In a two-part blog post, Bill Mitchell recently used the publication of the Icelandic paper on Sovereign Money to set out his position on the proposals. We believe that Bill (and other proponents of Modern Monetary Theory) and Positive Money have, to an extent, very similar objectives. Therefore, as we have previously suggested, there is scope for collaboration. Nevertheless, there are some key differences, some of which this blog shall highlight.
Like Bill, we are not looking to start a long-winded debate with him, nor are we looking to put forward a full critique of MMT. We do not propose to offer a detailed critique of Bill’s position (as Bill made some of the usual criticisms of PM which are clarified here) and will restrict our comments to the following points made by him:
1) The argument that the stock of money is currently determined by demand from borrowers
2) Issues around the endogenous nature of Sovereign Money system and the setting of interest rates
3) The argument that the notion that Governments are revenue constrained is nonsensical
4) The argument that it makes more sense to regulate the assets than the liabilities of a bank
5) Criticism of the democratic elements of a Sovereign Money system
1) Demand and the Money Stock
Bill states that:
“…the supply of money is determined endogenously by the level of GDP”, which essentially means “the ‘money supply’ in an ‘entrepreneurial economy’ is demand-determined – as the demand for credit expands so does the money supply”.
We agree that banks are demand constrained: clearly they cannot lend if none of their customers would like to borrow. However, we disagree with the notion that the money stock is determined endogenously by the level of GDP. The majority of bank lending – and therefore the majority of money creation – is not for activities that directly contribute to GDP. Money creation and the money stock is more likely to be determined by the demand for mortgages than by the level of GDP.
Indeed, implicit within Bill’s line of reasoning, is the notion that banks are limited to passively responding to the demand of the real economy. Bill’s analysis therefore ignores that banks actively market and ‘sell’ their loans to consumers, either through lowering rates, marketing personal loans, or even calling customers to ask if they’d like to borrow. (I for one see an advert for personal loans of up to £12k every time I sign into my internet banking). Banks can be proactive in creating the demand for loans; they’re not just passively waiting for entrepreneurs and first time buyers to walk through the door and request a loan.
The result is that banks do have the capacity to initiate and inflate property and financial asset prices, often resulting in speculative bubbles. This not only prompts financial instability and a host of other problems, but it also induces people to borrow more than they otherwise would want to. (As a potential first time buyer, I don’t want to borrow 5-7 times my annual income, but I have to because house prices have been inflated as a result of the amount of money creation that has financed mortgage lending.)
So it’s misguided to think of banks passively reacting to demand for loans from an “entrepreneurial economy”, merely facilitating the fine ideas of entrepreneurs and supporting the growth of GDP.
2) The endogenous nature of Sovereign Money system and the setting of interest rates
Bill also suggests that a Sovereign Money system will have to be endogenous, meaning that the central bank will still not really have control over the amount of money creation. The argument is that unless the central bank is willing to finance banks’ lending by creating new money, a shortage of credit will arise and interest rates will soar. As Bill writes:
“…essentially the money supply would still be endogenous under this proposal unless the central bank was willing to tolerate the interest rate going beyond its control or a lack of funds available for borrowing.”
Firstly, a report we shall be releasing next week, shows that a significant shortage of credit is highly unlikely to arise in a Sovereign Money system. The recycling of loan repayments coupled with new savings would be sufficient to fund business and consumer lending as well as a non-inflationary level of mortgage lending.
Secondly, and perhaps more importantly, the central bank would not be targeting a money stock for the mere sake of ensuring that the money stock stays at some particular level. It is not interested in the actual amount of money that exists, but in the effect this has on spending, inflation, employment and GDP. So its main concern is in adjusting the rate of money creation in order to achieve its economic objectives (which are set out by parliament). So if the central bank decides that a higher rate of money creation is necessary to lower rates across the economy in order to achieve those objectives, then it can make that change. So if the monetary policy committee felt that maintaining low interest rates was necessary to meet the inflation target, then it would have the flexibility to create more money to lend to banks. This is not ‘losing control’; it is using the tools as they are intended to be used.
Naturally, it is important that the central bank distinguishes between different sectors with regards to who receives the lending (to ensure that new money is created and put into the real economy rather than the financial sectors). However, we see the flexibility of a Sovereign Money system (i.e. the ability to create money endogenously and exogenously) as strength, not a weakness.
3) “The notion that governments are revenue constrained is nonsensical.”
Throughout both his blog posts, Bill frequently highlights how he thinks that governments are not revenue constrained.
“…a national government and its central bank does not need income in order to spend the currency of issue. It is simply a nonsense to worry about ‘income lost’ when considering the operations of a currency-issuing government…A sovereign government is never revenue constrained because it is the monopoly issuer of the currency.”
Technically it is true that a government can spend without first collecting taxes. But the fact is that governments don’t behave in this way, and most government policy makers don’t believe that this is possible. In a sovereign money system, the real constraint on how much new money the state could issue is the risk of inflation. If commercial banks are also issuing money in place of the state, that limits how much the state could issue, and therefore it makes perfect sense to talk about ‘income lost’ – or more accurately, spending power forsaken – when considering the operations of a currency-issuing government.
Even if we or Bill could get government officials to understand that the state could create money as well to fund useful government expenditure, that does not mean that the state can create and spend newly created money without constraint. As MMT rightly acknowledges, this would eventually run up against the ‘inflation constraint’. So taxation could be seen as a way to remove other peoples’ purchasing power in order to make room for its own expenditures.
To the extent that a growing economy needs an expanding stock of money, by placing monetary growth under direct control of the central bank, a Sovereign Money system increases the amount that a government can spend before money must be removed by taxes and borrowing to maintain price stability. In other words, it allows the government to spend more without having to tax more. However, the central bank should only allow for money creation at a rate that supports the government’s policy objectives without causing inflation to rise above the target rate.
4) “It makes more sense to regulate the assets rather than the liabilities of a bank.”
Bill suggests that it would be better to regulate the asset side of banks’ balance sheets versus their liabilities:
“We also see it when the Report claims the government has to “guarantee bank deposits” under the current system. This is alleged to promote ‘moral hazard’ – risky lending. Again this is really a regulative matter of limiting what banks can do with the assets creates. It makes much more sense to regulate the asset side of the bank rather than the liability side.”
Firstly, our position is that by guaranteeing bank liabilities the government currently promotes moral hazard. However, deposit insurance is not a form of regulation on the liability side of a bank’s balance – rather it functions as a subsidy to the banking sector as a whole. The best substitute for deposit insurance is therefore a Sovereign Money system, where money does not exist as the risk-baring liabilities of commercial bank.
Secondly, solely regulating the asset side of the banking sector’s balance sheet relies heavily on regulators to spot infringements in an increasingly complex financial system. While Bill uses the Icelandic example to show that deregulation resulted in crisis, our position is that the crisis exemplifies how ‘regulation’ failed to prevent the crisis. Accordingly, a simplified and systemically different monetary set-up (i.e. Sovereign Money) would not require complex regulation supported by an army of regulators (for a more in-depth explanation on the problems of regulation click here).
Thirdly, under a Sovereign Money system the status of bank liabilities would change, so that even failures on the asset sides of the balance sheet wouldn’t threaten the payments system. Losses would be shared with those investors (investment account holders) who stood to gain from the upside, rather than threatening the solvency of the entire bank, or being passed on to the state.
5) Key decisions handed to unelected unaccountable bodies:
Bill also makes his position on democracy and democratic deepening very clear. Many of these are valid concerns: it’s certain that central bank governance should be reformed to be more transparent and accountable. But these issues are not applicable to a Sovereign Money system exclusively but to our political system and central bank governance in general. (For example, issues of suitability or ideological biases of key decision makers need to be addressed separately from institutional structure).
Bill argues that in (the Icelandic) Sovereign Money system, decision-making powers would be handed to unelected and unaccountable bodies:
“The power to create money will be held by the CBI while parliament will decide how any new money is allocated. The power to create money is thereby separated from the power to allocate new money. So you immediately see that the conservative mistrust of elected democratic government persists in this proposal.”
We believe that the operations of administrative branch of the central bank should be as separate from the political branch of parliament as possible. The reason for ‘separation’ is to ensure that short-term political cycles don’t govern the decisions that must be taken over long-term economic and monetary policy. While Bill believes that votes and democracy may be enough to prevent politicians from misusing Sovereign Money, we suspect it is more likely that politicians would find it difficult to resist the temptation to use the power to create money to win votes prior to an election. This is not the “conservative mistrust of elected democratic government” as Bill suggests; it’s simply an understanding of how people respond to incentives and how difficult it is to resist temptation.
This is however, not to suggest that the creation of money would be undemocratic. Elected representatives would appoint the Monetary Policy Committee (MPC), and their mandate would be set by parliament. Accordingly, parliament would still retain power here, in the sense that it could always change the operative rules of the central bank. Moreover, the MPC would still be accountable to parliament, specifically the Treasury Select Committee, a cross-party group of MPs.
It is the aim of Modern Monetary Theory, of which Bill Mitchell is a leading exponent, to establish a coherent and consistent framework of economics founded on a realistic understanding of how money and credit actually work in today’s world, an understanding that we believe we share. All reform movements risk degenerating into fruitless squabbles over doctrinal differences and we want to minimise that risk by distinguishing carefully between criticism based on legitimate differences over alternative approaches, and that based on misunderstanding and misinterpretation of those alternatives.