Tim Worstall v. PositiveMoney

I note an interesting little discussion between Tim Worstall and Ralph Musgrave on money creation in the context of the Northern Rock bank crisis of 2007. Essentially Tim was claiming, against the PositiveMoney view, that the failure of the bank was evidence that it was not possible for banks to create money. Ralph’s point was that it is possible for banks to create money if they move ‘in step’, but since Northern Rock was creating money (by lending) faster than other banks this led to its problems.

In fact both Tim and Ralph are ignoring the role a crucial player here: the Central Bank – in this context the Bank of England (BofE).

The basis of our monetary system is money created by the BofE in the form of notes, coins and accounts held by commercial banks with the Bank of England. Let’s imagine a single commercial bank operating in the UK that holds a certain amount of this BofE money. This bank could certainly create additional money by lending up to the point that it could still cope with demands of depositors for banknotes and coin, or to pay taxes etc. to the government. Most transactions, however, would be between account-holders. All the bank need do for these is adjust its deposit records; no reserves would be required.

Money, Liquidity and Solvency

In the discussion it seems that Tim is trying to make a distinction between money (as issued by the BofE), and credit (as being what commercial banks create when they lend). But I think Ralph is right in that since commercial bank deposits are more or less freely interchangeable with notes and coin, and as far as non-banks are concerned seamlessly appear from government and return to it, the distinction is not a practical economic one.

We’ve described the situation for a single bank, but in reality of course, there are several major commercial banks in the UK. When a depositor with one commercial bank wants to pay a depositor with another bank, the receiving bank is only interested in Bank of England money. Money created by any another bank is worthless as far as it is concerned. Therefore the first bank must have some BofE money available to support this transfer. If it doesn’t it has a liquidity problem. (Note that lack of liquidity must be distinguished here from lack of solvency. If I owe £100,000, but have no cash, I am illiquid. If I do not have assets (a house for example) to a value of at least £100,000, I am also insolvent.)

Fortunately for most banks there are lots of deposit transfers going on every day between them, and the vast majority of these will cancel out. This is the sense in which banks can move in step – they are all lending at around the same rate, and all receiving deposits at around the same rate. In this case the banks as a whole are effectively operating as if they were a single bank in the description above. Of course, in the real world deposit transfers between banks never match up exactly from day to day. So banks may need to borrow BofE money from each other or, if this isn’t possible ‘overnight’ from the Bank of England, to make sure everything is settled at the end of the day. When they borrow from the Bank of England they generally have to hand over government bonds, as ‘collateral’, until the loans are repaid. Over time any cost of this overnight borrowing is offset by the interest earned on the loans the banks themselves make.

Northern Rock was unusual in that while it issued lots of loans, mainly as mortgages, it received relatively few deposits. This made it dependent on getting a regular supply of loans of BofE money from other banks, using bundles of its mortgages (created by a process known as securitisation) as the collateral to reassure its debtors. The crisis in the market for loans between banks that occurred in autumn 2007 was therefore disastrous for them. Irrespective of whether Northern Rock was solvent (which depended on whether their loans would be repaid), it was illiquid. If it couldn’t convert the value of its mortgages into cash, it could not continue operating.

The Fall of the Rock

As a result Northern Rock had to ask the Bank of England for special loans where not just government bonds were accepted as collateral, but also the mortgage bundles that the other banks were now unwilling to accept. The making public of these loans triggered a loss of confidence in Northern Rock depositors about the safety of their deposits. The resulting additional removal of BofE money from the Northern Rock naturally made its problems worse. In the end, the Bank of England had to lend Northern Rock so much of its money to make it liquid enough, that the security backing these loans amounted to the whole Northern Rock business itself. At this point it had to be accepted that the UK government itself was the ultimate backer of Northern Rock, and so the bank had effectively been nationalised.

Now the question here is not whether Northern Rock should have been rescued or not, although it should be borne in mind that since it was never actually insolvent, the government could (although it probably now won’t) have made a profit from taking it over. The question we are interested in is whether or not Northern Rock failed because commercial banks ‘cannot create money’. In fact Northern Rock created lots of money. All of its mortgage book that was accepted by the Bank of England as collateral for special rescue loans created money, as did the value of its business in subsequent loans. But in normal circumstances Tim is strictly correct; by acquiring loans from other banks they would not have been directly creating money. Yet in another sense, Ralph is also correct, because by using this mechanism to keep ‘in step’ they were increasing the amount of deposits the current level of total reserves (of BofE money) could support.

Banks Can Create Money, but…

In summary, the ability of commercial banks to create money, given a particular initial quantity of BofE money, depends firstly on the extent to which the public are likely to demand banknotes and coin and need to make payments to government; secondly on the extent to which banks can co-ordinate their operations to ensure that reserves follow deposits between banks as smoothly as possible; and lastly on the willingness of the central bank to accept non-government assets as collateral. The significance of them being non-government assets is that the issue of government bonds always involves a withdrawal of already-existing BofE money from the economy. In other words, if the BofE lends on government bonds it is just returning to circulation money it has previously created and then removed.

So to all intents and purposes, banks can and do create money, although not quite as easily and costlessly as the PositiveMoney campaigners would have us believe. It is still an extremely powerful thing to be able to do though, and certainly needs more social although not necessarily more government control.

Future Economics - People, Money and Power

Banking as Fraud

I’ve got involved with one or two on-line debates recently in which the issue of money in commercial banking is seen as a fraudulent process by which value is stolen from citizens. Usually the central bank is seen as the government’s enabler in this process, and so to blame for the resultant misallocation of credit or ‘malinvestment’. This is a view to be found among adherents of the ‘Austrian’ school of economics, and ties in nicely with their extreme views of the efficacy of markets and the villainy of governments. Even if they do not believe the only money used should be gold, they believe that its value should be tied to gold and that central banks consistently devalue the currency by setting too low the interest rates  at which commercial banks borrow from them.

While the Austrians’ views are so dogmatic as to be fairly easily ignored, there has also been a recent tendency among some campaigners, such as Positive Money or GolemXIV,  to blame the current discrepancy between rewards to the rich and punishment for nearly everyone else on the banking’s ability to ‘create money out of thin air’. According to this view the banks then profit from this costless activity by lending it to us at interest, either directly or indirectly via government.

In fact the truth is that the banks have being doing too little lending to us, and too much to each other, and for the wrong things. To start with understanding what is going wrong with banking we have to understand what banks are really supposed to do, why it’s not fraud, and why the central bank should not be blamed for everything.

What Banks are (Supposed to) Do

Money is a tangible (or semi-tangible in the case of a bank deposit entry) representation of an abstract entity. The abstract entity behind the representation of money is a credit contract. A credit contract is a promise to provide something in the future in exchange for something now. So as long as such a promise is offered and accepted in good faith, the representation of that is no counterfeit.

And that is what banking is (supposed to) do – for a fee (interest) banks monitor and guarantee credit contracts so that the representation of the promise is widely accepted. Socially speaking, the fee for banking is in exchange for enabling the acceptance of as many viable promises as possible, by allowing them to be made in the form of goods and services that those accepting the promise do not themselves desire, but which have value on the market.

This sort of thing was going on long before the existence of central banks, and would continue to go on without them.  The banks willingly provide the guarantee for their fee; the promisers voluntarily make their promises and pay the banker’s fee; the promisees willingly accept these promises; and crucially, those accepting the guaranteed representations of this contract (money) also do so voluntarily. Credit banking is therefore a classic free arrangement of individuals, and any objection could only arise collectively – and so should certainly be anathematic to (economic) Austrians and all that value personal freedom.

If central banks play a malign role in this, it is because their guarantee to those accepting the representations of contracts enabled by multiple banks is provided at too low (or possibly too high) a cost, particularly given the moral hazard implications of such a guarantee. Of course it’s possible to argue that such guarantees are worthless, and so any cost is too high, but if some want it, should it not be available?

Future Economics - People, Money and Power

Long piece today by the Guardian’s economics leader writer, Aditya Chakrabortty, on the cost of the banking crisis, bank misconduct and what should be done about it. I agree wholeheartedly with the thrust of this piece, and indeed said much the same two and half years ago in my piece on the Guardian Cif site. Aditya’s piece concludes that

any investigation needs to understand how to reform the finance sector so that crises like these don’t recur; and so that banks actually work in the public interest rather than hire propagandists to pretend they do. Because in the end, financial reform is not about technicalities, but about politics: deciding what role banks should play in an economy, and what kind of economy we want.

However, he says also that:

According to the IMF, the British stuck £1.2 trillion behind the finance sector. Read that again: well over a trillion pounds in bailouts, and loans and state guarantees on bankers’ trading. In just a few months, and with barely any public debate, every household subbed £46,774 to the City. A sliver of that money eventually went unused; as for the remaining hundreds of billions, we have no idea just how much we’ll get back – or when.

I have some concern with these numbers. And, as I suggested in response to David Malone also, I think this is important.

It’s not exactly transparent how the IMF figures (from July 2009) he sources are compiled. I strongly suspect they are aggregating several different measures with different implications in terms of their ultimate costs for the taxpayer. The ONS ‘Public Sector Interventions in the Financial Crisis’ document from November 2009 provides a much more detailed guide.

The bulk of the ‘£1.2 trillion’ represents one side (the liability side) of a balance sheet that formerly belonged in the private sector and now belongs in the public sector. This ‘reclassification’ occurred as a result of the whole or partial nationalisation of Northern Rock, Bradford and Bingley, RBS and Lloyds/HBOS. Since the balance sheets were transferred wholesale, as well as the huge liabilities we also got the huge assets in the form of their loans, securities, other assets and ongoing business. Most  of the rest of the injection, in the form of various guarantees, much of which have now been discharged, attracted fees for the government. They were essentially insurance policies – taking on risk for a premium. And thankfully we didn’t have to pay out.

Taking all this into account the overall negative impact on UK government finances of direct support to the banks was estimated by the ONS to be around £10 billion by the third quarter of 2009 - big enough, but over 100 times less than Aditya’s number! We can add to this the subsequent £400 million loss on the sale of Northern Rock to Virgin.

Of course the final cost of all this will ultimately depend on any losses/profits made on the government’s shares of RBS and Lloyds. This is probably more significant than inflated claims of past costs of bailouts, because it plays a part in the approach now adopted. I think there is an overwhelming case for some form of ‘socialisation’ (albeit protected from day-to-day political intervention) of RBS at least, to act as a public interest benchmark, but we will have to permanently swallow any cash losses this entails.

It’s also important important to get the numbers right so as to emphasise that the costs to the overall economy of our banking sector are not one-off costs due to a particular set of bankers or their behaviour, but to the ongoing relationship between finance and the real economy. That is what has to be investigated, and what must change.

Future Economics - People, Money and Power

David Malone, a documentary film maker, perhaps better known these days as blogger on the financial crisis and its causes – operating under the name GolemXIV – gave a talk in Edinburgh on the 6th of December.

He’s quite a charismatic guy and gave an effective talk in a church with no aids other than a radio microphone. I hope that he will continue to campaign against the current acceptance of continuing economic policies that will undoubtedly make the majority of us worse off. I have offered him this commentary in the hope of improving our mutual understanding of the problems faced and how we might deal with them.

—————————————————————-

Dear David,

I was at your talk in St John’s in Edinburgh last Tuesday night and was impressed by the eloquence and passion with which you make the case that the current economic situation is a travesty of democracy and fairness. With that view I am in complete agreement, and I think you have the qualities needed to get the required message across.

I am an economist belonging to what is regarded as the ‘heterodox’ school, which is a somewhat all-encompassing term but is probably best defined for me as those who find the assumption of a welfare-maximising general economic equilibrium neither credible in reality nor helpful for understanding.

My particular area of interest is in understanding the way monetary economies actually work, and how flows and stocks of financial assets (including money) structure and affect the production and distribution of real goods and services.

I am sure that you used some simplification in your talk, but let me just suggest my take on the issue of debt and banking.

The Nature of Debt and its Relation to Money
Firstly, debt is simply a promise to provide something in the future that cannot for some reason be provided now – because it does not yet exist or does not exist in a form in which it can be immediately transferred to the creditor. In exchange for this promise the debtor receives something of immediate value, in a monetary economy usually a quantity of liquid medium of exchange (money). For a loan that is acquired for the purposes of production, it is this production that provides the means of repayment. A loan acquired for the purposes of consumption (if done so rationally) is a means of shifting that consumption to a period when it may give more utility benefit. While the quantity of money lent may well have been acquired by the creditor in some previous transaction, it need not have been (ie: it has been created anew by the creditor) as long as two criteria are met:

1) The value of the promise (on average) matches the value of the money issued
2) The creditor guarantees to ensure that in due course an equivalent quantity of money will return to him and be ?destroyed’ (or failing this he will subtract this quantity from the money that he or shareholders can remove from the bank – a debt ‘write-off’).

It’s important to understand that in a modern monetary economy there are only two types of institutions that are able to create what is generally accepted by the population at large as money.

Firstly, state central banks issue money for governments to purchase public goods and services on behalf of their populations. The matching promise is that the government will return this money (or most of it) through taxation and the sale of government securities. Note that in a modern economy, since all money is non-commodity money, there will always be an outstanding government promise to match the level of central bank money in circulation and held by commercial banks. In other words even notes and coins are created by some form of promise or debt. Without this, we would be confined to transactions that could be carried out with gold or some other commodity that was desirable enough, portable enough, and durable enough to serve the purpose. This would tend to waste time, energy and the commodities themselves.

Secondly, commercial banks have the right to create deposits in the name of their customers that must be converted (more or less) on demand to notes and coin by other commercial banks. These deposits are essentially a right to control of the same quantity of state-issued money. Because the transfer of the right alone is in the vast majority of cases adequate for transactions, the actual need to transfer notes and coin (or their electronic equivalent) is relatively small. It is this that allows banks to create deposits far in excess of the state money in existence. The commitment of a commercial bank to ultimately cancel the deposits it has issued is represented by the corresponding entry of a loan asset on its books. It is only allowed to maintain this as an asset if it has a realistic chance of seeing the money (the loan) repaid. If it becomes clear that it will not be repaid, then the bank is obliged to mark the loan as a loss, thus limiting the benefits that can be paid out to shareholders.

All money thus issued, whether by the state central bank or by commercial banks, is ‘debt money’ in the sense that it is matched by a promise, either implicit in the government’s commitment to balance their books in accounting terms or explicit in the commercial banks’ commitment to enforce loan repayment.

It is important to distinguish this debt from other forms of debt that are not associated with the creation of money, because only this debt is multilateral in that the promises associated with the money that is issued are made not to a single party, but to everyone who uses that money as a medium of exchange. This is what makes money so widely acceptable. It is also the reason why central bank money and commercial bank money issue requires close and transparent regulation. If the government fails to balance its books, its money loses value; if the commercial banks fail to enforce repayment and hide failing loans on their books, the same happens to theirs. In both cases the eventual disruption of inflation will result.

Debt and the Financial Crisis
You make the insightful point in your ‘Hammer of Debt’ blog http://www.golemxiv.co.uk/2011/12/the-hammer-of-debt/ that borrowing associated with the creation of money is a form of impatience. This is quite true, but I don’t think this means it is a bad thing. If we can improve our lives sooner rather than later (how much later?) then it surely makes sense to do so. And sometimes what is needed to achieve this is simply to be able to give a credible guarantee to share the future benefits of some activity. Institutions that specialise in backing these guarantees and are more ?patient’ than we are as individuals can serve this purpose.

Digression on Interest
In the same piece referred to above I note your comment on how dependent the whole miracle becomes on continuing to grow and to do so ever faster and faster, in order to keep ahead of the increasing cost of the interest on the ever growing amount of debt.

It’s important to note that interest is not actually a special problem of debt, over and above the issue of whether the principal is repayable. In the end a debt contract is a real contract – where the right to obtain a real value of goods now is exchanged for the obligation to provide a higher real value of goods in the future. (Note that value and quantity here are not strictly the same thing. Under different conditions the same quantity of a good can have more or less value.) The share of this additional real value going to the lender, and represented by the flow of interest payments, cannot realistically exceed what is physically possible. If no real additional value can be obtained to pay interest, there is in fact no real value in the contract, and it takes place as a consequence not of impatience or greed but of miscalculation by one or both parties. I’ve discussed this issue in more detail at http://www.futureeconomics.org/2010/07/on-the-impossibility-of-paying-interest

The Money Contract
Government money issue is a contract between the state and its populace. A functioning democracy with political and economic transparency is required to optimise this contract. Failing to do so can result in excessive deficits (if the books are balanced, but only by issuing ever more securities) or inflation (if the books are not even balanced in accounting terms). Commercial bank issue, assuming adequate enforcement of bank obligations, is a contract between the bank and the borrower. Reneging on the contract should bring costs to the borrower (eg: bankruptcy and collateral loss) and to the bank (profit write-off). Only in extreme circumstances (of regulatory failure and/or fraud) should commercial banks issue such a quantity of poorly-assessed loans that their ability to write-off these loans exceeds their value to the extent that they become insolvent. This is, uniquely, what happened in Ireland, but has not yet happened in the UK. As a result it is important to draw distinctions between the UK and Irish debt situations.

The difficulty for banks in the UK and most other countries was not so much that they themselves had made particularly bad loans (although some such as RBS had sailed pretty close to the wind), but that they found themselves with a quantity of securitised assets of uncertain market value. Any bank with a surplus of central bank money on its books wanted, instead of lending it to those with a deficit as was normal, to hold on to this to shore up any further unpleasant discoveries. Unfortunately many banks had become dependent on making good their short-term deficits in this way and now found themselves in urgent need of cash. Their good assets would for the most part enable them to meet their borrowing needs eventually – but eventually was not at the time good enough. Thus the role of large-scale but temporary government lending, recapitalisation and guarantees.

For the UK, therefore, it is not generally true that the private debt of financial institutions simply became the debt of the UK government. There would indeed have been little sense or justice in such a move. In fact what happened was that the UK government provided capital in exchange for assets whose long term value was as far as could be ascertained no less than the money with which they were purchased. The problem for the banks was that this long-term value was of no use to them in a frozen market from which they needed immediate liquidity.

The UK Bail-out Costs
The addition to UK government borrowing from ?bailouts’ was in fact no more than £4.7 billion in 2008, and £3.3 billion in the first three quarters of 2009. Yet total government borrowing increased by around £140 billion in 2008, and by around £200 billion in the whole of 2009. This is in contrast to the Irish position where bailouts cost them €4 billion in extra borrowing in 2009 and €30.8 billion in 2010, out of total deficits of around €24 billion and €49 billion in those years respectively. The reason for this was that the funding difficulties had revealed that the Irish banks were holding quantities of property loans whose return was never likely to offset their likelihood of failing to be repaid.

Of course this isn’t all there is to it because there are estimated to be £328 billion in contingent liabilities resulting from the measures of the UK government to support financial institutions. Given that all the entities to which these liabilities are attached (with the exception of the Northern Rock ‘good bank’, which has been just been sold to Virgin Money at an estimated loss to the government of around £400 million) are turning a profit in government hands it can be hoped that these liabilities will not crystallise into losses. They certainly have not yet contributed anything further to additional UK public debt.

Why, why, why?
The questions then arise:

1) Why did the UK government ‘save’ these banks?
2) Why has public debt grown as much as it did?

Why Save the Banks rather than Replace them?
I think the answer to the first question is more than just a temporary problem with obtaining cash from ATMs. As I explained above any transaction involving transfers of customers’ deposits from an account held with one bank to one held with another involves the transfer of a right to control of state money. As long as these rights transfers are netted out between banks the actual transfers that take place are a tiny fraction of the gross deposit movements.

But if there is suddenly doubt about the ability of any one bank to make these actual transfers (which will also mean they may have difficulty in supplying notes and coins on demand) then things can get sticky very quickly, because at the same time as other banks become unwilling to lend state money, customers start wishing to withdraw deposits. It becomes increasingly difficult for a suspect bank to provide transfer funds at the same time as the flow of such funds becomes increasingly uni-directional – away from the struggling bank. Once this process starts, the other banks become increasingly reluctant to accept deposit transfers because they are not sure if the first bank has the state money funds to avoid them banks ending up with deposit liabilities unaccompanied by assets.

In a situation where there is doubt about the liquidity of more than one bank, it is almost inevitable that panic both among the banks and bank customers would lead to general paralysis of the banking system and virtually all economic activity. If large numbers of people are unable to access routine transactions for any length of time, serious social disorder is not at all unlikely. The potential costs that could have been incurred to re-establish the monetary economy and restore social order suggest that Brown and Darling may have contained the direct costs to public borrowing pretty well.

The Growth of Public Debt
So that leaves us with the second question: Why did the UK deficits and public debt grow so much and so rapidly, and why does it appear so difficult to deal with?

If the problem was simply that some incompetent bankers made silly deals and big losses, even had these losses been fully absorbed on the public balance sheet, then continuing growth of economic activity of 2-3% would fairly quickly wipe out this one-off debt blip. A couple of years of losses are neither here nor there in relation to an ?infinite’ economic horizon.

Unfortunately the problem is much more deep-seated. As the banks’ difficulties became apparent they ceased willingness to lend (to each other and to businesses and individuals) in an attempt to shore up their state money reserves. They realised that not only had these been inadequate for the risks they had previously faced – and over-optimistically ignored – but now the risks had hugely increased and become more uncertain. The consequent impact on businesses and consumers was to increase their risks and uncertainty. Consumption, investment, lending, borrowing and tax revenue all fell alarmingly and remain low. The last of these impacts combined with the costs of rising unemployment are the explanations for the explosion of UK deficits and debt. And it’s quite possible that allowing large banks to fail might well have made these consequential problems worse, and therefore the public deficits and debt worse rather than better.

The General Impact of Debt
If debt in itself – being simply a contract that harnesses future expectations to enhance present production and consumption – is not in itself a problem, what makes current levels of debt a concern?

Government and commercial bank debt is always associated with exactly the quantity of money required to repay that debt. The extent to which it is not ‘repayable’ depends on the money becoming distributed in a way that blocks an easy route back to the issuer. It is always possible for the superior monetary authority to negotiate or enforce a route out of the impasse, if political will is present. Until this is done, borrowers are paralysed by their inability to obtain further working liquidity and lenders by their hope of gaining more by sitting tight, than by taking a short-term loss for the longer term gain of a resumption of normal activity.

For debt that does not create money, the issue is often more straightforward since the contract is a simple bilateral one; if the borrower is unable to repay then he/she loses collateral or goes bankrupt and the lender has to accept the loss. Both can then once again utilise their real productive capacity, albeit from a lower level of capital wealth. There should be no recourse to and no direct implications for the wider economy. The potential complications, however, arise if the right to repayment is opaque and diffuse, as can happen with securitised loans, or if the lender is unwilling to accept the loss because of its implications for his/her balance sheet. In both cases paralysis in which ongoing production (and consumption) capacity is not properly utilised is a likely result. Again a politically willing superior authority must be willing to quickly negotiate/enforce a definitive distribution of losses in these situations.

Why the Crash and what to Do Now
I think that the ?bank bailout’ should not be the primary issue of concern, although I accept that in a way it can be used to crystallise the false and unbalanced way the economic situation has been presented. The bailout may well have been the least worst option – perhaps this is true even for Ireland – at the time. What should be of concern is an examination of the way the economy was operating before the financial crisis – was a crash inevitable? And an assessment of how it should operate in the future. The before and after questions are related, in that if a crash was inevitable then it is clear that a better-regulated version of ‘before’ will not serve us in the future.

I think that some sort of crash, whether social, economic or both, was inevitable. This is because a system that relies on progress driven in one dimension (in this case that of monetary profit) must eventually become unbalanced. Eventually the need for profit must squeeze out all other considerations (human, social, political and environmental). Temporary accommodation (in the form of increasing debt, social and political repression and blindness to environmental concerns) may be possible, but in the long run physical reality must bite and the sources of profit can no longer provide what is demanded of them.

Note that the social democratic settlement, founded on Keynes’s macroeconomic insights, was also a form of accommodation. The profit motive was paramount everywhere apart from a state strong enough to extract enough of the profit to return the proceeds to those from whose labour much of it came, whether by direct transfers or by maintaining full employment.

It was easy to see the inefficiencies and restrictions in such a system, perhaps less easy to see how fragile the balance was. In the 1980s the former outweighed the latter in the minds of the UK public and politicians. The power of profit was untied and became too strong for the state. The latter has been in retreat ever since while at the same time being ever more burdened with the fall-out from inadequately checked profit-seeking.

One obvious route of reform would be to attempt to return to the social democratic settlement, and there is no doubt that in many areas a more politically inclusive state should have more supervisory powers over economic activities. The reasons why this is true for the financial sector should be clear from the exposition I gave above. On the other hand such a settlement is inefficient and restrictive in that it introduces frictions between consumers and entrepreneurs as decisions on investment and allocation have to be processed centrally; and it is fragile in that it relies on a delicate balance of power (which could in theory go either way) between concentrated capital power and concentrated political power.

I would therefore advocate a system that enhances the power of the informed consumer, along with that of the socially-integrated entrepreneur who internalises at least some of the externalities of his economic activity. Such consumers and such entrepreneurs would represent multiple points of stability, rendering the economic system as a whole much more resilient.

As such I would suggest the main points of attack as follows:

1) Broadening the base of economic power, by weakening the financial interest (without removing it) in larger businesses at least.
2) Developing a tax regime that encourages the productive (and sustainable) use of wealth rather than speculation and accumulation.
3) Creating a more open and inclusive political sphere with reform of the media and political processes.

As well as conducting on-going research into the issues discussed here, I have written extensively on my blog at http://www.futureeconomics.org

Hope to have further discussions with you.

Best wishes

Diarmid Weir

Future Economics - People, Money and Power

NY Federal Reserve building reflected in a pond on Maiden Lane

There was an intriguing juxtaposition last week, as the chief executive of Barclays, John Varley, penned an article on banking reform in the Financial Times the day before Paul Volcker, 82 year-old former Federal Reserve chairman and now chair of the US Economic Recovery Advisory Board, made a speech to the Federal Reserve Bank of Chicago International Banking Conference. The contrast between the attitude and tone of the two statements is striking. Varley was mealy-mouthed and defensive of the privileges of banks; Volcker frank and robust, departing in his speech from his prepared text to give full vent to his criticism of banks’ activities and the need to rein them in.

Varley accepts on the behalf of ‘the banking system’ the existence of ‘failings’, but is vague on specifics. He characterises critics of banks as accusing them of ‘irresponsible lending’ while also complaining that they must provide more credit, but since these criticisms are ‘irreconcilable’ he presumably believes them both to be nonsense. Investment banks are not casinos, he says; those that think many of their activities to be ‘gambling’ are the victims of ignorance. In his conclusion he implies that it is the banks, rather than the public or its representatives, that will do ‘what is necessary to restore confidence, to secure economic recovery and to create a more stable and resilient financial system.’

Volcker contradicts this self-serving line. In his view, ‘the prolonged disequilibrium in the world economy, …the borrowing, the high leverage, and the truly unprecedented levels of debt’ were ‘facilitated and extended by innovations in finance’, in particular the ‘complexity and opaqueness’ of securitization. He believes many derivatives were created not for genuine hedging needs but simply to earn large fees for the originating investment banks. Credit default swaps massively exceeded the actually possible defaults they covered and money market funds are pure regulatory arbitrage with the purpose of avoiding costly prudential constraints. Despite so much of this having been revealed by the financial crisis he still sees ‘signs of longing…for pre-crisis patterns, with its rewards of extraordinary profits and compensation from risk-taking.’

Volcker has been reported as saying that ‘the biggest innovation in the industry over the past 20 years had been the ATM cash machine’, and in his Chicago speech he dismissed concerns that appropriate regulation puts at risk a ‘sensitive and efficient financial mechanism’. In this light, when Varley says that ‘banks have a simple role in society’, he may be making a point that has a rather different resonance than he might have intended. Indeed the role of banks is to ‘help customers take appropriate risks’ as Varley claims. But the emphasis has to be on the appropriate. Appropriate for whom? For the borrower, for wider society, or for the banks themselves? Of course they have to be appropriate for all three. Loans for important household purchases and for new business ventures have to be repayable without the loss of homes or livelihoods; the revenue to repay capital and interest must be obtainable without social and environmental erosion and the banks themselves should on average cover their administration costs and loan risk. In this way banks may lend more or less, but more importantly they must lend better. To the extent that insurance against future price and interest fluctuations (the ‘useful’ side of derivatives to which Varley selectively draws attention in his piece) can provide needed certainty for real business ventures in an uncertain world, this should be provided transparently and at a fair price.

Volcker has previously remarked on excessive pay in the banking sector, and in his Chicago text he pointed out how ‘memories may be short when large rewards are at stake’. Varley’s weasel words referring to ‘pay [that] is consistent with the minimum needed to remain competitive’ are clearly designed to defend the status quo. In his world, traders who can successfully ride the waves of finance they themselves create are a source of profit rather than of instability and the destruction of real value.

The central claim of Varley’s thesis is that there is a ‘difficult trade-off between nurturing economic growth and creating a more resilient financial system’, but Volcker clearly makes the case that there is no such trade off when he says

…to the extent that the complexity, the opacity, the ultimate fragility of financial markets has contributed to the depth and the extent of the recession and its aftermath of unemployment and slow recovery, the need for new regulatory approaches is clear.

Mr Volcker makes it clear that public authorities must act to restrict the freedom of the financial sector to wreak profitable havoc. In particular he advocates transparency and consistency in derivative dealing, more general supervision of non-bank institutions and internalisation of their own risks along with preventing own-account speculation by publicly-supported commercial banks. He points out, however, that ‘judgement’ always forms a large element in financial sector supervision and that it is always very difficult for regulators to act pre-emptively against powerful financial interests. Whether this difficulty can be overcome by the sort of structural changes he hopes to see in financial market regulation must be open to question. From Mr Varley’s approach it seems likely that he and his ilk will continue to do their utmost both to limit such regulation and to frustrate its operation if enacted.

Future Economics - People, Money and Power

Edinburgh from Calton Hill

The 2001 winner of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel, Professor Joseph Stiglitz, was in Edinburgh last week to give two talks as part of the Edinburgh International Book Festival. He is a pioneer of the economics of information, showing how markets can produce unexpected outcomes because information is unequally available to parties to a contract. These outcomes can include bankruptcies that transmit further failures. So he was one of the few economists to whom collapse of the financial system did not come as a complete surprise. He noted the irony of his appearance in a large tent sponsored by the Royal Bank of Scotland, an institution that perceptively backed a large tranche of mortgage-backed securities, and ended up mainly owned by the UK government as a result!

Professor Stiglitz is also famous for turning on his previous employers, the World Bank, and criticising the policy of ‘structural adjustment’ imposed by this institution and the IMF on developing world borrowers. These arguments appear in his book Globalisation and its Discontents.

I attended the first of his Edinburgh talks, in which Professor Stiglitz started by pointing out that the three decades of crisis-free rapid growth that followed the Great Depression were primarily a result of the financial regulation introduced following it. As that regulation has been removed crises have become more frequent and more damaging.

He is fairly gloomy about the US economic outlook, pointing to a large and continuing increase in US savings rates as an indicator of poor consumer demand. While the government ‘stimulus’ was essential, he argued that it was ‘too small, too short and not well designed’. He is particularly critical of the US bank bailout, which will only yield a return to the US taxpayer of 67c in the dollar. Most of the money received by the banks has ended up as bonuses and shareholder dividends. He commended the UK’s approach as much superior. The result of the bailouts was in any case to concentrate the banking sector, reducing competition and accessibility of loans.

The austerity approach, he believes, has been shown by the effects of IMF policies to be unambiguously disastrous. As he pointed out, whatever the faults of government, they have never wasted as much cash as the US financial markets! A particular problem that needs to be addressed in recessions is the damage done to people’s long-term employment prospects, the so-called ‘hysteresis‘ effect. Professor Stiglitz argued that
this needs to be addressed by measures such as expanding education and providing apprenticeships.

His recipe for future stability includes correcting the misallocation of physical and human capital to finance, the creation of new credit institutions to provide the missing lending and helping deeply indebted home-owners to pay off their mortgages. There needs to a new balance between markets and government. He is not impressed with the new US financial regulation Bill, which he believes has been severely impaired by financial sector lobbying. Such lobbying influence is an inevitable outcome of a situation where the Supreme Court can rule that corporations have the right to free speech, and where there are five financial sector lobbyists for every US Congressman!

Specific finance issues that need to be addressed involve the competition between the ratings agencies to ‘bless’ asset-backed securities such as the mortgage securities that triggered the financial crisis, and the aggregation of high risk investment banking activity with the retail banking needs of individuals and smaller businesses that results in conflicts of interest and banks that are ‘too big to fail’.

Prof Stiglitz also criticised the focus of economic policies on measurements of economic progress such as GDP that fail to account for costs such as those to the environment. Having spent the last 100 years finding innovations that save labour, Professor Stiglitz claims we could now, with the right incentives and the right regulation, find innovations to save energy.

Noting that Professor Stiglitz characterised many of the issues as conflicts between government and market institutions such as banks and corporations (with the latter generally winning), I would have liked to ask him if he didn’t feel that while these different social institutions had purposes that so often conflicted we were not locked into a perpetual cycle of deregulation, crisis and re-regulation? I would have asked him if we ought therefore to be considering how to better align banks and corporations with human, social and environmental needs through innovations in corporate governance? Sadly, there wasn’t time for my question!

Future Economics - People, Money and Power

Well, if I ever doubted the wisdom of my Guardian on-line piece about bankers and their remuneration, here’s a bit more evidence from Prof Randall Wray in Kansas City!

When a firm approaches an investment bank to arrange for finance, the modern investment bank immediately puts together two teams. The first team arranges finance on the most favorable terms for the bank that they can manage to push onto their client—maximizing fees and penalties. The second team puts together bets that the client will not be able to service its debt. Since the debt cannot be serviced, it will not be serviced. Heads and tails, the investment bank wins.

Read the full article here. There’s lots more interesting stuff on their site as well! Have a look round (after you’ve read all the good stuff here of course!)

Future Economics - People, Money and Power

As I have mentioned in previous posts, I have been having some interesting discussions on the Chris Martenson Crash Course website. Chris wasn’t very pleased with me because I (presumably quite effectively) challenged one of his core tenets – that the monetary system is intrinsically doomed. In his post asking me never to darken his virtual doors again, he accused me of ‘avoiding [his] points’ from his previous post and stated that he couldn’t ‘see a lick of daylight or imminent actions’ in the discussion.

In fact, I had avoided answering the points in his previous post partly because I wanted to see the ‘daylight’ of a consensus on reform of the monetary system, with a view to action of some sort – if possibly not ‘imminent’, since it depends on a lot of changed minds first! Secondly I believed I had addressed all of his ‘points’ before. But maybe the argument got scattered across a lot of posts, and so I present a detailed response here to that last substantive post. I hope, also, that this will stand on its own as an explanation of why we need to work with our current system, rather than expecting it to collapse under its own weight or tearing it down to replace it with some new and untried (or failed elsewhere) system.

Contrary to Chris Martenson’s view, I think that debate an important one, for reasons that should become clear when you read this. But I also hope that it can be moved on to one that is about reform and alternatives to our current monetary system.

Asking the Questions

We need to start by clarifying the important questions here. What is it about the monetary system, in terms of its accounting mechanisms for repayment, interest and default, that we need to know, if we agree on the fact that the monetary economy is in a mess?

1. Is the current system as an accounting mechanism involving promises of future revenue manageable? Can its current controllers keep it going and avoid some sort of crash?

2. Is the current system reformable? Can it be changed to provide equitable social benefit?

3. If the answer to 1 or 2 or both is negative, is there a viable alternative to the current system? Perhaps a ‘sovereign money’, a commodity money or a commodity-backed money?

Non-productive loans

Chris Martenson claims that ‘loans [that] do not add to production…cannot be serviced by the “immaculate interest flow theory…”’ by which he means that ‘all interest flows to where it’s needed when it’s needed’.

I think it’s fair to point out that, at least as far as I am concerned, this ‘immaculate interest flow theory’ is a bit of a straw man. We’ll see why later on. It’s also slightly disingenuous of Chris Martenson not to admit that rejecting an ‘immaculate interest flow theory’ is rather a different matter from claiming that

With every passing year, the money supply must expand by an amount at least equal to the interest charges due on all the past money that was borrowed

as he does in his piece ‘The End of Money’.

To return to the issue of loans for non-productive uses; from an accounting point of view it is actually irrelevant whether the uses of borrowed money are productive in the sense of producing new real usable output. A loan creates exactly the amount of money needed to repay the loan, as well as adding to the flow of money part of which the borrower and lender hope will be captured to provide compensating interest revenue.

To show this, let’s consider a mini-economy in which two loans are made, one productive and one ‘non-productive’. Employee E works for Firm F. Firm F borrows $1000 from Bank B and pays E this $1000 as wages for his labour in producing the firm’s output over 1 year. Firm F’s loan is repayable over 1 year, and Bank B charges interest of 10% per year of the loan.

At the beginning of this first year E wishes to buy a car that costs $1000. Since he also needs to purchase some goods from Firm F over the year, it is clear that he cannot afford to purchase the car without taking out a loan. He does so, borrowing $1000 from Bank B, and purchasing the car from C. The loan is repayable over 2 years, and again charged at 10% annual interest.

Over the first year E receives $1000 in wages, $400 of which he uses to purchase goods from Firm F, and $600 of which he uses to repay the first instalments of his loan and the annual interest. Bank B recycles $200 of the money it receives from E to purchase goods from F (directly or through its employees and shareholders). C also purchases goods worth $500 from F. F’s total revenue for the year is therefore $400 + $200 + $500 = $1100. F can thus repay Bank B as well as paying the interest due on his loan.

In the second year F borrows a further $1000, which he pays to E as wages over that year. E again spends $400 on purchasing goods from F, and pays $600 to Bank B, $200 of which again is used to purchase goods from F. C spends the rest of his proceeds from the sale of his car on goods from F. F’s revenue for the year is again $1100, and he can again repay his loan and pay the interest due.

Accounting-wise this works flawlessly. The fact that the car loan was ‘unproductive’ makes no difference. What has happened is that over the two years of the loan $200 worth of of F’s output that would otherwise have gone to E, now goes to Bank B.

Is there any real justification for the transfer of resources from E to B that this represents? Or is it just evidence of the rent-seeking power of a bank? The answer is that it depends on whether the additional benefit for E of acquiring the car earlier than he would otherwise have done is matched by the transfer of goods from E to B. To some extent this is a subjective issue, depending as it does on the additional utility gained by E, but there is an objective aspect in that it is largely possible to calculate the costs to B of administering, monitoring and bearing the non-repayment risk of the loan to E.

What impact does the loan to E have on the other parties here? F still
breaks even, paying off his loan and interest. C is enabled to sell his car and so purchase goods from F. Assuming the interest charged by B is matched by the bank’s real costs, then there is only gain, no losses, and the accounting position at the end of the process is the same as that at the beginning.

Now, of course we have grossly simplified reality here, and ‘immaculate interest flow’ is unequivocally present! There are in fact many Fs, many Es, many potential Cs and several Bs. When B makes the loan to F, he cannot be sure that enough of the money so created will flow, via E as well as via other banks, back to him. The repayment and interest on the loan to E, whether made by B or some other bank, also depends on the ability and willingness of F to pay E his anticipated wages over the period. So in the real world, there is of course no ‘immaculate interest flow’! But in an established economy with thousands, even millions, of actors some constant patterns will develop. This allows banks and borrowers to assess with some degree of confidence the likelihood that any particular loan and interest contract is actually repayable. Clearly, this likelihood depends in part on other loan and interest contracts that are being made! The degree of confidence that exists will be reflected in the rate of interest that is charged. If the degree of confidence is high, then interest is likely to be low; if the degree of confidence is low, then interest will be high. In the latter case the bank may wish to obtain additional risk protection by obtaining collateral, or may even perceive the risk as so high as to preclude any loan at all.

Particularly important to the working of this system is clearly the behaviour of banks. If they simply reabsorbed all money that flowed back to them, then obviously this system could not work. Debts could be repaid, or interest repaid, but never both. But reabsorption of all money is neither possible for real banks, nor would they wish to do this. Firstly, banks have real costs. They have employees and they own or lease buildings and equipment. To pay for these, money must flow out of banks and back into the economy. Secondly, of the surplus of revenue over costs, much will be paid out as dividends to shareholders or to purchase non-monetary financial assets (excluding government bonds, which have peculiar consequences of their own that I touch on below, and explain more fully here). Money that is not spent by banks will build up as reserves that earn relatively little return. In fact banks do require a certain level of such reserves, and this contributes to the start-up problem that probably requires government money (or some other money external to the private banking system). I say more about this below. But there is no reason from the point of view of the system itself why banks should keep the level of their reserves at anything other than the minimum level required to cover their loans and other risky assets. If the system can operate stably, then this level should be pretty much stable, with the result that money inflows and outflows from banks are more or less equal. What happens in the real world is not this simple, of course, and I explain why later.

It is also important here to note the existence of an important mechanism that both helps to prevent money and debt building up in the system, and keeps banks honest. At some point, when it becomes clear that a loan cannot be repaid, the loan asset is removed from the bank’s balance sheet and an equivalent negative entry is made in the bank’s profit and loss account. This has the effect of reducing the bank’s share capital and so limiting its future ability to pay out dividends or purchase additional capital, while keeping its balance sheet level. It is this cost, the risk of incurring which, banks must factor into their interest rate charges.

Assuming, temporarily, symmetry of information and power in the lending market between borrowers and lenders and no tendency for intermediate agents to hold onto money that is issued – banks should, as a whole, break even, and all money should be reabsorbed. The risk element of the interest payments will be exactly matched by losses to the banks from failures of the return flow of money. Neither of these assumptions hold in the real world. We’ll come back to the first one shortly, but I want to deal first with the tendency for money-holding.

Money Accumulation

Martenson argues that the ability and desire of individuals to accumulate money is another reason why the existing monetary system is either unmanageable, unreformable or both. It is inevitable that where money passes out of the hands of borrowers to those that have no debts, that some of the latter may wish to delay their spending to a later date. Since money (especially in the form of bank deposits) is possible to keep safely and, especially if earning interest, with minimal loss of value it may well be kept in this form. This certainly creates a problem, particularly in getting a credit-money system started. The risk of money being held and not returned to the bank may be so great as to make the interest rate that covers this risk unacceptable.

But clearly, since money is lent and interest is paid in the modern economy, this problem has somehow been overcome. I believe it has been overcome in two ways. Firstly, bank-created money is not the only form of money in circulation. There is also money created by the state, and this can fill in the gap created by the holding of bank credit-money. Secondly once the economy is established, and stocks of money are held throughout it, large changes in money holdings are less likely. The wealthy can be reliably assumed to calculate very carefully their optimal holdings of money as opposed to other forms of financial wealth, such as stocks and bonds etc. in proportion to their income. This reduces the risk to banks and borrowers that must be covered by interest.

The Martenson argument is that debts increase ‘exponentially’; that the addition to new debts each year is in proportion to the level of already existing debt. Now he makes great play of this, with alarming looking graphs and examples, but increasing numbers are hardly in themselves a problem. It is the underlying real consequences of these numbers that are important.

Biological growth tends to be exponential, and by extension quantitative social change might be expected to be. Economic exchange, as measured by real GDP, has risen exponentially in quantity over the last 50 years. Most people in the US and in Europe would regard this exponential increase as having (up to now) contributed to a considerable increase in their living standards – few would want to return to the world of 50 years ago. Now if more exchanges are taking place, we might expect more money to be circulating. If more money is circulating, we might expect more of it to be held. If more money is held, then the level of outstanding debt will also rise. It’s not unreasonable to expect that if exchanges are rising exponentially, money circulation, money holding and therefore debt will all also rise exponentially. But, note carefully, under this scenario debt could rise exponentially and be a constant proportion of money circulation and of people’s incomes. If debt is a constant proportion of income it is probably not an increasing burden on the debtor – since the ability to service it is rising in proportion.

So what matters is not whether money holding and debt are rising exponentially – this is really not unexpected – but whether it is rising in proportion to incomes. In fact, in general, it is, and I noted this as far back as 1998, rather before Chris Martenson apparently. And no doubt banks, too, have played their part in failing to keep debt and incomes in line, but this does not alter the overall picture. So there is indeed a problem, but the roots of the problem are not to be found in the exponential growth of debt but in the imbalance between the growth of debt and incomes.

So if money accumulation is a cause of a rising debt burden, then it is not enough that this money is accumulating exponentially, but that it must be accumulating faster than incomes are rising. For this to happen as a consequence of compound interest alone, then the interest rate applied to this accumulated money must be greater than the growth rate of incomes. The system does not set interest rates, so the system does not drive this – only the decisions of its human operators do so.

Manageability

So, to summarise what I have said so far, although we have a system with exponentially rising debt, we also have a system with exponentially rising incomes, so the debt burden is not necessarily rising exponentially. To the extent that debt is rising fast enough to cause problems, the managers of the system have various tools at their disposal to mitigate these problems when they threaten the system itself. They can issue government money to fill the debt overhang. They can encourage banks to write-off debt that is obviously unpayable. They can convert government tax liabilities into interest-bearing financial assets, in the form of bonds, that can be sold to those that have accumulated large monetary holdings. As we have seen in recent years, the holding of these bonds gives huge leverage over government activity. All in all, it seems most unlikely that the beneficiaries of the current monetary system are going to allow it to collapse! They have all the levers to ensure that it persists in their hands. So I would say conclusively that the current monetary system is manageable. It is unlikely that it will crash under its own imperfections any time soon.

Equitable Social Benefit

So we move on to the second issue. Is the system reformable? Well, I hope that I have shown that the existence (and indeed the necessity) for interest does not automatically lead to the exponential growth of debt, even when ‘non-productive loans’ are being made, and that even when debt is rising exponentially this does not mean that a monetary system is necessarily unsustainable.

Instead what I would identify as problems are money incomes that are rising out of proportion with increases in activity that are humanly, socially and environmentally possible, and the imbalance between the growth of debt and incomes. Clearly the latter is likely to be caused by the former, as promises of future real growth are not matched by the actual incomes that are realised.

Which brings us back to two statements of Chris Martenson’s that I do agree with:

…that’s how humans operate within the debt based money system…

;

and referring more specifically to the Efficient Markets Hypothesis, but equally relevant here,

…complete garbage…due to such things as asymmetry of information and human greed…

These are indeed causes of the rising debt burden that we observe. But the money system, while enabling these features to cause it, does not itself drive it. Would these human behaviours and failures be problems without a monetary system? Of course they would, whatever system we construct. Indeed, they might be worse under any other system.

So, if we were to give up on the current monetary system on the basis of behaviour that is observed always and everywhere among human beings we are behaving irrationally, unless we are sure that we can replace it with a system that can tame these behaviours rather better. And I guess we can include among the possible systems the option of ‘no system’, where we allow systems of exchange to develop spontaneously from a sort of economic ‘null position’. It should be obvious that this is a very risky option, where the initial advantage will be with those with powers of physical force and natural resource control. Is the ‘preparation’ aspect of the Martenson Crash Course perhaps an acknowledgement of this? If so, I happen to think it a very, very nihilistic and perhaps dangerously self-fulfilling outlook.

Leaving the ‘no-system’ option to one side, once we have excluded any monetary systems that are logically unsustainable (and I think we have now proved that the current system is not one of these) then which system is best is always going to be an empirical question – which one actually works best when used? And given the nature of monetary systems this is an almost impossible task for whole systems, so it would seem that the only realistic approach is one of piecemeal trial and error of reforms.

So the answer to the second question that I posed at the beginning is that ‘We don’t know, but we will only find out if we try’.

Alternatives

Given that we have identified the problems that seem to lead to the current system producing the results that it does, surely the best first option is to try to find ways of mitigating these behaviours? After all, human beings have often found clever ways of dealing with their own problematic tendencies through institutional solutions – such as marriage, legal systems and insurance for a start. I think that the ongoing discussion between Damon Vrabel and myself shows that there are ideas for reform of the monetary system that deserve to be considered and hopefully implemented. So the answer to the third question is ‘Maybe – but I don’t think we’ve found it yet’. I don’t think there is any harm in pursuing this question alongside ideas to reform the current system. The two strands will hopefully inform each other, in any case.

Future Economics - People, Money and Power

I ruffled a few feathers at www.chrismartenson.com (more info here) – so much so that the eponymous Chris eventually asked me to cease and desist! You can view the ‘naughty thread‘ here!

He accused me of not addressing his points. I don’t accept that, but I do intend to respond in detail to his last substantive post in due course. Since I respect virtual property rights, I shall post that response here!

A positive outcome is an ongoing discussion with Damon Vrabel, a climber, alpinist, trekker and monetary reformer (among other things!) from Seattle. You can find him at The Council on Spiritual, Psychological and Economic Renewal

He has agreed to allowing our further email exchange to be posted here. For clarity I will put Damon’s words in blue.

10/08/2010

hi, love your photography! as a climber, alpinist, trekker, I got
into amateur outdoor photography a while back. loved it. but like
most hobbies, I totally jumped in and got addicted and then it died
off. anyway, my stuff didn’t come close to yours.

so I’m very interested in picking your brain more about money. I’m
taking nuggets I learn from technicians as I try to deliver the
strategic message on videos/articles/etc…

- you say money has to be an asset/liability at the same time. but
why do you say my idea of sovereign money wouldn’t be? my only change
would be to issue the money as an asset to the people rather than an
asset to banks. it’s still a liability of the government and used to
pay taxes.

- you had me leaning toward a nationalized Fed-type bank to issue low-
cost debt money rather than Treasury issuing asset money because of
this issue, but another economist I’m working with said that would
only work AFTER we transition from our current blackhole. he said the
only way to get the math to work and save our current system is to
issue asset money into the system to start drawing down debt. and
this is true…either we draw down debt in a way that serves the
people or it’s going to happen in a way that serves the banks (Dr
Hudson says this too).

- do you agree that the current system issues money as an asset to
banks and debt to government, then the banks issue money as an asset
to themselves and debt to people? seems to me that’s the high-level
structural framework of our system. 1) that just doesn’t fit any
sense of a rational world in my mind, and 2) banks creating their own
assets is a disaster waiting to happen…of course the disaster may be
upon us now.


10/08/2010

Hi there Damon

Glad you liked the photos. Strange – this is the second discussion site I’ve been kicked off in a week, but both episodes ended with praise for my photos! Guess I should learn something from that!

Sadly, my adventuring has never reached your heights, but here in Scotland we don’t have to go far for stunning and accessible scenery.

Do you have any objection to my posting this email and my response on my website – just in case any others wish to defy the Martenson ukase?

‘my only change
would be to issue the money as an asset to the people rather than an
asset to banks.  it’s still a liability of the government and used to
pay taxes.’

I did address this idea in the discussion, and I said (with slight editing):

What I think you are suggesting is a system in which the government transfers money directly to individuals in exchange for their contribution to collective endeavour. There would be no private banking intermediaries. But this centralised banking system would find it more difficult to acquire all of the information it needed to respond accurately and flexibly to money needs in different regions, sectors and business units. It would undoubtedly be at risk of being captured by particular political interests. The forces of competition would be absent. And the costs of monitoring, administering and bearing the risk of failing to re-acquire money would remain – they would become internalised to the govt (and us all) instead of being allocated to borrowers in the form of interest and to bank shareholders in the form of profit write-downs for bad loans.

I think that on first principles it is not possible to say whether a centralised or decentralised money system is preferable. I would suggest that experience (eg of the Soviet bloc) suggests the centralised system would have considerable problems.

‘he said the
only way to get the math to work and save our current system is to
issue asset money into the system to start drawing down debt.’

I’m sure there is a lot of debt held by people and institutions that will never be able to repay it – no question. How you deal with it depends on the type of debt it is. It is big error, in my view, to lump all debt together. But even the Fed does this in their stats. I don’t know why – I suspect some idiotic political edict.

There are probably three important debt categories.

1. Money-creating bank credit. Ultimately, we are all liable through our use of money when this is done wrong. The banks will have to write down a lot of this – but there may be a limit to this if they are not to be bankrupted (see below). The govt may have to accept some of this debt and pass it on as taxes.

2. Bilateral debt between non-government parties. This debt doesn’t create money. Basically this is for these parties to sort out themselves. Some will be bankrupted, with wider effects. The banks that maintained the payment system were helped to overcome losses from bilateral asset-backed securities (and derivatives thereof), because these ‘wider effects’ were rightly or wrongly deemed unacceptable.

3. Government bond issues. This debt actually removes or ‘destroys’ money. This is a form of bilateral debt between the govt and citizens and institutions – mainly domestic ones for the UK and US. It’s obviously important to all citizens because the interest and repayment of these bonds comes in the form of tax revenue from our economic activity. I think there is a big issue here about why bonds are issued for the further enrichment of the wealthy, when these wealthy should probably be paying more tax.

I felt before you were a bit confused about the role of bonds in the system. I can send you a bit of my PhD thesis that covers this, if you wish. (It’s not particularly technical – just uses balance sheets.)

As for issuing more ‘asset money’ – I guess what you’re getting at is the idea that the government could issue the equivalent of private bank money (but on the govt’s books, not the banks’) without the issue of corresponding base money. Essentially, I think this would more or less be electronic cash. Actual cash is issued via banks but they can’t earn interest on it and have to get it from the Fed at 1:1 with base money – so I can’t see how this is much of an advantage to them. The big question would be whether banks, if and when they received the new money, would be allowed to use it as reserves for creating further loans. If not, they would try to avoid accepting it when they could get standard money. In particular, they would surely deem it as unacceptable in the repayment of loans. Inevitably this money would be less acceptable and less valuable than the standard sort. I guess the govt could mandate that it must be accepted as loan repayment – but this is effectively equivalent to mandating loan write-downs.

If private banks can use the new money as reserves, then I don’t see how the new money is effectively any different from the old.

You’ve also got the problem that issuing new money to get rid of a loan problem requires the new money to go to the right borrowers. If not, you just increase the price level. I really don’t know how you’d go about it!

‘do you agree that the current system issues money as an asset to
banks and debt to government, then the banks issue money as an asset
to themselves and debt to people?’

More or less. Although technically bank money is a liability to the bank backed by a loan asset.

‘banks creating their own
assets is a disaster waiting to happen…of course the disaster may be
upon us now.’

Given the current state of things it’s difficult to argue with this, and generally I haven’t. But I think the key word in that statement is ‘bank’. What exactly is a bank? What is its purpose? How should it be run? Who should run it? If we could get that right, I think we would see a different picture.

Hope that aids clarity!

All the best.

Diarmid

12/08/2010

if we discuss it publicly my goal is to focus on the systemic issues
that it seems to me aren’t even allowed to be addressed in econ since
neoclassical economics is a wholly-owned subsidiary of the banking
establishment:

1) banking system:  banks are not intermediaries (what depositor is
involved in the decision to loan his money, not to mention leverage it
50x, like he would be if it were an intermediated relationship?).
they are pyramidal power structures thanks to fractionalizing.  until
economists start modeling the pyramidal nature rather than just the
intermediary dynamics, the world’s population is in real trouble.
banking is not simply an issue of accounting, but rather it
centralizes control over assets, and once the guys at the top start
removing liquidity, i.e. deflation, the lower population loses
everything.  I can’t imagine anything with more destructive potential
than that, so if we’re going to allow something so powerful to exist,
it should be in the public’s hands somehow…banking should be an
asset to the commonwealth.

2) bond market:  not just an issue of accounting or the government
adding/removing money.  if that was all it was, the govt could simply
do exactly that…print/add/remove dollars rather than print/add/
remove debt instruments that funnel interest to private capital
holders behind the Fed which then adds/removes FRNs (not dollars).  so
assuming away the differences between those 2 systems basically
ignores entirely the issue of pyramid, oligarchy, systemic usury, and
the ability of concentrated financial powers to convert governments
into collection agents for them.   (checkout my latest short article
describing this…http://csper.wordpress.com/2010/08/12/monopoly-money-and-the-international-banking-cartel/)

fyi I’m going to be out of touch in the mountains for a week.

13/08/2010

Hi Damon

Hope you had a great trip – any photos?

if we discuss it publicly my goal is to focus on the systemic issues
that it seems to me aren’t even allowed to be addressed in econ since
neoclassical economics is a wholly-owned subsidiary of the banking
establishment:

Hold on there! Econ isn’t just neoclassical economics. And they do get addressed – admittedly not yet where it matters. But have you visited George Soros’s INET site at http://ineteconomics.org/? There are some flutterings there… See the paper by my former PhD supervisor, Professor Sheila Dow, for example – http://ineteconomics.org/sites/inet.civicactions.net/files/INET%20C%40K%20Paper%20Session%203%20-%20Dow.pdf

1) banking system:  banks are not intermediaries (what depositor is
involved in the decision to loan his money, not to mention leverage it
50x, like he would be if it were an intermediated relationship?).

I’m not sure that trust fund investors generally have much more control over what is done with their funds, do they? And banks are different in that the money deposited is itself created by lending, and in any case of course the deposits are insured in a way that trust fund investments are not. But if that is an issue (and I believe it is) why couldn’t mandated governance changes give depositors a say in how their bank is run?

they are pyramidal power structures thanks to fractionalizing.  until
economists start modeling the pyramidal nature rather than just the
intermediary dynamics, the world’s population is in real trouble.
banking is not simply an issue of accounting, but rather it
centralizes control over assets,

Well, indeed – but you could say that government centralises control over people. If government is necessary, then this means we have to make it democratic. If banking is necessary (and I believe it is, or certainly inevitable!) then we have to make it democratic too.

and once the guys at the top start
removing liquidity, i.e. deflation, the lower population loses
everything.  I can’t imagine anything with more destructive potential
than that, so if we’re going to allow something so powerful to exist,
it should be in the public’s hands somehow…banking should be an
asset to the commonwealth.

Of course – but that doesn’t mean that money itself can be an asset without also being a liability!

2) bond market:  not just an issue of accounting or the government
adding/removing money.  if that was all it was, the govt could simply
do exactly that…print/add/remove dollars rather than print/add/
remove debt instruments that funnel interest to private capital
holders behind the Fed which then adds/removes FRNs (not dollars).

There was a confusion before because when you referred to FRNs. I though you meant ‘Floating Rate Notes’, but I presume you mean ‘Federal Reserve Notes’ (aka Greenbacks.) Are we on the same page this time? I think there is still confusion here about the different roles of base money and bonds in the monetary system. I’ve posted the relevant bit from my thesis on the web-site at http://www.futureeconomics.org/2010/08/the-role-of-a-central-bank

And to think of a ‘dollar’ as something that has intrinsic value, is a bit like thinking of a ‘gallon’ as something that has intrinsic volume! A ‘silver dollar’ has intrinsic value, as a ‘gallon of petrol’ has intrinsic volume! A Federal Reserve Note only ‘represents’ value if ultimately it can be used to extinguish a tax liability that is due to the US govt. Unless it is a commodity money (or a 100% commodity-backed money) there is no other way to give a govt ‘dollar’ value.

so
assuming away the differences between those 2 systems basically
ignores entirely the issue of pyramid, oligarchy, systemic usury, and
the ability of concentrated financial powers to convert governments
into collection agents for them.   (checkout my latest short article
describing this…http://csper.wordpress.com/2010/08/12/monopoly-money-and-the-international-banking-cartel/)

There is, I believe, a major tendency not to enforce appropriate tax liabilities on the wealthy but instead to push the liabilities into the future by buying off the wealthy with bond interest. This is because the wealthy are allowed to control the system at every level. I say ‘allow’ because I think we could collectively do something about it, if we spent more time thinking for ourselves.

As for your article about the primary dealers – I would make two observations. Firstly, bonds are not the base of the system – Federal base money is. Bonds can only be purchased by first obtaining this base money. Secondly, it may well be true that base money is priced too cheaply for banks, and that the return on bonds for these dealers is too high. To some extent this may be because of the power of the finance sector, and to some extent it may be because of decisions made in the (supposed) interests of the real economy. Solutions: reduce the power of the finance sector to seek its own benefit, and ensure that any surplus profit of the finance sector returns to the community.

Interestingly, I have recently found an academic article claiming to show mathematically that the circulation of money ensures that ever-increasing growth is required for firms to survive. In other words a perfect proof of the Martenson exponential growth thesis! You can access it at http://mesharpe.metapress.com/media/92pnwgmxvren491hfj6u/contributions/m/0/2/5/m025558361146707.pdf

And do you know what? It’s wrong. It makes a fundamental error in one of its assumptions that is entirely responsible for driving its conclusions. I made a slight adjustment to the model to make a more realistic assumption…and zero growth turns out to be perfectly feasible.

Best wishes

Diarmid

Future Economics - People, Money and Power

This is a revised extract from my PhD thesis.

Correction and minor edit 10/8/2012.

Introduction
In a modern state, the government has a monopoly on physical force and so it is natural that the government should provide the final backing to contracts through the legal system. Moreover, the government can use physical force on its own account to enforce its own purchasing and debt-collecting activity, in which State or Central Bank Deposit Money (SBDM) is created and spent, circulates and is destroyed. By imposing liabilities in the form of taxes that must be paid in the money it has created, the state can control the quantity of this money in the economy. This also serves to establish this money as a unit of account and gives it the status of a means of payment. (1)

By insisting on credit payments of taxes taking place in central bank money, the central bank also forces the other banks to hold deposits with the central bank, these deposits being increased when the government makes a credit payment to one of their deposit-holders and decreased when a deposit-holder makes a tax payment in credit money. Transfers of credit money between banks can then occur via their deposits at the central bank, allowing them to settle asset-liability discrepancies that arise as deposit-holders transfer Commercial Bank Deposit Money (CBDM) between each other.

The Outward Path of SBDM
The central bank issues deposits with which the government credits commercial banks so that those banks can create deposit liabilities in the names of firms and individuals who provide goods and services, including labour, to the government. These liabilities for the commercial banks are thus matched by increases in the deposits the commercial banks hold with the central bank. Thus there is an equal increase in both the liabilities and assets of the commercial banks. Given reserve requirements either imposed by the central bank or chosen by the banks themselves to avoid costly overdrafts, the commercial banks then have the option of drawing down their increased central bank deposits and converting them into central bank notes, if required, or more profitable forms of assets such as government bonds. They can, of course, also use the additional SBDM as the basis for additional loans, in which further quantities of CBDM are created.

In many modern economies, there is no imposed reserve requirement, and so the nature of the assets held by commercial banks to offset their liabilities depends on their own assessment of their likely need to have central bank money available for the cash demands of their depositors and for their own transactions. This means that while there is clearly a relationship between the creation of loans (and thus the flow of CBDM into the economy) and the cost of access to reserves for commercial banks, it is by no means likely to be a mechanical and easily predictable one.

In our balance sheet example we have taken the case of Firm F at Time 0 in Figure 1 below, where it holds unsold output and still has an outstanding loan of £50. Households H hold liabilities of £50 they have received in the form of wages. We assume that the state purchases F’s output using SBDM at the price required to exactly cover Firm F’s outstanding loan to commercial Bank A. At Time 1 the SBDM deposits now form assets of Bank A, while there is an equivalent CBDM deposit forming a liability for Bank A and an asset for Firm F. This now allows Firm F to repay its loan to Bank A. At Time 2 Bank A is left with an SBDM deposit that matches the CBDM liability of the H deposit holding. While the SBDM deposit is clearly a more secure asset than the loan to Firm F, and can be converted into cash as demanded by Bank A’s depositors, it is also a lower-earning one and so there is incentive for Bank A to use part of its SBDM deposit to purchase or create higher-earning assets.

Figure 1 – The Creation of Central Bank Money by Government Spending

The Inward Path of SBDM
When tax bills become due, individuals and firms pay these from deposits with the commercial banks. Deposits held by the commercial banks are decreased by the amount of the tax bill, as are the deposits of the commercial banks held by the central bank. In this way both the liabilities and the assets of the commercial banks are decreased. For example, let’s refer to Time 2 in Diagram 1. If household H has a tax bill of £50 and they make payment to the government tax authority the £50 SBDM asset held by the bank is removed along with the £50 CBDM liability. Total liabilities and assets held by Bank B would return to zero.

In a democracy, the power of the state to issue money to make purchases and demand the payment of taxes must stem from the agreement of the population at large that this system is working to their overall advantage. For this to be the case the deferral of consumption that is represented by their acceptance from the government of central bank money must be compensated for by the additional future consumption that the actions of government, thus funded, will provide. In this way the justification for the creation of money by government transactions is exactly analogous to that for the creation of money by private transactions; except that while such transactions in the private sector depend on potential bilateral benefits, in the public sector they depend on perceived overall social improvement.

If the commercial banks guarantee to exchange state money (as cash or deposits) on a one for one basis then the value in terms of real goods and services of both commercial bank and central bank money will be identical, although individuals and other non-bank entities can only transact in cash or CBDM, and banks must complete all their transactions in SBDM.

Reserve Ratios and Transfers
Because of SBDM the importance of quantities of deposits depends on how they arrive on banks’ balance sheets. If due to loans they have created themselves, their deposit/reserve ratio is increased; if due to loans created by other banks their deposit/reserve ratio is decreased, since the arrival of these deposits is accompanied by transfer of reserves from the issuing bank.

[T]he rate at which the bank can, with safety, actively create deposits by lending and investing has to be in a proper relation to the rate at which it is passively creating them against the receipt of liquid resources from its deposits. For the latter increase the banks’ reserves…whereas the former diminish the reserves… (Keynes 1971[1930], p22).

If all banks expand credit together the strength of the banking system depends on the central bank issuing enough SBDM to keep reserve ratios at ‘prudential’ levels. If there is a compulsory reserve ratio for commercial banks of SBDM deposits to total assets, the credit potential of the banking system as a whole depends on this ratio, the quantity of SBDM, the compulsory reserve ratio and the preference of the public for cash versus deposits (Graziani 2003, p88). If there is no compulsory reserve ratio and the public do not generally require cash, banks can expand credit to the point that their perceived risk of default outweighs their interest income. Note that this risk of default is limited to the issuing bank by the mechanism of ‘loan write-offs’. The consequence of a loan default is that when the loan asset is ‘written off’ from the balance sheet there must be a compensating reduction in the liability side, and so the inflationary consequences of excessive loans are minimised.

Should the transfer to other banks of SBDM have the effect of reducing a commercial bank’s reserves below the compulsory or prudent level (according to the prevailing regime) the bank must acquire additional SBDM by borrowing at interest from other banks or financial institutions, or by the sale of government bonds, thus losing the return on these, or by borrowing from the central bank at the prevailing base rate.

The amount of reserves at the disposal of a single bank depends on the total amount of reserves created by the central bank and on the fraction of those reserves obtained by that bank – thus creating competition for depositing customers of other commercial banks, as they bring transfers of SBDM with them. The reserve requirement for a bank may be lower when that bank has a greater share of the market for deposits, since a greater proportion of deposit transfers will be between customers of that same bank and so will require no SBDM settlement.

The Role of Government Debt
As an alternative to removing SBDM from circulation by current taxation, the government can take the option of issuing bonds in exchange for SBDM. These bonds earn interest, so that they create an additional long-run burden of tax liability. This is putatively off-set by greater flexibility in the tax regime and by providing a way for the central bank to control the quantity of SBDM currently held by banks. The latter is achieved primarily by setting an interest rate for short-term loans of SBDM in which government bonds are used as collateral (so called repo transactions). A higher ‘bank base rate’ will discourage such borrowing, tending to reduce holdings of SBDM and the potential for the creation of CBDM. Overall liquidity in the economy is reduced. A lower base rate will have the reverse effect, increasing holdings of SBDM and tending to increase overall liquidity.

More drastically, particularly when the bank base rate is close to zero, government bonds and occasionally other secure assets can be directly purchased by the central bank as a way of increasing the quantity of SBDM held by banks and increasing liquidity. The process is reversible; the central bank simply reselling the bonds it has acquired and removing the base money it previously created.

Figure 2 below shows how the process of SBDM creation through bond purchase or repo arrangements takes place. At Time 0 Bank A holds loans of £70, matched by total CBDM liabilities of £70 held by Firm F and Household H. It holds secure assets in the form of £10 of CBDM reserves and £20 of government bonds, matched by a share capital liability of £30. Its current reserve to loan ratio is 10/70. If this is deemed prudent, then it cannot currently lend more CBDM. If at Time 1 £10 of bonds are exchanged for £10 of CBDM, Bank A now holds £20 in reserves and can now lend £140 (creating a total deposit liability of £140) while staying within its required reserve ratio. The reverse of this process, involving the purchase of bonds from the central bank would correspondingly reduce the reserves of Bank A and its lending power.

Figure 2 – Creation of Central Bank Money by Bond Purchase or ‘Repo’

Monetary Policy and the Central Bank
Given that the main form of money circulating in the economy is that created by the commercial banks from their lending, it is clear that at best the control of the central bank over the money supply can be an indirect one.

[T]he central bank cannot ordinarily control the quantity of money. Any attempt to do so succeeds only in temporarily disrupting the smooth workings of the system until the dormant credit money system can be activated (Mehrling 1996, p331).

While it is true that the central bank could control the quantity of SBDM issued, the very performance of its regulatory and enforcement role (and deposit insurance) tends to reduce the practical need for banks to maintain high reserve ratios, and even if it did seek to restrict supplying its money to commercial banks desiring it, the immediate effect is not to reduce the purchasing power of wage-earners, but to restrict the production activities of firms. Modern central banks mainly operate by establishing a rate of interest to stabilise the system of notes and bank deposits, while making loans and accepting deposits at that rate as the lender of last resort (Nell 1996). Nor is the central bank limited to providing reserves to prevent a crisis but is an integral part of the monetary circuit (Rochon 1999). The central bank exogenously sets the real and nominal rate of interest over which other interest rates are a mark up. Even this limited role can be damaging:

Central bankers…believe that the consistency of the credit network requires the perfect stability of the value of money… Stabilising money prices of goods should protect wealth-holders against losses of purchasing power: money values of firms would thus rise; this increase in real wealth could support a sound increase in investment…The central bank’s own thriftiness thus sustains the rentier economy…where the generation of wealth is not dependent on investment expenditures (Parguez 1996, p183).

Summarising the Role of the Central Bank
It should be clear from the above analysis that the collective institutions of government and the central bank play a huge and largely autonomous role in the shaping of monetary transactions. The main features of this role are:

1. Provision of the legal framework that supports commercial banks in enforcing repayment of loans, thus ensuring that the CBDM arising from loan contracts is valued.

2. Provision of central bank money by which transactions between banks and between individuals or banks and the state can be settled in monetary terms. This potentially enhances efficiency and competition in the commercial banking sector.

3. The autonomous ability of the government to make purchases of goods and services for collective use, by the issue of central bank money. The commercial banks match this with their own issued money (CBDM) through adjustment of their balance sheets. There are various reasons why the government chooses to acquire the goods and services it requires in this way rather than simply by confiscation (which it has the physical power to do). Firstly there is the issue of equity. The resources government requires to fulfil its delegated functions may not be held equally by all. By issuing its money in exchange for goods and services, and then selectively confiscating this money in the form of taxation, the government can redistribute the burden of providing its resources. Secondly, for this system to be effective it of course essential that the money the central bank issues on behalf of the government is accepted. This is achieved by the requirement that almost all individuals and firms have some tax liability, and by the fact that central bank money and commercial bank money (itself demanded for loan repayment) are always interchangeable at a rate of one to one.

4. By ensuring a demand for its own money for the payment of taxes and the settlement of interbank transactions and by taking advantage of the demand of individuals for the portability and liquidity of cash by monopolising its production, the government may also hope to influence the quantity of CBDM issued. This is generally performed by setting prices (interest rates) for the central bank’s purchase and re-purchase of high-grade financial assets (open-market operations), and for the last-resort lending of central bank reserve money. This latter ‘lender of last-resort’ function together with regulations governing acceptable asset risk composition for commercial banks also gives the central bank a role in ensuring that commercial banks remain solvent and capable of allowing individuals access to their deposits at all times.

Footnotes

(1) The Chartalists see the whole monetary system as imposed by the state and argue that the state uses its coercive powers to force the acceptance of tokens in exchange for the goods and services that it requires to carry out its functions (Wray 1996, Tymoigne and Wray 2006). In my view the state is responsible for the imposition of central bank money and ultimately responsible for enforcing the contracts involved in commercial bank loans, but the use of tokens of these loans in general exchange is a voluntary act arising from their superior liquidity to any other means of exchange.

References

Graziani, A. (2003). The Monetary Theory of Production. Cambridge, UK: Cambridge University Press.

Keynes, J.M. (1971[1930). A Treatise on Money. Vol V of The Collected Writings of John Maynard Keynes, ed. D. Moggridge, London and Basingstoke: Macmillan.

Mehrling , P. (1996). The Relevance to Modern Economics of the Banking School View. In G. Deleplace & E.J. Nell (Eds.), Money in Motion: The Post Keynesian and Circulation Approaches.(pp330-340) Basingstoke and London: Macmillan.

Nell, E.J. (1996). The Circuit of Money in a Production Economy. In G. Deleplace & E.J. Nell (Eds.), Money in Motion: The Post Keynesian and Circulation Approaches. Basingstoke and London: Macmillan.

Parguez, A. (1996). Beyond Scarcity: A Reappraisal of the Theory of the Monetary Circuit. In G. Deleplace & E.J. Nell (Eds.), Money in Motion: The Post Keynesian and Circulation Approaches, (pp. 155-199). Macmillan.

Rochon, L.-P. (1999). The Creation and Circulation of Endogenous Money: A Circuit Dynamique Approach. Journal of Economic Issues, 33, 1-21.

Tymoigne, É. & Wray L.R. (2006). Money: An alternative story. In P. Arestis and M. Sawyer (Eds.), A Handbook of Alternative Monetary Economics (pp1-16). Cheltenham: Edward Elgar.

Wray, L.R. (1996) Money in the Circular Flow. In E.J. Nell & G. Deleplace (Eds.), Money in Motion: The Post Keynesian and Circulation Approaches, (pp440-464). Basingstoke and London: Macmillan.

© Diarmid Weir 2010

Future Economics - People, Money and Power