RG9 Who Should Create Money?

PREVIOUS POST: RG8: Bagehot’s Engaging Naiveté (Sequence on HIstory of Central Banks, starts with initial post: Reading Course: Central Banking)

In this post, we will cover the remaining portion of Goodhart Ch2 Case for Free Banking It is worth noting that this chapter is a theoretical preliminary, and not part of the historical analysis which is the main strength of this book.  The Central Question of importance, to which no solution is known currently, is the following: Who should create money, and what should be the rules or guidelines for the creation of money? It should be obvious that the power to create money creates enormous benefits for the creator. The free banking debate takes the view that Central Banks are unnecessary government intervention which create a harmful monopoly over the power of money creation. The opposite point of view is that Central Banks are a conspiracy to benefit commercial banks at the expense of the government and the public. The historical evidence is more supportive of the second view. Competition among private banks is harmful to the banks, because to compete, they keep taking increasingly risky positions. The private interests of banks individually are opposed to the collective interests of the banking system as a whole. Thus, Central Banks evolved naturally out of the essential need to regulate private banking, in order to create some stability in a system which is inherently fragile and unstable under competitive forces. After this overall summery, we discuss the second part of Chapter 2, entitled “The Inherent Inflationary Tendencies of the Central Bank”. This completes our discussion of Chapter 2, and we will go on to Chapter 3 next week.

Theoretical Position: Central Banks will take advantage of this power to create large amounts of money, leading to inflation, and destroying the value of currency, causing massive damage to the economy.

Empirical Support: Several Historical episodes where convertibility of Central Bank issued notes to gold was suspended. This suspension indicates that Central Banks issued too many notes, and did not have sufficient gold to be able to provide backing for them.

Question: What is the alternative? Should private banks be allowed to create money? Another way to put the question is: What should be “legal tender”, money that is backed by the law?

Answer: Bagehot argues that if a bank is allowed to issue money freely, it will do so without restraint. However, the Bank of England had this power, and did not do so. WHY? Bagehot thinks that this is because the Board of Directors consisted of un-imaginative merchants, who were unaware of the possibilities open to them. However, Santoni argues that private sector directors were creditors, who had direct interests in maintaining the value of the currency. It was the government’s desire for funds which created inflationary pressures, which would be resisted by private sector directors of the Central Bank.

What does “Legal Tender” Signify? Goodhart makes the point that historically, currencies                                                                  were designated legal tender in times that they were weak – there was insufficient gold backing, so the government had to step in with a legal protection for acceptance of the currency as payment. Historically, this status has occasionally been given to private currencies issued by banks. The point being made is that governmental legislation and decree is only a small part of what makes money valuable, and other factors, not considered in the debate, matter a lot for money creation.

The Free Marketeers ideological position: Hayek’s claim that “practically all governments of history have used their exclusive power to issue money in order to defraud and plunder the people”. Is this really true? Historical evidence does not provide any clear examples, where governments used power of money creation against the public interest. Ellen Brown has argued that free marketeers make this argument in order to take control of money creation away from the government, in order to use it for private benefits of the financial sector.   For a more detailed discussion of this point of view, see “The Battle for the Control of Money”.

So what is the solution to this ALLEGED tendency of Central Banks to over-issue currency and thereby cause inflation? Free Marketeers argue that “competition” is the answer. One form of competition is with foreign currencies. If one Central Bank is irresponsible, the currency will be devalued and people will switch to more sound foreign currencies. Hayek did not consider this as a sufficient check on the power of money creation by Central Banks. Therefore he proposed a more radical alternative. Authorize private sector banks to issue money, and let them compete freely in the market for creation of money. However, there are many problems with this theoretical idea – the idea that the private sector would create sound money to maintain credibility is contradicted by the historical evidence. Private sector maintains appearances of credibility while doing extremely unsound and dangerous financial practices because they have inside information, and they are too big to fail. Realizing that there is no hope of creating private currencies, free marketeers have proposed to index money to a basked of commodities, in order to prevent inflationary tendencies. This is meant to replace the Gold Standard, which was a means to keep the currency anchored to a real resource, and thereby to prevent excessive issuance of currency. However, none of the commodity backed proposals have found much acceptability, and so this does not seem to be a viable approach.

Whereas the line of attack under discussion above says that Central Banks have inflationary tendencies and issue too much currency, there is another line of attack from the opposite direction. According to this line, Central Banks are too conservation and issue too little money, causing harm to the domestic economy. This is especially popular after the Keynesian critique of balanced budgets.

Resolution: The empirical evidence on this issue is quite clear. The central claim of the free bankers is that forces of competition would cause private banks to behave responsibly and not create excessive credit. Historical experience of more than 300 monetary and banking crises following the Reagan-Thatcher era of financial de-regulation proves conclusively that this is not the case. Given the power to create money without strict regulation, the shadow banking industry continues to create trillions of dollars of credit leading to extreme financial fragility.

The basis of this discussion is the question of how Central Banks should create money? Should they use their own discretion, or should they follow rules? Again, the empirical evidence on this question is very clear. The experience of rule-based monetary policy has been very bad. Central Banks were unable to control the money supply in accordance with the rules, and following rules limits the ability of Central Banks to take steps to help the domestic economy.

The reason for dis-satisfaction with Central Bank management of money supply arises from the fact that there are many different parties, with different interests. Managing money in any way will help some parties and hurt others, so there is bound to be dis-satisfaction. A brief summary of the conflicts of interest which surround monetary policy is given below, to provide some background for the remaining chapters of the book.

Some Background Information: The process of money creation affects everyone in the economy, but different parties have different interests. In general creditors would like to see stable currency and prevent inflation, while debtors would like to see easy money and inflation, so that the loans they have to pay would be cheaper to pay back. In general, creditors have power, and therefore keep the currency creation in check, to prevent inflation. Apart from this broad perspective, there are institutions and sectors with conflicting interests. The Government, which always needs money to finance projects and would like to see easy money creation. The Treasury must provide revenue to the government via taxation, and borrow money from Central Bank and/or private or foreign sources, to finance government operations. Although it is part of the government, it is interested in keeping spending in check, and raising taxes, both of which are in conflict with objectives of popular governments. The Central Bank, charged with the responsibility of money creation, has responsibility to preserve the value of the currency, and to regulate private banks. It is important to note that the interests of the Treasury and the Central Bank are not aligned. The Treasury, or Finance Ministry, would like to freely borrow from the Central Bank to finance the budget. The Central Bank would like to restrict lending in order to keep money supply in check, to control inflation. Then there are the private commercial banks and the financial sector of the economy. These are the creditors who have interest in keeping inflation low. A tight monetary policy suits them, as it makes it easier to sell credit. On the other hand, private real sector businesses would like to see easy credit, to cheaply borrow and invest. Then, there is the general public, which would like stability of money and prosperity, in the form of jobs created by easy money. In addition to all these conflicting interests, there are powerful effects on international trade. An easy monetary policy would lead to devaluation, making imports expensive and exports cheaper. Conversely, keeping the exchange rate stable might lead to a tight monetary policy harmful to the domestic economy.

NEXT POST: RG10 – Some Myths About Money

8 comments
  1. Round and round we go. There is no answer to this question because no one can have a definitive answer; not being able to agree upon, “What Is Money?” Depending upon as Soddy stated, (…”I feel for you and others in that you are not aware of being victimized.”) ” So elaborately has the real nature of this ridiculous proceeding been surrounded with
    confusion by some of the cleverest and most skilful advocates the world has ever known, that it still is something of a mystery to ordinary people, who hold their heads and confess they are ” unable to understand finance. It is not
    intended that they should.”(The Role Of Money) When one discovers “Money” as a concept is not the same as “Money” as an issuance; one word with multiple meanings, the reasoning of why, how, and who can create and issue.

  2. Dingo said:

    “The Central Question of importance, to which no solution is known currently, is the following: Who should create money, and what should be the rules or guidelines for the creation of money?”

    Shouldn’t the question be: who should be allowed to leverage the government issued base money? All money we use today, and all assets we price, are based on the very notes and coins government issues. Everything else is a promise to convert into this money, hence why it can be leveraged. Bank account deposits, although created out of thin air by banks, are always a legal obligation of the bank to convert into notes and coins on demand. If this legal obligation did not exist, the bank deposits could not be used as money, and would have no value. Central and commercial banks are all leveraging the base money, always.

    The true value of these notes and coins are the legal mandate of the government to accept them as payment of taxes, which was born out of the feudal age. Everything else is just a leverage of this. Even crypto-currencies only derive their value because they can be converted into bank deposits which can be converted into notes and coins.

    When the governments rid the world of all cash (notes and coins) and usher in government issued crypto-currencies, their value will be based on the same thing – a promise to accept them in payment of taxes, and then banks will leverage these promises into bank deposits, and all of this bank money leveraged into other financial assets. People will still hold in their mind the image that these crypto-currencies are the same as notes and coins until a generation or two passes.

    • “The Central Question of importance, to which no solution is known currently, is the following: Who should create money, and what should be the rules or guidelines for the creation of money?” (DINGO)
      Round and round we go. Who should create ????? What should be the rules or guidelines for the creation of ????
      Is ???? thin air? Is ???? something of value? Is ???? Money now is the NOTHING you get for SOMETHING before you can get ANYTHING? SOMETHING GIVEN UP NOW FOR A FUTURE ANYTHING.

      • No solution?? Who says so?
        (fiat)Money is a public utility and must be created as such by a democratically overseen public institution (a department of the Treasury?)
        The rules come out of the definition what is money?
        Draft definition “Money is a tokenised version of a nation’s gross product of useful goods and services.”
        The money system acts as an automatic rationing system and must be in balance with the total goods and services ready for sale. This is the only rule as to homuch money ther needs to be.

        Since money-tokens have virtually not cost of production they should be issued debt-free and and spent into the economy.

        This is enough for now. Any problems here?

    • “Wthe governments… usher in government issued crypto-currencies…”

      This, in my opinion, is a “workaround” in the misuse of the millennia old physical toke system.
      Stop treating money as a scarce commodity and the misuse is eliminated like the bug in a computer program.

    • Calgacus said:

      Bank account deposits, although created out of thin air by banks, are always a legal obligation of the bank to convert into notes and coins on demand. If this legal obligation did not exist, the bank deposits could not be used as money, and would have no value

      That’s not correct, nor what MMT says. Bank deposits are not historically or always or even usually legal obligations of the bank to convert into state money. (Mitchell Innes in 1914 addressed this point – said: show me what law in what nation says this.) And such an obligation is NOT enough to back bank money.

      That is not what backs bank money – and can’t be as the argument is circular. How could a bank back its promises by another promise? What backs bank money in a modern system is that the state accepts them as payment for taxes from individuals and firms.

      • “That is not what backs bank money – and can’t be as the argument is circular. How could a bank back its promises by another promise?” Isn’t your answer ‘circular’ A state promises to accept a promise as payment?
        But once again; none of these questions are answerable without a definition of “How must money be created?”
        Long before any ‘state’ people created “MONEY” with a handshake, or a tally stick, or mark on a stone, beads,coins or colorful notes.Once again, quote Frederick Soddy, ” So elaborately has the real nature of this ridiculous proceeding been surrounded with confusion by some of the cleverest and most skillful advocates the world has ever known, that it still is something of a mystery to ordinary people, who hold their heads and confess they are ‘unable to understand finance.’ It is not intended that they should.”(The Role Of Money)

  3. I like the little background summary at the end of the piece
    May i say, I beg to differ somewhat (re June 3 to 17th comments on the commendable central question) and wish to add in the concept of real estate. ONS says 60% of money arises from transactions in real estate. Promises to pay back a ‘loan’. Mervyn King while BofE governor said “97% of money is commercial-bank created [hence the ‘thin air’ point – sinking to 96% or 95% – still twenty times as much as currency notes]. Notes which UK’s Exchequer now get all the benefit from whereas, according to one BoE official post WW2 the habit was to hand over half the numerical value to the Exchequer, retaining the other half for stability activities (supporting the pound). But not much compared to what the commercial banks are now creating as money on screen (in normal times), . [at least upo to 2006 when QE distorted everything].
    Real estate, homes and buildings are what people are prepared to put money into while ever others are prepared to buy it – i e enter into a contract to pay back that over a working period of 20 years. Such agreements entered into while young and able-bodied are the stuff of societal stability. There are other reasons to want to work, but mainly its for food, clothing, transport, a roof that is secure and does not leak.
    it attracts the others wishing to have a partner in life – someone easy to get on with and likewise hardworking, the basis of families [sweep the kitchen floor each morning etc. ; invest in quality; be able to discern it as a result of concentrated effort to master hand-skill.

    “Central Question of importance, to which no solution is known currently, is the following: Who should create money, and what should be the rules or guidelines for the creation of money?” SUGGESTION: UK-Treasury to tell (via exchange of memoranda) Bank of England that a charge is to be brought in AT LEAST at the level of 3% on the amount of money issued that is more than the previously-exchanged property Price Difference between succeeding Land Registry figures in the property transaction process. That’s at least a start..
    at least it could be on greenER deal – new money ring-fenced for thorough “energy-enveloping” at 1.5% fixed and one-third of that to Exchequer (except for BofE’s 0.05% handling charge). Then at end of 20-years it can be cancelled, otherwise on typical £40k which homeowner would cough up the payback of up to £2000 p.a.. its a way in for your MMT. At an estimated 1 million homes and buildings a year £200m to exchequer p.a, then £400 £600 and so on up to £4bn p.a then lasting at that level for another 209 years (40m UK homes and bldgs – almost all leak heat at eaves and sideways into air or ground at low level, making a mockery of EWI savings claims. instead a greenER practical deal). savings on energy then would be easily equal to costs of interest as GD intended when devised over 10 years ago.. Wake up UK! and get busy £40 bn per year!

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