Bill Totten's Weblog

Wednesday, March 11, 2009

Should creation of money stay in private hands?

by Richard A Werner

The Daily Yomiuri (March 09 2009)

Governments all over the world are engaged in frantic efforts to avoid another Great Depression. Late last year, $700 billion still seemed a large sum. But since then the US Congress has been asked to approve government expenditure now counted in the trillions of dollars.

The main thrust of government policy worldwide has been to inject mind-boggling sums of public money into the banking system. Is this the most efficient, cost-effective and fair way of stabilizing economies and employment in this situation?

Further, the banking and economic crises as we are witnessing today are nothing new. Their frequency had already increased to record numbers in the past thirty years before the start of the current crisis. Indeed, the world has seen an apparently endless string of recurring banking crises and connected economic cycles, with all their costs and distortions. Should we not first step back and consider what the true common causes are, so that any policy response can be properly designed and also we could be surer that banking crises such as these will in future be avoided?

No such thing as a bank loan

First, we need to understand what causes banking crises. The core of the problem is that 95 percent to 98 percent of the money supply is not created by central banks or governments, but by privately owned commercial banks. It is a little-known fact that there is no such thing as a "bank loan".

Banks do not lend money. "Lending" refers to transferring control of the lent object to the borrower. If I lend you my car, I can't at the same time drive in it. That's not what banks do when they issue a "bank loan". Instead, they are allowed by the current regulatory framework to create new money out of nothing - which is called "credit creation". The collective decisions of commercial bank staff thus determine how much money is created, who gets the newly created money and for what purpose.

Mainstream economics assumes that the best possible outcome will be achieved, if banks are left alone in making their decisions about how much money should be created and to whom it should be handed over for whatever use. But the current crisis has disproven this claim. It has demonstrated that we can't expect banks' credit decisions to be in any way beneficial for the overall economy, social welfare, or even the bankers' own good - as former US Federal Reserve Board Chairman Alan Greenspan admitted to Congress last October. The incentive structure at banks is such that they tend to create too much credit when not needed, and for unproductive use; and when this has gone sour, too little money, though it is then badly needed by productive firms.

There are some simple rules for sound banking and sound economies that need to be followed: Whenever credit is created and used to increase the amount of goods and services provided, it will be noninflationary: more money comes about, but also more goods and services. This is boring banking, without excessive bankers' bonuses. But it is the kind of stable banking that created the postwar German and Japanese economic miracles, and also explains the rise of China and other East Asian so-called miracle economies.

But whenever credit is created and used for unproductive purposes, inflation comes about: more money chases a limited amount of goods or assets. The unproductive credit creation can take two forms: When credit is extended for consumption, it will result in consumer price inflation. When credit is extended for non-gross domestic product transactions (which means mainly financial and real estate transactions), there will be asset inflation. Both cases are unsustainable and if sufficiently large, result in banking and economic crises.

To prevent banking crises, it must be ensured that the bulk of credit creation is used for productive purposes. Specifically, the use of aggregate bank credit for transactions that are not part of GDP (something that can be easily verified by loan officers) needs to be monitored, and suppressed when it threatens to rise in excess of total bank credit growth.

This simple measure would have prevented the credit bubbles in the United States, Britain, Ireland, Spain and many emerging markets, which have now burst and caused the current crisis. It would also have prevented the Japanese recession since 1990 or the US depression of the 1930s. Central banks used to monitor precisely this, but following the deregulation advice of mainstream economics, they chose to abolish their "credit guidance" policies and instead let rip the unproductive bank credit expansions of the past decades. Ironically, it is now that the US, British, French and German governments say they want to monitor the allocation of new bank lending (to ensure lending to small firms and mortgage borrowers). The horse has already bolted.

Thus one also needs to ask why those institutions that could have prevented the bubbles have singularly failed to do so, although they had been given unusually strong powers with little accountability to democratic institutions: the central banks. Never have they been as independent and powerful as today.

This suggests that the very independence and lack of accountability of central banks has been a factor in allowing the creation of credit bubbles and the propagation of the current crisis: the central banks' erroneous belief in the infallibility of free and unfettered markets remained unchecked. Thus from now on, central banks should be made to monitor credit flows and made more directly accountable to democratically elected assemblies for the results.

How to fix the banking system

What should be done to end the current crisis and avoid large-scale unemployment? Just like the Japanese government in the early 1990s, governments have responded by increasing fiscal expenditure, funded by borrowing, and central banks have responded by lowering interest rates. Neither will help: The privately owned creators of the bulk of the money supply are battening down the hatches; in their increased risk aversion, they will reduce credit creation. Just as their excessive credit creation affects us all, so does their reduction of credit: For economic growth, as traditionally measured, credit creation is necessary.

This is why the current policies will not help. Fiscal policy on its own does not create credit. By borrowing more, national debt is increased, but the money for the fiscal stimulation is the same money that is removed from the economy through bond issuance. Thus fiscal policy, if not backed by credit creation, will crowd out private demand dollar by dollar. And lower interest rates will not help - even if they drop to zero - if the quantity of credit does not increase. This is why Japan will soon be in the 20th year of recession after its own credit bubble burst in 1990.

The solution is simple: We have been hearing much of the need to help banks write off nonperforming loans, but those burdened most by this debt - the households saddled with uneconomical mortgages - are not given significant debt relief. Instead, many are being made homeless. Their debt slates should be wiped clean before government money is injected into the banking system. Further, fiscal stimulation, in the form of purchases of nonperforming assets from banks, and public purchases of bank equity, should be funded either by the issuance of government money (such as former US President John F Kennedy's "United States Notes" issued in 1963, or the government money put into circulation by the Japanese or US governments in the 19th century), or, failing that, undertaken directly by the central banks, for their own account.

In both cases, national debt and interest liabilities will not increase, but credit creation will. Growth will not collapse. This also makes sense from a moral hazard perspective: It is not the taxpayer that is responsible for the current mess, but the central banks, so let them pay.

Finally, another topic should be discussed, although the ruling elites seem to consider it taboo: Is it really right that the creation and allocation of money - a public good - remains in private hands? Surely that's the ultimate reason why nobody seems interested in learning the lessons from the past and why experts feign surprise each time another banking crisis erupts. Many are conflicted, as they have been beneficiaries from this highly lucrative private monopoly.


Werner is professor of international banking at the University of Southampton and author of the books Princes of the Yen (2003) and New Paradigm in Macroeconomics (2005).

Bill Totten


  • the creation of money by the banks in this manner is a fact I have only recently discovered, and to be completely honest it baffles me as to why anyone would allow such an insane balance of power to be created within the economy. how is it beneficial to society to allow money to be created by only a few people?if someone borrows an apple from me, but instead of me taking the apple I already have and giving it to them, I conjour up an apple from nowhere. Ive still got an apple, and eventually the second apple will come back to me. in any case, Ive always got at least the amount i started with. this leaves the banks with a continuously increasing supply of money, and every other individual with a continously dwindling supply of money. it just seems ludicrous to allow this. the idea of money originally was to allow a common bartering currency amongst all things for easier transaction of goods and services. If these two properties are analogous(money, and goods and services), surely the most logical idea is to have a set amount of money for a set amount of goods and services. after all, apples dont just spring up from nowhere. they are the product of soil, water, sunlight and hard work. it just doesnt seem to make logically sense to allow something to be created from nothing.

    By Blogger leah, at 7:49 AM, March 11, 2009  

  • Thanks, Leah, well said. This scam may baffle you, but it surely doesn't baffle the banksters. Bill

    By Blogger Bill Totten, at 10:51 AM, March 11, 2009  

  • Government created money would be subject to the same unrealistic expectations about perpetual growth as private banker created money.

    Mainstream economics does not acknowledge any natural, ecosystem limits to real growth. It is a pseudo-science.

    Quantitative Finance modeling has proven to be a disaster, not being based on the flows and systematic constraints of energy, matter and waste in the real world, but on google-eyed assumptions of perpetual growth.

    Global collapse is inevitable. Optimism will not change the fact that there are far too many people consuming far too much to be sustained...

    By Anonymous Anonymous, at 11:46 PM, March 11, 2009  

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