The Bank of England Owns Up At Last
For those of us who have argued for a long time that orthodox monetary policy is fundamentally misconceived, a significant milestone was achieved this week. In an important paper published in the Bank of England Quarterly Bulletin*, three Bank of England economists have acknowledged that the overwhelmingly greatest proportion of money in the economy is created by the banks out of nothing.
This finding comes as no surprise to that growing number of economists and others who have recognised, as a consequence of simple observation, that this is the case. But it will no doubt be hotly denied, in the face of all common sense and evidence, by those (including bankers themselves) who, for reasons of self-interest or sheer ignorance, continue to adhere to the classical view that banks are simply intermediaries between lenders and borrowers.
The great British public is itself the victim of the confusion and obfuscation that has surrounded this issue for generations. Most people, if asked, will tell you that what the banks do is to lend out to borrowers the money that is deposited with them by savers. On this analysis, there is nothing particularly special about banks; they simply charge for the service they provide in bringing savers and borrowers together.
The truth, however, now conceded by the central bank, is very different. The banks enjoy a most spectacular and surprising monopoly power. They alone are able to create new money – vast quantities of it – by the stroke of a pen or, in modern terms, by pushing a key on a computer keyboard.
When a bank lends you money, it simply makes a book entry that credits you with an agreed sum; that sum represents nothing but the bank’s willingness to lend. The debt you thereby owe the bank does not represent in any sense money that was actually deposited with the bank or the capital held by the bank. Nevertheless, when it arrives in your account, and you use it to spend or invest, the overall money supply is increased by that amount.
The only attempt to regulate the volume of new money created by the banks comes through raising or lowering interest rates – a power exercised not by government but sub-contracted to – you’ve guessed it – another bank.
This means that, in practice, the only limit on bank lending is their willingness to lend to applicant borrowers at whatever the current rate of interest may be. The size of the market which provides the huge profits enjoyed by the banks is, in other words, decided by the banks themselves and their assessment of, and willingness to accept, the degree of risk involved.
There will, in the search for the ever higher profits to be made from lending more and more of the money which they themselves create, always be the temptation to lend more than is prudent in their own interests or desirable in the wider interest – and that is how the global financial crisis came about.
The astonishing feature of this monopoly power enjoyed by private companies seeking profits for their shareholders is that their decisions as to how much and for what purpose money should be created, made with virtually no external control or influence to restrain them, constitute by far the single greatest (and potentially distortional) influence on our economy.
The Bank of England paper has now laid all of this out for public inspection. The authors do not quite have the required courage of their convictions, since they attempt to downplay the significance of their conclusions by using the operations of a single bank to illustrate the process of credit creation, and thereby fail to register the immense scale, when looking at the banking system as a whole, of what they are describing. Even so, the policy implications of what they say are immense.
Our macro-economic policy at present is virtually limited to attempting to control the money supply as a means of regulating inflation. But since the volume of money is a function of bank lending and reflects nothing more than the banks’ search for profits at whatever the current interest rate may be, it follows that the whole thrust of current policy is entirely misplaced.
The banks, in deciding for themselves how much, to whom and for what purpose they will lend, will always give priority to lending for house purchase since it requires by far the least effort, and is the most secure and profitable form of lending. Can we be surprised that, as a result, those wishing to borrow for business investment are at the tail end of the queue while house prices – inflated by the volume of new money going into the housing market – go on rising inexorably?
It is bank-created credit that provides the major stimulus to asset inflation in the housing market, with all of its deleterious economic and social costs, while at the same time diverting essential investment capital away from where it is really needed – in the productive sector of the economy. If we wish to restrain inflation, why do we not target the most obvious cause, rather than burden the whole economy with deflationary interest rate hikes? And if we want a stronger real economy, why allow the banks the exclusive power to decide that the new money should go to housing rather than productive investment?
Our current monetary policy is based, in other words, on a complete misunderstanding of the role of money and its impact on economic activity. Our economy is awash with money, but it is neither the economically neutral phenomenon – interesting only because of its impact on inflation – that classical theory describes, nor does it provide the stimulus to new productive investment in the real economy that it could and should do.
Monetary policy need not be just a rather ineffectual tool for controlling inflation. It has the capacity instead to be a major stimulant and facilitator of real productive investment if we understand and use it properly. The banks’ monopoly of the power to create money prevents us from doing just that.
*Money Creation in the Modern Economy, by Michael McLeay, Amar Radla and Ryland Thomas.
Bryan Gould
22 March 2014
This article was published in the London Progressive Journal on 25 March 2014.
Holding Banks to Account
The dramatic and damaging collapse of the New Zealand finance company sector over the last three or four years has attracted a good deal of attention, largely because of the multi-billion losses that investors have suffered. One of the consequences has been a boost to the confidence felt in banks which have reinforced their reputation as the best place to put one’s money.
It is certainly true that, while overseas banks are up to their necks in scandal, our largely Australian-owned banks have maintained an enviable stability and reliability. But the tribulations of banks worldwide make it inevitable that the role of banks in the global economy should increasingly come under the spotlight.
The revelations that many of the world’s leading banks have been guilty of dishonestly rigging markets and misleading investors have already claimed one victim, in Barclay’s Bank, and seem certain to involve many more. And that comes on top of the role – dubious at best, irresponsible and dishonest at worst – that the banks played in bringing about the global financial crisis in 2008.
Not surprisingly, the British government is establishing a full-scale review of the banking sector, and few would now bet against the pressing of criminal charges. But it could be argued that these scandals are not just a reflection of the criminality of a handful of bank leaders but arise inevitably from the role that banks in general have been allowed to play.
Most people still see banks as institutions that provide a safe repository for our savings and that from time to time lend us money either on overdraft or on mortgage. But this is seriously to underestimate the power that banks wield in our economy and the extraordinary nature of the concessions that allow them to do so.
The central feature of banks, which seems only dimly understood even within the banking sector itself, is that they are private commercial enterprises which have been granted a unique and virtual monopoly over the creation of money. By far the largest proportion of the money in our economy (and in the economies of all advanced countries) is not notes and coins but bank-created credit. That credit represents no more than bank entries by bank officials; its status as money rests entirely on the suspension of disbelief – or, to put it another way, on our willingness to accept that it is money because the banks say it is money.
The failure to understand this fundamental aspect of our economy leads to serious errors in formulating economic policy. The overwhelming role of credit-creation by the banks in inflating the money supply should be our central concern in controlling inflation, particularly when the vast majority of that credit is created and lent for non-productive purposes like house purchase.
Because we don’t understand this inflation-engendering phenomenon, we grapple with inflation using seriously inadequate and inappropriate instruments like interest rates, which are not only slow-acting and poorly focused but do great damage to the rest of the economy. A more accurate analysis of inflation-producing pressures in our economy would lead to more effective measures to restrain them and at the same time encourage a more productive and competitive economy.
We can see how privileged and unaccountable banks are from the fact that their unique capacity to create and lend vast quantities of “money” for private profit passes under the radar, whereas a democratically accountable government that occasionally “prints money” in the public interest draws screams of blue murder.
But it is not only this aspect of the banks’ operations that should cause concern. Over the last two or three decades, the banks have used their ability to create money to invent a whole range of new financial instruments of dubious value which they are then able to sell to gullible investors; so profitable was this trade that it became much more important to banks than their traditional role.
It was this prospect of unlimited profits created out of nothing (to say nothing of the huge rewards and bonuses paid to individual bankers) that led in due course to the global financial crisis. And when that irresponsibility inevitably ended in collapse, it was that same mentality that led bankers into the realms of fraud and criminality. In a world where anything goes, the rules are made to be broken, and personal fortunes are there for the taking, who can wonder that bankers could not accept that the ordinary rules applied to them? We have reaped what we have sown.
In case we should assume that none of these problems afflict us, let us not forget that our own banks, pillars of propriety as they may seem by comparison with their overseas counterparts, have made strenuous attempts to avoid their tax liabilities and have only been made to pay up by court action.
And in our case, the banks have not only made huge profits by exploiting their unique capacity to create money, but have then exported those billions across the Tasman, thereby placing a huge burden on our already beleaguered balance of payments. Isn’t it time to establish a banking system that supports the economy rather than places it at risk?
Bryan Gould
8 July 2010
This article was published in the NZ Herald on 12 July.
Holding Banks to Account
The dramatic and damaging collapse of the New Zealand finance company sector over the last three or four years has attracted a good deal of attention, largely because of the multi-billion losses that investors have suffered. One of the consequences has been a boost to the confidence felt in banks which have reinforced their reputation as the best place to put one’s money.
It is certainly true that, while overseas banks are up to their necks in scandal, our largely Australian-owned banks have maintained an enviable stability and reliability. But the tribulations of banks worldwide make it inevitable that the role of banks in the global economy should increasingly come under the spotlight.
The revelations that many of the world’s leading banks have been guilty of dishonestly rigging markets and misleading investors have already claimed one victim, in Barclay’s Bank, and seem certain to involve many more. And that comes on top of the role – dubious at best, irresponsible and dishonest at worst – that the banks played in bringing about the global financial crisis in 2008.
Not surprisingly, the British government is establishing a full-scale review of the banking sector, and few would now bet against the pressing of criminal charges. But it could be argued that these scandals are not just a reflection of the criminality of a handful of bank leaders but arise inevitably from the role that banks in general have been allowed to play.
Most people still see banks as institutions that provide a safe repository for our savings and that from time to time lend us money either on overdraft or on mortgage. But this is seriously to underestimate the power that banks wield in our economy and the extraordinary nature of the concessions that allow them to do so.
The central feature of banks, which seems only dimly understood even within the banking sector itself, is that they are private commercial enterprises which have been granted a unique and virtual monopoly over the creation of money. By far the largest proportion of the money in our economy (and in the economies of all advanced countries) is not notes and coins but bank-created credit. That credit represents no more than bank entries by bank officials; its status as money rests entirely on the suspension of disbelief – or, to put it another way, on our willingness to accept that it is money because the banks say it is money.
The failure to understand this fundamental aspect of our economy leads to serious errors in formulating economic policy. The overwhelming role of credit-creation by the banks in inflating the money supply should be our central concern in controlling inflation, particularly when the vast majority of that credit is created and lent for non-productive purposes like house purchase.
Because we don’t understand this inflation-engendering phenomenon, we grapple with inflation using seriously inadequate and inappropriate instruments like interest rates, which are not only slow-acting and poorly focused but do great damage to the rest of the economy. A more accurate analysis of inflation-producing pressures in our economy would lead to more effective measures to restrain them and at the same time encourage a more productive and competitive economy.
We can see how privileged and unaccountable banks are from the fact that their unique capacity to create and lend vast quantities of “money” for private profit passes under the radar, whereas a democratically accountable government that occasionally “prints money” in the public interest draws screams of blue murder.
But it is not only this aspect of the banks’ operations that should cause concern. Over the last two or three decades, the banks have used their ability to create money to invent a whole range of new financial instruments of dubious value which they are then able to sell to gullible investors; so profitable was this trade that it became much more important to banks than their traditional role.
It was this prospect of unlimited profits created out of nothing (to say nothing of the huge rewards and bonuses paid to individual bankers) that led in due course to the global financial crisis. And when that irresponsibility inevitably ended in collapse, it was that same mentality that led bankers into the realms of fraud and criminality. In a world where anything goes, the rules are made to be broken, and personal fortunes are there for the taking, who can wonder that bankers could not accept that the ordinary rules applied to them? We have reaped what we have sown.
In case we should assume that none of these problems afflict us, let us not forget that our own banks, pillars of propriety as they may seem by comparison with their overseas counterparts, have made strenuous attempts to avoid their tax liabilities and have only been made to pay up by court action.
And in our case, the banks have not only made huge profits by exploiting their unique capacity to create money, but have then exported those billions across the Tasman, thereby placing a huge burden on our already beleaguered balance of payments. Isn’t it time to establish a banking system that supports the economy rather than places it at risk?
Bryan Gould
8 July 2010
This article was published in the NZ Herald on 12 July.
Who Controls The Banks?
The recession may not yet have reached its mid-way point, but already the lessons that seemed so stark in the immediate aftermath of the financial meltdown are receding fast. The way out of recession is apparently being directed by traffic lights and signposts controlled by worryingly familiar faces.
Foremost amongst these phoenix-like revivals are the banks. Just months after they were rightly seen as basket cases – their irresponsibility and greed the primary causes of the recession and their very survival requiring billions of pounds of handouts from the hard-pressed taxpayer – they are back in the box seat, not only apparently immune from reform or regulation, but again paying out huge bonuses, and their unchanged role accepted as essential to economic recovery.
According to their own pronouncements, the least surprised at any of this are the banks themselves. Are their affairs not directed by the most brilliant operators who can only be attracted by huge salaries, bonuses, fees and commissions? Is our economic future not totally dependent on their freedom to make as much money as they can for themselves and their shareholders? Is the recession not itself proof that the banking function is not only too important to be allowed to fail but is in the end best left to those who know what they are doing?
Some of these claims can be summarily dismissed as laughable examples of special pleading. A plumber or bus driver who proved himself so incompetent at what he was employed to do that he flooded the house or crashed the bus could not claim that he was uniquely qualified for a supremely demanding occupation, but would be out of a job. Bankers who destroy the financial system should be similarly judged.
And our supposed dependence on the City’s earnings is – far from being a reason for re-instating the status quo ante – a striking warning against allowing this dangerous situation to arise again. Among the many lessons we should not forget is that City earnings not only go to a tiny fraction of society but require support from an economic policy which – by giving priority to those who manipulate existing wealth over those who invest in and create new wealth – is guaranteed to destroy other kinds of economic activity, particularly in the real, as opposed to financial, economy. Those who have lost jobs in manufacturing, for example, have literally paid for the bonuses “earned” by City fat cats.
Perhaps the most surprising of the claims made is that the banking function is of central importance to the whole economy but should at the same time remain in the hands of a private oligopoly – and an oligopoly that is entitled to put its own interests ahead of the general interest. Even more surprisingly, after all that we have recently experienced, this argument seems to have been accepted without demur by the government that spent our billions on rescuing the banks.
It has always been a mystery that the banking function – which in macro-economic terms means essentially the creation of credit and therefore of money – should have been allowed to develop in private hands. The banks have avoided scrutiny on this issue, first by (improbably) denying that they create money, secondly by arguing that the function is in any case so important to the economy that it would be too dangerous to disturb it and finally by maintaining that only they have the expertise to discharge the function anyway – and all this at a time when the prevailing orthodoxy is that the most important factor in economic management is the rate of growth in the money supply, so that the banks’ central role in the creation of credit – the most important single factor in the excessive growth in the money supply – has an additional and unmistakeable macro-economic impact.
What the recession has demonstrated is that none of these defences can stand. The first stage of the financial crisis was largely one of liquidity and arose because the banks’ (supposedly non-existent) ability to create credit was brought to a halt. This required government intervention on a massive scale – so much for the argument that the bankers’ role should not be disturbed – and this in turn showed that it was not the bankers’ expertise (which was manifestly in very short supply) but government resources that underpinned the banking function.
So, if the public has an intense interest in the proper discharge of the banking function, and the last-resort guarantor is the public purse from which billions of our money have been spent, why are we content to allow the private oligopoly to proceed on its merry way and to decide in their own interests issues that matter to all of us and that should be placed under democratic control? Why would we not consider some form of public ownership (we have, after all, paid many times over for banks that were virtually worthless) or, at the very least, a degree of effective regulation to ensure that the public interest was protected and that the banking function served that interest rather than private greed?
The prize is, after all, a banking system that serves the wider economy and not just itself. Our failure (or refusal) to see this shows just how deeply ingrained is our frame of reference, and how much at risk we remain from a repetition of past errors.
Bryan Gould
10 August 2009
Governments As Banks
The G20 summit seems certain to demonstrate that for most world leaders the conversion to Keynesian economics is no more than skin-deep. The global crisis may have compelled some re-assessment of the “free” market doctrines previously thought to be unchallengeable, but many of those attending the summit are reluctant to accept the responsibilities that a Keynesian approach would require of them.
It is worth rehearsing therefore what the global recession now demands of governments if we are to avoid a further plunge into full-scale depression. Like so much of Keynes’ approach, the prescription rests on common sense rather than ideological prejudice or mathematical models.
The key feature of a recession is a shortage of demand or purchasing power in the economy. The danger is that, once that condition applies, it feeds upon itself. Despite the urgings of politicians, individual actors in the economy – both in their personal lives and in their businesses – understand that times are hard and that the economy is flat or shrinking, and they act accordingly in their own self-interest. They cut their personal spending and their business costs. They employ fewer people and they invest less. Their concern is entirely for their individual or family or business interests.
They cannot be criticised for this. Their behaviour is entirely rational. The problem is that the sum total of all these individual decisions is that the economy shrinks further – a kind of multiplier in reverse.
An economy left to resolve this for itself will take a long and damaging time to come right. If the process is to be short-circuited, and depression is to be avoided, there is only one agency that is capable of taking effective action. That agency is the government.
Only governments have the capability and the duty to act in the wider interest, to take decisions that would be directly contrary to their self-interest if they were individuals or businesses, and to act consciously to defy market logic by spending when others can and will not. Governments can afford to do this, if they choose, because their ability to borrow to fund investment for the future is – by the standards of any other agency – virtually unlimited, and their responsibility is not to particular economic actors, like banks or shopkeepers, but to the economy as a whole. They alone can afford to take a long view – long enough to live with a growing deficit while the economy regains its buoyancy.
It is governments in the end, not banks, who are the funders of last resort. If there was ever any doubt about this, it must surely have been put to rest by the collapse of the banks in most parts of the world, and the taxpayer-funded bail-outs that governments have had to organise. Why, then, are political leaders still so reluctant to recognise that is they, not the banks, who must provide the kind of stimulus to spending that is needed if we are to turn the recession round?
The reason is that they are still prisoners of the same intellectual straitjacket that created the crisis in the first place. Despite all the evidence to the contrary, they are still convinced that the major decisions in the economy should be taken by banks – or the private sector more generally – rather than governments. Even when they have spent billions on bail-outs, and the billions have disappeared into the banks’ balance sheets, they still somehow expect that the banks’ self-interested pursuit of their shareholders’ interests will revive the economy as a whole.
Old habits die hard. Privately owned banks have been allowed to develop a virtual monopoly of credit creation for more than 200 years. It is such a familiar feature of our landscape that it has been scarcely remarked, even when bank credit became by far the most significant element in the rapid growth of the money supply – and therefore the greatest factor in inflation. The banks’ impact on monetary policy – and the exclusive focus on that monetary policy – was itself a huge abdication of responsibility in favour of private interests. But just to make absolutely sure that the banks would not only monopolise credit creation but would also control monetary policy itself, governments surrendered the task they had been elected to fulfil by handing monetary policy over to an “independent” central bank.
Our politicians are still at it. We are told that we must give the banks some “breathing space”. That is after they have walked away with billions of our money. It does not seem to have occurred to our political leaders that it was not the interests of bank shareholders and the survival of banks as institutions that mattered. The focus of policy should have been, first, the security of deposits, and secondly, a re-thinking of whether the banking function should remain a private monopoly or should be seen properly as a public responsibility – as, de facto, it has become. If governments – for which read us – have had to put up the money, why should we not call the shots?
Bryan Gould
30 March 2009
This article was published in the online Guardian on 30 March