Money, banks and credit: a dilemma in need of an answer

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Andrew Fisher of the Left Economic Advisory Panel (LEAP) has written a blog in which he analyses recent disputes breaking out on what to do on the issue of banks, money and credit creation.

He notes on the one hand that the Bank if England have recently admitted that just about everything taught about money by conventional economics text books is wrong. Money, they have now admitted, is indeed created out of thin air as I, and others, have said for a long time. And therefore it is loans that create money deposits in banks, and not savings, as has been commonly presumed.

This recognition has , however. given rise to a dispute with Positive Money and  Martin Wolf of the FT on one side, arguing that banks should have this right to create money taken from them and should only be allowed to lend the money that has been deposited with them, and with my Green New Deal colleague, Ann Pettifor on the other, saying this cannot work and that banks have to retain the right to create credit, albeit that this right must be heavily directed and regulated.

Andrew wondered where I am on this issue, and also asked for one of my Venn diagrams on it (sorry, not forthcoming as yet). So, diagram or not, let me wade in.

In summary I am a lot closer to Ann Pettifor's (AP) position than the Positive Money / Martin Wolf (PM) one. I think that by definition banks create credit. If not they are savings and loans institutions (building societies as of old and credit unions being the obvious UK examples). There is good use for savings and loans institutions but it remains a fact that unless you replace fiat money created by credit with an asset backed currency e.g. by returning to the gold standard, then we need someone to create credit.

That credit creator could be a central authority, such as the Bank of England. I agree with Andrew that this power could also be devolved to a number of regional banks all under state control but to be candid, that feels like game playing. And it could be privately owned banks without any ties one to another by common ownership that still create this credit, subject to regulation.

Alternatively, it could be that we refuse to allow this process of credit creation by instead creating asset backed money in which case several things would happen. The first is there would be an immediate shortage of credit in a growing economy, and that would tip us into recession straight away. Second, we would face a very real risk of deflation ,which is profoundly economically destructive. Thirdly, and as a matter of fact, credit creation would become informal and move beyond any regulation. That could easily happen because all credit is based on the principle of a promise to pay, and large companies could happily create quite good credit based on their own promises. The rest of us might find we could also create credit but due to the problem of risk assessment we would find the process very expensive indeed, with the result that massive inequality in the cost of credit would open up even wider gaps in society than we have now . That is all really very unattractive. For that reasons, and because I agree with Ann Pettifor that to put all powers of credit creation in just one institution that might face all the usual problems of regulatory capture is in itself dangerous  I still prefer the idea of banks being involved in this process of credit creation, subject to regulation.

But that does not mean I think that banking should stay as it is now: far from it. Reform is essential and has not happened, which is one of the most important reasons why I have argued  that there is no economic good news at present. Unreformed banking means that all the frailties of 2007 remain in the UK economy now and that is a cause for real concern.

In that case I go back to some ideas I first mooted back in 2008 when this crisis emerged. I said then that we had to ensure that banks were not too big to fail again and I remain of that view. What I said then was in my view this required the separation of a number of their roles, but certainly not in the way Vickers proposed. I saw three such roles that required action to ensure they could withstand future shocks to the banking system.

The first role for the banks that I identified was to act as payment agents. That is the role which many see as most important. It is the banks' job to ensure cash moves around the economy and also comes out of cash point machines. It was the chance that this might not happen one morning in October 2008 that meant RBS and then Lloyd's had to be state supported (and might still mean the Coop Bank might be). The risk of mass inability to pay was so crippling within a modern economy that whatever the problems elsewhere in these banks they had to be kept going. That is precisely why I proposed then, and do so again now, that this payment platform be nationalised. I can see no other way in which it can be ensured that the failure of a bank cannot prejudice this system and so require a bail out. What I proposed was a model akin to that of Network Rail, with the infrastructure of the payments system in state control and operator's licences being granted to use that mechanism to banks who wanted access to it. Do that and you are in a position where the failure of any one bank does not prejudice the system. as a whole as their payment system could be taken over under the terms of their licence to ensure that the system could continue to function in a crisis.  That then, is new regime number one.

Reform number two is also quite radical. It is intended to remove the state subsidy to banks from the deposit guarantee scheme. The deposit guarantee scheme that means that depositors cannot lose (up to a limit) if the bank in which they hold funds fails is pragmatic. Without it the banking system will not work as people will not trust it. On the other hand it creates moral hazard: the banks know that they can use these funds without effectively assuming the risk for repaying them. This is a problem that has to be addressed if banking is to be reformed.

My answer to this is to create a new ring fenced deposit system for those who want their funds subject to guarantee. The funds in these accounts alone would be subject to guarantee in the event of a bank's failure but there would be a condition attached. The funds deposited in these accounts (which could include current accounts - which would have to be provided free of charge) would have to be deposited by the banks with the Bank of England. In exchange for the government guarantee on deposits the government would have use of these funds. This would then provide a new market for gilts. One day it may allow the unwinding of QE, if anyone was rash enough to think that appropriate. It could provide the funding for a green investment bank, or even the Green New Deal. But whatever the use the Bank of England wanted to make of the funds the price of the guarantee would be that the government would have control of the funds guaranteed and not the banks themselves.

Having said that, the Bank of England would of course pay interest (albeit modestly to reflect the low risk rating) on the funds provided to it and so the commercial banks providing the deposit arrangements could also pay a return on such accounts, albeit probably only on funds deposited for fixed periods. But that is the price of security and having it would then be a customer choice. That is reform number two.

Third, banks would then be free to operate as commercial lenders, subject of course to regulation, including credit controls. The split would not then be between High Street and investment banks. That regulatory environment would be reform number three. Given the length of this blog I will not explore the likely controls in greater depth here.

What this will mean though is that two core bank functions - acting as paying agents and as safe depositories for people's savings - would be brought under effective state control, albeit that banks would be licenced operators of the resulting arrangements. The process of credit creation, at risk, would then be ring fenced separately from these other two activities and would, ideally, be separately capitalised as well - as Vickers suggests. That also creates the possibility of developing tax systems for these credit creating banks that recognises the gain they make from creating money - and charges it to tax appropriately.

That would be my basis for bank reform. It's radical. It's very, very unlikely to happen. It would, I think, work. It would put the Bank of England in a central banking role. It would guarantee a market for gilts when government pension reform is likely to harm that market. It would protect people who value that service from the government. It would reduce moral hazard. It would ensure banking was available to all. And it would make commercial banking a distinct activity that required its own capital base for the activity undertaken. You can be sure that each of these is a good reason for bankers to oppose any such idea.