The World Economics Association has featured an article on Positive Money in its latest newsletter. Let me discuss some aspects of this text because I think that there are still many open questions regarding both the analysis and the policy recommendations. The article starts its analytical part like this:
Now, which are the malfunctions of the present monetary system?
1. Money is created as debt.Today, money comes into existence by debt creation when commercial banks borrow from central banks and when governments, producers or consumers borrow from commercial banks. Thus, the money supply of the economy can only be maintained if the private or public economic actors get into debt. Economic growth requires a proportionate increase in the money supply in order to avoid deflation that would paralyze business, but an increase in the quantity of money involves a simultaneous increase in debt. This way, economic actors run into danger of excessive indebtedness and bankruptcy. It is not necessary to say that overindebtedness causes serious problems to societies and individuals in the face of the ongoing debt crisis.
As I find myself in disagreement with almost all sentences, let me tackle them one by one. (I am doing this because I think that the analysis is flawed, not because I don’t like the conclusions.) The first sentence of the answer is correct, but imprecise. What is meant by money? Money-reserves created by the central bank? Money-deposits created by banks? Money-deposit certificates created by money market funds? As we start here with “money” being highlighted – although not defined – and loan demand and interest rates neglected we’re roughly in the Monetarist camp.
The next sentence could have cleared things up – but it doesn’t because the readers are not experts in monetary theory and don’t know that “when commercial banks borrow from central banks” it is central bank money (reserves) that is created while “when governments, producers or consumers borrow from commercial banks” it is bank money (deposits). And, it is wrong to put government in one list with the private sector. The government, while often able to do so to some extent, actually does not “borrow” from commercial banks. It is selling government bonds. Selling government bonds is different from getting a loan because in most monetary system the government is not in danger of a failed auction. Selling government bonds in countries with a sovereign currency always succeeds. Exceptions are few, and only the euro zone with its no-bail-out clause chose a difference path (which Draghi corrected in the meantime). So, while a loan is not always granted, a government bond is always placed in the market, and if banks don’t buy it the central bank will (if not in the primary than in the secondary market). I find it quite wrong to place government, which is issuing riskless assets in almost all sovereign money systems, in one category with private sector loans, which are prone to default. Especially since government bonds are promises to pay central bank money (reserves) while private sector bank loans only promise to pay deposits. Next sentence:
Thus, the money supply of the economy can only be maintained if the private or public economic actors get into debt.
With no clear definition of a money supply it is impossible to evaluate whether this is true or not. The next question is whether that “or” is an “and/or” or an “exclusive or” (in a closed economy private sector wealth equals public sector debt). As general as was written, the sentence is wrong. If the private sector keeps its share of loans steady, then no increase in public debt is necessary to maintain the money supply (if that includes deposits). Also, a country with a current account surplus can have a rise in deposits and hence the money supply while both the private sector and the public sector run a surplus, meaning that the private sector saves more than it invests and the government’s tax income is higher than its spending. Next sentence:
Economic growth requires a proportionate increase in the money supply in order to avoid deflation that would paralyze business, but an increase in the quantity of money involves a simultaneous increase in debt.
That’s nice, here we can check the available data to see whether it is true that “economic growth requires a proportionate increase in the money supply”. Here is the data for the US via FRED2:
Well, the consumer price index change from year to year is inflation (fat black line), and it is positive almost all of the time. However, some monetary aggregates (M1, M3, MB) had negative growth rates from time to time. Also, inflation in the late 1970s does not correlate with movement in the monetary aggregate (M1). A rise in the monetary base (cash plus reserves) in the last recession also did not coincide with the inflation rate. Comparing all those colored line with the inflation rate, I can hardly make out which one is proportionately increasing in relation to the inflation rate. Can you? (If you can, you’d be a monetarist.)
Now for the second part of that sentence (“an increase in the quantity of money involves a simultaneous increase in debt”) I can not see how that can be true. Money is debt, sure, but not all debt is money. Government can create huge debts, which would allow the private sector to use the additional deposits (from incomes paid by the public sector) to pay down its own debt. This would shrink the private sector debt and therefore money and increase the amounts of government bonds, which are not counted as “money”. So, an increase in (public) debt can decrease the quantity of money. Probably this is part of the Japanese story of the last 20+ years.
“This way, economic actors run into danger of excessive indebtedness and bankruptcy.” Well, except that a government with a sovereign currency cannot go bankrupt. The case of Japan shows that government spending can prop up an economy is the private sector decides to pay down debt. Technically there is not a problem with the monetary system, quite the opposite. One just has to use it right. Also, “excessive indebtedness” is very vague. What is the yardstick? Sure, we can outlaw any loans, but then you can only start production if are very, very rich. Only the super-rich do not have to worry about “excessive indebtedness”.
It is not necessary to say that overindebtedness causes serious problems to societies and individuals in the face of the ongoing debt crisis.
Hmmm. This is very one-sided. After 1945, many Western societies had good growth rates. Many firms borrowed from banks to start and expand businesses, households borrowed to buy houses, etc. Now there are some countries that suffer, but they are mostly inside the euro zone (Spain, Ireland, Greece, Cyprus, etc.), which is a special case due to the lack of exchange rate adjustment. The UK was a case of self-imposed austerity, which was not necessary under the monetary system. Iceland defaulted on its bank debt and seems to be doing more than OK.
Going through the rest of the text I encounter many expressions which I think are just plain wrong: “interest has to be paid on all the money in circulation” (I pay no interest on my cash, do you? And banks can acquire cash from the central bank by selling government bonds to it), “Interest is a subsidy to the banks because the account money they create is handled as legal tender” (no, it is not), “In a sovereign money system the unnecessarily complicated two-level banking system would be replaced by a single-level system, in which money is no longer backed by reserves” (money is not “backed” by reserves today), and last but not least, “the existing bad framework that governments attempt to straighten out with evermore complex regulation consisting of the fractional reserve system, …” (we don’t have a fractional reserve system because banks cannot lend out reserves).
While I believe that many Vollgeld (100% money) supporters have good intentions, I’m afraid that their analysis once and again builds on a neoclassical world view which should have been discarded decades ago. Building on flawed foundations, the new financial house will be unable to wheather the storm – like the euro, which has also been build on neoclassical foundations (crowding-out, monetarism). Nevertheless, there are still many issues that are of shared concern: the role of private banks and financial markets in the crisis, the lack of concern for the real economy (jobs) and ecology, and political economy and macroeconomic problems resulting from a very unequal income and wealth distribution.
To sum it up: I am not convinced that the economic malaise in some European countries has been caused by inherent flaws in our monetary system and I am not convinced that these flaws cannot be remedied in the existing framework (through higher capital requirements, for instance). Yes, bank loans financing real estate have caused the boom (and the bust), but without those loans we would have had lots of unemployment and very likely negative growth rates. Of course, fiscal spending could have been used to fill the gap in demand, but the politicians (and economists) did not want to touch that policy except for that brief time during 2009. I cannot see how we need a new monetary system in order to clean up the mess in Europe. There is much to be done, but from the macroeconomic perspective freeing us from the fiscal constraints should be enough to return Europe to growth and prosperity shared by all Europeans.