The images travelled around the world. In the early summer of 2015, long lines formed in front of cash machines and banks in Greece. A desperate pensioner complains on camera that he’s not able to buy the medication his wife needs because there is no access to cash. The Greek economy is on the brink of collapse. How lucky we are, some may have thought—and some journalists in fact wrote—that in 2008 we saved our banks across Europe. While that was very costly and drove up the public debt, it spared us from seeing similar images in Berlin and Paris.
In fact, the banking crisis of 2008/2009 and the crisis in Greece in the summer of 2015 were caused by completely different factors. Seven years earlier, the banks stumbled because they had gorged themselves on high risk papers and bad loans. When the debtors—U.S. house owners and Spanish real estate speculators—were no longer able to service their loans, causing massive losses in the derivatives based on these loans, losses piled up that far exceeded the capital of financial institutions. In order to prevent them from going bankrupt, states took over a large part of these losses. Public funds in excess of 4,500 billion (or 4.5 trillion) dollars were made available for this purpose in Europe alone. Bad loans of around 1,000 billion are still on the balance sheets of European banks. However, since the European Central Bank is flooding financial markets with cheap money, creating a state of permanent euphoria, few really care—until they are rudely awakened by the next crash.
In 2015 Greek banks sat on top of a mountain of bad debt—no big surprise after five years of economic depression that had already destroyed one quarter of Greece’s economic performance. But the trigger for those dramatic scenes was a different one. Greece was running short on cash. The sudden spike in demand was accounted for by fears on the part of the Greek population that their accounts might be switched back to the old currency, the drachma, in the process losing a substantial part of their value. This could not happen to a paper euro. For this reason the Greek population would have preferred to exchange their entire electronic euro holdings, i. e. the money in their checking accounts, into paper euros. An unusual situation since normally we consider the two kinds of euros to be equivalent. After all, with your bank card and electronic money you can pay for the same things that you buy with cash—unless the receiver is trying to evade taxes. The card has the additional advantage of having a PIN number, while cash money is lost when it is stolen.
For this reason, cash money usually no longer plays a central role in our lives. We pay for more than 80 percent of our purchases electronically. The situation was quite different in Greece in June 2015. After influential European politicians such as German finance minister Wolfgang Schäuble had publicly speculated about a return to the drachma, the Greeks worried about a devaluation of their money. This prospect unsettled them more than the fear of being robbed. In other words, they wanted cash. Cash itself is only paper banknotes, the supply of which can be easily increased. The problem, however, is that while banks are authorized to issue electronic money (and almost without limitations, as we will see), they are not permitted to print banknotes. Since the introduction of the euro, the Greek Central Bank has not been permitted to do so; printing money is exclusively done by the European Central Bank. Its job is to ensure the cash supply in the euro area. Well, at least in principle.
As the events in Greece have demonstrated, supplying the economy and the population with money is not simply a technical problem but an intensely political issue. In the early summer of 2015 the unruly Greek leftist government wanted to put an end to the policy of cutbacks dictated by the so-called troika of European Central Bank, International Monetary Fund, and European Commission. The Greek government had held a referendum on this question and won over 60 percent of the vote. There were obvious political interests in favour of forcing the Greek government to back down. Germany, Spain, as well as many Eastern European governments were among those interested parties. But the European Central Bank, which for the first time exerted its power without any restraint, made the decisive move. In spite of a growing demand for money, the bank restricted the supply of euro banknotes, further strengthening the desire for paper instead of electronic euros. As a result, with monetary transfers coming to an almost complete halt, the Greek economy was on the brink of collapse.
The blackmail worked, the Greek Syriza government caved in. As soon as the new program of cutbacks, which in its brutality far exceeded previous ones, was signed, the ECB resumed its job. People could again withdraw as much cash as they wanted. Gradually, the demand for cash subsided as speculation about a reintroduction of the drachma—at least for the time being—died down.
The fact that the Greek problems of early summer 2015 have been confused with the question of saving the banks at the start of the most recent major financial crisis clearly indicates just how little the working of our current financial system is understood. How does money come into existence today? Who launches it into circulation? Why does today’s financial system obviously not work the way it should? And why have the periods between financial crises over the past 30 years become shorter and shorter while their extent has grown dramatically?
No one can deny that the financial sector is of central importance for the development of an economy. All decisions that determine future prosperity—on research, investment, innovation, and the promotion of ideas—are related not only to entrepreneurial considerations but above all to the availability of funds. It would be the task of a well-functioning financial sector to allocate funds to economic sectors that can create a rising standard of living by using better, i. e. labour-saving and sustainable, technologies.
Loans or other types of financing are in demand from a wide range of enterprises—from corporations to small producers, from innovative start-ups to self-satisfied monopolists, from hostile take-over projects to speculative hedge funds. It is up to the banks to decide whose requests will be fulfilled and who will lose in the competitive race for money. This represents incredible power. You might think that a society has a strong interest in making sure that such power is used responsibly and does not fall into the wrong hands. Seen in this light, it is baffling how long and with what equanimity we have tolerated the fact that the key industry “financial economy” is profoundly and permanently damaging our prosperity on a global scale.
In the spring of 2008, the president of the Federal Republic of Germany, Horst Köhler, compared the international financial industry with a monster that was increasingly losing touch with the real economy. In the fall of the same year, it became abundantly clear what he had in mind, when the U.S. investment bank Lehman Brothers collapsed, taking down with it a large number of big and small banks, insurance companies, and other financial institutions around the world. More accurately, this is what would have happened had states not saved them at the cost of a rapidly increasing public debt.
Suddenly issues previously known only to experts on the international financial system became the subject of public debate: the obscure methods that for many years allowed large investment banks to earn absurd sums of money; the extent to which non-transparent financial instruments were dumped on the market—derivatives that in 2003 U.S. investor Warren Buffett called “financial weapons of mass destruction”; and the extent to which manipulation, explicit and implicit fraud, and other criminal machinations were part of the business model.
This realization produced a general feeling of shock, sanctimonious commitments from governments to root out the dangers of financial speculation, as well as one or the other half-hearted regulatory initiative that, if not immediately defanged by the financial lobby, just disappeared in the archives. The bankers were biding their time until the storm blew over, then returned to their desks and computers to continue working in the same way as before. Yet the stakes of the game they were playing had only increased as a result of the crisis.
We continue to tolerate the arrogant gamblers in the sales offices of the large betting shops we still call banks, and not only that—we even finance them. It was thanks to the many billions of dollars and euros that after a brief phase of uncertainty everything could continue as if there had never been a crash. Martin Hellwig, former Chair of the German Monopoly Commission and now a conservative critic of the banks, writes: “It is as if we were subsidizing the chemical industry so that they pollute our rivers and lakes, thus encouraging them to produce more pollution.”82 The situation is indeed pretty insane.
In Europe the project of a European banking union was launched, which for the first time established by law what previously had been only a de facto state liability guarantee for private banks. It was celebrated as major progress that in future, owners and creditors were to participate in the financial rehabilitation of a failed bank. Participate! That is, up to a maximum of 8 percent of the bank’s debt.
This fact alone demonstrates how far public debate has moved away from any market principles when dealing with banks. Why are its owners merely “participating” when a private enterprise goes bankrupt? In what other industry is their share of liability limited to 8 percent of the debt? In case of bankruptcy in the regular economy, owners lose their shares. If it is a partnership, even the owners’ private assets are included in the bankruptcy assets.
We permit the banks, on the other hand, to continue engaging in transactions of trillions of dollars with minimal equity of their own. While a medium-sized engineering company with less than 20 percent equity is not considered creditworthy, the large banks operate with equity capital of about 3 percent. And then European legislation is passed guaranteeing that not even those 3 percent will be included in case of bankruptcy, but only a portion thereof, and only to the extent that it won’t threaten the institution’s financial stability. A scene from the insane asylum, it seems. But this has become the reality we live in.
Of course state failure is the other side of the power that we have given the financial industry, which feeds on itself, becoming ever larger and more powerful. Jamie Dimon, Chair of the Board of JPMorgan Chase, which during the financial crisis rose to the rank of largest U.S. bank as a result of concluding very advantageous mergers, once remarked that his financial institution made a “good return in the bank’s ‘seventh business segment’—relations to the political establishment and the state bureaucracy.”83 And Joseph Stiglitz, Nobel laureate in economics, responded to the question why Goldman Sachs emerged as a winner from both the Asian financial crisis of 1997 and the financial crisis of 2008 as follows: “They have co-written the rules which permit them to do exceedingly well even in crises they have caused themselves.”84
The monster was set free during the global deregulation of financial markets in the early 1980s. From then on there was no stopping it. Whereas in the late 1970s, 100 billion dollars a day were traded on global currency markets, it is now over 4,000 billion. The annual volume of financial derivatives was less than 50 trillion dollars, the global casino is now trading 1,500 trillion derivatives every year. In the twenty years between 1990 and 2010 in which the size of the world economy tripled, the financial economy expanded by a factor of 300. The balance sheet of Deutsche Bank today is forty times that of its 1980 value.
Only 2 percent of global financial transactions have any relationship with the real economy. The financial gamblers prefer to trade with their own, i. e. with banks or other financial service institutions. An example for such incestuous monetary transactions is high frequency trade, which by now accounts for 70–80 percent of business in U.S. stock exchanges. In terms of the real economy, such transactions make no sense at all, much like most derivatives and bills. However, the manipulation of market prices generates billions in risk-free revenue for the financial institutions.
There is probably no other economic sector in which so much money is earned without providing any relevant product. This is possible since the economic power and closed markets in the case of oligopolies we discussed earlier apply to the financial sector as well. The global financial market is essentially run by the insider deals of a handful of large banks and a few large capital fund managers. Their “put” or “call” determines the value of currencies, bonds, and shares just as much as it does the interest rates a state pays on public debt.
That investment bankers should think themselves masters of the universe was occasionally ridiculed or viewed as a sign of their hubris during the financial crisis. But actually they are not suffering from an exaggerated sense of self-importance—they are indeed the masters of our economy because we have made so. So-called financial experts of the kind frequently invited to talk shows tell us that the “judgment of the markets” should be accepted not only by firms but by states as well. If “the markets” are of the opinion that Spain should pay 10 percent for its government bonds, this is viewed as the judgment by a sacred source, which humans ought not question. But who are “the markets”? For the emission of European government bonds, there are about 15 large international banks that are authorized by states with the exclusive right to place government bonds. This is not just a closed market, it is no market at all. It is 15 self-assured investment bankers whom we have given the right to make decisions on our prosperity and the financial room for manoeuvre of elected governments.
There is no need to discuss the quality of these “market judgments”, since prior to 2010 Greece received loans far exceeding the acceptable limits of public debt. More important, such a distribution of power between private institutions and elected governments makes democracy simply impossible. In this context it is not surprising that all attempts at government regulation have failed. Those who control the flow of money hold the longer end of the stick.
For this reason there is no such thing as the soft regulation of the financial industry. Either you cut the base of their power—their virtually limitless ability to generate money, which they use to make incredible profits and channel into economically unproductive or even destructive activities—or you lose. “Give me control over a nation’s money, and I won’t care who makes the laws,” the legendary founder of the Rothschild banking dynasty, Mayer Amschel Rothschild, observed at the end of the eighteenth century. Without a change in monetary order there cannot be a different economic order.
There was a time when bankers had few friends among politicians and even among economists. After the stock market crash on Wall Street and other financial centres had led the world economy into many years of depression with millions unemployed and dramatic political consequences, some lessons were learned. The financial institutions were put into a tight corset and virtually everything was regulated—interest on savings and loans, admissible fields of activity for commercial banks, de facto even the quantity of loans they were permitted to issue. The banks where your average Joe had an account and which gave loans to normal firms were small and stable. The radius of their commercial activities was regional, or at most national, and they were not engaged in trading shares. The job of a banker was boring, secure, and moderately paid—more suitable to honest employees with a public servant mentality than for high-flying minds with special mathematical talents. Stock markets were a place for trading shares and bonds, but without untransparent securities, and the volume of trade was low.
It was clearly a better financial system. In the period between 1945 and 1971 there were no significant banking crises. No one missed all the derivatives, securitizations, and other financial innovations, which the financial lobby now—wrongly—tells us are of fundamental economic significance.
That a small financial sector is more beneficial for the real economy than a bloated one pursuing its own incestuous money transactions and bets on derivatives can by now be considered a well-established fact. Numerous studies have confirmed that firms in countries with a large financial sector have reduced access to investment and innovation funds, which is why there is a negative relationship between the size of a country’s financial sector and its economic growth.85 Why this is the case can be easily understood. The financial industry should have the task of channelling funds into economic investments that make all of us more prosperous. If instead its primary activity is directing money into channels that only make financial gamblers richer, then the economy will necessarily have a lower level of development.
This has also been the German experience. When, around the turn of the millennium, Deutsche Bank, the other large private banks, as well as state banks started to do “investment banking on the high bar”, as Deutsche Bank’s former Chairman of the Board, Rolf-E. Breuer, referred to the bank’s new goal, lending by those banks collapsed almost completely. Had Germany not had the savings banks and credit unions, which were partially able to make up for this decline, medium-sized businesses, usually celebrated as “the backbone of our economy”, would have rapidly declined.
In conventional textbooks, banks are often represented as so-called intermediaries between savers and investors. Collecting individuals’ savings, they pass on the capital to those who are willing to go into debt. A criticism of the banks with respect to this model would be that they direct savings into the wrong channels. This would be bad enough, but reality is even worse. If the banks were only money brokers, they would never have become this powerful. The banks in our time don’t distribute money, they create it, and almost without limit. The money they have created is then channelled for the most part into the financial economy rather than the real economy. Why bother with small borrowers if it is so much easier and vastly more profitable to earn money in financial commerce? In this way, today’s financial industry feeds itself, becoming larger and more powerful, while—especially smaller—enterprises willing to invest are left to starve.
In order to better understand how the financial industry works, the following section will discuss the question what money is and how it Is made, looking at both past and present. Unfortunately, a certain degree of abstraction is unavoidable. If you have no interest in these more theoretical questions, you are advised to skip this section and continue reading the following section entitled “Money is a public good”. This is also where a proposal for a new monetary order is developed.
Speaking about money, many people may still be thinking about gold or silver coins, even though none of us has personal experience of such currencies. Money is related to gold only if gold is given a monetary function. What are the functions of money? First, and this has also been historically its original function, money is a unit of accounting with which goods and services are valued, which makes it possible to balance accounts.
To the extent that we are dealing with manufactured goods, it stands to reason that the value of a good is related to the work that has gone into its production. If the production of one kilogram of wheat requires twice as much work, or the employment of twice as many slaves, as the production of one kilogram of oats, this suggests that one kilogram of wheat is given double the value.
Bookkeeping of debts and assets is almost as old as economic activity itself. The reason is simple. Economic production requires time, and in order to bridge this time, the producer needs either to have reserves or someone who will let you pay up later. The latter generates debt that has to be measured in a certain unit. Those, on the other hand, who first supply goods without receiving immediate compensation, are building up claims or assets. Bookkeeping of debts and assets can be done in cuneiform writing on stone or scoring tallies on willow trees—how it is done doesn’t matter.
The usefulness of such a credit system is evident. It lends the creditor purchasing power she would not otherwise have. Without the opportunity to go into debt, her reserves would constitute the limit for planning purposes. Lean periods as a result of poor harvests or other calamities could thus be bridged without immediately starving to death. There has never been an economy without debt, and as such debt is not a bad thing, on the contrary: it makes possible economic projects that otherwise would not happen.
However, the downside of the debt system was already known in early antiquity—excessive indebtedness. Interest can drive up debt quickly, especially if the debtor is using it primarily for consumption rather than profitable investment. In order to prevent a majority of the population from falling into debt bondage and becoming serfs, ancient communities would from time to time cancel all debts.
A special kind of debt that also emerged early is debts from taxes that states impose on their subjects. Already the old Sumerians financed their state through levies that were calculated with the measuring unit they called the shekel.
To start with, money is merely a unit of calculation in order to make debt possible and thus create additional purchasing power. Debt measures the value of goods, work, or taxes in a common unit of accounting. We refer to this unit as a currency. It may be called shekel, guilder, euro, or whatever.
Obviously this is not the only function of money. We don’t just incur debt or build up assets, but we pay with money. When we have bought and paid for cherries at the grocer’s, we don’t owe him anything, he has our money, we’re all paid up. Since the seventh century before the start of the Christian calendar, when the first evidence for the existence of coins is available, money has not only been a measuring unit for calculating debts and assets, but also a means of payment.
In order to use it as such, we need some thing that represents a certain number of measuring units and that we can give to the seller. It is better if this thing is not too large or heavy. Some people used cows as a means of payment, but this is not very practical. Bars of precious metal were also used very early as payment. But this too is cumbersome. For small amounts, extremely accurate scales are needed, and for large purchases you would have to carry heavy weights. This is why it has become standard to just pay with symbols, the material value of which is significantly lower than the value of the goods that could be purchased with it.
The most important condition for being able to pay with a symbol is of course that the seller is willing to let us have her goods in exchange for this symbol. Symbols useful for this purpose are small round pieces of metal, paper notes, or digital entries on hard drives. They give us purchasing power if our counterpart accepts them.
A woman we shall call Ellie Rich might use her colour printer to produce small colourful bills with flowers and numbers. She could call her currency the ellar. If she finds a group of people who agree to value garden crops and mutual services in ellars and to accept these bills, then Ellie will be able to lend her bills to someone who purchases zucchini and potatoes from the garden of another person, so he can make it to his next salary payment. He then goes to fix a broken water pipe for the vegetable grocer, receiving in turn Ellie’s bills, which he returns to her, adding a few strawberries by way of interest. Alternatively, Ellie herself may go shopping with her bills and have the cherry harvest from all others delivered to her.
Ellie’s problem is that it might be difficult to find people who sell cherries, zucchini or potatoes in exchange for ellar bills, and even more difficult to find someone willing to borrow them. After all, anybody could print bills with flowers and numbers saying “5 ellars” or “10 ellars”. They would fulfill the same purpose without the need to go into debt. But those bills will hardly serve as money. It is not because it costs little to produce them, but because there is no reason why others should accept them.
True, there are exchange networks working along these lines. However, their currencies tend to be exclusively units of calculation, based on the agreement that hours of work or other services are accounted for in this currency. For good reason no one is authorized to print this currency, since they would be in the privileged position of receiving the services of others without giving anything in return simply by printing bills. Moreover, with this kind of incentive there would probably soon be more bills in circulation than members of the network who would be willing and able to babysit or do work in the garden. Exchange circles with their own currencies may survive for extended periods, but usually just on a small scale. They work best if members know each other personally. And people will probably be careful not to accumulate claims in this currency above a certain limit because you never know whether they will still be honoured in a few years time.
Another currency that was privately created is the bitcoin. They can be used to do transactions on the Internet. However, not every seller accepts bitcoins as payment. And members of this system have learned that it is not advisable to accumulate large amounts of bitcoins. This is because their value in terms of other currencies, and thus their real purchasing power, is subject to extreme fluctuations.
The money states put into circulation and accept for the payment of taxes is as a rule generally accepted within the borders of this state. A seller is assured that there is at least one address where these symbols of value will be honoured, i. e. by the state. In Europe state money initially consisted of coins denominated in a certain currency. The coins were made of metal, with the value of the metal usually lower than the value imprinted on the coins.
Money as a unit of value thus permits us to incur debt and in this way to have additional purchasing power. Money as a means of payment provides its owner with a symbol that gives him purchasing power without having to go into debt. It relieves the seller from the risk of his buyer in the end not being able to pay. It is of course always easier to buy than to borrow, and a shortage in the means of payment can seriously harm a country’s economic activity. This is precisely what occurred in Greece in the summer of 2015. The section of the population without credit or debit cards—a significant number among older Greeks—were all of a sudden unable to buy anything even though they had money in the bank.
After the invention of coins as money, other means of payment emerged as well. Coins were simply not available in sufficient quantities. In addition, long-distance trade was difficult to finance with a means of payment that was accepted only in certain territories. In order to avoid having to transport significant amounts of precious metal, economic actors proved extremely ingenious by introducing symbols into circulation that could be used as means of payment. Bonds, for example, fulfilled this purpose well if debtors were wealthy and respected, making it highly unlikely that upon completion they would not pay their debts.
If, for instance, a Florentine painter in the early sixteenth century was commissioned to produce a portrait of a member of the Medici family, for which he received in advance a document promising him 100 gold coins upon conclusion of the work, chances were good that he would be able to use this paper as a means of payment. He could pass it on to an inn in return for a hot meal a day for a year. The inn could have probably paid a supplier with this promissory note. Commercial bills of well-established businesses were also circulating as means of payment. If a debtor unexpectedly went bankrupt while having numerous bills in circulation, this could strongly affect economic life.
In classical Athens and again after the fourteenth century, deposit banks existed issuing their own bonds that could be used for payment purposes. Basically, these banks did what Ellie Rich would have liked to do—print notes to give them to merchants and other traders who would thus increase their purchasing power for other business projects. Unlike the case of Ellie, the system worked because these notes were generally accepted. The trick consisted in the banks as creditors guaranteeing that they would on request provide the value of the figure on the note in the form of silver or gold. They disposed of precious metal since others were storing their gold and silver in the banks, for which in turn they also received notes they could use as money.
The only precondition for the functioning of this system was the unblemished reputation of the banker. For if customers had actually acted on the promise of receiving precious metals in exchange, the old banks would have met with a similar fate as the Greek banks did in the early summer of 2015. Just as in the latter case, customers held much more electronic money than the bank held in cash, the old bankers had of course printed more notes than there was gold in their vaults. For the bankers concerned, the result would be rather unfortunate. After the bankruptcy of their bank, they would also be personally ruined, living out a their days in debtors’ prison. The Catalan authorities even passed a law in 1321, according to which bankers who could no longer honour the claims of their clients would be publicly denounced and beheaded in front of their bank.
In economic terms, this did not make sense, since the gold stored in bank vaults was not directly related to the emitted notes’ function as a means of payment. The notes endowed their owner with a specific amount of purchasing power with which to demand goods and services. The notes could fulfill this function completely independently of whether the banks stored tons of gold in their vaults or whether only rats lived there. However, since ultimately the notes were the banks’ private bonds, their acceptance was naturally a function of their ability to pay. And in a crisis situation this depended upon their stock of precious metals. This is why the erroneous view emerged that recoverable money had to be secured by silver or gold—a view that has survived for many centuries.
Bank failures in which a significant portion of the means of payment in circulation lost its value would regularly result in economic crises. This is why, in the second part of the nineteenth century, banks in most industrial countries lost their right to print notes. Only the state or a bank specifically invested with a monopoly of producing bank notes, the central bank, would now have this right. From then on not only coins but paper money as well became state money.
That’s when the financial architecture emerged that essentially remains in place to this day. It consists of commercial banks that accept deposits and offer loans, maintain accounts, and transfer funds—i. e. increasing the balance of one person and reducing that of another, thus effecting a payment. However, upon request commercial banks have to pay out a deposit in paper money. They therefore have to ensure that their cash holdings are sufficient, since they are not allowed to print any money themselves. The central bank is now responsible for supplying the economy with paper money, which it lends to commercial banks. In addition, the central bank is the lender of last resort, i. e. the emergency credit supplier of banks with the goal of preventing their collapse as a result of liquidity problems.
The currency system that emerged in the nineteenth century differed from our present system in its so-called gold standard. This was based on the theory that the precondition for a stable currency was limiting the quantity of money in circulation to the value of the gold stored in the central bank. For this purpose a fixed value of a currency unit in gold was established, making it possible to exchange a pound sterling or a dollar for a fixed amount of gold at any time.
With brief interruptions, the U.S. dollar was linked to a fixed rate in gold until 1971. However, regular citizens no longer had the option of exchanging their dollars into gold. This right was restricted to other central banks. Theoretically, the U.S. central bank (the “Fed”) would have had to cough up one ounce of gold for every 35 dollars. Of course everyone knew that it would not be in a position to do so since, in the three decades following World War II, a much greater amount of dollars was put into circulation than the central bank held in gold. When, on the initiative of President Charles de Gaulle, the French central bank did in fact demand to see gold for its dollars, U.S. President Richard Nixon simply abolished the gold standard.
In the period before World War I and in the 1920s, central banks were quite serious about the gold standard. Rather than trying to keep the money supply of the economy in line with growth and other economic considerations, the primary objective was to protect the fixed exchange rate in gold. On the plus side, there was therefore no inflation in the economy. Instead, shortages in the means of payment and falling prices would occur frequently, with even more damaging consequences for the economy.
Between 1873 and 1879, the price level in Britain declined by 18 percent, and a further 19 percent by 1886. Similarly, from 1870 to 1890 the price index in the United States fell continuously. For consumers this seemed to be a favourable situation, but economically falling prices intensify crises, since deflation means a decline in the value of production but not in the value of debt. As a result, there is an increased danger of over-indebtedness. In such an environment significantly more firms go bankrupt than would be the case with constant or gradually increasing prices.
An even greater problem was that the gold standard seriously reduced any political room for manoeuvre. Since individual currencies had a fixed relationship to gold, this also fixed their relationship to each other. As a result, at least between the industrialized countries, there were basically no revaluations or devaluations. To this extent, the situation was comparable with what is the case in today’s euro area where different states share a common currency. This is why the problems of the past were quite similar to those of today. Already prior to World War I, these countries had close trade relations. In addition, the movement of capital was free and uncontrolled. England, the birthplace of industrialization, continued to be the strongest industrial country in addition to being a large colonial power. The United States and Germany were rapidly catching up. The economic structure of France and other European countries, on the other hand, was still predominantly agrarian.
Whenever countries with different levels and speeds of development trade with each other, this usually results in imbalances. The more productive country will have a trade surplus since its products are more competitive, while the less productive country will have a trade deficit. This will occur if wages in one country stay lower than in another country. The country with lower wages can export more cheaply and therefore export greater quantities while at the same time importing less since lower wages limit consumption. Such a country will therefore realize an export surplus, while other countries are going into debt. What happens is thus precisely what we are familiar with in the euro area today.
If exchange rates are flexible, the currency of surplus countries will appreciate while the currency of deficit countries will depreciate. This means that exports of the more productive or lower-wage country become more expensive while its imports become cheaper. In the end this can re-establish a balance. Under fixed exchange rates or with a common currency, this valve remains closed. It is no accident that since the introduction of the euro, Germany has had 11 consecutive years of balance of payment surpluses of more than 4 percent of GDP, in 8 of those years they were even above 6 percent. Year after year, Germany has thus sold significantly more goods abroad than it has purchased from other countries. Other countries had correspondingly permanent deficits, some running to double figures. As long as currency revaluation and devaluation were possible between European countries, such extreme disparities never existed. Instead, the external value of the deutschmark would increase.
Theoretically, the imbalances under the conditions of the gold standard should have been offset by the movement of gold. The free flow of capital, however, ensured that gold would rarely leave the vaults. Instead of having to pay their deficits in gold, much like today deficit countries received loans.
All this worked only because at the time everyone assumed that defending fixed exchange rates and gold parity were the supreme goals of every central bank. Responding to large trade deficits thus took the form of interest hikes in order to attract capital. In such a system, individual states have basically lost authority over their currency. They are no longer able to use interest rate policy to target their own economic conditions. Instead, they are forced to respond to imbalances in the international financial balance, even if this means their high interest rate policy will trigger a serious economic crisis at home—with corporate bankruptcies and rapidly increasing unemployment. True, this may lead to a kind of rebalancing of trade, but at a very high price. Deficits have usually gone hand in hand with protectionist measures, i. e. tariff protection of domestic industries. In this way, the exchange rate could be defended.
The U.S. economist Barry Eichengreen argues that the gold standard, with its exchange rates fixed for decades, could be maintained only on account of an absence of democratic structures and the lack of universal and equal voting rights in most industrialized countries. For economic historian Karl Polanyi, the role of the gold standard was above all to enforce policies in the interest of capital owners and at the expense of workers. In order to break the resistance of trade unions and eliminate left parties from government, “currency threats” were repeatedly invoked, while the blame for this was regularly assigned to “inflated wages and budget deficits”86.
Polanyi refers to the brief period during the French popular front government under Leon Blum in the 1930s, which attempted to jump-start the economy using Keynesian policies. The government’s scope to create more demand through credit-financed state spending was destroyed by an immediate onset of capital flight. Already in the 1920s, France had experienced that debates about the introduction of a property tax were enough to trigger massive capital flight and a franc currency crisis. As soon as the tax project was abandoned, the external value of the Franc recovered.
Polanyi has strong reasons to believe that without suspending the gold standard, the American New Deal with which U.S. President Roosevelt fought the economic crisis would have never been possible. “The dethroning of Wall Street [as a result of a timely suspension of the gold standard] in the 1930s saved the United States from a social catastrophe of the continental European kind.”87
While the gold standard tied the hands of governments, it did not prevent banks from finding ways and means to expand lending, above all in order to fund financial projects. The central banks’ monopoly over paper money was not a problem, since no cash was needed to finance capital transactions.
The stock market bubble of the 1920s, which burst in 1929, was accompanied and inflated by a continuous expansion of bank loans. In order to make stock markets boom, those who buy shares must have additional purchasing power. An indispensable drug for stimulating this purchasing power is the financial credit extended by banks. Of course income distribution also plays a role. A society in which the rich keep earning more and more and normal workers and employees less and less will have a higher demand for shares and a lower demand for mid-range cars. Yet for a genuine bull market this is never enough. What is required is the unlimited growth in the banks’ creation of credit, which in turn contributes to making the rich who are active on the stock markets even richer.
In order to close off this channel, one of the consequences of the financial crash of 1929 in the United States and Britain was the institutional separation between credit banks and investment banks. While in Germany there were no such laws, the two central pillars of the German banking sector after 1945 were savings banks and cooperative banks, which as classic credit banks would not get involved in stock market activity. In addition, there were the Deutsche Bank, the Dresdner, and the Commerzbank, all of which owned company shares on a large scale but did not trade them. Most of the other business activities of today’s investment banks were simply illegal.
In the period after World War II, at the international level the gold standard was replaced by the Bretton Woods system. It made the dollar the international reserve currency. U.S. currency thus de facto assumed the role of gold. While formally the dollar itself was tied to gold at a fixed rate, from the start the system worked only because the Fed provided dollars, the international means of payment, in large quantities and far in excess of existing amounts of gold. This was hardly an act of selflessness, since the status of world reserve currency of course came with the great advantage of being able to buy abroad without providing anything in return. Our example of Ellie Rich showed how privileged those with the authority to print a particular currency are. The Fed and the U.S. commercial banks were now “printing” the currency for the whole world. This is why Keynes had suggested that rather than having a national currency elevated into international reserve currency, it would be better to create a fictitious one, the Bancor. For the United States, however, this would have been much less favourable, which is why the Americans rejected Keynes’s proposal.
While the exchange rates of all other currencies were fixed with respect to the dollar, they could be changed. The IMF was established in order to grant bridging loans to countries with deficits, while at the same time monitoring their economic policy, thus contributing to a situation in which deficits could be eliminated without altering the exchange rate.
This system however also quickly generated imbalances, i. e. deficits for some countries and surpluses for others. As long as capital flows were strictly regulated, these were caused by imbalances in the real economy. Later, speculative capital movements would further destabilize the Bretton Woods system. It was finally abandoned in 1971 in favour of flexible exchange rates.
The first crack in the strict legal regulation of Europe’s financial sector appeared in the late 1950s, when Euro markets were being established as an international trading zone for financial transactions. It was of course not euros—which didn’t exist at the time—that were traded on Euro markets, but generally foreign currencies that did not fall under the jurisdiction of individual governments. Those governments could have prohibited their banks from engaging in this trade, but for a variety of reasons did not do so.
On Euro markets, but also in the strictly regulated national banking sectors, electronic systems for financial transactions increasingly became the norm. In the early 1960s, wage payments were shifted from cash to direct account deposits. Ever since, digital accounting increasingly marginalized paper money as a means of payment. For banks this was of significant benefit. For electronic money’s march to victory meant that banks fully regained their power to create money, which the cash monopoly of central banks had to some extent restricted. In addition, computerization and digitalization were the technological preconditions for the ludicrous business ideas and financial constructs of today’s investment banking.
Unlike cash money, private banks have the power to create their own electronic money. This is their great privilege, which is not available to other economic actors. In order to extend loans, banks do not need cash savings or central bank loans. Electronic money is created by a bank representative crediting a checking account. This money thus emerges out of nothing, i. e. simply by the fact that it is being credited.88
Let us assume that a generous bank would like to extend a loan of 1 million euros to a valued client by the name of Max Lazybones. As the amount appeared in Max’s account, the item “debts of clients” increases the bank’s assets by 1 million. How does the bank finance this claim? The bank does its own financing, since with Max’s account balance growing by 1 million, the item “liabilities to clients” increases on the liabilities side of the bank’s balance sheet. Legally speaking, the money in our account is money we are lending to the bank, even if most of us are probably unaware. But this what makes our current monetary system so special.
In terms of its balance sheet, any bank can therefore simply create loans at the click of a mouse. With respect to regulation, the bank only has to ensure that its loans are covered by its own capital at a rate required by law. This rate tends to be rather lax. If the borrower has a good rating, it is possible that for every euro of its own equity, the bank can create 62.5 euros in loans. If the borrower is the state, there are no limits at all. The legal equity requirement is most limiting for the extension of loans to the real economy, in particular small firms and start-ups, which typically do not have a top credit rating. In financial business, on the other hand, innovative financial instruments that are accepted as equity are created at the same time as loans are issued to the real economy.89 Alternatively, derivatives are used that minimize equity requirements through supposed risk reduction. This is the reason for the economic boom in credit default swaps. With a modicum of imagination and creativity, today’s financial institutions active in investment banking have a virtually unlimited ability to create money. In this way they are financing the still unchecked growth of the financial sector as well as constantly growing asset and debt bubbles.
To be fair, it should be mentioned that for certain investments, banks are legally required to maintain a minimum reserve in their account with the central bank. This rule is even less effective in limiting credit extension than the equity rule, since banks can borrow the necessary money from the central bank at any time. All they have to do is pledge any of their infinite number of bonds as collateral.
If a business generates risk-free profits on a large scale, we say that someone has a “license to print money”. Private banks literally have this license. They are permitted to “print” electronic money on their own and without any authorization. They are not allowed to print paper money. It is therefore of some significance that cash is playing an increasingly minor role, whereas situations as happened in Greece where all of a sudden everybody wants only paper money are the absolute exception.
Let us return to our fortunate Max Lazybones and his 1 million-euro loan. What happens once the amount has been credited to his account? Usually individuals want loans because they have plans of some sort. There is no reason why the money should stay in his account. Let us assume that, true to his name, Max Lazybones treats himself to a luxury vacation in the Maldives, including a first-class flight and a private yacht. He is not going to withdraw the million euros in cash, but will transfer the money to the travel agency where he has booked the trip. If the travel agency has its account with the same bank as he does, nothing changes in the bank’s balance sheet. Except that the client who owes a debt to the bank is no longer Max but the travel agency. The larger the bank, the greater the likelihood that the travel agency is also one of its clients.
If the 1 million euro is transferred to an account at another bank, Max’s bank has to adjust its balance sheet. Of course not until the end of the day when numerous transfers between his bank and the other bank will have occurred. If nevertheless an imbalance remains, this is not really a problem. Max’s bank will get a loan on the interbank market in the amount of the sum required. What makes this loan different from the money the bank holds in the checking accounts of their own clients is that it has to pay a small amount of interest.
Things will be more difficult for Max’s bank if it has a bad reputation or if the entire banking system of a country has a bad reputation and his travel agency is located in another country. In that case it might not be possible to balance the amount through the interbank market, since foreign banks may not be willing to extend a loan to Max Lazybones’ bank. But this would also not be a serious problem. In order to assist banks with such problems, the European Central Bank comes into play.
Since the financial crisis, the ECB has extended thousands of billions of euros in loans to European banks that were no longer able to get money on the interbank market or would have had to pay much higher interest rates. The ECB claims that all that money has not been created out of thin air, but extended to the banks only against collateral. In fact, banks have to provide bonds in order to receive ECB loans. But the standards for such bonds have been repeatedly lowered during the crisis. By now almost anything is accepted, from government bonds to packaged mortgages.
Without the support of the ECB, the banks in question would have lost their ability for the creation of unlimited amounts of money. They would have been able only to extend additional loans if someone had first deposited new money with them. The ECB provides such new money by accepting a whole range of financial products not only as collateral but also by directly buying them. If the seller is a bank, it is directly credited in its account with the Central Bank. If the seller is a capital fund or a firm, the bank will receive the money as a deposit in the fund’s or firm’s account. Currently 60 billion euros per month are made available to banks in this way.
Theoretically, all banks in Europe have sufficient opportunities to expand their loan business. It is indeed what they do, but they do not extend loans where it would make sense, i. e. in the real economy. Actors in the real economy, especially in crisis-ridden countries, continue to face great difficulties in receiving new loans or even just extending old ones. This fact is often greatly lamented, but the reasons are obvious. We have now reached a point where it is becoming clear why Max Lazybones would have probably never received a 1-million euro loan to go on vacation in the Maldives. In all likelihood the bank would not have trusted him ever to pay it back.
Of course this is not to say that small and mid-sized entrepreneurs in general cannot pay back their loans. But there is a significant risk that a business plan will fail when it comes to investments in innovative products and technologies. If, in addition firms don’t have sufficient collateral, they are unlikely to get any money from their bank. True, a bank can create its own money, but if the loan goes sour it has to deduct the full amount from its own capital. If all of this happens in an environment of economic crisis of the kind that caused havoc in Portugal or Italy, not to mention Greece, the banker who may be hiding lots of bad loans in his balance sheet will be even more concerned that a small enterprise will sooner or later go under. As a result, the bankers prefer to keep their coffers closed.
An additional drawback for the banks is that mid-sized enterprises tend to ask for relatively small sums. A financial deal in the billions has a much more favourable cost-benefit ratio for banks. What is more, banks can rely on the fact that when the next crash happens, everyone will be affected. In that case either they will once again be saved by the state or it will all be over anyway. But as long as the music keeps playing, you have to dance, as the boss of the powerful U.S. bank Citigroup remarked in July 2007.
Thus there are reasons why the ability of today’s banking system to generate money and credit in a virtually unlimited fashion is above all financing new and increasingly larger bubbles on financial markets rather than constructive investments. The European Central Bank’s policy has been widely criticized in light of the real economy’s continuing undersupply with credit. It is a fact that if, after the crash of 2008 and the collapse of the European interbank market, the ECB had not intervened with billions of euros, the current bubbles on almost all asset markets would not have emerged. However, this would have made things even worse in the real economies of Southern Europe. Instead of a credit squeeze, we might have experienced a complete collapse of the credit system, and thus even more bankruptcies and higher unemployment.
A bank collapse would have massively interrupted the flow of payments. Precisely because nowadays more than 80 percent of the money we use to pay for our daily purchases and our rent is electronic money, the smooth flow of transactions depends on the stability of the banks. The Cypriots are the only ones in Europe so far to have experienced what it actually means for our electronic money legally to be a loan to the bank. It means that if this money is gone, the bank will be bankrupt. In Cyprus, even healthy firms were unable to pay their employees since failing financial institutions froze their wage accounts. The fear of such an event occurring is itself enough to destabilize an entire economy.
And this is the source of the banks’ outrageous power. We are permitting the same institutions entrusted with vital economic functions such as payment transactions and the provision of loans to firms to make their largest profits in wild orgies of financial speculation, and since for both the same resource, i. e. electronic money, is needed, this has made us subject to blackmail. We subsidize outlandish betting outfits since, as a sideline—with insufficient effort and without enthusiasm—they are responsible for financing business investments and allowing us to pay for our shopping. In the words of Martin Hellwig, quoted above: It is like paying the chemical industry for polluting our rivers and forests because they use the same poison to produce small amounts of a vital medication.
Of course we can continue doing this. Alternatively, we could think about restructuring the polluters of our environment in such a way that they manufacture a great deal more of the medication without having an opportunity to do their most profitable business by polluting our environment.
The core task of banks is to provide purchasing power for innovative economic development that will enhance our prosperity in an environmentally sustainable way. Neither more nor less. What would such a banking system look like?
We have demonstrated that money is not scarce since it doesn’t cost anything, even though everything can be bought with it. Whoever has a licence to create money has an immense privilege vis-à-vis all other economic actors. However, even if in principle there are no limits to increasing the money supply, it nevertheless ought to be kept scarce. If too much money is pumped into an economy, growth in demand will outstrip supply, and prices will increase. At the same time, if crucial investments cannot be financed because the emission of loans is blocked, this will also produce a crisis. What ultimately matters most is the question of who receives loans for what purpose. If the money flows into useful technologies and innovative products, it will create corresponding value. If it flows into expanding consumption, this may boost an economy in crisis, but there is the danger of inflation. If too much credit goes to a small number of financially strong borrowers, the result will be debt pyramids, as in the case of U.S. mortgage loans that at some point will collapse.
Why should the provision of a good with such characteristics be left in the hands of private profit-oriented businesses? There are no good reasons. This is why, in the nineteenth century, banks lost the right to print money. The argument supporting this move was that the creation of money was a public task—an argument also made at the time by economists of the liberal school, who generally did not have a favourable view of state intervention.
Many people therefore see the central goal of regulation as making banks into what most of us assume they are, i. e. mere middlemen who collect money from savers and pass it on to firms. Regulation should then deprive banks of the power to create credit from nothing. They would only be able to pass on what they have previously received from savers.
The question is, would that make sense? Credit is additional purchasing power introduced into an economy. Saving means that someone temporarily foregoes their purchasing power. Does this imply that in a stable monetary system the extension of credit comes after saving? Certainly not. If a loan finances an investment that makes economic sense, the equivalent value of the money will be generated by the additional production thus made possible. There is no reason why production should be preceded by saving. In economic terms, investment generates savings, since money spent on investment goods cannot be spent on consumption. To achieve this, no one has first to carry money to the bank.
Frequently, those who ultimately finance investments by forgoing consumption are not even consulted. Thus, in almost all capitalist countries, wage earners have financed industrialization through their involuntary sacrificing of consumption. Whether in England in the nineteenth century or in South Korea in the twentieth century, it was always the state that made sure wages stayed low—and it would usually not do so by democratic means. Large profits as well as additional purchasing power created by banks through loans made it possible to finance an enormous volume of investment.
The same dynamic of course also exists in the opposite direction. Low investment reduces incomes and ultimately has a negative effect on saving. Not taking into account foreign trade, at the end of a year savings and investments in an economy are always equal. What matters is the dynamic during the year, which determines whether they are equally high or equally low. And there are strong reasons why both investment performance and saving will be the higher the more purchasing power for sensible investments is available, regardless of whether anyone has first deposited money in their savings account.
From a different viewpoint, this demonstrates once more the absurdity of the thesis that capital income without work is somehow economically necessary to motivate people to save and reduce consumption, thus supplying the economy with sufficient capital. This thesis is obviously nonsense insofar as capital formation is due to profits driven up by involuntary reductions in consumption, i. e. by workers’ low wages. However, even if capital originates in banks creating purchasing power from nothing, thus financing investment, it is difficult to see why, after loans have been paid back, there is a legitimate claim to income without work in the form of dividends and other payouts proportional to the newly created capital. The value corresponding to the purchasing power created by banks emerges from new production and thus from the labour of those who do the work—from the manager and engineer to the unskilled worker.
As we have concluded in the first part of the book, capital therefore is the result of work rather than individual frugality. For most firms, the precondition for the formation of additional capital that makes investment projects possible is the purchasing power created by banks. Nowadays, such purchasing power is available only to those who already possess capital, since banks require a high degree of security. This is what makes capital ownership in the present system exclusive. Those who already own capital receive more, and not because they lead a frugal life of hardship and unstinting work.
Let’s return to the monetary order. Most of the purchases that used to be done in cash now use electronic money. There are even discussions about abolishing cash money altogether. If we want to have banks act as mere money brokers, we need to take away their power to create electronic money, just as in the past they lost the right to print money.
Technically that’s not much of a problem. All of us, citizens and firms, would no longer have our checking accounts with private banks but directly with the central bank. As a result, the money in our checking accounts would no longer be a loan to a private bank. If a bank went bankrupt, this would affect only our savings, but not the money in our interest-free checking accounts. As savers we would become once again very attractive to the banks which, reduced to the role of brokers, would need our money to do business. It would be the end of the era of zero-interest savings accounts. There would have to be incentives for us to move secure money from our checking accounts to a less secure savings account with a private bank.
Bank loans would originate in savings only. The only institution with the right to create money from nothing would be the central bank. A group of economists who call themselves “sovereign-money theorists” advocate this model. Most of them propose that the central bank put additional money into circulation by providing it to the state to finance sensible projects. The license to print money always implies that someone will be able to make a profit without significant costs. That someone would no longer be the banks, but the state. This is the most attractive aspect of the proposal advanced by the sovereign-money school, and we will return to it later.
At first glance this concept seems to be convincing. The fact that everyone would have access to a secure account would be an improvement over the current situation. Upon further inspection, however, there are problems. There are reasons to assume that the credit supply of the real economy might suffer if banks were only allowed to issue savings-based loans. Profit-oriented banks at any rate would charge their lenders in addition to the higher interest rates the banks are paying to savers. The selection process would become even tougher. It is all too predictable that, compared to today, more investment projects would be rejected. Under these conditions, financing prospects for risky innovations would be even worse. The same applies to smaller firms, which always represent a greater risk to lenders than established corporations.
The argument that under such conditions private banks would collapse is unconvincing. A bank collapse would still affect the savings deposited in the bank. As soon as some event were to call a bank’s stability into question—justified or not—people would start liquidating their savings and moving them to their checking accounts. In the system described above, this is all it would take to push a bank into insolvency. It means that simply shifting money from savings to checking accounts would have the same effect as did the bank run in Greece in June 2015, when everybody wanted cash. Under normal conditions—which did not obtain in Greece at the time—a central bank would just print more money in response to increasing demand for cash. In a sovereign money system, the central bank would be forced to compensate the bank in question for the withdrawal of savings. If the central bank fails to do that, the bank will collapse and savers will lose their money.
Why would anyone in such a system choose to hold their money in insecure savings accounts when they could safely keep it in an account with the central bank? Someone interested in investing 20,000 euros will, at a 3 percent interest rate, make 600 euros in the first year. A nice little sum, but hardly enough to risk savings intended for emergencies. Of course it is possible that interest rates may rise. But what does this entail for the credit supply of firms? And once the first bank has collapsed, with small investors losing their savings, millions of bank customers would liquidate their savings accounts at private banks. The only way to prevent such bank runs would be a public savings insurance of the kind that exists in Germany up to 100,000 euros. But a state guaranteeing by law the debts of private financial institutions has little to do with a market economy. Public savings insurance, however, we can safely assume, would constitute a significant incentive to keep completely insolvent banks alive through central bank loans.
Perhaps even more importantly, it should be remembered that until 1929, the cash monopoly of central banks did not prevent banks from financing an enormous stock market boom even though at the time there was no electronic money in today’s sense. But the banks didn’t need this. Even within the framework of a sovereign money system, it is possible for a bank to generate money from nothing if the recipient is credited the amount in a fixed-term deposit account rather than in a checking account. A certificate of these deposits could then be used for financial business.
It would be naive to assume that banks with access to a virtually infinite variety of derivatives would not find ways to create and bring into circulation credit money from nothing—above all for speculative purposes. Just as today’s equity capital rules are circumvented through special derivatives, in a sovereign-money world hordes of financial alchemists would be devoted to the task of figuring out new derivative constructs in order to finance excessive financial deals under new conditions. And they would succeed.
While the ideas of the sovereign money theorists go in the right direction, they don’t go far enough. It is not enough to scare the ghost into temporary hiding with holy water and spells. It has to be put back in the bottle. And the bottle has to be sealed permanently. In less metaphorical terms, an industry in which firms are not allowed to go bankrupt since that would have fatal consequences for the economy, while at the same time these firms can survive only with guaranteed state liability, should simply not be in private hands.
Money is a public good. Public goods are not suitable for the market. More specifically, there is no functioning market for them. A corporation manufacturing bad cars will sooner or later disappear from the market. A corporation producing bad financial products will become more and more powerful and eventually fill the post of U.S. Secretary of the Treasury. That’s the difference. The money supply for the economy does not belong in the sphere of profit-oriented private enterprises, but in the hands of institutions oriented toward the public good, chartered by the government and subject to strict rules. It’s basically the same as with water supply, hospitals, local transport, and many other public services. They can be privatized, but no one should be surprised if subsequently they no longer function properly.
The opposite of private providers is not simply government. There have been public banks with business models similar to those of private banks, as well as enterprises in other sectors that were state-owned but behaved like private profiteers. In Germany, there were Landesbanken (state banks located in the individual states of the Federal Republic), just like the Deutsche Bahn (German Rail) in rail transport, who eventually behaved in that way. However, this was not the case from the beginning. In its earlier life under the name of Bundesbahn, small towns still had their own railway connection, and its workers had no reason to strike. At the time when Landesbanken were simply clearinghouses for savings banks, with a responsibility for financing larger public and private investment projects, they made an important contribution to the economy. Eventually rules were relaxed in both sectors, and achieving the highest possible return became the supreme goal of these enterprises. It marked the end of their public mission and their commitment to the general good.
The business model of savings banks and cooperative banks represents a model for the financial sector that makes sense. These banks finance the regional economy and offer secure investment opportunities for small savers. At one time their model was called the 3-6-3 model. In the morning they take in money at 3 percent, at midday they lend it at 6 percent, and since they have little other business, bank managers are on the golf course by 3. Basically this simple model describes how banks should function, though of course it doesn’t have to be golf that’s on the agenda in the afternoon.
Even savings banks and cooperative banks are not protected against the negative developments of the financial system as a whole. They too sold obscure financial products to their clients. They too provide poor loan opportunities for innovative young entrepreneurs. And they too don’t pay their savers any interest on new deposits, whereas interest rates on loans for small businesses and overdrafts are significantly above 6 percent. These problems, however, can only be fixed with the help of a new framework and changed rules of the game for the entire financial industry.
The goal is thus a financial sector composed of small-sized units with a public mission which, while not profit-oriented, covers it own costs, providing the public good of money in such a way that the economy can develop in keeping with political priorities. The central actors of the financial order proposed here would be common-good banks. Common-good banks are primarily regional banks that conduct business only in a circumscribed territory, being familiar with the firms as well as local conditions. In addition, there should be a number of larger institutions that would function as clearinghouses, while also financing larger private or public investment projects. Their radius of action should not exceed the national scale.
Common-good banks are generally not permitted to do business with financial institutions that are not themselves common-good oriented. Finally, the common-good financial sector includes the central bank as the ultimate credit source for common-good banks, maintaining their liquidity and the cash supply. The central bank also acts as the government financier, with an eye not only to stable prices, but also a stable, innovative economy with a high level of investment and full employment.
The shrinking of banks and their business radius is of central importance. In order to avoid chain reactions, it is necessary to smash the chain. This is significantly more promising than trying to regulate and thus stabilize the banking industry across borders. History has demonstrated that the best way of ensuring that there will be no adequate regulation is to regulate only what different states can agree on. The smallest common denominator is always a weak one, as Hayek already pointed out. From the start, the EU financial market was a deregulation project in the interest of large banks. For the same reason, with respect to re-regulation in response to the most recent crisis, Europe has failed even more than the United States, which managed to impose at least some restrictions. If we want better rules, it is best to introduce them at the national level. If gradually other countries follow suit because it proves to be a better solution, an adequate financial architecture will eventually emerge in all of Europe. If we only regulate what EU members can agree on from the start, the goal will never be reached.
A monetary order for the common good can only be maintained if strict controls on capital transactions with other currencies exist. We have seen how the gold standard has restricted the scope for government policies, ultimately subordinating them to the interests of those who move the big money on an international scale. Even without the gold standard, free capital movement means that the value of a currency can be pushed up or down irrespective of real economic developments—depending on whether a country’s policies are approved or disapproved by big money players. As Robert Stiglitz, winner of the Nobel Prize for Economics, has pointed out, the global freedom of capital basically does not generate any efficiencies. The only “benefit” is a significant weakening of the employees’ position, since wage reductions, just like low capital taxes, can be extorted by threatening divestment.
There are many examples for this. French President Francois Mitterrand, who in the serious economic crisis of the early 1980s wanted to pursue Keynesian policies, and who with these instruments avoided the French economy’s slide into negative growth rates, was ultimately defeated by speculation against the Franc. He either had to accept a radical devaluation and leave the European Currency System, or give up his Keynesian policies. Mitterrand opted for the latter.
On a global scale, massive capital movements have occurred for many years that are unrelated to the financing of world trade but instead result from interest rate differences, among other things. So-called carry trades exert pressure towards currency appreciation on currencies with higher interest rates, making exports from such countries more expensive and thus damaging their economies. Sudden policy reversals may result in extreme drops of the exchange rate, a credit squeeze, and bank collapse, thus causing even greater crises.
Exchange rates should no longer be left to speculation, according to one of the objectives for the introduction of the euro. However, the idea of a common transnational currency has not lived up to expectations. A common-good oriented monetary order presupposes that there is a common political order with authority over its money and with the freedom to decide how to use it. In other words, a currency should be confined to a space that can be democratically controlled. The Eurozone cannot be democratically controlled, it does not even have democratic institutions. We have experienced how in a crisis euro countries with elected governments were disempowered by a technocratic gang composed of the EU Commission, European Central Bank, and IMF, and were forced to adopt policies that made the crisis worse and massively increased inequality. This gang was able to proceed much more ruthlessly than any elected government could have, since the population of the countries in question had no way of controlling or replacing them. Normally, we call such circumstances a dictatorship.
This applies not only to Greece. Spain, Portugal, and Ireland, and even Italy and France, have for some time not had any real freedom to choose their own policies. The events of the early summer 2015 could be repeated in any other euro country as soon as a government is elected that wants to set priorities deviating from neoliberal policies. The current plans for stabilizing the Eurozone will result in an even greater degree of de-democratization. In future, even in the absence of an acute crisis, Brussels technocrats may have the power to intervene in fiscal and tax policies, and even in the wage determination process, of individual euro countries.
This is precisely what the neoliberal fundamentalist Friedrich August von Hayek (1899–1992) had in mind—i. e. restricting democratic control over economic policy—as being the great advantage of a transnational currency. “With a common currency unit the room for action that central banks are given will be restricted at least as much as under a strict gold standard—perhaps even more … ” he wrote in one of his essays in Individualism and Economic Order. In fact, in the nineteenth century, tariffs and other protectionist measures were available that are not possible within the EU. Having a currency without a state and at the same time free trade and free capital flows ultimately makes democracy impossible.
Some are calling for a democratization of the Eurozone. But that doesn’t appear to be a promising project. All past attempts to establish supra-state institutions that would be democratically legitimated and workable have failed. The Brussels club of lobbyists is simply too removed and not transparent for Europe’s citizens. People barely know the individuals in charge there and do not speak their language. A parliament elected by a mere 30 percent of its citizens will never become a democratic authority.
It would therefore be a better idea to give democratic states their own currency back and introduce capital controls on currency exchange. This means that trade is financed but speculation is not. Under such conditions exchange rates would come under pressure in case of actual imbalances in the real economy. There would be an opportunity for adjustment by way of revaluation or devaluation. This would clearly be better than the straightjacket of the euro which does not permit use of this safety valve.
The alternative would be the continuation of the current situation. De-industrialization, mass unemployment, and extremely high youth unemployment at rates between 40 and 60 percent in practically Europe’s entire South, including Italy, have brought declining wages, stagnating economic performance, growing poverty, and the emigration of the most qualified. Those who deprive national economies in the corset of a permanently overvalued currency of the opportunity to ever experience an economic recovery should not be surprised if, as in France, an increasingly strong far right will offer to solve the problem in its own nationalist way. This, however, would mean the end not only of the euro, but of Europe as a whole.
As its point of departure, a functioning European currency system could use the Bancor Plan that Keynes developed as a draft for the Bretton Woods system. In such a system, the euro would be the anchor currency to which all other currencies would be pegged by fixed exchange rates which, however, could be changed if necessary. National central banks would guarantee exchange at these rates. Capital controls would pre-empt capital movements not based on real commercial transactions.
In such a system, long-term deficits and surpluses may occur if there are national divergences in productivity or wage trends—a probable development. European countries differ from each other not only in terms of culture and mentality, but also in terms of systems of trade union organization and other traditions of labour struggle. The period since the introduction of the euro has demonstrated that even under pressure of a common currency, these differences cannot be eliminated, which at any rate would not be beneficial.
A functioning European currency system with fixed exchange rates requires an institution that can finance deficits and surpluses in the short term and up to certain limits—the role the IMF was to play in Keynes’s original plan. The ECB could take on this role today. If there are excessive or long-term deviations from balanced terms of trade, Keynes proposed that countries with surpluses and countries with deficits should both be penalized. These penalties would increase with the size of the imbalances. Penalties could be avoided if the country in question revalues or devalues its currency. Such a system would link democratic sovereignty over national money with a sufficient degree of exchange rate stability.
Those who believe that such a domestically oriented financial sector would threaten the future of a strong export economy such as Germany should revisit the post-war period. In order to finance exports, you don’t need bank branches in Singapore, Panama, or Delaware. And since a country that is a strong exporter should in any event aim for equally large imports, there will be no need for extensive capital movements. A balanced trade account means just that, i. e. that exports and imports balance each other out. In contrast to most economists today, the head of the liberal Freiburg School, Walter Eucken, was aware that “[e]very export that does not make possible imports of at least the same value is harmful to the supply of goods.”90 It would thus be in the well-considered self-interest of surplus countries like Germany to increase their imports.
All kinds of financial dealings and financial papers will have to pass a financial check-up. Only transactions that have a demonstrable use in the real economy will be licensed. Everything else will be prohibited. A non-profit institution should make the decisions. Its experts would receive a higher salary than top bankers and would therefore not be corruptible by the prospect of a lucrative banking job. This will not be excessively expensive since in common-good banks, no one will earn more than a director of a savings bank does today. A financial system that no longer makes outrageous profits will no longer be able to pay million-dollar salaries. This may sound antiquated and very boring, but it is exactly what we need: solid, steady banks rather than overexcited gambling casinos.
What matters is that society re-establishes its authority over the conditions of credit. It is the task of democracy to decide which sectors, technologies, and innovations should receive preferential financing. Those shocked by such a display of mistrust in “the market” should acquaint themselves with the history of countries like Japan, South Korea, or China. Successful economies have never left crucial decisions on credit to bankers but have established their own framework. When they stopped this practice, it was usually also the end of their period of success.
Until the early 1980s Japan had a kind of planned economy in the form of the Ministry for International Trade and Industry (MITI), which issued quite specific instructions on priorities and product development. In addition, the central bank exercised credit control by directing individual banks on the extent of credit and the preferred industries to be financed. In this way, the country’s export economy and semiconductor industry received preferential support. South Korea copied this model in the 1960s and 1970s, achieving a similar degree of success. In 1993, a World Bank study on the economic miracle in the Far East came to the conclusion “that state intervention for the purpose of credit allocation has played an essential role in attaining superior economic performance.”91 By that point in time, the Southeast Asian countries as well as Japan had largely abandoned this model. In China, on the other hand, state development banks continue to play a key role in the selection of prioritized technologies and economic sectors.
If, in the future, we want to have an economy based on green energy and integrated processes, we need to provide extensive earmarked funds for research into and the application of innovative technologies that can move us closer to this goal. And if we want a flexible, competitive economy, it is necessary to direct banks to provide a minimum level of loans to new entrepreneurs and set a target for loans to small and medium-size enterprises. That the market is incapable of doing this on its own has been sufficiently demonstrated. The final decision who will receive credit and who will not will lie with the bank, assuming this will once again be a genuine local bank with knowledge of the enterprises in its region—rather than leaving the decision up to some distant central office or an algorithm producing firm ratings based on untransparent standards.
If many young and innovative firms are financed, this means that the number of loan defaults will go up. The venture capital market in Silicon Valley assumes a failure rate of 90 percent for start-ups. Nine out of ten firms receiving financing are thus expected to fail. The problem with innovative projects is that no one can know ahead of time which will be the nine failures and which one the success. Investors calculate that a firm that does not go bankrupt within ten years will yield a twenty-fold return on the initial investment. This means that in spite of the failures, the investor will have doubled her risk capital.
On account of the peculiarities of digital business models, this calculation has frequently worked out. For other industries, however, it would be an absurd calculation, since a bank loan could not yield a twenty-fold return in ten years. On the other hand, an anticipated failure rate of 90 percent seems extremely high even for innovative projects. If we assume a failure rate of 50 percent, then a 10-year bond would break even at an interest rate of 7 percent.
More important, even if in the model proposed here the banks had to write off a larger number of investment loans than today, this would be more than offset by the absence of bad financial loans and other absurd financing schemes such as those leading to mortgage bubbles. Credit control would also be beneficial for the real estate market, since loans to the mortgage industry could be limited before the boom has even started. Similarly, it would be possible to intervene by giving preferential financing to single-family dwellings or rent-controlled units. Ultimately, banks that are satisfied with low profits could better deal with a larger number of bad loans. If the result is a more innovative and productive economy, this might be a price worth paying.
We should keep firmly in mind that money does not cost anything. Money is purchasing power, and ultimately society has the power to decide for what purposes it does and does not want to provide money. A loan gone bad means that additional purchasing power has gone into circulation without creating equivalent value. The investment has not increased society’s prosperity. If this happens on a large scale, it can result in inflation. But banks always finance successful projects as well. So there is definitely room to take the risk of financing eventual failures since repayment of the loan plus interest removes more purchasing power than was initially created.
Such a model implies that banks may be involved in ventures in which making a loss is part of their calculation. It would be the task of management to keep losses of this kind limited. For a bank this entails that, when extending loans, it needs to select a wide range of projects, and on much broader scale than today. There can be no financial system in which every idea receives financing. However, we should create conditions in which a much larger number of innovative projects get a chance. In individual cases, a bank may still make a bad choice and get into trouble. If as a result it requires state aid in order to be stabilized, our taxes would at least be paying for the innovation power of our economy rather than the insatiable financial gambling of investment bankers. That would make a significant difference. In addition, any profits that common-good banks make will belong to the public.
As we have seen in previous sections, an economy’s capacity for innovation depends not only on the financing of innovative young entrepreneurs, but also on publicly funded research and development activity. Many innovations that young entrepreneurs have launched on the market were first developed in public research institutions. Yet successful public research requires that universities and research institutes don’t degenerate into low-wage zones. Creativity is not enhanced by researchers having to worry about their contracts being extended every two years. The fundamental condition for an innovative economy therefore is a state that has stable financial resources at its disposal. While taxes should finance normal state expenditures from welfare to the state bureaucracy, economically relevant research and public investment could be financed by creating additional purchasing power.
In contrast to other banks, a central bank is not only able to extend loans. It can bring money into circulation without loans as well. Within reason and according to clear rules, the central bank should make use of this right by helping to finance the state. Basically the same applies here as it does for loans to the real economy. To the extent that the state uses central bank money to finance investments that will increase our prosperity, the money will create its own equivalent value, and there will be no threat of inflation. In contrast to loans, the central bank’s direct creation of money does not create any debt and does not require interest payments. More money is simply put into circulation. This can also make sense in economic crises, since money that goes to the government—in contrast to the billions in loans extended by the European Central Bank today which only feed the banks—would contribute directly to the real economy in the form of additional demand.
At first glance, the idea that the state should receive money that no one pays for might appear a bit strange. There is no such thing as a free lunch, as economists like to remind us. Which means that in the economy, nothing is for free. This also applies to economic goods. But it does not apply to money. Since money does not cost anything, those providing it can demand goods without first receiving purchasing power from anyone. The kings and rulers of old gladly took advantage of this by putting into circulation coins with a material value significantly lower than their face value. Problems arose whenever the ruler used this privilege of coinage with excessive enthusiasm, thus creating a growing amount of coins in a stagnating economy. That’s when coins were devalued, first in international exchange and subsequently in their domestic purchasing power. The creation of new money works only within narrow limits if the currency is to remain relatively stable.
Things would become dangerous if a central bank kept pumping the same amount of money into the economy regardless of whether there was an economic boom or crisis, or if the government used the money for expenditures that failed to generate any additional production or value, such as when political rulers line their own pockets or buy warships. But with proper regulation, such misuse could be monitored and prevented more easily than is possible today. True, central banks today are not permitted to give loans to the government, yet private banks do excellent business by creating money out of nothing, charging states hefty interest rates for lending them that money. As long as banks have faith in the solvency of a particular state, its corrupt political elites and warships will be generously financed. The market has never prevented this from happening.
In addition to new money from the central bank that should only be available in a limited fashion, it would certainly make sense to finance public investment by offering savers direct investment opportunities, e.g. in the form of government savings bonds. For citizens, these would be secure investments with moderate interest rates, and for democracy it would be a much better way of financing government deficits than current government securities. For simply placing the latter, investment banks make a profit, while in addition giving themselves the power to put pressure on governments of which they disapprove. Other than financial gamblers, no one needs public debt securities for use as play money on international financial markets. Like other securitizations, tradable government securities are completely superfluous. If a state is no longer able to go into debt abroad, this will reduce not only its dependency but also its opportunity to go into debt beyond what its economy can support. Both would represent progress.
The question remains how the transition from the current monetary order sketched here can be achieved. How do we get from today’s casino and its betting outfits to a common-good oriented banking system?
This is actually much easier than it may initially appear. Every bank should be free to reorganize as a common good bank and to abide by the rules governing common-good oriented banks. Its legal form might be that of a common good corporation, as suggested in the next chapter. Under present conditions, institutions under public law and cooperative institutions would be compatible with this model, whereas joint-stock companies would not.
All banks that want to remain private and continue to work for profit will be released onto the free market. This means that there will no longer be any state liability for their capital owners, and there will be no legally guaranteed deposit insurance for their investors. Private banks will no longer have access to loans from the central bank and will lose their right to create electronic money. In order to issue loans, they will need savings deposits for a minimum term, or they will have to issue and sell bonds. The assets of their owners will be held liable for their business activities. Anyone is free to deposit their money in these banks, and the banks can do with it what they wish within the law.
These rules are not particularly onerous, they are simply rules of the market economy. They would result in similar business conditions in the banking sector that apply to all enterprises in the regular economy. Some private banks will survive in this environment. In the United States and in the United Kingdom, investment banks used to exist that were set up as full-liability partnerships, operating on more modest scales, and specializing in certain types of financial transactions such as the emission of shares and bonds. The state should leave banks alone that are able to survive in this way.
All banks not able to survive under such conditions—which will probably include most large banks like Deutsche Bank—will need post-bankruptcy restructuring, decontamination, and downsizing. The small state of Iceland offers a model which, in contrast to all other European countries, was adopted after the start of the financial crisis, allowing it to keep public debt within strict limits. Following this model would mean breaking up each bank into a “good bank” for all checking accounts, savings, and other deposits, as well as all recoverable loans and accounts, and a “bad bank” for bad loans and questionable financial instruments.
In order to write off bad loans, the shareholders of the old bank will carry primary liability, next come the owners of equity-type instruments, and finally the holders of bank bonds. In this way, losses can be liquidated. By including bank bonds and other financial instruments, offshore assets will be drawn into the liability pool, since such instruments tend to be held by international financial institutions and funds. They are also the front for the global financial elite’s money stashed away in the world’s tax havens.
Basically, this model means securing the assets of the middle class, while the assets of the upper class will pay for the dysfunctional developments of the past decades in the financial sector. This is only fair, since the upper class exclusively benefited form these developments. We can assume that the assets of the wealthiest will be more than enough to cover liability. Fifty percent of all financial assets, or 80 percent if offshore assets are included, today belong to the richest 1 percent.92 In order to secure the financial assets of 99 percent of the population, including life insurance and pension savings, only 20 percent of loans, papers, and other claims in today’s financial system would have to be recoverable. Notwithstanding the shady business practices in the industry over past decades, the share of financial junk will certainly lie significantly below 80 percent.
The good bank would be transformed into a common good bank. This transition would be largely without cost for the public sector. The more countries decided in favour of a common-good oriented banking sector, the better. Theoretically, the model proposed here could be introduced in Germany only or in a small number of European countries. For all countries embarking on this route, this would mean not only a significant gain in innovation capacity and efficiency but also in democracy. A sovereign monetary order is the precondition for state sovereignty. And only a sovereign state can be run democratically.