Bar Ilan University 7 th December 2015 Israel

On radical monetary reformMartin Wolf, Associate Editor & Chief Economics Commentator, Financial Times Bar Ilan University 7th December 2015 Israel

On radical monetary reform • Case for permanent government creation of money • Modalities of government-creation of money • Arguments against government-creation of money • Alternatives to radical monetary reform • Possible ways forward

1. Case for government-creation of money • The monetary system is both a social creation and a public good (non-excludable and non-rival) • It should not be handed over in full to private entities • Indeed, it cannot be handed over in full to private entities, since the latter cannot ensure monetary stability: • Central banks, which are part of the state, insure the “moneyness” of monetary liabilities of solvent banks • Since solvency cannot be known from outside, regulators also oversee the solvency of private banks

1. Case for government-creation of money • Government-created money could be distributed as the government saw fit • It would reclaim seignorage from the private banks • It would deleverage the economy • It would lead to a more stable financial system: • By eliminating inherently fragile fractional-reserve intermediation; and • Curbing the private credit cycle, which is driven by feast and famine in the creation of debt-backed money;

1. Case for government-creation of money • A government monopoly over the creation of money would limit the ability of the private financial system to extract rent and so generate massive inequality: • Banks lend against property collateral, thereby leveraging up and enhancing the value of the latter; • Banks earn fees and interest in return for providing money that is costless for them to create; • It is “money printing”, as many say of central bank money; • These fees and interest are then turned into income for employees and shareholders; • Under competition, the rent will be partly competed away, but end up as excessive leverage

1. Case for government-creation of money • In a crisis: • It should be possible for central banks to create money and hand it over to the citizens in a crisis, even if there were no agreement on a permanent government monopoly of money creation, it • This would be more effective than today’s form of quantitative easing • This works via the financial system. • But, after a crisis, the financial system is, by definition, dysfunctional. • So QE is quite ineffective

2. Modalities of government-creation of money • There are two main proposals for government-created money: • 100 per cent reserve banking, in which banks provide services to customers, but money is created by the central bank, on behalf of the government. • People then deposit government cheques in their bank. Banks are not allowed to create deposits against advances. • Direct government-created money, in which banks are purely agents for accounts containing government money. • The economic difference between these alternatives is unimportant. Under both, money-creation would be transferred to the state.

3. Arguments against government money • Governments will abuse the new privilege: • This is why the decision on how much money to create would have to be left to an independent institution • But this is not fundamentally different from the current situation, in which the central bank governs the terms on which people lend and borrow • That is also deeply political • We can remember when it was taken for granted that finance ministers would manipulate interest rates for political reasons • This would surely be better.

3. Arguments against government money • The borderline between banking and non-banking cannot be policed: • Here one should take into account why one might want to make the shift • Financing the government more cheaply would stand even if it were hard to distinguish banking from non-banking • I used to take the position that 100 per cent reserve banking (or a close relative) could not work because "banking" would reappear outside the banking sector • This must be true

3. Arguments against government money • But a counter-argument exists: • If we cannot police the borderline between banking and non-banking, the new regulatory structure is also likely to fail • Promises to repay on demand, at par, would be illegal, except for fully-reserved banks, while those who made implicit promises would must inform customers of the risks • Alternatively, high capital requirements could be imposed on institutions that made such implicit promises • Limited liability could even be removed from any company that invested in financial claims • In this way, chains of financial claims could be eliminated.

3. Arguments against government money • It would be impossible to do standard monetary policy: • If we assume 100 per cent reserve banking, monetary policy would become quantitative • The central bank would no longer be a lender of last resort. • Of course, the central bank might be a lender of last resort to non-banks. • In that case, the central bank's emergency lending rate would influence interest rates in the rest of the system. • The fundamental question is whether the authorities should allow such a commitment and so emergence of a hybrid system. It would subvert the principle of the reform

3. Arguments against government money • We would lose valuable financial intermediation: • But the bloated banking system of today has been doing little, if any, useful intermediation: productivity growth is slow; support for small business is a tiny part of the balance sheet; and much of the activity consists of leveraging up the value of land and creating exotic derivatives • Would we really lose much if this were to stop? • We could create the needed small-business banks with a mixture of equity and non-monetary debt • Or via peer-to-peer lending

3. Arguments against government money • We would lose flexible accommodation: • The supply of flexible bank credit is an alternative to investing in large holdings of money • With 100 per cent reserve banking, this flexibility would be lost • So all companies would need to hold excess money

4. Alternatives to radical reform: new orthodoxy • One approach is “macro-prudential policy”: • It is a way to protect the financial sector from the cycle and the cycle from the financial sector; • But it raises difficult challenges: • The interventions will be difficult to judge • They will be politically unpopular • They may conflict with monetary policy • They may have unintended consequences • Above all, the system’s riskiness will be managed by officials, not financiers

4. Alternatives to radical reform: deleveraging • Another approach is radical de-leveraging of the economy and the banks • Deleveraging of economies and so also finance: • Greater use of equity or equity-like instruments, notably in mortgage lending, which is the core of modern finance • Reform of fiscal systems, to discourage debt • Deleveraging of systemic financial institutions, with leverage down to 3:1 • But political obstacles to this are as big as to radical reform

4. Possible ways forward • Big bang reform is unlikely • Instead, make current reserves a permanent requirement. • Let the government finance itself through money creation and adjust bank reserve requirements, so taxing (and curbing) private credit creation. • Prepare a worked-out scheme to be implemented after a future crisis • Individual countries can embark on experiments

Bar Ilan University 7 th December 2015 Israel