Skip to content

Mark Carney Needs a Plan B

December 2, 2012

Mark Carney’s appointment as governor of the Bank of England from July next year has generally met with approval. Certainly he has a good reputation in Canada. The alternative view is that his appointment signals that there will be no change in the way the Bank operates[1]. “Above all, [the Chancellor] confirmed that there will be no reining-in of the banks; that banks will not be re-structured – to separate the retail and investment arms, and ensure that banks are no longer too big to fail.” Whilst I fear there is a danger that this may be the outcome, I believe it is unfair and unhelpful to suggest that Carney’s appointment will make it inevitable. There is little sign that any home grown candidate would effect the necessary changes.

Carney is no fool. He must recognise that the UK banking system represents a greater challenge than does the Canadian. He will not want another failure on his watch. Although his actions to date have been orthodox, he may be prepared to listen to new thinking in the future. Let’s hope so and let’s make sure he is exposed to them.

Carney is chair of the Basel based Financial Stability Board whose solution to the ‘too big to fail’ problem is market based. He says:

“…Achieving a stronger global banking system is the overriding priority. This means more capital. Before the crisis, international banks operated with 50 dollars of assets for every dollar of capital. With only a 2 per cent decline in the value of their assets, banks saw their capital wiped out…

In response, international regulators have increased the minimum amount of capital banks must hold by about five times and are making the largest, most complex firms hold even more. In addition, we have added a safety belt imported from Canada with a simple, but effective, leverage standard. This protects the system from risks we think are low but in fact are not.

These measures have lowered the probability of failure, but since failures will still happen, their impact must be reduced, which is one of the reasons to focus on ending “too-big-to-fail.” We must address, once and for all, the unfairness of a system that privatises gains and socialises losses. By restoring capitalism to the capitalists, discipline in the system will increase and, with time, systemic risks will be reduced. In addition, the knowledge that major firms in markets far away can fail, without meaningful consequences at home, will restore confidence in an open global system …

To ensure that bondholders, shareholders and management – rather than taxpayers – bear the brunt of losses, all FSB member countries have committed to have in place a bail-in authority and will have specific plans by the end of this year to recover or, if necessary, resolve these firms.

The framework for systemic institutions is now being extended to domestic banks, global insurers, and key shadow banks, such as hedge funds. When implemented, greater supervisory intensity and higher loss absorbency will ensure that the financial system is never again beholden to the fate of a single firm or group of firms.” [2]

These measures are intended to ensure the health of the banking system, rather than that of the economy as a whole. But they might not even achieve that limited objective. Given the extent of the over-valuation of bank assets, increasing capital from 2% to 10% may only have delayed the 2008 crash by a few months. Given the extent of the crash would the ‘bail in’ authority (which I assume provides mutual insurance) really succeed in protecting tax payers and/or retail customers? More importantly the next crash will result in another round of recapitalisation with the same freeze in business lending and hence disruption of the economy as we are now suffering.

This orthodox thinking ignores the role of the build up of excessive debt which the current system encourages, and which was perhaps the major factor in the crash. Orthodox economists who did not think the level of debt was important did not predict the crash; a number of heterodox economists who thought otherwise did predict it. They saw that as debt levels rise borrowers find it more and more difficult to service the loans, defaults increase and the value of banks’ loan assets plummets. Empirical support is provided by Reinhart and Rogoff in their great work, “This Time is Different: Eight Centuries of Financial Folly”. In the preface they write “If there is one common theme to the vast range of crises we consider in this book, it is that excessive debt accumulation, whether it be by the government, banks, corporations or consumers, often poses greater systemic risks than than it seems during a boom…” But it is not just the overall level of debt that causes problems; excessive lending to finance purchase of existing assets such as real estate is especially harmful as it leads to asset price bubbles.[3]

This suggests that the only way such crises can be avoided is to restrain the overall rate of lending, and hence credit extension, especially for the purchase of existing assets. Individual banks will not do this for themselves because they cannot reliably assess the extent of systemic risk. This is primarily because they are not independent of each other. Instead loans are bought and sold by banks to each other and other financial institutions using ever more complex derivative instruments. Only central banks or governments can apply the necessary restraints. Two means have been suggested:

  • Direct credit controls [4] of the sort that were applied in the West during the ‘financially repressive’ era of roughly 1944 to the early 1970s – a period of respectable and stable growth[5]. Similar controls are in successful use in some Asian countries today.
  • Full reserve banking, whereby money is created by the government or central bank rather than commercial banks which create 97% of our money at present. There is as yet no experience of this scheme, but it has recently gained academic support in the form of an IMF working paper[6]. The Bank of England is aware of this work but has not revealed its views.

Neither scheme will commend itself to commercial banks; either would reduce banks’ profits. But it is surely time to have a hard look at the national interest in the round. No one seems to have done this.

In saving Canada’s banks, Carney had two advantages over his British counterparts:

  • They were better capitalised at the start of the crisis.
  • They were not as large as Britain’s in relationship to the size of the economy. According to McKinsey figures for 2009 Britain’s total debt was 466% of GDP compared with Canada’s 276%. Britain’s figure was second only to Japan which had massive sovereign debt of 197% of GDP as against a modest 59% for Britain. Where Britain really stands out is the debt in the financial sector at 194% of GDP as against 63% for Canada and 110% for Japan its nearest rival. That means that British banks are much more exposed to other banks and financial institutions than are Canadian banks.

All this suggests to me that although Carney might start out applying orthodox remedies to Britain he would be wise to ensure that the Bank considers radical alternatives. He needs a Plan B.


[1] Ann Pettifor, ‘Mark Carney’s ‘shock’ appointment means more of the same:

Osborne’s choice for governor of the Bank of England will do nothing to prevent the next collapse of the financial system’, 26/11/12,


[2] Mark Carney’s remarks to Canadian Auto Workers, 22 August 2012 ,

[3] Even Establishment figure (Lord) Adair Turner, Chairman of the FSA acknowledges this.

[4] Advocated by for example Richard Werner, Professor of Banking at the University of Southampton and author of “New Paradigm in Macroeconomics: Solving the Riddle of Japanese MacroEconomic Performance”.

[5] According to Turner in, “The Future of Finance: The LSE Report”, LSE, 2010

[6]Jaromir Benes and Michael Kumhof, ‘The Chicago Plan Revisited’, IMF Working Paper 12/202, 1st Aug 2012, downloadable at:

Summary: At the height of the Great Depression a number of leading U.S. economists advanced a proposal for monetary reform that became known as the Chicago Plan. It envisaged the separation of the monetary and credit functions of the banking system, by requiring 100% reserve backing for deposits. Irving Fisher (1936) claimed the following advantages for this plan: (1) Much better control of a major source of business cycle fluctuations, sudden increases and contractions of bank credit and of the supply of bank-created money. (2) Complete elimination of bank runs. (3) Dramatic reduction of the (net) public debt. (4) Dramatic reduction of private debt, as money creation no longer requires simultaneous debt creation. We study these claims by embedding a comprehensive and carefully calibrated model of the banking system in a DSGE model of the U.S. economy. We find support for all four of Fisher’s claims. Furthermore, output gains approach 10 percent, and steady state inflation can drop to zero without posing problems for the conduct of monetary policy.


Leave a Comment

Leave a Reply

Please log in using one of these methods to post your comment: Logo

You are commenting using your account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: