The benefits of the new system proved immediately apparent. Interest rates on government borrowing dropped from 10-14 percent in the 1690s to 5-6 percent in the early 1700s. This allowed Britain a great deal of leeway when it came to military spending, which it soon put to use. But the privatization of money creation also came with drawbacks, namely the economic cycle of boom and bust. Leaving the money-lending and -creating decisions up to banks resulted in a system of extremes where bankers created speculative bubbles via vast quantities of loans and money when times were good, only to refuse to lend — in a sense destroying money — once an ensuing speculative bubble burst.

This led to liquidity crises, with the South Sea Bubble of 1720 providing early evidence of this mechanism kicking into action. The fact that banks were lending more money than they could back up with capital also left them exposed to bank runs whenever the public lost confidence in them. The reserve ratio, which requires banks to keep a fraction of their loans backed by safer assets such as government debt or central bank money, is an attempt to keep this threat at bay. But it is an inherent characteristic of so-called fractional reserve banking that the risk of bank runs is ultimately inescapable.

Britain, and indeed all the other countries that came to adopt the system, grew accustomed to a regular waxing and waning of the money supply and to the consequent up-and-down economy. There were ways to palliate this cycle, with the Bank of England slowly developing into the stabilizing force it is today. In times of crisis, the Bank of England would lower interest rates and flood the market with liquidity, bailing out any solvent but illiquid banks to keep the system functioning, thus smoothing the money supply's wilder fluctuations.

As British and then American influence spread, so did banks' power, and capital flowed ever more freely around the world as domestic deposits were used to finance international projects. The system was heading for a fall, however, when World War I created great economic imbalances between Europe and the United States. In the 1920s, the Federal Reserve attempted to restore prewar parity by keeping interest rates artificially low, but this led to abundant speculative U.S. capital flooding across the Atlantic, particularly into Germany. The ensuing giant bubble finally popped in 1929, leading to the dramatic liquidity shortages of the Great Depression and creating the circumstances that culminated in World War II. The experience led to the partial reining in of banks, with the Glass-Steagall legislation in the United States in the early 1930s limiting their ability to take part in speculative investments.

Time has a way of chipping away at such precautions, however, and the banks gradually escaped their shackles and capital came to flow freely around the world once again. More countries became accustomed to the ebb and flow of bubble and crisis, though these crises tended to be more regional in scope (e.g., Latin America, Asia, Scandinavia). When global crisis finally struck again in 2008 it was different from 1929 in that there was no world war to blame for the global economic imbalances; this crisis followed an extended period of the banks having had things pretty much their own way. Instead, it was a giant version of the regular crises inherent in the system. This led to the thinking that it is the banks, and indeed the system they created around themselves, that need changing. In the eight years since 2008, layer upon layer of 1933-style regulation and restriction have thus been heaped on the banking sector.

A Radical Reform

It is into this atmosphere that the idea of stripping banks of their money-creating abilities has gained currency (regained, in fact, since calls for it date back at least to the 1930s). According to its proponents, the way to root out the instability inherent to the system is to require banks to back their loans 100 percent with reserves. This essentially would be a step back to the point where banks would again function as conduits rather than creators of capital. Under the reformed system the creation of new money would instead be the prerogative of the central bank and the government. These national institutions would in theory be motivated by the needs of the state rather than by short-term profit and would keep the money supply growing at a fixed rate, doing away with the wild fluctuations of the credit cycle. (One challenge to overcome would be politicians attempting to hijack the money supply for short-term political gain.) Proponents of such a system point to many expected benefits: bank runs would be eliminated, the proceeds of money creation would go to the government and thus the taxpayer rather than to the banking elite, government debt would be a thing of the past, and private debt would be greatly reduced. (Indeed, the predominance of debt in today's world is partly a product of it being required in the money creation process.)