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.