The Public Credit

Chris Cook

A recent article in ‘Asia Times’ by Henry Liu <a href=””<China in Treasuries Cul de sac</a> crystallised the almighty misconception at the heart of the conventional monetarist economics which has driven Western economies generally, and the US and UK economies in particular, onto the rocks.
As Liu points out, there is a fundamental difference between credit and debt – the one being essentially the mirror image of the other.

In the language of finance economics, credit and debt are opposites but not identical. In fact, credit and debt operate in reverse relations. Credit requires a positive net worth and debt does not. One can have good credit and no debt. High debt lowers credit rating. When one understands credit, one understands the main force behind the modern finance economy, which is driven by credit and stalled by debt.

So a creditworthy business may take on debt - say from a bank – or be given time to pay for goods and services supplied on credit terms by a trade seller. He essentially does both by issuing his IOU – based upon his credit - in exchange for value received. If a trade seller is in turn able to take a buyer’s IOU and have it accepted by another seller in exchange for value, then an embryonic monetary system is in place, and such credit clearing is exemplified by the Swiss business-to-business WIR credit clearing union which has been in operation since 1934.

Sovereign Credit

The sovereign credit of UK Plc is backed by tax income and denominated in sterling: but what IS one pound sterling? Time was when it was a note redeemable in a specified amount of gold when presented in payment to the Bank of England. Now all you get when you present a ten pound note to the BoE is...errr...another ten pound note. As Liu puts it....
Monetary economists view government-issued money as a sovereign debt instrument with zero maturity, historically derived from the bill of exchange in free banking. This view is valid only for specie money, which is a debt certificate that can claim on demand a prescribed amount of gold or other specie of intrinsic value. But fiat money issued by a sovereign government is not a sovereign debt but a sovereign credit instrument.

So the general perception that when a government creates undated interest-free credit in the form of notes and coin it is getting into debt is not actually true. A moment’s thought concerning bank-notes confirms this – when the Bank of England consigns a few million in grubby bank-notes to be shredded and burnt at Debden this does not affect UK Plc’s real financial position in the slightest.

Moreover – and to debunk a canard of the accepted strain of Voodoo monetary economics – merely printing money is not inflationary in the slightest if that undated credit sits in a bank vault as paper IOUs or in an accounting ledger as a virtual IOU. In order to be inflationary, money has to be spent, or lent, and this is as true of book entry credits as it is to paper credits.
QE or not QE

The Bank of England programme of Quantitative Easing (QE) consists of the creation of the virtual equivalent of bank-notes. The BoE has created some £200bn of undated sovereign credit – NOT debt, as Liu points out – and has used this new money to acquire dated Treasury debt (gilts) from investors. As a result some £200bn of new deposits are created which banks hold as excess reserves with the Bank of England and in respect of which they receive 0.5% pa. To all intents and purposes this is analogous to the banks generally being paid 0.5% as a storage fee for holding £200bn in notes and coin – the effect is exactly the same.

Now, the investors who sold £200bn of gilts to the BoE did not rush out and spend the proceeds in the shops, potentially causing inflation. They typically used the proceeds to buy some other financial asset thereby creating the current bubble in shares, commodities and much else.

The effect of QE has been to artificially raise the price of gilts (and lower the yield), and if and when these gilts are sold by the BoE, the price will collapse and a huge loss – estimated at over £10bn at the moment – will be made. In order for that loss to be crystallised, of course, £200bn in existing money will disappear out of the system when the gilts are purchased, and the QE credit entry is cancelled. That credit could only be replaced by £200bn of new private bank credit: therefore it will not be happening any time soon, if ever.

In the meantime, the BoE has received £4.4bn in income from the Treasury in respect of the gilts it bought and holds. The net effect of QE for the Treasury – because it chooses to pay 0.5% on reserve balances – is therefore of a £200bn 0.5% overdraft from the banks, received via the BoE as agent.

Public Credit

The myth propagated by Voodoo economists – because of their misunderstanding of the nature of money as credit - is that ‘printing’ money QE style is inflationary of retail prices. This would only be the case if – in a Bernanke-style ‘helicopter drop’ – hundreds of billions of pounds were distributed to the population, and even then only to the extent that the recipients chose not to repay their mortgages and other debts, or save their windfall by investing it.

Another myth – and I have seen a letter from a Treasury minister stating this as fact – is that the creation of public credit is inherently inflationary: whereas the creation by banks of the same amount of private credit with the additional cost of a profit to shareholders is not inflationary. This is of course complete nonsense: it is the quantity, not the provenance, of credit/money which may potentially be inflationary if money is created and spent into the economy.

As Liu goes on to say, it is in fact one of a government’s principal roles to create the credit necessary for the circulation of goods and services and the creation of productive assets in private or public ownership. This is even more the case if, as now, banks are unwilling or unable to do so, because of a systemic shortage of capital.

Within the conventional system the solution to our current problems would be for massive public and private spending to create new productive assets - such as affordable housing; renewable energy and energy savings, and public infrastructure – to be funded by the creation of interest-free, but not cost-free, public credit. The creation of such productive assets would directly and indirectly create new tax flows and use value backing the credit created to produce them. The process may be managed by banks as service providers, not as intermediaries, on a cost plus performance fee basis.

As anyone who has read my previous posts may appreciate, I believe that credit creation by intermediaries – whether of undated interest-free public credit by Central Banks or Treasuries, or dated interest-bearing private credit by banks - is actually unnecessary in a world of direct instantaneous ‘Peer to Peer’ connections, but that is another story.
In the meantime, the Treasury has inadvertently stumbled upon a temporary solution to the credit crunch, and for as long as this QE transfusion continues the patient will survive. The removal of this transfusion of public credit – and the application of leeches prescribed by Doctor Cameron – will in all likelihood kill the patient.

– Chris Cook