Money’s golden connections

A recent email from Positive Money posed an interesting question:
“How is it that lack of money, the only resource that can be created at will, forms the main obstacle for addressing effectively society’s problems?”
If we presume that the resources they refer to are labour, land, energy and money, then it is delightfully true that only one of these is unlimited – and that’s money. And indeed only one of these has been completely invented by man – and that’s money.

How, when we’ve invented it, can we ever even think that there is no money – or even that there is not enough money? Who is limiting it and why?

Prevailing received wisdom seems still to be that money can be limited. And people don’t think of who is limiting it but what is limiting it. So the politician’s and banker’s most powerful weapon is actually there in the collective and individual minds of the electorate – all are still pretty much on the gold standard. Richard Nixon may have moved the world off the gold standard in 1971 but most people are still on it in their minds. And it is telling that the expression still forms part of the language as indicating the absolute best. For some purposes it could be – but it never can be for money.

When money is the preferred method of accounting for society’s resources then we don’t need to count by thinking it is irredeemably attached to a limited commodity.  At its most basic the world clearly has more resources than just gold. Gold makes good jewelry, is fine for filling teeth, is useful in electronics and sometimes compounded in medicine. But that’s about it, so why use it then to limit artificially both the quantity and allocation of your entire range of resources? It is not logical and certainly constrains an economy  – and that’s why we no longer do it.

A further disadvantage is that there is not much opportunity for river panning for gold these days so it is generally mined and refined using mercury or a cyanide compound – both pretty dangerous and dirty procedures. So you really would want to use it only for a beneficial purpose. It is crass stupidity to dig it up from one hole in the ground and refine it, only then to put it into another hole in the ground – probably thousands of miles away – under a bank.

So it needs to be properly recognised that money is society’s invention for the benefit of society and money’s use rests on confidence in its issuers. When people are told on the one hand that money makes the world go round and on the other that there isn’t enough of it that only helps to undermine that same confidence. Increasing private debt and increasing fraud are just two indications that money’s distribution is too limited.

Once we understand that money is created by society for the useful benefit of all its members we can arrive at the conclusion that its creation can be seen as a simple franchise scheme.

This seems to me rather a comforting suggestion and one that might be more understandable by the general public. The private banks are a bit like McDonalds franchisees and we are all partners in the franchisor. Indeed this is an additional reason to ask banks for extra tax – oh alright franchise fees – for having the right to produce almost all of our money.

To ensure the public and the banks get the message I think we should call it the seigniorage tax.

And please beware of anyone who flashes their gold.

The quantity of money

After considering what is money and how it is created, the next step is to look at how much there is, how the quantity changes over time, and what this is telling us. We are in luck because we can look at real data.*

Below I plot the amount of money in circulation in the UK over the last 3 decades. Money is a bit difficult to measure because it depends on what counts. This plot is for the broadest measure called M4 which includes credit and bonds. You can read about it and download the data from the Bank of England website.

When I saw this data I was shocked. Yes we all know that the global financial crisis was a big event and we are still reeling but I had not fully appreciated how dramatically things changed around 2008. Is this the end of neoliberal capitalism as some are suggesting? Look at the curve before 2010. The money supply keeps on growing. This could be regarded as normal. [Note added 17/08/2017: The growth in the money supply is demand driven. Money is created by households, business and governments borrowing on the basis of a promise to do something.] During the Lawson boom of the late `80s, the money supply was growing so fast that inflation rose to 8 percent and interest rates were increased to 15 percent in order to slow the rate of increase which led to the 90-92 recession. A classic boom and bust. But even during the bust, the money supply kept on growing – just at a slightly slower rate. And after 1992, the money supply kept on growing. As Raghuram G. Rajan said in his book Fault Lines, the policy was to “let them eat credit”, and we did. But then in 2008 everything changed.

The phase transition

In 2007-08 we knew we were in trouble and in 2009 the Bank of England decided to inject new money via quantitative easing (indicated by the black bars). The amounts were big – £200 billion in 2009 – but in terms of the total money supply it was a drop in the ocean and did very little. After 2010 the money supply began shrinking again – this was not normal. In 2011 and 2012 the Bank of England did more quantitative easing. Again the amounts were big but it had no noticeable effect. There was a bit of a pick up in 2016, then we had the referendum, more quantitative easing, but still the rate of money growth was no better than the ’90-92 recession.

Looking at the graph as a whole, the difference, before and after 2010 is stark – physicists call this a phase change, economists might call it a complete failure of monetary policy. So what exactly did change? The best explanation has been given by the economist Richard Koo (this is one of my favourite economics talks of all – my favorite moment is when Koo says “we live in a very strange world”). He calls our debt hangover a balance sheet recession and it works like this: For money to be created there needs to be borrowers but after 2010 there were too few borrowers, because rather than borrowing, people, companies and government were all trying to pay down debt, destroying money in the process. Consequently, rather than the normal phase where the money supply grows exponentially over time, after 2010 we observe an anomalous phase where the money supply is at best flat and at worse actually falls. It could have been fine if only households had decided to save but when individuals, companies and government all decide to pay off their debts at the same time then the economy stalls. Keynes called this, the paradox of thrift – saving is a virtue unless everyone does it.

Exactly the same kind of debt overhang or balance sheet recession happened in Japan after 1990. The lesson from Japan is that there is no quick fix. You can move the debt around, from private to public but the only way out is growth. Japan at least has a relatively strong manufacturing base, and relatively low inequality which both help growth.

What did not work?

In the UK, the government had hoped that by reducing corporation taxes they would encourage companies to borrow, to invest, to raise productivity and grow the economy, but it did not happen. At the same time they were trying to reduce government spending.  The Oxford economist Simon Wren Lewis calls this, “the most damaging UK macroeconomic policy mistake in my lifetime”. The problem is that if households are paying down debt and governments are reducing spending then comsumers have less surplus money and there is a lack of demand. If there is no demand, companies have no incentive to invest and the virtuous circle of rising production, rising wages and rising demand cannot begin. Also, by lowering corporation taxes, companies can increase profit without trying. If you look at the graph in Follow the money you can see that only corporations are sitting on a surplus. Households are back in the red which cannot last long.

End game

To end I will switch to a recurring theme. Throughout history, empires or economies fall not because the workers stop working, but because the elite become lazy, greedy, or corrupt. Economies stall when the elite focus on rent extraction rather than production. The historian Mikhail Rostovtzeff sums up the problem in this passage:

The prevailing outlook of the municipal bourgeoisie was that of the rentier: the chief object of economic activity was to secure for the individual or for the family a placid and inactive life on a safe, if moderate, income. The creative forces which [….] produced a rapid growth [….] suffered a gradual atrophy, which resulted in an increasing stagnation of economic life.

Rostovtzeff, M., The Social and Economic History of the Roman Empire, OUP 1957.

Sound familiar? The rentiers of today are the CEOs, the banks, the buy-to-let landlords, the stock market investors. They have no need to innovate, no need to find new ways to create wealth, because they are doing just fine while the rest are struggling. Until we rebalance tax incentives away from rent extraction towards production, until we switch power away from the financiers and back towards entrepreneurs and small business, and address the failing ratio of wages to capital, until then we cannot expect a more favourable outcome.

*In science there is data. Sometimes there is a theory – a hunch. Scientists test hunches by collecting data and then decide if a theory is useful. A theory without data remains no more than speculation. If economics wants to be a science, it can only do so by focusing on the data. Repeat after me. “No science without data.”

Why can’t a household be more like a bank?

The short answer to this question is of course that householders don’t issue their own money.

But banks do.

So perhaps we should be complaining less about the household analogy that is the bugbear of a proper understanding of how the economy works  – and suggesting another more fitting analogy.

A government with a sovereign currency is more like a bank.

There are other similarities – issuing money is good for business, indeed is the business.

Unlike a household, a bank doesn’t put money away for a rainy day into savings – it invests. Just as a competent government ought.

And a bank doesn’t want to be in surplus with extra money sloshing around in its coffers. Good business relies on the bank being in deficit.

So the government is like a bank.

Perhaps this analogy might yet get people thinking about banks – as well as about the government and the economy!

If it was a vote for anything, Brexit was a vote for import substitution

The UK is unable to properly negotiate trade deals until it has left the EU, so the government seems to be trying to soften up various countries with a view to signing deals as soon as possible after Brexit.  I imagine this is why Liam Fox has been to America and Boris Johnson to Australia.

It may be all fine and dandy to seek to substitute access to the largest Customs Union in the world with individual deals for access to countries – none of whom, even together, are markets of the same size as the market the Brexiteers are so keen to leave – but it is safe to say that no trade deal will be completed before the two year deadline from triggering Article 50.

The Brexit vote was seen by the government largely as a vote against immigration, presumably because Nigel Farage said so. (My opinion has always been that it was more likely to be a vote against the hopelessness of austerity.) Yet the EU’s central purpose is as a block for mutual trade so what the vote was most clearly, was a vote against international trading with our closest neighbours in Europe.

Yet we now have the government trying to increase our international trade with the rest of the world. This is a further indication of the English exceptionalism that has previously been mentioned here and elsewhere. The UK does not wish to trade with its nearest neighbours in Europe but really desperately wants to trade with countries on the other side of the world. That harks back to the empire. The two need not of course, be mutually exclusive but the Brexit vote seems to have made them so.

Given the lack of preparedness and general paucity of skilled capabilities in the current government we should be concentrating our limited resources less on world trade and much more on import substitution.

Land may be Britain’s most important resource but we cannot untie from our mooring off the coast of mainland Europe for a more desirable location. It is equally arguable that people are the country’s most important resource but certainly they are at least a very close second.

If, therefore, you treat the Brexit vote as an anti immigration vote then you need import substitution. That needs investment in that second most important resource: people. That means the finest possible training and education for the British population so immigrants find it so difficult to compete they are not required.

It means too, increasing minimum wages and – especially – enforcing minimum wages so that all jobs provide rewarding employment which enable a proper family life and so all the jobs which we are told the home population do not want to do, become desirable to someone.

It also needs investment in things. At the minimum this requires a National Investment Bank targeting funds towards industries where imports could be substituted. And Green QE would be beneficial for substituting energy imports.

And there is no danger this would not be useful whether or not the UK eventually parts company from the EU.

Even for the most ardent Brexiteer logically there is nothing ‘not to like’. Proper investment to make the country happy and glorious (as their National Anthem has it) and certainly happy and prosperous.

Instead the government lie to us that there is no money. And we have a toxic tribe of Brexiteers who think austerity is the future.

Never has a country been so utterly failed by its government.
Even when they call a binary referendum they do not understand the reply.

The Duopoly of Money Creation

How is money created?

Fiat money is created from nothing on the basis of a promise – a promise to deliver goods or service in the future. Another word for promise is debt – I prefer promise. Only if we believe in these promises does money have value. The teacher promises to teach. The roofer promises to mend the roof. Money creation facilitates things getting done, but create too much too fast – by promising more than we can deliver – and it looses its value. Therein lies the problem.

Money is created either when the government spends, or when a bank makes a loan. We can think of government spending and bank loans as the beginning of two interconnected money circuits, see Figures below. The government and bank circuits form the duopoly of money creation.

The money circuit

After money is created it flows [1] through the economy and eventually is returned to the issuer. In the government circuit, money is returned to the government via the payment of tax, as in Figure 1. In the bank circuit, money is returned to the bank by the repayment of the loan, see Figure 2.

Figure 1: The government spend and tax circuit. The difference between spend and tax equals private sector saving and is known as the deficit. 

When all the money is returned the quantity of money goes back to zero except that in practice the rate of new money creation is higher than the rate of money cancellation, such that we hardly notice the creation and annihilation process and instead the total amount of money in the economy grows (imagine the lines in Figures 1 and 2 getting thicker over time). Ideally the growth in the money supply should match the growth in economic activity, such that prices remain roughly stable and we maintain confidence in the value of our promissory notes. Control of the rate of money creation and destruction in the government and banking circuits are known fiscal and monetary policy, respectively.

Figure 2: The bank circuit where loans create private debt.

Note that the government circuit is leaky, by design. People are allowed to save – hoard promises – and avoid tax. The part of the government spend that is saved leads to a deficit on the governments books (red in Figure 1). Savings can serve a useful purpose but it is odd that we tolerate other leaks, like lower taxes on capital gains and tax havens, I shall come back to leaks and the deficit in a later post.

Why two circuits?

The obvious question is, why do we need a duopoly? Why do we need both a government circuit and a banking circuit? Why do we need both fiscal and monetary policy? As money is a collective good, should we transfer all money creation powers to government and demote private banks to the role of intermediaries as some propose? Or could we hand over all money creation to private banks as the free market fundamentalists would prefer?

Many people are shocked to learn that banks and government are the source of all money, in particular, that banks create money. By allowing the equivalence of bank money and government money, the government and hence all of us underpin the banking circuit and so we have a democratic right to keep them under control and to take a share of their profits. Still banks do provide a useful service, and those looking for the failings of the modern world as a failure of this system of money miss the real culprits. The duopoly is optimally designed to meet our needs. We just need to manage it better.

The reason for the duopoly is relatively easy to understand. Money creation needs to serve both individual need and those of the country as a whole. The bank circuit exists to serve individuals, while the government circuit exists to provide services to everyone.

  • Two circuits are necessary because there are individuals (private) and collective (common or public) interests.

We do not really want government to get involved in private consumption like car loans and we do not really want the vested interests of private banks to extract rent from public need, so two separate dedicated money circuits are required.

Economists often call our collective interests public goods. The most familiar examples are security and defence, health and education. Education is a public good because its consumption is intended to benefit society as a whole and not only the individual receiving the education. We educate people to become engineers and doctors so that we can all benefit from their expertise in the future. Other examples of a public good include transport and energy – we build roads or power stations such there is a net benefit to everyone.

Democratic control of money creation

We can still ask why we need a separate money circuit to provide public goods? There are many good reasons, but perhaps most important of all is that we should be granted a say on our collective interests – this is the essence of democracy. We elect a government to manage our collective needs. Capitalism and democracy are also a duopoly – each with their dedicated money circuit. The capitalist banking circuit represents private interests but fails completely in the provision of public goods. The democratic government circuit fills the gap. The duopoly of capitalism and democracy exist in parallel to support and complement each other.

The failure of the private interest bank circuit to provide public goods is easiest to understand by looking at specific examples. For example in health care, the market solution is to operate on the patient offering to pay the most. Even worse, the market may deliberately create a scarcity in order to charge a higher price. A market cannot operate effectively in matters of life and death, as Kenneth Arrow – a highly-respected pioneer of neoclassical economics – wrote:

the laissez-faire solution for medicine is intolerable.

The government solution in health care take a long-term perspective and addresses the scarcity in trained doctors such that more patients can be treated. Markets only operate effectively if there is genuine competition. For example, we need at least two – preferably more – companies operating on every bus route in order to give commuters a real choice, but this just creates overcapacity and congestion. In situations where competition is not viable, where demand is unlimited like health, and supply delivers societal benefits then collective democratic control is the optimal solution.

What can go wrong?

The duopoly of individual (or private) and collective (or public) needs leads naturally to the duopoly of monetary and fiscal policy. Those looking for the failings of the modern world as a failure of the system of money miss the real culprits. The failure lies in the inability of politicians to regulate the banks and to appropriately use fiscal policy.

The art of economic management is to balance fiscal and monetary policy. An over dependence of one or other is doomed in the long term. Since 1980 both the US and UK abandoned this balanced approach that had worked well up to the oil crises of the `70s. Over reliance on the banking circuit and bank deregulation led eventually to the private debt bubble that burst in 2007-08. Rather then correct their mistake, politicians left it to the central bankers to sort out the mess. The bankers, limited to monetary tools, turned to quantitative easing, but nearly a decade on, with interest rates still stuck at their zero lower bound, we still look on aghast, waiting for someone to wake up to the complete failure of monetarism – if only the younger Milton Friedman could come back to explain it to us all. In 1969, he said [2]:

The available evidence . . . casts grave doubts on the possibility of producing any fine adjustments in economic activity by fine adjustments in monetary policy – at least in the present state of knowledge . . . There are thus serious limitations to the possibility of a discretionary monetary policy and much danger that such a policy may make matters worse rather than better.

In contrast, fiscal policy is a far more powerful, and some may say more dangerous, beast. The collective has an ability not available to any individual. Only the collective has a super charge card where all the spend comes back via tax – the teacher does not cost anything as long as the money spent on them is also spent. In fact, more likely is that the collective will make a profit on employing the teacher by crowding in more economic activity (a multiplier greater than 1). Fiscal policy is intended to get things done. Let’s get on with it!

[1] As Marcus von Skym says: the most important property of money is to flow.

[2] Milton Friedman and Walter W. Heller, Monetary vs. Fiscal Policy, W. W. Norton and Company Inc., New York 1969.

Is the Institute for Fiscal Studies on to something?

In a recent ‘Times’ article (republished on the IFS website)
Paul Johnson of the IFS  comments extensively on their recent report on UK living standards:

“ far the biggest challenge to have reared its head over the past ten years or so … is the massive squeeze on incomes right across the population. After taking account of inflation, average earnings remain below where they were in 2008. That’s unique in at least 150 years.”

He continues:
“Increasing employment and dreadful earnings growth have put paid to another verity. Poverty is no longer overwhelmingly associated with lack of employment. The majority of those officially classified as poor live in a household where someone is in work. More than four in ten children in families where one parent works now fall below the poverty line.”
And further:
“Another profound change relates to what it means to be in the middle of the income distribution. The incomes of those in the middle are no further behind the top than they were 20 years ago. But today half of middle-income families with children live in a rented property. Less than a third did so in the mid 1990s. With the extension of in-work benefits they are also more reliant than before on welfare. In the mid-1990s both the rich and the middle were generally owner-occupiers dependent on their own earnings. Increasingly the renting, benefit-dependent middle earners have, and perhaps feel they have, more in common with the poor than with the rich.”

Although, as we have come to expect of the IFS, he goes off the rails at the end of the article, when he talks about tax revenues (that’s why I have quoted extensively to spare PP readers from having to read it throughout!) his comments are a pretty devastating critique of the current economic circumstances.

His conclusions suggest that Labour has an open goal on living standards. They also imply that the idea that you get more right wing as you age may, with so many still feeling the pinch for much longer, not be as pervasive as most imagined.

Labour’s remaining problem is Brexit on which they are giving mixed messages. A period of Labour silence would surely be advantageous in order to allow the Tories gradually to strangle themselves. It seems to be most unlikely that the government will be able to get its five Brexit bills through the Commons and Lords unscathed and it I would be unsurprising if the government fell at an early hurdle. Still, the longer the government lasts the clearer it will be that leaving the EU is a recipe for impoverishment of the nation and that will, by the day, be getting more obvious to voters. So when Labour seems to suggest that its Brexit policies will be practical and influenced by circumstances as they arise perhaps that is no bad thing.

Add to that the fact that Conservative voters are getting elderly and some will, like Brexit voters, be popping their clogs.

Time I think, is on Labour’s side.

Positive Money – a good campaigning organisation, but with a missing link

‘Positive Money’ have a decent idea. Money should be created with the consent of the public. Governments that have served the financial sector must look instead to serve the public.

In this endeavour they want to set up a commitee to create it – rather like a Monetary Policy Commitee with extra powers, although in this case directly answerable to Parliament.

They point out that creating money is absolutley essential to society. It is.

And at the moment the big banks that create about 90% of it are self serving and do not have any view of how they should serve society. True again.

There is little doubt that Banks tend to create crises because they are so all embracing – every financial possibility is considered to be also their interest. The ill conceived idea that they should be kept absolutely as they are is rather like planting one variety of potato and supposing that blight will affect only an infinitessimal amount of the crop. You’d have to be delusionally confident or else just simply lucky. This is not a policy.

So Positive Money suggest that creating money should be considered one of the ‘separate’ powers:  Legislature, Executive, Judiciary  – and Money Creation.

This is certainly an arguable case.

So create the money independent of private PLC banks. Itself an interesting idea.

But if money creation is a separate power shouldn’t taxation be a separate power too? Or is there too much concentration on the money creation at the expense of the money destruction?

Should we further revise the Separation of Powers to give us the Legislature, Executive, Judiciary, Money Creation, and then also Money Destruction (this means, in effect, Taxation).

Yet shouldn’t the Department of Money Creation and Department of Money Destruction -surely basically the same department, perhaps be merged?

If they should, then surely we end up with Parliament? They’re in charge of tax and spend – or as we now know, spend and tax.

Parliament’s members are the people who really need to know where money comes from.

Positive Money propose doing another survey of MP’s, which is certainly good news, but is it not also time for an Ofsted style report on all prospective MP’s? Surely if MP’s are unaware of where the nation’s resources come from they shouldn’t be allowed to stand?

And of course Positive Money need themselves to understand that ‘Positive Tax’ is their corollary and also equally essential –indeed perhaps  more so.


‘Euro scritturali’ and why Italians shouldn’t issue them

Times seem hard in Italy.

Recent statistics show that those unable to purchase basic essentials, reached 4.7 million last year, or 7.9% of the Italian population and up from almost 1.7 million in 2006.

Two banks have been bailed out but by the Italian taxpayer rather than by the European Central bank, which has proved once again that the ECB has no intention of being a lender of last resort. And means that Italy’s government is operating without a sovereign currency. The reason for the Italian government taking the pain seems to be that the bank bondholders comprised mostly small individual savers who were perhaps too numerous to lose all their savings.

With all this troubling news it is less of a surprise to read that Italians have been creating their own money. Yes, they have been creating ‘scriptural’ Euros in such quantities that the Banca d’Italia has had to ask them to desist!

The Bank says that writing Scriptural Euros or “scriptwriting, is an activity allowed by law only to authorised persons, such as banks, electronic money institutions and other payment institutions. “

It seems that the Euro writers rely on the fact that there is a copyright symbol “©” on every Euro note which is a private, not a government symbol in Italian law. (They also appear on UK notes in case anyone was wondering. But that too is odd – people are unable to copy notes because they are copyright seems an odd control for counterfeiting money – but perhaps they think people would like to steal the pictures?)

So in effect scriptural Euro issuers were trying to include citizens as ‘authorised persons’.
Allegedly only one payment has been made: 25 Euros to Facebook for advertising – I’m unclear how it was accepted, but it was on the basis of ‘just this one occasion’….

Curiouser and curiouser.

And ironically, if the Banca d’Italia really had the right to create money it wouldn’t have to rely on Italy’s taxpayers.

Let’s hope that at least the admonishment to the citizenry helps more people to realise where money really comes from.