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Banking School vs Currency School - Money Creation as State Monopoly?

Preprint · November 2016

DOI: 10.13140/RG.2.2.17433.47205

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 Banking School vs Currency School
Money Creation as State Monopoly?

History of Economic Theory – Final essay

Gergő Motyovszki, EUI
25th Nov 2016

Abstract

In the modern monetary system private banks engage simultaneously both in financial intermediation
between savers and borrowers, and in money creation by the act of lending. The money supply
is therefore determined endogenously according to the needs of the banking sector and the real
economy. This is made possible by fractional reserve banking. However, following the recent financial
crisis there are calls for full reserve banking, and thereby the separation of financial intermediation
from money creation. The current paper reviews similar historical proposals along the debate
between the Currency School and the Banking School (1844 British Banking Act, 1935 US Chicago
Plan), and compares them with recent proposals. We find both ideological and practical arguments
in the Currency School for why the state should have full control over money creation, while the
Banking School remains mainly on the ground of practical arguments in defending the current
system.

JEL: B12, B25, E42, E51

1 Introduction

Money creation in the modern economy is done – contrary to common misperceptions – mainly
by private banks, and not by the central bank (McLeay et al., 2014). The view according to
which banks are "intermediaries of loanable funds", collecting pre-existing real savings/funds
from savers in the form of deposits and then lending them out to borrowers, is mistaken. In
reality banks do no such thing, but instead create their own funds (deposits) by the act of
granting a loan to a borrower.

As Jakab and Kumhof (2015) describe,1 banks can create monetary purchasing power (i.e.
deposits) at will, out of thin air, without the need to first divert real resources (pre-existing
savings) from third parties, or without any action by the central bank. They do this by granting
a loan to a borrower and crediting her deposit account with the same amount. This is rather
described as financing, which does not involve any intermediation or any need to collect deposits
from savers beforehand. The borrower might use this loan to invest and transfer her deposit
1
For a non-technical summary see also Kumhof and Jakab (2016).

History of Economic Theory, EUI Page 1 / 18

to her business partners who, in turn, become savers since they accept this deposit as means of
payment. But notice, that they became savers as a result of the investment, rather than being
the enabling cause of that. Hence, saving is a consequence of lending, not a cause of it; and
therefore saving does not finance investment: financing does. Banks do not intermediate any
real loanable-funds, they are fundamentally monetary institutions that create the main medium
of exchange in the economy (deposits) to facilitate transactions.

That being said, banks are still financial intermediaries in the sense that they have expertise
(compared to individual savers) in deciding which investment projects to finance and whom to
grant a loan, whereby they mitigate asymmetric information problems inherent in the lending
market. Some authors refer to this activity as banking rather than intermediation, but for our
purposes we can settle at the starting point that banks today are both creators of money and
providers of financial intermediation.

In this framework, the money supply is endogenously determined. Banks are constrained in their
lending (and therefore in their creation of deposits) neither by the amount of real savings in
the economy, nor (to some extent) by the availability of central bank reserves. Under fractional
reserve banking banks have to hold at least a required minimum fraction of their deposits in
central bank reserves, but this is usually not a binding constraint and as long as it is like that,
private banks face no technical limit on their ability to lend and create deposits, except their own
assessment of profitability and risk-return trade-offs.2 Therefore, up to that point the central
bank has no direct control over the money supply, but rather it will be a result of decisions
made by private banks and investors based on their expectations about the future course of the
economy.3 Of course, a central bank can still influence monetary conditions by setting the short
term interest rates, but this is a rather indirect way of affecting the money supply, the large
part of which is created at the discretion of the private sector in an endogenous way.

All this is not a new realization. Ricardo (1824) was already writing about this in the 19th
century, and macroeconomists during the Great Depression, like Keynes or Irving Fisher were
also aware of this. Although non-mainstream schools of thought, like the Post-Keynesian tra-
dition (see, for instance, Howells (1995) or Moore (1997)), held on to the notion of endogenous
2
This is one reason why the "Money Multiplier" narrative, utilized in most introductory macro textbooks,
is also flawed. It suggests that in a fractional reserve banking system central bank reserves are automatically
"multiplied up" through lending and deposit creation to become the money supply. This assumes that the minimum
reserve requirement is always binding, but in reality this is not true, and extra reserve creation by the central
bank should by no means lead automatically to extra deposit creation by private banks. In other words, the
money multiplier is not stable, or better, it does not exist. This was demonstrated during the Great Depression
and also during recent rounds of Quantitative Easing by advanced country central banks.
3
Moreover, in most cases monetary policy is not conducted by using targets for the monetary base, but by
targeting short term interest rates. In this case, whenever the banking system as a whole would hit the minimum
reserve requirement and they would still want to lend more at the going interest rate, they can just go to the
discount window of the central bank who will automatically create new reserves as the need arises. This makes
money supply completely endogenous, and adds an additional layer of endogeneity, also to the monetary base
itself.

History of Economic Theory, EUI Page 2 / 18

money, for some reason it was not part of the mainstream thinking in the second half of the
20th century. The money creator role of banks was not in the spotlight during normal times
when monetary policy conducts business as usual. Probably this is why until very recently the
financial sector was included in modern macro models, if at all, as an intermediary and not as
a money creator. In addition, money supply was often assumed to be totally exogenous, fully
controlled by the central bank. However, now this "lost wisdom" is being rediscovered. After the
Great Financial Crisis of 2008-09, with many advanced economies falling into liquidity traps á
la Keynes where monetary policy looses traction and is constrained by the Zero Lower Bound,
it has become increasingly apparent that central banks fail fully to control the money supply (it
is another question, beyond the scope of this essay, whether it would matter if they did). The
above cited sources, which are published by the IMF and main central banks, are evidence of
this trend.

Together with this "rediscovery" came opinions that the current system is not good, and calls
to take money creation out of private hands and give the central bank truly full control over
money supply (Wolf, 2014), in essence transforming the current setup into a full reserve banking
system. These ideas are not new, either. One of the earliest of such suggestions dates back as
far as Ricardo (1824) on which the 1844 Banking Act in Britain was modeled. It resurfaced in
the US during the 1930s in the form of the Chicago Plan which was supported also by Fisher
(1935). These ideas can be put collectively under the umbrella of the so called Currency School,
which argues for the separation of the functions of money creation and financial intermediation,
and wants to give the state full monopoly over the money supply. Standing against this camp
is the Banking School which argues that the current system, in which private banks perform
the two functions simultaneously, is either better than the alternative or that the alternative is
simply not feasible.

The aim of this essay is to review this historical debate between the Currency and Banking
Schools and try to identify underlying ideological or practical motives for the respective argu-
ments. This could help in assessing the flaws and merits of current proposals.

2 Banking school vs Currency School – Historic proposals

2.1 1844 Bank Charter Act

After the Napoleonic wars Britain returned to the gold standard which was followed by a dam-
aging deflationary period and several banking crises (Skaggs, 1999). This prompted a heated
discussion about the currency and Bank of England policy which started the Currency School
- Banking School controversy. The proponents of the Currency School were convinced that the
severity of the credit cycle was due to the improper management of the money supply by the
Bank of England. They did not just want to ensure convertibility to gold but wanted to control

History of Economic Theory, EUI Page 3 / 18

the money supply "in a stabilizing manner" (Skaggs, 1999). Until then paper bank notes could
be issued by the Bank of England (a private institution) and other country banks without fully
backing them with gold or government debt. The potentially unchecked increase in circulating
currency (overissue) could have lead to price increases, which in turn could have lead to gold
outflows according to the price-specie flow mechanism. And this could endanger the very con-
vertibility on which the gold standard relied. So in this narrative the phrase "stabilizing manner"
mentioned above was not used in the sense we use it today, i.e. that countercyclical monetary
policy should be used to fight both excessive inflation and deflation. It was merely meant to
stabilize the amount of currency so that gold convertibility is not endangered, which they also
associated with stable prices.

The proposals of the Currency School built on the work of David Ricardo. As we see in Ricardo
(1824), the separation of money creation from banking was seen as the means to achieve the
above goals. It ensured that under a mixed currency (consisting of both metal and paper) inflows
and outflows of gold were exactly matched by an increase or decrease of the paper component –
which should lead to the same price level as under a purely metallic currency.

"The Bank of England performs two operations of banking, which are quite distinct, and
have no necessary connection with each other: it issues a paper currency as a substitute for
metallic one; and it advances money in the way of a loan, to merchants and others.

That these two operations of banking have no necessary connection, will appear obvious from
this, – that they might be carried on by two separate bodies, without the slightest loss of
advantage, either to the country, or to the merchants who receive accommodation from such
loans."

(Ricardo, 1824, p.2)

Ricardo’s plan was used as a guideline for the Bank Charter Act of 1844, which effectively
achieved the separation of paper money creation from lending. This was done by requiring
the 100% backing of new paper notes with either gold or government debt. That paper issues
could be backed also by government debt (in addition to gold) did not endanger convertibility
since government debt in turn was supposed to be backed by gold. The Act, in effect, gave the
government the possibility to control the paper currency more tightly: banks could only issue
additional paper notes if the government issued more debt (equivalent to increasing central bank
reserves nowadays) or if there was a positive net gold inflow to the banking system. Banks could
no longer fund new loans by printing paper money. Whether government debt was sufficiently
backed by gold, was another question, but it was certainly decided at the government’s discretion
which gave more control over monetary affairs. The same reforms were implemented in the
United States by the National Currency and Banking Acts of 1863 and 1864.

Banking School proponents, like Thomas Tooke, in contrast argued that no restrictions should be
placed on bank note (or bank deposit) issuance. They viewed money (credit) as an endogenous
variable, the quantity of which was demand determined by the "needs of trade": creating more of

History of Economic Theory, EUI Page 4 / 18

it by the government (the so called "overissue") would just result in a "reflux" of unwanted paper
notes to banks in exchange for deposits, gold or loan repayment.4 Therefore, controlling money
creation was not really effective in affecting prices or the credit cycle since the causation ran in
the other direction in their view. Money should be left to be determined by the needs of banks
and business, and the government should not intervene. To protect the value of the currency,
they argued that ensuring convertibility to gold is enough and no reserve requirement is needed.
In order to guarantee convertibility, the government should just keep large gold reserves to be
able to satisfy temporary withdrawal surges – but it should not squeeze paper money issuance
along with gold outflows since this would just disrupt credit markets (Skaggs, 1999).

As Lainá (2015) points out, the 1844 Bank Charter Act was a slight departure from the original
Ricardo plan who advocated a pure commodity standard, i.e. one in which not only cash and
central bank reserves but also bank deposits are backed with gold. In a regular commodity
standard (like the gold standard) only base money is backed with gold, and deposit creation is
less constrained. The 1844 Act did not extend to deposits, since bank notes were the dominant
means of payment at the time; they were regarded as the money supply. Nevertheless, over time
it became apparent that bank deposits can act as a substitute to bank notes in their function
as money (this argument was already put forward by the Banking School). Deposit creation by
banks were not constrained by the full-backing requirement of the Act, and it turned out that
banks and merchants just switched to using them instead of bank notes, the supply of which was
restricted. The insufficient backing of deposits then lead to bank runs whenever panic occurred:
in these cases the Act had to be suspended in order to be able to pay depositors in cash (Lainá,
2015). This was vindication for the Banking School, but later the achievements of the Currency
School prevailed insofar as restrictions on paper note issance were to remain, and eventually the
right to print them was given exclusively to the Bank of England.

2.2 Chicago Plan

Following the Great Depression of the 1930s, the Chicago Plan was presented and discussed
during Roosevelt’s New Deal banking reforms in the 1930s, mainly written by Henry Simons of
the University of Chicago and supported very much by Irving Fisher. In short, it advocated 100%
reserve requirement, so it can be viewed as a continuation of the Currency School. However,
this time the full reserve requirement did not only apply to paper currency (which was anyway
put solely in the hands of the Federal Reserve) but also to deposits, which had become the
main medium of exchange and the dominant component of the money supply. By imposing a
100% reserve requirement on commercial banks, they would be unable to extend credit at will
4
This law of reflux was a modification to the real bills doctrine. The latter said that overissue is not
impossible but can be avoided by extending loans only to finance real trade or working capital needs, which leads
to the expansion of output. This way the higher money stock would not lead to price increases. As Schwartz
(2008) points out, the real bills doctrine was flawed because, among other reasons, it confused the flow demand
for loanable funds with the stock demand for circulating notes.

History of Economic Theory, EUI Page 5 / 18

by financing it with newly created deposits – they would first need to acquire government-issued
money (central bank reserves) which are fully controlled by the Fed.5

Another difference with the 19th century Currency School is that stabilizing the value of money
was not proposed by pegging it to gold. The Chicago Plan was motivated by the experience
of the deflation of the Great Depression and the failure of the Federal Reserve to reflate the
economy. The reform would not have made much sense if the monetary authority, having just
regained full control over the money supply, at the same time tied its hands to the exogenous
quantity of gold reserves of the country. Instead they suggested other rules which monetary
policy could follow (like price stability or a steady growth of money supply).

Under the Chicago Plan proposal there was need neither for a central bank discount window, nor
for deposit insurance, since the full backing feature ensures the security of deposits and also the
ability of banks to settle payments. Bank runs would be completely eliminated. If banks were
allowed to borrow additional central bank reserves at will, they could create additional deposits
by increasing lending which is exactly what the proposal wanted to prevent. Central bank
reserves were to become exogenous, fully controlled by the Federal Reserve through open market
operations. The separation of money (deposit) creation and lending (financial intermediation)
was made very explicit in the Chicago Plan by delegating the two functions to two different
institutions: deposit banks were to provide only payment services without the ability to make
loans (Lainá, 2015).

Irving Fisher, who was a huge supporter of the full reserve idea, put it like this in his book,
100% money:

"The revival now of this ancient 100% system, with the readjustments demanded by modern
conditions, would effectually restrain the monetary inflation and deflation incident to our
present system; that is, would actually stop the irresponsible creation and destruction
of circulating medium by our thousands of commercial banks which now act like
so many private mints. [...]

The essence of the 100% plan is to make money independent of loans; that is, to divorce
the process of creating and destroying money from the business of banking. A
purely incidental result would be to make banking safer and more profitable; but by far the
most important result would be the prevention of great booms and depressions by ending the
chronic inflations and deflations which have ever been the curse of mankind and which have
sprung largely from banking."

(Fisher, 1935, Preface)

Fisher also realized – much like the "reflux" argument in the Banking School – that the connection
5
Or if some depositors choose to move their liquid deposit claims into a less liquid savings account, the reserve
requirement becomes non-binding allowing for additional deposit creation by lending. This, in effect, means that
if the government does not issue any more reserves, additional lending can only be funded by first collecting
savings and not by creating more deposits – rendering the banks to the sole financial intermediary role which
many (falsly) attribute to them today.

History of Economic Theory, EUI Page 6 / 18

between money creation and lending works in reverse as well: merely the act of paying back a
loan at the expense of a deposit balance destroys the money supply as the balance sheet of the
banking system shrinks. He wanted to disconnect these two.

"If all bank loans were paid, no one would have a bank deposit, and there would not be a
dollar of currency or coin in circulation.

This is a staggering thought. We are completely dependent on the commercial banks. Some-
one has to borrow every dollar we have in circulation, cash or credit. If the
banks create ample synthetic money, we are prosperous; if not, we starve. We
are absolutely without a permanent monetary system."

(Fisher, 1935, Preface)

It seems clear from these quotes that the primary motivation of Fisher for this reform was a better
management of the credit (and thereby the business) cycle. And since money creation would be
detached from lending, Fisher predicted that the economy could also see a dramatic reduction of
private debt. While it seems obvious how the new restrictions would prevent excessive deposit
(and debt) creation by the commercial banks, it is less clear how full reserve banking would
have prevented everyone from repaying their loans with their deposits. This would have just
pushed the reserve ratio above the required 100% level which would have been allowed under
the proposal. In any case, the Chicago Plan was not implemented in reality, as the political will
behind it was eroded by opposition from the banking industry.

2.3 Current proposals for full reserve banking

Following the Great Recession of 2008-09 the ideas of the Currency School are staging a come-
back. An increasing number of economists and policymakers (also from the mainstream) are
flirting with the possibility of a full reserve banking system, which would reduce the procyclical-
ity of the current credit cycle, would give firmer monetary control to central banks and would
therefore make such large credit crunches both more unlikely and easier to handle. Researchers
of the IMF, Kumhof and Benes (2012) are proposing a revival of the Chicago Plan.

"Because additional bank deposits can only be created through additional bank loans, sudden
changes in the willingness of banks to extend credit must therefore not only lead to credit
booms or busts, but also to an instant excess or shortage of money, and therefore of nominal
aggregate demand. By contrast, under the Chicago Plan the quantity of money and the
quantity of credit would become completely independent of each other. This would enable
policy to control these two aggregates independently and therefore more effectively."

(Kumhof and Benes, 2012, p.5)

They calibrate a DSGE model which supports all of Fisher’s claims about the advantages of
full reserve banking: 1) less procyclical credit cycles and enhanced ability to control them,
2) complete elimination of bank runs, 3) reduction in government and 4) private debt. The
reduction in debt levels is mainly due to a large one-off windfall in seigniorage revenue of the

History of Economic Theory, EUI Page 7 / 18

state which is generated by creating the extra reserves needed to back existing deposits. This
revenue is then used to buy and forgive certain private debts and to offset government debt
previously held by banks. In addition, the authors find that this monetary reform generates
longer-term output gains through lower real interest rates (due to smaller debt levels) and
lower distortionary taxation (due to higher seigniorage income of the state). Moreover, steady
state inflation can drop to zero since the separation of money and the credit functions of the
banking system allows the government to effectively control the money supply, the quantity
of bank lending and the price of government credit to banks. According to the authors, one
critical implication is that in this monetary environment liquidity traps cannot exist because
the policymaker can directly increase the quantity in agents’ hands, and because interest on
treasury credit can become negative without any problem as it is not an opportunity cost of
holding money any more (treasury credit is only accessible by banks).

Lainá (2015) lists several other proposals like that debated by the UK Parliament, the report
commissioned by Iceland’s prime minister or Switzerland’s Vollgeld-Initiative. Wolf (2014) also
describes many contemporary suggestions, and promotes the abolishment of private money cre-
ation on the grounds that it would lead to a more stable financial system.

"Banking is therefore not a normal market activity, because it provides two linked public
goods: money and the payments network. On one side of banks’ balance sheets lie risky
assets; on the other lie liabilities the public thinks safe. This is why central banks act as
lenders of last resort and governments provide deposit insurance and equity injections. It is
also why banking is heavily regulated. Yet credit cycles are still hugely destabilising. [...]

Our financial system is so unstable because the state first allowed it to create almost all the
money in the economy and was then forced to insure it when performing that function. This
is a giant hole at the heart of our market economies. It could be closed by separating the
provision of money, rightly a function of the state, from the provision of finance, a function
of the private sector."

Wolf (2014)

The suggestion of Wolf (2014) (which builds heavily on Jackson and Dyson (2012)) would create
two kinds of bank accounts: transaction and investment accounts. Only the former could be
used as a means of payment, all of it would be created by the state meaning that a 100% reserve
requirement would apply to it, basically giving the central bank full control over this form of
money in its pursuit of promoting non-inflationary growth. Investment accounts, on the other
hand, would be the ones funding loans. No reserve requirement would apply to them and their
holders (savers) would be vulnerable to losses, but banks would still be stopped from creating
such accounts out of thin air by regulation: this way they could only lend money which was
previously invested by savers, making banks the pure financial intermediary institutions that
many wrongly believe they now are. To prevent such investment accounts to start functioning
as money, their acceptance as means of payment must be forbidden.

History of Economic Theory, EUI Page 8 / 18

To put the aim of these proposals a bit differently, they want to replace debt-based private
money with debt-free government-money. A substantial part of outstanding debt was created
for the sole purpose of lending into existence an adequate amount of monetary purchasing power
(e.g. by mortgaging already existing physical assets) – now there would no longer be any need
for this type of credit since the money supply can easily be created debt-free by the government.
The other part, the "socially useful" credit that finances real investment into new physical assets,
would continue to exist, and the financial intermediary function of the banking system would
still facilitate the efficient allocation of savings/capital to their most productive uses as well as
to provide intertemporal consumption smoothing to households.

Now, it is apparent from the above discussion and also from the example of the 1844 Bank
Charter Act that any reform, which imposes full reserve requirement to a certain form of money,
must prevent the emergence of near monies which are exempt from the requirement. The
restrictions on paper note issuance in 1844 just lead to the emergence of bank deposits as the
main medium of exchange, and similarly, full reserve backing of deposits might prompt private
agents to start using other bank liabilities as money. Henry Simons realized this in the 1930s
and Kumhof and Benes (2012) also propose some remedies to solve this problem.

"...but the main point is likely to be lost if we fail to recognize that savings-deposits, treasury
certificates, and even commercial paper are almost as close to demand deposits as are demand
deposits to legal-tender currency. The whole problem which we now associate with commercial
banking might easily reappear in other forms of financial arrangements. [...] Little would be
gained by putting demand deposit banking on a 100% basis, if that change were accompanied
by increasing disposition to hold, and increasing facilities for holding, liquid ‘cash’ reserves in
the form of time deposits. [...] The expansion of time deposits might be just as inflationary
as expansion of demand deposits – and their contraction just as deflationary; and the problem
of runs would still be with us."

(Goodhart and Jensen, 2015, p.24) cites Henry Simons, 1934

"...the banking system’s credit assets must be funded by non-monetary liabilities that are not
subject to runs. This means that policy needs to ensure that such liabilities cannot
become near-monies. [...] The easiest is to require that banks fund all of their credit
assets with a combination of equity and loans from the government treasury, and completely
without private debt instruments. [...] By itself this would mean that there is no lending at all
between private agents. However, this can be insufficient when private agents exhibit highly
heterogeneous initial debt levels. [...] One [other solution] is debt-based investment trusts that
are true intermediaries, in that the trust can only lend government-issued money
to net borrowers after net savers have first deposited these funds in exchange
for debt instruments issued by the trust. But there is a risk that these debt instruments
could themselves become near-monies unless there are strict and effective regulations. This
risk would be eliminated under the remaining alternative, investment trusts that are funded
exclusively by net savers’ equity investments, with the funds lent to net borrowers."

(Kumhof and Benes, 2012, p.5)

History of Economic Theory, EUI Page 9 / 18

2.4 Banking School arguments

Representing the other side of the debate (which we can regard as heirs to the British Banking
School) Goodhart and Jensen (2015) points out that the above proposed remedies to the vul-
nerabilities of full reserve banking plans are not satisfactory. For them to work, there should
be a clear distinction between "money" and "near money", which is not true in reality. What
private agents regard as money can evolve flexibly over time as was demonstrated by the switch
to bank deposits from paper notes after the 1844 reform. Strict regulation like prohibition of
issuing such near-money bank liabilities or forbidding to use them for settling payments is un-
likely to succeed for long. "If authorities try to impose constraints on the private sector’s access
to liquidity, it will attempt to innovate its way around that" (p.22).

"Suppose that narrow, FRB, banks were established, while other (risky) banks continued to
be allowed to offer seven-day time deposits, as now. Banks would still be able to make loans
by writing up both sides of their balance sheet, only in the form of short-dated time deposits
rather than demand (sight) deposits. Borrowers would have to wait a week before accessing
their funds, but that is a short time for most purposes."

(Goodhart and Jensen, 2015, p.23)

Goodhart and Jensen (2015) also argues that this system would only increase the instability
and procyclicality of the financial system since people would just hold the less liquid, risky
investment accounts (offering higher returns) which now are not protected either by full reserve
backing or by deposit insurance. Therefore these bank liabilities would be subject to the same
runs as checking deposits, and could force the banking system into quick liquidation of assets
and sharp deleveraging.

But even if we assumed that the state could somehow establish full control over the money
supply and make a clear distinction with near-monies, it is likely that this "reduced" banking
system could not meet the short-term working capital needs of industry, as all bank lending
would have to be funded with less liquid, longer-maturity liabilities which are therefore also
more expensive. Therefore, access to both borrowing and liquid assets would be impaired unless
the government can flexibly respond by providing more money according to the "needs of trade"
– which is unlikely. This might be a small price to pay for financial stability, but maybe it would
not succeed at all (Goodhart and Jensen, 2015).

As mentioned before, Banking School proponents are in line with the Post Keynesian tradition
in viewing the determination of the money supply as largely endogenous, which cannot be
controlled fully. According to them, various monetary aggregates should respond "flexibly to
the needs of trade". Credit creation is the one which connects money with the real economy,
but it is difficult to control fully and directly. That said, they admit that in the current system
there is an inherent problem as borrowers and banks behave procyclically. The original solution
proposed to this issue was the real bills doctrine, i.e. to restrict/incentivize banks to lend only to
finance real trade and working capital needs, so that credit does not extend beyond real economic

History of Economic Theory, EUI Page 10 / 18

growth (as opposed to lending to finance speculative investments into assets). Unfortunately,
the real bills doctrine was wrong since real output can exceed its "sustainable" level and this
overheating would generate inflation. In other words, even without "credit going beyond real
growth", it can go beyond sustainable real growth. The best advice the Banking School has to
offer is to manage banks better on the micro level and improve macroprudential regulation by
the authorities of the whole banking system, in order to mitigate systemic risk.

3 Role of the state in money creation

3.1 Free market forces or government control?

After going through all the details of these proposals, the question naturally arises: which of
the two approaches is correct? To simplify and sharpen the conflict: is it the state or private
markets who should manage money? The answer has many dimensions, the first of which is
the most obvious, i.e. deciding between the two should be based on which one does a better
job in terms of economic outcomes or social welfare. In light of the above discussion, this
would include looking at performance in stabilizing credit cycles, delivering stable inflation and
flexibly providing sufficient credit for investment as well as liquidity to finance transactions
and thereby supporting sustainable real growth. The Currency School argues that it is their
plan which can achieve this by making credit cycles less procyclical, while the Banking School
argues that government interference would just make things worse and in any case is doomed
to fail, since markets will just innovate their way out of restrictions. Free market supporters
usually also point out that the state cannot react as flexibly to continuously changing economic
conditions (to the "needs of trade" in our context), as decentralized private actors can who,
through the mechanisms of the invisible hand, function most efficiently under a laissez faire
regime. In contrast, private management of money might create negative externalities which
call for government intervention.6

What is surprising, however, is that otherwise free market enthusiasts like those from the Uni-
versity of Chicago, including Milton Friedman or Henry Simons, or those in the Austrian School
like Friedrich Hayek, all supported the Currency School (with slightly different emphasis). While
they were indeed proponents of laissez faire in industry, the came down firmly for state monopoly
in money creation and against leaving it to private banks who are driven by market incentives.
Their motivations were different, though. While Simons and Coauthors (1933) wanted to assert
6
Deciding all the above is not any easy task and the question is still unsettled today. Historically, however,
it seems that private money creation started relatively late in history which is also when financial crises started
to become frequent. Earlier monarchs usually handled monetary affairs responsibly, with few exceptions. Even
the German hyperinflation of 1923 was due to private control of the Reichsbank. And the obvious cases where
government-issued currencies collapsed had more to do with corrupt officials and bad management than with
the inherent inability of a government-controlled institutional setup to manage money well (Kumhof and Benes,
2012).

History of Economic Theory, EUI Page 11 / 18

full government control over the money supply in order to better manage the credit cycle, Hayek
(1937) supported full reserve banking in order to preserve the value of the currency. Similarly
to Ricardo (1824) he proposed a pure gold standard, where deposits should be fully backed not
with government debt, but with gold. In Hayek’s version, the government would have no control
over monetary policy, since its hands would be tied to gold. So, as Lainá (2015) puts it, al-
though banks would be free from any government control, they could still not issue money freely.
Friedman (1960) supported the Chicago Plan, and similarly to Hayek, he suggested eliminating
the private creation of money not in order to be able to actively manage the money supply, but
rather in order to keep its growth under control. Therefore, he also wanted the government to
tie its own hands, but instead of by pegging to gold, rather by committing to fixed rules in terms
of money supply growth (k-percent rule) – see also Friedman (1967). Beyond this he wanted to
keep the state from interfering with borrowing and lending relationships, and leave the rest of
banking unregulated.

By contrast, it is mostly those from the Keynesian tradition, usually advocating the need for
active government management of aggregate demand by either monetary or fiscal policy, who
were now on the side of the Banking School, rejecting total government control over the money
supply and leaving it rather in the hands of private market participants.

Perhaps this apparent contradiction, i.e. that free market enthusiasts support full government
control of money creation while Keynesians are for keeping it in the hands of private market
actors, can be mitigated somewhat (though not fully) by considering the rules versus discretion
dimension. Many Currency School advocates wanted state monopoly over money but at the same
time wanted to constrain the government by rules (by either the gold standard, or monetary-
growth targets or price level targets in the case of Fisher). In this narrative, the proposed
monetary reform by the Currency School is not active government intervention, but rather much
needed government regulation, which just ensures the smooth functioning of financial markets,
once it is left on its own. This is of course not true for those, who view full reserve banking
as a way of making monetary policy omnipotent, providing it the means to escape liquidity
traps, like Kumhof and Benes (2012). Banking School representatives on the other hand, are
more associated with proposing discretion in monetary policy, citing that no monetary rule can
account for all eventualities (just look at the need for unconventional policies in the recent crisis).

3.2 The privilege of money creation

Deciding whether based on practical arguments, i.e. in terms of economic outcomes, it is

government-controlled or privately issued money that performs better has no obvious answer,
as we have seen above. However, deciding it based on "ideological" arguments, or "fairness"
grounds offers a more straightforward direction which favors the Currency School. Issuing the
medium of exchange results in seigniorage, a profit coming from the difference between the pur-
chasing power of the new money and the cost of creating it. Whoever has the privilege of money

History of Economic Theory, EUI Page 12 / 18

creation, commands this profit which can be seen as a pure rent.

In this analysis it is imperative to distinguish between debt-based private money and debt-
free government money. Privately created money is necessarily debt-based (a loan has to be
created together with the deposit), but at the same time it is a liability to the issuer bank.
The seigniorage in this case is part of the interest income the bank earns on the difference
between lending rates and deposit rates. And this rent is being accummulated in the hands of
a few private business, who are able to create money, which Kumhof and Benes (2012) call an
"extraordinary privilege":

"...money and credit would become detached and completely independent of each other. [...
B]anks would no longer be able to generate their own funding, deposits, in the act of lend-
ing, an extraordinary privilege that is not enjoyed by any other type of business.
Rather banks would become what many erroneously believe them to be today, pure intermedi-
aries that depend on obtaining outside funding before being able to lend."

(Kumhof and Benes, 2012, p.5)

The particular part of the interest income which can be regarded as seigniorage is generated on
those particular loans which were created solely in order to satisfy the economy’s demand for
monetary purchasing power (i.e. not those loans which finance real investments). Therefore this
income has nothing to do with the payment of the banker for bearing the risk of its loan book
or for providing financial intermediation services. In any case these loans are usually risk-free,
being collateralized with an existing physical asset, like mortgage. According to Kumhof and
Benes (2012), another consequence of the debt-based feature of private money is that high and
destabilizing debt levels become necessary just in order to create sufficient money supply in the
economy. This carries the potential for defaults which in turn lead to large wealth transfers
across agents and wealth concentration in the hands of bankers.

"Private money has to be borrowed into existence at a positive interest rate, while the holders
of that money, due to the non-pecuniary benefits of its liquidity, are content to receive no
or very low interest. Therefore, while part of the interest difference between lending rates
and rates on money is due to a lending risk premium, another large part is due to the
benefits of the liquidity services of money. This difference is privately appropriated
by the small group that owns the privilege to privately create money. This is a
privilege that, due to its enormous benefits, is often originally acquired as a result of intense
rent-seeking behavior. [...] [Debt-based private money creation] repeatedly led to systemic
borrower defaults, forfeiture of collateral, and therefore the concentration of wealth in
the hands of lenders."

(Kumhof and Benes, 2012, p.13)

In contrast, the government can create money in a debt-free manner. One might argue that
government-money (e.g. central bank reserves or currency in circulation) are liabilities of the
government, and therefore debt. But under a fiat money regime this is a special kind of liability,
which is not redeemable to anything but itself (which would not be the case under the gold

History of Economic Theory, EUI Page 13 / 18

standard). Therefore many argue that it is best viewed as equity for the government: by creating
money, the state created monetary purchasing power out of nothing without owing anything else
to anybody in return. In this narrative the whole stock of newly created money is pure profit,
seigniorage which adds to the equity of the consolidated government, which then can be spent
on fiscal transfers or tax cuts.7 In any case, irrespective of how we classify government-created
money, it would surely be debt-free in the sense that it does not require increasing private debt
levels, and is therefore free from the adverse and destabilizing consequences described above.
In addition, the resulting seigniorage would be public and not a quasi-rent concentrated in the
hands of a few privileged banker.

If we believe that the benefits resulting from the right to issue money should be shared equally
across society, then the Currency School proposal surely seems "fairer". But fairness also has a
lot to do with who invented money. In a more direct analogue, taxing away a large portion of
the wealth of the rich and redistributing it among the poor might be regarded as "fair" from an
equality perspective, but can be seen as gravely unfair to those who accumulated this wealth
not by luck but by their hard work. So we should establish whether private banks and markets
"worked hard" for their privilege to issue money in the sense that they invented it, or was it just
handed to them due to a historical coincidence? To answer this we must look at the origins of
money which will lead to the nature of money.

3.3 The nature of money

The commodity theory of money can be an argument for the private issuance and control of
money. This can be traced to Adam Smith or Karl Menger who hold that money arose in private
trading transactions to overcome the double coincidence of wants problem of barter economies.
In this narrative money is a commodity, and as it came into being by and due to the needs of
private market actors, the state has no business in taking money creation out of the hands of free
markets - similarly to any other commodity markets. In contrast, if money and the payments
system in general is viewed as a public good, which would otherwise not be created by anyone,
then the state can solve this coordination problem by issuing money, the value of which derives
from government fiat, i.e. the medium of exchange nature of it is established by law.

"Banking scholars demand that the government does not meddle in monetary and banking
affairs, for money is seen as a means of exchange which is spontaneously – or market-
7
This is related to recent debates among policy makers whether it would be a bad thing for a central bank
to operate with negative equity. Helicopter money could be implemented by central banks crediting the account
of the government with newly created money without buying any claims on the government in return. Under
current accounting rules this would reduce their equity potentially to negative territory, but they would still not
be insolvent in the usual sense, since their liabilities are to be paid by themselves. As the government uses the
proceeds to pay for fiscal deficits, on the consolidated government level this would just mean that fiscal spending
is financed by printing money, while the increasing equity of the private sector is mirrored by the negative equity
of the government, but the latter never has to be repaid.

History of Economic Theory, EUI Page 14 / 18

 endogenously, as it is called – created among traders. In the process, money itself becomes a
commodity. The banking school’s idea of money, and what is known today as the commodity
theory of money, was later expounded in more detail by Menger in 1871 and the subsequent
Austrian School. A commodity should be left to ’the markets’." Huber (n.d.)

The commodity money vs fiat money narratives might seem to have followed each other over
the course of history (the commodity view especially lends itself to metallic based monies, while
post-gold standard monetary regimes are regarded as fiat money). However, as documented
in Zarlenga (2002), even in the historical regimes based on precious metals, the relatively high
value of those metals was precisely due to their role as money which derived from government
fiat, e.g. that it was accepted for tax payments, and not from their "intrinsic" qualities. In
addition, there is little evidence that money emerged as a solution to barter, since barter was
virtually nonexistent already in primitive and ancient societies. On the other hand, there is
plenty of evidence that early credit systems and later monetary systems had their origins in the
needs of the state (Zarlenga, 2002).

In fact, it seems that "it was the English Free Coinage Act of 1666, which [first] placed control
of the money supply into private hands, and the founding of the privately controlled Bank of
England in 1694, that first saw a major sovereign relinquishing monetary control, not only to the
central bank but also to the private banking interests behind it (Kumhof and Benes, 2012, p.14).
Based on this, private money creation is a relatively fresh phenomenon and the commodity view
of money has little basis according to history. Therefore the nature of money has more to do
with government fiat.

While establishing that it was most likely the state which created money helps in determining
the true government fiat nature of money – and based on this we might say there is nothing
"unfair" in taking money creation out of the hands of private banks – it does not necessarily
mean that the state is a better manager of money than the private sector. As discussed above,
this debate is not decided.

4 Concluding remarks

In this essay we reviewed the historical controversy between the Currency and Banking Schools.
The debate revolves around the main question of whether money creation should be taken out
of private hands and given exclusively to the government. As a means to achieve this, the
Currency School proposes a full reserve banking system which would manage to unmount the
money creation activity from the financial intermediary function of modern banking, which
currently does both things simultaneously. They argue that this would result in a much more
stable financial system and more effective management of the business cycle.

In summary, Banking School proponents say that although the Currency School proposals can
be very seductive in their elegant simplicity, the reality is much messier than that. Separating

History of Economic Theory, EUI Page 15 / 18

money creation and financial intermediation, putting the former into the hands of the state with
a tightly managed, protected core payments/monetary system, and leaving the latter to free
market competition between unregulated private banks and without government interference or
any safety net – this seems like a neat idea, which is unlikely to be feasible.

This controversy bears every element of the ever-existing debate between free market enthusiasts
and those believing in a larger role for government. Who is better positioned to manage a
particular activity or carry out a certain economic function? And apart from that, which
solution is fairer for society in normative terms? I believe, we do not yet have a definitive
answer to these questions. However, in an interesting twist, it turns out that it is precisely those
otherwise advocating free markets who stand for state monopoly and full government control in
money creation, while usual proponents of active government policy would rather leave money
creation in private hands. This twist might also be a sign of the very special role which money
plays in our inherently monetary economies.

History of Economic Theory, EUI Page 16 / 18

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Friedman, Milton. 1967. “The Monetary Theory and Polcy of Henry Simons.” The Journal
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Goodhart, Charles, and Meinhard Jensen. 2015. “Currency School versus Banking School:
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