Laurence Kotlikoff’s “Jimmy Stewart is Dead”

Jimmy Stewart plays George Bailey who is cast as the “honest” and trustworthy banker in the classic Hollywood film, “It’s a Wonderful Life.” Kotlikoff’s book laments that in the real world of modern banking, such characters no longer exist.

Kotlikoff himself is a Professor of Economics at Boston. Several Nobel Prize winners have endorsed the book: George Akerlof, Robert Lucas, Robert Fogel, Edward Prescott, and Edmund Phelps. I count 36 endorsements from the great and the good of the academic world on the back cover and front pages. I do not recall ever seeing this in a book.

The book is written for the layman. It is very light on economic theory, but does reference some otherworldly models. It is very good at explaining what on the face of it appear to be complex financial phenomena, but are in fact con tricks that in any other industry would earn you a prison sentence. Kotlikoff shows his readers how the financial system has failed in its fiduciary duty, and presents a very simple and elegant solution for its salvation called Limited Purpose Banking (LPB). He also proposes a reduction of the financial service sector regulators in the USA from its current 115 down to one: the Federal Financial Authority (FFA).

In his opening remarks he discusses the Modigliani-Miller Theorem, written in 1958, showing in elegant maths how in the absence of bankruptcy costs, leverage does not matter. If a company takes on more risk by borrowing more, its owners will offset that risk by borrowing less, leaving total debt in the economy unchanged.  Kotlikoff makes no mention of the fact that leverage in itself is not a bad thing if it is made up of people forgoing their consumption today, i.e. saving and committing it to projects that will deliver up goods in the future.   This glaring omission does not impede him from telling the story of our financial meltdown and making a solid policy recommendation for this crisis. It does, however, prevent him from seeing the elephant in the room: that the credit creation process itself is the source of the boom and the bust.

The nature of fractional reserve banking is such that if you deposit your cash in a bank, it will lend it out many times over. This means that multiple claims come to exist on the original real money that was deposited. If you deposit £100 in bank A, which lends it to an entrepreneur who deposits it in Bank B, both you and the entrepreneur now have £100! Like magic, we have £200 in the system, with £100 of it created ex novo by the banking system itself! In the UK, with no legal reserve requirement, we have a only £3 on average kept in deposit for every £100 of IOU’s promised by the banking system.

Kotlikoff provides a mainstream justification for fractional reserve banking, citing the Diamond-Dybvig Model, which holds that we value immediate liquidity for emergencies. We do not need that money all the time, so banks can use this and get us a higher return in the meantime. Therefore, governments must do everything to prevent a bank run if more people want their money back than actually exists in the bank vaults.

This is the theoretical understanding we have today and the model is used to justify all sorts of bank bailouts, as we have seen.

Kotlikoff points out that whilst the bailouts have prevented a collapse of the system of fractional reserve banking, the bailouts do not preserve the purchasing power of money. They just guarantee that the money unit will still exist. This is a very good point. All the bailouts are being funded by more claims on the future taxpayer.  In the UK, we have a system of money debasement called Quantitative Easing, which will just debase and reduce our purchasing power.

In effect, the bailouts do not do what they say they do on the tin, and daily our purchasing power is getting weaker. It is hard enough to get politicians in the UK to acknowledge the scale of our official national debt, but we owe at least as much again “off balance sheet”, in unfunded pension liabilities and Private Finance Initiative obligations.  Debasement will be the most popular way forward for all future governments as they will not want to overtly extract more wealth from us. Dishonesty will be the preferred policy.

Limited purpose banking would be a simple solution to all of this. Banks would be limited to their main purpose of matching savers to borrowers.  All financial companies would act as pass though mutual fund companies. They would be middle men, never would they own the financial assets. They could thus never fail in the “run on the bank” sense — i.e. depositors wishing to withdraw money — but only if they were very bad at business.  This is thus as near as you will get to risk-free banking. Never again would the economy be held liable to bail out the bankers.

Kotlikoff foresees at least two mutual funds being offered, with custodians holding the assets: one that holds cash and one that holds insurance funds. He does stress that innovation could still happen, with a multiplicity of funds being offered.  The Federal Financial Authority (FFA) would regulate the custody element of the safe keeping of the various mutual fund assets. He assumes that regulators will be able to opine, like the current rating agencies, on the soundness of the assets that have been bought by the fund. He would trust the government over the rating agencies. I personally would trust neither! In my industry, selling meat and fish, we have a number of free market created quality assurance bodies such as the British Soil Association for organic certification, the Marine Stewardship Council for fish sustainability that require no government sanction.  These have the confidence of both the consumer and producer. I would suggest that this and not a super regulator is the way forward.

Cash funds are nice and easy; they hold cash and are 100% reserved. They can never go up or down in value. These cash mutual funds represent the demand deposits of the new spec banking system.  All services such as cheque writing and paying bills is done via this vehicle.

I have written about 100% reserve banking here and Steve Baker has specifically examined the 100% reserve banking proposal of Irving Fisher, to which Kotlikoff refers.  He notes that the current economic profession considers these ideas to be “crackpot”; the Diamond-Dybvig model remains dominant.  He goes go on to say, “I want to be clear that I am not an advocate of narrow banking in of itself. Narrow banking is a small feature of limited purpose banking and would hardly suffice to deal with today’s multifaceted financial problems.”

He notes that with the many cash mutual funds in place, the money measure in the USA, MI, would correspond exactly with what the government had printed. So to cover all obligations, a massive print up in US dollars would need to take place — many trillions of dollars to truly purge the system. What Kotlikoff misses is De Soto’s insight, based on the work of Fisher, that there will be a unique moment in history when instead of causing debasement, the printed money would cover all unfunded demand deposits, swapping them out for cash. Wipe out or retire these demand deposits and the banking system has no current creditors, only assets. Take out the equivalent amount of assets from the banking system, so the banking system has the same net worth as before, then put these assets into the mutuals and pay off the national debt. This is not inflationary, requires no debasement, and will help deliver up safe banking.  This is summarised in our Day of Reckoning article.

Insurance mutuals would have all the other banking instruments such as CDO’s in them and could market these funds to whomever they wished. These are essentially what we would term a hedge fund today, though Kotlikoff proposes that these be closed end. This means you have to sell your shares in the fund to redeem your money. Consequently, long term lending can take place in these funds without the fear of a maturity mismatch. The only money this type of fund can lose is what is invested in it. It could never in itself pull down the banking system.

I sense that the author does not feel comfortable with the 100% reserve label, with its “crackpot” associations. In discussing the transfer of Citigroup he says,

“Here we’d need to swap all of CitiGroup’s debt for equity and prevent it from ever borrowing again to fund risky investments. We can now think of CitiGroup as a huge mutual fund with lots of different assets, one big commercial bank with 100 percent capital requirement, or one LPB with a large number of different mutual funds corresponding to the different Citigroup asset classes.”

He also points out that LPB could not actually be that far away if you take into account all the reserves that have been created already. This is something George Reisman has also pointed out.

Kotlikoff defensively shows how LPB would not reduce liquidity. It would not reduce real credit, i.e. savers forwarding money to borrowers. It would stop credit created out of thin air via the banking system, the prime cause of the crisis, but this is not mentioned in his book. It would lead to an optimal size financial sector. Our cash assets would be safe as you can get. Government could still monetise debt as it could still create cash from nothing. The currency and thus the purchasing power of money could not collapse by the actions of the banking system, but only by the actions of the government.

Kotlikoff concludes,

Limited purpose banking is the answer. This simple and easily-implemented pass-though mutual fund system, with its built in firewalls, would preclude financial crises of the type we’re now experiencing. The system will rely on independent rating by the government, but private rating as well. It would require full disclosure and provide maximum transparency. Most important, it would make clear that risk is ultimately born by people, not companies, and that most people need, and have a right, to know what risks, including fiscal risk, they are facing. Finally, it would make clear what risks are, and are not, diversifiable. It would not pretend to insure the uninsurable or guarantee returns that can’t be guaranteed. In short, the system would be honest, and because of that, it would be safe-safe for ourselves and safe for our children.

Although I think he has failed to identify the state sponsored banking system, with its fractional reserve credit creation point as the cause of booms and busts, his solution has many merits and many similarities with the solution proposed by Fisher, De Soto, and others. He missed what I call the golden opportunity, or unique moment in history, to actually enact a reform that delivers up 100% reserve of LPB and pays off the national debt and other unfunded obligations at the same time. My own solution is the De Soto 100% reserve free banking solution with banks working within the existing commercial law to which all non-bank companies must adhere. However, both systems have the same effects and would do the job needed: to sort out the banking system, provide stability, and let capitalism flourish. Yet another workable solution has been proposed by our very own Paul Birch. Kotlikoff’s contribution to the debate, with all the Nobel endorsements, is timely, and I hope policy makers give due attention to innovative solutions like these.


The bankruptcy of governments

The following is a transcript of the “Adam Smith Lecture” I gave at a private gathering in London on 19 February.

For a long time governments have been redistributing peoples’ income and wealth in the name of fairness. They provide for the unemployed, the sick, and the elderly. The state provides. You can depend on the state. The result is nearly everyone in all advanced countries now depends on the state.

Unfortunately citizens are running out of accessible wealth. Having run out of our money, Governments are now themselves insolvent. They started printing money in a misguided attempt to manage our affairs for us and now have to print it just to survive. The final and inevitable outcome will be all major paper currencies will become worthless.

To appreciate the scale of these problems, we must understand the errors in economic and monetary policies. I shall start with economics.


Modern economists retreat into two comfort zones: empirical evidence and mathematics. They claim that because something has happened before, it will happen again. The weakness in this approach is to substitute precedence for the vagaries of human nature. We can never be sure of cause and effect. Human action is after all subjective and therefore inherently unpredictable.

The mathematicians like to think that economics is a physical science and is not a slippery social science. Economics is a branch of human psychology. It is plainly nonsensical to apply maths to human psychology.

The result is that much of the good work done by the classical economists like Adam Smith has been destroyed by modern economics. The classical economists explained the benefits of doing away with tariffs and the guilds. This revelation was instrumental to the industrial revolution. Then along came Marx who persuaded people that economics was a class interest, that free market economists were promoting the interests of the bourgeois businessman to the disadvantage of the worker. That became the justification for communism and socialism. Keynes and those that followed him never properly challenged Marxian fallacies. They were never involved in what became known as the socialist calculation debate.

It is not generally appreciated that Keynes was strongly socialistic. In the concluding remarks to his General Theory, Keynes looks forward to the euthanasia of the rentier (or saver) and that the State will eventually supply the resources for capital investment. He wanted the state to control profits.

Keynes was primarily a mathematician. Keynes was no more an economist than Karl Marx, whose beliefs led to the economic destruction of Russia and China; or John Law, who bankrupted France, with similar fallacies to those of Keynes.

The misconceptions of Keynesianism are so many that the great Austrian economist von Mises said that the only true statement to come out of the neo-British Cambridge school was “in the long run we are all dead”.

Let me define economics for you at the simplest level. We divide our labour. Each one of us is a consumer; an entrepreneur whether for wages or profit; and a saver for the future. We invest savings to improve production. Each of us discharges these three functions in the proportions we choose as individuals, we interact with others doing the same thing. We exchange our goods at mutually agreed prices using money to facilitate the exchange. We use money to keep score, and that money has to be sound for our calculations to mean anything. Together we are society itself, each providing things others want and will pay for.

The state has no role in this process. Instead it is a cost to society, because it takes some of our spending and savings to support itself. The more the state takes the greater the burden. It destroys society’s potential wealth. But it has not stopped there. Socialism forces the vast majority of people to give up saving and rely on the state to provide. Governments everywhere are now encumbered with obligations they cannot possibly discharge.


On the money side our mistakes go back to the Bank Charter Act of 1844.

The Bank Charter Act gave the Bank of England a note-issuing monopoly backed by gold and government debt. It failed to stop other banks issuing bank credit. This led to credit-driven business cycles which were socially destabilising, adding fuel to the various brands of communism and socialism that developed in the late nineteenth century.

Gold backing for the Bank of England’s notes was gradually eroded, starting in the late 1890s, with a number of countries, including Britain, abandoning it altogether in the interwar years. A gold-exchange standard was adopted for central banks at Bretton Woods. And finally President Nixon in August 1971 abandoned gold altogether.

Ever since then, the expansion of money supply has been increasing exponentially. Quantitative easing is now required to keep the pace of printing up, lest interest rates begin to rise.

Monetary policy from the 1920s has been used to manage an increasingly unstable global economy. The irony is that this instability has its origins in the expansion of money and credit itself. The growth of money supply and bank credit has as its counterpart debt. Few are the assets not encumbered with this debt. Asset prices need more money and credit to sustain them. It is a finite process that ended with the credit crunch five years ago.

That is the background. Now I shall look at the situation today, five years on from the credit crunch. There are four interlinked problems that cannot be resolved: the economy, the banks, government finances and population demographics.

The economy

The advanced economies have been progressively undermined by government intervention and unsound money. They are taxed and regulated to such a degree that laissez-faire hardly exists anymore.

Government spending typically amounts to 50% of GDP in the advanced economies; sometimes more, sometimes less. For productive businesses it is like running a marathon carrying a bureaucrat on your back who tells you how to run.

The misallocation of economic resources which is the result of decades of increasing government intervention cannot go on indefinitely. Businesses have stopped investing, which is why big business’s cash reserves are so high. Money is no longer being invested in production; it is going into asset bubbles. Dot-coms, residential property, and now on the back of zero interest rates government bonds and equities. These booms have hidden the underlying malaise. There can be no economic recovery. Our bureaucrat-carrying marathon runner is finally collapsing under his burden.

The burden of government is now too great to be sustained.


Banks are geared 25 to 30 times, which is fine if you can grow your way out of problems. That is no longer the case. They are vulnerable to existing but unrecognised bad debts, and now a fall in government bond prices. All that’s needed to trigger a collapse in the banks is absence of economic recovery. If we have a downturn it will be quicker. All that’s needed is a rise in interest rates, to reduce collateral values. All that’s needed is a fall in asset prices.

Then there is the shadow banking system, which the Bank for International Settlements reckoned amounts to over $60 trillion, of which $9 trillion is in the UK. If an investment bank goes under, the shadow banking system could make it virtually impossible to ring-fence the others.

Another area of risk is cross-border exposure. Cross border loans in Europe amount to EUR3.5tr. France is 1.2tr. Italy 700bn. Spain 500bn. These are only the obvious risks. Much of this is cross-border within the eurozone, meaning a default in any of those three is certain to wipe out the European banking system, and then everyone else’s.

For this not to happen requires the central banks to make available unlimited funds in the form of credit and raw money. As Mario Draghi said, whatever it takes. His solution is to print enough fiat currency to save the system.

Government finances.

From the time of the banking crisis, government finances have deteriorated sharply, and their debts rocketed. No country, except some in the Eurozone has managed to cut government spending, and only those which did, did so under extreme financial pressure and because they couldn’t print money. The fact is that everywhere government spending is increasingly mandated into pensions, social services and healthcare, which makes spending cuts extremely difficult.

Until recently it was assumed that economic recovery would generate the taxes to balance the books. That has not happened, nor can it happen. In the Eurozone governments are now taking on average over half of every working man’s income and deploying it unproductively. Take France. Government is 57% of GDP. The population is 66m, of which the employed working population is about 25m, 17m in the productive private sector. The taxes collected on 17m pay for the welfare of 66m. The taxes on 17m pay all government’s finances. The private sector is simply over-burdened and is being strangled.

The interest rates at which governments borrow are entirely artificial, made artificial by their own intervention in the debt markets. They are financing themselves by printing money to buy their own debt. The moment this ends, and it will, money will flow out of bonds, equities and even property priced on the back of low interest rates. The pressure for interest rates to rise will have to be met with yet more money printing, because governments cannot afford to pay higher interest rates, nor can they afford to see private sector asset values fall. Price inflation will create a real crisis, perhaps later this year.

Population demographics

Populations in the US, the UK, Japan and Europe are growing older. This is bad news for government finances. When someone retires, he stops paying income taxes and becomes a cost. High unemployment is also costly, because the unemployed are not funding future liabilities. Professor Kotlikoff of Boston University has calculated that in fiscal 2012 the net present value of the US Government’s future liabilities increased $11 trillion to $212tr. The whole US economy is only $15 trillion. Europe is worse, far worse: Europe has more pensioners as a proportion of the working population, high rates of unemployment and a large government relative to the private sector, which funds it all. The UK, taking these factors into account, is slightly worse off than the US. Japan has worse birth rates and longevity. They sell more nappies for the incontinent than they do for new-borns. The solution already is to issue increasing amounts of unsound currency.


The world’s economic problems have been building for a long time. Economic fallacies have been pursued first by Marx and then by Keynes in the 20th century, and monetary policy first took a wrong turn with the Bank Charter Act of 1844. The progressive replacement of sound money by fiat currency has destroyed economic calculation, and has destroyed private sector wealth. These policies were deliberate. We have now run out of accessible wealth to transfer from private individuals to governments. That is our true condition.

Governments will still seek to save themselves at the continuing expense of their citizens, and in the process destroy what wealth is left.

There can only be one outcome: the bankruptcy of governments. This means that their fiat currencies will inevitably lose all their purchasing power.

How soon? I’m afraid sooner than most people think. Japan is already entering the black hole, with her currency beginning its collapse. The UK is on the precipice and cannot afford further falls in sterling without triggering the rise in inflation that will force a rise in interest rates and a spiral into insolvency. Europe could go at any time. The US is probably the best of a very bad bunch, but even her economy is looking bad.

I do not make these statements because I am gloomy. I make them because I approach economics without emotion and without political bias. I make them because I have considered our true economic and monetary position using as far as I am able sound aprioristic theory applied to our current position.

Thank you.

This transcript was previously published at


Welfare costs rapidly escalating – everywhere

Many of us are aware of Professor Laurence Kotlikoff of Boston University’s calculation that the net present value of the US Government’s future liabilities rose by $11 trillion in fiscal 2012 to $222 trillion. These are principally welfare, healthcare and social security costs.

This is admittedly a high-end estimate, dependent on variables such as longevity, demographics and the interest rate at which future liabilities are discounted. It is an escalating problem, because baby-boomer retirees suddenly stop paying income and social security taxes and instead draw down on the system. The implication is that these costs are impacting government finances at an increasing rate, potentially undermining the creditworthiness of the US Government.

According to OECD figures other countries appear to be in far worse positions, as shown in the table below, where they are ranked by cash pension costs faced by governments in 2011.

Selected eurozone pension costs  
However, pensions are only part of the story, with all these countries providing healthcare and other social services, which with aging populations is a substantial and increasing cost. And while some state healthcare provisions are better than others, when healthcare is run by the state it is more likely to be better as the result of higher spending than greater efficiency. Furthermore, the OECD figures are for cash benefits, excluding benefits in kind; so in Ireland’s case, where pension benefits in kind are estimated by the OECD to be three times the cash amount, the true cost works out at closer to 15% of her GDP.

Japan’s demographic crisis has been well publicised, which is reflected in the figure of 35.5% for pensioners as a percentage of the working population, and presumably worse than that today. However, the financial press is less familiar with the enormous future commitments of European governments, which are truly alarming. And these figures do not even fully expose the difficulties for governments to deliver their welfare obligations.

Eurozone unemployment is over 10% on average. This means that 10% of tax contributors are out of the picture and become a welfare burden, so Spain and Greece where unemployment is at 26% are in immediate trouble with their welfare budgets. Another unfavourable factor is the dominance of the state.

Take France, whose general government is 57% of GDP. Her working population is 28 million out of a total population of 66 million; 3 million are unemployed, which leaves 25 million, of which 8 million are employed by government. We can disregard government employees, since they are a net government liability, not a source of revenue.

That leaves only 17 million productive taxpayers who have to pay for the welfare and pensions for 66 million in a heavily state-controlled economy. Furthermore, a significant proportion of private sector employees are working in nationalised or government-supported industries, so the true figure of real taxpayers is significantly less than 17 million.

We can draw two conclusions about the European states: their welfare, health and social service liabilities are, unless they ditch the majority of their welfare commitments, going to bankrupt them; and because their true taxpaying base to fund this largess is smaller than generally realised, taxes are going to have to rise to the point where it is not worth genuinely productive people working.

This article was previously published at


Easy, isn’t it?

With the halls no longer decked with boughs of holly and the wassailers at last stuffed full of figgy pudding, we have all reluctantly begun to struggle back to our desks, turn on our Bloomberg screens, and wearily face up to the long slog ahead towards the annual profit target.

Even though the New Year is still wrapped in its swaddling clothes, it is hard to avoid the jaded feeling that the market has already arrived at an all too cosy consensus about how events will unfold in 2013 and where the money is to be made as they do.

The Yen will continue to fall and fall under the maniacal compulsion of the new Japanese government; bond yields will finally cease their three-decade decline; and stocks will (of course) rally, probably dragging industrial commodities with them. In Europe, the worst is widely held to be behind us – even though nothing much has been done there beyond persuading traders that the line of least resistance lies in not calling Mario Draghi’s bluff when he insists that sovereign spreads must not widen. China’s typically sagacious new central planners will somehow ‘rebalance’ the ailing giant that is their fiefdom by pouring yet more concrete and digging yet more holes without this time stumbling into a further mindless duplication of capacity, sparking a divisive property rush, or re-igniting a socially disquieting round of consumer price rises. Perched high above, in the crow’s nest which sways alarmingly above this Ship of Fools, the Bernanke Fed will keep on buying however many of the obligations of an incurably profligate government it feels like monetizing, thereby hoping to prise the prudent out of their more passive habits of saving by means of the insidious, corrosive, time decay which negative real interest rates visit on the thrifty and, in doing so, it will seek to insure us against all possibility of renewed recession. 

Easy, isn’t it?

Well, perhaps. But before we start spending our bonuses before we have truly earned them, let us first pause to consider whether  any or all of these suppositions are really imbued with the full hue of inevitability or whether instead an all too typical mass disappointment will set in, either around the start of February (as has traditionally been the tendency when the last winning trade of the old year is carried too eagerly on into the new) or sometime in the Spring (as has been the case in the last three years of policy undulation and Risk-On/Off hysteresis).

Take the US, for example. Just like the Mayan fiasco of prophecy, the budgetary apocalypse of the so-called ‘fiscal cliff’ (a hackneyed phrase whose overuse grates on the ears almost as much as that damnable cliché relating to metallic containers, public highways, and coups de pieds) has been partly averted, even if we can all look forward, in the coming weeks, to another round of facile political posturing ahead of the near-inevitable debt ceiling extension.

Rather than cheer, however, any rational investor would find this procrastination a mater of deep anxiety for, as Laurence Kotlikoff points out, it is not so much the minor contour change of the ‘cliff’ which should be exercising our concerns, but the terrifying, Miltonian ‘abyss’ which lies beyond it in a country where the accelerated transmutation of ageing Baby Boom tax payers into voracious entitlement eating retirees is adding no less that $11 trillion a year to the unpayable $222 trillion NPV of the nation’s overall sum of actual and contingent liabilities.

For now, though, even if the recovery is a deal more anaemic than anyone seeking votes might hope, America has managed to avoid slipping back into the mire in the way so many of its peers have done, where, that is, these latter have been fortunate enough to free themselves from the choking quagmire of unresolved crisis in the first place.

By all accounts, the economy – and by extension, a stock market flattered by the artificially exiguous discount factors applied to its prospective earnings stream – has much going for it: corporate profits are elevated, cash flow is at record highs, wages are subdued, the buying-back of equities is proceeding apace, that last aided greatly by a booming market in corporate debt . Capital expenditures are on the rise (if not so impressive in inflation-adjusted, net – rather than nominal, gross – terms) and payrolls are indeed expanding if not as rapidly as some might wish.

Moreover, the broad brush of the overall jobs numbers has been obscuring the heartening detail that the country’s more productive sectors are making their contribution to re-employment (manufacturing and the extractive industries have, between them, added almost 600,000 to the roster since the trough), while the bulk of the retrenchments have come in the non-productive, if not parasitical, sectors of finance (mea culpa!) and government.

The main concern here is that, despite the Fed’s ongoing efforts to force everyone to swim by flooding the land in liquidity, overall business revenues have undergone something of a deceleration in recent months and regular surveys of small businesses are obstinately throwing off readings typical of a slump, while claims of rediscovered vigour in the enfeebled construction sector seem to be belied by the trifling gains in headcount and hours worked in the field, not to mention the refusal of mortgage purchase applications to shake off their post-crash sloth, or of office vacancy rates to decline in any meaningful manner.

In Europe, politics may yet play an unexpected part, not least in Italy where Il Caviliere seems to have found a way to manoeuvre himself back to the centre of things in the form of the partial self-denial of ambition encapsulated in his faction’s deal with its erstwhile allies of the Northern League, under the terms of which he would settle for the finance minister’s job. However that particular gambit pays out, it seems certain that the hustings everywhere will resound to cries of repudiation for anything associated with the slow grind of Orient Express Austerity (i.e., that pernicious assault on the commonwealth which seeks to keep an overgrown and intrusive state as large as possible, no matter what the cost to that enterprising and self-reliant middle which is otherwise most likely to spark a renaissance).

Even in Germany, the cracks have begun to appear as the Merkel coalition has already delivered a sackful of costly pre-election sweeteners to keep the electorate onside in this, the key year for the coalition. As one perceptive acquaintance put it, we should expect little else when the struggle for power will be conducted between what he sourly called the red socialists, the green socialists, the yellow socialists, and the black socialists.

For our part, it has always been the contention that the true test of Germany’s avowed resolve to insist upon budgetary discipline and at least the pretence of monetary rectitude would arrive if and when the country’s recent good fortune began to run out and its own mighty engines of growth were heard, at last, to sputter and cough.

With business revenues now falling in all sectors, except that of what are probably inflation-boosted consumer non-durables (making the MDAX, if not yet its larger sibling the DAX, seem historically expensive by comparison) and with industrial production and exports each having suffered a three-month retracement of a magnitude not seen outside either 2008’s global ‘sudden stop’ or the post-Reunification hangover, we’ll see the test of our thesis that the Bundesbank may soon pass from a show of Schlesinger-like sternness to its polar opposite of Welteke-like vacillation.

Curiously, this slowdown seems to be taking form despite an intensification of the Eurozone’s dysfunctional ‘biflation’, a sharp divergence in monetary trends between the core and the periphery which has seen the key aggregate grow at accelerating double digit rates in the Eastern Frankish Realm and barely growing (if not actively deflating) in the Western half of New Carolingia.

Some of this inconsistency is largely to be explained by the transfer of deposits from the PIIGS – where they run a risk, however vanishing one is meant to believe it is, of not only being lost in a local banking collapse, but of being summarily redenominated in a devalued numeraire – to the perceived safe havens of Germany, Luxembourg, Finland, and the Netherlands. When such monies come to rest in banks north and east of the Rhine, they are not immediately intended for spending on the output of the Mittelstand: their ‘velocity of circulation’ is preternaturally low, if you will.

However, that this is not the full story can be seen from the fact that, since Draghi quelled the incipient panic last summer when he issued his resounding boast to ‘do whatever it takes’, the tell-tale TARGET2 balances which reflect this twin-sided process of credit withdrawal and flight-to-quality have undergone a partial decline which we can quantify roughly either by way of the shrinkage of the joint Spanish-Italian total (or of that of its De-Fin-Nl-Lux counterpart) of some €110 billion seen between August and November. Alongside this, non-currency portion of the money supply in the former has shrunk by €6.2 billion (-1.8% annualized), while that in the latter has shot up by €77 billion (a massive 19.4% annualized which stretches to 26.0% in Germany alone).

If these funds, too, are not  being spent with quite the abandon they were a few short months ago, it might be taken to indicate that conditions are worsening and sentiment darkening more drastically than the superficial optimism of the securities markets would have us infer.

The one place where things do seem to have taken a decided downward lurch is in France. After coming back broadly into balance, its T2 debits jumped back up to €43 billion in October (the last period for which the BdF has seen fit to publish its balance sheet). Alongside this, there has been a sharp, €15 billion, -10.5% annualized decline in non-currency money supply which has served to take the annual rate of change close to zero in real terms and hence very much back into the danger zone.

It can hardly be a coincidence that this mini-run occurred in the context of the spat over the possible nationalization of Arcelor Mittal’s steel works; the implosion into internecine strife of the UMP opposition; and the disarray so evident at the heart of Hollande’s administration – not least regarding the status of the soak-the-rich tax – which led to the international embarrassment of Gerard Depardieu’s very public defection to the Russians.

The country, which has seen debt/GDP jump 20 points since the crisis (and with ongoing deficits of ~€2 billion a day do add to the tally) and which has a €40-45 billion structural–looking current account gap to fill, is not entirely securely placed in the affection of the world’s investing public even if the implicit support of the rest of the European mechanism makes a full-blown flight an unlikely prospect just yet.  Nonetheless, all this bears watching.

Just across the channel, the fall of the services sector PMI to a 3 1/2 –year low, coupled with a dip in the construction analogue the bottom reaches of its last two years’ range, has raised the spectre of a ‘triple dip’ recession. Notwithstanding this, the UK manages to run a record trade gap in goods, clearly in excess of £100 billion a year, leaving the overall trade deficit of £36 billion a bare £3.8 billion less deep than it was at the peak of the boom and a current account which is beginning to push into a zone which heralded the last two sterling crisis – in the mid-1970s and during the first ERM break-up.

Ironically, this has come about as the BOE’s latest efforts at QE have finally had some purchase on the nation’s stock of usable money. Between February and November last year, the Old Lady’s balance sheet expanded by £90-odd billion and money supply rebounded from its post-Crisis lows, climbing £70.6 billion at an annualized rate of no less than 10%.

Loose money, loose fiscal policy (the shortfall is still running at some £10 billion a month), low competitiveness, and a weak leadership unable to steel itself to do anything to address the issue. This all sounds horribly familiar to this particular seed of Albion.

All of which brings us to China (sigh!).

No-one can surely need to be told that the last few months have seen a modest improvement in the Middle Kingdom’s fortunes which has auspiciously coincided with the induction of the new leadership. In part, this was grounded on the usual year-end orgy of spending undisbursed government budgets, in part on the typical fourth quarter acceleration which took place in the money supply. This last quickened to a 34% annualized rate from the third quarter’s unchanged pace – impressive enough, perhaps, but still the slowest closing burst in four years. Furthermore, the volume of new loans granted – seemingly hamstrung by lacklustre deposit formation – touched a 3-year low, with the important medium-long term sub-category dipping to a 4-year nadir.

But if the banks were not officially in the game, the ‘shadow system’- including Xiao Gang’s Ponzi component – certainly came up trumps!

‘Total Social Financing’, as it is called (and less equity issuance), outstripped boring old bank loans by a factor or 1.7:1 in the final quarter of the year and constituted no less than 72% of all new credit extended in December. Compared with the same month in 2011, new, official, on-balance sheet bank loans declined 38% from CNY733 billion to CNY453 billion, while all other forms of credit rose 112% from CNY538 billion to CNY1, 139 billion.

Now some of this shift is probably not entirely a retrograde step, at least not to the extent that it represents a genuine entrepreneurial attempt to circumvent China’s antediluvian, financially-repressed, SOE-favouring, bank-coddling regulatory framework and instead tries to put people’s savings to work at a suitable rate of interest, funding genuine productive undertakings.

The problem is that some sizeable – if necessarily unquantifiable – fraction also comprises local government boondoggling, loan sharking, and outright fraud.  No wonder the central authorities moved last week to clamp down on the activities of the lower tiers of government in this regard.

To put all of this in come kind of context, it looks as though every extra renminbi of incremental GDP in 2011 was ‘bought’ with around CNY1.76 in new credit: last year the ratio was 3:1. Capital efficiency, anyone?

Moreover, when we look at liquidity, matters become even more pressing. In 2011, the system was already pyramiding Y5.50 on top of every new Y1 of actual new money created (2.54:1 for the shadow component). Last year the overall ratio was 8.22:1 and the shadow one stretched to 3.87:1.

And what is all this moolah being used for? For moving away from a malinvestment-led graveyard of capital such as has been constructed over the past decade of SOE princeling dominance? It certainly doesn’t look like it. 

‘Urbanization’ may be the new buzz word (and one about whose exact meaning we still maintain certain caveats), but this just means that instead of crushing returns at home and abroad (and piling up zombie loans on the books of the pliant state-owned banks) in such sectors as aluminium, steel, ship-building, photo-voltaic, etc., China now seems to wish to emulate post-bubble 1990s Japan with a whole host of non-paying propositions aimed at the domestic, rather than the international, market.

Take commercial real estate. Forced to cut back on their residential excesses, developers have been parlaying a good part of those new funds into building shopping malls wherever they can cut a deal with those paragons of municipal virtue, their buddies at the local land office. And, typically, they have not done things by halves for, as a recent press report made known, between now and 2015, if all goes according to schedule, China will add no less than 600 million square metres of mall floor space (around 120,000 football pitches’ worth). For comparison the ICSC estimate of the existing stock of US shopping malls comes in at around 650 million, around half the nations’ overall retail area. 

Then there are the subways. All well and good in principle to reduce congestion, increase safety and convenience and lower logistic costs, but they are hardly going to pay even their maintenance charges, much less their construction costs if the present economics are anything to go by.

As the China Daily reported in what was – for the sensitive tenor of the times – an unusually critical article, doubts are already surfacing about the sustainability of the current programme. 

Keen to spare the new bosses the loss of face of a soggy end to a soft year, in September, the NDRC suddenly approved 25 subway projects in 18 cities, for a total investment of more than CNY800 billion. Still furiously pump-priming, by November they had authorised four more cities — Beijing, Nanchang, Fuzhou, and Urumqi — to commit to plans requiring another CNY135 billion even though 35 cities had already broken ground on such projects in 2012, for an estimated ante of CNY260 billion, said the paper, citing a report of the Comprehensive Transport Research Institute of the commission.

Among the doubters, was one Wang Mengshu of the Chinese Academy of Engineering who told the interviewer that:- 

A city is eligible to build subways only if it has an urban population of more than 3 million, an annual GDP that exceeds 100 billion yuan, and a local government budget higher than 10 billion yuan. In addition, the one-way traffic flow must reach 38,000 people at peak time, according to the National Development and Reform Commission…

“However, some less developed cities in inland China have manipulated the figures to meet the requirement,” he concluded.

Quelle surprise!

One other thing to note is that, despite running a trade surplus of $235 billion and attracting FDI inflows of what will turn out to be around $95 billion over the 10 months since the last lunar holiday, the official count of foreign exchange reserve holdings shows zero net gain for the period. Subtracting outward FDI of an estimated $70 billion (and noting that euro and sterling parities versus the US did not undergo any significant changes in the interim), that leaves a cool $260 billion unaccounted for.

No wonder the North American and Australasian press is rife with tales of Chinese visitors getting stopped at customs for not declaring $10s of 1000s of bills stuffed into their luggage, or of their less than discreet presence at housing auctions in their destination countries. All well and good, you may say, if the external surpluses are being recycled into the hands of private individuals, rather than being directed, via purchases of government securities, to the dead hand of the state, but it nonetheless speaks volumes about how the insiders view the prospects for wealth preservation, much less further capital gain, at home.

It is presumably on such grounds as these that Bernard Connolly recently compared present day China to 1830s America – an era your author dealt with in the fifth chapter of ‘Santayana’s Revenge’. Glancing back at this today, we can see where the similarities lie: a vast orgy of infrastructure spending taking place in a wildly uncontrolled manner by eager local governments; a febrile property market in denationalized land, rampant speculation in commodities – all financed by pliable, politically-controlled banks and their shadow market counterparts. 

Tick…tock… tick… tock!

So, as we started by saying, we are uneasy regarding the consensus, but, for all the whispers that the Fed is about to become a deal less accommodative—and frankly, we’ll believe it when we see it—it doesn’t look as though anyone is short of anything out at the back end, even if that bear market dog-with-fleas, the 5-year, has seen specs switch to the other side of the trade in the past few weeks That said, a number of the key interest rate charts are showing some signs of stress, with a number of trend breaks to be found here and there, not least in the US. 

Hardly the calamity of 1994 as yet then, though the one area which does bear watching is the Japanese bond market.

It may be too much to hope that Abe and his coterie of economic illiterates can grasp the fact that by trying to favour his export lobby, he is raising Japanese input prices across the whole economy, and so not only potentially eroding margins but reducing real incomes and hence possibly hurting both the supply and the demand side of a system which hardly needs to be inflicted with any further disadvantages. But what he might take cognisance of is that any lack of trust he engenders in the value of both the currency and the mountain of government debt which, in the main, provides its backing—not least on the balance sheets of the banking system—might begin to cost him more than he can possibly hope to gain by stimulating ’consumption’ like the good little Keynesian he is.

Yes, the country needs, once again to re-orient itself, as it did in the wake of each of the major busts of the past 20 years. Further, it can probably not rely so heavily from here on upon supplying China’s vast, subsidized processing trade with high value-added inputs for incorporation into mass consumer products and transhipment to a West not so willing or able to indenture itself so as to buy them. This would have been the case even before the casus belli of the Diaoyu/Senkaku island dispute put business relations between the two prickly neighbours into the deep freeze. No one suggests that this will be swift or simple to effect, but given that the country has done it several times before, there is no prima facie case to suggest it will prove unable to do so again.

If Abe really wants to help, he should get someone to pull up a chart of what happened during the term of office of his predecessor Koizumi. Government shrank and a re-invigorated private sector expanded into the gap. Even if the aggregate GDP numbers recorded this as at best a minor victory, the quality of the whole was improved and hope of something greater briefly flickered into life before the experiment was prematurely abandoned.

The state and its pampered banks have everywhere reduced private initiative to near impotence, if not to outright Randian insurrection. It’s about time it quit its infernal meddling and let the wealth creators at the problem once again.

I suspect they’d be more than happy to have the opportunity to show what they can do, if asked.


Assume for the sake of argument that there were missed opportunities, now what?

During the financial crisis, my perspective has been hardened that the classical economist and even a hard nosed version of Austrianism is the appropriate policy position for practical political economy. I agree with Larry White, George Selgin and Steve Horowitz on the technical economics if we had either a free banking system, or if benevolent and omnipotent despots were running the Fed. But precisely because we have neither, I think the political economy position is one that basically focuses on flexibility of the price system and freezing the money supply and not stabilitzing MV. Isn’t any supply of money optimal given a flexible price system? And such a system would bind rulers’ hands by at least taking one policy tool out of their grasp.

Bottom line: I don’t think monetary expansion is a way to address a collapsing economy due to previous manipulations in money and credit; I don’t think fiscal stimulus is effective in revitalizing an economy for long run growth even if it was the size of WWII expenditures; I don’t believe that tax increases will bring fiscal responsibility, etc., etc. A good dose of laissez faire, in my opinion, is the only way out of our economic morass.

Whatever the soundness of those judgements, it is in a fundamental sense besides the point in our current policy discourse. Let’s assume for sake of argument that in the fall of 2008 an activist monetary policy could have avoided the financial crisis, that a much bigger stimulus could have kick started the economy in 2009 and 2010 (as Paul Krugman and Brad de Long argue), etc. But the fact is that those policies were not followed then, and we cannot go back in time. So rather than discuss what could have been (and whether that would have been the right or wrong path), the question we face now is what are we to do now?

Keep in mind two things: a loss of credibility by the US government and the key policy makers, and the anticipatory power of individuals that aids in engaging in off-setting behavior (not quite rational expectations and the invariance proposition, but not passive reaction to policy designs either). We cannot assume either of these realities away.

To me all that is left is hard decisions for politicians. They cannot reinflate the bubble; they cannot be anymore fiscally irresponsible. Calls for 4-6% inflation would be anticipated by market participants so the monetary illusion assumed would not in practice be in effect. In short, policy makers are trapped by their own policy designs, and the traditional answers only ensnare them further in the trap rather than offer a way out.

Laurence Kotlikoff has been issuing warnings on the coming generational storm due to fiscal irresponsibility for my entire professional career, let alone the warnings that James Buchanan issued from the 1950s throughout his career about the consequences of Lord Keynes and the breakdown of the old-time fiscal religion, see Public Principles of the Public Debt as well as Democracy in Deficit. And, of course, Hayek’s warnings about inflation getting us in the end from A Tiger By the Tail should always be heeded. In short, the sort of drastic policy shifts that were offered along with these warnings should be the starting point of any current discourse.

As Jerry O’Driscoll pointed out last week, our situation is the political economy legacy of Keynesianism, and it is the Keynesian death spiral we are caught up in at the moment. Ludwig von Mises once wrote that he started out as a reformer, but instead became a historian of decline.

Can we avoid this fate as economic thinkers?

This article was previously published at Coordination Problem


Loose Money, Asset Price Cycles and the Decapitalization of the United States

Ben’s Bubbles and the Bonfire of American Capital

Prepared by Kevin Dowd and Martin Hutchinson[1] for the 28th Cato Institute Annual Monetary Conference Asset Prices and Monetary Policy Washington DC, November 18, 2010


In the Gospel of Matthew (Matthew 25: 14-3), Jesus recounts the Parable of the Talents: the story of how the master goes away and leaves each of three servants with sums of money to look after in his absence. He then returns and holds them to account: the first two have invested wisely and give the master a good return, and he rewards them. The third, however, is a wicked servant who couldn’t be bothered even to put the money in the bank where it could earn interest; instead, he simply buried the money and gave his master a zero return; he is punished and thrown into the darkness where there is weeping and wailing and gnashing of teeth.

In the modern American version of the parable, the eternal truth of the original remains – good stewardship is as important as it always was – and there is still one master (the American public), albeit a master in name only, who entrusts his capital to the stewardship of his supposed servants. Instead of three, however, there are now only two (the Federal Reserve and the federal government); they are not especially wicked, but they certainly are incompetent: they run amok and manage to squander so much of their master’s capital that he is ultimately ruined, and it is he rather than they who goes on to suffer an eternity of wailing and teeth-gnashing, not to mention impoverishment. For their part, the two incompetent servants deny all responsibility, as politicians always do, and – since there is no accountability (let alone Biblical justice) in the modern version – ride off into the sunset insisting that none of this was their fault.

Asset Bubbles in the U.S.: Past and Present

The story starts with the Federal Reserve. Since October 1979, under Paul Volcker’s chairmanship, the Fed’s primary monetary policy goal had been the fight against inflation, a fight he went on to win though at great cost. Given this background, many monetarists were alarmed by Fed Chairman Alan Greenspan’s formal abandonment of monetarism in July 1993, but a subsequent tightening of policy in 1994-95 had caused satisfactory amounts of distress on Wall Street and seemed to indicate that the overall thrust of policy had not in fact changed.

The great change in U.S. monetary policy, so far as it can be dated, came early in 1995: in his bi-annual Humphrey-Hawkins testimony to Congress on February 22-23, Greenspan indicated that his program of rate rises, the last to a 6% Federal Funds rate on February 1st that year, had ended. Elliptical as ever, Greenspan’s hint of easing was veiled: “There may come a time when we hold our policy stance unchanged, or even ease, despite adverse price data, should we see that underlying forces are acting ultimately to reduce price pressures.”[2] The Dow Jones Index rose above 4,000 the following day, and was off to the races.

By December 5, 1996, the Dow was already at 6,400 and Greenspan famously expressed his doubts about the market’s “irrational exuberance”. Nonetheless, he did nothing tangible to reinforce his skepticism and pushed interest rates generally downwards over the next three years. In July 1997, he then came up with an explanation of why the high stock market might not be so excessive after all. In his usual Delphic manner, he remarked that “important pieces of information, while just suggestive at this point, could be read as indicating basic improvements in the longer-term efficiency of our economy.”[3] The press seized on these utterances as confirming a ‘productivity miracle’ that turned out later (like its predecessors the Philips curve and the Loch Ness monster) to be a myth, but not before it gave a nice boost to tech stocks in particular, which positively boomed. Only in 1999 did Greenspan begin to take action, pushing Fed Funds upwards to an eventual peak of 6.5% in 2000, by which time tech stock prices had reached stratospheric levels and then soon crashed.

The cycle then repeated. In January 2001, Greenspan began a series of interest rate cuts that saw the Fed Funds rate fall to 1% in 2003 – its lowest since 1961. He held it at that rate for a year and short-term interest rates were to remain below inflation for almost four years. This was a much more aggressive monetary policy and the results were entirely predictable: in Steve Hanke’s memorable phrase, there was “the mother of all liquidity cycles and yet another massive demand boom,”[4] the most notable feature of which was the real estate boom: subprime and all that. The rest is history.[5]

Greenspan’s successor Ben Bernanke then continued his predecessor’s loose monetary policy with missionary zeal. He brought the Fed Funds rate, which the Fed had belatedly pulled up to 5.25% in 2006 and held there for a year, back down to 2% by the onset of the crisis in September 2008; by then the rate of growth of MZM, the best currently available proxy for broad money, had been running into double digits for some time. Over the next six months MZM then increased at the rate of 20.4% per annum, while the monetary base doubled. Over this same period, the Fed funds rate was brought down from 2% to a mere 25 basis points, at which level it has remained ever since, and these loose money policies were supplemented with nearly $2 trillion in Quantitative Easing (QE). After March 2009, the monetary aggregates then remained flat for a year, but in April 2010 MZM started to rise again (at an annualized rate of 6.8% in the six months to October 2010) and, as we write, the Fed is embarking on QE2 – with yet another $600 billion in quantitative easing due to hit the system.

If past expansionary monetary policies led to bubbles, then we should expect the even more expansionary policies pursued since the onset of the crisis to produce new bubbles, and this is exactly what we find. Within the U.S.,[6] there are at least three very obvious bubbles currently in full swing, each fuelled by the flood of cheap money: Treasuries, financials and junk:[7]


The Treasury bond market has seen a massive boom since 2007, fuelled by a combination of large government deficits, enormous investor demand and low interest rates pushing prices up to record levels. Treasury bond issuance totaled $350 billion in the third quarter of 2010 compared with $73 billion in the third quarter of 2007 yet the long-term composite interest rate declined from 4.81% on October 1, 2007 to 3.26% on October 1, 2010. International official purchases for the Treasury bond market, which had declined from $52 billion in net purchases in the year to August 2006 to $9 billion in the following year, have rebounded to $194 billion in the latest twelve-month period. However that is nothing compared to private net purchases, which have soared from $175 billion in the year to August 2007 to no less than $569 billion in the latest twelve month period.


The current ‘recovery’ in financial stocks is almost entirely an artificial bubble. The Fed’s interest rate policy allows the banks to borrow short-term at close to zero and invest at 3% or so in long-term Treasuries or at about 4.5% in mortgage bonds (which are now openly guaranteed by the federal government). This enables them to sit back with their 3%+ spreads, leveraged 20 times to give a comfortable 60%+ gross return: becoming a yield curve player is far more profitable and avoids all the tiresome effort and risk of lending to small business.[8] It is therefore no wonder that lending to small and medium enterprises – on which economic recovery really depends – remains, at best, anemic, with small business loans down 25% since ’08. The result is a bizarre situation in which the banks appear to recover whilst their supposed core activity – lending – remains stuck; the reality, of course, is that lending is no longer their core business.

The banks’ true weakness is confirmed by other factors:

•    Current accounting rules – so called ‘fair value’ accounting rules – artificially inflate banks’ profitability in many ways. In practice, ‘fair value’ (sometimes known as market-to-market accounting, but in reality, mark-to-model accounting) boils down to giving practitioners license to abuse financial models for their own ends. This allows them to hide true losses and loot the system: you use a model to create fictitious valuations and hence fictitious profits, and then pay yourself a handsome (and very real) bonus for the ‘profit’ you have created. Needless to add, such practices are all the more damaging because they are so hidden.

•    Clever financial engineers are always finding ingenious ways to play the system and are currently very much hard at it. Many of the most lucrative of these schemes involve gaming the Basel capital rules to create fictitious profits and ‘unlock’ capital that can then be used to pay bonuses to clever financial engineers and their managers. U.K. banks seem to lead the field in this antisocial little game but one imagines that their NY colleagues must be pretty good at it too. A good example is the ingenious ‘pig on pork’ scam, introduced in the U.K. a decade ago and since widely copied; the current flavor of the month is the even more ingenious ‘failed sale’ scam, a transaction that looks like an innocent Repo, but which is really a backdoor way of hypothecating bank assets and deceiving bank counterparties who do not realize that the prime assets that appear to buttress banks’ balance sheets are in fact already furtively pledged to other parties.[9] Such practices secretly decapitalize the banks and are of course just another form of looting.

•    Underlying these, the banks are only able to continue operating because they are on state life support, propped up by repeated bailouts (including lender of last resort lending, TARP, government purchases of bank equity, repeated large-scale quantitative easing, etc) and government guarantees (including too-big-to-fail, deposit insurance, blanket guarantees of home mortgages, etc).


A third bubble is junk (sub-investment grade corporate bonds). In the year to September 15, 2010, junk bond issues raised $168.5 billion, more than the 2009 full-year record of $163 billion, and which itself represented an annual increase in total outstanding junk bonds of over 200%. Such growth is extraordinary in the deepest recession since World War II. Moreover, much of this growth takes the form of ‘covenant-lite’ bonds, which had been thought an aberration of the 2006-07 bubble. The key factor driving this growth would appear to be low interest rates: these not only reduce borrowing costs (for those able to borrow, i.e., larger firms rather than SMEs) and stimulate borrowing, itself encouraged by the tax-deductibility of debt; recent ultra-low interest rates also suppress yields on Treasuries, and this encourages yield-seeking investors to go for junk. These same causal factors have also given a big boost to the Leveraged Buy-Out (LBO) market, not least in so far as they have allowed company after company to avoid bankruptcy (and indeed prosper, temporarily) through aggressive refinancing.[10]

Each of these bubbles was/is characterized by obvious irrationality:

•       In the tech boom we had, based on the idea that there was money to be made fedexing catfood around the country, and which could not cover the costs of sending kitty litter through the post: it made its IPO in February 2000 amid a welter of Superbowl ads and went for its final walkies a mere 288 days later. As an investment, was a real dog.

•       In the housing bubble we had NINJA and ‘no doc’ loans, and house prices in some parts of the country running at 8-10 times annual income, i.e., we had loans being made with no concern for whether they would or could ever be repaid.

•       With interest rates so low, the prices of Treasuries are close to their peak and the only major change can be down; investors face a classic ‘one-way bet’ scenario reminiscent of a beleaguered currency facing a speculative attack: think of the U.K. currency crisis in September 1992, for example. In such circumstances the only rational response is to sell[11] and yet investors’ money still pours in.[12]

•       In the current financials market, we have the irrationality of the banks apparently profitable and prospering whilst the credit system is still jammed up and most of them remain dependent on state life support to continue in operation.

•       In the current junk bonds market, we have the irrationality of a major boom in lending to the riskiest corporate customers taking place in the middle of a major credit crunch and in the certain knowledge that many of these borrowers will default when interest rates rise.

We can be confident that these current bubbles will come to unpleasant ends like their predecessors, but on a potentially much grander scale. The bubbles will then burst in quick succession:

•       Sooner rather than later, it will dawn on investors that Treasuries are over-valued and confidence in the Treasuries market will crack: one possibility is that rising inflation expectations or higher deficits will then push up market interest rates, causing bond prices to falter and then fall; an even more imminent prospect is that some combination of the Fed’s quantitative easing and yawning Federal budget and U.S. balance of payments deficits will cause a further decline in the dollar that makes foreign holders of Treasury bonds lose confidence in their investments. In either case, there is then likely to be a rush to the exits – a flight from Treasuries on a massive scale – forcing up interest rates in general and inflicting heavy losses on bondholders, especially on those holding long-term bonds.

•       The collapse of the Treasuries market will cause the banks’ previously profitable ‘gapping’ adventure to unravel with a vengeance: the very positions that yielded them such easy returns will now suffer swingeing capital losses. Confidence in the banks – never strong since the onset of the crisis – will collapse (again) and we will enter a new (and severe) banking crisis.

•       The bursting of the Treasuries and financials bubbles will then feed through to the junk bond bubble: the collapse in the Treasuries market and the renewed banking crisis will lead to sharp falls in the values of corporate bonds and sharp rises in credit spreads. Highly leveraged firms will then default in droves, the junk bond market will collapse and LBO activity will dry up.

We also have to consider the nontrivial knock-on effects: the Treasuries collapse will trigger an immediate financing crisis for governments at all levels, and especially for the federal government, and one which will likely involve the downgrading of its AAA credit rating, and so further intensify the government’s by-then already chronic financing problems. Nor should we forget that these financial tsunamis are likely to overwhelm the Federal Reserve itself: the Fed has a highly leveraged balance sheet that would do any aggressive hedge fund proud; it too will therefore suffer horrendous losses and is likely to become insolvent. The events of the last three years will then look like a picnic.

There is also the problem of resurgent inflation. For a long time, the U.S. has been protected from much of the inflationary impact of Federal Reserve policies: developments in IT and the cost reductions attendant on the outsourcing of production to east Asia had the impact of suppressing prices and masking the domestic impact of Fed policies. Instead, these policies produced a massive buildup in global currency reserves: these have increased at 16% per annum since 1997-98[13] and caused soaring commodity prices and rampant inflation in countries such as India (current inflation 16%) and China (maybe 20%, judging by wage inflation, and definitely much higher than official figures acknowledge) whose currencies have been (more or less) aligned to the dollar. U.S. inflation was already rising by 2008 (annual rate 3.85%), but this rise was put into reverse when bank lending and consumer spending then fell sharply. However, there are good reasons to think that inflation will soon take off again: (1) The combination of booming commodity prices and a depreciating dollar (trade-weighted dollar exchange rate index down 15% since March ’09) means that imports will cost more in dollar terms and this must inevitably feed through to U.S. inflation. (2) Rising labor costs in the Asian economies mean that the outsourcing movement is coming to an end and even beginning to reverse itself,[14] and with it the associated cost reductions for American firms that outsource to Asia. Most importantly, (3), there is the huge additional monetary overhang created over the last couple of years (or, to put it more pointedly, the vast recent monetizations of government debt), the impact of which has been held temporarily in check by sluggish conditions over 2009-2010, but which will must eventually flood forth – and, when it does, inflation is likely to rise sharply.

Once inflation makes a comeback, a point will eventually come where the Fed policy has to go into sharp reverse – just like the late 1970s, interest rates will be hiked upwards to slow down monetary growth. The consequences would be most unpleasant: the U.S. would experience the renewed miseries of stagflation – and a severe one at that, given the carnage of a renewed financial crisis and the large increases in money supply working through the system. Moreover, as in the early 1980s, higher interest rates would lead to major falls in asset prices and inflict further losses on financial institutions, wiping out their capital bases in the process. Thus, renewed inflation and higher interest rates would deliver yet another blow to an already gravely weakened financial system.

The Decapitalizing Effects of Repeated Bubbles

Federal Reserve monetary policy over the last fifteen years or so has produced bubble after bubble, and each bubble (or each group of contemporaneous bubbles) is bigger in aggregate and more damaging than the one that preceded it. Each bubble destroys part of the capital stock by diverting capital into economically unjustified uses – artificially low interest rates make investments appear more profitable than they really are, and this is especially so for investments with long term horizons, i.e., in Austrian terms, there is an artificial lengthening of the investment horizon.[15] These distortions and resulting losses are magnified further once a bubble takes hold and inflicts its damage too: the end result is a lot of ruined investors and ‘bubble blight’ – massive over-capacity in the sectors affected.[16] This has happened again and again, in one sector after another: tech, real estate, Treasuries, financials, and junk – and the same policy also helps to spawn bubbles overseas, mostly notable in commodities and emerging markets right now.

We also have to consider how periods of prolonged low (and often sub-zero) real interest rates have led to sharply reduced saving and, hence, led to lower capital accumulation over time. U.S. savings rates have fallen progressively since the early 1980s, falling from nearly 12% to little more than zero in recent years.

Even without Federal budget deficits, it is manifestly obvious that U.S. savings rates over the last two decades are inadequate to provide for the maintenance, let alone growth, of the U.S. capital stock (or, for that matter, its citizens’ desires for a secure retirement): the U.S. economy is effectively eating its own seed-corn. Now add in the impact of federal budget deficits of around 10% of GDP and we see that the deficits alone take up more than the economy’s entire savings, without a penny left over for investment. It then becomes necessary to supply U.S. capital needs by foreign borrowing – hence the persistent and worrying balance of payments deficits – but even this borrowing is not enough. Hence over the long term, low interest rates are decapitalizing the U.S. economy, with damaging long-term implications for its residents’ living standards: in the long run, low interest leads to low saving and capital decline, and they in turn lead to stagnation and eventually to the prospect of declining living standards as America ceases to be a capital-rich economy.

Not to put too fine a point on it, savings have been suppressed for close on two decades, preventing the natural accumulation of capital as baby-boomers drew closer to retirement, while much of the country’s magnificent and once unmatched capital stock is being poured down a succession of ratholes.

The Federal Government is a Pretty Good Capital Destroyer Too …

We should also see these problems against the context of a vast number of other government policies that are decapitalizing the U.S. economy in myriad other ways. The wastefulness of government infrastructure projects is of course legendary. One instance is the Amtrak proposal for a Boston-Washington high speed railroad, costed at $117 billion, compared to $20 billion equivalent for similar lines in France and under $10 billion for a line recently opened in China. Even more striking is the ARC tunnel project between Manhattan and New Jersey, recently killed by Governor Christie because of its excessive cost of $8.7 billion plus likely overruns. Yet the Holland Tunnel, performing an identical function and opened by President Coolidge in November 1927, came in at $48 million, equivalent to $606 million in 2010 dollars. Even allowing for the higher real wages of today’s construction labor, and a certain amount of fiddling of the consumer price statistics by the BLS, it should have been possible to bring the ARC project in at under $1.5-2 billion, less than a quarter of the actual projected cost. The high costs of infrastructure problems boil down to the onerous regulations under which such projects are carried out, such as the 1931 Davis-Bacon mandate to use union labor on federally funded projects and a whole welter of health & safety and environmental regulations, which massively push up overheads.

We also have to consider the impact of government fiscal policy. Large government deficits reduce capital accumulation in so far as they crowd out private investments; large levels of government debt also reduce capital accumulation in so far as they imply large burdens on future taxpayers and these burdens reduce their ability (not to mention their willingness) to save. Over the three years, the government’s deficits have risen from 1.14% of GDP in 2007 to a projected 10.64% of GDP in 2010.[17] In the process, US government official debt has grown from almost 64% of GDP in 2007 to a little over 94% of GDP in 2010. This latter figure is very high by traditional standards and the rate at which it is rising would suggest that the U.S. government’s credit rating will soon be threatened, even without the racing certainty of an imminent Treasuries collapse; indeed, this figure alone portends a rapidly approaching solvency crisis.

Yet even these grim figures are merely the tip of a much bigger iceberg. The official debt of the United States, large as it is, is dwarfed by its unofficial debt: the Social Security and other entitlements (Medicare, Medicaid, etc) to which the federal government has committed itself, but not provided for, i.e., additional debts that future taxpayers are expected to pay for. Recent estimates of the size of this debt are hair-raising. Using CBO figures, Laurence Kotlikoff recently (Aug 11, 2010) estimated that this debt was now $202 trillion. To put this into perspective, this is 15 times the ‘official’ debt and nearly 14 times annual U.S. GDP – implying that the average U.S. citizen would need to spend almost 14 years of their life (and still counting) working to pay off this debt alone: no wonder Kotlikoff matter-of-factly concluded that the US is bankrupt and we don’t even know it.[18] This burden implies punitive tax rates on future employment income (and hence major disincentives to work or at least declare income), but will also greatly discourage future capital accumulation as investors will (rightly) fear that there is little point building up investments that will eventually be expropriated by the government.[19]

Long-term Outlook for the U.S. Economy

The long-term effect of U.S. economic decapitalization will not necessarily be apparent in day-to-day headlines; instead, the process will be almost glacial: mostly slow but utterly devastating in its longer term impact.

For all of its history, the United States has enjoyed many advantages over most other countries: abundant wealth and capital, world-class education and technology, a highly innovative culture and, underpinning these, a freer economy. However, the US economy is now far less free than it used to be 80 or more years ago; partly because of this, but partly because of the natural ongoing processes of globalization, the U.S. is steadily losing its other advantages as well. Owing to globalization and the outsourcing and wealth transfer that has brought about, the U.S. has long lost many of its advantages of technology and education against Europe and Japan. The same process then started relative to the small ‘tiger’ economies of east Asia and, more recently, relative to the giant Asian economies of China and India, whose wage levels are still only a fraction of those of the United States. In the long run, American citizens can expect higher living standards than Chinese or Indian citizens only if they maintain some ‘edge’ over them.  However, as the American capital stock gradually dissipates and their capital stocks increase, then that edge becomes increasingly tenuous and living standards will converge. Consequently, over the long term, there is no reason to expect U.S. living standards to exceed those in countries such as China, Malaysia, Thailand and Brazil that are coming to equal the U.S. in many of its factor inputs.

Americans might also take heed from the experiences of other once wealthy countries whose economies were crippled by progressive decapitalization:

•       One is Britain, which was still a wealthy country at the very frontier of technological advance in the late 1930s. However, when the War broke out the government took complete control of the economy and seized its entire capital stock, foreign investments and all. Over the next decades a bloated state sector and onerous controls deprived British industry of the capital it needed to refit, and the country went into long term economic decline. By the late 1970s, in consequence, Britain was being referred to as the new “sick man of Europe” and British living standards by the late 1970s were 30% lower than its European competitors’ and half those in the United States. By contrast, West Germany, which had suffered much more devastation in the War and the loss of most of its physical infrastructure, rebounded quickly under the free-market policies implemented by Konrad Adenauer and Ludwig Erhard from 1948, and soon rebuilt both its capital stock and its prosperity.

•       Another role model to avoid is Argentina, one of the world’s wealthiest economies in 1930, with enormous foreign exchange reserves from wartime trading as late as 1945, which embarked on wildly extravagant schemes of corruption, nationalization and income redistribution. Successive governments tried to restore Argentina’s position – it was after all superbly endowed with resources and in the 1940s had a highly competitive education system – but without adequate access to capital were unable to do so. The result was progressive impoverishment, repeated debt defaults and the country’s descent into its present Socialist squalor, in which even with high commodity prices it comes between Gabon and Libya in the global table of GDP per capita.

This will therefore be the fate of a decapitalized United States: its major cities will descend through the position of Cleveland, in which decay is mixed with dilapidated old-world charm, to that of Youngstown, Ohio in which devastation is universal, with the only flourishing markets being those for chain-link fences, tattoos and rottweilers.

What Can Be Done?

Thankfully, such a dire future is not inevitable – unless current policies persist – but radical reforms will be needed if it is to be avoided. Any reforms need to be based on a diagnosis of the underlying problems, however, and one of the most important of these is, quite simply, that U.S. policy-makers place too much emphasis on the short-term and fail to take adequate account of longer-term consequences. Nor should this be any surprise: the political environment in which they operate – the fact that they are accountable over limited terms of office, etc. – encourages them to focus on the short-term, so it is only to be expected that they would respond to such incentives: what happens after their watch is not their problem.

As far as monetary policy is concerned, these short-termist incentives create an inbuilt expansionary bias that has manifested itself in repeated asset price bubbles and now the prospect of renewed inflation, and the solution is to build-in barriers to contain his bias. The key here is to reduce – or better still – eliminate their discretionary powers; this would put a stop to those who would meddle with the short term interest rate and so kill the asset bubble cycle at its root. Interest rates would then be higher (and more stable) than they have been over recent years and so provide a stronger incentive for saving.

One possible reform would be to ‘Volckerize’ the Fed and give it a single overriding objective – namely the maintenance of price stability – and reform its institutional structure to protect its independence from the federal government. Reformers could take their lead from the Bundesbank: instead of a federated central bank accountable to the federal government and headquartered in the federal capital, the American central bank could be reconstituted as a unitary central bank accountable to the States and relocated in the heartland of the nation: our recommended choice would be St. Louis, which also has the attractions of a strong monetarist tradition and of being less susceptible to the influences of Washington DC or Wall Street. The ideal Fed chairman would then be more concerned with the St. Louis Post-Dispatch than the Washington Post or the WSJ, and even the feeblest appointee would be strong enough to stand up to the badgering of east coast politicians and financiers.

However, a far better reform – and a far more appropriate one, given the Fed’s dismal record since its founding – would be to abolish the Federal Reserve altogether and re-anchor the dollar to a sound commodity standard. A natural choice would be a gold standard, with the currency issued by commercial banks but pegged to and redeemable in gold. Interest rates and money supply would no longer be determined by central bankers but by market forces subject to the discipline of the gold standard. An alternative anchor might be some broader commodity basket, which has the additional attraction of promising greater price-level stability than a gold standard.[20]

Yet monetary reform on its own will not be enough to reverse the destruction of US capital: the federal government also needs to reform its own vast range of capital-destroying policies. Such reforms would include, among others, the following: [21] (1) Government should stop meddling in the financial system: it should stop giving guarantees such as mortgage guarantees or deposit insurance guarantees, and it should implement measures to prevent future bailouts and abolish government-supported enterprises such as Fannie, Freddie, etc. whose machinations have devastated the U.S. housing market. (2) Reformers should acknowledge the tendency of government to grow and be excessively short-term focused, and push for a systematic program that will cut government back and limit any future growth, the goal being to return the government back to the levels of the Coolidge Administration (motto: “The business of America is business”) in the 1920s. (3) A range of tax reforms is needed to abolish tax-based incentives to borrow, remove tax penalties from saving, investing and the transfer of capital between generations. (4) Government should tackle major budget imbalances. This requires a major reversal of current expansionary fiscal policies and, for once, the U.K. provides a positive role model: the U.K. faces similar problems, but the new Coalition Government acknowledges these problems and is in the process of implementing cutbacks to take Britain back from the brink; the U.S. needs to do the same.

The longer term fiscal prospects for both countries are of course dire but the good news is that most actuarial deficits are not so much hard and fast debt obligations as projections of what would happen if current policies persist, and there are obvious economies that can be made once the U.S government finds the courage to tackle these problems. Moreover, recent political developments – in particular, the recent Congressional elections, the rise of the Tea Party Movement and increasing dissatisfaction with the Federal Reserve, most notably the growing ‘end the Fed’ movement – suggest that the U.S. is at least beginning to move in the right direction.


Dowd, K., “An almost ideal monetary rule.” Greek Economic Review, Vol. 19, No. 2, Autumn 1999, pages 53-62.

Dowd, K., and M. Hutchinson, Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System, Wiley, 2010.

Hanke, S. H., “Greenspan’s bubbles.” Finance Asia, June 5, 2008. Available at

Hanke, S. H., “Booms and busts.” Finance Asia, January 2010. Available at

Hutchinson, M., “They don’t call them junk bonds for nothing.” The Bear’s Lair, September 27, 2010. Available at

Hagist, C., S. Moog, B. Raffelhüschen and J. Vatter, “Public debt and demography – an international comparison using generational accounting.” Research Center for Generational Contracts, Freiburg University, CESifo Dice Report 4/2009, 2009a.

Hagist, C., S. Moog, B. Raffelhüschen and J. Vatter, “Ehbare Staaten? Die deutsche Generationenbilanz im internationalen Vergleich.” Argumente zu Marktwirtschaft und Politik 107, Stiftung Marktwirtschaft, 2009b.

Kerr, G., “How To destroy the British banking system – regulatory arbitrage via ‘pig on pork’ derivatives.” Cobden Centre. Available at

Kotlikoff, L., “U.S. is bankrupt and we don’t even know it.” Bloomberg, August 11, 2010.

Norberg, J., (2009) Financial Fiasco: How America’s Infatuation with Homeownership and Easy Money Created the Economic Crisis.Washington DC: Cato Institite, 2009.

O’Driscoll, G. P, Jr., “Money and the present crisis.” Cato Journal, Vol. 29, No. 1, 2009, pp. 167-186.

Woods, T. E., Jr., Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse. Washington DC: Regnery, 2009.

[1] Kevin Dowd is a Visiting Professor at the Pensions Institute at Cass Business School, 106 Bunhill Row, London EC1Y 8TZ, United Kingdom and an adjunct scholar at the Cato Institute; email: Martin Hutchinson is a financial journalist and former banker, correspondent for Reuters BreakingViews and author of the weekly column “The Bear’s Lair”: 8307 Colby Street Vienna VA 22180, e-mail The authors thank Toby Baxendale, Steve Hanke and Gordon Kerr for helpful inputs. The usual caveat applies.

[2] Testimony to the House Banking Committee, February 22, 1995.

[3] Testimony before the Senate Banking Committee, July 23, 1997, p2. St. Louis Fed., FRASER.

[4] Hanke, 2008.

[5] There are many excellent accounts of this story, and we particularly recommend, e.g., O’Driscoll (2008), Hanke (2008), Norberg (2009) or Woods (2009). We also had a go at it ourselves in Dowd and Hutchinson (2010).

[6] There are also major bubbles overseas, most notably those in the Chinese and Indian real estate markets, and which (given the reserve currency status of the dollar and the huge expansions in these countries’ dollar holdings over a long period) are also due, in part, to the same expansionary Federal Reserve policies.

[7] We also mention two others in passing. (1) Stock prices are in a moderate bubble: analysis of stock fundamentals suggests that stocks (up 60%+ since the lows of March 2009) are now somewhat overpriced, though low interest rates are pushing up profits, especially for highly leveraged businesses. (2) Commodity prices are already approaching and in some cases surpassing their 2008 highs: e.g., since early ’09, gold is up nearly 60%, silver is up 100%, copper up 350% and crude oil up nearly 250%. Commodity prices are driven partly by rapidly growing demand in emerging markets and partly by continuing ultra-cheap money.

[8] There is also a large boom in fast/insider trading that illustrates, if not the irrationality, then at least the economic pointlessness of much of what the financial system currently does. High-frequency trading using fast computers and automated algorithms has grown enormously and now accounts for 70% or more of trading volume, up from very small amounts a few years ago. Its defenders claim it promotes market liquidity, but we would argue that their impact on market liquidity is at best minimal as markets are already liquid for the most part and the machines are switched off when markets become unstable. We would also argue that they are potentially destabilizing (as evidenced by the May 2010 ‘flash’ in the Dow Jones when the market fell 10% after a rogue machine went on a rampage) and in some cases their activities are fraudulent (e.g., when they program their computers to “ping” markets with orders that are instantaneously retracted). We would argue that most high-frequency trading is rent-seeking activity that has no place in a truly rational system and really needs to be shut down: this is where a Tobin tax would come in useful as a stop-gap, pending more radical reforms (free banking, extended liability, etc.) that would restore such a system.

[9] We thank Gordon Kerr for this information; further details on ‘pig on pork’ are provided by Kerr (2010).

[10] See also Hutchinson (2010).

[11] To give a simple illustration, take a Treasury bond with a duration (average time to cash flow) equal to say 25 years: using conventional duration analysis, a rise in interest rates of just 1% would lead to a capital loss of 25%; at the same time, with interest rates so low and the government flooding the market with more, thanks to its gaping borrowing requirements, the bond has little chance of going up in price.

[12] A free investment tip, guys: cash out and try the mattress – at least there is no danger of a capital loss when interest rates rise. Alternatively, you might take a leaf from the wicked servant in the Parable and bury the cash in the garden: that strategy is not as bad as it is cracked up to be – so long as you don’t just bury paper money in a damp garden.

[13] IMF COFER database

[14]As an example, recent stories in the U.S. press report that Indian helpdesk companies are now finding that they can operate more cheaply in the rural U.S. than in India itself: the fall in rural U.S. wage rates due to the recession has combined with the rise in Indian costs to produce an astonishing reversal of the original outsourcing driver.

[15] See also, e.g., Hanke (2010). We can illustrate this impact by applying duration analysis familiar from bond market analysis: if an investment with given expected future cashflows has a duration (or average time to cashflows) of T years, then a fall in interest rates of 1% will lead the value of the investment to rise by (approximately) T%. The impact on asset values will be ameliorated if longer term rates do not fall so much, but the essential story still holds.

[16] We gloss over various knock-on effects. One such is how the lowering of short-term interest rates depresses yields: this encourages investors to look for higher-yielding, investment outlets which, in turn, reduces credit spreads and diverts capital from ‘safe’ investments into higher risk investments such as junk bonds or emerging markets. If Vietnam, for example, can then raise money almost as easily as Ohio, then capital will be diverted to lower cost Vietnam and US manufacturing jobs will migrate with them.

[17] We gloss over here but take as read the vast amount of wastage and loss (much of it not even estimable) in recent federal government spending programs: TARP (cost said to be only about $30 billion) and other bank bailouts, the AIG rescue (which will be much higher than that), the rescue of Fannie and Freddie (currently worst case about $360 billion), the $1 trillion or so FHA loans made since it stepped in during the crash (and no one yet knows how many are bad), cash for clunkers and the auto bailouts, the over-hyped American Recovery and Reinvestment Act and quantitative easing, the costs of all of which are still unknown.

[18] See Kotlikoff (2010). Other scholars come up with different estimates, though still very alarming ones: for example, Hagist et al. (2009, 2010) suggest that the ratio of unofficial U.S. debt to GDP was 350.8% in 2004 and an update for 2009 gave an estimate of 567.4%. This suggests the problem is growing rather rapidly. The same study also provided an international comparison of the U.S. against selected European economies, and their results suggest that the U.S. has now displaced the U.K. as the country with the shakiest long-term public finances, a not inconsiderable achievement.

[19] Indeed, it would appear that the U.S. government is already laying the groundwork: the recently passed Foreign Account Tax Compliance Act requires U.S. taxpayers to inform the IRS of their foreign investments, and also requires foreign funds to name their U.S. investors on pain of a flat 30% confiscation tax each year. As one (non-U.S.) institutional investor informed us in private correspondence, “Naturally, we are divesting ourselves of all U.S. holdings.” This does not augur well for the future of the U.S. as a magnet for foreign investors; it also raises specter of the seizure of private gold holdings in 1934.

[20] An example of such a scheme is the ‘almost ideal monetary rule’ suggested by Dowd (1999). The idea is to create a monetary rule that stabilizes the CPI without the central bank having to buy and sell the CPI ‘basket’ of goods and services itself, which would obviously not be feasible. Instead, the Fed creates a new form of CPI-based financial derivative – in this particular case, this derivative would be a perpetual American put option on the U.S. CPI, the term ‘American’ here being used in the sense of standard options language to refer to an option with unrestricted early exercise rights. The Fed would then buy and sell these contracts on demand at a fixed price, and the system is so designed that its only zero-arbitrage equilibrium is one in which the expected change in the future CPI is zero; this would ensure that the system delivers price-level stability. In our (preferred) free-banking version of the scheme, commercial banks would be allowed to issue dollar-money on this same basis, and the Fed itself could then be abolished.

[21] For more on these reform proposals, we refer the reader to Dowd and Hutchinson (2010).


Banking: From Bagehot to Basel, and Back Again

As reported yesterday on, there were some very encouraging statements in Mervyn King’s Monday speech to the Buttonwood Gathering in New York.

King noted that “Of all the many ways of organising banking, the worst is the one we have today”. After considering various possible reforms, he moved on to some that were “more radical” (my emphasis):

One simple solution, advocated by my colleague David Miles, would be to move to very much higher levels of capital requirements – several orders of magnitude higher. A related proposal is to ensure there are large amounts of contingent capital in a bank’s liability structure. Much more loss- absorbing capital – actual or contingent – can substantially reduce the size of costs that might be borne outside of a financial firm. But unless complete, capital requirements will never be able to guarantee that costs will not spill over elsewhere. This leads to the limiting case of proposals such as Professor Kotlikoff’s idea to introduce what he calls “limited purpose banking” (Kotlikoff, 2010). That would ensure that each pool of investments made by a bank is turned into a mutual fund with no maturity mismatch. There is no possibility of alchemy. It is an idea worthy of further study.

Another avenue of reform is some form of functional separation. The Volcker Rule is one example. Another, more fundamental, example would be to divorce the payment system from risky lending activity – that is to prevent fractional reserve banking (for example, as proposed by Fisher, 1936, Friedman, 1960, Tobin, 1987 and more recently by Kay, 2009).

In essence these proposals recognise that if banks undertake risky activities then it is highly dangerous to allow such “gambling” to take place on the same balance sheet as is used to support the payments system, and other crucial parts of the financial infrastructure. And eliminating fractional reserve banking explicitly recognises that the pretence that risk-free deposits can be supported by risky assets is alchemy. If there is a need for genuinely safe deposits the only way they can be provided, while ensuring costs and benefits are fully aligned, is to insist such deposits do not coexist with risky assets.

On regulation, King notes

We certainly cannot rely on being able to expand the scope of regulation without limit to prevent the migration of maturity mismatch. Regulators will never be able to keep up with the pace and scale of financial innovation. Nor should we want to restrict innovation. But it should be undertaken by investors using their own money not by intermediaries who also provide crucial services to the economy, allowing them to reap an implicit public subsidy.

He concludes

There is no simple answer to the too important to fail nature of banks. Maturity transformation brings economic benefits but it creates real economic costs. The problem is that the costs do not fall on those who enjoy the benefits. The damaging externalities created by excessive maturity transformation and risk-taking must be internalised.

A market economy has proved to be the most reliable means for a society to expand its standard of living. But ever since the Industrial Revolution we have not cracked the problem of how to ensure a more stable banking system. We know that there will always be sharp and unpredictable movements in expectations, sentiment and hence valuations of financial assets. They represent our best guess as to what the future holds, and views about the future can change radically and unpredictably. It is a phenomenon that we must learn to live with. But changes in expectations can create havoc with the banking system because it relies so heavily on transforming short-term debt into long-term risky assets. For a society to base its financial system on alchemy is a poor advertisement for its rationality.

Change is, I believe, inevitable. The question is only whether we can think our way through to a better outcome before the next generation is damaged by a future and bigger crisis. This crisis has already left a legacy of debt to the next generation. We must not leave them the legacy of a fragile banking system too.

Related articles:


Niall Ferguson on Keynesianism

Steve Baker’s researcher, Tim Hewish, found an interesting CNN interview with Niall Ferguson on the US approach to the economic crisis:

… the way that the discussion is conducted it seems like there is only a Keynesian option and the alternative is just sort of passively waiting for disaster. I think there is a better strategy that we could adopt. Imagine radical fiscal reform that attacked not only the entitlements problem — that fundamental problem of Medicare and Social Security that is going to bankrupt the country if something isn’t done — and rationalised the tax code: simplified income tax, maybe even created just a simple flat tax rate; simplified, and indeed reduced corporate tax; created a federal sales tax. There is a way of creating a confidence-boosting fiscal reform … I’m depressed at how few people in Washington are prepared to talk about this option.

And later on:

one reason I’m sceptical of [Krugman’s proposed] response is that we used to do this. It’s not like we haven’t tried Keynesianism in the past. Indeed it was orthodoxy for most of the 60s and 70s that what you did in the face of unemployment was that you ran deficits and printed money. And guess what we ended up with? The 1970s — stagflation: double digit inflation and low growth. I don’t quite understand why Keynes is suddenly so fashionable … we need to look at some radical alternatives.

In his Ascent of Money, Ferguson takes a view of economic history that many Cobden Centre readers would question. Even after the financial crisis, he wrote,

The historical reality, as should by now be clear, is that states and financial markets have always existed in a symbiotic relationship. Indeed, without the exigencies of public finance, much of the financial innovation that produced central banks, the bond market and the stock market would never have occurred.

Read into that what you will. Personally, I suspect that two parasites can coexist symbiotically on a shared host. More encouraging was Ferguson’s December 2009 endorsement of Laurence Kotlikoff’s Limited Purpose Banking proposals.

Mutual funds are, effectively, small banks, with a 100 per cent capital requirement under all circumstances. Thus, LPB delivers what many advocate – small banks with more capital. Will this work? It has. Unlike so much of the financial system, the mutual fund industry came through this crisis unscathed. True, the Primary Reserve Fund broke the buck by investing in Lehman and had to be bailed out. But under LPB only cash mutual funds (invested solely in cash) would never lose investors’ principal. The first line of all other funds’ prospectuses would state: “This fund is risky and can break the buck.”

In any case, this interview is worth watching. High profile questioning of Keynesianism is always welcome.

There’s a follow-up article on Ferguson’s website:


Limited Purpose Banking?

In April, I reviewed Jimmy Stewart is Dead by Laurence Kotlikoff.

Yesterday, Jerry O’Driscoll posted a review of his own:

Chapter 1 of the book is titled “It’s a Horrible Mess,” and in it Laurence Kotlikoff, a professor of economics at Boston University, reminds the reader of the breadth, depth, and horror of the global financial crisis. It is a cure for the dispassionate observer of events, an indictment that would send all but those with ice water in their veins to sign up for the Tea Party Express. The book is a particularly well-written account of the crisis that begins in housing finance, spreads throughout the financial system, and then throughout the real economy. The crisis hit in tsunami-like waves beginning in 2007 and continued into 2009.

In Kotlikoff’s words, “We thought we had well-functioning banking and insurance companies with competent directors, world-class managers, responsible regulators, and incorruptible rating companies. But overnight, we it learned it was a sham.”

O’Driscoll thinks the Achilles heel of Kotlikoff’s proposals is their reliance on a financial regulator:

Kotlikoff excels at detailing the failings of the existing regulatory structure, but does not explain why his proposed system would work any better. If the regulators at the FFA face the same incentives as do those at the SEC (and the rest of Washington’s alphabet soup panoply of regulators), then we should expect the same outcome.

Government regulation, no matter the industry, typically fails for two reasons. First, there is the Hayekian knowledge problem. The information needed for effective regulation is dispersed across firms, the industry, and even the economy. There is no effective means for marshaling and centralizing the information within the agency.

Second, regulators are routinely captured by the industry they regulate. Through frequent interaction with members of the industry, regulators come to identify with the industry’s interests over the public’s. The revolving door between industry and government exacerbates that problem.

Even so, he concludes:

There is a great deal to recommend this book. First, there is Kotlikoff’s recounting of the crisis itself. Second, there is sense of the manifest injustice of a system in which bad actors get to gamble with other people’s money. Third, there is the challenge to do something radical to reform a system that is radically dysfunctional.

Read the whole review.


Ten plans for financial reform

Since The Cobden Centre was established by original founder Toby Baxendale, Dr Tim Evans, Dr Anthony J Evans and the author, we have assembled ten plans for financial reform which promise to deliver honest money and social progress. These are set out below.

There is today little doubt that the economic, fiscal and monetary crisis through which we are living was caused by the financial system. It turned out boom and bust had not been ended: we found we had been living on credit in a long unsustainable boom. Some of the flaws in the financial system have been pointed out on this site: in short, government intervention and flawed modern financial theory came together in a catastrophic mix.

Contemporary mainstream debate appears to neglect 200 years and more of monetary history, with an assumption that staying within the status quo is the only option. However, the Currency School vs Banking School debate and the Bullionist v Anti Bullionist Controversy were not, it seems, finally settled.

The Cobden Centre’s staff, fellows and board members have differing views on these plans. They are presented as competing routes to better banking and a more stable, sustainable and responsible system of social cooperation in the general interest.

For further information, please see our literature.