Policy Research in Macroeconomics

Our monetary system is a great, if wildly misunderstood, public good

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Britain and Europe’s economic discourse is embarrassingly er…vulgar. Treasury and Finance ministers’ determination to paper over the role of big banks in the 2007-9 crisis, and instead use the opportunity to re-structure Europe’s welfare states, is both crass in economic terms, but also crude politics.

Politicians are influenced by what I call the kitchen table monetarism of Mrs Thatcher and by the views of Mrs Merkel’s “Swabian housewife”. These reinforce the primitive ideas about money once expounded by Mrs Thatcher, namely that:

“The state has no source of money, other than the money people earn themselves….There is no such thing as public money. There is only taxpayers’ money.”

Another regular assertion is that nothing can be done without accumulating ‘savings’.  These assertions were contradicted in 2009 when it turned out that the state – via the ECB, the Bank of England and the Federal Reserve – did have a source of money.

It was named QE, and used (mainly by the Federal Reserve) to mobilise trillions of dollars that socialized the losses of German, British and American banks. The money was created by central bankers “out of thin air” – without once dipping into the pockets of taxpayers, or drawing down ‘savings’.

There was nothing new in this. QE is just another name for the everyday activities of central banks. In the past these were known as ‘money market operations’ – carried out since about 1694 when the Bank of England was founded. The difference between then and now is in the scale of operations undertaken by central bankers since 2009.

In an e-book published today –Just Money: how society can break the despotic power of Finance  (also available in Kindle edition here) – I map out how money is created “out of thin air” – not just by central banks, but mainly by private commercial banks. (The latter ‘print’ about 95% of the money circulating in, for example, Britain.) Above all, how this money creation – if managed well – can be used to finance all of society’s needs, not just those of the rapacious finance sector.

Advanced western democracies – unlike many countries in Africa – are beneficiaries of monetary systems that evolved over time as a result of great power struggles. These centuries-old contests were waged between the ‘robber barons’ of earlier times and broader, democratic society. The ‘robber barons’ were effectively defeated, and from the late 17th century onwards, western monetary systems were transformed. They became a great public good capable of serving the interests of wider society, not just the rich.

This victory over powerful financiers and creditors led to a fall in rates of interest on loans, to great innovations and to progress in health, housing, engineering and the arts. It was a public good that was always put at the disposal of military generals engaged in costly wars!

Over the last thirty years the system has been recaptured by today’s modern, technologically advanced ‘robber barons’. Just Money explains how society can once again regain democratic oversight and management of the public good that is the monetary system.

Finance capital has no greater fear than this: democratic regulation and reform of the monetary system.

We know the system can be regained for society, because its been done before. In the 1930s, western leaders, under political pressure and advised by Keynes, came to understand that the banking and finance sector had used the dogma of ‘freedom and liberal finance’ first to gain control over, and then trash, the global economy. So they began a two decade-long process that stripped the sector of powers, and restored democratic oversight and regulation of the monetary systems of western democracies.

After World War Two there followed a period of prosperity still known as the golden age of economics.

Today we face grave new threats to our security, the most urgent and costly of which is the need to transform our economies away from fossil fuels and excessive consumption.

That is why its time to talk about, and talk up, monetary reform – to ensure that the public good that is our money system once again serves the interests of wider society, not just those of private wealth.

This article appeared on Huffington Post on 13 January, 2014. 

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14 Responses

  1. The reason that creating money out of thin air is important is straightforward: it means that neither savings or deposits are needed for investment/creating economic activity.
    This has profound implications for economic theory. If Mr. Osborne does not need to make savings by cutting welfare, before the British government can invest in e.g. alternative energy – that is quite significant for policy-making.

    Second it has profound implications for the “pricing’ of money: the rate of interest. If the only “money” I can get hold of is a share of the surplus accumulated by fair means or foul by a ‘robber baron’ – then it is likely that he is going to be in a commanding position, and to set a high rate of interest. However, if I can obtain “money” from the bank as credit – and if the bank can create credit “out of thin air” – why then should it charge a high rate for that money? And why should it not lend to a sound customer?

    So once again: can I recommend that you read Just Money? Obtainable from this site, or Amazon. These ideas are spelled out there, as clearly as I could manage, and with as little jargon as possible.

  2. I think I was trying to ask a question about banking and non-bank lending, and was wondering (semi-aloud) why creating money “out of thin air” was seen – at least in some quarters – as being very important. I keep seeing this “out of thin air” phrase cropping up and I still don’t see it’s unique significance in creating economic crises.
    Following on from your reply either type of lending could fund new productive projects or new speculation.

    The advantage of productive investment – as well as meeting needs – is that it is sharing income out between profits and wages. But M–>C–>M’ is often also speculative, and so the future income streams may not i) meet expectations at the outset of a project of new investment, and so effect future investment and expenditure plans adversely. ii) even allow for servicing of the financial commitment entered into with the bank or non-bank at outset.

    It may even be that M–>C–>M’ requires a long term growth in private indebtedness “corrected” by periods of financial ruin. In either case I would consider the financial instability as a manifestation of the inherent economic instability of the productive process rather than an entirely independent cause.

  3. Sean Fernyhough….The economic point is this: credit does not create “money”; it creates economic activity, and it is the economic activity that generates income/profits/tax revenues…with which to repay the credit/debt. If I want to grow a wind farm, and the bank advances £100,000 of credit, that can be used to invest in the materials needed to build windmills, the people/skills that need to be employed etc…which will in turn generate the income/money needed to repay the initial credit.
    Of course if credit is used for speculation , it will not create economic activity (investment/employment/production) but rather capital gains and of course, losses…The point is that it is the investment in speculation that is destabilising…If credit is directed at productive, income-generating activity, then the system can be stable. That is why credit creation has to be managed and regulated…

    I hope that answers your question.

  4. Mr Wilson – your comment about free lunches and private businesses is bizarre. Business start-ups usually grow by the hard-working efforts and personal investment of their founders – it never felt like a free lunch to me. Although clearly the top echelons of the finance industries do get free lunches – paid for by the general public.
    Tyler – your comments about constraints upon the banking system are naive and ignore the many accounting and other tricks by which the banks brush aside capital requirements. All of our major banks have been exposed as engaging in criminal activities such as money laundering for drug cartels, price fixing and outright theft. Do you really think such people care a fig about some bureaucratic regulation. Wake up.

    Tyler: “Banks can create and extend credit, but that does not change the value of the underlying asset borrowed against or the medium of exchange used to measure it – money. ” Of course it does, by either deflation of inflation, depending upon the strategy. What do you think happens to the ‘value’ of property during a housing bubble?

    The real multilevel nature of wealth and happiness remains a mystery to most economists. Our understanding of the nature of money and it’s somewhat remote association with real human values (such as love, empathy, caring, succor) needs to be developed. This article is a good step in promoting that need.

  5. Tyler,
    Money is defined in dictionaries of economics as anything widely accepted in payment for goods and services or in settlement of debts. If I deposit collateral at a High Street bank and they credit my account, the contents of that account or “units” in that account will be “widely accepted in payment for goods and services”. Ergo, the money created by commercial banks falls within the definition of the word money.

    However, there are significant differences between central bank created money and commercial bank created money, so I agree with you to some extent. That is, I think it’s a bit misleading to simply say “commercial banks create money” without referring to those differences.

  6. Not only that but of course capital in banks can be bought with deposits in banks.
    So all you actually need to do is expand the loans, and then persuade some of the new holders of created deposits to buy some bank bonds.

    Capital problems solved – at a price.

    Bank liabilities are pegged to fiat money in what is essentially a currency peg. The important point is that the fiat side *has* to move to maintain that peg and keep the clearing system working.

  7. “I map out how money is created “out of thin air” – not just by central banks, but mainly by private commercial banks. (The latter ‘print’ about 95% of the money circulating in, for example, Britain.)”
    This is nonsense. Commercial Banks cannot create money. They can extend credit though. You seem to be willfully conflating the two, given any graduate in economics of finance should know the difference. Let me refresh your memory though.

    Money as a currency is a medium of exchange, unit of account and a store of value.
    Commercial banks can’t create this out of thin air, as you suggest.

    Credit is any form of defferred payment. Banks can create and extend credit, but that does not change the value of the underlying asset borrowed against or the medium of exchange used to measure it – money. Likewise a bank simply can’t extend credit indefinitely. They are fored to hold capital against loans up to a certain percentage, and to cover the money they have loaned thy have to borrow in the short term money markets – a bank simply has to make it’s balance sheet whole at the end of every day. This maturity transformation of money is what banks really do – they lend for a long period and cover that from short term borrowings from other sources, primarily pension funds.

    But, as I say, they do not “create money out of thin air” and it is nonsense to suggest so.

    1. Thank you for this comment. I would urge you to read the book, and in particular the reference to the fact that until recently banks were not forced to “hold capital against loans up to a certain percentage point”. Indeed they only began to hold capital against their lending with the “liberalisation” of lending rules. The reference is on page 67 – as Bernard Vallageas points out in his paper: Basel III and the Strengthening of Capital Requirement…..

    2. What is the difference between advancing credit that does not create money and credit that does create money? Both create claims on future income flows of borrowers to service the liabilities. Those expected income flows may not be realised – and hence a greater level of debt (irrespective of the changing level of money supply) increases financial instability.
      By the same token I don’t really get “quantitative easing” as a term. If the central bank is buying gilts with cash then the private sector is swapping something that is readily exchangeable for money for money. Quantities are only being eased because we exclude one of the financial assets in the transaction from our definition money.

  8. ” we see that in the extreme inflation and destruction of ordinary peoples’ wealth in Germany in the 1930s with hyper inflation”
    (i) it was in the 1920s (June 1921 – 1924)
    (ii) it was due to production collapse due to military invasion by the French and the reparation levels imposed by the Treaty of Versailles.

    which suggest that your understanding is somewhat shaky.

    There most certainly is a free lunch in a dynamic currency economy – because private businesses wouldn’t be able to invest and expand their business otherwise.

    There has been no hyper-inflation and there will be no hyper inflation, because QE type operations don’t cause hyper inflation.

    1. And the reparations had to be paid in a foreign currency and not one issued by the German government.

  9. This has been discussed and outlined in many books and websites – Web of debt, Money masters, positive money etc. – but sadly not by the mainstream media who are nothing more than a propaganda machine for the MAN behind the curtain, although in fairness it does get an airing on RT. Politicians have their campaigns paid for by the money out of thin air brigade and any advice they seek on policy comes from the same place, they own the major corporations, and the military industrial complex, so until the system collapses proper (massive derivatives chain reaction, tens of trillions?) then why would they want to change. Main stream politicians don’t talk about this either, I can only remember seeing one, UKIP’s Godfrey Bloom in a speech I saw online at the European Parliament. Finally the majority of people don’t understand the system either, if they did then MP’s mail would force more of them to look at this.

  10. ‘It was named QE, and used (mainly by the Federal Reserve) to mobilise trillions of dollars that socialized the losses of German, British and American banks. The money was created by central bankers “out of thin air” – without once dipping into the pockets of taxpayers, or drawing down ‘savings’.’
    but if done it creates losses – we see that in the extreme inflation and destruction of ordinary peoples’ wealth in Germany in the 1930s with hyper inflation – caused by creating money out of thin air.

    QE if done for a limited amount, for a limited time, can be useful. if done for too long and for too much then huge inflation. And just look at the outcry from developing countries at the US even margninally reducing their huge QE – so much so that they have been pressured into continuing creating money out of thin air.

    no such thing as a free lunch!

  11. If you read James Gibb Stuart’s The Money Bomb, it seems to suggest that not only did Thatcher understand QE, not that it was called that back then, but she used something similar in a clandestine and successful attempt to reduce the public debt. So much for her reputation for being the prudent housewife.

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