Positive Money is an increasingly popular organisation – supported by the Green Party of England and Wales – which argues “for the power to create money to be used in the public interest, in a democratic, transparent and accountable way, rather than by the same banks that caused the financial crisis.”

Economists of all types have tried to argue for and against schemes like Positive Money, but the argument often ends up complex and abstract. It seems to me that, in fact, economists have failed so far to argue any good reason why such a scheme is incorrect. As a result I have written the following article explaining the problems with Positive Money, whilst simplifying many terms so as you don’t have to be an economist to read it.

For example:

• money doesn’t strictly exist: we use ‘money’ to pay for things, to replace an otherwise more complicated system of bartering. In this essay I use the term ‘money’ in order to refer to physical manifestations of it, such as notes and coins, as I believe that is the way most people understand/use the term.
• ‘Credit’ refers to instances where you don’t have money, but have an equivalent ‘IOU’ agreement to pay for something – i.e., a loan or a credit card.
• I also commonly use the term ‘government’ when many economists would say ‘central bank’. I do so as I think it is easier to comprehend what the central bank is when it is referred to as ‘government. A ‘central bank’ is a government’s financial arm, which does things like setting interest rates.

 

How does money work?

The government controls how much money – i.e., notes and coins – is in circulation.

Banks are free to create as much credit as they like, in the form of loans, mortgages etc.  They do ‘create’ this credit in a very real sense: when a loan is approved, they don’t check they have the physical amount of money to make the loan, they simply ‘create’ the nominal figure that the loan is for. The amount of credit they create in this way is often many times the amount of physical money they actually have. This works because most of this credit never gets physically withdrawn as money; the loan for your mortgage goes straight to the recipient’s bank digitally, which in turn might go to a further account for that second person’s mortgage. Eventually, most of that credit which was created is sitting in bank accounts, not getting withdrawn to buy products in shops.

However if banks create too much credit, or too much credit of the wrong type (I’ll get to this later), they may not have the physical reserves of cash required to pay out the money when required.

This in turn would lead to them being deemed as having poor credit themselves, like any normal consumer who couldn’t pay their debts, thus being unable to enter into mortgage agreements with other banks (so other banks would not be keen to allow them to pay off their debts with credit of their own). It also, as happened with Northern Rock in this century, makes the public who hold deposit or savings accounts with the bank panic: if the bank are unable to pay out their debts, or are forecasting this might soon happen, people suddenly want to stop banking there. This is understandable: people will want to move their ‘money’ somewhere else that is able to pay their debts, in order to secure it. After all, if the bank crashes, everything that is not government insured will be lost. This can lead to the much faster collapse of entire banks, as people start to withdraw money that banks don’t physically have, compounding the problem.

Because governments ‘insure’ deposits in banks up to certain high levels, it then becomes useful for governments to bail out banks that are struggling: a few billion is better than potential hundreds of billions, etc. Similarly, the action and support of huge and able governments makes the public and companies alike feel more secure.

This problem of ‘withdrawal vs. credit’ is, in a nutshell, why banks prefer ‘asset’ backed loans, such as mortgages, over business loans. Asset loans are going in to the accounts of wealthier people, eventually – digital money is exchanging hands in property to buy other property, thus sitting in accounts. It’s rarely going to building companies to spend large amounts on wages, or being withdrawn to pay for things in shops. Whereas credit which is instead lent to business is more likely being spent on wages, and for making products which pay other wages, etc, which means more of those funds are actually being withdrawn from the bank.

Similarly, if a person can no longer pay their mortgage, they have a property which the bank can take and sell on. A business loan might have no physical ‘asset’ to back it up in this way. These two points – property leading to less physical cash withdrawal, and being backed by physical assets – are why we have a property boom, with ever increasing property prices. Banks are quick to give mortgages, most people can get one of some kind, and thus there is more competition for property. Higher demand then leads to bidding wars and higher prices.

Regulating how much banks can lend, in relation to their physical reserves, would mean banks don’t favour property over business loans as much as they do. One could even introduce a regulation on the proportion of mortgages a bank can provide in relation to other types of loans. This would also make interest rates more effective: if people feel they can get business loans, they are restricted more by the government’s incentives to borrow (low interest rates) than simply by a blanket bias against giving business loans.

 

Interest rates

I mentioned interest rates in the last paragraph, so here’s a short explanation on what they are:

The government sets interest rates. High interest rates encourage saving, by offering more interest on the money you have in the bank. Low interest rates encourage spending, by giving little interest on the money you save and by making loans cheaper to borrow (by reducing the interest on them). However, even under high interest rates – where banks make more in interest from creating loans – they still need to be careful they do not take risks which mean they cannot physically match withdrawal requests. Loans, remember, are a higher physical withdrawal risk than other types of credit, like mortgages.

 

Positive Money’s goals: admirable, but are they effective?

Positive Money’s primary goals are to allow banks to only create the money which they have in deposits – i.e., in savings or current accounts – and that government creates credit instead, by creating ‘free’ public services.

This has many potential advantages: we currently rack up billions in public debt when the government has to borrow for public services. This plan would mean zero government debt, but potentially unlimited public spending. Similarly, if banks are limited this strictly, they cannot directly influence things like property booms. Finally, banks are at lesser risk of collapse, as they aren’t stretching the ‘value’ of their physical reserves to create such high amounts of credit in relation.

These are genuinely admirable goals, there’s no debating that. But are they possible, and is it as simple as Positive Money makes out?

 

Government creating credit

Let’s first examine the idea of Government creating credit, instead of banks, primarily through funding public services. They would pay wages to build schools, hospitals and transport systems, not to mention the wages of the people working in them: pumping money into the economy by reducing unemployment, and giving money to real people to spend.

If they do create credit in this way though, to any significant degree, they would end up decreasing the value of currency more generally. So while it seems like they are getting public services and employing people for free, with payments from a manufactured central bank account, this is a serious problem. By increasing the flow of money (the creation of credit via public service would also have to include a creation of physical money, remember, as the money would be more wages and less assets) it would simply push up the price of goods and services. This is called inflation; there are only so many ‘things’ that can be purchased, and more importantly, businesses set prices based on demand. So when you create significantly more demand by increasing the amount of spare money in an economy, you create higher prices in the process.

This is a problem, as even though you have given jobs, and done so for free, the value of everybody’s employment is decreased, even though public services and employment have improved. There is no net gain. So currency gradually begins rising in value very quickly, as things become much more expensive. Thus wages everywhere then have to rise and government then has to create more and more credit to increase the wages it is paying.

This isn’t the only problem. Ironically, by trying to improve equality by virtue of boosting employment rates and public services, this would mean it is harder to employ people (as there are less unemployed people looking for jobs). This in turn increases the cost of running business – increasing wages and production costs – which in turn decreases the ability for businesses to survive. The logical progression for which is a quick reduction in private business activity and a rise in unemployment.

Every pound a government creates in order to spend ‘for free’ is creating an imbalance elsewhere. The economy works much like an eco-system in this regard. Banks are currently playing a positive role in this, by regulating themselves to ensure they do not lend that which they can’t allow in order to safeguard their survival. And they generally do so quite well; bank collapses are rare, yet incredibly unpopular and so the public like to think of banks as being more unstable then they generally are.

It is important to note that the government is not currently powerless, though: they can increase or decrease a bank’s ability to lend either by reducing the amount of physical currency available, or by changing interest rates. However it’s always a fine balance and – arguably – things like extremely high employment are never a realistic or desirable goal. That is true even for the most liberal of economic thinkers, as extremely high employment decreases a balance which quickly accelerates unemployment elsewhere; meaning, arguably, a faster, more expansive fall elsewhere, which hits lower-lows in employment than necessary.

 

What we have now probably works better

The government currently creates debt in the same way any consumer does – borrowing to pay for public services – but with the added benefits of:

• more favourable interest (due to being a large and uniquely safe borrower), and
• having the ability to stimulate economic growth in order to decrease the value of currency slightly, but faster than the interest that it owes, and thus pay the loan back at ever decreasing ‘real cost’.

These are relatively safe loans for banks, but they are still loans that are likely to result in withdrawal – unlike property loans, governments are likely to be paying wages with them. Those wages are more likely to exist as cash. However a country like the UK isn’t likely to default on its debt, so if a bank can afford to lend to us, they often will.

If governments create money, as already stated, it allows them more money for public services, but at the expense of its citizens elsewhere. To spend sensibly, it is thus limited by the same kinds of factors as when it is borrowing. Thereby gaining no benefit by actually creating the loans than when it is borrowing. Similarly, it is better for the government to hold a debt – both in today’s price and in future value – than for its citizens to hold the debt, by virtue of failings in private companies.

 

Does it make sense for government to regulate the level of money that banks create? Is it sensible for banks to be limited to lending what money they actually hold, from deposits?

Banks make mistakes and do great public disservice when they do. A limit of some kind – whether in ratio of deposits to credit, ratio of property loans to others, or both – is not a bad thing, and is a way for governments to safeguard the system.

However, for banks to be limited to lending only what they ‘have’ doesn’t make so much sense. To do so would need a huge reorganisation of the financial system – meaning governments created money directly either by public spending or by lending to banks. The former, as mentioned, is not great for private business: unless kept to very similar levels as exist now, which would mean a huge financial change for nothing. The latter – government lending to banks – would simply decrease the profit banks made (by adding an ‘interest’ rate), but likely still leave a large element of risk which the new system is meant to dissolve. It would need direct, regular and expensive auditing of all banks to ensure they don’t spend more than they have deposited, or else that which they have loaned from the government. And, let’s remember, banks already pay tax on their profits, which is similar in effect to an interest rate on the money that they would have to borrow in the new system. Very little is changing in terms of positive effects.

That’s just the tip of the iceberg in terms of problems, though. Most banks only create credit when it is profitable to do so: they want those debts they create to be safe and paid back, with the interest as the profit. The profit is necessarily big, as banks do suffer a lot of debts that default when people can’t pay them back. Those big profits are to safeguard against a sudden recession and lots more people defaulting (as we know, recessions can put banks out of business, so big profits are sensible from their point of view, not just greedy as we make out). So, if it then starts costing banks more to create the necessary credit to make most of its loans, it will either pass that price to consumers, else not lend in the instances where it is not profitable to do so. Or, more worryingly, not lend to any risky small business, or non-asset backed loan. Which is not what we want to encourage, unless we’re taking a very heavily biased view in favour of corporations.

Under our current system, you could increase the stimulus for banks to make business loans – as already mentioned – by reducing their limit of lending somewhat in relation to their reserves, or perhaps by setting quotas of property to business or personal loans. However if you then introduce what is nothing more than a ‘tax’ on borrowing money, for instance, on top of actual taxes, you essentially make it harder to borrow for the types of non-mortgage, non-corporation loans which most governments want to encourage.

The solution, of course, is to do exactly what we should be doing now: limit the lending in relation to a certain multiple of cash reserves, potentially also limiting the ratio of property loans allowed. The only thing that is different in effect under the Positive Money theory, is that it is the government that actually creates the money, changing the structure in a hugely expensive and needless, potentially counter-productive, manner. Moreover it goes further than we currently even have to, by balancing it’s regulation of banks with a complicated structure of loans to banks in order to ensure banks still function. Let’s also not forget that it has to regulate against its own weakness of providing greater incentives for banks to make safe, property loans, which is currently one of the great problems of the banking system: under Positive Money this problem is worse, not better.

 

The crucial failsafe

I think the criticism so far is sufficient to edge out Positive Money as a serious option. Yet the final criticism of the scheme is also important, and regards the lack of failsafe it allows.

Under our current system, one failing bank – and thus the livelihoods of millions of people – can be bailed out by a government that borrows from another bank to get the funds. It is far less likely that any of the individual banks will fail under Positive Money; this is one of its stated advantages. However, this puts all the risk with the government, who is being the sole regulator, and has no failsafe method of releasing pressure.

If governments make a mistake with the levels of regulation, or even just suffer a failure of predicting mass behaviour (something which economic history is littered with – it’s not an exact science), they only have the option of printing more money in vast sums at the expense of hyper-inflation. There is no bank to bail them out. This inflation, as earlier mentioned, means a decrease in the value of currency and a weakening economy; there’s no failsafe plan.

When we bailed out Northern Rock, we went into debt with other banks to balance things out. Government debt isn’t great but it’s a lot better than the race to the top madness of hyper-inflation, which potentially solves nothing except moving the problem around. Our current method of banking allows for a variety of failsafes, and for us – the public servicing government – to be the main one, rather than the only line of defence in the first place.

Arguably, this all might be avoided in the Positive Money system by borrowing from foreign banks, but, again, that sort of defeats the object of Positive Money. If the point of it is that we don’t want to be reliant on banks, but our failsafe is to hope that other countries don’t do it so as we can lean on them as our failsafe, then how does the scheme guarantee any level of security?

In actuality, and in contrast to my primary principles as an ethicist, a system of competitive banking – with multiple players – is far safer for governments, citizens and competitors alike, than a system where one central bank run by the government takes all the risk. We can become fixated on the greed in banker’s bonuses, or the failure of banks to navigate the latest economic crisis, but if you wipe away the tabloid sensationalism, these are simply problems that need to be fixed. They aren’t symptoms of a fatally flawed system.