Inflation or rising interest rates? The central bank dilemma is not inevitable…

The increase in the general level of prices is currently reaching, in many countries, levels not seen since the 1980s. This inflationary phenomenon is generally explained by an excessive growth in the money supply; and even if other causes contribute, inflation can always be avoided or corrected by an adjustment in the quantity of money in circulation. That’s why central banks, whose mandate is to stabilize the purchasing power of money, are now pledging to raise rates to fight inflation.

In our current monetary systems, however, central banks only indirectly and very imperfectly control the volume of money in circulation. Central bank money, directly issued by them, represents only a fraction of the total means of payment, essentially limited to coins and banknotes. The money supply today consists mainly of scriptural bank money (the balances of our current accounts transferable by credit card or bank transfer), which is created by commercial banks when they finance loans or investments.



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One of the shortcomings of this bank money is that it gives the medium of exchange a procyclical behavior: the volume of money increases (or contracts) as borrowers increase (or reduce) their debt to banks, which amplifies bubbles speculative where banks lend the most – in the real estate market in particular.

Between Charybdis and Scylla

This dependence of money creation on bank lending also explains why central banks, in the existing system, are inclined to manipulate the market price of loans (interest rates) to stabilize the price level. Using in particular the management of the reference rates, at which they lend to banks, or the purchase or sale of assets intended for the latter, will have an impact on the interest rates that the banks, in return, will apply to their customers. Central banks, in this very indirect way, can thus encourage or discourage the creation of bank money, in order to stabilize the purchasing power of money.

In times of inflation, like today, this translates into rate hikes which, apart from the monetary effects, are anything but painless: by increasing the cost of debt, they penalize investments. That’s why central bankers are now navigating between Charybdis and Scylla: If not a big enough rate hike lets inflation slip away, too big a hike could precipitate a recession.



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But is such a dilemma really inevitable? Far from it. Indeed, there is nothing inevitable about the fact that money creation depends so heavily on bank lending. As the English economist David Ricardo explained already two centuries ago, there is “no necessary link” between the issuance of money on the one hand and the advance of money as a loan on the other. These two functions, he asserted, could well be separated “without the slightest loss of advantage, either to the country, or to the merchants benefiting from these loans.” The issuance of banknotes has since become a central bank monopoly in most countries.

The track “Evaluate 100%”.

Similarly, several economists have called for the issuance of book money, transferable by check or wire transfer, to be dissociated from bank lending. This was the essence of the “100% money” proposal formulated in the United States during the Great Depression of the 1930s by several economists including the American Irving Fisher. According to this reform plan, which was the subject of our recent research, transactional deposits would be 100% backed by government foreign exchange reserves, so that only the monetary authority can create or destroy means of payment.

A number of economists, including Nobel laureates Maurice Allais, Milton Friedman and James Buchanan, have continued to advocate different versions of this reform idea. The latter, however, has often been rejected on the grounds that it would have ended bank intermediation – but this applies only to the more radical versions, which would impose 100% reserves on all bank deposits without distinction.

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The basic version of this reform plan would concern only transactional deposits, for payment purposes, leaving banks free to use savings accounts, for investment purposes (and whose balances would be convertible on demand or term but not transferable per se) , to finance loans. Bank intermediation would thus be maintained, but the volume of means of payment would no longer be affected.

The current system increases inequality

Following the global financial crisis of 2007-2008, various authors have argued for a modern version of this idea with the proposal of “sovereign money”, according to which central bank money would be used directly, in scriptural or digital form, by the entire payments community to replace bank money.

In such a system, monetary creation would cease to depend on bank loans and would become a monopoly of the monetary authority. This would inject new money into circulation through bothopen market (the secondary market for securities on which the central bank operates), or, in collaboration with the Treasury, through the fiscal channel, i.e. increasing public spending, reducing taxes (for the same expenditure), or even direct monetary transfers to taxpayers or citizens (according to the “helicopter currency” principle).

The volume of means of payment would thus cease to vary cyclically according to borrowing and investment decisions. The monetary authority would be able to perfectly control the issue of money and stabilize, through it, the value of the unit of account, without having to interfere with the loan market.

In the years following the 2008 crisis, a “100% money” or “sovereign money” system would have represented a clear advantage when, in a context of general over-indebtedness, the private sector was reluctant to borrow more. at very low rates) and banks reluctant to lend or invest. Central banks have therefore had to carry out massive purchases of bank assets, through their “quantitative easing” (QE) programs, to prevent the reduction of bank balance sheets from translating into monetary contraction. While these operations helped avoid deflation, they also kept interest rates artificially low and inflated asset prices, increasing inequality in the process.

Avoid currency distortions

In the current context, a system of “100% money” would symmetrically make it much easier to control inflation: faced with a rapid increase in the price level, the issuing authority could directly reduce the pace of money creation, without having to manipulate interest rates in any way.

This argument was made as early as 1935 by Irving Fisher:

“Even when the price level is, for a time, successfully stabilized, under the system in [vigueur]the effort itself to achieve this end by manipulating interest rates […] necessarily implies some distortion of the interest rate with respect to the normal, i.e. with respect to the rate that the demand and supply of loans alone would have established. This is because when the [banque centrale] raises or lowers the interest rate in order to prevent inflation or deflation, such increase or decrease necessarily interferes in some way with the natural money market”.

In a “100% money” system, he continued, “interest rates would naturally balance according to loan supply and demand, and real rates would not be perverted by monetary misconduct.” It is only by separating the issuance of money from the lending of money, as such a reform proposes, that the price level and the interest rate could separately and simultaneously reach their optimum levels.

Until such a system is put in place, monetary authorities will occasionally continue to face the kind of dilemma they are currently facing. The introduction of a central bank digital currency (MNBC), which is under consideration in many countries, could facilitate its adoption.

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