Friday, 21 May 2021

Who should create safe money: central banks or commercial banks?



Governments render a proportion of commercial bank created money safe via deposit insurance and bank bail outs. In contrast, much private / commercially created money is not safe: e.g. deposits over the limit covered by deposit insurance (€100k in the Eurozone) and Bitcoin type money.  But whence the assumption that that safe money should come in the form of commercial bank money rather than central bank created money (often called “base money”)?

One reason for thinking base money is preferable is that commercial banks actually use their freedom to create money in a highly irresponsible way, that is to create and lend out money in a boom, just when stimulus is not needed, and then come a recession, they do the reverse, i.e. reduce or cease lending, or even call in loans: again, exactly what is not needed. That is, commercial banks act in a pro cyclical manner. And that means central banks have to create or destroy money (via QE, interest rate changes etc) that counter that erratic money creation / destruction by commercial banks. So why don't we just abandon commercial bank safe money and have base money as the only form of safe money?

Of course, the fact of banning commercial bank created safe money does not mean an end to commercial banks' pro cyclical behavior as they are still free to create unsafe money. But the latter ban would at least cut down somewhat on pro cyclical behavior. Moreover, safe money is more powerful stuff per dollar than non-safe money: in fact banks don't even trust each others "home made" money - they always settle up with each other using base money.

A second reason for thinking base money is preferable is that having taxpayers back commercial bank created money via deposit insurance and bail outs is a subsidy of commercial banks or at the very least, it makes commercial bank money marginally more attractive, and subsidies are not justified, i. e. they do not maximise GDP unless there are very good social reasons for such subsidies.

But the social aspect of rendering commercial bank money safe can perfectly well catered for via base money. That is, the process of making a given amount of money per person safe (e.g. the €100k in the Eurozone) is clearly socially motivated, rather than motivated by economics: if there was a good economic reason for making ALL MONEY safe, then governments would do that. Indeed, the latter social provision is fully justified: everyone has a right to a very safe method of storing some minimum amount of money. That is a basic human right.

To summarise so far, the arguments for having safe money in the form of commercial bank money look weak.

A possible argument for having safe money in the form of commercial bank money is that that gives commercial banks greater flexibility than in the base money option (where commercial banks, would have to first borrow money before being able to lend it out.)

Unfortunately that’s a poor argument. First, commercial banks do not have complete freedom to create and lend out money willy nilly: they are constrained by capital requirements and reserve requirements, though those constraints vary from one jurisdiction to another.

Second, as is the case at the moment, a commercial bank with a sudden need for more reserves (aka base money) is always free to borrow it from other banks.

Third, it might seem that where commercial banks are free to create and lend out money rather than borrow money before lending it out, that that means they can avoid paying higher interest rates for that money. Unfortunately that argument is questionable (though it is an argument put by Joseph Huber and James Robertson on p.31 of their work “Creating New Money”).

Obviously IN THE FIRST INSTANCE, when a bank creates and lends out money it doesn’t need to pay interest to obtain that money. Unfortunately as soon as that loaned out money is spent, it ends up on sundry bank accounts, and those account holders will want extra interest for holding that money rather than trying to spend it away. Thus the latter “first instance” is very short lived.

Put another way, as soon as that money ends up in “sundry bank accounts” it will tend to be spent away (the “hot potato” effect) which will cause excess demand, which will induce the central bank to raise interest rates. The net result is that it is very debatable as to whether commercial banks’ freedom to create the money they lend out from thin air actually benefits those banks.

Incidentally, I have in the past cited the above Huber & Robertson point with approval: i.e. think I actually made a mistake there.



The conclusion is that advocates of full reserve banking are right: that is, depositors should have the choice of two types of account. First a totally safe account, which is backed 100% by reserves / base money at the central bank. Second, riskier accounts which have the advantage that depositors’ money is loaned out, which earns interest for depositors, but all relevant risks are carried by depositors.

Indeed, those who want their bank to lend out their money are into exactly the same business as those who want their stockbroker or a mutual fund (“unit trust” in the UK) to lend out or invest their money: they are into COMMERCE. And it is not the job of governments to support commerce, absent very clear social reasons for doing so.

Incidentally Huber & Robertson also argue for full reserve; i.e. I am saying they are right but for not quite the right reason.


  1. What you have here is pretty much the way I understand things.

    The curious fall-out is where we find ourselves in world economies today.

    Let's suppose that a commercial bank makes a loan to car makers to make cars. Money flows to car makers, then workers, then diffuses, but never leaves the bank(s).

    So then, for a while, we have the situation where the car maker has cars but can't repay the bank. Well, that can be fixed by lending to car buyers, so money can flow back to car makers who repay the banks, all while this same money is stored safely in bank(s) accounts.

    But then the workers say THEY can't repay the loans unless you give us work. It's HERE where we are today.

    So, what is the solution?

    It seems to me that building cars steadily is the solution. An inherently jerky building cycle can be smoothed by a slower, steady lending pattern.

  2. A comment follow-up:

    The bank lending to workers has a choice of lending standards: Lend based on ability to repay or lend based on asset value (thinking that repossession is an acceptable method of repayment).

    The problem with the second method is that valuation is extremely volatile. Think bitcoin volatility like. Think the root of boom and bust.


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