Debt addiction, USA: how much debt reduction has the crisis caused?

The purpose of this essay is to put the latest crisis in the context of longer-term debt trends in the US and to attempt some predictions in respect to the US economy and financial markets.

Statistics are records of past events. Analyzing statistics means interpreting history, and this can only be done on the basis of theory. We must first have some theoretical notions to be able to render past events intelligible. Of course, historic data cannot be in conflict with the theory used, as that would put the validity of the latter in doubt. But we can neither use statistics to prove the correctness of a theory nor directly discover new theories (although history may give us ideas about potential theories). Before we look at the data I should give a brief outline of my theory, which readers of my book Paper Money Collapse will be familiar with.

The theory – short version

Paper Money Collapse challenges the prevailing consensus on money. This consensus holds that it is good to have something called ‘monetary policy’. Most mainstream economists today, while accepting the superiority of markets when it comes to allocating scarce resources to their most urgent uses, also maintain that in the field of money state involvement is desirable, and that a smoothly functioning economy requires a constantly expanding supply of state paper money and the guidance (manipulation) of certain market prices (interest rates) by a central bureaucracy, i.e. the central bank. More precisely, this bureaucracy should keep expanding the supply of money in such a way that money’s purchasing power declines continuously (moderate, controlled inflation) and that, whenever the economy is weak, it should use its powers to ‘stimulate’ the economy towards faster growth, usually through accelerated base money production and administratively lowered interest rates.

Paper Money Collapse argues that all these notions are erroneous and dangerous. Constant monetary expansion is not needed (not even in a growing economy) and is always highly disruptive. The continuous expansion of fiat money, naturally via financial markets, systematically distorts interest rates, which must lead to capital misallocations and other economic imbalances that will make recessionary corrections at a later stage inevitable. The recessions that ‘easy’ monetary policy is then supposed to shorten or ease are thus nothing but the result of previous monetary expansion.

Recessions can only be avoided by avoiding artificial booms through credit expansion. Once monetary expansion has led to sizable economic distortions the recession becomes unavoidable – and even necessary to cleanse the economy of dislocations. But to make matters worse, in our present system of unconstrained fiat money creation, recessions are – whenever they occur – countered by accelerated money creation (usually via new bank reserves from the central bank) and further cuts in interest rates. Imbalances are thus not being purged from the economy. Instead they accumulate over time making the financial system and the economy overall progressively more unstable. The system is moving towards a point of catharsis: either a complete purge is finally allowed to unfold (painful) or ever more fiat money is created until the public loses confidence in fiat money itself and a hyperinflationary currency collapse occurs (more painful).

I maintain that this theory is logically consistent and not in conflict with past events.

The data

Clearly identifying, let alone quantifying, imbalances is exceedingly difficult if not impossible. It is usually during crises that imbalances become visible as such. Consequently, analyzing data requires a considerable degree of judgement. In the following I look at ‘excessive indebtedness’ as a major dislocation caused by fiat money expansion.

The present monetary system naturally encourages the excessive accumulation of debt, and discourages deleveraging and disinflation, although at certain points in time these may be difficult to avoid altogether. During the financial crisis deflationary and recessionary forces briefly gained the upper hand. To what extent have they purged the system of money-induced imbalances? Has a meaningful ‘cleansing’ of imbalances taken place? If so, has the economy ‘healed’?

I had a look at the Federal Reserve’s Flow of Funds data and the following picture emerges.

Over the 31 years from 1981 to the end of 2012, total debt outstanding in the US economy grew from $5,255 billion to $56,280 billion. The debt load has increased continuously from year to year – with only one single exception: 2009, when total debt declined by just 0.2%. Debt has grown faster than nominal GDP in 27 out of 31 years. The average growth rate in total debt was 8% per annum, compared to 5.4% for nominal GDP. In 1981, total debt outstanding was 168% of GDP, today it is 359% of GDP.

In 1981, total debt broke down as follows: household debt was about 48% of GDP; business debt was about 53% of GDP; the public sector owed about 38% of GDP and the financial sector 29% of GDP. Note that of the four major sectors, the public sector and the financial sector were the two smaller ones. Debt of the financial sector was only slightly more than half of corporate debt.

Things looked very different by the end of 2012: Household debt had ballooned to 82% of GDP and corporate debt to 81%. Public sector debt now stood at 93% of GDP and financial sector debt at 103% of GDP. The public and financial sector had become the largest debtors.

While corporate debt was about 7.5 times larger in absolute terms at the end of 2012 than at the end of 1981, financial sector debt was 17 times larger. Over the 26 years from 1981 to the eve of the current financial crisis in 2007, financial sector debt grew at an average clip of more than 12% per annum compared to about 6% for nominal GDP over the same period. When we entered the present financial crisis in 2007, financial sector debt stood at an all-time high for any sector in US financial history, at 131% of GDP.

I maintain that such a dramatic growth in overall indebtedness, as well as the specific breakdown of that growth by sector, is symptomatic of our unconstrained fiat money system with its constant money growth and lender-of-last-resort central banks that encourage debt accumulation and promote high-leverage strategies in the financial sector. That this has led to substantial economic instability is now self-evident.

Has the US economy deleveraged since 2007?

The two sectors that were most exposed in 2007 were households (via the residential mortgage market) and the financial sector. Both sectors have shed debt since 2007. Both have deleveraged. Households reduced their debt from a record $13,712 billion in 2007 to $12,831 billion at the end of 2012. These $881 billion mean a reduction of 6.4%. The financial sector was forced to cut debt even more: From 2007 to 2012, total outstanding debt of the financial sector was reduced by more than $2,100 billion, a reduction of 12%.

Such reductions in debt were unprecedented in the 31-year history we are looking at here. At no point before had household debt and financial sector debt declined on a year-over-year basis. In this respect, the events of the recent crisis were indeed unique. ‘Cleansing’ has occurred. But how meaningful are these reductions? In absolute terms – total amounts of debt outstanding – both sectors are roughly back to where they were … Q3 of 2006, barely a year before the crisis started! Not much has happened in absolute terms. However, in recent years, the economy has continued to grow moderately, so as a percentage of GDP, household debt is today roughly where it was in 2002/3, and financial sector debt is about where it was in 2001/2. In relative terms, a decade of excess has thus been unwound.

Nevertheless, as mentioned above, the total debt load has continued to grow and stands at an all-time record today. The reason for this is mainly the explosion in public sector debt. While households and financial firms have cut debt by $3 trillion since 2007, the state has taken on an additional $6.6 trillion in new debt over the same period– almost all of it at the federal level! In fact, outstanding debt of the federal government has more than doubled since 2007!

The trend of ever-rising overall debt has thus continued. The deleveraging in the household and financial sector has, however, resulted in a reduced pace of debt accumulation overall, despite heavy borrowing from the federal government. In 2010, for the first time since 1992, the economy has grown faster than total debt, and this has continued in 2011 and in 2012, if at a slowing pace. Consequently, total debt stands at 359% of GDP today, slightly down from its peak of 381% in 2009. At 359% debt-to-GDP is back to where it was at in early 2007. Again, not much deleveraging has occurred in total.

Conclusion and outlook

I cannot see that the recent crisis has already brought about some kind of fundamental healing of the US economy, some much needed purge of monetary excesses. Yes, households and the financial industry have trimmed back and are now probably in better shape than a few years ago. Household debt numbers now seem to be stabilizing, meaning deleveraging could be coming to an end, while there is no sign yet that financial deleveraging has concluded. Of course, given the prevailing belief system, those who control the levers of the fiat money system are doing what they can to discourage further deleveraging. Zero interest rates and open-ended QE are hardly conducive to debt reduction.

Here are my present forecasts, and they are necessarily highly speculative:

  • Super-easy monetary policy will continue as far as I can see. The Fed has declared that it wants to use monetary policy to boost employment (the hubris of the bureaucrat!). But deleveraging in the financial sector, if it persists, would be a problem for the Fed’s strategy. The financial sector is crucial in transmitting easy policy. The Fed can thus reasonably be expected to continue leaning against deleveraging with all its might. And if and when deleveraging turns into re-leveraging, the Fed will probably nurture it for some time.
  • Public sector profligacy is not a crisis phenomenon but has been in full bloom since 2002 and is now in large part structural. A political solution looks unlikely any time soon. The state will thus continue to be the main driver behind the overall growth in debt. Funding this debt accumulation is not a problem with the Fed now the biggest marginal buyer of Treasury securities and the Fed unlikely to abandon super-easy policy anytime soon.
  • The corporate sector has not been a major driver in this story so far. Recently, corporate debt has begun to expand again. It is not unreasonable to assume that this will continue.
  • In aggregate, the picture could be the following: outstanding debt of the public sector will continue to grow rapidly, corporate debt mildly to maybe strongly; household indebtedness might stagnate. The wild card remains the financial sector. My guess is that what little overall deleveraging we experienced – measured as a modest decline in total debt in relation to the economy’s capacity for income-generation, i.e. GDP – is in the process of being reversed. The interventionists (i.e. the mainstream) will hail this as a success of policy. ‘Debt-deflation’ has been avoided – for now. A more realistic assessment is that the economy is as much on financial steroids as a few years ago, and – in aggregate – as fragile. Expanding debt levels further from here will require interest rates that are continuously depressed through policy and an even more activist and interventionist central bank. The Fed is fully on board with this.
  • Deflation is very unlikely from here. The debasement of paper money continues. Inflation rates should begin to move higher.

Debt-GDP-ratios of 359% (now) or 381% (2009) are unusual historically. The ratio was below 200% at the start of the Great Depression and it peaked at a touch above 300% in 1933, when nominal GDP collapsed. The current debt load is unprecedented. But then, countries such as Japan and the UK have total debt in excess of 500 percent of GDP. Disaster still looks inevitable but maybe not imminent.

…a final word on the bond market.

It so happens that the start year of the above analysis – 1981 – also marked the peak in bond yields in the US. 10-year Treasury notes reached 15% back in 1981 and went on a downward path from there that lasts to this day. We have had an almost uninterrupted, 31-year bull market in bonds. Not only Treasuries but also corporate and mortgage debt are presently trading at or near historic lows in yield. Although the US economy never had to carry more debt – certainly never more in absolute terms and almost never more relative to GDP – the compensation that investors get for holding all this debt has never been lower!

Sure, inflation was still high in the early 1980s but the structural drop in inflation was over by 1992. CPI inflation has broadly moved sideways in a stable range since the early 1990s without any additional disinflationary momentum.

It seems that over the past three decades the debtors were encouraged to take out ever more debt because the lenders – the bond buyers – were happy to hold ever more debt at ever lower yields. A market in which demand for assets keeps rising at persistently rising prices (persistently falling yields) has all the ingredients of a bubble. I think the US bond market – and by extension, international bond markets – could be the greatest bubble in history.

The big question is when will this bubble pop?

This article was previously published at


Did the savings glut or massive monetary expansion cause the boom and the bust?

Ambrose Evans-Pritchard recently pinned the blame for the financial crisis on “Asia’s `Savings Glut’”. This idea is not new. For readers who may have missed it the first time, we’re republishing this article from September 2009 which argues that monetary policy caused the boom, the bust and the savings glut.

Martin Wolf - Global Imbalances

Martin Wolf – Global Imbalances

Distinguished commentator and economist Martin Wolf of the FT holds that the savings glut was the source of the excess liquidity that caused the current crisis in which we all find ourselves.

Wolf’s views are expressed crisply in this PowerPoint presentation. In summary, he tells how the Mercantilist approach of the emerging nations after the Asian crisis of the 90s led to a policy of setting exchange rates to encourage exports and limit imports, supported by the stockpiling of foreign currency (a majority in USD) to fund the whole program. The imbalances can be seen as either a “savings glut” or a “money glut.”

I believe from reading Wolf’s articles in the FT that the suggestion is that the savings glut nations not only have policies of fixing exchange rates to encourage exports over imports but also that the people in those nations have a much greater propensity to save than their Western counterparts. It is argued that this demand for money, certainly in USD, causes the Federal Reserve to embark on an expansionist policy.

From page 15 of Wolf’s presentation:

  • My own view is that the savings glut caused the money glut, by driving the Federal Reserve to pursue expansionary monetary policies, which then led to the reserve accumulations in the creditor countries
  • But it is also possible to view the Federal Reserve as the causal agent: the money glut causes the savings glut
  • Either way, the reserve accumulations and fixed exchange rates played a big role in the story

I interpret Wolf’s remarks to mean that when the massive accumulated USD reserves in the emerging nations were partially spent, a surge in liquidity arrived back at the shores of the USA, causing a housing bubble, subprime lending, less than secure CDO’s etc and the bust we now observe.

Wolf is in good company. It would seem that Federal Reserve Chairman Ben Bernanke has endorsed this view in at least the following two recent speeches.

Chairman Ben S. Bernanke, Council on Foreign Relations, Washington, D.C., March 10, 2009 :

Financial Reform to Address Systemic Risk

The world is suffering through the worst financial crisis since the 1930s, a crisis that has precipitated a sharp downturn in the global economy. Its fundamental causes remain in dispute. In my view, however, it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. In the simplest terms, these imbalances reflected a chronic lack of saving relative to investment in the United States and some other industrial countries, combined with an extraordinary increase in saving relative to investment in many emerging market nations. The increase in excess saving in the emerging world resulted in turn from factors such as rapid economic growth in high-saving East Asian economies accompanied, outside of China, by reduced investment rates; large buildups in foreign exchange reserves in a number of emerging markets; and substantial increases in revenues received by exporters of oil and other commodities. Like water seeking its level, saving flowed from where it was abundant to where it was deficient, with the result that the United States and some other advanced countries experienced large capital inflows for more than a decade, even as real long-term interest rates remained low.

Chairman Ben S. Bernanke, The Morehouse College, Atlanta, Georgia, April 14, 2009:

Four Questions about the Financial Crisis

Importantly, in our global financial system, saving need not be generated in the country in which it is put to work but can come from foreign as well as domestic sources. In the past 10 to 15 years, the United States and some other industrial countries have been the recipients of a great deal of foreign saving. Much of this foreign saving came from fast-growing emerging market countries in Asia and other places where consumption has lagged behind rising incomes, as well as from oil-exporting nations that could not profitably invest all their revenue at home and thus looked abroad for investment opportunities. Indeed, the net inflow of foreign saving to the United States, which was about 1-1/2 percent of our national output in 1995, reached about 6 percent of national output in 2006, an amount equal to about $825 billion in today’s Dollars.

Saving inflows from abroad can be beneficial if the country that receives those inflows invests them well. Unfortunately, that was not always the case in the United States and some other countries. Financial institutions reacted to the surplus of available funds by competing aggressively for borrowers, and, in the years leading up to the crisis, credit to both households and businesses became relatively cheap and easy to obtain.

The Error

I submit that these two great economists have made a grave error. The government of the USA has legal tender laws that allow only it, ultimately, to create USD via its sanctioned agent, the US Federal Reserve. As it is in charge of the stock of Dollars and the fractional-reserve banking system, it is (counterfeiting aside) the sole source of all issuances.

As I have pointed out in other articles on this site, we use money to exchage our goods and services that we make/provide for sale for other goods and services. Money is the final good for which all other goods and services exchange. Dollars in the USA are the final good you use to exchange your goods for goods offered by other people. A price of a good exchanged for another good is the amount of money paid for that good.

If the pool of money is getting larger, there will be more Dollars to exchange for goods and services. If the quantity of goods and services offered for sale and the number of Dollars in circulation are growing at the same rate, it is possible to argue, if you are prepared to set aside the problems of relative prices, that the “general price level” will be unaffected. However, any economist would argue that if the supply of money increases faster than the supply of goods and services, prices will rise: like any other good, money is devalued by creating more of it.

Therefore, the cause of the crisis can be found only at the door of the monetary authority that created the money in the first place – i.e. the Federal Reserve and other deficit-nation central banks – and not with the saving glut nations. All they have done is seek to exchange some of their goods and services for some of the goods and services of the USA, expressing a time preference along the way. This transfer of ownership does not in itself “bid up prices” to create an “asset price boom”: it is the creation of new money which devalues it.

If new Dollars are locked away for a time and only return to their original economy in an abrupt fashion, they could well seem to be the cause of a sudden asset price bubble, but the prior cause can only be the creation and supply of the wherewithal to do this in the first place.

A Note on Mercantilism

Wolf mentions in his PowerPoint presentation quite rightly that the modern trade regime we have is “in short, a mercantilist hybrid”. Many of the Classical Economist and Political Philosophers such as Hume, Locke, Smith and in later times David Ricardo, point out in various writings that the bullion (gold and silver) that was invariably money was not wealth as such but that the goods they exchanged against were. So, create more money with no associated increase in productivity and the prices of things will rise. Consequently, the Mercantalist goal of having exports higher than imports and thus more bullion at home would just mean that prices would rise at home and cause a flow of that specie to move away from home. Therefore, if in the analogy you substitute US Dollars for bullion, our saving glut nations will get nowhere fast pursuing this policy.

Gold represented claims on already produced wealth. Thus it makes perfect sense that the more wealthy (industrially-devloped, capitalistic etc) countries had more gold historically. As we do not have a link to gold anymore, the USD acts in its capacity as the World Reserve Currency, like gold of old. Using this analogy, the gold producer / gold miner writ large is the Fed and other Central Banks. Dollars will flow away from the mine in exchange for goods and services and this causes a transfer of ownership of goods and services from people in the USA to people in the saving glut nations but can have nothing to do with asset price bubbles as the money was printed by the Fed and no one else. To argue that the savings glut itself has caused the asset price boom is seemingly to endorse the Mercantalist doctrine that was so clearly discredited many moons ago.

Some other reflections on this concept of a “Savings Glut” disturb me and lead me to question whether it is really a meaningful concept at all.

These saving glut nations still seem to have massive gluts but if spending the glut caused the bubble, you would expect the glut to have fallen as well; seemingly, it has not.

If nations save to create a glut, they must indeed refrain from consumption on domestic goods to boost the supply of export goods. This means cheap goods arrive on the shores of the deficit nations. Can this cause a boom across the economy? I think not.

The deficit nations are largely well-developed. As a 40-year-old entrepreneur with a mature business and a happy family, all well rooted in Hertforsdhire, I often say to my wife, “If I was 18 again, I would be straight out to China to exploit some of those massive developmental opportunities. The whole economy seems to be like Manchester was in the Victorian times.” So why do savings there, which should attract a greater rate of return there, not stay there?

In summary, the Fed has more than doubled its money supply since the mid 90’s as have other leading deficit nations. The savings glut and the boom and bust is only attributable to the lax money creation programs of irresponsbile central bankers around the world. They have a poor understanding of economic history and they make an intellectual mistake in misunderstanding what those Classical thinkers knew: money is not wealth.


ECB money injection not a reason for optimism

Are you feeling optimistic yet? Are you confident that policy-makers have things under control? – If so, you must believe that we can solve any economic problem by throwing freshly printed money at it. Even problems that are evidently the result of previous periods of ‘easy money’– such as overstretched and weak banks.

The ECB this week allotted another €529.5 billion of new money to Europe’s banks. The banks get these funds for three years at 1 percent interest. That this is a gigantic subsidy for one specific industry does not require much explanation.

This operation, called long-term refinancing operation (LTRO) is only possible because the ECB has a printing press. The ECB can print unlimited amounts of euros and lend them to the banks at whatever rate it wants and against whatever collateral it deems appropriate. For this round of the LTRO collateral requirements have been eased again: the ECB gets ever more generous.

LTRO is nothing but the refinancing of struggling banks through money printing. This is one of the operations that the advocates of fiat money and opponents of a gold standard tell us we should all be grateful for. Such a ‘proactive’ policy of bailing out banks and ‘stimulating’ the economy would evidently be impossible in a system of hard and apolitical money. — True, but it would also be unnecessary. It is entirely inconceivable that the present mess, which is the result of a gigantic credit boom funded with a constantly expanding supply of fiat money, could have developed under a proper gold standard. The extent to which banks could over-lend, take risk, leverage their balance sheet and help blow various asset bubbles was only possible in a fiat money system with persistent expansion in bank reserves, with lender-of-last resort central banks, and repeated and lengthy periods of artificially low interest rates.

What we are seeing now is not the result of some unfortunate policy mistakes. The idea of the ‘policy mistake’ implies that the system itself is sound and would deliver the hoped-for results if only it was handled properly. “If only Greenspan had tightened earlier after the 2001 recession…”, “if only Greece had stayed out of the euro,…” — these deliberations are completely missing the point. Okay, maybe it would have taken longer for the system to reach its logical endpoint but it wouldn’t change the nature of that endpoint. Fiat money systems – systems of essentially fully elastic money – are fundamentally incompatible with capitalism.

The present crisis is therefore the crisis of our fiat money system. A system for cheapening credit artificially, systematically. A system in which the banks can grow, never shrink. A system in which prices always rise, never fall. A system in which we take on debt and never pay it back. A system in which the money supply always grows, never stalls and never shrinks. A system in which we only have booms, never busts. At least not big ones.

Never?—Well, until the system chokes on its own inevitable adiposity, its arteries clogged, its heart too weak. Or, in the parlance of economics, at the point at which the imbalances that a system of ‘elastic’ money constantly accumulates have reached system-threatening proportions. – That would be now.

Wednesday’s loans were on top of the €489.2 billion of similar loans the ECB dispensed to 523 banks in late December. The ECB’s goal is to help struggling banks pay off maturing debts and to coax them to lend to strained governments and customers.

The Wall Street Journal reports.

We are almost 5 years into the financial crisis. This crisis started in the US subprime market in July 2007. In August 2007, Germany’s IKB had to be bailed out. In September, the UK’s Northern Rock experienced a bank run. Since then the numerous bailouts, the trillions of newly printed currency units and the zero interest rates in all major countries have avoided or arrested or postponed the total collapse of the system, and have generated the intermittent pseudo-recoveries. That the underlying problems are not solved is resoundingly confirmed by yesterday’s move by the ECB. The crisis started in 2007 and we are still in it.

A banking system that needs €1 trillion in long term zero cost loans from its central bank within 3 months is not a healthy one. Those who advocate this policy will say that without it we would have faced disaster. I agree, and I do not relish the thought of what that means. But how does the present policy solve anything?

With essentially unlimited funding at essentially no cost, no bank will fail. But ‘unlimited’ is a word that has no place in economics, which is always about the best use of limited resources. ‘Unlimited funds’ from the central bank is a scam, a deceit, a trick, a mirage. This is not the healing of the market economy. It is the complete abandonment of a market economy.

Failure – bankruptcy – is as indispensible to a functioning economy as death is to the concept of life.

This policy is no solution. It is a policy of perpetuating the crisis, of deep-freezing the imbalances, and of magnifying the accumulated aberrations.

Do we know which banks are in good shape and able to stand on their own two feet? No, and policy-makers do not want us to find out. – Do we know how big the banking sector should be and what shape it should have in a post-bubble economy? No, and policymakers do not want us to find out. – Do we know what the cost of funding the deficits of countries like Spain and Italy are? No, and policymakers do not want us to find out. They want us to believe that all banks are money-good, that all countries are money-good and that we are in a recovery. “Don’t worry, be happy!”

I guess LTRO is to our time what LSD was in the 1960s. As they used to say back then, “I don’t have a problem with drugs, I have a problem with reality.”

The reality is that financial markets are rigged. Prices are manipulated. Nobody can tell to what extent asset prices, interest rates and risk premiums reflect true available savings and real risk appetite, and to what extent they simply reflect the skillful manipulations of central bankers and the wall of money sweeping through the system. I believe you should stay away from rigged markets as much as possible. Keep your exposure to banks to a minimum, and stay away from government bond markets altogether.

This is why gold remains so attractive. If they stop printing money, the gold price will correct. But then banks and governments will be in serious trouble. So you still cannot put your money there. My guess is that they won’t stop printing money, and what the ECB did this week – although it was already anticipated – further confirmed this. Gold got a considerable beating yesterday, supposedly because Bernanke did not hint at additional easing measures. Well, we will see. Given the aggressive measures we have seen since October from the Fed (swap lines), Bank of England (2 rounds of QE), the ECB (2 rounds of LTRO), and the Bank of Japan ($129 billion in QE), we may see another manufactured rise in financial asset prices and in certain economic indicators over coming months. Maybe we can all enjoy a spring ‘recovery’. The hangover can wait — we just opened another bottle of the really strong stuff.

Let’s see how long it lasts.

In the meantime, the debasement of paper money continues.

This article was previously published at Paper Money Collapse.


Phases of the crisis – are we approaching the endgame?

Phase 1: Greenspan, the arch money crank

The Greenspan “put”, and the collective adoption by most central bankers of low interest rates after the dot-com bust and 9/11, caused one of the largest injections of bank credit in history. Since bank credit circulates as money, we can say public policy has created the largest amount of new money in history.

This should never be confused with creating new wealth. That is what entrepreneurs do when they use the existing factors of production — land, labour and capital — in better ways, to make new and better products. The money unit facilitates this exchange.

Now to a money crank.  He will assume that new money will raise prices simultaneously and proportionately, so the net effect of the economy is that all the ships rise with the tide at the same rate. He’ll say that money is neutral and does not have any effect on the workings of the economy.

One of the great insights of the older classical economists, and in particular the Austrian School, is that new money has to enter the economy somewhere.  Injected money causes a rise in the price levels associated with the industry, businesses, or people who are fortunate enough to be in receipt of the new money. Prices change and move relative to other prices. It is often quite easy to see where the new money enters into the economy by observing where the booms are.

Suppose a banker sells government bonds to another part of the government (as has been the case with UK QE policy).  For selling, say, £30bn of government debt to the Bank of England, he gets a staggering, eye-popping bonus. With his newly minted money, he buys a new £10m house in Chelsea, a £5m yacht in Southampton, some diamonds for the wife to keep her happy, and lives a happy and rich life. The estate agent spends his commission on a luxury car, and some more humdrum items that mere mortals buy.  At each point in time, the prices of the goods favoured by the recipients of new money are being bid up relative to what they are not spending on.  Eventually these distortions ripple through the economy, and the people furthest from the injection of new money — those on fixed income, pensioners, welfare recipients — end up paying inflated prices on the basic goods and services they buy. A real transfer of wealth takes place, from the poorest members of society to the richest. You could not make this up. I am no fan of the “progressive” income tax, but I certainly can’t support a regressive wealth transfer from the poor to the rich!

Even when the government was not creating new money itself, it was setting the interest rate, or the costs of loanable funds, well underneath what would naturally be agreed between savers and borrowers.  Bankers are exclusively endowed with the ability to loan money into existence, so they welcome the low rates and happily lend, charging massive fees to enrich themselves in the process.

After the dot-com bubble, it was property prices that went up and up.  Not only do we have the richer first recipients of new money benefiting at the expense of the poor, we have a massive mis-allocation of capital to “boom” industries that can only be sustained so long as we keep the new money creation growing.

Our present monetary system is both unethical and wasteful of scarce resources. We do not let counterfeiters lower our purchasing power, and we should not let governments and bankers do it.

Phase 2: Bush & Brown – private debt nationalised by the Sovereign

This flood of new money brought more marginal lending possibilities onto the horizon of the bankers.

They devised a range of exotic products whose names are now familiar: CDO, MBS, CDO-squared, Synthetic CDO, and many more — all created to get lower quality risk off the issuing bank’s balance sheet, and onto anyone’s but theirs!

In 2007/2008, bankers started to wake up to the fact that everyone’s balance sheets were stuffed with candyfloss money, at which point they suddenly got the jitters and refused to lend to each other.  As we know, bankers are the only people on the planet who do not have to provide for their current creditors; they can lend long and borrow short. Thus, the credit crunch happened when the demand for overnight money to pay short-term creditor obligations ran dry.

Our political masters then decided that we could not let our noble bankers go bust; we had instead to make them the largest welfare state recipients this world has ever known! Not the £60 per week and housing benefit kind for these characters, but billions of full-on state support to bail out their banks. They failed at their jobs and bankrupted many, but they kept their jobs with 6, 7, or 8 figure salaries!

Bush told us that massive state intervention was needed to save the free market. Brown said the same. We were told that there would be no cash in the ATMs and society would most certainly come to an end if heroic action was not taken to “save the world”, as Brown so memorably put it (though he seemed to think he had accomplished this feat singlehandedly). Thank God for Gordon!

Now in Iceland, a country I was trading with at the time, their banks did go bust; no one could bail them out. But within days the Krona had re-floated itself and payments continued; within weeks they had a functioning economy.

Within days the good assets of Lehman Bros had been re-allocated, sold to better capitalists than they.

But with these notable exceptions, socialism was the order of the day. Bank’s inflated balance sheets were assumed by sovereign states. Like lager louts on a late night binge, after a Vindaloo as hot as hell itself, heads of government seemed to care little for the inevitable pain that would follow, as states tried to digest what they had so hastily ingested. Indeed, the failed organs of the nationalised banks survive only on life support, enjoying continuous subsidy through the overnight discount window.

But the sovereign governments, under various political colours, had a history of binging. In our case the Labour Party spent more than it could possibly ever raise off the people in open taxes, and the Tories offer “cuts” which in reality mean that the budgets of some departments will not increase as quickly as they were planned to.

Phase 3: King Canute, sovereign default

Default is the word that can’t be mentioned. In reality, we should embrace default. This debt is never going to be repaid. Never, that is, in purchasing power terms.

S&P ratings agency have hinted at this with the recent US rating downgrade. They know the American government can always mint up what it needs so long as it has a reserve currency. They also know that this is a soft default. In real terms, people seem likely to get back less than they put in.

Hard default should be embraced by the smaller nations like Greece and Ireland, so they can rid themselves of obligations they cant afford to pay. This will be good for taxpayers in the richer countries of Europe, as they will no longer be bailing out those who foolishly lent to these countries. It will be good, too, for the debtor nations, as they can remove themselves from the Euro and devalue until they are competitive again. They will, however, need to learn to live within their means. Honest politicians need to come to the fore to effect this.

Yes, this will be painful and the people who lent these profligate and feckless politicians the money will get burnt.

However, the FT has recently seen prominent advocates for a steady 4%-6% inflation target. This is the debtors’ choice and the creditors’ nightmare, with collateral damage for those on fixed or low incomes, for the reasons mentioned above. Should we let the Philosopher Kings have their way?

“Let all men know how empty and worthless is the power of kings. For there is none worthy of the name but God, whom heaven, earth and sea obey”.

So spoke King Canute the Great, the legend says, as waves lapped round his feet. Canute had learned that his flattering courtiers claimed he was “so great, he could command the tides of the sea to go back”. Now Canute was not only a religious man, but also a clever politician. He knew his limitations – even if his courtiers did not – so he had his throne carried to the seashore and sat on it as the tide came in, commanding the waves to advance no further. When they didn’t, he had made his point: though kings may appear ‘great’ in the minds of men, they are powerless against the fundamental laws of Nature.

King Canute, where are you today? We need honest politicians and brave men to step forward and point out the folly of trying paper over the cracks. Unless banks write off under-performing (or never-to-perform) securities from both the private sector and the public sector, we will progressively impoverish more and more people.

Let better business people buy the good assets of the bust banks, and let them provide essential banking services.

Let the sovereigns that can’t pay their way go bust and not impoverish us any further with on-going bailouts. In all my years in business, your first loss is always your best loss.

Yes, this will be painful. Politicians, fess up to the people: you do not have a magic bullet and you can’t offer sunshine today, tomorrow and forever.

I fear that if we do not do this, we approach the end game: the total destruction of paper money. Since August the 15th 1971, paper money has not been rooted in gold. It is the most extreme derivative product, entirely detatched from its underlying asset. Should the failure of this derivative come to pass, we will have to wait for the market to create something else. Will we be reduced to barter, as the German people were in the 20s?

A process of wipe out for all will be a hell of a lot harder than sensible action now.  It is still not too late.


My Journey to Austrianism via the City

Another classic article, brought forward. This is a speech by James Tyler to the Adam Smith Institute Next Generation Group on 6 October 2009. This speech is also available on

I have spent the best part of the last two decades pitting my wits against the market. It’s an unforgiving game: I’ve seen ups and downs, and many of my rivals buried under an avalanche of hubris, passion, illogical thought and unchecked emotion.

I have witnessed the sheer folly of the ERM crisis, the Asian crisis, the failure of the Gods at Long Term Capital Management and the insanity of the tech boom.

I have enjoyed the ‘NICE’ decade (Non-Inflationary Constant Expansion), and scared myself silly during the credit crisis.

I am a trader.

I risk my own money and live or die by my decisions, and face the threat of personal bankruptcy every time I switch my screens on. I get no salary – indeed I turn up at the start of the month with a large office overhead – a ‘negative’ salary. I have no fancy company pension scheme, no lucrative monopoly or franchise.

I eat what I kill.

Mistakes cost me my livelihood, so, above all, my decisions have to be rooted in practical and logical decision making.

Some have called my kind parasitic, but I would have said that I bring order, efficiency, predictability, stability and deep liquidity to a crucial process: a process that makes the whole world keep ticking.

I make money work.

I make the market in interest rate derivatives: a market born out of the neo classical revolution in finance fostered in Chicago during the 1970s. I am a child of Friedman, Fisher Black, Myron Scholes and the modern international financial system.

My analysis was steeped in the neo-classical, efficient markets paradigm.

Friedman’s ideal was working. Enlightened central bankers guided the free market with gentle nudges and short term liquidity infusions, free floating currencies gently adjusted themselves to the constant flow of new information and efficient and rational markets took all in their stride.

Credit flowed, people got wealthier, economies developed and all was well.

And then the crisis struck.
Continue reading “My Journey to Austrianism via the City”


Money is not working.

A speech to the Policy Exchange on 31st March 2009 by Cobden Centre sponsor James Tyler. This article first appeared on but it remains as relevant today.

I want to talk about two things today;

Number 1: Free markets did NOT cause this crisis… Governments did.

Number 2: Inflation targeting has failed. Money has failed. What should we do?

Free markets did not cause this problem.

In theory, markets work by reacting to prices and direct capital towards where it will be most productively used. This is how wealth is created. Usually this works well, but markets are made up of humans, and can be fooled into overshooting by false signals.

Bubbles build up, expanding until people lose confidence. Bubbles then burst. It’s a corrective process that, relatively benignly, irons out imbalances.

The problem only comes when bubbles go on for too long, because once they get too big, the pop can be terrifying. And that’s what we’ve got now – one hell of a big bang.

False signals have caused a spectacular mal-investment in real estate and its derivatives.

But these false signals did not come from the market, but from government.

False signals.

False signals came from Greenspan’s introduction of welfare for markets. Markets were taught that no matter how much risk they took, they would always be saved. 1987, 1994, 1998, 2001. Each bust bigger than the last, and disaster was only staved off with aggressive rate cuts and increased money supply.

Clearly this was not laissez faire. Just think if events had been allowed to take their course. I bet if LTCM had gone bust then a badly burned Wall Street would have learned a lesson and Lehman’s would still be around today.

In 1999 Clinton mandated that Fannie Mae and Freddie Mac reduce lending standards. The poor were encouraged into debt. This intervention triggered a race to the bottom of lending standards as commercial banks were forced to compete against the limitless pockets of Uncle Sam.

False signals came from deposit insurance. Deposit your money in a boring mutual? Why bother when you can lend it to a lump of volcanic rock in the Atlantic at 7% and be guaranteed to get your money back.

The Basle banking accords required banks to replace rock solid reserves with maths.

Government protected and regulated ratings agencies produced negligent ratings duping pension funds, who were obligated to buy high quality paper, into buying junk cleansed by untested mathematical models.

Central banks create boom-bust.

But most damaging of all was the absurdly low interest rates set between 2001 and 2004.

The resultant glut of cheap money fueled an unsustainable boom encouraging more mortgages to be taken out, and pushing property prices ever higher.

The market responded by pushing scarce economic capital towards highly speculative property development.

As prices rose people remortgaged, and borrowed to consume more. This unchecked process tended to be destructive, as scarce economic capital flowed out of our economy and headed to those economies efficiently producing consumer goods, such as China. Rampant asset inflation clouded our ability to see this depletion process in action.

Everyone had a great time whilst the party lasted, not least Governments who were incentivised to let it run, blinded by ever larger tax revenues.

But all parties come to an end, and central banks had to prick the bubble eventually. Interest rates went too high, and sub prime collapsed, and then all property prices plummeted. Trillions of dollars were ripped out of the financial system, and the credit crunch began.

It’s happened before.

But, despite its complexity, there was nothing new or unpredictable about this process. All the great busts of the 20th century were preceded by a Government sanctioned fiat currency booms.

In the 1920’s, the Fed pursued a ‘constant dollar’ policy. This was the era of the innovation, Model T Fords, radios and rapid technological advancement.

Things should have got cheaper for millions of people, but money supply was boosted to try and keep prices constant. All that extra money flowed into the stock market, pushing prices to crazy levels, and we all know how that ended.

In the modern day, targeting price changes has been an utter disaster for us too.

It let the Bank of England pretend they were doing their job, when money supply was growing at a double digit rate. It let the authorities relax whilst an economy threatening credit bubble was building up.

And it gave Gordon Brown the leeway to convince people that boom and bust was over.

Things should have got cheaper.

Inflation targeting made no allowance for globalisation, the rise of India and China, and the benign falls in general prices that should have been triggered. Think about it; if all those cheap goods were to become available, consumer prices should fall. We would have had greater purchasing power, and become wealthier for it.

But, the Bank of England was aiming at a symmetrical plus 2% target. Falling prices in some goods necessitated stimulating rises in others. They unleashed an avalanche of under priced debt and we had our own crazy asset boom.

Inflation targeting was a myopic policy.

Governments make terrible farmers.

When a central bank sets interest rates, they set the price of credit. Inevitably they create distortions.

Consider this; Governments cannot set food prices without causing a glut -or- painful shortages. Now, food is a pretty simple commodity, yet we all understand that central planners simply cannot gather enough information to set the price accurately.

It has to be left to the spontaneous interaction of thousands of buyers and sellers to set the price.

So, why do we think that enlightened bureaucrats can put an exact price on something as vital, yet complicated, as credit?

In a nutshell, if I can’t tell how much my wife will spend on Bond Street this weekend, how can they?

Let’s wake up from this fantasy.

There is a better way.

What’s the cure? Let the invisible hand to do its time honoured job. Leave interest rates to be set by the millions of suppliers and users of capital.

Get the central planners out of the way.

It’s the way it used to happen. The period of fastest economic growth the world has seen was America between the civil war and the end of the 19th century. Money was free and private and the Fed did not exist.

So, how do we get back to freedom in money? Fredrich Hayek – the great Austrian economist – did the best thinking on this. What he proposed was that private firms should be allowed to produce their own currencies, which would then be free to compete against each other. People would only hold currency that maintained its value, firms that over-issued would go bust Producers of ‘sound’ money would prosper.

History gives us plenty of successful examples of private money working well, 18th Century Scotland had competing banks, all with their own bank notes. People weren’t confused. It worked. There are many other examples.

In the modern age, technology makes the prospect of monetary competition even more tantalising. Mobile phones, oyster cards, smart tags, embedded chips, wireless networks. The internet. Prices could flash up in the shopper’s preferred currency.

A proposal.

Here’s an idea of how to kick the process off;

Tesco’s want to get into banking. Why not currencies as well? Tesco would print one million pieces of paper. Let’s call them Tesco pounds. It would be redeemable at any time for £10 or $15. They would then be auctioned, and the price of a Tesco set.

Anyone who owns a Tesco has a hedge against either the £ OR $ devaluing therefore the Tesco has an additional intrinsic value. Maybe they’ll auction at £12.

Tesco would specify a shopping basket of goods that cost £60. It would promise that 5 Tesco Pounds would always buy that weekly shop. The firm would use its assets to adjust the supply of Tesco Pounds so that they kept this stable value.

They would need to otherwise their shelves would be cleaned out!

As central banks inflated the £ and $ away over time, the convertibility into these currencies would matter less. We would be left with a hard currency that meant something.

There would be other competitors and a real choice about which money to hold your wealth in.

McDonalds has a better credit rating than Her Majesties Government, so maybe people would be happy to hold Big Mac tokens? I don’t know – it will be a free choice.

Currencies would sink or swim depending on how well they performed. What’s more, firms issuing the currencies would come up with different ways of maintaining their value. Some would offer Gold. Manufacturers may use notes backed up by steel, copper and oil.

Let’s see what a free market chooses. Somebody might have a brainwave and come up with an idea that nobody has thought of.

That is what free markets are best at.

I can guess the reactions that my proposal might inspire in some. How would the man on the street cope? Well, nobody would outlaw the Government’s money, and people could carry on as before. Through the operation of the market, we would find out what worked best . Step-by step, the economy would be transformed and standards driven up.

In economics, spontaneous orders are always so much more rational and stable than planned ones. Always.


This is not a crisis caused by free markets. A free and unregulated market in money has not existed for over a century.

This is a Government crisis. A crisis over the monopoly of money.

Inflation targeting seemed so persuasive…. but it was a false God, and we deserve better. Stability and sound money can only come if we put the money supply back where it belongs…

Under the control of the free market.


What is money?

77px-billets_de_5000In their working paper Assessing UK money supply measures in the light of the credit crunch, Toby Baxendale and Anthony J. Evans provide a better measure of the money supply. In this article, Steven Baker explores the background to the paper and indicates some key findings.

This article was originally published in October 2009.

Many people know the Bank of England is creating new money through quantitative easing but if the quantity of money is being increased, how is that quantity being measured? What is counted as money?

As the Bank of England explains:

When the Bank is concerned about the risks of very low inflation, it cuts Bank Rate – that is, it reduces the price of central bank money. But interest rates cannot fall below zero.

So if they are almost at zero, and there is still a significant risk of very low inflation, the Bank can increase the quantity of money – in other words, inject money directly into the economy. That process is sometimes known as ‘quantitative easing’.

But when I consider quantitative easing, I am concerned with the following problems:

  • It is not clear that the Bank of England has a useful definition of the money supply. The present measures do not correspond to economic activity — which is what the Bank is trying to increase with new money — and this crisis was famously not foreseen.
  • As commentators have reported, “the Bank’s Governor, Mervyn King, seemed pretty confident that QE could work. But even he would admit he has no idea how long it will take – or how much money he will have to print to get there.” This uncertainty seems less than ideal given the risk of price inflation.
  • As the end of the present round of QE approached, it appeared it was not working.
  • According to Austrian-School economic scholars including Hayek and Huerta de Soto, injecting new money can create only a harmful illusion of prosperity1.

As my colleagues point out in their working paper, the fact that the monetary authorities have turned to increasing the quantity of money will focus attention on how that quantity is measured. This article provides some background information and indicates Baxendale and Evans’ key findings.

Continue reading “What is money?”

  1. “The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate – or perhaps even only so long as it continues to accelerate at a given rate. What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained and which after some time can be maintained only by a rate of inflation which would rapidly lead to a disorganisation of all economic activity.” Hayek, 1974 Nobel Prize Lecture []


Greg Mankiw Ponders Greenspan’s Paper the Crisis and Considers 100% Reserves

We are grateful to Robert Arbon for pointing out this article on Greg Mankiw’s Blog:

I just returned from the spring meeting of the Brookings Papers on Economic Activity, where I was a discussant for Alan Greenspan’s new paper on “The Crisis,” which has gotten a bit of media attention. I thought blog readers might enjoy reading my comments on the paper. Here they are:

This is a great paper. It presents one of the best comprehensive narratives about what went wrong over the past several years that I have read. If you want to assign your students only one paper to read about the recent financial crisis, this would be a good choice.

There are, however, particular pieces of the analysis about which I am skeptical. But before I get to that, let me begin by emphasizing several important points of agreement.

To begin with, Alan refers to recent events in the housing market as a “classic euphoric bubble.” He is certainly right that asset markets can depart from apparent fundamentals in ways that are often hard to understand. This has happened before, and it will happen again. When the bubble bursts, the aftershocks are never pleasant.

Read more.


The Zimbabwe Stock Market

This is a great news report from Zimbabwe via Al Jazeeera. It examines the ‘fantastic returns’ on the Zimbabwe stock exchange – and how traders are becoming ‘paper millionaires’. ‘Traders are astounded by the performance’. ‘Stock soar despite inflation’. I kid ye not.

(Hat tip to

I love – a great financial markets website – very much sympathetic to the Austrian-School world view.

To my mind, this is a great explanation of the stock market ‘rally’ of the last year.


China’s empty city

Is an Austrian style boom followed by a bust just about to happen in China? See this video sent to us by Catlin Long, MD of Morgan Stanley and make up your mind yourself!