How we should fund our economy – Public credit not debt

The key is to fix our financial system. Our economy has failed due to malfeasance — financial, corporate, regulatory and political. We need a new financial system we can trust, not a new wig on our old pig. – Laurence J. Kotlikoff, professor of Economics at Boston University

The recent banking fiasco in Cyprus and the resultant debate in New Zealand about the Open Bank Resolution (OBR) has thrown the spotlight on New Zealand’s banking system, its vulnerabilities and the current level of regulation. What it has not done however is open to scrutiny or debate the logic behind the current monetary system, the way “money” is generated, private and government debt created and whether or not there is a better way of doing things. I have partially addressed these issues in previous articles on the New Zealand banking system and a possible alternative in a debt jubilee and public credit. This piece will extend on these by also referencing two recent speeches by Adair Turner, formerly head of Britain’s Financial Markets Authority, in 2012 and 2013; and a recent paper The Chicago Plan Revisited from two IMF economists, Jaromir Benes and Michael Kumhof that challenges that organization’s orthodoxy.

Any debate on the origins of money is not of merely academic interest, because it leads directly to a debate on the nature of money, which in turn has a critical bearing on arguments as to who should control the issuance of money.- Jaromir Benes and Michael Kumhof

The Chicago Plan Revisited, released in August 2012, caused a stir within academic and financial circles that deserved far more mention in the mainstream media than it got. There is no doubt that the subject of money, where it comes from and how it circulates through the economy is a difficult one to grasp. But at its heart is a simple fact.

Most of what the public accept as money, upwards of 95% in most western countries, comes into existence as interest bearing debt, created on a keyboard when a bank generates a loan. It is separate to the notes and coins minted by the Reserve Bank. Most of the public remain under the illusion that what the banks lend out is the fruit of bank customer’s labour ie that they are intermediaries between savers and borrowers, merely clipping the ticket for their service.

Deposits are not a prerequisite for loans and are usually created simultaneously. If a home loan is made by the same bank acting for the buyer and seller for instance, that new loan will form a deposit within the same bank. Ironically the loan or debt is now an “asset” as it is an ongoing profit stream and the deposit a “liability’ because there is now an obligation for the bank to pay it out at some future point. New “money” equal to the loan amount has now been created. The loan preceded the deposit and that deposit may have come from the very same loan. Thus the system perpetuates, with loans becoming deposits becoming more loans becoming more deposits….and all the time the banks are accruing interest and fees. For a more detailed description of the process have a look at

The only limit to this process is regulation and credit demand. New Zealand and many other countries no longer require deposit reserves. New Zealand is light on regulation and the dogma of the last 30 years essentially assumes that the banks will operate prudently because of self interest. The Reserve Bank tries to control the issue of credit mainly by the Official Cash Rate, trying to increase or decrease demand for credit by adjusting its price via interest rates. This is generally a slow acting and indirect method and central banks are usually regarded as being laggard in responding to changes in the economic environment. Which begs the question, is there a better way? Which is where the Chicago Plan comes in.

 “The essence of the contemporary monetary system is creation of money, out of nothing, by private banks’ often foolish lending. Why is such privatisation of a public function is right and proper, but action by the central bank, to meet pressing public need, a road to catastrophe?” – Martin Wolf, Financial Times

One of the plan’s main proponents was Depression era economist Irving Fisher who had experienced a personal epiphany courtesy of the 1929 crash and subsequent depression that had wiped out his personal wealth. He painfully recognized that the economic status quo he had supported prior to 1929 was guaranteed to produce massive booms and busts and along with Henry Simmons of ChicagoUniversity proposed a fundamental reform plan for the monetary system, as explained by Benes and Kumhof.

 The key feature of this plan was that it called for the separation of the monetary and credit functions of the banking system, first by requiring 100% backing of deposits by government-issued money, and second by ensuring that the financing of new bank credit can only take place through earnings that have been retained in the form of government-issued money, or through the borrowing of existing government-issued money from non-banks, but not through the creation of new deposits, ex nihilo, by banks.

Fisher (1936) claimed four major advantages for this plan.

 First, preventing banks from creating their own funds during credit booms, and then destroying these funds during subsequent contractions, would allow for a much better control of credit cycles, which were perceived to be the major source of business cycle fluctuations.

Second, 100% reserve backing would completely eliminate bank runs.

 Third, allowing the government to issue money directly at zero interest, rather than borrowing that same money from banks at interest, would lead to a reduction in the interest burden on government finances and to a dramatic reduction of (net) government debt, given that irredeemable government-issued money represents equity in the commonwealth rather than debt.

 Fourth, given that money creation would no longer require the simultaneous creation of mostly private debts on bank balance sheets, the economy could see a dramatic reduction not only of government debt but also of private debt levels.

 If we take each of these in turns we find they closely resemble the proposals of Public Credit proponents and banking system reformists like Joseph Huber and James Robertson for the UK think tank New Economics Foundation and Positive Money, a not for profit lobby group.

Firstly the plan proposes 100% reserve banking. Every loan by a commercial bank must have a prior matching deposit. This would bring banking into line with its common perception as an intermediary service. It would also smooth out the business cycle. As Huber and Robertson point out,

 commercial banks, as profit-seeking businesses, naturally behave pro-cyclically, not anti-cyclically. They expand credit creation in upswings, and reduce it in downswings. The result is that bank-created money positively contributes to overheating and overcooling business cycles, amplifying their peaks and troughs, causing recurrent over and undershooting of the optimum quantity of money in circulation, and systematically contributing to instability of prices in general and interest rates in particular.

Fisher and most notably Hyman Minsky with his Financial Instability Hypothesis noted that sudden increases and decreases in bank credit are often not driven by economic fundamentals but themselves become self reinforcing drivers behind asset bubbles and crashes. The Chicago Plan separates money and credit. The government would now create money which it spends directly into the economy via public works eg the Christchurch rebuild; or direct injection into citizens accounts eg  Guaranteed Minimum Income. The level of money created would be determined by money supply rules including inflation targets.

Huber and Robertson take a slightly different approach. They don’t propose either the legislative or executive arms of government have the right to create non-cash money but rather the increase or decrease of the money supply is controlled by a non partisan panel, in New Zealand’s case at the Reserve Bank. An inflation target would remain but at any given time they determine how much money the economy needs to maintain this target. The government of the day gets to decide how the money is spent rather than loaned into circulation and would have to determine its spending priorities accordingly.

Thus the Reserve Bank rather than relying on the indirect and often slow acting process of interest rate setting to influence the level of credit demand in the economy would instead have a more direct lever via government spending. Governments could still determine taxes but this Reserve Bank panel would adjust the level of additional funding to keep inflation in check. Because the Reserve Bank is creating money for the government to spend directly and it is not an interest bearing loan, the theory is more money can be put into circulation and/or taxes lower as the government does not have to worry about interest repayments.

Private banks could still extend credit but as Benes and Kumhof note

.…the control of credit growth would become much more straightforward because banks would no longer be able, as they are today, to generate their own funding, deposits, in the act of lending, an extraordinary privilege that is not enjoyed by any other type of business…. A realistic model needs to reflect the fact that under the present system banks do not have to wait for depositors to appear and make funds available before they can on-lend, or intermediate, those funds. Rather, they create their own funds, deposits, in the act of lending…. so that by relying entirely on intermediating slow-moving savings, banks would be unable to engineer the rapid lending booms and busts that are frequently observed in practice.

Secondly, this 100% reserve banking system would effectively prevent runs on banks. All loans would be backed by government issued money and all depositors would have to withdraw all their money for a bank to fail. Currently a bank’s loans are only partially backed by deposits and it requires only a relatively small ratio of withdrawals to make a bank illiquid. The rest of their loans are backed by the assets loaned against and in a crisis or falling asset markets both their reduction in value and the depositor withdrawals turn illiquidity into insolvency.

At the moment there is also a shareholder profit motive and executive salary/bonus incentive to resist regulation that restricts lending and raises capital/reserve requirements. Banks prefer deposit guarantee schemes backed by governments because ultimately the risk is borne by the taxpayer or the case of the OBR by the unsecured depositors. The banks have consciously made themselves systemically important by becoming “too big to fail”. They claim any attempts to strictly regulate them, to reign in their lending or raise their capital levels would send the economy into recession and may result in their failure creating a depression. They have persuaded politicians and bureaucrats that the status quo is far preferable to potential financial Armageddon.

100% reserve banking and Huber and Robertson’s idea of separating current accounts and the payment system from bank control, would essentially remove this Armageddon threat and allow the banks to be re-regulated without causing a financial crisis. No OBR or blanket guarantee required. Interest bearing investment accounts would be at an investors own risk, much like finance companies but without the banks having the ability to leverage up the level of credit by fractional reserve type means or the money multiplier effect. Or as Adair Turner put it;

 Essentially this would mean that banks which provided money services would face a 100% liquid assets requirement: while any institutions which made loans would face a 100% capital requirement….

Thirdly it allows governments to create and spend into existence money without interest attached. This would mean the end of governments funding part of its spending with borrowings from banks, borrowings that have interest attached and which ironically in the case of foreign purchases of New Zealand Government Bonds, were created from nothing by foreign reserve banks and “loaned” to commercial banks at much lower rates of interest. For instance the Auckland rail loop or the Christchurch rebuild could be entirely funded out of taxes and direct money creation by the government instead of borrowing. The money is spent into existence as payment for construction services and materials. The burden on the taxpayer is reduced as there is no interest to repay. It is not inflationary if it is payment for actual products and services that did not already exist ie new money matching new goods and services rather than new money chasing a fixed supply of existing goods. In addition new banking regulations preventing fractional reserve credit creation would dramatically reduce money supply from the private banks. If the government spending was equivalent or less than the prior bank credit creation it would in fact be deflationary.

In an extreme scenario by economist Steve Keen, massive money creation by the government distributed equally to every citizen with a concrete obligation to pay down any debt, a debt jubilee without the moral hazard, new government backed money would pay off bank created credit and then disappear. The banks would not be out of pocket but their balance sheets would dramatically shrink as would their cashflow from interest. However without strict new regulations preventing people from borrowing freely again and speculating in asset markets, the freed up income of the previously indebted and the new money of the previously un-indebted could be inflationary.

For instance in the housing market you would want a free supply of cheap land and sufficient building resources to encourage new home construction rather than creating huge extra demand for existing property. Changes in the tax system would have to accompany such a jubilee. Ample supply of new affordable housing, the removal of tax benefits and easy credit for existing property and restrictions on foreign ownership would lower property prices substantially with few ill effects apart from the most leveraged of property owners. Affordable state housing could be built alongside affordable private housing if the resources were available. This would also have the beneficial side effect of mopping up unemployed who would be retrained and redeployed into construction much as they were in the 1930’s with the Labour government’s state housing programme, which was essentially funded by public credit.

As Benes and Kumhof noted above, public credit financed infrastructure for the benefit of all “represents equity in the commonwealth rather than debt.” There would be no need for asset sales. Tax could be used to pay for operating expenses like welfare, government departments etc while long term capital projects are funded with new money. If human or material resources are too stretched funding can be slowed down to ease inflationary pressure or taxes increased temporarily to suck money out of the economy. Adair quotes free market economist and inflation hater Milton Friedman, who surprisingly wrote in a 1948  article,  A Monetary and Fiscal Framework for Economic Stability, that

the chief function of the monetary authority would be the creation of money to meet government deficits and the retirement of money when the government has a surplus….government expenditures would be financed entirely by tax revenues or the creation of money, that is, the use of non-interest bearing securities

The main opposition to public credit, besides the inflationary one, is that governments cannot be trusted with money creation or spending, that cronyism and the desire to be re-elected will result in a plethora of pet, publicly funded projects. This is indeed a real risk, but one that can be mitigated with absolute public transparency for all things government ie no commercial confidentiality as far as commercial relationships with the government are concerned; and Huber and Robertson’s belief that the money supply should reside with a panel of independent experts from different sectors who monitor inflation and employment and adjust the level of public credit available to the government of the day to spend.

The other benefit is that government spending is effective almost immediately, rather than relying on the Reserve Bank accurately pricing credit to control private bank credit creation, and spurring spending and investment indirectly. At the moment the banks essentially determine which sectors of the economy credit flows to. Property is the lowest risk for them and has the most demand so that is where most credit flows, and not surprisingly that is where the greatest inflationary pressures are.

In many ways the banks and not the government or the Reserve Bank are the gatekeepers of the economy. In a de-regulated economy this allows neo liberal governments from Labour and National to abdicate responsibility for the economy – “it’s the market!” This ties in conveniently with multinational agreements such as WTO and the current TPP negotiations.

Fourthly, residing money creation in the hands of the government or a Reserve Bank panel and a massive shrinking of the ability of commercial banks to make loans without prior deposits, would dramatically reduce private debt. Adair Turner points out that the 2008 Credit Crisis was caused by the “excess creation of private credit and money: we should be concerned if our only escape route implies building up future excess.”

Yet this is exactly what governments everywhere are doing, including New Zealand. The government wants people to borrow more to kick start economic activity, just not too much. Yet by relying on the banking system to do this it has no way of controlling where the money goes. At present the only mechanism seems to be allowing a debt based property bubble to inflate further and rely on a wealth effect to increase consumption. Despite all the government’s and Reserve Bank’s jawboning about the property market, they seem to have no plan B.

Much has been written about the pros and cons of Quantitative Easing. At its heart though is a faulty transfer mechanism. The additional money creation is still relying on an efficient distribution system by the banks as interest bearing debt. It is bank centric and primarily for the benefit of the banks. In the US there is the absurd situation where the Fed creates billions to loan to the commercial banks at 0.5% who in turn loan it to the government at 3% to finance the deficit and make a risk free 2.5% for nothing. Additionally, QE in the US and Japan, instead of being loaned to local businesses to generate economic activity, flows into the international markets for currency, commodity and share market speculation, including in New Zealand. Neither of these benefit anyone apart from the finance industry and are merely setting the stage for another bigger bust.

Change is, I believe, inevitable. The question is only whether we can think our way through to a better outcome before the next generation is damaged by a future and bigger crisis – Mervyn King, BoE Governor, 2010

Adair Turner favours what he calls Overt Monetary Finance, essentially Public Credit in limited amounts, either at a level determined by an independent panel as per Huber and Robertson, or for one off projects that are not focused on creating immediate nominal demand. The Christchurch rebuild would fall into this category. At the same time he feels the need for banks to be reigned in with significantly higher capital ratios. The amount of money in circulation may not change, but its makeup would. Less interest bearing bank created debt and more direct money spent into circulation by the government.

What are the obstacles to monetary reforms such as those mentioned above?

Huber and Robertson make considerable effort to outline these including a great quote from Machiavelli, The Prince

 There is nothing more difficult to execute, nor more dubious of success, nor more dangerous to administer, than to introduce a new order of things; for he who introduces it has all those who profit from the old order as his enemies, and he has only lukewarm allies in all those who might profit from the new. This lukewarmness partly stems from fear of their adversaries,.. and partly from the scepticism of men, who do not truly believe in new things unless they have actually had personal experience of them.

 As I see it the greatest obstacles are internal resistance from vested political, financial and academic interests and those of the middle class who feel they have too much to lose in the property market; and external resistance from banking corporations and the politicians they lobby in our bigger trading partners. We saw how the US reacted to New Zealand’s anti nuclear stance and its perceived contagion risk. The fear of contagion in the monetary system would be far more profound for political and economic elites and create the desire to make an example of this country. There would be the risk of capital flight, refusal to accept NZ dollars for trade, possible trade sanctions for affecting the size and power of foreign corporations in New Zealand. They would be aided by elites within this country that have done extremely well from the current system and would do everything they could to create fear and uncertainty about change.

Balanced against this is a growing mass awareness of the inequality and instability of the current financial system and the damage it has caused to not just economies and society but also the environment. The continual increase in debt, be in sovereign or private, with interest attached, demands unrealistic “growth” to pay it back that cannot be supported by the planet’s ecology. You cannot have infinite growth on a planet with finite resources. Monetary reform outlined above would be an ideal time to introduce and entrench a new economic philosophy based on steady state or at least more sustainable principles. Unfortunately any change is unlikely to happen smoothly and voluntarily but as a desperate response to financial or ecological crisis. In the meantime all viable alternatives should be investigated.


  1. […] something the 1935 Labour Government used for State Housing, and which I have championed here, here and here as an option many times. (Gould below with Campbell in […]

  2. […] is why Corbyn’s QE, or more accurately, Public Credit proposal is so […]

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