title: Money Creation, Banks and Macroeconomic Instability
Creators: name: Hilton, Henry
Publisher: name: Griffith University
Year: 2008
Subjects: subject: money creation
subject: banks
subject: macroeconomics
subject: macroeconomic instability
subject: Leon Walras
subject: regulation of money supply
subject: financial sector
subject: money market
subject: economics

description: The function of money creation by banks remains a mystery to many. Galbraith remarked "The process by which banks create money is so simple that the mind is repelled." (Galbraith 1975: 18) Creating money ex nihilo is an extraordinary phenomenon which has profound economic consequences. Curiously though, orthodox economic theory relegates money creation to the periphery. The convention is that the role of banks in macro-theories is solely to facilitate the conversion of savings into investment via the money market. Major macroeconomic schools maintain that governments (or central banks) have control over the money supply, that the money supply exhibits inelasticity and that the financial sector is a benign responder to the decisions taken by authorities. Although the genesis of macroeconomic instability is hotly contested, the role of banks is generally regarded as passive rather than active. In the history of economic thought, however, some notable economists have taken a very different view. They argued that the role of banks as money creators is the principal cause of macroeconomic instability. Banks are not passive agents whose balance sheets are directed by external causes. Rather banks are seen by them as the engine that drives the business cycle. What sparked this dissertation was my surprise discovery that Leon Walras identified banks as the chief cause of macroeconomic instability. Walras is well remembered for his derivation of the general equilibrium framework through which is demonstrated the efficient operations and optimality of a free-market system. So it came as a revelation to learn that Walras did not support the application of the free-market principles he had espoused for goods and services markets to financial markets. Walras stated unreservedly: "So the industry of credit and discount with the issue of bank notes is not an industry like any other; it is an industry that must be regulated and not given freedom." (Walras 1936: 368, emphasis added) Other eminent mainstream economists who came to a similar conclusion as Walras were Irving Fisher and members of the Chicago School – Henry Simons, Frank Knight, Lloyd Mints and Jacob Viner. They were all strongly committed to a policy of laissez faire with one crucial exception, the creation and supply of money. Milton Friedman also accepted the position but did not actively endorse it for practical and theoretical reasons. The argument put forward by Walras and others to arrest the institutionalized nature of money creation by private banks, stands in stark contrast to the widespread deregulation of banking and financial markets that began in the 1980’s. This deregulation effectively dismantled the constraints imposed by governments to support and sustain their countries’ economies in the face of the difficulties posed by deep recessions or depressions. The great monetary and banking debates in England through the course of the 19th century had linked those disturbances with the operations of financial markets and the British Parliament opted for regulatory measures in order to stave off similar events. Other nations in the developed world took Britain’s lead and also imposed regulatory measures upon banks for the same reasons. Yet the current orthodoxy it seems has either ignored those reasons or no longer deems them valid. This dissertation explores and extends Walras’ original insight in the context of the contemporary deregulated financial environment. Mainstream macro-theories are critically assessed and it is argued that insufficient regard is being paid in them to the role of money creation by private banks. A descriptive model of the money market is presented which highlights the effect of money creation. Finally, a policy proposal is offered as a solution for limiting financial sector sourced macroeconomic instability.