A special privilege

The controversy over the budget deficits, and the anxiety expressed by many that central banks are creating or 'printing' money through quantitative easing needs to be put into context.

It is natural to feel slightly uneasy about the fact that central banks have the power to create money out of nothing. Indeed there are very strict rules in place to limit their ability to do this except under exceptional circumstances. Now that they are actually using this power to add money to the financial system in order to stabilise it many are concerned that this could be inflationary.

What is not appreciated is that commercial banks also have the power to create money, and that the vast bulk of money in the financial system (>97% in the UK) was created by commercial banks. They do this by simply typing in numbers on a computer in the bank account of anyone that they loan money to. This money does not come from anywhere. It is created by the act of typing numbers in the equivalent of a spreadsheet maintained by the bank. Furthermore, commercial banks have very few external constraints on how much money they can create. Their only considerations are whether they can earn enough interest on the loan and whether the interest and capital will be repaid. In recent years the financial innovation has meant that they need not worry too much about repayment as they can often sell the loans on to others soon after making them, passing on the risk of default.

While there used to be tight credit controls which controlled bank lending, in recent decades these have been largely abolished. The only remaining control is what is called the capital adequacy ratio (CAR), which requires bank to put aside a certain amount of secure capital for every loan. The rules are quite complex as certain types of capital are considered more secure (and so less is required). This was as low as 3% of loan value in some cases during the credit bubble (although it is being increased in the wake of the global financial crisis - stable doors, bolting horses etc). However CAR provides little practical restraint on lending at times when it is most needed, which is during economic booms when there is a risk of asset bubbles. This is because banks can use retained profits from existing loans as capital which then allow them to make more loans etc etc. CAR do provide a restraint on bank lending when they are not needed such during a recession when bank profits are down and defaults are high!

The overall point is that the regulation of money creation by private banks is very limited whereas public institutions have very strict rules preventing them from creating money except under exceptional circumstances. Is this balance rational?

The growth of the money supply by banks has been remarkable. What is instructive is to compare how much money has been created by private banks versus central banks over the past 50 years. The figure below from the book 'Where does money come from?' show this for the UK. What is quite obvious is that money creation by private banks has far outstripped money creation by the central bank, even after the recent rounds of 'quantitative easing'.

How often do you recall economists or politicians expressing any concern about the inflationary effects of money creation by private banks? They did not. And it was inflationary. But the inflation was focused on asset prices rather than consumer prices for the simple reason that private lending tends to be directed towards asset purchases such as stocks and properties. Banks like these as the assets act a security and tend to increase in prices as long as bank lending continues to grow. Some have argued that the huge profits made by financial institutions were really just the result of them creating so much money that assets prices rose enabling them to keep plenty of the money that they created and get fantastically rich. It was really one giant scam with ordinary people as the suckers. Remember that commercial bank credit creation creates no net new money so what has happened is that most people have borrowed money and transferred it to the financial sector has net earnings and profits. Most of them got to keep this money while the vast majority are drowning in debt.

Given this context does it really seem so awful for central banks to create money?

Indeed would it not be better to allow more money creation by governments central banks and less by commercial banks?

Why should this remarkable privilege of money creation and all the profits that go with it be largely confined to commercial banks? Commercial banks have a serious conflict of interest since their profits and earning are dependent on increasing their lending, and they naturally favour lending to purchasing assets that they can use as security (e.g. property and shares) rather than lending to increase productive capacity (e.g. business investment).

If you are interested in the history of how we came to possess the bizarre system that we have now, where private banks have this exclusive right to create money and profit from it, I recommend that you read the above book or take a look at the excellent videos on the website Positive Money, which has been set up to campaign for reforms to the monetary system.