This article is from the August 2013 issue of Total Politics

“Why did no one see this coming?” asked the Queen on her post-crash visit to the London School of Economics. The LSE’s finest stared at their shoes. They thought their judicious mix of monetarism and Keynesianism had created lasting growth. They did not predict a crash, nor could they explain it.

In reality, the huge growth in the two decades up to 2007 was not produced by judicious economic management but by the reckless policies of central bankers and politicians. Advised by the mainstream economic theorists, they printed cash and kept interest rates down in order to stoke a boom – a fake, unsustainable boom.

Cheap interest rates encourage governments and shoppers to borrow in order to spend, and businesses to borrow in order to invest, and hire, and expand. Things boom. And the banks magnify the boom even more. When newly prosperous customers pay their money into their bank, the bank keeps only about three per cent of it on hand for everyday transactions, and lends out 97 per cent to others. They in turn pay that into their bank, which then lends out 97 per cent of it to others. They in turn pay in... Money spirals out of thin air.

At first, everyone is happy. But when interest rates are low, everyone wants to borrow – but nobody wants to lend. Eventually the banks simply run out of money. So they start calling in loans, and the spiralling boom becomes a spiralling crunch – as in 2007-08. High on cheap credit, we were spending too much and producing stuff we could not really afford. Now we need to write off our mistaken investments and start again.

It was a great party, and we should have expected a great hangover afterwards. Instead we took a hair of the dog, with even cheaper interest rates and even more quantitative easing. That’s politics, but it means our economic readjustment to reality is more prolonged and more damaging. Plainly, the best policy is to ignore mainstream economists and avoid creating fake booms. Then we avoid the pain of the inevitable bust, and the damaging dislocation of the whole sorry cycle. So what to do?

First, we must check the financial fecklessness of politicians. The rest of us have to live within our means, but governments have discovered that they can simply borrow and pass the bill on to the next generation. We need a balanced budget rule: the government’s income and spending has to balance over something like a five-year period.Unlike Gordon Brown’s failed ‘over the cycle’ rule, which all depends on how he defined ‘the cycle’. There should also be a limit on annual borrowing of say three per cent of GDP. Of course, the EU had just such a rule, but it was abandoned at the first sign of crisis. I suggest instead the sanction of an immediate election if the target is not met.

Second, we must curb the banks’ ability to create and destroy money in ways that magnify both boom and bust. We could do that by making them hold a large proportion of their assets, say 30-40 per cent, in cash – building slowly towards that target at one per cent a year over three or four decades. That greatly reduces their power to lend what others have borrowed and turn a small upturn into a massive fake boom and a downturn into a massive bust.

This is much more effective than the Basel III proposals, which demand that the banks hold ‘capital’ of up to 20 per cent of their assets. That is no use when a bank’s ‘capital’ includes the loans made by other banks! Basel III simply does not stop the banks creating money out of thin air, and destroying it just as fast.

Third, we need to stop central bankers keeping interest rates too low and setting off fake booms in the first place. Markets should decide interest rates, not bankers. But that is hard when central bankers have monopoly control of the currency. The solution, as the Nobel economist FA Hayek recommended, is to recognise that all monopolies are bad and to end this one too. We should scrap the legal tender laws and let people make deals in any currency they want – including ones created by private companies. The state currency would probably remain in use for everyday transactions, vending machines and the like. But large deals would be struck in currencies that were trusted to keep their value better than the Bank of England’s devalued product.

The idea is not so farfetched when you reflect that many companies are now much better credit risks than their governments. Even the threat of competition would keep central bankers – and their product – more honest. And honest money is surely the first step towards building a real recovery.

Tags: Issue 61, The idea