I am usually inclined to encourage the inquiry of the fundamental aspects of money and banking. This is because I tend to believe that only by going back to first principles is it possible to cut through the thicket of widely accepted but deeply flawed theories that dominate the current debate in mainstream media, politics and the financial industry. From my own experience in financial markets I can appreciate how convenient and tempting it is in a business context, where quick and easy communication is of the essence, to adopt a certain, widely shared set of paradigms, regardless of how flimsy their theoretical foundations. Fund managers, traders and financial journalists live in the immediate present, preoccupied as they are with what makes headlines today, and they work in intensely collaborative enterprises. They have neither the time nor inclination to question the body of theories – often no longer even perceived as ‘theories’ but considered accepted common wisdom – that shapes the way they view and talk about the outside world. Thus, erroneous concepts and even outright fallacies often remain unquestioned and, by virtue of constant repetition, live comfortably in the bloodstream of policy debates, economic analysis, and financial market reportage.
This goes a long way in explaining the undeserved survival of a number of persistent modern myths: deflation is the gravest economic danger we face; Japan has been crippled by deflation for years and would grow again if it only managed to create some inflation; lack of ‘aggregate demand’ explains recessions and must be countered with easy monetary policy; and money-printing, as long as it does not lead to higher inflation, is a free lunch, i.e. we can only expect good from it. None of these statements stand up to scrutiny. In fact, they are all utterly absurd. Yet, we can barely open a newspaper and not have this nonsense stare us in the face, if not quite as bluntly as stated above, than at least as the intellectual soil from which the analysis or commentary presented has sprung. Deep-rooted misconceptions can only be dismantled through dissection of their building blocs and a discussion of basic concepts.
The dangers of going back to basics
However, going back to basics and to first principles, analyzing critically the fundamental aspects of our financial system, is not free of danger. Here, too, lies a minefield of potentially grave intellectual error, and when things go wrong here, at the basic level, the results and policy recommendations derived from such analysis are bound to be nonsensical too, if not even more nonsensical than what the mainstream believes. In this and the following essays I am going to address some of the erroneous notions at the fundamental level of money and banking that seem to have gained currency in the public debate of late.
I get periodically confronted with these confusions through readers’ comments on my website. Some of the questions and suggestions expressed there reveal the same, or very similar, errors and misunderstandings, and these often seem to have their origin in other publications circulating elsewhere on the web. Among them are the following fallacies, in no particular order:
- The idea that the charging of interest, or in particular the charging of interest on money, is a fundamental problem in our financial system.
- The notion that there must be a systematic shortage of money in the economy because banks, through fractional-reserve banking, bring into circulation only amounts of money equivalent to the principal of the loans they create but not the necessary amount to pay the interest on these loans.
- The notion that it is a problem that money-creation is tied to debt-creation (again, as a consequence of fractional-reserve banking) and that it would be possible and advantageous to have the state issue money directly (debt-free) rather than have the banks do it.
- The idea that schemes are feasible that allow the painless shrinkage or even disappearance of the national debt.
All these ideas are nonsensical, based on bad economics and fundamental logical flaws, and to the extent that they entail policy proposals, these policies, if enacted, would not only not give us a stable and more prosperous economy but would surely lead to new instabilities or even outright chaos.
None of these misconceptions originate, or even resonate, as far as I can tell, with the ‘mainstream’. The mainstream– the financial market professionals, the central bankers, financial regulators, and the media – remain resolutely uninterested in dealing with fundamental questions of money and banking for the reasons given above. Here, the discussion continues to centre on how the economy can be ‘stimulated’ more, what ‘unconventional’ policies the central banks may still have up their sleeves, and if the central banks need new targets or better central bankers. Icebergs or no icebergs, these deckchairs need re-arranging.
But, outside the mainstream, among certain think tanks, ‘activists’, bloggers and some economists, even those at the IMF, the appetite for fundamental analysis has grown. In many cases this has led to utter confusion, as I will show in this set of essays.
I should declare a personal interest here. I feel the need to make my disagreements with these ideas and the resulting policy proposals as clear as I can as, on more than one occasion, casual readers of my website seemed to have assumed some sympathy on my part with the erroneous ideas put forward by others. The mere fact that somebody else also focuses his or her attention on the system’s same fault-lines, such as, for example, the instabilities created by fractional-reserve banking, has led them to believe that we must share considerable intellectual ground and arrive at similar conclusions and policy recommendations. Sometimes this confusion may be the result of a lack of familiarity with my work, sometimes with a lack of knowledge of or attention to the precise concepts articulated by others. In any case, this confusion needs to be cleared, partly because I do not want to be associated with what I consider economic nonsense, and partly because articulating the differences – and highlighting what, in my view, are the mistakes of the other side – should further clarify the issues and improve the debate. As I already said, the mix-up is usually greatest when the topic is fractional-reserve banking. So let me start right here:
Fallacy 1: As fractional-reserve banking is a source of economic instability, it would be better to force the banks to become fully-reserved banks with no ability to create money, and have the state create all money directly and inject it – wisely – into the economy. This would allow us to enjoy the benefits of more money without suffering the disadvantage of more debt. We may even use this process to reduce or eliminate existing debt.
This is the position of UK ‘think tank’ – or pressure group? – Positive Money, which has proposed legislative changes in the UK based on its analyses. Positive Money enjoys the support of the UK’s left-leaning ‘new economics foundation (nef)’ (so egalitarian and new age is nef that it doesn’t allow any capital letters undue dominance in the writing of its name) and of the Centre for Banking, Finance and Sustainable Development at the University of Southampton. Together these organizations have submitted a policy proposal to the Independent Commission on Banking.
The starting point of ‘Positive Money’s’ thesis – namely, that fractional-reserve banking is a source of economic instability – is essentially correct. But – as I will show in this essay – their analysis of fractional-reserve banking is incomplete, and their view lacks entirely any deeper understanding of money demand and of how changes in money demand are being met naturally in a market economy. Moreover, Positive Money has no perception of the necessary – and necessarily disruptive – effects of money-injections into the economy, regardless of who injects the money, and seems completely blind to the obvious disadvantages of channeling all new and free money through the state bureaucracy. Having shown – a bit flimsily and without resorting to any theories of capital or business cycles – that fractional-reserve banking is problematic Positive Money seems to have exhausted its critical faculties and jumps hastily to the conclusion that the privilege of money-creation should be given to a wise, independent and benevolent state agency. The arguments of Positive Money are economically unsound and politically naïve and dangerous.
If these resolutely anti-banking and pro-government proposals sound familiar to readers of this website, it is because they resemble the ones put forward by economists Benes and Kumhof in their widely quoted, less widely read and apparently even less understood IMF working paper 12/202, which I attempted to dissect here. In the following I will not repeat my criticism of Benes/Kumhof. Neither Benes/Kumhof nor Positive Money provide a single economic argument to support the claim that the state is a superior guardian of the privilege of money creation. This is not surprising because there is no such argument. Yet, we have to be grateful to Positive Money for at least not resorting to the bizarre line of reasoning that Benes and Kumhof came up with, namely that in order to improve upon our modern monetary order we have to first discover the ‘true nature of money’, which is apparently not open to the theoretical investigation of economists but can only be unlocked by anthropologists who tell us how money came about in primitive society thousands of years ago, and by certain monetary historians who re-interpret the historical record to tell us that the privilege of money creation has always been safe – and thus, in a logical jump of breathtaking audacity, is assumed to always be safe in the future – in the hands of government. Such mysticism is an insult to any true historian and to any proper economist. Sometimes it may be better to have no explanation at all than to put forward such rubbish. So thank you, Positive Money, for sparing us this nonsense.
Some thoughts on fractional-reserve banking
Let us start by briefly sketching the key problems with fractional-reserve banking.
Most of what we use as ‘money’ today is deposit-money and thus an item on a balance sheet of a bank. This form of money has come into existence through the banking system’s lending activities, i.e. through fractional-reserve banking.
Banks, for as long as they have been around, have never only just channeled saved funds into investments, such as fund management companies do today. Banks have always also been in the business of creating money derivatives (or fiduciary media), that is, financial instruments that are treated as money proper by the public (usually because they were issued with a promise of instant redemption in money proper), and thus circulate in the economy next to money proper. This process allows banks to fund a portion (and potentially a large one) of their lending through their own issuance of money derivatives, although today hardly anybody even distinguishes any longer between money proper and bank-created money derivatives. In a way, it can be said that the banks extend loans by drawing cheques on themselves and having these cheques circulate in the economy as money (and in the hope that they won’t be cashed!). These ‘cheques’ used to be the banknotes of the olden days, when banks were still allowed to print them, today there are deposit money, items on a bank balance sheet, like your current account balance.
This form of banking has made a considerable expansion of money in the economy possible. Fractional-reserve banking has been conducted in some shape or form for 300 years, and its effects on the economy have been the focus of the attention of economists for about as long (Cantillon, Ricardo, Mises – to name just some of the most outstanding social scientists dealing with it). Economists have long suspected, and over time have become ever more successful in demonstrating, that this activity is the source of economic instability. Fractional-reserve banking – and the elasticity of the supply of money that it creates – helps explain business cycles.
In my book Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown – I explain in some detail why elastic money is so undesirable, making use of the seminal work of Ludwig von Mises, in particular. In order to understand the full range of problems with fractional-reserve banking in a modern economy we need some knowledge of the origin and role of interest rates, of the nature of what is called ‘money demand’, of investment and saving, and thus the rudimentary elements of a theory of capital. I cannot provide this in a blog post and I am not going to try. Let it suffice to say that the extra money created by banks lowers interest rates on credit markets and expands the supply of investible funds beyond the volume of available true savings. Thus, investment and saving get out of line, misallocations of capital ensue, and what appears like a solid economic expansion for a while is ultimately revealed as an artificial and unsustainable credit boom that will end in a recession. Sustainable growth requires investment funded by proper saving, i.e. by the voluntary reallocation of real resources from present consumption to future consumption (that is saving). Bank credit expansion creates a dangerous and fleeting illusion of the availability of more savings, which means more resources for investment projects that are in fact not there.
Should fractional-reserve banking be banned?
Do I have some sympathy for the proposal to ban fractional-reserve banking? Well, I do agree that an inelastic monetary system, for example a 100% gold standard, would be the most stable (least disruptive) monetary system. (Interestingly, this is not what Positive Money suggests, but more about that later.) But I do not believe that fractional-reserve banking should be and can realistically be banned. Not only because it has been around for so long but also because the exact definition of what is being used as money by the public in a dynamic monetary economy at any moment in time must remain fluid. Financial intermediaries will always succeed in periodically bringing ‘near-monies’ into circulation and thus become de facto money producers, at least for a while.
Furthermore, there is no legal case for banning fractional-reserve banking. It is, in my view, not fraudulent (as some modern Austrian School writers maintain) and there is no basis for banning it on standard property rights considerations. Moreover, there is also little need to ban it as we can, in my view, rely on market forces and the superior regulators of capitalism – profit and loss – to ultimately keep it in check. (Some economists dispute this but here is not the place to discuss this point in detail. I will argue my case below. However, it is not even essential for a critique of the ideas of Positive Money.)
I think that the most straightforward and most obvious solution to these problems is that we remove the extensive framework – erected and maintained by the state – to actively support and systematically subsidize fractional-reserve banking. This means removing the institutions – implemented through acts of politics and maintained through acts of politics- of unlimited fiat money, which means unlimited bank reserves, and of lender-of-last-resort central banks that have the power to issue such unlimited bank reserves. Unlimited state fiat money and central banks are today the indispensable backstops for large-scale fractional-reserve banking activities of the nominally ‘private’ banks.
If fractional-reserve banking is disruptive – and I agree with Positive Money that it is – should we not – as a first step and before we even consider such authoritarian measures as universal bans – take away the state-run support system for fractional-reserve banking by which the banks and their clients are systematically shielded from the consequences of their activities, and through which the true costs of fractional-reserve banking are persistently being socialized?
Fractional-reserve banking and the state
What the folks at Positive Money fail to appreciate is that in a free market the ability of banks to create money is severely restricted. A deposit at bank X is only considered ‘money’ by the public to the extent that this deposit can be used for transactions with potentially everybody else in the economy, that is, not just with other customers of bank X but also any non-customers of bank X, and this is only the case if the deposit remains instantly redeemable in money proper (let’s say, gold or, in today’s world, state paper money) or can be transferred to any other bank. Thus, bank X runs the constant risk that its customers demand redemption of the type of money it CAN create (the deposit that sits on its own balance sheet) in a form of money that it CANNOT create: gold, state paper money or deposits at the central bank that are required for transfers to other banks. (Hint: these are the ‘reserves’ from which fractional-reserve banking gets its name!)
In an entirely free market, in which the state does not interfere in the economy and in which there is no central bank and no fiat money but in which money proper is necessarily a commodity chosen by the market, one the supply of which is outside political control or anybody else’s control for that matter, such as is the case with gold, in such a system fractional-reserve banking is an inherently risky enterprise. The constant fear of requests for large redemptions will severely restrict the ability of private banks to lower their reserve ratios and fund large parts of their lending by issuing ever more money derivatives. Each additional bank deposit that is created out of thin air will increase the risk of a bank run, which, in a world without central banks, bailouts and state deposit insurance, must lead to the failure of the bank.
Sure, banks may still be tempted to issue more deposit money but it requires a somewhat strange view of human nature to expect that even after a number of bank runs, in which bank shareholders and most depositors were wiped out, financially speaking, fractional-reserve banking would merrily continue and could in total be conducted at anywhere near the scale it is today, when banks do not have to content themselves with strictly limited reserves and do not have to operate under the constant risk of business failure but can safely rely – or, at least rely to a much larger degree than in a free market and a hard currency system - on an unlimited and constantly expanding pool of fiat reserves provided by lender-of-last resort central banks, and where depositors need to pay no attention to the soundness of the various deposit-taking institutions as they simply rely on the blanket cover provided by the state.
Positive Money’s account of fractional-reserve banking makes it appear as if the state and its agencies were simply innocent and powerless bystanders in the business of money creation, rather than active promoters of and eager and indeed indispensable accomplices in the exercise. Positive Money creates the impression that bloated bank balance sheets, real estate bubbles and excessive debt levels had all been created by scheming and out-of-control private banks, entirely on their own accord and behind the back of an unwitting and clueless state, rather than constitute the inevitable consequences of an institutional framework built on the widespread belief that constant bank credit expansion is a boon to the economy.
The truth is that the state, beholden to the generally accepted fallacy that cheap money – and even artificially cheapened money- is a source of prosperity and that we should never allow credit contraction or deflation, has actively supported the gigantic money creation of recent decades. Without an essentially unlimited and ever cheaper supply of bank reserves from the state central banks, private banks could never have expanded their balance sheets so aggressively and issued such vast amounts of deposit money.
Or, to put this differently, had the state wanted to stop or restrict the creation of deposit money by the banks at any point, the state – in form of the central bank – could have done this at the drop of a hat. Restricting the availability of new bank reserves and/or making bank reserves more expensive would have instantly put the brakes on fractional-reserve banking. Not only did the state not choose to do this (at least not for the past few decades), to the contrary, whenever the banks had maneuvered themselves into a position where they thought it themselves prudent to stop or at least slow down their balance sheet expansion for a while in order to protect limited capital or their limited reserves, the central banks invariably cheapened bank reserves further, specifically to encourage further deposit money creation.
In the present context, any criticism of fractional-reserve banking must include, in order to be consistent and complete, a rebuttal of the false beliefs in the benefits of cheap money and criticism of the state’s systematic support for this activity. Positive Money evidently fails to appreciate the role of state institutions and government policy in the present process of money creation or it would argue much more simply and straightforwardly for the voluntary restriction or abandonment of these policies first, and it would be less eager to hand full control over monetary affairs to the state.
Money injections must result in resource reallocations and mis-allocations
Furthermore, a proper understanding of fractional-reserve banking, one that is based on monetary economics and that does not stop at the most apparent symptoms of bank credit expansion, reveals that its core problem is its disruption of the pricing process that would normally co-ordinate economic activity smoothly (in this case, the co-ordination through market interest rates of voluntary saving with investment activity). The problem with fractional-reserve banking is precisely that it leads to persistent misallocation of resources. Would it not be sensible to ask if money injections through the state bureaucracy would also result in very similar or maybe even larger misallocations of resources or misdirection of economic activity?
This seems indeed very likely. We all know that whenever the market is replaced with administrative decisions by a bureaucracy, the results will be suboptimal as the bureaucrat has to make his decisions without the help of market prices, for if he would allow market prices to guide resource use and economic activity there would be no reason for his intervention in the first place. He might then as well leave everything to the market. It is precisely the political decision that the market should not be allowed to allocate resources through market prices and the profit and loss calculations of private enterprises that is the excuse for state involvement in the economy. According to the proposal by Positive Money, a state agency would determine centrally how much money the economy needs and then give this money to other departments of the state, which would spend it according to how it sees fit.
Positive Money does not provide any mechanism for how the state agency might determine who in the economy experiences a higher demand for money, and how the money would get to where it is needed. This is not surprising because there can be no such process, as I will explain shortly. According to Positive Money, the state agency would simply make a macro-level decision as to the amount of new money supposedly needed and hand the necessary amount over to other departments of the state (without the standard process of double-entry bookkeeping that is used today, I might add, by money-creating central banks. According to Positive Money’s proposal, the money is simply created and handed over to the state bureaucracy as a gift.) By putting this money into the economy the state will, of course, exert a tremendous influence on the pricing and the allocation of resources and the direction of economic activity. This does not bother Positive Money. It is simply assumed that this must be better than having private banks do this via the credit market.
It is clear that Positive Money has not fully understood why fractional-reserve banking is harmful. For a functioning economy an uninhibited pricing process for all resources is required in order to direct the use of these scarce resources in accordance with the preferences and demands of consumers. Fractional-reserve banking systematically distorts the pricing process (it corrupts the coordinating properties of interest-rates) but Positive Money suggests to replace it with a process that does away with market prices altogether, and that consists of the arbitrary and politically motivated allocation of resources through a state bureaucracy (even if the central bank is, as Positive Money naively assumes, ‘politically independent’ the departments of the state that are the first recipients of the new money and that decide how the money gets injected into the economy are certainly not).
Apart from the well-established and justified reasons to be suspicious of substantial state control over any part of the economy, there are other reasons to reject this proposal. As I have shown in Paper Money Collapse, EVERY injection of new money into the economy, regardless by whom, has to occur at a specific point from where the new money will disperse through a number of transactions. This process must always – from the point of view of a smoothly functioning, uninhibited market economy – lead to disruptions. It can never be neutral and it can certainly never enhance the functioning of the economy, or lead to a better plan-coordination between economic actors. Money injections always lead to arbitrary changes in relative prices, reallocations of resources and redistribution of wealth and income, without ever enhancing the wealth-generating properties of the economy overall. Money injections never benefit everyone, they always create winners and losers. It does not matter who injects the money.
Is a money producer needed at all?
Given all these problems, is it really necessary that anybody in the economy has the privilege of creating and allocating new money? Once fractional-reserve banking has been banned and money-creation by the banks has ceased (or, in my scenario, once the support for fractional-reserve banking has stopped and money-creation by banks has been much reduced), why not leave the economy to operate with a given and stable quantity of money?
“But that doesn’t necessarily mean that the economy will run smoothly on a fixed amount of money – we may still need to increase the amount of money in the economy in line with rises in population, productivity or other fundamental changes in the economy.”
Positive Money does not explain why this should be the case, simply because there is no reason why this should be the case. The quote above reflects another widespread fallacy about money, namely that a growing economy somehow needs a growing supply of money. Many people will find intuitively that this makes sense. Yet, on further reflection anybody who thinks for a minute about the purpose of money and about how we all use money every day can see quickly that this statement is without any basis in fact and lacks any economic logic.
A growing economy does not need a growing supply of money and therefore does not need a money producer. On the basis of a stable and given supply of widely accepted money the public can satisfy ANY demand for money it may have.
The person who has demand for money never has demand for a specific quantity of money. Nobody who demands money has demand for a specific number of paper notes or a specific weight in gold coins or a certain quantity of bits on a computer hard drive (or whatever is used as money). We have demand for a certain quantity of money because of what we can buy with it, and this depends not on the quantity of the monetary asset as such but on its exchange ratio versus non-money goods. We always have demand for money’s exchange value, for what we can buy with it, for its REAL purchasing power. The value that money has for us, it has because of its purchasing power in trade. Money does not have direct use value, such as any other good or service.
Whether a certain quantity of cash is sufficient for me to carry with me for a good night out in London, depends on what that quantity of money can buy, that is, its real purchasing power. My demand for money is always a function of its exchange value, but money’s exchange value is necessarily subject to constant change as a result of the constant buying and selling of money versus non-money goods by the trading public.
If the public at large has an additional demand for money (i.e. an additional demand for purchasing power in the form of money) what will the public do? – Answer: the public will do what every individual does who wants to increase his or her holding of money, the public will reduce its present ongoing money-outlays on non-money goods (i.e. spend less and accumulate cash) and/or sell non-money goods for money (i.e. liquidate assets). This process will immediately exert a downward pressure on the money-prices of non-money goods and an upward pressure on the purchasing power of the monetary asset (the result is deflation, if you like, but in contrast to all the excited scaremongering about deflation in the media this is a normal market process and nothing to be scared of). By raising the exchange value of each unit of money this process will satisfy the additional demand for money naturally and automatically. The same physical amount of money is circulating in the economy but now this same amount can satisfy a larger demand for money.
Of course, the reverse will happen if the public lowers its demand for money. The purchasing power of money will drop (inflation) and the same amount of (physical) money will still be held but now at a lower exchange value per unit reflecting the lower demand for money.
These processes do not work for other goods or services. If the public has a higher demand for cars, somebody has to produce more cars. This is because the demand for cars is demand for the use-value that cars provide. Additional demand for cars cannot be satisfied simply by raising the prices of cars. But money is demanded for its exchange value, and additional demand for money can be satisfied (and is in fact satisfied) by a higher exchange value of money, i.e. lower money-prices of non-money goods.
Importantly, the processes described here would not just commence once we converted to a system of inelastic money. These processes are by necessity at work all the time – even now in our economy of constantly expanding fiat money and excessive fractional-reserve banking where they are, of course, usually overshadowed by the inflation from constant monetary expansion.
Money qua money has two characteristics: it is the most fungible good in the economy and it is demanded exclusively for its exchange value. From this follows that every individual can hold exactly the desired portion of his or her wealth in the form of money at any moment in time, and it equally follows that the public at large can hold exactly the desired portion of its wealth in the form of money at any time.
If more economic transactions are to occur in a given period of time money can circulate faster, and in fact, money then IS GOING TO circulate faster. If the demand for money holdings rises, this demand can be satisfied automatically and naturally by a rise in the purchasing power of the monetary unit, and in fact, the purchasing power of the monetary unit IS THEN GOING TO rise.
Via the constant buying and selling of money versus non-money goods the public automatically adjusts the velocity of money and the exchange value of the monetary unit, and thus the public is always in possession of precisely the amount of money purchasing power it needs. It is in the very nature of a medium of exchange that any quantity of it – within reasonable limits – is sufficient (and indeed optimal) to satisfy ANY demand for money.
There is no need to fear that this process would lead to undue volatility in money’s purchasing power, to constant fluctuations between inflation and deflation. If some people have a higher demand for money and start selling non-money goods for money, and this is beginning to lift the purchasing power of the monetary unit, then those who have an unchanged demand for money will readily sell some of their money for non-money goods in order to merely maintain the same real purchasing power in the form of money that they had before. Nobody can say that this process will lead to complete stability of money’s purchasing power. Such stability is unachievable in human affairs. But dramatic swings in money’s purchasing power can reasonably be expected to be rare.
Be that as it may, there is certainly no process available by which even the most dedicated, smartest and impartial monopolist money producer could anticipate the discretionary changes in the public’s desire for money balances and neutralize the resulting changes in money’s purchasing power through pre-emptive money injections or withdrawals. Once the changing demand for money has articulated itself in any statistical variables (and, in particular, in rising or falling prices) the public will already have satisfied its changed money demand through the processes described above. The whole idea of superior monetary stability through a central state monopolist is entirely absurd.
Equally absurd is the idea – this one not being advocated by Positive Money, I shall add – that fractional-reserve banks could play a role in satisfying the public’s demand for money. This is, I fear, another widespread fallacy, and it has its origin in a confusion of demand for loans with demand for money. Banks are not in the business of meeting their customer’s money demand (which they could not do even if they tried) but in the business of meeting their clients’ loan demand. Banks conduct fractional-reserve banking in order to extend more loans (on which they collect interest!), not in order to bring more money into circulation. The deposit money that is also created in the process (the ‘cheques’ the banks write to fund the loans) is simply a by-product of their expanded lending business (and this money is absorbed by the public through inflation).
By the same token, nobody (or at least hardly anybody) who has a higher demand for money will go to a bank, take out a loan and pay interest just to hold a higher money balance. Demand for money is not demand for loans. The people who take out loans do not have a high demand for money. To the contrary, they have a high demand for the goods and services that they quickly spend the borrowed money on. That is why they are willing to incur the extra expense of interest. As explained above, people who have a high demand for money cut back on spending or sell assets.
Positive Money starts with a correct observation, namely that today’s large-scale fractional-reserve banking is unnecessary and destabilizing for the economy. However, their suggestion of a ban on fractional-reserve banking strikes me as overly authoritarian, unnecessary and probably unpractical and unrealistic. Simply removing the state-run support infrastructure for fractional-reserve banking would be sufficient, in my view. Where the ideas of Positive Money become bizarre and dangerous is when they propose to install the state as an all-powerful central money creator. There is absolutely no justification whatsoever for such a function in a market economy. It is entirely unnecessary and would probably entail the same, if not worse, misallocations of capital that we suffer now. We would be guaranteed to stumble from one dysfunctional system into another dysfunctional one. The lessons from a proper understanding of fractional-reserve banking and of money demand are very different from what Positive Money suggests.