In the search for a solution to the banking crisis, Matthew Elliot is right to argue for the interests of the taxpayer and against nationalisation, but an effective long-term solution is none the less required. There is an alternative to formal state ownership with its attendant obligations on the taxpayer. In order to understand it, we must remind ourselves exactly what the banking system is for, and the extent to which it been allowed to deviate from its original purpose in recent times.
Most of us use bank accounts as a convenient mechanism for managing our finances. Salary goes in, bill payments come out, cash machine gives access to any money left over to spend as we wish. If we earn more than we need, banks also provide a secure repository of our savings.
Because they look after such surplus balances on behalf of savers, banks are able to loan money at interest. By making connections between people with surplus funds and those who wish to borrow for investment or additional consumption, they help oil the wheels of the economy.
And this, essentially, is all we need the banks to do. Were they to limit themselves to these basic functions they would provide a valuable service. They would be entitled to charge their customers to cover their costs, pay their staff, and generate a profit, either to reinvest in improving services, or to distribute to their shareholders.
But today banks do much more than this. They make loans far in excess of the deposits they attract using the principle of fractional reserve banking. They can do this because they know it's unlikely all their depositors will withdraw their savings at the same time. In theory they keep enough funds to satisfy the likely demand for withdrawals.
In the course of loaning money they don't have, banks create new money. Furthermore, they create it as debt which has to be repaid at interest. The banks aren't just printing money at will, they are creating for themselves a guaranteed future income stream, a privilege not granted to any other kind of business. Unfortunately, from an economic point of view, none of this money is backed by any form of tangible wealth; it really is created out of thin air.
The Guardian acknowledged this in an editorial recently, "most money is never printed as currency, but is created by private banks." It could have gone on to say that around 97% of money exists only as figures on electronic ledgers in banks' computer systems; and that the overriding reason for its creation is the generation of ever increasing bank profits to pay executive bonuses and shareholder dividends.
The method by which money is created was described by JK Galbraith as "so simple, the mind is repelled by it". It is concisely described by John Lanchester in his essay Cityphilia. Lanchester uses the example of a fictitious bank in which the capacity to create money is limited by a cash reserve ratio of 20%, before pointing out that in the UK the ratio has fallen to just 0.15%. It was 20% back in 1968, but the statutory requirement on banks to maintain a sensible liquidity ratio was abandoned in 1981; it is now voluntary.
The craze for securitisation which lies at the heart of the current crisis is simply an extension of this process. When a bank gets close to a zero cash ratio, the only way it can raise money to make more loans is to package up part of its existing loan book into so-called asset backed securities and sell these to anyone looking for an investment opportunity. Of course, the money to buy these new securities was also created as debt. And so it goes on.
Will Hutton argues that we should "devise a system of public banks, government supported insurance companies and a robust regulatory framework that allows the economy to enjoy the benefits" of securitisation. But to adopt a system which is fundamentally flawed and then create all manner of institutions to prevent its inevitable collapse is bonkers. There must be another way.
Because of the way in which banks are allowed to create money and sell on debt, there is currently no connection between the amount of money in circulation and the value created through labour and entrepreneurship in the real economy. As Brian Hodgkinson points out, things would be different "were bankers to create credit by advancing money only to genuine producers of goods and services, who would repay out of the proceeds of future production". Today most lending is for consumption, land purchase or speculation, none of which produce any real wealth.
Re-establishing the link between money and the true value of economic activity could only be achieved by giving responsibility for the issue of money to the central bank. It could then regulate the supply of money in response to demands by commercial banks for funds to finance the legitimate borrowing requirements of their clients.
There would be some losers. Bank executives would see a drop in their absurd incomes. Bank profits would reduce and lower dividends would result. There would be less money in circulation, but less artificially created financial wealth need not mean less wellbeing. Inflated house prices would return to more sensible levels, making home ownership an option for many to whom it's currently denied.
Rather than banks merging into ever larger conglomerates and reducing consumer options, the barriers for entry to the sector would reduce. This would encourage the return of regional mutually-owned building societies into which people would feel secure placing their savings. And banks would be forced to compete properly with each other, again benefiting consumers.
Emergency measures may be required in the short term, but there is no need for nationalisation. All the government need do is relieve privately owned banks of the perverse privilege to create money. It would be the boldest policy initiative in decades, but one that would provide a sound financial footing on which we might begin to build a more stable economy.