One of our supporters Simon Davies has recently received a response from the Treasury to a letter he sent to George Osborne back in March. Below you can read the response from the Treasury (their standard ‘carbon copy’ response letter we’ve seen many times already). Simon has responded to some of the points made by them in blue text. We invite you to write your comments below.
Original letter by Simon Davies:
Dear Mr Osborne,
I am very concerned that we are being asked to pay the costs of a crisis caused by the banks. I recently discovered that while the UK government has supposedly ‘run out’ of money, commercial banks effectively have a licence to create money literally out of nothing. They do this by ‘extending credit’ in banking jargon, or typing numbers into a borrower’s account in plain English. The numbers in your account and mine were created not by the Bank of England, but by a high-street bank. I found this hard to believe at first, but the attached quotes – bsd.wpengine.com/how-banks-create-money/proof-that-banks-create-money/ from the Bank of England and Martin Wolf, of the government’s Independent Commission on Banking confirm that this is how the process works. Banks are able to create money only because the law that governs the creation of £5 or £10 notes has never been updated to take account of the digital money that now makes up 97% of all the money in the economy.
According to the Bank of England, the banks doubled the amount of money in the economy – through reckless lending – between 2000 and 2007 alone. If all the banks increase their lending together, they can expect new deposits to return to them and the money supply will increase. In other words, the new loan comes before the new deposit. No democratic decision has ever been made to entrust banks with the power and privilege to create money, and I feel that – given their performance over the last few years – now is the time when we should take this privilege away from them.
Could I ask you to watch the three minute video available at bsd.wpengine.com
The UK has huge debts in line with many other nations. The Public, Private, and Corporate debt total is several times annual GDP, and the public debt is forecast to grow by another £120 billion this year and is now more than £1 trillion. My own view is that these debts can never be reduced when nearly all money comes into the economy as a debt. We need the Central Bank to create debt free money, free from political influence, so this can be spent in the economy. This would be different to quantitative easing, in that the money would be directly spent on public infrastructure and / or injected into the private sector. QE has just helped to repair the banks’ balance sheets, and not much has got into the real economy. The other weakness with QE is that this money is required to be lent on again by the banking system. This would be done in such a way as to gradually reduce the debt money and replace it with debt free money, and so as not to cause inflation or deflation. The government here exhorts the banks to lend more, increase “credit”. This merely increases debt. Debt free money reduces the need for austerity, higher taxes, and the need for the government to keep borrowing more. We have gone from boom to bust as people try to pay back loans, banks become more cautious with their lending, and so there is less money in the economy. The UK government is relying on economic growth to help us repay our borrowings. This is usually accompanied by yet more debt and money in circulation, because debt equals money. For those who say introducing debt free money would be inflationary, then private bank generated credit certainly managed to produce a lot of inflation by causing property prices to rise by 200% in 10 years from 1997 to 2007.
Further economic benefits are highlighted on the Positive Money web site at bsd.wpengine.com.uk
It means the commercial banks have less power and influence, make less profits because their money making privilege is taken from them, but they become genuine intermediaries, and serve society, rather than the other way around. Banks balance sheets are reduced, and they have less power to hold society and countries to ransom, as we have recently seen in Cyprus. I am sure you will agree that it is wrong that innocent citizens and tax payers pay for the sins of others. The government has introduced a raft of complicated measures since 2010 to control the behaviour of big banks, but this measure is by far the most straightforward and beneficial for society.
Positive Money have produced 2 books :-
“Where does money come from ?” which is an accurate guide to the UK monetary and Banking system, in collaboration with the New Economics Foundation.
“Modernising Money” which shows how to fix our broken monetary system.
My father Bill Davies is a retired engineer who used to run his own business. He has been looking at money and banking for over 40 years, since we had the great inflation of the 1970s. My Welsh grandfather’s savings for his old age were severely depleted by this inflation. He has produced a web site detailing his views at www.legalforgery.com You might be interested by the illustration on the site of a horse and carriage rushing to save Backhouse’s bank in Darlington, in the 1800s. The Duke of Cleveland had instructed his employees to redeem their notes for gold, so as to cause a “run on the bank”. The Backhouse brothers managed to get to London and back in a few days with more gold to save the bank. I became interested through Dad’s work, and 5 years ago I had savings in Northern Rock. I was standing in line outside the bank thinking my money may have gone, a bit like the people of Cyprus were doing recently.
Thank you for your time and interest.
Simon Davies 22 March 2013
Treasury response May 2013 including responses by Simon Davies in blue color:
Thank you for your letter dated 22 March. As it is not practical for Ministers to respond to all letters they receive, I have been asked to reply on their behalf.
In referring to the creation of money by commercial banks, you may be referring to the system of Fractional Reserve Banking. Under this system commercial banks do not need to hold deposits wholly in cash. Instead, banks maintain a fraction of deposits in cash reserves and lend out the remainder. They remain obliged to redeem all deposits on demand.
You are describing the multiplier model which does not apply in the UK. It is more a “balloon” model where the loan comes before the deposit. When all the banks increase their lending together, they can expect new deposits to return to them, as described in the book “Where does money come from ?” and in the website legalforgery.com Plainly banks cannot redeem all deposits on demand, as happened recently with Northern Rock, and all banks are protected by the tax payer deposit guarantee up to £75,000. This allows them to take excessive risk, knowing they are underwritten by the tax payer.
This system is fundamental to the availability of credit
(Assuming there is a difference between credit and money, there is not when credit becomes new money)
in the economy and is not an illegal activity or exploitation of a legal loophole. The Independent Banking Commission’s Report stated that, “A complete move from fractional to full reserve banking would dramatically curtail the lending capacity of the UK banking system, reducing the amount of credit to households and business and destroying intermediation synergies”. This restriction on credit would dramatically limit investment in the economy, harming long term growth.
The whole point is to reduce bank created “credit”, and replace it with debt free money, so the money supply increases in line with increasing population, assets, and economic activity, and the economy is not harmed through inflation or deflation. Commercial bank created credit doubled the money supply between 1997 and 2007, being the main reason house prices tripled in this period. There is not a shortage of homes, just affordable ones in many areas. We now have a shortage of money as government and individuals try to pay back excessive debts after the boom years.
The Bank of England retain control of the monetary base, which consists of currency and reserves held by commercial banks at the Bank of England. Commercial banks are responsible for lending to individuals and businesses. When commercial banks make loans they also create deposits which are included in a broader measure of the money supply known as M4. Commercial banks’ ability to lend is constrained by the need to ensure they retain sufficient liquidity to meet the demands of their creditors.
Interest rates were much higher between 1997 and 2007 than they are now, and this did not constrain banks’ lending. The only constraint was the demand from good, or not so good borrowers, and the banks confidence in lending. Banks are much less confident now, despite record low interest rates, so there is less money in the economy and we have gone from boom to bust as people try to repay debts.
You also suggested an alternative way for the government to issue currency and it may be helpful if I explain why UK does not do this. The majority of the Government’s borrowing is financed through the issuance of UK government bonds known as “gilts” by the Debt Management Office (DMO). A gilt is a debt instrument that pays semi-annual coupons to the holder up to and including the date on which the principal is repaid. The DMO primarily issues gilts to the market via auctions. Gilts are typically purchased by large investment banks (known as Gilt-edged market makers (GEMMS)), which in turn sell the gilts onto end investors. The GEMMS consist of 21 firms who actively trade in the secondary market. Insurance companies, pension funds and overseas investors are currently the largest holders of gilts.
Investors would have to look elsewhere for a return, for example shares, and rely less on gilts if the government issued their own money.
Unfortunately your suggestion that the Government issue its own money is problematic as it does not allow for the separation of fiscal and monetary policy, which is a key feature of the UK’s economic policy framework.
In practical terms, they are not separate now.
The printing of money is a monetary policy tool, and to use this to meet fiscal objectives, such as financing government investments or spending, could conflict the Monetary Policy Committee’s (MPC) objective of price stability and undermine confidence in the UK’s monetary policy framework.
The money supply doubled with commercial bank created credit between 1997 and 2007, and it was the main reason why house prices tripled in this period, with an associated increase in private debt. The money supply and inflation is unlikely to increase when people are trying to pay down excessive debt, and there is plenty of spare capacity in the economy, as is the case now. The government is very happy to allow 3% of the money supply to be created free of debt and interest (physical cash), but not electronic money. Why is this the case ?
The MPC, which has full operational independence for setting monetary policy, is not permitted to issue loans to finance the Government’s’ borrowing requirements.
We are suggesting the MPC create the money free from debt and interest, and free from political influence, not issue it as a loan.
The current system does not permit uncontrolled expansion of the money supply. The UK has an inflation target of 2 per cent annual inflation as measured by the Consumer Prices Index.
This has been missed for much of the last 10 years, and the CPI is a poor indicator of inflation or control mechanism, especially when house prices are not taken into account.
The MPC at the Bank of England sets the Bank Rate, the interest paid on commercial banks’ deposits at the Bank of England, in order to achieve this target. An increase in the interest rate increases the incentive to save and makes it more expensive to borrow: the money supply adjusts accordingly.
Interest rates were and are a very weak regulator of money supply. The money supply more than doubled between 1997 and 2007, when interest rates were much higher than they are today, when the money supply is growing very much more slowly. See what I say above about the confidence of banks and borrowers for increasing debt and the money supply. The money supply has gone up by more than 100 times since 1960, when people and assets in the economy have not. Most of this increase is down to bank created credit.
You may also be interested in the Bank of England’s 2011 Q3 quarterly Bulletin which analysed in detail the impact of the 200bn of asset purchases carried out between March 2009 and January 2010 on nominal demand. Bank staff surveyed various econometric models and from these calculated arrange for the potential impact on GDP and inflation. They estimated QE had raised UK inflation by around ¾ to 1 ½ percentage points and increased real GDP by around 1 ½ to 2 per cent.
As the Bank of England has further explained in its paper entitled “The Distributional Effects of Asset Purchases” published on 23rd of August 2012. “Without the Bank’s asset purchases, most people in the UK would have been worse off. Economic growth would have been lower. Unemployment would have been higher. Many more companies would have gone out of business. This would have had a significant, detrimental impact on savers and pensioners along with every other group in society.”
QE is a halfway house solution, with much of the new money remaining in the banking system, helping them to repair their balance sheets, rather than benefitting society. I agree without it, the economy would be in an even more difficult situation. It is highly unlikely that QE will be reversed now, with Quantitative Tightening, because this would greatly reduce the money supply and make the recession much worse. It is likely the debt to the Bank of England will be written off.
Yours sincerely Ellie Canham, Macroeconomic Coordination and Strategy, HM Treasury