For an economy to grow it needs the money supply to expand. That’s the point that those who favour a return to the gold standard overlook. In a static economy with no innovation and which will look the same in a hundred years’ time, a gold standard would do nicely. But in an economy that has this thing called innovation, a gold standard spells permanent depression. This all begs the question: if we need the money supply to grow, whose responsibility should it be to decide how this should happen and by how much? Adair Turner, former chairman of the FSA, has a plan and it involves debt forgiveness and governments funding their spending via the printing press.

Let’s move sideways for one paragraph and pay homage to the late economist called Hyman Minsky. Mr Minsky had theories about debt. He reckoned that there comes a time when debt rises to such high levels that people can only afford to meet their credit obligations by borrowing even more. Such times are followed by a moment of realisation, and then markets crash. These days we refer to such an instant as a Minsky Moment. What is often overlooked, however, is that Minsky also believed debt was essential for growth to occur. See: Debt, do we need it?   So we need debt for growth, but then we get bubbles. That is why a growing economy is like West Ham supporters; it is forever blowing bubbles.

Now return to the main thrust of this article. These days, we have what is called fiat money, that is to say a money supply that is backed by nothing, other than confidence. In a gold standard you can theoretically swap your money for gold or silver. In a fiat system your money is worth money. One pound is worth one pound, nothing else. In such a system banks create money by their lending. Think of it this way. In an economy where there is only one bank, all money either exists in that bank or in notes and coins in circulation. If the bank works out that people like to hold, say, 10 per cent of their money as notes and coins, that means it can afford to lend out an amount of money roughly equal to ten times the amount of notes and coins that it has in its vaults. In the real world, the creation of money is a tad more complex than that, and involves fractional reserve banking. But you get the gist, when banks lend they create money.

It is by the process of banks’ lending that the money supply grows. That is why the credit crisis of 2008 was such a threat to stability. There was a real danger that as banks cut back on lending, as asset prices crashed, and the private sector tried to cut back on its borrowing, the money supply was going to crash out of sight. This is the point that those who thought QE would lead to hyperinflation overlooked. All it was ever going to do was stem the tide of a contracting money supply.

The critics of the current system of fiat money say that since we need the money supply to grow in order for growth to take place, and since money supply growth requires debt, that means the more the economy grows the higher the levels of debts. Lord Adair, who by the way was in the running for taking over at the Bank of England after Mervyn King, is worried about debt. He puts it this way: “In 1960, UK household debt was less than 15 per cent of GDP; by 2008, the ratio was over 90 per cent. Total US private credit grew from around 70 per cent of GDP in 1945 to well over 200 per cent in 2008.” See: Has financial reform been radical enough? 

Here is the idea then. Instead of promoting growth via debt why not promote it via printing more money. In this way you make banks follow much stricter rules on lending, adhere to much higher capital ratios, thereby limiting their ability to create money, but governments fund their spending by printing money. The idea is not new. It was suggested by the economist Irving Fisher during the US Great Depression. His proposal is now called the Chicago Plan. The IMF looked at a similar idea recently. See: The Chicago Plan Revisited 

Lord Turner put it this way: “Some combination of debt restructuring and permanent debt monetization (quantitative easing that is never reversed) will, in some countries, be unavoidable and appropriate.”

It all boils down to this. At the moment money is created by bank lending. Or to put it another way, market forces determine how much money there is via the interaction of demand and supply of money, savings and investment. Under the so-called Chicago Plan, the growth in the money supply is determined by governments. The advantage of this plan is that the money supply can grow without debt. The disadvantage is that without market forces occasionally blanching at debt levels, there is nothing to stop governments getting carried away and creating too much money, spending without the need to balance the books, and then crowding out the private sector and kicking off hyperinflation.

 

© Investment & Business News 2013