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Friday, August 20, 2010

More Detail on the Proposed BOE Act - Part Ten

Note: This is the tenth and last part of a series filling in details of the Proposed Bank of England Act on which I posted seven articles here from July 31st to August 3rd. Bill Totten

Overdrafts & General Liquidity in the System

Liquidity in the Post-Reform Banking System

This reform reduces the amount of 'credit' - or more accurately, lending - available in the economy, from around 100% of the existing money supply to around fifty to sixty per cent. Considering that the authorities focussed on the 'credit squeeze' as the biggest problem in the recent financial crisis, the idea of significantly reducing the amount of available credit (lending) raises alarm bells for many people.

However, most of these concerns stem from an incomplete understanding of how the monetary system works. The reality is that our dependence on credit is not a natural aspect of the economy - it is a direct result of allowing banks to create the nation's money as debt. When 97.5% of the existing money supply was created as debt, and is therefore earning interest, it creates inflation (especially in housing) that necessitates people borrowing more simply to survive.

Before we explain why a reduction in credit (lending) will not be a problem after the reform, we need to clear up a few misconceptions about 'credit', 'debt' and 'lending'.

Credit = Debt

The term 'credit' is used misleadingly. 'Credit' has positive associations - everyone wants a good credit rating, and your salary appears in your bank account under the 'credit' column. But in this case, 'credit' means 'debt'. If we say that businesses depend on access to credit, we are saying that that their financial situation is poor enough that they urgently need to go into debt. Of course, very new businesses and businesses which are expanding rapidly will need access to credit/debt, but the fact that many businesses will go bankrupt as soon as banks stop offering them further debt points to the poor financial health of most businesses. This poor financial health is not the natural state of affairs - it is a symptom of a monetary system where all new money is created by the banks.

We Are Dependent on Credit/Debt
Because Our Money Supply IS Debt

The absolute dependence on 'credit', and the fact that the economy grinds to a halt whenever 'credit' dries up, is used to point to the importance of credit in a modern economy. In reality, it points to a chronic shortage of debt-free money in the economy. By definition, if the economy needs 'credit' to continue functioning, we are dependent on debt.

Over the last few decades we have all become accustomed to having total debts equal to five or six times our annual salary, and businesses having debts as much as their annual turnover. However, this is not a natural state of affairs - it is a product of a system where almost all money only comes into existence when someone takes out a loan.

This means that, while economists argue that easy access to credit is essential to a well-functioning economy, in reality, dependence on credit is a symptom of a malfunctioning economy and a malfunctioning money supply. The debt-based monetary system actually creates the need for companies and households to access credit (debt). In other words, we are all so far in debt because we allow our money to be created as debt.

The answer to our debt-dependency is not more debt (despite political leaders shouting "Let's get banks lending again!") but newly created, debt-free money, which can help to cancel out the debt and reduce our debt-dependency.

As Debt-Free Money Cancels Out the Debt,
We Will Have Less Need for Credit

As we create and inject debt-free money into the economy, this will allow individuals and companies to gradually pay down their own debts and start to increase their savings. With great savings, people have less dependence on debt, and therefore access to credit (debt) becomes less critical to the health of the economy.

As the Amount of Credit Falls After the Reform,
Demand for Lending Will Also Be Falling

The amount of credit/lending available after the reform may gradually fall to around fifty per cent of the current level. At the same time, newly-created money will be injected into the economy, not as a debt into the housing market, but as tax cuts, tax rebates and government spending.

This newly created debt-free money provides a stronger stimulus than debt-based money created by the banks, since there is no need to pay an interest charge on the money as soon as it is created. As a result, the economy should improve, and people will be better able to pay off their existing debts, pay down mortgages, and improve their financial position. With lower taxes and a more buoyant economy, the need to go into debt will fall and apply to fewer people. In other words, the demand for credit will fall in tandem with the availability of credit.

If there are any shortfalls in the amount of credit available during the 'transition' phase between the two systems, these can be met by the Monetary Policy Committee choosing to create more money (if all the other economic indicators also point to the need for more money), or by lending money directly to banks on the condition that this money goes into 'productive' lending - funding businesses rather than consumer credit cards, for example.

Ensuring Liquidity Through Overdrafts

Overdrafts on Transaction Accounts can play a key part in the post-reform banking system. Firstly, they will provide a short-term 'liquidity buffer' to households and businesses. Secondly, they will provide a very useful indicator on the need for more (or less) new money to be injected into the economy.

'The Liquidity Buffer'

Overdrafts provide short-term liquidity and allow businesses and individuals to smooth out temporary mismatches between their incoming and outgoing cash flows (for example, if an individual's bills need to be paid just a few days before their salary is paid into the account). There would be no advantage to the bank, to the customer, and to the economy as a whole of removing the overdraft functionality from Transaction Accounts.

Indicating Changes in the Need for Money in the Economy

The balance of one overdraft may fluctuate wildly through the month and at different times in the year. However, averaged over millions of Transaction Account holders, the average balance will be fairly stable. This means that changes in this average balance will indicate significant changes in the economy. If this average balance is increasing (that is, people on average are going further into their overdrafts) then it indicates that people do not have enough money to meet their regular expenses, and could therefore mean that the economy needs a greater injection of new money. On the other hand, if average overdraft balances are falling (people are - on average - paying off their overdrafts) it could mean that there is 'spare' money in the economy and point to the possibility of inflation in the near future.

How Overdrafts Will Be Funded

It is suggested that overdrafts can be funded via borrowing from the Bank of England. The banks will pay a rate of interest on these funds. Rather than the interest rate being set by the Bank of England, it can be set via 'market forces' through auctions between the banks.

Recognising the importance of overdrafts in providing liquidity to the economy, it is suggested that the funds used for overdrafts should come not out of existing money, but be funded via newly created money. This would allow overdrafts to act as a type of 'float valve' to allow relatively small and temporary changes in the money supply of the economy.

Bill Totten


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