Without debt there’d be no money?

Summary.     If it were true that without debt there’d be no money, then it would be impossible to have an economy where there was money but no debt. In fact such an economy is perfectly possible. People would just deposit collateral at banks and have their accounts credited with $X, $Y or $Z and with a view to conducting day to day transactions. That WOULD GIVE RISE TO VERY SHORT TERM debts in the sense that the amount in each person’s account would rise above and fall below $X, $Y or $Z for short periods (e.g. there’d be a rise when people got their salary). However, there’d be little point in banks charging interest on those short term debts. Plus in such an economy there’d be no LONG TERM debts like mortgages, which is what advocates of the “without debt there’d be no money” idea really have in mind.

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When commercial banks grant loans (i.e. create debt) they create money. That point has been explained by the best economics text books for decades and is confirmed in the opening sentences of this Bank of England publication.

You might conclude from that that without debt there’d be no money. Indeed, the latter claim is often made by those advocating a change to the bank and monetary system.

If the latter claim were true, it would follow that it would be impossible to have a system where there was money but no debt. Of course that’s a bit of a hypothetical system or society, but a culture where no one wished to go into debt is certainly a theoretical possibility: i.e. everyone would want to pay cash on the nail for everything. So let’s examine such a hypothetical society to see if it’s possible for commercial banks to supply a form of money without anyone going into debt .

Incidentally, CENTRAL banks create or issue a form of money which can well be argued to be “debt free”, but let’s ignore central banks: we’re concerned here just with COMMERCIAL banks.


A barter economy.

So, let’s start with a barter economy where a commercial bank or series of commercial banks set up in business. They offer some wondrous new stuff called “money” to anyone banks regard as credit worthy (perhaps because they’ve deposited collateral or perhaps not). The actual units making up that money doesn’t matter: make it an ounce of gold if you like, and each unit is called a “dollar”.

And let’s say just to keep things simple that EVERYONE in this hypothetical society (including employers) wants $1,000 to enable them to do day to day transactions in a more efficient manner than under barter. So $1k is credited to everyone’s account.

Now at that stage, i.e. before any spending starts, is there any debt? The answer is “no”. Or to be more accurate, there are two equal and opposite debts: first, banks owe everyone $1k in that money in your current / checking account is a debt owed to you by your bank. Second, there’s a debt owed by everyone to their bank: that’s everyone’s undertaking to repay the $1k to the bank at some stage. (That “equal and opposite” scenario is actually set out in economics text books: it’s not some strange new invention of mine.)

So, before any spending starts, there is no net debt. That is, no REAL RESOURCES or goods and services have moved from one person to another or from people to banks or from banks to people. All that’s happened is that some book-keeping entries have been made.


Physical cash.

As to physical cash (dollar bills, pound notes, coins etc), bank customers might want some of that. But there again, creating and issuing paper notes involves virtually no consumption of REAL RESOURCES: printing bank notes costs next to nothing.

Incidentally, I have of course assumed that commercial banks ARE ALLOWED to issue their own bank notes, an activity that was stopped in the UK in 1844.


Spending starts.

As soon as spending starts, remember that any money leaving one person’s account arrives someone else’s account (or in someone else’s wallet in the case of physical cash). Thus the AVERAGE stock of money possessed by citizens in this society always remains at $1k.

Incidentally, to keep things simple, I’ll assume from now on that all transactions are done by check or debit card rather than physical cash.

Also bear in mind that assuming everyone has enough regular income (wage, pension, etc), to enable them to pay their way, the balance on their account will on average over a few months or a year remain at $1k. That is the balance will tend to rise above $1k on receipt of their wage, and then fall below $1k over the next 30 days assuming wages are paid monthly.

But where’s the long term debt? There isn't any!

There are of course a series of SHORT TERM debts: i.e. if someone spends $X they’re temporarily in debt to the tune of $X. But assuming that  citizens of this country are just after money or LIQUIDITY, i.e. enough money to day to day transactions, the latter individual’s bank balance will be $X ABOVE $1k as often as it is BELOW $1k.


Charges made by banks.

In the above scenario, banks would clearly have to charge for ADMINISTRATION costs, e.g. the cost of checking up on the value of collateral. Indeed in the real world, there is often a “set up fee” or something of that description charged by banks when arranging a mortgage. As to INTEREST, there’s not much point in banks charging interest because banks would owe each customer money as often as customers owe banks money. Of course banks COULD CHARGE interest to those whose bank balances fell below $X, but then people would by the same token be justified in demanding interest from banks when the balance on their accounts was ABOVE $X.
Certainly if banks WERE TO charge interest, the NET AMOUNT of interest over the year charged by banks would be zero. (Incidentally, I’m assuming there that any interest charges are what might be called “genuine interest”, that is a charge for money owed, as distinct from administration costs)


Long term debts.

In contrast to the above SHORT TERM debts, there are LONG TERM debts, like mortgages which very definitely DO INVOLVE interest. And it’s that sort of debt that people have in mind when they claim that “without debt there’d be no money”. But as I’ve just hopefully demonstrated, those sort of long term debts are not needed in order for commercial banks to create money. And as to any interest that is charged on short term debts, that doesn’t make much sense. So the payment of interest is not needed either,  for commercial banks to issue a form of money.


Moreover, long term loans tend to be matched by long term deposits, i.e. so called “term accounts” (maturity transformation apart). And so called “money” in term accounts is often not counted as money (depending on the exact length of the term). Thus even the claim that long term loans create money is questionable.

Lawrence Summers’s “secular stagnation” is complete nonsense.

Summary.    Secular stagnation is the idea that even at zero interest rates, it’s possible an economy does not achieve full employment. Ergo negative interest rates are needed, but implementing the latter is difficult. Ergo it’s conceivable there is no escape from excess unemployment.

The truth is that as Keynes pointed out and as MMTers keep repeating, it doesn’t matter how reluctant businesses are to invest or how reluctant households are to spend, if the state simply increases and carries on increasing the amount of money spent and fed into household pockets, the point must eventually come where households react by  spending enough to bring full employment. And until household spending rises far enough, there is no theoretical limit to the latter public spending.

As leading MMTer Warren Mosler put it in his “Mosler’s law” which appears at the top of his blog: “There is no financial crisis so deep that a sufficiently large tax cut or increase in public spending cannot deal with it.”

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Summers first proposed his secular stagnation idea in a speech at an IMF conference in 2013. Mostly it’s incoherent nonsense far as I can see, but if Summers is saying anything at all, I go along with the summary of his speech set out by Gavyn Davies in the Financial Times. As Davies puts it in his 2nd and 3rd paragraphs, the theory is that demand can decline to such an extent that even a zero interest rate won’t solve the problem, thus a NEGATIVE rate is needed, and allegedly because cutting interest rates “has been the only means available to boost demand”.

Now the first flaw there is that cutting interest rates is most certainly not the “only means available to boost demand”. That is, if a zero rate doesn’t bring full employment, the state can simply print money and spend it, and/or cut taxes. The effect of that is to boost household cash balances, and (if the increased public spending option is taken) to increase employment in all the usual public sector areas: education, health, infrastructure repair, law and order, defence and so on.

And if the latter policy is implemented in robust enough form and for long enough, then household cash balances must at some point induce households to spend enough to bring full employment.

Indeed, the latter is exactly what we’ve done over the last three years or so. That is we’ve implemented fiscal stimulus (i.e. have government borrow and spend (and/or cut taxes)), then we’ve had central banks print money and buy government bonds: that’s called “Quantitative Easing”. And that comes to the same thing as having government and central bank, i.e. “the state”, print money and spend it and/or cut taxes.

Perhaps Summers hasn’t heard of QE. Or if he has, it seems he doesn’t understand the basic central bank book keeping entries involved when central banks do QE.


Two years later: 2015.

Having briefly sumarized Summers’s ideas as of 2013, we’re now in 2015 and he seems to have learned nothing in the meantime. In this speech given a few days and entitled “Reflections on Secular Stagnation” he says:

“Go back to basic Keynesian economics, and imagine that the point where the IS curve coincides with full employment involves a nominal interest rate that is lower than the attainable nominal interest rate. In that case, the creation, the printing of more money will be unavailing in generating economic growth.”

What on Earth is he talking about? Robert Mugabe didn’t find the “IS curve” any problem when he was printing and churning out ludicrously large amounts of money. It would be nice if Harvard economists had the same grasp of this subject as Robert Mugabe, wouldn’t it? (As I pointed out here some time ago).

And later in his speech of a few days ago he says:

“Secular stagnation is the phenomenon that the equilibrium level that savings are chronically in excess of investment, at reasonable interest rates.”

Well obviously it’s possible there is a decline in the amount that firms want to invest, and obviously its also possible there is a rise in the desire by households to save – in particular save MONEY rather than save in the sense of acquiring bigger houses, newer cars, etc. But the solution is easy: GIVE PEOPLE MORE MONEY!

Of course if the latter process goes too far, then excess inflation ensues. But until that point is reached or looks as though it’s about to be reached, there’s nothing wrong with simply printing money and expanding public spending and/or cutting taxes.

Alexander Apostolides’s amazingly clever article on banking.

This article by AA seems to have impressed sundry people in the Twittersphere, e.g. see here and here, but not me (e.g. see my critical comment after the article). Anyway, with a view to resolving this, I’ll run through the article in detail.

The article is 650 words in length, and the first 450 simply make the point (scarcely believable this) that the bubonic plague in Europe and the Turkish invasion of Cyprus in 1974 were traumatic events for Europe and Cyprus respectively, and that such events can be turning points for countries concerned.  Well I bet you didn’t know that…:-) I could add that the Norman invasion of Britain in 1066 was a similar turning point, and I could point to other turning points, but I don’t want to bore you to death.

Now in view of the above 650 / 450 numbers, astute readers will notice that that only leaves 200 words in which to say something about banking. Given that banking is a complicated subject, the chance of anything original being said in 200 words is slim. But let’s give AA the benefit of the doubt and examine the 200 words.

The paragraph after the above stuff on the bubonic plague says “The bail-in of 2013 is another such juncture. In March 2013, the unprecedented step of punishing depositors for the mistakes of bankers and their regulators will permanently alter the economic infrastructure of the island.”

Well OK. But deploring the bail in of ordinary depositors is easy. Wooley minded lefties will approve of that.  But unfortunately that leaves unanswered the question as to exactly WHO SHOULD be bailed in: i.e. who should pay for bank failures? AA doesn’t tell us.

You could argue that the latter sentence of his suggests that “bankers and their regulators” should foot the bill for bank failures. Unfortunately “bankers and regulators” just don’t have access to the ENORMOUS SUMS needed to bail out large banks. So AA’s weeping and wailing on behalf of depositors isn't much use.

Moreover (and I very much doubt AA knows this) one proposed solution to the question as to how to deal with our obviously dysfunctional banking system ACTUALLY INVOLVES bailing in a particular type of depositor. That proposal is part and parcel of full reserve banking. But that’s far too complex a point to deal with here.


Vested interests.

Anyway, then comes the final section of AA’s article which is entitled “Vested resistance to change” and consists of 140 words. AA basically makes the point that vested interests stand in the way of bank reform. Well I never! Is there anyone who hasn’t worked that out?

And AA’s final paragraph reads “Like the peasants in the day of the Black Death, society at large should not tolerate efforts of interest groups to stop the root-and-branch reform of the institutions that led Cyprus to this crisis.” Well everyone will drink to that: just another statement of the obvious.

And the real irony there is that several people, who claim to be left of centre and “radical” (to use the fashionable word) favor patching up the existing banking system rather than implementing root and branch reforms. But as Bill Mitchell has pointed out ad nausiam, the political left worldwide is incapable to doing anything much more than aping the economic illiteracy of the political right. I.e. lefties are far from innocent when it comes to backing vested interests.

But as regards banking, the CRUCIAL question, the $64k question is: exactly what should “reforms” consist of? Dodd-Frank & Co in the US have got bogged down in horrendous complexity in trying to answer that question.  AA doesn’t tell us or even make any suggestions (apart from his dislike of depositors being bailed in).


Conclusion.

Alexander Apostolides’s article doesn’t amount to much.

Monetary offset is a joke.

One of the central ideas, if not THE CENTRAL idea of Market Monetarism is so called “monetary offset”. Scott Sumner is one of the World’s leading proponents of monetary offset, if not THE leading proponent. He explains the idea in an article entitled “Why the Fiscal Multiplier is Roughly Zero”.

Monetary offset according to Sumner is the idea that fiscal stimulus is very ineffective (as the title of his article implies) and THE REASON apparently is that if the fiscal authorities implement too much stimulus, the monetary authorities (i.e. the central bank) will “adopt a more contractionary monetary policy in order to prevent inflation from exceeding their 2 percent target.”

Now anyone with a grasp of economics ought to be able to spot the flaw in that idea. Incidentally I’ve put the relevant passage from Sumner’s article below under the heading “Sumner’s own words” and in italics. And of course readers wanting an even more detailed look at his ideas are free to read his whole article.

Anyway, for the benefit of readers who haven’t spotted the flaw, I’ll spell it out, and in fact the flaw can be illustrated very nicely by reference to a car, as follows.

Suppose one person has control of the accelerator (fiscal policy), and someone else controls the brakes (monetary policy), obviously one of the things the “brake controller” will do is to apply the brakes if the “accelerator controller” has stepped on the gas too much and the car is exceeding the speed limit.

Sumner’s conclusion from the latter is that the accelerator (fiscal policy) is near useless, because if too much of it is applied, the brake controller will slow down the car. Well hopefully most readers will by now have seen the flaw in the argument.

The flaw of course is that an accelerators is a good way of controlling a car’s speed. There’s nothing inherently wrong with accelerators. And the fact that drivers sometimes to too fast and need to apply the brakes is not an argument against accelerators.

Moreover, the idea that if inflation looks like getting excessive, that the central bank will apply the brakes is not exactly an original idea. Everyone including the average taxi driver knows central banks do that. I.e. there is no need whatever or a gradiouse new theory called “monetary offset”.

Monetary offset is nothing more than a verbal sleight of hand. It’s for people who don’t like fiscal policy, but can’t find any serious flaws in fiscal policy.



Sumner’s own words.

“Why has the effect of fiscal stimulus been so meager in recent years? After all, interest rates in the United States have been close to zero since the end of 2008. The most likely explanation is monetary offset, a concept built into modern central bank policy but poorly understood. We can visualize monetary offset with the Keynesian aggregate supply and demand diagram used in introductory economics textbooks. If fiscal stimulus works, it’s by shifting the aggregate demand (AD) curve to the right. This tends to raise both prices and output as the economy moves from point A to point B, although in the very long run, only prices are affected. Now let’s assume that the central bank is targeting inflation at 2 percent. If fiscal stimulus shifts the AD curve to the right, then prices will tend to rise. The central bank then must adopt a more contractionary monetary policy in order to prevent inflation from exceeding their 2 percent target. The contractionary monetary policy shifts AD back to the left, offsetting the effect of the fiscal stimulus. This is called monetary offset.”

Do central banks need assets?

Simon Wren-Lewis addresses the question as to why central banks don’t care for helicoptering. That’s the idea that central banks should simply create new money and distribute it to every household, or give the money to government with a view to government spending it on the usual public spending items: roads, education, etc. (or alternatively using the money to cut taxes).

As he puts it, “One reason why it is taboo among central banks is that they want an asset that they can later sell when the economy recovers.” I beg to differ.

If a central bank has NO ASSETS to sell, there’d be nothing to stop it wading into the market and offering to borrow at a rate just above the going rate for near risk free loans. That would have the desired deflationary effect.

Of course the latter “wading” is doubtless illegal under existing legislation in various countries. But that doesn’t matter: the law can easily be changed.

As to where a central bank would get the money from to pay the interest, obviously if the central bank just printed the money that would partially or wholly defeat the object of the exercise. That is, the effect of that printing would be stimulatory.

However, central banks normally make a profit every year and they remit that profit to the treasury. (Much of that profit comes from seigniorage) So if the central bank just debited that interest to its profit and loss account, then the treasury would get less at the end of the year, thus public spending on other items (roads, education, etc) would decline. The effect of that would DEFINITELY be deflationary: the desired effect.

And if the profits from seigniorage and so on weren’t enough to fund the above interest, then the central bank would just have to go along to the treasury (i.e. politicians) and say something like: “In order to implement the deflationary effect that we think is desirable, we’re going to need $X off you so as to fund interest on the money we’re borrowing”. And if politicians said “no”, then the central bank governor’s justifiable response would be: “OK then, I’ve told you what in my professional capacity I think needs to be done. If you don’t want to do it and inflation goes thru the roof, I’ll let the world know who’s to blame. And if you sack me as a result, I don’t care. I’d prefer a job where my professional expertise is appreciated even if it pays half as much.”

Greek roofs and steel rods.

I was at a Positive Money meeting over the weekend and someone told me that on a trip to Greece he noticed half the houses in several areas looked fine except that they had steel reinforcement bars sticking out of the roofs. Those are the so called “rebars” used to reinforce concrete.

He was informed that the innocent explanation for this is that householders are planning to build an additional storey for their children. But apparently the real explanation is that in Greece, one doesn’t pay property tax on a house which isn't complete. And if there are rebars sticking out of the house then obviously the house isn't  - er – “complete”.

The fact that a family has been living in the house for years is apparently irrelevant. There’s more about this tax dodge here.

Why do masochistic Greeks want to be in the Euro?

As everyone knows, poor downtrodden Greece has suffered horribly as a result of being in the Euro. Greece has been trampled on by wicked bullying Germany and it’s all a crying shame. Unemployment has rocketed in Greece, poverty is widespread, and so on.

But at the same time Greece is absolutely DETERMINED to stay in the Euro and continue to take punishment. Now that’s bizarre behavior isn't it? Why doesn’t Greece quit the Euro if the Euro regime is indeed so awful, and switch to the Drachma? Of course there’d be initial and costly disruption involved in the switch, but that change would pay off in the long run if indeed the Euro is so dreadful.

Indeed, another closely related question, is why was Greece so keen to join the Euro in the first place? After all, several small countries in Europe with populations similar in size to Greece have done very nicely since WWII and continue to do nicely while organising their OWN currencies: Switzerland, Denmark, Sweden, etc.

Well the answer is that organising your own currency requires a fair bit of responsibility, and Greeks, as Greeks themselves know perfectly well just aren’t responsible or honest. To illustrate:

1. Greece has spent 90 of the last 190 years in financial crisis. See here.

2. The amount of income declared by Greek lawyers is (hilariously) equal to their mortgage repayments. I.e. those lawyers claim to spending nothing on food, transport, clothes etc. Now you believe that, don’t you? (Ho ho).

3. There’s more on Greek corruption here.

4. There’s the old saying “Beware of Greeks bearing gifts”.

5. Greece had to fiddle its books in order to get into the Eurozone in the first place.

So the reason why the Greeks don’t want to leave the Euro is that, as they themselves suspect (probably quite rightly) they’d be no better off.

The Eurozone, rightly or wrongly, is a system in which each country has to pay its own way. Indeed almost every country in the world OUTSIDE Europe has to pay its own way. And any country that can’t get its act together and pay its own way is in trouble. Thus Greece’s troubles are not the fault of the Eurozone: if Greece was OUTSIDE the Eurozone, it would almost certainly still be in trouble.

EZ periphery reform.

There’s been much excitement about the chart below, which seems to indicate that Greece has done lots of reform. E.g. see here and here. Yet Greece and other PIGS still have problems. And that allegedly proves, at least according to some, that all those demands for reform are nonsense, so austerity in the periphery should be abandoned immediately.

 
Well, not so quick. First, the above chart doesn’t actually tell us HOW MUCH reform Greece and others have done. That is, could be that the amount of reform done by Greece is small, and the amount done by other countries is almost negligible. Indeed, if there’s been a big cut in tax evasion in Greece in recent years, that’s news to me.


Competitiveness.

The basic problem is that PIGS are uncompetitive relative to Germany etc. That is, PIG costs (in terms of Euros) are too high.

Now the word “reform” normally refers to sorting out problems like Greece’s notoriously inefficient tax collection system and its bloated and inefficient bureaucracy. And dealing with those problems would certainly help. However, no one ever suggested far as I know that “reforms” will TOTALLY solve the problem. That is, it’s widely accepted that internal devaluation in at least some PIG countries is needed as well.

That is, when a country with its own currency becomes uncompetitive, it can deal with that via conventional devaluation. But in a common currency area, that’s not possible, so internal devaluation is the only option. And unfortunately internal devaluation requires years of excess unemployment, i.e. “austerity”. Possibly the AMOUNT OF austerity could be reduced a bit, as suggested by Simon Wren-Lewis. But there’s no getting away from years of austerity.

Of course that’s daft. But that’s common currencies for you.




P.S. (Same day)
 
There’s more of the above sort of delusional thinking here by Dean Baker (who I nearly always agree with). He seems to think that all we need is stimulus in the periphery and everything will be fine. He doesn’t mention, and is thus presumably unaware of the fact that stimulus will suck imports into periphery countries which pushes them further into debt. Of course if Dean Baker is offering to lend his life savings to Greece, I’d have a SMALL amount of sympathy with his views. But he’s not.

Why do we let private banks produce counterfeit money?

Summary. When a commercial or “private” bank grants a loan, it doesn't need to get the relevant money from anywhere: it can just credit the borrowers account with money produced from thin air, as explained in this Bank of England publication. That money creation or “printing” is to some extent exactly what backstreet counterfeiters do with their printing presses when turning out $100 bills or £20 notes.

However, it’s certainly not true to say that every time a private bank grants an $X loan that the bank effectively prints $X. The extent to which new money is printed when that $X loan is granted is a bit complicated and the paragraphs below are an attempt to sort out the complexity. However the fact remains that what private banks do is to some extent exactly what back  street counterfeiters so, and it’s plain bizarre that we allow that “legal counterfeiting” to continue.


Where counterfeiting occurs.
 
Where counterfeiting takes place, obviously it takes place when the counterfeit notes are FIRST PRINTED and first used to purchase goods and services. That is the point at which harm is done. I.e., when those notes SUBSEQUENTLY passed from hand to hand, no further harm is done.

A similar point applies to “legal counterfeiting” as done by private banks.

That is, the money supply normally increases year after year, but in a recession, private banks tend to rein in their loans and cut down on new loans. Thus in a recession there is sometimes no monthly or annual increase in the money supply. In that scenario, banks grant new loans at the same speed with which old loans are repaid. And in that case, clearly no new money creation takes place, counterfeit or honest.

In short, legal counterfeiting if it takes place at all, only takes place when the money supply is increasing.


The basic money creation process.

When a bank accepts an £X deposit and the deposit is loaned on, both the depositor and borrower are in effect holders of £X. So £X has been turned into £2X. However, there is no sharp dividing line between money and other fairly liquid assets: in particular, money in a term account where the term still has more than about two to four months to run is often not counted as money.

So… if in the above £X scenario those who RECEIVE the £X spent by the borrower put the money into a term account where the term is say 6 months, then on most definitions of the word money, no money is created on balance. Put another way, money is only created where the £X is put into a CURRENT account (checking account to use US parlance), or into a short term term account (say less than about two months). I’ll refer to those two types of account from now on as checking accounts.

To summarise so far, we need to concentrate on money spent by borrowers which goes into checking accounts. Plus we need to concentrate on the INCREASE in the TOTAL AMOUNT in such accounts for the country as a whole.

That amount clearly increases most years and for two reasons. First one would expect households to want the amount of money at their disposal to increase along with real economic growth. Second, inflation eats away at the value of money, thus households will presumably want to add to their stock of checking money every year so as to compensate for inflation.

And as explained above, the origin of that increased stock is money produced out of thin air by private banks when they grant loans. So what’s going on here is that private banks create money out of thin air, give it to borrowers who in turn use the thin air money to purchase goods and services from various other people or firms, who in turn place the money in their checking accounts and leave it there.

Now the latter people and firms have in a sense been diddled: they sweated their guts out supplying real goods and services and return all they get is in effect a book keeping entry  - or if you like a “number” on their bank statements.

Of course, the latter people and firms who have been diddled aren’t TOO BOTHERED: in return for their hard work they get what might be called “magic numbers” which enable them to purchase goods and services. But remember we’re talking about the INCREASED STOCK of money in checking accounts, thus those magic numbers in the aggregate are in fact never spent: that is, on average over the year, the stock of money in checking accounts rises: it never declines.


Illegal printing presses.

The latter phenomenon is EXACTLY THE SAME as where someone with an illegal printing press turns out counterfeit £20 notes, and (out of the kindness of their heart) brings about an increase in the nation’s stock of current / checking account money. That is, the printing press owner acquires real goods and services in exchange for what might be called thin air money.

Now you might think that because borrowers eventually pay loans back to banks that that somehow makes commercial bank counterfeiting OK. Well it’s true that INDIVIDUAL borrowers repay banks. But IN THE AGGREGATE they don’t. That is the total amount loaned out increases nearly every year, just like the money supply increases every year.

So, in the aggregate, borrowers acquire real goods and services from those with checking accounts for free and of course banks take their cut. Put another way, people who want more money in their checking accounts have to provide $X of goods and services for every $X of additional money they acquire to stock up their accounts. And those goods and services flow to borrowers and private banks.


What about central bank created money?

Now as distinct from private bank created money, there’s another widely used form of money, namely central bank (CB) created money or if you like “government created” money. (That’s using the word “government” in a very broad sense, i.e. it involves regarding CBs as part of the overall government machine).

That CB money comes in the form of paper notes and coins ($100 bills etc), plus there’s a small amount of CB money which comes in book-keeping form just like PRIVATE BANK money comes in book-keeping form. (Incidentally the TOTAL AMOUNT of that CB book-keeping money is normally ROUGHLY equal to the amount of paper note money, though the amount of that book-keeping money has actually expanded enormously in recently years as a result of QE).


The big choice.

Now we have a choice here. It would be perfectly possible to have a system under which money production is done just by the state and private money creation is outlawed. Indeed, that’s exactly what Abraham Lincoln wanted. As he put it, “The Government should create, issue, and circulate all the currency and credits needed to satisfy the spending power of the Government and the buying power of consumers.”

Under such a system, there would be two ways of distributing state created money. First, the state could simply distribute for free a suitable amount of money to every household and firm. As to what constitutes a “suitable” amount, that’s easy: the best amount to distribute is whatever keeps households spending at a rate that gives us full employment, that is as high a level of employment as is possible without bringing excess inflation. That distribution system is often referred to as a “helicopter drop”.

That distribution system does however have a problem which is that one can get bogged down in arguments over how much “free money” should go to particular types of household.

The second and probably better way to distribute new money would be to have government simply use the new money to fund a proportion of its usual spending: on education, defence, roads and so on. Alternatively, a right of centre government might choose to leave public spending constant and use the new money to cut taxes.


Conclusion.

So let’s summarise. You want some more money for your checking account. The way you go about that under the existing system is to do some extra work or cut down on your consumption of goods and services for a month or two. That is, you “save money”.

Put another way, you sweat your guts out and supply real goods and services to someone somewhere, and in exchange get some extra magic numbers on your bank statement. Now whoever supplies those magic numbers is onto a good thing, aren’t they? I mean – supply magic numbers and get real goods and services in return? That’s nice work if you can get it. It’s extremely profitable. In fact there’s a name for that profit: seigniorage.

Now given that someone somewhere makes a seigniorage profit out of you when they supply you with extra money, who do you want that to be? Do you want it to be some collection of borrowers and banks unknown to you? Or do you want it to be the community as a whole, i.e. government? I prefer the latter.

When a private bank and those borrowing from it grab seigniorage profit they’re doing exactly what back street counterfeiters do. If there was no central bank, then private banks WOULD BE PERFORMING a useful service there: providing the country with money. But we DO HAVE central banks nowadays, and I suggest it’s central banks (in cooperation with government) that ought to provide our money supply.

Bring back the Deutschmark?

The Eurozone authorities should require Germany to declare openly whether it wants the standard 2% inflation or whether (as seems to be the case) it wants zero inflation and zero deficit.

If it wants the former and the rest of the EZ definitely want the standard 2% target, then Germany should quit using the Euro, and revert to the Deutschmark.

It is absurd to think that one country in a common currency area can achieve zero inflation while others have 2% inflation: all that happens is that the former country grows too competitive relative to the latter countries.

If Germany agrees to the 2% inflation target, then immediate steps should be taken to boost demand in the EZ and bring inflation in Germany back up to the 2% target. (Unfortunately it’s debatable as to whether the authorities in the EZ, just like the authorities in the US or UK,  actually know how to boost demand without getting their knickers in a twist on the subject of deficits, debts, etc. But that’s another matter.)

Alternatively, if Germany definitely wants zero inflation and zero deficits, it can live perfectly happily with other EU countries and trade with them, but it can’t share the same currency. In that case, Germany should revert to the Deutschmark.

As to the popular idea that that would amount to a revaluation of the currency used by Germany, and hence that Germany’s balance of payments would be hit, which would be a problem, that’s nonsense. A freely floating Deutschmark, like any other currency which floats, keeps the relevant country’s external position in balance in the long run. What’s wrong with that? That’s far better than a constant surplus, i.e. a constant accumulation of foreign currency, which is then loaned to irresponsible borrowers who don’t pay the money back.

Is more lending / debt desirable or not?

(Warning: this is yet another of my pro-full reserve banking rants)

The great and the good – aka the dozy elite – often deplore the rise in household and other debts over the last decade or so. But in the next breath they’re quite likely to warn that excessive bank regulation will cut bank loans and hence economic growth.  So do they want more lending / debt or less?

One of the worst offenders is Vince Cable, the UK’s so called “Business Secretary”. For example, according to this Financial Times article he claims (scarcely believable this) that commercial banks shouldn’t be forced to have more capital because  that would allegedly cut  down on bank lending and bank created debt, which would  damage economic growth. Well if there’s one thing nearly every economist now agrees on, it’s that banks SHOULD HAVE more capital. Indeed, Martin Wolf, chief economics commentator at the Financial Times argues that banks should have VASTLY MORE capital: much more than advocated by the Basel regulators.

But in contrast, Cable says here, “I am very concerned by the build-up of household debt in relation to income.” And if you want to watch more members of the great and the good brigade hyperventilating about excessive household debts, see here.
Anyone can take some event or variable, e.g. an interest rate rise, and point to one or two consequences. In contrast, and far more useful is to work out the OPTIMUM level of interest rates, debts, lending etc. So what set up would give us the OPTIMUM amount of lending and debt?


Optimisation: the free market.

It’s widely accepted that the FREE MARKET gives an optimum allocation of resources, bar a number of specific areas where a totally free market does obvious harm: e.g. giving factories freedom to pollute their surroundings. Or in economics jargon, we can’t allow externalities.  Also a free market is a scenario in which there are no subsidies (unless there are very good social reasons for subsidies). Indeed it is widely accepted that bank subsidies should be removed, though the elite is  moving at a snail’s pace to actually remove such subsidies. Or as Labour politician Michael Meacher so eloquently put it, “The pusillanimity of the new capital reserve requirements was accompanied by almost unbelievable procrastination.”

In fact, advocates of so called “free banking”  advocate a removal of all bank subsidies, and indeed  taking that further: letting private banks issue their own dollar bills, pound notes, etc.

Free banking is OK by me as long as depositors have the option of some sort of totally safe state backed account to lodge their money in. With a view to achieving the latter, William Hummel advocates that everyone should be able to open an account at the central bank. But that’s just one way of doing it. As an alternative, one could have commercial banks act as agents for the central bank.

Moreover, totally safe accounts of the latter sort are already up and running. In the UK there’s the state run savings bank National Savings and Investments. And in the US there are money market mutual funds which invest only in short term government debt.

And what do you know? The latter system, i.e.  totally safe, state run accounts combined with a more or less “anything goes” private banking system is pretty much what full reserve banking consists of, a system I back. There’s just one constraint that needs to be put on those private banks (and free banking enthusiasts won’t agree with this), and that is to restrict their freedom to issue any sort of liability which is too near to being money. Reason for that is that private banks, as is currently the case, issue most of the country’s money supply, and if a series of such banks collapse, the country’s money supply vanishes or is dramatically reduced. As Irving Fisher put it in the 1930s, “The most outstanding fact of the last depression is the destruction of eight billion dollars-over a third - of our "check-book money"- demand deposits.” That just isn't acceptable.

To put it in economics jargon, letting private banks issue the country’s money supply involves an externality: those banks periodically impose catastrophic crashes / credit crunches on the economy. That needs to be disposed of just as the pollution externality mentioned above needs to be disposed of.


Conclusion.

The optimum amount of lending and debt would arise where borrowers and lenders are free to come to any mutually acceptable agreement they like: using a bank as an intermediary or not. The main constraints needed are first, private banks’ freedom to portray their liabilities as money should be constrained or outlawed.  Second, to make up for that constraint, the state should make totally safe accounts available to anyone who wants them.


Under that system, there is no state support for lending entities / lending banks. And that in turn means that all stakeholders in those entities are effectively shareholders: i.e. in the worst case scenario, they stand to lose 100% of their stakes. So that means a big rise in capital ratios, which in turn would reduce lending somewhat. But if that lead to any reduced GDP, that’s no problem because the latter reduction can be dealt with by standard stimulatory measures: interest rate cuts, a bigger deficit or whatever.

Nick Rowe says debt is a burden on future generations.

The economically illiterate, as Nick Rowe rightly points out, think that the national debt is a burden on future generations, and for reasons which are nonsense. However, Nick argues that in fact there IS A REASON for accepting the “burden” argument, but not the one advocated by the above illiterates.

I’ll argue here that in fact Nick’s argument itself is flawed. Nick’s argument is set out here, and I’ve reproduced the essential paragraphs below under the heading “The Rowe theory in his own words”. For other articles where he enlarges on his argument, see here, here, here, and perhaps also elsewhere. (See what you can find by Googling).

Basically I’ll argue that in the real world, the amount of “burden transfer” between generations is determined PURELY BY the size of PENSIONS. As to any burden transfer stemming from national debt, no such transfer is INHERENT TO national debt. That is, a country COULD HAVE a substantial national debt, plus generous pension schemes which are FUNDED and which store up assets in the form of government bonds (i.e. debt). Alternatively, such a country could have equally generous pension arrangements implemented entirely by pay as you go pension schemes, in which case 100% of burden transfer would be attributable to pensions, not the debt.


The basic Nick Rowe argument.

His basic argument is as follows.

Suppose that during a particular decade or two, government borrows from working age people and hands out various government provided goodies to them. Those people are no worse off. Plus assume that government gives bonds to those people.

Assume also that during the retirement years of those people, they sell their bonds to the new generation of working age people. The net effect is that the first generation is better off: it consumes more than it otherwise would have.

Assume also that the above buying and selling of bonds between generations continues for several generations and eventually stops. That means that the FINAL GENERATION loses out: reason is that government has to tax it to buy back the bonds, but the final generation gets nothing in its retirement.


The flaw.

The latter argument is of course valid ASSUMING youngsters in each generation purchase bonds off those in retirement. But why would they do that? There’s only one possible reason: to fund the retirement years of todays youngsters.

Indeed, FUNDED pension schemes (as distinct from unfunded, aka “pay as you go” schemes) do just that. That is, they use the contributions of today’s working age people to purchase various assets including government bonds, and then sell those bonds during the retirement years of today’s working age people to fund the latter’s retirement.

Moreover, it is TOTALLY UNNECESSARY, as intimated above, to actually fund pension schemes. That is, there are pay as you go schemes which have no bonds or assets at all. The biggest pension scheme in the UK is like that. That’s the state pension scheme. And just as in the case of Nick Rowe’s “bond burden transfer” theory, people of working age pay in, and pensioners withdraw money from the scheme.


Conclusion.

The amount of inter generational burden transfer is determined SOLELY by the size of pensions. Government bonds CAN PLAY A ROLE in pension schemes, but there is no absolute need for them to do so. Thus there is no inherent “transferring burdens to future generations” characteristic in government debt.


The Rowe theory in his own words.

The government borrows 100 apples from each of cohort A, then gives each person in cohort A a transfer payment of 100 apples. It is exactly as if the government had simply given each person in cohort A an IOU for 100 apples. That IOU is a bond.

So far there is no change in cohort A's consumption of apples.

Cohort A then sells the bonds to the younger members of cohort B. So each person in cohort A gets an extra 110 apples (assume 10% interest per generation), which he eats. Cohort A then dies.

Cohort A is better off. Each member of cohort A eats an extra 110 apples. In present value terms, those extra 110 apples are worth 100 apples at the time the transfer payment is made.

Cohort B eats 110 fewer apples when young, but 121 extra apples when old, and they sell their bonds to cohort C. Although cohort B eats 11 more apples in their lifetimes, the present value of their total consumption of apples is the same. The rate of interest must be high enough to persuade them to eat fewer apples when young and more apples when old, otherwise they wouldn't have bought the bonds from cohort A. So cohort B is not worse off.

But (given my assumption) the debt is rising faster than GDP. The government knows this is unsustainable. It cannot rollover the debt forever, because eventually the next cohort will be unable to buy the bonds from the older cohort. So the government decides to pay off the debt by imposing a tax of 121 apples on each young person in cohort C, which it uses to buy back the bonds from cohort C.

Each member of cohort C eats 121 fewer apples.

Cohort A eats more apples, and cohort C eats fewer apples. It is exactly as if apples travelled back in time, out of the mouths of cohort C into the mouths of cohort A. (With interest subtracted as they travel back in time through the time machine.)

Yes, the national debt is a burden on future generations.

Should we give preference to GDP increasing loans?

There’s a currently popular idea which I’ll illustrate by reference to housing, as follows. If someone gets a loan to have a house built, there is a substantial effect on GDP: bricklayers, carpenters, plumbers etc are employed. In contrast, if someone gets a loan to buy a house which ALREADY EXISTS, there is LITTLE EFFECT on GDP (apart from a few hours work for lawyers doing the legal work, surveyors etc). Ergo we should favor “GDP increasing loans”.

That idea is pushed by Positive Money and Richard Werner.

The flaw in the idea is that it assumes that stimulus can only come via more lending and that there is some sort of fixed or limited amount of money that is available for stimulus purposes, and thus we better make best use of that money if we’re to maximist GDP.

In fact there is no limit to the potential amount of stimulus money. That is, government and central bank could if they wanted, print and spend a trillion trillion trillion trillion dollars or pounds any time they want. Alternatively and as part of the latter mega bout of stimulus, government could just stop collecting tax. Households would find they had hithertoo unprecedented piles of cash and would run out and buy new houses, existing houses, holiday homes, new cars, you name it, and of course inflation would go thru the roof.

Thus I suggest we can just leave it to the market to sort out how many brand new houses as distinct from existing houses are bought.

Another element in the above “preference for GDP increasing loans” idea is that preference should be given to loans to employers as distinct from loans to buy existing houses. The argument is that employers engage in real, productive, manly, GDP increasing activities whereas loans to buy existing houses do not increase GDP by much.

The problem with that idea is that there are about twice as many bad debtors amongst employers as compared to mortgagors. Indeed, the riskiness of loans to employers is reflected in the Basel bank rules. So is a borrower (employer or non-employer) who can’t repay a loan “productive”? I suggest not. And that further reinforces the above conclusion that this can all be left to the market.

Conclusion: there is no case for any sort of bias in favor of loans which allegedly boost GDP by more than other loans.

Is more lending / debt desirable or not?

The great and the good – aka the dozy elite - spend a significant amount of time deploring the rise in household and other debts over the last decade or so. But in the next breath they often warn that excessive bank regulation will cut bank loans and hence economic growth. So do they want more lending / debt or less?

One of the worst offenders is Vince Cable, the UK’s so called “business secretary”. For example, according to this Financial Times article he claims (scarcely believable this) that commercial banks shouldn’t be forced to have more capital because  that would allegedly damage economic growth. Well if there’s on thing nearly every economist now agrees on, it’s that banks SHOULD HAVE more capital. Indeed, Martin Wolf, chief economics commentator at the Financial Times argues that banks should have VASTLY MORE capital: much more than advocated by the Basel regulators.

But in contrast, Cable says here, “I am very concerned by the build-up of household debt in relation to income.” And if you want to watch more members of the great and the good brigade hyperventilating about excessive household debts, see here.
 

Optimisation.

Any old fool can take some event or variable, e.g. an interest rate rise, and point to one or two consequences. In contrast, and far more useful is work out the OPTIMUM level of interest rates, debts or any other variable.

So, does Vince Cable and the rest of the UK’s dozy elite think more lending is desirable or not, i.e. what do they think is the OPTIMUM policy here (if they understand the word “optimum”). Before they give us an answer, they should ponder the fact that it’s debatable as to whether increased capital for banks really has any effect on bank funding costs and for the following reason.

According to the Modigliani Miller theory, altering the way a corporation is funded (capital versus debt for example) has NO EFFECT on the cost of funding the corporation. And Messers Modigliani and Miller got Nobel Prizes for their efforts, so they weren’t stupid.


Bank subsidies.

A second and quite separate point here is that even if more capital DOES RAISE bank funding costs, that is not necessarily undesirable and for the following reason. It is widely accepted that all bank subsidies should be removed, though the dozy elite are moving at a snail’s pace in actually putting that into effect. Sweetners paid by banksters to politicians no doubt help ensure the snail’s pace doesn’t speed up. (The financial industry spends £90m a year on lobbying in the UK).

Now if all bank subsidies are removed, then those funding banks OTHER THAN shareholders (i.e. depositors, bond-holders, etc) effectively become shareholders. That’s “shareholder” as in “someone who stands to lose everything in the worst case scenario”. And that’s different to the CURRENT scenario where, at least in the UK, depositors are protected by insurance funded by taxpayers: a blatant subsidy of the bank industry. Clearly the latter depositors do not stand to lose everything. In fact, they don’t stand to lose ANYTHING!!!

Indeed, therein lies another self-contradiction in the brains of the great and the good. That is, ask them if bank subsidies should be removed, and they’ll say “yes”. But ask them if depositors should have to run the risk of losing their deposits and they’ll say “no”.

Of course if the above self-contradictions were put to Vince Cable or any other skilled politician they’d be able talk their way out of the self-contradiction. Doubtless they’d be able to argue that black is white. But those of us with a SERIOUS interest in this subject want to see some sort of OPTIMUM banking system, i.e. a system that gives us the OPTIMUM level of lending and debt. So here’s an idea for achieving that optimum.


Free banking.

It’s widely accepted that the FREE MARKET gives an optimum allocation of resources, bar a number of specific areas where a totally free market does obvious harm: e.g. giving factory owners freedom to pollute their surroundings. And in the case of banks, a free market would involve removing all bank subsidies. Indeed, advocates of so called “free banking”  advocate taking that further and letting private banks issue their own dollar bills, pound notes, etc.

Free banking is OK by me as long as depositors have the option of some sort of totally safe state backed account to lodge their money in. With a view to achieving the latter, William Hummel advocates that everyone should be able to open an account at the central bank. But that’s just one way of doing it. As an alternative, one could have commercial banks act as agents for the central bank.

And what do you know? The latter system, i.e.  totally safe, state run accounts combined with what might be called an “anything goes” private banking system is pretty much what full reserve banking consists of, a system I back. There’s just one constraint that needs to be put on those private banks (and free banking enthusiasts won’t agree with this), and that is to restrict their freedom to issue any sort of liability which is too near to being money. Reason for that is that private banks, as is currently the case, issue most of the country’s money supply, and if a series of such banks collapse, the country’s money supply vanishes or is dramatically reduced. As Irving Fisher put it in the 1930s, “The most outstanding fact of the last depression is the destruction of eight billion dollars-over a third - of our "check-book money"- demand deposits.”

A system under which it is possible for a third of what households and small businesses thought was safe money to disappear is just not acceptable.


Conclusion.

The optimum amount of lending and debt would arise where borrowers and lenders are free to come to any mutually acceptable agreement they like: using a bank as an intermediary or not. The main constraints needed are first, private banks’ freedom to portray their liabilities as money should be constrained. Second, to make up for that constraint, the state should make totally safe accounts available to anyone who wants them.

Cities issue local currencies. Why not Greece?

Numerous cities and regions have issued, and currently issue their own currencies. One of the first was Worgl in Austria in the 1930s, and there’s a currency called “Ithaca hours” in Ithaca in the US. Plus currently in the UK, the cities of Bristol and Lewis issue their own “pounds”. And for all I know there are others in the UK.

Those currencies of course run alongside another currency (the pound in the case of the UK) which serves a bigger “common currency area”. So if Greece issued it’s own Euros (or Drachmas to give the currency another name), that would be the direct equivalent of the Bristol or Lewis pound.

So do local currencies really make sense? Because if they do, that strongly suggests that a Greek local currency would make sense.

Local currencies arise for two reasons. First, as in the case of Worgl, there can be inadequate demand over the entire broader currency area: the 1930s depression in the case of Worgl. Given inadequate demand over such an area, the solution advocated by Keynes (and MMTers) is to print money and spend it (and/or cut taxes). That increases every households’ stock of money, which induces households to spend more, which solves the problem.

Second, and this is essentially the problem in the Eurozone, there can be inadequate demand in a relatively small area (e.g. Greece) caused by that area being uncompetitive relative to the rest of the broader area. The BEST SOLUTION there is internal devaluation which is what austerity in the Euro periphery is supposed to bring about, and indeed IS BRINGING about, but at a painfully slow pace.

The main obstacle to internal devaluation is a problem identified by Keynes long ago: it’s the fact that wages are as he put it “sticky downwards”. That is, employees are reluctant to accept nominal wage cuts. Though as Keynes rightly pointed out, employees are for some bizarre reason not nearly so averse to REAL WAGE CUTS (a phenomenon that occurs for example when the nominal wage remains constant and there’s some inflation). Indeed those real wage cuts were suffered by wide sections of the workforce during the recent crisis, yet mass demands for more pay have been muted.

Now a nominal wage cut is a reduction in the number of units of some widely accepted currency paid for an hour’s work. E.g. a British plumber used to getting £15/hr might refuse point blank to work for £14/hr. That involves loss of dignity for the plumber. The plumber might have nothing else do and might easily be in need of more money. But as Keynes rightly pointed out, many employees (and indeed to some extent the self-employed) refuse to take the logical step of working even a few hours a week at a rate which is lower than the one they are used to – using the conventional measure of pay, that is the broadly accepted currency.

So the solution is simple: use the a different “measure”, i.e. issue a local currency.

Of course there is the disadvantage for the plumber (and indeed ANYONE accepting payment in a local currency) namely that local currency is not accepted OUTSIDE the relevant area: i.e. the local currency will only purchase locally produced goods and services. But that’s EXACTLY WHAT WOULD HAPPEN where an uncompetitive country effects an internal devaluation: goods and services produced OUTSIDE the relevant “locality” become more expensive for “locals”. Thus they tend to switch to locally produce stuff. Indeed, exactly the same happens with conventional devaluation.

Running a local currency alongside a more widely accepted currency does involve some bureaucracy: that is, every firm or employer (private and public) has to work out to what extent it will make sense to take payment in the local currency and in contrast, the more widely accepted currency. For example, a Greek firm that imported cars made in Germany could only accept payment in official Euros.

In contrast, a restaurant in Greece that used only locally sourced food might get away with accepting payment 90% in a local currency and 10% in official Euros.

In fact the latter type of trade has actually ALREADY boomed in Greece in that a significant number of Greeks have give up using official Euros and resorted to barter. All that a local Greek currency would do would be to make that sort of trade more efficient and thus expand that sort of trade.


Eurozone regulations on currency issue.

I’m not an expert on this topic, but I don’t see any problems here. First, I suspect that the EZ doesn’t allow EZ member governments to issue their own currency. But that’s not a problem because as Hyman Minsky put it “Anyone can issue money. The problem is getting it accepted”. I.e. currency / money does not need to be issued by governments. Indeed, at least 90% of the money in circulation in the EZ is issued or “printed” by PRIVATE BANKS!!!! See this Bank of England publication for more details on that.

Next, it is widely accepted in economics that what helps gives any form of money acceptability and value is the fact that taxes can be or have to be paid in that currency. Now if, as I suspect, it is illegal under EZ law for a government to ISSUE a currency other than the Euro, that does not necessarily mean that government cannot accept the local currency in payment of taxes.

And finally on the subject of EZ law, the question as to what the law currency says is irrelevant in the long term. In the long term, the only important question is: “What benefits the country or Eurozone as a whole”. If a national local currency for a country like Greece brings all round benefits, then any laws hindering the issue of such a currency need to be abolished or modified.

Greece: get on with it and issue your own currency.

Private banks do not charge interest on the money they create.

Richard Werner claims they do in this article. As he puts it, “It is not a law of nature that profit-driven private enterprises can be relied on to responsibly create and allocate the money supply . . . while being in the privileged position of being able to charge interest for this task. The private banks do not have a particularly good track record in this regard. Furthermore, it is possible to create the money supply without attaching interest payments to it. This can be done if the money supply is produced by the community…”.

Positive Money often makes the same claim. So let’s examine this claim.

First, a definition of “interest” is in order. The definition I’ll use is “a payment made by a debtor to a creditor that compensates the creditor for abstaining from consumption so that the debtor CAN CONSUME resources.” In contrast, I won’t include the ADMINISTRATION COSTS that are involved in creating and distributing a form of money, like checking up on the value of any collateral supplied by those who want to be supplied with money. The reasons for not including administration costs are as follows.

First, administration costs are perfectly legitimate costs, assuming the basic activity concerned is legitimate: which is the case with most businesses. In contrast, I assume that those, like Werner, who object to the alleged interest that private banks charge on the money they create are onto some sort of free lunch and thus that interest is ILLEGITIMATE. That is, the allegation is presumably that private banks simply do a book-keeping entry for say £10k and then watch interest on £10k roll in.

Incidentally, that is not to say that those administration costs are irrelevant to the broader argument namely: should money be supplied by private or central banks, or both? Certainly given that private banks have to incur the cost of checking up on the value of collateral, whereas central banks don’t need to, is a strong point against private money creation.


Do private banks really create a form of money?

Some readers may have doubts as to whether private banks create a form of money. A good publication that explains how private banks do in fact create a form of money is this Bank of England publication. As the publication explains, banks create money when they grant loans. And it is all too easy to deduce from that (as Werner seems to) that since debtors pay interest on loans, banks must be charging interest on the money they create. I’ll argue below that money creation and second, intermediating between lenders and borrowers are in fact SEPARATE activities, and that interst is involved in intermediating, but not in money creation.

The reason why banks in fact do NOT NECESSARILY create money when they grant loans is as follows.

There is no sharp dividing line between money and other liquid assets. But a common way to draw the line between the two is to classify money in an account to which the account holder has access in less than about two months as real money. In contrast, so called money in an account where access takes longer than two or three months is often not classified as money. Indeed that’s very much how Positive Money itself distinguishes between money and non-money.

So, if a bank grants a loan for £X, and after the borrower has spent the money, the recipient/s of that new money put the £X into a term account where the term is more than about two months, then arguably no money is created. Plus the depositor will expect interest on the “money”, which the bank will pass on to the borrower. In short, interest is involved where a bank intermediates between lender and borrower.

In contrast, if after granting the £X loan, the money ends up in a current account (or “checking account” to use US parlance), and the account holder intends spending the money fairly quickly, then money IS CREATED. But in that case the depositor will get little or no interest, so the borrower won’t have to pay interest.

Of course the bank will still charge the borrower SOMETHING, and they’ll doubtless CALL THAT interest. But the charge will actually be for administration costs and something to cover bad debts etc. Strictly speaking, no interest is charged.


Cross subsidisation.

The latter claim that banks do not charge interest where they simply create money as opposed to grant loans assumes that banks do their costing 100% perfectly: i.e. that there is no cross-subsidisation between different types of borrower and depositor. That of course is unrealistic. I.e. plenty of cross-subsidisation takes place, thus in practice in many cases, banks WILL CHARGE INTEREST even where  they are creating money rather than organising loans.

However, it would be perfectly possible for a bank to supply a customer with money and not charge interest. Bank and customer would agree that $X was credited to the customer’s account, and that over the period of year or so, the AVERAGE balance on the account remained at $X. For all I know such accounts do actually exist, and assuming  the relevant banks do their costing correctly, they’d charge for administration costs and something in respect of bad debts, but would NOT CHARGE interest. In that sort of account, the bank would be supplying the customer with LIQUIDITY, not a loan.


What about negative interest rates?

In the last year or two negative interest rates have become increasingly common. So it’s reasonable to ask how this affects the argument here. I think the answer is “not much”. Reason is that any payment made by a debtor to a creditor (or vice-versa) is a number that results from two other numbers. First there is the charge made by  creditors to debtors for abstaining from consuming resources (as per the above definition of interest). Second, there is the amount that owners of wealth are prepared to pay someone to look after or “warehouse” their spare wealth. And of course if the latter second number is larger than the first, the the result is a negative interest rate.

Thus the existence of negative rates does not alter the fact that creditors charge debtors. It just happens that at the moment, that number is currently and in a few cases exceeded by another number: the “warehouse charge”.


Conclusion. 

Private banks do not charge interest on the money they create where they do their costing properly, i.e. avoid cross subsidisation between different types of customer. In contrast, THEY DO charge interest when intermediating between lenders and borrowers, but in that case the tendency is for no money to be created.

Ergo, basically banks do not charge interest on the money they create.

Joke: removing bank subsidies makes all bank funders shareholders.

It is widely accepted that bank capital should be raised and indeed that is happening. But there is much argument as to exactly HOW FAR it should be raised.

Capital ratios (i.e. the ratio of capital to total assets or liabilities) used to be very roughly 5%. They’re being raised to roughly 10%. And Martin Wolf (chief economics correspondent  of the Financial Times) argues the ratio should be about 25%. Anat Admati (professor of economics at Standford) argues likewise. And some advocates of full reserve banking (e.g. Milton Friedman and Laurence Kotlikoff) argue or have argued the ratio should be 100%. (To be accurate, under full reserve, the banking industry is split in two: on half accepts deposits and lodges those deposits in a totally safe manner  - i.e. it doesn’t lend to mortgagors or businesses. The other half lends, but it’s funded just by shareholders. And that by definition equals a 100% ratio.)

Now I suggest all arguments over bank capital are a waste of time and for the following reasons.

It is widely accepted that banks should not be subsidised, and indeed subsidies are being VERY SLOWLY withdrawn despite complaints from banksters. Banksters after all are keen on “socialism for the rich”.

But if and when all subsidies ARE WITHDRAWN, then all of those who fund banks (including bond-holders and depositors) become shareholders! That’s “shareholder” as in “anyone who stands to lose their entire stake in a bank if the bank’s assets decline in value to zero”.

To be more accurate, when all subsidies (including lender of last resort at favourable rates of interest) are withdrawn, bond-holders and depositors become a form of PREFERENCE shareholder since ordinary shareholders in the bank are still first in line for haircuts in the event of problems.

So the provisional conclusion is that the whole argument over capital ratios is hot air. That is, with a view to maximising bank safety, capital ratios might was well be raised to Martin Wolf’s 25% or so. And as to the 100% advocated by proponents of full reserve banking, well there might be something wrong with full reserve banking, but the 100% ratio isn't a problem.


Self insuring depositors.

It could be argued that deposits who are insured the FDIC way are not subsidised, and that that might be a cheaper way of funding banks than funding via capital. (Premiums for FDIC insurance are paid by banks, and the cost of that inevitably gets passed on to depositors).

Well FDIC type insurance is not a subsidy as long as there is no undertaking by government to come to the rescue in the event of the insurer itself failing or not having the funds to rescue a set of depositors. But in that case, depositors are shareholders in the sense that in the worst case scenario they stand to lose their money.

But let’s examine this in more detail. To keep things simple, suppose the chance of a bank’s assets being totally wiped out in any one year is one in a hundred, and that that’s the only risk. In that case, the FDIC type insurer would charge a premium of 1% (plus something for profit). And that gets passed on to depositors.

So the total return depositors would want would be the going rate for a risk-free loan plus 1%.

Now in the latter scenario, what return would shareholders require? Well their chance of being wiped out is also 1%. So they’d want a return of 1% over and  above the going rate for a risk-free loan: no different to what depositors would look for!


Money market mutual funds.

As distinct from the above theory, there is also EVIDENCE stemming from recent changes to the rules governing MMFs that capital is not expensive. The change is that MMFs which invest in anything other than government debt will not be allowed to promise not be break the buck. That is, stakes in those MMFs will have to FLOAT in value rather than (as has been normal practice to date) having each unit of “stake” fixed at one dollar. In short, those investing in those types of MMFs are being turned into shareholders. And remember that MMFs are very much “bank like” entities.

But I haven’t heard any stories about those MMFs going out of business because of the alleged high cost of capital.



Conclusion.

The whole idea that bank capital is expensive seems to be flawed.

Paper by Richard Werner.

I’m reading a paper by Werner entitled “Lessons from the 2008 Financial Crisis…”. I have a few quibbles with the paper, but the following witty passage made me laugh out loud.

In the early 1930s, after the Great Depression had begun, Michael Unterguggenberger, the mayor of the town of Wörgl in Tyrol in the Austrian Alps, lamented the level of unemployment at a time when the town needed to implement significant road and building works. It occurred to him that it did not make sense that people should be unemployed when he would actually like to hire them and put them to work for the benefit of the town and community. So he simply employed them and had bridges, roads, and buildings constructed and maintained by them. In exchange for their labor, he gave the workers “receipts for labor performed” from the town. These certificates were accepted for local tax payments, and were soon also welcomed in local shops and with local firms.

Within a year, the large-scale unemployment that was common elsewhere in Austria and Germany at the time was history in Wörgl and its surroundings. The mayor had conquered the Great Depression. Soon other municipalities in Austria and Germany, but also all over the world, began to copy the mayor’s actions. The most famous monetary economist at the time, Professor Irving Fisher, sent an associate to Wörgl to study events, and Fisher praised the mayor’s actions. Fisher was soon to become an advocate of restoring the right to create the money supply to the people to whom this sovereign prerogative belongs, by introducing regulations that would prevent banks from creating credit and money.

The story does not end there. One can easily imagine the reaction from the Austrian central bank to these events. It had been working hard and in close association with the German Reichsbank, the Bank of England, and the US Federal Reserve during the 1920s and early 1930s to create the Great Depression. Naturally, it was irate that its multiyear efforts to create large-scale unemployment and thousands of corporate bankruptcies should be scuppered in such a simple fashion by a lowly town mayor. So the Austrian central bank called in the police and the public prosecutors. The mayor was duly hauled to court and charged with counterfeiting money and other crimes. The Austrian central bank, the state prosecutor, and the courts threatened him with immediate imprisonment should he refuse to abandon his gross violation of the privileges acquired by the central bank and the commercial banks. The mayor was forced to abandon his currency. Accused of being a criminal, he stopped issuing his work certificates. Unemployment returned. Wörgl and its surroundings sank back into the Great Depression. The Austrian central bank was satisfied and relieved. The people’s challenge to the monetary control imposed by central banks and banks had been averted. Events returned to the plan carefully laid out by the central bankers. The rest is, of course, history.

It is up to the reader to decide who in this historical episode was truly the one engaging in criminal activities.

The novel Werner / Congdon money creation system.

Note. In a country that issues its own currency, government and central bank are arguably two separate entities.  On the other hand, for some purposes it is legitimate to regard government and central bank as a COMBINED entity. When referring to the latter combination, I’ll use the acronym GCB (“government and central bank”). Quite possibly I won’t get the distinction between GCB and government right at all points in the paragraphs below. In which case: apologies.
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With a view to implementing stimulus, government COULD (1) borrow from commercial banks, (2) spend the money (and/or cut taxes) and (3) give those commercial banks government bonds in return. That idea is advocated by Richard Werner (professor of economics at Southampton university in the UK) and Tim Congdon and others. (Incidentally, Werner introduced the term "quantitative easing" to the English language.)

For Werner, see 2nd last para here, starting “As Martin Wolf has pointed out…”. And for Congdon and others, see this Financial Times letter.

I’m puzzled as to what the point of that money creation system is because it amounts to paying commercial banks to create money out of thin air via a simple book-keeping entry: something GCB could perfectly well do itself. Moreover, commercial banks would presumably charge interest - perhaps one or two percent. And that interest would come to millions or tens of millions. Nice work if you can get it.

Of course it’s possible that government would tumble to the fact that commercial banks were charging tens of millions for doing almost nothing. Thus it’s possible that government would refuse to pay more than a near negligible rate of interest. But bankers often outwit politicians, so government would could easily end up paying a rate of interest near to the existing yield on government debt. But at the very least, private banks would take some sort of cut out of the above multi billion pound deal.

 
The details.

Anyway let’s consider the details – in particular let’s look at the NET RESULT of money creation the Werner / Congdon way and the “government do it yourself way (DIY).

Re the W/C way, the first effect is that GCB liabilities rise by the amount of the money created (say £X). That is, GCB issues bonds worth £X, and bonds at some point reach maturity, at which point you could argue that GCB has to “repay a debt”. But as is the case with all bonds issued by a government which issues its own currency, the only “debt repayment” on offer, is the offer by GCB to print £X and give it to bond holders. And that’s slightly odd form of “debt”. But to repeat, it’s no different from any other government bond. So that’s that. (Any normal debtor, e.g. mortgagors, do not of course have the option of paying off their creditors with £10 notes produced on their desktop printers, which is why I described the above debt as “odd”).

A second effect is that commercial bank assets rise by £X: that is, those banks become the owners of £X worth of government bonds.

Incidentally, Werner does not refer specifically to “bonds”, but uses the phrase “loan agreement”. However, the two are essentially the same.

Third, commercial bank LIABILITIES rise by £X because the £X borrowed by government, once it is spent, will end up being deposited in commercial banks. And bank deposits are a liability of relevant banks.


Government creates money itself (DIY).
 
The alternative to the W/C system, to repeat, is for government to do the whole thing itself. Granted governments in most countries GCB cannot simply print money and spend it. But they can to all intents and purposes do that when they implement fiscal stimulus (borrow £X and spend it) and then have the central bank do QE (i.e. print money and buy back the relevant bonds). That all comes to the same thing as “GCB prints £X and spends it (and/or cuts taxes)”.

Moreover, while as just mentioned there are legal restrictions in most countries that stop governments simply printing money and spending it, many argue that those legal restrictions should be lifted, while of course taking steps to ensure that politicians don’t go wild with the printing press.

(Indeed Werner himself advocates precisely that in a work co-authored with Positive Money and the New Economics Foundation – see bottom of p.10 – 12. And that makes his advocacy of W/C all the stranger. That is, does he favour DIY or W/C?)

Anyway, let’s just assume to keep things simple that GCB ACTUALLY CAN just print and spend £X. So, what’s the net effect of that?

Well GCB liabilities rise by £X (as in the case of the W/C system). That’s because money issued by any entity is a liability of that entity, at least in principle.

Second, commercial bank assets rise by £X. Those increased assets take the form of increased reserves. That’s because when GCB prints money and spends it, it effectively or actually writes cheques drawn on the central bank and pays for stuff (new roads, more teachers, etc). Those cheques are then deposited at commercial banks, and those banks then pass the cheques on to the central bank and demand that their reserves in the books of the central bank are increased.

Third, as in the case of the W/C system, commercial banks’ liabilities rise because an extra £X is deposited at commercial banks.


The aggregate effect is the same.
 
Hey presto: the net effect of the W/C and DIY are the same, at least in the aggregate. That is, GCB liabilities rise by £X. And commercial bank assets and liabilities rise by £X.

However the NATURE of those assets and liabilities is not quite the same. Under W/C, GCB liabilities consist of bonds, while under DIY, it consists of money. Plus commercial banks assets are correspondingly different: that is, under W/C the assets are bonds, while under DIY the assets are reserves.


The alleged merits of W/C.

But I’m baffled as to why those differences are important. So what do Congdon and Werner claim to be the merit of their system? Well Congdon and co-authors point out that their system feeds money into the private sector, which in a recession is obviously beneficial.  But then the DIY system does as well, so there’s no difference there.

Congdon and friends also claim “The motive here is that banks' buffer of safe government securities will help maintain financial stability (i.e. the convertibility of deposits into cash).” Well OK, but same goes for the DIY system: that is, as pointed out above, under the DIY system, instead of private banks having more securities, they have more reserves. What’s the big difference?

And if for some strange reason private bank “stability” is increased MORE under C/W than under DIY, I’m not impressed. That’s because, as pointed out above, there is probably a subsidy element in the C/W system: paying private banks millions for doing a simple book-keeping entry.

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P.S. (2nd Feb 2015).  I had a lively exchange of views with Richard Werner on Twitter during the 24 hours subsequent to publishing the above. Probably the most important point to come out of that is that there is a distinction to be made between applying W/C to a country which issues its own currency, and applying it to the Eurozone.

I still don’t think that W/C stands inspection in relation to the former, but I would think that wouldn’t I? As regards applying W/C to the Eurozone, Werner claims W/C could play a big role in solving Eurozone problems. Werner’s arguments are complicated (see link below). But I suspect W/C would be illegal in the Eurozone. However I’m not  an expert on Eurozone law.

http://www.sciencedirect.com/science/article/pii/S0261560614001132