Simpol and Monetary Reform

If the current banking crisis (and previous crises) holds a lesson, it is that the banking system that underpins the global economy is inherently unstable and prone to collapse.

The reasons for this though, are not all that clear to most people. There is a common misconception about the way in which banks actually work.

At the root of this is the fractional reserve banking system. When most people think of money, they probably think of 10 pound notes and 1 pound coins – physical money. If pressed, however, they would probably acknowledge that most money is not in this form – rather it is in digital form. We are all used to the digital age of banking nowadays and most people know that most of the digital money is not backed up by ‘real’ physical currency.

What most people probably don’t realise is where this digital money actually comes from. Physical money is created and distributed by the central Bank of England (BoE). But here’s a perhaps startling fact. This physical currency represents only 3% of the total money in circulation in the economy. So where does the rest come from?

The truth is that 97% of all money in the economy is created by commercial banks. What is likely to be even more startling to most people is that this money is created explicitly as debt by those banks.

The Positive Money Campaign (PCM) recently submitted a report to the Independent Banking Commision (ICB) in which they set out in full the failings of the fractional reserve system and propose an alternative called ‘full reserve banking’. Contained in the executive summary of that report is this statement:

The key feature of fractional reserve banking is that the lending activities of banks effectively creates new money, in the form of new bank deposits. As the Bank of England’s 2007 Q3 Quarterly Bulletin states: “When banks make loans they create additional (bank) deposits for those that have borrowed the money”. Put another way, the money supply of the real economy depends entirely on the lending decisions of the banking sector.

This, in truth, is what lies at the heart of the recent financial crisis. This system is designed and run in such a way that it can never be stable. The report describes it as ‘pro-cyclical and inflationary’. What does this mean?

  • Pro-cyclical:
  • The report describes this phenomenon thus:

    Fractional reserve banking is pro-cyclical, since rising debt creates an increasing money supply, which in turn generates a ‘credit-fuelled boom’. This seemingly benign environment encourages others to take on further debt to the extent that inflation becomes a problem, especially in asset prices (such as housing). Eventually the cost of servicing this debt starts to become excessive for certain groups, who then default, triggering a recession.

  • Inflationary:
  • The explanation for this is actually quite simple. If we consider two passages from the report. First this…

    Under fractional reserve banking, the only way that the public (households and businesses) as a whole can get additional money is to borrow it from the banking sector…bank deposits are only created when a member of the public (or a business) takes out a loan. In other words, the banking sector has an effective monopoly on the supply of money (in the form of bank deposits) to the public and the real economy. In effect, the aggregate money supply in the hands of the public is ‘on loan’ from the banking sector.

    …and then this:

    Every loan issued by a bank increases the money supply in the hands of the public [and] banks have a commercial incentive to lend whenever they can find a credit-worthy borrower… Consequently, under the fractional reserve banking system, the decision over how much money the economy requires is taken by thousands of loan officers who are incentivised to make only one decision: issue a loan and increase the money supply. This naturally leads to a constantly increasing money supply, regardless of the needs of the real economy.

    We can now see how the current system fuels inflation. This, coupled with the pro-cyclical tendencies outlined above clearly demonstrates exactly why the current system is unsustainable and will always be prone to exactly the kind of crises of which we are currently the victims.

    The problem, of course, is that we the people have no choice but to rely on this system as none other is available… Until now.

    What the PMC are proposing in their report is a new system called ‘full-reserve banking’. To set out all the details of the proposed system would take more space than is desirable here but it can be read about in full in the PMC report or via the (proposed) Bank of England Act

    Suffice to say for now that it deals in detail with the problems inherent to fractional reserve banking. It does this primarily by taking the the power to create money away from the banking sector and giving it instead to the Monetary Policy Committee (MPC) of the Bank of England (BoE). The MPC is a body entirely independent of both industry and govt and thus represents the best choice to manage the flow of money in the economy without prejudice or favour.

    The key question for Simpol then, is not whether such a change should take place – which surely it must – but whether it can be implemented unilaterally or whether it requires the simultaneous implementation process offered by Simpol?

    This question is addressed in the report and the argument offered is that:

    ‘any bank wishing to do business in pound sterling would need to operate under the full-reserve banking rules…there is no way to circumvent it, as long as a bank wants access to the huge sterling lending market.’

    So superficially it would appear that Simpol is not needed here. But perhaps it is not quite so simple as that. Firstly the banking sector is a powerful lobbying force indeed and just the threat of capital flight might be enough to force politicians to not implement these changes.

    Secondly, such a change in regulation would be likely to at least slightly decrease the profits made by banks in the sterling market. Since every bank has a constitutional responsibility to its shareholders to maximise profits, it seems likely that banks would move as much of their money and/or operations to other markets in order to meet this responsibility. Thus even if it does not represent a complete withdrawal from the UK market, such a move would be potentially damaging to the UK economy and so virtually unthinkable to the politician.

    What we have then, is a situation where the political fear of first mover disadvantage makes it perhaps unlikely that such necessarily radical changes would actually take place.

    Here, as ever, is where the Simpol process can help. Simultaneous Implementation removes the possibility of first mover disadvantage and thus allays the fear that prevents politicians from acting, even when change is so desperately required.

    Beyond this it is also true to say that the fractional reserve system is unfair and unsustainable wherever it may be and, in this sense, there is a need for an end to this system to be brought about the world over. Whilst it is not perhaps strictly necessary for all these systems to be undone at once, we can see from the above that it is more likely to occur that way (through simultaneous implementation).

    Finally, and perhaps most importantly, Simpol offers a way for citizens in each country to actively show that they want this change to occur and to use their democratic votes to drive their politicians to achieve it.

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    2 thoughts on “Simpol and Monetary Reform

    1. A good video on the subject of how money is created in our economy can be found at:

      It’s from the Positive Money campaign and is definitely worth a look.

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