Published in “GoldMoney” Research (23rd November 2011).
Many people blame the market economy as a whole and, in particular, the greedy evil speculators and selfish financial markets for the problems we have been suffering in most developed economies since 2007. Following this rationale, governments are set to intervene much more in the financial markets with new tougher regulations. However, financial and money markets are far from being unregulated free market “islands”. On the contrary, the state has played a major role in the money market at least since early-modern history. Additionally, most analysts recognise that loose monetary policy, and thus excessive money growth for too long, has been critical to explain the underlying imbalances and the distortions created in the economy during the “Great Moderation” years. Consequently, in order to assign responsibilities for the current crisis, we should first identify the main actors in the money markets.
In our 100% fiat monetary system, no commodity backs the value of the currency, nor the central bank has to redeem paper notes in a pre-set commodity (such as gold or silver). As C. Goodhart’s masterly put it in his (1988)’s The Evolution of Central Banks (The MIT Press), the central bank leads and commands a club of commercial banks legally authorised to issue means of payments, the bank money, in the form of bank deposits in the currency of the central bank. Banks can expand their balance and thus create new means of payments because they only have to keep in their vaults a small fraction of their clients’ deposits (in the jargon, a fractional reserve banking system).
In fact, this fraction is tiny: banks now are able to lend up to 95% or 98% or their deposits. The rest (yes, only a 2% to 5% of the deposits!) is kept by the commercial banks to meet customers’ demand for their deposited money. Most importantly, only fully-licensed banks are allowed to enter into the market of money creation, and thus competition is restricted and ultimately determined by the state. Finally, the issue of legal money (i.e., base money) is subject to state monopoly by law, as the central bank is the only one with the power to issue paper notes with “legal tender force”. Thus central banks form a legal monopoly in the issue of paper notes and an oligopoly in the supply of bank money, which is ultimately controlled by the central bank. These central banks are, in-turn, regulated by the state.
Inside this peculiar system, the central bank acts as the bank of the rest of commercial and profit-maximising banks, to which it provides the following financial services: (1) Provision of the monetary (fully fiat) standard of the economy, (2) holding of banks’ reserves, (3) clearing facilities and (4) provision of regular (and also extraordinary) credit to the banking system. The central bank also monitors and supervises banks’ operations and balances, and receives the so-called seignoriage; which is the huge difference between the face value of the notes in circulation and their intrinsic value (which is virtually nil in the case of paper money). The commercial banks associated to the club also get a non negligible gain from their highly protected position in the market, as they share the gains of the seignoriage resulting from the issue of bank money; which is the difference between the face value of the banks’ deposits and the cost of maintaining the (legal) reserve required by the central bank in cash. In sum, the central bank is the head of a sort of a legal cartel of commercial banks and all make an extraordinary profit from their privileged position in the money market.
Furthermore, the proper running of this uncompetitive money market ultimately relies on the monetary policy decisions made by a single actor, the central bank; in the absence of a strict monetary rule that preserves the purchasing power of the currency, this frequently leads to cyclical over-expansion of money and hence inflation. Thus, the monetary system becomes fragile and unstable, as a succession of mistaken monetary policy decisions by the central bank (e.g., maintaining a lax credit policy for too long) may lead to a distortion in relative prices and finally to an inefficient allocation of resources with unwanted effects in the medium to the long term.
This is why it is so important in our centralised monetary systems either to run a truly sound monetary policy such as the one conducted under the classical gold standard rule, or better, the introduction of true market forces and competition in the money market.