Friday, 8 January 2016

A Swiss solution?

When Swiss banks are in the news it usually concerns hiding clients’ ill gotten gains.

This time it’s because a referendum planned for 2016 may strip them of power to create money leaving Switzerland’s central bank as the sole creator of money.

Whatever Switzerland does won’t directly affect us here in Australia, but it will introduce another policy option as we search for budget sustainability at the Federal level which in turn is a necessary condition for the sustainability of Tasmania’s budgetary position.

There’s a prevailing view that governments and central banks determine how much money circulates in an economy and private banks simply facilitate arrangements between borrowers and lenders.

This is a myth. It may exist in textbooks but not in reality.

Almost all money is created by banks out of thin air. If a credit worthy customer wants a loan, a banker doesn’t need to check his vault to see if there are unlent deposits. He simply sets up two accounts.... one a loan account that will need to be repaid over time with interest and the other a deposit account of equal value ready to be spent. The deposit account is new money that has been created out of thin air.

Bankers confuse people by referring to their cost of funds as if funds are required before lending. The reality is funds are required to balance a bank’s books after lending and subsequent spending of newly created deposits. If the spent funds are redeposited there’s no funding problem. If deposited elsewhere funds may have to be found to settle the transaction with the receiving bank.

In the years preceding the Global Financial Crisis in 2008, credit and as a consequence, new money, increased faster than the real economy. This led to an increase in the price of existing assets particularly houses. Home owners felt wealthier. The wealth effect had some spill over benefits for the real economy as homeowners used their homes as ATMs and spent more. Little was done to discourage this behaviour. Supply and demand was the reason for rising house prices we were assured. Maybe, but it was the supply of credit that determined the demand for houses. What is supposed to stop the supply of credit if banks create money out of thin air?

The Swiss will soon decide if their banks can continue to create money out of thin air or be restricted to lending other people money, which as we’ve noted is something most people believe happens already.

There is no chance of such a referendum here in Australia.

There is also little chance of a unilateral decision to remove banks’ ability to create money.

But there is a chance we can move to a situation where our Reserve Bank can create more money, without the disasters of Zimbabwe or the Weimar Republic being cited as the inevitable outcome.

Central banks around the world have created lots of money with the click of a mouse and swapped the newly created cash reserves for bank assets. These bank bailouts known as quantitative easing were supposed to lead to new lending to help revive economies. It didn’t work for the simple reason that if there are credit worthy customers, banks will create money out of thin air. They don’t need pre existing cash reserves.

Why not allow our Reserve Bank to create cash reserves for the government and allow it get on with much needed infrastructure spending, both physical and social?

Until now the Federal governments has had a self imposed budget constraint to raise funds either by taxation or borrowing before spending.

Why not use money creation powers of the Reserve Bank as a third option? If it’s good enough for private banks....?

Any amounts repaid by us the government to the Reserve Bank could simply be repatriated back to the government because we own the Reserve Bank. In the event the loan was never repaid, forgiven in other words, the effect would be the same. When viewed as one, there are no loans to third parties. It’s just between us. It won’t burden future generations.

Wouldn’t it be a win-win situation for all? Taxes could still be levied to promote equity and efficiency. Government debt could continue to be issued and redeemed to allow for the functioning of the financial system and the conduct of monetary policy. But there would be a third string to the bow, governments creating money for socially and economically responsible projects rather than allowing the sole responsibility for money creation to be in the hands of private banks, which the recent financial crisis has demonstrated is not without significant risks.

The spectre of the debt and deficit disaster quickly disappeared from public gaze when Messrs Abbott and Hockey finally twigged that the only way to rid this country of the alleged crippling government debt was to run large surpluses which in current circumstances means the cure would be worse than the disease. Government surpluses imply private deficits which can only be funded by adding to the already huge pile of private debt accumulated in recent years. Most politicians and commentators don’t understand this simple link.

Money creation is both the cause of, and the solution to many of our problems. The discussion is gradually making it to the mainstream. Prominent economist Adair Turner previously head of the UK equivalent of our banking regulator APRA has lent support in a recently published book to the view that governments creating more money and hence purchasing power would likely lead to better outcomes.

Europeans have experienced more post crisis problems than we. The Swiss have proposed a change. Iceland is reportedly toying with a similar proposal. The governor of Canada’s central bank has also recently floated the possibility of government money creation to help transition their economy.

Complacency and rigid thinking still dominates here. We need to be bolder and more open to understanding our problems. Abandon ways that don’t work and embrace new ideas before our young and disadvantaged needlessly suffer.
(Published in The Mercury 8th January 2016 here )


  1. Do the banks create all money from thin air? During the GFC we were told that our banks had made wholesale borrowings from European banks?

    1. Yes they do.

      The deposits created out of thin air, when spent, may be paid to a customer of another bank.

      In that case the bank will have to adjust its balance sheet. That's when funds from other sources are required. It's not to fund the loan in the first place. If the deposits were spent with a customer of the same bank, then the outcomes for the bank would be different

      The wholesale borrowings are not needed to fund the loan in the first place, but rather as part of an ensuing banking housekeeping exercise. An important difference.

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