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roulettefinancePrior to the Global Financial Crisis (GFC 2007), many senior economists and policy makers expressed confidence that they had finally solved the problem of business cycles, booms and busts, that plagues capitalism. Because of this over-confidence, early warnings of a looming crisis by Nouriel Roubini, Ann Pettifor, Peter Schiff, Steven Keen, Dean Baker, and Raghuram Rajan, were ridiculed and dismissed. Even after the crisis, many economists thought this was a minor glitch, which would soon be remedied. Now however, while conventional economists continue to search for reasons for the mysterious stagnation besetting capitalistic economies, the weak and jobless recovery from the GFC has been labeled as an illusion and a false dawn by Schiff. Like him, deeper analysts are converging on the idea that the problems run deep, and that radical changes in the global financial architecture are required to solve current problems and prevent future crises.

For instance, consider Lord Mervyn King, the Governor of the Bank of England from 2003 to 2013. His experience at the heart of the global financial system led him to the conclusion that   “Of all the many ways of organising banking, the worst is the one we have today. … (can we) think our way through to a better outcome before the next generation is damaged by a future and bigger crisis?” Similarly, Minneapolis Federal Reserve President, Narayana Kocherlakota , after viewing the stark conflicts between the empirical evidence and the macroeconomic theories over the past ten years, writes the economists use “Toy Models” which do not work in face of the complexities of real life

There are two central elements which lie at the core of the fragility of the financial system. The first problem is credit-creation by banks. This means that when banks give loans, they create credit out of thin air. This ability enables corporate raiders to buy multi-billion dollar corporations without any money in their pockets using financial gimmicks. The second problem, closely related to the first one, is the use of interest instead of equity in the lending process. This means that banks can lend for mega-projects designed to fail, because they are guaranteed a return of their money regardless of outcomes. Bankers have successfully created the illusion that they are necessary, so that when borrowers can’t pay back outrageously risky loans, the government re-imburses the banks for their losses. Both of these problems at the heart of the financial system can be fixed, but the ability of high finance to create huge amounts of money at will gives the financiers ample resources to block any attempts at solving the problems. The 1% who benefit from this financial system have created a robust and resilient multidimensional system of defense to protect, preserve, and sustain the current fragile and crisis prone financial architecture. Using billions of dollars of funding, many different institutions, which include academia, media, think tanks, policy makers, regulators, politicians, and the military-corporate-industrial complex, have been co-opted by high finance. In an article entitled “It Takes a Village to Maintain a Dangerous Financial System,” Stanford professor Anat Admati describes how these different institutions work together to maintain and perpetuate the current financial system. In this article, I focus on the how economic theory itself has been captured by the top 1% and changed to serve their interests.

The role of economic theory should have been to clarify and expose the structure of the economic system, so that economists could understand it and make it work better for all. Instead, economic theory has been captured by the financiers and turned into a propaganda machine, which hides the realities of the system. Modern economics textbooks continue to teach myths which are overwhelmingly contradicted by the empirical evidence. In particular, they teach that the quantity of money and the levels of debt do not have any long run effects on the economy. They teach that consumers and businesses can accurately foresee that path of future prices, and of government policy, and plan purchases and investments accordingly. They teach that levels of inequality do not matter because wealth will trickle down. The distinction between needs and wants has been erased from the textbooks. Economists used to be concerned about rentiers – people who earn money without doing any work to deserve it. Current economics textbooks no longer mention the concept. Instead they teach that markets efficiently recognize and reward participants: if you make money, it means that you deserve to make money. This leads to the idea that the more wealthy you are, the greater is your contribution to society. When this myth is combined with the trickle-down myth, it leads to tax cuts for the rich advocated by Trump, and a guiding policy principle in the USA since the Reagan era. Small wonder that ex IMF Chief Economist Olivier Blanchard wrote that modern models used for conduct of monetary policy are based on “assumptions profoundly at odds with what we know about consumers and firms”.

Like Blanchard, economists who have contact with reality have come to recognize the deep flaws in the economic theories used for the conduct of monetary and fiscal policy around the globe. Highly respected economist Paul Romer, recently appointed Chief Economist at the World Bank, has created shock waves among economists by a trenchant critique entitled “The Trouble with Macroeconomics.”  He writes that for more than three decades, macroeconomics has gone backwards, losing knowledge instead of gaining it. Since banks, financiers, money, unemployment, debt, inequality, rentiers, and all other major drivers of the modern economy have been removed from the picture by economists, contemporary macroeconomic models  “attribute fluctuations in aggregate variables to imaginary causal forces .”  Romer notes that economists’ blatant disregard for facts in conflict with their imaginary theories is so extraordinary that it deserves its own label – he suggests “post-real”.   Even though there are formidable obstacles in the path from this imaginary post-real world of economists to reality, humanity urgently needs to find a way, if the bottom 99%, and the planet we live on, is to survive.

Originally published in Express Tribune, Dec 4, 2016. Related materials on the Global Financial Crisis. My author page on LinkedIn Index to my writings: AZPROJECTS. Closely related: Unlearning Economics. My personal webpage: Transforming Knowledge.

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Post 4/4 about Economic MethodologyFriedmanKeynes

Before Keynes, Classical Economic Theory (CET) was based on three principles. The First Principle is that Unemployment is automatically eliminated by the free market. The Second Principle is the Quantity Theory of Money, which states that money supply makes no difference to real economic outcomes. The Third Principle is that private investors automatically find the right investment opportunities to create the best economic outcomes for future. The realities of the Great Depression of 1929 clashed violently with these three principles which hold only in an imaginary world bound by axioms and logic. Keynes followed scientific methodology to create a new theory which rejected all three axioms of CET, so that Keynesian theory would match the experienced realities of the Great Depression. This is the distinguishing feature of science, that theories are devised and changed in light of experience. In contrast, Greek axiomatic-logical methodology disregards conflict with observational evidence.

The experience of the Great Depression showed that free markets cannot eliminate unemployment. The role of expansion of money stock in the boom, and of restrictive money in the recession, became clear to economists. Keynesian theory incorporates this experience and asserts the extreme importance of money in the real economy, contrary to the Quantity Theory of Money. Also, Keynes argued that the future was unpredictable. Investor sentiment and expectations about future governed their investment decisions, but these could become artificially depressed. This would choke off investment and badly affect the future of the economy. In such situations, the government should step in with investments to compensate for shortfalls in private investments. This type of fiscal policy would be able to restore full employment and generate growth. This Keynesian prescription is diametrically opposed to the Third Axiom of CET which argues that governments should not intervene in economic activity. Keynesian theories were “scientific” in the sense that they were based on observations and economic experiences, and conflicted with the Greek axiomatic approach of CET.

Banks had lost fortunes, and wiped out lifetime savings of many depositors in the Great Depression. Soon afterwards, a strong set of laws were enacted which sharply regulated financial institutions, prohibiting them from speculation, and placing many other restrictions on their activities. Financial regulation restricted the power of the wealthy to generate income from their existing wealth. This meant a sharp reduction in money generated by non-productive financial activities like interest based loans. At the same time, the main thrust of Keynesian theory was that the government had the responsibility to maintain full employment, and undertake investments necessary for growth. Investments flowed to the real sector, instead of the financial sector, and full employment meant that all the productive capacity of the economy was utilized. Empowering the working classes, investing in growth, and restricting the financial sector, led to decades of prosperity in the Western world.

In order to understand what happened next, we have to look at the dramatic impact of the three Keynesian policies of financial regulation, full employment, and government investments, on the income distribution in the USA. From 1930 to 1980, the share of wealth accruing to the bottom 90% increased from a low of 15% to a high of 35%. At the same time, the share of wealth accruing to the top 0.1% decreased from a high of 25% to a low of 5%. This reversal of fortunes was not acceptable to the extremely wealthy, who plotted a coup against Keynesian theories with patience and persistence. Their last bastion and stronghold was Chicago University, which was virtually solitary in its advocacy of free market economics in the days of dominance of Keynesian theories. In their paper “Winning Ideas”, Sabena Alkire and Angus Ritchie have provided detailed information about the campaign to spread, popularize and implement free market ideas. One key strategy was the utilization of economic and political crises and disasters to rush in with revolutionary changes. Naomi Klein has documented this aspect in her brilliant book “The Shock Doctrine: The Rise of Disaster Capitalism” which details how crises were used or generated all over the world as a means of introducing free market policies which could not be achieved by popular vote.

In the USA and UK, the oil crisis in early 1970’s created an opportunity which was seized upon by the Chicago School to create the Monetarist Counter-Revolution against Keynesian ideas. All economic troubles were blamed on Keynesian policies and financial regulation, and a strong push was made for financial liberalization, and for restricting the authorities and power of the government. One weakness of Keynesian theory was that while macroeconomics was scientifically based on observed behavior of real world economies, microeconomics was based on an axiomatic-logical Greek approach to consumer theory. Progress would have involved changing microeconomic theories to match observations of real world consumer behavior. Instead of this, the monetarist counter-revolution succeeded in dislodging Keynesian theory by arguing that these macro theories were not consistent with the axioms for consumer behavior in microeconomic theories. This return to Greek axiomatic methodology effectively divorced economics theories from reality. Keynesian Nobel Laureate Robert Solow remarked:  “Since I find the fundamental framework [of Chicago economists Lucas & Sargent] ludicrous, … I respond by laughing.” Financial liberalization together with repeal of Keynesian economics had exactly the effects desired by the wealthy. The share of the top 0.1% has steadily risen from its bottom at 5% to the current 25% and is steadily rising. The share of the bottom 90% has fallen from its top value of 35% to its current 15% and is steadily declining. The Global Financial Crisis has wiped out the middle classes and further enriched the wealthy financiers. The use of a Greek methodology which confines economists to the study of an imaginary world is extremely helpful in perpetuating the current state of affairs as it prevents the public from noticing essential aspects of the economic system. This is why scientific methodology, which would be based on close observations of contemporary realities of the economic system, is shunned by economists.

Posts on Diverse Topics:My author page on LinkedIn. Other works: Index . More material on Science & Scientific Methodology. Articles on the Nature of Human Knowledge.

The anniversary of his birth on 24th Feb 1934 is an appropriate occasion toHDI remember Mahbubul Haq, our unsung national hero. The depth of his achievements remain vastly under-appreciated, especially in his own country.  Virtually single-handedly, he changed the direction of the development discourse from a single-minded and harmful focus on wealth production, towards attention to the human beings who are both the drivers and beneficiaries of the process of growth. One of the greatest strengths of Mahbubul Haq was his ability to learn from experience. Unlike many others whose ideological commitments blind them to the facts, Mahbubul Haq was a lifelong learner, radically revising and sharpening his theories when confronted with adverse experiences. He also had the rare ability to translate idealistic and visionary ideas to the practical realm of the real world. In this article, we will trace his intellectual trajectory and legacy, which remains of great practical importance. Even today, most policy makers throughout the world are following practices which Mahbubul Haq tried and rejected as he moved on to a deeper and more sophisticated understanding of the complexities of the growth process.

During his Ph.D. at Yale, and post-doc at Harvard, Mahbubul Haq imbibed the same simple-minded and misleading economic models of growth which continue to be taught today at universities all over the world. Across the board, economics textbooks equate growth with the accumulation of capital. According to these theories, policy makers are faced with a cruel choice: either they can feed the population, or they can accumulate capital and achieve rapid growth by starving them. Under the influence of these disastrously wrong theories, planners throughout the world continue to sacrifice the social welfare of the public at the altar of economic growth. In the 1960’s, the young Mahbubul Haq implemented these policies as Chief Economist at the newly established Planning Commission, and achieved a startling 7% growth.  While the government was celebrating the Decade of Development, and offering him accolades, Mahbubul Haq did something which shows his rare qualities and character. He embarrassed the government and tarnished his own achievements by showing that the so-called development was superficial, and had enriched twenty two families without bringing about significant reductions in poverty.

With characteristic courage, Mahbubul Haq used his experience to challenge the deeply imbedded orthodoxy that GNP growth was the all-important goal of development. His powerful arguments for provision of basic needs, earned him the label of a ‘heretic among economists’. He started the trend towards attention to human development which has now established firm roots as an alternative to orthodoxy. World Bank President Wolfensohn, who carried on his legacy, acknowledged his contributions in the following words: “… more than anyone else, (Mahbub) provided the intellectual impetus for the Bank’s commitment to poverty reduction in the early 1970s.[…]His unique contributions were trend setters for the world and focused attention on the South Asian social realities, urging all of us to look at the dark corners of our social milieus’.

The breakdown of the Bretton-Woods agreement in the 1970’s led to an obviously unfair international monetary regime, where dollar replaced gold as the reserve currency, effectively enabling producers of dollars to purchase third world resources (including politicians) by printing money.   Mahbubul Haq played a leading role as an exponent of the New International Economic Order in the 1980’s, which was an  attempt by the Third World to counter the financial power of the first world.  His forceful advocacy earned him the title of “the most articulate and persuasive spokesman” for the developing world. Lacking leaders of his stature, the third world today has quietly acquiesced to a financial system which enables yearly transfers of about 600 billion of dollars in debt service from the poorest countries to the richest, plus an even greater amount in the form of capital flight via the multinationals.

It is impossible to cover the rich legacy of Mahbubul Haq within the scope of a brief article. The Human Development Index and the Human Development Report are the most well-known reminders of his human centered approach. Economists and planners have not yet absorbed his central insight that instead of sacrificing people to achieve growth, provision of social services is the best route to growth. If we just provide sufficient social support, our people will prove to be far more efficient drivers of growth than the false gods of capital accumulation currently at the center of economics textbooks. Unfortunately, planners continue to rely on primitive and obsolete Ivory tower theories, and ignore the advanced lessons learned by Mahbubul Haq based on a lifetime of experience. Greater recognition of Mahbubul Haq and his achievements would go a long way towards providing us guidance on the architecture of domestic and international policies desperately needed today.

Published in The Express Tribune, February 22nd,  2016.

While money and banking plays an extremely important role in the economy, economics textbooks teach the opposite. According to the quantity theory of money (QTM), money plays no role in the economy at all; it is a veil which covers the workings of the real economy. An increase or decrease in the money supply will cause an increase or decrease in the prices, and will have no long run real effects on the economy. According to QTM money is neutral: we must look beyond the veil of money to understand how the economy functions.

The truth is that the standard theories of money and banking are themselves a veil which covers the reality of how the system works. This veil was penetrated briefly following the Great Depression of 1929, which was completely incomprehensible according to standard economic theories of the time. To explain the Great Depression, Keynes invented a new economics, in which money was not neutral. He argued that shortages of money would lead to unemployment and recessions, while excess would lead to inflation. At the same time, leading economists such as Irving Fisher, Frank Knight, Simon Schultz and many others realized the crucial role played by excessive credit creation by banks in precipitating the Great Depression. In 1933, they came up with the Chicago Plan which takes away the power to create money from the banks and gives it back to the government. The Banking Act of 1935 created deposit insurance and many other regulatory measures to control banking, but did not implement the Chicago Plan. Keynesian insights about money and Chicago insights about banking were gradually forgotten. The eerie resemblance of the Global Financial Crisis of 2007 to the Great Depression led two IMF economists to dust off the bookshelves of history and re-visit the Chicago Plan. Since then, it has been gathering momentum in terms of public awareness, but has been mostly invisible in the dominant media and politics which are controlled by big finance. However, the Iceland Government recently published a report which proposed a variant of the Chicago Plan. Most recently, on 1st December 2015, the Swiss public created a successful petition with 112,000 signatures to ensure parliamentary hearing on the proposal for Sovereign Money, which is a core element of the revised Chicago Plan. Since powerful interests have been blocking and opposing the Chicago Plan, it is up to the public to learn about the issues and create a movement for change. In this connection, interested readers may look up “Corrupt Banking System explained by twelve year old” on internet for an entertaining and informative detailed video of explanation. We provide a very brief explanation of the central issuesswissrefvollgeld below.

In the fractional reserve banking system, banks are only required to keep a small fraction of cash against the demand deposits outstanding against them. For example, in order to create grant a loan of 10,000,000 to Mr X, Mozoon bank only needs 5% of the amount, only 500,000 in the form of cash deposits. The bank grants the loan simply by creating an electronic entry in its accounts. In advanced economies, money travels electronically between financial institutions, and cash reserves are little needed. When necessary, they can be borrowed from many sources; especially the Central Bank is under obligation to cover cash shortfalls of banks. At 10% interest on the loan, Mozoon Bank will make a cool profit of 1,000,000 based on its meagre cash reserves of only 500,000. Where did this profit come from? It came from the money created out of thin air by Mozoon Bank and then lent out to the borrower at 10% interest. Because Pakistan is financially primitive, banks keep larger reserves (nearly 30%) and cannot leverage their cash deposits to the extent possible in more advanced economies.

The conventional wisdom, taught in textbooks of monetary economics, is that the government creates money, not banks. Furthermore, banks are financial intermediaries: they lend money which they gather as deposits. The reality is that the banks invent the money that they lend. This means that the banks, and not the government, are in control of the money supply in the economy. Bank creation of money acts in ways that are opposite to Keynesian prescriptions, and de-stabilize the economy. According to Keynes, when the economy is in a recession, the government should expand the money supply. In a booming economy with full employment, the government should cut back on money supply to prevent inflation. However, banks lend less in recessions, reducing the money supply. They lend more in a booming economy, adding to inflationary forces. Following the Global Financial Crisis, theories of Hyman Minsky called the Financial Fragility Hypothesis have become very popular. Minsky adds details to this crude picture, and show that banks systematically de-stabilize economies, leading to crises and crashes. The empirical record showing more than 200 banking crises over the past thirty years bears out the theories of Minsky. The Global Financial Crisis, like most others, was caused by excess money creation by banks, which fueled the fires of speculation, leading to a crash.

The solution to this problem is the proposal for Sovereign Money which has been detailed in the Iceland Plan, and will now be up for discussion in the Swiss Parliament. Instead of fractional reserve, banks must keep 100% reserves, preventing them from creating money. Instead the Central Banks will create money in the right quantity designed to stabilize the economy according to the Keynesian prescriptions. IMF economists Benes and Kumhoff have shown that this radical reform of money and banking will bring multiple benefits. It will eliminate banking crises, increase growth, eliminate debt, and create more fiscal space for development projects. It will also decrease the massive inequality which allows a tiny minority to control the political and economic system. The present system enslaves the majority in chains of debt only because a large number of deceptive claims about its benefits are widely believed. If we learn the truth, it can set us free.

reprinted from Express Tribune, 8th June 2015

We live in a world awash with money. Not only can the banks create 20 times more money than the amount they receive as deposits, but an enormous shadow banking system has come into existence which creates massive amounts of credit without any regulatory restrictions. At a time of the global financial crisis, the value of financial instruments was more than 10 times the world GDP. Daily trade in foreign exchange is around $4 trillion, while actual merchandise trade is only $50 billion. This huge excess clearly represents speculation and gambling, rather than currency exchange for the needs of trade.

The ways of the super-rich Lords of Finance are far beyond the ken of ordinary mortals like you and I. Winning and losing bets in millions of dollars daily are just a small part of the thrill of living. One of the important tools they use is buying on margin. This means that you can buy $50 worth of stocks or foreign currency by paying just $1. In effect, the dealer loans you the remaining $49 by using your stocks as collateral. If the stock goes up to $51, you can sell and get out with a quick 100 per cent profit on your investment. If the stock declines to $49, you again sell and get out of the market, losing your marginal payment of $1.

In the 1970s, the dollar was de-linked from gold officially by former US president Nixon. Distrusting the unbacked dollar, the Hunt brothers decided to buy up all the silver in the world. By 1979, they had nearly cornered the global market, taking possession of nearly three million kilograms, about a third of the entire world supply. In the process, they drove up the price of silver from $6 to $50 an ounce, and became richer than the fabled King Croesus. The eight-fold price increase created a dire situation for jewellers around the world. Tiffany’s took out a full page ad in The New York Times, condemning the Hunt Brothers and stating “We think it is unconscionable for anyone to hoard several billion dollars worth of silver and thus drive the price up so high.”

The fates intervened to prevent the Hunt brothers from becoming the kings of silver. The Hunt brothers angered the Reagan Administration in the US, which played dirty to bring them down. COMEX, the regulatory body for commodity exchange, suddenly changed the rules for trading in silver, doubling the margin requirements. This required the Hunt brothers to put up about double the cash for the silver they had purchased on the margin. At the same time, the FDIC changed the rules to prevent banks from lending to purchase commodities. The bear trap closed around the Hunt brothers, who watched helplessly as silver prices started sliding and crashed on “Silver Thursday” on March 27, 1980. Although they lost billions, and eventually had to declare bankruptcy, we need not feel pity for the Hunt brothers. Their rich daddy had foreseen this possibility and created protected trust funds for both brothers amounting to $100 million each, more money than common folks see in a lifetime of earning.

One of the favourite games played by the super-rich is speculating in foreign exchange. Buying on margin provides enormous leverage; one can buy a billion dollars worth of currency for a paltry $20 million. This allows you to attack weak currencies and take them down, making an enormous profit in the process. George Soros created the Quantum Fundto attack the British Pound, speculating on its devaluation. The Bank of England tried to protect the pound with all the means at its disposal, but was eventually forced to yield, creating billions in profits for Soros. Similarly, big money forced open the doors of the East Asian Miracle economies to foreign investors, and crashed these economies while yielding tremendous profits to the investors.

The use of leveraging, derivatives and other complex financial tricks within the unregulated shadow banking system creates a huge amount of excessive credit, which actually changes the rules of game. As the Global Financial Crisis of 2007 demonstrated dramatically, the conventional textbook theories currently being taught in universities throughout the world, do not apply to the modern economy. The most radical change has been the failure of the quantity theory of money. Professional economists were very surprised when huge increases in the money supply did not result in proportional increase in prices, in violation of the quantity theory. The US printed trillions of dollars for the Iraq War and for bailouts and quantitative easing following the Global Financial Crisis, but there was no corresponding increase in consumer prices. Similar phenomena were observed throughout the world. In Pakistan, there has been a 350 per cent increase in the money supply, but only a 250 per cent increase in prices over the past decade.  Professor Richard Werner has solved the mystery by showing that the excess money goes into creating price bubbles in land, housing, stocks and other speculative financial assets. Prices of these assets do rise, but these do not enter the consumer price index, and hence do not cause inflation. Interestingly, Werner’s theories are not well known among economists.

Another serious consequence of excessive money supply being held in the form of inflated assets is that the concept of an equilibrium exchange rate is no longer well defined. Previously, the equilibrium was defined by matching supply and demand for currency, which was based on the real trade balance between exports and imports. Now the speculative transactions, being done at whims of the super-rich, overwhelm the real economy. What controls the exchange rate is largely expectations. The topic of self-fulfilling expectations has gained prominence in the recent literature on monetary theory. If rumours are spread that a currency will decline, people will sell the currency and cause it to decline. Equilibrium theories do not show any significant misalignment of the Pakistan rupee exchange rate, as current popular accounts would have it. The ultimate test today rests on Central Bank interventions. If the State Bank is intervening in the markets by selling dollars to prevent a fall in the price of the rupee, then the rupee is overvalued. However, State Bank Reserves are steadily growing, showing that the rupee is actually undervalued, contradicting the views of leading economic pundits in Pakistan.

The target of economics education is the comprehension of the reality in its economic dimensions, that is to say, the understanding of the practices and ideas that support the evolution of the reproduction of material life. However, following John Kenneth Galbraith, we can say that economics is overwhelmed by an “uncorrected obsolescence”.   Consequently, each generation faces many new economic and social challenges. As Alfred Marshall wrote in the preface to his Principles of Economics, economic conditions are constantly changing and each generation looks at its own problems in its own way”.

Indeed, the current political, economic and social features of  globalization configures a rupture in relation to the Bretton Woods institutions. The contemporary institutional set up is the result of deep transformations that characterized the outcomes of the crisis of the accumulation pattern in the 1970s and 1980s.  The financialization of the global economy produced great transformations in the growth dynamics since the decisions related to investment, production and employment are increasingly subordinated to the short-term financial commitments of big corporations.  Besides, further deep structural changes have involved increasing capital mobility and the growing importance of institutional investors as managers of “financial savings”.

As a matter of fact, the current developmental scenario is completely different from the “Golden Years” where national states were supposed to reduce social inequality by means of economic growth. Under the current global order, there is a trend to the corporatization of national policies on behalf of the implementation of government actions  that turn out to reinforce the concentration of corporate power. In particular, as most Western national states give support to the increasing competitiveness of corporations outside their national frontiers, these competitiveness’ strategies could turn out to be dissociated from the needs and vulnerabilites of their populations.  In other words, public policies happen to be subordinated to global financial and trade private strategies, instead of mainly facing social needs.  Consequently, the interaction between economic growth and development policies reveals new social conflicts that have arisen from the dynamics of global capital reproduction.

Considering this background, two main questions should be addressed to students of economics: Which are the main examples of policy resistance to the neo-liberal agenda? Which policy recommendations should contribute directly to economic and social development within national frontiers?

Newspaper article published in Express Tribune, on 25th May, 2015 Pakistan. It explains the defects of the fractional reserve banking system, and suggest switching to 100% reserve banking.

A long time ago, Ibn-e-Khaldoon noted the tendency of conquered nations to unthinkingly imitate the conquerors in all dimensions of life. After achieving freedom from colonization, the former colonies have tended to imitate or retain the colonial institutions, without reflecting on whether or not these institutions are suitable for them. In his classic, “Small is Beautiful,” Schumacher showed that appropriate technology for developing countries was often small and low-tech production techniques which empowered the people. Imitating the highly capital intensive and large scale industries of labor short capitalist countries is like trying to run before learning to walk. Today, large dams are being built all over the world at enormous financial and environmental costs, while smaller scale agile energy producing technologies which deliver quick results cheaply are being ignored. Similarly, we have retained colonial institutions which were designed to be top-down, hierarchical, and non-democratic; people being heavily taxed and exploited cannot be allowed to have a vote in the matter. Transiting to democratic institutions requires many reforms. For instance, the “police force” which maintains order by force, needs to be re-conceptualized as the police service, responsible for the security and protection of citizens.

Banking is another institution that has been copied without a cost benefit analysis. The Great Depression of 1929 was caused by a banking crisis which wiped out lifetime earnings and led to prolonged misery for millions. Stringent banking regulations prevented major crises for fifty years. Financial liberalization in the 1980’s led to the Savings and Loan crises; the bailout was more than the profits of banks for the entire century. Since the 1980’s financial de-regulation has been extended and globalized, resulting in more than 200 banking crises globally, with huge economic costs. The latest and greatest is the Global Financial Crisis of 2008, which cost trillions of dollars, and led to the highest levels of homelessness and hunger seen in the USA since World War 2. Overall, when we add up the benefits and subtract the costs of current banking systems, the net result is tremendously negative.

Many have analyzed the reasons for repeated banking crises, and found that the root cause is the fractional reserve banking system. In this system, banks holding a billion Rupees can freely create a large multiple – like five or ten billion Rupees – from nowhere. They only need to have a small fraction of the money that they create to give to lenders. The inherent injustice of a system which allows certain wealthy private parties to create money at will is hidden from public view. Henry Ford said that “It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.” An inherent feature of the system is that the claims on banks are far greater than their assets. When too many depositors wish to withdraw money, there is bound to be a crisis. In the words of Lord Mervyn King, the former Governor of the Bank of England “Of all the many ways of organizing banking, the worst is the one we have today – change is I believe inevitable. The question is only whether we can think our way through to a better outcome before the next generation is damaged by a future and bigger crises.”

The excellent documentary “Inside Job” shows that Iceland was badly mauled in the GFC 2008. Financial de-regulation crashed a small stable and robust economy, due to wild and excessive lending. Iceland Bankers, utilizing their powers of money creation, expanded the money supply by a factor of twenty over the decade leading upto the GFC 2008. The bloated money supply led to soaring prices of stocks and lands, and ultimately crashed the economy. The Central Bank of Iceland found that, contrary to what is written in monetary theory textbooks, it was completely unable to control the money supply. It utilized all the tools at its disposal, including raising the discount rates to extremely high levels, but could not prevent the private banks from creating excessive money.

Chastened by the experience of helplessness, watching an impending crisis without being able to do anything about it, the Iceland government has recently formulated a plan for monetary reform. The key ingredient of the plan is that the power to create money is taken away from the private banks. The proposed system of “Sovereign Money” puts the power of money creation in the hands of a panel of specialists at the Central Bank. They would use economic theory to create money in quantities which would allow for full employment without creating inflation. Specialists can download and read the Iceland proposal for monetary reform, full of fascinating details and information about the defects of our current banking system. The question of ‘why only Iceland?” when this reform is needed everywhere was addressed briefly in my previous article on The Shifting Battleground. A much more detailed historical explanation of the power and craftiness of the financial lobby is given in the writings of Ellen Brown.

The main problems of current banking system are that it is unjust, crisis prone, and anti-growth. Private money creation leads to a rentier economy, where the largest profits are made by owners of wealth, who invest in stocks and land, and earn interest on bonds. The producers, laborers, and farmers who make up the real economy, get very little reward for their labors. Instead, rewards accrue to the financiers who provide money – created from nothing – to all the real sectors. Not only is this unjust, but it causes growth prospects to shrivel, since all investment is directed towards financial sectors, and away from the productive sectors. Studies show that growth of GDP is very strongly correlated with the amount of investment in the real sector, and in human beings. This is only natural: growth is directly tied to how much we invest in our future. Although it is radical, the Iceland Plan for monetary reform offers the possibility of a dramatic increase in real investment and real growth, very much needed today in Pakistan.

Endnotes:
1. See also an intelligent critique of the Iceland Proposal at Re-inventing Money

2. See also my paper on “An Islamic Version of the Iceland Plan for Monetary Reform” — this extends the plan by adding the elimination of interest from the banking system.