Creating money: public-private partnership
by Mojmir Hampl
Central banks in the developed world have had one thing in common since 2008: they have been a target of criticism and a source of frustration for the general public. The criticism is often shallow and unconstructive. Politicians, pundits and academics complain but rarely offer alternative suggestions or plans for reform of the monetary order. Even when one asks the more erudite critics what they think the base rate should be in the euro area or the US, the usual reply is an awkward silence.
Sophisticated monetary system reform proposals such as those presented in recent years by Mervyn King, former governor of the Bank of England, or Adair Turner, former chairman of the UK Financial Services Authority, are thin on the ground. There is no doubt that, for many people, monetary policy has become almost a showcase for the ills of the modern western world. That is a problem for central bankers, no matter how much they believe their work to be meaningful and their decisions to be right.
Misunderstandings of money creation
After 2008, central banks started to tell a different ‘monetary story’ to the one people were used to. By contrast, public confidence in and understanding of the monetary system are still grounded in the previous narrative, which was based on three building blocks.
First, the central bank is the sole creator of money and therefore has perfect control over the quantity of money. Money is thus exogenous, to use the language of economics. Second, commercial banks do not create money but merely convert existing deposits (or loanable funds) passively into loans. And third, the lower the growth in the price level, the better.
This narrative did a good job of reconciling public preferences and central bank decisions when bankers were fighting inflation before 2008 and working successfully to stabilise it. However, this simplified story stopped functioniong as a bridge between the public and central banks when central bankers started to combat weak demand and the risk of deflation. They have also moved into new policy areas through expanded mandates, measured in a number of academic studies (see Chart). It is difficult to explain that the building blocks of the previous narrative are not working in practice. They never did. They were merely part of a myth that no one wanted to bust for fear of throwing a spanner in the works.
In a fractional reserve system, commercial banks (not just the central bank) create a large part of the money in circulation. Commercial banks therefore do not merely convert loanable funds passively into loans, but also create new deposits. The central bank does not and cannot have full control over the quantity of money in the system.
Money creation is a public-private partnership between the central bank and commercial banks. And the quantity of money in the system varies; in fact it must vary if the purchasing power of money is to be kept broadly constant over the cycle. Furthermore, deep and persistent deflation is just as disruptive to the economy as high inflation, often more so.
So the previous widely communicated story of ‘good money’ has been undermined. This gives rise to a growing lack of understanding and a communication gap between central bankers and the public. Most significantly, and paradoxically, they are stoking fears of a fall in the purchasing power of money at a time when inflation (the key measure of purchasing power) in developed countries is lower on average than it has been for years.
Escaping the monetary drought
To put it simply, central banks have been warning about the risk of flooding for so long that they are now unable to explain that drought can be just as big a problem. They are also unable to explain that at times of drought you should water the garden, not keep draining it dry. And if the hosepipes are blocked, you must use other means to water the plants.
In tough economic times, it is difficult to describe quickly such a story to a public which is inattentive to the mysteries of complex systems. This is particularly true in the case of financially conservative and wealthy populations who strongly prefer future consumption to present consumption (and even more so in populations of net lenders rather than net borrowers like Germany, Austria or many other countries in central Europe).
This is the challenge which we, as a community of occasionally tedious central bankers, now face. We should hurry up. There is a risk that, in addressing this challenge, someone will come along and tear down the current system without understanding its foundations and the consequences of the alternatives they want to usher in.
The US presidential campaign and the political attacks on central bankers in the UK show how easily an atmosphere might emerge in which central bankers could ultimately lose their operational independence. A system under which the volume of money is controlled according to price stability goals is under threat. It needs to be defended – and the time for doing so is running out.
Mojmír Hampl is Vice-Governor of the Czech National Bank. Back