Money Creation

Money creation

• Who does make money and who is making money out of it? You remember these guys?

2 Monetary misconceptions • Money doesn’t make you happy. Or does it?

• Money is the ‘mud of the earth’ and it is the root of all evil

• Pecunia non olet………..

• A world without money would be a better world. Which is true.. • …….if you are fond of extreme poverty • …….if you dislike economic freedom • …….or both

• Money is an essential precondition for economic freedom in an

advanced society 3 Content: above all a lot of questions!

• What is money? (wrap up)

• Who creates money and why?

• Is the production of money very profitable?

• What kind of reform is possible, if necessary? Some questions to start with

• All money is created by the central bank (Yes/No) • Some money is created by commercial banks (Yes/No) • Allmost all money is created by commercial banks (Yes/No) • The government can create money ‘for free’ (Yes/No) • Commercial banks can create money at will (Yes/No) • Commercial banks create unlimited amounts of money (Yes/No) • Commercial banks generate seigniorage income (Yes/No) • The ‘money creation privilege’ is highly profitable (Yes/No) • You can create and destroy money yourself (Yes/No) Today’s situation

• Governments/central banks create money: • Coins • Banknotes • Bank reserves • Sometimes: bank deposits (in case of monetary financing)

• Commercial banks create bank deposits • Today, this is the lion’s share of the money supply

6 The Dutch money supply (source: DNB, based on ECB-data, Oct. 2017)

Commercials banks

Central bank and governments

7 Position 1: governments should decide on the money supply

• Do you agree?

• Why?

• Who created money in the past?

• During the early coining of gold and silver, private parties decided on the amount of coins in circulation!

• Question: why did governments monopolize money creation?

8 Sound money?

9 Sound money!

10 Is money creation still profitable today? Yes it is. Enter seigniorage!

• Seigniorage (in Dutch: geldscheppingswinst) : the income earned by the entity that produces the money and that is the first to bring it into circulation.

• Example: the production of a € 100 banknote costs € 0.01 per note. Which means that its production is very profitable (to be precise € 99,99 pro note) for the first issuer. In this example: the central bank/government

• Printing banknotes (both by public and private entities) is potentially highly profitable and therefore a dangerous thing

• The production of bank money is of a different order…….

11 “History is largely inflation engineered by government”

“The source and root of all monetary evil …..[is] the government monopoly on the issue and control of money”

Friedrich A. Hayek (Nobel prize economics, 1974, 1978)

12 Is money creation by the government a bad thing?

• Not by definition. The creation of money by the government is a form of taxation and taxation is a legal form of fund raising of governments.

• Especially in countries with weak institutions seigniorage may be an essential part of the funding of the government budget. Absolutely no problem with that.

• The danger is that in countries with weak institutions and lack of effective parliamentary control it may be very dangerous.

• Germany 1923, Zimbabwe 2008, Venezuela 2018, Turkey 2019?

13 The road to hyperinflation

“A Government can live for a long time, even the German Government or the Russian Government, by printing paper money.”

What is raised by printing notes is just as much taken from the public as is a beer-duty or an income-tax. What a government spend the public pay for. There is no such thing as an uncovered deficit.’

John Maynard Keynes, A Tract on Monetary reform (1924) When money dies…… Germany 1923

15 ……. Zimbabwe 2008

16 The ugly face of hyperinflation (national currency/USD, index)

1E+15 1E+14 1E+13 1E+12 1E+11 1E+10 1E+09 100000000 10000000 1000000 100000 10000 1000 100 10 1 t=1 t=2 t=3 t=4 t=5 t=6 Germany Turkey Venezuela Zimbabwe

17 German hyperinflation: the run-up

Reichsmark/US dollar (1914 - 1921) 160

140

120

100

feb-15 feb-16 feb-17 feb-18 feb-19 feb-20 feb-21

aug-18 aug-19 aug-20 aug-21 aug-14 aug-15 aug-16 aug-17

nov-14 nov-15 nov-16 nov-17 nov-18 nov-19 nov-20

mei-21 mei-15 mei-16 mei-17 mei-18 mei-19 mei-20

18 When money died

Reichsmark/US dollar (1914 - 1923, logaritmische schaal) 1E+13 1E+12 1E+11 1E+10 1E+09 100000000 10000000 1000000 100000 10000 1000 100 10

jul-19 jul-21 jul-20 jul-22 jul-23

jan-21 jan-23 jan-19 jan-20 jan-22

sep-19 sep-22 sep-20 sep-21 sep-23

mrt-21 mrt-23 mrt-19 mrt-20 mrt-22

nov-19 nov-22 nov-20 nov-21 nov-23

mei-19 mei-21 mei-20 mei-22 mei-23

19 Hyperinflation: when money dies

Vrije Universiteit Amsterdam The highest hyperinflations

Hungary (1946) > 900.000.000.000.000.000.000.000.000%

Greece (1944) > 30.000.000.000%

Germany (1923) > 20.000.000.000%

Venezuela (2018) > 1.000.000.000%

Zimbabwe (2008) > 66.000%

Poland (1923) 51.699%

Russia (1990) 13.535%

Nicaragua (1987) 13.110%

Peru (1990) 7.482%

Brazil (1990) 2.948%

Source: Reinhart & Rogoff, This time is different, 2010, 182 -187

Vrije Universiteit Amsterdam Is money creation profitable? How about banks? And their clients?

• Banks don’t earn seigniorage: the money created by commercial banks is not owned by the bank but by their clients. And the clients are the first to bring it into circulation.

• But clients don’t earn seigniorage either. This is because against the newly created bank deposits (owned by the clients) stand newly created debt (owned by the banks).

• Money creation by the banks does not change net wealth or debt positions

• What changes is the degree of liquidity!

22 23 “Banks coin illiquid assets into liquidity”

Milton Friedman, Nobel prize economics, 1976

24 25 Money creation: governments and banks compared

Money creation by: Governments Commercial banks Seigniorage income Yes No Free funding Yes Yes Automatic brakes No Yes ‘out of thin air’ Yes No Initiative of money With the government With the banks and/or creation their clients

Note that seigniorage income is a form of taxation

26 In Europe monetary financing of public spending is explicitly forbidden by law.

• It is part of Treaty, article 123.1

• This reflects the German trauma of 1923, when hyperinflation effectively eliminated the middle class and paved the way for fascism.

• Germany would rather kill the euro than accept a government monopoly on money creation!

• Keep this in the back of your mind, we will come back to this later……

27 Monetary financing of government spending

Monetary base Banks can lend increases, bank more money , reserves larger which will result in increase of M1

Increase in government Money lands in bank spending, financed by accounts of Money is spend the central bank companies and and/or saved employee, involved in public projects (M1 increases) Money comes directly in circulation and economic activity will increase Helicopter Money

Monetary base Banks can lend increases, bank more money , reserves larger which will result in increase of M1

Government hands out Money lands in bank money to citizens as a accounts of the Money is spend present, financed by people that receive and/or saved the central bank this present Can money creation by commercial banks also run out of hand?

• Yes, it can. Banks can extend too much credit, buy to many securities……

• But supervisors have all instruments available to regulate it!

• Central banks regulate the size and costs of bank liquidity

• Banking supervisors demand minimum levels of solvency and liquidity ratios

• Competition authorities prevent dominant market positions 30 What seems to be the most stable situation?

• Governments: no, or little seigniorage by money creation

• Central banks: regulate market liquidity

• Bank supervisors: close monitoring of banking ratios

• Commercial banks: creating liquidity for their clients

• Central banks: ex-post monitoring of monetary aggregates and, if necessary, adapting market conditions

31 Central bank Loans to banks and goverments Open market operations

Government Base Money (M0) Foreign sector

General public Banks (cr) Money multiplier (rr)

Loans to consumers, business and governments

Money in circulation (M1, M2, M3) What are the problems with this system?

Banks are vulnerable for bank runs

Banks have a privilege in the shape of ‘free funding’

Bank may make mistakes in their lending decisions

People make take up too much debt

Supervisors may be too lax and/or make mistakes

The system may be procyclical

33 What are the problems with this system?

 Banks are vulnerable for bank runs This is a serious item, which only the central bank can solve

 Banks have a privilege in the shape of ‘free funding’ If this is the case, it can be easily solved by paying interest on payment accounts

 Bank may make mistakes in their lending decisions and/or people make take up too much debt. Yes, they usually do

 Supervisors may be too lax and/or make mistakes. Yes, but they’ve learned a lot

 The system may be procyclical. Yes, but supervisors have many way to prevent this to happen

34 Reform proposals • There are several proposals, viz.

1. The Chicago Plan (100% money) (Fisher, 1935) 1. Make payment systems a public function, executed by a public institution (basically the same proposal)

2. Digital cash

3. Denationalization of money (Hayek, 1975)

• We will focus on ad 1) and give some brief thoughts on ad 2). I will not go into ad 3), but you can always ask…..

35 The questions to be asked are….

• Which problems are solved?

• Are any new problems created?

• What is thee added value?

• What is the essence of these proposals?

• Is it possible?

• Which has already happened?

36 To start with: A simplified balance sheet of a “normal” bank

• ‘Normal’ meaning that the bank is active in the transformation of maturity • All liabilities are fully covered by the bank’s assets. But the degree of liquidity is different

• Assets are usually less liquid than liabilities 37 Full reserve banking

Making banks safer……

• Based on the so-called Chicago Plan (1930s) • International movement “full reserve money” • Modernizing money (UK), Ons Geld, SFL (NL), Vollgeld (SWI) Chicago Plan: Full reserve banking

• Background: US depresssion of the 1930s: money supply shrinking and the Fed failing as LOLR

• Proposal: banks must cover their current (‘liquid’) liabilities with 100% liquidity reserves

• No money creation by commercial banks ==> government is given a monopoly for the creation of money

• Bank lending to be financed with savings that already exist Full reserve banking

• Under Full-reserve banking all liquid liabilities are for 100% covered by liquid assets (reserves at the central banks and short-term gvt. bonds. • The transformation function is strongly diminished, but not completely eliminated • The phrase ‘full-reserve banking’ is misleading. The term ‘full-liquidity reserve banking’ is better. Effects of full reserve banking

• Probability of a bank run (almost) fully eliminated, as liquidity risk for individual banks becomes much smaller. This is an important positive factor.

• Savers are forced to hold their savings in depositi with a longer maturity. Liquid savings should be held on an non-interest current account. Otherwise the plan doesn’t work.

• All banks become secundary banks, just intermediation of existing money

• Banks lose a source of income, ==> holding a bank account becomes much more expensive

• Financial innovations should be eliminated, as near-monies may undermine the system Effects of full reserve banking (2)

• The government gets a monopoly on money creation. Open questions are: • Can the government create the right amount of liquidity on the right time, the right place, and in the right amount • Remember the large potential ways to create and/or destroy liquidity

• How can the government forecast the ex-ante right amount of money? Notice the importance of cross-border transactions.

• Government monopoly on money creation may be dangerous (see earlier)

• Banks become more stable because some risks are shifted back to depositors

42 Central bank Loans to banks and goverments Open market operations

Government Base Money (M0) Foreign sector

General public Banks (cr) Money multiplier (rr)

Loans to consumers, business and governments

Money in circulation (M1, M2, M3) Effects of full reserve banking (3)

• The international dimension is completely overlooked

• Cross-border flows have a potential major, but completely unpredictable influence on • The monetary base • The liquidity position of banks • The amount of money in circulation

• The whole idea that anyone can predict the ex-ante money supply is completely flawed.

• And cross-border flows are huge, especially for a small country like NL

44 Effects of full reserve banking (4)

• The consequences of full-reserve banking are highly uncertain

• To make it work and give it a chance there are three options: 1. It is introduced on a pan-EMU level (meaning the EU Treaty should be rewritten) 2. Cross-border flow within EMU are forbidden, which means partly dismantling the Internal Market 3. The Netherlands would have to leave EMU and, as a consequence, the EU

• My prediction: this is not going to fly

45 Other options

• The positive effect of the Chicago Plan can for a large extent be realized within the existing framework

• Some issues are already being addressed by the regulatory framework of BIS- 3, which introduces new criteria such as the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR)

• If you think that banks benefit too much form money creation  force them to pay interest on payment accounts.

• If you want make the payment systems safer  force banks to have collateral ready to increase their liquidity position if the circumstances deteriorate

46 Digital cash

• Digital cash: a digital variety of the bank note

• Everybody gets a bank account at the central bank

• Positive: everybody has a safe haven for his or her money

• Negative: a bank run is made much easier. Even a spark can trigger one  meaning the central bank should massively intervene to support banks

• Impact on stability potentially strongly negative. Therefore, most central banks are against this.

47 An ‘in-between’ solution: the deposit bank

• A deposit bank offers payment accounts that are fully covered by reserves at the central bank

• This means that a full-reserve bank is created in the current system

• Questions: • What is the earning model? • Why would this be more attractive than holding a normal bank account • Even this bank would have (operational) risk which must be ensured

• DNB has blocked this bank by refusing a banking licence. Good decision?

48 Conclusions

• Personally, I think that full-reserve banking is not a good idea. • It had never been tested in practice • Its economic consequences are uncertain • Against the positive effects are a lot of negatives (such as massive monetary financing by the government) • Most of the positive effects can be realised within the existing framework

• Even if you think that it is a good idea: it is not possible to introduce this on the national level within the EU

• The costs of exiting the E(M)U are huge. The are dwarfing any positive effect from full-reserve banking.

• A deposit bank may be reconsidered, although I have my doubt that it will work

49 50 Thank you

• Any questions?

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