A gap in the understanding of the money system at the Treasury

The Commons Debate on Money Creation and Society: both front bench spokespersons display a yawning gap in their understanding of how the money system works

A wake up call is needed

That both front bench spokespersons got it so wrong in the Commons debate on Money Creation and Society on Thursday 20th November 2014 is a sad commentary on their understanding of how banks work and on the poor quality advice given them by the Treasury and their economic advisors.  Have they not read the latest research and expert commentary into the causes of the crash in 2007 and the resulting Great Recession?  Speakers in the Commons debate were talking about the need for a wake up call of MPs.  They were being polite.  What is more pressing is a wake up call to senior economists in the Treasury, policy units and central bank!

The missing facts

Here are the facts which they could have offered their Minister or spokesperson:

Commercial banks have an unlimited ability to create money

The myth

Catherine McKinnell – Labour spokesperson: “Commercial banks do not have unlimited ability to create money, and monetary policy, financial stability and regulation all influence the amount of money they can create. In that sense, banks are regulated by the Prudential Regulation Authority, part of the Bank of England, and the Financial Conduct Authority.”

The Economic Secretary to the Treasury (Andrea Leadsom): “Whenever a bank makes a loan, it credits the borrower’s bank account with a new deposit and that creates “new money”. However, there are limits to how much new money is created at any point in time. When a bank makes a loan, it does so in the expectation that the loan will be repaid in the future—households repay their mortgages out of their salaries; businesses repay their loans out of income from their investments.”

The facts

1.     How the credit market works:  Banks have an unlimited ability to create credit.  Due to imperfect information about the credit worth of loan applicants, the credit market does not clear – using Walsrasian nomenclature – so that rationing is determined not by price but by quantity – whichever quantity of demand or supply of credit is smaller.  As the demand for credit is very large it is credit supply which is rationed.  Banks control interest rates to encourage borrowers to seek more loans [1,2].

2.     The banking crisis of 2007/8 was due to excessive money creation by banks lending to high risk borrowers.  The crisis was anticipated by some economists but their warnings were not heeded by central banks or the Treasury economists [3].

3.     Regulation and reserves: The new banking regulations and the increase in fractional reserves will not stop risky lending by banks.  The idea that commercial banks can only create credit or lend on the basis of a fraction of ‘reserves’ or cash or ‘capital’ in the bank is a delusion [4].  Commercial banks increase central bank reserves after not before lending for liquidity purposes [5].  Further regulations including Basel III have not and are unlikely to change the commercial practices of banks [6].

Interest rates directly influence lending – the higher the interest rates the lower the lending

The myth

The Economic Secretary to the Treasury (Andrea Leadsom): “Ultimately, money creation depends on the policies of the Bank of England. Changes to the bank rate affect market interest rates and, in turn, the saving and borrowing decisions of households and businesses.”

The facts

Empirical evidence in the 1990s demonstrate a positive not negative correlation between bank lending growth and nominal interest rates [7].  More recent evidence over a longer time span from Japan confirms this relationship [8].   And in a recession zero or near zero base interest rates do not on their own encourage new loans to firms which would increase the money supply and economic growth [9].

The high level of debt is having a profound deleterious effect on the economy

The myth

Neither front bench spokesperson mentioned our debt economy.  Yet the high level of private and commercial debt was the cause of the 2007 crash and the great recession since.  Why did their economists not brief them on the effects of the debt economy?

The facts

1.     Debt in this country has never been higher at 500% GDP .  And it is not public debt which is the big problem.  Public debt in August 2014 was 77.4% of GDP.  This is three times less than the peak debt in the aftermath of World War 2, and a quarter the debt arising from the Napoleonic wars.  In Quarter 2 of 2012 total debt was 507% of GDP, made up of 98% of GDP for households, 109% of GDP for non-financial institutions, 219% of GDP for financial institutions and 81%  of GDP for government [10].

2.     Private debt surges are a recurring antecedent to banking crises in many countries over  many years [11,12].

3.     The cost of servicing this debt drains the economy, reducing purchasing power and transferring money from ordinary people to the wealthy [13].  In 2013, 28% of the disposable income of mortgaged households and 19% of (non-financial) company output was used to service debt [14].  In combination this loss to mortgage owners of half their purchasing power is a measure of the lost opportunity created by the debt economy.

The solution is not more regulation

The myth

Catherine McKinnell – Labour spokesperson: “It is clear from this debate that there is a whole range of issues to consider, but our focus is that the banks need to be tightly and correctly regulated to ensure that they work for the whole economy, including individuals and small and large businesses. That is the key issue that we face at present.”

The Economic Secretary to the Treasury (Andrea Leadsom): “We are creating a better, safer financial system, with the Financial Policy Committee, created in this Parliament, focused on macro-prudential analysis and action.”

Both frontbench spokespersons believe that better regulation will solve our banking problems. Labour looks to improve banker incentives and professional standards; Conservatives look to change the banking culture, undertake macro-prudential analysis and action through the Financial Policy Committee and increase competition and diversity.  Why didn’t their economic advisers explain that regulating a fundamentally flawed system has not worked in the past and so is unlikely to work in the future?

The facts

1.     The “Financial Instability Hypothesis” developed by Hyman Minsky in the 1990s has not been refuted by economists but indeed endorsed by the current chair of the Federal Reserve Board [15].

2.     Milton Friedman supported 100% fractional reserve banking as it would allow banks to work in a free market unhampered by regulation.  There would be no need for bank bailouts as banks would be no different from other businesses which are not “too big to fail” [16].

3.     The Deposit guarantee scheme would not be required so removing the hidden subsidy to banks caused by the moral hazard of taking excessive risk on loans [17].  Commercial banks, without the role of money creation, would be just financial intermediaries, competing for custom in a market freed from regulation.

The purpose of Quantitative easing is to increase the money supply without increasing debt

The myth

The Economic Secretary to the Treasury (Andrea Leadsom): “I know that some of my hon. Friends and Opposition Members have a particular concern about quantitative easing—I have made it clear that I do too—specifically about how we might unwind it.”

Quantitative easing causes inflation and needs to be unwound.

The facts

1.     Quantitative easing through the purchase of existing assets made up overwhelmingly of government securities increased the money supply to financial market investors but not to the productive economy as shown by the use of £375 billion since 2007 only producing a 1.5-2% boost to the UK economy [18].  £10 billion sovereign money creation would have produced the same effect through direct investment in the productive economy enhanced through the multiplier effect [19].

2.     The Bank of Japan with the longest period of recession still has not learnt the lesson.  Buying government debt does not increase the supply of needed credit to firms [20].

Conclusion

Our economists have let us down.  While myths abound, the facts are clear.  Is it time for their replacement by economists who read the scientific literature, interpret the new findings and explain the consequences to their political masters?

References

1.     Stiglitz JE, Weiss A (1992) Asymmetric information in credit markets and its implications for macro-economics. Oxf Econ Pap: 694–724.

2.     Keeton WR (1979) Equilibrium credit rationing. Garland New York.

3.     Bezemer DJ (2010) Understanding financial crisis through accounting models. Account Organ Soc 35: 676–688. doi:10.1016/j.aos.2010.07.002.

4.     Pettifor A (2014) Just Money: how Society Can Break the Despotic Power of Finance. Commonwealth Publishing. 240 p.

5.     Ryan-Collins J, Greenham T, Jackson A (2013) Where Does Money Come From? 2 edition. The New Economics Foundation. 184 p.

6.     Haldane AG, Madouros V (2012) The dog and the frisbee. Speech presented at the Federal Reserve Bank of Kansas City’s Jackson Hole economic policy symposium. Available: http://www.thebrokenwindow.net/papers/a/ah.pdf. Accessed 2 December 2014.

7.     Leeper EM, Gordon DB (1992) In search of the liquidity effect. J Monet Econ 29: 341–369.

8.     Werner R (2005) New paradigm in macroeconomics: Solving the riddle of Japanese macroeconomic performance. Palgrave Macmillan. Available: http://eprints.soton.ac.uk/36543/. Accessed 2 December 2014.

9.     Werner RA (2012) Towards a new research programme on “banking and the economy” — Implications of the Quantity Theory of Credit for the prevention and resolution of banking and debt crises. Int Rev Financ Anal 25: 1–17. doi:10.1016/j.irfa.2012.06.002.

10.   Debt and deleveraging: Uneven progress on the path to growth | McKinsey & Company (n.d.). Available: http://www.mckinsey.com/insights/global_capital_markets/uneven_progress_on_the_path_to_growth. Accessed 3 December 2014.

11.   Reinhart CM, Rogoff KS (2010) From Financial Crash to Debt Crisis. Working Paper. National Bureau of Economic Research. Available: http://www.nber.org/papers/w15795. Accessed 2 December 2014.

12.   Sutherland D, Hoeller P (2012) Debt and Macroeconomic Stability: An Overview of the Literature and Some Empirics. OECD Economics Department Working Papers. Paris: Organisation for Economic Co-operation and Development. Available: http://www.oecd-ilibrary.org/content/workingpaper/5k8xb75txzf5-en. Accessed 3 December 2014.

13.   Rowbotham M (1998) The Grip of Death: A Study of Modern Money, Debt Slavery and Destructive Economics. Charlbury, Oxfordshire : Concord, MA: Jon Carpenter. 384 p.

14.   United Kingdom Economic Accounts (2014). Off Natl Stat. Available: http://www.ons.gov.uk/ons/rel/naa1-rd/united-kingdom-economic-accounts/q2-2014/index.html. Accessed 12 December 2014.

15.   Yellen J (2009) A minsky meltdown: lessons for central bankers. Speech at the 18th Annual Hyman P. Minsky Conference, New York. Available: http://www.frbsf.org/news/speeches/2009/0416.html. Accessed 12 December 2014.

16.   Milton Friedman (1965) A Program for Monetary Stability. In: Ketchum MD, Kendall LT, editors. Readings in financial institutions. Boston: Houghton Mifflin. pp. 189–209.

17.   Boone P, Johnson S (2010) Will the politics of global moral hazard sink us again? FuTurE FinancE: 247.

18.   Joyce M, Tong M, Woods R (2011) The United Kingdom’s quantitative easing policy: design, operation and impact. Bank Engl Q Bull 51: 200–212.

19.   Sovereign Money Creation: Paving the Way for a Sustainable Recovery (n.d.). Posit Money. Available: http://bsd.wpengine.com/our-proposals/sovereign-money-creation/. Accessed 12 December 2014.

20.   Lyonnet V, Werner R (2012) Lessons from the Bank of England on “quantitative easing” and other “unconventional” monetary policies. Int Rev Financ Anal 25: 94–105. doi:10.1016/j.irfa.2012.08.001.