28 Nov 2011

Are there any controls on money creation by banks?

Here's a question that I just posted on the Positive Money Forum. I wonder if anyone knows the answer.

Here's another "simple" question inspired by my reading of "Where does money come from?" (Excellent by the way). The question concerns the plausibility of having any mechanism that could control the amount of debt/money created by commercial banks under the current fractional reserve banking scheme.

OK, I understand that governments could attempt to regulate the amount of loans that banks can make by imposing a minimum level of reserves. For example, there could be a limit of 10%. Thus, if Bank A has reserves of £1 million, central government regulations could prevent Bank A issuing more than £10 million in loans.

But let us suppose that there is another bank, Bank B. Bank B lends Bank A another £1 million, allowing Bank A to issue a further £10 million in loans. Since there are presumably no real restrictions on who Bank A lends to, it seems obvious that Bank A could, for example, lend Bank B £1 million (potentially via a subsiduary in the Cayman Islands). This sort of mechanism could continue to generate more and more debt, with no way to control it - effectively turning into a gigantic Ponzi scheme. (By the way, if this is indeed possible, I'm confident that the banks will not have waited for me to post this comment on the positive money website to take advantage of such loopholes in the system).

If this picture is true, then taking the away the commercial banks' priviledge of money creation should be priority number one of any rational government. Money creation has to be done in one place and one place only - by central banks under the supervision of elected governments.

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