An interesting proposal - full reserve banking

Positive Money, a group of dynamic young economist in the UK, noting that the global financial crisis was a consequence of excessive money creation by commercial banks, have come up with a fairly ingenious solution, which they term full reserve banking. I would recommend that you take a look. The essence of the approach is to remove from commercial banks the powers of money creation and restrict this exclusively to the central banks. In other words bring the 1844 Bank Charter Act up to date!

An independent committee (like the UKs Monetary Policy Committee) would determine how much money should be created each year based on current and expected inflation rates. Importantly, they would look at both asset (e.g. house) and consumer price inflation. This money would be provided to the government to spend debt-free.  They anticipate this would be in the region of 5-7% of GDP pa. This additional money would enable governments to lower taxes or increase spending.

Meanwhile banks would only be able to lend money they actually had, and only with the consent of the person who deposited the money. They would not be permitted to lend money from current or deposit accounts. There would be no need for deposit insurance and even if banks collapsed this would have no effect on deposits as these would be legally separate, owned by the depositor.

Those who wanted to earn interest on bank deposits could put the money in special 'investment accounts'. They would earn a higher return but at the risk of losing all their money. Banks would have a strong incentive to be financially sound as this would attract more investment deposits.

Seems like a brilliant system to me. The banks would hate it of course.

An extraordinary injustice

I pointed out in a previous post that commercial banks create almost all new money, with little regulation. They create money to loan or purchase assets when they think they can profit from it. Money supply growth was allowed to reach 12-13% per annum in the USA, Europe and the UK, far greater than necessary for economic growth (it has now dropped precipitously). This extraordinarily relaxed approach has been a disaster. It lead to asset price inflation, enormous levels of debt, huge inequalities in the distribution of wealth, and eventually the global financial crisis (GFC).

As I have argued, all this could have been avoided if a more balanced approach to increasing the money supply had been used, with governments permitted to deficit spend, supported by central banks.

When the banking system was about to collapse in 2008 because mortgage debt defaults made many large banks insolvent, there was a desperate need to pour money into these banks. The obvious and pain free way to do this would have been for central banks to create the money and use this to recapitalise banks either directly or through governments.

Instead they did nothing. The approach taken was that governments would have to recapitalize banks funding this by cutting spending, raising taxes and increasing borrowing.

The financial system and commercial banks were rescued but this left governments with huge budget deficits. Note that these deficits were also a consequence of the severe recession precipitated by the GFC, which simultaneously reduced tax revenues and increased expenditure on, for example, unemployment benefits.

Soon the alarm was being expressed about the large government deficits and growing debts, leading to pressure for large spending cuts and tax increases, despite the fact that this will further reduce demand.

We are told that this austerity is necessary - that there is no alternative. This is wrong. It is unnecessary. The central banks can easily create the money to fund bank rescues and the budget deficit. They have, after all, created huge amounts of money to spend on quantitative easing (UK and USA) and long-term financing operation (ECB). Fears that this would create inflation, which never made sense given that this just replaced money that the GFC had 'destroyed', have been conclusively proven to be wrong.

Not only is it unnecessary, it is also unfair, particularly in the Eurozone, because the money created is primarily being used to support commercial banks rather than government spending. So the very sector that caused the problems and required rescue by the tax payer are the only ones receiving central bank help. Meanwhile Eurozone governments have been forced to impose fierce austerity and to pay high interest rates, if they can borrow at all (5-8%). That is apparently fine. But when Eurozone banks ran into difficulties late last year the ECB very quickly created and distribute over €1 trillion and loaned it to any bank that wanted it at 1%.

Why is it morally acceptable to create money to lend at low rates to commercial banks, who were the ultimate cause of the problem, but not to Eurozone governments and their voters, who have been forced to bear the costs of commercial bank excesses?

I am not arguing that banks should not be rescued. We need a functioning payment system. What I am saying is that central banks' power to create money should also be used to prevent the misery resulting from commercial bank excesses.

It may well be that central banks, especially the ECB, are constrained by self-imposed rules from doing anything else. But surely it is now obvious that these rules are absurd. In the UK and USA these rules can easily be bypassed or changed. In the Eurozone this is more difficult, especially since Germany is adamant that they be enforced.

In conclusion, I maintain that the approach to the GFC and sovereign debt crisis has been deeply irrational and unfair. The reluctance of central banks to create money to fund government spending is inconsistent with their willingness to create money to support commercial banks directly.

A bit of history

How did commercial banks obtain the privilege to create money?

The short answer to this is financial innovation.

Here is the longer answer. Commercial banks used to have the power to create paper money at will but this was banned in the UK by the 1844 Bank Charter Act after several periods of financial turmoil and banking collapse. The intention of this act was to confine the power of money creation in England* to the Bank of England. However, innovation by commercial banks, and a failure of legislation and regulation to respond to this innovation, allowed them to create money in other ways. For example, instead of creating bank notes they created demand deposits, which were just ledger entries, and allowed customers to write checks against these deposits in order to spend. Late they developed credit cards and internet payments as other means of payment from demand deposit accounts. Now paper money is used only for a tiny fraction of transactions by volume. Thus an inability to print money is now no restraint on money creation by commercial banks.

It is hardly surprising that legislators in 1844 failed to anticipate credit cards and electronic payment systems when writing this Act!

But surely it is time to update the 1844 Bank Charter Act so that it functions as intended: preventing commercial banks from creating money of any type?

*Interestingly this did not apply to Scotland and Wales where certain commercial banks are still allowed to create banknotes.

Unfair scientific publishing

Here is an interesting issue that casts an unflattering light on lobbying congress.

In the past there has been growing unhappiness that, when scientific research funded by taxpayers and charities is published in journals, publishers hold the exclusive copyright and charge high prices for access to these articles. Typically $35 for a single article, which may be only one page long. They also charge libraries very high prices for subscriptions (as much as £1,000,000 per year by a single publisher and for a single institution). As most of the work required to produce and assess the articles is not paid by the publishers, they make a tidy profit on the backs of taxpayers and donors to charity.

Now a few years ago those funding research started imposing a requirement that any reports of work funded by them should be available for free access after 6 months. This would mean that publishers could still profit but that work was accessible at low cost after a delay.

Publishers have responded in two ways. Firstly they charge an additional costs to authors for this,  demanding an additional £5,000 per article. Secondly, they have been lobbying the US congress to introduce a bill (the Research Works Act) that would actually ban the government from requiring this open access after 6 months for research that is publicly funded. It is very difficult to understand how anyone of sane mind outside the publishing industry could support such a bill. Fortunately the reaction of academics and scientists was so strong (they threatened a boycott) that Elsevier withdrew their support from the bill and, guess what, the bill was dropped. This reveals the ugly effect of lobbying on politicians. But the good guys won, thanks to the collective action of many.

A special privilege

The controversy over the budget deficits, and the anxiety expressed by many that central banks are creating or 'printing' money through quantitative easing needs to be put into context.

It is natural to feel slightly uneasy about the fact that central banks have the power to create money out of nothing. Indeed there are very strict rules in place to limit their ability to do this except under exceptional circumstances. Now that they are actually using this power to add money to the financial system in order to stabilise it many are concerned that this could be inflationary.

What is not appreciated is that commercial banks also have the power to create money, and that the vast bulk of money in the financial system (>97% in the UK) was created by commercial banks. They do this by simply typing in numbers on a computer in the bank account of anyone that they loan money to. This money does not come from anywhere. It is created by the act of typing numbers in the equivalent of a spreadsheet maintained by the bank. Furthermore, commercial banks have very few external constraints on how much money they can create. Their only considerations are whether they can earn enough interest on the loan and whether the interest and capital will be repaid. In recent years the financial innovation has meant that they need not worry too much about repayment as they can often sell the loans on to others soon after making them, passing on the risk of default.

While there used to be tight credit controls which controlled bank lending, in recent decades these have been largely abolished. The only remaining control is what is called the capital adequacy ratio (CAR), which requires bank to put aside a certain amount of secure capital for every loan. The rules are quite complex as certain types of capital are considered more secure (and so less is required). This was as low as 3% of loan value in some cases during the credit bubble (although it is being increased in the wake of the global financial crisis - stable doors, bolting horses etc). However CAR provides little practical restraint on lending at times when it is most needed, which is during economic booms when there is a risk of asset bubbles. This is because banks can use retained profits from existing loans as capital which then allow them to make more loans etc etc. CAR do provide a restraint on bank lending when they are not needed such during a recession when bank profits are down and defaults are high!

The overall point is that the regulation of money creation by private banks is very limited whereas public institutions have very strict rules preventing them from creating money except under exceptional circumstances. Is this balance rational?

The growth of the money supply by banks has been remarkable. What is instructive is to compare how much money has been created by private banks versus central banks over the past 50 years. The figure below from the book 'Where does money come from?' show this for the UK. What is quite obvious is that money creation by private banks has far outstripped money creation by the central bank, even after the recent rounds of 'quantitative easing'.

How often do you recall economists or politicians expressing any concern about the inflationary effects of money creation by private banks? They did not. And it was inflationary. But the inflation was focused on asset prices rather than consumer prices for the simple reason that private lending tends to be directed towards asset purchases such as stocks and properties. Banks like these as the assets act a security and tend to increase in prices as long as bank lending continues to grow. Some have argued that the huge profits made by financial institutions were really just the result of them creating so much money that assets prices rose enabling them to keep plenty of the money that they created and get fantastically rich. It was really one giant scam with ordinary people as the suckers. Remember that commercial bank credit creation creates no net new money so what has happened is that most people have borrowed money and transferred it to the financial sector has net earnings and profits. Most of them got to keep this money while the vast majority are drowning in debt.

Given this context does it really seem so awful for central banks to create money?

Indeed would it not be better to allow more money creation by governments central banks and less by commercial banks?

Why should this remarkable privilege of money creation and all the profits that go with it be largely confined to commercial banks? Commercial banks have a serious conflict of interest since their profits and earning are dependent on increasing their lending, and they naturally favour lending to purchasing assets that they can use as security (e.g. property and shares) rather than lending to increase productive capacity (e.g. business investment).

If you are interested in the history of how we came to possess the bizarre system that we have now, where private banks have this exclusive right to create money and profit from it, I recommend that you read the above book or take a look at the excellent videos on the website Positive Money, which has been set up to campaign for reforms to the monetary system.

Are economists ethical?

I recommend Inside Job, a documentary on the global financial crisis. It places the blame firmly on the financial sector and, interestingly, also on academic economists who endorsed deregulation thereof and provided intellectual respectability. The documentary accuses these economists of having a conflict of interest because they received very generous rewards from the financial sector and promoted policies (financial deregulation) enormously beneficial to this sector.

I was astonished that these practises were considered acceptable by some very famous economists that were interviewed. Indeed they seemed surprised by the suggestion that accepting financial reward from companies that benefit from your views was questionable.

This does the economics profession no credit. They need to develop a code of practise comparable to other professions were these conflicts are avoided and where it is compulsory to openly and publicly declare such conflicts whenever their views are sought or published.

These are the standards required in other professions, such as the medical profession. It was failure to declare such a conflict that resulted in the notorious MMR doctor Andrew Wakefield being struck off. I am not aware of any sanction imposed on economists who advocate policies and benefit enormously from their implementation. Nor am I aware of leading economist acknowledging that this is a problem and advocating reform.

It's time to clean up the economics profession.

Ascribing blame

One of the reasons for embarking on this blog was my frustration at watching various sections of society blame each other for the global financial crisis. It has been extremely divisive. It is also potentially dangerous. Ascribing blame provides moral justification for the heartless attitudes and cruel behaviour that we are seeing in Europe.

All this is pointless as it misses the real problem, which is the profound misunderstanding of modern monetary systems that lies at the heart of mainstream economic thinking. It is a human failing but the blame for this needs to be widely shared. Our responsibility as citizens is to educate ourselves and, once we understand, educate others. If we do not do this then we have only ourselves to blame.

Economic rock stars?

Stadium economics has arrived in Europe.
Let us hope that spreading this knowledge more widely will save Europe from economic devastation.

Two complementary ways of creating money

Economic growth requires a concomitant increase in the money supply. Without such an increase growth will be constrained because consumers and investors won't have the money required to increase demand through investment and consumption. While in theory economic activity can increase without expansion of the money supply if prices and wages decrease, i.e. if there is deflation, deflation depresses economic growth because it provides a powerful incentive to save money instead of borrowing or spending it.

There are two distinct and complimentary methods of money creation in modern financial systems. These first is private credit creation by bank lending. The second is deficit spending by governments. I will argue in this article that both methods are needed to allow sustainable economic growth, and that the global financial crisis was the result of excessive reliance bank lending because of misconceived opposition to deficit spending.

Private credit creation. It is not widely appreciated that banks are able to create money at will by making loans. They simply credit the bank account of the recipient. They have no obligation to raise or borrow that money in the first place. Of course, as this is a loan with an associated debt, this process does not create net new money; loans and debt always cancel each other out. The factors restricting money creation by banks through loan creation are capital requirements and the commercial decision as to whether the loan will be profitable. There is a notion that the central bank controls bank lending by requiring banks to hold some of their money as reserves at the central bank. However banks can in practice always borrow whatever reserves they need at the prevailing base rate, so reserve requirements are not a real restraint on lending.

The second mechanism of money creation is deficit spending. This mechanism of money creation is only available to governments that issue their own currency - which includes most countries. If more money is spent (created) than taxed (destroyed) then net money is created. Crucially, this money is not balanced by a loan. It is debt-free money. Deficit spending is the only way that net financial assets can be added to the banking system. By adding net financial assets deficit spending allows the private sector to increase its savings (or reduce its debts). Conversely a government budget surplus requires the private sector to reduce its savings (or increase its debts).

There is a widely held belief that deficit spending crowds out private investment because it requires that the government borrow money to fund the deficit in competition with the private sector. This is only true for governments that dont issue their own currency. There is a crucial difference between deficit spending by a currency-issuing versus currency-using governments (e.g. any Eurozone government).

A currency-using government has to borrow money BEFORE it can spend it, just like the rest of us. It is therefore competing with other borrowers for funds. This applies, for example, to Eurozone governments.

In contrast, currency-issuing governments borrow money AFTER they have spent it. They create money when spending, which flows into the banking system, creating extra reserves. Governments then usually 'remove' this extra money from the banking system by selling bonds of an amount almost exactly equal to the budget deficit. This is done for two reasons. Firstly, in most countries it is a formal, but entirely self-imposed, requirement that the government does this, supposedly to 'fund its budget deficit' or at least give the appearance that it is doing so. However this 'borrowing' can only happen AFTER the money has been added to the banking system by government spending. So clearly the government is not 'competing' for these funds with the private sector - it is simply providing a safe place for the private sector to store the extra funds that they received from the government through deficit spending.

The second reason that goverments sell bonds is to enable central banks to target interbank interest rates to a specific level. If there are excess reserves as a result of deficit spending banks will be unable to earn any interest on by lending these funds and the interbank interest rate will rapidly drop to zero. Since central banks are required to meet a specific interest rate target it is necessary for the government to 'drain' the excess reserves created by the deficit spending, and they do this by selling bonds. What this does is transfer bank reserves to the equivalent of a savings accounts. So currency-issuing governments 'borrow' the money after they had spent it. They are not really borrowing it to fund spending. Instead, they are keeping it in a savings account on behalf of the private sector. Government debt or the national debt is really just private savings. High levels of debt represent high levels of private savings. Conversely, paying off the national debt by running budget surpluses means reducing these private savings!

The neoliberal consensus that has prevailed for the past 3-4 decades has held that money creation by banks is good whereas money creation by deficit spendings is to be avoided. The basic argument, which is based on microeconomic theory, is that by coupling it with a debt obligation money creation is disciplined by commercial considerations. The fact that interest will need to be paid and the debt will eventually need to be repaid ensure that money is only created to fund a viable economic activity. Hence money creation is less likely to be excessive and therefore inflationary. In contrast deficit spending lacks the same discipline and is thus more likely to be excessive and inflationary.

Hence the neoliberal approach has been to aim to avoid budget deficits and balance the budget over the business cycle. Since deficit spending is one of two methods of money creation, avoiding deficit spending requires that governments rely exclusively on bank lending to meet demand for money. I would argue that this is profoundly mistaken, and indeed is the underlying cause of the global financial crisis. Unless this policy is changed sustainable growth cannot be restored.

The reason why it is flawed is that it requires an increase in bank lending (and private debt) without a concomitant increase in net financial assets. What this means is that as the economy grows the overall or aggregate ratio of debt to capital (i.e. the leverage) has to increase relentlessly. It can only stabilize or drop if private lending stops. However since, in the absence of deficit spending by governments, economic growth absolutely depends on private credit expansion, there is a powerful incentive to allow ever higher levels of bank lending and private debt. [I should add here for completeness that it is possible to grow without budget deficits or increased private borrowing through increases in net exports. However this simply shifts the borrowing to the private sector in importing countries. This aggravates the problem in other countries and is not sustainable in the long term.]

The need for ever increasing private sector borrowing to fuel growth was met by the relentless deregulation of banks and financial markets over the past 30 years. More recent support has come from central banks lowering interest rates to record low levels.

Unfortunately this private lending and the policies that support it can predispose to asset price inflation and asset bubbles. When money is so cheap it is tempting to borrow money to purchase assets (e.g. houses, stocks etc) that are increasing in value. Banks are also generally happy to lend money to purchase assets that are rising in price. This is self-perpetuating since more borrowing leads to further price increases which encourage further borrowing. Inevitably this results in credit bubbles as private debt reaches an unsustainable level before the bubble pops. That is what precipitated the global financial crisis. When asset bubbles pop bank lending will wind down as the private sector tries to reduce their debts. This deleveraging process is also inherently unstable because as people try to pay off their debts they reduce consumption and sell assets which decreases prices further and therefore aggravates the debt problem. This forces central banks to intervene to stop this process. They do this by lending freely to the banking sector at very low or zero interest rate. This can prevent collapse but it will, on its own, not stimulate growth until the private sector reverts to borrowing again, and this only likely when debt levels (and thus the money supply) have dropped substantially, creating much damage in the process. This will include immense human misery, destruction of wealth, deteriorating public goods such infrastructure and education, and a permanent reduction in the productive capacity of the economy, damaging the well being of future generations.

Growth may then restart from a low base but, as before, it will be constrained by the fact that balanced government budgets mean that no net new money (i.e. capital) is being made available, so economic growth requires increasing leverage and deregulation of lending practises. Eventually this will reach its leverage limit and the economy will shrink again. This cycle could take 30-40 years.

The way to avoid this cycle is to move away from relying exclusively on credit creation and instead use a combination of credit creation and deficit spending to grow the money supply. Because deficit spending adds net financial assets to the banking system it allow growth in bank lending without increased leverage.

In my next post I will discuss why deficit spending is particularly critical now as our economies struggle with the aftermath of the global credit crunch and why fears that deficit spending will bankrupt governments are misplaced.