Most people assume that the government directly controls the amount of money in the economy.
They assume that money is essentially tokens that get passed from person to person as they exchange goods.One would assume that the amount of tokens would remain constant except for occasional money printing by governments. Indeed money could work in this way should governments have chosen such a system, but in reality, money does not work like this at all*. Instead we have a system in which money is being continuously created and destroyed.
When someone goes to a bank asking to borrow money, the bank does not need to take that money from its reserves. Instead it creates that money on the spot. If someone asked to borrow $1,000, then the bank will simply hand them a chequebook (or a debit-card) and tell the borrower that they can spend up to $1,000 with their cheques. This is $1,000 of fresh new money that never existed before.
This $1,000 is then free to circulate in the economy, being passed from person to person during the course of ordinary trade. Money may pass through a great many hands between being created and destroyed.
This is the part that so few people seem to know about. When the borrower repays the loan to the bank that money disappears back out of existence. Thus the amount of money circulating in the economy at any one time is rather analogous to the population of a species of animal. The current population is determined by previous birth and death rates. Keeping the amount of money in the economy reasonably constant is a balancing act where the central banks attempt to encourage or discourage new lending so that the rate of new money creation is approximately equal to the rate at which existing money is expiring. One of the ways they can do this is by adjusting interest rates up and down. Lower interest rates encourage lending, higher rates discourage it – or at least that’s the plan.
Quantative Easing is not money printing
There are occasions however, where having interest rates near zero still does not lead to enough money creation (lending) to exceed the money expiration rate. In this case alternative strategies like quantitative easing (QE) may be employed. It should be noted that QE is not money printing. Money printing is in fact illegal under EU regulations. QE is money lending by the central bank – i.e. the money created by the central bank with QE is expected to be repaid and so expected to expire at some future time.
Limits on Money Creation – there are none!
Many textbooks as well as some popular videos on YouTube describe money creation in a way that imply rules and regulations about reserve requirements or capital adequacy place a rigid cap on the money supply. Sadly, for reasons beyond the scope of this article, neither mechanism works in practice and senior economists and central bankers are fully aware of this fact. The only limit on money creation is the size of the demand for loans from people that banks consider creditworthy.
So what is wrong with this system?
The problem with this monetary system is that it allows for a positive feedback mechanism with asset prices. People often borrow (create) money to purchase non-productive assets in the hope that they can sell that asset at a higher price at a later time. But of course the more money is created to purchase an asset, the higher the price of that asset will rise. This self fulfilling prophesy encourages more people to do the same, and a bubble ensues. Asset price bubbles are an inevitable consequence of our monetary system.
Is there an alternative?
Yes. A fixed money supply, where tokens are circulated indefinitely is known as full (or 100%) reserve banking. The system is rarely discussed these days, but after the great depression – the last comparable crisis of our monetary system, full reserve banking was taken very seriously. It is about time we looked at it again.
*A tiny fraction of the money supply does in fact work in this way, but the quantities are so small that this part of the money supply can be virtually ignored.