In a recently published article in the Sunday Herald, ISRS Senior Research Fellow, Chris Cook discusses the global debt problem and the road to recovery. The below article is published with the kind permission of the Sunday Herald.
The Myth of Debt
From the latest cuts to economic forecasts to the Italian elections to the gathering debate about how George Osborne should play this year’s Budget, all discussions about the financial system now lead swiftly back to the world’s sovereign debt problem. It towers over every effort to get back to prosperity, threatening to take decades at best before it can be resolved, very possibly with an almighty crash along the way.
But maybe that is because we are looking at a 21st Century problem in a 20th Century light. My research at University College London’s Institute for Security and Resilience Studies indicates that the answers might lie in modern versions of legal structures and instruments which pre-date the modern financial system and even the Act of Union. But before I explain this ‘Back to the Future’ proposal for recovery, a warning: we’ll need to turn much of the received wisdom that underlies modern economics and politics upside down as we proceed.
Prior to the advent of double-entry book-keeping and the concept of profit and loss in the Middle Ages, accounting typically involved the use of wooden tally sticks. Notches and marks were made on a stick, with two functions. One was as a memorandum tally or receipt evidencing a sale, and the other was as a record of an obligation – a loan tally. In both cases, the tally stick would be split down the middle with the longer portion (the ‘stock’) being given to the counter-party of a transaction and the shorter portion (counter-stock or foil) kept by the originator.
For over 600 years from the early 12th Century and even before, UK sovereigns were accustomed to raising funds to fight wars and for other sovereign expenditure by obtaining money, goods and services from their subjects as an advance on their tax liabilities. The subject would receive a loan tally in exchange, which represented a pre-payment of tax due.
It could be handed back (hence ‘Tax Return’) in lieu of more conventional money at any point in the future when they came to pay their taxes. This is different from a debt, which normally comes with a date on which it must be paid back. And naturally these Medieval taxpayers did not give the sovereign £10’s worth of value in exchange for a £10 prepayment of tax but received a discount for their trouble. The phrase ‘rate of return’ literally means the rate over time at which the stock could be returned to the issuer, enabling the initial discount to be realised.
In 1694, the Bank of England stepped in. Originally a private company, it was founded to create money backed by its gold holdings that could be exchanged for Treasury pledges over future taxes. In contrast to the old tally stick system, these pledges, known as ‘gilt-edged’ stock, or gilts, came with redemption dates and paid a fixed rate of interest.
These changed characteristics of a fixed date and rate of return made the pledges resemble debts. However, the difference is that these pledges are ownership claims created by an individual over his own income, whereas a debt claim is created by one individual over another individual’s income. The correct analogy is to think of gilt-edged stock as akin to interest-bearing shares or equity bought by investors in UK Incorporated, with a redemption date.
The position today is quite similar, except that the Bank of England is now State owned and the pound sterling is not backed by gold but by faith alone.
The fiscal myth of tax and spend shared by virtually all schools of economics is that tax is first collected and then spent. This has never been the case: the reality, as we have just seen, has always been that government spending has come first and taxation later. The reality is that taxation acts to remove money from circulation and to prevent inflation: it does not fund and never has funded public spending.
The Treasury does not, as we imagine, bank with the central bank in the same way that we maintain a bank account where our interest-bearing bank deposit asset is the bank’s interest-bearing debt liability and vice versa. The central bank creates credit/money on the Treasury’s behalf which it exchanges with the Treasury for gilts or lends to the clearing banks as necessary for them to balance their interest-bearing lending and deposits.
The clearing banks of course have their own power to create money, for the purposes of lending. They are responsible for most new money in the modern system, accounting for about 97% compared to 3% from the Bank of England.
Incidentally they too are the subject of a well peddled myth, which is that deposits are first collected by banks and then spent or lent into circulation on the basis of requiring a certain reserve level of deposits to be maintained. In fact, there is no constraint on UK credit/money creation of reserves: the constraint on modern money creation by private banks is the capital required to cover losses on loans. Private banks first lend or spend what are essentially ‘lookalikes’ of central bank money, and then fund their dated interest-bearing loans (assets) with dated interest-bearing deposits (liabilities).
Putting most money creation into the hands of organisations whose raison d’etre is to make money from lending (and more recently, from speculation) is behind much of what has gone wrong with the financial system. As with all historic bubbles, the profit motive drove excessive credit creation. Bank lending departments were abetted by everyone from bank lobbyists persuading the authorities to allow dangerously low capital ratios to trading departments devising increasingly complex instruments for shifting loans off bank balance sheets to make more and more lending possible.
From out of these observations, I reach two conclusions. First, the clearing banks cannot be trusted to freely create the credit which is modern money. If money is to be created by a middleman or intermediary then it should be the Central Bank or the Treasury: the question is, how and by whom such State credit issuance and allocation should be professionally managed and accountably supervised.
For instance in Hong Kong, there is no central bank. The Hong Kong Monetary Authority supervises the issuance of virtual currency and physical bank notes by three commercial banks including HSBC. The Hong Kong dollar is kept pegged to the US dollar between upper and lower rates which are defended by a currency board mechanism, putting strict limits on the amount of money that the commercial banks can create.
The idea of direct Treasury creation of money should not seem alien, by the way. During the First World War, UK Treasury notes known as Bradburys were temporarily issued as money to surmount a shortage of credit. In the US to this day, there remain a small amount of US Treasury Notes (greenbacks) in circulation which are worth exactly the same as the Federal Reserve Bank dollar notes which replaced them.
My second conclusion is that we must revisit the concept of the National Debt itself and recognise it for the National Equity it is in reality. We have only saddled ourselves with this debt delusion because we have forgotten what the true relationship actually is between public spending and taxation.
All existing UK gilt-edged stock could be consolidated as happened before with Goschen’s Conversion in 1888 which created the single class of undated Consolidated Stock (‘Consols’) which remain to this day. We could again create a single class of undated stock and the absence of dated ‘debt’ obligations would drastically reduce the UK’s funding costs to the rate of return paid in respect of this ‘National Equity’.
In fact, one could argue that the creation of £375 billion of quantitative easing (QE) reserves – upon which the Bank of England pays interest at 0.5% pa – has partially achieved such a Consolidation by the back door. These reserves of fiat money created and used by the Bank of England to buy and hold gilts are assets which are functionally equivalent to gilts, since both are created as claims over future tax income, just like the broken tally sticks from days long forgotten.
Such a centralised re-architecture by the UK government of the national balance sheet is admittedly difficult to foresee at present. But once you dispel the myth of the national debt, it creates a space for discussion of more practical solutions now emerging as a result of technological innovation. With the prospect of a Scottish Treasury emerging in the near future, this is worth serious consideration.
Panel: Open Capital
In Mathematics there is +1, -1 and 0; in Physics, positive, negative and neutral. But in Economics we see only conflicting absolutes of equity and debt; freehold and leasehold; public and private. The long forgotten prepay instrument which enabled UK sovereigns to fund themselves through tax prepayments opens up new neutral asset classes which I refer to as ‘Open Capital’.
Prepay instruments enable not only direct ‘Peer to Peer’ credit, but also direct ‘Peer to Asset’ investment in productive assets without Treasury or banking middlemen.
I’ll illustrate this by outlining a couple of prototypes under development. One involves a housing authority that is building new flats in a project financed by a bank on the basis that their construction loan will be refinanced by the local council once the block is complete. This way the bank gets repaid quickly and the council avoids taking the construction risk.
This model will get the flats built, but means that the money is tied up in the project for years while the housing authority repays the council. The concept of Open Capital ‘rental prepay’, is that once the flats are let, investors will buy (say) 40 or 50 years of rental units at a discount. For the sake of argument, it could be 22 million £1.00 units of index-linked rentals sold at a price of £15m to investors.
Long-term funding for the project becomes equity not debt, albeit not equity as we know it. The refinancing releases what is essentially a revolving pool of public credit to be reinvested in other projects. The Open Capital model is particularly well suited to affordable housing because the absence of compound interest and debt repayment drastically cuts funding costs and means a more reasonable rental may be charged. Since an affordable rental is by definition more likely to be paid; the risk of non-payment is lower; and this greater certainty justifies a lower rate of return.
My second example of Peer to Asset investment concerns energy saving schemes. Suppose investors are concerned about inflation and believe that natural gas will hold or increase its value relative to sterling. investors may buy units in a fund at the market price of gas in £/therm each of which equates to ownership of a standard number of therms of gas.
This fund would then invest in energy-saving projects and households or communities would take on a ‘gas loan’ obligation to buy back therm units from the fund at the gas market price. Suppose one was a community combined heat and power generator, where instead of heat going up the chimney of a power station, we are going to use it to heat people’s homes. Now suppose this halved the number of therms of gas that each household used per month, from 120 to 60. They would pay the supplier for 60 therms and would buy back the 60 saved therms from the fund thereby reducing their gas loan by 60 therms.
Instead of receiving a sterling loan, the generator is funded by a gas loan based on future consumption, though an electricity loan is equally viable The investor makes money if the price of the power goes up, and loses if it goes down.
Unlike the UK Government’s Green Deal, which is lending money for household energy saving projects, this idea lacks two disadvantages that some believe will make that scheme unworkable. It does not involve compound interest and there is less risk of the savings being undermined by people simply turning up the heating, because unless they save gas, they end up with higher bills during the repayment period.