Economic Policies for an Incoming Labour Government – Part 3
Economic Policies for an Incoming Labour Government
By Bryan Gould and George Tait Edwards
Part 3 of 9 – The Different Uses of Credit Creation
Credit creation when properly deployed can serve five main purposes, each
having major and differential effects on the real economy. We cannot
expect, and nor can an incoming Labour government, to produce better
economic outcomes unless we understand the differences between them.
First, credit creation may be undertaken (and usually is) for purely
speculative purposes. Its principal purpose and effect is to fund housing
purchase and speculative financial transactions; it is often the main factor
in the development of housing, land and asset bubbles. It is this aspect of
credit creation that attracts most attention in today’s economy and which is
the main focus of the banks’ activities, since it is the easiest business to
attract, the most secure (since mortgages guarantee the value of the credit
in most cases) and the most profitable.
It is also the principal factor in stimulating inflation; housing values, in
particular, rise sharply as large volumes of credit-created money flow into
the housing market, and the consequent asset inflation is inevitably
followed by consumer led inflation as home-owners use the increased value
of their equity to increase consumption. This is, of course, of great
significance, given that the control of inflation is the prime and virtually
only focus of macro-economic policy; it suggests that the use of interest
rates to tighten monetary conditions, impacting as it does on the whole
economy, fails to address effectively and accurately the real cause of
inflationary pressures and is an unnecessarily broad and badly focused
instrument that does great damage to the wider economy at the same time.
The overwhelming dominance of credit creation for speculative purposes –
for both housing and other financial transactions – has other adverse
features. It distorts the desired operation of the economy by diverting
investment capital away from productive purposes, and by creating asset
bubbles in both residential housing and financial assets, not least in western
stock exchanges; and the resultant constant inflationary impetus then has
to be restrained by measures such as higher interest rates, so that the
chances of greater innovation and productivity are further prejudiced.
Despite all of these downsides, credit creation for speculative purposes as a
major economic factor impacting on the real economy is virtually ignored
by our policy-makers, except to the extent that it is seen as perfectly
normal and relatively benign.
The second kind of credit creation operates as an important element in
demand management. It is used to raise purchasing power by putting more
money in people’s pockets, and thereby can help to resolve the problem of
deficient demand that Keynes identified as the key element in the Great
Depression and that continues to characterise recessionary conditions today.
It would normally be undertaken by the banks, under direction from the
central bank or the Treasury, though it could also be undertaken directly by
the central bank or the government. It is little used in today’s Britain, not
surprisingly, when the Coalition government does not recognise a deficiency
of demand as the feature of a recessionary situation that needs correction.
It has, however, returned to favour as a counter-recessionary instrument in
the thinking of some of our leading monetary economists. Keynes had
suggested in the 1930s – half-jokingly but so as to make a serious point –
that a valuable counter-recessionary outcome could be obtained by burying
money in the ground and then paying firms to employ people to dig it up.
Their increased income would represent a significant increase in purchasing
power and therefore demand.
Such a policy today is often pejoratively characterised as “helicopter
money” – the notion that demand could be raised if pound notes were
scattered from the air – but has been seriously analysed by economists such
as Adair Turner and Michael Woodford who have reached the point of
debating whether it would best be delivered by fiscal measures (such as tax
cuts) or by monetary policy (essentially printing money).1
Credit creation undertaken to raise demand does not mean that it cannot
serve other purposes at the same time; or, to put it in another way, credit
creation undertake for other purposes, such as funding the purchase of
assets or providing capital for investment, may well also have the additional
effect of lifting the level of demand. As we shall see, the crucial question
is then as to whether the increased demand is merely inflationary or is
matched by increased output.
Thirdly, credit creation can also be undertaken for the purpose of stabilising
the financial system; this technique, which has been called Quantitative
Easing over recent times, has been implemented by governments in both
the UK and the US, and was meant to remedy – in the wake of the Global
Financial Crisis – the precarious situation of an otherwise bankrupt financial
system. In the case of the UK, the policy took the form of the Bank of
England’s £375bn of financial credit to stabilise the UK Clearing Banks but it
did nothing to benefit the wider economy. The greater proportion of that
sum was used by the banks to strengthen their balance sheets (and to
resume paying large bonuses); very little found its way into lending to the
Small and Medium-Sized Enterprises that desperately needed help in
maintaining adequate liquidity (and for plant and equipment investment).
Credit creation for the purpose of funding major innovative programmes –
sometimes called Government Credit Creation (GCC) – is the fourth kind of
credit creation and is designed to enable major innovative structural
economic change, such as the invention of the atomic bomb, the mass production
of synthetic rubber in the US in 1940-44, and President Obama’s
Energy Initiative; it is often resorted to in wartime. The intention is to
stimulate innovation in the public sector or infrastructure area of the
economy and to undertake large-scale projects that are vitally important to
the economy but are too large or not commercially rewarding enough to
attract private capital.
This kind of credit creation for public purpose is being supplanted
increasingly in Britain today by Public/Private Partnerships, on the specious
ground that they offer better value to the taxpayer; the reality is that they
are much more expensive than publicly funded projects, but they have the
great merit in the eyes of right-wing governments of offering fat profits to
their friends in private industry.
The fifth and, for our purposes, most interesting and important form of
credit creation is usually called Investment Credit Creation (ICC). This form
of credit is targeted at increasing investment in the plant and equipment
level in private industry, with the goal of encouraging productivity
improvement, accelerating the rate of economic growth and providing full
employment. Investment Credit Creation is usually delivered through the
local banks (if you have any) at the behest of the central bank and the
government. It is this aspect of credit creation that has been virtually
ignored in western economies over recent decades but which offers by far
the best prospect of breaking out of our seemingly irreversible economic
decline.
There is today virtually no understanding in Britain and other western
countries of how Investment Credit Creation functions and of the benefits it
can bring to economic development. The provision of credit – that is, bank
lending – is seen almost exclusively in terms of its capacity to stimulate
inflation and is seen therefore as a potential threat rather than as an
essential element in producing a better economic performance.
This is notwithstanding Keynes’ perceptive assertion that there is no reason
why the provision of credit for the purpose of productive investment should
not precede the increase in output that it is intended to produce, provided
that the increase occurs over an appropriate time frame. Other economies
have understood and benefited from this insight and have used Investment
Credit Creation to stimulate growth, without being inhibited by the
conviction that any increase in the money supply must necessarily be
inflationary.
There are, in fact, many persuasive instances from both recent history and
from other countries of the successful deployment of Investment Credit
Creation. One of the most striking examples of the use of credit creation,
not to inflate the property market for private profit as is done in the West
at present, but to stimulate rapid industrial growth, was provided by the
United States at the outbreak of the Second World War, when Roosevelt
used the two years before Pearl Harbour to provide virtually unlimited
capital to American industry – simply by printing money – so that the
country could rapidly increase its military capability.
Roosevelt encountered the usual objections from conventional economists
but the exigencies of war and his own political strength and will prevailed.
The results were spectacular and hugely significant. American industrial
output grew on average by an unprecedented 12.2% per annum from 1938
to 1944 – an outcome that went a long way towards enabling the US, and
the Allies more generally, to win the Second World War.
An equally impressive instance is provided by Japan in the 1960s and 1970s,
when Japanese industry was enabled by similar means to grow at a rapid
rate so as to dominate the world market for mass-produced manufactured
goods. Western economists have typically shown no interest in how this was
done and are almost totally ignorant of the work of leading growth expert
economists such as the Japanese Osamu Shimomura and the American-
Japanese Kenneth Kurihara. We shall look in more detail 2 later at exactly
how Investment Credit Creation was specifically implemented by the Bank
of Japan, at the behest of the government and following the advice of
Shimomura and his colleagues, and accordingly brought about the Japanese
economic miracle.
More recently, China has used similar techniques to finance the rapid
expansion of Chinese manufacturing. The Chinese central bank, and their
provincial counterparts, under instructions from the government, makes
credit available to Chinese enterprises that can demonstrate their ability to
comply with the government’s economic priorities. Enterprises that wish to
build or buy new capacity in compliance with the overall industrial strategy
are provided with the required investment capital, obtained through cost-free
credit creation; Chinese manufacturing capacity in particular has
largely been funded by such government-authorised new credit, as has the
huge purchasing programme of strategic assets from around the world that
is currently being undertaken by Chinese enterprises. This is admittedly, in
principle at least, easier to bring about in a totalitarian regime than in the
UK, but in practice there is nothing to stop a British government from
requiring the central bank, as the Chinese have done, to create cost-free
credit for specific (and productive) purposes.
Other Asian countries, such as Korea and Taiwan, have applied similar
policies in order to produce rapid industrial growth. Typically, however,
Western economists have arrogantly assumed that these successful
economies have nothing to teach us, and are easily dismissed as
undeveloped economies relying for competitive advantage on cheap labour;
the reality is, of course, that these economies are, as a consequence of the
rapid economic growth and industrial development made possible by
Investment Credit Creation, delivering incomes and living standards to their
populations that are approaching and in some cases surpassing those in the
West.
1 See www.voxeu.org/article/helicopter-money-policy-option
© Bryan Gould and George Tait Edwards 2015