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That private banks should create almost all New Zealand's money supply

Michael Reddell

New Zealand Banking Reform Debate

Victoria University of Wellington

Thank you for the invitation to be here tonight.

It seems unlikely that there will be much of a meeting of minds between Mr Rowbotham and me, but I hope that as we both speak, you - the audience - will come away with a better appreciation of what the real issues are. There are real differences, but some apparent differences can simply reflect the fact that people operating from within different paradigms often end up talking past each other.

Mr Rowbotham stands in a tradition that now has a long history in New Zealand – the Major Douglas inspired Social Credit movement. Perhaps I should own up and say that a relative of mine was the Prime Minister responsible for setting up the 1950s Royal Commission to "examine"/discredit the Social Credit claims. In my time at the Reserve Bank, I've always found it stimulating dealing with the arguments of monetary reformers, Social Credit inspired or otherwise. For me anyway, intelligently countering the arguments of those with whom one disagrees should mean one ends up better understanding the strengths and weaknesses of one's perspective. I've read Mr Rowbotham's two substantial books and they've helped me understand much better what shapes his point of view. It is also clear that he has put a lot of effort into understanding the more "orthodox" perspective.

The organisers have asked me to affirm ‘that private banks should create almost all of New Zealand's money supply'. Can I make three points:

  • First, the views I express this evening are my own, and may not necessarily be shared by all my senior colleagues at the Reserve Bank,
  • Second, some advertising I've seen for this event - notably a poster in Unity Books - has me affirming that foreign banks should create our money supply. Can I stress that I am entirely indifferent whether banks operating in New Zealand are locally-owned or foreign-owned. I suspect that Mr Rowbotham would agree that the real points at issue have nothing much to do with the nationality of the owner of the banks. The credit-creating banks in the UK, for example, are predominantly British-owned.
  • Third, as I shall aim to make clear, my own view would be better expressed in the proposition that "bank credit creation probably does quite a bit of good, and has nothing like the baleful consequences that Mr Rowbotham asserts".

But to turn to the substance of the matter. It is suggested that there is something very wrong about the fact that most of our money supply is bank-created. Clearly, I disagree.

Note that I'm not disagreeing that "money" is bank-created: a bank loan does typically leads to a new bank deposit, and those bank deposits do make up the bulk of our statistical measures of the "money supply". It isn't always so – if I buy your house, my mortgage will probably go up and yours will presumably go down, but in aggregate it is of course true. If there was less borrowing from banks, our measures of the money supply would be lower.

But my sense is that monetary reformers attach far too much importance to money and measures of it - they certainly put far more weight on it than we central bankers do.

Money isn't what delivers the sort of staggering long-term economic growth (and improvement in living standards) we in the West have experienced in the last couple of hundred years. Economic growth is driven by all sorts of things: a country's natural resources, its geography, how forward-looking its people are, and the ability of its citizens and firms to innovate and apply new insights and techniques. My sense is that the monetary system is a distinctly second-order issue – but lets not forget that the wealthiest countries also tend to be those with some of best developed financial markets and easiest access to credit (the UK and the US spring immediately to mind).

Setting aside the longer-term perspective, how much can the economy produce now? That will depend on the number of people, how many of them are ready and willing to work, the technology and know-how we and our companies have. None of those things can be conjured out of thin air. So the question is who gets to use what is produced.

And this is where money and credit fit in. Modern money is just a way of expressing - and transferring - a claim over the things the economy has produced. A $20 note, or $20 in an account at one of the banks, is valuable to me only because I can go out and buy goods with it, either now or in the future. It has no intrinsic worth. And what primarily determines how much I can purchase is what I can sell in the market - my knowledge, experience and skills, my time, or whatever else it is the Reserve Bank pays me for.

If I choose to hold a stash of banknotes under my bed or – more typically - hold some deposits in a bank account, I am simply deferring consumption. I earned the right to consume when I went to work, but am choosing not to exercise that right until later. Perhaps I want a holiday next year, or am saving for a house, or for my retirement. And, like you I expect, I don't want to hold much government-created money – bank notes. Holding wads of banknotes would be a security risk, and those notes don't offer any return either - no interest or no dividends.

Credit is just the flipside of all this. Some of us want to – or need to – consume before we've earned the right to consume the things the economy has produced. Perhaps we need to pay for a university education: there are fees to meet, books to buy, rent to pay, and stomach to fill. We are pretty confident we will earn a good income in time, but we ourselves haven't yet produced anything ourselves. So, with luck, we find someone willing to lend to us - they lend to us in the form of money, but what is really all about is securing some command over resources - goods and services that others are producing.

Or perhaps we've got a great idea for a new business. But new businesses need stock, they need premises, they need advertising, and the proprietor needs to eat as well. Lots of new businesses do fail so it isn't easy to find someone to lend us the money – but perhaps a bank will do so, or perhaps a wealthy uncle might. What they give is the ability to secure the resources (good and services) we need.

Or, Air New Zealand needs to upgrade its fleet. Real resources go into building planes – labour and materials and the capital equipment Boeing or Airbus have to maintain. But the airline hasn't yet earned the income it expects those assets to provide. So it is willing go into debt. Reasonably enough it will expect to pay a price for that.

For most of us, of course, the real prompt to take on serious debt is housing. We get to the age and stage in life when we want to own our own home – we are sick of flatting, sick of renting, want to be able to design our own garden, knock out a wall, or nail the flying ducks to the wall. But we don't have $200,000 in the bank – let alone in cash. We are pretty sure we will go on earning a good income, so we are willing to buy the whole house now (and consume the services it provides). We do so by borrowing most of the purchase price. And a bank, after looking at our future income prospects, will typically be willing to lend us the money.

In effect, the bank gives me an IOU that others will accept, enabling me to have enough of a claim on what the economy has produced to enable me to employ a builder, and he his subcontractors and materials suppliers.

So where do interest rates come into all this? There is a lot of very technical discussion even in the newspapers, about interest rates, financial markets, our Official Cash Rate and all that. But when it is all boiled down, an interest rate is just the price that balances up two things. On the one hand, how willing are people to defer utilising claims they've already built up (in other words, how willing are they to save). And on the other hand, how strongly other people want to spend or invest in advance of earning the income. How much people want to invest will, of course, depend on the profits they expect to earn.

Everything else unchanged:

  • The more the economy is able to produce the lower interest rates will be (the tension between those who want to save and those who want to borrow will be easier to reconcile),
  • The more people come from a "savings culture" (accumulate the cash before you buy), the lower interest rates will be,
  • The more people want to consume ahead of earning the income (put that car or overseas holiday on the mortgage – go ahead treat yourself, the adverts tell us), the higher interest rates will be, and
  • The higher the profits companies see on the horizon, the higher interest rates will be. That might be because real economic prospects have improved, or just because firms and investors have got carried away, listening to too much hyped rhetoric about dot-coms.

To repeat, real goods and services can't be conjured out of thin air - particularly when available resources are pretty much fully employed. There are real choices to be made. There are various ways of making those choices, but there is no getting round the constraints. Bank deposits voluntarily held are simply the counterpart (in the form of people who are happy to hold off consuming) to the debts of the people/firms who want to (or have to) get ahead of themselves (consuming or investing).

And what of bank notes and coins: the little 2 per cent or so of the money supply? Issuing them is good for the government. To the extent people want to hold bank notes, they pay for the privilege of doing so (those notes in your pocket earn you nothing: we get real claims to resources and you get bits of paper). And that is great for the Crown - there even is a school of thought that says it is an efficient way to tax people - but unfortunately there isn't very much demand for notes these days. No one wants to hold any more than they have to: technology has improved and EFTPOS is cheaper and easier.

And as for the scheme that some monetary reformers are pushing - zero or low interest credit from the RB to local authorities – it would change hardly at all the amount of goods and service this economy could produce. It would give local authorities additional command over resources, but at the expense of all the rest of us: prices would have to rise to reduce the amount of real goods and services each of us could purchase with the claims we already had.

Now all this is all well and good when things are reasonably settled. But what if behaviour changes. So as not to be obtuse, lets take Mr Rowbotham's example. What if people en masse decided to borrow less and save more? The cellphones of bank mobile mortgage managers no longer ring, and credit card billings dry up. It is indisputable that if that happened there would be a sharp fall-off in economic activity. Builders' hammers and saws would fall silent, and the tills will no longer ring at Kirkcaldies. Total economic activty would drop, because some whole sectors were geared to meeting the needs of the borrowing classes. This is, incidentally, basically what has happened in the US this year - investment in high tech has dried up and with it activity in that sector. But these effects are not permanent. With less pressure on available resources, interest rates would drop and could keep on dropping until other borrowers came to the party, or until people who had put off consumption decided that perhaps the opportunities were now too good to miss. At the end of the process - and it might take a couple of years – overall lending and the measured money supply would both be lower, but a fully-employed economy would once again emerge.

Fewer people would be operating so far in advance of their income, and fewer people would have their spending lagging behind their income. But would the economy as a whole be worse off? Not obviously so. Would the economy be better off. Again, not obviously so.

Something like the reverse of this occurred in New Zealand in the 1990s. After decades when it had been relatively hard for individuals to borrow easily – to consume ahead of our earnings - in the 1990s we householders went on a bit of a borrowing binge. The amount of goods and services the economy could produce didn't rise just because we all wanted to consume more sooner. To match this unusually strong demand - to encourage some of us to hold off spending or investing – interest rates in New Zealand were relatively high for a long time.

Are we better off us as a result of that borrowing binge? To be honest, I don't know. I suspect our GDP might actually be higher today if we'd all kept in check our desire for the second car, the bigger house, or the winter holiday. Without that pressure, some productive investment opportunities might have gone ahead, that were in fact cancelled or deferred because of the high interest rates. But on the other hand, the people who borrowed presumably took the view that it was worth it to them to enjoy those luxuries now, rather than save up and wait.

So you can imagine that I don't have too much sympathy with Mr Rowbotham's view that it is "a complete contradiction" that the world's richest countries have the highest gross levels of debt. On the face of it, those high gross debt number reflect two things: that those countries have the highest incomes, hence the highest future earnings to borrow against, and second, those countries have a liberalised financial system that allows some of us to be net borrowers and some of us to be net lenders. Not only do those countries have the highest levels of debt; they also have the highest levels of financial assets.

Mr Rowbotham has also been reported as suggesting that the government should limit "how much people can borrow, say to twice their annual incomes for a mortgage". This seems like an odd halfway house to me. Yes, in the mid-1990s that would have left interest rates rather lower than they were, but most money would still be debt-created. We'd be in much the same situation we were ten years ago. I don't recall the Social Credit movement being any keener on bank created money then. How about a debt-free world instead?

I think it is a perfectly plausible option - and it certainly wouldn't be the end of the modern economy as we know it. I wouldn't champion it myself, but as an individual I get uncomfortable with the extent of debt we've all run up - the readiness of many to live on credit. And I've always found adverts urging people to "put the car on the house" bordering on the offensive. Debt is one of those things that has troubled societies, philosophers, and theologians for thousands of years – our own Judeo-Christian tradition was very wary for centuries. Our liberal age operates increasingly in the fond belief that we are better off letting people do as they please. In many areas that is almost certainly true, in other areas society sensibly concludes it isn't – we don't allow slavery, few advocate legalising hard drugs. But these are long-term experiments and we won't know the answers for a long time – I'm not sure we even know how to ask the questions. Many feel better off as a result of liberal access to alcohol or gambling, but for others they can be a terribly destructive trap. Access to credit can be powerfully liberating for some, but debt can be, and is, a trap for others, and most typically for people already near the bottom of the heap.

I want to develop this point precisely to rebut the suggestion that the modern economy is in a perpetual debt trap, and that we must go endlessly on racking up debt (the "grip of death" as Mr Rowbotham so strikingly puts it) to keep ourselves afloat. Being in debt is, by and large, a matter of choice - both for individuals and for the economy as a whole.

A debt-free economy would look different. You and I would still need somewhere to live, but we couldn't take out a mortgage to buy the house. Two things would tend to happen. First, many of us would rent for much more of our lives - and the houses would tend to be owned, and rented out, by older people, or perhaps by pension funds or insurance companies. We might, on average, buy our first house outright at nearer age 45, rather than around 30 which is more common today. In the interim of course, we'd be paying rent. And we'd be building up savings - though typically not with banks because they wouldn't be able to offer any interest if they couldn't put any loans on their books. We'd all probably own more shares, and be exposed to the risk of those. We might also see smart arrangements spring up. I might find a house I like, but I only have enough money saved to buy 20 per cent of it. So I might buy 20 per cent of the house and find an insurance or property company to buy the other 80 per cent. I'd pay them rent, and progressively buy out their share of the house as my savings accumulated.

Both of these are perfectly viable options – although presumably not preferable as there is nothing to stop them happening now. It isn't as though they are less risky schemes: as a renter one is free of the bondage of the mortgage, but in its place one assumes the insecurity of renting. One could take a long lease, but then I'm back with the fixed commitments like the mortgage, and at risk if my income dries up unexpectedly – whether through accident or redundancy.

Instead of being able to borrow when things went unexpectedly wrong, we'd simply have to hold back on the consumption and build up a little nest egg to draw on.

What of businesses? They couldn't borrow either. So they'd have to fund themselves entirely by selling shares. Borrowing and issuing shares are two different ways for firms to fund themselves. But how different would things really be? Individuals would presumably be willing to buy more shares, as bank deposits would not be very attractive at all (a zero return is fine on transaction balances, like notes and coins, but most of us want more than that on our savings). It would mean somewhat reduced flexibility - and perhaps particularly for small businesses who often finance themselves through a mortgage on the proprietor's house.

I suspect that all this would mean lower growth. There is a price for a loss of flexibility, but I don't think the differences would be huge. More than nothing, but it wouldn't make the difference between first and third world living standards.

Recall, growth depends mainly on smart people and smart businesses. And most of the smartest ideas (and the dumbest - like many of the dot coms) are financed mainly from venture capital companies and the share market. Overseas, many firms take on debt rather than issuing more shares simply because of the – sometimes rather odd - way tax systems are designed.

So we could have a debt free prosperous and full employed economy. And it isn't such an alien idea – Islam tries to teach something of the sort, and several countries have tried to implement systems inspired by the sort of vision (I've even tried to help one develop a way of running monetary policy in an interest-free country). Would it be more secure and less stressed? That seems less clear to me. I like the idea of having paid off my mortgage and work hard to clear it – it will be good to know I could work for much less income while I still had my house. But in the debt-free world mightn't people be just as driven to accumulate savings to finally buy the house, as they presently are to service and repay the debt on the house they've bought. Seems to me, much of all this comes down not to debt or financing arrangements, but to how much we want to consume how soon. Would the world be a happier better place if we were all less acquisitive and consumer oriented? Almost certainly. But changing those aspects of human behaviour is rather a big challenge.

But I am confident that a debt-free world would have no more need of zero interest Reserve Bank finance than our current world does. In most circumstances, the consequences – a rise in prices, a debasement of the value of money - would be just a pernicious as it is today.