sided incentives to over-issue new money, because the more they issue by lending, the more interest-bearing assets they own, the more interest they will collect and the greater their profits will be. So of course banks cannot be relied on to be restrained with their power to create money.

Politicians would be no better custodians of the power to create money; a couple of years prior to every election we would see the power to create money being abused to stimulate an artificial boom.

So since we cannot trust either banks or politicians, who do we rely on to manage the power to create money? Positive Money suggests it should be a public and transparent body that is given the job of increasing the money supply only when inflation is low and stable. If inflation starts increasing, then this body or committee should stop creating money.

Contrast this to the current situation, where, when inflation rises, banks see it as a sign of an improving economy, and decide to increase their lending, creating even more money in the process, and fuelling even more inflation.

The choice then, when it comes to money creation, is between placing it in the hands of:

1. Banks, who believe that they will maximise their profits by increasing their lending and therefore have the incentives to increase the money supply by as much as possible (subject to some loose concerns about risk management)

2. Politicians, who have the incentive to abuse the power to create money to create artificial booms in the economy prior to elections.

3. A public body whose role and remit is to increase the money supply only if inflation is low and steady, and to stop increasing the money supply as soon as that increase starts to cause inflation.

4. Or the ‘free market’ – a fourth ‘custodian’ of the power to create money, which we’ll discuss in a later article.

State support for the current monetary and banking system 

Schlichter puts forward the idea that rather than banning ‘fractional reserve banking’, we should instead remove all the state support for the current banking system?

If fractional-reserve banking is disruptive – and I agree with Positive Money that it is – should we not – as a first step and before we even consider such authoritarian measures as universal bans – take away the state-run support system for fractional-reserve banking by which the banks and their clients are systematically shielded from the consequences of their activities, and through which the true costs of fractional-reserve banking are persistently being socialized?

This is a common argument, that without all the state support from the Bank of England, from taxpayer-funded deposit insurance (the £85k guarantee on the money in your account), and other government support, such as bailouts, the ability of banks to create money would have been curtailed much sooner. We agree. In fact, we wrote in the conclusion of Modernising Money that:

The privileged, protected and subsidised position that banks hold is not a law of nature or economics. Banks only exist in the form they do today because of countless government interventions throughout history to save them from their own worst excesses. With each failure the banks have benefitted from some new guarantee or concession designed to patch up the system and get back to business as usual, be it deposit insurance after the crisis of the 1930s or the lender of last resort function after the Overend Gurney panic in 1866. Each crisis thus strengthens the remaining banks and protects them from their previous excesses, setting the stage for even bigger crises in the future.

But is removing the safety net from banks a feasible way of fixing the system? We don’t think so. We’d like to see the safety net removed, but no government will voluntarily do so as long as banks operate in the way they current do, and as long as 97% of the money supply consists of liabilities of banks that are, in all probability, bankrupt.

Our proposal of removing bank’s ability to create money and then requiring them to operate on a model of banking often referred to as ‘full reserve banking’ (which again, can be a misleading term) is a way of removing the safety net and making it possible for banks to be forced into the free market and allowed to fail when they screw up.

Detlev’s approach of withdrawing the safety net from under the existing banking system is one that no government will ever opt for. And regardless of how much some people would prefer to have little or no government, the reality is that in the absence of a complete breakdown in the monetary system, it is still the government that will make decisions like this.

Positive Money’s account of fractional-reserve banking makes it appear as if the state and its agencies were simply innocent and powerless bystanders in the business of money creation, rather than active promoters of and eager and indeed indispensable accomplices in the exercise. Positive Money creates the impression that bloated bank balance sheets, real estate bubbles and excessive debt levels had all been created by scheming and out-of-control private banks, entirely on their own accord and behind the back of an unwitting and clueless state, rather than constitute the inevitable consequences of an institutional framework built on the widespread belief that constant bank credit expansion is a boon to the economy.

This is a fair criticism. We could give more emphasis to the fact that it is successive rounds of politicians, regulators and central bankers who bear a lot of culpability for allowing the banking and monetary system to develop in this way. The current lack of any original thinking on ways to reform the monetary system has seen taxpayer money and the power of the Bank of England used to preserve a monetary and banking system that is hugely harmful to the economy and society. Our work is trying to show that the current structure of banking is not the only option, and to dispel the idea that ‘constant bank credit creation is a boon to the economy’.

The truth is that the state, beholden to the generally accepted fallacy that cheap money – and even artificially cheapened money- is a source of prosperity and that we should never allow credit contraction or deflation, has actively supported the gigantic money creation of recent decades. Without an essentially unlimited and ever cheaper supply of bank reserves from the state central banks, private banks could never have expanded their balance sheets so aggressively and issued such vast amounts of deposit money.

No arguments here.

Or, to put this differently, had the state wanted to stop or restrict the creation of deposit money by the banks at any point, the state – in form of the central bank – could have done this at the drop of a hat. Restricting the availability of new bank reserves and/or making bank reserves more expensive would have instantly put the brakes on fractional-reserve banking.

Doubtful. Both Where Does Money Come From? and Modernising Money explain why the Bank of England no longer has the ability to control the money supply through the control of either the quantity of central bank reserves, or even through control of interest rates.

Positive Money evidently fails to appreciate the role of state institutions and government policy in the present process of money creation or it would argue much more simply and straightforwardly for the voluntary restriction or abandonment of these policies first, and it would be less eager to hand full control over monetary affairs to the state.

We’re well aware that the current state support is essential to allow banks to create money in the way they do. What we are arguing for is an alternative model that does not allow banks to create money and therefore does not need that state support. Withdrawing the state support for the current monetary system is not a politically feasible option, so arguing for it would be a waste of time and energy.

We’ll address Schlichter’s further points in a later article.