The German Bundesbank has recently released an interesting report on the role of banks, non-banks, and the central bank in the money creation process. We have a few issues with the Bundesbank article; however, the majority of the analysis is good. More importantly, the conclusions drawn from the report by news outlets and the blogosphere are misleading.
Ultimately, full-reserve banking is different from Sovereign Money and the recent wave of civil society initiatives calling for the power to create money to be granted exclusively to a democratic, accountable, and transparent public body.
In this blog, we want to set the record straight and highlight the main differences between Sovereign Money and other full-reserve banking proposals. In an upcoming blog, I will go through our disagreements with the Bundesbank analysis.
The Bundesbank gets money right!
The Bundesbank report should be celebrated for highlighting that mainstream approaches to money creation are wrong. Central banks do not determine the stock of money in circulation. Instead, private commercial banks are responsible for creating the majority of money, when they make loans (and when they buy assets).
Here is a video that helps explain how mainstream theory gets money creation wrong. But you can find out more here and here.
Sovereign Money and full reserve banking proposals aren’t one and the same
The report then goes on to discuss full-reserve banking proposals (FRB) – specifically according to the Chicago Plan or 100%-money advocated by Irving Fisher. We are not completely certain if the authors at the Bundesbank understand the differences between the two sets of reforms, or whether there is another reason for referring to the 100%-reserve approach.
Most problematically, the press and the blogosphere have covered the Bundesbank paper as a criticism of Sovereign Money reforms. This is unfortunate because there are important technical differences between Sovereign Money and FRB proposals. Because of these differences, the substance of the criticism by the Bundesbank does not actually apply to Sovereign Money. In fact, in many senses, we agree with the points made in the paper.
The confusion between Sovereign Money proposals and FRB is not new – but it is becoming increasingly frustrating. Many well-known economists, policy-makers, and journalists have failed to understand these differences. On a personal note, I’ve been saddened to see many of my economic role models fail to make the proper distinction between Sovereign Money and FRB.
To an extent, although we have tried to clarify these differences, Positive Money has at times allowed our reforms to fall under the rubric of FRB. In this sense, we must take a bit of responsibility for muddying the waters. So the remainder of this blog aims to clarify the difference between Sovereign Money and FRB.
The difference between Sovereign Money and other full-reserve banking proposals
Sovereign Money proposals are often mentioned alongside FRB proposals. And they do indeed have a same goal; that is to stop banks creating money in the process of making loans (or buying assets). However, the method is different – and there happens to be a number of other goals and benefits of implementing a Sovereign Money system.
In the case of FRB it is done by forcing banks to hold reserves against their deposits. As the Bundesbank correctly notes, this doesn’t necessarily stop banks creating money – that is, it is quite possible for there to be money creation by the banking sector with 100% reserves.
Why? Simply put, banks create money and look for the reserves later. Central banks always accommodate private banks’ demand for reserves. So even in an FRB system, private banks could create new money through the process of lending, and then get the required reserves from the central bank. Incidentally, for exactly the same reasons a 10% reserve ratio doesn’t constrain deposit creation, although it does require the central bank to play along.
Our Sovereign Money proposal, on the other hand, does not suffer from this problem. Instead of backing deposits with reserves, we give people access to the state-created means of payment itself. Sovereign Money is different from the current system and the FRB proposals, where two types of money circulate separately – central bank created reserves which are only used by the banking sector, and commercial bank created deposit money which is used by everyone else. Under a Sovereign Money system, there is no longer a split circulation of money, just one integrated quantity of money circulating among banks and non-banks alike.
This is achieved by removing the current account deposits from the banks’ balance sheets and placing them onto the central bank’s balance sheet (in what we call transaction accounts). The private banks then obtain a new liability of the same size to the central bank, and correspondingly the central bank an asset from the banks. Banks’ liabilities to the central bank are to be repaid as their assets mature, with the money repaid in this way to be recycled back into the economy by the central bank granting money to the government to be spent into circulation.
In effect, the central bank has ‘extinguished’ the banks’ demand liabilities to their customers by creating new state-issued electronic currency and transferring ownership of that currency to the customers in question. In a sense, everyone starts banking at the central bank, although we would contract with the banks and/or other financial technology companies to administer our accounts for us.
Lending occurs in this system when people move their money from their transaction account (held at the central bank) to an ‘investment account’. This will be broadly similar to a time deposit today – there will be minimum notice periods; however, unlike today they will also carry some risk (i.e. if the underlying assets go bad they may lose some of their money).
The money transferred to the banks will then be transferred to a borrower. So, in this system – the Sovereign Money system – lending by banks merely transfers money around the system; no new money or purchasing power is created when loans are made. All electronic money is held on the central bank’s balance sheet and therefore any bank can be allowed to fail, without affecting the money supply.
The point here is that the Bundesbank article explicitly only refers to FRB proposals and not Sovereign Money. In FRB proposals, there is still a split monetary circuit – between the money that the public has access to (bank deposits) and the money used by banks to make payments amongst themselves (central bank reserves – remember the general public does not have access to reserves). In this system, as the Bundesbank notes, banks can still proactively create money.
A sovereign money system is essentially a single-circuit system. Professor Joseph Huber has explained brilliantly that by design a Sovereign Money system:
“Abandons the split-circuit structure based on a mixed money supply of deposits and reserves in favour of a single circuit on the basis of sovereign money only, issued by the central bank.”
Therefore, in a Sovereign Money system banks would no longer have the ability to create new money, and this power would be retained exclusively by a democratic, transparent, and accountable public body.
This, however, should not be seen as a complete endorsement of the Bundesbank article or conclusions. While the report does a great job of highlighting how banks create money and correctly notes some of the issues with FRB – the Bundesbank does make a few misgivings based on mainstream banking theory. I’ll address these issues in a separate post…