Positive Money’s proposals to reform the creation of money have recently been commented on by Martin Wolf, the chief economics commentator at the Financial Times. Ann Pettifor argues that the proposal is ‘deeply flawed’ and would lead to “a shortage of money, high unemployment and low economic activity”.
I want to address some related points Ann raises, many of which are common misunderstandings. In particular, the idea that preventing banks from creating money would result in a deflationary, low economic activity, high unemployment environment, in which business are unable to obtain credit in the economy.
Related to this is the fear that there is a political agenda behind reform of the monetary system. At various points in the article Ann associates the reforms with various schools of economic thought: the Chicago school of economics, Austrian school, neoclassical school, monetarism, Margaret Thatcher, Milton Friedman, and the Gold Standard are all invoked.
The theme that runs through all of these links is presumably that banking reform is inherently political, and biased towards a right-wing agenda. This agenda, it is implied, is to be achieved through the economic policy of restricting money creation, spending, and credit to businesses. This would make it difficult for individuals to borrow to set up and start businesses. This restricts entrepreneurial activity, and the potential for economic advancement, to the already wealthy. Entrepreneurs, are, as Schumpeter remarked, likely to have ideas but no money.
In this short article I want to argue that banking reform of the type advocated by Positive Money is inherently non-political. In fact in one sense the reform proposal can be thought of as a simple regulatory/legal change. Once this change has been achieved there are different policy choices available which would make it more appealing to left-wing or right-wing commentators respectively, but the proposal itself does not automatically lead to either more or less spending, lending, employment or economic activity.
For those unfamiliar with our proposals, here is Martin Wolf’s concise summary. More details can be found here.
“First, the state, not banks, would create all transactions money, just as it creates cash today. Customers would own the money in transaction accounts, and would pay the banks a fee for managing them.
Second, banks could offer investment accounts, which would provide loans. But they could only loan money actually invested by customers. They would be stopped from creating such accounts out of thin air and so would become the intermediaries that many wrongly believe they now are. Holdings in such accounts could not be reassigned as a means of payment. Holders of investment accounts would be vulnerable to losses. Regulators might impose equity requirements and other prudential rules against such accounts.
Third, the central bank would create new money as needed to promote non-inflationary growth. Decisions on money creation would, as now, be taken by a committee independent of government.
Finally, the new money would be injected into the economy in four possible ways: to finance government spending, in place of taxes or borrowing; to make direct payments to citizens; to redeem outstanding debts, public or private; or to make new loans through banks or other intermediaries. All such mechanisms could (and should) be made as transparent as one might wish.”
Would the proposal lead to a “shortage of money”?
Ann states that this system would result in “a shortage of money, high unemployment and low economic activity”. Presumably therefore, Ann believes that those tasked with creating new money in a reformed system – the central bank – would deliberately act to restrict the creation of new money in order to reduce spending in the economy as a whole.
However, we explicitly argue against this policy choice in Modernising Money, (shorter paper available here), as Martin Wolf points out above.
Instead, a committee at the central bank would be tasked with hitting an inflation/employment target, just as the Monetary Policy Committee at the central bank does today. Only instead of using interest rates to influence how much people borrow (and therefore how much money private banks create), they would create money directly and inject it into the economy through the mechanisms outlined above (government spending, tax cuts, repayment of public debts, or provision of funding to banks to on-lend to businesses that contribute to GDP).
So, for example, if unemployment was high, the central bank would create larger amounts of money and grant it to the government to spend into circulation, increasing aggregate demand and reducing unemployment in the process. Consequently, there need never be a shortage of money. And there need never be a shortage of spending, so deflation is out the question.
In fact, a drop in inflation below the target rate would automatically lead to more money creation and more spending in the economy. There are no grounds for Ann’s conclusion that this would lead to “a shortage of money” in the economy. Indeed it is far less likely to lead to a shortage of money than the current system, in which loan repayments destroy money and must be continually replaced up with new loans issued by banks to avoid a fall in spending and a rise in unemployment.
Would there be a shortage of credit to businesses?
There is however another related argument which Ann discusses in her article, namely that there may be a lack of credit to businesses:
“If the issuance of credit or money is to be restricted to equal the money set aside in peoples’ piggy banks – the “savings” that Martin Wolf refers to – then society would revert back to the Middle Ages, or to the age of the Gold Standard. We would have to restrict what society can do, in economic terms. That would mean a shortage of money, high unemployment and low economic activity – while those with savings would charge high rates and flourish.”
Its important to note that under the specific policy choices outlined in Modernising Money, the amount of credit (lending) available to businesses is not limited to people’s savings, as Ann claims. Indeed, Martin Wolf’s summary above makes this clear: in fact the quantity of bank lending would be limited to peoples savings plus the amount that the Bank of England made available to banks to on lend into the economy. In Modernising Money we suggest that the Bank of England should only lend new money to banks on the condition that the new money will be subsequently lent to businesses in the real economy.
So if the amount of savings in the economy were too low, resulting in a shortage of finance for entrepreneurs and businesses (or excessively high interest rates for the lending that is available), the Bank of England could create new money to make funds available to the banks, who would then re-lend this money to businesses. There is therefore no need for the proposal to lead to a shortage of credit for businesses or real economic activity.
There are numerous ways that this provision of credit to businesses, by creating new money, could work:
Providing new credit only when there’s a shortage
At one end of the spectrum the Bank of England could monitor business lending, as it does now through its credit conditions survey and by watching economic indicators such as interest rates on business loans. If interest rates increased markedly, or if businesses started reporting problems obtaining loans, then the Bank of England could loan money to banks on the proviso that this was used for on lending to businesses. In this situation, the power to create money for lending to businesses would be an emergency measure to use when banks are failing to provide sufficient credit themselves, but in most situations, credit to businesses would be provided by savers who are looking for a return.
Providing new credit for the real economy on-demand
At the other end of the spectrum, the Bank of England could essentially provide new funds on-demand to banks on the condition that any money borrowed through these facilities is used only for productive business lending (i.e. businesses whose activities directly contribute to GDP, so excluding many financial market businesses).
Decentralising the provision of credit to businesses
Alternatively, the government could set up a series of regional business investment banks, which the Bank of England could fund to engage in business lending.
The system that is chosen would in large part reflect the economic conditions of the time. So in an economy in the middle of a large recession, the Bank of England may want to make overdrafts available to banks, to ensure that there is no delay in the provision of credit to businesses. On the other hand, in a booming economy with very low unemployment the bigger risk might be inflation, so the Bank of England may want to return to making one off loans to the banking sector when required.
A Flexible and Responsive Monetary System
The key point is that the system is flexible, rather than rigid. It is able to adapt to the changing needs of businesses, households, and the economy at large. As a result in a full reserve/ sovereign money system there need never be a lack of credit for businesses, or a shortage of money for the real economy.
Indeed, this system is likely to be more appropriate to the needs of the economy than the existing system. The existing system, in which banks create money, created far too much money in the run up to the crisis, and far too little in the aftermath.
Later this week we’ll address the other issues that Ann raises:
- The questions about who should make the decision over money creation, whether they can work in the public interest, and whether they could (or should) be independent of government.
- Can we achieve a significant improvement in the economy simply by regulating the banking system (given that household debt levels are now at historically high levels and are set to rise even further as long as the power to create money rests in the hands of banks?)