Parliament discusses the creation of money

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Magician Show, Le Saltimbanque Der Taschenspieler, The Mountebank Peint Par Louis Knaus Grave Par Paul Girardet

Today the British Parliament discussed the creation of money. The debate was led by Peter Baker, MP for Wycombe for the Conservatives and Michael Meacher, MP for Oldham for the Labour Party.

It was exciting that at last this issue is being raised at a political level. Much credit for this must go to the Positive Money campaign. However, we at PRIME have grave reservations about the proposals promoted by MPs for the centralised creation of the nation’s money supply.

We will write more about these reservations in due course. Watch this space.

Central Banking, State Capitalism, and the Future of the Monetary System

First published on the CFA Institute website 

The role of commercial and central banks in the process of providing credit may seem to be clearly understood by economists, bankers, and policymakers. But there are common misunderstandings about money creation, equilibrium, public money, central banks, and interest rates. The outlook for the global monetary system is not overly optimistic in the absence of overcoming these misunderstandings and altering the philosophies of bankers.

This presentation comes from the 67th CFA Institute Annual Conference held in Seattle on 4–7 May 2014 in partnership with CFA Society Seattle.

The liberalization of finance after the 1970s led to a significant buildup of debt in many parts of the world, especially in Africa, Latin America, and parts of Asia. The inexorable rise in private corporate, household, and individual debt leads to the question of whether professional economists truly understand money, finance, and credit. Good predictions and sound investments cannot, in my view, be made without a solid understanding of money.

Misunderstandings about Money Creation

Satyajit Das (2010) noted in a post on his blog that “modern finance is generally incomprehensible to ordinary men and women. The level of comprehension of many bankers is not significantly higher. It was probably designed that way. Like the wolf in the fairy tale: ‘All the better to fleece you with.’” Misunderstandings about money creation are not uncommon, as can be seen from the title and content of Martin Wolf’s (2014) recent article in the Financial Times: “Strip Private Banks of Their Power to Create Money.” Wolf does not acknowledge that the power to create money is shared jointly between borrowers and bankers. Without applications for loans, banks would not enjoy the power to “create money (deposits) out of thin air.” As a result of this misunderstanding, and because Wolf regards bankers as irresponsible, he calls for a form of centralized control of the money supply. His proposed solution should worry us all.

Most economists conceptualize money as a commodity. By conceptualizing money in this way, economists have come to believe there can be either a shortage or a surplus of money. Furthermore, they believe that the role of bankers is to act as intermediaries between those holding stocks of money and those wanting to “rent” or borrow money—that is, savers and borrowers. This theory is deeply flawed, as is the orthodox neoliberal economic theory that assumes central banks serve as a powerful control system for sound money. An example of this thinking is Allan H. Meltzer’s (2014) article in the Wall Street Journal in which he berates the Federal Reserve Board for its role in the growing threat of inflation. A more realistic assessment is that central banks do not have as much power to control the supply of money as is typically assumed by neoclassical thinkers like Meltzer.

The Bank of England (BOE) helped shed light on the issue in its recent Quarterly Bulletin (2014a). The BOE’s staff explained that “the majority of money in the modern economy is created by commercial banks making loans” (p. 16). Mervyn King, the recent governor of the BOE, explained that UK private banks are usually responsible for 95% of the money supply; the central bank only provides 5%. The BOE staff went on to explain that “banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits” (p. 16).

The bottom line is that there is no such thing as “fractional reserve banking,” which is the theory that a fraction of a licensed, commercial bank’s loans are backed by actual cash (or “reserves”) on hand. In contrast, savings banks do indeed lend out savings. There has been no such thing as fractional reserve banking since the BOE was founded to manage the banking system in 1694. This misperception is very common, even among respected economists.
Continue reading… ›

Vicious loop: rising private debt merging with falling wages, productivity & inflation

The Bank of England’s Andy Haldane is a fine economist. He occupies an ideology-free zone. This is highly unusual in central bank circles. He has just made a particularly skilful, and nuanced speech. Many gushed over it. Gillian Tett of the Financial Times suggested that it was good enough to qualify Haldane as a journalist.

But Haldane is not a journalist. He is a central banker. And that makes his ‘Twin Peaks’ speech particularly ominous. For while he bows to his political masters in the Treasury by acknowledging the growth in UK employment, his speech tilts definitively towards gloom. Let’s analyse it more carefully than I was able to do in a brief BBC Newsnight interview (eleven minutes into the show).

First, as part of his positive ‘Peak’, Haldane notes that “consumer price inflation, at 1.2%” has reduced “the squeeze on households’ real disposable incomes”. That is questionable, given the ongoing squeeze on household incomes. [Later in the speech he gives it to us straight: “average weekly earnings growth adjusted for consumer price inflation – is currently running at close to minus 1%” (My emphasis).]

He then goes on to make a remarkable “positive” statement. “According to financial markets inflation is expected to return and stay close to target over the medium term.” That is in my view a highly unlikely trajectory. And Haldane appears to agree, because later, in his conclusion he makes a tortured reference to disinflation as “the weak pipeline of inflationary pressures” – weak because of falling wages and commodity prices. So the financial markets are likely to be wrong again. And all the while deflationary pressures intensify.

Note that he, a policy-maker at the Bank of England is not telling us what the Bank considers the future direction of inflation to be. Instead he implies that the future direction of inflation is in the hands of markets, and not the central bank. That is depressing, but right of course, because the Bank of England, like the Federal Reserve has done almost all that can be done to manage inflation, given that the committee of men and women who decide on policy, have only one, not very effective weapon or policy tool: the central bank rate of interest. The current rate cannot reasonably fall much lower. Indeed the Bank can only maintain a 0% nominal rate – or as it is known, a Zero interest-rate policy (ZIRP).

What Haldane is saying here quite pointedly is this: the Bank of England can do no more. Continue reading… ›

Secular stagnation is the outcome of deliberate policy; it can (still) be reversed

Secular stagnation within a deflationary context, let us be clear, is the outcome of deliberate policy choices. It has not come about by accident. It has not come about for lack of economic understanding, learning or analysis. It has not come about for lack of economic tools – both fiscal and monetary, or indeed for lack of human agency. Instead secular stagnation is the deliberate outcome of policy choices made by those dominant in the world’s most powerful policy-making institutions, including the IMF.

Calculated choices, including the following, have led to stagnation:

  • policies to liberalise/de-regulate finance, and in particular debt creation – and a deliberate refusal to manage the very unstable, and de-stabilising global financial system.
  • a policy to allow the potentially dangerous shadow banking system to expand, without rigorous micro-prudential regulation or oversight. (According to the IMF “the global shadow system peaked at $62 trillion in 2007, declined to $59 trillion during the crisis, and rebounded to $67 trillion at the end of 2011.”)
  • policies to use taxpayer resources to rescue the private finance sector from its own fraudulent and anti-free market conduct – without imposing and carrying through severe conditionalities.
  •  policy to leave the banking system pretty much as it operated before the crisis: with deliberate decisions not to re-structure too-big-to-fail banks, and separate retail from the speculative arms of banks.
  • A refusal to write off, re-structure or manage the repayment of vast debts owed by, and to the private banking system.
  • A deliberate decision to allow effectively insolvent banks to carry on speculative activities – but this time with taxpayer backed-guarantees, and with resources obtained at very low, central bank rates.
  • policies to lower wages (through globalisation/liberalisation/attacks on trade unionism).
  • policies for liberalising trade, without policies for managing and transitioning the complex impacts of what is often wrongly defined as “free” trade.
  • A deliberate refusal to act to re-balance the unbalanced global economy – away from speculative, rentier activity and towards full and meaningful investment and employment of both human and other (finite) resources.
  • A deliberate refusal by powerful leaders and policy-makers to co-operate at an international level to fix imbalances (trade, financial and ecological) between surplus and deficit countries.

Debt-deflationary policies which lead to stagnation are the policies of choice of institutions dominated by creditors.

This is because deflation has one great macroeconomic upside: it inflates the value and the cost of debt. Just as inflation erodes the value of debt.
Continue reading… ›

Why the Scottish Uprising will not lead to independence

It is a campaign to end allegiance to Westminster politicians that promote and/or tolerate austerity and the accelerating privatisation of the NHS and other national assets.

Rising anger against the establishment has mobilised support behind the campaign for Scottish independence. We share this anger and believe the Scots are right to challenge both the above, and also the narrow focus of Britain’s politicians on, e.g., voters in marginal seats.

But the uprising is led by a political party (the SNP) whose campaign will lead to Scottish subordination to the British state on the one hand, and to multinational corporations on the other. And make no mistake: the SNP’s determination to fragment the British state—even if achieved peacefully and even if it were possible to define a Scottish government as progressive—ultimately serves the interests of footloose finance capital more than those of the Scottish people.

The currency question

The SNP seems to have ruled out an independent Scottish currency and central bank, which we and other economists recommend as the only solution consistent with sovereignty and independence—even if it, too, is a risky strategy for a country of less than five million taxpayers.

The SNP’s commitment to a currency union with Britain, as many have argued, is a commitment to subordinate Scottish economic independence to the control of the British Treasury and the Bank of England (BoE). As the Governor of the BoE Mark Carney repeatedly says: a currency union is not compatible with sovereignty.

Under a currency union, the Bank of England and Treasury will influence and shape the exchange rate of Scotland’s currency (sterling) and Scotland’s interest rates. Furthermore, the British Treasury will insist on final control over an independent Scotland’s taxation and spending policies, and the management of its public debt. Scotland can today have some say over Treasury policies. An independent Scotland in a monetary union will have no say.

Post-independence, 59 million British taxpayers will not be willing to guarantee, via the BoE, the bank deposits of 5 million Scottish citizens. The BoE will no longer regulate, manage or lend to Scottish banks. As a result and over time, money will flow out of Scottish banks, bankruptcy will loom, so banks will quickly migrate their HQs to London, to flout free market ideology and seek protection from losses from British taxpayers. Continue reading… ›

Twenty Two Days that Changed the World

In this carefully researched book, Ed Conway tells a gripping human tale about the July 1944 Bretton Woods Conference – “the biggest battle of the Second World War – fought behind closed doors”. He provides remarkable insights into the personal, geopolitical and intellectual dynamics that played out that summer within the confines of the Mount Washington Hotel, nestled within New Hampshire’s Bretton Woods.

His story of how 730 delegates from 44 nations worked together to build the post-war international monetary system is a highly readable account of a gathering that was to transform the global economy. Pivotal to the success of the conference was President Roosevelt’s and Keynes’s determination to bar Wall St. and the City of London from participating in preparations for the conference; and to deny the private finance sector (with one exception) access to the conference proceedings. After the catastrophic economic failures of the 1930s Haute Finance was to be denied a role in the construction of the post-war international economic order.

The book details the well-known tensions that arose both before and after the conference between the US Treasury’s Harry Dexter White and John Maynard Keynes, representing Britain. As importantly Conway reveals “the surprising influence of China, Brazil and India” but also the significant role that Russia played at Bretton Woods. Conway is the first to consult Russian Finance Ministry archives on the part played by the Soviets at Bretton Woods; files made available to researchers at the end of the Cold War but never before used.

Conway explores the controversy surrounding Harry Dexter White’s supposed collusion with the Soviet authorities during the negotiations. He shares a growing consensus that as late as 1946

“the general opinion in Washington was that ‘Stalin has been our best friend’…In other words, there simply  was not during this period the stigma attached to  dealing with the Soviets that developed over the following years…White simply viewed his interactions with the Russians as a means of carrying out broader American foreign policy – without having to go through the odious State Department.” (p.162)

The Bretton Woods conference is often relegated in importance to the summits held at Yalta and Potsdam. Conway writes that:

“For some reason, while it remains one of economics’ few household names, Bretton Woods is frequently ignored in accounts of the period.” Continue reading… ›

Out of thin air - Why banks must be allowed to create money

‘I know of only three people who really understand money. A professor at another university; one of my students; and a rather junior clerk at the Bank of England.’  Attributed to Keynes [1]

In a recent paper, ‘Money creation in the modern economy’[2] Bank of England staff explained that:

‘[B]anks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits … Commercial banks create money, in the form of bank deposits, by making new loans.’

Because there is widespread confusion about the role of banks in creating money, it did not take long for the Bank of England’s report to ignite debate on the comment pages of the Financial Times. In his regular column, Martin Wolf called for private banks to be stripped of their power to create money. [3]

Wolf’s proposals are radical, and would give a small committee – independent of the state – a monopoly on money creation. His ideas are based on the Chicago Plan, advanced among others by Irving Fisher in the 1930s, and shared today by the UK NGO, Positive Money. They agree that all ‘decisions on money creation would … be taken by a committee independent of government’.

Furthermore, Wolf argues, private commercial banks would only be allowed to:

‘…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.’

Because I am a vocal critic of the private finance sector, many assume that I would agree with Wolf and Positive Money on nationalising money creation. Not so.

I have no objection to the nationalisation of banks. But nationalising banks is a different proposition from nationalising (and centralising) money creation in the hands of a small ‘independent committee’. Indeed, the notion to my mind is preposterous. It is an approach reminiscent of the misguided and failed monetarist policy prescriptions for controlling the money supply in the 1980s.

Second, the proposal that only money already saved should be made available for lending assumes that money exists as a consequence of economic activity, and equals savings. But that is to get things the wrong way around. Rather, it is credit that functions as money, and it is credit that creates economic activity and employment. Deposits and/or savings are the consequence of the creation of credit and its role in stimulating investment and employment. Employment, as we all know from our own experience, generates income – wages, salaries, profits and tax revenues. A share of this income can then be set aside as savings.

To restrict all economic activity to savings would be to contract economic activity to an ever-diminishing sum of existing savings. Furthermore, the restriction of all lending to existing savings would lead to higher rates of interest, because the level of savings is much lower than the level of potential economic activity and employment. Savers would be in a position to demand a higher return on the loan of their savings. This would return society to the dark ages, when investment and economic activity was subject to the whims of great feudal landowners, putting the financial elite in control of society’s surpluses or ‘savings’.

Money in an historical context As Douglas Coe and I explain in a recent PRIME report,[4] the UK monetary system – complete with the power to create money ‘out of thin air’ – was established back in 1694 with the goal, among others, of facilitating commercial transactions and the financing of the king’s wars. But there was an additional and just as important goal: to mimic the Dutch in reducing the rate of interest facing commercial interests. British firms, households and individuals were keen to bring rates down and into line with those that prevailed in the financially more advanced Netherlands. Lower rates made investment and employment viable. Continue reading… ›

Why I disagree with Martin Wolf and Positive Money

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.

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. As such his proposal, like the Chicago Plan, would contract and restrict economic activity – to the level of existing savings. That is why the Chicago Plan was so enthusiastically endorsed by monetarists like Milton Friedman.

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.

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. Continue reading… ›

Today’s Budget and the crisis in Ukraine

This year’s Budget takes place at a time of high international tension. The issue of energy security has once again shot to the top of the political agenda. The crisis in Ukraine demonstrates once again the extent to which Britain is exposed to political and economic risks beyond our control.

The fact is Britain’s dependency on external sources of energy means that we are dangerously exposed to this crisis – at a time when North Sea Oil and Gas production has fallen by over 20% since the Coalition government took office.

And while Russia supplies only a small percentage of Britain’s natural gas, the crisis has the potential to drive the price of carbon fuels higher.  Brent crude is already at a high for 2014. Further tensions and conflict in Eastern Europe could trigger even higher rises in gas and oil prices.

To compound this threat, Britain has one of the lowest shares of alternative energy supplies in Europe. Renewables form just 4.3% of our energy mix, a figure just a little higher than that for tiny Malta and Luxembourg. By comparison renewable sources of energy in Germany and France form about 12-13% of the energy mix.

The Chancellor should therefore use the opportunity of the Budget to address this grave threat to Britain’s security; to invest to urgently diversify Britain’s energy mix; and to achieve greater energy efficiency.

Such investment is sorely needed. In Q4 2013, total investment (public and private) was still 1.3% below the 2010 figure.  Business investment has finally started a modest increase, and is up 1.5% on the 2010 figure.  But government Gross Fixed Capital Formation or investment is down a huge 9.3%.  (And despite all the media interest in the housing bubble, housing investment (which includes maintenance etc. as well as new build) is up just 1.4%.)

As many economists have argued, the Chancellor could finance such urgently needed investment at historically unprecedented low rates of interest.  Such low-cost public investment in energy infrastructure would achieve five important economic, energy and environmental goals.

First it would provide greater energy security to Britain’s households and firms.

Second, investment in greater efficiency would lead to cost savings for both households and firms.

Third, alternative sources of energy could help reduce Britain’s carbon emissions, which in turn destabilize the climate.

Fourth, such investment in alternative and more efficient energy would lead to the creation of local, skilled, and higher-paid jobs.

Fifth, the income from such jobs would generate the tax revenues needed to repay the government’s low-cost borrowing.

This is the win-win economic and energy strategy first proposed by the Green New Deal Group in our ground-breaking report launched back in 2008.

The Ukraine crisis exposes the failures of Britain’s economic and energy model; a model based on high levels of private debt fuelling asset bubbles; disproportionate consumption; energy inefficiency and dependency, trade imbalances and chronic low investment.

The first task of any government is to plan for, and defend the security, including the energy security, of its citizens. As a leading member of this government, the Chancellor has a duty to plan for, and defend both the economic and the energy security of Britain’s households and firms. The Green New Deal is the plan his Budget should confirm today.

This text was originally published by the Center for Labour and Social Studies (CLASS).

If interest rates rise “God help us all with mortgages

… In a debate with Fraser Nelson of the Spectator on the BBC´s Daily Politics programme on 24th June, 2014. Even a gradual rise in the bank´s base rate would put around 2.3 million households at risk. Marginal increases in household incomes make debtors highly vulnerable to any additional borrowing costs. Pettifor also said that a rise in rates would be particularly harmful for those on low incomes that had been actively encouraged to take out high loan-to-value mortgages by the government’s Help to Buy scheme. Watch the full interview on BBC.