17th November 2010
Below is the shorter version of my article on the ‘alchemy of credit’ that appeared on reuters on October 27th (sorry it’s late!) . You can read the original on the reuters site here :
The governor of the BoE argues that: “We will have to save more, even though the immediate concern is to ensure a recovery in demand.” This is contradictory because saving will lower demand. It is also a counsel of despair. Most economists argue that savings drive capital investment, lower interest rates, and allow firms to create jobs. As Professor Victoria Chick notes, this confusion arises from our early experience of bank money. We leave school, get a job and then find a deposit in the bank.
Apparently our effort created that deposit. The reverse is true: we were able to work because credit, or bank money, created deposits in the first instance. And this credit (created through a process closest to alchemy) starts with ‘Quantitative Easing’ (QE). If the banking system functions well, QE cascades through the commercial banking system. The employer borrows, invests, and creates jobs.
Sadly, the British banking system is now dysfunctional, and neither the BoE nor government dare fix it. Credit creation was until recently mysterious. Then we heard of something apparently new – ‘QE’. Money or credit, we realised, was not mobilised from savings of individuals, or taxpayers. It was simply conjured out of thin air. Governor Ben Bernanke explained how on CBS’s ’60 Minutes’ . Asked “was the $160 billion for the AIG bail-out raised from taxpayers?” he replied:
“No. The banks have accounts with the Fed, much the same way that you have an account with a commercial bank. So to lend to a bank we simply use the computer to mark up the size of the account that they have with the Fed”.
‘Using the computer to mark up the size of the account’ is a process shrouded in opacity by bankers and academics. A pity – because credit created ‘out of thin air’ is one of mankind’s most ingenious inventions. As a result of QE, economic activity — and our prosperity — has not depended on savings, on the silver and gold in vaults, or on what we can afford now. Instead it has depended on what we can do.
The creation of credit by a well-functioning regulated banking system allows us to do what we can do – on condition that demand for that activity is appropriately stimulated. Otherwise ‘Queasing’ alone is like buying a belt three times your size, and hoping to get fatter. QE and fiscal stimulus, carefully sequenced, stimulate and enable economic activity to take place. Economic activity in turn, creates income – to repay the credit. Not the other way around.
Of course, if the banking system creates more credit than potential for economic activity, it fuels inflation. If the system creates less credit than economic potential, as now, then we face today’s threat: deflation and prolonged recession.
It has been extraordinarily difficult for economists, not to mention ordinary punters, to get their heads around QE despite enjoying its benefits since the 18th century. In the UK QE was used in 2008-9 to support government borrowing. The government needed £155 billion in 2009-10. Under QE, the BoE purchased gilts to the total value of £185 billion. From this perspective, over this period, QE financed, in a roundabout way, the whole of government borrowing.
This gives the lie to the ‘bond market vigilantes’. Under QE, the bond market is circumvented. Credit creation is a formidable, dangerous power, which if unregulated foments the kind of crises endured since the 1970s, when credit creation was liberalised. Private bankers used their powers recklessly. Whereas the consensus blames unions for the inflation of 70s, Mr Posen of the BoE argues that mistakes were due to bankers who “overestimated potential growth and overheated our economies, causing high inflation.”
Credit was created and money lent recklessly, at high real rates of interest. This explains the inflationary asset bubble of the last two decades – to which central bankers turned a blind eye. Recently Andrew Moss, CEO of Aviva, assembled a group of thinkers to debate the decline in individual savings. I argued (á la Charlie Bean ) that savings are harmful in a recession, especially when government deliberately contracts public investment. In the UK public sector losses of £84bn will be piled on the £64bn of GDP lost since the beginning of 2008 – including a £44 billion collapse in private sector investment – when the British economy is more than 10 percent below trend growth.
At times of crises, the banking system creates credit, disburses it affordably to both public and private sectors to invest to tackle the gravest threats facing society. Today, those threats – to insurance companies like Aviva – include prolonged economic failure and extreme weather events.
To deal with these we should focus once more on the ‘alchemy’ of credit creation, sequence it with demand stimulus , and turn our economies around. Sadly, we lack both a Roosevelt and a Keynes to make this happen.
Sadly, so does the US (Roosevelt/Keynes). The absurd thing is that it isn’t as if we haven’t been here before, as it were. There is a wealth of evidence that shows that austerity measures are counterproductive. Cowardice, stupidity, or as is likely, social vested interests each play their part.
Moreover, the distinction between the private and social sectors has become quite blurred, so interconnected are these two realms. Thus, an attack on the public sector, so-called, becomes an attack on the private sector as well.
The intellectual failures to deal effectively with the financial crisis in the UK and the US have different roots, but the result is similar – anguish for the poor and shelter for the really rich. This is grotesque.
There are two other factors that need to be taken into account with respect to comparing the Great Depression and the US policy response to that of the US and the UK today. And these are Roosevelt’s conscience, Harry Hopkins, and Congressional investigator, Ferdinand Pecora.
Without Hopkins, Roosevelt might not have gone as far as he did in his New Deal, and it wasn’t until war preparations were underway that he did. And without Pecora, the Congressional investigation into the bond scandals, especially that involving the Peruvian bonds, would probably have foundered. While Pecora had no training in either economics or finance, he was an effective interrogator nevertheless of those bankers who claimed that they had “done no wrong”.
There is no Hopkins to act as Obama’s conscience in the way that Hopkins did for Roosevelt. And no Pecora figure in sight either, whether on that or on this side of the Atlantic. Perhaps public agitation in the context of the current coalition can bring a Hopkins or Pecora into the forefront? The auspices for this happening do not look very promising.