No such thing as a bank loan says Richard Werner

Emeritus Professor Charles Goodhart, eminent economist addressed an audience of nearly 300 on 5 November at Southampton University at the launch of the world’s first Centre for Banking, Finance & Sustainable Development founded by fellow speaker Professor Richard Werner. It was a memorable occasion and highly significant in giving rarely heard solutions in the current international economic crisis.

Prof Goodhart spoke on the causes of the current economic crisis: a lax monetary policy, a long period of low interest rates and a huge credit expansion, a bet that house prices would always rise, a lack of transparency in lending combined with complexity, and a weakening in bank asset quality. The crisis was not unforeseen but the authorities only had interest rates as a means of control, and in the UK, house price inflation makes no impact on their decisions. The Lehman bank collapse on Sept 15 was a point of ‘sheer panic as near as you can get’. He said that early warning signals are beside the point - what is needed in future are extra instruments ‘to control the cycles in financial leverage’. He said that big crashes such as this one do not happen at times of high inflation.

He did not think that the actual collapse of the ‘house of cards’ was generally triggered by ‘bad behaviour or lack of due diligence’. The sub-prime lending presupposition that house prices will generally rise and fairly rapidly cover the 100% mortgages granted to low earners, was largely true. In the US, borrowers can walk away from their mortgage debt without any future penalty, in the UK the lenders can continue to make claims against them even if they have lost the property.

He said that the banking and financial procedures to be followed to get out of the problem were now clear. On a macro-prudential level the Central Banks should rule for systemic risk and the Financial Services Authority for micro-prudential matters. But no clear new procedure was yet obvious for housing. On an economic level an expansionary policy is needed and he foresaw interest rates in the UK approaching 1% or lower. Timings of the appropriate changes needed, will need to be very carefully gauged due to the ensuing danger of inflation.

Comment: Prof Goodhart did not mention the notable work of economist Fred Harrison in clearly identifying the well-established, 18 year cycle of boom and bust associated with property prices for over 200 years. (See this blog Refs: ‘Harrison’). Harrison advocates that the ‘new procedure for housing’ should be land value taxation which would place a permanent damper on land and real estate price booms.

Prof Werner began with quotations from Alan Greenspan who was for many years the Chairman of the world’s leading central bank - the US Federal Reserve. AG has experienced a profound shock over the past few months as he has admitted that his presuppositions about how banking systems operated have been ‘partially wrong’. Werner said that the intellectual edifice around banking has collapsed due to the current crisis. Deregulation has been the fashionable keyword preached by the IMF and the World Bank to any country enduring one of the many more localized banking crises in recent decades. He said that this policy is in fact a new problem and not a solution.

He enlightened the meeting with ‘What you need to know about credit creation’. Credit creation is the hidden key at the heart of banking which, very strangely, you rarely find in the index of standard economics textbooks. Received wisdom is that banks are a form of broker or a financial intermediary and do not need special regulation. But banks are special, they have monopoly power, they have the legal right to create money. Banks do not issue loans – they create credit, which is different. In physics we have the thermodynamics principle [that nothing can be created out of nothing] but banking is different. A £100 deposit in a bank can be turned into £9,900 to be lent out to a customer. He illustrated by producing a glass of water. He could loan the drink to another person, but banks did not have the same amount of money at the start that they lend out - they create it. JK Galbraith said ‘the process by which banks create money is so simple that the mind is repelled’.

He explained that (following Keynes), credit can be identified in two streams: for the growth of the economy and for financial speculation. Some of the uncontrolled use of credit causes such as a house price bubble with an ensuing crisis.

The solutions to the crisis should not crowd out the private sector thus deepening a recession, but the danger is that taxpayer-funded solutions proposed so far, will do this. He illustrated an alternative way for governments to act by creating credit directly themselves, with a copy of one of the dollar bills that President Kennedy had issued in 1963, which bypassed the Federal Reserve system. Governments/central banks should stop issuing bonds and gilts but issue credit directly into the economy thus avoiding interest costs for future taxpayers.

Comment: Again an extra tool in the fight against speculative property bubbles is land value taxation. Prof Werner seems to be advocating close regulation of what credit is used for, so that for instance, speculative dealing in property is curtailed. But how draconian would the measures be and wouldn’t people find ways round the system?

Land value tax would be an automatic damper – it could be increased if speculation was getting out of hand and lightened if stimulation was needed. It would need to be accompanied by reductions in other taxes and by other measures. (See elsewhere on this Blog and read The Free Lunch – Fairness with Freedom)

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