Economists have recently taken to discussing the viability of banning banks. Though the thought seems completely far-fetched, and almost crazy, it’s not as crazy as it sounds. However, before we discuss what it means for the banking system to get banned, let’s just review what it is that a bank does.
What most people imagine banks being is one of a savings and loan. Essentially, think of the scene from the movie “It’s a Wonderful Life“. Customers deposit money with the bank in the form of checking and savings accounts. The bank, in turn, loans out that money in the form of student loans, business loans, mortgages, etc., which is where the depositors’ money goes. However, it’s not that simple, and that’s not entirely how banks work.
The reality is that banks don’t actually make loans out of existing deposits. When the bank issues a mortgage or any other type of loan, it doesn’t go into the vaults to see if there’s enough cash available in the vault from other customers’ deposits to satisfy the loan amount. Instead, the bank digitally credits your account with the amount of money consistent with the loan you’ve been approve for.
The Bank of England recently published a fantastic paper titled “Money Creation in the Modern Economy” in which it is explained that banks – rather than serving as a middle-man between depositors and borrowers – are actually in the business of creating money. Here’s the basic summary on how it works:
Essentially, modern banking represents the outsourcing of money creation from the federal government to the banking system. There are, of course, limits on the amount of money that banks are authorized to create (some limitations are based on regulation, some stem from monetary policy, and some from the market itself). But, at the heart of it, most money creation comes from banks. The new discussions revolve around banks being banned from creating money, and that the burden of money creation should rest on the shoulders of the government by itself.
But, why change the current system? Is there something wrong with banks creating money? It is, after all, an institution that has lasted since the first financial institution created by the Medici’s during the Italian Renaissance. Well, ever since the 2008 financial crisis, there has been a great deal of discussion regarding how to make the financial system safer for consumers. The debate really gained steam when Financial Times columnist Marin Wolf called for government legislation stripping banks of their ability to create money. The argument was that banks’ arbitrary ability to create money out of thin air is what is responsible for destabilizing the credit markets and the creation of bubbles and busts (the writing was on the wall with the boom-bust concept from John Maynard-Keynes). People expect that their bank deposits are safe, which allows banks to get riskier with their loans, thus forcing the government to step in as a backstop should things go sour. If the government is going to be holding the bag at the end of the day, why not just give the government the bag permanently?
Wolf wants the banks to function solely as depository and payment institutions – essentially making them nothing more than a utility, without the ability to create money. This is not a new idea by any means.
In a 1939 proposal, noted economist Irving Fisher sought to recreate a more stable banking system in the wake of the Great Depression. That paper spoke extensively about the need to prevent banks from creating money. The paper contains a stern warning about how the modern banking system is a “loose screw” in the American financial system, and that banks had too much power to create money. The paper explains that banks would still be able to function as lending intermediaries. For example, CD deposit accounts (deposit accounts that restrict how quickly one could access the funds deposited into it) would be a legitimate source of loanable funds.
So now, the million dollar question: Will this happen?
Probably not. In Wolf’s piece, he addresses that another crisis would have to happen before the topic is discussed seriously.
Our financial system is so unstable because the state first allowed it to create almost all the money in the economy and was then forced to insure it when performing that function. This is a giant hole at the heart of our market economies. It could be closed by separating the provision of money, rightly a function of the state, from the provision of finance, a function of the private sector. This will not happen now. But remember the possibility. When the next crisis comes – and it surely will – we need to be ready.
There are some big objections to the idea. Paul Krugman addresses the issue in a blog post, and notes that one big problem with Wolf’s suggestion is the creation and cultivation of a black market banking system. Krugman raises questions about complexity and whether the problem runs even deeper than financial instability.