A new financial system
Can we create an alternative money system? In the age of Bitcoin, but also economic failures, Alexander Galushka and Artur Niyazmetov propose new economic mechanisms for growing the welfare of nations in a sustainable way.
Published: July 31, 2019, 7:17 am
Money is one of the most important inventions of civilization. From tea leaves to bitcoins, the content and forms of money over centuries have always been changing.
In the modern world, the institution of money is facing unprecedented challenges, with “money out of thin air” being created. After the crisis of 2008, the key central banks of the world — the USA and European Banks — increased the amount of unsecured money supply dramatically, in fact creating trillions of banknotes out of thin air, and the central banks of a few countries — Japan, Switzerland, Sweden — practise an abnormal policy by lending money at negative interest.
The world is in great debt
World debt went up to a shocking $243 trillion, which is 317 percent of global GDP ($78 trillion), including $72 trillion corporate debt, $65 trillion public debt, $60 trillion financial-sector debt and $46 trillion household debt.
The debt of the leading countries of the world in relation to GDP shows the following: Japan – 537 percent, Eurozone countries (Euro Area) – 388 percent, USA – 326 percent, China – 293 percent.
At the same time, more than half of world government debt is held by three countries: the United States (31,8 percent), Japan (18,8 percent) and China (7,9 percent).
After decades of deliberate displacement of gold to the periphery of the monetary system, Basel III immediately returned gold from the third – to first-tier banking capital, equating gold to money, and purchase of gold by central banks reached a record level since 1971 – the year in which the dollar-gold link was cancelled.
In 2018, central banks all over the world increased the gold reserves growth rate by 74 percent as compared to 2017. In the first quarter of 2019, global gold reserves increased by 145,5 tons, which is 68 percent more than a year earlier.
Significant cash turnover restrictions have become a commonplace of monetary policy in the overwhelming majority of countries.
In the 21st century any person or corporation can create its own personal currency by using a blockchain, while cryptocurrencies, for example Bitcoin, directly compete with conventional currencies.
In total these challenges do not only reflect a fundamental transformation of confidence in the institution of money, but also testify to the vagueness of the concept of money in the modern world.
The problem is extremely aggravated by serious doubts about the ability of central banks to conduct an adequate monetary policy and to respond correctly to emerging challenges.
For example, the reaction of the central banks in the United States and Europe to the crisis of 2008 was the active printing of new coupons (Quantitative Easing). After 10 years of the said policy, the critical mass (80 percent) of its benefits is doubtful. In the US, 85 percent of money fed by the Fedеral Reserve System were not into the economy, but into reserve accounts of banks.
In Europe, in the course of monetary incentives, the European Central Bank (ECB) bought bonds worth €2,54 trillion, of which €1,36 trillion today is a “dead weight” on accounts in commercial banks and do not give the economy anything, while €657 billion amount to losses and are placed by banks in the ECB at a negative interest.
As a result, despite huge emissions, leading central banks failed to provide the economy with the money necessary for sustainable development and solve its structural and institutional problems, whether it is the development of new industries (diversification), innovative development, the creation of new jobs or the reduction of inequality.
Here it is necessary to draw an important conclusion: it’s not just the amount of money that matters, but the quality of money that matters.
At the same time, the generally accepted monetary-policy tools of central banks designed to stimulate economic development are extremely limited: it is the reduction of the key rate or the purchase of debt. If in modern conditions we continue implementing only these tools, it may be possible to avoid a massive crisis by introducing long-term stagnation in the best-case scenario. The most striking example of such a trajectory is Japan, where stagnation has continued for 40 years. The largest economies in the world are facing the same stagnation tunnel.
Moreover, according to expert consensus estimates, this is an optimistic scenario.
In the second half of 2018, the Group of Thirty, the G30, the intellectual centre that includes the chairmen of various Central Banks, heads of the world’s largest commercial banks, leading experts and representatives of international organisations, released a report entitled “Managing the next financial crisis. An assessment of emergency arrangements in the major economies”.
The title of the report itself says that the G30 considers the crisis inevitable and offers management measures.
The G30 concluded that “financial institutions had too little capital of sufficient quality”, and recommended that Central Banks show flexibility and innovation, create new effective instruments of monetary policy, work as a team with governments and parliament to increase the level of cooperation.
But what has happened?
Generals are always fighting the last war
Central Banks are trying to solve problems using strategies which have actually caused the problems in the first place — 2008 clearly showed that the absolute majority of macroeconomists were theoretically not ready for it.
That is why the question emerges: how to create high-quality money in the face of modern realities? The main requirement (imperative) of the national strategy for creating money should be productivity — the complete use of the country’s potential and ensuring sustainable economic growth and the well-being of people.
This requirement may correspond to the money creation mechanism, which is capable of simultaneously meeting three basic conditions:
1) to link the emissions of new money with the creation of new added value;
2) to attract investors in the creation of new industries;
3) to ensure the highest possible number of new investment projects that are profitable to investors and long-term financing.
The strategy potentially able to meet these requirements may be to target project emissions using escrow accounts.
An algorithm for its realisation
Such an algorithm includes the following:
First stage: Creating an investment portfolio. In this case, the key role of the government is the attraction of private investors, system integration, coordination and interaction between projects. When managing large-scale projects the government and investment advisers can take up structuring and carrying projects to banking (it may be major infrastructure projects and complex projects aimed at development of new spheres or products). While creating an investment portfolio we should take into account its potential contribution to economic growth — the planned added value and the required financing.
Second stage: Achieving value-added indicators is included as an indispensable condition in an investment contract that is concluded between an investor, a commercial bank and an authorized state body.
Under these conditions, the investor undertakes achieving indicators of value-added, a commercial bank — providing the investor with the required financing, and an authorized state body — accepting the necessary source from the central bank to finance a specific investment project.
The investment contract is concluded in the presence of a confirmed financial model, design estimates, independent pricing and technological audit (if the last is necessary).
Third stage: After the conclusion of the investment contract, the central bank issues money for project financing of investments and deposits them in the amount specified in the investment contract in the escrow account of a commercial bank.
In the conservative version, the volume of emissions may exclude expenses on salaries and imports in order to reduce the risks of inflation and devaluation. However, the temporary gap between the money received on the consumer or foreign exchange market and the new goods produced can be insignificant in the scale of the specific national economy.
The funds in the escrow account are not charged interest and are not recovered. Only reliable commercial banks can take part in this financing mechanism.
Fourth stage: A commercial bank (investor’s bank) at the expense of deposited funds provides project crediting of the investment project on its own. Since a commercial bank has no expenses on raising funds , the interest rate on the loan to the investor includes only the risk premium and is determined by the formula: 0% + risk premium.
The allocated funds can be used exclusively to pay for the investment actually made. If it is necessary to advance to the contractor and subcontractors, special accounts are opened in the investor’s bank. This eliminates the risks of misuse of invested funds.
Also banks can receive a state guarantee, which will reduce the loan rate for investors to the minimum level.
For a particular state, this means that the implementation of a much larger number of investment projects becomes possible.
Fifth stage: When the planned results are achieved under the terms of the investment contract — the launch of a new production and the creation of added value — the investor’s principal debt on a loan to a commercial bank (in the amount of added value) is repaid with funds from the central bank deposited in the escrow account (see the picture below).
The best and widespread international practice of investment promotion support for an investor is the repayment of a loan or the payment of compensation by the State for capital investments upon the successful launch of production.
In case of non-fulfilment of the investor’s obligations under an investment contract — the non-launch of a new production — the issue is withdrawn — funds deposited by the central bank, and the relationship between the commercial bank and the investor continues under normal conditions.
The mechanism of the target project emissions
The essence of the target project emissions: A key feature of the proposed new mechanism is the identification of investment projects that are actually being implemented, creating economic growth as a channel for issuing money and using escrow accounts to eliminate ineffective emission and inflation risks.
The operation of escrow accounts legally allows one to leave the title of the issued money to the central bank, while allowing commercial banks to carry out investment loans within the limits of the amounts in the escrow accounts. These funds will finally go into cash circulation only after the creation of added value, strictly in its size by writing off the main debt of the investor to a commercial bank.
When using this model for the state, the risks of not launching investment projects are excluded. Investors and commercial banks are responsible for these risks. Commercial banks use standard collateral procedures and take an adequate risk premium — their rewards — motivated by the end result of the project — starting production and creating added value.
The following relationship system appears: the state provides investors with profitable financing. Investors pay compensation to commercial banks for the risks they take, and the government rewards investors for the result.
Target project emissions provide commercial banks with the highest level of liquidity quality for investment lending: the central bank provides funds for any period necessary to finance an investment project.
As a result, a chain (channel) is created: emission – investment – launch of new productions – release of new goods – creation of added value – inclusion of emission in money circulation.
In this chain, the situation “emission – money turnover” is excluded, bypassing the stages “investment – launching new productions – releasing new goods – creating added value”.
This means that extra money enters the economy not through the consumer or foreign exchange market, but through investments and the production of new goods.
Up to a certain point, credit growth is co-directed with the growth of the economy and supports it, but when credit activity becomes excessively high, there is an accumulation of excessive debt load. This works as a deterrent to economic growth and adversely affects the financial stability of the real sector.
This issue of money stimulates investment, project financing and economic growth, and also enters the economy through investment, the production of new goods.
Also, using a standard credit system, the growth of borrowing does not always correspond to the growth of the economy and supports it. After the release of credit activity at excessively high levels, an excess debt load accumulates. This works as a deterrent to further growth of the economy and negatively affects the financial stability of the real sector. Therefore, the write-off by profitable investors of the principal amount of the debt in proportion to their contribution to the economic growth of the country is an important element of the target project emissions using escrow accounts. This element of the system allows one to move to a higher rate of economic development, relying on efficient companies — creators of added value.
In conclusion, the proposed mechanism allows solving the problem of forming money and accomplishing following functions in any country:
- stimulate economic growth;
- not create inflation;
- not create public debt;
- reduce corporate debt;
- create cheap and long-term credit
Quality money drastically increases the possibilities for the mass implementation of new investment projects and the creation of new jobs, as well as the sustainable growth of the welfare of nations.
Alexander Galushka is the former Minister of the Development of the Russian Far East.
Artur Niyazmetov is the Deputy of the Representative of the President of the Russian Federation in the Central Federal District.
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