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By Steven Baker MP, on 30 September 09
FT columnist Martin Wolf considers narrow banking and 100% reserves.
The FT has a new series on the future of investment. But what, I wonder, is the future of finance itself? Who is confident that the financial system now emerging from the crisis is safer, or better at servicing the public’s needs, than the one that went into it? The answer has to be: few people. The question is how to remedy this dire situation.
What entered the crisis was, we now know, an ill-managed, irresponsible, highly concentrated and undercapitalised financial sector, riddled with conflicts of interest and benefiting from implicit state guarantees. What is emerging is a slightly better capitalised financial sector, but one even more concentrated and benefiting from explicit state guarantees. This is not progress: it has to mean still more and bigger crises in the years ahead.
via FT.com / Columnists / Martin Wolf – Why narrow banking alone is not the finance solution.
By Sean Corrigan, on 30 September 09
Sean Corrigan’s Material Evidence: the declaration of the end of the recession vs cries of crisis, the role of business spending, new money, the divorce of stock prices from reality and commodities.
 Material Evidence 2009 09 16 Read the report here.
By Toby Baxendale, on 29 September 09
Toby Baxendale explains that, contrary to some mainstream analysis, monetary policy caused the boom, the bust and the savings glut.  Martin Wolf - Global Imbalances Distinguished commentator and economist Martin Wolf of the FT holds that the savings glut was the source of the excess liquidity that caused the current crisis in which we all find ourselves.
Wolf’s views are expressed crisply in this PowerPoint presentation. In summary, he tells how the Mercantilist approach of the emerging nations after the Asian crisis of the 90s led to a policy of setting exchange rates to encourage exports and limit imports, supported by the stockpiling of foreign currency (a majority in USD) to fund the whole program. The imbalances can be seen as either a “savings glut” or a “money glut.”
I believe from reading Wolf’s articles in the FT that the suggestion is that the savings glut nations not only have policies of fixing exchange rates to encourage exports over imports but also that the people in those nations have a much greater propensity to save than their Western counterparts. It is argued that this demand for money, certainly in USD, causes the Federal Reserve to embark on an expansionist policy.
From page 15 of Wolf’s presentation:
- My own view is that the savings glut caused the money glut, by driving the Federal Reserve to pursue expansionary monetary policies, which then led to the reserve accumulations in the creditor countries
- But it is also possible to view the Federal Reserve as the causal agent: the money glut causes the savings glut
- Either way, the reserve accumulations and fixed exchange rates played a big role in the story
I interpret Wolf’s remarks to mean that when the massive accumulated USD reserves in the emerging nations were partially spent, a surge in liquidity arrived back at the shores of the USA, causing a housing bubble, subprime lending, less than secure CDO’s etc and the bust we now observe.
Wolf is in good company. It would seem that Federal Reserve Chairman Ben Bernanke has endorsed this view in at least the following two recent speeches.
Chairman Ben S. Bernanke, Council on Foreign Relations, Washington, D.C., March 10, 2009 :
Financial Reform to Address Systemic Risk
The world is suffering through the worst financial crisis since the 1930s, a crisis that has precipitated a sharp downturn in the global economy. Its fundamental causes remain in dispute. In my view, however, it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. In the simplest terms, these imbalances reflected a chronic lack of saving relative to investment in the United States and some other industrial countries, combined with an extraordinary increase in saving relative to investment in many emerging market nations. The increase in excess saving in the emerging world resulted in turn from factors such as rapid economic growth in high-saving East Asian economies accompanied, outside of China, by reduced investment rates; large buildups in foreign exchange reserves in a number of emerging markets; and substantial increases in revenues received by exporters of oil and other commodities. Like water seeking its level, saving flowed from where it was abundant to where it was deficient, with the result that the United States and some other advanced countries experienced large capital inflows for more than a decade, even as real long-term interest rates remained low.
Chairman Ben S. Bernanke, The Morehouse College, Atlanta, Georgia, April 14, 2009:
Four Questions about the Financial Crisis
Importantly, in our global financial system, saving need not be generated in the country in which it is put to work but can come from foreign as well as domestic sources. In the past 10 to 15 years, the United States and some other industrial countries have been the recipients of a great deal of foreign saving. Much of this foreign saving came from fast-growing emerging market countries in Asia and other places where consumption has lagged behind rising incomes, as well as from oil-exporting nations that could not profitably invest all their revenue at home and thus looked abroad for investment opportunities. Indeed, the net inflow of foreign saving to the United States, which was about 1-1/2 percent of our national output in 1995, reached about 6 percent of national output in 2006, an amount equal to about $825 billion in today’s Dollars.
Saving inflows from abroad can be beneficial if the country that receives those inflows invests them well. Unfortunately, that was not always the case in the United States and some other countries. Financial institutions reacted to the surplus of available funds by competing aggressively for borrowers, and, in the years leading up to the crisis, credit to both households and businesses became relatively cheap and easy to obtain.
The Error
I submit that these two great economists have made a grave error. The government of the USA has legal tender laws that allow only it, ultimately, to create USD via its sanctioned agent, the US Federal Reserve. As it is in charge of the stock of Dollars and the fractional-reserve banking system, it is (counterfeiting aside) the sole source of all issuances.
As I have pointed out in other articles on this site, we use money to exchage our goods and services that we make/provide for sale for other goods and services. Money is the final good for which all other goods and services exchange. Dollars in the USA are the final good you use to exchange your goods for goods offered by other people. A price of a good exchanged for another good is the amount of money paid for that good.
If the pool of money is getting larger, there will be more Dollars to exchange for goods and services. If the quantity of goods and services offered for sale and the number of Dollars in circulation are growing at the same rate, it is possible to argue, if you are prepared to set aside the problems of relative prices, that the “general price level” will be unaffected. However, any economist would argue that if the supply of money increases faster than the supply of goods and services, prices will rise: like any other good, money is devalued by creating more of it.
Therefore, the cause of the crisis can be found only at the door of the monetary authority that created the money in the first place – i.e. the Federal Reserve and other deficit-nation central banks – and not with the saving glut nations. All they have done is seek to exchange some of their goods and services for some of the goods and services of the USA, expressing a time preference along the way. This transfer of ownership does not in itself “bid up prices” to create an “asset price boom”: it is the creation of new money which devalues it.
If new Dollars are locked away for a time and only return to their original economy in an abrupt fashion, they could well seem to be the cause of a sudden asset price bubble, but the prior cause can only be the creation and supply of the wherewithal to do this in the first place.
A Note on Mercantilism
Wolf mentions in his PowerPoint presentation quite rightly that the modern trade regime we have is “in short, a mercantilist hybrid”. Many of the Classical Economist and Political Philosophers such as Hume, Locke, Smith and in later times David Ricardo, point out in various writings that the bullion (gold and silver) that was invariably money was not wealth as such but that the goods they exchanged against were. So, create more money with no associated increase in productivity and the prices of things will rise. Consequently, the Mercantalist goal of having exports higher than imports and thus more bullion at home would just mean that prices would rise at home and cause a flow of that specie to move away from home. Therefore, if in the analogy you substitute US Dollars for bullion, our saving glut nations will get nowhere fast pursuing this policy.
Gold represented claims on already produced wealth. Thus it makes perfect sense that the more wealthy (industrially-devloped, capitalistic etc) countries had more gold historically. As we do not have a link to gold anymore, the USD acts in its capacity as the World Reserve Currency, like gold of old. Using this analogy, the gold producer / gold miner writ large is the Fed and other Central Banks. Dollars will flow away from the mine in exchange for goods and services and this causes a transfer of ownership of goods and services from people in the USA to people in the saving glut nations but can have nothing to do with asset price bubbles as the money was printed by the Fed and no one else. To argue that the savings glut itself has caused the asset price boom is seemingly to endorse the Mercantalist doctrine that was so clearly discredited many moons ago.
Some other reflections on this concept of a “Savings Glut” disturb me and lead me to question whether it is really a meaningful concept at all.
These saving glut nations still seem to have massive gluts but if spending the glut caused the bubble, you would expect the glut to have fallen as well; seemingly, it has not.
If nations save to create a glut, they must indeed refrain from consumption on domestic goods to boost the supply of export goods. This means cheap goods arrive on the shores of the deficit nations. Can this cause a boom across the economy? I think not.
The deficit nations are largely well-developed. As a 40-year-old entrepreneur with a mature business and a happy family, all well rooted in Hertforsdhire, I often say to my wife, “If I was 18 again, I would be straight out to China to exploit some of those massive developmental opportunities. The whole economy seems to be like Manchester was in the Victorian times.” So why do savings there, which should attract a greater rate of return there, not stay there?
In summary, the Fed has more than doubled its money supply since the mid 90’s as have other leading deficit nations. The savings glut and the boom and bust is only attributable to the lax money creation programs of irresponsbile central bankers around the world. They have a poor understanding of economic history and they make an intellectual mistake in misunderstanding what those Classical thinkers knew: money is not wealth.
By Sean Corrigan, on 28 September 09
Sean Corrigan’s Material Evidence: US unemployment, the UK’s staggering recovery to 1974 levels of manufacturing output, energy investment and the performance of gold and silver.
 Material Evidence Read the report here.
By Toby Baxendale, on 22 September 09
 No to Keynes' Circular Flow The essential idea of a Liquidity Trap as expounded by J M Keynes in this “General Theory” is that there is a point in time, when the interest rate has fallen so low, that investment bonds, be they public or private, are returning so little, that the investor then decides to keep all his money as a cash balance. This then snuffs out any further economic activity that may have been brought about by the former investments. There is a general freezing up in the economy and a Recession becomes a Depression.
It is fashionable in all sectors of the media, politicians and economists to say that they think this event is happening right in front of our very own eyes
In the famous circular flow of income that the Keynesians adhere to, one man’s spending is a another man’s income.
Is it possible that a person would not spend anything in a Liquidity Trap? I think not. All people have to buy their day to day food stuffs, pay for heating, pay for shelter and other such basics.
Having an excess cash balance simply means that you are choosing to keep your money as cash for later use. You produced goods and services in exchange for money (cash) which you have kept as money, ready to exchange for other goods and services at a moment of your choosing.
Please reflect on this very salient point: a rise in your personal demand for money held as cash does not effect the production of goods and services because money is only employed to exchange things. If it did effect production, an unlimited rise in the demand for money (IE a Liquidity Trap) would mean that no one was exchanging goods and services for other goods and services. Society would cease to be!
We actually have a situation where we have the balance sheets of Central Banks showing cash reserves increasing to startling percentages since the start of the recession in August 2007 with a massive uplift since the Lehman Brothers crash on September 15th 2008 at 07:58. In the USA there are $760 billion of extra cash reserves that now sit in the USA banking system, some 123% more than the same period a year ago. By July of this year, the BoE had increased its balance sheet by £153 billion or 158% over the same time last year.
It would seem that the Keynesians have a point: there is all this cash in the system, untold amounts of liquidity that we have never seen before, and it is not being spent. Is this not the classic Keynesian circumstance in which a Liquidity Trap emerges? This is when silly Monetarist ideas of sprinkling money “from a helicopter” come into vogue: I recently saw a very nutty idea being put forward in the FT by Wolfgan Manchau saying that we should have some electronic devise inserted into money that makes it expire as legal tender after a period of time so people are forced to spend:
Central banks could deploy policies to discourage cash hoarding. One extreme possibility would be to stamp cash, putting an expiry date on banknotes that would force their holders to pay a fee equivalent to the negative interest rates.
Seemingly, people with these views are so divorced from reality they have forgotten, or perhaps never knew, how real wealth is created. I have explained this within Can the Manipulation of Interest Rates Create Wealth?
I find it useful to point out here that if we all spend our salaries on consumption goods only each month, we would not be able to buy any capital goods such as a house or a car, unless we are paid each month a net equivalent to buy a house or a car. Clearly, only a handful of football players and bankers are in a position to do this. No savings would be made if this policy was ever recommended which, in the medium term, would lead to large scale impoverishment of society. From savings, you have the wellspring of investment to produce the new goods and services of the future.
The massive build up of liquidity has come about as the economy has gone into recession. Governments around the world have reacted by putting newly minted money into the economy.
Why did the boom turn into bust? I would always argue that it was the prior large scale expansion of liquidity that led to excessive credit creation under Gordon Brown’s Chancellorship and indeed his Prime Ministry. From 1997 to today, we have seen an increase in money supply (as measured by M4) from £700 billion to £2 trillion.
The bust happened because the structure of production had become so distorted that the production sector was producing goods that the consumer did not want and/or could not afford to buy. How could this collectively happen? For some help with the answers to this, I turn to Hayek which I summarise. I funded the publication of Prices and Production and Other Works, which prints Hayek’s works written during his time at the LSE.
Capital Theory, the Structure of Production and Boom and Bust
From 1931-50, F A Hayek, the 1974 Nobel Price winner in Economics worked out the following in summary and was awarded the Prize for this work;
- A depression is always a shortening of the capital structure of production. Entrepreneurs have invested in things that people do not want in significant numbers such that when people collectively wake up to this fact, the bubble bursts and a realignment of production to the needs of the consumer takes place.
- This is caused by a concept that at the time was called “forced savings” as opposed to voluntary savings. To understand this further, we must look voluntary savings.
- When there are voluntary savings — in my business, using part of my cuts of meat to keep me sustained so I can invest in making a steel to sharpen my knives to “up” my productive output for any given time period — these can support the elongated structure of production that matches, via the interest rate, the prices and thus the needs of the consumers. This increase in voluntary savings causes a larger demand for producers’ goods in relation to consumers’ goods, so goods in the higher stages, those most removed from the production of consumer goods will see an increase in prices relative to the consumer good prices. The consequent narrowing of the spread or margin between the two furthest ends of the production structure and the consumer good end, or in other words, the lowering of the rate of interest, make possible a prolonged and indeed a permanent new process of production. This is steady capitalistic, very safe and very boring non boom growth.
- A lengthening of the structure of production caused by the opposite of voluntary savings — which Hayek called, in keeping with the time, “forced savings” — happens, simply put, when bank credit becomes more available via the demand deposit money creation multiplier described here or through the process known in modern parlance as “Quantitive Easing”. Both credit expansion and QE give the same signals to entrepreneurs that there is now a very low interest rate. This suggests there are plentiful real savings — money is cheap — therefore we can bring those production plans forward that we held at the margin of our thoughts and start investing. However, the consequent elongation of the structure of production is not sustainable because a reversal in the price spread between the producers’ goods and the consumers’ goods takes place as soon as the increase in the supply of cheap money via the private banking or central banking system slows or stops altogether. This is because the spending habits of the consumer have not actually changed.
- This has been compounded in our case by something else Hayek was hot on, if government expenditure rises , more is extracted from the citizens via either taxation or government-induced inflation. This too will cause a shortening of the process of production and a lengthening of the depression.
- If money were kept inelastic — i.e. a fixed supply in relation to the productive needs of the economy, then this could not happen.
In summary, any change in the money supply, through giving new loans to entrepreneurs or to consumers, first lengthens the production structure, then shortens it as real consumer needs have not changed.
Our problem arises from the prior elongation of the structure of production unbacked by real savings, brought about in particular via the low interest rate policy of Gordon Brown’s Government post 2000. This was enhanced by the massive and unprecedented increase in the money supply under his Chancellorship. That caused more investment in the heavy stages of production: the building of houses, or car factories, or to produce consumer goods that indeed, when push came to shove, not enough people could afford. The correction is now taking place. This is when entrepreneurs rebalance or redirect the factors of production that they have under their command to focus on the actual needs and demands of their customers.
There is no Liquidity Trap (I doubt that this is even a meaningful concept), just a badly misallocated structure of production which, despite the government, is in fact slowly but surely fixing itself.
Further reading
By Sean Corrigan, on 21 September 09
Sept. 17 (Bloomberg) — Private investors in China, the world’s largest metals user, have stockpiled “substantial” quantities of copper as the government ramps up stimulus spending to spur the economy, according to Sucden Financial Ltd.
Pig farmers and other speculators may have amassed more than 50,000 metric tons, Jeremy Goldwyn, who oversees business development in Asia for London-based Sucden, wrote in an e- mailed report after a visit to China. That’s about half the level of inventories tallied by the Shanghai Futures Exchange, which stood last week at a two-year high of 97,396 tons.
Many of us will have chuckled over the story that Chinese farmers are piling up base metals next to the barnyard muck-heap and as we do we will all be guilty of condescending to those sucked into a speculative whirl created when hot money met the Asian gambling instinct, forgetful of the fact that – though we have a penchant for intangibles rather than things you can stub your toe on – we are just as much at fault ourselves and for the very same reasons, to boot.
For, if we look behind the surface, we must see that our Oriental Farmer Giles’ actions are not exactly an irrational response to the vast monetary over-supply prevalent in a China where prospectively profitable outlets for all that ‘stimulus’ money are in decidedly short supply. The result is a ‘Flucht in die Sachwerte’ as Mises put it – a “flight to real values”.
We can already see that the brief stock market pullback which occurred when they feathered the throttle earlier this summer has completely terrified the Chinese authorities – helping them realize they have what Hayek called a ‘tiger by the tail’. By this we mean that they know no good can come of holding to their present course, but that they are also aware they will be instantly eaten alive if they dare to let go. As a result, PboC Vice Governor Su Ning was on the newswires today talking of continuing the present ‘moderately loose policy’ – i.e., naked inflationism – out into 2010. Heaven help us all!
But no illusions of Occidental superiority should be allowed to intrude, for we cannot expect our worthy central bankers to be any less pusillanimous when their turn comes to act – for all the current rumour-mongering about tough talk behind closed doors at the Fed.
As we said almost from Day One of the crisis, Bernanke’s utter misreading of the 1930s has fixed the Fed’s ‘mistake’ of 1937 just a large in his sights as that of 1930. Needless to say, while they focus on the drama of that one, blighted decade, he and his peers completely neglect the whole sad chronicle of mistakes committed during the years 1913-1929 and 1938-2009, as its flawed doctrines and political biddability have combined to gut the far more pure ‘capitalism’ which preceded the Fed’s establishment and which have promoted in its place the pandemonium of bank-led, crony corporatist welfare we practice so disastrously today.
At present, the main difficulty we face in our own work is that of not being too repetitive in laying out what he have been saying since the Crisis started (and hinting at long before then): namely, that Government activism + central bank accommodation = more money despite lowered levels of direct commercial bank lending to the private sector and that this, in turn, is enough to set the stage for an ill-founded revival in real-side activity.
This, of course, is already proving enough to bedazzle the intellectual goldfish who teem in our waters and it is certainly providing plentiful ammunition for our recently state-sponsored stock promoting class – this even though the upswing is becoming ever more dependent on a government interventionism littered with ‘broken windows’ and scarred with the smoking craters of economic collateral damage. Furthermore – and much sooner than anyone really credits it – it will also result in higher goods prices despite the presence of the so-called ‘output gaps’ (i.e., the many abandoned factories, deserted shipyards, uncompetitive vehicle assembly lines, and dust-blown construction sites) which, despite their evident disutility, are deemed to offer a safety valve, according to the tenets of Keynesian Groupthink.
As a result, it is very likely – if not quite fully guaranteed – that we have, as predicted, avoided our 1931-33 reprise. So, let’s hand it to those recidivist drunk drivers, Ben and Merv and Jean-Claude, for being canny enough to ferry some of their victims straight to the local hospital in the hope of impressing the judge at their hearing.
The sad truth is that, whether we are spared our mini-1937 moment as the stimulus is wound down (if only in real, not nominal, magnitude, and probably not in its application, per se), or whether the avid desire to avoid the stutter of a ‘double-dip’ is to forego all meaningful attempt at Cold Turkey, the central bankers’ much-acclaimed ‘success’ implies that we will fully realise our impoverishment amid a re-run of the stagflationary 1970s instead.
This will come about as a direct result of the way in which the over-extension of monetary loosening and the intensification of an already gross degree of state interference will impede the necessary healing processes of private entrepreneurialism while fostering both a divisive economic nationalism across borders and a febrile social factionalism within them.
To sum it up in a quote:-
“We are currently in a market where government bonds, corporate bonds, industrial commodities, precious metals, major and emerging market stocks are ALL rising while the volatilities and risk spreads associated with of most of the above are falling. This is not a bull market for gold and silver – it’s a bear market for paper currencies, led by the USD and driven by a deliberate, rapid inflation of the narrow money supply almost everywhere you look. Do not expect this policy to be reversed anytime soon”
By Sean Corrigan, on 17 September 09
 Superhighway to Serfdom By kind permission of Sean Corrigan, we make available the September edition of his Resource Ruminations “Superhighway to Serfdom”:
“The danger of modern liberty is that, absorbed in the enjoyment of our private independence, and in the pursuit of our particular interests, we should surrender our right to share in political power too easily. The holders of authority are only too anxious to encourage us to do so. They are so ready to spare us all sort of troubles, except those of obeying and paying! They will say to us: what, in the end, is the aim of your efforts, the motive of your labours, the object of all your hopes? Is it not happiness? Well, leave this happiness to us and we shall give it to you. No, Sirs, we must not leave it to them. No matter how touching such a tender commitment may be, let us ask the authorities to keep within their limits. Let them confine themselves to being just. We shall assume the responsibility of being happy for ourselves”
Benjamin Constant, ‘The Liberty of Ancients Compared with that of Moderns’, 1816
…
Imagine, if you will, that we stand today at a cross-roads and that we see to our right a minor road which branches away to climb rapidly upward in an ultra- (even a hyper-) inflationary surge to ruin. On our left, we find a trackway which twists downward, descending rapidly into a Slough of Despond after threading its way past the rusting ironwork, boarded windows, and unfinished building work of a renewed financial crisis and after jolting its users horribly about in the ruts and potholes of further, poor political decision-making as they motor to their doom.
In all likelihood, however, our state-employed bus driver will avoid these two offshoots and will rather stick steadfastly to the busy highway along which we are currently speeding, a broad Road of Good Intentions along whose dreary verges we see an army of labourers sweating over the construction of an ever more ramshackle confusion of governmental props, buttresses, and scaffolding as they try manfully to shore up the crumbling Babel of bad debt and faltering businesses to be found there, at least beyond the next election date.
Read the full report.
By Toby Baxendale, on 16 September 09
 UK Savings Ratio The Cobden Centre’s Chairman, Toby Baxendale, explores whether cheaper money will make for greater prosperity.
You often hear politicians and economic commentators say that we must have low interest rates to make sure the price of money is as low as possible to allow people to borrow and thus spend. This is very much the common view whatever your political outlook. The thought behind this is the Keynesian notion that one person’s spending is another person’s income. This is the famous circular flow of income. In a further article, I will address the latter notion. The first notion — whether cheaper money will make for greater prosperity — I will address now.
First of all, I would like to recap how we entrepreneurs create wealth.
How is Wealth Created?
I would like you to absent the concept of money and consider a situation of barter. As a butcher, when I kill an animal, I may get for the sake of argument, 10 cuts of meat: this is my production. I only need 2 for my immediate consumption, so with the remaining 8 cuts, I trade with Andrew, a garment manufacturer, for some garments to keep me warm. I consume 2 cuts and I save 8 cuts in order to trade for other goods and services. I need to produce to consume: I need to save/invest to consume.
If I wish to consume more of Andrew’s garments as I have a family to dress and keep warm, 8 cuts of meat may well not be enough to purchase these new needs and requirements of mine. At this point in time, I am faced with a choice, either my production has to increase so I can generate more cuts to exchange for other goods, or I accept my fate and stay where I am. I decide that I can invent a method of cutting up the parts quicker by using a sharper knife, thus I seek to invent the “steel” or knife sharpener that improves my productivity from generating 10 cuts in a day to 15. With these 5 extra cuts, I can get more garments.
The problem is , that in order to get the steel built, I need to spend some of my time that would be making the 10 cuts. Thus, I have to save and forgo some consumption while I have the steel built. I also have to rely on my savings — those stored cuts of meat — that I have not consumed to keep me afloat. This is what an economist may mean when he says adding capital to an economy lengthens the structure of production. The steel in this example adds a stage to the capital structure of society, to make me more productive, so I can consume more things.
To be clear, saving is the only thing that allows this to happen. In this example, my personal capital structure has gone from me with a knife in my hand consuming two cuts a day and exchanging 8 saved portions, to me and a knife and a steel to produce 15 cuts of which I consume 2 and exchange 13 saved cuts. Now Andrew will be doing the same, i.e. lengthening his structure of production to meet my new found desires for more goods. He will also have to save — i.e. forgo consumption — to invest with the sustenance that savings gives him, to become more “capitalistic” or capital intensive in his production structure, to meet my demand.
Money, as we have established elsewhere, like language, never arose by government decree, but by the spontaneity of individual human action to solve the problem of barter. If my cuts of meat were exchanged for 13 monetary units of gold from Andrew as I did not want his garments, I would now have 13 monetary units of gold as this was the final good chosen by most to exchange for other goods and services. Note that the gold in this illustration has been “backed” by my productive activities i.e. the cutting of the cuts in the first place.
Consider now the advent of money by decree or the fiat currency or paper money we have now, that could be just created at the touch of a computer key board as I have written here. In this simple example, enter the bandit into the economy, who I am going to call Gordon Brown, who says to Andrew and me, “from hence forth, you will accept, by pain of imprisonment, my new money paper notes.“ With this new money, he offers me the paper money in exchange for my saved cuts of meat. He has achieved an exchange whereby he gets my meat i.e. real goods and services and I get his bits of paper. There has been a one-off wealth transfer from me to him. Granted that I now have this new purchasing power and can spend on other things, but Gordon has got goods, my meat, for which he has done no prior production. My article on Quantitive Easing here, explains this process further.
What is the Interest Rate?
The Time Preference view of interest says that there is always a difference in value between present goods and future goods of equal quality and quantity.
Simply put, you value more highly present goods of the same quality and quantity than you do future goods. Furthermore, the value of future goods diminishes as the length of time necessary for their completion increases. This sets up a price differential between goods now or goods later. This price differential is called an interest rate. In reality it is also the rate of profit in the economy as it is these saved resources that are the only source of future funding for investment and the associated return on that investment. So it is arguable to say that this is the most important metric in the economy.
In our simple economy of Toby, Andrew and Gordon, we have demonstrated that in order for Toby to gain more of Andrew’s goods, he must save i.e. forgo consumption and invest the saving that is sustaining him. Time and resource to make the steel is required — a lengthening of the structure of production from just knife, to knife and steel that is now more capitalistic — that allows him to sharpen his knife, to be more productive, to produce more to buy more of Andrew’s garments.
Andrew to has to save to invest more in, say, a loom rather than hand stitching to be able to meet Toby’s new demand. How do we get this right? How does entrepreneurial insight work more times than it does not? The price mechanism helps us know what is needed most in society. Thus Andrew noting that Toby will pay more for his garments, “reads” this price signal and chooses to invest in a loom.
For every given structure of production, every allocation of goods through its various stages of production needs a relationship between the final finished goods — the meat and the garments — and the means of production — the labour, the knife, the steel, the stitching the loom. If we are in perfect equilibrium, these two sets of prices must equal the interest rate; at this rate, just enough money is saved from production to facilitate just enough investment to support this capitalistic production structure.
If Toby’s time preference changes and he decides to postpone even more consumption and saves in a bank, he is notifying to the likes of Andrew that he is putting away consumption today and postponing it until a future date. Taken as a whole economy and in the light of what we have said in the above Toby and Andrew example, it is clear that the more savings, the more postponement of extra consumption, so that more investment in more capitalistic methods can be developed, the more production and consumption of goods and services there will be. Disturb this symbiotic relationship and you will get a structure of production in society that does not reflect the needs and desires of its citizens.
It is bizarre in the extreme to hear the mass of politicians and commentators advising us to “spend, spend, spend” without giving any thought to where the future investment / profits of the economy are going to come from. It is bizarre that they always argue for a lower interest rate or “cheaper money” so you can spend more. A quick reflection on your personal circumstances will tell you that if you just spent the entire sum of your monthly salary each month on consumption goods, could you ever save to purchase a large capital item such as a car or a house.
It is a tragedy today that we have governments trying to tell the world, “consume! consume! consume!” when in fact, they need to consume and save as well so they can consume ever more of the things they want later with their saved money. One-sided consumption will only lead to an impoverishment of society.
Very low interest rates not artificially set low would reflect plentiful savings. This would be a postponement of present consumption for future consumption, for entrepreneurs to use this money, via bank intermediaries, to invest in making our processes of production longer or more capitalistic to bring forth more consumer goods to provide for future consumption. Higher rates should indicate the reverse.
It is of no surprise that at the height of the boom period during 2007/08, the savings ratio hit rock bottom. When you have just consumption you can never save to invest in the future. As these savings are the future profits of business, it is no wonder that the whole economy fell off the edge of the cliff.
UK Savings Ratio Interfere with this process and set a rate under or over that natural rate of interest of all economic agents and you will distort the capital structure away from that which people want to serve their needs and requirements. This is boom and bust that we have all become so accustomed to. In my business for sure I have had activity and customers that have only been supported by low interest rates over the 10 years or so.
Now the merry go round has stopped.
The lesson for politicians is let the market rate of interest prevail as this matches investment and profits with future needs of society. Artificially setting a low rate of interest distorts the productive structure through investment to make more goods and services — a boom — than consumers actually can afford or want — the bust.
Further reading
By Steven Baker MP, on 15 September 09
President of the Adam Smith Institute Madsen Pirie says, “It is no time to be squeamish”:
The Government is trying to pitch the debate as one between cuddly and sensible economies from Labour, versus Tories “salivating about wielding the axe”. The debate has changed, however, in that the public now expects cuts and even supports them. Moreover, they trust the Tories to better implement them.
They are correct. Several studies have identified savings to be made without cutting essential services. The James report identified £35bn, the Taxpayers’ Alliance and Institute of Directors report pointed to £50bn, and the European Central Bank has said that Britain could save £96bn if its public services could operate with the efficiency achieved in the US, Australia and Japan – and without reducing actual services.
via It is no time for Westminster to be squeamish over spending cuts – Telegraph.
By Steven Baker MP, on 15 September 09
 Taking a line with which we closely identify, Guido writes Pound Whacked After Mervyn King Admits : QE Isn’t Working:
The pound is getting whacked after Mervyn King implicitly admitted that despite printing £175 billion of he might still need to cut rates or even effectively charge banks for putting cash on deposit with the central bank.
We are entering into a monetary policy twilight zone where the governor of the Bank of England, in the words of the FT, has to “entertain more outlandish concepts like negative rates”. The QE disaster unfolds…
Further reading
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