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If I understand correctly, under the dominant system of fractional reserve banking, many (all?) private banks can create money by lending. See, for example, Implications of abolishing Fractional Reserve Banking on mortgages and interest rates. So, money created when people (or other entities) go in debt, and destroyed when those debts are paid back.

Some organisations, such as Positive Money, advocate there would be considerably advantages if we step away from this system, and only the government could create money. Quoting from their website:

History has shown that when banks have the power to create money, they create too much in the good times, causing financial crises, and then create too little money in the bad times, making recessions and unemployment even worse. They put most of the money that they create into house price bubbles and speculation on financial markets, and only put a small amount into businesses outside the financial sector. We simply don’t think that banks, with all their incentives and need to maximise their profits, can be trusted with something as powerful as the ability to create money. And it’s not enough to regulate them, because regulators have already failed to keep them under control, and there’s no reason why they should get it right this time around. We need to stop banks being able to create money. Instead, we want to see the power to create money transferred to a democratic, accountable and transparent process (...)

My question:

What would be the consequence if only a single institution, accountable to the national government, had the ability to create money? Assume that this institution would use a more or less objective set of criteria to determine how much money to create, for example, in order to meet particular targets.

Edit: A commenter requested more background motivation why this question is specifically about banks. Allegedly, the system leads to increasing house prices and debts, along with other problems. My question here is not whether the issues that Positive Money are correct in attributing those problems the current system of private banks creating money; regardless of their correctness, my question is, as stated above, what the consequences would be of having only a single government-controlled institute create money.

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gerrit
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  • In case this question contains not enough details, assume we would implement the system as proposed in papers on the linked Positive Money website. What would happen? – gerrit Feb 19 '15 at 23:03
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    What if only the government could grow food? How can farms, with all their incentives to maximize profit, be trusted with something as powerful as the ability to create food? If your question is "Why shouldn't the government do everything?", then that's the question you should ask. If your question is specific to the banking sector, then you should have some sort of a story (beyond the vague blather in the quote) about why banking differs from, say, farming. In the absence of such a story, you might as well post 1600 other questions asking about 1600 other industries, one by one. – Steven Landsburg Feb 20 '15 at 00:02
  • My question is not why shouldn't the government do everything. My question is specific to the banking sector. The specific issue with banking, that (afaik) does not exist with any other sector, is that the current system leads to a large amount of debt (correct me if I'm wrong). What specifically would I need to address that is not in the quote? – gerrit Feb 20 '15 at 00:04
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    @StevenLandsburg I added a paragraph motivating why I am specifically asking about the ability to create money. (On a side note, I don't know about the rest of the world, but in the EU, farms are very heavily subsidised, so apparently, the private market is not trusted with the ability to create food) – gerrit Feb 20 '15 at 00:16
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    This is too broad. The main aspect of it is already covered in http://economics.stackexchange.com/q/444/44 , so this is a dupe . Also, please bear in mind that the Positive Money mob are, errm, let's say at the fringes (of economic thought, of reason, of honesty) – 410 gone Feb 20 '15 at 07:32
  • I don't agree that it is a duplicate. The proposal is not to have a fixed money supply. I recognise it may be a bit broad, I might try to narrow the question down.. I realise that what Positive Money states may not be in agreement with canonical economic theory. That shouldn't render the question unsuitable — in fact, that is precisely why I ask it here. What makes you say they are at the fringe of reason or honesty, though? – gerrit Feb 20 '15 at 15:55
  • @EnergyNumbers It appears similar (identical?) to what is considered on a high level in Iceland. Is the Icelandic government dishonest? – gerrit Apr 04 '15 at 02:34
  • @StevenLandsburg For paper money it's already the case that only the government can create it, I think, but apparently it's different for non-paper money. – gerrit Apr 04 '15 at 02:35
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    This is really an open research question. @gerrit - it might be worth reflecting, or even throwing back at sites like Positive Money the question of on what scientific basis do they advocate making such extreme changes to socially critical infrastructure. This is not to say that banking doesn't need reform, but that such reforms must be well grounded and scientifically otherwise they are quite capable of being incredibly destructive . – Lumi Jun 22 '15 at 17:47
  • @Lumi That makes sense. However, as a non-economist it's difficult for me to distinguish economical science from pseudoscience, and this is exacerbated by the fact that economical science is less exact, and thus more open to interpretation, than the natural sciences. One could split Positive Money's analysis in two parts: the problem statement, and their proposed solutions. To me, the positive money website gives the impression of being more serious than a typical pseudoscience website against climate change, GMO, vaccines, etc. — they don't seem cranks to me. Am I being fooled? – gerrit Jun 22 '15 at 18:16
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    @gerrit - This is my research area, and I'm also from a non-economic but scientific background, so I'm inclined to agree with you on economic research, especially as it applies to the monetary system. I think the key question for Positive Money, and anybody else including regulatory authorities, mainstream economists on the subject of reform, is what is your scientific evidence to back your claim. F.ex. in any other field some kind of simulation, series of experiments under laboratory conditions etc. would be required at a minimum. – Lumi Jun 22 '15 at 20:18

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When you dig down, this questions is very nearly a duplicate of this:

Implications of abolishing Fractional Reserve Banking on mortgages and interest rates

but based on the comments, it seems that the connection isn't obvious.

This question asking about what would happen if only a government institution could create money, but equally you say the proposal is not to have a fixed money supply. They are, in practice, the same thing.

The central bank makes the money base, M0, and then the banks create the money supply, with some multiplier to this. In a full reserve system, that multiplier is 1.0, and so the money supply is always equal to the money base.

In your question, we consider having a M0, but also have a state run bank that chooses the money multiplier to some number, that may or may not be 1.0.

From that point on things become almost identical - it doesn't really matter from the point of view of the economy, whether you make M0 ten times larger or smaller, if you offset it with changing multiplier. It should be the total money supply that matters - the money base never leaves the central bank, and so may be thought of as a "construct" onto which the monetary system is hung. The important point is that the government gets to directly control the money supply.

Before the era of quantitative easing, when a central bank wanted to increase the money supply, they lowered rates and that increased the multiplier. With quantitative easing, they simply increase M0 and force the money supply up in a 1:1 ratio. Either works (for a given value of "work").

There is, however, one very important difference:

  • With full reserve banking borrowing money is very expensive - it is economically the same as capital
  • With a state run lending bank, borrowing could be done at any rate the government chooses, including at an economic loss.

So, in your system, you could have a state run bank, that effectively subsidises business and/or people's mortgages using money raised from taxes or elsewhere. This would be like an extreme version of the UK forcing RBS and Lloyds to increase lending.

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Corvus
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  • I don't understand why a system where the power to create money is centralised implies that this multiplier is constant. In such a system a central bank can still decide to create money based on incoming loans in a way that private banks do currently. Your last point agrees with my (lay) understanding of what Positive Money proposes, where one of their alternatives is for the central bank to lend money (effectively subsidising) only to economic activity deemed to be valuable (i.e. yes to innovation or infrastructure, no to speculation on existing real estate). – gerrit Jun 22 '15 at 09:38
  • Also, isn't the contemporary system also effectively subsidising major banks, by guaranteeing that they are not allowed to fail — thus effectively socialising major risks/losses? – gerrit Jun 22 '15 at 09:39
  • @gerrit I tried to clarify I little bit. Constancy is not an important feature in either case. The point is simply that the multiplier is "set", rather like the central bank base rate is "set" to a constant - it is a constant that changes through time, but it is something that is chosen, rather than just the result of market forces. – Corvus Jun 22 '15 at 10:49
  • @gerrit so it doesn't really matter if you have fixed multiplier of 1.0, or variable multiplier, because the central bank is at liberty to set M0 where it likes. The policy decision to keep M0 constant and raising the multiplier from 1.0 to 1.1 is exactly the same as increasing M0 by 10% – Corvus Jun 22 '15 at 10:51
  • @gerrit as to the question of subsidy, then that isn't really answerable, at least not by me. I can tell you that such a system allows you to do that, but whether or not you believe a centrally "planned" allocation of leverage leads to happiness or whatever your yardstick is, who can say. – Corvus Jun 22 '15 at 10:54
  • But isn't the money supply already limited through reserve requirements, capital requirements, etc.? How would a reserve requirement of 5% be different — for the economy as a whole — than a central bank monopoly on creating money with a multiplier that will rever rise above 20? – gerrit Jun 22 '15 at 13:37
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    Reserve requirements only limit things on one side, and many countries don't bother with them. The UK has a 0% reserve requirement (or rather it is chosen by the banks themselves and signed off). The EU has 2%. By and large most developed nations don't have reserve requirements that banks actually hit. – Corvus Jun 22 '15 at 13:58
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    @gerrit as for capital requirements, they work in a very indirect way on the money multiplication - since it is weighted capital based, so in principle can move almost independently of reserve ratio (but in practice is what limits banks). But yes, ultimately that is exactly the point of all these regulations are for - to control things. The point is controlling things "a bit" is considered better than going whole-hog and making the banking sector part of the state. Positive money people believe the current control is too lax, others disagree and say it is sufficient. – Corvus Jun 22 '15 at 14:01
  • Full reserve as originally specified by Fisher et al. in the 30's was not as described here. Another issue with the whole full reserve idea is in fact, what exactly is being proposed? (Fisher wanted full reserve essentially to cover checking and short term savings accounts.) – Lumi Jun 22 '15 at 20:21