This week I was planning to start a new section of the blog on distribution (last week I loaded a new overview and summary of the blog, accessed by clicking “Overview” in the menu bar above).
But literally 6 days ago I came across a new paper promoted on Twitter, which is too exciting and too relevant to one of the conclusions of this blog not to write about. It was published in November 2018 by the Institute for Innovation and Public Purpose (IIPP) at Univerity College London. The IIPP was set up by Mariana Mazzucato, whose work I covered a few weeks ago. The paper was written by Dirk Bezemer, Josh Ryan-Collins, Frank van Lerven and Lu Zhang (the first two of whom have also had brief references on the blog before) and was titled “Credit where it’s due: A historical, theoretical and empirical review of credit guidance policies in the 20th century”. The full paper is here, and you can read a blog post on it by one of the authors here.
So why all the excitement? Three weeks ago I published a summary of conclusions that are emerging from the analysis on this blog. The second of these was:
2) The creation of new money by banks should be limited to loans that support investment spending
This is the exact focus of this paper. The “credit” referred to in the paper’s title is specifically bank credit. And as you’ll know if you’ve been following this blog, when a bank extends credit it is not lending from its reserves, it is creating new money, so we’re talking about the same thing here.
The “credit guidance policies” they refer to are the policies that central banks around the world used until the early ‘80s to ensure that credit was guided to productive areas of the economy: funding for fixed capital investment, for SMEs and for new technologies, rather than real estate or financial speculation.
In the early ‘80s free market fundamentalism became the dominant ideology in the most powerful Western nations. The mantra was to deregulate and privatise everything that moved, and leave everything to the market with no Government intervention. And because these nations controlled international aid, particularly through the IMF and World Bank, accepting such policies became a condition for countries to receive aid (known as “the Washington consensus”, as this is where these institutions, along with the US Government, are based). (The promotion of unregulated free markets was theoretically justified by the efficient market hypothesis, explained here and criticised here. This theory is now accepted to be inadequate by financial economists, but this news has not filtered out from this niche area of study!)
The paper examines the theories that promoted the use of credit guidance, and the later theories that led to their removal. And then it looks at the empirical evidence of the impact of these policies, and the impact of their removal. Because there are now long periods of modern history with data for economies both with and without credit controls, and various studies have been published analysing this data, the authors have been able to review all this evidence and publish it in this paper.
In sum, the conclusions are that economies grow when credit is extended to productive investment in non-financial businesses (as I have continuously emphasised on the blog), as opposed to the financial sector or real estate; and that since the removal of credit controls we have seen a marked shift from such lending to lending for mortgages and financial speculation. (This post and this post explain why banks prefer lending for these purposes.)
The authors are very careful to point out the limitations of their evidence. To mathematically correlate credit controls with levels of credit to the productive economy they have to create a numerical scale of credit controls, and this is necessarily a subjective exercise. In addition, correlation does not prove causation, and they do point out alternative interpretations of the data and of the direction of causation. And since the financial crash credit controls have been introduced in some countries that have not led to more credit flowing to the productive economy. The authors point out the obvious explanation, that these controls were not designed to do this, their purpose was to stabilise the economy following the crash. But they are very fair and balanced in pointing out this lack of correlation in the data. Indeed, one of their conclusions is that further research is needed.
Notwithstanding their caution, I found the presentation of all this empirical evidence highly exciting. In my post 3 weeks ago I made the point that until the early ‘80s regulation prevented banks from offering mortgages, which were offered instead by mutual associations (e.g. building societies in the UK), and suggested that we need to return to such arrangements. This is exactly the kind of conclusion pointed to by this paper. Indeed, the paper confirms several assertions made in this blog, such as that extending credit for the purchase of financial assets simply has the effect of inflating asset prices (see page 7 of the paper, and compare to here, here or here).
And of course, the single focus of this paper is the conclusion I presented 3 weeks ago, cited above. For me the excitement is not primarily that the paper specifically confirms one of the conclusions I had reached myself, but rather the extent of evidence they present for this conclusion.
Most mainstream economics is driven by ideological beliefs rather than empirical evidence. This paper draws on a large number of empirical studies, all listed in the references, adding uncontrollably to my reading list! As well as the argument being incontrovertibly logical, it is backed by solid evidence (although the authors are appropriately cautious in pointing out alternative explanations for the data, the conclusions of the paper are pretty compelling).
This paper is the future of economics: collating the empirical evidence, analysing the data, and then presenting conclusions that are based on economic reality not political ideology. Only when we have such a science of economics can we hope to build an economy that provides enough for everyone.