With opinion polls consistently showing the Conservatives more than 30% ahead on the question of economic competence it is critical that Labour sets out an economic strategy that might begin to convince a sceptical public that the party can pay for the promises it has made.
The makings of an effective platform are in place. The attempt to think through a New Economics focused on investment has been perhaps the most interesting project pursued under Jeremy Corbyn and John McDonnell’s leadership.
The initiative has sponsored a series of events over the past 18 months that have invited leading political economists including Mariana Mazzucato, Joseph Stiglitz, Ha-Joon Chang, Yanis Varoufakis and Nick Srnicek to share ideas for developing an alternative economic policy able to meet challenges including Brexit, automation, low pay, productivity and climate change.
As ever with Labour over the past couple of years the process has not been untroubled, as some well placed observers have noted, including Richard Murphy, whose ideas for a People’s Quantative Easing formed the basis of Corbyn’s 2015 leadership manifesto.
But the project seems to have informed the ambitious proposals for economic investment that were elaborated most fully in McDonnell’s 2016 conference speech, which promised a National Investment Bank, backed up by a network of regional development banks, designed to ‘supply the long-term, patient finance needed to sustain a new, more productive economy’.
McDonnell suggests some £250 to £500 billion could be injected into the economy to fund projects such as clean energy, the extension of broadband, and investment in major infrastructure projects such as HS3.
It sounds promising, if still rather unfocused, signalling a serious intention to rebalance the economy away from excessive dependence on finance and services, and to channel significant investment into regions that have suffered comparative neglect.
But it is wide open to the elemental question that confronts all Labour economic strategies: how will it be paid for? – a question asked with particular urgency today by an electorate persuaded by the Tory narrative that austerity is a necessary consequence of ‘reckless Labour spending’ that ‘caused the banking crisis’.
Some excellent resources are available to help start the long process of uprooting the economic story the Tories have implanted within the national consciousness so effectively.
One is the Framing the Economy report by the New Economics Foundation that suggests how the false image of the economy as a household budget might be challenged and how metaphors more open to the possibilities of investment encouraged.
Another is a powerful new book by Ann Pettifor, co-founder of the Jubilee 2000 debt relief campaign and the Prime Economics consultancy. The Production of Money takes on a fundamental, but unspoken, question that lies at the heart of economic debate: where does money come from? In doing so it illuminates a false image of money that informs the austerity narrative.
The popular assumption is that money is scarce, representing a physical asset or scarce commodity, traditionally gold or silver. According to this picture a central bank creates money by issuing notes and coins which are exchanged, accumulated and saved by individuals, organisations and companies, then deposited in bank accounts in the form of savings, and in turn lent to borrowers. Commercial banks are envisaged as mere intermediaries between creditors and debtors, and the rate of interest as the price of money set by the market according to the laws of supply and demand.
But while central banks are responsible for maintaining a currency’s value they do not, as that picture supposes, create and oversee a nation’s money supply. In fact, in a modern economy, the power to create money is vested in commercial banks, which print 95% of ‘broad money’ (money in any form including bank or other deposits as well as notes and coins).
Commercial banks do not act as go-betweens, able only to lend the savings deposited with them. Rather the act of lending itself creates those deposits. Private bankers really do create credit ‘out of thin air’ by entering numbers into a computer and digitally transferring that figure into a borrower’s bank account. They lend not on the basis of how much money they have available in the form of savings but on the basis of a promise made by borrowers to repay at a certain time and a certain rate of interest.
This capacity to make money available as required for productive economic activity is the fuel that drives all sophisticated monetary systems. As Pettifor explains with typical clarity:
The creation of money by a well-developed monetary and banking system, first in Florence, then in Holland, and finally in Britain with the founding of the Bank of England in 1694, can be viewed as a great civilizational advance. As a result of the development of these sound monetary systems, there was no longer a shortage of finance for private enterprise or for the public good. Bold adventurers did not need to rely on rich and powerful ‘robber barons’ for finance. Instead bankers disbursed loans on the basis of a borrower’s credibility. This led to the greater availability of finance for a wider range of private and public entrepreneurs, and not just for select groups of the powerful. The new and slowly developed monetary and financial systems both democratised access to finance, and simultaneously lowered the ‘price’ or rate of interest charged on loans. As a result, there was no shortage of money to invest in and create economic activity and employment.
The extraordinary privilege commercial banks exercise to issue credit and set the rates of interest they charge is made possible by sophisticated financial infrastructures that have developed over centuries, backed by the intricate legal systems that regulate financial relationships, the guarantees provided by a central bank as lender of last resort, and, ultimately, the nation’s taxpayers.
In short, the motor that powers a mature financial system is trust. Credit, and the rates of interest according to which it is made available, are in the end social constructs:
The thing we call money has its original basis in belief. Credit is a word based on the Latin word credo: I believe. ‘I believe you will pay, or repay me now or at some point in the future.’ Money and its ‘price’ – the rate of interest – became the measure of that trust and/or promise.
A stable monetary system, backed by taxpayers, is an engine for making funds available for whatever economic activity a nation wishes to prioritise:
If the banking system is properly regulated by public authorities, and operated in the interests of the economy as a whole, there need never be a shortage of finance for sound productive activity.
Money is not simply the result of economic activity: money, in the form of credit, creates economic activity.
Pettifor’s understanding of the nature of debt isn’t new: it was central to the thought of John Maynard Keynes who in turn drew on a lineage dating at least to John Law’s discussion of money in 1705. It only seems radical because economic debate over the past 40 years has been dominated by neoliberal orthodoxies.
The consequences of liberalisation
A clear-eyed understanding of how money is produced makes it easier to develop and – crucially – to advocate economic strategies that seek to prioritise investment. A well-regulated monetary system allows wealth to be generated through a boot-strapping effect: banks offer credit for productive employment-generating activity that brings a return on that investment, a return that can be re-invested to begin the cycle again.
But the system can only work as intended if credit generation is regulated effectively to fulfill two essential conditions. First, credit must be made available at an affordable rate. Second, credit must be directed to activity likely to generate a return in the real economy, and so fund further investment cycles. Without effective regulation the power to create credit will be abused.
Pettifor shows that during the postwar social democratic ’Golden Era’, from around 1945 to 1971, the world’s leading economies – under the influence of Keynes – designed and enforced a range of regulations that helped ensure banks channeled credit towards productive activities.
But since the early 70s that delicate web of regulations has been unravelled by piecemeal liberalisation of the financial sector, freeing bankers to create, price and manage credit without effective supervision, and to move capital across borders, putting it beyond the oversight of regulators.
Deregulation has been motivated both by the self-interest of a powerful financial lobby and a philosophical belief in the market’s capacity to regulate itself – a sanguine assurance that the mechanism of competition is of itself sufficient to ensure cheating and fraud are kept in check.
Liberalisation has made it ever harder for governments to pursue economic policies that prioritise investment in the real economy. The removal of strictures on what money can be created for allows bankers to yield to the temptation to make credit more easily available for speculative rather than productive activity: banks can charge higher rates of interest on credit extended for speculation – in the property or financial markets – because it promises borrowers higher short-term returns than patient investment in productive activity.
As the banking crisis vividly illustrated, runaway speculative credit leads to financial breakdown. Banks lent to individuals, households and firms at usurious rates of interest without properly assessing their ability to pay, leading to eventual collapse of the system when ‘sub-prime’ borrowers defaulted on their mortgages.
Restoring an effective monetary system
Radical economists have proposed a variety of options for re-regulating the monetary system to ensure stable lines of credit.
An increasingly popular initiative led by the Positive Money campaign, which has attracted prominent advocates such as Martin Wolf, Adair Turner and Caroline Lucas, challenges the exclusive right of commercial banks to create credit, advocating a process called Sovereign Money Creation, which would allow the Bank of England to create and grant money to government for direct spending into the real economy.
Sovereign Money advocates argue it would relieve the wider economy’s dependence on the financial sector, ensuring a dependable stream of affordable finance would be available through future banking crises. The idea recalls Corbyn’s ‘People’s Quantitative Easing’ and offers possibilities for funding McDonnell’s investment banks.
Pettifor is sceptical, arguing that credit is more effectively channeled through a well regulated commercial banking system. For her, commercial banks, when operating according to sound guidelines, are able to provide a lending service tailored to the particular requirements of each prospective borrower, and to accurately risk-assess each new application.
Rather than expanding the the central bank’s capacity to issue money she proposes revisiting some of the measures used to regulate the monetary system during the postwar years. Briefly:
- The central bank could take tougher action to hold down commercial interest rates – which continue to be much higher than the headline central bank rate – by making government bonds more attractive to investors.
- Tougher lending criteria could help ensure finance for productive activity is made available at significantly lower interest rates than for speculation.
- Controls could be introduced to restrict the flow of capital across borders: governments cannot manage their interest rates effectively if money is fully mobile, flowing across borders in pursuit of the highest rates of interest, movements that force governments to keep interest rates artificially high to attract capital.
- Stable exchange rates, important for holding down interest rates, could be managed through the buying and selling of currency rather than interest rate manipulation. Ideally exchange rates could be managed through the restoration of a system similar to the Bretton Woods framework that facilitated exchange rate stability during the postwar period.
A critical assessment of the intricate debate between advocates of Sovereign Money Creation and advocates of stronger regulation is well beyond the scope of this article: an excellent review of Pettifor’s book by Positive Money Director Fran Boait offers a fair introduction to the merits of both perspectives, and notes they need not be pursued exclusively.
Crucially, both schools of thought share the same view of money as a social resource rather than a limited commodity, a resource that can be generated through a sound financial system to allow investment in those projects – housing, social care, transport, clean energy, vocational training – that societies deem most essential. As Pettifor argues, quoting Keynes: ‘What we create, we can afford.’ It sounds like a revelatory declaration, but this is precisely what modern monetary systems were designed to enable.
Labour faces a long road before it gets an opportunity to make enlightened use of our monetary system for the common good. Sophisticated economic strategies have to be developed, ideological battles won, and – vitally – narratives sold to doubting electorates.
But the party has been here before, in the 1930s and 40s, when seeking a mandate to pursue the economic policies that help fund Britain’s postwar reconstruction. As Labour’s NEC asserted in 1944, the year before forming the government that laid the foundations for social democracy:
Finance must be the servant, and the intelligent servant, of the community and productive industry; not their stupid master.
The Production of Money by Ann Pettifor is published by Verso Books.
Image: Still from Royal Mint, British Pathé, 1956.