The Shortage of Money: A Fallacious Problem

Whether they are implemented in Latin America (1970-90s), in the UK (under Thatcher) or in Greece (since 2012), austerity measures are all justified by the fact that “there is not enough money.” People are told that “there is no alternative,” and that the state needs to implement structural adjustment programs—usually including across-the-board spending cuts—to restore investors’ confidence and to hope for a better future.

What if this shortage of money could be overcome? What if this problem was ultimately the wrong one? What if we could have money for everything we needed?

In her latest book, The Production of Money: how to break the power of Bankers, Ann Pettifor argues that:

  • YES the society can afford everything that it needs,
  • YES we are able to ensure enough money for education, healthcare, sustainable development and the well-being of our communities, 
  • YES we can discard money shortage, contrary to the human or physical (land and resources) ones.

However, one condition needs to be fulfilled: our monetary system should be well-regulated and managed.

To understand how and why, Ann Pettifor takes us back to basics. She starts by defining money as a “social construct based primarily and ultimately on trust”. One of the  reasons why we use money in the first place is because we know that others will accept it in the future; it is the means “not for which we use to exchange goods and services, but by which we undertake this exchange” (Law). Your 100-dollar bill would be worthless if others didn’t accept it. The value of money depends on the “acceptance” of money, i.e. on the trust you and others have in money.

Contrary to popular belief, 95% of (broad) money (i.e. cash and coins + bank deposits) is created by private banks and not by the central bank. When a bank makes a loan to a firm, it creates simultaneously a deposit account from which the firm withdraws the loan. Money is therefore created “out of thin air” when the account of the borrower is credited—i.e. when loans are made. This has two implications:

 

  1. When money is created, so is debt. This debt needs to be repaid. Ann Pettifor uses the example of a credit card  which allows you to purchase goods and services today. The spending (= purchasing power) on a credit card “is created out of thin air”. You will ultimately need to pay back the amount spent plus a pre-agreed interest rate. Money is therefore a promise of a future productive value.
  2. The money supply depends on private borrowers and their demand for loans. Central banks influence (but do not control) the money supply by increasing or decreasing the cost of borrowing with their policy interest rate. Money creation is therefore a bottom-up process rather than a top-down one.

Does this mean that we should create as much money as people want loans?  Of course not. According to Ann Pettifor, there are constraints that make unlimited borrowing impossible: inflation (and deflation). Indeed, if money is not channeled toward productive purposes, the claim associated to it might not be reimbursed. In other words, the promise of a future productive value might not be fulfilled. When there is too much money “chasing too few goods and services”, reflecting over-confidence in the economy, it results in inflation, eroding the value of assets (such as pensions). Similarly, when there is not enough borrowing (either because borrowers need to repay their debts, as it has been the case in Japan and the US right after the last recession, or because the cost of borrowing is effectively too high), reflecting distrust in the ability to repay debt, deflation steps in.

Therefore, as money can be created “out of thin air”, there is no reason to have a shortage of money as long as it is channeled towards productive purposes. An unlimited amount of money can be created for projects that will ultimately result in the production of value, which will allow the repayment of debt. However, the author does not define what “value” or “productive purposes” are, which in my opinion is the main drawback of the book.

Although Pettifor does give some hints by opposing “productive purposes” to “speculative” ones and by associating “value” to the notion of “income, employment and sustainability”, her approach is rather imprecise and in this sense disappointing. To her credit, defining value is a difficult task, especially if we want to define what is valuable to the society as a whole. Pinning down the definition of value is, in my opinion, ultimately a political debate. If one considers that democracies reflect “collective preferences”, it can be said that societies decide through elections on what is most valuable to them at a given point in time.

Unfortunately, the current monetary system does neither enable nor guarantee that money and credit are used for productive purposes. It is characterized by “easy” and “dear” money; the former refers to unregulated and easy access to borrowing, while the latter conveys the idea of expensive borrowing, i.e. with loans charged at high interest rate. The issue with this system is that (1) with unregulated borrowing, money will be used for unproductive purposes, (2) with high interests, debtors will meet difficulties reimbursing their loans. 

Such a system is harmful to society. In the words of Ann Pettifor:

“If rates of interest are too high, debtors have to raise the funds of debt repayment by increasing rates of profits, and by the further extraction of value. These pressures to increase income at exponential rates for the repayment of debt implies that both labor and the land (defined broadly) must be exploited at ever-rising rates. Those who labor by hand or brain work harder and longer to repay rising, real levels of mortgage or credit card debt. It is no accident therefore that the deregulation of finance led to the deregulation of working hours.”

A sound financial and monetary system would precisely have opposite features, with “tight but cheap credit” (Keynes), in which loans are regulated but cheap. “Tight credit” would ensure the soundness and creditworthiness of loans, while “cheap credit”, secures the affordability and thus the repayment of loans.  

Hence, Ann Pettifor makes a remarkable argument by providing an in-depth but accessible insight into the workings of the monetary system and the debates surrounding it. Both economists and non-economists should give it a read.

It is indeed quite astonishing that money, ever-present in our lives, is so poorly understood; even by many economic experts themselves. According to Ann Pettifor, this incomprehension stems from the deliberate efforts of the financial sector to “obscure its activities” in order to maintain its omnipotence. The Production of Money aims at addressing this “crisis of ignorance” by providing an intelligible and comprehensive overview of money in the hope of empowering people against finance’s grip over society.

By Céline Tcheng
Disclaimer: views are my own.

About the Author

Céline grew up between Paris, China and Singapore. After graduating in a Master’s degree in Economics and Public Policy,  she now works for a public policy institution in France. In her free time, she coordinates INET (Institute for New Economic Thinking) YSI (Young Scholars Initiative)’s Financial Stability Working Group and performs with her dance crew “Slash Art”. Her main interests are: macroprudential policy, financial stability, monetary policy. Follow her on Twitter: @celine_tcheng

Hidden in Plain Sight: Illicit Financial Flows

The importance of Illicit Financial Flows (IFFs) in the context of economic development has slowly come to grasp people’s attention. The World Bank defines IFFs as “money illegally earned, transferred, or used that crosses borders.” Since 2006, the Global Financial Integrity (GFI), a Washington, DC-based think tank, has done extensive research on IFFs. Their studies emphasize that the developing world lost $7.8 trillion in IFFs between 2004-2013—whereby $1.1 trillion was lost in 2013 alone. Studies have shown there is a strong correlation between IFFs and higher levels of poverty and economic inequality. The United Nations just passed its first resolution on combatting IFFs, as it is pertinent to achieving the Sustainable Development Goals. This article explores further how IFFs occur, their role in keeping economies from developing—especially in the African continent, and some suggestions to tackle them.

Illicit financial flows are often mistaken as capital flight. This assumption is false because capital flight could be entirely licit. We can group the IFFs in three categories: commercial activities, which account for 65% of IFFs; criminal activities, estimated to be about 30%; and corruption, amounting to around 5%. Trade mis-invoicing is the most common way illicit funds leave developing nations, averaging 83.4%. Trade mis-invoicing means moving money illicitly across borders by misreporting the value of a commercial transaction on an invoice that is submitted to customs. It is carried out by under-invoicing exports and over-invoicing imports. Under-invoicing the value of exports means writing the price of a good as being less than the price actually paid, in order to show reduced profits and then pay less in taxes. Once the good is exported, it will be sold at full price and the excess money will be put in an offshore account. Over-invoicing the value of imports is when the price of a good is listed as being higher than the seller actually intends to charge the client. The excess money is deposited in the importer’s offshore bank account. There is the misconception that IFFs are largely due to corruption when in fact they account only for 5%, as mentioned above. With invoice manipulation of prices, there is no need for bribing anymore.

Another scheme used in IFFs is misreporting the quality or quantity of the traded products and services. According to a report by the United Nations Economic Commission for Africa and the African Union Commission, in 2012, Mozambican records showed a total export of 260,385 cubic meters of timber, while Chinese records alone show an import of 450,000 cubic meters of the same timber from Mozambique. Other strategies consist of creating fictitious transactions (which consists of making payments on goods or services that never materialize), transfer mispricing (which involves the manipulation of prices), and profit shifting (which is popular among corporations looking for favorable tax rates).

 

Role of IFFs in Keeping Economies from Developing

Illicit Financial Flows act as a barrier to economies from developing and achieving the UN Sustainable Development Goals. Illicit financial outflows—facilitated by secrecy in the global financial system—are bleeding developing countries dry. UNCTAD emphasizes that developing countries will need $2.5 trillion every year until 2030 to achieve their goals on health, nutrition, education and the rest. But pledged capital inflows are only around $1.2 trillion. Preventing or even reducing IFFs can fill this funding gap. Seven out of the past 10 years, IFFs were greater than Official Development Assistance (ODA) and Foreign Direct Investment (FDI) given to poor nations.

The IMF estimates that developing nations lose $200 billion from tax revenues per year due to IFFs, while OECD countries lose $500 billion. Specifically, the United States (US) loses $100 billion annually. Tackling IFFs is in the interest of the US. Even though both developed and developing countries are victims of IFFs, developing countries suffer greater losses.

When it comes to most significant volume of IFFs, Asia is leading by 38.8% of the developing world over the ten years of this study. However, when IFFs are scaled as a percentage of gross domestic product (GDP), Sub-Saharan Africa tops the list averaging 6.1% of the region’s GDP.

At the Seventh Joint  Annual Meetings of the ECA Conference of African Ministers of Finance, Planning and  Economic  Development  and  African  Union  Conference  of  Ministers of  Economy  and  Finance  in  March  2014  in  Abuja,  Nigeria, a Ministerial Statement was issued, which states that:

Africa loses $50 billion a year in illicit financial flows. These flows relate principally to commercial transactions, tax evasion, criminal activities (money laundering, and drug, arms and human trafficking), bribery, corruption and abuse of office. Countries that are rich in natural resources and countries with inadequate or non-existent institutional architecture are the most at risk of falling victim to illicit financial flows. These illicit flows have a negative impact on Africa’s development efforts: the most serious consequences are the loss of investment capital and revenue that could have been used to finance development programmes, the undermining of State institutions and a weakening of the rule of law.”

Former South African president Thabo Mbeki stated at a High-Level Panel on IFFs “Africa is a net creditor to the rest of the world.” The amount of IFFs out of Africa were between $854 billion and $1.8 trillion over the period 1970-2008, according to estimates by GFI. There is a campaign to end IFFs, “Stop the Bleeding”, led by Trust Africa Foundation. Mr. Mbeki stressed that Africa can no longer afford to have its resources depleted through IFFs. On the other hand, illicit financial transfers by African elites paint a different picture. It shows that African elites lack confidence in their own economies. Because they have the privilege to go abroad for education and healthcare, they are less likely to invest in their own countries.

Curbing IFFs

When searching the literature on IFFs, the focus seems to be on developing nations, which are the source. However, there is little focus on the destination countries like Switzerland, Ireland, United Kingdom, etc. A paper by GFI titled “The Absorption of Illicit Financial Flows from Developing Countries: 2000-2006”, discusses that there are two types of destinations for money leaving the developing world. These are offshore financial centers and non-offshore developed country banks. The greatest challenge is getting the money back from the destination countries.

The OECD and the Stolen Asset Recovery Initiative (StAR) surveyed frozen assets held by OECD countries and how much of them were returned to the countries of origin . Between 2010 and June 2012, $1.4 billion of corruption-related assets were frozen and only $147 million was returned.

During the Arab Spring, banks and governments froze billions of dollars held by previous leaders along with their associates from Tunisia, Egypt, and Libya. However, following the Arab Spring, only few assets have been returned and the process of recovering stolen assets is very cumbersome. In order to recover stolen assets, there needs to be solid enough proof that these assets were in fact gained through corruption to begin with.

Illicit financial flows is an issue that plagues the developing world. Nations are denied tax revenues that could be geared towards providing necessities, employment, and economic growth. Nations should hold their financial institutions accountable if they participate in tax evasion activities. There is a need for the creation of financial supervision agencies focused on IFFs. Another suggestion would be the development of a global trade-pricing database so that customs officials are not tricked by false prices. Lastly, the Bank of International Settlement should publish data on international banking assets by country of origin and country of destination in order to better comprehend where IFFs are headed.

Written by Mariamawit F. Tadesse

Using Minsky to Better Understand Economic Development – Part 2

The work of Hyman Minsky highlighted the essential role of finance in the capital development of an economy. The greater a nation’s reliance on debt relative to internal funds, the more “fragile” the economy becomes. The first part of this post used these insights to uncover the weaknesses of today’s global economy. This part will discuss an alternative international structure that could address these issues.

Minsky defines our current economic system as “money manager capitalism,” a structure composed of huge pools of highly leveraged private debt.  He explains that this system originated in the US following the end of Bretton Woods, and has since been expanded with the help of  financial innovations and a series of economic and institutional reforms. Observing how this system gave rise to fragile economies, Minsky looked to the work of John Maynard Keynes as a start point for an alternative.

In the original discussions of the post-war Bretton Woods, Keynes proposed the creation of a stable financial system in which credits and debits between countries would clear off through an international clearing union (see Keynes’s collected writings, 1980).

This idea can be put in reasonably simple terms: countries would hold accounts in an International Clearing Union (ICU) that works like a “bank.” These accounts are denominated in a notional unit of account to which nation’s own currencies have a previously agreed to an exchange rate. The notional unit of account – Keynes called it the bancor – then serves to clear the trade imbalances between member countries. Nations would have a yearly adjusted quota of credits and debts that could be accumulated based on previous results of their trade balance. If this quota is surpassed, an “incentive” – e.g. taxes or interest charges – is applied. If the imbalances are more than a defined amount of the quota, further adjustments might be required, such as exchange, fiscal, and monetary policies.

The most interesting feature of this plan is the symmetric adjustment to both debtors and creditors. Instead of having the burden being placed only on the weakest party, surplus countries would also have to adapt their economies to meet the balance requirement. That means they would have to increase the monetary and fiscal stimulus to their domestic economies in order to raise the demand for foreign goods. Unlike a pro-cyclical contractionist policy forced onto debtor countries, the ICU system would act counter-cyclically by stimulating demand.

Because the bancor cannot be exchanged or accumulated, it would operate without a freely convertible international standard (which today is the dollar). This way, the system’s deflationary bias would be mitigated.  Developing countries would no longer accumulate foreign reserves to counter potential balance-of-payment crises. Capital flows would also be controlled since no speculation or flow to finance excessive deficits would be required. Current accounts would be balanced by increasing trade rather than capital flows. Moreover, the ICU would be able to act as an international lender of last resort, providing liquidity in times of stress by crediting countries’ accounts.

Such a system would support international trade and domestic demand, countercyclical policies, and financial stability. It would pave the way not only for development in emerging economies (who would completely free their domestic policies from the boom-bust cycle of capital flows) but also for job creation in the developed world. Instead of curbing fiscal expansion and foreign trade, it would stimulate them – as it is much needed to take the world economy off the current low growth trap.

It should be noted that a balanced current account is not well suited for two common development strategies. The first is  import substitution industrialization, which involves running a current account deficit.  The second is export-led development, which involves  a current account surplus. However, the ICU removes much of the need for such approaches to development. Since all payments would be expressed in the nation’s own currency, every country, regardless it’s size or economic power, would have the necessary policy space to fully mobilize its domestic resources while sustaining its hedge profile and monetary sovereignty.

Minsky showed that capable international institutions are crucial to creating the conditions for capital development. Thus far, our international institutions have failed in this respect, and we are due for a reform.

Undeniably, some measures towards a structural change have already been taken in the past decade. The IMF, for example, now has less power over emerging economies than before. But this is not sufficient, and it is up to the emerging economies to push for more. Unfortunately, the ICU system requires an international cooperation of a level that will be hard to accomplish. Aiming for a second-best solution is tempting. But let’s keep in mind that Brexit and Trump were improbable too. So why not consider that the next unlikely thing could be a positive one?

How the Government Deficit Helps the Economy

When we talk about the government deficit, it’s often in the context of bad news. Whether it’s the cover of Time magazine, appointing us each a strangely precise debt of $42,998.12, or the US Debt Clock webpage, which portrays the debt as some sort of apocalypse countdown, we are meant to fear our government’s excessive spending. Standard economics warns against high deficits out of fear that government spending will “crowd out” private investment. This assumes that, when facing a limited money supply, the government will use up all the savings in the economy, in turn reducing private investment and raising interest rates. Clearly, this is not the case, as interest rates have been extremely low in the US despite our deficit.

        Let’s look at deficit spending from an accounting perspective, where we divide the economy into three main sectors: the government, the private sector, and the foreign sector. The private sector includes all private entities (households and companies), and the foreign sector represents trade. This approach was pioneered by Wynne Godley and a detailed technical explanation can be found in this paper. In a given time, the amount of money spent and received by these sectors must add up to zero. In other words, a surplus of money in one sector always corresponds to a deficit in another. There can’t be one without the other. Here’s how this manifests in the United States: In a given year, the government spends X amount of money, and receives Y amount back in taxes. If the government spent more than it received, it means the private sector, along with the foreign sector, received more than they spent. Thus, the deficit of the government reflects forms the  surplus of foreign and the private sector. In order to look at the foreign sector, we use the inverse of the capital account, which illustrates the trade surplus of the US. By using its inverse we are looking at the surplus of foreign countries against the US.       

Applying this approach to the US, we can use the data from the US Financial Accounts to compile the following graph:

 

Untitled

This graph illustrates the perfect mirror image between the government’s financial balance, the private sector balance, and the inverse of the capital account (because we are looking at the surplus of the rest of the world).

        The mirror image from the graph clearly illustrates how the government deficit is reflected into a private sector surplus. If the government is spending more than it is taxing, it is stimulating the economy, not taking away from it.  

The History of Money: Not What You Think

Most of us have an idea of how money came to be. It goes something like this: People wanted to exchange goods for other goods, but it was difficult to coordinate. So they started exchanging goods for money, and money for goods. This tells us that money is a medium of exchange. It’s a nice and simple story. The problem is that it may not be true. We may be understanding money entirely wrong.  Continue reading “The History of Money: Not What You Think”

Bloated Bodies & Starved Economies: Two harmful misconceptions

Over 35% of American adults are considered obese. These numbers are disproportionately higher in communities of color, whose access to healthy food is limited by time, money, and location. American Big Fast Food pushes “healthy” options which are laden with sugar, but advertised as “fat free”. The nutrition science community sold the idea that fat free meant free from creating fat, but the distinction is not quite true. Likewise, “low calorie” diets were sold on a similar idea that all calories are equal. The body in fact has different subsystems for digesting different types of calories. Carbohydrates go one place, proteins another, and fats themselves are digested separately. Carbohydrates are easily stored as glycogen and when present in the system the body prefers the quick use of them. When no carbohydrates are present, gluconeogenesis breaks down fats and proteins for use as energy. Looked at from this system perspective, the high carb low fat diet commonly advocated from the 1980s onward seems rather foolish if one wishes to burn fat stored on the body. In fact, the opposite should be advocated, a low-carbohydrate diet which starves the body of the fast glycogen deposits and forces it to switch into ketosis. The aphorism that “fat makes you fat” was wrongly sold to the public. While an understanding of the body system seems to clearly disprove the old ideas, the fact that the old paradigm pervaded common thought means communities continue to suffer from obesity without access to the new knowledge and healthy diets. 

fatisnotfatAmerica has another problem caused by a common misconception. There is a pervasive view that the government should not have a deficit, and should in fact run a surplus and pay down all of its debt. Of course, any good American pays down their debts. The banking system is gracious enough to give us loans to buy houses, cars, and get educations. We pay them back for the opportunity, never wanting to default on payments and enter bankruptcy. It makes sense that we think that our government, which so well represents us, should similarly pay back its debts. It is not quite that simple. Much like the fat in food being different from the fat in our bodies, the idea that government debt is the same as household debt is a harmful misconception. Like not all calories are the same, not all debts are the same. When the government runs a deficit, and spends more than it collects in taxes, it is engaging in an act of money creation. When it runs a surplus, and spends less than it collects in taxes, it is engaging in an act of money deletion. Like understanding the subsystems of the body helped us understand how different calories are used, understanding the economic subsystem of money helps us understand how different debts are used and created. 

The government determines what is used for money. Today, USD denominated deposits within the banking system are the main thing we use for money. They are widely accepted and we use them to pay taxes. Deposits enter into the system in two ways. The first is through the budget process which determines the amount of fiscal spending, most of it largely mandatory based on existing law. The budget has some discretionary spending which can be increased by Congress, which can go towards things like education, public jobs, and infrastructure. As the Treasury deficit spends deposits in bank accounts are created, and the Treasury issues a bond as the matching liability on its balance sheet (“the debt”). The other way deposits enter the system is through private banks making loans to households and firms. Banks can always extend loans if they think the venture will be profitable. They make the loan, which creates a deposit as a liability in another bank. After loans are created, the banking system needs to meet reserve requirements for the amount of deposits in the system. If they are not holding enough reserves they can sell assets to the Fed to get them. So banks make loans whenever they see profitable business ventures, and the government accommodates with enough reserves for them to do so. money creation3.jpg

After deposits are created, they circulate hopefully a few times within the banking system but ultimately are collected as taxes or used to pay down private debts. When taxes are collected the Treasury extinguishes some bonds as the debt is now paid. So running a surplus means the government is removing deposits from the system (“paying down the debt”). What happens if we rely on only the private sector to add deposits? Bill Clinton tried in the 1990s when he ran an unprecedented surplus for a couple years. It turns out however that Americans are stubborn and still wanted to buy houses, cars, and get educations. So as our real incomes fell rather than reduce our standards of living we graciously racked up debt with the banking sector. The banks saw us as profitable ventures and gave us loans as deposits, causing the central bank to create the reserves to accommodate this lending. This debt that households accumulated is fundamentally different than the debt pinned on the government as this process unfolds. This is because the government can never be forced to default. Looking at the net flows of financial balances yearly sheds some light into this process. Every year, the net amount spent by the government (red line) matches the net amount saved (or dissaved) by the rest of the world (blue is domestic, green is foreign). This exact mirroring is the result of accounting identities within the system. 

sectoral_balances1

In the 1990s and 2000s you see the private sector as a whole taking on debt and dissaving for the first time in recent history, as the government ran a surplus and other countries bought up large amounts of US securities. Today many US households are still holding onto these debts. The misconception that government debt is the same as these private debts has starved our economy. Much like the mistake of the nutritional science community in prescribing low fat diets to reduce fat, it has been the mistake of the economic science community to prescribe low government debts in order to fix our household debts. debtisnotdebt3In order for households to get enough deposits so they can pay back their debts, the government should run deficits that end up in their hands. The reliance on the private sector has taken priority over the public good, and most of the deposits have landed in the hands of the top 1%. They were supposed to “trickle-down” the wealth to the rest of us, but after forty years of trying this has not happened. The private sector only employs as many people as it finds profitable to do so, and if they can deploy their capital in financial casinos to make more profit than employing people to build stuff that enhances society, they will do just that. So how can we get money into the hands of the financially responsible Americans who just want to work and pay back their debts? A answer to this problem is to rely on direct government job creation, much like the New Deal after the Great Depression. This spending will cause the government to accumulate more debt in the short term, but if spent on education, infrastructure, public jobs, worker co-ops, and raising the minimum wage then these new deposits would funnel into the bottom of the income distribution, and American households could pay down their own debts. Maybe then we’ll realize: government debt, like a nice fatty avocado, is good for us.

Written by Bradley Voracek