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By Toby Baxendale, on 11 March 10
Why Even the Best Banks are Insolvent and Inherently Dishonest
We are told that Barclays is a good bank and it did well not to take the taxpayers shilling. We are told that it has recovered and is prospering and this indeed is a sign of the economic recovery.
Part of the mission of the Honest Money Movement is to explore and expose these fallacies.
Banks only exist with entrenched legal and accountancy privilege. Privilege for all sectors of the political spectrum is a bad thing. Trade Union privilege to operate a closed shop cuts back on employment and price gouges the customers who buy the goods that the closed shop workers produce. A group of countries who restrict the price of say oil will push up the price of oil and gouge their customers and so on and so forth. All privilege is bad.
Contrast Normal Commercial Activity…
Any business in this country from the plumber to BP will have current creditors, those people it owes money to such as suppliers and current debtors, those people who owe it money for the goods and services sold. It is a legal offense to not pay your assets and your liabilities as and when they fall due. Indeed as a company director you become personally liable should you trade in this position whilst you are insolvent.
…With That of a Bank
A bank has current creditors: on the whole, these are people like you and me who have our salaries or savings paid or deposited into our accounts on our behalf. We do not actually “own our money” that is deposited in the bank. The bank does.
This may come as a surprise to you. However this is a very well established point of law. Since 1811 in Carr v Carr, this has been the case. So you and I are the current creditors to the bank i.e. we are owed money by the bank. In fact your bank statement is just an IOU from the bank acknowledging that it owes you however much it says on the statement on demand.
The assets of the bank are those people to whom the bank has lent its (formerly your) money to i.e. all the borrowers of loans. As has been so clearly displayed during this crisis, they have lent their money out (formerly yours) over 33 times on average to borrowers. I explain the money credit creation multiplier here for a refresher on understanding this process. So when more than 1 of 33 of us wish to withdraw our money that is on demand, the bank can not pay it back as it does not have it.
I enclose a link to the balance sheet of the UK’s largest company, BP here here. Page 106 has the balance sheet.
| Non-current assets |
£161,854M |
| Current assets |
£66,384M |
| Total Assets |
£228,238M |
| Current liabilities |
£69,793M |
| Non Current liabilities |
£136,129M |
| Net Assets |
£92,109M |
This would suggest that BP has current liabilities marginally greater than their current assets. No doubt the timing of the payment to suppliers is carefully balanced off otherwise their auditors could not sign off the accounts if they thought the company could not pay off its assets as and when they fall due.
Contrast this with the Barclays Bank full year 2009 results shown on this spreadsheet.
See tab 4 where we have the consolidated balance sheet. There are just assets and liabilities and there is not a distinction in their accounts between current liabilities i.e. your and my money that has been deposited that is on demand now and a long term liability such as a mortgage to pay off a loan on some property they may occupy etc over a long period of time. There is £322 billion of money on deposit in current creditors that could be withdrawn “on demand” as that is what the bank tells you that you can do with it. Indeed you only deposit it that way because you need to make sure payments happen on demand. They have no requirement to provide you with the ability to make this happen despite the fact that you may have deposited money there!
So unlike BP and any commercial business from the lowest one man band plumber to the mighty BP, who have to account for keeping payments set aside to cover their current liabilities, a bank is not required to. Indeed, it is specifically allowed not to by accounting law and legal privilege under law. If the deposit base of Barclays wanted what it thought was “its” money back i.e. it wanted the £322 billion redeemed into cash or taken out of the bank and moved to another, then as there is no corresponding current asset to pay for this and only assets that have long term payment implications, it would have to suspend redemptions as North Rock did and hope people would wait until it could try to sell some of its long term assets or collect in its loans. In reality, this would be a run on a bank. Barclays by its very nature is inherently insolvent and can only exist by this accounting / legal privilege that does not apply to any other non bank business in the UK!
One of the first things you will ever learn in a law of contract course is that an agreement is reached between parties and a contract established when an offer is accepted with a mirror image of understanding , from the Latin “pacta sunt servanda” or agreements must be kept. So it would strike me that as the vast majority of people think that they deposit their money and it remains their money in a bank and that the law and accounting standards say otherwise, there is a very good argument that there is not a contract in place between any depositor and bank. Certainly as most depositors also want easy access.
I commissioned a survey for the Cobden Centre in Oct 2009 with ICM over 2,000 people. 74% of people think that they are the legal owner of the money in their current account rather than the bank. Paradoxically 61% know that their money is lent out even though 67% want convenient (now) on demand access. The full results of this survey will be published shortly in another paper.
Now we can understand how the banks have the biggest salaries, the biggest bonuses , the biggest offices, the most plush terms and conditions of employment and so on and so forth. If you do not have to provide for your creditors then you can use their money to do what you like with and this is what happens!
Just to give you an idea what this would mean for me in my company Seafood Holdings Ltd if I was allowed to do what the banks are allowed to do. As of December 2009, I had trade current creditors of £8.276m against trade debtors of £12.275m. If I was a bank, I could pick up the full £8.276m and pay a dividend or bonus and still be lawful. I could build a megalomaniac size corporate head office and stick a gold plated statue with me dressed in a Roman Caesar like uniform to please my demented ego! I could behave like the worst most vulgar of City bankers.
We must always remember their key service other than the safe keeping of our money is to act as an intermediary between saver and borrower. This is “Captain Mannering” style boring banking. Like and estate agent who mediates between buyer and seller of houses, he has a High Street presence like most providing a consumer service. Places like the City of London / Canary Wharf and Wall Street etc can only exist as they do today on this legal privilege and on the welfare state of credit whereby we allow them to exist at the tax payers’ expense.
By Toby Baxendale, on 10 March 10
Some of my City friends who work in banking have had a look at the 2009 Barclays balance sheet and made comment on how the profits are made up.
They report to me that the one off profit from the disposal of BGI to Blackrock was £6.3bn. Add that to the trading profit of £7bn and you get 130% of the total profit of this “bank.”
Accounting like this is like Manchester United selling top player Ronaldo in the last financial year for £80 million when the average sale of a player in the football world produces only £1 – £5 million and kidding themselves that this is a result of them trading profitably in a sustainable way. It seems unlikely that shareholders in this football club will be relying on a spectacular cash event occurring each year as a regular occurrence. Therefore, many analysts are inclined to deduct from the profits such one off events to get a better view of predictable stable cashflow. (see tab 18 of the spreadsheet previously mentioned in yesterdays article and downloaded from here, http://group.barclays.com/Investor-Relations/Financial-results-and-publications/Results-announcements ).
Further, I’m told that a brief review of the numbers indicates that £7bn of the £10.2bn profits are expressed as “trading income” (last year £1.3bn).
I would pose three questions:
a) What if the markets had gone the other way? Would we be told these are not real cash losses?
b) How many politicians that want Glass Steagall separation of retail banking from casino banking will criticise them?
The political class want both the cake and to eat it, or they are just ignorant.
They no doubt are content that 74% of the TOTAL ASSETS of Barclays sit in Barclays Capital – the investment banking or casino arm..
c) Let’s have a look at bonuses – having slashed cost income ratios from 76% q4 08 to 55% q1 09, ratio is now back up at 64% q4 09. Is this what the political class meant when they wanted to see a more equitable salary to profit ratio?
Let us also consider the consequences of mark to market accounting FOR P&L PROFITS. The wisdom of MTM for balance sheet and transparency is not in dispute, but in a government bailout environment, the profit and loss accounts of banks is boosted artificially by the very bailout itself. The effect of interest rates being forced down from 5% to 0.5% artificially boosts the mark to market value of any unhedged long term assets on trading book. I urge you to think about what imputed capital value you have on an income stream today with interest rates at 0.5% as against an interest rate of say 5%, they work in inverse proportion i.e. the lower the rate the higher the capital value. A property generating rent of £1,000 per week, should be multiplied by 200 times to get its capital value or the value of its income stream. A little bit Alice in Wonderland I am sure you will agree.
Bonuses should not be paid on these numbers because the “profits” are unrealised, and will turn to huge losses if interest rates go up as they are still unhedged, remember! The bankers are making sure they can take a bonus on 30 years implied profits today in this low welfare state of credit environment with you and me, aka the taxpayer paying for it.
Let me explain in another way. MTM accounting takes a payment due in the future, say £100 after 1 year, and “discounts this by the interest rate to value the payment today taking into account the delay and the cost of money. So if rates are 5% in this simple example then the MTM value today is a shade over £95, since £95 invested at 5% for 1 year will produce about £100. If the interest rate is 0%, then the MTM value is £100. Therefore, the reduction in interest rates increases the MTM value of payments due in the future..
I question the long term value to profits of:
1) buying alphabet soup bombed out CLOs CDOs, CDO squared structures and funding them at 0.5% courtesy of the taxpayer via the Band of England Discount Window.
The Discount Window remember is being used as the lender of last resort in the banking system and has been very active since the October 2008 crash with us the taxpayer subsidizing all of this!
2) Present valuing (ie booking to p&l as if realised, earned income today) under synthetic (credit default swap) structures of say 30 year loan margins as day 1 profits.
For a more detailed explanation see Gordon Kerr’s presentation March 2nd at the European Parliament reported on this site as “Iceland and the Western Banking System”
http://www.cobdencentre.org/2010/03/iceland-and-the-western-banking-system/
Allister Heath (City AM) further notes that the accounts declare that cost of capital is 12% but return on capital employed is 8% – “shocking – makes no sense” is the comment.
Surely is not Barclays Bank effectively operating as a hedge fund with a modest high street retail bank attached?
I have only the following comment to make on this. If Barclays wants to list in the Caymans and invite me to invest in its shares, that is capitalism operating perfectly in a free market.
Where the Cobden Centre takes issue with this is the operation of the free market being distorted by taxpayer intervention. It is surely unacceptable for the taxpayer to be asked to:
a) underwrite the solvency of this hedge fund,
b) fund it through the Bank of England’s discount window, and
c) pay its employees bonuses based on asset valuations that not even a hedge fund at the racier end would attempt to classify as profits.
Any hedge fund with a cost of capital of 12% and a return on capital of 8% would be asking its “partners” (ie employees) to inject more money to evidence commitment or ’skin in the game’…as the hedgies in Mayfair term it.
So much for the new found stability of our banking system. Our money system continues to get more dishonest every day.
By Steven Baker, on 9 March 10
 This post is excerpted from Mises’ “The Causes of the Economic Crisis and Other Essays Before and After the Great Depression” which is available to buy here and download here. Both Andreas Acavalos and Toby Baxendale supported the production of this book.
Emphasis mine.
On covering government deficits by creating new money (pp 2-3):
If the practice persists of covering government deficits with the issue of notes, then the day will come without fail, sooner or later, when the monetary systems of those nations pursuing this course will break down completely. The purchasing power of the monetary unit will decline more and more, until finally it disappears completely. To be sure, one could conceive of the possibility that the process of monetary depreciation could go on forever. The purchasing power of the monetary unit could become increasingly smaller without ever disappearing entirely. Prices would then rise more and more. It would still continue to be possible to exchange notes for commodities. Finally, the situation would reach such a state that people would be operating with billions and trillions and then even higher sums for small transactions. The monetary system would still continue to function. However, this prospect scarcely resembles reality.
On credit expansion by banks, its effects on the economy and the ensuing crisis (pp 113-115):
The crisis breaks out only when the banks alter their conduct to the extent that they discontinue issuing any more new fiduciary media and stop undercutting the “natural interest rate.” They may even take steps to restrict circulation credit. When they actually do this, and why, is still to be examined. First of all, however, we must ask ourselves whether it is possible for the banks to stay on the course upon which they have embarked, permitting new quantities of fiduciary media to flow into circulation continuously and proceeding always to make loans below the rate of interest which would prevail on the market in the absence of their interference with newly created fiduciary media.
If the banks could proceed in this manner, with businesses improving continually, could they then provide for lasting good times? Would they then be able to make the boom eternal?
They cannot do this. The reason they cannot is that inflationism carried on ad infinitum is not a workable policy. If the issue of fiduciary media is expanded continuously, prices rise ever higher and at the same time the positive price premium also rises. (We shall disregard the fact that consideration for (1) the continually declining monetary reserves relative to fiduciary media and (2) the banks’ operating costs must sooner or later compel them to discontinue the further expansion of circulation credit.) It is precisely because, and only because, no end to the prolonged “flood” of expanding fiduciary media is foreseen, that it leads to still sharper price increases and, finally, to a panic in which prices and the loan rate move erratically upward.
Suppose the banks still did not want to give up the race? Suppose, in order to depress the loan rate, they wanted to satisfy the continuously expanding desire for credit by issuing still more circulation credit? Then they would only hasten the end, the collapse of the entire system of fiduciary media. The inflation can continue only so long as the conviction persists that it will one day cease. Once people are persuaded that the inflation will not stop, they turn from the use of this money. They flee then to “real values,” foreign money, the precious metals, and barter.
Sooner or later, the crisis must inevitably break out as the result of a change in the conduct of the banks. The later the crack-up comes, the longer the period in which the calculation of the entrepreneurs is misguided by the issue of additional fiduciary media. The greater this additional quantity of fiduciary money, the more factors of production have been firmly committed in the form of investments which appeared profitable only because of the artificially reduced interest rate and which prove to be unprofitable now that the interest rate has again been raised.
Great losses are sustained as a result of misdirected capital investments. Many new structures remain unfinished. Others, already completed, close down operations. Still others are carried on because, after writing off losses which represent a waste of capital, operation of the existing structure pays at least something.
The crisis, with its unique characteristics, is followed by stagnation. The misguided enterprises and businesses of the boom period are already liquidated. Bankruptcy and adjustment have cleared up the situation. The banks have become cautious. They fight shy of expanding circulation credit. They are not inclined to give an ear to credit applications from schemers and promoters. Not only is the artificial stimulus to business, through the expansion of circulation credit, lacking, but even businesses which would be feasible, considering the capital goods available, are not attempted because the general feeling of discouragement makes every innovation appear doubtful. Prevailing “money interest rates” fall below the “natural interest rates.”
When the crisis breaks out, loan rates bound sharply upward because threatened enterprises offer extremely high interest rates for the funds to acquire the resources, with the help of which they hope to save themselves. Later, as the panic subsides, a situation develops, as a result of the restriction of circulation credit and attempts to dispose of large inventories, causing prices [and the “money interest rate”] to fall steadily and leading to the appearance of a negative price premium. This reduced rate of loan interest is adhered to for some time, even after the decline in prices comes to a standstill, when a negative price premium no longer corresponds to conditions. Thus, it comes about that the “money interest rate” is lower than the “natural rate.” Yet, because the unfortunate experiences of the recent crisis have made everyone uneasy, the incentive to business activity is not as strong as circumstances would otherwise warrant. Quite a time passes before capital funds, increased once again by savings accumulated in the meantime, exert sufficient pressure on the loan interest rate for an expansion of entrepreneurial activity to resume. With this development, the low point is passed and the new boom begins.
Further reading
By Toby Baxendale, on 8 March 10
The current debate about bankers’ bonuses is often seen as one of fairness pitted against the greed of those nasty capitalists,.
To me, bankers are lawfully working within the system – one that is rotten to the core. The banking system is the greatest of all examples of State corporate capitalism. We have a central bank that is State owned, we have a legal tender law that prevents competition in the provision of the production of money, and we have private sectors banks which are licensed by the State to be its agent when it wants to monetise its very own debts and create inflation at the expense of its citizens: people who have been prudent and thrifty as well as those on fixed income.
The State has one important central intention: to hide its prolific over spending. We have private sector banks that have legal privilege granted to them so they can use their depositors’ money to lend out many times over to entrepreneurs. They are the only type of business in the whole country permitted do this. All other commercial enterprises at all points in time need to keep their current creditors whole, otherwise they are insolvent. There is no requirement at all in this country for any bank to keep even one penny in reserves against their depositors’ funds. In fact, it has been a stated fact of law since 1811 in Carr V Carr that “his” deposited funds are not his, but are in fact the banks’.
This fractional reserve banking system we have can only work with a lender of last resort i.e. the State owned central bank with legal tender laws. This means that in partnership with the State, the State can monetise its debts (at the expense of you and me) and the banks can keep as little reserves as they can get away with to make a return on capital that you and I in the real capitalist private sector could never do. This encourages risk. Indeed with the banks now able to borrow at the taxpayers’ expense via the discount window (heavily subsidised short term central bank funding) and know there is a guarantee of a bail out should their gambles go wrong makes the state and the bankers two equal partners in a very unjust process.
The resulting situation is what I call ‘corporate capitalism’ (thoroughly amoral) as opposed to ‘capitalism’, which is totally moral. This needs some explaining, as I suspect worthy people are shooting arrows at the wrong target.
We know that the free market capitalist system is without doubt the most efficient creator and allocator of resources. Adam Smith taught us that “It is not from the benevolence of the butcher, the brewer, or the baker, that we can expect our dinner, but from their regard to their own interest” in his Wealth of Nations. Self interest or the profit motive drives man to create and to provide all the multiplicity of goods and services we have enjoyed and will enjoy.
Mises in his famous book Socialism, http://mises.org/books/socialism.pdf showed us that if Society was run by planners, the price system which allows resources to flow to their most desired uses would not function. Indeed it would impoverish anyone nation that tried it. If, say. the planner could not correctly witness all the competing bids and resource allocations for metals that were capable of being used in the construction of railroad tracks (that involves many companies competing for scarce resources) he would never know which metal would be the most cost effective to build his railroad. No one planner would be able to economically calculate, or indeed, no army of planners would be able to calculate and allocate all the resources of Society in the socialist economy better than the many millions of participants in the economy allocating resources via the price mechanism. The experiment in the Soviet bloc with socialism impoverished at least three generations and lead to wide scale death and a general shortage of life, and misery.
Hayek, in his very famous essay “The Use of Knowledge in Society” http://www.econlib.org/library/Essays/hykKnw1.html added to the critique of Mises by pointing out that absenting the price system would mean that the central planning officials would need to absorb the entire knowledge of all the people in society to effectively plan their needs. This was absurd and impossible.
All State planned schemes, from the provision of money to the provision of health and education – even in our cosy mixed economy – could be done better by an unhampered market. We are thus weary of all bloated government departments and officials who say they can do something better for us – they can’t.
The efficiency case for an unhampered market, or free market capitalism is clear and unchallengeable. The subjective actions of freely consenting adults in a capitalist system produce the most amount of goods in the most efficient way. But is there an objectively moral case for the capitalist system? I attempt to answer it in the remaining part of this Insight article.
First Principles: Secular Argument
I Argue
One thing that distinguishes human beings from all other life forms is our ability to communicate with each other via talking. Only human beings can make a proposition. The question of what is just or unjust only arises because I can debate or argue this point with another person. To be able to argue my position I must be in control of my physical and mental self. I must own myself in order to be to be a human being. I have the total right to use all my physical and mental faculties to participate in life, otherwise I cannot even exist as a human being expressing an opinion. I do not know many people who would argue with this. If I did not own my own faculties I could not participate in life except under the command of who owned me. This also implies that just so much as I own myself, I do not own anyone else. It also follows that if I do something that violates another human being without their consent I violate their right to express their very humanness.
Thus, I deduce that by my very being , I own myself , I own my own property as me, I have a right not to be interfered with so long as I do not interfere with anyone else. It clearly follows that if I were to interfere with someone else’s property, they would not own it. This would deprive them of their own humanity, I suggest. This is a deduction from the axiom that to exist I need to argue. I come to this conclusion via the Haberrmasian axiom of interpersonal argument that has been so cleverly adapted by Hans Herman Hoppe in his book The Economics and Ethics of Private Property: full text, http://mises.org/books/economicsethics.pdf .
To argue against this you explicitly acknowledge control of your faculties, at the very least. Following Kant’s Golden Rule that a norm should be universal in its applicability should it be objectively valid, this proposition surely fulfils this requirement to be a totally objective axiomatic principle.
All ethical propositions, such as socialism, that say that you owe a duty to the State to provide for others, are violations of the very distinguishing thing that makes you a human being and not a rock or a colony of ants. To advocate any form or socialism, be it of the democratic variety, the communist variety, or indeed the mixed economy is to violate your very essence of being a human.
John Locke in his “Two Treatises of Government” spells out that property or, if you like all resources exist prior to any government. Man mixes his labour with what he finds and it is by right his. Government cannot ‘dispose of the estates of the subjects arbitrarily’. Locke left us with a conundrum called “Locke’s proviso.” This is where if a man mixes his labour to own something that was not owned before; he must always leave a “sufficient” amount for other human beings.
Jesus Huerta de Soto, one of the greatest living polymath Austrian School teachers in his essay “The Ethics of Capitalism” http://www.acton.org/files/mm-v2n2-desoto.pdf , shows us how possibly the other living giant of the Austrian School, Israel Kirzner in “Discovery, Capitalism, and Distributive Justice” has solved this proviso of Locke. And allows us to build the objective moral ethic of capitalism.
Socialist, social democrats and a large body of modern day liberals and conservatives have a distributive conception of justice that is about a top down approach of redistribution of scarce resources from those who do have to those who that have less, or nothing , or whose lobby groups has succeeded in extracting something from those that have. Kirzner shows us how as all human being are creative actor: they are always engaging in entrepreneurial activity to generate new goods and services. All human beings are alert to opportunity, some to a greater degree than others. The fruits of this alertness arises via their actions. This is universally so. To not act would not create these things. So he proposes an axiom that all human beings have a natural right to the fruits of their own entrepreneurial creativity. As these things are created out of nothing, it implies that the acting person has an undoubted right to the quiet and peaceful enjoyment of the fruits of his or her labour. If it did not exist before, it cannot be a negative to anyone else. So Locke’s proviso is overcome by the understanding of society as dynamic and spontaneous constantly evolving process with alert actors constantly creating new goods and services that they must have an unquestionable right to own.
De Soto coins the term ‘Dynamic Efficiency’ to describe this process. He also points out that the free market capitalist system – that we know is the most efficient system – is also the most just and in fact, these two concepts are indeed two sides of the same one coin. Any form of intervention is immoral as it impedes the creative capacity of individuals to express their creativity and create all the wide range of goods and services we have. It should be pointed out that top down provision of health, education, transport, industry etc is inefficient and hence unjust as it suppresses the creative activity of human beings. Absent the profit motive and you will get sub optimal results.
Do Soto points out that the last Pope, Pope John Paul II in his Centesimus Annus http://www.vatican.va/holy_father/john_paul_ii/encyclicals/documents/hf_jp-ii_enc_01051991_centesimus-annus_en.html , which built on the earlier work of the Rerum Novarum http://www.vatican.va/holy_father/leo_xiii/encyclicals/documents/hf_l-xiii_enc_15051891_rerum-novarum_en.html of Pope Leo XIII, established the universal moral capitalist ethic by acknowledging the natural right (God given) to express your very creativity unhindered so long and you hinder no one else.
First Principle: Theological – God Endowed Rights
I Exist
Writing about the morality of capitalism in glowing positive terms as I have done above and setting it in the backdrop of universally applicable objective axioms is not as unfashionable as talking to any thinking person about God, but only just! Such is the secular society we live in; you are considered to be an ill informed mystic should you engage in “god bothering.” The See of Peter would naturally see this differently and I am very grateful for De Soto to direct me to the pro capitalist teachings of the Catholic Church.
Are the above self evident axioms that are universally applicable in all times and in all places to everybody there because we are human or are they there because they are God endowed?
I can ague both, but I favour self evident God endowed over self evident secular, although the latter can stand on its own legs. Why?
I wrote this article about the proof God three years ago: http://www.lewrockwell.com/orig4/baxendale2.html . In short, I take the Aristotelian inspired position that as I exist I know that other physical things exist. I know that each and every one of these physical things must have been caused by another physical thing. I know that nothing is infinite. If it was, I would not exist as for it to be infinite, it would occupy all time and space and I would not exist. As I exist, I know this cannot be the case. I know there is a beginning to the universe and that there are physical boundaries to the universe, therefore I know there cannot be an infinite series of physical causes and effects as there would be no boundary and no beginning. Therefore what caused the first physical thing must indeed be immaterial if it cannot be a physical cause. This immaterial thing is what I label as ‘God’. So I conclude God does exist and the only act I can attribute to God by a priori reasoning is that God created everything. As I like to exist I am very grateful for this and can only conclude that God has good intentions. If I do not like to exist, I can choose not to and commit suicide. God is therefore good for me and objectively good for all human beings. As God has created everything, he has endowed us with the ability to reason and engage in the formation of reasoned propositions, the latter which is undoubtedly a unique attribute to mankind the former quite possible unique to mankind, sets the foundation for the derivation of the rights of man and the very ethics of capitalism.
Further reading
By Gordon Kerr, on 4 March 10
Gordon Kerr’s second address this year at the European Parliament was at a meeting of the European Enterprise Institute. The meeting was chaired by Diego Feio MEP and the meeting organised by Christopher Pichonnier. The platform was shared with Tryggvi Thor Herbertsson (MP, Iceland) and Rok Spruk, a Lithuania based economist.
1. Introduction
Mr Feio, Mr Pichonnier, ladies and gentlemen, thankyou for inviting me to address you today. We are here to explain and hopefully start to resolve the Icelandic banking collapse.
By way of brief personal introduction I am a banker. In my 29 year career I have experienced several banking crises. In the early 80’s I worked on Paris Club restructurings for Latin American sovereign defaulters.
Later in the 80’s I travelled frequently to the US in connection with the Savings and Loan crisis. In the early 90’s I worked mainly in Stockholm on mortgage backed transactions during the Swedish banking collapse.
A few years later I designed instruments that would in turn play a small but significant role in precipitating the collapse of the Western banking system. These instruments were called synthetic capital structures. They created the appearance of an increase in capital on bank balance sheets when in reality the economic risk and return positions of the banks concerned were essentially the same after the transactions as before.
I am a member of the Advisory Board of a London based banking educational charity – The Cobden Centre, and I work for a small investment banking firm in London.
My message to you today is simple. There is nothing specific about the way the Icelandic authorities managed its economy or its banking system that caused this massive failure. The root of the problem lies within the very essence of the banking system itself. Iceland, as a very small country with an aggressive banking industry, was just at the tipping point when the system itself failed, and has therefore suffered to a disproportionately greater extent than others.
2. Were the Western Governments correct to bail out the banks?
Imagine the feeling of going to see a doctor with a puzzling medical condition, having both legs amputated, and three months later experiencing a recurrence of the symptoms. You are admitted to hospital again, but this time the doctor who greets you post examination is far more sombre.
He explains that you have had a pancreatic tumour all along. Had it been correctly diagnosed on first consultation the tumour would have been annulled, but now it is out of control and certain to kill you.
This, I believe, is a fair parallel with the way in which banks in the UK and many other European countries have been rescued. I believe the bailouts are having the opposite effect to that which was intended. They are not helping to re-stimulate lending to small and medium sized businesses – the engines of these economies.
A smarter observer than I has compared the UK solution to the actions of an alcoholic, accepting with equanimity inevitable long term pain as the consequence of his inability to resist the temptation of one more short term, fuzzy high.
There is a danger that solutions presently proposed could accidentally cut the legs off Iceland and condemn its economy to years of stasis, instead of helping to cure its crippled banking condition.
Let us look now at the banking system itself. The legal rules which allow banks to gamble depositors’ demand funds on long term investments have simply created a liquidity pyramid scheme which, enhanced by various other banking developments, have boosted a variety of assets to unsustainable price levels that cannot be supported by the wealth of the relevant underlying economy. Iceland, being both part of this system and a tiny country with its own currency, simply sits at the pinnacle of this Western banking system crisis.
3. Iceland and the Global Collapse.
I urge you to resist the temptation of embracing the political exculpation of ‘global credit crunch’. Although the crisis was truly global this simple linguistic term seeks if anything to discourage serious analysis of what went wrong.
Many papers and speeches I have read are good quality diarised timelines of events in Iceland, without presenting credible cures or accurate analyses of the cause.
Iceland’s collapse was clearly related to the global failure, but each country does not necessarily need a global solution. Indeed, whenever I hear of a problem that can only be solved by global accord I cannot avoid the conclusion that such a problem is being expressed as intractable. The climate change issue is but one other example of a problem looking for a global solution.
Before addressing Iceland’s unique challenges, may I present some of the “banking developments” to which I referred earlier. I am about to set out just some of the features of permitted banking activity which have combined to create an unsustainable pyramid of asset prices which Western liquidity may struggle to support.
Most of the features I am about to describe do not appear on the radar screen of the press or blissfully ignorant politicians. For brevity I will set out only five such features:
a) The circular effect whereby asset prices are inflated merely by the creation of loans provided by banks to finance the purchase of such assets. I have many times witnessed competitive bidding wars between two purchasers wherein the independent valuer has simply up valued the assets each time one side or the other’s bank has issued a larger loan offer. It is essentially the case that the size of the loan determines the asset price, not the other way around. Therefore it is impossible to divorce the independent valuation of assets from the quantity of debt which banks are willing to issue against the assets.
b) Under EU fractional reserve regulations banks are required to maintain a minimum of say 8% “fraction” of their exposures as capital. Since the bulk of European banks are shareholder owned, market forces virtually compel them to push fractional reserve regulation to the limit. It is very difficult for the CEO of a major bank to keep his job if he is not fully leveraged in supposedly stable market conditions.
c) The absurd accounting regime that encourages banks to transfer as much exposure as possible into derivative format. The derivatives accounting regime presents two important benefits to banks: 1) the front ending of multi year’s hoped for income as Day 1 “profit”, and 2) the ability of a bank to leverage its capital not 12 times (the reciprocal of the 8% basic capital ratio) but up to 200 times (the reciprocal of 1/16 of the basic capital ratio). The 200 times leverage rule has historically been the starting point for calculating the capital to be reserved against derivative exposures, and now, under Basel 2 rules, this higher level of leverage is permitted against any AAA rated assets even in non-derivative format provided the bank concerned is regarded as sufficiently sophisticated).
I have a second confession to make. I was involved in designing the early forms of credit derivatives. I have written articles about this activity on the Cobden Centre website and I am grateful to its founder, Toby Baxendale, for inviting me to write about this. Let me clarify for the record one frequently confused point. The motivation behind the emergence of credit derivatives was not the enabling of banks to distribute loans to non-banks. That activity was operating perfectly well before the advent of credit derivatives via other financial instruments.
The overriding motive behind the emergence of credit derivatives was in the accounting rules. Credit derivatives allow banks to book multi-year profits, subject to supposedly conservative reserves, before they have been realised or earned in a sense that would satisfy an accountant in any industry other than banking.
d) I referred earlier to the liquidity pyramid that results from the legal relationship between banks and depositors. Depositors’ money belongs in law to the bank, not depositors. The EU seems aware of this concern and some proposed new regulations talk about inhibiting banks’ future ability to mismatch the maturities of assets and liabilities. This mismatching has, I believe, been a major contributor to the crisis in a very simple way:
- Person ‘A’ deposits £100 of cash into his instant-access bank account and receives a promise to return the cash on demand.
- The bank retains a small reserve (say £3), and lends out £97 to Person ‘B’.
- Person B purchases £97 worth of goods from person C who in turn redeposits the money in the bank.
- Both ‘A’ and ‘C’ both have a claim to instant access on this money.
- In three steps, the bank has turned £100 into £197 of useable money.
e) The use of the ECB discount window to finance banks purchase of assets post crisis. There has, in the last 10 months, been a gradual rise in the prices of large volumes of the very type of banking assets that many UK commentators have termed “alphabet soup”. Less kind commentators have termed some of these assets a “Liverpudlian Stew” – a rather unpleasant menu item, even by British culinary standards. It is in essence an attempt to present undigestible left over food as attractively as possible. (On behalf of Liverpool may I thank the EU for ordaining it as European City of Culture in 2008).
These price rises seem inconsistent with present reduced liquidity within the banking system. The only explanation I can reach is that some financial institutions have been able to fund their purchases of such assets via the central bank discounting windows such as the ECB itself. Banks are then, as rational players in a regulated industry, motivated to make money by the monetisation of unrealised future profits by entering into synthetic arrangements on these same assets. If true this effect will dash all our hopes that we may be coming out of the crisis.
4. ICELAND
Let us look at Iceland more specifically. The root of the problem lay not in the failure of Iceland’s specific regulators or its national regulation system per se, but in the simple combination of three factors:
- i. Its small size and status as a country;
- ii. Its banks seeking aggressive growth;
- iii. Its acceptance of the Western bank regulatory regime.
The scale of the problem measured against Iceland’s GDP was simply incredible. The country effectively staked its economic future on international banking, raising capital internationally and lending it out in highly leveraged packages relying on rating agencies and more experienced capital markets arrangers.
The deposit base which lay at the root of the banks’ efforts to prop up the pyramid should have collapsed before the problems became quite so bad, but thanks to Iceland’s status as a sovereign state and international conventions whereby one country’s banks can be “passported” to raise deposits in another, Iceland’s banks succeeded in raising considerable sums of demand deposits from other countries’ savers, in particular the UK and the Netherlands. Those savers looked only to their own national regulators who, under passporting rules, in capital markets parlance simply “wrapped” the Icelandic Central Bank.’’
Ironically the taxpayers of countries such as the UK and Netherlands in effect wrote credit default protection on Iceland, and now, having been called on this protection, seek to exercise rights of subrogation against the Icelandic taxpaying citizenry. But if the Icelandic people did not understand what was going on, are these actions not akin to luring the demented old lady next door into leaving you her house in her will and thereby disinheriting her children?
Icelanders who had saved in its major banks, supervised by its national regulators, were effectively performing the function of a junior mezzanine investor (ie just above the shareholders) in the capital structure of a typical “alphabet soup” investment whose fragility was almost impossible for the ordinary taxpayer to understand.
And so, the pyramid inflated further until September 29 2008. On that date Glitnir, on seeing its credit lines withdrawn following the collapse of Lehman, knew it was unable to raise funds to satisfy a €750 million payment due on October 15th and approached the Central Bank of Iceland for an emergency loan. The loan request was turned down and instead Glitnir was forced to accept €600m from the central bank in return for a 75% stake. Its shareholders were practically wiped out[i].
Iceland therefore suffered like no other country, and at a rapacious rate. At less than 6% of GDP, government debt was tiny at the beginning of 2008. Under an FRB system that mirrored that of all major European countries its banking system was quickly destroyed and its people burdened with unimaginable levels of debt.
5. What Should Iceland Do?
We have just heard from Dr. Tryggvi Thor Herbertsson MP that there is great doubt as to whether it will join the Euro. Even if the Eurozone states can fund the PIGS and other bailouts presently planned, should Iceland ask for an EU bailout?
The short term appeal is obvious, is the longer term outlook as rosy? What of the concerns of abandonment of control over fiscal and monetary policy? Are these measures consistent with the Icelandic character and way of doing things?
Let us consider Greece very briefly. The calm 2 weeks ago when the Greek bailout was announced has been replaced by concern. The austerity measures the EU would impose will be as unpopular in Iceland as they are in Greece.
There is clearly a gulf between the positions of the bailor and the bailee. As I prepare this speech I read in February 25th Daily Telegraph the following report by Ambrose Evans Pritchard:
“Hans-Werner Sinn, head of Germany’s IFO economic institute, said Athens was holding Euroland to ransom, threatening to set off mayhem if there is no bail-out. “Greece should never have entered the euro zone because they did not qualify and they are now blackmailing other European countries via the euro. It’s not for the EU to help Greece. We have an institution that is very experienced in bailing-out activities: the IMF,” he said.
Otmar Issing, former doyen of the European Central Bank, echoed this view in Germany’s Bundestag last Wednesday, warning that a Greek rescue would “open the floodgates” for serial bail-outs and destroy EMU discipline. “The crisis is made in Greece. It is the result of bad policy, not outside forces like an earthquake.” “
Does this rhetoric imply that life under the EU will be much better for Icelanders? That is clearly a decision for Iceland’s Government and people.
If Iceland joins the EU then I would urge the EU to reform its own regulatory regime fundamentally to protect Iceland from further catastrophe. Relying on rating agencies as the basis of regulation, rather than markets, makes little sense.
It is not impossible to devise a fractional reserve regulatory system that will work if its practitioners are expert bankers and fully appraised of everything that its banks are engaged in post reform. But this is fraught with risks.
A far easier solution for Iceland is to make one simple law change. Grant depositors title to their deposits, stipulate that the state and taxpayers will never again bail out the banks, and allow free market forces to create a safe and transparent banking system. A ban on the maturity mismatching of assets, combined with a clear policy of NOT bailing out the banks in future, will enable free markets to flourish.
Do not blame the bankers, they were merely acting like rational capitalist players in a wrongly regulated system. If we are to allocate blame then look to yourselves right here in the Brussels Parliament. It is you rulemakers who have made the mistakes. You should have worked this out.
6. Conclusion
The way forward for Iceland should be to look to itself. Tryggvi, your people have a powerful sense of identity. You have a wonderful natural economy, a well educated population and a well documented strength of character. You can fix your problems yourselves, but maybe with a little help from my firm! The detail of implementation needs to be set in the context of modern banking. A restructured banking system as proposed today would ensure:
1) Depositors could NEVER AGAIN lose their money;
2) Credit would resume flowing from savers to entrepreneurs;
3) The reopening of the international capital markets to Iceland
Without these measures I fear it will be back to the operating theatre in a year or two, with little prospect of a speedy recovery.
Mr Feio, Mr Pichonnier, ladies and gentlemen, thank you for your time.
END
Gordon Kerr – March 2nd 2010
EU Parliament, Brussels
[i] What the Icelandic Collapse has Taught Us, February 2009, Tryggvi Thor Herbertsson
Further Reading
- Huerta de Soto, Money, Bank Credit and Economic Cycles
- Baxendale, A day of reckoning: how to end the banking crisis now
- What is wrong with banking, part 1: the legal nature of banking contracts
- Frank Whitson Fetter, Development of British Monetary Orthodoxy 1797 – 1875
- F. A. Hayek, Denationalisation of Money: The Argument Refined
- Gordon Kerr, How To Destroy the British Banking System and Bailing out the Banks – Glaring Evidence of Moral Hazard
- James Tyler, My Journey to Austrianism via the City, Money is not working and How to avoid future encounters with financial meltdown
- Irving Fisher, 100% Money, 1935
By James, on 3 March 10
Some people doodle pictures, but I’m the type who mucks around random bits of historical price data just to see where it goes. For example, I love charts of the Dow Jones Stock index in the 1920s – it me it tells a vivid story of hopes and dreams and pain mixed with desperation. The wild fluctuations in the early 20’s, the solid gains of the mid 20’s then the euphoria and ensuing panic, well.. you know the rest.
A while a go, I came across a quote;
With an ounce of Gold, a man could buy a fine suit of clothes in the time of Shakespeare, in that of Beethoven and Jefferson…
What does a ‘fine suit’ cost today? Well, an ounce of Gold is just short of £700. If you went into Harrods, and asked for a fine suit, would that see you into an Armani or Zegna number? I think so.
So, the maxim seems to ring as true today as it ever did.
So my mind got to thinking – if an ounce of gold seems to buy the same stuff over the centuries as it does today, then it would seem to be a great proxy for true purchasing power.
The problem with looking at historical charts of stock movements, especially if you are trying to learn the lessons of history, is that the picture is muddied by the fact that the unit of account – i.e. money, does not do a very good job. It is rapidly decaying so when you compare over time, it just gives the wrong impression of what is going on.
For example, look at the stock market over the whole of the 70’s, and you think that equities didn’t do too badly. But adjust for inflation, and you soon realize that stocks lost over three quarters of their value in the first half of the 70’s!
So, the idea dawned on me: the price of stocks and shares are only represented in terms of money. What if you priced them in Gold instead of pounds and dollars?
Firstly: what data? Well, I stuck to the UK, and I chose the FTSE all share index. I took the index value for each day, going back a few decades. I then converted them into ounces of gold. The chart gave me a pretty shocking picture.
But then I realised I’d missed something pretty important. Stocks pay dividends. So, I added a 5% annual dividend return, and then reinvested it into my index. Surely that’d make my chart look less ridiculous? Erm, a bit… but not by very much.
What I was left with was a completely different view of history, and some pretty worrying revelations.
Firstly, my chart had nothing to say until the 70’s. This is because until then, money was gold – therefore priced in money or gold – it didn’t make a difference. In essence, the chart had no surprises.
But in the 1970’s, money was cut loose from gold, with some pretty shocking results.
 FTSE All Share in terms of in oz of Gold (click to enlarge) Some salient observations.
1. The mayhem of the early 70’s had some pretty catastrophic consequences for the world, and recovery only came in the 1980’s. From over 12 ounces of gold, down to nearly 1 ounce of gold is a pretty insane move.
2. Real growth took off in the 80’s, but something happened in the mid 90’s – the internet. This was a period of real economic growth, that morphed into a bubble, thanks to some pretty silly policy mistakes by Greenspan et al.
3. What happened in the 00’s? Wasn’t that supposed to be the ‘NICE’ decade? Wasn’t the stock market supposed to have risen back to its peaks?
My answer to this is that the noughties were a period of stagnation, economic misalignment, and we were all swamped by a money fraud.
The authorities were in such a blind funk in 2001, with the overriding perception that we were facing a 1929 style collapse, that they turned on the money gusher, and flooded the whole world with liquidity. This found its way into the greatest worldwide property bubble the world has ever seen.
But… this was not true growth – at least for the Western economies. Sure, great advances were made in some sectors of their economies, but huge misalignments of capital were occurring, and this decade of false signals to producers, but especially to Western consumers, is why we had the economic crisis of 2008.
Look where we stand now. In ruinous debt. Shackled to low interest rates and nervously watching retail sales and property prices. This is a direct consequence of our societies living the high life for ten years, without actually realising we were in decline.
We have been living like cannibals. Hollowing out ourselves out, yet living the high life. And this is all down to a pseudo neo-Keynesian/monetarist aggregate kabala fetish.
I feel a sense of panic looking at this chart, so what is the solution?
Free markets built on the bedrock of honest money.
By Toby Baxendale, on 1 March 10
 I founded the Cobden Centre inspired by the writing of F A Hayek, particularly his reference in “Denationalization of Money: the Argument Refined” (IEA, 1976) from which the following quote is taken.
Free Money Movement
What we now need is a Free Money Movement comparable to the Free Trade Movement of the 19th century, demonstrating not merely the harm caused by acute inflation, which could justifiably be argued to be avoidable even with present institutions, but the deeper effects of producing periods of stagnation that are indeed inherent in the present monetary arrangements.
Now of course that Free Trade Movement was the movement set up by the businessman and radical social reforming liberal, Richard Cobden. Hayek knew that the original founders of that movement attacked the import tariffs or “Corn Laws” that harmed ordinary people. The Corn Laws forced the price of basic food stuffs so high that the working man was almost paying what we would pay today on our mortgages.
The legal privilege that this gave landowners to price gouge the masses at the expense of the privileged few was an outrage and the courageous corn law reformers did away with this invidious protection by repealing the Importation Act of 1815 with the Importation Act of 1846.
In Bright, J. and Thorold Rogers, J.E. (eds.) [1870](1908) Speeches on Questions of Public Policy by Richard Cobden, M.P., Vol. 1, London: T. Fisher Unwin, republished as Cobden, R. (1995), London: Routledge/Thoemmes, they cite a quote from a working man who sums up the iniquities of the Corn Laws that Richard Cobden used:
When provisions are high, the people have so much to pay for them that they have little or nothing left to buy clothes with; and when they have little to buy clothes with, there are few clothes sold; and when there are few clothes sold, there are too many to sell, they are very cheap; and when they are very cheap, there cannot be much paid for making them: and that, consequently, the manufacturing working man’s wages are reduced, the mills are shut up, business is ruined, and general distress is spread through the country. But when, as now, the working man has the said 25s. left in his pocket, he buys more clothing with it (ay, and other articles of comfort too), and that increases the demand for them, and the greater the demand…makes them rise in price, and the rising price enables the working man to get higher wages and the masters better profits. This, therefore, is the way I prove that high provisions make lower wages, and cheap provisions make higher wages.
Sir Robert Peel, who was Prime Minster at the time, was very educated in the works of Hume, Ricardo and Smith: he understood the law of comparative advantage. With a massive starving Irish population (the “potato famine”) and pressure from the likes of Cobden at home, Peel powered through the repeal of the laws. In Morley, J. (1905) The Life of Richard Cobden, 12th ed., London: T. Fisher Unwin, 985 p., republished by London: Routledge/Thoemmes (1995), Peel said in his resignation speech after the repeal had been done for the UK:
In reference to our proposing these measures, I have no wish to rob any person of the credit which is justly due to him for them. But I may say that neither the gentlemen sitting on the benches opposite, nor myself, nor the gentlemen sitting round me—I say that neither of us are the parties who are strictly entitled to the merit. There has been a combination of parties, and that combination of parties together with the influence of the Government, has led to the ultimate success of the measures. But, Sir, there is a name which ought to be associated with the success of these measures: it is not the name of the noble Lord, the member for London, neither is it my name. Sir, the name which ought to be, and which will be associated with the success of these measures is the name of a man who, acting, I believe, from pure and disinterested motives, has advocated their cause with untiring energy, and by appeals to reason, expressed by an eloquence, the more to be admired because it was unaffected and unadorned—the name which ought to be and will be associated with the success of these measures is the name of Richard Cobden. Without scruple, Sir, I attribute the success of these measures to him.
The pound Sterling has lost some 99% of its value since the suspension of commodity-backed money post World War I, as successive governments have chosen not to confront their electorates in an honest fashion and say how much all the activities they say they are doing for you to get your vote will cost you. Instead, tax receipts pick up the majority of the costs of government, but there is always a bit of debt they choose to monetize. This means printing it out of nothing or creating it electronically our of nothing, a term which today is now called QE or quantitive easing.
So, instead of a Free Money Movement, I have started what I call the “Honest Money Movement”.
Why do I use the word honest?
Well I simply use it to show that, like the iniquitous Corn Laws that our forefathers sought to destroy as they gave privilege and wealth to one minority party at the expense of the masses, governments can take everyone’s wealth to benefit them and the few who organize this wealth transfer for them, i.e. the Central Bank and its client banks in the private sector who organize bond sales and purchases. They get the new money wealth effect first, just like the aristocratic land owners of old got the excess price of corn at the expense of the masses of working people.
If honest money is demanded, a government can no longer monetize debt it has to live or fall by its tax receipts only. This means when a politician comes to you at election time with a menu saying “we are going to give you X and Y” they will now have to say, “we propose to take £A and £B from you and give £A and £B to Mr X and Mrs Y” and you can then decide the merits of this knowing what you are getting yourself involved with.
Sir Robert Peel plays another role in our story. He was the first Prime Minster to do something about the bad effects of private sector bankers issuing notes purporting to convert into gold on demand. The trouble being, just as the landed aristocrats kept corn high at the expense of the wealth of the people, so the goldsmiths issued promises to pay on demand on bits of paper that functioned as money, over the actual amount of gold in their safe keeping. This criminality was stopped by the Bank Charter Act of 1844: the original text can be seen here and the amended text, that is still in force today, can be seen here.
Unfortunately for us, there was no restriction on the creation of demand deposits. A demand deposit is where a bank creates an IOU or a bank deposit out of thin air which functions as money.
You as the deposit holder can make payments to anyone who will accept your transfer of this IOU to them. Whenever you write a cheque it is drawn on a bank deposit, whenever you make an electronic payment, you make it from a bank deposit. In Peel’s day, there were over 20 bits of paper, called promissory notes, issued by the goldsmiths of the day, to every unit of gold. When people tried to redeem in gold, there was a “panic” and bust followed the boom.
The rapid creation of bank demand deposits since then has had the same effect. I seek to encourage an amendment to the Bank Charter Act to include deposits and finish off the job that Peel so courageously started. This would stop credit-fuelled boom and bust. All booms and busts, even the South Sea Bubble and the Tulip Mania, can be traced back to credit-fuelled binges that have been created by governments. Remove this power from the governments and their proxies, the bankers, and we can have honest money, peaceful enjoyment of the fruits of our labours and the enrichment of only those who earn it.
A starting point to advance this honest money movement is our banking reform proposal is available here. I hope you will help push for reform and end dishonest money and dishonest government.
More information
- Toby’s interview with Brian Micklethwait explores Toby’s philosophy in more detail: it can be found here.
- The staggering errors behind the policy of QE.
- In The Causes of the Economic Crisis, Mises forecasts and explains the breakdown of the German mark and the market crash of 1929: buy here or read online here (PDF).
By Toby Baxendale, on 26 February 10
A bank , building society that uses factional reserves, lends long and pays out short is only going to exist should confidence be kept in it. The “Run on the Rock” in the summer of 2007 saw people queuing to get their cash out of the Northern Rock which resulted in the first systematic run on a bank since the 1866 run on the Overend, Gurney & Company bank in the UK.
Readers of this site will know that a bank can only exist with the legal and accounting privilege that allows them to use current creditors – i.e. the depositors of the Presbyterian Mutual Society (PMS) – to lend out a multiple number of times to property loans and other entrepreneurial loans. Readers will also know that when they deposit money they in effect lend it to the bank and become a creditor to the bank. A deposit of cash into a bank/Mutual means you as the depositee lend money to the bank/Mutual That is, to be very clear, when you deposit, you cease to own the money – the bank does. This was established by law in 1811 in Carr V Carr and reaffirmed in Foley V Hill 1846.
The History
The Society’s audited accounts for the year ended 31st March 2008 showed £305m of loans and £5m of liquid assets to pay up to £310m on demand deposits. So one can deduce that there was only £5m of cash supporting £310m IOUs to its creditors, the depositors. This means that the PMS multiplied its credit creation to the tune of 62 times! This is nearly twice the average of all the banks licensed by the Bank of England. In fairness to the Society, they did pay out £21m before they were left with only £5m of cash, so £26m of cash was in their vaults when the run happened. Thus a more conservative 12 x credit was created out of thin air or a leverage ratio of 1 part cash to 12 parts credit existed in this Society.
A quick refresher on how the banking system allows this creation of credit out of thin air can be found here http://www.cobdencentre.org/2010/02/a-day-of-reckoning/ where I say, “ It is often forgotten but when you place £1m in a savings account (in cash) in say the Royal Bank of Scotland, which has no legal reserve requirement, they then lend £970k (in credit) , keeping on average 3% of cash back in reserves, to an entrepreneur in say HSBC, who then deposits that money in HSBC. We now have one claim to the original £1m and one claim to the £970k. The money supply has moved from £1m to £1.97m – just like magic! This is credit expansion.
The reality is that across all the banks in the United Kingdom licensed by the Bank of England, we have for every £1 of money (in cash), £34 in claims to money (credit)!”
The Administrators’ report tells the sorry story of events in summary which I list underneath, but one glaring fact is omitted. This is that the very Government of the UK actually triggered the loss of confidence in this Bank. When our Prime Minister in his own words was “saving the world” he ordered a full guarantee , government backed, on all deposits. The PMS, which had 10,000 members, went into administration following a rush by savers to withdraw their money at the height of the banking crisis in October 2008. People withdrew their money as they learned the Society was not covered by the government’s bank deposit guarantee scheme. Previously they were content to leave their money in the Society. For the purposes of this article, it is not needed to debate the point: was it or was it not a bank that should have been supported by this guarantee? The salient point being that not being guaranteed scared people into making withdrawals where little existed before.
From the Administrators’ report of the12th January 2009 that can be down loaded here http://www.presbyterianmutualsociety.co.uk/files/Administrator’s%20Proposals%2012.1.09.pdf the Society was placed into Administration by the Directors on 17th November 2008. The following are selected quotes from this report which speak for themselves:
“the demand for withdrawals by members of their investments exceeded its cash reserves;”
“the members’ investments were historically withdrawable on demand but the cash was invested by the Society in longer term investments such as property and loans.”
“For the Society to allow members to withdraw their investments on demand and invest members’ money in longer term investments, the Society required a high degree of confidence among its members that their investments were secure. However this confidence has been severely tested by the current economic climate and eventually the demand by members for withdrawals exceeded the Society’s cash reserves. …I believe it will be difficult for the Society in its current form to continue as a going concern.”
“loan capital will be treated as creditors and will therefore be paid in preference to members’ shares.”
“Government Guarantee
As you will be aware the Society does not benefit from the deposit guarantee scheme.
During the month of October 2008 the Society experienced an unprecedented increase in the number of requests for repayment of members’ investments. It was common practice for the Society to repay investments on receipt of a request, and payments of £21 million were made up to Friday 24th October 2008, leaving £4 million in the Society’s bank account.
An emergency meeting of the Society’s Board of Directors was convened on 25th October 2008 and it was resolved that:
…the 21 day notice period for the repayment of members’ investments be invoked in respect of requests received from members as at that date and any new requests received from members.
On 6th November 2008 the Society’s Board of Directors met again and it was reported that the demand among the Society’s members to withdraw their investments had increased which further exacerbated the Society’s liquidity. It was also reported at this meeting that legal proceedings had been commenced by three members seeking repayment of their investments. It was resolved by the Society’s Board of Directors on 6th November 2008 that the Society should be placed into Administration so that its assets could be protected, subject to enabling legislation being passed to permit the Society to go into administration.
During the period 27th October 2008 to 17th November 2008, the Society had received requests for withdrawals in excess of £50 million but the Society had cash reserves of only £4 million to meet such requests.”
Now this would have been the story of every bank in the UK if the government had not acted as it did as we were ‘panicking’ as a nation. We should also note that all banks are in the same precarious situation as the PMS was with regard to lending long and paying out short still, to this day. Do we need to live like this?
The Future Safe Way to Run Banks and Provide Interest for Savers and Lending to the needs of Trade.
If banks were mandated to hold 100% reserves of cash in their vaults, they could issue their bank statements saying what they owe you each month and you would know that you actually had cash in the vault to support your deposit that is represented by your bank statement. The bank statement after all is only a thing that would more accurately be called a “bank IOU statement.” Should you want interest you could ask for the cash you have deposited to be placed in a highly liquid government bond that could be converted into cash when you need it, paying you a rate of interest. Should you want a higher rate of interest, you can lend your money i.e. cease ownership and place in a bond that has in turn been lent to an entrepreneur for 6 months, 1 year, 2 years, 3 years, 5 years etc with the highest rate of interest being given for the longer term locked away and lent to somebody.
The Solution for Paying Out 100% of the PMS Depositors’ Lost Money- £310m – Now, Today
Following the work of 5 Nobel Prize winners and the founder of the American Chicago School, I would suggest the following written about in the Day of Reckoning article;
The Bank of England immediately issues notes to cover all the deposits i.e. redeem all the depositors for 100% cash notes and coins to be placed in their accounts. Please note, this costs the Bank of England the price of paper and the ink and nothing else and IS NOT INFLATIONARY and generates no liability to the UK taxpayer – see next point.
At the same time, get the administrator of the PMS to delete all current creditors (the depositors) as these have now been redeemed from the bank’s books by the Bank of England. The deleting of these bank obligations means that the money the depositors did lend on deposit to the PSM no longer exists, so for the sake of argument, if there was £310m of deposits, these have been redeemed in cash by the Bank of England and the equivalent amount of deposits have been removed from the money supply. Cost to the Bank of England = zero and cost to the UK tax payer = zero. Money supply stays the same.
The PMS in administration now has only assets i.e. loans from entrepreneurs /people who are repaying the loans or mortgages. These can now continue to get repaid, but instead of paying the creditors of the PMS, there are now none, so these loans can go into paying off the National Debt.
This way all parties win.
A courageous politician in Northern Ireland or in mainland GB could well put forward a Private Members’ bill which could be the first legislative move to establishing Honest Money.
The Day of Reckoning article linked to above provides the start of the legislative solution to the whole UK wide banking system whose model is sadly no different to that of the little PMS.
By Toby Baxendale, on 24 February 10
Our Corporate Affairs Director Steve Baker has posed this question to some of his fellow board members, “Would be great to nail this phenomenon on the system of money – that is to demonstrate clearly that it is credit expansion which redistributes wealth to the wealthy:
In other words, the trickle-down effect that is meant to spring from wealth accumulation has not worked as it should have. Flexible labour markets have delivered big time for bankers and shareholders, but failed to improve the lot of ordinary workers in the same way. In Britain, growth in consumption was funded not by real economic advancement, but by the fool’s paradise of ever-increasing debt.
http://www.telegraph.co.uk/finance/comment/jeremy-warner/7105004/Capitalism-has-forgotten-to-share-the-wealth.html
The essence of a credit expansion starts with the policy of the Treasury / Bank of England aka “the State”. The aim is to make money cheaper so that more money / credit is granted to borrowers, more economic activity is then meant to take place.
How is this done?
If you wanted to make jam cheaper, you would need to produce more of it for the same level of demand. The only way the jam market would clear is for the jam to sell at that demand for a lower price.
The State has the monopoly issue of money under its control. If the whole history of man was displayed in the form of a 12 hour clock, with today being the 12th hour, the State has only had this monopoly of the production of money since the end of the Gold Standard at the outbreak of the 1st World War. Attempts to get back on the Standard took place in the 20’s but were abandoned in the 30’s. Post World War II until 1971 there was a weak form of Gold Standard under the Bretton Woods system. Since that date, there has only been paper standards in different countries. So from the dawn of civilization until about the 11th hour and the 59th minute of human existence, Gold was money. It was a commodity for which all things exchanged for, it was produced by private individuals and no one person controlled the production of gold. Like language, it was a spontaneous invention of human beings to facilitate working together. It is thus one of the greatest inventions of man.
If the the State, as the monopoly issuer of paper money decided that the economy needs more liquidity (we have done this with our £200bn QE program), the bank will buy its governments outstanding debt obligations , or IOU’s, commonly called Gilts or Bonds, with newly minted money (to monetize). Thus the new money, like the new jam, or the jam over supply illustrated in the above example , enters the economy via the recipients of the new money.
Dear reader, I would like you to pause for a minute and ask yourself how comfortable would you feel about the government setting the price of jam and issuing all of its supply? Is this not what they tried to do in the Soviet Union? Absenting the price mechanism, that coordinates the choices of many millions of people, to allow suppliers of jam to know how much to produce to satisfy the demand for jam, and we have shortages for jam leaving shops empty for sometimes many months on end. Why do we trust the State to do this?
We seem to accept that the government, in its wisdom, that must be greater than that of all its citizens , can plan the production and supply of money as the old Soviet system did for a whole host of goods and services, for its subjects.
Experience will tell us, that like the Soviet production of jam, our State production of money will cause shortages and surpluses of varying degrees. Worst still, constructivist policy activism by the State via its agents at the Bank of England attempt each time they set the interest rate, to produce just enough money to keep the economy on an even keel. The evidence that they get this wrong is called “Boom and Bust.”
If you got jam production wrong, your surplus jam goes to waste or you can not feed your demand.
An over supply of money is called a “boom.” An undersupply is called “bust.” Every single boom from the Soutth Sea Bubble onwards can be traced back to some artificial expansion of money / credit not brought about by the free interplay of market forces determining the production of money. As money permeates every aspect of the economy, an over or under supply of it has far more consequences than an over or under supply of money. In this current “bust” I would submit that virtually all people in the world wide system of capitalistic production have been effected in their personal lives to some degree of negativity as they have had to adjust to the new world order.
The effects of this over supply are so little understood, it is worth while explaining once more by looking Richard Cantillon in his Essai sur la Nature du Commerce en Général (1755). This showed us that if money supply doubled, prices do not necessarily double. Money is not neutral in terms of consumption and production. Money goes into the system when created by the government to the bond holders whose bonds are redeemed. With this new money they have the first wealth effect of this new money. Like a counterfeiter he exchanges his new bits of paper for real goods and services, bidding up the prices of these goods and services. The producers of these initial goods and services then do the same with the goods and services that they buy and so on and so forth until the prices for the last people, those who spend less in the economy, the poor, those on fixed income (pensioners, the thrifty saver) etc, spend on goods and services that now have a higher money price. Thus, the insidious effect is a transfer of wealth away from the poorest in society to the richest in society: those banksters who buy / sell the bonds and the bond holders who have received the newly minted money.
We must remember, the bankster in all of this is often the agent of the State when he sells and buys the government debt either creating over supply or under supply of money. He takes his commission right at the well spring or the fountain of this money making process. He gets the first ability to benefit from the wealth effect as he can spend his money on goods and services at the same time as the bond investor. He is a direct recipient of the first order of the wealth transferred from the poorest to the richest members of society. The bankster is on the welfare state of credit. The government is totally in control of this process yet does not seem to realize it.
This is why Jeremy Warner in his well argued Telegraph article wonders how so much wealth has been created for so few and why his the trickle down did not have a positive effect on the poorest members of our society. I hope I have demonstrated that as the production of paper money in itself does not create wealth , as if it did, world poverty could be ended tomorrow, like a counterfeiter, new money allows its first recipients to exchange nothing (bits of paper) for real things such as Mayfair town houses etc. The sad salient point, is as the “wealth effect” works its way through society bidding up prices, the poorest people pay more for their goods and services. They have what little wealth they have confiscated to the benefit of the likes of the banksters who are knee deep on the welfare state of credit. Real wealth creation happens when entrepreneurs start coming up with better methods of production to make better goods and services more efficiently then before. There has been too much of the former providing the illusion of wealth and too little of the latter.
By Steven Baker, on 23 February 10
James M. Buchanan (Nobel Laureate, economics, 1986) on reform of the monetary regime through constitutional 100% reserves:
The market will not work effectively with monetary anarchy. Politicization is not an effective alternative. We must commence meaningful dialogue with acceptance of these elementary verities. Far too much has been said and written in elaboration of the first statement, which too often is taken to be equivalent to the assertion that “capitalism” or “the market” has failed. Admittedly claims for market efficacy without qualifiers can be found. But economists should know that anarchy can only generate disorder rather than its opposite.
Later:
It follows that there is no economic reason why any money system, in an idealized setting, would allow for leverage at any level. No holder of a unit of money, as an entry in a balance sheet, should be authorized to lend more than the face value of this unit, quite independent of probabilistically determined expectations concerning potential redemptions.
Why not? Because to allow separate banks to create short-term liabilities to a multiple of the base money on the asset side of the account removes from the issuing authority some of the control of the aggregate amount of that value treated as money in the economy without offsetting benefits, thereby making the financial structure vulnerable to unpredictable shifts among instruments, which, in turn, generate changes in real values.
The modern dilemma is that we are left with a massive resource-using, financial- banking structure that has a functional purpose quite different from that which is widely accepted. The system in existence emerged from a historical process, the characteristics of which were partially appropriate for a monetary standard defined in terms of some commodity base, but which, ultimately, make no sense under a fiat system.
Finally:
Let us not waste this set of crises by exclusive recourse to jerry-built efforts to patch up the failed monetary anarchy we have witnessed.
Read more: http://www.mps2009.org/files/Buchanan.pdf
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