GDPR Notice

GDPR Notice:
Please note that Google, Blogger, Adsense and other Google services may be using cookies and doing whatever they do. Please take notice that by using this blog you give your consent to those activities.

Thursday, August 18, 2016

Should banks create money?

Bloomberg has a post about centralizing money supply - whole money, as they call it. It is not a very good idea. This is not the first time such suggestions have come up. As mentioned in the article, Irving Fisher first proposed a similar plan in the wake of the great depression. Since then many have proposed this idea but not many understand money creation.

Taxonomy of centralized money creation idea
The money creation ideas are varied:
  1. Gold money: This is natural money creation. No one has any control over the money creation. Previously, gold, silver, diamonds, precious stones and other valuables (and sometimes sea shells too) were used. Many serendipitous discoveries of valuables created havoc with the money supply. Discovery of Potosi in South America and thereafter further discoveries of gold and silver had the effect of expanding Spanish money supply. 
      1. Not under any control: Neither governments nor banks, no one has any control over the money creation process.
      2. But Non-Arbitrary: It depends on the amount of gold you have. If you want more gold, you better import more gold by giving some valuable service to the other countries  who have gold. Over time as the total amount of gold available starts reducing you need to offer more and more to the countries that have gold.
      3. Though subject to Nature: If by chance you discover a gold mine, you will be filthy rich, though if you discover too much then it may unleash inflation. Spain is believed to have faced such inflation on the discovery of silver mines in the South American colonies.
      4. Deflationary and restrictive: As economic activity grows it becomes too high compared to the total amount of gold available to back it. Thus it tends to slow the economic growth pace. (Don't know if that is good or bad).
      5. Favours status quo, old money and advantageous to miserly: Since total value of gold you have increases with time, people tend to postpone purchases and hold on to gold. Spending happens when absolutely necessary.
      6. Exploitation and Theft prone: A doctor can charge atrocious fees from a rich person because of bargaining power equations. Gold can also be stolen. Stealing credit cards is less useful.
  2. Gold-backed money: Introduced to circumvent the deflationary gold currency, countries peg the value of their currency to the gold they can back it with. When people talk of gold standard they are referring to this type of money creation. 
    1. Partly Government controlled: Government issues currency and states the total amount of gold they back it with. So a gold-to-dollar exchange rate is established. The government can improve its reserves and thus improve money creation. 
    2. Non-arbitrary: In its pure form it is non-arbitrary and similar to gold-money.
    3. Not purely nature driven but subject to shocks: Since the government has control over the amount of money and amount of gold, the money creation is not as whimsical as simply discovering a gold mountain. Governments can reset the exchange rate to compensate for some changes. But arbitrary government intervention results in shocks and disruptions.
    4. Mostly deflationary: Governments cannot measure economic activity easily (yes GDP calculations are guess-work and there is no Santa Claus just in case you were wondering). That leaves money creation open to political whims and fancies and invites tampering of measurement of the economic health. Mostly governments are slow to acknowledge the real growth in economy since it is always backward looking. It realises the growth till the growth results in deflationary pressures then increases money supply and causes a spike.
    5. Perception of money losing value as government reset gold rate: As total amount of product and services of value in the economy rise more than amount of gold to back it up, the government is forced to alter the gold-dollar exchange rate downward leading to people feeling that each dollar is worth lesser in terms of gold though purchasing power may be higher.
  3. Government-created money: This is non-gold standard money. Simply speaking the government issues money and backs it with a promise. This is what people wrongly believe is the current regime. 
    1. Full government control: The government has effective control over the process. This is a mixed bag. It depends on the government. 
    2. Some central bank control: The exact control depends on how money is created, is it by using government bonds then bought to a certain extent by central banks or some other way (simply printing).
    3. Depends on confidence in Government: Prudent governments enjoy advantages but if you are Zimbabwe then you will end up in trouble.
    4. Inflation/deflation depends on policy: If a government print too much then it stokes inflation and too little results in deflation. Prudently executed (Milton Friedman's about 3% money supply growth) works fine.
    5. Value of money depends on inflation: If the government is able to deal with money creation effectively then a mild inflation - say 2% may result. There is not too much loss in value and it can be notices only over long time frames when quality of life changes are also noticeable.
  4. Money created by banks: Mostly commercial banks create money by giving loans. These loans do not exist as money. This is the most misunderstood money creation mechanism. It is distributed money creation, without extreme control. Bankers and regulators forget that its success depends on devising proper incentives. 
    1. Less government control:No country uses this method exclusively. Both Government-created and bank-created money is deployed. Thus there is always government control of some sort. Also since government is also a borrower (a big one at that), it has control.
    2. Part central bank control: Central bank exercises additional kind of controls in this mechanism. First, it can partner with government in its money creation process by buying government bonds etc. Second, it controls the lending to the banks and thus influences at what levels of risk do banks create money. The key word is influences and not dictates. Thus this process is often likened to "pushing at a string" (which is difficult, you can pull at a string pushing does nothing unless there is pulling at other end by the banks).
    3. Control to banks: In this scenario, Banks can ALSO determine whether to create money or not. That decision is based on whether the person demanding the money will be able to repay it or not. If he can, it means he is creating value with this money and thus able to repay it. 
    4. Decision at the point of demand of debt: The decision to create money is forward looking. It is made at the point the person makes a demand for the debt. That borrower is expecting to create future value. If by banks assessment that value can be generated ONLY then money is created.
    5. Depends on incentives: After reading this if you wonder why banks lend for consumption goods or lend to uncreditworthy borrowers - it is because of incentives. The power to create money is substantial power and with bad incentives, it can cause systemic harm as seen in 2008 crisis.
    6. Central bank oversight: Central banks have oversight duty to watch what kind of money is created by the banks. The nature of lending is supposed to be value-focussed. Some consumer lending at the time economy is entering a pro-longed boom phase can be advantageous. But in an economy which cannot sustain a prolonged growth phase, these are risky loans and their proportion needs to be limited.

My suggestion
Out of the options, I prefer the last one - a combination of bank created and government created money. It is quite forward looking and takes place at the point of demand. It needs a lot of oversight and decentralisation. I have argued that IT systems have in fact centralized the loan decision making than allow the front-line managers to make them. This has resulted in an inaccurate assessment of borrowers and partly responsible for the 2008 crises. Amar Bhide also makes a case for intelligent decision making in his book "A call for judgement".