[R-G] [BillTottenWeblog] Should creation of money stay in private hands?

[Bill Totten]

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).

http://www.yomiuri.co.jp/dy/columns/commentary/20090309dy02.htm


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