November 18, 2008

Solution to fiscal crisis by creditory economists

Productive Financial Heresy

How to Fix the Banking System and Ensure Employment Now

Open Letter to All Political Leaders from Creditary Economists

The present proposals to solve the current crisis mainly include interest reductions and loan based fiscal stimulus, and some belated limitations on speculation.

These ‘solutions’ will not function; not in the short term and not in the long term.

They will fail to invigorate the banking system and also add to the public debt burden.

The ‘solutions’ are based in a lack of understanding of the how the financial systems works.

We will try to explain why, and how to solve the problem.

A solution, put shortly

Some 98 % of credit in the financial system is normally created privately by banks etc..
The immediate solution must therefore ensure that the private credit system again will create credit. This is done simply by letting governments print new money to buy rotten debt and finance fiscal stimuli for productive purposes. This will not cost tax-payers anything, nor will it produce inflation.

A longer term solution is to establish credit channelling, guiding credit to productive purposes and thereby limiting non-productive speculation. This will reduce both consumer price inflation and also limit asset inflation, reducing the risk of credit bubbles.


In response to the current crisis, the world needs

(1) an efficient, and socially just way of stabilising economies and employment, and

(2) a mechanism to reduce the frequent recurrence of banking crises and significant economic cycles, with all their costs, distortions and injustices.

Any proposal must meet these two criteria. The proposals aired hitherto in the mainstream media fail. Here is an outline of a proposal that passes.

First, we need to understand:

The credit creation’ process:

Empirical research shows that close to 98% of the money supply is not created by central banks or governments, but by privately-owned commercial banks and other financial institutions.

Furthermore, there is no such thing as a ‘bank loan’. Banks do not mainly lend ‘old’ money from deposits belonging to customers. Instead, banks are allowed by the regulatory framework to create new money out of nothing. This process is called ‘credit creation’. After initial requests for credit from the public, the bank staffs then determine how much money is created, who gets the newly created money and they also see what it is going to be used for.

The only institutions that have both the knowledge and the power to interfere in this process are the central banks.

Projects are evaluated by the banks according to potential (in) security and gain, and it is normally assumed that the decisions made by banks will be the best possible.

Unsound banking

The current crisis has once again demonstrated that indeed we can not always expect banks’ credit decisions to be beneficial, for the overall economy or social welfare. Apart from creating ‘innovative’ and speculative financial instruments, the incentive structure at banks tend to create too much credit, when not needed, and in the large for unproductive use, thereby also stimulating inflation.

And again, we now see that this is followed by banks creating too little money, when precisely more would be needed.

How to End Banking Crises and Severe Economic Cycles

Productive vs. unproductive credit creation

There are some simple rules for sound banking and sound economies:

Whenever credit is created and used for productive purposes, to increase the amount of goods and services provided, it will be non-inflationary and wealth promoting: More money comes about, but also more goods and services.

Whenever credit is created and used for unproductive purposes, inflation comes about: more money chases limited goods or assets. The unproductive credit creation can take two forms: When credit is extended for consumption, it will result in consumer price inflation.
When credit is extended for ‘non-productive’ transactions (meaning financial and real estate transactions) , there will be inflation in these markets; asset inflation.
Both cases are unsustainable and if sufficiently large, result in banking and economic crises.

Credit channelling against bubbles and depressions

To prevent banking crises, the bulk of credit creation must be guided to productive purposes. Specifically, aggregate bank credit for transactions that are not directly productive (something that can be easily verified by loan officers) needs to be monitored, and suppressed when it rises in excess of overall bank credit growth.

This simple measure would have prevented the recent credit bubbles, which have now burst and caused crisis. It would also have prevented depressions, such as in Japan since 1990 or internationally in the 1930s.

Such credit guidance differs from commando economics and ‘dirigisme’, but corresponds well with proposals from Nobel laureates such as Ragnar Frisch’s Channelling Model, a Quality Theory of Credit, and ideas initiated by J.M. Keynes in 1946

Deregulation abolished ‘credit guidance ‘

Central banks used to monitor credit usage, but in the wake of financial deregulation most abolished their ‘credit guidance’ policies and instead let go unproductive bank credit expansion. Accompanied by excessive speculation in ‘innovative’ financial instruments, this once again caused bubbles of ‘asset inflation’.

Where Were the Regulatory Authorities?

We need to ask why those institutions that could have prevented the bubbles and thus the current bust, failed to do so, although they had expressly been given unusually strong powers: The central banks (and the Banking, Insurance and Securities Commissions) .

This suggests that the very independence and lack of accountability of central banks has been a major factor in allowing the creation of credit bubbles and the propagation of the current crisis. Not only have private banks failed, but also the central banks have failed, not despite, but perhaps because of their excessive independence.

Thus central banks should be made far more directly accountable to democratically elected assemblies and their independence reduced.

Furthermore, it is doubtful that the private ownership of The Federal Reserve by the Wall Street banks is socially optimal.

Modern Money Creation

More profoundly; the archaic system of money creation by unaccountable privately-owned commercial banks is dubiously beneficial. Today, technology allows more efficient, transparent, and harmonious systems of money creation, for instance directly through the government, which would ease a framework. Such a system of money creation would reduce national debt.

The above are key long-term lessons.

Current policies will not help

What are the immediate measures to end the current crisis and avoid large-scale unemployment? Just like the Japanese government in the early 1990s, governments have responded by increasing fiscal expenditure, funded by borrowing, and central banks have responded by lowering interest rates.

However, neither will help:

The privately-owned creators of the bulk of the money supply are
seeking refuge; in their increased risk aversion they will continue to reduce credit creation. Just as their excessive credit creation affects us all, so does their reduction of credit.

Fiscal expenditure as such does not create credit, but also depends on how this is financed. By borrowing the money for public fiscal stimulation, the same money is removed from the private economy through bond issuance. Thus fiscal policy, if not backed by new credit creation, will crowd out private demand and the stimulus is ‘sterilised’. Furthermore, national debt is increased by this policy, which places an unfair future burden upon tax payers.

And lower interest rates will not help – even if they drop to zero – if the quantity (NB!) of credit does not increase. This is why Japan will soon be in the twentieth year of recession after its own credit bubble burst in 1990.

The solution is simple

For productive economic growth, new credit creation is necessary.

Fiscal stimulation, in the form of purchases of non-performing assets from banks, and public purchases of bank equity, should be funded either by the issuance of ‘new’ government money, by the governments’ Treasury or, by the central banks. In both cases, national debt and interest liabilities will not increase, but credit creation will.
Growth will hence not collapse.

This also makes sense from a moral hazard perspective:

Tax payers are not responsible for the current mess, but the central banks are – so let them pay, by issuing new money. As explained above this will not create inflation, nor will it put new burdens upon tax payers.

Conclusion repeated

The immediate solution must therefore ensure that the private credit system again will create credit, by letting governments print new money to buy rotten debt and finance fiscal stimuli for productive purposes. This will neither burden tax-payers nor produce inflation.

A longer term solution is to establish credit channelling, for productive purposes. This will reduce consumer price inflation and limit asset inflation, reducing the risk of credit bubbles.

1 comment:

Anonymous said...

[ private comment ]

Subj: TPM Spam, your comments


The TPM blog changed, and the IP numbers are not visible. However, you can still enter the IP numbers into the search option on TPM and still find the posts, even though the IP numbers aren't visible.

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2. Your points:

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Copy this link to a new browser before posting/connecting to the URL:

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use this link to search using IP numbers. Notice, the IP numbers are not visible, but they're indexed.

Note the IP number is 128.135, which goes to the University of Chicago.

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[ end private comment ]