Central Banking and

the Governance of Credit Creation

Professor Richard A. Werner

Director, Centre for Banking, Finance and
Sustainable Development
School of Management
University of Southampton

Danish Institute for International Studies (DIIS)

Copenhagen
17 March 2009
 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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 Is it the fault of the new, complex financial products?

 The transformation from ‚toxic waste‘ to top-investment:

‚financial engineering‘ or Alchemy?

credit extension for financial Triple-A rating

speculative engineering
investments
Toxic Waste Top Asset

Bank Diversified int’l

Investors
Risk transfer away from
bank’s balance sheet

Profits

3
 The problem is more fundamental
It’s official: There is a flaw in mainstream thinking
 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”.

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But this is not the first banking crisis…

 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.

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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.

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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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 Puzzles

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 Banks Investment RR = 1%

(Borrowers)
(Lenders, (‘Financial
Depositors) Intermediaries’)
=“indirect finance”
$99
$100

“direct finance”

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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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Banks create money – out of nothing
Balance Sheet of Bank A
Step 1 New deposit of $100 with Bank A
Assets Liabilitie
s$ 100

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

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.
Assets Liabilities
$ 100 $ 100
+ +
$ 9,900 $ 9,900

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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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The effect of credit creation depends on the use of money

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

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Credit flows explain the boom/bust cycles

 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: CF/C

30%
Loans to the real estate industry,
construction companies and non-
bank financial institutions

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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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 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
asset prices rise
corporate balance
sheets improve

Financial credit creation rises

collateral values
rise
banks increase
loan/valuation generally
ratios, more positive/euphoric outlook
willing to lend
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 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...“

credit creation falls

credit crunch,
bankruptcies
banks get more risk averse,
shrink risk-assets
unemployment
rises
bad debts demand, growth
increase fall; deflation

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The Cause of Past Banking Crises
 USA 1920er Jahre (‚Margin Loans‘):
speculative credit creation
 Scandinavia in the 1980s:
 Japan in the 1980s: speculative credit creation
 Asian Crisis, 1990s:
 UK property bubble until 2007: speculative credit creation
 US property bubble until 2006:
speculative credit creation
 Irish property bubble until 2007:
 Spanish property bubble until 2007:
speculative credit creation

speculative credit creation

speculative credit creation

speculative credit creation

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

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
two possibilities

(a) Inflation without growth: (b) Growth without inflation:

Credit creation is used for
consumption:
More money, but same amount of
goods and services
= consumptive credit creation
Credit creation is used for
productive credit creation:
More money, but also more goods
and services
= productive credit creation

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How to avoid banking and economic crises:
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.

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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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Who carries greatest responsibility for the crisis?
 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.

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How can we end the cycle of recurring banking crises?
 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).

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The activities of central banks need to be scrutinised

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.”

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 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
Nominal GDP and Call rate YoY% Nominal GDP and Call Rate ％

Japan 10
Call rate ％ 12
9 10
8
8 8
Nominal GDP (L)
7 6 6
6 4
4
5 2
4 0 2
3 -2
2 Call rate (R) 0
-4
1 Nominal GDP YoY% -6 -2
0 81 83 85 87 89 91 93 95 97 99 01 03
-4 1 6 11

U S N o m in al G D P an d Lo n g-Term In terest R ates

U S N o m in a l G D P a n d L o n g- T e rm In t e r e st R a t e s
Y oY % R ate %
R a te %
15
14
US
20
U S In terest R ates (R ) 12
15 10 10
8
10 6
5
4
5
U S N om inal G D P (L) 2
U S N o m in a l G D P Y o Y % 0 0
0
0 5 10 15 80 82 84 86 88 90 92 94 96 98 00 02 04
Cognitive dissonance: Traditional story vs. fact

 Traditional story:

“Low rates lead to high growth;

high rates lead to low growth.”
 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.
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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 Wrong policy responses are more frequent

Banking Crisis

Correct Response Wrong Response I Wrong Response II

USA 1907 Japan since 1990 USA 2000

UK 1914 Thailand 1997 UK 1991
Germany 1933 Indonesia 1997
Japan 1945 Korea 1997
Malaysia 1998 Scandinavia 1990
USA 1929-1935
Germany 1929-1933
Germany 1880s

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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.

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 Evidence from Japan in the 1990s: Complete crowding out
- Estimation Results of Private Demand Model sample 1990 (1) to 2000 (4)
Private and Government Demand
Bn yen Bn yen
Coeff. Std. err t-value t-prob. Part.R2 10000 3000

2500
8000 G (R)
Const 430.797 323.8 1.33 0.191 0.043
2000
6000
∆GDP1 0.369 0.128 2.90 0.006 0.177 1500

4000 1000
∆GDP3 0.203 0.111 1.83 0.075 0.079
2000 500

∆CR 0.015 0.004 3.45 0.001 0.233 0

0
90 92 94 96 98 00 -500
∆G -0.957 0.206 -4.65 0.000 0.357
-2000
C+I+NX (L) -1000

-4000 -1500

Latest: Q4 2000

Result: β G
= –1

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

Fiscal stimulation funded by bond issuance

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

Non-bank private sector

　 (no credit creation）
　　　　
-¥20trn +¥20trn
Funding
via Fiscal
bond stimulus
issuance 　
Ministry of Finance

(no credit creation)

Net Effect = Zero

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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

Fiscal stimulation funded by bank

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

Bank sector deposit Non-bank private

　
(credit creation power) sector
Assets　　　　　　 Liabilities (no credit creation)
¥20 trn ¥20 trn
+¥ 20 trn
Fiscal
Funding
MoF stimulus
via bank
Loans (No credit
creation)

Net Effect = ¥ 20 trn

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

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.

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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

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

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The standard
‘Federal Reserve
Note’

JFK’s 1963 ‘United

States Note’:
No Fed seal

42
Further Reading:

Palgrave Vahlen,
Macmillan, 2007
2005
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 Appendix: What economics has proven, and what it hasn‘t

 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’.