Response to `Making Money’

All about Money2 -Art (c) Mani Navasothy 2013Reader’s Response to  “Making Money: A word on monetary Reform by Bruce Nixon”.

By Kumar Devasan

This is a response to the article in GT #19 November 2013.

Mr. Nixon makes a number of statements:

  1. 97% of our money is created by commercial banks when they make loans, i.e. interest bearing debt, not by the Bank of England or the Mint. Only 3% is created in the form of notes and coins….. The current method of creating money gives the big banks enormous power.
  2. The way money is created is at the root of the environmental and economic crisis. Firstly, it drives unsustainable growth and consumption. Corporations must produce and sell more to pay interest and repay loans. Easy credit encourages more and more unsustainable consumption.
  3. Secondly, this way of creating money increases the cost of everything and fuels the nation’s escalating debt. It adds to the cost of investment in schools, hospitals and infrastructure. It inflates house prices, making them unaffordable for many hard working people and the young.
  4. .Speculation in commodities, like food, further drives up prices, when there are already growing shortages resulting from climate change, the greed of big companies and waste.
  5. Reckless speculation by banks contributes to boom and bust in financial markets. That leads to enormous instability and regular financial crises. Huge short term profits and excessively high salaries result in a brain drain into banking and financial services.
  6. Our economy has become unbalanced: too few people making things; over-dependence on the financial sector. And this economic system increasingly transfers wealth from those who create it to a tiny super-rich minority.
  7. We are encouraged to grow our businesses (GDP) rather than create of wellbeing.
  8. Meanwhile millions of people suffer unemployment and needless austerity through so-called “Neo-Liberal” policies which have never worked.

Unfortunately, Mr Nixon makes fundamental mistakes throughout his whole article when he deals with economics and banking.

Witnessing the amount of such mistakes, I looked to Mr.Nixon’s background for reasons; and indeed found them. Mr. Nixon graduated in Politics, Phliosophy and Economics (PPE) at Oxford in 1959 and then worked in various parts in the world within people management.

Economics during Mr. Nixon’s university days was an art and a pure social science that was linked to philosophy and politics. It was not seen as the stand alone science that it is now. Since the mid-80s economics has become a mathematically centred science and universities robust in the subject award Science degrees such as Batchelor of Science, etc. It has now been properly cleansed of the philosophical and political corruption and is what it was meant to be in the first place:

The science of allocating scarce resources optimally to achieve a selected objective with a dynamically changing environment. The original “Economics of the Oxbridge PPE is now relegated to the discipline of Economic History, where the impact of philosophy and politics are analysed.

With this in mind, I will deal with each point stated in Mr. Nixon’s article.

Banks do not create 97% of our money as a result of the amount of (3% in his article) in the form of notes and coins in deposit. Mr. Nixon is out-of-date, what he actually talks about is the reserve requirement. The economic theory that a reserve requirement can act as a tool of monetary policy is frequently found in old or out-of-date economics textbooks. The higher the reserve requirement is set, the theory supposes, the less funds banks will have to loan out, leading to lower money creation and perhaps ultimately to higher purchasing power of the money previously in use. The effect is multiplied, because money obtained as loan proceeds can be re-deposited; a portion of those deposits may again be loaned out, and so on.

The Bank of England still requires a minimum reserve requirement to be maintained by the banks with it. This minimum reserve requirement is indeed a faction of the deposits in banks and if the banks are not deposit takers, formulaic obligation. This does impact on market liquidity but does little for money creation. In the early days after Bretton Woods in 1944 and the end of World War 2, the economy was indeed held back to notes and coins or M0. However, with War Loans and “accounting” credit being available on assets collateral and credit being given by suppliers, M0 became unrepresentative of money stock. The situation was exacerbated by post war economic growth. Even the innovative social safety nets had to be funded before the economic improvement gained strength. This was done by government debt. Therefore, this was comprised part of monetary policy, which was one of two policies for controlling the economy. Monetary policy controlled money supply that was denoted by the money stock and how quickly it circulated within the economy and the price of transactions applied to the number of transactions or MV=PT. M0 as a stock of money, originally controlled by the state thought the amount of notes and coins it issued and withdrew via the Bank of England, was no longer representative under the economic growth taking place. It has now evolved to M4, which includes M0.

Due to banking failures in the US, an international bank for settlements was formed in the ‘70s and in 1988, the reserve requirement was officially no longer in use as the world moved to capital requirements. A more robust and reflective framework was introduced in 1999 but had short-coming in calibration and definitions of items within. In addition, the USA did not adopt it until December 2007 (too late as the financial crisis was underway) and never implemented it. This was because it had a different model and securing a robust risk framework would increase the costs in the banking industry, some or all of which would be passed into its economy, holding it back. However, as banking is an international industry, this allowed the US banks to undercut other banks and it was sanctioned by the US government. In 2003, the US Securities and Exchange Commission, a regulating body, allowed the US banks to leverage more by letting them increase their total liabilities to net asset ratio from 10:1 to 30:1 (Source: Return of the Master (J.M.Keynes) by Robert Skidelsky). This was unopposed by European and UK regulators and politicians, and this is still status quo. The regulators did nothing in tightening operating requirements or definition to counter this and so to remain in business and not be taken over, most likely by US entities because they had the resulting financial muscle, regional banks used innovative products to reduce actual capital requirements or operate from subsidiaries in the US. Therefore regional banks increased their US operations during this period. With the financial crisis, the deficiencies of Basel 2, which was never really had the chance to operate properly (because of the US) was upgrade to address deficiencies and Basel 3 was born. The US has announced intentions of adopting it but is quibbling over certain issues, one of which allows it to recognise toxic assets at a model dependent value when they actually has none and had to be absorbed from the banks in the US by the US government in the Toxic Assets programme called TARP.

So the mechanism for lending described by Mr. Nixon has not been used for many decades and lending now depends on the degree of risk of transactions undertaken by the banks supported by a regulator set amount of capital consisting solely of equity stock issued, realised retained profits and issued instruments that behave like equity stock. The determination of the degree of risk of a transaction is directed b y the regulator. For example, the greater the risk in a loan or transaction, the greater is the amount of this type of capital that needs to be set against it. The quanta of both of these can now be re-set according to the economic cycle affecting the country. In addition, all banks have to assess their capital requirements supporting the risks taken under stress conditions set by the Bank of England and also on their own. The latter is expected to deliver more stringent stressed results that the Bank of England’s. The original regulator was found wanting and closed. The responsibility has been transferred to the Bank of England, which has also been given the responsibility for Financial Stability of the country together with its initial inflation mandate. Therefore more capital and less risky transactions can be sanctioned in good times holding back capacity to address bad times when this is need to sustain the economy then. So one might ask what the banks do with customers’ deposits.

There are two types of banks, deposit-takers and non-deposit takers, both of which have to operate within the capital requirements described above. Both banks need liquidity and solvency to support the loans and transactions they undertake. Non-deposit taking banks borrow from the inter-bank market. Deposit taking banks also use the deposits made by customers and pay them a return referenced to the inter-bank rate less the costs of administering the deposits, which depend on the type of deposit product.

Therefore, Mr. Nixon is fundamentally wrong, the way money is created is NOT at the root of the environmental and economic crisis., it does NOT drive unsustainable growth and consumption. Corporations have many ways of securing finance; they may be equity stock, debt or other more innovative structures. Corporations will chose finance with the lowest cost to them. They will also take into account that interest paid on loans can be deducted from tax but dividends on equity stock cannot. Corporations must produce and sell to cover costs and earn a return after tax is deducted. Under a low interest rate financing environment, which is what has existing for at least a decade, it is cheaper for corporations to finance using debt. So, Mr. Nixon is also wrong that easy credit encourages more and more unsustainable consumption.

In any case, from a consumer point of view it assumes that the consumer is irresponsible and cannot be held to account for this decision. Prior to the financial crisis, credit card holders were switching from one card to another using zero cost balance transfers. They would change cards before payments on the card were due while they increased spending on the card before transfer. This was done intentionally to keep ahead of the system. However, this practice like a financial bubble is unsustainable and it caught them up. Banks and credit card companies were able to lend like this because they repackaged this extended credit and sold it off to investors who were looking for higher returns that were not possible under low interest rates without assuming the credit risk. Under accounting standards used by Europe and the UK, there rules that prevented this, unlike the accounting rules in the US. However, for some reason, the UK and European regulators, government bodies and auditors did not enforce this accounting rule and the practice was deemed allowable by default. This situation is now being remedied but the US is dragging its heels in accepting these rules, while the rest of the world has agreed. Unfortunately, it needs everyone to agree, otherwise the weak link can be taken advantage of and the whole system may be compromised. Talks are obtaining positive results, but slowly due to US reticence.

Because Mr. Nixon has not understood how banks and financial institutions works he has wrongly concluded that this increases the cost of everything and fuels the nation’s escalating debt. Debt had indeed increased under the last (Labour) government partly because of bailing two banks in the country but mainly because of creating employment that did not contribute or produce anything other than improve the unemployment statistics. However, in theory this is unsustainable and history proved this theory once again.

He also claims that it inflates house prices, making them unaffordable for many hard working people and the young. If one examines the house price statics in greater detail, it will be noticed that the average national house price statistic is driven up by very high increases in certain areas of the country that more than offset areas where is no increase and areas where there is some decrease. This is because of increasing population in these expensive areas (this correlation is evidenced by HMSO data) that causes demand to outstrip supply that is limited by land available within that area. These areas tend to be where more economic activity that brings in higher returns takes place, one of which is London.

Another of Mr. Nixon’s complaints is that speculation in commodities, like food, further drives up prices, when there are already growing shortages resulting from climate change, the greed of big companies and waste. Speculation can be for buying, which drives prices up and also selling which drives prices down. For speculation to occur there must be a buyer and a seller who is happy to receive what the buyer wants to pay. The seller thinks he is getting good price or he may be speculating that the buyer’s view is wrong. In any case, speculation sets a price for the producers of the commodities so that they get a degree of protection from future production outcomes. This has been the way it has worked since at least Roman times. If Mr. Nixon is talking about the speculation in commodities that took place in 2011 to part of 2013, which drove inflation up, he should realise that this was due to partly to a period of some poorer harvests but more to the expectation that the economies of China, India, Indonesia and some others would grow more and demand more commodities, and not because of climate change. In addition, there was threat of war in the Middle East that would compromise the cost of supplying commodities. As it turns out, these economies did not grow as much and the Middle East war threat has subsided. As such, the speculators who bought lost out to the speculators who sold, thus reducing prices.

Mr. Nixon uses his comment on speculation to exacerbate it into reckless speculation by banks contributes to boom and bust in financial markets. Unfortunately, his ignorance on how banks have been working since at least 1996, has failed to show him in most of the world, the accounting and risk management capital requirements have made it unviable for banks to attempt speculation. This last boom-bust was due to over-borrowing which became unsustainable. In the first quarter of 2009, the percentage of debt of household and non-financial firms compared to GDP was 214%, a very high level of borrowing, which is obviously unsustainable.

Prior to the recent recalibration of risk and the provision of clear definition of risk management issues by regulators in 2010, the operating field did favour short term profits and incorrectly gave rise excessively high bonuses that did result in a brain drain into banking and financial services. If the costs were awarded against risk correctly, these short term profit transactions would not have taken place as they would no longer be profitable and this would have led to lower salaries. However, I do not agree with Mr.Nixon’s implication that the brain drain into banking and financial services is a bad thing. This is because banking and financial services (not including positive net contribution from the insurance sector), before the political act of distracting the public and incorrect measures against the banking system, were providing bout 66% of the contribution to achieving the excess of exports over imports to the UK’s international trade in services, it was 47% in 2012. This overall positive contribution from services reduced the deficit where imports vastly exceeded exports in manufacturing and goods. This is because the UK’s industry in manufacturing and goods doe s not add sufficient high value to overcome the costs of imports. Imports of basic and simple goods requiring low skill are cheaper because of the competitive advantage from emerging economies overseas that was not faced by the UK before, especially before World War Two. For example, a cushion sewing would generally be more expensive in the UK than in, say Indonesia, even if wages were the same because Indonesia factories do not need heating – hence the competitive advantage. What Britain needs is high value added exports and this was being provided by banking and financial services. In 2008, banking and financial services exported £54.8 billion, the surplus of services exported over imports was £55bn and the deficit of goods and manufacturing imported over those exported was £93.3bn. Therefore, skills and talent should be drawn to areas where high value exports can occur. This actually leads into the cause of the economic imbalance.

Putting it in simple terms, the majority of the people make things that require low skill and can be made elsewhere because of the type of competitive advantage described before above. To make things or provide services that people want, the significant level of value has to be added. This may be in the form of intellectual property, design, innovative financing, new techniques or specialised and skilled engineering a s is being done in Germany. One such company provides the highly specialised ‘mirrolets’ and the engineering that implements their bespoke advanced mathematics to correct for atmospheric distortions 10,000 times a second to the largest reflector telescope in the world. Germany has indeed championed the middle-sized companies, (the ‘Mittelstant’ companies and not the small ones as Mr. Nixon believe s), whose workers are skilled in this type of production. They are highly trained and highly skilled. However, it should also be noted that the government provided a guarantee against the riskiness of these companies that allowed the banks to lend to them. This has not been done in the UK under governments of different political persuasion.

The disparity in income is not due to birth, inheritance, speculation or the attraction to short term profits but it is due to skill. A simple regression analysis of the population will show a large number of low skilled people providing good and services with low added value are earning lower salaries than a lesser number of much more skilled people who have taken more time in acquiring these skills and taken the chance that these skills will still be in demand when they have completed acquiring them. If the imbalance is to be addressed, more of the population will have to acquire skills that provide higher value. It is not the first time that income disparity occurred because of the disparity of skills and knowledge. Britain saw this before during the industrial revolution and hunter-gatherer societies experienced this at the advent of agriculture.

This time reducing income disparity would mean increasing skills in technological and intellectual disciplines in the country and rewarding them appropriately not just with salary but also recognition. For example, an electrician who is called an electrical engineer is not the same as an electrical engineer who has graduated in the discipline of electrical engineering from a university and can design electrical frameworks for buildings and power plants.

Therefore, the content of Mr. Nixon’s article has little meaning because he has not understood the manner in which banks now work and indeed economics. He has applied outdated knowledge that has supported incorrect analysis that has resulted in the wrong conclusions. His monetary reforms are therefore not only unnecessary, but they will only work to hinder the economy.

Ordinary people feel that there is something wrong perhaps because they are not in possession of the facts or the comprehension to know what is going on. Their situation is exacerbated by politicians who would prefer the finger not being pointed to their short-comings.

Kumar Devadasan

MSc. Economics and Econometrics, F.C.C.A

16th February 2014

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