Today I posted a blog “Savings and the alchemy of credit’ on the Reuters site…which you can access here. What follows is the longer original.
Over the last twenty years or so, neoliberal economists have held sway over the profession – and over the economy. Individual transactions in markets; the supply and demand for goods and services and letting individuals pursue their own interests – these ideas, and this very narrow approach to the economy – were considered vital for the greatest social welfare. The role of the banking system and of credit-creation was considered peripheral. Instead economists (such as Friedrich Hayek and more recently Mark Skousen ) argue that it is the savings (of individuals and corporations) that “drives capital investment, lowers interest rates, and allows firms to adopt new production processes, technologies and create new jobs.”
The public, believes on the whole that ‘savings’ are required to finance e.g. private sector investment. Which is why there is such wholehearted support in Britain for cuts in government expenditure – with most believing George Osborne’s strongly held view, that these cuts would lead to ‘savings’ which could then be used by the private sector to ‘create jobs’. Just like individuals saving to pay off credit cards, as Mr Osborne asserted at the recent Tory Party Conference.
This analysis was considered by John Maynard Keynes to be deeply flawed. Not only because of his ‘paradox of thrift’ theory: that in a recession thrift, or cuts in government and private sector spending lowers demand and thereby contracts supply. But mainly because the neoliberal savings equals investment analysis ignores the role of credit (or bank money) in driving consumption, capital investment and in creating jobs.
For the public as a whole, especially those excluded from economic debate, the notion that pursuing their own individual interests is for the best of all worlds is, of course, appealing. This explains why neoclassical economics has such a grip on the public imagination.
Even more appealing in the Anglo-American economies was the notion that ‘easy credit’ could finance this self-interest. Less palatable was the ‘price’ or interest rates at which easy credit was made available by the banking system, rates which consumers rather foolishly took in their stride before credit ‘crunched’. But the systemic breakdown of the financial system in 2007-8; the deep and prolonged economic slump, the high levels and cost of debt revealed first: that the neoclassical approach is not just flawed, but also dangerous, because it can lead to systemic breakdown. Second, that while easy, if costly credit and a deep and prolonged financial crisis may have enriched some, it has turned out not to be in the interests of most individuals.
This is the context in which Andrew Moss, CEO of Aviva, one of the largest insurance companies in the world, assembled a group of thinkers to debate the worrying issue of the decline of individual savings – a matter of great interest to an institution whose role it is to collect the savings of individuals, keep them intact, increase their value, while at the same time making the business profitable.
Aviva had assembled a most impressive group including Philip Coggan, the Buttonwood columnist at the Economist to help us think about savings that would create ‘Paths to Prosperity’.
The group considered ways in which individuals could be encouraged to save, even in a recession. It was down to me to play the role of party-pooper and argue (as Charlie Bean deputy governor of the Bank of England has recently done) that the savings of both individuals and companies can be harmful, particularly in a recession. They will not create ‘paths to prosperity’.
The illusion that savings can play this role, stems, as Professor Victoria Chick has argued, from our early experience of bank money. We leave school, go to work, and at the end of a month of effort, find a sum of money in the bank, paid as a wage, or salary. Thus we are led to believe that our effort created that deposit and those ‘savings’. In fact the reverse is true: we were only able to work, because credit, or bank money, created deposits (or savings) in the bank in the first instance. This credit initially enabled economic activity to take place. It is what enabled the company to employ another worker. And the creation of this initial credit (through a process that is closest to alchemy) starts with the central bank’s ‘quantitative easing’ and then cascades through the commercial banking system – enabling the employer to borrow, to invest, increase production and create jobs. That is, if the banking system is functioning as it should.
The trouble is that this ‘alchemic’ process was ‘liberalised’ in the 1970s (most notably by the UK’s 1971 ‘Competition and Credit Control Act’) and placed largely in the hands of the private banking sector. During the 1980s and 90s this power was used unwisely. Credit was created and money was lent recklessly to e.g. sub-prime borrowers, at very high real rates of interest.
Properly regulated, bank money or credit, is a wonderful thing. It dispenses with the need for savings, in the traditional sense. It creates economic activity.
At low rates of interest ‘tight’ credit enables sound economic activity to take place, especially during a recession. Conversely, de-regulated ‘easy’ credit, offered at high real rates, becomes an uncontrollable power – not unlike that accidentally discovered by the Sorcerer’s Apprentice in Goethe’s famous poem.
If the central bank and the banking system create more credit than the potential for economic activity within the economy, inflation is the result. Which helps explain the massive inflationary asset bubble created by the banking sector over this last two decades – inflation to which central bankers turned a blind eye.
Conversely, if the banking system creates less credit than there is potential for economic activity – deflation is the result. This is the debt deflationary crisis that has stalled Japan’s economy; one in which property prices are still falling – after more than 20 years! A crisis that now threatens the United States and Britain.
So it is important for prosperity that the banking system is carefully regulated and managed, and that sufficient credit is created to generate economic activity. The fact that the British banking system today operates as a giant borrowing machine – borrowing from the real economy – rather than a lending machine, is evidence of its deeply dysfunctional nature, as we argued in a recent report (‘Where did our money go?’) from the new economics foundation.
Increasing individual savings will not fix the banking system. On the contrary, it will only encourage bankers to go on borrowing from savers – at very low, exploitative rates of interest. Instead, to create ‘paths to prosperity’ we should first fix the banking system – and leave the behaviour of individuals to respond to a healthy financial system.
In an age of prosperity, individuals, companies and governments will feel confident and will invest to deal with the gravest threat facing society: climate change. In an age of austerity, these actors will contract economic activity and save. This will worsen the multiple threats of a dysfunctional banking system, recession and deflation. Above all it will distract us from the biggest threat of all: extreme weather events may intensify, as our planet becomes hotter.
And that might prove very costly for insurance companies like Aviva.