Princes of Yen

Centre for Banking, Finance
& Sustainable Development
Management School
The Quantity Theory of Credit

and Some of its Applications
Professor Richard A. Werner, D.Phil. (Oxon)
Director, Centre for Banking, Finance and Sustainable Development
School of Management
University of Southampton
[email protected]
Robinson College
Cambridge
30 October 2012

Management School
Some Open Questions in Macroeconomics

1. Why are interest rates often not effective in moving the economy?
2. Why do we have recurring banking crises?

3. Why are banks special?
4. What is money and how can we measure it accurately?
5. The anomaly of the velocity decline
6. What determines asset prices?
7. Why is fiscal policy often not very effective even in the short-run?

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What is the Link between Money and the Economy?

Classical Economics
MV=PY; price of money i
Keynesian Economics
IS-LM Synthesis
Phillips Curve
Monetarism
New Classical Economics

Rational Expectations
Real Business Cycles / Supply-side
MV=PY
Fiscalist / Post-Keynesian
MV=PY
New Monetary Policy Consensus
M does not matter;

price of money i is key

Management School
The Link Between Money and the Economy

Conventional theory assumed that all money is used for GDP transactions.
Effective Money
MV
nominal GDP
PY
with constant or stable V
an identity, a truism (M. Friedman, 1992)

valid under any set of circumstances whatever (Handa, 2000)
Really?

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The relationship between Money and Economy broke down

MV = PY; Md = kPY
(V const.; k const)
20
nGDP/M1(R)
18
3.5
16
3
14
12
2.5
nGDP/M0(L)
10
But:
Velocity of M deposit aggregates declined
Breakdown of the money demand

function in Japan, US, UK, Scand., Asia
8
6
1.5
80
82
84
86
88
90
92
94
96
98
00
1980Q1-2002Q1
Source: Bank of Japan, Cabinet Office, Government of Japan
1.5
1.4
1.3
This is a world-wide puzzling anomaly

Belongia Chalfant (1990).
The quantity relationship came apart at
the seams during the course of the 1980s
Goodhart (1989).
1.2
1.1
nGDP/M2+CD
Mystery of the missing money
02
0.9
0.8
0.7
70
72
74
76
78
80
82
84
86
88
90
92
94
96
98
00
02
1970Q1-2002Q1
Source: Bank of Japan, Cabinet Office, Government of Japan

Management School
The Link Between Money and the Economy

Instead of solving the puzzle of the velocity decline (where did the money
go?), many economists took the easier route of adopting moneyless
economic models, thus simply assuming the problems away

Management School
But: The puzzle of the link between money and

the economy can be solved
The standard equation of exchange
(1)
PY = MV
is a special case of
(2)
PQ = MV
(Fisher, 1911)
Implicit assumption:
(3)
PY = PQ (i.e. all transactions are part of GDP)
But: asset transactions are not part of GDP.

Problem of traditional approach: it ignores financial transactions,
which are often larger than real economy transactions
(Werner, 1992, 1997)
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Management School
Explanation of the anomalies:

The Quantity Theory of Credit (Werner, 1992, 1997)
The link between money and the economy
What is true:
money used
MV
=
=
value of all transactions

PQ
Since a substantial proportion of money is used for transactions that are

not part of GDP, we need to divide money into two streams:
M
MR
MF
Money used for GDP transactions, used for the real economy (real
circulation) (MR)
Money used for non-GDP transactions (financial circulation) (MF)

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Considering growth:
nGDP
M
assets
nGDP growth
= proportional to growth in real circulation money
(PRY)
= VR MR
asset transaction growth = proportional to financial circulation money

(PFQF)
= VFMF
This explains many puzzles in economics:

- velocity decline
- asset prices - the Great Moderation
- why interest rate and fiscal policy have been ineffective
- why there are recurring banking crises
But: How can we separate money M into two streams in practice?
Fisher, Keynes and Friedman considered but failed to disaggregate money

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How to measure money M? --- What is money?

Textbooks say they do not know. They talk about deposit aggregates
M1, M2, M3 or M4, but admit that these are not very useful measures of
the money supply.
The M measures are not in a stable and reliable relationship to
economic activity (velocity decline, breakdown of money demand)
Once viewed as a pillar of macroeconomic models, it is now one
of the weakest stones in the foundation (Boughton, 1991).
Even the Federal Reserve does not tell us just what money is:
there is still no definitive answer in terms of all its final
uses to the question: What is money?

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Do we understand banks properly?

What makes banks special?
- Fama (1985) shows that banks must have some special power
a monopoly power compared to other financial institutions.
- Mainstream theories offer no clear answer what this is.
- Leading textbooks represent banks as mere financial intermediaries:
Saving
Banks
(Lenders,
Depositors)
(Financial
Intermediaries)
$100
=indirect finance
Investment
(Borrowers)
RR = 1%
$99
direct finance
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Some crucial facts about banking that textbooks neglect
A loan is when the use of something is handed over to someone else.
If I lend you my car, I cant also use it myself.
There is no such thing as a bank loan.
When banks lend money, they are not extending loans.
What banks do is more important the single most important fact

about how economies actually work.
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What is money?
Where does it come from?
Only about 3% of the money supply comes from the central bank.
Who creates the remaining 97% of our money supply and
who allocates this money?
A: The commercial banks

This explains why banks are special: They are not (just)
financial intermediaries. They have a license to print money by
creating credit. There is no such thing as a bank loan. Banks do not
lend money, they create it.
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Banks create money out of nothing

Balance Sheet of Bank A
Step 1
New deposit of $100 with Bank A
Assets
Liabilities
$ 100
Step 2
Bank A uses the $100 as reserve with the central bank

Assets
Liabilities
$ 100
$ 100
Schritt 3 With a reserve requirement of 1%, Bank A can now extend $ 9,900 in
credits. Where do the $ 9,900 come from? From nowhere.
Assets
Liabilities
$ 100
+
$ 9,900
$ 100
+
$ 9,900
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Management School
This makes banks special: They create the money supply

Their role as the economys accountants AND their ability to individually
create credit makes banks special (MacLeod 1855; Schumpeter 1912)
The textbook representation is incorrect: banks are not merely financial
intermediaries. They are special, because they create new money out of
nothing = credit creation
This is how 95-98% of our money is created by commercial enterprises.
The creation of the money supply has been in private, commercial hands
for a long time.
Schumpeter (1954): it proved extraordinarily difficult for economists to

recognise that bank loans and bank investments do create deposits. In fact,
throughout the period under survey they refused with practical unanimity to do so.
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Bank Credit Creation: Not in Economics Textbooks,

but Admitted by Central Banks:
The actual process of money creation takes place primarily in banks.
(Federal Reserve Bank of Chicago, 1961, p. 3);
By far the largest role in creating broad money is played by the banking sector
... When banks make loans they create additional deposits for those that have
borrowed.
Bank of England (2007)
Over time Banknotes and commercial bank money became fully
interchangeable payment media that customers could use according to their
needs (ECB, 2000).
Contemporary monetary systems are based on the mutually reinforcing roles of
central bank money and commercial bank monies. (BIS, 2003).
The commercial banks can also create money themselves in the eurosystem,
money is primarily created by the extension of credit . (Bundesbank, 2009)
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Management School
Banking and the Economy

How to measure money M?
- standard deposit measures inadequate; they measure money
not used for transactions, i.e. money out of circulation
- the equation of exchange says that
the money used for transactions must be equal to the
value of these transactions.
- the majority of transactions takes place without cash, as
book-entries in the banking system
- for growth, i.e. an increase in transactions, more purchasing
power/money must have been created.
- in our financial system this is possible only via credit creation.
- thus the right measure of money in the equation of exchange is
credit/ credit creation.

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Disaggregated Equation of Exchange:
(4)
CRVR = PRQR = PRY
real circulation
(5)
CFVF =
PFQF
financial circulation
(6)
(PRY)
= VRCR
(7)
(PFQF) = VFCF
Growth:
determination of nom. GDP
det. of asset markets

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This Explains Major Puzzles in Macroeconomics

1. The anomaly of the ineffectiveness of interest rate policy
2. The anomaly of banks
3. The anomaly of the recurring banking crises
4. The anomaly of the velocity decline
5. The anomaly of the inability to measure money
6. The anomaly of asset price determination
7. The anomaly of the ineffectiveness of fiscal policy
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Explaining the Velocity Decline

- If credit for financial transactions rises, the traditional definition of
velocity will give the illusion of a velocity decline.
- The correctly defined velocity of real circulation remains constant.
Old and New Velocities VM and VR
1.3
VR (L)
1.9
1.2
1.1
1.5
1
0.9
1.1
VM (R)
0.8
0.7
0.7
79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96 97 98 99 00
source: Cabinet Office, Government of Japan, Bank of Japan
1979Q1-2000Q4

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Determinants of Japanese Growth

- Empirical test/estimation of theoretical relationship
(6)
(PRY) = VRCR
- strictest test: Hendry approach of general-to-specific reduction

- general empirical model: GDP
= f (call rate, JGB yield, M2+CD,

HPM, CPI, ODR and CR)
- downward reduction to parsimonious (specific) form yields:

(8)
GDPt = j +
1GDPt-1 + 1C Rt +
2 C Rt -3 + t
- Only credit variable CR survives general-to-specific downward reduction

- No normality problems; Granger causality unidirectional from CR to GDP

Management School
Determinants of Japanese Growth

Eye inspection: CR and nominal GDP (PRY)
YoY %
YoY %
12
12
10
10
nGDP (R)
-2
-4
83
85
87
89
91
93
95
97
99
CR (L)
Latest: Q4 2000
-2
-4

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Some Implications:
1.
Cause of the Japanese recession: banks were burdened with bad

debts, became more risk-averse and reduced lending (CR fell).
2.
If the central bank does not compensate, total credit shrinks and
growth must fall.
3.
Necessary and sufficient condition for more growth is a rise in credit

creation used for GDP transactions. This did not happen sufficiently
during the 1990s in Japan.
4.
The Bank of Japan could have created a recovery at any time

How? Just like in 1945 (asset purchases incl. bad loans; direct
lending; loan guarantees).

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Determinants of Asset Prices

- If CF rises, asset transaction values will rise:
(7)
(PFQF) = VFCF
- for land prices:

(7)
PF = (VF / A ) CF
- empirical test yields:

(9)
PF = PF t-1 + 1 CF t-1 + 5 CF t-5 + t
- no normality problems; Granger causality unidirectional from CF to PF

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Determinants of Asset Prices

- More credit used for real estate transactions pushed up land prices
(and vice versa).
Eye inspection: CF and land prices
YoY %
YoY %
80
40
70
35
60
30
25
50
40
30
20
Nationwide Residential
Land Price (R)
Real Estate
Credit (L)
15
10
20
10
-5
-10
-10
71
73
75
77
79
81
83
85
87
89
91
93
95
97
99
01
Latest: H1 2001

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Credit explains the boom/bust cycles

A significant rise in speculative credit creation CF/C must lead to:
- increased financialisation and lack of support for productive
industries
- asset bubbles and busts
- banking and economic crises
30%
28%
26%
CF/C
24%
22%
Case Study Japan in the 1980s:
20%
18%
16%
14%
12%
79
81
83
85
87
89
91
93
Loans to the real estate industry,

construction companies and nonbank financial institutions
Source: Bank of Japan
25

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Types of Speculative Credit Creation (CF)

Margin loans (credit for financial speculation)
Loans to non-bank financial institutions
Credit for real estate speculation:
to construction companies
Mortgages, buy-to-let mortgages
real estate investment funds, other financial investors
Loans to structured investment vehicles

Loans to Hedge Fonds
Loans for M&A
Loans to Private Equity Funds
Direct financial investments by banks
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Management School
This is how the Bubble Economy works:

The proportion of financial credit creation rises (CF /C ).
This creates capital gains from speculation and bolsters balance sheets.
The myth of the continually rising asset price comes about
asset prices rise
corporate balance
sheets improve
Financial credit creation rises
banks increase
loan/valuation
ratios, more
willing to lend
collateral values
rise
generally
positive/euphoric outlook
27

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This is how the banking crisis and debt deflation works

The creation of speculative credit suddenly drops (CF).
Usually triggered by central banks
IMF 28 July 2008: The vicious cycle has started...
credit creation falls
credit crunch,
bankruptcies
banks get more risk averse,
shrink risk-assets
unemployment
rises
bad debts
increase
demand, growth
fall; deflation
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The Cause of Past Banking Crises

USA 1920er Jahre (Margin Loans):
speculative credit creation
Scandinavia in the 1980s:
Japan in the 1980s:
Asian Crisis, 1990s:
UK property bubble until 2007:
US property bubble until 2006:
Irish property bubble until 2007:
Spanish property bubble until 2007:
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(PRY)
= VR CR
nominal GDP
(PFQF)
real economy credit creation
YoY %
YoY %
12
12
10
10
nGDP (R)
-4
83
85
87
89
91
93
95
97
99
CR (L)
40
70
35
60
30
-2
-4
25
50
30
YoY %
80
financial credit creation
YoY %
40
-2
asset markets
= VFCF
20
Nationwide Residential
Land Price (R)
Real Estate
Credit (L)
15
10
20
10
-5
-10
-10
71
73
75
77
79
81
83
85
87
89
91
93
95
97
99
01
Latest: H1 2001
Latest: Q4 2000
Real circulation credit determines

nominal GDP growth
Financial circulation credit determines

asset prices leads to asset cycles
and banking crises

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Bank credit creation determines economic growth.

The effect of bank credit allocation depends on
the use money is put to
Case 1: Consumption credit

Result: Inflation without growth
Investment credit
(= credit for the creation of new
goods and services or
productivity gains)
Case 2: Financial credit

(= credit for transactions that do
not contribute to and are not part
of GDP):
Result: Growth without inflation,

even at full employment
Result: Asset inflation, bubbles

and banking crises
= unproductive credit
creation
= productive credit
creation
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Warning Sign: Broad Bank Credit Growth > nGDP Growth

This Created Japan's Bubble.
YoY %
20
Broad Bank Credit

15
10
Excess Credit Creation
Nominal GDP
5
0
-5
-10
81
83
85
87
89
91
93
95
97
99
01
03
05
07
09
11
Latest: Q3 2011
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Management School
When broad credit creation exceeds nominal GDP

growth significantly for several years a bubble is
created that must end with a banking crisis
Broad Bank Credit and GDP (Spain)
BroadBankCredit andGDP(Ireland)
30
100
90
80
70
Ireland
25
20
60
15
50
40
10
30
20
10
Spain
nGDP
nGDP
-5
-10
-20
19
9
19 8/Q1
98
19 /Q3
99
19 /Q1
99
20 /Q3
00
20 /Q1
00
20 /Q3
0
20 1/Q1
01
20 /Q3
02
20 /Q1
02
20 /Q3
03
20 /Q1
03
20 /Q3
04
20 /Q1
04
20 /Q3
05
20 /Q1
05
20 /Q3
0
20 6/Q1
06
20 /Q3
07
20 /Q1
07
20 /Q3
08
20 /Q1
08
20 /Q3
0
20 9/Q1
09
/Q
3
-10
1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1
/Q /Q /Q /Q /Q /Q /Q /Q /Q /Q /Q /Q /Q /Q /Q /Q /Q /Q /Q /Q /Q /Q /Q
87 988 989 990 991 992 993 994 995 996 997 998 999 000 001 002 003 004 005 006 007 008 009
9
1 1 1 1 1 1 1 1 1 1 1 1 1 2 2 2 2 2 2 2 2 2 2
bank credit creation > nominal GDP growth

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Management School
Germany could avoid this because its banking sector

consists to 70% of small, local banks that create credit
mainly for GDP (non-financial) transactions.
Broad Bank Credit and GDP Growth (Germany)
15
10
nGDP
0
-5
19
9
19 7 /Q
9 2
1 9 7 /Q
9 4
19 8/Q
9 2
19 8 /Q
9 4
1 9 9 /Q
9 2
20 9/Q
0 4
20 0 /Q
0 2
2 0 0 /Q
0 4
20 1/Q
0 2
20 1 /Q
0 4
20 2/Q
0 2
20 2/Q
0 4
20 3 /Q
0 2
2 0 3 /Q
0 4
20 4/Q
0 2
20 4 /Q
0 4
20 5/Q
0 2
20 5/Q
0 4
20 6 /Q
0 2
20 6/Q
0 4
20 7/Q
0 2
20 7/Q
0 4
20 8/Q
0 2
20 8/Q
0 4
20 9/Q
09 2
/Q
4
-10
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Management School
The Role of Banks in Shaping the Economy

Once we recognise that banks create and allocate 97% of the money
supply, it stands to reason that some kind of responsibility goes with
this privilege.
Banks are profit-seeking institutions that have not been asked to
consider other factors in their credit creation and allocation decisions.
They do not consider the macroeconomic or social welfare
implications of their creation and allocation of money.
They do not even consider how their actions might affect themselves
in the long-run
Banking has been an industry oblivious to sustainability considerations
or the aim of the greater good for decades.
35

Management School
Bank credit creation is a public privilege

It is not a law of nature that commercial banks should be the
institutions creating and allocating the money supply.
It is a public privilege granted to banks, on the implicit
understanding that they will not use it against the public interest.
However, governments and regulators have failed to ask banks to
create and allocate credit mainly for productive purposes and
transactions that are part of GDP. Only productive credit
creation is sustainable.
Markets simply do not ensure an efficient allocation of credit.
Banks have responded by using the privilege to create the money
supply for their own short-term (speculative) gains.
This creates unsustainable asset bubbles and costly banking
crises and subsequent recessions.
36

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Policy Lessons
How to avoid the boom-bust cycles and banking crises
37

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Policy Lessons
Given the pivotal role of credit creation and its allocation all
methods to encourage productive credit creation and restrict
unproductive bank credit need to be considered.
Capital adequacy-based rules, as recommended by the Basel
Committee, have no track record of doing the job. They cannot
end the boom-bust cycles and banking crises.
The only tool that has an empirical track record in delivering both
the right quantity and allocation of credit is a form of direct credit
guidance or credit controls, used in many countries (France until
the 1980s: encadrement du credit; East Asia: window
guidance).
This tool has been at the core of the East Asian economic miracle
and remains the central mechanism explaining decades-long high
and stable growth in China.
38

Management School
Quantitative policy tools of central banking

The literature neglected the frequent practice by central banks to control
bank credit creation directly which is rational in world of imperfect
information and market rationing:
informal, unofficial control of bank credit called:
- credit control, lending ceilings, corset (US, UK)
- lencadrement du credit (France)
- Kreditlenkung/Kreditplafondierung (Germany, Austria)
- credit planning scheme (Thailand)
- window guidance (Japan, Korea, China)

Management School
Empirical Results:
Official policy tools:
Unofficial policy tool:
1. Price Tool (ODR, call rate):
not relevant
2. Quantity Tool (operations, lending):
not relevant
3. Regulatory Tool (reserve ratio):
not relevant
Direct credit controls: no. 1 policy tool
Bank Lending and "Window Guidance"

YoY %
18
16
14
12
10
8
6
4
Window Guidance
Bank Lending
74
76
78
80
82
84
86
88
90

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How to avoid banking and economic crises:

1. Avoid unproductive credit creation (speculative and consumptive
credit creation).
If this form of credit creation rises in the banking system, it cannot be
repaid without major problems. Crises follow.
2. Focus on productive credit creation.

Then banks have the highest chance of avoiding non-performing loans,
asset bubbles, crises and bank failure. There will also be stable, noninflationary growth without recessions.
The definition of productive should include sustainability.
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Management School
What is required: transparent quantitative and qualitative

regulation of credit creation
In the past this was rejected as inefficient interference in the
efficient functioning of free markets
Ironically, today, the UK, French, German and US governments are
trying to re-assert influence on bank credit (to small firms, for
mortgages). The French PM threatened to nationalise banks if they
did not increase lending.
Had proper regulation of the qualitative allocation of credit taken
place earlier, the bubble could have been avoided.
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Management School
Who carries greatest responsibility for the crisis?

Investors, bank employees and mortgage borrowers merely
responded to the incentive structure presented to them.
The creation of bubbles and hence the crisis could have been
prevented by monitoring and directly targeting speculative
credit creation.
Central banks have the means and know-how to do this; they
did so world-wide until the early 1970s.
In the 1980s they said that such credit guidance had to stop as
free markets would deliver better results, and, besides, that
they should be granted total independence from the
government.
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Management School
Macroprudential policy
Goal: to avoid boom-bust cycles and banking crises
Tools available:
Interest rates
Basel capital adequacy (even anti-cyclical)
Basel risk-weights adjusted for productive vs. unproductive credit
creation (currently punishing productive and favouring unproductive
credit creation)
Direct monitoring of bank credit creation for non-GDP transactions,
and using an array of tools to restrict it
loan/income ceilings
LTVs (Germany: 60%)
Banking sector structural policy (Germany)
Quantitative Credit Guidance (QCG)
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Management School
Policy Lessons
Another way to obtain a sustainable allocation of credit creation is to
shape the structure of the banking sector so that banks dominate,
which have no interest in harmful speculative credit creation:
small, locally-headquartered banks.
Banking in Germany
Regional,
foreign,
other
banks
Large, nationwide
Banks 12.5%
Local govt-owned
Sparkassen
Local cooperative
banks (credit unions)
17.8%
26.6%
42.9%
70% of banking sector

accounted for by hundreds
of locally-controlled
small banks
45

Management School
Macroprudential policy
Quantitative Credit Guidance (QCG):
Japan, Korea, Taiwan, China,
before 1945: Germany
after 1945: France, Austria, Italy, Spain, Sweden, India, Malaysia,
Thailand, Singapore, Greece
In many countries it was abandoned after 1972, due to the rise of
the argument for deregulation, liberalisation and privatisation
This produced usually asset bubbles and banking crises in regular
and increasing intervals, of increased amplitude.
The record of abandoning it/not using it: over 100 banking crises
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The Case Against QCG Credit Allocation

It is less efficient than the market on its own
This is a claim based on theoretical analysis. It is correct within the
theoretical dream world described.
In such a world there are no banking crises. Indeed there are no banks!
In our world, the hurdle for intervention such as QCG to improve on
outcomes is far lower: if markets are rationed then banks always engage
in QCG, but just not with the aim to further overall welfare or stable,
sustainable growth
47

Management School
The Interest Rate Story

Low or falling interest rates stimulate the economy; high or
rising rates slow the economy
Interest rates are negatively correlated with economic
growth
Interest rates are the cause, economic growth follows
Thus interest rates should be used as the main policy tool to
move the economy
48

Management School
Keynesian, Monetarist, New Consensus Approaches:

Interest rate reductions will end the Japanese recession.
They didnt.
10 Year Government Bond Yield
and Call Rate (uncol.o/n)
%
9.0
8.0
7.0
6.0
5.0
Gov. Bond Yield
4.0
3.0
Call Rate
2.0
1.0
0.0
91
92
93
94
95
96
97
98
99
00
Latest: December 2000
49

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The elephant in the room:

Why have successive interest rate reductions failed to
stimulate the economy?
Has the liquidity trap argument answered this question?
Has the zero bound literature provided answers?
50

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The Anomaly of Ineffective Interest Rate Policy:

Attempted explanations
Liquidity Trap when rates cant fall further
Ito (2000): Horizontal LM (money demand infinitely interest-elastic) at lowest
interest rates wont fall further no room for further monetary (interest) policy,
but economy still below Yf. ineffective monetary policy, and fiscal pol. effective
Krugman (1998), Svensson (2003), Eggertsson and Woodford (2004): rationalexpectations equilibrium is unaffected by the composition of the central banks
balance sheet. Transmission purely via expectations, based on interest rate
policy.
Problems:
1. Fiscal policy not as effective as the Ito (2000)/IS-LM explanation claims
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Management School
2. The main problem with the liquidity trap argument:

The cause of the trap remains unexplained (exogenous expectations; flat LM)
The trap is applied to the point of lowest interest rates. In Japan this was
reached only in March 2003, thus the analysis does not apply to the entire
decade of the 1990s, when rates fell continuously
The liquidity trap argument does not answer question why interest rate
reductions were not helpful throughout the 1990s; it collapses into the
tautology of stating that rates cant fall further, because they have fallen as low
as they can fall.
Hence the liquidity trap argument cannot be considered an explanation or
theory of what happened to Japan in the 1990s.
The puzzle of ineffectiveness of falling rates which contradicts the New
Consensus approach remains unexplained.

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The Interest Rate Story

What are the empirical facts?
53

Management School
Rates are not negatively correlated to growth but positively

Interest rates dont lead economic growth they follow it
True for long, short, nominal and real rates - and in almost all countries
Japan
Nominal GDP and Call rate
12
10
9
8
7
6
5
4
3
2
1
0
-4
Nominal GDP (L)
6
4
Call rate (R)
-4
0
-2
-6
11
0
-2
10
Nominal GDP YoY%
81 83 85 87 89 91 93 95 97 99 01 03
US Nominal GDP and Long-Term Interest Rates
US Nominal GDP and Long-Term Interest Rates
YoY %
Rate %
US
Nominal GDP and Call Rate
YoY%
Call rate
20
15
15
10
Rate %
US Interest Rates (R)
10
US Nominal GDP YoY%
0
0
10
15
US Nominal GDP (L)

80 82 84 86 88 90 92 94 96 98 00 02 04
14
12
10
8
6
4
2
0

Management School
Cognitive dissonance: Traditional story vs. fact
Traditional story:
Low rates lead to high growth;
high rates lead to low growth.
Fact:
High growth leads to high rates;

Low growth leads to low rates.
Interest rates are the result and hence cannot be the

cause of growth.
Thus why would central banks use interest rates as

policy tool? It is an impossibility.

Management School
The facts are occasionally but not systematically recognised in the literature:
Because of information problems interest rates do not clear credit markets
and quantities of credit may move with no price change.
Miles and Wilcox (1991: 251).
interest rates, and interest rate adjustments, do not play the central role
that they do in traditional monetary theories. credit is not primarily
allocated via an auction market. Rather, credit is largely allocated by a
system in which potential lenders make judgments
Stiglitz and Greenwald (2003: 295).
a recurrent theme in the literature and among market participants is
that the interest rate alone does not adequately reflect the links between
financial markets and the rest of the economy. Rather, it is argued, the
availability of credit and the quality of balance sheets are important
determinants of the rate of investment. Blanchard and Fischer (1989)
56

Management School
Where does the interest rate theory of

monetary transmission come from?
It is a general argument in equilibrium economics
Interest rates are the price of money
The idea that prices are crucial and determine market outcomes is
pervasive in economics
It is based on the most familiar diagramme in economics: a
downwardsloping demand curve and an upwardsloping supply curve
57

Management School
The Theory of Equilibrium

Where the two curves intersect, we get equilibrium
How do we get there?
Prices adjust to make sure
we get to equilibrium.
Price
P, i, w
Hence prices are the key

determinant. Ditto for money
and its price.
Central banks cannot both
target prices and quantities,
as both are in a unique
relationship
Quantity
Q, M, C, L
58

Management School
A convenient political implication:

The interest rate theory of central banking allows central banks to
claim that they do not allocate credit, but operate in a neutral,
objective fashion via the price of money.
This could be politically relevant in the discussion of their status,
independence, accountability and de facto power.
59

Management School
The Theory of Equilibrium

The equilibrium theory is entirely based on the hypothetico-deductive
methodology. It is a theory not derived from empirical facts
FACT: Market equilibrium
is only obtained when
a long list of
assumptions hold:
MS
1. Perfect information
2. Complete markets
i*
3. Perfect competition
4. No transaction costs
5. Utility maximisation of
rational agents
MD
M*
6. Prices adjust
instantaneously
7. All are price-takers
60

Management School
Perception:
Neoclassical economics has shown that
prices move to equalise demand and supply = equilibrium.
Reality:
Neoclassical economics has shown that
equilibrium exists if and only if we lived in a world of perfect
information, complete markets, flexible prices, perfect
competition, etc.
61

Management School
The Reality of Rationing

There has never been any empirical evidence that money and credit
markets are predominantly in equilibrium. It is a theoretical supposition.
On the planet we live, there is no perfect information
In our world, information, time and money are rationed.
Neoclassical economics has demonstrated that therefore markets
cannot be expected to be in equilibrium.
What happens when markets do not clear (i.e. always)?
Demand does not equal supply. Markets are rationed.
Rationed markets are determined by quantities, not prices.
62

Management School
The Reality of Rationing

Rationed markets are determined by quantities, not prices.
(Muellbauer & Portes, 1978; Clower, 1965; Leijonhufvud, 1968, Benassy)
The outcome is determined by the short-side principle.
The short side has allocation power. E.g. job market; newsreaders
Concerning money, the short side is supply:

- limited liability of directors
- small firms are always credit constrained
- money is uniquely useful, hence demand is infinite
Concerning bank credit, rationing is well recognised
63

Management School
Its now official: There is a flaw in economics

For almost 20 years, Alan Greenspan, Fed Chairman (Aug 1987 Jan
2006), was the oracle on banking, monetary, fiscal and economic policy.
A pillar of the Washington Consensus, he recommended deregulation,
liberalisation and privatisation, because markets, left to their own devices,
would produce the best possible result (e.g. his advice to Asia 10 years ago).
In October 2008, all this changed. The Maestro testified to Congress that his
fundamental grasp of the operation of banking systems and markets
was partially wrong.
He had uncovered a flaw in how the free market system works.
He charged that the modern risk-management paradigm the whole
intellectual edifice has collapsed due to the banking crisis.
His belief in the self-regulatory forces of the markets had been shaken.
Its the presumption of equilibrium

64

Management School
The Case For QCG Credit Allocation

Markets are rationed, so banks always engage in QCG, just not with the
aim to further overall welfare or stable, sustainable growth
Since banks and indeed central banks always engage in credit
allocation, it is sensible to make this transparent and accountable, by
publicising the rules.
The only rule required to avoid asset bubbles and banking crises:
banks must not lend for non-GDP transactions.
65

Management School
Credit Allocation
Are We Allocating Credit? Our actions are aimed at increasing credit
flows for the entire economy; we are not trying to favor some sectors
over others. However, an element of credit allocation is inherent in
some of our interventions.
we have recognized that the resulting effects can be uneven across
markets and lenders. This outcome is not a comfortable one for the
central bank
(Kohn, BGFRS, 18 April 2009)
66

Management School
Policy Lessons
How to end banking crises and ensuing recessions
67

Management School
Successful and Unsuccessful Bank Restructuring

Japan 1945-47 vs. Japan 1990s
Bad debts in 1945 approached 100%. Yet, the problem was quickly solved
and a healthy banking sector and strong economic growth re-established.
The solution: bad loans were quickly removed from bank balance sheets,
without costs to economy or government.
How? The central bank bought the bad loans above market value. On the
central banks balance sheet, they will cause no harm.
The costs of this solution are zero. Tax money is not used. The central
bank merely credits the sellers in its accounts.
Even if loans with a face value of 100 but a market value of 20 are
purchased at face value by the central bank, it will make a profit (of 20).
(The magic of credit creation).
1990s: the Bank of Japan refused to do this, insisting on its independence.
68

Management School
The Solution: How to recapitalise banks, increase

credit creation and boost demand - at zero cost!
All the government needs to do is change the way the bailout is funded: it
should not be the government who pays for this, but the central bank.
If the central bank pays, and the assets stay on its balance sheet, there
will be no liability for the government, no increased debt, no
increased interest burden, and no crowding out of private demand.
Most of all, there will be zero costs for anyone.
Even the Bank of England is sure to make a profit (as it acquires assets
of a value higher than zero; but its funding costs are zero).
A radical idea, never implemented? Think again.
Bank von England 1914, Bank von Japan 1945, Federal Reserve 2008
69

Management School
Werner-proposal of 1994: A monetary policy called

Quantitative Easing = Expansion of broad credit creation
Richard A. Werner, Create a Recovery Through Quantitative Easing,
2 September 1995, Nihon Keizai Shinbun (Nikkei)
70

Management School
The Ineffectiveness of Fiscal Policy

- We know from the disaggregated equation of exchange:
(6)
(PRY)
= VRCR
- Without an increase in credit used for GDP transactions, nominal GDP

cannot grow:
- Substituting
(6)
VRCR
= (PRY) = (c + i + g + nx)
- If there is no credit creation, then there cannot be nom. GDP growth, even
if there is greater government expenditure g
Then:
(14)
CR = 0 = (c + i + nx) + g
(15)
(c + i + nx) = g
= complete quantity crowding out
- Testable hypothesis: the coefficient of g should be 1

Management School

- Empirical test: (breaking GDP into its components in eq. (8) and solving for
domestic demand)
(16) (ct+it+nxt) = b1 + b2GDPt-1 + b3CRt +
b4 CRt -3 + b5Gt + et
- A regression should yield as coefficient for government expenditure: = -1

- Estimation Results of Private Demand Model
- sample length from 1983 to 2001
- sample length from 1990 to 2001
- linear restriction tests

Management School

Private and Government Demand
Bn yen
Bn yen
3000
10000
2500
G (R)
8000
2000
6000
1500
4000
1000
2000
500
0
90
-2000
-4000
92
94
C+I+NX (L)
96
98
00
-500
-1000
-1500
Latest: Q4 2000

Management School
Credit Explains Ineffectiveness of Fiscal Spending

- Estimation Results of Private Demand Model sample 1990 (1) to 2000 (4)
Private and Government Demand
Bn yen
Const
Coeff.
Std. err
t-value
t-prob.
Part.R2
430.797
323.8
1.33
0.191
0.043
GDP1
0.369
0.128
2.90
0.006
0.177
GDP3
0.203
0.111
1.83
0.075
0.079
CR
0.015
0.004
3.45
0.001
0.233
-0.957
0.206
-4.65
0.000
0.357
Bn yen
3000
10000
2500
G (R)
8000
2000
6000
1500
4000
1000
2000
500
0
90
-2000
92
94
96
98
-500
00
C+I+NX (L)
-1000
-4000
-1500
Latest: Q4 2000
Result: G = -1
Without a rise in credit used for GDP transactions, nominal GDP cant grow
(complete quantity crowding out; govt share of given pie rises).

Management School
Without bank credit creation the economy will shrink

Griechenland
Kreditschpfung
Index
500
50
Bankkredit (R)
400
40
300
30
200
20
100
10
0
0
-100
-10
Zentralbankkredit (L)
-20
-200
81
83
85
87
89
91
93
95
97
99
01
03
05
07
09
Irland
Kreditschpfung
Index
YoY
11
1200
1100
1000
900
800
700
600
500
400
300
200
100
0
-100
-200
YoY(%)
Zentralbankkredit
Bankkredit (R)
Neu Bankkredit (R)
81
83
85
87
89
91
93
95
97
99
01
03
05
Latest: Mar 2012
RESEARCH CENTER LTD.
110
100
90
80
70
60
50
40
30
20
10
0
-10
-20
07
09
11
Latest: Apr 2012
RESEARCH CENTER LTD.
Bank credit creation is negative in Greece, Ireland,

Spain, Portugal
75

Management School
Applying this Framework to Solving the

European Sovereign Debt Crisis
Werner-Proposal of 2011 (and 1996)
Ireland, Portugal, Spain, Italy and Greece need to stimulate economic
growth
Their governments need to save money and reduce borrowing costs.
Bank credit growth needs to expand and banks need a safe way to
expand their business and their returns
Here is how all of this can be achieved:
Governments need to stop the issuance of government bonds
Instead of borrowing from the bond markets who do not create
money governments should fund their borrowing requirements
entirely by borrowing from all the banks in their country.
76

Management School
Werner-Proposal: The solution that maintains the euro and

avoids default
Governments should enter into 3-year loan contracts at the much lower
prime borrowing rate.
Eurozone governments remain zero risk borrowers according to the
Basel capital adequacy framework (banks are thus happy to lend).
The prime rate is close to the banks refinancing costs of 1% - say 3.5%.
Instead of governments injecting money into banks, banks create
new money and give it to the governments.
77

Management School
Why fiscal spending programmes alone are ineffective

Fiscal stimulation funded by bond issuance
(e.g. : 20trn government spending package)
Non-bank private sector

(no credit creation
-20trn
Funding
via
bond
issuance
+20trn
Fiscal
stimulus
Ministry of Finance
(no credit creation)
Net Effect = Zero
78

Management School
How to Make Fiscal Policy Effective

Fiscal stimulation funded by bank
borrowing
(e.g. : 20trn government spending package)
Bank sector
deposit Non-bank private
(credit creation power)
sector
Assets Liabilities
(no credit creation)
20 trn
20 trn
+ 20 trn
Funding
via bank
Loans
MoF
(No credit
creation)
Fiscal
stimulus
Net Effect = 20 trn
79

Management School
Advantages of this Proposal

The proposal will not increase aggregate debt.
The incentive structure is right, as each country remains in charge of
and liable for its debts. Thus e.g. Germanys credit rating will not be
damaged.
But it takes the monthly market pressure out of the picture: no more
rising bond yields as old bonds mature, so also no further ECB
intervention required or purchases by the EFSF, etc.
The immediate savings will be substantial, as this method of enhanced
debt management reduces the new borrowing costs, even below postECB-purchase yields (E 10bn in the coming year for Italy alone).
80

Management School
Advantages (II)
This proposal addresses the core underlying problem: slowing growth
and the need to stimulate it. The proposal will boost nominal GDP
growth and avoid crowding out from the bond markets.
This is a problem as tight fiscal policy and tight credit conditions slow
growth, with bank credit shrinking: Germany (-0.1%), Greece (-3.5%),
Spain (-0.5%), Ireland (-14%).
Bank credit extension adds to the money supply. From the credit model
we know that the proposal will boost nominal GDP growth and avoid
crowding out from the bond markets.
This increases employment and tax revenues.
It can push countries back from the brink of a deflationary and
contractionary downward spiral into a positive cycle of growth, greater
tax revenues and falling debt/GDP.
81

Management School
Prime Rate vs. Market Yield of Benchmark Bonds: Italy
20
12
20
11
20
10
20
09
20
08
20
07
20
06
20
05
7.40%
6.90%
6.40%
5.90%
5.40%
4.90%
4.40%
3.90%
3.40%
2.90%
2.40%
20
04
20
03
7.40%
6.90%
6.40%
5.90%
5.40%
4.90%
4.40%
3.90%
3.40%
2.90%
2.40%
Latest July 2012
Italy Prime Rates on Existing Loans to Non-Fin. Corps., Over 5 Year Maturity (%)
Italy 5y Government Benchmark Bid Yield - Redemption Yield (%)
Italy 10y Government Benchmark Bid Yield - Redemption Yield (%)
Source: Thomson
Reuters Datastream, ECB

Management School
Prime Rate vs. Market Yield of Benchmark Bonds: Greece
22.00%
12.00%
12.00%
2.00%
2.00%
20
20
10
20
20
20
20
20
20
20
20
12
22.00%
11
32.00%
09
32.00%
08
42.00%
07
42.00%
06
52.00%
05
52.00%
04
62.00%
03
62.00%
Latest: July 2012
Greece Prime Rates on Existing Loans to Non-Fin. Corps., Over 5 Year Maturity (%)
Greece 10y Government Benchmark Bid Yield - Redemption Yield (%)
Greece 5y Government Benchmark Bid Yield - Redemption Yield (%)
Source: Thomson

Management School
Prime Rate vs. Market Yield of Benchmark Bonds: Portugal
8.00%
6.00%
6.00%
4.00%
4.00%
2.00%
2.00%
20
12
8.00%
20
11
10.00%
20
10
10.00%
20
09
12.00%
20
08
12.00%
20
07
14.00%
20
06
14.00%
20
05
16.00%
20
04
16.00%
20
03
18.00%
20
03
18.00%
Latest July 2012
Portugal Prime Rates on Existing Loans to Non-Fin. Crops., Over 5 Year Maturity (%)
Portugal 10y Government Benchmark Bid Yield - Redemption Yield (%)
Portugal 5y Government Benchmark Bid Yield - Redemption Yield (%)
Source: Thomson

Management School
Prime Rate vs. Market Yield of Benchmark Bonds: Ireland
4.00%
4.00%
2.00%
2.00%
20
12
6.00%
20
11
6.00%
20
10
8.00%
20
09
8.00%
20
08
10.00%
20
07
10.00%
20
06
12.00%
20
05
12.00%
20
04
14.00%
20
03
14.00%
Latest July 2012
Ireland Prime Rates on Existing Loans to Non-Fin. Corps., Over 5 Year Maturity (%)
Ireland 5y Government Benchmark Bid Yield - Redemption Yield (%)
Ireland 10y Government Benchmark Bid Yield - Redemption Yield (%)
Source: Thomson

Management School
Prime Rate vs. Market Yield of Benchmark Bonds: Spain
1.70%
1.70%
20
12
2.70%
20
11
2.70%
20
10
3.70%
20
09
3.70%
20
08
4.70%
20
07
4.70%
20
06
5.70%
20
05
5.70%
20
04
6.70%
20
03
6.70%
Latest July 2012
Spain Prim e Rates on Existing Loans to Non-Fin. Corps., Over 1 Year Maturity (%)
Spain 5y Governm ent Benchm ark Bid Yield - Redem ption Yield (%)
Spain 10y Governm ent Benchm ark Bid Yield - Redem ption Yield (%)
Source: Thom son
Reuters Datastream , ECB

Management School
Further Reading:
Basingstoke: Palgrave Macmillan, 2005
New Economics Foundation, 2011

Management School
Weitere Details:
Mnchen: Vahlen Verlag, 2007
M. E. Sharpe, 2003

Management School
Warnings had been given:

Chapter 19 of the Japanese original of Princes of the Yen: When the US stock market
collapses and overextended banks veer on the brink of bankruptcy, individual savers will
not lose their livelihood, as they did in the 1920s. America now has a deposit insurance system.
The problem is, however, that due to financial deregulation, the money is not in the bank
anymore. Over the past 25 years, a dramatic shift of savings has taken place, from bank
deposits to the equity market. Whether directly or via mutual funds, up to 50% of individual
savings are now invested in the stock market. And there is no insurance against capital losses
in the stock market yet. Alan Greenspan knows that the economic dislocation that will
follow his bubble will let previous post-war economic crises pale by comparison.
Individual savers will lose their money. In the words of Alan Greenspan (1967): The
financial policy of the welfare state requires that there be no way for the owners of wealth to
protect themselves. Large losses will be incurred by most Americans, when the Fed
changes its policy and sharply and consistently reduces credit creation, as it ultimately
will. A Great Depression is possible. Of course, it could be avoided by the right policies.
Richard A. Werner (2001). En no Shihaisha (Princes of the Yen), Tokyo: Soshisha
In the English Version of Princes of the Yen (last chapter) I also warn of a major boom-bust
cycle in Europe, with the European asset bubbles caused by an excessively powerful and
unaccountable ECB. Richard A. Werner (2003), Princes of the Yen, Japans Central Bankers
and the Structural Transformation of the Economy, M. E. Sharpe.
89

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Centre for Banking, Finance

& Sustainable Development

The Quantity Theory of Credit

Centre for Banking, Finance

Some Open Questions in Macroeconomics

2. Why do we have recurring banking crises?

Centre for Banking, Finance

What is the Link between Money and the Economy?

MV=PY; price of money i

MV=PY; price of money i

MV=PY; price of money i

New Classical Economics

New Monetary Policy Consensus

M does not matter;

Centre for Banking, Finance

The Link Between Money and the Economy

with constant or stable V

an identity, a truism (M. Friedman, 1992)

Centre for Banking, Finance

The relationship between Money and Economy broke down

Breakdown of the money demand

This is a world-wide puzzling anomaly

Mystery of the missing money

Centre for Banking, Finance

The Link Between Money and the Economy

Centre for Banking, Finance

But: The puzzle of the link between money and

PY = PQ (i.e. all transactions are part of GDP)

But: asset transactions are not part of GDP.

Centre for Banking, Finance

Explanation of the anomalies:

value of all transactions

Since a substantial proportion of money is used for transactions that are

Centre for Banking, Finance

= proportional to growth in real circulation money

asset transaction growth = proportional to financial circulation money

This explains many puzzles in economics:

Centre for Banking, Finance

How to measure money M? --- What is money?

Centre for Banking, Finance

Do we understand banks properly?

Centre for Banking, Finance

Some crucial facts about banking that textbooks neglect

A loan is when the use of something is handed over to someone else.

If I lend you my car, I cant also use it myself.

There is no such thing as a bank loan.

When banks lend money, they are not extending loans.

What banks do is more important the single most important fact

Centre for Banking, Finance

A: The commercial banks

Centre for Banking, Finance

Banks create money out of nothing

Bank A uses the $100 as reserve with the central bank

Centre for Banking, Finance

This makes banks special: They create the money supply

Schumpeter (1954): it proved extraordinarily difficult for economists to

Centre for Banking, Finance

Bank Credit Creation: Not in Economics Textbooks,