Is it possible to stop banks creating money? Or would shadow banks just take over?

In a recent FT Alphaville article Izabella Kaminska argues that it is ‘naïve’ to attempt to constrain banks’ ability to create money, because this will only prompt other financial sector firms (‘shadow banks’) to create other forms of money that could be used as a substitute for money created by the state. Naturally, we disagree. Kaminska’s article misses some key points of economic history, and also overlooks other reasons why it is unlikely that substitutes for money will compete with state-created money.

Kaminska writes:

“…A central bank with a clear-cut reputation to protect is never going to be as competitive as the private sector when “money printing” and risk is concerned. Which means, there will always be a market for some sort of entity to come in and undercut it in the private market. So, just as you constrain one set of banks from over-issuing money, a whole new category of banks spring up to service areas the central bank can’t touch, overlook or under-banks due prudence.”

Making reference to the 1844 Bank Charter Act, which prohibited private banks from printing their own paper money, Kaminska shows how she arrived at this conclusion:

“The 1844 Act gave the Bank [of England] the note issue, and the nation a sound currency. But it placed, in effect, a limitation on the Bank’s ability to develop its commercial business, and during the nineteenth century it was overtaken in size by the great joint-stock deposit banks which emerged from a series of amalgamations. The Bank chose not to compete directly with these joint-stock, or clearing banks, but to develop its role as the central bank.”

This analysis is partially accurate. Prior to 1844, private banks could issue their own paper notes, which businesses and members of the public treated as money. This ability to create money, in the hands of the banks, led to reckless lending, rampant speculation, and a series of crises. The 1844 Bank Charter Act was therefore aimed at removing private banks’ “money creating powers”, to prevent further credit booms and busts. Unfortunately, the proponents of the Act failed to realise that banks could still create new money  in other forms, specifically in the form of the bills of exchange and deposits that banks issued when they made loans.

So for Kaminska, updating the 1844 Bank Charter Act to the modern day, by removing banks’ ability to create money in the form of deposits, will merely prompt shadow banks to generate new monetary substitutes or ‘near-monies’, to  compete with and even replace sovereign money created by the Bank of England. This is a risk that we should pay close attention to, but it’s also overstated.

Banks are only able to create money today because their liabilities (i.e. bank deposits that represent a promise to repay state money to some entity in the future) are widely accepted as a means of payment. A sovereign money system is designed to stop the banking sector from issuing liabilities that can be used to make payments, since all money that could be used for payments will be in the form of electronic money and cash, both created by the Bank of England.

For a shadow bank to create a money substitute that could compete with sovereign money, it would be essential for that money to be ‘spendable’ as easily as sovereign money. In other words, you would need to be able to use it to pay your rent, to spend money online, and to receive your salary. That means that you’d need to be able to spend your money substitutes through the primary UK payment networks that traditional banks use: BACS, CHAPS, Faster Payment etc.

By simply restricting access to these payment systems to banks that operate according to sovereign money principles, it means that any substitute created by a shadow bank would be harder to spend, and therefore not a substitute for state money.

If a shadow bank still chose to try and create a money substitute to be used outside the primary payment networks, the payment services it provided would be inconvenient to use, and would not be commonly accepted, making it an ineffective money substitute.

Of course, in a Sovereign Money system regulators and policy makers would still have the option to further regulate such activities, or simply make them illegal. Many would argue that shadow banks are simply banks that avoid registering as banks in order to avoid much of the regulation. But if they behave like a bank, then surely they should also be regulated like a bank.

Ultimately it is unlikely that monetary substitutes would emerge and make Sovereign Money reforms ineffective. On the contrary, a Sovereign Money system would effectively separate the public prerogative of issuing money, from the private prerogative of extending credit.