An Incoherent Financial and Banking System by Dr Robert Howell

An Incoherent Financial and Banking System

Dr Robert Howell


How serious is the threat that current banking and financial systems pose to a stable, safe and secure future?  Are there aspects that can be easily fixed, or is drastic reform needed?  Is the state of the financial and banking sector such that it is a major global driver, and something that needs careful factoring into strategic considerations?  This article describes the likely risk of another 2008 financial crash, considers the effectiveness and efficiency of the current system, and evaluates whether the current system enables a solution to the threat of ecological collapse.




The current international banking and financial system is currently operating with a culture of selfishness and greed, ignoring or minimalising social and ecological impacts, and with an emphasis on short-term behaviour and rewards.  There are inadequate penalties to punish wrongdoing so that there are limited financial and criminal measures for reform.  These characteristics, however, if altered will not be sufficient to avoid future financial crashes, most probably worse than 2008.  The 2008 crash was not predicted by mainstream economists because the behaviour of the financial sector was not included in their models.  This exclusion is due to neoclassical economists’ inadequate understanding of how money is created, and their treating the financial sector as having a neutral impact on economic stability. (Ingham calls the orthodox concept of money for practical monetary policy, “incoherent”).  If the neoclassical economists included the impact of the financial sector in their models, they would have to recognise that the market alone is not able to deliver efficient goods and services.  If they continue to believe that the market is the best mechanism for the allocation of resources, then their ability to predict instability, economic collapses and depressions is severely compromised.   The obsessive reliance on the market in money creation is ideological: the theorists refuse to acknowledge the roles of the government monetary authority, the banking system, and the agencies of production.  The cost of money creation is excessive (roughly one third of everything we buy goes to pay interest) and the system is unstable. The profits by the sector are privatised, the losses are borne by everyone, and government budgets suffer.


The privatisation of the bulk of money creation needs to be changed:  money creation at the minimum should be brought under control, but should be primarily the responsibility of government.  We should move away from fractional banking, and government creation of money should enable public funding at zero or minimal interest.  The current system is predicated on a growth economy and this cannot continue without major ecological collapse.  Major reform is unlikely without considerable public understanding of how inadequate the system is, and this will be difficult to achieve. 


Risks of the Financial and Banking Sector


The risks of the financial and banking sector include a culture of selfishness and greed, and ignore social and environmental threats.  The emphasis on short-termism, and inadequate penalties to punish wrongdoing, incentivise rather than discourage, the continuance of “business-as-usual”.  In 2011 the head of Aviva Investors in London, Paul Abberley, attacked the City for failing to rise to the challenge of climate change and other key sustainability issues. “He said the financial system needed reforming because the City was ‘amoral’ and that investors were not willing to walk away from profitable investment opportunities, even when it was clear they caused damage to the environment or the social fabric of society. Abberley said financial institutions are riddled with climate change sceptics and investment professionals who are dismissive of important social issues such as labour rights” (Confino, 2011).


In March 2012, Greg Smith, Goldman Sachs executive director and head of the firm’s United States equity derivatives business in Europe, the Middle East and Africa announced that he was leaving the firm. “I believe I have worked here long enough to understand the trajectory of its culture, its people and its identity. And I can honestly say that the environment now is as toxic and destructive as I have ever seen it. To put the problem in the simplest terms, the interests of the client continue to be side lined in the way the firm operates and thinks about making money. …Today, many of these leaders display a Goldman Sachs culture quotient of exactly zero percent. I attend derivatives sales meetings where not one single minute is spent asking questions about how we can help clients. It’s purely about how we can make the most possible money off of them” (Smith, 2012)


In the UK the 2012 Kay Review concluded that UK equity markets were not as effective as they should be in achieving their core purpose of enhancing the long term performance of companies and enabling savers to implement their financial plans.  The problem is short-termism through misalignment of incentives within the investment chain. The Review identified the need to encourage a change of philosophy and culture that restores relationships of trust and confidence (Kay Review).


Penalties paid for illegal behaviour are substantial but despite record amounts in fines there are inadequate penalties and enforcement.  Between 2009 and 2013 payments of £166bn in fines have been paid for misdeeds dealing with foreign exchange price manipulation, consumer insurance, money laundering, and selling faulty mortgages (Kollewe, J, Teanor, J, and Hickey, S).  Yet very few people are penalised, and bank share prices and earnings still perform generally well. 


There is has been no significant financial system reform and thereby no reassurance, that another 2008 financial collapse will be avoided.  Ben Bernanke, former Chairman, Federal Reserve Board and Mark Carney, Chairman, Financial Stability Board and Governor of the Bank of England have stated that there have been a number of attempts at reform but the ‘too-big-to-fail’ issue has not been dealt with, and the expectation that these institutions can privatise gains and socialise losses remains. This encourages excessive private sector risk-taking and can be ruinous for public finances. The IMF has estimated that the world’s largest banks benefitted from implicit government subsidies of $630 billion in the year 2011-12 (IMF Report).


A More Basic Reform Needed: the Creation of Money Issue


Changing the ethical culture, introducing a longer term perspective (including changing short-term reward systems), removing subsidies, increasing and enforcing adequate penalties, are necessary but not sufficient.  Currently around 5% of managed and sovereign wealth funds can be said to be socially and environmentally responsible (Howell, 2012). But in addition to the inability of the current system to efficiently and effectively shift funds towards activities that will enable humankind to live within the carrying capacity of earth’s supporting ecosystems, the current financial system is inconsistent and incoherent. One significant critic is Martin Wolf (Wolf).


Wolf is the associate editor and chief economics commentator at the Financial Times.  He is widely considered to be one of the world’s most influential writers on economics, and regarded as “staggeringly well connected” within elite financial elite circles.  As a young man he supported Keynesian economics, but gradually became disillusioned and moved to become an influential advocate of globalisation and the free market.   This changed after reflecting on the 2008 meltdown.  He states that he is guilty of working with a mental model of the economy that did not allow for the possibility of another great depression.  He concludes that economic, financial, intellectual and political elites have misunderstood the consequences of headlong financial liberalisation.   Policy-making elites failed to appreciate risks of systemic breakdown; intellectual elites failed to anticipate crisis and agree on what to do; and political elites discredited themselves by their willingness to finance the rescue.


Wolf describes the role of private banking in money creation (97% in UK) and fractional banking as very destabilising.  At the very minimum there should be a tightening of regulations and increases in the reserve ratio.  At the maximum governments should be given responsibility for money creation.  (Wolf reviews at some length Fisher’s work in the 1930’s, the IMF 2012 study, and Kotlikoff of Boston University and Dyson in Modernising Money).  Wolf states that banks could loan money invested by customers (ie, act as intermediaries).  The central bank should create new money for non-inflationary growth (via a Committee independent of government).  New money should go to finance government spending, direct payments to citizens, redeem debt, and make loans to banks.  Wolf does not agree that the economy would die for lack of credit because about 10% of UK banks have financed business investment in sectors other than property.


Wolf states that benefits of the Chicago Plan (Fisher), where Government has the responsibility of a monopoly monetary policy, include the elimination of the biggest source of instability.  With 100% reserves the bank runs would cease.  If Government issued money for public goods and services at 0%, debt interest would fall.  Overall debt would fall.  Wolf cannot see the current system continuing because it is too unstable.  He foresees, broadly two outcomes: less globalised finance or more globalised regulation.


Current Monetary Policy


A very common public assumption is that the government creates money.   Banks are like piggy banks that store money for when we want to pay for goods and services.  This store can be lent out to support economic activity and get interest.  This is wrong – normally less than 5% of money is usually created this way (coins and paper notes).


Paper money in Europe came about when people kept gold or silver with goldsmiths,

who gave them a note or receipt of their deposit.   Rather than going to the goldsmiths to collect the gold or silver each time a payment was made, the note became the means of exchange between people providing and receiving goods and services. Not all the gold and silver that was deposited in a bank will be called on, so banks used that money to make loans.  This marked a transition from just guarding bullion (and earning a fee for safe storage) to an interest bearing operation.  Because the reserve of gold and silver was less than 100% of the notes issued, this is called a fractional banking system. Hence, the majority of money is created by banks when a loan is generated.  Banks create money by recording that in their accounts.  When the loan is repaid, the money supply decreases accordingly.  The Bank of England carried on the procedures of the goldsmith bankers (Positive Money).


The Bank of England was created in 1694.  It was a way of reducing the sovereignty of the King by an elite group of Whig financiers, who only supported William on the following conditions:  a charter to establish the Bank of England that would create and issue banknotes as the national paper currency, the bank would create money to loan to the government, and a payment of interest at 8% would be paid for from taxes.  The Bank was the only joint stock company: other banks were limited to having no more than six partners, and had to observe usury laws.  The English financial system at that time was designed to maximise government access to war finance, to increase the power of the Government and the Bank of England’s elite owners.  The industrial revolution was financed by traders and manufacturers, not through bank lending.  Over time the Bank of England changed from a retail bank to a bank of last resort (a bank to assist other banks when they are in danger of collapse).   But a model of the primary money creation through privately owned banks, at times under control through government regulation, was established (Bank of England).


Functions of Money


It is generally accepted by historians and commentators that there are three functions of money [1]:


1)    Medium of Exchange and payment.  Money is something that facilitates payment for goods and services.

2)    Store of Value.  Money enables the value of surpluses or excess goods and services being able to be saved for future use.

3)    Money of Account or Measure of Value.  Money is an abstract notion like a metre which is a unit of measurement that enables a value to be quantified.


Mainstream economics sees the function of money primarily as 1), ie, real economic analysis operates on the assumption that the economic process can be understood in the barter exchange of real goods and services, and this is carried out in the market, and money is primarily created by the market.  Orthodox economics sees money as neutral, as not contributing to economic activity, except in assisting in the exchange of payments.   This is different from monetary analysis that includes the cost of acquiring financial resources (the rate of interest) as an integral part of the economic process, and that the function in 3) is critical, ie, a Money of Account or Measure of Value is needed.  (It is like a metre, which is a unit of measurement that enables a value to be quantified.)


An Incoherent Model


Critics of the orthodox theory include Randell Wray (Wray).  He states that the historical account of the creation of money by orthodox economists as primarily being created by the market is inaccurate.   It ignores the role of Governments in establishing a measure of value and its application, historically and currently.  (Wray calls the expectation that the state has no role to play, and that money can be created by market means, “Peter Pan Never-Never Land”).


Ingham states that the relationship between the orthodox conception of money in economic analysis and practical monetary policy is now tenuous to the point of incoherence (Ingham).    All monetary systems, if they are to produce market prices and produce and store abstract value, are necessarily precarious and unstable.  They require constant intervention to both regulate and legitimize monetary practice and policy, to control economic agents’ disruptive and destabilising pursuit of self-interest.   At the centre of this process is a complex triangular power struggle between the monetary authority, the banking system, and the agencies of production.


Stiglitz states that flawed monetary and regulatory policies were guided by inadequate modeling of credit markets (banks and shadow banks).  The perspective that low and stable inflation leads to a stable real economy was never supported by either economic theory or evidence.  Models did not include agency problems or the risk taking of banks (Blanchard, O, et al).


The two diagrams below picture the growth of the finance industry over recent decades, showing the significant increase in the % of the industry of the total corporate profits in the US (Economist), and the share of the financial sector in GDP for selected countries (Brown, 2013). 





If the financial sector activity is not included in any analysis of the economy then it is not a surprise that mainstream economics is unable to adequately describe modern economies and why neoclassical economists are unable to foresee banking and financial collapses.  If, however, the sector is included in any analysis, it needs to be recognised that the market alone is inadequate to control money supply.   This comes back to writers like Ingham who state that at the centre of this process is a complex triangular power struggle between the monetary authority, the banking system, and the agencies of production.  These grounds alone provide more than enough substance for rejecting the current neo-classical economic model as incoherent.


Some Reformers


James Robertson has written extensively over many years, and has been involved with the formation of New Economics Foundation, and Positive Money (the international movement for monetary reform).  In his most recent book, Future Money he argues for the transfer of national money supply away from commercial banks (as a source of private profit) to a central bank as a source of public revenue to be spent into circulation by the Government for public purposes.  Banks should operate with a full reserve, with money issued debt and interest free.  He argues for the creation of  an international money supply based on a new international currency to operate parallel with national currencies.  There should be independent community currencies.  Tax reform is also required (Robertson).


Ellen Brown in The Web of Debt and The Public Bank Solution argues for the issuance of interest-free credit from a government-controlled and fully owned central bank (Brown 2010, Brown, 2013). These interest free but repayable loans would be used for public infrastructure and productive private investment. Historical examples of government created money:  North Dakota, New Zealand, Australia, Canada, USA, and BRICs (Brazil, Russia, India, China and South Africa).  She states that roughly one third of everything we buy goes to interest (using research from economist Helmut Creutz (Germany) and Michael Hudson (USA)).


In her book Healthy Money Healthy Planet Deidre Kent provides a brief history of money creation in New Zealand (Kent).  The first Labour Government nationalised the Reserve Bank and used bank credit at 1.25% for state housing and public works. The Social Credit League was an advocate of money reform (and that party changed to call itself Democrats). In the 1980’s Roger Douglas deregulated and eliminated many government functions. The Reserve Bank has ‘prudential supervision’ and capital adequacy requirements, but 98% of money is created by private banks.

Kent argues for the introduction of an interest free debt money system, a land valuation tax to avoid land speculation, and complementary currencies.


Bernard Lietaer has had wide experience in money systems and has written extensively.  His most recent work (with others) is Money and Sustainability, published on behalf of the Club of Rome.  He does not support the Chicago Plan because while it deals with the 145 banking and 76 sovereign debt crises (since 1970) it does not deal with the 208 monetary crashes (when a currency drops significantly).  He states that reformers need to be politically realistic – in 2010 for every elected official in Washington there were 3 high level lobbyists working for the banking system.  There is a need to have diversity in a system, with complementary incentive systems (Lietaer, B et al).


Ecological Economics


Ecological economics is a branch of economics premised on the thermodynamic laws of science, and the need to live within the capacity of the Earth to support life (Howell, 2015 a & b).  An example of an ecological economist is Herman Daly who has put forward three rules for doing this (Daly):


  • Output rule - wastes should be kept within the assimilative capacity of the local environment;
  • Input Rule - harvest rates of renewable inputs shall not exceed the regenerative capacity of the natural system that generates them; 

§  Non-renewable Rule - depletion rate shall equal the rate at which renewable substitutes are developed by human invention and investment


Meeting these rules entails recognition that uncontrolled debt is not consistent with living within a sustainable ecological footprint.  What kind of money system is able to operate within these principles?   Imagine a world where there is abundant work and proper care of the needy (young, old, ill and disabled people, and people unable to earn a living wage).  Work would include not just the basic activities of providing such things as food, shelter, and transport, but also the planning and implementation of more efficient and effective operations (research and development) and support services (such as health, education, legal regulation and enforcement, disaster relief and renewal).   This world is not static, but is dynamic because it is renewing and improving itself.  It is developing while keeping within the Earth’s capacity to support life.  


Money facilitates the many and varied components of the planning and production of these goods and services and can do so for a fee for services (Money Function 1: Medium of Exchange).   The creation of money is a public good and best left to government because the cost is cheaper.  Banks and financial institutions will hold 100% of reserves and act as intermediaries between savers and producers of goods and services.   A surplus in operations that is desirable for future safety nets, for holidays or for future material benefits, can be built into the pricing, savings and economy without the need for interest growing funds (Money Function 2: Store of Value).     If the money supply is insufficient to facilitate these activities, the Government can print more money debt free but not so much that the value drops and leads to inflation.


Can an interest bearing banking system be consistent with the principles?   If banks are required to provide interest to a depositor, they have to obtain the money by providing credit to a borrower.  For the borrower to be able to pay the interest to the bank, he/she needs to carry out some productive and profitable activity that is in addition to what they normally do to remain steady, ie, they have to grow.  To do this they will need to employ extra staff, and purchase the tools, facilities and raw materials they will use, including energy.    Is this ‘extra’ going beyond the Earth’s limits? In a world that has a very ‘light’ human footprint in terms of population numbers and settlement through the world, it is not necessarily inconsistent with a sustainable and resilient model.  It may use some of the Earth’s dirty resources, such as coal, as long as the waste is kept within the assimilative local environment (Daly Rule 1), and that renewable substitutes are developed by human invention and investment equal to the rate of using the non-renewable resource rate (Daly Rule 3).


Interest bearing debt will encourage growth and, all other factors being constant, will lead to a depletion of stored energy and greater use of continual energy through sunlight.  This can be possible in the short term without the application of the Daly Rules, but at some stage limits will be reached.  Prior to the 1960’s, the human footprint was less than 100% of the world’s resources.  But today it is estimated to be 150%.  Unlimited growth in these circumstances is not consistent with a sustainable and resilient world.   Daly has a place for interest, as does Wolf, but within a 100% reserve, and hence it can be seen as a fee for an intermediary service.


Reform Options for New Zealand


Some of the options, briefly, include providing a way for the wider public to know about the inadequacies of the neoclassical economic model, with particular reference to money creation, and the privatisation of banking:

ü  Start an investigation into the cost of money creation, and in particular the cost of government debt for public goods and services.

ü  Require an economic framework for public policy options that takes into account banking and financial activity. 

ü  Make Government responsible for money creation, rather than the banks. 

ü  Stop fractional banking (move to 100% reserves). 

ü  Develop a modern version of State Advances Corporation to provide money at no/minimal interest rates for key activities, such as housing and transport. 


It is unlikely that these reforms will be made easily, but as further financial and banking collapses occur, opportunities will arise that seem unlikely at the present.




The current international neo-classical model is based on outdated science, and unacceptable ethics.  It is also incoherent, in that it excludes the financial sector from its models, on the grounds that money supply is neutral in its effect.  As a result it is unable to accurately describe and predict economic activity.  If it did include the financial sector in its model, it would have to acknowledge that the market is unable to control the creation of money without government regulation and intervention.  The obsessive reliance on the market in money creation is ideological: the neoclassical economists refuse to acknowledge the roles of the government monetary authority, the banking system, and the agencies of production.   The debt that is created through the privatised money supply is primarily used for property purchase and development. When property prices rise they fuel another financial crash, and it is likely that the next one will be worse than 2008. 


The privatisation of the bulk of money creation needs to be changed:  money creation should be primarily the responsibility of government.   We should move away from fractional banking, and government creation of money should enable public funding at zero or minimal interest.  The current system is predicated on a growth economy and this cannot continue without major ecological collapse.  Major reform is unlikely without considerable public understanding of how inadequate the current system is.  Reform will then be difficult to achieve, perhaps without a major financial collapse and depression.




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[1] Some include a fourth, namely, a standard of deferred payment, but this is really a subset of Money of Account.