“Of all the many ways of organising banking, the worst is the one we have today.”
Sir Mervyn King Governor of the Bank of England, 2003 - 2013 October 25th 2010
After the experience of the last few years, few people would disagree with Mervyn King’s claim above. The 2007-08 financial crisis led to massive increases in unemployment and cuts to public services as governments around the world were forced to bail out failing banks. While the complete collapse of the financial system may have been averted, six years later the countries at the centre of the crisis have still not recovered. In economic terms the permanent loss to the world economy has been estimated at a staggering $60 - $200 trillion, between one and three years of global production. For the UK the figures are between £1.8 and £7.4 trillion (Haldane, 2010).
Yet while the 2007/08 crisis was undoubtedly a surprise to many, it would be wrong to think that banking crises are somehow rare events. In the UK there has been a banking crisis on average once every 15 years since 1945 (Reinhart and Rogoff, 2009), whilst worldwide there have been 147 banking crises between 1970 and 2011 (Laeven and Valencia, 2012).
It seems clear that our banking system is fundamentally dysfunctional, yet for all the millions of words of analysis in the press and financial papers, very little has been written about the real reasons for why this is the case. Although there are many problems with banking, the underlying issue is that successive governments have ceded the responsibility creating new money to banks.
Today, almost all of the money used by people and businesses across the world is created not by the state or central banks (such as the Bank of England), but by the private banking sector. Banks create new money, in the form of the numbers (deposits) that appear in bank accounts, through the accounting process used when they make loans. In the words of Sir Mervyn King, Governor of the Bank of England from 2003-2013, “When banks extend loans to their customers, they create money by crediting their customers’ accounts.” (2012) Conversely, when people use those deposits to repay loans, the process is reversed and money effectively disappears from the economy.
Allowing money to be created in this way affects us all. The current monetary system is the reason we have such a pronounced and destructive cycle of boom and bust, and it is the reason that individuals, businesses and governments are overburdened with debt.
When banks feel confident and are willing to lend, new money is created. Banks profit from the interest they charge on loans, and therefore incentivise their staff to make loans (and create money) through bonuses, commissions and other incentive schemes. These loans tend to be disproportionately allocated towards the financial and property markets as a result of banks’ preference for lending against collateral. As a result our economy has become skewed towards property bubbles and speculation, while the public has become buried under a mountain of debt. When the burden of debt becomes too much for some borrowers, they default on their loans, putting the solvency of their banks at risk. Worried about the state of the economy and the ability of individuals and businesses to repay their loans, all banks reduce their lending, harming businesses across the economy.
When banks make new loans at a slower rate than the rate at * which their old loans are repaid, the money supply starts to shrink. This restriction in the money supply causes the economy to slow down, leading to job losses, bankruptcies and defaults on debt, which lead to further losses for the banks, which react by restricting their lending even further. This downward spiral continues until the banks eventually regain their ‘confidence’ and start creating new money again by increasing their lending.
We have no hope of living in a stable economy while the money supply - the foundation of our economy - depends entirely on the lending activities of banks that are chasing short-term profits. While the Bank of England maintains that it has the process of money creation under control, a quick glance at the growth of the bank-issued money supply over the last 40 years (shown opposite) calls this claim into question.
By ceding the power to create money to banks – private sector corporations – the state has built instability into the economy, since the incentives facing banks guarantee that they will create too much money (and debt) until the financial system becomes unstable. This is a view recently vindicated by the chairman of the UK’s Financial Services Authority, Lord (Adair) Turner, who stated that: “The financial crisis of 2007/08 occurred because we failed to constrain the private financial system’s creation of private credit and money” (2012).
Yet if this instability in the money supply weren’t enough of a problem, newly created money is accompanied by an equivalent amount of debt. It is therefore extremely difficult to reduce the overall burden of personal and household debt when any attempt to pay it down leads to a reduction in the money supply, which may in turn lead to a recession.
The years following the recent financial crisis have clearly shown that we have a dysfunctional banking system. However, the problem runs deeper than bad banking practice. It is not just the structures, governance, culture or the size of banks that are the problem; it is that banks are responsible for creating the nation’s money supply. It is this process of creating and allocating new money that needs fundamental and urgent reform.
This book explores how the monetary system could be changed to work better for businesses, households, society and the environment, and lays out a workable, detailed and effective plan for such a reform.
Our proposed reforms
We have little hope of living in a stable and prosperous economy while the money supply depends entirely on the lending activities of banks chasing short-term profits. Attempt to regulate the current monetary system are unlikely to be successful – as economist Hyman Minsky argued, stability itself is destabilising. Indeed, financial crises are a common feature of financial history, regardless of the country, government, or economic policies in place: Crises have occurred in rich and poor countries, under fixed and flexible exchange rate regimes, gold standards and pure fiat money systems, as well as a huge variety of regulatory regimes. Pretty much the only common denominator in all these systems is that the banks have been the creators of the money supply. As Reinhart and Rogoff (2009) put it:
“Throughout history, rich and poor countries alike have been lending, borrowing, crashing -- and recovering -- their way through an extraordinary range of financial crises. Each time, the experts have chimed, 'this time is different', claiming that the old rules of valuation no longer apply and that the new situation bears little similarity to past disasters.”
Rather than attempt to regulate the current monetary system, instead it is the fundamental method of issuing and allocating money that needs to change. These proposals are based on plans initially put forward by Frederick Soddy in the 1920s, and then subsequently by Irving Fisher and Henry Simons in the aftermath of the Great Depression. Different variations of these ideas have since been proposed by Nobel Prize winners including Milton Friedman (1960), and James Tobin (1987), as well as eminent economists Laurence Kotlikoff (2010) and John Kay (2009). Most recently, a working paper by economists at the International Monetary Fund modelled Irving Fisher’s original proposal and found “strong support” for all of its claimed benefits (Benes & Kumhof, 2012).
While inspired by Irving Fisher’s original work and variants on it, the proposals in this book have some significant differences. Our starting point has been the work of Joseph Huber and James Robertson in their book Creating New Money (2000), which updated and modified Fisher’s proposals to take account of the fact that money, the payments system and banking in general is now electronic, rather than paper-based. This book develops these ideas even further, strengthening the proposal in response to feedback and criticism from a wide range of people.
There are four main objectives of the reforms outlined in this book:
To create a stable money supply based on the needs of the economy. Currently money is created by banks when they make loans, driven by the drive to maximise their profit. Under our proposals, the money supply would be increased or decreased by an independent public body, accountable to Parliament, in response to the levels of inflation, unemployment and growth in the economy. This would protect the economy from credit bubbles and crunches, and limit monetary sources of inflation.
To reduce the burden of personal, household and government debt. New money would be created free of any corresponding debt, and spent into the economy to replace the outstanding stock of debt-based money that has been issued by banks. By directing new money towards the roots of the economy - the high street and the real (non-financial) economy - we can allow ordinary people to pay down the debts that have been built up under the current monetary system.
To re-align risk and reward. Currently the government (and therefore the UK taxpayer) promises to repay customers up to £85,000 of any deposits they hold at a bank that fails. This means that banks can make risky investments and reap the rewards if they go well, but be confident of a bail out if their investments go badly. Our proposals will ensure that those individuals that want to keep their money safe can do so, at no risk, while those that wish to make a return will take both the upside and downside of any risk taking. This should encourage more responsible risk taking.
To provide a structure of banking that allows banks to fail, no matter their size. With the current structure of banking no large bank can be permitted to fail, as to do so would create economic chaos. Simple changes outlined in this book would ensure that banks could be liquidated while ensuring that customers would keep access to their current account money at all times. The changes outlined actually reduce the likelihood of bank failure, providing additional protection for savers.
In order to achieve these aims, the key element of the reforms is to remove the ability of banks to create new money (in the form of bank deposits) when they issue loans. The simplest way to do this is to require banks to make a clear distinction between bank accounts where they promise to repay the customer ‘on demand’ or with instant access, and other accounts where the customer consciously requests their funds to be placed at risk and invested. Current accounts are then converted into state-issued electronic currency, rather than being promises to pay from a bank, and the payments system is functionally separated from the lending side of a bank’s business. The act of lending would then involve transferring state-issued electronic currency from savers to borrowers. Banks would become money brokers, rather than money creators, and the money supply would be stable regardless of whether banks are currently expanding or contracting their lending.
Taken together, the reforms end the practice of ‘fractional reserve banking’, a slightly inaccurate term used to describe a banking system where banks promise to repay all customers on demand despite being unable to do so. In late 2010 Mervyn King discussed such ideas in a speech:
“A more fundamental, example [of reform] would be to divorce the payment system from risky lending activity – that is to prevent fractional reserve banking … In essence these proposals recognise that if banks undertake risky activities then it is highly dangerous to allow such ‘gambling’ to take place on the same balance sheet as is used to support the payments system, and other crucial parts of the financial infrastructure. And eliminating fractional reserve banking explicitly recognises that the pretence that risk-free deposits can be supported by risky assets is alchemy. If there is a need for genuinely safe deposits the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not coexist with risky assets.” (King, 2010)
After describing the current system as requiring a belief in ‘financial alchemy’, King went on to say that, “For a society to base its financial system on alchemy is a poor advertisement for its rationality.” Indeed, over the next few chapters we expect readers to find themselves questioning the sanity of our existing monetary system.
The structure of this book
Part 1: The Current Monetary System
Chapter 1 provides a brief history of money and banking and describes the emergence of the monetary system we have today.
Chapter 2 describes how the current monetary system works and how commercial banks are able to create the nation's money supply.
Chapter 3 considers the wide range of influences that affect that amount of money that the banks create.
Chapter 4 analyses the economic effects of the current monetary system.
Chapter 5 looks at the social and ecological impacts of the current monetary system.
Part 2: The Reformed Monetary System
Chapter 6 describes the changes that must be made to the operations of banks in order to remove their ability to create money.
Chapter 7 describes how new money will instead be created by a public body, and how that money will be put into the economy.
Chapter 8 outlines the transition between the current system and reformed system (with further technical details provided in Appendix III).
Chapter 9 covers the likely social, economic and environmental impacts of a monetary system where money is issued solely by the state, without a corresponding debt.
Chapter 10 considers the likely impact of these reforms on the banking and financial sector.