Paper Review

"Creating Money Out of Nothing?", Quakernomics and Mike King.

Mike King is a science graduate and software engineer with a post graduate qualification in mysticism. Physics is an excellent foundation for all understanding, but at the moment empirical science is only the start point for the understanding of complex human behaviour. The mathematics of neoclassical equilibrium economics has often proved misleading so Mike's studies in mysticism may be an appropriate way to wrestle with animal spirits and the imponderables of economics! Especially when 'mysticism' is defined by Wikipedia as 'aspects of reality, beyond normal human perception' ...

Mike King's paper, creating money out of nothing: the history of an idea, is currently awaiting publication and is an enjoyable & challenging read. A trip through history raises all the intriguing questions about banking which are relevant to our current global predicament. Every student of economics should have a go at answering Mike's question -

Do the commercial banks create money out of nothing?

The underlying theme of the paper describes how an erroneous idea has led to the destruction of the traditional Quaker banking system exemplified by john freame, the founder of Barclays Bank.

Marx - "fictitious monies are merely claims on the banker which never exist" - all the issues which Marx originally raised are particularly relevant to commercial banking -

is commercial banking a class conspiracy?

is there a labour theory of value?

is the State a guarantor of the public interest?

can economics be analysed as unemotional scientific materialism?

All are issues which compound mental indigestion and immediately feed scepticism, and often cynicism, leading to understandable persecution of money lenders.

But does Marx describe the Quaker banking system? 

Schumpeter - "out of nothing" - the words were introduced by Schumpeter but there were two complicating issues which proved difficult to pin down but impossible to ignore in any credible analysis –

wealth creation & economic growth are involved in the sale of credit. Synergies are involved 2+2=5 - neoclassical equilibrium models don't seem to provide us with a growth theory. The sale of credit supports the borrower's skill in executing profitable projects which generate the income stream for growth. Without an income stream the deal is dead, interest cannot be paid and capital cannot be repaid. Profits come from the synergies of the deal, lender & borrower both gain, it is a collaborative effort, a mutual benefit, otherwise nobody would have shaken hands on the exchange deal in the first place.

investment in an unknowable future is also involved in the sale of credit. Time shifts postpone current consumption satisfaction for a promise of an income stream and repayment of the debt in the future. The sale of credit depends on a reciprocal promise to repay bank depositors on demand.

The bankers skill involves selecting investment projects for loans which generate future surpluses. It is a risky business, nobody knows in advance which innovative projects will be successful. For the Quaker bankers this was just like investment in a child's education. Costs now but surpluses later.

But is analysis of future economic growth possible?

Mises - "they do it because they can" - two further issues arise from the words of Mises -

 bad debts are the problem but risk is unavoidable and deals do not necessarily collapse because of fraud. 'Force majeure' is a defence against fraud; a question for the jury to decide. Only when a debt is repaid and the depositors paid on demand, is an honest deal completed.

 trust & confidence are required in any exchange deal about the future. The bankers 'can do it' only because of the reputation they have earned. Their Balance Sheets have to balance; if the delivery promise is broken by the borrower, the lender loses his reserves, if the payment on demand promise is broken, the borrower loses his deposit. Both are accountable for the curse of the bad debt. If either promise is broken there is also a corresponding loss of reputation to borrower & lender, which will erode trust & confidence.

Banking is an intriguing story about an exchange of promises. The Quaker Bankers were ‘commercial’ banks, they lent money to earn a living, to feed the family and educate the kids, to earn a surplus, to increase deposits, and some deposits were payments for services and went into their own personal accounts. This was no longer an effort to replace gold that other people had left with them in safe deposits. This was honest business not fraud, they could only ‘do it’ because of their reputation for profitable selection of projects and depositor trust that their deposits were safe. John Freame’s lending was backed by his reputation for creating wealth by synergies with his customers; he paid the bills with his IOUs, and his customers operated the Gadlys lead smelters and turned the rocks of Halkyn Mountain into valuable lead ingots.

But who do you trust? Would you buy a second hand car from this man? How do you decide?

  Keynes - "oh never mind, I no longer believe all that" or "when the facts change, I change my mind. What do you do, sir?"

"dig holes in the ground" or "more sensible projects"

"idle balances" or "the animal sprits of liquidity preferences"

 "the process is governed by total reserves" or "by a process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method, they not only confiscate, but they confiscate arbitrarily; and while the process impoverishes many, it actually enriches some" - Keynes was an intellectual giant and thought deeply about money. Perhaps, he is remembered for misleading one liners, rather than his insights into human behaviour which qualified his memorable quotes.

Contrary to some popular interpretations, Keynes grasped the complexity of circulating money and trite one liners inadequately described a complex adaptive system -

 loans make deposits but only if deposits are safe. Banks cannot lend what they do not have.

 deposits make reserves but only if investment is in profitable projects. A promise to repay on demand requires a surplus, a profit, an income stream or the bank goes bust.

The Quaker bankers did not try to design the details of the banking system, as Keynes tried to do at Bretton Woods. As dissenters they were excluded from many professions but they earned a reputation for hard work, honesty & thrift and they discovered a lucrative way of co-operating with their customers to produce synergies. Some called it the 3-6-3 system; 3% interest paid on deposits, 6% interest received from loans and on the golf course by 3pm!

But if banks were no longer lending gold, were their promises now backed by their successful reputation for attracting deposits?

Murray N Rothbald - "fake money" - sooner or later rent seeking elites succumbed to bribery & corruption through a perpetual cycle of general taxation, discriminatory taxation, borrowing, borrowing from future generations, printing which inevitably led to inflation & the collapse of fake money. The historical evidence is everywhere -

 coin clipping is perhaps the first manifestation of the disease. 

 moral hazard is a cancer first recognised by English insurance companies in the 17th century and now more widely seen when personal IOU promises are replaced by taxpayer 'guarantees'.

Any Tom, Dick or Harry could attract deposits if there was a taxpayer guarantee. In this way fake money destroyed John Freame's buusiness and with it went the skills in project selection.

Why was the bank of England nationalised in 1945?

De Soto - "the whole financial system is based on the legal privilege given by the state to private bankers" - "bankers have been permitted to make self interested use of demand deposits" -  the manipulation de Soto described embroiled the private bankers into selling cheap credit. Low interest rates benefitted the biggest borrower of all, the state; asset price bubbles proliferated and the risk of bad debts escalated.

The banker's traditional skill was based on wealth creating positive feedback loops -

synergies, co-operation & trusted customers

diversity & portfolio theory

profit chasing & loss cutting

This synergistic system was replaced by the latest coin clipping scheme; a system of financial repression involving -

nationalisation of private money & legal tender laws

administrative regulations & taxpayer guarantees

interest rate manipulation & central planning of monetary policy 

 Like everyone else the Quaker bankers understood the Gold Standard as sensible policy because it acted directly on the problem of coin clipping & money printing. But John Freame also sold credit. His private IOUs backed by the trust & confidence of his reputation for paying depositors on demand, were far more efficient & flexible than gold. And his credit was not fake money, the 'control' of supply was in his Balance Sheet, where loans (assets) had to balance deposits (liabilities) or the bank went bust. This was not 'financial repression' which delivered fake money in abundance.

Is the criticism of commercial banks and fractional reserve banking just a the red herring in the inflation blame game?

Steve Keen - "the fact that these promises by banks to pay are accepted as money in their own right is what makes it possible for banks to expand the money supply by creating a new loan. The new loan creates a debt between the borrower and the bank and it also creates additional spending power. It’s this capacity to create money out of nothing which state policies like Reserve Requirements and Basel rules attempted to control, but the empirical evidence shown in the last chapter shows that these control mechanisms have failed: the banks create as much new money as they can get away with, because, fundamentally, banks create profit by creating debt" - Keen's colourful language generated heated responses.

Paul Krugman led the way, he had impeccable credentials as a Nobel Laureate and a regular column in the New York Times as a platform to promote his policy proposals. The debate was polarised, the experts disagreed; the modern equivalent of Keynes v Hayek. This disagreement is not only a threat to financial stability, it is also a threat democracy itself. With such immense risks and no agreement, should my earnings be available for such contentions experiments?

The debate raised two opposing ideas about the origins of money -

 endogenous money supply - money emerged from the commercial practices of selling credit.

 exogenous money supply - money is controlled by central banks as agents of the state.

The commercial Quaker banks were involved in the endogenous supply of non inflationary money as credit. They did not think in terms of 'control', but, more simply, their Balance Sheets accounting for widgets produced and money created always had to balanced otherwise the banks went bust.

The Fed and Monetary Policy Committee are now involved in the exogenous supply of money through interest rate manipulation, but 'control' is elusive, the global bond markets have an alternative viewpoint.

Is your expert Nobel Laureate any better than my expert Nobel Laureate?

Ann Pettifor - "because the central bank provides cash on demand, there is therefore no limit to the cash, bank money or credit that can be created by commercial banks" - "the truth or falsity of this thesis could affect attitudes to debt, and even the policies of governments" - Pettifor’s work is timely because the issue of usury, default & debt forgiveness is thrown into stark relief in a recession. Here the focus switches to morality, but morality turns out to be elusive.

The usury issue has plagued the history of money & morality. In ‘God and the Money Lenders’, Norman Jones describes how & why attitudes to morality in England changed over a span of just 50 years -

 The Act of Usury 1575 - the Bishops are clear; usury is immoral.

 The Act of Usury 1624 - the Bishops changed their minds; usury is a matter for personal conscience and individual deals.

Did lending at interest to finance the voyages of discovery change attitudes to risk & usury?

New Economics Foundation & Positive Money Website - "allocate money" - "make the confusing world of money much simpler" - these relatively new contributions to the debate, tended to regurgitate two old issues about how money is, or ought to be, supplied to markets -  

calculation by expert committees acting in the public interest

discovery by market deals which satisfy individual customers

The Quaker system was based on earning money; there is now an alternative which allocates money.

What is the difference between earning money by hard work, honesty & thrift and allocating money by printing £ notes 'out of nothing'?

Summary -

In 1911 Irving Fisher produced his Equation of Exchange, MV=PT, the maths must be right but we know to our cost that we cannot measure nor control any of the factors in the equation. Mike King's paper illuminates the debate by focusing on important differences between two reserve theories -

Fractional Reserve Theories - "Risk always exists in fractional reserve banking, and those wishing to avoid risk with their sight deposits have the choice of safe-deposit boxes" - this system involves bailment of existing money, as banks transfer possession but not ownership. The process increases the velocity of circulation and risks illiquidity.

Negative Reserve Theories - "Banks can produce all kinds of paper money substitutes that are backed by savings, they can also produce unbacked paper money substitutes" - this system involves unbacked paper money, fake money, as banks lend out more than deposits. This process can create too much money chasing too few widgets & inflation and risks insolvency.

John Freame traded his promises, not gold. But there was no doubt in his mind about the distinction between fractional and negative reserves. He would not have used such words he would probably have thought about a distinction between risks.

 Fractional reserve banking was a manageable risk; if the loan was still performing there could be a liquidity problem but the Quaker community would step in to help. A lender of last resort ...

Negative reserve banking was a crazy risk, if the loan stopped performing there could be a solvency problem. In such cases the Quaker community would ostracise the bank and exclude the perpetrator who was spoiling the party. It would never happen ...

The interesting issue is that the Balance Sheet valuation process is a snapshot in time of economic activity. There is a dynamic circulation of money as widgets are produced & exchanged but no one stops the juggernaut after every deal to check that the Balance Sheet balances and the valuations are correct. John Freame's decision to lend was based on promises about the future; he looked into the whites of the eyes of his customers and shook hands on a deal, as he desperately tried to find profitable investment projects which produced new widgets. Negative reserves only become visible with hindsight as bad debts proliferated and banks went bust.

This issue encapsulates the dynamic nature of the time shift and of economic growth. John Freame would have been happy with a suggestion that an important source of funds for investment was the sale of credit by banks, which originated not by a direct transfer funds from savers to borrowers, but by a process of simultaneously creating both a deposit and a debt for a borrower without reducing the spending capacity of savers. Thus making a link between changes in money and real economic activity. By financing investment and economic growth the banks became an essential means of endogenous expansion of the money supply. Money and debt were created simultaneously and 'controlled' endogenously by the bookkeeping operations of banks'. No inflation and no lending out more than deposits just sound valuation judgements of loans.

What would the Balance Sheet of a bank which lent out more than deposits look like?

Language and Accounting - a conclusion -

What is the meaning of the words 'created out of nothing'?

How do accountants put a value on the 'created' money on bank Balance Sheets?

These are systemic issues associated with how human beings communicate and behave as they do their deals of choice.

Walter Bagehot (1826-77) wrote about the evolution of the banking system in his book 'Lombard Street' in 1873 - 

 A system of credit which has slowly grown up as years went on, which has suited itself to the course of business, which has forced itself on the habits of men, will not be altered because theorists disapprove of it, or because books are written against it. You might as well, or better, try to alter the English monarchy and substitute a republic, as to alter the present constitution of the English money market, founded on the Bank of England, and substitute for it a system in which each bank shall keep its own reserve. There is no force to be found adequate to so vast a reconstruction, and so vast a destructions and therefore it is useless proposing them.
No one who has not long considered the subject can have a notion how much this dependence on the Bank of England is fixed in our national habits.
The direct appointment of the Governor of the Bank of England by the executive Government would not lessen our evils or help our difficulties. I fear it would rather make both worse.
We must therefore have recourse to feeble and humble palliatives such as I have suggested. With good sense, good judgment, and good care, I have no doubt that they may be enough. But I have written in vain if I require to say now that the problem is delicate, that the solution is varying and difficult, and that the result is inestimable to us all.

Such is the nature of evolved complex adaptive systems buried deep in our social culture? ... 

 Conclusions -

As Bagehot suggests, evolution cannot be unravelled but it can always be speeded up. Perhaps a start is to understand how the Quaker banking system worked and how it was destroyed -

 John Freame's system worked because he earned a reputation for keeping his promise to repay the deposits of savers by diligent selection of profitable investment projects.

 John Freame's system was destroyed by moral hazard introduced when coins were clipped, fiat money became legal tender, central banks were nationalised, deposits 'guaranteed' & taxpayers bailed out insolvent banks. At a stroke the trust & confidence in the bankers skills for hard work, honesty & thrift became irrelevant and the door opened for fraud.

john p birchall

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