Our Magic Money Tree: Fixing the Financial Crisis
“There is no magic money tree.” — David Cameron, UK Prime Minister
Regular readers of this blog will be well aware that David Cameron is quite wrong here. In fact, creating money is as easy as the flick of a pen and the clattering of some computer keys. While the UK’s “magic money tree” is currently controlled by the private banking system, the UK government is quite capable of altering this situation. All it requires is the political will to act. Once the nature of our current monetary system is understood by the public and they are clamouring for action from their elected representatives, it is actually trifleingly easy to get out of this financial crisis and reduce people’s indebtedness. It just takes a little creative accounting. Part 2 of Positive Money’s new book Modernising Money, for instance, has some nice concrete suggestions for us.
The rest of this article will go on to explain some simple ways to get out of the crisis without inflicting further painful sacrifices upon the UK population. My suggestions and commentary here are lifted directly from Prof. Richard Werner’s excellent book New Paradigm in Macroeconomics, which all concerned citizens should rush out to read!
Stimulating demand – three proposals
The problem we have during a recession is lack of effective demand caused by insufficient creation of credit by private banks (plenty of empirical evidence for this statement is provided in Prof. Werner’s book). With aggregate demand down, individual banks are reluctant to make new “loans” (i.e. create new credit) because they are worried about not turning a profit when indebted and/or unemployed consumers can’t afford new goods and services. If our government would like to “get the banks lending again”, how could it go about this? In chapter 18 of his book, Prof. Werner suggests three ways:
1:- The govenment (meaning, in our case, the Bank of England) can issue bonds (basically, government I.O.Us) and sell these to the private sector investors in exchange for funds to stimulate the economy.
2:- The government can borrow money directly from the private banking sector, by allowing private banks to “lend” directly to the Bank of England.
3:- The government can create new digital money debt free to invest in new infrastructure and stimulate demand.
The first option is the one currently being pursued by EU governments. According to Prof. Werner, it is the worst of all three options, because it both incurs debt to private investors and does not create new purchasing power – it merely transfers purchasing power from the private sector bond-buyers to the government, so net demand is not increased. This is called “crowding out” by economists – each pound of increased government investment is only achieved via a £1 reduction in private sector purchasing power.
The second option has been suggested for the UK by Prof. Werner in a recent letter to the Financial Times. There would be no problem getting private banks to lend directly to the government, since the government is basically zero-risk as a borrower – governments cannot go bankrupt so long as taxpayers exist! Its key advantage over the first options is that new net purchasing power is created, rather than existing purchasing power being transferred from the private sector to the government. This is due to banks’ creation of new money when they make a “loan” to the government. The disadvantage is that interest payments must be made to the private sector investors the government has gone into debt to (option 1 has the same problem, but is without option 2’s advantage of net credit creation).
The third option is the best of all, according to Prof. Werner, since like option 2 it creates new purchasing power to stimulate more demand, but unlike option 2 does not need to incur debt to private investors to do so. However, option 3 is not currently allowed by UK laws and so would require financial reforms such as those Positive Money is proposing to be passed by parliament.
In conclusion, for the meanwhile, option 2 is the most realistic and sensible stopgap measure. Think of it as “QE for the people.” What has been called QE thus far is actually the creation of additional central bank reserves – the money that banks use to make payments to each other and NOT the money businesses require for new investment and job creation. Prof. Werner (who actually coined the expression “quantitative easing” – ryouteki kinyuu kanwa in Japanese) comments that:
“It is such a broad policy of broadly expanded credit creation [such as option 2] that should properly be referred to as ‘quantitative monetary easing’ in line with the traditional Bank of Japan nomenclature (ryouteki kinyuu kanwa). The policy adopted since March 2001 of increasing banks’ reserves with the central bank cannot properly be called that, since it does not increase the quantity of credit creation.”
Cleaning up the toxic mess – magicing away “bad debts”.
Another reason we are stuck in recession is the accumulation of “toxic assets” / “bad debts” on banks’ balance sheets in the aftermath of the sub-prime mortgage bubble bursting. These “bad debts” make it difficult for banks to expand their balance sheets and issue new “loans” (i.e. create additional purchasing power required to invest in business and job creation). What this means is that millions of people are being made to suffer because a fairly simple accounting problem is not being addressed – mostly because politicians and the public don’t understand the problem (and vested interests may not particularly want them to – for example, Prof. Werner gives several examples of obtuse statements from Bank of Japan officials that have mislead the public about what they were doing throughout the 80s and 90s. To cut a long story short, interest rate manipulations were little more than a cover story for what the bank was really doing – (mis)allocating credit. Interest rates don’t really matter, as Prof. Werner shows convincingly in chapter 6 of his book).
Prof. Werner suggests how the government can clean up the banks’ dirty balance sheets without costing taxpayers anything:
“For bank credit creation to rise, banks’ risk aversion needs to be reduced, which can be done by writing off the bad debts. To do so the banks require money. The question is therefore reduced to determining where this money should come from. A non-exhaustive list would be: the taxpayers / the government, the central bank and private investors. Concerning each sector, many different schemes are possible, each time hinging on the issue of just how much money is put up and what would be received in return. …
“Economists can, however, suggest the most efficient scheme from the viewpoint of the entire economy. This would be for the central bank, in fulfillment of its function, to solve the bad debt problem in the banking system at zero cost to society, namely by conducting a one-off purchase of all declared bad debts from the bank at the original book value. The banks’ balance sheets would be among the strongest in the world and they could begin to engage in their normal credit business again. Unlike a normal fiscal bank bailout [i.e. option 1] this would not burden the taxpayer and thus would also not crowd out the private sector. Moreover, it would be a ‘free lunch’, since there would be no cost to the economy. The central bank could simply keep these assets on its books at face value ad infinitum.” [my emphasis, in bold]
So basically, the Bank of England could just make up the money required to purchase the bad debts from private banks, at zero cost to society. The money it makes up would be accounted as a liability on the central banks’ balance sheet, to balance the accquired assets. But the central bank is actually “liable” to no-one – there is no social cost, as Prof. Werner explains in a later footnote:
“Central banks often argue that they should not expand their credit creation during times of crisis, as they would make a loss and/or their balance sheets would deteriorate. This argument has no merit for several reasons. First of all, even if central banks’ balance sheets were to deteriorate, there are no negative consequences. Loss of reputation cannot be an argument, since not adopting the right policies,as has occurred in the case of the Bank of Japan, would cause a more severe loss of reputation. Further, if central banks were not to engage in such transactions in times of crisis, when should they engage in such transactions? They certainly would not be necessary in times of financial boom. Most of all, the argument that central banks’ balance sheets and reputation would suffer is based on the assumption that the balance sheet of the central bank is of the same nature as the balance sheet of a private sector corporation or bank. However a central bank is special.
“Take the case of a central bank purchasing bad loans from banks at book value (say for £10 billion) although their market value is lower (say only £2 billion). It may superficially appear as if a loss of £8 billion is made. This would be true in the case of agents other than the central bank. The central bank, however, in this case will make a profit of (at least) £2 billion (since it creates money at zero cost and obtains something worth £2 billion with it). While it is possible to represent this transaction on the central banks’ balance sheet such that the false impression of a loss of £8 billion is created, there is no logically compelling reason to do so. The habit of treating note issuance as a liability is only a bookkeeping convention due to the historical experience when cash was to be exchanged into gold on demand, and today does not imply that the central bank has any costs or actual liabilities when issuing new money.”
[Note: I took the liberty of changing Prof. Werner’s original example figures in yen for similar amounts in pounds sterling. Incidentally, in the reforms Positive Money proposes, new money created by the central bank is more sensibly accounted as an asset of the central bank, and not a liability to nobody for some non-existent gold!]
It is just a clever piece of accounting “magic” to fix an accounting problem. It is time to demand a bailout for the people along such lines. It is certainly possible and actually quite straightforward – assertions by Prime Ministers (or central bankers) to the contrary.
There is an alternative: making banking socially useful
We can (and arguable should) go further than simply getting out of this recession. The problem with our current financial system is not just that private banks are allowed to create money, largely unregulated. They are also allowed to allocate it. In the real world, as Prof. Werner explains at length in his book, information is imperfect and markets do not clear. In the real world, there is no magical, impersonal “free market” deciding things – rather, allocators decide things. In the credit market, demand for credit vastly exceeds supply (and is perhaps even infinite) and so the supply of credit is rationed by its allocators – the banks. New money is thus channeled into whatever activity is most profitable to private banks – certainly not the same as whatever is socially optimal.
But David Cameron is quite wrong to suggest that “there is no alternative” to the government’s present “hands off” banking policies. In the past, governments have been much more “hands on” with private banks – in Japan and Germany for instance (the worlds third and fourth largest economies, respectively) for decades quotas were set for the allocation of credit by private banks to different sectors of the economy. This sectoral allocation of credit is called “window guidance” (madoguchi shido in Japanese) and Prof. Werner concludes that its judicious use largely accounts for Japan’s post-WW2 “economic miracle”. China is currently pursuing a similar strategy, incidentally.
The empirical evidence suggests that under this “window guidance” system both economic growth and various social health metrics were significantly higher than for more “hands-off” banking systems such as the US and UK. There are also dangers however, pointed out by Prof. Werner in his book, if central banks become too “independent” and over-allocate credit to dubious sectors of the economy prone to asset inflation bubbles (as happened in Japan in the 1980s with its real estate bubble, caused by the Bank of Japan forcing banks to over-allocate credit to this sector, Prof. Werner concludes). Thus, it is very important that money creation and allocation to different sectors of the economy is made both transparent and accountable to the public through proper checks and balances upon central banks’ decisions.
I would argue that democracy is largely a sham if a handful of unelected central bank officials (or equally, “big five” CEOs) are able to “independently” make key economic decisions affecting the lives of millions of people. As anarchist Mikhail Bakunin wryly observed long ago of “democracies”: “When the people are being beaten with a stick, they are not much happier if it is called the People’s Stick”. As anarchist David Graeber, author of Debt: The First 5000 Years has argued much more recently in an interview with Steve Paulson:
“I think there’s a kind of democratic awakening happening. It’s what’s happened in places like Spain and Greece and it’s spread to the U.S. There’s this realization like, no, this isn’t true. Money is just a promise. It’s a social construct, it’s something we make up. If banks can lend us money, it’s not because they have that money. It’s because we, the people, have given them the right to make up money. Well, if that is the situation, we have given them the right to make up money because we think it will help people have houses, it will help the economy grow. The economy isn’t growing, people don’t have houses, something went wrong. We can change that around because it really comes from us to begin with, so I think if democracy is to mean anything, it has to mean that everybody can weigh in on that process of deciding what kind of promises we make and what kind of promises we readjust when we have to do that.”
So, let’s demand the democratisation of money creation and allocation, loud and clear, in unison. It is our money, after all – when the banks get into difficulties, who rides to their rescue? That would be the government, meaning taxpayers, meaning all of us. So shouldn’t we all have a say in what our money is used for? How about schools, hospitals, jobs, poverty alleviation, public infra-structure investment, de-carbonising our economy and repairing the damage wrought to global ecosystems, for starters? Prof. Werner concludes his book with the proposal that citizens could vote on how their money is allocated. I’ll give him the last word:
“Once the facts of credit creation and its potential are more widely known, democratic processes can be used to decide upon the goals that should be achieved and the most suitable mechanism to achieve them. A clever use of institutional design and credit allocation will allow far more ambitious goals to be implemented than has thus far been the case. Not only recessions, boom-bust cycles and unemployment, but also poverty and destitution can in principle be eliminated.
“As an example, an improved form of macroeconomic management can thus take the following form: through democratic institutions society decides upon overall goals that the economy should fulfill. This may for instance be environmentally sustainable, stable economic growth which gives highest priority to quality of life of present and future generations. To achieve this goal, the democratically accountable credit control mechanism would openly discuss and decide upon a priority ranking for the issuance of credit. Thus research into new environmentally friendly energy sources may be given priority, as well as the creation of green urban spaces and leisure areas. Credit would then be created to fund such research and investment in such projects. Meanwhile, purely wasteful or environmentally destructive types of activities or activities that affect the well-being of people negatively would not receive newly created purchasing power. The decisions would have to be made in the open and subject to debates and voting.”