Sovereign Money – Response to Andrea Leadsom, Economic Secretary to the Treasury

Last Thursday, the UK parliament debated the issue of “money creation and society”. This was a backbench debate, which means that no vote is taken at the end and no laws are changed; it is simply an opportunity to discuss important policy issues outside of the government’s agenda.

The government’s view on this debate was provided by Andrea Leadsom MP. Leadsom is the Economic Secretary to the Treasury, a position which is also known by the title “City Minister” (as in the City of London, the UK’s financial centre). She is responsible for the government’s financial reform and regulation agenda.

So we would hardly expect the government’s City Minister to come out as an advocate of Positive Money’s proposals. However, her critique of the proposals was surprisingly mild. Rather than making sweeping assertions (as some critics have done) she simply raised a number of ‘important questions’. I’ve addressed those questions below.

Leadsom comes on to the topic of a sovereign money system (as advocated by Positive Money) by saying:

“But first I just want to briefly set out why we don’t believe that the right solution is the wholesale replacement of the current system by something else such as a Sovereign Money system.

“Under a sovereign monetary system it would be the state not banks creating new money. The central bank via a committee would decide how much money is created and this money would mostly be transferred to the government. Lending would then come from the pool of customer’s investment account deposits held by commercial banks.

Such a system would raise a number of very important questions.”

She then lists 7 questions, which we’ve quoted verbatim below:

1) “How would that committee assess how much money would be created to meet the inflation targets and support the economy?”

Today the Bank of England’s Monetary Policy Committee is responsible for setting interest rates as a very indirect way of influencing how much money banks create. The 9-person committee has a team of researchers and access to a wealth of data about the health of the economy. The members of the committee spend up to two days deliberating before casting their vote to raise or lower interest rates.

In a sovereign money system, the process would be much the same, but instead of raising or lowering interest rates, the Monetary Policy Committee (or a new Money Creation Committee) would directly increase or decrease the rate at which new money is created by the Bank of England. (The banks by this point would no longer be able to create money.) [showmore]

If, in the current system, the MPC would have voted to lower interest rates (encouraging people to borrow more and therefore getting banks to create money) then in a sovereign money system they would vote to increase the rate at which money is created. The opposite also applies: if they would have voted to raise interest rates (to discourage borrowing and therefore reduce money creation by banks), then in a sovereign money system they would vote to slow the rate at which money is created.

Some critics seem to get confused at this point. They think that the MPC must somehow magically know how much money every single person needs across the economy. This is caricatured in Ann Pettifor’s statement that a sovereign money system would amount to “granting huge powers to a committee of men to decide how much money we should all have…”. But the Committee would not be deciding that, for example, “There should be £X billion in the economy”, and then next month deciding that £X should instead by £Y. The stock of money in the economy would always be growing at some rate, and the Committee’s job is to make that rate faster or slower. They will need to respond to feedback from the economy and adjust their decisions month-to-month.

If critics believe that making such a decision is impossible, then it logically follows that they must also believe it is impossible for the Monetary Policy Committee to choose the right interest rate for the economy.  If you agree with this view point, then having a committee making decisions is a disadvantage of both systems. If you believe that the Monetary Policy Committee is suited to setting interest rates – with the intention of influencing the rate at which banks create money – then it should be clear to you why it’s not a major difference to manage the rate of money creation directly rather than indirectly.[/showmore]

2) “If the central bank had the power to finance government’s policies what would the implications be for the credibility of the fiscal framework and the government’s ability to borrow from the market if it needed to?”

This relates to the fear that if the government is allowed to create money directly, it will get carried away and print money to pay for every white elephant or vote-winning project they can think of. It is thought that even the fear that this might happen is enough to scare investors in financial markets to the extent that they’ll stop buying the government’s bonds. This is normally put foward as the reason for prohibiting governments from creating money, and placing that power in the hands of commercial banks, that we know would never use it recklessly or excessively(!).

It doesn’t take much thought to find an answer to this. [showmore]

Firstly, we are not proposing that the government itself (which is made up of politicians who are trying to win the next election) would be allowed to make the decision over money creation. Their incentives to abuse that power are too strong, especially in the run up to an election. That is why we argue that the power to create money must rest in the hands of a transparent, democratic and accountable body that is tasked with working in the public interest. The decision over whether to increase or decrease the rate of money creation is made not on the basis of what the government wants or needs, but on the basis of what is appropriate for the economy as a whole. If Parliament continues to set the Committee the task of meeting a specific inflation target, then that inflation target will stop the Committee from creating excessive amounts of money to finance government projects (as that would feed through into inflation). This framework should reassure financial markets and investors that the government is not about to go on a Zimbabwe-esque spending spree.

Ultimately this is a question about state power and checks and balances. The government could always abuse its military power to shoot anyone who is likely to vote for the opposition, but we have confidence in developed countries that there are adequate checks and balances to stop this from happening. In the same way, a corrupt government could abuse the power to create money, but we can put in place safeguards and checks and balances that are designed to prevent that from happening. Providing the safeguards are adequate and transparent enough, and checks and balances on the power of the Money Creation Committee are in place, then there should be no long-term damage to the credibility of the fiscal and monetary framework.

On the flipside, consider how a sovereign money system will boost the credibility of the government’s management of its finances and the economy. Because banks in a sovereign money system do not need to be bailed out (because the payments system is not exposed to their risk-taking), there is no risk that the government’s finances will be shot by the costs of bailouts. With less risk of boom and bust, there is less risk of a recession leading to a fall in government tax revenue (and a rise in how much it needs to borrow). The national currency would likely be more – not less – trusted, because there would be transparency about how much new money would be created each year, whereas in the current system money is created by private banks that are competing with each other to create the most money (i.e. to grow their market share and size), with the result that the stock of money has grown by an average of 11.5% a year over the last 40 years. That’s much, much higher than the average rate of real economic growth over the same period of time.[/showmore]

3) “What would be the impact on the availability of credit for businesses and households?”

This is certainly a topic that requires greater study, and we will be releasing a paper on this in the near future. But a few points are important here:

• Banks would still be able to lend; they’d just need to get money from savers before they could do so.

• The amount of credit provided by banks to households to date has been totally excessive. Because most of it went into property (through mortgages) it has resulted in a huge increase in the cost of housing relative to salaries. There is an appropriate amount of credit: enough to allow people to buy houses, but not enough to push the price of those houses up at 20% or more in the space of a year.

• With regards to credit provides to businesses:

o   Only around a tenth of UK banks’ loans are to businesses. Lending to business is a sideshow compared to their main business (i.e. lending secured on property).

o   Around 66% of SMEs (small and medium enterprises) said they never used bank loans anyway. Instead, they finance their investment through retained profits and other sources of funding.

o   In a survey of UK businesses, the majority said that the primary barrier to their growth was not their access to finance from banks, but whether they could increase their sales. In other words, to boost the economy, we need more money in consumers’ pockets. Sovereign money makes it possible to get money in consumers’ pockets without relying on them to take on ever greater amounts of debt.

4) “Wouldn’t credit become pro-cyclical?”

Leadsom doesn’t elaborate here, meaning that we have to guess what her thinking was on this point.

Clearly, the level of credit is already hugely pro-cyclical. Banks provide too much credit (and therefore create too much money) when the economy is growing, leading to the kind of debt-fuelled boom we had before the financial crisis. Then, in the recession, they restrict their lending (therefore restricting their money creation), which makes the recession worse. You can read more about this process here, but it’s clear that credit is already pro-cyclical, and it’s hard to imagine that it would become even more so.  [showmore]

But perhaps Andrea Leadsom (or the researcher who prepared her speech) has a different point in mind. Perhaps she thinks that in good economic times, everyone will put their money into investment accounts (i.e. making their funds available for the banks to lend to borrowers) whilst in the bad times, everyone will withdraw their funds from Investment Accounts and keep them stashed in transaction accounts. This idea is based on a technical misunderstanding of how investment accounts would work. Investment Accounts are records of the amount of money that account holders have handed over to the bank in order for the bank to lend them out. Shortly after an investment account is opened, the bank will have lent the money to a borrower, so the money placed ‘in’ the Investment Account will now be in the borrower’s Transaction Account (or the account of whoever the borrower spent the money with). However, some people get the idea that money can either be in an Investment Account or in a Transaction Account, and that all money could move from the Investment Accounts to the Transaction Accounts if there was a panic about the near-term economic situation. In reality, money would ALWAYS be held either in Transaction Accounts or in the bank’s own accounts, waiting to be lent. No money is ever held in Investment Accounts.

So what might happen in a panic? Savers who had Investment Accounts maturing in the near future might decide they want to hold money in risk-free Transaction Accounts rather than holding a risk-bearing Investment Account. Banks would find themselves repaying Investment Account holders, which would mean the money is unavailable to fund further loans. At the same time, potential investors might choose not to take risks for the meantime until it’s clearer what will happen in the economy and which banks are healthy (or otherwise).

However, is this  really likely to make the provision of credit more pro-cyclical than the current system? In the recent crisis, even when banks were refusing to lend, there were numerous reports of pensioners and savers who were searching for a higher rate of interest on their savings and looking for something to invest it. There will always be people with savings looking for a return. The real pro-cyclicality in the current system comes not from savers’ decisions to invest, but from banks’ willingness to lend (and therefore create money).

So it’s far from clear that a sovereign money system would have credit that is more pro-cyclical than the current system. In addition, only someone who has had their eyes closed for the last decade could suggest that the availability of credit is not pro-cyclical already.[/showmore]

5) “Wouldn’t we incentivise financing households over businesses, because in the case of businesses presumably expect the state to step in?”

It’s hard to make sense of this point, and Leadsom doesn’t elaborate, so we’ll have to guess at what she means.

Leadsom suggests we would incentivise financing households over businesses because “presumably the state would step in” [to lend to businesses?]. But this point makes no sense. Firstly, in a sovereign money system, the Bank of England would be able to create money to lend to banks so that those banks could lend more to businesses. But this money goes through the banks, not around them. The banks would therefore have a role to play in lending to businesses. Why would this incentivise banks to not lend to businesses? [showmore]

Secondly, if Leadsom believes that the provision of finance from the state directed at businesses will dissuade banks from lending to businesses, then what steps is she taking to shut down the Business Investment Bank that her government has just set up? Surely by her logic such a scheme would disincentivise banks to lend to businesses?

Finally, this point shows zero recognition of the fact that, in the current monetary system, banks already face huge incentives to finance households (read: mortgages) over businesses. There are a few reasons for this:

1) With a mortgage, the bank has a nice house that it can repossess if the borrower is unable to repay the loan. This makes it very low-risk.

2) Because house prices tend to rise in good times (largely as a result of all the money that banks create and pump into mortgages), even mortgages that seem risky at first soon become effectively risk-free. If a bank issues a 90% loan-to-value mortgage, then some time later it has to repossess the house, the house price would have to have dropped by 10% before the bank lost money overall. But if house prices rise by 10% a year, then by the end of year 1 of the mortgage they’d only suffer a loss if house prices had fallen by 18.2%, and by the end of year 2 they’d have lost money only if house prices had fallen by more than 25.6%. Because these falls are highly unlikely, much mortgage lending is effectively risk-free and even more so in the context of rapidly inflated house prices.

3) Businesses have little collateral to repossess. Much of a loan to a business will be spent on staff or other services. For example, if a bank makes a loan to a cafe, the only thing they could repossess is a few display cabinets and kitchen equipment, which will sell for less than the cafe initially paid for them.  Even with  capital-intensive businesses, such as a factory, the machinery is likely to be very job-specific, difficult to resell and would sell at less than the price initially paid for it. So relative to a mortgage, business loans have much less collateral and are therefore riskier.

4) The Basel capital accords require banks to hold twice as much capital against a business loan than against a property loan. Put another way, if the Basel rules are adhered to, then for X amount of capital, banks could lend twice as much for a mortgage as they could for a business loan.

So in the current system there are HUGE systemic biases towards financing households (i.e. mortgages) over businesses. Nothing in the government’s reform agenda tackles that issue, but there is absolutely no reason to think that a sovereign money system would make it any worse. In fact, in a sovereign money system there would be no need for any Basel capital accords. [/showmore]

6) “Wouldn’t we be encouraging the emergence of an unregulated set of new shadow banks?”

The argument here is that by prohibiting banks from creating money, a whole collection of companies that are not banks but act like them will spring up and start creating equivalent substitutes for money, in effect creating the same situation we have today.

Most shadow banks are simply entities that behave like banks but avoid registering as banks in order to escape regulation. So the government approach to shadow banks should really be, “If it looks like a bank and behaves like a bank, then regulate it as a bank.” And who has responsibility for making sure that the regulators do their job properly? Funnily enough, Andrea Leadsom, the City Minister. [showmore]

So if unregulated shadow banks spring up and start creating money, it will only be because of the failure of Andrea Leadsom and her government to regulate companies that need to be regulated. This is not a valid criticism of a sovereign money system; it’s a criticism of the current approach to regulating shadow banks.

Secondly, let’s look at what would actually be required for shadow banks to be able to ‘create money’. They would need to be able to issue liabilities that could be withdrawn on demand and used to pay other people. In order for these liabilities to be as useful as bank money or sovereign money, it would have to be possible for them to be transferred through the main payment systems e.g. BACS, Faster Payments, CHAPS and so on. Access to those payment systems is tightly controlled. It’s simple enough to prevent shadow banks from becoming members of those payment systems, making it impossible for them to create money-like liabilities that can be easily used to pay other people.

What shadow banks could potentially provide, depending on the timidity of the regulator, would be instant access liabilities, but these would be risk-bearing investments, whereas money in transaction accounts would be completely risk-free. If the regulator was even half competent, all money-like substitutes provided by shadow banks would need to be covered in health warnings making it very clear that the investor is taking a risk. Then, anyone who is willing to invest with a financial services provider that promises to repay you your funds whenever you want them, whilst knowing full well that those funds aren’t available, does so at their own risk and should not expect to be rescued by the taxpayer.[/showmore]

7) “Wouldn’t the introduction of totally new system untested across modern advanced economies create unnecessary risk at a time when people need stability?”

This final point rests on the assumption that the current system can provide ‘stability’, and that the government’s reforms since the crisis have been adequate. But even her own Prime Minister has recently been warning about danger signs in the global economy, and the former head of the Financial Services Authority, Lord Adair Turner, has been warning about the dangers financial stability from rising household debt.

Right now, what Andrea Leadsom thinks is ‘stability’ may in fact be the calm before the storm. The major benefit of a sovereign money system is that it would provide greater stability.

To the Andrea Leadsom’s expressed concerns about the makeup of the committee that would create money:

Andrea Leadsom makes a rather silly point, parrotting points made earlier by Ann Pettifor. Leadsom says:

“And of course bearing in mind our current set of regulators we would presumably then be looking at a committee of middle aged white men making the decision on what the economy needs and that’s also would be a significant concern to me were that to happen.”

“In addition, of course, bearing in mind our current set of regulators, presumably we would then be looking at a committee of middle-aged, white men deciding what the economy needs, which would also be of significant concern to me.”

Yes, the Monetary Policy Committee, which makes decisions on interest rates, is made up of white, middle class, middle aged men with similar backgrounds. To the best of my knowledge, Andrea Leadsom has never campaigned for the Monetary Policy Committee to be made more representative or diverse, so it’s interesting that she has suddenly taken an interest. Presumably if she objects to the Monetary Policy Committee having the power to directly manage money creation, she would also object to them having the power to set Bank of England’s interest rates for the lending of reserves to the banks (which indirectly influences money creation).

However, the makeup of the committee in a sovereign money system is up for grabs. [showmore]

The committee could be completely white and middle class in either system, or it could be hugely diverse in either system. We are designing a new system that works in the public interest, so if the key decision makers need to be more diverse, then make them more diverse. If we want that committee to be more diverse and more representative of society, then it shouldn’t be beyond a government minister to figure out how to achieve that.

This point rests on a logical error. When choosing between two systems, something that is a disadvantage of both is not an argument in favour of one. Part of the debate that would have to be had around a sovereign money system is about who we want to have the power to create money. But for anyone who can think about it logically, it should be clear that the fact that we currently give the power to set interest rates to an undiverse committee of men is an argument for reforming that committee, but it is not an argument against reforming the monetary system more fundamentally.[/showmore]

Creating a Sovereign Monetary System