Authors

Money

Spare dollars

Last week I wrote that contrary to the prevailing mood US dollar strength could reverse at any time. This week I look at another aspect of the dollar, which almost certainly will become a significant source of supply: a global shift out of it by foreign holders.

As well as multinational corporations that account in dollars, there are non-US entities that use dollars purely for trade. And so long as governments intervene in currency markets, governments end up with those trade dollars in their foreign reserves. Some of these governments are now pushing hard to replace the dollar, having seen its debasement, which is beyond their control. This has upset nations like China, and that is before we speculate about any geopolitical angle.

The consequence of China’s currency management has been a massive accumulation of dollars which China cannot easily sell. All she can do is stop accumulating them and not reinvest the proceeds from maturing Treasuries, and this has broadly been her policy for at least the last year. So this problem has been in the works for some time and doubtless contributed to China’s determination to reduce her dependency on the dollar. Furthermore, it is why thirteen months ago George Osborne was summoned (that is the only word for it) to Beijing to discuss a move to urgently develop offshore renminbi capital markets, utilising the historic links between Hong Kong and London. Since then, it is reported that last month over 22% of China’s external trade was settled in its own currency.

Given the short time involved, it is clear that there is a major change happening in cross-border trade hardly noticed by financial commentators. But this is not all: sanctions against Russia have turned her urgently against the dollar as well, and together with China these two nations dominate and carry with them the bulk of Asia, representing nearly four billion rapidly industrialising souls. To this we should add the Middle East, most of whose oil is now exported to China, India and South-East Asia, making the petro-dollar potentially redundant as well.

In a dollar-centric currency system, China is restricted in what she can do, because with nearly $4 trillion in total foreign exchange reserves she cannot sell enough dollars to make a difference without driving the renminbi substantially higher. In the past she has reduced her dollar balances by selling them for other currencies, such as the euro, but she cannot rely on the other major central banks to neutralise the market effect of her dollar sales on her behalf. Partly for this reason China now intends to redeploy her reserves into international investment to develop her export markets for capital goods, as well as into major infrastructure projects, such as the $40bn Silk Road scheme.

This simply amounts to dispersing China’s dollars into diverse hands to conceal their disposal. Meanwhile currency markets have charged off in the opposite direction, with the dollar’s strength undermining commodity prices, most noticeably oil, very much to China’s benefit. And while the talking-heads are debating the effect on Russia and America’s shale, they are oblivious to the potential tsunami of dollars just waiting for the opportunity to return to the good old US of A.

Economics

Models, Damn Models and Statistics, or Math Gone Mad

Parliamentary committees are not especially noted for entertainment, but the November Treasury Select Committee hearing on the Bank of England’s Inflation Report is a refreshing exception. The fun starts on p. 30 of the transcript of the hearings with Steve Baker MP and Bank of England Governor Mark Carney light-heartedly jousting with each other.

Steve begins by asking Dr. Carney if the Bank is all model-driven. To quote from the transcript:

Dr Carney: No. If we were all model driven, then you would not need an MPC.

Q81 Steve Baker: All right. But we do have plenty of models floating around.

Dr Carney: I presume you feel we do need an MPC, Mr Baker?

Steve Baker: I think you know I think we don’t.

Dr Carney: I just thought we would get that read into the record.

[KD: First goal to Dr. Carney, but looks to me like it went into the wrong net.]

Steve Baker: I want to turn to a criticism by Chris Giles in The Financial Times of the model for labour market slack, which called it a nonsense. If I may I will just share a couple of quotes with you. He said that, according to a chart in the inflation report, the average-hours gap hit a standard deviation of -6, and this is something we would expect to happen once in 254 million years. He also said that the Bank of England is again implying the recent recession, as far as labour market participation is concerned, was worse than any moment in 800 times the period in which homo sapiens have walked on the earth. How will the Bank reply to a criticism as strident as this one?

[KD: The article referred to is Chris Giles, “Money Supply: Why the BoE is talking nonsense”, Nov 17 2014: http://ftalphaville.ft.com/2014/11/17/2045002/moneysupply-why-the-boe-is-talking-nonsense/#]

Dr Carney: Since you asked, let me reply objectively. Calculations such as that presume that there is a normal distribution around the equilibrium rate. Let me make it clear. First off, what is the point of the chart? The chart is to show a deviation relative to historic averages. It is an illustrative chart that serves the purpose of showing where the slack is relative to average equilibrium rates, just to give a sense of relative degrees of slack. That is the first point. The second point is that the calculation erroneously, perhaps on purpose to make the point but erroneously, assumes that there is a normal distribution around that equilibrium rate. So in other words to say that there is a normal distribution of unemployment outcomes around a medium-term equilibrium rate of 5.5%. So it is just as likely that something would be down in the twos as it would be up in the eights. Well, who really believes that? Certainly not the MPC and I suspect not the author of that article. It also ignores that the period of time was during the great moderation for all of these variables as well, so it is a relatively short period. These are not normal distributions. You would not expect them. You would expect a skew with quite a fat tail. So using normal calculations to extrapolate from a chart that is there for illustrative purposes is—I will not apply an adjective to it—misleading and I am not sure it is a productive use of our time.

Q82 Steve Baker: That is a fantastic answer. I am much encouraged by it, because it does seem to me it has been known for a long time that it is not reasonable to use normal distributions to model market events and yet so much mathematical economics is based on it.

[KD: Carney’s is an excellent answer: one should not “read in” a normal distribution to this chart, and the Bank explicitly rejects normality in this context.

Slight issue, however: didn’t the Bank’s economists use the normality assumption to represent the noise processes in the models they used to generate the chart? I am sure they did. One wonders how the charts would look if they used more suitable noise processes instead? And just how robust is the chart to the modelling assumptions on which it is based?]

Dr Carney: People do it because it is simple—it is the one thing they understand—and then they apply it without thinking, which is not what the MPC does.

Steve Baker: That is great. I can move on quickly. But I will just say congratulations to the Bank on deciding to commission anti-orthodox research because I think this is going to be critical to drilling into some of these problems.

Dr Carney: Thank you.

[KD: Incredulous chair then intervenes.]

Q83 Chair: To be clear, the conclusion that we should draw from this is that we should look at all economic models with a very high degree of scepticism indeed.

Dr Carney: Absolutely.

[KD: So you heard it from the horse’s mouth: don’t trust those any of those damn models. Still incredulous, the chair then intervenes again to seek confirmation of what he has just heard.]

Chair: Can I just add that it is an astonishing conclusion? I do not want to cut into Steve Baker’s questions, but is that the right conclusion?

Dr Carney: Absolutely. Models are tools. You should use multiple ones. You have to have judgment, you have to understand how the models work and particularly, if I may underscore, dynamic stochastic general equilibrium forecasting models, which are the workhorse models of central banks. What they are useful for is looking at the dynamics around shocks in the short term. What they are not useful for is the dynamics further out where—

[KD: Dr. Carney reiterates the point so there can be no confusion about it. So let me pull his points together: (1) He “absolutely” agrees that “we should look at all economic models with a very high degree of scepticism.” (2) He suggests “You should use multiple [models]”, presumably to safeguard against model risk, i.e., the risks that any individual model might be wrong. (3) He endorses one particular – and controversial – class of models, Dynamic Stochastic General Equilibrium (DSGE) models as the “workhorse models” of central banks, whilst acknowledging that they are of no use for longer-term forecasting or policy projections.

I certainly agree that none of the models is of any longer-term term use, but what I don’t understand is how (1), (2) and (3) fit together. In particular, if we are to be skeptical of all models, then why should we rely on one particular and highly controversial, if fashionable, class of models, never mind – and perhaps I should say, especially – when that class of models is regarded as the central banks’ workhorse. After all, the models’ forecast performance hasn’t been very good, has it?

The discussion then goes from the ridiculous to the sublime:]

Chair: I am just thinking about all those economists out there whose jobs have been put at risk.

Dr Carney: No, we have enhanced their jobs to further improve DSG models.

Steve Baker: We are all Austrians now.

[Laughter.]

[A little later, Steve asks Sir Jon Cunliffe about the risk models used by banks.]

Q84 Steve Baker: Sir Jon, before I move too much further down this path, can I ask you what would be the implications for financial stability and bank capital if risk modelling moved away from using normal distributions?

Sir Jon Cunliffe: Maybe I will answer the question another way. It is because of some of the risks around modelling, the risk-weighted approach within bank capital, that we brought forward our proposals on the leverage ratio. So you have to look at bank capital through a number of lenses. One way of doing is to have a standardised risk model for everyone and there is a standardised approach and it works on, if you like, data for everybody that does not suit any particular institution and the bigger institutions run their own models, which tend to have these risks in them. Then you have a leverage ratio that is not risk-weighted, and therefore takes no account of these models, and that forms a check. So with banks, the best way to look at their capital is through a number of different lenses.

[KD: Sir Humphrey is clearly a very good civil servant: he responds to the question by offering to answer it in a different way, but does not actually answer it. The answer is that we do not use a non-normal distribution because doing so would lead to higher capital requirements but that would never do as the banks would not be happy with it: they would then lobby like crazy and we can’t have that. Instead, he evades the question and says that there are different approaches with pros and cons etc. etc. – straight out of “Yes, Minister”.

However, notwithstanding that Sir Jon didn’t answer the question on the dangers of the normal distribution, I would also ask him a number of other (im)pertinent questions relating to bad practices in bank risk management and bank risk regulation:

1. Why does the Bank continue to allow banks to use the discredited Value-at-Risk (or VaR) risk measure to help determine their regulatory capital requirements, a measure which is known to grossly under-estimate banks true risk exposures?

The answer, of course, is obvious: the banks are allowed to use the VaR risk measure because it grossly under-estimates their exposures and no-one in the regulatory system is willing to stand up to the banks on this issue.

2. Given the abundant evidence – much of it published by the Bank itself – that complex risk-models have much worse forecast performance than simple models (such as those based on leverage ratios), then why does the Bank continue to allow banks to use complex and effectively useless risk models to determine their regulatory capital requirements?

I would put it to him that the answer is the same as the answer to the previous question.

3. Why does the Bank continue to rely on regulatory stress tests in view of their record of repeated failure to identify the build-up of subsequently important stress events? Or, put it differently, can the Bank identify even a single instance where a regulatory stress test correctly identified a subsequent major problem?

Answer: The Northern Rock ‘war game’. But even that stress test turned out to be of no use at all, because none of the UK regulatory authorities did anything to act on it.

In the meantime, perhaps I can interest readers in my Cato Institute Policy Analysis “Math Gone Mad”, which provides a deeper – if not exactly exhaustive but certainly exhausting – analysis of these issues:

http://www.cato.org/publications/policy-analysis/math-gone-mad

1. http://data.parliament.uk/writtenevidence/committeeevidence.svc/evidencedocument/treasury-committee/bank-of-england-inflation-report-hearings-session-201415/oral/15826.pdf

Politics

Money Creation and Society Debate in Full

[Editor’s Note: The “Money Creation and Society” debate, which took place in the UK Parliament on Thursday the 20th November 2014, is shown below in both video and transcribed text formats.]

11.18 am

Steve Baker (Wycombe) (Con): I beg to move,

That this House has considered money creation and society.

The methods of money production in society today are profoundly corrupting in ways that would matter to everyone if they were clearly understood. The essence of this debate is: who should be allowed to create money, how and at whose risk? It is no wonder that it has attracted support from across the political spectrum, although, looking around the Chamber, I think that the Rochester and Strood by-election has perhaps taken its toll. None the less, I am grateful to right hon. and hon. Friends from all political parties, including the hon. Members for Clacton (Douglas Carswell) and for Brighton, Pavilion (Caroline Lucas) and the right hon. Member for Oldham West and Royton (Mr Meacher), for their support in securing this debate.

One of the most memorable quotes about money and banking is usually attributed to Henry Ford:

“It is well enough that people of the nation do not understand our banking and monetary system, for if they did I believe there would be a revolution before tomorrow morning.”

Let us hope we do not have a revolution, as I feel sure we are all conservatives on that issue.

How is it done? The process is so simple that the mind is repelled. It is this:

“Whenever a bank makes a loan, it simultaneously creates a matching deposit in the borrower’s bank account, thereby creating new money.”

I have been told many times that this is ridiculous, even by one employee who had previously worked for the Federal Deposit Insurance Corporation of the United States. The explanation is taken from the Bank of England article, “Money creation in the modern economy”, and it seems to me it is rather hard to dismiss.

Today, while the state maintains a monopoly on the creation of notes and coins in central bank reserves, that monopoly has been diluted to give us a hybrid system because private banks can create claims on money, and those claims are precisely equivalent to notes and coins in their economic function. It is a criminal offence to counterfeit bank notes or coins, but a banking licence is formal permission from the Government to create equivalent money at interest.

There is a wide range of perspectives on whether that is legitimate. The Spanish economist, Jesús Huerta de Soto explains in his book “Money, Bank Credit and Economic Cycles” that it is positively a fraud—a fraud that causes the business cycle. Positive Money, a British campaign group, is campaigning for the complete nationalisation of money production. On the other hand, free banking scholars, George Selgin, Kevin Dowd and others would argue that although the state might define money in terms of a commodity such as gold, banking should be conducted under the ordinary commercial law without legal privileges of any kind. They would allow the issue of claims on money proper, backed by other assets—provided that the issuer bore

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all of the risk. Some want the complete denationalisation of money. Cryptocurrencies are now performing the task of showing us that that is possible.

The argument that banks should not be allowed to create money has an honourable history. The Bank Charter Act 1844 was enacted because banks’ issue of notes in excess of gold was causing economic chaos, particularly through reckless lending and imprudent speculation. I am once again reminded that the only thing we learn from history is that we learn nothing from history.

Thomas Docherty (Dunfermline and West Fife) (Lab): I welcome today’s debate. The hon. Gentleman makes a valid point about learning from history. Does he agree with me that we should look seriously at putting this subject on the curriculum so that young people gain a better understanding of the history of this issue?

Steve Baker: That is absolutely right. It would be wonderful if the history curriculum covered the Bank Charter Act 1844. I would be full of joy about that, but we would of course need to cover economics, too, in order for people to really understand the issue. Since the hon. Gentleman raises the subject, there were ideas at the time of that Act that would be considered idiocy today, while some ideas rejected then are now part of the economic mainstream. Sir Robert Peel spent some considerable time emphasising that the definition of a pound was a specific quantity and quality of gold. The notion that anyone could reject that was considered ridiculous. How times change.

One problem with the Bank Charter Act 1844 was that it failed to recognise that bank deposits were functioning as equivalent to notes, so it did not succeed in its aim. There was a massive controversy at the time between the so-called currency school and the banking school. It appeared that the currency school had won; in fact, in practice, the banks went on to create deposits drawn by cheque and the ideas of the banking school went forward. The idea that one school or the other won should be rejected; the truth is that we have ended up with something of a mess.

We are in a debt crisis of historic proportions because for far too long profit-maximising banks have been lending money into existence as debt with too few effective restraints on their conduct and all the risks of doing so forced on the taxpayer by the power of the state. A blend of legal privilege, private interest and political necessity has created, over the centuries, a system that today lawfully promotes the excesses for which capitalism is so frequently condemned. It is undermining faith in the market economy on which we rely not merely for our prosperity, but for our lives.

Thankfully, the institution of money is a human, social institution and it can be changed. It has been changed and I believe it should be changed further. The timing of today’s debate is serendipitous, with the Prime Minister explaining that the warning lights are flashing on the dashboard of the world economy, and it looks like quantitative easing is going to be stepped up in Europe and Japan, just as it is being ramped out in America—and, of course, it has stopped in the UK. If anything, we are not at the end of a great experiment

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in monetary policy; we are at some mid point of it. The experiment will not be over until all the quantitative easing has been unwound, if it ever is.

We cannot really understand the effect of money production on society without remembering that our society is founded on the division of labour. We have to share the burden of providing for one another, and we must therefore have money as a means of exchange and final payment of debts, and also as a store of value and unit of account. It is through the price system that money allows us to reckon profit and loss, guiding entrepreneurs and investors to allocate resources in the way that best meets the needs of society. That is why every party in the House now accepts the market economy. The question is whether our society is vulnerable to false signals through that price system, and I believe that it is. That is why any flaws in our monetary arrangements feed into the price system and permeate the whole of society. In their own ways, Keynes and Mises—two economists who never particularly agreed with one another—were both able to say that currency debasement was the best way in which to overturn the existing basis of society.

Even before quantitative easing began, we lived in an era of chronic monetary inflation, unprecedented in the industrial age. Between 1991 and 2009, the money supply increased fourfold. It tripled between 1997 and 2010, from £700 billion to £2.2 trillion, and that accelerated into the crisis. It is simply not possible to increase the money supply at such a rate without profound consequences, and they are the consequences that are with us today, but it goes back further. The House of Commons Library and the Office for National Statistics produced a paper tracing consumer price inflation back to 1750. It shows that there was a flat line until about the 20th century, when there was some inflation over the wars, but from 1971 onwards, the value of money collapsed. What had happened? The Bretton Woods agreement had come to an end. The last link to gold had been severed, and that removed one of the most effective restraints on credit expansion. Perhaps in another debate we might consider why.

Mr Angus Brendan MacNeil (Na h-Eileanan an Iar) (SNP): Does the hon. Gentleman agree that the end of the gold standard and the increased supply of money enabled business, enterprise and the economy to grow? Once we were no longer tied to the supply of gold, other avenues could be used for the growth of the economy.

Steve Baker: The hon. Gentleman has made an important point, which has pre-empted some of the questions that I intended to raise later in my speech. There is no doubt that the period of our lives has been a time of enormous economic, social and political transformation, but so was the 19th century, and during that century there was a secular decline in prices overall.

The truth is that any reasonable amount of money is adequate if prices are allowed to adjust. We are all aware of the phenomenon whereby the prices of computers, cars, and more or less anything else whose production is not determined by the state become gently lower as productivity increases. That is a rise in real living standards. We want prices to become lower in real terms compared to wages, which is why we argue about living standards.

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Sir William Cash (Stone) (Con): My hon. Friend is making an incredibly important speech. I only wish that more people were here to listen to it. I wonder whether he has read Nicholas Wapshott’s book about Hayek and Keynes, which deals very carefully with the question that he has raised. Does he agree that the unpleasantness of the Weimar republic and the inflationary increase at that time led to the troubles with Germany later on, but that we are now in a new cycle which also needs to be addressed along the lines that he has just been describing?

Steve Baker: I am grateful to my hon. Friend. What he has said emphasises that the subject that is at issue today goes to the heart of the survival of a free civilisation. That is something that Hayek wrote about, and I think it is absolutely true.

If I were allowed props in the Chamber, Mr Speaker, I might wave this 100 trillion Zimbabwe dollar note. You can hold bad politics in your hand: that is the truth of the matter. People try to explain that hyperinflation has never happened just through technocratic error, and that it happens in the context of, for example, extremely high debt levels and the inability of politicians to constrain them. In what circumstances do we find ourselves today, when we are still borrowing broadly triple what Labour was borrowing?

Ann McKechin (Glasgow North) (Lab): I am interested to hear what the hon. Gentleman is saying. He will be aware that the balance between wages and capital has shifted significantly in favour of capital over the past 30 years. Does he agree that the way in which we tax and provide reliefs to capital is key to controlling that balance? Does he also agree that we need to do more to increase wage levels, which have historically been going down in relation to capital over a long period of time?

Steve Baker: I think I hear the echoes of a particularly fashionable economist there. If the hon. Lady is saying that she would like rising real wage levels, of course I agree with her. Who wouldn’t? I want rising real wage levels, but something about which I get incredibly frustrated is the use of that word “capital”. I have heard economists talk about capital when what they really mean is money, and typically what they mean by money is new bank credit, because 97% of the money supply is bank credit. That is not capital; capital is the means of production. There is a lengthy conversation to be had on this subject, but if the hon. Lady will forgive me, I do not want to go into that today. I fear that we have started to label as capital money that has been loaned into existence without any real backing. That might explain why our capital stock has been undermined as we have de-industrialised, and why real wages have dropped. In the end, real wages can rise only if productivity increases, and that means an increase in the real stock of capital.

To return to where I wanted to go: where did all the money that was created as debt go? The sectoral lending figures show that while some of it went into commercial property, and some into personal loans, credit cards and so on, the rise of lending into real productive businesses excluding the financial sector was relatively moderate. Overwhelmingly, the new debt went into mortgages and the financial sector. Exchange and the distribution of wealth are part of the same social process. If I buy an apple, the distribution of apples and money will change. Money is used to buy houses, and we

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should not be at all surprised that an increased supply of money into house-buying will boost the price of those homes.

Mr Ronnie Campbell (Blyth Valley) (Lab): This is a great debate, but let us talk about ordinary people and their labour, because that involves money as well. To those people, talking about how capitalism works is like talking about something at the end of the universe. They simply need money to survive, and anything else might as well be at the end of the universe.

Steve Baker: The hon. Gentleman is quite right, and I welcome the spirit in which he asks that question. The vast majority of us, on both sides of the House, live on our labour. We work in order to obtain money so that we can obtain the things we need to survive.

The hon. Gentleman pre-empts another remark that I was going to make, which is that there is a categorical difference between earning money through the sweat of one’s brow and making money by lending it to someone in exchange for a claim on the deeds to their house. Those two concepts are fundamentally, categorically different, and this goes to the heart of how capitalism works. I appreciate that very little of this would find its way on to an election leaflet, but it matters a great deal nevertheless. Perhaps I shall need to ask my opponent if he has followed this debate.

My point is that if a great fountain of new money gushes up into the financial sector, we should not be surprised to find that the banking system is far wealthier than anyone else. We should not be surprised if financing and housing in London and the south-east are far wealthier than anywhere else. Indeed, I remember that when quantitative easing began, house prices started rising in Chiswick and Islington. Money is not neutral. It redistributes real income from later to earlier owners—that is, from the poor to the rich, on the whole. That distribution effect is key to understanding the effect of new money on society. It is the primary cause of almost all conflicts revolving around the production of money and around the relations between creditors and debtors.

Sir William Cash: My hon. Friend might be aware that, before the last general election, my right hon. Friend the Member for Wokingham (Mr Redwood) and I and one or two others attacked the Labour party for the lack of growth and expressed our concern about the level of debt. If we add in all the debts from Network Rail, nuclear decommissioning, unfunded pension liabilities and so on, the actual debt is reaching extremely high levels. According to the Government’s own statements, it could now be between £3.5 trillion and £4 trillion. Does my hon. Friend agree that that is extremely dangerous?

Steve Baker: It is extremely dangerous and it has been repeated around the world. An extremely good book by economist and writer Philip Coggan, of The Economist, sets out just how dangerous it is. In “Paper Promises: Money, Debt and the New World Order”; a journalist from The Economist seriously suggests that this huge pile of debt created as money will lead to a wholly new monetary system.

I have not yet touched on quantitative easing, and I will try to shorten my remarks, Mr Speaker, but the point is this: having lived through this era where the

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money supply tripled through new lending, the whole system, of course, blew up—the real world caught up with this fiction of a monetary policy—and so QE was engaged in. A paper from the Bank of England on the distributional effects of monetary policy explains that people would have been worse off if the Bank had not engaged in QE—it was, of course, an emergency measure. But one thing the paper says is that asset purchases by the Bank

“have pushed up the price of equities by as least as much as they have pushed up the price of gilts.”

The Bank’s Andy Haldane said, “We have deliberately inflated the biggest bond market bubble in history.”

Mr Jim Cunningham (Coventry South) (Lab): What is the hon. Gentleman’s view of QE? How does he see it fitting into the great scheme of things?

Steve Baker: As I am explaining, QE is a great evil; it is a substitute for proper reform of the banking system. But this is the point: if the greatest bubble has been blown in the bond markets and equities have been pushed up by broadly the same amount, that is a terrible risk to the financial system.

Mr MacNeil: Surely there is a difference depending on where the QE goes. In an economy that has a demand deficit and needs demand to be stimulated, if QE goes into the pockets of those who are going to spend the money, surely QE can create some more motion in the economy, but if QE goes into already deep pockets and makes them larger and deeper, that is a very different thing.

Steve Baker: Again, the hon. Gentleman touches on an interesting issue. Once the Bank legitimises the idea of money creation and giving it to people in order to get the economy going, the question then arises: if you are going to create it and give it away, why not give it to other people? That then goes to the question: what is money? I think it is the basis of a moral existence, because in our lives we should be exchanging value for value. One problem with the current system is that we are not doing that; something is being created in vast quantities out of nothing and given away. The Bank explains that 40% of the assets that have been inflated are held by 5% of households, with 80% held by people over 45. It seems clear that QE—a policy of the state to intervene deeply in money—is a deliberate policy of increasing the wealth of people who are older and wealthier.

Mr MacNeil: One word the hon. Gentleman used was “moral”, and he touches on what the economist Paul Krugman will say: some on the right see the recession and so on as a morality play, and confuse economics and morals. Sometimes getting things going economically is not about the straightforward “morality” money the hon. Gentleman has touched on. That could be one reason why the recovery is taking so long.

Steve Baker: I am conscious that I have already used slightly more time than I intended, Mr Speaker, and I have a little more to say because of these interventions. All these subjects, as my bookshelves attest, are easily

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capable of being explained over hundreds of pages. My bottom line on this is: I want to live in a society where even the most selfish person is compelled by our institutions to serve the needs of other people. The institution in question is called a free market economy, because in a free market economy people do not get any bail-outs and do not get to live at somebody else’s expense; they have to produce what other people want. One thing that has gone wrong is that those on the right have ended up defending institutions that are fundamentally statist.

Douglas Carswell (Clacton) (UKIP): I congratulate the hon. Gentleman on bringing this important subject to the attention of the House. Does he agree that, far from shoring up free market capitalism, the candy floss credit system the state is presiding over replaces it with a system of crony corporatism that gives capitalism a bad name and undermines its very foundations?

Steve Baker: I am delighted to agree with my hon. Friend—he is that, despite the fact I will not be seeing Nigel later. We have ended up pretending that the banking system and the financial system is a free market when the truth is that it is the most hideous corporatist mess. What I want is a free market banking system, and I will come on to discuss that.

I wanted to make some remarks about price signals, but I will foreshorten them, and try to cover the issue as briskly as I can—it was the subject of my maiden speech. Interest rates are a price signal like any other. They should be telling markets about people’s preferences for goods now compared with goods later. If they are deliberately manipulated, they will tell entrepreneurs the wrong thing and will therefore corrupt people’s investment decisions. The bond and equity markets are there to allocate capital. If interest rates are manipulated and if new money is thrown into the system, prices get detached from the real world values they are supposed to be connected to—what resources are available, what technology is available, what people prefer. The problem is that these prices, which have been detached from reality, continue to guide entrepreneurs and investors, but if they are now guiding entrepreneurs and investors in a direction that takes them away from the real desires of the public and the available resources and the technology, we should not then be surprised if we end up with a later disaster.

In short, after prices have been bid up by a credit expansion, they are bound to fall when later the real world catches up with it. That is why economies are now suffering this wrecking ball of inflation followed by deflation, and here is the rub: throughout most of my life, the monetary policy authorities have responded to these corrections by pumping in more new money—previously through ever cheaper credit, and now through QE. This raises the question of where this all goes, and brings me back to the point my hon. Friend the Member for Stone (Sir William Cash) provoked from me: that this might be pointing towards an end of this monetary order. That is not necessarily something to be feared, because the monetary order changed several times in the 20th century.

We have ended up in something of a mess. The Governor said about the transition once interest rates normalise:

“The orderliness of that transition is an open question.”

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I believe the Governor is demonstrating the optimism appropriate to his role, because I think it is extremely unlikely that we will have an orderly transition once interest rates start to normalise. The problem is basically that Governments want to spend too much money. That has always been the case throughout history. Governments used to want to fund wars. Now, for all good, moral, decent, humanitarian reasons, we want to fund health, welfare and education well beyond what the public will pay in taxes. That has meant we needed easy money to support the borrowing.

What is to be done? A range of remedies are being proposed. Positive Money proposes the complete nationalisation of the production of money, some want variations on a return to gold, perhaps with free banking, and some want a spontaneous emergence of alternative moneys like Bitcoin.

I would just point out that Walter Bagehot is often prayed in aid of central banking policy, but his book “Lombard Street” shows that he did not support central banking; he thought it was useless to try to propose any change. What we see today is that, with alternative currencies such as Bitcoin spontaneously emerging, it is now possible through technology that, within a generation, we will not all be putting our money in a few big mega-banks, held as liabilities, issued out of nothing.

I want to propose three things the Government can practically do. First, the present trajectory of reform should be continued with. After 15 years of studying these matters, and now having made it to the Treasury Committee, I am ever more convinced that there is no way to change the present monetary order until the ideas behind it have been tested to destruction—and I do mean tested to destruction. This is an extremely serious issue. It will not change until it becomes apparent that the ideas behind the system are untenable.

Secondly, and very much with that in mind, we should strongly welcome proposals from the Bank’s chief economist, Andy Haldane, that it will commission “anti-orthodox research”, and it will

“put into the public domain research and analysis which as often challenges as supports the prevailing policy orthodoxy on certain key issues.”

That research could make possible fundamental monetary reform in the event of another major calamity.

Thirdly, we should welcome the Chancellor’s recent interest in crypto-currencies and his commitment to make Britain a “centre of financial innovation.” Imperfect and possibly doomed as it may be, Bitcoin shows us that peer-to-peer, non-state money is practical and effective. I have used it to buy an accessory for a camera; it is a perfectly ordinary legal product and it was easier to use than a credit card and it showed me the price in pounds or any other currency I liked. It is becoming possible for people to move away from state money.

Every obstacle to the creation of alternative currencies within ordinary commercial law should be removed. We should expand the range of commodities and instruments related to those commodities that are treated like money, such as gold. That should include exempting VAT and capital gains tax and it should be possible to pay tax on those new moneys. We must not fall into the same trap as the United States of obstructing innovation. In the case of the Liberty Dollar and Bernard von NotHaus, it

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seems that a man may spend the rest of his life in prison simply for committing the supposed crime of creating reliable money.

Finally, we are in the midst of an unprecedented global experiment in monetary policy and debt. It is likely, as Philip Coggan set out, that this will result in a new global monetary order. Whether it will be for good or ill, I do not know, but as technology and debt advance, I am sure that we should be ready for a transformation. Society has suffered too much already under the present monetary orthodoxy; free enterprise should now be allowed to change it.

11.45 am

Mr Michael Meacher (Oldham West and Royton) (Lab): I, too, strongly congratulate the hon. Member for Wycombe (Steve Baker) on securing this debate, which everyone recognises is vital and which has not been debated in this House for 170 years, since Sir Robert Peel’s Bank Charter Act 1844. The hon. Gentleman drew that fact to my attention when we were last speaking in a similar debate. That Act prohibited the private banks from printing paper money. In light of the financial crash of 2008-09 and the colossal expansion of money supply that underpinned it—no less than a twenty-two-fold increase in the 30 neo-liberal years between 1980 and 2010—the issue is whether that prohibition should be extended to include electronic money.

It is unfortunate that it is so little understood by the public that money is created by the banks every time they make a loan. In effect, the banks have a virtual monopoly—about 97%—over domestic credit creation, so they determine how money is allocated across the economy. That has led to the vast majority of money being channelled into property markets and the financial sector. According to Bank of England figures for the decade to 2007, 31% of additional money created by bank lending went to mortgage lending, 20% to commercial property, and 32% to the financial sector, including to mergers and acquisitions and trading and financial markets. Those are extraordinary figures.

Mr Jim Cunningham (Coventry South) (Lab): Given what my right hon. Friend has just said, is there not an argument, in this situation of unlimited credit from banks, for the Bank of England to intervene?

Mr Meacher: My hon. Friend anticipates the main line of my argument, so if he is patient I think I will be able to satisfy him. Crucially, only 8% of the money referred to went to businesses outside the financial sector, with a further 8% funding credit cards and personal loans.

Mr MacNeil: I hear what the right hon. Gentleman says about money going into building, housing and mortgages, but is that not because the holders of money reckon that they can get a decent return from that sector? They would invest elsewhere if they thought that they could get a better return. One reason why the UK gets a better return from that area than, say, Germany is that we have no rent controls. As a result, money is more likely to go into property than into developing industry, which is more likely to happen in Germany.

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Mr Meacher: I very much agree with that argument. Again, I assure the hon. Gentleman that I will return to that matter later in my speech. He is absolutely right that the reason is the greater returns that the banks can get from the housing and rental sector. Our rental sector, which is different from that in Germany and other countries, is the cause of that.

It is only this last 16%—the 8% lent to businesses and the 8% to consumer credit—that has a real impact on GDP and economic growth. The conclusion is unavoidable: we cannot continue with a system in which so little of the money created by banks is used for the purposes of economic growth and value creation and in which, instead, to pick up on the point made by the hon. Member for Na h-Eileanan an Iar (Mr MacNeil), the overwhelming majority of the money created inflates property prices, pushing up the cost of living.

In a nutshell, the banks have too much power and they have greatly abused it. First, they have been granted enormous privileges since they can create wealth simply by writing an accounting entry on a register. They decide who uses that wealth and for what purpose and they have used their power of credit creation hugely to favour property and consumption lending over business investment because the returns are higher and more secure. Thus the banks maximise their own interests but not the national interest.

Secondly, if they fail to meet their liabilities, the banks are not penalised. Someone else pays up for them. The first £85,000 of deposits are covered by a guarantee underwritten by the state and in the event of a major financial crash they are bailed out by the implicit taxpayer guarantee—

Steve Baker rose—

Mr Meacher: Let me finish, and I will of course give way.

The banks have been encouraged by that provision into much more risky, even reckless, investment, especially in the case of exotic financial derivatives—

Mr Jim Cunningham rose—

Mr Meacher: Members are beginning to queue up to intervene, but let me finish my point first.

The banks have been encouraged even to the point at which after the financial crash of 2008-09 the state was obliged to undertake the direct bail-out costs of nearly £70 billion as well as to provide a mere £1 trillion in support of loan guarantees, liquidity schemes and asset protection arrangements.

Steve Baker: I wholly agree with the right hon. Gentleman. The moral hazard problem is absolutely enormous and one of the most fundamental problems. However, the British Bankers Association picked me up when I said it was a state-funded deposit insurance scheme and told me it was industry-funded. I think the issue now is that nobody really believes for a moment that the scheme will not be back-stopped by the taxpayer.

Mr Meacher: As always, I am grateful for the intervention from the hon. Gentleman—let me call him my hon. Friend, as I think that on this issue he probably is.

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Mr Jim Cunningham: On the question of banks investing in the property market, does my right hon. Friend think we could learn anything from the United States and the collapse of Fannie Mae? Are we in a similar situation?

Mr Meacher: Again, that takes me down a different path, but there is considerable read-across.

Douglas Carswell: The right hon. Gentleman has been absolutely magnificent in diagnosing the problem, but when it comes to the solution and passing power away from banks, rather than passing the power upwards to a regulator or to the state, would he entertain the idea of empowering the consumer who deposits money with the bank? Surely the real failure is that the Bank Charter Act 1844 does not give legal ownership of deposits to the person paying money into the bank. The basis of fractional-reserve banking is the legal ownership the bank has when money is paid in. If we tackle that, the power will pass from the big state-subsidised corporations and banks outwards to the wider economy.

Mr Meacher: I have great sympathy with what the hon. Gentleman is saying—

Ms Diane Abbott (Hackney North and Stoke Newington) (Lab) rose—

Mr Meacher: One at a time, please. I was going to say a little bit more than that I had sympathy with what the hon. Member for Clacton (Douglas Carswell) said.

I will argue that the capacity to regulate an increasingly and exceedingly complex financial sector is not the proper way, and I will propose an alternative solution. I am strongly in favour of structural changes that enable people to achieve greater control over the money that they have contributed.

Ms Abbott: I was intrigued to hear my right hon. Friend mention depositor protection. Is he saying that he is against any form of depositor protection?

Mr Meacher: The protection of deposits is up to £85,000 and is underwritten by the state.

Ms Abbott: Is my right hon. Friend against?

Mr Meacher: I am neither for nor against. I am making the point that the arrangement encourages the banks to increase their risk taking. If they are caught out, for each depositor £85,000 is guaranteed by the state. I agree with the hon. Member for Wycombe that we need much wider structural change. It is not a question of tweaking one thing here or there.

The question at the heart of the debate is who should create the money? Would Parliament ever have voted to delegate power to create money to those same banks that caused the horrendous financial crisis that the world is still suffering? I think the answer is unambiguously no. The question that needs to be put is how we should achieve the switch from unbridled consumerism to a framework of productive investment capable of generating a successful and sustainable manufacturing and industrial base that can securely underpin UK living standards.

Two models have hitherto been used to operate such a system. One was the centralised direction of finance, which was used extremely successfully by several Asian countries, especially the south-east Asian so-called tiger

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economies, after the second world war, to achieve take-off. I am not suggesting that that method is appropriate for us today. It is not suited to advanced industrial democracies. The other method was to bring about through official “guidance” the rationing of bank credit in accordance with national targets and, where necessary, through quantitative direct controls. In the post-war period, that policy worked well in the UK for a quarter of a century, until the 1970s when it was steadily replaced by the purely market system of competition and credit control based exclusively on interest rates. In our experience of the past 30 or 40 years, that has proved deeply unstable, dysfunctional and profoundly costly.

Since then there have been sporadic attempts to create a safer banking system, but these have been deeply flawed. Regulation under the dictates of the neo-liberal ideology has been so light-touch—by new Labour just as much as by the other Government—that it has been entirely ineffective. Regulation has been too detailed. I remind the House that Basel III has more than 400 pages, and the US Dodd-Frank Bill has a staggering 8,000 pages or more. It is impossibly bureaucratic and almost certainly full of loopholes. Other regulation has been so cautious—for example, the Vickers commission proposal for Chinese walls between the investment and retail arms of a bank—that it missed the main point. Whatever regulatory safeguards the authorities put in place faced regulatory arbitrage from the phalanx of lawyers and accountants in the City earning their ill-gotten bonuses by unpicking or circumventing them.

Mr Ronnie Campbell (Blyth Valley) (Lab): My right hon. Friend is always very good on these subjects. Would I be going too far if I were to suggest that we should nationalise the City, nationalise the banks and run ourselves a Government on behalf of the people?

Mr Meacher: Public ownership of the banks is a significant issue, but I am not going to propose it in my speech. It would be a mistake to return RBS and Lloyds to the private sector, and the arguments about Barclays and HSBC need to be made, but not in this debate. I shall suggest an alternative solution that removes the power of money creation from the banks and puts it in different hands to ensure better results in the national interest.

Against that background, there are solid grounds for examining—this is where I come to my proposal—the creation of a sovereign monetary system, as recommended by several expert commentators recently. Martin Wolf, who, as everyone in this House will know, is an influential chief economics commentator for the Financial Times, wrote an article a few months ago—on 24 April, to be precise—entitled, “Strip private banks of their power to create money”. He recommends switching from bank-created debt to a nationalised money supply.

Lord Adair Turner, the former chair of the Financial Services Authority, delivered a speech about 18 months ago, in February 2013, discussing an alternative to quantitative easing that he termed “overt money finance,” which is also known as a from of sovereign money. Such a system—I will describe its main outline—would restrict the power to create all money to the state via the central bank. Changes to the rules governing how banks operate would still permit them to make loans, but would make it impossible for them to create new money in the

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process. The central bank would continue to follow the remit set by the Chancellor of the Exchequer, which is currently to deliver price stability, which is defined at the present time as an inflation target of 2%. The central bank would be exclusively responsible for creating as much new money as was necessary to support non-inflationary growth. Decisions on money creation would be taken independently of Government by a newly formed money creation committee or by the existing Monetary Policy Committee, either of which would be accountable to the Treasury Committee. Accountability to the House is crucial to the whole process.

Mr Jim Cunningham: Going back to the question I asked my right hon. Friend earlier, what would be the role of the Bank of England?

Mr Meacher: I will come on to explain that. The Bank of England has an absolutely crucial role to play. If my hon. Friend listens to the last bit of my speech, he will get a full answer to that question.

A sovereign money system thus offers—if I may say this—a clear thermostat to balance the economy, which is notoriously lacking at present. In times when the economy is in recession or growth is slow, the money creation committee would be able to increase the rate of money creation, to boost aggregate demand. If growth is very high and inflationary pressures are increasing, it could slow down the rate of money creation. That would be a crucial improvement over the current system, whereby the banks either produce too much mortgage credit in a boom because of the high profit prospects, which produces a housing bubble and raises house prices, or produce too little credit in a recession, which exacerbates the lack of demand.

Lending to businesses is central to this whole debate.

Derek Twigg (Halton) (Lab): I want to take my right hon. Friend back to when he mentioned accountability to Parliament and the Select Committee. Could he enlarge on that point? On accountability, what powers would Parliament have to ensure that his proposal was being followed through properly and the rules were being laid down?

Mr Meacher: The purpose of accountability to the Treasury Committee would be to enable Parliament fully to explore the manner in which the money creation committee or the Monetary Policy Committee was working. I would anticipate a full three-hour discussion with the leading officials of those committees before the Treasury Committee, and if necessary they could be given a hard time. Certainly, the persons in this House who are most competent to deal with the matter would make clear their priorities, and where they thought the money creation committee was not paying sufficient attention to the way in which it was operating, and they would suggest changes. They would not have the power formally to compel the money creation committee to change, but I think the whole point about Select Committees, which are televised and discussed in the media, is that they have a very big effect. That would be a major change compared with what we have at present. Like all systems, if it is inadequate it can be modified, changed and increasingly enforced.

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Sir William Cash: With reference to the Treasury Committee, does the right hon. Gentleman see a potential role for some form of joint Committee, perhaps with the Public Accounts Committee, whose origins are to do with taxation and spending? Does he think that broadening scrutiny a little in that direction might be helpful so that we get the full benefit of the all-party agreement of both Committees?

Mr Meacher: That is a helpful intervention. Although it is a relatively big part of what I am proposing, it is not for me to suggest exactly what the structure of accountability should be. I would be strongly in favour of increasing it as the hon. Gentleman proposes. Until this House is content that it has a proper channel of accountability which is effective in terms of the way our financial system is run, we should bring in further changes to the structure of accountability as may be necessary, such as along the lines that he suggests.

On lending to businesses, the experience that we have had in the past half-decade has been very unsatisfactory. Under a sovereign monetary system, the central bank would be empowered to create money for the express purpose of that funding role. The money would be lent to banks with the requirement that the funds were used for productive purposes, whereas lending for speculative purposes—for example, to purchase pre-existing assets, either financial or property—would not be allowed. The central bank could also create and lend funds to other intermediaries—the hon. Member for Wycombe referred to this—such as regional or publicly owned business banks, which would ensure that a floor could be placed under the level of lending to businesses, which would be a great relief to British business, guaranteeing support for the real economy.

To avoid misunderstanding, I should add that within the limits imposed by the central bank on the broad purposes for which money may be lent, lending decisions would be entirely at the discretion of the lending institutions, not of the Government or the central bank.

I believe that a sovereign monetary system offers very considerable advantages over the current system. First, it would create a better and safer banking system because banks would have an incentive to take lower levels of risk, as there would be no option of a bail-out or rescue from taxpayers and thus moral hazard would be reduced. Secondly, it would increase economic stability because money creation by banks tends to be pro-cyclical, as I explained, whereas money creation by the central bank would be counter-cyclical. Thirdly, sovereign money crucially supports the real economy, whereas under the current system 83% of lending does not at present go into productive investment. I underline that three times.

Ann McKechin: My right hon. Friend said that the aim would be to reduce risk and for banks to be more cautious, but if we are to encourage innovation in manufacturing, would we not require an investment bank at state level that could fund the riskier levels of innovation to ensure that they get to market, because they are not at the point where they would be commercially viable?

Mr Meacher: That is an extremely important point and, again, I strongly support it. The current Secretary of State for Business, Innovation and Skills has been

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struggling to introduce a Government-supported business investment bank and has recently announced something along those lines. I think that should be greatly expanded. The book by Mariana Mazzucato, which I hope most of us have read, “The Entrepreneurial State”, shows the degree to which funding for major innovation, not just in this country but in many other countries which she cites, has been financed through the state because the private sector was not willing to take on board the risk involved. One understands that, but one does need to recognise that the role of the state is extremely important, and under a Labour Government I would like to see something like this being brought in.

Ian Murray (Edinburgh South) (Lab): My right hon. Friend makes a tremendous case for money creation and what we should be considering in this House, but I wonder whether there is also a cultural issue. Many businesses and lenders tell me that there is a cultural problem in the United Kingdom for businesses, particularly entrepreneurial businesses that we have heard about from my hon. Friend the Member for Glasgow North (Ann McKechin), with regard to giving away equity rather than creating debt—funding businesses through equity rather than debt. Other countries throughout Europe that are incredibly successful at giving away equity rather than creating debt have much more growth in their entrepreneurial economy.

Mr Meacher: That is perfectly true, and my hon. Friend makes an important point. The proposals that I am making would support that. There is a very different climate in this country, largely brought about by the churning in the City of London where profits have to be increased or reach a relevant size within a very short period, such as three or six months. Most entrepreneurial businesses cannot possibly produce a decent profit within that period, so the current financial system does not encourage what my hon. Friend wants. These proposals would make money creation available to those we really want to support much more fully than at present.

Fourthly, under the current system, house price bubbles transfer wealth, as we all know, from the young to the old and from those who cannot get on the property ladder to existing house owners, which increases wealth inequality, while removing the ability of banks to create money should dampen house price rises and thus reduce the rate of wealth inequality.

My fifth and last point, which I think is very important, is that sovereign money redresses a major democratic deficit. Under the current system, around just 80 board members across the largest five banks make decisions that shape the entire UK economy, even though these individuals have no obligation or mandate to consider the needs of society or the economy as a whole, and are not accountable in any way to the public: it is for the maximisation of their own interests, not the national interest. Under sovereign money, the money creation committee would be highly transparent—we have discussed this already—and accountable to Parliament.

For all those reasons, the examination of the merits of a sovereign monetary system is now urgently needed, and I call on the Government to set up a commission on money and credit, with particular reference to the potential benefits of sovereign money, which offers a way out of

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the continuing and worsening financial crises that have blighted this country and the whole international economy for decades.

12.13 pm

Mr Peter Lilley (Hitchin and Harpenden) (Con): It is a pleasure, as always, to follow the right hon. Member for Oldham West and Royton (Mr Meacher), who gave us a characteristically thoughtful and radical speech. I do not necessarily start from the same premises as him, but what he says is an important contribution to the debate, on the securing of which I credit my hon. Friend the Member for Wycombe (Steve Baker). He has done the House and the country a service by forcing us to focus on the issue of where money comes from and what banks do. He did so in an insightful way. Above all, he showed that he sees, as our old universities used to see, economics as a branch of moral sciences. It is not just a narrow, analytical, economic issue, but a moral, philosophical and ultimately a theological issue, which he illuminated well for the House.

A lot has been made of the ignorance of Members of Parliament of how money is created. I suspect that that ignorance, not just in Members of Parliament but in the intellectual elite in this country, explains many things, not least why we entered the financial crisis with a regulatory system that was so unprepared for a banking crisis. I suspect that it is because people have not reflected on why banks are so different from all other capitalist companies. They are different in three crucial respects, which is why they need a very different regulatory system from normal companies.

First, all bankers—not just rogue bankers but even the best, the most honourable and the most honest—do things that would land the rest of us in jail. Near my house in France is a large grain silo. After the harvest, farmers deposit grain in it. The silo gives them a certificate for every tonne of grain that they deposit. They can withdraw that amount of grain whenever they want by presenting that certificate. If the silo owner issued more certificates than there was grain kept in his silo, he would go to jail, but that is effectively what bankers do. They keep as reserves only a fraction of the money deposited with them, which is why we call the system the fractional reserve banking system. Murray Rothbard, a much neglected Austrian economist in this country, said very flatly that banking is therefore fraud: fractional reserve banking is fraud; it should be outlawed; banks should be required to keep 100% reserves against the money they lend out. I reject that conclusion, because there is a value in what banks do in transforming short-term savings into long-term investments. That is socially valuable and that is the function banks serve.

We should recognise the second distinctive feature of banks that arises directly from the fact that they have only a fraction of the reserves against the loans they make: banks, individually and collectively, are intrinsically unstable. They are unstable because they borrow short and lend long. I have been constantly amazed throughout the financial crisis to hear intelligent people say that the problem with Northern Rock, RBS or HBOS, or with the German, French, Greek and other banks that ran into problems, was the result of their borrowing short and lending long, and they should not have been doing it, as if it was a deviation from their normal role. Of course banks borrow short and lend long. That is what

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banks do. That is what they are there for. If they had not done that they would not be banks. Banking works so long as too many depositors do not try to withdraw their funds simultaneously. However, if depositors, retail or wholesale, withdraw or refuse to renew their short-term deposits, a bank will fail.

If normal companies fail, there is no need for the Government to intervene. Their assets will be redeployed in a more profitable use or taken over by a better-managed company. But if one bank fails, depositors are likely to withdraw deposits from other banks, about which there may also be doubts. A bank facing a run, whether or not initially justified, would be forced to call in loans or sell collateral, causing asset prices to fall, thereby undermining the solvency of other banks. So the failure of one bank may lead to the collapse of the whole banking system.

The third distinctive feature of banks was highlighted by my hon. Friend the Member for Wycombe: banks create money. The vast majority of money consists of bank deposits. If a bank lends a company £10 million, it does not need to go and borrow that money from a saver; it simply creates an extra £10 million by electronically crediting the company’s bank account with that sum. It creates £10 million out of thin air. By contrast, when a bank loan is repaid, that extinguishes money; it disappears into thin air. The total money supply increases when banks create new loans faster than old loans are repaid. That is where growth in the money supply usually comes from, and it is the normal situation in a growing economy. Ideally, credit should expand so that the supply of money grows sufficiently rapidly to finance growth in economic activity. When a bank or banks collapse, they will call in loans, which will reduce the money supply, which in turn will cause a contraction of activity throughout the economy.

In that respect, banks are totally different from other companies—even companies that also lend things. If a car rental company collapses, it does not lead to a reduction in the number of cars available in the economy. Its stock of cars can be sold off to other rental companies or to individuals. Nor does the collapse of one rental company weaken the position of other car rental companies; on the contrary, they then face less competition, which should strengthen their margins.

The collapse of a car rental company has no systemic implications, whereas the collapse of a bank can pull down the whole banking system and plunge the economy into recession. That is why we need a special regulatory regime for banks and, above all, a lender of last resort to pump in money if there is a run on the banks or a credit crunch, yet this was barely discussed when the new regulatory structure of our financial and banking system was set up in 1998. The focus then was on consumer protection issues. Systemic stability and the lender-of-last-resort function were scarcely mentioned. That is why the UK was so unprepared when the credit crunch struck in 2007. Nor were these aspects properly considered when the euro was set up. As a result, a currency and a banking system were established without the new central bank being given the power to act as lender of last resort. It has had to usurp that power, more or less illegally, but that is its own problem.

This analysis is not one of those insights that come from hindsight. Some while ago, Michael Howard, now the noble Lord Howard, reminded Parliament—and

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indeed me; I had completely forgotten—that I was shadow Chancellor when the Bill that became the Bank of England Act 1998 was introduced. He pointed out that I then warned the House that

“With the removal of banking control to the Financial Services Authority…it is difficult to see how…the Bank remains, as it surely must, responsible for ensuring the liquidity of the banking system and preventing systemic collapse.”

And so it turned out. I added:

“setting up the FSA may cause regulators to take their eye off the ball, while spivs and crooks have a field day.”—[Official Report, 11 November 1997; Vol. 300, c. 731-32.]

So that turned out, too. I could foresee that, because the problem was not deregulation, but the regulatory confusion and the proliferation of regulation introduced by the former Chancellor, which resulted from a failure to focus on the banking system’s inherent instability, and to provide for its stability.

This failure to focus on the fundamentals was not a peculiarly British thing. The EU made the same mistakes in spades when setting up the euro, and at the very apogee of the world financial system, they deluded themselves that instability was a thing of the past. In its “Global Financial Stability Report” of April 2006, less than 18 months before the crisis erupted, the International Monetary Fund, no less, said:

“There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped to make the banking and overall financial system more resilient…The improved resilience may be seen in fewer bank failures and more consistent credit provision. Consequently, the commercial banks…may be less vulnerable today to credit or economic shocks.”

The supreme irony is that those at the pinnacle of the world regulatory system believed that the very complex derivatives that contributed to the collapse of the financial system would render it immune to such instability. We need constantly to be aware that banks are unstable, and are the source of money. If instability leads to a crash, that leads to a contraction in the money supply, and that can exacerbate and intensify a recession.

Bob Stewart (Beckenham) (Con): I am listening carefully to my right hon. Friend. Does that mean that the banks are uncontrollable, as things stand?

Mr Lilley: No; they can and should be controlled. They are controlled both by being required to have assets, and ultimately by the measures that Government should take to ensure that they do not expand lending too rapidly. That is the point that I want to come on to, because a failure to focus on the nature of banking and money creation causes confusion about the causes of inflation and the role of quantitative easing.

As too many people do not understand where money comes from, there is confusion about quantitative easing. To some extent, the monetarists, of whom I am one, are responsible for that confusion. For most of our lifetime, the basic economic problem has been inflation. There have been great debates about its causes. Ultimately, those debates were won by the monetarists. They said, “Inflation is caused by too much money—by money growing more rapidly than output. If that happens, inevitably and inexorably, prices will rise.” The trouble was that all too often, monetarists used the shorthand

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phrase, “Inflation is caused by Government printing too much money.” In fact, it is caused not by Government printing the money, but by banks lending money and then creating new money at too great a rate for the needs of the economy. We should have said, “Inflation follows when Governments allow or encourage banks to create money too rapidly.” The inflationary problem was not who created the money, but the fact that too much money was created.

The banks are now not lending enough to create enough money to finance the growth and expansion of the economy that we need. That is why the central bank steps in with quantitative easing, which is often described as the bank printing money. Those who have been brought up to believe that printing money was what caused inflation think that quantitative easing must, by definition, cause inflation. It only causes inflation if there is too much of it—if we create too much money at a faster rate than the growth of output, and therefore drive up prices—but that is not the situation at present.

Mr MacNeil: The right hon. Gentleman is giving a very good explanation of the different circumstances in which money is created. He has spoken about the morality, and about quantitative easing. When there is demand, what is his view of the theory of helicopter money, and where that money gets spread to?

Mr Lilley: As a disciple of Milton Friedman, I am rather attracted to the idea of helicopter money; I think it was he who introduced the metaphor, and said that it would be just as effective if money were sprayed by a helicopter as if it were created by banks. Hopefully, as I live quite near the helicopter route to Battersea, I would be a principal recipient. I do not think that there is a mechanism available that would allow us to do that, but I am not averse to that in principle, if someone could do it. My point is that the banks, either spontaneously or encouraged by the central bank through quantitative easing, must generate enough money to ensure that the economy can grow steadily and stably.

Mr MacNeil: Could it not be argued that increasing welfare payments would be a form of helicopter money, because the people most likely to spend money are those with very little money? If we put money in the pockets of those who have little money, it would be very positive, because of the economic multiplier; the money would be spent, and would circulate, very quickly.

Mr Lilley: There are far better reasons for giving money to poor people than because their money will circulate more rapidly—and there is no evidence for that; I invite the hon. Gentleman to read Milton Friedman’s “A Theory of the Consumption Function”, which showed that that is all nonsense. There are good reasons for giving money to poor people, namely that they are poor and need money. Whether the money should be injected by the Government spending more than they are raising, rather than by the central bank expanding its balance sheet, is a moot point.

All I want to argue today is that we should recognise that the economy is as much threatened by a shortage of money as it is by an excess of money. For most of our lifetimes the problem has been an excess, but now it is a shortage. We therefore need to balance in either occasion

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the rate of growth of money with the rate of growth of output if we are to have stability of prices and stable economic activity. I congratulate my hon. Friend the Member for Wycombe on bringing these important matters to the House’s attention.

12.30 pm

Austin Mitchell (Great Grimsby) (Lab): I welcome this debate and congratulate hon. Friends on securing it, because we have not debated this matter for over 100 years, and it is time we did so. This House and the Government are obsessed with money and the economy, but we never debate the creation of money or credit, and we should, because, when it comes to our present economic situation and the way the banks and the economy are run, that is the elephant in the room. It is time to think not outside the box, but outside the banks; it is time to think about the creation of credit and money.

I speak as a renegade social creditor who is still influenced by social credit thinking; I do not pledge total allegiance to Major Douglas, but I am still influenced by him. As has just been pointed out, 93% of credit is created by the banks, and a characteristic of what has happened to the economy since the ’70s is the enormous expansion of that credit. I have here a graph from Positive Money showing that the money created by the banks was £109 billion in 1980. Thanks to the financial reforms and the huge increase in the power of the banks since then, by 2010 that figure had risen to £2,213 billion, whereas the total cash created by the Government—the other 3%—had barely increased at all. Since 2000 we have seen the amount of money created by the banks more than double.

That has transformed the economy, because it has financialised everything and made money far more important. It has created debt-fuelled growth followed by collapse. It is being controlled by the banks, which have directed the money into property and financial speculation. Only 8% of the credit created has been lent to new businesses. The Government talk about the march of the makers, but the makers are not marching into the banks, because the banks are turning them away. Even commercial property is more important than makers. That has created a very lop-sided economy, with a weak industrial base that cannot pay the nation’s way in the world because investment has been directed elsewhere, and a very unequal society, which has showered wealth on those at the top, as Piketty shows, and taken it away from those at the bottom.

A very undesirable situation is being created. We have built an unstable economy that is very exposed to risk and to bubble economics, thanks to the financialisation process that has gone on since 1979. The state allocates all credit creation to the banks and then has to bail them out and guarantee them, at enormous expense and with the creation of debt for the public, when the bubble bursts and they collapse.

Some argue—Major Douglas would have argued this—that credit should therefore be issued only by the state, through the Bank of England. That would probably be a step too far in the present situation, given our present lack of education, but we can and should create the credit issued by the banks. We can and should separate the banks’ utility function—servicing our needs, with cheque books, pay and so on—and their speculative

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role. The Americans have moved a step further, with the Volcker rule, but it is not quite strong enough. In this country we tend to rely on Chinese walls, which are not strong at all. I think that only a total separation of the banks’ utility and speculative arms will do it, because Chinese walls are infinitely penetrable and are regularly penetrated.

We can limit the credit creation by the banks by increasing the reserve ratios, which are comparatively low at the moment—the Government have been trying to edge them up, but not sufficiently—or we could limit their power to create credit to the amount of money deposited with the banks as a salutary control. We could tax them on the hidden benefit they get from creating credit, because they get the signorage on the credit they create. If credit is created by banknotes and cash issued by the Government, the Government get the profit on that—the signorage. The banks just take the signorage on all the credit they issue and stash it away as a kind of hidden benefit, so why not tax that and give some of the profit from printing money to the state?

Martin Wolf, in an interesting article cited by my right hon. Friend the Member for Oldham West and Royton (Mr Meacher), has argued that only central banks should create new money and that it should be regulated by a public credit authority, rather like the Monetary Policy Committee. I think that that would be a solution and a possible approach. Why should we not regulate the issue of credit in that fashion?

That brings us back to the old argument about monetarism: whether credit creation is exogenous or endogenous. The monetarists thought that it was exogenous, so all we have to do is cut the supply of money into the economy in order to bring inflation under control. That was a myth, of course, because we cannot actually control the supply of money; it is endogenous. The economy, like a plant, sucks in the money it needs. But that can be regulated by a public credit authority so that the supply matches the needs of the economy, rather than being excessive, as it has been over the past few years. I think that that kind of credit authority needs to be created to regulate the flow of credit.

That brings me to the Government’s economic policy. The Government tell us that they have a long-term economic plan, which of course is total nonsense. Their only long-term economic plan is slash and burn. The only long-term economic planning that has been done is by the Bank of England.

Mr MacNeil: To quote Harry S. Truman, the worst thing about economists is that they always say, “On the other hand”. The hon. Gentleman talks about limiting and regulating how much money is to be sucked in by the economy, but who would decide that? The difficulty is that although the economy might be overheating in a certain part of the country, such as the south-east of England, it could be very cool in others, such as the north of Scotland. What might be the geographical effects of limiting the money going into the economic bloodstream if some parts of the plant—I am extending his metaphor—need the nutrients while other parts are getting too much?

Austin Mitchell: The hon. Gentleman often asks tricky questions, but this one is perfectly clear-cut. The credit supply for the peripheral and old industrial parts of the

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economy, which include Scotland, but also Grimsby, has been totally inadequate, and the banks have been totally reluctant to invest there. I once argued for helicopter money, as Simon Jenkins has proposed, whereby we stimulate the economy by putting money into helicopters and dropping it all over the country so that people will spend it. I would agree to that, provided that the helicopters hover over Grimsby, but I would have them go to Scotland as well, because it certainly deserves its share, as does the north of England. However, I do not want to get involved in a geographical dispute over where credit should be created.

The only long-term plan has been that of the Bank of England, which has kept interest rates flat to the floor for six years or so—an economy in that situation is bound to grow—and has supplemented that with quantitative easing. We have created £375 billion of money through quantitative easing. It has been stashed away in the banks, unfortunately, so it has served no great useful purpose. If that supply of money can be created for the purpose of saving the banks and building up their reserve ratios, it can be used for more important purposes—the development of investment and expansion in the economy. This is literally about printing money. Those of us with a glimmering of social credit in our economics have been told for decades, “You can’t print money—it would be terrible. It would be disastrous for the economy to print money because it leads to inflation.” Well, we have printed £375 billion of money, and it has not produced inflation. Inflation is falling.

Steve Baker rose—

Austin Mitchell: I am sorry—I am mid-diatribe and do not want to be interrupted.

It has proved possible to print money. The Americans have done it—there has been well over $1 trillion of quantitative easing in the United States. The European Central Bank is now contemplating it, as Mr Draghi casts around for desperate solutions to the stagnation that has hit the eurozone. The Japanese, surprisingly, did it only last week. If all can do it, and if it has been successful here and has not led to inflation, we should be able to use it for more useful and productive economic purposes than shoring up the banks.

If we go on creating more money through quantitative easing, we should channel it through a national investment bank into productive investment such as contracts for house building and new town generation. Through massive infrastructure work—although I would not include HS2 in that—we can stimulate the economy, stimulate growth, and achieve useful purposes that we have not been able to achieve. This is a solution to a lot of the problems that have bedevilled the Labour party. How do we get investment without the private finance initiative and the heavy burden that that imposes on health services, schools, and all kinds of activities? Why not, through quantitative easing, create contracts for housing or other infrastructure work that have a pay-off point and produce assets for the state?

I mentioned the article in which Martin Wolf advocates the approach of the Monetary Policy Committee. That is how we should approach this. I welcome this debate because it has to be the beginning of a wider debate in

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which we open our minds to the possibilities of managing credit more effectively for the better building of the strength of the British economy.

12.44 pm

Zac Goldsmith (Richmond Park) (Con): I want to put on record my gratitude to my hon. Friend the Member for Wycombe (Steve Baker) for having initiated this debate, and to his supporters from various parties. Having heard his speech—or most of it; I apologise for being late—I am even more satisfied that it was right to cast my vote for him to join the Treasury Committee.

My hon. Friend has introduced an incredibly important debate. As we have heard, this issue has not been debated here for well over a century. We would not be having it were it not for the fact that we are still in the midst of tumultuous times. We had the banking crash and the corresponding crash in confidence in the banking system and in the wider economy, and now, partly as a consequence, we have the problem of under-lending, particularly to small and medium-sized businesses. This subject could not be more important.

The right hon. Member for Oldham West and Royton (Mr Meacher)—I will call him my right hon. Friend because we work together on many issues—pointed out at the beginning of his speech that this issue is not well understood by members of the public. As I think he said later—if not, I will add it—it is also not well understood by Members of Parliament. I would include myself in that. I suspect that most people here would be humble enough to recognise that the banking wizardry we are discussing is such a complex issue that very few people properly understand it.

Bob Stewart: I totally associate myself with my hon. Friend’s comments about ignorance and include myself in that. It seems to me that the system is broken. The banks will not lend money because the Government have told them that they have to keep reserves. We do not like quantitative easing because that means that the banks are not lending. There is something very wrong with the system. It is not a case of “if the system isn’t broke, don’t fix it”, but “the system is broke, and someone’s got to fix it”.

Zac Goldsmith: My hon. Friend makes a valuable point that I will come to later.

If Members of Parliament do not really understand how money is created—I believe that that is the majority position, based on discussions that I have been having—how on earth can we be confident that the reforms that we have brought in over the past few years are going to work in preventing repeated collapses of the sort that we saw before the last election? In my view, we cannot be confident of that. The problem is the impulsive position taken by ignorant Members. I do not intend to be rude; as I said, I include myself in that bracket. For too many people, the impulse has been simply to call for more regulation, as though that is going to magic away these problems. As my hon. Friend the Member for Wycombe said, there are 8,000 pages of guidance in relation to one aspect of banking that he discussed. The problem is not a lack of regulation; it is the fact that the

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existing regulations miss the goal in so many respects. Banking has become so complex and convoluted that we need an entirely different approach.

When we talk to people outside Parliament about banking, the majority have a fairly simple view—the bank takes deposits and then lends, and that is the way it has always been. Of course, there is an element of truth in that, but it is so far removed from where we are today that it is only a very tiny element.

Steve Baker: My hon. Friend mentions the idea of straightforward, carry-through lending. When people talk about shadow banking, they are usually talking about asset managers who are lending and are passing funds straight through—similarly with peer-to-peer lenders. I am encouraged by the fact that when people are freely choosing to get involved with lending, they are not using the expansionary process but lending directly. Whereas the banks are seen simultaneously to fail savers and borrowers, things like peer-to-peer lending are simultaneously serving them both.

Zac Goldsmith: That is a really important point. There is a move towards such lending, but unfortunately it is only a fringe move that we see in the credit unions, for example. It is much closer to what original banking—pure banking or traditional banking—might have looked like. We even see it in some of the new start-ups such as Metro bank; I hesitate to call it a start-up because it is appearing on every high street. Those banks have much more conservative policies than the household-name banks that we have been discussing.

Most people understand the concept of fractional reserve banking even if they do not know the term—it is the idea that banks lend more than they can back up with the reserves they hold.

Guy Opperman (Hexham) (Con): My hon. Friend mentioned Metro, whose founder is setting up a bank—in which I should declare an interest—called Atom in the north-east. It is one of some 22 challenger banks of which Metro was the first. I missed the opening of the debate, so I have not heard everything that has been said, but I do not accept that it is all doom and gloom in banking. Does he agree that these new developments are proof that the banking system is changing and the old big banks are being replaced with the increased competition that we all need?

Zac Goldsmith: I certainly agree with the sentiment expressed. I am excited by the challengers, but I do not believe that it is enough. Competition has to be good because it minimises risk. I know that my hon. Friend the Economic Secretary has dwelt on and looked at this issue in great detail.

Even fractional reserve banking is only the start of the story. I will not repeat in detail what we have already heard, but banks themselves create money. They do so by making advances, and with every advance they make a deposit. That is very poorly understood by people outside and inside the House. It has conferred extraordinary power on the banks. Necessarily, naturally and understandably, banks will use and have used that power in their own interests. It has also created extraordinary risk and, unfortunately, because of the size and interconnectedness of the banks, the risk is on us. That

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is why I am so excited by the challengers that my hon. Friend has just described. As I have said, that is happening on the fringe: it is right on the edge. It is extraordinary to imagine that at the height of the collapse the banks held just £1.25 for every £100 they had lent out. We are in a very precarious situation.

When I was much younger, I listened to a discussion, most of which I did not understand, between my father and people who were asking for his advice. He was a man with a pretty good track record on anticipating turbulence in the world economy. He was asked when the next crash would happen, and he said, “The last person you should ask is an economist or a business man. You need to ask a psychiatrist, because so much of it involves confidence.” The point was proven just a few years ago.

The banking system and the wider economy have become extraordinarily unhinged or detached from reality. I would like to elaborate on the extraordinary situation in which it is possible to imagine economic growth even as the last of the world’s great ecosystems or the last of the great forests are coming down. The economy is no longer linked to the reality of the natural world from which all goods originally derive. That is probably a debate for another time, however, so I will not dwell on it.

Mr MacNeil: The hon. Gentleman is making a good point that we should remember. It was brought home to me by Icelandic publisher Bjorn Jonasson, who pointed out that we are not in a situation where volcanoes have blown up or there have been huge national disasters, famines or catastrophes brought on by war; as a couple of the hon. Gentleman’s colleagues have said, this is about a system failure within the rules, and it is worth keeping that in mind. Although there is much gloom in relation to the banking system, in many ways that should at the same time give us some hope.

Zac Goldsmith: The hon. Gentleman is right, but a growing number of commentators and voices are anticipating a much larger crash than anything we have seen in the past few years. I will not add to or detract from the credence of such statements, but it is possible to imagine how such a collapse might happen, certainly in the ecological system. We are talking about the banking system, but the two systems are not entirely separate.

We had a wake-up call before the election just a few years ago. My concern is that we have not actually woken up. It seems to me that we have not introduced any significant or meaningful reforms that go to the heart of the problems we are discussing. We have been tinkering on the edges. I do not believe that Parliament has been as closely involved in the process as it should be, partly because of the ignorance that I described at the beginning of my speech.

I want to put on the record my support for the establishment of a meaningful monetary commission or some equivalent in which we can examine the pros and cons of shifting from a fractional reserve banking system to something closer to a full reserve banking system, as some hon. Members have said. We need to understand the pros and cons of such a move, how possible it is, and who wins and who loses. I do not think that many people fully know the answers.

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We need to look at quantitative easing. I think that hon. Members on both sides of the House have accepted that it is not objective. Some believe that it is good and others believe that it is bad, but no one believes that it is objective. If the majority view is that quantitative easing is necessary, we need to ask this question: why not inject those funds into the real economy—into housing and energy projects of the kind that Opposition Members have spoken about—rather than using the mechanism in a way that clearly benefits only very few people within the world of financial and banking wizardry that we are discussing?

The issues need to be explored. The time has come to establish a monetary commission and for Parliament to become much more engaged. This debate is a very small step in that direction, and I am very grateful to its sponsors. I wish more Members were in the Chamber—I had intended to listen, not to speak—but, unfortunately, there have not been many speakers. This is a beginning, however, and I hope that we will have many more such debates.

12.55 pm

Mark Durkan (Foyle) (SDLP): I rise to endorse the very significant points made by hon. Members. In particular, I pay tribute to the hon. Member for Wycombe (Steve Baker) for securing the debate and for opening it so strongly. From hearing him speak in Public Bill Committees on banking reform and related questions, I know that he is dubious about our having almost feng shui arguments on the regulatory furniture when there are fundamental questions to be asked about the very foundations of the system. He amplified that point in his speech.

My right hon. Friend the Member for Oldham West and Royton (Mr Meacher) made the point that the whole approach to quantitative easing—several Members have questioned it at a number of levels—proves that the underlying logic of sovereign money creation is feasible and workable. It is strange that some of the people who would dispute or refute the case for sovereign money creation sometimes defend quantitative easing in its existing form and with its current features.

In many ways, quantitative easing has shown that if we are to use the facility of the state—in this situation, the state’s main tool is the Bank of England—to alter or prime the money supply in a particular way, we could choose a much better way of doing so than through quantitative easing. It is meant to have increased the money supply, but where have people felt that in terms of business credit, wages or the stimulus that consumer power can provide?

When we look back at the financial crash and its aftermath, we can see evidence—not just in the UK, but in Ireland and elsewhere—showing that much of what we were told about the worth or the wealth of various sectors in the economy up until the crash has turned out to be vacuous, while the poverty lying in its trail has been vicious. The worth or the wealth was not real, but the poverty is real. People in organisations such as Positive Money in the UK or Sensible Money in Ireland are therefore saying, rightly, that politics—those of us charged with overseeing public policy as it affects the

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economy—need to have more of a basic look at how we treat the banking system and at the very nature of money creation.

As someone who grew up in Northern Ireland, I am very used to the idea of having different banknotes—banks issuing their own money—but we do not think much about that, because we think that all that happens in the Bank of England or under its licence. As a member of the Financial Services Public Bill Committee and the Financial Services (Banking Reform) Public Bill Committee, it seems to me that although it has been recognised that some regulatory powers should go back to the Bank of England, the arrangements for regulation and the Bank of England’s role are still very cluttered.

In fact, in trying to correct the regulatory deficiencies that existed before the crash, there is a risk that we have perhaps created too many conflicting and confusing roles for the Bank of England. Given the various personages, different roles and job descriptions that attach to some of those committees, it seems to me that there is potential for clutter in the Treasury. The common denominator and reference point in the range of different committees and bodies and the things they do, is the Treasury. When the Treasury exercises its powers, influences judgments, and informs the criteria and considerations of those different committees under the Bank of England, there is not enough scrutiny or back play through Parliament.

I endorse the points made by other hon. Members about ensuring more accountability, whether through more formal reference to the Treasury Committee or some other hybrid, as suggested in an intervention on the right hon. Member for Oldham West and Royton. There should be more parliamentary insight—and definitely parliamentary oversight—on these matters. We cannot suddenly be shocked that all the confidence in various regulatory systems turned out to have been badly placed. That was our experience the last time, when people who now criticise the previous Government for not having had enough regulation were saying that there was too much regulation and calling for more deregulation.

If we in this Parliament have produced a new regulatory order, we must be prepared to face and follow through the questions that arise. It is not good enough to ensure that the issue returns to Parliament only the next time there is a crisis, when we will have to legislate again. We should do more to be on our watch. The hon. Member for Wycombe and other hon. Members who secured this debate have done us a service. We want more of a parliamentary watch window on these issues.

There is a necessary role for banks in the creation of money and quantitative easing, but we must entrust them with the right role and with the appropriate controls and disciplines. That is fundamental. It is not good or strong enough that we leave it to the whims of the banks and their lending—supposedly reinforced and stimulated by quantitative easing—to profile the performance of the economy.

If quantitative easing works on the basis of the Bank of England, through the asset purchase facility, essentially using money that it creates under quantitative easing to buy gilts from a pension fund whose bank account is with RBS—which in essence is owned by the Bank of England—then RBS’s bank account with the Bank of England goes up by the value of that gilt purchase. Simultaneously, the bank account of the pension fund

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goes up by that amount, and we are told that the UK money supply has increased. Yes, in theory the pension fund can purchase other assets—is that what is happening?—but while 1% of the big money holders and players appear to have been advantaged through quantitative easing, where is the trickledown to the rest of the economy? It is not there.

The sovereign money creation model seems to be primed much more specifically on a view of the total economy and providing a broad, stable and more balanced approach to stimulus and economic performance. We have had the slowest recovery coming out of a recession with quantitative easing. I do not say that to get some voice-activated reaction from the Government about how good the recovery and performance is, but in broader historical terms it is the slowest recovery, which also leaves questions about quantitative easing.

We heard from the Prime Minister about red warning lights on the dashboard of the world economy, and I wonder whether he would ever say that, to his mind, those warning lights include the degree to which global banks are now playing heavily in derivatives again, and there needs to be more action. That raises issues not just of regulation at national level, but at international level.

1.5 pm

Catherine McKinnell (Newcastle upon Tyne North) (Lab): I congratulate the hon. Member for Wycombe (Steve Baker) on his thoughtful and thorough opening speech, as well as my right hon. Friend the Member for Oldham West and Royton (Mr Meacher) on his remarks. In their absence I also congratulate the hon. Members for Brighton, Pavilion (Caroline Lucas) and for Clacton (Douglas Carswell) on securing today’s important debate.

This debate follows a significant campaign by Positive Money, which has raised important issues about how we ensure financial stability, and how we as parliamentarians and members of the public can gain a greater understanding of the way our economy works, in particular how money is supplied not just in this country but around the world.

Some important questions have been highlighted in the debate, although not all have been answered. There are questions about how money is created, how money or credit is used by banks and others, how our financial system can be more transparent and accountable, and particularly how it can benefit the country as a whole. That latter point is something that Labour Members have been acutely focused on. How do we re-work our economy, whether in banking or in relation to jobs and wages, so that it works for the country as a whole?

It is worth reflecting on our current system and what it means for money creation. As the hon. Member for Wycombe set out eloquently in his opening speech, we know that currency is created in the conventional sense of being printed by the Bank of England, but commercial banks can create money through account holders depositing money in their accounts, or by issuing loans to borrowers. That obviously increases the amount of money available to borrowers and within the wider economy. As the Bank of England made clear in an article accompanying its first quarterly bulletin in 2014:

“When a bank makes a loan to one of its customers it simply credits the customer’s account with a higher deposit balance. At that instant, new money is created.”

Bank loans and deposits are essentially IOUs from banks, and therefore a form of money creation.

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Commercial banks do not have unlimited ability to create money, and monetary policy, financial stability and regulation all influence the amount of money they can create. In that sense, banks are regulated by the Prudential Regulation Authority, part of the Bank of England, and the Financial Conduct Authority. Those regulators, some of which are—rightly—independent, are the stewards of “safety and soundness” in financial institutions, especially regarding banks’ money-creating practices.

Banks are compelled to manage the liabilities on their balance sheets to ensure that they have capital and longer-term liabilities precisely to mitigate risks and prevent them from effectively having a licence to print money. Banks must adhere to a leverage ratio—the limit on their balance sheets, compared with the actual equity or capital they hold—and we strongly support that. Limiting a bank’s balance sheet limits the amount of money it can create through lending or deposits. There are a series of checks and balances in place when it comes to creating money, some of which the Opposition strongly supported when we debated legislative changes in recent years. It remains our view that the central issue, the instability of money supply within the banking system, is less to do with the powers banks hold and how they create money than with how they conduct themselves and whether they act in the public interest in other ways too.

We believe the issues relate to the incentives in place for banks to ensure that loans and debts are repaid, and granted only when there is a strong likelihood of repayment. When the money supply increases rapidly with no certainty of repayment, that is when real risks emerge in the economy. Those issues were debated at great length when the Financial Services (Banking Reform) Act 2013 made its way through Parliament, following recommendations from Sir John Vickers’ Independent Commission on Banking and the Parliamentary Commission on Banking Standards, which considered professional standards and culture in the industry. The 2013 Act created the Prudential Regulation Authority and gives regulators the power to split up banks to safeguard their future, to name just two examples of changes that were made. However, we feel that it did not go far enough.

The Opposition’s concern is that the Government’s actions to date in this area have fallen short of the mark. They have failed to boost sufficient competition in the banking industry to raise those standards and to create public confidence in the sector. As hon. Members with an interest in this area know, we tabled a number of amendments to try to strengthen the Bill, and to prevent banks from overreaching themselves and taking greater risks, by ensuring that the leverage ratio is effective. That goes to the heart of many of the issues we are debating today. The Government rejected our proposals to impose on all those working in the banking industry a duty of care to customers. That would help to reform banking so that it works in the interests of customers and the economy, and not solely those of the banks. Those are the areas on which we still feel that reform is needed in the sector.

It is clear from this debate that there is a whole range of issues to consider, but our focus is that the banks need to be tightly and correctly regulated to ensure that they work for the whole economy, including individuals

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and small and large businesses. That is the key issue that we face at present. Only when the banks operate in that way and work in the interests of the whole economy will we find our way out of the cost of living crisis that so many people are facing.

I thank hon. Members for securing this very important debate and for the very interesting contributions that have been made from all sides of the House. I am pretty certain that this is not the end of the conversation. The debate will go on.

1.12 pm

The Economic Secretary to the Treasury (Andrea Leadsom): I too congratulate hon. Members on securing this fascinating debate. It is long overdue and has allowed us to consider not just what more we can do to improve what we have but whether we should be throwing it away and starting again. I genuinely welcome the debate and hope that many more will follow. In particular, I pay tribute to my hon. Friend the Member for Wycombe (Steve Baker), who now sits on the Treasury Committee on which I had the great honour to serve for four years. I am sure that his challenge to orthodoxy will have been extremely welcomed by the Committee and by many others. I wish him good luck on that.

Steve Baker: May I just say how much I am enjoying my hon. Friend’s place on the Committee? I congratulate her on her promotion once again.

Andrea Leadsom: I am grateful to my hon. Friend.

My right hon. Friend the Member for Hitchin and Harpenden (Mr Lilley) gave a fantastic explanation that I would commend to anybody who wants to understand how money is created. He might consider delivering it under the financial education curriculum in schools. It was very enlightening, not least because it highlighted the appalling failure of regulation in the run-up to the financial crisis that is still reverberating in our economy today. All hon. Members made interesting points on what we can do better and whether we should be thinking again. I pay tribute to the right hon. Member for Oldham West and Royton (Mr Meacher) for his good explanation of the Positive Money agenda, which is certainly an idea worthy of thought and I will come on to it.

Money creation is an important and complex aspect of our economy that I agree is often misunderstood. I would therefore like quickly to set out how the system works. The money held by households and companies takes two forms: currency, which is banknotes and coins, and bank deposits. The vast majority, as my hon. Friend pointed out, is in the form of bank deposits. He is absolutely right to say that bank deposits are primarily created by commercial banks themselves each time they make a loan. Whenever a bank makes a loan, it credits the borrower’s bank account with a new deposit and that creates “new money”. However, there are limits to how much new money is created at any point in time. When a bank makes a loan, it does so in the expectation that the loan will be repaid in the future—households repay their mortgages out of their salaries; businesses repay their loans out of income from their investments.

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In other words, banks will not create new money unless they think that new value will also in due course be created, enabling that loan to be paid back.

Ultimately, money creation depends on the policies of the Bank of England. Changes to the bank rate affect market interest rates and, in turn, the saving and borrowing decisions of households and businesses. Prudential regulation is used if excessive risk-taking or asset price bubbles are creating excessive lending. Those checks and balances are an integral part of the system.

I agree fully that the regulatory system was totally unfit in the run-up to the financial crisis. We saw risky behaviour, excessive lending and a general lack of restraint on all sides. The key problem was that the buck did not stop anywhere. When there were problems in the banking system, regulators looked at each other for who was responsible. We all know that the outcome was the financial crisis of 2008. I, too, see the financial crisis as a prime example of why we need not just change but a better banking culture: a culture where people do not spend their time thinking about how to get around the rules; a culture where there is no tension between what is good for the firm and what is good for the customer; and a culture where infringements of the rules are properly and seriously dealt with.

I will touch on what we are doing to change the regulations and the culture, but first I will set out why we do not believe that the right solution is the wholesale replacement of the current system by something else, such as a sovereign monetary system. Under a sovereign monetary system, it would be the state, not banks, that creates new money. The central bank, via a committee, would decide how much money is created and this money would mostly be transferred to the Government. Lending would come from the pool of customers’ investment account deposits held by commercial banks.

Such a system would raise a number of very important questions. How would that committee assess how much money should be created to meet the inflation target and support the economy? If the central bank had the power to finance the Government’s policies, what would the implications be for the credibility of the fiscal framework and the Government’s ability to borrow from the market if they needed to? What would be the impact on the availability of credit for businesses and households? Would not credit become pro-cyclical? Would we not incentivise financing households over businesses, because for businesses, banks would presumably expect the state to step in? Would we not be encouraging the emergence of an unregulated set of new shadow banks? Would not the introduction of a totally new system, untested across modern advanced economies, create unnecessary risk at a time when people need stability?

Steve Baker: I do not actually support Positive Money’s proposals, although I am glad to work with it because I support its diagnosis of the problem. Of course, this argument could have been advanced in 1844 and it was not. I have not proposed throwing away the system and doing something radically new; I have proposed getting rid of all the obstacles to the free market creating alternative currencies.

Andrea Leadsom: I am grateful to my hon. Friend for pointing that out. I must confess that before the debate I was puzzled that such an intelligent and extremely

20 Nov 2014 : Column 465

sensible person should be making the case for a sovereign monetary system, which I would consider to be an extraordinarily state-interventionist proposal. I am glad to hear that is not the case. In addition, of course, bearing in mind our current set of regulators, presumably we would then be looking at a committee of middle-aged, white men deciding what the economy needs, which would also be of significant concern to me.

Mr Meacher: Before the Minister leaves the question of a sovereign monetary system, which she obviously totally opposes and to which she raised several objections that I cannot answer in an intervention, does she not believe that the system of bank money creation is highly pro-cyclical and has enormously benefited property and financial sectors to the disadvantage of the vast range of industries outside the financial sector?

Andrea Leadsom: As I said, I sincerely congratulate the right hon. Gentleman on raising this matter; it is certainly worthy of discussion, and I look forward to him responding to some of my arguments. I agree that where we were in the run-up to the financial crisis was entirely inappropriate, and I will come to some of the steps we have taken to improve—not throw away the baby with the bathwater—what we have now, rather than throwing it away and starting again.

I know that some of my hon. Friends and Opposition Members have a particular concern about quantitative easing—I have made it clear that I do too—specifically about how we might unwind it. However, they must agree that at least it can be unwound, unlike the proposal for “helicopter money”, which would seem to be a giant step beyond QE—a step where money would be created by the state with no obvious way to rein it back if necessary.

If the tap in my bathroom breaks, rather than wrenching the sink off the wall, I would prefer to fix the tap. As Martin Wolf said last week,

“nobody can say with confidence”

how a monetary system should be structured and what laws and regulations it should have. Given that and the economic tumult across the world, we should be devoting our energies to fixing the system we have—mending the problems but keeping what works. For that reason, the Government have taken significant steps to improve the banking sector, making sure it fulfils its core purpose of keeping the wheels of the economy well oiled.

We are creating a better, safer financial system, with the Financial Policy Committee, created in this Parliament, focused on macro-prudential analysis and action. As the hon. Member for Newcastle upon Tyne North (Catherine McKinnell) pointed out, the FPC has been given counter-cyclical tools to require more capital to be held and to increase the leverage ratio and the counter-cyclical capital buffers when the economy is over-exuberant in order to push back against it—as the previous Governor of the Bank of England said, to remove the punch bowl while the party is still in full flow. That is incredibly important. We are also reducing dependence on debt. Since the financial crisis, the UK banking system has been forced significantly to strengthen its capital and liquidity position, and it is continuing to do so.

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I must stress, however, that regulation alone will never be enough, which is why the Government are promoting choice, competition and diversity. I am delighted that 25 new banks are talking to the Prudential Regulatory Authority about getting a bank licence. We are also making strong efforts to promote the mutual sector; to enhance the capacity of credit unions to serve the real economy better; to enable booster funding for small businesses; to help families; and to improve customer service. We have put in place schemes to help the transmission of money from banks to customers, including the funding for lending scheme, which has lowered the price and increased the availability of credit for small and medium-sized businesses. As I think the hon. Member for Newcastle upon Tyne North said, we have also created the British business bank, which is helping finance markets work better for small firms, and are investing much resource and effort to build that up and help businesses in our economy.

We also have a programme of measures to increase competition in the SME lending market, including flagship proposals to open up access to SME credit information, which will help challengers to get in on the act, and to have banks pass on declined applications for finance to challenger banks. In addition, we now have an appeals process whereby small businesses turned down for funding can get a second chance, which has secured an additional £42 million of lending since its launch. These are all measures to help small businesses access finance. Then, to mitigate the problem of house price bubbles, we are putting in place supply-side reforms to promote home building and home owning, as well as measures enabling the PRA to limit the amount of lending that households can take on.

I agree with Members on both sides of the House, however, that we should not be content with the system as it stands. We must seek to improve it and make it function better. In Mark Carney, we have an excellent central banker who has the experience and knowledge to put the right reforms in place and see them through. As he says:

“Reform should stop only when industry and society are content, and finance justifiably proud.”

In the medium to long term, we need to create a culture where research and analysis do not shy away from going against the orthodoxy. As hon. Members across the House have said, we need to consider alternatives, and we should be having that discussion; it is healthy to do so, because that is how to make progress. For that reason, the call from Andy Haldane, the Deputy Governor of the Bank of England, for a broader look at new and existing monetary ideas is exactly right.

Mr Meacher: I am pleased the Minister thinks that alternative ways of improving the monetary system should be explored. Will she support the idea of a setting up a commission to examine the alternatives, as recommended by the hon. Member for Richmond Park (Zac Goldsmith), as well as by me—so there is some cross-part support on this? Is that not an idea whose time has come?

Andrea Leadsom: I think that an organisation such as the Treasury Committee, of which my hon. Friend the Member for Wycombe is member, would be entirely the right place to have such a discussion, and of course we

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also had the Vickers commission, which looked at what went wrong and what measures could be put in place, and the Parliamentary Commission on Banking Standards, which specifically addressed the issue of incentives and motivations in banking. I would not normally advocate the establishment of great new commissions; we already have the bodies to look further at different orthodoxies, and as Andy Haldane has said, the Bank itself will be looking at, and encouraging, the exploration of alternative views.

Of course, we also need to continue embracing innovation, both in the “software” of how payments are made and in the “hardware” of new currencies, such as crypto-currencies and digital currencies—both could open up competition and give customers greater choice and access to funding—but we must do so with caution. In November, we published a call for information inviting views and evidence on the benefits and risks of digital currencies so that digital currency businesses can continue to set up in the UK and people can expect to use them safely.

I am the last person who could be described as statist, but I accept that we must always be ruthless in our determination to regulate new ideas that come to the fore, because as sure as night follows day, as new ideas come in, through shadow banking, new lending ideas and so on, some people will seek to manipulate new schemes and currencies for fraudulent purposes. I am absolutely alive to that fact. It is important, therefore, that the Government carry out the necessary research.

The Government believe that the current system, modified and improved with far greater competition, can service the economy best. However, reform is vital. Again as Andy Haldane puts it:

“Historically, flexing policy frameworks has often been taken as a sign of regime failure. Quite the opposite ought to be the case”.

We need banks to lend—to young families wanting to buy houses and repay out of future labour income rather than relying on the bank of mum and dad, and to businesses wanting to seize opportunities, gain new markets and create jobs and growth. We have an existing system that offers a forward-looking and dynamic framework in which tomorrow’s opportunities are not wholly reliant on yesterday’s savings and which builds on banks’ expertise in assessing risk and making the lending decisions we badly need. During my 25 years at

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the heart of the industry, I saw the sector at its best, but sometimes sadly also at its worst. We are trying to remedy the worst, but let us also keep the best.

1.29 pm

Steve Baker: This debate has been a joy at times, and I am extremely grateful to right hon. and hon. Members who helped me to secure it. The right hon. Member for Oldham West and Royton (Mr Meacher) made clear his support for sovereign money. One of the great advantages of such a system is that it would make explicit what is currently hidden—that it is the state that is trying to steer the monetary system—and if such a system failed, it would at least be clear that it was a centrally planned monetary order that had failed.

The hon. Member for Clacton (Douglas Carswell) talked about the ownership of deposits, and I was glad to support his private Member’s Bill. I am reminded of the intervention from the hon. Member for Hackney North and Stoke Newington (Ms Abbott), who talked about deposit insurance. One of the problems, as seen in Cyprus in the context of depositor “bail-ins”, is that deposits are akin to a share in a risky investment vehicle, so a little more clarity about what a deposit means and what risks depositors take could go a long way.

My right hon. Friend the Member for Hitchin and Harpenden (Mr Lilley) highlighted one of the greatest controversies among free marketeers—whether or not fractional reserve deposit taking is legitimate.

The hon. Member for Great Grimsby (Austin Mitchell) mentioned Major Douglas, which he will have seen put a smile on my face. Major Douglas was dismissed as a crank, even by Keynes who dismissed him in his writing as a “private”. This highlights the fact that the possible range of debate is enormous.

I would like to leave my final words with Richard Cobden, the Member representing Stockport back in the time when this was also a big issue. He said:

“I hold all idea of regulating the currency to be an absurdity; the very terms of regulating the currency…I look upon to be an absurdity”.

The currency, for him,

“should be regulated by the trade and commerce of the world.”

I wholeheartedly agree.

Question put and agreed to.

Resolved,

That this House has considered money creation and society.

Economics

The wages-fuel-demand fallacy

In recent months talking heads, disappointed with the lack of economic recovery, have turned their attention to wages. If only wages could grow, they say, there would be more demand for goods and services: without wage growth, economies will continue to stagnate. It amounts to a non-specific call to stimulate aggregate demand by continuing with or even accelerating the expansion of money supply. The thinking is the same as that behind Bernanke’s monetary distribution by helicopter. Unfortunately for these wishful-thinkers the disciplines of the markets cannot be bypassed. If you give everyone more money without a balancing increase in the supply of goods, there is no surer way of stimulating price inflation, collapsing a currency’s purchasing power and losing all control of interest rates.

The underlying error is to fail to understand that economising individuals make things in order to be able to buy things. That is the order of events, earn it first and spend it second. No amount of monetary shenanigans can change this basic fact. Instead, expanding the quantity of money will always end up devaluing the wealth and earning-power of ordinary people, the same people that are being encouraged to spend, and destroying genuine economic activity in the process.

This is the reason monetary stimulation never works, except for a short period if and when the public are fooled by the process. Businesses – owned and managed by ordinary people – are not fooled by it any more: they are buying in their equity instead of investing in new production because they know that investing in production doesn’t earn a return. This is the logical response by businesses to the destruction of their customers’ wealth through currency debasement.

Let me sum up currency debasement with an aphorism:

“You print some money to rob the wealth of ordinary people to give to the banks to lend to business to make their products for customers to buy with money devalued by printing.”

It is as ridiculous a circular proposition as perpetual motion, yet central banks never seem to question it. Monetary stimulus fails with every credit cycle when the destruction of wealth is exposed by rising prices. But in this credit cycle the deception was so obvious to the general public that it failed from the outset.

The last five years have seen all beliefs in the manageability of aggregate demand comprehensively demolished by experience. The unfortunate result of this failure is that central bankers now see no alternative to maintaining things as they are, because the financial system has become horribly over-geared and probably wouldn’t survive the rise in interest rates a genuine economic recovery entails anyway. Price inflation would almost certainly rise well above the 2% target forcing central banks to raise interest rates, throwing bonds and stocks into a severe bear market, and imperilling government finances. The financial system is simply too highly geared to survive a credit-driven recovery.

Japan, which has accelerated monetary debasement of the yen at an unprecedented rate, finds itself in this trap. If anything, the pace of its economic deterioration is increasing. The explanation is simple and confirms the obvious: monetary debasement impoverishes ordinary people. Far from boosting the economy it is rapidly driving us into a global slump.

The solution is not higher wages.

Economics

Bedtime for Bondo

 “By sacrificing quality an investor can obtain a higher income return from his bonds. Long experience has demonstrated that the ordinary investor is wiser to keep away from such high-yield bonds. While, taken as a whole, they may work out somewhat better in terms of overall return than the first-quality issues, they expose the owner to too many individual risks of untoward developments, ranging from disquieting price declines to actual default.”

  • Ben Graham, ‘The Intelligent Investor’.

They call them ‘junk bonds’ for a reason. They now constitute an offence against linguistic decency: ‘high yield’ no longer even is. Consider the chart below:

BofA Merrill Lynch High Yield Master II Index (spread vs US Treasuries)

High Yield Master II Index

(Source: BofA Merrill Lynch, St. Louis Federal Reserve)

(The index in question is a benchmark for the broad high yield bond market.) Not for nothing did the Financial Times report at the weekend that “Retail investors are getting increasingly nervous about high-yield bonds”.

They should also be getting increasingly nervous about government bonds. Consider, first, this chart:

                                                                                                                                                                             UK long bond yield

(Source: Thomson Reuters, Credit Suisse)

In the entire history of the UK Gilt market, yields have never been as low. This suggests that Gilt buyers at current levels are unlikely to enjoy an entirely blissful investment experience.

Just to round up this analysis of bond investor hyper-exuberance, consider this last chart, which puts interest rates (in this case, the UK base rate) in their historical context:

UK base rates, 1700 to 2014

UK Base Rates

(Source: The Bank of England, Church House)

(*The Bank Rate has comprised variously the Bank Rate, Minimum Lending Rate, Minimum Band 1 Dealing Rate, Repo Rate and Official Bank Rate.)

There is one (inverse) correlation in investment markets that is pretty much iron-clad. If interest rates go up, bond prices go down. This is entirely logical, since the coupon payments on bonds are typically fixed. If interest rates rise, that stream of fixed coupon payments loses its relative attractiveness. The bond price must therefore fall to compensate fixed coupon investors. So now ask yourself a question: in what direction are interest rates likely to go next ? Your answer may have some bearing on your preferred asset allocation.

Bond investors may be acting rationally inasmuch as they believe that central banks will keep interest rates “lower for longer”. But even more rational investors are now starting, loudly, to question the wisdom of central banks’ maintenance of emergency monetary stimulus measures, at least five years after the Global Financial Crisis flared up. Speaking at the ‘Delivering Alpha’ conference covered by CNBC, respected hedge fund manager Stanley Druckenmiller commented as follows:

“As a macro investor, my job for 30 years was to anticipate changes in the economic trends that were not expected by others – and therefore not yet reflected in securities prices. I certainly made my share of mistakes over the years, but I was fortunate enough to make outsized gains a number of times when we had different views from various central banks. Since most investors like betting with the central bank, these occasions provided our most outsized returns – and the subsequent price adjustments were quite extreme. Today’s Fed policy is as puzzling to me as during any of those periods and, frankly, rivals 2003 in the late-stages to early-2004, as the most baffling of a number of instances I have in mind. We at Duquesne [Capital Management] were mystified back at that time why the funds rate was one percent with the ‘considerable period’ attached to it, given the vigorous economic growth statistics available at the time. I recall walking in one day and showing my partners a bunch of charts of economics statistics of that day and asking them to take the following quiz: Suppose you had been on Mars the last five years and had just come back to planet Earth. I showed them five charts and I said, ‘If you had to guess, where would you guess the Federal funds rate was?’ Without exception, everyone guessed way north of one percent, as opposed to the policy at the time which was a verbal guarantee that they would stay at one percent for a ‘considerable period of time.’ So we were confident the Fed was making a mistake, but we were much less confident in how it would manifest itself. However, our assessment by mid-2005 that the Fed was fueling an unsustainable housing Bubble, with dire repercussions for the greater economy, allowed our investors to profit handsomely as the financial crisis unfolded. Maybe we got lucky. But the leadership of the Federal Reserve did not foresee the coming consequences as late as mid-2007. And, surprisingly, many Fed officials still do not acknowledge any connection between loose monetary policy and subsequent events..”

“I hope we can all agree that these once-in-a-century emergency measures are no longer necessary five years into an economic and balance sheet recovery. There is a heated debate as to what a ‘neutral’ Fed funds rate would be. We should be debating why we haven’t moved more meaningfully towards a neutral funds rate. If for no other reason, so the Fed will have additional weapons available if the outlook darkens again. Many Fed officials and other economists defend their current policies by claiming the economy is better than it would have been without their ongoing stimulus. No one knows for sure, but I believe that is logical and correct. However, I also believe if you’d asked the same question in 2006 – that the economy was better in 2004 to 2006 than it would have been without the monetary stimulus that preceded it. But was the economy better in total from 2003 to 2010 – without the monetary stimulus that preceded it? The same applies today. To economists and Fed officials who continually cite that we are better off than we would have been without zero rate policies for long, I ask ‘Why is that the relevant policy time frame?’ Five years after the crisis, and with growing signs of economic normalization, it seems time to let go of myopic goals. Given the charts I just showed and looking at economic history, today’s Fed policy seems not only unnecessary but fraught with unappreciated risk. When Ben Bernanke and his colleagues instituted QE1 in 2009, financial conditions in the real economy were in a dysfunctional meltdown. The policy was brilliantly conceived and a no-brainer from a risk/reward perspective. But the current policy makes no sense from a risk/reward perspective. Five years into an economic and balance sheet recovery, extraordinary money measures are likely running into sharply diminishing returns. On the other hand, history shows potential long-term costs can be quite severe. I don’t know whether we’re going to end with a mal-investment bust due to a misallocation of resources; whether it’s inflation; or whether the outcome will actually be benign. I really don’t. Neither does the Fed.”

No more charts. If these three don’t get the message across, nothing will.

The bond environment, ranging from high yield nonsense to government nonsense, is now fraught, littered with uncertainty and unexploded ammunition, and waiting nervously for the inevitable rate hike to come (or bracing for a perhaps messy inflationary outbreak if it doesn’t). There are clearly superior choices on a risk-reward basis; we think Ben Graham-style value stocks are the logical and compelling alternative.

Economics

Is there room for Austrian ideas at the top table?

[Editor’s note: now that Steve Baker MP is on the Treasury Select Committee, it should be of interest to all Austrianists, and those interested in monetary reform in general, to re-visit Anthony Evans and Toby Baxendale’s 2008 paper on whether there is room for Austrian ideas at the top table. Within the paper they also reference William White, of the BIS, who has made several comments in the past that are sympathetic to the Austrian School. The recent BIS Annual Report, at least relative to individual, national central banks, shows some consideration of the distorting effects of monetary policy, and the cleansing effects of liquidation (note that the BIS does not face the same political pressures as supposedly independent national central banks).  It will be of major importance to followers of the Austrian School around the world to follow the progress of Steve as things develop. Below is the introduction to the paper, the paper in its entirety can be downloaded here aje_2008_toptable]

 

Introduction

 

At a speech in London in 2006 Fynn Kydland surveyed ‘the’ three ways in which governments can achieve credible monetary policy: the gold standard, a currency board or independent central banks. After taking minimal time to dismiss the first two as either outdated or unsuitable for a modern, prosperous economy the majority of the speech was focused on the latter, and the issue of independence. However, the hegemony of this monetary system belies the relative novelty of its use. Indeed the UK presents an especially peculiar history, given the genesis of independence with the New Labour government of 1997. A decade is a short time and two large coincidences should not be ignored. First, independence has coincided with an unprecedented period of global growth, giving the Monetary Policy Committee (MPC) a relatively easy ride. Second, the political system has been amazingly consistent with the same government in place throughout, and just two Chancellors of the Exchequer (Gordon Brown and Alistair Darling). These two conditions have meant that from its inception the UK system of central bank independence has not been properly tested.

Our main claim in this article is that monetary policy has converged into a blend of two theoretical approaches, despite there being three established schools of thought. We feel that there is room at the top table of policy debate for more explicit attention to Austrianideas, and will survey emerging and prevailing attention amongst policy commentary.

 

Troubling times to be a central banker

 

Current economic conditions are proving to be of almost universal concern. In the UK general price levels are rising (with the rise in the consumer price index (CPI) hitting 3.8% and in the retail price index reaching 4.6% in June 2008) whilst output growth is falling (with GDP growth slowing to 0.2% in quarter two 2008), raising the possibility of stagflation. This comes after a serious credit crunch that has led to the nationalisation of Northern Rock and an estimated £50 billion being used as a credit lifeline. Most of the prevailing winds are global and are related to two recent financial bubbles. From late 2000 to 2003 the NASDAQ composite index (of primarily US technology stocks) lost a fifth of its value. This was followed with a bubble in the housing market that burst in 2005/06 leading to a liquidity crisis concentrated on sub-prime mortgages. Although the UK has fewer sub-prime lendings, British banks were exposed through their US counterparts and it is now widely acknowledged that a house price bubble has occurred (the ratio of median house prices to median earnings rising steadily from 3.54 in 1997 to 7.26 in 2007) and that a fall in prices is still to come. Also worrying, we see signs that people are diverting their wealth from financial assets altogether and putting them into hard commodities such as gold or oil.

Although academic attention to developing new models is high, there seems to be a request on the part of central bankers for less formal theory building and more empirical evidence.

Alan Greenspan has ‘always argued that an up-to-date set of the most detailed estimates for the latest available quarter are far more useful for forecasting accuracy than a more sophisticated model structure’ (Greenspan, 2007), which N. Gregory Mankiw interprets to mean ‘better monetary policy . . . is more likely to follow from better data than from better models’. But despite the settled hegemony of theoretical frameworks, there is a genuine crisis in some of the fundamental principles of central bank independence. Indeed three points help to demonstrate that some of the key tenets of the independence doctrine are crumbling.

 

Monetary policy is not independent of political pressures

 

The UK government grants operational independence to the Bank of England, but sets the targets that are required to be hit. This has the potential to mask inflation by moving the goalposts, as Gordon Brown did in 1997 when he switched the target from the retail price index (RPIX) to the narrower CPI. Although the relatively harmonious macroeconomic conditions of the first decade of UK independence has created little room for conflict, the rarity of disagreement between the Bank of England and Treasury also hints at some operational alignment. On the other side of the Atlantic the distinction between de facto and de jure independence is even more evident, as Allan Meltzer says,

The Fed has done too much to prevent a possible recession and too little to prevent another round of inflation. Its mistake comes from responding to pressure from Congress and the financial markets. The Fed has sacrificed its independence by yielding to that pressure.’

 

Monetary policy is not merely a technical exercise

 

The point of removing monetary policy from the hands of politicians was to provide a degree of objectivity and technical competence. Whilst the Treasury is at the behest of vested interests, the Bank of England is deemed impartial and able to make purely technical decisions. In other words, the Treasury targets the destination but the Bank steers the car. But the aftermath of the Northern Rock bailout has demonstrated the failure of this philosophy. As Axel Leijonhufvud says,

monetary policy comes to involve choices of inflating or deflating, of favouring debtors or creditors, of selectively bailing out some and not others, of allowing or preventing banks to collude, no democratic country can leave these decisions to unelected technicians. The independence doctrine becomes impossible to uphold [italics in original].’

As these political judgments are made, there will be an increasing conflict between politicians and central bankers.

 

Inflation targeting is too simplistic

 

The key problem with the UK is that a monetary system of inflation targeting supposes that interest rates should rise to combat inflation, regardless of the source. Treating inflation as the primary target downplays conflicting signals from elsewhere in the economy. In an increasingly complex global economy it seems simplistic at best to assume such a degree of control. We have seen productivity gains and cheaper imports that should result in falling prices, but a commitment to 2% inflation forces an expansionary monetary policy. As Joseph Stiglitz has said, ‘today inflation targeting is being put to the test – and it will almost certainly fail’. He believes that rising commodity prices are importing inflation, and therefore domestic policy changes will be counterproductive. We would also point out the possibility of reverse causation, and instead of viewing rising oil prices as the cause of economic troubles, it might be a sign of capital flight from financial assets into hard commodities (Frankel, 2006). Underlying this point is a fundamental fallacy that treats aggregate demand as being the main cause of inflationary pressure. This emphasis on price inflation rather than monetary inflation neglects the overall size of the monetary footprint, which is ‘the stock of saved goods that allow entrepreneurs to invest in more roundabout production’ (Baxendale and Evans, 2008). It is actually the money supply that has generated inflationary pressures.

The current challenges have thus led to an increasingly unorthodox use of policy tools, with the British government making up the rules as it went along over Northern Rock, and the Fed going to the ‘very edge’ of its legal authority over Bear Stearns. Paul Volcker made the accusation that ‘out of perceived necessity, sweeping powers have been exercised in a manner that is neither natural nor comfortable for a central bank’, McCallum’s rule and Taylor’s rule fall by the wayside as the New York Times screams out, ‘It’s a Crisis, and Ideas Are Scarce’.

 

 

Economics

Time for change in the London bullion market

[Editor’s note: The Cobden Centre is happy to republish this commentary by Alasdair Macleod, the original can be found here.]

 

The London bullion market is an over-the-counter unregulated market and has had this status since the mid-1980s. The disadvantage of an OTC market being unregulated is that change often ends up being driven by a cartel of members promoting their own vested interests. Sadly, this has meant London has not kept pace with developments in market standards elsewhere.

 

The current row is focused on the twice-daily gold fix. The fix has been giving daily reference prices for gold since 1919, useful in the past when dealing was unrecorded and over-the-counter by telephone. The London gold fix could be described as an antiquated deal-based version of the LIBOR fix that has itself been discredited.

 

It was with this in mind that the House of Commons Treasury Committee called witnesses before it to give evidence on the matter on 2nd July. This dramatically exposed the inconsistences in the current situation, and was summed up by the Chairman Andrew Tyrie as follows: “Is there any reason we should not be treating this as an appalling story?”

 

These were strong words and his question remains hanging over the heads of all involved. It would be a mistake to think the Financial Conduct Authority which was given a rough ride by the Committee can ignore this “appalling story”. The FCA will almost certainly seek significant reforms, and reform means greater market transparency and no fix procedure that does not comply with IOSCO’s nineteen principles.

 

The current fix is thought to comply with only four of them, which is a measure of how things have moved on while the London bullion market has stood still. London effectively remains a cartel between bullion banks and the Bank of England (BoE). It has worked well for London in the past, because the BoE has used its position as the principal custodian of central bank gold to enhance liquidity. And when bailouts are required, the Bank has provided them behind closed doors.

 

The world has moved on. IOSCO has provided a standard for behaviour not just to cherry-pick, but as a minimum for credibility. China, which we routinely deride for the quality of official information, has a fully functioning gold bullion market which provides turnover and delivery statistics, as well as trade by the ten largest participants by both volume and bar sizes. China has also tied up mine output in Asia, Australia and Africa which now bypasses London completely. Dubai also has ambitions to become a major physical market, being in the centre of middle-eastern bullion stockpiles and with strong links into the Indian market.

 

Even Singapore sees itself servicing South East Asia and becoming a global centre. These realities are reflected in the 995 LBMA 400oz bar being outdated and being replaced by a new Asian 1kg 9999 standard, with refiners working overtime to affect the transition. London cannot possibly meet these global challenges without major reform.

 

Central banks are now net buyers of bullion, withdrawing liquidity from the London market instead of adding to it. With the FCA as one of its new responsibilities, the ability of the BoE to act as ringmaster in the LBMA is changing from an interventionist to a regulatory role. If it is to retain the physical gold business, London’s standards, on which users’ trust is ultimately based, must be of the highest order with the maximum levels of information disclosure.

Economics

Taming the markets

A recent report by the Official Monetary and Financial Institutions Forum (OMFIF) entitled Global Public Investor 2014 discussed the investment strategies of 400 government investors split into 157 central banks, 156 government pension funds and 87 sovereign wealth funds, with $29 trillion at their disposal. We normally assume that government pension and sovereign wealth funds are invested to maximise returns and are not used for political and economic purposes, but the same cannot be said of central banks.

 

According to the OMFIF report the principal reasons central banks are now investing in a wider range of assets include an appetite for higher returns in a low interest rate environment, and geopolitical reasons, whereby stakes in foreign corporations are acquired for strategic purposes. However, central banks are the conduit for a government’s financial management of an economy, and the function has been generally limited to setting interest rates, currency issuance and overseeing the expansion of bank credit. Foreign currency management and gold dealing have been grey areas, with these functions often managed by a government’s finance ministry in an exchange stabilisation fund. So a central bank investing in equities is clearly a case of mission-creep.

Perhaps we should not be surprised that the Peoples Bank of China through its $3.9 trillion State Administration of Foreign Exchange Fund is acquiring equity stakes in European and other companies, but we should note that central banks, such as the Swiss, Danish and Italians are also investing significant sums in equities. Other central banks yet to buy equities will be watching with interest, and analysing the potential benefits of equity investment as an ancillary tool for managing markets.

It will be far easier for the Fed, the ECB or the Bank of England to buy equities if the trail is already blazed by other smaller and respectable central banks. Perhaps an analyst at the Bank for International Settlements will open the door by writing paper on the subject. Given the abject failure of monetary policy to stimulate the major advanced economies, surely it is only a matter of time before our “animal spirits” are kept alive with this new tool.

Equity bulls are unlikely to complain. If the ECB can help recapitalise the eurozone’s banks by subscribing to capital issues, what’s not to like? If a failing industrial conglomerate is given a new lease of life by a share support scheme paid for by a central bank, think of all the jobs saved at no apparent cost! By issuing government currency to support industrial investment, Keynes’s dream explicitly stated in the conclusion to his General Theory can finally be realised, with the state replacing despised savers as the source of funding for industrial investment.

The acquisition of equities by central banks, government pension funds and sovereign wealth funds amounts to enormous power to sway markets the state’s way; all that’s required is a bit of inter-departmental cooperation and $29 trillion (and rising) can be fully utilised to this end. This intervention could increase until governments end up as significant shareholders in most major companies. Norway’s Government Pension fund alone is buying 5% of every major listed European company.

So do not under-estimate the potential scope for further government intervention. Politicians and crony-capitalists will relish this new state-sponsored capitalism, which promises to tame bear markets and enhance share options. Unfortunately such idealist thinking is in defiance of economic reality with all the eventual consequences that entails.

 

Economics

Money derivative creation in the modern economy

It isn’t often that a Bank of England Quarterly Bulletin starts “A revolution in how we understand economic policy” but, according to some, that is just what Money creation in the modern economy, a much discussed article in the most recent bulletin, has done.

In the article Michael McLeay, Amar Radia, and Ryland Thomas of the Bank’s Monetary Analysis Directorate seek to debunk the allegedly commonplace, textbook understanding of money creation. These unnamed textbooks, they claim, describe how the central bank conducts monetary policy by varying the amount of narrow or base money (M0). This monetary base is then multiplied out by banks, via loans, in some multiple into broader monetary measures (e.g. M4).

Not so, say the authors. They begin by noting that most of what we think of as money is actually composed of bank deposits. These deposits are created by banks when they make loans. Banks then borrow the amount of narrow or base money they require to support these deposits from the central bank at the base rate, and the quantity of the monetary base is determined that way. In short, the textbook argument that central bank narrow or base money creation leads to broad money creation is the wrong way round; bank broad money creation leads to central bank narrow money creation. The supposedly revolutionary connotations are that monetary policy is useless, even that there is no limit to the amount of money banks can create.

In fact there is much less to this ‘revolution’ than meets the eye. Economists and their textbooks have long believed that broad money is created and destroyed by banks and borrowers(1). None that I am aware of actually thinks that bank lending is solely or even largely based on the savings deposited with it. Likewise, no one thinks the money multiplier is a fixed ratio. It might be of interest as a descriptive datum, but it is of no use as a prescriptive tool of policy. All the Bank of England economists have really done is to describe fractional reserve banking which is the way that, these days, pretty much every bank works everywhere.

But there’s an important point which the Bank’s article misses; banks do not create money, they create money derivatives. The narrow or base money issued by central banks comprises coins, notes, and reserves which the holder can exchange for coins and notes at the central bank. The economist George Reisman calls this standard money; “money that is not a claim to anything beyond itself…which, when received, constitutes payment”.

This is not the case with the broad money created by banks. If a bank makes a loan and creates deposits of £X in the process, it is creating a claim to £X of standard money. If the borrower makes a cheque payment of £Y they are handing over their claim on £Y of reserve money. The economist Ludwig von Mises called this fiduciary media, as Reisman describes it, “transferable claims to standard money, payable by the issuer on demand, and accepted in commerce as the equivalent of standard money, but for which no standard money actually exists”. They are standard money derivatives, in other words.

Banks know that they are highly unlikely to be called upon to redeem all the fiduciary media claims to standard money in a given period so, as the Bank of England economists explain, they expand their issue of fiduciary media by making loans; they leverage. Between May 2006 and March 2009 the ratio of M4 to M0, how many pounds of broad money each pound of narrow money was supporting, stood around 25:1.

But because central banks and banks create different things consumer preferences between the two, standard money or standard money derivatives, can change. In one state of affairs, call it ‘confidence’, economic agents are happy to hold these derivatives as substitutes for standard money. In another state of affairs, call it ‘panic’, those same economic agents want to swap their derivatives for the standard money it represents a claim on. This is what people were doing when they queued up outside Northern Rock. A bank run can be described as a shift in depositors’ preferences from fiduciary media to standard money.

Why should people’s preferences switch? In the case of Northern Rock people came to doubt that they would be able to actually redeem their fiduciary media for the standard money it entitled them to because of the vast over issue of fiduciary media claims relative to the standard money the bank held to honour them. Indeed, when Northern Rock borrowed from the Bank of England in September 2007 to support the commitments under its broad money expansion it increased the monetary base just as the Bank of England economists argue.

But there are limits to this. A bank will need some quantity of standard money to support its fiduciary media issue, either to honour withdrawals by depositors or settle accounts with other banks. If it perceives its reserves to be inadequate it will need to access new reserves. And the price at which it can access those reserves is the Bank of England base rate. If this base rate is relatively high banks will constrain their fiduciary media/broad money issue because the profits earned from making new loans will not cover the potential cost of the standard/narrow money necessary to support it. And if the base rate is relatively low banks will expand their fiduciary media/broad money issue because the standard/narrow money necessary to support it is relatively cheap.

Some commentators need to calm themselves. As the Bank of England paper says, the central bank does influence broader monetary conditions but it does so via its control of base rates rather than the control of the quantity of bank reserves. The reports of the death of monetary policy have been greatly exaggerated.

Notes:
(1) “Banks create money. Literally. But they don’t do so by printing up more green pieces of paper. Let’s see how it happens. Suppose your application for a loan of $500 from the First National Bank is approved. The lending officer will make out a deposit slip in your name for $500, initial it, and hand it to a teller, who will then credit your checking account with an additional $500. Total demand deposits will immediately increase by $500. The money stock will be larger by that amount. Contrary to what most people believe, the bank does not take the $500 it lends you out of someone else’s account. That person would surely complain if it did! The bank created the $500 it lent you” – The Economic Way of Thinking by Paul Heyne, Peter Boettke, and David Prychitko, 11th ed., 2006, page 403. Perhaps the Bank of England economists need to read a better textbook?

Economics

Five years of disastrously low interest rates have left Britain addicted to cheap credit

The Bank of England

This article originally appeared in The Telegraph on 5 March 2014. It is reproduced by permission of the author.

Five years ago today, the Bank of England cut interest rates about as low as they can go: 0.5 percent. And there they have remained.

If rates have been rock bottom for five years, our central bankers have been cutting them for even longer. You need to go back almost nine years to find a time when real interest rates last rose. Almost a million mortgage holders have never known a rate rise.

And this is all a Good Thing, according to the orthodoxy in SW1. Sure, low rates might hit savers, who don’t get such good returns, but for home owners and businesses, it’s been a blessing.

Don’t just compare the winners with the losers, say the pundits. Think of the whole economy. Rates were set at rock bottom shortly after banks started to go bust. Slashing the official cost of borrowing saved the day, they say.

I disagree. Low interest rates did not save the UK economy from the financial crisis. Low interest rates helped caused the crisis – and keeping rates low means many of the chronic imbalances remain.

To see why, cast your mind back to 1997 and Gordon Brown’s decision to allow the Bank of England to set interest rates independent of any ministerial oversight.

Why did Chancellor Brown make that move? Fear that populist politicians did not have enough discipline. Desperate to curry favour with the electorate, ministers might show themselves to be mere mortals, slashing rates as an electoral bribe.

The oppostite turned out to be the case.  Since independence, those supermen at the central bank set rates far lower than any minister previously dared.  And the results of leaving these decisions to supposedly benign technocrats at the central bank has been pretty disastrous.

Setting interest rates low is simply a form of price fixing. Set the price of anything – bread, coffee, rental accommodation – artificially low and first you get a glut, as whatever is available gets bought up.

Then comes the shortage. With less incentive to produce more of those things, the supply dries up. So, too, with credit.

With interest rates low, there is less incentive to save. Since one persons savings mean another’s borrowing, less saving means less real credit in the system. With no real credit, along comes the candyfloss variety, conjured up by the banks – and we know what happened next.  See Northern Rock…

When politicians praise low interest rates, yet lament the lack of credit, they demonstrate an extraordinary, almost pre-modern, economic illiteracy.

Too many politicians and central bankers believe cheap credit is a cause of economic success, rather than a consequence of it. We will pay a terrible price for this conceit.

Low interest rates might stimulate the economy in the short term, but not in a way that is good for long-term growth. As I show in my paper on monetary policy, cheap credit encourages over-consumption, explaining why we remain more dependent than ever on consumer- (and credit-) induced growth.

Cheap credit cannot rebalance the economy. By encouraging over-consumption, it leads to further imbalances.

Think of too much cheap credit as cholesterol, clogging up our economic arteries, laying down layer upon layer of so-called “malinvestment”.

“Saved” by low rates, an estimated one in 10 British businesses is now a zombie firm, able to service its debts, but with no chance of ever being able to pay them off.

Undead, these zombie firms can sell to their existing customer base, keeping out new competition. But what they cannot do is move into new markets or restructure and reorganise. Might this help explain Britain’s relatively poor export and productivity performance?

What was supposed to be an emergency measure to get UK plc through the financial storm, has taken on an appearance of permanence. We are addicted to cheap credit. Even a modest 1 per cent rate rise would have serious consequences for many.

Sooner or later, interest rates will have to rise. The extent to which low interest rates have merely delayed the moment of reckoning, preventing us from making the necessary readjustments, will then become painfully evident.

We are going to need a different monetary policy, perhaps rather sooner than we realise.