Cooking the Books – No One’s in Control

SINCE WORLD War Two governments have adopted various policies to try to control bank lending. This, to try to make the economy work smoothly without booms and slumps or “stop-go” as it used to be called. They are still trying.

At first they tried fixing a limit on the total amount of bank loans. Then they required banks to hold a given percentage of their assets as cash and hoped to influence  bank lending by increasing or decreasing this (this was known as “fractional reserve banking”, though this term has since taken on a wider meaning). This in turn was eventually abandoned in favour of trying to influence bank lending by manipulating interest rates.

Over time the language changed too. Instead of talking of controlling bank lending, economists began to talk about controlling the “money supply”. This led to a redefinition of money, which had previously meant currency (notes and coins issued by the state), so as to include bank and other loans. There are now at least five official definitions of money (M0, M1, M2, M3 and M4). Even so, economists have still found it necessary to maintain a distinction between “base money” and “bank money”, the former being what is directly controlled by the central bank (notes and coins plus banks’ cash reserves with the central bank, which is what M0 measures).

The failure of all these policies has led to a controversy among economists which is still going on. Some have come to the conclusion that the level of bank lending is linked to the state of the economy and so cannot be controlled by the central bank. This is undoubtedly true.

Banks lend more to businesses (and individuals) when the economy is expanding and less when it is not. This is being confirmed today when, despite government exhortations and incentives, the banks are not keen to lend more; they have calculated that with a depressed economy the risk of them not getting their money back is higher. Nor are established businesses keen to borrow as they know that the market for their products is stagnating.

So, on this point, these economists are right. However, some of them don’t see the banks as merely reacting to the state of the economy but as contributing to it by their lending policies; they attribute to banks an autonomous power to influence the economy. This leads them to offer a purely monetary explanation of the present (and past) economic downturn, in, precisely, the irresponsible use by the banks of their ability to “create money” outside the control of the central bank.

It also leads them to offer a purely monetary solution. Here some of them have crossed the fringe to join the currency cranks in advocating a return to gold-based money (as if there weren’t economic downturns when this applied) or to require banks to lend only what they’ve got (as if this wasn’t the case anyway).

Since the economic cycle is built in to capitalism, and slumps occur when during a boom one sector overproduces in relation to its market, their reforms won’t stop this any more than anything the central bank can do. The capitalist economy can be controlled neither by monetary policy nor by banking reform.