Government Money and Democracy

‘Government money’ takes two forms: cash and reserve balances. Cash comprises notes and coins. Reserve balances are required for final settlement of transactions. Government is the sole issuer of both cash and reserve balances.

Government money is issued in one of two ways: through government spending and government lending.

Government spending adds net financial assets (which are the sum of cash, reserves and outstanding government bonds) because it involves the crediting of reserve accounts. The added reserves may be exchanged for government bonds (if government deficits are to be matched with ‘bond sales to the private sector’) or left as reserves (in the case of ‘interest on reserves’ or ‘overt monetary financing’).

Government lending has no direct impact on net financial assets. It is a swap of one non-government financial asset for another (e.g. a reserve add in exchange for bonds).

Commercial bank deposits are lower in the ‘hierarchy of money’. They are a promise to provide government money at par to the amount of the account holder’s balance. The account holder can demand cash either at any time or after some duration of time. And the account holder is assured that the commercial bank will obtain reserves as necessary for final settlement of purchases made out of the account.

The government’s monetary authority, however, stands ready to provide reserves as required by the commercial banking system, though at a price and on terms of its choosing. So long as it is profitable, commercial banks will lend. If short of reserves, they can obtain these after the fact. In this way, the endogenous creation of ‘private bank money’ (deposits) necessitates an accommodating creation of government money (in the form of reserve balances) by the monetary authority.

The first avenue to government money creation is democratic. The second is undemocratic. In the first case, the decision to issue government money is arrived at collectively through a governmental budgeting process. Any charges applied by government function as taxes, which enrich nobody and function in part to drain government money, income and spending power from the economy. In the second case, a for-profit institution pursuing its own purposes issues private loans, creating commercial bank deposits in the process, and applies private charges (in the form of interest) that enrich the lender. Government money in the form of reserves is created as necessary to accommodate this undemocratic private credit creation in accordance with the monetary authority’s lender-of-last-resort function.

The resistance of a large part of the economics profession to the notion of endogenous money perhaps partly reflects a desire to conceal this second, undemocratic avenue to government money creation.

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8 thoughts on “Government Money and Democracy

  1. Nice, short and to the point article.

    However I’m not sure about the underlying assumption that because a particular form of economic activity is not “democratic”, that there is therefor something wrong with it. My decision to drink beer rather than wine is not democratic: no one else has a say in that economic decision (my decision to drink beer). But I see nothing wrong with millions of individual consumers taking the latter sort of “undemocratic” decision every day.

    The basic flaw in private money creation or “printing” I suggest is that it amounts to a subsidy of money lenders (aka commercial banks). That is, there is clearly a difference between money lenders who have to borrow or earn the money they lend out, and in contrast, a money lenders who can create the money loaned out from thin air, which is what happens in the real world. As Joseph Huber put it in his work “Creating New Money”, “Allowing banks to create new money out of nothing enables them to cream off a special profit. They lend the money to their customers at the full rate of interest, without having to pay any interest on it themselves.”

    There’s a paper of mine which will be online in a week or two on this subject. I’ll leave a link to it here when it appears.

  2. ” If short of reserves, they can obtain these after the fact”

    They can never be short of reserves, because reserves are actually irrelevant in a modern banking system.

    In normal operation, at the end of clearing all the commercial banks lend to each other and the central bank is out of the loop. The central bank provides liquidity during the day, but looks to drop out of the loop overnight.

    It’s only in times of stress that the CB gets involved as ‘lender of last resort’. But we’ve been in banking stress so long now it is starting to look normal.

    And it’s important to note that the CB doesn’t really lend. It is always a repo – a ‘repurchase’ operation. So the CB is actually buying things with government money, and that falls into undemocratic territory when those things become mortgages or mortgage securities created by the private banks.

  3. “They can never be short of reserves, because reserves are actually irrelevant in a modern banking system.”

    What the hell? No, they are extremely relevant in modern banking systems! Banks do need to keep reserves above zero or above the minimum requirements.

    And banks can run short of reserves! There is actually an Asset and Liabilities Committee or something equivalent in every single bank. And one of the responsibilities of the committee is to make sure that there will be liquidity at the end of the day.

    If a bank lends too much and borrows to little it can actually break. And there are individual stress scenarios, where a single bank faces difficulties and the other banks don’t.

  4. “No, they are extremely relevant in modern banking systems! ”

    They really aren’t at all. That is just the clearing mechanism.

    If one bank is up, another bank is down. The bank that is up lends to the bank that is down and the net result is zero at clearing.

    The Treasury committees at banks are just trying to get what they need at the best price in competition with everybody else. But overall it is all smoke and mirrors. Completely unnecessary.

    “If a bank lends too much and borrows to little it can actually break.” Not in any structural sense. A bank can lend until it runs out of creditworthy borrowers. At that point the question is whether its capital buffers are adequate or not. Then it has to persuade people to swap the deposits it created for capital to restore its buffer. That happens at a price. If the price it happens at is higher than the loan, the bank loses money.

  5. A good summary Peter and I particularly like your closing sentence as it highlights the fact that the whole monetary system rests on a foundation of an ideology of minority power.

  6. Ralph says: “I’m not sure about the underlying assumption that because a particular form of economic activity is not “democratic”, that there is therefor something wrong with it. My decision to drink beer rather than wine is not democratic: no one else has a say in that economic decision (my decision to drink beer). But I see nothing wrong with millions of individual consumers taking the latter sort of “undemocratic” decision every day.”

    I don’t think this captures the essence of our system or how to think of what democracy means. How about a billionaire’s decision to buy a new luxury yacht? I’d argue this is fundamentally undemocratic in a very wrong sense for it demonstrates that material power rests in the hands of small minority and that society at the macro level is fundamentally undemocratic and unfree.

    I think it’s difficult to draw the lines between ‘democratic’ state spending and ‘undemocratic’ bank money creation. Ideologies of power tightly control the degree the state (as an institution) is permitted to spend and also the purposes – in the US, it’s heavily weighted toward military, intelligence, and the like. And banks are regulated by the state, albeit in a way that assures that banks conform to the strictures of profit.

    I think it’s better to think of the entire system, along with its key institutions, as fundamentally undemocratic in a very wrong way.

  7. No channel of government spending is democratic, rather it is all republican in the sense of republic. It makes all the difference in the world because of the large spread between large and small states. This spread is and has been either the first or second constitutional issue we always face, always.

    If you fall for the fad of using ‘democracy’, then you fail miserably in understanding just about anything in the American economy.

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