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Money safe

12 December 2014 By Edward Hadas

The finance-monetary system works badly. That is an anomaly in the modern economy. Compared to the industrial system, the research and development complex and the welfare state, the money machine is inflexible and prone to collapse. The poor outsourcing arrangement for the creation of money is a problem that needs to be addressed.

The anatomy of the curiously created money system is well described in Felix Martin’s book, Money: The Unauthorised Biography. Governments, he notes, are directly responsible for the creation of money that comes in the form of coins and bills and, for the cognoscenti, central bank reserves. But in modern economies, most of what people think of as money is made when banks put the proceeds of a loan into the borrower’s account.

In theory, bank account balances are quite different from legal tender. Governments back the nominal value of its coins and notes and reserves. They do not stand unequivocally behind bank ledgers.

In theory, depositors are supposed to lose money if their bank has made too many bad loans. In practice, over the last two centuries, governments have increasingly treated bank-made money as their own. The effective guarantee turns most money-creation into a public-private partnership where governments outsource the job to banks.

The arrangement makes many politicians and economists uncomfortable. They would prefer that bank-made money did not have state support. However, almost every time the value of private money is seriously threatened, it seems safer to shore up the private part of the system than to take the chance that the whole economy will unravel.

Quite a lot of the time, the outsourcing of money creation appears to work fairly well. Central banks and financial regulators believe that they are guiding the banks to make roughly the right amount of money and to put it mostly in safe hands.

The appearance is deceptive. A long series of financial crises around the world demonstrates that the quantity of new money made is often excessive and that the variations in the pace of creation are dangerously variable. Uncertainty about just what money is guaranteed by the government encourages foolish confidence in good times and paralysing fears whenever there are serious economic or financial problems. And throughout, the private contractors – the banks and investment houses – collect large fees.

It’s time for a rethink. Governments can learn from what a hospital does when it decides that a cleaning contractor is charging too much for poor service.

The first step is to improve supervision of the subcontractor. In the financial system, hopes should be modest. Reforms have followed each malfunction dating back at least as far as the panic of 1907. But more than a century of effort has not prevented a toxic cycle of money creation that ended in the 2008 collapse of Lehman Brothers, followed by a deep recession and six years of stumbling recovery in most developed economies.

A more promising approach is to reduce outsourcing. Hospitals can bring cleaners onto their own payrolls. It is trickier for governments to take money creation in-house, but they do not actually need to rely on banks or investors to create and distribute new money. They can make money directly, whether by distributing notes in the streets or, more sensibly, by unilaterally adding sums to bank accounts without any corresponding increase in debts. For the cognoscenti, that amounts to increasing central banks’ reserve balances.

Bankers usually respond to the idea of direct monetary creation with horror. Governments, they say, cannot be trusted with so much power. They will run huge deficits or will bribe voters with inflationary giveaways. The dire warnings are vastly exaggerated. Besides, the banks are in a poor position to complain. They have shown time and time again that they are unreliable stewards of the monetary system.

Finally, when a system works badly, it is a good idea to rethink the whole thing. Hospitals might close central cleaning departments and give the responsibility to other managers. Governments can do something similar by making a much sharper distinction between credit for investments and money for spending.

The simplest way to do that is through the creation of what economists call narrow banks, institutions which manage transactions but do not make any loans. Narrow banks cannot easily lose money, especially now that account balances can be verified electronically before any transfer is attempted.

In a narrow banking world, none of the funds for consumer, inventory financing and long-term investments come from banks. Rather, they come from investments which cannot automatically be cashed in and whose value is expected to vary. Common equity is a template.

There may be many ways to make finance more robust and resilient. Whichever path is chosen, the task is historic. The outsourcing of money creation was adopted by accident. The world needs a system that is fit for purpose.

 

 

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