Something strange is happening in discussion about money, debt, interest and monetary policy. I would almost say that there are signs that the debate is growing up, based on my reading of a number of articles this week.
Gillan Tett in the FT frames this. As she notes, in August we will mark the 50th anniversary of the USA coming off the gold standard. It's an event that had seismic consequences, and it is still remarkably little understood. Fundamentally, it changed the view of the state. Instead of the state relying on a third party - gold - to give the money it issued value it said that its promise alone was good enough to achieve that goal. It simultaneously claimed that it was capable of being trusted to manage the resulting responsibility to manage the money supply, the value of money, and its availability in the interests of all. Those were big claims. Although Tett thinks they might change again in the next fifty years - and she clearly sees crypto as the source of that threat - I cannot agree. I do not see the state retreating from this monetary claim for sovereignty, which now underlines a great deal of its basis for the claim that it has the ability to govern.
But in that case, as Brendan Greeley argued in the FT, the state really does have a duty to understand money better than it does. His argument is relatively straightforward. First, he says that there is a great deal of money in the world, much of which has little apparent use as it is simply conglomerating in massive cash piles. This is a point the IMF also made recently when they noted the adverse consequences of this for monetary policy. Second, he acknowledges that much of this money is bank made (albeit under licence from the state), saying:
That, of course, is a modern money understanding of the way banking works. It's also now indisputable.
Third, and critically, he then notes that Fed-created money is different, In particular, he is referring to the central reserves created by the quantitative easing (QE) process. The central bank reserve accounts that are created as a result of this are held by the clearing banks with the Fed (in the UK with the Bank of England, in an identical process). But what he, correctly, notes is that this Fed-created money - and there are now trillions of dollars of it and in the UK in excess of £800 billion of it - might be denominated in dollars (or sterling) but they are simply not the same thing as bank-created money. That's not least because there is literally nothing that the banks can do with this money except pass it between themselves as a means of payment which ensures bank solvency in the event of another crisis. They can't redeem this cash, offload it, or destroy it unlike other money, so to call it money like all other balances makes no sense.
Simon Wren-Lewis has made the same point, but does so in the context of interest rate policy, where he argues that there is absolutely no reason why the Bank of England, Fed or any other central bank need pay base rate on these central bank reserve accounts that central banks have themselves created and given to clearing banks. His argument is one that I have used a number of times here before now, which is that in practice whatever happens to base rates interest rates on these central bank reserve accounts can stay fixed at 0.1% or even be 0% if the Bank wanted, and there is nothing the clearing banks can do about it.
Simon links to an article by Irish economist Karl Whelan when doing so. Karl makes the point that:
I've always been uncomfortable with the labelling of central bank reserves as liabilities. Yes, in recent years, central banks have chosen to pay interest on them but they get to choose that interest rate and it can be zero if they want it to be. These are not debts that look like a normal person's debts.
That is correct, and it needs to be appreciated by government and central banks (in fairness, the Bank of Japan and ECB do seem to get this point: it is the UK and USA that do not). These reserves are simply not debt.
What this means for interest rate policy is an issue I will look at in another blog. The IMF already think world cash balances basically destroy the effectiveness of that policy. I agree with Sim0n Wren-Lewis and Karl Whelan that central bank reserves are neither debt nor money as such. And I agree with Brendan Greeley that there is a cash mountain floating around the world unproductively that the corporate sector, that is in possession of a large part of it, has literally no idea what to do with.
What does this all mean? It means that we are living in a world where not all pounds, dollars, euros, yen or whatever are equal. How they came into being makes a big difference to what they are and what interest rate should be used on them, and whether they should be considered as debt, or not. This is a theme of a paper I will be issuing very soon. But what that also means is that if this power to create and manage money is to be properly used - and it is essential that it is - then this has to be understood and I do not think that is the case. I know that because the world's central banks still think they can change a single interest rate and that this will result in a transmission effect flowing through the economy to change the way in which people think and behave. But that is not true.
The IMF have noted that the world's largest companies are exempt from this because they have their own cash hoards.
Dan Davies in the Guardian has noted that the transmission mechanism with regard to housing is creating considerable distortions in society that may not be sustainable.
Gertjan Vlieghe in his retirement speech from the Bank of England monetary policy committee has noted that there are so many feedback loops from the financial economy around demographics, debt and income distribution now that raising interest rates may be nigh on impossible and poses a fascinating range of questions as a consequence.
Govenments have reserved for themselves the right to make money. Now they really have done just that. But in the process they have, it seems, lost control over the ability of cash to be destructive, and they have lost control of interest rates in the way that they at least once thought they had.
It is welcome that this need for deeper understanding to regain control is being appreciated now. It is to be hoped that central banks get the message.
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Just when I thought I was getting to understand MMT you add another wrinkle!
If a (non-central) bank creates money each time it gives a loan, how come it matters whether a country has a fiat currency? That seems to imply any bank could just as easily create Dollars or Euros by making loans in those currencies.
Unless a pre-requisite for giving those loans is holding a reserve account at the currency-issuing central bank, but in that case those reserves are linked to the money being loaned and not a “different sort of pound”. However I agree that there is no consequent reason interest rates should be aligned.
Apologies if I misunderstand, as with much of my slow comprehension of economics it probably needs you to repeat the message a few times in different words for all the implications to become clear.
This is not a wrinkle – it’s always been true!
BUT banks can only do this under licence from a government
And the holding of the reserve account is not the issue – you can create new loans without them (although it’s true that without them clearing the balances is hard)
Instead it is regulation that imposes the limit
I know it is far from straightforward. Does this help? http://www.progressivepulse.org/economics/the-duopoly-of-money-creation
Thanks for the good link. I like the idea of the two circuits and the way savings and government bonds equalise the transitions.
What this doesn’t explain to me is the necessity for a fiat currency. If I can ask a bank to create money for me by applying for a mortgage (and neither I nor the bank issue our own currency), why can’t a government do the same of its own (state) bank even if doesn’t issue its own currency?
(Not that I don’t believe you, I just want to understand the logic).
The bank can only create money becau8se it is licenced to do so by the government
So in that case the government must have a fiat currency
Without it it uses someone else’s currency which must be in the bank before it can be lent
This is not how Minsky explained it. He famously said that anyone can create money, but the problem is getting it accepted.
The banks are, as you say, licenced by the government so when they issue a bank cheque or a loan we can all be very confident they will make good on it. The backing of government helps increase confidence but, as we saw when Northern Rock was in difficulties, account holders still did not fully trust them. So the confidence in banks comes from a combination of their financial health and government guarantees.
In principle, anyone can write out notes, or issue electronic equivalents, saying that they are worth a certain amount each. If they have sufficient trust they can be used as money. An example of this would be a £10 postal order, if they still exist. Most people would take one at face value and did double up as bank notes during the problems of WW1.
Northern Rock was believed when the government-backed it
That is my point
For some reason the foreign exchange aspects have been troubling me, and I wonder if there is an obvious answer I’m not seeing.
Most UK banks will lend not just in sterling, but also in Euro or US dollars or Renminbi, or whatever else their customers ask for. Presumably their “licence to operate” from the UK government allows them to do that, and subject to regulation on their exposure to risk.
But conversely, does it matter if say a bank in France, or China, or where ever, extends loans in sterling? Would that sterling be worth as much as lending from a UK clearing bank? How would you know where the countervailing debit to match the credit sits? Does it matter if sterling created under a different regulatory regime comes back to the UK? Would that create risks, and is there any way to control it?
All excellent questions
And ultimately, all sterling clears through London….hence the need for correspondent banking systems if a clearing mechanism is not available otherwise
Is there a risk then in the lines of communication and regulation? Yes, I suspect. Do I know for sure? No….is the honest anwer
If you want to know more about this, search for Richard Werner. Most of his research has been into money creation. He has termed a theory of money called, Quantity theory of credit. Like most economic theories, he did not originally come up with the idea. It is based on Schumpeter’s credit theory of money.
That is a credit is created when someone makes a purchase or has to make a tax payment The one who makes the purchase or faces to tax burden is the debtor. The debtor releases himself of his debt by offering money. The only purpose of money is then paying debt or paying taxes.
Banks create money exactly for this purpose. Which means all finance is funded by banks, who provide loans to investors who then provide money by buying financial products. Banks can create money as long as there is someone who was first willing to be come a debtor. If no one wants to be a debtor, then banks can not create money. The money just becomes stuck in the system, not doing anything.
Bill W says: “The only purpose of money is then paying debt or paying taxes.” To this I’d add the elimination of barter from routine trading transactions, although I recognise that barter can still apply if the parties agree to it and can find a mutually agreed exchange/valuation mechanism. The existence of money just simplifies the process by establishing a start-point value for any transaction.
Totally agree, Bill.
Proof Werners, (and the first in 5000 years) empirical research paper that confirms that banks ‘create money’ ( using a small German bank following the paper trail of a loan, even the bank was surprised).
https://www.sciencedirect.com/science/article/pii/S1057521914001070
Thus we had the Clinton surplus of 97 which was private debt ( ie bank loans, credit cards etc) and followed a recession in 2000. And they still didn’t understand.
Have to admit to being a bit of a ‘Werner fan boy’ after seeing him on RT’s the Renegades a few years ago, this 15 minute clip explains the smoke and mirrors of financial language to give the impression that banks are ‘intermediaries’ (read innocent) in the flow of money deposited and lent. They are not, they are B/O/E licensed creators of currency.
https://www.youtube.com/watch?app=desktop&v=EC0G7pY4wRE
Re Andrew
“Most UK banks will lend not just in sterling, but also in Euro or US dollars or Renminbi, or whatever else their customers ask for.”
A UK bank cannot create another nations currency. When it offers to lend non-sterling amounts the bank is acting as an intermediary not as a direct lender of that currency. It can trade currency with other foreign banks to supply those who want that currency. The chain of lending clears more or less instantly so the currencies are “spent” in the correct country.
Currency is a debt obligation on the nation that licences that currency. If I “own” Euros I cannot spend them in the UK but only in a country that accepts Euros as a currency. So a Euro country has a debt to me to the value of those euros. If I want to spend my Euros I either can buy something from Europe using that currency or I can trade them to someone who wants to use them in Europe for Sterling at a price (the exchange rate) someone is willing to swap my Euro debt call for pounds. I can then spend my converted euros in the UK for things I want but not the euros themselves.
Whereas a nations currency is no longer backed by precious metal its external value is backed by the productive capacity of the nation state which could be natural resources, productive capacity in goods or the demand for services. Should a country chose to effect the external demand for its goods and services say by damaging trade relations with its nearest and most valuable trading partner the loss in demand pushes down the exchange rate for the national currency because if demand falls the price to outsiders falls in an attempt to clear the capacity. The price in this case is the exchange rate which has a balancing effect of putting up the price of imported foreign goods because you now need more pounds to purchase the currency needed to buy the overseas goods. It is this mechanism that could create inflation. In MMT terms if a country chooses to create more currency in order to clear its external requirements for imports as opposed to fund internal capacity then that could push the exchange rate lower and push up the costs of external goods. The only way to reverse that is to stimulate the demand for exports by making trade easier not harder. In simple terms if you want to import then you have to export otherwise a country has to provide all its requirements internally which as was seen in the communist countries of the post war era was very difficult and did not serve their populations well.
“A UK bank cannot create another nations currency.“ Why not? More to the point, what can’t a foreign bank create sterling?
If a UK bank can create sterling by opening two accounts, one showing a receivable and the other a payable (or credit loans and debit cash, if you prefer) then what stops that bank doing exactly the same in another currency? All you need is a counterparty who will accept a payment from the bank out of the cash account, show a positive entry in its accounts, and provide goods or services in return. After a few steps, and a bit of mixing, who knows where a fungible amount come from?
Andrew
They can only do this if they have a clearing arrangement with the appropriate central bank, either directly or via a corresponding bank
Richard
“The IMF have noted that the world’s largest companies are exempt from this”
The IMF said no such things. They didn’t say ‘exempt’, they said “Our study finds that firms with greater market power respond less to monetary policy actions possibly because of their bigger profits. Larger profits make these firms less sensitive to changes in external financing conditions”
“Responding less” and being “less sensitive” is not “exempt”.
The IMF then expanded – “we find that high-markup firms respond a lot less to a monetary policy shock–an unexpected change in the policy rate–than the average firm in the economy. For example, in the US, a 100 basis point increase in the policy rate causes a low-markup firm to cut sales by about 2 percent after four quarters, while a high-markup firm barely reduces its sales.”
The IMF produced a nuanced report, you are miss-stating and over-simplifying what they said.
Stop misleading your readers.
Respectfully, that’s drivel and I entirely appropriately summarised the alarm call the IMF were making, albeit stated in more diplomatic language as is appropriate on their site (I know, I have an IMF blog coming)
Both FT articles are interesting. The fact that these types of article are appearing all over the place suggests that a change in thinking is afoot.
I have always thought that CB reserve money was only called a liability because we did not want to upset the accountants who still like to think that the Bank of England is a bank like any other.
There is clearly no obligation to pay interest on reserves but, if at some point, we wish to restrain credit creation using interest rates then it will make sense to pay interest on reserves. (This would be part of a policy cocktail that included fiscal policy and possibly credit controls etc.). But why is anyone bothered by this? If higher rates are required it means that the economy is doing well and we should be happy. Yes, this will mean increased payments to savers but if this is a problem it can be addressed by the tax system.
I’ve always rated Gillian Tett – an anthropologist by training.
I too feel a sense of change but also that this is already in danger of being thwarted by the adherents and inheritors of the Mont Perelin Society. I’m sure that they are well drilled and mobilising in some expensive room somewhere even as I write .
Couldn’t one argue that ‘real’ money for any currency is the reserve money held at the central bank as bank credit is merely a claim on that money (as credit generated through loan creation doesn’t have ‘moneyness’ until it is spent & the transaction is settled through adjustments in reserve accounts) ? I.e. We predominantly spend using banks’ pretend money but the true final settlement only ever occurs at the central bank.
No, in a word
Prior to 2009 central reserve balances were tiny – a few billion, and not £800+ billion
So capacity to clear is not linked to availability of central bank reserves
Since these massive CBRAs are because the clearing banks don’t trust each other to, y’know, *clear* any more, perhaps the CBRAs should be split into separate facilities. The “real” reserve accounts (along the lines of what they had in 2008, adjusted for the intervening time, and seriously audited) would be, say £40bn tops, aggregate. Much of the rest could be designated as the limit for a massive auto-yes, zero (or minimal) interest clearing facility. Again, closely audited.
More speculation/ideas than concrete proposals.
I hope to do more on that next week
Good to hear. 🙂
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Great short and concise article. Thank you.
Reminds me of a large book I am slowly working my way through about the anthropological ‘Weirdness’ of the individualism of modern western society.
In that context this is ‘Weird Money’
An aside, it does seem that slowly the message is getting through whether it’s conversations in a work van, academic debate or newspaper articles, the drip, drip of understanding (logic) of where money comes from, what currency is and what is the point of tax is getting people to question the standard tropes of ‘Like a Household’, ‘Government debt’ and ‘Future Generations debt’. Also the more more difficult and vexed questions around taxation.
As usual your work is appreciated and helps those of us at ground level.
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