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By Toby Baxendale, on 1 September 11
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.
By James Tyler, on 4 March 11
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 hedgehedge.com.
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”
By Dr Frank Shostak, on 24 September 10
Most commentators are of the view that the key for US economic recovery is drastically lowering the number of unemployed Americans. Once more people will be employed, this is going to lift overall spending in the economy and consequently general economic activity will follow suit, so it is held. We suggest that unemployment is not the key issue for economic growth. What matters for individuals is not whether they are employed as such but the purchasing power of their earnings. The key for this is the infrastructure individuals utilize in the production of goods and services. What permits an increase of the production of goods and services and hence raises people’s living standards is an expansion and enhancement of infrastructure. What in turn permits this is an expanding pool of real savings. Contrary to popular thinking, the Fed’s and the government policies that are aiming at lowering unemployment don’t improve people’s living standards, but on the contrary they undermine the process of real wealth generation and thus set in motion an economic impoverishment. In fact the latest government data indicates that many more Americans have fallen below the poverty line in 2009 despite all the massive stimulus packages. For the time being, the latest US economic data remains subdued. Also in China a visible fall in the growth momentum of money supply M1 raises the likelihood of a visible fall ahead in economic activity indicators.
Is a reduction in unemployment the key to US economic recovery?
Most experts are almost unanimous that the key to economic recovery is a reduction in the unemployment rate, which stood at 9.6% in August. The number of unemployed stood in August at almost 15 million. Also the under-employment rate climbed to 16.7% in August from 16.5% in the month before.
But does it make sense that the key to economic growth is the lowering of unemployment? If this is the case then it is valid to conclude that changes in unemployment are an important causative factor of real economic growth.
This way of thinking is based on the view that a reduction in the number of unemployed means that more people can now afford to boost their expenditure. As a result, economic activity follows suit.
In our report last week we have shown that the main driver of economic growth is an expansion in the pool of real savings. Fixing unemployment without addressing the issue of real savings is not going to lift the economy.
We have seen that it is real savings that fund the enhancement and the expansion of the infrastructure. An enhanced and expanded infrastructure permits an expansion in the production of final goods and services required to maintain and promote individuals life and well being.
Now, if unemployment were the key driving force of economic growth then it would have made a lot of sense to eradicate unemployment as soon as possible by generating all sorts of employments. For instance, policy makers could follow the advice of Keynes and Paul Krugman and employ people in digging ditches, or various other government sponsored activities. Again the aim is just to employ as many people as possible.
A simple common sense analysis however would have quickly established that such a policy would amount to a waste of scarce real savings. Remember that every activity whether productive or non-productive must be funded. Hence employing individuals in various useless activities would lead to a transfer of real savings from wealth generating activities and thereby undermine the real wealth generating process.
Now the unemployment as such can be relatively easy fixed if the labour market were to be free of tampering by the government. In an unhampered labour market any individual that wants to work will be able to find a job at a going wage for his particular skills. Obviously if an individual will demand a non market related salary and is not prepared to move to other locations, etc, there is no guarantee that he will find a job. For instance, if a market wage for John the baker is $80,000 per year yet he insists on a salary of $500,000 obviously he is likely to be unemployed.
Over time a free labour market makes sure that every individual earns in accordance to his contribution to the so called overall “real pie”. Any deviation from the value of his true contribution sets in motion corrective competitive forces.
Ultimately, however, what matters for the well being of most individuals is not that they are employed as such but the purchasing power in terms of goods and services that they earn. This is the key here. It is not going to be of much help to individuals if what they are earning will not allow them to support their life and well being. Individuals’ purchasing power is conditioned upon the infrastructure that they operate. The better the infrastructure the more output an individual can generate. A higher output means that a worker can now command higher wages in terms of purchasing power.
As we have seen the key for an enhanced and expanded infrastructure is the increase in the pool of real saving. Consequently any government and central bank policies aimed at lowering unemployment by means of stimulus policies amounts to a policy of redistribution, which leads to economic impoverishment, i.e. undermines the living standards of most individuals.
According to the government data the percentage of Americans living in poverty rose to 14.3% in 2009 from 13.2% in 2008 – its highest level since 1994. A record 43.6 million Americans were living in poverty last year, the Census Bureau reported. Note that the increase in poverty came about in-spite of massive fiscal and monetary stimulus measures, which supposedly meant to lift people’s living standards.
Even the former Fed Chairman Alan Greenspan is getting uneasy with all the stimulus measures to which the American economy has been subjected. At the gathering on September 15 held at the Council on Foreign Relations in New York he said,
We have to find a way to simmer down the extent of activism that is going on with government stimulus spending and allow the economy to heal itself.
Unfortunately Alan Greenspan is currently in the minority on this issue. As a result, we have been constantly reminded that the Fed is carefully watching the unemployment market and other economic activity data.
This means that if the unemployment does not show any sign of a reasonable decline then the Fed is likely to push more money into the economy.
For the time being we have been spared another onslaught by the Fed because US central bank officials differ on the question of how weak the economic outlook should get before they start pushing a massive amount of money.
In the event Fed policy makers do agree to renew their stimulus program, a likely option is that they will adopt resuming a bond-purchasing program.
The point of buying bonds is to drive down long-term interest rates and encourage more private borrowing. This it is held will give boost to economic growth.
The artificial lowering of interest rates cannot as such lift the supply of credit if the pool of real savings is in trouble. Remember that banks just fulfill the role of intermediaries – they can facilitate available real savings. However, they cannot create real savings – the key for economic growth.
Hence, bank activities as such cannot boost real economic growth.
It follows then that an artificial lowering of interest rates cannot generate more lending that is fully backed by real savings. The only credit that commercial banks can expand is credit out of “thin air”, or inflationary credit.
At present we are observing that commercial banks are starting to make use of the massive amount of cash reserves pumped by the Fed during September 2008 to October 2009. (For instance the yearly rate of growth of the Fed’s balance sheet jumped to 152% in December 2008 against 3.8% in January of that year).
In early September the level of commercial bank excess reserves stood at $1.007 trillion versus $1.026 trillion in August and $1.192 trillion in February.
As a result the latest data shows that the inflationary credit of commercial banks is starting to display a visible strengthening. The yearly rate of growth of this type of credit stood at 4.2% so far in September against minus 13.6% at the end of February.
It must be realized that an increase in inflationary credit amounts to an increase in money supply and hence to a diversion of real savings from wealth producers to non-wealth generating activities – obviously then the expansion in credit on account of inflationary credit is bad news for economic growth.
After closing at 2.4% in June the yearly rate of growth of our monetary measure AMS, which excludes Treasury special financing accounts, climbed to 3.9% in early September.
On account of a likely further strengthening in the growth momentum of inflationary credit we forecast the yearly rate of growth of AMS to rise to 5.2% by April next year. (At present we forecast the yearly rate of growth in inflationary credit to climb to 4.9% by April from 4.2% in September)
We suggest that if banks were to start utilizing the surplus cash reserves much faster than what they are doing currently this is likely to prompt Fed officials to express concern.
In the meantime, seasonally adjusted retail sales increased by 0.4% in August after rising by 0.3% in July. However the growth momentum of retail sales had a visible decline last month. Year-on-year the rate of growth fell to 3.6% from 5.4% in July and 8.7% in April. A fall in the lagged growth momentum of AMS doesn’t bode well for the growth momentum of retail sales (see chart).
Also the growth momentum of industrial production has visibly eased in August. The yearly rate of growth fell to 6.2% from 7.4% in July and 8.2% in June. Our monetary analysis points to a further weakening ahead in the growth momentum of industrial production.
Furthermore, the New York Fed manufacturing index fell to 4.14 in September from 7.1 in the previous month. A record number of US homeowners lost houses to their banks in August. Banks foreclosed on 95,364 properties in August, topping the May 2010 record by 2%. Total foreclosure actions last month, including notice of default, scheduled auction and repossession, were made on a total of 338,836 properties in August, up 4% from July. One in every 381 housing units got a foreclosure filing last month.
By Toby Baxendale, on 21 April 10
Jimmy Stewart plays George Bailey who is cast as the “honest” and trustworthy banker in the classic Hollywood film, “It’s a Wonderful Life.” Kotlikoff’s book laments that in the real world of modern banking, such characters no longer exist.
Kotlikoff himself is a Professor of Economics at Boston. Several Nobel Prize winners have endorsed the book: George Akerlof, Robert Lucas, Robert Fogel, Edward Prescott, and Edmund Phelps. I count 36 endorsements from the great and the good of the academic world on the back cover and front pages. I do not recall ever seeing this in a book.
The book is written for the layman. It is very light on economic theory, but does reference some otherworldly models. It is very good at explaining what on the face of it appear to be complex financial phenomena, but are in fact con tricks that in any other industry would earn you a prison sentence. Kotlikoff shows his readers how the financial system has failed in its fiduciary duty, and presents a very simple and elegant solution for its salvation called Limited Purpose Banking (LPB). He also proposes a reduction of the financial service sector regulators in the USA from its current 115 down to one: the Federal Financial Authority (FFA).
In his opening remarks he discusses the Modigliani-Miller Theorem, written in 1958, showing in elegant maths how in the absence of bankruptcy costs, leverage does not matter. If a company takes on more risk by borrowing more, its owners will offset that risk by borrowing less, leaving total debt in the economy unchanged. Kotlikoff makes no mention of the fact that leverage in itself is not a bad thing if it is made up of people forgoing their consumption today, i.e. saving and committing it to projects that will deliver up goods in the future. This glaring omission does not impede him from telling the story of our financial meltdown and making a solid policy recommendation for this crisis. It does, however, prevent him from seeing the elephant in the room: that the credit creation process itself is the source of the boom and the bust.
The nature of fractional reserve banking is such that if you deposit your cash in a bank, it will lend it out many times over. This means that multiple claims come to exist on the original real money that was deposited. If you deposit £100 in bank A, which lends it to an entrepreneur who deposits it in Bank B, both you and the entrepreneur now have £100! Like magic, we have £200 in the system, with £100 of it created ex novo by the banking system itself! In the UK, with no legal reserve requirement, we have a only £3 on average kept in deposit for every £100 of IOU’s promised by the banking system.
Kotlikoff provides a mainstream justification for fractional reserve banking, citing the Diamond-Dybvig Model, which holds that we value immediate liquidity for emergencies. We do not need that money all the time, so banks can use this and get us a higher return in the meantime. Therefore, governments must do everything to prevent a bank run if more people want their money back than actually exists in the bank vaults.
This is the theoretical understanding we have today and the model is used to justify all sorts of bank bailouts, as we have seen.
Kotlikoff points out that whilst the bailouts have prevented a collapse of the system of fractional reserve banking, the bailouts do not preserve the purchasing power of money. They just guarantee that the money unit will still exist. This is a very good point. All the bailouts are being funded by more claims on the future taxpayer. In the UK, we have a system of money debasement called Quantitative Easing, which will just debase and reduce our purchasing power.
In effect, the bailouts do not do what they say they do on the tin, and daily our purchasing power is getting weaker. It is hard enough to get politicians in the UK to acknowledge the scale of our official national debt, but we owe at least as much again “off balance sheet”, in unfunded pension liabilities and Private Finance Initiative obligations. Debasement will be the most popular way forward for all future governments as they will not want to overtly extract more wealth from us. Dishonesty will be the preferred policy.
Limited purpose banking would be a simple solution to all of this. Banks would be limited to their main purpose of matching savers to borrowers. All financial companies would act as pass though mutual fund companies. They would be middle men, never would they own the financial assets. They could thus never fail in the “run on the bank” sense — i.e. depositors wishing to withdraw money — but only if they were very bad at business. This is thus as near as you will get to risk-free banking. Never again would the economy be held liable to bail out the bankers.
Kotlikoff foresees at least two mutual funds being offered, with custodians holding the assets: one that holds cash and one that holds insurance funds. He does stress that innovation could still happen, with a multiplicity of funds being offered. The Federal Financial Authority (FFA) would regulate the custody element of the safe keeping of the various mutual fund assets. He assumes that regulators will be able to opine, like the current rating agencies, on the soundness of the assets that have been bought by the fund. He would trust the government over the rating agencies. I personally would trust neither! In my industry, selling meat and fish, we have a number of free market created quality assurance bodies such as the British Soil Association for organic certification, the Marine Stewardship Council for fish sustainability that require no government sanction. These have the confidence of both the consumer and producer. I would suggest that this and not a super regulator is the way forward.
Cash funds are nice and easy; they hold cash and are 100% reserved. They can never go up or down in value. These cash mutual funds represent the demand deposits of the new spec banking system. All services such as cheque writing and paying bills is done via this vehicle.
I have written about 100% reserve banking here and Steve Baker has specifically examined the 100% reserve banking proposal of Irving Fisher, to which Kotlikoff refers. He notes that the current economic profession considers these ideas to be “crackpot”; the Diamond-Dybvig model remains dominant. He goes go on to say, “I want to be clear that I am not an advocate of narrow banking in of itself. Narrow banking is a small feature of limited purpose banking and would hardly suffice to deal with today’s multifaceted financial problems.”
He notes that with the many cash mutual funds in place, the money measure in the USA, MI, would correspond exactly with what the government had printed. So to cover all obligations, a massive print up in US dollars would need to take place — many trillions of dollars to truly purge the system. What Kotlikoff misses is De Soto’s insight, based on the work of Fisher, that there will be a unique moment in history when instead of causing debasement, the printed money would cover all unfunded demand deposits, swapping them out for cash. Wipe out or retire these demand deposits and the banking system has no current creditors, only assets. Take out the equivalent amount of assets from the banking system, so the banking system has the same net worth as before, then put these assets into the mutuals and pay off the national debt. This is not inflationary, requires no debasement, and will help deliver up safe banking. This is summarised in our Day of Reckoning article.
Insurance mutuals would have all the other banking instruments such as CDO’s in them and could market these funds to whomever they wished. These are essentially what we would term a hedge fund today, though Kotlikoff proposes that these be closed end. This means you have to sell your shares in the fund to redeem your money. Consequently, long term lending can take place in these funds without the fear of a maturity mismatch. The only money this type of fund can lose is what is invested in it. It could never in itself pull down the banking system.
I sense that the author does not feel comfortable with the 100% reserve label, with its “crackpot” associations. In discussing the transfer of Citigroup he says,
“Here we’d need to swap all of CitiGroup’s debt for equity and prevent it from ever borrowing again to fund risky investments. We can now think of CitiGroup as a huge mutual fund with lots of different assets, one big commercial bank with 100 percent capital requirement, or one LPB with a large number of different mutual funds corresponding to the different Citigroup asset classes.”
He also points out that LPB could not actually be that far away if you take into account all the reserves that have been created already. This is something George Reisman has also pointed out.
Kotlikoff defensively shows how LPB would not reduce liquidity. It would not reduce real credit, i.e. savers forwarding money to borrowers. It would stop credit created out of thin air via the banking system, the prime cause of the crisis, but this is not mentioned in his book. It would lead to an optimal size financial sector. Our cash assets would be safe as you can get. Government could still monetise debt as it could still create cash from nothing. The currency and thus the purchasing power of money could not collapse by the actions of the banking system, but only by the actions of the government.
Kotlikoff concludes,
Limited purpose banking is the answer. This simple and easily-implemented pass-though mutual fund system, with its built in firewalls, would preclude financial crises of the type we’re now experiencing. The system will rely on independent rating by the government, but private rating as well. It would require full disclosure and provide maximum transparency. Most important, it would make clear that risk is ultimately born by people, not companies, and that most people need, and have a right, to know what risks, including fiscal risk, they are facing. Finally, it would make clear what risks are, and are not, diversifiable. It would not pretend to insure the uninsurable or guarantee returns that can’t be guaranteed. In short, the system would be honest, and because of that, it would be safe-safe for ourselves and safe for our children.
Although I think he has failed to identify the state sponsored banking system, with its fractional reserve credit creation point as the cause of booms and busts, his solution has many merits and many similarities with the solution proposed by Fisher, De Soto, and others. He missed what I call the golden opportunity, or unique moment in history, to actually enact a reform that delivers up 100% reserve of LPB and pays off the national debt and other unfunded obligations at the same time. My own solution is the De Soto 100% reserve free banking solution with banks working within the existing commercial law to which all non-bank companies must adhere. However, both systems have the same effects and would do the job needed: to sort out the banking system, provide stability, and let capitalism flourish. Yet another workable solution has been proposed by our very own Paul Birch. Kotlikoff’s contribution to the debate, with all the Nobel endorsements, is timely, and I hope policy makers give due attention to innovative solutions like these.
By Toby Baxendale, on 15 March 10
For new readers to this site who are not aware of the debate that exists within the Austrian School, there are those who are supporters of 100% Reserve Free Banking and those who are for Fractional Reserve Free Banking. The importance of this debate is that the School, whilst being the only School in economics to predict the crash, does not have a uniform policy prescription, or at least one policy prescription to fix our economy and put it on a sound and stable footing going forward.
There are a number of policy recommendations from varying branches of the School. We have given a platform to some of them on this site. To caricature: for the Keynesians, it is a matter of spending more via the government, for the monetarists it is print more and more money until the economy fixes itself. Until the differences are resolved within the Austrian School, there can’t be one coherent message to enable us to get out and engage with the political, academic and journalistic fraternities. This article is an attempt to resolve those differences that lie at the heart of our School, rendering it currently impotent in its forward-looking policy prescriptions.
So far, the only two point I see amounting to total agreement between both sides is that the Central Bank should be abolished. If there was a free choice in currency, people would almost certainly choose a commodity-backed currency, as always existed in history prior to the total move to money set by decree of the State. The flavour of what this would be is hotly debated though.
This article is not written to scholarly Journal standards, indeed it is written on a Saturday afternoon and my working life is entrepreneurship and not academia. I aim to stimulate debate within the wider Austrian academic community and beyond, to thoroughly flesh out some of the research areas I recommend and, hopefully, provide grounds for moving forward on a unified, or as near as damn it unified, basis.
A Quick and Dirty Recap on the Differences
The Fractional Reserve Free Banking School
They say all bank deposits are loans. This is the correct position in law since Carr v Carr 1811 in this country.
Therefore in a free banking world, if bank A issues promissory notes (this is a throw back to when the promissory note was redeemable in gold, but the word credit could just as easily be inserted in the place of promissory notes and is more applicable to our day and age) and if bank A lends to its customers in excess of its inherent worth, then Bank B, a more conservative bank and a competitor, may present Bank A’s notes for redemption (or create rumors in the market place to encourage Bank A’s notes to be redeemed) in the knowledge that it has been over inflating its issue. This will cause a run on their competitor’s bank.
This is a good free-market self correcting mechanism that will make sure all parties behave honestly, as large credit-induced booms that will go bust would not happen under this system. Therefore, by removing the ability of banks to go to a Central Bank to be bailed out over night via the discount window, in a Fractional Reserve Free Banking system with a multiplicity of credit / promissory note issuers, never could an over issuing bank go to the Lender of Last Resort, the Central Bank, and get overnight funds to pay its depositors’ redemption requests. The fear of imminent bankruptcy keeps the over issue of credit / promissory notes in a very stable position.
If we think about what has happened since the “Big Bang” in the mid 80s under Lawson when lots of restrictive practices in the City of London were abolished and the legal reserve ratio was abolished (it is now a voluntary system and sits at around 3%), we saw an explosion of credit that has created at least the late 80s / early 90s boom and bust, the late 90s /early 2000 boom and bust and the mother of all booms and busts in the late 2000s. So the free market has certainly been allowed to work as much as possible. As it over extends and under extends it produces catastrophic and distorting results, as we have seen.
This system is not, in fact, free market capitalism, but corporate capitalism. This is because the whole system is underpinned by the Central bank, which lends overnight to the banking systems so they can match their lending with their redemption demands. On the plus side for the State, they can run this system whereby debt is sold via the banking system i.e. their client banks, as all require some kind of liquidity support at some point in time be it explicit or implicit. They can, more importantly, monetize the debt – or, in modern parlance, do QE, which is nothing more than putting more money into circulation than existed before, thus devaluing the pound in our pocket.
This self correcting mechanism of the market is compatible with liberty and does indeed free money from state control. What is more, if you allow people to choose their own money, then the state becomes totally uninvolved with banking and money, and just as we do not have an apple or jam boom and bust, we shall not have a money or credit boom and bust.
The 100% Reserve Free Banking School
Turning to supporters of 100% reserves, the participants in this debate would agree that there should be no Central Bank and free choice in currency with a strong disposition that people, if left to their own devices, would choose gold or silver or a combination as they have overwhelmingly done in history in most places of the world.
Their problem and, indeed, mine is with the very nature of the demand deposit: the relationship between the bank and its depositing customer. Unlike the Fractional Reserve Free Bankers, the 100% Reserve Free Bankers say that when the vast majority of people deposit money in their bank account, such as their salary and their savings, they think that it is “theirs” and indeed it is safe. Of course we all know that banks own “your money” and indeed they owe you “your” money. A bank statement is the bank saying they owe you want you think is “yours.”
The loan you make to the bank is used by the bank (one loans to the bank in ignorance, I suggest). Indeed, once in the banking system, with its ability to multiply on average in the UK up to 33 times the level of credit, with only 3% of your money ever kept in reserves, it is clear that you only have 3% of “your” money in the banking system at any one point in time. As long as no more than one in 33 people walk into the bank to withdraw that which they think is theirs at the same time, then the claim or “their” money is still safe.
This rapid expansion of credit is the start of the Austrian Theory of the Business Cycle. I struggle to see how anyone can doubt the causes of the Business Cycle and both parts of the Austrian School are united on this. Now, the 100% Reserve advocates say that even under a free banking system with no Central Bank, there will still be boom and bust. This is because as the economy grows and there are more participants in the economy, transacting the sale of more goods and services (it is said by all economists except the 100% Reserve Free Banking advocates) the need for the services of more money grows. A series of fractional reserve free banks can issue extra money in the form of credit or promissory notes and you can thus accommodate the needs of trade.
This will cause a boom and bust, just as the current set up with a Central Bank under pinning the system does. This will be the case as every bit of credit issued not backed by prior real savings will cause a lengthening of the structure of production that will set in motion the capital misallocation of resourses that will look like a boom. But as there are no real savings to support the outcome of this new investment activity backed by bank created credit, that will indeed lead to a bust. If you are not happy with why this will cause boom and bust, I suggest cribbing up on the Austrian Theory of the Business Cycle, in particular Hayek in Prices and Production (PDF).
100% Reserve Free Banking advocates will say that to accommodate the growing population and the needs of trade, we should be happy at the spontaneous increase in our purchasing power of our monetary unit (i.e. falling prices). This is wholly beneficial to us all and is not in any way ever going to cause boom and bust.
Jesus Huerta de Soto in his brilliant book Money, Bank Credit, and Economic Cycles (PDF) in Chapter 9 adds a very seductive and interesting twist to the debate when he outlines a reform program that would lead to the total paying off of the National Debt (a very topical issue now!) and a very sound, solid banking system going forward. I have summarized these thought here: A Day of Reckoning .
A Way Forward, the Balance Sheet and Contract Law Approach to Free Banking
On the Nature of a Bank Deposit
I outlined the start of my case in this article last week: Why All Banks Are Insolvent. It does seem to me that it is critical to decide: should current bank deposit contracts be loans, as they lawfully are, or safe keeping / custodian deposits? If they are loans, the Fractional Reserve Free Bankers have the day, if they are custodian accounts or safe keeping accounts the 100% Reserve Free Bankers have the day.
As mentioned in that article:
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.
This would overwhelmingly suggest that people want safety, they think their money is theirs, even though it is the banks’. They would also like it lent out as long as they can have it back when they want it. I conclude people want safety and easy access, but really they are confused!
It is worth while understanding how a legally binding contract is determined and pondering the glaring confusion that exists with a bank deposit contract.
Law of Contract
Traditionally the formation of contracts has been analysed in terms of offer, acceptance, consideration (and later, intention to create legal relations).
Meeting of the Minds
Horrocks v Foray [1976]:
In order to establish a contract, whether it be an express contract or a contract implied by law, there has to be shown a meeting of the minds of the parties, with a definition of the contractual terms reasonably clearly made out, with an intention to affect the legal relationship: that is that the agreement that is made is one which is properly to be regarded as being enforced by the court if one or the other fails to comply with it; and it still remains a part of the law of this country, though many people think that it is time that it was changed to some other criterion, that there must be consideration moving in order to establish a contract.
Clearly, the depositor does not think he is making a loan to the bank, and the bank knows it is not safe-keeping but on-lending. There is no “meeting of minds.”
The standard which is adopted in deciding whether or not a contract has been concluded is objective rather than subjective. Smith v Hughes (1871):
If, whatever a man’s real intention may be, he so conducts himself that a reasonable man would believe that he was assenting to the terms proposed by the other party, and that other party upon that belief enters into the contract with him, the man thus conducting himself would be equally bound as if he had intended to agree to the other party’s terms.
It would seem that there is confusion at best about the real intentions of the depositor.
Acceptance
Acceptance must be communicated to the offeror – Entores v Miles Far East Corp [1955].
The general rule is that acceptance of an offer will not be implied from mere silence on the part of the offeree and that an offeror cannot impose a contractual obligation upon the offeree by stating that, unless the latter expressly rejects the offer, he will be held to have accepted it – Felthouse v Bindley (1862) 11 CB (NS) 869.
In Order to Create a Binding Contract, the Contract Must be Certain
Scammell and Nephew Ltd v Ouston [1941] – Viscount Maugham – “in order to constitute a valid contract the parties must so express themselves that their meaning can be determined with a reasonable degree of certainty. It is plain that unless this can be done…consensus ad idem would be a matter of mere conjecture.”
Confusion does not constitute a lawful contract.
Previous Course of Dealing Does not Mean Binding Contract Exists
University of Plymouth v European Language Center Ltd [2009] – one party could not rely on an exchange of e-mails and telephone calls as establishing a binding contract with another party, even though the parties had worked together for some years.
It would be very interesting to test that if over the course of a lifetime of banking you always thought that you were depositing for safekeeping if the law courts would give the above interpretation when there has in the vast majority of cases, never been a meeting of the minds.
Consideration
Tweedle v Atkinson (1861) – consideration must move from the promise.
The classic definition of consideration was expressed in Currie v Misa (1875) LR 10 Ex 153:
a valuable consideration, in the sense of the law, may consist either in some right, interest, profit or benefit accruing to the one party, or some forbearance, detriment, loss or responsibility given, suffered or undertaken by the other.
Your banking in some way shape or form , even your “free” bank account, does invariably have some charge somewhere down the line, they get you somewhere, so I would be happy that there is consideration in the current bank arrangements.
Intention to Create Legal Relations
Meritt v Meritt [1970] – In determining the intention of the parties an objective test is used by asking if reasonable people would regard the agreement as legally binding.
With two parties so at odds, I cannot see how we have any intention to create legal relations in the vast majority of deposit contracts.
I would even go as far to say that the vast majority of deposit contracts are unlawful under the Law of Contract.
A sensible policy prescription should be to align the banks to the account holders’ wishes and make the deposit contract one where the bank holds the depositors’ money as custodian / safe keeper and not as borrower. Make this contract explicit. Charge a fee for custodianship / safe keeping.
When a depositor wants to earn some interest on his money, allow an explicit lending contract to be put in place so that the depositor understands that his money has been loaned out, and that it is his no more. He now has a right to his lent money back some agreed time in the future, with a coupon paid.
This allows banks to go back and do what their time honoured role has been, to mediate between the saver and the borrower and to act as custodian and safe keep money for their clients. This is unashamedly boring, and steady as you go banking.
Should a bank be allowed to offer explicitly a fractional reserve account, when you as the depositor know right from the off that they are going to lend your money out a number of times over so there are many claims to this original money that you have deposited? I would say yes under contract law so long as it was explicit and conformed to all the case law listed above, but fundamentally no as this would require the bank to exist under legal and accounting privilege. I work from the assumption that all state sanctioned privilege is a bad as one party is exploiting another lawfully at the expense of the other party. This is antithetical to liberty. I would also add that there could be a similar type of fractional contract but this would be within the realm of hedge funds which operate under the normal commercial law that we all work under – except banks. This will be explored later.
The Balance Sheet Approach
In an article I wrote last week, I outline what I term the Balance Sheet approach to banking. I compare the balance sheet of the UK’s largest company BP, with that of one of our largest banks, Barclays. In a separate article, I look at the accounting treatment of its record profits for 2009 and some remarkable accounting trickery , all perfectly lawful - except that I would not be able to do and such trickery in my business. The link is here More on Banking and the Barclays 2009 Results. The important thing to note is that BP has current creditors and long term or non current creditors. Barclays has only creditors. Why does BP split out its current creditors from its long term ones?
As far as I am aware, in the UK Under International Financial Reporting Standards and UK Generally Accepted Accounting Principles, you have to report your creditors as current, under one year and over one year. This shows the outside world what your ability is to pay your debts, as and when they fall due. Most companies will always aim to match their current creditors with their current debtors, their less than one year creditors, but over current creditors, with the equivalent matching on the debtors’ side and with the long term debt being matched with long term creditors.
Most companies in this sense in the commercial world, other than banks, would indeed be 100% reserve companies and not companies that only keep a small fraction of money aside to pay their creditors. A very good research project for a graduate would be to map out all the FTSE 100 companies and see what percentage were 100% reserved and what were not. With those that were not, what were above 95% , 90%, 85% etc. In reality, if they are not very highly reserved their auditors will not sign off their accounts and they run the risk of insolvency. There is a grey area between a 99%, 95% reserved company as to if it is solvent and at the extreme end, the banks, where they are 3% reserved to current creditors!
Banks need another set of laws that only apply to themselves to operate. Thus they have a privilege accorded only to them. This allows them, like Barclays, to have creditors and debtors only. So all the current money on demand is lumped in with a catch-all lump of all creditors. This implies to the outside world that they perfectly balance their short term creditor needs, i.e. withdrawals with their long term debtors’ repayment profiles such that they never prejudice the current creditor losing his/her shirt. I do not know what specific accounting laws that the banks are allowed to audit to, but they sure are not GAAP that applies to all other commercial organizations. I do intend to find out when I have time, and again, this could be a rich source of research work for a graduate. Notwithstanding, it is clear there is one law for all commercial companies and one law for banks.
It should be clear that a lending and custodian bank where a deposit contract of either type conforms to the Law of Contract, at all points in time will conform to the normal commercial law.
It is clear that a Fractional Reserve Free Bank violates the law of contract and the normal commercial law for every company, thus they have accounting and legal privilege. A custodian / lending bank, conforming to the law of contract and normal commercial accounting law, could not compete with a fractional reserve free bank as the latter would be able to fully use all of its clients’ deposited money to do whatever it pleases, including the creation, on average, of 33 times more deposits. If we take the example of Barclays with some £300 billion of current creditors, the ability to fully use this would place it at a distinct unfair advantage with all other commercial enterprises. Indeed, under the current law, if would be very difficult indeed for a custody / safe keeping bank to get off the ground, the odds are so stacked in favour of the current arrangement.
The Case for Free Banking Under the Normal Commercial Law
Hence I conclude that the current system of making sure companies disclose and match timed liabilities to keep solvent is good and fair to all parties. The anomaly that is fractional reserve banking, be it in its Central Bank sponsored format or in its hypothetical format with no Central Bank, can only work with this legal and accounting privilege in place. This sets one party (the banks/bankers) at a distinct and unfair advantage to another parties (ie all other people / enterprises).
As the Fractional Reserve Free Banking system ex the central bank can only work with the positive intervention of legal privilege and a setting aside of all the principles of contract law, it would seem the case for it is negligible indeed. Added to the fact that there is still the possibility of business cycle inducing properties as they could automatically grow to the needs of trade, we need to map out an alternative that allows people to keep safe, save, invest and speculate.
In the above, I outlined the two forms of deposit that would accord with the normal commercial law that would exist without legal and accounting privilege, i.e. a straight forward safe keeping or custodian contract and a straight forward loan contract.
I would also propose the possibility of a third, called a “High Risk” deposit. This is a deposit contract that again is explicit, that allows one party to deposit in the full knowledge that the institution may or may not engage an over issue of credit, or even promissory notes that may take the form of money if they can become a generally accepted medium of exchange, provided that like in any other company, they are subject to audit and a market valuation up or down of underlying assets at least once per year. As in a normal company’s balance sheet, each year, your properties or other chattels are re valued up, or impaired down, so you can and should do this with the “High Risk” deposit account. This way, there is no extension or contraction of credit over the audit year that does not have real wealth behind it. The boom and bust implications of functioning this way are that of any normal commercial activity.
Conclusion
Any deposit can be made between freely consenting adults provided it is enforceable under the Law of Contract and does not rely on the grant of a state sanction / privilege under commercial law and accounting standards to operate. This would be supporting something that was antithetical to liberty.
Personally, I would prefer to keep these kind of “High Risk” deposits in Hedge Funds and the like – clearly away from banks so as not to confuse. It would be quite possible for somebody with a higher risk profile to place all his money at the disposal of a hedge fund and the hedge fund to offer normal banking services, such as transacting cheques, direct debits, standing orders, issuing debit cards that the hedge fund would subcontract back to the regular standard custodian / safe keeping lending bank. This would give the appearance in almost every respect of the current fractional reserve banking.
To all intents and purposes the overwhelmingly vast majority of non bank companies are 100% reserve companies i.e. they square up with their creditors as and when they fall due or could fall due, unlike fractional reserve banks who make very little provision and rely on state sanction to exist like this.
The balance sheet and contract law approach to free banking allows a solid safe and traditional approach to banking to be the banking system’s default position, but then allows freely consenting adults all other options to enter into whatever deposit contracts they like so long as they are truly lawful.
If this is accepted, I would think it is clear that the proposal of De Soto mentioned above, concerning banking reform, becomes a real possibility in order to be the key policy solution and recommendation of the Austrian School.
It would be right and proper that the School that was the only School to predict the Great Credit Crunch / Meltdown, could provide a series of solutions for a lasting and sustainable recovery.
Afterthought
I have laid out my case that there is such a discrepancy between what the overwhelming majority think happens with their deposited money that under contract law, I doubt very much that an enforceable contract exists as currently offered by the banking system. I propose a reform that would very clearly demarcate what is a custodian / safe keeping contract and what is a lending contract. I agree that freely consenting adults who do no harm to others should be allowed to do as they please which means contract as they please, but entering into a fractional reserve free banking contract would violate very solid good balance sheet accounting and financial reporting standards that have been developed over many years to make sure trade happens without violation of people’s property rights. After that I propose a third contract that could have similar characteristics to a fractional reserve free bank account, called a High Risk account that would allow more speculative activities. The market would evolve in time, and new ways of doing things would no doubt emerge. As long as these new ways of doing things conform to commercial law and do not exist on privilege, then there would be no reason to get het up about this type of innovation.
Some of the debates existing in the wider free banking school need to be addressed.
What is the Difference Between a Fractional Reserve Contract and a House Insurance Contract?
With my house insurance, I pay, not loan, money to an insurance company in exchange for the right to a policy, my consumable item if you like, with the explicit knowledge that they are hoping to charge me and all the other policy holders more than they would pay out in the eventuality of a disaster that I am trying to insure against. There is a small risk that the insurance company will get its sums wrong and not be able to pay me out in full or at all. The policy tells me this.
With a deposit contract, I think I am depositing for custody and safe keeping and only the enlightened few know they are loaning their forgone purchasing power i.e. money to the bank.
So insurance is paying for a product that you consume by virtue of holding the policy for its life time. You know that there is a small risk that you may not get 100% of what you have bought.
With banking, you loan your purchasing power with the overwhelming people doing this in ignorance of what they have committed to. The vast majority expect to have the quiet and peaceful enjoyment of their purchasing power at their convenience and do not deposit in the knowledge that there may be wholesale default.
If we Accept the Legal Position that a Demand Deposit is a Bank Loan, can you Ever Have a Loan with no Fixed Term i.e. an Indefinite Loan?
This is an impossibility.
The loan under these circumstances should properly be called a gift. Fractional Reserve Free Banking relies on the fact that the legal position says all deposits are loans. In 22 years in business I have never borrowed money without a term implied. Even in the most friendly of loans where I have borrowed from a family member and they have said “pay me back when you can,” there is an implied term, when I can, and that it is not a gift.
You can vary terms then reset the period, re cut it, re dice it , re jig it, re price it, etc, but there are still implied terms. At some point in time, a lender always wants to get paid back, otherwise he/she would not be a lender, but someone giving a gift. Depositors are not giving a gift!
In the three banks that I use, representing a very large chunk of the UK banking business, I see nothing whatsoever in any documentation that leads me to believe that when I deposit I am making a loan. What is more, it does not fit my understanding of what a loan is unless we accept it is a callable loan on demand. If it is on demand, it needs to be provisioned for. Prudent management would dictate 100% reserves against my loan. General accounting principles that apply to all commercial activities bar the banks do not have to.
Everything I have ever seen in banking when I have deposited leads me to believe I am depositing money for custody / safe keeping and not as a loan. The language is always that of custody / safe keeping. Free banking going forward needs to be very explicit in nailing in contract what is custody / safe keeping and what is loaning and what is speculating.
Do Fractional Reserve Banks in a Free Market Environment, i.e. one with no Central Bank, Create Inflation?
I touched upon this point in the main body of the article. The price of money is determined, like all things, by demand and supply. Mises called this the money relation. If there is an increase in both, then there will be no inflation. To be clear, Fractional Reserve Free Banking people who advocate this are correct, there will be no price inflation. However, the number of money units has now gone up, so there has been a money inflation. Do we care? Yes, as Austrians we do. Why? Whoever is in receipt of the new money, in a Fractional Reserve Free Banking world with no Central Bank, the first recipients are the new demanders of money. They will get the wealth effect of having new purchasing power first. Where there should have been an increase in purchasing power (falling prices) for all the existing money holders, there is no increase, thus impoverishing those who are holding the existing monetary unit. Again, this gives special privilege to a certain class of person over another class of person. That is antithetical to liberty. The only way this can be avoided is to have Free Banking that sits within commercial law, accounting rules that apply to everyone, and framed within the time-honoured principles of the law of contract.
Do Grain Store Examples Shed any Useful Light into this Debate?
I am often told by advocates of Fractional Reserve Free Banking that banking is like a grain store. That if ten tons were to be deposited by one man who took a certificate from the store holder explicitly stating that the store will be lending 9 ton of the grain out to bread makers in exchange for the original depositor not having to pay for the storage, or even being paid to store there – what would be wrong with this? Also, it would tell me under what time period my grain would be being used by others, and when I could get my grain back. Well, the answer is nothing at all as the contract is explicit – except that I will never get my grain back at all as it is being consumed by someone else. I will never get it back!
Grain examples should be avoided, for they certainly do not stack up.
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 Steven Baker MP, 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
By Toby Baxendale, on 21 February 10
Via Darius Guppy: our world balances on a sea of debt
What is needed is a root and branch re-evaluation of that most curious of cultural inventions – money, argues Darius Guppy.
See the enclosed article above, it could be written for this site.
I am delighted by the comments that show more and more people are questioning the madness of fractional reserve banking.
Soddy was our first Nobel price winner to suggest 100% reserves as a solution and I am delighted that Guppy is aware of this academic and his work.
By Steven Baker MP, on 12 February 10
ECONOMISTS IN THE TRADITION OF THE AUSTRIAN SCHOOL have shown that one type of maturity mismatching can cause maladjustments and business cycles. When banks expand credit, by granting loans and creating demand deposits, they generate immediately withdrawable liabilities to finance longer-term loans. The newly created demand deposits do not represent a reduction of consumption, i.e., that characterized by real savings. As a consequence, interest rates are artificially reduced under the level they would have been in a free market reflecting real savings and time preference rates. Thus, entrepreneurs are prone to engage in more and longer projects than could be financed with the available supply of real savings. Before all projects that are financed by the credit expansion are finished, a bust occurs. An absence of real savings to sustain the factors of production in the production processes and to produce complementary and necessary capital goods becomes evident. As a result, malinvestments are liquidated and the structure of production is brought in line with consumer preferences again. This is the Austrian Business Cycle Theory (ABCT) in a nutshell.
In his paper, Philipp goes on to explain that other types of maturity mismatching can cause cycles:
At the core of the traditional Austrian business cycle there is maturity mismatching in the term structure of the assets and liabilities of the banking system. In the process that underlies the business cycle, banks use short-term liabilities with zero “maturity” (i.e., demand deposits) to finance long-term projects via longer-term loans. However, the current economic turmoil is marked not only by massive maturity mismatching in the form of fractional reserve banking, but also by maturity mismatching on the part of investment banks via structured investment vehicles (SIVs), that use short-term repurchase agreements or short-term financial papers to finance longer-term investments. Naturally, the following question comes to mind: If one kind of maturity mismatching, i.e., the use of demand deposits to finance loans, can cause the business cycle, would not other kinds of maturity mismatching have similar effects, i.e., the use of funds obtained from the issue of short-term commercial paper to finance longer-term loans.
The full paper is recommended for the technical reader. Available here.
By Toby Baxendale, on 4 February 10
Drawing on the work of Nobel Laureates in economics from three traditions, plus numerous other distinguished scholars, Cobden Centre Chairman, economist and successful entrepreneur Toby Baxendale presents an informal introduction to our proposal for honest money and the benefits consequent on the reform. See also our precis of Irving Fisher’s 100% Money.
Fact
- The average overhang of credit to money of all banks in the United Kingdom is 34 x to its reserves i.e. its actual money base.
- If more than one person in 34 walks into all banks simultaneously to withdraw their deposits, there will be a system wide bank run and a mass liquidity event with systematic default and insolvency.
- We saw the start of this with Northern Rock in the summer of 2007.
- We attempt to paper over the cracks and restore confidence in the banking system still today – with little success.
 Sterling Liquid Assets (BoE FSR, Jun 2009) A practical, politically-acceptable proposal
Our proposal is, as Irving Fisher wrote, “The opposite of radical”:
- Require 100% cash reserves to be held against all demand deposits; there can never be a crisis if a bank always holds 100% cash against all its demand deposits.
- Parliament can do this with one Act.
A similar Act took place in 1844. The Bank Charter Act or “Peel’s Act” established a 100% reserve requirement for bank notes that were issued claiming to be redeemable in gold. The reality was that there were 23 notes in issue for every one unit of gold at the time, creating instability, “panic” and general economic chaos. Not a too dissimilar situation from today where we have 34 claims on money to one unit of money. Politicians in the 19th century did not see the creation of unbacked credit through accounting entries as a problem, since it was only done on a very small scale. The problem then was rampant note issue (claims to real money) well over and above the monetary base, as this was the preferred method the bankers used at the time.
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)!
Peel’s problem was the over issue of notes to gold: our problem is the over issue of credit to money.
Continue reading “A day of reckoning: how to end the banking crisis now”
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