Ch. 8: Dethroning Finance
Last updated in 2020
As the West stumbles its way into the 21st century, it does so with a burden of debt on its back which, should it not be lightened, may incur death by exhaustion. This situation requires correcting, but any attempt to do so must confront the power of money, the rise of which is an essential part of Spengler’s civilisational life cycle.[95]
This dictature, as Spengler called it, meant not just that money reigns over politics but that it even shapes thought, becoming itself the proxy for good and bad.[96] The epitome of this is GDP growth becoming the main criterion for national success, at the expense of other measures more reflective of the capacity for national survival such as the number of people earning salaries capable of supporting a household.
This mode of thought led to a growth of financial activity. The main claim of the promoters of finance was that it would promote GDP growth by ensuring the efficient allocation of capital at home and abroad. Any restrictions would only hinder this task. Thus we saw the deregulation of finance and the liberalisation of international capital markets. But such markets are fickle, and prone to panic, so countries will go far to retain their confidence; bailing out banks, introducing austerity to fund such bail-outs, and even suspending national sovereignty when austerity cannot deliver. Thus rules finance.
That dominance of finance is also evident from the exceptionally high salaries and large size of the financial sector, despite the fact that its efficiency has not improved: the unit cost of financial intermediation – essentially, how much money the financial middleman charges in order to take savings from savers and invest it in the economy – is the same now as it was in 1900 at 1.5 to 2 percent of intermediated assets, despite the rise of technology and big data theoretically making the job easier.[97]
Other examples of this exalted status abound. One of the key privileges banks enjoy is that of money creation. As of October 2017, private money creation in the euro area of €8.7 trillion accounted for around 74% of the M3 money supply (a broad measure of the money supply) in the euro area. On this amount, banks earn a significant amount of interest plus the revenue from creating additional money every year. Historically speaking, that level was low due to the quantitative easing measures pursued by the ECB. In 2007, before the crisis response and unconventional monetary policy, the amount of private money creation was around 90% of the broad (M3) money supply.
Yet another example is the exceptionally large amount of public money that was put into the banking system during and even after the banking crisis. The bailouts of countries such as Greece, Ireland, and Portugal was motivated by the need for the French and German governments to protect the interests of their own banking sector. Had Greece defaulted substantially for instance, it is certain that French banks would have found themselves in dire straits and in need of public money.
Such privileges show no sign of vanishing. Too-big-to-fail banks remain intact. New rules, such as the EU’s Bank Recovery and Resolution Directive, were supposed to cease the transfer of state funds to the banking sector. However, these rules are sufficiently relaxed that a government will always find a legal way of funnelling money to banks should such an action be necessary. While one could advocate tightening these rules, they may still have a credibility problem: if a national government is faced with a choice of seeing a major part of its banking sector collapse, or breaking the rules, it would probably choose to break the rules.
The core of the problem is that if large banks fail, a large part of the financial system would likely cease functioning. As long as this remains true, national authorities will be unlikely to test out innovations such as living wills – plans to rapidly wind down financial firms to avoid uncertainty – in the midst of a major financial crisis, and will instead opt to guarantee bank liabilities. This implicit government guarantee means that they are less risky than smaller banks, and therefore have access to cheaper funding which in turn allows them to make cheaper loans, outcompeting smaller banks in the process.[98] A recent study from the IMF found that this implicit subsidy is now at around its pre-crisis level in the euro area, the UK and the US.[99]
In order to solve the above problems, I propose a monetary system based on various proposals such as those proposed in an IMF working paper and by the Positive Money movement.[100, 101] Such reforms involve taking away the power of money creation from banks by imposing a reserve requirement of 100pc; this means that no bank can lend out money received on deposit, but rather must hold that money as reserves at the central bank. This chapter shall outline in detail how such a proposal could work.
Such a reform could have many beneficial effects. For example, depending on the implementation, the effectiveness of monetary policy could increase, thereby helping to increase financial stability. In addition, seigniorage revenues — the revenues of the central bank from money creation — would rise significantly, as all revenue from money creation would go to the public sector rather than mostly to the private sector as at present.
Attentive observers of European politics will note that a referendum took place in Switzerland in 2018 on a similar proposal. However, the Swiss proposal was flawed as it would have banned the central bank from paying interests on deposits.[102] This would have reduced the incentive to save and would have prevented the central bank from performing maturity transformation: the process whereby a bank borrows short-term (such as with deposits you can withdraw from the bank at any time) and lends long-term (such as with 30-year mortgages). Such transformation is the key function of the financial system; one of the goals of the reform in this chapter is to keep it intact.
But before designing our new system to put an end to the primacy of finance, we must fully identify the defects in the financial system, of which excessive money creation is just one.
10.1 Defects in the Current Monetary System
Within the current fractional reserve banking system, a bank in the euro area can lend out 99 percent of money which is placed on deposit. According to the fractional reserve theory of banking, the total money supply is determined by the level of money created by the central bank (also known as reserves) and the reserve requirement ratio.[103] A 1 percent reserve requirement means that if the central bank creates money totalling €1 billion, private banks can create an additional €99 billion.
Now, the logic underlying the fractional reserve banking system has been shaky for quite some time. Fractional reserve banking arose in the world of the gold standard, when the currency was backed by a given amount of gold. For example, under the post-War Bretton Woods Agreement one could redeem $35 for one ounce of gold. Fractional-reserve banking may have been desirable in such a gold standard monetary system as it allowed the state to expand an otherwise fixed money supply by applying a lower reserve requirement.
However, Nobel laureate James Buchanan noted that this advantage is nullified in the current fiat-money system, where money is not linked to any commodity and expanding the money supply is therefore almost costless for the central bank.[104] In other words, it makes little sense to economise on the usage of money as if supply is constrained by a physical commodity.[105] This problem of course is somewhat theoretical.
A far more pertinent point is that high levels of outstanding debt pose serious problems that simply cannot be resolved within the current system. As explained by Charles Goodhart and Manoj Pradhan, interest rates are likely to rise in the future due to demographic factors; thus, repaying debt will become more difficult, raising the probability that markets will lose faith in sovereign bonds.[106]
If high levels of debt are not reduced, then a trap could develop whereby the debt overhang requires central banks to keep interest rates low, and such low interest rates encourage even more debt finance. Goodhart and Pradhan thus advocate a move to equity instead of debt over time — this means raising money by issuing shares instead of taking out a loan: a change also facilitated by the plan in this chapter.
Moving to equity finance could aid investment in intangible assets, lending an enhanced vigour to the emerging digital economy. Intangible assets are defined as assets which are not physical or financial in nature. Examples include the value of a company’s brand, software, and patents. As described in the recent book Capitalism without Capital, intangible investment is increasingly important.[107] However, the current monetary system favours tangible investment as debt financing generally requires collateral – something pledged against the loan which the lender can take if the loan is not repaid.
As providing collateral is not possible in the case of intangible goods because you cannot repossess the code, non-patented ideas, or human capital of a firm, debt financing is inappropriate for investment in intangibles. Therefore, it is probable that the banking system is in general allocating too much capital to industries and sectors with high amount of physical capital such as real estate, where collateral is easily repossessed. This likely results in lower productivity growth than in a system that would encourage more equity financing. According to one study from the Bank of International Settlements, the negative relationship between the growth rate of the financial sector and productivity growth is due to the fact that financial growth disproportionately benefits high-collateral low-productivity industries, at the expense of research and development intensive industries.[108]
This is before we even begin to take into account money creation in the expanding shadow banking system, which had a key role in the 2008 financial crisis. For example, one study noted that when the central bank took action to reduce bank lending such as by increasing interest rates, the shadow banking system increased lending, thereby undermining the policy set by the central bank.[109] But what is this sector, and what should we do about it?
Whither shadow banking?
Shadow banking involves the creation of credit by non-banks. Its spectre is often invoked to thwart any tough regulations on banks, the argument being that activity will only move towards the shadow banking system. An example of such regulatory avoidance is when a bank sets up a special purpose vehicle – the special purpose being to avoid capital requirements.[110] This vehicle is just a company with assets such as mortgage-backed securities, which are funded by short-term debt. This short-term debt would be guaranteed by the sponsoring bank. Such a guarantee does not appear on the balance sheet of the bank, and therefore the standard capital requirements do not apply to the loans.
Shadow banking can also involve the re-usage of collateral in overnight repurchase agreements (also known as repos) which have the effect of creating money. To understand the concept of a repo, imagine your friend Jens wants to borrow e100 from you. But let’s say he has a history of forgetting to pay people back. Furthermore, let’s say you don’t want to get the reputation of giving loans out to friends, in case more come with the same request.
One arrangement can satisfy all these conditions. You agree to buy something from him for €100 — say, his nice watch — which he will then buy back at some time in the future. That way, if he doesn’t honour the agreement and give you back the money, at least you’ll get to keep the watch.
But you’re taking on some risk in this whole arrangement, plus you are parting with your money which could otherwise earn interest, so you want some compensation. How do you get it? Even though you “buy” the watch for €100, he agrees to buy it back for €101 — thereby leaving you with a profit or interest of €1.
But there is another element of risk. Imagine that watch is not actually worth €100: maybe it’s a counterfeit, the battery is about to run out, or it’s defective in some other way. This risk makes you downgrade the value of the watch — so you’ll only agree to buy it for €90, and then Jens can buy it back for €91. This downgrade in the value is known as a haircut.
This is essentially what a repo is, but insisted of watches you’ll have a financial instrument such as a bond. A bond is a type of a loan except on that is very large and therefore needs to be broken up into chunks. For example, a country may wish to borrow €10 billion in one year. This is probably too big for any individual bank or pension fund. The solution is to break it up into chunks of say €1,000, and people can sign up to buy as many as they want. As a result, it is easier to sell these chunks on the open market.
Huge numbers of such repurchase agreements are made daily, and often they have a length of just one night. But there’s an extra twist — collateral can be reused multiple times. To illustrate this point, let’s resume the above example. You’ve given Jens €90 and now have the watch. But now you want to borrow money from someone else, so you strike anther repurchase agreement, meaning you temporarily sell the watch to them. They then do the exact some thing, so at this stage the watch has gone through the hands of four people. In the world of repos, this is known as a collateral chain.[111] According to the empirical evidence, collateral is usually re-used two to three times.[112]
If you found the above description bewildering, this is no fault of yours. It is rather reflective of the dizzying complexity of finance, which by rendering democratic debate impossible, makes the position of finance near impregnable. The complexity of finance thus serves as a moat to protect the bankers. Should we wish to defeat the political power of finance, and to ensure that this defeat is permanent, then we must move to a system which is both simple to understand, and sufficient to fund the economy.
And few financial phenonema are as complex and opaque as shadow banking. It is often spoken of as a force of nature, and indeed technology did have a key role to play in facilitating the increasingly complex transactions upon which shadow banking depends; the scale of modern banking would simply not have been possible in a world where transactions had to be recorded on paper.[113]
However, certain regulatory decisions also had a key role in facilitating the growth of securitised banking. For example, the phenomenal growth of repos as a source of credit was enabled by changes to bankruptcy law in the EU and the US, heavily lobbied for by the financial industry. These changes made lending by repo more secure by ensuring that repo lenders are repaid before other creditors, such as depositors, in the event of bankruptcy (thereby increasing the cost of deposit insurance to the taxpayer).[114]
It should not be surprising then that the shadow banking sector grew tremendously over the following years. In the euro area, the assets of shadow banks grew from around €5 trillion at the beginning of 2004 to nearly €10 trillion in 2008.[115]
This change was undesirable as any uncertainty in the financial markets would result in market participants demanding higher repo haircuts so that their losses are minimised in the event of a default, leading to a collapse in the supply of shadow money.
Indeed, the 2007-2008 financial crisis began with a run on the repo markets.[116] If the financial system has evolved in a way that runs are once again possible on liabilities other than deposits, then we can expect the guarantee on deposits to be extended to these new types of liabilities. This also happened many times during the 2008 financial crisis — for example, in Ireland, where all creditors secured an overnight guarantee from the Irish government. However, this also happened in the US, where the Treasury guaranteed the share price of money market funds.[117]
Similar moves to support the shadow banking sector occured in early 2020. According to an article in the Financial Times, the Federal Reserve sought to boost the shadow banking sector by buying very risky bonds: the size of the facility used for this purpose was $750 billion.[118] The effects of this were considerable: the yield on Ford’s $1.8bn bond maturing in 2031 dropped from almost 13 percent to 9.3 percent after the announcement, as its price recovered. This was a massive gain to those who owned those bonds, as the price of a bond rises when the yields fall. In light of all this, one investor commented “if you think people were upset about bailing out banks where the CEOs were making $50m a year, how are they going to feel about bailing out private equity firms where the CEOs make $500m a year?” We previously discussed the implicit subsidy to banks. After all these efforts, there is now an implicit subsidy to shadow banks as well.
There are other disadvantages. For example, the shadow banking system results in a waste of talent. People may spend entire careers initiating and managing the complex instruments and vehicles that create money, even though money can be created almost without cost by the central bank. These are people who could otherwise have worked in productive activities, such as research and manufacturing.
It also results in a transfer of resources, as for a given inflation target private money creation could crowd out public money creation. If money demand increases, and this demand is satisfied by money creation in the shadow banking system, then such money will not be created by the central bank – central bank revenue is thus lower, and the financial sector is enriched at the expense of the general population.
This transfer could be significant; under a system with GDP growth of 1% and inflation of 2%, the euro area could benefit from seigniorage revenue of just under 3% of GDP, or around €300 billion per year. This compares with seigniorage revenues of around €10 billion accruing to the ECB, as estimated in 2015.[119] Such a low amount arises from the negative interest rate policy pursued by the ECB, which currently pays interest on its assets and receives interest on its liabilities, which historically speaking is an anomalous situation.[120] If monetary policy begins to normalise, we should expect seigniorage revenues to rise. However, if we return to a situation where most money is created by the private banking system, seigniorage revenues will still remain much lower than they should be.
10.2 Reclaiming Money Creation
The reform I present prohibits money creation by entities other than the central bank. In the case of retail banking, we would impose a 100% reserve requirement on all deposits with a maturity up to two years, implying that banks can no longer lend money that has been granted to them on deposit. Two immediate questions arise at this point. First, where would banks find the funds to fulfil the reserve requirement? Second, where would the economy get credit from?
Switching public for private money
In order to satisfy the 100pc reserve requirement, banks would need to borrow reserves from the central bank — we will call this new borrowing the Special Liability. This is not an increase in the money supply, but rather the replacement of private money with public money.
The Special Liability arising from the introduction of a 100 percent reserve requirement would be around €12 trillion. We can see this from ECB data, as the total amount of assets to which the 1 percent reserve requirement applies equals €14.4 trillion as of July 2020, whereas the total number of reserves held by euro area credit institutions is €2.4 trillion. The effect of the reform on the Balance Sheet of the euro area banking system is shown in Tables 10.1 and 10.2.
A key question with the transition is at what interest rate the Special Liability would be lent to the banks, and the maturity (how long they would have to repay it). Regarding the maturity, Jackson and Dyson note that it would be ideal if the maturity of the Special Liability would match the maturity of the loan book of the bank.[121]
The central bank must also decide on two interest rates: the interest rate on reserves and the interest rate on the Special Liability. In order not to create financial instability in the first stage of the transition, the interest rate on reserves should then equal the interest rate on the Special Liability, as there would then be no immediate effect on bank cash-flow or profitability. Interestingly, the fact that there would be an interest rate on reserves also may ultimately allow an interest rate on demand deposits. However, future bank profitability would fall as revenues from money creation would accrue to the public sector rather than the banking sector. Therefore, as we move away from the date of implementation, we would expect the average interest rate on central bank loans to exceed the average interest rate on central bank reserves. This is logical as the central bank, in lending to banks, is taking on credit risk. This interest rate differential would also ultimately affect the volume of seigniorage revenues.
Having detailed the core part of the reform, we must now address three criticisms of full-reserve banking systems: that they necessarily reduce credit creation, that the central bank would take on too much risk, and that it would push more activity towards the shadow banking system.
Table 10.1: Pre-reform Euro Area Banking System Balance Sheet
| As of 2020Q2 | |||||
| Assets | €tn | Liabilities | €tn | ||
| Loans | 21.1 | Deposits | 21.1 | ||
| Debt Securities | 3.6 | Debt Securities | 3.6 | ||
| Equity/Fund Shares | 1.2 | Capital/Reserves | 2.5 | ||
| Other assets | 5.7 | External liabilities | 3.5 | ||
| Reserves | 2.4 | Remaining liabilities | 3.3 | ||
| Total Assets | 34 | Total Liabilities | 34 | ||
Table 10.2: Post-reform Euro Area Banking System Balance Sheet
| As of 2020Q2 | |||||
| Assets | €tn | Liabilities | €tn | ||
| Loans | 21.1 | Deposits | 21.1 | ||
| Debt Securities | 3.6 | Debt Securities | 3.6 | ||
| Equity/Fund Shares | 1.2 | Capital/Reserves | 2.5 | ||
| Other assets | 5.7 | External liabilities | 3.5 | ||
| Reserves | 2.4 | Remaining liabilities | 3.3 | ||
| New Reserves | 12 | Special Liability | 12 | ||
| Total Assets | 46 | Total Liabilities | 46 | ||
Ensuring credit provision
A common but fallacious argument against full-reserve banking systems is that they cannot provide as much credit to the economy as a fractionalreserve banking system. This argument is wrong as the central bank could supply credit by setting a given interest rate, and lending to banks whatever they demand at that interest rate as long as such banks fulfil their capital and other regulatory requirements. The interest rate could be determined in order to maintain inflation at a certain level, as in the current system. For longer-term lending, the central bank could lend at lower rates through an auctioning process.
It is important to note that in this system the central bank would not vary the terms of the loan depending on the type of loan the bank is making. Some would argue that if a bank is making risky loans, they should pay a higher interest rate. However, it is already the case that bank capital requirements are modified depending on the risk categorisation of the loans they have made. This already introduces significant distortions into the market.
For example, real estate is treated very favourably under this system of risk-weighted assets: banks need less equity to fund a mortgage of e100,000 than they would need to fund an equally-risky, equally-sized loan to a company. This favourable treatment may have contributed to the significant increases in real estate prices across the developed world since the implementation of Basel I, the first set of international banking regulations. This bias may hobble economic growth, by incentivising investment in real estate rather then manufacturing or research.
This a problem if we want to create a technologically advanced economy. We shall therefore need to propose a reform of capital requirements, while ensuring that bank failure does not threaten this new model.
Bank Regulation
It would still be possible for banks to fail in this system, resulting in the central bank losing money. How could we mitigate this? In theory, such risk could be compensated by the enhanced seigniorage revenues of the central bank. There are two other ways of mitigating this loss.
Consider the hypothetical situation whereby a bank is lending to risky sectors, and funds this by borrowing directly from companies or individuals through non-deposit instruments (such as a normal loan). Therefore, no deposits are placed by this bank at the central bank in the form of reserves. In addition, the bank’s borrows short-term at low interest rates, while lending long-term at higher interest rates. Therefore, there is some maturity transformation, the profits from which (due to the interest rate differential) accrue to the private bank.
What exactly is wrong with this situation? Imagine that the assets of the bank begin to look like they will lose value. Those who have lent to the bank would quickly withdraw their money. The bank in return could replace that with funds from the central bank before the losses are recognised. If the bank goes bankrupt, the central bank would bear losses despite not having gained from the earlier profits.
To prevent this situation occurring, companies, individuals, or financial institutions who wish to lend to the banks would only be able to do so in the form of a deposit. This ensures that the central bank would gain the profits from maturity transformation, which can then compensate for any later losses.
Second, there would be a flat capital requirement of 15pc of total bank assets, similar to that proposed by Martin Hellwig.[122] This means that the bank’s assets would need to lose more then 15pc of their value before the central bank bears any loss. This flat capital requirement is a departure from the risk-weighted capital requirement. Aside from the problem mentioned previously, there are two other reasons to abandon this framework.
First, risk weights actually measure risk quite poorly. For example, one IMF study indicated that risk-based capital ratios cannot distinguish between a safe and an insolvent bank.[123] This is not surprising when you consider that the financial crisis emerged from loans deemed relatively safe by regulators, such as mortgages.
Second, risk-weighted capital is complex to calculate. According to Andrew Haldane, former Chief Economist at the Bank of England, for a large representative bank the number of calculations needed to estimate the capital ratio has increased from single digits to over 200 million, requiring a large number of quantitative analysts.[124] If risk weights are unreliable, such efforts would appear to be yet another waste of talent – one our reform can remedy.
The other waste of talent resides in the shadow banking system. We previously discussed how the creation of shadow money could undermine such reforms — how can we prevent this being a problem?
Constraining shadow money creation
As we saw earlier, shadow banking has real costs but illusory benefits. It has no place in a safe banking system. How then can we prevent it from undermining full-reserve banking reforms?
McMillan (the pseudonym of an investment banker and an economist) proposes the following new Systemic Solvency Rule which would prevent the creation of money out of credit by any firm:
“The value of the non-financial assets of a company has to be greater than or equal to the value of the company’s liabilities in the worst financial state”[125]
As equity (e.g. common shares) is not counted as a liability in this context, what this rule essentially means is that all financial assets have to be fully funded with equity. The bindingness of this rule for different sectors is outlined in Table 10.3. For each industry, data is taken from five companies listed on the Euronext Stock Exchange. The Systemic Solvency Ratio is calculated as total financial assets divided by total equity. A company is compliant with the Systemic Solvency Rule if the Systemic Solvency Ratio is less than or equal to 1; this means that the amount of financial assets is lower than the amount of equity. As we see, in fifteen of twenty industries, at least three out of five of companies are already compliant. Eleven of the twenty have a weighted average ratio of less than or equal to one.
From the table, it is clear that such a rule would pose a significant problem to insurance companies. As Laurence Kotlikoff describes, in the worst financial state insurance companies would not be able to satisfy all of the promises they have made — they simply wouldn’t have enough reserves to pay all claims if every single car and house were destroyed.[126] Therefore, one could exclude insurers from this particular provision, on the condition that they do not abuse this privilege by participating in the creation of money, for example by insuring the values of certain financial instruments such that they become near-monies. It may be necessary to prevent them providing insurance on any financial asset.
The second exception to this provision would be licensed banks, a necessary exception so that our new method of credit provision would function.
For the remaining industries in breach of the rule, a transition can be easily engineered. Any company breaching the rule would be forbidden from issuing any further debt. They would then be given 10 years in order to comply with the rule. If they cannot dispose of financial assets, then they would be required to replace debt funding with equity funding.
In addition, the new rule also restricts the use of certain financial instruments such as short selling. This is because in theory a share price can keep going up; therefore when short selling, one could expose oneself to a loss much larger than the value of the company’s equity. However, it would still be possible for individuals and partnerships to short-sell as the rule only applies to corporate entities.
10.3 Benefits of the New System
Ensuring equity provision
As all money is currently created in the form of debt, there may be a relative shortage of equity in the present system. This is problematic as the growth of the intangible economy is mostly funded by equity. The old banking system was well-suited to funding the old industrial economy which had a high amount of collateral with which to secure loans. But as intangible enterprises have little or no collateral to provide, debt financing is harder to come by, so a change in the financial system is necessary. By moving away from fractional-reserve banking, and giving the central bank the sole responsibility for money creation, we can ensure that some money is created in the form of equity. By thus reducing the shortage of equity, we can ensure that the intangible economy can grow, and thereby prevent the economic decline of the West.
Consider the following situation. In a fractional reserve system where around 90pc of money is privately created and 10pc is created by the central bank, the central bank has limited room to create money in the form of equity for the following reasons. If it wanted 5pc of the total money supply to be created in the form of equity, then half of the money created by the central bank would need to be in the form of equity. This could result in a lack of reserves which could hinder the interbank payments system and result in a rising reliance on the shadow banking sector.
Table 10.3: Bindingness of Systemic Solvency Rule
| *For each sector, 2017 balance sheet data is taken for five Euronext companies. | ||
| Industry | Compliant companies (%) | Systemic Solvency Ratio |
|---|---|---|
| Real Estate | 60 | 0.03 |
| Personal and household goods | 100 | 0.28 |
| Oil and gas | 60 | 0.47 |
| Technology | 100 | 0.5 |
| Telecommunications | 60 | 0.5 |
| Chemicals | 60 | 0.51 |
| Basic resources | 80 | 0.71 |
| Construction and materials | 40 | 0.73 |
| Media | 80 | 0.78 |
| Retail | 100 | 0.81 |
| Health care | 80 | 1 |
| Travel and leisure | 40 | 1.05 |
| Investment Instruments | 60 | 1.12 |
| Financial services | 60 | 1.16 |
| Industrial goods and services | 40 | 1.59 |
| Food and beverage | 60 | 1.79 |
| Automobile and parts | 80 | 1.91 |
| Utilities | 60 | 2.08 |
| Banking | 0 | 6.41 |
| Insurance | 0 | 13.97 |
Furthermore, given the volatility of equities, it could introduce an uncomfortable level of risk onto the central bank’s balance sheet. For example, in the event of a permanent fall in output, in order to contain inflation the central bank would need to decrease the money supply. However, if the price of the stocks also fell, then the ability of the central bank to withdraw money from the economy is also reduced.
However, if the central bank creates 100pc of the money supply, then reducing its margin of manoeuvre by issuing 5pc of money in the form of equity is very unlikely to introduce a similar difficulty.
How would creating money in the form of equity work in practise? The central bank could simply purchase an index of stocks. While this would not result in more investment in intangible enterprises directly, it would increase the general supply of equity, making IPOs more attractive to companies.
One danger would be that if the central bank became a large holder of stocks and shares, it would acquire a large amount of political influence. Even if it would never use that influence to vote, it would certainly become the target of civil society campaigns to invest into the fashionable industries of the day. Given this, it would be best if the decision regarding investment was decentralised to whatever degree feasible.
In addition, such central banks should not invest within their own borders for two reasons. First, from the perspective of portfolio diversification most of the portfolio should be invested outside national borders, as if an idiosyncratic economic shock hits a country then at least overall national wealth is partly hedged. Second, it is a way to prevent the central bank becoming overly-embroiled in domestic affairs. How such a fund could be managed will be explored in more detail in the next chapter.
Such plentiful equity financing could make it much easier to start a business. This is a factor that currently hold Europe back compared to the United States. In Europe we have traditionally relied on bank-based financing, which is inimical to equity financing. Rectifying the shortage of equity would thus go far in remedying the weak rate of business formation in Europe.
Reducing public debt
The introduction of a reserve requirement in essence represents a reclamation of all privately-created money. The size of this windfall depends on the long-run differential in the interest rate between the reserves private banks have deposited at the central bank, and the funds lent to private banks.
Under historically normal conditions, there would be a significant rise in seigniorage as the central bank is now the sole creator of money. The details of this calculation, identical to the approach of Corsetti et al.[127], are provided in the notes. Data for debt and GDP levels refer to the 2016 values for the euro area.
Table 8.4: 50-year seigniorage (trillions) – No change scenario
| *Inflation rate is assumed to be 1.8%. | |||
| Annual real growth rate | |||
| Nominal Interest Rate | 1% | 1.5% | 2% |
|---|---|---|---|
| 3.0% | 2.8 | 3.3 | 3.7 |
| 4.0% | 2.3 | 2.7 | 3.0 |
| 5.0% | 1.9 | 2.2 | 2.5 |
Table 8.5: Increase in 50-year seigniorage (billions): M3 becomes monetary base
| *Inflation rate is assumed to be 1.8%. | |||
| Annual real growth rate | |||
| Nominal Interest Rate | 1% | 1.5% | 2% |
|---|---|---|---|
| 3.0% | 16.7 | 21.7 | 27.7 |
| 4.0% | 13.2 | 17.1 | 21.7 |
| 5.0% | 10.8 | 13.8 | 17.4 |
Seigniorage is calculated assuming an inflation rate of 1.8%. In Table 10.4 we see projections for seigniorage revenue for the current monetary system. In Table 10.5 we see the expected increase in seigniorage revenues from moving to the system outlined in this paper.
What would be the effect on the public sector balance sheet of the proposed reforms? In order to evaluate this, we look at the revenues in the most pessimistic scenario from Table 10.5 and distribute them across countries according to their contribution to the ECB’s capital – therefore the windfall explicitly concerns the expected increase in seigniorage revenues over a 50-year period, not total seigniorage revenues over that period. We then assume a similar scheme to that described in Coresetti et al. occurs, whereby future seigniorage revenues above the current level are used in order to buy back debt.[128] The mechanism for this is an entity to which all future seigniorage revenues are pledged. The entity then borrows today on the strength of these future revenues, and uses the funds raised in order to buy and cancel public debt.
With the expected windfall, we see that the debt-to-GDP ratio of all countries would fall significantly. Before Coronavirus-induced expenses, this would have brought debt below the 60% designated as the maximum level by European rules. The country with the highest debt-to-GDP ratio would have been Greece, with a debt-to-GDP ratio of 52.8%, down from 181%. Italy’s ratio would have become 52%, down from 132%. For most countries, such as Germany, the Netherlands, and the Baltics, government debt would have been completely eliminated or nearly so.
The move to a low-debt situation would permit the introduction of reforms which would disincentivise states from accumulating debt once again such the 60% debt-to-GDP ratios is exceeded. This could include automatic write-down of public debt, a requirement that all future bonds issued should have their repayments linked to GDP, and a positive risk weight attached to all sovereign bonds for the calculation of bank capital requirements.
Finally, note that the above estimate does not take into account nearmoney instruments that have been generated through the shadow banking system. The replacement of shadow money with public money could introduce an additional windfall. While the opacity of the shadow banking system means this would be quite difficult to estimate, it would undoubtedly be significant.
Thus we have reviewed the main benefit of this new monetary system. But there are many other benefits, which we will now review.
A Robust Payment System
A major advantage of the system outlined above is that there would be an effective separation between the loan-making and deposit-taking activities of a bank. Every euro on deposit at a bank is held on reserve at the central bank. Therefore, if the bank fails, these deposits are safe, and payments can continue unaffected. The incentive for a government to bail-out a bank to is greatly diminished.
The competitive dimension
Banking is a very uncompetitive sector. This is because banks that are too big to fail benefit from an implicit subsidy as their lenders know that such banks would probably be bailed out if they are ever in difficulty; therefore such lenders require a lower interest rate when lending to those banks, making them more profitable at the expense of the taxpayer.
Table 8.6: 50yr Gains from Monetary Reform by Country
| *The windfall is calculated assuming the most pessimistic scenario where the annual real growth rate is 1% and the nominal interest rate is 5%. | ||||
| Debt-to-GDP Ratio (%) | ||||
| Country | Windfall (€bn) | Pre | Post | |
|---|---|---|---|---|
| Austria | 259.5 | 70.5 | 5.3 | |
| Belgium | 323.0 | 98.7 | 30.5 | |
| Cyprus | 19.1 | 94.0 | 8.4 | |
| Estonia | 25.0 | 8.4 | -80.5 | |
| Finland | 162.9 | 59.2 | -8.5 | |
| France | 1811.0 | 98.1 | 23.5 | |
| Germany | 2337.5 | 59.5 | -8.2 | |
| Greece | 219.3 | 176.6 | 59.6 | |
| Ireland | 150.2 | 57.3 | 15.1 | |
| Italy | 1506.4 | 134.6 | 50.5 | |
| Latvia | 34.6 | 36.9 | -76.5 | |
| Lithuania | 51.3 | 35.9 | -69.3 | |
| Luxembourg | 29.2 | 22.1 | -23.9 | |
| Malta | 9.3 | 42.5 | -26.9 | |
| Netherlands | 519.6 | 48.7 | -15.4 | |
| Portugal | 207.5 | 117.2 | 19.9 | |
| Slovakia | 101.5 | 48.2 | -60.0 | |
| Slovenia | 42.7 | 65.6 | -22.6 | |
| Spain | 1057.4 | 95.5 | 10.6 | |
But uncompetitiveness breeds inefficiency. Removing the implicit subsidy would result in smaller banks and therefore a more competitive banking industry. The greater degree of competition would possibly reduce the cost of financial intermediation, and thereby result in lower interest rates for borrowers.
Conclusion
This chapter started by describing the excessive privilege of finance. It is apparent that the reforms outlined in this paper have the potential to reduce the power of this sector while solving many economic problems that would otherwise be difficult to solve.
For example, it reduces public debt significantly without any crossborder transfers. This would eliminate the political tensions between creditor and debtor nations in the euro area. With risks reduced sufficiently, there would simply be no need for risk-sharing. There would be no need for an EU-level deposit insurance scheme as deposits, fully backed by reserves, would be completely secure.
But of course, before implementing any plan along these lines, further research would be required in the following areas. The full impact of the systemic solvency rule on different sectors would need to be evaluated. The new framework for monetary policy would also need to be clearly specified, in particular to process for determining what interest rate should be set on central bank reserves.
The system proposed would not be perfect. Banks would still fail, and this would impose some losses on the central bank. Therefore, other prudential regulation must remain in place or even be strengthened. However, in reclaiming seigniorage revenues, we would ensure that the public sector gains when times are good, which would compensate any losses. This is a major contrast to the current system, where the private sector gains when times are good, while then the public sector bears the losses when times are bad.
Endnotes
[95] Spengler, Oswald. Decline of the West: Volumes 1 and 2. Random Shack. Kindle Edition. Location 19603
[96] Ibid. Kindle Locations 11690- 11692
[97] Thomas Philippon. “Has the US Finance Industry Become Less Efficient? On the Theory and Measurement of Financial Intermediation”. In: American Economic Review 105.4 (Apr. 2015), pp. 1408–38. URL: http://www.aeaweb.org/articlesid=10.1257/aer.20120578
[98] Truly eliminating this implicit subsidy means that if a bank is to fail, the government would have no incentive to intervene. This implies three things: first, there can be no risk of a run on deposits or any other short-term debt. Government guarantees such as deposit insurance are a false solution to this problem, as they introduce an incentive for government to intervene. For example, a government could either recapitalise a bank, or face paying out a much larger amount on deposit insurance not just to the depositors at that bank, but possibly to other depositors at other banks if the failure of one bank sparks contagion. Thus, our second condition is that there cannot be deposit insurance or other guarantees of banks’ liabilities. Third, the payments system and the supply of credit to the economy must be unaf- fected by the failure of any one bank.
[99] International Monetary Fund. “Chapter 2: Regulatory Reform 10 Years After the Global Financial Crisis: Looking Back, Looking Forward”. In: Global Financial Stability Report (2018). URL: https://www.imf.org/~/media/Files/Publications/GFSR/2018/Oct/CH1/doc/CH1.ashx?la=en
[100] Michael Kumhof and Jaromir Benes. The Chicago Plan Revisited. IMF Working Papers 12/202. International Monetary Fund, Aug. 2012. URL: https://ideas.repec.org/p/imf/imfwpa/12-202.html
[101] Andrew Jackson and Ben Dyson. Modernising Money: Why Our Monetary System is Broken and How it Can be Fixed. Positive Money, 2013
[102] Philippe Bacchetta. “The sovereign money initiative in Switzerland: an economic assessment”. In: Swiss Journal of Economics and Statistics 154.1 (Jan. 2018), p. 3. ISSN: 2235-6282. URL: https://doi.org/10.1186/s41937-017-0010-y
[103] Richard A. Werner. “Can banks individually create money out of nothing? — The theories and the empirical evidence”. In: International Review of Financial Analysis 36 (2014), pp. 1–19. ISSN: 1057-5219. URL: http://www.sciencedirect.com/science/article/pii/S1057521914001070
[104] James Buchanan. “The Constitutionalization of Money”. In: Cato Journal 30.2 (2010), pp. 251–258. URL: https://EconPapers.repec.org/RePEc:cto:journl:v:30:y:2010:i:2:p:251-258
[105] In addition, it has been noted by Laurence Kotlikoff that according to the Diamond and Dybvig model the key condition required to justify fractional reserve banking – that the purchasing power of deposits is insured, not just the nominal value – does not hold in the real world. For more details, consult Laurence J. Kotlikoff. Jimmy Stewart Is Dead: Ending the World’s Ongoing Financial Plague with Limited Purpose Banking. 1st ed. Wiley, Apr. 2011 and Douglas W Diamond and Philip H Dybvig. “Bank Runs, Deposit Insurance, and Liquidity”. In: Journal of Political Economy 91.3 (June 1983), pp. 401–419. URL: https://ideas.repec.org/a/ucp/jpolec/v91y1983i3p401-19.html
[106] Charles Goodhart and Manoj Pradhan. Demographics will reverse three multi-decade global trends. BIS Working Papers 656. Bank for International Settlements, Aug. 2017. URL: https://ideas.repec.org/p/bis/biswps/656.html
[107] Jonathan Haskel and Stian Westlake. Capitalism without Capital: The Rise of the Intangible Economy. Princeton University Press, 2017
[108] Stephen G Cecchetti and Enisse Kharroubi. Why does financial sector growth crowd out real economic growth? BIS Working Papers 490. Bank for International Settlements, Feb. 2015. URL: https://ideas.repec.org/p/bis/biswps/490.html
[109] Benjamin Nelson, Gabor Pinter, and Konstantinos Theodoridis. “Do contractionary monetary policy shocks expand shadow banking?” In: Journal of Applied Econometrics 33.2 (Aug. 2017), pp. 198–211. URL: https://onlinelibrary.wiley.com/doi/abs/10.1002/jae.2594
[110] John Cochrane. “Toward a Run-free Financial System”. In: Across the Great Divide: New Perspectives on the Financial Crisis. Ed. by Martin Neil Baily and John B. Taylor. Hoover Institution, Stanford University, 2014. Chap. 10. URL: https://EconPapers. repec.org/RePEc:hoo:bookch:8-10
[111] This entire system also called “securitised banking” and is analogous to the model of traditional banking described earlier. For a full presentation of this argument, see Gary B. Gorton and Andrew Metrick. Securitized Banking and the Run on Repo. NBER Working Papers 15223. National Bureau of Economic Research, Inc, Aug. 2009. URL: https://ideas.repec.org/p/nbr/nberwo/15223.html. A brief summary is as follows: in securitised banking the loan is risky, so the buyer requires a haircut; if the borrower temporarily sells a loan with a face value of e100 for e90, the haircut is 10%. This 10% repo haircut is equivalent to the reserve requirement. The repo rate is deter- mined by the price at which the loan is bought back; if the borrower buy back the loan for e90.90, the interest of 90 cent implies a repo rate of 1%. This is equivalent to the deposit rate. To understand the potential implication, consider an example. In a system with a collateral base of around 1 trillion, and an average repo haircut of 10%, then the total supply of shadow money could equal 10 trillion, 90pc of which we could deem to be privately created. But as the collateral chains are not likely to be very long, the true number would be much lower, but still hugely significant.
[112] Manmohan Singh. Velocity of Pledged Collateral; Analysis and Implications. IMF Working Papers 11/256. International Monetary Fund, 2011. URL: https://EconPapers.repec.org/RePEc:imf:imfwpa:11/256
[113] Jonathan McMillan. The end of banking: money, credit, and the digital revolution. Zero/One Economics, Zurich, 2014
[114] Enrico Perotti. Systemic liquidity risk and bankruptcy exceptions. Policy Insight 52. Centre for Economic Policy Research, Oct. 2010. URL: www.cepr.org/pubs/policyinsights/PolicyInsight52.pdf According to Perotti, the complete list is as follows: the EU Fi- nancial Collateral Directive of 6 June 2002 (OJ L168/43), the EU Settlement Finality Directive of 19 May 1998 (OJ L 166/45), Directive 2009/44/EC of 6 May 2009 amending Directive 98/26/EC on settlement finality in payment and securities settlement sys- tems, and Directive 2002/47/ EC on financial collateral arrangements as regards linked systems and credit claims. In the US, the Bankruptcy Code was amended in 2005
[115] Klára Bakk-Simon et al. Shadow banking in the Euro area: An overview. Occasional Paper Series 133. European Central Bank, Apr. 2012. URL: https://ideas.repec.org/p/ecb/ecbops/20120133.html
[116] Gary B. Gorton and Andrew Metrick. Securitized Banking and the Run on Repo. NBER Working Papers 15223. National Bureau of Economic Research, Inc, Aug. 2009. URL: https://ideas.repec.org/p/nbr/nberwo/15223.html
[117] See https://www.treasury.gov/press-center/press-releases/Pages/hp1161.aspx. Guaranteeing the value of these makes the shares even more money-like – therefore, the effect of shadow money creation is government guarantees, which results in its use as money becoming even stronger.
[118] Joe Rennison, Robin Wigglesworth, and Colby Smith. “Federal Reserve enters new territory with support for risky debt”. In: Financial Times (Apr. 2020). URL: https://www.ft.com/content/c0b78bc9-0ea8-461c-a5a2-89067ca94ea4
[120] Daniel Gros. Negative Rates and Seigniorage: Turning the central bank business model upside down? The special case of the ECB. CEPS Papers 11754. Centre for European Policy Studies, July 2016. URL: https://ideas.repec.org/p/eps/cepswp/11754.html
[121] Andrew Jackson and Ben Dyson. Modernising Money: Why Our Monetary System is Broken and How it Can be Fixed. Positive Money, 2013
[122] Martin Hellwig. “Capital Regulation after the Crisis: Business as Usual?” In: ifo DICE Report 8.2 (July 2010), pp. 40–46. URL: https://ideas.repec.org/a/ces/ifodic/v8y2010i2p14566986.html
123International Monetary Fund (IMF). “Detecting Systemic Risk”. In: Global Financial Stability Report (Apr. 2009). URL: https://www.imf.org/~/media/Websites/IMF/imported- flagship-issues/external/pubs/ft/GFSR/2009/01/pdf/_chap3pdf.ashx
[124] Andrew G Haldane. Capital Discipline (Based on a speech given at the American Economic Association, Denver). https://www.bankofengland.co.uk/-/media/boe/files/ speech/ 2011 / capital- discipline- speech- by- andrew- haldane. pdf. Accessed: 2018-11-2. Jan. 2011
[125] Jonathan McMillan. The end of banking: money, credit, and the digital revolution. Zero/One Economics, Zurich, 2014
[126] Laurence J. Kotlikoff. Jimmy Stewart Is Dead: Ending the World’s Ongoing Financial Plague with Limited Purpose Banking. 1st ed. Wiley, Apr. 2011
[127] Giancarlo Corsetti et al. A New Start for the Eurozone: Dealing with Debt. CEPR Press, 2015. URL: http://voxeu.org/content/new-start-eurozone-dealing-debt
[128] Giancarlo Corsetti et al. A New Start for the Eurozone: Dealing with Debt. CEPR Press, 2015. URL: http://voxeu.org/content/new-start-eurozone-dealing-debt