After Neoliberalism II

Bryan Gould writes: 

Credit Creation for Productive Investment 

The most important of the measures needed to build on a base of improved competitiveness is a second major policy initiative - the provision of sufficient credit for investment purposes. We have grown so accustomed, after nearly four decades of monetarism, to regarding control of the money supply as relevant only to the battle against inflation that we have lost sight of how essential is an accommodating monetary policy if growth is to be secured.

The monetarist approach takes a narrowly focused, backward-looking and static view of the economy; it treats monetary policy as though it were a minefield, and any growth in the money supply as a dangerous beast that must be kept strictly muzzled and leashed.

The consequence is that monetarism has become a recipe for slow growth and high unemployment. As soon as there is any sign of growth, an almost superstitious fear of inflation (which is almost always code for a potential rise in wage levels) dictates that demand must be choked off and job growth restrained. Monetarism looks at only one side of the supply and demand equation; it totally overlooks the potential of a market economy to grow and the importance of liquidity and the availability of investment capital in allowing it to do so - even more surprising when one considers that the proponents of monetarism claim to be the most committed supporters of the “free” market.

In addition to its intrinsically anti-growth stance, monetarist policy requires, through its reliance on higher interest rates as a counter-inflation tool, that the cost of borrowing for investment is forced up and becomes a further barrier to improved competitiveness. Higher interest rates, and the consequently high exchange rate, are a poorly focused and slow-acting counter-inflationary instrument that produces a good deal of collateral damage while addressing a problem that in recessionary times is hardly the top priority. The limitations of interest rates as a tool of macro-economic policy can be clearly seen in the unsuccessful current attempt to use lower interest rates as a stimulus to an economy mired in recession; without help from other elements of policy, bringing down interest rates is, as Keynes observed, like pushing on a piece of string.

But while monetarist theory inhibits us from realising the possibilities of growth, it does not tell us what is really happening in respect of inflation and monetary policy. In the real world, there is virtually no control over the money supply. While the wider economy - and manufacturing in particular - are continually denied the liquidity and investment capital they need in the supposed interests of controlling inflation, there is virtually a private sector free-for-all in terms of credit creation for non-productive purposes.

In this world, the size of and growth in the supply of money is almost entirely within the control of the commercial banks, which are able to create vast volumes of credit at the stroke of a computer key. The interest of the banks is of course to lend as much as possible, and they do so, constrained only by their own need for security if irresponsible lending goes wrong. As a result, bank lending (or, as we should say, bank credit creation) is mainly devoted to lending secured by property, which means in most cases, residential properties which are the most reliable and easily realised form of security.

This is not only damaging in itself, not least in the stimulus it provides to inflation, but it also diverts investment capital away from productive purposes.

Monetarism, in other words, operates so as to shackle the real economy while being scarcely relevant to the real causes of inflation. This is in marked contrast to the approach taken at other times and in other countries. We have focused for so long on restraint and protecting the value of existing assets rather than creating new wealth that we are simply unfamiliar with the thinking that has enabled other economies to use monetary policy and credit creation for productive purposes as essential elements in boosting economic performance.

History provides compelling evidence to support Keynes’ pre-war contention that “there are no intrinsic reasons for the scarcity of capital.” Two of the most striking instances of how credit creation was used, not to inflate the property market for private profit, but to stimulate rapid industrial growth, were the United States at the outbreak of the Second World War, when Roosevelt used the two years before Pearl Harbour to provide virtually unlimited capital to American industry so that the country could rapidly multiply its military capability, and Japan in the 1960s and 1970s, when Japanese industry was enabled by similar means to grow at a rapid rate so as to dominate the world market for mass-produced manufactured goods. Western economists have typically shown no interest in how this was done and are almost totally ignorant of the work of leading Japanese economists such as Shimomura and Kurihara.

More recently, China has used similar techniques to finance the rapid expansion of Chinese manufacturing. The Chinese central bank, under instructions from the government, makes credit available to Chinese enterprises that can demonstrate their ability to comply with the government’s economic priorities in the course of building or buying new capacity. This is admittedly, in principle at least, easier to bring about in a totalitarian regime than in the UK, but in practice there is nothing to stop our government from requiring the central bank, as the Chinese have done, to create cost-free credit for specific (and productive) purposes.

The Bank of England has of course already undertaken quantitative easing on a significant scale, and - interestingly - this has had no discernible influence on inflation. The difference between that exercise and what is now required is that the quantitative easing so far undertaken has merely had the effect of shoring up the banks’ balance sheets, whereas an effective creation of credit for investment purposes would be applied directly to the strengthening of our productive base.

Significantly, the incoming governor of the Bank of England, Mark Carney, has already pointed to this aspect of the policy that enabled Canada (under his watch) to escape most of the adverse consequences of the global financial crisis. He has also indicated his interest in adopting a nominal GDP target rather than inflation as the preferred goal of monetary policy - a suggestion that immediately indicates a non-standard form of monetary policy.

Thinking of this kind is rapidly gaining ground. Leading monetary economists like Adair Turner and Michael Woodford are publicly debating which precise mechanisms of both fiscal and monetary policy would be most effective in raising the level of economic activity; they recognise that the quantitative easing practised so far has failed to focus on this most desirable outcome.

The rationale underpinning such a strategy is a simple one. Whereas a sudden expansion in the money supply would, according to monetarist theory, feed directly into increased inflation, that would be true only when the economy is already fully utilising its productive capacity; as Keynes argued, credit creation will not be inflationary if it results in increased output. As we have seen, orthodox monetarism makes it is all too easy to assume that there are strict limits to that capacity - unfortunately all too true of an economy that is fundamentally uncompetitive.

Where an economy is manifestly operating at less than full capacity, there is no point in restricting the money supply - especially in the matter of capital for investment. What is needed in a recession is a lift in demand so that markets at home expand, coupled with an improvement in competitiveness so that exports are encouraged. In these circumstances, a deliberate policy of investment credit creation would bring a double benefit. It would provide readily available finance to support productive investment and to rebuild a sadly weakened manufacturing base, and at the same time it would encourage a welcome fall in the value of Sterling as the foreign exchange markets recognised that this was a deliberate and long-term goal of policy.

These are both key features of the strategy now being pursued by Shinzo Abe’s government in Japan - a welcome return to the policies that served Japan so well in earlier decades and that are justified - and largely accepted by Japan’s trading partners - on the basis that everyone will benefit from a more buoyant Japanese economy. 

More Helpful Banking 

Policies of this kind would be equally welcome and effective in Western countries if we are to escape from what Paul Krugman calls the “liquidity trap”, but it is important to understand that enlarging the monetary base by itself will do little. What matters is what is done with it. If it simply goes into the banks’ reserves, or is made available so as to boost demand and consumption in an undirected way, it will miss the point. The successful example of other countries is that - to be effective in building a stronger productive base - it must be directed into productive investment.

Sadly, the £16.5 billion of quantitative easing made available by the Bank of England to the commercial banks through the funding for lending scheme has failed to show up in increased lending to the small and medium-sized businesses which desperately need a boost to their available funding. The excuses trotted out for this failure include the age-old claim by British banks that the comparatively low level of their lending to business does not evidence any reluctance to do so, but merely a shortage of demand - or, to put it another way, a shortage of suitable projects on which to lend. But no sense of this can be made unless we know not only how much is available to lend but also - and more importantly - the terms on which the banks are offering to lend.

And that is precisely, of course, what we are not allowed to know. The banks are always very coy about the terms they offer. But, in the absence of information made available by the banks, we are entitled to make some assumptions on the basis of what is known of the long-term attitude of the British banking system to lending to industry.

The information that is available shows that, by comparison with other and more successful economies, our banks lend over a shorter term - repayment, in other words, has to be made faster. This means that the annual repayment costs of bank loans for British firms over the life of the loan are much higher, the adverse impact on cash-flow is therefore more severe, and the need to make an immediate return on investment (and a quick boost to profitability) is much greater.

Annual repayment costs that are several multiples lower than British equivalents are a large part of the reason for the greater amount and ease of bank borrowing enjoyed by businesses in, for example, Germany and Japan, and in the new powerhouses of China, Korea and Taiwan - and that is, of course, why they are able to buy up and make a profit from our failing assets.

This is the fons et origo of the much-lamented British disease of short-termism. Short-term cash-flow or liquidity is at least as important to British firms as longer-term profitability; indeed, it is literally a matter of life and death. It is a factor that both inhibits the willingness to borrow (and therefore the access to essential investment capital) in the first place, and - if the loan is made - greatly increases the chances that it cannot be repaid in accordance with the loan period and terms insisted upon by the banks.

If, as is all too likely, a business borrowing on these terms runs into difficulties before the return on the investment funded by the borrowing becomes available, the news gets worse. British banks, unlike their overseas counterparts, show little interest in the survival of their customers. Their sole concern is to recover the loan and interest payments due to them over the short period specified in the loan arrangement. If that means receivership or liquidation - even if the business had a good chance of survival were the investment plans funded by the loan allowed to proceed - so be it. The banks can congratulate themselves not only on the return of the loan and other payments due to them sooner than if the business had been allowed to survive but also on the money to be made from the disposal of the assets (sometimes to foreign buyers) and the receivership process.

Many people are vaguely aware of these factors but our lack of interest in what makes competitor economies more successful than ours - indeed, our conviction that we have nothing to learn from them - blinds us to these truths.

It is time we opened our minds and demanded better from our banking system. And shouldn’t these decisions in any case be taken in the public interest and not those of self-interested bankers?