Transcription
Um, I just want to have you to have a look at this. This graph, to frame it, it's UK private debt since 1880. You can see what happens around the Great Depression. Uh, and then suddenly Thatcher comes to power, private debt takes off. Richard, a bloated or a dominant financial sector, its effect in your view on the real economy?
First of all, it's interesting that, um, the national income accountants, who think a lot about the overall economy, how to measure it, and how to, you know, structure the data, they actually have been struggling for decades with, uh, the question what to do with the financial sector. Why? Because, uh, GDP is actually created by national income accounting by adding up value-added activities, and that's where the financial sector has a problem. What is the value added?
And it's, it's been so difficult that essentially the, um, national accounting statistics have to make up a fictional value and just add it on to GDP and say, "Okay, that's, we can say that maybe is, is what the financial sector is doing." Because essentially, there is no value added, there's value extracted. And so, really, you need to subtract it from GDP. Has the finance sector, the FIRE sector, has it become a cost center? Because is, is the, as you know, is there a sweet spot where it's actually serving humanity, society, and facilitating business, and when it becomes a profit generator in and of itself, it becomes detrimental to the wider, to the wider world?
Start with you. Well, exactly. Um, even the mainstream textbooks in finance, banking, and macro-monetary economics will, will show banks as financial intermediaries. Now, there's, there's a problem with that. It's clear there is a high price that we're paying for this what should be a humble intermediation service that's being performed. And the salaries that are being paid, uh, you know, famously very high, which is very strange if they're just intermediaries.
Literally, where does that end up? I think there's a structural problem, that is the concentration of the banking sector. So, in the UK, five banks account for 90% of deposits, which is one of the most concentrated banking systems in the world. In Germany, um, those high street banks account for 12% of deposits, and 70% of deposits are accounted for by 1,500 local, not-for-profit community banks.
There is a general tendency when an organization gets large and larger and larger and gets very big, um, essentially decisions are made without accountability. And the temptations of power strike. Lord Acton famously put it this way, you know, um, "Power corrupts, and absolute power corrupts absolutely." So when you have very large banks, and only five of them dominating the economy, and through the political mechanism, and the already financial sector-centered political system and political infrastructure, you know, the City of London having a person in Parliament that is not elected, the remembrance, and, you know, all these rights of this square mile as a sovereign state, you know, all these things, and the Queen needs permission to go there, right? Exactly.
And so, what you will get is large banks only wanting to deal with large customers in order to do large deals. And that's also where you get the large bonuses. We've done a study on the US, which has the biggest banking sector in the world, over 15,000 banks of all sizes and shapes. The very large banks deal with the very large customers, give very large loans. The medium-sized banks give medium-sized loans. Who is lending to small firms? It is only the small banks. Now, the UK doesn't have those. So the structure has become too concentrated. And what is badly needed in the UK is decentralization. One has to break up the, the financial sector and, um, have much smaller units. Because small banks, community banks, are locally accountable. You can't suddenly do a crazy project or corrupt, you know, big corruption because people see what you're doing.
But I think you'd argue for a decentralized banking system, wouldn't you? Even though you're a city devotee. Without a doubt. But because it's anti-Richard. Like Richard to comment on this because I am, and as I'm sure Richard is, but we've had our Metro Banks, we've had our Old Mutuals, we've had our One Savings Challenger Banks, all the Challenger, Challenger Banks. We've had Handelsbanken, or Handelsbanken, and done a fantastic job, but it's still tiny. Exactly. Now, they will stay tiny, the ones, um, that are UK Challenger Banks and that are profit-oriented. And you, you know why? Because the moment they get a bit bigger, yeah, they will be bought up and they will disappear. This is exactly what happened over the last 100 years.
Richard, when you think about inequality, inequality in the UK, and it's a hot topic, and you think about, as you'd like the banking sector to be, uh, decentralized, flatter structure, more resilient, how do you begin to, uh, talk to the public or the political class about achieving those goals? Essentially, you know, if, if, um, we want to produce something, we need funding. So there was a role for banks in almost everything that's happening in the economy. But what exactly is that role?
I just quickly, I'd like to reflect on that. Banks are being thought of as intermediaries, but this is not really what's happening. Banks, what are they then? The creators of the money supply. So you're firmly of the view that banks create money out of thin air? Yes. Well, I, I produced the first empirical studies to prove that. Um, in the 5,000-year history of banking, banks are thought of as, uh, deposit-taking institutions that lent money. The legal reality, it is, banks don't take deposits, and banks don't lend money.
So, what is a deposit? A deposit is not actually a deposit. It's not a bailment. It's not held in custody. U, at law, the word "deposit" is meaningless. The law courts and various judgments have made very clear, if you give your money to a bank, even though it's called a deposit, this money is simply a loan to the bank. That's true. Yeah. So there is no such thing as a deposit. You name it. So banks borrow from the public. Okay. So much we've established. What about lending? Surely they're lending money.
Um, no, they don't. Banks don't lend money. Banks, again, at law, it's very clear, they're in the business of purchasing securities. That's it. So you say, "Okay, don't, you know, confuse me with all that legalities. I want a loan. I want a loan." "Yeah, fine. Here's the loan contract. Here's the offer letter." And you sign. At law, it's very clear, you have issued a security, namely a promissory note, and the bank is going to purchase that. That's what's happening.
Put it in layman's terms, what does that mean? It means that, um, what the bank is doing is very different from what it presents to the public that it's doing. How does this fit together? So you say, "Fine, the bank purchases my promissory note, but how do I get my money? I want, you know, it's a loan. I want the grant. Don't care about the details. I want the money." The bank will say, "Well, you'll find it in your account with us." That would be technically correct. If they say, "We'll transfer it to your account," that's wrong because no money is transferred at all. It's already from anywhere inside the bank or outside the bank. Why? Because what we call a deposit is simply the bank's record of its debt to the public. Now, it also owes you money, and its record of the money it owes you is what you think you're getting as money. And that's all it is. And that is how the banks create the money supply. The money supply consists to 97% of bank deposits, and these are created out of nothing by banks when they lend because they invent fictitious customer deposits. Why? They simply restate, slightly incorrectly in accounting terms, what is an accounts payable liability arising from the loan contract having purchased your promissory note as a customer deposit. But nobody has deposited any money.
I wonder how the FCA deals with this, because in the financial sector, you're supposed to not mislead your customers. Um, anyway, I, I don't have the. So, so the banks create the money supply by inventing these claims on themselves, the, you know, the fictitious deposits that can be actually positive for the economy, as long as this money creation is in line with the creation of new goods and services, implementation of new technologies, and therefore adding value. And adding value in the economy is funded by this money creation. If that happens, and we're talking about, um, business investment, productive loans, productive bank credit, you will have no inflation. These loans can also be serviced and repaid. You have a stable economy without problems and with low inequality.
And so countries that achieved this, that the banks lent mainly for productive purposes, whether it's Germany in much of its 200-year history, or, um, in the last century, the East Asian economies where bank credit was largely for productive purposes, then you're fine. But there's two more cases I quickly need to point them out because that's the contract. Just, just clarify that that inequality is, is significantly lower, lower inflation is low, yes, and the real economy booming, yes. That's when bank credit creation is focused on, um, productive lending for productive purposes, as opposed to speculation and asset price. As opposed to, there's two other types. If banks create credit for consumption, it's obviously what's going to happen. You suddenly have more money created and more demand for goods, but it's the same amount of goods and services. So you're creating consumer price inflation. That's well understood, and and central banks are watching that a little bit.
But what, what's less well understood, and what's the biggest in the UK, um, it's probably more than 70% of all lending, um, actually way more than that, um, is bank credit creation, so money creation, uh, for financial transactions, for asset transactions, for purchasing ownership rights. Now, then you have a problem. Why? Because you're creating new money, but you're not creating new goods and services. You simply, they're constant, aren't they? You're giving somebody new purchasing power over existing assets, and therefore you must push up asset prices. So this, you can, you can draw a chart where you show, you know, asset prices, land prices, property prices in the UK, and it will match very closely, as, as I've shown in, in Japan and other countries. And that also creates the inequality when the, the banking sector has focused too much on unproductive lending. And the UK is dominant.
It strikes me that what you're telling me, and tell me I'm wrong, is that lending in order to get round this deposit-stroke-loan situation needs to be categorized. You're right. Exactly. Is that right? That's right. Um, we need to look at where the money is going. That makes a whole world of difference. So if money is, is bank credit is extended for productive purposes, you're fine. You get a good economy, no inflation, and financial stability. And also you don't have this inequality problem.
And do you think there should be different capital ratios towards each? Capital? The whole Basel capital approach doesn't work because it's, it's premised on the idea that banks are just financial intermediaries, but they're not, they're money creators. We need bank regulation that recognizes the reality of how the banks actually operate. So what you're saying, this is a regulation problem, clearly? Yes, it's a regulation problem. That's right. We need a different regulation.
And the only regulation that actually has succeeded in, in history, and we have good data for the 20th century in particular, in preventing asset bubbles and banking crises, which are all driven by this bank credit for financial transactions, it leads to this asset boom. And it's, it's a game of musical chairs. You know, you have to play it. It's rational to play it while the music is playing, which is how asset prices are driven by ever more bank credit for financial transactions. The moment it stops, asset prices fall, you get the first bankruptcies, banks get risk-averse, the whole thing goes into reverse, and banks go bust. But you can avoid this. And the only regulation that has succeeded in avoiding this is guidance of bank credit. Simple rules. Um, the simplest form of bank credit guidance is to simply ban bank credit for, um, financial transactions. It doesn't mean financial transactions are banned. No, let the speculators speculate, and let them even borrow money, but not from banks. That would make a whole world of difference.
Who do they borrow it from? Well, they can issue bonds or, you know, borrow in the markets, whatever they want, but they shouldn't get access to the public privilege of money creation. You see. I, you mean, and that creates the problem, that creates the boom cycles. But in some countries, they've succeeded in preventing this asset inflation. Which ones? Such as Germany, without even credit guidance, by having a banking structure, banking system that's dominated by banks that don't want to do this financial speculation in the first place. These are the community banks. So Germany, with 70% of bank call the Lenders Banks being, no, not the Lenders Banks, the smaller ones, the 1,500 Volksbank and Raiffeisenbank. They're actually the main banks in Germany. There's so many of them. Each is small, and they lend mainly for productive purposes to small and medium-sized enterprises, the Mittelstand, which has been the backbone of German economic success for the last 200 years, despite wars and disasters, has only been successful because they also have to have local small banks funding them all the way through. That doesn't exist in the UK, and that's been why the small and medium-sized enterprise sector always has has had a problem in the UK. So we're stuck with speculation and horrific property porn renovation shows.
Well, the solution is, of course, to create these small banks. We need to create small banks. They're the natural lenders to small firms. The public wants stable growth, none of those boom-bust cycle banking crises, public money used to bail out banks. People don't want that. In Germany, these community banks, it's very, because they've never used public money in these 200 years, not a single one has ever been bailed out with public money, and no depositor has lost any money. Although, Richard, your argument is complex, principles are terribly simple. It is very simple. And although you, although you're a little defeatist, I'm not. Maybe I'm defeatist, but, but I like it, but it's just the idea of, how can I put it, getting, getting through the regulatory. They are so reluctant. But that's why hard work. That's why we got you in. We're going to, we're going to have you.
I think I have to say, this has been brilliantly explained. Has the UK got a finance city? Is it a trick question? Because the UK doesn't have a finance city. The City of London has, and is not part of the UK. Good answer. Good answer. It's international. He's right. The City of London is outside the United Kingdom. Do you know that? It's, it's really shocking. And therefore, it's also not part of the EU, which explains the, although it couldn't be part of the EU because you have to have democratic elections, and the City of London doesn't. Right. It's, it's the banks that have the votes. Right. Periphery, you know, how do you, how do you start unpicking this puzzle? I never knew that. That's very useful piece of information. It's not part of. Pretty dangerous piece of information. And it's not part of the UK because the Queen is not allowed to enter without permission. She's not the sovereign. Therefore, it's not part of the UK. You know, of course, that's since, you know, 1688. I have to make a note. Since the Glorious Revolution.