Bank Capitalization

“If the banks relinquish risk to the state, they must also relinquish interest in the same proportion.” [1]

Following the banking crisis of 2007 – 9 I read avidly into the question of Debt, Credit and Money Supply. I am particularly indebted to Tony Weekes & Sue Holden [2], Michael Rowbotham [3], and Richard Werner [4] for their clear expositions of the manner in which a very large fraction of our ‘money’ is generated as credit, and its corresponding debt. Their clarity triggered a train of thought in which I re-designed the whole banking system on a more logical and less pernicious basis. Let me explain.

When the owner of a business accumulates more capital than he can usefully employ, he is willing to lend it to friends to enable them to build or acquire plant and the means of producing goods and wealth. The borrower is willing to offer, and (depending on his religion) the lender is willing to accept, a small and regular fee proportional to the outstanding value of the loan, i.e. 'interest'. In a free market where there are numerous independent lenders and borrowers, the level of interest should indicate the real value of the loaned capital. Banks arise as clearing houses to link depositors and borrowers.

Banks are keen to lend at interest, for that is the way they make much of their profit. It soon became clear to banks that (in times of peace and stability) they could lend more money than they strictly owned, for the chance of all the depositors demanding repayment simultaneously was very small. As long as their borrowers eventually paid back all the borrowed money (or forfeited equivalent collateral) they could lend out their capital 5 times over, or 10 or 100 times. Lord Turner suggests [5] that banks should be allowed to lend 5 times as much money as they own, the Swiss bankers suggest 14 times; the risk-takers of Wall Street and the City of London may have dared to go to 30 times, but that seems to have been too far. (I am talking of ratios of capital to total lending of 20%, 7% and 3.3% respectively.) It does seem crazy that there is as yet no agreed ratio of total bank assets to capital held, and no mechanism of insisting that it is adhered to. The old mechanism was to let the over-extended banks fail, and then lock up the board of directors for debt [6]. That worked well enough to inculcate a generation or two of prudent bankers; but it created hardship for thousands of innocent depositors, and governments now-a-days step in and supply the missing money, with the consequence that bankers have become progressively less prudent.

It could be argued that the money that banks lend over and above their own capital, the debt-based money (or credit-based money), is not in any sense the banks’ money, and the interest on it should therefore not be their interest. I am going to argue that it could instead be regarded as a state asset. This is especially reasonable when it is ultimately the state that underwrites the bad debts. Under the present system it can be argued that when a bank makes a loan it takes a risk, and that risk gives it a right to the profit which is the interest; the bigger the risk the higher the interest. But it is the state that ultimately takes the risk. If the banks relinquish the risk to the state, they must also relinquish the interest. On this principle, banks would only keep the interest they earn on the capital they hold; interest they earn on their lending of debt-money must be handed to the treasury. On this basis there would be much less incentive for the banks to over-extend. They would still earn fees on the contracts they draw up; their income would consist of fee income plus interest on their lent capital, but it would not include interest on money they do not own –– which is the current anomalous position.

This rationalization effectively takes from banks the power of generating money and passes it to the government. The banks would be the brokers by which the treasurer generates debt. Fee income suffices for doctors and lawyers, so why not bankers?

Pursuing the argument further we can consider bad debts of two types: [a] when the debt is totally written off, and [b] when there is collateral. For clarity let us suppose that the bank that issued the loan is operating a ratio of capital to total assets of 10%. In case [a] the bank would lose its 10% portion of the loan, while the state loses its 90% portion. The bank would also lose its brokerage fee, as a punitive incentive towards prudent lending. In the case where there is collateral (type [b]), the collateral would revert to bank and government in the ratio 10:90; but the bank would again lose their brokerage fee as a punishment for arranging a ‘bad’ debt. (Or the collateral could revert wholly to the government with the bank being paid its lost capital minus its forfeited brokerage fee).

Note that a ‘bad’ debt with collateral is hardly a bad debt, for the lending bank can end with a more valuable real asset than the virtual debt they created in the first place. They lend money of which they own as little as 10% or even 3%, in exchange for the title-deeds of a real property worth 100%; so of course they are perfectly content to foreclose! This situation can lead to what is called ‘predatory lending’ whereby banks deliberately lend to someone who cannot easily pay back the loan, and where the object is to acquire the collateral; for example, the selling of ‘sub-prime mortgages’. This destructive practice is possible under the present laissez faire system; and indeed it is encouraged by the system, in so far as banks are encouraged to make profit. The cynical onlooker can shrug and say “We cannot stop stupid people signing stupid contacts”. But it is repugnant to the average citizen to see clever people taking money off simpler people in this way; or in any other of the manifold ways currently permitted, practiced, and encouraged by our corrosive financial system. The argument developed above would largely eliminate the problem of predatory lending.

How might this reform of the financial sector be implemented? It would be as simple as the Inland Revenue taxing all lending institution on their interest-income at a rate of not 20% nor 40% nor 50% but in proportion to their capitalization ratio; so at 97% if they are capitalized at 3%, and at 99% if they operate at 1% capitalization. This might seem a very high tax rate, but as argued above, the portion of the interest that I propose to tax in no way belongs to the banks, and letting them keep it seems even more anomalous than claiming it for the Inland Revenue.

References:
[1]  This idea stems from my post of 2011/11/ Debt-and-banks; it was also deployed (2014/8/12) on my IanWest2 blog: "Debt-Money, and the Banking system".
[2]  The Friend, 27 May & 3 June, 2011.
[3] http://www.freewebs.com/whosemoney/gripofdeathchapter1.htm.
[4] http://www.youtube.com/watch?v=wDHSUgA29L
[5]  https://www.theguardian.com/business/blog/2011/oct/12/financial-policy-committee-bankofenglandgovernor
[6]  Overend, Gurney and Co. crashed in 1866, City of Glasgow in 1878.

Werner on GDP and Interest

Werner on GDP and Interest Rates

Lee and Werner have posted a paper  destined for the Journal of Ecological Economics in 2018. According to Lee and Werner there is essentially complete agreement amongst all schools of economic thought, that lower interest rates stimulate economic growth; they extrapolate to a belief that when the Bank of England lowers ‘Bank Rate’ (the overnight rate of interest at which it lends to commercial banks) it is trying to boost growth of the economy. Lee and Werner’s object is to test, against the data, whether low interest rates cause the economy to grow. Of course, they cannot show causation, but they can test whether or not a fall in interest rate precedes a rise in ‘growth’. Their answer is the complete opposite – not only does increased rate of ‘growth’ lead a change of interest rate (rather than lag it), but raised rate of ‘growth’ correlates with a raised interest rate (rather than a fall).

I propose to return to the question of how to determine the growth of the economy, but wish first to consider why the Bank of England tinkers with the base rate of interest on the overnight loans it offers to its commercial bank customers, which we call “Bank Rate” or “Base Rate”. Ostensibly ‘Friedmanite’ central banks such as the Bank of England (BoE) are tasked with maintaining the stability of the currency by controlling inflation at a steady rate of 2%. The Bank of England currently uses two methods to manipulate the purchasing power (in Britain) of the pound (i.e. the cost of the basket of goods in the Consumer Price Index). These are: [i] rate of interest charged on overnight loans from the Bank of England, and [ii] asset purchase (i.e. Quantitative Easing). 

The idea behind the first is presumably the monetarist belief that the quantity of money in circulation directly affects prices; doubling the money will double the price of goods (and halve the value of the money). And of course, money nowadays is mostly credit, rather than coin. I have no idea what volume of business flows into and out of the BoE reserves every night, nor what a commercial bank would do if the BoE said “sorry, you cannot borrow from us this evening.” I imagine that Bank Rate is largely operating as a signal. If Bank rate rises, all the lenders in the country gleefully raise their rates. If the economy stagnates and the Governor fears a recession, he will signal a willingness to encourage lending by lowering base rate. However, when base rate is essentially zero he cannot use that tool to encourage inflation; he turns to Quantitative Easing.

The idea behind Quantitative Easing seems to be as follows. The Treasury issues gilt-edged IOUs at such an interest rate that they do not all get sold. The Bank of England buys (up to 70% of) them, so holding down longer-term interest rates. If the Bank of England buys these ‘assets’ from commercial banks these latter acquire (in exchange) money they can lend out, or reserves at the BoE they can use as surety against extending credit to smaller customers. You might ask where the BoE gets the money with which to buy the Gilts? But remember, it has the power to print notes; so it (therefore) does not need to; it simply gives the liquid asset of digital cash in exchange for the gilt-edged IOU; it can always swap it back again. In many ways QE is simply doing, for longer-term interest rates, what the BoE routinely does for its overnight Bank Rate. But the process injects ‘broad money’ (in the form of credit) into circulation, and that can cause inflation if it gets into the hands of the general public. There can be a delay, of months or years, depending on what the commercial banks do with their new money (sit on it or lend it out); and on whether the general public borrow that money to build factories or fund purchases. But it will eventually cause inflation, unless the BoE swaps back the IOUs it purchased. 

Lee and Werner’s question (whether low interest rates cause the economy to grow) is timely in that there seems to be a growing disconnect between the efforts of the central bank and the performance of the economy. However, the performance of the economy is a preoccupation of the government, and above all of the media. It is not the concern of the BoE which is is focussed on keeping inflation low and stable.

For two centuries Britain has watched the economies of other countries grow faster than its own. This growth represents capital accumulation and in its early phase is logarithmic (auto-catalytic). It is usually measured as gross domestic production (GDP), which is a compilation of all the incomes of all the people in an economy, expressed in the local currency. If we do not grow as fast as our competitors we loose market share; and we cannot grow as fast because we are no longer in the logarithmic phase of growth. 

Because nominal GDP is expressed in local currency, it reflects not just accumulation of capital, but also inflation. Let us consider a peculiarly simple but quite plausible form of inflation in which, at the beginning of every financial year, all prices and all wages rise abruptly by 5%. The citizens and businesses would be no better off; nor worse off. A bag of flour would cost 105% of what it did the previous year, but citizens would soon realise that their salary would stretch exactly as far as before.  At the end of the year the macroeconomists would note a 5% jump in nominal GDP, but this is not growth – except to ‘the media’. Any sensible discussion of GDP must start by correcting nominal GDP for the change in value of the currency (using e.g. RPI or CPI). (See also my post on Growth; and on Coppola Comment.)

Let us now look at the data of Lee and Werner. They plot the “year-on-year growth” in nominal GDP over a period of 50 years from 1960, presumably taking the published GDP for each 3-month interval and subtracting that of 12-months before (thereby introducing a 6-month offset into the profile; any growth in the 12 months to December 1970 being ascribed to December 1970 and not to June 1970). On the same graph they plot interest rates on 3-month Treasury bills or (on another graph) 10-year government bonds. These interest rates are not simply base rate, but are complex reflections of (a) instantaneous base rate, (b) what the markets think will happen to base rate and (c) what the markets think will happen to inflation over the period of the loan. 

My interpretation of their data is that in all 4 major economies the rate of inflation rises and falls irregularly (but with a tendency towards a 5-7 year periodicity) over the 50 years of the study, causing a similar fluctuation in nominal GDP, and (with a slight lag) the 3-month and 10-year interest rates. Lags are the essence of the over-shoots and under-shoots of the business cycle. If information were instantly available to businesses and bankers, and if the spreading of rumours and building of factories were instantaneous, there would be no business cycle.

(It would be interesting to compare, for each time-point, (i) the 3-month rate, (ii) 10-year rate, (iii) base rate, (iv) inflation rate, and (v) ‘corrected’ GDP growth-rate ascribable to that time-point; but that was not done.)

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‡‡  There are old men in pubs remembering when beer was 20p a pint and their first car cost £600. In 1970 the average house cost £4975 and the average annual wage was £5700 [http://www.independent.co.uk/news/uk/this-britain/1970-vs-2010-40-years-when-we-got-older-richer-and-fatter-2017240.html; https://www.theguardian.com/uk/2004/mar/05/health.drugsandalcohol]. So in 1970 the annual wage was equivalent to 28,500 beers or 9.5 cars, or 1.1 houses.  Today our average annual wage of £25,000 is equivalent to 8,000 beers or 2.5 average cars, or 0.11 average houses.  But these figures do not capture the whole picture, or you might think we were considerably worse off now than in 1970. We work less, live longer, fly to the sunshine for our holidays. We throw away worn clothes and broken umbrellas, and play with our smartphones in front of our flat-screen TVs. I have not met anyone who would prefer 1970 to 2017. Nor would I, even if it meant being young again – I think. 

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★★  If the real (i.e. corrected) GDP of Britain increased 5% on the previous year, what has increased? To simplify, it could be the population, leaving us identically well off on a per caput basis; or we could all work longer days; or (finally) it could be that a new machine makes 110 shirts per diem instead of a mere 100. That new machine could be bought on credit if interest rates were temptingly low. Believing that is easy; proving it is hard.