The policy implications of the fact that banks create most of the new money in a modern economy
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Contents
Should private banks arrogate the money creation role to themselves?
What bank regulation should achieve
Economic growth need not be constrained by a lack of monetary capital
The true source of inflation is the misallocation of newly-created money
Interest rates are not linked to deposit rates or to the inflation rate
Debt forgiveness is far easier and a lot more practical than we have been led to believe
Waxing philosophical: should all money be credit?
Introduction
In the previous article, we established that banks create new money when they lend. We now address ourselves to the policy implications of this fact.
Should private banks arrogate the money creation role to themselves?
The first question we must answer, of course, is a normative one: should banks be allowed to create new money in an economy?
The answer to this question can be found in the answer to a deeper and far more important question: what should newly-created money be used for?
Newly-created money should be used to finance – enhance – an economy’s productive capacities. In other words, new money should support the growth of trade and industry. It should support firstly, increased and (later) improved production. Any other use of newly-created money results merely in one form of inflation or the other, as we shall see shortly. The use of newly-created money to build productive businesses and industries (driving down unemployment and increasing the productive capacity of a nation) is the sole correct application of the money-creation power.
Who, then, is best-placed to identify the right businesses to lend to?
In a Utopian world, government would be best-placed to decide how new supplies of what Gesell calls “money-capital” should be allocated, in line with economic policy and a sensible development plan. However, this author submits that while money-capital is a public good, and the sensible allocation of it should therefore be a public task, government has too many perverse incentives to be rightly entrusted with these duties. Our own nation’s history demonstrates that government and banking do not go well together. The audited financial statements of the Development Bank of Kenya, in which the government has an 89.3% stake, show that from 2019 to 2022 the bank was loss-making in 2020, barely broke even in 2021, and was once again loss-making in 2022. The Consolidated Bank of Kenya, which is fully-owned by the government, has had 7 straight years of losses (2016 to 2022).
The main reason why government and banking do not go well together may be discerned from the Auditor-General’s report on the Agricultural Finance Corporation for the year ended June 2020. The Agricultural Finance Corporation is mandated, in the main, to “assist in the development of agriculture and agricultural industries by making loans.” From the aforementioned Auditor-General’s report, we learn that KES 2.1 billion was written off for loans issued during the calendar years 2013-2016. A further KES 2.5 billion of loans (from a total of KES 7.7 billion) were underperforming (33.5%). The private banking industry’s average is 14.6%. Government, it can be seen, does not pair well with banking.
We can conclude from the comparatively better performance of private banks that private banks are a more prudent allocator of capital than the government is. What drives this prudence is the profit motive: although banks have this awesome money-creating power, properly shackled to the need to make profits, the ceding of this power to the private sector should result in more prudent allocation of money-capital. Banks are less likely to lend to cronies who will not pay back their loans because to do so would reduce their profits (although this line can be blurred, as in the case of Chase Bank, etc; the solution is effective regulation).
What bank regulation should achieve
The problem is that, left to their own devices, banks will seek to make profits from their money-creating power as easily as possible – indeed without lifting a finger, if possible. The heavy lifting needed to determine the creditworthiness of small and mid-sized enterprises, for example, is significant. Banks will not, on their own, lend to boost trade and industry (thereby powering job creation) when there exist easier paths to profit. There exist two such paths at present: lending to government, and mortgage lending.
A significant proportion of banks’ loan books go towards funding government: according to the Central Bank’s Annual Banking Sector Report (2022), by December 2022 commercial banks held KES 1.884 trillion shillings in government securities. The other sink for bank funding is mortgage lending.[1] The total mortgage lending as at December 2022 was KES 261.8 billion in December 2022. Total lending in that year was KES 5.233 trillion, so that fully 41% of bank lending went into these two sectors.
In order to channel most/all newly-created funds in the direction of trade and industry, with the ultimate and more important aim of driving job-creation, banks should be more tightly regulated by restricting them (a) from lending to the government and (b) from mortgage lending. Restricting lending to the government can be achieved best, of course, by the government living within its means, and not running trillion-shilling annual budget deficits.[2] Restricting mortgage lending could be done by, for example, by only allowing pension funds to lend into this sector (pension funds cannot create money-capital), or by having only certain special savings and loans institutions that do not have money-creating power lend for mortgages, or, thirdly, by restricting banks to have only 1%-5% of their loan books comprise mortgage lending.
Economic growth need not be constrained by a lack of monetary capital
Since money-capital is already being created domestically, economic growth need not be constrained by a lack of it. An interesting case study for this is Japan. Japan grew at 8.7% per annum in the 1950s and at 10% per annum in the 1960s (Werner, 2018, p 205).[3] In fact from 1960 to 1970, Japan’s real GDP multiplied 2.6 times, so that by 1970 Japan had overtaken Germany to become the world’s second-largest economy (Werner, 2018, p 89).[4]
We have seen in another article that land redistribution that enabled labour-intensive agriculture was the first step in Japan’s growth to a global economic power (a rung on the economic ladder that we should not bypass because this is the most efficient way to combat our primary economic problem – unemployment). The other key policy tool behind this phenomenal growth was that bank lending was very closely controlled by Japan’s central bank (the Bank of Japan) through a process known as window guidance. Under this process, the Bank of Japan (BoJ) would control how much banks could lend by issuing them with quotas by which they could increase their lending within a given period. The quotas themselves were very precise percentages of their current lending. The BoJ forced banks to use up these quotas in full and kept a close eye on the sectors into which this lending could go. Not only did the BoJ require banks to report which sectors were lent to, but loans were also categorized by sub-sector, (iron, steel, etc); size of company (large companies (by name), vs small- and medium-sized enterprises); and even use (investments into new plant, working capital (Werner, 2018, p 86[5])). Using these tight controls, the BoJ was able to direct which sectors received new lending, and to (using this and other tools) reorient the economy in the direction of becoming a global exporter. At the same time, inflation remained relatively moderate at 4.1% in the 1950s and 5.7% in the 1960s.[6] It has been thought that Japan’s high savings rate was the driver of this growth. In fact, the high savings rate was (and is) more useful as a hedge against inflation (Werner, 2005, p 361).[7] Judicious use of the banking sector’s ability to create money was the real driver of this growth.
The true source of inflation is the misallocation of newly-created money
While inflation is the result of excess money creation, this causal explanation is imprecise. Inflation arises from creation of new money that does not go towards funding the increase or the improvement of productive capacity (i.e. money that does not fund GDP transactions). When newly-created money (bank lending) results in the production of new goods and/or the provision of new services, inflation is held back since the new money has goods and services to represent it. The use of the money-creating power to drive the purchase of already-existing land, buildings, or stocks leads to asset price bubbles. The use of the money-creating power to fund consumption leads to rises in the consumer price index (as happened in the US as a result of the Covid-19 stimulus).
A lack of precision about the true origin of inflation leads to the policy prescription – for which we again have economic orthodoxy to blame – that inflation is best controlled by raising interest rates. Inflation is not, primarily, caused by a fall in the price of money but by a rise in the quantity of money being channelled into unproductive uses. It is therefore not mainly a function of interest rates, but of the misuse (if not, indeed, the abuse) of the money-creation power. While interest rates can control inflation, this control is only indirect. Further, the use of interest rates to control inflation results in an enrichment of the banking sector and the already-rich – often at significant cost to the truly productive sectors of the economy; finance is meant to be an industry enabler, not an industry in its own right. Direct credit control through judicious bank regulation in the manner described earlier would be more effective as a means of controlling inflation than adjusting interest rates is.
Interest rates are not linked to deposit rates or to the inflation rate
The question then arises: what is the correct interest rate for newly-created money? Traditional views on the interest rate are buttressed by the twin misunderstandings, widely spread by economic orthodoxy, (a) that banks lend deposits and (b) that the return on lending must exceed inflation.
We have seen that banks do not lend already-existing deposits. Instead, banks create new deposits at the point of lending. It is therefore incorrect, inefficient (and, frankly, immoral) to set the floor of the interest rate at the rate of interest on deposits. No interest should be paid on deposits that are created at no cost.
Since banks are able to create money at no cost, it follows quite simply that banks should not charge interest. The only answer to the question of what the correct interest rate is under the conditions of economic reality that we have outlined, is 0%. A 2005 paper by Mathew Forstater and Warren Mosler entitled The Natural Rate of Interest is Zero arrives at the same conclusion by a very similar path, i.e. by recognizing that governments are able to issue currency (i.e. to create money by increasing banks’ deposits at the central bank) at no cost (Forstater and Mosler, 2005).[8]
We have also seen that inflation is caused by the misuse of banks’ money-creating power. Therefore, the floor of the interest rate cannot be inflation if inflation itself is driven by the abuse of the money-creation process. This would amount to forcing legitimate borrowers – entrepreneurs with the capacity to drive production and reduce unemployment – to pay for the banking sector’s inefficiencies and/or for regulatory ineffectiveness.
In truth, however, banks do incur costs in the process of allocating capital. A “Cost + Margin” approach to arriving at bank profitability would result in a far fairer “interest” rate – if indeed we must call such a charge interest. It would be better to call it a “lending charge” and charge it to borrowers as a charge.
For illustrative purposes we shall wax a bit practical here, and take, by way of example, three of the largest banks in Kenya (Cooperative Bank, Equity Bank, and Kenya Commercial Bank). Staff costs, operating costs, and depreciation costs for these three banks for the financial years 2021 and 2022 amount to 298.196 billion, or 5.53% of loans and other financial assets (valued at 5.394 trillion). Adding a 15% margin to these costs suggests a lending charge of 6.36% would be sufficient for these banks to be profitable.[9] No doubt further savings could be realised by more efficient lending, digitisation, and the like.
This approach, of course, would necessitate not paying interest on deposits. That is the point of this article. Since deposits are created at zero cost, paying interest on deposits does not make sense. At a time when Kenyan businesses are having to pay 17.56% interest to access credit, another paradigm – so long as it is based on truth rather than on the smoke and mirrors of economic orthodoxy – is not only welcome, but also necessary.
Debt forgiveness is far easier and a lot more practical than we have been led to believe
Private indebtedness is a key macroeconomic metric. A high level of private debt is what enabled Steve Keen, one of the Bezemer 12,[10] to predict that the global financial crisis was looming.
Should privately-incurred debt be forgiven? Debt forgiveness has a long history, dating back to Biblical times. Where debtors are unable to pay, forgiveness becomes inevitable. In modern times, and where banks are involved, for forgiveness to be viable the lender’s balance sheet needs to be made whole. This means that the non-performing assets on a bank’s balance sheet need to be bought off in order to re-enable banks to lend. In this sense therefore, the forgiving of private debt is inseparable from bailouts.
Since governments can create their own currency (which is a significant advantage of not being part of a currency union), such bailouts can be funded through central bank money creation. The central bank can acquire these loans – even at full value – at no real cost to itself since the money for the bailout can be created. This also does not result in inflation since the newly-created purchasing power does not end up in the economy. This solution was suggested by Richard Werner in 2005 (Werner, 2005, p 254).[11] (Ben Bernanke partly adopted this approach (the purchase of non-performing assets (mortgage-backed securities)) as part of the Federal Reserve’s response to the global financial crisis.)
The upshot of this is that where local debts remain unpaid and are unpayable, they can be absorbed by a nation’s central bank, and that it need not cost the taxpayer or the central bank anything to absorb banks’ bad debts.
To avoid moral hazard, such drastic intervention should be stringently avoided. There should be Constitutional safeguards against it, and even when such action requires to be taken, it should require parliamentary approval. It is not this author’s view that banks can be too big to fail, particularly when such failure is the result of wanton and reckless lending. However, it should be an available option in the event that widespread banking sector failure is envisioned. The bailout option should always be paired with serious legal consequences for bank executives who have engaged in indiscriminate lending necessitating a bailout.
Waxing philosophical: should all money be credit?
We have to this point discussed some of the practical, policy implications of the fact that the main money-creating power in many an economy. We now briefly wax slightly philosophical. The point can be made that if banks are the main money-creating power in an economy, then practically all new money enters the economy as credit. Nor is this credit free; interest is charged on it. If the bulk of the money-creating power in an economy came from the printing and minting of notes and coins, respectively, money would enter the economy interest-free. This means that interest is a charge on the entire economy for the public good of money as a means of exchange. Viewed in this manner, this interest as a charge is a drag on the growth of the economy. (It is particularly counterintuitive that the poor – assuming the businesses they wish to fund are viable – pay the highest costs in order to access credit, in the name of risk, while already-wealthy corporations enjoy the lowest interest rates for loans issued to them. A full philosophical discussion of these outcomes is beyond the scope of this piece. Suffice it to say that a journey to the spring from which the river of interest flows, with Silvio Gesell as our guide, makes for interesting travel and would help us to resolve this matter once and for all.
Conclusion
In last week’s article and in this article, we have established that a nation with its own currency creates its own money supply. Perhaps counterintuitively, this money supply is not created by the government, but by that nation’s banks. This power should rightly belong to the people, via government, but governments being what they are, particularly in this part of the world, pragmatism dictates that this power is delegated to the private sector. However, this power should only be delegated under strict conditions – that newly-created money is utilised strictly to support the growth and the improvement of that nation’s productive capacity. This means, mainly, that newly-created money must not be used to lend to the government, nor should it be used to finance mortgages / in other ways inflate the price of already-existing assets such as land and stocks. We have also seen that all this implies that the floor of the interest rate cannot be the deposit rate on deposits that are created free of charge for the purpose of lending. Nor, indeed, can inflation be the floor of the interest rate as inflation is a function of misallocated newly-created money. We would therefore do better to dispense with the concept of interest entirely, and have banks, more justly, operate on a cost + margin basis, which we have shown would result in lower lending charges than are currently experienced in Kenya. Lastly, we have noted that debt forgiveness is more easily achievable than we have generally been led to believe.
Footnotes:
[1] Strictly speaking, mortgages for construction of new homes are not a harmful use of the money-creating power.
[2] The 2024/25 budget deficit is taken to be total expenditure (KES 4.2 trillion) less ordinary revenue receipts (KES 2.96 trillion)
[3] Werner, R. A. (2018). Princes of the yen: Japan’s central bankers and the transformation of the economy. Quantum Publishers, ISBN: 978-3-946333-01-2.
[4] Werner, R. A. (2018). Princes of the yen: Japan’s central bankers and the transformation of the economy. Quantum Publishers, ISBN: 978-3-946333-01-2.
[5] Werner, R. A. (2018). Princes of the yen: Japan’s central bankers and the transformation of the economy. Quantum Publishers, ISBN: 978-3-946333-01-2.
[6] Takatoshi Ito, 2013. “Great Inflation and Central Bank Independence in Japan,” NBER Chapters, in: The Great Inflation: The Rebirth of Modern Central Banking, pages 357-387, National Bureau of Economic Research, Inc.
[7] Werner, R. A. (2005). New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance. Palgrave Macmillan.
[8] Forstater, M., & Warren Mosler. (2005). The Natural Rate of Interest Is Zero. Journal of Economic Issues, 39(2), 535–542. http://www.jstor.org/stable/4228167
[9] Note: Including bad debt provisions as an expense almost doubles the cost + margins rate to 11.68%, suggesting the quality of our banks’ loan books may require review.
[10] The Bezemer 12 is very useful as a list of economists whose writing it is actually worth paying attention to.
[11] Werner, R. A. (2005). New Paradigm in Macroeconomics: Solving the Riddle of Japanese Macroeconomic Performance. Palgrave Macmillan.