In a way this blog is being written to stop the relentless onslaught of E-mails coming, which seek to promote so-called positive money. I am regularly told that I need to forget Modern Monetary Theory (MMT) and instead see the benefits of this alleged revelationary approach to running the economy. Other E-mailers are less complimentary but just as insistent. Then there are the numerous E-mails recently with the following document attached – Monetary Reform: A Better Monetary System for Iceland – which I am repeatedly told is the progressive solution to bank fraud and, just about all the other ills of the monetary system. The Iceland Report was commissioned by the Icelandic Prime Minister and is being held out as the solution to economic and financial instability because it would wipe out the credit-creating capacity of banks. It has been endorsed by the British conservative Adair Turner, who formerly was the chairman of the UK Financial Services Authority and who recently advocated so-called overt monetary financing (OMF) as a way to resolve the Eurozone crisis. I agree with OMF but disagree with his view that it is the credit-creation capacity of banks that caused the crisis. The crisis was caused by banks becoming non-banks and engaging in non-bank behaviour rather than their intrinsic capacity to create loans out of thin air. A properly regulated banking system does not need to abandon credit-creation. Further, I am aware that in holding this view, I and other Modern Monetary Theory (MMT) proponents are accused of being lackeys to the crooked financial cabals that hold governments to ransom and brought the world economy to its knees. Let me state my position clearly: I am against private banking per se but consider a properly regulated and managed public banking system with credit-creation capacities would be entirely reliable and would advance public purpose. I also consider a tightly regulated private banking system with credit-creation capacities would also still be workable but less desirable.
This is a two-part series given the topic is rather massive.
Please note that I do not want my blog to become a forum for a long discussion on positive money. I hope this two-part series states my position and I plan to end it at that. I will also delete comments that provide links to positive money sites.
As background, please read the following blogs – Operational design arising from modern monetary theory and Asset bubbles and the conduct of banks – for further discussion.
Please also read the following introductory suite of blogs – Deficit spending 101 – Part 1 – Deficit spending 101 – Part 2 – Deficit spending 101 – Part 3 – for basic Modern Monetary Theory (MMT) concepts.
Please also note that the term ‘money’ is quite difficult to pin down given that it is a social construct with embedded power relationships. For us to understand the history of money requires us to also be sociologists and anthropologists among other things to penetrate the broader relationships that govern the use of a ‘thing’ which might be called money.
We have a tendency to think of money in numerical terms and construct additions and subtractions when talking about it. But we should always be mindful that underlying these ‘transactions’ (or the “arithmetic problem” as Randy Wray calls it in his work – The Credit Money and State Money Approaches) are complex social relationships.
Economic exchange is always embedded in a power hierarchy, which determines, among other things, how the surplus production is generated and how it is distributed.
Note also that:
- Modern monetary economies use money as the unit of account to pay for goods and services. An important notion is that money is a fiat currency, that is, it is convertible only into itself and not legally convertible by government into gold, for instance, as it was under the gold standard.
- The sovereign government has the exclusive legal right to issue the particular fiat currency which it also demands as payment of taxes – in this sense it has a monopoly over the provision its own, fiat currency.
- The viability of the fiat currency is ensured by the fact that it is the only unit which is acceptable for payment of taxes and other financial demands of the government.
In a modern monetary economy, the consolidated government sector (central bank and treasury) determines the extent of the net financial assets position (denominated in the unit of account) in the economy.
The only way the non-government sector can increase its stocks of net financial assets is if there is a transaction with the government sector (for example, if the government spends).
As a matter of accounting between the sectors, a government fiscal deficit adds net financial assets (adding to non government savings) available to the private sector and a fiscal surplus has the opposite effect.
Treasury operations which may deliver surpluses (destruction of net financial assets) could also be countered by a deficit (of say equal magnitude) as a result of central bank operations. This particular combination would leave a neutral net financial position.
However, most central bank operations merely shift non-government financial assets between reserves and bonds, so for all practical purposes the central bank is not involved in altering net financial assets.
The exceptions include the central bank purchasing and selling foreign exchange and paying its own operating expenses.
So we are clear – the government is the only entity that can provide the non-government sector with net financial assets (net financial savings).
In general, the government deficit (treasury operation) determines the cumulative stock of net financial assets in the private sector. Central bank decisions then determine the composition of this stock in terms of notes and coins (cash), bank reserves (clearing balances) and government bonds.
A net financial asset created in this way provides the non-government sector with the capacity to spend without any offsetting liability being created.
This is not the case, however, in private credit markets, which involve the leveraging of credit activity by commercial banks, business firms, and households (including foreigners).
Many economists in the Post Keynesian tradition consider this activity to define the endogenous circuit of money.
The theory of endogenous money is central to the horizontal analysis in MMT. When we talk about endogenous money we are referring to the outcomes that are arrived at after market participants respond to their own market prospects and central bank policy settings and make decisions about the liquid assets they will hold (deposits) and new liquid assets they will seek (loans).
The essential idea is that the ‘money supply’ in an ‘entrepreneurial economy’ is demand-determined – as the demand for credit expands so does the money supply. As credit is repaid the money supply shrinks. These flows are going on all the time and the stock measure we choose to call the money supply, say M3 is just an arbitrary reflection of the credit circuit.
Please read my blog – Understanding central bank operations – for more discussion on this point.
The supply of money is determined endogenously by the level of GDP, which means it is a dynamic (rather than a static) concept.
Central banks clearly do not determine the volume of deposits held each day. These arise largely from decisions by commercial banks to make loans. The central bank can determine the price of ‘money’ by setting the interest rate on bank reserves.
However, the only way you can understand why all this non-government leveraging activity (borrowing, repaying etc) can take place is to consider the role of the Government initially – that is, as the centrepiece of the macroeconomic theory.
Banks clearly do expand the money supply endogenously – that is, without the ability of the central bank to control it. But all this activity is leveraging the high powered money (HPM) created by the interaction between the government and non-government sectors.
HPM or the monetary base is the sum of the currency issued by the State (notes and coins) and bank reserves (which are liabilities of the central bank). HPM is an IOU of the sovereign government – it promises to pay you $A10 for every $A10 you give them! All Government spending involves the same process – the reserve accounts that the commercial banks keep with the central bank are credited in HPM (an IOU is created). This is why the “printing money” claims are so ignorant.
The reverse happens when taxes are paid – the reserves are debited in HPM and the assets are drained from the system (an IOU is destroyed).
We can think of the accumulated sum of the transactions between the government and non-government sectors as being reflected in an accounting sense in the store of wealth that the non-government sector has. When the government runs a deficit there is a build up of wealth (in $A) in the non-government sector and vice-versa. Budget surpluses force the private sector to ‘run down’ the wealth they accumulated from previous deficits.
One we understand the ‘vertical’ transactions between the government and non-government then we can consider the non-government credit creation process.
Private capitalist firms (including banks) try to profit from taking so-called asset positions through the creation of liabilities denominated in the unit of account that defines the HPM (for example, $A). So for banks, these activities – the so-called credit creation – involve leveraging the HPM created by the vertical transactions because when a bank issues a liability it can readily be exchanged on demand for HPM.
When a bank makes a $A-denominated loan it simultaneously creates an equal $A-denominated deposit. So it buys an asset (the borrower’s IOU) and creates a deposit (bank liability). For the borrower, the IOU is a liability and the deposit is an asset (money).
The bank does this in the expectation that the borrower will demand HPM (withdraw the deposit) and spend it. The act of spending then shifts reserves between banks.
These bank liabilities (deposits) become ‘money’ within the non-government sector. But you can see that nothing net has been created. Only vertical transactions create/destroy assets that do not have corresponding liabilities.
The crucial distinction is that the horizontal transactions do not create net financial assets – all assets created are matched by a liability of equivalent magnitude so all transactions net to zero. This has implications for government spending impacts on liquidity in the economy and central bank operations designed to maintain a target interest rate.
The other important point is that the commercial banks do not need reserves to generate credit, contrary to the popular representation in standard textbooks.
Quantity or price
The money account defined by the government as the unit it will accept in payment to extinguish non-government tax liabilities is issued under monopoly conditions.
The State is the monopolist in the provision of the currency. The private banks cannot issue currency. They can create credit backed by an offsetting debt but not issue the money account.
Basic theory tells us that a monopolist has a choice – it can either control the quantity or the price of the monopoly good.
It cannot do both. So it could ban private credit leveraging (as the Sovereign Monetary Proposal we discuss next advocates) and thus control the quantity of ‘money’ in the economy. But then it would lose control over monetary policy, if we define that in terms of the capacity to set the interest rate and condition the term structure of interest rates (the longer maturity rates associated with mortgages, investment loans etc).
If it then tried to control interest rates, then it would lose control over the quantity of ‘money’ in circulation. This is a point I will return to further on.
Iceland’s Sovereign Money Proposal – Overview
The Iceland Sovereign Money Proposal (SMS) claims the regulatory changes to the financial system since the 2008 financial crises have been substantial (“increasing bank capital and liquidity requirements, developing bank resolution plans, and requiring derivatives trading to go through central clearing houses”).
In his introduction to the Icelandic Monetary Reform report, Adair Turner then claims:
But they have still failed to address the fundamental issue – the ability of banks to create credit, money and purchasing power, and the instability which inevitably follows. As a result, the reforms agreed to date still leave the world dangerously vulnerable to future financial and economic instability.
The Monetary Reform report goes to this “fundamental issue”.
It concludes that the:
… the fractional reserve system may have limited the Central Bank’s ability to control the money supply while giving banks both the power and incentive to create too much money.
This is the nub of issue for this group. They somehow consider that all the major ills of the capitalist system can be traced to the ability of the private banks to create loans without necessarily having the reserve backing in advance.
A whole host of proposals come under this umbrella – “100% Reserves, Narrow Banking, Limited Purpose Banking” etc. They have nuances with differentiate them but they are essentially united in their desire to stop banks creating credit.
The so-called “Sovereign Money proposal” says:
… only the central bank, owned by the state, may create money as coin, notes or electronic money. Commercial banks would be prevented from creating money.
The document then proceeds to justify that proposal. It is a long document so I will only summarise the salient points inasmuch as they apply to all these ‘positive money’ proposals.
In modern monetary economies, the central bank clearly does not control the money supply. It controls the interest rate. Please read the following blogs for more information:
The Report acknowledges that:
The Central Bank of Iceland must provide banks with reserves (money in accounts at the CBI) as needed, in order not to lose control of interest rates or even trigger a liquidity crisis between banks. The Central Bank of Iceland therefore had to create and provide new central bank reserves to accommodate banks as they expanded the money supply nineteen fold between 1994 and 2008.
This is clearly valid. But it also conflates several points. First, the CBI did have to supply reserves on demand to ensure the clearing system worked each day. All central banks have to do that and as we will see that capacity would not really change under this proposal.
The central bank operations might be called something different and the fancy names given to accounts but essentially the money supply would still be endogenous under this proposal unless the central bank was willing to tolerate the interest rate going beyond its control or a lack of funds available for borrowing. I will discuss that more in Part 2.
Second, this is not the reason that the privatised banks went crazy. The provision of reserves as Lender of Last Resort can be easily supplemented with other legislative powers either vested in the central bank or a related prudential authority to ensure that banks behave as banks.
Consider the following case study of the Icelandic banking explosion before we go on.
It is clear that the capacity to create credit was not the reason Iceland’s banking system went overboard.
Case study: The Iceland Parliament’s Special Investigation Commission (SIC)
The Iceland Parliament’s Special Investigation Commission (SIC) published a major report in 2010 – The Report of the Investigation Commission of Althing – covering the Icelandic Banking collapse in 2008.
An English language version of aspects of the – Report of the Special Investigation Commission (SIC) – covers Chapters 2, 17, 18, 21 and Appendixes 3 and 8. There is also an English version of the main conclusions of the Working Group on Ethics available.
We learned that:
1. “The main cause of the failure of the banks was the rapid growth of the banks and their size at the time of the collapse” – the “big three banks grew 20-fold in size in seven years”.
2. The “quality of the Icelandic banks loan portfolios eroded under these circumstances” and internal incentive structures drove the growth rather than commercial risk analysis.
3. The rapid expansion of “global debt financing markets drove the growth of the banks”.
4. The “Icelandic banks received high credit ratings, which was mostly inherited from Iceland’s sovereign debt rating” – the three banks issued more than Iceland’s GDP in 2005 into foreign debt markets and most of the debt was relatively short-term (3-5 years), which meant it required refinancing around 2008.
5. The international debt funding markets dried up as early as 2006 and by 2007, “foreign deposits and short-term securatised funding became the main source of funding for the three banks”. This was highly market-sensitive funding.
6. Massive repayment burdens emerged in 2008 while funds available to refinance had dried up.
7. The prudential regulator was inexperienced and understaffed given the massive foreign exposure of the banking system.
8. The Central bank of Iceland did not have sufficent foreign currency reserves relative to the foreign deposits in the banking system (more than 8 times the forex reserves) and the short-term, foreign currency liabilities (more than 16 times the forex reserve).
There was no chance the central bank could underwrite the banking system at that stage. It is clear that the central bank was aware of the massive exposure of the system to increased risk and warned the neo-liberal government accordingly. The government chose to talk up the safety of the banking system rather than intervene.
There was a massive rise in foreign deposits (in Dutch and British branches of the banks) from late 2006 to the middle of 2007. Ridiculous deposit rates were being offered to shore up the funding bases. From mid-2007, there was a huge outflow of wholesale deposits from the banks “much more than the inflow rate of retail deposits”
9. Things get murkier when you consider that the corporations that owned the three main banks – Kaupthing, Landsbanki and Glitnir – “were the banks’ principal owners”. Was lending done “at arms length”?
It was found that the owners had created a sequence of shelf companies with fictitious transactions to hide what was going on.
The SIC found that:
The operations of the banks were in many ways characterised by their maximising the benefit of majority shareholders, who held the reins in the banks, rather than by running reliable banks with the interests of all shareholders in mind and to show due responsibility towards creditors.
10. The “banks risks exposure due to funding of own shares was excessive”. That is, they financed the equity of the owners based on borrowing from foreigners.
As a result, the capital structure was dodgy in the extreme and “did not reflect the real ability of the banks nor of the financial system as a whole to withstand losses”.
The inflated (but essentially fictitious) capital allowed the banks to grow further than they could if the equity was stronger.
11. Several large Icelandic investment companies (non-bank financial speculators) borrowed huge amounts in foreign currencies and gained securities from the Icelandic banks, who utlimately had to take “over the financing so that loans to foriegn banks could be paid up”.
What did these investment companies do with the loans? The:
… loans were largely made in order to finance the purchase of shares in the banks themselves. To prevent sales of the shares the banks overtook the financing in an effort to maintain the value of the shares.
Again, to maximise the wealth of the banks’ owners!
The banks were also buying up their own shares to maintain value for the owners.
12. By November 2008, the asset values of the three big banks which were on the books as IKR 11,764 billion were adjusted downward to IKR 4,427 billion – a 60 per cent write-down.
The SIC said that in 2008, Iceland’s GDP was around IKR 1,476 billion, which means “that the write-down of the assets of the financial companies” was equivalent to around 5 years of GDP – five years of national production and income. Massive, in other words.
I know there is debate about the role that neo-liberalism played in Iceland. The free market lobby claim that the period of market liberalism which began in the early 1990s, ended around 2004. After that, Iceland should be better described as being a ‘crony capitalist’ nation, and it was this period that coincided with the massive credit growth.
But it was the market liberalism that gave birth to the crooked bankster class.
A coherent left view of the crisis in Iceland is presented by Martin Hart-Landsberg in the Monthly Review, 2013 (Vol 65, Issue 3) – Lessons from Iceland: Capitalism, Crisis, and Resistance.
He argues that:
In 1991, the Icelandic government began an aggressive program of liberalization and privatization which gave rise to the hyper-expansion of three Icelandic banks.
He provides an interesting historical account of the transition from the large, state-owned banks that rationed capital between industries and home-owners” with the central bank setting nominal interest rates under the control of the government.
The system was not perfect but “by the 1980s [Iceland] had attained both a level and a distribution of disposable income equal to the Nordic average.”
The privatisation of the banking system which began in the 1990s and was complete by 2003, favoured those with political influence in the new free market-oriented government.
The banks became cash cows for the owners who used the funds, in part, to fund the political parties that gave them favour. In this sense, the liberalisation was really reinforcing the crony nature of the state-corporate nexus that dominated Iceland in the Post World War 2 period.
We learn that:
While the banking elite used their access to funds to purchase control of many Icelandic businesses, they also engaged in heavy investing outside of Iceland. Major targets were fashion outlets, toyshops, soccer teams in Britain, and supermarkets in the United States and throughout Scandinavia.
They used their influence within the Icelandic government and Chamber of Commerce to build a smokescreen of stability. In this blog – Wrong is still wrong and should be disregarded – I traced the role of the credit rating agencies and consulting reports provided by hired academics, which waxed lyrical about the solid state of the economy.
One of those academics was Columbia University’s Frederick Mishkin, who featured in the 2010 movie Inside Job and was paid a considerable sum by the Iceland Chamber of Commerce in 2006 to produce the report the – Financial Stability in Iceland.
At the same time that Mishkin and his co-author were giving the financial system in Iceland a clean bill of health, the Icelandic banks were engaged in elaborate and not so elaborate growth schemes based on refinancing debt with extra borrowing using both accounting mirages and illegal manipulation of markets to allow them to become many times bigger than they could justify on fundamentals.
After the crisis broke, Mishkin was caught changing his CV by renaming the paper ‘Financial Instability in Iceland’.
When the Inside Job challenged him about this during an interview, he stumbled, in a dissembling fashion and eventually managed to get it out that it must have been a ‘typo’.
The following year (2007) LSE Professor Richard Portes co-authored a 65-page consulting report – also for the Iceland Chamber of Commerce – The Internationalisation of Iceland’s Financial Sector which the NLR says he was paid £58,000. It was actually co-authored by Icelandic economist in collaboration with the Iceland Chamber of Commerce.
It also said that the banking system in Iceland was “highly resilient” and that “Overall, the internationalisation of the Icelandic financial sector is a remarkable success story that the markets should better acknowledge”.
There were many cases documented of that sort of behaviour and deception.
What the Icelandic experiment demonstrated was that the instability of capitalism and its tendency to promote dishonest behaviour by the owners of capital will lead to breakdowns more quickly and more profoundly in an unregulated environment.
It also demonstrated that if the State intervenes as it did in 2008 and 2009 when the banking system collapsed stability can be restored relatively quickly.
Ask yourselves whether the problem was the credit-creation capacity of the banks or other factors that drove Iceland’s banking crisis.
What other factors?
1. Banks speculating in foreign-currency debt and assets and no longer behaving like banks.
2. The ownership of the banks engaging in devious and self-serving behaviour.
3. A lack of prudential control.
4. Neo-liberal government serving the interests of the wealthy and ignoring their responsibilities to advance general well-being.
In Part 2, I will consider the mechanics of the SMS in more detail and tell you why it is not an improvement on the current system.
I will also outline why broader, quite radical reforms are needed to the banking and financial sectors, which do not involve restricting the capacity of ‘banks’ to create create credit.
That is enough for today!
(c) Copyright 2015 William Mitchell. All Rights Reserved.