Tuesday, 12 May 2015

Would a Sovereign money system be flexible enough?

Positive Money have just published the above work. It aims to deal with a criticism made of PM’s full reserve banking system, namely that the system would not be flexible enough: in particular commercial banks would allegedly have a severely reduced freedom to lend to any viable borrower they spot under PM’s system, a criticism made for example by Anne Pettifor.

My first quibble with the above PM work is that the authors have missed a trick: that is, their case is stronger than they think, and for the following reasons.

A major flaw in the above “Pettifor” argument is that the commercial bank system does not in fact have TOTAL freedom to expand total amounts loaned under the EXISTING SYSTEM (as made clear in this Bank of England publication). Indeed, I’ll argue in the section just below that they have no more freedom under the existing system than under a PM system.

Assume the economy is at capacity.

Let’s take two possible scenarios, first that the economy is at capacity or “full employment” and second that it is not. And we’ll deal with the first scenario first.

Where an economy is at capacity, and commercial banks want to create extra money out of thin air and lend it out, the effect, when that extra money is spent will be inflationary. That in turn means the central bank will raise interest rates or take other steps to constrain demand. Net effect, roughly speaking, is no extra lending!!!

So at full employment, the commercial bank system just DOESN’T HAVE complete freedom to lend more. Of course, given an increased desire to borrow and lend in the private sector, and assuming the central bank raises interest rates to counter the inflationary effect of that, there’d still be SOME increase in lending. Reason is that increased interest rates would cause increased SAVINGS, and as Keynes rightly pointed out, saving money has a deflationary effect. So to the extent that more saving takes place, then more lending can take place.

To that extent, the claim by the Pettifor's of this world that the commercial bank system has total freedom to make extra loans as soon as they spot more lenders who are viable is wide of the mark.

Lending under PM’s system.

Now let’s consider what would happen under PM’s system. In the submission to Vickers made by PM, Prof Richard Werner and the New Economics Foundation, that authors positively CRITICISED deliberate interest rate adjustments by the central bank as a means of controlling demand, and I agree with those criticisms.

Plus I assume PM’s policy there hasn’t changed (though I could be wrong). I.e. I assume their policy is: “leave interest rates to market forces”, a policy I agree with.

So…. under a PM regime and given an increased desire to borrow, interest rates would rise. And the overall effect of that would be much like the scenario set out above, where when the commercial bank system spots a series of new and viable lending opportunities: it fires ahead, but the central bank raises interest rates to choke off excess demand, though lending DOES STILL rise a finite amount.

So what’s the big difference for the commercial bank system as between the existing set up and a PM set up? Not much, far as I can see. I.e. as far as the much vaunted “flexibility” goes, there’s not much difference.

The economy is not at capacity.

Having dealt with the “at capacity” scenario, let’s now consider an economy which is NOT AT capacity. In that scenario there is of course  no harm in commercial banks lending more. But there is a big problem there, namely that commercial banks just DON’T LEND MORE when the economy is in recession! Or to put it more accurately, commercial banks act in a pro-cyclical manner, not an anti-cyclical manner. So the “extra lending” that allegedly takes place in a recession is a figment of Pettifor & Co’s imagination.

What DOES GET economies out of recession is extra government spending, which in turn encourages more commercial bank lending. (Incidentally I’m assuming that the market forces which get economies out of a recession – Say’s law, the Pigou effect, etc – are ineffective. That’s not ENTIRELY correct: I think they do work TO SOME EXTENT. But I agree with Keynes who said that those market forces were not effective enough, and that in a recession, government implemented stimulus is needed.)

To summarise so far, the alleged weakness in a PM / Werner / NEF system, namely that it reduces commercial banks’ freedom to lend, i.e. reduces “flexibility” is very questionable, if not totally untrue.

Loans which increase GDP.

My second quibble with the above PM publication is the idea that in granting loans, banks should give preference to loans which increase GDP as compared to those which don’t.

One argument sometimes put in support of that argument (though I don’t think it appears in the PM publication) is that loans for small and medium size enterprises (SMEs) result in REAL output, whereas loans to enable people to buy EXISTING assets like houses do not result in extra output (apart from a few days work for bank staff, lawyers, and furniture movers).

The answer to that is that loans to SMEs fail about twice as often as loans for property purchase. Thus it is far from clear just how productive SMEs are.

Loans for existing versus new houses.

Anyway, returning to the GDP idea, I actually explained the flaw in that idea a few weeks ago here. But I’ll reiterate it, and with particular reference to housing.

The GDP idea is essentially as set out just above.  That is, 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 days work for bank staff, lawyers, surveyors etc). Ergo we should favor “GDP increasing loans”.

The flaw in the idea is that it assumes 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 maximise 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 large 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, and as often pointed out by MMTers, there is only one constraint on stimulus, namely inflation.

Now if there’s an increase in demand for loans to buy EXISTING houses, there is little increased demand, i.e. very little extra employment is created, thus there is little effect on inflation! Thus, assuming the economy is not at capacity and that extra loans are granted to people wanting to buy existing houses, and little extra employment is created as a result, that just isn't a problem:  FURTHER stimulus can easily be applied so as to GET THE ECONOMY up to capacity.

In short, there is no problem in allowing extra loans to fund the purchase of existing houses, if that’s what the population wants.

House prices and inflation.

An obvious objection to the latter argument is that if there’s an increased demand for “existing house loans”, that will bump up the price of houses, which itself is inflationary. Well that’s true, but assuming market forces are working properly, then an increase in the price of houses means that house building becomes more profitable, which means more houses are built, which in turn means that the price of houses will eventually revert to the level where the price of houses equals the cost of erecting them (plus a normal level of profit for house builders).

Of course in the UK and maybe elsewhere, market forces are not allowed to operate properly: that is, it is very difficult to get permission to use farmland to construct houses on. The result is that is that land now accounts for about a third of the cost of a house in the UK.

But to repeat, assuming a reasonably free market, an increased demand for loans to buy existing houses WILL NOT result in the price of houses rising in the long term.

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. If the economy is not at capacity or “full employment” and there is a big increase in demand for loans to buy EXISTING houses, that’s unlikely to raise demand by enough to have much impact on unemployment. But who cares? The solution is to carry on incresing stimulus till the economy IS AT capacity.

Incidentally the above PM idea on new versus existing houses is part of a more general point, namely that where PM advocates the same ideas (essentially full reserve banking) as Irving Fisher, Milton Friedman, John Cochrane and others who advocate full reserve, PM is obviously on solid ground. In contrast, where PM advocates ideas that are unique to PM and not shared by others (e.g. the latter three individuals), then clearly PM is on thin ice.

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



P.S. (14th May 2015). “KK” in the comments below makes a good point, namely that lending was rising rapidly just prior to the crunch and that was a time when the economy was more or less at capacity. And that conflicts with my above theory that lending is constrained at full employment (aka “capacity”).

My answer to that is that prior to the crunch, house prices were rising rapidly, and that rise would have required additional lending if houses were to be bought and sold at the same rate as in earlier years. (In fact they were probably being bought and sold FASTER than in earlier years, which would have AMPLIFIED the effect).

Plus a large majority of lending is for property purchase, plus a large majority OF THAT is for the purchase of EXISTING property / houses, not new property or houses.

However, as Positive Money keep reminding us, loans which fund the purchase of EXISTING assets have little effect on demand or GDP. Thus I should have said in the above article that my theory about lending being constrained at full employment applies to what Positive Money would call “GDP increasing loans”, rather than to loans aimed at funding the purchase of EXISTING houses.


  1. "Where an economy is at capacity...Net effect, roughly speaking, is no extra lending!!!"
    Last time I looked, the historical statistical data does not support your theory in UK, US or anywhere else. Where is your evidence?
    You may find the following a useful starting point:

    If you haven't checked the evidence, its better to keep quiet.

    1. What am I supposed to be looking for in the above link? Far as I can see, your first sentence queries my claim that higher interest rates discourage borrowing an encourage lending.

      If that's what you're saying, you aren't entirely wrong. I can point to studies which claim there is only a weak relationship between interest rates and borrowing from banks.

      But to the extent that that's true, the state will have to rely more on fiscal measures to counter the inflationary effects of increased lending by private banks. Thus the existing system becomes even MORE SIMILAR to the PM system!!! Anne Pettifor: eat your heart out..:-)

  2. Your theory is that: "Where an economy is at capacity...Net effect, roughly speaking, is no extra lending!!!"
    So kindly produce the evidence that bank lending stops increasing at full capacity. All the evidence that I can find is that this is false.
    The purpose of link I gave is obvious. It contains good links to masses of relevant data, at which it seems you haven't looked.
    P.S. I never mentioned the effects of interest rates. This and the rest of your reply seems to be a distraction from my point, which is that you have no evidence.
    In propounding your theory and criticizing others you have totally failed to discharge the onus of proof which rests on you.
    You ask "What am I supposed to be looking for in the above link? "
    Answer: Evidence for your theory.
    Or do you have some better data?

  3. According to BoE data (referenced in the link given above above):
    During 2007-8 M4 lending was 11-15% higher in every month compared with the previous year.
    During 1988-90 M4 lending was 15-25% higher in every month compared with the previous year.
    M4 lending is defined as monetary financial institutions sterling net lending to the private sector.

    Doesn't this suggest that your theory is .

    1. KK,

      That’s a good point you make about increased lending in 2007-8. In fact I’ll add a P.S. to the above article to take account of your point.

      Clearly lending was rising rapidly prior to the crunch. There are plenty of relevant charts at for example the Economist House Price Index:


      But my answer to that is the vast bulk of that extra lending will have been for the purchase of EXISTING houses, rather than new machinery for businesses, construction of new houses, etc. (a distinction I deal with in the 2nd half of the above article). And the basic point I make in the 1st half of the article is that lending is constrained at full employment because there are problems involved in imposing more demand on an economy when it is already at capacity. But of course (and as Positive Money keep reminding us) in as far as lending just funds the purchase of existing houses, there is little effect on GDP: i.e. little effect on demand.

      Thus I should have made it clear above that my theory about lending being constrained at full employment is confined to lending that REALLY DOES boost demand (e.g. loans to fund the purchase of NEW machinery, buildings, etc).

  4. I think that a look at the following article might be useful: "A Letter on Full-Reserve Banking and Friedman’s Rule in Chicago Tradition", in Kredit und Kapital/Credit and Capital Markets, 2014, 47(4), 677-687

  5. Net lending for productive "machinery, buildings, etc". remained positive in 2007, and likewise in previous booms.
    See BoE data on the industrial analysis of lending.

    1. Have you got the URL for that? Sorry: I need to be spoon fed...:-)

      But whatever those figures show, I'm sticking to my basic theoretical point, namely that if an economy is at capacity, and extra demand arises from increased lending, then something HAS TO GIVE: e.g. there must be increased saving.

  6. I support FR and find your blog informative, but was bemused by the section on house price inflation, where it seems to me to simply ignore or at least vastly oversimplify the reality of land as distinct from capital in an economy.

    'assuming market forces are working properly'

    Here I'm with Steve Keen, as soon as an economist say they assume something, be very afraid! My fears were justified on this occasion. There is assuming the can opener, and then there is assuming the tooth fairy.
    Land being a natural monopoly Efficient price=no economic rent. Price = normal cost of production = perfect market
    Land has NO cost of production So land has no pricing mechanism therefor the 'market' in land cannot be perfect!
    That is why economic rents must be either taxed away (LVT) or mitigated against with rent controls and/or social housing (as in Germany where house prices are mostly stable and have actually fallen over the last 20 years) .
    'it is very difficult to get permission to use farmland to construct houses on.'
    Yes, but this is not the main source of the problem and no more insightful than the legions of Ukkipers who bang on about immigration bumping up demand. If demand falls supply will contract long term as in any monopoly power market to begin bidding up speculative prices again. If planning permission is relaxed similarly it at best just kicks the can further down the road until new limits are met, I cannot under any circumstance import land to compete with land in Mayfair owned by the Duke of Westminster (net worth £8.5Billion, net contribution to society..trace..).
    Thus acres of brownfield lots sit idle today WITH full planning permission granted, and 700,000+ buildings sit vacant often in prime locations. Why? Because developers are fully aware that the value of that land will rise over the coming boom, it is simply more profitable to drip feed supply. We need a stick, not a carrot to get the land we need into usage.
    'The result is that is that land now accounts for about a third of the cost of a house in the UK.'
    Now perhaps, but it varies greatly both between locations and more significantly over the course of the boom bust cycle, of course it was Fred Harrison who first predicted both the 88/89 crash in 83 and 2008 in 1997 precisely by following the land price speculative distortion and it's distinct 18 year cycle. Thus, with the Tory's huge subsidies pushing it to extremes ie 'Help to buy' (really help to bubble) it is likely to rise till a mid cycle crash in 2019 and then again to a full cycle crash in 2026/27.
    Friedman didn't only support FR, https://youtu.be/yS7Jb58hcsc
    We need a holistic approach or risk undermining a good idea which is incomplete.

    1. Hi Mark,

      That’s a long thoughtful comment!!

      Re inability to import land, that would be relevant if almost every square mile of the UK was developed. But it’s not – anywhere near. That is, there are near limitless amounts of land that can be supplied or if you like “imported” to the house building industry.

      Re developers sitting on land with planning permission and doing nothing with it, there’s bound to be demand for any asset which all and sundry think will rise in value: antiques are an example. But if government made enough land with planning permission available, the price would start dropping, and the land hoarders would very quickly change their strategy.

      No sure that I’ve confounded your argument there, but I’ve tried!!


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