ECONOMICS by Colin TeeseNews Weekly
Bank of England puts orthodox theory to the test
, August 1, 2015
The Bank of England has taken on the characteristics of an economic chameleon: on the one hand trapped in orthodoxy and, on the other, struggling to break free of its worst constraints. Nevertheless, the bank has pushed important straws out into the swift flowing stream of reality.
Now, for its own reasons the bank has opened its mind to the British public on how exactly banks work. The bank’s Quarterly Bulletin 2014 Q1 confronts, head on, what is taught about bank operation to undergraduate economics students in universities around the world, including in Australia.
The bulletin’s clear, easily understandable account of how banks work and how money is created differs fundamentally from what the economic textbooks tell us.
Market the measure of money
All Britons know money is essential to the workings of a modern economy; less understood, perhaps, is that its nature has changed over time. Since Britain abandoned the gold standard in 1931, its currency no longer maintains a fixed value measured against an agreed price of gold.
It is in fact a currency issued by the British Government with its value not measured against any fixed price. Market forces determine its value against other currencies at any given moment.
The Bank of England identifies three types of money: currency (issued by the government in the form of notes and coins), bank deposits and central bank reserves.
We all exchange money, in one or other of these forms, to buy or sell everyday things, to pay or be paid, or to write or settle contracts.
This apart, it is important for all of us to understand the wider realities of banking and money creation, because money matters can, and do, impact on the health of our economy.
We can acknowledge that, these days, only a tiny fraction of these exchanges are conducted with notes or coins. The remainder involves private banks creating deposits in borrowers’ accounts, which can be drawn down to serve the purposes agreed with the lending bank.
The system works because people are confident about the relative security of government-issued money. It therefore becomes an acceptable medium of exchange which one party is content to accept in payment for goods or services the other needs or wants. For much the same reasons it is also accepted as a reliable store of value. Moreover, money enables us to measure and compare value, since goods or services in shops will be labeled with a money price.
In most countries prices of goods and services are expressed in the currency issued by the government (such as dollars or pounds). As the issuer of the British pound, the British Government is technically in debt to all those holding the money it issues. But the debt is something of a fiction; the British Government only agrees to pay what it owes up to the equivalent of the debt’s value in pounds sterling. For example, it agrees to pay those holding ten pounds sterling, ten pounds sterling.
A British banknote actually says just this.
Orthodox economists are uncomfortable with all these realities about money. They would prefer to believe – and at least pretend to believe – in a world where money is not really part of the operation of the real economy but is actually a modern form of barter.
Lending, they urge us to believe, comes from the savings of depositors. Bank lending is nothing more than the lending of one person’s savings to a borrower.
No new money (or spending power) is created: one person has more to spend, the other less. The economy as a whole is unaffected. Banks act as intermediaries in transactions between the owners of capital and would-be borrowers.
‘Let there be money’
This misguided view, called the “loanable funds theory”, maintains that bank lending amounts to nothing more than the accumulated sum of a country’s savings. Almost all first-year economics students are indoctrinated to believe banks operate in this way.
According to this theory, bank depositors’ savings make it possible for banks to advance loan money.
The Bank of England’s Quarterly Bulletin 2014 Q1 makes it clear that exactly the opposite happens. Private banks don’t lend depositors’ savings, they actually inject new money into the economy to fund new business activity and house purchases. The bank records loans to borrowers as an asset on its books to be repaid by the borrower. No bank depositor’s account is involved.
Private-bank money creation allows the economy to expand independently of the country’s accumulated savings. The funds so created, which support the growth of the British economy, are, in the final analysis, guaranteed by the Bank of England, behind which stands the money-issuing British Government.
Banks are not mere intermediaries bringing lenders and borrowers together. By virtue of their ability to create funds for lending they are parties-principal in borrowing and lending transactions.
And, what holds for the Bank of England is more or less true for banking in all Western economies, at least those with their own government-issued free floating sovereign currencies, normally called fiat currencies.
(Readers interested in pursuing this in more detail should delve deeper into Quarterly Bulletin 2014 Q1.)
No overload safeguards
A question occurs. What safeguards exist to prevent the private banks issuing too much money into the economy and so disturbing its balance?
On this the assurances of the bulletin are unpersuasive. The bank points out that it sets basic interest rates, which are moved up or down as needed to encourage or discourage private bank lending.
That may be the theory, but in the run-up to the global financial crisis, private banks under central bank guidance, not only in England but elsewhere, did in fact lend too much. In the process they almost wrecked the world economy.
Since then there has been pressure to bring private bank lending arrangements under stricter regulatory control. Yet the matter of stricter regulation remains to be resolved.
Several alternative mechanisms for ensuring that an excess of funds is not released into the economy can obviously be found, but, thus far, none has found favour within the financial community, let alone with the politically influential private banks.
The politics of changing the present structure, over the objection of powerful private banks, is fraught with difficulty. Many therefore conclude that the better strategy may be to find ways of improving the present system.
Perhaps with this in mind, in May of this year the Bank of England allowed its researchers, under their own authority, to issue Working Paper 529, this time not necessarily representing the view of the bank but as a discussion paper.
Working Paper 529, which its authors suggest is a paper to encourage debate, actually builds on what was revealed by the Bank of England in its Quarterly Bulletin 2014 Q1. In particular it explains why it was so important to make clear that private banks did not lend depositors’ money but created funds to lend to approved borrowers.
Because the working paper is a research and discussion paper, its authors have introduced much technical data to back up their findings. Its purpose, however, is to persuade us of the importance of accepting the realities of banking operations as they are.
To bring the question into clear focus the researchers constructed two theoretical models: one describing the impact on the economy of the operation of the “loanable funds” model of banking operations put forward by orthodox economic opinion; and the other modeling “fiat money creation” as described in the Quarterly Bulletin 2014 Q1.
The results are stunning. The “loanable funds” model, if banks were actually using it, would deliver stable results for the economy during a crisis. The “fiat money creation” model (the way the system really operates) delivers much instability.
Why is this so? The researchers believe it is because in real-world banking no appropriate mechanisms exist to prevent private banks from destabilising economies by lending too much money in boom times.
No wonder a former governor of the Bank of England was prompted say that the system we have is the worst possible. We may assume he too was aware of the need to control private-bank lending.
If this were only a matter for discussion among academic economists it would be less interesting to ordinary people, but it does have vitally important practical implications.
The tragedy of what has happened in Greece is directly related to the question of how money operates.
Because Greece does not have its own currency, its private banks cannot stimulate economic activity by injecting government-issued money into its economy in the manner of, say, Britain. Instead, it must use an overvalued fixed currency, the euro.
Greece cannot make itself more competitive or reduce the value of its borrowings by devaluation because it does not have the authority to devalue the euro. The European Central Bank only has that authority. In effect, for Greece, the euro is a fixed currency.
As a result, it has accumulated euro debts, which should never have been borrowed (or lent). The austerity alternative being imposed on it by Germany-led Europe also can’t work. Its purpose is to lower wages and other benefits, which are impoverishing both the nation and its people.
Mismanagement, mainly within the European Union, and to a lesser extent in Greece, means these loans can never be repaid. Until this is recognised, both in the EU and in Greece, there can be no future for Greece; and perhaps even for the euro.
The only real solution is for Greece to regain control over its currency. And that means leaving the Eurozone.