Money In A Digital Age
In the post – Money And Marketing����� I tried to explain the instability of our monetary system with some simple analogies. In this post I am going to offer a few thoughts on one proposed way to deal with this instability. The proposal in question is that of the campaign group��Positive money which is arguing for what it calls a Sovereign Monetary system.
I find myself in an odd position with respect to the arguments of Positive Money. As far I can tell their analysis of the causes of financial instability are in complete agreement with my own thinking. On the other hand, when it comes to their proposed remedy for this instability I find myself disagreeing with both the details of their proposed solution and its objectives.
From the��Positive Money website:
���What We Need:
Take the power to create money away from the banks, and return it to a democratic transparent and accountable processCreate money free of debtPut new money into the real economy rather than financial markets and property bubbles
Most of the money that banks create goes straight into the property and financial markets, pushing up house prices and increasing inequality. This money doesn���t create jobs ��� it simply makes life more expensive and unstable for people. Instead, any newly-created money should be used to fund public spending, reduce taxes, or be distributed directly to citizens to spend as they choose. This means that the money will start its life in the real (non-financial) economy instead of getting trapped in financial and property markets. This will help the economy grow, creating jobs in the process.���
And from Positive Money���s report��Creating a Sovereign Monetary System:
���The power to create all money, both cash and electronic, would be restricted to the state via the central bank (such as the Bank of England or European Central Bank). Changes to the rules governing how banks operate would still permit them to make loans, but would make it impossible for them to create new money in the process.
The central bank would be exclusively responsible for creating as much new money as was necessary to support non-inflationary growth.���
Under the current system, when a bank makes a loan it creates both an asset ��� new money ��� and a matching liability ��� debt. In practice the borrower of the money either places it in their own bank account or spends it, thereby placing the money in someone else���s bank account. Either way the loaned money becomes a new deposit within the banking system which is then available to be loaned once more. For this reason there is no practical limit on the amount of lending the banking system can generate.
Under the Positive Money proposal the ability of banks to generate their own deposits is curtailed. As far as I can tell the proposal would work as follows:
The central bank would allocate a fixed amount of money to each of the private sector banks. The private sector banks could then lend that money to their borrowers, receiving debts or IOU���s in return.
The borrowers could not then redeposit the borrowed money within the private sector banks, to do so would create a new pool of money to be re-lent. Instead they must place their money in deposit accounts which reside at the central bank. The private sector banks would act only as administrators for these central bank deposit accounts. This mechanism would give the central bank the ability to cap the lending of each bank directly. Which is, I think, the aim of the proposal:
���Decisions on money creation would be taken independently of government, by a newly formed Money Creation Committee (or by the existing Monetary Policy Commitee). The Committee would be accountable to the Treasury Select Committee, a crossparty committee of Members of Parliament who scrutinise the actions of the Bank of England and Treasury.���
The Money Creation Committee would determine how much credit the economy needed at any given point. The committee would then allocate this credit quota to private sector banks. These institutions would in effect become an outsourced channel to distribute central bank lending to individual borrowers. I presume the intention is for these banks to bear the credit risk of these loans directly and in return to be compensated for this risk through the margin on the loan. That said the intention is clearly not to give the private sector banks free-rein to direct the lending as they see fit:
���money would be lent to banks with the requirement that the funds are used for ���productive purposes���. Lending for speculative purposes, or for the purpose of purchasing pre-existing assets, either financial or property, would not be allowed.���
My first issue with this plan is the burden it appears to place on the Money Creation Committee. I find it difficult to believe that the committee could reliably determine how much credit the economy needed, which institutions should be permitted to lend it, and which end borrowers were worthy of the funds. I also find it difficult to believe the committee will be able to stay out of the realm of political influence. The list of proposed powers for this committee reads like a politician���s re-election wish list:
���Any new money the central bank created would be transferred to government and injected into the economy through four possible ways:
To finance additional government spendingTo finance tax cuts (with newly created money substituting for the lost tax revenue)To make direct payments to citizens, with each person able to spend the money as they see fit (or to invest or pay down existing debts)To pay down the national debt���
My second concern is that the Money Creation Committee may inexorably be drawn into making more and more detailed individual lending decisions, eventually becoming the de facto overseer of much of the private sector.
Consider for example what would happen if one large company wished to purchase another large company. Most likely the committee would have to decide whether to accommodate this transaction, presumably ruling on whether it was a case of financial speculation or genuine investment. I suspect in practice the Positive Money proposal would therefore degenerate into something resembling a state controlled command-economy.
My third concern is with the internal logic of the plan. As Martin Wolf reminds us in his article discussing a similar proposal �����Financial reform: Call to arms����� Hyman Minsky warned us that ���stability ultimately destabilizes���. Minksy���s warning in this regard refers to his recognition that borrowing levels inexorably rise during periods of financial stability until the point at which the loans become destabilizing.
We should think through what Minsky���s warning implies for the long term viability of the Positive Money proposal. Assuming the proposal could be successfully implemented and it achieved its stated goal of stabilizing the economy ��� What would happen next?
If Minsky is correct, the success of this new monetary system would lead to increased confidence, an increased willingness to borrow and an increased perception that doing so was safe. The private sector would soon be clamoring for the Money Creation Committee to increase its provision of credit. The committee may be able to resist these calls for a while, maybe even for a few years. However, eventually the very success of the committee would appear to vindicate the arguments of those calling for more credit.
The impression would grow that the committee was running the policy too tight and in doing so was holding back economic development. Inevitably the cautious would appear foolish and the reckless would appear wise. The committee would inevitably increase the provision of credit to the economy. This process would continue until an unsustainable credit expansion was facilitated.
The proposal of the Positive Money group is based on an analysis of the credit system which closely matches that of Hyman Minksy���s financial instability hypothesis. However Minsky���s own warnings suggest any successful stabilization policy would inevitably engineer its own failure.
Minsky���s catch phrase ��� stability causes instability ��� could be re-written for regulators as ��� success breads failure.
This final point is a criticism which applies broadly to almost all of the regulatory responses to the financial crisis. Across the board policies are being implemented with the stated purpose of making the economy less volatile ��� if successful in the short term these policies will inevitably fail in the long term.
We would be better served by thinking more deeply about Minsky���s message. We should be looking not for ways to keep the economy perfectly stable but instead for ways to allow credit cycles to play out safely. We should be seeking smaller more manageable cycles which become part of the process of training the financial system to discipline itself.
Credit cycles are an inherent and valuable part of our financial system. We should not delude ourselves into believing credit cycles can be safely banished.
