How is money created?
Fiat money is created from nothing on the basis of a promise – a promise to deliver goods or service in the future. Another word for promise is debt – I prefer promise. Only if we believe in these promises does money have value. The teacher promises to teach. The roofer promises to mend the roof. Money creation facilitates things getting done, but create too much too fast – by promising more than we can deliver – and it looses its value. Therein lies the problem.
Money is created either when the government spends, or when a bank makes a loan. We can think of government spending and bank loans as the beginning of two interconnected money circuits, see Figures below. The government and bank circuits form the duopoly of money creation.
The money circuit
After money is created it flows  through the economy and eventually is returned to the issuer. In the government circuit, money is returned to the government via the payment of tax, as in Figure 1. In the bank circuit, money is returned to the bank by the repayment of the loan, see Figure 2.
Figure 1: The government spend and tax circuit. The difference between spend and tax equals private sector saving and is known as the deficit.
When all the money is returned the quantity of money goes back to zero except that in practice the rate of new money creation is higher than the rate of money cancellation, such that we hardly notice the creation and annihilation process and instead the total amount of money in the economy grows (imagine the lines in Figures 1 and 2 getting thicker over time). Ideally the growth in the money supply should match the growth in economic activity, such that prices remain roughly stable and we maintain confidence in the value of our promissory notes. Control of the rate of money creation and destruction in the government and banking circuits are known fiscal and monetary policy, respectively.
Figure 2: The bank circuit where loans create private debt.
Note that the government circuit is leaky, by design. People are allowed to save – hoard promises – and avoid tax. The part of the government spend that is saved leads to a deficit on the governments books (red in Figure 1). Savings can serve a useful purpose but it is odd that we tolerate other leaks, like lower taxes on capital gains and tax havens, I shall come back to leaks and the deficit in a later post.
Why two circuits?
The obvious question is, why do we need a duopoly? Why do we need both a government circuit and a banking circuit? Why do we need both fiscal and monetary policy? As money is a collective good, should we transfer all money creation powers to government and demote private banks to the role of intermediaries as some propose? Or could we hand over all money creation to private banks as the free market fundamentalists would prefer?
Many people are shocked to learn that banks and government are the source of all money, in particular, that banks create money. By allowing the equivalence of bank money and government money, the government and hence all of us underpin the banking circuit and so we have a democratic right to keep them under control and to take a share of their profits. Still banks do provide a useful service, and those looking for the failings of the modern world as a failure of this system of money miss the real culprits. The duopoly is optimally designed to meet our needs. We just need to manage it better.
The reason for the duopoly is relatively easy to understand. Money creation needs to serve both individual need and those of the country as a whole. The bank circuit exists to serve individuals, while the government circuit exists to provide services to everyone.
- Two circuits are necessary because there are individuals (private) and collective (common or public) interests.
We do not really want government to get involved in private consumption like car loans and we do not really want the vested interests of private banks to extract rent from public need, so two separate dedicated money circuits are required.
Economists often call our collective interests public goods. The most familiar examples are security and defence, health and education. Education is a public good because its consumption is intended to benefit society as a whole and not only the individual receiving the education. We educate people to become engineers and doctors so that we can all benefit from their expertise in the future. Other examples of a public good include transport and energy – we build roads or power stations such there is a net benefit to everyone.
Democratic control of money creation
We can still ask why we need a separate money circuit to provide public goods? There are many good reasons, but perhaps most important of all is that we should be granted a say on our collective interests – this is the essence of democracy. We elect a government to manage our collective needs. Capitalism and democracy are also a duopoly – each with their dedicated money circuit. The capitalist banking circuit represents private interests but fails completely in the provision of public goods. The democratic government circuit fills the gap. The duopoly of capitalism and democracy exist in parallel to support and complement each other.
The failure of the private interest bank circuit to provide public goods is easiest to understand by looking at specific examples. For example in health care, the market solution is to operate on the patient offering to pay the most. Even worse, the market may deliberately create a scarcity in order to charge a higher price. A market cannot operate effectively in matters of life and death, as Kenneth Arrow – a highly-respected pioneer of neoclassical economics – wrote:
the laissez-faire solution for medicine is intolerable.
The government solution in health care take a long-term perspective and addresses the scarcity in trained doctors such that more patients can be treated. Markets only operate effectively if there is genuine competition. For example, we need at least two – preferably more – companies operating on every bus route in order to give commuters a real choice, but this just creates overcapacity and congestion. In situations where competition is not viable, where demand is unlimited like health, and supply delivers societal benefits then collective democratic control is the optimal solution.
What can go wrong?
The duopoly of individual (or private) and collective (or public) needs leads naturally to the duopoly of monetary and fiscal policy. Those looking for the failings of the modern world as a failure of the system of money miss the real culprits. The failure lies in the inability of politicians to regulate the banks and to appropriately use fiscal policy.
The art of economic management is to balance fiscal and monetary policy. An over dependence of one or other is doomed in the long term. Since 1980 both the US and UK abandoned this balanced approach that had worked well up to the oil crises of the `70s. Over reliance on the banking circuit and bank deregulation led eventually to the private debt bubble that burst in 2007-08. Rather then correct their mistake, politicians left it to the central bankers to sort out the mess. The bankers, limited to monetary tools, turned to quantitative easing, but nearly a decade on, with interest rates still stuck at their zero lower bound, we still look on aghast, waiting for someone to wake up to the complete failure of monetarism – if only the younger Milton Friedman could come back to explain it to us all. In 1969, he said :
The available evidence . . . casts grave doubts on the possibility of producing any fine adjustments in economic activity by fine adjustments in monetary policy – at least in the present state of knowledge . . . There are thus serious limitations to the possibility of a discretionary monetary policy and much danger that such a policy may make matters worse rather than better.
In contrast, fiscal policy is a far more powerful, and some may say more dangerous, beast. The collective has an ability not available to any individual. Only the collective has a super charge card where all the spend comes back via tax – the teacher does not cost anything as long as the money spent on them is also spent. In fact, more likely is that the collective will make a profit on employing the teacher by crowding in more economic activity (a multiplier greater than 1). Fiscal policy is intended to get things done. Let’s get on with it!
 As Marcus von Skym says: the most important property of money is to flow.
 Milton Friedman and Walter W. Heller, Monetary vs. Fiscal Policy, W. W. Norton and Company Inc., New York 1969.