Slide 1

Category: The Pamphleteers

The 2008 financial crisis and its subsequent bailouts has put a rather critical spotlight on large banks and the financial system. This scrutiny and ill feeling has now combined with an actual genuine grey area within our monetary system, to produce a potent reform narrative. The grey area in question is concerned with the way which in our system, new money is created by banks creating loans. This has always been kind of known by some economists, although certain theories and the education of students have often misled in this area. A prominent organization publicizing the issues and putting forward reform suggestions in this area is Positive Money. They are a group of serious people with a lot of good content on their website. Amongst others, respected FT journalist Martin Wolf has previously shown his support for some of their core arguments.

The two points I want to make regarding this subject, is firstly that alluding to this area of potential monetary reform as being 'a Money Tree', which phrase Positive Money actually use, is a slightly dangerous and misleading analogy. Secondly I want to show, by including a chunk of text from one of his lesser read books, that Keynes was familiar with similar what he called 'heretical' calls for reform to money creation, and had his own opinions as to their potential.

The Positive Money narrative in my opinion undoubtedly points out some important issues. Banks do inhabit a position within our system which gives them the privilege to create money through issuing loans, fairly unrestrained by the other factors which used to, or we used to theorise used to, restrain them. As Positive Money emphasize, the periods before and after the financial crisis highlight that, in that instance, it was mainly only confidence in the economy that dictated how many loans banks generated, and therefore the amount of money they created for the economy.

But despite Positive Money's insightful analysis, I cant help feeling uneasy about presenting to an online readership, no doubt made up of much anti bank and progressive left-wing readers, arguments which hold out the technicalities of providing money to use within the economy as 'a Money Tree' from which the proceeds can be diverted to different progressive causes. Although there might arguably be a windfall available to be taken out of the banking system and diverted to the state, it should be stressed more that it is of an inherently finite nature.

A rule of thumb for how big this windfall could be can be illustrated by looking at the wider picture. Money is the medium of exchange which is required to, as it were 'make the world go round', or 'to oil the cogs of the economy', and it is obvious that as an economy grows, the amount of different types of money an economy is using needs to roughly follow the same growth trajectory over the long term. (It is also worth noting here that measures of 'money' are notoriously difficult to define and use, which presents further complications to these questions.) Positive Money report that 3 percent of what we can consider money is actual physical cash, which obviously the Bank of England get the windfall from as the economy grows, leaving the 97 percent we are interested in.

So for example that means an average of 2 percent growth in a certain country over 10 years, means roughly 2 percent growth in the money in peoples and businesses bank accounts in that country. This value of the total funds in bank accounts, times by the growth of the economy, can be claimed to be a ball park figure of the actual yearly windfall up for grabs which banks presently pocket. Trends and changes in monetary habits will distort this ratio for sure, but the windfall must always in the long-term be roughly related to the growth in the economy in question. By definition it must be the case that, all other things being equal, increasing money in the system at a greater rate than the rate of growth, will lead to inflationary pressures.

Positive Money are right to highlight how much the money creation by banks fluctuated up before the financial crisis, and then down during and after. But just because the relationship is sloppy, does not mean it does not exist in the long run. The Positive Money narrative also neglects the role of monetary policy, which although perhaps put out of kilter by the exceptionally low inflationary factors in the last two decades, previously controlled the creation of money by banks a lot better. For whatever global savings glut, or cheap imported goods or global imbalance reasons, there have been factors holding down inflation in the last few decades. Although recently it did seem to be all down to confidence (some of which of course turned out to be hubris) monetary policy through the inflation feedback dial and base rate lever, did used to limit money creation by banks reasonably well. But this system failed to work when the inflation level as a feedback mechanism, did not go into the red in the credit bubble before the financial crisis. It is an indirect kind of mechanism, but it used to kind of work, and could work again in the future.

We now know that QE was used to counter the dramatic contraction in the money creation by banks after 2008. The banks stopped creating money by stopping creating loans, and the authorities had to step in to take up the slack. But this dramatic economic spectacle of QE understandably creates many questions for people with anti bank and progressive views. “Wait a minuet, nobody told us it was that easy to get money !” “The government has been going on about austerity, while behind the scenes the monetary authorities have effectively bought about a quarter of the total government debt off the private sector, using QE money created out of thin air?” The well analysed outcomes of QE also feed the radicals fervour, as the QE money just pumped up the asset values of the already wealthy, making inequality worse. Positive Money and others have a point that QE could have been applied in ways to improve inequality rather than make it worse. One cautionary note in favour of the QE in the way it has been performed is that it is conducive to being easily reversed or unwound, where as reversing the more progressive 'QE for the people' would be more complex.

As the saying goes, 'when you are holding a hammer, every problem looks like a nail'. If you are of a left-wing, anti capitalist, anti banker disposition, and you are told their exists a money tree which extracts money from bankers pockets, that idea is understandably very appealing. But progressive thinkers in this area need to be self disciplined, and emphasize the finite nature of the windfall which could potentially be available to be transferred to the state. Also it is easy for groups like Positive Money to experience a kind of mission creep which crowds out the initial remit and puts off those who see some sense in their core concepts. Seek to set up a system which creams more off the banking system than the rough formula above allows for is a very old trick called debasing the currency, which short-sighted or plain greedy leaders have done ever since money was first used centuries ago.

The timing of the interest in this area is notable as being after a period of low inflation; people have forgotten how bad inflation can be. Global inflationary pressures have been very low, but the very nature of inflation means that factors which affect it can be temporary, and once absorbed into one years numbers, are literally history, washed out and have no effect on the next years metric. The future of China's massive and unique economy is a large unknown quantity in world economic stability, and China is not going to be a low cost exporter and savings glut supplier for ever. Economies around the world are starting to experience better growth numbers, so the potential reflationary motive for a 'peoples QE' could look perverse in a few years.

But few ideas in economics are completely new, and concluding upon an alchemy or panacea within the intricate and opaque way in which money and banking interact, is a fallacy which has reoccurred over the decades. John Maynard Keynes was, besides being one of the greatest economists, of an intellectually agile and daring disposition, which made him willing to suggest upending any convention or established wisdom. As such, as he describes below, he became a magnet for those who also believed they had found their own version of the magic money tree, whose supporters, called heretics by Keynes, likewise claimed could answer the problems of their day. He wrote this in 'A Treatise On Money' vol 2, published in 1930, (The Collected Writings of JMK vol VI)

“By writing a 'Tract on Monetary Reform' and opposing the return to gold, the author of this book has gained amongst them a better name than he deserves for being a sympathetic spirit. From all quarters of the world, and in all languages, scarcely a week passes when he does not receive a book, a pamphlet, an article, a letter, each in the same vein and using substantially the same arguments. It is a problem for any student of monetary theory to decide how to treat this flood, how much respect and courtesy to show, how much time to spend on it—especially if he feels that the fierce discontent of these heretics is far preferable to the complacency of the bankers. At any rate, we cannot be right to ignore them altogether. For when, as in this case, the heretics have flourished in undiminished vigour for two hundred years—so long in fact as representative money has existed—we may be sure that the orthodox arguments cannot be entirely satisfactory. The heretic is an honest intellectualist, who has the pluck to stick to his conclusions, even when they are surprising, so long as the line of thought by which he reaches them has not been refuted to his own understanding. When, as in this case, his surprising conclusions are also of such a kind that, if they were true, they would resolve many of the economic ills of suffering humanity, a moral enthusiasm exalts and strengthens his obstinacy.” P193-4 'A Treatise On Money' vol 2 (The Collected Writings of JMK vol VI)

“It has been a principle object of this treatise to give a clear answer to these perplexities. What is the true criterion of a creation of credit which shall be non-inflationary (free, that is to say, from the taint of profit inflation—income inflation is a different matter)? We have found the answer to lie in the preservation of a balance between the rate of saving and the value of new investment. (Positive Money are correct to highlight that individual banks are not reliant on having savings deposited with them before they can give out loans. This perception of how banking works may have been partly true a long time ago, but now the norms on banks matching liabilities with assets / deposits with lending are much changed. However Keynes is highlighting that although on a specific bank level the balance does not matter, at the economic system level, the balance between savings and loan creation does matter. On a basic system level, saving is taking money out of circulation, while creating loans is adding money to the circulation.) That is to say, bankers are only entitled to create credit, without laying themselves open to the charge of inflationary tendencies, if the net effect of such credit creation on the value of new investment is not to raise the value of such investment above the amount of the current savings of the public; and, similarly, they will lay themselves open to the charge of deflationary action unless they create enough credit to prevent the value of new investment from falling below the amount of current savings. How much credit has to be created in order to preserve equilibrium is a complicated matter—because it depends upon how the credit is being used and upon what is happening to the other monetary factors. But the answer, though it is not simple, is definite; and the test as to whether or not such equilibrium is being preserved in fact can always be found in the stability or instability of the price level of output as a whole.

The mistake which the heretics have made is to be found, therefore, in their failure to allow for the possibility of 'profit inflation' (Keynes used this distinction between profit inflation and income inflation a lot within these two books. He categorizes a 'profit inflation' as a period where entrepreneurs are gaining faster than workers, while an income inflation is opposite. In a period of profit inflation, the price of commodities and other goods will be rising faster than workers wages, benefiting the entrepreneur and capital owners, and increasing a countries wealth. P264 vol 1 p144 Vol 2.). They admit the nature and evils of income inflation; they perceive that to advance credit to the entrepreneur, not to increase the remuneration of the factors of production, but to enable him to increase their employment and hence their output, is not the same thing as income inflation, since new wealth is created to an amount corresponding to the new credit—which is not the case with income inflation; but they have neglected the last term of the fundamental equation—they have not allowed for the contingency of investment outpacing savings, of the new wealth which is created not being in consumable form simultaneously with the new spending power allotted as their remuneration to the factors of production.” p197-8 'A Treatise On Money' vol 2 (The Collected Writings of JMK vol VI)

“It is not surprising that saving and investment should often fail to keep step. … the decisions which determine saving and investment respectively are taken by two different sets of people influenced by different sets of motives, each not paying very much attention to the other.” p250 'A Treatise On Money' vol 1 (The Collected Writings of JMK vol V)

This emphasis was probably influenced by the fact that Keynes' book was to a large extent observing and reflecting on the extreme economic conditions produced in Britain and Europe by the WWI and total war economies, and then the period after. The massive deployment, borrowing for military spending and then the sharp drop in activity at the end of the war was a disruptive tsunami in economic terms. A total war economy illustrated for Keynes a laboratory experiment in what happens when forced new economic activity is created through government finance (credit creation) beyond the equilibrium level in relation to savings. The war economy created a tension in that money was flowing into the pockets of the workers involved in the extra labour demands of the military effort, but they were not producing goods which would absorb consumer spending. The armaments etc were being consumed by war, and not sold back to workers. This left the extra spending power chasing the same goods.

It is as if Keynes is saying that the heretics are claiming that their schemes for using the magic of money creation to employ the unemployed would not create inflation, because their wages would be the same as the going rate. But Keynes is saying in that last sentence that extra employment paid for, not out of the proceeds of normal production of goods and services by a business, but instead created out of the magic of the monetary system, would be inherently inflationary, as their wages came into existence without contributing to anything for them to be spent on.

Much of Keynes' two volumes of 'A Treatise On Money', published in 1930, besides being heavily influenced by the economic shock of WWI and its aftermath, was also a hymn to having an enabling, slightly growing amount of money in an economy, to provide the oxygen needed for growth and enterprise. The economic environment of the 1920s in Britain were dominated by the now widely considered unwise desire to meet a deflationary Gold Standard re-entry, which Keynes was famously critical of. With authorities having obviously learned about the dangers of deflationary monetary environments, (with possibly the EU regarding Greece excepted ! ) what kind of book would Keynes write today? Keynes' name is usually associated with reflationary policies, but that is only partly fair, while being partly an accidental effect of the times in which he was commenting on. Reading of this book shows he was also thinking about balance and equilibrium, and not wedded to only reflationary policies in all weathers.

Arguably now the pendulum has swung too far in the other direction, past a money creation system which, unlike the Gold Standard, enables the growth of the real economy, onto a system which creates money all too freely when banks have the confidence to see a profit up for grabs. The path is one of more asset bubbles, more debt, and more parasitic speculation, in an inflated financial services sector which is less and less about 'serving' and enabling the real economy though such tangible things as business loans and corporate finance. The governments / central banks are then frightened into enabling this addiction as it maintains an asymmetric stance towards asset bubbles, loosening monetary conditions and using QE to combat the fallout from crises, while never being that hard on perceived bubble conditions. The medicine used to heal one crisis feeds the next bubble forming. ***

The aim should be to have a money creation system which serves its role better, without being put off course by swings in confidence and fear. If the state can capture some windfalls along the way, great, but it would be wrong to replace the temptation of private banks excess money creation with the temptation of government excess money creation.





 'The Collected Writings of John Maynard Keynes'. vol V & vol VI

 *** 'The Illusion of the Perpetual Money Machine'. Swiss Finance Institute. Authors Peter Cauwels & Didier Sornette p4 & p23


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