Intervening in bankers’ pay

I attended a lecture recently given by Dr. John Thanassoulis from Oxford University.  His objective in this lecture was to explore the question of whether there is a case for financial regulation which intervenes in bankers’ pay.  To cut a long story short, Thanassoulis’s conclusion was that, yes, effectively the Government should intervene in bankers’ pay and cap it at an appropriate level to lower the overall risk of the banking industry.  Leaving aside who decides what “an appropriate level” to pay bankers is, in my view there are a host of problems with Thanassoulis’s analysis and conclusions.

Before getting into the problems I will describe Thanassoulis’s argument.  Fundamentally, he believes that the level of remuneration at banks is a legitimate source of concern because the higher the remuneration the greater the following:

a)      Restriction of bank lending

b)      Increased risk incentive for the banker

c)      Increased risk taking by banks in general.

Thanassoulis characterises these aspects as an externality (in other words a cost that others have to pay rather than the banks themselves) thus requiring intervention.  Interestingly, he views competition in the banking industry as a problem, because in order to compete for the best banking employees banks must pay higher remuneration thus increasing risk.  In his view, competition in a free market can sometimes be a problem. 

Thanassoulis’s analysis results in him drawing other bizarre conclusions.  Because he is concerned that that banking executives are overly concerned with the short-term (unlike say government regulators) and because bankers discount deferred pay, banks should be forced to defer pay to force bankers to focus on the long-term.  Secondly, remuneration should be capped to a proportion of assets under management or profits, nominally to lower risk but also to refocus banking towards lending.  Banks exist to lend money but apparently this is not sufficient motivation for them to actually lend money.  It is also not clear who is qualified to actually decide what the cap should be or who can define the long-term versus the short-term.  Is the long-term 20 years or three?  Is the short-term three months or one year?  How far into the future can one accurately divine?  That is a question for mystics perhaps or maybe left for analysis after the fact.

Oftentimes, when you find yourself making conclusions that on their face are absurd it is wise to go back and revisit your premises.  In this case, Thanassoulis’s basic premise is that for whatever reason bankers took excessive risks.  Fundamentally, he believes that bankers took excessive risks because they were incentivised to do so by their compensation package.  And furthermore, he seems to lump “bankers” into one homogeneous group when in fact, there are many types of bankers who perform various different functions.  Essentially, when many people think of bankers, they often seem to have in mind equity traders, a group I could imagine would fit the public image of an aggressive, all caution to the wind, testosterone charged bankers.  Indeed, Thanassoulis appears to refer interchangeably between traders and bankers without defining either.  The reality of course is far more complex.

Certainly commercial bankers (such as RBS, HBOS, Lloyds, who needed varying amounts of bail-outs) tend to be a much more genteel group than might be suggested by their public image.  The approach taken by such bankers to lending is consideration of the borrower’s ability to pay them back, whether this is over three years or twenty (long term?).  Simply put, banks will not lend if they do not believe there is a reasonable chance of regaining their principal.  It is true that during boom times a lot of loans were made that ex post have proven to be unwise, but the risks weren’t fully appreciated at the time. Bankers, like many individuals, conducted themselves as though the good times would continue to roll.  The issue here, therefore, is not excessive risk-taking but a misspecification of risk.  Commercial lenders base their specification of risk on actuarial models which unfortunately, can be biased based on recent events.  Furthermore, these models cannot account accurately for the business cycle, thus risk estimates are biased downwards.  As such, bankers are making loans based on a belief that the risk is lower than it really is. 

Furthermore, the very nature of banks allows them to have more funds available for these improperly specified loans than they otherwise would.  This is for two reasons.  First, modern commercial banks hold fractional reserves.  At the height of the boom period banks were holding perhaps 1% of deposits on reserve and lending the rest out.  Secondly, where necessary, the central bank would provide additional liquidity (i.e. print money to support banks’ lending).

And so not only was the risk estimate of lending understated, the amount of money available to lend was too high.  If banks have money to be lent it will be lent.  This is the modern function of banks.  The pressure on banks to lend will increase over time as profits that are made on earlier successful projects need to be reinvested.  This results in the banks increasing in size (due to increased asset values, new employees required to manage the multiplying projects etc.) necessitating further lending in a crowded loan market.  Furthermore the increasing esteem of banks provides further pressure to become involved in prestigious new projects.  These developments will also cause banking pay to rise and increase competition in the market to hire bankers.

Additionally, with a lowered perception of risk the interest rate charged to borrowers will be lower than it otherwise would be.  This in turn encourages companies and individuals to borrow money and invest in projects or spend on frivolities. Indeed, borrowers will also have a lowered perception of risk, essentially for the same reason as bankers.  And so while the cross-hairs of blame are centred on bankers, the same mistakes were made by all market participants.  HMV and Woolworths are two such casualties that borrowed money for investment in projects that ultimately proved to be wasteful. 

Fiddling around with bankers pay, capping it, deferring it, re-portioning it is a complete waste of time, trying to solve a problem that does not exist.  Bankers’ pay, its composition or amount, has nothing to do the causes of the recent economic bust, other than that it is merely another symptom of the business cycle.  Bankers are well paid because the economy is set up to reward them in this manner.  The majority of the financial resources in the economy are funnelled through the banking system and bankers take their cut.  This is because of the legal and economic structure in which banks operate.  That is, the central bank fractional reserve system.  Thus, in good times and bad, banks disproportionately benefit.

In any event, the compensation of banking employees is not a major source of risk in banking.  The major risk factors in banking include (but are not limited to) the risk of the project itself, market risk (i.e. movement in variables such as interest rates) and the gap between short-term borrowing and long-term lending.  If well paid banking executives steer the bank towards high yield projects it is because they have the appearance of being relatively low risk, not because they are anxious to take on high risk, high yield projects.  Unfortunately, they are unaware that the benefits from such projects are an illusion created by the very business cycle that banks perpetuate.

The obvious solution is to abolish every aspect of fractional reserve banking, including central banking and fiat currency.  This will not happen any time soon as it benefits the government to have this system in place.  The government has access to a hidden tax through inflation and a willing scapegoat when things go wrong.  The villagers will go armed with pitchforks and torches trying to kill the wrong monster.

Indeed, while complaining that banks are not lending, (after criticising them for lending too much!) the government assures that banks will not lend in any great amount by making it impossible to do so.  The low interest rate environment, created by that agency of the government, the Bank of England, has made it impossible for banks to exit many of their positions for many years.  But we should recognise here that the primary objective of the government is to ensure the survival of their colleagues at banks around the country (and by extension the world) and not either a quick end to the depression or lending to businesses that may or may not need the funds.

As such, John Thanassoulis’s conclusions are quite invalid and will not solve any particular economic problem.  Instead, he has fallen prey to the smoke screen promoted by the Government which has focused the causes of the depression on trivial issues like bankers’ pay.  Indeed, in this manner the Government takes advantage of feelings of envy amongst the population at large to focus their rage away from government policy and the fundamental causes of the depression.  This is slightly analogous to a similar method used with petrol prices.  When prices are too high, it’s not because of the approximately 150% tax on petrol but because of greedy oil companies and price-gouging petrol station owners.


What is Money?

There exists a certain amount of confusion today about what money truly is, how it originated and who should produce it (the government or private individuals).  For this reason, it is useful to provide a brief summary of the origin or money and the differences between the various types of money.  In this manner it will become clear that money should only be produced by the market.

According to Ludwig von Mises [i], money evolved from the practice of indirect exchange.  Indirect exchange is where the seller of a particular good sells his good for another good, not for the purposes of consuming that that second good but because it is highly marketable.  In other words, now that he has obtained this highly marketable good, he has full confidence that he can now sell it to obtain the consumption goods he ultimately desires.  This highly marketable good is the common medium of exchange and is generally known as money.  There are secondary functions (store of value, measure of value, etc.) but these merely derive from the medium of exchange function.

The question remains, why is this good so highly marketable in the first place?  What original characteristics made it so desirable for people to use it as money?

To answer this question we must define what a good is.  Carl Menger[ii] identifies the following prerequisites for a good:

  • A human need for the item
  • Capacity for the item to satisfy this need
  • Human knowledge that the item can satisfy this need
  • Sufficient control of the item such that one can satisfy their need.

Absent one or all of these prerequisites the thing ceases to become a good.  Menger also notes that some items are treated by people as though they were goods even though they lack all four of these prerequisites.  This occurs when attributes are “erroneously ascribed to things that do not really possess them” or when “non-existent human needs are mistakenly assumed to exist”.  Menger called such items imaginary goods.

Next we must determine what makes a good valuable.  Menger[iii] makes it clear that there are two qualities that imbue a good with value.  The first is that it should be an economic (i.e. scarce) good.  In other words, the requirements (or demand) for a good must be greater than the quantity of the good available.  Second, men must be “conscious of being dependent on command of them for the satisfaction of our needs”.  To summarise, only scarce goods which we know can satisfy our needs have value.

Now we know what a good is and what gives it value, but what makes it useful as money?  According to Jorg Guido Hulsmann[iv], to be used as money the good must be marketable.  It must be a commodity; i.e. a valuable good that can be widely bought and sold.  One must know that if they sell their produce and receive this commodity in return, that they can instantly sell this commodity to obtain the goods they desire (i.e. food, clothing, etc.).

The monetary use of a commodity is derived from its non-monetary use. When we consider how money comes into being (through indirect exchange) we know this must be the case.  This is because (as Hulsmann[v] tells us) the prices initially being paid for a commodity’s non-monetary use allow one to estimate the future price for the commodity when it is resold.  This is the basis for its use in indirect exchange.

In the case of gold or silver, it is obvious that these commodities have a value independent of their monetary use. Gold has historically primarily been used as jewellery and today, like silver, it has many industrial uses that establish a non-monetary value.

Paper money

It is clear now that paper money established by government fiat cannot have any non-monetary value.  It is not a good (according to the definition by Menger) or a commodity that can be widely bought and sold.  No man desires paper money for its own sake.  It cannot satisfy any need of man.  As such, the quantity available infinitely exceeds the requirements for it.  It is valueless.  It is arguably, an imaginary good, as described by Menger.  Value has been attributed to it by the government even though none exists.

Paper money is useless to individuals and is only truly useful to the government which can use it to more easily tax us.  But if fiat currency has no value why then do people accept it in payment for goods and services rendered?

Over time people became accustomed to accepting “paper” money certificates having previously received and transferred warehouse receipts in the form of banknotes.  Nominally, these banknotes were backed by gold and people were generally confident of receiving gold from banks should they wish to redeem the banknote for such.  (In truth, however, banks, generally holding fractional reserves, strongly discouraged their customers from redeeming their banknotes).

Later, the practice of fractional reserve banking in which such banks issue banknotes only partially backed by specie was legalised.  In time only one bank (i.e. the central bank) was granted a monopoly on the issuance of banknotes governed by a gold standard in which each banknote can be exchanged for a fixed amount of gold.

This bank note monopoly would be reinforced with legal tender laws, put in place by the government.  Having taken control of money in this way, the government can “fiddle” the money supply in its favour by manipulating the gold standard (by arbitrarily fixing the exchange rate between bank notes and gold) until finally specie payments are permanently suspended.  At this point, the population has already become accustomed to paper money and whether or not it is backed by gold no longer seems important to them.  There is no significant protest of what is in effect, an appalling violation of property rights.  In the final stage, governments completely remove the gold backing from banknotes, granting them a new and powerful method of taxing the population.

Some critics argue that paper money has value not because of the government but because someone will always accept it.  This of course does not take in account the progression described above nor does it consider what would happen in a free market of money.  Were the government to cease its intervention in the money market people would attempt to hoard hard money (gold, silver, etc.) and spend only the paper money in an attempt to rid themselves of this worthless “currency”.  Everyone would want to spend the paper money and no one would want to accept it.  The value of paper money would quickly fall to zero in a free market.  Paper money has nominal value today because the government has full control of money production.

Misconceptions of money

Confusion concerning the difference between gold money and paper money is common.  To some money is money and what does it matter whether it is made of gold or paper?  Going further, some observers suggest that the best way to determine which money is superior is to allow fiat paper money and gold money to circulate in the free market and see what happens.  This is nonsense.  As we have seen above, paper money has no value and without government support would vanish very quickly.  Further, in a free market, there would be no such thing as fiat money.

A further misconception concerns the gold standard.  There are those who propose that our monetary problems would be solved if we would only return to a gold standard.  Often it seems that people confuse gold money with a gold standard.  They are not the same.  A gold standard is fundamentally a legal tender law established by the government.  It sets up an exchange rate between banknotes and specie (gold) which can be modified to suit the government and suspended at will (in times of war for example) in order to raise funds via inflation or protect favoured banks from bankruptcy.

There are those who consider money to be credit and vice versa.  While credit can conceivably serve as part of an indirect exchange (Hulsmann[vi]), it is not money per se.  It has certain disadvantages when compared to commodity money.  For example, credit is not homogeneous but can vary in terms of maturity, interest rate, amount, and of course the creditworthiness of the borrower.  Credit money is unlikely to be widely traded by individuals since it carries credit risk (i.e. the risk that the borrower will be unable of repaying the credit note).  Thus, it is unlikely that credit money will ever arise on the free market as the primary money.  Rather, it will remain the primary province of investors and money lenders.

Why should money be produced by the market and not the government?

Money should and can only be produced by the market.  The market will select the most efficient valuable commodity (gold, silver, etc.) as the optimal money.  This protects individuals from the costs of monetary manipulation by government (including the ultimate results we are witnessing now, the collapse not just of major banks but also the governments who are their clients).  Market selected money also reduces the likelihood and severity of the business cycle as it places a significant constraint on the fraudulent operations of fractional reserve banks.

Fiat paper money produced by the government represents a massive violation of people’s property rights and effectively amounts to fraud, counterfeiting and theft on a grand scale.  There can be no rational ethical or economic argument in favour of government intervention in money.  Fiat paper money is the tool by which government surreptitiously transfers wealth from the general population to itself or those whom it favours.

Can gold ever be inflationary?

Inflation is properly defined as an increase in the number of banknotes that is not backed by specie (i.e. gold).  Defined thus, we can see immediately that an increase in gold does not cause inflation or result in the business cycle.  As Murray Rothbard[vii] tells us and as discussed above, gold provides a non-monetary value in addition to its monetary value, and so an increase in gold implies an increase in the wealth of society (greater amounts of gold for industrial, medical or consumer purposes).  Will prices of other goods in terms of gold increase?  Possibly, but now we can see the confusion that can occur as a consequence of erroneously defining inflation as merely a rise in prices.  An increase in gold would be no more an issue than an increase in the supply of iron ore, oil or any other critical raw material.

Inflation is a result of some form of fraud (fractional reserve banking) or counterfeiting.  Consider the recent stories of tungsten filled gold bars – if true, then someone is getting something for nothing.  The buyer of the gold bars is paying in anticipation of receiving the value of a certain quantity of gold but in reality is receiving significantly less.  The buyer is receiving a “fraction” of the value he expects.  The value of this “gold” bar has been inflated and losses will result.  It follows therefore that losses will result from the fractional reserve system of banking, especially when the buyer of a gold certificate discovers that there is insufficient gold to cover the value of his certificate.


To conclude, we have found that the optimal money derives its value from its prior non-monetary use (i.e. that of being a valuable commodity).  Paper money has no prior non-monetary use and thus derives its value from government legal tender laws.  In other words, it has merely an imagined value.  In free market, there would be no fiat paper money.  Government has no place in the production of money.  Free money protects the population from the costs of fractional reserve banking and stunts the growth of government.  Furthermore, with free market gold money (or similar) inflation will be limited to the illicit activities of fractional reserve banks thus the length and depth of the business cycle will be greatly reduced.

[i] Ludwig von Mises, The Theory of Money and Credit (New Haven:  Yale University Press, 1953) 30-37.

[ii] Carl Menger, Principles of Economics (Ludwig von Mises Institute, 2007) 52-53.

[iii] Ibid. 114-115.

[iv] Jorg Guido Hulsmann, The Ethics of Money Production (Ludwig von Mises Institute, 2008) 23-24.

[v] Idem.

[vi] Ibid. 28-29.

[vii] Murray Rothbard, The Mystery of Banking (Ludwig von Mises Institute, 2008) 47-48.


Masters of disaster

I had the good fortune recently to attend a presentation given by Matthew Hancock MP, at the Houses of Parliament.  Mr Hancock was giving a presentation based on his latest book, Masters of Nothing. The purpose of his book was to discuss the causes of the perennial financial crisis and provide his conclusions on what should be done to prevent further crises.  Mr Hancock spoke at length of his admiration and support of capitalism, discussing how it has raised the average family in the West from a subsistence level two centuries ago to the comfortable existence we have today, and how it is transforming other nations around the world.  Unfortunately, his proposed solutions would have done nothing to prevent the crisis and also contradict his own purported belief in capitalism.

Mr Hancock identified several failings in banks which he believed had led to the financial crisis and if remedied, would prevent further crises.  Ultimately, these failings reduce to the following: poor decision making at banks, and too few women on their boards.

It has been determined after the fact that the decision making at the banks was poor.  Thus Mr Hancock proposes several solutions, all of which are disturbing.  The first is to appoint a “public protagonist” authorised to question major corporate transactions, such as mergers and takeovers, as management is apparently highly-incentivised to deliver deals that may not be in the interests of stakeholders.  Such a protagonist would be authorised to call special shareholder meetings on behalf of the public and challenge decisions made by the firm’s management.  Leaving aside the fact that this is an egregious example of government intervention in the affairs of (nominally) free market institutions, one would question how an individual or party removed from the day-to-day affairs of a firm would be able to have any useful input into the decisions of the firm.  Given that they have not been instructed or remunerated by the company itself but rather by the government, it is unlikely that they would have the requisite experience, information, or incentive to perform the task set out for them.  On what basis can government employees evaluate business plans?  None whatsoever.

Another proposed “solution” referred to creating a new crime known as professional gross negligence. This crime would only apply to managers at “systemically-important financial institutions”.  This suggestion is rather unsettling as it appears that poor decision making (determined ex post) as a manager at a financial institution could get you locked up.  Presumably, government officials who make poor financial or economic decisions affecting the nation would also face the same penalty.

Another peculiar idea is barring directors of failed financial institutions (i.e. those that accepted public bail-out funds) from joining the boards of other companies.  In essence, if the company of which you are a director fails, you are fired, by the Government, permanently.

For a man who speaks fervently of his admiration for capitalism these are disquieting suggestions.  They appear to move us along the path towards an authoritarian regime, overseeing a society that bears a capitalist veneer, overlaying an intrinsically dictatorial system where orders flow from the government to “businesses” and where the penalties for non-compliance are severe.

Mr Hancock does not stop here.

He suggests that 30 percent of company board members should be female.  If businesses do not comply with this gender “recommendation” then they will be forced to comply.  You get further with a kind word and a gun than a kind word alone, apparently.

Mr Hancock suggested that he had uncovered researched that showed that companies with a higher percentage of female board members outperformed those with lower percentages.  If this is the case then there is no need for government coercion.  The outperforming companies will succeed and the companies with lower percentages of female board members will be marginalised or go out of business.  Market discipline will force the change without need for authoritarian government action.

Mr Hancock clearly demonstrates the benevolent but authoritarian side of democratic government.  He appears sincere in his wishes to prevent a re-occurrence of the current crisis but his proposed measures are surely another well intentioned brick in the road to Hell.  And of course, they have nothing to do with the causes of the financial crisis.  It is instructive to note that Mr Hancock essentially blames excessive risk-taking by male executives as a cause of the crisis.  However, this crisis began with a subprime bust, wherein previously AAA rated bonds defaulted.  Additionally, the current stage of the crisis concerns sovereign debt – what could be safer?  While there were undoubtedly unwise loans or investments made, banks as a group are fanatical about protecting themselves from risk.  Thus the question is, why did these supposedly conservative investments result in such catastrophic losses?

The answer has been known for decades and we have seen the same scenario played out repeatedly.  It is the very nature of the financial and economic system that governments have created in the West, to continually create this cycle of boom and bust.  The deadly combination of fiat currency and fractional reserve banking necessarily leads to crisis after crisis.  These supposedly conservative investments resulted in losses because of the chain of events that is set in process by the inflation of the central banks and fractional reserve banks.  This inflation (i.e. fundamentally printing money and holding less than a 100% reserve) distorts the capital structure of the economy, creating an illusion of greater capital for investment than there actually is.  No value is created, merely the illusion of value.

This illusory capital is invested into the project of the day (subprime mortgages, commercial real estate, sovereign debt, etc.) inflating asset prices, which leads bankers to project ever higher capital returns and governments to project ever higher tax revenues.  As profits continue to increase, banks, entrepreneurs, and governments become ever more confident and ever more ambitious with new projects.  This leads to a greater appetite for risk at the same time that the assessment of risk is underestimated.

The probability of default is underestimated and recoveries from bankruptcies are overestimated while at the same time, general market interest rates are artificially low.  The default probabilities and recoveries are in error because generally, risk models are biased upwards by the recent positive data.  Furthermore, it is impossible for them to predict such a financial collapse.  Artificially low interest rates lead to lower discount rates for projects, thus encouraging managers to invest in projects that otherwise would have been dismissed.  This is why the rating agencies made poor risk assessments.

Consequently, reality will assert itself.  Businesses will make losses on projects begun that the market cannot support.  Projects will be cancelled and employees made unemployed.  Unemployed people will default on their mortgages – it is notable that the crisis began in the subprime market where the mortgagees were financially unstable.  New houses and office buildings are created but stand empty; other building projects remain uncompleted as new capital is unforthcoming.  Banks begin to make catastrophic losses in their formerly conservative asset portfolios as large numbers of bonds default simultaneously.  Governments find that as business profits fall their tax revenues also fall sharply, putting pressure on their ability to repay sovereign debt.

This has little to do with poor decision making at banks.  Bankers made rational decisions based on the information available to them.  However, they could not account for the business cycle which is an intrinsic part of the financial system in which they operate.  Mr Hancock’s “solutions” will increase the authoritarian nature of our government and introduce further distortions into the economy, but they will do nothing to prevent a further crisis.   This, of course, is the great danger of our political and economical system.  It goes beyond merely financial crisis and recession.  It leads to calls by wilfully ignorant politicians with the support of the confused and battered masses to increase the size and power of the State to interfere with the mechanisms of free and voluntary exchange, with disastrous and serious consequences for liberty.  It has its roots in the government control of money and its symbiotic relationship with fractional reserve banks.  This disaster will continue to unfold over time until money production is returned to the market and the practice of unethical banking is ended.


The collapse of capitalism

It is notable that as the continuing financial crisis (credit crunch, recession, sovereign debt crisis, whatever you will) develops, there are those observers who claim that capitalism itself is in crisis while others describe plainly the confusion about what economic system we currently have and what will happen if it does collapse.

Will Hutton hits upon the problem (this “…entire financial edifice, underwritten by tiny amounts of capital…”) but fails to draw the logical conclusion.  Unfortunately, Mr. Hutton fails to clearly define capitalism and does not show how the current system we have meets that definition.  Mr. Hutton, like many critics and commentators on the current crisis, seems to lack a unified theory that allows him to fully understand the causes of the current crisis and obvious solutions.  As a result, he is reduced to rather confused speculation and unsupported assertions.

There is a school of thought, (to which Mr. Hutton belongs) that asserts that businesses and state work together to increase wealth for society as a whole.  We are in the current mess because we have deviated from this basic principle and transformed into a system where entrepreneurs do what they want without any thought to state or society.

Strangely, the actual economic system we have seems to more closely resemble Mr. Hutton’s ideal society rather than the one which he criticises – but only superficially.  Government is heavily involved in business and banking, but businesses and government are necessarily antagonistic towards each other.  The primary source of this antagonism is, of course, taxation wherein the government helps itself, at many levels, to shares of the business’s income.  It also imposes tax collection responsibilities upon the business and the bureaucratic costs that go along with that.

Capitalism may be defined as “an economic system in which the means of production are privately owned and operated for profit”.  Similarly, a “free market” is one free of government control and intervention.  Individuals may freely and voluntarily transact with each other with no interference from the government (which may, for example, prohibit certain services or products, or impose certain terms through legislation).  There can be no crisis in such a system because it clearly is an intrinsic part of human nature.  One person’s will to trade their personal property in return for personal property voluntarily traded by another.  Even in the most government controlled environment (say a prison) this process of voluntary exchange will occur.  It cannot be stopped.

The actual system that is under threat of collapse is the system by which governments finance themselves over and above their explicit tax revenues.  It is the fiat money central banking system.  This system has grown and developed over the centuries and began in England during the seventeenth century with the establishment of the Bank of England.  The original purpose of the Bank of England was to finance the wars of England but it is now used to indirectly finance the welfare state and the various pet projects of bureaucrats.  It is the key method by which the state maintains its legitimacy as an agency with the ability to grant benefits to the populace.  This is to ensure a grumbling compliance while the state significantly and covertly increases taxes, through a range of methods, to enable its continued expansion.

By combining the existence of a central bank with a fiat currency and fractional reserve banking, the state can raise funds significantly in excess of the official tax rates.  The central bank buys the government bonds by printing money.  This purchase therefore is entirely financed by inflation.  Since it’s a rare thing for a government to run a budget surplus, this debt will never be repaid.  Rather there is a tendency for the debt to increase until the inevitable crisis hits.  But growing interest payments on this debt lead to a smaller slice of the budget pie for the population, future higher official taxes or higher future inflation when the central bank prints more money to buy more bonds (think Quantitative Easing).  In this way, the population are gradually taxed through the reduction of their currency’s purchasing power.

However, there is another link in this chain: fractional reserve banks.  The banks provide a capitalist veneer to the veiled and unofficial tax system.  On the one hand they purchase domestic government debt which they can either hold or sell on to the central bank (for a profit).  On the other hand they will buy foreign sovereign debt (such as Greek debt) which now apparently carries an implicit guarantee from the European Union and European Central Bank.  These banks create new money through the fractional reserve process and in practice, for every £100 a customer “deposits” into the system, the bank lends £99.  This vastly multiplies the funds available to the bank and allows them to not only increase their lending to individuals and businesses but also to governments, foreign or domestic.  Moreover, in the short term, the increased supply of credit lowers the cost of this debt.

It is easy to see how governments benefit from this system.  It allows them, not only to benefit from inflation but to vastly increase taxes on both current and future generations! This is essentially what government debt is – a higher tax in the future.  Much like a narcotic it is pleasure now but pain later.  But while the governments and banks generally benefit from the pleasure, the pain is felt by the citizenry.

In this manner, the government uses this cheap and apparently endless supply of credit to pursue its goals, whether they are war, welfare or infrastructure projects.  Additionally, this process creates an unsustainable boom, initially raising business profits and by extension, tax revenues.  This is the “financial edifice, underwritten by tiny amounts of capital”.  And it is government that is responsible for its existence as well as being a major beneficiary of it.

Inevitably, the boom must come to an end.  Not only are banks hammered by bad debts accruing from failing businesses, or individuals who can no longer afford to pay their mortgages, but governments are hit by plummeting tax revenues at the same time that interest rates on their debt shoot upwards.  For the banks the hits keep on coming with sovereign debt (from Greece, Spain, Italy and others for example) now effectively worthless and heading towards default. Therein lay the causes of the European sovereign debt crisis.

Now we can see clearly that this is not a crisis of capitalism or free markets.  It is a crisis of government caused by fraud on a grand scale.  The fraud of the fractional reserve banks which pervert the very nature of a bank “deposit”; the fraud of the central bank which counterfeits money and manipulates prices; and finally, the fraud of the government, which as an institution has over time created this inflationary and unstable financial system as a method to surreptitiously expropriate resources from the population which it serves, in order to finance its expansion.

Unfortunately for the governments, they are as vulnerable to market realities as are the banks.  And there is a limit to their ability to tax the population no matter what the method.  The Keynesian idea was that the increased government spending financed by the inflationary banking system will boost the economy so that the government can repay debt with increased tax receipts in the future.  Thus, it was believed that the boom would carry on indefinitely.  However, there is no escaping economic reality and the inflationary boom must end in a bust.

When the crisis initially started it was easy for governments to simply blame the banks.  As we have moved from a sub-prime housing debt crisis to a sovereign debt crisis, this story is less convincing.  Regardless, no matter how much governments publicly criticise the banks, they are bound to bail them out since banks are a crucial factor in government financing. And it is the population who will meet the cost of this bail-out.

Free markets will survive this crisis simply because the will to voluntarily produce and trade is an intrinsic part of human nature.  There is no crisis of capitalism, but there is a crisis of government.  Specifically, the fraud of government debt financing is now unravelling, having come face to face with economic reality.  Unwilling to confront this crisis (which would require a default by several governments at best and the likely bankruptcy of several major banks) governments will take the steps to prolong it until the inevitable and total failure of this deceitful system.


Why aren’t the banks lending?

It is notable that on a periodic basis, complaints are made in the press by concerned individuals, politicians, journalists etc. about the lack of bank lending to home owners, small businesses and others.  Loans are either priced too high or simply not available.  Small business owners complain they are starved of necessary funds and individuals cannot buy their first home.  House prices continue to fall due to a lack of liquidity and relative inactivity in the housing market.  The crosshairs of blame are centred squarely on the banks.

The approach is typically to bemoan the lack of lending and suggest that the Government should “do something about it”.  Rarely do these commentators turn introspective and consider the question “why”.  Why are banks restricting lending and requiring more onerous terms than during the boom times?  To ask the question is to answer it.  We are not in a boom, and leaving aside the Government’s arbitrary definition of recession, the economy has not yet recovered.  But obviously the banks must lend – this is how they make money.  If banks do not lend they go out of business.

Banks still have a significant amount of high risk debt on their books that needs to be liquidised.  Until this debt is repaid there is a limited supply of funds available for new loans.  Given the law of supply and demand, the cost of these new loans will be higher. Furthermore, given the riskiness on the banks’ loan book, the terms will need to be restrictive so that banks can reduce their risk profile.  This is, of course, the type of activity we should expect in the recovery phase generally.  That is, businesses liquidating malinvestments, taking losses, and should the business survive, making more profitable but less risky investments in the near term.  Banks are not behaving differently from other businesses, in this regard.

However, there is another factor affecting banks appetite for lending to businesses and individuals:  the Government.  It has been reported lately in the press that British banks have been the largest purchaser by far of Government debt in the past six months.  Of £39.8bn issued, British banks have purchased £36.2bn.  £36.2bn of bank lending going to the Government is £36.2bn less available to be lent to the private sector.  As the Government soaks up the supply of cheap credit this in turn increases the cost of this credit to the private sector.  Given the choice between a nominally risk-free loan to the Government and lending to a risky small business, it is obvious which borrower the banks will prefer.

This is indicative of the general irrationality of government.  On the one hand to insist the banks start lending and on the other hand, to take all the available funds for themselves.  It is clear that government cannot “kick-start” the economy, they can only slow it down, dragging out a recession for so long that few can remember what a boom feels like.

On the other side of the equation, it is likely that demand for bank lending has fallen.  This makes sense since if businesses are conducting the same risk reducing policies as banks (liquidating malinvestments and taking losses) then their requirement for bank finance would be lower.  Additionally, businesses would seek to fund from equity rather than debt in order to reduce the riskiness of their capital structure.  Ultimately, once businesses and banks alike have reduced their risk profile to a more sustainable level, the quantity of debt demanded and supplied will increase.

However, if all this is the case, why is it that certain politicians are demanding that banks increase their lending?  It is for two broad reasons.  On the one hand, they feel the need to be seen to be doing something.  This is to satisfy their various constituents (in this case it seems to be Small and Medium-sized Enterprises – SMEs – and the voting public).  The second reason is because they appear to be ignorant of economic reality (wilfully or otherwise) and are certainly entirely ignorant of the concept of risk as it pertains to both banking and business.

As noted above, the economy needs to be cleared of malinvestments or in other words, unprofitable product and service projects.  Capital (in the form of bank credit) needs to be redirected from these projects towards the most efficient use of these funds.  This occurs once these projects are sold off and losses taken, by the business or bank or both.  New loans will be made for lower risk projects and priced accordingly relative to the riskiness of the project and/or organisation managing the project.  As SME’s have shallower pockets than large organisations, naturally the price of credit that SMEs are offered will be higher, with more restrictive terms.  In some cases, if the bank’s appetite for this particular risk is insufficient, credit will not be extended at all.  This is rational behaviour.

The Government wishes to short-circuit this process and follow a political process for allocating capital and disregard the credit risk process.  This will result in an irrational allocation of capital, with funds directed by the Government towards an inferior place for it, one chosen by the Government rather than the market.  Thus the pricing for the credit will be lower than that dictated by the market, leading to a shortage of credit in other areas (say for first time mortgage borrowers), likely requiring further government intervention in the future.  Furthermore, projects that were previously unviable may instead of being liquidised continue to tie up scarce resources.  Thus the spectre of “zombie” companies, feeding on the lifeblood of potentially healthy and profitable projects.  This is not withstanding the distortion of the banks’ risk profile, possibility contributing to further financial instability in the future.

Thus the Government introduces further instability, uncertainly and inefficiency into the economy.  This cause of action is unsustainable and will result in capital consumption while retarding the recovery.  Already, the Bank of England is warning that the economy will remain depressed for a further three years.  This does not inspire confidence in either the Bank of England or the Government.  Government handling of the initial crisis has given us a prospective seven years of recession.  This is astonishing by historical standards but was predictable based on an Austrian economics analysis.

The reason this (unofficial) recession is set to continue is primarily down to the actions taken by the Government and its agency, the Bank of England.  On the one hand, raising taxes effectively slays the goose that lays the golden egg.  On the other hand, quantitative easing has resulted in an insidious transfer of wealth from the population at large to the banks, making people in general, poorer.  The banking bail-out represents a reward to banks for their excessive risk taking and incentivises them to continue their excessive risk taking in the future.  This is beside the fact that these bail-out funds support the malinvestments in the economy and delay their liquidation, thus drawing the recovery out further and further into the future, as Mervyn King has confirmed for us.

We can see clearly how the Government/BoE recovery plan has failed.  GDP growth has sputtered, manufacturing is on the slide, housing market activity is depressed, consumer spending is down and inflation is growing faster than income.  We are getting poorer, which is precisely the result we should expect based on a firm understanding of basic economics.  This understanding appears to elude the Bank of England which sticks stubbornly to its low interest policy.  Low interest rates are, ironically, one of the impediments to increased bank lending, not withstanding its negative effect on the recovery process generally.

There is no need to wait a further three years for recovery.  The answer is for the Government and the Bank of England to get out of the way and cease their obstructive activities.  This means the Government reducing spending and taxes, and the Bank of England to cease its interest rate manipulation, alongside an end to fractional reserve banking.  This will force banks to curtail risky lending, reduce the likelihood of the damaging business cycle and end the socialisation of risk and losses.


The Crime Known as Quantitative Easing

Recent economic data has convinced the Bank of England not to expand its Quantitative Easing program.  According to the Office of National Statistics, annual CPI inflation rose from 3.3% in November to 3.7% in December, 2010 and is now currently 4%. The overall expectation is that CPI inflation will peak at 4.4% by the middle of 2011.

This increase in inflation coupled with poor economic data (with GDP contracting 0.5% last quarter) has come as something of a shock to the Bank of England.  The Bank was apparently operating under the assumption that printing money was the way to get the economy going.  They are surprised that the result has been a significant increase in inflation and a worsening economy.

Rather helpfully, on the Bank’s website there is an explanation of how Quantitative Easing was supposed to improve the economy.  Quite clearly, the Bank explains that they purchased British Government bonds (gilts) and high quality (investment grade) bonds from private sector companies (banks, pension funds, insurance companies and non-financial institutions).  The Bank’s concern was that there was too little money “circulating” in the economy.  Using this method, the Bank was able to inject the much needed money directly into the economy and the companies that needed it.  The idea was two-fold; a) asset prices increase, wealth increases and spending increases; b) more money, means more spending, bank reserves increase, meaning more lending, spending and income increases, inflation arrives at the magic 2% rate and we all live happily ever after, growing fat off of the magic wealth creation machine at the Bank.  But there is a dark side to this fairy tale and at the risk of sounding clichéd, it is because in this case, more money really does mean more problems.

The problem is that the Bank is operating under the rather naïve assumption that printing money and rising prices mean that they are creating value.  If this were true, none of us would need to work.  The government could just issue us all with paper, ink and printing presses.  Whenever we needed to buy something we could just print off some money and go to the shops and buy what we need.  And of course, prices would rise, the shops would make lots of profits and apparent wealth would increase.  There is one nagging doubt however.  Who would make all the goods that we would buy, if we are all sitting at home printing money?  Perhaps we could get the Morlocks to do it.  Or maybe specially trained chimps.

Clearly, the Wizards of Oz, currently residing at the Bank of England, do not understand how value is created, how capital grows and how the wealth in society is generated.  To create value one must produce something of value, a good that someone can use to improve their wellbeing or allow them to subsist.  This good can be sold for money and the money can be used for consumption, held as a cash balance or to improve the tools needed to produce a greater quantity and quality of goods.  Ultimately, all money will be spent on either a consumer good (like a loaf of bread or a new pair of shoes) or a capital good (like a baker’s oven or shoe-making machinery).  The latter choice would result in an increase in capital (the value of all capital goods) and capital goods, and in the long run, a general increase in wealth.  The increase in wealth occurs because an improvement in the quality and quantity of capital goods allows us to create a greater number of better quality consumer goods in a shorter period of time.  This increase in the supply of consumer goods means that their price will fall resulting in a reduction in the cost of living for the society at large.  We will all be better off.  The important concept to take away is that for this increase in wealth to occur, somebody had to sacrifice some of their consumption to instead purchase a capital good (otherwise known as an income producing asset).  This increases the price of income producing assets relative to consumer goods.  From the perspective of a consumer like you and me, the goods we buy become cheaper and in a healthy economy, the prices of consumer goods fall over time.

The Bank of England does not believe that any sacrifice is needed today for an increase in wealth tomorrow.  In the Land of Oz you do not need to sell something of value in order to get money in exchange, you can just print money instead.  Obviously, printing up banknotes does not create anything of value.  What happens instead is the reverse of the process described above.  The increased supply of money, according to the fundamental laws of economics, will reduce its purchasing power, meaning that the relative prices of consumer goods will rise over time.  This will increase the cost of living for people in general, meaning their real wages will fall.  Because the cost of labour is now comparatively cheaper, rather than invest in an increase in capital goods, companies will invest in labour instead (Jesus Huerta De Soto, 2009).  This means there will be a lower quantity and quality of capital goods and a reduction in the future supply of consumer goods.  For the average person, this means a lower salary and a smaller selection of more expensive goods to spend it on.  Most of us become poorer.

But not all of us will become poorer.  By printing this money and handing it over to a favoured few in society (i.e. the banks) this is in one sense, handing them nothing and in another sense, pure and simple counterfeiting.  This is because, in the case of Quantitative Easing, the banks will trade this money for real or financial assets, or to their employees in exchange for their services.  This increased monetary demand for financial assets or banking services will bid up their prices.  The assets can then be sold in the near term at a profit and the banking employees will spend their increased salaries and bonuses on consumer goods before prices start to rise.  Bankers will certainly feel wealthier.  In fact, this whole process represents a wealth transfer from one group of people in society to the banks and a shadow tax on much of the population.  This is because the early recipients of the new money (the bankers and the Government) will get to spend this money before the prices rise significantly.  Slowly this new money will be dispersed around the economy but the further you are from the source the less it will be worth when you finally receive it.

The main beneficiaries of Quantitative Easing therefore, are the Government and the banks.  The banks buy gilts from the Government and then sell them to the Bank of England (just under £200bn’s worth) at a profit.  The Bank of England pays for these gilts with freshly printed money.  Thus the Government has a ready buyer for its debt and the banks become more profitable and apparently more stable.  Because of their now greater reserves and new found stability, the official rationale behind Quantitative Easing was that banks would then lend out these reserves to businesses and households thus stimulating the economy.  Except, in fact the opposite has occurred.  The economy has contracted, inflation is continuing to rise, net lending is down and unemployment has risen.

With a firm understanding of the basics of how wealth is created the Bank of England would have known this would happen.  Unfortunately, they operate under the Keynesian delusion of how the world works and their main objective would appear to be saving the banks (because we are all doomed without them) rather saving the economy.  With inflation getting higher and higher one might wonder why Mervyn King, the Governor of the Bank of England, does not simply raise interest rates or resell the gilts.  However, this would set the Bank of England’s plan into reverse, with higher rates leading to lower asset values, weakened balance sheets and an increase in mortgage defaults, leading to more bank losses and bankruptcies.

Clearly, the Bank of England’s plan is doomed to failure and has been from the start.  Mervyn King would have greater luck trying to empty the ocean with a bucket.  The problem is two-fold; a) the Bank of England views the recovery or liquidation stage of the business cycle as a problem to be solved and; b) it tries to solve this problem by doing more of what caused this problem in the first place.  This “solution” has prevented the necessary liquidation of unprofitable projects and write-offs of bad loans, and has continued to subsidise inefficient operations.  Quantitative Easing has resulted in a transfer of wealth from society at large to the banks and the Government, and has vastly extended the length of what would have been a short but sharp recession.  Quantitative Easing has made us poorer while benefiting a select few in society.

This is a crime by any measure.


Are the Banks to Blame?

Much has been made of the recent appearance of Bob Diamond, the Barclays Chief Executive, before the Treasury Select Committee.  Diamond attempted to defend the British banking industry from various charges such as “casino banking”, “bonus culture” and more simply “not lending”.  The fundamental accusation that has been laid against the banks is that they are responsible for the financial crisis and all of the problems that have occurred as a result.  It is often far easier to pick a scapegoat and punish them rather than face one’s own responsibility for personal failure.  But are banks a scapegoat or are they indeed to blame?

As usual with questions of this kind, the answer is complex, more complex that one might discern from reading the front page of a tabloid.  But the truth is out there, as it is said, and it has its roots in the special privilege awarded to banks by the State.  What is clear is that the State has established the legal structure within which banks operate.  This government mandated legal structure is a privilege granted exclusively to banks and it allows them to violate the property rights of their depositors by lending out their money while at the same time guaranteeing to return their deposit upon demand.  This unethical legal privilege (as explained by Jesus Huerta de Soto in his excellent book Money, Bank Credit and Economic Cycles, 2009) has authorized banks to operate in a fraudulent manner, laying the groundwork for the current depression.  And as if this were not enough, the British Government has acted to increase the severity of this latest depression by taxing the population to pay for the failure of the banking industry.  To add further insult to injury, the Government has reduced benefits for the poorest in society and increased them for the wealthiest (i.e. the banking bailout) in a bizarre reverse socialism.  In order to convince the population of the necessity of this unjust punishment, the message from the Government, oft repeated through the media, is that this bailout is necessary because we “need” banks.

In actuality this is close to the truth but not quite true.  The Government “needs” banks in their current form.  Everyone else would be far better off without them.  It is questionable just how beneficial such an industry is when the cost of it is increased taxes and an increased debt burden which has the potential to ruin the Government.  But Government officials operate with a short-term vision.  The crises of tomorrow are an issue for the government officials of tomorrow.  Today, the Government needs banks to buy their debt so they bail-out the banks with future taxes to be levied on less important members of society.  Bringing bankers before the Treasury Select Committee is merely a dog and pony show to placate the confused and angry masses.  The bankers are yelled at, an angry finger is waived, the bankers make one or two token concessions and the primary problem – fractional reserve banking backed by a central bank – is ignored.

Indeed, the Government had previously established a red herring for the masses to cheer by targeting banker’s bonuses.  So we are told that the “bonus culture” is the reason for the “excessive” risk taking of bankers.  All that need be done is that bonuses be reduced to a token amount, say, £2000, and the problem of banking crises would go away.  If only all complex problems in economics could be solved so simply.  Unfortunately for the government, the banks have made it clear that the bonuses will not be cut.

This emphasis on bonuses and bankers pay (or the banking crisis more generally) is much like the global warming hysteria; yet another excuse for increasing the size and power of government and for increasing taxes.  After all, what has been the end result of the bail-out but increased taxes?  Some may argue, with some justification, that an increase in taxes is necessary to cut the budget deficit and reduce the debt.  An alternative view is that is that is entirely unethical to impoverish one group of people in society to repay a debt to which they are not a party.  A staunch libertarian might argue that the only ethical approach would be for taxes to be made entirely voluntary and what debt the Government is unable to repay it would be forced to repudiate.  The functions that the Government currently arrogates to itself would be returned to private hands and the Government would return to doing what it does best – as little as possible.

Realistically, in the short term this is simply not going to happen.  The Government is not yet at the point of capitulating to economic reality.  So in the first instance it continues its strategy of slaying the goose that lays the golden egg by raising taxes.  This is in line with the expectation that changes in government spending are a predictor of changes in tax rates.  The Government increased its spending most recently with the bail-outs, so taxes are now raised to cover this increased spending. Thus one group in society is plundered for the benefit of another.  To be fair, the banks are not alone in participating in this plunder as a visit to any council estate will illustrate.

However, banks are the most important recipient of state aid because their operations impact all other participants in the economy.  Virtually everyone interacts with banks at some level, but more importantly the operations of fractional reserve banks set into motion the business cycle.  This occurs because of the special privilege awarded to banks by the state.  This is in fact a powerful form of state subsidy that allows banks to effectively lend money they do not have.  This process creates a supply of money at an artificially low interest rate for which there is no prior saving.  This can only lead to a distortion of the capital and property markets.  Projects are commenced to create products for which there will be no buyers and mortgages are made en masse to borrowers who will not be able to repay them.  Initially, businesses will prosper and people will feel wealthier.  However, the net result of this process is the bankruptcy or default of homeowners, businesses and ultimately banks, as we have seen most recently.

Banking failures prompted the establishment of the central bank as a lender of last resort to bail-out troubled and valued banks when needed.  The recent financial crisis has shown that even this is not enough and now we have the British Government supplanting the Bank of England as the lender of last resort in directly bailing out the banks.  It is likely that during the next, inevitable financial crisis the British Government itself will need to be bailed out as it has been in the past and as the Irish Government has been recently. It is clear that no matter how big or how often the bail-outs are made we eventually reach a point at which the system will fail absolutely.  We will reach a point at which there is no willing lender of last resort, at least on favourable terms.  This is the key danger of allowing this system of fractional reserve banking to exist.

To return to our initial question, are the banks to blame?  Yes they are, but they share the burden of blame with the architect of the current legal structure of our financial system, the British Government.  The State has permitted this special legal privilege that allows the existence of fractional reserve banking.  Fractional reserve banking allows banks to make loans not backed by savings at artificially low interest rates.  This in turn leads to the business cycle as described by Austrian Business Cycle Theory.  The State has created the system and the banks are willing participants in it.  Together, they share the burden of blame for the continuing crisis.


Spending Cuts, Student Revolts, and the Debt Crisis

It has been impossible not to notice the widespread student protests over the past couple of months against the government plans to raise tuition fees.  News reports have fluctuated between scenes of peaceful protest and more frequently, of scenes of chaotic violence, street brawls and vandalism.  Clearly if a point is worth being made, it is worth being made aggressively.

To more mature eyes these protests can appear to be nothing more than an almighty temper tantrum.  After all the justifications for the protests seem somewhat incoherent, ranging from refrains of “it’s not fair” that students should have to pay because the bankers created a crisis or “it’s not fair” since their parents attended university for “free”.  “It’s not fair” is the refrain of many a child when a parent refuses them “sweeties” or a stuffed toy for reasons known only to the “mean” parent.  As a child is dependent on its parents for its day to day living, many in this country have become dependent on the State for food, shelter and education.

Doubtless it has occurred to very few prospective students that perhaps paying for your own education, of which you will likely be the main and possibly exclusive beneficiary, is perhaps quite reasonable.  Certainly, in other countries — notably the USA — this is perfectly normal.

Interestingly enough, the debate appears to have taken place within a certain vacuum, in which certain questions have not been asked and have certainly not been answered.  The first question to ask is why students should not pay for their own education?”  The second, and more important question is whether the Government afford to pay anything at all towards education, university or otherwise?

The answer to the first question is intertwined with questions of fairness and entitlement.  In the UK over the past say, sixty years, we have been brought up to believe that we should all compete on a level playing field.  We are entitled to a free education, free healthcare, guaranteed employment or unemployment benefit when we are out of work.  We have a right to housing and a free pension when we retire.  There are countless other “rights” and “benefits” that we should have by virtue of being alive.  Not only are we entitled to a psychologically rewarding job but we are entitled to a fair wage.

It is fair to say (no pun intended) that the State has created an entitlement society where citizens without question assume these rights are self-evident and that they will continue indefinitely.  The mere notion that these rights are unsustainable is inconceivable to the citizens.  The idea that a student should pay for his own education is therefore too preposterous a question to pose.

At every turn the State has convinced the citizenry that these rights can be provided at will and continuously.  The dogma we are taught at school or fed to us through the media keeps us convinced.  Everything in society should be “fair”.  Unfortunately, the State’s own insistence that it can and should provide these benefits has provided the foundation for the massive protests we have seen and worse protests to come.  The State has studiously avoided explaining to its citizens the economics behind the benefits it offers.  To ask the average person the question of how these benefits are are to be paid for, it is as if one were speaking a foreign language.   Most people have a vague notion that taxes will somehow cover it.  They are aware that there is something called a “deficit” and something else called a “debt” but have little clue as to what these concepts have to do with them.  For some time, it has been to the advantage of the State to promote this kind of ignorance.  But now, the money is running out.  The benefits need to be cut.  And unfortunately the children do not understand.

This feeds naturally into the next question: can the British Government afford to pay for its citizen’s university education?

Britain currently has a budget deficit of approximately £149bn and official gross debt of £1.1 trillion (tn) – according to the Maastricht definition – forecast for 2010 to 2011.  Interest payments on this debt are forecast to be £44bn.  If we hold the budget deficit constant for the foreseeable future it is plain to see that the debt will increase by £149bn each year.  This in turn means that interest payments will increase each year.  Looking at this simplistically, drawn to its logical conclusion, this means that the interest payments will eventually crowd out the rest of the budget leaving no money for students, single mothers, the police or anyone else.  We would all be paying taxes just to pay the debt.

Most likely the Government would default a long time before reaching this point.  Therefore, it is important to gauge how close Britain is to bankruptcy.  Current GDP is just over £1.4tn.   We will leave aside the theoretical issues with GDP and for now assume it is a good proxy for the national income of Britain.  In this case we have a debt to GDP percentage of 79%.  The last time it was so high was during the mid-sixties when Britain was still recovering from an astonishing post wartime high (late 1940s) debt of over 230% GDP.  The average debt to GDP percentage over the past 20 years was 40%.  Total government expenditure for 2010-11 is forecast to be £697bn (50% of GDP).  Receipts forecast for 2010-11 are £638bn.

It might be objected that historically speaking the current debt figure is not disastrous since Britain survived the post-war debt.  However, while Britain survived the post-war debt crisis the British Empire did not.  As one colony and then another departed the ever diminishing Empire, ultimately Britain lost its “Great Power” status and was replaced by the United States in many of the regions that Britain previously dominated.  Furthermore, because Britain was virtually bankrupt after the Second World War, it was forced to accept the onerous Anglo-American Loan Agreement from the only friendly “World Power”, the United States.  Britain endured decades of economic depression and turmoil, suffering the loss of its manufacturing base and becoming known as “the sick man of Europe”.  Britain only really began to recover in the mid-Eighties.  It is fair to say, this is not a time we want to revisit.

According to the Government’s recent spending review (November 2010) the recent spending cuts will result in total spending cuts of £81bn by 2015.  This implies that the country’s debt will rise to 93% of current GDP by 2015 and interest payments will rise to £63bn per year (the third largest line item on the Government’s budget and larger than the entire education budget).  If no cuts are made then Government debt could rise as high as 121% of current GDP with interest payments greater than £78bn.  If the cost of servicing the debt rises above 13% of government revenues the country will have its credit rating downgraded (a definite prospect in the latter case).  This in turn leads to higher interest payments, greater difficulty in securing debt financing and increases the probability of cash-flow insolvency.

None of this considers the upward pressure on expenditures caused by the rising pension liability (contributing to a total on-balance sheet and off-balance sheet gross national debt of £6.5tn).  So while GDP may or may not increase over the next five years, expenditure certainly will increase.

As we can see, Britain is teetering on a knife-edge.  Another crisis such as the recent banking crisis (and it has not finished yet) could push Britain over the edge into bankruptcy and a repeat of the misery of the early post-war years.  Britain cannot afford to pay for student university fees or much else at the moment.  Clearly, the relatively conservative spending cuts will still result in a dangerous increase in debt and interest payments.  Without these cuts being made today, harsher and more drastic cuts will be made in the future.  The welfare state has had its day and it is crumbling.

Prospective university students are a fairly small and powerless group which is probably why they were among those targeted for these relatively minor cuts.  Given the considerable amount of disruption this small group has caused after being asked to contribute more for their subsidised education, it is disturbing to contemplate the public disorder that would likely erupt should more drastic cuts occur down the road.  It is not fair that the students should pay for university when their parents attended for free.  Likewise it is not fair that people who do not attend university should subsidise those that do.  More importantly, it is not fair that any of us living today should contribute to the future bankruptcy of this country and the squandered opportunities of our descendants.

The only moral and fair solution is a continuous and sustained reduction of the size of government in Britain. This will result in an increase in the prosperity of everyone living in this country and will make Britain a shining example of free-market economics to the rest of the world.


Eric Cantona’s Revolution

Eric Cantona, the former professional football player, recently called for a “bloodless revolution” against the banks. The idea, according to Cantona, is that people should, en masse, withdraw all of their money from the banks, causing a general banking collapse, ensuring the end of the current system and hopefully, a better tomorrow.

The attempt predictably failed but as a result of his suggestion, Cantona was heavily criticised by various bankers, politicians and journalists for his irresponsibility. Cantona was told to stick to football and leave economics to the “experts”. His proposal was suicidal and would lead to ordinary people losing their money were it successful.

Perhaps the fairest criticism of Cantona’s suggestion would centre on whether or not it would achieve the aims it appears to represent. Cantona’s objective of bringing down the system was crystallised within the context of a popular protest in France in October of this year, against government plans to raise the retirement age from 60 to 62. Clearly, if “the system” was brought down there would be no government pension for anyone.

The issue for the pension system in France is similar to that in the UK. As indicated in a recent IEA report the pension liabilities of the UK government are now so large it is impossible that they will ever be able to honour all of the payments. What will happen is that the UK will default on these obligations. The retirement age will continue to rise until it is unlikely that anyone will live long enough to draw a significant pension. It is instructive to note that when Bismarck created the national pension in 1889 he set the retirement age 20 years beyond the average life expectancy existing at that time in Germany. Either something similar will happen in the UK or these pension liabilities combined with the other debts of the UK government (now estimated to be £6.5 trillion) along with the persistent budget deficit, will precipitate a complete financial collapse of the government.

The primary criticism directed at Cantona is that a general banking collapse would cause more harm than good, that we need banks as much as they need us. If banks go down we all go down with them. This is the same rationale for the various banking bail-outs.

Apparently, without these banks economic growth will be sluggish and life would be more difficult (without electronic cash, banks to give us mortgages etc.). We would have no online purchases, no credit cards, and would be forced to keep a pile of cash in the house.

The truth of this is apparently self-evident and I have heard many an intelligent and educated person make many similar comments. Of course it takes very little thought to conceive of alternatives to the present system and indeed, these alternatives do exist. Depositary institutions that keep 100% reserves are available, non-bank lending marketplaces are popping up all over the Internet and you can buy cash-cards that allow you to transact online or wherever else you like. I would venture to say that banks in their current form are rapidly becoming obsolete.

However, in amongst the criticisms, as we would expect crucial questions are left out. None of these experts asks why our banking system is so fragile that provocative comments from an eccentric French footballer can create such consternation. After all, Cantona has merely pointed out an obvious flaw in the banking system which has continuously led to bank failures. The most crucial question to ask is why we have such a dangerous system that not only is so fragile that it tremors at the merest criticism but if we do not reach into our pockets to bail it out it will drag us all down into financial oblivion.

Why indeed do we have a banking system the existence of which is heavily dependent on the confidence that people have in it?

The answer of course, is that powerful interests in Western societies depend on this system as a surreptitious method to extract wealth from the population at large. Banks earn significant profits from fractional reserve banking but even more importantly, they provide a cheap source of funds for Western governments. These governments have a tremendous interest in protecting fractional reserve banks and allowing them to operate their confidence game. In fact, one could argue that governments could not exist in their current form without the fractional reserve banking system. And arguably, fractional reserve banks could not exist as they do today, without the government. So while publicly disparaging banks for their reckless lending, at the same time governments are taxing future generations in order to save their brothers in arms at the banks.

Of course, now it appears that the European governments cannot find a bucket big enough to bail out the sinking ship. Germany’s appetite for bailing out other countries banks appears to be sated amid concerns that these continual bail-outs threaten Germany’s financial stability. Thus it appears that the process of bailing out banks may drag us all down the sinkhole anyway.

It is possible that the reality of the situation is beginning to dawn on Western governments. Fractional reserve banking is unsustainable in the long run. And Keynesians are possibly, just possibly, beginning to realise we are all still alive in the long run. There is only so much (real) money and eventually we will run out if we continue to consume our capital – capital consumption being a key effect of fractional reserve banking – in this case by having European governments overtly divert resources from wealth generators (i.e. productive individuals) to failing and unproductive fractional reserve banks.

There is nothing new in stating this. But the important take away here is that people at large are beginning to realise how fragile the banking system is. Cantona’s interview is a YouTube hit and there are plenty of people who are angry at the banks or who have realised that banks are not safe places to keep your savings.

The idea that fractional reserve banking is fraudulent and risky is beginning to take hold. It is at its early stages yet but this idea will spread. It has been said before that ideas, especially ideas that are compelling in their simple truth, can spread like viruses and become impossible to stop. This is how regimes can appear to collapse almost overnight (such as the Soviet Union). Nobody accepts the old idea anymore and it is replaced with a new one.

There is however, no need to name a date for everyone to yank their savings out of the system. Unfortunately, at the moment most people would not know where to put their cash (if they have any) afterwards. However, as the knowledge eventually spreads, savings will transfer from fractional reserve banks to either 100% reserve institutions or be invested in transparent lending marketplaces at rates far higher than what one can earn in a savings account. There is no need for a con-man acting as middleman.

The collapse of fractional reserve banking is inevitable and it will be the market process that causes this collapse, no matter how governments or bankers fight to preserve it. It is only a matter of time and as Cantona suggests it is unlikely blood will need to be spilt. Reality has a way of making itself known sometimes brutally and abruptly, and other times more gradually. It remains to be seen how swiftly the process of monetary revolution occurs.