Money Creation As Public Policy: A Brief Argument For A Public Sector Solution
Posted on Nov 4, 2021Geeta Minocha
Three theories exist to explain the role of banks in capital creation. Per the financial intermediation theory of banking, banks, like all financial institutions, are intermediaries that have no part in money creation.[1] Under the fractional reserve theory, individual banks are mere intermediaries, but the collective interactions of banks within the system create money.[2] Finally, a third theory, the credit creation theory, posits that each individual bank may create new money when it lends.[3]
Today, the financial intermediation theory dominates economics,[4] but it remains unclear whether this theory is the correct one. Particularly after the Financial Crisis, the notion that the money multiplier controls the money supply—a key implication of the financial intermediation theory—has come under intense scrutiny.[5]New empirical research indicates at least some support for the credit creation theory.[6] Moreover, a few characteristics of the current financial system seem to support the credit creation theory because they likely promote money creation by individual institutions: 1) 95% of all economic transactions are non-cash transactions, and 2) Banks are exempt from “client money rules”, which bar non-bank financial organizations from integrating client money into the organizational assets and liabilities.[7] If the credit creation theory indeed holds true, it necessitates a reconsideration of existing economic models, banking regulation, and monetary policy.
I. Implications of Credit Creation Theory
In practice, the credit creation theory means that banks do not lend merely what they are given in deposits, but rather that they create deposits in order to lend.[8] The perception of risk influences the amount of money in the economy: New deposits generate new money, while debt repayment destroys money by reducing bank assets.[9] Through this theory, private banks may be considered regulated franchises of the sovereign government, tasked with money creation.[10] If this is true, it begs the question: Why shouldn’t public financial institutions be given this same power?
II. Why Is Money Creation Important?
Answering this question of franchising requires understanding the importance of money creation. Some economists believe money supply strictly impacts economies in the short-term, influencing crises or recessions, while others believe it to impact long-term economic development.[11] What is certain is that money supply affects interest rates, and in turn the public’s ability to borrow and consume, and that more money means lower rates.
The policy mechanisms used to control the money supply also have significant economic effects, though their precise impacts are debated. For instance, some economists believe that, because governments cannot force bank actions to shift the money supply, the result is endogenous money that increases in good times and decreases in bad.[12] If true, this causes policy problems, since the common practice is to increase the supply in bad times.[13]
III. Effects of Existing Regulations
The significant impact of the money supply makes it vital that good actors control it and that regulations are tight. In the current regulatory regime, the Dodd-Frank Wall Street Reform and Consumer Protection Act rules vary for banks depending on the amount of assets they hold. Auditing and governance requirements are different for banks with $500 million in assets and those with $1 billion in assets, for example.[14] Below a $3 billion asset threshold, banks may be examined less frequently and take on more debt.[15] Below a $10 billion asset threshold, they are not subject to proprietary trading restrictions, limitations on debit card interchange fees, or primary consumer compliance supervision by the Consumer Financial Protection Bureau.[16] Moreover, there are mixed data about whether risk has truly decreased with these new measures. A 2016 study noted that, in fact, “measures of volatility and risk premiums today are no lower and perhaps somewhat higher than they were prior to the financial crisis,” with a sharp decline in common equity to assets ratios and higher credit default swap spreads compared to those of pre-Recession periods.[17] It is fair to ask, then, whether the existing laws are enough to properly regulate the money supply changes by commercial banks.
Today’s high risk may be due to the abundant optimism of the pre-Recession years that underestimated risk values, or a diminishment in bank franchise value, which would decrease the value of bank equity.[18] But the profit motive that drives private banks cannot be ignored, and is at least part of the problem; banks may be driven to manipulate numbers according to opaque accounting principles or engage in regulatory arbitrage.[19] The result is monetary policy that benefits private financial institutions at the expense of society. As Illinois Senator Dick Durbin famously put it, these institutions “frankly own the place.”[20]
IV. Public Banks As Generators of Money
Movements pushing for the creation of public banks are gaining momentum around the country. In just the last few months, for instance, the cities of San Francisco and Los Angeles approved steps to create their own municipal banks.[21] As these public financial institutions become more ubiquitous, it is critical to reassess the typical responsibilities we have imposed on private institutions and think of innovative ways to leverage new public ones.
The current system of money creation forces governments to borrow from private banks at market interest rates, leading to significant amounts of taxpayer money going to interest payments as opposed to the services that would help taxpayers; the United States is currently paying over $900 million per day in such payments.[22] But giving public banks a mandate to control the money supply would likely lead to lower taxes and a smaller deficit in the long run—a consequence of the zero percent interest rates governments would be charged. This means more money for public investment that benefits citizens. Importantly, the fewer institutions involved and the lack of a profit motive suggest a public banking system of regulating the money supply would be much more effective: Only a small number of coordinated, good faith actors would be at the helm of this important economic policy tool.
In his seminal treatise on money, the economist John Kenneth Galbraith wrote, “The process by which banks create money is so simple that the mind is repelled when something so important is involved, a deeper mystery seems only decent.”[23] Indeed, this process is simple, so simple that there is no reason to believe a public sector solution would not be effective. Lawmakers and public and private stakeholders alike would do well to use public banks to remedy the inefficiencies in the financial system.
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[1] Richard A. Werner, Can Banks Individually Create Money Out of Nothing? — The Theories and the Empirical Evidence, 36 Int. Rev. Fin. Analysis 1 (2014).
[2] Id.
[3] Id.
[4] Richard A. Werner, A Lost Century in Economics: Three Theories of Banking and the Conclusive Evidence, 46 Int. Rev. Fin. Analysis 361 (2016).
[5] See, e.g., Michael McLeay, et al., Money Creation In the Modern Economy, Bank of England (2014). (“While the money multiplier may be a useful way of introducing money and banking in economic textbooks, it is not an accurate description of how money is created in reality.”)
[6] Kristaps Freimanis and Maija Senfelde, Credit Creation Theory and Financial Intermediation Theory: Different Insights on Banks’ Operations, Int. Scientific Conf. (2019).
[7] Id.
[8] Maurice Starkey, Credit Creation Theory of Banking (2018).
[9] Id.
[10] Hartley Withers, The Business of Finance, 54 (1916).
[11] See, e.g., Dinh Doan Van, Money Supply and Inflation Impact on Economic Growth, 12 J. Fin. Econ. Pol. 121 (2020).
[12] Arkadiusz Sieroń, Endogenous Versus Exogenous Money: Does the Debate Really Matter?, 73 Rsch. Econ. 329 (2019).
[13] See, e.g., Karen Brettell, Analysis: Economists Eye Surging Money Supply As Inflation Fears Mount, Reuters, Jun. 17, 2021.
[14] Marc Labonte and David. W. Perkins, Over the Line: Asset Thresholds In Bank Regulations, Cong. Rsch. Serv. (2021).
[15] Id.
[16] Id.
[17] Natasha Sarin and Lawrence H. Summers, Understanding Bank Risk Through Market Measures, Brookings Papers on Economic Activity (2016).
[18] Id.
[19] See, e.g., European Comm’n, High-Level Expert Group on Reforming the Structure of the EU Banking Sector, at 77 (2012), https://ec.europa.eu/commission/presscorner/detail/en/IP_12_1048 (“However, as accounting standards are the basis for prudential regulation and supervision, the continuing divergences between accounting standards in different jurisdictions create significant scope for opacity and regulatory arbitrage.”)
[20] Ciara Torres-Spelliscy, “Durbin: The Banks Own Capitol Hill”, Brennan Ctr. Just., Apr. 30, 2009.
[21] LA Takes A Step Toward Launching A City-Owned Bank, L.A. Times, Oct. 5, 2021 and SF Supes Approve Plan to Create First Public Bank In U.S., CBS SF BayArea, June 15, 2021.
[22] Peter G. Peterson Foundation, “The Fiscal and Economic Impact”, Peter G. Peterson Foundation (2021).
[23] John Kenneth Galbraith, Money: Whence It Came, Where It Went 21 (Princeton Univ. Press 2017).