The Bank of England’s chief economist Andy Haldane’s speech. caused some raised eyebrows recently. It sounds like he knows we’re in for some tough economic times ahead. Things are so desperate that it might require the abolition of cash in the economy! People will be forced to hold money in banks and see its value dwindle.
As Andy Haldane has put it “A more radical proposal still would be to remove the ZLB (zero lower bound) constraint entirely by abolishing paper currency.”
We could perhaps begrudgingly say Andy Haldane has shown political and economic courage in saying this. If we are being charitable we could credit Mr Haldane for highlighting the intellectual bankruptcy of most mainstream modern economic thinking. If we wished to be less charitable we’d have to say the idea of abolishing cash is about as stupid as it gets!
I hope it is the former and that cash won’t be abolished. But this isn’t the first time we’ve heard this silly argument argument from monetarist economists and in particular from Kenneth Rogoff. See here and here. That they feel the need to make it shows they still haven’t really grasped that interest rates can’t have the controlling effect they think they have on the wider economy.
When intelligent men like Rogoff and Haldane have silly ideas, political ideology is usually to blame. The main argument for banning cash, other than to hinder criminals and tax-dodgers, which is no stronger an argument now than it has ever been, is to facilitate sharply negative interest rates. But if we want to stimulate the economy, as we do right now, there’s an obvious and much easier alternative: ie loosen fiscal policy. Increase government spending and reduce levels of taxation.
The only reason to suggest something as outlandish as banning printed currency is that you believe this alternative to be impossible. Or, rather impossible according to one’s own political ideology.
Monetarism all sounds fine – superficially. When times are good interest rates are increased to slow the economy down. When times are bad they are lowered to stimulate lending and get it moving again. There’s no need for government to be involved at all. They can concentrate on balancing the books like any good business should.
Except that every stimulus leads to the build up of private debt in the economy. This build up slows down economic activity, and so we later have to have another reduction in interest rates. Then another and yet another after that . If we get it all wrong then there can even be a giant crash in the economy when those who’ve taken on too much private debt go bust and cause their creditors to go bust too.
So, eventually we arrive at the situation, as we have now, where interest rates in much of the western world are close to zero and they need to go negative according to the theory to stimulate the economy again. Economists with more intelligence are saying “Whoa! There must be something wrong with the theory”. Others with less insight are saying “But this is just the special case of the zero lower bound” and those with no insight at all, or are stupefied by their own political ideology, are ploughing on regardless and calling for the abolition of cash!
Leaving aside the argument that many of us quite like the convenience of using cash, it’s much quicker than messing about with credit cards at the petrol station for example, it is a genuinely bad idea to go down the road of negative interest rates which will lead to an ever increasing build up of private debt in the economy.
Mainstream (ie Neo -Classical and Monetarist in outlook) economists didn’t spot the onset of the GFC because they didn’t know where to look for the warning signals. The role of private debt in leading to booms and busts was denied. Expanding the “money supply” was the only standard remedy for stimulating economic activity and the risk of creating asset bubbles was largely ignored with disastrous consequences.
I may come back to the question of private debt in the economy later but for now I’ll just reference Prof Steve Keen’s excellent blog on the perils of debt deflation.
The economic clash between Greece and Germany is invariably portrayed as a clash of cultures. The majority of Germans resent what they see, and are assured by those who should know better, as a bailing out, at their expense, of those in the southern peripheral European countries who appear to be unable to manage their economic affairs as well as they can.
That seems a perfectly commonsensical point of view but raw ‘common sense’, as always, in economics cannot be relied upon to be the best guide. Our common sense is invariably derived from our own micro-economic experience. The principle that it is better to be in surplus than deficit, for example, works fine for us as individuals in the micro world, but taking a wider view, that commonsensical notion is inconsistent with the basic accounting principle that for every asset there has to be a debt. For every surplus there has to be a deficit. Not everyone can be in surplus and not everyone can be in deficit.
So we need to correct our ‘commonsense’. Physicists, like Angela Merkel who therefore can have no excuse, are used to doing exactly that. They know that their commonsense viewpoints of the world will only take them so far. It fails completely after that. Anyone who has studied Maxwell’s equations, Quantum Mechanics or Einstein’s Relativity knows that these subjects can make your brain hurt! After a while, we have to come to the conclusion that it is better to try to understand via the mathematics of it all rather than understand completely.
It is nowhere near as bad in economics, but still just a little lateral thought is required. The easiest way to understand what needs to happen in the single currency eurozone, is to make a comparison with what already does happen in a successful currency union.
Let’s take a look at how it all works in the USA. The United States has, as we all know, a common currency but also a Federal Government to conduct macroeconomic policy, and transfer surpluses from the wealthy parts of the US to the poorer parts. It transfers surpluses. It does not arrange loans, except perhaps for special projects. If it did, the wealthier parts of the USA would end up as massive creditors. The poorer parts would end up as massive debtors. There would be clashes between New Jersey, the wealthiest state, and Mississippi the poorest. I had to look this up , by the way. I suspected that Mississippi might be the poorest but I had no idea which was the wealthiest. I had thought maybe California. That’s as it should be. It should not be like it is in the Eurozone where the wealthy states never tire of letting everyone else know who is paying the bills.
So, imagine New Jersey providing big loans to an impoverished Mississippi, dictating that it implement privatisation of public assets at knock down prices and drastic cuts to state spending, pensions, its education service etc to be able to repay those loans. The Mississipians and the New Jerseyites would be saying exactly the same things about each other as the Germans and Greeks are saying now!
So, just as any transfer of funds between New Jersey and Mississippi has to be just that, ie a transfer and not a loan, so too it needs to be between Germany and Greece in the Eurozone.
The German taxpayers may well not like that idea. It certainly would not have been properly explained to them just what they were letting themselves in for when the Euro was created. No politician in any of the Eurozone countries would have dared make that explanation! It would have been career suicide. There were economists around who did their best to explain it all but they weren’t listened too.
It is too late for that now, but the reality of what has been created, in their name now needs to be recognised and understood by all. Some rethinking is in order. That has to start with the Germans, then the Dutch and then everyone else too. The sooner the better.
Stefano Pessina, UK tax dodger, and the acting chief executive of Boots, has recently created a stir in Britain by claiming the Labour Party’s economic policies are “not helpful” for business or the country. It is rarely a good idea for chiefs of industry to enter the political arena in this fashion. Mr Pessina can speak for Mr Pessina but he cannot speak for Boots as a company. There are many people who have a share in, or work for Boots, each with their own personal view. He is entitled to a personal opinion, of course, but why would he single out the Labour Party? They are far from perfect but their current policies are more pro-business (just about) than the Tories!
All businesses, and presumably Boots is no exception, want a healthy demand for their goods and services. They want paying customers, with money to spend in their pockets.
They aren’t going to get that if their customers don’t have a job, or are in some poorly paid job. Or even a non-job like a zero hour contract which gives them employment for zero hours! Just about every town in Britain has boarded up pubs, cafes and and shops, and also unemployed youngsters hanging around those closed down businesses . This should give common ground for the political parties which traditionally would be expected to represent business and those who may traditionally represent those working for, or hoping to work for, those businesses.
Of course, it is less like this in some areas than others. It’s not as bad in Maidenhead as it is in Middlesbrough. Is it that there’s nothing that needs doing in Middlesbrough? The phrase ‘full employment’ isn’t much used these days. There’s a general acceptance, among Labour and Tory politicians alike, that the term ‘full employment’ cannot apply any more. It’s even worse in Euroland. There the conventional wisdom, at least in pro-German governing class circles, is that Greece, Spain, Italy and France need even more bouts of austerity to cure the ravages of previous bouts of austerity. The remedy for any economic problem invariably involves cuts and more taxes. The Labour party, in Britain, are offering nice fluffy socially responsible cuts. Whereas the perception is that that Tory policy, if freed from any LibDem influence, would involve more severe and socially irresponsible cuts which, no doubt, would get a nod of approval from Angela Merkel.
No leading politican, in any of the major parties, has the courage to question the conventional wisdom that budgets can be balanced by increasing taxes and reducing spending. It’s obvious they cannot. It should also be obvious that this is the economic equivalent of a dog chasing its own tail. There is no evidence in the slightest that this approach has ever worked or will ever work. There’s lots of evidence that it closes down businesses and deprives the former employees of work though.
It is in the interests of both business and labour to challenge this failed concept. It shouldn’t be a left/right issue. It should be one that unites everyone.
To fix the UK economy requires that aggregate demand be increased. Nearly all politicians understand that. Except, the favoured way, and some might say the only way, for those on the right of the political spectrum is to create a credit bubble to encourage more private spending through more private borrowing. That’s not an option for the foreseeable future as the private sector is now saturated in debt. So saturated , in fact, that we’ll have another crash in the next couple of years unless the next government acts quickly to prevent it. That will require them to spend in a sensible fashion but nevertheless spend big time. Realistically, it is going to be a difficult sell electorally. The problem, for those politicians wishing to advocate this line, will be questions such as “where’s the money going to come from?” and comments such as we “can’t afford” to do that.
Of course, the money comes from where all money comes from in the first instance, and as Keynes said, if something can be done it can be afforded. The only danger of too much spending is too much inflation. The danger of too little spending is the recession we have now, both in the UK and, even worse, in the Eurozone.
The problem is that the electorate, and most politicians, don’t understand economics. That’s not surprising. The mainstream media don’t explain it at all correctly. To most people, the government is like a company or a household. To spend money it has first to acquire money. That’s true for a user but not at all the case with an issuer of currency.
It’s rather like living in society where everyone thinks the world is flat. If we insist the world is really round then they might not like that and vote for someone else. We, in turn, wouldn’t like that so the best approach may be to pretend we think the world is flat too, and work our way around the problem as best we can!
One way is to redefine what we mean by ‘government deficit’. As Neil Wilson has recently noticed, Ed Balls has been astute enough to use the term ‘current deficit’.
I think we all missed the inclusion of the extra word for slightly too long, so full marks to Neil for spotting that. Maybe, we gave Ed slightly more criticism than he may have deserved over his advocacy of ‘balancing the books’.
So what could be the plan? The idea is simply that we shouldn’t count capital spending, just current spending. On a personal level, current spending is our going down to the pub and drinking a few pints. We’ve nothing to show for it the morning after. Capital , or investment spending, would be on building a house or investing in a viable business. The value of that would, if we drew one up, appear on our personal balance sheet, so even if we went into the red financially we would still be in the black overall once the value of the physical assets was counted.
So how’s it going to work for government? Current spending is, amongst other things, paying out unemployment benefits. Capital spending includes electrifying all railways and building houses. The government is in a very advantageous position when it comes to doing anything in the economy. Unlike you or I, it doesn’t have to borrow money at high interest rates. It can either just create the money or borrow it via the sale of gilts at very low interest payments. Also unlike a private developer which has to pay taxes to government during the course of the development, government actually receives taxes. Therefore if a private developer can build at a profit, then government can do the same thing and make an even bigger ‘profit’.
So say it decides to build a £100 million residential development. It classes that as investment spending or capital spending so it doesn’t appear on the books as a ‘current deficit’. It hands out contracts to builders in the private sector and most of that money gets spent on wages. Either directly, on the wages and salaries of building workers, architects etc, or in the process of the labour that goes into making bricks, concrete, timber, tiles etc. So straightway some £30 million or so comes back as taxes and NI payments. The bricks, concrete etc attract VAT when they are purchased. So that’s probably another £10 million or so going back into government coffers. That revenue is classed as current revenue so it reduces the ‘current deficit’.
Then that remaining £60 million gets spent and respent in the economy. At every stage taxes are levied. 20% VAT, corporation tax, capital gains tax, fuel taxes, alcohol and tobacco taxes, yet more income tax and NI, plus lots more taxes too that we can all think of. The end result is that nearly all that £100 million goes back to government. At the same time building workers who were unemployed have now found jobs so don’t need to be paid dole money any longer.
Then government can take delivery of those £100 million worth of flats or houses , say about 400 of them at £250k each. It then sells them to a housing association or co-operative and gets all its money back. But it’s already got it back anyway! Alternatively it can rent out the residences directly, or via a lease arrangement with the co-operative, and collect the lease or rents, which at present day prices, especially in London, will pay off any interest multiple times. That way it still owns the properties and their value appears as an asset on the government’s balance sheet.
In other words it makes a tidy profit on the deal. And no it’s not necessarily inflationary, when there are unused resources available. Government will have created something extra for sale in the economy. Inflation has to be about more money chasing the same amount of goods not more money chasing extra goods.
It can repeat the same idea in lots of other ways too. For example, it can extend and modernise the Underground in London. It can start to construct Underground railways in other major cities like Manchester, Birmingham and Liverpool. The spending is classed as ‘investment’ or ‘capital.’ The revenue from the spending is classed as ‘current’. The price tag is not important, providing that the resources are available and unused, and providing we create useful jobs paying living wages, we can always afford to pay for them. By creating jobs we are not just investing in infrastructure, but we are also investing in people, enhancing their participation in society and providing them with the means to support themselves and their dependents. We can always afford that.
Is this what Ed Balls has in mind? His Bloomberg speech shows he knows enough about economics to suggest that he does.
Arguably, it did work reasonably well for the first few years of its public existence from 2002 onwards, but now, unarguably, it does not. Recession and high levels of unemployment is the norm, not just in the peripheral countries of Spain, Greece, Portugal, Ireland, Poland, etc but increasingly in the original group of six too. Italy and France are both experiencing double digit levels of unemployment; and the problem is now spreading to Germany itself, as its export markets in the Eurozone start to dry up. The high levels of unemployment in the peripheral regions of the Eurozone naturally leads to increased levels of migration to other areas of the EU which are performing better. Whatever we feel should be the case, our observations tell us that this is causing social and political problems too, especially in the UK, which we would be foolish to ignore.
There are many theories offered to explain the origins of the problem. The stated opinion of German right wing politicians and their ordo-liberal economic supporters is that there is nothing wrong with the Euro. If they can manage perfectly well with the Euro then so should everyone else. If they, like Germany would only just get close to balancing their budgets then all would be well.
Furthermore, there tends to be a lot of finger pointing in the German circles directed particularly, but not exclusively, towards Greece. The criticisms generally include a past reliance on an oversized pubic sector, an inefficient system of tax collection, a past over-reliance on ‘money printing’ to fund government spending leading to higher than desirable levels of inflation and even systemic corruption. They probably do have a something of a point, no countries are ‘perfect’ not even Germany; but are the German right missing the point completely? From an understanding of just basic economics we can clearly see they are.
The fundamental problem is none of the above. There is also a widely accepted, but not necessarily correct, argument that countries need their own currency, which should be allowed to vary to allow countries to devalue or revalue their way out of economic trouble. That certainly would help but neither is it the core problem. Rather it is a problem of financial transfers, albeit an easily solved one, that is to be expected whenever two or more countries decide to share a common currency; one or more of which are large net exporters and one or more of which are large net importers. There is nothing wrong with wanting to be a net exporter, if that is what countries want to do. Of course, for every net exporter there has to be a net importer willing to buy those exports. So, we firstly have to disabuse ourselves of the idea that the net exporters, like Germany, the Netherlands, Austria, Switzerland (even though the Swiss are not in the EU) are somehow more virtuous than the USA and the UK (in the EU but not the EZ) who are net importers.
It makes sense, all round, to allow countries to choose whether to be net exporters or net importers. The alternative would mean clashes over trade, the imposition of high tariff barriers, and currency wars. It is no exaggeration to say that these clashes can lead, and have led in previous eras, to real wars too. No-one wants to see any re-occurrence of that.
How does it work when a net importer and a net exporter trade together using their own and, therefore, different currencies? Assuming that the two countries have the same trade pattern with each other as they do globally, there is an inevitable imbalance when it comes to the net importer being able to pay in its own currency. There is always going to be a ‘glut’ of that currency on the market, which if left alone would cause the currency to depreciate. That country would then be able to afford fewer imports, its exports would look more competitive, and so its trade would naturally move into balance. Neither country wants that, so the importer issues bonds which are obligingly bought by the exporter using the excess of the importer’s currency. The importer then re-issues the money obtained from the sale of those bonds into its economy by government deficit spending. In other words, the supplier lends money to its customer to be able to continue to be a good customer. The central bank of the exporter then stores the purchased bonds and just creates, or ‘prints’, extra amounts of its own currency to satisfy the need of its internal exporting companies to be paid in that currency.
So, despite all German assertions to the contrary, the policy of the Bundesbank has never been solely the minimisation of inflation. The Bundesbank was quite willing to ‘print’ as many DMs as was considered necessary to hold down its value to maintain the sales of German exports. An artificially lower exchange rate also translates into higher prices in German shops and so contributes to a higher level of inflation than may be the case otherwise.
This kind of arrangement can continue indefinitely. Of course, as the currencies are separate, they can vary over time in value in relation to each other, but, providing that inflation rates in the two countries are approximately the same, they do not need to. In principle they could be fixed, providing the exporter and importer co-operate to equalise their monetary transfers by the necessary issuance and purchase of government securities.
Therefore, if this arrangement can work with fixed exchange rates, it must be able to work with the same currency too. The process is simply same one, as before, of the exporting country lending back its surplus to the importing country so that it can continue to be a good customer. As the currencies are the same there does not have to be any bonds involved, it just needs money to be lent back, but there can be a transfer via bonds if that is mutually preferred. Money and bonds are just different forms of government IOUs in any case.
In the case of the Eurozone these would be the so-called Eurobonds which are widely being discussed, but adamantly opposed by German ordo-liberals. I fail to understand why. These are essentially the same people who were happy to lend their customers money when their currencies were different, so why do they have a problem now they are the same?
Ordo-liberals compound their mistake of not wanting to lend back the surpluses of the exporting countries in the EZ to the importing countries, by insisting that the importers should not borrow from anywhere else either. It may make sense for an exporter to have a balanced budget, but not an importer. The importer needs to sell securities and deficit spend the money received back into its economy. That deficit could be 3% of GDP, the Euro limit, but equally it could be higher. It makes no sense to even try to impose arbitrary limits on government deficits, which are also affected by the desire of populations to save financially. The deficits can, and should be, varied, as need be, to ensure the consistency of levels of inflation in different EZ economies. So a possible strategy for the ECB would be to set an inflation target of something like 3% for every EZ economy and issue Euros either via the process of quantitative easing if the exporting countries were unwilling to recycle their surpluses, or the encouragement of bond issuance or even straight lending of euros if they were, or a mixture of both.
3% inflation may be too high, even if only for a limited time, for many in the more prosperous regions of the EZ to contemplate, and they have said so in no uncertain terms. See for example: http://www.telegraph.co.uk/finance/comment/ambroseevans_pritchard/11211973/Mario-Draghis-efforts-to-save-EMU-have-hit-the-Berlin-Wall.html
However, the alternative is to leave things as they are. It will only be a matter of time before France is ruled by their National Front. Greece ruled by Syriza, Spain by Podemos, Ireland by Sinn Fein, the UK by UKIP. There will be an upsurge in support for new Eurosceptic movements emanating from both the extremes of left and right as the EZ economies, including the now prosperous ones, go from bad to worse to disaster. It is hard to see how that could be any preferable than paying a small price by way of an acceptance of slightly higher inflation, and the issuance of as many Euros and Eurobonds as are required to fix the problem right now.
What’s the rationale of a country like Germany wishing to run a perpetual current account trade surplus? Some $250 billion last year and expected to rise to $300 billion in 2015. That’s a bigger surplus than the Chinese. That desire seems to be causing a lot of trouble in the Euro Zone right now. Of course, everyone knows surpluses are good and deficits are bad. But, is that really the case?
Running a trade surplus in euros means running a trade deficit in real goods and services. That deficit must mean that German living standards aren’t what they should be. As anyone who has visited Germany recently will know, there are many Germans who aren’t at all wealthy, and struggle to get by.
If the Germans sell more to the UK in one year, that then gives them more ££ in their kitty to buy more stuff from the UK in the following year, which would of course be fair enough. But what is the point of their wanting to continue to do the same thing year in year out? They are just building up large reserves of UK government securities denominated in ££ which they won’t ever spend. That is, until they decide to become a net importer, but that seems totally contrary to German economic “philosophy.” If that’s the right word!
It’s the same story with America and many other countries too.The Germans like to accumulate US$ which they can never spend. What’s the point of always swapping 4 pigs for 3 equally valuable sheep and taking an IOU to make up the difference? They end up with more IOUs for sheep than they need and more than the sheep producers can possibly supply.
The Germans could do just as well by selling cars to the fictitious state of Atlantis. They could sell as many BMWs, Audis and as much of whatever else they make as they liked, then just dump the lot in the middle of the Atlantic ocean. They would get paid in pretend Atlantis dollars which they could never spend of course. (Except perhaps with the Chinese?) But, as they seem happy to accumulate large reserves of other currencies which they have no intention of ever spending, what would be the difference?
There needs to be a general rethink of how countries should balance their trade. It seems to make little sense to wish to have a perpetual surplus of exports for the exporters. If the importers were wise to the ways of MMT then they might not worry about their deficits, both external and internal, quite so much as they do. That doesn’t seem likely to happen any time soon, unfortunately, so the next best thing would be for everyone else to be challenge the big exporting countries like Germany, Denmark, Singapore, Switzerland and China and ask them why they are so keen to earn money which they can’t or won’t spend.
I don’t know why anyone has a problem seeing that. But, many of us are so caught up in the thought that saving must be a good thing that we sometimes miss it. Saving is what the virtuous do. Spending, on the other hand, must be a bad thing. That is what the reckless do. Except, of course, if the spending can be classed as “investment”. Then it might be classed as a good thing too! Income, naturally, is a good thing. At least we all agree on that. Everyone needs some income to survive.
It should be a self-evident ‘truism’ that everyone, everywhere, who has earned any money has done so only because someone else has made a decision to spend some money. If people are not earning enough it must follow this is because other people are not spending enough. Spending may be “investing” in new infrastructure or, equally, it may be simply you or I just going down to the pub and buying a pint or two!
Of course, if anyone wants to put aside some of their hard earned money then there is no reason why they should not. But, as a simple matter of accountancy, it needs to be recognised, by all, that if someone is spending less than they earn someone else has to spend more, otherwise our economy will spiral downwards as it has in the Eurozone. The foreign sector in the UK spend less than it earns. Overseas buyers spend less on buying products from the UK, our exports, than sellers earn from sales of products to the UK , our imports. That needs to be made up for.
Many baby boomers are nearing retirement. They are spending less than they earn, as they put aside money into their pension funds. More generally, the private domestic sector needs to net save to clear past debts and avoid new ones. That needs to be compensated for too.
That has to be down to Government. There is no one else. It needs to spend more than it earns, ie run a deficit, to “balance the books”. It is all so simple, and so obvious, but many of us are just so conditioned to be the way we are that we can be blind to what should be apparent to an intelligent 5 year old and mess up our economies as a consequence.
Part 1 on this topic seemed to generate a lot of discussion both on the comments section here and here
The consensus being that I was wrong ! So, what’s the correct view?
Let’s make it all as simple as possible. Let’s consider the example of someone walking into the Royal Bank of Scotland to borrow one of their £10 notes. The RBS are one of those banks ‘north of the border’ who are allowed to print their own banknotes. They are essentially their IOUs . So these notes are the type of credit money we have been talking about. They tend to be well accepted in Scotland but less so in England.
So they borrow £10 and spend it on whatever! When the time comes to repay the RBS the borrower could , leaving aside the complications of fees and interest payments, give them a Bank of England £10 note, the BoE being the Central bank of the UK, and the debt is cleared. The credit money is still in circulation. It isn’t destroyed.
Alternatively, they could repay with a RBS £10 note in which case the credit money is destroyed.
I probably should have said “not necessarily” rather than “they don’t” but I think that’s all there is to the argument.
One common argument made by neoliberals is that government debts, and the interest payments that go with them, are potentially a burden to the next generation. You’ll hear that sort of thing all the time from politicians. Of course there is no empirical evidence for this assertion. The immediate post war generation don’t seem to have suffered from a collective war debt burden. That generation has been lucky and has done remarkably well, on the whole.
But why should this be? Let’s start from the understanding that dollars and pounds are no more than government IOUs. This view is now held right across the political spectrum. There is no real controversy. There’s no gold , no silver backing them up they arejust government IOUs as described by the Bank of England.
So let’s just think about our own IOUs. Suppose we have run out of sugar and ‘buy’ a kilo from our neighbour by issuing an IOU. So our neighbour gives us the sugar and we give out an IOU. That’s how governments buy things of course. Suppose we use up that sugar and need some more. What can we do? We can write out another IOU and give that to another neighbour and get some more sugar.
From a government’s perspective that would correspond to printing more money. After a while our neighbours lose confidence in these written IOUs , so the conventional argument goes, and therefore responsible governments should borrow funds in the market rather than just keep on printing new money. So how do we borrow back these IOUs? It’s really not possible. All we can do is offer to swap them for new IOUs called bonds. So we write out a new IOU to one of our neighbours promising that we will repay not just one kilo but two kilos of sugar but the catch is that our good neighbour has to wait 10 years to get them. If you do the arithmetic our neighbour will get approximately 3.5% interest on his bond over the ten year period. In return we get back our original IOU which we can then spend, responsibly, with a new neighbour. Responsibly? Because we haven’t printed new money 🙂 But we have printed a new bond 😦 Its better not to mention that!
So the first logical conclusion to be drawn is that there is really no such thing as government borrowing. More correctly, it should be described as government issuing. Governments issue either currency ( one form of IOU) directly or issue bonds (another form of IOU with interest) in order to get back their currency IOUs to be able to respend them.
Incidentally, if they do it the other way around from normal, and issue currency IOUs and swap them for bond IOUs the process is then known as Quantitative Easing! That’s another story!
So governments are in this odd position of never having anything except their own IOUs, so how can they possibly ever properly repay the holders of these IOUs? Governments can’t create any sugar (real wealth) directly, how can they? So how can they ever repay their debts in any meaningful way? They can’t. They can forcibly confiscate IOUs through the process of taxation but that is not at all the same thing as repaying debts.
That all needs a bit of thinking about, but logically it must mean that no matter what governments borrow today there is no need for our children to worry about ever repaying our debts at some future time. If the government of the future time tries to impose a too high regime of taxation, in relation to what it spends back into the economy, and thereby creating recession and excessive unemployment, our grown-up-by-then children will vote them out at the next future election. At least they will if they have any sense and don’t succumb to the neoliberals of their future time who will be spinning them a yarn about debt burdens to future generations!
Positive money advocates a system of full reserve banking to address the problem, as they see it, of private banks creating too much money in the process of credit creation.
So how, in simple terms, would full reserve banking actually work? It is actually directed towards making banks work more in the way many mistakenly think they do already work. Current accounts, or checking accounts as they are known in the USA, would outwardly remain the same. No interest will be paid on these. The difference will be that the money in them would not be IOUs of the commercial bank but instead would be the IOUs of government. The commercial bank would therefore have to keep an account at the reserve or central bank, the BoE, the Fed, or RBA for example, which held an amount equal to the total of all customer current accounts. This would cover the possibility that all customers may simultaneously wish to drain their current accounts. If the commercial bank became bankrupt customers would be easily able to reclaim their money from the account held at the central bank.
Interest bearing accounts would work slightly differently. Money would be deposited for a fixed term, say 6 months or 1 year and so the usual practice, from a customer’s point of view, of easily moving their funds from one account to the other would have to end. This would give the bank the opportunity to lend out money during this period without having to create extra money itself. Money lent out from these accounts would not, according to PM, be guaranteed in the event of a bank failure. Although, I’m not quite sure why not. If banks weren’t allowed to write their own IOUs any longer then there would be nothing for them to default on. The pool of deposit money, having been lent out, would only be at risk if the borrowers of that money defaulted rather than if the bank itself defaulted. Depositors could choose to invest in relatively safe ways for a modest interest, or if they wished to take a greater risk could aim for a higher return.
The idea of course is that as all money is the IOU of government, therefore the money supply is totally controlled by government and problems of inflation, booms and busts caused by stop-start bank lending will be ended.
Does this superficially plausible argument stack up?
The PM group tend towards the nonsensical quantity theory of money. The idea is that money simply in the process of existing has an effect on prices. Would doubling the supply of money mean the price of bread doubled? Maybe, if it were spent and the doubling caused spending to double but if it just sat as cash in a bank vault it would obviously have absolutely no effect whatsoever. It is the spending of money which has an effect on prices. Not its mere existence. Lenders of money, almost by definition, have no pressing need to spend it. Borrowers do. So all lending tends to have an inflationary or stimulatory effect in the economy. Changing all lending to be via government money does not change that in the slightest.
It should be recognised that no country anywhere in the world has a system of full reserve accounting. If any one country tried to impose one it would cause the banks, in that country, to be at a disadvantage to their foreign competition. It would risk pushing any problem underground or, more likely, overseas. There is no reason why , in the age of the internet, any bank operating in a country, would need much physical presence at all in that particular country. It would be quite possible for a Hong Kong based bank to offer a banking service to UK customers in UK £. If that bank was well capitalised, and their issued IOUs were credible then no sensible person or organisation would refuse to accept them. (edit: see Neil Wilson’s comment about this below)
But leaving these practical arguments aside, would FRB work any better in principle? Would making all money an IOU of government rather than an IOU of the bank stop the cycle of booms and busts? That would happen if all banks were nationalised and put under the control of the central bank. If they carried on as normal then nothing much would change, so the type of IOUs, pe se, cannot be the fundamental problem. Governments, at present, have control over the lending practices of banks, except they tend to misuse it.
It is often said, especially in MMT circles, that banks don’t lend out their reserves ie they don’t lend out government created money. This is literally true. If I borrow £1000 then the bank just credits my account by keystroke. The bank has created the money out of thin air as we hear often enough. But, if I then put my bank card into the ATM and take the money in cash, or use it to pay my taxes, or maybe buy some premium bonds, or whatever, then effectively the bank has done just that. ie lent out some of its reserves. Even if I left it in the bank until spent via, say, an internet transaction, I would almost certainly use that money to purchase goods and services. Sooner or later, whoever held the IOUs created by the bank would want to buy UK government bonds or pay UK taxes, or they would be held by a different bank which would not want to hold another bank’s IOUs. My bank would have to take them back and pay with real government cash. The half-life of any bank created money is probably no more than a few months.
The banks understand all this and they know they can’t be quite as gung-ho about creating new money, or writing out IOUs, as the PM group would have us believe. Having said that, the problem for most banks is usually not that they have too little government money but they have too much. It is therefore not a restraint on their lending. Because governments, in the UK , the USA and Australia tend to issue more money into the economy than they receive back in taxes, it is easy to see that the excess is going to largely end up with the commercial banks. This causes them a problem. It pays no interest if they just hold it. So their first reaction might be to ask if other banks wish to borrow it from them. They ask 5%, or the pro-rata equivalent for a short term loan, but they have no takers. All the other banks have plenty of government cash too! So they ask 4%, 3%, 2% and they eventually drop down to almost 0%. There is hardly any point lending it out if it really is 0%!
So, as part of the Government’s monetary policy their central bank set a floor on interest rates by taking their money back temporarily. Not that they need the money. Why would they? They can write out as many IOUs as they like. They do it to control interest rates in the economy and therefore the level of lending. So rather than let the level fall to 0% they will intervene and offer interest at, say, 3% (pa) pro-rata on an overnight rate. The Australians have the most descriptive term. They call it the OCR or overnight cash rate. The Australian Reserve Bank, like all central banks, sets the level at whatever rate it likes. Governments and their central banks also have the power to mop up excess reserves on a longer term basis, which they do as part of their monetary policies, through the issuing of bonds/gilts and other securities which pay a return to those holding them. As the RBA put it themselves:
“Monetary policy involves setting the interest rate on overnight loans in the money market (‘the cash rate’). The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation.”
Note that the banks would get short shrift if they tried to ask for 3% on money they have created themselves! That would make life just too easy for them. The Central Banks may be generous enough to pay interest on their own issued money but they aren’t quite so generous as to pay it on someone else’s issued money. Positive Money really ought to do more to explain that.
As the system works at present, the commercial banks can choose to lend risk free to their central banks at a rate influenced by the overnight rate or they can choose to lend at a higher rate to home buyers, industry and others but with the acceptance of a higher associated risk and administrative expenses.
Therefore I would argue that Governments already have the ability to control the level of lending without having to radically change their banking systems. If they want banks to lend more they should lower interest rates. If they want them to lend less they should increase them. It all seems simple enough. So why don’t they just do it?
The answer to that is they like the temporary effect of banks’ over-lending. It makes the economy zip along. The banks’ issued IOUs end up back with government, in taxes, which are then exchanged for real government money from the banks and so the governments finances look temporarily very good. Their deficits fall. They claim the credit for reducing unemployment. Until the crunch comes of course. The blame for letting that cycle happen rests with government itself. Not the banks. In the boom times they should raise interest rates to slow down lending, but to keep the economy moving they should increase their deficits. If inflation starts to be an issue they should think about raising their interest rates rather than just reducing their deficits which is their first reaction right now.
The main problem governments have right now is that interest rates are far too low. They are almost at zero in many countries. Incidentally this is the main reason for high house prices, another PM concern, FRB wouldn’t necessarily fix that. Governments can’t do anything with monetary policy. They have relied far too much, for far too long, on it to keep their economies growing and forgotten they have fiscal policy at their disposal too. But they are so debt averse that is almost unthinkable! If pressed, they will try any other kind of irrational approach instead such as the nonsense known as Quantitative Easing.