Saturday, 17 January 2015

Ann Pettifor versus Positive Money.

There’s a difference of opinion between AP and PM over whether in the event of money creation by commercial banks being banned, there’d be any sort of deflationary or other undesirable effect. I’ll argue below that AP's arguments don't add up, while PM's answer to AP is unnecessarily complicated.

To put this in its historical context, the basic argument put by PM is close to the standard argument for full reserve banking put for example by Irving Fisher (in the 1930s), Milton Freidman (1960s), Laurence Kotlikoff and (very recently) Adam Levitin.

Ann Pettifor's argument is basically that if private banks cannot create and lend out money, then sundry viable investments based on bank loans will not take place. And PM responded recently with a publication entitled “Would a Sovereign Money System be Flexible Enough?” The basic answer to AP given in the latter work is that sovereign money creation can be as flexible as you like and in numerous different ways, thus any lack of flexibility deriving from the imposition of full reserve can be countered by a sufficiently flexible sovereign money system. (Incidentally, “sovereign money” is just a synonym for “base money”, and in a system where private banks can't create money, obviously the entire money creation process is then in the hands of the state or "sovereign").

The flaw in Pettifor’s argument.

Under full reserve banking, commercial banks cannot create money out of thin air, so to fund loans, they first have to attract funds from willing savers. And that might seem like a constraint on bank lending. The flaw in that argument is that the latter constraint actually exists anyway – i.e. it exists under the current banking system. Thus full reserve would not increase that constraint.

To illustrate why the constraint already exists, it’s best take two possible scenarios in turn: first, the economy is at capacity (aka full employment), and second, it isn't.


The economy is at capacity.

If the economy is at capacity and banks spot new and viable lending opportunities and banks lend out newly created money to those borrowers, that will increase demand. But that’s not possible if the economy is at capacity, else excess inflation ensues. Hence the government / central bank will have to calm things down with an interest rate increase or similar. The net effect, roughly speaking is no extra borrowing.

Ergo under the EXISTING SYSTEM, and assuming the economy is at capacity, commercial banks cannot lend more unless additional new savers are found. Put another way, assuming the economy is at capacity, any demand increasing effect stemming from extra lending must be matched by the deflationary effect of extra saving, all else equal. So the above mentioned “constraint” exists anyway.


The economy is not at capacity.

Alternatively, if the economy is NOT AT capacity, then there might seem to be some merit in commercial banks creating and lending out new money: that would have a stimulatory effect which is just what’s needed when the economy is operating at below capacity.

Unfortunately there is a major flaw in the latter argument, which is that commercial banks JUST DON’T lend out additional sums come a recession! In fact they do the opposite: they act in a pro-cyclical fashion. That is, they create and lend out new money like there’s no tomorrow in a boom (just what’s not needed). Then come the bust, they call in loans and their “lending out new money” activities grind to a halt (again, just what’s not needed).

Put another way, come a recession, it’s in practice governments and central banks which get us out of the problem (by running deficits, cutting interest rates, etc). It’s not private banks that get us out of the problem (although given long enough, arguably free markets eventually recover from recessions).

To summarise, if under the existing system the economy is at capacity, commercial banks have to find savers to fund new loans. Thus AP’s alleged constraint (namely that under full reserve, banks have to find savers before they can lend) is irrelevant. Alternatively, if the economy is NOT AT capacity, then commercial banks’ ability to create and lend out new money just doesn’t take place. Thus contrary to AP’s claims, banning private money creation has no effect!

In short, AP’s basic objection to full reserve doesn’t add up.


Positive Money’s answer to Ann Pettifor.

PM’s basic answer to AP is that the alleged reduced flexibility that commercial banks have under full reserve can be countered by any degree of flexibility in the “sovereign money” creation system.

And PM then goes into numerous details (see p.8 in particular) on how flexible a sovereign money creation system can be. E.g. according to PM it can give preference to loans for new house building as distinct from loans for purchasing existing houses. Or it can create a fixed amount of new money every year, which as PM rightly points out is what Milton Friedman advocated.

Well those various forms of flexibility are irrelevant because as shown above, AP’s basic objection to full reserve doesn’t add up. Put another way, “flexible sovereign money creation” doesn’t need to rescue full reserve for the simple reason that full reserve isn't in trouble.

Or put it yet another way, sovereign money creation (QE etc) under the EXISTING banking system has to be highly flexible because of the glaring deficiencies in the existing system ( e.g. credit crunches followed by five years of recession).

And as to whether sovereign money creation would need to be MORE FLEXIBLE under full reserve, it wouldn’t and for the simple reason that some of the major problems of the existing system disappear under full reserve. For example, under full reserve, it’s impossible for a bank (or “lending entity” to be more accurate) to go insolvent for the simple reason that it doesn’t owe anything to anyone: it’s funded entirely by shares. So….. no credit crunches! Or at least the severity of booms and busts ought to be much reduced.

(Incidentally under PM’s system, IT IS POSSIBLE for lenders to go bust because they are funded partially by depositors rather than shares. Thus I prefer the full reserve systems advocated by Friedman, Kotlikoff and Levitin. But even under PM’s system, the chance of insolvency can be reduced to vanishingly small levels if capital ratios are high enough.)


  1. I think you have a faulty argument regarding bank lending at full employment. However, there is a better argument which you don't mention.

    The faulty argument. You say:
    "assuming the economy is at capacity, commercial banks cannot lend more unless additional new savers are found"..."The net effect, roughly speaking is no extra borrowing."
    NO. NO.
    Even at full employment there is no constraint on lending if banks can borrow from the Central Bank. The historical record shows that investment and consumption financed by bank lending can increase approaching full employment without higher private sector savings.
    Excess demand could be eliminated by cuts in government expenditure, or reduced consumption due higher taxes on goods or incomes.
    Or higher interest rates and/or "confidence" could attract foreign funds leading to a higher exchange rate, with some of the excess demand met by more imports and reduced exports.

    A better argument is:
    1. Much of the extra bank lending in a boom tends to be for speculative or other relatively unproductive purposes. Some loss of "flexibilty" in financing such investments is probably desirable.
    2. Some of the investment financed by bank lending in booms is worthwhile. A revamped investment banking industry should be able to spot good prospects just as well or better than existing bank managers. Note that investment banks have access to overseas capital and are not entirely reliant on domestic savings. So although the institutional arrangements would be different it is far from clear that there would be any serious loss of flexibility.

    1. Hi KK,

      Taking your points in turn, it’s true that at full employment more bank lending could come about if the central bank lends to commercial banks at favorable rates of interest and compensates for that by cutting other government spending. Indeed Pos Money themselves make that sort of point so as to illustrate how flexible their sovereign money system can be.

      But I don’t see the case for interfering with market forces in that way unless one can prove market forces are at fault in some way. Plus governments don’t actually interfere in that way at full employment, and I think quite rightly.

      Re your “better argument” No.1 (curtailing speculative lending) Pos Money is keen on that sort of thing. But the rules and administration are complicated there. Strikes me that full reserve actually deals pretty well with the speculative lending problem because under FR lenders carry all losses. Adam Levitin draws attention the simplicity of bank regulation under FR, and I agree with him.

  2. In a previous comment, I claimed that a Central Bank will create Notes and then exchange the notes for Government
    Bonds. Government will then pay it's bills with Notes and the CB will sit happily with the Bonds.

    Of course the Notes are money. Money was created but there has been no mention of de-creation. In other words, once created, money will exist in the form of Notes (or electronic accounting equivalent) until some event occurs that cancels the original Bond. (Notes are cancelled simultaneous with Bond cancellation.)

    The reality just described defeats the concept of "willing savers". So long as Notes exist, they are available for lending. We should search for willing lenders.

    Once we have willing lenders, all we need for expanded lending is to have one person save and a second person borrow. The chain of saving and borrowing can expand without limit using the identical original Note.

    Here is the problem: What happens when Government taxes the original Note completely away to retire the original Bond?

    The answer: the chained system will collapse for lack of Notes.

    If we think about this money creating sequence, we can see the importance of the concept of velocity of money. A rapid sequence of lending and borrowing will generate a large GDP. A slow sequence (or no borrowing) will result in low (or even zero) GDP.

    A bank facilitates an increase in the velocity of money. It only appears to create money because we count deposits as money. What we should do is to count loans (not deposits) as money when we wish to learn how much money is in existence.

    This description of money creation is not difficult. Despite it's simplicity, it is not a mainstream description.

    1. Roger, I agree up to where you say “the chained system will collapse for lack of Notes”. But I don’t agree with that “lack of notes” claim of yours. You’re assuming that a commercial bank system needs what you call “notes” and what most people would call “monetary base”.

      Most economists (wittingly or unwittingly) make that assumption. The assumption is correct in that to get a commercial bank system up and running there has to be some generally agreed money unit (in practice that’s often been some given weight of some rare metal). But once the system is up and running (and this is very blue skies and unconventional thinking) it seems to me that the monetary base can be disposed of altogether. The base has certainly become irrelevant nowadays in that we’re off the gold standard, i.e. the $ or £ is no longer tied to a specific amount of gold. But taking that further, if there were no base at all, what would be the problem? Obviously commercial banks would not be able to settle up using the base, but as an alternative they could let intra-bank debts last longer, and where necessary, settle up using other assets (shares, property, etc).

      A significant problem would be that the state would not be able to create new base money and help us escape recessions. On the other hand the evidence from the 1800s is that free markets eventually recover from recessions of their own accord.

      Next, you claim that “What we should do is to count loans (not deposits) as money..”. What’s the big difference? A bank loan is an artificial debt owed by a borrower to a bank. And that artificial debt falls within the dictionary definition of the word money, which is something like “anything widely accepted in payment for goods and services”. Then when that artificial debt has actually been used to buy stuff off X, Y & Z, the money / debt ends up as a deposit in the banks used by X,Y&Z.

  3. Thanks for thinking through my comment.

    I will deal with the second question first. "“What we should do is to count loans (not deposits) as money..”. What’s the big difference?

    If we accept that a deposit is created for each loan, then we also need to accept that a deposit is de-created for each loan paid down. In that case, deposits should equal loans. When we examine the quantities of deposits and loans they do NOT balance, but why not?

    The answer is that the Government controls the amount of deposits by borrowing them away and using the original money to once again pay the bills of government. This action bifurcates the money supply by reusing the original money and creating a new loan document. This new spending recreates the deposits the borrowing just depleted.

    Notice that this round of Government borrowing from Note holders has increased the amount of Bonds but not the amount of Notes. The bifurcation of money has resulted in more financial property (Bonds) but left the quantity of deposits (Notes) unchanged.

    Now to answer the second question: "But I don’t agree with that “lack of notes” claim of yours."

    In my answer to the first question, I effectively make the claim that Government is borrowing it's own notes. Yes, it is borrowing them from private note holders, but none-the-less, it is borrowing it's own notes.

    Well, thinking that way, if Government removed the Notes from circulation, there would be no Notes to borrow. Any further use of money would need to use an alternatively based money system.

    I will close saying that total loans are a measure of all the money that has been created. Deposits are a remainder that Government allows to float in the banking system, available for use in transactions.


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