Since the failure of the Bretton-Woods system where gold acted as a fundamental backstop to currencies, the financial world has developed a lot. The digitalization has created many opportunities, but has also enabled the introduction of many unnecessary and complex systems. The price of gold is almost a thirty-fold of its nominal value in the seventies, back when it had an essential function as insurance against potential monetary expansion by central banks. However, the value of gold as assurance of trust and protection against financial repression was found inferior to the negative consequences of a fixed gold standard; the money supply should grow when productivity grows, a gold standard could cause a credit crunch and therefore negatively influence potential growth. Moreover, a gold standard is more prone to deflation which severely harms economic activity as wages and prices are sticky on the short run.
However, since the seventies fiat currencies have created large financial institutions, which are driven by commercial incentives, but hold an essential public function as creators of money. A role which is severely entangled with their function as credit facilitators, creating a conflict of interest where they reap the benefits of economic booms, but are protected by governments in recessions. Since the last financial crisis it became clear that both banks and governments are not always as resistant as was thought. This created the necessity for central banks to intervene, a development that seemingly resolved the last financial crisis, but actually only postponed the necessary real revolution needed in the financial system.
Commercial Banks Are The Big Winners Of Money Creation
To explain this we need to take a look at how the financial system works. The first thing to understand is that cash is different than money deposited at the bank. Banks deposits’ current function is to safe-harbor assets of the public. A bank deposit is a loan to the bank, that directly benefits from having this excess liquidity. With this deposit the bank, allegedly, can loan out new money to people in need of money through loans. Interestingly, under the current zero interest rate environment bank deposits yield close to zero or zero (interest). However, as banks hold a monopolistic role in the economic systems as facilitators of digital transactions, people have almost no choice but to stall money at the bank. Here is where it becomes more interesting, because the same banks can offer mortgages at significantly higher interest rates for people in need of money. The increasing concentration of banks has created a situation where every new loan, and thus new money has a large chance to flow back into the bank’s balance sheet as there are not many options for the money to be deposited elsewhere. Newly created money by commercial banks is enabling profits through still relatively high interest rates paid by lenders to the bank, but is also partially flowing back into different bank deposits of the bank, that at the moment pay-out no interest at all.
This is where banks in their essence make their profit, but also creates a vicious cycle of unlimited profits for banks as a result of their ability to create money. This effect is often described as marginal, as there are also costs related to offering digital payment systems as provided by the banks, however it is believed to create large net profits for banks. How large these profits are is hard to estimate as commercial banks lack transparency on the amount of costs related to this service. It seems clear that this lack of transparency is most likely due to the profitable nature of this scheme. But there is yet another factor playing a role here that undermines the interest of the public. This is where the money multiplier comes to play a role, a very disputed phenomenon.
The Money Multiplier Effect, How It Actually Works And What Is Wrong With It
Old economic theory explains the money multiplier effect as follows: If a bank receives an amount of 100 dollars, with a reserve ratio of 10 percent set by the central bank, it can lend out 90 dollars to potential clients, effectively creating 90 new dollars. This continues up to a point where, under this reserve ratio, almost ten times the base money can be created. However, as many bankers and economists have pointed out, it works differently.
The first thing that is wrong with this model is that banks do not have to wait for deposits before they can start lending out money. It also assumes that the central bank has complete control over how much money is created in the real economy, by either adjusting the amount of base money or changing the reserve ratio for banks. What actually happens is more complex than the old model describes.
At the end of every day banks net-out the amount of money being transferred from one bank to the other, by doing so reducing the amount of transactions. More importantly, it is not cash that is being transferred, it are central banks reserves which are an equivalent of cash for commercial banks. Because the amount of money actually being transferred at the end of the day is only a margin of all the transactions made, banks do not need to hold large excessive reserves to fund all these transactions.
However, when banks do not hold enough central bank money at the end of the day they can lend money from other banks on the inter-bank market, also known as the LIBOR market, The London Inter-bank Offered Rate. It is an interest-rate average calculated from estimates submitted by the leading banks in London. In other words, as banks can get extra reserves from this inter-banking market if necessary, they can sell new loans, effectively increasing the money supply, without having to worry about holding too little reserves. However, it should be noted that this assumption only holds if all banks create new loans at roughly the same pace. This means that banks can increase the money supply without needing extra central bank reserves. What went wrong in the financial crisis, is that banks had underestimated the risks involving mortgage-backed securities which created large suspicion within this inter-bank market. Central banks all over the world had to create extra central bank reserves so that each bank had enough reserves to be able to survive without the need of the inter-bank market. What this has created is a system where in order to safe economies new debt has to be made by banks because the central bank has absolutely no control over how much money is created.
Quantitative Easing Plays An Essential Role In Maintaining This Unhealthy System
Central banks only tool left at this zero interest rate environment is to flush commercial banks with cash to make sure they atleast do not have to worry about lack of liquidity. However, in return for extra central banks reserves banks send over bonds to the central bank. Before the corona crisis this was mainly done through government bonds, driving down interest rates at which countries can issue new debt. However, since the corona crisis also corporate bonds and private debt has been bought up in quantitative easing programmes. Essentially this has created a system where debt holders get the financial opportunity to create new debt to refinance old (bad) debt, simply postponing an inevitable bust.
The Problem With The Current Banking System, Where It All Comes Together
Just as when bank loans are issued bank deposits are created, bank deposits are destroyed when the debt is re-payed. Thus decreasing the total money supply in the economy for other firms wanting to pay down their debt or interest charges on their debts. Firms with debts still on their balance sheets are now potentially in trouble, since the money available to pay these remaining debts has contracted, while the debts themselves have not. The only way to get out of a recession within the current monetary system is to supply new money to service existing debts. However, as central banks have absolutely no control over the money supply, new debt has to be created in order for this to work. The current recession is escaped, but only by loading the system down with ever more debt, ensuring that each subsequent recession will be more serious than the last one. Money is put into circulation as bank loans; meaning that if we want to have more money we also need more debt. At some point then, debts will grow so large relative to the money supply, that the money to service interest on them can no longer be transacted causing a collapse of the system. However, we are still far from such a reckoning, but this does not take away the necessity to change the system as we know it.
There Is A High Need For An Independent, Non-Profit Deposit Bank For The Public
The above mentioned potential dangers emphasize the need for a deposit bank where people can store their cash without having to take the risk involving holding a bank account. Commercial banks, the current intermediaries have maneuvered themselves into a position where they can reap the profits, while being backed by the government in times of failure, thus creating a situation where commercial banks can make profits while the public effectively takes on the risk. As the creators of money the banks have the power over who gets loans and who does not, while being essential for the public for making digital transactions. While the main incentive for banks is to make profits, this creates a huge conflict of interest. And while at the same time productive workers, a.k.a. non-financial workers effectively pay for this self-fulfilling bust time after time.
Why The Central-Bank Digital Currency (CBDC) Is A Potentially Good Development
In this article we have mainly talked about central bank reserves as main store of value, but also cash plays an important role. However, the role of cash has been decreasing due to the digitalization of the financial sector. In other words, people use cash less and less. This has stimulated the amount and percentage of assets held on bank deposits, creating a situation where banks have almost complete power over the financial system and over the public. As only commercial banks can hold central bank reserves, the number showed on bank accounts is merely a made-up number and has no backing at all. By pushing cash out of society banks effectively try to create a situation where there is no possibility for bank-runs anymore, taking away the risk of insolvency. But also taking away the only real risk over which the bank has almost no control over. Central banks have finally been aware of this undesired situation, recently the ECB started to research the possibility for central-bank digital currencies that could take away much of the power of commercial banks.
The solution it creates to the commercial banks’ monopoly over the people’s money, taking away large chunks of the too-big-to-fail risks, also brings along a potential danger. When too many people will move their assets into the CBDC-system, banks will be forced to raise interest rates on their bank deposit facilities to attain enough credit to finance their loans to the public. This would mean that banks will also raise interest rates on their loans, therefore destroying potential economic growth.
On a side note: it should be pointed out that more than 75 percent of the created money since the start of fiat money has gone to the financial and housing sector. Effectively raising inequality and crowding out non-capital holders on the housing market. This vicious circle has been supported by vast amounts of quantitative easing necessary to support commercial banks in the current system, which only strengthens this vicious circle.
Central-bank digital currencies can make it easier for digital payment companies to enter the market, creating a healthier digital payment sector that is not dependent or dominated by one monopolistic company. More importantly, the ever-ongoing battle of central banks to create inflation will be made way more easy by the ability to directly transfer money as central bank to the public.
However, the biggest risk is that with the introduction of central-bank digital currencies central banks could more effectively induce negative interest rates on the public, as cash is likely to be taken out of the system. This brings along a large responsibility for central banks to act responsible and independent of government officials or bankers, something that is easier said than done. This requirement should not be underestimated as it could undermine the functioning of the whole system. Moreover, digital currencies are prone to cyber-attacks, which unlike robberies on cash reserves could turn-off or glitch the whole economic system at once, a big danger. Here is where blockchain potentially could offer a solution.
There Is No Easy Solution, But Alternatives Deserve A Chance
Deposit banks and central-bank digital currencies both deserve a chance in the effort to decrease to power of commercial banks over the public economy. It is time to separate the payment sector from the financing sector and we have to take away the ability to create money from commercial banks whose only incentive is to create profit.
Governments have been slow to act on the digitalization of the financial sector, but there is a desperate need for a revolution. The current evolution of the monetary system is broken and mainly beneficial for those at control of the financial sector. It is not the government, nor the central bank with the control over the economy, it are financial institutions that continue to rule the economy. At the same time the public remains to wear the burden of a decades-long liberalization of the financial sector that thrives for profit for capital holders, instead fighting for the common good. A terrifying and disastrous conclusion in this already frightening time of a massive health crisis, which will be an excellent excuse for bad actors to wave-off responsibility. As long as this system is not changed bad actors will shake their hands with cash retrieved from workers who actually did add value to society.
- Boot, A. W. A., Bovens, M. A. P., Engbersen, G. B. M., Hirsch Ballin, E. M. H., Prins, J. E. J., De Visser, M., & De Vries, C. G. (2019). Money and Debt: The Public Role of Banks. Retrieved from https://english.wrr.nl/publications/publications/2019/06/04/summary-money-and-debt
- Bank of International Settlements. (2020). Central bank digital currencies : foundational principles and core features, (1), 26. Retrieved from http://www.bis.org