Odd Lots - What The Weak Recovery In Japan Can Teach Us About Re-Igniting The U.S. Economy

Episode Date: May 21, 2020

Even with the recent stock market rally, expectations are poor for a robust recovery in the U.S. So what does history teach us about what works and what doesn’t? Richard Werner is an economist at Linacre College at the University of Oxford, and the proponent of what he calls the “Quantity Theory of Credit.” On this episode, he tells us about what he learned studying years of the Japanese economy, and what it means for the current crisis.See omnystudio.com/listener for privacy information.

Thanks for listening to Odd Lots. Follow the show on Amazon Music for more future episodes or just ask, Alexa, play the Odd Lots podcast on Amazon Music. And welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway. And I'm Joe Weissenthal. So, Joe, we like talking about money, don't we? We do. The nature of money, the origin of money, where it comes from, how we talk about the language of money, it's, I would say, for both of us, one of our favorite topic. Yeah, although I think for you, your eyes sort of light up whenever we say we're going to do a money episode.

But I have good news for you. This is one of those episodes. That's great news because you're right. My eyes do light up. And I think that it's always sort of interesting this topic, but there are times when it could feel anthropological where it's like, you know, oh, that's interesting. You know, okay.

But I actually think that it's particularly important now because the sort of the nature of the policies that we choose or that governments choose around the world, well, I think in many cases, be informed, so to speak, by very real conceptions of like what money is and what you can do it. Oh, absolutely. The way you think money actually works and is in fact created is going to inform a lot of what you do as a central bank. So, you know, for instance, right now, a lot of central banks are trying to lend to various businesses and parts of the economy to enable them to get through the coronavirus containment efforts. And that usually entails some form of money creation. So what we're going to talk about today is exactly that. We're going to talk about where money comes from, from someone who has a very, very specific and particular theory about it. and someone who's also credited at various times with actually coining the term quantitative easing, which of course is something that we are also talking a lot about in the current environment.

I can't wait. I mean, you know, quantitative easing, this idea of central banks having purchased assets, trying to strengthen the economy, loosen monetary policy. It really sort of became a big thing last time. now we're seeing central banks all over the world, use that as just part of the playbook. So what it takes to get actual money into people's hands who need it desperately is a huge and important topic. Excellent.

All right. Well, without further ado, and I should mention by popular request from quite a few of our listeners, we're going to bring on Dr. Richard Vana. He is a professor in banking and finance at a whole bunch of universities and a long time professor of economics. So Richard, it's so great to have you on. Thank you very much. It's a pleasure to be on. So maybe just to begin with, you know, I sort of shortened your title there, but you have a very long and lengthy professional history. So maybe give us an idea of how you got interested in money creation in the first place. When did you start studying it exactly? Well, that happened when I was in Tokyo. I was a

a graduate research student at the University of Tokyo, having come over from Oxford on essentially a leave while doing my doctorate in economics at Oxford University, but I was in Japan on a government scholarship at the University of Tokyo. And I had just applied to the Japan Development Bank. It's one of the big, actually now it's called Development Bank of Japan in Central Tokyo, or Temachi, which is the sort of the bank, the bank, a government bank that's been helping in the post-war reconstruction, and they had a research fellowship in their research institute. And my professors had recommended me for that one,

but you had to fill in an application form with a research topic because when I wrote this was in 1990, actually just before, because probably in advance, at the end of 89, early 1990, I wrote this. And of course, these were dramatic times for Japan. I was there in the summer of 89. when the NICA peaked at close to 40,000. So we're still in just barely half of that amount.

Haven't really recovered ever from this peak. And a lot of people were talking about capital flows. So my research started with capital flows. And the story that was, in our younger listeners, the big story in the second half of the 80s and a few years after that was Japanese capital flows. They were everywhere. They're on Time magazine on the cover,

Newsweek. Japanese money was buying up. Foreign companies left right and center, foreign land and foreign investment. Of course, bond market investment. It was just all over the place, Columbia Pictures,

Pepple Beach, Gulf Corps, Australian, Hawaiian, real estate, you name it. So this flood of Japanese money. And I was, you know, I was doing my doctoral research in economics. But the funny thing was that in economics, nobody could explain these capital

flows where they, you know, why so much? And there were a few studies, two or three, by some known professors about, well, trying to explain this, but they concluded, intriguingly, oh, this is so much money, we can't explain this. Our standard models don't work. And so that was the puzzle. And, you know, being a young research, and that was my first piece of research. research, you think, hey, you know, that's a good challenge. I'll solve that puzzle. So the trouble was, I had now given myself the most difficult research question at the time on the globe. And the thing is that Japanese who are extremely friendly and welcoming to foreigners and, you know, treated me really well. But one thing is they do like to stick to things and, you know,

stick to rules and they're quite, you know, there's lots of forms to fill in. And that was my topic. They'd given me a scholarship at the Japan Devolvent Bank, a fellowship even, the first Shimomura Fellowship. Actually, if we have time, we can briefly talk about Shimomura. It's an interesting angle, but anyway, and certainly I couldn't change the topic. So I was stuck with this, because what happened then was my research advisors at the universities in Tokyo and Oxford told me, start with the data, because just the data work, because my time period is only six months, which is very short for a research project from start to finish. And you can easily spend that on data alone, just some gathering data, sorting the data, cleaning the data,

doing your econometric careful analysis. I mean, if you do that all within six months, then that's, you know, that's, that's normal. And so they said, look at the data, but I thought, well, hang on, what data, what data? You know, we're looking at a puzzle here. So first, I want wanted to get an angle on how one could explain this. And my hypothesis was, because the capital flows were one puzzle, but there was another puzzle. And at that time, it was still a bit early, so people weren't really talking about this. And with hindsight, it emerged that something strange was going on. But I already thought at the time, and if you're in Tokyo, you'd think there's something strange.

Certainly as a Western economy, Ethiopia, Japanese land prices. They were absolutely crazy. So the property prices. And so the Imperial Palace Garden in Tokyo, which is a nice little park in central Tokyo, but if you valued that at the property prices of that location, you'd have the same market values, the entire state of California, including L.A., San Francisco, everything. And that was just completely mind-boggling.

So I thought, maybe there's a link. And that was my hypothesis. And so I went out to try to explain this. But the trouble was there was no paper, no model, no theory that would link, land prices to capital flows. And so I started to run out of time and I hadn't started the data yet. This is the second time we've had an episode recently where this factoid or this fact about the value of the imperial palace relative to the size of California came up. We actually spoke to Richard Koo as well recently. So what is the answer? I mean, not to, you know, obviously I'm sure

it's complicated, but as you examined this question of where all of this money was coming from, what did you find? Yes, exactly. And also, why was so much money flowing abroad because they were losing money on it? Right. They were losing money on the exchange because the yen was rising and rising and rising, the second half of the 80s, right? So your foreign investment was actually losing money.

It was also against the interest differentials because that's the standard, you know, theory explanation, interest differentials. and if there's higher rates in New York, you know, in America, then you invest abroad. But that also wasn't the case at the time. So all these theories didn't work. And that was the big puzzle. And by the way, it was in 1990. During, this is just before I started this research, I was an intern at the Nomura Research

Institute where I talked a lot to Richard Koo. And he did talk a lot about land prices. And so, I mean, once you look into it, it's. clear that this is such a big phenomenon that it had to be connected to this. In my research, I couldn't find a link. And then at one stage, somebody said, well, hang on because I was looking around in Tokyo and talking to people, go to Miti, you know, the famous Ministry of International Trade and Industry famed for its role in post-war economic success and the miracle system. Go there because there were some foreign researchers there, maybe somebody famous even from America,

and they were looking exactly at this question. And they looked at the question. And they looked at the question whether there's a link to the high land prices. So high land prices. The idea is very simple. If you've got such overpriced land prices, then it's just selling a tiny little plot. You can buy half of California. Why wouldn't you do that? That makes perfect sense, right? It's better for diversification. I mean, you know, if something happens, why not diversifying? You get so much more abroad. So quite reasonable. And I went there and they said, oh yeah, Jeffrey Sachs from from the US, who's now at Columbia University, he was here and his PhD student, Peter Boone, and they wrote a paper exactly on this.

Now, I was delighted because, you know, I was just starting out. This is my first paper. Nobody expected me to come up with anything new. So it's fine to take the work of famous scholars and you have just a slight different angle would be sufficient. So I thought, this is great. This, you know, this will really help me out here. I'm running out of time.

And I looked at that paper. And there it was, land prices, crazy, capital flows, mind-boggling, standard theories can't explain it. So should there be a link? Yes, there should be a link. And then it went through the analysis. And conclusion is, there is no link. What? There is no link, my jaw dropped.

Why not? And see, their argument was, well, if the Japanese want to do the sensible thing, sell a tiny bit of the land in Tokyo and purchase a huge, you know, huge swathes of land. and say in the US or in England, the catch is they have to find a buyer for their land in Japan. And as long as the buyer is Japanese, and that's actually what we had to assume because foreigners were not buying this Japanese land because it's so ridiculously overpriced.

So actually, the only buyers were other Japanese. And then think about it. It just means there's money shifting from Japanese investor A, to Japanese investor B. And so this is nothing to do with the rest of the world. And that's why there's no link to the rest of the world. Now, so much for the analysis of Professor Jeffrey Sachs and Dr. Peter Boone. But I didn't give up.

I thought, okay, so the famous experts say there is no link. I asked Richard Kuh at the time, of course, also. And while he was a land price expert and also a capital flight expert at that time, He wasn't yet into sort of general economics. So he was an expert on both topics that I was trying to link. He said to me, Richard, forget that topic. Give up on that one. You will not find a model of Japanese capital flows.

You can't do this in a model. Still, I didn't give up. Well, actually, I had no choice. I couldn't. I wasn't allowed to chase the topic. So I needed a miracle. And, well, to come straight to the, the point. I did get a miracle because I had just in time sort of one and a half months before

the deadline the inspiration on one day about how this works. I came to the office on a Monday morning. I was very concerned because I was running out of time. They were all treating me so well. They give me this huge five-bedroom apartment in central Tokyo at these real estate prices. Well, rental prices also being equally high. Anyway, treating me really well like a VAP, but I couldn't deliver. So I was pretty much under stress and I prayed about it and I prayed for a miracle. And then I came to the office on this Monday morning and I sat down and it's just, it was in my head the answer. And here's the answer. If you want to hear it. Does anyone want to hear it? Please. Okay. Well, this is where Jeffrey Sachs and Peter Boone went wrong.

They made the wrong assumption that you have to sell your land to get. the money. And actually what you do is you use your land as collateral and you borrow money from the banks. And the other thing that was in my head suddenly was the realization. What happens then is not what the textbooks tell you because they say banks are financial intermediaries that gather deposits and they lend out the existing money. No, I also realized this is new money creation because when a bank gives out a loan, it's actually adding new money to the money supply that didn't exist before. And as it later turned out, that's how, if you look at the data and when I prove this later, 97% of the money supply is created in this way.

So when banks lend, that's what creates our money supply. That adds to the money supply. It's not existing money they lend, but new money. And so then back to the Japanese real estate story. So the bank lending with land as collateral and for the property sector and for property transactions, that is the key variable I was looking for to explain capital flows. Now, in the meantime, so this is in 1991, in the meantime, actually Japanese capital flows had started to collapse. And there was such a dramatic collapse that again, all the experts were puzzled.

They couldn't explain the huge surge, and they certainly couldn't explain the sudden collapse, actually by the early 92, Japan, who was previously before the largest net long-term capital exporter in world history, superseding any other capital exporter in history, had suddenly, in early 1992, become a net importer of capital. So not only were no capital flows outgoing anymore, it was actually borrowing money. So this was another mind-blowing puzzle. But my model worked brilliantly, and it's still the only model that can explain is published. Review of International Economics, 1994, if you look it up, Japanese capital flows and the role of land.

So this bank credit creation for real estate transactions created new money. out of nothing, which goes into financial circulation, and some of that spills over the borders abroad, which makes sense. That's the diversification we talk about. And that explains capital flows. And then, of course, from 1990, Japanese credit creation completely shrank, collapsed, and the bubble burst. Of course, stock markets started to collapse essentially from January 1990, just after the peak, December 89 peak and after that started to go down and down and down something we're perhaps reminded off in these days and has been going down well a lot in total 80 percent collapse and capital flows also collapsed and so the model stands up and I realized at that time

the importance of bank credit creation so essentially all my work afterwards has been built on this and so I could write I then found out that the the division of bank credit creation is important between credit, bank credit for the real economy for GDP transactions. The standard quantity theory, MV equals PY, assumes that money is used always for GDP, but it's not true. In many economies, most of the money doesn't go into GDP. It's used to asset transactions and you have to split it up. And so that's my quantity theory of disaggregated credit on the basis of which I then proposed quantitative easing when the Japanese banking system collapsed. So, Richard, I want to ask you about the policy response that we saw in Japan. But before we get onto that, just talk to us a little bit

about how your credit creation theory actually stacked up against dominant ideas of how money is created at the time. I mean, dominant ideas that are still dominant today, things like fractional reserve lending, stuff like that. Exactly, exactly. And also the standard quantity equation, monetarism and standard monetary macroeconomics, well, actually, there was a big puzzle in macroeconomics and monetary economics and also the monetaries. Since the 80s, they've been in trouble. Why? Because the link between the money supply and GDP had broken down.

What had happened is that money supply had been rising much faster than GDP. And so the so-called velocity was declining. But people didn't realize where the money's going. And also meant that because velocity was unstable, policy majors didn't. have a link between money and the economy. So then the whole monetary policy concept, and at the time in the early 80s, it was the monetarist concept, just money aggregates used to control the economy. All that broke down. Now, I could explain this with my findings in Japan very easily because actually there was a fundamental flaw in their theories. Two flaws, actually. One is their

definition of money. And secondly, they assumed wrongly that all money is used. used for GDP transactions, which is ridiculous because actually the majority of transactions is asset transactions, but asset transactions are not part of GDP. They don't teach national income accounting anymore. You used to get that as sort of economics 101, but they don't teach it anymore. So people don't realize that asset transactions, real estate transactions, property transactions, they're not part of GDP. And so what happened then, particularly there was a lot of,

this big bout in the 80s, is that in many countries, money supply was rising, but it wasn't used for GDP transactions, used to asset transactions. So your standard traditional models would give you the illusion of a velocity decline. It also meant that the policy makers didn't really know what to do. The money supply is not linked to GDP. But the true story is you have to split money into money going into GDP for the real circulation, for the real economy, and money going into asset transactions, which I do in my disaggregated quantity theory. However, how can you split money by its use? Well, you can't, if you use the traditional definition of money, which is the monetary aggregates, M1, M2, M3, around London, we've got M25, all these Ms,

these M aggregates. But actually, that's the other mistake they're making in these standard theories, that's not a measure of the money supply. These are actually deposits. That's money out of circulation. That's money not spent. These are savings aggregates. We want to measure, and anyone who's interested in the markets wants to measure money that is in circulation, that's used for purchasing things for transactions. So the real liquidity, the money that's doing stuff, not the money that's been parked and is savings. And that's been the other problem in the traditional approach. So in my approach, I actually measure the money that, is in circulation. How can we do that? Well, you can do it if you look at the money creation

process. The money creation process is this question, you know, where does money come from? Now, most people will answer this question by saying, well, the central banks, they create money, they inject money. Well, not really very much because central bank money, notes and coins and circulation is only 3% of the money supply. The majority is created by banks through bank lending. And that is the proper measure of the money supply. Because if we measure it by credit creation, bank credit creation, then we have the additional advantage that we can split it up into bank credit used to GDP transactions and bank credit used for asset transactions.

That's what I did. And that's why my models have been extremely stable. And they've worked extremely well and stood up the test of time really well. So, Richard, let's fast forward a little bit. to this crisis quite yet, but last, you know, the central bank actions during the last crisis, 2009, the Federal Reserve undertook asset purchases, quantitative easing, central banks all around the world had done it. What does your, what did your model anticipate about the efficacy of these efforts and what does it reveal about the degree to which they were effective in

achieving their goal. And at what time period? Well, in the post crisis, I mean, there's been, you know, in the sense that like... So like 2009? Yeah, 2009 and beyond because there has, there was this extreme increase in the sort of in the Fed's balance sheet. And yet, you know, most people would say, okay, the post-crisis, post-2008, post-2009 crisis recovery was not particularly impressive by any stretch, despite what, at least on paper

or looked like extraordinary action. Exactly. Well, there's also a link to my time in Japan because the next thing I found out in Japan then in 91 was because there's been so much credit creation going to asset transactions. This is totally unsustainable. It's an acid bubble that must crash. And this will take the banking system down. So here I was a graduate student at Oxford in 1991 when the top 20 banks in the world were all Japanese. And I put out the discussion paper back at Oxford, having just come back from Tokyo, with the prediction that we unfortunately have to expect that Japanese banks will go bankrupt and Japan will go into the biggest recession since the Great Depression.

Why? Because of this asset bubble. So you have so much bank credit, which is money creation, used for asset transactions, created the bubble. And when that bursts, you just, from the peak, you only need to go down by 10%. because that's all capital banks have, right? And that's why we have so many banking crises. They follow the asset bubbles because the asset bubbles are bank credit created. So it's very, very simple, actually.

It's always the same story, and that's why it's so relevant also in 2008, 2009. Now, because of my predictions, I then actually quickly got a job as chief economist. I had various offers, Goldman Sachs, Swiss Bank Corporation. I accepted the offer from Jardine Fleming securities because they gave me a complete free hand, maybe chief economist, and I could use my new. credit creation-based models. And I then worked out that, well, we're going to move into this recession. That's happening.

But, of course, what are the ways out? And I started to publish papers and advise, you know, the policy makers in Japan how to get out. Unfortunately, they didn't listen. But there was this landmark paper in the Niki, published in the Niki, in the Nihonkese-Shimbo in the major Japanese newspaper in September 1995, in which I advised the Bank of Japan and policymaking. to adopt a new monetary policy because the traditional stuff is not going to work. Now, in those days, we still had 5% on the JGB, on the government bond yield, 4.7%.

And the central bank was, you know, of course, cutting interest rates. And I said, stop cutting rates. This is not going to help. In fact, I even wrote, you can cut rates to zero, which, you know, is trying to be dramatic. It's not going to help. I didn't really think that they would try to definitely prove me right with that one. because it's not the price of money that's the problem. It's the quantity of bank credit.

Once the banks have so many non-performing assets, they will not lend, and then you're stuck, you won't get money creation, because that's what you need for growth, money creation for GDP transaction. So what do you do? Well, the monitors were saying just print money,

some money supply. And they also said, no, that's not going to work. So I was suggesting a monetary policy that's stimulatory, but expands credit creation. And initially had credit creation in the title of this article, and the Niki. But the editors told me, look, can you make this title simpler? People want to understand what is credit creation?

What do you call your monetary policy? Is it, you know, is it, if it's an expansionary monetary monetary policy, so expanding the money supply? No, that's not it. It's not the traditional M1, M2, M3 monetarist policy. So is it lowering rates? No, that's not it either. So what is it then?

Well, it is a quantitative policy. And the Japanese traditional word for an expansionary policy is. easing. So I called it quantitative easing to distinguish it from all the previous and monetarist approaches to stimulate the economy through monetary policy. And it's defined in this article as an expansion in bank credit creation and credit creation for GDP transactions. How can you achieve that? Well, there's a package, mainly three things you should do. Number one, the central bank should step in and help the banks to make sure that the banks become strong enough to lend again. And there's various measures you can do to accelerate that.

And in fact, the fastest is that the central bank purchases the non-performing assets from the banks at face value. So you shift them to the central bank. And of course, clearly immediately you've completely cleaned up the balance sheet of the banks, more liquid and stronger than ever before so they can lend again. But you still want to stimulate things. So you also get the government to stop the issuance of government bonds. and instead fund the public sector borrowing requirement by borrowing through loan contracts, which are not tradable debt, from the banks.

And that stimulates bank credit creation. With these two measures, you will kickstart the economy so dramatically. You won't believe it. Now, sadly, the Japanese wouldn't have any of this. They were advised by Richard Koo, who they listened to for 20 years. And so they stayed in recession for 20 years because he said, no, no, no. What Richard said is wrong. It's nothing to do with credit creation.

That doesn't matter. we just need more fiscal spending. But the trouble was they were funding the fiscal spending by government bond issuance and borrowing from the non-bank private sector through bonds. So they increased fiscal spending dramatically, world record peacetime fiscal expansion. Of course, now we're going to beat those records, but that's another story. And it didn't help. It didn't have any positive impact because the same money they were putting in the economy

through the right hand through the fiscal spending, they took out of the economy through their bond issuance. And I proved that actually in empirical paper one by one yen, one yen crowding out. But you can change that if you stop the issuance of government bonds and get the government to borrow from banks through loan contracts, then you kickstart bank credit creation. I like that we're getting into this. Now I wish we had had you and Richard on at the same time because then we could have had a real fight or at least a debate.

But something I'm curious about, you know, in the beginning of our conversation, You were talking about the analytical error that economists made thinking, talking about the zero-sumness of real estate transactions. And so you said, well, real estate couldn't have been the driver of these capital outflows. They thought because someone had to buy, someone had to sell, but obviously the real estate could be posted as collateral to create new money. The argument, one argument for why bond issuance doesn't crowd out private sector borrowing and spending is that bond. safe haven government bond can be posted also as collateral for new money. So why is it that bond issuance, in your view, has a dampening effect on private sector activity if, like real estate, they could theoretically be posted as collateral for credit and it should be very good, very good high quality collateral? Right. But then you still need the borrower. So it becomes a derivative process, you know, and whereas if you get the government to borrow, directly from banks, you cut through all these intermediaries, which may or may not be willing

to borrow when you're in the recession, you know, and bank balance sheets are hurt by non-performing assets. They're reluctant to lend. So that's why. But of course, also, the Japanese did not follow my first advice, which was for the central bank to take off the non-performing assets off the bank balance sheets. They didn't do that either. And so if you don't do either of these methods, you can't expect the recovery. They just, continue to implement this advice from Richie Koo. More fiscal spending, more fiscal spending. And yes, rates to zero, rates to zero.

And it would just stay in recession. And it's extraordinary because, I mean, essentially, after 15 years, I gave up. I thought, okay, because I was well known. My book had become a number one bestseller in Japan. That's the book, Princes of the Yen about the Bank of Japan with all the analysis, all the solutions in there. I was invited to Parliament as advising leading politicians, people who were then finance minister and so on. So I had the ear of the decision makers, but they just wouldn't do it. The main

thing was the Bank of Japan leadership was unwilling to do this. And as I reveal in my book, they had very different goals. They understood this. And that was a shocking thing. In fact, several key Bank of Japan people had told me that they did not want a recovery. Why? Because the recession was serving a political purpose. They were engineering structural reform. form. And as a result, they were totally unwilling to do this. But it was clearly possible. And it could have been done. Now, in these debates at the time in the 90s in Japan, there was one American scholar who joined these debates, and that was Ben Ben Ben Bernanke. Now, when he then became chairman of the Board of Governors of the Federal Reserve system, soon after, of course, we had the 2008

crisis. And then it looks like he very much remembered what I was saying, because he was the only central bank leader at the time who implemented at least my first advice of this, what I called quantitative easing. This is the original definition of quantitative easing, expanding credit creation by first taking the non-performing assets of the bank balance sheets and also kick-starting bank credits to the real economy, such as by shifting government funding from the bond markets to direct borrowing from banks. Anyway, he took the first one and the Federal Reserve took huge amounts of bad assets of financial institutions balance sheets. And as a result, bank lending recovered first in the U.S.

And GDP growth recovered first and was the strongest in the U.S. in the post-crisis period, way ahead of the Eurozone, way ahead of other countries, whether it's the UK or Japan, because he took that policy. Of course, it would have been even better had he ensured that this bank credit creation goes mainly into the real economy. I mean, that's why your other point is correct. It was sort of a weak recovery because still too much was going into asset markets,

which is the other point I was trying to make. So if we fast forward to today, I'm curious, what is your credit creation theory and your definition of quantitative easing tell you about the current crisis and the policy response that we've seen? Let's keep it to the U.S. for now that we've seen there because we do have QE or an expansion of the Fed's balance sheet happening again, but we do also have a sort of interaction between the government and the banks through the PPP program, which is something slightly new.

So what do you think of all that? Yes, the responses have been even more dramatic now than in 2008. And I think there is a, so there is a quantitative and there's a qualitative difference. Essentially, the Fed's response already started September last year. This is the solution to the puzzle that we already saw September last year. And people were saying, something big is going to happen. Something's big going to happen. What is it going to be?

In many ways, you could say that already pressure was building in the U.S. financial system, as the same in other countries' financial systems. And so there was already a problem. Liquidity, for some reason. big banks were getting reluctant to lend to each other again, and the Fed stepped in and became very, very active, very aggressively. But then, of course, from March this year, things were accelerated further. And here, this is where we see, I think, a difference to 2008 responses. I think more is done now than in 2008 to ensure that money goes into the real economy and, at least

in theory, it should also reach ordinary people. I mean, you've heard all these proposals about and policies to try to put money into people's pockets because the reality is a different story now that we're bankrupting thousands and thousands of small firms and sole traders, business people. Essentially, it's a government-imposed cruncation of the economy. It's like an amputation of the small business sector, not, of course, all industries, because those that can work online, you know, they will survive. But there's all these industries and activities that need human contact and that are not

privileged, they're dying now. And of course, in the US, this means immediately unemployment. And just the figures out today is quite extraordinary, isn't it? We're up to 33 million that are claiming jobless benefits. This is 1930s Great Depression sort of levels. And so that means we need a response that helps people, ordinary people affected by this. And there has been a greater attempt now than 2008 to help with that. I'm not saying this is the best they can do because we know that there's still not so much money getting through to, you know, small entrepreneurs, business people, and catering, hotel, all these industries, restaurants affected.

and all the casual jobs and zero-outo jobs and all these. So they're not, you know, they should probably still be looked after better, but at least there has been a shift to get more money to them. So what does that mean specifically, though? Because again, you know, going back to post-2009, there was this general view that the activities did a very good job, reinflating financial markets, but the real economy side was never,

particularly impressive, even though we had this incredible bull market. So how do you make policies that tilt the new money creation more towards real activity as opposed to money going into speculative assets? Yes, exactly. Well, the main thing is to ensure that there are many small banks, because small banks lend to small firms. The U.S. used to be uniquely well-endowed on this front in the whole world because only 10, 15 years back, America had 12,000 banks. And a bit earlier, America had 20,000 banks. But the U.S., like other countries, has had this policy where central banks want to concentrate the banking system.

So the number of banks has been declining. And in the last decade, they've fallen to, you know, from 12,000 to only barely 5,000 banks. So that's bad, but still, it's been so many that 5,000 are still left, and that is much better than other countries. So the U.S. is next to China. These are the two countries with most banks. The next one in this ranking is Germany, which has 1,500 banks, which by far the largest number of any country in the EU. And so Germany is also likely to do better.

Because America still has these 5,000 banks. many of which are small local community banks, it can get the money to small companies. That needs to be strengthened, and these banks need to be helped. And the best way to help them is to end this ridiculous policy of zero interest rates or in Europe negative interest rates, because that's actually a key factor in forcing the banks to merge and getting rid of small banks and getting concentration in the banking system. So instead, we should end that. The Fed should, as a part of this policy,

package, raise interest rates in order to push up long rates, steepen the yield curve, and give banks a perspective that they can actually earn some money by lending. Because at the moment, they're still barely surviving, and they know this is an opportunity now. They're getting government supports. Of course, they're aggressively trying to write loans. But it's not sustainable. You need a positive yield curve for that, which is why the yield curve is a great business

cycle indicator. And sadly, that's still pointing down. Fed needs to work on that one. They've been working in the wrong direction when it comes to interest rate policy. So your point about small banks in the U.S. is a really interesting one. And I remember writing stories after the financial crisis about how there were no new banks created for, I think it was three or four years after that. And then the one that was created was the first one post-financial crisis was an Amish bank in Pennsylvania called Bank of bird in hand with a very specific business model. So definitely an issue in the States.

What are you seeing in terms of other countries and specifically Germany where you've been doing some work? Yes. I mean, it's sad that we don't get many new banks being set up, particularly these local community banks, which we need. They've been driven out of business. So we need to work in the opposite direction. I'm working to set up not-for-profit community banks leading the project in the UK. We've got the Hampshire community. community bank coming up and other community banks. And I mean, think about this. Here's Germany, which has been a successful economy for the last 200 years despite wars

and disasters in between. And the core of the success has been the small and medium-sized enterprises that are disproportionately strong in German exports. And German exports are still as large as Chinese exports, you know, the biggest in the world. And many are from small firms. So how can the small firms be so strong? It's because of the banking sector. It consists mainly of not-for-profit community banks.

80% of German banks are not-for-profit local community banks. It's like local public savings banks and also cooperative banks. And because they're small, they want to lend to small companies. There's a very simple principle in banking. Big banks want to do big deals, you know. That's the truth. Who wants to lend? to small firms, it is only small banks. Only for them does it make sense. But small firms are the biggest

employer in the US, 70% of employment. And the same is true for Germany. Japan, 80% of employment is small firms. So if you have many small banks, Japan also has a lot of them, then your economy is going to be strong and resilient also under crisis. So we need to set them up. And that's what policymakers should focus on. So they should help the movement to set up new banks. So I'm delighted to do you there were a few in the U.S., like the Amish Bank, but we need much more than that. I want to just before we wrap up, sort of get back at some of the core principles here, because I keep going back to this idea, and I think it's really important one and probably not a fully appreciated one, this idea that banks aren't intermediaries.

They create money, they create money in part by when you post collateral in a boom, where collateral is strong and expected to rise like land prices, it can really accelerate credit creation and create new money. Why is it then is it particularly important for the central bank to get non-performing loans or weekly performing loans off of bank balance sheets when there's no like hard limit on the amount of new money that banks can create? How does that create space, I guess, in other words, for the creation of new money? Well, you could structure banks in such a way and also regulate it in such a way that it wouldn't become a problem.

But the regulations we do have and the accounting rules we do have mean that, well, banks have to stick to the rules and therefore when you have non-performing assets, you're essentially disabled. You can't do your job well. You can't lend because, I mean, think about it this way. So let's say a bank has lots of non-performing assets, which means that on the asset side of the balance sheet, the loans is given out, they're on the asset side. Let's say you had 100 before.

Now it turns out, oops, they're non-performing. They're not worth 100 anymore. They're worth 20. So you've got a gap there. And of course, your liability side is still there on the balance sheet. That means, I mean, how do you fund this gap? Where does the money come from? You want to get rid of this gap.

The only place it can come from is equity. And equity, and this is standard double entry accounting. The equity is very small in banks. It's less than 10%. Usually the smaller banks have stronger equity, actually. The international banks, when 2008, the crisis hit, they only had 2 to 3% equity. And that means they're insolvent. So banks are very quickly insolvent.

Then, of course, when you're insolvent, you don't want to add new risk. you become super risk averse and you're not lending. And that's the connection. But of course, there's ways regulators could help. They could just suspend certain rules, certain capital adequacy rules. The Basel regime could be suspended. The Basel regime has been very counterproductive because it's encouraged the acid lending since it was introduced in 1988. Basel 1, Basel 2, Basel 3.

And they don't want to learn from the lessons of history. So that definitely needs reforming. So actually, your question is a good way to. point to this problem because really we don't need to have this problem. It's an artificial problem, which is why I guess you have this question. Well, Richard, we're going to have to leave it there. I'm sure we could go on for much, much longer, but we'll have to have you back on with we'll get you together with Richard Koo and you guys can sort of hash it out. Yeah, I'd love to do that. That'd be fun. Yeah. Okay. Dr. Richard Donovan. Thank you so much for being on all thoughts.

Thank you very much. It's a pleasure. So, Joe, I found that absolutely fascinating, a bit iconoclastic, but you and I have discussed this before, and it does feel like the idea of how the banking system actually works is something that occasionally is missing from a lot of macroeconomic theory. And I do think also, this is probably the most controversial of everything that Richard was talking about, but I do think also there might be something to his argument about. low interest rates being more damaging than helpful for the global economy at this point. Yeah, I don't disagree with that. You know, I find what's interesting about his views is it seems to be a blend of, and I guess is why he's distinct, a few different schools of thought, because obviously he is critical of the sort of like aggressive fiscal approach, which is the Richard Koo approach and also the preferred approach of many people we've talked to. But also his views on banking and where money comes from is clearly a break from the sort of like classical orthodox view,

which is that banks are just, yeah, financial intermediaries. And so he's sort of this very interesting blend of sort of heterodox, but also sort of monetarist views, which I think then culminates in his idea that the answer is a structurally different banking system, banks that serve the real economy more as opposed to the financial economy. Yeah. But it's an interesting thought. And it's one that, you know, in the whole massive toolkit that we've seen central banks reach for in the multiple crises that we've had over the past couple of decades, we've never really seen them attempt to fix the problem in that way through either encouraging banks to sort of, well, encouraging new banks to spring up or figuring out

some way of supporting the banking system. And again, to that low interest rate point, if anything, we've seen lower interest rates and other policies from the central banks actually hurt the banking model time and time again, especially in Japan. Yeah, no, totally. It's also interesting, too, and he talked about this a little bit, is that, you know, we've seen the central bank of the U.S. move more into just cutting out the banks entirely in this crisis because someone of their operation. I think technically the banks still, in some cases, have an operational role in some of these things, but less of a credit creation role in more the central bank directly getting involved in credit markets, which is interesting and make some people uncomfortable. It's like, well, why do we have banks? And is this really capitalism or whatever?

But you can also see how that model could, in theory, mean more money getting into the real economy, supporting employment if it were effective, then then. you know, sort of the traditional models of balance sheet expansion of, you know, buying treasury bonds or buying mortgage back security. Yeah. Yeah. It's true. I mean, if the intermediaries won't lend, then why not bypass them completely? This is one of those sort of like big thought episodes, I think.

Yeah, totally. I'm going to be thinking about for a while. So, okay, why don't we leave it there? This has been another episode of the Alldots podcast. I'm Tracy Allaway. You can find me on Twitter. at Tracy Holloway. And I'm Joe Wisenthall.

You can follow me on Twitter at The Stallwork. And you should follow our producer on Twitter, Laura Carlson. She's at Laura M. Carlson. Follow the Bloomberg head of podcast, Francesca Levy, at Francesca Today. And check out all of our podcasts at Bloomberg under the handle at podcasts. Thanks for listening.