Supplying the Economy with Loans as a Condition of Economic Dynamism
An Article in the Compendium of Market-Based Social-Ecological Economics
Key issues in view of the neoliberal crisis:
How can we guarantee employment and fair income?
How can we protect the environment effectively?
How should we shape the economic globalization?
What should the economic sciences contribute?
What must be the vital tasks of economic policy?
How can we legitimize economic policy democratically?
|Table of Contents
In light of the devastations emanating from the ongoing financial and economic crisis, the instrument of money creation may seem as the crucial economic sin. Precisely for that reason it is worthwhile to envisage the original function of this instrument. Since money creation, when focused on qualitative growth, is an essential condition for economic dynamism and social welfare. Therefore, it has to play a key role in the transition from the current neoliberal to a socio-ecological economic system.
2. The Definition of Money
In the modern monetary economy money constitutes, in the broadest sense, all claims that natural and legal persons can assert against an economy within a currency area. Whether a claim has the same and lasting value when asserted beyond the borders of a currency area depends, however, on the exchange rates and the modalities of cross-border money transfers. Within a currency area, for example, the following applies: If a person disposes of 100 Euro in cash or a credit balance of 100 Euro on a bank account, the person is in possession of a claim of such value that he or she can assert at any time against anyone within the currency area offering goods or services. If a person, however, disposes of 100 Euro on a savings account, the claim can be asserted only with a time delay due to the period of notice of such accounts.
Therefore, the modern concept of money includes claims that can be asserted immediately as well as those that can only be asserted after a time delay.
In addition, there are mutual claims between the central bank and the commercial banks within a currency area that arise in the context of the central bank’s monetary policy. These claims, however, are not included in the definition of money as described above.
3. The Money Supply
The management of the aforementioned claims – meaning the management of money in all its forms – is the responsibility of commercial banks. For the purpose of monetary policy governance exerted by the Central Bank, the money within a currency area is subdivided into four different categories of money supply:
4. The Monetary Policy of the Central Bank
With the failure of the Bretton Woods Agreement (see the article Bretton Woods System) and the end of the gold standards an ambiguous development begins: On the one hand, the economic policy powers of the nation states erode due to the gaining of independence of global economic activities conducted by powerful private players, on the other hand, the national central banks, having originated in the nineteenth century, refine their instruments for controlling the monetary economy. These instruments have reached a surprisingly high level of quality, although they can no longer be effectively applied under the prevailing conditions of the neoliberal globalization, at least not in terms of an economic policy aimed at social welfare and environmental sustainability (as a compliment see the article Economic Globalization). More details are covered below in the section Critical Remarks on Neoliberalism.
In democratically constituted countries the monetary policy should ideally be the sole responsibility of a central bank, that is, a central bank should by law be independent of political directives of other bodies. Under these conditions, a central bank can focus its monetary policy objectives solely on the optimal growth of the M3 money supply to primarily stabilize the price level and to adequately supply the economy with loans by taking into account the respective (cyclical) economic condition. For the further understanding it is crucial that a central bank can control the growth of the money supply only indirectly by means of the terms on which it offers central bank money to commercial banks. Depending on the respective economic condition, a central bank can use one of two opposing strategies:
In case of an economic downturn (recession) a central bank should provide greater amounts of central bank money at low key interest rates to the commercial banks to enable them in turn to offer favorable loans for investments and consumption by means of money creation to all economic players (see below). Thereby, the quantity of money in circulation is increased and, at the same time, pressure is created on the general level of interest rates. Rising lending volumes and falling interest rates together exert a stimulating effect on the real economy – but with the risk of rising price levels, which a central bank has to counteract once a downturn turns into an upswing.
In case of an economic upswing (recovery), but no later than during a boom, a central bank should apply the opposing strategy: It should provide lower amounts of central bank money at higher key interest rates to the commercial banks in order to indirectly limit their money creation. As a consequence, the amount of money in circulation will grow more slowly or even shrink (which is rare). Falling lending volumes and rising interest rates will prevent an overheating of the economy, especially the risk of overcapacity, and will have a dampening effect on the rise of price levels.
In order not to be caught by surprise by the economic development, a central bank should adjust its money supply already in advance of the expected development of the gross domestic product (GDP). If a higher production of goods and services is expected, a central bank should offer central bank money at an early stage to prepare the conditions for an increase of the money supply, so that all economic players can be supplied with fresh money (liquidity) by the commercial banks in due time and that a sufficient amount of money is in circulation for the rising number of economic transactions. If a declining production is expected, a central bank should conversely create the conditions for slower growth of the money supply or even for a shrinking money supply.
To determine the M3 money supply (the monetary target) for a future period, a central bank needs to estimate the economic growth, the price increase and the velocity of the money circulation – the latter being the number of payments to be settled within a period. It is essential that the amount of money in circulation must grow in accordance with economic growth and price increase, while the opposite is true for the velocity of the money circulation: If more payments are expected with economic players holding less money in their coffers and, consequently, a higher velocity of the money circulation is expected, the monetary target should be reduced by the expected rate. If fewer payments are expected with economic players holding more money in their coffers and thus a lower velocity is expected, the monetary target must be increased by the expected rate.
Usually a central bank would announce its planned monetary target at the beginning of a period, so that, on the one hand, all economic players can be sure to have access to sufficient amounts of loans at reasonable interest rates and conditions for their planned investments, and, on the other hand, that the limit of the economic investment volume is pointed out to them. This is crucial, because exceeding the limit targeted by a central bank would increase the interest rates due to the incipient shortage of money (deflation of the money supply) and would therefore slow down the devaluation of money or even increase the value of money. Rising interest rates and a deflationary tendency would, however, sooner or later limit the investment opportunities and activities as intended by the monetary policy and secure the economic equilibrium – to the detriment of latecomers. If a central bank misjudges a development and excessively raises the money supply (inflation of the money supply), the interest rates and the monetary value would fall.
5. Assets and Liabilities of the Central Bank
In the course of a central bank’s monetary governance claims arise against third parties (assets) as well as claims from third parties (liabilities).
The assets include
The liabilities include
6. The Monetary Policy Responsibilities of the Central Bank
The entire monetary policy responsibilities of the central bank can finally be summarized in seven points:
All told, the function of the central bank in the modern monetary economy has the effect that the fundamental means of securing the value preservation of money (as the last debtor) is no longer primarily the gold, but the economy as a whole, guaranteed by the quality of the monetary policy, specifically by the degree of independence of the central bank. This development provides unique economic and social benefits: For the first time in economic history a general awareness has emerged for the importance that a stringent national monetary policy has for economic stability and general welfare.
Ever since the last financial crisis, which took its course in 2008, gold is indeed increasingly stockpiled again by central banks worldwide as a fundamental security. The cause of the crisis and the renewed importance of gold reserves lies in the deregulation of financial markets and in the imminent danger of uncontrollable disturbances provoked by negligent and criminal transactions on the capital markets worldwide.
7. The European Central Bank (ECB)
A distinctive feature is the European System of Central Banks (ESCB) which is composed of the European Central Bank, established with the introduction of the Euro in 1998, and the national central banks of the EMU (Economic and Monetary Union) member states. The EMU member states have relinquished several of their powers to the ECB. The so-called euro system exists within the ESCB and is composed of the ECB and national central banks of the euro countries.
The primary monetary policy objective of the ESCB is the stabilization of the price level within the euro zone, measured by the consumer price index that is intended to rise no more than two percent per annum, as laid down in the EC Treaty. Mainly due to the heterogeneity of the euro zone, the two percent target has been missed several times. All other targets, such as the contribution of the ESCB to the economic development, particularly to economic growth and employment, are, in accordance with the EC Treaty, subordinated to the price stability. However, it is shown for years now that the subordinated objectives can not be achieved with monetary policy measures, or can at best trigger a flash in the pan, given the neoliberal conditions of open global markets.
A positive note is that the ESCB is prohibited by the EC Treaty to grant loans to public budgets. A monetary financing of budget deficits by means of the »money printing press« with the risk of hyperinflation should therefore actually be excluded. The government over-indebtednesses within the euro zone, particularly the recent attempts to keep Greece in the euro zone at any price, have unfortunately shown that the treaty texts are not worth the paper they are written on: Under political pressure the ECB is obviously not afraid to buy government bonds of indebted countries against third-rate securities. In addition, I recommend the article EU: Federal Superstate or Confederation?.
8. Money Creation and Destruction Practised by the Central Bank
Money creation is the process of interaction between the central bank and commercial banks by which new money is brought into circulation and, consequently, the money supply is increased. Money destruction is the reverse process by which money is withdrawn from the economic cycle. For an accurate understanding it is crucial to distinguish the function of the central bank from the function of commercial banks.
(To avoid confusion: In the given context the term money destruction does not refer to the routine destruction of damaged notes and coins and their immediate replacement by new notes and coins.)
The central bank regularly creates or destructs central bank money in the course of its autonomous monetary governance to determine the quantity of the monetary base, or, more precisely, to determine the binding monetary base for the control of the money and credit creation practised by commercial banks, and ultimately for the control of M3. The monetary base is comprised of the entire cash and sight deposits of commercial banks on central bank accounts maintained in currency units. Transactions between commercial banks and the central bank are carried out via these accounts, including the purchase of cash that commercial banks bring into circulation in accordance with the demand of non-banks. Moreover, these accounts are used by commercial banks for interbank trading in central bank money to set-off short-term surpluses and deficits against each other.
The central bank deploys two main instruments for its monetary governance: the minimum reserve and the refinancing operations.
The central bank deploys the minimum reserve to demand commercial banks to hold a certain percentage of their customer deposits (liabilities) on a central bank account. Once a month, the absolute amount of the minimum reserve is recalculated and determined for each bank. The minimum reserve is part of the monetary base and continually increases it if interest is allowed and added by the central bank. The ECB, for example, currently requires a minimum reserve ratio (reserve requirement rate) of 2 percent and pays interest on the reserve to disburden the commercial banks. The banks may dispose of the remaining liquidity freely – the remaining 98 percent – either for lending or for temporary deposits on central bank interest accounts. The lower the central bank fixes the reserve ratio, the more free liquidity will remain with the commercial banks and the stronger the M3 money supply will grow due to the money and credit creation practised by the commercial banks. However, the lower the reserve ratio is fixed, the more likely commercial banks are tempted to take on inappropriate business risks at the same time. The opposite effect occurs when the reserve ratio is raised. In short, with the reserve ratio the central bank can indirectly control the M3 money supply as well as parts of the general economic risks of financial transactions. The deposited minimum reserves are inviolable and are excluded from trading with central bank money.
The central bank deploys its refinancing operations to allow commercial banks to acquire additional central bank money – irrespective of their customer deposits – against eligible collateral (assets such as bonds, foreign exchange and precious metals). Because of the minimum reserve, which ties up a part of their customer deposits and liquidity, commercial banks are forced to use the refinancing operations even more extensively – thereby automatically intensifying the controlling effect in accordance with the monetary policy of the central bank. Credit balances from refinancing operations are called excess reserves and are, by themselves, not subject to reserve requirements, thus commercial banks can use them one-to-one to increase their liquidity for further lending to customers. In other words, they can refinance additional customer loans based on the additional central bank money. Conversely, they can deposit excess liquidity as central bank money on central bank interest accounts.
With the medium and long-term refinancing operations (the so-called open market operations) – which have a maturity between one week and three months – the central bank explicitly offers commercial banks the opportunity to either temporarily pledge a specific volume of assets as cover for central bank money credit and pay a certain key interest rate thereon – in this case, commercial banks borrow from the central bank and incur debts – or conversely temporarily pledge excess central bank money against central bank assets and be compensated with a key interest rate thereon – in this case, the central bank borrows from commercial banks and incurs debts.
The short-term refinancing operations (the so-called standing facilities) – which follow the same procedure but have a maturity of only one day and mostly lower key interest rates – can be used by commercial banks at any time on their own initiative and for any volume required. In this case, the credit of central bank money is called marginal lending facility and the investment of excess central bank money is referred to as deposit facility. The key interest rates of the two facilities also form the upper and lower limit of interest rates on the money market, for example for call deposits.
In short, the central bank can indirectly fuel the growth of M3 (expansionary monetary policy) by offering commercial banks to acquire central bank money temporarily credited against pledged assets and the payment of a relatively low key interest rate, or it can indirectly slow down the M3 growth (tight monetary policy) by offering commercial banks to temporarily invest central bank money against central bank assets at a relatively high key interest rate, in other words: to temporarily deactivate central bank money. The key interest rates, which are different for long-term and short-term refinancing operations, at the same time indirectly affect the corresponding levels of interest rates within the economy.
9. Money Creation and Destruction Practised by Commercial Banks
Commercial banks can create money in two ways:
Every purchase of assets and every commercial bank’s customer loan, whether paid out in cash or credited as demand deposits, directly increases the money supply M1 and thus also the aggregate M3. When a customer repays his credit and the debt instrument is dissolved, the money supply is immediately reduced again by the corresponding volume – the money drawn is destroyed again, so to speak, hence the misleading term money destruction. At the same time, however, repayment increases the liquidity of the lending commercial bank, so that it can immediately grant new loans in the same amount, i. e. create money again.
A special feature of commercial banks’ money creation is the so-called money multiplier, whose effect is often misunderstood as black magic or sinful propagation of money. However, the mechanism is easy to understand from what has been said so far:
I start with the misunderstandably-simplified notion that any credit wish would be met unconditionally and drive the amount of money up: If a commercial bank A grants a customer a credit of 1,000 euros, this customer then makes a purchase and pays with the credit, the seller can invest the 1,000 euros at his bank B, whose customer deposits increase by this amount. Bank B’s liquidity growth will then enable it to grant a credit of EUR 1,000 to one of its customers, which the customer can use for a purchase, whose seller can invest the amount at his bank C, and so on and so forth. At some point, the money would end up back at the original bank A, the creation of money would continue indefinitely and would result in an infinitely high total amount of credit and money supply.
In practice, however, there is no infinite increase in money supply because the multiple creation of money is limited by three factors:
In practice, in the above example, Bank B’s liquidity would immediately decrease by 22 percent to 780 euros following the customer deposit of 1,000 euros when assuming a minimum reserve rate of 2 percent (ECB rate) and a realistic cash reserve rate of 20 percent .Bank C’s liquidity growth now amounts to only EUR 780 minus 22 per cent, i. e. EUR 608.40. If you add up all the amounts of the infinite series you only get a total amount of 4545,45 Euro instead of an infinite amount. Accordingly, the money multiplier is reduced from infinity to around 4.54. In addition, as already mentioned, the demand for credit from non-banks is limited by their available collateral and the available economic resources for the sensible economic use of credit.
In general, each commercial bank can only grant loans and create money by means of loans until its free liquidity is exhausted. Although the banks as a whole can, as illustrated, boost the creation of credit by means of the money multiplier – but only to the limits set by the central bank with the instruments of its monetary policy. In practice, the money supply in an economy only increases by the difference between the total borrowing and the total loan repayment. The creation of credit does not entail any macroeconomic risk as long as the commercial banks hedge their loans to such an extent that repayment is still possible in the event of their customers’ insolvency and even in the event of a value decline of the collaterals. Finally, it should be emphasised that the creation of credit, when adequately controlled by the central bank, is a prerequisite for a dynamic economic development and – as long as the economic growth induced is sufficient to meet qualitative criteria – is also a prerequisite for sustainable welfare.
The financial market crisis that took its course in 2008 has impressively demonstrated the devastating consequences that badly hedged loans can have – in this case US mortgage loans. And the crisis has also revealed that it would have been the task of the Federal Reserve System to prevent the value decline of collaterals by means of an adjusted interest rate policy – in this case regarding US real estate. Alan Greenspan, the then highly respected head of the Federal Reserve Bank, has since to live with the fact that he will go down in history as the main causer of the financial market crisis. But the ECB also stood and watched instead of stopping trading in high-risk US securities, in particular regarding the mortgage-backed securities.
10. »Philosophical« Reflections on Money
Money is, in all its forms, a debt security of an economy with risky value stability and redeemability. Whoever accepts money, places a bet on being able to redeem it at any time and with lasting value for goods and services. The redeemability and value stability of money is inextricably linked to the fate of the liable economy.
Money creation is a balancing act along the fine line of inflation that is beneficial to economic progress. Fresh money devalues the entire money supply, while at the same time effecting lower interest rates on loans, promising investments, accelerated economic cycles and rising demand for labor. Those who only consume and do not invest during inflation find themselves on the losing side. Too much fresh money (too much inflation) runs ahead of wage development, creates panic in consumer behaviour, reduces the planning security of investments and ultimately slows down economic cycles and labour demand. A static or shrinking money supply (deflationary monetary policy) by renouncing fresh money secures or increases the value of money with simultaneously rising interest rates, declining credit demand and investment activity as well as declining consumption and ultimately also slows down economic cycles and labour demand. The art of money creation is therefore to continuously increase the money supply to such an extent that all the influencing variables of the economic cycles are always in equilibrium.
Credits are the carrot of economic development. They open up the opportunity for penniless, imaginative capital seekers to convert their intellectual capital into real capital; provide solvent investors with the opportunity to invest their surplus money at interest for their own benefit and, at best, for the common good. Money owners are therefore well advised to keep their cash on hand as low as possible, even under the pillow, if they want to avoid the inevitable depreciation of money. As lenders, they should insist on value stabilising and guaranteed hedging through real assets or guarantees from third parties, also in order to oblige borrowers to make an effort in their projects and to pay interest and repayment on time. As far as lenders’ income from interest is concerned, they should keep both feet on the ground and not expect much more than an inflationary adjustment for their investments in the long term.
11. Critical Remarks on Neoliberalism
First of all, it should be emphasised that the evolutionary development of the monetary system over several millennia represents a unique cultural achievement. The importance of this development is further enhanced by the cross-fertilization of monetary and market principles. The experience we can draw on as a result of this synergy should actually enable us to shape our economic and social future with great confidence. Obviously, however, there is a lack of an accurate assessment of the destructive potential of the enormous financial and economic distortions inherent in the neoliberal free trade doctrine.
The excesses begin with the failure of the Bretton Woods Agreement at the beginning of the seventies of the last century and the subsequent »liberalization« of money and capital markets:
Since then, monetary policy has been increasingly losing its impact because free movement of money and capital creates international competition for the most favourable credit terms. On the one hand, it leaves central banks committed to national or supranational objectives no choice but to grant commercial banks internationally »competitive« conditions for the provision of central bank money and other liquidity. On the other hand, it compels commercial banks and borrowers to relocate their activities to countries with more favourable conditions.
Even more dangerous is proprietary trading between commercial banks, which does not create any added value but can cause major economic damage, especially if it is globally conducted with opaque financial products. The financial market crisis starting in 2008 has clearly demonstrated this threat to the whole world. Instead of engaging in proprietary trading, commercial banks must be urged by financial supervision and their central bank to return to their original banking business: namely, to attract savings deposits from regional customers and to grant the deposits to other regional customers as loans.
In the course of the »liberalisation« of monetary and capital markets the fixed exchange rates also had to be abandoned because rates were now determined primarily by supply and demand on the »liberalised« foreign exchange market. At the same time, this increased the incentives for global currency speculation and made exchange rates the plaything of financially strong speculators. Therefore, the influence of central banks on exchange rates is currently limited to curbing the worst excesses of exchange rate movements with countervailing currency transactions.
Finally, following the money and capital markets, goods and services markets were also »liberalized« step by step. Ever since and due to chaotic currency parities, suppliers compete in international trade on the basis of the US dollar as the »natural« key currency. Accordingly this means, that the natural differences in productivity between competing economies are no longer neutralised by agreed exchange rates. Whoever offers at the lowest dollar price wins the competition. In order to remain competitive, economies are forced to cut their social and environmental standards, triggering a worldwide downward spiral of corresponding devastations. Genuine pricing is replaced by continued dumping.
Concerning the euro-zone, it should be noted that the internal »market liberalisations« are leading to distortions and devastations equivalent to those on the global scale. The euro zone is, in this respect, a neoliberal model zone in which countries with differing levels of productivity and tradition are combined to form open and therefore heterogeneous markets. Heterogeneity increases with each new accession country. Increasing cost pressure from competition in open markets is accelerating the process of concentration of economic capital and economic power, which is one of the causes of high unemployment in the EU and worldwide. The gradual opening up (»liberalisation«) of the labour markets reinforces the imbalance still further: Now, not only can capital be transferred to countries with »cheap« labour in order to achieve the highest returns on capital, but conversely, »cheap« labour can also immigrate to high-wage countries and there undermine the historically developed balance of productivity, wages and purchasing power. Regardless of that, nothing is to be said against the controlled exchange of workers or controlled migratory movements. The only thing to be pilloried is the dominant neoliberal economic doctrine, which stands in the way of the development of productive regional economic cycles. It would require a number of economically independent regions to form the foundation on which supraregional developments and supraregional trade can be based.
The answer to the question “What is to be done?” seems simple in a sober analysis: To demand and promote regional economic autonomy, democratically legitimised, as the foundation for supraregional cooperation of all kinds – in accordance with the principle of subsidiarity, which is still upheld in all EU treaties! In other words, regional autonomy is essential to enable a return to regional resources, the use of which is a prerequisite for diversity, robustness and progress in the world, i.e. ultimately for social and ecological sustainability, meaning full employment and environmental protection. Since equal autonomous regions do everything in their power to shape their relations in such a way as to avoid devastations and instead generate social and ecological returns.
With regard to the exchange rates mentioned above, this means that these must be regularly calculated and agreed between trading partners in such a way that the natural price gap (and thus indirectly the natural productivity gap) is neutralised on average. Competition can then take place on the basis of relative price advantages to induce learning progress and prosperity gains instead of the crowding-out effect caused by neoliberal competion on the basis of absolute price advantages in key currency (US dollar or euro).
With regard to the money and capital markets, this means that under the supervision of the central bank, money and capital movements – especially cross-border transactions – must be focussed on serving the real economy and its foreign trade.
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