A. So, last time you discussed how understanding how money really works leads to insights that can help make the real economy perform better, and increase the real material well-being of a country. And all this talk about problems with a “national debt” is just non-sense. It seems only to serve the rich who would like to impose “austerity” on the rest of us. You focused on the national debt and how the household analogy is false, but still haven’t explained the crash of 2008. You said it was and still is about private debt.
B. Yes.
A. How?
B. Well, we talked about how all the so called “national debt” is mirrored exactly by the net financial assets of the private sector. So what is usually called the national debt should really be thought of as a good number that reflects the amount of assets the private sector holds. Government spending is what allows that accumulation in the private sector.
A. Yes
B. However, not all money is created through government bonds.
A. What do you mean?
B. The vast majority of money is created by banks out of thin air. When banks make loans, someone walks away with money, an asset, a plus in their account. Yet the bank also records that loan as an asset, a plus in their account. This increases the effective money supply (more or less what is known as M2 in the US), which in turn increases effective demand in the economy. This effect is large, with the vast majority of money actually being private bank-credit money, not money based on US bonds. [Note this has nothing to do with reserve requirements, which under the modern banking system are an anachronism, but with the ability of banks to make loans and get reserves later, which the central bank has to accommodate (bc it targets interest rates) and record the loans as pluses.]
This seems fine when the economy is doing well. But it means the effective money supply is largely based on private debt. The debt ratchets up until a point where the non-financial private sector is deeply indebted to the finance private sector and cannot easily take on new debt. Eventually, with some slight downturn in the economy, there is a loss of creditworthy borrowers, so the system collapses and with it a great portion of the effective money supply. Thus exactly when the economy needs a boost in demand, it instead suffers a sharp contraction. And the banks are the ones holding either the money or the ownership of assets that are defaulted on. The non-finance private sector loses greatly to the benefit of the finance private sector.
A. So what can be done about this?
B. Well, mainstream economists do not even recognize the factors that matter in this scenario. So they literally have nothing useful to say about fixing the economy in this situation. With their bad theory they are like monkeys with razor blades in an operating room – worse than useless. Just one example: they don’t understand the process where private bank-credit money is created only due to the demand for loans by the private sector. So they thought that essentially giving money to the banks, “quantitative easing”, would stimulate the economy. But with no creditworthy borrowers, that money just sits there. To really understand what is at the heart of this finance-based depression, you have to look to economists who understand the interactions of finance factors & the economy in the first place.
Among them there is one view that if both 1) the MMT policies we discussed in Part 1 were followed and 2) better banking practices followed, the economy would not fall into the trap just mentioned. Aggregate demand would be provided through intelligent fiscal policy, not widespread private debt. And the banking sector would be regulated in a way so as not to allow bad assets to back loans and to limit the many financial shenanigans the wealthy created to game the system. So the system would be more stable. Warren Mosler presents perhaps the best clear statement of the needed bank reforms, and regardless of any other changes discussed here, they should be implemented ASAP to stop much of the current harmful or downright corrupt practices in the current system.
A. Would this work?
B. Maybe. The worry is that the effective money supply is still created largely through private bank lending. This provides a huge incentive for the banks, which under this system are likely to be rich and influential, to always, little by little, manipulate regulations in their favor. This is known as “regulatory capture” and in turn leads to an unstable buildup of private debt and the finance sector gaining at the expense of everyone else. Remember, the banks gain no matter what under the current system – either they earn directly from their loans and dubious investment vehicles in the good times, or in a downturn, they earn from claiming the assets that the private sector used as collateral and by being propped up by the government because they are “too big to fail”. Privatized (finance sector) gains and socialized losses. The headlines in recent years that the 1% has done well by the crash of 2008 are sadly true.
A. Is there an alternative?
B. Possibly. It is possible to simply not allow banks to create private bank-credit money. Rather than banks being able to credit borrowers’ accounts with money out of thin air, they would have to lend already existing money, either that they already own, or that they have pooled from investors seeking interest on money they actually hold. A loan would not show as a plus on their balance sheets, but as a minus on someone’s balance sheet – real money that they or their investors have transferred to a borrower. And they would not be allowed to sell their loans, but would have to keep them on their own books. This incidentally would give them a large incentive to raise their scrutiny of borrowers, and thus increase the quality of loans in the first place.
A. Why is this important?
B. This would mean that banks would no longer in effect create new money. They would only be intermediaries, uniting willing investors actually transferring their existing money to borrowers, nothing more. Crucially, this means that the money supply would not collapse in an economic downturn, what is known as a “cascading liquidity crisis”. Lenders might lose money if borrowers did not pay them back, but the total amount of money in existence would remain the same, and so would effective demand. Also, banks would not be earning money through creating money out of thin air. The system would thus both be much simpler and tremendously more transparent, and additionally the banks would be less powerful to change rules in their favor. A crash like 2008 would simply not be possible under this system.
A. So are there any drawbacks to this system?
B. Well, some think that under this system the less wealthy would actually suffer.
A. Why?
B. Because under the current system, even the less wealthy, at least when the economy is good, are sometimes able to get loans and financing for projects. Under the new system, the less wealthy would depend on existing holders of money to finance them, argued by some to mean putting economic power even further into the hands of “the haves”. And some seem to think that having a private system that can create money in response to private demand is good, a dynamic system that responds to the needs of the economy naturally.
A. What do you think?
B. We must balance the true, full cost of the proven inbuilt instability of the current system with the possible good and bad of an alternative system. The true costs of instability in the current bank-credit money system are seldom weighed as a whole, nor presented in a way the general public can understand. What is the true and total cost to the public of the crises of 1907, 1929, 2008, the many smaller crises such as S & L, the Japanese asset price bubble, LCTM, banking crises in Finland, Sweden, Asia, Russia, Mexico, Argentina, Ecuador, Uruguay, and throughout Europe, the dot.com and housing bubbles, the bailouts of AIG, Northern Rock etc.? The true cost of the current system to the non-finance private sector are probably much much greater than is commonly thought, if proper accounting standards were used to measure it.
Also, there are other very real costs from the inherent instability and uncertainty of the current system. These costs arise from the uncountable suboptimal (due to high uncertainty regarding inflation, interest rates, and possible recessions and depressions) decisions on investment, insurance, and allocation of resources made by big business, government, and private households alike. The alternative system would be much more stable on every front, and there would be real gains in efficiency from this increased stability.
A. So that is the main downside some see to an alternative system where banks cannot create private credit money?
B. Yes, it seems the main concern by some seems to be that the little guys won’t easily be able to get loans and the system will not provide enough financing in general for the private sector.
But there seem to be good ways to finance worthy needs without banks creating money. There are lots of investors willing to risk their existing money to earn interest on loans. Additionally, there are many tried-and-true alternative finance options, such as tontine-type mutual funds, pari-mutuel mutual funds, and other banking arrangements that would provide plenty of access to funding for the private sector without allowing banks to create private bank-credit money.
Overall, the huge gain in stability would help everyone, from big business down to individual households.
A. So why isn’t the change tried?
B. The banks would fight it tooth and nail for a start.
Also, although directly using government bonds has worked well in the past, there has never been a pure system of this type – the banks always managed to force governments to allow them to create private bank-credit money.
Notable successful examples include US greenbacks, and the 700 years that the English/UK government used tally sticks. As we know, this period of British economic history was overall highly successful. But tally sticks and greenbacks were only part of their respective systems. The modern proposal for systemic change would essentially make the entire system run purely on what are in effect tally sticks or greenbacks.
A. So people would be afraid to try a system that has never been tried in full it seems.
B. Yes.
But there has never been a system like the current mostly bank credit-money one that has NOT suffered crashes like 2008. It may make sense to finally try something new.
At any rate, the take-home message is that the crash of 2008 was about private bank-credit money and private debt. Any full understanding of the real economy must take into account the long history of bank-credit money recessions and depressions and of ratcheting private debt causing real trouble in the real economy, and the close empirical correlations between changes in private debt, private credit money, effective demand, financial regulatory capture, and recessions/occasional massive depressions.
In Part 1 we discussed how MMT insights show ways to raise the productivity of the real economy to its natural limit, and thus the material well-being of a country. The theoretical debates concerning MMT have largely been worked out, and it is just a matter of time before the logic of it is accepted by the mainstream.
However, the debate on the full scope of the impact of the private credit-money system on the real economy has only begun to be worked on again in earnest.
Maybe implementing better fiscal policy and more logical banking regulations, as many MMTers propose, is enough to stop crashes like 2008 from occurring, and the ongoing regulatory capture of the finance system by the very rich.
But it may make sense to also change the finance system to a system where circulating Treasury notes alone forms the money supply, and banks can only serve as intermediaries of this money, and not create private bank-credit money through escalating private sector debt that alters effective demand, causes socialized losses and privatized gains (only for the finance sector), and ultimately leads to massive busts for the non-finance private sector.
A. Yes, that may make sense.
I’m not well versed in these matters but you are talking about ways that the money supply is
increased. Public deficits and private loans increase the money supply -as you indicate. But doesn’t a general increase in private sector inoomes and demand also increase the money supply? E.G., if a corporation hires more employees, they now get paychecks and the money supply would increase. In general, it would seem that any increase in private sector incomes (which lead to consumption),investment and net exports would increase the money supply, in addition to the impact of deficits and private loan creation. Or am I missing something? Thanks.
As Warren Mosler might say, the point of public-private banking is to make credit available that is non-market dependent for further public purpose. Every loan extended by an FDIC insured bank is supposed to fit in a box designed by Congress. So the banks are best thought of as the ‘designated agents’ of the government (gov’t contractors) and they should be regulated for public purpose.
Having a ‘flexible’ money supply is not the problem. It’s a problem of gov’t not regulating its own agents for public purpose.
Gov’t provides the funding, regulation, and insurance, and the private side is supposed to make loans based on sound credit analysis.
And we can get into why you might want private agents doing the work vs. completely nationalized banking.
I agree that public deficits and private loans increase the money supply. But if you want to claim that “private sector incomes and demand” increases the money supply, it’s up to you to explain why, because no one else thinks that, far as I know.
So it’s like, if you want to make a loan that doesn’t serve public purpose, find your own funding. Government has no obligation to support you, and if you fail because borrowers default, that’s tough shit on you.
Charles – just glanced at your comments – will look at them more closely asap, thanks for the feedback. Clint
Hi Clint,
I agree with most of the above. Just a few niggles as follows.
You say “When banks make loans, someone walks away with money, an asset. Yet the bank also records that loan as an asset. This increases the effective money supply…”
I suggest the above “asset” point is not relevant. The money supply increase comes about as follows. Someone deposits $X at a bank, and the bank lends that money on, then both the depositor and borrower have access to $X: i.e. $X has been turned into $2X.
In contrast, under the system advocated by Laurence Kotlikoff (which is similar to yours) depositors who want their money loaned on or invested by a bank have to buy into a mutual fund. And there is no way a mutual fund stake is ever counted as money. Thus when banks/mutual funds extend loans, no money creation takes place. (I’m assuming there that banks simply connect lenders to borrowers which is over simple. But the latter is their MAIN activity, so I’ll gloss over that for the sake of brevity.)
Re your claim that “They would not be able to count loans as assets..”, I don’t get that point. Under Kotlikoff’s system, loans made by a bank/mutual fund still appear as assets on the bank/fund’s balance sheet, in just the same way as investments made by a traditional mutual fund are counted as assets.
The big difference is not on the asset side of the balance sheet: it’s on the liability side. That is, instead of a bank/fund owing any specific sum of money to anyone, all that appears on the liability side are in effect shareholders. (Those with stakes in existing mutual funds are in effect shareholders).
And of course you are right to say that makes runs on banks, or SUDDEN failures impossible. George Selgin made that point in his book “The Theory of Free Banking” (available online for free). He said “For a balance sheet without debt liabilities, insolvency is ruled out”.
Next, you rightly point out that in a system where commercial banks find it more difficult to lend money into existence, those who are short of cash would find it more difficult to borrow (para starting “Because under the current system..”).
That’s true, plus all else equal, the effect is deflationary. I.e. all else equal, unemployment would rise. But of course, if such a system were implemented, there’d be absolutely nothing to stop the state (as proposed by MMTers) creating and spending new money into the economy. That way, households and firms would have a larger stock of money, and WOULDN’T NEED to borrow so much. Plus the latter unemployment raising effect would be neutered.
And that, as you rightly say, raises the question as to what the best system is: a system where commercial banks can lend money into existence, or one where they can’t. I think the best answer to that question is that the existing system is ABSOLUTELY DEPENDENT on state or taxpayer backing. I.e. the existing system CANNOT DO WITHOUT taxpayer funded subsidies.
That fact is very nicely illustrated by the fact that Dodd-Frank and similar bodies in other countries have produced MILLIONS OF WORDS of bank re-regulation, but have COMPLETELY FAILED to get rid of the TBTF subsidy. I.e. they haven’t grasped the FUNDAMENTAL CHANGE that needs to be made in order to dispense with those subsidies.
So the fundamental flaw in the existing system is that it has to be subsidised, and subsidies do not make economic sense (unless someone can produce very good justifications for a subsidy).
Incidentally, there’s a good description of Kotlikoff’s system here:
http://www.bloomberg.com/news/2013-03-27/the-best-way-to-save-banking-is-to-kill-it.html
Ralph,
As always, good points.
However, on one point there is a problem.
You write: “I suggest the above “asset” point is not relevant. The money supply increase comes about as follows. Someone deposits $X at a bank, and the bank lends that money on, then both the depositor and borrower have access to $X: i.e. $X has been turned into $2X.”
This is not correct – this is the old discredited “loanable funds” idea [and, incidentally, the reason some people get hung up on reserve requirements, which are not important bc the system does not work that way].
Banks do NOT wait for anyone to deposit before they loan. They loan to any creditworthy person who walks in the door, regardless of their reserves. They then find reserves, and the Fed (in the US) has to accommodate them since they target interest rates. So the tail wags the dog here – the private banks force the hand of the Fed on money creation. This is what is usually meant when people talk about money being “endogenous” – its creation comes from “within” the economy, and is not dictated by “outside”, by the government.
It is crucial to understand that the “loanable funds” model is false to understand why quantitative easing does not work. Mainstream economists still believe in QE, because they still DO think banks are waiting to have money to be able to loan it.
So they gave the banks money and…..nothing happened.
That is because the loanable funds model is false. Banks make loans whenever there are creditworthy customers, and after 2008, there aren’t many.
So it is the desire and quality of borrowers that allows banks to lend, and private bank-credit money rises and falls with this process. Some people see this as a good thing – an elegant system that allows the private sector to create the funds needed to make the economy work without the government interfering. They think anyone who criticizes this system just doesn’t “get it”.
I think they are mesmerized by the elegance of it.
Box- jellyfish are also elegant, but I don’t want to swim with them.
A system of only circulating Treasury notes as money seems overall much fairer, more functional, and more stable. A nice golden retriever instead of a box-jellyfish.
Thanks Ralph, for your interesting post. Here is Ralph’s longer reply as a post on his site http://ralphanomics.blogspot.com/2013/11/the-loanable-funds-doctrine-is-not.html
Re loanable funds, that was essentially the point I said I was glossing over “for the sake of brevity” above. This is a complicated point, but it strikes me that in some ways the loanable fund idea is valid. I’ve just set out my reasons in a post on my own blog because explaining those reasons takes up more space than is suitable for a comment on your blog or anyone else’s. I’ve given some credit to you for forcing me to think this point thru!! See:
http://ralphanomics.blogspot.co.uk/2013/11/the-loanable-funds-doctrine-is-not.html
“A loan would not show as a plus on their balance sheets, but as a minus on someone’s balance sheet – real money that they or their investors have transferred to a borrower. And they would not be allowed to sell their loans, but would have to keep them on their own books.”
I don’t understand this part. This appears to be conflating two incompatible models for loan intermediation.
In the first model, the intermediary pools together the contributions of investors and issues loans from the pool. This would have to be managed through a balance sheet showing the investors’ interest in the pool on the liabilities side (whether as debt or equity) and the loans and residual pool on the assets side. This is the mutual model. Here the intermediary is free to assign revenue streams to third parties to raise liquidity, but remains liable to reimburse investors with interest.
In the other model, investors’ contributions are kept separately in custody accounts and then each loan is assembled from increments taken from each custody account, each increment being a separate loan belonging to the individual investor. This is the peer-to-peer model of Funding Circle, for example, in the UK. Here, the intermediary has no rights over the loan parts or the revenue streams.
I suspect that what you have in mind is the second model, but then it would be incorrect to describe the investors’ contributions as being pooled.
I just mean that at the most fundamental level, lending would operate like with normal people – if we each have 100$ to start with, and I give you 10 dollars, then I have 90$, and you have 110$. It is a real negative in my account, and a real positive in your account. That can be made more complex in all kinds of ways, pooling being perhaps the most obvious and useful. But the underlying accounting must be like the above example no matter how complex the arrangements are, or else bank money is being created.
Additionally, loans should have to be held by the originator. Otherwise the note itself will still act like money and in effect create bank-credit money. A not insignificant side benefit of forcing lenders to hold their loans is that it gets rid of the strong incentive in the current system to loan as much as possible and try to hide and pawn off the risk on later buyers of the loans and/or eventually the public.
OK. But the problem isn’t that the loan’s recorded as an asset, it’s that the asset doesn’t replace an existing asset, like my note replaces your $10, but balances a new liability, the bank’s promise embodied in the deposit.