Sunday, 1 February 2015

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.


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.

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.

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