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Money

Understanding the Money Creation and Society Debate

Together with colleagues spanning four parties – Michael Meacher (Lab), Caroline Lucas (Green), Douglas Carswell (UKIP) and David Davis (Con) – I have secured a debate on Money Creation and Society for Thursday 20 November. Here’s a quick guide to understanding the debate.

First, we have a system of paper or “fiat” money: it exists due to legal mandate as opposed to being a physical commodity like gold. Reserves, notes and coins are created by the state but claims on money are created by the banks when they lend. Most of the money we have was created by banks lending.

This excellent video from Dominic Frisby is a great place to begin:

There was once a time when the literature about money creation was sufficiently off the mainstream to be dismissed. The Bank of England now explains:

I published a short paper on what is wrong with the current system and what to do about it, first inBanking 2020 and then Jesús Huerta de Soto kindly republished it in his journal Procesos De Mercado Vol.X nº2 2013. A further monetary economist privately reviewed the paper but errors and omissions remain my own. You can download it here:

Recent emergency monetary policy has been dominated by Quantitative Easing: the Bank of England has provided a report on The distributional effects of asset purchases (PDF). However, the financial system has been chronically inflationary throughout my lifetime, ever since the Bretton Woods currency system ended.

If QE has distributional effects, why not all money creation?

Here is a historic price index from the Office for National Statistics and House of Commons Library: Consumer Price Inflation since 1750 (PDF).

Price Index 1750-2003

And here is the growth of broad money from 1982 to date via the Bank of England (series LPMAUYM). Note that the money supply stopped accelerating in the course of the crisis, during the period of QE:

M4: 1982-2014

No one can argue prosperity has not increased over the period but if distributional effects matter at all, one must ask “Who benefits?” Via Positive Money, here’s where the new money went:

Sectoral lending

As I said in debate on 6 Dec 2011:

Why are we in this debt crisis? I have just checked the M4 money supply figures—I am sorry to return to aggregates, but needs must. When Labour came to power the money supply was about £700 billion and it is now about £2.1 trillion, so it has tripled over the past 14 years. Unfortunately, most economists talk about money flowing into the economy as if it were water poured into a tank that found its own level immediately, but what if it is like treacle or honey? What if it builds up in piles when poured into the economy and takes a while to spread out? What if that money was loaned into existence in response to individual choices led by the excessively low interest rates pushed by the central bank? What if it was loaned into existence in particular sectors, such as the housing sector, where prices have more than doubled over the same period, and what if it was the financial sector that received the benefit of that new money first? Would that not explain why financiers and bankers are so much wealthier than everyone else, and why economic activity and wealth has been reorientated towards the south-east?

This debate will explore the effects on society of long-term money creation by private banks’ lending in the context of the present financial system.

Further reading:

Ethics

In defence of capitali$m

[This article was written for BMS World Mission and can be found here.]

I want an end to poverty. I want a social system which operates justly in the general interest without boom and bust. I want to force even the most selfish into the service of others. I want to bring good news to the poor.

We do not live in the Garden of Eden. Scarcity is a fundamental fact. I see a world in which I cannot survive alone. In so far as we enjoy abundance, it is because we share the work of providing for one another.

That sharing of work implies a serious problem: how shall we decide how much of what to produce?

There is a choice: either voluntary ownership, control and risk bearing in the means of production, or collective ownership through the state plus economic planning. We must choose between capitalism or socialism.

Capitalism allocates effort and resources through the price system plus profit and loss accounting. When prices are formed through voluntary exchange of the goods and services people want, a profit shows that value is being created for customers, in their opinion. A loss indicates the collective opinion of society that value is being destroyed.

Only the price system reveals the shifting preferences in the minds of billions of individuals. That is why economic planning by authority always fails. It is why actual socialist societies are highly authoritarian: ever more power is applied in a futile attempt to make planning work.

"only the price system reveals the shifting preferences of billions"

Understanding our present plight requires insight into the financial system.

Banks lend money into existence. They do not merely lend what people have saved. When a loan is made, bank deposits are created out of nothing. That’s why the UK money supply tripled between 1997 and 2010 from about £700 billion to just over £2.2 trillion.

A society simply cannot triple its money supply in 13 years without profound consequences. Understand that new money went first into the financial system and housing, London and the South East and you have a good explanation for the structural problems in our economy.

We had a chronic oversupply of credit, then sudden undersupply. It is a typical failure of economic planning by authority, a failure of central banking.

The “greedy bankers” argument is inadequate. Thanks to various state-provided guarantees, bankers were gambling with other people’s money, at other people’s risk. Of course they frequently succumbed to temptation. Then governments forced us to bail them out. The injustice of it is palpable.

Look at the cost of energy, the queues on our roads or land use decisions and the story is the same: comprehensive regulation failing to produce the right results. Yes, there is often private investment but it is protected by legal privileges. Even without considering the high level of state spending, it is impossible to sustain the argument that our economy has been too free.

We have preached capitalism but practiced socialism before blaming inevitable failure on the market.

The Peruvian economist Hernando De Soto asked why people in the developing world do not prosper despite being clever, industrious and willing to take risks. Marx believed the problem is that the poor have formal rights but no property.

De Soto demonstrated the opposite. The poorest of the poor in the developing world possess $9.3 trillion worth of land, roughly the size of US GDP and over 70 times the entire world’s foreign aid budget. It turns out the poor in developing countries possess real property but inadequate rights. Co-operation cannot work for the common good without strong property rights and contractual exchange.

We have lived through a deep crisis of the Third Way. How we respond to it is crucial. Is justice and sustained, inclusive prosperity to be delivered through a return to comprehensive economic planning by authority or should we try freedom?

The only system capable of co-ordinating the shared work of providing for one another in this world of scarcity is founded on property rights, voluntary exchange, prices, profit and loss. It is the only system capable of bending even the most selfish to the service of others. Governments must stop deranging it if we are to bring good news to the poor through voluntary co-operation in free markets.

Economics

The success of “credit easing” on its own terms

Click for Telegraph Story

Click for Telegraph Story

Today, the Telegraph reports, UK house price growth ‘approaching madness’:

The speed UK property prices are rising at is “approaching madness”, analysts have warned, after data showed house prices jumped 2.4pc in February, the biggest monthly increase in five years.

The rise, revealed in the latest Halifax House Price Index, outstripped analysts’ expectations of a 0.7pc rise, renewing fears of a house price bubble.

House prices advanced 7.9pc on an year-on-year basis, the figures showed, taking the average price across the UK to £179,872 and marking the strongest annual uplift since October 2007.

The Chancellor’s policies of “monetary activism” and “credit easing” including Funding for Lending and Help to Buy have, on their own terms, succeeded. According to Kaleidic Economics, the Austrian measure of the money supply is now expanding by over 12% year on year:

Click for Kaleidic's data

Click for Kaleidic’s data

Nothing has been learned since Hayek wrote Monetary Theory and the Trade Cycle. His preface could have been written today:

It is a curious fact that the general disinclination to explain the past boom by monetary factors has been quickly replaced by an even greater readiness to hold the present working of our monetary organization exclusively responsible for our present plight. And the same stabilizers who believed that nothing was wrong with the boom and that it might last indefinitely because prices did not rise, now believe that everything could be set right again if only we would use the weapons of monetary policy to prevent prices from falling.The same superficial view,which sees no other harmful effect of a credit expansion but the rise of the price level, now believes that our only difficulty is a fall in the price level, caused by credit contraction.

… There is no reason to assume that the crisis was started by a deliberate deflationary action on the part of the monetary authorities, or that the deflation itself is anything but a secondary phenomenon, a process induced by the maladjustments of industry left over from the boom. If, however, the deflation is not a cause but an effect of the unprofitableness of industry, then it is surely vain to hope that by reversing the deflationary process, we can regain lasting prosperity. Far from following a deflationary policy, central banks, particularly in the United States, have been making earlier and more far-reaching efforts than have ever been undertaken before to combat the depression by a policy of credit expansion—with the result that the depression has lasted longer and has become more severe than any preceding one. What we need is a readjustment of those elements in the structure of production and of prices that existed before the deflation began and which then made it unprofitable for industry to borrow. But, instead of furthering the inevitable liquidation of the maladjustments brought about by the boom during the last three years, all conceivable means have been used to prevent that readjustment from taking place; and one of these means, which has been repeatedly tried though without success, from the earliest to the most recent stages of depression, has been this deliberate policy of credit expansion.

On its own terms, systematic intervention in the market for credit has succeeded: it has restarted the Domesday machine which delivered us into this mess. Those of us who have studied Mises, Hayek and the other Austrian-School masters will know that our present economic system remains built on sand.

Economics

TTIP – when free trade goes wrong?

Röpke, International Economic Disintegration

In 1942, Wilhelm Röpke’s International Economic Disintegration was published. An international order of liberal free trade collapsed through nationalism, protectionism and monetary destruction. Many other factors were at work. The various events occupying the forefront of public attention were “only surface symptoms of a deep-set structural change affecting our economic, social, political and cultural system in its entirety”. The social sciences were in crisis and found themselves in a new situation. Monopoly and state intervention had led to the degeneration of competitive capitalism. What had gone before was unhampered trade. What came after was widespread acceptance of state intervention in business life.

Globalisation in the sense of international trade is by no means a new phenomenon: the internationalisation of business regulations is and it has consequences. On 4 December 2012, I reported a problem with the EU regulation of biocidal products which was hammering two UK businesses whose products fight legionella by ionisation. Over a year later, the problem still rattles on with special interests apparently capturing the regulatory apparatus to the detriment of smaller, more effective firms. The financial risks to our stretched hospitals are considerable.

It’s just one example of how the regulatory state fails: how it makes us poorer, discourages innovation and entrenches special interests. It takes power out of the hands of the elected and hands it to technocrats: technocrats who tend to continue down their chosen path irrespective of the futile cries of those of us who represent the victims of bad rules.

The situation is dire enough at European Union level but now here comes the Transatlantic Trade and Investment Partnership:

The Transatlantic Trade and Investment Partnership (TTIP) is a trade agreement that is presently being negotiated between the European Union and the United States.

It aims at removing trade barriers in a wide range of economic sectors to make it easier to buy and sell goods and services between the EU and the US.

On top of cutting tariffs across all sectors, the EU and the US want to tackle barriers behind the customs border – such as differences in technical regulations, standards and approval procedures. These often cost unnecessary time and money for companies who want to sell their products on both markets. For example, when a car is approved as safe in the EU, it has to undergo a new approval procedure in the US even though the safety standards are similar.

The TTIP negotiations will also look at opening both markets for services, investment, and public procurement. They could also shape global rules on trade.

Big firms such as car manufacturers tell me they love it. And why not? One set of rules is in their commercial interests. One set of officials is easier to lobby than several. It’s possible to argue enthusiastically for TTIP and state-directed trade policy, as the EU demonstrates:

But this is not free trade. This is not merely the abolition of tariffs. It is the elevation of the principle of all-encompassing networks of regulation to ever more international and less accountable levels. Woe betide the company which falls foul of a rule agreed by the EU and the US Federal Government: your representatives will have no vote and their correspondence in protest will be just so much chaff in the email storm.

I’m no scholar of Röpke but it seems at least one thing about his analysis was correct: competitive capitalism degenerated into a dangerous interventionism and a crisis of the social sciences which has brought us to our current predicament. Once again, the events which occupy the public consciousness are mere symptoms of much deeper issues: the belief that political power on an ever greater scale is required to shape our lives.

At the Cobden Centre, we believe liberal free trade is much more important to international social progress than political power. We’ve concentrated on the state’s incompetence in monetary matters so far. It seems over the months and years ahead, as more bad ideas work themselves out in public policy, there will be ever more to say on free trade. We hope you will help us.

Peace

The General Treaty for Renunciation of War as an Instrument of National Policy remains in force

Click for scan

Click for scan

The 1928 Kellogg–Briand Pact, officially the General Treaty for Renunciation of War as an Instrument of National Policy, is a simple read. It’s so simple that its three short articles are easy to miss in the text of the Treaty.

These are the two substantial articles (the third deals with ratification):

ARTICLE I

The High Contracting Parties solemly declare in the names of their respective peoples that they condemn recourse to war for the solution of international controversies, and renounce it, as an instrument of national policy in their relations with one another.

ARTICLE II

The High Contracting Parties agree that the settlement or solution of all disputes or conflicts of whatever nature or of whatever origin they may be, which may arise among them, shall never be sought except by pacific means.

The fact of the Second World War proves the Treaty’s failure in practice but I was grateful to the Attorney General’s department for confirming in an answer to a recent Parliamentary question that it remains in force:

Conflict Prevention: Treaties

Steve Baker: To ask the Attorney-General if he will make an assessment of whether the General Treaty for Renunciation of War as an Instrument of National Policy remains binding on the UK.

The Solicitor-General: I am advised by the Foreign and Commonwealth Office that the General Treaty for the Renunciation of War as an Instrument of National Policy (also known as the Kellogg-Briand Pact) remains in force and that the United Kingdom remains a party.

Perhaps the brevity, simplicity and directness of the Treaty and its historic failure explain why certain statesmen continue to believe in war as an instrument of policy, with or without the support of the United Nations. The US State Department comments:

The first major test of the pact came just a few years later in 1931, when the Mukden Incident led to the Japanese invasion of Manchuria. Though Japan had signed the pact, the combination of the worldwide depression and a limited desire to go to war to preserve China prevented the League of Nations or the United States from taking any action to enforce it. Further threats to the Peace Agreement also came from fellow signatories Germany, Austria and Italy. It soon became clear that there was no way to enforce the pact or sanction those who broke it; it also never fully defined what constituted “self-defense,” so there were many ways around its terms. In the end, the Kellogg-Briand Pact did little to prevent World War II or any of the conflicts that followed. Its legacy remains as a statement of the idealism expressed by advocates for peace in the interwar period. Frank Kellogg earned the Nobel Peace Prize in 1929 for his work on the Peace Pact.

Idealistic the Treaty may be but the British Government just confirmed in the season of goodwill that it remains in force and the UK remains a party.

The spirit of it is simple enough: the UK may not engage in acts of aggression under any circumstances. I hope this straightforward lesson in international law will become widely known.

Economics

Goodbye Detlev – for now

Writing on his website, Detlev Schlichter has announced his exit from the sphere of ideas and writing:

This is the final blog entry in the ‘Schlichter Files’. Pretty soon, this website will be taken offline. I would like to take this opportunity to thank all my readers for following my commentaries, essays and occasional rants over the past two-and-a-half years. Thank you.

Read the rest of the article here.

In the past few years, Detlev has made a spectacular contribution to Austrian School economics in the UK. When I first found his book Paper Money Collapse: The Folly of Elastic Money and the Coming Monetary Breakdown, I knew I had found the contemporary Austrian analysis I was looking for. I was delighted to endorse it.

That giant intellectual contribution to our economic circumstances has been complemented by Detlev’s unique ability to explain his ideas with a compelling charm from the perspective of experience. I will never forget his astonishing appearance on Radio 4’s Start the Week.

We wish Detlev all the best as he moves on to new enterprises, just as we wonder how to fill the vacuum he will leave. We’re delighted to host his articles and we hope one day to welcome him back to the sphere of ideas.

Economics

The German way of 1923

Book coverI chanced this morning on the superb collection of essays from Ludwig von Mises, The Causes of the Economic Crisis and Other Essays Before and After the Great Depression (PDF).

In his Stabilization of the Monetary Unit—From the Viewpoint of Theory written in 1923, he showed considerable foresight:

Only the hopelessly confirmed statist can cherish the hope that a money, continually declining in value, may be maintained in use as money over the long run. That the German mark is still used as money today [January 1923] is due simply to the fact that the belief generally prevails that its progressive depreciation will soon stop, or perhaps even that its value per unit will once more improve. The moment that this opinion is recognized as untenable, the process of ousting paper notes from their position as money will begin. If the process can still be delayed somewhat, it can only denote another sudden shift of opinion as to the state of the mark’s future value. The phenomena described as frenzied purchases have given us some advance warning as to how the process will begin. It may be that we shall see it run its full course.

Obviously the notes cannot be forced out of their position as the legal media of exchange, except by an act of law. Even if they become completely worthless, even if nothing at all could be purchased for a billion marks, obligations payable in marks could still be legally satisfied by the delivery of mark notes. This means simply that creditors, to whom marks are owed, are precisely those who will be hurt most by the collapse of the paper standard. As a result, it will become impossible to save the purchasing power of the mark from destruction.

And in 1946, he commented on using easy money and deficit spending to stimulate the economy after a long period of cheap credit (The Trade Cycle and Credit Expansion):

In discussing the situation as it developed under the expansionist pressure on trade created by years of cheap interest rates policy, one must be fully aware of the fact that the termination of this policy will make visible the havoc it has spread. The incorrigible inflationists will cry out against alleged deflation and will advertise again their patent medicine, inflation, rebaptizing it re-deflation. What generates the evils is the expansionist policy. Its termination only makes the evils visible. This termination must at any rate come sooner or later, and the later it comes, the more severe are the damages which the artificial boom has caused. As things are now, after a long period of artificially low interest rates, the question is not how to avoid the hardships of the process of recovery altogether, but how to reduce them to a minimum. If one does not terminate the expansionist policy in time by a return to balanced budgets, by abstaining from government borrowing from the commercial banks and by letting the market determine the height of interest rates, one chooses the German way of 1923.

The Bank of England hopes to avoid all this by manipulating people’s expectations about inflation and GDP growth. I don’t think it can be done – too many commentators can see through it.

Nevertheless, they are going to give it a try. The best that can be said for it in the context of the German experience which Mises predicted and lived through is that at least if coming events are well understood, contemporary errors may at last produce the paradigm shift in economic thought necessary to put us on a more just and moral economic path.

This post originally appeared on www.stevebaker.info.

Economics

The injustice of easy money is going mainstream

The Daily Mail reports Interest rates: How keeping them at a record low is a deliberate government ploy to pay off its debts:

A stealth raid by the Bank of England has stripped savers of more than £170billion, a Money Mail investigation can reveal.

By slashing the base rate to a record low of 0.5?per cent and allowing the cost of living to soar for more than four years, the Bank has whittled away the value of cash sitting in High Street accounts through a ‘secret tax’.

And it is not just savers who have effectively had their money pinched. Anyone who has a fixed monthly income, such as pensioners, or has had a tiny pay rise, has also lost out.

campaign constantly against the injustice which is being manufactured by our centrally-planned system of money and bank credit so I am glad that the arguments are going mainstream.

We are in the midst of a great battle between debtors and creditors. Deeply indebted governments are on the side of those in debt. Too many claims on real goods have been created by bank lending so now the central banks are destroying those claims by stealth.

The implications for our society will be profound. I cannot help thinking that the whole enterprise would have already come crashing down if the public could see the tens and hundreds of billions of Pounds – and Dollars and Yen… – as paper in wheelbarrows going to governments’ favoured friends.

Given that the alternative is higher interest rates, sound money and a painful correction, governments and central banks think they are taking the easy way out. We’ll see.

See also:

This article was previously published at SteveBaker.info.

Economics

Mark Carney’s grand experiment began today

I was grateful to the BBC World at One programme for giving me the opportunity today to comment on Mark Carney’s first Inflation Report. You can listen to what I said here.

The essence of what the Bank has announced is well known: they have begun using forward guidance to anchor both inflation and interest rate expectations as a cover for more active monetary policy.

This will usher in a new age of monetary Kremlinology.

The policy is all about the Committee’s intentions and judgments. It’s hedged about with provisos and escape routes. Journalists were quick to ask who thought what on the Committee, spotting that which thresholds are used and which judgments are made is dependent on the opinions of a few wise men.

If you read Mark Carney’s speech to the U.S. Monetary Policy Forum in New York last year, it is clear what he intends. Mark Carney apparently understands the critique of the Austrian School, but he believes it is “a counsel of despair for current problems” so he proposes to prevent the disruption easy money creates using “broader macroprudential management”.

Today’s announcement includes,

The  guidance will remain in place only if, in the MPC’s view, CPI inflation 18 to 24 months  ahead is more likely than not to be below 2.5%, medium-term inflation expectations remain  sufficiently well anchored, and the FPC has not judged that the stance of monetary policy poses a significant threat to financial stability that cannot otherwise be contained through the  considerable supervisory and regulatory policy tools of the various authorities.

In so far as we did not already, we now live in a world of extensive explicit discretionary power over both money and the financial system which ought to allocate real capital to the most productive uses. To believe this will end well is hubris.

Manipulating the expectations of millions of individuals, households, businesses and financial market participants will create herding on a mass scale. Like a loose load in a ship, that will result in severe instability.

Employment created through an “exceptionally stimulative monetary stance” will come to an end when that stimulation is withdrawn. In chasing its employment threshold, the Bank will paint the economy and society into a corner.

Inflation will take the Bank by surprise. The “slack in the economy”, on which the Bank is relying to avoid price inflation, will turn out to be wasted capital, not idle capital waiting to come back into use. Prices will rise.

I’m reminded of something I heard economist Steve Horwitz say, and I feel sure he will forgive and correct me if my notes are not faithful,

Central banks cannot solve the problems they created any more than an arsonist makes a good firefighter.

Unfortunately, Mark Carney is nevertheless about to conduct a grand experiment which will prove that this is so.

Economics

Bank reform demands monetary reform – an essay for Banking 2020

This article was published yesterday at stevebaker.info.

A vision for the future

Today sees the return of the Financial Services (Banking Reform) Bill to Parliament. It does not do enough.

In the book Banking 2020: A vision for the future, my essay summarises the institutional problems with our monetary and banking orthodoxy:

The features of today’s banking system

As Governor of the Bank of England Sir Mervyn King told us in 2010: ‘Of all the many ways of organising banking, the worst is the one we have today.’

Notes and coins are irredeemable: the promise to pay the bearer on demand cannot be fulfilled, except with another note or coin with the same face value. Notes and coins are tokens worth less than their face value and are issued lawfully and exclusively by the state. This is fiat money.

When this money is deposited at the bank it becomes the bank’s property and a liability. The bank does not retain a full reserve on demand deposits. In the days of gold as money, fractional reserves on demand deposits explained how banks created credit. Today, credit expansion is not bounded by the redemption of notes, coins, and bank deposits in gold.

Because banks are funded by demand deposits but create credit on longer terms, they are risky investment vehicles subject to runs in a loss of confidence. States have come to provide taxpayer-funded deposit insurance. This subsidises commercial risk, producing more of it and creating moral hazard amongst depositors who need not concern themselves with the conduct of banks.

The state also provides a privileged lender of last resort: the central bank. It lends to illiquid but solvent banks getting them through moments of crisis. In a fiat money system, central banks have the power to create reserves and otherwise intervene openly in the money markets. Today this is most evident in the purchase of government bonds with new money, so-called quantitative easing.

The central banks also manipulate interest rates in the hope of maintaining a particular rate of price inflation through just the right rate of credit expansion to match economic growth. That otherwise free-market economists and commentators support such obvious economic central planning is one of the absurdities of contemporary life.

Compounding these flaws is the limited liability corporate form. Whereas limited liability was introduced to protect stockholders from rapacious directors, its consequence today is ensuring no one taking commercial risks within banks stands to share in the downside. This creates further moral hazard.

Regulatory decisions have been taken to encourage banks to make bad loans and dispose of them irresponsibly. Among these are the US Community Reinvestment Act and the present government’s various initiatives to promote the housing market and further credit expansion.

Having insisted banks make bad loans, the regulatory state imposed the counterproductive International Financial Reporting Standards (IFRS) which can over-value assets and over-state the capital position of banks. This drives the creation of financial products and deals which appear profitable but which are actually loss-making. Since these notoriously involve vast quantities of instruments tied to default, the system is booby-trapped.

Amongst the many practical consequences of these policies was the tripling of the money supply (M4) in the UK from £700 billion in 1997 to £2.2 trillion in 2010. Credit expansion at this rate has had predictable and profound consequences including asset bubbles, sectoral and geographic imbalances, unjust wealth inequality, erosion of physical capital, excess consumption over saving, and the redirection of scarce resources into unsustainable uses.

Moreover, credit cannot be expanded without limit. Eventually, the real world catches up with credit not backed by tangible assets: booms are followed by busts.

The essay provides some objectives for monetary reform and sets out proposals from Dowd et al and Huerta de Soto.

I was pleased that the Parliamentary Commission on Banking Standards highlighted problems with incentives and accounting – the conversation is going in the right direction. At some point, when it becomes apparent that Mervyn King was right and we do have the worst possible banking system, I hope decision makers will realise that banks and the product in which they deal, money, are inseparable and that meaningful banking reform demands monetary reform.

You can download the book here.