Since 2008, parliaments and governments have been confronted with a series of financial emergencies. The collapse of the world financial system was successfully avoided, but only to be transformed into a public-debt crisis that has been paralysing the Eurozone economy for the last four years.
Just take a look at public debt, which is just a portion of all debts in the economy. The Euro area and the United States are slowly heading toward a Japanese-like situation, where public debt exceeds GDP. If governments were analysed as corporations or households, the message would be clear: such levels are unsustainable. To bring back public debt to 60% of GDP, a country with a 100% debt/GDP ratio and an average growth rate of 1% would need a 1.6% government surplus every single year until 2030. This is not going to happen.
Why, then, is the market so relaxed? Governments are paying extremely low premiums on sovereign bonds, developed countries do not want to default and, thanks to extraordinary central bank actions (negative rates for deposits, quantitative easing, and repurchases of securitised loans), markets crave low-risk assets. If Germany were not so adamantly opposed to it, the ECB would probably be buying sovereign bonds on the primary market right now.
Taken to an extreme, these policies start to challenge monetary orthodoxy. In October 2014, a (small) German bank decided to set negative interest rates for some of its consumers. If people are charged to deposit their savings, is the whole financial world gone crazy?
To make sense of this and the post-2008 challenges, reformers have launched a major discussion on money, its nature, and its role in the economy.
A blind spot in financial reform
The money system has hardly featured on the financial reform agenda so far. The independence and clear mandate of the ECB has led to a stable low-inflation world (at least if asset prices are left aside) where the existence and the value of money seem to be absolute, unquestionable, a fact of nature. The only major change in the last 25 years was the introduction of the euro, a fixed-rate conversion that from a technical perspective was marvellously executed at the time and that implied a shared political commitment to containing inflation.
Until the crisis, that stability had discouraged people from studying money. When the system works smoothly, there is indeed no immediate need for monetary analysis in macroeconomic models: “A currency that is fully trusted by all economic actors de facto functions like a mere instrument for exchanges” (Orléan, 2007).
In France for example, monetary debates in the non-specialised press have focused on pragmatic questions, such as the impact of the adoption of the euro on purchasing power, rather than on money itself.
But the crisis and recessions are slowly changing that. As the unconventional central bank policies show, there is a new openness in the way policymakers talk about credit and the money supply. The UK’s House of Commons has even scheduled a debate on money creation and society, the first for 170 years. Finance Watch’s mission, which includes raising awareness of the policy implications of credit and money-creation by the banking sector, aims to support this momentum. Although Finance Watch currently has no position on monetary reform itself, one of its Members, Positive Money (UK), is at the forefront of these discussions.
The impact of technology
A new book, written under the pseudonym of Jonathan McMillan, The End of Banking: Money, Credit, and the Digital Revolution [to be published in November] explains that “the digital revolution unsettled the balance of government guarantees and banking regulation”. The authors claim that the possibility to record credit electronically made all the difference and helped provoke the collapse of the regulatory scheme of the 20th century.
Technology also accelerated the decline of cash. 97% of money is now electronic money. Since the emission of cash is a state monopoly, whereas electronic money can be created by the banks as they grant credit, that percentage has a huge impact: the immense majority of money creation is now in the hands of private actors (a fact that surprisingly few people and policymakers are aware of).
Digitalisation of financial activities had a destabilising effect that gives a new youth to old, essential questions: what is money, why do we need it, how should it be supplied and organised?
The nature of money
To simplify, there are three common conceptions of money. The first one, advocated by classical Austrian economists and their present-time followers from the Ludwig von Mises Institute, considers money as any other commodity. The only reason why money is linked to the State is because States use money to assert their power. “Freedom can run a monetary system as superbly as it runs the rest of the economy. […] There is nothing special about money that requires extensive governmental dictation” (Rothbard, 1981). Any economic actor should have the right to issue money. The free market would ensure the stability of the system, as they claim it did during the early days of American colonies. Libertarians denounce most forms of present regulation: deposit protection mechanisms, interventionism of central banks, and prudential rules.
The second conception, which is dominant, considers that money is a special kind of commodity, because it provides fundamental functions. Historically, this corresponds to the vision that money was invented to fulfil the needs of the market. “Without money, people were forced to exchange goods and services directly for other goods or services through bartering” (ECB, 2011). The political implications are quite conservative: if money is “an asset accepted by general consent as a medium of exchange” (ECB), then the primary role of regulators is to facilitate exchanges and to make sure that prices are stable.
The third conception presents money as a social construct, not as a commodity (Orléan & Aglietta, 1998). It puts the “general consent” element at the heart of the analysis. A currency is something people decide to believe in because it responds to a fundamental social need for abstract value. Money cannot be “a useful commodity chosen by the free market as a medium of exchange” (Rothbard, 1981), simply because the word “market” does not have any meaning without money. Therefore, the historical explanation of the emergence of money as a response to the limits of barter is strongly rejected (Graeber, 2011).
This concept holds that money systems merely reflect the power of various social groups in society; they are social constructs and society can re-shape them if it wishes. A social definition of money does not mean abandoning economics for anthropology. It means that economic analysis will show the political consequences of different monetary choices, instead of telling politicians how to adapt to the financial situation, as if they could not change that situation. An extreme version of that is Modern Money Theory, which claims that “monetary sovereign governments are always solvent, and can afford to buy anything for sale in their domestic unit of account even though they may face inflationary and political constraints” (Tymoigne and Wray, 2013).
A public service in private hands
The present organisation of the monetary system is just one possibility, which corresponds to a given conception of money. Both Austrian economists and supporters of state intervention agree that this system suffers from a contradiction between the key role of central banks and the delegation of money creation to private banks.
But why is it problematic that banks create money? After all, banks face market and regulatory constraints, so that “setting monetary policy appropriately […] should ultimately ensure a stable rate of credit and money creation” (Bank of England, 2014). But central banks do not seem able to control the “credit cycle”, or how much credit is in the system, however hard they try. According to Positive Money, as long as money is created by credit, it will be subject to the private interests of the banks: “the primary determinant of bank lending is how profitable banks believe that lending will be” (Jackson and Dyson, 2013, p. 112).
The recent credit boom and bust show that there is no guarantee that the amount banks lend will match the needs of the economy. For example, in a crisis economic actors tend to deleverage. In the present system, a reduction in the overall amount of debt implies a shrinking of the money supply, which in turn contracts demand and economic activity, making the crisis even worse (Fisher, 1936).
A further issue is the sectorial allocation of credit. It is estimated that only 10% of UK bank lending actually finances the real economy and the proportion is likely to be similar in the EU. This is the figure which convinced Martin Wolf, chief economics commentator at the Financial Times, to openly support the reestablishment of a central bank monopoly on money creation.
Proposals for reform
There are many proposals to change things, too many to present them all here (see last piece of this blog for a presentation of the main actors). The reform advocated by Positive Money in the UK is interesting, because it has been developed into practical proposals and lobbying activities.
First of all, money creation would be a monopoly of the central bank. Regular banks would only be allowed to lend the money collected in investment accounts. Debt and money used for payments would be completely separated. Consumers would be faced with a clear alternative between transaction accounts and investment accounts. Hence, the payment system would be risk-free, because it would not depend on the repayment of any debt. An important side-effect is that new money could be created without creating new debt. Over time, this would enable public and private debt levels to reduce significantly.
The restriction of credit to savings has led to a controversy with left-wing activists, who fear a tightening of credit conditions and a strengthening of the political power of the wealthy (Pettifor, 2014), a criticism to which Positive Money has lengthily responded. The debate is revealing of the dynamism of monetary economics and the willingness of new movements to discuss their ideas (see for example Tymoigne and Wray, 2013).
The hard political question is the monitoring of the money supply. It could be linked with economic growth, and new money could either be distributed to citizens or spent by government. Positive Money suggests that an independent committee should make those decisions, which has triggered a debate on the democratic implications of the system.
The proposal would have a huge impact on banking structure. It would remove the too-big-to-fail problem, because banks could go bankrupt without any harm to the payment system. The existence of a direct way to control money supply would also make redundant most of the rules and programs implemented by central banks to try and influence credit decisions made by banks, which explains why, from very different perspectives, reformers like Positive Money and Austrian economists agree that the financial system is too regulated.
The less radical alternatives
Despite his support of Positive Money’s ideas, Martin Wolf does not believe their option to be politically feasible in the short term, at least not until the “next crisis”. If the system cannot be reformed at once, a good start might be to think of precise areas where money creation by credit is problematic.
A salient problem in the public-debt crisis of the Eurozone is the dependence on banks. Banks have access to unlimited liquidity from the ECB, at extremely low rates. Part of that is used to finance governments, which, in turn, guarantee banks against defaults and bankruptcy with taxpayers’ money. Banks make risk-free profits, at the expense of governments.
Why cannot central banks directly finance governments, and squeeze the margin made by commercial banks? Lord Turner, former Chairman of the FSA, has put forward proposals to have central banks finance deficits with what he calls “Overt Money Finance” or OMF (Turner, 2013). Financing governments with central bank money is called monetisation. It is a taboo, formally prohibited by article 123 of the Treaty on the Functioning on the European Union. Turner convincingly shows that monetisation has been advocated by economists such as Milton Friedman, and that it should be considered “in extreme circumstances” (Turner, 2013).
Finally, the least radical way to reform the system would be to expand the range of activities of state-owned banks (as they do in Germany). This would be a simple way to give public entities access to the power of creating money, in order to balance the system. In the United States, the Bank of North Dakota is the last remaining public bank, an oddity in one of the most Republican States in the country. In the last couple of years, the BND has gained a lot of media attention and several States are considering a rebirth of “socialist banking” in the US.
Another problematic aspect of the present system is the overfinancing of real estate and the underfinancing of the real economy. Central banks in the UK, China and South Korea, among others, have already adopted measures to guide bank credit towards more productive uses. A more extreme solution could be the direct regulation of credit allocation, for example by setting ratios that would force banks to loan x out of 10 euros to specific sectors of the real economy.
More generally, all structural reforms contribute to addressing the problem of uncontrolled money creation. If banks were not protected by the too-big-to-fail effect, they would probably not choose to lend as much money for asset purchases, feeding instability. On the other hand, the political economy aspects of removing the privilege of money creation from private banks and finding a suitable home for it in a public institution are challenging.
Regardless of how feasible and desirable they may be, proposals to reform the monetary system have provided a new perspective on financial reform. Numerous policy problems are tied to the way money reaches the economy, such as a lack of aggregate demand, high public debt, inequality, house prices and other asset bubbles. Once understood, the mechanism of money creation helps comprehend the reality of the financial system, and that is already a considerable help.
The next article will cover attempts to reform the money system by innovation: are alternative and digital currencies paving the way for a new monetary world, or are they mere practical tools designed for specific niche uses?