by Richard A. Werner
Introduction
Crises Have Disproven Mainstream Neo-Classical Economics
What’s Wrong with Mainstream Economics?
The Reality of Credit Creation: There Is No Such Thing As a Bank Loan
How to Fix the Banking System and Ensure Employment
The Reality of Credit Creation: There Is No Such Thing As a Bank Loan
What are the implications for finance and banking? For small firms, the price of money (the interest rate) is usually less important than the question of whether a loan can be obtained at all. Banks prefer to ration and allocate credit—even in the best of times—because due to the high demand for this useful thing called money, the theoretical market-clearing interest rate would be so high as to leave them with only risky projects, while sensible projects could not service the loans. This explains why interest rates are far less important in the economy than is generally claimed. Instead, the quantity of credit is the most important variable determining growth, asset prices, and exchange rates.
The most important institutional reality that has been neglected by theoretical equilibrium economics is the key function banks perform: they create between 95% and 98% of the money supply. The first and most important form of privatization that has swept the world has been the privatization of the creation and allocation of money, which is implemented by privately-owned commercial banks.
This means that there is no such thing as a “bank loan.” Banks do not lend money. “Lending” refers to transferring control of the lent object to the borrower. If I lend you my car, I can’t drive it at the same time. That’s not what banks do when they issue a “bank loan.” Instead, they are allowed by the current regulatory framework to create new money out of nothing—which is called “credit creation.” The collective decisions of commercial bank staff thus determine how much money is created, who gets the newly created money and to what use it is put.
Mainstream economics assumes that the best possible outcome will be achieved if banks are left alone in making their decisions about how much money should be created, to whom it should be handed over, and for what purpose. But the current crisis has demonstrated that we can’t expect banks’ credit decisions to be in any way beneficial to the overall economy, social welfare, or even the bankers themselves—as Alan Greenspan has now admitted. The incentive structure at banks is such that they tend to create too much credit, when not needed, and for unproductive use. This is followed by banks creating too little money, when more would be needed.
There are some simple rules for sound banking and sound economics that need to be followed. Whenever credit is created and used to increase the amount of goods and services provided, it will result in noninflationary growth; more money comes about, but also more goods and services. Whenever credit is created and used for unproductive purposes, inflation comes about; more money chases limited goods or assets. The unproductive credit creation can take two forms. When credit is extended for consumption, it will result in consumer price inflation. When credit is extended for non-GDP transactions (which means mainly financial and real estate transactions), there will be asset inflation. Both cases are unsustainable and, if sufficiently large, result in banking and economic crises.
In the research experience of this author, this framework (first proposed in a 1992 paper, published as Werner, 1997) delivers the most reliable models for forecasting nominal GDP growth, equity markets, bond markets, and even currencies. Credit used for GDP transactions is the most reliable forecaster of nominal GDP growth. Credit used for non-GDP transactions ends up driving up real estate and asset prices, and ultimately turns into bad debts. It is thus a key variable to watch by policy makers, if one wants to prevent asset bubbles and banking crises, as I have suggested many times in the past two decades. Empirical evidence and further details can be found in the book, New Paradigm in Macroeconomics.
To prevent banking crises, it must be ensured that the bulk of credit creation is used for productive purposes. Specifically, aggregate bank credit for transactions that are not part of GDP (something that can be easily verified by loan officers) needs to be monitored, and suppressed when it rises in excess of overall bank credit growth (see Werner, 1997, 1999). This simple measure would have prevented the credit bubbles in the United States, the United Kingdom, Ireland, Spain, and many emerging markets, which have now burst and caused the current crisis. It would also have prevented the Japanese depression since 1990 or the US Depression of the 1930s, among others. Central banks used to monitor precisely this but, following the deregulation advice of mainstream economics, they chose to abolish their “credit guidance” policies and instead let rip the unproductive bank credit expansions. Ironically, now the UK, French, and German governments want to monitor the allocation of new bank lending (to small firms) policy advice of the kind I have given consistently and repeatedly since 1991, but which was rejected as ‘inefficient interference’ in ‘free markets’. This amounts to closing stable doors when the horse has already bolted.
Thus one also needs to ask why those institutions that could have prevented the bubbles have singularly failed to do so, although they had been given unusually strong powers with little accountability to democratic institutions—the central banks. They cannot feign ignorance: apart from employing the largest number of economists of any institution and spending vast resources on ‘research’ (none of it on the taboo topic of credit creation), I have also contacted many central banks and finance ministries and have in the past twenty years published many articles based on my credit model, warning of pending crises (such as today’s UK banking collapse) and indicating that bubbles and subsequent collapses could easily be prevented by monitoring and restricting speculative (non-GDP) credit creation. Central banks – and governments for that matter – were not interested. This suggests that the very independence and lack of accountability of central banks has been a factor in allowing the creation of credit bubbles and the propagation of the current crisis. Central banks should be made to monitor credit flows and be more directly accountable to democratically elected assemblies for the macroeconomic results.
