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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.