This blog series will engage briefly with some of the contemporary, as well as older, theories, models and concepts in economics and political economy, and will draw on the potential advantages of these approaches. I hope this, as well as future blogs, will help spark a healthy debate on the alternative approaches to these fields, something which is regrettably rare in the lecture theatres and seminar rooms.
Money and Alternative Banking Systems
On Thursday 20th November, for the first time in 170 years, MPs were invited to take part in a parliamentary debate on money creation and society, a topic which has remained stagnant since the rise of Monetarism – and the quantity theory of money it held gospel – in the 1970s. Such a debate, in part, was sparked by the Positive Money campaign group, which has long argued that under the current fractional reserve banking system, private banks have been given the concealed privilege of being able to create money out of what seems to be thin air. This process leaves banks unable to facilitate the majority of savers demands to convert their savings into money all at once (known as a ‘bank run’). In addition this process is heavily pro-cyclical, as banks tend only to extend credit, and thus the money supply, in times of good confidence, whilst creating a ‘credit crunch’ by reducing the money supply in times of low confidence.
Such a process begins whenever banks credit the accounts of a borrower, by simply typing digits into a computer, and then destroying the money once it has been repaid. (The whole process itself is rather mind-boggling, an in-depth analysis can be found in the additional material below.) Consider the textbook example: a saver wishes to deposit £100 in their bank account. A fraction of this is reserved by the bank for when you wish to withdraw money for your daily/monthly transactions, let’s say 20% for this case. The rest is used to credit the account of a borrower, by say, £80. This is despite the fact that the £80 in the savers account has not disappeared from the savers account but has simultaneously reappeared in the borrowers account. The money appears in both the accounts of the saver and the borrower. The borrower then stores that £80 in another account (now acting as a saver) and the whole process starts again.
However, this system assumes that the amount of new money that can be created is limited by the reserve ratio, yet in reality the reserve ratio is 0%, as private banks are able to acquire liquid assets from the central bank (via OMO’s), or alternatively, and more commonly, banks can lend between themselves in the inter-bank lending system. Therefore, the creation of new money is only limited by the amount to which banks are willing to lend central bank reserves to one another, and thus outside of the public realm altogether. In this sense, rather than banks having to wait for additional savings from depositors, they can create new loans by simultaneously creating an asset (the agreement that the borrower will repay the loan) and a liability (the assumption that the bank will convert the borrowers funds into cash).
According to Positive Money, this process can only be stopped when banks are forced to hold 100% of savers savings rather than a fractional amount, as first proposed by Irving Fisher (1939) in the Chicago Plan (see below). However, this system would only apply to current/transaction accounts. For savings/investment accounts, the money will be directly appropriated from the savers and later returned (with interest) once the money invested has been repaid by the individuals, firms, governments, etc. who required credit. Banks once again become ‘middle men’ between savers and borrowers. However inconvenient this may be, it is argued such an approach ceases the possibility of ‘bank runs’, and may have the potential to increase investment in the real economy (as opposed to speculative or unethical investment) if savers are given the opportunity to decline the use of their savings for particular investments (arms or oil for example).
It is claimed that the current system has created billions of pounds of debt-based money (strangely without any substantial increase in inflation!) and is heavily pro-cyclical. Positive Money argues that new money should be created counter-cyclically by an independent public body accountable to parliament, yet the potential consequences of this ‘state-centric’ approach remains largely unknown. We will explore this relationship between money and government in more depth next time, looking at the approach of Modern Money Theory more specifically. In the meantime please feel free to share your ideas on the monetary system and alternative banking system more generally.
Additional Material
20th November Parliamentary Debate: http://www.parliament.uk/business/committees/committees-a-z/commons-select/backbench-business-committee/news/mps-debate-money-creation-and-society/
‘Chicago Plan’ (A Program for Monetary Reform): http://home.comcast.net/~zthustra/pdf/a_program_for_monetary_reform.pdf
Positive Money – Creating a Sovereign Monetary System (pdf): http://2joz611prdme3eogq61h5p3gr08.wpengine.netdna-cdn.com/wp-content/uploads/2014/07/Creating_a_Sovereign_Monetary_System_Web20130615.pdf
Positive Money – How Money Works: Banking 101 (video guide): http://www.positivemoney.org/how-money-works/banking-101-video-course/
Ryan-Collins, J., Greenham, T., Werner, R. A. and Jackson, A. (2012) Where Does Money Come From? A Guide to the UK Monetary and Banking System. 2nd Edition. London: NEF (New Economics Foundation).