In this article that first appeared in the April 2013 edition of the Pensions Insight, I explain why unrestrained money creation by the banks is bad news for pension schemes.
With the British economy stuck in the longest recession since the 1930s, former chairman of the Financial Services Authority Lord Turner has been openly discussing the hitherto unthinkable policy of government-issued ‘helicopter’ money as a way out of the deflationary mire.
Given the failure of quantitative easing – the practice of exchanging bonds for bank reserves – to stimulate activity, Turner and also Financial Times commentator Martin Wolf have been questioning the bar on directly issued money, famously advocated by economist Milton Friedman in the metaphor of money dropped from helicopters to the general public.
“An obscure piece of legislation in 1971 (Competition & Credit Control) began to remove all constraints on credit creation.”
More people are beginning to appreciate how our money supply is created, thanks to the efforts of campaign groups such as Positive Money. Ninety-seven per cent of our public money supply, the money that is in our bank accounts, originates as credit created by private banks as accounting entries, literally out of nothing. Until about 40 years ago, this ability to create credit was strictly controlled by the Bank of England, but an obscure piece of legislation in 1971 (Competition & Credit Control) began to remove all constraints on credit creation and was completed under the Thatcher government in the 1980s.
Unrestrained credit creation is correctly identified by Turner as lying at the heart of the financial crisis. Just how is shown by the growth of this ‘broad’ money. In 1990 it was £500bn. Ten years later it was £1trn. In less than a decade it had doubled again to £2trn.
“When loans are repaid, money is destroyed, so new credit is needed constantly to keep the money supply stable.”
Basing the money supply almost entirely upon interest-bearing debt has dire consequences. It loads the economy with an exponentially growing debt overhead that inevitably reaches a limit. It stimulates asset price bubbles, most notably in housing, when what the economy needs most is credit to finance new investment. And it is unstable. When loans are repaid, money is destroyed, so new credit is needed constantly to keep the money supply stable. When banks cease to be net lenders to the economy, the money supply contracts, as it has by 17% in the past five years, creating havoc.
“Low long-term interest rates, aggravated by QE, give the worst of all worlds.”
For pension schemes, unrestrained credit money is bad news. Asset price bubbles lure investors into buying at the top and selling at the bottom. Low long-term interest rates, aggravated by QE, give the worst of all worlds – they fail to stimulate investment yet penalise savers and add to pension fund liabilities.
All this credit money would be worthless were it not for bank reserves (which are used to settle transactions between banks) and notes and coins in circulation, so-called narrow money. Banks are required to keep reserves (essentially electronic cash) with the Bank of England as a fraction of their deposits. It would, however, be a simple matter to require 100% reserves and give the Bank of England responsibility for maintaining the money supply, as it did successfully until 1971.
It could bring greater stability to financial markets, giving confidence to savers. Inflation would (at least according to modelling by the IMF), all but be eliminated, excellent news for pensioners. The money supply could also be managed under a brief to maintain full employment, another successful policy abandoned 40 years ago. This all seems too good to turn down, so when will senior politicians start to take notice?