Central Banking, State Capitalism, and the Future of the Monetary System

First published on the CFA Institute website 

The role of commercial and central banks in the process of providing credit may seem to be clearly understood by economists, bankers, and policymakers. But there are common misunderstandings about money creation, equilibrium, public money, central banks, and interest rates. The outlook for the global monetary system is not overly optimistic in the absence of overcoming these misunderstandings and altering the philosophies of bankers.

This presentation comes from the 67th CFA Institute Annual Conference held in Seattle on 4–7 May 2014 in partnership with CFA Society Seattle.

The liberalization of finance after the 1970s led to a significant buildup of debt in many parts of the world, especially in Africa, Latin America, and parts of Asia. The inexorable rise in private corporate, household, and individual debt leads to the question of whether professional economists truly understand money, finance, and credit. Good predictions and sound investments cannot, in my view, be made without a solid understanding of money.


Misunderstandings about Money Creation

Satyajit Das (2010) noted in a post on his blog that “modern finance is generally incomprehensible to ordinary men and women. The level of comprehension of many bankers is not significantly higher. It was probably designed that way. Like the wolf in the fairy tale: ‘All the better to fleece you with.’” Misunderstandings about money creation are not uncommon, as can be seen from the title and content of Martin Wolf’s (2014) recent article in the Financial Times: “Strip Private Banks of Their Power to Create Money.” Wolf does not acknowledge that the power to create money is shared jointly between borrowers and bankers. Without applications for loans, banks would not enjoy the power to “create money (deposits) out of thin air.” As a result of this misunderstanding, and because Wolf regards bankers as irresponsible, he calls for a form of centralized control of the money supply. His proposed solution should worry us all.

Most economists conceptualize money as a commodity. By conceptualizing money in this way, economists have come to believe there can be either a shortage or a surplus of money. Furthermore, they believe that the role of bankers is to act as intermediaries between those holding stocks of money and those wanting to “rent” or borrow money—that is, savers and borrowers. This theory is deeply flawed, as is the orthodox neoliberal economic theory that assumes central banks serve as a powerful control system for sound money. An example of this thinking is Allan H. Meltzer’s (2014) article in the Wall Street Journal in which he berates the Federal Reserve Board for its role in the growing threat of inflation. A more realistic assessment is that central banks do not have as much power to control the supply of money as is typically assumed by neoclassical thinkers like Meltzer.

The Bank of England (BOE) helped shed light on the issue in its recent Quarterly Bulletin (2014a). The BOE’s staff explained that “the majority of money in the modern economy is created by commercial banks making loans” (p. 16). Mervyn King, the recent governor of the BOE, explained that UK private banks are usually responsible for 95% of the money supply; the central bank only provides 5%. The BOE staff went on to explain that “banks do not act simply as intermediaries, lending out deposits that savers place with them, and nor do they ‘multiply up’ central bank money to create new loans and deposits” (p. 16).

The bottom line is that there is no such thing as “fractional reserve banking,” which is the theory that a fraction of a licensed, commercial bank’s loans are backed by actual cash (or “reserves”) on hand. In contrast, savings banks do indeed lend out savings. There has been no such thing as fractional reserve banking since the BOE was founded to manage the banking system in 1694. This misperception is very common, even among respected economists.

Paul Sheard, chief economist at Standard & Poor’s, expressed his frustration with this widespread misunderstanding of reserves in his white paper “Repeat after Me: Banks Cannot and Do Not ‘Lend Out’ Reserves” (2013). In plain English, he explained a process that so few professional economists understand: “The loan is not created out of reserves and the loan is not created out of deposits. Loans create deposits, not the other way around” (p. 7).

The truth is that the money for a loan is not in the bank when an application for a loan is made. Savings are not needed for a loan. And savings are not needed for investment. What is needed for credit or bank money to be created (for the purposes of either investment or speculation) is an application by an individual or firm for financing.

Once the loan application is accepted and terms are agreed on, commercial banks “print” 99% of the broadly defined money in the United States. This bank money is produced as a result of a contractual arrangement with borrowers and out of nothing more than the promise of repayment. The contract promises repayment over a term and at a rate of interest. Collateral is provided to back up the promise. The law and criminal justice system uphold the contractual arrangement.

This money, created jointly “out of thin air” by both the borrower and the bank, creates economic activity; it does not come into existence as a result of economic activity. Banks were established and monetary policy and institutions were created to support economic activity (and particularly employment) through the lending of money. For a monetary system to work effectively, it requires institutions that (1) uphold contracts (the law, the criminal justice system), (2) regulate the supply of money (to avoid inflation or deflation), (3) maintain the value of the currency (the central bank), and (4) account properly for assets and liabilities (the accounting system).


Equilibrium and Disequilibrium

How can equilibrium be attained in a system in which banks can essentially create money out of thin air? The answer is through a process that, if it works well, becomes a “virtuous circle.” As part of this circle, credit is created and invested in sound productive activity at low rates of interest. This investment and activity lead, in turn, to employment. Investment can create employment and generate income and profits for firms. Employment also generates income in the form of wages and tax revenues. Income can then be used to repay the credit/debt.

But if too much credit is created and aimed at speculation rather than at productive activity, a cycle of high and unpayable debt ensues. Too much credit (money) chasing too few goods and services expands the money supply and leads, in turn, to the inflation of wages, prices, and assets and then to bankruptcies and economic failure. Alternatively, too few applications for credit contracts the money supply and threatens deflation, which leads to a downward spiral of prices, profits, bankruptcies, and wider failure.

This disequilibrium in the money supply explains the periodic crises that economies have faced. Figure 1shows a massive expansion of the US money supply leading to a sustained rise in credit market debt as a percentage of annual GDP from 1915 to 2002. The figure shows the spike in credit creation that led to the 1929 crisis as well as the stabilization of credit markets for about 30 years after World War II. During the period of stability, banks, credit creation, and capital mobility were deliberately managed by the international central banking system and by finance ministries. It is a period known by economists as “the Golden Age” in economics. As Ed Conway (2014) notes in his recent book about Bretton Woods, the Golden Age

Figure 1. US Credit Market Debt as a Percentage of Annual GDP, 1915–2002

Note: Data are as of September 2002.

Sources: Based on data from the Gabelli GAMCO Mathers Fund Quarterly and Elliott Wave International.

permitted the longest period of stability and economic growth in history. . . . The incidence of financial crises was lower than ever before. Fewer banks failed. Imbalances. . . were smaller. Over the same period, inflation was low and the income gap between the rich and the poor remained narrow.

There is no such thing as a perfect economic system; but based on its performance, many economists still argue that Bretton Woods was as close as the global economy has ever come to it. (p. xix)

It was the breakdown of the Bretton Woods system (or monetary architecture) of managed finance, coupled with the deregulation of banking and credit creation, that culminated in the economic implosion of 2007.

The state of disequilibrium that has since prevailed, and that since 2008 has come to be known as the Great Recession, can be observed in Europe and, to a lesser extent, in the United States. The 2007–09 failures of the international banking system have led to a contraction of both credit and economic activity. The contraction of credit has contracted productive activity; raised unemployment; and led to reductions in wages, profits, and tax revenues. These consequences, in turn, threaten continued deflation in Japan and raise the threat of deflation in Europe. The global economy has not within living memory experienced an era of deflation, and thus the phenomenon is not widely understood. Most economics textbooks do not even define deflation, although some dedicate several pages to discussions of inflation. In a global economy burdened with very high levels of private debt, deflation poses a serious systemic threat because although prices, wages, and profits can fall, debt repayments and debt stocks not only maintain value but also rise in value relative to falling incomes. So, although inflation erodes the cost and value of debt, deflation inflates the cost of debt.

Central Banks and Public Money

Turning to the role of public money, central banks—especially the Fed—can be perceived as being “Janus-faced”1 organizations that are aimed in two opposite directions. On the one hand, they defend the interests of the private banking sector, as in the current crisis. On the other hand, they protect the national currency and set values for it, minting a very small amount (proportionally) of paper money and coins. To a certain extent, they also manage public finances. But different central banks have different mandates.

The US Fed is largely a privately managed central bank. In contrast, the BOE is a public bank that was nationalized in 1945 because of its failure to manage the economy in the 1930s. The Fed is seen as having a dual mandate of price stability and full employment. The BOE, in contrast, has a single mandate: price stability. In further contrast, the European Central Bank operates largely in the pursuit of private interests and does not have a mandate to secure wider public interests. The absence of a public mandate and of public accountability helps explain why today there are 26 million unemployed people in Europe.

What central banks have done recently is to provide a minimum of $2.3 trillion in liquidity to the private banking sector in the United States, as well as $16 trillion in liquidity, according to the US Congress, to international banks. To be clear, that is $16 trillion backed by US taxpayers and advanced to international banks and financial institutions. There is really no reason that central banks could not use these funds to support public investment at a time of private retrenchment. But for what I perceive to be ideological reasons, policymakers shy away from proactively reviving the economy. Public investment at a time of private retrenchment could help close the virtuous circle—the public-money circuit. The closing of the circle would be completed by “the multiplier,” or the repayment of debt to the authorities by way of taxes and other revenues earned from the private incomes generated by public investment in, for example, infrastructure.

Central Banks and Interest Rates

Recall the flawed theory of money creation—promoted by professional economists—that it is a supply of savings available to borrowers and that savers are responding to borrowing demand. This theory leads to the so-called natural rate of interest at which markets clear and the economy, economists argue, reaches equilibrium. But the privilege and the power to create money offers the creator the benefit of the first use of that money, known as seigniorage. Commercial banks have seigniorage in their ability to first fix a rate and then to earn interest on the money they create. In today’s world of deregulated finance, banks fix the rate on each loan created without guidance from the central bank. Within central banks, policy rates are fixed by a committee. These independent practices of commercial and central banks demonstrate that interest rates are not the result of some magic free market supply of and demand for money. Instead, they are social constructs determined by committees of men and women in central banks and by risk assessors in private banks.

Credit oils the wheels of the economy and is based on trust—the promise of repayment. The word’s origin is “credo,” which means “I believe” (that you will repay your debt). Given the nature of credit, it can be created ad infinitum by private banks. Unlike commodities, credit can never be scarce or in short supply.

Because of the economics profession’s flawed theory of money creation—that is, based on the supply and demand for savings—most people also have a flawed understanding of interest rates and how they are managed.

Central bankers deliberately pushed policy rates to ultra-low levels after the crisis in 2009 and have left them there ever since. But these ultra-low policy rates are irrelevant to the real economy. No private firm, with the exception of private banks, borrows money at the “base rate.” Under normal circumstances, only licensed banks and financial institutions may borrow from the central bank.

This rule did not apply during the crisis when such firms as American International Group (AIG)—an insurance company—were granted access to the resources of the Federal Reserve Banks. But those were desperate times. The day after the Fed provided an $85 billion bailout to AIG, Ben Bernanke, during a rare interview, was asked where the money for the bailout came from. Was it raised through taxation? Bernanke said that it was not taxation but that the Fed, similar to any commercial bank, had at its command a computer, and that, similar to private banks, it entered numbers into the computer and charged the sum to AIG’s account.

Some have asked why central banks lower rates to help out banks, financial institutions, and certain privileged firms. Commercial banks certainly do not extend the same favor to the real economy. Figure 2 shows the spread between the bank policy rate and the rate charged to small and medium-sized enterprises (SMEs) in the United Kingdom. There is a decent spread in favor of the commercial banks, and it is a costly spread to the SMEs. What the figure shows is the result of a public bank backed by taxpayers providing low rates to the banking system so that bankers can clean up their own balance sheets at the expense of those firms active in the real economy.

Figure 2. Bank Policy Rate and Rates Charged to SMEs in the United Kingdom, January 2009–January 2014

Note: Private nonfinancial corporation loans are for £1 million or less.

Sources: Based on data from the Bank for International Settlements, the BOE, and bank calculations.

It is no wonder then that loan demand is low. A similar situation occurs with fees other than interest that are charged by commercial banks. For example, interest on overdraft fees can be as high as 20% in the United Kingdom, and again, the public is effectively aiding banks in fixing their balance sheets. The situation is similar in the United States.

Figure 3 depicts a recent unprecedented relationship between gross and net lending to UK nonfinancial businesses from 2011 to 2013. Although the price (i.e., interest rate) is very low, lending since 2011 is negative. In other words, banks are not lending to the real economy, but rather, the real economy is lending to banks by increasing deposits in banks. This development is bizarre because the banking system was designed and created by the Italians, the Dutch, and the British to create institutions that facilitate economic activity by lending into the real economy. The process has been reversed since the economic crisis and little is being done about it.

Figure 3. Gross and Net Lending to UK Nonfinancial Businesses, 2011–2013

Source: BOE (2014b).

In the United States, lending is just beginning to recover from the collapse that occurred after the crisis, but activity is nowhere near what it was before the crisis. The recovery is less advanced in the United Kingdom, where capital investment has collapsed. German investment has likewise fallen, and Germany’s current growth is largely a function of the decline in value of the euro rather than a result of sound investment. These trends should be worrisome for anyone considering the future of the global economy. Compounding the negative trend in private investment, public investment—at least in the United States—has fallen to its lowest level since World War II, which is concerning because of the combined fall in investment and because much needs to be done to refurbish the overall infrastructure of the United States and thereby strengthen private economic activity.


Given these observations, what is the outlook for the global economy? I am, unfortunately, not very optimistic.

Because of the flawed economic orthodoxy that is dominant in the economics profession and among policymakers, there has been a failure in both the banking and shadow banking sectors to regulate or to manage the private printing of money so that it is aimed at productive investment and not credit-fueled speculation. Private debt levels remain high across all the major economies, particularly the Anglo-American economies: the United States, the United Kingdom, Australia, and New Zealand.

Some deleveraging is evident in the United States, although the process has been brutal for many households because deleveraging has taken the form of home foreclosures and bankruptcies. But deleveraging is limited to the household sector in the United States; gross nonfinancial corporate debt is on the rise. Corporations are hoarding cash, but they are also increasing their leverage, even in the midst of a slump. In the United Kingdom, private debt levels remain extraordinarily high, especially in relation to GDP.

Although financial institutions are beginning to deleverage, the International Monetary Fund (IMF) remains very worried about the buildup in debt. In its most recent Global Financial Stability Report (2014), the IMF argues that debt in highly leveraged US loans now amounts to nearly seven times earnings before interest, taxes, depreciation, and amortization (EBITDA), which is close to the levels last seen in the period from 2006 to 2008. Bond yields are going to rise at some point, and any increase in interest rates will be particularly tough for heavily indebted corporates as well as for many households. A report from McKinsey Global Institute (Dobbs, Lund, Koller, Shwayder 2013) outlined that for every 100 bp increase in interest rates, total household debt payments could increase by 7% in the United States and by 19% in the United Kingdom.

Perhaps more disturbing than the concern about household debt is the level of margin debt balances at NYSE firms. Figure 4 shows the real values (adjusted for inflation) of margin debt for NYSE firms along with the performance of the S&P 500 Index from January 1995 to August 2014. The debt levels are higher now than during 2007 before the economic crisis. This high level of margin debt is a confirmation of today’s stock market euphoria. The result is that financial bubbles are emerging in many parts of the economy.

Figure 4. Margin Debt Balances for NYSE Firms and the S&P 500, January 1995–August 2014


Note: Values are real values adjusted for inflation to present-day dollars by using the US Consumer Price Index as the deflator.

Source: Based on data from Short (2014).

There are currently no real signs of inflation in the economy, despite arguments from such economists as Meltzer. The reason is because quantitative easing (QE) is misunderstood by most orthodox economists. The Fed is not printing money but merely stocking up on assets. A group of prominent economists wrote to Bernanke in 2010 stating their belief that QE should be reconsidered because it would cause inflation. They were proven very wrong. But the obsession with inflation by those who hold to flawed economic orthodoxy ignores the real threat of deflation. Deflation ratchets up the cost and value of debt service payments as well as of stocks of debt, which should worry investors. Eurostat2 has declared deflation to be a major threat in the EU, which makes the complacency of the European Central Bank frightening.

Flawed economic theories can severely distort investment priorities and fail in the analysis and prediction of crises. The people and organizations the world depends on for sound economic advice do not seem to be providing that advice. For example, central bank presidents and other policymakers met in 2013 in Jackson Hole, Wyoming. They reviewed what has transpired since the economic crisis and concluded that, despite the success of unconventional monetary policy and recent upgrades in financial regulation, there is still no way to tackle imbalances in the global economy. This conclusion means that they accept that new crises will occur in the future. I regard their attitude as irresponsible. Policymakers and economists are expected to offer sound economic advice and to manage the system so that the economy is not subjected to periodic crises. Instead, central bankers are refusing to take responsibility for stabilizing imbalances. The result, as Robin Harding of the Financial Times wrote, is that “the world is doomed to an endless cycle of bubble, financial crisis and currency collapse. Get used to it” (2013).


Question and Answer Session

Ann Pettifor

Question: Do you consider how the Basel Committee defines assets and risk weightings to be part of the issue in the misunderstanding about how credit and reserves work?

Pettifor: I do not really understand what the Basel Committee is attempting to do, but what has happened is that banks have combined their speculative investment activity with retail banking because the banks implicitly believe that they will be bailed out if necessary. Basel appears to want banks to back their loans with additional equity.

But I do not understand why banks would need capital to lend. What they need is a sound application from a sound borrower. They need a contract and collateral to lend, and they need to determine the level of risk to set a rate of interest, but they do not need equity. The fact that bankers are not currently lending has nothing to do with capital requirements. They are not lending because their balance sheets are still effectively a mess. They also do not have customers coming through their doors, and the economy is not growing at a rate that indicates sustainability.

Question: Which central banks, if any, do you think are truly helping to get their economies out of disequilibrium?

Pettifor: The BOE was very slow to understand the nature of the crisis. The European Central Bank made some very large mistakes, such as hiking interest rates at the height of the crisis in 2009. The Fed has perhaps been the most sound in its logic, but the problem is that it is “pushing on a string.”3

My criticism of central bankers is that they do not understand that fixing the banks is insufficient. Demand has to be effectively created, and if banks cannot accomplish that through lending, then the state needs to intervene to create public investment. When the economy recovers, the state should withdraw from that activity. That is what governments are for, but central banks have taken a hands-off position. To an extent, they have financed government deficits, but they have been very quiet about whether the public sector should do more to revive economic activity.

Question: Do you think there is a model that would not require nations to have central banks?

Pettifor: No, I think central banks are very important to the management of the financial system. Whenever a bank makes a loan, the central bank will create new reserves on demand in response to that loan application. That is a critical role in helping banks manage their assets and liabilities and clear with other banks. If a central bank did not do that, then currencies would not be stable, which is needed to conduct business.

Question: Is there any limit to the amount of money or credit that is created?

Pettifor: You cannot think of credit as being equivalent to income or equivalent to a set amount of economic activity. What credit does is enable people to undertake transactions, and that is all that it does. Without credit, two people or two firms who want to do business cannot do so. But credit is not a quantifiable number. People who espouse the quantity theory of money envision a select committee at the central bank that decides on a specific amount of money that is needed in the economy.

There can be too much credit in an economy, which leads to inflation, but inflation also occurs if credit is aimed at speculation rather than at productive activity. In addition, inflation occurs if credit includes very high rates of interest and cannot be repaid. Over the long run, firms make (real) profits of about 3% per year. If interest rates over time exceed 3%, the loan does not get repaid. Credit is a great thing, but it has to be managed.

Question: How does an economy get out of cycles of inflation and rapid credit without a period of deflation, or is deflation needed to return to a steady state?

Pettifor: Deflation is a threat. Policymakers and central bankers need to recognize that deflation in an environment of very high levels of debt is a terrifying prospect. There are three ways of dealing with debt: generate income to pay it down, write it off, or inflate it away. Central banks can help make any of the three options happen.

I am against inflating debt away. I believe that it should be written off because some of the loans should have never been made. In the case of write-offs, both lender and borrower should face losses. The best way of dealing with an overhang of debt is to generate income, and the best way to do that is to create employment by creating investment opportunities. That is what central banks should be arguing for instead of not taking responsibility while 26 million people in Europe are unemployed and thus not generating income.

Question: How big should the balance sheet of the Fed be: $4 trillion, $6 trillion, or $10 trillion?

Pettifor: It does not matter. What matters is getting the banks back to health. What upsets me is the way that taxpayers have to pay for the banks. Central banks should demand that banks lend into the productive sector for activities that will generate employment. Instead, central banks seem to have the view that banks can take the money and do with it as they want. That, to me, is reckless. I am not against bailing out the banking system, but it should have been done on condition that if the taxpayer is going to be paying for keeping banks clean and restoring their health, then taxpayers should have some assurances attached to the manner in which banks lend money.

Question: Do you see a return to the cycle of excess lending to sovereigns—for example, in Africa, where the debt levels are perceived to not be that high—and subsequent debt renegotiation?

Pettifor: Yes, because the process is not being managed. It is seen as safe and very profitable to lend to sovereigns. So, the view seems to be, Why not lend to Greece when the European Central Bank will bail you out if Greece defaults? Banks do not have that security when they make private loans, so such prospects as Greece appear to be attractive. But Greece cannot afford to take on additional debt. Unemployment is rising and its economy is shriveling. In the absence of a bankruptcy framework for sovereigns, creditors never lose and vulture funds, in particular, do very well.

The burden of losses falls almost entirely on the debtor, and it does not necessarily fall on the political elite who borrowed the money. It falls on the poor and those who are most innocent. I have worked in African countries where even the official institutions, such as the IMF or the World Bank, reward their staff for the number of loans they make to these countries. The more risky the country, the higher the interest rate that is charged. In the short run, lenders make large profits. In the long run, lenders may lose some of the profit, but if they hang on long enough, the taxpayer is going to bail the lender out. The world is still a place where Goldman Sachs can lend to Greece and never fear losses. The debt is backed by German taxpayers and the European Central Bank. That structure needs to change.

Question: What do you see as some of the reasonable processes that can be used to avoid speculation or excesses?

Pettifor: The BOE has already introduced legislation that requires banks to spend three hours questioning each borrower before a loan can be made. It represents a step forward. Borrowing has not historically been as easy a process as it has become, with loans and credit cards being thrown around with very few questions asked about the ability to repay. Before 1971, the BOE offered guidance to banks in making loans. There needs to be more accountability for loans being made on a sustainable basis and for productive, rather than speculative, reasons.

Question: Regarding QE, who benefited from it and what was the point of it?

Pettifor: The point was to save the banking system, and I believe the banks have benefited enormously. Banks are now under pressure to build up capital but, on the whole, are free to lend and are speculating in a large manner. QE may have saved the banking system from a systemic failure, but what it has also accomplished is to further enrich those who were rich. This result has accelerated growth in income inequality, which leads to social and political instability, as has already happened in Europe and as will happen in the United States if nothing is done to counter it.

Question: Could China be the catalyst for another financial crisis?

Pettifor: I am very concerned about China’s buildup of credit and debt. It is interesting to note that in the 1989 bond market crisis, Japan came to the rescue of the Anglo-American (the United States, the United Kingdom, Australia, and New Zealand) financial system by offering loans at very low rates. This action triggered the carry trade, in which banks borrowed near 0% in Japan and lent at 3%–4% in New York City, and in so doing, the banks cleaned up their balance sheets.

Japan subsequently paid a very heavy price with an asset bubble that imploded and from which it has never fully recovered. China provided the same service to Western economies in 2007 by massively expanding credit and investing on a large scale both domestically and abroad. Of course, China has more centralized control than Japan and thus may be able to manage this financial expansion better than Japan, but it may face the same problems.

Question: What are some of the key takeaways or policy recommendations that you would like to give?

Pettifor: First, I would like everyone to question the orthodox economic theory as presented in the Wall Street Journal or the New York Times and elsewhere. Second, I would like everyone to understand that although money creation is a wonderful thing, it needs to be managed in the interest of society as a whole. The financial sector cannot continue as master of the economy but must become the servant of the economy.

1 Janus is the mythological Roman god of gates and doorways and is depicted with two faces looking in opposite directions.

2 The European Commission’s statistical agency: http://epp.eurostat.ec.europa.eu.

3 This phrase refers to a metaphor credited to John Maynard Keynes that describes the ineffectiveness of monetary policy to stimulate the economy in the face of insufficient demand.



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