Modern governments claim a monopoly on the creation of cash, and it is often said to be the source of their economic power. But the state’s grip on the money supply is weaker than it appears. In the UK, banknotes and coins with images of the Queen’s head may be the most visible instruments of economic exchange, but they represent less than a 20th of the money supply. Much of the rest is bank deposits – in fact, private debt that financial institutions owe their customers. These deposits work like money; they can be transferred from person to person with the flick of a pen, card or even a cell phone. However, they are created by private contracts between citizens, and not by government decree.
Writing in these pages, Martin Wolf pleaded for the abolition of this “private money”. Our economies would be more stable, he believes, if money creation were left entirely to the state. It is an attractive proposition; the monetary system is devilishly complicated, and simple solutions to complex problems are often attractive. But this is misguided.
When an account holder gives a bank money in exchange for an increased deposit balance, the bank keeps only a tiny fraction of what it has received as cash reserves. The rest is loaned to borrowers, who in turn deposit the money, creating even more private money. Because borrowers pay interest, this process leads to the special position that I both receive interest on my checking account balance and pay no fees for the bank’s transaction services.
The abolition of private money would put an end to “fractional reserve” banking. Banks should match pound-for-pound deposits with cash instead of loans. Account holders would have to pay fees and would not earn any interest on their deposits. The gains from money creation that are currently accruing to banks and their customers would rather be pocketed by the state. This could help finance public spending, reducing the government’s borrowing requirement or perhaps eliminating it altogether.
But this is not a recipe for monetary stability. On the contrary: it is striking how many of the great inflations of the past have been caused by libertine or greedy governments indulging in deficit financing – and destructive wars have also been financed in this way.
Since the 1970s, economists have been convinced that public borrowing should be financed transparently by bond issues and not stealthily by money creation. Allowing the state to pay for its activities with new money would reverse the progress made.
There is another difficulty with the proposal to ban fractional reserve banking: it is patently unworkable. It’s all right to say that when money changes hands it must be government money – notes, coins or balances on non-interest bearing accounts that are not used to fund any form. loan. But how can the government realistically prevent the reallocation of investment account balances? People cannot be stopped from giving what is theirs, and recipients of such largesse cannot be prohibited from offering goods or services in return.
Perhaps the government could criminalize the use of government issued notes and coins in a fractional reserve system. But that wouldn’t stop the determined financier. In many countries, mobile phone credits are used as a medium of exchange. Someday, a successor to Bitcoin could serve this purpose. Or Britons hungry for interest-bearing bank accounts might start using dollars or euros instead of pounds. What will prevent them from lending such things to a bank, or preventing the bank from lending to others in turn? Very little: unless there is a ban on lending any good that can be assimilated to money.
There would be a big difference between this fractional reserve banking samizdat system and what we have today: it could go bankrupt, because there would be no central bank on hand to bail out deposit institutions in the event of a failure. ’emergency. This calls for caution. Perhaps we should abolish central banks rather than fractional reserve banks – but that’s an argument for another day.
Private money is not a threat. And it is for the best – because we cannot wish it.
The writer is program director at the Institute of Economic Affairs
Letters in response to this article:
Transparency – and everything except / By Dr Niccolo Caldararo
It’s time for a debate on money creation / By Mr. Gottfried Hoerich
The monetary system is not yet stable or transparent / By Mr. Andrew Cichocki
Rose-tinted view of economic history / By Mr. Rod Price
New environment of low inflation requires new policy ideas / From Professor Stephany Griffith-Jones