Central Banking and the Governance of Credit Creation

1. Central Banking and the Governance of Credit Creation Professor Richard A. Werner Director, Centre for Banking, Finance and Sustainable Development School of Management University of Southampton Danish Institute for International Studies (DIIS) Copenhagen 17 March 2009

2. The achievements of free financial markets, until AD 2007: sub-prime mortgages, predatory lending securitisation und asset-backed securities (ABS; MBS, ABCP, etc.) credit-derivatives: credit default swaps (CDS), collateralised debt obligations (CDOs), etc. structured investment vehicles (SIVs), special purpose companies (SPCs) financial ‘products’ with high credit rating that combine the above hedge funds investing in the above with significant ‘leverage’ (e.g. Bear Stearns High Grade Structured Credit Strategies Enhanced Leverage Fund) Is it the fault of the new, complex financial products? 1

3. The transformation from ‚toxic waste‘ to top-investment:‚financial engineering‘ or Alchemy? Is it the fault of the new, complex financial products? GAME OVER financial engineering credit extension for speculative investments Triple-A rating Top Asset Toxic Waste Bank Diversified int’l Investors Risk transfer away from bank’s balance sheet Profits 2

4. For almost 20 years, Alan Greenspan, Fed Chairman (Aug 1987 – Jan 2006), was the oracle on banking, monetary, fiscal and economic policy. A pillar of the Washington Consensus, he recommended deregulation, liberalisation and privatisation, because markets, left to their own devices, would produce the best possible result (e.g. his advice to Asia 10 years ago). In October 2008, all this changed. The Maestro testified to Congress that his fundamental grasp of the operation of banking systems and markets was ‘partially wrong‘. He had uncovered “a flaw”in how the free market system works. He charged that “the modern risk-management paradigm… – the whole intellectual edifice – has collapsed” due to the banking crisis. His belief in the self-regulatory forces of the markets had been “shaken”. The problem is more fundamental It’s official: There is a flaw in mainstream thinking 3

5. A significant break-down in the inter-bank market is rare in industrialised countries – the last time was in the 1930s. The nominal extent of the problem is larger than ever before. But there have been many, recurring banking crises. The number and magnitude of financial/banking crises has not decreased but increased in the last 30 years During the 1980s and 1990s, systemic financial crises occurred in at least 93 countries (Caprio & Klingebiel, 1999), 88 were in developing countries. But this is not the first banking crisis… 4

6. Mostly the IMF, World Bank and regional development banks stepped in and demanded structural reform to ‘free the markets’ from regulation and controls. This has now been recognised as being part of the problem, not the solutation. So why do we observe recurring banking and economic crises? What are the true lessons that need to get learned? Why do we observe recurring banking crises? 5

7. It is always the same old – but little known - cause • The underlying cause of the crisis is not new. • To the contrary: the problem can be traced to a fundamental problem, which is as old as banking and the use of credit money (5000 years). • Should we have been warned? --- You have been warned. (Werner, 2001, 2003, 2005, etc.) • Time to ask some basic questions. 6

8. What is money? • Textbooks say they do not know. They talk about deposit aggregates M1, M2, M3 or M4, but admit that these are not very useful measures of the money supply. • The M measures are not in a stable and reliable relationship to economic activity (‘velocity decline’, ‘breakdown of money demand’) • This is a world-wide “puzzling” anomaly (Belongia Chalfant, 1990). The quantity relationship “came apart at the seams during the course of the 1980s” (Goodhart, 1989). “Once viewed as a pillar of macroeconomic models”, it “is now … one of the weakest stones in the foundation” (Boughton, 1991). • Even the Federal Reserve does not tell us just what money is: “there is still no definitive answer in terms of all its final uses to the question: What is money?” 7

9. Who creates money? How is it allocated? • Are they taking us for a ride? Or should we press on finding an answer to the question ‘what is money’? • The answer can be found when considering where the money supply comes from. • Only about 2% or so of the money supply comes from the central bank. • Who creates the remaining 98% or so of our money supply and how is this money allocated? 8

10. Saving (Lenders, Depositors) $100 Banks (‘Financial Intermediaries’) =“indirect finance” Investment (Borrowers) $99 Puzzles Do we Understand Banks Properly? What makes banks special? - Fama (1985) shows that banks must have some special power – a monopoly power – compared to other financial institutions. - Mainstream theories offer no clear answer what this is. - Leading textbooks represent banks as mere financial intermediaries: RR = 1% “direct finance” 9

11. What Makes Banks Special? • History of Banking: Banking has been at the core of the economy, business cycles, wars, many major political developments • Schumpeter (1912): Banks are special. They are the central settlement system of the economy. They operate “a huge system of credits and debits, of claims and debts, by which capitalist society carries on its daily business of production and consumption.” Thus it is “more useful to start from the credit transactions and look upon capitalist finance as a clearing system that cancels claims and debts and carries forward the differences – so that money payments come in only as a special case without any fundamental importance.” • In other words, credit is the key. 10

12. Some crucial facts that you are not supposed to know • There is no such thing as a bank loan. • A loan is when the use of something is handed over to someone else. • If I lend you my car, I can’t also use it myself. • When banks ‘lend’ money, they are not extending loans. • What they do is much more important – the single most important fact about how economies actually work. 11

13. Assets Assets Liabilities Liabilities $ 100 $ 100 $ 100 Assets Liabilities $ 100 + $ 9,900 $ 100 + $ 9,900 Banks create money – out of nothing Balance Sheet of Bank A Step 1 New deposit of $100 with Bank A Step 2 Bank A uses the $100 as reserve with the central bank Schritt 3 With a reserve requirement of 1%, Bank A can now extend $ 9,900 in credits. Where do the $ 9,900 come from? From nowhere. 12

14. What makes banks special? They create 98% of our money - Their role as the economy’s accountants AND their ability to individually create credit makes banks special (MacLeod 1855; Schumpeter 1912) - The textbook representation is incorrect: banks are not merely financial intermediaries. They are special, because they create new money ‘out of nothing’ = credit creation - This is how 95-98% of our ‘money’ is created – by commercial enterprises. - In other words: the creation of the money supply has been in private, commercial hands for a long time. 13

15. Banks are profit-seeking institutions. They do not consider the macroeconomic or social welfare implications of their creation and allocation of money. They do not even consider how their actions might affect themselves in the long-run Banking has been an industry oblivious to sustainability considerations for centuries. This system has been put in place by interested parties without any public debate about it. The fundamental cause of banking crises: The privatised creation and allocation of money 14

16. Some features of the credit market • - Banks ration credit to maximise profits (Stiglitz and Weiss, 1981) • (as loan demand > supply, equilibrium rates would be too high) • - The credit market is rationed and supply-determined • - There is no indication that their selection of projects/firms to give newly created money to is the best possible for the economy as a whole. • Given the reality of credit creation, the quantity of credit is the key • budget constraint on activity and thus determines growth, asset prices • and should be used for policy 15

17. The effect of credit creation depends on the use of money Case 1. Newly created purchasing power is used for transactions that are not part of GDP (financial and real estate transactions). In this case, GDP is not directly affected, but asset prices must rise (asset inflation). Credit creation for financial transactions CF ➙ Asset Markets Asset Inflation: Credit is used for financial and real estate speculation: More money circulates in the financial markets = speculative credit creation 16

18. A significant rise in speculative credit creation CF/C must lead to: - increased ‘financialisation’ and lack of support for productive industries - asset bubbles and busts - banking and economic crises Case Study Japan in the 1980s: Credit flows explain the boom/bust cycles CF/C Loans to the real estate industry, construction companies and non-bank financial institutions 17

19. Types of Speculative Credit Creation (CF) • Margin loans (credit for financial speculation) • Loans to non-bank financial institutions • Credit for real estate speculation: • to construction companies • Mortgages, buy-to-let mortgages • real estate investment funds, other financial investors • Loans to structured investment vehicles • Loans to Hedge Fonds • Loans for M&A • Loans to Private Equity Funds • Direct financial investments by banks 18

20. This is how the ‚Bubble Economy‘ works: • The proportion of financial credit creation rises (CF /C ↑). • This creates capital gains from speculation and bolsters balance sheets. • The myth of the continually rising asset price comes about asset prices rise corporate balance sheets improve Financial credit creation rises collateral values rise banks increase loan/valuation ratios, more willing to lend generally positive/euphoric outlook 19

21. This is how the banking crisis and debt deflation works • The creation of speculative credit suddenly drops (CF↓). • Usually triggered by central banks • IMF 28 July 2008: „The vicious cycle has started...“ credit creation falls credit crunch, bankruptcies banks get more risk averse, shrink risk-assets unemployment rises bad debts increase demand, growth fall; deflation 20

22. USA 1920er Jahre (‚Margin Loans‘): Scandinavia in the 1980s: Japan in the 1980s: Asian Crisis, 1990s: UK property bubble until 2007: US property bubble until 2006: Irish property bubble until 2007: Spanish property bubble until 2007: The Cause of Past Banking Crises speculative credit creation speculative credit creation speculative credit creation speculative credit creation speculative credit creation speculative credit creation speculative credit creation speculative credit creation 21

23. Case 2. The newly created purchasing power is used for transactions that are part of GDP. In this case, nominal GDP will expand: credit creation for ‘real economy transactions’ CR➙ nominal growth The effect of the credit creation depends on the use of money two possibilities (a) Inflation without growth: Credit creation is used for consumption: More money, but same amount of goods and services = consumptive credit creation (b) Growth without inflation: Credit creation is used for productive credit creation: More money, but also more goods and services = productive credit creation 22

24. 1. Avoid unproductive credit creation (speculative and consumptive credit creation). If this form of credit creation rises in the banking system, it cannot be repaid without major problems. Crises follow. 2. Focus on productive credit creation. Then banks have the highest chance of avoiding non-performing loans, asset bubbles, crises and bank failure. There will also be stable, non-inflationary growth without recessions. The definition of ‘productive’ should include sustainability. How to avoid banking and economic crises: 23

25. What is required: transparent regulation of the qualitative allocation of credit creation • In the past this was rejected as ‘inefficient interference’ in the efficient functioning of ‘free markets’ • Ironically, today, the UK, French, German and US governments are trying to re-assert influence on bank credit (to small firms, for mortgages). The French PM two days ago threatened to nationalise banks if they did not increase lending. • Had proper regulation of the qualitative allocation of credit taken place earlier, the bubble could have been avoided. 24

26. Who carries greatest responsibility for the crisis? • Investors, bank employees and mortgage borrowers merely responded to the incentive structure presented to them. • The creation of bubbles and hence the crisis could have been prevented by monitoring and directly targeting speculative credit creation. • Central banks have the means and know-how to do this; they did so world-wide until the early 1970s. • In the 1980s they said that such ‘credit guidance’ had to stop as free markets would deliver better results, and, besides, that they should be granted total independence from the government. • Their role and independence needs to be reviewed. 25

27. How can we end the cycle of recurring banking crises? • Either return the power to create the money supply to the public • or institute rigorous controls and transparency over the money creation and allocation decisions of banks. • Either abolish central banks and render them departments of the gov‘t (finance ministry) • Or make them legally dependent on democratically elected institutions, accountable and transparent concerning their credit creation policies. • Then monitor and restrict the allocation of credit to productive uses (defined as being sustainable and welfare enhancing). 26

28. The activities of central banks need to be scrutinised • These are the claims made by central banks about the goal of their policies and about how they achieve them: • There is precious little empirical evidence to support any of these claims. 1. “Central banks aim at price, economic and currency stability.” 2. “To do this, they use interest rates as the main monetary policy tool.” 3. “Interest rates are the key variable driving prices, exchange rates, growth, stock markets and bond markets.” 27

29. Interest rates don’t lead economic growth – they follow itRates are not negatively correlated to growth – but positively • True for long, short, nominal and real rates - and in almost all countries Japan US

30. Cognitive dissonance: Traditional story vs. fact • Traditional story: • Fact:High growth leads to high rates; Low growth leads to low rates. • Interest rates are the result – and hence cannot be the cause of growth. • Thus why would central banks use interest rates as policy tool? That is an impossibility. “Low rates lead to high growth; high rates lead to low growth.”

31. What will happen next? – This depends on the policy response. • Often economists are in danger of staying far too optimistic in this type of banking crisis. • The reason is that it is not difficult to end it quickly, at zero costs. • But: this requires an understanding of the correct policy response and its implementation • Unfortunately there are more examples of misguided (if well-intentioned) policy responses 30

32. Wrong policy responses are more frequent Banking Crisis Correct Response Wrong Response I Wrong Response II USA 2000UK 1991 USA 1907 UK 1914 Germany 1933Japan 1945Malaysia 1998 Japan since 1990Thailand 1997Indonesia 1997Korea 1997Scandinavia 1990USA 1929-1935Germany 1929-1933Germany 1880s 31

33. Problems with the current bail-out programmes: • Banks will remain risk-averse and could even become more vicious in foreclosing to reduce their assets (the most aggressive mortgage forecloser currently is Northern Rock). • Credit creation in the economy is likely to fall; this means declining nominal GDP and moving towards debt deflation and depression • Meanwhile, the total amount of debt – which caused the crisis in the first place – is increased: national debt will rise by tens if not hundreds of billions of pounds in the UK • This debt will have to be serviced at compounding interest, and repaid. The total burden on the economy will thus be even larger. • Moral hazard: Tax payers should not be burdened with the costs. 32

34. The biggest problem with the gov‘t spending programme: • Nominal GDP can’t grow without more credit used for GDP transactions • Fiscal expenditure does not increase credit creation. • The money for the government expenditure (bailout plus increased ‘Keynesian‘ spending programmes) is being raised through bond issuance, i.e. borrowing from the economy! • This constitutes merely a re-allocation of existing money. • The national income pie stays the same size; the gov’t share of the pie merely rises. • What the government injects with the right hand, it takes out with the left – at best a zero sum game. 33

35. Coeff. Std. err t-value t-prob. Part.R2 Const 430.797 323.8 1.33 0.191 0.043 ∆GDP1 0.369 0.128 2.90 0.006 0.177 ∆GDP3 0.203 0.111 1.83 0.075 0.079 ∆CR 0.015 0.004 3.45 0.001 0.233 ∆G -0.957 0.206 -4.65 0.000 0.357 Evidence from Japan in the 1990s: Complete crowding out - Estimation Results of Private Demand Modelsample 1990 (1) to 2000 (4) Result: bG= –1 Without a rise in credit used for GDP transactions, nominal GDP can’t grow. Without credit creation, fiscal policy will crowd out private demand completely. 34

36. Why fiscal spending programmes will not work 35

37. The Solution: How to recapitalise banks, increase credit creation and boost demand - at zero cost! • All the government needs to do is change the way the bailout is funded: it should not be the government who pays for this, but the central bank. • If the central bank pays, and keeps the assets, there will be no liability for the government, no increased debt, no increased interest burden, and no crowding out of private demand. Most of all, there will be zero costs for anyone. • Even the Bank of England is sure to make a profit (as it acquires assets of a value higher than zero; but its funding costs are zero). • A radical idea, never implemented? Think again. 36

38. The Solution (II): How to make gov‘t spending effective • Government debt: Public debt can be reduced significantly, fiscal policy rendered effective • Euro: Governments can stimulate growth, even without ECB cooperation or new fiscal spending 37

39. The Solution (III): How to make gov‘t spending effective Time to re-think our financial architecture. There are better, more sustainable systems. Milton Friedman (1982): abolish the central bank and make it a (small) department within the Treasury. Do we need central banks? The government could just issue its own money. This way, it would not have to pay interest on its borrowing, as it would not borrow money. 38

40. Why are these policies not adopted? • Lack of awareness by the public and civil servants • Role of vested interests:according to the World Bank, a “crisis can be a window for structural reform”, and it can “be an opportunity to reform the ownership structure in the country” (Claessens et al., 2001, p. 13). • They were, when it suited:- Bank of England 1914- Germany 1933-37- Japan 1945-47- USA 1963, JFK 39

41. Successful and Unsuccessful Bank Restructuring Japan 1945-47 vs. Japan 1990s • Bad debts in 1945 approached 100%. Yet, the problem was quickly solved and a healthy banking sector and strong economic growth re-established. • The solution: bad loans were quickly removed from bank balance sheets, without costs to economy or government. • How? The central bank bought the bad loans above market value. On the central bank’s balance sheet, they will cause no harm. • The costs of this solution are zero. Tax money is not used. The central bank merely credits the sellers in its accounts. • Even if loans with a face value of 100 but a market value of 20 are purchased at face value by the central bank, it will make a profit (of 20). (The magic of credit creation). • 1990s: the Bank of Japan refused to do this, insisting on its independence. 40

42. The standard ‘Federal Reserve Note’ JFK’s 1963 ‘United States Note’: No Fed seal 41

43. Further Reading: Palgrave Macmillan, 2005 Vahlen, 2007 42

44. Appendix: What economics has proven, and what it hasn‘t • Perception: Mainstream neoclassical economics has proven that- only free markets and free trade can lead to economic success- government intervention of any kind is inefficient and must fail- deregulation, liberalisation and privatisation increase efficiency. • Reality:Mainstream neoclassical economics has proven that - free markets and free trade would only then optimise welfare… - government intervention would only then be inefficient… - privatisation, liberalisation, deregulation would only then increase efficiency… if and only if we lived in a world of perfect information.

45. Appendix: What economics has proven, and what it hasn‘t • The most familiar diagram in economics: a downward-sloping demand and upward-sloping supply curve. • Perception: Mainstream economics has shown that- prices move to equalise demand and supply = equilibrium. • Reality:Mainstream economics has shown that- equilibrium exists if and only ifwe lived in a world of perfect information (etc.).

46. Appendix: What economics has proven, and what it hasn‘t • Market clearing requires perfect information (etc.). • In our world, information, time and money are rationed. • Economics must recognise pervasive disequilibrium. • Yet almost all economics is based on equilibrium. What happens when markets do not clear (i.e. always)? • Demand does not equal supply. Markets are rationed. • Rationed markets are determined by quantities, not prices. • The outcome is determined by the ‘short-side principle’.