We need nationalised money, not nationalised banks

The recent loss of £24 billion by RBS, together with the £11 billion loss declared by HBOS, almost wiping out the profits of its parent company, LloydsTSB, has brought the idea of total nationalisation of most or all of the British commercial banking sector once more into the arena of political commentary.

The reason why so many British banks (like many others around the world) have had to go cap in hand to government to buy up some, or all, of their shares, is that UK banks, like those of all the major industrial countries, are bound by the Basel Capital Accord which, since 1988, has determined how much a bank can lend.

Many people are under the misguided apprehension that banks lend out their savers' deposits and therefore they can only lend out as much as their savers have deposited. This has not been the way that most commercial banks have operated for more than three hundred years.

Banks used to operate under a concept called 'fractional reserve banking', which effectively meant that banks only needed to have in their vaults a fraction of the money that they lent out. When money meant gold or silver, then banks created loans to many multiples of their holdings of bullion. Since legal tender came to mean bank-notes, then a bank could create credit to the the value of many times its stock of 'real' money.

The Basel Capital Accord (known as Basel II since 2004) has taken this money creation process one step further. A bank's lending is now determined by a set ratio of its capital value on the stock market. The minimum capital ratio is 8%. Meaning that for each £8 of its capital value, a bank can create £100 of new credit.

What this means, of course, is that as a bank's share price rises so its capacity to create more credit rises and conversely, when its share price falls, so its lending capacity also falls. The banks that took up the offer of extra capital from HM Government did so because their falling share price meant that they were in danger of breaching their agreed capital ratios.

The whole basis of the Basel Capital Accord is further proof that bankers have simply lost touch with reality. Its fundamental weakness is that is a pro-cyclical or positive feed-back system. It creates dangerous excesses for the banks operating under its rules, both in good times and bad. It is a wholly flawed concept which has contributed greatly to the global credit crunch.

We do not need to base banks' lending capacity upon capital ratios, nor upon a fractional reserve. Instead, for simplicity, stability, honesty and sustainability, we need a 100% reserve banking system, which operates in the manner that most people think that banks do operate, by lending out such money as they have, and not by creating credit based on money they have not got.

The commercial banks currently create our money supply as an initially matching asset and liability on their books. These assets and liabilities do not remain matching for long, of course, as the interest charged on assets (loans) soon outstrips the interest paid on liabilities (deposits). Out of nothing, a commercial bank can create for itself a myriad of profitable income streams against a very much lower level of costs.

This arrangement currently constitutes 97% of the UK money supply. If the commercial banks were limited to lending out only such legal tender as they have on their books, our nation's money supply would shrink to 3% of its present size. More money would be needed to fill the gap.

The 3% of the money supply that consists of bank notes issued by the Bank of England would have to be expanded to 100% to meet the need for money within the banking system. The profit from the money creation process would then go to the public purse. This would give us a nationalised money supply.

With a money supply entirely and directly controlled by a single public agency, inflation could be eliminated from the economy through the simple process of creating no more money at any given moment than is required to maintain inflation at 0% (or between +0.5% and -0.5%).

A nationalised money supply should constitute one of the basic services provided by government in even the most free-market orientated of societies. Few, if any, would advocate that Britain should be defended by privatised armed services, or that our streets be protected by privatised police-forces, or our courts run by a privately-owned judiciary, or that every road and street in the land should be privately-owned with no public rights of way. A publicly-provided money supply is as essential as these services.

By requiring banks to operate in the manner that most people actually believe they do – lending out only so much legal tender as they hold in their vaults – bank regulation could be made very simple and very possible. The capacity for banks to lend would not depend upon the rise and fall of the stock market, but upon their customers' capacity to save.

This would be counter-cyclical. If people spent more and saved less, so increasing the demand for goods and services, thereby 'overheating' the economy and creating inflationary pressures, so the capacity for borrowing would diminish, automatically curbing such pressures.

In such an environment, banks could not get themselves into the mess that they recently have, requiring government bail-out plans. They could be left to get on and operate as privately-owned commercial businesses, just like building societies, credit unions and like most of the rest of the economy. They would no longer be massively profitable, as they would no longer create the money supply, but then why should they be massively profitable, when such profitability occurs at the expense of the productive part of the economy?

For a genuine free-market, both in the financial and the productive sectors of the economy, free from the cumbersome bureaucracy of excessive regulation, a nationalised money supply is a must.