It’s always good to have a mate you can disagree with. Dave has been emailing me lately about money creation. It seems that a large proportion of scientific non-economists (such as biologists, environmental scientists and the ilk) are of the opinion that fractional reserve banking cannot survive a move to a steady state economy.

But more on that at some other post. Every time I have a robust discussion about money supply, my brain begins ticking over at its possibilities and ideas pop up.

There are natural limits to fractional lending. Banks cannot, for example, lend out less than 0% of their deposits. Nor can they lend out anything beyond 100% of their deposits (reserve requirements notwithstanding). These are natural limits.

These limits are being felt now through ZIRP – Zero Interest Rate Policy. The problem with ZIRP is that it announces the limit of what monetary policy can do. Once central banks like the Federal Reserve lower rates down below 1%, monetary policy becomes increasingly ineffective. The problem is that once interest rates fall to that level, it is an indication that the demand for government bonds has sky-rocketed. Through the standard open market operations of buying back bonds, the central bank creates a profitable form of investment for the market – the price of bonds sky-rockets as the central bank begins to buy them and the market reacts by holding them even tighter. The end result is, unfortunately, no real addition to the money supply and a vicious cycle of government bond purchases that is, in the end, not unlike an investment bubble. ZIRP ends up preventing money creation – which is ironic considering that its purpose is to encourage money creation.

Of course, this wouldn’t happen if interest rates could go negative. But negative interest rates are prevented by the natural limits of fractional reserve banking.

Given that this is the case, a new phrase has entered the economic vernacular – quantitative easing. For amateurs, this is essentially money printing – the central banks creates money by fiat and then somehow injects this money into the money supply.

From what I can gather, however, the result of quantitative easing is the same as standard monetary policy – bonds are bought back. Yet, as I have mentioned above about ZIRP, this procedure won’t result in anything but a bond bubble and won’t actually enter the money supply.

One solution is for the central bank to lend money to the government, who then uses it as part of any stimulus package. If we take the current Obama stimulus as an example, then we could see how the Fed could create money by loaning it to the Government, who then spends it on the stimulus.

Creating money out of thin air does, of course, have its risks – most notably the hyperinflationary experiences of Weimar Germany and Mugabe’s Zimbabwe. But what is important here is that the amount of money created is limited by concerns over inflation. The Fed is hardly likely to create $15 trillion out of thin air and dump it into the economy because such an event would be hyperinflationary. But if the Fed created, say, $150 billion (10% of the previous amount), the inflationary effects would be less. Couple this with a deflationary environment and you have the recipe for modest price stability.

Yet there is more to Quantitative easing than simply lending it out to government. I would go one step further. And this is my idea:

The Central Bank creates money by lending it to Commercial Banks.

This would take the form of a deposit. The central bank creates money by fiat, and then deposits this money in as many banks and financial institutions (institutions that are part of the fractional banking structure) as it can find. This won’t be a bond buyback, but a simple deposit. It is not important as to whether the commercial banks pay interest on such a deposit since paying back interest is not important – expanding the money supply is.

Of course, with more money deposited, commercial banks would then have more money to lend out, thus alleviating any credit crisis. There is no money entering the money supply via any bond buybacks or stimulus plans. It’s simply money appearing by fiat and being deposited into banks.

But what happens once the economy begins to recover, credit begins to flow again and inflation begins to rise? Well obviously the central bank could then withdraw all or part of its deposit with commercial banks. This would reduce the amount of money commercial banks could lend out and act as a contraction of the money supply.

And then I got thinking again – what if this form of quantitative easing replaced current monetary policy completely? So rather than money being removed or injected into the money supply through bond issues or buybacks – why not simply have the central bank deposit money into commercial banks or withdraw money from its commercial bank accounts? It would still be an open market operation, but one which doesn’t require a government bond market to exist or even some form of centrally set level of interest – rates would be completely market controlled and dependent upon how much money the central bank deposits into, or withdraws from, commercial banks.

So, to summarise:

To stimulate growth in the money supply (to battle deflation and thus stimulate economic growth), the central bank creates money by fiat and deposits it into commercial banks.

To restrict growth in the money supply (to battle inflation and thus restrict economic growth), the central bank withdraws money from its commercial bank accounts.

In both cases, the money supply is affected by the ability of the commerical bank to lend up to 100% of its deposits – the more deposits, the more money is lent; the less deposits, the less money is lent.