30 December 2013 | By Frances Coppola | forbes.com
We are used to money being created by the state. Or rather, we are used to money being created by banks on behalf of the state. The state has no direct control over the quantity of money created by the private sector on its behalf, though it does influence that quantity through monetary policy and, in these days of near-zero interest rates, fiscal policy. But it does guarantee it. Or rather, it used to.
Money created by the private sector on behalf of the state always ends up in a bank, and once it is there it is indistinguishable from money actually created by the state (bank reserves and physical currency). Private sector money and state money are “fungible”, or as Izabella Kaminska puts it, “entangled“. Trying to disentangle them is like unscrambling an omelet. So we don’t try to. We simply accept that all of it is equally valuable. Anything called a “dollar” and sporting the symbol $ is fully backed by the US government, however it was created – even actual counterfeits if they escape detection.
But the implied cost to the state of guaranteeing the value of all the money created by private sector lending activity is enormous,as we discovered when Lehman fell. So governments have been attempting to limit that guarantee – for example by capping the amount of private sector money that can be converted to safe government money (that’s what the depositor haircuts in Cyprus did), or limiting the types of institution whose money-creating they will guarantee. The trouble is that far from making the system stronger and safer, it’s actually making it riskier. Since private-sector-created money is indistinguishable from state-created money once it gets into a bank, limiting the state guarantee makes state-created money less safe.
