After my last post on stimulating growth, inspired by the riots, I stumbled across an article on the q-finance website by Richard Werner, the rebel economist from Southampton University. As a layman’s introduction to his ideas on credit and economic growth, it was pretty thought provoking.
Werner is a heterodox (as in, not orthodox) economist whose theories on credit creation and money are proving a major challenge to mainstream economics. He invented the term “quantitative easing” while working on the Japanese banking crisis in the 1990s and his book “New Paradigm in Macroeconomics” has been hailed as a classic in the making. Despite his dubious choice of words, he recently become a Qualified Member of Finance Watch and seems to be working hard to live up to his 2003 Davos billing as a “Global Leader for Tomorrow”.
Here is a summary of the article and a few thoughts about what it could mean for growth:
Werner says mainstream, or neoclassical, economics relies on theories of equilibria and perfect markets that can never exist in real life because of shortages of information, time and money. In most real markets, “short-side” economics prevail, in other words the most constrained side of the market determines the volume of transactions. This confers huge market power on corporate bureaucrats who decide how much to produce. They make decisions for their own benefit not society’s, so the invisible hand does not deliver the social benefits predicted by Adam Smith.
When this is applied to banking, where 95-98% of credit creation is done by private banks, the result is over-lending in booms, under-lending in busts and credit allocation with no regard to growth. This leads to consumer price inflation when credit is used to finance consumption, and asset price inflation when credit is used to fund transactions that do not contribute to GDP, such as those involving real estate and financial assets.
This is what happens now and explains our recurring financial crises and poor economic outlook. It should be contrasted with a situation - which does not yet exist but Werner wants to bring about - in which credit is created mainly for productive use. In his view, if credit were used only to fund activities that contributed to GDP, then it should lead to non-inflationary growth.
Werner’s proposal is to restrict banks so they can only create a tiny amount of "non-GDP" credit, less than the increase in aggregate credit, ie if total credit in the economy increases by 10%, then unproductive loans should make up no more than 10% of the total.
But central banks have apparently ignored Werner’s calls to monitor and control the proportion of GDP vs non-GDP lending by private banks, presumably leaving that to Basel rules and banks themselves. And in times of crisis central banks have relied on interest rate reductions, which are useless because growth depends on the availability of credit not its price, and QE which has failed because it has been used to buy gilts instead of going into the productive economy.
Werner's advice in times of crisis is for central banks to create new money and use this to de-zombify failed banks by acquiring their non-performing loans and buying new bank equity. This would allow failed banks to lend again without increasing national debt.
Overall, it seems intuitively right that some markets fail to serve society because of “short-side” volume constraints that confer excess power to special interests. This seems especially so in finance, supermarkets, energy and utilities where scale economies and barriers to entry are high and producers find it easy to capture the market for their own benefit.
In more fragmented industries - such as personal services, web-design, media, local retail, small scale construction and maintenance - the market seems to work much more as it should, as producers respond both to demand and competition from rival producers.
Government intervention therefore seems more appropriate at a strategic, industrial level, either to address specific cases of market capture, such as in finance, or to favour industries where positive social externalities are ignored, such as job creation, food or energy security, carbon reduction, environmental protection, skills development and R&D.
As Werner says, the self-regulation approach to financial markets based on mainstream economic theory has been discredited by events but is not yet dead in policy makers' minds. His argument is worth making over and over until it replaces the Washington Consensus. Vested political and financial interest will make this a long and difficult shift, but Werner’s ideas on credit creation could play a key part in getting the message across.
There are a few problems, or at least unanswered questions, in the article.
First, with defining GDP. For example, lending for consumption, which Werner says is unproductive and inflationary, is hard to distinguish from lending to support the retail sector, which contributes to GDP. And lending for financial and real estate transactions produces revenue that is part of the finance sector’s contribution to GDP. The boundaries would always be contested, and there is a growing view that GDP has serious shortcomings as a measure of well-being.
Second, is sovereign debt a GDP or a non-GDP activity? Private bank holdings of sovereign debt are a major threat to stability in the Eurozone and a significant source of funding for overstretched governments. If they were considered non-GDP, how would governments replace the funds they currently get from private banks (at near-zero cost to the banks, thanks to Basel risk weight rules)? A serious transition plan would be needed.
Similarly, a huge portion of current private bank assets are “non-GDP” financial and real estate assets. Restricting these to the level of aggregate credit growth, which could be a tiny fraction of the current total, would be hugely dislocating and would need another serious transition plan.
Finally, the idea of Werner-style QE, where central banks create money to rehabilitate zombie banks so they can lend again, looks horribly difficult to implement. It is only worth doing if those banks can be trusted to lend productively but current bank rules ignore productivity completely, focusing mainly on default risk instead. Changing the consensus view might take a generation. Meanwhile, zombie recapitalisations would be seen by the right as unacceptable nationalisation and by the left as unacceptable bail-outs. None of this is easy to achieve.
But perhaps the sea change in regulatory thinking is not so far away. Regulators are already looking at ways to reduce systemic risk with capital surcharges based on size and interconnectedness, among other factors. The Bank of England has considered variable risk weights on certain assets (eg mortgage securities) for the same reason. It would be a short step to extend this thinking to include economic productivity and easily justified if you consider economic failure also to be a systemic risk.
A more extreme approach would be to fully nationalise credit creation in the central bank. This would give central banks full control over the money supply and could be advantageous if inflation becomes a major concern, as seems likely after previous rounds of QE. A quota of new money could be set centrally, with private banks bidding to distribute the new credit. Distribution would still need to be directed to gain the best possible growth benefits, perhaps using the productivity-based capital requirements approach outlined above.
A less interventionist approach would be simply to replace existing capital requirements with a strict overall leverage ratio for banks, who would then be free to create credit where they like regardless of risk and productivity. Banks would set interest rates and lending conditions to maximise profits, automatically channelling credit to the highest returning ventures.
The danger here is that banks might favour high-risk high-reward ventures at the expense of all other businesses, for example lending to financial engineering and leveraged speculation but not to SMEs. If we accept Werner’s view that policy should favour productive over unproductive credit, a tougher approach is called for.
In conclusion, while some of his policies raise questions, Werner's theory about credit sets up a much-needed debate about how credit should be allocated in the economy if we want it to help rather than hinder economic life.