In any economy there must be someone with the power and authority to create money. This power historically sat with the king and the Royal Mint, until it was transferred to state control under the Bank of England. But now the power to create money sits ultimately with commercial banks, which create new bank deposits as they make loans. These deposits make up 97% of the UK money supply.
Writing in the Financial Times, Martin Wolf argues that we should “strip banks of their power to create money”. Philip Booth of the Institute for Economic Affairs responds in his article entitled “Money creation is too vital to be left to the state” that this would put the power to create money in the hands of the “greedy or profligate” governments who have been responsible for many of the great inflations of the past.
He draws the wrong lessons from history.
Firstly, the common assumption that allowing the state to create money would automatically lead to a Zimbabwe-style hyperinflation is based on a mis-reading of history. A Cato Institute study of all 56 recorded hyperinflations found that hyperinflations only occur under extreme conditions such as war or a complete collapse in the productive capacity of a country (as in Zimbabwe). They are not a result of politicians turning on the printing presses just before an election. It is true that dictators and despots could abuse their power to create money, just as they regularly abuse their power over the military, but this is not an argument against allowing well-governed democracies to reclaim their power to create money.
Still, as former FSA chairman Lord Turner highlights (Debt, Money and Mephistopheles, 6th February 2013), it is almost taboo to suggest that states should create money directly and use it to fund public spending or tax cuts. The fear is that politicians would switch on the printing presses in the years before an election, causing inflation and distortions that must be cleaned up in the years after. But in the proposals from book Modernising Money, which I and my co-author Andrew Jackson released in early 2013, we provide detailed proposals to prevent this from happening.
To design a system of checks and balances that prevent the abuse of the power to create money, we have to think about the incentives of the people involved. If those who are creating money benefit personally from doing so, then this conflict of interest will lead them to create too much money.
This is why relying on banks to create an economy’s money is never optimal. Banks create new money when they make loans. The more they lend, the greater their interest-bearing assets and the greater their overall profit. Prior to the crisis, bank leadership teams designed incentive schemes that turned loan officers into salespeople. Their incentives to lend – and therefore to create money – involved bonuses, commissions, and the prospect of promotion. Their incentives to be prudent (and to hold off from creating money) were weak: salespeople who don’t meet targets are ultimately let go.
Politicians with the power to create money would face similar conflicts of interest. The decision over how much money should be injected into the economy to meet growth and inflation targets would be conflated with the government’s need for spending that helps to win elections. The need to win elections would almost certainly win out.
That is why it is essential to transfer the power to create money to a body that has as few conflicts of interest as possible. We have suggested that the Monetary Policy Committee could be responsible for decisions on money creation. They would have the facility to create money directly, instead of using base rates to indirectly influence money creation by banks.
There are valid criticisms of the structure of the existing Monetary Policy Committee, and a newly established independent body might be more reassuring. But the important thing to note is that the decision over how much money is created would not be driven by either a) a drive for banks to increase the size of their balance sheets or b) a need for government to finance its expenditure. Instead it would be driven by an assessment of the needs of the wider economy, in much the same way that decisions over interest rates are currently set today.
Crucially, the proposal does not “allow the state to pay for its activities by minting fresh cash”, as Philip Booth suggests. HM Treasury would still need to borrow funds from the markets if it found that taxes plus the money created by the Bank of England were not sufficient to cover expenditure.
Throughout history, when the power to create money has been over-used it has typically been as a result of excessive lending by over-exuberant banks. This is the basis of the argument for stripping them of their power to create money.
(This was originally drafted as an op-ed for the FT; unfortunately the editors didn’t reply so we’re publishing it here.)