Ann Pettifor is a director of Prime Economics, which advocates for a more Keynesian view of macroeconomics, and has been involved in development and environmental economics for many years. In The Production of Money: How to Break the Power of the Bankers (Verso, 2017) she correctly identifies that ‘money enables us to do what we can within our limited natural and human resources’, and so ‘creates economic activity’ rather than being a result of it. It does this by creating the finance needed for productive employment and investment. Bank finance ensures that there is never a ‘shortage of money’ and so we are only limited by humanity’s capacity and the physical ecosystem. Yet when 95% of the money in existence has been created by the commercial banking system, whose aim (quoting Michael Hudson) ‘is not to minimise the cost of roads, electric power, transportation, water or education, but to maximise what can be charged as monopoly rent’, this power must be rigorously regulated. So much should be uncontroversial today and I have written about this here.
The second main part of Pettifor’s argument is that because money is a social construct, then so are interest rates. ‘Savings are not necessary to fund purchases or investment’ because banks can create money along with debt. Saving in the sense of obtaining a financial claim, whether a banknote, deposit, bond or share, always requires the prior issue of a debt from a process that involves time – an investment. The saving flow is a consequence of the investment flow rather than the reverse. This financial sense of saving is contrasted with the physical sense of saving a commodity for later use rather than consuming it now. If saving follows automatically from investment, interest rates do not derive from a supply and demand nexus for savings and investment but from the costs of issuing the debt that sets the whole process off.
Pettifor argues that
unmanaged and unregulated credit creation…leads invariably to excessive credit creation, the inflation of assets, prices or wages, the build-up of unpayable debts, and then catastrophic failure of the financial system as debts are defaulted upon.
Subsequently we may enter a period in which credit may be under-produced due to risk-aversion, leading to deflation and the rise of debt-burdens. These risks and the fact that the public sector plays an important role in allowing commercial banks to operate, mean that there must always be public oversight of money creation.
Since high interest rates are a critical element in the evolution of ‘mountains of unpayable debt’ which lead to economic stagnation, crises, and the transfer of democratic power to powerful wealthy elites, how interest rates are determined is crucial to our economic future. According to Pettifor, ‘credit is essentially a free good’, so interest rates should always be low in real terms on the basis that there is no opportunity cost to lenders in the sense that the money lent could be spent on consumption instead. Pettifor also argues that compound interest leads to exponential growth on debt and thus a requirement for exponential increases in income to service this debt. This leads to increases in working hours and the unsustainable exploitation of natural resources. In particular she believes that high interest rates followed on from the liberalisation of bank lending from 1971. Credit was ‘easy’, but ‘dear’.
Pettifor invokes Keynes’s ‘liquidity preference’ to argue that the influence of central banks depends on the desire for safe assets. A lack of safe assets due to austerity and Quantitative Easing (QE) where central banks buy up large quantities of public debt, has led to asset-price bubbles, especially in property, increasing the wealth of the already rich. Her recognition of the vital role of credit and money creation in economic activity leads her to reject calls for ‘Sovereign Money’ reform where all money is issued by the state. She believes that what is required is ‘to strengthen the hand of ‘the makers’ in relation to the private banking system, that is, the entrepreneurs and workers that create employment, provide services and undertake risky innovation.’
In Pettifor’s view of monetary policy, quantity is only a limiting factor and it is the volume of expenditure that matters. She therefore suggests new policies for regulating lending. We need to encourage productive activity with low interest rates and discourage speculation with high rates. Another proposal she supports is the adoption of standards for property loan-to-value, ensuring that credit for property purchase is tied to the long-term fundamental features of the property itself. Central banks should use the tools of debt-to-income ratios and limits on leverage. Monetary policy should aim to keep interest rates low by providing safe government assets that match the different private-sector time-preferences for liquidity. When this fails to induce the private sector to invest and spend, governments need to step in to fill the gap.
The general thrust of Pettifor’s argument is that the ‘Production of Money’ by banks is of vital importance to a well-functioning economy but one that has been poorly controlled, allowing its benefits to be accompanied by great harms. I believe this to be correct and that many of her proposed solutions are eminently sensible. Yet I believe that some important aspects of the problem are partially obscured by some errors of detail in her account.
I find some issue with her discussion of interest rates. Since ‘credit is essentially a free good’ if prior savings are not required, then interest rates charged to borrowers are ‘socially constructed’ just as money is, she argues. Yet this seems incorrect – banks may not be providing a scarce commodity when they create money, but they are providing a service for which the required resources such as monitoring attention, the capacity to make good the losses of debt default and the infrastructure required to attract deposits are all limited. Even if access to central bank reserves is cheap, the cost of acquiring these and other resources needs to be set off against the interest rate revenue received. The puzzle then becomes why banks have so often miscalculated the default risk element of their lending costs – an element which has no direct connection to the level of the bank rate. Interestingly the critique of the free-market Austrian school of economists, while ignorant of the workings of the finance system and mistakenly clinging to the idea that there is a ‘natural’ rate of interest that matches supply and demand for savings, also blame interest rates for the Great Financial Crisis. In their case, however, they believe that central banks set rates too low in the run-up – creating a demand for investment that exceeded the savings available. But the same critique applies – the cost of reserves alters the potential gains on a risky loan, but should not make the calculation of that risk more prone to error.
Another doubtful issue raised by Pettifor is the apparent exponential nature of debt growth linked to the compounding of interest. Interest only compounds if it is unpaid. If it is paid as it comes due it is recirculated as purchasing power by the recipient bank. A loan created where compounding is anticipated is recklessly risky for both parties – why should it be contemplated under normal business incentives? A productive loan (and this may mean various things, including the welfare benefit of time-shifted consumption) creates an income flow that exceeds outlay, allowing profit for the borrower and interest revenue for the lender along with debt repayment. There is no inevitability of the exponential rise in debt – it is not driven intrinsically by the way money and credit are created by banks.
So I think we need to look closely at the causes of excessive indebtedness rather than simply the consequences of ‘easy’ but ‘dear’ credit. For some reason systematic miscalculation is being made when loans are issued. Why might this arise?
- Interest payments are high enough and loan periods are long enough that expectation of default on the principal can be tolerated, particularly when collateral (such as residential property) is provided. This may arise due to asymmetric information and/or lack of competition. Policy such as loan-to-value and leverage limits, as suggested by Pettifor, could be helpful here.
- The lack of safe assets may lead to the substitution of more risky ones – even when diversified there may be underestimation of systemic risks. Even without such underestimation there are greater extremes in profits and busts, which may fuel volatility. This supports Pettifor’s conclusion that there should be less concern about the quantity of government debt, and more about packaging it in a way that delivers a range of desirable assets to the private sector.
It does seem however that there is also a perverse response to incentives, so that it is perhaps necessary to change the ‘material’ upon which those incentives act – ie: who makes lending decisions. This leads to a final point:
- Incentives of loan decision-makers are misaligned with business realities, let alone social ones, due to short-termism driven by the focus on ‘shareholder value’, remuneration considerations or due to herding in asset bubbles. Limited liability, particularly for the managers, of lenders and borrowers may misprice risks to firms and the economy as a whole. This suggests a major review of corporate governance and company law, particularly for major financial institutions.
Such a review might lead to a more ‘stakeholder’ approach to lending – so that decisions are taken under a dispersed democratic process rather than direct centralised state control or regulation. This may be expected to lead to less ‘speculative’ lending for purely financial gains, and more ‘productive’ lending for social, environmental and human welfare gains. I have previously written about this idea here. At the very least, managers of firms driven overwhelmingly by financial considerations should not expect to gain from the upside of their firms’ fortunes whilst being insulated by limited liability from the downside.