Credit where it’s due

The Chris Cook Economics 3.0 column

The new Bank of England Monetary Policy Committee member Adam Posen had his job interview at the Treasury Select Committee today.

Posen said policy-makers would face tough decisions in the coming months about when to withdraw the costly life support from the part-nationalised banking system and when to start reining in public spending:

He warned:

“You cannot indefinitely substitute government spending for private credit creation. You can spend government money on a lot of things, but when you start using government money directly for credit uses it tends to be very inefficient.”

However, he said fixing the banking system must be the first priority:

“The complication is, first you have this political and social imperative that throwing a lot of money at the banks is not necessarily what you want to do first. Against that, if you can’t fix the banks at some point, everyone in the economy suffers. You come back to this basic trade-off that you want to have the banks recapitalised and on a firmer basis before you withdraw fiscal stimulus.”

Let’s have a look at what he’s saying.

“You cannot indefinitely substitute government spending for private credit creation. You can spend government money on a lot of things, but when you start using government money directly for credit uses it tends to be very inefficient.”

Government credit creation is very different from government spending.

Whether credit is created by government directly eg the Treasury; by Central Banks; by private banks; or even directly from seller to buyer (trade credit), it costs nothing to create.

The cost of credit is in fact the operating cost of the system; the cost of defaults; and any additional charges aka “Profits”.

Now it is arguable that government spending is less “efficient” than private spending. Unfortunately, efficiency is defined in terms of how much profit – denominated in the IOUs issued by the banking system – can be extracted for the benefit of rentier shareholders. But let’s put that issue to one side.

Cutting the Cost of Credit
To borrow from the neo-classical rhetoric, it is clearly more efficient for credit creation to take place without the unnecessary cost of profits payable to unproductive rentier shareholders. In order to achieve this desirable state of affairs, I advocate that Treasury Branches should be created (as they were in the 30’s in the province of Alberta) whose function it will be to issue credit directly as necessary to businesses and individuals requiring it. No interest would be charged in respect of this credit, but a provision – a “guarantee charge” – would be made by the users (sellers, buyers, and borrowers) of a Treasury guarantee and this would go into a default “Pool”.

Service-Providers-Formerly-Known-As-Banks would receive a performance related fee for managing this system of direct credit creation, handling defaults etc within the parameters set by the Monetary Authority (formerly known as the Bank of England).
Too radical? Hong Kong is already half way there: they have never had a Central Bank, and a Monetary Authority manages credit creation by private banks. Since there is no Central Bank as “lender of last resort”, Hong Kong Banks have necessarily been better capitalised than others.

Moving on.

“The complication is, first you have this political and social imperative that throwing a lot of money at the banks is not necessarily what you want to do first. Against that, if you can’t fix the banks at some point, everyone in the economy suffers. You come back to this basic trade-off that you want to have the banks recapitalised and on a firmer basis before you withdraw fiscal stimulus.”

As I imply above, the best way to fix the banks is to cut them out of credit creation altogether by “dis-intermediating” them, so that they evolve into pure service providers. That way, the only capital they need is the fairly trivial amount needed to cover their operating costs (eg staff, systems and premises). This capital requirement would be monitored by a Financial Services Authority much reduced in size and scope because much of the rest of the existing regime of financial regulation of financial intermediaries is no longer necessary.

Fiscal Stimulus
But what about fiscal stimulus? Well, isn’t that where spending comes in?

The problem is that Banks are not in the business of spending (other than on salaries and bonuses) and all the quantitative easing in the world can only make banks more liquid – it can’t make them lend. Moreover, as we see, the arbitrary central bank rate of interest has nothing whatever to do with the interest and other charges banks are currently making, which are all about maximising profits and rebuilding their balance sheets.

Why are banks not lending? The sad fact is that the combination of compound interest on debt and private property in land has done what it always has for thousands of years and concentrated wealth unsustainably in the hands of the few at the expense of the many. The outcome is that there is a shortage of creditworthy people and projects to whom to lend.

So the true policy requirement is, as I have stated here before, for Systemic Fiscal Reform, which should in my opinion take the form of a move away from taxes on earned income to taxes on unearned rents from privilege.

Another policy requirement is for massively increased government investment in new energy and transport infrastructure, and decent affordable housing and services. The necessary development credit should be funded by the State, but managed by the private sector using a new generation of “social businesses” as Dr Yunus of Grameen Bank puts it. No debt is necessary, since the development credit will be a new form of equity, paying a reasonable return to long term investors such as pension investors and sovereign wealth funds, but with no repayment date.

So must we, as Posen has it “rein in public spending”?

In the mad, mad, world of conventional political economy, then yes; but in reality, no.

In fact we can and should not only massively boost public investment in infrastructure but also directly provide the necessary credit for affordable housing and much else, managed by the private sector as service providers. We cannot afford not to do this.

We are accustomed to thinking that public investment is literally impossible other than by borrowing, and this is because the only conventional means for investment is the conventional Joint Stock Limited Liability Company. But in fact it is possible to invest in public and private assets using legal frameworks based upon trust or partnership law, and by using credit created directly by the Treasury, and the sooner policy-makers realise this, the better.