How can we do better? The alternative: money creation by the state

A well-functioning monetary system is essential for a well-functioning economy and thereby, for the common good. The state is the agency responsible for the public interest. The responsibility for and control over the monetary system and money creation should therefore be placed with the state and not with private, profit-oriented enterprises. The logical alternative to money creation by private banks, therefore, is money creation by the state. In such a system it’s not only coins and paper money that are created by the state but also the non-cash money now created by private banks. Meaning electronic money is then created by the same agency now responsible for coins and paper money.

Reform of the monetary system should lead to a more transparent management of the money supply with as its primary aim the short and long term common good, not private profit. Under the new system the responsibility for money creation would rest with a public monetary authority acting according to statutory objectives and guidelines. Such an authority already exists in most countries: the central bank. It would therefore be logical to give the money creation mandate to the central bank. In the following the terms monetary authority and central bank are used interchangeably.

At the same time the right of private banks to create money would be taken away. Banks would no longer, as presently, be able to create money by the simple accounting exercise linked to lending. Rather than creating their own money they would have to work with money created by the central bank. Such money would come from deposits, money borrowed from the central bank or in financial markets, and the bank’s equity. Banking would be limited to the role that most people think banks perform today: managing the money of depositors by lending it to people and businesses willing to borrow it.

Money created by the monetary authority would be channelled into the economy in several ways. Directly by transferring the money to government to finance part of public spending, in particular investments. And indirectly by making the money available to banks for lending on to consumers and businesses.

Public or private banking?

Whether in addition to money creation by the central bank the task of bringing it into the economy should also become a public service is a separate topic of discussion. Many monetary reformers emphasize that monetary reform involves only the separation of the functions of money creation and money distribution. Existing private banks would continue banking, though no longer with money they would create themselves. However, there are good arguments for combining monetary reform with a public banking system. Public banks would ensure lending would be aimed less at maximizing profits for shareholders and more at public goals such as support to small and medium enterprises, job creation, and environmentally beneficial investments. Commercial, profit-oriented banking would not necessarily be banned: one can imagine a mixed system of public, private non-profit and private commercial banks in order to foster competition and thereby, service provision. It would be important to limit the size of both public and private banks to make sure there would be enough suppliers to guarantee genuine competition.

Advantages of money creation by the state

There are many advantages to a monetary system based on money creation by the state: a central bank / monetary authority making newly created, debt free money available to the state. It would resolve the debt problems of governments and thereby the current crisis as the governments borrowing needs would be greatly reduced. The current public debt could be paid off gradually without having to cut back on public expenditure. This would make more money available for government investment in sectors such as education, health care, research, infrastructure, environment, and safety, creating jobs and growth.

Money creation by the state would also allow directing private investment. An example would be promoting private investments contributing to a sustainable use of resources, in the form of grants or interest free loans for companies that develop green technology.

Whether the benefit of money creation would be invested for the public good would be a political choice. Cabinet and parliament could also opt to channel those benefits to citizens and businesses by lowering taxes, increasing benefits and reducing public service fees.

Some monetary reformers propose, after the transition to money creation by the state, giving every citizen a one-time payment, a “citizen’s dividend”. This would become possible since as a result of the transition all “debt money” previously created by private banks would become state money. Citizens would be required to use this money to pay off their debts. Everyone would get an equal amount; the total amount paid would be equal to the total debt of all citizens. Because some citizens have more debts than others some would still be in debt, though much less so than before, whereas others would have money to spare.

Some reformers propose a dividend only for citizens, others, such as the proponents of the Chicago Plan, suggest a dividend for all debts other than those spent on capital goods (such as buildings and machinery). Including companies would be especially beneficial for small and medium enterprises, for some of which relief from a sizeable part or all debt could mean the difference between survival and bankruptcy.

Payment of a citizen’s dividend could carry the risk of large numbers of people and businesses having money left wanting to spend it fast. This could lead to such a large increase in the demand for goods and services that producers would see an opportunity to raise their prices. If this would happen on a large scale, across economic sectors, this would result in an overall rise in prices: inflation. To prevent this some proponents of the Chicago Plan propose not to pay out any money remaining after all debt has been cancelled, but to deposit that remainder into a kind of investment fund. The returns generated by the fund would be paid out to the owner. This would mean much smaller payments spread over a prolonged period.

In practice the benefits of money creation by the state would probably be used to finance a mixture of policies: paying of government debt, public investment, tax cuts and a citizen’s dividend. The focus would depend on the political orientation of the government: conservatives would be more inclined to have citizens and businesses benefit whereas social democrats would be likely to put more emphasis on public investment to address environmental and social concerns.

An end to the growth imperative

Money creation by the state would remove the drive for economic growth that is inextricably linked to private money creation. That would open the way to the transition to a stable economy in which the future can be secured through the sustainable use of finite resources.

A more stable economy

Another advantage of money creation by the state is that it would help to reduce the ups and downs in the economy that have marked the past centuries. As previously indicated these highs and lows are exacerbated by private banks which in good times boost the economy by too much lending and speculation, usually ending in a crisis. Conversely, in times of economic contraction they lend and thus create too little money, exactly when more money is needed for economic recovery. Public money creation, particularly when combined with public banking, would put an end to this phenomenon and would generally ensure that sufficient money enters the economy to make it function properly.

Less speculation, no more bail-outs

Money creation by the state would curtail the speculation that, even after the 2008 crisis, has been creating new financial bubbles, thereby laying the basis for the next crisis.[1] Banks getting into trouble through such speculation would no longer need to be rescued by the state and thus, the taxpayer. A bankruptcy of a big financial player would only have unpleasant consequences for those directly involved but not, as now, threaten the entire financial system and global economy.

Fewer risks, savings safe

Overall the risk of bank failures would be reduced because banks would manage only their own money and the deposits entrusted to them: it would no longer be possible to create large amounts of money by lending for speculation, with all the risks involved in the latter. Thus banks would become more stable and secure.

At the same time a significant advantage for savers would be that their deposits would be safe. As indicated earlier a saver now loses his money in case of a bankruptcy of the bank where he parked his money, except for the part guaranteed by government. Under the new system deposits would get the same status as shares or other securities managed by banks today. These remain the property of the owner even if the bank fails. In the new system this would also be the case for savings, meaning government guarantees would no longer be necessary (note that this does not mean all deposits would be risk free: regular savings accounts would bear no risk but investment accounts would bear the normal risk of fluctuations in the value of the underlying securities).

Transparency

Finally, the new system would ensure that money creation and allocation are much more transparent and therefore more controllable. The current disproportionate influence of the financial sector on society and politics would decrease, with less pressure on decision makers to represent the interests of the financial sector at the expense of the public interest.

Risks of money creation by the state

What are the risks of money creation by the state? Defenders of the current system often indicate that governments are prone to abuse the privilege and would create too much money, causing inflation. This would be a genuine risk if those deciding on money creation would be exposed to political influence. Politicians, to humour voters and satisfy special interest groups could exert pressure to create more money than warranted. The solution to this problem was already given: eliminate political influence by giving the monetary authority the status of an independent entity that cannot be subjected to political pressure.[2] Thus decision making on the money supply would be based only on technical criteria and remain in line with the authority’s mandate.

Central bank independence already exists in almost all developed countries. To the extent necessary this autonomy could be confirmed through legislation. The central bank could thus acquire the status of what some experts have called a “fourth power”: an institution with its own mandate, autonomy and responsibility, as the other three branches of power: executive, legislative and judicial.

The risk remains that too much money would be created if those responsible at the central bank / monetary authority would overestimate the economy’s productive capacity. This could lead to a situation in which producers would feel that they could raise prices at will because their products would be sold anyway. Such price increases could raise the overall price level causing unwanted inflation: so-called “demand-pull inflation”, or demand inflation for short.

On the other hand employees might raise their wage demands if they became aware of higher prices as well as the fact that employers would be competing for their labour. Employers might yield to such demands if they perceived they could pass on the extra cost to the buyers of their product by raising prices. Suppliers of raw materials and semi-finished products or components could also increase their prices in the expectation that their buyers – the makers of the end products – would pay them anyway. The resulting overall increase in price levels is called “cost-push inflation”, cost inflation for short.

Demand-pull and cost-push inflation could result in a so-called “wage-price spiral”, in which the two types of inflation coincide in pushing up prices. This phenomenon occurred in the 1970s and came to an end only after a severe economic downturn in the early 1980s. It is, therefore, something to be avoided.

Preventing demand and cost inflation

In general the monetary authority would prevent demand and cost inflation by making sure the amount of money added to the existing money supply would not be such that the demand it would generate would exceed the productive capacity of the economy. This could be achieved among others by government projects and programs not being awarded to private companies charging higher prices than warranted. In cases in which all parties making a bid would overcharge the activities to be funded should be postponed until they could be contracted at a reasonable price.[3] Such policies would also restrain excessive wage demands in the productive sectors concerned.

Overall excessive wage demands in both private and public sector should be avoided too. To start with, before the transition to money creation by the state, employers, employees and other stakeholders should be briefed thoroughly on both the benefits of public money creation and its preconditions – notably, restraint on the part of workers and producers in wage and price demands. Agreements on the latter should be developed with, and signed by all parties. Thereafter there should be regular rounds of consultation to adapt those agreements to changing circumstances.

It may be expected that with a public monetary system and responsible behaviour on the part of producers and workers inflation would decrease and possibly disappear. That’s because as stated earlier central banks currently aim at inflation of around two percent to promote economic growth; growth that is necessary to meet debt obligations. In a system of money creation by the state, system debt would be greatly reduced, meaning that growth and inflation would no longer be needed. The aim would be to attain price stability and thereby, savings maintaining their value.

Transition

What would the transition from private to money creation by the state look like? Andrew Jackson and Ben Dyson of the British organization Positive Money, the leading organization in the field of monetary reform, chart the transition in a book titled Modernising Money. [4]. They describe two phases. The first phase involves the overnight transition to the new system when the new regulations for money creation and credit become law and the necessary accounting adjustments are made on the balance sheets of banks and government.

In the second phase, which could last from ten to twenty years, the debt created under the old system is repaid gradually, with existing money or money created by the central bank under the new system. The Positive Money publication describes this process as recovering from the “debt hangover”. Government debt could be repaid according to schedule with newly created central bank money. Private debts could be paid from the aforementioned “citizen’s dividend” and money from the regular money supply.

Mandate of the monetary authority

After the transition the monetary authority decides on the amount of new money to be created. The mandate of this authority, as that of the central bank, is to be established by law, and will amount to the double function of preventing inflation and ensuring an optimal money supply. This translates into a money supply that is adequate for meeting both public needs and the demand for money from individual citizens and businesses, in a manner that prevents inflation and makes optimal use of the productive capacity of the economy. This implies that the money supply and thereby overall demand is limited to a level where producers meet total demand without raising their prices.

Channelling new money into the economy

As indicated newly created money would be brought into the economy through government and banks. The government could do so in several ways: through government spending, direct payments to citizens, such as the aforementioned citizen’s dividend, and by paying off government debt. Another possibility is tax cuts, with newly created money compensating for lower tax revenues.

Government and parliament would decide which of these forms would be used and to what extent. The monetary authority and government would cooperate closely to align and coordinate money creation, the generation of government income in other ways such as taxation, and public expenditure.

[1] The huge amounts of money circulating in the financial markets would not disappear right off in the transition to a new system, so large scale speculation would continue for the time being. But the amounts of money involved would grow much more slowly, stagnate or diminish because private banks could no longer create money for speculation. In the meantime central banks and governments would jointly look at ways to gradually reduce the enormous amounts of money circulating in the financial markets. How to achieve this would probably vary by type of financial product. Measures should be taken to avoid large amounts of speculation money flowing to the real economy as that could raise demand to such an extent that it could lead to inflation. This problem might be smaller than assumed as the massive selling off of financial products would cause their price to plummet. Speculation in financial markets could be reduced further with a tax on financial transactions, the so-called Tobin tax, named after a well-known American economist and Nobel laureate.

[2] The British organization for monetary reform, Positive Money, suggests a “Monetary Creation Committee”, comparable to the present Monetary Policy Committee of the British central bank, the Bank of England.

[3]    Such a course of action would require a different way of government budgeting. Now there is often the urge to spend a budget because if not the money involved will be reclaimed by the treasury. This may lead to a lower budget allocation in the following year. Thus in the current situation careful management by postponing expenditures is punished – something that needs to change even if government would not be able to create its own money.

[4]The following link provides an overview of the contents of the book: http://www.positivemoney.org/wp-content/uploads/2013/01/Modernising-Money-Free-Overview.pdf

This was the 7th chapter of the booklet “Our Money” by Frans Doorman. This booklet explains, in plain English, what money is and how our current monetary system came about. It discusses the problems inherent to the present system and proposes an alternative.

It also explains how the current monetary system restrains us in addressing our economic, social and environmental problems, and even worsens them. It discusses the transition to a system that would work better, the main traits of that system, and the reasons why such a better alternative is hardly considered at present.  This booklet is intended for a broad audience: anyone with an interest in the solution of society’s social, environmental and economic challenges. People who are concerned about the continuing impact of the economic crisis that started in 2008 and about its aftermath: growing economic insecurity, inequality, and poverty. And people who are distressed about the environmental problems our global society is facing: the degradation of ecosystems and the environment in general, the depletion of natural resources, climate change, loss of agricultural land, and looming fresh water shortages. People who, even though they do not expect to be affected by these problems directly themselves are concerned about the future of their children and in general, of future generations.

Free Download – PDF format A5