Where does money come from?

A growing economy requires a growing stock of money to facilitate trading. New money is created every day. Where does it come from?

A common misconception is that the Reserve Bank or the government creates all New Zealand’s money.  Actually, the Reserve Bank creates our notes and coins, but these make up less than 3% of the money supply[1].

The other 97% of our money supply is electronic money created by commercial banks. Banks create money out of thin air via a simple bookkeeping entry.  “Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.”[2] Banks do not merely loan out the savings of other bank customers as is commonly believed:  banks create deposits.

The amount of new money issued is critical: too much money will cause inflation; too little will cause a recession.

Currently, the banks decide how much money to create and where it is allocated.  Banks base their decisions on what is the most profitable for the bank, not on what is best for the community.

Problems with how money is currently issued

Too Much Money

For decades, commercial banks in New Zealand have expanded the money supply much faster than was required to support economic growth in New Zealand. In the thirty years from 1989 to 2019, GDP grew by a factor of 4.2[3]. In the same period banks expanded the money supply by a factor of 8.8¹.   Banks expanded the supply of NZD more than twice as much as was needed for economic growth and allocated more than 90% of new money to buying existing houses and farms.  The result has been sky-rocketing prices – creating some of the most unaffordable housing in the world[4] – and in turn creating mountainous debt, poverty and hardship for regular New Zealanders.

Poor Allocation of New Money

While banks have poured too much money into the housing sector, at the same time communities around the country are starved for funds and cannot afford desperately needed infrastructure, such as wastewater and public transport.  Businesses, such as Rocketlab, are starved of funds to develop and grow, and often must move overseas to access growth funds[5].  The suffering and lost opportunities are completely unnecessary.

Unnecessary Interest Expense

The government has the power to issue its own money debt-free and interest-free via the Reserve Bank.  But instead of creating its own money (as it has done in the past), the government borrows from commercial banks, spending over $4.7B per year on interest[6].  If the government simply ‘changed banks’ it would not need to pay this interest and would free up tax dollars to be spent on health, education or other social programs.

Bigger Booms and Busts

“When the economic outlook is positive, banks acting to maximize profit will lend more (so the money supply grows at a faster rate) but when the economy is doing badly, banks’ lending slows down (so the money supply grows at a slower rate, or even starts to contract). This lending behaviour amplifies the economic cycle, increasing suffering and inequality.”[7]

Growing Debt

Every dollar is loaned into existence.  In order to supply money for the economy to grow, households and businesses must go deeper into debt.

Proposed Solution: Sovereign Money

Sovereign Money is a system of managing New Zealand’s money supply in which the Reserve Bank creates all the country’s money (coins, notes and electronic) debt-free. The Reserve Bank decides what quantity of money is created, considering what is best for the productive economy and society as a whole.

While the Reserve Bank decides the quantity of new money, the government of the day decides how new money is allocated. To introduce new money into the economy the government can increase government spending, reduce taxes, reduce public debt, pay a dividend to citizens, provide extra funds for business lending, or any combination of these.

In a Sovereign Money system, the power to create money will be removed from private banks. However, though banks will not be able to create money, banks will continue to make loans by acting as intermediaries between savers and borrowers and will continue to administer payment services for customers.  

Transaction accounts will be held at the Reserve Bank on behalf of customers, not at the commercial banks. The banks will manage payments and transactions in a very similar fashion to what they do now, except they will be managing funds held at the Reserve Bank rather than in their own bank. The accounts will not pay interest, the money will be available on demand, and banks will charge a management fee similar to what they do now.

Banks will offer Investment Accounts which earn interest, at a rate depending on the level of risk and the duration of the investment.  People who want to invest will loan money to commercial banks by transferring money from their Transaction Accounts to the commercial bank’s Investment Pool Account which will also be held at the Reserve Bank.   Money in Investment Accounts will be at risk, and will not be available to be withdrawn until its maturity date.

Key Benefits of Sovereign Money

Appropriate Funding

The amount of money in the economy is controlled directly by the Reserve Bank, preventing private banks from expanding it.  There will be sufficient money for a growing, productive economy, infrastructure and other necessary government expenditure without inflating prices in some sectors (such as housing) by providing too much money. 

No Conflict of Interest

The power to create money is kept separate from the power to decide how that new money is used.  This removes a conflict of interest so that neither too much nor too little money is created, and ensures money is created for public, rather than private, benefit.

Safer

The money supply is safer and more reliable. Transaction Accounts are held at the Reserve Bank on behalf of customers, not at the commercial banks.   If a bank fails then money in transaction accounts is not affected, and management of the accounts can be easily transferred to a different bank.  A deposit guarantee scheme is unnecessary for Transaction Accounts.

Reduced Risk of Bank Bail-outs

Because funds in Transaction Accounts are held securely at the Reserve Bank, a failure of one bank does not jeopardize the whole financial system.   The government will not be compelled to bail out a failing bank with public money.  The current “Open Banking Resolution” which allows banks to claim a portion of their depositors’ money to re-capitalize the bank in the event of a failure, will not be needed.   The system will be safer by design, dramatically reducing the risk involved in commercial banking. This could open the way to some reduction in regulatory burden in banking and reduction of overhead costs.

New Zealand has done it before

Back in the 1930s the Reserve Bank successfully created money to build the first state houses, fund infrastructure and new businesses via the State Advances Corporation. “The sums advanced by the Reserve Bank were not subscribed or underwritten by other financial institutions. This action showed the Government’s intention to demonstrate it was possible for the State to use the country’s credit in creating new assets for the country.”[8]

Many older people remember the low interest loans received from the State Advances Corporation for their homes or businesses.  What they may not realize is that the source of the funds was sovereign money created by the Reserve Bank and issued directly into the economy.  The money was not borrowed from commercial banks, not borrowed from overseas, did not come from Private Public Partnerships or Special Purpose Vehicles.

With the money created by the Reserve Bank, many kiwis were able to buy houses, were lifted out of poverty and were able to start businesses. New Zealand came out of the depression better and faster than most other countries in the world.

Comparison of Current System to Proposed Sovereign Money

 

	Now	Proposed
Who creates new electronic money?	Commercial Banks	Reserve Bank
Who decides how much money is created?	Commercial banks with a profit motive	The Monetary Policy Committee, a body of experts independent of Government
Who decides where new money is directed?	Commercial Banks	The Government of the day
Who sets the OCR?	Reserve Bank	Not needed
Who sets interest rates?	Commercial Banks /RBNZ	The market
Proportion of new funding going to the productive sector (approx)?	10%	90%
Proportion of new funding going to existing assets such as existing housing (approx)?	90%	10%
Business cycle amplitude (Boom and Bust)	High	Low
What happens to the principal of loans once they are repaid	Destroyed.  Unable to be re-lent.  New money needs to be created.	Available to be reinvested in the economy.
Inequality	High	Low
Risk of Government bailout in crisis	High	Eliminated
Risk of ordinary people losing money Transaction Accounts in a crisis?	High (open banking resolution)	Eliminated
Risk of ordinary people losing money in Investment Accounts in a crisis?	High	High
Government’s Cost of borrowing	Commercial bank loan rates	zero

 

About Positive Money NZ

Positive Money NZ is an independent, non-profit group advocating for monetary reform in New Zealand.  We are part of a global movement[9] with organizations and people from across the world campaigning to change the way money is created so that money serves society.

Bibliography

Money Creation in the Modern Economy, Bank of England, Quarterly Bulletin 2014 Q1

Monetary Reform – a better monetary system for Iceland, Frosti Sigurjonsson, Edition 1.0, March 2015

Sovereign Money – an introduction, Ben Dyson, Graham Hodgson & Frank van Lerven, Positive Money, December 2016

State Housing in New Zealand, Cedric Firth, Ministry of Works, 1949

The role of banks, non- banks and the central bank in the money creation process, Deutsche Bundesbank, Monthly Report, April 2017

Other Links

There were many proposals similar to sovereign Money put forth around the time of the great depression.

• 1933 The Chicago plan
• 1935 Irving Fisher, “100% Money”
• 1939 A Program for Monetary Reform (Wiki)

Then in more modern times…

• 1948 A Fiscal and Monetary Framework for Economic Stability Milton Friedman
• 1960 A Program for Monetary Stability Milton Friedman
• 1987 James Tobin, “The Case for Preserving Regulatory Distinctions”
• 2000 Creating New Money New Economics Foundation
• 2009 The Reform of Banking Regulation John Kay
• 2009 Presenting the American Monetary Act
• 2010 Towards a Twenty-First Century Banking and Monetary System Submission to the Independent Commission on Banking (UK)
• 2010 National Emergency Employment Defense Act Congressman Dennis Kucinich’s legislative proposal
• 2014 Creating a Sovereign Monetary System Ben Dyson, Andrew Jackson and Graham Hodgson. Positive Money

 

 

[1] Reserve Bank of New Zealand, hc50-long-run.xlsx, July 2019, Currency held by the public / Broad money = 1.9%

[2] Money Creation in the Modern Economy, Bank of England, Quarterly Bulletin 2014 Q1, page 14.

[3] Reserve Bank of New Zealand, hm50.xlsx, June 2019

[4] 15th Annual Demographia International Housing Affordability Survey: 2019, page 20

[5] “Rocket Lab founder Peter Beck blasts lack of NZ venture capital for other firms”, NZ Herald, 22 April 2018

[6] Stats NZ, National Accounts, Table: General government, Income & Outlay account, Current Prices (Annual-Mar), Interest Paid

[7] Monetary Reform – a better monetary system for Iceland, Frosti Sigurjonsson, Edition 1.0, March 2015

[8] State Housing in New Zealand, Cedric Firth, Ministry of Works, 1949, page 7.

[9] International Movement for Monetary Reform, https://internationalmoneyreform.org/