Wednesday, December 24, 2014

Clarity amidst muddlement. Richard Werner proves credit creation. PLUS - New YouTube documentary: Princes of the Yen

Has you ever done this? Asked your bank manager for a €200,000 loan 'for research purposes'. That is just what Professor Richard Werner did last year to prove a point that has been absorbing eminent economists since the mid-19th century. An academic battle has been raging for well over 150 years about what exactly banks do when they lend money to customers. It has involved economists of high international standing including Macleod, Wicksell, Withers, Marshall, Keynes, Crick, Phillips, Stamp, Mints, Schumpeter, Stiglitz, Samuelson, Tobin, Klein, Gurley and Shaw and many, many more.

Whilst these notables discoursed around the matter of how banks produce a loan, the banks themselves carried on regardless of academically discerned niceties. The trouble is that over that period many financial crises stemming from bad banking practices have taken place with the most recent one possibly the worst it over yet? Clearly whatever goes for economic policy that has flowed from universities to governments since the mid-C19 has not been very effective in controlling banks which regularly create asset bubbles which burst causing financial disruption. 

So we have high confusion. Bankers seems to know just what they are doing, having made between the crises, extraordinarily powerful and profitable businesses. Meanwhile politicians guided by academics have been chasing around trying to understand what the banks are doing in order to prevent the next crisis.

Into this steps Richard Werner wanting to get to the heart of the problem. Having proved to his academic satisfaction that individual banks create credit, he resolved that a good way to convince others of this particular economics conundrum was to observe it happening in an ordinary bank branch. So with some panache he embarked on an experiment to do just that and to find out which of three historical theories stands up to scrutiny. He was assisted by helpful bank officials, a photographer to capture screen shots and BBC reporter Alastair Fee with a cameraman to record it all. Werner's aim was to cut through the 'hypothetico-deductive' method of the economic establishment where ''unproven 'axioms' are 'posed' and unrealistic assumptions added''. He just wanted to see what happens in a bank's internal accounts when it lends money and so hopefully trace the birth of a loan. This was in Germany on 7th August 2013, when the directors and staff of a small bank enabled him to borrow the €200,000, and the next day when he paid the cash into another account at another bank, just to show it was real money.

You can study the theme and the experiment in a new academic paper just published by Elsevier and the International Review of Financial Analysis. In this Werner (with K.Voutsinas and S.Dhanda) gives the history of how banking as a function has been viewed over the last 170 years by the leading economists of their day. Title: Can banks individual create money out of nothing? The theories and the empirical evidence.  [Feb 2016 NOTE: This is a 'corrected proof' see note at head of the paper] Starting with Henry Macleod (1855) Werner explains three theories of what banks do in passing loans to customers, here generally described: 
Theory 1. They do actually create credit out of thin air and lend it on. 
Theory 2. They do not as individual banks create credit themselves, but the whole banking system 'somehow' does create credit utilising the fractional reserve system, according to the ascertained central bank reserves of the individual bank. The mysteriousness of the 'somehow' problem was acknowledged by eminent economist Mints (1945) who said it 'proved to be one of the most baffling for writers on banking theory'. 
Theory 3.  From two pre-existing sources of money - their equity and deposits of various types - banks lend out only from what they already have. The process being known as 'financial intermediation'.

From the mid-C19 Theory 1 prevailed and now Theory 3 is top. Keynes moved from Theory 1 through 2 to 3.  In very recent years there has been a shift back towards Theory 1. Even the Bank of England acknowledged in March 2014 that individual banks create credit out of nothing.  However as academics seem largely ignorant of this simple fact, Werner wanted through his experiment to prevent a toilsome debate for yet another century about the three theories, with the possibility of reaching no conclusion even then. After all, long ago in 1927 economist Sir Josiah Stamp (Bank of England director) said: 'there is a fair amount of muddlement ...on the apparently simple question : 'Can the banks create credit, and if so, how, and how much?' '.

To Werner's satisfaction the German bank in August 2013 created credit out of nothing which accords with Theory 1. In the paper Werner explains how Theory 2 ( based on pre-existing fractional reserves) and Theory 3 (intermediation of existing money) cannot hold for the loan the bank created for him. He explains that the fractional reserve theory is a half-truth but that the financial intermediation theory now prevalent is quite false.  Werner claims that his experiment  to prove that banks create credit out of nothing is likely to have been the first such in 5000 years of banking history. Its outcome has huge implications as economists and politicians grapple with how to direct this money supply created by banks for productive purposes. 

Over many years holders of the theory of credit creation by banks have been denigrated as 'cranks' and 'agitators' by scoffers who have never bothered to examine it for its scientific veracity. Werner has it that grand economists have brushed aside real truth whilst peddling their own inadequate explanations. Meanwhile banks have done their credit creation work beneath the radar of public gaze, thereby amassing fortunes and leading to the crashing of the financial system from time to time as their bubbles burst. Werner's researches have over many years led him to expect that there is a way to a 'fair, effective, accountable, stable, sustainable and democratic creation and allocation of money' and hopes that 'the awesome power to create money is returned directly to those to whom it belongs: ordinary people, not technocrats.'  Read the paper for his ideas on how. 
Werner has also just launched a film version of his 2003 book Princes of the Yen as a full length YouTube video Princes of the Yen: Central Banks and the Transformation of the Economy.  The theme of this 90 minute documentary is about the power of central banks, in particular the Bank of Japan from WW2 and the post war period to date. There is a terse commentary with historic news clips resulting in a documentary of high forensic quality. It illustrates how US-centred institutions influenced events in Japan and the Far East over a long period and 'how crises can be re-engineered to facilitate redistribution of economic ownership and facilitate legal, structural and political changes' with  a suggestion that the Eurozone crisis is similarly being used to centralise power. The film was issued in November and now has over 30,000 hits. The book was reviewed on this blog in 2009.   
Posted by Charles Bazlinton.

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