Category Archives: Political economy

Creating Money Out of Thin Air and Trained Incapacity

Two days ago, I posted on DailyKos a summary of the very important article on money creation that Jon had featured. Jon asked me to also post my DailyKos summary here, which I am happy to do.

But I also want to draw your attention to some of the comments my DailyKos posting attracted, because they are a wonderful example of the "trained incapacity" Veblen analyzed in in his 1914 book, The Instinct of Workmanship and the Industrial Arts. As regular readers of this blog know, Jon and I have had more than one occasion to invoke "trained incapacity" in trying to understand the absurdity and inanity of political and economic positions, ideas, and arguments of people who otherwise appear to be smart. Jon has a number of posts on the subject of trained incapacity here - just scroll down until you see the phrase on the left.

There were at least three commenters to my DailyKos post who simply refused to accept the fact that banks create money out of nothing. They insisted that the banks would later have to meet reserve requirements, or that the borrower was the actual source of the money created because the borrower signs a pledge to pay back the money. One pointed to the Basel requirements regarding banks' T1 capital, a strong sign that that person is professionally involved in banking and finance. Yet another objected that it is the property pledged as security for the loan that is actually the money which I mistakenly believe (according to them) was created out of thin air. Another snidely argued that if banks can create money out of nothing, no bank would ever go bankrupt, so why "not lend to everyone under the sun, without expectation of repayment?" Then added, trying to dismiss the idea that banks create money out of nothing as the fantasy of some wild-eyed radical, "That may be in fact be what the diarist is driving at: what a wonderful world that would be to live in!" This person either did not see or deliberately failed to mention Jon's observation, which I quoted near the beginning of my posting, "don't create money will-nilly—only create money to pay for things that make the society richer."

When I asked a couple commenters, "Then please explain how the amount of money (measured as M2) grew from $1.28 billion in 1867, to $11,654.3 billion now. Where did the $11.653 trillion come from? Which accounts was it withdrawn from? Who created $11.653 trillion in money, and how, over the past 148 years?" one of my interlocutors could only reply, "economic growth." 

Now, I also want to point out that these people objecting to the idea that banks create money out of thin air, are supposedly "on our side." These are not knuckle-dragging conservatives or Republicans; they are liberals and progressives who regularly follow and contribute to one of the leading openly partisan Democratic Party websites on the tubez. With friends like these, who needs enemies?!? Are these people serious about addressing the problem of climate change? If they are, then I feel it is their duty to us, and to humanity in general, to explain what solutions they propose, and how to fund them. If they are not serious, I feel they should be candid and forthright, and express their rejection that climate change is the problem almost all scientists contend it is - a problem that threatens the very survival of our existence as a species.

Alternatively, they can be candid and forthright in informing us they are willing to allow the planet be burnt and rendered uninhabitable, rather than accept economic paradigms that are contrary to their beliefs of what reality is.

The other alternative, of course, is they are just being stupid by clinging to their belief of how money is created. In which case, we come back to Veblen's analysis of trained incapacity. As John Kenneth Galbraith once noted, "The process by which banks create money is so simple that the mind is repelled."

The thing to understand is that the real political fight in the USA, and the rest of the world, is not Democrat versus Republican, or liberal versus conservative, or left versus right. As Jon has pointed out numerous times, the real fight is the Producer Class versus the Predator Class (the Leisure Class as Veblen named it). What makes the prospect of a Hillary Clinton presidency so distasteful to many people who conservatives and Republicans stupidly believe are lefties and therefore Hillary's hardcore base? It is the fact that the Clintons sold out to, and became part of, the Predator Class many, many, many years ago, and the policies they support and espouse will do serious material harm to the members of the Producer Class. So go through the comments, and see for yourself the taint of the Predator Class within our own ranks.

As one of the Predator commenters wrote: "The real issue is that a faction here hates banks and wants to undermine the system somehow." That's exactly what we want to do, and that's what the Predator Class is terrified of.

He or she was exposed by another commenter.

Creating money out of thin air

...it can now be said with confidence for the first time – possibly in the 5000 years' history of banking - that it has been empirically demonstrated that each individual bank creates credit and money out of nothing, when it extends what is called a ‘bank loan’. The bank does not loan any existing money, but instead creates new money. The money supply is created as ‘fairy dust’ produced by the banks out of thin air. The implications are far-reaching.
That's the conclusion of a December 2014 article, by Richard A. Werner, in the scholarly journal International Review of Financial Analysis, entitled Can banks individually create money out of nothing? — The theories and the empirical evidence. I don't know what I can write to convince you how important this article is. The implications for economic and financial policies of government the world over are staggering - and in a good way. A very good way. Because anyone who looks at the simple evidence presented in this scholarly paper can reach no other conclusion than
  • we really don't need banks,
  • we don't need bankers,
  • we don't have to borrow money to fund government programs,
  • we don't have to cut social programs to balance government budgets,
A big tip of the hat is due to Jon Larson, at Real Economics, for highlighting Dr. Werner's article at RE. This is important material, because the cost of stopping climate change has been pegged by experts at $100 trillion, as I wrote a few weeks ago. And, as Larson explains:
...if guys like Tony and I are going to run around telling folks that their only hope for survival lies in spending $100 trillion for infrastructure upgrades, we owe it to them to explain where all that money will come from.
Actually, the source of that money is blindingly obvious—we will get those funds the same way modern society always gets those funds. We will create them out of thin air. But, scream the monetary Puritans, if you just create money willy-nilly out of thin air, what will stop us from becoming Zimbabwe with runaway inflation? Again the answer is obvious—don't create money will-nilly—only create money to pay for things that make the society richer.
There are three basic hypotheses of money creation that professional economists recognize. First, and probably the most widely accepted among professional economists today, is the financial intermediation theory of banking. This idea is that banks are merely intermediaries between savers and borrowers: the banks take in deposits, then when someone needs a loan, the banks lend them some of the money they have collected as deposits. Thus banks do not really create money, they just aggregate it and distribute it. Moreover, since any other institution can do pretty much the same thing - General Motors Acceptance Corp, for example, or General Electric's GE Capital, or even your local chain of grocery stores, then banks are really not that special, and all those fancy models of how the economy works can pretty safely ignore the existence of banks. Uh huh. Well, that's their theory, and they're sticking to it, even though it has, cough, cough, some difficulty in explaining why what happened in 2007-2008, uh, happened.

The second basic hypothesis is the fractional reserve theory of banking. This was the predominant hypothesis in economics from the 1930s to the late 1960s. In this view, banks are financial intermediaries, just like in the first view, but the banks as an aggregate system can create money by lending out some fraction above and beyond what they actually hold in deposits. For example, say a bank has $100 million in deposits. It can lend out $90 million and hold a reserve of $10 million. The borrower of the $90 million then deposits it in another bank, which in turn can now lend out $81 million while holding a reserve of $9 million. The borrower of the $81 million then deposits it in yet another bank, which, in turn, can now lend out $71.9 million while holding $8.1 million in reserve. And so on and so on, to the final iteration. In this way, the banking system as a whole can create new money, while any one individual bank cannot. Bank regulators can adjust the "reserve requirement" to either increase or decrease the amount of new money the banking system as a whole can create and lend out.

The third basic hypothesis of money creation is the credit creation theory of banking, and it holds that banks create money out of nothing when they grant a loan. The key to understanding why all this arcane banking stuff is so important is to realize that if the credit creation theory of banking is correct, then why does it necessarily have to be banks that do the creating? Why can't it be governments also? Interestingly, most professional economists - including Keynes - dismiss the credit creation theory of banking as the work of a lunatic fringe. But the credit creation theory of banking has been gaining adherents since the financial crashes of 2007-2008, as people like you and me have turned our attention to these matters that were previously the lonely province of professional economists. Or as Dr, Werner puts it:
Since the American and European banking crisis of 2007–8, the role of banks in the economy has increasingly attracted interest within and outside the disciplines of banking, finance and economics.
As the credit creation theory of banking has fought for acceptance, the debate has been rather furious at times: recall the controversy a few years ago over the idea of the U.S. national government erasing its budget deficit by minting a special coin with a face value of $1 trillion, and depositing it with the Federal Reserve. The thing is, as Dr. Werner dryly notes in his paper:
Surprisingly, despite the longstanding controversy, until now no empirical study has tested the theories.
So what Dr. Werner, a German-born economist at the University of Southampton in Britain, and some colleagues set out to do was to borrow a large sum of money from a bank, and track what actually happens in the bank's internal accounting and management systems.
The simplest possible test design is to examine a bank's internal accounting during the process of granting a bank loan. When all the necessary bank credit procedures have been undertaken (starting from ‘know-your-customer’ and anti-money laundering regulations to credit analysis, risk rating to the negotiation of the details of the loan contract) and signatures are exchanged on the bank loan, the borrower's current account will be credited with the amount of the loan. The key question is whether as a prerequisite of this accounting operation of booking the borrower's loan principal into their bank account the bank actually withdraws this amount from another account, resulting in a reduction of equal value in the balance of another entity — either drawing down reserves (as the fractional reserve theory maintains) or other funds (as the financial intermediation theory maintains). Should it be found that the bank is able to credit the borrower's account with the loan principal without having withdrawn money from any other internal or external account, or without transferring the money from any other source internally or externally, this would constitute prima facie evidence that the bank was able to create the loan principal out of nothing. In that case, the credit creation theory would be supported and the theory that the individual bank acts as an intermediary that needs to obtain savings or funds first, before being able to extend credit (whether in conformity with the fractional reserve theory or the financial intermediation theory), would be rejected.
Dr. Werner and his colleagues approached a number of banks in Europe, but all the big banks they asked declined to be involved in the experiment. All the big banks gave two basic reasons for their refusal: they were unwilling to risk compromising their internal management and IT systems, and the amount of money the team wanted to borrow - 200,000 Euros - was too small. I quote: "... the transactions volumes of the banks were so large that the planned test would be very difficult to conduct..." OK, then.
It was therefore decided to approach smaller banks, of which there are many in Germany (there are approximately 1700 local, mostly small banks in Germany). Each owns a full banking license and engages in universal banking, offering all major banking services, including stock trading and currencies, to the general public. A local bank with a balance sheet of approximately €3 billion was approached, as well as a bank with a balance sheet of about €700 million. Both declined on the same grounds as the larger banks, but one suggested that a much smaller bank might be able to oblige, pointing out the advantage that there would be fewer transactions booked during the day, allowing a clearer identification of the empirical test transaction. At the same time the empirical information value would not diminish with bank size, since all banks in the EU conform to identical European bank regulations.
Thus an introduction to Raiffeisenbank Wildenberg e.G., located in a small town in the district of Lower Bavaria was made....
It was agreed that the researcher would personally borrow €200,000 from the bank. The transaction was undertaken on 7 August 2013 in the offices of the bank in Wildenberg in Bavaria. Apart from the two (sole) directors, also the head (and sole staff) of the credit department, Mr. Ludwig Keil was present. The directors were bystanders not engaging in any action. Mr. Keil was the only bank representative involved in processing the loan from the start of the customer documentation, to the signing of the loan contract and finally paying out the loan into the borrower's account. The entire transaction, including the manual entries made by Mr. Keil, was filmed. The screens of the bank's internal IT terminal were also photographed. Moreover, a team from the BBC was present and filmed the central part of the empirical bank credit experiment (Reporter Alistair Fee and a cameraman).
Dr. Werner presents the full results in his article, including
  • a numbered sequence of the steps the bank took in reviewing and granting the loan, then crediting the loan amount to the researcher's account;
  • the bank's balance sheet the day before the loan was made, and the balance sheet the day after the loan;
  • the key asset positions of the bank the day before the loan, and the key asset positions the day after;
  • the key liability positions for the same periods;
  • the account summary table for the new account of the borrower;
  • a standard T-account of the transaction from the borrower's perspective.
The critical question is: where did Raiffeisenbank Wildenberg e.G. obtain the funds from that the borrower (researcher) was credited with?
Well, you can probably guess the result of this very, very interesting experiment. It turns out that the bank neither took the €200,000 from the funds it already had as deposits, nor did it obtain €200,000 from a regional or national banking authority, or from the European Central Bank. The €200,000 was simply credited to the borrower's account. Period. The €200,000, in other words, was, created out of thin air. I will close by quoting from the U.S. Constitution.
Article I, Section 8, Clause 5: The Congress shall have Power…To coin Money, [and] regulate the Value thereof...
Aargh... if only the Framers had used the word "create" instead of "coin"! Then it would be much more difficult for the oligarchs who now control the creation and allocation of money and credit, to convince the chowderheads on the right that "government has to live within its means" is our big problem, instead of what our big problem really is: the creation and allocation of money and credit is being misused and abused by oligarchs who speculate and arbitrage with that new money and credit, instead of using it for something economically productive.

Wray on MMT

Modern Monetary Theory is a concept that makes me a tad nervous because I find that most monetary ideas have been around for at least a century and likely more.  In fact, it is pretty damn hard to top the monetary ideas of Lincoln and his Greenbacks, or for that matter, Peter Cooper and the Greenback Party of the 1870s.

But since MMT seems to be the preferred description of the current monetary position of progressives, I am trying to get myself up to speed.  First up is a positive explanation of MMT by L. Randall Wray of U Missouri Kansas City followed by a really thoughtful discussion of progressive monetary ideas by Bill Mitchell.  All I can say is that if this is what they are calling MMT, it is certainly something that would have made old Peter Cooper happy.

Is It Time for MMT To Become Mainstream to Save Us from the Second Global Financial Crisis of the Millennium?

L. Randall Wray · January 10th, 2015

Some of you will remember that MMT got its first huge mainstream exposure through a Washington Post article written by Dylan Matthews.

He’s just written another excellent story, this time about Stephanie Kelton going to Washington.

Finally, there might be an alternative to the deficit hawk and timid deficit dove lovefest!

As Dylan says: “For years, the main disagreement between Democratic and Republican budget negotiators was about how to balance the budget — what to cut, what to tax, how fast to implement it — but not whether to balance it. Even most liberal economists agree that, in the medium-run, it’s better to have less government debt rather than more. Kelton denies that premise. She thinks that, in many cases, government surpluses are actively destructive and balancing the budget is very dangerous. For example, Kelton thinks the Clinton surpluses are nothing to brag about and they actually inflicted economic damage lasting over a decade.”

Yep, there’s no daylight between a Bush or a Clinton.

Isn’t it pretty funny that if the mainstream Dems get their way, we will get a Bush or a Clinton this time around (again!). Yep, it will be a legacy hire either way, and it makes no difference which one wins–both will do their damnest to limit budget deficits even as the economy falls into the second Global Financial Crisis of this millennium.

There’s now a choice, folks. Just Say No!
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Creating money out of thin air

This week, I intend to cover the subject of money creation.  It is not like I haven't covered this subject pretty thoroughly before.  In fact, I made it the subject of Chapter Six of Elegant Technology.  The reason is pretty obvious—if guys like Tony and me are going to run around telling folks that their only hope for survival lies in spending $100trillion for infrastructure upgrades, we owe it to them to explain where all that money will come from.

Actually, the source of that money is blindingly obvious—we will get those funds the same way modern society always gets those funds.  We will create them out of thin air.  But, scream the monetary Puritans, if you just create money willy-nilly out of thin air, what will stop us from becoming Zimbabwe with runaway inflation?  Again the answer is obvious—don't create money will-nilly—only create money to pay for things that make the society richer.

What the monetary Puritans forget is that while money can be made valuable by specifying convertibility to rare metals like gold, the really important value of money is the ability to convert it into necessary items of survival—food, shelter, energy, water, etc.  Fiat money derives its value from funding the clever use of resources.  Producers make money valuable!  And so long a money is created to fund Producer projects—and converting the world into a giant solar-powered fire-free zone would most definitely qualify as a Producer project—new money brings actual prosperity and NOT inflation.

Besides, creating money out of thin air is what bankers do!  It is the rest of us who make that money valuable.  They create a new mortgage with a few keystrokes and folks like us work like slaves for 30 years to pay it off.  It is our hard work that makes that money valuable.  Starving the society of funds necessary for the creation and maintenance of our infrastructure is easily sin #1 of the bankster classes.  Because of this madness, we are not only destroying the only inhabitable biosphere for light-years in any direction, we are going broke doing it.

Can banks individually create money out of nothing? — The theories and the empirical evidence

Richard A. Werner

Open Access
Abstract

This paper presents the first empirical evidence in the history of banking on the question of whether banks can create money out of nothing. The banking crisis has revived interest in this issue, but it had remained unsettled. Three hypotheses are recognised in the literature. According to the financial intermediation theory of banking, banks are merely intermediaries like other non-bank financial institutions, collecting deposits that are then lent out. According to the fractional reserve theory of banking, individual banks are mere financial intermediaries that cannot create money, but collectively they end up creating money through systemic interaction. A third theory maintains that each individual bank has the power to create money ‘out of nothing’ and does so when it extends credit (the credit creation theory of banking). The question which of the theories is correct has far-reaching implications for research and policy. Surprisingly, despite the longstanding controversy, until now no empirical study has tested the theories. This is the contribution of the present paper. An empirical test is conducted, whereby money is borrowed from a cooperating bank, while its internal records are being monitored, to establish whether in the process of making the loan available to the borrower, the bank transfers these funds from other accounts within or outside the bank, or whether they are newly created. This study establishes for the first time empirically that banks individually create money out of nothing. The money supply is created as ‘fairy dust’ produced by the banks individually, "out of thin air".

“The choice of a measure of value, of a monetary system, of currency and credit legislation — all are in the hands of society, and natural conditions … are relatively unimportant. Here, then, the decision-makers in society have the opportunity to directly demonstrate and test their economic wisdom — or folly. History shows that the latter has often prevailed.”1

Wicksell (1922, p. 3)

1. Introduction

Since the American and European banking crisis of 2007–8, the role of banks in the economy has increasingly attracted interest within and outside the disciplines of banking, finance and economics. This interest is well justified: Thanks to the crisis, awareness has risen that the most widely used macroeconomic models and finance theories did not provide an adequate description of crucial features of our economies and financial systems, and, most notably, failed to include banks.2 These bank-less dominant theories are likely to have influenced bank regulators and may thus have contributed to sub-optimal bank regulation: Systemic issues emanating from the banking sector are impossible to detect in economic models that do not include banks, or in finance models that are based on individual, representative financial institutions without embedding these appropriately into macroeconomic models.3

Consequently, many researchers have since been directing their efforts at incorporating banks or banking sectors in economic models.4 This is a positive development, and the European Conferences on Banking and the Economy (ECOBATE) are contributing to this task, showcased in this second special issue, on ECOBATE 2013, held on 6 March 2013 in Winchester Guildhall and organised by the University of Southampton Centre for Banking, Finance and Sustainable Development. As the work in this area remains highly diverse, this article aims to contribute to a better understanding of crucial features of banks, which would facilitate their suitable incorporation in economic models. Researchers need to know which aspects of bank activity are essential — including important characteristics that may distinguish banks from non-bank financial institutions. In other words, researchers need to know whether banks are unique in crucial aspects, and if so, why.

In this paper the question of their potential ability to create money is examined, which is a candidate for a central distinguishing feature. A review of the literature identifies three different, mutually exclusive views on the matter, each holding sway for about a third of the twentieth century. The present conventional view is that banks are mere financial intermediaries that gather resources and re-allocate them, just like other non-bank financial institutions, and without any special powers. Any differences between banks and non-bank financial institutions are seen as being due to regulation and effectively so minimal that they are immaterial for modelling or for policy-makers. Thus it is thought to be permissible to model the economy without featuring banks directly. This view shall be called the financial intermediation theory of banking. It has been the dominant view since about the late 1960s.

Between approximately the 1930s and the late 1960s, the dominant view was that the banking system is ‘unique’, since banks, unlike other financial intermediaries, can collectively create money, based on the fractional reserve or ‘money multiplier’ model of banking. Despite their collective power, however, each individual bank is in this view considered to be a mere financial intermediary, gathering deposits and lending these out, without the ability to create money. This view shall be called the fractional reserve theory of banking.

There is a third theory about the functioning of the banking sector, with an ascendancy in the first two decades of the 20th century. Unlike the financial intermediation theory and in line with the fractional reserve theory it maintains that the banking system creates new money. However, it goes further than the latter and differs from it in a number of respects. It argues that each individual bank is not a financial intermediary that passes on deposits, or reserves from the central bank in its lending, but instead creates the entire loan amount out of nothing. This view shall be called the credit creation theory of banking.

The three theories are based on a different description of how money and banking work and they differ in their policy implications. Intriguingly, the controversy about which theory is correct has never been settled. As a result, confusion reigns: Today we find central banks – sometimes the very same central bank – supporting different theories; in the case of the Bank of England, central bank staff are on record supporting each one of the three mutually exclusive theories at the same time, as will be seen below.

It matters which of the three theories is right — not only for understanding and modelling the role of banks correctly within the economy, but also for the design of appropriate bank regulation that aims at sustainable economic growth without crises. The modern approach to bank regulation, as implemented at least since Basel I (1988), is predicated on the understanding that the financial intermediation theory is correct. 5 Capital adequacy-based bank regulation, even of the counter-cyclical type, is less likely to deliver financial stability, if one of the other two banking hypotheses is correct. 6 The capital-adequacy based approach to bank regulation adopted by the BCBS, as seen in Basel I and II, has so far not been successful in preventing major banking crises. If the financial intermediation theory is not an accurate description of reality, it would throw doubt on the suitability of Basel III and similar national approaches to bank regulation, such as in the UK. 7

It is thus of importance for research and policy to determine which of the three theories is an accurate description of reality. Empirical evidence can be used to test the relative merits of the theories. Surprisingly, no such test has so far been performed. This is the contribution of the present paper.

The remainder of the paper is structured as follows. Section 2 provides an overview of relevant literature, differentiating authors by their adherence to one of the three banking theories. It will be seen that leading economists have gone on the record in support of each one of the theories. In Section 3, I then present an empirical test that is able to settle the question of whether banks are unique and whether they can individually create money ‘out of nothing’. It involves the actual processing of a ‘live’ bank loan, taken out by the researcher from a representative bank that cooperates in the monitoring of its internal records and operations, allowing access to its documentation and accounting systems. The results and some implications are discussed in Section 4
2. The literature on whether banks can create money

Much has been written on the role of banks in the economy in the past century and beyond. Often authors have not been concerned with the question of whether banks can create money, as they often simply assume their preferred theory to be true, without discussing it directly, let alone in a comparative fashion. This literature review is restricted to authors that have contributed directly and explicitly to the question of whether banks can create credit and money. During time periods when in the authors' countries banks issued promissory notes (bank notes) that circulated as paper money, writers would often, as a matter of course, mention, even if only in passing, that banks create or issue money. In England and Wales, the Bank Charter Act of 1844 forbade banks to “make any engagement for the payment of money payable to bearer on demand.” This ended bank note issuance for most banks in England and Wales, leaving the (until 1946 officially privately owned) Bank of England with a monopoly on bank note issuance. Meanwhile, the practice continued in the United States until the 20th century (and was in fact expanded with the similarly timed New York Free Banking Act of 1838), so that US authors would refer to bank note issuance as evidence of the money creation function of banks until much later.8 For sake of clarity, our main interest in this paper is the question whether banks that do not issue bank notes are able to create money and credit out of nothing. As a result, earlier authors, writing mainly about paper money issuance, are only mentioned in passing here, even if it could be said that their arguments might also apply to banks that do not issue bank notes. These includeJohn Law (1705), James Steuart (1767), Adam Smith (1776), Henry Thornton (1802), Thomas Tooke (1838), and Adam Müller (1816), among others, who either directly or indirectly state that banks can individually create credit (in line with the credit creation theory). 9

2.1. The credit creation theory of banking

Influential early writers that argue that non-issuing banks have the power to individually create money and credit out of nothing wrote mainly in English or German, namely Wicksell, 1898 and Wicksell, 1907, Withers (1909), Schumpeter (1912), Moeller (1925) and Hahn (1920).10 The review of proponents of the credit creation theory must start with Henry Dunning Macleod, of Trinity College, Cambridge, and Barrister at Law at the Inner Temple. 11 Macleod produced an influential opus on banking, entitled The Theory and Practice of Banking, in two volumes. It was published in numerous editions well into the 20th century ( Macleod, 1855–6; the quotes here are from the 6th edition of 1905). Concerning credit creation by individual banks, Macleod unequivocally argued that individual banks create credit and money out of nothing, whenever they do what is called ‘lending’:

“In modern times private bankers discontinued issuing notes, and merely created Credits in their customers' favour to be drawn against by Cheques. These Credits are in banking language termed Deposits. Now many persons seeing a material Bank Note, which is only a Right recorded on paper, are willing to admit that a Bank Note is cash. But, from the want of a little reflection, they feel a difficulty with regard to what they see as Deposits. They admit that a Bank Note is an “Issue”, and “Currency,” but they fail to see that a Bank Credit is exactly in the same sense equally an “Issue,” “Currency,” and “Circulation”.”

Macleod (1905, vol. 2, p. 310)

“… Sir Robert Peel was quite mistaken in supposing that bankers only make advances out of bona fide capital. This is so fully set forth in the chapter on the Theory of Banking, that we need only to remind our readers that all banking advances are made, in the first instance, by creating credit” (p. 370, emphasis in original).

In his Theory of Credit Macleod (1891) put it this way:

“A bank is therefore not an office for “borrowing” and “lending” money, but it is a Manufactory of Credit.” 
Macleod (1891: II/2, 594)

According to the credit creation theory then, banks create credit in the form of what bankers call ‘deposits’, and this credit is money. But how much credit can they create? Wicksell (1907) described a credit-based economy in the Economic Journal, arguing that

“The banks in their lending business are not only not limited by their own capital; they are not, at least not immediately, limited by any capital whatever; by concentrating in their hands almost all payments, they themselves create the money required….”

“In a pure system of credit, where all payments were made by transference in the bank-books, the banks would be able to grant at any moment any amount of loans at any, however diminutive, rate of interest.” 12

Wicksell (1907, 214)

Withers (1909), from 1916 to 1921 the editor of the Economist, also saw few restraints on the amount of money banks could create out of nothing:

“… it is a common popular mistake, when one is told that the banks of the United Kingdom hold over 900 millions of deposits, to open one's eyes in astonishment at the thought of this huge amount of cash that has been saved by the community as a whole, and stored by them in the hands of their bankers, and to regard it as a tremendous evidence of wealth. But this is not quite the true view of the case. Most of the money that is stored by the community in the banks consists of book-keeping credits lent to it by its bankers.”

Withers (1909, pp. 57 ff.)

“… The greater part of the banks' deposits is thus seen to consist, not of cash paid in, but of credits borrowed. For every loan makes a deposit ….”

Withers (1909, p. 63)

“When notes were the currency of commerce a bank which made an advance or discounted a bill gave its customer its own notes as the proceeds of the operation, and created a liability for itself. Now, a bank makes an advance or discounts a bill, and makes a liability for itself in the corresponding credit in its books.”

Withers (1909, p. 66)

“… It comes to this that, whenever a bank makes an advance or buys a security, it gives some one the right to draw a cheque upon it, which cheque will be paid in either to it or to some other banks, and so the volume of banking deposits as a whole will be increased and the cash resources of the banks as a whole will be unaltered.”

Withers (1916, p. 45)

“When once this fact is recognised, that the banks are still, among other things, manufacturers of currency, just as much as they were in the days when they issued notes, we see how important a function the banks exercise in the economic world, because it is now generally admitted that the volume of currency created has a direct and important effect upon prices. This arises from what is called the “quantity theory” of money ….”

Withers (1916, p. 47)

“If, then, the quantity theory is, as I believe, broadly true, we see how great is the responsibility of the bankers as manufacturers of currency, seeing that by their action they affect, not only the convenience of their customers and the profits of their shareholders, but the general level of prices. If banks create currency faster than the rate at which goods are being produced, their action will cause a rise in prices which will have a perhaps disastrous effect ….”13

Withers (1916, pp. 54 ff.)

“And so it becomes evident, as before stated, that the deposits of the banks which give the commercial community the right to draw cheques are chiefly created by the action of the banks themselves in lending, discounting, and investing” (pp. 71 ff.).

“… then, it thus appears that credit is the machinery by which a very important part of modern currency is created …” (p. 72).

Withers argues that the sovereign prerogative to manufacture the currency of the nation has effectively beenprivatised and granted to the commercial banks:

“By this interesting development the manufacture of currency, which for centuries has been in the hands of Government, has now passed, in regard to a very important part of it, into the hands of companies, working for the convenience of their customers and the profits of their shareholders.”

Withers (1916, p. 40)

While Withers was a financial journalist, his writings had a high circulation and likely contributed to the dissemination of the credit creation theory in the form proposed by Macleod (1855–6). This view also caught on in Germany with the publication of Schumpeter's (1912, English 1934) influential book The Theory of Economic Development, in which he was unequivocal in his view that each individual bank has the power to create money out of nothing.

“Something like a certificate of future output or the award of purchasing power on the basis of promises of the entrepreneur actually exists. That is the service that the banker performs for the entrepreneur and to obtain which the entrepreneur approaches the banker. … (The banker) would not be an intermediary, but manufacturer of credit, i.e. he would create himself the purchasing power that he lends to the entrepreneur …. One could say, without committing a major sin, that the banker creates money.” 14

Schumpeter (1912, p. 197, emphasis in original)

“[C]redit is essentially the creation of purchasing power for the purpose of transferring it to the entrepreneur, but not simply the transfer of existing purchasing power. … By credit, entrepreneurs are given access to the social stream of goods before they have acquired the normal claim to it. And this function constitutes the keystone of the modern credit structure.”

Schumpeter (1954, p. 107)

“The fictitious certification of products, which, as it were, the credit means of payment originally represented, has become truth.”15
Schumpeter (1912, p. 223)

This view was also well represented across the Atlantic, as the writings of Davenport (1913) or Robert H. Howe (1915) indicate. Hawtrey (1919), another leading British economist who like Keynes, had a Treasury background and moved into academia, took a clear stance in favour of the credit creation theory:

“… for the manufacturers and others who have to pay money out, credits are still created by the exchange of obligations, the banker's immediate obligation being given to his customer in exchange for the customer's obligation to repay at a future date. We shall still describe this dual operation as the creation of credit. By its means the banker creates the means of payment out of nothing, whereas when he receives a bag of money from his customer, one means of payment, a bank credit, is merely substituted for another, an equal amount of cash” (p. 20).

Apart from Schumpeter, a number of other German-language authors also argued that banks create money and credit individually through the process of lending.16 Highly influential in both academic discourse and public debate was Dr. Albert L. Hahn (1920), scion of a Frankfurt banking dynasty (similarly to Thornton who had been a banker) and since 1919 director of the major family-owned Effecten- und Wechsel-Bank, Frankfurt. Like Macleod a trained lawyer, he became an honorary professor at Goethe-University Frankfurt in 1928. Clearly not only aware of the works of Macleod, whom he cites, but also likely aware of actual banking practice from his family business, Hahn argued that banks do indeed ‘create money out of nothing’:

“Every credit that is extended in the economy creates a deposit and thus the means to fund it. … The conclusion from the process described can be expressed in reverse by saying … that every deposit that exists somewhere and somehow in the economy has come about by a prior extension of credit.”17

Hahn (1920, p. 28)

“We thus maintain – contrary to the entire literature on banking and credit – that the primary business of banks is not the liability business, especially the deposit business, but that in general and in each and every case an asset transaction of a bank must have previously taken place, in order to allow the possibility of a liability business and to cause it: The liability business of banks is nothing but a reflex of prior credit extension. The opposite view is based on a kind of optical illusion ….”18

Hahn (1920, p. 29)

Overall, Hahn probably did more than anyone to popularise the credit creation theory in Germany, his book becoming a bestseller, and spawning much controversy and new research among economists in Germany. It also greatly heightened awareness among journalists and the general public of the topic in the following decades. The broad impact of his book was likely one of the reasons why this theory remained entrenched in Germany, when it had long been discarded in the UK or the US, namely well into the post-war period. Hahn's book was however not just a popular explanation without academic credibility. Schumpeter cited it positively in the second (German) edition of his Theory of Economic Development ( Schumpeter, 1926), praising it as a further development in line with, but beyond, his own book. The English translation of Schumpeter's influential book Schumpeter (1912 [1934]) also favourably cites Hahn.

It can be said that support for the credit creation theory appears to have been fairly widespread in the late 19th and early 20th century in English and German language academic publications. By 1920, the credit creation theory had become so widespread that it was dubbed the ‘current view’, the ‘traditional theory’ or the ‘time-worn theory of bank credit’ by later critics. 19

The early Keynes seemed to also have been a supporter of this dominant view. In his Tract on Monetary Reform ( Keynes, 1924), he asserts, apparently without feeling the need to establish this further, that banks create credit and money, at least in aggregate:

“The internal price level is mainly determined by the amount of credit created by the banks, chiefly the Big Five …” (p. 178).

“The amount of credit, so created, is in its turn roughly measured by the volume of the banks' deposits — since variations in this total must correspond to the variations in the total of their investments, bill-holdings, and advances” (p. 178).

We know from Keynes' contribution to the Macmillan Committee (1931) that Keynes meant with this that each individual bank was able to create credit:

“It is not unnatural to think of the deposits of a bank as being created by the public through the deposit of cash representing either savings or amounts which are not for the time being required to meet expenditure. But the bulk of the deposits arise out of the action of the banks themselves, for by granting loans, allowing money to be drawn on an overdraft or purchasing securities a bank creates a credit in its books, which is the equivalent of a deposit” (p. 34).

Concerning the banking system as a whole, this bank credit and deposit creation was thought to influence aggregate demand and the formation of prices, as Schumpeter (1912) had argued:

“The volume of bankers' loans is elastic, and so therefore is the mass of purchasing power …. The banking system thus forms the vital link between the two aspects of the complex structure with which we have to deal. For it relates the problems of the price level with the problems of finance, since the price level is undoubtedly influenced by the mass of purchasing power which the banking system creates and controls, and by the structure of credit which it builds …. Thus, questions relating to the volume of purchasing power and questions relating to the distribution of purchasing power find a common focus in the banking system” (Macmillan Committee, 1931, pp. 12 ff.).

“… if, finally, the banks pursue an easier credit policy and lend more freely to the business community, forces are set in motion increasing profits and wages, and therefore the possibility of additional spending arises” (p. 13).

Concerning the question whether credit demand or credit supply is more important, the report argued that the root cause is the movement of the supply of credit:

“The expansion or contraction of the amount of credit made available by the banking system in other directions will, through a variety of channels, affect the ease of embarking on new investment propositions. This, in turn, will affect the volume and profitableness of business, and hence react in due course on the amount of accommodation required by industry from the banking system. … Thus what started as an alteration in the supply of credit ends up in the guise of an alteration in the demand for credit” (p. 99). 20

While money is thus seen as endogenous to credit, when what is called a ‘bank loan’ is extended, the Committee argued that bank credit was exogenous as far as loan applicants are concerned:

“There can be no doubt as to the power of the banking system … to increase or decrease the volume of bank money” (p. 102).

“In normal conditions we see no reason to doubt the capacity of the banking system to influence the volume of active investment by increasing the volume and reducing the cost of bank credit. … Thus we consider that in any ordinary times the power of the banking system … to increase or diminish the active employment of money in enterprise and investment is indisputable” (p. 102).

The Macmillan Committee also argued that bank credit could be manipulated by the Bank of England, and thus was also considered exogenous in this sense. 
The credit creation theory remained influential until the early post-war years. The links of credit creation to macroeconomic and financial variables were later formalised in the Quantity Theory of Credit (Werner, 1992,Werner, 1997, Werner, 2005 and Werner, 2012), which argues that credit for (a) productive use in the form of investments for the production of goods and services is sustainable and non-inflationary, as well as less likely to become a non-performing loan, (b) unproductive use in the form of consumption results in consumer price inflation and (c) unproductive use in the form of asset transactions results in asset inflation and, if large enough, banking crises. However, since the 1920s serious doubts had spread about the veracity of the credit creation theory of banking. These doubts were initially uttered by economists who in principle supported the theory, but downplayed its significance. It is this group of writers that served as a stepping stone to the formulation of the modern fractional reserve theory, which in its most widespread (and later) version however argues that individual banks cannot create credit, but only the banking system in aggregate. It is this theory about banks that we now turn to. more

Gloating over the ruble’s fall

A guy by the name of Jason Bordoff was on The Colbert Report last night gloating over the economic problems facing Russia because of the crash in oil prices and the speculative run on the ruble.  He seemed overjoyed that Putin was finally in big trouble.  Colbert was mostly happy that gasoline prices were heading below the $2 per gallon mark.

Small problem.  Even though Bordoff has an impressive CV that includes a gig as one of Obama's energy advisors, he has been sucked in by the fracking BS.  He talks casually about how Peak Oil was wrong and that fracking only proves that innovation will become more effective and widespread as oil prices go up.  In other words, a typical neoliberal fool who seems to think what is obviously a speculative attack on the Russian ruble is really a sign that history is changing.  Wow!

Recently, I was working on a post dealing with the rituals of remembering Pearl Harbor (never completed) when I uncovered this photograph.  It was also taken in that first week of December, 1941.  Since the invasion in June, the German blitzkrieg had roared across USSR and were now just a few miles from Moscow.  The occupation forces were incredibly brutal, had inflicted millions of deaths, and had leveled hundreds of cities.  The people of Moscow had a really good idea what they faced.  So an army of 250,000 women went out and dug tanks traps.  They moved 3 million cubic meters of dirt by hand!  The weather was horrible.  This was not exactly people being caught by surprise while relaxing in an island paradise.  The Germans never took Moscow because those tank traps helped take the blitz out of blitzkrieg.

The people of Russia have survived crises almost infinitely worse than a run on their currency.  They have followed leaders like Stalin during these crises who were far more brutal than Putin will ever be on his worst day.  And people should never forget that Putin's mother survived the Siege of Leningrad—which means she was at least as tough as any of the women pictured below.  My guess is that Russia is in FAR less trouble than that smirking Jason Bordoff could ever imagine.



Of course, just because Russia is taking this opportunity to reenforce her economic independence does not mean she won't be making some serious mis-steps.  They just made one when they raised interest rates to 17%.  Someone in Moscow seems to believe that Paul Volcker successfully broke the back of inflation in 1981 by introducing gangster-levels of usury.  Well he night have actually killed off inflation but he did it at enormous costs including the destruction of middle-class agriculture and the massive de-industrialization of USA.  This destruction is felt to this day.  There were dozens of ways to have fought the global inflation of the early 1980s but a central banker settled on usury.  Who would have thunk?

In the very interesting piece below, Sergei Glazyev blasts the actions of Russia's Central Bank.  Glazyev is an interesting guy.  If I heard he was a friend of Michael Hudson, I would not be the least surprised.  He has also made considerable noise about running Russia's Central Bank so we can take this as his plans for what he would do.  Historically, he would probably have enjoyed the company of Marriner Eccles.

Why did the Central Bank raise the interest rate and let the ruble flow?

Sergei Glazyev

Another increase in key interest rates on loans issued by the Bank of Russia, for the purpose of refinancing commercial banks, made loans completely inaccessible for the majority of enterprises of the real sector of the economy. When the average profitability of the manufacturing industry is 7.5-8%, credit issued at rates of 10% or higher cannot be used by most businesses, either for investment or for replenishing working capital. Such decisions cut off the real economy, with the exception of some sectors of the oil, gas, and chemical-metallurgical sector, from credit issued by the State.

Prior to that, the consumer lending boom drove millions of citizens into a 10-trillion ruble debt and the real economy lost the savings of the population, becoming a net debtor. Also, the Government withdrew pension savings from the economy. Sanctions imposed by NATO countries deprive the economy of the bulk of external credit. Most businesses have only their own funds to finance working capital and investments, which is clearly not enough to provide even simple reproduction, never mind an expanded one. The amount of profit of enterprises this year (taking into account the fall in the prices of export goods) will be no more than 10% of the required rate of investment of 25-30% of GDP. It’s no surprise that as a result of such decisions amidst the economic recovery in almost all countries of the world this year, Russia is experiencing an unexpected decline in investment and production.

According to the Central Bank’s report, On the key rate of the Bank of Russia, October 31, 2014, its decision to raise interest rates was made because of external circumstances: “In September-October the external environment has changed significantly: oil prices dropped significantly while there has been a tightening of sanctions imposed by individual countries to a number of large Russian companies. The ruble has been weakening in this environment, which, against the backdrop of August’s restrictions on import of certain food products, led to a further acceleration of growth of consumer prices”. To support its previous decision to raise interest rates, the Central Bank argued that “inflationary risks had increased, including rising geopolitical tensions and their possible impact on the dynamics of the course of the national currency, as well as changes in the tax and tariff policy.” In the same policy statement, the Central Bank explained its decision to raise interest rates by “a stronger than expected effect of exchange rate dynamics on consumer prices, rising inflation expectations, as well as the unfavorable trends in the market for certain goods.”

This reasoning does not stand up to criticism.

Any entrepreneur dealing with the real economy and not with the utopian models of market equilibrium will say that the increase in the interest rate leads to a rise in the cost of credit. This leads to increased costs for the borrowing enterprises and, consequently, to higher prices for their products. Increasing percentage in excess of the rate of return on assets does not make sense for financing investments, nor does excess of profitability of manufactured products make sense for working capital. It results in reduced production, which in return causes an increase in cost per unit of production and a further increase in its prices. The inability to get investment loans deprives businesses of opportunities to reduce costs by increasing scale and technological improvements of production, which shuts off the main ways of reducing prices.

All of the above have been proven many times theoretically and confirmed in practice. An increase in interest rates and accompanying contraction of the money supply led to the same consequences in all countries - the decline in investment and production on the one hand and increased costs on the other. The result was a dramatic bankruptcy of many enterprises faced with the impossibility of refinancing their production processes. Today, just as in the 1990s, this policy drives the economy into a stagflationary trap and deprives it of development opportunities.

Apparently, the heads of the Central Bank are guided by fantasies gleaned from student textbooks on macroeconomics. In some of them, to facilitate students’ understanding, market mechanisms are simplified to primitive mathematical equilibrium models, which were brought to economic science from classical mechanics almost a century ago. The economy in these mechanistic models is presented as a set of economic agents oriented towards maximizing profits, having perfect knowledge, and working in conditions of perfect competition and instant availability of any resource. According to these models, an increase in the money supply, as with any other product, leads to lower prices, which is equivalent to higher inflation. And vice versa, an increase in the price of money (interest rates) entails reducing their supply and falling inflation. On this basis, a favorite monetarists’ Fisher identity (equation) postulates a direct proportional relationship between money growth and prices. Despite the fact that it is not statistically confirmed, the advocates of this theory continue steadfastly to profess the dogma of a direct linear relationship between money supply growth and inflation, and, accordingly, the inverse relationship between inflation and the interest rate. Amateurs, in their simplicity, seem to believe it’s obvious and impose it on public opinion. It’s an equivalent of trying to cure all diseases by bloodletting, a practice of medieval doctors on trusting patients.

In reality, none of the assumptions taken as an axiom in equilibrium models is being observed. Being guided by them in economic policy is akin to building socialism guided by the Communist Manifesto of Marx and Engels, without taking into account the diversity of the people and institutions built by them, without distinction of enterprises, industries and technologies, and without mechanisms of development. Such economic “theory” degenerates into scholasticism, unsuitable for practical use. Therefore, none of the managers in developed countries uses the equilibrium theory in practice. Instead, they are guided by extracting profits in non-equilibrium situations and developing an economy by its complexity. A mechanistic picture of the equilibrium of the economy remains for amateurs; it is used to convince them of the uselessness of government intervention in the economy. This theory is being hammered with special tenacity into the public consciousness of developing countries in order to deprive them of the ability to creatively develop their institutions, which are replaced with the “free market” forces and managed by developed capitalist countries’ monopolies. Unfortunately, our monetary authorities willingly adhere to this mythology without understanding the basic meaning of how credit functions in a modern economy. This meaning should be explained.

The birth of modern capitalism is associated with the invention of public money as an unlimited source of credit through the issue of national currency by a special institution, the Central Bank. Currency issue is essentially a mechanism to advance economic growth, and its use is in both the private and public interest. In the first case, of which the US Federal Reserve is an example, the money issue is subordinate to the interests of the owners of the Central Bank, which receive huge access to market manipulation. From the experience of financial crises, these manipulations are undertaken by them to not only receive income from the emission but also to appropriate national wealth. By lowering interest rates and expanding the money supply, the Central Bank stimulates the growth of production and investment. By increasing interest rates, it provokes bankruptcy of companies that are hooked on the cheap loans needle. The assets of these companies are transferred to the banks that are close to the Central Bank, which gives them unlimited access to the created loans.

When the Central Bank is a state monopoly, as is the case in most countries, its right to issue money can be used to ensure the development and growth of the national economy by providing the necessary amount of loans. This happens in Japan, China, India, Brazil, the Eurozone, Iran, and Turkey. In other cases the right to issue money may not be used if the country is not independent and transfers control of its Central Bank to external management. This is typical of many former colonies, the elite of which have their interests closely linked to those of their colonial masters, who still control their monetary policy.

In the postwar period, many developing countries were caught in the debt trap when trying to finance their development through external loans. Under the threat of bankruptcy, they were forced to give up control over their monetary policy to creditors, whose collective interests were represented by the International Monetary Fund. These interests mainly came down to the opening of the national economies to the free flow of foreign capital; the requirements of which the monetary policy was subordinated to. The latter include free convertibility of the national currency, removing any restrictions on foreign investment and outflow of capital, and the binding of the issue of the national currency to the growth of foreign exchange reserves, which were formed in the currencies of creditor countries. Thus the economies of the debtor countries were subordinated to the interests of capital of creditor countries, an absolute leader of which was the United States, which imposed the use of the dollar as a world currency in the capitalist world.

Russia, having taken upon herself the external responsibilities of the Soviet Union, found herself in precisely such a colonial state, caught in the debt trap. Moreover, even though the Russian state has now paid off those debts the Russian Central bank still subordinates itself to the interests of International capital. As a result the fiscal authorities refuse to implement capital controls, subordinating fiscal policy and particularly the stimulation of the money supply to the growth of foreign currency reserves and handing over the grading of credit risk to the American rating agencies. These policies are justified by the expectation that this will attract inward investment and that the chief engine of economic growth is indeed such foreign investment.

Actually, the expectation of an inflow of foreign capital yielded the opposite outcome - colossal capital flight. Russia became one the main net donors to the world financial system, giving practically free credit to the USA and the other G7 economies cash reserves of almost 100 billion USD annually. As a direct result of these policies serving international capital we see the further degradation of an economy already based on low value-add extractive industries whose production is sold again on the market denominated in USD and Euros. Under such conditions foreign capital extracts, as a result of these financial policies, enormous profits which again artificially inflate the domestic financial markets.

It is straightforward to evidence that for every dollar invested in speculation on vouchers and securities issued as a result of the privatisation carried out between 1993 and 1996 international 'investors' received up to five dollars in profit. The expansion of speculation as a result of the State issued short term bonds (GKOs) between 1996 and 1998 doubled that profit. International investors then repatriated of that capital from Russia and the resultant destabilisation of the financial markets led the state to default which, in turn led to securities being devalued to a 10th of their previous value. The International investors then returned and scooped up those securities at fire-sale prices creating a new spike in the market and, yet again doubling their capital and then, predictably, withdrawing the lot just before the 2007 global financial crisis struck.

It was in precisely this way that the subordination of national fiscal policy to international capital gave the international investors a return of two hundred dollars for ever invested dollar. The vast majority of that profit was simply taken out of the country. These profits were harvested from the state and the Russian population. The share of that money which translated into direct investment in productive industry or into tangible securities was negligible.

It follows that the Russians who collaborated with these 'investors' were not left out in the cold. Many of them became genuine pioneers of the 'offshoring' of the Russian Economy constituting themselves a new caste – The Offshore Oligarchy. The temporary commission of the Russian Federation set up to investigate the reasons, circumstances and consequences of the 1998 default were given evidence of direct collusion between the representatives of international capital and an entire pantheon of the 'great and the good' of both the Central Bank and the Russian government. Some of those individuals to the present day, regardless of the recommendations of the federal council, still occupy influential posts within the state. I quote “To ensure that persons involved in the preparation and decision-making of 17 August, could no longer hold any position or in the public service or in organizations where there is state ownership”

During the 2008 financial crisis the Russian Oligarchy, having by now mastered the methods of the earlier foreign investors began to interfere with the money supply themselves. Having now paid external debts, the Russian financial authorities no longer needed to subordinate themselves to the IMF or to their masters in the United States. Under pressure from crisis-driven capital flight they started to stimulate the money supply with no further regard to pegging it to hard currency reserves. However this was not done with the aim of stabilising industry, shrunk by the crisis by around 5 to 40% but rather to enrich a group of privileged commercial banks. They directed that expanded, tax and interest-free money supply straight to the financial markets extracting 300 Billion Rubles (12 Billion USD) of profit again, with the cost being borne by the devaluation of domestic savers' holdings.

And today the majority of the cash issued by the Russian Central Bank to refinance the commercial banks has been used for pure speculation which contradicts the policy aims of the central bank itself. It is clear that by increasing the interest rate while adopting a free floating currency rate, the central bank, on one hand is blocking the inflow of credits to the industrial sector and on the other is enabling the extraction of super-profits from speculation against the Ruble. Its precisely by doing this that a speculative vortex has been created where the savings of the population are (yet again) converted into super profits in speculators' bank accounts not to mention the equities of Russian corporations which, when unable to pay the spiralling interest rates thus created are more fodder for the hard currency speculators pillaging the market from their offshore accounts.

In this way the “holy Simplicity” of the managers of the central bank, these unquestioning believers in the inconvertible truth of the mechanical representation of the world given to them by the laws of economic equilibrium, but not innocent rather subordinated to transnational capital, of which the Russian offshore forms a part. It is entirely plausible that being true believers in the Washington Consensus, they not know not what they do. However their activities are highly regarded by the academic priesthood in the American universities. In the not-to-distant future those finance ministers and central bank representatives will again be singled out for praise as “best practice” just like their predecessors in earlier years. “Best practice” in the sense that they have created the most efficient conditions for the legal enrichment of the “oligarchic international” on the backs of the wealth of our country and its citizens.

The escalating crisis that we see today in more than one way, reminds us of the situation which prevailed in 1997. Now, as then the government decided to sharply decrease export duties which removed significant resources from the budget. International capital began to move out. Now as then, instead of instituting capital controls, interest rates were raised leading to capital contraction on the financial markets. As a result, then as now, there was no incentive to provide credit to the industrial sector and the rate of investment in industry began to fall.

The main difference is that the budget is in surplus and there is no state debt (this is made up for by similar amounts of corporate debt) and decision not to maintain a stable ruble is made in the presence of large foreign exchange reserves. In summary, default does not threaten the state but the same cannot be said of corporate borrowers.

Given that there is far more stability than in 1997, the fiscal authorities are actually themselves the greatest threat provoking a collapse in business activity and destabilising the currency. However this will not avert crisis, simply prolonging it to the delight of the offshore oligarchy who can now, without risk and at their leisure plan their speculation. It is inevitable that the consequences of these policies will be a fall in the rate of industrial activity and investment, a fall in profits and a stream of bankrupt corporations and thus the subsequent and successive devaluation of the population's savings.

This fiscal policy is taking place in the background of a sustained global trend towards stagflation which manifests as a volatile ruble and high inflation on one hand coupled with a fall in the rate of investment and economic activity on the other. The trigger for this crisis was the imposition of economic sanctions. On one hand this materialised in the refusal by western creditors to renew / rollover loans made to Russian corporations and the collapse of foreign investment. On the other side we see acceleration in already unprecedented capital flight. The volume of which, in the current year, is expected to exceed 100 billion USD. Incorporated into this is tax evasion which, comprising up to one third of this amount, represents a direct loss to the state budget of up to one trillion rubles annually.

Currently more than 50% of the fiscal base created by external credit and through offshore accounts comprises between 30% and 40% of the non-state investment. The aggregate external debt of Russia stands at 650 billion USD (74% of which is denominated in Euro or Dollars), which exceeds the currency reserves standing at 420 Billion USD. The majority of this debt at over 60% is owed by state owned corporations and banks. In fact the majority of external debts are from countries residing under the jurisdiction of the NATO member states. The sanctions imposed by them lead to a capital outflow of 11000 billion rubles to the end of 2014. The intensification of sanctions could lead to the blockade of Russian capital from offshore zones, through which flow over 50 billion USD yearly in investment.

As a result of the ruble destabilisation we shall see the 'dollarization' of the population's savings which in turn will become another form of capital flight which already amounts, through this means alone 30 billion USD.

Regardless of the US imposed war on Russia, our central bank continues to treat the US Dollar as the reserve currency, referring to it as the definition of value, the means of capital accumulation and the base rate for FX trading. The central banks current politics envision the dollar being utilised as a parallel, de-facto base currency in which the foreign currency reserves, external trade debts and credits are denominated and to which the ruble is effectively a subordinate currency. These policies clearly resemble those inflicted by the 3rd Reich on the Soviet territory occupied by them during the 2nd World War.

The Central Bank does not take any measures either to stop capital outflows, or to replace ebbing external sources of loans with internal ones. Though the U.S. has waged a financial war against Russia, the Bank is still governed by the Washington consensus, which develops macroeconomic policy in favor of foreign capital. This exacerbates the impact of sanctions in manifold ways, whereas it could be neutralized by simple measures of currency control combined with amplifying internal sources of credit.

The latter is exactly what Mr Gerashchenko [ex-chairman of the Russian Central Bank] did in order to pull the country out of the 1998 crisis. Having pegged the currency position of commercial banks and refused the IMF-initiated rise in interest rate, the Bank of Russia was able to increase the money supply. Contrary to what the Central Bank’s managers thought, this did not cause a rise but in fact a swift fall in inflation accompanied by an upsurge in production and stabilization of the value of the ruble. Today the Central Bank is doing the opposite and the results are as expected: a fall in production, the ruble’s depreciation, and the growth of inflation.

Loans allocated by the Bank of Russia to the banking system offset neither capital withdrawn by western creditors nor money transferred by the Government to stabilization funds. This causes the monetary base to shrink and consequently results in credit crunch and slumps in investment and production. So far, the Government has taken money out of productive industry, having withdrawn 7 trillion rubles into reserve funds. At the same time, the Central Bank has provided 5 trillion rubles in loans to the banks, which then use these loans for monetary and financial speculation. In this way, the monetary authorities pump money from the productive industrial sector into the financial sector, reducing its supply. By the end of the next year, if the Central Bank’s policy is not changed, the external loan freeze will lead to a monetary base squeeze of 15-10 %. This in turn will cause spasmodic contraction of the money supply, investment fall-off by more than 5 %, and production decline of 3-4 %. The reduction of money supply poses the threat of a 2007-2008-like crash of the finance market. The capital outflow may provoke defaults in many lending entities, and the number of defaults might become overwhelming.

The policy of increasing the refinancing rate set by the Central Bank results in a rise in the cost of credit, and secures a tendency to shrink the money supply and worsen the deficit in addition to the aforementioned negative consequences. For all that, inflation does not decrease, due to the ongoing influence of non-monetary factors, increased losses due to the rise in the cost of credit, production decline, and ruble devaluation. Since credit is inaccessible, currency devaluation has no net positive effect on export expansion and import substitution. Due to the worsened conditions for capital growth, money continues to be exported, despite the increase in interest rates. The economy is artificially sucked into a whirlpool of dropping supply and demand, and sagging incomes and investments. Attempting to hold onto budget gains by increasing taxes exacerbates the capital outflow and decline in business activity.

Forcing the economy into this stagnation trap happens solely due to monetary and loan policy. Meanwhile there are available production capacities that are only 30-80 % employed, part-time idleness, savings exceeding investments, and an excess of raw materials. The economy, which continues to be a donor to the world financial system, uses just 2/3 of its potential capacity.

To exit this stagnation trap it is necessary to halt the “capital outflow – money supply reduction – demand drop and credit crunch – rise in costs - inflation growth - production and investment decline” spiral. To do so, simultaneous measures to stop capital outflow, to stabilize macroeconomic situation, to de-offshore the economy, and to create mechanisms to nourish economic growth from internal sources must be taken.

In order to stop capital outflow it is critical, first, to burden cross-border transactions so that their illicit gains are offset, second, to cut speculative operations meant to destabilize the currency and finance markets, and third, to close off the channels of internal flow of capital into accounts in foreign currency.

The first task can be performed by introducing a tax on capital outflow at the rate of the VAT imposed on cashless cross-border transactions in foreign currency. In the event the legality of those transactions is confirmed (delivery of imported goods, service rendition, confirmation of interest payments and cancellation of loans, dividends and other legal returns on invested capital), the VAT is refunded. In this manner, only the illegal, tax-dodging outflow of capital will be subject to taxation. Whilst the tax is being introduced, the Central Bank can call for reservation of the potential tax money for all suspicious cross-border operations for up to a year or until their legality is confirmed.

In addition, the VAT should be reimbursed to exporters only after submission of export earnings. A penalty must be imposed for overdue debit debt under importation contracts, non-reporting of export earnings and other types of capital export in its full amount. It is essential to stop including non-residents´ distressed debts owed to Russian enterprises into non-operational expenses (and thus decrease assessable income). Claims must also be filed to indemnify an entity or state for losses against managers, if such debts are reported.

To restrain illicit capital export accompanied by tax evasion, a unified information system of currency and tax control must be created, including electronic declaration of operation IDs and insertion of these IDs into databases of currency and tax monitoring institutions. Rules must be introduced to determine the responsibility of the entities´ managers in cases where there is an accumulation of overdue debit debts related to export and import operations.

To stem cash export, a rational limit must be set, which, if hit, signals capital export operations (e.g., 1 million rubles, a sum obviously greater than gastarbeiters’ combined wages, tourism expenses, and other day-to-day operations). The export of foreign cash in an amount exceeding 1 million rubles shall then be taxed (tax on capital outflow).

Transparency of cross-border transactions for tax and currency control must be achieved. Following the example of America, agreements with foreign countries must be concluded in which tax information is exchanged and foreign banks register and share information concerning all global transactions involving Russian Banks’ money. At the same time, Russian beneficiaries must be responsible for declaration and taxation of their foreign accounts, assets, and operations in conformity with Russian laws.

To separate legal and illegal export of capital, the Central Bank should require licensing of capital export operations in foreign currency. This should include in-advance notification of capital export, increased regulation of operations in foreign currency by Russian banks, and a limit on the scaling-up of the currency positions of commercial banks.

To avoid excessive losses, restrictions should be placed on the amount of foreign off-balance sheet assets and valuables, including U.S. treasury bonds and securities having large budget deficits or high national debt.

To stop internal capital outflow, opening deposit accounts in foreign currency or depositing the money into previously-opened accounts should be banned. The system of safeguarding citizens’ bank deposits should be confined to deposits in rubles. These measures are necessary because the state cannot secure preservation of valuables denominated in foreign currency while there is a financial war against Russia. At any moment, they could be devalued or frozen due to enemy activities or for other reasons beyond Russia’s influence.

Currency control should encompass not only bank operations, but all financial operations including those involving insurance, which can be used to export capital and evade taxes. It is necessary to at least stop making insurance agreements in foreign currency. In addition, the monopoly wielded by the City of London on reinsurance operations, through which much income is exported, must be abolished. Experience shows that, if a party asserts force majeure, it is idle to expect foreign companies to meet their insurance obligations. The most efficient and sustainable solution is to establish a state monopoly on reinsurance, which could be allotted, for example, to the Export Insurance Agency of Russia.

Generally, during financial war regulators must deem transactions performed in rubles more reliable than those conducted in foreign currency. At the same time transactions in the currencies of the belligerent countries (which imposed sanctions against Russia) should be considered the most risky ones. In view of this, the Central Bank should establish higher reserve requirements and standards of evaluation of risks involved in bank operations in foreign currency vs. those made in rubles.

In order to de-dollarize the economy and to insulate the currency and financial system of the country from speculative attacks, it makes sense to levy a 5% tax on the purchase of foreign currency or bonds denominated in foreign currency.

Aforementioned measures to regulate cross-border transactions should be applied exclusively to foreign-currency transactions. Up until the 2007 financial crisis, the lack of such operations did not have a great impact on macroeconomic stability due to a more robust trade-surplus growth, which was greater than a non-trade deficit. Although the Russian financial system suffered big losses, the foreign currency reserves grew and secured the strength of the ruble. But as capital is exported and corporations’ and banks’ external debt went up, the risk of destabilization of the finance and currency system appeared. This risk was manifested in a 1.5-fold reduction in the ruble’s value and a three-fold stock market crash, along with the loss of the 2007-2008 reserves worth $200-billion dollars.

In the near future, the same thing, but on a larger scale, might take place.

Unlike the export of foreign-currency assets, the export of ruble assets does not create a direct threat of macroeconomic destabilization provided the above-mentioned measures of currency control are in place. There is, of course, the risk that an avalanche of foreign-accumulated rubles could flood the internal market causing inflation and/or strengthening of the national currency beyond the equilibrium level. However, applying the above measures to discourage speculations against the ruble creates a fairly high and essentially insurmountable barrier against speculators when there are sufficient currency reserves.

At the same time, ruble export of rubles implies that the profit accruing to the currency issuer (seigniorage) remains in Russia´s financial system where it can be used to multiply investments, to boost imports of vital commodities and services and to expand reserves. Within certain bounds, building up capacities of the financial system, decreasing foreign transaction costs and increasing competitive edges are beneficial to the national economy. Making the ruble the reserve currency is indispensable to ensuring the stability of the Eurasian integration. This is why it is necessary to withdraw from imposing restraints on cross-border ruble operations, create conditions for recognition of the ruble as a reserve currency by money authorities in other countries, and stimulate the import and export paid for in rubles.

To widen the demand for rubles and thus impart more stability to the national currency and finance system, switching to mutual payments in rubles within the CIS must be encouraged and also when arranging payments with the EU – in rubles and euros, and with China – in rubles and yuans. It is appropriate to recommend business entities to settle payments for exported and imported goods and services in rubles. Herewith it is necessary to provide for allocation of tied rouble loans meant for the countries that import Russian commodities, in order to maintain the commodity circulation, and also to use the currency-linked credit swaps.

It is of the utmost importance to expand the settlement system in national currencies between establishments of the CIS states through the CIS´ Interstatebank or through Russia-controlled international financial organizations (IBEC [International Bank of Economic Cooperation], MIB [Moscow Industrial Bank], Eurasian Bank of Development [EABD] and others). It would make sense to create a payment and settlement system in the national currencies of the EurAsEC [Eurasian Economic Community] members, develop and deploy internal independent system of international payments, having included Russian banks, those of the Customs Union and CIS member states as well as those of Chinese, Iranian, Indian, Syrian, Venezuelan and other traditional partners.

These measures will create all necessary conditions protect the value of the ruble and the financial market to external threats. Therewith, the internal threats related to migration of the money supply into the currency market persist. Although this threat became apparent in the 90s, when rubles were emitted to provide agriculture and other branches of non-financial sector of economy with loans and these rubles then migrated into speculation in the currency market. It revealed itself in 2008 as well: 2-trillion rubles emitted for anti-crisis purposes went into currency market speculation and this depreciated savings once again. The monetary authorities keep disregarding this threat and do so despite the fact that, while the Central Bank amplifies the refinancing of commercial banks, capital export grows. This leads us to assume that commercial banks use most of the loans received from the Central Bank to speculate against the ruble in the global currency market.

In order to stabilize the currency and finance market, it is necessary to stop inflating the finance and currency market by emitting rubles. It does not mean that the Bank of Russia should cease refinancing commercial banks. Quite the opposite; to overcome the recession and ensure economic growth, refinancing should be stepped up. But it should be done cleverly, imposing liabilities on banks which resort to refinancing for illegitimate ends. In particular, the receipt of a loan from the Bank of Russia might only happen on the condition that commercial banks assume responsibility to properly use the credit, excluding the possibility of banks using loans for speculation. To control the fulfillment of this liability, the currency position of commercial banks could be fixed, special accounts used, the bank margin restricted, and project financing tools applied.

The Central Bank could considerably enlarge and extend refinancing operations for banks that consent to the Central Bank’s monitoring of loan use. And the Central Bank should preferably do so on security of bills receivable of end-use borrowers, which exclusively should be manufacturing enterprises, than upon sale and repurchase agreements. The manufacturing enterprises should be monitored by lending banks in order to see whether the loans are properly used, solely to replenish the current capital or investments into core assets. Considering that either company can carry out a vast range of financial operations, including the speculative ones (among them those of capital export), there are good reasons to bring the standards of maximum allowed ratio between credit and debit debt on all legal bodies and to limit financial leverage to no greater than double value the principle.

The very mechanism of refinancing commercial banks should be varied to comply with objective needs for credit. Refinancing service for loans made to manufacturing enterprises should be rendered at interest rate of less than 4%, with bank margin reduced to 1%, so that manufacturing enterprises could take out a loan at a rate that does not exceed their profitability; for other purposes, at current rate according to financial market.

The above measures are about monitoring the offer rate of the ruble and designed to limit demand for foreign currency, purely in order to pay for imported commodities and services, pay interests on external loans and recompense other legal operations. It is obvious that measures to ensure stable offering of sufficient currency are required for stable ruble value. More specifically, it makes sense to reestablish obligatory sale of currency earning by exporters.

After taking the above measures to block rampant speculation, the ruble value could be taken under control. To stop speculation in foreign exchange, it is possible to temporarily fix the exchange rate of the ruble with a value lower than the market one, then to purposefully adjust it without warning. The market insiders will therefore have to consider the balance of payment and optimization of a balance between the need for import and the need for maintaining the competitiveness of national commodity prices. International experience convincingly shows that, when stabilizing, discrete modification of the value of a national currency is better that the floating one, because it halts speculative eddies.

Applying the specified macroeconomic stabilization measures creates conditions for resolving the issue of replacement of external loan sources with internal ones without the risk of starting the inflation.

In order to prevent bankruptcy of backbone companies, it is necessary to replace external loans taken out by Russian corporations with Russian banks’ loans. For this the Central Bank must conduct well-aimed emission of credit resources and supply them to companies on the same conditions as external creditors do. Taking into account the scale of this task (credits subject to cancelation before the end of the next year are worth $180-billion), it needs to be completed only through state-controlled lending institutions. Their managers must bear personal responsibility for appropriate use of credits allocated to specified corporations so that they could meet their obligations to external creditors.

In order to prevent commercial banks’ default on external bonds, those banks should undergo stress tests, while the Central Bank, if needed, allocates stabilization loans to them on terms equal to those of external borrowings.

A special problem is presented by the need to replace the foreign loans which Russian enterprises obtained from European development institutions in order to pay for new equipment. In particular, to prevent the termination of equipment leases financed by foreign lenders, credit facilities must be issued to fund [new] development institutions that would operate in a similar way, using the funds allocated to them for that same purpose. In each case we have to consider, in parallel, whether domestic products could be substituted for foreign imports. Even if they cost more and are inferior in quality, ultimately this approach may be more advantageous, as it reduces the risks, expands the revenue base and opens the way to modernization and growth. We should also stop using state credit resources to lease foreign technology.

The de-offshorization of the economy should begin with the selection of those business activities that are most vulnerable to the corrupt practices that tend to go hand in hand with the use of offshore tax havens. For this, it makes sense to introduce a legal definition of the term “national company” – a company registered in Russia and having no affiliation with foreign entities and jurisdictions. Only such companies should be given access to mineral resources, state subsidies, and to work that is strategically important for the state.

The ultimate owners of shares in Russia’s strategic enterprises should be required to step out of the shadows off-shore and register their ownership in the Russian registers. There has been talk, for a long time now, about the need to follow the example of developed countries by concluding agreements covering the exchange of tax information with offshore tax havens and doing away with existing agreements on avoidance of double taxation, including with Cyprus and Luxembourg, which are known to be offshore transit points. We need to define a uniform list of offshore companies, including those that are part of onshore companies. Transferring assets to offshore jurisdictions that shy away from such agreements must be prohibited.

In addition, we need to require offshore companies owned by Russian residents to abide by Russian legislative provisions on furnishing information about the members of the company, as well as on the disclosure, for tax purposes in Russia, of tax information on all income received from Russian sources, under threat of establishing a 30% tax on all transactions with those who are “un-cooperative”.

Implementing the above measures will create the conditions necessary for the extension of credit without the risk of a flood of money being issued and returned to the currency and financial markets from offshore for speculative purposes. After these measures are adopted, the non-inflationary expansion of the money supply becomes possible along with the re-monetization of the economy in order to increase investment and business activity.

The current decline in production is mainly caused by a contraction in the money supply, deteriorating credit conditions, and the destabilization of the currency and financial markets which resulted in the flight of capital and a drop in investment activity. To stop the downward trend in investment activity, we have to give businesses the opportunity to increase their working capital to allow for the optimal utilization of existing production facilities.

As explained above, we need to establish channels for the unlimited refinancing of commercial banks by the Russian Central Bank, secured by manufacturing companies with the credit already granted requirements to production companies already issued credits at a rate not higher than the average profitability of the manufacturing industry, with the mandatory condition that the credit resources be provided exclusively to manufacturing enterprises, with bank margins limited to 1%. This will result in the changing the credit market from a buyer’s market, where banks enjoy the advantage of a monopoly and business-borrowers have to take loans at usurious rates, into a seller’s market, in which banks will have to compete for customers. This will give solvent manufacturers access to credit on the same terms their competitors see in the West and in the East.

Providing a way to finance working capital will put an end to declining production and will ensure growth at existing facilities. In this way the output of the manufacturing industry, construction and agriculture will be increased by 10–15% within two years.

If we take extra steps toward import substitution, the returns will be commensurate. This would require establishing a lending mechanism earmarked for projects to expand existing production facilities and to create new ones based on the existing technological base. The relevant sectors and agencies need to work actively to prepare and evaluate the proposed import substitution projects. Projects that are selected as promising should receive guarantees from the government or federal agencies in order to attract loans from development institutions and commercial banks, which would subsequently be refinanced by the Bank of Russia at a rate of 2%, while bank margins are limited to 1%.

Productivity growth and import substitution will provide economic growth in the next 3 to 4 years. Sustainable growth in the future requires long-term investment in the modernization of existing production facilities. This means creating a means for the Bank of Russia to refinance commercial banks, through loans secured by bonds and shares in strategic enterprises, at a rate no higher than the average return on shares in the manufacturing industry, while holding the commercial banks liable for the proper use of the credit received. The principles of project financing must be applied broadly.

To achieve rapid development, we need a sharp increase in R & D and investment in the development of promising new technologies, which form the material and technological basis for a long new wave of economic growth. At present, the institutions supporting innovation are patently unable to cope with the task. In order to increase investment in the creation of new industries and the development of new technologies, channels must be established for the refinancing of development banks and state-controlled commercial banks by the Bank of Russia, with the right to claim 2% of the assets generated per annum and on the condition that the credit facilities are used in accordance with the principles of project financing with a margin of no more than 1%. In order to expand the means of financing development institutions, it is desirable that the budget line for their funding be supplemented with a mechanism for refinancing by the Bank of Russia at 2% per annum for the purpose of project financing, secured by the assets thus created.

Along with creating mechanisms for greater lending and for investment in general, special lending institutions should be designed to encourage large scale expansion of those industries that show low profitability. These include strongly seasonal industries, where the turnover cycle is not less than a year (agriculture, resorts and recreational services) and industries with a long production cycle (machine building, construction) lasting more than 3 years. For companies in these sectors, there should be mechanisms for subsidizing interest rates through specialized credit institutions, some of which are already in place. These funds could come from stabilization funds accumulated by the government out of oil and gas revenues. In this case, the Reserve Fund should be converted into a development budget, whose funds should be spent to encourage investment in promising areas of economic growth by funding development institutions. To do this, the capital accumulated in the Reserve Fund should be placed in development institutions, bonds of state-owned corporations, and in infrastructure bonds.

To start on the path of accelerated development requires a multipronged expansion of financing for innovation and investment projects. But this will make sense only if responsibility for their effective implementation is radically increased. This means we should make a transition to our own domestic way of evaluating a project’s economic worth. In particular, to reduce systemic risks, we must replace foreign credit rating agencies, and auditing and consulting companies with Russian ones for every step involved in investment decision-making by public authorities and by banks that are partly state owned. In addition, to make the investments more efficient, a system needs to be created for evaluating and selecting the priority areas for scientific-technical and economic development within the framework set by the strategic planning system.

The implementation of such a comprehensive system of measures to stop capital flight and make the transition from foreign to domestic sources of credit, with the simultaneous de-offshorization of the economy, makes it possible to pursue a policy of rapid development on the basis of a multi-faceted increase in investment and innovation, in key areas of building a new technological foundation. The re-monetization of the economy by having the state boost the lending capacity of the banking system, and the return from offshore tax havens of the capital that has been taken out, will enable us in the next 2 years to see annual GDP growth of 6–8% per year, while investment increases by 15% per year, and R & D spending by 20% per year, all while keeping inflation in the single digits.  more