Centre for Banking, Finance & Sustainable Development Management School Solutions for Greece –...

Centre for Banking, Finance & Sustainable Development Management School

Solutions for Greece

– other than default, euro-exit or giving up national sovereignty

Richard A. WernerCentre for Banking, Finance and Sustainable Development

University of Southampton Management School

Athens University of Economics and Business

Athens

24 January 2013


2

How did Greece get into trouble?

• We all know, it started by Greece giving up control over its money and joining the euro

• Since then, the ECB has been making monetary policy in Greece.

• What sort of monetary policy did it pursue?

• What is the best way to measure monetary policy?

• What is money?


Textbooks and central banks do not tell us clearly:

“It is much harder to measure than one would have first thought.” (p. 119) Chamberlin and Yueh (2006)

“Although there is widespread agreement among economists that money is important, they have never agreed on how to define and how to measure money” (Miller and Van Hoose, 2004:42)

Today, even the Federal Reserve cannot tell us just what money is:“there is still no definitive answer in terms of all its final

uses to the question: What is money?”

What is Money?


Saving

(Lenders,Depositors)

Banks& other financial

intermediaries= “indirect finance”

Investment

(Borrowers)

Purchase of Newly Issued Debt/Equity = “direct finance”/disintermediation

4

RR = 1%

Textbook View of Banks as Financial Intermediaries

What is the Role of Banks?

Thus when the financial crisis hit, the leading economics models and theories did not include banks as they were not considered important or special.


55

What Makes Banks Special?

But empirically, it had been found that banks are special!

Their function cannot be easily replaced by other financial players or markets.

- Fama (1985) shows that banks must have monopoly power compared to other financial institutions.

- Ashcraft (2005) shows that the closure of small regional banks significantly hurts the local economy.

But economic theory could not explain why.

Here is why.


6

Over 80% of the population thinks that it comes from the central bank or the government.

No money comes from the government.

Only about 3% of the money supply comes from the central bank.

Who creates the remaining 97% of our money supply and who allocates this money?

6

Where Does Money Come From?

Answer: The banks

They are not financial intermediaries but the main creators of money. They have a license to create money out of nothing.

The ‘leading’ economic journals and textbooks are silent on this.


7

Balance Sheet of Bank A

Step 1 Deposit of $100 by customer at Bank A

Assets Liabilities

$100

Step 2 $100 used to increase the reserve of Bank A

Assets Liabilities

$100 $100

Banks Do Not Lend MoneyBanks Do Not Lend Money


8

Step 3 Loan of $9,900 granted, by crediting borrower’s bank account. Where do the £9,900 come from? From nowhere. The borrower is treated as if she/he or the bank had actually deposited the money, but no moneywas deposited or transferred from anywhere else.

Assets Liabilities

$100 +$9,900

$100+$9,900

Banks Do Not Lend Money, They Create it!

NB: No money is transferred from

elsewhere

There is no such thing as a ‘bank loan‘.

Banks create money through ‘credit creation‘.

This is how 97% of the money supply is created.


9

“The actual process of money creation takes place primarily in banks.” (Federal Reserve Bank of Chicago, 1961, p. 3);

“By far the largest role in creating broad money is played by the banking sector ... When banks make loans they create additional deposits for those that have borrowed.” (Bank of England, 2007)

“Over time… Banknotes and commercial bank money became fully interchangeable payment media that customers could use according to their needs” (ECB, 2000).

“The commercial banks can also create money themselves… in the eurosystem, money is primarily created by the extension of credit… ….” (Bundesbank, 2009)

Bank Credit Creation: Not in Economics Textbooks, but Admitted by Central Banks:


Banks are Not Financial Intermediaries

They are the Creators of the Money Supply.

And they decide who gets the money and for which purpose it is used.

This decision shapes the economic landscape.

Banks thus decide over the economic destiny of a country.

Credit creation is the most important macroeconomic variable.

Saving(Lenders,Depositors)

$100

Banks(‘Financial Intermediaries’)=“indirect finance”

Investment(Borrowers)

$99

/

“direct finance”

10

RR = 1%


11

Money is best measured by its credit counterpart (C) which created it.

Financial transactions are not part of GDP.

If we want a link to GDP, we must divide money/credit into two streams:

Credit used for GDP transactions, used for the ‘real economy’ (‘real circulation credit’ = CR)

Credit used for non-GDP transactions (‘financial circulation credit’ = CF)

The Quantity Theory of Credit (Werner, 1992, 1997):

C


-4

-2

0

2

4

6

8

10

12

83 85 87 89 91 93 95 97 99

-4

-2

0

2

4

6

8

10

12

Latest: Q4 2000

YoY %

CR (L)

nGDP (R)

YoY %

The Quantity Theory of Credit (Werner, 1992, 1997)

∆(PRY) = VR ∆CR ∆(PFQF) = VF∆CF

nominal GDP real economy credit creation asset markets financial credit creation

-10

0

10

20

30

40

50

60

70

80

71 73 75 77 79 81 83 85 87 89 91 93 95 97 99 01

YoY %

-10

-5

0

5

10

15

20

25

30

35

40

Latest: H1 2001

YoY %

Nationwide ResidentialLand Price (R)Real Estate

Credit (L)

Real circulation credit determines nominal GDP growth

Financial circulation credit determines asset prices – leads to asset cycles and banking crises


13

Investment credit (= credit for the creation of new goods and services or productivity gains)

Result: Growth without inflation, even at full employment

Case 1: Consumption credit

Result: Inflation without growth

Bank credit creation determines economic growth. The effect of bank credit allocation depends on

the use money is put to

Case 2: Financial credit (= credit for transactions that do not contribute to and are not part of GDP):

Result: Asset inflation, bubbles and banking crises

= unproductive credit creation

= productive credit creation


1414

A significant rise in credit creation for non-GDP transactions (financial credit CF) must lead to:

- asset bubbles and busts- banking and economic crises

USA in 1920s: margin loans rosefrom 23.8% of all loans in 1919to over 35%

Case Study Japan in the 1980s:CF/C rose from about 15% at the beginning of the 1980s to almost twice this share

Credit for financial transactions explains boom/bust cycles and banking crises

CF/C = Share of loans to the real estate industry, construction companies and non-bank financial institutions

12%

14%

16%

18%

20%

22%

24%

26%

28%

30%

79 81 83 85 87 89 91 93

Source: Bank of Japan

CF/C


15

Warning Sign: Broad Bank Credit Growth > nGDP Growth

This Created Japan's Bubble.

-10

-5

0

5

10

15

20

81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

YoY %

Latest: Q3 2011

Excess Credit Creation

Nominal GDP

Broad Bank Credit


16

Out-of-control CF is the problem, creating the Bubbles and Crises in Ireland, Spain

Broad Bank Credit and GDP (Ireland)

-20

-10

0

10

20

30

40

50

60

70

80

90

100

Broad Bank Credit and GDP (Spain)

-10

-5

0

5

10

15

20

25

30

nGDP

nGDP

Broad Bank Credit Growth > nGDP Growth


17

Greece: 1993-2009: over 10% credit growth1995-97: over 20% credit growth2001-2: over 30% credit growth

nGDP

Broad Bank Credit Growth > nGDP Growth

Greece: Credit Creation

-200

-100

0

100

200

300

400

500

81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

-20

-10

0

10

20

30

40

50

Central Bank LLI (L)

Bank Loans (R)

YoY (%)Index

RESEARCH CENTER LTD.

Latest: Oct 2012


18

What happened in 1993/4? And in 2000/1?

• The Bank of Greece was established by League of Nations (Annex to the Geneva Protocol of 1927) in 1928, as a Société Anonyme

• In 1994, the Bank of Greece was made more independent from the government, and monetisation of government policy stopped.

“As of 1994 the Bank of Greece no longer provides finance in any form to the public sector. …prohibition of monetary financing.” (Bank of Greece)

• In 2000, the Bank of Greece was made fully independent from the government, without democratic accountability.

• In 2001, the Bank of Greece became an integral part of the ECB.

• Note: the ECB is independent of and unaccountable to any government or democratically elected assembly in Europe


19

The Great Greek Asset Bubble of 1994-2009

• was created by the policy of excessive credit creation by the Greek central bank and the ECB.

• increased tax revenues and economic growth projections.

• encouraged the government to overspend and undersave significantly

• the bubble was unsustainable – as they always are – and thus would, without fail, result in a banking crisis and a fiscal crisis

• what happened since 2009 has been predictable and was caused by the monetary policy of the central bank and the ECB.


20

Greece: 1995-97: over 20% credit growth2001-2: over 30% credit growth


-200

-100

0

100

200

300

400

500

81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

-20

-10

0

10

20

30

40

50


Bank Loans (R)

YoY (%)Index


Latest: Oct 2012

Independence from govt

ECB control


21

The Solution, as told by the ECB:

• Greece must increase its debts by borrowing more from the IMF/EU/ECB.

• An exit from the euro or full default must not happen.

• Greece must implement deep fiscal and welfare cuts.

• All must tighten their belts.

• The ESM must be established and fiscal policy controlled centrally by the EU/ECB (loss of national sovereignty).

BUT: No policies to stimulate growth and employment!


22

What must happen with shrinking credit creation?

A deepening slump and higher unemployment


-200

-100

0

100

200

300

400

500

81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

-20

-10

0

10

20

30

40

50


Bank Loans (R)

YoY (%)Index


Latest: Oct 2012

Bank credit creation:

-7.2% YoY


23

The same is happening in Ireland, Portugal, Spain & ItalyIreland Liquidity

-200-100

0100200300400500600700800900

100011001200

81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

-20

-10

0

10

20

30

40

50

60

70

80

90

100

110YoY(%)

Latest: Aug 2012

LLI (L)

Index

Bank Loans (R)


Bank credit: -17% YoY

Portugal Liquidity

-150-100

-500

50100150200250300350400450500550600650700750800

81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

-10-5

0510152025303540455055

YoY(%)

Latest: Oct 2012

LLI (L)

Index

Bank Loans (R)


Bank credit: -6.6% YoY

Spain Liquidity

-150

-100

-50

0

50

100

150

200

250

300

87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12

-15

-10

-5

0

5

10

15

20

25

30YoY(%)

Latest: Oct 2012

LLI (L)

Index

Bank Loans (R)


C

Bank credit: -1% YoY

Italy Liquidity

-200

-100

0

100

200

300

400

500

81 83 85 87 89 91 93 95 97 99 01 03 05 07 09 11

-10

-5

0

5

10

15

20

25YoY %

Latest: Oct 2012

LLI (L)

Index

Bank Loans (R)


Bank credit: -0.3% YoY


24

But there is a solution – without costs and fiscal pain, producing a recovery and lower unemployment

• the policy proposal would have reduced government debt and deficits

• it would solve the funding problem in the bond markets

• it would help the banks and increase credit creation without extra costs

• no need for centralisation of fiscal policy or issuance of European gov’t

bonds


2525

How to Create A Recovery After a Banking Crisis: Werner-Proposal of 1994:

A new policy called “Quantitative Easing” = Expansion in Credit Creation = Total Effective Purchasing Power

Richard A. Werner, Create a Recovery Through Quantitative Easing, 2 September 1995, Nihon Keizai Shinbun (Nikkei)


26

Applying this Framework to Solving the European Sovereign Debt Crisis

Werner-Proposal of 2011

Greece, Ireland, Portugal, Spain and Italy need to stimulate economic growth. This means stimulation of credit creation.

Their governments need to save money and reduce borrowing costs.

Bank credit growth needs to expand and banks need a safe way to expand their business and their returns

Here is how all of this can be achieved:

Governments need to stop the issuance of government bonds

Instead of borrowing from the bond markets – who do not create money – governments should fund their borrowing requirements entirely by borrowing from all the banks in their country.


27

Werner-Proposal: The solution that maintains the euro and avoids default

Governments should enter into 3-year loan contracts at the much lower prime borrowing rate.

Eurozone governments remain zero risk borrowers according to the Basel capital adequacy framework (banks are thus happy to lend).

The prime rate is close to the banks’ refinancing costs of 1% - say 3.5%.

Instead of governments injecting money into banks, banks create new money and give it to the governments.


28

　

Ministry of Finance

(no credit creation)

Funding viabond issuance

Fiscal stimulus

Net Effect = Zero

Non-bank private sector　 (no credit creation）　　　　

Fiscal stimulation funded by bond issuance(e.g. : ¥20trn government spending package)

-¥20trn +¥20trn

Why fiscal spending programmes alone are ineffective


29

Non-bank private sector

(no credit creation)

+¥ 20 trn

Bank sector(credit creation power)

Assets　　　　　　 Liabilities ¥20 trn ¥20 trn

MoF(No credit creation)

Funding via bank Loans

Fiscal stimulus

　 deposit

Net Effect = ¥ 20 trn

Fiscal stimulation funded by bank borrowing

(e.g. : ¥20trn government spending package)

How to Make Fiscal Policy EffectiveHow to Make Fiscal Policy Effective


30

Advantages of this Proposal

The proposal will not increase aggregate debt.

Each country remains in charge of and liable for its debts.

No further ECB intervention required or purchases by the EFSF/ESM

The immediate savings will be substantial, as this method of enhanced debt management reduces the new borrowing costs, even below post-ECB-purchase yields (E 10bn in the coming year for Italy alone).

This helps the banking sector, as its core business, to extend credit, is expanded, thus increasing retained earnings.

These can then be used by banks to shore up their capital. Thus there are substantial savings to the taxpayer as new bank rescues become

unnecessary.


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Advantages (II)

This proposal addresses the core underlying problem: slowing growth and the need to stimulate it. The proposal will boost nominal GDP growth – and avoid crowding out from the bond markets.

This is a problem as tight fiscal policy and tight credit conditions slow growth, with bank credit shrinking: Germany (-0.1%), Greece (-3.5%), Spain (-0.5%), Ireland (-14%).

Bank credit extension adds to the money supply. From the credit model we know that the proposal will boost nominal GDP growth – and avoid crowding out from the bond markets.

This increases employment and tax revenues.

It can push countries back from the brink of a deflationary and contractionary downward spiral into a positive cycle of growth, greater tax revenues and falling debt/GDP.


Prime Rate vs. Market Yield of Benchmark Bonds: Portugal

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

Latest July 2012

Source: Thomson Reuters Datastream, ECB

2.00%

4.00%

6.00%

8.00%

10.00%

12.00%

14.00%

16.00%

18.00%

Portugal Prime Rates on Existing Loans to Non-Fin. Crops., Over 5 Year Maturity (%)

Portugal 10y Government Benchmark Bid Yield - Redemption Yield (%)

Portugal 5y Government Benchmark Bid Yield - Redemption Yield (%)


Prime Rate vs. Market Yield of Benchmark Bonds: Spain

1.70%

2.70%

3.70%

4.70%

5.70%

6.70%

Latest July 2012


1.70%

2.70%

3.70%

4.70%

5.70%

6.70%

Spain Prime Rates on Existing Loans to Non-Fin. Corps., Over 1 Year Maturity (%)

Spain 5y Government Benchmark Bid Yield - Redemption Yield (%)

Spain 10y Government Benchmark Bid Yield - Redemption Yield (%)


Prime Rate vs. Market Yield of Benchmark Bonds: Greece

2.00%

12.00%

22.00%

32.00%

42.00%

52.00%

62.00%

Latest: July 2012


2.00%

12.00%

22.00%

32.00%

42.00%

52.00%

62.00%

Greece Prime Rates on Existing Loans to Non-Fin. Corps., Over 5 Year Maturity (%)

Greece 10y Government Benchmark Bid Yield - Redemption Yield (%)

Greece 5y Government Benchmark Bid Yield - Redemption Yield (%)


35

Other solutions exist

Bad debts in the banking system: can be extinguished at zero cost by central bank purchases at face value (and not marking to market). As done by the Bank of England 1914 and Bank of Japan 1945

Central banks should be made accountable to parliaments– This was the lesson from the Bundesbank. Normally it is said that the ECB is a

good central bank, because it is modelled on the successful Bundesbank.

– This is not true. The lesson from the Bundesbank was to make the central bank accountable to parliament – its predecessor was not, and it was one of the most disastrous central banks (Reichsbank).

– The ECB is the revived Reichsbank, unaccountable to parliaments

Bank credit should be monitored to prevent harmful speculative credit creation and encourage productivity (credit guidance – the secret of the success of Japan, Taiwan, Korea and China).


36

Solutions exist

Redesign the banking sector so that it consists of not-for-profit, local banks (like in Germany, public savings and cooperative banks)

The monetary system should be changed: do banks need to be the creators of the money supply?

Local gov’t-owned Savings Banks 42.9%

Large, nationwide Banks 12.5%

Regional, foreign, other banks

17.8%

Local cooperative banks (credit unions)

26.6%


37

China: Government-issued paper money (Kublai Khan)Zero Government Debt, Zero Interest Payments

State Money: Less Debt, Lower Taxes, More Growth, More Equality and Fairness


38

Japan: Government-issued paper money: 1868

太政官

札

Dajōkan

satsu

State-Issued MoneyState-Issued Money


39

Colonial Scrip in North American British Colonies“In the Colonies we issue our own money. It is called Colonial Scrip. …we control its purchasing power, and we have no interest to pay to no one.” (Banjamin Franklin, quoted by Senate Robert Owen, National Economy and the Banking System, Senate document 23, Washington DC: US Gov’t Printing Office, 1939, p. 98)



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Was the War of Independence fought over taxes on tea? (‘Boston Tea Party’)Or over new English legislation forcing colonies to abandon their paper money and use gold and silver?“The Colonies would gladly have borne the little tax on tea and other matters had it not been that England took away from the Colonies money, which created unemployment and dissatisfaction” Benjamin Franklin (as quoted by R. Owen, 1939, op. cit).

Colonial Scrip Banned by Britain (Currency Act 1751 and 1764, forbidding scrip to be designated legal tender and to settle private debt.)


41

1862, President Lincoln signed the First Legal Tender Act“The underlying idea in the greenback philosophy… is that the issue of currency is a function of the government, a sovereign right which ought not to be delegated to corporations.” Davis Rich Dewey (MIT, 1902)

State-Issued MoneyState-Issued MoneyPresident Lincoln issued United States NotesPresident Lincoln issued United States Notes

1863 United States Notes, aka ‘Greenbacks’


42Deutsches Reich: German government-issued paper money



UK: Government-issued paper money: 1914-1928

BritainBritain

1917


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Island of Guernsey: Government-issued paper money‘In 1817, the Island was desperately in need of infrastructure investment, but it was bereft of money. The interest payments alone accounted for most of their tax revenue. They found that they could not bleed any more taxes out of the people and they could not afford to borrow any more money.’



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The standard ‘Federal Reserve Note’

JFK’s 1963 ‘United States Note’:No Fed seal



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This is the terrible thing about interest ... But here is the point: If the Nation can issue a dollar bond it can issue a dollar bill. The element that makes the bond good makes the bill good also. The difference between the bond and the bill is that the bond lets the money broker collect twice the amount of the bond and an additional twenty percent. Whereas the currency, the honest sort provided by the Constitution, pays nobody but those who contribute in some useful way. It is absurd to say our Country can issue bonds and cannot issue currency. Both are promises to pay, but one fattens the usurer and the other helps the People. If the currency issued by the People were no good, then the bonds would be no good either. It is a terrible situation when the Government, to insure the National Wealth, must go in debt and submit to ruinous interest charges at the hands of men who control the fictitious value of gold. Interest is the invention of Satan.”

in The New York Times, December 6, 1921

Thomas Edison:“People who will not turn a shovel full of dirt on the project (Muscle Shoals Dam) nor contribute a pound of material, will collect more money from the United States than will the People who supply all the material and do all the work.


Further Reading:

Basingstoke: Palgrave Macmillan, 2005 New Economics Foundation, 2011


Weitere Details:

München: Vahlen Verlag, 2007 M. E. Sharpe, 2003

Centre for Banking, Finance & Sustainable Development Management School Solutions for Greece –...

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