Two Victims of the Euro – Causes and Escape Routes for Greece and Germany

1. Two Victims of the Euro – Causes and Escape Routes for Greece and Germany Prof.Richard A. Werner, D.Phil. (Oxon)Centre for Banking, Finance and Sustainable DevelopmentUniversity of Southampton Business School 17 May 2017 SymposiumGreece Out of the Crisis: Debt-End or Dead End? Webster University, Business Management Dept., ViennaSofitel Stefansdom, Vienna

2. Unresolved Major Puzzles in Modern Economics: 1. The Anomaly of Banks 2. The Anomaly of Bank Lending 3. The Anomaly of Recurring Banking Crises 4. The Anomaly of Fiscal Policy Ineffectiveness 5. The Anomaly of Interest Policy Ineffectiveness 6. The Anomaly of Interest Rates and Growth 7. The Anomaly of Ineffectiveness of ‘Quantitative Easing’ 8. The Anomaly of the Velocity Decline 9. The Anomaly of Money 10. The Anomaly of Asset Prices 11. The Anomaly of Japanese Capital Flows 12. The Anomaly of Exchange Rates 13. The Anomaly of the Failure of Deregulation/Liberalisation (Supply Side Policy Ineffectiveness) 14. The Anomaly of the Irrelevance of Central Bank Independence 1

3. The Key Determinant of the Cycle Official Story: Interest Rates • Central bankers, market pundits, journalists have been repeating the mantra that interest rates are the key variable driving the business cycle. • Lower rates are supposed to stimulate the economy and equity markets, higher rates are supposed to slow the economy and depress markets. • The story has been retold so many times over the past three decades, we all assume that it has long been empirically tested and is well-proven and established. • What is the empirical evidence for the official story? • Are there hundreds of empirical papers that have proven this? 2

4. No. There isn’t any empirical support for these claims whatsoever.

5. Fact: How interest rates and growth are actually related Correlation Statistical Causation Japan US 4

6. An empirical analysis of the relationship between interest rates and economic growth in the UK, US, Germany and Japan over half a century Lee and Werner (2016, forthcoming): Using diverse tests and estimation methods (including DCC-GARCH* models and Granger causality test), we implemented a comprehensive analysis of correlation and statistical causality in order to describe the empirical relationships between the nominal GDP growth rate and interest rates. * Dynamic Conditional Correlation – Generalised AutoRegressive Conditional Heteroskedasticity

7. The relationship between short-term interest rates and economic growth in the UK, US, Germany and Japan (~1958-2008):

8. The correlation between short-term interest rates and economic growth in the UK, US, Germany and Japan (~1958-2008):

9. Empirical analysis of the relationship between long-term interest rates and economic growth in the UK, US, Germany and Japan:

10. Correlation between long-term interest rates and economic growth in the UK, US, Germany and Japan:

11. Statistical causation (Granger causality) between long-term interest rates and economic growth in the UK, US, Germany and Japan: Concl.: Interest rates follow nom. GDP growth & are positively correlated.

12. Rule 2: Rates Follow the Cycle Trade Secret 2: Central banks don’t use rates to run the economy • Official Story: High interest leads to low growth; • Low interest leads to high growth • Empirical Reality: High growth leads to high interest; • Low growth leads to low interest. • Interest rates are the result of economic growth. • So they cannot at the same time be the cause of economic growth. • The facts contradict the official story of monetary and banking policy. • Questions: If not rates, what then determines economic growth? Why do central bankers keep repeating the mantra that they use interest rates as policy tool? Cognitive Dissonance 11

13. 3. Markets Official Story: Markets always clear and they are efficient. Hence prices are key. • Assume: 1. Perfect information; 2. Complete markets; 3. Perfect competition; 4. Instantaneous price adjustment; 5. Zero transaction costs; 6. No time constraints; 7. Profit maximisation of rational agents; 8. Nobody is influenced in any way by actions of the others. • Then: It can be shown that markets clear, as prices adjust to deliver equilibrium. • Hence pricesare key, incl.the price of money (interest) • Market ‘efficiency’ is a more advanced condition,requiring more assumptionsto hold. Equilibrium 12

14. 3. Markets Fact: Markets almost never clear • Assume: 1. Perfect information; 2. Complete markets; 3. Perfect competition; 4. Instantaneous price adjustment; 5. Zero transaction costs; 6. No time constraints; 7. Profit maximisation of rational agents; 8. Nobody is influenced in any way by actions of the others. • If each assumption has a probability of 55% of being true, what is the probability of all assumptions being jointly true? • (55%)8 = 0.8% • But the individual probability is much lower. • Result: Markets can never be expected to clear. Market Equilibrium 13

15. 3. Markets Rule 3: Markets are rationed and determined by quantities. Trade Secret 3: The short side has allocation power and uses it to extract non-market benefits • Since we cannot expect these assumptions to ever jointly hold true, we know thatthere cannot possibly be market equilibrium. • Thus all markets must be expected to be rationed. • Rationed markets are determined by quantities, by the ‘short-side principle’:Whichever quantity of demand or supply is smaller determines the outcome. • The short side has the power to pick and choose who to do business with. • This power is usually abused to extract non-market benefits. • Think of how Hollywood starlets are selected. 14

16. 4. Money and Banking Official Story: We don’t know what it is, and it doesn’t matter • What is Money? Textbooks say they do not know. They talk about deposit aggregates M1, M2, M3 or M4, are not sure which one it is, and admit that these are not very useful measures of the money supply. • Money and Banking textbook: “Although there is widespread agreement among economists that money is important, they have never agreed on how to define and how to measure it” (Miller and VanHoose, p. 42) • Even the Federal Reserve does not tell us just what money is:“there is still no definitive answer in terms of all its final uses to the question: What is money?” • The leading textbook in advanced (Master-level) economics at leading British and US universities is David Romer (2006), Advanced Macroeconomics, 3rd ed.: “Incorporating money in models of [economic] growth would only obscure the analysis” (p. 3). 15

17. Could banks have anything to do with it? If so why? Rule: Banks are the creators of the money supply. • Unlike all other non-bank financial institutions, banks can create money out of nothing. • They do this by what is called ‘bank lending’ – better: credit creation. This creates bank credit and deposit money simultaneously. • Through this process banks are the lynchpin of the economy. • They decide who gets newly created money and for what purpose. • This is why banks are unique and different from all other non-bank financial institutions. 16

18. Saving (Lenders, Depositors) $100 Banks (‘Financial Intermediaries’) =“indirect finance” Investment (Borrowers) $99 / Banks are Not Financial Intermediaries RR = 1% “direct finance” They are the Creators of the Money Supply. And they decide who gets the money and for which purpose it is used. This decision shapes the economic landscape. Banks thus decide over the economic destiny of a country. Credit creation is the most important macroeconomic variable. 17

19. Rule: Banks are the creators of the money supply, they follow the central bank guidance • Banks create money. • One pound in net new ‘lending’ increases the money supply by one pound. • Banks decide who gets the money and for which purpose it is used. • This decision shapes the economic landscape. • Banks thus decide over the economic destiny of a country. • Credit creation is the most important macroeconomic variable. • This is a simple message, but reflecting it in economics means discarding the currently prevailing models – a veritable revolution. And about time. 18

20. Recognition of Bank Credit Creation is a Game Changer for… • Economics, finance, banking research and forecasting • Government policy (monetary policy, fiscal policy, regulatory policy) • Recognition of the banks’ true role is the precondition for solving many of the world’s problems, including • the problem of the recurring banking crises, • unemployment, • business cycles • underdevelopment and the • depletion of finite resources. 19

21. The Quantity Theory of Credit (Werner, 1992, 1997): • Money is best measured by its credit counterpart (C) which created it. • Financial transactions are not part of GDP. • If we want a link to GDP, we must divide money/credit into two streams: • Credit used for GDP transactions, used for the ‘real economy’ (‘real circulation credit’ = CR) • Credit used for non-GDP transactions (‘financial circulation credit’ = CF) C 20

22. Quantity Theory of Credit (Werner, 1992, 1997):Rule: The allocation of bank credit creation determines what will happen to the economy – good or bad... non-GDP credit GDP credit Case 1: Consumption credit Result: Inflation without growth = unproductive credit creation Case 2: Financial credit(= credit for transactions that do not contribute to and are not part of GDP): Result: Asset inflation, bubbles and banking crises Case 3: Investment credit (= credit for the creation of new goods and services or productivity gains) Result: Growth without inflation, even at full employment = productive credit creation 21

23. The Quantity Theory of Credit (Werner, 1992, 1997) ∆(PRY) = VR ∆CR ∆(PFQF) = VF∆CFnominal GDP real economy credit creation asset markets financial credit creation Real circulation credit determines nominal GDP growth Financial circulation credit determines asset prices – leads to asset cycles and banking crises

24. A significant rise in credit creation for non-GDP transactions (financial credit CF)must lead to:- asset bubbles and busts- banking and economic crises USA in 1920s: margin loans rosefrom 23.8% of all loans in 1919to over 35% Case Study Japan in the 1980s:CF/C rose from about 15% at the beginning of the 1980s to almost twice this share Rule: Credit for financial transactions explains boom/bust cycles and banking crises CF/C CF/C = Share of loans to the real estate industry, construction companies and non-bank financial institutions 23 23

25. Rule: Broad Bank Credit Growth > nGDP Growth = banking crisis 24

26. Rule: Out-of-control CF creates bubbles and crises, e.g. in Ireland & Spain nGDP nGDP Broad Bank Credit Growth > nGDP Growth 25

27. Greece: 1993-2009: over 10% credit growth 1995-97: over 20% credit growth 2001-2: over 30% credit growth nGDP Broad Bank Credit Growth > nGDP Growth 26

28. What happened in 1993/4? And in 2000/1? • The Bank of Greece was established by League of Nations (Annex to the Geneva Protocol of 1927) in 1928, as a Société Anonyme • In 1994, the Bank of Greece was made moreindependent from the government, and monetisation of government policy stopped. • “As of 1994 the Bank of Greece no longer provides finance in any form to the public sector. …prohibition of monetary financing.” (Bank of Greece) • In 2000, the Bank of Greece was made fully independent from the government, without democratic accountability. • In 2001, the Bank of Greece became an integral part of the ECB. • Note: the ECB is independent of and unaccountable to any government or democratically elected assembly in Europe 27

29. The Great Greek Asset Bubble of 1994-2009 • was created by the policy of excessive credit creation by theGreek central bank and the ECB. • increased tax revenues and economic growth projections. • encouraged the government to overspend and undersave significantly • the bubble was unsustainable – as they always are – and thus would, without fail, result in a banking crisis and a fiscal crisis • what happened since 2009 has been predictable and was caused by the monetary policy of the central bank and the ECB. 28

30. Greece: 1995-97: over 20% credit growth 2001-2: over 30% credit growth ECB control Independence from govt 29

31. The Solution, as told by the ECB: • Greece must increase its debts by borrowing more from the IMF/EU/ECB. • An exit from the euro or full default must not happen. • Greece must implement deep fiscal and welfare cuts. • All must tighten their belts. • The ESM must be established and fiscal policy controlled centrally by the EU/ECB (loss of national sovereignty). • BUT: No policies to stimulate growth and employment! 30

32. What must happen with shrinking credit creation? A deepening slump and higher unemployment Bank credit creation: -7.2% YoY 31

33. The same is happening in Ireland, Portugal, Spain & Italy Bank credit: -17% YoY Bank credit: -6.6% YoY Bank credit: -0.3% YoY Bank credit: -1% YoY 32

34. But there is a solution – without costs and fiscal pain, producing a recovery and lower unemployment • the policy proposal would have reduced government debt and deficits • it would solve the funding problem in the bond markets • it would help the banks and increase credit creation without extra costs • no need for centralisation of fiscal policy or issuance of European gov’t bonds 33

35. How to Create A Recovery After a Banking Crisis: Werner-Proposal of 1994:A new policy called “Quantitative Easing” = Expansion in Credit Creation = Total Effective Purchasing Power Richard A. Werner, Create a Recovery Through Quantitative Easing, 2 September 1995, Nihon Keizai Shinbun (Nikkei) 34 34

36. Applying this Framework to Solving the European Sovereign Debt Crisis Werner-Proposal of 2011 • Greece, Ireland, Portugal, Spain and Italy need to stimulate economic growth. This means stimulation of credit creation. • Their governments need to save money and reduce borrowing costs. • Bank credit growth needs to expand and banks need a safe way to expand their business and their returns • Here is how all of this can be achieved: • Governments need to stop the issuance of government bonds • Instead of borrowing from the bond markets – who do not create money – governments should fund their borrowing requirements entirely by borrowing from all the banks in their country. 35

37. Werner-Proposal: The solution that maintains the euro and avoids default • Governments should enter into 3-year loan contracts at the much lower prime borrowing rate. • Eurozone governments remain zero risk borrowers according to the Basel capital adequacy framework (banks are thus happy to lend). • The prime rate is close to the banks’ refinancing costs of 1% - say 3.5%. • Instead of governments injecting money into banks, banks create new money and give it to the governments. 36

38. Why fiscal spending programmes alone are ineffective 37

39. How to Make Fiscal Policy Effective 38

40. Rule: Concentrated banking systems are prone to recurring crises and instability • Banks and bankers maximise their benefits by growing quickly • The easiest way to grow is to create credit for non-GDP (speculative) transactions • This is why we have had hundreds of banking crises since the 17th century (when modern banking started) 39

41. Central Banks Official Story: They aim at stability of prices, growth, currencies • What is the empirical evidence for this assertion? • There isn’t any: Stability of prices, growth and currencies is not what we observe. • Central banks also claim that they pursue these goals by manipulating interest rates. • But interest rates follow growth, and hence are useless as monetary policy tool 40

42. Central Banks Fact: Central banks often cause, exacerbate cycles • Prediction in 2003 (Princes of the Yen): The ECB will create massive credit bubbles, banking crises and recessions in the eurozone. • Between 2004 and 2008 the ECB oversaw between 20% and 40% broad credit growth in Ireland, Spain, Portugal and Greece. • This could not fail to create massive asset bubbles, banking crises and recessions. • The ECB has said that the recessions in these countries are ‘opportunities’ to implement structural changes and increase EU control over national budgets. • The Bank of Japan has said that the long recession was ‘doing good’, by imposing the pressure for deregulation, liberalisation and privatisation. • The World Bank has said that the central bank-created Asian crisis was a ‘window of opportunity’ for structural changes and the ‘transfer of ownership’. 41

43. Central Banks Rule: The job of central banks is to create cycles • Legal independence of central banks has increased significantly in the past 30 years world-wide. • Central banks are more powerful than ever before in history. • They can choose their tools, instruments and often also their policy goals. • After each crisis, they demand greater powers still, which is always granted. • The principle of Revealed Preference (Samuelson, 1939) indicates that central banks are choosing to create massive cycles. • Theory of Bureaucracy: Policies are taken by bureaucracies to perpetuate their power. Central banks increase their power through business cycles. 42

44. Bank credit is the key variable in the economy That’s why central banks have always attempted to control bank credit creation directly through ’informal’, unofficial control of bank credit called: - ‘credit control’, ‘lending ceilings’, ‘corset’ (US, UK) - ‘l’encadrement du credit’ (France) - ‘Kreditlenkung/Kreditplafondierung’ (Germany, Austria) - ‘credit planning scheme’ (Thailand, India) - ‘window guidance’ (Japan, Korea, China) Japan: Officially discontinued in 1982. Empirical research, using primary eye-witness accounts, and econometric tests, showed: What determined bank lending in Japan in the 1980s? 43

45. Official policy tools: 1. Price Tool (ODR, call rate): not relevant 2. Quantity Tool (operations, lending): not relevant 3. Regulatory Tool (reserve ratio): not relevant Unofficial policy tool: Direct credit controls: no. 1 policy tool 44

46. How to Avoid Asset Bubbles & Home-Grown Banking Crises – and ensure ample funding for small firms nGDP 45

47. Regional, foreign, other banks 17.8% Local cooperative banks (credit unions) 26.6% Large, nationwide banks 12.5% Local gov’t-owned Savings Banks42.9% 70% of banking sector accounted for by hundreds of locally-controlled, small banks, lending mostly to productive SMEs Rule: A banking sector dominated by local, not-for-profit banks avoids asset bubbles and banking crises German banking sector 46

48. Mario Draghi, EZB-Chef, 21 Sept 2016: “Overcapacities in the banking sector in some countries” – The ECB has been aiming to decrease the number of banks. QUIZ: Which countries could Draghi have been talking about? Zahl der Banken in der EU – nach Land In Deutschland gibt es zehn mal so viele Banken, die KMU Kredite vergeben als im Vereinigten Königreich. 47

49. ‘Informal guidance’ of bank credit by central banks This practice is known world-wide, for instance, in the UK as ‘Corset’ Germany as ‘Kreditplafondierung’ the US as ‘credit controls’ France as ‘encadrement du crédit’ Korea, Taiwan, China as ‘window guidance’ Thailand as ‘credit planning scheme’ Central banks can require banks to primarily create productive credit, delivering stable, non-inflationary economic growth without banking crises (Japan 1937-1982; Taiwan, Korea, China) and with less inequality than when most of credit creation is used for financial purposes (UK). 48

50. Secrets of Japan’s Success • The central bank operated a credit guidance mechanism, banning harmful credit creation for financial speculation and for consumption. • Thanks to productive credit creation, sustainable, non-inflationary growth was possible. • In addition, incentive-structures at companies were changed, to align them with the national interest and ensure a growth-orientation. • Thus the influence of shareholders was reduced. Managers were empowered. • Competition for market-share (not profits) became so fierce, that the introduction of cartels became necessary, further enhancing efficiency • Dividend payments were reduced, funds were re-invested to grow the firms • Corporate finance was shifted away from capital markets to bank finance. • The labour market was changed from US-style hiring and firing to long-term employment, job security, seniority pay and loyalty to the company. 49