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Bank reform will fail without action on credit creation, warns nef

The proposals of the Independent Commission on Banking will not deliver financial stability and economic prosperity because they fail to rigorously analyse or challenge commercial banks’ control over the money supply, according to a new book published by independent think-tank nef (the new economics foundation).

Where Does Money Come From? will be launched at a major conference on 29 September 2011 – “Banking: A New Paradigm” – where speakers include Lord (Adair) Turner, Chair of the Financial Services Authority and Professor Charles Goodhart, former member of the Bank of England’s Monetary Policy Committee, who has written the foreword to the book.

The book argues that the process of money creation, and how new money is allocated within the economy, is widely misunderstood by economists and policymakers, and yet needs to be reformed if future financial crises are avoided.

  • The UK’s money supply is created by commercial banks when they extend or create credit, giving such institutions vast power over our economic destiny
  • This system over-expands the money supply during booms, causing credit bubbles, and reinforces monetary contraction during the bust, causing longer and deeper recession
  • Quantitative easing (QE), as currently practised, is highly ineffective in stimulating new employment and investment
  • There is no strategic regulatory guidance to ensure that commercial bank credit supports productive investment rather than speculation, in contrast to previous practice in the UK, and widespread current practice among our industrial competitors

And yet, the ICB does not examine the implications of the role of banks as creators of new money in its 358 page final report.

Tony Greenham, head of Finance and Business at nef, former investment banker and co-author of the report said: “The Vickers Commission was charged with preventing a repeat of the financial crisis of 2008, but their proposals do not touch the root cause of that crisis: namely, the process of money creation when banks extend credit. How can the ICB expect to prevent another huge credit bubble when they haven’t even asked, let alone answered, the question ‘where does money come from?’. Unless policymakers understand the process of money creation, and ensure that it serves the public interest, we will never get sustained economic growth in the sectors that provide jobs and improve society, and we will always be at risk from financial crisis.”

The book identifies several implications of the power of banks to create new money:

  • The system is inherently unstable because it depends on the confidence of the private banks themselves, and not on interest rates..
  • The government has no direct involvement in the money creation and allocation process, through fiscal policy or otherwise.
  • Banks make the decision where to allocate credit in the economy, but are inherently incentivised to channel new money into property and financial speculation rather than small businesses and manufacturing.
  • Current capital adequacy requirements have not and do not constrain money creation, and are unable to prevent credit booms.

Josh Ryan-Collins, Senior Researcher on Monetary Policy at nef and co-author of the book, said: For too long the general public, policymakers and even economists at the Independent Commission on Banking, have had an incorrect understanding of banks’ role in the economy. Banks do not just take our deposits and lend them out. Rather, the tail wags the dog: banks create deposits when they issue loans. They have a crucial macroeconomic role as credit creators that must be taken seriously in any reforms of our financial and banking system.”

Professor Richard Werner, economist and banking expert at the University of Southampton and co-author of the book, said: “The 2008 crisis was caused by a huge credit bubble, fuelled by investment in property and financial speculation. It seems pretty clear that if we want to avoid future crashes then regulators need to have more control over the credit creation process – both its quantity and quality. The current “hands-off” approach in the UK and US is out of kilter with the way we did things for decades after the Great Depression, and the way that credit is currently regulated in rapidly growing economies across Asia. The UK opens itself to unnecessary risk by failing even to consider this

Related publication

A guide to the UK monetary and banking system.

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