Saturday, April 26, 2014

Why We Should Strip Banks From The Power To Create Money

Martin Wolf, writing in the Financial Times raises a huge question that has a long history in economic thought.  Money is created in our economies when banks make loans.  They acquire an asset which is some form of an IOU.  They make an entry in the borrowers bank account which then increases the supply of money. In our fractional reserve banking system they can also make loans which exceed the value of their deposits. Banks also provide a payments system which is a public service.  Wolf argues that banks should retain the payments system but that government should directly determine the money supply.  The reason for making this change is that our current system is fraught with peril.  We always have financial crises that have to be solved by central banks which provide liquidity and solvency to the failed system.

One of the arguments against this proposal is that banks play an important role in the economy.  They allocate our savings to their most productive uses when they make loans.  Wolf responds to this point by showing that only about 10% of business investment funding comes from bank loans.  The majority of bank loans are devoted to the funding of commercial real estate investments.  Wolf also realizes that his proposal will not go anywhere in our current environment.  He understands, however, that our next financial crisis is just around the corner.  Maybe it will be reconsidered in the next crisis.

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