Economic Policies for an Incoming Labour Government (Part 3 of 9)

Credit creation when properly deployed can serve five main purposes, each having major and differential effects on the real economy. We cannot expect, and nor can an incoming Labour government, to produce better economic outcomes unless we understand the differences between them.

First, credit creation may be undertaken (and usually is) for purely speculative purposes. Its principal purpose and effect is to fund housing purchase and speculative financial transactions; it is often the main factor in the development of housing, land and asset bubbles. It is this aspect of credit creation that attracts most attention in today’s economy and which is the main focus of the banks’ activities, since it is the easiest business to attract, the most secure (since mortgages guarantee the value of the credit in most cases) and the most profitable.

It is also the principal factor in stimulating inflation; housing values, in particular, rise sharply as large volumes of credit-created money flow into the housing market, and the consequent asset inflation is inevitably followed by consumer led inflation as home-owners use the increased value of their equity to increase consumption. This is, of course, of great significance, given that the control of inflation is the prime and virtually only focus of macro-economic policy; it suggests that the use of interest rates to tighten monetary conditions, impacting as it does on the whole economy, fails to address effectively and accurately the real cause of inflationary pressures and is an unnecessarily broad and badly focused instrument that does great damage to the wider economy at the same time.

The overwhelming dominance of credit creation for speculative purposes – for both housing and other financial transactions – has other adverse features. It distorts the desired operation of the economy by diverting investment capital away from productive purposes, and by creating asset bubbles in both residential housing and financial assets, not least in western stock exchanges; and the resultant constant inflationary impetus then has to be restrained by measures such as higher interest rates, so that the chances of greater innovation and productivity are further prejudiced. Despite all of these downsides, credit creation for speculative purposes as a major economic factor impacting on the real economy is virtually ignored by our policy-makers, except to the extent that it is seen as perfectly normal and relatively benign.

The second kind of credit creation operates as an important element in demand management. It is used to raise purchasing power by putting more money in people’s pockets, and thereby can help to resolve the problem of deficient demand that Keynes identified as the key element in the Great Depression and that continues to characterise recessionary conditions today. It would normally be undertaken by the banks, under direction from the central bank or the Treasury, though it could also be undertaken directly by the central bank or the government. It is little used in today’s Britain, not surprisingly, when the Coalition government does not recognise a deficiency of demand as the feature of a recessionary situation that needs correction.

It has, however, returned to favour as a counter-recessionary instrument in the thinking of some of our leading monetary economists. Keynes had suggested in the 1930s – half-jokingly but so as to make a serious point – that a valuable counter-recessionary outcome could be obtained by burying money in the ground and then paying firms to employ people to dig it up. Their increased income would represent a significant increase in purchasing power and therefore demand.

Such a policy today is often pejoratively characterised as “helicopter money” – the notion that demand could be raised if pound notes were scattered from the air – but has been seriously analysed by economists such as Adair Turner and Michael Woodford who have reached the point of debating whether it would best be delivered by fiscal measures (such as tax cuts) or by monetary policy (essentially printing money) [1].

Credit creation undertaken to raise demand does not mean that it cannot serve other purposes at the same time; or, to put it in another way, credit creation undertake for other purposes, such as funding the purchase of assets or providing capital for investment, may well also have the additional effect of lifting the level of demand. As we shall see, the crucial question is then as to whether the increased demand is merely inflationary or is matched by increased output.

Thirdly, credit creation can also be undertaken for the purpose of stabilising the financial system; this technique, which has been called Quantitative Easing over recent times, has been implemented by governments in both the UK and the US, and was meant to remedy – in the wake of the Global Financial Crisis – the precarious situation of an otherwise bankrupt financial system. In the case of the UK, the policy took the form of the Bank of England’s £375bn of financial credit to stabilise the UK Clearing Banks but it did nothing to benefit the wider economy. The greater proportion of that sum was used by the banks to strengthen their balance sheets (and to resume paying large bonuses); very little found its way into lending to the Small and Medium-Sized Enterprises that desperately needed help in maintaining adequate liquidity (and for plant and equipment investment).

Credit creation for the purpose of funding major innovative programmes – sometimes called Government Credit Creation (GCC) – is the fourth kind of credit creation and is designed to enable major innovative structural economic change, such as the invention of the atomic bomb, the mass-production of synthetic rubber in the US in 1940-44, and President Obama’s Energy Initiative; it is often resorted to in wartime. The intention is to stimulate innovation in the public sector or infrastructure area of the economy and to undertake large-scale projects that are vitally important to the economy but are too large or not commercially rewarding enough to attract private capital.

This kind of credit creation for public purpose is being supplanted increasingly in Britain today by Public/Private Partnerships, on the specious ground that they offer better value to the taxpayer; the reality is that they are much more expensive than publicly funded projects, but they have the great merit in the eyes of right-wing governments of offering fat profits to their friends in private industry.

The fifth and, for our purposes, most interesting and important form of credit creation is usually called Investment Credit Creation (ICC). This form of credit is targeted at increasing investment in the plant and equipment level in private industry, with the goal of encouraging productivity improvement, accelerating the rate of economic growth and providing full employment. Investment Credit Creation is usually delivered through the local banks (if you have any) at the behest of the central bank and the government. It is this aspect of credit creation that has been virtually ignored in western economies over recent decades but which offers by far the best prospect of breaking out of our seemingly irreversible economic decline.

There is today virtually no understanding in Britain and other western countries of how Investment Credit Creation functions and of the benefits it can bring to economic development. The provision of credit – that is, bank lending – is seen almost exclusively in terms of its capacity to stimulate inflation and is seen therefore as a potential threat rather than as an essential element in producing a better economic performance.

This is notwithstanding Keynes’ perceptive assertion that there is no reason why the provision of credit for the purpose of productive investment should not precede the increase in output that it is intended to produce, provided that the increase occurs over an appropriate time frame. Other economies have understood and benefited from this insight and have used Investment Credit Creation to stimulate growth, without being inhibited by the conviction that any increase in the money supply must necessarily be inflationary.

There are, in fact, many persuasive instances from both recent history and from other countries of the successful deployment of Investment Credit Creation. One of the most striking examples of the use of credit creation, not to inflate the property market for private profit as is done in the West at present, but to stimulate rapid industrial growth, was provided by the United States at the outbreak of the Second World War, when Roosevelt used the two years before Pearl Harbour to provide virtually unlimited capital to American industry – simply by printing money – so that the country could rapidly increase its military capability.

Roosevelt encountered the usual objections from conventional economists but the exigencies of war and his own political strength and will prevailed. The results were spectacular and hugely significant. American industrial output grew on average by an unprecedented 12.2% per annum from 1938 to 1944 – an outcome that went a long way towards enabling the US, and the Allies more generally, to win the Second World War.

An equally impressive instance is provided by Japan in the 1960s and 1970s, when Japanese industry was enabled by similar means to grow at a rapid rate so as to dominate the world market for mass-produced manufactured goods. Western economists have typically shown no interest in how this was done and are almost totally ignorant of the work of leading growth expert economists such as the Japanese Osamu Shimomura and the American-Japanese Kenneth Kurihara [2]. We shall look in more detail later at exactly how Investment Credit Creation was specifically implemented by the Bank of Japan, at the behest of the government and following the advice of Shimomura and his colleagues, and accordingly brought about the Japanese economic miracle.

More recently, China has used similar techniques to finance the rapid expansion of Chinese manufacturing. The Chinese central bank, and their provincial counterparts, under instructions from the government, makes credit available to Chinese enterprises that can demonstrate their ability to comply with the government’s economic priorities. Enterprises that wish to build or buy new capacity in compliance with the overall industrial strategy are provided with the required investment capital, obtained through cost-free credit creation; Chinese manufacturing capacity in particular has largely been funded by such government-authorised new credit, as has the huge purchasing programme of strategic assets from around the world that is currently being undertaken by Chinese enterprises. This is admittedly, in principle at least, easier to bring about in a totalitarian regime than in the UK, but in practice there is nothing to stop a British government from requiring the central bank, as the Chinese have done, to create cost-free credit for specific (and productive) purposes.

Other Asian countries, such as Korea and Taiwan, have applied similar policies in order to produce rapid industrial growth. Typically, however, Western economists have arrogantly assumed that these successful economies have nothing to teach us, and are easily dismissed as undeveloped economies relying for competitive advantage on cheap labour; the reality is, of course, that these economies are, as a consequence of the rapid economic growth and industrial development made possible by Investment Credit Creation, delivering incomes and living standards to their populations that are approaching and in some cases surpassing those in the West.

© Bryan Gould and George Tait Edwards 2015

[1] See www.voxeu.org/article/helicopter-money-policy-option

[2] http://londonprogressivejournal.com/article/view/1565/the-key-relevance-of-the-writings-of-professor-kenneth-kenkichi-kurihara

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This post was written by Bryan Gould and George Tait Edwards

Economic Policies for an Incoming Labour Government (Part 2 of 9)

If we are to find that better way, we must clearly understand the failures and deficiencies of what has gone before. A major milestone in that quest for understanding was reached earlier this year when the Bank of England, in an article published in its first quarterly bulletin for the year [1] became the first significant central bank to acknowledge that the vast proportion of money in our economy (calculated by the authors at 97% of the total money supply) is created by the banks. This admission, which has been hotly contested and denied by bankers and economists for decades, if not centuries, casts a whole new light on the meaning of money and its significance for economic policy, and is the key to a new approach – not only as a response to recession – but as the foundation of a successful economic policy.

We need not explore here the mechanisms by which the banks create credit; suffice to say that they are well set out in the Bank of England paper, and in the end amount to the simple fact that the banks are not simply intermediaries, bringing savers and lenders together. They do not lend money deposited with them but instead lend money that they themselves create by making book entries unsupported by anything other than their willingness to lend. But while the mechanisms may be simple, the implications for policy are huge.

The facts that the quantity of money is almost entirely a function of bank policy and that its continuing but regulated growth is the normal and required condition for a well-functioning economy suggest strongly that the conventional treatment of money as a neutral factor in economic policy is completely mistaken. Current monetarist orthodoxy treats the money supply as reflecting more or less automatically the needs of the real economy, and impacting on it only in the sense that, if it is allowed to grow too fast, it will generate inflation. The reality is, however, that the rate of growth in the money supply is not just a function of the level of real economic activity but is, as we shall see and according to the purposes to which it is put, an important determinant of that level.

It is worth registering at this point that the banks’ remarkable monopoly power to create (or “print”) money is exercised entirely in the interests of profits for their own shareholders rather than of the economy as a whole. It might be thought that this private exploitation of such an important power would warrant the most careful public scrutiny, yet it attracts virtually no attention from policymakers, other than in terms of countering inflation; the Coalition government prefers to focus on reducing government spending, as the supposedly essential feature of macro-economic policy.

They thereby totally overlook the fact that it is extraordinarily important for the purposes of economic policy-making as a whole to understand the impact of private money-creation on this scale and, in particular, to analyse the purposes for which that credit is created.

A Labour government should no longer, in other words, accept that credit creation by the banks is benign, and automatically serves – because it is allegedly self-regulating – the public interest; a more effective economic policy depends crucially on an acknowledgment that credit creation (and therefore the whole of monetary policy) is hugely important and impacts directly and substantially on the development of the real economy, and can be made to serve a variety of wider economic interests rather than simply those of private profit-seeking bank shareholders. A Labour government that took this position would surely be encouraged to find that, on this issue, public opinion had got there first.

Keynes was well aware of the fact, and of the almost unlimited potential, of credit creation by the banks and recognised it as an important element in macroeconomic policy. His pre-war contention that “there are no intrinsic reasons for the scarcity of capital” is supported by compelling evidence, not least now by the Bank of England’s recognition that money is created by the banks from nothing. What should now be fully recognised, however, is that the purposes of credit creation could and should extend well beyond the funding of house purchase, which is currently its major feature.

Credit creation at the central bank, if properly directed and managed, can be used to selectively increase the private investment level of the country, as has previously occurred in all very high-growth economies, and as could happen in Britain.

[1] Bank of England Quarterly Bulletin, 2014, Q1 “Money Creation in the Modern Economy” by Michael McLeay, Amar Radia and Ryland Thomas of the Bank’s Monetary Analysis Directorate.

© Bryan Gould and George Tait Edwards 2015

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This post was written by Bryan Gould and George Tait Edwards