A couple of months ago, Positive Money’s proposals to reform the creation of money were featured by Martin Wolf (the chief economics commentator at the Financial Times). In an article entitled “Why I disagree with Martin Wolf and Positive Money“, veteran campaigner and economist Ann Pettifor responded that the proposal is ‘deeply flawed’, ‘outlandish’, and would lead to “a shortage of money, high unemployment and low economic activity”.
Ann has written about money creation, successfully warned of the impending financial crisis in her book “The Coming First World Debt Crisis” and was one of the co-founders of the Jubilee 2000 campaign, which led to the write-off of $100 billion of third world debt. In other words, someone whose comments are not lightly dismissed.
Unfortunately, Ann’s interpretation of the likely effects of our proposals is itself ‘deeply flawed’, and if other people take the assertions above as gospel, it could lead to the retention of the current debt-based monetary system, and divert us from reforms that are essential if we’re to have a chance of dealing with the big social and economic challenges we’re facing today.
We responded in detail to explain why the proposal won’t lead to a shortage of credit and why we can’t simply rely on better regulation. But after re-reading Ann’s original article, I wanted to respond to the other numerous misunderstandings or problematic claims in the article.
Ann Pettifor opens the article:
The Financial Times is hosting a major debate on whether the private banking system should be allowed to continue creating 97% of the credit or money circulating within the economy. Martin Wolf, its respected economics commentator, supports the ‘Chicago Plan’ that effectively calls for private banks to lend out only as much as they have in “reserves”. “Banks”, writes Wolf (FT 24th April), “could only loan money actually invested by customers.” Private banks would be prevented from creating money, and instead all money would be issued by the state. The quantity issued would be decided by an independent committee as argued by amongst others, the IMF’s Kumhof and Benes and Positive Money.
All accurate so far.
Because of the finance sector’s despotic power, about which I have been very vocal, many readers would expect me to support a proposal that prevents private banks from creating money, and to enthusiastically back the nationalization of money issuance. I do not however, and want to explain why.
While Wolf has helped bring the role of private bankers in “printing” most of the money in circulation to public attention, the proposal he advances is deeply flawed. It is not very different from the monetarist or neoclassical understanding of money, as based on a commodity.
Most people who have read any of our materials will be aware that we don’t see money as a commodity. We clearly explain that money now is nothing more than a number in a computer system, and that essentially infinite amounts of it can be created at no cost. Money gets its value because people have faith that they can walk into a shop and exchange it for food, goods or other services. Other than that, it has no intrinsic value. It certainly isn’t a commodity.
As such his proposal, like the Chicago Plan, would contract and restrict economic activity – to the level of existing savings.
The proposal would mean that banks could only make loans after first raising the funds from savers, rather than creating the money they lend through an accounting entry. But it’s jumping to conclusions to assume that this would ‘contract’ or ‘restrict’ economic activity, and there’s little evidence to support that assertion, as we’ll explain below.
That is why the Chicago Plan was so enthusiastically endorsed by monetarists like Milton Friedman.
The Chicago Plan itself was a very specific implementation of full-reserve banking, and there are some technical differences between that proposal and our reforms. Friedman supported the orignal idea because it would make it possible to limit the growth in money supply (something that is difficult or impossible to do when banks are able to create money). There are countless other benefits of these reforms beyond the one that caught Friedman’s interest. But the fact that Friedman (who is something of a hate figure for left-wing economists) supported it bears no relation on whether it’s a good idea of not. The idea has been supported by numerous economists on either side of the political/economic spectrum. (As an aside, the logical fallacy of dismissing ideas based on the fact that a certain person was in favour of it is known as the Genetic Fallacy.)
To understand why the plan is flawed, one has to first understand that credit is nothing more than a promise to repay, as Schumpeter once argued. Furthermore, the issuance of credit results in deposits, or bank money, as Wolf argues.
It is possible to confuse ‘credit’ and ‘money’, as Ann does throughout her article. When someone makes a loan, they extend credit. When banks extend credit, they simultaneously create new bank deposits in the account of the borrower, through double-entry accounting. Those bank deposits function as money, because they can be used to make payments to third parties (and indeed, electronic bank deposits are used as money far more than paper bank notes or coins).
But not all lending creates money – only lending by banks. Peer-to-peer lenders for example take existing money (bank deposits created by the bank) and transfer it between a saver and a borrower. Credit is extended between the saver and borrower, but no new money is created in the process. It is only banks that have the privilege of creating money when they lend, and that privilege occurs purely because their liabilities – the IOUs on their balance sheet – are what the rest of the economy uses to make payments to each other. So the issuance of credit only results in money creation when it is done by banks – and only as a result of the current structure of banking.
More to the point, certain types of money are not promises to repay. Bank deposits could be seen as a promise by the bank to repay you cash equivalent to the amount of your bank balance. But is the cash that they give you also a promise to repay? The Bank of England, oddly, still pretends that it is, with the words “I promise to pay the bearer on demand the sum of £10” on bank notes, but this line became meaningless more than 80 years ago, when the Bank of England stopped promising to pay out gold in exchange for bank notes (as they explain here). Take a £10 note back to the Bank of England now and ask to be repaid, and they’ll give you another identical £10 note.
So it’s more appropriate to see some forms of money as a token. Cash is not a promise to repay. No specific individual owes you anything. However, it is a token that you know will be valued by the rest of society, and which you can exchange with someone else for goods or services to the value of £10.
There are two conclusions to draw from that:
- If you can create the tokens that people believe have value, you can acquire value for yourself. As Bank of England director Paul Fisher stated, “When you start printing money, you create value for yourself. If you could issue one thousand pounds worth of IOUs, you’ve got a thousand pounds for nothing. And so we do restrict people’s ability to create their own notes in that way.” He was talking about counterfeiters who print paper money. But the same applies to banks who create electronic money. The value that the banks acquire for themselves is the loan contracts – loans, mortgages and personal loans – on which the general public must pay interest.
- Money doesn’t intrinsically have to be a ‘promise to repay’. It can just as well be a token that society trusts, but which is issued by the state rather than a private bank.
Credit or money created by banks does not necessarily correspond to what we understand as income. Nor does it correspond to savings. It does not correspond to any economic activity. The one-to-one link that existed between commodity money and economic activity in the Middle Ages does not exist in today’s banking system. Instead credit merely facilitates transactions – and in that way creates economic activity – investment, employment and income.
Unlike commodity money, which is of necessity scarce, credit is able to facilitate society’s myriad transactions, and to satisfy our varied needs.
By defining ‘money’ as ‘credit’, the article presents a false dichotomy between scarce commodity money (e.g. gold) and adequate ‘credit’ money. And since credit is created by banks, this suggests that we must have banks creating money in order to avoid the perils of an inflexible and scarce commodity form of money.
This ignores the fact that you can have a form of money that is not scarce, and which does not have to be created by banks. How? By allowing the Bank of England to create an electronic version of cash. As I’ve explained above, a £10 note issued by the Bank of England is not a promise to repay anything (whatever it still says on the side of the note).
However, there is a useful distinction between commodity and fiat money. Physical commodity money such as gold (or a synthetic commodity money such as Bitcoin) is scarce by nature, whereas paper or electronic money can be as scarce or abundant as we want them to be. This is why neither Positive Money nor Martin Wolf are proposing a commodity-like currency.
The issuance of credit enables society to do what we can do.
Again, this conflates ‘credit’ and ‘money’. Credit can be extended (as with peer-to-peer lending) without the creation of new money. What ‘enables society to do what we can do’ is getting money to where it’s needed at the right time, in particular to entrepreneurs and innovators. If there’s a scarcity of money, that causes a problem. But it’s perfectly possible to provide sufficient credit (i.e. lending) to entrepreneurs and productive parts of the economy without needing banks to create new money in the process of lending. In fact, with large UK banks broadly losing interest in lending to businesses, peer-to-peer lenders such as Funding Circle and Rebuilding Society (disclosure: RS is a donor to Positive Money) are taking up the slack by facilitating the lending of pre-existing money from savers to small firms.
And that is why it is a very good thing. Before the establishment of a banking system, society could only embark on ventures that could be financed by “savings” – inevitably the surpluses built up, stolen or appropriated by the already wealthy. Because savings were scarce, they would be lent out at high rates of interest – inhibiting investment, and above all employment.
Because credit [Ben Dyson (BD): conflated with money] (buttressed by contract law, the criminal justice system, the central bank and an accounting system) can be created with such ease, it is a great power, and must of course be regulated in the interests of society as a whole. If, as now its creation is not properly regulated, the finance sector’s hold over society becomes despotic. It is in society’s interests that credit [BD: money creation] is carefully regulated and directed at productive activity that generates income for repayment – and not speculation or the self-enrichment of bankers.
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.
This is hyperbole and a complete misunderstanding of what we’re proposing. We are specifically proposing a flexible monetary system in which the amount of money creation bears some kind of relationship to the growth of the real economy. In the Gold Standard the amount of money was fixed and could only grow arbritrarily whenever someone managed to dig gold out of the ground. It shouldn’t be difficult for an economist to understand the difference between these two proposals.
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.
Let’s identify the assumptions behind this statement:
- The level of savings isn’t sufficient to finance the level of investment needed in the economy
- This would mean there would be high interest rates
- This would lead to high unemployment and a shrinking economy
- Those with savings would be able to charge high rates and ‘flourish’.
The first assumption really focuses on the level of lending to productive businesses. As we’ve seen, the main thing that banks do is create money for mortgages; this doesn’t grow the economy – it just pushes up prices. They create money for financial market speculation – this eventually caused a crisis. Lending to businesses is a tiny part of what they do. In the ten years up to the financial crisis, just 8% of all additional bank lending (i.e. 8% of all newly created money) was lent to businesses outside the financial sector.
Many businesses don’t even rely much on bank lending: smaller startups typically rely on friends and family. Larger businesses go to investment firms or issues bonds. So it’s quite a narrow sector of businesses that are dependent on bank lending – and even those businesses are starting to find that things like peer-to-peer lending platforms (which take money from savers to borrowers) are more interested than the banks. So a huge amount of lending to business is done with pre-existing money, not money that is newly created by banks. There might not be enough savings to finance all the speculation that the banks have been involved in in recent years, but there should certainly be enough savings to finance the productive part of the economy. (My colleagues are in the process of assessing the real dependence of the productive economy on bank lending, and we’ll have something to publish in the next few weeks).
If there isn’t a shortage of savings to finance the real economy, then all the other assumed consequences become invalid. But if there ever was a shortage of credit, the Bank of England still has the ability to create additional money specifically for the purposes of lending to businesses. More about this here.
I’ve seen payday lender Wonga used as an example of the interest rates that would be charged if a bank had to acquire all its lending from savers. This is highly misleading. A more appropriate example would be Zopa, which is a peer-to-peer lender facilitating the direct lending from borrowers to savers. Zopa currently charges around 6% on a personal loan, undercutting many of the larger banks (which can create money).
The article continues:
Now many environmentalists want to restrict economic activity – and I agree with them. The creation of “easy” i.e. unregulated money has fuelled unsustainable consumption. Worse, credit has been directed at inflating the value of assets (e.g. property) that have enriched the rich, and impoverished those who do not on the whole own assets. Easy credit has been at the heart of the rise in inequality in western economies.
But while we may want to limit consumption, and re-direct credit to more sustainable, useful activity, it would be a mistake to limit the things that society can do. We need, for example, to tackle climate change, a major threat to a liveable future. That will require huge resources to be directed at transforming and de-carbonising the economy. Carefully managed and regulated credit will help finance those activities. The money in our piggy banks would be woefully insufficient.
Absolutely. But is it really likely that the Financial Conduct Authority (successor to the Financial Services Authority) is going to design regulations that will force banks to invest in this kind of work? Ann’s proposals (below) assume that they will.
Our proposals are not about restricting what we can do. In fact the opposite: they’re about making it possible for us to achieve what is technically and physically possible. In the current system, things that can be done are not done because the only creators of money are banks that have no interest in the things that we really need to do. In the aftermath of the financial crisis, we had construction workers out of work, school buildings in appalling condition and a school re-building already scheduled, and then the government cancelled this program because there was ‘no money’. Reclaiming from the banks the power to create money at that point would have meant that the new money which we needed to get into the economy could have first been used to rebuild those schools, boosting employment and helping to end the recession.
So once again, the suggestion that our proposals would contract the economy imply either a huge misunderstanding on Ann Pettifor’s part, or that she hasn’t actually read them. Our proposals are about making sure that money is used for something productive, for the public benefit, rather than to inflate property bubbles and flood financial markets. Tackling climate change definitely counts as something in the public benefit. Our proposals would mean that when new money is created, it would be the government rather than the banks that decides how to spend it. Newly created money would get added to the taxes we pay, to be spent into the real economy. Our Sovereign Money paper explains how using this power to create money to build sustainable homes and retrofit existing homes to make them more energy efficient would have been more than 30 times more effective than Quantitative Easing in stimulating the economy.
This debate exposes a profound misunderstanding at the heart of economics, one heavily promoted by monetarists and the Austrian school: namely that it is possible to manage aggregate economic activity within an economy like Britain’s if an “independent committee” can just pre-determine money growth, and then shrink or expand activity.
It’s unlikely that any committee can make a perfectly correct decision over how much money should be created. But the difference between them and the banks is that the banks only have one incentive: to keep creating more money, right until the point that it causes a financial crisis. They have no interest in the health of the wider economy, and no accountability to society. In contrast, members of a body working in the public interest would have a feedback loop and a remit that requires them to stop creating money if it starts to result in property bubbles, inflation or an unstable economy.
This is very close to what monetarists tried to achieve, but failed to do under Mrs Thatcher.
Monetarists thought they could control how much money banks could create by influencing reserves. They couldn’t – the current system is difficult or impossible to control. For a more detailed explanation of why, see our Banking 101 video course, Modernising Money or Where Does Money Come From?
It is also what economists and bankers tried to achieve under the Gold Standard. Then aggregate economic activity was expanded or shrunk to (apparently) equal a quantity of gold buried in the vaults of central banks. The result was predictable: a shortage of money, economic failure, instability, financial and currency crises and rising unemployment.
Once again, what we’re proposing is nothing like the Gold Standard, and this comparison is highly misleading.
The reason why the Gold Standard was to Keynes a “barbaric relic” – was that gold in the bank could never be made to equate to society’s economic activity – and potential activity. By contracting economic activity to attempt that false equation – governments shrunk the availability of money, caused unemployment to rise, profits to fall and economic activity to wane.
And again, we’re talking about getting the right amount of money into the economy. Not so much that it causes the kind of boom and bust that we’ve just been through, and not so little that it causes unemployment. The Gold Standard was about tying money to an arbitrary quantity of an arbitrary metal. We’re talking about completely different systems, which should be clear to anyone who has read our proposals.
Wolf’s proposal is problematic for other reasons. First, the idea that society can set up a single “independent” committee of men to make far-reaching decisions about the quantity of money needed by a nation of sixty four million people, all engaged in varied and complex activities – is bordering on authoritarian. First there is no possibility of such a committee being independent. One has only to think of the “independent” UKFI committee – set up to oversee the banks, including RBS, in which the state has a stake – to question the possibility of such a body being independent.
Instead I would argue, we should once again regulate the banks and bankers.
Again, we’ll have to take these claims one at a time:
1. The idea that having a committee deciding on money creation is ‘authoritarian’. This is a bizarre argument. We already have a committee of men (and it is all men) – the Monetary Policy Committee – who set and influence the interest rates that millions of people will pay on their mortgages and which millions of savers and pensioners will receive on their savings. This seems like an incredibly ‘far-reaching’ decision to make.
We’re proposing that they would lose that power to set and manipulate interest rates, so that interest rates would depend much more on the supply of savings between savers and borrowers. (Ann would likely argue that this would lead to very high interest rates, yet Zopa – a peer-to-peer lender – already works on this basis and currently charges lower rates than both Nationwide and Natwest on personal loans). Transferring the power to create money directly to an independent government body such as a Money Creation Committee would in fact greatly reduce banks’ influence over the lives of much of the population.
2. The idea that the committee can’t be independent. Yet Ann’s proposal is that we should regulate banks better. Regulators are made up of committees. If the Money Creation Committee cannot be independent, then neither can Ann’s regulator.
The article continues:
We may have to begin by acknowledging that, without the guarantees provided by central banks, most banks are effectively insolvent, and will have to be re-structured. Because of their weakness, caused by their own greed and recklessness, they are unable to provide affordable credit in quantities needed by the economy. This is a major cause of ongoing economic weakness, falling incomes and high unemployment across western economies.
If the current business model of banking has led us to this state, is it really something that we want to retain? The “greed and recklessness” isn’t going to go away. Ann is proposing that a committee of regulators will be able to stop them being too greedy and reckless. We’ve taken a different approach: to assume that bankers will do stupid things and lose money from time to time, but that this poses much lower threats to the wider economy when they no longer also create all the money we use.
In addition, the banks are not “unable” to provide affordable credit: they created an additional £22bn of money by lending for mortgages in 2013 alone. But they are not willing to create money for the right parts of the economy.
Next, banks’ retail arms should be separated from their speculative, “investment” arms. The creation of credit should be carefully regulated, managed and directed at productive, sustainable activity.
So it’s impossible for the Money Creation Committee to make the right decision on how much money to create, but it’s possible for another committee to judge how much credit (lending) should go to each part of the economy? To spot bubbles before they burst? To know when to go against the crowd and identify a speculative mania? Will we be relying on the same regulators that were asleep at the wheel in the years before the financial crisis? (Answer: yes – there hasn’t been significant change in staffing at all at any of the big regulators.)
Thousands of bank clerks should be put to work assessing the risk of every request for a loan, and determining whether that loan would be put to sustainable use and whether it would be repayable – just as was done until very recently.
How is this to be achieved? Banks have switched to a system of centralised loan decision making, run by computers. How practically are we to force them to return to the old system of individual loan officers judging various loans?
It was only thirty years ago that restrictions on the creation of credit were lifted under a measure wrongly defined as “Competition and Credit Control” – and bankers were freed up to aim credit at speculation. They were later freed up to use their great powers for their own self-enrichment, when the prohibition on mixing their retail and speculative arms was removed.
Restoring banking regulation to its proper place, and managing cross-border lending would once again restore balance to our financial system, just as it did in the period 1945-71. It would bring to an end the despotic power now exercised by bankers and the finance sector.
By contrast, outlandish proposals for nationalizing money and granting huge powers to a committee of men to decide how much money we should all have, and whether to shrink or expand the money supply and economic activity will only add to the economic confusion that shrouds the banking system.
Whereas Ann’s radically different proposal is that we should grant “huge powers” to a “committee of men” to regulate the thousands of bank clerks who will decide “how much money we should all have” when they make decisions on who to lend to or not. The decisions of that regulatory committee will also expand or shrink the money supply, spending and consequently influence economic activity. But if that regulatory committee turns out to be less than competent, or unable to fully control the banks, then we could easily see a repeat of the financial crisis, and another need to bail out the banks.
And without a doubt, this system will retain the confusion that shrouds the banking system. In contrast, our proposals make the banking system work the way that most people think it does – and most students of economics are taught that it does, and most economics textbooks say that it does: with banks as middlemen between savers and borrowers, and the state being the only creator of new money.
Above all, it will ensure that things stay just as they are.
Unfortunately, I would bet good money that Ann’s proposal to rely on regulators outsmarting the banks is far more likely to ensure everything will stay the same. Removing the power of banks to create money is the reform that would give us the greatest chance of getting a financial system that works for society and not against it.