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.
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.
6 replies on “Commentary on GolemXIV in Edinburgh”
[…] After a long absence, Dr.D returns with a long post on money & banking. Dear David, […]
You are back, just in time for Christmas! The link that I added didn’t seem to alert you to the fact that I’ve started looking at this post.
Disclaimer – I’m not an economist.
Interesting analysis. A couple of questions
“The difficulty for banks in the UK and most other countries was not so much that they themselves had made particularly bad loans ”
How can this be reconciled with the reality of any UK bank lending into a housing market that had entered into a speculative bubble?
On money creation – isn’t the problem that
“1) The value of the promise (on average) matches the value of the money issued”
didn’t happen on a large scale, the reason for which is that commercial bank’s incentives were not aligned with this premise. The result being debt based asset speculation along with its associated misallocation of capital.
“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’).”
and that for 2 governments have done everything they can to prevent the destruction of this money, via changing the rules on how banks “mark to market” their “assets” and accommodative monetary policy now verging on financial repression.
On the “Growth of public debt” along with the causes you outline wasn’t there also a substantial stimulus package including a VAT cut that contributed to this.
Isn’t it a measure of how much speculative and unproductive debt was created that even despite the efforts to prevent recognition of this debt and despite the stimulus the economy is still faltering.
Thanks Dave. Interesting points.
I would consider that there are two categories of ‘bad loans’.
Firstly there are loans that are unlikely to be repaid. If a bank makes a lot of this type of loans then they are either incompetent or some sort of fraud is going on. A lot of this type of loans were made in the US and were subsequently securitised and sold to banks in the US, UK and elsewhere. Some of this type of loans were made in the UK by some banks but not enough I think to be the primary problem.
The second type of bad loan is that which is likely to be repaid but only with revenue which the borrower has obtained without creating genuine value. Loans repaid with the proceeds of a continuing speculative bubble would come into this category. This clearly does involve the misallocation of capital. On that I am in complete agreement with you.
It is certainly true that governments have put a lot of effort into preventing banks collapsing as a result of their holdings of unmarketable assets. They might justify this on two counts. Firstly the fact that assets are currently unmarketable does not mean that they have no value in the long-term. Secondly the consequence for the economy of a large-scale banking collapse is likely to be the same as the absence of oil for an engine – catastrophic.
On the other hand it is clear that we (through the actions of our governments) have earned the right to ensure that in future banks work for us instead of themselves and do indeed create real value with their lending.
As for there being a ‘substantial stimulus package’ for the UK, I’m not sure whether this is a correct description or not. It is true that for the 2 years subsequent to the crisis pre-existing UK govt expenditure plans were enacted while revenues fell off a cliff. You could call this a stimulus by default I suppose! It’s difficult to believe the VAT cut had a major impact on revenue reduction.
This chart of real expenditure and receipts may clarify the picture somewhat.
“It is true that for the 2 years subsequent to the crisis pre-existing UK govt expenditure plans were enacted while revenues fell off a cliff.”
I think your right, however, the key is how much of that pre-existing spending was based on revenue that wasn’t “real”, i.e., growth and hence revenue which were being artificially inflated by unsustainable credit growth.
On the banks, It’s not my contention that the banks should be allowed to collapse but that until some reality is imposed on the banks valuation of their assets they will not engage in real productive lending.
Of course a whole host of other reforms will be needed to prevent a recurrence of this mess..
Thanks for the reply and the graph. As a lay person, both having the time and knowing where to ascertain good data is not easy.
Yes, but as it stands that argument can easily be turned against the BofE (and thus any form of state intervention), if low base rates are blamed for the credit growth. Maybe base rates did not reflect the true cost of state backing of the system – but the need to keep them low was surely a consequence of imbalances in the economy.
Indeed, but I think it’s not just the banks. There has to be some reality checking about the value of all financial assets. Their value can only be that of the real assets upon which they are based – and that value can only be realised by their proper employment.