The Cobden Centre

In my previous article, I considered the possibility that Germany may finally succumb to the malaise spreading around it, causing German rectitude gave way to a little Keynesian counter-cyclicality, and the ECB to begin unreservedly to emulate the Anglo central banks.

A second, less probable outcome, if one hardly to be excluded, is that things have simply gone too far to be retrieved: that there is either a full or partial break-up of the single-currency, for either financial or political motives. Were this to occur, we might expect the newly-liberated nations to make a swift and vigorous recourse to that printing-press over which they would have thereby regained domestic control, with drachma, peseta, escudo, and lira being offered forthwith in profusion and PSI haircuts go hang!

The corollary might be – just as it was with Germanic Europe in the aftermath of the dissolution of Bretton Woods (and as it has been with the SNB in recent quarters) – that the initial response of the stronger nations would be to try to offset the knee-jerk appreciation of their own currencies – with the aim of sheltering their exporters and subsidising their bankers – to the point that their own rates of money creation were left helplessly hostage to the profligacy of their post-devaluation trading partners.

Though such a programme would not do much to save the population of the Olive Belt from facing the full consequences of the long years of public misgovernment and private malfeasance, even so the realisation of their loss of wealth would certainly not be able to be held up by coteries of creditors abroad and by political obstructionism and unfocused street protest at home.

Though we would still prefer to see these countries price themselves back into the market through successive reductions in costs and prices – and by shedding their insupportable indebtedness through administrative means, not force majeure – one sometimes has to wearily admit the pragmatism of Wilhelm Roepke’s formulation that sometimes a country becomes just so uncompetitive that a devaluation, backed up by credit restraint, is the only route out of the Slough of Despond, as it arguably was for 1992 Britain.

The only problem with this is the explicit proviso – that a fall in the exchange rate must not be accompanied by a new superabundance of credit with which to squander the chances of a more deliberate if protracted round of winning orders and securing investment by being cheap and working harder for lower real wages. Historically speaking that has decidedly been the road less travelled – look at Argentina today, for an off-the-peg (!) example of how easy it is to climb back on the old inflationary treadmill which has kept the nations who have ridden it in penury for centuries.

Thus, the greater risk is that the breaking of the shackles would see an abdication of all self-restraint to match it, adding licence to liberty: that nations already tired of the hair shirt would seek to maximise their short-term relief at the expense of their long-term health. They will certainly not lack for advice that this is exactly the course they should pursue. One can almost see the shrill triumphalism filling the op-ed columns of the NY Times even as one writes.

Before embarking upon this perditious way forward, we would do well instead to heed the words of the man we quoted at the start of this series, William Graham Sumner:-

To go on to further inflation… [by whatever methods]… means simply bankruptcy and repudiation. Each new issue will produce, only for a time, ease and apparent prosperity, to be followed in a few years by a new crisis and new distress, then a new issue, and so on over again. Reform will then be no longer possible, and we must run the course to its end, in which the paper disappears as ignominiously as the Continental notes.

As Sumner went on to write of the Greenback era of paper money, with a pertinent moral for us today:-

If we want [sound money], we here see how we must go to work to get it. It is not possible, save by withdrawing a portion of the paper. When we [left the standard], we overissued. The consequence was a rise of prices, increase of speculation, and export of specie. Large importations of merchandise followed, and exportation was loaded with disadvantages.

The course of resumption is the opposite in every particular. When the paper is withdrawn, prices fall, speculation is restrained, [hard currency] flows in. Importations are discouraged, exportations increase and go to pay for [the currency]. It may be added that, as the former process was smooth and agreeable, so the latter is hard and distressing.

No nation has ever had the courage to pursue this course except England, and she only entered upon it after two or three commercial revulsions had destroyed a large part of the paper, never immoderately redundant…  Other nations, like Austria and Russia, have gone on for generations, sinking deeper and deeper, crippled in their military and industrial strength by this inheritance, not knowing how to endure it or how to get rid of it, or, like France and our own colonies, have gone through bankruptcy and repudiation.

These are the alternatives, and it has been well likened to the choice of a man in a house on fire who jumps out of the second story rather than wait to be driven up to the third or fourth or the roof.

We rather suspect that, having set the fire themselves, when those who quit the single currency first smell its smoke, they will take the escalator straight to the penthouse, exulting as they do, and then go littering the stairwell with tinder from on high, the better to feed the flames licking about their feet.

In our modern world, where – as our author rightly said – few realise that neither is credit capital, nor money, wealth, but that the first of each pair can be, in over-supply, the destroyer of the second, we are only likely to be free of our pyromania, of our worship of the inflationary fire, when it has burned itself out completely. Hopefully, when it does, we shall find it has not devoured all that we are and all that we possess in its awful, final, fiat money conflagration.

I concluded my previous article with the observation that

in many regions of the world, the inevitable lag between cause and effect has seen a more slowly growing stock of money meet with a higher basket cost of goods. This is a toxic combination with which to confront such sickly economies, one which is now leading to a diminution of demand and, ipso facto, to a deceleration of the pace of those same price rises, as the inflationary impetus behind them slackens. Far from being an idiosyncrasy, this is no more than a normal, cyclical overlay on what are admittedly very abnormal underlying conditions.

In this, we can see the nucleus of an explanation for the recent downturn in the economic indicators as well as both the current and expected underperformance of many companies. In a world where the job of economic ‘recalculation’ has been falsified by heavy government intervention and where entrepreneurial repair-work has been paralysed by the elevated levels of uncertainty surrounding both the policy outlook and the fundamental soundness of so many customers, suppliers, and even competitors, such recovery as has been achieved, has been rooted in shallow, infertile soil. Thus, the adverse reaction to the diminuendo of many stimulus programmes has been all too predictable.

As such, this rollercoaster of incomplete recuperation, alternating between stimulus-driven boomlets and stimulus-starved mini-busts – with each successive switchback attaining lesser new peaks of output and generating more inflationary friction earlier in the ride – is something we foretold way back at the start of the crisis.

It may seem a long way off at this juncture – and the possible consequences of a Euro break-up or a gross miscalculation on the part of China’s central planners in the interim add an extra seasoning of doubt to the question of timing – but, as we seem otherwise destined to repeat this pattern for the foreseeable future, we can hardly hope to diminish the risk of repeating the mistakes of the 1960s in all their dubious glory.

Unwilling to countenance any increase in unemployment, those in charge of monetary policy will ease the pressure on the gas pedal only grudgingly and will effect the merest feint at the brakes when the bus starts fishtailing too wildly through the esses. The minute, however that any speed is lost or any of the passengers fall out of their seats and into the unemployment queue, the pedal will be planted firmly to the metal once more. And, yes, Mr. El-Erian and all you other naysayers, there is still enough in the tank to get the tyres smoking – as this whole series has been arguing from the start.

Eventually, of course, the passengers will learn to anticipate what the driver is going to do and will start to rush, en masse, to the outside of each approaching curve so as not to be slammed into windows or even thrown out of the open doorway when the driver floors it and wrenches the wheel into the bend. Though perfectly rational behaviour in a highly irrational situation, this will have the doubly detrimental effect of both increasing the instability of the vehicle and impeding its forward progress. In other words, the temporary boost to output and employment which each acceleration hopes to deliver will become more and more short-lived and the rise in prices will come faster and faster while each ascent will start from a higher and higher base until a complete degradation threatens.

The problem with this behaviour is that it is like that of a reforming alcoholic who treats himself to a wee dram every time the shakes get too bad, or a weight-watcher who treats herself to a midnight snack in order to stave off the hunger pangs until the dawn. This will be not just a Red Queen dilemma of running to stand still; not just Ben Bernanke and his clones reprising the role of Keanu Reeves in ‘Speed’, but a game in which it requires not just an acceleration to stay ahead of the self-cancelling change in prices which has been brought about, but a rising third derivative to outrace people’s growing awareness of what is afoot, on top of that.

What we should be concerned about is the sort of spiral which slowly, but progressively emanated from the 1960s Fed’s politically craven, ‘even-keel policy’ of facilitating Washington’s fiscal incontinence and of the one-sided focus it gave then – and is giving again -  to the unemployment side of its infamous ‘dual-mandate’.

Forty years ago, this led to a ratchet effect of higher inflation, higher unemployment, lower (real) equity prices, a massacre for bond holders, and soaring raw materials prices. It also broke up the post-war financial architecture which arrogantly presumed to mimic the eternal constant of scarce gold by linking values to an ephemeral dollar supposedly redeemable in the metal by fallible human diktat. The collapse of this flawed system ushered in the chaos of currencies free to gyrate wildly against one another, to the discomfit of investors and businessmen everywhere and triggering a race to the bottom among those wrongly convinced they could inflate the armies of the displaced back into work.

While it is easy to envisage such a deplorable scenario being re-run in the US, in the UK, in China, and in many of the emerging market economies, the suggestion that Europe might participate is usually treated with scorn, a nasty bout of Continental inflation seeming far too remote to contemplate, what with banks buckling and exchequers exhausted. Even here, however, there are two, admittedly divergent, scenarios which could see the balance shift decisively to the Dark Side.

The first is that Germany – despite its admirable international competitiveness and the fillip of a real-exchange rate touching eight year lows – may finally succumb to the malaise spreading around it in a ‘Zone where it directs almost two-fifths of its exports, or in those parts of Asia for which another one-sixth are destined. Given that it was happy to expand its fiscal deficit by more than 3% of GDP at a clip during the late Crash, one presumes that Frau Merkel’s strictures on good housekeeping might be somewhat less vehement were that to happen.

Once German rectitude gave way to a little Keynesian counter-cyclicality, it might just be that the non-Teutonic majority at the ECB would be able to overcome the now hollow-sounding objections of their Bundesbank colleagues and so could start unreservedly to emulate the Anglo central banks, as some of them have no doubt been itching to do all along.

This possibility does have form, for a great deal of the blame for the Continent’s current ills can be traced back to the fact that Euro-launch only shortly preceded the German weak patch suffered subsequent to the TMT implosion and that this led to a sustained period of monetary accommodation.

Note the stark contrast between the actions of the Bundesbankers then in office and those of their far less pliable predecessors. These latter had been anxious for the outcome when the Berlin Wall came down and Germany thus entered into a currency union with a poorer, less productive nation which had been used to less readily available and more expensive credit. So, they aggressively hiked interest rates while the adjustment went ahead, seeking to buffer the dangerous dilution brought about by the 1:1 conversion of Ostmarks to the real thing and damn the prospect of a recession anywhere in Europe, including in the (enlarged) Heimat itself.

A decade later, however, Germany entered into a wider currency union with several poorer, less productive nations used to less readily available and more expensive credit. This time, after a brief, 15-month, 1.7% real rate hike, its erstwhile guardians became so worried about a recession sullying the early years of the Project that they pushed real rates down, down, down for the next 4 years to the point that they plunged into the here-be-dragons territory of negative values (and that, on an EZ-wide basis which understated the price increases and hence the sub-zero depth, in the periphery). They would stay there all the way to early 2007, fermenting fiscal indiscipline in the public sphere and financial demoralization in the private one – from Countrywide, to RBS, to Amaranth and Sempra, to Michael Lewis’ ‘idiots’ in Dusseldorf.

Given the scale of this temptation, we might well ask: whose Bubble was it that finally burst around the time of the tenth birthday celebrations of the euro? Do the Greeks and Irish actually have a point when they insist they are not solely to blame for the miseries they now must suffer? More to the point, should the whole experience give us pause to wonder how resolute the stand for austerity will remain when it is German jobs – and German votes – which are next at stake and not far away Italian and Spanish ones?

In the classic textbooks, it is correctly said that it is mainly through the process of (private or public) credit creation that money itself comes into being – but those same books are also filled with an outdated depiction of the operation of a fractional reserve system which had long fallen into abeyance, in many of the major countries, even before the post-Crisis orgy of gargantuan over-reserving swamped all such calculation and further blinded those fond of reckoning everything in terms of the ‘multiplier’ between the monetary base and some broader credit aggregate (which they likewise infuriatingly insist of thinking of as ‘money’).

For example, from the halcyon days of the early 1960s, when certain important categories of US banks had to hold anything up to 18% of reserves against their net demand deposits, alongside somewhat lower percentages against numerous other classes of liabilities, the progressively less stringent nature of the regulations culminated in Greenspan’s reductions of the early 1990s and his ensuing authorisation of the regulatory arbitrage involved in so-called ‘overnight sweep accounts’. After this, banks could more than satisfy their piffling on-balance sheet needs (as well as avoid even more by exploiting the plethora of off-balance sheet possibilities open to them) by means of nothing more than the notes and coin routinely held in their vaults and ATMs.

Thus was yet another Faustian bargain consummated in an act intended to ward off an existing threat to ‘growth’ which provoked behaviour which would ultimately throw up an even greater one on someone else’s beat.

Not long afterwards, the newly-independent Bank of England was allowing its banks to set their own reserve requirements (!) and would even penalise them for being too cautious (sic) in their choice. Nor were the SNB or the BOC too modest to play the game. For its part, the fledgling ECB, under pressure not to make the new, single-currency landscape ‘uncompetitive’ for the poor darlings with whose care it was entrusted, opted for a derisory 2% levy and then trusted to the horribly-flawed Basel capital regulations to effect any real measure of restraint – with the execrable results with which we are still struggling today!

One consequence of their superficial understanding of a defunct mechanism is that a decisive majority of pundits and policy-makers alike now fears that any degree of credit contraction whatsoever necessarily signals that the economy has crossed the event horizon on its way into the maw of a crushing black hole of unstoppable monetary deflation.

The small kernel of truth around which this canard has been constructed is that where credit has been perniciously turned by the banks into money, the termination of that credit must be reflected back in the stock of money, too. But there is no longer any foundation to the hoary old premise that, just as the fractional reserve process is supposed to be the determining factor in multiplying money up during the expansion, then any later monetary cancellation must cascade through an equal and opposite number of deflationary iterations during the contraction. If you doubt this, go out and look for yourself. You will search in vain for a currency area of any note – Turkey, perhaps? Brazil of late? HK? – where there has been much in the way of a nominal decline at all, regardless of how the higher aggregates have behaved.

Thanks to this misapprehension, far too much is being made of the fact that the banks are not today taking the deluge of ‘high-powered money’ with which they have been presented and multiplying it up with the kind of relish the textbooks suggest they could – and the underconsumptionists and monetary cranks of all stripes say they should. As we all know, they currently rather prefer to park $100s of billions back at the central bank out of distrust for their peers and from fear for their own future funding abilities.

But again, this cavil entirely misses the mark: it is the nature of the entries on the liability side of the commercial banks’ balance sheets which constitute money, not those on the asset side, and the ones that count have, in general, been rising.

Granted, the CBs have to be more far aggressive in their actions if they are to provide all the combustible means for a monetary expansion and not just the catalyst for it, as in less troubled times, but that does not mean that they lie powerless, just that their interference must be more nakedly undertaken, more ‘unorthodox’, if you will. As the merest glance at the size of their balance sheets will show, they have taken up the challenge with unprecedented relish these past few, troubled years: the Fed, the ECB, the BOJ, the PBOC, the BOE, the SNB, the RBA  – to name but a few.

Nor has the world changed in any untoward way so that, no matter now much new money is conjured into existence, it will miraculously remain inert – that it will have no influence on either individual prices, nor the general trend of such prices. We thought to have shown enough charts demonstrating the undeniable effect of the Fed’s actions these past three years to dispel that particular myth, but, for those of you asleep at the back of the class, here we go again.

In the period since the Lehman-AIG debacle, the Fed has tripled its balance sheet and swelled its security portfolio by a factor of 5 ½.  Far from being in vain, this has boosted money supply by 37%, a sustained, double-digit annual pace of increase only seen twice before in the 50-year record: the first in the months which included the last, feverish run to the Crash of ’87; the second directly following those same regulatory changes of the mid-90s mentioned above, a relaxation which lead to a sustained outbreak of what its author described with what one hopes was a touch of faux consternation as ‘irrational exuberance’ and so onto a mania which achieved its apotheosis in the Nasdaq bubble, six, heady years later.

This time, too, after a couple of months’ lag as the new money filtered in, the results of the inflation were similarly unequivocal: the S&P rose 40%, the Value Line more than twice that, as junk bond spreads halved. US business revenues grew by more than a fifth, while non-financial profits rose by four-fifths. Aided by a like display of monetary largesse elsewhere, world industrial production bounced 20% from its spring ’09 trough to hit a new, all-time high: world trade volumes did likewise with a 27% rebound. Despite the correction of the past six months, commodity prices still stand almost 90% above the levels of three years ago, with oil up 160%, copper up 150%, and gold 145% higher than they were.

In more familiar, macro terms, this period also saw the third-fastest biennial acceleration in the US PPI index in the post-WII era (places one and two go to the time of the Korean War and the first oil shock), while the yearly US CPI change climbed by no less than 5.7% from its trough to register its fourth largest acceleration in sixty years (being beaten additionally by the second oil shock during that stretch).

So, please, don’t tell us money no longer matters, or give us any nonsense about liquidity traps and deferred purchasing behaviour amid a deflationary mindset. None of these largely phantom phenomena are able to repeal the laws of economics, period.

What is true, however, is that lately the rate of money creation – and in particular real money creation – has been slowing in most regions outside the US itself – not least in China, Brazil, India, Britain, and the Eurozone. Real money supply matters since it is the volume of goods able to be moved per unit of the medium of exchange which is a primary short-run determinant of activity and, to paraphrase Andrew Dickson White’s observations about Revolutionary France’s disastrous experiment with a paper currency, money is never so scarce as when there is too much of it.

What he meant was that once people learn to adjust to the inflationary impact of a greater issuance of money, their very anticipation tends to push prices up ahead of its influx. Every buyer still has a seller, but the former becomes ever more keen to be rid of his cash while the latter quotes high, adding a premium for fear of the loss of purchasing power he fears to suffer when he comes to buy, in his turn. Such a psychological reinforcement of the quantity theory reduces the stock of money’s real total even faster to leave many of its users short of the means to obtain feed and clothing for themselves, even as the printing presses are running flat out to boost its nominal supply.

In less extreme circumstances, the same features apply. If the Fed manages to put another $10 in your pocket, but its actions simultaneously push the price of groceries up by $15 dollars, you are inarguably worse off. Thus, we should stop our ears to the prevarications of the state’s paid apologists and recognise that, even in the benighted West, the initial inflationary impact of the various, post-LEH stimulus programmes was to cause prices everywhere to rise.

And, yes, Mr Keynes, even amid relatively high levels of unemployment and alongside the low utilization of a phantasmagorical concept of utilizable ‘capacity’. This embarrassing departure from the canon is simply explained by the fact that the endowment of labour and capital is far more richly heterogeneous than the aggregative simpletons can conceive. Should we be surprised that the  total was riddled with far too many errors under the infatuation of the Boom and that these now linger on as  hopelessly redundant relics which contribute little or nothing to the functional core upon which we can call.

As those prices continued to rise, they became politically embarrassing enough, in the majority of cases, to see the same pump-priming which had caused them diminished or even partially reversed. Even in Ben Bernanke’s 1937-phobic America, ‘quantitative easing’ has been suspended since June – though its echoes continue to be heard most strongly – pending sufficient excuse for the Mighty Oz to begin hauling again at the levers hidden behind his curtain, probably just in time to aid the incumbent’s campaign for re-election.

As we have already discussed in some detail, in the Eurozone, the far less purposeful retardant to ongoing money growth has been the repercussions arising from the belated realisation that it is simply farcical for the most intractably indebted Provider States to pretend to guarantee the credit of those banks reduced to friendless penury by earlier buying the debt that same dissipating state issued in order to prop them up, or to compensate – in grand Keynesian, push-me-pull-you fashion – for their enervated retreat from that orgy of uncritical lending which had first undermined them. Here, too, the change in real M1 has been barely positive from some time past.

Thus, in many regions of the world, the inevitable lag between cause and effect has seen a more slowly growing stock of money meet with a higher basket cost of goods. This is a toxic combination with which to confront such sickly economies, one which is now leading to a diminution of demand and, ipso facto, to a deceleration of the pace of those same price rises, as the inflationary impetus behind them slackens. Far from being an idiosyncrasy, this is no more than a normal, cyclical overlay on what are admittedly very abnormal underlying conditions.

This article is the sixth in a nine-part series on credit.

The other great class of credit whose extinction is not to be trembled at, but instead warmly welcomed, is the otiose round of ‘pig on pork’ interbank (and inter-‘shadow’ bank) lending and borrowing. This is an activity which serves little useful purpose beyond the basic one of allowing a limited series of transfers from a depository with preternaturally cash rich clients and atypically few cash poor ones, so that it may fruitfully collaborate with a sister institution in the converse situation, to the shared benefit of all. Outside of this, for Bank A to lend to Bank B so that B can buy the paper issued by Bank C which then deposits the funds with Bank A, each hoping to extract a few basis points advantage from the deal in their turn, is a gross exercise of financial incest, needlessly tying up resources and capital, both.

In fact, if we look at the instance of Europe, the truth is that, for all the undoubted pain and dislocation being suffered as we transition from an unsustainable whirl to something (hopefully) more sober and well-proportioned, this has been exactly what has been taking place.

In the three-and-a-quarter years since Fannie, Freddie, Fuld and AIG FP exploded our mass delusion that we had reached the Land of Cockaigne simply by pooling, slicing, and layering in upon itself more and more debt, granted on easier and easier terms to worse and worse borrowers, European banks have actually increased their aggregate lending to households and private non-banks in the Zone by €760 billion and they have extended €350 billion more in credit to EZ governments (not an unmitigated benefit, this, of course). In marked contrast, they have reduced lending to one another by over €310 billion, withdrawing another €500 billion or so from non-Eurozone banks along the way. [There are, naturally, exceptions to this broad generalization, notably in Spain – where business lending is a hefty €100 billion below its April'09 peak. The point, nonetheless, remains a valid one].

None of this is to argue that the stresses are not very elevated, nor to pretend that the inevitable differences in the applied microstructure of such vast sums have not thrown up large numbers of winners and losers – whether deserving or undeserving – but it cannot be overlooked that with 35% of their total Eurozone assets consisting of exposures to one another (and 55% of the extra-EZ loans and non-equity securities on their balance sheets funding banks outside the single-currency area), they still have €11 trillion – some five times their combined capital – to go, if they are to shrink back to a less leveraged footing without doing more harm than is necessary to the world of work it is supposedly their primary purpose to serve.

Back in the day, arch Eurocrat, Jean-Claude Juncker, boasted that he and his fellow King Canutes vouched to ‘fully assure’ that no ‘systemically-important financial institution’ in their fiefdom would be ‘allowed to fail’ – the arrogant aside being that all the Zone’s 6,000-plus credit institutions fell into that category of NTBTF – No-one Too Bad To Fail.

Such an exercise in Hubris inevitably called forth the savage shade of Nemesis and so, three years and more later, we have reached a pass where hardly a single SIFI can assure its peers that it can be saved, nor its sovereign’s rating with it.

Accordingly, many observers point to Europe as making the case that the crisis has finally vindicated Keynes and delivered us, not just to the zero-bound, but to a veritable absolute zero of economics where the ability of money to have any effect has been completely frozen out.

But, far from Europe being the exception that proves the rule, so hopelessly have its drowning banks and foundering governments come to clutch at one another as they sink that much of the ECB’s present intervention – vast as it is – may not be a means of direct inflation, at all, and so cannot be deemed to have ‘failed’.  You see, what is mostly afoot in Europe is that the national components of the system are simply being drawn into inserting themselves – providing a credit wrap if you will – between former correspondent banks in the different member states who have come to harbour unallayable suspicions about each other’s true standing and so will not deal directly with one another as was their wont.

If we imagine that, in the good old days, a Spanish house-buyer might have borrowed from his local bank to stock his house with shiny, new German, kitchen appliances, this would have led to their export manufacturer adding to his monetary holdings at a German bank, with this last being happy to ‘recycle’ this fraction of the Great Teutonic Current Account Surplus by lending it back to the original Iberian agent of inflation.

Nowadays, alas, such insouciant laissez passer has become unthinkable, forcing the Spanish lender to close the gap by repoing or selling some of its securities holdings to the Banca de Espana. The German creditor likewise prefers to place his funds on deposit with the Buba and the transmission is completed between the two via the TARGET system. ECB assets – and the portion involving government bonds – will thereby have risen without any new monetization of debt whatsoever having taken place.

To see some evidence of this putative exchange in action, note that the Bundesbank’s intra-ECSB exposures rose €360 billion in the three years after September’08, the Netherlands’ by €80 billion (the pair having put on another €90 billion between them in the following two months), while German bank claims on other EZ members declined €180 billion and Dutch ones by €35 billion. A further leakage was to be found in whatever part of their €245 billion combined cutback of exposures to EU banks outside the single currency it was which related to the three English clearers who access the system via the DNB.

On the other side of the ledger, the data show also that the ECB’s balance sheet waxed €540 billion fatter, (to which not insubstantial total the NCBs added another €910 billion during the period in question), by way of the acquiring – among other ‘assets’ – €250 billion in Euro area governments and €690 billion in claims on the region’s banks and offsetting this with €1,040 billion in deposits accepted from the MFIs in their turn.

To gain a sense of the scale of these numbers, we may note that, in the year to last November, the Buba’s TARGET balance rose to 20% of German GDP and the change was equivalent to 125% of the whole twelvemonth’s current account surplus. For the DNB, the comparables were 25% of GDP and 100% of the surplus – and lest us not forget that the Bank’s dealings with Lloyds, HSBC, and Standard Chartered may make that a low-ball estimate, given the net drain likely to result from the UK’s own deficits.

Now we come to the nub of the matter. Note that, in the 22 months from August’08 to June’10, Eurozone government net liabilities increased by around €1.150 trillion. Of that total, no less than €573 billion – pretty much a half! – was bought (monetized) by the MFIs (+€443bln) and the ECSB (+€130bln) between them. In that same stretch, EZ M1 expanded at a rip-roaring 12.6% annualized pace, or by €920 billion – so the fiscal deficit alone was responsible for five-eighths of this significant inflationary impulse.

From that point on, it was downhill all the way, however, and while the next year-and-a-half saw the central bank increase its rate of accumulation (+€151bln), MFIs were now trying to dump some of the toxic waste they had been previously seduced into warehousing, cutting their total by €119 bln to leave a picayune, combined addition of €31bln (again giving some credence to our ideas of a shift between monetizers occurring, rather than an outright intensification of their joint efforts).

Guess what was the upshot? If you said money supply slowed to a recession-threatening stall, you qualify for a gold star. In contrast to the incipient Weimarian rush which went before it, M1 inched up by just €62bln, or less than 1% annualized – barely a twelfth of the increment per month which prevailed in the preceding spurt. Reversing from multi-year highs, this spurt just pipped the time-span to the LEH Crash itself to set a Euro-era record nadir for any like period.

Keeping in mind this direct, intuitive linkage, there is therefore no prima facie reason to bemoan the supposed inability of the modern, unanchored central bank to influence the money supply, no matter how firmly the course is set for a general retrenchment of borrowing: it simply needs to make up its mind to ruin the currency and act in a way which is consonant with its aims.

We re-iterate the point we have made over and over again throughout this episode, following the ideas of Leland Yeager: for as long as the national currency has not been totally repudiated by its habitual users, money does not have to be lent into existence, it can be spent into existence by the state. Should that state be temporarily indisposed – which may be the case in the ‘Zone – as our Lords and Masters at the central banks have gleefully discovered, they nonetheless enjoy a near unlimited scope to buy up existing, as well as newly-issued, non-money assets from the non-monetary sectors by writing cheques upon themselves and so, by this means can engineer any increase in demand deposits they wish – i.e., create as much new bank money as they will, even if it means they must nationalize the whole apparatus of finance along the way.

Thus, the issue is a matter of politics, not economics. As central banking insider par excellence, Charles Goodhart, aphoristically put it, long before the current turmoil erupted, ‘deflation is a policy choice’.

As I argued in yesterday’s article, disruptions caused by an artificial excess of credit will squeeze margins and lead inevitably to the demand for yet more credit. Taking this particular tiger by the tail may well defer the day of reckoning, but only at a steep cost. The business first becomes unprofitable, then barely cash generative and, at last, a mere Ponzi scheme reliant on infatuated bankers and intoxicated shareholders for its continued existence, but ever more susceptible to any shock to its credulous sponsors’ confidence as its balance sheet deteriorates in lockstep with its chances of achieving any more than a specious, bubble-supported, stock-jobbing sort of return on invested capital.

Indeed, it is in this pathology that we might seek the explanation for a very curious observation; namely, that certain key measures of business confidence, such as the US NAPM or the German IfO (themselves usually responsive to changes in business revenue), tend to wax and wane in opposition of the ratio of a ‘broad money’ measure – such as M3 or total banking assets – to a narrower, more proper M1-type gauge.

One has to think about this for a moment to see how perplexing it appears on the surface. Here we have the blessed ‘multiplier’ in full operation, with several dollars of credit being added for each unit of new money created and yet industry is becoming more, not less, uncertain of its prospects as they are.

From a mainstream perspective this makes no sense at all, but, to an Austrian the answer may be that the oversupply of credit has served to hyper-extend the chain of production in the manner outlined above. The fundamentally alien, unintegrated nature of much of that incremental activity means its cash flow is at best scanty, at worst negative. We might say that the ‘length’ of the Hayekian triangle or cone we use to envisage the productive structure has become disproportionate to its volume (broadly the total revenue flow rate of the economy), given that the height of end-spending has not only not become reduced to compensate (as saving takes place), but is actually now pushing higher.

Only the cement of credit can shore up this unstable edifice, but with the mortar increasingly lacking the  monetary fixative necessary to maintain its integrity (through generating sufficient means to make interest payments, meet amortization schedules and the like), this, too, will soon give way and – barring the implementation of an ill-advised, official policy of forced petrification – which seeks to immure the living so that the zombies may be spared the tomb – the ensuing crash will usher in the grim austerity of the Bust to succeed the giddy abandon of the Boom.

Up to that last roll of the dice, as Hayek himself phrased it, we will be suffering from the foredoomed tail-chasing of ‘an investment that raises to the demand for (finance) capital’, though some will see this fateful scramble as a sign of a potentially remunerative chance to fulfil the falterers’ importunate demand for funds. Sadly, those who hold that ‘as long as the music is playing, you’ve got to get up and dance’ tend to find this is no Jazz Age Charleston, but rather a deadly tarantella.

In a passage we have frequently quoted for its insight, the great Richard Cantillon expressed it thus, according to the usages of his own time:

In 1720 the capital of public stock and of Bubbles which were snares and enterprises of private companies at London, rose to the value of £800 millions, yet the purchases and sales of such pestilential stocks were carried on without difficulty through the quantity of notes of all kinds which were issued, while the same paper money was accepted in payment of interest. But as soon as the idea of great fortunes induced many individuals to increase their expenses, to buy carriages, foreign linen and silk, cash was needed for all that, I mean for the expenditure of the interest, and this broke up all the systems.

This example shews that the paper and credit of public and private Banks may cause surprising results in everything which does not concern ordinary expenditure for drink and food, clothing, and other family requirements, but that in the regular course of the circulation the help of Banks and credit of this kind is much smaller and less solid than is generally supposed. Silver alone is the true sinews of circulation.

Substitute properly-defined ‘money’ for ‘silver’ and think TMT, sub-prime, and Chinese reflation instead of the South Sea Bubble, and you have it in a nutshell.

Once the mood shifts, of course, there arises a general desire to pay down existing debts and an anxiety not to incur more, a restorative tendency which strikes terror into the heart of all the capering tribe of macromancers – befuddled to a man, as they are, by their economics of collective paradox, their reverse quantum mechanics of counter-intuitive large-scale phenomena.

For, by their will-o-the-wisp lights, if no-one stands ready to reinforce failure by outspending his means, the moment his neighbour rediscovers the compelling logic of good husbandry, this disavowal of a dreary cortège of serial ruination implies that a total and coincident ruin must instead be the sorry result.

It should, however, be clear from what we have argued above that since much credit is not in any way actively monetized, and that money is what ultimately counts, the discharge of that portion of the stock of credit should have few further consequences beyond the benign ones of reducing one man’s exposure to the soundness of another and hence of lessening the financial vulnerability of all – not least that of any bank which happened to intermediate between the two.

After all, where this is the case, in order to pay off his borrowing, the debtor must either have gained command over a valuable asset, contributed to the production of a good, or performed a useful service – i.e., he must have been a net economic contributor. To extinguish the charge held against him, he must make shift to offer one of these directly to his creditor, or else to sell them for money to a third party and offer that in its turn.

His obligor, who earlier was only holding an unfulfilled title to a future economic satisfaction, is thereby given the concrete means with which to enjoy the fruits of his former thrift with no further delay, whether by reinvesting the money (or goods) received in a productive undertaking, or by going out and spending what he has been rendered – or what he has thus been spared from expending elsewhere – on some good, old-fashioned, exhaustively indulgent consumption.

How can this be an ill? Is not to say so the same as to argue that if I borrow my neighbour’s lawn mower, promising to cut his lawn, too, as a quid pro quo when I return it a week hence, I occasion my benefactor real harm by actually doing what I promised to do? In the same vein, if we do consider this an evil, should we insist, henceforth, that no-one ever be permitted to deliver into an expiring futures contract, but that he must roll the position eternally forward, lest he bring the market for grain, or gasoline – nay! the entire global economy – shuddering to a halt by closing out his position?

Moreover, if it is (almost) universally accepted that we all routinely partake of the bounties of voluntary exchange in order to increase our mutual satisfaction beyond what we can each hope singly to achieve, how can we argue that the mere introduction of a time delay between the two halves which make up every bargain transmogrifies the second component – but never the first, you will note! – into an act of social violence? And if it is so insisted, where are we to set the threshold for this noxious change? Five minutes after the first goods have been dispatched? Five days? Five weeks? Five months? Five years?

In my previous article I explored the disco-ordinating effects of unnatural interest rates.

Let us go back for a moment to construct a simplified version of what it is we are considering, with the aim of better understanding it. Imagine that along the chain from seed merchant to farmer to grain shipper to miller to baker to wholesaler to retailer to Mrs. Jones, out for her weekly quota of patisseries, there is a flow of goods from the higher orders (i.e., starting with the seed merchant) through the lower and on into our dear housewife’s shopping basket. While this segmented process of production takes place, time inevitably passes as an incomestible, raw material is sequentially transformed into a sought-after item of everyday consumption, with value being incrementally added as the metamorphosis takes place.

Initially, the farmer may lack the means to pay the seed merchant so he asks for, and is granted credit by his vendor – the one generates an entry for accounts receivable, the other for accounts payable. The farmer, in turn, may well have to do the same to the man who comes to collect his grain and so on, all the way down to Mrs. Jones. Such credit as is granted here is implicitly connected to a decision on the part of the grantor to forego an equal amount of current, monetary recompense and hence, makes him automatically him into a saver. Not in the least inflationary, such a process of credit creation is thus an entirely benign aid to industry and commerce, if practised in due proportion and with a due degree of diligence.

As our Mrs. Jones dips into her purse and passes over her pennies to the shop assistant, MONEY now moves back up the chain, and extinguishes each debit in turn as the promissory notes, invoices, or bills of exchange come due and are settled. By way of avoiding an infinite regression, Mrs Jones, we may assume, gets her cash from her husband’s job at one of the firms involved, this first amount coming into being when someone saved the money to provide the firm with its start-up capital, long before it was generating any saleable output. Thus, Mr. Jones’ effort provides the household with its daily bread, both literally and metaphorically.

Note here that each member of this division of labour has to await his own fulfilment until after the final good has been sold. Once that has been accomplished, each receives a portion of this selling price to the extent of his individual contribution to the value attached to it by Mrs. Jones’ decisive exercise of consumer sovereignty. To the degree that each member has correctly judged the management of his affairs, he will receive a little more than he himself laid out – whether this expense took the form of his purchase of the products of those passing firstly the raw, then the several intermediate, and lastly the finished good onto him, or as part of his direct outlay to his workers, his landlord, and his equipment suppliers.

At that point, his entrepreneurial judgement having been fully validated in the marketplace, he and his capital backers can enjoy a well-merited reward. However, it is also the case that, having received both his revenue and the endorsement of the firm’s owners, each of our captains of industry has the choice to buy more or less of what he bought before, to put the difference to use in improving the firm’s chance of future success, or to quit the business entirely, extracting what capital he can along the way.

This means that, far from being something which we can take for granted once Mrs. Jones steps into the store – as the traditional, GDP-type, consumption-fixated methodology insists is the case – each of these steps is highly discretionary. Each is, moreover, subject to the continuing practice of good management and unwavering entrepreneurship to maintain an unbroken flow of goods. At any point, changes in any of the constellation of conditions influencing each business, or in the motivation of and possibilities of compensation for those running it and investing in it, may mean it becomes either not possible or simply not desirable, to carry on with it– an eventuality which cannot fail to have significant ramifications for both customers downstream and suppliers upstream of that business.

Contrary to the way they are normally dismissed from contemplation, as being mere residuals to be cancelled out in our measurement of that misleading aggregate of aggregates we call ‘the economy’, all these activities are therefore vital to its functioning and should be treated as such in our every analysis. Importantly, we should bear in mind that while net new investment may be what is needed to improve the capital stock and to increase the division of labour (to add ‘roundaboutness’, to use Boehm-Bawerk’s formulation), it is gross investment – i.e., spending with a view to creating, not exhausting, value – which is a sine qua non for the very maintenance of the extant stock of productive machinery. Anything which serves to reduce it, therefore, ultimately reduces both our wealth and our income, even if its temporary substitution with more end-good spending gives a speciously attractive boost to the guiding calculus of the GDP numbers.

Thus, by way of analogy, we can imagine the step-by-step generation of income as being akin to a relay in which each participant passes a baton on to the next to signify both the movement and further working of the goods-in-process all the way to their final destination in our good lady’s larder (perhaps the baton should be marked with notches as a tally to record the credit being extended at each stage as well).

Once the finishing line has been crossed – and the palm awarded by the end-consumers gathered there – the prize money is passed back up among the runners, with each subtracting his cut as the pot reaches him in his turn. For each, that cut constitutes his own spendable portion, i.e., that part beyond the requirements of his continued involvement in the scheme of production. Further ensuring economic harmony – what we Austrians call ‘plan co-ordination’ – their sum matches exactly with that quantity of final consumption goods which all those involved have helped put on the shelves and which have been duly selected for purchase from among all the competing merchandise ranged alongside them there.

Now consider what happens when each man can take his evidence of a credit claim on another and have it turned into money at the bank. Effectively, each of our relay runners now has his own baton and he can choose to leave his lane, dash across the infield to the finishing line, and there compete with all his fellows in pre-empting the goods piled up there by others, well before they have collectively ensured that their own have been successfully delivered to be offered in exchange.

More money chasing fewer goods – i.e., the potential for giving rise to what Charles Holt Carroll called ‘price without value’ – is the first result. The second is the temptation to start ‘check kiting’; i.e., to divert the monetized claims in their entirety – not just the expected net income component of them – to non-essential or even ultra vires purposes, such as, stock market or real estate speculation, hoping then to meet each bill as it comes due, not out of cash flow, but by cashing in speculative gains or raising further inflationary finance. The third is the disconnection of effective demand from profitable supply with the risk that, in one’s own hunger to spend earlier than one has earned the means, one ends up earning less than one had thought to, as prices and quantities become adversely affected by the consequences of one’s own impatience.

In Holt Carroll’s own words of 1855:-

The immense variations in the quantity of this delusive currency that we call money, the greater part of which is but a mere “promise to pay” money that has no existence, produce corresponding variations in the money value of property and debts, so that no reliable estimate can be made of property for any considerable period of time. There can be no reasonable reliance that the quantity of money which measures an obligation for six months will be anywhere at its maturity to discharge the debt; and this baffling uncertainty renders the trade of the country but little better than licensed gambling.

While the examples from my previous article may well complete our bestiary of what does and does not constitute inflationary credit formation, what we have not dealt with here is the more insidious evil which wraps itself around the apple tree of our earthly paradise, even when post hoc savings do serve for a while to lend a spurious justification to the speculative, advance extension of credit by a bank.

We refer here to the broad prescription of that Austrian theory of the business cycle to which we adhere. This has it that when such loans are made to business in the absence of a genuine desire on the part of others to save, this inversion of the holistic order is not a boon to be welcomed, but a bane of which to be wary.  This is because the act of severing the link between the decision to save – and hence to free up real resources for other uses – and the appetite to borrow means that such loans can be granted in a manner and on a scale likely to be at odds with social time preference and so at a market rate of interest below the natural rate of future discount. In so doing, a great and dangerous discoordination of the productive structure is encouraged, rife with the unrecognised perils of incompatible planning, contradictory time horizons, and the falsely signalled degree of abundance of sufficient key resources at the price anticipated to see each project through to a timely and lucrative conclusion.

The difficulty here is that what post hoc saving there is tends, at first, to mute the impact as the purchasing power which corresponds to this new credit flows into the hands of what are technically termed the ‘end factors of production’ – principally the wage earners and the salaried classes.  This lull is, however, an insidious one. Indeed, such restraint is better understood using its technical designation of ‘forced saving’ since the phrase better expresses the limited enthusiasm with which it is carried out by people who receive a larger pay cheque but who are not fully convinced that the good times will continue to roll. To begin with, they will not be ready to spend all the extra proceeds, not when nothing on their usual shopping list seems to offer exceptional value and when nothing new has arrived from the expanding, higher-order industries so as to whet their jaded appetites.

Given their reluctance to participate in the necessary forbearance, it does not, however, take much to undam this reservoir of grudgingly-made ‘savings’. Some of that pool’s owners may become more optimistic about the duration of their improved circumstances; some may just be naturally less provident. Either way, their joint succumbence to temptation may edge prices up just enough to trigger a defensive response in their less avid fellows who either begin to notice that the real value of their nest-egg is shrinking or who are forced to dip into it by the higher call being made upon on their income.

However it happens, soon end-consumption will be picking up among those who never really had any deep desire to forgo every trip to the mall until the high-speed rail network, the aluminium smelter, and the new power grid could be built out and could begin facilitating the delivery of just the required amount of extra consumables, thus partaking of a sustainable, self-renewing stream of income as the reward for their contribution.

The usual sorry denouement, then, is that the extra cash (and encashable) balances eventually come to burn a hole in the pockets of wage earners and profit sharers who have benefited from the trickling-down of the initial credit boost given to their employers’ or their customers’ order books. As they start buying more things, it quickly becomes obvious that no-one has thought to increase the provision of these, so fixated have so many would-be entrepreneurs become on coat-tailing on whatever happens to be the main medium for the Boom – a field of activity whose fatal attraction is often that it represents a ‘New Era’ phenomenon, to boot.

More demand being expressed for a temporarily inelastic supply of end-consumer goods means higher prices and, hence, a more elevated reading for the key statistical measure which tracks these – either that or a yawning trade deficit opens up. This can bring with it its own dangers, not least for the hapless foreign suppliers who may also be intoxicated by the miasma of false prosperity and thus induced to commit too much capital of their own to satisfying what cannot be a durable demand. Worse, should their own monetary authority seek to dull the tendency of the home currency to appreciate on this score, the inflationary plague bacillus will have crossed the border with the buyers’ remittances to blight another land in addition to their own.

In modern times it is the first of these, as in olden times it was often the second, which brings forth the threat of policy restriction. More generally, the newly-lit, secondary boom will not complement the primary one, but rather conflict with it, to the point where it may complete vitiate the latter’s evolution. After all, this is taking place in an area which the earlier availability of plentiful, cheap credit was signalling would remain quiescent while the new industries remoulded the overall revenue stream of the economy comfortably to include them. To their utter discomfit, the unexpected vibrancy up at the sharp end of the productive chain cannot fail to divert resources of all kinds – including labour, which they must therefore battle to retain – to seek a greater income by servicing the upswing – a phase Hayek dubbed the ‘Ricardo Effect’.

As a consequence, those involved in such lines of new businesses – remote as they are from satisfying the immediate needs of our reinvigorated shoppers – will face higher costs and lengthened supply schedules because of the same scrambled to meet the reawakened desire for things they are, by definition not geared up to producing. Worse, the reassertion of consumer preferences must shrink the niche in the market they thought they had identified for their own product when credit was easy, inputs seemed abundant, and lucrative outlets readily assured.

For those in thrall to the simplistic ‘circular flow’ concept of the economy, not only does too little of what the parvenus lay out come back to them, but what they themselves need to disburse to stay in business starts is driven inexorably higher by the greater activity they have instigated in spaces they cannot access.

Ultimately, the only way such artificial grafts on can seek to stave off their impending rejection is to raise yet more credit and to try to leapfrog ahead of the mounting cost-revenue occlusion in which they are being strangled.

I concluded yesterday’s article with a note of caution:

we should strictly talk here of such a swollen, but partly immobilized supply of money being potentially inflationary, rather than ineluctably so the instant it is augmented in this fashion.

This point is worthy of extra emphasis in our present circumstances when all too many pundits are pulling up simplistic chart overlays which purport to show that we need have no fear that central bank hyperactivity engenders any risk to our material well-being since generalized consumer price rises (in the West, at least) have been relatively hidebound compared to the vast efflux of ‘liquidity’ provision experienced since the collapse.

One answer to this charge is simply to pose the counter-factual: how much more elevated are prices today above the market-clearing levels they would have – and probably should have – reached absent such an effusion? While empirically irresolvable, this is no mere quibble for if – as was proven by its implosion – Bubble levels of activity included much that was horribly misdirected and, hence, Bubble Era prices were, in many cases, higher than they sustainably should have been, the policy-makers’ success in not only restoring such average levels but exceeding them can only have introduced a greater degree of falsity into the economic matrix which we must take to be our guide in all the exchanges we make.

Indeed, such distortions must be even more severe than they first appear since we must recognise that while it is easy to parrot the news that the general price level is higher or lower than once it was, the single number by which we are accustomed to measure that state hides a world of complex interrelations. In practice, this means that the monetary inflation has not only outweighed the credit contraction in aggregate, but that it has exerted its pressure not so much in propping up values among the main casualties of the credit contraction, but in boosting others – possibly much further in relative terms than they otherwise deserve.

A further refutation works with reference to the mindlessly mechanical usage of many macromancers who spend their days seeking nothing so much as a time series to be set against another, regardless of their provenance or compatibility so as to offer up a sage-sounding divination from the accidental pattern of their overlay.

Just because we can measure an economic quantity (or, more correctly, statistically estimate it according to the available means and subject to certain preconceived prejudices about what exactly it is we are to reckon and why), this does not make it anything other than a crude yardstick of the seething foam of individual decision making whose shape, expanse, rigidity, durability and evolution is the reality we are trying to capture.

Nor does the physics-envy scientism of much economic calculus stand too close a scrutiny. Yes, ceteris paribus, more money chasing the same number of goods should imply higher prices, but the truth is there is very little paribus to much of that ceteris – not least in the intensity with which that ‘chase’ will be conducted, or in the distinction made by the ‘chasers’ (themselves a highly variable population) between different classes of available goods.

As a concrete example of this, consider the fact that the collapse of the credit available in certain (highly-variegated) areas of the economy has meant that less transactional substitution is taking place, with money therefore being made to do more and more of the work, in these dark days of trepidation, for which credit used to suffice when skies were an unblemished azure. Add in a greater penchant for holding financial wealth in the form of money – the addition of whose wonderful optionality in a world of radical uncertainty is something of a no-brainer given the vanishing opportunity costs which have arisen thanks to concerted official action to suppress less risky bond yields – and we have another dampener in place, as mentioned above.

To give this some small degree of context, note that the total of currency and demand accounts held by the non-monetary sector in the US has risen no less than 60% since the pre-crisis year of 2007, with the household component rising 150%, and the non-financial corporate one, 300%. Obviously, not all of this increment represents a precautionary store of wealth – an instant snapshot of a game of pass-the-parcel must show someone in possession of the package, no matter how keen they are to be rid of it – but, doubtless, some good proportion does constitute a ‘hoard’, especially that part held by businesses. This component has risen from 1% of total financial assets (and effectively 0% in QI’09) to a sixteen-year high of just over 4%.

Put another way, in the 18-months to end-September, a sum equivalent to two-fifths of cumulative after-tax profits has been squirreled away by American CEOs desperate for a little clarity of vision instead of being laid out to buy more plant and equipment, to conduct more R&D, or to hire extra workers.

Note, too, that this factor is one which is ironically reinforced by the very same subdued rate of overall price rises to which the naysayers seek to draw attention. That this will prove to be something of a double-edged sword as and when either conditions – or simply perceptions thereof – change, is something to which far too little attention is devoted by those who like to assume what is past (or, in this case, present) must unfailingly be prologue.

Whatever the private sector may or not decide among its members, historically, the most violent and destructive agent of inflation has been Leviathan himself for , in the typical practice, we find ourselves most readily in a situation of blithely turning debt into money when the borrower is the state. Readily able to persuade themselves that the purchase is ostensibly a social service, if all too often a disguised and thoroughly venal buying of votes, the acolytes of the Beast are typically the least considered and most unrepentant of debtors. Indeed, if they ever do entertain any doubts as to their conduct, they have an entire body of Unholy Writ to insist that their studied indifference to the bourgeois values of good housekeeping is, in fact, a blessing to all.

Even this evil is not always a self-fuelling one. If, for example, the bond which is issued to bridge the gap between tax and spend is held by individuals or collectives unable themselves to create the money with which to buy it, we may deplore the redirection of scarce resources into the least efficient and most conflicted of hands, but we cannot call it ’inflationary’: to buy the bond is to deny oneself the ability to purchase other things and to allow these to be conferred upon the welfare case, the defence contractor, or the traffic warden in one’s place.

If, however, the bond is bought by a bank—whether central or commercial—or is pledged as collateral for a loan from one of these, and the resulting dole, once having been disbursed, finds its way back as a demand deposit onto the books of either that same bank or one of its many sisters, the treasury’s deficit has now been monetized in exactly the same way as was the credit granted in the course of the private arrangement we discussed above. No deferral of a claim upon other goods need result from the bond issue, so, in effect, two units of money are chasing what previously only one could – clearly, an inflationary situation, once more.

Likewise, though the pretence is maintained that the government does not simply ‘print’ the currency which comes into our hands, the modern practice by which the central bank issues the relevant notes against the purchase of government bonds makes the distinction a highly academic one. The subterfuge becomes all the more flimsy in the usual case wherein the monetary authority subsequently returns the bulk of the seigniorage gains to the fisc – an act which reduces the ‘cost’ to the exchequer of issuing such happily perpetual liabilities to near zero, even in times when term interest rates have not been almost completely ‘euthanatized’.

As if there were not enough confusion over what policy the authorities should pursue and when in order to extract themselves from a mess largely of their own making (you know our answer: NONE! and NOW!), the analysts of such policy possibilities are greatly hampered in their attempts at exegesis because they are continually tripping up over their hopelessly entangled bootlaces—the one marked ’MONEY’ and the other marked ’CREDIT.’

Moreover, since few of them are careful enough to distinguish between the asset and the liability side of bank balance sheets, further conceptual errors are rife even before anyone tries to bolt his faulty monetary apparatus onto the alarmingly creaky machinery of mainstream macro.

So, let’s start at square one, in the attempt to introduce a little clarity to the situation.

Firstly, MONEY is the medium of exchange—a present good, readily exchangeable into all others at full par value, on demand, and in final settlement of all the transactions in which it participates. In the modern world, this means notes and coins in circulation and demand deposits held at monetary financial institutions by all other non-MFIs, whether firms, individuals, or government departments.

CREDIT, in contrast, is the evidence of a future money claim, of the deferral of final settlement—a very different animal. Although sometimes exchangeable in practice (with or without a haircut) in place of MONEY, it is neither so universally nor so continuously employed. Rather, its circumstantial acceptance is effectively a kind of barter transaction, albeit the kind most regularly performed in financial markets under normal circumstances

As individuals, we are of course fully entitled to give or take credit instead of demanding or offering money, as it suits our mutual convenience. This is especially likely to occur where we are habituated to repeating the process on some quasi-regular basis with a customer or supplier, or where the total invoice is too large for it to be practicable to meet this charge in full and at the point-of-sale.

Note, however, that when non-monetary actors extend credit, they are effectively exchanging enjoyment of a present good for the promise of a future one and, hence, they are principally engaged in altering intertemporal relations—typically via a discount factor. In general, this cannot be inflationary since the lender, by foregoing a cash payment, must surrender his claim on some other present good (effectively, he must simultaneously become a saver) unless he can persuade someone else to take over the claim in his place.

Even if he does succeed in doing this, the resulting swap is simply that—a substitution of one temporary abstainer for another. As such, this can certainly alter the disposition of relative prices— since the seller of the claim has now acquired the means to buy the good at the top of his unique list of preferences, while its third-party buyer has chosen to postpone the realisation of something high up on his somewhat different menu of choices—but this cannot move all (or even many) prices up together.

In contrast, once a bank enters the picture, matters are greatly altered since banks possess the privilege of being able to issue claims on themselves which unquestionably function as money, in the form of demand or other chequable deposits, in this, an era when the issuance of banknotes is typically denied to them and instead is monopolized by the state.

Armed with this capability, the bank can open a loan account for a would-be buyer, allow him to transfer the balance to his vendor, and then sit back and wait until the vendor (or some combination of persons from the chain of subsequent net sellers who are sequentially connected to the first recipient) decides to place the newly-created claim back at the originating bank (or, at minimum, with one of its counterparty banks which latter will then make an interbank loan to the originator of the credit, so as to complete the circle at one remove).

To the extent that these new deposits take the form of demand deposits, the initial CREDIT—which is an asset on the bank’s book—has generated a corresponding MONEY entry on the other, liability side of the ledger.

This is where the inflation creeps in for it implies that the act of granting the loan did not oblige anyone to give up their call on the stock of present goods as recompense for that quantum which was transferred to the debtor, since the seller now holds, not an IOU to be settled many days hence, but a freshly-spawned unit of MONEY, that present good by means of which one can have instant access to all others.

In insisting upon the point that credit granted outside such an intermediation is not inflationary in any overall sense, we do not deny that it can often serve as the basis for a loan-collateral spiral if enough people become sucked into such a Tulipmania of buying and selling a certain class of goods (or claims thereto) on tick – though it must also be accepted that such outbreaks of mass insanity almost invariably accompany periods when money itself is anything but tight and interest rates depressed.

Nor, is all banking involvement of necessity inflationary, for the newly incurred, ex post liabilities which spring up to balance its ex ante lending could take non-monetary form—as time or savings deposits, or as holdings of bank bonds or other term securities issued by the lender – according to the whim of each bank’s customer. (The holding of securities issued by a non-bank is beside the point here, since it begs the question of what their seller – on either the primary or secondary market – will himself do with the funds he has received by dint of their sale).

Moreover, even where they do materialize as demand liabilities—i.e., as money—their owner may voluntarily treat them as part of his portfolio of financial claims and choose NOT to disburse them for long periods of time. ‘Sterilization’ can thus be a passive course followed by the individual, as well as an active policy pursued by the authorities and so we should strictly talk here of such a swollen, but partly immobilized supply of money being potentially inflationary, rather than ineluctably so the instant it is augmented in this fashion.