Would a Positive Money system be inflationary?

When we suggest that the state (or the Bank of England) should be allowed to create new money, some people automatically react with the suggestion that this would cause inflation. Indeed, the most common misguided criticism of the type of reform that we are proposing is that it will cause significant inflation, as an irresponsible government prints as much money as it requires for its own needs.

[sws_grey_box box_size=”527″] HOW WELL HAS THE CURRENT SYSTEM PREVENTED INFLATION?    Between 1970 and 2010, the banks have been inflating the money supply by an average of 11.5% per year. While consumer prices have only experienced low levels of inflation during this period, the housing market has experienced significant levels of inflation. Indeed, between 1990 and 2007 house prices almost tripled! [/sws_grey_box]

There is absolutely no risk of this happening under the Positive Money proposals. Decisions on changes in the money supply will be made not by vote-seeking politicians but by an independent body (the Money Creation Committee); politicians will have no influence whatsoever in the amount of money that will be created.

The Money Creation Committee will be instructed to consider the needs of the economy as a whole in deciding how much new money should be injected into the economy. The needs or desires of the elected government do not factor in this decision at all. In fact, the members of the MCC could be expressly forbidden from considering political matters or the intentions of the current government in making the decision.

Deciding how much money to create: The Money Creation Committee (MCC)

The decision over how much new money to create would be given to an independent body, to be known as the Monetary Creation Committee. As is the case today, the target of monetary policy will be the rate of inflation. However, in line with democratic principles, if Parliament deems targets other than price stability to be more desirable, it will have the ability to change the MCC’s mandate.

In deciding the amount of money that would be added or removed from circulation, the MCC would broadly aim to change the growth rate of the money supply in order to keep inflation at around the 2% a year target. Creation of new money by the MCC will increase the amount of spending in the economy. Depending on the state of the economy at the time, this may push up the inflation rate. If inflation is above the target rate, then it is unlikely the MCC will choose to further increase the money supply.

Note that the MCC’s decision will be based on the amount of additional money they consider necessary to meet the inflation target. Under no circumstances would they be creating as much money as the government needs to fulfil its election manifesto promises.

With the MCC having direct control over the amount of money in the economy, the Monetary Policy Committee at the Bank of England would no longer be needed and could be disbanded. Currently the Monetary Policy Committee attempts to control bank lending – and therefore the quantity of broad money in the economy – by influencing the interest rate at which banks lend to each other on the interbank market. Post-reform, central banks would have direct control over the money supply and so there would be no need for them to set interest rates. Instead, interest rates would be determined by the markets.

The Money Creation Committee will have no control over how the newly created money is used. Whilst the way the money is used will determine to some degree its effect on inflation, giving the MCC any influence over how the money is spent would introduce a conflict of interest, whereby its members might find that their judgement is swayed by their opinion on the government’s policies and projects. In order to prevent this conflict of interest from arising, and to ensure that the MCC does not become politicised, the decision over how much money is created and what that money is used for must be taken by separate bodies.

[sws_grey_box box_size=”527″]Appointments and neutrality of the MCC

The MCC must be politically independent and neutral, just as the Monetary Policy Committee (responsible for setting interest rates) is today. As well as being shielded from the influence of vote-seeking politicians, it is essential that the MCC is sheltered from conflicts of interest and lobbyists for the banking sector and other industries. Building on the rules that currently cover the Monetary Policy Committee’s transparency and accountability, all increases in the money supply will be made publicly known. In addition, while the MCC will not be answerable to the Chancellor of the day (who will likely have his own political objectives to achieve), they will be accountable to a cross-party Parliamentary Group, such as the Treasury Select Committee.

Appointments to the MCC will automatically include the Governor and two Deputy Governors of the Bank of England, as is the case with the Monetary Policy Committee today. Likewise the Governor is still best placed to recommend the two internal members of the committee. However, unlike today, where the internal appointments are referred to the Chancellor of the Exchequer for approval, under the reformed system these internal members will instead be referred to a cross party group of MPs for approval. The intention is to provide democratic oversight and scrutiny of the appointment process by Parliament while reducing the powers of the Chancellor. Likewise, for the same reasons, the appointment of the four external members of the MCC will also be decided by a cross party group of MPs. In total, the MCC will be made up of nine members, which, with the exception of the Governor and the Deputy Governors, will serve three-year terms. [/sws_grey_box]

How the Money Creation Committee would work

Each month, the Money Creation Committee would meet and decide whether to increase, decrease, or hold constant the level of money in the economy. During their monthly meetings the MCC would decide upon two figures:

1. The amount of new money needed in order to maintain aggregate demand in line with the inflation target (similar to the setting of interest rates today), and;

2. The amount of new lending needed in order to avoid a credit crunch in the real economy and therefore a fall in output and employment.

Both figures would be determined, as is the case now when setting interest rates, by reference to appropriate macroeconomic data, including the Bank of England’s Credit Conditions Survey (a survey of business borrowing conditions).

Once a conclusion had been made on the two figures mentioned above, then the Money Creation Committee would authorise the creation of a specific amount of new money. This newly created money could then enter the economy in two ways:

The first (and most common) of these would be to grant the money to the government (by increasing the balance of the Central Government Account), which would then spend this money into circulation, as discussed in the next section. This process increases the money supply without increasing the level of debt in the economy and can therefore be thought of as ‘debt-free’ money creation.

The second method would be for the central bank to create new money via the MCC and lend it to banks, which would then lend this money to businesses and the productive economy (but not for mortgages or financial speculation). This increases the money supply but simultaneously increases the level of debt, and so does not constitute debt-free money creation. This option provides a tool to ensure that businesses and the real economy do not suffer from a lack of access to credit.

Is it possible for the Money Creation Committee to determine the ‘correct’ money supply?

To begin with, it is important to note that the MCC would not determine how much money the economy needs from scratch. Instead, it would decide whether to increase or decrease the money supply from its existing level (which had been determined by historical events), given current levels of inflation and economic activity. This requires that the MCC take a view on the likely future path of the economy in addition to reacting to economic events. Essentially the MCC will be guided by both theory and the results of their previous decisions.

There is of course no way for the MCC to predict perfectly what the growth in the money supply ‘should’ be. However, this is true of all monetary and political decisions – including the Monetary Policy Committee’s decision to increase or decrease interest rates in the present system. The question therefore becomes one of who is most likely to supply the economy with the ‘correct’ amount of money: commercial banks in the current system, or an independent committee in the reformed system?

Today, commercial banks create money when they make loans. Bank officials therefore are not making a decision about how much money they think should be in the economy; they are instead making a decision about whether a particular loan will be profitable. This means that the money supply is currently determined as a by-product of bank lending decisions, made in the pursuit of profit. Because the majority of banks’ profits come from the interest they charge on loans, in relatively benign periods banks are incentivised to lend as much as possible, creating money in the process.

However, although the money supply is determined by the actions of companies in the private sector, it would be a mistake to believe that the money supply is determined by market forces, for several reasons. First, the top five banks in the UK dominate almost the entire market, making it an oligopolistic market. Second, the money supply is not determined by the demand for money, but by the demand for credit. Third, even the market for credit is not determined by market forces – banks ration credit. Of course, the overall strategies of banks, and therefore their lending priorities, are determined at board level. Consequently, it is a small group of senior board members at the largest banks who determine the growth rate of lending and inadvertently the money supply of the economy. These incentives, combined with a lack of constraint on bank lending, led to a doubling of the money supply from 2002-2008.

Banks therefore create too much money in good times, leading to economic booms, asset bubbles and occasional financial crises. Because this money is created with an accompanying debt, eventually the economy becomes over-indebted, with a bust occurring when individuals cut back spending to repay their debts. During the bust, banks’ pessimistic views as to the future state of the economy (which are magnified by disaster myopia) lead them to create too little money and as a result the economy suffers more than it needs to. The story of this type of business cycle is therefore one of banks creating too much credit, which causes a boom and eventually a bust when debt gets too high. Then, during the bust banks lend too little, worsening the downturn. In short, there is no reason to think that the level of money creation that maximises banks’ profits will be the level of money creation that is best for the economy as a whole.

In contrast, under the reformed system the decision to create or destroy money will be determined by the MCC, a committee charged with creating the right amount of money for the economy as a whole. While it is unlikely that this committee will be able to get the level exactly right, history has shown that the current system rarely provides the ‘right’ amount of money, and more often than not gets it disastrously wrong. The choice is not therefore between a ‘perfect’ market-determined system on one hand and one determined by a committee on the other, but rather between leaving the nation’s money at the mercy of the interests of banks or organising it squarely in the interests of the national economy. Given the above, it is difficult to imagine that the Money Creation Committee could manage the money supply more destructively than the banks have done to date. 

This is an extract from the book Modernising Money which explains in detail how exactly can the monetary system be fixed.

Here you can read the Positive Money system explained in Plain English.