PAVING the WAY for a SUSTAINABLE RECOVERY Email: [email protected] Website

Author: Andrew Jackson Editor: Ben Dyson Design: Henry Edmonds Positive Money 205 Davina House 137-149 Goswell Road London EC1V 7ET SOVEREIGN MONEY Tel: 0207 253 3235 PAVING THE WAY FOR A SUSTAINABLE RECOVERY Email: [email protected] Website: www.positivemoney.org ISBN 978-0-9574448-2-9 © November 2013, Positive Money PositiveMoney Acknowledgements We would like to thank Vicky Chick, Nick Edmonds, Dominic Haldane, Graham Hodgson, Michael Reiss, Stephen Stretton and the whole Money and Credit group at UCL for their useful comments and sugges- tions. We would also like to thank Joseph Huber and James Robertson, whose work in Creating New Money partly inspired this paper. Finally, we would like to express our gratitude to the supporters of Positive Money, without whom this paper would not have been possible. Of course the contents of this paper and any mistakes, errors or omissions remain the author’s own. Contents Executive Summary 4 Part 1: An introduction to Sovereign Money Creation 7 Introduction 7 The financial crisis 7 The post-crisis recession and recovery 9 Policy responses to the recession 10 Conventional monetary policy: interest rates 11 Unconventional monetary policy 11 Why monetary policy was ineffective in boosting the economy 13 Fiscal policy 14 Summary: The policy dilemma 14 Prospects for a sustainable recovery 15 An alternative policy: Sovereign Money Creation 16 A step-by-step procedure for Sovereign Money Creation 18 Using Sovereign Money Creation during downturns 19 Using Sovereign Money Creation as a conventional policy tool 23 Benefits of Sovereign Money Creation as a conventional policy tool 29 Central bank targets when Sovereign Money Creation is used as a conventional tool 30 Conclusion 30 Part 2: Sovereign Money Creation in detail 32 How sovereign money could be distributed 32 Technical aspects of Sovereign Money Creation 36 Setting interest rates under SMC 38 Appendices 44 Appendix 1 - Concerns over Sovereign Money Creation 44 Appendix 2 - Academic Support for Sovereign Money Creation 45 Appendix 3 - Historical examples of Sovereign Money Creation and fiscal-monetary cooperation 49 Endnotes 52 Bibliography 59 4 Sovereign Money Executive Summary Overview The financial crisis of 2007-08 occurred because of There is therefore a need for an alternative strat- a massive increase in private sector debt relative to egy to create a sustainable economic recovery, one income in the two decades prior to 2008. In the UK, the that increases incomes in the private sector, without debts of the non-financial sector increased from just the need for an increase in private debts. This paper under 94% of GDP in 1988 to just over 200% of GDP provides that alternative, which we term Sovereign by 2007. Since the crisis the level of private debt in the Money Creation (SMC). In a similar way to Quanti- UK economy has only fallen marginally, yet govern- tative Easing, SMC relies on the state creating money ment policy revolves around ‘getting banks lending and putting it into the economy. But whereas QE relied again’ and consequently increasing private debt. on purchasing pre-existing financial assets and hoping that some of this money would ‘trickle down’ to the Hangovers from private debt-fuelled booms are seri- real economy, SMC works by injecting new money ous, yet, as Adair Turner puts it, the government is directly into the real economy. Consequently, pound engaging in a ‘hair of the dog’ strategy for economic for pound SMC will be far more effective at increasing recovery, treating the cause of the financial crisis – GDP than QE has been. excessive borrowing for unproductive purposes – as though it could also be the solution. With the private Crucially, whereas the government’s current growth sector’s debt-to-income ratio at a historically high strategy relies on an over-indebted household sector level, and set to rise further as a result of govern- going even further into debt, SMC does not require ment policy encouraging easier lending by banks, the that either the government or households increase current economic recovery is unlikely to be sustain- their debts. In contrast, SMC can actually lead to a able. Increasing private sector debt is only sustainable reduction in the overall level of household debt. It if it also leads to an increase in economic output. Given also makes banks more liquid and makes the economy that much of the recent lending has been for mort- more robust. gages, this is unlikely to be the case. Detailed summary Excessive private debt as the cause of the lower incomes, making it increasingly difficult for financial crisis others to pay down their own debts. This is Keynes’ We argue that the financial crisis occurred as a result paradox of thrift. of unconstrained bank lending to the property and financial markets, which led to a large increase in asset Government reponses to the recession prices and the economy’s (the private sectors) debt-to- Given already high levels of private debts, a sustainable GDP ratio. Although asset prices collapsed during the recovery requires that private sector incomes grow at a crisis, the debts incurred in their purchase remained, faster rate than private debts, in order that households leaving the economy in a ‘balance sheet’ recession. and businesses can reduce their debt burden. While a Following the crisis the private sector – households fiscal expansion could have provided such an increase and businesses – stopped borrowing and attempted to in income, this was ruled out due to concerns over the pay down their debts. But any attempt by the private level of national debt (which had increased largely as sector to repay its debts leads to lower spending and Executive Summary 5 a result of the financial crisis and subsequent reces- However, there is a way out of this ‘Catch-22’ situation: sion). Instead the government embarked on a deficit the government can increase private sector incomes reduction strategy. Having ruled out fiscal policy as and spending without increasing public debt. It can a way to increase aggregate demand, the government do this by creating money and using it to finance an and Bank of England attempted to boost spending and increase in spending, a reduction in taxes or a “citizens’ GDP through monetary policy. Initially this took the dividend”. We term this policy ‘Sovereign Money Crea- form of lowering interests to close to zero, followed tion’ (SMC). It is fundamentally different from Quan- by a range of other policies and schemes designed titative Easing (QE), which involved the central bank to increase bank lending (and therefore spending). buying part of the government’s debt after it was issued However, bleak economic prospects and the high levels (and so didn’t directly affect government spending of household and business debt meant that few people at all). QE injected its newly created spending power were willing to increase their borrowing and spending into the financial markets, relying on indirect effects despite historically low interest rates. to boost spending in the real economy. In contrast, SMC actually increases government spending beyond With households, businesses and the government all what it would otherwise be, and so gets newly created attempting to cut their spending at the same time, it money directly into the real economy. The increase has been extremely difficult for the private sector (and in spending will increase private sector incomes, the public sector) to significantly reduce their debts economic output and employment. Most importantly, relative to incomes. Consequently, six years after the SMC would allow the private sector to reduce its debt- crisis there has still been no significant reduction in to-income ratio. Therefore, Sovereign Money Crea- the level of private debt relative to income. tion, if implemented in the near future, would make Is the current economic recovery the current economic recovery sustainable. sustainable? Sovereign Money Creation as a macropru- Recent economic figures suggest that government poli- dential tool cies (such as Help to Buy) have finally been successful In the longer term, SMC could also become an impor- in encouraging households to borrow more, mainly tant macroprudential tool. Before the crisis the central for mortgages. This has led to an increase in house bank had one policy lever, interest rates, but two prices, and a subsequent increase in spending due to targets, price stability and financial stability. While the the ‘wealth effect’. However, while economic output countercyclical capital ratios that have been brought in is increasing, the expansion will not be sustainable if since the crisis to prevent excessive bank lending may private debts continue to increase at a faster rate than be useful in preventing asset price bubbles, they are private incomes. Given that mortgage lending does not less effective at constraining the level of private debt to directly increase economic output, the government is a safe level given current incomes. However, SMC can essentially relying on the increase in spending gener- be used to ensure that aggregate demand is maintained ated by the higher house prices to incentivise busi- even as other monetary polices – such as countercycli- nesses to invest. This is however a dangerous strategy, cal capital buffers – are used to restrict bank lending given excessive private debt was the primary cause of and prevent an unsustainable boom from continuing. the financial crisis. Unless the increase in spending This means that there would no longer be a trade-off incentivises large amounts of business investment, between financial stability and economic growth. the private debt-to-income ratio is likely to increase further, setting the stage for a future crisis and/or Governance and risks with Sovereign recession. Money Creation Sovereign Money Creation as a way to make Of course, the danger with using money creation as the recovery sustainable a policy tool is that it could be abused, resulting in excessive inflation.

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