So What, Actually, Do We Need To Do?

This week I’m going to give an overview of the type of reforms that might be necessary to create an economy that provides enough for everyone. Right from the outset I need to be clear that I’m not interested in proposing some armchair utopian manifesto. This is not a definitive list of everything that needs to be done, nor are the points below specific recommendations of the exact action required.

Rather, I’m highlighting those areas of the economy that require direct intervention and reform. In some cases I make concrete examples, but these are for the purpose of highlighting the underlying principle. There is so much complex technical detail in the blog, I felt it was time to bring these principles to the fore by highlighting the implications they hold for action. The closing section of the blog will look at the process by which society could begin learning how to bring about such a transformation of the economy.

1) New money must be created each year and spent into the economy by the government – the most logical use of this money would be investment in future productivity

One concept made clear in the “Models” section of the blog is that if productivity is continually increasing (which it usually is), then you need the money supply to expand at the same rate. And even if productivity flat-lines, you always want a small level of inflation, so you always want a small increase in the money supply.

At present, as the “Money” section explains, money is created when banks make loans. All the money that you and I spend is created by someone else being in debt, and the money supply can only increase as private debt increases. However, once private debt reaches too high a proportion of GDP the system becomes unstable and a crash always follows. Therefore, we need a way to increase the money supply that isn’t tied to private debt, and the only way is for the Government to spend it into the economy.

This is not an argument for unlimited government spending – the money could be used on corporate tax rebates if you like or paying down the national debt if you have some ideological aversion to public spending. But from an accounting point of view, this would still be a government deficit. And ultimately, this new money must enter the real economy or it defeats the whole object in doing this, and the most effective way to do this would be through direct government expenditure. It would be safest to ensure that this spending is on areas that increase productivity, such as investment in infrastructure or spending on education, health and R&D.

The amount of new money must be determined independently according to economic factors, not by how much the government wants to spend. If the government wanted to spend above this level it could raise money through borrowing in the normal way.

2) The creation of new money by banks should be limited to loans that support investment spending

I was reading a finance textbook recently which that the “competitive advantage” of banks is their ability to assess credit-risk when making loans. This is complete nonsense (and no evidence was provided for the assertion). I realised I’d read this in other books, and that economists are assuming this is the case because they are looking for a reason for the distinct role of banks.

Because they don’t understand how the monetary system works, they don’t realise that banks’ competitive advantage is their access to the Central Bank’s final settlement system, which enables them to create money when they make loans. This is a major cause of instability in our economy, as described in the section on “Money”, and it is obvious that significant reform is needed in this system. Various ideas have been proposed by different economists and campaigners (some of which are summarised here). My main purpose here is to emphasise that reforms need to limit the capacity of banks to create new money, and money creation must be tied to increases in productivity.

It would actually be quite straight forward to place restrictions on the purposes for which banks can extend loans. Access to the final settlement system is a major competitive advantage and privilege, and therefore tight regulations should be placed on how this advantage is used. If we define banks as institutions with access to this system, then banks should only be allowed to make loans for the purpose of productive investment by businesses – not for mortgages, nor financial investment. At present, banks are averse to lending to business because it is regarded as risky. But if this was the only type of loan they were allowed to do, then it would force them to re-engage with this traditional activity of banking.

But where would we then get our mortgages from? There was a time in the UK when regulations severely restricted the ability of banks to offer mortgages, and we all got our mortgages from building societies. These were mutual associations – they took in people’s savings (at reasonable rates of interest), and used the accumulated capital to offer mortgages (how textbooks describe banking). Building societies themselves had to have accounts with banks to have access to the final settlement system. Returning to this system would stop the constant house price bubbles, caused by banks creating most of the new money in the economy for the purpose of buying houses.

Germany already has a banking system that does lend to small businesses, and this is part of the recipe for their current economic success. A network of 1,500 local, not-for-profit community banks (i.e. mutual associations, the same as traditional British building societies) serve local customers and businesses, taking in savings and making loans to small and medium sized enterprises. They account for 70% of deposits in Germany, and not one of these banks has needed to be bailed out in their 200 year history. The brilliant economist Richard Werner has championed such banks, even setting one up in Hampshire.

Another aspect to this could be that banks buy equity (shares) in businesses as well as offering loans. This is an idea proposed by the likes of Minsky, Keen and UNCTAD. Businesses would not be tied to monthly debt repayments – when businesses are struggling these repayments are often the first thing to be renegotiated to give them breathing space, and if this isn’t possible then it is these creditors who will push them into bankruptcy. But if banks bought equity instead, businesses would pay a part of their profits as dividends to the banks, so by definition payments would always be affordable. Compared to loans, banks will lose out to businesses that fail to turn sufficient profit, but make significantly more from the most successful businesses.

Update 11/01/19: Just 2 weeks after writing this I came across a paper that presents empirical evidence to confirm this exact conclusion. I summarise it here.

3) Household savings held by insurance companies and pension funds (ICPFs) should be channelled to financial assets that are funding productive investment

This is a massively complicated area. At present, ICPFs are mostly buying assets off the market – occasionally the seller of that asset will use the funds on real economy expenditure, but more often they’re just adjusting their portfolio of assets, and wealth churns around financial markets without finding its way back into the real economy, causing asset prices to inflate in the process. (This is a major theme of this section of the blog and the previous section on “Productivity” – you will find many descriptions of this dynamic, but I recommend this one.)

So a simple “solution” would be to require ICPFs only to purchase assets off companies that will use the funds raised to finance investment expenditure. But this would have grievous consequences. We can think of financial markets in terms of “primary” and “secondary” markets. Primary markets are the sale of newly created assets by businesses to raise capital; secondary markets are investors selling these assets to each other. But if investors don’t have the security of knowing they can sell an asset on in secondary markets, they will be much less willing to purchase in primary markets and the entire market could freeze.

This an area that would have to be approached with great care and armed with detailed knowledge and understanding of financial markets (which very few people have, even those actively trading). But there are ways forward that could be explored.

What matters is the principle – there have to be mechanisms that ensure that households savings are funding investment in real productivity. This would require extensive reform of the pension and insurance industries, and in financial markets themselves. But ICPFs are investing the public’s money and therefore should be subject to the same degree of democratic oversight as is applied to public money (i.e. government expenditure).

4) Reform and regulate financial markets to ensure that they channel saving to productive investment (requiring extensive international cooperation in regulation)

This follows on from point 3, but extends it into even more controversial territory. Not only should there be closer public scrutiny of money invested on behalf of the public, financial markets in general need reform and regulation to prevent the severe dysfunctionality described in detail in the opening posts of this section of the blog, drawing particularly on the work of Zoltan Pozsar.

Pozsar himself doesn’t recommend such reforms, although his own recommendations are just as controversial, and set out in points 5 and 6 below. Indeed, progress on points 3, 5, 6 and 7 would have such profound effects on financial markets that they would take us a good distance along the road we need to travel.

So this is really just a statement of principle – this area is just far too complex to start making detailed proposals. And before we can even begin thinking of what to do, there are certain sacred cows that must be slaughtered.

Foremost among these is the idea that unregulated free markets will manage capital flows most efficiently – all the empirical evidence demonstrates that this is fundamentally untrue. Free market ideology is based on the idea that we have “perfect information”. A horrendous assumption at the best of times, it is particularly inappropriate for financial markets, because these markets are entirely based upon predictions of the future, and the future is always uncertain and unknown.

All the empirical evidence (only a part of which is set out in this blog) is that financial markets are doing a terrible job. Meanwhile, Minsky gave us a flawless explanation of why unregulated financial markets, and therefore free market capitalism itself, will be unavoidably unstable and suffer cycles of boom and bust.

At present, there appears almost no hope of those with the necessary power coming even remotely close to recognising this reality (the final section of the blog will explore why this is). And hence, the first step towards reform has to be simply to accept that this is what needs to happen.

But if we achieve this, we will simply have to move on to the next sacred cow for slaughter! Because financial markets are global in character, the regulation of them needs to be globally coordinated, involving extensive cooperation by national governments. In these days of raising nationalism, the hide on this cow will be almost as tough as on the first.

At this point you may think that this all seems impossible to accomplish. But if this is what it takes, yet you don’t accept it because you want easier answers, then you’re part of the problem.

5) Use taxation to redistribute vast pools of wealth

This recommendation is lifted straight from Pozsar’s work. As with point 4, at present it seems crazy to think that such a proposal could reach widespread acceptance among those who control the global financial system. Indeed, when Pozsar worked for the US Department of the Treasury he wasted no time dwelling on such ideas, dismissing them as “unpalatable”. It was only after he left that he could write papers stating what he actually believed is needed.

Such reform of taxation would obviously be ineffective without measures to address tax avoidance and evasion, and this would again require extensive global cooperation.

Although I’ve said it before, it cannot be emphasised enough: this proposal is in no way based on any conception that wealth inequality is in some way unjust. It is purely based on the empirical evidence that such huge concentrations of wealth are inherently destabilising and cause great inefficiency in the functioning of financial markets.

This question of distribution will be explored in the next section of the blog (starting in the new year) – again, from a scientific perspective rather than a moral one.

6) Address global trade imbalances

Again, this is lifted straight from Pozsar. The political barriers to this happening are even greater than with points 4 and 5. Indeed, this requires a degree of international cooperation that might seem impossible even to conceive of at the present time. Pozsar therefore doesn’t dwell on the details of such a proposal – instead, he just invites us to imagine if excess foreign exchange reserves were taxed and redistributed to the household sector.

I might be more inclined to suggest that this tax revenue be used to support economic development in those countries that lack the capacity to earn their own foreign exchange (the ‘poverty trap’), just as American trade surpluses funded the Marshall Plan that enabled the reconstruction of Western Europe after WWII. Indeed, this would be a logical source of the state funding for innovation and investment proposed in point 7 below.

But how would you even collect such tax, and who would do this? The implications of this are truly revolutionary – a stable global economy providing enough for everyone requires a stable global monetary system, with global institutions! Right now, political ideology makes such steps impossible – but if we free ourselves from the chains and fetters of intellectually bankrupt ideologies developed in a different era of human history, then we will see that a scientific analysis of the empirical evidence shows this step to be incontrovertibly necessary.

Economists who have made the greatest contribution to this scientific analysis include Michal Kalecki, Nicholas Kaldor, Anthony Thirlwall and Wynne Godley. The brilliant blog “The Case for Concerted Action” is based on this concept (the “concerted action” that the blog’s author Ramanan is making the “case” for is the need for international cooperation to address trade imbalances). An important concept here is the “balance of payments constraint”, which I briefly describe in this post.

Even though such cooperation may seem politically impossible, in the aftermath of the financial crisis Central Banks around the world have put in place measures to coordinate their activity and stabilise markets. These steps are so detailed and technical that only the greatest nerds would have noticed them and understood their significance. Rather than extend this post further, I will write one more post next week explaining this system (along with some analysis from the IMF on international monetary stability). For now, note that this is one more area within which action needs to be taken, and I will explain a bit more next week.

7) Acknowledge and actively implement the role of the state in funding innovation and shaping markets

This time I’m lifting directly from Mazzucato’s work, summarised 2 weeks ago. This is not an area I’ve studied in detail, but I had to write a post on her her work because her research and conclusions cohere so completely with the other material presented in this blog, and indeed with several of the points made above.

As with point 4, this point requires the slaughtering of some sacred cows, the first being to accept the reality of how all economies have developed, including in the West: the government is always a significant source of funding for infrastructure development, science research and applied research. Ideologically driven calls for “small government” are not, in fact, rooted in historical reality. Mazzucato herself emphasises that advocating for this role of the state – which simply means making people aware of the facts of history – is a significant task at this time. She also makes practical suggestions for reform, a few of which are mentioned in the relevant post and I won’t repeat here.

This is a summary of points – in most cases, they are broad areas for exploration, not detailed proposals. But all of these areas arise from the logical analysis of empirical evidence presented on this blog. The greatest objection to many of these points would not actually be based on rational, empirically-based economic arguments, but on political ideology, and the final section of the blog will look at what it would take for society to start moving in the direction of such reforms. But first we must deepen our understanding of the economy by looking more deeply at the question of distribution, which I will begin after next week’s post explores the coordination of the international monetary system (point 6) in a little more detail.

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