The supercooperators

In a previous post I argued that economic growth was compelling evidence that human society has become increasingly cooperative. This is because economic growth depends on commerce, which involves specialising in activities that we are good at and then exchanging the products of that activity with others who specialise in what they are good at. I chose commerce as an example of cooperation because many see it as exemplifying the selfish aspects of human behaviour and rail against it. In doing so they miss out on the bigger picture. Commerce implies cooperation. Global trade implies global cooperation.

There is plenty of other evidence that human cooperation is increasing and is now greater than ever, despite occasional set backs. I provide two more examples.

One example is the extent to which countries adopt support systems for their vulnerable members. This includes support for the disabled, social housing, unemployment benefits, healthcare, and pensions. This support has increased steadily to the extent that it is considered unacceptable for countries to not provide such systems. There is of course considerable debate about these welfare provisions but this debate is mostly about how they should be provided, to what extent they are being abuses by certain segments of society, and how much money should be spent on them. There is very little if any support for abolishing these systems. 

Another example is the extent to which over time people voluntarily organise themselves on ever increasing scales. This is exemplified by the spread of the nation states ruled by the consent of its people, and the increase in supranational organisations, where nation states voluntarily cooperate. This culminated in the creation of the United Nations and numerous other sister organisations. The Europe Community represents perhaps the 'next level' of this cooperation as joining countries sacrifice considerable freedom of action by agreeing to adopt rules agreed to by all members. 

The good guys are winning

One of the most striking, and under-appreciated features of humans is their facility for cooperation and altruism. It is under-appreciated because we are constantly exasperated by news of problems which seem to illustrate a propensity to NOT cooperate and instead act selfishly. This can lead to pessimism and apathy, which is damaging. 

To counter this pessimism we need to remind ourselves constantly of two things. Firstly, that the vast majority of humans on the planet are good people like us, who want to do the right thing. Secondly, that despite what seems like a blizzard of examples of human cruelty and selfishness, the basic direction of travel is ever-increasing cooperating and ever-increasing improvement in the way we treat our fellow human beings and the planet as a whole. The 'good guys' are winning and, despite losses along the way, they will almost certainly win in the long run.

Why do I think we are winning? How can I claim this in the face of all the evidence of the harm that humans do to each other and to other species? 

One reason is that our treatment of each other has continued to improve and is now better than it has ever been. The evidence for this is overwhelming. Cruel behaviour that was previously common and widely tolerated has become much less common and in some case has been eliminated. For example slavery, torture, racial discrimination, violence towards children, the death penalty, public executions. Of course bad things still happen, and there are periods where there is a big increase in this behaviour, notably during war, but the direction of travel is very clear. For those still skeptical I recommend Steven Pinker's book The better angels of our nature, which documents the remarkable decline in violence in human society. 

A second reason is that the level of cooperation amongst humans has also continued to increase, despite occasional setbacks. What is the evidence for this? The most compelling evidence is economic growth, which has, despite setbacks such as the global financial crisis, continued across the world. Increases in economic activity can only happen when there is an increase in productivity and this comes about through the twin processes of specialisation and exchange. Specialisation means that we  as individuals do what we are best at rather than doing everything. Take, for example, farmers who produce all they consume, but for whatever reason are much better at producing wheat. Because they are good at it they can produce more using fewer resources and in less time than others. However if they were to concentrater on wheat production they would produce more than they need and not produce other foods that they need to survive. However if other farmers agree to produce these other products and exchange them for the surplus wheat the problem is resolved, and everyone is better off. This process requires people to make complex arrangements with, and become very reliant on, each other. It implies considerable trust since those not producing essential items, such as food, could starve if those producing them fail to supply them. Since specialisation and exchange require and therefore represent cooperation, and are essential for increases in productivity, it follows that sustained growth in economic output can only come about through increases in cooperation. The fact that economic output is higher than ever is strong evidence that cooperation amongst humans has never been greater than it is now. 

Of course many types of economic activity are harmful in some way and so could be considered evidence of increasing selfishness. However this is compensated for by activity that is beneficial. Furthermore, as we learn how to mitigate these harmful effects, the proportion of activity that is harmful is continually decreasing. 

Creating money

An economy needs money. The question is how to provide it in amounts that are sufficient to allow optimal amounts of economic growth. Too little limits growth. Too much can result in inflation. 

How is money created? Most people think that it is created exclusively by the central bank. This is not the case. The central bank only creates base money, which consists of the electronic money in the reserve accounts at the central bank held by commercial banks and all physical cash (notes and coins). When commercial banks order cash from the central bank their reserve accounts are debited, and vica versa.

How is the amount of base money controlled? In principle any govertment with its own currency it can simply create it by adding numbers to reserve accounts. However in most modern economies there are self-imposed rules in place to prevent governments from creating money. The reasoning behind this seems to be that politicians (and voters) cannot be trusted to do this responsibly. Instead this power is given to a central bank. Of course central banks are created and ultimately controlled by governments (and thus the people) so this is a somewhat artificial excercise. Nevertheless in normal times only central banks can create base money. 

Although the amount of base money is tightly controlled it represents only a small fraction of the money circulating in the economy - currently under 5% of the broad money supply in the UK. So who creates the rest of the money? Commercial, privately owned banks. 

Yes that is correct. Most of the spendable money that we absolutely depend on is created by private banks. When private banks make a loan to a customer they usually just add numbers to that customers bank account, creating 'bank money'. At the same time they get the customer to sign a debt or mortgage contract which compels them to repay the loan by a certain date and also pay interest. The money is created out of nothing together with a matching debt contract. This does not mean that all money that is lent by banks is newly created. But it does mean that banks do not need to wait for customers to deposit money with them before they make loans. Most people are surprised and disbelieving when they are told that banks are able to create money out of nothing. Ask any central bankers and they will acknowledge this as a simple fact. The best evidence for this is that there is vastly more money in private bank accounts (bank money) than the amount of base money created by central banks. It must have come from somewhere!

There is a notion that private banks are limited as to how much money they can lend by having to keep a certain fraction of money in their reserve accounts, and this is termed fractional reserve banking. In fact this is not a real limit as there is no longer any reserve requirement in many countries (such as the UK), and in countries with reserve requirements (eg USA) banks can always borrow additional reserves from the central banks. Banks lend first and then obtain the reserves later. The central banks will always provide the reserves because failure to do so would undermine the financial system. 

Bank lending is legally limited by a requirement to meet a 'capital adequacy ratio', but this is nothing to do with reserves so is not limited by base money. All it means is that banks need to have assets that exceed their liabilities by a certain amount. Incredibly, this amount, also called equity, is only around 3-4% of assets. Any businessman will tell you that having equity of 4% is incredibly risky because if your assets decrease by 4% (through defaults or decreases in asset prices) you will be insolvent. Equity buffers of 20-30% are more typical of businesses. Bizarrely, given their importance, banks are allowed to operate with dangerously low equity buffers. Banks can expand total lending by simply retaining profits. With current rules retaining profits of £1 billion enables them to create a £25 billion of new money through lending. Their only real constraint on lending is being able to find customers wiling to borrow and their judgment as to whether they will be paid back.

The fact that most spendable money in the economy is created by private banks when they make loans had important consequences. All such loans are matched by an equivalent debt, so no NET new money is created. When loan are repaid the money is 'destroyed'. When the private sector reduces its debt levels by paying back its existing loans and taking out fewer new ones the overall money supply shrinks, which depresses the economy. That is why governments and central banks are desperately trying to encourage more credit creation by banks.

To counter the contraction in the money supply that economies are experiencing because of the reduction in bank credit creation, central banks are increasing the dramatically amount of base money by quantitative easing or QE.  This involves central banks purchasing various assets from the private sector, typically government bonds.

Some people are concerned that this increase in base money will result in inflation. This always seemed unlikely given that the level of total bank money was and still is actually shrinking, despite QE. What is odd is that the same people that are worried about this increase in base money were unperturbed by the far greater increase in the broad money supply in the 20 years before 2008. Indeed the money supply tripled in the UK and USA in the 10 years leading up to 2008, with almost all of this increase being accounted for by commercial bank created money. This did not result in consumer price inflation, but it was responsible for asset price inflation, especially property prices. 

To conclude, the rules that are in place to prevent governments from creating money have had the curious and underappreciated effect of placing most of the responsibility for money creation in the hands of private banks. In effect we rent our money from banks. In my view this was a mistake and one of the underlying cause of the global financial crisis (GFC). This crisis was a result of excessive credit creation by private banks which governments had enabled by loosening regulations governing banking. Many of these regulations had been introduced after the financial crash that precipitated in the Great Depression, which was also ultimately caused by a bank-created credit bubble. The reason why the GFC did not result in another depression is almost certainly because this time central banks flooded the financial system with enough base money to prevent banks collapsing. Unfortunately, however, this extra base money may not be enough, on its own, to restore growth. The reason for this will be discussed in the next post.