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.
Re-opening the Debate
Something important has happened in New Zealand politics. After two and a half decades in which economic policy has been a no-go area for political discussion, we have at last seen the beginnings of a debate about what is potentially the central issue of our politics.
“There is no alternative” was very much Mrs Thatcher’s mantra, but it held equal sway in New Zealand. Indeed, it has been even more significant here, because the aggressive free-market orthodoxy first introduced by a Labour government was then reinforced by their National successors. As a consequence, the major parties chose not to engage each other over the basic principles of economic policy, and the whole question of how our economy should be run was consigned to the sidelines.
The reluctance to discuss economic policy was nevertheless surprising, given the constantly expressed concern and disappointment at our poor economic performance. As the gap between New Zealand and Australia widened, and our productivity figures remained stubbornly unimpressive, the finger was pointed at every conceivable explanation – bar the obvious one. It is only now that the realisation seems at last to have dawned that our comparative economic decline might – just might – have something to do with the economic policy settings we have faithfully followed for twenty five years.
For most of that period, we have slavishly adhered to the view that government’s involvement in the economy should be limited to regulating monetary conditions and that even that limited function should be delegated to unelected bankers charged with the equally limited goal of controlling inflation. Beyond that, the rest of the economy could safely be left, it was thought, to look after itself.
It turned out that things were not so simple. The apparently simple and technical question of controlling inflation through interest rates and exchange rates proved to have important and unfortunate consequences for the real economy. The productive sectors of our economy were constantly handicapped by high interest rates and an overvalued dollar, and by secondary consequences like the relative attractiveness of investing in property as opposed to productive capacity and of bingeing on cheap imports as opposed to saving. There was, in other words, a price to pay for using instruments like the exchange rate for purposes they were not meant for.
Government over this period, of course, was let off the hook, disclaiming any responsibility for managing the economy as a whole. It was content to dabble in micro-economics, and in balancing its own books, but showed no interest in issues of competitiveness or demand management. Macro-economics simply did not exist.
So, what has changed? The Labour opposition has been thinking. They seem to have grasped that there is no upside in either electoral or practical terms in simply agreeing with the government, and that the evidence before our eyes demands that New Zealand should strike out in a new direction.
So, the two-party consensus on economic policy is at an end. It is proposed that the purpose and techniques of government’s involvement in economic policy should change. Macro-economic policy is back.
What are the chances of the debate taking off? They are better than one might imagine. The current government continues to stick to orthodoxy, but they are led by a pragmatist. Sooner or later, and hopefully sooner, John Key is going to realise that he and his government will get nowhere near the goals they have set themselves if they continue to slog along the same road that has led nowhere for so long. That would mean just watching the Australian tail lights disappearing into the distance.
There is also reason to hope that the official mind might be less rigid than it has seemed for so long. The regime at the Reserve Bank under Alan Bollard is clearly less doctrinaire than it was under Don Brash. Even the Treasury cannot be entirely immune from common sense.
To get the debate under way is not of course to win the argument. But whatever the outcome, our public life will be stronger for re-opening a real discussion about the role of government in achieving economic success. And not for the first time, we might even lead a world-wide trend.
The voters may or may not reward Labour for its courage in challenging an orthodoxy that has prevailed for so long. But we all owe Labour a debt of gratitude for starting a debate that is long overdue.
Bryan Gould
25 October 2010
This article was published in the NZ Herald on 27 October.
Learning the Lessons
As the world-wide recession seems to be bottoming out, one question is being asked with increasing frequency and urgency. Have we learnt the lessons so that it will not happen again?
The answer – at least in the US and the UK – is not a reassuring one. As the hard-pressed taxpayer, already burdened with the threat to homes and livelihoods, is left to pick up the bill for market failure – a bill in the billions which will not be paid for years, not to say decades – those whose recklessness and greed caused the crisis have already returned to the bad old ways.
We see the same outrageous bonuses, the same disregard for prudence, the same confidence that the price of failure will always be paid by someone else. It is almost as though the publicly financed bail-out has provided the fat cats with a renewed belief in their own infallibility, by convincing them that they will always be protected because they are too big and too important to be allowed to fail.
In New Zealand, where the financial sector is too small to exhibit these attitudes, we have nevertheless seen our own somewhat paradoxical response to market failure. It might have been thought that, in an economy where public finances had been unusually well and prudently managed over recent years, the public sector would be the last place that would be required to bear the brunt of recessionary retraction.
In other countries (notably Australia), and in line with the revival around the world of Keynesian insights into how to respond to recession, the public sector has been seen – not as the problem – but as an important part of the solution. We, however, seem to have become obsessed with the size of the government deficit, which is still relatively low in historical and international terms, with the result that the salami slicer has been applied with very little discrimination across the whole range of public spending.
No one can cavil at an increased drive to ensure value for money in public spending. The suspicion must remain, however, that the recession has been a not unwelcome excuse to rein back the public sector on ideological rather than economic grounds.
There is, however, a more significant respect in which we seem to have decided not to apply the lessons we should have learned. We should not forget that we have been in recession since the end of 2007 – long before the financial crisis broke. That home-grown downturn was the direct consequence of the policy directions we had been following for 25 years having finally run into the buffers.
Inflation then was still enough of a worry to lead the Governor of the Reserve Bank to keep interest rates at an internationally very high level. That in turn, through pushing up the exchange rate, had destroyed the competitiveness of our industries, created a current account in serious imbalance, increased our need to borrow to finance the gap between what we earned and what we spent, pushed up the exchange rate and stoked inflation still further as “hot” money flowed in to take advantage of the high interest rates, and so on round an increasingly vicious circle.
As we contemplate the post-recession scenario, those fundamental problems are no nearer solution. Indeed, some are a good deal worse; the overvalued dollar is destroying our productive economy with every day that passes. Our only response to these pressing problems seems to be that “there is nothing we can do.”
But there are things we can do. We could acknowledge that the strategy of defining macro-economic policy in exclusively monetary terms, and of directing the whole force of that policy to the single goal of controlling inflation, using a single instrument in the hands of a single unelected official, has failed – both as an effective way of controlling inflation, and in terms of its disastrous impact on our overall economic performance.
If we want to do better, and in particular, if we want to raise our poor productivity levels, we have to do things differently. If we go on with the same policy prescriptions as we have applied for the last 25 years, we will get the same disappointing results as we have endured over the last 25 years.
What is needed is a fundamental shift in perspective. It would mean, in line with the revival of Keynesian thinking, re-defining macro-economic policy so as to include the whole range of fiscal as well as monetary measures. It would mean setting the goals of macro policy (including interest and exchange rates) in terms, not of inflation, but of competitiveness, as the Singaporeans do. It would mean, rather than clobbering the whole economy with a poorly focused counter-inflation strategy, continuing the battle against inflation with specific micro measures directed at defined inflationary pressures, such as excessive bank lending and the favourable tax treatment of housing, and encouraging saving by strengthening the incentives to save.
It probably won’t happen. It is amazing that an orthodoxy that has been so thoroughly discredited by experience still has such a hold on official thinking. The government might be encouraged, however, to undertake an “agonising re-appraisal” by the thought that a change of tack might produce a better outcome, not least for their own pet preoccupation. Nothing, after all, would do more to get the government deficit down in a hurry than a newly buoyant economy.
Bryan Gould
26 September 2009
This article was published in the New Zealnd Herald on 1 October.
An Ideological Straitjacket
With inflation falling, a full percentage point cut in interest rates at the end of the month now looks like a done deal. But while a relaxation of monetary policy is both welcome and overdue, it does not remotely measure up to what is now required if we are to ward off what could be the most serious recession in most people’s lifetimes.
That isn’t to say that home owners should not see some small reduction in their mortgage interest payments. Businesses – at least those still willing to borrow – should get marginally better deals from those lenders still willing and able to lend. And lower rates should mean that overseas speculators are less likely to push up the value of our dollar by chasing the interest rate premium we have insisted on offering them over recent years.
Even so, the impact of the Reserve Bank governor’s expected decision will be pretty marginal. Any slight easing in the cost and availability of credit at home will be offset by the higher cost and greater difficulty our banks will encounter in borrowing overseas. And even if credit is a little cheaper and easier, that may not be of much use if fears of a recession mean that people are no longer willing to borrow and spend. Relying on monetary policy in these circumstances is a bit like pushing on a piece of string.
When Treasury advised the government a week or two ago that the economic situation had worsened over the three weeks of the Christmas break, they revealed themselves as the only observers who failed to see – from some months back – that a further and rapid deterioration was inevitable. The suspicion must be that they are still fighting the last war, still fondly hoping that the measures that were too late to deal with last year’s home-grown recession – already well entrenched long before the global meltdown – will now serve to deal with the world crisis. Following along in the wake of events, relying on tax cuts planned last year and a belated cut in interest rates, will simply not cut the mustard now that the world economy is in free fall.
It is of course true that we have not so far had to grapple with the financial crisis that has engulfed much of the world’s banking system. Our (largely Australian) banks have so far avoided those problems, though they may find the going gets tougher over coming months. But what we haven’t seemed to have grasped is that the shattering loss of confidence in the world’s banks is now spilling over in to the real world economy – the one where people actually live and work and spend and try to make a living.
As recession gathers pace overseas, we have yet to feel the full impact of export markets that are going backwards, of commodity prices that are falling, of import prices that are rising, of credit from overseas sources (on which – as proportionately the world’s second most indebted nation – we are dangerously dependent) becoming more difficult and expensive to arrange.
Nor have we understood the impact on our domestic economy of falling house prices, rising unemployment, tighter government spending levels and more bankruptcies, closures and bad debts. As people feel less wealthy – as the perceived value of their assets falls, and doubts grow over their future income levels and job security – they become less likely to spend and invest, compounding the recessionary impact of the meltdown overseas.
This is not to say that there is an easy consensus about what does need to be done. But what is clear is that most overseas governments, with varying degrees of reluctance, have accepted that simply cutting the cost of credit when people may not wish or be able to borrow is not the answer. What is now needed, as Keynes recognised 75 years ago, is a fiscal stimulus that will raise the actual level of spending in the economy. That means government investment in infrastructure and services that will benefit the economy, and possibly putting money into the pockets of people – like the poor and the retired – who will spend it, even if this means temporarily rising government deficits.
While others have accepted that difficult times require special measures, we seem locked into an ideological straitjacket which is obsessed with monetary policy and seems more frightened of a burgeoning government deficit than of national bankruptcy. Yet there is no reason why we should be less courageous than others in making our response to recession. The one bright spot in our economic situation, after all, is that the government’s finances are, by comparison with other countries, reasonably healthy. We must hope that our new government will have the courage to recognise this, to understand what they must now do, and to do it before it is too late.
Bryan Gould
21 January 2009
This article was published in the Sunday Star-Times on 25 January.
So Much for Liquidity – Now Let’s Have a Serious Approach to Inflation
The Reserve Bank’s announcement of new provisions to improve the trading banks’ liquidity in the face of the world-wide credit crisis will be widely and justifiably welcomed. It is just a pity that the Reserve Bank is not similarly proactive when it comes to the battle against inflation.
Any liquidity problem for our banks is, of course, prospective rather than actual or immediate. It nevertheless makes sense, both for current confidence and as a practical response to the possibility of problems ahead, to ensure that the banks have a wider base of liquidity on which to operate. As the Reserve Bank makes clear in its Financial Stability Statement, we cannot assume that a banking system that relies heavily on borrowing from overseas will remain immune forever from the problems that threaten the liquidity of overseas financial institutions.
While the Reserve Bank deserves a tick for its foresight in this respect, it is less deserving of plaudits when it comes to other areas of its operations. It is reassuring that it has moved promptly to forestall liquidity problems, but this contrasts sadly with its failure to exercise effective prudential supervision over non-bank lenders. The failure of so many finance companies over the past year or so – at a cost to investors of over $1 billion – has left the Reserve Bank seeming more concerned with the viability of the banks than with the savings of ordinary New Zealanders.
Perhaps we should not be surprised at this apparent peculiarity in the spectrum of the Bank’s concerns. The Reserve Bank is, after all, a bank. It owes a particular loyalty to and has a particular concern for the interests of other banks. It has acted quickly, and properly, to ensure that the banks are able to maintain their operations – something that is very much in everyone’s interests of course – but it has been much less assiduous in meeting its other responsibilities.
That criticism applies with even more force if we look at a field of operations that is even more significant than the viability of the banking sector or the prudential supervision of finance companies – the Bank’s role in controlling inflation. It is now apparent to everyone that the Reserve Bank is struggling – and failing – to keep inflation under control except at a price that threatens the rest of us with recession.
The search is therefore on for counter-inflationary policy measures that are both more effective and less damaging than the single blunt instrument of constantly raising interest rates. The Reserve Bank went so far in 2006 as to commission a report on what it described as “supplementary stabilisation measures” – in other words, on further measures that might be taken in addition to what we are usually assured is a policy instrument to which there “is no alternative” – while the Finance and Expenditure Select Committee is currently engaged in a similar exercise in preparing its report on the future monetary policy framework.
In neither case, however, is it likely that the Reserve Bank or those who advise them will notice what is staring them in the face – that the most obvious (and easily dealt with) cause of inflation in our economy is the high and fast-growing volume of bank lending. Private sector credit has grown by six times over the last twenty years, from $44 billion in 1988 to $266 billion in 2008; the largest and fastest-growing element in that credit growth has been bank lending on mortgage for the purpose of buying residential property.
Current interest rate policy actually makes matter worse. As interest rates have risen, the banks have had to market their lending more and more aggressively – and they have protected themselves against the consequent risk of lending inappropriately by concentrating especially on the housing market where they can at least take adequate security over people’s houses.
Why has the Reserve Bank not focused immediately on this and imposed limits on the banks’ freedom to inflate the economy in this way? If the key to controlling inflation is to limit the growth in the money supply, why not deal with the fastest-growing element in that money supply? If the Reserve Bank is ready to improve the banks’ liquidity at times of credit stress, why do they not intervene to restrain that liquidity at time of inflationary pressure? Why destroy the viability of large parts of our productive economy, but leave the banks free to do as they please?
The answer is that there is a perhaps unconscious and certainly unstated bias in the way the Reserve Bank looks at these issues. They are unwilling to act against the banks, and would rather burden the rest of us with the responsibility for grappling with inflation. They see measures such as regulating capital requirements or loan-to-value ratios for bank lending – as amended and sometimes extended by the Basel II international agreement – as appropriate for prudential supervision and for ensuring adequate bank liquidity but not for controlling inflation. This point is made explicitly by the Bank’s External Monetary Policy Adviser in his submission to the Select Committee.
The Bank gets away with this bias because the bank economists who dominate the economic policy debate in the media have a vested interest in diverting attention away from it. It is time that the darker corners of this debate saw the light of day and that the banks were brought within the purview of counter-inflation policy.
Bryan Gould
8 May 2008
This article was published in the NZ Herald on 16 May 2008