Money creation: a reply to my MP

A month or so back I wrote to my MP on the back of the discovery that 75% of our MPs didn't actually understand the role of banks in creating money and the lack of control the government has over the money supply. My MP seems to have passed the test somewhat, though her reply gave me some pause for further questioning. Here's what I wrote to her having considered things a bit.

Thank for your response of 5 November to my email about money supply and banking.

It was heartening to see that you had clearly given consideration to the issue and could articulate a position which reaches beyond some of the popular (mis)understandings. I hope you'll be okay to consider and perhaps comment further on a handful of further points that, it seems to me, arise from what you wrote back to me.

I was intrigued by your use of the phrase 'banks are technically able to create money'. I wasn't sure just what the hedging adverb was meant to convey. To be clear: 97% + of the British money supply is created by bank loans. These loans while not notes or coins can be converted to notes and coins (though only a tiny fraction ever are, hence the figure just quoted), and the money so generated is spent (mainly electronically) into the British economy. If by 'technically' you mean to make a distinction to 'traditional' money consisting of notes and coins then, fair enough. However, if you mean something else, some further explanation might be needed.

Clearly, and perhaps this was what you were alluding to in mentioning market forces, the making of loans is a supply-to-demand issue. So in that sense I would agree that there is a demand-limited element to the creation of bank-money. However, there is more to be said about this.

One thing is that the elasticity of the demand is not simply related to actual economic activity but to perceptions of future activity. And of course the sub-prime lending issue indicates that latent demand is huge but some of it needs to be resisted. It is this latter issue that has prompted the concern of Postive Money and a growing network of economists (who recognise that the failure of many economists to predict the recession does place a question mark against some of the discipline's modi operandi and assumptions). Currently this perception is left to banks to manage and respond to and therein lies a difficulty: their aim is not to manage the economy overall well but to make profit and so the slip into ever riskier money creation strategies becomes nigh-on inevitable. This should have been a lesson drawn from history looking back to the global financial system before the Bretton Woods accords. From that perspective it is no surprise that the crash took place. It was only a surprise from the point of view of the current orthodoxy.

In addition, commenting on your remark about management of bank-created money supply via the BoE base rate. I think that it is worth remembering that this only really factors into the thinking of banks when they have to go to the BoE for a loan to maintain liquidity and this is actually something of a marginal activity and generally very short-term. So this particular lever is not a very powerful one most of the time. So the idea that this is regarded as an efficient and effective way to run a modern financial system is both increasingly and rightly contested and also contradicted by the evidence.

Therefore the issue of monetary instability can indeed, as you say, be seen as largely due to irresponsible loans and debts. But the issue is not just to make sure they are repaid, but to limit the risk-taking behaviour and mindset that encouraged those loans in the first place. Currently, the way that the banking and finance system operates, there are real incentives not to address that until we go over the event horizon of a further crash cycle.

That means that (given that economies are complex dynamical systems) while it is true to some extant, as you say, that the lack of housing creates property price inflation, we should not lose sight of the fact that supply is always relative to demand and so demand-side factors can and do affect price. So while I agree with your implicit recommendation to increase supply of housing, I fear that it could be rendered relatively ineffective unless we address the issue that property is seen as an investment attractive to the increasingly rich financial sector. This increases demand and contributes, I would argue, significantly to housing inflation (personally I think that a land value tax, such as used to be Labour Party policy, ought to be considered to help address this and other issues related to rentier behaviour, but that's another conversation).

So, I think I agree with you about regulation of the banks and the restriction of lending. However, I am not sure that you are proposing to  significantly-enough pull back the ability of banks to, bluntly, create money. One thing that gives me pause for concern about your reply is the phrase “how much that money is leveraged”. To me 'leverage' means using a financial asset to create a further financial product or package. I wondered whether this was an allusion to fractional reserve lending? If so, I would have to say that it would be misplaced as, in effect, it is not the way that loan creation works any longer. I know that our economics textbooks often give it as an example, but it's out of date. There is no fractional reserve system. If you are talking about the run-away growth in derivatives, I tend to agree that action is needed there too.

Putting that aside to one side, I think that the real issue is of accountability (if you'll pardon the pun). Money supply should be seen as a public good and managed for the benefit of society as a whole and either not in the gift of private, for-profit, enterprises to arrange according to their own business plans and estimations of risk which are clearly blindsided at regular intervals and only tangentially and sporadically serve the common good. So, I think that we need to substantially return money creation to a democratically accountable system analogous to the legal tender approach to notes and coins but extended into the electronic realm.

Now it may be that what you have in mind in terms of regulation and controls might amount to that.  I'd be interested to hear your comments. In the run up to the election, I intend to ask all of the candidates for this constituency about this issue.

So that is what I wrote. On reflection, I didn't express well the issue about supply and demand in relation to bank loans. it would have been simpler to say, simply, that the banks' tendency toward profit pushes towards more finance tied up in riskier loans because demand is potentially infinite and only limited by price, in effect.

A further consideration I had thought about including but didn't in the end was to point out the disadvantage of money created by loans to be repaid at interest. Margrit Kennedy (free book outlining some of the issues here). In here book Occupy Money, she points out that by creating money as debt, we introduce automatically interest into the pricing of virtually the whole economic system. In effect, the banks are taxing us through practically every financial transaction. Her estimates are that in some cases this is compounded into quite significant price inflation. (Remember this next time banks propose to charge you to hold a current account). So restricting banks' ability to create money through loans could mean that we collectively subsidise the financial system's fat cats rather less.