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Summary

This paper discusses

      (1) whether the government could create directly the amount of new credit judged necessary from time to time to increase the money stock without inflationary effects, and

      (2) whether, at the same time, the commercial banking and financial system could be limited to credit-broking and excluded from credit-creating. 

It summarises some of the arguments for this, outlines a possible approach to doing it, and touches on some of the implications. 

It suggests that making this change could bring important benefits, fiscal and others, and that the repercussions for monetary policy and other aspects of public policy should be manageable without undue difficulty.  It also suggests, for further study, a possible way to introduce the change.

It concludes that the feasibility of this change should be examined seriously.  Given the professional capability now developed by UK monetary institutions, this should be done before a decision is taken whether or not the UK should join EMU and replace sterling with the euro.

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Introduction

“Government financing policy is fundamentally linked to monetary policy.  If the budget deficit could be covered simply by printing money (i.e. at zero interest-rate cost) with no harmful effects on the rest of the economy, it would make sense for the government to use this means.  But it is widely accepted that the monetary consequences of such financing would be harmful to the economy”.[3]

This paper does not suggest that the government should print money to cover the budget deficit, regardless of how large or small the deficit may be.  It accepts that high inflation is harmful.  It supports the UK government’s decision to make an independent monetary authority operationally responsible for monetary control. 

However, it suggests that we ought:

a)   to look afresh at the link between government financing policy and monetary policy,

b)   to consider if it would make sense to change the present method of issuing new money (creating new credit), and

c)   to examine how it might be practicable to do so.

Following the 1998 Bank of England Act, the Bank now has operationally independent responsibility for the conduct of monetary policy.   Responsibility for banking supervision (to protect the interests of bank customers and to promote financial stability) has been transferred to the Financial Services Authority.  And responsibility for issuing and managing the government’s gilt-edged debt (and eventually for the government’s day-to-day cash management) has been transferred to a new Debt Management Office under the Treasury. ^[4]  Thus the Bank’s attention is now concentrated on monetary policy as never before.  Moreover, there has been a marked development in its monetary expertise over the past two decades.  This suggests that, if the public interest and the national interest would be served by changing the present method of credit creation, the Bank now has the expert professional capability to advise on the practicalities, and to implement whatever changes are decided.

The present UK government is committed to modernising the country’s institutions.  The scope for further progress in the field of monetary policy and public finance should be explored before the UK decides whether or not to give up sterling and join the euro - see pp 11-12 below.

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The Present Method of Credit Creation, and a Proposal for Change

At present only a small proportion of the money stock is issued as notes and coins.  Government receives “seignorage” revenue from this.  The net revenue amounts to the annual increase in the value of notes and coins in circulation minus the cost of producing and putting new ones into circulation and withdrawing old ones.  In January 1994 the value of notes and coins in circulation in the UK was £20.5 bn.  Five years later, in January 1999 it was £27.7 bn.  The increase between January 1998 and January 1999 was £1.3 bn., indicating that the annual net revenue to the government from seignorage is running at about that level.[5]

But more than 95% of the continuing growth of the money stock is “printed” by the commercial banking system and other financial institutions.  They put it into circulation as loans to their customers, i.e. as credits issued in the form of interest-bearing debts. ^[6] In the first quarter of 1994 private sector holdings of broad money (M4) were £543 bn.  Five years later, by January 1999, they had risen to £779 bn - an increase of £236 bn.  The annual increase from January 1998 to January 1999 was £52.6 bn.  This indicates that public revenue foregone from this source - i.e. not collected by the government as seignorage for this increase in the money stock - may be running at an annual level of about £50bn.  That would be a significant contribution to total annual government revenue of about £300 bn (£303 bn in 1998 - Financial Statistics, March 1999, Table 2.1A).

The change proposed is as follows.

(1) The government itself should create the amount of new credit judged necessary from time to time by an independent monetary authority, in order to increase the money stock as required without inflationary effects.  The government should “print” it and put it into circulation interest-free as Treasury Credits to public spending programmes.

(2) The banking system should no longer put new credit into circulation.  In other words, banks (and other financial institutions) should become credit brokers and stop being credit creators.

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Arguments For Change

The first argument for the proposed change is that the monetary value of the new credit/money created according to official monetary policy and under official monetary controls should be seen as a “common resource”, i.e. a resource created by society.  It should be treated as a source of public revenue, as notes and coins now are, not as a source of commercial profit.[7]

Second, treating additions to the money stock as a source of public revenue will enable governments to increase public spending (as favoured by the traditional Left), or to reduce taxation and public borrowing (as favoured by the traditional Right), or both.  At present, by allowing the banking system to create new money/credit instead of creating it directly itself, government has to borrow the money at interest from the banking system.  This does not make sense from the point of view of taxpayers and citizens.

Third, issuing most new money/credit in the form of debts, as at present, automatically ensures that the total indebtedness of society rises more or less in step with the money stock.  This rising indebtedness has damaging economic, social and environmental consequences.  Economically, the growing scale of interest payments throughout the economy adds to the cost of everything, including the necessities of life.  This is regressive, in that it bears relatively harder on the poor than on the rich.  It also has a sustained inflationary effect.  Socially it is perverse, in that it systematically accelerates the transfer of money from poor to rich individuals and localities (and countries) and widens the gap between them.  (The poor, who have less money, have a greater need to borrow it and pay interest, while the rich, who have more money, are better placed to lend it and receive interest.)  Environmentally, continually growing financial pressure to earn the money needed to pay off interest on ever-increasing levels of debt speeds up the exploitation of natural resources.

Fourth, using the banking system and bank customers as the channel for putting new money/credit into circulation distorts the economy.  It means that the new money is used to support activities to which banks and bank borrowers give priority.  Channelling public resources towards particular sections of the economy and particular kinds of economic activity is to subsidise them and discriminate against others.  Subsidies should be implemented transparently, as an aspect of public expenditure policy, if and when government judges them to be desirable.

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Proposed New Arrangements

A new method of issuing new money/credit into circulation thus appears to be desirable which will meet those four arguments.  To summarise,

The first part of the proposal is that all new money/credit should be directly issued by the government.[8] 

It should be issued debt-free.  It should consist partly of notes and coins put into circulation as at present via the Bank of England and the commercial banks, with the profit (seignorage) continuing to contribute to public revenue. ^[9]  But the greater part of it, corresponding to the credit currently created by the banking and financial system, should be issued directly by the government in the form of Treasury Credits to government spending programmes.[10]  Treasury Credits would not be issued to the banking system to be on-lent to bank customers as interest-bearing loans.[11]

The increases in the money stock created as Treasury Credits should be strictly and clearly limited to the amounts judged necessary from the point of view of monetary control.  In order to insulate politicians from political pressures to create too much (inflationary) new money in this way, the amount to be created should be decided at regular intervals by an independent money supply authority - as, at present, the Bank of England’s Monetary Policy Committee decides whether interest rates should change.  In fact, the Monetary Policy Committee could take on this new function.

The second part of the proposal is that the banks (and other financial institutions) should no longer be allowed to issue new money/credit?  How are they to be stopped? 

One possible way of stopping them would be to make it obligatory for them to match the liquidity of their liabilities (i.e. their obligations to repay customers’ deposits and savings) with the liquidity of their assets (i.e. their claims to recover what is owing to them).  In other words, sight deposits, overdraft facilities and credit limits which customers can access immediately would have to be matched by assets which banks, etc., can realise immediately, such as cash and their operational deposits with the central bank; whereas savings deposits and other claims which customers can access only after a period of notice would have to be matched by assets which banks, etc., can realise within the same period.  The matching deposits held by banks, etc, with the central bank would be held out of circulation and would earn no interest.  A bank would pay into and draw out of its operational deposit account with the central bank the net daily increases and decreases in the total value of its customers’ sight deposits.[12]

A transitional problem is discussed in the next section.  Two other points should be noted here.

∑   Confining the commercial banks, etc, to credit broking and excluding them from credit creation would probably lead to clearer distinctions than now exist between the payments services, savings services, and loans services which they offer to their customers.  For example, they might need to change the basis on which they now provide overdrafts.

∑   Under the proposed arrangement, monetary regulation of banks and financial institutions and supervision of their solvency and financial stability would be based on the same reserve requirements.  This would contribute to administrative effectiveness, especially now that two different agencies - Bank of England and Financial Services Authority - are responsible for monetary regulation and financial supervision.

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Introduction of the New Arrangements

In January 1999, the value of the banks’ operational deposits with the Bank of England totalled about £250 million, whereas (in the first Quarter of 1999) the value of non-interest-bearing and interest-bearing sight deposits held with the banks by household and corporate customers totalled about £306 bn.[13] How could the banks raise the value of their deposits with the Bank of England by over £300 bn, in order to match the value of the sight deposits held by their customers? To require them to do this by selling interest-earning assets would be retrospectively punitive and unrealistic.

To avoid that effect, the government might decide to enable the banks to start the new arrangements on a new footing.  It might give every affected bank “Transitional Treasury Credits” to the value needed to bring their deposits at the central bank up to, or nearly up to, the new level required.  These Transitional Treasury Credits would be “printed” with, so to speak, a stroke of the pen.  The banks could use them for no other purpose than to match the sight deposits of bank customers.  Their creation would be a one-off measure, based on the sight deposits held by customers with their banks on a specified date, minus the cash and deposits already held by the banks with the central bank on that date. 

The feasibility of this needs to be studied.  If, in the judgement of banking and monetary experts, it was likely to be a practicable solution, without undesirable consequences, credit creation by the banking and financial system could be brought to an end virtually at once - as a “big bang” -  and not have to be phased out gradually over a period of years.

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Government Borrowing

The government’s ability to issue new money/credit of the order of £50bn a year directly in the form of public expenditure, will no doubt reduce the government’s borrowing requirements.  But it will not eliminate them.  Not for many years, if ever, will the National Debt be reduced to zero. 

Short-term fluctuations in the balance between incoming government revenue from taxation and outgoing government expenditure will continue to create short-term revenue deficits that will have to be covered by temporary borrowing.  So far as public investment is concerned, the argument that taxpayers of the future should share the costs of long-term public investment projects with the taxpayers of today will support the case for financing at least some of those investments by long-term loans.  Issues of government stock and National Savings will continue to have significant roles.  Over the course of time, today’s scale and patterns of government borrowing will no doubt steadily change. A long-term trend for interest rates to fall could further reduce the costs of government borrowing.  But there is no reason to suppose that the conversion of banks, etc, from credit creators into credit brokers will introduce problems that the Treasury’s new Debt Management Office and the Bank of England will be unable to handle.

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Monetary Control

“There is no single, ideal structure of monetary policy targets or money market operations...  One of the most fundamental issues is to decide which target to adopt: the quantity of money or its price, the rate of interest.” ^[14]

Currently the Monetary Policy Committee of the Bank of England is required to aim for a target annual inflation rate of 2.5%, and to use short-term interest rates as the main instrument for achieving it.  Turning the banks, etc, into credit brokers instead of credit creators, and arranging for the government itself to issue increases in the money supply directly in the form of Treasury Credits for public expenditure, will not imply any change in the target - the inflation rate.  But it will make it necessary to change the main instrument for achieving it.  It will become a question of deciding what increases to make in the money stock, rather than what changes in interest rates.  Changes in interest rates will then increasingly be influenced by changes in the money stock, rather than vice versa as now.  In other words, the price of money will increasingly be influenced by supply and demand in the market for money, in contrast to the way supply and demand in the market for money are now influenced by administered prices.  (There will no doubt remain decisions about interest rates which the central bank will still have to take, e.g.  about rates at which it will lend to the commercial banks when they require it to do so.  How such decisions on interest rates will interact with decisions on increases in the money stock will be a question that the central bank will have to take into account.)

It must be recognised that the proposal to shift the emphasis from controlling interest rates to controlling increases in the money stock is contrary to the prevailing tendency over the past 25 years.  That has been for monetary policy to move away from direct controls to control of interest rates.  The Supplementary Special Deposit Scheme (or “Corset”), which reintroduced a form of quantitative control in 1973, was abolished in 1980.  In the early 1980s there was extensive debate about whether control of “base money” (the banking system’s holdings of balances at the Bank of England, and notes and coin) might enable the authorities to control the money supply.  But the authorities were not convinced that this could provide as effective a means of monetary control as was provided by the management of short-term interest rates.  Also in the early 1980s it was found that the broad money targets of the Medium Term Financial Strategy gave misleading signals, since the relationship between broad money aggregates (as then compiled) and national income was unstable.  Although by the later 1980s broad money and narrow money were both being used as indicators to guide interest-rate policy, the conventional wisdom today is that the most effective practicable form of monetary control is to regulate the demand for money/credit (and therefore the supply of it) by controlling short-term interest rates.  Alternatives such as monetary base control, direct controls on lending, and reserve requirements are not thought very useful.[15] 

However, today’s conventional wisdom necessarily involves accepting that banks, etc, should be allowed to create over 95% of new money/credit as interest-bearing loans.  That is what needs to be questioned.  The following paragraph suggests that the consequences of questioning it may not raise insuperable difficulties from the viewpoint of monetary control.

In a recent report on “The Transmission Mechanism of Monetary Policy”[16] The Bank of England describes how the interest-rate changes decided by the Monetary Policy Committee feed through the economy and affect various features of it culminating with the inflation rate.  It explains (pp 10-11) how, at present, although the money supply plays an important role in the transmission mechanism,

“it is not, under the United Kingdom’s monetary arrangements, a policy instrument. It could be a target of policy, but it need not be so. In the United Kingdom it is not, as we have an inflation target, and so monetary aggregates are indicators only. However, for each path of the official rate given by the decisions of the MPC, there is an implied path for the monetary aggregates. And in some circumstances, monetary aggregates might be a better indicator than interest rates of the stance of monetary policy.  In the long run, there is a positive relationship between each monetary aggregate and the general level of prices.  Sustained increases in prices cannot occur without accompanying increases in the monetary aggregates. It is in this sense that money is the nominal anchor of the system”.

So, although control of interest rates is currently preferred to control of increases in the money stock as the main instrument of monetary policy, it appears that this need not rule out a shift of emphasis toward the latter.  As the Governor of the Bank of England recently stressed, monetary policy “is a kind of art, not a science; it is an art which can be, more or less, carefully crafted but an art it is, nevertheless”.[17]  If, in response to arguments such as those at pp 3-4 above, and after careful analysis of the feasibility of the change, the government were to ask the Bank of England’s Monetary Policy Committee to use control over increases in the money stock (rather than control over interest rates) as the main instrument of monetary policy, it would surely not find it impossible to develop the carefully crafted art of doing so.[18]

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Parallel Currencies, Quasi-Currencies and Electronic Money 

An opinion increasingly heard is that various new developments are diminishing the power of governments to control the supply of money and the demand for it, whatever instruments they use.  For example, even if the UK does not join the euro, UK citizens are likely to use it for an increasing number of transactions, in the same way as many non-Americans use the $US for overseas transactions, and - within a number of countries - as a parallel currency alongside their own.  At the same time, more and more non-banks, including retailers and credit card and debit card companies, are providing banking services.  It is suggested that these developments, together with electronic money transmission, electronic money storage (as in electronic "purses"), electronic commerce (internet trading), and the increasing use of non-official currencies and quasi-currencies like Air Miles and LETS units, will increasingly lead to the money supply slipping out of the monetary authorities’ control.  So, it is asked, will changing the present way of regulating the creation of credit be like trying to shut the stable door when the horse is already half way through it?

Innovations in the monetary, banking and financial system will obviously continue to affect the way money is used, and its supply and velocity.  Decisions on how much the money stock should be increased will require understanding of these changes and their consequences, just as decisions on short-term interest rates do.  But, for the foreseeable future, two things seem certain.  First, governments will generally continue to be responsible for the official currency, for monetary policy and for public finance.  Second, demand deposit accounts denominated in the official currency will continue to provide the ultimate source and destination for the majority of payment transactions for many years to come.  In other words, the need to manage the creation of new money/credit denominated in official currencies has not been overtaken by the new developments.  So the case for changing the present way of managing it is not invalidated by them.

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Implications for Exchange Rate Policy

The proposed change in the present methods of credit creation is likely to bring about a long-term reduction in the growth of (and probably the actual levels of) government debt and of indebtedness in the economy as a whole.  This could be a factor tending to reduce the level of domestic interest rates.  That, in turn, would have an effect on the exchange rate.[19]

However, this does not seem likely to prompt a need to change the present approach of government and central bank toward exchange-rate policy and external financial flows.  There may be other arguments for making regulatory changes in those areas.  But those do not appear to affect the proposals about credit creation which are the subject of discussion here.

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The Maastricht and Amsterdam Treaties

In the EU, central bank financing of the government is prohibited: central banks are not allowed to provide direct credits to their governments, nor to purchase government securities in the primary market.  Might this rule out the proposal that the government itself should create Treasury Credits as a direct contribution to public expenditure (up to a limit independently authorised as an acceptable increase to the money supply)? The provision in question is Article 101 of the Amsterdam Treaty, previously Article 104 of the Maastricht Treaty. Whatever its intention, its wording does not appear to relate any such proposal.  It is as follows:

“Overdraft facilities or any other type of credit facility with the ECB or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Community institutions or bodies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the ECB or national central banks of debt instruments.”

It says nothing about the direct creation of Treasury Credits by the government itself.

A Proposal for Britain or for EMU?

If Britain - as a member of the European Monetary Union (EMU) - was now replacing sterling with the euro, a proposal for changing the present method of creating new money/credit would have to be addressed to the institutions of the European Union (EU) and the European Central Bank (ECB).  Is the likelihood of Britain joining EMU within the next few years so great that that is the right course to take now?

The professional competence of monetary institutions, as an element of democratic government, is not yet as highly developed in the EU and ECB as it is now in Britain.  A current member of the Bank of England’s Monetary Policy Committee discusses it in a recent paper on prospects for the euro.

“The lack of openness, transparency and accountability written into the statutes of the ECB and reinforced by the ECB’s own operating procedures could yet undermine the viability of the whole enterprise.  From this perspective, it is a pity indeed that the UK is not among the founding members of EMU.  The British ‘common law’ genius for pragmatic institutional design and adaptation, and the example of openness and transparency set by the Bank of England since its independence in June 1997, would have provided a welcome counterpoint to the continental ‘statute law’ approach and the enduring continental tradition of opaqueness and secrecy in monetary arrangements and procedures.”[20]

This suggests that, far from putting the matter off until a decision on joining the euro has been taken, the UK should examine the desirability and the practicalities of a new approach to credit creation, while we have the monetary independence to do so.  If study shows the new approach to be desirable and feasible in the public and national interest, we would then have two options.  If we continued to stay out of EMU, we would be in a position to make the change ourselves.  If, on the other hand, we joined EMU, we would be in a stronger position to support the new approach to credit creation in EMU as a whole.[21] 

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Conclusions

This paper has suggested that the government could itself create directly the amount of new credit judged necessary from time to time to increase the money supply without inflationary effects, and that the commercial banking system would then no longer create it.  It has summarised some of the arguments in favour of this.  It has proposed changes that could bring it about, and discussed some of their implications. 

It concludes that the advantages of the changes might significantly outweigh any disadvantages and difficulties, and that their repercussions for monetary policy and other aspects of public policy could probably be handled without undue problems.  It might be possible to introduce them as a “big bang”, rather than as a gradually phased-in programme.

It also concludes that the desirability and feasibility of this approach  should be seriously studied and discussed before a decision is taken whether the UK should join EMU and replace sterling with the euro.

James Robertson         May 1999

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