Financial Stability and Money Creation

4.1 What should banks do?

Ricks wants to restore “the first banking law” of money issuance: The privilege to issue deposit instruments. It follows that unauthorized firms should be prohibited from issuing the same instruments (Ricks, 2016, p.5). The primary job of banks would be to issue money, and not to link savers and borrowers. Their lending volumes would be subsumed under the overall monetary policy goals (see Table 3 on banking charter privilege).

Ricks correctly describes banking as the business of “issuing large quantities of money-claims that are continuously rolled over” (Ibid., p. 2) as opposed to the more traditional view of banking as deposit-taking.^[14] The traditional view of banking has been weakened lately by official central bank statements acknowledging that “banks create money whenever they lend to someone in the economy” (Mcleay, Radia, & Thomas, 2014). But despite such statements, there has not yet been a general acceptance of Ricks’ view that “issuing money” should be the primary role of banks.^[15]

As Ricks notes, it has been remarkably difficult to agree on “what banks should do”: “why would any business choose to fund itself with large quantities of money-claims instead of exclusively with longer-term debt and equity? These basic questions turn out to be surprisingly hard to answer” (Ricks, 2016, p.53).^[16] So hard, that even the European banking regulator (EBA) have asked the European Commission for guidance:

The key terms ‘deposits’, ‘other repayable funds’, ‘grant credits’, ‘from the public’ are not defined in the CRR (capital requirements regulation). Therefore, there remains a degree of variation between the Member States as to the interpretation of the term ‘credit institution’ and therefore the entities to which the requirement to obtain a banking licence applies in the Member States. (EBA, 2014, p.2, cursive added)

This lack of a clear definition of deposits and banking make it hard to police the borders of banking and open up the field for “ad hoc judgments and gut feelings” (Ricks, 2016, p.210). Since the definition of “shadow banking” is equally unclear (Ibid., p. 96), the expansion of shadow banking has been almost inevitable.^[17] There has in reality been no restrictions on issuing deposit equivalent instruments (Table 3) - the hallmark of shadow banking (Ibid., p. 6).

Ricks notes that the growth of shadow banking is just another twist of the historical failure to grasp the nature of money. The history of banking “is one of exasperating formalism” where lawmakers and scholars alike have been blinded by institutional forms rather the substance (Ibid., p. 223). Ricks instead wants to “deal with money creation comprehensively and functionally” (Ibid., p. 252). His new R-currency is a theoretical construct that could take different forms, e. g. as a digital central bank currency (more on this below) with commercial banks hired as private investment agents to lend the money into existence. Ricks’ new public-private partnership institutions will once and for all settle the boundaries of money creation.

Whereas I sympathize with Ricks attempt to bring order in the monetary chaos, I wonder if his favored model is too ideal. We need to put the monetary reform discussion in context, and relate it to social relations, power structures and the hierarchy of money, ref. the chartalist literature by Goodhart, Ingham and Wray.^[18]

Ingham (2004) notes that to identify different forms of money by their “moneyness” - as done by Ricks - is a basic “category error” which has persisted since the classical Greek commodity theory of metallic coinage. This “has produced enormous analytical difficulties and quite bizarre intellectual contortion in orthodox economics (Ingham, 2004, p.24).^[19] Following the tradition of Innes, Knapp and Keynes, Ingham argues that money needs to be understood as “a social relation of credit and debt denominated in a money of account” and “a form of sovereignty and as such it cannot be understood without reference to an authority.” The State sets “the monetary tone” and decides which private monies to accept at par with its own currency (Ingham, 2004, p.25). In fact, private monies may circulate in parallel as functional-equivalents to currency, especially in good times, but during a crisis the flight to safety may re-establish a hierarchical preference.

Hyman Minsky describes the monetary system as a pyramid of liabilities, with those of the central bank at the top. Private bank liabilities are convertible on demand into central bank liabilities, by agreement with and declaration by the State (Wray, 2012, p.19; my emphasis). Schumpeter adds that this production of ‘credit-money’ is an essential feature of capitalism, whereby private debts are ‘monetized’ in the banking system (Biondi, 2018; Ingham, 2003). In this context, two kinds of monetized private debts emerge: credit money by banks that has been authorized by a licence; and escalating (parallel) credit monies by un-licensed shadow banks. Actually, the latter may have relied either on unrealistic faith in their private issuer, or on an implicit expectation of a governmental bailout - as Market Maker of Last Resort (MMLR) (Carney, 2013). But according to Keynes (building on Knapp, 1905) it is the state that determines what will serve as money (of account), as well as dictating what “things” will be accepted as money (Keynes, 1978, p.4):

The State, therefore, comes in first of all as the authority of law which enforces the payment of the thing which corresponds to the name or description in the contracts. But it comes in doubly when, in addition, it claims the right to determine and declare what thing corresponds to the name, and to vary its declaration from time to time – when, that is to say, it claims the right to re-edit the dictionary. This right is claimed by all modern states and has been so claimed for some four thousand years at least.

Ricks wants to reestablish the State’s monopoly of money issuance in partnership with private lending agents (“Member banks”). However, it is not entirely clear what is achieved with his R-currency scheme, apart from centralizing all money creation in a huge “monobank”. Its design may also be understood as an integrated network of credit institutions, a sort of currency platform (like a telecommunication grid over which credit institutions operate). Minsky’s pyramid of liabilities is truncated into one “very liquid and acceptable IOU” - “r-currency” - issued with a sovereign guarantee. But as Minsky noted: Banks do not have a monopoly on “money creation”; anyone can create money; the problem is to get them accepted (Wray, 2012, p.20; my emphasis). The challenge will therefore be to stop all these “anyones” from issuing their own IOUs, as illustrated with this quote from Henry Thornton:

When confidence rises to a certain height in a country, it occurs to some persons, that profit may be obtained by issuing notes, which purport to be exchangeable for money; and which, through the known facility of thus exchanging them, may circulate in its steadcirculate in its stead. (Thornton, 1802)

Judge (Judge, 2016, p.5) is also skeptical of Ricks’ regulators ability to police the boundaries of “R-currency” creation since:

Shadow banks will reappear, in one form or another, and private money creation will emerge, whether driven by insufficient authorized money or the high cost of holding such money. … The inherent dynamism of financial markets ensures that policymakers will never succeed in identifying and addressing all sources of systemic instability in advance.

4.2 Boundary issues

Ricks wants to ban fragile short-term funding for all financial firms – other than member banks. The aim is to confine “issuance of instruments that have moneyness properties (like checkable deposits and their close substitutes)” to banks (Ricks, 2016, p.235). The challenge is obviously how to define, and police licensed “R-currency” and by implication what will be “unauthorized banking”.

Ricks provides a draft legal text (in Appendix to Chapter 9) where money (“money claims”) is defined as “any debt instrument that is payable in cash or its equivalent and that has a maturity of less than one year” and “any sale and repurchase agreement that functionally resembles such debt instruments” (Ibid., p. 243). Trade credits would not be banned^[20] and there are also exceptions for groups of less than five persons and smaller loans (under $1,000,000).

Ricks is well aware of the risk of circumvention and possible creation of money substitutes, but he is confident that “confining money creation is neither conceptually nor practically different from other types of economic regulation”. In fact, he asserts that “detecting hidden run-prone financing … is an order of magnitude easier than current forms of financial regulation, including capital regulation” (Ibid., pp. 235–236; quoting Chicago economist John Cochrane). Still, the boundary problem will have to be tackled.

There is certainly merit in Ricks attempt to segregate “proper” banking from shadow banking. Unfettered issuance of “cash equivalent instruments - the hallmark of shadow banking - often with funding coming from the traditional banking system, has blurred the regulatory lines and exposed traditional banks to new and unpredictable risk (Moe, 2015; Unger, 2016). Despite the claim from the Financial Stability Board that “shadow banking has been transformed into resilient market-based finance” (FSB, 2015), the system remains fragile and the issuance of money-like instruments continues – without a licence.

Ricks proposal for outright prohibition on short-term funding for non-bank financial firms draws heavily on Henry Simons, who put forward similar proposals in the 1930s. Ricks acknowledges his intellectual debt and admires Simon’s perceptive observations of the fragility of a financial system based on short term funding.^[21] He adds that “Simons’ concerns look remarkably prescient: “he was describing shadow banking” (Ibid., p. 172). The” “shadow banking problem” is, according to Ricks, “the central challenge of financial reform today.”

Separating the two types of banking invites evasion, and while Ricks recognizes the challenge posed by near-monies, he tends to downplay it. Simons, on the other hand, was more concerned with the “boundary problem”, and wrote to Irving Fisher – who wanted to establish 100 % reserve banks (narrow banking), that his new system “would encourage credit extension outside the regulated system: “Standing by itself, it would promise little but evasion, and would deserve classification as merely another crank scheme” (Ricks, 2016; p.172; Simons, 1936; fn. 17). Simons was also quite realistic about realizing his ideal financial system based on just equity and cash: “To propose abolition of all borrowing, or even of all borrowing at short-term, is merely to dream” (Ibid., p. 16). Ricks’ proposal highlights the fragility of short-term money issauance by non-bank financial institutions, but he “doesn’t share Simons’ occasional defeatism” in policing the monetary boundary (Ricks, 2016, p.173).

4.3 Private or public money?

“Why should the government involve itself in monetary matters to begin with?” (Ricks, 2016, p.9). The restoration of sovereign money is predicated on the assumption that “money matters” and that the Government should have some control of the money supply - however defined (Schwartz, 1987). Ricks view is inspired in part by early monetarist writing where the money supply was important - but often entirely determined by the Government’s budget policy (Friedman, 1948). Today the situation is almost reversed, with little attention to the supply of money, most of the money supply issued by private banks (except for some cash), and government deficits formally outlawed in some countries, in principle at least. Ricks claims that his proposal should be “compatible with a variety of fiscal environments, including a balanced budget” (Ricks, 2016, p.172), but he favors a “Public-Private Partnership” model where private agents would lend the money into existence. Base money and the money supply merge into one “r-currency” and the Government sets a target for the amount of “r-currency” compatible with e. g. inflation and unemployment.

The reformed system proposed by Ricks (Table 5) is very different from our current monetary system, summarized in Table 4.

Today, central banks issue physical currency (cash) while licensed banks issue deposits account money, with limited deposit guarantee. Issuance of “cash equivalent” monies (“near monies”) requires no licence. Since the use of cash is diminishing in most developed countries, the share of private money creation has increased. In some countries, most money creation is already private. Should we worry? The interesting thing is that this dramatic shift in money creation has received relatively little public attention, while the focus has been mostly on credit allocation. It has been a long-held view that this is best done by the private sector; however, since the recent financial crisis public opinion have shifted somewhat.^[22]

Ricks wants to retain a large role for the private sector in allocating credit, while curtailing their role in the money supply. This is achieved by hiring privately owned member banks as “lending agents” - for a fee and providing a full sovereign guarantee for all the money they lend into existence.^[23] “The monetary authority enters into a joint venture agreement with private managers that have expertise in credit granting (Ricks, 2016, p.159).

This will, according to Ricks, improve credit allocation, and more importantly insulate the lending process from political influence. Member banks will only issue high quality loans and underwrite high quality bonds, and they will not be permitted to invest in equity securities, real estate, or commodities.^[24] The challenge will obviously be to calibrate the (simplified) capital requirements and seigniorage fees without impairing member banks’ money creation function (Ibid., p. 21). The aggregate lending volume will then be determined by the monetary policy goals set by the Government (Ibid., p. 22). This could become interesting if lending is too low; will the capital requirements be relaxed?^[25]

4.4 How much money?

The monetary authority would set a money growth target in the new system, compatible with the macroeconomic policy mandate, e. g. a dual mandate of full employment and price stability. Since there would be no “inside money”, money issuance of (outside) r-currency would be fully determined by Member banks issuance. However, fine tuning could be performed, like today, with open market operations (Ibid., p. 228).^[26]

Ricks favors the lending approach to issuing money; “it has big advantages over the spending (by Government) approach”. “Under the lending approach the government never spends money wastefully on real goods and service”; instead private member banks would buy financial assets, at a much lower transaction costs. The Government will also receive a smoother seigniorage revenue stream from member banks, instead of taking direct credit risk (Ibid., p. 152).

There are at least two problems with a “spending approach”, according to Ricks: First, there would be no necessary connection between the optimal path of the money supply and the desired level of government expenditure over any given period: “Buying battleships for purely monetary purposes would be a waste of resources” (Ibid., p. 149). Second, if the government would spend the money directly into circulation it would be impossible to separate monetary policy from fiscal affairs - as “they would be hopelessly entangled.” Contrary to Abba Lerner and Milton Friedman (1948) who preferred the government expenditure way of creating money, Ricks argues that “yet another reason to prefer lending rather than spending the money supply into circulation; it makes monetary policy independence possible (Ibid., p. 156).

What about QE - quantitative easing - where central banks issue money when it buys credit instruments from banks or the private sector? This should only be considered if the government budget deficit dwindles or bank lending stalls. Such purchases would expose the monetary authority to credit risk, perhaps even towards private borrowers. This is not a favored course of action by Ricks:

Ifthe monetary authority is a bad credit investor, resources will be poorly allocated. Compounding this dilemma is another problem: whenever the monetary authority is investing in private credit, there is the potential for political controversy and the appearance (or reality) of favoritism. Such controversies, in turn, could end up undermining the cherished independence of themonetary authority. (Ibid., p. 159)

Ricks reformed monetary system thus blends well with the mainstream view of balanced budget, private credit allocation and central bank independence. Member banks retain a pivotal role in the new system, although in a revised and truncated role.

4.5 R-currency infrastructure

How will Ricks monetary system be organized? Since all banks issue the same guaranteed r-currency, the traditional clearing and settlement system can be drastically simplified. Payments between bank customers will involve credit and debiting accounts with the monetary authority in the same currency - as if “there were just a single member bank effecting payment through ledger entries” (Ibid., p. 225). Unused balances in r-currency can be exchanged in a cap-and-trade system. Since there is limited credit risk, banks don’t need to hold reserves of base money (as today) or pledge collateral. Indeed, there is no such thing as “base” money in the system (Ibid., p. 23). The system is a “pure accounting system” where individual banks run up debit or credit balances vis-à-vis each other, very similar to the current Target 2 settlement system for the Eurozone (for countries).

The system could in fact be run by the central bank as a monolithic payment system, where everybody would have a central bank account in r-currency, and all payments would be conducted on the books of the central bank. This resembles an account based central bank digital currency system, as is currently debated among some central banks (Mersch, 2017; Sveriges Riksbank, 2017). However, Ricks wants the private sector to retain its pivotal role in credit allocation, and in his system the Government therefore outsources the money creation to private agents: Privately owned member banks are chartered by the Government to issue money. Citizens will hold r-currency deposits accounts in private Member banks and these claims will be 100 % insured by the State.^[27]

The private member banks can be part of a financial holding company, but any such affiliation would be subject to strict limitations on affiliate transactions (Ibid., p. 226). In theory, then, affiliate distress shouldn’t produce significant losses for a member bank. Specifically, banks would have to discontinue funding their broker-dealer affiliates, and securities firms would have to end their unstable short-term funding; they would have to “term out their funding structure” (Ibid, p. 25). This will be costly, but as Ricks correctly observe, “there appears to be little reason to regard Wall Street’s current funding model as sacrosanct— particularly in view of the events of recent years” (Ibid.).

4.6 Lender of last resort

Don’t we already have a good enough answer to the panic problem? Could not central bank liquidity support, in combination with capital regulations, be viewed as a sound and adequate respond to the panic problem? No, say Ricks, and argue that LOLR is a flawed answer to panics (Ibid., 184). It constitutes a massive wealth transfer to the banks that “screw up”, it creates bad incentives and it certainly distorts pricing. And there is the inherent problem of separating solvency and liquidity problems (Madigan, 2009). The very existence of LOLR is a major source of the financial system’s excesses.^[28] It has created a huge imbalance between the stock of near-monies waiting to be rescued in a crisis, and the State’s capacity to backstop a run on such liabilities (Moe, 2012).

Ricks has deep misgivings about the recent drive to extend central bank liquidity support beyond banks, operating as “dealer of last resort” if required (Mehrling, 2011) or extending LOLR to broker-dealers, central counterparties or other collateral management companies (Carney, 2013).^[29] This shift in LOLR policy “generate subsidies and have troubling incentive effects” (Ricks, 2016, p. 199). The panic problem cannot be solved by extending liquidity support as market liquidity vanishes, nor can it be managed adequately by creating special resolution tools for complex financial firms. “Other institutional designs need to be considered” (Ibid.)^[30]

4.7 International issues

Ricks recognizes that there is an international dimension to implementing “unauthorized banking” in the US: “What is to stop overseas entities from issuing such instruments outside the jurisdiction of US law?” (Ibid., p. 237). Nothing! And this is part of the problem, according to Ricks. Foreign banks issue (short-term) dollar loans all the time in the Eurodollar market. This is so common that we take it for granted. But the market is fragile, so much so that a former IMF managing director noted way back that: “The explosive growth of this lending now saddles the world with a debt problem that fundamentally threatens the international financial system” (Witteveen, 1983).

We could dismiss the fragile Eurodollar market as other countries’ problem (Ricks, 2016, p. 238). But the recent crisis made it abundantly clear that this activity is also of concern to US monetary authorities; the Fed lent massive amounts of dollars to foreign central banks to help them prop up their domestic banking systems.^[31] According to Ricks, “the Eurodollar markets are incompatible with financial stability” (Ibid., p. 239).

If we accept Ricks position that money creation should be a “sovereign prerogative”, it follows that overseas money creation (of dollars) is unacceptable. What can we do about it? Ricks suggest three approaches:

1. US authorities could deny clearing to foreign banks that issue dollar denominated money claims, or

2. US authorities could seek agreement with foreign central banks to prohibit their domestic banks from issuing dollar denominated money claims^[32]

3. Alternatively, US authorities could seek a global “Money Claim Accord” (MCA), similar to the Basel Accord for capital requirement

“Money creation would be recognized as a sovereign prerogative; each country or currency area would have jurisdiction over its own broad money supply” (Ibid., p. 240). Ricks is quick to add that this MCA accord would not represent capital controls, since overseas financial institutions would be free to own and deal in dollar-denominated securities.^[33] The accord would “only” restrict overseas money creation - money-claim issuance - and nothing else. This should be in the interest of Governments that wish to restore jurisdiction over their broad money supplies (Ibid., p. 240).^[34]

Ricks description of the Eurodollar market dilemma illustrates the challenges facing his monetary reform proposal. The market has long been subject to scrutiny and reform proposals. But the risk involved in this off-shore dollar creation has either gone unrecognized or been poorly understood (Truman, 2011, p.7). Ricks describes his approach to restricting overseas money creation as fairly “modest and narrowly tailored” (Ibid., p. 240). That would be an understatement!

5.1 Narrow banking

The basic idea of narrow banking is to divorce the issuance of monetary instruments (deposits) from risky assets.^[35] Under the original and purest version of narrow banking, called 100 % reserve banking, banks would hold nothing but base money (Ricks, 2016, p.169) A proposal for a 100 % reserve bank was proposed in the 1930s by Irving Fisher and Henry Simons, but the idea was not embraced by Congress, who instead put an upper limit on the reserve requirement in the new 1935 banking law. Ricks is inspired by their diagnosis but reject their narrow banking solution. “The main problem has to do with … whether such a system can issue “enough” money” (Ricks, 2016, p. 170), especially if the Government’s is running balanced budgets. If the supply of government debt is exhausted, the central bank might even have to buy private credit assets - not a “particularly appealing option” according to Ricks (and Milton Friedman) (Ibid., p. 171). An alternative could be to let the narrow banks invest in private credit assets like commercial paper, but this would undercut the very idea of narrow banking (Litan, 1987), resembling more to the functional separation between commercial and investment banking. Capital allocation would therefore be done by investment banks or mutual fund structures that would be funded (and constrained) by available long-term funding. The narrow banking proposal would thus be a rather rigid system; capital allocation would be constrained by available savings and the money supply fixed by the Government.

5.2 Tobin’s deposited currency

Tobin’s proposal introduces a bit more flexibility in the monetary system, by allowing a more diversified group of financial institutions to coexist. Deposited currency accounts would be offered to the public, alongside regular commercial bank deposits (with deposit insurance) and traditional investment banks. Deposited currency accounts could be offered “in the central bank or in branches of it established for the purpose and perhaps located in post offices” (Tobin, 1985, p.25), and would offer the public “a perfect store of value in the unit of account” (Ibid.).^[36] Tobin would impose portfolio restrictions on commercial banks, like Ricks, but limit the deposit guarantee (as today). Thus, his proposal would be more flexible than the narrow banking proposal and include a more diversified set of financial institutions.^[37]

5.3 Central bank digital currency (CBDC)

Central banks are currently considering various options for issuing digital currency, as a supplement to issuing physical cash (Barrdear & Kumhof, 2016; Coeuré, 2018; Committee on Payments and Market Infrastructure & Markets Committee, 2018; Mersch, 2017). This could be done in either a value-based card system or an account-based system. An account-based system has interesting parallels to Ricks r-currency system, since the central bank would then issue safe money to the public, either through agent banks or on its own. Private banks would, however, continue to issue the bulk of the money supply, as current thinking among central bankers certainly is not to limit the role of banks noticeably. That leaves them with a conundrum since a shift of money balances from commercial banks into central bank digital currency would drain base money from the system and leave the central bank with surplus cash. Either the central bank will have to start investing itself (or through state banks) or they would have to inject the surplus balance back into the money market - in order to keep the interest rate steady. Ricks notes rhetorically, that if central banks could do the capital allocation - “then why have any deposit banks at all - why not just let everyone hold an account at the central bank?” (Ricks, 2016, p. 171). However, he prefers a system where r-currency is issued with full government backing, almost like Central Bank Digital Currency (CBDC), but the capital allocation will remain with private banks.^[38]

5.4 Community banks/alternative finance

A less radical view would be to encourage alternative financial structures, such as cooperative or savings banks through simpler and more supportive regulations (Butzbach & Von Mettenheim, 2015). Hyman Minsky favored a proactive government policy toward small community development banks, since “the capital development of the nation and of communities is (better) fostered via their provision of a broad range of financial services” (Minsky et al., 1993). Since the key role of banking is lending, Minsky felt that local banks were better positioned to do the capital allocation required for healthy growing communities. These local banks would be allowed to offer a variety of financial services, including investment services. However, they would be subject to portfolio restrictions similar to Ricks member banks, in order to protect depositors. Do we still need community banks?^[39] Or are community banks largely obsolete remnants of the past (Sandbu, 2018)? There seems to be bipartisan agreement to simplify the rulebook for smaller banks. However, most banking regulations continue to favor the bigger banks, unless something like Ricks proposal is enacted. We clearly need a simpler and more equitable financial system.