Category Archives: Economics

The Coming UK Economic Crisis.

cruiseliner

Summary.
1. Wealth and Poverty.
2. Overseas Indebtedness.
3. Housing and Mortgage Debt.
4. Personal Debt and Consumption.
5. Banking and Credit Contraction.
6. UK Government Debt and Austerity.
7. The Work Crisis.
8. Corporate Savings.
9. Failing Consumerism.
10. The Bank of England is stuck.
11. Europe and Brexit.
12. The Crisis – addressing it or full judgment?

Summary.

This paper suggests the United Kingdom will have an economic recession beginning this autumn with a downturn in effective demand. It will become serious when the self-interested rich begin to move money around precipitating a fall in the £ and a collapse of the housing market in the South East and will then extend into the banking international and public sectors in 2018. Its underlying causes are the inequalities in income and wealth, the indebtedness of the poor and young, the banks dependence on credit expansion and UK international debt. This paper sets out how most of the important UK sectors have structural problems which have been growing since the time of Thatcher. Government policy since 2010 of continued support for banking-led credit and austerity for the poor has made the pattern worse. This crisis will dominate Brexit and shape necessary government policy and politics for a decade or more. It will require a new radical Government in 2018 if it is to be addressed.

1. The Wealth and Poverty Crisis.

As people are now realising, there is a crisis of poverty and wealth. For decades “wealth creation” has been preached as a justification for controlling national and international economic activity. Actually, of course, there has been no such thing, but a polarisation of wealth and poverty, financial and other windfalls to the South East, and a concentration of benefits to one class and age group, creating an underlying problem in the concentration of wealth. The top 10% in wealth in the UK own as much as the bottom 80%. This inequality is destroying the economy.
First, it is leading to stagnation and under-consumption. The poor are often in debt with tight budgets and have almost no room to take economic hits or adjust their household budgets; so their consumption is low and under acute pressure. They just cannot afford to buy much. Many others are constrained by housing costs and low wages; they have been functioning on debt and credit with low savings, but now cutting consumption is becoming inevitable. On the other hand, the rich have too much to spend. They save a lot of it and therefore under-consume in relation to their income. Over the coming months demand will fall on this bipolar pressure. Unequal societies are structured towards this inflexible under-consumption, and we are approaching this situation now.
At the same time, a lot of strategic decisions are in the hands of a few rich people in these unstable times, and they act on an immediate mercenary basis. Many of these rich hold their assets off-shore, move them about internationally, and escape tax. They will move fast out of falling markets and precipitate crises in housing, international assets, the stock exchange and other sectors. With a Conservative economic policy dominating public policy, the crisis will not be addressed and a recession will set in. The present Government has no intention of correcting the fundamental imbalances in the economy, although Labour, the Greens and other parties have seen the inequality problem, they have not yet thought through the business of addressing this recession and crisis.

2. Overseas Indebtedness.

The United Kingdom is running a deficit in its international trade. It is sometimes called the “hidden deficit”, is usually measured by the Current Account and is running at some £80-100 billion a year, or about 4-5% of GDP. This is big money. Each household is spending £2k a year more on goods, services, holidays and companies from abroad than we are earning from abroad. Although these patterns can go on for a long while, they also have a habit of being called to account. It is not unreasonable to say that every household, to pay its way, should expect a fall in income of £2k sometime in the near or medium future, a point all parties have ignored.
But the bigger issue is not the immediate deficit, but the accumulated external debt from repeated current account deficits. First, we need to be aware that we do not know how big this is. The problem is the banking sector which borrows from abroad and then holds assets, often from abroad. The quoted amount for Gross External Debt is some £6 trillion, but that is largely the banking sector which has some £4 trillion of external liabilities and we presume similar assets. But we do not know. It is a black hole of knowledge. There are no Net External Debt figures for the UK, unlike other EU countries. The best we can do is guess. The current account deficit has been going on for three decades, ever since North Sea oil and a high £ in the Thatcher era hit our exports. We have overspent an average of, say, at least 2% of GDP for thirty years, or a total of some £1 trillion or 60% plus of GDP over the whole period.
How has this been absorbed? Some of this money has been used to buy shares in British companies. This was welcomed by Thatcher and the Conservatives since then, as good international business. With oil, our external debts did not seem to matter, but now they have grown big. At the end of 2014 foreign investors owned 54% of UK domiciled companies, putting some £930bn, nearly £1trillion, into UK shares. Other have bought property; Private Eye identified £170bn of such property in 2015. The Government is at present considering forming a register of foreigners owning UK property to address money laundering and international crime; so again we do not know the net position on international ownership. Partly to invite informed knowledge we guess that some £0.5 trillion net is owed abroad on property. So, something like £1-1.5 trillion of UK assets are owned abroad by people who would be quite willing to move their money if they saw falls in their assets coming. It is ironic, given the rhetoric of Brexit, that most UK companies and much UK property is already owned abroad. These are two important triggers for falls in the Stock Market and the Housing and Property Markets, centred largely on London, and the guns are loaded on the desk.
They will go off. Though the trade position is important, far more significant is the view of international money on where they should put their funds. The precipitant is likely to be a downturn in the property market in the South East. This fall in the £ will be structural as analysts put together the underlying weakness of the currency, the housing market, share prices and the ability to earn returns in Britain. The lower £ will increase exports in the longer term, but increase the cost of imports in the shorter, leading to a further outflow of funds, making the downturn substantial. The effect of this outflow is masked by other factors, but it is a substantial depression to the domestic economy.

3. Housing and Mortgage Debt.

The UK housing market has a long-term shape – a failure to build the houses needed by new generations. In the 1980s Margaret Thatcher initiated the selling of council houses, but the money so raised was not ploughed back into local authorities for more house building, but syphoned off for other Government expenditure and lower taxes. Whereas the level of new builds was over 300,000 in the seventies, since then it has averaged well under 200,000. This is against a background where immigration is strong requiring more dwellings, households have shrunk in size, there has been a strong gathering of jobs and income in London and overseas demand for luxury property has increased. House prices have risen in surges throughout the period and now stand at about £230,000 in England and approaching £500,000 in London. A traditional way of looking at these figures is to say that a house is 8-10 times the average wage and more in London. It used to be about 3.5 the average wage. Only about 2% of the housing stock can be built in any year, and so supply is inelastic. We are short of houses. If this is so, how can the housing market collapse? The suggestion is that falling foreign demand, a lower supply of mortgages, tougher terms for landlords and profit-taking by speculators will bring it about. House prices in the South East could fall 5-10% or more quite quickly.
Behind this is the level to which mortgages fund the purchase of houses. At present some £1.3 trillion is held in mortgages. This, of course, was the main market which went awry in 2007-8 when banks and building societies suffered defaults. Since then the terms for a mortgage have been stiffened to prevent the same kind of collapse. Now the borrower is required to have a bigger cushion against negative equity. Mortgages now need a bigger deposit – something like £30,000 on a £100,000 loan and they are often for shorter periods.
They seem safer for the banks and building societies, even though the levels of debt are higher. First, let us look at mortgages, and correct the average figures. First, not everyone has mortgages because a lot of people do not live in (part) owner occupied houses. We take the average household debt (minus consumer debt) to give mortgage levels of about £50,000. The owner-occupied housing stock is about 18 million, and the council housing, housing association and privately rented stock about 7 million. They will not be paying mortgages. This pushes the average for those paying mortgages up over £69,000. But, of course, this average is also misleading because some have big mortgages and some small; so there are many with mortgages pushing up and beyond £100,000.

The banks and building societies seem safer, but does this strategy of pushing the risk of default onto the mortgage holder work? The Bank of England’s Financial Stability Report in June, 2017 noted that the average mortgage debt to income ratio is now up at 101%, close to the level in 2006. How secure are the households who hold this debt? They could not cope with a rise in interest rates, as the Bank of England well knows. They therefore fix the Bank of England without its most normal policy instrument of changing interests rates; it must not raise rates, except very slowly. Now households who cannot pay their mortgages will be forced by the banks to sell their houses, a move they will desperately resist, but when it arrives, it will be another tidal wave of downward pressure on house prices; the lenders’ security depends on further depressing the housing market. Households are vulnerable to a recession, loss of jobs, and poverty and many will fail. If a lot of houses have to be sold off, house prices will further decline and the threat of negative equity still emerges. Indeed, the process may now be underway as mortgages decline so that the banks are more secure. The downward pressure on house and property prices is already there. If mortgages fail, the financial institutions which have lent to them will be threatened. The transfer of risk does not really work.

4. Personal Debt and Consumption.

Personal credit, (or more accurately personal debt) has been a strong driver of economic activity for a number of years. The public sector, exports, wages and company expenditure and investment have been relatively muted, but domestic demand has held up backed by consumer credit. Average unsecured debts have climbed to £13-15,000 per household over the last few years, but, of course, the average figure does not tell us much since many do not have debt and others have more. It is also a shadowy figure, because there is a penumbra of loan sharks and other forms of debt, and immediate credit card payments are not debt. Debt is both a stock, a cumulative amount, and also a flow, as new credit is given or withdrawn. The flow looks bad. People are moving to living in credit in areas of their lives. A key one is cars. Over the last decade we have moved from one in five to four in five having a Personal Contract Purchase where cars are leased on a monthly payment. We used to own cars, but now we borrow them. In many families not being able to pay and losing the car would be a family crisis. Mark Carney and Alex Brazier at the Bank of England have both issued warnings about these levels of personal debt. The banks are being asked to tighten up by the Bank of England. But the tightening is not easy and may even be dangerous.

Those with large levels of credit amount to millions of people and many have few resources. Some five million or so have no savings. Three million have rent arrears. Six million are financially vulnerable. We tend to ignore the significance of these households because they are small economic units, but actually many are teetering on the edge of financial collapse. In the first three months of this year, 2017, savings out of disposable income were the lowest since the 1960s, when records began, at 1.7%. Households without reserves could fail in large numbers; then there could be another rise in bad debts for the banks calling on their reserves. Again, the banks are lending to a lot of people, directly and through intermediaries in the loan shark end of the market, who are up to their necks in debt on the understanding, or vague hope, that they will not go under. But people floundering do go under. The high returns on this kind of debt shortens the risk that clients will default. We are talking about several hundred billion unsecured debt. Cutting personal debt when people are on the edge of insolvency will generate bankruptcies on a large scale. Again the market is fragile.

5. Banking and Credit Contraction.

We have become used to credit creation for several decades, but it is still not properly understood and there is a danger which has not been recognised – a credit contraction multiplier effect in the banks. As banks expand credit, they give themselves newly created electronic money through a kind of seigniorage process. When the Bank of England printed money it got a windfall of most of the value of the paper money. Banks create electronic money by extending credit, not directly for themselves, but disseminated through the banking system. For all the money finishes up redeposited in one bank or another. This process has given the banking system a windfall of £20-30bn a year. Their profits expand, not through their competence, but through this windfall, allowing exorbitant bonuses and spreading affluence in the London area. This explains the growth of the banking sector to over 10% of the economy over the last few decades. The broad calculation of the money supply M3 expanded from about £0.8 trillion in 1998 to about £2 trillion in 2008. It was this which allowed the loose banking of the crisis of 2007-8 in the UK and US, in which the banks showed their incompetence in the area they were supposed to understand, namely lending money. The same pattern has picked up since then, increasing more steeply over the last two years than at any time outside the crisis response in 2010. This money has kept the expenditure relatively buoyant in the middle of this decade.

But there is a downside to this pattern, aside the dangers of massive levels of debt. When credit falls, the money supply undergoes a multiple contraction through a reverse effect. When A is given credit, their funds are moved to banks X, Y and Z, but when credit is withdrawn, so money disappears from these banks irrespective of their own transactions. Mervyn King understood this process. A contraction of credit is fraught with danger by reducing the money the banks have beyond their own accounting by a multiplier effect according to the leverage they have built up. It can only happen properly through a steady required contraction of credit, which has been absent since 2010.

This process the Bank of England has now set in train in order to reduce the exposure of the banks to debt. The Governor of the Bank of England is requiring higher reserves from the banks and building societies – some £5bn now and another £5bn in November. It will curtail the levels of mortgage and personal debt – a sound move in principle – but it will involve a sharp contraction in the money supply this autumn and Christmas. It may actually contribute to the crisis through this multiplier effect, both too big and too late.

6. UK Government Debt and Austerity.

The UK government has had a deficit in its budget for some time. The deficit is an annual calculation of government expenditure minus tax income, and it accumulates into the National Debt or Sovereign Debt as a total. The phrase, “National Debt” is often used in an alarmist way, but it is really money owed by the State mainly to British people and institutions on a long-term basis because it has not taxed the rich enough and has fought too many wars. The accumulated total is now about £1.7 trillion, about 90% of a year’s GDP. It would take a long time to repay and the debt interest has been used in the past to fund pensions and give returns to savings.

In the 2010 election the Conservatives claimed that the 2007-8 crisis was caused by Government overspending by the New Labour Party, and that a period of “austerity” was required. It was largely an inaccurate charge, first, because rescuing the banks had pushed up government debt, second because the tax deficit was largely caused by failing to tax the rich; companies and individuals were moving into tax havens to avoid taxes, and third, because the banking sector was almost entirely untaxed and had grown to some 10% of the economy through windfall profits. There was some loose expenditure in the Blair-Brown era, but the problem was misdiagnosed, deliberately and through ignorance, by the Conservatives. The deficit was not the problem. Rather, it reflected money owed to the rich by the State because the rich have been under-taxed for nearly four decades. More than this, the extra borrowing needed mainly to address the financial crisis has cost little because interest rates were so low. The Conservatives, in favour of banking deregulation for three decades and even more in favour of supporting and subsidising the banking system, were dishonest in the way they cast the problem. They stated the answer was to eliminate the deficit by 2015 through cuts in Government expenditure mainly in public services and benefits. Osborne’s ministrations as Chancellor failed to have that effect. That date has now changed to 2025. Most commentators reckon that more government expenditure and a more dynamic economy would have increased tax revenue enough to produce results similar to those we now have. The main consequence of this situation is that the Bank of England cannot raise interest rates without increasing substantially the interest it must pay on this debt of £1.7 trillion, which now run at about £60bn annually.

The Conservative “Austerity” policy of 2010-20 was a cut in expenditure in public services and benefits, substantially falling on the poor. Austerity for the rich was absent. The main kinds of tax are: Income Tax (27%), National Insurance – employment (19%), taxes on bought goods and services (29%), Capital Taxes (4%), Company taxes (11%), Council Tax (5%), Other (5%). The impact of these taxes together is rarely recognised. It hits the poor proportionately more than the rich. For several decades the overall tax system has been regressive; the bottom 20% by earnings pay proportionately more than the top 20%, increasing disparities between the rich and poor. The Conservatives have tended to cut taxes on high income groups. So, it is a tax system which tends towards inequality. But this is less than the full story, because a lot of rich people and companies from the UK and overseas have used tax havens and off shore companies to avoid taxes on a massive scale. The cost of this to the tax system are estimated to be somewhere between £40-100bn. So, the rich are evading taxes and that is the main reason why the Exchequer is awry. The cuts were the wrong policy for the wrong problem.

The present system has also destroyed a number of income stabilisation methods. It reflects a pre-Keynesian lack of awareness of income analysis in the Treasury. People used to be given good levels of unemployment pay without being hounded. This cushioned the economy against an unemployment recession. Now they are not. The amount is desultory, and falls in employment mean a multiplier effect follows. Quite a few areas are already experiencing this. Other benefit cuts have a similar effect, holding up income and consumption in poor areas. Most of these are gone. More than this the long-term loss of public assets (rail, electricity, water, telephone, post office, steel, coach, gas, council houses, libraries, schools, hospitals, land, manufacturing) to the value of perhaps £1 trillion, extracts more from household budgets than used to be the case in the 50s and 60s, and costs the Exchequer vast amounts more in Private Finance Initiatives, School and Hospital budgets and other subsidies. These buffers against recession have been lost by Conservative policy in their great privatisation con and the lessons of Keynesian economics have been lost. The recession, when it comes, will build.

Finally, the policy of the Government and the Treasury does not address recessions and cannot address them. The obvious well-tried mechanism is public works regenerating local economies, but this was demonised in 2010 and thrown out of the tool-kit. And U turns, although the Treasury makes them behind the scenes, are not easy for a Conservative Government which has so loudly condemned Labour’s tendency to overspend. So the present Government cannot address the crisis. It has tied its own hands.

7. The Work Crisis.

Let us look at a conundrum. There are more people working in paid employment than ever before in the UK. In 1971 there were 25 million people over 16 working and now there are 32 million. If we think about this for a moment, it is rather strange. Over that period we have lost maybe 5 million jobs to automation in higher technology manufacturing and service provision; you will hardly remember telephone operators. If the computer and electronic revolutions are taken into account, the figure is probably closer to ten million. A similar level of job transfer has taken place in manufacturing. The making of chairs, computers, bikes, tools, and hundreds of other goods now happens in China, India or many other countries with cheaper labour, better technology or more abundant resources. Let us say some 15 million jobs have been lost as a result of these two factors. Between five and six million people born outside the UK are now working here, more than three million from outside the EU and more than two million from inside the EU. In all we are, and this is very rough, “doing”, or absorbing, perhaps 21 million more jobs now than we were in the early 70s. We are now doing twice as much work as a nation compared with the early 70s. This is astonishing. Why? Of course, the normal answer is that we are working to produce a more affluent lifestyle now. But that is not fully the case. We do not have enough houses. We do not have time for many of our children or old people, and many of us are not rich, but in debt.

The real reason for this large number of employed is that there has been intense pressure to generate jobs, partly through poor unemployment pay and a requirement that they register each day as looking for work, and partly by the creation of a lot of poorly paid self-employed people with little capital. Many of these jobs do work which produces some income but has little longer-term rationale or structure. Often employers try to use “self-employed” people, so that they can get rid of them quickly. When the economy starts a recession, the shedding of these kinds of jobs could be severe. It is another process whereby the down-turn can gather momentum. Jobs can evaporate as quickly as they have come.

8. Corporate Savings.

Of course, if UK companies were investing strongly, this too could add to effective demand and result in a growing GDP. Yet something strange is happening in companies. They are saving on an unprecedented scale. In the era of international capitalism we must look at the big picture, not just British firms. Corporate excess saving of companies in the US amounts to perhaps $1.7 trillion and €1 trillion in the EU. The companies have made the money in profits, but they are holding them in a complex mix of off-shore tax havens, buying up their own shares, and lending to government and other banking operations. Perhaps there is just so much capital investment that it is difficult to do more. Perhaps the structure of companies requires this hoarding of funds. Perhaps there is a fear of a coming downturn, or perhaps a few of the major shareholders are concentrating their assets in non risk-taking assets and avoiding tax by the way they hold their assets. Perhaps the difficulty of repatriating profits keeps them stored. Whatever is going on, these companies are emphatically not going to invest during a recession, but more money will stack up in accounts off-shore and in the domestic economy. Again, a sector has a policy which is inherently recessionary.

Perhaps profits-driven companies have fewer options. All the routes to quick profits – exploiting resources – poor workers, new products, establishing state-wide monopolies, capturing addicted or psychologically dependent consumers, picking up windfall profits, buying cheap assets or companies, bribing governments, buying land, obtaining technological monopolies, infiltrating health, care, military, transport, energy and other markets – and others, have been exploited, and the pickings are now more meagre. China and other non-western countries stand as a competent alternative to western capitalism to which the West is already in debt. In this situation, the perceived options for profit driven investment are small. Looking to this sector to turn around a recession is not fruitful. Come a downturn, it will hoard and wait.

9. Failing Consumerism.

We have had decades of advertisement led consumerism, pushing products and services into every area of our lives. We can have our toe-nails polished or our hair coloured, our holidays in the Arctic or the Caribbean, our films horror or humour, our cars pink or magenta. The future beckons; it is one where millions of drivers sit in driverless cars emoting their responses as the vehicle takes from them the one area of competence where they still feel in control. Or we can all walk with our mobile phones in front of us guiding us through life. Of course, the possibilities to buy and want are limitless, especially when pushed by addictive, manipulative advertising, but there are limits which arise when we actually think about what is good for us. Consumers become aware that overeating is bad, that roads are congested and cars often move at 10mph, that product promises do not work, that the rich are often miserable, that broken families in a mansion rattle, that drinking holidays involve hangovers, that the rich die, and stuff around the house is a nuisance. The downside of consumerism is also a big part of the public psyche. The cosmetics of promise do not cover the face of reality, and really the face without cosmetics is quite nice anyway.

Another way of approaching consumption is to identify goods, bads, remedials and indifferents. The goods are often simple – enough food, water, warmth and being at peace with people. The bads include too much food and alcohol, smoking, traffic jams, many drugs, weapons, clothes we don’t need and will not wear, stuff in the garage and attic, instant disposables, adult toys and many other things that mess up our lives. There are bad quality films, books, magazines, pictures, garden furniture, computer games, cars, holidays, hairdressers and many other goods and services. There are thousands of ways in which we can be defrauded. These bads may be 20% or 40% of many people’s consumption, so that buying less is better, especially if the effort of earning the money in the first place is taken into account. Then there are things to address other things that have gone wrong, and consumption that is remedial. We have locks, bolts, security systems for money, cars and houses to prevent theft, diet and fitness aids, ways of relaxing from stress, doctors, dentists, car repair people and many others. Often, these would not be needed if we lived more wisely. Finally, there are a lot of things to which we are really indifferent a week or two after we have bought them – the empty picture frame, the lamp that has no-where to go, the expensive meal we did not need. So, the consumption drive has its downside. It could cease to be the treadmill of the economy, especially if money is tight. This change could become significant in a month, a year or ten years, but it will become stronger, aside global warming, the biggest aside of all in our need to consume less. Consumption can, and probably will, fall sometime because it does not work on the scale we now have.

Of course, when the sun comes out people buy summer clothes, ice cream and go to the beach and Christmas rescues retail outlets. But the Centre for Retail Research in Norwich forecasts retail sales to grow 1.2% in 2018, not very promising.

10. The Bank of England is Stuck.

The crisis of 2007-8 was mainly a banking crisis in the US and the UK. Banks and Building Societies had lent money carelessly and their bad debts accumulated on such a vast scale that they had to be rescued in packages amounting to $2.5 trillion. This stabilised most of the banks involved or allowed them to be taken over at favourable rates by other banks. The process of assessing the assets bundled up after these failures is still going on among the merchant banks. The effects are still being understood and assessed by economists, but include a subsidy to the banking sector of perhaps £100-200 billion. That is in addition to the windfalls of £20-30billion the banking sector received before that period through the creation of credit and electronic money. So the banks have been vastly subsidised and not contracted their levels of lending.
Because housing debt is so large, the Bank cannot use interest rate rises as a tool of policy; too many people would default on higher payments. They also cannot raise rates because of a policy called Quantitative Easing (QE). When the Banking Crisis broke, in order to make the balance sheets of the banks easier, the Bank of England started buying its bonds. Normally, it sells bonds to the banks for money to meet its debts and pays interest on the bonds. The more bonds it sells, increasing the supply of bonds to the market, the lower the price and the higher the rate of interest. When it does the opposite, buying its bonds, it pushes the price up and lowers interest rates. It also transfers money out to the banks who are able to increase the liquidity of their balance sheets and are not likely to run out of money. In 2009 the Bank of England bought some £350 billion of loans, mainly its own bonds, and made sure that the banks could weather the storm. It bought another £60 billion in 2016 to stabilise any perturbations around Brexit. An easy way to think of QE is that it is the same as if the Government had paid for its debt by printing money in the first place.
The obvious question in relation to QE is, “Will it cause inflation?” Economic orthodoxy used to be that more money, especially on this scale, meant higher prices almost on a proportional basis. Why has it not happened over the last decade? It is not clear. In part, the money is not in the pockets of ordinary people, except as credit, so they do not bid up prices. Second, goods often come from abroad and so their prices do not rise, but probably the most important is that Conservative policies prevent wages from going up by keeping a competitive, low wage class, fearing unemployment. Somehow, apart from concentrating in areas of London and other places of affluence, where it does cause inflation, the money does not generate demand inflation and does not generate much demand except in certain areas like luxury housing. All of this is by way of suggesting that the Bank of England does not have much ability to stimulate the economy, even by using QE.

11. Europe and Brexit.

We have not really mentioned Brexit, although many feared negotiations and a likely decrease in European trade would lead to a recession. That prediction was always suspect, given the long negotiations, but it is possible that the process or substance of the exit. Perhaps there could be market reactions made more sensitive by the Brexit negotiations or political crises. Yet, this paper suggests the domestic sclerosis of the sectors presented here is a far bigger problem than the presenting one of leaving the EU, and the present Brexit obsession is a displacement from the real issues.

12. The Crisis, addressing it or full judgement.

It seems the structural problems perceived in the various sectors of the economy will interact and lead this autumn to a slowdown in growth to stagnation. The car and housebuilding markets will be sluggish especially as the banks lower the credit they offer. There will be a rise in the level of unemployment, and the housing market in the South-east will fall in price quite markedly. As the banks cut credit, so the money supply will contract. Definitive will be the time when the international finance in the property market begins to withdraw, say, late August-November. Then the momentum of the crisis will be underway. The value of the £ will fall putting further pressure on international money to withdraw. The Chancellor will wrestle with the difficulties, but given the ideology of the Conservative Party, without the policies to address them properly, though the Autumn Budget statement will be the last chance. There are policies which would avoid an acute crisis. One, for example, would be for the State to offer to buy a proportion of houses where households face mortgage default allowing reduced mortgages and State ownership of part of houses. There are some issues about valuating and requiring building societies and banks to redraw mortgage contracts, but it can be done. Taxes on wealth, banks and high income can make Government expenditure on benefits and public works available fairly quickly. So there is an opportunity to respond, but it will recede.

Christmas will probably be well below normal for the retail trade, credit default and family poverty will be acute, together with hospital and other public sector problems through underfunding. Stagnation in demand, especially in the South-east, unemployment, higher prices of imports and low benefits will produce a recession and the need for quite drastic action. The crisis will reflect judgment on the last forty years of concentration of wealth and the neglect of poverty and will feed again into the banking sector.

By the Spring it is likely to bring down the Government, and then perhaps some quite basic reforms to the economy can be undertaken, including a wealth tax, the closing down of tax evasion, offshore and within the UK banking system, the proper funding of public services, the transfer of taxation from the poor and young to the rich and old, and the proper taxing of the banking sector for the common good. Then, perhaps, we will learn that economies are not run by bogus wealth creation, but through loving your neighbour as yourself, fair trade and markets, public service and making sure that all have the proper means of livelihood. We will see the magic money tree of the bankers does not exist, and it is better to love God and your neighbour than run an economy on greed and self interest.

Money Creation, Credit Seigniorage, Vanishing Money and the Banking Crises

email comments to alan@storkey.com. Any reasonable use may be made of all or parts of this paper. This version: 05/11/2011, early versions 2008-9.

Summary.
As a series of severe banking crises occur throughout the western world, it is not clear that all the underlying causes have been understood. This paper examines quite a simple part of the pattern which has been ignored. The electronic creation of money through credit is one of the components of the world-wide surge in banking disorder and has created massive structural distortions. One aspect of this process is credit seigniorage, the windfall that accrues to any agent who has money accepted into circulation. This article argues that credit seigniorage has fuelled the boom in world-wide banking credit and is more recently creating problems for the banks. Further, the mistakes in understanding this basic concept are reverberating and becoming more serious with the sovereign debt crisis and the extensive use of quantitative easing.
The “creation” of credit money by the banks has become a large scale phenomenon over the last three decades or more. It creates a long-term skewing of resources which needs to be understood more thoroughly and is perceived by those who say that the banks have become rich at the expense of the rest of us. Seigniorage explains how this happens. Traditionally, of course, state banks have received this windfall through the issuing of notes and coin, and we have been happy, given discipline over the money supply, for this windfall to accrue to the state and be offset against tax. Most commentators on seigniorage mistakenly seem to limit the term only to state-created money. Yet, of course, for decades most of the money supply has been electronic money created within the banking system by the expansion of credit. This money, measured by M1-M3 in different economies, generates windfall seigniorage by exactly the same logic as operates through fiat money, though in a slightly disguised form.
No real notice has been taken of this windfall, running into trillions of dollars, accruing over the last few decades, and its effects on the world’s banking systems. It has predisposed towards undisciplined expansion, high bonuses, and the presumption that all banking business is more profitable that it actually is in proper accounting terms. It has encouraged leveraged credit expansion of financial markets when this is without economic justification and a range of financial illusions. The full etiology of these processes is complex, because they involve national budgets, bank policies, forms of institutional lending, international currencies, reserve currencies and the policies of state and trans-state banks, but the underlying electronic seigniorage effect has been present from Iceland to Greece.
As these crises have unfolded, seigniorage has become crucial in two other developments. The first is through negative seigniorage, the reverse of the seigniorage windfall outlined above, which many banks find eroding their cash position when they try to contract credit. As banks contract in concert – a requirement in the face of debt difficulties – they also face negative seigniorage generated by other banks doing the same thing. Although this effect is not equally distributed, it creates further difficulties for the return to stability, through what we will call “vanishing money”. Addressing this problem has been vital for the Bank of England and shows the importance of quantitative easing.
Second, qualitative easing, QE, prevents the banks from entering a crisis of contraction through vanishing money and this concept shows why it has especially needed to be used by the Bank of England to stabilize the system. It can also be partly understood as an attempt by central banks to wrest back some seigniorage windfall for themselves to offset sovereign debt. As they issue cash for bonds, the sovereign bank reclaims some of windfall that has accrued to the commercial banks. The banks increase their holdings of cash reserves and the seigniorage effect accrues to the state by amortizing billions of debt payments and effectively calling in private seigniorage. But the main point is that as the banks deleverage and contract credit, they are in a long and difficult process of adjustment which prevents many normal credit operations and the Bank of England has facilitated this process.
The argument here is that these windfall and blow-away effects must be taken into account in relation to investment banking, bank lending policy, bankers’ bonuses, reserve currencies, banking regulation and banking contraction. This study merely opens the discussion; it focusses, partly parochially, on the United Kingdom, but it has obvious similar significance for the United States and the Euro-zone countries. Obviously, this paper can only sketch the issue.

1. Why the “success” of British banking?
One way into the issues is the question posed above. Over the last few decades we have been regaled with the idea that the banking industry has been highly successful, especially in the City of London, through the global supply of financial services. For example, the City of London claimed in early 2008 that 60% of the growth of GDP over the last five years had come from the financial sector. This is an astonishing claim, but we have not asked why this sectorial growth might have occurred. If financial services in the UK economy have grown from something like 5% of GDP to 10% five years later, why has this skewing occurred and why so suddenly? After all banking has been around for quite a time. It can be seen as a “banking success”, reflecting the genius of the bankers involved, or perhaps as a particular distortion of the economy resulting from a totally new development. Much attention has been focussed on the collapse of particular banks in 2008, but relatively little on why this sector had earlier become so big, particularly in Britain. Was it a sudden miraculous gain in market efficiency among companies which had long been involved in international finance or is there some other explanation? This buoyancy of UK banking is really an unexplained phenomenon, aside the self-promotion of bankers.
The suggestion here is that it is substantially the outcome of a seigniorage effect resulting from the creation of near money resulting in a windfall, for example, to the banking sector in the UK of £30bn and more a year over a substantial period of time.

2. The re-emergence of private sector money creation and seigniorage.
The structure of money creation is well known, but is also ambiguous. Fiat money, traditionally bank notes and coin, is created by the central bank putting them into circulation through its normal operations. Extra paper money produces seigniorage, the value of notes minus the cost of producing them, say £19.80p on a twenty pound note; it is a one-off windfall bonus to the Bank of England and the Treasury, reflecting the simple fact that paper money has only the value given it by conventional usage and not the production costs of gold or silver. Seigniorage remains significant wherever money can be brought into conventional usage; it is a pure windfall to its creators. Gradually, commercial banks have ceased printing their own notes, outside Scotland, where the seigniorage effect is now nullified by the Bank of England, so that printing notes has not normally been a matter of private profiteering, and we have forgotten the important issue of private money creation. On the whole, we do not mind fiat money windfall, because it is received by the central bank, can be offset against taxes and does not accrue to private bankers. The central bank is expected not to make excess seigniorage profit by expanding the paper money supply by more than the growth in GDP, otherwise it is skewing the economy towards the public sector without proper fiscal decisions.
Yet, in more recent times money “creation”, or more accurately, money making, has moved from the central bank to being generated largely by private banks through credit expansion. The money is electronic in the sense that it does not even require paper manufacture, but merely exists in a variety of accounts and transfers. The cost of manufacture is even lower than fiat money. How is this money created? Before Reagan and Thatcher there was a crude control of credit through fractional banking, which to some extent disciplined the banks. In the early 80s the banks themselves pushed for deregulation, and met willing support in Reagan and Thatcher and the new era began. During that period the Monetarist myth was that as long as the State money supply was held stable, preventing inflation, the banks could be free to manage their own credit and liquidity, which they then did. Gradually, the expansion of credit and the money supply grew to something between 5-10% year on year. The reserve ratio of cash and near money to liabilities fell, say, from 8-10% to 3%, and fractional control became quite passive through general processes of deregulation. So, notes and coin have been vastly overtaken as the normal form of money by electronic money in bank accounts allowing instant or relatively short-term withdrawals of cash. As a result of these trends banks increased their leveraging from, say, ten to twenty or thirty.
There are two ways of looking at these accounts. At one level each transaction is a debit and a credit and the whole system, except bad debts, is a matter of the balance sheet. That is the conventional understanding and it remains true as a matter of bank accounting. Even though accounts may be balanced, it matters whether M3 is one or two trillion; it is a difference of enormous economic significance. Mere accounting does not address the importance of money creation which adds to the money supply and must produce a windfall equivalent to its size. We have ignored the scale and significance of this process for the last three decades or so, partly because it is disguised. Yet, b anks have been extending credit to the tune of an extra £30 billion or so a year, and provided they roughly keep in step, they receive back deposits of roughly an extra £30 billion a year. The money which has been loaned on credit must find its way into one bank account or another, because today there is nothing else you can do with money. We, the public treat our demand and savings accounts as money and thereby give the banks a windfall of these extraordinary proportions. Because electronic money is now currency, the banks get back what they have lent and are free to invest most of it again. It is as if Fred came up to me, the banker, and asked to borrow a hundred quid at 10% interest, but then handed the notes back to me, and said, “Here you are, look after these. I probably won’t be back for a while. Do what you like with these.” Individually we do not usually do this, but collectively that is exactly the effect. If Fred pays someone else the hundred quid, they also put it in the bank, because bank accounts have become the dominant form of money.
Let us check the question of whether this money is created. The money comes into them through current and savings accounts. The current accounts cost the banks no interest and the savings accounts realise one or two percent for the customers against an inflation rate of two percent or more. Customers pay mildly for the banks holding the money and the provision of services. There are service charges, but the main “service” is holding money in our accounts, which the banks say is money. They, not the Bank of England, as we are rediscovering, validate money by having sound accounts and on the basis of habitual trust. As long as they have some kind of cash reserve to meet the normal demands of transactions (which will merely be moved from one account to another), the banks have the money back from Fred and can use it again.
This phenomenon has been largely ignored in the literature. Alan Greenspan back in the mid 90s put his toes in the water and recognised the possibility of seigniorage being garnered by the private banks from the public sector in a pithy comment.
That signal may not be so readily evident in the case of electronic money. The problem is seigniorage, that is, the income one obtains from being able to induce market participants to employ one’s liabilities as a money. Such income reflects the return on interest-bearing assets that are financed by the issuance of currency, which pays no interest, or at most a below-market rate, to the holder.
Historically when private currency was widespread, banks garnered seigniorage profits. Seigniorage increasingly shifted to the federal government after passage of the National Bank Act, when the federal government imposed federal regulation on bank note issuance, taxed state bank notes, and ultimately became the sole issuer of currency.
Today, there continue to be incentives for private businesses to recapture seigniorage from the federal government. Seigniorage profits are likely to be part of the business calculation for issuers of prepaid payment instruments, such as prepaid cards, as well as for traditional instruments like travelers’ checks. As a result, in the short term, it may be difficult for us to determine whether profitable and popular new products are actually efficient alternatives to official paper currency or simply a diversion of seigniorage from the government to the private sector. Yet we must also recognize that a diversion of seigniorage may be an inevitable by-product of creating a more efficient retail payment system in the long run.
Greenspan interestingly signals the strategic way in which seigniorage can be captured from the federal government, but it does not seem that he sees the full significance of electronic money creation, the full scale of the process of “recapture” that has gone on in the private sector. He seems to see it as quite a marginal part of private banking, limited to travellers’ checks and the like. Yet, the “by-product” may be the elephant in the room. It is ubiquitous. The argument here is that all electronic money creation, save some minimal administrative, interest and risk costs, is windfall seigniorage.
3. Seigniorage and leveraging in the banking system.
Where does the windfall fall with this long-term creation of money through credit? Where are these windfall profits fluttering down? Strangely, the outcome is masked, because the archetypal move occurs after credit has been extended and the money is returned to demand or near demand accounts. The general pattern is roughly as follows. Bank A issues credit, money made over to a customer in return for interest. This first relationship is a credit-debt transaction, and results in no seigniorage to the bank concerned; it is the normal accounting we assume in all financial transactions. Money has been lent – let us treat it as new lending – and a debt ensues from which the bank receives interest, but it has no more money. Bank A has to make sure that it is a sound loan. It is when the person who has taken out debt puts his money in “another” bank that the seigniorage occurs. Suddenly bank B has an influx of cash which adds to its funds; it is created money which it has received largely as a holding bank. As the accounts of incoming customers grow, they constitute a vast pile of electronic money, assuming quasi-permanent status distributed through the system by millions of transactions. All banks are bank Bs. It is this that makes the effect unnoticed. It is not easy to make a trillion pounds of windfall profits invisible, but because the process is disseminated, we do not notice it as such. The banks who probably have not even worked out what is going on – this is not a conspiracy but a muddle – claim the credit for the windfall (pun intended). The liquid reserves needed to service these accounts is merely some fraction of its total, say 10% at a maximum, and the bank perceives that it has 90% of this new incoming money to invest, spend on bonuses, construct new offices and so on. It is effectively double lending on all the newly created money. But it does not stop at double lending, because the 90% of the 90% can be lent as well, and the bank can leverage its lending still further. Broadly speaking banks have been able to leverage up to thirty times the value of their assets. This leveraging, over against the capital base has become the distinctive feature of the new megabanks.
We note that this pattern arises from the windfall from seigniorage. Because people treat credit-created bank money as money, and hold it at near zero or below zero rates, the banks are able to lend and relend, generating enormous power beyond their capital base. This is why the banks are post-capitalist, in the sense that their capital base has relatively little importance in relation to their overall lending. The leveraging of the banks has increased vastly since the era of fractional reserve controls. For example Barclays Bank has loans of above a trillion or so on capital base of about $62 billion, and is thus leveraged at about twenty times in the 2010 Annual Report, and this level has risen quite markedly at certain times. It is this situation that generates the need for financial instruments to try to cover the risks of this level of leverage. This is quite dangerous in difficult times because all the banks face similar levels of changed risk, and deleveraging on this scale is well nigh impossible. Further, there is little hope of meeting risk from capital reserves, although the Governor of the Bank of England wisely counsels this. The banks rely largely on their immediate policy of liquidity, and thence on the Central Bank. This explains many of the characteristics of the banking boom which is now in crisis, but cannot end. It has dominated the system and has driven the actual money supply to near exponential growth over some three decades and has no possibility of contraction without facing the seigniorage losses of credit contraction which we consider below. Historically the loss of control of credit expansion under Reagan and Thatcher unlocked this slow explosion. We also need to be aware of the way this skews the economy away from manufacturing and other sectors especially because British banks have tended to lend internationally. Further, we need to see that the availability of this seigniorage windfall also makes it easy for governments to borrow money and increase sovereign debt, since one of the dominant uses of these vast amounts of bank credit has been to lend to states willing to expand their debt, rather than tax or cut. The sovereign debt crisis we are now struggling with has been in part demand led by the banks.
5. The Scale of Credit Seigniorage.
Credit seigniorage has been growing for the last three decades. An obvious way of estimating it is through the growth in the various measures of the money supply. Let us quickly review what they are. M0 is notes and coin. M1 includes current accounts. M2 also includes savings accounts and small Credit Deposits or fixed term loans to the bank. M3 includes larger CDs and M4 in Britain includes other commercial loans. M1 and M2 receive low rates of interest, especially in real terms, where they are often negative. Which measure is most helpful in this case is a matter of debate. M4 may be too broad, but it is a good approximation to the overall seigniorage phenomenon we are considering. M2 is roughly two thirds of M4 for much of the period with which we are concerned with and offers a conservative estimate of the phenomenon we are examining. If we begin with the Thatcher era, the money supply, measured by M4, was around £100 billion. By 1990 it was up to £477 billion. Clearly this was the period when the brakes really came off. One of the best kept banking secrets was the way Midland Bank was kept afloat after its crisis in the mid eighties associated with large South American loans, partly because of the easy money which was now beginning to flow. During this period, too, the more conservative mutual and trustee banks were taken over, often by near illegal activities (especially in the case of the Trustee Savings Bank, whose assets were appropriated to the State through promises to the Trustees of lucrative directorships). We take up the fuller story in 1990, looking at M4, M2 and their annual increases as a rough guide to the scale of the seigniorage effect.
Table One: 1990-2009 UK M4 Money stock, annual increase, M2 money stock and annual increase. Figures in £billions
Year M4 Increment M2 Increment
1990 £477bn 50bn 310 18bn
1991 504 28 336 23
1992 518 18 373 10
1993 544 24 395 19
1994 567 25 410 18
1995 624 56 437 27
1996 683 59 460 24
1997 722 80 485 36
1998 783 60 515 31
1999 815 32 559 39
2000 883 67 598 39
2001 943 59 650 53
2002 1,009 69 704 54
2003 1,082 73 777 72
2004 1,179 100 846 69
2005 1,328 150 923 78
2006 1,499 167 997 73
2007 1,675 189 1,071 65
2008 1,937 259 1,124 49
2009 2,049 134 1,184 60

This table, retaining the actual amounts, shows tens of billions of seigniorage flowing into the banking system each year in the biggest bonanza British banking has ever known. There are some transactions costs and low interest rate costs on these billions, but largely they are a windfall to the full banking system. Of course, the same process was underway in the United States and other western economies. In the UK the seigniorage effect was something over £1 trillion. In the United States it is about $8 trillion and in Europe about €9 trillion. In each area the same kind of effect is evident. Roundly, we could say that it has been quite usual to pump £30 billion windfall profit into the UK banking sector in any year, but in the naughties it was two or three times this amount. This is enough to explain the kind of skewing we examined at the beginning of the article towards banking expansion and the growth of the City of London financial sector. It also explains bankers’ bonuses, as we consider later. The annual growth in the money supply is something between 5-10%, way above the overall growth of GDP, and again explains the skewing towards the financial sector. Because this money comes to be seen as a nearly permanent part of the money supply, it becomes a presumptive source of profit within the financial sector. The sector boasts of its profits; the only problem is that it has not earned them.
This is especially a problem of the United Kingdom. This can be seen by is to consider the ratio between M0 (notes and coin) and a broader measure, in this case M3. Using standardized data prepared by Mike Hewitt , the ratio stands at about 1 to 14 for the European Union as a whole, 1 to 16 for Japan, 1 to 11 for Saudi Arabia and 1 to 7 for India. For the UK it is 1 to 39. Even the United States generates a ratio of only 1 to 17, although that relaxed after the 2008 crisis to about 1 to 28. It is largely a western phenomenon and the UK has been especially bad in allowing this expansion of the money supply. New Labour carried on the trend started in the Thatcher era. Broad money, and the resultant seigniorage has grown at approaching 10% a year for much of the last thirty years since the easing of credit that took place under the Thatcher Conservative Government, way ahead of the growth in the real economy, and the Blair Government merely continued the same trend. Brown’s (really the Treasury’s) emphasis on the Bank of England having an independent role in controlling inflation merely continued the deregulated credit boom. Inordinate attention was paid to interest rates, while this fundamental expansion in the wider money supply was ignored. Meanwhile, the financial sector, buoyed by its windfall profits, was becoming financially lax and slowly undermining the credit-worthiness of its major operations in housing, government lending and personal credit, because this windfall was misinterpreted as good banking. This was a process of pouring free funds into the banking sector. After all, a windfall of £1 trillion or more is enough to loosen the financial accountability of the banking system, hasten its inefficiency and create a bonus bonanza culture of the kind that has happened in the banking sector.
6. Some reflections on money.
We need briefly to consider in principle the place of money in the structure of the economy. Often texts look for neutral or technical definitions of money. This is not possible, because money is a communal phenomenon. Money is for everyone to use in their transactions and must reflect and represent their contributions in work, goods, production, saving and service in a roughly equitable way. It requires trust and must carry value fairly across the transactions of the economy. St Paul’s Cathedral oversees the financial sector, and it denotes the way in which the biblical principle that we are to love our neighbours as ourselves undergirds financial transactions and establish the trust that we must have in the money we use. Money should be fair to everyone. Counterfeiters, bank robbers, printers of inflationary sovereign debt and creators of electronic money have departed from that. They have found a way to love themselves at the expense of the rest of us. If one group is given a windfall of £1 trillion, that grossly undervalues the work and contributions of others. The creation of money should be spread fairly throughout an economy to reflect the mutual contribution of all its participants.
Conversely, the worship of money as something which is self-referencing, worshipping Mammon, creates a cultural lie. That the post Thatcher economy in part has done, and the bankers have become the owners of the cult. The City of London believes it “makes money”, and has an inflated sense of its own value, simply because it has been allowed to take over and dominate the business of creating money and receives these vast, untaxed, windfalls. It does make money, but simply through the process outlined above. Bankers deserve no credit for the seigniorage windfall, but have clothed themselves in supposed virtue and competence. Of course, useful functions are performed in the City, as they have always done, but when the bankers have dressed up to pose as leading the economy, they have no clothes. Jesus words, “You cannot serve God and Mammon” resonate to us. Then, as now, the money lovers will sneer at those words, but they remain true. The worship of money has actually detracted from good economic activity and moved the whole economy towards financial speculation and the emptiness of the belief that economic activity is about “making money” rather than living fairly with one another.
Yet another part of the picture is the problem of debt. Debt occurs for several reasons. One of the main ones is the big division between the rich and the poor. When 10% of the UK population own over four times more than the bottom 50%, it is clear that many will be desperate to borrow. Moreover, when the old have accumulated and are slow passing on economic resources to the young, many will spend much of their lives chasing debt. Further the UK tax system is actually regressive, taking more from the bottom fifth than the top fifth. The early precepts of the Mosaic Law show a commitment to the limitation of debt giving most of the population more independence throughout their lives. Our economies have been perversely geared towards maximising debt, and therefore the likelihood of default.
Finally, we have had a toxic mix of banks finding it immensely profitable to push consumer and property “credit” or debt at the population, and consumption-orientated advertising which pushes products, experiences, domestic bliss and personal fulfilment at the population in the biggest pattern of indoctrination ever experienced. The result has been a population orientated towards high consumption now, and therefore addicted to credit, to the glee of the banks. The result has also been that the UK also has foreign debt equivalent to four years of GDP and will soon face an acute fall in living standards as a result of our international debt. We face a crisis both of consumer and financial capitalism.
7. Bankers’ bonuses.
Over these three decades in the United States and Britain especially a pattern of bankers’ bonuses has grown up which is justified on the basis of performance, expertise and the profits of the banking sector. The scale of these bonuses in the United Kingdom is something like £10 billion during the good years and £6 billion during the bad, and a similar kind of level in the United States. One question is where these vast sums come from? The answer suggested here is that they come from seigniorage, the windfall in the UK of £30 billion or more a year that the bankers have appropriated.
Of course, the self-validation of banker’s bonuses is that they have earned it by a high level of expertise. They are worth it. Moreover, they can easily move around from company to company, and the only way they can be retained in a near perfect market is through the award of bonuses. Bonuses are often related to “performance”, that is the ability of some bankers to generate profits through their own decisions and skill. This is odd for a number of reasons. First, it is very difficult to calculate the marginal productivity of any worker, let alone a banker. Attribution is also a problem; when markets are moving up, any donkey can make profits, but, of course, the donkey has not been responsible for them. Second, the underlying technique of banking is charging more on loans than is paid on borrowing, a principle which a six year old can understand. Third, many financial markets are actually zero-sum games; this includes international currency markets, stock exchanges and commodity markets when they are flat and that produces a scenario of swings and roundabouts. When the vast seigniorage gains in banking are stripped out, the performance levels of bankers, even before the crash, were probably pretty mediocre.
The other validation of bonuses is the ability to take risks. Risk taking is interesting; Does the reduction or escalation of risk, other than changes which everybody can appreciate, inhere in one particular skilled person or another? Might a risk taker at one time succeed, and then fail later? In an industry supposedly aiming at the reduction of risk so that our money is safe, why is risk taking lauded and rewarded as the apogee of the profession? Taking higher risks can be reduced somewhat by more knowledge, as Keynes showed (1921), by formalizing the levels of our ignorance, but as the gross errors in the banking crises show, bankers have operated in corporate ignorance incapable of assessing quite basic levels of risk. They can hardly have been truly rewarded for a skill which they have grossly failed to excercise. The crises of Lehman Brothers, Bear Sterns, Merrill Lynch, Goldman Sachs, Morgan Stanley, Fannie Mae, Freddie Mac, Washington Mutual were hardly marginal to American banking. The TARP handouts to Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley and others suggest that most bankers failed to handle risk with expertise. They could not have been rewarded for what they did not have. In the United Kingdom, Northern Rock, Royal Bank of Scotland, HBOS, Lloyds similarly constituted another large lump of failure in the banking sector. We throw in the crises in Ireland, Belgium, Spain, Iceland and elsewhere and have to recognize that bankers rewarded for their risk-taking skills were perpetrating a corporate myth; there was none, or very little. We further lob in Bernard Madoff and the most basic of Ponzi schemes which spirited $65 billion out of the accounts of bankers and others, and we have a glorious failure on a Wagnerian scale in the noble art of risk-taking. Some bankers were sound and reliable, making decisions that any professional should properly make, but on the whole skill was not the source of bankers’ bonuses. Rather, snouts were in a trough, and the question is, where did the trough come from? The obvious answer is that the trough has been filled with seigniorage windfall profits accruing from the electronic creation of money. Bankers were, and are, taking their cut. The only skill was to be standing in the right place when the money wafted down, or to return to the metaphor, to be at the trough when the swill arrived.
The solution is not to try to modify the bonus system by engaging in some kind of marginal tax constraint of “excessive” bonuses, but to remove this massive, unearned, windfall from the system and return the overall economy to some kind of balance and end the myth and bankers’ bonuses. This has not happened. Rather, in the United Kingdom, the United States and Europe, to name but three, the financial system is being reconstructed to maintain the privileged bonanza status of the bankers, and incidentally, of their bonuses.
7. Why no inflation?
We need briefly to consider an issue which seems scarcely to have been raised in banking circles. The dominant theory of money is the quantity theory which says that if money increases, inflation will follow. It was sacrosanct around the time this trend began, and you would expect bankers to anguish over it. Yet since 1980 the money supply (M4) has grown from about £100 billion to over £2,000 billion, a twenty fold increase. Surely, this is an irresponsible increase in the money supply. Yet it has not yet led to high inflation. Why?
There are a number of likely answers. In the 1980s Mrs Thatcher broke the unions and the back of working class wage inflation by unemployment, immigration and strike-breaking. Further, during this period very low wage goods from China, India and elsewhere flooded the economy, not allowing any domestic price inflation. Further income flows have gone to China, Germany and other producers. Loans have also gone abroad keeping domestic demand low. But one main reason must surely be that the banking sector has kept control of most of the effects of money supply expansion. In case we had not noticed bankers’ pay and rewards have undergone severe inflation, catastrophic inflation if it occurred more widely, but we have not attributed it to quantity theory inflation and seigniorage, but only to the inordinate skills of the money pushers. We have had inflation confined to one sector and its employees. The quantity theory explanation of inflation was always too simple. It was also politically used. Strangely, it has been ignored by financial capitalists who are supposed to understand money…
8. The Banks and “Vanishing Money”.
We are now (2011) going through a long crisis of credit and sovereign debt, mainly owed to the banks. This paper does not look at sovereign debt, but it raises an obvious issue that arises from the previous analysis. We have looked at money creation and seigniorage, the vast windfall profits that banks have received, but as credit is drawn down in a range of financial markets in response to the crises we have been through, the opposite of credit seigniorage occurs. We will call it “vanishing money”. As credit falls, so banks find accounts to the value of billions dropping out of their accounts in the reverse process to the credit seigniorage one. To use our earlier parallel, when Fred pays back the loan to me the banker, it is because he has already obtained the funds from other bank accounts, who suddenly see their deposits disappear. The contraction of credit reduces the holdings of electronic money available to the banks on a scale which it would be difficult to assess at this stage, especially since the seigniorage effect, both positive and negative, has not even been acknowledged by the banks. Nevertheless, it is likely to be very large and create a range of unforeseen difficulties.
The central banks have addressed this problem of the sudden shrinkage of the money supply. So, for example, a journalist’s report in the Daily Telegraph of May 2010 addressed the United States money supply: “The M3 figures – which include broad range of bank accounts and are tracked by British and European monetarists for warning signals about the direction of the US economy a year or so in advance – began shrinking last summer. The pace has since quickened. The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc. The assets of institutional money market funds fell at a 37pc rate, the sharpest drop ever. “It’s frightening,” said Professor Tim Congdon from International Monetary Research. “The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly,” he said.
This kind of contraction problem has been recurring throughout the system and in the United Kingdom. Indeed, the Bank of England has addressed it remarkably well. Because there is a contraction of a similar kind to the earlier growth with each case of credit removed from the system, the banks enter a period of difficulty when they face blow away losses.
It is sufficient to note that it is likely to make the transition to secure banking for a whole range of banks very much more difficult than we might otherwise assume is the case. The point is that unless we explicitly understand the economics of credit seigniorage and the vanishing of money which happens through dis-crediting, we, and especially central banks, are unlikely to have a good grasp of the policies which should be pursued in the coming crises created by problems with sovereign debt.

9. Quantitative Easing.
The crises that have occurred and are still occurring have been met in a variety of ways. Governments and the European Central Bank have bought up assets at a variety of discounted prices, or have provided loan funds as lender of last resort. The overriding concern is that none of these banking institutions should fail, and the extent to which banks in the United States, Europe and the United Kingdom have been supported runs into an additional vast subsidy to the industry. For example, at present much of the European Union’s concern with Greece, Ireland, Spain and Portugal is to make sure that there are not defaults on the substantial bank loans which are vested in the debts of those countries. Banks’ control of electronic money allows them to blackmail governments into automatic support. Governments and the European Union have, on the whole fallen into line, requiring populations to pay for this level of support to the banks.
Yet, in terms of seigniorage, another interesting development in this pattern is the emergence of quantitiative easing as a method of supporting the system. It involves buying government debt and mortgage-backed securities for cash, and thus both supporting potentially weak financial institutions and also increasing the money supply. Now we can see one aspect of quantitative easing, for it is an attempt by the State to reclaim some of this vast amount of seigniorage, as it buys back debt and replaces the interest on sovereign debt merely with funds made available to the banks. Low interest rates and quantitative easing result in the temporary ability of states to finance sovereign debt cheaply, but at the cost of losing control over credit, for by giving the banks money the State allows them to extend credit further or at least stay at the levels of M4 money supply they have already generated. It buttresses but does not reform the present structure of banking. Because this loss of control has occurred during a recession it has not yet been too significant, but it does mean that discipline over bankers and regulation has been theoretical rather than real. The level of QE in the States is something like $2 trillion, about 15% of total national debt. That is a substantial temporary advantage, but it is not systemic reform, and it involves no structural departure from the unfettered credit expansion model pursued by the State and the banks..

9. Banking and Taxation.
In the longer term the question arises as to whether the banks have any right to a windfall resulting from the expansion of credit. The classic answer to the seigniorage effect for fiat money is that the central bank does not have a “right” to this, but provided it keeps firm control on the money supply, since this windfall is to the fiscal benefit of everyone, it can be ignored. Banks, as is the case with the Scottish note issuing banks, do not have a right to this windfall, A windfall of £50 billion a year by one sector, not only makes them unfairly rich – expressed through share prices and employee bonuses and other effects, but it also distorts economic activity towards an area where it might be relatively useless. The windfall should be taxed. But what kind of tax? The IMF Interim response makes a number of suggestions . A tax on transactions, the Tobin Tax, and stability fund charges may well be valid. We note that UK banks pay no VAT at all on their transactions, though they claim to be providing a service and to be adding value to the economy. Why banking services should be excluded from taxation on their services is merely one level of bias. But it does not touch the issue of seigniorage windfalls. If money is being created by banks to the tune of £30 billion or more, then this amount should be taxed, either fully or at a high percentage. The UK “bank levy” of the Brown administration had no formal economic justification, and the 1910 Coalition’s bank tax was based only on some vague moral dis-ease against the gross profiteering of the City. Here is the proper justification of a bank tax, a bank levy. It should be directed at the seigniorage bonus accruing in that year to the banks, through the expansion of the money supply. The seigniorage windfall to the banking system should be taxed, because it is unearned and merely poaching resources from the rest of us. The tax should be a substantial proportion of the annual increase in deposits to each bank or financial institution, or a substantial proportion of it. In a contracting bank the tax would disappear. Though there are some issues in relation to the immediate stabilization and taxation of banks, this is the tax with the proper economic rationale giving stability to the financial system and trimming out this unearned windfall from sustained money creation. Then the economy might move into structural stability and these dangerous effects purged from the economy.
10. The Efficiency of banking transactions
In the light of this, the efficiency of many banking transactions needs to be radically questioned, especially the efficiency of moving assets and liabilities through a series of transactions within the banking sector. We may have been suffering from disguised inefficiency upheld by the seigniorage windfall. Efficient investment banking should involve moving funds as directly as possible to good investment uses. It is likely that the present inefficient structure of banking occurs because this process increases the seigniorage effect. It is a recipe for creating electronic pseudo-money, with limited economic efficiency. It is also likely these profits have encouraged banks to move away from careful lending to businesses, based on good knowledge and security, towards centralised global investments and sovereign debt in risky markets. If these transactions were taxed, by a Tobin like transactions tax and a seigniorage tax, they would be far fewer and more focussed. Thus, it seems that the banking sector has been on a banking holiday from taxation, both in relation to its transactions and in relation to the enormous windfall that it has received through money creation and the seigniorage effect. It is time for the sector to contract substantially and begin to be more useful.
alan@storkey.com