Demand for money

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https://en.wikipedia.org/wiki/Demand_for_money 

Macroeconomics

In monetary economics, the demand for money is the desired holding of financial assets in the form of money: that is, cash or bank deposits rather than investments. It can refer to the demand for money narrowly defined as M1 (directly spendable holdings), or for money in the broader sense of M2 or M3.

Money in the sense of M1 is dominated as a store of value (even a temporary one) by interest-bearing assets. However, M1 is necessary to carry out transactions; in other words, it provides liquidity. This creates a trade-off between the liquidity advantage of holding money for near-future expenditure and the interest advantage of temporarily holding other assets. The demand for M1 is a result of this trade-off regarding the form in which a person's funds to be spent should be held. In macroeconomics motivations for holding one's wealth in the form of M1 can roughly be divided into the transaction motive and the precautionary motive. The demand for those parts of the broader money concept M2 that bear a non-trivial interest rate is based on the asset demand. These can be further subdivided into more microeconomically founded motivations for holding money.

Generally, the nominal demand for money increases with the level of nominal output (price level times real output) and decreases with the nominal interest rate. The real demand for money is defined as the nominal amount of money demanded divided by the price level. For a given money supply the locus of income-interest rate pairs at which money demand equals money supply is known as the LM curve.

The magnitude of the volatility of money demand has crucial implications for the optimal way in which a central bank should carry out monetary policy and its choice of a nominal anchor.

Conditions under which the LM curve is flat, so that increases in the money supply have no stimulatory effect (a liquidity trap), play an important role in Keynesian theory. This situation occurs when the demand for money is infinitely elastic with respect to the interest rate.

A typical money-demand function may be written as

${\displaystyle M^d=P\times L(R,Y)}$

where ${\displaystyle M^d}$ is the nominal amount of money demanded, P is the price level, R is the nominal interest rate, Y is real income, and L(.) is real money demand. An alternate name for ${\displaystyle L(R,Y)}$ is the liquidity preference function.

Motives for holding money

Transaction motive

Main article: Transactions demand

The transactions motive for the demand for M1 (directly spendable money balances) results from the need for liquidity for day-to-day transactions in the near future. This need arises when income is received only occasionally (say once per month) in discrete amounts but expenditures occur continuously.

Quantity theory

The most basic "classical" transaction motive can be illustrated with reference to the Quantity Theory of Money. According to the equation of exchange MV = PY, where M is the stock of money, V is its velocity (how many times a unit of money turns over during a period of time), P is the price level and Y is real income. Consequently, PY is nominal income or in other words the number of transactions carried out in an economy during a period of time. Rearranging the above identity and giving it a behavioral interpretation as a demand for money we have

${\displaystyle M^d=P\frac{Y}{V}}$

or in terms of demand for real balances

${\displaystyle \frac{M^d}{P}=\frac{Y}{V}}$

Hence in this simple formulation demand for money is a function of prices and income, as long as its velocity is constant.

Inventory models

The amount of money demanded for transactions however is also likely to depend on the nominal interest rate. This arises due to the lack of synchronization in time between when purchases are desired and when factor payments (such as wages) are made. In other words, while workers may get paid only once a month they generally will wish to make purchases, and hence need money, over the course of the entire month.

The most well-known example of an economic model that is based on such considerations is the Baumol-Tobin model. In this model an individual receives her income periodically, for example, only once per month, but wishes to make purchases continuously. The person could carry her entire income with her at all times and use it to make purchases. However, in this case she would be giving up the (nominal) interest rate that she can get by holding her income in the bank. The optimal strategy involves holding a portion of one's income in the bank and portion as liquid money. The money portion is continuously run down as the individual makes purchases and then she makes periodic (costly) trips to the bank to replenish the holdings of money. Under some simplifying assumptions the demand for money resulting from the Baumol-Tobin model is given by

${\displaystyle \frac{M^d}{P}=\sqrt{\frac{tY}{2R}}}$

where t is the cost of a trip to the bank, R is the nominal interest rate and P and Y are as before.

The key difference between this formulation and the one based on a simple version of Quantity Theory is that now the demand for real balances depends on both income (positively) or the desired level of transactions, and on the nominal interest rate (negatively).

Microfoundations for money demand

While the Baumol–Tobin model provides a microeconomic explanation for the form of the money demand function, it is generally too stylized to be included in modern macroeconomic models, particularly dynamic stochastic general equilibrium models. As a result, most models of this type resort to simpler indirect methods which capture the spirit of the transactions motive. The two most commonly used methods are the cash-in-advance model (sometimes called the Clower constraint model) and the money-in-the-utility-function (MIU) model (as known as the Sidrauski model).

In the cash-in-advance model agents are restricted to carrying out a volume of transactions equal to or less than their money holdings. In the MIU model, money directly enters agents' utility functions, capturing the 'liquidity services' provided by money.

Precautionary demand

Main article: Precautionary demand

The precautionary demand for M1 is the holding of transaction funds for use if unexpected needs for immediate expenditure arise.

Asset motive

The asset motive for the demand for broader monetary measures, M2 and M3, states that people demand money as a way to hold wealth. While it is still assumed that money in the sense of M1 is held in order to carry out transactions, this approach focuses on the potential return on various assets (including money broadly defined) as an additional motivation.

Speculative motive

Main article: Speculative demand for money

John Maynard Keynes, in laying out speculative reasons for holding money, stressed the choice between money and bonds. If agents expect the future nominal interest rate (the return on bonds) to be lower than the current rate they will then reduce their holdings of money and increase their holdings of bonds. If the future interest rate falls, then the price of bonds will increase and the agents will have realized a capital gain on the bonds they purchased. This means that the demand for money in any period will depend on both the current nominal interest rate and the expected future interest rate (in addition to the standard transaction motives which depend on income).

The fact that the current demand for money can depend on expectations of the future interest rates has implications for volatility of money demand. If these expectations are formed, as in Keynes' view, by "animal spirits" they are likely to change erratically and cause money demand to be quite unstable.

Portfolio motive

The portfolio motive also focuses on demand for money over and above that required for carrying out transactions. The basic framework is due to James Tobin, who considered a situation where agents can hold their wealth in a form of a low risk/low return asset (here, money) or high risk/high return asset (bonds or equity). Agents will choose a mix of these two types of assets (their portfolio) based on the risk-expected return trade-off. For a given expected rate of return, more risk averse individuals will choose a greater share for money in their portfolio. Similarly, given a person's degree of risk aversion, a higher expected return (nominal interest rate plus expected capital gains on bonds) will cause agents to shift away from safe money and into risky assets. Like in the other motivations above, this creates a negative relationship between the nominal interest rate and the demand for money. However, what matters additionally in the Tobin model is the subjective rate of risk aversion, as well as the objective degree of risk of other assets, as, say, measured by the standard deviation of capital gains and losses resulting from holding bonds and/or equity.

Empirical estimations of money demand functions

Is money demand stable?

Friedman and Schwartz in their 1963 work A Monetary History of the United States argued that the demand for real balances was a function of income and the interest rate. For the time period they were studying this appeared to be true. However, shortly after the publication of the book, due to changes in financial markets and financial regulation money demand became more unstable. Various researchers showed that money demand became much more unstable after 1975. Ericsson, Hendry and Prestwich (1998) consider a model of money demand based on the various motives outlined above and test it with empirical data. The basic model turns out to work well for the period 1878 to 1975 and there doesn't appear to be much volatility in money demand, in a result analogous to that of Friedman and Schwartz. This is true even despite the fact that the two world wars during this time period could have led to changes in the velocity of money. However, when the same basic model is used on data spanning 1976 to 1993, it performs poorly. In particular, money demand appears not to be sensitive to interest rates and there appears to be much more exogenous volatility. The authors attribute the difference to technological innovations in the financial markets, financial deregulation, and the related issue of the changing menu of assets considered in the definition of money. Other researchers confirmed this finding with recent data and over a longer period. Money demand appears to be time varying which also depends on household's real balance effects.

Laurence M. Ball suggests that the use of adapted aggregates, such as near monies, can produce a more stable demand function. He shows that using the return on near monies produced smaller deviations than previous models.

Importance of money demand volatility for monetary policy

If the demand for money is stable then a monetary policy which consists of a monetary rule which targets the growth rate of some monetary aggregate (such as M1 or M2) can help to stabilize the economy or at least remove monetary policy as a source of macroeconomic volatility. Additionally, if the demand for money does not change unpredictably then money supply targeting is a reliable way of attaining a constant inflation rate. This can be most easily seen with the quantity theory of money equation given above. When that equation is converted into growth rates we have:

${\displaystyle g_m+g_v=\pi +g_y}$

which says that the growth rate of money supply plus the growth rate of its velocity equals the inflation rate plus the growth rate of real output. If money demand is stable then velocity is constant and ${\displaystyle g_v=0}$. Additionally, in the long run real output grows at a constant rate equal to the sum of the rates of growth of population, technological know-how, and technology in place, and as such is exogenous. In this case the above equation can be solved for the inflation rate:

${\displaystyle \pi =-g_y+g_m}$

Here, given the long-run output growth rate, the only determinant of the inflation rate is the growth rate of the money supply. In this case inflation in the long run is a purely monetary phenomenon; a monetary policy which targets the money supply can stabilize the economy and ensure a non-variable inflation rate.

This analysis however breaks down if the demand for money is not stable — for example, if velocity in the above equation is not constant. In that case, shocks to money demand under money supply targeting will translate into changes in real and nominal interest rates and result in economic fluctuations. An alternative policy of targeting interest rates rather than the money supply can improve upon this outcome as the money supply is adjusted to shocks in money demand, keeping interest rates (and hence, economic activity) relatively constant.

The above discussion implies that the volatility of money demand matters for how monetary policy should be conducted. If most of the aggregate demand shocks which affect the economy come from the expenditure side, the IS curve, then a policy of targeting the money supply will be stabilizing, relative to a policy of targeting interest rates. However, if most of the aggregate demand shocks come from changes in money demand, which influences the LM curve, then a policy of targeting the money supply will be destabilizing.

Money creation

From Wikipedia, the free encyclopedia

https://en.wikipedia.org/wiki/Money_creation 

Money creation, or money issuance, is the process by which the money supply of a country, or of an economic or monetary region, is increased. In most modern economies, money creation is controlled by the central banks. Money issued by central banks is termed base money. Central banks can increase the quantity of base money directly, by engaging in open market operations. However, the majority of the money supply is created by the commercial banking system in the form of bank deposits. Bank loans issued by commercial banks that practice fractional reserve banking expands the quantity of broad money to more than the original amount of base money issued by the central bank.

Central banks monitor the amount of money in the economy by measuring monetary aggregates (termed broad money), consisting of cash and bank deposits. Money creation occurs when the quantity of monetary aggregates increase. Governmental authorities, including central banks and other bank regulators, can use policies such as reserve requirements and capital adequacy ratios to influence the amount of broad money created by commercial banks.

Money supply

Main article: Money supply

The term "money supply" commonly denotes the total, safe, financial assets that households and businesses can use to make payments or to hold as short-term investment. The money supply is measured using the so-called "monetary aggregates", defined in accordance to their respective level of liquidity. In the United States, for example:

• M0: The total of all physical currency including coinage. Using the United States dollar as an example, M0 = Federal Reserve notes + US notes + coins. It is not relevant whether the currency is held inside or outside of the private banking system as reserves.
• M1: The total amount of M0 (cash/coin) outside of the private banking system plus the amount of demand deposits, travelers checks and other checkable deposits
• M2: M1 + most savings accounts, money market accounts, retail money market mutual funds, and small denomination time deposits (certificates of deposit of under $100,000).

The money supply is understood to increase through activities by government authorities, by the central bank of the nation, and by commercial banks.

Money creation by the central bank

Central banks

Main article: Central banks

The authority through which monetary policy is conducted is the central bank of the nation. The mandate of a central bank typically includes either one of the three following objectives or a combination of them, in varying order of preference, according to the country or the region: Price stability, i.e. inflation-targeting; the facilitation of maximum employment in the economy; the assurance of moderate, long term, interest rates.

The central bank is the banker of the government and provides to the government a range of services at the operational level, such as managing the Treasury's single account, and also acting as its fiscal agent (e.g. by running auctions), its settlement agent, and its bond registrar. A central bank cannot become insolvent in its own currency. However, a central bank can become insolvent in liabilities on foreign currency.

Central banks operate in practically every nation in the world, with few exceptions. There are some groups of countries, for which, through agreement, a single entity acts as their central bank, such as the organization of states of Central Africa,  which all have a common central bank, the Bank of Central African States; or monetary unions, such as the Eurozone, whereby nations retain their respective central bank yet submit to the policies of the central entity, the European Central Bank. Central banking institutions are generally independent of the government executive.

The central bank's activities directly affect interest rates, through controlling the base rate, and indirectly affect stock prices, the economy's wealth, and the national currency's exchange rate. Monetarists and some Austrians argue that the central bank should control the money supply, through its monetary operations. Critics of the mainstream view maintain that central-bank operations can affect but not control the money supply.

Open-market operations

Open-market operations (OMOs) concern the purchase and sale of securities in the open market by a central bank. OMOs essentially swap one type of financial assets for another; when the central bank buys bonds held by the banks or the private sector, bank reserves increase while bonds held by the banks or the public decrease. Temporary operations are typically used to address reserve needs that are deemed to be transitory in nature, while permanent operations accommodate the longer-term factors driving the expansion of the central bank's balance sheet; such a primary factor is typically the trend of the money-supply growth in the economy. Among the temporary, open-market operations are repurchase agreements (repos) or reverse repos, while permanent ones involve outright purchases or sales of securities. Each open-market operation by the central bank affects its balance sheet.

Monetary policy

Main article: Monetary policy

Monetary policy is the process by which the monetary authority of a country, typically the central bank (or the currency board), manages the level of short-term interest rates and influences the availability and the cost of credit in the economy, as well as overall economic activity.

Central banks conduct monetary policy usually through open market operations. The purchase of debt, and the resulting increase in bank reserves, is called "monetary easing". An extraordinary process of monetary easing is denoted as "quantitative easing", whose intent is to stimulate the economy by increasing liquidity and promoting bank lending.

Physical currency

The central bank, or other competent, state authorities (such as the treasury), are typically empowered to create new, physical currency, i.e. paper notes and coins, in order to meet the needs of commercial banks for cash withdrawals, and to replace worn and/or destroyed currency. The process does not increase the money supply, as such; the term "printing [new] money" is considered a misnomer.

In modern economies, relatively little of the supply of broad money is in physical currency.

Role of commercial banks

Main article: Money multiplier

When commercial banks lend money, they expand the amount of bank deposits. The banking system can expand the money supply of a country beyond the amount created or targeted by the central bank, creating most of the broad money in a process called the multiplier effect.

Banks are limited in the total amount they can lend by their capital adequacy ratios, and their required reserve ratios. The required-reserves ratio obliges banks to keep a minimum, predetermined, percentage of their deposits at an account at the central bank. The theory holds that, in a system of fractional-reserve banking, where banks ordinarily keep only a fraction of their deposits in reserves, an initial bank loan creates more money than it initially lent out.

The maximum ratio of loans to deposits is the required-reserve ratio RRR, which is determined by the central bank, as

${\displaystyle \mathit{R}\mathit{R}\mathit{R}=\frac{R}{D}}$

where R are reserves and D are deposits.

Rather than holding the quantity of base money fixed, central banks have recently pursued an interest rate target to control bank issuance of credit indirectly so the ceiling implied by the money multiplier does not impose a limit on money creation in practice.

Credit theory of money

Main article: Credit theory of money

The fractional reserve theory where the money supply is limited by the money multiplier has come under increased criticism since the financial crisis of 2007–2008. It has been observed that the bank reserves are not a limiting factor because the central banks supply more reserves than necessary and because banks have been able to build up additional reserves when they were needed. Many economists and bankers now believe that the amount of money in circulation is limited only by the demand for loans, not by reserve requirements.

A study of banking software demonstrates that the bank does nothing else than adding an amount to the two accounts when they issue a loan. The observation that there appears to be no limit to the amount of credit money that banks can bring into circulation in this way has given rise to the often-heard expression that "Banks are creating money out of thin air". The exact mechanism behind the creation of commercial bank money has been a controversial issue. In 2014, a study titled "Can banks individually create money out of nothing? — The theories and the empirical evidence" empirically tested the manner in which this type of money is created by monitoring a cooperating bank's internal records:

This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, "out of thin air".

The credit theory of money, initiated by Joseph Schumpeter, asserts the central role of banks as creators and allocators of the money supply, and distinguishes between "productive credit creation" (allowing non-inflationary economic growth even at full employment, in the presence of technological progress) and "unproductive credit creation" (resulting in inflation of either the consumer- or asset-price variety).

The model of bank lending stimulated through central-bank operations (such as "monetary easing") has been rejected by Neo-Keynesian and Post-Keynesian analysis as well as central banks. The major argument offered by dissident analysis is that any bank balance-sheet expansion (e.g. through a new loan) that leaves the bank short of the required reserves may affect the return it can expect on the loan, because of the extra cost the bank will undertake to return within the ratios limits – but this does not and "will never impede the bank's capacity to give the loan in the first place". Banks first lend and then cover their reserve ratios: The decision whether or not to lend is generally independent of their reserves with the central bank or their deposits from customers; banks are not lending out deposits or reserves, anyway. Banks lend on the basis of lending criteria, such as the status of the customer's business, the loan's prospects, and/or the overall economic situation.

Monetary financing

Main article: Debt monetization

Policy

"Monetary financing", also "debt monetization", occurs when the country's central bank purchases government debt. It is considered by mainstream analysis to cause inflation, and often hyperinflation. IMF's former chief economist Olivier Blanchard states that

governments do not create money; the central bank does. But with the central bank's cooperation, the government can in effect finance itself by money creation. It can issue bonds and ask the central bank to buy them. The central bank then pays the government with money it creates, and the government in turn uses that money to finance the deficit. This process is called debt monetization.

The description of the process differs in heterodox analysis. Modern chartalists state:

the central bank does not have the option to monetize any of the outstanding government debt or newly issued government debt...[A]s long as the central bank has a mandate to maintain a short-term interest rate target, the size of its purchases and sales of government debt are not discretionary. The central bank's lack of control over the quantity of reserves underscores the impossibility of debt monetization. The central bank is unable to monetize the government debt by purchasing government securities at will because to do so would cause the short-term target rate to fall to zero or to any support rate that it might have in place for excess reserves.

Restrictions

Monetary financing used to be standard monetary policy in many countries, such as Canada or France, while in others it was and still is prohibited. In the Eurozone, Article 123 of the Lisbon Treaty explicitly prohibits the European Central Bank from financing public institutions and state governments. In Japan, the nation's central bank "routinely" purchases approximately 70% of state debt issued each month, and owns, as of Oct 2018, approximately 440 trillion JP¥ (approx. $4trillion) or over 40% of all outstanding government bonds. In the United States, the 1913 Federal Reserve Act allowed federal banks to purchase short-term securities directly from the Treasury, in order to facilitate its cash-management operations. The Banking Act of 1935 prohibited the central bank from directly purchasing Treasury securities, and permitted their purchase and sale only "in the open market". In 1942, during wartime, Congress amended the Banking Act's provisions to allow purchases of government debt by the federal banks, with the total amount they'd hold "not [to] exceed $5 billion". After the war, the exemption was renewed, with time limitations, until it was allowed to expire in June 1981.

Monetary reform

From Wikipedia, the free encyclopedia

https://en.wikipedia.org/wiki/Monetary_reform 

 

Public finance

Monetary reform is any movement or theory that proposes a system of supplying money and financing the economy that is different from the current system.

Monetary reformers may advocate any of the following, among other proposals:

• A return to the gold standard (or silver standard or bimetallism).
• Abolition of central bank support of the banking system during periods of crisis and/or the enforcement of full reserve banking for the privately owned banking system to remove the possibility of bank runs, possibly combined with sovereign money issued and controlled by the government or a central bank under the direction of the government. There is an associated debate within Austrian School whether free banking or full reserve banking should be advocated but regardless Austrian School economists such as Murray Rothbard support ending central bank bail outs ("ending the Fed").
• The issuance of interest-free credit by a government-controlled and fully owned central bank. Such interest-free but repayable loans could be used for public infrastructure and productive private investment. This proposal seeks to avoid debt-free money causing inflation.
• The issuance of social credit – "debt-free" or "pure" money issued directly from the Treasury – rather than the sourcing of fresh money from a central bank in the form of interest-bearing bonds. These direct cash payments would be made to "replenish" or compensate people for the net losses some monetary reformers believe they suffer in a fractional reserve-based monetary system.

Common targets for reform

Of all the aspects of monetary policy, certain topics reoccur as targets for reform:

Reserve requirements

Main article: Fractional-reserve banking

Banks typically make loans to customers by crediting new demand deposits to the account of the customer. This practice, which is known as fractional reserve banking, permits the total supply of credit to exceed the liquid legal reserves of the bank. The amount of this excess is expressed as the "reserve ratio" and is limited by government regulators not to exceed a level which they deem adequate to ensure the ability of banks to meet their payment obligations. Under this system, which is currently practiced throughout the world, the money supply varies with the quantity of legal reserves and the amount of credit issuance by banks.

Several major historical examples of financial regulatory reform occurred in the 20th century relating to fractional-reserve banking, made in response to the Great Depression and the many bank runs following the crash of 1929. These reforms included the creation of deposit insurance (such as the Federal Deposit Insurance Corporation) to mitigate against the danger of bank runs. Countries have also implemented legal reserve requirements which impose minimum reserve requirements on banks. Mainstream economists believe that these monetary reforms have made sudden disruptions in the banking system less frequent.

However, some critics of fractional reserve banking argue that the practice inherently artificially lowers real interest rates and leads to business cycles propagated by excessive capital investment and subsequent contraction. A small number of critics, such as Michael Rowbotham, equate the practice to counterfeiting, because banks are granted the legal right to issue new loans while charging interest on the money thus created. Rowbotham argues that this concentrates wealth in the banking sector with various pernicious effects.

Money creation by the central bank

Some critics discuss the fact that governments pay interest for the use of money which the central bank creates "out of nothing". These critics claim that this system causes economic activity to depend on the actions of privately owned banks, which are motivated by self-interest rather than by any explicit social purpose or obligation.

International organizations and developing nations

Some monetary reformers criticise existing global financial institutions such as the World Bank, International Monetary Fund, Bank of International Settlements and their policies regarding money supply, banks and debt in developing nations, in that they appear to these writers to be "forcing" a regime of extortionate or unpayable debt on weak Third World governments that do not have the capacity to pay the interest on these loans without severely affecting the well-being or even the viability of the local population. The attempt by weak Third World governments to service external debt with the sale of valuable hard and soft commodities on world markets is seen by some to be destructive of local cultures, destroying local communities and their environment.

Arguments for reform

Among the arguments for a transition to full-reserve banking or sovereign money are as follows:

• Money are created when a loan is made and this money disappear when the loan is paid down. The central banks cannot control the money supply when private banks are creating credit money. Credit money can be converted to reserve money in various ways so that there is no practical limit to the amount of credit money that can be created by private banks. This increases the risk of economic crises, unemployment, and bank bailouts or bank runs.

• Less than 6% of the money in circulation in the world is coins and bank notes, the rest originates from bank credit, carrying interest. This interest allows banks to earn rents from the mere fact that money exist. Reformers do not think it fair that the whole society is paying rents to the banks just for having money to circulate.

• The total amount of public and private debt in the world is now between two and three times the amount of broad money in circulation. This is a result of the accumulated compound interest of credit money. This counterintuitive fact makes it virtually impossible to repay all debt. The mathematical consequence is that somebody will have to go bankrupt even if they have done nothing wrong. It seems unfair that somebody will become destitute as a consequence of the money system rather than because of their own reckless behavior.

• It is not only individual persons and businesses that go bankrupt as a consequence of the fact that there is more debt than money in circulation. Many states have gone bankrupt and some states have done so many times. The debt problem is particularly severe for developing countries that have debt in foreign currencies. The International Monetary Fund and the World Bank have been promoting loans to resource-rich developing countries for the expressed purpose of promoting economic growth in these countries, yet these loans were denominated in foreign currencies and most of the money were used for paying transnational entrepreneurs without ever entering the local economy. These countries have been forced to sell off national assets in order to service the debt. Also a number of countries in the European Union are affected when a large part of the money circulating in the country originates from banks in other member countries. The spiraling, unpayable national debt has led to social chaos and even war in some cases.
  

• A major part of all new credit money that is created is spent on changing the ownership of existing assets rather than creating new assets. This process inflates the prices of assets, including real estate, factories, land, and intellectual rights. This makes living unnecessarily costly for everybody. It contributes to growing inequality and it makes the economy unstable because of the creation of asset bubbles.

• The exponentially increasing debt in society can only be serviced as long as the rate of economic growth exceeds the interest rate. This creates an imperative for perpetual growth in production and consumption. This leads to overconsumption and overexploitation of resources. The technological progress in labor-saving technologies has not given us more leisure as we expected, because of the necessary growth in consumption.

• The unpayable debt leads to bankruptcies of homeowners and foreclosure of their homes. This allows banks to replace their virtual assets in the form of money created 'out of thin air' with physical assets in the form of real estate. In 1968, a court in Minnesota decided that this practice was unconstitutional because the process by which the bank had created money from nothing was fraudulent (see First National Bank of Montgomery v. Daly).

Arguments against reform

Among the arguments for keeping the current system of money creation based on the credit theory of money or fractional reserve banking are as follows:

• Switching to an untested banking system that differs from that of other countries would lead to a situation of extreme uncertainty.
• A reform would make it difficult for the central bank to implement a monetary policy that secures price stability.
• The creation of money free of debt would make it difficult for the central bank to later reduce the money supply.
• The central bank would quite likely be subjected to political pressures for producing more money for whatever purpose is high on the political agenda. Giving in to such pressures would lead to inflation.
• The finance sector would be weakened because its profit is reduced.
• A reform would not offer complete protection against financial crises abroad.
• A reform would lead to an unhealthy concentration of power at the central bank. Critics doubt that the central bank can determine the required money supply better than the private banks can.
• The central bank may have to provide credit to commercial banks and accept the accompanying risk.
• A sovereign money system would stimulate the creation of shadow banking and alternative means of payment.
• In the traditional banking system, the central bank controls the interest rate while the money supply is determined by the market. In a sovereign money system, the central bank controls the money supply while the market controls the interest rate. In the traditional system, the need for investments determines the amount of credit that is issued. In a sovereign money system, the amount of saving determines the investments. This change of influences will generate a new and different system with its own dynamics and possible instabilities. The interest rate may fluctuate as well as the liquidity. It is not certain that the market will find an equilibrium where the liquidity is sufficient for the needs of the real economy and full employment.

Alternative money systems

Government Control vs Central Bank independence

To regulate credit creation, some countries have created a currency board, or granted independence to their central bank. The Reserve Bank of New Zealand, the Reserve Bank of Australia, the Federal Reserve, and the Bank of England are examples where the central bank is explicitly given the power to set interest rates and conduct monetary policy independent of any direct political interference or direction from the central government. This may enable the setting of interest rates to be less susceptible to political interference and thereby assist in combating inflation (or debasement of the currency) by allowing the central bank to more effectively restrict the growth of M3.

However, given that these policies do not address the more fundamental issues inherent in fractional reserve banking, many suggest that only more radical monetary reform such as government directly taking over central banks such as the China or Swiss models can promote positive economic or social change. Although central banks may appear to control inflation, through periodic bank rescues and other means, they may inadvertently be forced to increase the money supply (and thereby debase the currency) to save the banking system from bankruptcy or collapse during periodic bank runs, thereby inducing moral hazard in the financial system, making the system susceptible to economic bubbles.

International monetary reform

Theorists such as Robert Mundell (and more radical thinkers such as James Robertson) see a role for global monetary reform as part of a system of global institutions alongside the United Nations to provide global ecological management and move towards world peace, with Robert Mundell in particular advocating the revived use of gold as a stabilising factor in the international financial system. Henry Liu of the Asia Times Online argues that monetary reform is an important part of a move towards post-autistic economics.

While some mainstream economists favour monetary reforms to reduce inflation and currency risk and to increase efficiency in the allocation of financial capital, the idea of all-encompassing reform for green or peace objectives is typically espoused by those on the left-wing of the subject and those associated with the anti-globalization movement.

Social credit and the provision of debt-free money directly from government

Still other radical reform proposals emphasise monetary, tax and capital budget reform which empowers government to direct the economy toward sustainable solutions which are not possible if government spending can only be financed with more government debt from the private banking system. In particular, a number of monetary reformers, such as Michael Rowbotham, Stephen Zarlenga and Ellen Brown, support the restriction or banning of fractional-reserve banking (characterizing it as an illegitimate banking practice akin to embezzlement) and advocate the replacement of fractional-reserve banking with government-issued debt-free fiat currency issued directly from the Treasury rather than from the quasi-government Federal Reserve. Austrian commentator Gary North has sharply criticized these views in his writings.

Alternatively, some monetary reformers such as those in the social credit movement, support the issuance of repayable interest-free credit from a government-owned central bank to fund infrastructure and sustainable social projects. This social credit movement flourished briefly in the early 20th century, but then became marginalized. In Canada, it was an important political movement that ruled Alberta through nine legislatures between 1935 and 1971, and also won many seats in Québec. It died out in the 1980s.

Both these groups (those who advocate the replacement of fractional-reserve banking with debt-free government-issued fiat, and those who support the issuance of repayable interest-free credit from a government-owned central bank) see the provision of interest-free money as a way of freeing the working populace from the bonds of "debt slavery" and facilitating a transformation of the economy away from environmentally damaging consumerism and towards sustainable economic policies and environment-friendly business practices.

Examples of government issued debt-free money

Some governments have experimented in the past with debt-free government-created money independent of a bank. The American Colonies used the "Colonial Scrip" system prior to the Revolution, much to the praise of Benjamin Franklin. He believed it was the efforts of English bankers to revoke this government-issued money that caused the Revolution.

Abraham Lincoln used interest-free money created by the government to help the Union win the American Civil War. He is sometimes quoted (probably apocryphally) calling these 'Greenbacks' "the greatest blessing the people of this republic ever had."

Local barter, local currency

Some go further and suggest that wholesale reform of money and currency, based on ideas from green economics or Natural Capitalism, would be beneficial. These include the ideas of soft currency, barter and the local service economy.

Local currency systems can operate within small communities, outside of government systems, and use specially printed notes or tokens called scrips for exchange. Barter takes this further by swapping goods and services directly; a compromise being the Local Exchange Trading Systems (LETS) scheme: a formalised system of community-based economics that records members' mutual credit in a central location.

Commodity money

Some proponents of monetary reform desire a move away from fiat money towards a hard currency or asset-backed currency, which is often argued to be an antidote to inflation. This may involve using commodity money such as money backed by the gold, silver or both, commodities which supporters argue possess unique properties: their extraordinary malleability, their strong resistance to forgery, their character as stable and impervious to decay, and their inherently limited supply.

Digital means are also now possible to allow trading in hard currencies such as gold, and some believe a new free market will emerge in money production and distribution, as the internet allows renewed decentralisation and competition in this area, eroding the central government's and bankers' old monopoly control of the means of exchange.

Free banking

Some monetary reformers favour permitting competing banks to issue private banknotes whilst also eliminating the central bank's role as lender of last resort. In the absence of these factors, they believe a gold standard or silver standard would arise spontaneously out of the free market.

Free banking

From Wikipedia, the free encyclopedia

https://en.wikipedia.org/wiki/Free_banking

Free banking is a monetary arrangement where banks are free to issue their own paper currency (banknotes) while also subject to no special regulations beyond those applicable to most enterprises.

In a free banking system, market forces control the supply of total quantity of banknotes and deposits that can be supported by any given stock of cash reserves, where such reserves consist either of a scarce commodity (such as gold) or of an artificially limited stock of fiat money issued by a central bank.

In the strictest versions of free banking, however, there either is no role at all for a central bank, or the supply of central bank money is supposed to be permanently "frozen". There is, therefore, no government agency acting as a monopoly "lender of last resort", leaving that to the private sector as happened in the US in the panic of 1907. Nor is there any government insurance of banknotes or bank deposit accounts.

Supporters include Fred Foldvary, David D. Friedman, Friedrich Hayek, George Selgin, Steven Horwitz, and Richard Timberlake.

History

Banking has been more regulated in some times and places than others, and some times and places it has hardly been regulated at all, giving some experiences of more or less free banking. Free banking systems have existed in more than 60 countries. The first system of competitive issue of notes began more than 1,000 years ago in China (see below). Free banking was widespread in the 19th century and the early 20th century. Dowd, Kevin, ed. (1992), The Experience of Free Banking, London: Routledge lists most currently known episodes of free banking and discusses in some depth a number of them, including Canada, Colombia, Foochow, France, and Ireland. Monetary arrangements with monopoly issue of notes, including government treasury issue, currency boards, and central banking, replaced all episodes of free banking by the mid 20th century. There were several reasons for the demise of free banking:

• Economic theories claiming the superiority of central banking.
• Desire to imitate the institutions of more advanced economies, especially Great Britain. The Bank of England was the model for many later central banks, even outside the British Empire.
• Desire of national governments to collect seigniorage (revenue from issue) from note issue.
• Financial crises in some free banking systems that created demands to replace free banking with another system that advocates hoped would have fewer problems.

Some prominent 18th and 19th century economists defended free banking, most notably Adam Smith, as opposed to the real bills doctrine. After the mid 19th century, though, economists interested in monetary issues focused their attention elsewhere, and free banking received little attention. Free banking as a subject of renewed debate among economists got its modern start in 1976 with The Denationalization of Money, by economist Friedrich Hayek, who advocated that national governments stop claiming a monopoly on the issuing of currency, and allow private issuers like banks to voluntarily compete to do so.

In the 1980s, this expanded into an increasingly elaborate theory of free market money and banking, with proponents Lawrence White, George Selgin, and Richard Timberlake increasingly centering their writing and research around the concept, either regarding modern theory and application, or researching the history of spontaneously free banking.

Australia

In the late 19th century, banking in Australia was subject to little regulation. There were four large banks with over 100 branches each, that together had about half of the banking business, and branch banking and deposit banking were much more advanced than other more regulated countries such as the UK and US. Banks accepted each other's notes at par. Interest margins were about 4% p.a. In the 1890s a land price crash caused the failure of many smaller banks and building societies. Bankruptcy legislation put in place at the time gave bank debtors generous terms they could restructure under, and most of the banks used this as a means to restructure their debts in their favor, even though they did not really need to.

Switzerland

In the 19th century, several Swiss cantons deregulated banking, allowing free entry and issue of notes. Cantons retained jurisdiction over banking until the enactment of the Federal Banking Law of 1881. The centralisation of note issue reduced the problem of the existence of "a bewildering variety of notes of varying qualities ... at fluctuating exchange rates."

Scotland

Scottish free banking lasted between 1716 and 1845, and is arguably the most researched and developed instance of free banking. The system was organized around three chartered banks – the Bank of Scotland, the Royal Bank of Scotland, and the British Linen Company – and numerous unchartered banks. It resulted in a highly stable and competitive banking system.

United States

Main article: History of central banking in the United States § 1837–1862: "Free Banking" Era

See also: Wildcat banking

Although the period from 1837 to 1864 in the US is often referred to as the Free Banking Era, the term is a misnomer in terms of the definition of "free banking" above. Free Banking in the United States before the Civil War refers to various state banking systems based on what were called at the time "free banking" laws. These laws made it necessary for new entrants to secure charters, each of which was subject to a vote by the state legislature with obvious opportunities for corruption. These general banking laws also restricted banks' activities in important ways. Most importantly, US free banks could have only one office and had to provide security for their notes by gold reserves but also by purchasing and surrendering to state banking authorities certain securities the state law deemed acceptable for the purpose. The securities generally included bonds of state governments. The depreciation of these bonds was the chief cause of free bank failures in various episodes when many banks in a state failed. The lack of branch banking, in turn, caused state-issued banknotes to be discounted at varying rates once they had traveled any considerable distance from their sources, which was an inconvenience. Depreciation of assets more generally is also used to explain failures. Several authors attribute the high-rate of bank failures during the Free Banking era in the US ultimately to restrictions on banks' portfolios of assets. Then, from 1863 to 1913, known as the National Banks Era, state-chartered banks were operating under a free banking system. Some scholars have found that the system was mostly stable compared to National Banks of that era.

Sweden

Sweden had two periods of free banking, 1830–1860 and 1860–1902. Following a bank crisis in 1857, there was a rise in popular support for private banks and private money issuers (especially Stockholms Enskilda Bank, founded in 1856). A new bank law was adopted by parliament in 1864, deregulating the interest rate. The following decades marked the height of the Swedish free banking era. After 1874, no new private banks were founded. In 1901, issuing of private money was prohibited. Research on the Swedish free banking era suggest stability, and a single bank failure related to fraud in 70 years.

China

Jiaozi was a form of banknote which appeared around 10th century in the Sichuan capital of Chengdu, China. Between 960 and 1004, the bank notes were totally run by private merchants. Until government decided to regulate the business on alleged increasing fraud cases and disputes, and it granted 16 licenses to the biggest merchants of all.