This archived content originally appeared at, the predecessor site to, and does not carry the sponsorship of the Cato Institute.

Let's not ban private money

[originally posted at the Institute for Economic Affairs on 6 May 2014]

In a recent Financial Times article Martin Wolf announced his conversion to the view that private banks should be stripped of their ability to create money. The proposal to end private money is an old idea that periodically resurfaces in the history of economic thought, typically during crises of confidence in mainstream economic thinking when the conventional wisdom becomes discredited. An early example was the early 19th century Currency School; they succeeded in implementing it in the form of the Bank Chart Act of 1844, which imposed a 100 per cent marginal reserve requirement on the note issue and effectively gave the Bank of England a monopoly of the note supply. Later versions included the Chicago Plan advocated by Irving Fisher and Henry Simons in the 1930s; and it has surfaced repeatedly in the recent financial crisis. These more modern versions boil down to monopolising the issue of bank deposits through a 100 per cent reserve requirement.

Its proponents make extraordinary claims for it: it would slash public debt, stabilise the financial system, make the banking system run-proof and make it much easier for the government to achieve price stability. If these claims seem too good to be true, it is because they are.

In essence, this proposal is just another instance of what Ronald Coase once derided as ‘blackboard economics’ – a scheme that works well on the blackboard, but does not actually work in the real world because the economy never works the way its proponents imagine it to.

The Bank Charter Act is a perfect example. The note issue restrictions of the Act were supposed to ensure banking stability based on the premise that the underlying cause of instability was an unstable private note supply. However, it soon became apparent these restrictions created additional instability of their own, as they suppressed the note issue elasticity that previously worked to calm markets. In subsequent years – 1847, 1857 and 1866 – crises erupted that were only resolved when these note issue restrictions were temporarily suspended. The Bank Charter Act was, thus, a failure.

A second problem with the proposal to prohibit private money is that it would seriously impact the credit system because it would entail a massive switch in bank assets from private lending to government securities. Bank lending to the private sector would go to zero and banks would then exist primarily to finance government. Mr. Wolf acknowledges the issue, but almost casually dismisses it on the grounds that ‘we’ could find new (non-bank) channels to finance investment, as if the problem were easily resolved. These new credit channels would take time to emerge, however, and in the meantime the provision of credit would be to a large extent stopped in its tracks. This amounts to hitting our already fragile credit system with a sledgehammer and would probably be enough to push the economy into a depression.

But perhaps the biggest problem with any proposals to prohibit private money is not practical but intellectual: they are based on a mistaken view of the causes of economic and financial instability. Major fluctuations are not caused by volatile behaviour on the part of the private sector, but by government or central bank interventions that have destabilised the economy again and again. The Currency School is a case in point; it overlooked the point that the main causes of instability were the erratic policies of the Bank of England and the restrictions under which other banks were forced to operate. As a result, they applied the wrong medicine which then didn’t work.

More recent government interventions have created further instability: the botched policies of the Federal Reserve were the key factors behind the length and severity of the Great Depression; deposit insurance and the lender of last resort have created major incentives for banks to take excessive risks; and erratic monetary policies have greatly destabilised the macroeconomy over much of the last century. As Milton Friedman observed back in 1960:

The failure of government to provide a stable monetary framework has…been a major if not the major factor accounting for our really severe inflations and depressions. Perhaps the most remarkable feature of the record is the adaptability and flexibility that the private sector has so frequently shown under such extreme provocation.

So let’s challenge the conventional wisdom by all means, but proposals to prohibit private money are based on a false diagnosis and go in the wrong direction. The problem is not the instability created by private money, but rather the instability created by government intervention into the monetary system. Government money is not the solution; it is the problem.

  • Mike Sproul

    Amen. One thing that helps to protect us from the money-fascists is that new kinds of money (credit cards, etc) are always being invented. So as they suppress paper dollars and checking account dollars, credit card dollars etc. fill in the void.

    • I don’t see what’s fundamentally “new” about credit cards. They basically just amount to your bank allowing you to run up an overdraft. That’s the same as a bank granting you an overdraft in the pre-credit card days when we used checks and physical cash rather than cards.

      The difference is that everything is done electronically and more quickly, but the basic principles are the same.

    • That which 'credit' card debt fills in the money spectrum is the lack on wage-money going to the real wealth-creators, requiring the demand for 'credit' to feed, clothe and house working families.
      So, instead of a money stream that funds real economic needs, we get a new money-form, a line of credit(debt) from the Debts-R-Us bankers' back room.
      Thanks a lot for that.

  • The way regulators are requiring more bank capital when lending to the private sector than when lending to the government; means our banks will lend more and more to the government and less and less to the private; and so we might anyhow end up effectively banning private money.

  • As a supporter of full reserve banking, i.e. the ideas put by Martin Wolf, I’m constantly encouraged by the hopeless criticisms made of full reserve. And Kevin Dowd’s aricle is very much in the latter genre.

    His second paragraph contains a series of “man of straw” arguments: that is, claims for full reserve which are obvious nonsense and which I agree are mostly nonsense. So that’s that point dealt with.

    He then makes a claim I’ve seen a dozen times before: “A second problem with the proposal to prohibit private money is that it would seriously impact the credit system because it would entail a massive switch in bank assets from private lending to government securities. Bank lending to the private sector would go to zero…”

    Dowd gives us no coherent reasons for this disastrous outcome. But the outcome certainly would transpire TO SOME EXTENT and for the obvious reason that under full reserve, those who fund loans and investments made by a bank have to accept the risk involved (rather than have the taxpayer accept the ultimate risk). But hilariously, Dowd himself later in his article criticises deposit insurance (i.e. taxpayer backing for depositors).

    So we’re agreed are we? Deposit insurance should be abandonned, which in effect means that depositors stand to lose when a bank fails, which in effect means that depositors are shareholders, which is what Martin Wolf and advocates of full reserve want!!!!

    And finally it’s good to see Dowd quoting Milton Friedman because Friedman actually supported full reseve (aka stopping private money production). As he said in Ch 3 of his book “A Program for Monetary Stability” under the heading “How 100% reserves would work”:

    The effect of this proposal would be to require our present commercial banks to divide themselves into two separate institutions. One would be a pure depositary institution, a literal warehouse for money. It would accept deposits payable on demand or transferable by check. For every dollar of deposit liabilities, it would be required to have a dollar of high-powered money among its assets in the form, say, either of Federal Reserve notes or Federal Reserve deposits. This institution would have no funds, except the capital of its proprietors, which it could lend on the market. An increase in deposits would not provide it with funds to lend since it would be required to increase its assets in the form of high-powered money dollar for dollar. The other institution that would be formed would be an investment trust or brokerage firm. It would acquire capital by selling shares or debentures and would use the capital to make loans or acquire investments. Since it would have no power to create or destroy money…”

    • Thanks Ralph for explaining what is not obvious to free banking advocates.

      That full-reserve banking does NOT inhibit growth and DOES enhance both economic growth and debt reduction, is proven beyond argument mainly in the work of Dr. Kaoru Yamaguchi who modeled the American Monetary Institute's reform proposal and found these exact results in what Prof. Steve Keen described as the most sophisticated 'systems-dynamic' modeling he as ever seen.

      From the free-bankers, we get unsupported rhetoric.

      Also, the work of Benes and Kumhof found that the Chicago Plan's claims of just those results(growth-enhancement without inflation or deflation, major reduction in public AND private debt, greater stability to the pro-cyclical economy, etc.) came forward in their "Revisit" of the Chicago Plan almost a couple of years ago now.

      Their's was using an enhanced version of the IMF's DSGE model which was expanded to include all those things that Keen finds missing from debunked standard DSGE macro-economic modeling.

      Anyway, Dr. Yamaguchi's work stands awaiting criticism, the lack of which leaves the heavy free-banking rhetoric without any clothes.

      That which Martin Wolf recognized is the disconnect between the needs for stable money creation and the willingness of banks to lend the new money needed into a balance sheet recession. Private money creation just ain't working for The Restofus.

      The Times They're A Changing.

  • MichaelM

    Shareholders hold equity. Depositors hold bank debt. Two different things.

  • Paul Marks

    The commercial banking system does not create "money" – it creates CREDIT, this is not the same thing.

    Every banking "boom" bubble (every effort to lend out "money" that was never really saved) inevitably ends in BUST. Only if the government (and Central Bank) comes to the rescue by really "creating money" (more "monetary base" to prop the bubble of CREDIT "broad money") can the bubble be maintained – at the price of an ever more distorted capital structure (as in the case of Japan, Britain and the United States and……).

    As for Martin Wolf – he is not really a hard money man (anything but).

    In reality M.W. wants the government to meet the "needs of borrower".

    Like that well known fiscal and monetary conservative (sarcasm alert) General Peron of Argentina.

    General Peron replaced credit bubble banking with the government printing press.

    A "cure" that the Keynesian Martin W. would also favour – and a "cure" that is worse than the disease.

  • Kevin Dowd’s claim that banning private money would “entail a massive switch in bank assets from private lending to government securities” is inconsistent with the common claim by advocates of free banking, namely that there is no demand for warehouse, i.e. ultra safe banks.

    Government securities are of course a poor substitute for money in a bank: on cannot draw checks on a holding of US Treasuries. But that doesn’t matter too much: at least in the UK there is “National Savings and Investments” which is a government run savings bank that invests only in UK government debt and pays a miserable rate of interest.

    So would there be a “massive switch” to NSI accounts in the UK? According to Kevin Dowd the answer seems to be “yes”. But according to most advocates of free banking the answer is “no” because there is allegedly little demand for ultra safe banks that pay little or no interest (a curious claim given that a third of the UK population have an account at NSI).

  • MichaelM

    I don't know about any of that, I was just addressing the portion of your post where you said that the removal of public deposit insurance makes depositors shareholders, which isn't true. Depositors are bank creditors. The risk they bear is because they loan money to the bank, not because they are shareholders. Holding a bank's debt and holding a bank's equity are not the same thing at all.

    • Good point. However shareholders are people who make a loss when the entity in which they have a shareholding makes a loss. And when deposit insurance (and the TBTF subsidy and all other bank subsidies) are removed then depositors stand to make a loss when a bank goes under. Thus they become NEARER to being shareholders than they were.

      But advocates of full reserve argue that that process should be taken further, because if one simply removes bank subsidies, depositors still have a motive to run, and runs have damaging systemic effects (at least where large banks are concerned). Thus advocates of full reserve argue that loans and investments should be funded only by full blown shareholders, and not depositors.

      • MichaelM

        Then in that case full reserve requirements would just be a band-aid for option clauses on bank deposits and notes being outlawed. A much simpler solution that would lead to far fewer changes in how the financial system operates once public deposit insurance and other public subsidies are repealed would be to also repeal laws against option clauses on bank issued financial instruments.

        Deposits are just a particular form of credit instrument: the bank sells you a demand deposit account in exchange for your cash. Setting a particular reserve requirement for deposit accounts is un-necessary central planning in the financial system.

        Am I to understand that you advocate not only not allowing demand deposits to be used to fund loan activities but also time deposits?

  • Strikes me the option clause is a good system for dealing with IRRATIONAL runs on a bank, i.e rumor etc. That is, when the heat dies down, the bank can pay despositors who want their money out. But it doesn’t deal with GENUINE insolvency or bankruptcy: i.e. where the bank’s liabilities exceed it’s assets by so much that prospects of recovery are negligible.

    In contrast, where a bank or lending entity is funded JUST BY shareholders, bankruptcy is near impossible: e.g. if assets fall to half their book value, then all that happens is that the shares fall to half their original value.

    As George Selgin himself said in his book on banking, “For a balance sheet without debt liabilities, insolvency is ruled out…”

    Re your final question, yes advocates of full reserve (certainly Milton Friedman and Laurence Kotlikoff) argue that there should be only shares, i.e. no deposits or bonds on the liability side of a lender’s balance sheet. (Of course there’s no need to impose that on the smallest shadow banks and on every back street loan shark.)

  • MichaelM

    Of course, if assets fall to half their book value then that may precipitate a sell off and lead to a bankruptcy, anyway.

    I don't see what's wrong with a genuinely insolvent bank going bankrupt. If you really want you can give depositors priority in bankruptcy proceedings by law so they get a crack at recovering at least part of their money quickest.

    Really what it seems is you're objecting to the use of debt to fund financial activities. What's wrong with that? It's a particular kind of risk-taking and performs an important economic function in terms of making liquidity available and performing rate arbitrage.