ANDREW JACKSON & BEN DYSON

r jr i

V.

MODERNISING

MONEYWHY OUR MONETARY SYSTEM IS BROKEN

AND HOW IT CAN BE FIXED

WITH A FOREWORD BY PROFESSOR HERMAN E DALY

TableofContents

AcknowledgementsAnoteforreadersoutsidetheUKForewordSummaryofKeyPointsINTRODUCTION

ThestructureofthisbookASHORTHISTORYOFMONEY

1.1TheoriginsofmoneyAtextbookhistoryThehistoricalreality

1.2TheemergenceofbankingTHECURRENTMONETARYSYSTEM

2.1Commercial(high-street)banksTheBankofEngland

2.2ThebusinessmodelofbankingUnderstandingbalancesheetsStayinginbusiness

2.3MoneycreationCreatingmoneybymakingloanstocustomers

2.4OtherfunctionsofbankingMakingelectronicpaymentsbetweencustomers

2.5Moneydestruction2.6Liquidityandcentralbankreserves

HowcentralbankreservesarecreatedHowcommercialbanksacquirecentralbankreserves

2.7MoneycreationacrossthewholebankingsystemThemoneymultipliermodelEndogenousmoneytheory

WHATDETERMINESTHEMONEYSUPPLY?3.1Thedemandforcredit

BorrowingduetoinsufficientwealthBorrowingforspeculativereasonsBorrowingduetolegalincentives

3.2ThedemandformoneyConclusion:thedemandformoney&credit

3.3Factorsaffectingbanks’lendingdecisionsThedrivetomaximiseprofit

Governmentguarantees&‘toobigtofail’Externalitiesandcompetition

3.4FactorslimitingthecreationofmoneyCapitalrequirements(theBaselAccords)Reserveratios&limitingthesupplyofcentralbankreservesControllingmoneycreationthroughinterestratesUnusedregulations

3.5Sowhatdeterminesthemoneysupply?CreditrationingSohowmuchmoneyhasbeencreatedbybanks?

ECONOMICCONSEQUENCESOFTHECURRENTSYSTEM4.1Economiceffectsofcreditcreation

Werner’sQuantityTheoryofCreditHowassetpriceinflationfuelsconsumerpriceinflation

4.2Financialinstabilityand‘boom&bust’Minsky’sFinancialInstabilityHypothesisTheburstingofthebubble

4.3EvidenceFinancialcrisesNormalrecessions

4.4OthereconomicdistortionsduetothecurrentbankingsystemProblemswithdepositinsurance&underwritingbanksSubsidisingbanksDistortionscausedbytheBaselCapitalAccords

SOCIALANDENVIRONMENTALIMPACTSOFTHECURRENTMONETARYSYSTEM

5.1Inequality5.2Privatedebt5.3Publicdebt,highertaxes&fewerpublicservices5.4Environmentalimpacts

GovernmentresponsestotheboombustcycleFundingbusinessesForcedgrowth

5.5ThemonetarysystemanddemocracyUseof‘our’moneyThemisconceptionsaroundbankingThepowertoshapetheeconomyDependencyConfusingthebenefitsandcostsofbanking

PREVENTINGBANKSFROMCREATINGMONEY

6.1Anoverview6.2Current/TransactionAccountsandthepaymentssystem6.3InvestmentAccounts6.4AccountsattheBankofEngland

TherelationshipbetweenTransactionAccountsandabank’sCustomerFundsAccount

6.5PostReformBalanceSheetsforBanksandtheBankofEnglandCommercialbanksCentralbankMeasuringthemoneysupply

6.6Makingpayments1.Customersatthesamebank2.CustomersatdifferentbanksAnoteonsettlementinthereformedsystem

6.7MakingloansLoanrepayments

6.8HowtorealignriskinbankingInvestmentAccountGuaranteesTheregulatormayforbidspecificguarantees

6.9LettingbanksfailTHENEWPROCESSFORCREATINGMONEY

7.1Whoshouldhavetheauthoritytocreatemoney?7.2Decidinghowmuchmoneytocreate:TheMoneyCreationCommittee(MCC)

HowtheMoneyCreationCommitteewouldworkIsitpossiblefortheMoneyCreationCommitteetodeterminethe‘correct’moneysupply?

7.3Accountingformoneycreation7.4Themechanicsofcreatingnewmoney7.5Spendingnewmoneyintocirculation

Weighinguptheoptions7.6Lendingmoneyintocirculationtoensureadequatecreditforbusinesses7.7Reducingthemoneysupply

MAKINGTHETRANSITIONAnoverviewoftheprocess8.1Theovernight‘switchover’tothenewsystem

Step1:UpdatingtheBankofEngland’sbalancesheetStep2:Convertingtheliabilitiesofbanksintoelectronicstate-issuedmoneyStep3:Thecreationofthe‘ConversionLiability’frombankstotheBankofEngland

8.2Ensuringbankswillbeabletoprovideadequatecreditimmediatelyafterthe

switchoverFundsfromcustomersLendingthemoneycreatedthroughquantitativeeasingProvidingfundstothebanksviaauctions

8.3Thelonger-termtransitionRepaymentoftheConversionLiabilityAllowingdeleveragingbyreducinghouseholddebtForcingadeleveragingofthehouseholdsector

UNDERSTANDINGTHEIMPACTSOFTHEREFORMS9.1Differencesbetweenthecurrent&reformedmonetarysystems

9.2Effectsofnewlycreatedmoneyoninflationandoutput9.3Effectsoflendingpre-existingmoneyviaInvestmentAccounts

Lendingpre-existingmoneyforproductivepurposesLendingpre-existingmoneyforhousepurchasesandunproductivepurposesLendingpre-existingmoneyforconsumerspending

9.4Limitationsinpredictingtheeffectsoninflationandoutput9.5Possiblefinancialinstabilityinareformedsystem

AreducedpossibilityofassetpricebubblesCentralbankinterventioninassetbubblesWhenanassetbubblebursts

9.6Debt9.7Inequality9.8Environment9.9Democracy

IMPACTSONTHEBANKINGSECTOR10.1Impactsoncommercialbanks

BankswillneedtoacquirefundsbeforelendingTheimpactontheavailabilityoflendingBankswillbeallowedtofailThe‘toobigtofail’subsidyisremovedTheneedfordebtisreduced,shrinkingthebankingsector’sbalancesheetBaselCapitalAdequacyRatioscouldbesimplifiedEasierforbankstomanagecashflowandliquidityReducingthe‘liquiditygap’

10.2ImpactsonthecentralbankDirectcontrolofmoneysupplyNoneedtomanipulateinterestratesAslimmeddownoperationattheBankofEngland

10.3ImpactsontheUKinaninternationalcontextTheUKasasafehavenformoney

PoundsterlingwouldholditsvaluebetterthanothercurrenciesNoimplicationsforinternationalcurrencyexchangeWouldspeculatorsattackthecurrencybeforethechangeover?

10.4ImpactsonthepaymentsystemNationalsecurityOpeningthedoortocompetitionamongTransactionAccountproviders

CONCLUSIONAPPENDIXI:EXAMPLESOFMONEYCREATIONBYTHESTATE:ZIMBABWEVS.PENNSYLVANIA

ZimbabweOtherhyperinflationPennsylvaniaConclusionsfromhistoricalexamples

APPENDIXII:REDUCINGTHENATIONALDEBTWhatisthenationaldebt?Whodoesthegovernmentborrowmoneyfrom?Doesgovernmentborrowingcreatenewmoney?Isitpossibletoreducethenationaldebt?Isitdesirabletoreducethenationaldebt?PayingdownthenationaldebtinareformedmonetarysystemIsthis'monetising'thenationaldebt?

APPENDIXIII:ACCOUNTINGFORTHEMONEYCREATIONPROCESSThecurrent'backing'forbanknotesTheprocessforissuingcoinsintheUSAThekeydifferencesbetweenUScoinsandUKnotesThepost-reformprocessforissuingelectronicmoneyEnsuringthatelectronicmoneycannotbeforgedReclaimingtheseigniorageonnotes&electronicmoneyModernisingthenoteissuanceAnalternativeaccountingtreatment

Balancesheets:alternativetreatment(withmoneyasaliablityoftheBankofEngland)

BIBLIOGRAPHYAbouttheAuthors

FirstpublishedintheUKin2012byPositiveMoneyCopyright©2012AndrewJacksonandBenDysonAllrightsreservedTheauthorshaveassertedtheirrightsinaccordancewiththeCopyright,DesignsandPatentsAct1988PositiveMoney205DavinaHouse137-149GoswellRoadLondonEC1V7ETTel:+44(0)2072533235www.positivemoney.orgISBN:978-0-9574448-0-5KindleversionproducedbyHermanMittleholzerandHenryEdmonds

ACKNOWLEDGEMENTSWewould like to thankGrahamHodgson for his numerous contributions to this book, aswell asMarioViselandMariiaDomina, for theirworkonhistoricalepisodesofstatemoneycreationandinternationalfinancerespectively.The discussion of the existing banking system in the first two chapters of this book is based onresearch and thinking by Josh Ryan-Collins, Tony Greenham and Richard Werner and AndrewJacksonforthebookWhereDoesMoneyComeFrom?(publishedbytheNewEconomicsFoundation)andweareverygratefulfortheirinputandconsiderableexpertise.WearealsogratefultotheteamatPositiveMoney:MiraTekelovaforholdingthefortwhilethebookwas written, Henry Edmonds for his work on the design and layout, and Miriam Morris, JamesMurrayandanumberofothertirelessvolunteerswhohavehelpedwiththeeditingandproofing.We are indebted to Jamie Walton for the numerous conversations in 2010–2011 that led to thedevelopment and strengthening of these proposals, and Joseph Huber and James Robertson forprovidingthestartingpointintheirbookCreatingNewMoney.These ideaswerefurtherdevelopedwithJoshRyan-Collins,TonyGreenhamandRichardWernerinajointsubmissiontotheIndependentCommissiononBankinginlate2010.Wewouldalsoliketothankallthosewhohaveprovidedhelpfulinsights,commentsandsuggestionsontheproposalsandthemanuscript.WeareparticularlygratefulfortheexpertiseandguidanceofDrDavid Bholat, Dr Fran Boait, Prof. Victoria Chick, Prof. HermanDaly, Prof. JosephHuber, PeterKellow,DrMichaelReiss,andJamesRobertson.Finally,wewouldliketoexpressourgratitudetotheJamesGibbStuartTrustandothersupportersofPositiveMoney,withoutwhomthebookwouldnothavebeenwritten.Ofcourse,thecontentsofthisbook,andanymistakes,errorsoromissionsremainentirelytheresponsibilityoftheauthors.

ANOTEFORREADERSOUTSIDETHEUKAlthoughthisbookiswrittenwiththeUKbankingsysteminmind,theanalysisisequallyapplicabletothebankingandmonetarysystemofanymoderneconomy.Whilethereareminordifferencesin

rulesandregulationsbetweencountries,almostalleconomiestodayarebasedonamonetarysystemthatisfundamentallythesameasthatoftheUK.Equally, thereformsproposedherecanbeappliedtoanycountrythathasitsowncurrency,oranycurrencybloc,withonlyminortailoringtotheuniquesituationofeachcountry.

FOREWORDMoney ranks with fire and the wheel as an invention without which the modern world would beunimaginable. Unfortunately, out-of-control money now injures more people than both out-of-control fires andwheels.Loss of control stems from the privilege enjoyedby the private bankingsectorofcreatingmoneyfromnothingandlendingitatinterestintheformofdemanddeposits.Thispowerderivesfromthecurrentdesignofthebankingsystem,andcanbecorrectedbymovingtoasystemwherenewmoneycanonlybecreatedbyapublicbody,workinginthepublicinterest.Thisissimpletostate,butdifficulttobringabout.AndrewJacksonandBenDysondoafinejobofexplaining themalfunctioning present banking system, and showing the clear institutional reformsnecessaryforasoundmonetarysystem.Themainideasgobacktotheleadingeconomicthinkersof50 to75yearsago, including IrvingFisher,FrankKnightandFrederickSoddy.Thisbook revivesand modernises these ideas, and shows with clarity and in detail why they must be a key part ofeconomicreformtoday.

PROFESSORHERMANDALY

ProfessorEmeritusSchoolofPublicPolicyUniversityofMarylandFormerSeniorEconomistattheWorldBank

SUMMARYOFKEYPOINTSCHAPTER1:ASHORTHISTORYOFMONEYWhenearly-daygoldsmithsstartedtoprovidebankingservicestomembersofthepublic,theywouldissuedepositorswithpaperreceipts.Thesereceiptsstartedtocirculateintheeconomy,beingusedinplaceofmetalmoneyandbecomingaformofpapermoney.In1844thegovernmentprohibitedtheissuanceofthispapermoneybyanyinstitutionotherthantheBankofEngland,returningthepowerto createmoney to the state.However, the failure to include bank deposits in the 1844 legislationallowedbankstocontinuetocreateaclosesubstituteformoney,intheformofaccountingentriesthatcouldbeusedtomakepaymentstoothersviacheque.Theriseofelectronicmeansofpayment(debitcardsandinternetbanking)hasmadetheseaccountingentriesmoreconvenienttouseasmoneythanphysical cash.Asa result, todaybankdepositsnowmakeup thevastmajorityof themoney in theeconomy.

CHAPTER2:MONEY&BANKINGTODAYThe vast majority of money today is created not by the state, as most would assume, but by theprivate,commercial(orhigh-street)bankingsector.Over97%ofmoneyexistsintheformofbankdeposits(theaccountingliabilitiesofbanks),whicharecreatedwhenbanksmakeloansorbuyassets.Weexplainhowthisprocess takesplaceandshowthe(simplified)accountingthatenablesbankstocreatemoney.Wealsolookatthecrucialroleofcentralbankreserves(moneycreatedbytheBankofEngland)inthepaymentssystem,andexplainwhyitisthatbanksdonotneeddepositsfromsaversorcentralbankreservesinordertolend.

CHAPTER3:WHATDETERMINESTHEMONEYSUPPLY?Withmostmoney being created by banksmaking loans, the level of bank lending determines themoney supply.What determines howmuch banks can lend? The demand for credit (lending) willalwaystendtobehighdueto:insufficientwealth,thedesiretospeculate(includingonhouseprices),andvariouslegalincentives.The supplyof credit dependson the extent towhichbanks are incentivised to lend.Duringbenigneconomic conditions banks are incentivised to lend as much as possible – creating money in theprocess–by thedrive tomaximiseprofit, and thisprocess isexacerbated through theexistenceofsecuritisation,depositinsurance,externalitiesandcompetition.Theregulatoryfactorsthataremeanttolimitthecreationofmoneysuchascapitalrequirements,reserveratiosandthesettingofinterestratesbytheMonetaryPolicyCommitteeareforavarietyofreasonsineffective.Yet despite the high demand for credit, the strong incentives for banks to create money throughlending,and the limitedconstraintson theirability todoso,banksdonotsimply lend toeveryonewhowantstoborrow.Instead,theyrationtheirlending.Forthisreason,thelevelofbanklending,andthereforethemoneysupply,isdeterminedmainlybytheirwillingnesstolend,whichdependsontheconfidencetheyhaveinthehealthoftheeconomy.

CHAPTER4:ECONOMICCONSEQUENCESOFTHECURRENTSYSTEMTheeconomiceffectsofmoneycreationdependonhowthatmoneyisused.Ifnewlycreatedmoneyisused to increase theproductivecapacityof theeconomy, theeffect isunlikely tobe inflationary.However, banks currently direct the vast majority of their lending towards non-productive

investment,suchasmortgagelendingandspeculationinfinancialmarkets.Thisdoesnotincreasetheproductive capacity of the economy, and instead simply causes prices in these markets to rise,drawing in speculators, leading to more lending, higher prices, and so on in a self-reinforcingprocess.Thisisknownasanassetpricebubble.While the increases in asset prices and themoney supplymay create the impression of a healthy,growingeconomy,this‘boom’isinfactfuelledbyanincreasingbuild-upofdebt(sinceallincreasesinthemoneysupplyarearesultofincreasesinborrowing).Thecurrentmonetarysystemthereforesows the seeds of its own destruction – households and businesses cannot take on ever-increasinglevelsofdebt,andwheneitherstart todefaultonloans, itcancauseachainreactionthat leadstoabankingcrisis,awiderfinancialcrisis,andaneconomy-widerecession.Financialcrisesthereforecomeaboutasaresultofbanks’lendingactivities.AsAdairTurner,headoftheUK’sFinancialServicesAuthority,putsit:“Thefinancialcrisisof2007/08occurredbecausewefailedtoconstraintheprivatefinancialsystem’screationofprivatecreditandmoney.”(2012)Theboom-bustcycleisalsocausedbybanks’creditcreationactivities.Somemeasuresimplementedtodampenormitigateagainsttheseeffectshavetheperverseeffectofactuallymakingacrisismorelikely.Depositinsurance,forexample,isintendedtomakethebankingsystem safer but in reality enables banks to take higher risks without being scrutinised by theircustomers. The Basel Capital Accords, again designed to make the system safer, gives banksincentivestochoosemortgagelendingoverlendingtobusinesses,makingassetpricebubblesandtheresultingcrisesmoreratherthanlesslikely.

CHAPTER5:SOCIALANDENVIRONMENTALIMPACTSOFTHECURRENTSYSTEMMuchofthemoneycreatedbythebankingsystemisdirectedintohousing,causinghousepricestorisefasterthantheriseinsalaries.Aswellasmakinghousingunaffordableforthosewhowerenoton thehousing ladderbeforepricesstarted to rise, italso leads toa largenumberofpeopleusingpropertyasanalternativetootherformsofpensionorretirementsavings,withoutthemrealisingtherisingpricesareartificiallyfuelledbytheriseinmortgagelendingandmoneysupply.Thefactthatourmoneyisissuedasdebtmeansthatthelevelofdebtmustbehigherthanitotherwisewouldbe.Theinterestthatmustbepaidonthisdebtresultsinatransferofwealthfromthebottom90%ofthepopulation(byincome)tothetop10%,exacerbatinginequality.Inaddition,anyattemptbythe public to paydown its debtswill result in a shrinkingof themoney supply, usually leading torecessionandmakingitdifficulttocontinuereducingdebt.Thestatecurrentlyearnsaprofit,knownasseigniorage,fromthecreationofbanknotes.However,becauseithasleftthecreationofelectronicmoneyinthehandsofthebankingsector,itisthebanksthatearnaformofseigniorageon97%ofthemoneysupply.Thisisasignificantandhiddensubsidyto the banking sector, and the loss of this seigniorage requires that higher taxes are levied on thepopulation.The instability causedby themonetary systemharms the environment.Theburdenof servicing aninflated level of debt creates a drive for constant growth, evenwhen that growth is harmful to theenvironment and has limited social benefit. When the inevitable recessions occur, regulationsprotecting the environment are often discarded, as is longer-term thinking with regards to thechanges thatneedtobemade.Inaddition, there is littlecontroloverwhatbanks invest in,meaningthattheyoftenoptforenvironmentallyharmfulprojectsoverlonger-termbeneficialinvestments.

Finally, the current monetary system places incredible power in the hands of banks that have noresponsibilityoraccountabilitytosociety.Theamountofmoneycreatedbythebankingsectorgiveitmorepowertoshapetheeconomythanthewholeofourelectedgovernment,yetthereisverylittleunderstandingofthispower.Thisisasignificantdemocraticdeficit.

CHAPTER6:PREVENTINGBANKSFROMCREATINGMONEYItispossibletoremovetheabilityofbankstocreatemoneywithafewrelativelyminorchangestothewaytheydobusiness.Thiswillensurethatbanklendingwillactuallytransferpre-existingmoneyfromsaverstoborrowers,ratherthancreatingnewmoney.Fromtheperspectiveofbankcustomers, littlewillchange,except for the fact that theywillhaveaclearchoicebetweenhavingtheirmoneykeptsafe,availableondemand,butearningnointerest,orhavingitplacedatriskforafixedorminimumperiodoftimeinordertoearninterest.Thespecificchangesmade to thestructureofbankingmake itpossible forbanks tobeallowed tofail,withnoimpactonthepaymentssystemoroncustomerswhooptedtokeeptheirmoneysafe.

CHAPTER7:THENEWPROCESSFORCREATINGNEWMONEYWith banks no longer creatingmoney, an independent but accountable public body, known as theMoneyCreationCommittee (MCC),would instead createmoney.TheMCCwould only be able tocreate money if inflation was low and stable. Newly created money would be injected into theeconomythroughoneoffivemethods,fourofwhichare:a)governmentspending,b)cuttingtaxes,c)directpaymentstocitizensord)payingdownthenationaldebt.Whichofthesemethodsisusedtodistributenewmoneyintotheeconomyisultimatelyapoliticaldecision.Ensuringthatbusinessesareprovidedwithadequatecreditisalwaysaconcernwheneverchangesaremade to theway thatbanksoperate.However, rather than resulting inadamaging fall in thecreditprovided to businesses, the reforms ensure that theBank of England has amechanism to providefunds to banks that can only be used for lending to productive businesses. This fifth method ofinjectingmoney into the economy is likely to boost investment in the real economy and businesssectoraboveitscurrentlevel.

CHAPTER8:MAKINGTHETRANSITIONThe transition from the current monetary system to the reformed system is made in two distinctstages:1)anovernightswitchover,whenthenewrulesandprocessesgoverningmoneycreationandbank lending takeplace, and2) a longer transitionperiod,of around10-20years, as the economyrecovers from the ‘hangover ’ofdebt from the currentmonetary system.Changes aremade to thebalancesheetsof theBankofEnglandandcommercialbanks,andadditionalmeasuresaretakentoensurethatbankshaveadequatefundstolendimmediatelyaftertheswitchoversothatthereisnoriskof a temporary credit crunch (however unlikely). The changes can be made without altering thequantityofmoneyincirculation.Thelonger-termtransitionallowsforasignificantreductioninpersonalandhouseholddebt,asnewmoney is injected into the economy and existing loan repayments to banks are recycled into theeconomyasdebt-freemoney.Thepotentialde-leveragingofthebankingsectorcouldbeinexcessof£1trillion.

CHAPTER9:UNDERSTANDINGTHEIMPACTSOFTHEREFORMS

In the reformed system money enters circulation in one of five ways, with each method havingdifferenteconomiceffects.Asinthecurrentmonetarysystem,moneythatincreasesproductivitywillbenon-inflationary,whilenewmoneythatdoesnotincreaseproductivitywillbeinflationary.Becausebankswillnolongercreatenewmoneywhentheymakeloans,lendingforproductivepurposeswillbedisinflationary,whilelendingforconsumerpurchaseswillhavenoeconomiceffect.AssuchtheBank of Englandwill have to closelymonitor the lending activities of banks when deciding howmuchnewmoneytoinjectintotheeconomy.Lendingforthepurchaseofpropertyorfinancialassetswouldbeself-correcting,insomuchastheeconomyislessabletosustainassetpricebubbles.Asaresultfinancialinstabilitywouldbereduced,whiletheeffectofbankfailuresordeflationismuchmilderthaniscurrentlythecase,duetomoneynolongerbeingcreatedwithacorrespondingdebt.As money is created without a corresponding debt, individuals are able to pay down their debtswithout contracting the money supply. Likewise the government gains an additional source ofrevenue, reducing both the need for taxes and the borrowing requirement. Many of the negativeenvironmentalimpactsofthecurrentmonetarysystemarelessenedinlinewiththereductionoftheboom-bust cycle. In particular, the pressure to remove environmental regulation in downturns isreduced as is the constant need to grow in order to service debt. Likewise, the directed nature ofInvestmentAccountsmeanstheinvestmentprioritiesofbanksstarttoreflecttheinvestmentprioritiesofsociety.Thisalsohaspositiveeffectsondemocracybyreducingthepowerofthebankstoshapesocietyintheirowninterests.Finally,thereformedsystemensuresthatthecreationofmoneyisbothtransparentandaccountabletoparliament.

CHAPTER10:IMPACTSONTHEBANKINGSECTORWithmoneyno longer issuedwhenbanksmake loansorbuyassets,deleveragingof theeconomybecomespossible.Asthelevelofdebtfalls, thebankingsector ’sbalancesheetwillshrink.Becausebankscannowbeallowedtofail,the‘toobigtofail’subsidiesforlargebanksdisappear.However,atthesametimeitbecomesmucheasier forbanks tomanage theircashflow(becauseall investmentsaremade for fixed timeperiodsorhavenoticeperiods), and regulations suchas theBaselCapitalAccords could be simplified when applied to the reformed banking system. An effect of theaccounting changesmade during the transition period is that the ‘liquidity gap’ that is endemic tomodernbankingwouldbesignificantlyreduced,makingbanksmuchsaferinliquidityterms.Thereformsmeanthatthecentralbankwouldhavedirectcontroloverthemoneysupply,ratherthanhavingtoindirectlycontrolitthroughinterestrates.Asinterestrateswouldbesetbythemarkets,thecentralbankwouldnolongerneedtoplaythisrole.From an international perspective, there are no practical implications with regards to how themonetary system connects to those of other countries, and international trade and finance cancontinue as normal. With regards to exchange rates between sterling and other currencies, thecommonfear thatsterlingwouldbeattackedanddevalued ismisguided; thegreater risk is that thecurrencywouldappreciate.However,thedesignofthereformedmonetarysystemensuresthatlargechanges in exchange rates are self-balancing. Finally, the reforms have advantages for nationalsecurity,bymakingthepaymentssystemmorerobust.

CONCLUSIONThereareveryrealchallengesfacingtheworldoverthenextfewdecades,includinglikelycrisesin

foodproduction,climate,energy,andnaturalresources(includingwater).Tofocusondealingwiththeseextremechallenges,itisessentialthatwehaveastablemonetarysystemandarenotdistractedbycrisesthatareinevitableinthecurrentmonetarysystem.Themonetarysystem,beingman-madeandlittlemorethanacollectionofrulesandcomputersystems,iseasytofix,oncethepoliticalwillisthereandoppositionfromvestedinterestsisovercome.Therealchallengesofhowtoprovideforagrowingglobalpopulation,achangingclimate,andincreasinglyscarcenaturalresources,requireamonetary system thatworks for society and the economy as awhole. For that reason, our currentmonetarysystemisnolongerfitforpurposeandmustbereformed.

INTRODUCTION“Ofallthemanywaysoforganisingbanking,theworstistheonewehavetoday.”SIRMERVYNKING

GovernoroftheBankofEngland,2003-2013October25th2010

After the experience of the last few years, few people would disagree withMervyn King’s claimabove. The 2007-08 financial crisis led to massive increases in unemployment and cuts to publicservicesasgovernmentsaroundtheworldwereforcedtobailoutfailingbanks.Whilethecompletecollapseofthefinancialsystemmayhavebeenaverted,sixyearslaterthecountriesatthecentreofthecrisishavestillnotrecovered.Ineconomictermsthepermanentlosstotheworldeconomyhasbeenestimatedatastaggering$60-$200trillion,betweenoneandthreeyearsofglobalproduction.FortheUKthefiguresarebetween£1.8and£7.4trillion(Haldane,2010).Yetwhile the 2007/08 crisiswas undoubtedly a surprise tomany, it would bewrong to think thatbankingcrisesaresomehowrareevents.IntheUKtherehasbeenabankingcrisisonaverageonceevery 15 years since 1945 (Reinhart and Rogoff, 2009), whilst worldwide there have been 147bankingcrisesbetween1970and2011(LaevenandValencia,2012).It seems clear that our banking system is fundamentally dysfunctional, yet for all themillions ofwordsofanalysisinthepressandfinancialpapers,verylittlehasbeenwrittenabouttherealreasonsforwhythisisthecase.Althoughtherearemanyproblemswithbanking,theunderlyingissueisthatsuccessivegovernmentshavecededtheresponsibilityofcreatingnewmoneytobanks.Today,almostallofthemoneyusedbypeopleandbusinessesacrosstheworldiscreatednotbythestateorcentralbanks(suchastheBankofEngland),butbytheprivatebankingsector.Bankscreatenew money, in the form of the numbers (deposits) that appear in bank accounts, through theaccountingprocessusedwhentheymakeloans.InthewordsofSirMervynKing,Governorof theBankofEnglandfrom2003-2013,“Whenbanksextendloanstotheircustomers,theycreatemoneybycreditingtheircustomers’accounts.”(2012)Conversely,whenpeopleusethosedepositstorepayloans,theprocessisreversedandmoneyeffectivelydisappearsfromtheeconomy.Allowingmoneytobecreatedinthiswayaffectsusall.Thecurrentmonetarysystemisthereasonwehavesuchapronouncedanddestructivecycleofboomandbust,anditisthereasonthatindividuals,businessesandgovernmentsareoverburdenedwithdebt.When banks feel confident and are willing to lend, newmoney is created. Banks profit from theinteresttheychargeonloans,andthereforeincentivisetheirstafftomakeloans(andcreatemoney)through bonuses, commissions and other incentive schemes. These loans tend to bedisproportionately allocated towards the financial and property markets as a result of banks’preference for lending against collateral. As a result our economy has become skewed towardsproperty bubbles and speculation, while the public has become buried under a mountain of debt.Whentheburdenofdebtbecomestoomuchforsomeborrowers,theydefaultontheirloans,puttingthe solvency of their banks at risk. Worried about the state of the economy and the ability ofindividuals andbusinesses to repay their loans, all banks reduce their lending, harmingbusinessesacrosstheeconomy.Whenbanksmakenew loans at a slower rate than the rate atwhich their old loans are repaid, the

moneysupplystartstoshrink.Thisrestrictioninthemoneysupplycausestheeconomytoslowdown,leading to job losses,bankruptciesanddefaultsondebt,which lead to further losses for thebanks,whichreactbyrestrictingtheirlendingevenfurther.Thisdownwardspiralcontinuesuntilthebankseventuallyregaintheir‘confidence’andstartcreatingnewmoneyagainbyincreasingtheirlending.We have no hope of living in a stable economywhile the money supply - the foundation of oureconomy - depends entirely on the lending activities of banks that are chasing short-term profits.WhiletheBankofEnglandmaintainsthatithastheprocessofmoneycreationundercontrol,aquickglanceatthegrowthofthebank-issuedmoneysupplyoverthelast40years(shownopposite)callsthisclaimintoquestion.Cashvsbank-issuedmoney,1964-2012

By ceding the power to createmoney to banks – private sector corporations – the state has builtinstabilityintotheeconomy,sincetheincentivesfacingbanksguaranteethattheywillcreatetoomuchmoney(anddebt)until thefinancialsystembecomesunstable.This isaviewrecentlyvindicatedbythechairmanof theUK’sFinancialServicesAuthority,Lord (Adair)Turner,who stated that: “Thefinancial crisis of 2007/08 occurred because we failed to constrain the private financial system’screationofprivatecreditandmoney”(2012).Yet if this instability in the money supply weren’t enough of a problem, newly createdmoney isaccompaniedbyanequivalentamountofdebt.Itisthereforeextremelydifficulttoreducetheoverallburdenofpersonalandhouseholddebtwhenanyattempt topay itdownleads toa reduction in themoneysupply,whichmayinturnleadtoarecession.The years following the recent financial crisis have clearly shown that we have a dysfunctional

banking system. However, the problem runs deeper than bad banking practice. It is not just thestructures, governance, culture or the size of banks that are the problem; it is that banks areresponsibleforcreatingthenation’smoneysupply.It isthisprocessofcreatingandallocatingnewmoneythatneedsfundamentalandurgentreform.This book explores how the monetary system could be changed to work better for businesses,households,societyandtheenvironment,andlaysoutaworkable,detailedandeffectiveplanforsuchareform.

OURPROPOSEDREFORMSWehave littlehopeof living inastableandprosperouseconomywhile themoneysupplydependsentirelyonthelendingactivitiesofbankschasingshort-termprofits.Attempttoregulatethecurrentmonetarysystemareunlikelytobesuccessful–aseconomistHymanMinskyargued,stabilityitselfisdestabilising. Indeed, financial crises are a common feature of financial history, regardless of thecountry,government,oreconomicpoliciesinplace:Criseshaveoccurredinrichandpoorcountries,underfixedandflexibleexchangerateregimes,goldstandardsandpurefiatmoneysystems,aswellas a huge variety of regulatory regimes. Pretty much the only common denominator in all thesesystemsisthatthebankshavebeenthecreatorsofthemoneysupply.AsReinhartandRogoff(2009)putit:“Throughouthistory,richandpoorcountriesalikehavebeenlending,borrowing,crashing--andrecovering-- theirwaythroughanextraordinaryrangeoffinancialcrises.Eachtime, theexpertshavechimed,'thistimeisdifferent',claimingthattheoldrulesofvaluationnolongerapplyandthatthenewsituationbearslittlesimilaritytopastdisasters.”

Ratherthanattempttoregulatethecurrentmonetarysystem,insteaditisthefundamentalmethodofissuingandallocatingmoneythatneedstochange.TheseproposalsarebasedonplansinitiallyputforwardbyFrederickSoddyinthe1920s,andthensubsequentlybyIrvingFisherandHenrySimonsintheaftermathoftheGreatDepression.Differentvariationsoftheseideashavesincebeenproposedby Nobel Prize winners including Milton Friedman (1960), and James Tobin (1987), as well aseminenteconomistsLaurenceKotlikoff(2010)andJohnKay(2009).Mostrecently,aworkingpaperby economists at the InternationalMonetary Fundmodelled Irving Fisher ’s original proposal andfound“strongsupport”forallofitsclaimedbenefits(Benes&Kumhof,2012).While inspiredbyIrvingFisher ’soriginalworkandvariantsonit, theproposals in thisbookhavesome significant differences. Our starting point has been the work of Joseph Huber and JamesRobertsonintheirbookCreatingNewMoney(2000),whichupdatedandmodifiedFisher ’sproposalstotakeaccountofthefactthatmoney,thepaymentssystemandbankingingeneralisnowelectronic,rather thanpaper-based.Thisbookdevelops these ideasevenfurther,strengthening theproposal inresponsetofeedbackandcriticismfromawiderangeofpeople.Therearefourmainobjectivesofthereformsoutlinedinthisbook:

1. Tocreateastablemoneysupplybasedontheneedsoftheeconomy.Currentlymoneyiscreatedbybankswhentheymakeloans,drivenbythedrivetomaximisetheirprofit.Underourproposals,themoneysupplywouldbeincreasedordecreasedbyanindependentpublicbody,accountable toParliament, inresponseto thelevelsof inflation,unemploymentandgrowthintheeconomy.Thiswouldprotecttheeconomyfromcreditbubblesandcrunches,andlimitmonetarysourcesofinflation.

2. Toreducetheburdenofpersonal,householdandgovernmentdebt.Newmoneywouldbe created free of any corresponding debt, and spent into the economy to replace theoutstanding stock of debt-based money that has been issued by banks. By directing newmoney towards the roots of the economy - the high street and the real (non-financial)economy - we can allow ordinary people to pay down the debts that have been built upunderthecurrentmonetarysystem.

3. Tore-alignriskandreward.Currently the government (and therefore theUK taxpayer)promises to repaycustomersup to£85,000ofanydeposits theyholdat abank that fails.Thismeansthatbankscanmakeriskyinvestmentsandreaptherewardsiftheygowell,butbeconfidentofabailoutiftheirinvestmentsgobadly.Ourproposalswillensurethatthoseindividualsthatwanttokeeptheirmoneysafecandoso,atnorisk,whilethosethatwishtomake a return will take both the upside and downside of any risk taking. This shouldencouragemoreresponsiblerisktaking.

4. Toprovideastructureofbankingthatallowsbankstofail,nomattertheirsize.Withthecurrentstructureofbankingnolargebankcanbepermittedtofail,astodosowouldcreateeconomic chaos. Simple changes outlined in this bookwould ensure that banks could beliquidatedwhileensuringthatcustomerswouldkeepaccesstotheircurrentaccountmoneyatalltimes.Thechangesoutlinedactuallyreducethelikelihoodofbankfailure,providingadditionalprotectionforsavers.

Inorder toachieve theseaims, thekeyelementof the reforms is to remove theabilityofbanks tocreatenewmoney(intheformofbankdeposits)whentheyissueloans.Thesimplestwaytodothisistorequirebankstomakeacleardistinctionbetweenbankaccountswheretheypromisetorepaythecustomer ‘on demand’ or with instant access, and other accounts where the customer consciouslyrequeststheirfundstobeplacedatriskandinvested.Currentaccountsarethenconvertedintostate-issuedelectroniccurrency,ratherthanbeingpromisestopayfromabank,andthepaymentssystemisfunctionally separated from the lending side of a bank’s business. The act of lending would theninvolvetransferringstate-issuedelectroniccurrencyfromsaverstoborrowers.Bankswouldbecomemoney brokers, rather thanmoney creators, and themoney supply would be stable regardless ofwhetherbanksarecurrentlyexpandingorcontractingtheirlending.Taken together, the reforms end the practice of ‘fractional reserve banking’, a slightly inaccurateterm used to describe a banking system where banks promise to repay all customers on demanddespitebeingunabletodoso.Inlate2010MervynKingdiscussedsuchideasinaspeech:“Amore fundamental, example [of reform]would be to divorce the payment system from riskylending activity – that is to prevent fractional reserve banking … In essence these proposalsrecognise that if banks undertake risky activities then it is highly dangerous to allow such‘gambling’totakeplaceonthesamebalancesheetasisusedtosupportthepaymentssystem,andother crucial parts of the financial infrastructure. And eliminating fractional reserve bankingexplicitly recognises that the pretence that risk-free deposits can be supported by risky assets isalchemy. If there is a need for genuinely safe deposits the onlyway they can be provided,whileensuring costs and benefits are fully aligned, is to insist such deposits do not coexistwith riskyassets.”(King,2010)

Afterdescribingthecurrentsystemasrequiringabeliefin‘financialalchemy’,Kingwentontosaythat,“Forasocietytobaseitsfinancialsystemonalchemyisapooradvertisementforitsrationality.”

Indeed,overthenextfewchaptersweexpectreaderstofindthemselvesquestioningthesanityofourexistingmonetarysystem.

THESTRUCTUREOFTHISBOOKPart1:TheCurrentMonetarySystemChapter1providesabriefhistoryofmoneyandbankinganddescribestheemergenceofthemonetarysystemwehavetoday.Chapter2describeshowthecurrentmonetarysystemworksandhowcommercialbanksareabletocreatethenation'smoneysupply.Chapter3considersthewiderangeofinfluencesthataffectthatamountofmoneythatthebankscreate.Chapter4analysestheeconomiceffectsofthecurrentmonetarysystem.Chapter5looksatthesocialandecologicalimpactsofthecurrentmonetarysystem.Part2:TheReformedMonetarySystemChapter6describesthechangesthatmustbemadetotheoperationsofbanksinordertoremovetheirabilitytocreatemoney.Chapter7describeshownewmoneywillinsteadbecreatedbyapublicbody,andhowthatmoneywillbeputintotheeconomy.Chapter8outlinesthetransitionbetweenthecurrentsystemandreformedsystem(withfurthertechnicaldetailsprovidedinAppendixIII).Chapter9coversthelikelysocial,economicandenvironmentalimpactsofamonetarysystemwheremoneyisissuedsolelybythestate,withoutacorrespondingdebt.Chapter10considersthelikelyimpactofthesereformsonthebankingandfinancialsector.

CHAPTER1ASHORTHISTORYOFMONEY

Inthischapterweoutlineabriefhistoryofmoneyandbanking.Westartbylookingatthetextbookhistory of the origins of money, before examining the alternative accounts of historians andanthropologists,whichcontradictthetextbookhistory.WethendiscussthedevelopmentofbankingintheUnitedKingdomanditsevolutionuptothepresentday.

1.1THEORIGINSOFMONEY

AtextbookhistoryThestandardtheoryoftheoriginsofmoney,commonlyfoundineconomicstextbooks,wasperhapsfirstputforwardbyAristotle(in“Politics”)andrestatedbyAdamSmithinhisbook“TheWealthofNations”(1776).AccordingtoSmith’sstory,moneyemergednaturallywiththedivisionoflabour,asindividuals found themselveswithoutmanyof thenecessities they requiredbutat the same timeanexcessoftheirownproduce.Withoutameansofexchangeindividualshadtoresorttobarterinorderto trade,whichwas problematic as both sides of the deal had to have something the other personwanted (the “double coincidence of wants”). To avoid this inconvenience people began to acceptcertain typesof commodities for their goods and services.These commodities tended to have twospecific characteristics. First, themajority of people had to find themvaluable, so that theywouldaccepttheminexchangefortheirgoodsorservices.Secondly,thesegoodshadtobeeasilydivisibleinto smaller units in order to make payments of varying amounts. It is suggested that as metalsatisfiedbothrequirements,itnaturallyemergedascurrency.However,metalhadtobeweighedandchecked for purity every time a transaction was made. Governments thus began minting coins inordertostandardisequantitiesandensurepurity.Therefore,inAdamSmith’sstory,certaincommoditiescometobeusedasmoneyduetotheiruniquecharacteristics.Ineffectmoneywassimplyatokenthatservedtooilthewheelsoftrade.Moneycanbethoughtofassimplya‘veil’overbarter,maskingthefactthatpeoplearestilljustexchangingonegoodorserviceforanother.Consequently,doublingthesupplyofmoneywouldsimplycausepricestodouble,soinrealtermsnoonewouldbeanybetterorworseoff.Writingin1848,JohnStuartMillstatedtheconsensusview,whichisstillcommontoday:“Therecannot,inshort,beintrinsicallyamoreinsignificantthing,intheeconomyofsociety,thanmoney; except in the character of a contrivance for sparing time and labour. It is amachine fordoing quickly and commodiously, whatwould be done, though less quickly and commodiously,without it: and like many other kinds of machinery, it only exerts a distinct and independentinfluenceofitsownwhenitgetsoutoforder.”

Inthisview,bankscomeonthescenemuchlateron,initiallyasplaceswherepeoplecouldkeeptheircoinssafe.Thesebanks thenstart to lend thecoins thathavebeendepositedwith them.Yetbecausemoney is simply another physical commodity, this lending has no real effects; rather, it merelytransfersresourcesfromonepersontoanother:“Often is an extension of credit talked of as equivalent to a creation of capital, or as if creditactuallywerecapital. Itseemsstrangethat thereshouldbeanyneedtopointout, thatcreditbeingonlypermissiontousethecapitalofanotherperson,themeansofproductioncannotbeincreased

by it, but only transferred. If the borrower ’smeans of production and of employing labour areincreasedby thecreditgivenhim, the lender ’sareasmuchdiminished.Thesamesumcannotbeusedascapitalbothbytheownerandalsobythepersontowhomitislent:itcannotsupplyitsentirevalueinwages,tools,andmaterials,totwosetsoflabourersatonce.”(Mill,1909)

Soin thisorthodoxview,banksaremerefinancial intermediaries,passivelywaitingfordepositorsbefore lending.By lendingabank transferspurchasingpower fromone individual toanother, andthustheyhavenospecialsignificancefortheeconomy.fig.1.1-Commonconceptionofbanking

Thishypothesishasbeenwidelyperpetuatedbyeconomistsandineconomicmodelsupuntil today.Money,banksanddebtarebelievedtohavenomacroeconomiceffectotherthanto‘oilthewheels’oftradeandsocanbeignoredwhenconsideringtheworkingsoftheeconomy.Thisbeliefmeansthattodayhardlyanyeconomicmodelshaveaplaceforbanks,moneyordebt.Asaresult,evenafterthe2007-2008 financial crisis,NobelPrize1winning economists have beenknown tomake statementssuchas“I’mallforincludingthebankingsectorinstorieswhereit’srelevant;butwhyisitsocrucialtoastoryaboutdebtandleverage?”(Krugman,2012).ThehistoricalrealityTheproblemwiththeideathatmoneyemerged‘spontaneously’frombarteristhat,inthewordsofanthropologistDavidGraeber,“there’snoevidencethatiteverhappened,andanenormousamountof evidence suggesting that it did not”. (2011, p. 29)2 As Graeber explains, the historical andanthropologicalevidenceindicatesthatbeforetheexistenceofmoneypeopledidnotengageinbartertradeswitheachother.Rather,goodswerefreelygivenwiththecaveatthatthepersonreceivingthemwouldhavetoreturnthefavouratsomepoint.Forexample,inmanytribalsocietiestheconceptofhavingpossessionsand‘owning’ thingscoulddisruptgroupharmony,but theycouldalsopromotesocialcohesionthroughacultureofgiftgiving.Likewise,inpre-monetarycomplexsocieties,certainconventionsemergedenablingindividualstoshowthattheydesiredsomebodyelse’spossession,withthepossessorthengivingthepossessionasagift,toestablishabondofobligationtobereciprocatedinduecourse.So,ratherthanexchangethroughbarter,earlysocietiesinsteadusedavaguelydefinedsystemofdebtsandcredits.Thequantificationofthesedebtsandcredits–thefirststepinthedevelopmentofmoneyasaunitofaccount–isthoughttohavecomeaboutasaconsequenceofthereactionofsocietiestodisputesand

feuds,specificallytheattemptstopreventthemfromturningintomattersoflifeanddeath.AccordingtoGraeber:“the first step toward creating realmoney comeswhenwe start calculatingmuchmore specificdebtstosociety,systemsoffines,fees,andpenalties,orevendebtsweowetospecificindividualswhowehavewrongedinsomeway…eventheEnglishword"topay"isoriginallyderivedfromawordfor"topacify,appease"–asin,togivesomeonesomethingprecious,forinstance,toexpressjusthowbadlyyoufeelabouthavingjustkilledhisbrotherinadrunkenbrawl,andhowmuchyouwouldreallyliketoavoidthisbecomingthebasisforanongoingblood-feud.”

Ratios betweenvarious commoditieswere thus established tomeasurewhether a gift or grievancehad been adequately compensated, and over time, gifts and counter-gifts became quantifiable ascreditsanddebts.Inasensethiscreatedmoneyasaunitofaccount(althoughitdidn’texistinphysicalform). This directly contradicts the orthodox story,which states thatmoney emerged from barter,whichitselfwasdrivenbymarketforces.SimilarevidenceispresentedbyeconomistandhistorianMichael Hudson, who traces the emergence of money as a unit of account to the Mesopotamiantempleandpalaceadministrationsin3500BC:“It did not occur ... to Aristotle ... that specialization developed mainly within single largehouseholds of chieftains in tribally organised communities ... Such households supported non-agriculturallaborwithrationsratherthanobligingeachprofessiontomarketitsoutputinexchangeforfood,clothingandotherbasicnecessities.Administratorsallocatedrationsandrawmaterialinkeepingwithwhatwasdeemednecessaryforproductionandforceremonialandotherinstitutionalfunctions rather than resorting to private-sector markets, which had not yet come into being.”(Hudson,2004)

Moneyintheformofpreciousmetalsshapedintocoinscamemuchlater,appearinginthreeseparateplaces(northernChina,northeastIndia,andaroundtheAegeanSea)betweenaround600and500BC.During thisperiod,“warand the threatofviolence [was]everywhere”,andasGraeberdetails, thiswas theprimaryreasonfor theshift fromtheconvenientcreditanddebtrelationships to theuseofpreciousmetalsasmoney:“Ontheonehand,soldiers tend tohaveaccess toagreatdealof loot,muchofwhichconsistsofgoldandsilver,andwillalwaysseekawaytotradeitforthebetter thingsinlife.Ontheother,aheavilyarmeditinerantsoldieristheverydefinitionofapoorcreditrisk.Theeconomists’barterscenariomightbeabsurdwhenappliedto transactionsbetweenneighbors in thesamesmallruralcommunity, butwhendealingwith a transactionbetween the resident of such a community and apassingmercenary,itsuddenlybeginstomakeagreatdealofsense…“Asa result,while credit systems tend todominate inperiodsof relative social peace, or acrossnetworks of trust (whether created by states or, in most periods, transnational institutions likemerchantguildsorcommunitiesoffaith),inperiodscharacterizedbywidespreadwarandplunder,theytendtobereplacedbypreciousmetal.”(Graeber,2011,p.213)

Jewellers soonbegan stamping thesepreciousmetalswith insignia, and in sodoing created coins.However this privatemoneywas almost immediately superseded by coinsmanufactured by rulerswhointroducedthecoinsintocirculationbypayingtheirarmieswiththem.Theythenleviedataxonthe entire population payable only in those coins, thus ensuring they were accepted in generalpayment.Ultimately,theevidenceoutlinedbyhistoriansandanthropologistsheresuggeststhat:

“Our standardaccountofmonetaryhistory ispreciselybackwards.Wedidnotbeginwithbarter,discovermoney, and then eventually develop credit systems. It happened precisely the otherwayaround.Whatwenowcallvirtualmoneycamefirst.Coinscamemuch later,and theirusespreadonlyunevenly,nevercompletely replacingcredit systems.Barter, in turn,appears tobe largelyakindofaccidentalby-productoftheuseofcoinageorpapermoney:historically,ithasmainlybeenwhat peoplewho are used to cash transactions dowhen for one reason or another they have noaccesstocurrency.”(Graeber,2011,p.40)

1.2THEEMERGENCEOFBANKINGThefirstbanksThe earliest prototype banks were probably associated with the temple and palace complexes ofancientMesopotamia,wherethetempleadministratorsmadeinterestbearingloanstomerchantsandfarmers.3BythefourthcenturyBCinGreece,amoremodernformofbankinghaddeveloped(whichitself had probably developed from the activities of the moneychangers). In addition to lending,Athenianbankerswereengagedindeposittaking,theprocessingofpaymentsandmoneychanging.WhileRomanbankingdevelopedafewhundredyearslaterthanAthenianbanking,itsactivitieswerelargelyconfinedtothefinancingoflandpurchases.HoweverafterthecollapseoftheWesternRomanEmpire in the5thcenturyADthewidespreaduseofcoinsandbanking largelydiedout inWesternEurope as the population reverted to peasant farming and local production, with trade conductedlargelyoncredit.Meanwhile,thecontroloftradeandofmoneypassedtotheEasternRomanEmpire.Deposit banking was only able to resume in Western Europe in the 12th century followingimprovements in numeracy, literacy, and financial and trade innovations4 that came about after anincrease in available coinage5 led to a resurgence in international trade (Spufford, 2002). In thisenvironment the moneychangers prospered, and adopted the merchant companies' practice ofaccepting deposits. By also holding deposits with each other, their customers were able to makecashlesspaymentsbetweeneachother(evenwhenthistookaccountsintooverdraft)(Spufford,2002).Depositbanking,asithadbeenpractisedbytheAthenians,wasthusrediscovered.BankinginEnglandInmediaevalEngland,therewerenoprivatemoneychangersforbankstodevelopoutof,sincethiswas a royal monopoly associated with the mints (Spufford, 2002). The monopoly had howeverbecomeerodedover time,asCharlesIattempted torevive it in1627,butwas left to“fumeinvainagainst thegrowingpowerof thegoldsmithswhohad ‘leftoff theirproper tradeand turned [into]exchangers of plate and foreign coins for ourEnglish coins, though they had no right.’” (Davies,1994)Thesegoldsmithsofferedsafekeepingfacilitiestomerchantsandthepublicforcoins,bullionandothervaluables.Anycoinsdepositedforsafekeepingwithgoldsmithswereacknowledgedwithanotepromisingtopayoutanequivalentsum.Providedthat thegoldsmith’snamewastrustedintheareawheretheyoperated,holdingagoldsmith’spromissorynotebecameconsideredtobeasgoodashavingtheactualcoinsinhand,astherewascompleteconfidencethattheholderofthenotewouldbeabletogetthecoinsfromthegoldsmithasandwhentheyneeded.Asaresult,peoplebegantoacceptthe promissory notes as money, in place of coins, and would rarely come back to the bank towithdrawthecoinsthemselves:“…the crucial innovations inEnglish bankinghistory seem to havebeenmainly theworkof thegoldsmithbankersinthemiddledecadesoftheseventeenthcentury.Theyaccepteddepositsbothon

currentand timeaccountsfrommerchantsand landowners; theymade loansanddiscountedbills;abovealltheylearnttoissuepromissorynotesandmadetheirdepositstransferableby‘drawnnote’or cheque; so creditmight be created either bynote issueor by the creationof deposits, againstwhich only a proportionate cash reserve was held.” (Joslin, 1954, as quoted in He, Huang, &Wright,2005)

Havingnoticedthattheirnoteswerenowbeingusedtotradeinplaceofcoinsandthatthebulkofthecoins deposited in their vaultswere never taken out, the goldsmiths saw a profit opportunity: theycouldissueandlendadditionalpromissorynotes(whichwouldbeseenbytheborrowerasaloanofmoney)andchargearateofinterestontheloan.Thegoldsmithshadmanagedtocreateasubstituteformoney,andintheprocessbecomebanks.fig.1.2-Banknoteslikethefollowing(from1889)begantobephasedoutfollowingtheBankCharterActin1844

Oneoftheprincipalborrowersfromthegoldsmithbankswasthesovereign.In1640,CharlesIhadshockedthebankingsystembyborrowingbullionthatmerchantshaddepositedattheRoyalMint,intheprocessdestroying theMint's reputationas a safeplaceof custodyandalsodamaginghisowncreditrating.Thirtytwoyearslaterhisson,CharlesII,suspendedalmostallrepaymentofsovereigndebtsinordertofinanceanavalexpeditionagainsttheDutch(Kindleberger,2007).Theharmtothesovereign’screditratingoftheseepisodesindirectlyledtothefoundingoftheBankofEngland,asthestatewasforcedtodevelopnewwaysoffinancingitself.ThefoundingoftheBankofEnglandIn 1688Charles II's successor, James II,was deposed in the ‘GloriousRevolution’ andParliamentofferedthecrowntohisdaughterMaryandherhusbandtheDutchPrinceWilliamofOrange.Withthe newKing andQueen camewarwith France,which in 1690 led to a crushing naval defeat forBritain at theBattle ofBeachyHead. In order to rebuildBritain’s navy, the government needed to

raise £1.2million.To induce subscriptions to the loan, the subscriberswere to be incorporated asshareholdersofanewjointstockbank,theBankofEngland,whichwouldbeauthorisedtoissuebanknotes(uptotheamountofthefund)andtakedeposits.Theshareissuewasfullysubscribedwithin14days.Nevertheless,thegovernment’staxrevenuewasstillnotenoughtocoveritsdebts.Thegovernmentreacted by passing a Bill (in 1697) permitting the Bank to issue new shares in exchange forsubscribers'ownholdingsofgovernmentdebt(80%)andBankofEnglandnotes(20%).Asaresultthe Bank was further authorised to issue banknotes up to the total amount raised from the newsubscribers (of £1,001,171) (Davies, 1994, p. 261), with the notes to be underwritten by thegovernment.TheBankwasalsograntedamonopolyasabankingcorporationand limited liabilityfor its shareholders,whilst the goldsmithswere all partnershipswith unlimited liability.TheBankwasthusestablishedasaprincipalmanagerofpartatleastofthegovernmentdebt.ManyoftheBank'searlydepositorswerethegoldsmithbanks,inspiteoftheirhostilitytowardstheirnewcompetitor.6Thesebankshadfoundthatthenotesthattheyissuedwouldoftenbepaidacrosstocustomersofotherbanks,whowoulddepositthemwiththeirownbanks.Bankerswouldperiodicallymeettoexchangethenotestheyhadreceivedforthosethattheyhadthemselvesissued,andsettleanydifferences in coin.They soon found that itwasmore convenient to settle usingBank ofEnglandnotes,ratherthancarryinglargeamountsofcoinstotheirsettlementmeetings:“[S]ometime between the Bank of England’s foundation (1694) and the 1770s, London bankersswitched fromsettling in specie [coins] to settling inBankofEnglandnotes.Suchclaimswereasuperiorformofmoneytothenotesofanyotherbank.TheprimaryreasonforthiswastheBank’sfinancialstandingrelativetootherbanks.Thisarosefromthelegalprivilegeofbeingtheonlyjointstockbankallowedtoissuenotes,whichenabledittoexpanditsnoteissueandgeneratewidespreadacceptability for its notes.BankofEnglandmoneywaswidelyusedas the settlement asset, sincecountry banks settled inter-regional payments via correspondent relationships which ultimatelysettledviatheLondonclearingarrangements.AndtheformalprovincialclearingsestablishedlaterinthenineteenthcenturysettledacrossaccountsatthelocalbranchoftheBankofEngland(asforexampleinManchester,thelargestprovincialclearing).”(Norman,Shaw,&Speight,2011)

TheBankofEnglandhadbeguntotakeonitsroleasbankertothebankingsystemanditsliabilities(banknotes)hadstartedtobeusedbyotherbanksasasettlementasset.CountrybankingandtheBankCharterActThesilverrecoinageof1696(seefootnote6)wasnotrepeatedandasaresultBritain’ssilver(andcopper) coins quickly deteriorated in quality.7 In addition, therewas a constant draining of silverfromthecountryduetoboththemintpriceofsilverbeingsetbelowthemarketprice,aswellastherequirementsof foreign trade.Thiswasproblematicasat the time itwas silver,notgold, thatwasconsidered the monetary standard. By the 1770s, employers outside London were finding itincreasinglydifficult to acquire sufficient coins topay theirworkers, and resorted to issuing theirown tokens or credit notes. This ledmany into the business of banking and the creation of papermoney.AftertheendoftheNapoleonicWarsin1815,tradeandthedemandforfinanceincreased.Likewisethe opening up of South America and the Industrial Revolution sparked a wave of speculation incompany start-ups, leading to increasingly reckless lending (and so banknote creation) and theinevitablewaveofbankfailuresandcrisesfrom1825to1839(whentheBankofEnglandwasforced

toreplenishitsgoldreservesbyborrowingfromFrance).Blameforthecollapsewasplacedatthetimeonbanknoteover-issuebythecountrybanks.Inresponsetothesecrises,theConservativegovernmentofthedayissuedthe1844BankCharterAct,whichcurtailedtheprivatesector ’srighttoissuebanknotes(andeventuallyphaseditoutaltogether).TherighttoissuepapermoneybecamethesoleprerogativeoftheBankofEngland(althoughsomeScottish and Irish banks were given permission to effectively ‘rebrand’ Bank of England notes).However,the1844BankCharterActaddressedonlythecreationofpaperbanknotes–itdidnotrefertoother substitutes formoney, suchasbankdeposits,whichweresimplyaccountingentrieson theliabilities side of the banks’ balance sheets. Banks had retained, albeit imperfectly, their ability tocreatesubstitutesthatcouldfunctionasmoney.Inordertomakethemostoftheirmoneycreationpowers,bankswereforcedtoinnovateinordertofindwaysaroundthenewlegislation.Theuseofchequesbecamecommonastheymadeiteasierforbusinesses and individuals to make payments to each other using bank-created money (bankliabilities, or ‘deposits’) in place of cash.At the same time, the development ofwholesalemoneymarkets(wherebankscouldborrowfromeachother)andthewillingnessoftheBankofEnglandtoprovide fundsondemand tobanks ingoodhealth, further reduced theamountofBankofEnglandmoneythatbanksneededtohold,relativetotheircustomerdeposits:“[C]entral bankshave facilitated settlement in central bankmoneyby allowing low-cost transfersacrosstheirbooks,eitherofgrossamounts(aboveallforwholesalepayments,facilitatingthisbyproviding banks with cheap intraday liquidity) or ofmultilateral net amounts (more usually forretail payments, minimising the amount of liquidity that participating banks need to hold).”(Norman,Shaw,&Speight,2011)

Theendresultoftheseinnovationswasthatbankscontinuedtocreatemoney.AsKindleberger(2007)explains,“TheBankActof1844hadrestrictedbanknotesbutnotbillsofexchangeorbankdepositsandtheseexpandedinEnglandbylargeamounts”.Finally,in1866afinancialcrisisbroughtonbythefailureoftheOverend,Gurney&CompanyBank(towhomtheBankofEnglandhadrefusedanemergency loan) led to theBankofEnglandfinallyacceptingtheresponsibilityoflenderoflastresort.Upuntilthatpointithadoftenrefusedtointerveneandprovideemergencyloanstostrugglingbanks,withtheresultthatcriseswereoftenexacerbated.Byagreeingtobethelenderoflastresort,theBankofEnglandprovidedafurtherguaranteetobanksthatfundingwouldbeavailableshouldtheyneedit,limitingthedownsidestothemofoverextendingthemselves.TheBankofEnglandhadthustakenonalltherolesofamoderncentralbank,responsiblesinceitsinceptionforraisingmoneytolendtothegovernment(1694),assumingmanagementofpartofthegovernmentdebt(1697),providingthroughitsnoteissueanddeposit-takingservicesthemeansforotherbankstoclearpaymentsbetweenthemselves(by1770),andstandingaslenderoflastresortforthebankingsector(1866).Asthenineteenthcenturyprogressedandcommerceandinternationaltraderocketed, othermajor countries also developed central banks with similar functions.. This systemcameintofullusewithinthemajoreconomiesin1913withtheestablishmentoftheFederalReserveBank(‘theFed’)intheUnitedStates,ayearbeforetheoutbreakoftheFirstWorldWar.ThegoldstandardThegoldstandardranfrom1717to1931inBritain,thoughtherewereshortsuspensionsfrom1797to1819and1914to1925.8TheCoinageActof1816redefinedthepoundsterlingasbeingthevalue

of113grainsofpuregold(about7.3grams).In1914,toconservestocksofgoldneededtofinancethe war effort, convertibility of banknotes was suspended and gold coins were withdrawn fromcirculation.Toreplacethesovereignsandhalf-sovereignstheTreasuryissueditsownonepoundandtenshillingnoteschristened‘Bradburys’.Since1826theBankofEnglandhadbeenbarredfromissuingnoteslowerthan£5.Thisprohibitionagainstissuingsmalldenominationbanknoteswasliftedin1928andtheTreasurynotes(Bradburys)weretransferredtotheBankofEnglandandconvertedtobanknotes.The1928ActalsoauthorisedtheBanktoissuebanknotesbackedbygovernmentdebt,ratherthanbygoldandtousethesenotesratherthangoldcoinstoredeemitshigher-denominationbanknotesondemand.In1925, theUKhad returned to thegold standardat the rate set in1816,whichoverpricedBritishexportsbyabout10%sparkingasevere recession,ashortgeneralstrike,andaprotractedminers’strike.Bytheendofthatdecadethefinancialsystemandtheglobaleconomywithithadcollapsed,onceagainasaresultofanassetbubblecreatedbyexcessivecommercialbanklending(intothestockmarket).Goldconvertibilitywassuspendedagainandforthelasttimein1933,withthepoundlefttofloat(finditsownlevelagainstothercurrencies).Towards theendof the1930s,economies in theWestbegantorecover throughgovernmentdeficitspending:civicreconstructionintheUSandre-armamentintheUKandEurope.HalfadecadelaterastheSecondWorldWardrewtoaclose,anewarrangementwasagreedsuchthatallnationalcentralbanks would hold accounts at the US Federal Reserve Bank, and the Fed would settle paymentsbetween accounts, which were redeemable, if necessary, in gold. This was the Bretton Woodsagreement.Nationsagreedtomanagetheircurrenciestomaintainafixedexchangerateagainst thedollar, and America agreed to fix the dollar against gold. Maintenance of the Bretton Woodsexchangeratesshiftedfocusontotheflowofcapitalintoandoutofcountries.Topreventtheseflowsinterferingwiththefixedexchangerates,theUKusedacombinationofcapitalcontrols(tolimittheoutflows due to the acquisition of foreign assets), quantitative and qualitative restrictions on banklending,andcontrolofinterestrates(tolimittheavailabilityanddemandfordomesticcreditwhichcouldfuelimports).Despite the huge government deficits run up during the war, the destruction of large swathes ofEurope,andahighlyrepressedfinancialsystem,from1945to1971growthwasuniformlyhighandunemploymentverylow.Forthesereasonsthisperiodiscommonlyreferredtoasthegoldenageofcapitalism.FloatingexchangeratesBetween1945and1971anewdynamicdeveloped.Byinternationalagreement,oilhadalwaysbeenpricedinUSdollarsandasaconsequencetheoilexportingnationsoftheMiddleEasthadamassedasubstantial surplus of dollars, investedmainly inUSGovernment securities (bonds). By 1965, theFrench President, Charles de Gaulle, was decrying the world’s dependence on the US dollar andcallingforareturntoanationalgoldstandard,andin1971SwitzerlandandFranceeachdemandedredemptioningoldofitscentralbank’sholdingsofdollars.America,fearingasimilarcallfromtheMiddleEast,declareditwouldnolongerredeemdollarholdingsforgold,defaultingonitsBrettonWoodsobligationsandleadingtothecollapseoftheBrettonWoodssystem.Thefinallinkbetweennationalcurrenciesandgoldwastherebyabolished.The oil-exporting nations of theMiddle East retaliated by cutting production and quadrupling thepriceofoil (resulting in the1973oilcrisis),whilstothercountries struggled tomaintain the fixed

exchangeratestheyhadagreedatBrettonWoods.Adecadeofeconomicchaosensued.Bytheendofthe 1980s the current system had emerged, whereby the major trading currencies floated freelyagainst each other. Minor currencies were either fixed informally against one of the majors orabandonedinfavourofcurrencyunion.Meanwhile, in1971 theBankofEngland introduced ‘Competition andCreditControl’.Thiswas apackageofregulatoryreformsthatremovedtheceilingsonbanklendingandreducedtheamountofliquidassetsbankshadtoholdagainsttheirdepositsfrom28%to12.5%(SeeFigure1.3).9Aspartofthereforms,thefocusswitchedfromusingdirectcontrolstotargettherateofgrowthofthemoneystock(i.e.banklending)tousinginterestrates.Consequently:“This combination of regulatory and economic factors coincided with one of the most rapidperiodsofcreditgrowthinthe20thcentury…Italsocontributedtoanongoingdeclineinbanks’liquidity holdings, ultimately to below 5% of total assets by the end of the 1970s.” (Davies,Richardson,Katinaite,&Manning,2010)

Sincethe1980sthefocusofmonetarypolicyhasswitchedtothecontrolofconsumerpriceinflationviatheuseofinterestrates.Meanwhile,furthertechnologicaladvances,suchastheadoptionofdebitandcreditcardsandelectronicfundtransfers,havelessenedthepublic’srelianceoncashasameansofpayment,withbankstodayneedingtoholdonlyatinyamountofcashrelativetothetotalbalancesofcustomers’accounts.Likewise,theyfacelittlerestrictionontheirabilitytocreatenewmoneybymaking loans (for reasons explained inChapter 3). Consequently, almost allmoney in circulationtodaytakestheformofdepositscreatedbyprivatebanksintheprocessofmakingloans.Thefollowingchapterwilldescribethepresentdaymonetarysystemingreaterdetail.fig.1.3-SterlingliquidassetsrelativetototalassetholdingsoftheUKbankingsector

(a)Databefore1967coveronlytheLondonclearingbanks.(b)Cash+BankofEnglandbalances+moneyatcall+eligiblebills+UKgilts.(c)BankofEnglandbalances+moneyatcall+eligiblebills.(d)Cash+BankofEnglandbalances+eligiblebills.

Source:BankofEngland,BankersMagazine(1960-68)andBankcalculations.

Footnotes1.Technically,thereisnosuchthingasaNobelPrizeineconomics.Officiallytheprizeisreferredtoasthe‘SverigesRiksbankPrizeinEconomicSciencesinMemoryofAlfredNobel’.2.Thisisnottosaythatbarterdoesnotexistorhasnotexistedinthepast,merelythatmoneydidnotemerge from it. In reality, barter tends to happenonlybetweenpeoplewho are strangers (i.e. theyhavenoongoingrelationship),or isrevertedtoamongstpeoplewhoareusedtocashtransactions,but forwhatever reasonhave no currency available, such as those in prisoner ofwar camps. (SeeRadford(1945)forafascinatingexample.)3.However, problems emergedwith this system.When the harvests failed the loanswould not berepaid:everyonewouldstartfallingintodebttraps(anddebtslavery).Thesocialunrestthiscreatedwouldbesogreatthattheonlywaytostopsocietybreakingdown(ortherulersbeingoverturned)wouldbetoperiodicallyforgiveeveryonetheirdebts–adebtjubilee.4.Theseinnovationsincluded:courierservicestoconveymessages;carrierservicesforthetransportof goods; double entry bookkeeping; the extension of joint enterprises for longer durations(previously these had been established for single ventures and then dissolved); the accepting ofdepositsbybusinessesforfundingpurposesandthepaymentofinterestonthem(ratherthanashareintheprofits);andbillsofexchange(whichallowedlocalpaymentstobemadewithouttheneedtotransportcoinsorbullion).5.Includinga24-foldincreaseinEnglandbetweenthemid1100sand1319.6.Thegoldsmithsdidnot take to thenewbankwithoutfirst tryingtodestroyit. In1696,England'sworn, clipped and underweight silver coins had been recalled for reminting and this led to atemporaryshortageofcoinsneededbythenewBankofEnglandtoredeemitsnotes.Thisthreatenedthestabilityofthebank,andattemptsweremadebythegoldsmithstobringitdown,althoughwhentheyfailedthisonlyhadtheeffectoffurtherenhancingitsreputation.7.Whilegoldcoinsweremaintainedtoareasonablestandardtheystillsufferedfromattrition.8.Althoughdemonetisationofsilverdidnotfullyoccuruntilthegoldrecoinageof1774eliminatedsilveraslegaltenderforsumsover£25(Kindleberger,2007).9. The bank introduced another system to attempt to control bank lending (the corset) in 1973.However,thiswasabolishedin1980.

THECURRENTMONETARYSYSTEM

CHAPTER2THECURRENTMONETARYSYSTEM

In this chapter we build up an understanding of the monetary system.We start by looking at themodern banking system, focussing on the role of the two key players: commercial (high street)banks,andthecentralbank(theBankofEngland).Weexplainthefundamentalbusinessmodelofamodernbankandthenlookatthemechanicsbywhichcommercialbankscreate(anddestroy)moneyandcentralbankscreate(anddestroy)centralbankreservesandcash.Thischapterprovidesenoughknowledgeof the existingbanking system tounderstand the analysis that follows in the restof thebook. However, for those who would like a much more in-depth understanding of the modernmonetary system, the book Where Does Money Come From? published by the New EconomicsFoundationisveryhighlyrecommended.

2.1COMMERCIAL(HIGH-STREET)BANKSThebanksthatmostofususetodayarereferredtoascommercialbanksorhigh-streetbanks.Theyperformanumberofpracticalfunctions:Theymakeloans.Thiscouldbeseenastheraisond’êtreofmodernbanking.Itisbymakingloansthattheyexpandandgeneratethebulkoftheirprofits.Theyallowcustomers tomakeelectronicpaymentsbetween each other through electronic fundstransfers(accessedbyinternetortelephonebanking)orviatheuseofdebitcards.TheyprovidephysicalcashtocustomerseitherthroughbankbranchesorviaATMcashmachines.Theyacceptdeposits.This is the rolemost of us associate bankswith, from our first childhoodexperiencesofputtingmoney‘inthebank’.It is the first function, themaking of loans,which is of crucial importance for the stability of theeconomyandthelevelofdebtinsociety.Asdiscussedinthesectionsbelow,banksdonotmakeloansbytakingmoneyfromasaverandtransferringittoaborrower,asmostofuswouldassume.Instead,theymakeloansbyincreasingtheirliabilitiesandassetsintandem,creatinganewliability(thebankdeposit i.e. the numbers that appear in the borrower ’s account) and a new asset (the loan contract,signed by the borrower, promising to repay the same amount). This process will be described indetaillaterinthechapter.Thisisnothoweverlendinginthecommonsenseoftheword,astheactoflendingimpliesthatthelendergivesupaccesstowhatisbeinglentforthedurationoftheloan.AseconomistHymanMinskyputsit:“Banking is not money lending; to lend, a money lender must have money. The fundamentalbanking activity is accepting, that is, guaranteeing that some party is creditworthy. A bank, byacceptingadebt instrument, agrees tomake specifiedpayments if thedebtorwill notor cannot.”(1986,p.256)

Becausebank‘lending’increasesthebalanceoftheborrower ’sbankaccountwithoutdecreasingthevalueofanyoneelse’saccount, it increasesthelevelofpurchasingpowerintheeconomy.Ineffectthis creates newmoney, just as banks did when they printed their own bank notes. Currently this‘commercial bank money’ accounts for approximately 97% of the total money supply, with cash

issued by the Bank of Englandmaking up the remaining 3%. Therefore, the lending decisions ofcommercial banks have huge significance for the economy, for two reasons. First, because newmoneyiscreatedwhenbanksmakeloans,thelendingdecisionsofbanksdeterminethetotalquantityofmoneythatcirculatesintheeconomy.Second,asbanksdecidewhotheywilllendtoandforwhatpurposestheloancanbeused,theirlendingprioritiesdeterminewhichsectorsoftheeconomythisnewly createdmoney is allocated to.As a result they have a huge impact on the shape and futuredirectionof theeconomy.Manyof theeconomic,socialandenvironmentalchallenges thatwefacetodayareconnected,inonewayoranother,tothesetwokeyimpactsofbanklending.Wewill shortly look at each of the four functions described above, showingwhat happens in theaccountsandonthebalancesheet,inordertoshowhowthecurrentmonetarysystemworks.Butfirst,weneedtolookattheotherkeyelementofthemodernbankingsystem–thecentralbank.

Box2.A-Money:Whatitisandwhatit'sfor

Whatismoneyfor?Textbookstendtoassignmoneyfourfunctions:

Astoreofvalue:Moneyshouldpreserveitspurchasingpower–aunitofcurrencyshouldbeabletopurchasethesameamountofgoodstomorrowasitdoestoday.

Amediumofexchange:Moneyisacceptedinallcircumstancesinexchangeforgoodsandservices.

Aunitofaccount:Moneyistheyardstickagainstwhichallothergoodsandservicesaremeasured.

Ameansoffinalsettlementorpayment:Oncemoneyhasbeentransferredthetransactionbetweentwoparties iscomplete.This is importantasitdistinguishesmoneyfromcredit,whichinvolvesafutureobligation.

Whatismoney?Today,therearebroadlythreetypesofmoneycirculatingintheeconomy:

Cash: Physicalmoney, or cash, is created under the authority of theBank ofEngland,with coinsmanufactured by theRoyalMint, andnotesprintedbyspecialistprinterDeLaRue.Theprofits fromthecreationofcash(knownasseigniorage)godirectly to thegovernment.Today,cashmakesuplessthan3%ofthetotalmoneysupply.

Centralbankreserves:Centralbankreservesareatypeofelectronicmoney,createdbythecentralbankandusedbycommercialbankstomakepaymentsbetweenthemselves.Insomerespectscentralbankreservesarelikeanelectronicversionofcash.However,membersofthepublicandnormalbusinessescannotaccesscentralbankreserves;theyareonlyavailabletothoseorganisationswhohaveaccountsattheBankofEngland,i.e.banks.Centralbankreservesarenotusuallycountedaspartofthemoneysupplyfortheeconomy,duetothefacttheyareonlyusedbybankstomakepaymentsbetweenthemselves.

Commercial bankmoney: The third type of money accounts for approximately 97% of the money supply. However, unlike central bankreservesandcash, it isnotcreatedby thecentralbankoranyotherpartofgovernment. Instead,commercialbankmoney iscreatedbyprivate, high-street or 'commercial' banks, in the process ofmaking loans or buying assets (as described below).While thismoney iselectronicinform,itneednotbe–beforecomputers,bankscouldstill'createmoney'bysimplyaddingdepositstotheirledgerbooksandbalancesheets.

TheBankofEnglandTheBankofEnglandisthecentralbankoftheUnitedKingdom.Itiscrucialtoanydiscussionofthecurrentmonetary system because it effectively provides the infrastructure and the specific type of‘base’ money on which the wider system is built and operates. It is also assumed by many to beresponsibleformanagingthemoneysupply,althoughaswillbecomeclearinChapter3,itdoesnothavethetoolstobeabletodothissuccessfully.Unlike commercial banks,whichdealwithbusinesses andmembersof thepublic, the central banktypically acts as banker to commercial banks and the central government. Itwill also tend to holdaccountsinthenation’scurrencyforcentralbanksofothercountries.Also,whilecommercialbanks

are typically privately owned for-profit enterprises, in the UK the central bank is owned by thegovernment.TheBankofEnglandperformsfiverolesthatarerelevanttoourdiscussion.Theseare:1.ThecreationofcentralbankmoneyAlthoughnomemberofthepublicwillhaveanaccountwiththeBankofEngland,mostpeoplewillbefamiliarwiththenameforthesimplereasonthatitisprintedonmostofthe£5,£10,£20or£50notesthatexistintheUK.Thisisthemostcommonlyknownfunctionofacentralbank:tocreatethecashthatisusedtomakemostsmallerpaymentsacrosstheUK.However, cash is not the only type of money created by the central bank. In fact, as the Bank ofEngland describes, “Central bank money takes two forms — the banknotes used in everydaytransactions,andthebalances(‘reserves’) thatareheldbycommercialbanksandbuildingsocieties(‘banks’)attheBank[ofEngland].”(2012)These‘reserves’,or‘centralbankreserves’,canbeseenasanelectronicequivalentofcash, inthattheyarecreatedexclusivelyby theBankofEngland.However,unlikecash,membersof thepublicandnormalbusinessescannotaccessorusecentralbankreserves;insteadtheyareonlyavailabletothose organisations that have accounts at the Bank of England, i.e. banks and building societies.Centralbankreservesareusedalmostexclusivelybybankstosettlepaymentsamongstthemselves.Taken together, central bank reserves and cash (notes and coins) are commonly referred to ineconomics textbooks as ‘base money’, ‘high powered money’, or ‘outside money’. The Bank ofEngland prefers to use the term ‘central bank money’, but to avoid possible confusion with thesimilarsounding‘commercialbankmoney’,wewillusetheterm‘basemoney’throughoutthisbooktorefertocashandcentralbankreservescollectively.fig.2.1-Hierarchyofaccounts

2.BankertocommercialbanksAn important function of the Bank of England is to be the ‘banker to the banks’. This involvesproviding bank accounts to commercial (‘high-street’) banks that hold the central bank reservesoutlinedabove.Theseaccountsplayacriticalroleinallowingbankstomakepaymentstoeachother:in the sameway that I couldmakeapayment toyoubymakinga transfer frommypersonalbankaccount toyour's,commercialbankscanmakepayments toeachotherbytransferringcentralbankreservesbetweentheirrespectiveaccountsattheBankofEngland.In order to provide the commercial bankswith the reserves they need in order to settle paymentsbetween themselves, the Bank of England also regularly lends central bank reserves to banks, ondemand.Thelendingofreservesandtheprovisionofaccountstobanksenablesthecentralbanktoaffecttheinterestrateatwhichbankslendreservestoeachother,facilitatingitsconductofmonetarypolicy.ThiswillbediscussedinmoredetailinChapter3.3.BankertothegovernmentTheBankofEnglandalsoprovidesanumberofbankaccounts to thegovernment, inwhich fundsfromtaxationandborrowingareheld, temporarily,beforebeingusedforgovernmentspendingorpayingtheinterestonpreviousborrowing.BecausetheseaccountsareattheBankofEngland,theycanonlyholdcentralbankreserves.4.Maintainingmonetarystability

TheBankofEnglandhastwolegalmandates,asenshrinedinlawbytheBankofEnglandAct1998and 2009. The first of these mandates is to maintain monetary stability. This gives the Bank ofEnglandanobligationtomaintain thepurchasingpowerof thecurrencysothatapoundtomorrowwill buy the same amount of goods and services as does a pound today. This is equivalent topreventing inflation, commonly defined as “a sustained rise in the general level of prices”(Blanchard,2006).IntheUKthesepricechangesaremeasuredusingtheConsumerPriceIndex(CPI),whichcalculatestheaveragechangeinthepriceofabasketofconsumergoodsandservicesoverthepreviousyear.1 Inpractice, theBankofEngland is currently committed tomaintaining a ‘lowandstable’inflationrateof2%ayear.TomanagetherateofinflationintheeconomytheBankofEnglandattemptstoinfluencethelevelofaggregatedemand(definedasthedemandforfinalgoodsandservicesintheeconomyataparticulartime) by targeting the rate of interest at which commercial banks lend to each other. The targetinterest rate (the ‘policy rate’) is set by the Monetary Policy Committee (MPC) of the Bank ofEngland, a body that is independent from the government. Section 3.4 describes the theoreticalrationale behind using the interest rate to influence inflation, as well as highlighting some of thelimitationsofthisapproach.5.PreservingfinancialstabilityThe Bank of England’s second mandate is to protect and enhance the stability of the UnitedKingdom’s financial system. This involves theBank of Englandworking to detect and reduce thethreatstothefinancialsystem,whichincludesdevelopingtoolswhichallowittomonitorandtowarnof impending problems, as well as ensuring the resilience of the financial system (especially thepayments system) should such a shock occur. If a threat is discovered appropriate action can betaken,2whileinthecaseofunexpectedshocks,suchasthe2007/08crisis, theBankofEnglandcanintervene toprotect financial stability.Thismay take the formof reducing interest rates,providingemergencyfundingforilliquidbanks(thelenderoflastresortfunction),purchasingassetsfinancedbycreatingbasemoney (inorder to set a floorunderassetpricesor reduce interest rates), and/orpurchasingcurrencyonforeignexchangemarkets(inordertomaintainthevalueofthecurrencyandthereforethepriceofimports/exports).

2.2THEBUSINESSMODELOFBANKINGUnderstandingbalancesheetsNotes and coins todaymakeup just threeout of everyhundredpounds in the economy.Theotherninety-sevenpoundsexistasaccountingentriesonthebooksofcommercialbanks.Forthatreason,abasicunderstandingofaccountingandbalancesheetsisessentialinordertounderstandhowmoneyiscreated.Thereisnoreasontobeputoffbytheaccountingterminology;ifyouhaveeverborrowedmoneyfromafriendandleftanoteonthefridgetoremindyoutorepaythem,thenyouhavealreadydoneonehalfoftheaccountingnecessarytounderstandbanking.Inshort,abank’sbalancesheetisarecordofeverythingitowns,isowed,orowes.Thebalancesheetcomprisesthreedistinctparts:assets,liabilitiesandshareholderequity.Assets:Ononesideof thebalancesheetare theassets.Theassets includeeverything that thebankowns or is owed, from cash in its vaults, to bank branch buildings in town centres, through togovernmentbondsandvarious financialproducts.Loansmadeby thebankusuallyaccount for thelargestportionofabank’sassets.

Loansandmortgagesareassetsofthebankbecausetheyrepresentalegalobligationoftheborrowertopaymoneytothebank.Sowhensomeonetakesout£200,000foramortgage,thisloanisrecordedon the assets side of the balance sheet as being worth £200,000. Of course, the borrower alsopromises topay interestonayearlybasis.Notehowever that this interest isnever recordedon thebalancesheet,butisrecordedeachyearasincomeonaseparateaccountingstatement,alsoknownasthe income statement or ‘profit and loss’ statement.For example, even though the contract that theborrower signed commits them to paying £200,000 plus interest over 25 years (making a totalrepayable of £333,499 at 4.5% interest) only the £200,000 amount originally borrowed (the‘principal’)isrecordedonthebalancesheet.Asloanrepaymentsaremade,thisprincipalisgraduallyreduced.Liabilities:Liabilities are simply things that thebankowes tootherpeople, organisationsorotherbanks. Contrary to the perception of most of the public, when you (as a bank customer) depositphysical cash into a bank it becomes the property (an asset) of the bank, and you lose your legalownership over it.What you receive in return is a promise from the bank to pay you an amountequivalenttothesumdeposited.Thispromiseisrecordedontheliabilitiessideofthebalancesheet,andiswhatyouseewhenyoucheckthebalanceofyourbankaccount.Thereforethe‘money’inyourbank account does not representmoney in the bank’s safe, it simply represents the promise of thebanktorepayyou–eitherincashorasanelectronictransfertoanotheraccount–whenyouaskitto.Thebulkofatypicalbank’sliabilitiesaremadeupof‘deposits’whichareowedtothe‘depositors’.Thesewillgenerallybeindividuals,businessesorotherorganisations.Depositsinabankcanbesplitintotwobroadgroups:sight(ordemand)depositsandtime(orterm)deposits.Sightdepositsaredepositsthatcanbewithdrawnorspentimmediatelywhenthecustomerasks, in other words ‘on demand’ or ‘on sight’ of the customer. These accounts are commonlyreferred to as current accounts (in the UK) or checking accounts (in the USA), or instant accesssavingsaccounts.Incontrast,timedepositshaveanoticeperiodorafixedmaturitydate,sothatthemoney cannot be withdrawn on demand. These accounts are commonly referred to as savingsaccounts.ShareholderEquity:Thefinalpartofthebalancesheetistheequity.Equityissimplythedifferencebetweenassetsandliabilities,andrepresentswhatwouldbeleftoverfortheshareholders(owners)ofthebankifalltheassetsweresoldandtheproceedsusedtosettlethebank’sliabilities(i.e.payoffthecreditors).Equity is calculatedby subtracting liabilities fromassets.Apositivenet equity indicatesthatabank’sassetsareworthmorethanitsliabilities.Ontheotherhandanegativeequityshowsthatitsliabilitiesareworthmorethanitsassets-inotherwords,thatthebankisinsolvent.fig.2.2-Assetsandliabilities

PresentingbalancesheetsdiagrammaticallyOnofficial annual accounts, assets are typically presented first, followed by liabilities underneath,withequitycominglast,asshownbelow:

However, it can help to present the balance sheet diagrammatically with assets on one side, andliabilitiesandequityontheoppositeside.Bydefinition,liabilitiesplusequitymustbeequaltoassets,sothetotalofboththeleftandrightsidesofthebalancesheetmustbeequal.InthisbookwefollowtheconventionofAmericanbankingtextbooks,withassetsontheleftandliabilitiesplusequityontheright,althoughinotherbooksthecolumnsmaybereversed.

StayinginbusinessFor abank, staying inbusiness andmakingaprofit essentially comesdown to three rules: 1) staysolvent,2)stayliquid,and3)earnapositivemargin.We’lllookateachoftheseindetailnow.1.StayingsolventAsdiscussedearlier,thedifferencebetweenassetsandliabilitiesisreferredtoasshareholderequity.If assets are greater than liabilities then shareholder equity is positive and the bank is solvent,meaningthatifitsoldallitsassets,itwouldhaveenoughtopayallofitscreditorsinfull,andstillhavesomethingleftovertoreturntoshareholders(theownersofthebank).However,thevalueofitsassets is not guaranteed – borrowers may fail to repay loans, or investments such as bonds andequities(stocksorshares)maygoupanddowninvalue.Ifalargenumberofthebank’sborrowersbecameunabletorepayandthendefaultedontheirloans,theseloanswouldbe‘writtenoff’andtheirvalue on the balance sheet would disappear, causing an equal reduction in equity. If a significantpercentage of the assets arewritten off, the total value of assetsmay fall below the total value ofliabilities, shareholder equity would become negative, and the bank would become insolvent i.e.unabletorepayallofitscreditors.Ifabank(oranycompany)findsitself inthissituation,withnoreasonable prospect of assets recovering their value, it is required to cease trading and startliquidationproceedings.

Toguardagainst thishappening,bankstrytoensurethatassetsareacertainlevelaboveliabilities;thisdifferenceisreferredtoasacapitalbufferorequitybuffer.Forexample,ifthecapitalbufferis£10 billion, then the bank can afford to take £10 billion of losses on its assets before it becomesinsolvent.Sothefirstruleofbankingis tokeepthebank’sassetsgreater thanits liabilities.Failuretodothisamountsto‘gameover ’forabank.Trying to avoid insolvencydependson thebank’s riskmanagement; it needs to ensure that only asmall(andpredictable)percentageofloansdefault.Complexregulations,knownastheBaselCapitalAccords, attempt to give banks a standardised framework for ensuring that their capital buffer issufficient toprotect thebank fromfailure in theeventof losseson its assets.Section3.4discussestheseregulationsandwhytheyhavebeenineffective.2.StayingliquidBanksalsoruntheriskofbecominginsolventthroughbeingunabletomeettheirliabilitiesastheyfall due, even though their assetsmay be greater than their liabilities. In accounting terms, this isknownascashflowinsolvency. Inbanking jargon it is reffered toasa ‘liquiditycrisis’.A liquiditycrisis can happen if there is a significant outflowof funds (central bank reserves) from a bank tootherbanksortocustomerswhoarewithdrawingcash.Thisprocesscanhappenveryquickly,asinabankrun,orslowlyif its liabilitiesarewithdrawnslightlyfasterthanitsloanassetsarerepaid.Ifabank becomes unable to settle its liabilities to either customers or to other banks, then it is againdeclaredinsolventandwillneedtoceasetrading.Avoidingaliquiditycrisisreliesonaprocessknownas‘assetliabilitymanagement’,whichinvolvesmanaging and predicting inflows and outflows to ensure that a bank is always able to make itspayments as andwhen it needs to. Inmany cases, thismay involve borrowing funds (central bankreserves) from other banks for periods as short as overnight in order to stay liquid and makepaymentstootherbanks.3.Earningapositivemargin

Finally, to earn a profit banks must ensure that the interest they receive across all their interest-bearing assets is greater than the interest they pay across their interest-bearing liabilities. Thedifferencebetween the interestpaidand the interestcharged iscalled the‘margin’or ‘spread’.Thepracticeofassetliabilitymanagementalsotakesintoaccounttheinterestrateriskofabank’sassetsandliabilities(theriskthattheratesdeterminingtheinterestreceivablefromassetsmaydeterioraterelativetotheratesdeterminingtheinterestpayableonliabilities),toensurethatthismarginremainspositive(withinterestrateschargedbeinghigherthaninterestratespaid)andsufficienttocoverthecostsofthebank’soperations.Banksalsoreceiveadditional incomefromothersources.Theseincludechargingfeesforservicesrendered and on overdrawn accounts. Universal banks may also profit from trading securities,charging commissionon securities transactions, assisting companies to issuenewequity financingandbyprovidingwealthmanagementfunctions.

Box2.B-ConfusingReserveRatiosandCapitalReserves

It is important not to confuse reserve ratios (or liquidity ratios) with capital requirements. These two things are very different and servecompletelydifferentpurposes.

Liquidityratiosor‘reserveratios’asoftendiscussed,refertotheliabilitiessideofabank’sbalancesheet.Apurereserveratio,suchasthe10% that is often given in textbook examples (which incidentally has never applied in the UK) states that for every £100 of customerdepositsabankmusthave£10ofbase (i.e.centralbank)money, in the formofeithera)cash in itsvaultsorb)deposits (centralbankreserves)atthecentralbank.Aliquidityratioissimilar,butallowsbankstoholdhighly-liquidassetssuchasgovernmentbondsinplaceof cash and central bank reserves, with the idea being that bonds can easily be exchanged for cash and central bank reserves ifcustomersaremakinghigherthanusualwithdrawalsfromtheiraccounts.

In short, liquidity ratios and reserve ratios say, “What percentage of customers couldwithdraw their deposits simultaneously before thebankrunsoutofbasemoney?”Areserveratioorliquidityratioof10%wouldimplythatthebankcouldsufferawithdrawalofupto10%ofitsdepositsbeforeitwouldbecomeilliquidandhavetocloseitsdoors.

Incontrast, thecapitalor ‘capital reserves’ thatarerequiredby theBaselCapitalAccordsrelate to theassetssideof thebalancesheet.Capital requirements say, in essence, “What percentage of our loans can default before we become insolvent?” (See 3.4 to recap theimportanceofthiscapital.)

Asimplewaytoavoidconfusionistorememberthatliquidityisaboutliabilities(thetwoLs),whereascapitalisaboutthebank’sassets.

2.3MONEYCREATIONWithanunderstandingofcommercial(high-street)banks,theBankofEnglandandbalancesheets,wecannowlookatthemechanismsthatenablebankstocreatemoneyasaccountingentries.Themoneycreationprocesscanbedifficulttounderstand,chieflybecausewedealwithmoneyeverydayandsohavepreconceivedideasofbanksandmoneyderivedfromourpersonalexperiences.AsJohnMaynardKeynes remarked in the introduction to hisGeneral Theory (1936), “The difficultylies,notinthenewideas,butinescapingfromtheoldones,whichramify…intoeverycornerofourminds”.Forexample,aschildrenwemayhavebeengivenmoneythatweputinapiggybanktokeepsafe.Wethencarrythisconceptionofbanksandmoneyintoadulthood–whenwethinkofmoneywethinkof cash, andbanksare thoughtof asplaces tokeepourmoney safe.Yet thevastmajorityofmoneyisnotcash,andbanksarebytheirnaturenotplaceswheremoneyiskept‘safe’.Aswewillsee,inrealitythe‘money’inourbankaccountsmerelyconsistsofbookkeepingentries;moneynowis very literally just numbers on a balance sheet in a computer system. Since it is the banks thatmanagetheirownaccounts,theycanincreasetheirliabilitiesastheywish(withsomecaveatswhichwewill discuss shortly), and in doing so create and destroy the type ofmoney that is used by thepublic.Wewillnowlookathowthisprocessactuallyworks.

Inalltheexamplesbelow,weignoreallbalancesheetitemsapartfromtheonesinquestion.Wealsoassumethatbalancesheetitemsarezerobeforethetransactioninquestiontakesplace.Thisispurelytokeeptheexamplessimpleanduncluttered.CreatingmoneybymakingloanstocustomersHowdobankscreatemoneybymakingloans?Inthisexample,aself-employedbuilder,Jack,walksintoMegaBankandaskstoborrow£10,000tobuyanewvanandsomepowertools.(Chapter3willshow that loans to productive businesses like this make up just a small proportion of all banklending.)Jacksignsacontractwiththebackconfirmingthathewillrepay£10,000overaperiodoffiveyears,plusinterest.Thislegallyenforceablecontractrepresentsanassetforthebankandwhenthebankcomestodrawupitsbalancesheetitwillbeincludedasanadditionalassetworth£10,000.Jack,havingcommittedtopaythebank£10,000,wantstoreceivethe‘money’hehasborrowed,soMegaBankopensupanaccountforhim,andrecordsabalanceof£10,000.Thereisnoneed,intheimmediateterm,forthebanktofirst‘find’themoneyfromanywhereelse.OncetheyhavedecidedthatJackiscredit-worthyandlikelytorepay,theycanmaketheloan.Inthewords of Paul Tucker, Deputy Governor of the Bank of England: “[Banks] can lend simply byexpanding the twosidesof theirbalancesheet simultaneously,creating (broad)money.” (2012)OnMegabank’sbalancesheetthisappearsasso:

Byincreasingbothsidesofthebalancesheetsimultaneously,thebankhasmanagedtoissuealoan,andcreatenewmoney–intheformofdepositsthatappearinJack’sbankaccount–simultaneouslywithoutaffectingitsotherassetholdingsorshareholderequity.Andthatisit.Noticethatnomoneywastransferredortakenfromanyotheraccount;thebanksimplyupdatedacomputerdatabase.Abankcannotreallybesaidto‘lend’money–tolendonemusthavemoneytolendinthefirstplace.Inrealityabankcreatesbankdepositswhenitadvancesloans.Thesebankdepositsareliabilitiesofthebank,andcanbeused,justlikephysicalmoney,tomakepaymentsin the economy (through debit cards and electronic fund transfers).Nomoney has to be acquiredfromasaverbeforealoancanbemadetoaborrower.Assuchwhenabankmakesloansitincreases

boththequantityofmoneyintheeconomy,aswellasthequantityofdebt.Note that a bank can also ‘create money’ in this way when buying financial assets, such as agovernmentbondfromapensionfund.Justaswitha loan, thebond is recordedasanasseton thebalancesheetandthebankcreditsthepensionfund’saccountwiththeequivalentvalue.

Box2.C-DoBanksCreate‘Credit’orMoney?

Someeconomistswillargue thatbanksdonotcreatemoney; theysimplycreatecredit.Thispointofviewargues thatbankdepositsareliabilitiesofbanksandarenotdeclaredlegaltender,thereforetheyshouldnotbedescribedasmoney.Instead,theyarepromisestopay,whichmembersofthepublicvoluntarilyaccept inexchangefortheconvenienceofbeingabletomakepaymentswithoutneedingtoholdlargeamountsofcash.Whenabankfails,itbecomesapparentthatbankshavenotcreatedmoney,buthavesimplycreatedcreditthatislesssafethanstate-issuedcurrency.

However,forsomethingtobe‘credit’ ,itmusthavesomethingcalled‘creditrisk’.Creditriskistheriskthatapersonorcompanythatowesyoumoneywillnotrepayyou.Ifyoulend£50toanunreliablefriendwhostillowesyoumoneyfromthelasttimeyoulenttohim,thenthereisalotofcreditriskassociatedtothatloan.

Soifthenumbersthatbanksaddtoyourbankaccountarenotmoney,butjustcredit,thentheremustbesomecreditriskattachedtothatmoney.Inotherwords,theremustbeariskthatthebankwon’tbeabletorepayyou.

TheBankofEnglandmakesthisargumentinadistinctionbetweencashandbank-createdmoney–the2010Q3QuarterlyBulletinstates:“BankofEnglandnotesareaformof‘centralbankmoney’,whichthepublicholdswithoutincurringcreditrisk.Thisisbecausethecentralbankisbackedbythegovernment”(p.302).Theyimplythatcashhasnocreditriskbecauseit isbackedbythecentralbank,whichisinturnbackedbythegovernment.

While this is true, they fail tomention that the government has a scheme called the Financial ServicesCompensationScheme (FSCS),which promises to repay the customers of failed banks up to £85,000 of their account. This guarantee is supposed to be funded bycontributionspooledacross thebanks.But if thecontributions fromthebanksaren’tsufficient–ashappenedduring the financialcrisis–thenthegovernmentisrequiredtofindtherestofthemoneythroughtaxationorborrowing.

Asaresult,thegovernmentguaranteesindividuals'bankaccounts.Therefore,tousetheBankofEngland’sowndefinition,depositshavenocreditriskbecausetheyare“backedbythegovernment”,justascashis.Withnodistinctionbetweenbankdepositsandcashintermsofcreditrisk,theBankofEngland’sowndefinitionofthedifferencebetweencashandbankdepositsisrenderedmeaningless.Infact,bankdepositsmayincurevenlessriskthanphysicalcash,ascashcanbestolenorlostwhilebankdepositsareguaranteedbythestate.Byprovidingthisguarantee, thegovernment turnsrisky ‘bankcredit’ into theequivalentofstate-issuedmoney,andremovesanymeaningfuldifferencebetweencentralbankmoneyandbankdeposits.

2.4OTHERFUNCTIONSOFBANKINGMakingelectronicpaymentsbetweencustomersHavingborrowed£10,000fromhisbank,Jacknowwantstopurchaseavan.Becausethisisalargepurchase, he prefers tomake the payment electronically.Wewill consider two possible scenarioshere: firstly that Jack and the van dealer bank at the same bank, and secondly, that they bankwithdifferentbanks.CustomersatthesamebankInthisexample,JackandthevandealerbothbankwithMegaBank(seefigure2.7).Afterpickingoutthevanhelikes(costing£9,500),Jackpaysforitusinghisdebitcard(theendresultisbasicallythesameforbothinternetbankingandpaymentbycheque).Thedebitcardpaymentsystem(e.g.VisaorMasterCard)sendsamessage toMegabank, telling it that Jackwants tomakeapayment to thevandealer.ThebanknowsimplyupdatesitsowninternalrecordstoreducethebalanceofJack’saccountand simultaneously increases the balance of the van dealer ’s account. No cash or central bankreserveshavemovedinthisprocess;MegaBankhassimplyturneditsliabilitytoJackintoaliabilitytothevandealer,atJack’sinstruction(figure2.7).CustomersatdifferentbanksWhatif thevandealeractuallybankswithRegalBank,whichisaseparateentitytoMegaBank?By

usinghisdebitcardJacksendsamessagetohisbanktomakeapaymentof£9,500tothevandealer'saccountatRegalBank(seefigure2.8).MegaBankimmediatelyreducesthebalanceofJack’saccountby£9,500.InordertosettlethispaymentMegaBankwillneedtotransfercentralbankreservesfromitsownaccountattheBankofEnglandtoRegalBank’saccountattheBankofEngland.ItdoesthisbysendingapaymentinstructiontotheBankofEngland,tosay“Pleasetransfer£9,500frommyBankof England account to Regal Bank’s Bank of England account”. Assuming that £10,000 of ‘otherassets’MegaBankheldwereinfactcentralbankreserves,itscentralbankreservesnowfallto£500.WhenRegalBankreceivesthepaymentofcentralbankreservesintoitsbankaccountattheBankofEngland,itscentralbankreservesincrease(ontheassetsside-seefig2.9).RegalBankwillalsohaveincreasedthevandealer ’saccountbythe£9,500atthepointwhenJackmadethepayment(althoughthiswouldhaveshownas‘uncleared’untilthecentralbankreservesarrivedinRegalBank’scentralbankaccount).

ThesametransactioncanalsobeviewedfromtheperspectiveoftheBankofEngland’sbalancesheet.With both banks holding accounts at the Bank of England, transferring reserves between reserveaccounts follows the same process aswhen two individuals at the same commercial bankmake apaymentbetween themselves;a liability toonebank(in thiscaseMegaBank)becomesa liability toanother bank (RegalBank).While reserves appear as an asset on the balance sheet of commercialbanks, they are a liability of the central bank (in the same way that bank deposits are assets ofindividuals,butliabilitiesofcommercialbanks).So,whenMegabankmakesapaymenttoRegalBank,thetransferappearsontheBankofEngland’sbalancesheetasso:

fig.2.11-Relationbetweenassetsofcommercialbanksandliabilitiesofcentralbank

Box2.D-Anoteonmultilateralnetsettlement

Wesawearlierthatwhenapaymentismadebetweencustomersofdifferentbanks,somecentralbankreserveswillneedtomovebetweenaccountsat theBankofEngland.However, it iscertainlynot thecasethateverypoundtransferredelectronicallybetweenmembersof thepublicismatchedbyapoundbeingtransferredattheBankofEngland.

Forarelativelysmalltransactionlikethe£9,500givenabove,MegaBankwouldnotactuallytransferthe£9,500incentralbankreservesasa single payment. Instead, all the payments from its customers to customers of other banks would be queued in a computer system,namelyoneof thepaymentsystemssuchasBACS,FasterPaymentsetc.Everyfewhoursorat theendofeveryday(dependingonthesystem),allthepaymentsinwouldbeaddedtogethertofindthetotalflowsineachdirection,thenpaymentsthatgoinoppositedirectionswouldbecancelledoutagainsteachothertofindthenetamountthateachbankowestootherbanks.ThesenetamountsarethensettledwithtransfersmadebetweenthereserveaccountsattheBankofEnglandi.e.theyaresettledusingcentralbankreserves.

This process of netting out payment flows is known as ‘multilateral net settlement’ and significantly reduces the amount of central bankreserves that need to be held at theBank ofEngland.As an example of this, in 2008 a total average of £784 billion of paymentswassettledeachdaywithjust£32billionofcentralbankreserves(BankofEngland,2009).Ineffect,every£1ofcentralbankreserveswouldbesufficienttosupport£25ofdailytransactionsbetweencustomersofbanks.

Despite this, banks still doneed tohavecentral bank reservesonhand tomake their endof daypayments tootherbanks.How thesecentralbankreservesarecreatedandhowbanksacquirethemisthesubjectofsection2.6.

ProvidingcashtodepositorsthroughbranchesandATMsNow let’s assume that a fewdays later Jack needs the remaining £500 in his account to buy somepowertools,andwantstopayincash.Hegoestothelocalbranch,andaskstowithdraw£500fromhisaccount.ThecashierhandsJack£500andwhenJacknextcheckshisbalance,ithasbeenreducedby£500,toanewbalanceof£0.Thebalancesheetchangesareasfollows.PriortoJackreceivinganymoney,MegaBankwouldhavehadtoswapcentralbankreservesforcash(whichitcandowiththeBankofEngland).Then,thebanktakes£500fromitsowncash(whichisanassetofthebank)andgivesittoJack.SimultaneouslythebankreducesthevalueofitsliabilitytoJack(i.e.thebalanceofJack’sbankaccount)to£0,asshowninfig2.12.

From Jack’s perspective, it appears he has taken out £500 of cash from the £10,000 that he hadinitiallyborrowed.However,inreality,Jackdidnothave‘cashinthebank’–hesimplyhadaliability(apromisetopay)fromthebank.Jackhasswappedapromisefromthebanktopay£500(thebank’sliability tohim) for£500 incash.Lookedatanotherway, Jackhasusedhisdepositsat thebank to

‘buy’anequivalentamountofphysicalcashthatthebankalreadyowned.Wecouldalsosaythatthebankhas‘settled’or‘extinguished’its£500liabilitytoJackbygivinghimthecash.AcceptingcashfromdepositorsJackthentakeshis£500incashtoaDIYshopandexchangesitforsometools.Attheendofthedaythe DIY shop takes this £500 to its bank (NewBank) and deposits it there. The cash becomes thepropertyofthebank,andsoisrecordedontheassetssideofthebalancesheet.Simultaneously,theDIYshop’saccount(aliabilityofthebank)iscreditedwithanequalamount,andtheDIYshopseesthebalanceofitsaccountriseby£500:

Contrary to popular opinion, when you deposit cash into a bank, that cash does not remain yourproperty.Instead,itbecomesthepropertyofthebank,andinreturnyouacquirealiabilityofthebank–theincreasedbalancethatappearsonyourbankstatement.Thisliabilityisapromisebythebanktoeitherrepayyouincashormakeelectronicpaymentsuptotheequivalentvalueofthecashonyourbehalf.TotheDIYstore,itappearsthatthe£500hasbeen‘putinto’theiraccount.However,itwouldbemoreaccuratetosaythateithera)theDIYstorehaslentthebank£500,inreturnforapromisetoberepaidas and when it needs the money, or b) the DIY store has exchanged £500 in cash for £500 ofcommercial bankmoney,which it can then spend electronically (or swap for cash again at a laterdate).Bothdescriptionsarevalid.

2.5MONEYDESTRUCTIONAswehaveseen,whenbanksmakeloans,newmoneyiscreated(intheformofnumbersinabankaccount).Whathappenswhentheseloansarerepaid?Exactlytheopposite:whereasloansarecreatedbyincreasingassetsandliabilitiessimultaneously,loansarerepaidbyreducingassetsand liabilitiessimultaneously.Thereductioninliabilitiesmeansthemoneysupplyhasshrunk;ineffect,money(intheformusedmostoftenbythepublic)hasbeendestroyed.Tokeeptheexamplesimple,let’simagineJackispaid£11,000forajobhehasrecentlycompleted.

Thispaymentismadeelectronicallyfromacustomerofanotherbank,sothatcentralbankreservesaretransferredfromthepayer ’sBanktoMegaBank’sreserveaccountat theBankofEngland.Jackthenseesthevalueofhisaccountincreaseby£11,000,asshownbelow.

Jackdecides topayoffhisoutstandingcar loan inonego (£10,000principal+£1,000 in interest).Uponinformingthebankthathewantstopayoff theloan, itreducesthebalanceofhisaccountby£11,000andsimultaneouslychangestheamountoutstandingonhisloantozero.Thisleavesthebankwith£11,000incentralbankreserves.Consequentlyshareholderequityhasincreasedby£1,000,thesameamountastheinterestpaidonJack’sloan–thisisthebank'sprofitontheloan,asbelow.

The simultaneous cancellation of the asset and the liability has removed £11,000 ofmoney, in theform of bank deposits, from the economy.However, some of it only disappears temporarily. Theinterestwillbecountedasincomeforthebank,andcanbeusedtopaysalariestostaff,dividendstoshareholdersandsoon.BelowMegaBanktakesthe£1,000inprofitandpaysitoutequallybetweenitsshareholdersasdividendsandstaffassalaries:

Nowthatwehavecoveredthefourmajorfunctionsofcommercialbanks,wecanmoveontoaddressthefunctionsofcentralbanks.

2.6LIQUIDITYANDCENTRALBANKRESERVESHowcentralbankreservesarecreatedAswesawintheprevioussection,centralbankreservesareaformofelectronicmoneythatbanksusetomakepaymentsbetweenthemselves.Inthissectionweshowhowthesereservesarecreatedbythecentralbank.InitiallytheBankofEngland’sbalancesheetappearsasso(thisisasimplifiedexamplewherewe’veignoredeverythingexceptthisparticulartransaction):

MegaBank’s shareholders have put up £10,000 of their own money, which has been invested ingovernmentbonds(knownas‘gilts’intheUK).MegaBank’sbalancesheetisnow:

IftheBankofEnglandwishestoinjectcentralbankreservesintothebankingsystem(forexampleinresponsetoademandforreservesfromthecommercialbanks),onewayforittodosoistosimplypurchasebondsheldbythebankingsector inexchangefor thereserves.This isknownasanOpenMarket Operation. In this example Megabank sells £10,000 of bonds to the Bank of England inexchange for £10,000 of central bank reserves. TheBank of England creditsMegaBank’s reserveaccount with £10,000. This increases the Bank of England’s liability (in the form of central bankreserves)toMegaBank,butatthesametimeithasreceivedanasset(thegilts).AssuchtheBankofEngland’sbalancesheetnowappearsasso:

TheBank of England’s balance sheet has ‘expanded’ by £10,000 and £10,000 of new central bankreserves have been created. However, from the point of view ofMegaBank’s balance sheet it hassimply swapped £10,000 in gilts for £10,000 in reserves, without affecting its liabilities. Thecompositionbutnotthesizeofitsbalancesheethaschanged:

Today,openmarketoperationsarenolongerusedbytheBankofEnglandastheprimarymethodforinjectingcentralbankreservesintothebankingsystem.Instead,innormaltimesthecentralbankusessaleandrepurchaseagreements(outlinedinBox2.E)whicharesimilartocollateralisedloans(whichitcouldalsouse).MorerecentlyreserveshavebeeninjectedthroughQuantitativeEasing.HowcommercialbanksacquirecentralbankreservesUltimately,commercialbanksneedtoacquirecentralbankreservesinordertosettlenettransactionswithotherbanks.Thesenet‘settlementobligations’arisewhenpaymentsbycustomersofonebanktoanotheraregreaterthanthepaymentscomingintheoppositedirection.Banksmayobtainreservesinoneofthreeways:a)FromthecentralbankThecentralbankretainsamonopolyontheproductionofcentralbankreserves.Thereforeultimatelyall central bank reserves initially come from the central bank. The central bank can inject thesereservesintothesystemthroughavarietyofchannels,includingthroughopenmarketoperationsandquantitative easing. Herewewill restrict ourselves to caseswhere the central bank lends reservesdirectlytocommercialbanks,whichitmaydoinoneofthreeways:

1. Longtermlending:BeforethefinancialcrisistheBankofEnglandranwhatwasknownasa‘reservesaveragingscheme’.Thisallowedcommercialbankstospecifyatthebeginningofeachmonthwhatquantityofreservesonaveragetheyexpectedtoneedinordertomaketheir payments. Theywould then borrow this amount from the central bank using repos.However, as a result ofQuantitative Easing,which flooded the bankswith reserves, thismechanismisnotcurrentlyrequired.

2. Short term lending:Anothermethod of borrowing from the central bank is viawhat isknownas the‘standingfacilities’.Theseallowbanks toborrowreservesfromthecentralbankovernight,incaseofliquidityproblems(iftheylackthemoneytopayotherbanks),usinggovernmentbondsascollateral.

3. Emergency lending: Finally, the central bank, in its role as lender of last resort, standsready to lend reserves to a commercial bank if for some reason it faces an unexpected

liquidityproblem(but isotherwisesolvent).This iscoveredinmoredetail insection3.4.TheBankofEnglandmayalsoprovide reserves to theentirebankingsystemin timesofmarket stress through large-scale asset purchases. A recent example of this was theQuantitativeEasingcarriedoutthroughtheBankofEngland’sAssetPurchaseFacility.

BoththereservesaveragingschemeandshorttermlendingthroughthestandingfacilitiesalsohelptheBankofEnglandtosettheinterestrate(seeBox3.Aformoredetails).Itisimportanttonoteherethat the level of reserves in the banking system is usually driven by demand for reserves fromcommercialbanks. In thewordsof theGovernorof theBankofEngland(2003-2013),SirMervynKing,“IntheUnitedKingdom,moneyisendogenous—theBanksuppliesbasemoneyondemandatitsprevailing interest rate, andbroadmoney [i.e.bankdeposits] is createdby thebanking system.”(1994,p.264)NotethatonlytheBankofEnglandcancreatecentralbankreserves.However,bankscanalsoacquirepre-existingcentralbankreservesinotherways:b)ByattractingdepositsfromcustomersBanks provide a deposit facility (i.e. current, checking or savings accounts) to individuals andorganisations.Theseaccountsallowindividualstodepositcashwiththebank,withthemoneythatisdeposited becoming the legal property of the bank.Thebank can then exchange this cashwith thecentral bank for reserves. Likewise, banks also accept payments to their own customers fromcustomersofotherbanks,eitherbyelectronicfundtransferorbycheque.Thesepaymentsaresettledusingcentralbankreserves.While thebankgains legalownershipof thecentralbankreserves, theindividual acquires abankdeposit (liabilityof thebank to the customer).However,while thebankmaydowhat itwantswith thecentralbankreserves, italsoknowsthat thedepositormayrequestapayment bemade to a customer of another bank up to the full value of their account at any time.Banksthereforeofferahigherinterestrateontimedeposits(suchasfixedtermsavingsaccounts),toencouragedepositorsto‘tieup’theirfundsandincreasethepredictabilityofoutflowsforthebank.Thepresenceofdepositinsurance(aguaranteethatthegovernmentwillreimbursethecustomersofbanksthatcollapse)oncustomerdepositsmeansthatdepositorsarelesslikelytoattempttowithdrawwhenabankfacesdifficulties.c)ViawholesalefundingmarketsBanksmayalsoborrowcentralbankreservesfromotherbanksontheinterbankmarket.Thistypeoflending tends to be short term in nature, and is generally carried out using sale and repurchaseagreements(repos–seeBox2.E).Inaddition,banksmayalsoacquirereservesfromotherfinancialmarketparticipantsusingavarietyofcontractsincludingcertificatesofdeposits,brokereddeposits,repurchase agreements, and commercial paper. In practice,wholesale funders are typically able towithdraw their own funds from a bank beforemembers of the public, and therefore tend to enjoy'seniority'intermsofrepaymentasaresultoftheirbetteraccesstoinformationandtheslowerspeedofnormaldepositors(duetodeposit insurance).AsHuangandRatnovski(2010)explaininanIMFworkingpaper:“This was the main reason why in almost all recent bank failures (e.g., Continental Illinois,Northern Rock, IndyMac) short-term wholesale financiers were able to exit ahead of retaildepositors without incurring significant losses. Interestingly, the well-publicized retail run onNorthernRocktookplaceonlyafter thebankhadnearlyexhausted its liquidassets topayoff theexitofshort-termwholesalefunds.”

Box2.E-Repos(SaleandRepurchaseAgreements)

Thestandardmethodbywhich theBankofEnglandcreates reserves is throughwhat isknownasasaleand repurchaseagreement (a'repo').Thisissimilarinconcepttoacollateralisedloan,inwhichtheborrowermustputupsomecollateralthattheywillloseiftheyfailtorepay.

Theprocessofobtainingreservesusingarepoisasfollows.Megabanktemporarilysellsan‘interest’ inanasset(usuallyagovernmentbond)tothecentralbankinexchangeforcentralbankreserves,whileagreeingtorepurchasethesameinterestintheassetforaspecific(higher)priceonaspecificdateinthefuture.Iftherepurchasepriceis10%higherthanthepurchaseprice(i.e.10%higherthan£10,000=£11,000) then the ‘repo rate’ issaid tobe10%.Under internationalaccountingstandards (IAS39asadoptedunder thenew InternationalFinancialReportingStandardIFRS9)arepotransactionhasdifferentaccountingrulesfromanoutrightsale.

UnlikeintheOpenMarketOperationexample,theBankofEnglandbalancesheetwouldnotactuallyshowthegiltsastheassetbalancingthereserves,butthevalueoftheinterestinthegilts(valuedatthe£10,000paid,notthe£11,000promised).MegaBankwouldretainthegiltsonitsbalancesheetinadditiontothecentralbankreservesbutrecordasanadditionalliabilityits£10,000obligationtocompleteitsendoftherepurchaseagreement.

Theextra£1,000doesnotappearoneitherbalancesheetbut,whenpaid,isrecordedasrevenuefortheBankofEnglandandanexpenseforMegaBank.Forsimplicity,andbecauseitisnotcoretounderstandingthemonetarysystem,thebalancesheetsabovedonotshowthiscompleteaccountingtreatment.

WheredoesMegabankgetthemoneytopaythereporate(theinterestontherepo)?TheBankofEnglandactuallypaysarateofinterestoncentralbank reservesequal to the repo rate - so ifRBSborrows£10,000usinga repoat10% itmust repay£10,000plus£1,000 ininterest.PriortoRBS’srepaymenttheBankofEnglandpaysinterestonthereservesat10%.ThisgivesRBS£1,000extrareserveswhichitmustpromptlyusetorepaytheoutstanding£11,000.

Whilstthisprocessmayseemabitodd,thereareactuallytworeasonsforpayinginterestonreservesinthismanner.Firstly,itmeansthatbanksarenotpenalised forholding reserves:having toborrow reservesat interestbutnot receiving intereston them (asused tobe thecase)meantthatbankswereeffectivelychargedforholdingreserves.Unsurprisinglythisledtothemattemptingtominimisetheirholdingsofreserves,whichcouldposeproblemsforsettlingpayments.

Secondly, paying interest on reserves (and charging interest on loans) allows the central bank to control the rate of interest at whichcommercialbankslendtoeachotherontheinterbankmarket–acrucialtoolofmonetarypolicy.ThisiscoveredinmoredetailinBox3.A.

2.7MONEYCREATIONACROSSTHEWHOLE

BANKINGSYSTEMWehavelookedattheissuingofasingleloanthroughtheentryofnumbersintotheaccountsofthebankinquestion.However,weshouldconsiderwhathappensacrossthebankingsystemasawhole.Therearetwoalternativedescriptionsoftheprocessofmoneycreationcommonlydiscussedtoday.Oneisthe‘moneymultipliermodel’foundinmostmainstreammacroeconomicstextbooks,whichisconsidered(bycentralbankers)tobeanoutdatedandamisleadingviewofhowthebankingsystemoperates.Amore realisticdescriptionof themonetarysystem is ‘endogenousmoney theory’.Bothareexplainedbelow.ThemoneymultipliermodelIn 1984 Charles Goodhart, who became a member of the Monetary Policy Committee and chiefadvisortotheBankofEngland,describedthemoneymultipliermodelusedintextbooksas“…suchan incomplete way of describing the process of the determination of the stock of money that itamountstomis-instruction”.(Goodhart,1984)Yetdespitethefactthatmanyeconomistsandcentralbankers have long known this model to be a fallacy, it is still taught to students today as factualdescriptionofhowthemonetarysystemoperates.fig.2.21-Themoneymultipliermodel

Themodelisadescriptivestoryofhowbanks’operationsserveto‘multiply’themoneysupply.Thestorybeginswithamanwalkingintoabankanddepositing£1000incash.Thebankknowsthat,onaverage,thecustomerwon’tneedthewholeofhis£1000returnedallatonce,soitkeepsbackasmall‘reserve’ of say 10% (£100), and lends out the other £900 to somebody who needs a loan. Theborrower takes this £900 and spends it at a local car dealer. The car dealer takes thismoney anddepositsitinanotherbank.Atthispointthemoneysupplyhasincreasedto£1900(theoriginal£1000thatthefirstcustomerstillhasondepositandthe£900thatthecardealerhasdeposited).Thenthecardealer ’s bank keeps 10%back of this new deposit as reserve (£90) and lends the remaining £810.Every time themoney is re-depositedatabank,newbankdeposits (liabilities fromthebank to thecustomermaking thedeposit)are recordedon thebank’sbalancesheet.Thisprocessof re-lendingcontinues,upuntilthepointwheremerepenniesarebeingrelent,withthemoneysupplytoppingoutataround£10,000despitethefactthatthereisonly£1,000of‘base’money(cash)incirculation.fig.2.22-Relationofreserveratiotomoneysupply

Youcanimaginethismodelasapyramid(fig2.22).Thecash(createdbythecentralbank)isthebaseofthepyramid,anddependingonthelevelofthereserveratio,banksmultiplyupthetotalamountofmoneyby re-lending it over andover again to amultiple of this original amount.More advancedtreatmentsincludecentralbankreservesaspartofbasemoneyaswellascash,howeverthebasicideaisthesame.Themoneymultipliermodelofbankingimpliesthreethings:

1. Banks have to wait until someone putsmoney into a bank before they can start makingloans.Essentially they aremere intermediaries and react passively towhat customersdo.Depositsfromcustomersthereforeprecedelending.

2. Thecentralbankhasultimatecontroloverthetotalamountofmoneyintheeconomy.Itcancontroltheamountofmoneybychangingeitherthereserveratio(theproportionofeachnew deposit that banksmust keep in reserve) or the amount of ‘basemoney’ – cash (orreserves)–atthebottomofthepyramid.

3. The money supply can never get out of control, unless the central bank deliberately ornegligentlyallowsitto.

Inconclusion,themoneymultipliertheoryseesthecausalityinthemoneycreationprocessoccurringinthefollowingway:

Thecentralbanksetsthereserveratio,createsbasemoney,andinjectsthismoneyintotheeconomy.

Onceintheeconomythismoneycirculatesbeforebeingdepositedwithbanks.Banksthenlendoutafractionofthemoneydepositedwiththemandkeepafractionback‘inreserve’.

Theloansarespent,themoneycirculates,beforeitisre-depositedintoanotherbank.Thebankusesthisnew(smaller)deposittomakeafurther(smaller)loan,againkeepingafractionofthe

deposit‘inreserve’.

Theprocesscontinuesuntiltheamountsbeingrelentareminiscule.Themoneysupplyisnowamultipleofthebasemoney(withthemultiplebeingdeterminedbythereserveratio).

EndogenousmoneytheoryEndogenousmoneytheoryexplainsthat,ratherthanbankswaitingforadepositortocomealongwithadditionalmoney,withincertainconstraintsbanksareabletolendasandwhentheywant.Itisbytheprocess of lending that banks create deposits and increase the money supply. This leads to newpurchasingpowerintheeconomy,asnoonehasseenareductioninthevalueoftheiraccount.IfthebankneedscentralbankreservesattheBankofEnglandtosettleanypaymentsthatariseasaresultofitslending,itwillbeabletoborrowthemeitherfromthecentralbankorfromotherbanks.AsAlanHolmes,thenSeniorVicePresidentoftheFederalReserveBankofNewYorkputitin1969:“Intherealworld,banksextendcredit,creatingdepositsintheprocess,andlookforthereserveslater.”(p.73)

The question then is,Are banks restricted inmaking loans as a result of any potential inability toobtain reserves? In contrast to themoneymultiplier view of banking, in reality bankswill almostalwaysbeabletoobtainreserves–ifnotfromthemarketsthenfromthecentralbankitself,whichisrequiredto“supplybasemoneyondemand”inordertomaintainaconstantinterestrate.Restrictingreserveswouldseeasharpincreaseinthisrate(thisisexplainedinmoredetailinSection3.4).Restrictingreservesmayalsocreatealiquiditycrisis,asthebankinquestionwillnotbeabletosettlepaymentsonbehalfofitscustomersduetoalackofreserves.Duetothepotentialforliquiditycrisesto turn into solvency crises, and because a solvency issue at one bank can cause a cascade ofbankruptciesthroughouttheentirebankingsystem,thecentralbankisunlikelytopursuethesecondoption. Indeed, it goes against one of the central bank’s core functions – its mandate to protectfinancialstability.Thevalidityoftheendogenousmoneytheoryhasbeenconfirmedbyprominentcentralbankersandregulators.BeforehebecameGovernoroftheBankofEngland,MervynKingwrotein1994that:“In theUnitedKingdom,money is endogenous—theBank suppliesbasemoneyondemandat itsprevailinginterestrate,andbroadmoneyiscreatedbythebankingsystem.”

In a speech at Southampton University in 2011, Adair Turner, head of the Financial ServicesAuthority,said:“Banksitisoftensaidtakedepositsfromsavers(forinstancehouseholds)andlendittoborrowers(forinstancebusinesses)withthequalityofthiscreditallocationprocessakeydriverofallocativeefficiencywithintheeconomy.Butinfacttheydon’tjustallocatepre-existingsavings,collectivelythey create both credit and the depositmoneywhich appears to finance that credit. Banks createcreditandmoney.”

Alsoina2011speech,VítorConstâncio,Vice-PresidentoftheEuropeanCentralBank,explainedthat:“Itisarguedbysomethatfinancialinstitutionswouldbefreetoinstantlytransformtheirloansfromthecentralbankintocredittothenon-financialsector.Thisfitsintotheoldtheoreticalviewaboutthe creditmultiplier according towhich the sequence ofmoney creation goes from the primary

liquiditycreatedbycentralbankstototalmoneysupplycreatedbybanksviatheircreditdecisions.In reality the sequence worksmore in the opposite direction with banks taking first their creditdecisionsandthenlookingforthenecessaryfundingandreservesofcentralbankmoney.”

Finally,ina2010paper,PitiDistayatoftheBankforInternationalSettlementsstated:“This paper contends that the emphasis on policy-induced changes in deposits is misplaced. Ifanything, the process actually works in reverse, with loans driving deposits. In particular, it isarguedthattheconceptofthemoneymultiplierisflawedanduninformativeintermsofanalyzingthedynamicsofbanklending.Underafiatmoneystandardandliberalizedfinancialsystem,thereisnoexogenousconstraintonthesupplyofcreditexceptthroughregulatorycapitalrequirements.Anadequatelycapitalizedbankingsystemcanalwaysfulfillthedemandforloansifitwishesto.”

Empirical analysis has also been carried out on this topic. In a 1990 paper Finn Kydland and EdPrescott test for whether the monetary base (i.e. reserves and cash) increases before banks makeloans, as suggestedby themoneymultipier theory, or afterwards, as suggestedby the endogenousmoneytheory.Theyfindthat:“ThereisnoevidencethateitherthemonetarybaseorM1leadsthe[credit]cycle,althoughsomeeconomists stillbelieve thismonetarymyth.Both themonetarybaseandM1seriesaregenerallyprocyclical and, if anything, themonetary base lags the [credit] cycle slightly.” [Our addition inbrackets].

Inhis1988bookHorizontalistsandVerticalistsBasilMoorealsopresentscompellingevidencethatbankslendbeforeacquiringthenecessaryreserves:“Theevidencepresentedstronglysuggeststhatunidirectionalcausalityrunsfrombanklendingtoeachofthefourmonetaryaggregates.Eachmonetaryaggregatehasbeenshowninturntocausethemonetarybaseunidirectionally.”

Finally, in a survey of the empirical literature, Peter Howells finds that: “The present state ofempiricalknowledgeappearstoconfirmthehypothesisthatloanscausedeposits”.(2005)Inconclusion, the endogenousmoney theory sees causality in thebanking systemoccurring in thefollowingway:

Bankslend,creatingdepositsintheprocess.

Thisincreasesdemandforreservesinordertosettlepayments.

Thecentralbankprovidesreservestobanksondemand,thusaccommodatingthebankingsector'slendingdecisions.

The fundamental implication of the endogenousmoney theory is that it is the commercial banks,rather than the central bank, that determine themoney supply. The central bankmust facilitate thelendingdecisionsofbanksbyprovidingsufficient reserves toensure thatallpaymentssettleat theendoftheday–forallintentsandpurposesitisthecommercialbanktailthatwagsthecentralbankdog.Thisistheoppositeofthemoneymultipliertheory,whichimpliesthatthecentralbankdecidesthemoneysupplyandbanksreactpassively,simplylendingthedepositsthattheyreceive.Ofcourse,therearelimitstomoneycreation,althoughaswewillseeinthefollowingchapter,theselimitstendtobeself-imposedbythecommercialbanksratherthanaresultofoversightorcontrolbytheBankofEngland.

Footnotes1.AlthoughcruciallytheCPIbasketdoesnotincludehouseprices.2.Thishoweverhasnotalwaysbeenconsideredpossible–beforetherunuptothe2007/08crisistheconsensus amongst central bankerswas that asset bubbles couldnot be spotted in advance, that thecentralbankdidnothavethetools toprevent them,andthatevenif itcoulditwouldbecheaper tocleanupafterthebubblehadburstthanattempttopopitbeforehand.

CHAPTER3WHATDETERMINESTHEMONEYSUPPLY?

Inthepreviouschapterwesawthatbankscreatemoney,intheformofbankdeposits,whentheymakeloansandbuyassets.Inthischapterwediscusstheincentivesbankshaveforcreatingmoneyinthisway,aswellaslookingattherestrictionsandregulationsthatpreventthemfromdoingso.Webeginbylookingatwhatdeterminesthedemandforbankloans,concludingthatasaresultofthedistributionofwealth, thedesire tospeculate,and theeffectofvarious laws, thedemandforcreditwill almost always be very high. The demand formoney is also discussed, as is the effect on theeconomyofanyattempttopaydowndebtsinaggregate.Second,wewilllookattheincentivesfacingbanks:giventhehighdemandforcredit,whydobanksnot simply lend toevery individualorbusiness thatapplies fora loan?Wewill see thatdue to theprofitmotive,financialinnovationsandsomeotherinstitutionalquirks,bankswillattempttolendasmuchastheycanaslongasitisprofitableforthemtodoso.Third,wewill look at the reaction of the regulators. Facedwith a banking sector that has a hugenumberofwillingborrowersandanincentivetolendtothem,inthecurrentinstitutionalstructure,isit possible to temper banks’ natural desire to create credit?Wewill conclude that despite thewidevarietyoftoolsavailable,noneareparticularlyeffective,andthusbanksarerelativelyunconstrainedin their ability to create credit. The main determinant of bank lending, and therefore the moneysupply,willbefoundtobethedesireandwillingnessofbankstolend,whichinturnwillrestontheirconfidence in thewider economy, the profitability of lending and the likelihood that loanswill berepaid.

3.1THEDEMANDFORCREDITWhat determines the demand for credit? There are broadly three main reasons that people andbusinesseswillneedtoborrow:1.Duetotheborrowerhavinginsufficientwealth2.Inordertospeculate3.DuetolegalincentivesBorrowingduetoinsufficientwealthIntheUKthewealthiest10%ofthepopulationholds45%ofthewealth,whereasthebottom50%ofthepopulationhasjust12%ofthewealth(seefig3.1).Thoseundertheageof44havetheleastwealth–47%haveanetwealthoflessthan£50,000,andalmost70%haveanetwealthoflessthan£100,000.(HMRevenue&Customs,2011)Borrowingthereforeallowsindividualsandbusinessestopurchasetodaysomethingthatcouldnotbeaffordedotherwise.Thisisnottosaythatinaworldwherewealthwasequallydistributedtherewouldbenoborrowing;merelythatifwealthweredistributedmoreevenly,individualswouldnothavetoborrowasmuchastheydonow.LendingforinvestmentduetoinsufficientwealthOnegroupthatalmostalwaysneedtoborrowduetoinsufficientwealthisentrepreneurs.Individualsbetweentheagesof25and44arethemostlikelytosetuporrunanewbusiness(Hart&Levie,2011;

Kauffman Foundation, 2009), yet those 45 or older hold much of society’s wealth. The fact thatentrepreneurs typically have a wealth of ideas but little money to implement them was noted bySchumpeter:“The entrepreneur – in principle and as a rule – does need credit, in the sense of a temporarytransfer to him of purchasing power, in order to produce at all, to be able to carry out his newcombinations, tobecomeanentrepreneur.And thispurchasingpowerdoesnot flow towardshimautomatically,astotheproducerinthecircularflow,bythesaleofwhatheproducedinprecedingperiods. If he does not happen to possess it … he must borrow it … He can only become anentrepreneurbypreviouslybecomingadebtor…hisbecomingadebtorarisesfromthenecessityofthe case and is not something abnormal, an accidental event to be explained by particularcircumstances.Whathefirstwantsiscredit.Beforeherequiresanygoodswhatsoever,herequirespurchasingpower.”(Schumpeter,1934,p.102)

AccordingtoSchumpeterentrepreneursare theheroesofcapitalism–creatingjobsandprosperityforall.Yet,astheabovequoteattests,whenwealthisnotequallydistributedtheyarehighlydependentonbankstofacilitatetheirentrepreneurialactivities.Larger,establishedbusinessesalsoneedtoborrow,fortwomainreasons:Toexpand:Afirmthatwantstobuynewmachineryoropennewstoresmustpayforthegoodsandequipmentbeforeitcanactuallysellanything.Forthatreasonitneedstoborrowupfrontandrepaytheloanoncethenewstoreorequipmentisgeneratingrevenue.Tomanagethecashflowgapbetweenpaymentscominginandoutofthebusiness.Thisiscommonwhenafirmreceivesalargeorder:itmustpayforthematerialsitusestoproducetheorderbeforeitactuallygetspaid for the finishedgoods,so itneeds toborrowforashortperiodof timewith theloan(oroverdraft)beingrepaidassoonasthefinishedgoodsaresoldandpaidfor.LendingforpropertypurchaseduetoinsufficientwealthIndividualsalsoneedtoborrowtopurchaseproperty.Housesarethemostexpensivepurchasesthatmostindividualswillevermake,withonlyasmallminoritywealthyenoughtoaffordtobuyahouseoutright.Most peoplewill need to takeout amortgage, typically tobe repaidover a periodof 25years.Thelevelofdemandformortgagelendingislargelyafunctionofhouseprices;whenhousepricesareatanaverageof£165,000,astheywereinmid-2012,thentheamountthatpeopleneedtoborrowwillnaturallybemuchhigher thanwhenaveragehousepriceswere£58,000,as theywere in1997(Nationwide,2012).Risinghousepricesarelikelytoincreasethedemandformortgagelending,aspeoplewilleitherwantto‘getinearly’toavoidbeingpricedoutofthemarketorinordertoprofitfromrisingprices.LendingforconsumptionspendingduetoinsufficientwealthIndividualsmayalsoborrow inorder to spread theirpaymentsover aperiodof time.Historicallypeoplemadepurchasesonconsumercreditfordurablegoods,suchaswashingmachinesorcookers,whichallowedthemtospreadthecostofanexpensiveitemoveraperiodofyears.Economiststermthis‘consumptionsmoothing’.Morerecently,therehasbeenanincreaseinthesupplyofandaccesstoconsumercredit,(throughcreditcardsforexample),aswellaschangesintheculturalacceptabilityof debt. This has resulted in an increase in the number and type of goods that are commonlypurchasedoncredit.Accordingtoagovernmentreport,intheUK“thelongertermtrend,would,onbalance,tendtosuggestthatdebtisbecomingaproblemforanincreasingnumberofhouseholds”.

(BERR,2007)fig.3.1–Distributionofwealthbydecile,2001–2003

Source:HMRCPersonalwealthstatistics2001–2003(table13.8)BorrowingforspeculativereasonsThesecondreasonpeoplemightwishtoborrowisinordertospeculate–byborrowingtospeculateanindividualcanincreasetheirreturnsoverthatwhichtheycouldachieveiftheyusedonlytheirownmoney.Thiscaninvolveborrowingtobuyanasset(financialorreal)whosepriceisrising,andthenselling the asset againwhen it has reached a higher price.Most peoplemay associate this type ofbehaviourwithtradersintheCityoronWallStreet,butitisalsothebusinessmodelofeverybuy-to-let investorwhobought a secondor thirdhouse inorder tobenefit from risinghouseprices.Thedemandforcreditinordertospeculateisnaturallyhighestinatimeofrisingassetprices.Aswewillseeinlaterchapters,speculationcanbecomeaself-fulfillingprophecy.Incertainmarketsrisingpricescanleadtoanincreaseindemand,aspeopleborrowtopurchasetheassetinexpectationof even further price rises.The extra purchases pushupprices,which leads to further borrowing,increasesindemand,andpricerisesinaself-reinforcingmechanism.Marketswith a limitedor inelastic supply, such as financial andpropertymarkets, are particularlyvulnerable to this typeofassetprice speculation. It canbeparticularlydamagingwhen theasset inquestionisanecessity(e.g.housing).ThedynamicsofthissituationanditsimpactontheeconomywillbecoveredinmoredetailinChapter4.Borrowingduetolegalincentives

The third reason that borrowing may be higher than it otherwise would be is due to legislation.Specific lawsmaychange the incentives for individualsandfirms toborrow.Forexample, limitedliabilitylawsthatapplytocompaniesalterthedemandforcreditthroughtheincentivestheyplaceoncorporatemanagement:“AsStiglitzandWeiss(1981)havepointedout,thelegalconstructofcorporateentitieswithlimitedliabilityofdirectorscreatesanasymmetricincentivestructure,wheredirectorswhoborrowmoneytobuilduptheirbusinessmaygainmuchiftheysucceed,buttheirdownsidewillbelimitediftheydon’t(theirpersonalwealthwillremainuntouched).IftheysucceedtheymaybethenextBillGates.Iftheyfail,theywilllosetheirpaid-inequitycapital,butnotmore.Theactualdemandforcreditisthereforealwaysrelativelylarge(eveniffromcrankentrepreneurswithhighriskideas).”(Werner,2005,p.195)

Taxlawsalsoalterthedemandforcredit.Forexample,in1965corporationtaxwasintroducedintheUK.Oneof its featureswas that loan financingwas tobe treateddifferently fromfinancing raisedthroughequity–debtfinancingwastobetaxedatalowerratethanequityfinancing.Thisisdespitethefactthereisnogoodeconomicreasonforthistobethecase.TheresultisthatUKcompaniesareincentivisedtotakeonmoredebtthantheywouldotherwise.

3.2THEDEMANDFORMONEYImagineanunlikely scenario inwhichnobody in thenationwanted toborrow:everyonewouldbelivingwithin theirmeans, peoplewould save up beforemaking large purchases, and bankswouldhavenobodytolendto,asno-onewouldbewillingtotakeondebt.Buteveninthissituation,therewouldstillbeaneedformoneyasameansofpaymentso thatpeoplecould tradewitheachother.Thereisacertainlevelof‘demand’formoney,independentofthedesireofsomepeopletoborrow.‘Demand’isaspecificconceptineconomics:itrefersto“thewillingnessandabilitytopayasumofmoneyforsomeamountofaparticulargood.”(Bannock,1978)Thedemandformoneyrefersnot,therefore, to how much money people would like (presumably most people would like to havemillions),buttohowmuchtheyarewillingandabletoretainintheirwalletsandbankaccountsatanyone time instead of spending it on goods, services, holidays or exchanging it for other financialassetssuchasbondsorshares.Whatdeterminesthelevelofthisdemandformoney?Mostobviously,peoplechoosetohold(i.e.‘demand’)moneybecauseitisusefulwhenevertheyneedto buy something.While cash is useful for smaller purchases, for larger purchases and shoppingonline, electronicmeans of payment are essential. So there is a need for electronicmoney in theeconomy simply to allow trade to take place. Peoplewill typically hold at least enoughmoney tocovertheirplannedspendingfromonepay-chequetothenext.Others may also want to hold a certain additional amount of money aside in case of unexpecteddevelopments, such as urgent car repairs or to cover an unexpected loss of income. Therefore inadditiontothedemandformoneyinordertomaketransactions,peoplealsoholdmoneybecausethefuture is inherentlyuncertain.Even individualswhomakesignificant investments inother financialassets (suchas shares)maykeepsome‘money in thebank’ to limit their losses incase theirotherinvestments fall invalue. In this sense,holdingmoney is a safetymeasure.Tradersmayevenholdmoneyinordertospeculate–iftheybelieveafinancialassettheyholdisgoingtofallinvaluetheycouldsellitformoneyandwaitforthevaluetofallbeforebuyingitbackatthenew,cheaperprice.Inconclusion,thereisacleardemandformoneyas

1. Ameansofpayment.2. Acontingencymeasureduetotheuncertaintyoffutureexpenditureandincome.3. Acontingencyduetouncertaintyastothevalueofotherassets.

How then do people obtain this money? Currently the banking sector is the only issuer of bankdeposits.Aswehaveseen,bankscreatedepositsintheprocessofmakingloans–unlesssomebodyisfirstwillingtogointodebttoabank,noonewillbeabletoholdabankdeposit.Theotherformofmoneythatindividualsareabletoholdisofcoursecash.However,aswellasacash-onlyeconomybeinghighlyinconvenient(nottomentionriskyforthoseholdinglargeamountsof cash), it is also now an impossibility.Under the currentmonetary system the central bank sellsnotesandcoinstothebanksinexchangeforcentralbankreserves,meaningthattheonlywayforthiscashtoentertheeconomyisforindividualstowithdrawitfromthebank,inexchangeforareductionintheirbankdeposits.Withoutsomebodyfirstholdingbankdeposits–i.e.unlesssomeonehasfirstborrowedfromabank–thereisnowayforcashtocomeintocirculation.This problem points to one of the quirks (or flaws) in the existingmonetary system. Economistsdistinguishbetweentheneedforcredit(forinvestment,consumptionsmoothingorspeculation)andthe need for money (as a means of payment or a hedge against uncertainty). Yet in the currentmonetarysystemthereisonlyonesourceofbothcreditandmoney:commercialbanks.Thedemandof one person to hold money in the form of bank deposits therefore creates a requirement forsomeoneelsetobeindebttoabank.Thus,inorderfortheretobemoneysothattheeconomycanfunctionandpeopleandbusinessescantrade,someonemustfirsthaveborrowedfromabank.Conclusion:thedemandformoney&creditWe have seen that credit is demanded in order to make investments in businesses, smoothconsumptionoveraperiodoftime(suchashousingorconsumerfinance),ortospeculate.Thelegalconstructofcorporationsandcertaintaxincentivescanincreasethelevelofdemandforcreditfrombusinesses.Assuchtherewillalwaysbesubstantialdemandforborrowingfrombanks.However,becausethebankingsectoristheonlysourceofbothcashandbankdeposits,thereisalsoastructural demand for borrowing from the economy itself, determined by the demand for money(althoughthiswillnotdirectlyresultinanincreaseinthedemandforcredit).Individualsoperatingwithinaneconomyrequiremoney,butbecausebankdepositsarecreatedwhenbanksmakeloans,foranindividualtoobtainmoney–whethertomaketransactionsortostoreagainstfuturecontingencies–someoneelsemusthavepreviouslygoneintodebt.1Thismeansthatfortheretobemoney,theremustalsobedebt.What’smore,ifpeopleenmassetrytorepaytheirdebtsthemoneysupplywillshrink.Asdescribedin section 4.2, this can lead to debt deflation,2 bankruptcies, increased unemployment and lowergrowth.Undersuchconditionsitisreasonabletoexpectthatbothindividualsandfirmswillbeforcedtoborrowinordertomakeendsmeet,increasingthedebtthattheywereinitiallytryingtopaydown.This leads to the paradoxical result that an attempt to pay down debts in aggregate may invokeeconomicconditionsthatactuallyleadtoanincreaseinthedemandforcredit/debt.In conclusion, in addition to the demand for credit that occurs as a result of people wanting toborrow,thereisalsoaneedforcreditfromtheeconomyitselfsothatitcanfunction.Anysignificantattempttopaydowndebtsisparadoxicallylikelytoleadtoanincreaseindemandforcredit/debt.The

demandforcreditwillthereforealwaysbeveryhigh–atleastwithinthecurrentmonetarysystem.

3.3FACTORSAFFECTINGBANKS’LENDINGDECISIONSTheprevioussection lookedat the factors that influence thedemandforcredit,concluding that thedemand for borrowing from banks will always be very high. The following section looks at theincentivesbankshavetolend.Willtheytrytomeetthelevelofdemandforcreditbymakingloanstoeveryone who is willing to go into debt (in the same way that Apple would supply an iPhone toeveryonewhoiswillingtopaytheaskingprice)?Orwilltheyturnawaypotentialborrowerswhoarewillingtosignonthedottedline?ThedrivetomaximiseprofitThebusinessofbankingisingeneralaprivatefor-profitenterprise.Banksprofitbyextendingloans,with theprofitbeing the interestchargedon the loan,minusanycosts (suchas the interestpaidontheir liabilities, the wages of staff, etc.). During relatively benign or stable periods banks areunderstandably keen to lend: themore (successful) loans theymake, the higher their profits. Thisprofit incentive is exacerbated by three additional factors: the ability of banks to securitise theirassets, theprovisionof deposit insurance, and the ability to externalise their costs (i.e. because thecostsofexcessivemoneycreationarebornenotbythebanksbutbysocietyasawhole).SecuritisationTraditionallyforabanktomakeprofitsitwasimportantthatitsloanswererepaid.Whenaborrowerdefaults (refuses to repay) on a loan, the assets side of the bank’s balance sheet shrinks, yet theliabilitiessideremainsthesame–essentiallydefaultseatintoshareholderequity,decreasingthenetworthofthebank.Withenoughdefaultsshareholderequitycanbecompletelywipedout,turningthebankinsolvent.Therefore,asdescribedbyDavidson(2008),because“loanswereilliquidassetsandhadtobecarriedonthebookstillthepersoneitherpaidoffthemortgageordefaulted”,banksmadetheir profits gradually as loanswere serviced and eventually repaid.Therefore, “Beforemaking aloan, the banker checked the classical three C’s: collateral, credit history and character of theborrower.”However,more recentlybankshaveswitchedfromamodelofbanking inwhich theymakeprofitsoverthelifetimeofaloantooneinwhichprofitsonloanscanbebookedwithinweeksofitbeingmade. This is the “originate and distribute” model of banking made possible by securitisation.Securitisation is the practice of pooling multiple loans (including mortgages) together, and thenselling these consolidated loans to investors asCollateralisedDebtObligations (CDOs). The bankreceives an upfront payment, and the investors receive a stream of income over the life of thefinancial instrument. The bank’s profit comes from a fee for arranging the loans, instead ofcollectingtheinterestastheloanisrepaid.Accordingly,banksnolongerneededtoworryaboutthethreeC’s:“Whenyousecuritizemortgageyoudon’tcareabouttherisk,becauseyou’regoingtopassit off”. (Davidson, 2008) The ability to securitise loansmeans banks canmake profits not by thequalityoftheloanstheymake,butbytheirquantity.Thewillingnessofbankstolendtothesubprimemarketwaspartially(andpossiblypredominantly)attributabletosecuritisation.Governmentguarantees&‘toobigtofail’“Bank runs are a common feature of the extreme crises that have played a prominent role inmonetaryhistory.Duringabankrun,depositorsrushtowithdrawtheirdepositsbecausetheyexpectthebanktofail.Infact,thesuddenwithdrawalscanforcethebanktoliquidatemanyofitsassetsata

loss and to fail. During a panic with many bank failures, there is a disruption of the monetarysystemandareductioninproduction.”(Diamond&Dybvig,1983)

Whenacompanybecomesinsolvent,creditorstothatcompanywillusuallyloseaproportionoftheirmoney. In thecaseofabank, thiswould involvedepositorsonlyreceivingapercentageof thefullvalueoftheiraccount.However,intheUK(andinmostothercountries)thegovernmentguaranteesthatifabankfails,thecustomersofthatbankwillbeabletoclaimacertainpercentageoracappedamountoftheirdepositbackfromthegovernment.Thisguaranteeonthemoneyinabankaccountisknown as ‘deposit insurance’. In a country with deposit insurance, in the event of insolvency theinsolvent bank will have its assets sold off. Any funds raised in this way are used to reimburseddepositors,withanyshortfallbeingmadeupwithfundsfromtaxpayers.ThefirstsystemofdepositinsurancewasestablishedinAmericainresponsetotheGreatDepression.Itspurposewastopreventthebankrunsthatcontributedtothedepressionfromeverhappeningagain.Deposit insurance is based on the idea that if depositors know that the governmentwill reimbursetheirdeposits in the resultof abank failure, then theywillnotbother attempting towithdraw theirdepositseveniftheyfindoutthebankisinsolvent.Thisisintendedtopreventrunsonbanksthatarerumoured to be insolvent or experiencing financial difficulty. In addition those banks that areinsolventwillnothavetoundertakeafiresaleof theirassets inorder toquicklyraisemoney.Firesales are undesirable because they can lead to a crash in asset prices, which can also lead to theinsolvencyofothers(includingbanks)thatholdsimilarassets.Leftunchecked,adebtdeflationmayresult(asoutlinedinsection4.2).IntheUKtodaythegovernmentprovidesdepositinsurance(viatheFinancialServicesCompensationScheme,FSCS)tomostbankaccountsuptoalimitof£85,000.IntheorytheFSCSisfundedbyleviesonbankswhosecustomersarecoveredbytheguarantee,butinpracticethemajorcontributorstothecost of the scheme have been taxpayers.Due to the failure of certain banks in 2008-09, just £171millionofthe£19.86billion(lessthan1%)wasfundedthroughlevies,whiletherestwasprovidedbygovernment(FinancialServicesCompensationScheme,2009).Thereare twomainproblemswithdeposit insurance.The first is thatbybeing insured, customerswilltakelittleornointerestinthewaythatthebanklendsandtakesrisks.Thisisknownas‘moralhazard’.3

In a system without deposit insurance, depositors would have a strong incentive to monitor theirbank’sbehaviourtoensurethebankdoesnotactinamannerthatmayendangeritsownsolvency.Forexample, a depositor would be concerned with the types of loans their bank was making and theamount of capital their bank had (capital acts as a buffer, protecting depositors from losseswhenloansgobad).Otherthingsbeingequalabankwithahighercapitalratiowouldbeconsideredsaferand inconsequencecouldbeexpected toattractmorecustomers thanabankwitha smallercapitalbase.However,inasystemwithdepositinsurancethereisnoincentiveforcustomerstomonitortheirbank’sbehaviour,asdepositorsareguaranteedtoreceivetheirmoneybackregardlessofthelevelofrisktakenbythebank.Thislackofscrutinyfromcustomers(orthefinancialpress)meansthatbanksarenotrestrictedtotakingthelevelofriskthattheirdepositorswouldbecomfortablewith.Instead,theyarefreetolendasmuchastheyliketowhomevertheylike,intheprocessloweringtheircapitalratio (increasing their leverage).4 Thus the presence of deposit insurance removes one potentialconstraintonthebanks’desiretolendandincreasestheriskinessoftheirlending.Thesecondproblemwithdepositinsuranceregardstheinsolvencyprocedureanditscostsinthecase

of a bank failure. In a countrywith a deposit guarantee scheme, bank insolvency normallymeanseitheragovernmentbailoutofthebankinquestion,ortheclosingofthebank,thesaleofitsassetsandcompensation fordepositholdersup to thedesignatedamount.Howlikelyaregovernments totakethesecondoption?ThecaseofRBS(RoyalBankofScotland)isusefulhere.WhenRBS ran into trouble during the financial crisis, the government had theoption to close thebank and let it fail (as would happen to any non-bank business that became insolvent). However,because of its obligation to reimburse the depositors of RBS, the government would have beenobligedtofindapproximately£800bn–greaterthantheentirenationaldebtatthattime,andsimilarin size to the UK government’s annual tax take. Of course, in an ideal worldmuch of this couldpotentiallyhavebeenraisedbythesaleofRBS’sremaining(good)assets.However,thegovernmentwas constrained in its actions – it had to resolveRBSquickly.Anydelay could cause the panic tospreadtootherbanks,amplifyingtheoriginalproblem.Findingbuyersfor£800billionofassetsishard at the best of times, especially when those assets are from a failed bank. In themiddle of afinancialcrisis it isclose to impossible.Asa result thegovernmentwouldhavemost likelyhad toacceptaprice for theassets farbelowtheirmarketvalue,andwouldneed tomakeup theshortfallfromtaxpayer ’sfundsorborrowing.Inaddition,themajorityofRBS’sassetswereloans.Thesearedifficulttovaluequickly(duediligencetakestime),andinconsequencethegovernmentwouldonceagainhavehad toacceptapricebelowmarketvalue. InvokingbankruptcyproceduresagainstRBSwouldhavethereforebeenhighlycostlytothegovernment.Afurtherproblemwithallowingalargebanktofailisthatitcouldleadtoproblemsatotherbanks.First,becausebanksoweeachotherlargeamountsofmoneyafailurecouldleadtoinsolvenciesatotherbanksduetothenon-repaymentofloans.Thiscanleadtoacascadeofbankruptciesthroughoutthe entire system. Second, insolvency at one bank can lead to runs on solvent banks as depositorspanic about their own bank’s position. The belief a bank is insolvent can become a self fulfillingprophecy,asafiresaleofassetsreducestheirvalue.Third,thepaymentsystemitselfmaybeaffectedbybankinsolvency:manybanksdonothavedirectaccesstothehighvaluepaymentsystems,insteadaccessing them indirectly through a correspondent bank (known as a settlement bank). If thesettlementbankbecameinsolventthiscouldcreateproblemsinthepaymentsystem,asthe‘customerbank’wouldnotbeabletomakeorreceivepayments.Inaddition,insolvencyateitherthecustomeror thesettlementbankcouldleadtoinsolvencyat theotherbank.Forexample, ifasettlementbankmakespaymentswiththeirownliquidityonbehalfoftheircustomerbanks,theyareineffectlendingto their customerbankuntil the accounts are settled at the endof theday.Likewise, if a settlementbankreceivesmorepayments to theircustomerbank than thecustomerbankmakesduring thedaythenineffectthecustomerbankislendingtothesettlementbank(againuntiltheaccountsaresettledat the end of the day). Depending on who owes who, bankruptcy (and therefore default onborrowings) of either bankduring the daymay create problems for the other bank.These are notsimply theoretical risks: “During the great depression 247USbankswere closed between January1929andMarch1933due to the failureofacorrespondent [bank]”. (Salmon,2011)Similar issuesalmostmaterialisedinthe2007/08financialcrisis:“InoneoftheUKpaymentsystems,aUKbankthatgotintodifficultymadeitspaymentsthroughamuchsmallerbank,intermsofbalancesheetsize.Theseexposurescouldwellhaveputthesmallerbankinsignificantfinancialdifficultyhadtheauthoritiesnotintervenedinthefailingbank.”

These risks may also spill over into the rest of the payment system if banks start delaying theirpaymentsduetouncertaintyastothestatusofoneormorebanks.

Fourth, thefailureofabankmaynegativelyaffect theflowofcredit (i.e. lending) to theeconomy,particularlyifthebankservicesalargeproportionofthelendingmarket.Forexample,RBSaccountsforasignificantproportionofalllendingtoUKbusinesses,meaningthatitsfailurewouldhavebeendevastatingforsmallandmediumsizedbusinesses(whichemployaroundhalfofallworkersintheUK).

Forallofthesereasons,bankscanbedeemed‘toobig’,or‘toosystematicallyimportant’tofail.5Asa result of these costs and potential risks, a cheaper and safer option for the government was toeffectivelygiveRBS£45.5billioninexchangefornewlyissuedshares.ThisbecameanassetofRBS,makingitsnetworthpositiveagain.Largebanksfullyunderstandthatdeposit insurancemeansthat if theybecomeinsolvent, thechoicefacinggovernmentisbetweenrepayingalltheircustomersduetodepositinsurance,orrescuingthebankthroughan‘injectionofcapital’(abailout).Inpractice,itwillalwaysbemanytimescheaperandsafer to rescue a bank that to let it fail. This knowledge will lead the bank to take higher risks,knowingfullwellthatthegovernmentwillbeunabletoaffordnottorescueitifitshouldfail.Thelargerthebank,thegreaterthecosttogovernmentofallowingittofail,andthemoreconfidentthebank will be that it has a guaranteed safety net even if the risks it takes backfire and it becomesinsolvent. Banks will therefore lend greater amounts and lend to riskier borrowers than theyotherwisewoulddo,whichwillinturnleadtoalargermoneysupply.

Externalitiesandcompetition6Banksmayalsomakemore loans than is sociallyoptimalbecause theydon’t face the fullcostsoftheir lending (i.e. they externalise costs ontoothermembers of society).For example,whenbanksmake loans they increase the amount of purchasing power in the economy and this can result ininflation in consumer and asset prices (discussed in detail inChapter 4).Both asset and consumerpriceinflationimposecostsonsocietyasawhole,withassetpriceinflationparticularlyproblematicduetoitspotentialtocausefinancialcrises.Thisistheclassiceconomicexternalityproblem:ifthecostsofinflationandfinancialcriseswerebornesolelybythebanks,theywouldhavenoincentivetocreatetoomuchcredit,orallocatecreditintoassetpricebubbles.Theproblemofexcessmoneycreationisamplifiedbycompetitionbetweenbanks.Togainmarketshareandincreaseprofits,banksmustmakemore(successful)loansthantheircompetitors.Thisinitselfcreatesatendencyforbankstomaketoomanyloans.Inarecentpaper,HartandZingales(2011)createasimpleframeworktoanalysetheeffectofbanklendingoninflationintheeconomy,askingthequestion:“Doesacompetitivebankingsectorgeneratethesociallyoptimalamountofthemeansofpayment?In this paper we show that the answer is no, even if we abstract from any moral hazard andasymmetry of information. In particular, we analyse the general equilibrium effects that theavailabilityofmoneyhasonpricesandidentifytwopecuniaryexternalities:moremoneyincreasestheequilibriumpriceofthegoodsthatthosewiththemoneybuy;butitalsoincreasesthewealthoftheagentssupplyingthesegoodsandsothepricesofthegoodstheybuy.Acompetitivebank,whichignorestheexternalityimposedonotherbuyers,willgeneratetoomuchmoney…Asaresult,weshowthattheprivateprovisionofinsidemoney[bankdeposits]isgenerallyinefficient.”(p.2)[Ouradditioninsquarebrackets]

In short, the impossibility of internalising these inflationary externalities means that the private

bankingsectorwillnevercreatethesociallyoptimallevelofcurrency.

3.4FACTORSLIMITINGTHECREATIONOFMONEYBecause of the negative impact excessive bank lending can have on the economy, historically theauthoritieshaveimplementedvariousregulationsinanattempttocontrolthequantityanddirectionoftheir lending activities. The following section will look at the effectiveness of some of theseregulations.Inparticular,itwilllookattheeffectivenessofcontrollingbanklendingthroughcapitalrequirements,reserverequirements,andinterestrates.Capitalrequirements(theBaselAccords)Asoutlinedinsection2.3,shareholdercapital(orequity),isthoughttobeimportantfortworeasons.First,itprovidesabufferfordepositorsandotherbankcreditorswhenabank’sassetsfallinvalue.Inthis situation, rather than depositors losing money (or the state losing money in countries wheredepositinsuranceexists),shareholderstakethefirsthit.Thisisintendedtogivedepositorsandothercreditorsconfidenceinthebankandhopefullythebankingsectorasawhole.Second, it is thought that the ratioofcapital toassetscanbeusedasa regulatory tool tocontrolabank’s lending.This isakeyaspectof theBaselCapitalAccords,whichstipulate that theratioofabank’s capital to its (risk-weighted) assets must not fall below some pre-determined amount. ForBaselIandII,thiswas8%.ForBaselIIItheratiowillriseto10.5%.7IntheoryunderBaselIIiftheratio of a bank’s capital to its risk-weighted assets falls below 8% the bank would be unable toincreaseitslendinganyfurther.However,capital requirementsdonotfullyconstrainbanklendingforseveral reasons.First,banksprofit throughcharging intereston loans.Anyprofits thatare retained increaseshareholderequity,and therefore capital. This higher capital allows a bank to further increase its lending, which,providing the loansare repaid,will lead to further increases inprofits and shareholder capital.Aslongasabank’slendingisprofitable(suchasinaboom)thiscyclewillbeabletocontinue.Second,banks are able to raise additional capital throughnewshare issues.Duringboomperiods,banks’profitstendtobehigh,andthisleadstohigherdividendsandanincreaseinthepriceofbanks’shares. Consequently banks will face little difficulty increasing their capital through this avenueduringbooms.Third,asdiscussedearlier,bankscanalsoengageinaprocessknownas‘securitisation’.Thisallowsbankstopackageassets(loans)ontheirbalancesheetandsellthemonto‘specialpurposevehicles’,receivingapaymentinexchange.Thishastheeffectoffreeingupthecapitalwhichwasbeingheldtocoverpotential lossesontheloans.Asaresultmore(new)loanscanthenbemadeandthepaceoflending(andmoneycreation)canincrease.Fourth,theBaselAccordsallowbankstocalculatetheircapitalrequirementsusingwhatisknownasthe ‘InternalRatingsBasedApproach’.Abank thatuses thisapproachcan,given theconsentof itslocalregulator,developitsownempiricalmodelstocalculatetheamountofcapitalitisrequiredtoholdagainst its assets.Anybankusing thisapproachcould therefore theoreticallyhold lesscapitalthan itwouldotherwisebe required to.As such this couldbe consideredde-regulation.Of course,whetherBaselIIincreasedordecreasedregulationdependsontheapproachtakenbytheregulator.IntheUK,theFinancialServicesAuthority(FSA)regulationwasbasedonthephilosophythat:“Marketsareingeneralselfcorrecting,withmarketdisciplineamoreeffectivetoolthanregulationor supervisory oversight through which to ensure that firms’ strategies are sound and risks

contained.....“Theprimaryresponsibilityformanagingriskslieswiththeseniormanagementandboardsoftheindividualfirms,whoarebetterplacedtoassessbusinessmodelriskthanbankregulators,andwhocanbereliedontomakeappropriatedecisionsaboutthebalancebetweenriskandreturn,providedappropriate systems, procedures and skilled people are in place.” (Financial Services Authority,2009)

BeforethefinancialcrisistheFSA’sregulatorystanceborneoutbythisphilosophywascommonlyreferredtoas‘lighttouch’.Althoughtherehasbeenachangeofdirectionsincethen,asaresultoftheotherissueshighlightedinthissection,capitalremainsanineffectivetoolforcontrollingbankcreditcreation,eventakingintoaccountthecountercyclicalbufferproposedbyBaselIII.Reserveratios&limitingthesupplyofcentralbankreservesRecallthatcentralbankreservesareusedbycommercialbanksinordertomakepaymentsbetweeneachother,and thecentralbankhas themonopolyon theircreation. In theory,by forcingbanks toholdacertainpercentageofcentralbankreservesagainsttheirdeposits,thecentralbankcanrestrictthequantityofdepositstoamultipleofthequantityofcentralbankreserves.CurrentlythereisnocompulsoryorevenadvisoryreserveratioinplaceintheUK.However,ifonewereinplace,wouldtheBankofEnglandbeabletocontrolbanklendingbyrestrictingtheamountofreservesinthemonetarysystem?Thebelief that thecentralbankcanmanage themoneysupply through thecreationofcentralbankreserves is prevalent inmainstreameconomics textbooks.This is largely due to their belief in themoneymultipliermodel(outlinedinsection2.7),inwhichthecentralbankfirstcreatesbasemoney,andbanksthenusethisbasemoneytolend,withthetotalnumberofloanslimitedbythequantityofreservesandthereserveratio.However,asexplainedearlier,“Intherealworld,banksextendcredit,creatingdepositsintheprocess,andlookforthereserveslater.”(Holmes,1969,p.73)Ifbanksmakeloansfirstthengolookingforthereserveslater,isitpossibleforthecentralbanktorestrictlendingbylimitingthesupplyofreserves?Intheory,ifabankhadaninsufficientquantityofreserves(thatitneededtomakeinter-bankpaymentsarisingfromitscustomersmakingpaymentstocustomers of other banks) then the bank in questionwould need to restrain its loanmaking. Thiswouldintheorydecreasethenumberofpaymentsitscustomersmadetocustomersofotherbanks(aspeopleborrowinordertospend),reducingtheoutflowsofreservesfromitintheprocess.However,inrealitytheBankofEnglandcannotmanagethemoneysupplybyrestrictingthesupplyofreservesunlessitiswillingtocreateeitheraliquidity(andpossiblyasolvency)crisis,orseeinterestrates riseabove the level atwhich ithascommitted tomaintain them.AsCharlesGoodhart (1994)explains:“Virtuallyeverymonetaryeconomistbelieves that thecentralbankcancontrol themonetarybase[thestockofcashandcentralbankreserves]…Almostallthosewhohaveworkedinacentralbankbelievethatthisviewistotallymistaken.”[Ouradditioninbrackets.]

Toseewhythisisthecase,imaginethatthecentralbanktriedtocontrolbanklendingbylimitingthequantityofreservesinaccountsattheBankofEngland.Asoutlinedpreviously,reservesareusedtomake payments, and by limiting the quantity of reserves the ability of banks to make paymentsbetweeneachotherisalsoreduced.Ifabank,eitherdeliberatelyorthroughmiscalculation,madetoomany loansand this resulted inanoutflowof reserves inexcessof itsholdings,would thecentral

bankbeforcedtoprovidemore?If the central bank refused to create excess reserves, then the bank in questionwould be unable tomakepaymentstootherbanks.Undersuchcircumstancesthebankmayattempttoraisereservesbysellingsomeofitsassets.Whileliquidassetsmaybesoldquicklyfortheirfullvalue,quicksalesofilliquidassetsoftenmeanacceptingapricebelowfairvalue.Liquidityproblemscanthereforesoonbecome solvency problems, with a solvency issue at one bank causing a cascade of bankruptciesthroughouttheentirebankingsystem.Accordingly,thecentralbankisunlikelytorefuseanyrequestforadditionalreserves,indeeddoingsowouldgoagainstoneofthecentralbank’scorefunctions–itsmandatetoprotectfinancialstability.AstheBankofEnglanddescribesit:“If there isa shortageof liquidity, then thecentralbankwill (almost)alwayssupply theneed...Asregardsashortageofcommercialbankreservesheldatthecentralbank,theriskisthatashortagewouldmeanpaymentscouldnotbeclearedattheendoftheday.Itistoavoidthisriskthatcentralbanks have in place credit standing facilities (SFs)— though they will normally aim to supplyliquidity via openmarket operations (OMO)— to avoid spikes inmarket interest rates.” (Gary,2008)

Astheabovequoteattests,thereisanotherreasonwhythecentralbankmaywishtosupplyreservestothebankingsystemondemand:anyexcessdemandforreservesabovetheirsupplywillbiduptheprice of reserves (i.e. the interest rate they are lent at). At this point the central bank, which iscommittedtomaintainingtheinterestrateoninterbanklending,willbeabletobringtheinterestratebackdownonlyby injecting reserves into the system.Bydoing so, itwillhave failed toconstrainbanklendingbyimplementingreserveratios.AsVictoriaChick(1992)explains:“Ifapolicyofstableinterestratesisinplace...reservesvirtuallydisappearasaconstraintonbankbehaviour.Banksarenowabletomeetanyreasonableriseinthedemandforloans.Depositswillriseasa resultand theshortfallof reserves ismetby thesystem.ThismechanismhasbeenusedoftenenoughinBritainfortheBankofEnglandtobereferredtoas‘lenderoffirstresort’.”

Therearealsootherreasonswhyreservesmaynotconstrainlendingorpayments.First,totheextentthatpaymentsaremadebetweencustomersofthesamebank,noreserveswillberequired.Themoreabankingsystemisdominatedbyafewlargebanks(suchas in theUK) thegreater thenumberofpayments that canbemadeacross thebanks’ownbooks, and the lessbankswillneedcentralbankreservestomakepayments.Second,whenabanklendsmoneyitwillusuallyresultinanoutflowofreservesfromthebank(whenthecustomerspendstheirloan).However,everyflowmustgosomewhere,sothatonebank’soutflowof reserves ismatchedwithanotherbank’s inflow.Therefore, ifallbanks increase their lending instepwitheachother,thepaymentsbetweencustomersofdifferentbankswilltendtocanceleachotherout and therefore a fixed quantity of reserves will be able to support an increasing quantity ofpayments (and lending). This pointwasmade quite explicitly byKeynes (1930) in his Treatise onMoney:“Therateatwhichthebankcan,withsafety,activelycreatedepositsbylendingandinvestinghastobeinaproperrelationtotherateatwhichitispassivelycreatingthemagainstthereceiptofliquidresourcesfromitsdepositors.Forthelatterincreasethebank’sreservesevenifonlyapartofthemisultimatelyretainedbythebank,whereastheformerdiminishthereservesevenifonlyapartofthem is paid away to customers of other banks; indeed we might express our conclusion morestrongly than this, since the borrowing customers generally borrowwith the intention of paying

awayatoncethedepositsthuscreatedintheirfavour,whereasthedepositingcustomersoftenhavenosuchintention.[…]It isevident that there isno limit to theamountofbankmoneywhich thebankscansafelycreateprovidedtheymoveforwardinstep.Thewordsitalicisedarethecluetothebehaviourofthesystem.Everymovementforwardbyanindividualbankweakensit,buteverysuchmovementbyoneofitsneighbourbanksstrengthensit;sothatifallmoveforwardtogether,nooneisweakenedonbalance.Thusthebehaviourofeachbank,thoughitcannotaffordtomovemorethanastepinadvanceoftheothers,will be governed by the average behaviour of the banks as awhole – towhich average,however,itisabletocontributeitsquotasmallorlarge.EachBankChairmansittinginhisparlourmayregardhimselfasthepassiveinstrumentofoutsideforcesoverwhichhehasnocontrol;yetthe‘outside forces’ may be nothing but himself and his fellow-chairmen, and certainly not hisdepositors.”

The argument that the central banks cannot restrict bank lending through reserves is therefore notneworobscure–theabovestatementwasmadeover80yearsagobyarguablythemostinfluentialeconomistof all time.Furthermore,during themonetarist experimentof the1980s, the theory thatcentralbankscouldcontrolbanklendingbylimitingthemonetarybasewasputtothetestandfailed.8Yet despite this, many economists still believe the central bank can control the money supply byrestrictingthelevelofcashandreservesincirculation.Inthenextsectionwewillconsiderarelatedargument–thatthecentralbankcancontrolthemoneysupply(andthusthelevelofaggregatedemandandinflation)bymanipulatinginterestrates.

Box3.A-Settingtheinterestrate

Thecentralbank’sability toset interest ratescomes from itspositionas themonopoly issuerofcentralbankreserves.Bychanging thisratethecentralbankattemptstolimitaggregatedemandintheeconomy,andindoingsoaffectthelevelofinflation.InthelasttenyearstheBankofEnglandhasusedthreedifferentmethodstosettheinterestrate:

Pre2006: Inorder toset interest rates theBankofEnglandartificially limited thequantityof reserves incirculation,so thebankingsectorwouldalways find itself short, inaggregate,of theamount it needed to settlepayments.This forced thebanks toapproach theBankofEnglandtoborrowthereservestheyrequired.Bychoosingtheinterestrateonthereservesthatitlent,theBankofEnglandcouldinfluencetheinterestrateonreserves inthesystemasawhole.Thisapproachwasmanagement-intensive, involvingtheinjectionofreservestwiceandsometimesthreetimeseveryday.

2006–2008:In2006theBankofEnglandmovedtowhatisknownasa‘reservesaveraging’scheme.Underthisscheme,atthebeginningofeverymonththecommercialbanksinformedthecentralbankastohowmanyreservestheywouldneedonaverageoverthecourseofthemonth.Thecentralbankthensuppliedthisquantityofreservestothecommercialbanks(usingrepos)andthecommercialbankswererequiredtoholdthisquantityofreservesonaverageacrossthemonth.Ifanybankfounditselfwithexcessreservesthenitcouldeitherlendthese reserves to another bank, or, if there were no borrowers, deposit these reserves in the ‘deposit facility’ at the Bank of England.Likewise, if a bank found itself short, it could borrow reserves from other banks or, if there were no willing lenders, from the Bank ofEngland’s ‘lendingfacility’.Thecentralbank incentivisedbankstohit their reservetargetbypaying interestonreservesat thepolicyratewhentheyhittheirtarget.

Bystandingreadytolendreservestobanksatahigherrateofinterest(thanthepolicyrate),andpayinterestonreservesdepositedwithitatalowerrateofinterest(thanthepolicyrate),thecentralbankcontrolledtheinterestrateatwhichprivatebankslentreservestoeachotheron the interbankmarket (known as the London InterbankOfferedRate, or LIBOR for short). This is because a bank looking to borrowreserves fromanotherbankon the interbankmarketwouldnotpaymore than the interest rateatwhich it couldborrow from theBankofEngland.Similarly,abanklendingreserveswouldnotacceptalowerinterestratethanthatwhichitcouldreceivebyleavingitsreservesinitsownaccountattheBankofEngland.Thesetwointerestratescreateda‘corridor’aroundtheinterestrateatwhichtheBankofEnglandwantedbankstolendtoeachother(thepolicyrate).

Post2008:Since2008 thecentralbankhasoperatedwhat isknownasa ‘floorsystem’of setting interest rates. In2008 thecentralbankflooded the commercial bankswith excess reserves through itsQuantitativeEasing program. This led to the reserves targeting schemebeingdropped,withallreservesthenremuneratedatthepolicyrate.Becausebanksnowhadmorereservesthantheyrequired,theneedto

borrowreservesontheinterbankmarketwasgreatlydiminished.Consequently,theovernightinterbanklendingratenowcloselymirrorsthepolicyrate.

ControllingmoneycreationthroughinterestratesCurrently, one of theBankofEngland’s two core purposes is tomaintain price stability,which inpracticemeanskeepinginflationatatargetlevelof2%ayear.Itdoesthisbymanipulatingtheshortterminterestratesatwhichbankslendreservestoeachotherontheinterbankmarket.Inthissectionwediscusshowthecentralbankattemptstocontrolinflationthroughinterestrates,thetransmissionmechanismsfrominterestratestoinflation,andtheeffectivenessoftheinterestrateasatooltolimitthegrowthinmoneycreationbybanks.Webeginwithashortoutlineofwhatinflationisanditslinkstothemoneysupply.InflationandthemoneysupplyInflationisdefinedas“asustainedrise in thegeneral levelofprices.”(Blanchard,2006)IntheUKinflationismeasuredusingtheConsumerPriceIndex(CPI),whichcalculatestheaveragechangeinthepriceofabasketofconsumergoodsandservicesoverthepreviousyear.Economistsdisagreeonwhatcausesinflation.Somebelieveinflationisentirelyduetothecreationofnewmoney,astheholdersofthenewlycreatedmoneypushupthepriceofgoodsandservices.ThiswasaviewheldbyMiltonFriedman,whofamouslyassertedthat“inflationisalwaysandeverywherea monetary phenomenon” (1970). Others believe that “inflation usually does not have monetaryorigins” (Tymoigne, 2009, p. 40), and instead focus on non-monetary explanations such as wageincreases.9 In his textbook Olivier Blanchard tries to forge some common ground between thesedisparategroupsbyshowingthatwhile intheshortruninflationmightbecausedbynon-monetaryphenomena, in the long run “unless they lead to higher nominal money growth, factors like themonopolypoweroffirms,strongunions,strikes,fiscaldeficits,thepriceofoil,andsoonhavenoeffect on inflation.” (2006, p. 191)One explanation for the lack of consensus between economistsmightbethat:“Inflationisacomplexsocialprocess,anditseemsunlikelythatthereisanyoneexplanationofthephenomenon valid for all times and all places. For any theory which asserts, for example, thathighergrowthisalwaysassociatedwithhigherinflation,itisalwayspossibletopointtoempiricalinstancesoftheopposite,eitherstagflation(lowgrowthwithhighinflation)or,morebenignly,non-inflationarygrowth.”(Smithin,2003,p.190)

However,despitethefactthatintheshortruninflationcanbecausedbyotherfactors,thereseemstobe little doubt thatmonetary factors are important in the long run. Indeed, theBankofEngland isquiteexplicit:“Inthelongrun,thereisapositiverelationshipbetweeneachmonetaryaggregateandthegenerallevelofprices.Sustained increases inpricescannotoccurwithoutaccompanying increases in themonetaryaggregates.Itisinthissensethatmoneyisthenominalanchorofthesystem.”(BankofEngland,1999)10

Inthecurrentmonetarysystembanklendingincreasesthemoneysupply(themonetaryaggregates).Ifthemoneysupplygrowsinexcessoftheproductivecapacityoftheeconomyitwillcreateinflation:“Inthelongrun,monetaryandcreditaggregatesmustbewillinglyheldbyagentsintheeconomy.Monetary growth persistently in excess of that warranted by growth in the real economy willinevitably be the reflection of an interest rate policy that is inconsistentwith stable inflation. So

control of inflation always ultimately implies control of the monetary growth rate.” (Bank ofEngland,1999)

Becausehighandvariableratesofinflationimposecostsonsociety,centralbanksarechargedwithkeepingtheinflationratelowandstable.Howthecentralbanksetstheinterestrate,itseffectivenessincontrollingthegrowthinlending,andthesubsequenteffectsoninflationarediscussedbelow.TheinterestrateandinflationCurrently, theMonetary Policy Committee is the groupwithin the Bank of England chargedwithkeepinginflationatatargetrateof2%.Itsmaintoolfordoingsoisthe‘policyrate’ofinterest.TheBankofEnglanddesignsitsoperationsinsuchawaysothatshortterminterestrates(inparticulartherate atwhichbanks lend reserves to eachotheron the interbankmarket) closely follow thepolicyrate.“Policymakersattempttoachieveacertaininflationgoalbyusingtheircontroloverinterestratestorestrainthetotaldemandforgoodsandservicesintheeconomy.”(IMF,2010,p.9)

However,thishasnotalwaysbeenthecase;theinterestratewasinfactfirstintroducedbytheBankofEnglandinordertodefendtheexchangerate(andthereforethecountry’sgoldreserves).Crucially,thewayinwhichmonetarypolicywasconductedwasdesigned:“withaviewtowardsmakingthecentralbank’schosenkeyshort-termrateeffectiveindeterminingthesetofothershorter-termmarketrates,andnot inorder toachieveanypredeterminedlevelofmonetarybase.”(Goodhart,2001)

Although the target of monetary policy has changed, the central bank still attempts to achieve itsobjectivesbyinfluencingshortterminterestrates,whichinthiscaseistherateatwhichbankslendreserves toeachotheron the interbankmarket.Thetheoryis thathigherratesof interest lower thelevel of economic activity, which leads to a reduction in aggregate demand, hence lessening theupwardpressure onprices.Conversely, lower rates of interest are thought to increase the level ofeconomic activity,which leads to an increase in aggregate demand and an increase in the upwardpressureonprices.Thetransmissionmechanismofmonetarypolicy(interestrates)Suppose thatdue to an expected increase in inflation, theBankofEngland raises thepolicy (base)rate. If a bank wants to make loans, but does not have sufficient reserves to make the additionalpaymentsthattheloanwill(likely)entailwhentheloansarespent,itwillnowcostitmoretoacquirereserves.Inordertomaintainitsprofitmarginthebankmustincreasetheinterestrateitchargesonitsnewloanstobusinessesandindividuals.Intheorythisislikelytodecreasethedemandforloans,withbanks then lending less than they otherwise would. As such there will be less borrowing byindividualsandfirms,alowermoneysupply,andthiswillleadtolowerspending.Lowerspendingonbothassetsandongoodsandservices reduces thedemandfor them,and insodoing reduces theirprices.Thisisthe‘direct’effectofmonetarypolicyonaggregatedemandandinflation.Therearealsoseveral‘indirect’routesthroughwhichchangesininterestratesmayaffectinflation.First,changesininterestratesaltertheexpectationsandconfidenceofindividualsandorganisationsas to the future path of the economy, aswell as to the future path of interest ratemovements (andtherefore the viability of certain business models). Other things being equal, falling interest ratesreducetheproportionofincomeneededtoservicedebtandincreasetheperceivedvalueofexpectedfutureprofitsrelativetotheimmediatecostsofnewinvestment.Thisshouldinturnengineerpositiveviewsofthefuturewhicharelikelytoleadtohigherlevelsofspendingandborrowing.Asaresult

inflationshouldincrease(oratleast,deflationarypressuresshoulddecrease).Second, a change in the interest rate has an effect on the exchange rate. In general, a reduction ininterest rates will tend to lead to depreciation of the currency, as investors sell their domesticcurrency for foreign currency,whereas an increase in interest rates is likely to lead to a currencyappreciation,asinvestmentinthecountryincreasesdemandforthecurrency.Changesinthevalueofthe domestic currency vis-à-vis foreign currencies then leads to changes in the price of importedgoodsandservices.Third,achangeintheinterestratealtersthewealthofindividualsandfirms.Inparticular,areductionin the interest rate make savers worse off (as they receive lower returns on their savings) whilemakingborrowersbetteroff (as theypay lower levelsof interest).Theseeffects then feed throughintopeoplesspendingandborrowingbehaviour.Finally, changes in wealth also affect the ability of individuals and businesses to borrow. Lowerinterestratesincreasethepriceoffinancialassets,increasingthewealthofthoseholdingthem.Otherthingsbeingequal, an increase inassetpriceswill increase theassetowner ’sability toborrow(astheycanuse theassetsascollateral).Withmorecollateralavailable,bankswillbemorewilling tolend.Ifthislendingmaterialisesthemoneysupply,spending,andinflationwillallincrease.fig.3.2-Transmissionmechanismsofmonetarypolicy

Forsimplicity,thisfiguredoesnotshowallinteractionsbetweenvariables.(BankofEngland,1999)ProblemswithusinginterestratestocontrolinflationTheabovesectionoutlinedtheorthodoxinterpretationofhowinterestratesaffectinflation.However,thereare severalproblemswith thisanalysis.First, it is theviewof thecentralbank thatmonetarypolicyhas“littledirecteffectonthetrendpathofsupplycapacity”,insteadworking“largelyviaitsinfluence on aggregate demand in the economy.” (Bank of England, 1999, p. 3) Yet this is notnecessarilytrue.Ifbanklendingfundsinvestmentbybusinessesinthereal(non-financial)economy,itmayincreasetheproductivecapacityoftheeconomy(evenat‘full’employment).Thiswouldmeanthatmore couldbeproducedusing the samequantity of resources, and consequently priceswouldfall. For example, if there is a decrease in the policy rate, and this disproportionately increasesborrowing by firms to finance investment (over borrowing for other reasons), then the higherborrowingwillincreasetheamountofgoodsandservicesavailabletopurchaseintheeconomy.Assuchalowerinterestratecouldpotentiallylowerinflation,incontrasttotheorthodoxposition.TheempiricalobservationofthiseffectistermedGibson’sParadox.

Second,“itisalonganduncertainchainofeventsfromanadjustmentintheinterestratecontrolledbythecentralbanktoadesiredchangeintherateofinflation.”(Arestis&Sawyer,2003,p.17)ThisislikelytoposedifficultiesforthoseontheMonetaryPolicyCommitteewhensettingrates.Figure3.2outlines this ‘longanduncertain’chainofevents.Yet thisdiagramisactuallyasimplification-manyofthesefactorsinteractwitheachotherinunpredictableways.Asaresultitwouldonlytakeasmallmiscalculationfortheeffectofaninterestratechangetobequitedifferentfromthatwhichwaspredicted.11

Third, the impact of monetary policy on the exchange rate places constraints on its use as aninstrumenttoreduceinflation.AsArestis&Sawyerexplain:“In light of the relationship between the exchange rate and the interest rate posited by economictheory,thereareconstraintsonthedegreetowhichthedomesticinterestratecanbesettoaddressthelevelsofaggregatedemandandinflationwithoutdestabilizingthecurrency.”(2003,p.17)

Thecentralbank is also likely tobe limited to theextent that it cares about thecompetitivenessofexporters and thebalanceof trade. If increases in the interest rate lead to large inflowsof foreigncurrency, the price of the domestic currency will be pushed up, making domestic goods moreexpensivetoforeignpurchasersandleadingtoalossofcompetitivenessoftheexportsector.Furthermore,MarcelSanchezoftheEuropeanCentralBankhasfoundthatthelinkbetweenchangesininterestratesandchangesinexchangeratesdependsonwhethertheincreaseinpricesofforeigngoods following an exchange rate depreciation leads to reduced economic activity (contraction -because raw material costs have increased) or increased output (expansion - because consumersswitch tocheaperhome-producedgoods).Withexpansion, falling interest ratesareassociatedwithexchangeratedepreciationand therefore increased importprices,whereaswithcontraction, fallinginterest ratesareassociatedwithexchange rateappreciationand thereforedecreased importprices.(Sanchez,2005)Fourth,theuseofinterestratestosteminflationisinherentlyflawed,asinterestpaymentsareacostto businesses.Higher interest rateswill either eat into the profitmargins of businesses (making itmore difficult for them to invest from retained earnings) or will drive firms to pass on costs tocustomersbyraisingprices,whichisbydefinitioninflationary.Interestratesalsochangethewealthof individuals and businesses in the economy – increasing interest rates makes savers richer andborrowerspoorer,andthisaffectstheirdecisionstospendandtheirabilitytoborrow.Theeffectofanincreaseininterestratesoninflationwilldependtoanextentonwhethertheeffectofincreasingsavers’ wealth cancels out the decrease in debtors’ wealth, or whether one dominates the other.Moreover,ifsaversandborrowershavedifferentconsumptionpatternsthentheeffectofincreasingrateswillbetoincreasethedemandforthegoodsthatinterestearnersbuy,pushinguptheirprices.(Tymoigne,2009)Fifth, the control of inflation by interest rates can place the two core central bank functions intoconflict with each other, namely price stability and financial stability. For example, if asset priceinflation ishigh, then itwill takea large increase in the interest rate (above the rateof assetpriceinflation)inordertostemtheriseincreditcreationforassetpurchaseandburstthebubble.Thisislikelytocreatestrongdisruptiveeffectsontheproductiveeconomy(possiblybankruptingfirms).Ifthisassetinflationisnotspottedearly,thelikelihoodwillbethatalargenumberofeconomicagentswillbedrawnintospeculativepositions(buyingahouseasan‘investment’ isoneexampleofhowubiquitousspeculativebehaviourhasbecome).Anydecreaseinassetpricescanimpairtheabilityof

speculative investors to repay their loans, increasing the riskofdefaults,andpotentially leading tobankbankruptciesandfinancialcrisis(damagingfinancialstability).Thiscanspilloverintotherealeconomy,leadingtomassunemployment,recession(orevendepression)andpossibledebtdeflation.Inconclusion, the theoreticalarguments that the interest ratecanbeused tocontrol thecreationofmoneybythebankingsector,andthereforeinflationareatbestweak.Inaddition,empiricalevidencesuggeststhatinterestrates“tendtobepositivelycorrelatedwitheconomicactivityandthereisatleastasmuchevidencethat…causalityrunsfromeconomicgrowthtointerestrates.(Werner,2011).UnusedregulationsIt is not impossible to control the amount (or direction) of credit created by banks in a fractionalreservesystem.Credit/windowguidancecanandhasbeenusedtocontrolboththeamountofcreditbankscreate,aswellastowhichsectorsoftheeconomyitisallocated.Werner(2010)describestheprocessusedinJapan:“[T]he central bank (or the finance ministry) imposes quantitative and qualitative quotas on theentire banking sector, allocated according to a principle that is accepted by the banks, whilemaintaining competitive behaviour between them (proportionally to existing size). Furthermore,strictlimitsorevenbansareimposedonthecreationofcreditbybanksforparticulartransactionsthatmayotherwisecreatemoreharmthangood,especiallyfinancialandassetmarkettransactions(i.e.transactionsnotdirectlycontributingtoGDP)andtosomeextentalsoconsumerloans.”

Almost everymajor industrialised nation (with the exception of theUSA) has used some form ofcredit guidance since the SecondWorldWar.However, it has since fallen out of fashion,with theresultbeingthatbanksfacelittlerestrictionontheamountofcredittheycreateandwhattheycreatethiscreditfor.

3.5SOWHATDETERMINESTHEMONEYSUPPLY?The aim of this chapterwas tomake several things clear. First, therewill always be a substantialdemandforcredit(andmoney).Wealthdisparitiesensurethatindividualswillneedtoborrowmorethantheyotherwisewouldtobuyhousesandtosmoothconsumption,whilebusinesseswillneedtoborrowtoinvest.Borrowingalsoallowspeopletoincreasethereturnstospeculationandinvestment,andlimitedliabilityandtaxlawsleadbusinessestofavourdebtoverequityfinancing.Second, banks are overwhelmingly incentivised tomake asmany loans as possible during benigneconomic periods. Traditionally the major source of profit for the banking sector was lending –more loans mean greater profits, provided that the loans are repaid. However, the ability tocollateraliseandsecuritiseloanshasmeanteventhisconstraintisnolongerbinding–bankscanevenmakeprofits from loans that aren’t repaid (as it is thebuyerof collateraliseddebtobligations thattakestheloss).Asaresultbanklendingbecamequantityratherthanqualitydriven.Theseincentiveswerefurtheracceleratedduetotheexistenceofdepositinsuranceandthe‘toobigtofail’safetynet,the externalisation of the social and economic costs of excess money creation, and competitivepressures.Third, thehighdemandformoneyandcreditand thewillingnessofbanks toprovide itwouldnotmatter if the various regulations that are meant to limit bank credit creation actually worked.However,theydonot.Capitalrequirementsareflawedanddonotsignificantlylimitmoneycreationbecause the extra profits that come from increased lending boost capital and increase the lendingcapacityofthebankinapro-cyclicalfashion.Neithercancentralbanksrestrictthequantityofcentral

bankreservesmadeavailabletobanks,becausetodosowouldriskeitheraliquiditycrisis,orcausethebase rateof interest tomoveawayfromtheBankofEngland’s target rate.Finally, theBankofEnglandcannot reliably limitmoneycreationbychanging thepriceof centralbank reserves– thebaseorpolicyrateofinterest–forthewidevarietyofreasonsdiscussedabove.CreditrationingWhatthendeterminesthelevelofbanklending,andthereforethemoneysupply?Facedwithahugedemandforcredit,andlittlelimitonhowmuchtheyareabletosupply,bankscouldsimplysupplyasmuchlendingasisdemanded,bygrantingaloantoeveryonewhoappliedforone.Withsuchhighdemand, however, the market-clearing rate of interest would be very high. As Stiglitz andWeiss(1988)pointoutthiswillcreatetwoproblems.First:“among thosewho aremost likely to bid high interest rates are risk lovers (who arewilling toundertakeveryriskyprojects,withasmallprobabilityofsuccess,buthighreturns ifsuccessful);optimists(whooverestimatetheprobabilityofprojectssucceedingandthereturnifsuccessful);andcrooks(who,becausetheydonotplantopaybackthemoneyanyway,arevirtuallyindifferenttotheinterestratewhichtheypromise).“Asaconsequence,as thebank raises the rateof interest, there isanadverseselectioneffect; themixofloanapplicantschangesadversely,somuchsothattheexpectedreturnfromthosereceivingloansmayactuallydecreaseastheinterestratechargedincreased.”

Theproblemofadverseselectionhaslongbeenknown–AdamSmithnotedintheWealthofNationsthat when interest rates are high the only people wishing to borrow would be “prodigals andprojectors”:“Soberpeople,whowillgivefortheuseofmoneynomorethanapartofwhattheyarelikelytomake by the use of it, would not venture into the competition.A great part of the capital of thecountry would thus be kept out of the hands which were most likely to make a profitable andadvantageoususeofit,andthrownintothosewhichweremostlikelytowasteanddestroyit.Wherethelegalrateofinterest,onthecontrary,isfixedbutaverylittleabovethelowestmarketrate,soberpeopleareuniversallypreferred,asborrowers,toprodigalsandprojectors.”(Smith,1776)

fig.3.3–Relationshipbetweeninterestratechargedonloansandprofits

Thesecondproblemisthatinordertocompensateforthehigherloancost,“theremaybeanadverseincentiveeffect;borrowerstakeriskieractions,whichincreasestheprobabilityofdefault.”(Stiglitz&Weiss,1988)Therefore,ifbankschargeinterestratesatthemarketclearingleveltheywilldrivethelessriskyborrowersoutofthemarket,leavingonlythehigh-riskborrowers.Higherriskimpliesa higher number of defaults on loans, which will adversely affect bank profits. The relationshipbetweenbankprofitsandtheinterestratechargedonloansisshowninfigure3.3.Inresponsetothesetheoreticalissuesandanecdotalandempiricalevidenceonthenumberofrejectedloanapplications,StiglitzandWeiss(1981)developedatheoryofcreditrationing.Creditrationingimplies thatbanks respond toa situationwhereby theyhave imperfect information (i.e. theycannottell good borrowers from bad) by setting interest rates below themarket clearing rate (to a levelwhichmaximisestheirprofits–i*onfigure3.3)andrationcreditinstead.12Inconclusion,thecreditrationing theory sees causality in the banking system occurring in the following way (shownoverleaf).

Facedwithalargedemandforcredit,bankssetinterestratesbelowthemarketclearingrateandrationcreditinstead

(byrejectingsomeloanapplications).

Whenbankslend,depositsarecreated.

Thisincreasesdemandforreservesinordertosettlepayments.

Thecentralbankprovidesreservestobanksondemand,thusaccommodatingabank’slendingdecisions.

Wecanconclude that theprimarydeterminantofbank lending ishowprofitablebanksbelieve that

lending will be. For banks, profitability depends on the proceeds of a loan (the interest charged)exceeding the costs of making a loan (the interest paid to acquire the funds needed to settle netpaymentstootherbanks,plusothercosts–e.g.salaries).Aslongasthecostsofmakingaloanarebelowtheprofitsexpectedfromtheloanattherateofinterestthatmaximizesbankprofitability(duetoimperfectinformation/creditrationing)thenabankwillmaketheloan.Ifthebankisplanningtokeep the loan on its books then the loan’s profitability will depend upon it being repaid. Positiveeconomicconditions,suchashighgrowthandlowunemployment,increasetheprobabilityofaloanbeing repaid, as businesses aremore likely to succeed and individuals are less likely to lose theirjobs.Theoppositeistrueofnegativeeconomicconditions.ThispointhasbeenmadequiteclearlybyAdairTurner:“bankscancreatecreditandprivatemoney,andunlesscontrolled,willtendtocreatesub-optimallylargeorsub-optimallyunstablequantitiesofbothcreditandprivatemoney.”(2012)

However, if a bank plans to securitise the loans it makes then it doesn’t have to worry aboutrepayment – it can make the loan safe in the knowledge that it can sell it off to someone else.Likewise,whena loan iscollateralisedwithanasset that isnotexpected to fall invalue (suchasahouse), the bank canmake the loan safe in the knowledge that if a default does occur itmay takecontroloftheasset,sellit,andsostillmakeaprofit.13Freedfromthedownsideofdefault,theprofitmotivecausesbankstomaximisetheirlending,increasingthemoneysupplyanddebtintheprocess.fig.3.4-UKresidentmonetaryfinancialinstitutions’lending

Source:BankofEnglandStatisticalDatabaseSohowmuchmoneyhasbeencreatedbybanks?The chart of “Cash vs Bank-IssuedMoney” from the Introduction shows the effect on themoneysupplyofahighdemandforcreditcombinedwithalackofregulation.Between1970and2012banksincreasedthemoneysupplyfrom£25billionto£2,050billion–an82foldincrease.Whathavebanksbeenlendingfor?Figure3.4showsthetotalsterlingamountsofloansoutstandingin theUK since1997.By far thegreatest proportionof bank lending is to thepropertymarket: In

2010, 45% of the value of total loans outstanding in the UK was to individuals (and secured onproperty),withanadditional15%tocommercialrealestatecompanies.14Afurther20%oflendingwas for financial intermediation,15 7% was unsecured personal debt, 1% went to insurancecompanies and pension funds and 9%was to ‘public and other services’.Meanwhile, the value ofloansoutstandingtotheproductivepartoftheeconomy(i.e.thosesectorswhichcontributetoGDP)accountedforjust8%oftotallending.

Footnotes1.BanksoperateasthemiddlemenbetweentheBankofEnglandandeveryoneelseforcash,sothateventoobtaincashatleastonepersonintheeconomymusthaveabankaccountwithapositivebankbalance,whichmeansthatsomebodyelsemustbeindebt.2.SeeforexampleIrvingFisher ’spaper,‘TheDebtDeflationTheoryofGreatDepressions’(1933).3.Moralhazardiswhentheprovisionofinsurancechangesthebehaviourofthosewhoreceivetheinsurance,usuallyinanundesirableway.Forexample,ifyouhavecontentsinsuranceonyourhouseyoumaybelesscarefulaboutsecuringitagainstburglarythanyoumightotherwisebe.4. Furthermore, instead of caring about their bank’s solvency, depositors are incentivised by theinterestrateondifferentbankaccounts.Inordertoattractfunds,bankswillhavetoofferhigherratesof intereston theiraccounts than theircompetitors.Thus, inorder tomaintain theirprofitmarginstheywillhavetochargeborrowershigherratesofinterest.Otherthingsbeingequalthosewillingtoborrow at higher interest rates will be those taking the greatest risks, which increases the risk ofdefault.5. The idea of something being too big to fail runs contrary to the very principle of capitalism –underacapitalistsystemabusinessthatdoesbadlyismeanttofail!6. An externality can be defined as a cost or benefit that is not transmitted through prices, oralternativelyacostorbenefit thatis incurredbyapartywhowasnotinvolvedinthetransaction.Acommonexampleofanegativeexternalityispollution.7.However,banksclassifiedas‘SystemicallyImportantFinancialInstitutions’(SIFIs)willberequiredtoholdupto3.5%inadditionalcapital,and,dependingonthelevelofcreditinaneconomyallbanksmayberequiredtoholdanadditional2.5%incapitalasacountercyclicalbuffer.AsaresultthetotallevelofcapitalsomebankswillberequiredtoholdunderBaselIIImaybeashighas16.5%.8. Although technically they attempted to do this through interest rates rather than by limitingreserves.9.Intheshortrunthepricelevelcanchangeforavarietyofreasons.Forexample,suddenincreasesindemandforgoodsandservicesmaypushuptheirprices(demand-pullinflation).Orincreasesinthe cost of productionmay forceproducers to increase theprice they charge in order tomaintainmargins(cost-pushinflation).Orworkersmaybiduptheirwages,eitherindividuallyorcollectively,inordertomaintaintheirrealwage(thewage-pricespiral).Othertheorieslinkthechangeintherateof inflation to deviations from a ‘natural’ rate of growth/unemployment (the non-acceleratinginflationrateofunemployment).10.Thisisnotstrictlytrue-sustainedincreasesinpricescanalsooccurwithaconstantmoneysupplyandacontinualfallinproductivecapacity.11.Anincreaseintheinterestratemightmakespeculationonassetsunattractive,buthavelittleeffecton borrowing for investment. Or the same increase might make borrowing for investmentunattractivebutleaveassetspeculationunchanged.Whilethechangeintheinterestrateis thesame,the effect on demand and inflation is likely to be very different. For example, take the situationwhereby a rise in the interest rate primarily lowers the demand for borrowing to purchase assets.Under these conditions fewer assets will be purchased and this should lower asset prices. Assetownerswillfindthattheirwealthhasdecreased,andsowillbelesslikelytospendandlessabletoborrow(lesscollateral).Yetsaverswillnowreceiveahigherinterestrateontheirsavings,increasing

theirwealthandsoimprovingtheirabilitytospendandborrow.Whateffectdominateswillbehardtosay-allthatcanbesaidwithcertaintyisthewealthandimperfectinformationchannelsofmonetarypolicy(asoutlinedabove)aredifficulttopredict.12. In addition, in their model banks cannot overcome the problem of imperfect information byincreasingtheircollateralrequirementsonborrowers,duetoadverseselectionissues.13.TheNINJAmortgagesmadeintherunuptothefinancialcrisisareanexampleofsuchlendinginaction(socalledbecausetheyweremadetoindividualswithNoIncome,NoJoborAssets,whowereunlikelytobeabletorepay).14.‘Businessservices’accountforatinyproportionofthis15%figure.15. This includes lending to financial leasing corporations, securities dealers, investment and unittrustsandotherfinancialintermediaries.

CHAPTER4ECONOMICCONSEQUENCESOFTHECURRENTSYSTEM

Chapter 2 discussed the mechanics of bank lending, showing that when a bank makes a loan itincreasesboththebroadmoneysupplyandthelevelofdebtintheeconomy.Chapter3showedthatbanksprofitfrommakingloans,thatthedemandforcredittendstobeveryhigh,andthatbanksfacelittle constraint on their ability to lend. Consequently, in the current monetary system it is thecommercialbanks,ratherthanthecentralbank,whichdetermineboththequantityofmoneyanddebtintheeconomy,aswellasthefirstuseofnewlycreatedmoney.Inthischapterweanalysetheeconomiceffectsofsuchamonetarysystem.Fornon-economiststhischaptermaybe themostchallenging,althoughwehaveattempted toconvey the theoriesas simplyandwithaslittle jargonaspossible.SomereadersmaywishtoskiptoChapter5andreturntothischapterafterreadingtherestofthebook.Webeginbylookingattheshort-runimpactofbanklending,distinguishingbetweenlendingtothe‘productive’and‘non-productive’sectorsoftheeconomy.Particularattentionispaidtotheeffectofmoney created (via bank lending) to fundpurchases of financial assets, in contrast to the effect ofmoneycreatedtoinvestinbusinessesthatcontributetoGDP.Wealsoconsiderthelinksbetweenassetandconsumerpriceinflation.Thelonger-rundynamiceffectsofbanklendingontheeconomyarethendiscussedwithreferencetoHymanMinsky’s‘FinancialInstabilityHypothesis’.Minsky’stheoryexplorestheroleofthefinancialsector indriving theboom-bust cycle, financial crises anddebtdeflation, showing that in the longtermstabilityisitselfdestabilising.EvidenceforMinsky'stheorieswillalsobeexamined.Finally,weconsidertheeconomicdistortionsthatoccurwhenthegovernmentintervenestostabilisethebanking system. Ironically,deposit insurance is shown to incentivise riskybehaviourbybanks,increasingthelikelihoodthattheinsurancewillberequired,whilstatthesametimeprovidingalargesubsidytothebankingsector.Theeffectsof theBaselCapitalAccordsonbanks’ lendingdecisionsarealsoshowntohavethepotentialtomakecrisesmoreratherthanlesslikely.

4.1ECONOMICEFFECTSOFCREDITCREATIONNon-economistsmightexpectthattheeconomicsprofessiontakesmoney,banksanddebtseriously;afterall,theseinstitutionsareatthecentreofalmostalleconomicactivityontheplanet.Yettherealityisthattheeconomicsprofessiontendstoignorethem:“In the monetarist view of Friedman and Schwartz ... but also in the recently dominant Neo-Keynesiansynthesis...macroeconomicoutcomesarelargelyindependentoftheperformanceofthefinancialsystem.”(Schularick&Taylor,2009)

Some of the reasons economists ignore finance were briefly alluded to in Chapter 1: if moneyemerges naturally out of barter (as a token that serves to oil the wheels of trade), money can bethoughtofassimplya ‘veil’overbarter,masking the fact thatpeoplearestill justexchangingonegoodorserviceforanother.Consequently,moneycanbethoughtofasneutral-doublingthesupplyofmoney simply doubles prices, so in real terms no one is any better orworse off.While some

economistsmightconcede thatchanges in thestockofmoneyhaveshort runeffects (forexample,duetopricesreactingslowly),oncetheyhaveadjusted(inthelongrun)moneycanagainbesafelyignored.Similarly,iflendingisatransferofpurchasingpowerfromonepersontoanother,thentheamountofdebtintheeconomyhasnoeffectunlessdebtorsandcreditorsbehavedifferently(intermsofspending).Likewise,inChapter3wesawthatthecentralbankbelievesmonetarypolicyhas“littledirect effect on the trend path of supply capacity”, instead working “largely via its influence onaggregatedemand”(BankofEngland,1999,p.3).The problem is that none of this is true –money is not a commodity or a token – today the vastmajority ofmoney is created by banks when theymake loans. As a result the amount of lendingdeterminestheamountofpurchasingpowerintheeconomy–forthisreason(andothers)thequantityof debt does matter. Similarly, the amount of lending determines the productive capacity of theeconomy–asSchumpeter(1936)pointsout,entrepreneursingeneralcanonlybecomeentrepreneursbypreviouslybecomingdebtors.Inshort,financematters:“we cannot understand how our economy works by first solving allocation problems and thenaddingfinancingrelations;inacapitalisteconomyresourceallocationandpricedeterminationareintegratedwiththefinancingofoutputs,positionsincapitalassets,andthevalidatingofliabilities.Thismeansthatnominalvalues(moneyprices)matter:moneyisnotneutral”.(Minsky,1986)

Inthefollowingsectionwewillattempttounraveltheeffectsbankshaveontheeconomy,firstlybydiscussingRichardWerner ’s 'QuantityTheory ofCredit', followed byHymanMinsky’s ‘FinancialInstabilityHypothesis’.1

Werner’sQuantityTheoryofCreditInhis2005book,‘NewParadigminMacroeconomics’,Wernersetsoutasimpleframeworkwhichdescribes the effects of the current monetary system upon output and prices. (SeeWerner (1992,1997), and The Economist (1992) for earlier presentations.) This framework is useful for thefollowingdiscussion,wherewesee that the impactofmoneycreationon theeconomydependsontwofactors:First,howmuchmoneyiscreated,andsecond,whatthatmoneyisusedfor.Wernerstartswith theclassicalquantityequationofmoney,whichsetsout therelationshipbetweenmoney,pricesandthenumberoftransactionsintheeconomy,shownbelow.eq.4.1

Intheequationabove,Mstandsforthequantityofmoneyincirculation,Vforthevelocityofmoney(thenumberof timesmoneyisusedfora transaction inagiventimeperiod),Tfor thenumberoftransactions in thatperiod,andP for theaverageprice levelof the transactions.The lefthandside(MV)ofthisequationrepresentsthetotaleffectivemoneysupplyforagiventimeperiod,whereastherighthandside (PT)shows the totalvalue inmonetary termsof thenumberof transactions for thesametimeperiod.Thequantityequationisnotactuallyanequationbutanequality–thatisitistruebydefinition.Thequantityequationsimplystatesthatthetotalrevenuefromallthegoodsandservicessoldinagiventimeperiodmustequaltheamountofmoneyspentongoodsandservicesduringthesametimeperiod.

Thequantityequationcantheoreticallybeusedtoanalysehowachangeinthemoneysupply(M),canleadtoachangeinprices(P).However,thetraditionalversionofthisequationhasseveralproblems.First,thereisnoreliabledataonthenumberoftransactions(T),soinordertoestimatetheequationeconomists had to find a suitable proxy. There is data available on the quantity of nationalincome/outputmeasured (realGDP, representedby the symbolY) involume terms, soeconomistsdecided touse this inplaceof transactions.Thenewquantity equation thenbecameMV=PY.Therighthandsideoftheequation(PY)isthenrealgrossdomesticproduct(Y)multipliedbyprices(P)whichtogethermakeupnominalGDP.However,asWerner(2005)pointsout,replacingTwithYisrational only if PT = PY, that is if all transactions (T) are accounted for in real GDP (Y).Unfortunately this isnot thecase–Tmeasuresall transactions inaneconomy, including those forpre-existingassets(suchasfinancialassetsandpre-existingproperty).BecausethesearenotincludedinmeasuresofGDP(whichonlymeasuresthequantityofnewgoodsandservices),PTdoesnotequalPY,soYcannotbeusedinplaceofT.Second,theformuladoesnotidentifywhatismeantbymoney(M).Shouldjustmoneycreatedbythestatebe included?Or shouldmoneycreatedbyprivatebanksbe includedaswell?Andwhat aboutthingsthathavemoney-likeproperties,suchasbondsorgold?In response to the first difficultly,Werner (2005) separates out the quantity equation into the twoseparateequations.Oneequationcomprisesthemoney,prices,transactionsandvelocityinthepartoftheeconomy thatproducesgoodsandservices that are included inGDP,whichwewill refer toas‘realeconomy’.TheothercomprisesthesamevariablesbutfortransactionsthatdonotcontributetoGDP (generally financial transactionsonassets).2This ‘disaggregated quantity theory of credit’ isshowbelow:eq.4.2

eq.4.3

Inthesemodels,anyincreaseinmoney(givenaconstantvelocity,VR)usedfortransactionsinthereal

economy(MR)willleadtoariseinnominalGDP(eitherthroughitseffectonprices,outputorboth).3

Likewiseanyincreaseinmoneyspentinthefinancialsectorwill,givenastablevelocity,leadtoanincreaseinthepriceoffinancialassets.In response to the seconddifficulty– theuncleardefinitionofmoney–Wernerusesdataonbankloans (that iscredit/moneycreation)asaproxyforM.Thishas twobenefits.First,becausepeopleborrow to spend, this measure of the money supply is a record of money in use. Conversely,traditionalmeasuresofthemoneysupply(suchasM4),aresimplymeasuresofmoneythatissittinginbankaccounts–thereisnowayofknowinghowmuchofthesedepositsareactive(i.e.beingusedintrade)andhowmanyaresimplylyingdormant.Second,banklendingincludesinformationontheintendeduseoftheloan,whichallowsthequantityequationtobedisaggregated,sothataloantoasectorwhichcontributestoGDPshowsupasanincreaseinmoneyintherealeconomy(MR),whereasa loan for a mortgage or to buy shares shows up as an increase in the amount of money in thefinancialeconomy(MF).4

With an updated quantity equation ofmoney that accounts for the true nature ofmoney aswell asfinancial transactions,Werner ’smodel reveals that bank lendingwill have different effects on theeconomydependingonhowthatmoneyisused.ThispointwasalsomadebyKeynes,whospokeoftwo circulations of money – industrial circulation, i.e. money used to undertake normal businessoperations; and financial circulation –money used to buy and sell financial assets. The followingsectionsdetailtheeffectsofdifferenttypesoflending,suchasforconsumption(consumerspending),investmentandfinancialtransactions.MoneycreationforconsumerspendingatfullemploymentAssuming(andsuspendingdisbeliefforamoment)thattheeconomyisoperatingatitsfullcapacity,sothatactualoutputisequaltopotentialoutput(seeBox4.A)andallresourcesarefullyemployed,includinglabour.Undertheseconditionsifabankextendsaloanforconsumptionpurposes(C)thenthiscreditcreationincreasesthepurchasingpowerintheeconomy(theMCcomponentofMR),withnocorrespondingincreaseinoutput(Y).Withincreaseddemandbutnoincreaseinoutput,theonlyeffect(withastablevelocityofmoney,V)wouldbetopushupprices.Thus,weshouldexpectcreditcreationforconsumptionatfullemploymenttobepurelyinflationary,sothat:eq.4.4

Box4.A-Output(GDP),potentialoutput,andgrowth

Output, in economics jargon, simply refers to the total amount of goodsand servicesproduced in aneconomywithin somegiven timeperiod.Aneconomy’soutputmayriseor falldependingonwhether theeconomy is inaboomor recession.Ontheotherhandpotentialoutputistheoutputtheeconomycouldachieveifitwasutilisingallitsresourcesfully.

In the longrunpotentialoutput isdependenton twofactors.Thefirst is the ‘quantityof factor inputs’ (QFI).These inputs include landandlabour(whichareconsideredthe‘fundamental’ factors)aswellascapital(suchasmachines).

For example, for a bakery the quantity of factor inputswould include ingredients, equipment (capital), the kitchen (land) aswell as thepeople (labour) doing the baking. The second factor which contributes to potential output is ‘total factor productivity’ (TFP). TFP is theoutputinaneconomyoverandabovethatwhichisaccountedforbythequantityofinputs.Somethinkofitastheskillofthosewithinthe

economy incombining inputs,oralternatively the levelof technology in theeconomy. Ifwe return toourexampleof thebaker, then totalfactorproductivitycouldmeasuretheskillofthepersondoingthebaking.Itmayalsorepresentanimprovementinthetechnologyusedbythebaker.Puttingthetwotogether,PotentialOutput(Y*)isdependentonthe‘quantityoffactorinputs’and‘totalfactorproductivity’sothat:

eq.4.5

Potential output thereforemeasures themaximum level of output that an economy could achieve if everyone who wanted to work wasworkingasefficientlyastheycouldandeverymachinewasrunningatfullcapacity.However,inrealitywhattheeconomyactuallyproduceswillbedeterminedbyhowmuchdemandthereisintheeconomyforthesegoodsandservices.

Each year the value of all the goods and services producedwithin a country are added together giving the economy’s output. This isknownastheGrossDomesticProductofaneconomyandisrepresentedinthequantityequationsasthepriceofgoodsmultipliedbythequantityofgoodssold(PRY).

Gross Domestic Product can be split into further sub categories: those purchases which are for consumption (C), those which are forinvestment(I),thosewhichareduetogovernmentspending(G),andnetexports,whichismadeupofExports(X)minusimports(M),sothattheequationforoutputis:

TheOutput(Y)ofaneconomyconsistsofConsumption(C),Investment(I)andGovernment(G)spendingplusnetexports.Forsimplicity,we’llignorenetexportsintheanalysisbelow.Becausethegovernmentdoesnottypicallyborrowfrombankstofunditsspending(thoughitcould),governmentspendingdoesnotincreasethemoneysupply,sowewillnotconcernourselveswithitseffectseitherandinsteadfocusonlyonconsumptionandinvestment.ReturningtoWerner’sQuantitytheoryofcredit,GDPisdeterminedbypurchasesof investmentandconsumptiongoods.

eq.4.6

This equation says that GDP (the right hand side of the equation) depends uponmoney spent in the real (non-financial) economy oninvestment(MIRVIR)andmoneyspentonconsumption(MCRVCR).

Wenowhavea framework inplace toanalyse theeffectsofmoneycreation (viabank lending)when that lending is foreitherconsumerspendingorinvestmentpurposes.

MoneycreationforproductivepurposesatfullemploymentWhat about money creation (via bank lending) for investment in productive capacity i.e. for abusiness investing to increase its output? As with money creation for consumer spending, thisincreases the purchasing power in the economy (the MI R portion of MR), but also increases the

quantity of goods produced – the productive capacity of the economy. For example, investmentincludes money spent on research and development, which can lead to the discovery of newtechnology, inventions,andproduction techniques that increase thepotentialoutputof theeconomybeyonditscurrentlevel(i.e.theyincrease‘totalfactorproductivity’).Creditcreationforinvestmentalsoallowsfirmstoputinplacenewtechnologiesorproductiontechniques(i.e.increasethequantityoffactorinputs).In a situation where the economy is operating below potential output (less than full employment,howeveritisdefined)creditcreationforproductivepurposeswillincreasethequantityofgoodsandservicesproducedintheeconomy,withoutbiddingupthepriceofanyinputs(astheyarecurrentlyidle).Asaresultitshouldincreaseoutputwithoutincreasinginflation(Werner,2005,p.212).eq.4.7

However, if the economy is already running at full capacity and a firm borrows to invest in newmachinery, the borrowing would in theory bid up the price of inputs by virtue of the economyrunningatfullcapacity.Thiswouldincreasepriceswithoutincreasingoutput(andsocauseinflation).However,eveninthisfullemploymentscenario,creditcreationmaynotnecessarilybeinflationary.For example, even in the so-called ‘boom’ years, when unemployment was relatively low, manypeople(at least in theUK)wereemployedinsectors thatdidnotcontributedirectly toGDP.Inthisenvironmentitispossibleforcreditcreationforinvestmentpurposestobenon-inflationary,evenifunemploymentislow.For example, a loanmayallowa company tohiremoreworkers. In aworldwhere everyonewasworkinginaproductivecompany(i.e.acompanywhoseoutputcontributestoGDP)thenthiswouldinvolvebiddingupthepriceoflabourinordertoattractworkersfromonecompanytoanother.Withnochangeinthetotalamountofhoursworkedoutputwouldbethesameandthereforetheonlyeffectwould be to increase inflation. However, in today’s economy workers may move from the non-productive sector to a productive sector, and in so doing increase output and GDP. Even withincompaniestheremaybescopeforincreasingoutput.InthewordsofHymanMinsky:“Onlyaportion,andinmanycasesonlyasmallportion,ofthecostofdoingbusinessreflectslaborandpurchased inputs thatare technologicallynecessary.The laboremployedinexecutiveoffices,advertising,marketing,sales, lobbying,research,productdevelopment,corporatelawyers,andsoforth is not required by the technology embodied in capital assets. The services supplied by thislabor may be vital to the functioning and survival of the organization in a given businessenvironment,but innosensearethesecosts technologicallydetermined.”(Minsky,1986,pp.173-174)

In today’s economy increases in lending for investment may also be non-inflationary at fullemploymentsolongas itattracts labourandcapital thatwaspreviouslynotusedtoproducegoodsandservices–thatis,itmustleadtoanincreaseintheamountofgoodsproducedinaneconomy.InaneconomyoperatingbelowfullcapacityIt is unlikely that many people would argue that today’s economy is at ‘full employment’, evenallowing for ‘natural’or ‘frictional’unemployment. Ina situationwhere theeconomy isoperatingbelowpotentialoutput(lessthanfullemployment,howeverdefined)manyresourcesarelyingidle.Creditcreationforproductiveinvestmentpurposesshouldthereforeincreaseoutput.

eq.4.8

Likewise,anincreaseincreditcreationforconsumptionpurposesatbelowfullemploymentwouldnotincreaseprices.Althoughtheloanwouldincreasethelevelofdemandintheeconomy,itwouldalsoincreaseoutput,asfirmswouldstarttousesomeoftheirunusedcapacity.MoneycreationforhousepurchasesandfinancialassetsAswellascreatingcreditforinvestmentandconsumerpurchases,banksmayalsolendmoneyforthepurchase of pre-existing assets, such as housing or shares. Unlike when credit is created forinvestment,creditcreationforassetpurchasesdoesnotincreasethequantityofgoodsproducedinaneconomy.ConsiderWerner ’squantityequationforfinancialtransactions(MFVF=PFTF).An increase inbankloansforhouseorassetpurchases (MF)will lead toan increase in thepriceof theassetpurchased(PF),aslongasthenumberoftransactions(TF)remainsrelativelyconstant.

eq.4.9

This is not surprising – mortgage lending creates new money and allocates it into the propertymarket, increasing the demand for houses.With no change in the quantity of houses available topurchase,themostlikelyeffectwillbetoincreasehouseprices.AsSteveKeen(2011)putsit:“Populationdynamics–evenimmigrationdynamics–havenothingtodowithhouseprices.Whatdetermines house prices is not the number of babies being born, or immigrants – illegal orotherwise–arriving,butthenumberofpeoplewhohavetakenoutamortgage,andthedollarvalueof thosemortgages…Forchanges inhouseprices,whatmatters is theaccelerationofmortgagedebt.”

Inresponsetothesuggestionthatmortgagelendingincreaseshousepricessomemayarguethatanincreaseinthepriceofanassetactsasasignal(inthehousingmarket)todeveloperstobuildmorehouses: increasinghouseprices leadtoan increase in thenumberofhousesbeingbuilt, increasingtheirsupplyandsoleadingtoafallintheirprice.However,thisargumentfallsdownontwofronts.First,anincreaseinhousepricestendstoincreasethepriceofland.Asaresultalthoughdeveloperssee their revenues rise theyalsosee theircosts riseandso risingpricesdonot turn into increasedprofitmargins.Second,risingpricesattractspeculators:“Thoughdebtaccelerationcanenableincreasedconstructionorturnover,thefargreaterflexibilityof prices, and the treatment of housing as a vehicle for speculation rather than accommodation,meansthatthebruntoftheaccelerationdriveshousepriceappreciation.Thesameeffectappliesinthefarmorevolatilesharemarket:acceleratingdebtleadstorisingassetprices,whichencouragesmoredebtacceleration.”(Keen,2012,p.25)

Thatassetpricerisesareinherentlypro-cyclicalisapointthathasalsobeenmadebyAdairTurner,chairmanoftheFinancialServicesAuthority.Inadditiontoincreasingthedemandforcredit,henotesthatassetpricerisesmayalsoincreaseabank'sabilitytosupplycredit:“Weneedalsotorecognisetherolethatcreditcanplayindrivingassetpricecycleswhichinturn

drive credit supply in a self-reinforcing and potentially destabilising process. Thus… increasedcredit extended to commercial real estate developers can drive up the price of buildings whosesupply is inelastic, or of landwhose supply iswholly fixed. Increased asset prices in turn driveexpectationsoffurtherpriceincreaseswhichdrivedemandforcredit:buttheyalsoimprovebankprofits, bank capital bases, and lending officer confidence, generating favourable assessments ofcreditriskandanincreasedsupplyofcredittomeettheextrademand.”(Turner,2010,pp.37-38)

That asset price inflation and credit creation by banks interact with each other in potentiallydestabilisingwayswillbe lookedat inmoredetail in section4.2.Thenext sectionwilldiscuss thepossibilitythatassetpriceinflationmayfeedintoconsumerpriceinflation.

Box4.B-‘Fullemployment’

In neoclassical economics the term ‘full employment’ I has a very specific meaning. It is not the level of employment where there is nounemployment, as onemight expect, or even the level of employmentwhich allows for a small amount of temporary unemployment aspeopleshiftbetweenjobs.Insteadthetermfullemploymentreferstothelevelofemploymentatwhichanyincreaseinemploymentleadstoanaccelerationintherateofinflation.IneconomicsthisisknownastheNonAcceleratingInflationRateofUnemployment(NAIRU).

Despite its name, theNAIRU theory is actually remarkably simple. The theory supposes that in the long run the level of unemploymentdependsonstructural,or‘supplyside’factorsintheeconomy,suchastaxratesandregulation.Withtheunemploymentrateinthelongrundetermined solely by these ‘supply side’ factors, the government is not thought to be able to alter the long-term level of unemploymentthroughspending.i iAnyattemptby thegovernment todecreaseunemploymentbelow itsNAIRU level in theshort runwill lead toupwardpressureonwages,whichwill increase costs to firmsand lead them to increase their prices (so leading to anacceleration in inflation).Higher prices lowers demand and this feeds through into an increase in unemployment back to its pre-intervention (NAIRU) level.EssentiallythereforetheNAIRUistheideathattheeconomyhasamaximumcapacity–anyincreaseindemandbeyondthislevelwillonlyleadtoinflation.

TherearehowevernumeroustheoreticalandempiricalissueswiththeNAIRU,agoodsummaryofwhichisgivenbyGalbraith(1997).Mostofthesehavelongbeenknown–indeed,acentralthemeofKeynes’‘GeneralTheory’(1936)isthatmarkets,lefttotheirowndevices,willnotnecessarilydeliver fullemployment.Nevertheless,despite theseproblems itwillbeuseful toconsider theeffectsofbank lending inascenariowheretheeconomyisatits‘fullcapacity’.Therationalefordoingsoistoexaminewhetherbanklending–i.e.increasingdemandthroughthecreationofnewpurchasingpower–canactuallybenon-inflationary,despitetheeconomybeingatfullcapacity.i i i

i.Fullemployment isacontroversial termamongsteconomists.Some(suchasTobin)arguethetermshouldbetaken literally, that is fullemploymentreferstoa0%unemploymentrate.Similarly,someusethetermtorefertothelevelofemploymentthatwouldexistiftherewereno ‘structural’ (i.e. long term) unemployment, so that ‘frictional’ unemployment (i.e. those between jobs) would not be counted asunemployed.Conversely, full employment isusedbymainstreameconomists to refer toa levelofemployment thatdoesnot lead toanaccelerationininflation(theNAIRU).

ii.Underthemoreextreme‘rationalexpectations’hypothesisthegovernmentcannotevenincreaseoutputintheshortrun.Suchtheoriesarehoweverclearlycontradictedbybothcommonsenseandempiricalreality,andsowillnotbepursuedhere.

iii.Thisideawaspreviouslymentionedinsection3.4,whichquestionedtheprevailingwisdomthatmonetarypolicyworkedlargelythroughchangesindemandratherthanchangesinsupply.

HowassetpriceinflationfuelsconsumerpriceinflationTheprevioussectionshowedhowthebankingsystem,throughitsabilitytocreatecreditandchannelittonon-productivepurposes,cancreatebothassetpriceandconsumerpriceinflation.Inparticular,thecreationofcreditforpurchaseofpre-existingassets,suchasproperty,wasshowntopushupitsprice.However,itisalsopossibleforsomeofthisinflationinassetpricestoeventually‘spillover ’intoconsumerprices.Thissectionoutlinesthechannelsthroughwhichthismightoccur.Forexample,takethecasewherethepriceofhousinghasbeenpushedupduetoanincreaseincreditcreation forhousepurchases.Any increase inhouseprices that isconsidered tobepermanentwillalsoincreasetheperceivedlifetimewealthofhomeowners.Theempiricalliteraturesuggestsamajordeterminantofconsumptionspendingiswealth,thereforeanyincreaseinwealthwilllikelyleadtoan

increaseinconsumption.5Thisconsumption,however,mustbefinancedinsomeway.Onemethodisoutofsavings–forexample,anindividualmayconsidertheirwealthtobethesumofthevalueoftheir financial assets (including their house) and themoney they have in their bank account. If thevalueof theirhouse increases, thentheycanspendsomeof themoneyin theirbankaccountwhilstleavingtotalwealthunchanged.Thiscanaffectconsumerprices,asmoneywhichwasbeingtreatedassavings (andwasessentiallyoutof circulation) isnowbeing spent, increasing theeffectivemoneysupply. To the extent that thismoney is spent on consumer goods, prices will increase. However,increasesinconsumptionthroughthischannelarelimitedtotheextentofanindividual’ssavings.Ratherthanspendtheirsavingsanindividualcouldchoosetoborrowagainstthevalueoftheirhouse.One method of doing so would be to simply borrow more from banks through pre-existingarrangements, such as credit cards and overdrafts, i.e. to increase the uptake of already availablecredit. However, increases in wealth may also increase the total amount of credit available toindividuals(thisisknownasthefinancialaccelerator;seeBox4.Dformoredetails).Tobrieflysumup, because of asymmetric information between borrowers and lenders, financial markets sufferfrom moral hazard and adverse selection problems. As such lending to households is largelydeterminedbytheamountofcollateraltheycanoffer–increasesinthepriceofhousing(whichcanbe used as collateral) increase the quantity of credit available and decrease its price (Goodhart&Hofmann,2007).6Furthermore,totheextentthatabank’sloansaresecuredonproperty,increasesinhousepricesmaylowertheamountofcapitalbanksfeelitisprudentialtoholdagainstthesetypesofloans,andso increase their lendingcapacity. Inshort, risinghouseprices increasewealth,and thisincreasesboththewillingnessofhomeownerstoborrowandbankstolend.Morelendingincreasesthemoneysupplyandthustheamountofmoneyspentonconsumergoods.Withnocorrespondingincreaseinproduction,anincreaseinconsumerpriceswillresult.Anadditionalmethodthroughwhichrisinghousepricesmayleadtoanincreaseinconsumerpriceinflation is through the effectonworkers’wages.For example, risingpropertypriceswill tend toleadtoanincreaseinrentsaslandlordsseektomaintaintherateofreturnontheirinvestments.Boththe increase in rents and house prices are likely to lead to workers who do not own a homedemanding higher wages in order to maintain their standard of living. The success of any suchdemandislikelytorestonmultiplefactors,someindividualtotheemployeeandothersdeterminedbytheeconomy(e.g.theunemploymentrate).Ifsuccessful,thesedemandswillincreasefirm’scosts,whichmaybepassedontotheconsumerintheformofhigherprices.

4.2FINANCIALINSTABILITYAND‘BOOM&BUST’The previous section looked at how, by lending to different sectors of the economy, banks affecteconomicgrowth and inflation in consumer and asset prices. In particular the economic effects ofbanklendingwereshowntovarydependingonwhatthenewlycreatedmoneywasusedfor.However,certainelementsweremissingfromtheanalysis.Chiefly,thelong-rundynamicimplicationsofcreditcreation were ignored, such as the self-reinforcing nature of asset price bubbles, the long runimplications of increasing debt, the speculative behaviour of individuals and businesses, and thepotential for recessions,depressions, financial crisesanddebtdeflations.This sectioncorrects thatomissionbyoutliningHymanMinsky’sFinancialInstabilityHypothesis.Minsky’sFinancialInstabilityHypothesisHymanMinsky developed the ‘financial instability hypothesis’ as an explanation of how financial

crisesareendogenouslycreatedbyamoderncapitalisteconomy.Minsky’sfundamentalinsightwasthat periods of stability led to greater risk taking and debt – that is, that stability was itselfdestabilising.Furthermore this instability tended tobeupwards–capitalismtended towardsbooms.Overtimetheseboomandbustcyclesandtheresponseoftheauthoritiestothemleadtochangesinthevulnerabilityoftheeconomytofinancialcrises,which,iftheyoccur,canleadtodepressionsanddebtdeflations.Minsky’sanalysisbeginsinagrowingeconomythathasjustemergedfromaprolongedrecession.Asaresultofrecession-inducedbankruptcies,writeoffsanddeleveraging,firmsandindividualstendtohave lowlevelsofdebt relative to theirequity. Inaddition,due to therecent recessionfirmsareconservative in their borrowing decisions (only small, low risk investments are undertaken), andbanksareconservativeintheirlendingdecisions.Borrowinginthisstageisbroadlyofthehedgetype(seeBox4.C), so that the revenueexpected from thenew investmentswouldbe sufficient to coverboththeinterestandprincipalrepaymentsontheinvestmentloan.Conservativeinvestmentscombinedwithagrowingeconomyresultsinthemajorityofloansbeingrepaid and the projects that the loans funded succeeding, with those firms that borrow the mostmaking thehighest returns.Thisapparentsuccessvindicatesfirms’decisions toborrowandbanks’decisions to lend, and it becomes apparent thatmargins of safety can be revised downwards – i.e.more debt can be taken on and cash flowprojections can be revised upwards.Greater investment,financedbyanincreaseinlendingfromthebankingsector,increasesprofits,lowersunemploymentand increases economic growth. Increasing confidence in the future state of the economy leads toassetpricesbeingrevisedupwards,andthis,combinedwiththerevisionofacceptabledebtstructuresincreasesfirms’‘borrowingpower ’.

Box4.C-Minsky'sHedge,SpeculativeandPonziUnits

TofacilitatehisanalysisMinskyclassifiedfirmsand individualsbytheway inwhichtheyfinancetheiractivities,with theseclassificationsbeinghedge,speculativeandponzi.

Hedgeunitsexpecttobeabletofulfiltheirfinancialobligations(includingdebtobligations)throughtheirincomealone.Hedgeunitsarethemostrobusttypeofunitastheyareonlyvulnerabletochangesindemandfortheirgoodsorthecostsoftheirinputs.

Speculativeunitsarenotabletofulfiltheirdebtobligationsthroughtheirincomealone.Intheshorttermtheirincomeisonlyexpectedtobeenoughtocovertheinterestontheirloans,nottheprincipal–theirdebtsmustberolledoverastheymature.Thus,inordertocarryouttheirday-to-daybusiness,speculativefinancingunitsrequireaccesstofinancialmarkets,makingthemvulnerabletochangesintheinterestrateandtheavailabilityoffinance.

Ponzii units do not earn sufficient income to pay either the interest or the principle on their debts. To pay their debts they must eithercontinuallyborrowmoreorsell theirassets.Theseponziunitsmakemoneyeither through turning intoahedgeorspeculativeunitsaftersometime(theunitmayhavebeenengaginginalongterminvestment,forexample),orbysellingtheirassetsatahigherpricethantheypurchased them for. In addition to having the same vulnerabilities as hedge and speculative units, ponzi units’ balance sheets alsodeteriorateovertimeasmoredebtistakenon.

Theweightofeach typeof financing in theeconomydetermines the fragilityof theeconomy to financial crisis.Economieswhichhaveahigherweight of firmswhich fund their operations throughponzi and speculative financingarrangementsaremore vulnerable than thosewith a large proportion of hedge firms, which can rely on the income from their investments to service both the interest and principalrepaymentsontheirdebt.

i. The term ‘ponzi’ is in no way meant to entail that the firm is engaged in any illegal or unsavoury behaviour. It is a normal state ofbusinessthatsomefirmswillbecomeponzifinancing.

Theincreaseininvestment,employment,assetpricesandgrowth,financedbyanaccelerationofdebtprovidedby thebanking sector, leads to thebeginningof ‘theeuphoriceconomy’.Minskydefinedeuphoria as when “gross profits in the present-value calculations that had reflected expected

recessions are replaced by those that reflect continuing expansion. Simultaneously there is lessuncertainty about the future behaviour of the economy” (Minsky, 1966, p. 8).Growing confidencemeansfirmsarehappytotakeonmoredebt,debt-to-equityratiosarefurtherreduced,andthismakesfirmsmoresusceptibletoariseininterestrates.Withrisingassetpricesandlowinterestrates(duetotherecentrecession)economicagentscanprofitbyspeculatingonthepriceofassets,andbankscanmakeprofitsbyintroducingspeculativefinancingmethods.Lending for speculationonassetspushesup thepriceofassets, and increases feelingsofwealth. From the bank’s perspective, rising asset prices mean loans are almost always repaid.Collateralised loanscanbemade to thosewhocannotafford them(forexample, sub-prime/NINJAmortgages), safe in the knowledge that even if the borrower defaults, the assets (houses) can berepossessed and sold for a profit. Secondly, the increased demand for lending increases profits aslong as banks are able to meet the increased demand for loans. This puts pressure on banks toinnovateinordertoincreasetheirlendingasmuchaspossible(e.g.through‘regulatoryarbitrage’).7

The ability to profit from speculating on asset prices leads to the emergence of the ‘ponzi unit’(whichborrowstoinvestinrisingassetprices).Becausethecashflowsgeneratedbytheassetsarenotenoughtocovereithertheinterestorprinciplerepaymentsontheloan,theloancanonlyberepaidiftheassetscanbesoldformorethanwhatisowed.Thelongertheeuphoricstageoftheeconomylastsandthelongerassetspricescontinuetorise,themoreunitswillshifttoponzipositions,relyingonrisingassetpricesinordertobeabletoservicedebts.Thisincreasesthefragilityoftheeconomytofinancialcrisis.Meanwhile,theinterestratesonliquidassetsincreases,aspeopleselltheminordertopurchasethose(lessliquid)assetswhosepricesarerising.Undereuphoric conditions theeconomybecomes increasingly indebted.As thesedebts areused tofinance non-productive asset price speculation, the debt of the economy increases without acorrespondingincreaseinthecapacityoftheeconomytopaybackitsdebt.Furthermore,duetoprofitopportunities brought about by the economy’s apparent stability, the proportion of economic unitsengaged in ‘speculative’and ‘ponzi’ financing increases.While theeconomymaybebooming, theincreased debt burden and over reliance on financial markets have made the economy morevulnerabletofinancialcrisis.Asinterestratescontinuetorise,eitherbecauseofmarketforcesorbecauseofthecentralbanktryingto prevent the economy from overheating, some projects that were ‘hedge’ (self-financing) at thelower ratesof interestbecome‘speculative’ (dependenton furtherborrowing),andsome thatwere‘speculative’become‘ponzi’(dependentoncapitalgains).Becauseponziunitshavetoselltheirassetsin order to service their borrowings, the increasing number of ponzi units results inmore assetsbeing brought to market. Meanwhile, the increase in the interest rate reduces the level of newborrowingforassetpurchases.Thesuddenincreaseinthesupplyofassetsalongwiththedecreaseindemandforthemleadstoareduction(oraslowdown)intheirprice.Consequently,ponziunitsfindthatneitherthesaleofassetsnorthecashflowwhichtheassetgeneratesisenoughtocoverthedebtincurredinthepurchaseoftheasset,andarethereforeunabletorepaytheirloans.

Box4.D-Irrationalexuberance

“Historianswillmarvelatthestabilityofourera”

GerardBakerTheTimes,January2007

Prior tothemostrecent financialcrisis,optimisticexpectationswithinfinancialmarkets, theeconomicsprofession,andthegeneralpublicwerenothardtofind.Beliefina‘greatmoderation’–thatimprovementsinunderstandingtheeconomyledtogreatercontrolofthebusinesscyclethroughmonetarypolicy–wereendorsedbyawiderangeofeconomistsincludingBenBernanke,GovernoroftheFederalReserve(Bernanke, 2004). This behaviour is not surprising – psychologists have shown that success boosts confidence (Shiller, 1999). Thusextended periods of stability lead economic agents to revise what they believe to be ‘safe’ debt-equity ratios, spurred on by theproclamationsof‘experts’(whobelievethemselvestohavetamedthebusinesscycle).

One cause of over-optimismas to the future state of the economy is ‘disastermyopia’.Guttentag andHerring (1984) describe disastermyopia as the systemic underestimation by decision makers of the likely occurrence of low frequency events, such as asset pricecollapses. The lower the frequency of an event and the greater length of time since the last event occurred the less accurate decisionmakers’predictionswillbe.Whenappliedtoeconomicsandbanking,disastermyopiaexplainsthepsychologicalreasonswhybankersareunabletoincorporatetheriskofassetpricesfallingintotheirlendingdecisions.

Anexampleofdisastermyopiacanbeseen inHerringandWachter’s (2002)model, inwhich realestatemarketsareprone tobubblesbecausethesupplyofrealestateisfixed(intheshortterm)anddifficulttoshortsell.Asaresulthousepricesrarelyfall,andthisleadstodisastermyopiaamongstbankers,whothereforelendmoremoneythantheyotherwisewouldintothepropertymarket,pushinguppricesintheprocess.

Disastermyopiaalsooccursduringacrash.Theoccurrenceofalowfrequencyshock(suchasabubbleburstinginthehousingmarket)in the recent past leads decisionmakers to overestimate the probability of a similar shock occurring soonafter.Banks react by cuttinglendingbymorethanthetrueprobabilityofacrashreoccurringsuggests theyshould.Regulators,whoalsosuffer fromdisastermyopia,will likewiseoverestimatetheprobabilityoftheeventreoccurring,andincreaseregulationmorethantheyotherwisewouldwhichmayleadtofurthercontractionsinlending(Herring&Wachter,2002).

TheburstingofthebubbleTheincreaseinnonperformingloansandthedropinthepriceofassetsleadsbanksandbusinessestorevisetheirexpectationsofthefuturedownwards.Banksrespondbyreducinglending,aswellasbyincreasingthepriceofloans(theinterestrate),whichpushesevenmoreborrowersintospeculativeandponzipositions.Decreasedoptimismaboutthefuturealsolowersthedemandforfundingfrombusinesses,asdoestherisingprice.Asaresultthemoneysupply,whichexpandedduringtheboom,beginstocontract.Intheabsenceofgovernmentinterventionthiscreatesdeflationarypressuresintheeconomy, increasing the real value of debt andmaking it even harder for indebted firms to repaytheir loans.Asdefaultsoccurondebts,bankassets shrink,whichcan result in a financial crisis asbanksbecomeinsolventorseetheircapitalfallbelowlevelsmandatedbytheBaselCapitalAccords,(seesection3.4)leadingtofurthercontractionsinlending.Theunwillingnessofbankstolendduetoincreasedpessimismaboutthefutureoftheeconomy,ageneralincreaseindebttoequityratiosdueto capital attrition throughdebtdefaults, and thedesire to rebuildbalance sheetsmakes it hard forbusinesses to acquire funding, including thosewhichwere not directly affected by the crisis.Eventhosebusinessesthatcanacquirefundingmayfindinterestratestoohigh.Thefocusonpayingdowndebts,combinedwithlowerinvestment,leadstoloweroutput,loweremploymentandthereforelowerwages. This lowers demand for goods and services, with the end result that otherwise healthybusinessesthatwerenotdirectlyinvolvedinthebubblecangobust.This decrease in demand is likely to be particularly painful for smaller firms –without access tocapital markets small firms are likely to find it difficult to roll over their debts, increasing theirlikelihoodofbankruptcy.Forexample,after10yearsofrecessioninJapan“193,000,mainlysmallandmedium-sizedcompanies”hadgonebankrupt(Werner,2005,p.303).Largefirms,ontheotherhand,arelikelytohaveaccesstocapitalmarketsandtheabilitytopledgecollateralforbankloans.When the bubble bursts the fundamental problem facing the economy is that the debts incurred inpurchasingassetscannotberepaidwiththeearningstheassetsgenerate.Asaresult,Minskyarguedthattheburstingofanassetpricebubblecouldresultinavarietyofoutcomes,dependingonthelevelofinflationandextentofgovernmentintervention.

Nogovernmentintervention,highinflation:Iftherateofinflationishighwhenthebubblebursts,thecashflowsfromassetswillsoonincreasetoalevelwheretheycoverthecostsofdebtrepayment(whichdonotrisewithinflation),despitethefactthat investment and growth have decreased. Because of this bankruptcies are limited, althoughliquidityisdecreased.Whileadepressionisavoided,littleelseischanged,andthis,combinedwiththeabsenceofa‘real’crisissetsthestageforarepeatperformance.Nogovernmentintervention,lowinflation:Ifafterthebubbleburststherateofinflationislow,thecashflowsfrominvestmentswillnotincreasequicklyenoughtoalevelwhichallowsinvestorstorepaytheirdebts.Inthissituationtheburstingofthebubblecan lead toamasssellingoffofassets, resulting inadebtdeflationprocessof the typedescribedbyIrvingFisher.InFisher ’s(1933)formulation,theprocessisasfollows:“(1)Debt liquidation leads todistress sellingand to (2)Contractionofdeposit currency, asbankloansarepaidoff,andtoaslowingdownofvelocityofcirculation…cause[ing](3)Afallinthelevelofprices…[asa result] theremustbe (4)Astillgreater fall in thenetworthsofbusiness,precipitatingbankruptciesand(5)Alikefall inprofits,whichina“capitalistic,”thatis,aprivate-profitsociety,leadstheconcernswhicharerunningatalosstomake(6)Areductioninoutput,intradeandinemploymentof labor…lead[ing] to(7)Pessimismandlossofconfidence,whichinturnleadto(8)Hoardingandslowingdownstillmorethevelocityofcirculation.Theaboveeightchangescause(9)Complicateddisturbancesintheratesofinterest.”(p.342)

Thustheactionsofthemarketparticipantsservestoexacerbatetheinitialfallinassetprices,andtheeconomyentersadownwardspiralfromwhichitisdifficulttoescape.Debtdeflationsarelikelytobeparticularlypainfulforsmallerfirms.Minsky(1986),showsthat intheeventofamodestdeclineindemand(e.g.inarecession),firmsthatarepricetakerswillbeforcedtolowerprices.Withcostsfixedintheshortrun,lowerpricesmayaffectfirms’abilitytorepayanyoutstandingdebts.Conversely,thosefirmswhicharepricesetters(i.e.thosethathavemarketpower)will be able to resist the downward pressure on prices. Because of this, Minsky concludes that“Market power, which allows a firm to constrain price movements when demand falls, may be aprerequisite for the use of expensive and highly specialized capital assets and large-scale debtfinancing”(1986,p.181).Essentially,bankswillfavourlendingtofirmswithmarketpower,astheirabilitytoconstraindownwardpricemovementsduringrecessionsanddepressionsdecreasestheriskofthemdefaultingonaloan.Duetothenegativeeffectofdebtdeflationsonsmallfirmsandbanksfavouritisminlendingtofirmswithmarketpower,oncetheeconomyrecoverspricesarelikelytoincrease,astheremaininglargeformsexercisetheirmarketpowerinordertoincreaseprices.Withgovernmentintervention:Alternatively,thegovernmentmaychoosetointerveneandattempttoincreasecashflowstopreventthedebtdeflationandassociateddepression.Themostvisibleinterventionsinthemostrecentcrisiswere the bank bailouts, which were mainly designed to ensure the continual functioning of thefinancialmarketsandpreventthespreadofpanic.Inaddition,thegovernmentmayincreasespendingongoodsand services– socalledcountercyclical spending. Ina countrywitha social safetynet aproportionof this spendingwilloccurautomatically,asan increase inunemployment results inanincrease in transfer payments to individuals (e.g. benefits).Both autonomous and non-autonomousspendingwillatleastpartlyoffsetthefallindemandbyincreasingcashflowstobusinessesandthe

newlyunemployed.Thegovernmentmayalsointervene(throughthecentralbank)inordertopreventthemoneysupplyfromcontracting.Thiscommonlytakestheformofareductionininterestrates.However,asshowninsection3.5,confidence,nottheinterestrate,istheprimarydeterminantofbanklending.Asaresultduringthecurrentfinancialcrisisthecentralbankengagedindirectpurchaseofgovernmentbondsfromnon-banks(alsoknownasQuantitativeEasing),whicheffectivelyincreasedboththebroadandbasemoneysuppliesinequalamounts,aswellasthepriceofgiltsandotherassets.Monetarypolicyinterventionshave thereforeattempted tomaintainassetprices andprevent themoney supply fromcontracting.Thegovernmentmayalsoattempt toengineerhigher levelsofconsumer inflation, inanattempt tomakedebtseasiertorepay(asabove).AsMinskydescribes,“Inflation,whichincreasesnominalcashflows,canbecomeapolicyinstrumenttovalidatedebt.”(1986,p.190)

Box4.E-Supplementaryreasonsforassetbubbles

TheFinancialAccelerator: Bernanke andGertler (1989) present amodel as to how asset price rises can fuel further asset price rises.Imperfect informationbetweenborrowersandlenders(i.e. theborrowerknowsmorethanthelenderastotheir likelihoodtorepay)creates‘agencycosts’ forbanks.Borrowing isaccordinglymoreexpensivethan itwouldotherwisebe.Becauseof theirability topostcollateral,highernetworthborrowershaveloweragencycosts.Thisreducesasymmetric informationandmoralhazardproblems,makingthebankmore willing to lend. When asset prices rise during a boom, agency costs fall for those that hold the assets. This is the ‘financialaccelerator’mechanism:highernetworthduringbooms(duetohigherassetprices) leadstoloweragencycostsandthereforeincreasedborrowing.Thisborrowingtendstoincreasedemandforassets,raisingtheirprices.Thisincreasesnetworthfurther,whichreducesagencycostsandsoallowsfurtherborrowing.

Leveragetargets:Theleverageratioforabankisgiven,broadly,bydividingthebank’sshareholderequity(includingretainedearnings)by itsaggregate tangibleassets.i Its leverage,or levelof leverage, is the inverseof this ratio.AdrianandShin (2008) findevidence thatfinancial institutions target a specific level of leverage. As a bank holds capital assets, during a boom an increase in asset pricesstrengthensthebank'sbalancesheet.Thisleadstoafallinthebank’sleverage.

Asbankstargetaspecificlevelofleverage,inordertorestorethedesiredratiotheyborrowmore,andusetheproceedstobuymoreoftheassetsthattheyalreadyhold.Increasedassetpurchasespushesupassetprices,whichleadstoafallinthelevelofleverage,whichinturnleadstofurtherpurchases–apositivefeedbackloop.Conversely,duringassetpricedownturnstheexactoppositeoccurs–fallingpricesleadtohigherleverageratios,andasthebankistargetingaspecificlevelofleveragetheystartsellingoffassets.Ifthisleadstoafall inthepriceoftheassetthenleveragewillincrease,requiringfurtherassetsales–apositivefeedbackloop.AdrianandShinconcludethattheprocyclicalbehaviourofbanksinresponsetochangesinleverageislikelytoexacerbatefluctuationsinassetmarkets.

i.Technically,itisdefinedasTier1capital∕(Totalassets–intangibleassets)–seeD’Hulster(2009).

Problemswithintervening–unintendedconsequencesoffiscalpolicyGovernment interventioncancreateproblems for theeconomy in the long run.Taking thecaseoffiscalinterventionsfirst,thesuggestionthatthegovernmentshouldactcounter-cyclicallyisrelativelyuncontroversialandhasbeenstandardeconomicpracticesinceKeynes.However,financialcrisesandtheiraccompanyingrecessions/depressionsrequiregovernmentinterventionsofadifferentorderofmagnitudethanthestandardboom-bustcycle.Inparticular,themostrecentsetofbankbailoutshavepushedUKgovernmentdebttoarecordpost-warlevel.8Whileacountrythathasthepowertoprintmoney cannot default on its debts denominated in its own currency (as it could in extreme casessimplyprintmoney topay its debts), there are economic andpolitical reasons towant tokeep thegovernmentdebtburdenwithinaparticularrange.First,anincreaseinnational(government)debtnecessitateslargeinterestpaymentstobondholderswhichmayleadtopoliticalpressuretocutgovernmentspendingonpublicservices.Totheextentthatsomeoftheseservicesarecrucialfortheprivatesectortoprosper,loweringspendingonthemmay

slow the long-termpotential growth rateof the economy.Furthermore,high levelsofgovernmentdebtmay limit (politically or economically) the government’s ability to engage in countercyclicalspendingthatmayhelptheeconomyemergefromrecession.ThisresulthasbeenfoundempiricallybyTaylor(2012):“Exposuretoacreditboomcanmakerecessionspainful,butwhencombinedwithanadversefiscalposition at the onset of the crash, economies are perhaps evenmore vulnerable. Such empiricalevidencewouldsuggestthatevenifthestakesarelowerinnormalrecessions,countrieswithmore“fiscal space” are better able to withstand a financial crisis, perhaps by having room to offerstabilizingsupporttotheireconomy(oratleastdodgeausterity).”

Second,ratherthancutspendingthegovernmentmayattempttoincreasetaxesinordertopaybackitsdebt.Anincreaseintaxesmayharmanyrecovery,byloweringdisposableincomeandthereforedemandforgoodsandservices.Third,althoughlessofaprobleminthemiddleofarecession,publicdebtmaycrowdoutprivatesectorinvestmentwhentheeconomypicksupagain.Problemswithintervening–unintendedconsequencesofmonetarypolicyMonetary policy interventions may also create unintended consequences. When the central banklowerstheinterestrateinresponsetorecessionaryconditionsitbenefitsborrowersattheexpenseofsavers.Pensionfundsinparticularmaysuffer: lowerinterestratesincreasethenetpresentvalueoffutureliabilities,increasingtheneedforhighercurrentfundcontributions.Financialcrisesmayalsoleadtounorthodoxmonetarypolicy(suchasQuantitativeEasing).Becausequantitativeeasingpushesup thepriceofbonds it also lowers theiryield,again increasing requiredcontributions topensionfunds.Furthermorebydecreasingtheyieldonbonds,QEincreasesthedesirabilityofotherassets,pushingup their prices.This can have long run effects.Bypurchasing assets the central bankmaypreventprices from falling, and so ‘set a floor ’ under their price, implicitly guaranteeing prices andlegitimisingprior investmentdecisions.Rightlyorwrongly the investor is led tobelieve thatassetpriceswillnotbeallowedtofallbelowacertainlevel.Withtheinvestorgainingfromtheupsidebutnotsufferingfromthedownsideofhisorherdecisions,furtherrisktakingandspeculativebehaviourisencouraged,whichmayleadtofurtherassetpriceinflationandfinancialcrisis.Ineffectprofitsareprivatisedandlossesaresocialised.9

Consequently,while thegovernmentmayoffset theworstofafinancialcrisis, itsactionsmayhaveunintendedconsequences,namelyincreasinginflationandmakingafuturecrisismorelikely:“theeconomicrelationsthatmakeadebtdeflationandalong-lastingdeepdepressionlikethatofthe1930s unlikely in a Big Government economy can lead to chronic and, at times, acceleratinginflation. In effect, inflation may be the price we pay for depression proofing our economy.”(Minsky,1986,p.165)

TheFinancialInstabilityHypothesisTo sumup, the essence of the Financial InstabilityHypothesis is that booms and busts, asset pricebubbles,financialcrises,depressions,andevendebtdeflationsalloccurinthenormalfunctioningofacapitalisteconomy.Whatismore,periodsofrelativestabilityincreasethelikelihoodofinstabilityand crisis by increasing returns and thus the desirability of leverage. The banking sector,with itsability tocreatecredit, facilitates thisdesire for leverage,whichsets in trainaseriesofevents thatculminate in recession and in some cases a financial crisis and depression. In short, Minskyconsideredthecapitalistsystemtobeinherentlyunstable.Thenextsectionwillexaminesomerecent

evidencefortheroleofcreditcreationbybanksincausingbooms,busts,andfinancialcrises.

4.3EVIDENCEThecentralcontentionoftheprevioussectionwasthatbanklendinghasrealmacroeconomiceffects.Inparticular, itwas argued that bank loans– i.e.moneycreation– for thepurchaseofpre-existingassets,suchasproperty,leadstoanincreaseinitsprice.Thispriceincreaseleadsovertimetoaself-reinforcing and destabilising process whereby price increases lead to more lending and so everincreasingdebt,untileventuallythedebtburdenbecomestoolargeandtheassetbubblebursts.Oftenthiswill lead toa recession,and in themostextremecases itmayalso lead toa financialcrisisasdefaultsonloanssetintrainachainofeventsthatresultinbankruns,bankruptciesandpotentialdebtdeflation.The following section will briefly look at the evidence for this theory, by examining the role ofprivatedebt–predominantly,bankloans–onfinancialcrises,includingtheGreatDepressionofthe1930s and the Financial Crisis of 2007/08. It will also consider whether recessions that are notassociatedwithfinancialcrisesarealsotheresultofexcessivebanklending.fig.4.1USDebttoGDPfrom1920

fig4.2UKDebttoGDPfrom1987

Source,Fig4.1&4.2:Keen,2012aFinancialcrisesFigure4.1showsdataonprivateandpublicdebt in theUSsince1920.Prior toboth the1930sand2007privatedebt–banklending–increaseddramaticallyrelativetoGDP,withdebtlevelsplungingthereafter.Thisdataisunsurprisingconsideringwhatweknowaboutfinancialcrises.Inthe1930sbankswereprimarily lending for the purchase of securities on the stock market. The increase in lendingincreasedthemoneysupplyandpushedupthedemandforsecurities,leadingtoanincreaseintheirprice(the1920’sstockmarketboom).Eventuallybanklendingslowed,loweringdemand,andthisfedthroughintolower(ordecelerating)securitiesprices.Theburstingofthebubbletriggeredawaveofdefaults,bankrunsandinsolvencies,adebtdeflationandadepression.Likewise,asshownbyfigure4.1fortheUSand4.2fortheUK,therunuptothe2007/08financialcrisiswascharacterisedbybanksrapidlyincreasingthemoneysupplythroughtheirlending,muchofwhichwentintothefinancialandpropertymarkets,pushingupthepriceofpropertyintheprocess(outlined in detail in Box 4.E). As Adair Turner (2012) put it: “The financial crisis of 2007/08occurredbecausewefailedtoconstraintheprivatefinancialsystem’screationofprivatecreditandmoney”.When the debt burden became too large, speculators began selling property, leading to alargedrop in itspriceandawaveofdefaultsas ‘ponzi’ investorscouldno longerafford tomakeloan repayments. This bursting of the property bubble precipitated the financial crisis as financialproductsbackedbythesemortgages(mortgagebackedsecurities)fellinvalue,whichledtoacrisisin the shadowbanking systemand thebanking systemas thebanksholding theseproducts saw theassetsidesoftheirbalancesheetsshrink.

Increased lending by banks in the run up to a financial crisis is in fact a common feature of allfinancial crises. Looking at a dataset comprising 14 advanced countries between 1870 and 2008,SchularickandTaylor(2009)findthat“forthemostpart,financialcrisesthroughoutmodernhistorycan be viewed as “credit booms gone wrong” (Eichengreen and Mitchener, 2003)”. The mostimportant variable in predicting financial crises, they find, is past credit growth, a resultwhich isrobustevenwhentheycontrolforotherkeymacrovariables.InaseparatepaperTaylor(2012)goesfurther,statingthat:“Over 140 years there has been no systematic correlation of financial crises with either priorcurrent account deficits or prior growth in public debt levels. Private credit has always been theonlyusefulandreliablepredictivefactor.”

TheseresultswouldseemtovalidatethetheoriesofeconomistssuchasMinsky.Whataretheeffectsoffinancialcrisisontheeconomy?Asoutlinedearlier,anincreaseinlendingbybanksincreasespurchasingpowerandsoaggregatedemandintheeconomy,andthisleadstoaboom– either directly through increases in lending to businesses or consumers, or indirectly due to theeffectsof lendingonassetsprices and thereforeonwealth andconsumption.Asa result there is astrongcausallinkbetweenincreasingdebtandfallingunemployment.However,cruciallyanincreaseindebtbeyondtheearningcapacityoftheeconomyisunsustainable.fig.4.3-ChangeinDebtandEmploymentsince1992

Source:Keen,2012bFigure4.3showsthedataoutliningtherelationshipintheUKbetweenthechangeinprivatedebtandunemployment since 1992. As expected, changes in debt (i.e. changes in the money supply) arestrongly correlatedwith the level of unemployment. The unproductive lending that resulted in the2007/08 financial crisis brought about a collapse in assets prices and a sharp reduction in banklendingasbanksre-evaluatedtheirviewsofthefuturedownwards.Thenetrepaymentofloanscausedthemoneysupplytoshrink,whichloweredaggregatedemandandthusincreasedunemployment.Likewise,GDPalsofallssharplyduringandafterfinancialcrises.SchularickandTaylor(2009)findthat for 14 developed countries over a 140 year period, on average “in the aftermath of postwarfinancial crises output dropped a cumulative 6.2 percent relative to trend.” These financial crisis-associatedrecessionstendedtobearoundathirdmorecostlythannormalrecessionsandresultedinaslowdownininflation(althoughsinceWorldWarTwothiseffecthasbeenlesspronounced,possiblyduetomoreaggressivepoliciesbythecentralbankandthegovernmenttoavoiddebtdeflation(Jordàetal.2010).Realinvestmentalsofallsafterfinancialcrisesfallsbymorethan22percentonaverage,whichislikelytoleadtoareductioninfutureoutput.

These resultspoint toa seriousproblemwith thecurrentmonetarysystem– the financial sector isperfectly capable of destroying itself and the rest of the economy with it on a periodic basis.Worryingly thesecrises tend tooccurwith some regularity– in theUK therehasbeen12bankingcrises since 1800, with 4 of those coming since 1945 (Reinhart & Rogoff, 2009). Globally thesituationissimilar–Figure4.4showsthepercentageofcountriesinabankingcrisisbetween1800and2007(soexcludingthemostrecentfinancialcrisis)fig.4.4-PercentageofCountriesaffectedbyBankingCrises

Source:ReinhartandRogoff,2008

Box4.F-Thehousepricebubble

In the years preceding the most recent financial crisis, bank lending created a bubble in the property market in several countries. Forexample, Keen (2012) calculates that 78% of the change in American house prices over the past 25 years and 60% of the change inAustralianhousepricesoverthepast30yearscanbeexplainedbytheaccelerationinmortgagedebt.Meanwhile,intheUKhousepricesincreasedthreefoldbetween1995and2007(Nationwide,2012).Contrarytopopularbelief,theincreaseinhousepriceswasnotfuelledbytherebeing‘toomanypeopleandnotenoughhouses’.AsFigure4.5shows,between1997and2007,thenumberofhousingunitsactuallygrewby8%,whilethepopulationonlygrewby5%.Meanwhilemortgagelendingincreasedby370%overits1997level.

Theresulting206%increaseinhousepricessignificantlyreducedthedisposableincomeofanyonewhopurchasedahouseafter1997.Asanexample,ifanindividualonanaveragesalaryof£25,200tookouta25yearmortgageonanaveragehousein2007,therepaymentswouldaccountfor47%oftheirsalaryoverthatperiod(assumingtheunlikelyscenariothataverageinterestratesonmortgagesremainatthe historically low level of 4.5%). In contrast, the same person buying the same house in 1995 would only spend 24% of their salaryservicing their mortgage debt. Today, most young people have effectively been priced out of ever being able to own their own homebecauseofexcessivemoneycreationbythebankingsector.

fig.4.5-UKpropertyprices,1997–2010(Indexed,1997=100)

Source:Nationwidehousepricesurvey2012,BankofEnglandStatisticalDatabase

Theflipsideof this ispeoplethatownedorpurchasedproperty intherunuptothecrisisnowfeelmuchwealthier.Howeverformanythiswealthisnotaccessibleasitistiedupintheirhouse.Theonlywaytoreleaseitistoeitherrundowntheirothersavings,orborrowagainstthe value of the house through housing equitywithdrawal/release schemes (i.e. taking on debt secured against the value of the house).Therefore,therealbeneficiariesofthehousingbubblewerethosewhopurchasedseveralpropertiesinordertospeculateonpricesrising.The banks also benefitted – banks’ profit fromdebt, and higher house pricesmean largermortgage loans, longer loan durations, andmoremoneyearnedininterest.

Thehousingbubblecan thereforebeseenasamassive transferofwealth, from thosewithoutproperty (i.e. thepoorand theyoung), tothosewithproperty(i.e.thewealthyandtheold),aswellastospeculatorsandbanks.

NormalrecessionsWhataboutnormalnon-financialcrisisassociatedrecessions–canthesealsobecausedbyexcessivecredit creation by banks? Using the same 14 country 140 year dataset as Schularick and Taylor(2009), Jordà, Schularick and Taylor (2012) show “that throughout a century ormore ofmoderneconomichistoryinadvancedcountriesacloserelationshiphasexistedbetweenthebuild-upofcreditduring an expansion and the severity of the subsequent recession.”AsTaylor (2012) explains in asubsequentpaper:“…thatcreditboomsmatterasafinancialcrisisriskfactorisarathernarrowconclusion,andthatamoregeneralandworryingcorrelationisevident.Duringanybusinesscycle,whetherendinginafinancialcrisisrecessionorjustanormalrecession,thereisaverystrongrelationshipbetweenthegrowthofcredit(relativetoGDP)ontheupswing,andthedepthofthesubsequentcollapseinGDPonthedownswing.”

Essentially, excess credit creation by the banking sector increases the severity of any subsequentdownturn,whetheritresultsinafinancialcrisisorjustanormal‘gardenvariety’recession.Figures4.6and4.7showthepathofrealGDPpercapitaandrealinvestmentpercapitafromthebeginningofarecession.Thesolidgreylinesshowrecessionsassociatedwithafinancialcrisis,whilethedashedgreylinesshowrecessionsassociatedwithafinancialcrisiswheretherewas‘excess’creditcreationduring theboom.Thesolidblack linesshownormalrecessions,while thedashedblack linesshownormalrecessionswheretherewas‘excess’creditcreationduringtheboom.fig.4.6-RealGDPpercapitafollowingarecession

Source:Jordà,SchularickandTaylor,2012Thechartsshowaclearrelationshipbetweenthequantityofexcesscreditcreationduringa‘boom’andthedepthandlengthofanysubsequent‘bust’.Whilefinancialcrisesassociatedwithexcesscreditcreation stand out as particularly painful, excess credit growth also results in longer lasting anddeeper recessions ingeneral,whetherornot theyareaccompaniedbya financialcrisis.AsTaylor(2012) notes, “economic outcomes are systematically worse the larger has been the prior creditboom”.fig.4.7-Realinvestmentpercapitafollowingarecession

Source:Jordà,SchularickandTaylor,2012

4.4OTHERECONOMICDISTORTIONSDUETOTHECURRENTBANKINGSYSTEMAsshowninChapter3,underthecurrentbankingsystemthekeydeterminantofabank’slendingishowprofitableitbelievesaloanwillbe.Inaboomalmostallloansareprofitableandsobankscreatetoomuchcredit,whichhastheeffectofamplifyingtheboom.Thiscanleadtoassetpricebubblesandfinancial crises,which endanger theverybanks that created thebubble in the first place.For thesereasons,overtheyearsarangeofmethodsthatattempttocontrolcreditcreationbybankshavebeenintroduced (as outlined in section 3.4), as have various regulations to protect banks and theirdepositorsintheeventofacrisis.While someof these interventionshavebeenmore successful thanothers, all havehadunintendedconsequences.Theseareoutlinedbelow.

Box4.G-Mal-Investment

Because credit creation increasespurchasingpower in the economy it canalter prices, particularlywhenapplied to assets that haveafixed supply, suchas land.Whilst credit is not a scarce resource, pricesare the signallingmethod throughwhich scarce resourcesareallocated (premises, equipment, labour etc). Money creation can therefore distort price signals, changing the returns on investment incertainsectors,whilstdiverting investmentaway fromothersectorsof theeconomy.Whentheexpansionofcredit is reversed,so tooare

thepricechanges.Accordingly, investments thatwereexpected tobeprofitableare revealed tobesoonlybecauseof theeffectofbanklendingonprices.

A prominent example ofmal-investment caused by credit creation occurred in Ireland in the run up to the financial crisis. Bank lendingalteredpricesbysomuchthatafifthoftheentireIrishworkforceendedupemployedbuildinghousesandalmostaquarterofthecountry’sGDPcamefromconstruction.ThisresultedinIrelandbuildingoverseventimesasmanynewhousesayear,proportionaltoitspopulation,astheUK.

The house price bubble also reduced investment in pensions, as people began to see houses as a better long-term investment. Datareleased by the Office of National Statistics in connection with the 2006-08 Wealth and Assets Survey shows that in the UK 60% ofrespondents overall agreed or tended to agree that property was the best way to save for retirement, compared with 49% supportingpensions (Daffin, 2009). Comparable figures are not yet available for the 2008-10 follow-up, however preliminary analysis shows thatpeople overestimated the value of their property in 2006-07 comparedwith figures from the LandRegistry,Halifax andNationwide, andunderestimatedtheextenttowhichthesehaddeclinedsincethen(Black,2011).

It isunlikelythatmany,ifany,ofthoseusingpropertyinvestmentsasawayofpreparingfortheirretirementfullyunderstoodthattherisinghousepriceswerenot due toeconomic fundamentals, but rather due toa370% increase in theamount ofmoneybeing createdby thebanking sector for property purchases. In other words, those people using property as an alternative to a pension did not have theknowledge to understand why the house price inflation was an artificially fuelled bubble. Their underinvestment in other assetsmay becompoundedif/whenthebubbleintheUKhousingmarketbursts–theymayfindtheirsavings(intheformofproperty)insufficienttocovertheiroutgoings.Anincreaseinthefuturepovertyofpensionersisthelikelyresult.

Inaddition,theburstingofthehousingbubblewillleavemanywithpropertiesthatareworthlessthanthemortgagethattheytookouttobuythem(i.e.negativeequity).Consequently,housepricebubblesfuelledbybankshavetheeffectofmisleadingpeopleabouttheirlong-terminterests and diverting savings away from pensions provision, with people slow to revise their beliefs appropriately when the bubblescollapses.

Finally,excessreturnsinthefinancialsectorresultingfromthedesignofthemonetarysystembidsresourcesawayfromother,productiveenterprises.AsJamesTobinremarked in1984:"Weare throwingmoreandmoreofourresources, including thecreamofouryouth, intofinancialactivitiesremotefromtheproductionofgoodsandservices, intoactivitiesthatgeneratehighprivaterewardsdisproportionatetotheirsocialproductivity."Asaresulttheeconomyasawholesuffers.CecchettiandKharroubi(2012)havefoundthat:"Financeliterallybidsrocketscientistsawayfromthesatelliteindustry.Theresultisthaterstwhilescientists,peoplewhoinanotheragedreamtofcuringcancerorflyingtoMars,todaydreamofbecominghedgefundmanagers."

Problemswithdepositinsurance&underwritingbanks“Many treat loans tobanksas if theywere riskless. In isolation, thiswouldbeakin toabelief inalchemy–risk-freedepositscanneverbesupportedbylong-termriskyinvestmentsinisolation.Towork, financial alchemy requires the implicit supportof the taxpayer ...Fora society tobase itsfinancialsystemonalchemyisapooradvertisementforitsrationality.”(King,2010)

Assection3.3showed,inabankingsystemwithdepositinsuranceorbanksthatare‘toobigtofail’there is no incentive for a bank’s creditors tomonitor the bank’s behaviour. Instead of those thatbenefitfromtheupsideoflendingtobanksalsolosingoutiftheloansgobad,itisthetaxpayerthatstandstolose–riskandrewardarenotaligned.Conversely,inasystemwithoutinsurance,depositorsandbankcreditorshaveabigincentivetomonitortheirbank’sbehaviour,toensureitdoesnotactinamannerwhichmayendangeritssolvency.Whiletheymaybenefitfromtheupsideofaninvestment(byreceivinginterestontheirdeposits/lending),theyalsosufferthedownsideifthingsgowrong(i.e.theymaynotreceivethefullvalueoftheirdepositback).Riskandrewardarealigned.Deposit insurance removesadepositor ’s incentive tomonitorbank lendingdecisionsbecause theyareguaranteed to receive theirmoneyback.This isknownasmoralhazard.10Becausedeposits indifferentbanksareequally‘risky’whentheyareallunderwrittenby thegovernment, forbanks thecost of attracting central bank reserves (via customerdeposits) is not affectedbywhether they aremaking high-risk or low-risk investments. With all investments via banks effectively risk-freebecauseofgovernmentguarantees, thebank thatoffers thehighest interest rateon itsdepositswilltend to find that funds flow to it from the other banks. This problem is explicitly referred to in ahandbookwrittenbytheBankofEngland’sCentreforCentralBankingStudies:

“Bankdepositorsmay,therefore,contributetomoralhazardifdepositinsurancemeansthattheynolongerfeelobligedtoassessthecreditriskassociatedwithdepositingmoneywithaparticularbank.In such a situation, depositors may choose banks without reference to their relative financialcondition. This means that they will probably choose banks solely in accordance with theattractivenessof theinterestratestheyoffer.Consequently, thenormalimpactofmarketforcesinpromoting prudent economic behaviour is reduced and unsound banks may attract additionaldeposits.”(MacDonald,1996)

However,anybankthatwishestoattractdepositorsbyraisingtheinterestrateitpaysondepositswillhavetoincreasetheinterestrateitchargesonitsloansinordertomaintainitsspreadandthereforeitsprofits.Ingeneral,higherratesofinterestresult inriskierprojectsbeingfinanced.Additionally,thelackofmonitoringbydepositorsmayencouragebankstomakeriskierloans.So,despitethefactthatdeposit insuranceis intendedtoincreasethestabilityof thebankingsystembypreventingbankruns,itmayinfactreducestabilitybyencouragingriskybehaviour:“TheU.S.Savings&Loancrisisofthe1980shasbeenwidelyattributedtothemoralhazardcreatedbyacombinationofgenerousdepositinsurance,financialliberalization,andregulatoryfailure…Thus, according to economic theory, while deposit insurance may increase bank stability byreducing self-fulfilling or information-driven depositor runs, it may decrease bank stability byencouragingrisk-takingonthepartofbanks.”(Demirguc-Kunt&Detragiache,2002)

Demirguc-Kunt&Detragiachegoontoempiricallytestforwhetherdeposit insuranceincreasesordecreasesthestabilityofabankingsystem.Basedonananalysisofalargepanelofcountriesovertheyears1980-1997theyfindthat:“explicitdepositinsurancetendstobedetrimentaltobankstability,themoresowherebankinterestrateshavebeenderegulatedandwheretheinstitutionalenvironmentisweak.Weinterpretthelatterresult to mean that, where institutions are good it is more likely that an effective system ofprudentialregulationandsupervisionisinplacetooffset thelackofmarketdisciplinecreatedbydepositinsurance.”

As well as making banks riskier, deposit insurance also contributes to a subsidy for the bankingsector,asexplainedbelow.fig.4.8-Variationintheimplicitsubsidy

Source:Noss&Sowerbutts,2012SubsidisingbanksAs a result of deposit insurance and the negative effects of bank insolvency on the economy as awhole, some banks are seen as being too big or systemically important to fail. Aswe have seen,insurancehashadunintendedconsequences,chieflybycreating‘moralhazard’–thosethatlendtothebankpaylessattentiontohowtheirmoneyisusedbecausetheyknowthatthebankwon’tbeallowedtogobust.Inbothcasesthisleadstothebankengaginginriskierbehaviourthanitotherwisewoulddo–both in termsof thequantityof its lending (i.e. its leverage) andwho it lends to.Thismakesbanksmorelikelytoneedtheinsuranceinthefirstplace.However, insurance also results in the banks receiving a subsidy – those that lend to the bank(including depositors) arewilling to accept lower interest rates on their loans than they otherwisemight, because the loan is less risky to them. Instead, it is the government, and by implication thetaxpayer, that underwrites the risk of the loan going bad.TheBank ofEngland has calculated thatsomeyearsthissubsidyisworthinexcessof£300bn(Noss&Sowerbutts,2012)(althoughthisfiguredependsonthemethodusedtocalculatethesubsidy).Thesubsidytendstobehigherinyearswherethebanksareseenasmorelikelytoneedgovernmentsupport.11 Noss and Sowerbutts conclude that, “despite their differences, all measures point tosignificanttransfersofresourcesfromthegovernmenttothebankingsystem.”(2012,p.15)Insomeyearsthevalueofthesubsidyhasbeenhighenoughthatitisdifficulttoseehowthebankswouldhavebeenprofitablewithoutit.Aswellastransferringresourcefromthepublictothebankingsector,thesubsidyalsodistortscompetitionbetweenbanks–thelarger/moresystemicallyimportantabankis,themorelikelyitistoberescuedifitfindsitselfindistress.Asaresultlargebanksreceiveabiggerimplicitsubsidy,loweringtherateofinteresttheyhavetopaytoborrow.Thisplaceslargebanksatacompetitiveadvantagetosmallerbanks,stiflingnewentrantsandcompetition.Furthermorelargerbanks thatoffersubstandardproductsare less likely tobeforcedoutof themarket, (as they

wouldbeinotherindustries),reducingsocialwelfare.Inconclusion,theinherentinstabilityofthebankingsectorandthenegativeimpactsofthisinstabilitycompels the government to provide insurance, which, due tomoral hazard, actually increases therisksthatbankstake–soincreasingfinancialinstability.Ontopofthisitresultsinasubsidytothebiggestbanks,whichdistortsthemarketandpreventscompetition,loweringsocialwelfare.DistortionscausedbytheBaselCapitalAccordsSection 3.4 outlined the effect of theBaselCapitalAccords on a bank’s ability tomake loans. Tobrieflyrecap,thesecondBaselAccordrequiresthatabank’scapitalisatleast8%ofitsrisk-weightedassets.Thereasonsabankisrequiredtoholdasetamountofcapitalaretwofold.Firstly,itprotectsdepositors if someof abank’sassets aredefaultedupon.Secondly, it canbeusedby regulators tolimitabank’slending.The Basel Accords also stipulate that a bank’s assets should be ‘risk weighted’ when calculatingcapitalrequirements.‘Riskweighting’referstothefactthatdifferentassetsrequiredifferingamountsof capital to be held against them, reflecting the riskiness of different types of lending.When thecapital requirements are calculated, the value of each type of asset on a bank’s balance sheet ismultipliedbyitsrisk-weightingtogiveafigurefortotalrisk-weightedassets.Forexample,banksareallowedtoholdlesscapitalagainstloansforhousepurchase(35%risk-weighting)thanagainstloansthey make to business (75% risk-weighting). Loans to governments have a 0% risk weighting –meaningbanksdon’thavetoholdanycapitalagainstthistypeoflendingatall(whichusuallytakestheformofholdingbonds).While the wisdom of allowing banks to treat government bonds as a risk free asset seemsquestionable in the wake of the European sovereign debt crisis, something that has received lessattentionistheincentiveeffectofallowingbankstoholdlowercapitalagainstmortgagelending.Atthelevelofanindividualbankthismakesperfectsense–becausemortgagelendingisbydefinitioncollateralised,evenintheeventthattheborrowerdefaultsthebankwillnotmakeasignificantloss(aslong as the value of the house does not fall). However, this also incentivises the bank to favourmortgage lending over other types of bank lending, as its capital basewill supportmore of thesetypesofloans.At the levelof theentirebanking industry, lower riskweightsonhousingmay in fact increase thelikelihoodofthebankbecominginsolvent.Aswesawinsection4.1,thelimitedavailabilityofland,combinedwithbanks’ability to increase thepurchasingpower inaneconomywhenmaking loans,makes the housingmarket particularly prone to asset price bubbles.When the bubble bursts bankstendtofindthemselveswithloansthatcannotberepaid,andhousesthatareworthlessthattheloanstheymadeagainstthem.Asaresultbanksmayfindthemselvesinsolvent.Thus,forcingbankstorisk-weight their assetsmay increase the potential for asset bubbles and financial crisis, and thereforeincreasethechancesofbankinsolvency–theverythingtheriskweightingwasmeanttopreventinthefirstplace.

Footnotes1.Itisimportanttonotethatthefollowingsectionoutlinesvariouseconomicmodels.Thesemodelsarenotintendedtodescribehowtheeconomyfunctionsasawhole;rathertheyaredevicestoaidthereader ’sunderstandingoftheeffectofdifferenttypesofcreditcreationonoutputandprices.2.WernerusesthesymbolsCinplaceofM,tostandforcredit,andQinplaceofTtostandforthequantityoftransactions.However,apartfromthesesemanticdifferencestheequationsarethesame.3. In recent years, velocity (V) has declined, which is often thought to be due to technologicalinnovation.However,Werner (2005) shows thatVhas actually remained constant,with the declineduetoanincreasingnumberoftransactionsnotincludedinGDP.ForadiscussionseeWerner(2005),chapters13&14.4.SteveKeen(2011)presentsasimilarmodeltoWerner ’swhichdistinguishesbetweenpreexistingmoneyandnewbankcreditcreation:

(i) Income+changeindebt=(pricelevelxoutput)+netassetsales

(ii) Netassetsales=assetpricelevelxquantityofassetsxfractionofassetssold

5. Of course, if only a small percentage of people own their home then any increase in housingwealthwillnotincreaseconsumptioninthepopulationasawhole.Andifincreasesinhousingwealthlead toeither increases in rentorexpectedrents then theeffectonconsumptionwilldependon thepercentageofpeoplerenting.In2002thepercentageofUKhouseholdsthatownedpropertywas69%.6.Toborrowagainstrisinghousepriceswillalsodepend,toanextent,ontheavailabilityofhousingequitywithdrawalproducts.7.Aprominentexampleofsuchinnovationintherunuptothemostrecentcrisiswasthecreationofcollateraliseddebtobligations,whichallowedbankstomoveassetsofftheirbalancesheets,freeingupcapitalformorelending.8.ThisismainlyasaresultofthegrowthoftheBritishbankingindustryrelativetothesizeoftheeconomy–currentlyintheUKtheratioofdomesticbankingassetstoGDPisthehighestithasbeenatanycomparabletimeinhistory(from50%ofGDPinthe1950sto550%ofGDPin2010).9. A recent example of such behaviour was the ‘Greenspan put’, which was the name given byfinancialmarketsparticipants to thebelief thatwhen financialmarketsunravel the chairmanof theFederalReserve(AlanGreenspan),wouldcometotherescue.NobelLaureateinEconomicsJosephStiglitz cited the ‘Greenspan put’ as one of the causes of the speculative bubble which led to thefinancialcrisis.(Stiglitz,2010)10.Moralhazardiswhentheprovisionofinsurancechangesthebehaviourofthosewhoreceivetheinsuranceinanundesirableway.Forexample,ifyouhavecontentsinsuranceonyourhouseyoumaybelesscarefulaboutsecuringitagainstburglarythanyouotherwisemightbe.11.Thedifferingvaluesarearesultofthedifferentmethodsusedtocalculatethesubsidy,witheachapproachhavingvariousadvantagesanddisadvantages.

CHAPTER5SOCIALANDENVIRONMENTALIMPACTSOFTHECURRENTMONETARYSYSTEM

Thepreviouschapterdiscussed theeconomiceffectsof thecurrentmonetarysystem,showinghowthrough itsnormal functioning it could lead tobooms,busts, andoccasionally financialcrisesanddepressions. In this chapterwewill address some of the other impacts of themonetary system. Inparticular,wewilllookattheeffectofthemonetarysystemoninequality,publicandprivatedebt,theenvironmentandthelevelofdemocracy.

5.1INEQUALITYThe current economic system depends on an adequate supply of money being available fortransactions between households, businesses and government.However, as section 3.2 showed, fortheretobeasupplyofmoney,somepeoplemustbeindebt.Eventhesmallamountofcashmoneywhichisnotcreatedbythecommercialbankingsectorcanonlyentertheeconomyinexchangeforbankdeposits.Consequently,ineffectthenon-banksectormust‘rent’theentiremoneysupplyfromcommercial banks, resulting in a constant transfer of wealth from the rest of the economy to thebankingsector(throughinterestpayments).In the UK the money supply currently stands at approximately £2 trillion. Assuming an averageinterestrateof8%onbankloans,inordertokeepthemoneysupplyataconstantlevelrequiresthenon-bank sector to transfer £160billion a year to the banking sector in interest charges.This is achargeforsomethingthatcouldbeprovidedatalmostnocostbythestate.1

fig.5.1-Bankingburdenonhouseholds

Source:Hodgson(forthcoming)

Figure5.12showshowthebankingsectortransfersmoneytowardsthewealthy.Ontheverticalaxisisthepercentageof household incomewhich is either received fromor paidout to banks,while thehorizontal axis splits households into deciles by income. The black line shows the net monetaryburden/benefitofbanksoneachdecile.Asisshown,theburdenofinterestpaymentsasapercentageof household income disproportionately falls on those households in the lower deciles, while thebenefitsof this interest, in theformofbankdividendsandstaffpay,disproportionatelybenefits thetopdecileofincomeearners.Are these results surprising? In the previous chapter we saw that house prices have increasedenormously since themid1990s, largelyasa resultof the surge inbank lending into thepropertymarket. Consequently, individuals have had to devote a greater percentage of their income tomortgage repayment and rent (as higher house prices tend to lead to higher rents).This implies aproportionallylargerreductionindisposableincomeforpoorerhouseholds.Meanwhile,thosewithmore than one property, buy-to-let landlords and property speculators have all benefited from theincreaseinhouseprices.Unsurprisingly,thesegroupstendtobelocatedinthehigherincomedeciles.Higherhousepriceshave therefore acted as amechanism to transferwealth from lower tohigherincomehouseholds.Bankshavealsobenefitedfromtheincrease inhouseprices.Higherhouseprices increaseboththesize of the average mortgage and the length of time over which it will be repaid, increasing theamountofinterestpaidtobanks.Theincreaseinprofitsproduceshigherlevelsofstaffremunerationanddividendpayments tobankshareholders.Because (some)bankemployees tend tobeverywellremunerated,andbecausefinancialassetstendtobeunequallydistributed,theincreaseinbankprofitsalsohadtheeffectoftransferringwealthtowardsthehigherincomedeciles.

Inadditiontothelargeincreaseinlendingforproperty,thelast20yearshasseenalargeincreaseinbank lending to the financial sector (see chart 3.4), and this has fuelled asset price inflation. Thisdisproportionately benefited the financial sector (including investment banks), the employees ofwhichagaintendtobeconcentratedintheupperincomedeciles.Thecurrentmonetarysystemalsotends toredistributewealthgeographically.Aswehaveseen, theeffectofcharginganinterestrateoneverypoundinexistenceleadstoalargetransferofwealthfromtherestoftheeconomytothebankingsector.IntheUKtheheadquartersofthemajorbanks(andthusthe high earning bank employees) are located in the London area, and this has the effect oftransferringwealthtowardsLondon.Finally, as section 4.2 showed, the banking sector periodically experiences criseswhen asset pricebubbles (themselvescreatedbybank lending)burst.While the initial effectofa fall inassetpriceswillaffectmainlythosewhoholdtheassets,thesubsequentbankbailoutsandrecessionwillleadtoboth increases in government debt and unemployment. An increase in government debt beyond acertain level tends to trigger fiscalausteritybygovernment, resulting incuts to thepublicservicesthatareoftenrelieduponbythoseonlowincomes.3

5.2PRIVATEDEBTUnder the current monetary system almost all money is created with a corresponding debt. Thismeansthatforonegroupofpeopletohaveapositivebankbalance,anothergroupneedstobeindebtbythesameamount.Fortheretobemoney,theremustalsobedebt.Moneyisvitalfortheeconomyto function;without it, individuals and businesseswould not be able to trade. Thus in themodernmonetarysystemdebtisnotachoice–fortheeconomytofunctionefficientlysomepeoplemustbeindebt.Debtisalsohigherthanitneedstobeasaresultofthefactthatbanklendingcausesassetbubblesinnecessities such as housing. When banks lend against assets that have an inelastic supply (e.g.housing)or totally fixedsupply(e.g. land)such lendingpushesuphouseand landpricesandoftenresults in a bubble.Consequently individuals have to borrowmore in order to purchase property,increasingthelevelofdebtevenfurther.Any attempt by individuals and businesses to partially repay debts in aggregate will result insignificantproblemsfor theeconomy,asdebtrepayment leads toashrinkingof themoneysupply.Formoneythatiscirculatinginthereal(ratherthanthefinancial)sectoroftheeconomy,unlessitsvelocityofcirculationincreasesenoughtooffsetthefallinthequantityofmoney,economicoutputwilldecrease.Aswehaveseen,thiscanresultinrecessionandincreasedunemployment,andintheworsecase,debtdeflationandfinancialcrisis.Isitlikelythatanincreaseinvelocitywilloffsetafallinthemoneysupply?Debtstendtoincreaseinboomperiods(e.g.duringMinsky’s‘euphoric’economy),andthistendstoinflateassetpricesandsofeelings of wealth. Boom periods are also characterised by a reduction in ‘margins of safety’ aspeopleattempttodecreasetheirmoneyholdingsbyshiftingtheirwealthintolessliquidassets.Boththeincreasedlevelofwealthandthedesiretolowerholdingsofliquidassets(suchasmoney)leadtoanincreaseinspending,increasingthevelocityofmoney.However, the ‘bust’ period is characterised by a deflation in asset prices as people attempt to paydowntheirdebts (quicker thannewloansarebeingmade).This in itself leads toa reduction in themoney supply.Likewise in the bust the perceived level of uncertainty is higher and as a result the

demandforliquidassets(suchasmoney)asastoreofwealthincreases.Theincreaseinthedemandformoneyasastoreofwealthlowersthepercentageavailablefortransactions,loweringthevelocityof circulation. As a result, it is difficult for there to be a reduction in private debt without anaccompanyingrecession.Furthermorerecessionsthemselvescanactuallyleadtoincreasesindebt,astheincreaseinunemploymentandbankruptciesandthedecreaseinincomecanleadpeopletoborrowmoreinordertomakeendsmeet.ThistrendcanbeseenintheUKwiththeincreasingprominenceofpaydayloansandsimilarschemesinthewakeofthefinancialcrisisandsubsequentrecession.Inconclusion,aslongasthemajorityofthemoneysupplytakestheformofmoneycreatedbybanksmaking loans, it isverydifficult for thepublic to significantlypaydownprivatedebtwithout alsocreatingarecession.

5.3PUBLICDEBT,HIGHERTAXES&FEWERPUBLICSERVICESSeigniorageisthenamegiventothe‘profit’thatisderivedbythegovernmentasaresultofitsabilitytocreatemoney,intheformofnotesandcoins.IntheUKtheRoyalMintcreatesandsellscoinsatthecostofproduction(metalplusmanufacturing)toHMTreasury.ThecoinsthenbecomeassetsoftheTreasury,heldon thebalancesheet.Theyare thensold tobanksat facevalue, so that theTreasuryearns theprofiton theproductionofcoins,with theprofitbeing thedifferencebetween thecostofmanufactureandthefacevalueofthecoins.Banknotes,ontheotherhand,arecreatedundertheauthorityoftheBankofEnglandbythespecialistprinterDeLaRue.As is thecasewithcoins,DeLaRue ispaida fee tocover thecostofprintingnotes.Howeverunlikecoins,banknotesarenotassetsoftheTreasury,butliabilitiesoftheBankofEngland.Asa result, the seigniorage theTreasury receives fromnotes isnot the facevalueof thenotesminus thecostsofprinting.Instead, theseignioragecomesfromthefact thatunlike theotherliabilitiesof theBankofEngland,banknotesdonotpayany interest (reserves, forexample,payarateofinterest,currentlyequaltothepolicyrate).FornotestoentercirculationtheBankofEnglandsellsthenotestothecommercialbanksinexchangeforcentralbankreserves.Thesereservesareinnormal timesborrowed from theBankofEnglandusing repos, and,because theBankofEnglandpaysinterestonthem(aswellaschargingbanksthesamerateofinterest toborrowthem)theyarerevenueneutralfortheBank(seeBox2.E).However,banknotesdonotpayinterest,andsotheBankofEngland saves the interest payable. Seigniorage is therefore the quantity of notes in circulationtimestheinterestratepaidonreserves(currentlythepolicyrate).Between2000and2009,thiscameto£18billion,andwaspaiddirectlyovertotheTreasury,savingthepublic£18billionintaxes.However,notesandcoinsmakeuponlyatinyproportionofthetotalmoneysupply.BecausetheBankofEngland(andthegovernment)haslefttheresponsibilityforcreatingthemajorityofmoneytotheprivate banking sector, it has forsaken the profit that comes on creating thismoney. For example,from2002to2009banksincreasedthemoneysupplybyroughly£1trillion.Ifthegovernmenthadinsteadbenefitedfromthismoneycreation,thenUKresidentscouldhavepaid£1trillionpoundslessintaxes,orpublicservicescouldhavereceived£1trillionmore.Alternatively,theentiretyoftheUKgovernment’snationaldebt,whichcurrentlystandsat justover£1 trillionpounds,couldhavebeenrepaid.Needlesstosay,thesearenottrivialsums.

5.4ENVIRONMENTALIMPACTSThe following section looks at how the monetary system impacts on the environment as aconsequenceofthegovernment’sresponsetotheboombustcycle,thefundingofbusinesses,andthe

effectofthemonetarysystemongrowth.4

GovernmentresponsestotheboombustcycleAsoutlinedinChapter4,thecurrentmonetarysystemcreatesaninbuilttendencyfortheeconomytoexperiencetemporaryboomsfollowedbyrecessions.Thismayalsobefollowedbyfinancialcrisiswhentheburdenofdebtbecomestoolargetoservice.Whilethebusinesscycleitselfhasarelativelyneutral effect on the environment (excluding themal-investment effect on resource use) the samecannot be said of the government’s response to these cycles, which tends to involve removingenvironmentalregulationsandreducingspending,asoutlinedbelow.EnvironmentalregulationineconomicdownturnsIn a recession it is common to hear the argument that the costs of businesses are too high due toregulationswhicharerepresentedasonerous,andthattherelaxationoftheseregulationswouldallowbusinessestohire,resultinginreducedunemploymentandincreasedoutput.Althoughthevalidityofthisargumentisdebatable, therecanbenodoubtthat it ispropagatedbythosewhobelieveit tobetrue,bythosewhoseetherecessionasanopportunitytolowertheircosts,andbythosewhodidnotbelieve the regulationswere required in any case.While the benefits of environmental regulationsaccrueoverthelong-term,thegovernment’schancesofre-electionusuallyhingeontheshort-termhealthoftheeconomy.Assuchthelong-termenvironmentalbenefitsofregulationoftenloseouttoshort-termpoliticalandeconomicconsiderations.GovernmentspendingineconomicdownturnsDueto thevolatilenatureof theeconomicsystemthegovernmentperiodicallyengages incounter-cyclical spending to mitigate downturns, prevent debt deflations, and bail out failing banks. Toincrease spending usually requires an increase in government debt as taxes tend to fall duringrecessions.GovernmentsmayalsotargetadebttoGDPratiobelowacertainlevel–intheEU,forexample, theMaastrichtTreatyrequiresgovernments tocutexpenditurewhen itsdebt toGDPratioexceeds 60%. Thus, to be able to borrow during recessions the government must ensure its debtburdendoesnotbecometoolargebeforehand.Todoso,itmustnotsuccumbtothegeneraleuphoriathatispervasiveduringtheboom,andinsteadusetheboomingeconomyasanopportunitytobuildupbudgetsurpluses.Needlesstosay,overtheyearsgovernmentshaveprovedthemselvesunabletofollow these rules, or prevent boom and bust. The majority of regulators, central bankers andacademic economists, although not facing election, also appear to be incapable of resisting theprevailingconsensus.BenBernanke,forexample,famouslyspokeofa“greatmoderation”andtheendofthebusinesscyclejustpriortothefinancialcrisis.Consequently,thegovernmentisoftennotinanidealfinancialsituationwhenarecessionorfinancialcrisisoccurs.Themostrecentfinancialcrisisisagoodexampleofthis–manygovernmentsfelttheneedtoimplementausteritymeasuresastheirdebttoGDPratiosexplodedduetolargeincreasesingovernmentspending(asaresultofbankbailoutsandincreasedtransferpayments)andreductionsintaxrevenues(duetotherecession).The pressure to cut spendingmay result in environmentally beneficial projects being cut, such asgreen energy subsidies or long term investments in science and technology that are not wellprovisionedforbytheprivatesector.5Afterall,fromapoliticalperspectiveitismucheasiertocutaprogramofprimaryscientificresearchthatmayormaynotbebeneficialatsomeunspecifiedpointin the future than it is tocutpublic services thatpeople relyupon in thepresent (suchashealthoreducation).

FundingbusinessesUnderthecurrentmonetarysystembanksacquirecentralbankreserves(basemoney)whenpaymentsaremadetotheircustomers’bankaccounts.Customerdepositsprovidebankswithacheapsourceofcentralbankreserves,whicharerequiredtomakethepaymentstootherbanksthatmayresultfromtheissuingofloans.However,despitehelpingtofundtheloans,depositorshavenosayandlittleideaover the use of ‘their ’ money. They may therefore be unwittingly helping to fund loans toorganisationsthatharmtheenvironment.Becauseofalackoftransparencyanddepositorcontroltheinvestmentdecisionsofbanks(andthereforeofsociety)aredrivenalmostexclusivelybytheshort-termprofitconsiderationsofbankemployees.6Theeffectof this is todecreasethecostoffundingforcertainindustriesoverothers,whileignoringsociety’spreferencesastowhatisfunded.Thisisinmarkedcontrasttootherformsoflending,wherethoseprovidingthefundsknowwhattheywillbeusedforandareabletowithholdthembasedonthisinformation.ForcedgrowthManyconcernedwiththeenvironmentfavourasteadystateeconomy,whichcanbedefinedas:“…aneconomywithconstantstocksofpeopleandartefacts,maintainedatsomedesired,sufficientlevelsbylowratesofmaintenance‘throughput’,thatis,bythelowestfeasibleflowsofmatterandenergyfromthefirststageofproductiontothelaststageofconsumption.”(Daly,1991)

Thecrucialdefiningfactorofasteadystateeconomyisthatitdoesnotexceedthe‘carryingcapacity’ofitsnaturalenvironment.Carryingcapacitycanbedefinedasthemaximumpopulationthatcanbesustained indefinitelyby theenvironment,given that thephysicalcomponentsof theplanet (naturalresources, human populations, etc.) are constrained by the laws of physics and the ecologicalrelationships that determine their rates of renewal. This is problematic as any economy thatcontinually grows (typically characterised by increased use of physical resources) will eventuallyexceedthe‘carryingcapacity’ofitsnaturalenvironment.Is a steady state economy possible?Mainstream economics claims it is, as growth is merely onepotential option for the economy. However, traditional growth models abstract from importantfeatures of the economic systemwhichmightmake such an economy unsustainable in the longerterm. In particular they do not include banks,money or debt.Oncewe allow for these institutionsthereareseveralreasonsforthinkingthatasteadystateeconomymaynotbepossible.First, according to Duesenberry’s relative-income hypothesis, individuals attempt to emulate thespending habits of their peers. However, as outlined earlier in the chapter, the current monetarysystem transferswealth towards thosewith higher incomes. The increase in inequality leads to anincreaseindebtaspeopleborrowinanattemptto‘keepupwiththeJoneses’’.Theincreaseindebtincreases inequality (through themechanismsoutlinedearlier),which further increasesborrowing,debt,andsoon,inaselfreinforcingcycle.Theincreaseindemandanddebtforcesgrowthasfirmsproducemoretosatisfydemandandindividualsworkmoreinordertopayoffhigherlevelsofdebt.Second, borrowing from a bank requires payments to be made on fixed dates, with penalties forfailingtorepayontime.Therequirementtorepaythemoneyborrowedplusinterestwithinafixedperiodoftimeincentivisestheborrower(whetherabusinessorahousehold)topursueactivitiesthatprovidequickreturns inexcessof theamountrepayable.To theextent thatpeoplepayoffdebtsbyproducinggoodsandservices,higherlevelsofdebtincentiviseshigherlevelsofgrowth.Third,themonetarysystemfacilitatesassetpricebubblesinessentialssuchashousing.Morerecently,

speculation has been blamed for increasing food prices.7 In order tomaintain standards of livingwhenfacedwithanincreaseinthecostofessentials,individualsmusteitherworkmoreinordertopay thehigherprices,orborrowmore tomakeup thedifference.Bothborrowingandmoreworkincreaseeconomicgrowth,asoutlinedintheprevioustwoparagraphs.Fourth,therepaymentofbankloansdestroysmoney(intheformofbankdepositsheldbythepublic),which tends to lower economic activity. For the money supply not to shrink as loans are repaidrequires that new loans are taken out to replace the loans repaid. If this level of borrowing is notmaintained,stagnationandrecessionmayresult,whichcanleadtodebtdeflationandothernegativeconsequences. Thus the government must design policy in order to encourage individuals andbusinessestobecomeindebted,toensurethatgrowthismaintainedanddebtdeflationsandrecessionsdonotoccur.IntheUKexamplesofsuchpolicies(whetherdeliberatelydesignedforthispurposeornot) include the recentBankofEngland ‘Funding forLendingScheme’ and the abilityof firms todeductinterestpaymentsagainsttaxes.Fifth,accordingtoapaperbyBinswanger(2009),anyrateofgrowthbelowapositivethresholdlevelwill be unsustainable in the long term. Binswanger explains that banks profit from creating andlendingmoneytofirmsforinvestment,andinreturntheyreceivearateofinterestontheloan.Firmsuse these loans inorder to invest and increase their output.When loans are repaid theprincipal isdestroyed,removingmoneyfromtheeconomy,whiletheinterestontheloanisprofitforthebank.Much of this interest is recycled into the economy in the formof staff payments and dividends toshareholders; however, the bank may retain some of this interest income in order to increase itscapital.Theactofremovingpurchasingpowerfromtheeconomy(becausemoneyisdestroyedwhenloans are repaid and a proportion of interest repayments goes into retained earnings) reduces theamount of money available to purchase the additional goods that the firms in question initiallyborrowedtoproduce.Thisrepresentsalossofincometofirmsastheirpaymentstobankswillnotflowback to them.Assuch firmswillonlybeable tomakeaprofit in theaggregate if themoneyremoved from the economy through debt servicing and the retention of bank earnings is replacedwithfurtherborrowing,whichwillcreateadditionalproductionandconsequentiallygrowth.Withouttheadditionalborrowingfirms’outgoingswillexceedrevenue(i.e.theywillmakelosses),whichinthe long runwill lead to a fall in investment and bankruptcies. Thiswill slow growth and profitsfurther,andthewholeeconomywillspiraldownwards.Asaresult,Binswangerclaimsthat in thecurrentmonetarysystemtherecanonlybeagrowingorshrinkingeconomy–azerogrowtheconomydesiredbyenvironmentalistsisnotpossible,asitwillcollapseintoanegativegrowtheconomy.Thisnegativegrowtheconomyisnottheoneofdecliningresource use and sustainable lifestyles that is required to deal with the environmental and energycrises;itisoneofrecession,unemploymentandthesamepressuresongovernmentdescribedearlier.

5.5THEMONETARYSYSTEMANDDEMOCRACYThe following section looks at how themonetary system impacts on democracy as a result of themisconceptionsaroundwhatitactuallyisbanksdo,confusionastothebenefitsandcostsofbanking,the lackofdepositorcontrolover‘their ’money,andthedependencyonbanks tocreate themoneysupply.Useof‘our’moneyBanksrequirereservesinordertomakepaymentstootherbanks(facilitatingthetransferofdeposits

aroundthebankingsystem).Abankcanacquirethesereservesthroughseveralchannels.Forabank,thecheapestoftheseistosimplyallowcustomerstodepositcash,whichcanthenbeexchangedwiththecentralbankforreserves.Additionally, thebankallowsitsdepositorstoreceivepaymentsfromthecustomersofotherbanks,whichwilleventuallyinvolveatransferofreservesfromthebankinquestion to itself (after all payments have been netted). Thus, depositors help fund bank’s lendingactivities(although,aswehaveseen,banksdonotrequirereservesinordertolend).The absence of any control by depositors over how banks are able to use the funds they providemeans that an environmentalist’s deposits could be funding oil extraction and a pacifist’s depositscouldbefundingarmsmanufacturers.Itcouldbearguedthatenvironmentalistsandactivistsshouldtakecaretobankethically.However,asthissectionmakesclear,alargeproportionofthepopulationareunawarethatbanksarenotlargesafetydepositboxes.Ofcoursenooneisforcedtoopenabankaccountortokeeptheirmoneyinit,andmembersofthepubliccouldrefusetofundbanks’activitiesbysimplyrefusingtohaveabankaccountanddealingonly incash.However, it isalmost impossible to live in themodernworldwithoutabankaccount,andmostemployerswillnotpaysalariesincash.Itisalsoimpossibleforeveryonetooptout.Inthiswaypeopleareeffectivelyforcedtofundthelendingandinvestmentdecisionsofbanks,potentiallyagainsttheirownethicsandwishes.ThemisconceptionsaroundbankingThereiswidespreadignoranceandconfusionamongthepublicabouthowbanksactuallyworkandwhat theydowith thefundsweprovideto them.ApollconductedbyICMonbehalfof theCobdenCentre found that74%of thepublic thought that theywere the legalownersof themoney in theiraccount(Evans,2010).Infact,allmoneydepositedinbankaccountsisthelegalpropertyofthebank,leavingthebankfreetousethemoneyasitseesfit.Instead,ofhavingownershipoftheirownmoney,thecustomerinsteadhasaclaimonthebank,whichallowsthemtorequestthebanktomakepaymentsontheirbehalf.Notonlyaremanycustomersunawarethatanymoneytheydepositintoabankisnolongerlegallytheirs,asignificantproportionareunawarethatthebankusesdepositedmoneytohelpfunditsloansandinvestments.Whentoldthatthebankdoesnotkeeptheirmoneysafeinitsvaultsbutwillputatleastsomeofitatrisk,33%mostagreedwiththestatement:“Thisiswrong–Ihaven’tgiventhempermissiontodoso.”(Evans,2010)Thecontrastwiththepensionsindustryinthisregardisstriking.Inthe1990scampaignersensuredthat the Pensions Act was amended to require that the trustees of occupational pension schemesdisclose“theextent(ifatall)towhichsocial,environmentalorethicalconsiderationsaretakenintoaccount in the selection, retention and realisation of investment” (The Occupational PensionsSchemes (Investment) Regulations 2005). Yet nothing even vaguely similar is on the horizon inbanking.Thelackofknowledgeastowhatbanksdohassevereimplicationsforthestateofdemocracy.Afterall, how can there be ameaningful democracywithout public understanding of such an importantissueaswhathappenstoyourmoneywhenitisdepositedinabankaccount?ThepowertoshapetheeconomyThe previous section showed that banks are able to use the funds that flow to them, as a result ofpaymentsmade to their depositors,without thepermissionof thedepositor.Yet the actual depositsthemselveswerecreatedbybanksthroughtheprocessofmakingloans.PriortoQuantitativeEasing,

97%of theUK’smoney supply in the hands of the public existed in the formof deposits held bybanks. That is, 97% of themoney supply was created by private banks. In contrast, only 3%wascreatedbythegovernment–only3%ofthemoneysupplyiscash.ThebanksthereforehavemassivepowertoshapetheUKeconomy.Thispowerisevengreaterthanthat of democratically elected government, because the banking sector allocates more money vialendingthanthegovernmentallocatesviapublicspending.Inthefiveyearsrunninguptothestartofthe financial crisis, the banking sector ’s gross lending to households and individuals alone (notincluding lending to businesses) came to a total of £2.9 trillion. Meanwhile, total governmentspendingduringthesameperiodwaslessat£2.1trillion.Becausethebanksdecidewheretolend(forexample,onhousing,personalloans,carfinanceorinvestmentinsmallbusinesses),theycanshapemuchof thespendingandactivity in theeconomy.Indeed,asshowninsection4.1, ifbanks lendtoproductivebusiness theeconomywill thrive. If instead they lend for speculativeornonproductivepurposesearningswillstagnate,andrisingdebtwillcreaterecessionsandpotentiallyfinancialcrises.It is important tonote that neither thequantitynordirectionofbank lending is determinedby ‘themarket’.Asshowninsection3.5(oncreditrationing),thequantityoflendingisnotdeterminedbytheinteractionofthedemandfor,andsupplyof,credit.Instead,duetothefactthattheleveloftheinterestrate alters theprobabilityof repayment,banks limit the interest rate theychargeand instead rationcredit.Banksdeterminethequantityoflending,andthereforethequantityofmoneyanddebtintheeconomy.Likewise,theallocationofnewlendingisnotdeterminedbytherelativereturnsondifferentprojects.Rather,itisdeterminedbythelikelihoodofrepayment,andtheabilitytocollateraliseloanstoensurethatnon-repaymentdoesnot result in a loss to thebank. In fact, less than10%ofallbank lendingtoday goes to businesses that contribute toGDP – the vastmajority goes towardsmortgages, realestate companies, and financial intermediation. If these lending decisions had beenmade by localbankmanagerswhowereintouchwiththelocaleconomyandknewwhereanyinvestmentcouldbemost productive, then banks having greater ‘spending power ’ than governmentmay not be such amatterforconcern.However,lendingdecisionsarenotmadebylocalbranchmanagers,insteadtheyaremadebyseniormanagersat theheadofficesof thebanks,basedonastatisticalanalysisof therelativelikelihoodsofrepayment.Inaneconomywithalargenumberofsmallbanks,nosinglebankwouldhaveanycontroloverthedirectionoftheeconomy.However,intheUKthefivelargestbanks(HSBC, Barclays, Santander, RBS, Lloyds/HBOS) account for 85% of the current accountmarket(2010), 61% of the savings account market (2010), 64% of the unsecured personal loan market(2009),74%ofthemortgagemarket(2009)and84%ofliquiditymanagementservicestosmallandmedium-sizedbusinesses.(Treasury,2011)8AsofSeptember2011,thesefivebankshadjustatotalof78boardmembers.9

Theforcedrivingtheboardmembersofbanksistheneedtomaximiseprofitovertheshortterm(tomaximiseshareholdervalue).However,what’sprofitableintheshorttermislikelytobebadforthebankandtheeconomyin the longer term.In theshort runbanksprefer to lendto theunproductivesector:it’seasier,cheaper,andappearstobesaferthanlendingtorealbusiness.Indeed,aslongasthepriceoftheassetthatcollateralisestheloanisincreasing,thebankdoesn’tevenneedtoworryabouttheborrower ’sability torepay,as itcanrepossess theassetandrecover theamountoriginally lent(thesameappliesifthebankcansecuritisetheloan.)Yetinthelongertermthistypeoflendingisnotsustainable, andwill inevitably lead, if left longenough, to recessionandpossibly financial crisis.

Profitmaximisationbybanksthereforetendstoleadtogovernmentbailoutsofbanks,reducingtheamountthatgovernmentsareabletospendonprogrammestheywereelectedtopursue,andinsomecasesendangeringthesolvencyofthegovernment.AsAlessandriandHaldane(2009)putit:“In theMiddle Ages…the biggest risk to the banks was from the sovereign. Today, perhaps thebiggestrisktothesovereigncomesfromthebanks.Causalityhasreversed.”

Whyshouldprofitmaximisationbyaprivatecompanyreducetheabilityofademocraticallyelectedgovernmenttoundertakeitsmandate?DependencyIn 1943 Michal Kalecki argued that it was the government’s reliance on big business to provideinvestmentandjobsthatgavecapitaliststhepowertoinfluencegovernment:“Under a laissez-faire system the levelof employmentdepends to agreat extenton the so-calledstateofconfidence.Ifthisdeteriorates,privateinvestmentdeclines,whichresultsinafallofoutputand employment (both directly and through the secondary effect of the fall in incomes uponconsumption and investment). This gives the capitalists a powerful indirect control overgovernmentpolicy:everythingwhichmayshakethestateofconfidencemustbecarefullyavoidedbecauseitwouldcauseaneconomiccrisis.”(Kalecki,1943)

Today,thegovernment’sdependenceonbanksgivesthemsimilarpowers–foramoderneconomytofunctionmoney and banks are required. Small andmedium sized businesses, unable to access thecapitalmarkets,relyonbankstoprovidefundssothattheycaninvestandgrow.Thesefirmsprovidea largepart of thegrowthand themajorityof the employment in anyeconomy, so their ability tosecure financing is of crucial importance to the health of the economy – hence the government’sattemptsto‘getbankslendingagain’.10

Today, the banking sector regularly argues against any reform or regulations by reminding thegovernmentthattheyarecompletelyreliantonthebankstoprovidefundingtoindustry,astherecentcommentsbyJosefAckermannofDeutscheBankAGattest:“Therecanbenodoubtthatreformswillproduceadragoneconomicrecoveryandthismeansthatjobs that should be created and that need to be created may not be created. The actions by theregulatoryauthorities…maysteercreditawayfromimportantsegmentsoftheeconomy,suchassmallandmedium-sizedenterprises,whicharetheenginesofjobcreationinthematureeconomiestoday.”(2010)

Thecurrentmonetarysystemmeanswearereliantonbankstoissuethenation’smoneyandtoensurethat sufficient amounts of thismoney reach businesses in the real economy. It is this reliance thatgivesbankspowerovergovernmentsthemselves.ConfusingthebenefitsandcostsofbankingThefinancialsectorisoftenviewedas,atleastintermsoftaxrevenue,‘thegoosethatlaidthegoldeneggs’,implyingthatweshouldnottobetoohastyininterferingwiththewaythesefirmsdobusiness.However,thetaxraisedfromthebankingindustryisonlyonesideoftheequation–thepositiveside.Buttherearealsocostsassociatedwithbanking:justaspollutionisacostoftheoilindustry,financialcrises,debt,andeconomicinstabilityarecostsofthebankingindustry.Themostobviousandquantifiableof thesecosts is thedirectcostofbailingoutfailedbanks.Lessdirectcostsassociatedwiththeunemployment,lostproduction,andlowergrowththatresultfromabanking crisis are not as easy tomeasure.Moreover, financial crises are not the only itemon the

negativesideoftheequation:thebankingindustryhaslongbenefitedfromvarioussubsidieswhichareoftenoverlookedduetoignoranceabouthowbanksactuallywork.Ifourdemocraticallyelecteddecision-makers are led to believe that the financial sectormakes a bigger net contribution to theExchequer than it actually does, then the decisions they make regarding banking reform will bedistortedinfavourofbanksattheexpenseofsocietyasawhole.BenefitsofbankingWhat are the benefits of the banking sector? In 2009-2010 the government’s total tax revenuewas£490.6bn,ofwhichonly£2.1bn (less thanhalfofonepercent)camedirectly from thebanks in theform of corporation tax. Another £15.2bn (3%) came from the banks’ employees in the form ofincometaxandnationalinsurancecontributions.Theother£473bn(97%)intaxescamefromoutsidethebankingsector.So,whilstcontributingamodestpercentage,thebankingindustryishardlyoneofthebiggestcontributorstothegovernment’scoffers(HMRC,2011).Bankshavealsofacedaone-offpayrolltax(commonlyknownasthe‘bonustax’),andcurrentlypayayearly‘banklevy’.Thepayrolltaxwasatemporaryone-offtaxonbankers’bonuses,whichtotalled£2.3bn (net) in2010-11.Thebank levywasexpected to raise£1.9bn in2011-12, and£2.5bnayearfrom 2012-13, roughly equivalent to the revenue raised by airport taxes. However, whilst theseamountsarenotinsignificant,theyonlyaddafractiontothetotaltaxbillbankswillhavetopay.Itisworthnotingthatbanks,unlikeotherindustries,areexemptfrompayingVAT-anexemptionthattheInstituteforFiscalStudieshassaidisneithernecessarynorlogical(InstituteforFiscalStudies,2011).Sincethecrisis,thebankingsectorhascontributedlesstaxasitstaxableincomehasbeenreducedbylarge losses and write-downs. However, even when banks’ tax payments were at their highest -£23.3bnin2007-2008-theywerestilldwarfedbytaxreceiptsfromthemanufacturingsector,whichtotalled£63.3bninthesameperiod(Erturketal.,2011).CostsofbankingThemostobviouscostassociatedwiththebankingsectoristaxpayersupporttothebanks.Althoughthegovernment’sguaranteestothebanksatonepointtotalled£1.16trillion,thisamountnowstandsat£456.3billion.Overthelongtermithasbeensuggestedthatthetotaldirectcosttothetaxpayerwillbebelow£20billion(Haldane,2012),andrepresentativesofthebankingindustryhavearguedthatthegovernmentmayactuallymakeaprofitonthesaleofpartlynationalisedbanks.Viewedinthislight,thefinancialcrisishasnotbeenthatbad–infactthetaxrevenuefromthebankingsectorin2009-10alonemaycoverthebill.However,thisconvenientlyignoresalltheothercostsofthefinancialcrisis,suchastheredundancies,unemployment,failedbusinessesandthemassiveriseinnationaldebtthatresulted from the recession.These costs far exceed anypotential profit that the governmentmightmake on its ‘investments’ in RBS and Lloyds/HBOS. AsMervyn King, Governor of the Bank ofEngland(2003-2013),pointedoutinarecentspeech:“Thelossofworldoutputfromthefinancialcrisisisenormous,eventhoughsuchacrisismightbeconsideredaonceinageneration,orevenonceinacentury,event.It isnotdifficult toseethatacrisis that reducesoutputbybetween5%and10%foranumberofyears,andoccursonceeveryfiftyyears,amountstoanannualcostseveralmultiplesoftherevenuethatwillbegeneratedbytheUKbanklevy.”(2010)

Estimatesastothesecostsvary.AsHaldane(2012)pointsout,withworldGDParound6.5%lowerin2009thanitwouldotherwisehavebeen,lostoutputfortheworldeconomycouldbeashighas£2.5trillionthatyear.IntheUK,economicoutputin2009wasabout10%lowerthanitwouldotherwise

have been, corresponding to £140 billion in lost output or about £3,000 per adult.Moreover, lowoutput is likely to persist with the present value of output losses for the world predicted to beanywherebetween$60trillionand$200trillionandintheUKbetween£1.8trillionand£7.4trillion.Forthebankingsectortoactuallycoverthecostsofthecrisesitcreates,itwouldneedtopayagloballevy of around $1.5 trillion a year (Haldane, 2012),making theUK’s £2.5 billion bank levy looktrivialandcompletelydisproportionatetotherealcostsofthebankingsystem.SubsidiesWehavealreadydiscussedthesubsidythatthebankingsectorreceivesinsection3.3,withestimatesranging fromaround£20billion ayear on average, up to£350billionplus inparticular years.Afurther subsidy to thebanking sector arises fromallowingbanks thepower to createmoneywhenthey make loans. Without this power, banks would have to attract deposits before lending.Furthermore,banksthatwishedtolendmoneywouldhavetofinddepositorswhowouldbehappytoput their money into the equivalent of a ‘time deposit’ (a deposit that cannot be withdrawn for acertainperiodoftime).Depositorswouldbelikelytodemandahigherinterestrateontheirsavingstocompensatethemforthisinconvenience,decreasingtheprofitabilityonanygivenloan.HuberandRobertson(2000)calculatethatthisspecialprofitwasworth£21bnintheyear2000.However,sincethen the UK’s money supply has been more than doubled by private bank lending. As such, this‘special’profitisalsolikelytohavemorethandoubled.Toconclude,bankscontributeonlyasmallproportionofthetotaltaxtake,receivemassivesubsidies,levyhiddeninflationtaxesandperiodicallyrequirebailingoutatgreatexpensetothetaxpayer.

Footnotes1.In2011theBankofEnglandcalculatedthatbanksearnedjustunder£109billionininterestayear.However,thisfigureisartificiallylowduetothehistoricallylowinterestrates.Forexample,beforetheBankofEnglandloweredinterestrates(in2008),banksearnedjustover£213billionininterestpaymentsalone.2. The figures are drawn from analyses conducted by PositiveMoney combining statistics on therevenues and expenditure of UK banks (published by the Bank of England) and surveys of thefinances of British households and small and medium-sized businesses commissioned by UKgovernmentdepartmentsandheldattheUKDataArchive.3.For example, in theEU theMaastrichtTreaty requiresgovernments to cut expenditurewhen thedebttoGDPratioexceeds60%.4.WewouldliketothankBethStratfordforherinput,whichhasgreatlyimprovedourunderstandingoftheseimpacts.5. The private sector is often unwilling to engage in the primary scientific research that advancesscientific knowledge, due to extremely long and uncertain time periods between projectimplementation and fruition, the lack of certainty that anything of (marketable) value will bediscovered,andthedifficultiesinmonopolisingandmonetisingtheprofitsonanythingthatis.6. The requirement to maximise short term shareholder value is passed on to bank staff throughbonusandincentivestructures.7. For information about speculation on food prices see Schutter (2010) and Baffes & Haniotis(2010).8.ForthiscalculationSantanderisnotoneofthefivelargestproviders,andassuchthefigureinsteadincludesdatafromAllianceandLeicester.9.RBS:14boardmembers;Lloyds12;HSBC19;Santander20;Barclays13.AsofSeptember2011.10. Furthermore, the supply ofmoney crucially depends on banks’ willingness to lend at least asquicklyasloansarebeingrepaid.Ifbanksareunwillingtodoso,eventuallythemoneysupplywillshrinktozero.Asaresult,wearecompletelyreliantonbankstoprovidethemoneyrequiredinorderthattheeconomyfunctionssmoothly.

THEREFORMEDMONETARYSYSTEM

CHAPTER6PREVENTINGBANKSFROMCREATINGMONEY

PartOne of this book critically examined the currentmonetary system.Chapters 1-2 beganwith abrief history of money and banking, before moving on to discuss the mechanics of the currentsystem.Inparticularwesawthatbankscreatemoneywhentheymakeloans.Chapter3lookedatwhatdetermines thedemand and supplyof credit, concluding that thehighdemand for credit combinedwithineffectiveregulationsleavesthedeterminationofthemoneysupplyinthehandsofthebanks.Chapters4and5asked,giventhestructureofthecurrentmonetarysystem,whatisthelikelyresult?The normal functioning of such a system was shown to result in periodic booms, busts, andoccasionallyfinancialcrises,depressionsandevendebtdeflations,aswellasseriousconsequencesfor growth, unemployment, investment, house prices, public and private debts, inequality, theenvironment,anddemocracy.Withsuchawidearrayofnegativeconsequences,wefeelobliged toaskthequestionfirstputforwardbyMervynKing-ofallthewaysoforganisingmoneyandbanking,isthebestreallytheonewehavetoday?Inthesecondpartofthisbookwedescribeanalternativemonetarysystemthatwebelieveaddressesmanyoftheweaknessesofthesystemwehavetoday.Chapters6-8outlinehowthereformedbankingandmonetarysystemwouldwork,contrasting thisagainst theexistingsystem,whileChapters9-10explain the impactsof the reformedsystem. In this sense the secondpartof thisbookparallels thefirstpart:Chapters6-8correspondtoChapters1-3,withChapters9-10correspondingtoChapters4-5.Inthischapterthenewmonetarysystemisintroduced,beginningwiththedifferenttypesofaccountavailable to customersand thenewaccounts at thecentralbank.Adescriptionof themechanicsofhowbankswillmakeloansisthengiven,followedbyabriefdescriptionofhowthereformedsystemaligns risk and reward and allows banks to fail. The procedure for injecting newmoney into theeconomyiscoveredinchapter7,whilechapter8dealswiththetransitionfromthecurrentsystemtothereformedsystem.AdetailedexplanationoftheaccountingstructureofthenewsystemiscoveredinAppendixIII.

6.1ANOVERVIEWAfterthereformcommercialbankswillnolongerhavetheabilitytocreatemoney,intheformofthenumberswhichappearinacustomer ’scurrentaccount.Instead,allmoneythatcanbeusedtomakepaymentswillbecreatedexclusivelybythecentralbank.Thus,unlikeinthecurrentsystemwheretwotypes of money circulate separately – central bank created reserves which are only used by thebankingsector,andcommercialbankcreateddepositmoneywhichisusedbyeveryoneelse–inthereformedsystemthereisnolongerasplitcirculationofmoney,justoneintegratedquantityofmoneycirculatingamongbanksandnon-banksalike.Thismoneywillexistintwoforms–physicalcashandelectronicmoneycreatedbythecentralbank.Physicalmoney, or cash, will be created under the authority of the Bank of England, with coinsmanufacturedbytheRoyalMint,andnotesprintedbyspecialistprinterDeLaRue.Thereisthereforeno significant change from the existing arrangements (although seeAppendix IV for someminortechnicalchangesthatneedtobemadewithregardstogettingnewphysicalcashintocirculation).

Electronicmoney,createdbythecentralbank,willbetheequivalentofcentralbankreserves.Thiselectronicmoneywillexistinacomputersystematthecentralbank,justascentralbankreservesdotoday.However,whereaspresent-daycentralbankreservescanonlybeheldorusedbybanksandthecentral government, after the reform the electronicmoney created by the central bankwill belongdirectlytomembersofthepublic,businesses,andalsotobanks.Thisdoesnotmeanthatthecentralbankwillneedtoprovidemillionsofaccountstothegeneralpublic.Asexplainedbelow,commercialbanks will continue to administer this electronic money and the payments system on behalf ofcustomers.TheprocessgoverningthecreationofthismoneyisdiscussedindetailinChapter7.Afterthereformtherewillbetwodistincttypesofbankaccountavailabletobusinessesandmembersofthepublic:TransactionAccountswillholdtherisk-freeelectronicmoney(createdbythecentralbank),whichcanbeusedtomakepaymentsvia theusualchannels.Theywillnotbeusedbythebanktofunditsownlendingandinvestments,andwillthereforeneverbeputatanyrisk.Behindthescenes,thisrisk-freemoneyisactuallyheldattheBankofEngland,ratherthanbeingheldonthebank’sbalancesheet,sothatevenifthebankbecomesinsolventandfails,themoneyinTransactionAccountsisprotectedand not lost. Transaction Accounts, and the payment networks that allow electronic money to betransferredfromoneTransactionAccounttoanother,collectivelywillmakeupthepaymentsystem.InvestmentAccountsareawayforacustomertohandmoneytothebankontheunderstandingthatthebankwillinvestorlendit–i.e.intentionallyplaceitatriskandtrytoearnarateofreturnforthecustomer.ThecustomerplacingfundsintoanInvestmentAccountwillhavetoagreetoloseaccesstothosefundsforaperiodoftime,andwillalsobearsomeoftheriskoftheinvestment.From the perspective of a bank customer, these two account types broadly correspond to a) thepresent-day current/checking account,wheremoney canbewithdrawnor spent ondemand, andb)savingsaccountsthathavefixedtermsorminimumnoticeperiods.However,asexplainedlaterinthischapter,therearefundamentaldifferencesbehindthescenes.Crucially,thesechangesmeanthatbankscannolongercreatethetypeof(demand)depositsthatcanbeusedtomakepaymentsandthereforecannolongerincreasethetotalmoneysupplyasaresultoftheirlendingactivities.The finer details of these changes are described in the pages that follow. Taken as a whole, theyensurethat:

1. Thepaymentssystemisseparatedfromthelending/investingsideofabank’sbalancesheet(andassuchisshelteredfrombankfailure).

2. There is a clear distinction between truly risk-freemoney in a bank account, and a risk-bearinginvestmentthatcouldlosevalue.

3. Banksbecomemoneybrokers,ratherthanmoneycreators.Newlendingwillnotcreatenewmoney, but simply transfer existingmoney (and purchasing power) from one person toanother.

4. Asbanklendingwillnotincreasetheamountofmoneyintheeconomy,themoneysupplywillbestableandpermanentregardlessoftheoverorunder-lendingofbanks.

5. Therewillbe risk-alignmentonall investments,so that thosewhostand togainfromtheupsideofariskyinvestmentalsostandtotakethedownside.

6. Therewillbedifferent InvestmentAccounts fordifferent typesof loan.Thiswillprevent

bankstakinglargeriskswithfundsfromcustomerswhowantalowlevelofrisk.7. Banks that failwill be liquidated.Customerswho opted to keep theirmoney in risk-free

TransactionAccountswillhavetheirmoneytransferredtoahealthybankwithinhoursandwillnotloseaccesstothepaymentsystem.Therewillbenoneedfordepositinsuranceortaxpayer-fundedbailouts.InvestmentAccountholderswillbecomecreditorstothebankandawaitliquidationproceedings.

Finally,withbanksunabletoincreaseordecreasethemoneysupply(butfullyabletoplaytheroleofintermediarybetweensaversandborrowers),theBankofEnglandwillbecomesolelyresponsibleforcreatingnewmoney,under theauthorityofanewMoneyCreationCommittee.Newmoneywillbecreatedonlytotheextentthatitdoesnotfuelinflation.TheprocessofcreatingmoneyandinjectingitintotheeconomyisdiscussedindetailinChapter7.Wenowlookattheprocessforrestructuringtheoperationsofbanksinordertoremovetheirabilitytoincreaseordecreasethemoneysupply.Westartbylookingatthetwodistincttypesofaccountsthatbankswill be able to provide, the first ofwhichwill hold the state-issued currency created by theBankofEngland.

6.2CURRENT/TRANSACTIONACCOUNTSANDTHEPAYMENTSSYSTEMPresent-daycurrentaccountswillbereplacedbyTransactionAccounts.TransactionAccountswillstill:

1. ProvidechequesandATMordebitcards.2. Provideelectronicpaymentservices,includingforsalariesandotherpayments.3. Beinstantaccess,forbothelectronicmoneytransfersandcashwithdrawals.4. Provideoverdrafts,ifthebankseesfit.

However,unlikepresent-daycurrentaccounts,wherethesafetyofthedepositsinacurrentaccountdependsonthehealthofthebank’sbalancesheet,TransactionAccountswillbeentirelyrisk-freeandsecure.Thisisbecause,whileaTransactionAccountholdermayappeartobebankingwithaprivatecommercialbank,themoneyinaTransactionAccountisnolongeraliabilityofthebank.Insteaditactuallyrepresentselectronicmoney,issuedbytheBankofEngland,whichbelongstothecustomer.Thisisacrucialdifferencebetweenthepresentandreformedsystem.AswesawinChapter1,present-daycurrentaccountsaremerelypromisesfrombanksthattheywillusetheirownmoneyatthecentralbanktosettlepaymentsonourbehalf.Thesepromisesareonlyworthsomethingaslongasthebankisabletostaysolventandliquid.Incontrast,TransactionAccountswillbeactualmoneyatthecentralbank,whichbankswilladministerontheircustomers’behalf.ThismeansthatfundsplacedintoaTransactionAccountremainthelegalpropertyoftheaccountholder,ratherthanbecomingthepropertyofthebank(ashappensinthecurrentsystem).Thecustomerisinasensehiringthebanktoactasamiddleman,whoseroleistorelayinstructionsandinformationbetweenthecustomerandthecentralbank.Thebankneveractuallytakespossessionofthemoney,andisnotallowedtoinstructthecentralbanktotransferitwithoutthecustomer ’sexpresspermission.Asaresult,abankwillnolongerbeabletousethemoneyinTransactionAccountsformakingloansorfundingitsowninvestments.BecauseTransactionAccountsarenotheldonthebank’sbalance

sheetandareactuallyheldinfullattheBankofEngland,theycouldberepaidinfull(toallcustomers)atanytime,withouthavinganyimpactonthebank’soverallfinancialhealth(andregardlessofthefinancialhealthofthebank).Ineffect,thisturnsTransactionAccountsinto100%risk-free,electronic‘safedepositboxes’formoney.1

WiththemoneyinTransactionAccountssafebydesign,thereisnolongeraneedforadepositguaranteescheme.Infact,TransactionAccountshaveanadvantageoverpresent-daygovernmentguaranteedbankaccountsinthatthereisnolimittotheamountthatcansafelybekeptinthem.Presentlythegovernmentguaranteestandsat£85,000peraccount,butanyamountofmoneycouldbeheldinaTransactionAccountwithzeroriskoflossandnoexposuretothefinancialhealthofthebank.AccountFeesforTransactionAccounts:ThefundsplacedintoTransactionAccountswillnotbeavailabletothebanktolendorinvest,andthereforethebankwillbeunabletoearnareturnonthesefunds.However,theywillstillincurthecostsofadministeringtheseaccounts(staffwagesetc.)andprovidingservicesassociatedwiththem(chequebooks,ATMcards,paymentsysteminfrastructure,cashhandlingetc.).Consequentlythebanksprovidingtheseaccountswillneedtochargefeestocustomerstocovertheircostsandmakeaprofit.Table6.1:YearlycostsofprovidingacurrentaccountChequeBook £10(perbook)

DebitCard £2

Branch £5

CallCentre £8

Staff £15

BankingITsystems £4

CustomerDueDiligence(onaccountopening) £8

MasterCard/Visa £2

Link(cashmachinenetwork) £2

BACSandotherpaymentsystems £5

OtherITinfrastructure £2

Total £63

Source:Tusmor,aconsultancyfirmthathasbeeninvolvedinsettingupnewbanksintheUK(http://www.tusmor.com/)Howmuchwouldtheaccountfeesactuallybe?Table6.1givearealisticbreakdownofthecurrentyearlycostsofprovidingacurrentaccount.Thecostsequatetoaround£5permonth(andpossiblylessaftertheone-offcostsofopeningtheaccounthavebeenrecovered),plusamark-upforthebank’sprofit.Thesechargesarealreadyincurredbybanksinthepresent-daybankingsystem,andareunlikelytochangeunderareformedsystem.Theintroductionofaccountfeesmaycausesomeobjections,sincenobodylikestostartpayingforsomethingthatiscurrentlyfree.However,weshouldrecognisethatpresent-daycurrentaccountsonly

appeartobe‘free’.Inrealitythecostsofprovidingtheservicearerecoveredthroughunauthorisedoverdraft fines, cross-subsidisation from loans and selling of additional products (such as travelinsurance, credit cards etc.). There is now a growing movement towards ending ‘free’ currentaccounts,withtheBankofEngland’sAndrewBaileyandPaulTucker,theFSA’sAdairTurnerandSirDavidWalker,thenewchairmanofBarclaysspeakingoutinfavourofaccountfeesthatmorecloselyresemblethecostsofprovidingtheservice.Itshouldbenotedthatmanybankshavealreadystartedintroducing feesoncurrent accounts andalso thatmostbusinessespayaccount fees as amatterofcourse.Inrealitythecostsoftheseaccountswillbemanytimeslessthanthedirectandindirectcoststoeachindividualduetotheinstabilitycausedbythepresentmonetarysystem.Inpractice,therewillbesignificantmarketpressuretokeepaccountfeesaslowaspossible.Onceacustomer starts banking with a bank, they are more likely to use the same bank for savings,mortgages, credit cards and overdrafts, which will likely be more profitable for the bank.Consequently,marketpressurewillencouragebankstolowertheirfeestoattractnewcustomersandgrowtheirmarketshare.2

6.3INVESTMENTACCOUNTSAfter the reform, the bankwould need to attract the funds that it wants to use for any investmentpurpose(whetheritisforloans,creditcards,mortgages,longterminvestinginstocksorshort-termtrading). These funds would be provided by customers, via their Investment Accounts. InvestmentAccounts will replace present-day savings accounts, including instant access savings accounts andfixed-terminvestments throughabank.The term“InvestmentAccount”hasbeenchosenas itmoreaccuratelydescribesthepurposeoftheseaccounts-asitisarisk-bearinginvestmentratherthanasa‘safe’placeto‘save’money.InvestmentAccounts,likepresent-daysavingsaccounts,willstill:

1. Beusedbycustomerswhowishtoearninterestontheirsparemoney(savings).2. Payvaryingratesofinterest.3. Beprovidedbynormalhigh-streetbanks.4. Beliabilitiesofthebanktothecustomerwhomadetheinvestment.

However,InvestmentAccountshavesomesignificantdifferencesfrompresent-daysavingsaccounts:TheInvestmentAccountwillnotholdmoney:TheInvestmentAccountwillneveractuallyholdanymoney.Anymoney ‘placed in’ an InvestmentAccount by a customerwill actually be immediatelytransferredfromthecustomer ’sTransactionAccount(whichrepresentselectronicmoneyheldattheBank of England) to the bank’s ‘Investment Pool’ account (also held at the Bank of England anddiscussed inmore detail below).At this point, themoneywill belong to the bank, rather than theInvestmentAccountholder,andthebankwill recordthat itowes theInvestmentAccountholder theamountofmoneythattheyinvestedasaliabilitytothecustomer.Ineffect,InvestmentAccountsaresimplyrecordsofinvestmentsmadebycustomersthroughabank,equivalenttoasavingscertificate.Whenthemoneyinvestedisthenlenttoaborrower,itwillbetransferredfromthebank’sInvestmentPool(heldattheBankofEngland)totheborrower ’sTransactionAccount(withthemoneybeingheldintheCustomerFundsAccountattheBankofEngland).Astep-by-stepdemonstrationoftheprocessoflendingandinvestmentisgivenlaterinthischapter.

TheInvestmentAccountwillnotbemoney:Ifabankweretoprovideaservicewherebyacustomercould‘reassign’ownershipofallorpartofhisInvestmentAccount,thenitwouldbepossibletouseInvestmentAccounts tomakepayments.For example, take the case if an individualwhowished topurchaseacarbutwhoseonlyassetwasa£1000InvestmentAccountthatmaturedin4weeks.IfthecarsellerwaswillingtoacceptownershipoftheInvestmentAccountinpayment,theindividualcouldpayforthecarbytransferringownershipoftheInvestmentAccount.Thiswouldbeproblematicforthe system as a whole, as it would effectively give banks the ability to create money again,particularly if they made it very easy for customers to reassign Investment Account ownership.Consequently,topreventbanksbeingabletousetheirliabilitiesassubstitutesforstate-issuedmoney,itwillbenecessarytoensurethatownershipofInvestmentAccountscannotbe‘reassigned’.InvestmentAccountsareilliquid:At thepointof investment,customerswould loseaccess to theirmoneyforapre-agreedperiodoftime.Customerswouldagreetoeithera‘maturitydate’ora‘noticeperiod’ that would apply to the account. Thematurity date would be a specific date on which thecustomerwishestoberepaidthefullamountoftheinvestment,plusanyinterest.Thenoticeperiodrefers to an agreed number of weeks’ notice that the customer would give to the bank beforedemandingrepayment.Therewouldnolongerbeanyformof‘instantaccess’savingsaccounts.Thisprohibitiononinstantaccess savings isanecessity inorder topreventbankscreating liabilities thatcanbeused tomakepaymentsandtherebyreplicatingtheabilitytocreatemoneythattheyhaveinthepresentsystem.Investment Accounts will not be protected by government guarantee: The Financial ServicesCompensationSchemewouldnotapplytoInvestmentAccounts(orTransactionAccounts-althoughTransaction Accounts would be entirely risk-free). Customers who wish to keep their moneycompletelyfreeofriskcanputtheirmoneyintoTransactionAccounts,whilecustomerswhowanttoearnareturnwillbeexpectedtotakesomerisk(ratherthanhavingtheriskpassedontothetaxpayer,ascurrentlyhappens).InvestmentAccountswillberisk-bearing:Ifsomeborrowersfailtorepaytheirloans,thenthelosswill be split between the bank and the holder of the InvestmentAccount. This sharing of riskwillensurethatincentivesarealignedcorrectly,asproblemswouldariseifalltheriskfelloneitherthebankortheinvestor.Forexample,placingalltheriskontheaccountholderwillincentivisethebanktomaketheinvestmentsthathavethehighestriskandhighestreturnpossible,asthecustomerwouldtake all the downside of bad investment decisions. Alternatively, if the bank takes all the risk bypromising to repay thecustomer in full regardlessof theperformanceof the investments, then theaccountholderwouldfacenodownsideandwouldconsequentlyonlybemotivatedbyhighreturns,regardlessoftherisktaken.Thiswouldforcebankstocompetebyofferinghigherinterestratesinorder to attract funds,which theywould thenneed to invest in riskier projects in order tomake aprofit.AnyinvestoropeninganInvestmentAccountwillbemadefullyawareoftherisksatthetimeoftheinvestment,andthosewhodonotwishtotakeacertainlevelofriskwillbeabletooptforalternativeaccounts that offer lower risks and consequently lower returns.Risk and rewardwill therefore bealigned,whilemuchofthemoralhazardassociatedwiththecurrentbankingsystemwillberemoved.Ifthebanksufferssuchalargenumberofdefaults(borrowerswhoareunabletorepaytheirloans)that it becomes insolvent and fails, thebankwillbeclosed, the remainingassets liquidatedand thecreditorspaidoff.InvestmentAccountholdersshouldhavedepositpreference,meaningthattheywill

come first in the queue of creditorswaiting to be repaid if the bank fails.Amongst all InvestmentAccount holders, thosewhoopted for the lowest risk accounts should be repaid before thosewhooptedforthehigherriskaccounts.InvestmentAccountswill have a specific purpose: At the point of opening an account, the bankwouldberequired to informthecustomerof the intendeduses for themoney thatwillbe invested.Typically thebroadcategoryof investmentwillcorrespond to the levelof risk taken (asdiscussedabove),soInvestmentAccountsthatfundedresidentialmortgagesandloanstobusinesseswouldrankaslowerriskthanthosethatfundspeculativetradinginstockmarketsandcommodities.Thebroadcategoriesofinvestmentwillneedtobesetbytheauthorities.This change is designed to ensure that the types of investmentmade by the bank (with customers’money)moreclosely represent the typesof investments that thecustomers themselveswouldwant.Wedonotexpectindividualstomakedetaileddecisionsoverhowtoallocatetheirinvestmentsacrossdifferentassetclasses;butexpectthatsomecustomerswouldprefertohavemoreinformationaboutwhattheirfundswouldbeusedfor.

6.4ACCOUNTSATTHEBANKOFENGLANDUnderthepresent-daysystem,alllargebankshaveanaccountattheBankofEnglandinwhichtheykeep‘centralbankreserves’.Banksusethesereservestomakepaymentstootherbanks(seeChapter2).After the reform,eachbankwill insteadmanage threedistinctaccountsat theBankofEngland.These accounts would hold electronic money that had been created exclusively by the Bank ofEngland.Theaccountsare:TheOperationalAccount:Thisisanaccountwherethebankcanholdfundsforitsownpurposes-retainedprofits,newcapitalfromshareholders,moneytopaystaffwagesetc.Inshort,itisabank’s‘ownmoney’acquiredthroughtherunningofthebank.Themoneyinthisaccountisownedbythebankandtheaccountisanassetofthebank.TheInvestmentPool:Thisistheaccountthatabankwillusetoreceiveinvestmentsfromcustomers,receive loan repayments fromborrowers,makepayments back to InvestmentAccount holders andmake loans toborrowers. In short, this account represents the lending sideof thebank’s activities.Themoneyinthisaccountisownedbythebankandtheaccountisanassetofthebank.The Customer Funds Account: This is the account in which the bank’s customers’ TransactionAccountfundsareheld.WhensomeoneatanotherbankmakesapaymenttoaTransactionAccountholder,thebalanceoftheCustomerFundsAccountwillincrease.WhenaTransactionAccountholdermakesapaymenttosomeonewhousesadifferentbank,thebalanceofthisaccountwilldecrease.Themoney in this account is not ownedby the banknor is the account an asset of the bank.Thebankmerelyadministersthisaccount.fig.6.1-Accountsatcentralbankpostreform

*TheseaccountareadministeredbythebanksbutarenottheirpropertyTherelationshipbetweenTransactionAccountsandabank’sCustomerFundsAccountThemoneyplacedintoTransactionAccountsatabankwillactuallybeheld,inelectronicform,attheBankofEngland.Thesumtotalofabank’scustomerTransactionAccountswouldbereferredtoastheCustomerFundsAccountadministeredby thatbankandheldat theBankofEngland.However,whilethebankwouldadministerthisaccountonbehalfofitscustomers,itwouldnotownanyofthemoneywithin thecustomerfundsaccount itself.Furthermore,although theBankofEnglandwouldholdtheaggregatedpoolofrealelectronicmoney(whichitcreatedinthefirstplace),itneednotholdany information on individual customers or the balance of individual customer accounts, whichwouldbetheresponsibilityoftheindividualbanks.FortheCustomerFundsAccountitadministered,eachbankwouldrecordtheamountofthismoneythatisownedbyeachandeveryoneofitsindividualcustomers,andthetransactionsmadeinandoutofeachcustomer ’saccount.Asasimplisticexample,abank’sinternaldatabasemaylooksomethinglikethis:

Meanwhile, theBankofEngland’sowndatabasewill appear as shown in figure6.3, recording theaggregate balance of the Customer Funds Account each bank administers, but no details of anyindividual’saccounts:

fig.6.4-RelationshipbetweenCustomerFundsAccountsandTransactionAccounts

*Administeredbythebankbutnotitsproperty

6.5POST-REFORMBALANCESHEETSFORBANKSANDTHEBANKOFENGLANDChapter8discussesthemethodfortransitioningbetweenthecurrentandreformedmonetarysystemindetail.Fortherestofthischapterhoweveritisassumedthatthereformhasbeenenactedandthetransitioniscompleted.Thefollowingsectionlooksatboththecommercialbankandthecentralbank

balancesheets.CommercialbanksAfter thereform,commercialbankswillhave theusual rangeofassets.Under theusual ‘CashandCashEquivalents’willbeincludedthebank’sOperationalAccountandInvestmentPoolattheBankofEngland,replacingtheformerentryof‘DepositsattheBankofEngland’(i.e.centralbankreserves).Investment Accounts are recorded as a liability, just as present-day time deposits are. However,demanddeposits(currentaccounts)areremovedfromthebalancesheet,convertedintostate-issuedcurrency held at the central bank, and recorded on a separate register, ‘Customer Funds’, whichshowsthefundsadministeredbyRegalBankonbehalfofitscustomers.Forexample:

CentralbankThe central bank’s balance sheet has also lost many of its former liabilities, as these have beenconvertedintorealstate-issuedcurrencyandtransferredontoacustodialregister.

Itisimportanttonotethatthisisnottheonlywayinwhichtheaccountingforareformedsystemcanbe presented. Appendix III has an alternative treatment, in whichmoney remains a liability of theCentralBank.MeasuringthemoneysupplyThe existing statistical measure of ‘broad’money supply,M4, is calculated in a rather crude andpotentiallyimpreciseway.Attheendofeachmonth,thetreasuryteamofeachbankisrequiredtofillin a formdetailing the sum total of different types of customers’ accounts.These figures are thenaggregated across all banks to give the total figure forM4. This statistical measure occasionallyjumpsupordown-changesintheefficiencyofreportingatonebankresultedina£8billionjumpinM4fromonemonthtothenext,whereasachangeinthemeasurementproceduresonceresultedina

£176billionjump!ItshouldberecognisedthatM4issimplyaroughstatisticalmeasureofthetotalliabilities of banks to members of the public - not a precise count of the quantity of ‘electronicpounds’intheeconomy.Incontrast,post-reformthetotalmoneysupplywillbemucheasiertocount,asitissimplythetotalbalanceofalltheaccountsheldintheBankofEngland’scomputersystem.Precisely,itis:

ThesumofallCustomerFundsAccounts+

Thesumofallbanks’InvestmentAccounts+

Thesumofallbanks’OperationalAccounts+

ThebalanceoftheCentralGovernmentAccount+

ThebalanceoftheBankofEngland'sOwnFundsAccount&AnyotherbalancesattheBankofEngland(includingaccountsforothercentralbanks)

The total figure formoney supplywill be a precise number, accurate to the penny, which can becalculatedbytheBankofEngland’scomputersystemsinafractionofasecond.Thisfigurewouldthenbepublished,inrealtime,ontheBankofEnglandwebsite.TherewouldstillneedtobeamanualreportingprocesstogetthesumtotalofInvestmentAccountbalancesfromthebanks,asthesearenotrecordedattheBankofEngland.Inanycasethesewouldnotcountaspartofthemoneysupply,astheywouldnotbeavailableforspendinguntiltheymatured.

6.6MAKINGPAYMENTSThepost-reformprocessofmakingpaymentsisverysimple.Let’slookattheexamplefromChapter2,whereJackwanted topay foravanby transferringmoney to thevandealer,only this time inareformedbankingsystem.1.CustomersatthesamebankIfbothJackandthevandealerhaveaccountsatMegaBank,thenthetransfercanbemadeinternallywithinthebank’scomputersystems:

In effect, Jack has simply transferred his ownership of £10,000 at theBank ofEngland to the vandealer, although from theirperspective asbankcustomers, theywill simply seemoney transferredbetweenthetwoTransactionAccounts.Notehoweverthatnomoneymovesbetweenaccountsat theBank of England, as all the money still sits in the Customer Funds Account administered byMegaBankattheBankofEngland.2.CustomersatdifferentbanksIfthevandealeractuallywantstoreceivethe£10,000intoaseparateaccountatRegalBank,thenthemoneybelongingtoJack,whichisstoredintheMegaBankadministeredCustomerFundsAccountattheBankofEngland,will need to be transferred across to theRegalBank administeredCustomerFundsAccount,whereitwillbecomethepropertyofthevandealer.WhenJackaskshisbanktosend£10,000tothevandealer ’saccountatRegalBank,thenMegaBankwillsendaninstructiontotheBankofEnglandtotransfer£10,000fromtheCustomerFundsAccountitadministerstotheCustomerFundsAccountthatRegalBankadministers.Asthetransferiscarriedout, MegaBank reduces the recorded balance of Jack’s account, and Regal Bank increases therecorded balance of the van dealer ’s account. The transfer at the Bank of England is showndiagrammaticallyhere:

AnoteonsettlementinthereformedsystemInChapter2wesawthathighvalueortimesensitivepaymentsaremadeacrossthereserveaccountsat the Bank of England instantly, for example by using the CHAPS payment system. Conversely,smallervaluepaymentsarenotsettledimmediatelyattheBankofEnglandbutareinsteadqueuedinone of the other payment systems, such as BACS or Faster Payments. These payments are addedtogether and the net payment flows calculated, so that only the net debt/credit position needs to betransferred,loweringthesystem'sneedforcentralbankreserves.Under the reformed system it is possible to completely do away with the smaller value paymentsystems that clear on a net basis and instead settle all payments in real time across the Bank ofEngland’sbooks,aswithonlyoneintegratedquantityofmoneyusedbybanksandthepublicalike,thereisnolongeranyneedtoeconomiseonliquidity.3

However,thismayrequirealargeupgradeinthecapacityoftheBankofEngland’sRTGSsysteminorder tohandle the larger flowofpayments:BACS,FasterPaymentsandLink (theATMnetwork)together processed an average of 33 million transactions per day throughout 2011, whereas only300,000transactionsadayweresettleddirectlyviatheBankofEngland’sreserveaccounts(BankofEngland, 2012).As a result it is important to note that the smaller valuepayment systems are alsoentirely compatible with these proposals, with no need to change any of the existing paymentinfrastructures.Retaining these systems will reduce the load on the Bank of England’s computer systems. In areformedsystemwithnetsettlement,insteadoftheend-of-daynetsettlementhappeningacrosscentralbank reserve accounts, it would take place across the Customer Funds Accounts at the Bank ofEngland.Note that although multilateral net settlement reduces the amount of money that actually movesbetween banks, it does not allow banks to createmoney, as they do not own the Customer FundsAccountsorthemoneywithinthem.

6.7MAKINGLOANS

Thefollowingsectionexplainshowbankswillnormallymakeloans(includingviaoverdrafts)underthe reformed system.Note that for thepurposeof thedemonstration,wewill consider an examplewhereonecustomer ’sinvestmentof£1,000isfundinganequalloantoanotherindividualcustomer.In reality, the amounts loaned may be smaller than the investment and spread across multiplecustomers,oralternatively,multipleinvestmentsmayfundonelargerloan.Theredoesnotneedtobeanydirectlinkbetweenindividualsaversandborrowers.fig.6.9-Indirectrelationshipbetweensaversandborrowers

Undertheseproposals,inorderforabanktomakealoanitmustalreadyhavefundsonhand.Initiallythisrequiresacustomer,John,whowantstomakeaninvestmentusingsomeofthefundscurrentlyinhisTransactionAccount.HefirstneedstoopenanInvestmentAccountatthebankand‘fund’itwithatransfer from his Transaction Account. John sees the balance of his Transaction Account fall by£1,000,andseesthebalanceofhisnewInvestmentAccountincreaseby£1,000.However, inrealitythemoneyfromhisTransactionAccounthasactuallymovedtoRegalBank’sInvestmentPoolattheBankofEngland.TheBankofEngland’sbalancesheethaschangedasfollows:

OnRegal Bank’s balance sheet, the funds are transferred from John’s TransactionAccount to thebank’sInvestmentPool,andthebankcreatesanewliabilityof£1,000,whichisJohn’snewInvestmentAccount.

ThemoneyinRegalBank’sInvestmentPoolisthenusedtomakealoantoaborrower,David.Davidsigns a contract with the back confirming that he will repay £1,000 plus interest. This legallyenforceablecontract representsanasset for thebank,and is recordedon thebalancesheetas such.Simultaneously,moneyismovedfromRegalBank’sInvestmentPoolattheBankofEnglandtotheCustomerFundsAccountadministeredbyRegalBank,andRegalBankincreasesthevalueofDavid’sTransactionAccount.

Thebalancesheetstillbalances,withtheInvestmentAccountliabilitytoJohnoffsetbytheloanassetmadetoDavid.Throughouttheprocess,electronicmoneyintheaccountsattheBankofEnglandhasmoved from theCustomerFundsAccount to the InvestmentPool, andback to theCustomerFundsAccount.OwnershipofthemoneyhasmovedfromJohntoDavid.Insummary,anymoney‘placedin’anInvestmentAccountbyacustomerwillactuallybeimmediatelytransferred from that customer ’s TransactionAccount (held at theBank of England) to the bank’s‘InvestmentPool’account(alsoheldattheBankofEngland).Atthispoint,themoneywillbelongtothebank,ratherthantheInvestmentAccountholder,andthebankwillnotethatitowestheInvestmentAccountholdertheamountofmoneythattheaccountholderinvested(i.e.theInvestmentAccountwillberecordedasaliabilityonthebank’sbalancesheet).Whenthismoneyisthenlent,themoneywillbetransferredfromitsInvestmentPool(heldattheBankofEngland)totheborrowersTransactionAccount (held at the Bank of England). At no point did any money leave the Bank of England’sBalanceSheet,andnoadditionaldepositswerecreatedanywhereinthesystem.Thisensuresthattheact of lending does not increase the level of purchasing power in the economy, as it does in thecurrentsystem.fig.6.13-Diagramofflows

LoanrepaymentsTorepaytheloanthesameprocesshappensinreverse.AfterinformingtheBankhewishestorepayhisloan,Davidtransfers£1,000,plustheinteresthewascharged,fromhisTransactionAccounttothebank’sInvestmentPool.IfJohnwishestowithdrawhisInvestmentAccount,then,ontheconditionthathehasalreadygivenhisbankthenecessaryamountofnotice,RegalBankwill transfer£1,000plustheinterestpaidontheInvestmentAccountbackintoJohn’sTransactionAccount.RegalBank'sprofit(the difference between the interest rate charged on the loan and the interest rate paid on theInvestment Account) remains in Regal Bank's Investment Pool, and may be used to make furtherloans,orwithdrawntothebank'sOperationalAccountandusedtopaystaff,otheroperatingcosts,orpayshareholderdividends,etc.Ontheotherhand,ifJohndoesnotwishtowithdrawhisInvestmentAccountthebankwillbefreetousethemoneytomakefurtherloans.Ineithercaseloanrepaymentdoesnotcausethemoneysupplytoshrink,asisthecaseinthecurrentmonetarysystem.Thismeansthat, following the repayments, the publicwould be able to pay down significant amounts of debtwithout this causing the economic recession that typically accompanies a shrinkage in themoneysupply.

Box6.A–Maturitytransformationunderthereformedsystem

Apopularmisconceptionisthatthereformsproposedherepreventmaturitytransformation–theconversionofshort-termsavingsintolong-termloans-sothatanindividualwishingtoborrow£250,000over25yearsmustfindanindividualwishingtolend£250,000for25years.Obviously thiswouldbehighly inefficient.However, theproposalsoutlinedhere requireneither thevalueofa loan,nor itsmaturity, tobematchedbyasingleindividual’sinvestment.Instead,multipleindividualsareabletofundsingleloansandwithdrawtheirfundingbeforetheloanmatures. Thus the systemwill operatemuch as the bondmarket does today, onlywith fixedmaturity or redemption dates (and ingeneralnocapitalgainsorlosses).

Forexample,10peoplemayplace£1,000each intoan InvestmentAccount,and thebankmayuse this£10,000 tomakea loan toanindividualtobepaidbackover10years.Aftertwomonths,2ofthe10originalInvestmentAccountholdersmaywishtocashout,andasaresultthebankwillneedtofindpeoplewillingtolendatotalof£2,000toreplacethemoneythathasbeenremovedfromtheaccount.Sobothmaturity transformationandpoolingof fundscancontinue. In reality1,000sof loanswillmatureandbemadeeveryday,witheachinvestmentaccountholderfundingatinyproportionofeachloan.Consequentlyriskwillalsobepooled.

6.8HOWTOREALIGNRISKINBANKINGInvestmentAccountGuaranteesFrom the customer ’s perspective the fundamental principle of these reforms is that the customerdecideshowmuchrisktheywanttotakewiththeirmoney.Thosewhowanttokeeptheirmoney100%safecandosobyplacingtheirmoneyintoaTransactionAccount.Ontheotherhand,thosethatwishtoreceiveareturnontheirmoneymustacceptadegreeofriskandgiveupaccesstotheirmoneyforaperiodoftime.TheywilldothisbyplacingtheirmoneyintoanInvestmentAccount.Becauseall themoneyinTransactionAccountsisheldattheBankofEngland,andtherefore100%safe,theFinancialServicesCompensationSchemewouldbecancelledasitappliestobankaccounts.InordertoensureriskandrewardarealignedInvestmentAccountswouldnotbeguaranteedbythegovernmentorFSCSinanyway.Customerswhowishtokeeptheirmoneycompletelyfreeofriskcanput theirmoney intoTransactionAccounts,whilecustomerswhowant toearna returnwillbeexpected to take on some risk (rather than having the risk passed onto the taxpayer through the£85,000guarantee).However,thisinitselfcouldcreatenewproblems.Forexample,ifthebanksimplypassesalltheriskontotheInvestmentAccountholder,thenthebanktakestheupsideofitslendingdecisionsbutlittleofthe downside. This would encourage the bank to use customers’money to pursue only high-risk,

high-returnactivities.Likewise, if thebankretainedall the riskon its lending,customerswouldbeincentivised to put theirmoney into the highest risk, highest return Investment Accounts, with theresultthat‘safer ’butlowerreturninvestmentswouldstruggletosecurefunding.Thus, in order to ensure that incentives are correctly aligned, those that stand to benefit from theupside of an investment (both the bank and the InvestmentAccount holder) alsomust share in thedownside if things go wrong. Therefore, in order to ensure that risk and reward are aligned thereformswillallowbankstooffertheInvestmentAccountholderaguaranteeonapercentageoftheirinitial investment. For example, as well as offering a return of 5% a year if the investments aresuccessful,banksmayguaranteethat95%ofthevalueofanInvestmentAccountwillberepaid,withthebankcoveringanyfallinthevalueoftheaccountbelow95%outofitsownprofits.Ineachcase,investors would have been made aware of the guarantees and made their decision to invest in aparticularInvestmentAccount,knowingtherisksaswellasthepotentialupside.Byvarying the guarantees it offers on InvestmentAccounts according to the degree of risk in theunderlyinginvestments,bankswillbeabletocompetebyofferingavarietyofproductsthatcatertodifferentriskappetites.Investorswhowantahighrateofreturnwillneedtotakeonsomeoftheriskthemselves,whileinvestorswhoarehappywithalowrateofreturnwillbeabletoinvestalmostrisk-free.Of course, these guarantees will only be valid as long as the bank is solvent. If a bank becomesbankrupt,InvestmentAccountholderswouldbecomecreditorsofthebankandwouldhavetowaitfornormalliquidationprocedurestotakeplacetoseeiftheywillgetbackpartoftheirinvestment.Thegovernmentwillnotbacktheguaranteesmadebythebanks.TheregulatormayforbidspecificguaranteesWhichever institution ischargedwithsupervising theUKbankingsystemmayforbidan institutionfromofferingaspecificrateofreturnorguaranteeonaparticularInvestmentAccount.Thereasonfor this is twofold. First, ‘irrational exuberance’ amongst individuals and banks may lead tounrealisticreturnsbeingofferedandacceptedbasedonchangesinprofitabilitythatareunsustainablein the long term.Because regulators themselves are not immune to irrational exuberance (see thebelief in a ‘greatmoderation’ (Bernanke, 2004)), guarantees that promise returns in excess of theaveragelong-runhistoricalreturnswillbeforbidden.Furthermore,thetimeperiodsusedtocalculatetheselong-runaveragesmustalsoincludeperiodsofrecession,depression,andfinancialcrisis.4

Second, the regulatormayforbidspecificguaranteesor returns inorder toprotect individualsandbankshareholdersfromunscrupulousactivitybybankstaff.Forexample,assumethecase(whichiscommon)whereseniorbankstaffareremuneratedbasedonthebank’smarketshare.Inthissituationguarantees may be offered based not on the profitability of the underlying investment, but toencouragemoreindividualstoplacetheirmoneyintothatbank’sInvestmentAccountinsteadoftheircompetitors.Whiletheseinvestmentsmayeventuallyleadtolossesforthebank,inthemeantimethesenior staffwill receive large payouts due to the increase inmarket share.Although this chain ofeventsmayseemunlikely,somecommentators(forexampleSmith,2010)sawjustsuch‘looting’ofbanksbytheirstaffasoneofthecausesofthe2007-08financialcrisis.1

6.9LETTINGBANKSFAILRecall that in thecurrent system,whenabank fails, itscustomerscannotaccess theiraccounts (i.e.theycannotmakepaymentsandcannotwithdrawcash).InthecaseofthefailureofRBS,thiswould

have left millions of account holders with potentially no access to money or means of payment,especially if their only account was at RBS. As outlined in previous chapters, the resulting chaoscouldhaveledtopanicandbankruns,bringingtheentirepaymentssystemtoahalt.Inaddition,aswesawinchapter4,theexistenceofdepositinsurancemeansthatitwillalwaysbemoreexpensiveforthegovernmenttoallowamajorbanktofailthantorescueitwithacapitalinjection.Inthereformedsystem,itisfareasiertoallowabanktofail.Ifabankmadebadinvestmentchoicesthatleadtoitsinsolvency,itwouldceaseoperatingandtheliquidationprocedureswouldbeinitiated.However,holdersofTransactionAccountswouldnotloseaccesstotheirmoney,becausethismoneyisheldat theBankofEngland-ratherthanonthebalancesheetof thefailedbank-andwasneverplacedat risk.Theelectronicpaymentsmadeon theseaccountscouldcontinue through thenormalpayments system,and in timeadministrationof theseTransactionAccountscouldbe takenoverbyhealthybanks(withcustomersselecting thebanktheywant toadminister theiraccounts).Providingthe IT systems are designed in the right way, banks could be allowed to fail without TransactionAccountcustomerslosingtheabilitytomakepaymentsforevenafewhours.WhataboutInvestmentAccountholders?Theymadeaconsciousdecisiontoinvestviathebankandtoplace theirmoney at risk.At thepoint of investment theywouldhavebeenmade aware that theinvestmentwasnotguaranteedandthat,intheeventofthebankfailing,theywouldbecomecreditorsof thebankandwouldneed towait for the liquidationprocedure to takeplacebefore theyfindouthowmuchoftheirinvestmenttheywillreceiveback.Astheassetsofthefailedbankaresoldoff,theInvestment Account holders will be repaid, although they are unlikely to receive 100% of theiroriginal investment.Thoseaccountholderswhooptedfor the lowriskInvestmentAccountsshouldhavedepositorpreference(i.e.shouldbepaidbackearlierandingreaterproportion)overthosewhooptedforthehigher-riskaccounts.Ofcourse,iftheBankofEnglandfeelsthatabankisgoingthroughtemporaryliquidity(cashflow)problemsbutfeelsitisfundamentallysolventinthelongterm(i.e.itsassets,correctlyvalued,arestillgreater than its liabilities), then itmayopt tomakeanemergency loan to thatbankforaperiodoftime,toallowthebanktocontinuetofunctionwhileitlooksforinvestors.ItwillbefortheBankofEnglandtodecidewhetherabankintroubleisfacingtemporaryliquidityproblemsorwhetheritisfundamentallyinsolvent,andtotaketheappropriatecourseofaction.

Footnotes1.Despitethefactthatthismoneyisnotavailabletoprivatebanksduetothedesignofthesystem,itwouldalsobea legaloffence foranybank tobeunable to repay (i.e. transfer) thesum totalof itsTransactionAccountsinaggregateatanytime.ThisrequirementpreventsbanksfromofferinginstantaccessaccountswherethemoneyisnotheldattheBankofEngland(intheCustomerFundsAccount).Anybankthatdidtakecustomer ’sfunds,promiserepaymentofthefundsondemandandthenlentthefunds would be in breach of this law. This catch-all requirement prevents banks from offeringalternativeproductsthatofferthesameservicesasTransactionAccountsbutallowthebanktousethefundsforotherpurposes(whichwouldeffectivelybeareturntothecurrentmonetarysystem).2.OneconcernisthatchargingfeesfortheprovisionofTransactionAccountswillhurtthepoorandincrease financial exclusion. A solution to this problem is for the government to simply provideanyoneearningbelowacertainthresholdwithasmallgrantwhichcanbeusedtoopenaTransactionAccount.3.Inaddition,theneedfortheBankofEnglandtoprovideadditionalintradayliquiditythroughsamedayrepoforsecuritiestransactions(asitcurrentlydoesinCRESTunderaprocedureknownasauto-collateralisation)willnolongerberequired,asduetothereformseveryaccountwillbefullyliquid.4.Offeringguaranteesmaybeproblematiciftheunderlyinginvestmentshavenotexistedforenoughtime for long run averages to be calculated. One solutionwould be for the regulator to disallowguaranteeson these InvestmentAccounts.Anotherwouldbe for it to allowonlyvery conservativeguarantees tobeoffered (i.e. low returns, a lowpercentageguaranteed tobe repaid) and require awarningtobeplacedonthemastotheuncertaintyoftheirreturns.

Footnotes1.ForamoregeneraldiscussionseeAkerlof&Romer.(1993)

CHAPTER7THENEWPROCESSFORCREATINGMONEY

After thereform,bankswouldnolongerbeable tocreatemoney– in theformofbankdeposits–when they made loans or bought financial assets. As a result, an alternative method for injectingmoney into the economy will be required. However, before we address the question of how newmoneyistobecreated,wefirstmustaddressthequestions:

1. Whoshoulddecidehowmuchnewmoneyistobecreated?2. Whoshoulddecidehowthatmoneyistobeused?

Wewillnowlookatbothofthesequestionsindetail.

7.1WHOSHOULDHAVETHEAUTHORITYTOCREATEMONEY?The overriding principlewhenwe are decidingwho should have the authority to createmoney iswhetherornotthe‘creator ’canbenefitpersonallyfromcreatingmoney.Iftheanswerisyes,thenwehaveaconflictofinterest.Banksprofitfrommakingloans,andassuchtheyincentivisetheirstafftomaximiselendingthroughsales targets, bonuses, commissions, the opportunity of promotion, etc. During periods whereeconomicconditionsarerelativelybenignbanksandbankersprofitbyincreasingtheirlendingandbyimplicationincreasingthemoneysupplyasfastaspossible.Intheorytherisk-managementsideofbanksshouldplacesomekindoflimitationuponthisincreaseinlendingandconsequentincreaseinthemoneysupply,buthistoryhasshownthatriskmanagementandprudenceisoftenforgotteninthechaseforprofits.Besides,whilethepercentageincreaseinthemoneysupplywasmostextremeintheyears running up to the recent financial crisis, the average growth rate in the M4 money supplybetween1970and2010wasstillasignificant11.5%perannum.ThisgrowthrateinthemoneysupplybearsnorelationtothegrowthinGDPortheneedsoftheeconomyasawhole-itisdrivenpurelybytheneedofbankstomaximiseprofitbymaximisinglending.Itisalsoreasonabletoassumethatvote-seekingpoliticianswouldbelittlebetterasmanagersofthemoney supply. An important rationale for taking monetary policy away from the Treasury andhanding it to theBankofEnglandwas that itwasassumed thatpoliticianswere liable toabuse thispower,particularlyintherun-uptoelections,oftenleadingtorecurrentcyclesofboomandbust(theso-called ‘political business cycle’). Similarly, there would be significant temptation for theChancellororPrimeMinistertosanctionthecreationofnewmoneyinorderto‘buy’thegoodwillofvoters.Inshort,neitherprofit-seekingbankersnorvote-seekingpoliticianscanbetrustedwiththepowertocreatemoney, as the incentives both groups facewill lead them to abuse this power for personal,partyorcompanygain.Instead,wemustensurethatthecreatorsofthemoneysupplydonotbenefitfrom creating it. This requires the separation of the decision on how much new money is to becreatedfromhowthatnewlycreatedmoneyistobeused.We do this by giving these two decisions to completely separate bodies. We recommend that anindependentbody,theMoneyCreationCommittee(MCC),shouldtakedecisionsoverhowmuchnew

moneyshouldbecreated,whiletheelectedgovernmentofthedayshouldmakethedecisionoverhowthatmoneywill be spent.Alternatively, theMCCmay lendmoney to the banks to on-lend into the‘real’economy,inwhichcasethedecisionoverwherethemoneyislentwillbemade,withinbroadguidelines,bythebanks.

7.2DECIDINGHOWMUCHMONEYTOCREATE:THEMONEYCREATION

COMMITTEE(MCC)The decision over howmuch newmoney to createwould be given to an independent body, to beknownastheMonetaryCreationCommittee.Asisthecasetoday,thetargetofmonetarypolicywillbetherateofinflation.However,inlinewithdemocraticprinciples,ifParliamentdeemstargetsotherthanpricestabilitytobemoredesirable,itwillhavetheabilitytochangetheMCC’smandate.Indecidingtheamountofmoneythatwouldbeaddedorremovedfromcirculation,theMCCwouldbroadlyaimtochangethegrowthrateofthemoneysupplyinordertokeepinflationataroundthe2%ayear target.Creationofnewmoneyby theMCCwill increase theamountof spending in theeconomy.Dependingonthestateoftheeconomyatthetime,thismaypushuptheinflationrate(theactual effect ofmoney creation upon inflation and the output of the economywill be discussed indetail inChapter9). If inflation is above the target rate, then it isunlikely theMCCwill choose tofurtherincreasethemoneysupply.Note that the MCC’s decision will be based on the amount of additional money they considernecessarytomeettheinflationtarget.Undernocircumstanceswouldtheybecreatingasmuchmoneyasthegovernmentneedstofulfilitselectionmanifestopromises.WiththeMCChavingdirectcontrolovertheamountofmoneyintheeconomy,theMonetaryPolicyCommitteeattheBankofEnglandwouldnolongerbeneededandcouldbedisbanded.CurrentlytheMonetaryPolicyCommitteeattempts tocontrolbank lending–and therefore thequantityofbroadmoney in the economy– by influencing the interest rate atwhich banks lend to each other on theinterbankmarket.Post-reform,centralbankswouldhavedirectcontroloverthemoneysupplyandsotherewouldbenoneedforthemtosetinterestrates.Instead,interestrateswouldbedeterminedbythemarkets.TheMoneyCreationCommitteewill have no control over how the newly createdmoney is used.Whilst theway themoney isusedwill determine to somedegree its effecton inflation,giving theMCCanyinfluenceoverhowthemoneyisspentwouldintroduceaconflictofinterest,wherebyitsmembersmightfindthattheirjudgementisswayedbytheiropiniononthegovernment’spoliciesandprojects.Inordertopreventthisconflictofinterestfromarising,andtoensurethattheMCCdoesnotbecomepoliticised, thedecisionoverhowmuchmoney iscreatedandwhat thatmoney isusedformustbetakenbyseparatebodies.

Box7.A-AppointmentsandneutralityoftheMCC

TheMCCmust be politically independent and neutral, just as the Monetary Policy Committee (responsible for setting interest rates) istoday.Aswell as being shielded from the influenceof vote-seeking politicians, it is essential that theMCC is sheltered fromconflicts ofinterestandlobbyistsforthebankingsectorandotherindustries.BuildingontherulesthatcurrentlycovertheMonetaryPolicyCommittee’stransparency andaccountability, all increases in themoney supplywill bemadepublicly known. In addition,while theMCCwill not beanswerabletotheChancelloroftheday(whowill likelyhavehisownpoliticalobjectivestoachieve),theywillbeaccountabletoacross-partyParliamentaryGroup,suchastheTreasurySelectCommittee.

Appointments to theMCCwillautomatically includetheGovernorandtwoDeputyGovernorsof theBankofEngland,as is thecasewiththeMonetaryPolicyCommitteetoday.LikewisetheGovernorisstillbestplacedtorecommendthetwointernalmembersofthecommittee.

However, unlike today,where the internal appointments are referred to theChancellor of theExchequer for approval, under the reformedsystemtheseinternalmemberswill insteadbereferredtoacrosspartygroupofMPsforapproval.Theintentionistoprovidedemocraticoversight and scrutiny of the appointment process by Parliament while reducing the powers of the Chancellor. Likewise, for the samereasons,theappointmentofthefourexternalmembersoftheMCCwillalsobedecidedbyacrosspartygroupofMPs.Intotal,theMCCwillbemadeupofninemembers,which,withtheexceptionoftheGovernorandtheDeputyGovernors,willservethree-yearterms.

HowtheMoneyCreationCommitteewouldworkEachmonth,theMoneyCreationCommitteewouldmeetanddecidewhethertoincrease,decrease,orhold constant the level ofmoney in the economy.During theirmonthlymeetings theMCCwoulddecideupontwofigures:

1. Theamountofnewmoneyneededinordertomaintainaggregatedemandinlinewiththeinflationtarget(similartothesettingofinterestratestoday),and;

2. Theamountofnewlendingneededinordertoavoidacreditcrunchintherealeconomyandthereforeafallinoutputandemployment(discussedinsection7.6).

Both figures would be determined, as is the case nowwhen setting interest rates, by reference toappropriate macroeconomic data, including the Bank of England’s Credit Conditions Survey (asurveyofbusinessborrowingconditions,outlinedinBox7.C).Once a conclusion had beenmade on the two figuresmentioned above, then theMoney CreationCommittee would authorise the creation of a specific amount of new money. This newly createdmoneycouldthenentertheeconomyintwoways:Thefirst(andmostcommon)ofthesewouldbetograntthemoneytothegovernment(byincreasingthebalanceoftheCentralGovernmentAccount),whichwouldthenspendthismoneyintocirculation,asdiscussedinthenextsection.Thisprocessincreasesthemoneysupplywithoutincreasingthelevelofdebtintheeconomyandcanthereforebethoughtofas‘debt-free’moneycreation.Thesecondmethodwouldbe for thecentralbank tocreatenewmoneyvia theMCCand lend it tobanks, which would then lend this money to businesses and the productive economy (but not formortgagesor financial speculation).This increases themoney supplybut simultaneously increasesthelevelofdebt,andsodoesnotconstitutedebt-freemoneycreation.Thisoptionprovidesatooltoensurethatbusinessesandtherealeconomydonotsufferfromalackofaccesstocredit.Itwillbediscussedfurtherbelow.

Box7.B-WhatmeasureofinflationshouldtheMCCtarget?

InthecurrentregimetheMonetaryPolicyCommitteetargetsa2%inflationrate,asmeasuredbytheConsumerPriceIndex(CPI).However,theCPIdoesnotincludethecostofhousing,eventhoughhousingisoftenthegreatestportionofanyone’scostofliving.Theabsenceofhouseprices inthemeasureof inflationtargetedbytheMPCmeantthattheBankofEnglandwasabletoclaim,evenin2011,that ithadsuccessfullymanagedinflationoverthelastdecade,whilstignoringhousepriceinflationthataveraged12%(andpeakedat18%)between1997and2007(Nationwide,2012).

ShouldtheMonetaryCreationCommitteeberequiredtoincludehousepriceinflationintheirmeasureofinflation?Webelievethiscouldbeproblematic.Althoughthesereformswouldsignificantlyreducethelikelihoodofhouse-pricebubbles,therewillstillbechangesinaveragehouse prices from year to year. However, under the reformed system these price changes would be more likely to reflect changes ineconomic fundamentals, such as changes in the demand for housing (e.g. due to changes in population) or changes in the supply ofhousing(e.g.duetochangesinplanninglaws).

Normally,achangeinthepriceofagoodowingtoeconomicfundamentals(overandabovethatcausedbymonetarychanges)isnotaproblem–ifthepriceofagoodthatisincludedintheCPIcalculationincreasesmarkedly,itisreplacedwithasubstitutegood.

Thismakesintuitivesense–ifthecostofchickendoubled,forexample,peoplemightbeexpectedtosubstituteawayfromchickenandeatmorebeefinstead.

However, if thecostof livingsomewheredoubles(eitherbecauseofhousepricesorrents increasing) it isnotpossibletosubstituteawayfromthegoodinquestion–peopleneedtolivesomewhere.Asaresult,housingwouldremaininthebasketofgoodsusedtocalculatetheinflationrate,andtherecordedlevelofinflationwouldincreaseabovetarget.Unabletoremovehousingfromthebasketofgoods,inorderto keep inflationwithin the target range theMCCwould have to engineer either deflation or reduced inflation in the rest of the basket ofgoodsthatmadeuptheinflationindex,withpotentiallydamagingresults.

Inordertoavoidtheseissuesandpreventhousepricebubbles, insteadof includinghouseprices inthetargetedmeasureof inflationtheBank of England should bemandated to prevent house price bubbles (for example, price changes caused by speculative behaviour),whilsttheMCCshouldcontinuetotargettheCPImeasureofinflation.

IsitpossiblefortheMoneyCreationCommitteetodeterminethe‘correct’moneysupply?To begin with, it is important to note that the MCC would not determine how much money theeconomy needs from scratch. Instead, it would decidewhether to increase or decrease themoneysupplyfromitsexistinglevel(whichhadbeendeterminedbyhistoricalevents),givencurrentlevelsofinflationandeconomicactivity.ThisrequiresthattheMCCtakeaviewonthelikelyfuturepathoftheeconomyinadditiontoreactingtoeconomicevents.EssentiallytheMCCwillbeguidedbyboththeoryandtheresultsoftheirpreviousdecisions.There is of course noway for theMCC to predict perfectlywhat the growth in themoney supply‘should’be.However, this is trueofallmonetaryandpoliticaldecisions– including theMonetaryPolicyCommittee’sdecisiontoincreaseordecreaseinterestratesinthepresentsystem.Thequestiontherefore becomes one ofwho ismost likely to supply the economywith the ‘correct’ amount ofmoney: commercial banks in the current system, or an independent committee in the reformedsystem?AswasoutlinedinChapter2,commercialbankscreatemoneywhentheymakeloans.Bankofficialsthereforearenotmakingadecisionabouthowmuchmoney they think shouldbe in theeconomy;theyareinsteadmakingadecisionaboutwhetheraparticularloanwillbeprofitable.Thismeansthatthemoney supply is currently determined as a by-product of bank lending decisions,made in thepursuitofprofit.Becausethemajorityofbanks’profitscomefromtheinteresttheychargeonloans,inrelativelybenignperiodsbanksareincentivisedtolendasmuchaspossible,creatingmoneyintheprocess.However,althoughthemoneysupplyisdeterminedbytheactionsofcompaniesintheprivatesector,itwouldbeamistake tobelieve that themoneysupply isdeterminedbymarket forces, forseveralreasons. First, the top five banks in the UK dominate almost the entire market, making it anoligopolisticmarket.Second,themoneysupplyisnotdeterminedbythedemandformoney,butbythe demand for credit. Third, even themarket for credit is not determined bymarket forces – assection3.5showed,banksrationcredit.Ofcourse,theoverallstrategiesofbanks,andthereforetheirlendingpriorities,aredeterminedatboard level.Consequently, it isasmallgroupofseniorboardmembersatthelargestbankswhodeterminethegrowthrateoflendingandinadvertentlythemoneysupplyoftheeconomy.Asthe“cashvsbankissuedmoney”chartintheintroductionshowed,theseincentives,combinedwithalackofconstraintonbanklending,ledtoadoublingofthemoneysupplyfrom2002-2008.Banksthereforecreatetoomuchmoneyingoodtimes,leadingtoeconomicbooms,assetbubblesandoccasionalfinancialcrises.Becausethismoneyiscreatedwithanaccompanyingdebt,eventuallytheeconomybecomesover-indebted,withabustoccurringwhenindividualscutbackspendingtorepaytheirdebts.Duringthebust,banks’pessimisticviewsastothefuturestateoftheeconomy(whichare

magnifiedbydisastermyopia–seeBox4.C)leadthemtocreatetoolittlemoneyandasaresulttheeconomysuffersmore than itneeds to.Thestoryof this typeofbusinesscycle is thereforeoneofbankscreatingtoomuchcredit,whichcausesaboomandeventuallyabustwhendebtgetstoohigh.Then,during thebustbanks lend too little,worsening thedownturn. In short, there isno reason tothink that the level of money creation that maximises banks’ profits will be the level of moneycreationthatisbestfortheeconomyasawhole.Incontrast,underthereformedsystemthedecisiontocreateordestroymoneywillbedeterminedbytheMCC,acommitteechargedwithcreatingtherightamountofmoneyfortheeconomyasawhole.Whileitisunlikelythatthiscommitteewillbeabletogetthelevelexactlyright,historyhasshownthatthecurrentsystemrarelyprovidesthe‘right’amountofmoney,andmoreoftenthannotgetsitdisastrouslywrong.Thechoiceisnotthereforebetweena‘perfect’market-determinedsystemononehandandonedeterminedbyacommitteeontheother,butratherbetweenleavingthenation’smoneyat the mercy of the interests of banks or organising it squarely in the interests of the nationaleconomy.Given theabove, it isdifficult to imagine that theMCCcouldmanage themoneysupplymoredestructivelythanthebankshavedonetodate.

7.3ACCOUNTINGFORMONEYCREATIONWhentheBankofEnglandcreatesbanknotes,thesearerecordedontheBankofEngland’sbalancesheetasaliability(apromisetorepay),balancedbygovernmentbondsheldontheassetsideofitsbalance sheet. This accounting convention is a throwback to the era when bank notes wereexchangeable for gold and therefore an asset (the gold) had to be held to ‘back’ the notes incirculation.However, notes have not been redeemable for gold since 1931; as a result the currentconventionforaccountingforthecreationofmoneyhasbeenobsoleteformorethan80years.Appendix III explains how this accounting process can bemodernised andwhy there is no soundreasonfortheBankofEnglandtorecordnotes(or,post-reform,thestate-issuedelectroniccurrency)as a liability, or to hold assets against this liability. It explains that in some countries coins areaccountedfordifferently:whiletheyareassetsoftheholder,theyareliabilitiesofno-one.Itisarguedthat thenoteissuanceshouldbemodernisedtobeconsistentwiththeaccountingforthecreationofcoinsandthatelectronicstate-issuedcurrencyshouldalsobeaccountedforinthesameway.1Fortherest of this chapter it is enough simply to appreciate that electronic, state-issuedmoneywill be anassetoftheholderbutnotaliabilityofthecentralbankortheTreasury.Thereisthereforenoneedtohaveanyasset‘backing’thecurrency,sincethecurrencygetsitsvaluefrompeople’swillingnesstoexchangeitforgoodsandservices.

7.4THEMECHANICSOFCREATINGNEWMONEYAfter the reformsare implemented, electronic state-issuedcurrencywill simplybeanumber inanaccountattheBankofEngland.TheseaccountswillbeheldofftheBankofEngland’sbalancesheet,sothesenumbersarenotliabilitiesoftheBankofEngland.Instead,theyshouldbeseenaselectronictokens,heldincustodyfortheownersofthemoney.Theownersmaybebanks(fortheInvestmentPoolsandOperationalAccounts),thegovernment(fortheCentralGovernmentAccount)ormembersofthepublic(fortheaggregatedCustomerFundsAccounts).WhentheMCCmakesadecisiontoincreasethemoneysupply,itwillsimplyincreasethebalanceoftheCentralGovernmentAccountattheBankofEnglandbythatamount.Thisisanon-repayablegrantofthenewmoneytothegovernment,whichwilltreatthemoneyasadditionalrevenue,addingtothe

revenue it gets from tax and borrowing. How this money enters the wider economy is discussedbelow.

7.5SPENDINGNEWMONEYINTOCIRCULATIONTherearefourwaysthatthismoneycanbespentintotheeconomy:IncreasinggovernmentspendingByusingthenewlycreatedmoneytoincreasegovernmentspending,thegovernmentcanincreasetheprovision or quality of public services such as education, health care or public transport, withoutincreasingthetaxburdenonthepublic.Whatifthegovernmentusesthemoneytoincreaseitsspendingbutwastesitonsomethingthathaslimitedbenefitsforsocietyortaxpayers?First,thisconsiderationappliestoalltaxrevenuealready.Ifthereisariskthatthenewlycreatedmoneywillbespentfoolishlybythegovernment,thenthesameriskapplies to the restof themoney that thegovernment spendseachyear.Second,wemustavoidmakingtheerrorofthinkingthatmoneycanonlybespentonce.Asanindividual,youhavealimitedamountofmoney.Ifyouspenditfoolishlyand‘waste’itthemoneyisgoneforgood.Butthatmoneydoesn’tdisappear;onceyou’vespentit,itisinthehandsofsomeoneelseandmaybespentagain.Inthesameway,evenifthegovernmentwastesnewlycreatedmoneythemoneywillendupinthehandsofgovernmentemployeesandcontractors,whowillthengoontospenditintherealeconomy.CuttingtaxesRather than increasing government spending, the elected government of the day could choose toreducetheoveralltaxburden.Thiscouldbeachievedinoneofthreeways(oracombination):

1. Through maintaining the current tax regime but redistributing the newly created moneybacktothepublicviataxrebates(payments)aftertheyear ’staxeshavebeenreceivedandusingthenewlycreatedmoneytocovertheresultingshortfall.Administrativelythiscouldbeverycomplicated,asHMRC(theUK’staxcollector)doesnothavebankaccountdetailsforthelargemajorityofpeoplewhosetaxesarepaidontheirbehalfbytheiremployer,andsoitwouldrelyonmembersofthepublicactuallyreclaimingtherebate.

2. Byreducingtheratesoftaxchargedonincome,VAT(ValueAddedTax),corporationtax,National Insurance etc., therefore collecting less money from taxation. The governmentwould thenmake up the shortfall with the newly createdmoney.With this approach, theadministrativeburdenfallsmainlyonbusinesses.

3. Bycancellingor reducingparticular taxes, thereforecollecting lessmoneyfromtaxationandusingnewlycreatedmoneytomakeuptheshortfall.

Asageneralprinciple,anygovernmentusing theproceedsof this reformtoreduce taxationcouldaimtoreduceoreliminatesomeofthemostregressiveormarketdistortingtaxes.Therearehoweverproblemswiththisplan:whilechangesintaxesaremadeinfrequently, theamountofnewlycreatedmoneyspent into theeconomywillbedeterminedonamonthlybasis.Notbeingable topredictorinfluence the decisions of theMCCwillmean the governmentwill have little idea howmuchnewmoneywillbecreatedeachyearandthereforebyhowmuchitwillbeabletoreducetaxes.Forthisreason,cancellingorreducingtaxesmaynotbethemosteffectiveway(intermsofthegovernmentfinancialplanning)ofdistributingnewlycreatedmoneyintotheeconomy.Makingdirectpaymentstocitizens

Onealternativeisforthenewlycreatedmoneytobesharedequallybetweenallcitizens(oralladults,or all registered taxpayers). This would also mean that the newly created money is most widelydistributedacross theeconomy,rather thanbeingconcentratedinparticularareasof thecountryorsectorsoftheeconomyasaresultoflargegovernmentprojects,forexample.PayingdownthenationaldebtThegovernmentcouldusethenewlycreatedmoneytoretire(paydown)someofthenationaldebt.However,thereareproblemswiththisapproach,oneofwhichisthefactthatthenewlycreatedmoneywouldgofirsttoholdersofgovernmentbondsandwouldtendtostaycirculatingwithinthefinancialmarkets,ratherthanreachingtherealeconomy.Manyofthebondsthatmakeupthenationaldebtareheldbypensionfundsandinsurancecompanies,whichmeansthatwhilesomeof thenewlycreatedmoneypaidtothesebondholderswouldendupinthehandsofpensionersorinsuranceclaimants,themajority will stay within financial markets, providing no stimulus to the real (non-financial)economy. The potential problemswith using newly createdmoney to reduce the national debt arediscussedindetailinAppendixII.WeighinguptheoptionsTheexactmixoftheabovewilldependontheprioritiesandideologyofthegovernmentoftheday.Sincethenewlycreatedmoneycansimplybeaddedtothegovernment’staxrevenue,thereisnoneedforaspecialprocesstodecidehowtospendit.Ifthepublichaselectedagovernmentthatpromisestoincrease public spending, then the government can justifiably use the money for this purpose.Likewise,ifthepublicelectedagovernmentthatpromisedtoreducetheoveralltaxtake,orpaydownthenationaldebt,thenthegovernmentcanusethemoneytotheseends.Directdistributiontocitizensmay be a votewinner formany andwould avoidmany of the distortions that could be caused byfunnellingevenmoremoneythroughgovernment.Therewillnodoubtbeaheatedpoliticaldebateabouthowsuchmoneycouldbeused.However,theimportantthingisnotnecessarilyhowthemoneyisfirstspent,butthatitreachesordinarypeopleandtherealeconomy,ratherthangettingtrappedinthefinancialsector.Forthisreasonitmaybebetterthatnewly-createdmoney isnotused topaydown thenationaldebt,as thismoney is likely to staycirculatingwithinthefinancialmarkets.Withregardstotheremainingthreeoptions,thechoicemustbemadethroughawiderpublicdebate.TheanalysisinChapter9providesaframeworkforunderstandingtheeconomicimpactsofdifferentmethodsofinjectingmoneyintotheeconomy,andaneffectivegovernmentshouldmakeitselfawareofthesevaryingimpactstogetthegreatesteconomicbenefitofnewlycreatedmoney.

Box7.C-Determininganunmetdemandforloans

Currently, as part of its work to maintain monetary and financial stability, the Bank of England conducts a quarterly survey of creditconditions in the UK. Its purpose is to monitor and ‘assess trends in the demand for, and the supply of credit, including terms andconditions’(Driver,2007).TheinformationgatheredinformstheBankofEngland’sworkinmaintainingfinancialstabilityandsettinginterestrates, whilst helping to deconstruct the underlying drivers of bank lending and gain a richer understanding of credit conditions. Thequestionsaskedaimtoassesshowthedemandandsupplyofcredittodifferentsectorshaschangedoverthepreviousthreemonthsandhowthesetrendsareexpectedtochangeintheupcomingthreemonths.

UnderthesereformstheCreditConditionsSurveywouldgainadditionalimportance.Becausebankswouldonlybeabletolendoutmoneythathadalreadybeendeposited in InvestmentAccounts,a lackofcustomerswilling to invest(perhapsduetoanegativeoutlookfor theeconomy)wouldnegativelyaffectabanks’abilitytolend,withpotentiallyharmfuleffectsontheeconomy.

TheCreditConditionsSurveywouldhelptoforewarntheBankofEnglandifsuchasituationwasimminent,givingittimetoprovidefundingtobanks(exclusivelyforlendingtobusinesses)inordertoavertapotentialcreditcrunch.

InthelongertermtheBankofEnglandcouldalsomonitortheinterestratechargedonloanstobusinesses.Generallyspeaking,ahigherinterest rate would suggest the need for the Bank of England to intervene to provide funding to the banks. However, there are severaldrawbackstothisapproach.Firstly,arisinginterestratemaysignaleitherafall inthesupplyoffundsinInvestmentAccountsorariseinthedemand for loans.AsDriver (2007, p. 389) notes, “if changes in thequantity of credit areassociatedwith changes indemand fromborrowers,theimplicationsforactivityandinflationcanbedifferentthaniftheyareassociatedwithchangesinsupplybylenders”.

Byinterveningsimplybecausemarket-setinterestratesarerising,theBankofEnglandmayriskinterveninginawell-functioningmarketforlendingandborrowing,causingdistortionsintheprocess.Second,ifbanksdosettheinterestratelowerthanthemarket-clearingrateandinstead rationcredit,asdescribed inChapter3, there isa limit to theamount that the interest ratescan increase.Once the rate isat thisrationedlimitanyriseinthedemandfororreductioninthesupplyofmoneyin investmentaccountswillnot increasetheinterestrate,andnofurtherinformationwillbeconveyedbythem.

7.6LENDINGMONEYINTOCIRCULATIONTOENSUREADEQUATECREDITFORBUSINESSESAfterthereformtheMoneyCreationCommitteewillalsobetaskedwithensuringthatbusinessesinthereal(non-financial)economyhaveanadequateaccesstocredit(thisisespeciallyimportantintheUK,wherelessthan10%ofallbanklendinggoestowardsbusinessesthatcontributetoGDP(Ryan-Collinsetal.2011)).Forexample,theMCCmaydecideinitsmonthlymeetingstolendsomenewlycreatedmoneytobanks,withtherestrictionthatthebankscanonlylendthismoneytobusinessesthatcontribute toGDP(i.e. itcannotbe lent for financial speculation,consumer financeormortgages).Thiswillmeanthatthenewmoneycomesintotheeconomynotasnewspending,butasnewcreditavailable forbusinesses (in theory thiswillnot interferewith theMCC’s inflation target,asmoneythatislentforproductivepurposestendsnottobeinflationary,asdiscussedinChapter4).Thisabilitytomakefundsavailableforlendingtobusinessshouldnotbeusedasatooltomanagetheeconomy;itshouldonlybeusedtoensurethattheeconomydoesnotsufferduetoalackofcreditforbusinesses.Bankswill still be responsible for decidingwhich businesses they should lend to.ThismeansthattheBankofEnglandisneverputinthepositionof‘pickingwinners’.InordertolendmoneyinthiswaytheBankofEnglandwillmonitortheUKeconomyboththroughquantitativeandqualitativemethods(suchastheCreditConditionsSurvey).If,basedonthisanalysis,theBankofEnglandconcludes thatbanksareunable tomeetdemand for loans fromcreditworthyborrowersandbusinessesandthisisnegativelyaffectingtheeconomy(perhapsbecausedifficultiesinsecuringfundingisplacinglargenumbersofotherwisehealthycompanies infinancialdistress),then the Bank of England may make up the shortfall by lending a pre-determined amount tocommercialbanks.Theallocationof loansthroughthelendingfacilitymayoccur inanynumberofways.Perhapsthemost ‘market orientated’ of these would be to use an auction mechanism. Currently the Bank ofEnglandusesa‘uniformprice’auctiontoallocatecentralbankreservestobanksinlong-termrepo(sale and repurchase) operations (Bank of England, 2012). Such a mechanism could be used toallocateloanstobanksinareformedbankingsystem.ThiswouldensurethattheinterestratepaidontheseloansfromtheBankofEnglandwouldbesetbywhatbanksarewillingtopay,whichinturnwouldbedeterminedbythedemandforloansfrombusinessesinthewidereconomy.Any loans that theBankofEnglandmakes tobanks specifically for thepurposesof on-lending tobusinesseswillbefundedbymoneycreatedbytheBankofEngland.So,ifforexample,MegaBankweresuccessful insecuring£10billion in loanfinancingfromtheBankofEngland, its InvestmentPoolwouldbecreditedwith£10billion(andthemoneysupplywouldthereforeincreasebythesameamount)2.

The repayment of the loan principal will occur by debiting the bank’s Investment Pool andsimultaneously updating theBank ofEngland’s records (themoney is destroyed upon repayment).TherepaymentoftheinterestontheseloanswillbecreditedtotheCentralGovernmentAccountattheBankofEngland, toensure that these interestpayments–whichwithdrawmoneyfromthe realeconomy–arere-circulatedbackintotheeconomythroughgovernmentexpenditure.

Box7.D–Makingbankslendtobusinesses

Post-reform,bankswillhavetocompetewitheachotherbybiddingforthefundsprovidedbytheBankofEnglandinanauction.Becausebankswillno longerbeprotectedfromfailure, theywillonlybid if theybelievethat theyareable tomake loanswhichwillberepaidandthereforeprofitableforthebank.Asaresult,thebetterabankisatjudgingthebusinessplansofbusinessesthatwanttoborrow,thehigherthepriceitwillbeabletobidforfundsfromtheBankofEnglandandthemorelikelyitwillbetowintheauction.Becauseanyloansmadefromthesefundsshouldprovideasourceofadditionalprofittobanks,theywillbeincentivisedtoinvestinthestaffandequipmentthatarebestatlendingtobusinesses.Thisinvestmentwillencouragefurtherlendingtoproductivebusinessesbybankswithalternativesourcesoffunds(i.e.notthoseborrowedfromtheBankofEngland),astheirabilitytoassessbusinessloanapplicationswillbeenhanced–loweringthelikelihoodtheywillmakebadloans,andtherebyincreasingtheirprofitfromthisformoflending.Essentially,bankswillbeincentivisedtocompeteontheirabilitytomakeloanstobusinesses,withpositivebenefitsfortheeconomyasawhole.

7.7REDUCINGTHEMONEYSUPPLYTheMoneyCreationCommitteeshouldaimtobecautiousintheircreationofmoneyandincreasethemoney supply slowly and steadily.This should ensure that there is little need to reduce themoneysupplyinordertocorrectearlier‘overshooting’.InagrowingeconomyitisunlikelythatthemoneysupplywillneedtobereducedaslongasitbroadlygrowsinlinewithGDP.However,thisisnottosaythattherearenotsomecircumstanceswhereitmaybenecessarytoreducethemoneysupply.AsexplainedinthecasestudyonZimbabweinAppendixI,significantinflationcanbetriggeredwhenthelevelofgoodsandservicescirculatingintheeconomycollapses.Thismayhappenforanumberof reasons, such as war, bad economic policies or natural disaster. Alternatively, there is thepossibilitythatduetotheenvironmentallimitsofgrowthbeingreachedtherewillbenocapacityforfurther growth. In a zero growth economy an increasingmoney supplywould likely feed throughinto inflation.Likewisewemayfindwehavetodecreaseeconomicoutput inorder to livewith thenaturalcapacityof theenvironment. In thiscase toavoid inflation themoneysupplywouldneed toshrink. Finally, it may be argued that the huge increase in the money supply in the run-up to thefinancialcrisismayneedtobepartiallyreversedasadeleveragingofdebtandbank-createdmoneyoccurs.In a reformed system theBankofEnglandwouldhave anumberof tools bywhich it can removemoneyfromcirculation.Theseare:

By removing money (with agreement) from the government’s account at the Bank ofEngland,directlyreducingthemoneysupply.Thiseffectivelyinvolvestaxingmoneyoutofexistence.Whilethiswouldpotentiallybethemostefficientwayofdecreasingthemoneysupply, it may also be the most difficult politically and likely to be resisted by thegovernment.Bysellingsecurities italreadyowns (suchasGiltsorTreasurybonds)andremoving themoneyreceived for themfromcirculation.Similarly, theBankofEnglandcould removemoneyby issuingnewbonds, suchas theBankofEnglandbills it currentlyuses for thispurpose.Thismethodwouldbemost likely tobeused toeffect temporaryandreversiblereductionsinthemoneysupply.

Bychoosingnottorolloverloanstothebankingsystemthatithadpreviouslymade.Afterthereform,bycreatingandlendingmoneytobankstoon-lendtobusinesses,theBankofEngland would increase money in circulation. Conversely, the repayment of these loanswould remove money from circulation. The Bank of England could then re-inject thisrepaidmoneyby relending it to thebanks,butbychoosingnot todo this, theamountofmoney incirculationwould fall.Ofcourse, thismechanism isonlyuseful if theBankofEnglandhasalreadycreatedsomemoneyforbankstoon-lendtobusinesses;ifthislendingfacilityisneverused,thenthismethodofreducingthemoneysupplywillnotbeanoption.Bynotrecirculatingsomeofthe‘ConversionLiability’tothegovernment.Asdiscussedinthe next chapter, when the demand liabilities of banks are converted into state-issuedelectroniccurrency,theywillbereplacedwithanewliabilitytotheBankofEngland,whichis effectively a charge to the banks for the electronic state-issued currency. This‘ConversionLiability’willberepaidtotheBankofEnglandovertimeasthebank’sloansare repaid. Normally, this money would automatically be granted to the Treasuryimmediatelyand spentback intocirculation. If theBankofEnglandneeded to reduce themoney supply, it could choose not to recirculate some of the funds it receives via theConversion Liability and instead destroy this money, reducing the money supply in theprocess.This isprobably theeasiestmethodforpermanently removing largeamountsofmoneyfromcirculation,althoughitwillonlyapplyduringthetransitionalperiod.

Footnotes1.Itisimportanttonotethatthisisnottheonlywayinwhichtheaccountingforareformedsystemcanbepresented.AppendixIIIhasanalternativetreatment,inwhichmoneyisaliabilityoftheCentralBank.2.TopreventspikesinlendingjustaftertheBankofEnglandlendstothebanks(duetobankswantingto lend it as quickly as possible to avoid incurring interest charges from theBank ofEngland onmoneythathasnotyetbeenlent),bankswouldonlypayinterestontheseloansoncethemoneyhadactuallybeenon-lenttobusinesses.Then,tostopbankshoardingthismoney,oronlyborrowinginordertopreventtheircompetitorsfromdoingso,theborrowingbankswouldberequiredtoloanthismoneycreatedwithinasettimeperiodorbeforcedtoreturnittotheBankofEnglandandpayafine(to prevent anti-competitive practices). This would prevent the situation where the MCC had tocalculatehowmuchmoneytocreateyetalsohadtoaccountforabankthathadsofarnotlentintocirculationallthemoneythatitborrowed.

CHAPTER8MAKINGTHETRANSITION

This chapter explains how we make the transition between the current system and the reformedsystem.It isnecessarilyquitetechnical.Readerswhowishtoavoidthebalancesheetsmayskipthischapter,asthefollowingchaptersassumethatthisprocesshasalreadybeencompleted.AnoverviewoftheprocessTherearetwoelementsofthetransitiontothenewbankingsystem:

1. Theovernight‘switchover ’onaspecifieddatewhenthedemanddepositsofbankswillbeconverted into state-issued currency and customers’ accounts will be converted intoTransactionAccountsandInvestmentAccounts.

2. A longer period, potentially 10-30 years after the reforms, as the consequences of theconversionofdemanddepositsintostate-issuedcurrencyallowsasignificantreductioninhouseholddebtandagradual reduction in thesizeof theaggregatedbalancesheetof thebankingsector.

Theeconomywillbeoperatingonthebasisofthereformedmonetarysystemimmediatelyfollowingtheswitchover.However,itwilltakealongerperiodoftransitiontorecoverfromthe‘hangover ’ofdebtcreatedbythecurrentdebt-basedmonetarysystem.Themonetarysystemcannotbeconsideredfullyreformeduntilthisprocessiscomplete.ThebalancesheetsfortheBankofEngland,thecommercialbankingsectorandthehouseholdsector(i.e. the non-bank sector) before, just after, and around 20 years after the reforms take place areshownattheendofthischapter.Analternativeaccountingtreatmentofthereformsandthesebalancesheets,inwhichmoneyremainsontheliabilitiessideofthecentralbank’sbalancesheet,canbefoundinAppendixIII.

8.1THEOVERNIGHT‘SWITCHOVER’TOTHENEWSYSTEMThe following stepswill takeplace instantaneouslyon a specifieddate, knownas the ‘switchover ’date.ThebalancesheetsoftheBankofEngland,thecommercialbankingsector,andthehouseholdsector before this date can be found at the end of this chapter (figure 8.11).All the figures in thissectionarecorrrectasofFebuary2012.Step1:UpdatingtheBankofEngland’sbalancesheetThereareanumberofchangesthatneedtobemadetotheBankofEngland’sbalancesheet.ThefirststepistoacceptthatnotesshouldnotberecordedasliabilitiesoftheBankofEngland,forthereasonsdiscussed inAppendix III.This immediately removes£54.9billion (asofFebruary2012) from theliabilitiessideoftheIssueDepartment’sbalancesheet.However, theassets(bondsetc.)ontheIssueDepartment’sbalancesheetaresofarunchanged,givingtheIssueDepartmentanetworthof£54.9bn.

TheBankofEnglandkeepsaseparatebalancesheetcovering its issuanceofpaperbanknotes,butthisconventionisarelicoftheerawhenBankofEnglandnoteswereredeemableforgold,andisno

longernecessaryinthisreformedmonetarysystem.WethereforemergethetwobalancesheetsoftheBankofEngland–theIssueDepartmentandtheBankingDepartment.ThebalancesheetoftheBankofEngland’sBankingDepartmentinitiallyappearsasshownoverleaf(fromtheBankofEngland’s2012AnnualReport).

Whenmergingthetwobalancesheets,theBankingDepartment’sdepositfromtheIssueDepartment,a

liability,iscancelledoutbytheIssueDepartment’sdepositattheBankingDepartment,anasset.Theseitemsbecomezeroandareremovedfromthebalancesheet.Theequityof theIssueDepartment,at£54.9bnisaddedtothe£2.9bnpositiveequityoftheBankingDepartment,givingthemergedbalancesheetsnetworthof£57.9bn(shownopposite).

Next we convert the liabilities of the Bank of England that are effectively electronic money, andremovethemfromthebalancesheet,ontoarecordofFundsHeldinCustody,asfollows(showninfigure8.5).Deposits frombanks,which represent thepresent-daycentralbank reserveaccounts, are convertedintostate-issuedelectroniccurrencyandbecomethenewOperationalAccounts.Theoriginalliabilitybecomeszeroandcanberemovedfromthebalancesheet.Publicdeposits,whichwouldincludetheConsolidatedFund(thegovernment’saccountattheBankofEngland)areconverted into thenewCentralGovernmentAccount (andagain is removed from theliabilitiessideoftheBankofEngland’sbalancesheet).Depositsfromothercentralbankswouldbeconvertedintoaccountsforthosecentralbanks.We can also add the InvestmentPools of the commercial banks.These accountswill initially havezerobalances.Wewilllookathowtheseaccountsare‘funded’insection8.2.Withthereserveaccountsandotherdepositsnowconvertedintoelectronicstate-issuedmoneyratherthanbeing liabilities of theBankofEngland, theBankofEnglandwill havepositivenetworthof£312.9billion.This networthhas come from thepurchases of government bonds through issuingbank notes, and the purchase of government bonds through the creation of central bank reservesthrough theQuantitative Easing scheme. In effect, this £313 billion is seignioragewhich has beenearnedfromthecreationofmoney,butwhichhasonlybeenrecognisedasaresultofthefactthatthisreformdoesnotrequirebackingassets tobeheldagainst thestate-issuedcurrency(for thereasonsdiscussedinAppendixIII).WenowneedtocompleteourchangestothebalancesheetoftheBankofEnglandbyconverting thedemanddepositsofbanks intostate-issuedcurrencyheldat theBankofEngland.

Box8.A-DealingwiththebondspurchasedthroughQuantitativeEasing

QuantitativeEasingwasaschemesetupinresponsetothefinancialcrisis.OneeffectofQEwastoboostthebroadmoneysupply,oratleastnegatethecontractioninthemoneysupplywhicharosewhenbanksstoppedlendingbutpeoplecontinuedpayingdowntheirdebts.Theschemewasundertakenbybuyinggovernmentbondsfrompensionfundsandothernon-bankinvestors.Pensionfundsreceivedbankdepositsinexchangeforthebonds,andthepensionfunds’banksreceivednewcentralbankreservesintheiraccountsattheBankofEngland.Aswellascreatingnewbankdeposits,thisboostedthelevelofcentralbankreservesfromapre-crisislevelofaround£20bntoover£217bn,meaningthattherewaslessneedforbankstolendtoeachotherinordertoacquirethereservesneededtosettlepayments.

Intheory,theBankofEnglandwillreversethisprocessoncetheeconomyhasrecovered,bysellingthebondsbackintothemarket,soreducingthestockofcentralbankreservesbacktotheirpre-QElevel.However,thelikelihoodofthereversaloccurringisquestionable.Oneofthemostobviousobstaclesisthat,bysellingthegovernmentbondsthatitboughtbackintothemarket,itwillactuallybecompetingwiththegovernment’sownissuanceofbonds.Therefore,itwouldneedtowaituntilatimewhenthegovernmentisborrowingverylittleandconsequentlyissuingaverylowlevelofbonds.

Withthatinmind,therearetwowaysthattheBankofEnglandcouldhandlethegovernmentbondsthatitowns.First,itcouldcontinuetoholdthemtomaturity,withthegovernmentpayinginteresttotheBankofEnglandandtheBankofEnglandrecordingthisinterestasprofitandreturningitstraightbacktothegovernment.Thiswould,ineffect,makethisportionofthenationaldebtinterestfreeforthegovernment(becausealltheinterestisreturned).Astheindividualbondsmature,thegovernmentcouldpaytheBankofEnglandthefacevalueofthebonds,andthiswouldalsobereturnedtotheTreasuryasprofit.

Thesecondoptionistosimplyaccepttherealitythatthesebondswerepurchasedthroughthecreationofmoney,bytheQEschemeornoteissuance,andforthebondstobecancelled.Thiswilllowerthenationaldebtsignificantly.Itdoesconstitutemonetisingthedebt(printingmoneytopaythegovernment’sdebts),whichisgenerallyconsideredtobepooreconomicpolicy,butinrealitythishasalreadyhappenedasaresultoftheactionsoftheBankofEnglandandgovernmentinresponsetothefinancialcrisis.

Step2:Convertingtheliabilitiesofbanksintoelectronicstate-issuedmoneyWiththeBankofEngland’sbalancesheetsconsolidatedandexistingcentralbankreservesconvertedintonewelectronicmoneyheldofftheBankofEngland’sbalancesheet,wearenowreadytoconvertthedemanddepositsofcommercialbanksintoelectronicstate-issuedmoney.The first step is to calculate each bank’s total amount of pound sterling demand liabilities toindividuals,businessesandpublicsectororganisations.Eachbankhasthisdatareadilyavailable.Asaworkedexample,let’sassumethatMegaBankhasdemandliabilitiesof£300bn.

Secondly,thetotalaggregatedemandliabilityofeachbankisremovedfromitsbalancesheet,andanequalamountofnewstate-issuedcurrencyiscreatedandplacedintotheCustomerFundsAccountthat

bankadministers.TheCustomerFundsAccountadministeredbyMegaBank(heldoffbalancesheet)wouldnowbe£300bnwhereasitsdemandliabilitywouldnowbezero.

This is state-issued currency, held at the Bank of England, which belongs to the customers ofMegaBank.ForactualUKfigures,thetotalstockofdemandliabilitiesisapproximatelyhalfofM4,ataround£1,041bn(asofSeptember2012,accordingtoTableB1.4oftheBankofEngland’sBankStatspublication),sothetotalquantityofmoneyinalltheCustomerFundsAccountscombinedwouldbe£1,041bnonthedayoftheswitchover(showninfigure8.8).Ineffect,theBankofEnglandhas‘extinguished’thebanks’demandliabilitiestotheircustomersbycreating new state-issued electronic currency and transferring ownership of that currency to thecustomersinquestion.Customersofbanksnowhaveeithera)electronicmoneyintheirTransactionAccount, with the actual money being held at the central bank, and which can be used to makepaymentsondemand,orb)aclaimonabank,viatheirInvestmentAccount,whichhasamaturitydateornoticeperiodandwhichisstillaliabilityofthebank,tobepaidinthefuture.Eachbankwouldnolonger have any demand deposits at all, and the only accounts held on its balance sheetwould beInvestmentAccounts,withfixednoticeperiods.Wouldthecreationof£1,041billionofelectroniccurrencybeinflationary?No,forthesimplereasonthatthis‘creation’issimplyconvertingbank-issuedmoneyintostate-issuedmoney,andtheprocessneither increases nor reduces the existingmoney supply.However, thismoney has already had aninflationaryeffect,butatthepointwhenitwasinitiallycreatedbythebankingsector ’sloanmakingactivity.

Step3:Thecreationofthe‘ConversionLiability’frombankstotheBankofEnglandIfremovingthedemandliabilitiesfrombankbalancesheetsweretheendoftheprocess,thentheUKbanking sector in aggregate would have lost around £1,041bn of liabilities. With their assetsunchanged,thiswouldhaveincreasedtheircollectivenetworthandshareholderequityby£1,041bn.Thiswouldrepresentahugepaperprofitforbanksandtheirshareholders.Tonegatethiseffect,wereplacetheolddemandliabilitytothecustomerswithanewliability,whichwe’llcalltheConversionLiability,which is to theBank ofEngland.Thismeans that the networth and balance sheet of thebanksiscompletelyunchanged,astheaggregatebalancesheetfor thebankingsectorshowsbelow.Theassetssideisalsounchanged,asreserveaccounts–depositsofbanksattheBankofEngland–havesimplybeenconvertedintothenewOperationalAccounts,whicharestillheldasanassetofthecommercialbank.

ThisliabilitytotheBankofEnglandwouldineffectbeacharge,atfacevalue,forthemoneythattheBankofEnglandcreatedtoextinguishthebank’sdemandliabilitiestocustomers.Theliabilitywouldbeinterest-free,andrepayabletotheBankofEnglandataschedulethatmatchesthematurityprofileofthebank’sassets(i.e.asthebank’sloanstobusinessesandthepublicaregraduallyrepaid,thebankwillrepaytheBankofEngland).UndernormalcircumstancestheBankofEnglandwillberequiredtoautomaticallygrantthemoneypaidtoitasaresultoftheConversionLiabilitytotheTreasurytobespentbackintotheeconomy.OtherchangesSimultaneously with the changes above, each bank will convert its fixed-term and fixed-noticesavingsaccounts intoInvestmentAccounts.TheseInvestmentAccountswillstillberecordedonthebalance sheet as liabilities of the bank to the customer. Current accounts will be converted intoTransactionAccounts,andthenewlegalcustodialrelationshipwillstarttoapplytotheseaccounts.At this point the balance sheets of the economy will appear as they do in figure 8.12. The largeincreaseinequityattheBankofEnglandisadirectresultofremovingmoneyfrombothbanksandthecentralbank’sbalancesheet.This increase inequity is ineffectareclaimingof theseigniorage

revenue from the banking sector to be repaid to the government as the commercial banks’ assetsmature,fromwhereitwillbespentbackintotheeconomy.

8.2ENSURINGBANKSWILLBEABLETOPROVIDEADEQUATECREDITIMMEDIATELYAFTERTHESWITCHOVERFrom the changes made in the previous section, we can see that on the morning immediatelyfollowing the switchover, the Investment Pools of bankswill have balances of zero, implying thatbankswouldbeunabletolenduntiltheyhadfirstacquiredfundsfromelsewhere.Thissectionlooksatwherethisfundingforlendingcouldcomefrom.FundsfromcustomersTherearetwosourcesofmoneythatthebankswillbeabletolendfromasamatterofroutine:

1. FromnewInvestmentAccountsopenedbycustomers.Onanyparticularday,therewillbeanumber of customerswhowish to putmoney aside to earn some interest.UponopeningInvestmentAccountstheywillprovidefundsforlending.

2. Fromloanrepaymentsfromexistingborrowers.Themoneyfromtheseborrowers,ifitisnot needed to repay InvestmentAccount holders (many ofwhomwill typically roll overtheirinvestments)canbere-lent.Onanyparticularday,significantsumsofmoneywillbecollectedfromborrowersinloanrepayments,muchofwhichcouldbere-lent.

Thesetwoalonesuggestthatbanksshouldhavelittleshortageoffundstolendimmediatelyafterthereformisimplemented.However,therearetwoadditionalsourcesoffundstoensurethatbanksareable to lend sufficient amounts to support the economy immediately after the switchover.Wewillconsiderthesetwosourcesbelow.LendingthemoneycreatedthroughquantitativeeasingInmuchofthepress,QuantitativeEasingwasdescribedas‘printingmoneyandlendingittobankssothattheycanlendittobusinessesandthepublic’.Thisdescriptionishighlyinaccurate;bankscouldnotlendthereservesthatwerecreatedthroughQEtothepublic,ascentralbankreservescanonlybeheld by organisations that can hold accounts at the Bank of England (i.e. banks and centralgovernment).However, as discussed above, during theovernight switchover the reserve accounts at theBankofEngland (which hold liabilities of theBank of England) are converted intoOperationalAccounts,whichwill hold state-issued electronic currency.Crucially, unlike central bank reserves, this state-issuedcurrencycanbelenttomembersofthepublic.Thismeansthatonthemorningaftertheswitchover,therewillbe£217.6bnofstate-issuedcurrencyin the bank’sOperationalAccounts. This sum is far beyondwhat the bankswould need for actualoperating funds (i.e. to cover staff, salaries, rent and other operating costs) and so they wouldprobablywish to use a significant proportion of these funds for lending. For that reason, there isunlikelytobeanyshortageoffundsavailableforlendingbybanksonthedayaftertheswitchover.Infact,thedangerimmediatelyafterthereformmaynotbethatthereisashortageoflendablefunds,butthatthereisaglutoffundsduetothelargebalancesintheseOperationalAccounts,andasaresultanincentiveforbankstolendtoomuchtooquickly.Forthatreason,theBankofEnglandmaywanttorestrict bank lending (through a temporary regulation) for a brief period immediately after the

overnightswitchover,ortakestepstoactuallyreducetheamountofcentralbankreservesbeforetheswitchover,toavoidtheriskofapotentiallendingboom.ProvidingfundstothebanksviaauctionsBox8.Aexplained that it ishighlyunlikely that theQEschemewillbe reversed in thenear future.However, in theunlikelyscenario that it is reversedand thebanksonlyhaveenoughfunds in theircentralbankOperationalAccountstocovertheirownoperations,butnottofundlending,whatwillbetheresult?In this case, theBank ofEngland could an the auctionmechanismdiscussed in section 7.6 to lendfundstobanks,whichthebankscouldthenlendontobusinessesandmembersofthepublic.Therewouldneedtobesomestringsattachedtothesefunds(forexample,thefundsshouldnotbeusedforspeculativepurposes).Thebankswouldentertheauctionforfundsthedaybeforetheswitchover,biddingfortheamountoffunds theywish to borrow (theBank of England already runs auctions in thisway as amatter ofroutine).BankswouldthenfindthatthesefundshavebeenplacedintotheirInvestmentPoolsonthemorningaftertheswitchover.The four sources of funds described above show that there is no real risk of a credit crunchimmediatelyaftertheswitchover.

8.3THELONGER-TERMTRANSITIONRepaymentoftheConversionLiabilityFigure8.13details thebalancesheetsof theeconomyafter the transition iscomplete.Asdiscussedearlier,whenthedemandliabilitiesofbanksareconvertedintostate-issuedelectroniccurrency, thebankslosethosedemandliabilitiesbutacquireanew,equal-valueConversionLiabilitytotheBankofEngland. This Conversion Liability is interest-free and will be repaid as the bank’s loans aregradually repaid.Theexact rateof repaymentwill be agreedbetween thebank inquestionand theBankofEngland,toensurethattherepaymentsarespreadfairlyevenlyoveranumberofyearsandthat the rate of repayment does not reduce the bank’s ability to provide a useful level of lendingthroughoutthetransition.The repayment of the Conversion Liability converts one asset held by the Bank of England (theConversionLiability) to another, electronicmoneyheld in theBankofEngland’s own account, asfundsaretransferredfromthecommercialbankstothecentralbank.ThetransferofthismoneytotheTreasuryreducestheequityoftheBankofEnglandwhileatthesametimereducingitsassets.TheTreasury then spends the money back into the economy via any of the mechanisms outlined inChapter 7, giving the government an additional £1,041 billion in what is essentially seignioragerevenueoveraperiodofaround20years.Thisseignioragerevenueisnon-inflationary,as itdoesnot increasethemoneysupply; it issimplytherecyclingofloanrepayments(bybusinessesandhouseholds)backintotheeconomyviaspendingratherthannewlending.AllowingdeleveragingbyreducinghouseholddebtThere is a crucial difference between loan repayments made by borrowers in the reformed andcurrentmonetarysystems.Withinthecurrentsystem,whenloansarerepaid,thebankreducesbothitsassets(theloan)anditsliabilities(theborrower ’sbankaccountbalance)intandem(Seesection2.5).

Afterthereform,loanrepaymentsdonotreducethemoneysupply,becausetheactofrepayingaloansimply involves transferring state-owned electronic currency from the borrower ’s TransactionAccounttothebank’sInvestmentPool.fig.8.10-Flowofloanrepaymentprofitspostreform

Thereformsthereforeintroduceafundamentalandprofoundchangeinthemonetarysystem.Inthecurrentsystem,debtrepaymentsreducethequantityofbankdepositsandthusthemoneysupply.Forthemoneysupplytoberestoredtoitspreviouslevelrequiresthatsomeoneelseborrows,increasingtheoveralllevelofdebt.Thisprecludesanysignificantreductionsofthelevelofhouseholddebt,asasmallerbroadmoneysupply tends tobeassociatedwitha lower levelofeconomicactivityandanincreasedlikelihoodofrecession.Incontrast,inthereformedsystemdebtrepaymentsdonotaffectthe money supply, as debt repayment involves the transfer of an asset (state-issued electroniccurrency)fromtheborrower ’sTransactionAccounttothebank’sInvestmentPool.Fromthebank’sInvestment Pool the money will either be used to make further loans, repay Investment Accountholders,ortransferredtotheOperationalAccountandusedtopaystaffordividends,or,duringthetransitionalperiod,repaythebank’sConversionLiabilitytotheTreasury.Thustherepaymentoftheconversion liability will transfermoney to the government’s bank account, fromwhere it will bespentbackintotheeconomy.Asaresult,themoneysupplywillbemaintained,althoughbecausethemoneyisspentandnotlentintocirculation,itispossiblefordebttobelowerthanitotherwisewouldbe.ItisimportanttorememberthatwhiletheConversionLiabilityrequiresbankstopay£1,041bntotheBankofEngland,itdoesnotrequiretheretobe£1,041bnincirculation;thesameunitsofstate-issuedcurrency, when recycled through the system, can be used to repay debts numerous times.Consequently,just£50bnofcurrency,transferredthroughtheConversionLiabilityeachyear,couldclear the entire Conversion Liability in around 20 years. Each time that it is spent back into theeconomy, itwillprovidedebt-freemoney to theeconomyandallow individualsandhouseholds to

furtherreducetheirdebts.ItisalsocruciallyimportanttorecognisethatrepaymentoftheConversionLiabilitydoesnotdrain£1,041bn from the banking system.When the money received by Treasury is spent back into theeconomy(ordistributedbacktocitizens)itwillbetransferredbacktotheCustomerFundsAccountsadministeredbythebanks.Bankswill thenbeabletoencouragecustomersto transfersomeof thismoneyintoInvestmentAccountstofundtheirownlending.ForcingadeleveragingofthehouseholdsectorTheextenttowhichtheConversionLiabilityleadstoareductioninhouseholddebtdependsentirelyonwhatthepeoplewhoreceivethismoneydowithit(afterithasbeenspentbytheTreasury).Ifthosewhoreceivethemoneydecidetospenditratherthanpaydowndebts,thentherewillbenosignificantdeleveragingimmediately.However,overtimeitislikelythattherepaymentoftheConversionLiabilitywillleadtoasignificantdeleveraging, especially given the indebtedness of the household sector and the desire of manypeopletoreducetheircurrentlevelsofdebt.Itisalsopossibletoforceadeleveragingofhouseholdsand a reduction in the size of the aggregate banking sector ’s balance sheet. This can be done asfollows:

1. As repayments are made on the Conversion Liability, the Treasury must distribute thismoneydirectlytocitizensinequalproportions(i.e.dividedequallybyeveryeligibleadult).

2. If ancitizen receiving themoneyhasdebts, thepaymentmustbeused topaydown thosedebts.

3. Citizenswhohavenodebtscanuse the fundsas theywish (eg. to spend, toplace intoanInvestmentAccountortoinvestinotherassets).

As most individuals and households have at least some debt, this will ensure that most of therepayments on theConversionLiability are recycled into paying down the debts of the householdsector.Therearesignificantbenefitstothisapproach:

1. Thedeleveragingwould reduce thesizeof thebankingsector ’sbalancesheet inabsoluteterms and relative to GDP. This would reduce the risk that banks pose to the economythroughtheirfailure.Whilstafterthereformbankfailureswouldnotcauseacontractioninthemoneysupply, therearestillsignificant implicationsifabankthathadalargemarketshareofsay,businesslending,weretofail.

2. Theresultingreductioninhouseholddebtwouldleavehouseholdswithhigherdisposableincome(because lesshas tobespentondebtservicing),whichshould increaseeconomicgrowthoverall.

3. Areductioninthedebtofthehouseholdsectorisbydefinitionanincreaseinthenetwealthof households. Higher net wealth of households should reduce dependency on the state(reducing the demands placed on government expenditure), and allow households to putmoreincomeintopreparationsforretirement.

DeleveragingispossibleeveniftheMCCnevercreatesmoney

TherecyclingeffectofrepaymentsontheConversionLiabilitymeansthatdeleveraging(areductioninhouseholddebt)ofupto£1,041billionispossibleevenif theMoneyCreationCommitteechosenever to increase the money supply (and therefore does not create any additional new debt-freemoney).ThisensuresthatregardlessofthedecisionsoftheMCC,theeconomywillbetransformedfromonethatisdependentonbank-issued,debt-basedmoney,toonethathasamoneysupplythatisindependentoftheamountofdebtandthelendingdecisionsofbanks.

CHAPTER9UNDERSTANDINGTHEIMPACTSOFTHEREFORMS

ThischapterlooksattheeconomicimpactsofamonetarysystemwheremoneyisissuedsolelybythestateandinjectedintotheeconomythroughthevariousmechanismsoutlinedinChapter7.Webeginbybrieflysummarisingafewkeydifferencesbetweenthecurrentmonetarysystemandthereformedsystem.Wethenlookatthelikelyimpactofbanks’lendingandcentralbankmoneycreationin a reformed system, before addressing the reform's impact on financial stability and asset pricebubbles.Finally,weaddresstheenvironmentalandsocialimpactsofareformedmonetarysystem.

9.1DIFFERENCESBETWEENTHECURRENT&REFORMEDMONETARYSYSTEMSThere are a few key differences between the current monetary system and the reformed systemoutlinedinChapters7and8.Inessencetherulesofthemonetarysystemhavechangedandthiswillchangethedynamicsoftheeconomicsystem.Thekeydifferencesareshowninthetableoverleaf.CurrentSystem ReformedSystem

Moneyandpurchasingpoweriscreatedbybankswhentheymakeloans

MoneyandpurchasingpoweriscreatedbythestateinresponsetodecisionsmadebytheMoneyCreationCommittee

Loanscreatenewpurchasingpower Loanssimplytransferpurchasingpowerbetweensaversandborrowers

Loansincreasethemoneysupply Loanshavenoimpactonthemoneysupply

Loanrepaymentsdecreasethemoneysupply Loanrepaymentshavenoimpactonthemoneysupply

Newmoneyiscreatedintandemwithanequalamountofdebt

Newmoneyiscreatedfreeofanycorrespondingdebt

Anincreaseinbankinvestmentinonepartoftheeconomydoesnotrequireareductioninspendingelsewhere

Anincreaseinbankinvestmentinonepartoftheeconomyrequiresareductionin(or‘deferment’of)spendingelsewhereintheeconomy,sothatthepurchasingpowercanbetransferredfromasavertoaborrower

Bankscanlendasandwhentheyfindacredit-worthyborrower,andcanfindanynecessarycentralbankreservesaftertheloanhasbeenmade

BanksmustfirstraisefundsfromInvestmentAccountholdersandotherinvestorsbeforetheycanmakealoan1

9.2EFFECTSOFNEWLYCREATEDMONEYONINFLATIONANDOUTPUTWhatwillbetheeconomiceffects(intheshortrun)ofbanklendinginareformedmonetarysystem?Inthefollowingsectionwelookattheeffectofmoneycreationunderfourdifferentscenarios:

1. Distributingnewlycreatedmoneytocitizensviaa‘citizen’sdividend’2. Usingnewlycreatedmoneytoincreasegovernmentspending3. Usingnewlycreatedmoneytocuttaxes4. Lendingnewlycreatedmoneytobankstoon-lendtoproductivebusinesses

Distributingnewlycreatedmoneytocitizensviaa‘citizen’sdividend’

Forconsistencywithchapter4,wereapplythequantityequationtoshowtheeffectofmoneycreationandbanklendingonoutputandprices.Torecap,Mstandsforthequantityofmoneyincirculation,Vfor the velocity of money (the number of times money is used for a transaction in a given timeperiod), T for the number of transactions in a period, and P for the average price level of thetransactions.Thelefthandside(MV)ofthisequationrepresentsthetotaleffectivemoneysupplyforagiventimeperiod,whereas therighthandside(PT)showsthe totalvalue inmonetary termsof thenumberoftransactionsforthesametimeperiod.Inalloftheexamplesthatfollowforpurposesofintuitionitwillhelptoimaginethattheeconomyinquestion is initially in a steady state.1 Let us first take the simplest case where the newly createdmoney is granted directly to citizens, via a formof citizen's dividend. In this case the newmoneyincreases the purchasing power of the citizens that receive the dividend, and thereby the level ofpurchasingpowerintheeconomy.Ifallthismoneyisspentspecificallyonconsumerspendingandtheeconomyisnearfullcapacity,thenwithnocorrespondingincreaseinthelevelofoutput(Y),wewouldexpecttoseeinflation:eq.9.1

Alternatively,iftheeconomyissignificantlybelowfullcapacity(asinarecession)thentheincreaseinspendingwould likely lead toa rise inoutputofgoodsandservices,as firmsusemachines thatwerelayingidleandhiretheunemployed:eq.9.2

However, it ishighlyunlikely that all citizenswho receive thedividendwould spend it entirelyonconsumergoodsandservices.SomeofthismoneywouldbeusedtopaydowndebtandsomewouldbeinvestedviaInvestmentAccounts.Inthesecasestheeffectoftheincreaseinthemoneysupplywilldependonhowthemoneythatisinvestedisused,anissuewewilllookatshortly.UsingnewlycreatedmoneytoincreasegovernmentspendingAlternatively,thegovernmentmaydecidetousethenewlycreatedmoneyitreceivesfromtheMoneyCreationCommitteetoincreasegovernmentspending.Aswithacitizen’sdividend,whatthemoneyisspentonwilldeterminetheeffects.Ifthemoneyisdistributedviatransferpaymentssuchasthestate

pension,taxcreditsandbenefits,thentheeffectwillbethesameaswithacitizen’sdividend,withthedifferencethat itwill initiallybeanarrowergroupofpeoplespendingthenewlycreatedmoney.Iftheyspendthismoneypurelyonconsumergoodsandservicesandtheeconomyisnearfullcapacitythen this may lead to consumer price inflation. If the economywere below full capacity then theadditionalspendingwouldbeexpectedtoleadtoadditionaloutput(i.e.growthinGDP)butwithoutinflation.However,asbefore,ifthosewhoreceivethemoneytheninvestitviaInvestmentAccounts,theeffectwilldependonhowthatmoneyisinvested.Alternatively, the government may decide to spend the newly created money on something thatincreases theproductivecapacityof theeconomy(forexample, transport infrastructure, improvingthe quality of the broadband network, etc.). In this case both themoney supply and the productivecapacityof theeconomywill increase,as inequation2.For thatreason,wewouldexpectoutput toincrease,butwithnosignificantchanges inprices.That said, if the improvements in infrastructurewere significant, it could actually lower costs to businesses and so be deflationary (pushing downprices).However,newlycreatedmoneywillbespentmorethanonce;whenitisspentbythegovernmentitwillbetransferredtotheaccountsofgovernmentemployeesandemployeesofcompaniesworkingongovernmentcontracts.Whatthesepeopledowiththemoneytheyreceivewillalsohaveaneffectoninflationandoutput,justaswithacitizen’sdividend.Thiswillbeaddressedinsection9.4.UsingnewlycreatedmoneytocuttaxesAlternatively,thegovernmentmaydecidethatitwillusethenewlycreatedmoneytodecreasetaxes.Ifitdecidestodecreasetaxesonindividuals(usingnewly-createdmoneytocovertheresultingshortfallin tax revenue), the effectwill be exactly the same aswith the citizen's dividend– the citizens thatreceivedthetaxcutwillhavemoredisposableincome,increasingpurchasingpowerintheeconomywhile not changing the productive capacity. If all of this extra disposable income is spent onconsumergoodsandservicesandtheeconomyisnearfullcapacity,thenwemightexpectinflation.Iftheeconomyisbelowfullcapacitywecouldexpectoutput(i.e.GDP)toincreasewithnochangeinprices. However, if some of this extra income is invested, then the effect may be inflationary ordisinflationary(aslowingrateofpositiveinflation),dependingonhowthatmoneyisused.If the government decreases taxes on business instead, then this may also lead to inflation if thebusinessesthatreceivedthetaxcutsusetheadditionalmoneytoraisewagesordistributeprofitsandthe recipients of this money (staff and shareholders) use this money for further spending onconsumergoodsandservices).However,ifbusinessesusedtheproceedstoinvestinincreasingtheirproductivecapacity,thentheincreaseinthemoneysupplywillhaveexactlythesameeffectaswhenthecentralbanklendstobankstoon-lendtoproductivebusinesses(discussedinthenextsection);themoneysupply,M,willincrease,leadingtoanincreaseinproductivecapacity,andsoanincreaseinoutput,Y,withoutasignificantchangeinprices:eq.9.3

Lendingnewlycreatedmoneytobankstoon-lendtoproductivebusinessesAsdescribedinsection7.6,theMoneyCreationCommitteemaychoosetolendapartofthemoneythat itcreates tobanks,on thecondition that thebanks thenon-lendthismoneytobusinesses in thereal,non-financialeconomy.

Theeconomiceffectsofthistypeofmoneycreationareidenticaltotheeffectsofcreditcreationbybanks for investmentpurposes in thecurrent system.As the loansaremade themoney supply (M)increases. Because the loans are made for investment in the productive sector of the economy,althoughthemoneysupplyincreasessotoodoesinvestment,andhencetheproductivecapacityoftheeconomy.Consequentlywewouldnotexpect toseeany inflation in this scenario.Theeffectof theincreaseinMwillbetoincreaseGDP,asbelow.eq.9.4

9.3EFFECTSOFLENDINGPRE-EXISTINGMONEYVIAINVESTMENTACCOUNTSWewillnowlookattheeffectsofdifferenttypesofbanklendingafterthereform.Underareformedbankingsystem,banklendingwillsimplytransferexistingmoney(andthereforepurchasingpower)from lender to borrower, without increasing the money supply. For example, after the reforms apersonplacing theirmoney in an InvestmentAccountwill see their purchasingpower fall, as theywill not be able to access the money for a period of time (although they will gain an asset, theInvestmentAccount, inexchange).Themoneytheyplacedintheaccountwill thenbetransferredtotheTransactionAccountoftheborrower(viathebank’sInvestmentPool).Thisisunlikethecurrentsystem,wherebankloansdonotrequireanyone'saccounttofallinvalue.Lendingpre-existingmoneyforproductivepurposesTakethecaseofabusinessborrowingtoinvest.Bydoingsoitincreasestheproductivecapacityofthe economy. However, inmaking the loan the bank does not increase themoney supply; insteadmoney is simply transferredaround thesystem.Lookingatequation5,moneyspenton investmentincreases(MIR),andthishastheeffectofincreasingoutput(Y).eq.9.5

However,thisisnottheendofthestory.Themoneyfortheloaninitiallycamefromsomeoneelse’sTransaction Account, i.e. the initial investor has deferred consumption (in order to invest in theaccount) and this should decrease the upward pressure on prices. In addition, the increase inproduction arising from the investment will lead to there being more goods and services in theeconomy. The deferment of spending and increase in productive capacity should have a counter-inflationaryeffect.Asaresultpricesarelikelytoriselessquicklythantheywouldotherwise.eq.9.6

Itisimportanttonotethatinasystemwheremoneyiscreateddebt-free,fallingprices(deflation)isnotasproblematicasitcanbeinthecurrentsystem(seesection9.5).However,alowandstablerateofinflationmaystillbemoredesirablethanoutrightdeflation,andsoanydeflationarypressurewilllead to an injection ofmoney by theMCC in order to hit its 2% inflation target. Thus increasedinvestmentbybusinessesasaresultofbanklendingmayneedtobeoffsetbytheMCCgrantingnewlycreatedmoneytogovernmenttobespentintocirculation.2

However,intherealworldtheeffectonpricesandoutputislikelytotaketime.Investmentdoesnottakeplaceinstantaneouslyandthereforethedeflationaryimpactsoftheadditionalproductionwillnotbe felt until later. Also,moneywill circulate several times each period. Thus anymoney lent forproductiveinvestmentwillbeusedtopaystaff(eitheroftheinvestingfirm,orofthefirmthatsellstheequipmentetc.totheinvestingfirm).Anyconsumptionspendingbythesestaffislikelytohaveaninflationaryeffect,counteringthedeflationaryeffectoftheinvestment.Lendingpre-existingmoneyforhousepurchasesandunproductivepurposesWhataboutanincreaseinnon-productivelending,suchasloansmadetopurchaseexistingproperty?Inthissituationthequantityofmoneyincirculationdoesnotchange,butpropertypurchasesincrease.Thisincreasesthedemandforproperty,withoutincreasingitssupply.Asaresult,propertypriceswillincrease:eq.9.7

Howeverthisincreaseinlendingforpropertymustbefundedbysomeonechoosingtoinvest,ratherthan spend, some of their income. This reduction in potential consumer spendingmay have somedeflationaryeffectonconsumerprices(assumingaconstantvelocity).eq.9.8

Alternatively,ifthemoneyisdivertedfrominvestmentaccountsthatwerefundinginvestmentinthe

real, non-financial economy, theproductive capacity of the economywill grow less slowly than itotherwisecould,leadingto(future)inflationintheconsumergoodsmarkets,asinvestmentswillnotbemadeand(future)productionwillthereforenotincreasebyasmuchasitwouldotherwise.eq.9.9

Regardlessofwherethemoneyisdivertedfrom,housepriceinflationisnotsustainableinthelong-termasitrequiresmoneytobetransferredawayfromthepurchaseortheproductionofconsumergoods,whichwillleadtoadecreaseindemandandoutput.3Thisisincontrasttothecurrentsystemwhere the rest of the economy is not impairedby asset pricesbubblesuntil after theyburst.4 Thiscould mean that house price bubbles would naturally correct themselves in the reformed system:increased investment in housing would imply less investment in the productive economy, lessspendingonconsumergoods,lesseconomicactivityandlessabilitytoservicehigherhouseprices,meaningthatthepriceswouldthenfall(oratleaststopincreasing).Lendingpre-existingmoneyforconsumerspendingInaddition to lendingforassetpurchases,unproductive lendingbybanksalso includes loansmadeforthepurchaseofconsumergoods.IfthemoneyforthislendingcomesfromatransferofmoneyfromTransactionAccountstoInvestmentAccountsthennothingchanges:thequantityofmoneyspentonconsumergoodsandservicesremainsthesame,asmoneyhasbeentransferredfromanindividualororganisationthatwishestodelaytheirconsumptiontoanindividualororganisationthatwishestoconsumenow.Bothoutputandpricesareunaffected.

Box9.A-Malinvestment

AsChapter3showed,under thecurrentmonetarysystemtheeconomyperiodicallysuffers fromboomsfollowedbybusts,asaresultofbanks’ credit creation activities. Entrepreneurs and businesses are harmed by both the boomand the bust in the current system. In theboom,easyaccesstocreditand inflatedfeelingsofwealthpushesmany intoentrepreneurialactivities thatareunsustainable in thebust,leaving them with debts that cannot be repaid (damaging their ability to be entrepreneurial in the future). Meanwhile, in the bustentrepreneurscannotsecurecreditevenforgoodideas,asbanksnowhaveanegativeviewofthefutureandarealsoattemptingtorebuildtheirbalancesheets.

Inareformedmonetarysystemthesituationwillberatherdifferent,asbanklendingwillnolongerexpandthemoneysupply.Accordingly,the propensity for the economy to experience asset price bubbles, recessions and depressions should be greatly reduced. Instead ofbanks’lendingpro-cyclically,theirlendingdecisionswill insteadreflectthelongtermsavingspreferencesofthepublic.Entrepreneursandbusinessesshouldbe incentivised to invest, safe in the knowledge that there isamuch lower likelihoodof eventsoutside their control -suchasfinancialcrisesandrecessionswhichleadtoafallindemandfortheirproductsandthereforebankruptcy.

Thereisalsoalowerchanceofmal-investmentinareformedmonetarysystem.Inthecurrentsystem,mal-investmentiscreatedasaresultofbanks’lending(andincreasingpurchasingpower)againstassetswithaninelasticorwhollyfixedsupply.Thisaffectspricesandinsodoingalters the relative returnsondifferent investments,draggingpeople intootherwiseunprofitableorsociallyuselessactivities (see forexamplebox4.F).As theprevioussectionmadeclear, the likelihoodofsuchassetbubblesand themal investment thatgoeswith themoccurringinareformedsystemismuchlowerthanisthecasetoday.

9.4LIMITATIONSINPREDICTINGTHEEFFECTSONINFLATIONANDOUTPUTItshouldbeclearfromthescenariosintheprecedingtwosectionsthattheeffectofmoneycreation

ontheeconomydependsonawiderangeofdifferentfactorsandthe individualchoices takenbyalargenumberofpeople.Thismakespredictionsabout theexacteffecton inflationandoutputverydifficult.Somebroadprincipleswillhelpalthougheventhesearenothardandfastrules:

1. If the money is allocated towards increasing productive capacity (such as loans tobusinesses in the real, non-financial economy or investment in boosting nationalinfrastructure),thenthisislikelytohaveadeflationaryordisinflationaryeffect.

2. If themoney is allocated towards spending on goods and serviceswhile the economy issignificantlybelow‘fullcapacity’,thenwewouldexpecttoseeoutput(i.e.GDP)increasingwithoutacorrespondingriseininflation.

3. Iftheeconomyisclosetofullcapacity,thenadditionallendingormoneycreationthatfeedsthroughintoconsumerspendingcouldbeinflationary.

Itshouldbenotedthatratherthanthesimplistic‘allmoneycreationcreatesinflation’argumentthatisoften heard, the reality ismuchmore complicated, and the deflationary impacts of certain uses ofnewlycreatedmoneycouldcancelouttheinflationaryimpactsofincreasingthemoneysupply.It should also be remembered that the models presented here are simply devices for aiding ourintuition.Inrealitytheeffectsofanyactionsbycentralorcommercialbanksarefarmorecomplexthan the simple mechanical process displayed here. Individuals and organisations will alter theirbehaviourandadapttothenewcircumstancesbroughtaboutbytheinitialaction,settingofffurtherseriesofeventsintothefuture.

Box9.B-Interestrates

Inthereformedsystemtheinterestratewillbedeterminedbythemarket,ratherthanbeingmanipulatedbythecentralbankinanattempttocontrol the lendingdecisionsofbanksand therefore thebusinesscycle.Asa result the interestchargedon loanswill reflect thereal timepreferencesofsocietyasawhole:ifsocietywishesonaggregatetodeferconsumptiontoafutureperiod(i.e.save),therateofinterestwillbe low as individuals will placemore of theirmoney into Investment Accounts. Likewise production should increase asmore businessinvestment takes place, ensuring that the economy as awhole can satisfy the demand for increased future consumption.Conversely, ifindividualsprefertoconsumenow,therateof interestwillbehigh,andconsequently lessinvestmentwillbeundertaken.Insuchasystemthe rateof interestand thequantityof funds in InvestmentAccounts,which isdeterminedby individuals’preferences forpresentor futureconsumption (spending vs saving), determines the amount of investment, so matching future demand for goods to future levels ofproduction.

9.5POSSIBLEFINANCIALINSTABILITYINAREFORMEDSYSTEMChapter 4 outlined Hyman Minsky’s Financial Instability Hypothesis. To sum up, the essence ofMinsky's hypothesis is that boomsandbusts, asset pricebubbles, financial crises, depressions, andeven debt deflations all occur in the normal functioning of a capitalist economy. What is more,periodsofrelativestabilityincreasethelikelihoodofinstabilityandcrisesbyincreasingreturnsandthus thedesirabilityof leverage.Thebanking sector,with its ability to create credit, facilitates thisdesireforleverage,whichsetsintrainaseriesofeventsthatculminateinrecessionandinsomecasesa financial crisis anddepression. In short,Minskyconsidered the capitalist system tobe inherentlyunstable. In this section we discuss the likelihood of financial instability in a reformed bankingsystem.Inthecurrentmonetarysystem,whenabankmakesaloanthebroadmoneysupplyincreases.Whenthis new money is used to purchase an asset whose supply is inelastic (i.e. does not increase inresponsetoanincreaseindemand),itspriceincreases.Underareformedsystembanklendingwill

nolongerincreasethebroadmoneysupplyandsotheabilityofbankstoinflateassetbubbleswillbeseverely reduced.However,althoughbank lendingwillnot increase themoneysupply, itmayshiftmoneythatwouldhavebeenspentinonesectortoanothersector.Ifmoneyismovedtosectorswherethe supplyofgoods is inelastic, thepriceof thegoodswill rise.Thereforebank lendingmay stillhaveanabilitytofuelassetpricebubbles,althoughtoalesserextent.

Box9.C-Unemployment

The fact thatassetpricebubbleswillbe less likely tooccur (andsmallerwhen theydo)means that the riskof financialcriseswillbe farlower.Financialcrisestendtobeassociatedwithlargerecessionsandevendepressions,whichthemselvesareassociatedwithincreasedlevelsofunemployment.Financial crisesalso tend tonecessitate largegovernmentbailoutsof failingbanks,which lead to increases ingovernmentdebt.Whilstpotentiallyundesirableinthelongterm,highlevelsofgovernmentdebtcanalsobeusedintheshorttermtojustifytheremovalofspendingonsociallybeneficialschemes,suchashealth,education,lawandorderetc.thatarenotwellprovisionedforbytheprivatesector.Theremovalofassetpricebubbleswillthereforeseelessofapushtolowergovernmentspendingonsociallybeneficialschemes.Furthermoreunemployment thatarises fromeconomicdownturnscausedby thecredit cycleshouldbe reduced.Bothof thesefactorsshouldhavesociallybeneficialeffects.

AreducedpossibilityofassetpricebubblesInorderforbanklendingtoinflateanassetpricebubble(forexampleinproperty),underareformedsystem, banks would have to continually increase the flow of money from either TransactionAccountsorotherInvestmentAccountstoInvestmentAccountsthatfundmortgages.To seewhy this process is unsustainable in the long term, let us first examine the casewhere themoney to finance the increase inmortgage lending comes from people transferringmoney fromtheirTransactionAccounts to InvestmentAccounts.As individuals investmore of theirmoney viaInvestmentAccounts,purchasesofconsumergoodswillhavetodecrease(assumingthevelocityofcirculationdoesnotchange).Thiswilltemporarilylowerdemandforgoodsandservices,intheorylowering prices and leading to lower growth and output. The more money that is diverted fromimmediatespendingtofundmortgagelending,themoredemandwilldecrease.Iflowerpricesdonottemptpeopletospendmore,theneventuallythelowerdemandwillleadtoloweroutputandincreasedunemployment.Duetoalowerlevelofincomethosealreadywithahouse(andamortgage)willfindtheirabilitytorepayreduced.Facedwiththepossibilityofdefault,manywillbeforcedtobringtheirproperty to market in order to repay their outstanding debts. Likewise, in a weaker economyindividualswillbediscouragedbythehigherpropertypricesandweakereconomicconditions,andbankswillbelesswillingtolend.Allthiswillcauseanincreaseinthesupplyofhousesbroughttomarketand lower thedemandfor them.Inaddition, individualswhoarestruggling toservice theirmortgagesmay start to default. This in turn should lead to a reduction in house prices.Banks arelikely to reactby lowering the returnson InvestmentAccounts that fundmortgages, lowering theirattractivenesstoinvestorsandlimitingtheextentofthebubble.Alternatively,if themoneytofundthesemortgagesisdivertedfromInvestmentAccountsthatwerebeing used to fund productive investments then investment will fall. Output will fall accordingly,whichwillleadtoafallindemandandemployment.Themoremoneythatisdivertedintomortgagelendingandawayfromprofitable investment in thisway themore theeconomywill suffer.Again,lowergrowthandhigherunemploymentwillmakeitmoredifficultforthosewhohaveborrowedtorepaytheirmortgagesandthismayforcemanywhohaveunaffordablemortgagestotrytoselltheirhouses.Inaddition,inaweakereconomynewborrowerswillbediscouragedfromborrowing,andbankswill be lesswilling to lend.The supply of houses tomarketwill therefore increase and thedemandforthemwillfall,leadingtoareductionintheirprice.Again,banksarelikelytorespondby

loweringthereturnsonmortgageinvestmentaccounts,loweringtheirattractivenesstoinvestorsandlimitingtheextentofthebubble.We should compare these outcomes with those that occur in the current monetary system. In thecurrentsystem,whenabankmakesaloanitdoesnotrequireanyoneelsetogiveupaccesstotheirmoney–purchasingpowerisnotreducedwhenadditionalmoneyiscreated(bylending).Infacttheeconomymayappeartobenefitintheshortterm–peoplefeelricherandforthatreasonstarttospendmore.Speculativeboomscanthereforegoonmuchlongerunchecked.Thelongerthebubblelasts,thegreateristheproportionofbuyersthatwillhaveshiftedinto‘ponzi’and‘speculative’positions.Thuswhen problems domaterialise they aremuchmore intractable than if they had been spottedearlyon.Essentiallythecurrentmonetarysystemmakestheeconomyhighlypro-cyclical.Incontrast,undera reformedsystem it ismuchmoredifficult forhousepricebubbles tocontinueunchecked;insteadtheyarenaturallyself-limiting.OtherfactorslimitingbubblesInadditiontotheabove,thereareotherfactorsthatmaypreventabubblefromforminginthefirstplace.First,removingmoneyfromthoseInvestmentAccountsthatfundbusinesses,andputtingitintoInvestmentAccountsthatfundmortgageswillaltertheinterestratesofferedonthetwoaccounts.Withbusinessesstilllookingforfundstoborrow,interestratesofferedonInvestmentAccountsthatinvestinbusinessshouldincrease,whichshouldsloworreversetheoutflowofmoneyfromthem.Second,underareformedbankingsystemriskandrewardwillbealigned.WithnodepositinsuranceonInvestmentAccounts,accountholdersbearaproportionoftheriskontheinvestment.Asshowninsection4.4,byensuringdepositorsgettheirmoneybacknomatterwhat,depositinsuranceremovestheincentivefordepositorstomonitortheirbank’slendingdecisions.However,inareformedsystemboth the customer and the bank share the risk of the bank’s loans failing. This eliminates moralhazard, and incentivises account holders tomonitor their bank’s investment decisions.This shouldmake themwaryofreturnson investmentaccounts thatappear‘toogoodtobe true’.Banksshouldalsobelesswillingtocontinueinvestingfundsinpotentialbubblesastheywillshareinanylossesthatarisefromtheirinvestments,withnooptionofbeingbailedoutbygovernment.In conclusion, it appears that asset bubbles under the post-reform monetary system will still bepossible, butwill bemuch less likely to get out of control.The effects outlined above ensure thatthere are anumberof feedback loops thatmakeassetbubbles self-limiting,whereas in the currentsystemassetpricebubblesareself-reinforcing.

Box9.D-Houseprices

Section 4.2, showed how house prices are heavily determined by the amount of money created by banks via mortgages. As well ascreatingaffordabilityproblemsforpeoplewishingtopurchaseahouse, italsoresults inatransferofwealthfromthosewithouthousestothosewiththem.Thishastheeffectofincreasinginequality.

Undera the reformedsystem,bank lendingwouldno longer lead toan increase in themoneysupply,andasa result thepropensity forbubblestooccur inthehousingmarketwouldbegreatlyreduced.Becausehousepriceswouldbefarmorestable,theywouldnolongerbeseenas‘investments’andsospeculationonhousepriceswouldceasetobeprofitable.Inaddition,withhousepricesincreasingmoreslowly(ifatall)peoplewillbelesslikelytotreathousesasasubstituteforotherformsofsavingforretirement.

Thesocialeffectsoflowerhousepriceswouldbeenormous–asmentionedearlier,ifapersononanaveragesalaryboughtanaveragehousetoday,overthenext25yearstheywouldendupspendingalmosthalftheirsalaryonmortgagerepayments.Incomparison,in1995mortgage repayments would have accounted for around a quarter of their salary. Reducing the likelihood of house price bubbles willthereforelowerthecostofliving,withobvioussocialbenefits.Thislowercostoflivingshouldalsoreducedemandsforhighersalaries,andleaveconsumerswithmoredisposableincome,withsignificantpotentialbenefitsforbusinessesandemployment.

CentralbankinterventioninassetbubblesTheabovediscussionassumedthatthecentralbankdidnotinterveneinanywaytoattempttostoptheassetbubbleforming.Underthereformproposalsthecentralbankcouldberequiredtostepintotrytopreventassetpricebubblesinhousing,sincehousing(whetherboughtorrented)isanecessity.Itmay also wish to try to prevent asset bubbles in other financial assets if it appears that the assetbubblesmayharmordinarypeopleratherthanjustspeculators.Currently thecentralbankalreadyperforms this role through thenewFinancialPolicyCommittee,whichischargedwith“monitoringandtakingactiontoremoveorreducesystemicriskswithaviewtoprotectingandenhancingtheresilienceoftheUKfinancialsystem”(BankofEnglandwebsite).Itspowers include the ability to limit the availability of credit for asset bubbles.Under the reformedsystem,theBankofEnglandwouldhavesimilarpowers.If,basedonitsresearchandmonitoringofthe economy, it believed there to be an asset price bubble developing as a consequence of banklending,itwouldbeobligedtointervene.Forexample,ifitwasworriedthatabubblewasforminginthehousingmarketitcouldobligethebankstoreduceorremovetheguaranteesontheirmortgageInvestmentAccounts(seesection6.8).Otherthingsbeingequalthisshoulddiscourageinvestorsfromplacingmoney in them. If this didn’twork, or if the bubblewasmore advanced, the central bankcouldplaceanupperlimitonmortgagelendingforeachbank,inlinewiththeircurrentmarketshare.BankswouldthenhavetolimitmortgageInvestmentAccountsandinsteaddirectmoneyplacedintoInvestmentAccountstoothersectorsoftheeconomy.Lendingforpropertywouldthenfall,andthisshould deflate the bubble.Once prices have deflated to a satisfactory level, the central bank couldremovetherestrictionsonbanklending.WhenanassetbubbleburstsThe previous section discussedwhy asset price bubbles are less likely to occur under a reformedbankingsystem,aswellaswhythosethatdooccurarelikelytobesignificantlysmallerandlastforashorterdurationthaninthecurrentsystem.Nevertheless,assetpricebubblesarestillpossible.Whatwould happen when such a bubble eventually burst? The next section contrasts the bursting of abubbleunderthecurrentmonetarysystemwiththelikelyoutcomeinareformedmonetarysystem.Deflation–withoutgovernmentinterventionIrvingFisher ’sdebtdeflationtheoryofdepressions(seesection4.2)showedhowtheburstingofanassetbubblecouldleadtodebtdeflationandrecession.Inhistheorybanksplayedacrucialrole–theylentmoney to thosewhowished to borrow to buy into the bubble, increasing debt in the process.Becausebanklendingincreasespurchasingpower,theactoflendingforthepurchaseofassetshelpsfacilitateassetpricerises.Fisher ’sanalysisbeginsinanover-indebtedeconomy.Thisleadstostep1of his theory: “Debt liquidation leads to distress[ed] selling”, followed by step 2: “Contraction ofdepositcurrency,asbankloansarepaidoff,andtoaslowingdownofvelocityofcirculation”(1933).The contractionof deposit currencyonly applies to the currentmonetary system, since today loanrepaymentsreducethemoneysupply.Incontrast,underthereformedsystemtherepaymentofloanswillnotcontractthemoneysupply,asitsimplyinvolvestransferringstate-issuedcurrencyfromtheborrowertothebank,andthenbacktotheinvestmentaccountholder.Inaddition,asshowninsection10.1,althoughbanksthatgobustwillnotberescued,thefundsofTransactionAccountcustomerswillcontinue to exist and will be transferred to other banks, meaning that the failure of a bank in areformedsystemwillnotleadtoadamagingcontractioninthemoneysupply.However, the velocity of circulation of money may still slow down. With loan repayments not

alteringthequantityofcurrencyincirculationstep3,“Afall inthelevelofprices”,step4,“Astillgreaterfallinthenetworthsofbusiness,precipitatingbankruptcies”,step5,“Alikefallinprofits”,step6,“Areductioninoutput,intradeandinemploymentoflabor”andstep7“Pessimismandlossofconfidence”willonlyoccurdue to thedecrease invelocity rather thanbecauseof theshrinkingmoneysupply,andassuchwillbesmallerthanotherwise(Fisher,1933,p.342).TheeffectoffallingpricesthatcomesaboutfromaslowervelocityofmoneymaybecancelledoutbywhatisknownasthePigou-Panatkineffect.Thisimpliesthatfallingpriceswillmakethosewithmoney feel wealthier (as they can buymore with themoney they have), which should lead to anincreaseinspending,automaticallystabilisingpricesandoutput.Thisdynamicdoesnotoccurinthecurrentmonetarysystem,becausewhile thosewhoholdpositivemoneybalancesdo indeedsee thevalueoftheirmoneyincreaseinrealtermsduringadeflation,thosewhoareindebtseethevalueoftheirdebtsincreaseinrealterms(becausetheirdebtsdonotfallinvaluewhenpricesfall).Becauseinthe current systemdeposits are created bybanks’ lending, eachpoundof deposits ismatchedby apoundof debt, and so the positivewealth effect and the negative debt effect cancel eachother out.Conversely, under post-reform banking the stock ofmoney (state-issued currency, which replacesdeposits) exists independentlyof the stockof loans.As such if deflationoccurs thePigou-Patinkineffect is likely to be positive in aggregate,which should act as an automatic stabiliser, increasingdemandwhenpricesfall.Deflation-withgovernmentinterventionTheaboveanalysisshowswhatmighthappenifthegovernmentandcentralbankdidnotinterveneinthemarket.Inreality,boththecentralbankandgovernmentarelikelytointervene.Inresponsetoadeflationinconsumerprices(duetohoardingoraslowdowninvelocity)thecentralbankislikelytoinjectmoneyintotherealeconomyviagovernmentspending(inordertohititsinflationtarget).Theincreaseinthemoneysupplywillcounteractthedecreaseinthevelocityofcirculation/hoardingofcurrencyinTransactionAccounts.Consequently,whentheassetbubblepopsthosesectionsofsocietythatwere not directly engaged in the bubblewill be protected from the negative spill-over effectscausedbyalowervelocityofcirculation.Likewise the governmentmay also attempt to increase its spending to counteract any downturn indemand.Unlikeinthecurrentsystemitsabilitytoengageincountercyclicalspendingwillbeaidedbythefactthatitwillnothavetoprovidefundstobailoutbanksandwilllikelybeinlowerdebttobeginwithduetoitgainingasourceofrevenuefrommoneycreation.

Box9.E-Bankfailures

Underareformedsystembankfailurewillnolongerrequiregovernmentbailoutsandsotherewillbenoincreaseingovernmentdebtafterabank fails and therefore noneed for the government to increase taxes/borrowingor decrease spending.No longer too important to fail,bankswillbemorewaryaboutlendingintoperceivedassetbubblesandindividualswillbemorecautiousaboutwhichbankstheylendto.Thiswilldecreasemoralhazardandthusdecreasethelikelihoodofassetbubblesandbankfailure.

Additionally,becausebankswillnolongerneedtobebailedoutbythegovernment, ifthereisarecessionordepressionthegovernmentwill be in a better financial situation to counteract the downturn through countercyclical spending. Conversely, in the current system thefinancial crisis was associated with large bank bailouts which limited (politically) the ability of the government to borrow to engage incountercyclicalspending,withnegativeeffectsfortheeconomyasawhole(seeTaylor,2012).

LongtermeffectsofgovernmentactionsSection4.2outlinedhow,inthelongerterm,inflationmaybeengineeredbygovernmentstoreducetherealvalueofdebtand insodoingpreventdebtdeflations, financialcrisesanddepressions.Forexample, in the 2007-08 crisis the central bank slashed interest rates anddirectly purchased assets.

Theseactionspreventedfinancialassetsfromfallinginvalue(andinfactmayhaveincreasedtheirprice). In effect a floor was set under the price of certain assets, which legitimised previousinvestmentandlendingdecisionsandprotectedsomefinancialmarketparticipantsfromlosses.Althoughtheseactionspreventedanevenworsefinancialcrisisfromdeveloping,inthelongruntheyimparted an inflationary tendency to the economy. Not suffering from the downsides of theirinvestment decisions, banks aremorewilling to extend credit and borrowers aremorewilling toinvestinassetstheybelievetobe‘protected’.Furthermore,theimplicitinsurancethegovernmenthasprovidedislikelytoleadtoanincreaseintheriskybehaviour(duetomoralhazard)thatledtothecrisisinthefirstplace,settingthestageforanevenbiggercrisisinthefuture.Conversely,underthereformedsystem,bankswouldbeallowedtofail.Thegovernmentandcentralbank would be under no obligation to intervene in the market and in so doing validate riskybehaviour.Thiswilllowermoralhazard,asbankswillnowfacethefulldownsideoftheirinvestmentdecisions. This should decrease their willingness to participate in asset price bubbles. As aconsequencethetendencyforassetpriceinflationduetoriskybankbehaviourshouldbelower.Also,theneedforthegovernmenttouseconsumerpriceinflationinordertoreducetherealvalueofdebtwillbedecreased.

Box9.F-Anadditionalsourceofwealth

Because money will be created by the central bank free of any corresponding debt, money will now be a source of wealth for thepopulation in aggregate.Currently,with almost allmoney created as debt,money cannot be a source ofwealth for everyone– for onepersontohaveapositivemoneybalanceanothermusthaveadebt.Withdebt-freemoneycirculating,theeconomyasawholewillbeabletopaydownitsdebts,withoutcorrespondingreductionsinthemoneysupply.Asaresultdebtislesslikelytoberequiredfortheeverydayrunning of business, small expansions, and everyday purchases by individuals. However, whilst those starting businesses or thosebusinessesundergoingarapidexpansionarestilllikelytorequiredebtfinancing,theproportionoffinancingthroughownfundsshouldbehigherthaniscurrentlythecase.

Theincreasesinwealthwilllikelyleadtoareductionintheinterestratesbankschargebusinesses.AsBernankeandGertler(1989)explain:

“thegreateristheborrower’snetworth–definedoperationallyasthesumofherliquidassetsandmarketablecollateral–thelowertheexternalfinancepremiumshouldbe.Intuitively,astrongerfinancialposition(greaternetworth)enablesaborrowertoreduceherpotentialconflict of interest with the lender, either by self-financing a greater share of her investment project or purchase or by offering morecollateraltoguaranteetheliabilitiesshedoesissue."

Withmoneyasourceofwealth inaggregate,and theeconomyasawholeable topaydown itsdebts, thebalancesheetsof theentireeconomyshouldimprove.Strongerbalancesheetswill ‘lowertheexternalfinancepremium’andincreasetheabilityofbusinessestoself-finance.

9.6DEBTBecause97%ofthemoneysupplyconsistsofbankdeposits,andthesedepositsarecreatedbybanksmaking loans, in order for there to bemoney, someonemust be in debt. In the currentmonetarysystem,theabsenceofastate-issued,debt-freeelectronicmoneysupplymeansthatthemoneyneededfortheeconomytofunctionmustbeborrowedfromthebankingsector.Inaddition,anyattemptbythe public to repay debt in any significant amount has the effect of shrinking the money supply,potentiallytriggeringrecession,whichmakesitdifficulttofurtherreducedebt.Incontrast,thereformswouldintroduceapermanent,debt-free,stablestate-issuedmoneysupplythatisnotdependentonbanks’ lending.The recyclingofmoney through theConversionLiability (seesection 8.3) would make it possible to significantly reduce the debt burden of the public withoutreducing the money supply and triggering recession. As explained in Chapter 8, during theconversion to the new system, the bank’s demand liabilities would be converted into state-issued

currencyandthebankwouldacquireanewConversionLiabilitytotheBankofEngland,effectivelyasacharge,atfacevalue,forthestate-issuedcurrencyusedtoconvertthedemandliabilitiesintorealmoney.As thebankuses themoney from loan repayments topaydown this liability to the centralbank,themoneywillbegrantedtothegovernmentbytheBankofEnglandtobespentbackintotheeconomy. There is no change in themoney supply, asmeasured by the total stock of state-issuedcurrency at theBank of England.When the state-issued currency is injected into the economy viagovernmentspending,taxrebatesorsimplybyacitizen’sdividend,thereisnodebtcorrespondingtothe newly-issuedmoney. In effect themoney is ‘debt-free’.Through this recycling ofmoney, it ispossible to pay downover £1 trillion of household, consumer and business debt over a period ofaround20years.

9.7INEQUALITYUnderthecurrentsystem,moneyusedtorepaybanklendingsinkswithouttrace-theeconomycanonlycontinuetofunctionifmoneyiscontinuallyborrowedbackintoexistence.Withinthereformedsystemtheamountofmoneyincirculationwillexistindependentlyofbanklendingdecisions.Whatismore,under thereformedsystemmoneywillpredominantlybespent into theeconomy‘debt-free’.Thus,moneywillexistwithoutacorrespondingdebt–therewillnolongerbeaneedfortherestoftheeconomy to ‘rent’ themediumofexchange from thebankingsector. Instead, themoneysupplywillbeprovidedtotheeconomybythecentralbankforessentiallyzerocost.Ofcourse,bankswillstilllendinthereformedsystem,andthiswillresultinpaymentstothebankasaresultoftheinterestthattheychargeonloans.Likewisepeoplewillstillneedtoborrow.However,unlike in thecurrentsystemthequantityof loanswillexist independentlyof themoneysupply,andthus thegrossquantityof interestpayments tobankswill likelybe lower.Additionally, inorder tolendbankswillfirstneedtoacquirefundsfromInvestmentAccountholders.Becausetheseaccountswillcarryrisk,InvestmentAccountholderswilldemandahigherrateofreturnthantheycurrentlydoontheirbankdeposits(whicharerisklessduetodepositinsurance).Bothfactorswillleadtolowerbank profits, lower staff wages, and as long as Investment Account holders are not overlyconcentratedinonearea,anincreaseinthegeographicaldispersionofinterestpayments.Inthelongertermalowerpropensityforassetpricebubbleswillstabiliseassetprices,particularlyinthehousingmarket.Stablepropertypriceswill lower theattractivenessofhousingasavehicle forspeculation,increasingitsaffordabilityparticularlyforthelowestearners.Inaddition,theremovalofcreditdrivenassetpricecyclesshouldlowertheriskofbanking/financialcrises,andremovetheneedforbankbailoutsshouldoneoccur.Nobankbailoutsmeanlowergovernmentdebt,negatingtheneedforcutsinpublicspending(whichdisproportionatelyaffectthepoor)duringrecessions.

9.8ENVIRONMENTAssection5.4showed,thecurrentmonetarysystemnegativelyimpactsontheenvironmentinseveralways.First,itcreatesabusinesscyclewhererecessionsarepositivelycorrelatedwiththeremovalofregulation protecting the environment. In addition the increase in government debt associatedwithlargerecessionsandfinancialcrisescaneventuallyleadtocutsingovernmentspending,whichmayinclude investments in technologies that may benefit the environment. Furthermore, banking iscompletelyundemocratic,andthiscanleadtoindividualshelpingtofundlendingtoindustriestheywould otherwise notwish to. Finally the currentmonetary systemmay create a growth imperativewhichmakesthesteadystateeconomydesiredbyenvironmentalistsimpossible.

Underareformedsystem,amajorcauseof theboombustcycle– thecreationofmoneybybankswhenmakingloans–willberemoved.Hencetheeconomyshouldbefarmorestable,withfewerandsmallerrecessions.Consequently,thereshouldbelesspressureongovernmenttoremoveregulationsthatprotecttheenvironmentduringdownturns.Smallerboomsandbustswilllowertheneedforthegovernmenttoengageincountercyclicalspending,orbailoutbanksinafinancialcrisis.Thisshouldfreeupmoney,whichcouldbeusedtoincreasespendingontheresearchanddevelopmentofgreentechnologies.Another aspect of the reforms that would benefit the environment is the directed nature of theInvestmentAccounts. Individuals and organisationswould have a choice over how themoney thattheysaveistobeused.Forexample,eachbankwouldprovidearangeofInvestmentAccountswithdifferentinterestratesandrisksattachedtothem.Eachaccountwouldfundadifferentbroadsectorofthe economy.So, a typicalbankmightoffer avarietyof InvestmentAccounts, oneofwhich fundsmortgagelending,anotherthatfundssmallandmediumsizedbusinesses,athirdthatfundsconsumerlending,etc.Bankscouldevenmarketaccountsbasedontheir‘greenness’.Forexample,abankcouldoffer an account that funded only ‘green’ businesses, and excluded big energy companies, orcompanieswithahistoryofpollution. In reality thepossibilities are endless.Crucially, individualswouldnolongerbeunwittinglyfundingactivitiesthattheydisagreedwith.Asaresult,theinvestmentdecisionsofbankswouldstarttoreflecttheinvestmentprioritiesofsociety.Inaddition,theactofchoosingnottoputmoneyincertaintypesofInvestmentAccount(e.g.onethatfunds companies that damage the environment)will decrease the amount of funds that banks haveavailable to lend to a particular sector.Other things being equal this should lower the quantity oflendingandincreasetheinterestrateonanyloanstothatsector.Thiswillleadtoanincreaseincostsforthesecompanies,potentiallymakinganynewinvestmentsunprofitable.Alternatively,theincreaseincostsmaybepassedontotheconsumer,whichwilllowerdemandforgoodsfromcompaniesthatdamagetheenvironment.Likewise,anincreaseinthemoneyplacedintoInvestmentAccountsfundinggreen companies will lower the cost of funding to these companies. Again, this benefit could bepassedontotheconsumerorreinvested.Thiswillchangerelativeprices,alteringthedemandfortheproducts and creating a market mechanism that will lead people to favour products produced byenvironmentallyresponsiblecompaniesonpricegrounds.A further aspect of the reforms that could benefit the environment is the removal of the growthimperative incapitalisteconomies,asdescribed insection5.4.Thiswouldallowthekindofsteadystate economy favoured by many environmentalists. Indeed, one of CASSE’s (the Centre for theAdvancementofSteadyStateEconomics)fifteenpoliciesforachievingasteadystateeconomyisto“Overhaulbankingregulations,startingwithgradualeliminationoffractionalreservebanking,suchthat the monetary system moves away from a debt structure that requires continuous economicgrowth.”Whydoes a reformed system lessen thegrowth imperative?First, in a reformed system inequalityshouldbeloweras‘rent’isnolongerbeingpaidontheentiremoneysupply.Lowerinequalityshouldlowerborrowingandworkinghoursbypeoplepreviouslyattemptingto‘keepupwiththeJoneses’’.Second, in a reformed systemcontinuousborrowing is no longer requiredmerely tomaintain themoneysupply.Accordinglygovernmentsneednotfearthedeflationaryeffectsofacreditcontraction(althoughtheywillwanttomaintainacertainleveloflendingforotherreasons)andsocanremoveanyincentivesthatpromoteexcessiveindebtednessandasaresulteconomicgrowth.Third,asbanklending no longer increases the level of purchasing power in an economy, asset price bubbles in

essentialsshouldbelesslikely.Alowpropensityforassetpriceinflationshouldlowertherequiredlevels of borrowing in order to purchase a house, which push people to work harder. Fifth, anyincrease inabank’scapitalwillnot removemoneyfromcirculation,and loanrepaymentswillnotdestroymoney.Consequentlythegrowthimperativewhichappliestothecurrentsystem(aspostulatedbyBinswanger(2009))willnotapply.Evenifsomeeconomicactorschoosetohoardmoneyintheiraccounts(effectivelytakingitoutofcirculation)thecentralbankcaneasilyoffsetanynegativeeffectsbyincreasingthequantityofmoneyspentintocirculation.

9.9DEMOCRACYAssection5.5showed,thecurrentmonetarysystemimpactsupondemocracyinseveralways.First,thereareproblemsduetothelackofunderstandingastowhatbanksactuallydo.Second,thepowertocreateandallocatemoneygivesa smallnumberofbanksahugeamountofpowerover the futuredirectionoftheeconomy.Third,thegovernmentisreliantonbankstolendtosmallbusinessesandentrepreneurstoensurethelevelofinvestmentandthereforegrowthandemploymentismaintained.Fourth,thecomplexnatureofthemonetaryandbankingsystemdisguisesfromthegeneralpublicandgovernmentthebanks'truefiscalcontributiontosociety.Underareformedsystem,InvestmentAccountswouldallowpeopletochoosewhatbroadsectoroftheeconomytheirmoneygoesto.Furthermore,becauseInvestmentAccountsrequirepeopletogiveup access to theirmoney for a periodof time and accept a degreeof risk, peoplewouldbemorelikely to understand what banks actually did. Likewise, the removal of deposit insurance and theability to letbanksfailwouldremovethe‘toobig tofail’subsidy.Thuspoliticiansandthegeneralpubliccouldbeabletobetterassessthecontributionofthebankingsectortosociety.Likewiseinareformedsystemthepowertocreatemoneywouldberemovedfrombanksaltogether.Whilebankswouldstilldeterminewhichfirmstograntloanstoandtheinterestratesonthoseloans,this lending would no longer create new purchasing power. Instead, the amount of money in theeconomywouldbedeterminedbyabodythatwastransparentandaccountabletosocietyasawhole.Finally, thedecisionsonwhatsectorsof theeconomywouldreceivefundingwouldbemuchmoredemocratic.Ifindividualsdidn’twantthebanktolendtheirmoney,thenthebankwouldn’tbeableto.However, ifan individualwanted to lendsomeof theirmoney then theywouldactuallyhavesomecontroloverhowtheirmoneywastobeused–unliketoday.Whilebankscouldstillchoosewhichfirms within a sector receive funding, the quantity of funds available to each sector would bedeterminedbythesavingdecisionsofthepopulationasawhole.Bankscouldstillattempttoinfluenceindividuals’choicesbyalteringthereturnsondifferentInvestmentAccounts,basedonhowprofitabletheyfoundittolendtodifferentsectors.However,ifthepopulationweretrulyaversetolendingtoaparticularsector,thenlessmoneywouldgointothoseInvestmentAccounts,andasaresultthebanks’lending to these sectors would be considerably lower. Essentially individuals would have somecontroloverwhattheirmoneyisusedfor.Intermsofhowthefundsareallocated,itwouldbesimilartoastockmarkettrackerorexchangetradedfund–theinvestordecidesonthebroadsectortheywanttoinvestin,withthebankpickingthespecificcompaniestolendtowithinthatsector.

Footnotes1.Bythis,wemeanthatthelevelsofoutput,pricesandemploymentareneitherfallingnorrising.Justenoughloansarebeingprovided,throughInvestmentAccounts,tosupportproductionandpricesattheircurrentlevels.Consumerpricesarestableastheamountofmoneycirculating(viaTransactionAccounts,assumingvelocitystaysconstant)isbalancedwiththelevelofproductionintheeconomy.Obviouslyasituationinwhichallkeyvariablesarestaticandunchangingisunrealistic,howeveritisusefultoaidourunderstandingandbuildintuition.2.TheMCCneedstobeawarethatthemoneyitcreatesandgrantstogovernmentmayallowanassetpricebubbletocontinueforlongerthanitcouldotherwise.3.Neitherprocessissustainableinthelongtermwithafixedmoneysupply,asbothleadtoadecreasein the production of consumer goods, either due to lower demand, or directly by decreasinginvestment and therefore output. As the economy enters a downturn the ability of individuals topurchasehousesatincreasedpricesisimpaired,leadingtoafallinborrowingforhousepurchasesandareductioninprices.4.Ifthecentralbankincreasedthemoneysupplytocompensateforthedecreaseindemandthenthebubblecouldcontinue.Asaresult thecentralbankwillbeobligedtoact topreventbubblesinlandandproperty.ItispertinenttonotethatthenewlyestablishedFinancialPolicyCommitteeattheBankof England already has the power to curb lending by placing limits on the public’s access tomortgages.

CHAPTER10IMPACTSONTHEBANKINGSECTOR

10.1IMPACTSONCOMMERCIALBANKSThereformsoutlinedinChapter6and7havebothadvantagesanddisadvantagesforthebankingandfinancialsector.Theseeffectsarediscussedbelow.BankswillneedtoacquirefundsbeforelendingAswesawinChapter2,currentlywhenabankmakesa loanitcreatesnewdepositsfor thosewhohaveborrowedthemoney.Afterthereform,thiswillnolongerbethecase,althoughbankswillstillbeabletomakeloansusingfundsthatcustomershaveprovidedspecificallyforthispurpose.Bankswillnolongerbeabletomakeloansfirst(bymakinganaccountingentry)and‘golookingforthereserveslater ’,astheydointhecurrentsystem.Instead,theywillhavetofindthemoneytheyneedtomakeloansbeforetheymakethem.Bankswillthusbecometrueintermediaries,merelytransferringpre-existingpurchasingpowerfromsaverstoborrowers.ItisdifficulttopredicthowindividualswillallocatetheirfundsbetweenInvestmentandTransactionAccountsafterthereform.However,thecurrentratioofmoneyinsightdeposits(whicharesimilartoTransactionAccounts) to time deposits (which are similar to InvestmentAccounts)may give us aclue.Currentlythebalanceoftimedeposits tosightdeposits is£1.5trillionto£1.1trillion(58%intimedepositsvs.42%insightdeposits).1

Whetherthisratioremainsthesameafterthereformdependsonseveralfactors.Ononehand,peoplewill have an incentive to place theirmoney into InvestmentAccounts. For one, bankswill pay nointerestonTransactionAccounts,andwillalsochargeasmallmonthlyorannualfeetocovertheiradministrationcosts.Second,becauseTransactionAccountspaynointerest,apositiveinflationrateimpliesanegativerealinterestrateonTransactionAccounts.AssumingtheBankofEnglandretainsitstwopercentinflationtarget,therealinterestrateonTransactionAccountswouldequalminus2%.2Other thingsbeingequal, this should incentivisepeople toplacemoney theyarenot spending intoInvestmentAccounts.Conversely, the fact that InvestmentAccountswillcarryanelementof risk islikely to counteract this affect somewhat.3Which affect dominateswill depend upon a function ofindividuals’ riskaversion, the interest rateofferedon InvestmentAccountsand the levelof riskoneachtypeofInvestmentAccount.Marketforcesshouldgoalongwaytomakingsurethattheappropriateleveloffundsareavailablefor investment.Banksareunlikely topassivelywait formoneytocomein,particularly if theyfeeltheyaremissingoutonprofitableopportunitiestolend.Underthereformedsystemthecentralbankwill decide on the quantity ofmoney. The price ofmoney – the interest rate – will be set by themarket. By ceding control of the interest rate, the central bank gives commercial banks a tool toattractmoney into InvestmentAccounts. For example, in a situationwhere a bank had a profitablelending opportunity but no money in its Investment Pool it could seek to attract more funds bychangingtheinterestrateitoffersonitsInvestmentAccounts.4AnincreaseintheofferedratewouldattractmoneyintoitsInvestmentAccounts.Converselyinterestratescouldbeloweredifthesupplyoffundsoutweigheddemandfromeligibleandcreditworthyborrowers.Bankscouldalsoseektoalter

thefundsinInvestmentAccountsthroughnon-interestratemeasures,suchasalteringanyguaranteesprovidedon theaccounts.Bydoingso(e.g.byguaranteeing90%of thevalueofanaccountratherthan 80%) the bank alters the risk-adjusted return which – other things equal – will affect theattractivenessoftheinvestmentandtheamountoffundsputintosuchanInvestmentAccount.IfabankdidwishtoattractmoneyintoInvestmentAccountsbyraisinginterestrates,itwouldneedtoeither increase the interest rates it charged on loans in order tomaintain profits (the ‘spread’) oraccept a lowermargin.However, it is important tonote that any increase in the interest ratebankschargeon loans is limited in scope.Beyonda certainpoint higher interest rates eventually lead tolowerprofits(forbanks),ashigherratesleadtoriskierprojectsbeingfundedandriskierbehaviourbyborrowers(seesection3.4formoredetails).TheimpactontheavailabilityoflendingAcommoncriticismofproposalsthatseektoremovetheabilityofbankstocreatemoneyisthatitwould cause a reduction in the level of lending in the economy. For example, the IndependentCommission on Banking wrote that full reserve banking “would drastically curtail the lendingcapacity of the UK banking system, reducing the amount of credit available to households andbusinesses”(2011,p.98).Inresponsetorequests,theCommissionwouldnotclarifywhattheymeantby theword ‘drastic’,why they thought lendingwould fall,ordisclosewhether theyhaddoneanycalculationstoreachsuchaconclusion.However,despitethelackofevidenceforsuchanassertion,itisstillacommonargumentandthereforerequiresinvestigation.Thebasicpremiseofthisargumentisthatremovingthebankingsector ’sabilitytocreatemoneywillreduce its capacity tomake loans, and as a result the economywill suffer. However, this ignoresseveralcrucialissues:First, the implicit assumption is that more lending is always better. This is in turn based on theassumptionthatbanklendingprimarilyfundsproductiveinvestment.However,asfig.3.4showed,themostdesirableformoflending,fromaneconomicpointofview,accountsforlessthan10%oftotallending.TherestdoesnotcontributetoGDP,andmuchofitmayinfactbeharmfultotheeconomy-unconstrainedlendingforpropertywasaprimecauseofthehousingbubblethattriggeredthe2007-08financialcrisis.5

Second,afurtherimplicitassumptionisthatunderthecurrentsystemtherewillneverbeashortageofbanksthatarewillingtolend,andthatbankswillalwayssatisfythedemandforcredit.Yetnothingcouldbefurtherfromthetruth–banklendingtodayispro-cyclical.AsChapter4showed,bankslendtoo much in the good times (particularly for unproductive purposes), which creates a boom. Aspeoplebecomeover-indebted,spendingdecreases,theeconomystartstofalteranddebtsaredefaultedupon.Asaresultoftherecessionbanksbecomepessimisticastothefuturepathoftheeconomy,andreduce their lending, while individuals attempt to pay down their debts. The banks’ initial over-lendingsows theseed for their later reverse.AsMarkTwain famouslysaid:“Abanker isa fellowwholendsyouhisumbrellawhenthesunisshining,butwantsitbacktheminuteitbeginstorain.”Third,underthereformedsystembanksdonotneedtowaitpassivelyforfundstocomeintothebank.Theywill instead raise the interest rates they offer to attractmore funds from customers.Marketmechanismswillthereforeensurethatanyshortageofcreditwillpushuptheinterestrate,attractingnewfundsfromsavers.Fourth,anybankfacedwithashortageoffundstoinvestcouldapproachotherbankstoenquireaboutany excess funds theymight beholding andborrow from thesebanks. If therewere a shortageof

fundsacrosstheentirebankingsystem,particularlyforlendingtobusinessesthatcontributetoGDP,the Bank of England would possibly opt to auction newly created money to the banks, on theprovisiontheyareonlentintotherealeconomy(i.e.tonon-financialbusinesses,seesection8.2formoredetails).Fifth,theargumentthatthereformswould‘drasticallycurtail’lendingseemsinparttobebasedonviewingbanklendingasaone-shotgame,ratherthanacyclicalongoingprocess.Thisassumesthatmoney can either be a) in a Transaction Account, where it is available for spending, or b) in anInvestmentAccount,whereitistiedupforaperiodoftime.Whileitmayappearthiswayfromtheperspective of each individual (they may see, for example, £1,000 in a Transaction Account and£4,000astheirInvestmentAccountbalance),itisnothowtheeconomyasawholeworks.Money,interms of state-issued electronic currency, is never actually ‘held’ in an Investment Account. AsdescribedinChapter6theInvestmentAccountissimplyarecordofmoneythathasbeenprovidedtoa bank to be invested. Through the process of making a loan the bank moves money from itsInvestment Pool to the borrower ’s Transaction Account. As a result the money ‘in’ InvestmentAccounts is almost always in another customer ’s Transaction Account, and so is available forlending.ConsequentlyitisalogicalerrortothinkthattherewillbeashortageoffundsavailableforInvestmentAccounts-ifmoneylenttoaborrowerisspentandendsupwithsomeonewhodoesnotneeditatthetime,theymayplaceitbackintoanInvestmentAccount,whereitcanbeusedforlendingagain.Inotherwords,thesamemoney,whencirculatingaroundtheeconomy,canbere-lentmultipletimes.Inconclusion,concernsabouttheimpactofthesereformsontheleveloflendingprovidedbybanksareoverstated.Muchofcurrentbanklendingservesnousefulpurposeandcouldbelostwithoutanyimpacton theperformanceof the economy. Indeed, a largeproportionofbank lending is actuallyharmfultothehealthoftheeconomy,asthelastfewyearshaveclearlyshown.Therefore,areductioninbanklendingneednotbeharmfultotheeconomy,particularlyasunderareformedsystemitwillnotmeanareductioninthemoneysupplyandtheadversemacroeconomicconditionsthisbrings.Asaresultof thefactorsoutlinedhere,banklendingisunlikelytofall‘drastically’,andif itdoes, theBankofEnglandwillbeabletostepintoensurethatfundsareavailableforthebankstoon-lendintotheeconomy.BankswillbeallowedtofailAsdescribedinChapter6,theproposalsmeanthatbankscanbeallowedtofail.Theycannolongerrely on government bailouts if they become insolvent. Thiswillmean that they should, in theory,improve their risk-management and take fewer risks that could threaten the solvency of thewholebank.Whetherthischangeinbankbehaviourwillactuallyhappenisnotguaranteed,butregardless,banksthatbecomeinsolventwillbeallowedtofail,ratherthanbeingrescuedbythetaxpayer.The‘toobigtofail’subsidyisremovedSinceitispossibletoallowbankstofailunderthereformedsystem,thebankingsectorwillloseits‘too big to fail’ subsidy. This subsidywas partly a consequence of the implicit guarantee that thegovernmentwould rescue any banks that failed, due to the fact thatwithin the current system it ismoreexpensiveforthegovernmenttoallowabanktofailthantorescueit.The ‘too big to fail’ subsidy also arose as a direct result of deposit insurance. Deposit insuranceeffectivelymakes lending to a bank risk-free, lowering the interest rates that banks need to pay todepositorsandon theirotherborrowings.This resulted in“significant transfersof resources from

thegovernmenttothebankingsystem.”(Noss&Sowerbutts,2012,p.15)Ofcourse,thelossofthesubsidywillmakebankslessprofitable.Whenabankborrowsmoney,theinterestrateitpayswillbehighertoaccountfortheriskthattheloanwillnotberepaid.Whilethiswillincreasethecoststothebank,italsoincreasesthereturnstothepersonlendingtothebank(i.e.theInvestmentAccountholder).Lobbyists for the banking sector have argued that this subsidy to banking is beneficial for bankcustomersasitlowersthecostofborrowing.Yetthisfailstotakeintoaccountthelowerinterestratepaid on deposits, and the increase in the risk of financial crises such insurance brings about(Demirguc-Kunt&Detragiache,2002).Furthermore,thequestionofwhyahighlyprofitableindustryshould receive a subsidy from the public sector is not clear. Subsidies should be reserved forbusinessesthathavepositiveexternalities(benefitsthattheycannotberewardedfordirectlythroughtheprice of their products).With the current financial crisis costing theworld economyanywherebetween $60 trillion and $200 trillion in lost output (Haldane, 2010), it is quite clear that banks’negativeexternalitiesfaroutweighanypositivecontributiontheymaymake.IndeedinarecentspeechAndrewHaldane, theExecutiveDirector of Financial Stability at theBank ofEngland,wentmuchfurther:“Assumingthata[financial]crisisoccursevery20years,thesystemiclevyneededtorecoupthesecrisiscostswouldbeinexcessof$1.5trillionperyear.Thetotalmarketcapitalisationofthelargestglobalbanksiscurrentlyonlyaround$1.2trillion.Fullyinternalisingtheoutputcostsoffinancialcriseswould riskputtingbankson thesame trajectoryas thedinosaurs,with the levyplaying theroleofthemeteorite.”(2010)

Doesitreallymakesensetosubsidiseanindustrythatimposessuchmassivecostsonsocietyevery20years?Theneedfordebtisreduced,shrinkingthebankingsector’sbalancesheetAsdiscussedinsection9.6,thesereformssignificantlyreducethesystemicneedfordebtthatexistsinthe current system (because money is currently only created when someone takes on debt). Inaddition,theinjectionbytheMoneyCreationCommitteeofnewdebt-freemoneyintotheeconomy,alongwiththerecyclingofrepaidloansthroughthebankingsector ’snewConversionLiabilitytotheBankofEngland(seesection8.3),meansthattheoveralllevelofdebtwillfallsignificantly.Thiswill naturallyhave a significant impact on thebanking sector.Debt is themain ‘product’ thatbanks sell, and these reforms reduce the need for their products. The banking sector ’s aggregatebalancesheet,overthe10-30yearsafterthereforms,willshrinkconsiderablyasbothapercentageofGDPand in absolute terms.While thiswill obviouslybe threatening to thebanking sector, it is anadvantageforsocietyandtheeconomyasawhole.Alowerburdenofdebtmeanslessincomeisspentonservicingdebt,andthereforemorewillbespentintherealeconomy.Byreducingthesizeofthebankingsectorandtheburdenofhouseholddebt,weallowtherealeconomytogrow.BaselCapitalAdequacyRatioscouldbesimplifiedThe‘CapitalAdequacyRatios’,setbytheBaselcommittee,areintendedtoensurethatbankskeepasufficient‘capitalbuffer ’toabsorblossesonbadloans.Thefearisthatifabank’scapitalbufferistoolow,itwillquicklybecomeinsolventintheeventofdefaults,andwillthenturntothegovernment(andtherefore taxpayers) forabailoutorothersupport.This isbecause,within thecurrentsystem,mostbankscannotbeallowedtofail.

Underareformedsystemthecentralbankandgovernmentwouldnolongerneedtobailoutbanksiftheybecameinsolvent,astheinsolvencyofabankwouldnotreducethemoneysupplyorhaveseverenegative economic consequences. However, the retention of minimum capital requirements isimportant toprevent seniormanagement ‘looting’ thebank: i.e. running thebank in ahighly riskywaytomaximiseshorttermprofits(andthereforetheirremuneration)attheexpenseofthelong-terminterestsofshareholders(Akerlof&Romer,1993).Nevertheless, regulators may wish to remove Basel II’s requirement to risk weight lending todifferent asset classes, as it exacerbates a systemic bias against lending to business, which whenmultipliedacrossallbankscanincreasetheriskoffinancialcrisis.Forexample,bankshavetoholdlesscapitalagainstmortgagelendingthantheydoagainstsmallbusinesslendingandasaresultcanmake more loans to mortgages. This gives banks a strong, systemic bias away from lending tobusinessesand towards lending toproperty.Thus regulationadds to thebank’spre-existingbias toprefertolendforproperty,asunlikeamortgagesecuredonahouse,smallbusinesswillrarelyhavesignificantassetsthatcanberepossessedandsoldiftheborrowerdefaults.However,whilelendingforpropertylowerstheriskoflossforanindividualbankintheshortterm,itincreasestheriskoflossesforthebankingsectorasawhole.Ifthebankingsectordirectsmostofitslendingtomortgagesandawayfrombusinesslending,thenhousepriceswillinflateandbecomeincreasingly unaffordable, while the real economy stagnates from a lack of investment. With astagnant real economy expected to pay salaries that will cover increasingly unaffordable housingcosts,housepriceinflationeventuallyresultsindefaultsonmortgages,whichcouldbringdowntheentire banking sector. The Basel Accords may therefore make asset price bubbles, banking andfinancialcrisesmoreratherthanlesslikely.Giventhatriskweightingprobablydoesmoreharmthangood,itmaybedesirabletoremoveit.EasierforbankstomanagecashflowandliquidityAfterthereform,allloansmadebyabankwillbefundedusingfundsfromInvestmentAccounts.AseveryInvestmentAccounthasadefinedrepaymentdate(oramaturitydate),theamountsthatthebankwill need to repay on anyone daywill be statistically farmore predictable than under the currentsystem.ForInvestmentAccountswithmaturitydates,thebankwillknowtheexactamountthatmustbe repaidonanyparticulardate. Itwillalsoknow, fromexperience,whatpercentageofcustomerswithmaturing accountswill ask for the investment to be rolled over for another period (in otherwords,whatpercentageofaccountswillnotneedtoberepaidonthatdate).Withregardstominimumnoticeperiods,itwillknow–fromanalysisofitsowndata–thestatisticallikelihoodofanaccountbeingredeemedwithinthenext‘x’days.Thismeansthatitsoutgoingsarefarmorepredictable.Inaddition,incomingfundsarealsohighlypredictablebecausethebankhasacollectionofcontractswithspecifiedmonthlyrepaymentdatesandamountsontheassetssideofitsbalancesheet(asitdoestoday).Thismeans that itknowsalmostexactlyhowmuchmoney itwill receiveonanyparticulardate(allowingforasmalldegreeofvarianceduetodefaultsandlatepayments).Consequentlythebanks’computersystemswilleasilybeabletoforecastcashflow(moneycominginand out) and identify any future shortfallswith amuch greater degree of certainty than under thepresent system. These shortfalls could be prepared for by scaling back loan making activity andbuildingupabuffer.Atthesametime,itwillbeabletoidentifyperiodswhenthemoneycominginwillbegreaterthantherepaymentsduetocustomers,andthereforeincreaseloan-makingactivitytosoakupthesurplus.

Reducingthe‘liquiditygap’Bankswithinthecurrentsystemtendtohaveasignificantamountof their liabilitiesredeemableondemand(i.e.thecurrentaccountbalancesthatwepresentlyuseasmoney).However,theirassetstendtomature (i.e. be repaid) over amuch longer period of time. Consequently, there is a significant‘liquiditygap’between their liabilities and their assets,with liabilities being short-termand liquid,andassetsbeinglong-termandmuchmoreilliquid.These proposals significantly reduce this liquidity gap. As described in section 8.1, when theconversionismadebetweenthecurrentandreformedsystems,banks’demandliabilitiesareremovedfromthebalancesheetandconvertedintostate-issuedcurrencyheldattheBankofEngland.Inplaceofthisdemandliabilitythebanksreceiveanewliability,whichisaConversionLiabilitytotheBankofEngland.ThisConversionLiabilitywillberepaidoveraschedulethatcorrespondstothematurityprofileof thebank’sassets i.e.as thebank’sloansarerepaid, thebankwillrepayits liabilitytotheBank of England. As a result the maturity mismatch between the assets and liabilities thatcorrespondedtotheirsightdepositswillbereducedtozero.Thisradicallyreducestheliquiditygapof every bank that is affected by the reforms. Instead of having half its liabilities repayable ondemand, it will now have no on-demand liabilities and its remaining liabilities (the ConversionLiability, plus its Investment Accounts) will have a maturity profile that is much more closelymatchedwiththatofitsassets.Thiswillmakethebanksfarmoresecureandmuchlessvulnerabletoliquiditycrises.

10.2IMPACTSONTHECENTRALBANKDirectcontrolofmoneysupplyInChapter3wearguedthattheBankofEnglandhaslittleabilitytomanagethemoneysupplyofthenationasitstoolstodosoareweak,indirectandineffective.ThisargumentappearstobesupportedbycommentsmadebytheBank’sGovernorin2010:“TheBankofEngland’skeyrolehasalwaysbeentoensurethattheeconomyissuppliedwiththerightquantityofmoney–neithertoomuchnortoolittle.Forfiftyyears,mypredecessorsstruggledto prevent there being too much, so leading to inflation. I find myself in the opposite situationhavingtoexplainthatthereistoolittlemoneyintheeconomy.”(King,2010)

Thesuggestionthatoneofthemostpowerfulbankinginstitutionsintheworld‘struggled’tocontrolthemoneysupplypointseithertoinadequatetools,ortoamonetarysystemthatcan’tbecontrolled.Incontrast, thesereformsgive theBankofEnglanddirectcontrolover themoneysupply(throughtheMoneyCreationCommittee),withtheabilitytoincreaseordecreasethemoneysupplybypreciseamounts,withoutrelyingonacomplexseriesofuncertainconnectionswhicharethemselvessubjecttolonganduncertainlags(e.g.seefig.3.2).NoneedtomanipulateinterestratesWith theability tomanage themoney supplydirectly, there isno longer anyneed for theBankofEngland to set interest rates as ameans of influencing aggregate demand. This should benefit theeconomy, since in addition to being an ineffective tool, themanipulation of interest rates can alsonegativelyimpactonpensioners(whenratesarelowered)andyoungborrowersorfirst-timebuyers(whenratesareraised).AslimmeddownoperationattheBankofEngland

Post-reform,thecentralbankwouldhavetwoessentialfunctions,asnow:

1. To maintain monetary stability, that is, to keep inflation at a low and steady rate asdeterminedbythegovernment.ThiswouldbeprimarilyachievedbyitsmanagementofthemoneysupplyviatheMoneyCreationCommittee.

2. Tomaintainfinancialstability.Thiswouldinclude:

Providingthepaymentssysteminwhichallelectronicstate-issuedcurrencyisheld,andthemeansforbanksandotherpaymentssystems(e.g.BACS,Visa)tointerfacewiththis.OverseeingtheliquidationofbanksthatfailandensuringthatTransactionAccountsaretransferredtohealthybanksquicklywithminimallossofservice.Monitoringthefinancialsystemforweakness,includingpotentialassetpricebubbles.

RecentchangesintheUKmeanthattheBankofEnglandwillhaveawiderangeofresponsibilitiesbeyond this andwill serve as the chief regulatorofbanks.However,when it comes tomaking themoneysystemwork,thefollowingaspects,programmesandfunctionsoftheBankofEnglandwillnolongerberequired:

OpenMarketOperationsTheCashRatioDepositsSchemeTheDiscountWindowFacilityTheSpecialLiquidityScheme‘Funding for lending’ – although the proposals do replace thiswith a facility to providefundingtobankstobeon-lenttobusinessesQuantitativeEasing

ItisquitepossiblethatthiscouldallowforamuchmorestreamlinedfunctionaloperationattheBankofEngland.

10.3IMPACTSONTHEUKINANINTERNATIONALCONTEXTTheUKasasafehavenformoneyTo thebestofourknowledge,TransactionAccountswouldbe theonly typeofaccountworldwidewhereamemberofthepubliccanholdtheirmoneyatthecentralbankwithzeroriskofloss.Whilstanyone with deposits at a bank is exposed to the risk of that bank failing (even allowing for the£85,000governmentguarantee),aholderofaTransactionAccounthaszeroriskofloss,regardlessof theamountofmoneytheyholdin thataccount.For thisreason,aUKbankingsystemprovidingTransaction Accounts may find that it becomes a ‘safe haven’ for people wanting to holdmoneywithoutrisk,whilststillhavingtheconvenienceofdebitcards,chequebooksandinternetbanking.PoundsterlingwouldholditsvaluebetterthanothercurrenciesTheUKmoneysupplyhas increasedbyanaverageof11.5%ayearover the last40years.Similarpatternsarefollowedaroundtheworld.Incontrast,areformedsystemwouldputthecontrolofthemoneysupplyinthehandsofanindependent,transparentbodywhichwillbetaskedwithmaintainingalowandstableinflationrate.TheMoneyCreationCommitteewouldannounce,onamonthlybasis,

exactlybyhowmuchthemoneysupplywouldbe increased,providinggreater transparencythan isavailablewithanyothercurrency.ItishighlyunlikelythattheMCCwilleverincreasethemoneysupplyasquicklyasthebankingsectorhasdoneover the last40years.Thismeans that inflation is likely tobe lowerand thevalueof thecurrencywillbedebasedmuchmoreslowlythananyothercurrency.Again,thiscouldmaketheUKanattractiveplacetoholdmoneyandthepoundsterlinganattractivecurrencytohold.Infact,thisincreasedattractivenessofpoundsterlingasa‘safehaven’currencycouldraiseforeigndemand for thecurrencyandcausesterling toappreciateagainstothercurrencies.However, if thishappens to a significant extent, theprocesswouldeventually self-correct: anappreciatingcurrencymakesforeigngoodscheaperintermsofthedomesticcurrency,withcheaperimportsthenfeedingintolowerinflation.TheMCCresponsetofallingpriceswouldbetoincreasethegrowthrateofthemoney supply.This should lead tomore spendingand thereforemore imports, thus increasing thesupplyofpoundsontheforeignexchangemarket.Anincreasedsupplyofcurrencyshouldloweritspriceintermsofothercurrencies-reversingtheinitialappreciation.Theabovefactorsmeanthatiftheexchangeratedoeschangeasaresultofthesereforms,itislikelyto appreciate, rather than depreciate. However, at the same time the self-balancing mechanismoutlinedaboveensuresthatanyappreciationwouldbechecked.NoimplicationsforinternationalcurrencyexchangeBecauseofthestructureofthepaymentssystemsthathandlecurrencyexchangesbetweencountries,these reforms have no practical implications for trade between the UK and the rest of the world.Currently, internationalcurrencyexchangesare settledover thebanks’accountsat thecentralbankfor eachof the respectivecurrencies (e.g. theBankofEngland forpound sterling, theFed forUSdollars,theBankofJapanforYen).Post-reform,thesetradeswillsettleovertheequivalentaccounts(i.e.thebanks’OperationalAccountsattheBankofEngland).Forinternationalbankswishingtobuyor sell sterling, theywill notice no difference at all in theway the processworks, even if theUKswitches to a reformed systemwhilst other countries continue to allowcommercial banks to issuetheirmoneysupply.Wouldspeculatorsattackthecurrencybeforethechangeover?Tradersinfinancialmarketshaveatendencytoreacttothenewsannouncementfirst,andthenthinkandanalyseoncethefirstreactionisover.Sowheneveracountryannouncesadecisiontoswitchtoanewsystem,itispossiblethattherewillbeashort-termdepreciation(fall)inthatcurrency.However,speculators are always over-ruled, sooner or later, by the economic fundamentals.As the reformswouldmake theUKa fundamentally strongereconomy,with lesshouseholddebt, lessexposure tobanking crises, and a currency thatwill not be debased by the profit-seeking lending activities ofcommercialbanks, there isno reasonwhyany fall in thecurrency (as a resultofpanic)wouldbepermanent.

10.4IMPACTSONTHEPAYMENTSYSTEMNationalsecurityThe stability and resilience of the payments system is a matter of national security. The formerChairmanoftheFederalReserveBoard,AlanGreenspan,hascommentedthat:“We’d always thought that if youwanted to cripple theUSeconomy,you’d takeout thepaymentsystems.Bankswouldbeforcedtofallbackoninefficientphysicaltransfersofmoney.Businesses

wouldresorttobarterandIOUs;thelevelofeconomicactivityacrossthecountrywoulddroplikearock.”(Greenspan,2007)

Acoupleofhigh-profilebankfailuresmightbesufficienttoleadmostshopkeepersandbusinessestoacceptcashonlyaspayment(becausetheycouldnotbeguaranteedthattheywouldevergetthemoneyiftheywerepaidelectronically).Wedonotwishtodwellonthepotentialconsequencesofacollapseinthepaymentsystem,butinacountrythatreliesmainlyonjust-in-timefooddistribution,withonlyafewday’ssupplyof foodonsupermarketshelvesatanyone time, thepotential impactof the largesupermarketsbeingunabletomakepaymentstotheirforeignsuppliersissobering.However,sincetheseproposalsallowbankstofailwithnointerruptiontothepaymentssystem,theysignificantlyincreasetheresilienceoftheeconomyandnation.Undertheseproposals,abankthesizeofRBScouldhavebeenallowed to fail,yet itscurrentaccountcustomerswouldhavebeenable tocontinuetomakeandreceivepayments.Ratherthanbankfailuresbecomingathreattosocialorder,theywouldbecomeamoderateinconvenience.OpeningthedoortocompetitionamongTransactionAccountprovidersThereformsalsoopenthewayforanewtypeofbankthatonlyprovidesTransactionAccounts.Thisbankwoulddonolendingorinvestment;itwouldonlyadministeraccountsonbehalfofcustomers.Itsincomeandprofitswouldcomefromaccountfees,anditwouldcompetewithotherbanksonthegrounds of customer service and price.Because there is no risk of this service failing due to badinvestments (because there are no investments), there is a hugely reduced need for this type ofpayments-onlybanktoberegulated.Asaresult,thecoststoregulatorswouldbesignificantlylower(these costs are discussed in section 6.2). Providing that the Bank of England was committed toincreasing choice and fostering competition among Transaction Account providers, the Bank ofEngland could design its IT systems in such away that it would be very cost effective for a newentrantto‘pluginto’thepaymentssystemandstartprovidingservices.Byopeningthedoortothistypeofbank,itispossibletoincreasethelevelofcompetitionwithinthebankingsector,whichshouldforcethelargerUKbankstobemoreinnovativewithregardstotheirpaymentservices.

Footnotes1.Thesefigureswerearrivedatbyaddingtogetherallsightdepositcategories(MFIs,publicsector,private sector and non-residents – Bank of England codes: RPMB3GL, RPMB3MM, RPMB3NM,RPMB3OM)andall timedepositcategories(MFIs,publicsector,privatesectorandnon-residents–Bank of England codes: RPMB3PM, RPMB3QM, RPMB3TM, RPMB3HL) for the 30th September2011.2.Therealinterestrateistheinterestrateafterinflationhasbeentakenintoaccount.Ifinflationisat2%andtheinterestrateisat5%,thentherealinterestratewillbe3%.So,therealinterestrate(atlowlevelsofinflationandinterest)isapproximatelynominalinterestminustheexpectedinflationrate.IftheinterestrateonTransactionAccountsis0%andexpectedinflationisat2%then0-2=minus2%real interest rate. At this rate of inflation, in real terms the spending power of the money in theaccountwillfallby2%eachyear.3.Inthecurrentsystem,timedepositsareguaranteedbydepositinsurance.However,theriskoflossunderthereformedsystemislikelytoberelativelysmall,aslongastheprobabilityofdefaultontheloansisuncorrelatedandthebank’sloanbookisofsufficientsizetoensureadequatepoolingofrisk.4. Equally, if the bank had toomany funds it could reduce the interest rate offered on InvestmentAccounts,orlendtheexcessfundstootherbanks.5. This is not to say that lending to non-productive purposes should be stopped, merely that anexcessivelevelcanresultinassetpriceinflationandfinancialcrisis.

CONCLUSION“Whenyoustartprintingmoney,youcreatesomevalueforyourself.Ifyoucanissueathousandpounds-worthofIOUstoeverybody,you’vegotathousandpoundsfornothing.Andsowedorestricttheabilityofpeopletocreatetheirown[bank]notes…We’reprotectingyoufromcharlatans.”PAULFISHER1ExecutiveDirector,BankofEngland

Thereisacuriouscontradictionattheheartofthecontemporarymonetarysystem.Whileoneagencyofthestate–thepolice–spendconsiderabletimeandresourcestryingtopreventtheprivatecreationofpapermoney (commonly referred toas ‘counterfeiting’), anotheragencyof state– theBankofEngland–spendssignificantlymoretimeenablingandfacilitatingtheprivatecreationofmoneybythe corporations that we know as banks. Banks are able to create money because their IOUs(liabilities)canbeused,viaasophisticatedelectronicpaymentsystem,asasubstitute for thepapermoneyissuedbythestate.Theseprivately-issuedIOUsnowmakeup97%ofallthemoneyintheUKeconomy.Yet as Paul Fisher ’s quote attests, theBank ofEngland is clearly aware that the ability to issue “athousandpounds-worthofIOUs”givestheissuer“somethingfornothing”.Inthelastdecadealone,UKbanks have issuedmore than a trillion pounds of additional IOUs.The value that they got for“nothing”wasatrillionpounds-worthofinterestbearingassetsintheformofdebtcontractssecuredonthepropertyandfuturelabouroftheUKpublic.Nootherbusinessisabletoobtainvalueforitselfinthisway.Asaresult,personalandhouseholddebtisatitshighestlevelinhistory,causinghardshipandstressfor millions. The biases of banks towards lending for property over investing in business haveensuredthathousinghasbecomeunaffordableforanentiregeneration,whiletherealeconomyhasbecomeweak and stagnant, starvedof investment by thebankswhose corepurpose is allegedly toinvestinbusinessandhelptheeconomygrow.Sometakethisasproofthatmarkets,lefttotheirowndevices,areinefficientandpronetofailure.Yetthe reality is that there is perhaps no industry in theworld that conforms less to the principles ofcapitalism than banking does.No industry other than banking2has its creditors reimbursed by thegovernment if it is unable to do so. No other industry has themonopoly privilege of issuing themoney that everyone else must use in order to trade and do business. No high-street shop orrestaurant will be rescued by the government in the event of financial mismanagement or badbusinesspractice.AndinnootherindustrywouldthefailureofonefirmthreatentobringdowntheentireUKeconomy.Yetbanksareabletocontinueinbusinesswhilstcontraveningalmosteveryruleofcapitalismintheprocess.Theprivileged,protectedandsubsidisedpositionthatbanksholdisnotalawofnatureoreconomics.Banksonlyexistintheformtheydotodaybecauseofcountlessgovernmentinterventionsthroughouthistorytosavethemfromtheirownworstexcesses.Witheachfailurethebankshavebenefittedfromsomenewguaranteeorconcessiondesignedtopatchupthesystemandgetbacktobusinessasusual,be it deposit insurance after the crisis of the 1930s or the lender of last resort function after theOverendGurneypanic in1866.Eachcrisis thusstrengthens theremainingbanksandprotects them

fromtheirpreviousexcesses,settingthestageforevenbiggercrisesinthefuture.Thecurrentsystemcannotbefixedbysubjectingittoevermorerulesandregulations;housesbuiltonsandwilleventuallycollapsenomatterhowcarefultheoccupantsareaskedtobe.Theissuethatmustbeaddressed is theabilityof thebankingsector tocreatemoney.Fordecades, suchconcernshavebeensidelined.Yettheseconcernsarebecomingmorewidespreadthateverbefore,witheventhechiefeconomicscommentatorfortheFinancialTimes,MartinWolf,expressingtheviewthat:“It is the normalmonetary system, inwhich the ‘printing’ ofmoney is delegated to commercialbanks, that needsdefending.This delegates a corepublic function - the creationofmoney - to aprivateandoftenirresponsiblecommercialoligopoly.”(Wolf,2012)

Thiscorepublicfunctionisoneuponwhichthestabilityoftheentireeconomydepends.Asaresultinstabilityandfragilityarebuiltintothecurrentmonetarysystem.Despite thedestructivenessof thecurrentmonetarysystem, therearestill thosewhodefend it.Onereasonforthisisadeeplevelofignoranceofhowthemonetarysystemactuallyworks.Mostofthepopulation (andmost politicians) are under the impression that only the state has the authority tocreatemoney.Many of thosewho do understand thatmostmoney is created by banks believe thishappens through the limited and predictable ‘money multiplier ’ model of money creation, whichplaces control of the money supply firmly in the hands of the central bank. As the evidence andanalysisinthisbookhasmadeclear,theBankofEnglanddoesnothavethatlevelofcontrol.Infact,Sir Mervyn King’s admission (section 10.2) that for half a century the Bank of England has“struggled”tocontrolthemoneysupplysuggeststhatthisisnotasystemthatcanbecontrolled.Thereformsoutlinedinthisbookwouldbringthemoneysupplybackundercontrol.Byremovingthepowertocreatemoneyfrombanksandreturningittoanindependentbutaccountablepublicbody,whichmay only sanction its creation during periods when inflation is low and stable, themoneysupplycanbemadetogrowinlinewiththegrowthoftherealeconomy.Insteadofnewmoneybeingallocatedwhereitisofgreatestbenefittothebanks,itwouldinsteadbeallocatedwhereitwouldmostbenefit the population as a whole – in the real economy, through the salaries of governmentemployees, tax rebatesand reductions,orviadirectpayments tocitizens. Indoingso it returns theprivilegeandbenefitsofmoneycreationtothepeople.Astheylosetheirpowertocreatemoney,bankswouldalsolosetheirpowertoshapetheeconomy.Arequirementforbankstoinformtheircustomersexactlywhatwillbedonewiththemoneytheyputinto InvestmentAccountswillensure that, toa reasonableextent, the investmentprioritiesofbanksstarttoreflecttheinvestmentprioritiesofsocietyasawhole.Byremovingthepowerofbankstocreatemoney,thesereformsaddressmanyoftheproblemsofthecurrenteconomicsystemattheirsource.Theyalsoturnbanksbackintoordinarybusinesseswhosefailureposesnothreattothewidereconomicsystem.Butwouldthesechangesbankruptthebanks?WouldwelosetheUK’smostprofitableindustry?Afewissuesneedtobeconsideredhere.First,anindustrythatcanonlybeprofitablethankstopermanenttaxpayer-funded subsidies is not profitable in any real sense. Second, much of the profits of thebanking sector come from its monopoly on the creation of money and the fact that – with theexception of cash – all of themoney needed in the economymust be borrowed from them. Thissignificantly overstates the true profitability of banking. Third, banking itself (as opposed to thewider financial sector) employsonlyoneoutof every53workers in theUK (ONS,2012),yet theconsequencesofthecurrentdesignofthisbankingsystemcausesinstability,insecurityandtheriskof

unemploymentfortheother98%oftheworkforce.Somereductioninthesizeofthebankingsectorwouldbeafairpricetopayforgreaterstability,investmentandemploymentinthereal,non-financialeconomy.However,themostpowerfulargumenttosuggestthatthesechangeswouldnotbeharmfulisthatthereforms simply require banks to work the way that the rest of the investment industry alreadyoperates.With the exception of banks, the rest of the investment sector must acquire funds fromsavers first before they can lend. If these companies can be (very) profitablewithout the ability tocreatemoney,thereisnoreasonthatwell-runbankscouldnotbetoo.

THENEXT40YEARS

“Ourproblemsareman-made,thereforetheymaybesolvedbyman.Noproblemofhumandestinyisbeyondhumanbeings.”JOHNFKENNEDY

35thPresidentoftheUnitedStatesWithoutdoubt, the changesoutlinedherewill bebitterlyopposedby thebanks and their lobbyists.Thereisanaturaldesireonbehalfofbankstogetbackto‘businessasusual’asquicklyaspossible.Buttherewillbenomore‘businessasusual’–thelevelsofpersonalandhouseholddebtaresimplytoohightoallowforanotherlendingboom.Thereisalsoahighprobabilitythatmanyofthelargestbanksworldwidearebankruptinastrictaccountingsense,althoughfewgovernmentswouldforceastrictauditofbankassetswhentheywillbeforcedtopickupthetabforanybankinsolvency.Ifwekeep thecurrentdebt-basedmonetarysystem, financialcriseswillcontinue tooccur,with thecostspassedontoordinarypeopleandbusinesses.Thereisnojustificationforthiswhenthechangesthatneedtobemadearebothbeneficialandrelativelysimpletoenact.The monetary system, being man-made and little more than a collection of rules and computersystems, is easy to fix, once the political will is there and opposition from vested interests isovercome.The realchallengeswhich faceusover thenext40years, suchashow toprovide foragrowingglobalpopulation,achangingclimate,andincreasinglyscarcenaturalresources,requireamonetary system thatworks for society and the economy as awhole. For that reason, our currentsystem is no longer fit for purpose andmust be reformed.This bookhas provided a detailed andworkableproposalthatwouldaddressthedeepestflawsinthecurrentsystemandallowustomoveontodealingwiththeotherissuesfacingsocietyandtheworld.Thechallengenowistoensurethatthesechangesaremade so thatwecanall start to reap thebenefitsof amonetary system thatworks forsocietyratherthanagainstit.

Footnotes1.SpeakingtoBBCRadio4“Analysis–WhatIsMoney?”,1stApril2012.2.Andcertainotherfinancialbusinesses,suchasinsurance,pensionandendowmentproviders.

APPENDIXIEXAMPLESOFMONEYCREATIONBYTHESTATE:ZIMBABWEVS.PENNSYLVANIA

Thecommonresponsetotheideaofallowingthestatetoissuemoneyandspenditintotheeconomyis that such an approach would be highly inflationary. The examples of the hyperinflation inZimbabweorWeimarRepublicGermanyareoftenmentionedasareasonwhystatescannotbetrustedto issue currency. However, thosemaking these claims rarely have any in-depth understanding ofwhathappenedinZimbabwe,Germanyoranyoftheotherhyperinflationaryperiods.Inreality,eachperiodofhyperinflationhappensduetoauniquesetofcircumstancesthatarecompletelyinapplicabletotheUKoranyofthecountrieswherethesereformsarelikelytobeimplemented.In this appendixwe look first at theZimbabweanexperiencebetween2007and2008, as this is themost recent example of a hyperinflation. We also briefly look at the period of hyperinflation inWeimarRepublicGermany.WethenlookataPennsylvanianmoneysysteminthe1720s,toshowthatifmanagedproperly,moneycreation can lead to a prosperous and low inflation economy. Unfortunately there are fewcontemporary examples of responsible state-issued currency; every country world-wide runs onsome variant of the banking system outlined inChapter 2, and as a result has suffered significantinflation and indebtedness (whether at a household or government level, or both). Inmany cases,countries under the current systemcanonly attempt to keep inflation lowby raising interest rates,which can stifle beneficial investment (Chang, 2007).Under the proposals outlined in this book, itwouldbemuchmorestraightforwardtomaintaininflationatareasonablelevelwithouttheneedtousehighinvestment-stiflinginterestrates.ZimbabweWhileinflationcanbedescribedasageneralincreaseinthepricelevel,orequivalentlyafallinthepurchasing power of a currency, hyperinflation is a different phenomenon entirely. Althoughdefinitionsareingeneralratherarbitrary,manyeconomistsdistinguishhyperinflationfrommerelyhighinflationbydefiningitasapricelevelincreaseofatleast50%permonth(Cagen,1956).Thisisin contrast with ‘normal’ inflation, which many countries, including the UK, target at 2% a year.Fortunately,hyperinflationstendtoberare,withonlythirtyoccurrencesinmoderneconomichistory.ThelatestofthesetookplaceinZimbabweunderPresidentMugabe.Zimbabwe is endowed with rich resources and mineral reserves. It possesses huge deposits ofdiamonds, gold, nickel, iron, platinum, coal and other natural goods. Compared to other Africancountries, ithadasophisticated industrymanufacturing textiles,cement,chemicals,steel,woodandotherproducts.Agriculturalproduction, themainstayof its economy, is supportedby10,747dams(out of 12,430 water dams in the entire Southern African region) (Sugunan, 1997). The tobaccoindustry was Zimbabwe’s most successful generator of foreign exchange, earning about US$600million in 2000. Zimbabwe was also a popular tourist destination. Perhaps most important toZimbabwe was its strong banking sector and a well-functioning property rights system, which“allowedownerstousetheequityintheirlandtodevelopandbuildnewbusinesses,orexpandtheir

oldones.”(Richardson,2005,p.1)Aftergaining independence in1980,Zimbabwewason itswaytoprosperity,withanaverageGDPgrowthrateof4.3percentayear.Forabouttwodecadesitexperiencedsustainedgrowth,whichwasonlyoccasionally interrupted.1However, by the endof the 1990s this progress came to a halt andZimbabwe’seconomyentered intoadepression.Whatcaused this turnaround?Media reportsoftensimplistically imply that the printing of money was the cause of Zimbabwe’s economic collapse.However, in reality the economic collapse came first, and themass printing ofmoney came as aconsequenceofthis.Zimbabwe’spresident,RobertMugabe,andothermembersoftheleadingpartyZANU-PF,havebeeneagertoblamethecontinuousyearsofdroughtandthetargetedsanctionsofWesterncountriesasthemain reasons for the economic decay. Yet these claims are easily refuted - sanctions on topgovernment officials only came into effect in 2002. Empirical research questions the claim thatdroughtistoblame:“ThehistoricallycloserelationshipbetweenrainfallandGDPgrowthendedin2000–thefirstyearsafterthelandreforms.”(Coltart,2008,p.10)Sowhatwere the real reasons forZimbabwe’sdecline? In themid90s, about4,500white familiesowned most of the commercial farms, employing 350,000 black workers and often providingfinancial support for local infrastructure, hospitals and schools. Simultaneously about 8,500 blackfarmers ransmall-scalecommercial farms thatwereable toaccesscredit fromZimbabweanbanksandvitallycontributedtotheagriculturalproduction(Richardson,2005).However,theprevalenceofwhitefarmersinagriculturalproduction–commonlyviewedasaheritageofcolonialism–sparkednegativesentiment,andfuelledcallsbyMugabeandotherstoreturnthefertile‘stolenlands’toblackZimbabweans(Hill,2003,p.102).2

Nevertheless,theseconflictsdidnotconstrainthegrowthoftheeconomyuntiltherhetoricwasactedon. The ‘point of no return’, according to Coltart (2008), took place in 1997 with three crucialdevelopments.Thefirstwasthatthewarveterans,whofoughtforindependenceandhadtraditionallybeenloyaltotheZANU-PF,becameevermoredisgruntledwiththerulingelite’sgrowingwealthandbegandemandingabiggerstake.Inresponse,Mugabecommittedtoincreasepensionpaymentsandother forms of benefits. Secondly, Mugabe ordered an expensive deployment of the Zimbabweanmilitary in the Democratic Republic of Congo (which lasted until 2003), in order to support theregimeofLaurentKabila,andinsodoingprotectthemininginvestmentsmadebymembersoftheZimbabweanrulingelite.Thirdly,andprobablymostcrucially,theZimbabweangovernmentfinallybegan to make good on its threats to acquire vast tracts of land that were owned by the whitecommercialfarmers.Whilstthefirsttwoeventsincreasedgovernmentspending,thethirdloweredproductionandexports,which negatively affected tax revenues. This rise in government spending and fall in governmentincomewas“thebeginningof theZimbabweaneconomy’sdownwardspiral.”(Coltart,2008,p.14)Theeffectofthelandredistributionpolicywasseveral-fold.3Firstly,foreigninvestorsfled,fearingtheirassetscouldbeseizednext.By2001foreigndirectinvestmentinZimbabwefelltozero,whilsttheWorld Bank’s risk premium on foreign investment rose from 4% to 20%. Secondly, the non-enforcementoflandtitlesremovedamajorsourceofcollateralforbankloans.Asaresultlendingtofarmersdriedup,andinvestmentinagricultureplummeted.Thirdly,thosefarmerswhowereevictedfoundthemselvesunabletopaybacktheirloans.This,combinedwiththelossofincomefromfarmloans, lead to dozens of banks collapsing, with massive negative repercussions for Zimbabwean

businesses. Fourthly, the land redistribution, although supposedly meant to benefit the poorestZimbabweans, actually largely benefited the ruling elites who cherry picked the most fertilefarmlands. With the commercial farmers deserting Zimbabwe, crop yields collapsed and famineensued.4 Fifth, land values collapsed due to the removal of property rights, and with it much ofZimbabwe’swealth(Richardson,2005).With sucha large loss inoutput, tax revenuealso fell dramatically.Combinedwith the increase inspending,thegovernment’sbudgetcameunderseverepressure.Thiswasexacerbatedin2001whenthegovernmentdefaultedontheservicingofitsloanfromtheInternationalMonetaryFund(IMF).Inresponse, the IMF refused to make any concessions (such as refinancing or loan forgiveness) topunish the government for its policies,most significantly the land reformmeasures.With reducedfood production due to the land reforms, the government had to buy food from abroad to try topreventmass starvation.But, because of the default on the IMF loan,Zimbabwe’s creditworthinesswas effectively ruined, making it impossible to get loans elsewhere. As a result, the ZimbabwegovernmentstartedtoissueitsownnationalcurrencyandusedthemoneytobuyU.S.dollarsontheforeign-exchange market. The attempt by the government to plug the increasing deficit betweenspendingandrevenuethroughthecreationofmoneyincreasedthepurchasingpowerintheeconomy,justasthefallinoutputintheagriculturalandmanufacturingsectordecreasedtheamountofgoodsavailable topurchase.Theresultwas theclassiccaseof ‘toomuchmoneychasing toofewgoods’.Highinflationensued,withannualratesabove100%from2001.By2003thevalueoftheZimbabwedollarhaddeterioratedtosuchanextent that itwascostingthegovernmentmoreto issuethenotesand coins than theywereworth at face value. In light of this the government began issuing time-limited‘bearerchecks’inveryhighdenominations.After defaulting on the IMF loan, the situation in Zimbabwe rapidly deteriorated, with each newpoliticalmeasurefromZANU-PFaimedsolelyatkeepingaholdonpower.Itachievedthisgoalbyshufflingasideanyopposition,andbyappropriatingthecountry’sresourcesthroughtheconfiscationandredistributionofprivatelyownedassets.This includedkillingrepresentativesof theoppositionandseveralwhitefarmersinordertooccupytheirlands.5Theintimidationofnotonlythepoliticalopposition and the judiciary but the whole population became crucial to maintain political andeconomicpower.For example, in 2004human rights groups reported that about 90percent of theopposition members suffered from criminal violation, 24 percent had survived potentially lethalattacksand42percenthadbeentortured.By2005,economicconditionshadgrownparticularlybad.Morethan80percentoftheZimbabweanpopulationwasofficiallyunemployed.Theinformalsectoroftheeconomy,whichaccountedforlessthan 10% of the total in 1980, was by 2005 the main source of income for the majority ofZimbabweans:more than3millionpeopleworked in the informal economycompared toonly1.3million in the formal sector (Tibaijuka, 2005). With economic conditions rapidly worsening, thegovernment resorted to extrememeasures to both bolster its position and get the economy undercontrol.Forexample,in2005thegovernmentimplementedalawwhichrequiredexporterstosellupto30percentoftheirforeignexchangeearningstotheZimbabweReserveBankatanartificiallylowexchange rate. This immediately imposed a huge cost on the manufacturing sector, which wasexacerbatedwhentheZimbabweandollarwasstrengtheneddue toforeignaid(as thepriceof theirexports,intermsofothercurrencies,increasedwhilethepriceofimportsdecreased).Withcostsalsorapidly increasing (particularly interest rates) local manufacturers were struggling to survive

(Coltart,2008).6

Further pressure was placed on the economy through government attempts to control inflation.However, inflation continued to rise, with price rises reaching the 50% a month necessary to beclassified as hyperinflation by mid to late 2007 (McIndoe, 2009). The government continued toattempttorestrictinflation,includingthroughdirectpricecontrolmechanismsin2007yetwithlittlesuccess.Pricescontinuedtoincrease,andeveryeconomicindicatormarkedlyworsened.TohelpcovertheshortfallontheZimbabweangovernment’sshrinkingincome,theReserveBankofZimbabweincreasedtheamountofcurrencyincirculationatanalarmingrateafter2003,leadingtotheintroductionofthesecondZimbabwedollarin2006,atavalueof1000oldZimbabwedollarsanddevalued60%againsttheUSdollar.Thiswasfollowedbyafurtherdevaluationof92%in2007.ThethirdZimbabwedollarwasintroducedin2008at10billiontimesthesecondZimbabwedollar(Noko,2011).ByNovember2008,therateofinflationinZimbabwehadpeakedat79.6billionpercentpermonth(Hanke&Kwok,2009). In thebuildup to the inflationarypeak,priceswere revisedupwardsataneverfasterpace,indaily,hourlyorwithinevenshorterperiods.ThepricesofgoodsinZimbabweandollarswereupdatedvis-à-vis theexchange rateof foreigncurrencies,whichwereexchanged inacurrency black-market in the streets, shops and backyards where people tried ‘to get rid of theirZimbabwean dollars’ as soon as they got them (The Economist, 2008). With the value of theZimbabweandollardecreasingvis-à-visothercurrenciesatanever-increasingrate,‘dollarisation’–theuseofUSdollarsinsteadofthelocalcurrency–becamewidespread7as“peoplesimplyrefusedto use the Zimbabwe dollar” (Hanke & Kwok, 2009, p. 354). By February 2009 the authoritiesofficially recognised the demise of the Zimbabwean dollar, and a ‘multicurrency system’ wasadopted.8Thisbrought to an end tenyearsof high inflation and twoyearsof hyperinflation.As aresult theprice level (inUSdollars) stabilised, and theeconomystarted to recover.BankaccountsdenominatedinZimbabwedollarsweresuspendedatthecurrentexchangerateofZ$35quadrilliontoUS$1(IMF,2010).In the end, thedamagedone to theZimbabwean economywas staggering.Between2000 and2008output contracted by 40 percent, while the government’s budget revenue fell from more than 28percentofGDP(in1998)tolessthan5percent(in2008).Thisresultedinthe:“almosttotalcollapseinpublicservices.Bytheendof2008,mostschoolsandmanyhospitalshadclosed, transportandelectricitynetworkswereseverelycompromised,andawater-bornecholeraepidemichadclaimedmorethan4,000lives.”(IMF,2010,p.51)

In conclusion, it was the struggle to maintain political power that led the Mugabe regime toimplement policies that caused a significant fall in the productive capacity of what had been aprosperous and growing economy. This fall in output, and the consequent fall in tax revenues(combined with some expensive military forays) squeezed government revenues further. Theexpropriation of farmland in order to appease political allies destroyed Zimbabwe’s agriculturalsector, with subsequent detrimental knock-on effects on other economic sectors. Consequently taxrevenuesfelldramatically,andwithgovernmentexpenditures increasing(againtoappeasepoliticalallies) the government, via its control of the Reserve Bank of Zimbabwe (and therefore politicalcontrolofmoneycreation)wasforcedtoturntotheprintingofmoneytofillthegap.fig.I.1-OnehundredtrillionZimbaweandollarnote

So,whilethehyperinflationwasmadepossiblebytheprintingofmoney,itisnotthecasethatmoneyprinting always leads to high or hyper-inflations. Rather, it was the printing ofmoney to financeexpenditure, with no regard for the inflationary consequences, and following a collapse in theproductive capacityof the economy,whichpushedZimbabwe intohyperinflation.HadZimbabwe’scentral bank been independent of politicians, and focused on price stability rather than facilitatinggovernmentspending(withmorecarefulcontrolover themoneysupply), thehyperinflationwouldhavebeenimpossible.TwoconclusionscanbedrawnfromtheZimbabweexperience:

1. There is a dangerwhen thosewith the power to createmoney can also benefit from itscreation.Thisisthebasisforourargumentthatneithervote-seekingpoliticiansnorprofit-seekingbankersshouldbegiventheabilitytocreatemoney.Instead,thispowershouldbewithanindependentbodywhoseremitistokeepinflationlowandsteady.

2. Hyperinflations do not happen simply because of an increase in themoney supply; theremustalsobeacollapseintheproductivecapacityoftheeconomytostart theinflationarypressure.

Table1–InflationratesinZimbabwe

Date Month-on-monthinflationrate(%) Year-over-yearinflationrate(%)

April2007 100.7 3,713.9

June2007 86.2 7,251.1

August2007 11.8 6,592.8

October2007 135.6 14,840.7

December2007 240.0 66,212.3

January2008 120.8 100,580.2

February2008 125.8 164,900.3

March2008 281.2 417,823.1

April2008 212.5 650,599.0

May2008 433.4 2,233,713.4

June2008 839.3 11,268,758.9

July2008 2,600.2 231,150,888.8

August2008 3,190.0 9,690,000,000.0

September2008 12,400.0 471,000,000,000.0

October2008 690,000,000.0 3,840,000,000,000,000,000.0

November2008 79,600,000,000.0 89,700,000,000,000,000,000,000.0

Source:Hanke&Kwok,2009OtherhyperinflationsGermany’shyperinflationof1923isalso typicallyheldupasanexampleof thedangersofmoneycreation by governments.A recentworking paper by economists at the IMF unpicks this commoninterpretationofevents:“TheReichsbankpresidentatthetime,HjalmarSchacht,puttherecordstraightontherealcausesofthatepisodeinSchacht(1967).Specifically,inMay1922theAlliesinsistedongrantingtotalprivatecontrol over theReichsbank.This private institution then allowed private banks to issuemassiveamounts of currency, until half the money in circulation was private bank money that theReichsbank readily exchanged forReichsmarksondemand.TheprivateReichsbank also enabledspeculatorstoshort-sellthecurrency,whichwasalreadyunderseverepressureduetothetransferproblem of the reparations payments pointed out byKeynes (1929). It did so by granting lavishReichsmarkloanstospeculatorsondemand,whichtheycouldexchangeforforeigncurrencywhenforward sales of Reichsmarks matured. When Schacht was appointed, in late 1923, he stoppedconverting privatemonies to Reichsmark on demand, he stopped granting Reichsmark loans ondemand,andfurthermorehemadethenewRentenmarknon-convertibleagainstforeigncurrencies.Theresultwasthatspeculatorswerecrushedandthehyperinflationwasstopped.FurthersupportforthecurrencycamefromtheDawesplan thatsignificantlyreducedunrealisticallyhighreparationspayments.”(Benes&Kumhof,2012)

Theauthorsoftheworkingpaperconcludethat,“thisepisodecanthereforeclearlynotbeblamedonexcessivemoneyprintingbyagovernment-runcentralbank,butratheronacombinationofexcessivereparations claims and of massive money creation by private speculators, aided and abetted by aprivatecentralbank.”Anotherworking paper from theCato Institute (Hanke&Kwok, 2009)analyzed all 56 episodes ofhyperinflationaroundtheworld.AsaReutersjournalistsummarizedthefindings:“Bylookingdownthelistyoucanseewhatisn’tthere—and,strikingly,whatyoudon’tseeareanyinstances of central banks gone mad in otherwise-productive economies…[H]yperinflation iscausedbymany things, suchas losingawar,or regimecollapse,oramassivedrop indomestic

production.Butonethingisclear:it’snotcausedbytechnocratsgoingmadorbad.”(Salmon,2012)The empirical reality, both when looking at quantitative data and qualitative descriptions of whatactuallyhappensinhyperinflationsshowsthattheyarenottheresultsofwell-governedstatesabusingthemoneycreationprocess.PennsylvaniaOneof thedefiningaspectsof earlyAmericanhistory is theuseofmoney,byBritain, inorder tomaintainitspowerovertheAmericancolonies.Byrestrictingthecolonies’abilitytocreatetheirownmoney, which they needed in order to trade with each other, the colonies were forced to deliverresources and materials to Great Britain to earn foreign currency, which they could then use topurchasegoodselsewhere(Middleton,2002).Thisrelegatedthecolonies tomereprovidersofrawmaterials,allowingBritaintopreserveitshegemony.Nevertheless, thenortherncoloniesofNewEngland started to establishproductionandprocessingindustries and by the 1750s they became the New World’s centre for processing, transportation,storage, distribution,marketing andmercantile services (Rousseau& Stroup, 2011). However, thecolonieswerestillin“direneedforamonetarysystem”(Zarlenga,2002,p.364)orasaPennsylvaniamerchantwrote to a correspondent in London, they required “some propermedium forCurrencywithout which Commerce is a perplexing Employment.” (Lester R. , 1938) In fact, the colonialmerchantsat that timewerequite inventive regarding the tradeandexchangeofgoods,evenusingsomegoodsasmeansofpayment,9includingtobacco,rice,sugar,beaverskins,wampum,‘countrypay’10andothers.Yetthesemethodsofpaymentsufferedfromvariousweaknesses,andassuchdidnotlastforlong.Asaresulttradewithinthecolonialterritoriesremainedweak.So, without an adequate means of payment for day-to-day transactions, merchants, traders andproducersusedavarietyof substitutes suchasbarter, commoditymonies, shopnotes,bookcredit,andbillsofexchange.However,eachofthesealternativescreatedtransactionfrictionsbecausetradescould not be completed until a double coincidence of wants was identified (Baxter, 1945). Tradewithin townswas often coordinated by shopkeeperswho, in addition to supplying finished goods,alsokepttransactionsrecordsfortheresidents.Butshopnotes,whichwereissuedbyshopkeepersinexchangeforgoodsandwereinturnoftenpaidoutbyemployerstolabourersforredemptionatthestore, tended to limitconsumption to items thataparticularshopkeeperhadonhand(Davis,1900).Bookcredit,aclose relativeof shopnotes,could remainunused formonthsuntila shopkeeperorcustomerpresentedanitemforexchangethattheotherdesired(Rousseau&Stroup,2011).With the means of payment in general a poor substitute for money, the colonies continued toexperiment:

In 1652 John Hull set up the ‘Hull Mint’ or ‘tree’ coinage in Massachusetts. The coinsproducedwereuseduntil1685whenitwasremovedfromcirculationbyaBritishdecree.In 1675 a private land bank was set up in South Carolina, issuing paper bank notes asconvertible securities (collateralised by secured estates). It was however ultimatelyunsuccessful, because although South Carolina could create money, it failed to get itacceptedforgeneralpayments.11AprivatelandbankwasalsosetupinBostonin1686,andfailedforsimilarreasons.In1690 thestateofMassachusettsbegan issuing‘BillsofCredits’.This“papermoneyof

Massachusettswasbackedonlybythe‘fullfaithandcredit’ofthegovernment”,(Goodwin,2003,p.36),ratherthanlandorsomeothercommodity.Althoughinitiallynotintendedtobelegaltender(aspecialtaxwasplannedtobeleviedthenextyearthatcouldbepaidinrealgoods, specie or tax bills), it became more and more accepted for payments, withsubsequentpositiveimpactsontradeandproduction.Assuch,theMassachusettsassemblydeclareditlegaltenderforallpaymentsin1692(Hutchinson,1936).In1709and1710,Hartford,NewHampshireandRhodeIslandfollowedMassachusetts’leadand issued theirownBillsofCredit.Thesecirculatedacrossbordersandatparwithoneanother, and in1712became legal tender forpublic andprivatedebts (McCallum,1992).However,withmanyofthestatesatwaragainsttheFrench,toomanybillswereproduced(formilitaryexpenditure)and thevalueof thecurrencydeclinedsubstantially.Yetdespitethe eventual problems with the currency, the infrastructure it helped to build and thememoryofthepositiveeffectitinitiallyhadontheeconomyremained(Zarlenga,2002).

Colonialmoniescould(anddid)failforavarietyofreasons.Somewereunsuccessfulduetoexternalevents (such as the British shutting them down), while others failed because they could not getaccepted.Severalwereunsuccessful(in thelongrun)becauseof thetemptationtothoseissuingthecurrency tocreate toomuch.Yetnotall colonialmonieswerebesetbyproblems–NewYork, forexample,hadahighlyregardedcurrency,asdidPennsylvania.Butwhatmadethesecurrenciesworkwhenothersfailed?In the lead up to the 1720s Pennsylvania found its economy suffering.Reflecting on this situationsomeyearslater,FrancisRawle,asuccessfulPhiladelphiamerchant,wrotethat“arunningStockofMoneynowwantingistheCauseofthisDecay:ThecommonNecessariesforFamiliesbroughttotheMarketarenotbought,becauseChange(asSilverandCopperiscommonlycalled)isnottobehad;allourDomesticTradeisbecomenothingbutDiscount,amiserableMake-shiftgoodforNought,buttoenrichKnavesandbeggarFools”.(AsquotedinLesterR.,1938,citedinZarlenga,2002.)The problems arising from the lack of amediumof exchangewere exacerbated by theSouthSeaBubbleburstingin1720,whichcausedafinancialcrisisandawaveofbankruptcies(asthosewhohadborrowedtoinvestlostmorethantheirinitialinvestment).WithBritain(andsomepartsofAmerica)in recession and prices deflating, people began hoarding their money. This had three effects onPennsylvania. Firstly, the lower demand for goods negatively affected Pennsylvania’s exports toBritain. Secondly, imports from Great Britain to Pennsylvania (which included a variety ofcommoditiesthathadnotbeenmanufacturedinthecoloniesbecauseoftheunderdevelopmentofitsinfrastructureanddivisionoflabour)begantofall.Thirdly,thehoardingofcurrencyledtofurtherscarcity inanalreadyscarcemediumofexchange.Thecombinationof these three factors led toasharpfallintheavailabilityofacurrencytomaketransactions:“WhenBritishpurchasesfelloffandthe colonies shipped less than would pay for their imports, sterling bills became scarce andexpensive,andpeoplesoughthardmoneytomakepaymentsabroad.”(Ferguson,1953)With exports toBritain depressed, and no currency to trade between themselves, the economy andpeopleofPennsylvaniawereintrouble.So,in1723thegovernorofPennsylvaniatoldthelegislature:“IdailyperceivemoreandmorethatthePeoplelanguishforwantofsomeCurrencytoreviveTradeandBusiness,whichiswhollyataStand;thereforeIamofOpinion,thatalltheDispatchimaginableought to be given to the Paper Bill.” (Lester R., 1938) Crucially, he also added that in order tomaintain the value of the currency “the Quantity must be moderate”. So, on March 2, 1723, the

Pennsylvanian assembly passed an act for the provision of a 15,000 issue of papermoney.Eleventhousandwastobeloanedintotheeconomy(tobusinessesandindividualsat5percentinterest),while4,000wastobespent intotheeconomyonpublicworks- i.e. itdidnotenterwithacorrespondingdebt.(ProvinceandCommonwealthofPennsylvania,1723)Additionally,theloanshadtobesecuredon land and were to be paid back in eight annual instalments (with the money to be relent uponrepayment).Nomorethan100couldbeloanedtoanyoneperson,sincethispapermoneychieflywasintendedtobenefitthepoorandindustrious.Within a short period of time business and trade was revived with the governor of Pennsylvaniastatingthat“aprodigiousgoodeffectimmediatelyensuedonalltheaffairsofthatprovince”,(Keith1740,p.213,citedinZarlenga,2002,p.370).Throughoutthefirstyearaveragepriceschangedlittle.Withdemandfornewloanshighandthecurrencyasuccess, theassemblydecidedto issueanother30,000inDecemberofthesameyear.Thistime26,500wasloanedintoexistenceandtheremaining3,500wasspentintocirculation.12

In1726,theassemblystatedina“Representation”totheauthoritiesinEnglandthatwith“thewholeQuantitythatwasstruckthusinaveryshortTimeemitted,anddiffusedintothePeoplesHands, theFaceofourAffairsappearedentirelychanged.”(Lester,1938)Withbusinessandtraderevived,pricesbegantorecoverandstabilise.Propertyvaluesalsorecoveredwiththeissuesofpapermoney.Thesedevelopmentsrelieveddebtors,merchants,andproducersbyhelpingtorestoreprofitmargins.Withmoney issuedby the state rather thanprivatebanks, “the interest receivedby thegovernment frommoneyouton loansupported thecostsofprovincialadministration,without thenecessityofdirecttaxes. This relative freedom from taxation probably contributed to Pennsylvania’s remarkablegrowth”.(Ferguson,1953,p.169)Yet a currency, high growth rates, freedom from taxation and a source of funding to allowgovernmenttoundertakesociallybeneficialinvestmentswerenottheonlyadvantagesofstateissuedmoney.Lesterfoundthatpricesfrom1721until1775weremorestablethaninanysubsequentperiodofequallength.Furthermore,loansofpapermoneyat5percentinteresttended,foratime,tolowerthe general rate of interest in Pennsylvania, which had been at 8 percent. (Lester, 1938, cited inZarlenga,2002)Inconclusion,historiansagree thatPennsylvania’s systemof issuingcurrencywas ‘to themanifestbenefitoftheprovince’(Ferguson,1953).Indeed,Fergusonnotesthat“Pennsylvania’scurrencywasesteemed by all classes and regarded as having contributed to the growth and prosperity of thecolony”(p.159),andthat“Favourabletestimonycanbefoundinnearlyallcommentators,modernorcontemporary”.(p.163)AdamSmith,writingintheWealthofNations,commentedthatthesuccessofthesystemwasdependentonthreecircumstances:“First,uponthedemandforsomeotherinstrumentofcommerce,besidesgoldandsilvermoney,orupon the demand for such a quantity of consumable stock as could not be had without sendingabroadthegreaterpartoftheirgoldandsilvermoney,inordertopurchaseit;secondly,uponthegoodcreditofthegovernmentwhichmadeuseofthisexpedient;and,thirdly,uponthemoderationwithwhichitwasused,thewholevalueofthepaperbillsofcreditneverexceedingthatofthegoldandsilvermoneywhichwouldhavebeennecessaryforcarryingontheircirculation,hadtherebeennopaperbillsofcredit.”(Smith,1776)

ItisclearthatthereasonforthesuccessofthePennsylvaniansystemwastheadherenceinparticularto the third circumstance. Indeed, Smith goes on to say, “The same expedient was, upon different

occasions, adopted by several other American colonies; but, from want of this moderation, itproduced,inthegreaterpartofthem,muchmoredisorderthanconveniency.”ConclusionsfromhistoricalexamplesThesetwocasestudiesshowwhenmoneycreationisandisnotinflationary.Inshort,moneycreationthatisundertakensolelytoboostgovernmentrevenue,withlittleornoregardfortheconsequences,will be inflationary (as was the case in Zimbabwe). Conversely, printingmoney to spend into theeconomy,whenperformedresponsiblyandwithaviewtoprovideameansofexchange,candeliveralow inflation environment (as was the case in Pennsylvania).While the Pennsylvanian experimentshowsthatalowinflationenvironmentisachievable,itreliedontheresponsiblebehaviourofthoseadministeringit.Many governments are not known for spending responsibly, particularly when elections areapproaching.Inordertopreventthisconflictofinterest,theproposalsinthisbooksplitsthedecisionoverhowmuchmoneytocreatefromthedecisionoverhowthatmoneywillbespent,toensurethatmoneyisonlycreated,ifnecessary,duringperiodswheninflationislowandstable.

Footnotes1. For example, in 1992 GDP dropped by nine percent due to the worst drought in 50 years(Richardson,2005).2. While these political tensions were present before Zimbabwe’s independence, the election ofRobertMugabeincreasedthehostilerhetoric.3. In fact, theReserveBank ofZimbabwepredicted such a response in early 2000.AsRichardson(2005) states: “In early 2000,Mugabewas handed a confidentialmemo from theReserveBank ofZimbabwe, the country’s central bank. The memo predicted that going forward with farmlandseizureswouldresultinapulloutofforeigninvestment,defaultsonfarmbankloans,andamassivedeclineinagriculturalproduction.”4.Althoughthereisnoreliabledatadisplayingthefinancialcostsof landreform,economistshaveestimatedtheaggregatedagriculturalindustry’soutputfallingfrom4.3milliontonsin2000(worth,at today’s prices US$3.35 billion) to just 1.4 million tons in 2009 (worth some US$1 billion), adecline of more than two thirds in overall volume and value. Smallholder farmers’ productionsufferedsimilarlosses,withoutputdecreasingsome73percentinthesameperiod.5. In response both the opposition and the Commercial Farmers Union (CFU) took legal action.AlthoughinitiallyapprovedbytheSupremeCourt,whichchallengedthelegalityofthelandreformprogramme,theChiefJusticeAntonyGubbaywassubsequentlythreatenedwithphysicalviolenceandforcedtoresign.Hewasimmediatelyreplacedbyajudgesympathetictothegovernment.In2005thegovernment completely removed any remaining right of commercial farmers to have the courtsadjudicateontheconfiscationoftheirproperties(ConstitutionalAmendmentno.17).6.Themanufacturingsector ’soutputhadalreadyshrunkbymorethan47percentbetween1998and2006(Coltart,2008).7.Theterm‘dollarisation’canbedefinedaswhentheinhabitantsofacountryuseaforeigncurrency(usuallytheUSdollar)foreverydaytransactions.Theforeigncurrencycaneitherreplaceorsimplyoperatealongsidethedomesticcurrency.8.AsreportedbytheIMF:“Underthissystem,transactionsinhardforeigncurrenciesareauthorized,paymentsoftaxesaremandatoryinforeignexchange,andtheexchangesystemlargelyisliberalized.SincetheabolitionofallsurrenderrequirementsonforeignexchangeproceedsonMarch19,2009,there has not been a functioning foreign exchange market for Zimbabwe dollars. Bank accountsdenominated inZimbabwedollars (equivalent to aboutUS$6million at the exchange rate ofZ$35quadrillion per US$1) are dormant. Use of the Zimbabwe dollar as domestic currency has beendiscontinued until 2012. While five foreign currencies have been granted official status, the U.S.dollarhasbecometheprincipalcurrency.”(IMF,2010)9.Thismethodofpaymentisdistinctfrombartertradefortworeasons.Firstly,themonetaryvalueoftheseproductswasfixedbylawindifferenttimesandregions.Secondly,debtorswere“permittedbystatute to pay certain debts with their choice of these commodities at nominal values set by thecoloniallegislature.”(Michener,2010)10.Countrypayconsistedofvariousagriculturalproductsthathadbeenmonetisedbylaw.11. As Hyman Minsky noted, “anyone can create money, the problem is in getting it accepted.”(Minsky,1986)12.Until1729severaladditionalamountsofpapermoneywereissuedinPennsylvania,butoverallno

morethan85,000cameintocirculationatanytimeduringthefirsthalfoftheeighteenthcentury(seeMiddleton2002).

APPENDIXIIREDUCINGTHENATIONALDEBT

As discussed in Chapter 7, one potential use of newly created money could be to pay down theexisting national (government) debt. In this appendix we explain the basic concepts necessary tounderstandthenationaldebt.Wethendiscussthereasonswhyinthecontextofthesereforms,payingdownthenationaldebtisnotthetoppriority.Whatisthenationaldebt?Thegovernmenthasthreemainsourcesofrevenue:

1. Taxes&fees-suchasIncomeTax,NationalInsurance,ValueAddedTax(VAT),taxesonalcohol,fuel,airticketsandsoon.

2. Borrowing-thisismainlyachievedthroughtheissuingofbonds.3. Creationofmoney-therevenuefromthissourceisminisculeunderthecurrentmonetary

system.

Ifgovernmentspendsmorethanitcollectsintaxesthedifferenceiscalledthe‘deficit’.Ifitcollectsmoreintaxesthanitspends,thisdifferenceiscalleda‘surplus’.SurpluseshavebeenrelativelyrareintheUKinrecentdecades,withthegovernmenttypicallyrunningdeficits,spendingmorethantheycollectintaxesandborrowingtomakeupthedifference.Thesedeficitshaveincreasedthenominalvalueofthenationaldebt(whereassurpluseswouldhavereducedit).Whodoesthegovernmentborrowfrom?Ratherthanborrowingfrombanks,thegovernmenttypicallyborrowsfromthe‘market’-primarilypensionfundsandinsurancecompanies.Thesecompanieslendmoneytothegovernmentbybuyingthebonds that thegovernment issues for thispurpose.Manycompanies favour investingmoney ingovernmentbondsduetothelackofriskinvolved–theUKgovernmenthasneverdefaultedonitsdebtobligationsandisunlikelytointhefuture(primarilybecauseitisabletocollectmoneyfromthepublicviataxation).Themarketingovernmentdebtalsotendstobestableandliquid,andoffersaninterestrateinexcessofthatwhichisavailableonotherrisklessinvestments.Doesgovernmentborrowingcreatenewmoney?Inmost cases government borrowingdoesnot create anynewmoney.Whilemost individuals andbusinesses accept bank deposits in payment, the UK government does not; they require that thepurchasers of new bonds ‘settle’ the transaction by transferring central bank reserves into agovernment-ownedaccountattheBankofEngland.Forexample,let’ssayapensionfundholdsanaccountatMegaBank,andwishestobuy£1millioningovernmentbonds.ThefundasksMegaBank,whichisoneoftheGilt-EdgedMarketMakers(abankauthorizedtodealdirectlywiththegovernmentinthepurchaseofnewbonds),tobuy£1millionofnew government bonds. MegaBank decreases the pension fund’s account by £1 million and thenpurchases thebondsonbehalfof thepension fund.Tosettle its transactionwith thegovernment, ittransfers£1millionofreservestothegovernment’saccountattheBankofEngland.ThebalanceofMegaBank’saccountat theBankofEnglandwilldropby£1million.Thegovernmentnowhas£1

millionof centralbank reserves in its accountat theBankofEngland,whichcanbeused tomakepayments.Ithasborrowedthemoneywithoutanyadditionaldepositsbeingcreated.TospendthemoneyitcouldnowtransferthereservestoRegalBankwhereanNHShospitalholdsanaccount.Regalbankwouldthenreceive£1millionofcentralbankreserves,andcouldincreasetheaccountbalanceofthehospitalby£1million.So througha rather convolutedprocess,£1millionofbank-createdbankdepositshavebeen takenfrom pension fund contributors and passed to an NHS hospital. No additional money has beencreated;onlypre-existingdepositshavebeenmovedfromoneplacetoanother.Becausethemajorityof government borrowing is done in this way it does not constitute a monetary stimulus to theeconomy.Isitpossibletoreducethenationaldebt?Thedebtiscurrentlyhigher(innominalterms)thanit’severbeenbefore.Whilethegovernmenttalksaboutreducingthedeficit,therealityisthatthetotalnationaldebtwillkeepgrowing.Evenifitstopsthedebtgrowing,taxpayerswillcontinuepayingaround£120millionadayininterestonthenationaldebt.To understand why, consider what would need to happen for the debt to be paid down. First, thegovernmentwouldneedtostartpayingtheannual interestonthenationaldebteachyearoutof taxrevenue,ratherthansimplyborrowingthemoneytodoso.Interestpaymentstotalled£43bnfor2012–so,ifthegovernmentwantedtoreducethedebtitwouldhavetofindanadditional£43bnintaxes,whichwouldrequire,everythingelsebeingequal,raisingVAT(salestax)toroughly30%(fromitscurrentlevelof20%).In addition, in the five years before the banking crisis the government spent an average of 10.6%morethanitreceivedintaxeseveryyear.Soevenafterthe£43bninterestonthenationaldebtispaid,to run a ‘balanced budget’ right now, itwould need to raise an extra £22bn in taxes (to cover the10.6%shortfall),orcutpublicservicesby£22bn-equivalenttoshuttingdownafifthoftheNHS.Sofarinthisexample,thegovernmenthasraisedVATby30%andcut£22bnofpublicservicesandhasstillonlymanagedtostopthedebtgrowing.Inordertoactuallyreducethedebt,itneedstoraisetaxesevenfurther,orreducepublicspendingevenmore.Ifthegovernmentdecidedthatitwantedtopayoff£30bnofnationaldebteverysingleyear,thenitwouldneedtoraiseanotherextra£30bnintaxes:equivalent todoublingcouncil tax.Evenat this level itwould take30years topaydown thenationaldebt,assumingtaxrevenueisunaffectedbythesechanges.Themajorproblemwiththesesortsofcalculationsisofcoursethateverythingelseisnotheldequal.Increasing taxes by such large amounts is likely to lead to a recession and even a depression:businesseswillpassonthecostsofhighertaxestotheirconsumers,withtheincreaseinpriceslikelyto lower demand for goods and services. Likewise, faced with higher taxes individuals will havelower levels of disposable income, and, independent of the increase in prices this will negativelyaffectdemand.Bothfactorswillfeedthroughtolowersalesandthereforelowersalestaxes,forcingthegovernmenttofurtherincreasetaxestohititsdebtreductiontarget.Lowerdemandforgoodsandserviceswill also lead tobusinesses cutting employment, lowering thegovernment’s income fromemploymenttaxes.Higherlevelsofunemploymentwillalsoincreasethegovernment’sspendingonunemploymentbenefits,whichwillhave tobe funded through furtherborrowing,againpreventingthegovernmentfromhittingitstargets.Alternativelythegovernmentcouldcutitsspending.However,thisislikelytohavesimilareffectsto

increasing taxes. During recessions people tend to cut their spending - if the government cuts itsspending at the same time the result can be a catastrophic drop in demand.This of course lowersoutputandthereforethetaxtake.Indeed,inapaperlookingateightepisodesoffiscalconsolidations(cutsingovernmentspending),ChickandPettifor(2010)findthat:“Theempiricalevidencerunsexactlycountertoconventionalthinking.Fiscalconsolidationshavenot improved the public finances.This is true of all episodes examined, except at the end of theconsolidationafterWorldWar II,whereactionwas taken tobolsterprivatedemand inparallel topublicretrenchment.”

As theypointout this runscontrary tomainstream thinking,where recessionsare thought tobe,atleastinthelong-term,self-correcting.Thepresumptionisthateventuallythefallindemandwillleadto lower prices, at which point demand increases (as the fall in prices increases relative wealth),whichincreasesdemand(thePigou-Pantinkineffect).However,aswasdiscussedinchapter9,whenmoneyiscreatedwithacorrespondingdebt,afallinpricesleadstoanincreaseintherealvalueofdebt, thus the negative debt effect offsets the positive wealth effects. Thus loweringspending/increasing taxes is likely to lead to a fall in tax revenues, requiring even further taxincreases/spendingcutsandsoon.Infact,inthissituationadebtdeflationscenarioisfarmorelikelyifthepopulationishighlyindebtedtobeginwith.Isitdesirabletoreducethenationaldebt?Onthesurface,payingoffgovernmentdebtmaybebeneficialbecauselowergovernmentdebtfreesupgovernmentrevenueforcoreservices.Itisarguedthathighlevelsofgovernmentdebtmayalsobeproblematicinthelongrunbecause:

1. Government bonds compete with private sector investments for funds, so governmentborrowingdivertsmoneyawayfromtheprivatesectorinvestmentsandincreasestherateofinteresttheprivatesectorpaystoattractfunds.

2. Individualsstartsavingmore(andsospendingless)inexpectationofanincreaseinfuturetaxes(topayoffthedebt).

3. Because of the potential for adverse affects to long term interest rates and the exchangerate.1

Thereisalsothedangerthatexcessivegovernmentdebtcanleadtoasovereigndebtcrisis,asseeninGreeceandotherEurozonecountries.However,forcountriesthatretaincontroloftheircurrencies(i.e. those thathavecentralbanks thatareable toprintcurrency,suchas theUK, theUS,Japan,butcrucially not the Eurozone countries) defaulting on debt is always a choice, as the country couldsimplyprintcurrencytopayoff itsdebts.Ofcourse, if thisprintingofcurrencycausedsignificantinflationitwouldreducetherealvalueofthedebtandrepresentaformofhiddendefault,inthattheholdersofthedebtwouldnotberepaidasmuch,inrealterms,astheyinitiallyinvested.Howeveritisimportanttoalsorecognisethepositiveeffectsthatcomefromhavinganationaldebt.First,asmentionedpreviously,thedebtgivestheprivatesectorasafeassetinwhichitcaninvest.Thisstrengthens private sector balance sheets, increasing their robustness in the face of downturns andnegativeshocks.Second, itallowsadegreeofcertaintyfor institutional investors lookingfor longtermreturns.Third, itallows theprivatesector (excluding thegovernment), inaggregate toholdapositivebalanceofwealth(seeforexampleGodleyandLavoie(2012)).Fourth,itisnotappropriate

tothinkofthenationaldebtinthesamewayaswethinkaboutprivatedebts–inthemainitisnotadebt thatweowe tootherpeople.Themajorholdersof thenationaldebtareUKinvestors:mainlypensionfundsandinsurancecompanies.Thus,itisinmanysensesadebtweowetoourselves(albeititoneowedbycurrenttaxpayerstocurrentholdersofthedebt).Inaddition,itisimportanttorememberthatthenominalvalueofthedebtisnotactuallyimportant;itis the level of debt (and its maturity) relative to the earning capacity of the economy that is theimportant figure.Forexample,an individualwithno incomeandnoassetsmayconsideradebtof£10,000impossibletorepay,yetanindividualthatearns£1millionayearwouldconsiderthesamedebtaninconsequentialsum.Broadlyspeaking,the‘income’oftheeconomycanberepresentedbyGDP.FigureII.1showsthenationaldebtasapercentageofthecountry’sGDP.fig.II.1Nationaldebtas%ofGDP

Source:Krugman,2011Thisbringsintocontextthecommentsmadeearlieraboutthegovernmentneverreallypayingoffitsdebt.Insteadofpayingoffthedebtbyactuallyreducingitsnominalvalue,insteadthedebttendstobereduced over time in terms of its burden.Rather than decrease the debt, the earning ability of theeconomy(GDP)isincreased.UnsurprisinglythenationaldebttoGDPratiotendstoshootupduringwars–suchasWorldWarI(from£650min1914to£7.4bnin1919)andWorldWarII(from£7.1bnin1939to£24.7bnin1949).It also shot up significantly in 2008 onwards, as the tax take plummeted due to the recession andspending(forexampleonunemploymentbenefits) increased(theborrowingtobailoutbanksisnotincludedinthemainnationaldebtfigures).Itispertinenttonoteherethatdespitethefinancialcrisis,publicdebtisactuallyatahistoricallylowlevel.Inaddition,wemustbeclearthatthelargestpartoftherecentincreaseinpublicdebtcameaboutnotduetotoomuchspending,butratherasaresultof

thegovernment’sreactiontothefinancialcrisis.Thisbringsustothecruxoftheargument.Thefirsthalfofthisbookwaslargelyconcernedwiththeeffectofthebankingsectorontheeconomyandsocietyasawhole.Theexcessivecreationofprivatedebtwasshowntobeamajorcauseofboombustcycles,financialcrises,recessions,etc.Ascanbeseenfromfigure4.1, the levelofprivatedebt farexceeds the levelofpublicdebt,andassuch thisshouldbethefocusofdebtreductionefforts.Aswellaslookingatabsolutevalues,thecostofdebtshouldalsobeconsidered(i.e.theinterestrateon the debt). In this context the overall interest rate on the national debt between 2000 and 2012worked out at around 5.6% per annum (Webb& Bardens, 2012). In contrast, the interest rate forhouseholddebtrangesbetween6%andaboveformortgages,rightupto17%oncreditcardsandupto29%onstorecards.Overall,theaverageinterestrateisundoubtedlyhigherforhouseholdsthanitis for the government. For these reasons, the government should focus on enabling the public toreduceitsdebts.PayingdownthenationaldebtinareformedmonetarysystemAsoutlinedinChapter7,oneusefornewlycreatedmoneyinareformedbankingsystemistopaydownapartofthenationaldebt.Giventheargumentsabove,itwouldbemisguidedtoconcentrateonattemptingtodothisimmediatelyfollowingthereforms.Afarbetteruseofthemoneywouldbetoencouragepeopletopaydowntheirown,larger,moreexpensivedebts(viataxcuts,publicspendingordirectpaymentstocitizens).However,inthelongertermitmaybeconsidereddesirabletoreducethedebt toGDPratio,andevenperhapspaydownsomeof thedebt innominal terms ifconditionsallowforit.However,reducingtheabsolutelevelofthedebtmayalsobeundesirableforotherreasons.Payingoffpartofthenationaldebtinvolvesreducingthequantityofgovernmentbondsincirculation,which,if it is done too quickly, will force pension funds to shift their investments from bonds to otherinvestments,suchascorporatebonds(riskier)andthestockmarket(muchriskier).Furthermore, ifthis was done too quickly the effect of over £1 trillion (the current national debt, approximately)shiftingfromthebondmarkettothestockmarketandcorporatebondmarketwouldbeliketippingabathofwaterintoasmallpond–creatinghugewavesinthemarket,possiblycreatingbubbles.Inaddition,anymoneythatisusedtorepaygovernmentdebtwillbetransferredtothoseinstitutionsthatwereholdinggovernmentbonds.Becausemostofthesebondswereinitiallyaformofsavings,itislikelythatthismoneywillbeputbackintothefinancialmarkets(i.e.peoplewon’tsuddenlystartspendingmoneytheyhadalloctedassaving).Usingnewly-createdmoneytopaydownthenationaldebtwillpumpthismoneyintothefinancialmarkets,whereitmaystaycirculating,fuellingfinancialmarketbubblesanddoinglittleornothingtohelptherealeconomy.Toavoid this, if itwas thoughtdesirable to reduce thenominalvalueof thedebt,bonds shouldberemovedfromcirculationoveraperiodoftime.Fundmanagerswouldbewellawarethataportionofgovernmentbondswerebeing‘phasedout’,butwouldhavearoundtentofifteenyears inwhichtheycouldgraduallyshifttheirinvestmentsawayfromthebondmarketandintocorporatebondsandthe stock market. This would avoid causing any bubbles in the market, avoid a flood of ‘cheap’moneyintothecorporatebondmarket,andsafeguardthevalueofpensions.Isthis‘monetising’thenationaldebt?Theproposalsoutlinedinthisbookdonotpermittheelectedgovernmenttohaveanysayoverhowmuchmoneyiscreated,ortocreatemoneysimplytopayoffthenationaldebt.Thisdecisionisgiven

toanindependentcommittee,theMoneyCreationCommittee.Moneywouldonlybecreatedaslongas inflation is low, steady, andwithin the target range. Ifmoney used to pay off the national debtstartedtofeedintoinflation,theMCCwouldthenbeunabletocontinuecreatingnewmoneyandthegovernmentwouldberestrictedtopayingdownthenationaldebtusingmoneyfromtaxrevenue.Asimilarargumentappliestothechargethatthiswouldallowthegovernmenttoinflateawaythedebtbyprintingmoney.Inthissituationsaverssufferasthepurchasingpoweroftheirsavingsfallsasaresultoftheinflation.Converselydebtorsbenefit,astheirdebts,whichdonotincreasewithinflation,aresmallerinrealterms.Itishowevernotpossibleforthegovernmenttosimplyturnontheprintingpress,forthesamereasonasbefore–theMCCisanindependentbodythatwillonlycreatemoney,ifnecessary,duringperiodswheninflationislowandstable.

Footnotes1.Thesearealltheoreticalarguments;theempiricalevidencefortheseeffectsismixedatbest.

APPENDIXIIIACCOUNTINGFORTHEMONEYCREATIONPROCESS

ThereformsoutlinedinthisbookmodernisetheprocessbywhichmoneycreationisaccountedforattheBankofEnglandandtheTreasury.Insteadoftreatingmoneyasaliabilityoftheissuer(asisthecurrentsetupforbanknotes),wetreatmoney as a token, issued by the state. Thismoney is accepted and used by people and businessesbecausetheyareconfidenttheycanexchangethesetokenswithotherpeopleforgoodsorservicesofequivalentvalue.Ingeneral,iftoomanyofthesetokensareissued,theirvaluewillfall,intermsoftheamountofgoodsorservicestheycanbuy.Thisisinflation.Conversely,ifinsufficienttokensareissued,theirvaluewillrise–thisisdeflation.Thecurrent‘backing’forbanknotesTheconceptof‘backing’thecurrencyisahangoverfromthedayswhenpoundsterlingbanknoteswereineffectreceiptsforgoldheldattheBankofEngland.Banknoteshavenotbeenbackedbyorredeemableforgoldsince1931,anddespitethephrase“Ipromisetopaythebearerondemandthesumof£10”ona tenpoundsterlingbanknote, ifyoureturnthisnoteto theBankofEngland,youwillbegivennotgold,butan identicalnoteofequalvalue.TheBankofEngland’sownwebsite isquiteclearaboutthis:“Thewords‘Ipromisetopaythebearerondemandthesumoffive[ten/twenty/fifty]pounds’datefromlongagowhenournotesrepresenteddepositsofgold.Atthat time,amemberofthepubliccouldexchangeoneofourbanknotesforgoldtothesamevalue.Forexample,a£5notecouldbeexchangedforfivegoldcoins,calledsovereigns.Butthevalueofthepoundhasnotbeenlinkedtogoldformanyyears,sothemeaningofthepromisetopayhaschanged.ExchangeintogoldisnolongerpossibleandBankofEnglandnotescanonlybeexchangedforotherBankofEnglandnotesofthesamefacevalue.”(BankofEnglandwebsite–FAQs)

However, theBank of England still retains the accounting structure it usedwhen bank noteswereredeemableforgold.Banknotesarerecordedasliabilities(promisestopay)onthebalancesheetofthe Bank of England’s Issue Department. These liabilities are backed by assets, in the form ofgovernmentbondsandother financialassets.The IssueDepartment’sbalancesheet,asofFebruary2012,wasasfollows:

Assets 2012£million

Britishgovernmentbonds 5,749

DepositwiththeBankingDepartmentoftheBankofEngland(i.e.centralbankreserves) 47,172

ReverseRepurchaseAgreements 1,610

Totalassets 54,921

Liabilities

Notesissuedincirculation 54,921

TotalLiabilities 54,921

Theimplicationofthisbalancesheetisthatthenoteissueisbackedbygovernmentbondsi.e.thedebtof thegovernment. (The£47bn‘Depositwith theBankingDepartmentof theBankofEngland’ isaliability of the Bank of England’s ‘Banking Department’ balance sheet, which is effectively itselfbackedbyanotherasset-anotherholdingofgovernmentbondsthroughtheAssetPurchaseFacilityFund.)Thereisonelogicalreasonwhythenoteissueis‘backed’bybonds.Whennotesarefirstprinted,theyaresold tocommercialbanksat facevalue.Commercialbankscanpay for thesenotesbyhandingover an equivalent value ofBritish government bonds, orwith a transfer from the bank’s reserveaccountattheBankofEngland.SothebondsandthedepositattheBankingDepartmentwhichappearon theassetssideof theIssueDepartment’sbalancesheetactuallyrepresent thefinancialassets thatbankshaveusedto‘pay’forthenotesissuedtothem.Butinreality,notesshouldhaveceasedtobeliabilitiesoftheBankofEngland,orofanypartofthestate,whentheyceasedtoberedeemableforgoldin1931.Aliabilityisapromisetopaysomevaluein the future,but theBankofEngland isnot required togiveanythingofvalue toholdersofbanknotes,otherthanidenticalbanknotes.Soalthoughthenotesappeartobe‘backed’bythegovernmentbonds, this is nonsensical; if notes are backed by government bonds, thenwhat backs governmentbonds? The answer is that government bonds are backed by the ability of government to collectmoneyfromthepublic,forcibly,throughtaxation.Soclaimingthatnotesare‘backed’bygovernmentbondsisentirelycircular:theargumentwouldbethatnotesarebackedbybonds,whicharebackedbytheabilityofthegovernmenttogetnotesfromthepublicthroughtaxation.Inotherwords,thenoteswouldbebackedindirectlybythemselves.

BoxIII.A-BankofEngland’sBalanceSheet

Eversincethe1844BankCharterAct,theBankofEnglandhasbeenrequiredbylawtomaintaintwoseparatebalancesheets.Oneofthebalancesheets, theIssueDepartment,coversthebusinessof issuingbanknotes(coinsaredealtwithbytheTreasury),whiletheother–theBankingDepartment–coversalltherestofthebank’sactivities.TheIssueDepartmentdoesnotcorrespondtoanyactualdepartmentorofficeintheBankofEngland;itissimplyasetofaccountsthatmeasuresacertainpartoftheBankofEngland’sassetsandliabilities.

Therealityisthatnotesgettheirvalue,notfromwhatassetsareonthebalancesheetoftheBankofEngland,butfromwhattheycanbeexchangedforintheeconomy.SothereisnoneedfortheBankof England to hold backing assets to ‘back’ the currency it issues. This applies to notes, andwillequallyapplytoelectronicmoneyissuedbythestate,post-reform.Surprisinglyhowever,italreadyappliestocoinsissuedintheUnitedStates,asdescribedbelow.TheprocessforissuingcoinsintheUSATheaccountingregimeusedbytheUnitedStatesgovernmentfortheissuancesofcoinsismuchmoreappropriate,andwithsomesmalladaptations,providesthebasisfortheissuanceofelectronicmoneyinareformedsystem.WithintheexistingsystemintheUS,coinsaremanufacturedbytheUSMint,whichsellsthecoinsatfacevalue to theFederalReserves,who in turn sells themat facevalue to commercial banks.Theprofitonthecreationofcoins,1whichisthedifferencebetweenthecostofmanufactureandthefacevalue,isknownasseigniorage,asdescribedintheUSMint’sannualreport:“Seigniorage equals the face value of newly minted coins less the cost of production (which

includes the cost of metal, manufacturing, and transportation). Seigniorage adds to thegovernment’scashbalance,butunlikethepaymentoftaxesorotherreceipts,itdoesnotinvolveatransferoffinancialassetsfromthepublic.Instead,itarisesfromtheexerciseofthegovernment’ssovereign power to createmoney and the public’s desire to hold financial assets in the form ofcoins.”(USMint,2011)

ThekeydifferencesbetweenUScoinsandUKnotesAsdescribedabove,notesarestillconsideredtobeliabilitiesoftheBankofEngland,eventhoughthe‘promisetopay’elementofthenoteismeaningless,asitcanonlybeexchangedforanotheridenticalnote. In theUK, coins are also treatedas a liabilityof thegovernment and recordedaspart of thenationaldebt,eventhoughthereisnologicalbasisforthis.Incontrast,coinsintheUSaretreatedasatoken,createdbytheUSMint,butthenheldasanassetoftheFederalReserve.Onceincirculation,coinsareanassetoftheholder,buttheyarenotaliabilityofanypartofthegovernmentortheUSMint.Webelievethat theprocessofissuingnotesshouldbeadaptedtobeconsistentwiththeprocessforissuingcoinsused in theUS,and that the issuanceofelectronicmoneypost-reformshouldalsobeconsistentwiththeprocessforcoins.Thiswouldmeanthatcoins,notesandelectronicpoundswouldallbeassetsoftheholder,butwouldnotbealiabilitytoanybody.ThissameapproachisendorsedinaworkingpaperfromIMFeconomistsconsideringtheoriginalChicagoplanformonetaryreform:“[It]iscriticaltorealizethatthestockofreserves,ormoney,newlyissuedbythegovernmentisnota debt [i.e. liability] of the government. The reason is that fiatmoney is not redeemable, in thatholders of money cannot claim repayment in something other than money. Money is thereforeproperlytreatedasgovernmentequityratherthangovernmentdebt,whichisexactlyhowtreasurycoiniscurrentlytreatedunderU.S.accountingconventions.”(Benes&Kumhof,2012)

Thepost-reformprocessforissuingelectronicmoneyElectronic,state-issuedcurrencywillsimplybeanumberinanaccountattheBankofEngland.TheseaccountswillbeheldofftheBankofEngland’sbalancesheet,sothesenumbersarenotliabilitiesoftheBankofEngland.Instead,theyshouldbeseenaselectronictokens,heldincustodyfortheownersof the tokens (money). The owners may be banks (for the Investment Pools and OperationalAccounts),thegovernment(fortheCentralGovernmentAccount)ormembersofthepublic(fortheaggregatedCustomerFundsAccounts).WhentheMoneyCreationCommitteemakesadecisiontoincreasethemoneysupply,theywilldososimplybyincreasingthebalanceoftheCentralGovernmentAccountbythatamount.EnsuringthatelectronicmoneycannotbeforgedTherearetwoapproachestoensuringthatelectronicmoneycannotbeforgedorcreatedbyanyoneother than the state.The first,most complex approach is tomake every electronic pound a uniquetoken,with serialnumbers and some formof encryptionandvalidationprocess to check that eachtokenisvalid.Butnomatterhowsecuretheencryption,thisprocesswouldbeamagnetforcomputerhackers, since successfully ‘breaking the code’ would mean that the hacker had quite literallyacquiredthepowertocreatemoney.Afarsimplerway,andtheapproachwehavetaken,istoholdallstate-issuedelectroniccurrencyinaccountsatthecentralbank(theBankofEngland).Withthisapproach,thereisnoneedtoencryptthemoney–itcansimplybenumbersinanaccount.TheBankofEngland’scurrentpaymentsystem,the

‘RTGS processor ’, would be more than sufficient for this purpose. Banks would connect to thissystem (as they currently do to theBank ofEngland’sRTGS system).However, the systemwouldonlyacceptonetypeofmessage,intheformat:“Move£…fromAccountYtoAccountZ”.

Thisensuresthatthetotalbalanceofallaccounts–andthereforethetotalelectronicmoneysupply–cannot be increased in anyway by banks. Bankswould only be able to transfermoney from oneaccounttoanother.Reclaimingseigniorageonnotes&electronicmoneyPost-reform, the state will earn the seigniorage on the creation of electronic money. The cost ofproductionofelectronicmoneyispracticallyzero,meaningthattheseigniorageiseffectively100%ofthefacevalue.Strictly theonlycostsof theproductionofelectronicmoneywouldbepayinganofficial at theBankofEngland to increase thebalanceof theCentralGovernmentAccount, plus acouple of other officials (probably including the Governor) to validate the process and enternecessarypasswords.Thisreformreclaimstheseigniorageonthecreationofmoneyfromcommercialbanks.Withinthecurrent system, the commercial banks do not earn the full face value of the money they create;instead,theygainbytheinteresttheyearnfromtheinterest-bearingassets(i.e.loans,mortgages)thattheybuywiththemoneytheycreate.Howeverbyissuingelectronicmoney,thestatewillgainthefullfacevalueoftheelectronicmoney,meaningthattheimmediatecosttobanksoflosingthismoney-issuingpowerisactuallylessthanthebenefittothestate(andtaxpayers)ofreclaimingit.ModernisingthenoteissuanceThereisonefinalmodernisationtomaketotheissuanceofbanknotesandcoins.Asdescribedabove,bank notes are sold to banks at face value, in exchange for government bonds. The governmentcontinuestopayinterestonthesebondstotheBankofEngland,andtheBankofEnglandrecordsthisas a profit of its Issue Department’s balance sheet and returns 100% of this profit back to thegovernment.Sowithinthecurrentsystem,theseigniorageonbanknotesisnotthedifferencebetweencostofproductionandthefacevalue,buttheinterestthatisearnedonthebondsthatare‘bought’withthenotes.Ineffect,thisconvolutedprocesssimplymeansthatsomeoftheinterestthatthegovernmentmustpayonnationaldebtisreturneddirectlytothegovernment,makingthispartofthenationaldebt‘interestfree’.However,post-reform,coinsandnoteswillnotbesoldtothebanksinexchangeforbondsandotherassets.Instead,theywillbeprintedinresponsetodemandfrombanksandthenswapped,one-for-one,withelectronicstate-issuedcurrencyownedbythebanks.Soifabankwishestoincreasetheamountof physical cash it is holding, theBankofEnglandwill provide the cash anddeduct an equivalentamount of electronic money from the bank’s Operational Account at the Bank of England. Theelectronicmoneydeductedwillbetransferredintoanaccountcalledthe‘CashinCirculationDummyAccount’,whichwilleffectivelykeeptheelectronicmoneyoutofcirculation,sothattheissuanceofextraphysicalcashintotheeconomy(forexample,intherunuptotheChristmasshoppingperiod)doesnotaltertheoverallmoneysupply.Seignioragewillbeearnedatthepointwhenelectronicmoneyiscreated.Coinsandnotesbecome,ineffect,physicalportableversionsoftheelectronicmoney,andsonoseignioragewillbeearnedatthepointwhereelectroniccurrencyisswappedforphysicalcash.

ANALTERNATIVEACCOUNTINGTREATMENTThe accounting treatment outlined in this book is not the onlyway inwhich the accounting for areformedsystemcanbepresented.Forexample,intheirbook‘CreatingNewMoney’(2000),JosephHuber and James Robertson present a monetary reform which served as the inspiration for theproposals outlined in this book. However, unlike the treatment presented in Chapter 8, Huber andRobertson’sproposalmaintainscustomeraccountsontheliabilitiessideofthecentralbank’sbalancesheet.Whichever system of accounting is used is mainly a matter of taste and is largely immaterial.Accountancyisafterallnotthereality,ratheritistherecordingofthereality.TheAmericanInstituteofCertifiedPublicAccountants(AICPA)definesaccountancyas:“theartofrecording,classifying,andsummarizinginasignificantmannerandintermsofmoney,transactionsandeventswhichare,inpartatleast,offinancialcharacter,andinterpretingtheresultsthereof.”(AICPACommitteeonTerminology,1953).

Inordertounderstandhowmoney,andtheassets‘backing’moneyareclassifiedonabalancesheetinareformedsystem,wemustfirstbrieflyexaminethecurrentarrangements.ThisisaddressedinBoxIII.B.

BoxIII.B-Classifyingmoneyonabalancesheet

Withinthecurrentsystemaccountingrulesandassociatedlegislationrequirethatthecurrencyissuedbybanks-banknotes,reservesandcustomeraccounts-beclassedasliabilitiesofthosebanks(coinsaretreatedascontingentliabilitiesofthecentralgovernmentintheUK).However, a liability implies that value is expected to be paid over to a creditor. This is inappropriate treatment for fiatmoney since fiatmoney is its ownmeansof settlement. In addition, the assets that backor balance these liabilities are in general government bondsorloans(repos)collateralisedwithgovernmentbonds.Yetbondsaremerelypromises topaymoneyata futuredate–asa result,moneyheldinhandtodayissupposedlybackedbythepromiseofmoneyinthefuture.

The current system is therefore logically incoherent – money neither has anything backing it nor conforms to the proper definition of aliability.However,thisleavesuswiththequestionofhowshouldmoneythenbeaccountedforonabalancesheet?Oneoption,whichwasoutlinedinchapter8,wastoremovemoneyfromthebalancesheetentirelyandtreatitasanelectronictoken.Whilethismethodisperfectlylegitimate,itisalsopossibletoaccountformoneycreationunderareformedsystemusingtheconventionalapproach.

To see how this canwork, itmust be noted that within countries, those that use a currency constitute an economic community that co-operateintheproductionofgoodsandservices:thosethatacceptmoneytrustthattherewillbethingsavailabletospendthemoneyoninthe future, entailing production by other members of the community. Holding currency therefore entitles the holder to a share of theproductivecapacityoftheeconomyinlinewiththeirmoneyholding.Whatbacksmoneyisthereforenotbondsorloans,butthebeliefthattherewillbesomethingavailabletoswapthatmoneyforinthefuture.AsNiallFergusonputsitintheAscentofMoney:“Moneyisnotmetal.It is trust inscribed.And it doesnot seem tomattermuchwhere it is inscribed:onsilver, on clay, onpaper, ona liquid crystal display.”(2008) Money is in fact backed by the productive capacity of the economy – this can be seen quite clearly with reference to certainhistoricalepisodesofinflation.Forexample,asoutlinedinAppendixI,inthecaseofZimbabweitwasthesuddendropintheproductivecapacity of the economy that lead to the initial surge in inflation – the change in economic output lead to a change in the value of theZimbabweandollar.

Whatbacksmoneyisthe‘productivecapacityoftheeconomy’,andtheassetsideofthecentralbank’sbalancesheetshouldreflectthisfact.This leavesuswiththequestionof justhowtoclassifytheactualmonetaryunit itself.Asmentionedpreviously,a liability impliesthatvalue isexpected tobepaidover toa creditor,which isan inappropriate treatment for fiatmoneysince fiatmoney is itsownmeansofsettlement.Sinceaccountsatthecentralbank

(under the current or the reformed system) cannot reasonably be classified as liabilities of the issuing authority, whereas they areundoubtedly assets of the holder, they can only be classed as capital (equity). Indeed, this is the accountingmethod used by the USTreasurytoaccountforcoins.

Shouldmoneybeclassifiedascapital?Again,letusreturntoourobservationthatwithincountries,thosethatuseacurrencyconstituteaneconomiccommunitythatco-operateintheproductionofgoodsandservices.Individualsthatgivetheirownresourcesarepartnersintheenterprise,withthemoral(althoughnotalwaysthelegal)righttoashareinthebenefits in linewiththeir inputarisingfromtheoperationofthatenterprise.Inshort,holdingsofacurrencygiveevidenceofthecommitmentofproductiveresources,byoronbehalfoftheholdersofthecurrency, to thecommonenterprisedelimitedby thatcurrency.Currencyholdersare thereforeshareholders in thatenterpriseand their

currency holdings represent their share in the benefits arising from that enterprise, benefits that take the formof the goods and servicesavailableforsale,ortobemadeavailable,andpricedinthatcurrency.

In conclusion, the ‘asset’ backingmoney is in fact the productive capacity of the economy, whilemoney itself should be classified asequityinthecommonwealthratherthangovernmentdebt.

Thediagramsattheendofthissectionshowhowthebalancesheetofthecentralbankappearsunderthealternativeaccountingsystemproposedhere,onthedayafterthereformandalso30yearsafterthereform.Theotherbalancesheets(ofthecommercialbankingsectorandthehouseholdsector)areidenticaltothosethatappearinchapter8.Onthedayafter thereform, there isnodifferencebetweentheBankofEngland’sassetsunder thisapproachandundertheaccountingtreatmentusedinchapter8.Thereishoweveradifferenceinthecomposition of the liabilities side – equity has been split into four parts, three of which are themonetaryaccountsheldbya)banks,b)individuals,andc)thegovernment,andoneofwhichistheBank of England’s ‘shareholder equity’ (with the UK government being the only shareholder).Otherwise,everythingelseisexactlythesame,asitshouldbe–afteralltheaccountingoutlinedhereissimplyadifferentaccountingmethodofrepresentingthesamereality.ThetransitionthenproceedsexactlyasoutlinedinChapter8.Torepayloansindividualspaymoneyfrom theirTransactionAccounts to thebank fromwhom theyborrowed.Moneymoves from theirTransactionAccount to thebank’s InvestmentPooland then transferred to theOperationalAccount(alloftheseaccountswouldbeliabilitiesoftheBankofEngland).ThemoneyisthenpaidtotheBankofEngland,whowouldinnormalcircumstancesautomaticallygrantthismoneytothegovernmenttobespentbackintotheeconomy.Thesameprocessalsoapplies to therepaymentof loansthatwereinitiallymadefromthecentralbanktothecommercialbanks.Thecreationbythecentralbankofnewmoneytobegrantedtothegovernmentwillfirstincreasethegovernment’s account at thecentralbank, then, as themoney is spent, theTransactionAccountsofindividuals.ThiswillincreasetheliabilitiessideoftheBankofEngland’sbalancesheet,which,ifitisnotmatchedbyanincreaseinitsassets,willmakethecentralbankinsolvent.Inthiscasethecentralbankwillincreasethe‘productivepotentialoftheeconomy’asset,whichwillaccountforthebenefitsaccruingtotheeconomyfromthenewlyissuedmoney.So,iftheMoneyCreationCommitteewishesto increase the money supply of the economy it will simultaneously increase the balance of theCentral Government Account and the ‘productive potential of the economy’ asset on the centralbank’sbalancesheet.Anyloansfromthecentralbank toprivatebankswillbeaccountedfor in thenormalway.BecausetheMCCwillonlybechargedwithincreasingthemoneysupplywheninflationisbelowitstarget rate, this ensures that inflation will not result from the growth rate of the money supplyoutstrippingtheproductivecapacityoftheeconomy.However,ifinflationisoccurring(asaresultoftoomuchmoneychasingtoofewgoods),theMCCmaychoosetodecreasethemoneysupply.Thiscould be achieved by the Bank of England removing some tax revenue from the government’saccount(workingincollaborationwiththeTreasury)whilesimultaneouslyreducingthe‘productivecapacity of the economy’ asset. Alternatively, the central bank may choose to reduce the moneysupplythroughoneoftheothermethodsoutlinedinsection7.7.

Footnotes1.Inpracticethecostofcertainmetalscanmeanthatsmallercoins,suchas1pand2pcoinsintheUK,or5centcoinsintheUS,canattimescostmoretoproducethantheactualfacevalue,andsohavenegative seigniorage. However, this is always offset by the positive seigniorage on larger valuecoins.

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ABOUTTHEAUTHORSAndrew Jackson holds a BSc in Economics and a MSc in Development Economics from theUniversityofSussex,andiscurrentlystudyingforaPhDinManagement(specialisinginfinanceandbanking) at the University of Southampton. He co-authored the book “Where DoesMoney ComeFrom?AguidetotheUKmonetaryandbankingsystem”withJoshRyan-CollinsandTonyGreenhamfrom the New Economics Foundation, and Professor Richard Werner from the University ofSouthampton.HeiscurrentlyHeadofResearchatPositiveMoney.Andrewcanbecontactedatandrew.jackson@positivemoney.orgBenDysonhasspentthelast5yearsresearchingthecurrentmonetarysystemandunderstandingtheimpacts it has on the economy and society as awhole.He is the founder and director of PositiveMoney, a not-for-profit dedicated to raising awareness of problems with our monetary systemamongst the general public, policy makers, think tanks, charities, academics and unions. He hasspokenateventsaroundtheUK,inChicago,andfortheBBC.Bencanbecontactedatben.dyson@positivemoney.orgYou can keep in touch with Positive Money by signing up to its regular email update atwww.positivemoney.org