Who Controls the Economy’s Money Supply?
Submittted by CCEC member Joan Woodward
Most of us have been led to believe that the boom-bust cycle is inevitable. We have been sold vague notions about “business confidence”, “herd psychology”, and best of all, “mysterious market forces”. We are expected to have blind faith in the “crumbs from the table effect” (alternately know as the trickle-down effect) and to immediately genuflect in the presence of the banker priests of our economic destiny.
While a great many of us intuitively feel that there is something wrong with the economic structures that direct our collective destiny, we find ourselves unable to define the precise changes needed. This is the result of a great many oft repeated myths about who, or what, controls the money supply and how the money supply machine works.
In an effort to clarify and debunk many of the commonly held beliefs about how the banking system works, a small group of people founded an organization in Britain with the ambitious objective of bringing about monetary reform. This organization quickly blossomed into a group of 30,000 plus members and followers and now has affiliates all across Europe.
To begin with, Positive Money surveyed the ways in which people typically view the role of banks.
About a third of those surveyed believe that the bank is like a piggy bank which keeps money in a safe place on behalf of the saver. In other words, no one is using the money while it is sitting the bank.
The other two thirds had a slightly more sophisticated understanding of the banking industry. They believe that banks are an intermediary between savers and borrowers. Savers deposit money which can then be lent out to borrowers. This implies that the amount of money available for loans is dependent on the amount of savings that have been deposited in the banks. It also implies that reckless lending would cause the banks to run out of lending ability. A third assumption is that governments control the amount of money circulating in a given country through institutions such as the Royal Mint, where coins are punched out of metal and bank notes are printed.
Those who have studied a bit of economics in school typically understand the creation of money through classical economic theory. This theory teaches that a bank won’t need to keep all its depositors’ money on hand at any given time. Instead, the bank keeps back a small reserve, of say, 10%, and lends out the other 90%. If a bank had a $1000 deposit and lent out $ 900 of that, the $ 900 would probably be deposited into a different bank, from which deposit, the bank could lend out 90%, or $810. Supposedly this cycle continues until almost all of the original money is lent out which would be about 200 cycles. The sum total of all these loans would add up to about $10,000 dollars. This implies that the reserve ratio dictates how much money can be circulating in the economy at any given time. If the 10% reserve ratio were increased, less money would be available for lending: if the reserve ratio were decreased, more money would be available for lending. This also implies that the money supply is finite and has natural limits based on the reserve quota, or base money in the banking system.
Unfortunately, the reserve ratio is an antiquated notion. According to Chris Ferreira who writes for http://www.economicreason.com , the reserve requirement for Canadian Banks is zero and has been for many years. Unfortunately, many people who hold influential positions in the Canadian economy still cling to these outmoded economic theories.
The money supply is therefore, not finite, and can be expanded or contracted at the will of the banks. In order to better understand this, we need to have a look at the three forms of money circulating in the economy. These are: inter-bank settlement money (central bank reserves); cash; and electronic bank deposit money. Interbank settlement money is an electronic system designed to cancel out payments that the banks owe to each other. At the end of a business day, the amount of money not cancelled out by the debts individual banks owe to each other is infinitesimally small. The term “fractional reserve banking’ come from a time before computers when banks were required to have a percentage of their holdings at the ready for inter-bank and other liabilities at the end of each business day. Thus, there are only two forms of money that really matter in today’s world. They are the 97% of all money used by the public in the electronic (based on deposits) money and the 3% constituted in cash.
If there were a reserve ratio, a fraction of the bank’s assets held back immediate payouts would constrict the amount of lending a bank could do. A reserve ratio of 10% would mean that the same money could only be lent out again ten times over. This would limit the extent to which the banks expand the amount of money present in the economy through the creation of loans. In the modern era, the fractional reserve system has been partially replaced by the capital adequacy requirements. This buffer of financial assets is meant to absorb unexpected financial losses by the bank. This buffer is not intended to limit the amount of reckless lending the banks can engage in. It only ensures that when a financial crisis hits and everyone else is going under, the banks will not. The only thing that really reigns in the amount of capital created through loans is the willingness of the banks to lend. This business confidence of the banks is bolstered when banks are not held responsible for reckless and immoral banking practices.
Now there some who argue that banks create credit and not money. Credit implies risk, so if a bank grants a customer a loan, it creates that loan in figures on the customer’s bank statement. The amount of money in the customer’s account is then guaranteed by the government of Canada. The customer’s bank account has now become risk free for the customer. In this way, banks are creating money (no risk) not credit.
When more businesses and individuals are borrowing money, more money is created by the banks. More money is circulating, more people are employed, and the economy is said to be doing well. When people choose not to borrow, or worse yet, to save, the amount of money in circulation is reduced. Given that the banks’ ability to loan is in no way connected to the level of bank deposits, so is there any inherent social value in saving? What is good for an individual does not seem to coincide with what is good for the economy as a whole. What can we do as individuals to improve the amount of money in circulation for everyone?
At present, the successes of the banks result in house price bubbles and gambling on financial markets. What can we do to see that money comes into the real economy before it goes into gambling on real estate and financial markets? In other words, can we take the power of money creation away from the banks? Under a transparent and accountable form of democratic process, newly created money could be used to refurbish public infrastructure and raise the incomes of ordinary people. Could this be done under a politically non-partisan government body at arm’s length from the government of the day? These are question posed by Positive Money, a European group presently looking at a change in the economic paradigm. For more information, please refer to www.positivemoney.org