Monday, December 16, 2013

Should commercial banks create money?

Commercial banks create a form of money when they extend loans to their customers, a process opposed by advocates of full reserve like Positive Money.
But against that, it can be argued that lending by commercial banks is a legitimate free market activity. So who’s right? I’ll argue that the activity is legitimate and generally beneficial where gold or some other commodity is the monetary base. In contrast, where the base is fiat (as it is in most countries nowadays), the activity is not justified.

The gold standard.
Under the gold standard, the value of the monetary unit (some given weight of gold) is determined by the market price for gold. E.g. if there’s a sudden increase in demand for gold for jewelery purposes, the price of gold rises. Plus the rate of increase in the amount of gold is determine by the amount that has recently been dug out of the ground. Now those are two factors which sweet nothing to do with the optimum size of the monetary base. I.e. the total quantity of money / monetary base is highly unlikely to be what the economy needs, and that being the case it’s obviously beneficial for commercial banks to be able to “lend money into existence” where the economy needs that extra money.
That was the system that operated in the 1700s and 1800s in Britian. It got us thru the industrial revolution, and it’s a system that works.
That system does have the disadvantage that interest rates are artificially low, for reasons I argued here.But that’s probably better than banning private money creation, since the latter ban would constrain economic activity.
However, once the decision is taken to have a fiat monetary base, there is then no limit to the potential size of the base. And that being the case, the right of commercial banks to lend money into existence becomes obsolete because the base, at least in theory, can be adjusted to meet whatever need the economy has for a form of money.
Put another way, if commercial banks as well as the central bank can created money, that’s duplication of effort. Plus commercial banks, as should be obvious from the recent crisis, do not act in the best interests of the economy. For example they were lending money into existence and boosting the housing bubble prior to the crisis. And then, just when the economy needs a boost, i.e. during the recession, banks and their customers went into cautious mode and the private money creation system ground to a halt.

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