Central Banking and the Governance of Credit Creation

Professor Richard A. WernerDirector, Centre for Banking, Finance and

Sustainable DevelopmentSchool of Management

University of Southampton

Danish Institute for International Studies (DIIS)Copenhagen

17 March 2009

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Is it the fault of the new, complex financial products?

The achievements of free financial markets, until AD 2007:- sub-prime mortgages, predatory lending

- securitisation und asset-backed securities (ABS; MBS, ABCP, etc.)

- credit-derivatives: credit default swaps (CDS), collateralised debt obligations (CDOs), etc.

- structured investment vehicles (SIVs), special purpose companies (SPCs)

- financial ‘products’ with high credit rating that combine the above

- hedge funds investing in the above with significant ‘leverage’ (e.g. Bear Stearns High Grade Structured Credit Strategies Enhanced Leverage Fund)

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The transformation from ‚toxic waste‘ to top-investment:‚financial engineering‘ or Alchemy?

Bank Diversified int’l Investors

Toxic Waste Top Asset

Profits

Is it the fault of the new, complex financial products?

credit extension for speculative investments

financial engineering

Triple-A rating

Risk transfer away from bank’s balance sheet

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For almost 20 years, Alan Greenspan, Fed Chairman (Aug 1987 – Jan 2006), was the oracle on banking, monetary, fiscal and economic policy.

A pillar of the Washington Consensus, he recommended deregulation, liberalisation and privatisation, because markets, left to their own devices, would produce the best possible result (e.g. his advice to Asia 10 years ago).

In October 2008, all this changed. The Maestro testified to Congress that his fundamental grasp of the operation of banking systems and markets was ‘partially wrong‘.

He had uncovered “a flaw” in how the free market system works.

He charged that “the modern risk-management paradigm… – the whole intellectual edifice – has collapsed” due to the banking crisis.

His belief in the self-regulatory forces of the markets had been “shaken”.

The problem is more fundamental It’s official: There is a flaw in mainstream thinking

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A significant break-down in the inter-bank market is rare in industrialised countries – the last time was in the 1930s.

The nominal extent of the problem is larger than ever before.

But there have been many, recurring banking crises.

The number and magnitude of financial/banking crises has not decreased but increased in the last 30 years

During the 1980s and 1990s, systemic financial crises occurred in at least 93 countries (Caprio & Klingebiel, 1999), 88 were in developing countries.

But this is not the first banking crisis…

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Why do we observe recurring banking crises?

Mostly the IMF, World Bank and regional development banks stepped in and demanded structural reform to ‘free the markets’ from regulation and controls.

This has now been recognised as being part of the problem, not the solutation.

So why do we observe recurring banking and economic crises? What are the true lessons that need to get learned?

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It is always the same old – but little known - cause

The underlying cause of the crisis is not new.

To the contrary: the problem can be traced to a fundamental problem, which is as old as banking and the use of credit money (5000 years).

Should we have been warned? --- You have been warned. (Werner, 2001, 2003, 2005, etc.)

Time to ask some basic questions.

What is money?

Textbooks say they do not know. They talk about deposit aggregates M1, M2, M3 or M4, but admit that these are not very useful measures of the money supply.

The M measures are not in a stable and reliable relationship to economic activity (‘velocity decline’, ‘breakdown of money demand’)

This is a world-wide “puzzling” anomaly (Belongia Chalfant, 1990). The quantity relationship “came apart at the seams during the course of the 1980s” (Goodhart, 1989). “Once viewed as a pillar of macroeconomic models”, it “is now … one of the weakest stones in the foundation” (Boughton, 1991).

Even the Federal Reserve does not tell us just what money is:

“there is still no definitive answer in terms of all its final uses to the question: What is money?”

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Who creates money? How is it allocated?

Are they taking us for a ride? Or should we press on finding an answer to the question ‘what is money’?

The answer can be found when considering where the money supply comes from.

Only about 2% or so of the money supply comes from the central bank.

Who creates the remaining 98% or so of our money supply and how is this money allocated?

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Do we Understand Banks Properly?

What makes banks special?

- Fama (1985) shows that banks must have some special power – a monopoly power – compared to other financial institutions.

- Mainstream theories offer no clear answer what this is.

- Leading textbooks represent banks as mere financial intermediaries:

Saving(Lenders,Depositors)

$100

Banks(‘Financial Intermediaries’)=“indirect finance”

Investment(Borrowers)

$99

Puzzles

“direct finance”

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RR = 1%

What Makes Banks Special? History of Banking: Banking has been at the core of the economy, business

cycles, wars, many major political developments

Schumpeter (1912): Banks are special.

They are the central settlement system of the economy. They operate “a huge system of credits and debits, of claims and debts, by which capitalist society carries on its daily business of production and consumption.”

Thus it is “more useful to start from the credit transactions and look upon capitalist finance as a clearing system that cancels claims and debts and carries forward the differences – so that money payments come in only as a special case without any fundamental importance.”

In other words, credit is the key.

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Some crucial facts that you are not supposed to know

There is no such thing as a bank loan.

A loan is when the use of something is handed over to someone else.

If I lend you my car, I can’t also use it myself.

When banks ‘lend’ money, they are not extending loans.

What they do is much more important – the single most important fact about how economies actually work.

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$ 100

Liabilities

Assets

Step 2 Bank A uses the $100 as reserve with the central bank

Banks create money – out of nothing

Balance Sheet of Bank AStep 1 New deposit of $100 with Bank A

$ 100$ 100

Liabilities

Assets

Schritt 3 With a reserve requirement of 1%, Bank A can now extend $ 9,900 in credits. Where do the $ 9,900 come from? From nowhere.

$ 100+$ 9,900

$ 100 +$ 9,900

LiabilitiesAssets

What makes banks special? They create 98% of our money

- Their role as the economy’s accountants AND their ability to individually create credit makes banks special (MacLeod 1855; Schumpeter 1912)

- The textbook representation is incorrect: banks are not merely financial intermediaries. They are special, because they create new money ‘out of nothing’ = credit creation

- This is how 95-98% of our ‘money’ is created – by commercial enterprises.

- In other words: the creation of the money supply has been in private, commercial hands for a long time.

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The fundamental cause of banking crises:

The privatised creation and allocation of money

Banks are profit-seeking institutions.

They do not consider the macroeconomic or social welfare implications of their creation and allocation of money.

They do not even consider how their actions might affect themselves in the long-run

Banking has been an industry oblivious to sustainability considerations for centuries.

This system has been put in place by interested parties without any public debate about it.

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Some features of the credit market

- Banks ration credit to maximise profits (Stiglitz and Weiss, 1981)

(as loan demand > supply, equilibrium rates would be too high)

- The credit market is rationed and supply-determined

- There is no indication that their selection of projects/firms to give newly created money to is the best possible for the economy as a whole.

- Given the reality of credit creation, the quantity of credit is the key

budget constraint on activity and thus determines growth, asset prices

and should be used for policy

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Case 1. Newly created purchasing power is used for transactions that are not part of GDP (financial and real estate transactions). In this case, GDP is not directly affected, but asset prices must rise (asset inflation).

Credit creation for financial transactions CF ➙ Asset Markets

Asset Inflation:

Credit is used for financial and real estate speculation:

More money circulates in the financial markets

= speculative credit creation

The effect of credit creation depends on the use of money

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A significant rise in speculative credit creation CF/C must lead to:

- increased ‘financialisation’ and lack of support for productive industries

- asset bubbles and busts

- banking and economic crises

Case Study Japan in the 1980s:

Credit flows explain the boom/bust cycles

Loans to the real estate industry, construction companies and non-bank financial institutions

12%

14%

16%

18%

20%

22%

24%

26%

28%

30%

79 81 83 85 87 89 91 93

Source: Bank of Japan

CF/C

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Types of Speculative Credit Creation (CF) Margin loans (credit for financial speculation)

Loans to non-bank financial institutions

Credit for real estate speculation:– to construction companies

– Mortgages, buy-to-let mortgages

– real estate investment funds, other financial investors

Loans to structured investment vehicles

Loans to Hedge Fonds

Loans for M&A

Loans to Private Equity Funds

Direct financial investments by banks

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asset prices risecorporate balance sheets improve

generally positive/euphoric outlook

banks increase loan/valuation ratios, more willing to lend

Financial credit creation rises

This is how the ‚Bubble Economy‘ works:

The proportion of financial credit creation rises (CF /C ↑).

This creates capital gains from speculation and bolsters balance sheets.

The myth of the continually rising asset price comes about

collateral values rise

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credit creation falls

credit crunch, bankruptcies

unemployment rises

demand, growth fall; deflation

bad debts increase

banks get more risk averse, shrink risk-assets

This is how the banking crisis and debt deflation works

The creation of speculative credit suddenly drops (CF↓).

Usually triggered by central banks

IMF 28 July 2008: „The vicious cycle has started...“

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USA 1920er Jahre (‚Margin Loans‘):

Scandinavia in the 1980s:

Japan in the 1980s:

Asian Crisis, 1990s:

UK property bubble until 2007:

US property bubble until 2006:

Irish property bubble until 2007:

Spanish property bubble until 2007:

The Cause of Past Banking Crises

speculative credit creation

speculative credit creation

speculative credit creation

speculative credit creation

speculative credit creation

speculative credit creation

speculative credit creation

speculative credit creation

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Case 2. The newly created purchasing power is used for transactions that are part of GDP. In this case, nominal GDP will expand:

credit creation for ‘real economy transactions’ CR ➙ nominal growth

The effect of the credit creation depends on the use of money

(b) Growth without inflation:

Credit creation is used for productive credit creation:

More money, but also more goods and services

= productive credit creation

(a) Inflation without growth:

Credit creation is used for consumption:

More money, but same amount of goods and services

= consumptive credit creation

two possibilities

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1. Avoid unproductive credit creation (speculative and consumptive credit creation).

If this form of credit creation rises in the banking system, it cannot be repaid without major problems. Crises follow.

2. Focus on productive credit creation.

Then banks have the highest chance of avoiding non-performing loans, asset bubbles, crises and bank failure. There will also be stable, non-inflationary growth without recessions.

The definition of ‘productive’ should include sustainability.

How to avoid banking and economic crises:

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What is required: transparent regulation of the qualitative allocation of credit creation

In the past this was rejected as ‘inefficient interference’ in the efficient functioning of ‘free markets’

Ironically, today, the UK, French, German and US governments are trying to re-assert influence on bank credit (to small firms, for mortgages). The French PM two days ago threatened to nationalise banks if they did not increase lending.

Had proper regulation of the qualitative allocation of credit taken place earlier, the bubble could have been avoided.

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Investors, bank employees and mortgage borrowers merely responded to the incentive structure presented to them.

The creation of bubbles and hence the crisis could have been prevented by monitoring and directly targeting speculative credit creation.

Central banks have the means and know-how to do this; they did so world-wide until the early 1970s.

In the 1980s they said that such ‘credit guidance’ had to stop as free markets would deliver better results, and, besides, that they should be granted total independence from the government.

Their role and independence needs to be reviewed.

Who carries greatest responsibility for the crisis?

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Either return the power to create the money supply to the public

or institute rigorous controls and transparency over the money creation and allocation decisions of banks.

Either abolish central banks and render them departments of the gov‘t (finance ministry)

Or make them legally dependent on democratically elected institutions, accountable and transparent concerning their credit creation policies.

Then monitor and restrict the allocation of credit to productive uses (defined as being sustainable and welfare enhancing).

How can we end the cycle of recurring banking crises?

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The activities of central banks need to be scrutinised

These are the claims made by central banks about the goal of their policies and about how they achieve them:

There is precious little empirical evidence to support any of these claims.

1. “Central banks aim at price, economic and

currency stability.”

2. “To do this, they use interest rates as the

main monetary policy tool.”

3. “Interest rates are the key variable

driving prices, exchange rates, growth,

stock markets and bond markets.”

Interest rates don’t lead economic growth – they follow it

Rates are not negatively correlated to growth – but positively

True for long, short, nominal and real rates - and in almost all countries

Japan

US

Nominal GDP and Call rate

0123456789

-4 1 6 11

Nominal GDP YoY%

Call rate％Nominal GDP and Call Rate

-6

-4

-2

0

2

4

6

8

10

12

81 83 85 87 89 91 93 95 97 99 01 03

YoY%

-2

0

2

4

6

8

10

Nominal GDP (L)

Call rate (R)

％

US Nominal GDP and Long-Term Interest Rates

0

5

10

15

20

0 5 10 15

US Nominal GDP YoY%

Rate %

US Nominal GDP and Long-Term Interest Rates

0

5

10

15

80 82 84 86 88 90 92 94 96 98 00 02 04

02468101214

US Interest Rates (R)

US Nominal GDP (L)

YoY % Rate %

Cognitive dissonance: Traditional story vs. fact

Traditional story:

Fact: High growth leads to high rates;

Low growth leads to low rates.

Interest rates are the result – and hence cannot be the cause of growth.

Thus why would central banks use interest rates as policy tool? That is an impossibility.

“Low rates lead to high growth;

high rates lead to low growth.”

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What will happen next?

– This depends on the policy response.

Often economists are in danger of staying far too optimistic in this type of banking crisis.

The reason is that it is not difficult to end it quickly, at zero costs.

But: this requires an understanding of the correct policy response and its implementation

Unfortunately there are more examples of misguided (if well-intentioned) policy responses

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Banking Crisis

Correct Response Wrong Response I Wrong Response II

USA 1907 UK 1914 Germany 1933Japan 1945Malaysia 1998

Japan since 1990Thailand 1997Indonesia 1997Korea 1997Scandinavia 1990USA 1929-1935Germany 1929-1933Germany 1880s

USA 2000UK 1991

Wrong policy responses are more frequent

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Problems with the current bail-out programmes:

Banks will remain risk-averse and could even become more vicious in foreclosing to reduce their assets (the most aggressive mortgage forecloser currently is Northern Rock).

Credit creation in the economy is likely to fall; this means declining nominal GDP and moving towards debt deflation and depression

Meanwhile, the total amount of debt – which caused the crisis in the first place – is increased: national debt will rise by tens if not hundreds of billions of pounds in the UK

This debt will have to be serviced at compounding interest, and repaid. The total burden on the economy will thus be even larger.

Moral hazard: Tax payers should not be burdened with the costs.

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The biggest problem with the gov‘t spending programme:

Nominal GDP can’t grow without more credit used for GDP transactions

Fiscal expenditure does not increase credit creation.

The money for the government expenditure (bailout plus increased ‘Keynesian‘ spending programmes) is being raised through bond issuance, i.e. borrowing from the economy!

This constitutes merely a re-allocation of existing money.

The national income pie stays the same size; the gov’t share of the pie merely rises.

What the government injects with the right hand, it takes out with the left – at best a zero sum game.

- Estimation Results of Private Demand Model sample 1990 (1) to 2000 (4)

Coeff. Std. err t-value t-prob. Part.R2

Const 430.797

323.8 1.33 0.191 0.043

∆GDP1

0.369 0.128

2.90 0.006 0.177

∆GDP3

0.203 0.111 1.83 0.075 0.079

∆CR

0.015 0.004 3.45 0.001 0.233

∆G -0.957 0.206 -4.65 0.000 0.357

Evidence from Japan in the 1990s: Complete crowding outEvidence from Japan in the 1990s: Complete crowding out

Result: G= –1

Private and Government Demand

-4000

-2000

0

2000

4000

6000

8000

10000

90 92 94 96 98 00

-1500

-1000

-500

0

500

1000

1500

2000

2500

3000

Latest: Q4 2000

Bn yen

C+I+NX (L)

G (R)

Bn yen

Without a rise in credit used for GDP transactions, nominal GDP can’t grow. Without credit creation, fiscal policy will crowd out private demand completely.

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Why fiscal spending programmes will not work

　

Ministry of Finance

(no credit creation)

Funding viabond issuance

Fiscal stimulus

Net Effect = Zero

Non-bank private sector　 (no credit creation）　 　 　 　

Fiscal stimulation funded by bond issuance(e.g. : ¥20trn government spending package)

-¥20trn +¥20trn

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The Solution: How to recapitalise banks, increase credit creation and boost demand - at zero cost!

All the government needs to do is change the way the bailout is funded: it should not be the government who pays for this, but the central bank.

If the central bank pays, and keeps the assets, there will be no liability for the government, no increased debt, no increased interest burden, and no crowding out of private demand. Most of all, there will be zero costs for anyone.

Even the Bank of England is sure to make a profit (as it acquires assets of a value higher than zero; but its funding costs are zero).

A radical idea, never implemented? Think again.

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The Solution (II): How to make gov‘t spending effective

Non-bank private sector

(no credit creation)

+¥ 20 trn

Bank sector(credit creation power)

Assets　 　 　 　 　 　 Liabilities ¥20 trn ¥20 trn

MoF(No credit creation)

Funding via bank Loans

Fiscal stimulus

　 deposit

Net Effect = ¥ 20 trn

Fiscal stimulation funded by bank borrowing

(e.g. : ¥20trn government spending package)

- Government debt: Public debt can be reduced significantly, fiscal policy rendered effective

- Euro: Governments can stimulate growth, even without ECB cooperation or new fiscal spending

Time to re-think our financial architecture. There are better, more sustainable systems.

Milton Friedman (1982): abolish the central bank and make it a (small) department within the Treasury.

Do we need central banks? The government could just issue its own money. This way, it would not have to pay interest on its borrowing, as it would not borrow money.

The Solution (III): How to make gov‘t spending effective

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Why are these policies not adopted?

Lack of awareness by the public and civil servants

Role of vested interests: according to the World Bank, a “crisis can be a window for structural reform”, and it can “be an opportunity to reform the ownership structure in the country” (Claessens et al., 2001, p. 13).

They were, when it suited:- Bank of England 1914- Germany 1933-37- Japan 1945-47- USA 1963, JFK

Bad debts in 1945 approached 100%. Yet, the problem was quickly solved and a healthy banking sector and strong economic growth re-established.

The solution: bad loans were quickly removed from bank balance sheets, without costs to economy or government.

How? The central bank bought the bad loans above market value. On the central bank’s balance sheet, they will cause no harm.

The costs of this solution are zero. Tax money is not used. The central bank merely credits the sellers in its accounts.

Even if loans with a face value of 100 but a market value of 20 are purchased at face value by the central bank, it will make a profit (of 20). (The magic of credit creation).

1990s: the Bank of Japan refused to do this, insisting on its independence.

Successful and Unsuccessful Bank RestructuringJapan 1945-47 vs. Japan 1990s

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The standard ‘Federal Reserve Note’

JFK’s 1963 ‘United States Note’:No Fed seal

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Palgrave Macmillan,

2005

Further Reading:

Vahlen, 2007

Perception: Mainstream neoclassical economics has proven that- only free markets and free trade can lead to economic success- government intervention of any kind is inefficient and must fail- deregulation, liberalisation and privatisation increase efficiency.

Reality:Mainstream neoclassical economics has proven that

- free markets and free trade would only then optimise welfare…

- government intervention would only then be inefficient…

- privatisation, liberalisation, deregulation would only then

increase efficiency…

if and only if we lived in a world of perfect information.

Appendix: What economics has proven, and what it hasn‘t

The most familiar diagram in economics: a downward-sloping demand and upward-sloping supply curve.

Perception: Mainstream economics has shown that- prices move to equalise demand and supply = equilibrium.

Reality:Mainstream economics has shown that- equilibrium exists if and only if we lived in a world of perfect information (etc.).

Appendix: What economics has proven, and what it hasn‘t

Market clearing requires perfect information (etc.).

In our world, information, time and money are rationed.

Economics must recognise pervasive disequilibrium.

Yet almost all economics is based on equilibrium.

What happens when markets do not clear (i.e. always)?

Demand does not equal supply. Markets are rationed.

Rationed markets are determined by quantities, not prices.

The outcome is determined by the ‘short-side principle’.

Appendix: What economics has proven, and what it hasn‘t