Book Review; Post-War Banking Policy by the Rght Hon Reginald McKenna, a former Coalition Chancellor

Mensa emblemWe have here a book of speeches (made to bankers) from The Right Hon. McKenna, interesting to us in our pursuit of truth about our banking system as he's a former Chancellor of the Exchequer here in the UK, back in the days of the Asquith coalition government. He served from 1915 to 1916.

This arouses our interest, on page 5;

"We have now reached the point at which we may say that payments into banks of currency and bank loans, giving to the word loan the widest meaning are the only sources of increase of the aggregate of bank deposits which we need consider. At the risk of wearying you with a discussion of a process with which you are probably already thoroughly familiar, let me give a brief illustration of how bank deposits arc increased by bank loans. When a bank makes a loan to a customer or allows him an overdraft, in the ordinary course the loan will be drawn upon, or the overdraft will be made, by a cheque upon the bank drawn by the customer and paid in to someone's credit at the same or another bank. The drawer of the cheque will not have reduced any deposit already in existence because we are supposing a case in which he has been given a loan or allowed an overdraft. The receiver of the cheque, however, when he pays it into his own account, will be credited with its value and thereby a new deposit will be created. The only case when a bank loan docs not lead to a new deposit is when the cheque drawn against the loan is used by the receiver to pay off a loan which he had himself at his own bank. In the same way, when a bank buys or discounts a bill, the proceeds of the sale are paid into the credit of the seller's account and increase the total of bank deposits; and in the same way also, when a bank buys War Loan or makes any other investment, the purchase money goes to the credit of somebody's account in some bank and increases the total of deposits."

Well it's plain enough in there if you care to read it, while we would be using electronic production rather than writing cheques these days banks create money when they make, ahem, loans (giving the word its widest meaning, as he says), and even the Right Hon. McKenna seems to feel that describing this process as lending is not entirely plausible. I'd say it was impossible to describe it as a loan on the basis that you can't lend someone what you don't have and never had. See here; "The drawer of the cheque will not have reduced any deposit already in existence because we are supposing a case in which he has been given a loan or allowed an overdraft". No transfer of funds, then, while describing it as a loan would presume prior ownership. Here there is none. I'm reminded here of tales of 'old' magic, where it's often said a mysterious and baleful entity may be disempowered by its naming. Are we familiar with the tale of Rumpelstiltskin?  A troublesome and small magical creature (think dwarf), he was in the habit of popping up out of nowhere into some random domestic environment and asking seemingly unanswerable riddles. Upon any failure to answer he'd make off, by magical means, with the daughter of the household. The only way to stop him was to correctly answer the riddles, which ultimately involved naming him. Once named, he was powerless. Revealed for who he was he lost his ability to confuse and confound, in other words. Similarly shrouding what occurrs in banking as 'lending' is perhaps to furnish it with something of the same impenetrable mystery. If we came right out and called it what it surely is, money creation, then the true relationahip between banks and the public could be seen in the clear light of day for what it is, wholly unfair.

Here's more on the subject of bank loans and also growth of the money supply from Mr McKenna;
"Now that we have cleared so much ground, we must not forget the real object of our search. We are seeking the relation between the increase of bank deposits, the increase of currency, and high prices; and ... we have got so far as to see that bank loans arc the main source of the growth of bank deposits. As an increase of deposits means an addition to our purchasing power, we should expect such an increase to be followed by a rise in prices. But we must guard ourselves here from a generalisation which may be too broad. If money is borrowed by manufacturers and traders for the purpose of the production or movement of commodities, the in- crease of purchasing power consequent upon the loans is followed in due course by an increase in the amount of commodities available, and the rise in prices which might be expected from a greater demand is corrected by a greater supply."

You get what he's saying there? Create money from nowhere for the purpose of creating goods and services and (assuming of course that the money created is properly used for that purpose) there's no consequent inflation. I agree, and it's a very important principle that's often overlooked when there's any discussion of inflation. Mention money creation as a plausible solution to any kind of financial problem and the ignorati will roar in concert about the Weimar Republic and Nazis by way of argument. The Germans, it might be noted in passing, lost the first world war, convincingly too one could say, and were left with huge reparations to pay to the victor countries, yet scant decades later, they're invading Poland, bristling with guns and tanks. How'd they afford that then? A story for another day there... (topical clue - follow this link to news which surfaced when I was writing this newsletter but a moment's consideration will arouse suspicions that perhaps we don't know quite as much about inflation as we thought we did.

This next passage, though, from page 18, could have been spoken by the youthful Osborne (and, perhaps, will be, ahem...);


"The only condition on which we shall be able to check the rise in prices is that our annual expenditure is brought within the compass of our revenue. In State as in domestic finance we must learn to make both ends meet"

I have to disagree here. If the aforementioned State can create legal tender itself or give license to banks to create it then the circumstances are wholly different from any domestic environment. The householder is both unable to create legal tender nor give license to any useful third party to do so. They have to go out and earn it from the existing pool. It's interesting that he says what he does, though, particularly in light of what he says later on... (but not just yet)

"and the case is not in the least bettered if we only balance our accounts by selling out capital stock and placing the proceeds to the credit of our revenue account. The expenditure of the Government is tantamount to the consumption of the quantity of commodities which the money would buy, and this must not exceed the amount of commodities the consumption of which the community are compelled to deny themselves by reason of the taxes they have to pay. If it does, we run the risk, as is indeed now the fact, that our consumption may exceed our production. This is not a plea for additional taxation. Far from it. Our existing taxation, which is, I believe, higher than in any other country in the world, is already danger-ously near the point at which thrift, business enterprise, needful development become seriously impaired. But it is a plea for economy in expenditure. It is a plea for such ruthless cutting down or postponement of all financial outlay by the State as will reduce our expenditure to a figure less than our tax revenue, for by this method alone can we hope to restrict the issue of currency, check the rise in prices, restore our foreign exchange, and re-establish London in her old position as the financial centre and free gold market of the world."

Same old, same old. We don't seem to have progressed very far in the 90-odd years since this was written. Plus ca change, as they say. Further mention of inflation appears later on; "First, then, let us consider inflation. An increase of purchasing power without any corresponding increase of commodities, or a reduction of commodities without any reduction of purchasing power, will each produce inflation, which, if expenditure on consumption remains unchanged, will be followed by a rise in prices. Purchasing power is increased by additional bank loans or advances."

A reminder of more innocent times here where he says; "In considering monetary inflation it is necessary to ask you to recall the distinction already made between the different kinds of bank advances. So far I have been speaking of the effect of loans made or purporting to be made for some object of trade or manufacture. The second category of bank loans consists of those made in order to enable the borrower to buy commodities for the purpose of con-sumption. Goods bought to be consumed are not ordinarily paid for out of an advance by a bank. It may happen now and then that banks make loans for this purpose, but they would be trivial in amount and are not worth considering in the general view of banking transactions."

Time was when risk couldn't be parcelled up and sold on to greater fools - halcyon days, eh?

He returns to the subject of money creation;


"Under the system which prevails in our country, there is only one method by which we can add to or diminish the aggregate amount of our money. Gold coin is no longer minted, and additional paper currency is not issued except to meet the demands of the public.  When the public require more currency they draw it from the banks and deposits are reduced as currency in circulation is increased. The amount of money in existence varies only with the action of the banks in increasing or diminishing deposits. We know how this is effected. Every bank loan and every bank purchase of securities creates a deposit, and every repayment of a bank loan and every bank sale destroys one. People often talk of money going abroad or of foreign money coming here, but as a fact when gold is not in use money is incapable of migration. The title to money may change. An individual may sell his sterling to an American for dollars, but the American will then own the sterling in England and the Englishman dollars in the United States. If there is pressure to sell sterling the exchange value of the will be lowered and temporarily the burden of British payments in America will be increased. But the change of ownership does not remove the money, which necessarily remains and can only be expended where it waa created. No exchange trans- action, no purchase or sale of securities, no import of foreign foods or export of our own can take money out of the country or bring it here. Those who wish to be meticulous may say that British travellers sometimes carry currency notes and change them in foreign countries, but the total of such transactions is too trifling to be taken into account. Bank loans and their repayment, bank purchases and sales are in substance the sole causes of variation inn the amount of our money."

Wowsers! So it's all gravy for the banks then? Er, no;

"While banks have this power of creating money it will be found that they exercise it only within the strict limits of sound banking policy. Any one who studies the monthly statements of the London Clearing Banks will see that these banks keep a reserve of cash fairly constant in relation to the amount of their deposits. If banks increased their loans and investments the result would be to increase the aggregate amount of their deposits but to add nothing to their cash resources. The proportion of cash to deposits would be reduced and, in the judgment of those responsible for the management of the banks, would be less than sound banking principles dictated. Thus a limit is placed on a bank's power of lending by the amount of its cash and, so long as the canons of conservative banking are conformed to, additional loans can only be made if this cash is increased. Banks lend or invest up to the full amount permitted by their cash resources, but they do not go beyond that point."

Um. I liked this bit; "While banks have this power of creating money it will be found that they exercise it only within the strict limits of sound banking policy." I can't help wondering if this was wishful thinking even back in those days!

Moving on, why some loans are not only desirable but necessary, why we shouldn't confuse this kind of money expansion with inflation. In a section called


we read the folowing;

"Before I conclude this part of my address let me make one further observation. Many people look upon any increase in the amount of money as inflation. They fail to observe the distinction between the different kinds of bank loans which create additional money and denounce them all in one sweeping judgment. When a Government shrinks from raising sufficient revenue by taxation to cover its current expenditure and makes good the deficiency by borrowing from banks, I agree that inflation of this kind deserves unqualified condemnation. It leads to a depreciation of the currency, and I need not dwell upon the social and commercial evils that must befall a nation in these circumstances. But a bank loan to a manufacturer or merchant, as the result of which more goods are brought into existence and placed upon the market, is on a different footing. In the first case the loan remains outstanding after the proceeds have been spent; in the second, when the goods have been produced and sold, the money received for them is available for repayment of the bank loan, or, to use a common phrase, the loan is self-liquidating. There is a distinct limit however to the justifiable creation even of productive credits. As soon as there is sufficient money to carry the full volume of production of which the nation is capable, no more should be created and the repayment of past loans should balance the extension of new ones. I hesitate to apply the term inflation to additional trade loans of this nature because of the evil associations of the word; but whatever name we give to this expansion of credit, it is indispensable to the proper functioning of our commercial system and is imperatively needed when trade is depressed and unemployment general."

One has to wonder what the Hon McKenna would make then of the Coalition's decision to overturn the loan to the Forgemasters. They are a group of Sheffield steelmakers, their sound reputation itself forged over several centuries of successful trading. They wanted 80m to equip themselves with facilities capable of making specific parts for nuclear reactors, a sensible and self-evidently practical proposition given the likelihood of high demand for the product in the coming years. This had already been agreed to by the recent Labour administration, but the newly installed Coalition overturned it, packing them off instead to seek loans from the privately-owned banks. It was later reported one of the wealthy backers of the Conservatives/LibDems (I forget which) wants to buy the Forgemasters company. A loan from the Government would mean they didn't need his money, or him, or anyone else's. I suspect that in turning down this loan the Coalition government has nailed its colours to the mast. They couldn't care less about the welfare of the country overall else they'd have happily allowed the obviously sound and, as described above, 'self-liquidating' loan. Instead they chose to refuse it, arguably in the interests of their backers but clearly against the interests of the country they're supposed to be serving as a whole. The Forgemasters wanted a loan of 80m. I couldn't say whether or not this was an appropriate sum, 8m or 800m might have been more fitting, I don't know their business so I couldn't say, but the principle is clear from the above "... a bank loan to a manufacturer or merchant, as the result of which more goods are brought into exist- ence and placed upon the market, is on a different footing... when the goods have been produced and sold, the money received for them is available for repayment of the bank loan, or, to use a common phrase, the loan is self-liquidating." And the country as a whole would have been better off. This is just within the confines of what we might call normal, established economic theory. Under my view of economics they simply should have been given the money by their government, no need for any loan at all. No inflation because the money was for the production of commensurate goods and services. The consequence of not having it returned and so destroyed as would be the case with a loan again wouldn't be inflation, leaving the money in circulation would simply leave the population better off on a per capita basis. If you want to introduce more money into circulation without devaluing the currency, then give it to those people who can create in-demand goods or services. This is where government can come in and be useful. A responsible government would be one determining the difference between monies created for recreational purposes like buying consumer products or going on holiday for example, which would be refused by the state, and monies created for business growth and expansion, which would be granted. I don't suggest that privately owned banks shouldn't be allowed to offer loans for such things though, but at the moment I'm thinking of this only on a full reserve basis, so no fractional lending (and no money creation) at all.

Read more about the Foregemasters here

Returning to our book review, we find the Hon McKenna obligingly soon provides us with our money shot. On page 93 he observes (and you might want to remember this is a banker talking to other bankers here, effectively entre nous);

"I am afraid the ordinary citizen will not like to be told that the banks or the Hank of England can create or destroy money. We are in the habit of thinking of money as wealth, as indeed it is in the hands of the individual who owns it, wealth in the most liquid form, and we do not like to hear that some private institution can create it at pleasure. It conjures up a picture of an autoctratic and irresponsible body which by some black art of its own contriving can increase or diminish wealth, and presumably make a great deal of profit in the process. But I need hardly say nothing of the sort happens."

Hmmm... I think it might be happening as a matter of routine and has done for centuries. However, the great problem we have is that this money creation by the banks is a) mostly a big secret and b) the only source of money creation that we have. In a society as dependant on money as we are this leaves us wholly at the mercy of the banks, privately-owned banks at that. This is an intolerable situation, one that should never have been allowed to come into being. As our exact situation, long-disguised by banking's traditional obfuscation, becomes better understood, expect a greater and greater clamour of voices insisting on some manner of industry reform. Bearing in mind our own situations today, this next takes on an interesting perspective;

"if ... we look at Germany we find that, notwithstanding a comparatively low level of wages and a tolerably high degree of efficiency of plant and organisation, trade is depressed and unemployment is rife. Here again we recognise the cause at once in the internal monetary conditions following upon the collapse of the mark. There is not enough currency or bank credit in Germany to carry anything like the volume of trade she is capable of con- ducting. The country has not yet recovered from the severe deflation necessarily forced upon her after the orgy of inflation which destroyed her old currency, and the basis of credit is still far too restricted for commercial needs."

True enough, they had the means of production but not the money to effect it, much as many of our businesses don't now. How did they get round this? How did they from this sorry situation create enough guns and tanks to be invading Poland a few decades later? They invented new money, is how. From what I can gather here and there, they ignored the Mark for the time being, created the Rentenmark out of thin air and worked with that. Eventually they executed some financial jiggery-pokery and made the Rentenmark and the Mark equals, then dropped the Rentenmark. If you want a full account then you could try locating the book 'The Magic of Money' by Hjamjald Schacht. 'Hitler's banker', he was known as. I've not read it, only a few extracts. There's a copy (I think) in the British Library, and I know there's one in the Australian equivalent as if you're resident down there you can read it online, no Poms though, so I can't. No wonder we whinge, eh? :-) I have heard that there are going to be reprints available but I have no idea where to source one myself. I have TRIED to find a copy on the internet but to no avail! If you read Ellen Brown's Web of Debt she refers to it, and here's a related article by her;
Note the quote by Professor C K Liu;
 “The Nazis came to power in Germany in 1933, at a time when its economy was in total collapse, with ruinous war-reparation obligations and zero prospects for foreign investment or credit. Yet through an independent monetary policy of sovereign credit and a full-employment public-works program, the Third Reich was able to turn a bankrupt Germany, stripped of overseas colonies it could exploit, into the strongest economy in Europe within four years, even before armament spending began".

Whether this is an accurate portrayal of events or not (and some do say not), we know SOMETHING happened in there. What was it? I want to read the book for myself (translated reliably, of course) to find out. I'll be looking more into the subject of alternative currencies in a future newsletter.

It seems to me this is an important subject, so why isn't there more discussion? You might well ask... consider this from the Right Hon McKenna;

"Thus in France and Germany we can estimate quite dispassionately the influence of monetary and credit conditions, it is only when we turn our view from  foreign  countries and come to consider our own case that we meet a certain reluctance to discuss the effect of monetary policy upon trade and employment. That such influence exists is not categoricallv denied, but the subject is too often treated as one better left alone lest we be led on to unorthodox conclusions."

Well well. Unorthodox conclusions, eh? One might assume from this that the financial plutocrats of the day, then and now, don't want the public getting 'unorthodox' ideas any more than they want us 'to be told that the banks or the Bank of England can create or destroy money'. Hmmmm. Difficult not to think that one of the unorthodox ideas we might get is that any equality in society is a charade perpetuated specifically so a minority with a clear understanding of how money works can make the rest of us work for them by keeping us in the dark. Just think about this last. Did you know before reading this that banks make up money and that that's where it comes from? Kind of important, isn't it? Why weren't you taught it at school then, you might wonder, why isn't this crucial fact discussed freely in the media? Caution; that way unorthodox conclusions lie!

Referring to the then situation in The US, McKenna says; "Those who think that any increase in the volume of money must be stigmatised as inflation will doubtless be alarmed by this growth of credit in the United States; but if the supply of new money does no more than keep pace with the increase in production, there is in fact no inflation whatever. An enlargement of credit, which in one set of conditions may be inflation, in another is an indispens- able accompaniment of trade expansions. We have to distinguish clearly between inflationary and non-inflationary growth in the volume of credit; and to do so we must start with the question of how additional money comes into being."

He then goes into a discussion of what he counts as money which we don't need to go into here. He observes that the public themselves can't increase the volume of money and notes significantly; "The Government, independently of action by the Bank of England, are no less passive than the public as regards the volume of money. It is conceivable indeed that they might issue currency notes for the purpose of putting themselves in funds, in which case the total of money would be increased. But in fact this is not done." he says.

What he doesn't say though is the significance of this. If the government issued its own notes, (and he clearly believes, this former Chancellor of the Exchequer, that it can) it wouldn't have to be paying the banks interest for loans, would it? So why oh why oh why is our elected government borrowing money from banks when it can create the money it wants and needs itself, interest-free? Surely that would be in the best interests of the electorate? The answer would seem to be that the government doesn't have the best interests of the electorate at heart. Simple as that.

On inflation again;


"The arguments against both inflation and deflation are sufficiently clear to make it evident that our proper course is to have nothing to do with either. But it is not always easy to know when we are in fact inflating or deflating. Let me illustrate what I mean by turning to the United States, where, as I have mentioned already, the volume of money has expanded enormously in recent years. On the face of it this might appear to be a case of inflation, but if we examine statistics of production over the same period (here the publisher, I think, inserts a table of production figures to support his point, which they do - BB) we shall see that a very large increase has taken place in industrial output. As a result there has been no rise in prices and and no inflation. I will not trouble you with details of the figures, either of production or prices, for these are readily available in official publications. Such are the facts, and Americans rightly claim that the additional money has been needed to carry the greater volume of trade. The creation of additional money was indeed an essential condition of trade expansion, and if the Federal Reserve Board had allowed themselves to discover an inflationary taint in the growth of bank deposits, as the deflationists in England would certainly have done, the trade prosperity which has grown up and flourished in the United States would have been strangled at its birth. Here we have an example of very considerable expansion of credit without inflation".

As indeed we do. Perhaps we should contrast this with our own position, cuts everywhere. It's nonsense, isn't it?  What does it achieve at the end of the day? Osborne, Clegg and Cameron are far richer than most of us, and when all this has subsided, they still will be. The status quo will have been maintained. Is that their real job, maintaining the status quo? You can make the case, can't you? - Permission granted to freely distribute this article for non-commercial purposes if attributed to Bill Kruse, unedited and copied in full, including this notice.

Since this article was written, Schacht's The Magic of Money has indeed become more widely available as a PDF

Members can discuss this and other articles on the economics forum at International Mensa.

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