Money and Banking

Transcript, presentation 1.20.13, London, Positive Money Conference
Victoria Chick
Professor emeritus, University College London
author of Macroeconomics After Keynes

Money and Banking

I’ve chosen to look at this from the standpoint of academic economists, because I am one and that’s what I know, and there’s some interesting things, I think, to say about that. The rest of academics would look to us for answers, claiming this was our area of expertise and we ought to be able to enlighten them. It is a very strange fact of Fate that I’ve been in this business long enough for the kind of understanding that you’ve been exposed to through “Where Money Comes From” and this new book constitute a return to what I was taught as an undergraduate.

Dennis Robertson, a Cambridge economist, used to say, “Highbrow opinion is like a hunted hare. If you stand in the same place long enough, it will come around again.” Well, it has come around again. The shocking thing to me is the amount of energy that people in Positive Money and places like that have to expend to get a point of view across that was taught tome as an undergraduate and then forgotten. So there has been a deliberate regression. Well, deliberate? There has been a regression from the understanding which pertained in the late Fifties and early Sixties, and now we’re fighting to restore that understanding. That is a very peculiar state of affairs, and I hope to give you a few ideas, nothing more, as to how it might have come about.

The question has to be treated in two parts. According to a very strange split in the way that money is talked about in academic economics. First of all, it has a role to play in what we call “macroeconomics.” And I think most of you have a fairly good idea of what that is. It is the theory of the economy as a whole and the policies that you might use to change the economy in some way from time to time. Then, quite separate from Macroeconomics, there are always courses in Money and Banking. Macroeconomics is sort of thought of as a core part of economics, and money and banking a kind of optional, slightly frivolous thing that some people spend a little time thinking about.

So what I have to say will fall into those two parts. But they are, it turns out, connected. In macroeconomics, money in the mainstream of economics has a very limited sphere of influence. And it doesn’t connect at all well even with the kind of money and banking which is taught as this frivolous option that I spoke of. Keynes – John Maynard Keynes – in his famous letter to George Bernard Shaw said, when he was writing the General Theory, that he thought what he was writing would revolutionize the way the world thought about economic problems.

And later on in a small article he spelled out what was different about the kind of economics he was creating from what had gone before. He said, “I want to talk about a money production economics. And the kind of economics we have been doing is about a real, exchange economy.” That was his basic contrast. That was what he thought would be his big revolution. His was the theory in which money permeated the entire economy. Labor bargains for money wages. Saving and investment were analyzed by him in money terms. The rate of interest was a monetary phenomenon and it was determined by exchanges of money assets. All these aspects are missing from today’s mainstream economics, as they were from the economics that surrounded Keynes when he was writing. We have gone back in mainstream economics to talking about a real, exchange economy, which has an extremely limited role for money.

Classical economics, or pre-Keynesian economics, models everything in real terms. It’s “real” wages, that is, the amount of goods money can buy, and so on down the line. Money is only brought in at the very last minute to determine prices. So the role of money is separate from this whole analysis of the real economy. It has this little role to play in determining the price level. The term “pure” economics, as used by Alfred Marshall and Walras, meant the economics of this real economy, this barter economy. So by implication money is profoundly “impure,” I suppose.

And the idea was that money was neutral. It didn’t really affect these real relationships. All it did was determine price. Prices could be anything, it didn’t really matter. The real relationships were set up by the system elsewhere, without money, the pure economy, the barter economy, the exchange economy.

This kind of system – dividing the economy between the real and the monetary – was known as the “Classical Dichotomy.” On the monetary side, you had the Quantity Theory of Money. The quantity of money determined prices. Full stop. End of story. Not very interesting, actually, for a role for money.

Now, Keynes showed that the Quantity Theory of Money was based on enormously restrictive assumptions which were very unlikely to pertain in practice. But Milton Friedman – whose name I’m sure you know, too – was able to use the QT as the foundation of his Monetarist revolution in the late Sixties, early Seventies. And as I am sure you know, the Monetarist revolution touched the heart of Margaret Thatcher and found its way into monetary policy.

Monetarism – you may not know, but you ought to – is also the basis for the construction of the euro (Can’t be very good, then, can it?) and determines the way the ECB is doomed to function, and is responsible for inflation targeting more generally in the Western World. And it could be said to be the foundation also of Quantitative Easing, though that interpretation is open to some dispute.

Monetarism and the Quantity Theory of Money and the Classical Dichotomy are all over Western economies like a kind of skin disease. Quite extraordinary. And the Keynesian story, in which money influences everything that happens, has been forgotten, which I think is a tragedy.

Now this simple, sequestered role of money in an analysis which uses the Classical Dichotomy gives rise to some wonderful supporting rhetoric. After all, it must be more interesting to study the “real” economy than the monetary economy. And the “real” economy is a “pure” economy. Money is imagined to be only a veil thinly drawn across the real economy, not affecting anything. And anybody which thinks it does affect anything is subject to “money illusion,” which is a terrible mental illness.

Now, How does this happen? What is the appeal of this way of analyzing the economy? We know, if we keep our common sense about us that money does affect everything. One reason pertains to academic economics and not to common sense people like yourselves: Economics does not really understand its discipline to be historically situated. It thinks of itself as uncovering universal truths. And it therefore fails to recognize the institutional basis of its theories.

The Quantity Theory of Money was devised in the days of circulating gold coin, not in the days when the banks were overwhelmingly the suppliers of money. And yet the Quantity Theory of Money has been carried forward, and as I have told you, has influenced major institutions to this day. The idea that money should have something do with the determination of prices has a certain intuitive appeal. And of course, it DOES have something to do with the determination of prices. But the Quantity Theory of Money says that its ONLY function is to determine prices, and prices are determined solely by the quantity of money. And that is going far too far.

Another possibility of money of explaining how Macroeconomics has come to this pass is sheer laziness. Hayek, an unlikely source for what I am going to read to you, put it like this.

The task of monetary theory is much wider than is commonly assumed. Its task is nothing less than to cover a second time the whole field which is treated by pure theory [“pure” theory, real theory, yes?] under the assumption of barter, and to investigate what changes in the conclusions of pure theory are made necessary.

So if you want to take money seriously, you have to do the whole thing again.

Now I think Keynes DID do the whole thing again, and he has been wiped off the face of mainstream economics. He’s not taught. Nobody knows what he said. Nobody reads his book. We’ve regressed to pre-Keynesian economics.

Let me turn to this separation between Macroeconomics and Money and Banking that is enshrined in the academic curriculum. As I said, when I was a student in the late Fifties and early Sixties, it was widely understood, absolutely taken for granted, that the causality went from loans to deposits. Loans create deposits. Now students are all taught that banks lend on deposits, that deposits create the ability to lend, and banks respond to that. This is a regression, which people like Ben are trying to redress or reverse.

And again, I tried to think of reasons why this idea of deposits pre-existing and determining the volume of loans has such a tremendous appeal, and why the idea that loans create deposits is so difficult for people to grasp.

One factor is that there is a great fault in the language that we use, or a great bias in the language that we use in relation to banking. The word “deposit” is a hangover from the days of the goldsmiths who took bags of gold for safekeeping. And you’ll find if you look closely that much of the Neoclassical theory of banking still regards banks as kinds of glorified safes, which they clearly are not.

Add to this the failure to understand banks as a system, as an interrelated system. You heard much in the breaking of the crisis about the lack of systemic understanding, of the risks that the banks were running. If one DID think systemically, one would realize easily the check you deposit in your bank came from somebody else’s deposit. It’s not new money at all. It’s just moving around. Then if you think systemically, or macroeconomically, about banks, there are very few sources of new money to the system, EXCEPT when banks are all expanding their balance sheets together. So the language is bad.

And we also speak of “lending money.” Banks do not lend money. It may feel like that when you get a loan. But that’s not what they’re doing. They don’t have a pot of money which they are passing on. What they’re doing is accepting your IOU and agreeing to pay your outgoings while you don’t have any money in your account in an overdraft system. In a loan system, they simply write up your account.

This leads us to another point, which is very powerful, which illustrates that it is in the banker’s interest not to let you know what they are doing, because you really wouldn’t like it. That they have too much power. And others, including academic economists, might not like the power of bankers to be recognized either. They know that if they expose the bankers, they will be in deep trouble, and their funding will be cut, and all kinds of terrible things will happen to them. So they go along with it. You’ve all seen “Inside Job,” I take it. It is a kind of Inside Job problem.

Furthermore, there is a long history of wanting to believe that money is something real. The idea that bankers can manufacture money with the flick of a pen is just too unpalatable. And that leads to rejecting it. The idea that should depend for its money-ness only on the fact that we all accept it, is just too freaky for words. So it doesn’t come into the textbooks. It would also make it very clear that money is very fragile. Once that trust is breached, the whole thing could collapse.

But then, finally, there is a connection between that macroeconomic separation of money from the rest of the economy and the difficulty of making people understand that banks create money out of nothing, that loans are the engine of the creation of money. A deep-seated and long-standing idea in macroeconomics is that saving is necessary before you can have investment. Read the reports of the World Bank, and they all talk about insufficient saving for development. It’s absolute nonsense if the banks can create money.

And it was the ability of banks to create money out of nothing that led Keynes to say, “No, Savings is not the engine of growth in the economy. Investment is. Investment comes BEFORE savings.” And it’s the banks that permit that to happen.

So that brings me full circle. To tie those two strands together. They are related. If macroeconomics is going to regress to a pre-Keynesian form, so also did the understanding of banking have to regress. And that is what is happened.

Corporate Control

Institutionalism.  The way we use it at Demand Side, this is the "political" in political economy.  For our purposes today, it is the skewing of the economy toward the interests of the corporate elite, the corporate oligarchy.  This has been done in three significant ways: capturing the bureaucracy of government, capturing the political parties, and controlling the media.

Control of the courts was accomplished by the Reagan and Bush administrations' appointments of justices with little to recommend them except ideology and willingness to actively dismantle government, epitomized by Clarence Thomas.  The court has recently elected presidents, subverted elections and pushed corporate power to the top.

Control of the regulatory bureaucracy is a natural consequence of the revolving door, with management desks and lobbyist desks revolving as the pro-corporate stuffed suit simply sits and collects.  Bureaucracy is further corrupted by armies of lobbyists controlling the process simply by their sophisticated participation as others are locked out.

As to Congress.  We have the best Congress money can  buy.  It turns out money can't buy a very good Congress.  The Republicans have two factions: business interests that are anti-government market fundamentalists and a quasi-libertarian zealot wing that is just anti-government, but is funded by anti-government corporate interests, possibly just in a cynical move to screw up government.  The past thirty years have been a series of experiments in testing the philosophy of less government and lower taxes.  Results are in.  The approach is a failure.  But they are not deterred, and they are well-funded and in power, so we have to continue the experiments until the patient dies.

The Democrats have two factions:  The progressives and the pro-business centrists, who have been neutered by big money and the necessity of campaign finance.

The functional government of pragmatists is gone.  The progressives are the pragmatists, of course. Not exclusively for their understanding of climate change, but because policies that are equitable are economically efficient, public goods as the province of the government, as in health care, is economically efficient, and it is economically efficient to regulate when no regulation means markets are structured to the specifications of the strong, not to the ideals of the invisible hand.

An essential aid to the direct control of government by the corporate institutions is the control of the media.  The concept of "liberal media" is laughable today, though you still here it.  While there may be pockets, the media has an unmistakable corporate bias.  Why not  corporate advertisers are paying the bills.  You have also the phenomenon of FoxNews and FoxNews facts.  My car is going to have a bumper sticker one day that says, "Global warming is real, FoxNews is a hoax." You can borrow that.

But more insidious is Bubblegum news.  This is not news, but accounts of violence and sex and celebrity.  Bubblegum news dovetails nicely with the sports culture and the celebrity culture.  Everything gets turned into a contest between two teams, the Republicans and Democrats, the Americans and the fill in the blanks, this side and that side.  Who will win?  Who are the big players?  Did the last zinger hit home?  Choose your side and it comes complete with ideology and convenient facts, no critical thinking necessary.

The Internet may have the potential of leveling the playing field, or it may be just another distraction, reducing attention spans to bubblegum card length, or balkanizing information and opinion and exacerbating the conflict.

I mentioned I was reading Shiela Bair's book, "Bull by the Horns."  Bair was the Republican head of the FDIC through the Great Financial Crisis. But she was close enough to see what was going on.

page 358

"The thing I hate hearing most when people talk about the crisis is the bailouts "saved the system" or ended up "making money." Participating in bailout measures was the most distasteful thing I have ever had to do, and those ex post facto rationalizations make my skin crawl.  Why system were we trying to save, anyway?  A system in which well-connected big financial institutions get government handouts while smaller institutions and homeowners are left to fend for themselves?  A system that allows government agencies unfettered discretion to pick winners and losers with taxpayer money?  A system that has created cynicism and despair among honest, average working people who take responsibility for their own actions and would never in a million years ask for a government bailout?  A system that has spawned two angry political movements on the left side and the right side that are united in their desire to end the crony capitalism characterized by too-big-to-fail policies?  That is not a system I want to save.

"With the millions of lost jobs and lost homes and the trillions of dollars of lost tax revenue, how can anyone try to rationalize what happened by saying that the bailouts "made money?" In point of fact, they did not make money.

"When the Treasury Department states that the bailouts "made money," they are referring to the dollar amounts that were invested in the financial sector offset by the amounts that were paid back.  Thus, the department does not count as a "cost" the very generous subsidies taxpayers provided financial institutions.  As one distinguished group of academic experts has pointed out, this cash flow method of measuring bailout costs is inconsistent with government accounting rules. ....If those funds and guarantees had been priced at or near their true market value, taxpayers would have been entitled to substantially higher rates of return."

Or as Joseph Stiglitz is fond of saying, "We got cheated."

but down here.

"The bailouts, while stabilizing the financial system in the short term, have created a long-term drag on our economy.  Because we propped up the mismanaged institutions, our financial sector remains bloated. The well-managed institutions have to compete with the boneheads. We did not force financial institutions to shed their bad assets and recognize their losses.  Lingering uncertainty about the true extent of those losses made previously profligate management more risk averse when prudent risk taking and lending were most needed, particularly by small businesses.  Only in 2012 are we finally seeing some meaningful pickup in lending by the big financial institutions. Economic growth is sluggish, unemployment remains high. The housing market still struggles.  I hope that our economy continues to improve.  But it will do so despite the bailouts, not because of them."

"In my farewell remarks to the FDIC, I expressed amazement at the conduct we tolerated in the years leading up to the crisis.  I said:

Looking back, How could we rationalize letting big firms take on leverage at 30 or 40 to 1, giving millions of people mortgages they couldn't afford, a mortgage refinance system which divorced the decision to make the mortgage from the responsibility if the loan went sour, the trading of hundreds of trillions of dollars' worth of derivatives without any ability of the government to police it."...

And on here, to end the chapter with,

It would be hard to find anyone on Main Street who was not in one way or another hurt by the horrible debacle. Government fundamentally failed in its role of protecting us."

Shiela Bair,


And I have to include some mention of the forecast.  The consensus is now complete, or nearly so, that we are in the great spring of recovery.  The zero interest rates and massive purchases of securities by the Fed have done their work.  Ooops.  We're actually not supposed to notice that part.  It is some kind of natural rebound.  As you know, Demand Side and Laksman Achuthan of ECRI are in the same small boat , with maybe a few others.

From the Demand Side there can be no recovery without an increase in incomes, and there is no increase in incomes, so any recovery is really a debt-fueled bubble.

This past week, we had noted regional forecaster Dick Conway in to the Seattle Economics Council.  Dick talked most about tax reform, but he did present us with a provocative chart under the title "The Great Depression and the Great Recession, Two Peas in a Pod."  We thought at first he was going to point to the debt bubble or the massive disparities in incomes and wealth that marked the decade prior to the great recession.  But the chart was in fact, GDP between 1929 and 1940 and a similar eleven-year period between 2000 and 2011.  Turns out the level of GDP in index terms was the same.  In fact, in 1940, the level was actually further above 1929, very slightly, than 2011 was above 2000.  How is that possible.  Because of the stagnation of the 2000's.  Yes, the enormous collapse of the economy between 1929 and 1933 was followed by a very strong recovery, excepting 1938.  The dot com crash was followed by seven years of a jobless recovery and then the Great Financial Crisis and Great Recession, followed by the non-recovery to date.

Dick's chart is online.

companies

Banking, Credit, Money

The precedent for the Great Financial Crisis was set only three decades ago in the 1980s with the Savings & Loan Debacle. In the early 1980s, the S&L’s or “thrifts” saw their business model undermined by high interest rates. The thrifts borrowed short, chiefly by taking deposits, and lent long, chiefly for mortgages. When interest rates ballooned from the Fed’s war on inflation under Paul Volcker, the thrift’s borrowing rate ran up well above the rate of its lending.

The answer under Ronald Reagan was not to admit insolvency and deal with the crisis in its infancy, but instead was to deregulate the thrifts in an effort to let them “grow” out of their problems. Instead it was the problem that would grow. Deregulated thrifts offered high rates and attracted massive amounts of capital, which they were then compelled to lend at even higher rates to make their profits. With the lax regulation they enjoyed, the environment was set for fraud and irrational, or at least rash, lending, and within a few years the spectacular collapse of the industry.

By 1995, half the thrifts had gone out of business. The Federal Savings & Loan Insurance Corporation (FSLIC) was abolished and replaced by the Office of Thrift Supervision (OTS). A massive takeover and rationalization of the industry took place, with the determination, “This will never happen again.” Twenty years later the OTS was abolished in the wake of a second and far greater financial sector collapse. Deregulation had returned within a decade, in even more complete form, with the repeal of New Deal banking laws (Glass-Steagal) and the rise of the anti-regulators of the George W. Bush administration.

The housing boom of the 2000’s depended on mortgage originators and mortgage lenders who were virtually unregulated, but it also depended on the banks and Wall Street. Originators found takers for fraudulent, onerous and undocumented mortgages and sold them to mortgage lenders. The banks provided the short-term “warehouse” loans to bridge the deal on into the Wall Street securitization market. Here the individual mortgages were combined to form securities that were sold as solid investments around the world. At the same time, banks themselves originated their own somewhat better, but still suspect, subprime and non-traditional mortgages to turn into securities.

When the inherent weakness of the mortgages came to the top and the securities found their true value, the Great Financial Crisis was triggered.

In the S&L debacle it was high interest rates instigated by the Fed’s war on inflation that led to a Wild West of fraud and excess. In the Great Financial Crisis, it was low interest rates forced by the Fed in fear of deflation that created another Wild West, as massive amounts of capital searching for yield flooded into the “safe” mortgage market.

Regulators who saw each crisis forming and who advocated strong action at the outset or strict rules governing lending activities were muted and frustrated by other, “captured” regulators and pressured directly by elected politicians acting on behalf of big donors. The “Keating Five” was a memorable example from the S&L debacle. Five Senators were censured for their efforts to protect Charles Keating, an S&L billionaire. When the S&aL debacle was over, more than 3,000 bankers and thrift officers went to jail.

That number is about 3,000 more than the Great Financial Crisis. Many banks have failed, but a certain class is still with us – the too big to fail. (These now include JP Morgan Chase, Wells Fargo, Bank of America, Goldman Sachs, Morgan Stanley, and Citigroup.) These institutions continue to receive special concessions, but more than anything else, it is the too big to fail insurance they enjoy that gives these enormous companies lower cost capital and an advantage over their smaller rivals. (Banking is not an industry with economies of scale.)

That favoritism arises in part from the efforts of Fed Chairman Ben Bernanke, one of the economists who has failed. Bernanke himself, or the Fed itself, took over the original mandate of TARP, or one of them, and bought one and quarter trillion dollars of mortgage backed securities. This year the Fed is ready to take another trillion dollars on to its balance sheet. Thus we see incredible efforts to expand credit to the private sector at the same time we are determined that the public sector do nothing of the sort.

The recent turn in the housing market, in terms of price and volume, is thought of as a recovery. Indeed, it is. As in going up. The upturn is a blip with respect to the long term, and the foregoing shows that every effort has been made to do this without recognizing it in the lives of the underwater homeowners. What that means is that as prices recover, at each step, shadow inventory will come back on line.

So credit and banking, success or failure?