Chapter 35 - Counter-Cyclical Money

The concept of counter-cyclical finance is to provide credit when the private banks fail to do so. The process involves using a government owned and operated public bank to supply credit in a steady and uniform manner to enhance the business development in the nation. In particular, the public bank maintains the supply of credit in a consistent manner to counteract the cyclical nature of private bank credit provision. As these graph show, the private banking system tends to supply credit in a manner that causes the Money Supply to fluctuate. The business, industry, and economic activity of a nation is heavily dependent upon its system of provision of credit. There is a cyclical nature to the provision of Bank Credit to society by private banks. The private banks plentifully for a few years, then they slow the provision of credit. The result of this is a fall in the magnitude of the Money Supply. The banks cut back on their lending whilst continuing to collect repayments. This causes the Money Supply to contract. This is politely called an ‘economic shock’ which conveniently hides the origin of the Money Supply decrease. The supply of credit from private banks also tends to be selective and often favors more profitable speculative activity rather than business activities in the real economy. The inconsistency of the Money Supply can be seen in the next three graphs:

Money Supply Annual Change USA by Andy Chalkley. Data from Fred. Creative Commons Attribute - Andy Chalkley.
Money Supply Annual Change USA by Andy Chalkley. Data from Fred. Creative Commons Attribute - Andy Chalkley.
Money Supply Annual Change USA by Andy Chalkley. Data from Fred. Creative Commons Attribute - Andy Chalkley.

However, not all of the Money Supply circulates. A large portion of the Money Supply sits idle in bank accounts for months and years on end. Only a small portion of the Money Supply can be classed as Circulating Money. I class Circulating Money as money that changes hands at least once a month. This is the money that is active in the Real Economy because it is enabling transactions. The economy is all about transactions. Hoarding is a serious hindrance to the economy. Because Circulating Money is such a small portion of the Money Supply, it is adversely affected by changes in Circulating Money. When the Money Supply falls, the fall tends to be taken from Circulating Money because the hoarders do not release money. Circulating Money is changing hands regularly and is much easier to siphon. Taxes tend to be taken from money when it changes hands or is a calculation based on a series of transactions, such as annual income. Interest is taken from Circulating Money because people who hoard do not need to borrow money. This graph shows the percentage change in the Circulating Money against time:

Circulating Money Annual Change USA by Andy Chalkley data from Fred. Creative Commons Attribute - Andy Chalkley.

The magnitude of the Money Supply is heavily dependent on the rate at which loans are issued. This horrendous graph shows the wildly changing level of Commercial and Industrial Loans:

Commercial and Industrial Loans. Creative Commons Attribute - Andy Chalkley.

This greatly affects the economic activity as shown in this graph of GDP change.

GDP Annual Change USA by Andy Chalkley data from Fred. Creative Commons Attribute - Andy Chalkley.

You have seen this graph before, but look at the changes at 2008. You can see a falter in the Money Supply and a fall in the volume of private debt.

USA graph of debt and money. Creative Commons Attribute - Andy Chalkley.

Here is a graph of the change in Circulating Money over a longer time span. So much for a central bank stabilizing the Money Supply. The Federal Reserve System has never managed to keep it steady. They have had long enough to prove that they cannot maintain a steady volume of Circulating Money.

Circulating Money Annual Change USA by Andy Chalkley data from Fred. Creative Commons Attribute - Andy Chalkley.

The major component of the Money Supply is the Bank Credit which is created by banks when they make loans. It is numbers in bank accounts. If the banks cease lending, the Money Supply and Circulating Money fall dramatically with dire consequences for the economy. This graph shows the change in lending during the inappropriately named ‘Great Depression’. It was not ‘Great’. It was awful:

Loans by banks during the Great Depression. Creative Commons Attribute - Andy Chalkley.

When the banks cut back on lending, the Money Supply falls. The effect on business can be magnified because the repayments tend to come from Circulating Money rather than Hoarded Money. People with Hoarded Money tend not to borrow. Borrowing is done by those with no Hoarded Money. So when the Money Supply falls, the Circulating Money is liable to fall by a bigger percentage than the fall in the Money Supply. This can be shown as a fall in velocity, which is incorrectly diagnosed as “more money is being hoarded”. The error is that the hoarders are still hoarding their money whilst tax and interest are removed from Circulating Money. This next diagram shows how this happens. Velocity equals two. Money is removed from the Circulating Money. The ratio of Hoarded Money to Circulating Money increases. Measured velocity now has a lower value:

When the Money Supply falls, the Hoarded Money stays hoarded and the reduction takes place in the easy to siphon Circulating Money and so the Real Economy is hit hard. An 8% fall in the Money Supply has the potential to reduce the Circulating Money by 50%. Drawn by Andy Chalkley. Creative Commons Attribute - Andy Chalkley.

I shall use the figures for the USA as an example. Up to 2016, the Federal Reserve Bank of the U.S.A. has created $1460 billion in cash folding notes. The Money Supply is listed as $18000 billion. This comprises the Cash Currency ($1460 billion) and money in various bank accounts. Thus the bulk of the money in the nation is the credit listed in bank accounts. As the banks make loans, this figure increases. It is the main reason the Money Supply increases. Only 8% of the Money Supply increase comes from the Federal Reserve Bank. The annual increase in the Money Supply significantly exceeds the volume of Cash Currency issued by the Central Bank. When loans are paid back, bank balances decrease. It is bank credit that is used to extinguish debt. If the rate of payment of repayments exceeds the rate of issue of new loans, the Money Supply falls. Thus the magnitude of the Money Supply entirely depends on the lending practices of the private banks. The notion that the government controls the Money Supply is incorrect. The government collects taxes, which citizens pay into a government bank account and the government spends the same money back out into society. The government collects pre-existing bank credit and spends the same bank credit back into society. This is why tax is called ‘government revenue’. The government does not use Cash Currency issued by the Federal Reserve Bank. It pays its bills with Bank Credit.

The concept of counter-cyclical finance is to provide credit to the economy when the private banks fail to do so. This is effectively an admission that the private banking sector should not be trusted with the maintenance of the magnitude of the Money Supply. When private banks create the bulk of the Money Supply, the magnitude of the Money Supply is prone to rise and fall depending on the profit available to the private banks. Counter-cyclical finance is a ham-fisted attempt to enable the private banks to maintain their profitability without destroying the economy in the process. However, this counter-cyclical finance solution has benefits that go beyond repairing the problems created by private banking sector lending practices. Never forget that money has no value. It is freely created in any volume to enable the transactions that are needed for a vibrant economy. All that money needs to do is hold its value long enough so that the value of the previous transaction is transferred to the next transaction. The solution is for the government to bolster the Money Supply in the event of a reduction of the lending by private banking interests. This could be the treasury creating money in one of the forms of money, whether it be Cash Currency or Digital units of currency or bank credit. It could be as simple as the government setting up a bank owned by the government, commonly called a ‘public bank’. One form of a public bank is known as a ‘public development bank’ or ‘national development bank’. The role of a National Development Bank is to lend money into all levels of society for the purposes of infrastructure projects and national development and for business development at all levels right down to microfinance. The concept of counter-cyclical finance is that this same National Development Bank can lend whilst the private banks are having a ‘slack attack’. This makes good economic sense, but it also demonstrates the inadequacy of a money system dominated by private banks. It is an admission that a private-bank-dominated money system cannot be entrusted with the maintenance of a Money Supply. A government entity is required to do the heavy lifting when the private banks fail to maintain an adequate supply of money and credit in society. It is also of note that a National Development Bank is required to cover for the private banking system’s unwillingness or failure to provide credit for certain infrastructure projects.

I am generally a pro-business type of person having run a few businesses in my time. I recognize that: when a government runs an operation, it becomes inefficient. In the limit, a government enterprise avoids doing the task for which it was created and its daily efforts are absorbed in supporting its own infrastructure without providing service. You can imagine a department such as an ‘Inspectorate of Swimming Pools’ that has hundreds of staff in a multistory building walking around with sheets of paper calling meetings to decide on meeting schedules without ever sending inspectors out of the building. They may even collect swimming pool fees to cover their administration costs. However, when an operation is privatized, it tends to be profit-motivated, leading to cuts in service and increases in fees. An even bigger problem arises when private industry manages to engineer a monopoly situation or a group monopoly or cartel arrangement. Various inappropriate practices tend to occur. Money, water, military supplies, supermarkets and transport immediately come to mind.

This is not an argument against the use of a National Development Bank. It is a very strong reason for having a National Development Bank. The same logic also shows that private banks should not be trusted to maintain a Money Supply.

It is very necessary that the banking system, irrespective of whether it is private or public, should serve society and not just its own interests. Money needs to be channeled into appropriate investments and no level of business should be starved of funds to operate.

The private financial sector has not performed well in some areas. They have been over-lending in boom times and limiting credit in lean times in a pro-cyclical manner. Their lending has been inappropriate. It has limited working capital and neglected long-term finance crucial for large projects. It has hampered the growth of businesses and employment. Small and medium enterprises have been particularly hurt by inadequate and costly credit. The private financial sector also lends for speculation. Private banks can favor speculative house purchasers over potential homeowners, forcing an ever-increasing number of young families into insecure rental accommodation.

National Development Banks correct the limitations of the private financial sector by providing counter-cyclical finance in lean times, effective finance to all levels and sizes of business for a dynamic economy and finance for public infrastructure.

In Brazil, their National Development Bank, the BNDES, served the nation well particularly during and after the 2008 crisis.When private bank lending fell after of the financial crisis, the BNDES continued lending. This countercyclical lending helped Brazil through the crisis much better than many other nations. [Bevins, 2010] [1]

Égert, 2010: “The banking system has become more pro-cyclical.” [3]

There are many reasons for the pro-cyclical behavior in credit supply. This can arise for a number of reasons which are not destructive in intent. Banks tend to lend for profit. As such, they will naturally lend into the most profitable area. If that currently happens to be housing or financial assets it will push up the value of those assets until the profitability disappears in what some might call a bubble. The lending then falls. Business lending in the mean time has suffered from a lack of available credit and an increase in costs due to escalating costs due to inflated land prices affecting land rents for the business and its employees. Basically, rents rise to the maximum the business tenants and business employees can afford. Effectively, the local landowners take a high portion of the income of the business and a high portion of the income of the employees to the point that the business collapses and moves to a nation where the usury of land is not so excessive. Land was provided by god or nature for all living creatures to share. Land only has value if there is employment in the area and government provided facilities. Thus the landowner is making money from infrastructure not provided by himself. Bank lending plays the big part in providing credit to landlords who extract the rent from business.

The lack of available credit to business is particularly harmful to business. Business needs money before it can make money. Whereas, the availability of credit to purchase land and improvements for speculation is detrimental to business as it escalates rents for business and employees in favor of the bank. Current bank lending practices tend to inflate asset prices and consequently, business costs, whilst hampering the development of the real economy by a reluctance to lend to business. The solution here is to create National Development Banks that have lending practices that:

National banks tend to be taken over by private interests. Banks have an unbelievably massive lobby contingent at parliament with exceedingly long pockets. Their ‘generosity‘ extends to campaign funding for ‘approved’ candidates and jobs for life for the compliant. They argue strongly against the government running banks claiming ‘unfair competition’. They appear not to realize that the economy will be damaged by the pro-cyclical lending practices of their private banking industry. The private banking industry is ill-equipped to provide a stable Money Supply. Their lending is profit-driven with little concern for the health of the economy. When lending dries up they simply repossess the houses that they accepted as collateral when they made the loans. Their excess profits allow them to purchase ownership shares in companies in a cozy arrangement where expanding businesses are forced to sell shares in the company to obtain the funds to expand. The tax system has been adjusted through the use of depreciation schedules to be punishing on expanding businesses. The result of the bank’s mode of operation is cyclical fluctuation in the Money Supply. The Central Bank is supposed to control the magnitude of the Money Supply but it is ill-equipped and incapable of doing so. It gives a good illusion in its attempts to do so all amplified by the press. It can be argued that the central bank is designed to give the illusion that the Money Supply and the banks are carefully controlled.

National banks are not popular with private banks. National banks tend to be transferred to the private banking system.

In the 2008 reduction in lending, the solution used was slightly different. The government was induced to borrow more money in a process euphemistically called ‘Quantitative Easing’. The process involved the central bank acquiring government bonds. This enabled the Money Supply to be maintained, but the money fell into the hands of the hoarders and consequently the volume of Circulating Money did not increase.

Graph showing that money became hoarded after Quantitative Easing. Creative Commons Attribute - Andy Chalkley.

Quantitative Easing is a process that is not well understood. The central bank, like the treasury, has the ability to create money out of thin air. The central bank avoids doing so. The treasury was stopped from doing this when William of Orange signed away the power to create money to the central bank. Private banks only create money in the form of Bank Credit when they make equal and opposite quantities of debt in the process called double entry bookkeeping. During the 2008 crisis, the phrase ‘Quantitative Easing’ covered for some clever actions. The central bank creates money by simple account entries and purchases government securities. These securities are government debt in the form of government IOUs, otherwise known as government bonds. It tends to purchase these from financial institutions. These financial entities do not operate in the real economy and so the freshly created money does not boost the real economy. The financial vultures have a feeding frenzy and the money becomes hoarded.

What is not appreciated about the solution for 2008 was the nature of money movements associated with Quantitative Easing. It was believed that central Bank purchases of government bonds would release fresh money into the Money Supply. This is correct. Some might consider it a stroke of genius. The central bank creates money out of thin air and purchases government bonds. However, these bonds are purchased from institutional investors. These people have plenty of money and do not go out and spend it at the grocery store. The money finds its way into Hoarded Money. It does not enter Circulating Money. It is more likely to be put into another investment scheme and not spent in the real economy that supports the nation. Following 2008, the velocity fell as the fresh money became hoarded.

Graph USA velocity of money. Creative Commons Attribute - Andy Chalkley.

To lift an economy it is necessary to spend money into the real economy as was done in Australia.

Please read this article: “The positive role of good development banks” by Professor Stephany Griffith-Jones for the Third Annual Conference – ‘Financing For Development’ 20 May 2015 [2]