[Editor's note: this article, by Robert Batemarco, first appeared at Mises.org]
John Tamny recently wrote a piece at Forbes titled, “The Closing of the Austrian School’s Economic Mind” in which he critiqued certain claims made in Frank Hollenbeck’s Mises Daily article, “Confusing Capitalism with Fractional Reserve Banking.”
Tamny goes far beyond taking Hollenbeck to task, asserting that many modern Austrian economists have certain views of monetary policy that are at odds with much of the rest of the contribution of the Austrian School. Tamny’s biggest point of disagreement with Austrians is over the low regard with which many Austrians hold the practice of fractional reserve banking. In so doing, he makes several arguments which cannot stand up to critical scrutiny.
The crux of the Austrian position is that the practice of fractional reserve banking gives ownership claims to the same funds to more than one person. The person depositing the funds clearly has a property claim to those funds. Yet when a loan is made from those funds, the borrower now has a claim to the same funds. Two or more people owning the same funds is what makes bank runs possible. The existence of deposit insurance since the 1930s has minimized the number of these runs, in which multiple owners sought to claim their funds at the same time. The deposit insurance that prevents bank runs really amounts to a pre-emptive bailout of the banks. As this is a special privilege, rather than a natural development of the market, it follows that restrictions on fractional reserve banking would be a libertarian validation of the market rather than the statist interference that Tamny claims it to be.
His inability to see that fractional reserves lead to two or more people having claim to the same funds at the same time leads him to deny the logic of the money multiplier. To quote him:
The problem is that the very notion of a “money multiplier” is a logical impossibility; one that dies of its illogic rather quickly if analyzed in the lightest of ways. … To the Austrians, money can be multiplied. Bank A takes in $1,000, lends $900 to Bank B, then Bank B lends $810 to Bank C, only for Bank C to lend $729 to Bank D, etc. Pretty soon $1,000 has been “multiplied” many times over as the credit is passed around.
The notion of the money multiplier is by no means uniquely Austrian. I learned it forty years ago from the Paul Samuelson textbook and from the Fed publication Modern Money Mechanics. It is also the centerpiece of the monetary system chapter of virtually every textbook right up to Paul Krugman’s most recent edition. Indeed, the nature of the process is one of the most uncontroversial propositions in economics — a good definition of an uncontroversial economic proposition being one on which both Murray Rothbard and Paul Krugman are in substantive agreement. Indeed, if there were no money multiplier, one would be at a loss to explain why, until QE1 in 2008, M1 was a 1.6 times size of the monetary base, having historically been even higher. Nor would the required reserve ratio, a tool of monetary policy that became too powerful to be used after 1937, have any effect on the money supply in the absence of the money multiplier effect.
What is controversial about the money multiplier is not its existence, but whether or not it creates distortions in the economy. The distortions introduced into the economy by fractional reserve banking, and to an even greater extent by central banking, comprise the central element of Austrian business cycle theory. The basic idea is that the creation of money (which is also credit, since that new money is loaned into existence) increases the supply of loanable funds and lowers market interest rates without increasing the supply of voluntary saving. This misleads investors into believing that more resources have been made available by savers for investment projects than actually have been made available. Thus, projects are started on too big a scale since many investors try to exercise a claim on the same productive resources. In so doing, they will bid up the resource prices, slashing the profitability of many of these investment projects. This is the real goods sector counterpart of bank runs in the monetary sector. Since there is no real goods sector counterpart to deposit insurance, firms will run short of the resources necessary to profitably complete their investment projects, exposing them as malinvestments and turning boom to bust.
Tamny disputes the above claims, largely on the basis of what seems to me an idiosyncratic definition of credit. He states that, “credit can’t be multiplied. Period. For every individual who attains credit successfully, there must be a saver willing to give up near-term access to the economy’s resources.” This statement is informed by the valuable insight that lending money to those who wish to buy goods they could not otherwise afford does not create additional goods. Where the equivocation arises is in his use of the word credit to describe the goods that credit permits one to buy. I believe this eccentric use of that word is what leads to many of Tamny’s disagreements with the Austrians. Here is Exhibit A:
Perhaps another logical response to this line of thinking is the housing boom that took place in the 2000s. Wasn’t the latter most certainly a function of easy credit? Let’s be serious. To believe it was, that low rates set by the Fed were what made housing credit easy is to believe that rent control renders apartments abundant. But it doesn’t, nor were low rates decreed by the Fed the driver of the housing boom.
Austrians agree that making loans more available than the market would make them does not make more goods available. But there is the illusion of more resources in the short run because the credit-creation process does initially commandeer resources from those whose money decreases in value through the Cantillon Effect. Unfortunately, many entrepreneurs seeking to expand their operations act on this illusion. Only when the new money reaches those whose money lost its value initially and they re-assert their demand, does the inability of new credit to create new goods become obvious.
The last critique Tamny makes that I will discuss here is his implication that Austrian support for 100 percent reserves on demand deposits would make it impossible for borrowers to borrow from savers in order to lend those savings out. This is wrong. Austrians have no problem with savers buying the bonds of a firm seeking additional financing, nor with their buying stock, either directly from the company or its investment bank through an IPO or on the secondary market where it helps keep the market liquid, nor with their buying a bank CD or time deposit knowing that they will not have a claim on the funds they have entrusted to the bank until maturity. In all of these cases, intermediaries are borrowing from savers in order to lend those savings out (this is not exactly a loan in the case of stocks). What Austrians object to is banks telling depositors they still have an instantaneous claim on the funds deposited when they have given someone else a claim on the same funds.
Under the elimination of fractional reserve banking, investment spending would be reduced, not to zero, but to a more sustainable level. This would not eliminate entrepreneurial errors, which are part and parcel of having to act in the face of uncertainty, but it would eliminate the cluster of errors generated by the inconsistent plans that would be made on the basis of falsified market signals of interest rates below their natural rate, thus moderating, or in the best-case scenario, eliminating the business cycle.
When it comes to the world of international finance, Jim Rickards has quite nearly seen it all. As a young man, he worked for Citibank in Pakistan, of all places. In the 1990s, he served as General Counsel for Long-Term Capital Management, Jim Merriwether’s large, notorious hedge fund that collapsed spectacularly in 1998. In recent years, he has been a regular participant in Pentagon ‘wargames’, in particular those incorporating financial or currency warfare in some way, and he has served as an advisor to the US intelligence community.
Yet while his experiences are vast in breadth, they have all occurred within the historically narrow confines of a peculiar international monetary regime, one lacking a gold- or silver-backed international reserve currency. Yes, reserve currencies have come and gone through history, but it is the US dollar, and only the US dollar, that has ever served as an unbacked global monetary reserve.
Nevertheless, in CURRENCY WARS and THE DEATH OF MONEY, Jim does an excellent job of exploring pertinent historical parallels to the situation as it exists today, in which the international monetary regime has been critically undermined by a series of crises and flawed policy responses thereto. He also applies not only economic but also complexity theory to provide a framework and deepen understanding.
As for what happens next, he does have a few compelling ideas, as we explore in the following pages. To begin, however, we explore what it was that got him interested in international monetary relations in the first place.
BACK TO THE 1970S: THE DECADE OF DISCO AND DOLLAR CRISES
JB: Jim, you might recall the rolling crises of the 1970s, beginning with the ‘Nixon Shock’ in 1971, when the US ‘closed the gold window’, to the related oil shocks and then the de facto global ‘run on the dollar’ at the end of the decade. At the time, as a student, did you have a sense as to what was happening, or any inclination to see this as the dollar’s first real test as an unbacked global monetary reserve? Did these events have any influence on your decision to study international economics and to work in finance?
JR: I was a graduate student in international economics in 1972-74, and a law student from 1974-77, so my student years coincided exactly with the most tumultous years of the combined oil, inflation and dollar crises of the 1970s. Most observers know that Nixon closed the gold window in 1971, but that was not considered the end of the gold standard at the time. Nixon said he was ‘temporarily’ suspending convertibility, but the dollar was still officially valued at 1/35th of an ounce of gold. It was not until 1975 that the IMF officially demonitised gold although, at French insistence, gold could still be counted as part of a country’s reserve position. I was in the last class of students who were actually taught about gold as a monetary asset. Since 1975, any student who learns anything about gold as money is self-taught because it is no longer part of any economics curriculum. During the dark days of the dollar crisis in 1977, I spoke to one of my international law professors about whether the Deutschemark would replace the dollar as the global reserve currency. He smiled and said, “No, there aren’t enough of them.” That was an important lesson in the built-in resilience of the dollar and the fact that no currency could replace the dollar unless it had a sufficiently large, liquid bond market – something the euro does not yet have to this day. From law school I joined Citibank as their international tax counsel. There is no question that my academic experiences in a period of borderline hyperinflation and currency turmoil played a powerful role in my decision to pursue a career in international finance.
JB: As you argued in CURRENCY WARS and now again in THE DEATH OF MONEY, the US debt situation, public and private, is now critical. It would be exceedingly difficult for another Paul Volcker to arrive at the Federal Reserve and shore up confidence in the system with high real interest rates. But why has it come to this? Why is it that the ‘power of the printing press’ has been so abused, so corrupted? Is this due to poor federal governance, as David Stockman argues in THE GREAT DEFORMATION? Is it due to the incompetence or ignorance of the series of Federal Reserve officials who failed to appreciate the threat of global economic imbalances? Or is it due perhaps to a fundamental flaw in the US economic and monetary policy regime itself?
JR: It is still possible to strengthen the dollar and cement its position as the keystone of the international financial system, but not without costs. Reducing money printing and raising interest rates would strengthen the dollar, but they would pop the asset bubbles in stocks and housing that have been re-created since 2009. This would also put the policy problem in the laps of Congress and the White House where it belongs. The problems in the economy today are structural, not liquidity-related. The Fed is trying to solve structural problems with liquidity solutions. That will never work, but it might destroy confidence in the dollar in the process. Federal Reserve officials have misperceived the problem and misapprehend the statistical properties of risk. They are using equilbirium models in a complex system. (Ed note: Complexity Theory explores the fundamental properties of dynamic rather than equilibrium systems and how they react and adapt to exogenous or endogenous stimuli.) That is also bound to fail. Fiat money can work but only if money issuance is rule-based and designed to maintain confidence. Today’s Fed has no rule and is destroying confidence. Based on present policy, a complete loss of confidence in the dollar and a global currency crisis is just a matter of time.
JB: Thinking more internationally, the dollar is in quite good company. ‘Abenomics’ in Japan appears to have failed to confer any meaningful, lasting benefits and has further undermined what little confidence was left in the yen; China’s bursting credit and investment bubble threatens the yuan; the other BRICS have similar if less dramatic credit excess to work off; and while the European Central Bank and most EU fiscal authorities have been highly restrained for domestic political reasons in the past few years, there are signs that this may be about to change. Clearly this is not a situation in which countries can easily trust one another in monetary matters. But as monetary trust supports trust in trade and commerce generally, isn’t it just a matter of time before the currency wars of today morph into the trade wars of tomorrow? And wouldn’t a modern-day Smoot-Hawley be an unparalleled disaster for today’s globalised, highly-integrated economy?
JR: Currency wars can turn into trade wars as happened in the 1920s and 1930s. Such an outcome is certainly possible today. The root cause is lack of growth on a global basis. When growth is robust, large countries don’t care if smaller trading partners grab some temporary advantage by devaluing their currencies. But when global growth in anemic, as it is now, a positive sum game becomes a zero-sum game and trading partners fight for every scrap of growth. Cheapening your currency, which simultaneously promotes exports and imports inflation via the cross rate mechanism, is a tempting strategy when there’s not enough growth to go around. We are already seeing a twenty-first century version of Smoot-Hawley in the form of economic sanctions imposed on major countries like Iran and Russia by the United States. This has more to do with geopolitics than economics, but the result is the same – reduced global growth that makes the existing depression even worse.
JB: You may recall that, in my book, THE GOLDEN REVOLUTION, I borrow your scenario of how Russia could, conceivably, undermine the remaining international trust in the dollar with a pre-emptive ‘monetary strike’ by backing the rouble with gold. Do you regard the escalating situation in Ukraine, as well as US policies in much of the Black Sea/Caucasus/Caspian region generally, as a potential trigger for such a move?
JR: There is almost no possibility that either the Russian rouble or the Chinese yuan can be a global reserve currency in the next ten years. This is because both Russia and China lack a good rule or law and a well-developed liquid bond market. Both things are required for reserve curreny status. The reason Russia and China are acquiring gold and will continue to do so is not to launch a new gold-backed currency, but rather to hedge their dollar positions and reduce their dependence on dollar reserves. If there is a replacement for the dollar as the leading reserve currency, it will either be the euro, the special drawing right (SDRs), or perhaps a new currency devised by the BRICS.
JB: Leaving geo-politics aside for the moment, you mention right at the start of THE DEATH OF MONEY, citing the classic financial thriller ROLLOVER, that even non-state actors could, perhaps for a variety of reasons, spontaneously begin to act in ways that, given the fragility of the current global monetary order, cascade into a run on the dollar and rush to accumulate gold. If you were to do a remake of ROLLOVER today, how would you structure the plot? Who could be the first to begin selling dollars and accumulating gold? Who might join them? What would be the trigger that turned a trickle of dollar selling into a flood? How might the US government respond?
JR: If Rollover were re-made today, it would not be a simple Arab v. US monetary plot. The action would be multilateral including Russia, China, Iran, the Arabs and others. Massive dumping of dollars might be the consequence but it would not be the cause of the panic. A more likely scenario is something entirely unexpected such as a failure to deliver physical gold by a major gold exchange or dealer. That would start panic buying of gold and dumping of dollars. Another scenario might begin with a real estate collapse and credit crash in China. That could cause a demand shock for gold among ordinary Chinese investors, which would cause a hyperbolic price spike in gold. A rising gold price is just the flip side of a collapsing dollar.
JB: This entire discussion all follows from the fragility of the current international monetary system. Were the system more robust, we could leave the dollar crisis topic to Hollywood for entertainment rather than to treat it with utmost concern for personal, national or even international security. But what is it that makes systems fragile? Authors ranging from George Gilder (KNOWLEDGE AND POWER), to Joseph Tainter (THE COLLAPSE OF COMPLEX SOCIETIES) and even Edward Gibbon (THE RISE AND FALL OF THE ROMAN EMPIRE) have applied such thinking to ancient and modern economies and societies. They all conclude that, beyond a certain point, centralisation of power is destabilising. Does this mean that a robust monetary system would ‘de-centralise’ monetary power? Isn’t this incompatible with any attempt by the G20 and IMF to transform the Special Drawing Right (SDR) from a unit of account into a centrally-managed, global reserve currency?
JR: Yes. Complex systems collapse because increases in complexity require exponential increases in energy to maintain the system. Energy can take many forms including money, which can be thought of as a form of stored energy. We are already past the point where there is enough real money to support the complexity of the financial system. Elites are now resorting to psuedo-money such as deriviatives and other forms of leverage to keep the system going but even that will collapse in time. The proper solution is to reduce the complexity of the system and restore the energy/money inputs to a sustainable level. This means reducing leverage, banning most derivatives and breaking up big banks. None of this is very likely because it cuts against the financial interests of the power elites who run the system. Therefore a continued path toward near-term collapse is the most likely outcome.
JB: In CURRENCY WARS you make plain that, although you are highly critical of the current economic policy mainstream for a variety of reasons, you are an agnostic when it comes to economic theory. Yet clearly you draw heavily on economists of the Austrian School (eg Hayek) and in THE DEATH OF MONEY you even mention the pre-classicist and proto-Austrian Richard Cantillon. While I doubt you are a closet convert to the Austrian School, could you perhaps describe what it is about it that you do find compelling, vis-à-vis the increasingly obvious flaws of current, mainstream economic thinking?
JR: There is much to admire in Austrian economics. Austrians are correct that central planning is bound to fail and free markets produce optimal solutions to the problem of scarce resources. Complexity Theory as applied to capital markets is just an extension of that thinking with a more rigorous scientific foundation. Computers have allowed complexity theorists to conduct experiments that were beyond the capabilities of early Austrians. The results verify the intuition of the Austrians, but frame the issue in formal mathematical models that are useful in risk management and portfolio allocation. If Ludwig von Mises were alive today he would be a complexity theorist.
JB: You may have heard the old Irish adage of the young man, lost in the countryside, who happens across an older man and asks him for directions to Dublin, to which the old man replies, unhelpfully, “Well I wouldn’t start from here.” If you were tasked with trying, as best you could, to restore monetary stability to the United States and by extension the global economy, how would you go about it? You have suggested devaluing the dollar (or other currencies) versus gold to a point that would make the existing debt burdens, public and private, credibly serviceable. But does this solve the fundamental systemic problem? What is to stop the US and global economy from printing excessive money and leveraging up all over again, and in a decade or two facing the same issues, only on a grander scale? Is there a better system? Could a proper remonetisation of gold a la the classical gold standard do the trick? Might there be a role for new monetary technology such as cryptocurrency?
JR: The classic definition of money involves three functions: store of value, medium of exchange and unit of account. Of these, store of value is the most important. If users have confidence in value then they will accept the money as a medium of exchange. The unit of account function is trivial. The store of value is maintained by trust and confidence. Gold is an excellent store of value because it is scarce and no trust in third parties is required since gold is an asset that is not simultaneously the liability of another party. Fiat money can also be a store of value if confidence is maintained in the party issuing the money. The best way to do that is to use a monetary rule. Such rules can take many forms including gold backing or a mathematical formula linked to inflation. The problem today is that there is no monetary rule of any kind. Also, trust is being abused in the effort to create inflation, which is form of theft. As knowledge of this abuse of trust becomes more widespread, confidence will be lost and the currency will collapse. Cryptocurrencies offer some technological advantages but they also rely on confidence to mainatin value and, in that sense, they are not an improvement on traditional fiat currencies. Confidence in cryptocurrencies is also fragile and can easily be lost. It is true that stable systems have failed repeatedly and may do so again. The solution for individual investors is to go on a personal gold standard by acquiring physical gold. That way, they will preserve wealth regardless of the monetary rule or lack thereof pursued by monetary authorities.
JB: Thanks Jim for your time. I’m sure it is greatly appreciated by all readers of the Amphora Report many of whom have probably already acquired a copy of THE DEATH OF MONEY.
In a world of rapidly escalating crises in several regions, all of which have a clear economic or financial dimension, Jim’s answers to the various questions above are immensely helpful. The world is changing rapidly, arguably more rapidly that at any time since the implosion of the Soviet Union in the early 1990s. Yet back then, the changes had the near-term effect of strengthening rather than weakening the dominant US position in global geopolitical, economic and monetary affairs. Today, the trend is clearly the opposite.
Jim’s use of Complexity Theory specifically is particularly helpful, as the balance of power now shifts away from the US, destabilising the entire system. Were the US economy more robust and resilient, perhaps a general global rebalancing could be a gradual and entirely peaceful affair. But with the single most powerful actor weakening not only in relative but arguably in absolute terms, for structural reasons Jim explains above, the risks of a disorderly rebalancing are commensurately greater.
The more disorderly the transition, however, the less trust will exist between countries, at least for a time, and as Jim points out it is just not realistic for either the Russian rouble or Chinese yuan to replace the dollar any time soon. As I argue in THE GOLDEN REVOLUTION, this makes it highly likely that as the dollar’s share of global trade declines, not only will other currencies be competing with the dollar; all currencies, including the dollar, will increasingly be competing with gold. There is simply nothing to prevent one or more countries lacking trust in the system to demand gold or gold-backed securities of some kind in exchange for exports, such as oil, gas or other vital commodities.
Jim puts the IMF’s SDR forward as a possible alternative, but here, too, he is sceptical there is sufficient global cooperation at present to turn the SDR into a functioning global reserve currency. The world may indeed be on the path to monetary collapse, as Jim fears, but history demonstrates that collapse leads to reset and renewal, and in this case it seems more likely that not that gold will provide part of the necessary global monetary foundation, at least during the collapse, reset and renewal period. Once trust in the new system is sufficient, perhaps the world will once again drift away from gold, and perhaps toward unbacked cryptocurrencies such as bitcoin, but it seems unlikely that a great leap forward into the monetary unknown would occur prior to a falling-back onto what is known to have provided for the relative monetary and economic stability that prevailed prior to the catastrophic First World War, which as readers may note began 100 years ago this month.
[Editor's note: this piece was first published at Zero Hedge, which has had several excellent articles tracking the effusions of the PBOC and their effect on credit markets]
Shortly after we exposed the real liquidity crisis facing Chinese banks recently (when no repo occurred and money market rates surged), China (very quietly) announced CNY 1 trillion of ‘Pledged Supplementary Lending’ (PSL) by the PBOC to China Development Bank. This first use of the facility “smacks of quantitative easing” according to StanChart’s Stephen Green, noting it is “deliberate and significant expansion of the PBOC’s balance sheet via creating bank reserves/cash” and likens the exercise to the UK’s Funding For Lending scheme. BofA is less convinced of the PBOC’s quantitative loosening, suggesting it is more like a targeted line of credit (focused on lowering the costs of funding) and arguing with a record “asset” creation by Chinese banks in Q1 does China really need standalone QE?
China still has a liquidity crisis without the help of the PBOC… (when last week the PBOC did not inject liquidty via repo, money market rates spiked to six-month highs…)
And so the PBOC decided to unleash PSL (via BofA)
The China Business News (CBN, 18 June), suggests that the PBoC has been preparing a new monetary policy tool named “Pledged Supplementary Lending” (PSL) as a new facility to provide base money and to guide medium-term interest rates. Within the big picture of interest rate liberalization, the central banks may wish to have a series of policy instruments at hand, guaranteeing the smooth transition of the monetary policy making framework from quantity tools towards price tools.
PSL: a new tool for base money creation
Since end-1990s, China’s major source of base money expansion was through PBoC’s purchase of FX exchanges, but money created from FX inflows outpaced money demand of the economy. To sterilize excess inflows, the PBoC imposed quite high required reserve ratio (RRR) for banks at 17.5-20.0% currently, and issued its own bills to banks to lock up cash. With FX inflows most likely to slow after CNY/USD stopped its one-way appreciation and China’s current account surplus narrowed, there could be less need for sterilization. The PBoC may instead need to expand its monetary base with sources other than FX inflows, and PSL could become an important tool in this regard.
…and a tool for impacting medium-term policy rate
Moreover, we interpret the introduction of the PSL as echoing the remarks by PBoC Governor Zhou Xiaochuan in a Finance Forum this May that “the policy tool could be a short-term policy rate or a range of it, possibly plus a medium-term interest rate”. The PBoC is likely to gradually set short-term interbank rates as new benchmark rates while using a new policy scheme similar to the rate corridor operating frameworks currently used in dozens of other economies. A medium-term policy rate could be desirable for helping the transmission of short-term policy rate to longer tenors so that the PBoC could manage financing costs for the real economy.
Key features of PSL
Through PSL, the PBoC could provide liquidity with maturity of 3-month to a few years to commercial banks for credit expansion. In some way, it could be similar to relending, and it’s reported that the PBoC has recently provided relending to several policy and commercial banks to support credit to certain areas, such as public infrastructure, social housing, rural sector and smaller enterprises.
However, PSL could be designed more sophisticatedly and serve a much bigger monetary role compared to relending.
First, no collateral is required for relending so there is credit risk associated with it. By contrast, PSL most likely will require certain types of eligible collaterals from banks.
Second, the information disclosure for relending is quite discretionary, and the market may not know the timing, amount and interest rates of relending. If the PBoC wishes to use PSL to guide medium-term market rate, the PBoC perhaps need to set up proper mechanism to disclose PSL operations.
Third, relending nowadays is mostly used by the PBoC to support specific sectors or used as emergency funding facility to certain banks. PSL could be a standing liquidity facility, at least for a considerable period of time during China’s interest rate liberalization.
Some think China’s PSL Is QE (via Market News International reports),
Standard Chartered economist Stephen Green says in a note that reports of the CNY1 trillion in Pledged Supplementary Lending (PSL) that the People’s Bank of China recently conducted in the market smacks of quantitative easing. He notes that the funds which have been relent to China Development Bank are “deliberate and significant expansion of the PBOC’s balance sheet via creating bank reserves/cash” and likens the exercise to the UK’s Funding For Lending scheme. CDB’s balance sheet reflects the transfer of funds, even if the PBOC’s doesn’t.
The CNY1 trillion reported — no details confirmed by the PBOC yet — will wind up in the broader economy and boost demand and “sends a signal that the PBOC is in the mood for quantitative loosening,” Green writes
The impact will depend on whether the details are correct and if all the funds have been transferred already, or if it’s just a jumped up credit facility that CDB will be allowed to tap in stages.
But BofA believes it is more likely a targeted rate cut tool (via BofA)
The investment community and media are assessing the possible form and consequence of the first case of Pledged Supplementary Lending (PSL) by PBoC to China Development Bank (CDB). The planned total amount of RMB1.0tn of PSL is more like a line of credit rather than a direct Quantitative Easing (QE). The new facility can be understood as a “targeted rate cut” rather than QE. We reckon that only some amount has been withdrawn by CDB so far. Despite its initial focus on shantytown redevelopment, we believe the lending could boost the overall liquidity and offer extra help to interbank market. Depending on its timespan of depletion, the actual impact on growth could be limited but sufficient to help deliver the growth target.
Relending/PSL to CDB yet to be confirmed
The reported debut of PSL was not a straightforward one. The initial news report by China Business News gave no clues on many of the details of the deal expect for the total amount and purpose of the lending. With the limited information, we believe the lending arrangement is most likely a credit line offered by PBoC to CDB. The total amount of RMB1.0tn was not likely being used already even for a strong June money and credit data. According to PBoC balance sheet, its claims to other financial institutions increased by RMB150bn in April and May. If the full amount has been withdrawn by CDB, it is equivalent to say PBoC conducted RMB850bn net injection via CDB in June, since CDB has to park the massive deposits in commercial banks. We assess the amount could be too big for the market as the interbank rates were still rising to the mid-year regulatory assessment. The PBoC could disclose the June balance after first week of August, we expect some increase of PBoC’s claims on banks, but would be much less than RMB850bn.
Difference with expected one
In our introductory PSL report, we argue that the operation has its root in policy reform of major central banks. However, we do not wish to compare literally with these existing instruments, namely ECB’s TLTRO or BoE’s FLS. Admittedly, the PBoC has its discretion to design the tailor-made currency arrangement due to the special nature of policy need. However, the opaque operation of PSL will eventually prove it a temporary arrangement and perhaps not serving as an example for other PSLs for its initial policy design to be achieved. According to Governor Zhou, the PSL is supposed to provide a reference to medium-term interest rate, which is missing in today’s case.
The focus is lowering cost of funding
We have been arguing that relending is a Chinese version of QE. Although relending is granted to certain banks, but there is no restriction on how banks use the funding. However, we believe PSL is more than that. The purpose of CDB’s PSL has been narrowed down to shantytown redevelopment, an area usually demands fiscal budget or subsidy in the past. Funding cost is the key to this arrangement.
Indeed, the PBoC has been working hard to reduce the cost of funding in the economy since massive easing is not an option under the increasing leverage of the economy. A currency-depreciation easing has been initiated by PBoC to bring down the interbank rate. Since then the central bank carefully manages the OMO in order to prevent liquidity squeeze from happening. On 24 July, State Council and CBRC have introduced workable measures to reduce funding cost of small and micro-enterprises.
Impact of the lending
PSL is not a direct QE, but there could be some side effect by this targeted lending. PSL to CDB means the funding demand and provision come hand-inhand. Targeted credit easing by nature is a requirement by targeted areas demanding policy support, which could be SMEs, infrastructure or social housing. In this regard, it is not surprising to see more PSL to support infrastructure financing. In addition to the direct impact on those targeted areas, we expect the overall funding cost could benefit from liquidity spillover.
Since the news about PSL with CDB last Monday, we have seen a rally in the Shanghai Composite Index. However we believe multiple factors may have contributed to the rebound in the stock market including: (1) better than expected macro data in 2Q/June and HSBC PMI surprising on the upside leading to improved sentiment; (2) The State Council and the CBRC have introduced measures to reduce funding cost of small and micro-enterprises; (3) More property easing with the removal of home purchase restrictions in several cities. PSL could have contributed to the improved sentiment on expectation of further easing.
Since as we noted previously, China’s massive bank asset creation (dwarfing the US) hardly looks like it needs QE…
As Bank Assets exploded in Q1…
dramatically outpacing the US…
Unless something really bad is going on that needs an even bigger bucket of liquidity.
* * *
So whatever way you look at it, the PBOC thinks China needs more credit (through one channel or another) to keep the ponzi alive. Anyone still harboring any belief in reform, rotation to consumerism is sadly mistaken. One day of illiquidity appears to have been enough to prove that they need to keep the pipes wide open. The question is where that hot money flows as they clamp down (or not) on external funding channels.
Notably CNY has strengthened recently as the PSL appears to have encouraged flows back into China.
* * *
The plot thickened a little this evening as China news reports:
- *CBRC ALLOWS CHINA DEV. BANK TO START HOUSING FINANCE BUSINESS
- *CHINA APPROVES CDB’S HOME FINANCE DEPT TO START BUSINESS: NEWS
Thus it appears the PSL is a QE/funding channel directly aimed at supporting housing. CNY 1 trillion to start and maybe China is trying to create a “Fannie-Mae” for China.
According to the French historian Fernand Braudel, to understand the present we should master the whole of world history. The same may be said for the rate of interest: to grasp its significance we should have a full understanding of the whole of economics. Interest is the most important price of economy, the most pervading, as pointed out by the American economist Irving Fisher. Interest plays a key role in affecting all economic activity: interest and the price level are strictly interconnected, subject to leads and lags, they move in the same direction. A falling interest rate induces falling prices and a rising interest induces rising prices. Capital values are derived from income value: if interest is 5%, a capital amount yielding $100 every year has a value of $2,000. The interest rate translates, as it were, the future into the present bridging capital to its income.
When interest drops from a high down to a low level it raises the capitalized value of equipments, bonds, annuities or any other assets providing a stream of future incomes. The rate of interest reveals the individual’s rate of time preference or their “impatience for money”: the inclination towards current consumption over future consumption and vice versa. For example if the individual is indifferent between €1.04 next year and €1.00 today, his rate of time per preference per annum is four percent.
Interest can therefore be considered the minimum future amount of money required to compensate the consumer for foregoing current consumption. It is as it were, the return on sacrificing consumption towards more future consumption. When time preference falls, savings rise and interest falls. And the lower the time preference the more the supply of income saved and transferred in the form of credit to satisfy investment demand. In the economy there cannot be any real net investment without an equal amount of real net saving. The price balancing the supply of income (from savings) and the demand for it (for spending and investment) was defined by the Scandinavian economist Kurt Wicksell, the “natural rate of interest”.
Its function is to ration out existing scarce savings into productive uses and to induce to sacrifice current consumption to add to the stock of capital. The 18th century French finance minister Anne-Robert-JacquesTurgot put it this way:
The current interest of money is the is the thermometer by which the abundance or scarcity of capitals may be judged; it is the scale on which the extent of a nation’s capacity for enterprises in agriculture, manufactures, and commerce, may be reckoned.. Interest may be looked upon as a kind of like a sea level …… under which all labor, culture, industry, commerce cease to exist». In the contemporary economy interest is a monetary tool by which central banks pretend to regulate the abundance of capital. Unfortunately in doing so they make the economy sink under the sea level. To understand this effect the rate of interest has to be investigated through its relation with money and capital.
Interest and Money
In ordinary language interest is defined either as the cost or the price for borrowing money, but these notions are partly true. If interest is a cost for the borrower is also an income for the lender. On the other hand by defining interest as a “price” we are lead into thinking that it varies inversely to the money quantity. This is what the monetary theory of the interest holds. Despite some appearance of truth it is a fallacious doctrine because being also the interest a quantity of money paid or collected against a loan it varies in direct proportion to the quantity of money. For example, if a loan was $100 earning $5, and the money supply doubled, it will rise to $200 earning $10. Interest must double to make loans equivalent (in fact: 5/100=10/200) although in percentage remains unchanged. If anything, other things being equal, an increase of money supply causes interest to rise, not to fall, for the “price of money” is not interest but money purchasing power. Furthermore the definition of interest as the price for money obscures the fact that what is exchanged in a loan is not money but present money against future money, namely credit. Credit is the temporary transfer of wealth or purchasing power from one person to another upon payment of interest. Since purchasing power is wealth and wealth producing income is capital, the rate of interest is the income paid for the use of capital. But what is used is not “abstract capital” because there is not a generic demand for capital, otherwise there would be no difference between the interest rate and the discount rate, but between the money market and the capital market. When a person asks for a loan for consumption he is not asking for capital but for money as means of payment. Who discounts bills or notes does not need capital he already has in some form or another, he wants to transform it in a more liquid form. Ultimately he needs “liquidity” not to expand his capital or business but to anticipate its monetary form. Because most businesses due to seasonal fluctuations cannot be conducted on a cash basis they need credit or liquidity just to compensate these fluctuations. The price for the temporary use of liquidity is the rate of discount. It doesn’t represent interest on capital but a rent, as it were, measuring the value of the money services namely for specific services: making the flow of the production smooth, keeping solvency or allowing specific profits in money transactions. The whole all transactions involving transfers of liquidity used to increase the marketability of all the forms of wealth as to render them more fluid, form the money market. Here money is invested without losing its form, without turning itself into capital which is the money income employed in production. However, liquidity emerging as cash surpluses to fund cash balances deficits, is always grounded on capital operations and being limited by the use of capital depends on the rate of interest.
Interest and capital
While the rate of discount concerns money or short term credit to anticipate the monetary form of real capital, the rate of interest concern the money or long term credit to extend real capital. So it is a long rate not a discount rate because what is lent is not money but capital (which is wealth employed in view of more future production). Hence the purpose of capital or long credit market is to provide the nexus between savers and borrowers to finance productive investments and expand the economy. Thus interest is the price balancing the supply and demand for money capital. An increased supply competing for borrowers pushes down the interest. An increases demand competing for lenders pushes up interest. The interaction supply/demand establishes the rate of interest at the point where the lenders rate of time preference tends to equal the borrowers rate of profit. This is because the use of capital depends on its marginal utility: in the market it is convenient to borrow till the income earned from the use of capital will exceed the cost of its use coinciding with the rate of time preference. So interest is the price of money capital as determined by the interaction between the least productive use and the savers’ return on sacrificing consumption. In practice it oscillates between an upper limit and a lower limit. The former is the rate of profit, otherwise borrowing would not be convenient, and the latter the rate of time preference which represents for the economy as a whole the cost of capital accumulation. This lower limit cannot be zero otherwise lenders would use income directly giving up sacrificing current consumption.
However because the rate of interest reflects the productivity of capital and it’s convenient to borrow until capital yields a positive income, it is the rate of profit that commands the rate of interest. Hence interest may also be defined as the market price of money capital typified by the rate of profit.
To the extent people are provident and have a low time preference, the capital is abundant, the rate of interest is low and long term capital-intensive projects can be undertaken, the economy expands, technological progress advances and wages productivity rises. Conversely, if the time preference is high, capital is scarce, interest higher and more liquid projects prevail. However according to the monetary theory the market rate of interest is typified by the return or yield per year on riskless long term government bonds which are deemed to typify the benchmark for the rate of profit on capital assets. Yet because governments consume instead of producing the bond yield typifies the shifts of income supply towards consumption uses. In fact the lower the bond yield the higher the government consumption and the lesser the capital available for production. Therefore bond yields reflect propensity to consume, in contrast with interests on capital reflecting propensity to invest.
Because capital it is tied up for long time in production and regain its liquid form after the sale of products, the rate of interest has a different economic nature than the rate of discount: while the latter is subject to money fluctuations, the former is less sensitive to them for it gives up its monetary form for an extended period until the time of loan repayment. Moreover by borrowing liquidity one looks at prospects of immediate gain while by borrowing capital one looks at incomes over a longer period of time. In general, the interest rate is higher than the discount rate because being less liquid commands a premium for liquidity. However when production languishes, profits fall, capital withdraws from production, interest falls while discount rate rises as demand for short-term loans rises to preserve liquidity. Interest rises during periods of economic development when present income is sacrificed and invested in capital. Once capital starts to produce new income, interest falls setting the pace for the boom period when discount rises because the higher volume of spending increases demand for money. So in general they vary independently from one another. Although there is a constellation of rates of interest depending on the loan maturities, all tend to a same level. Money capital moves where it is most needed, runs from less profitable assets to more profitable ones and like water flows to find its level. So by continuous market oscillations any capital tends to provide the same income any difference due to the risk.
It’s worth noting that if the liquidity of capital invested is lost for many years it can be regained at any time in the stock exchange by selling shares. However because shares represent titles on already existing capital, their sale does not adds to capital stock and doesn’t affect the rate of interest, rather it adds to liquidity affecting the discount rate.
Other interest rate determinants
Interest as a market price arising from the interaction between the rate of profit and the time preferences governs the price of capital assets as well as their allocation other things being equal. In fact, because the rate of profit arises in the economic system as a difference between the prices of products and the prices of factors of production to manufacture them, it is affected by these price levels. Fluctuations in these prices cause fluctuations in the rate of profit and as consequence in the rate of interest which is typified by the rate of profit. And because capital assets are determined by discounting their expected returns by interest rates of the same maturities as the life of the capital assets,it follows that all capital allocation in the market is affected by the ratio of demand to supply of both products and factors of production.
However, the value of money is also determined by supply and demand of money. If interest, in essence, depends on real factors such as time preferences, rate of profit and supply and demand, being itself a money sum must logically be dependent on the value of money although indirectly. To explain the emergence of interest the Austrian economist Eugene Bohm Bawerk argued that because present goods due to the time preference worth more than future goods of like kind and quantity, they command a premium over the future goods. In other terms, interest is the discount of future goods as against present goods or the demand price of present goods in term of future goods. However, once goods are priced in term of money, the interest rate becomes a ratio of exchange between present and future money sums and its value may not coincide with the ratio between their physical quantities because of changes occurring in the prices level. If, for example the money supply rises, the value of the expected monetary sum lent falls. Then savers expecting a rise in prices will ask for a higher interest to compensate for the loss in the value of loan capital (this confirms the mistake of monetary theory in claiming that a rise in the money supply lowers interest). Because money affects the value of real capital it’s wrong to assert (as Knut Wicksell did) that a loan might be likened to a temporary transfer of goods repayable in goods rewarded by an interest paid also in goods and determined by the supply and demand of physical goods. Interest cannot be appraised by abstracting from money because as the money value changes so does the value of real factors determining interest, all acting through money. Only if the value of money were constant would the “real” and “monetary” interest coincide.
As Ludwig von Mises pointed out, interest is a category of human action, a primordial phenomenon unlikely to disappear even in the most ideal world. In fact the forces determining interest prevents it from falling permanently to zero or even below. If it were zero saved income could not be exchanged for more future income or to say it differently, the valuation between present and future goods would be at par which may happen only in world where all goods would be free and no capital would be necessary to produce them. If the interest were negative future goods would command a premium on present goods, a reversal of human nature whereby present goods would be valued less than future goods and lenders would have to pay an interest instead of receiving it. The capital would shrink and the economy would regress. Such extreme values which are a little like to the absolute zero in physics, may be only inflicted to interest by exceptional circumstances such as revolutions, seizures, thefts, invasions all situations of great danger when people would prefer to pay a “penal rate” rather than lose their entire capital. Still, in the contemporary economy, similar abnormal situations are artificially created. This is because interest is not commanded by the self generating forces regulating the rate of interest, but by the central banks planned monetary policy closely related to the governments’ fiscal policy.
Central banks set an official or discount rate, a minimum and arbitrary lending rate, the “price for liquidity”, which varies through monetary policy consisting of buying and selling in the open market governments issued bonds against such liquidity. Thus monetary policy acts as a pressure and suction pump alternately decreasing and increasing the quantity of money to push the interest up and down either to keep bonds in the desired relationship with the official rate or to provide a money supply favorable to economic stability and growth. In so doing central banks mimic the natural tendency of interest. For example by expanding money supply during recessions they lower the official rate as this were the after effect of new income streams arising out of foregoing savings required to restore economic growth. The long term rate then changes through expectations towards the official rate: if the latter falls the former is expected to rise and vice versa. However because interests are used to determine the present value of capital assets by discounting their expected income, monetary policy misprices capital assets and misallocate them. This is because the entire interest market structure (the relationship among interest rates influencing prices of income producing assets of different maturity) depends solely on liquidity fluctuations commanded by monetary policy which is completely divorced from the real factors that determine the interest and lay the foundation of liquidity. So not in any sense can the market rate of interest be compared with the one determined by central banks. By ignoring the distinction between money and capital, monetary policy denies the natural function of time preferences and rate of profit confining them to an adaptive role vis-à-vis of their monetary manipulation.
On the other hand because government bonds provide the basis for the money expansion that grows as interest drops, the official rate may be looked upon as a tool of fiscal policy reflecting capital dissipation.This is because central banks pay for these bonds not with income released by foregoing capital operations, but with means of payment they themselves “coin” and lend as they were saved income. This manoeuvre – also known as credit easing – is tantamount to discounting and putting into circulation expected wealth as if it were current wealth, to consume or to use as capital. In other words, central banks by advancing means of payment act as the future were so prosperous as to pledge an ever increasing wealth allowing for their repayment. But the fact is that the most of these means of payment passed off as an existent wealth besides using up, without replacing, the wealth already produced, will never be repaid for they will be misallocated into unproductive uses by a rate of interest not reflecting the existence of money capital but the mere expansion of means of payment that, as already pointed out, should cause interest to rise, not to fall. The paradox is that subsequent rounds of this expansion entail equivalent rounds of waste making capital scarcer and scarcer. Thus economic downturns are just the result of the attempt to create capital on the foundation of monetary policy rather than on the foundation of the real factors determining the rate of interest. Unfortunately, they tend to become permanent to the extent central banks in trying to alleviate them expand money by buying bonds on a huge scale so as to push interest down to zero. But at this level lenders, having no incentive to turn income into capital, will turn capital into income which means they will be living out of their capital until is depleted. As interest vanishes “under the sea level” so does capital till “labour, culture, industry, or commerce will cease to exist” as Turgot predicted long ago.
Editor’s note: this article, under the title “No end to central bank meddling as ECB embraces ‘quantitative easing’, faulty logic” appears on Detlev Schlichter’s site. It is reprinted with kind permission.
The 2nd edition of his excellent Paper Money Collapse is available for pre-order.
“Who can print money, will print money” is how my friend Patrick Barron put it succinctly the other day. This adage is worth remembering particularly for those periods when central bankers occasionally take the foot off the gas, either because they genuinely believe they solved the problem, or because they want to make a show of appearing careful and measured.
The US Federal Reserve is a case in point. Last year the Fed announced that it was beginning to ‘taper’, that is, carefully reduce its debt monetization program (‘quantitative easing’, QE), and this policy, now enacted, is widely considered the beginning of policy normalization and part of an ‘exit strategy’. But as Jim Rickards pointed out, the Fed already fully tapered twice – after QE1 and after QE2 – only to feel obliged to ‘qe’ again some time later. Whether Ms Yellen is going to see the present ‘taper’ through to its conclusion and whether the whole project will in future be remembered as an ‘exit strategy’ remains to be seen.
So far none of the big central banks has achieved the ‘exit’ despite occasional noises to the contrary. Since the start of the financial crisis in the summer of 2007, the global trend has been in one direction and one direction only: From easy money we moved to easier money. QE has been followed by more QE. As I mentioned before, the Fed’s most generous year in its 100-year history was 2013, any talk of ‘tapering’ notwithstanding.
ECB mistrusted by Keynesian consensus
Whenever the European Central Bank reduces its money printing and scales back its market rigging, it invariably unleashes the fury of the Keynesian and inflationist commentariat. In the eyes of its numerous critics, the ECB lacks the proper money-printing credentials of the more pro-active and allegedly more ‘modern’ central banks. It still has a whiff of the old Bundesbank about it, although a few years back, when the ECB flooded the European banking system with cheap liquidity, its balance sheet was larger as a share of GDP than those of its comrades, the Fed and the Bank of England.
The ECB went through two periods of restraint since the crisis: In early 2011 it began to hike interest rates, and in 2013, after the eurozone debt crisis died down, the ECB allowed its balance sheet to shrink by more than €700 billion as banks repaid cheap loans from the central bank. This stood in stark contrast to the Fed’s balance sheet expansion of about $1,000 billion over the same period. The first episode of restraint came to an end in 2012 when the ECB reversed its rate hikes and then cut rates further, ultimately to a new low of just 0.25 percent. Presently, we are still in the second period of restraint, although it too appears to be about to end soon as the ECB’s boss Mario Draghi hinted in his press conference last week at a newfound willingness to embrace unconventional policies to combat ‘deflation’ or even ‘long periods of low inflation’. (The ECB’s harmonized index of consumer prices stood probably at just 0.5% last month.) This means the ECB is likely to cut rates to zero or below soon, or to start asset purchases (‘QE’), or probably both.
This move is hardly surprising in the big scheme of things as outlined above, and the ECB will explain it officially with its mandate to keep inflation below but close to 2 percent, from which it does not want to deviate in either direction. This target itself is silly as it assumes that inflation of 1.8 percent is inherently better than inflation of zero (true price stability, if it ever was attainable), or inflation of minus 1.8 percent (deflation). This is, of course, precisely the argument that has been relentlessly and noisily trumpeted by the easy-money advocates in the media, the likes of Martin Wolf and Wolfgang Münchau in the Financial Times, and the reliably shrill Ambrose Evans-Pritchard in The Daily Telegraph, among others. A certain measure of inflation is deemed good, very low inflation is bad, and anything below zero, even mild deflation, potentially a disaster. But why should this be the case?
Moderate deflation, that is, slowly declining money prices, may or may not be a symptom of problems elsewhere in the economy, but that slowly declining money prices as such constitute an economic problem lacks any foundation in economics and can easily and quickly be refuted by even a cursory look at economic history. In the 19th century we find extended periods of ongoing, moderate deflation in many economies that simultaneously experienced solid growth in output and substantial rises in living standards, a “coincidence”, wrote Milton Friedman and Anna Schwartz in their influential A Monetary History of the United States, 1867 – 1960, that “casts serious doubts on the validity of the now widely held view that secular price deflation and rapid economic growth are incompatible.”
Many commentators advance the argument that falling prices depress consumption as purchases get constantly deferred. Even the usually more sober FT-writer John Authers seems to have succumbed to this argument as he explained to his readers last Saturday that prices “fall, thanks to sluggish economic activity. Consumers do not buy now, as goods will be cheaper in future. This lack of consumption slows growth further, and pushes prices down even further.” (John Authers, “Draghi has to back his QE words with action” Financial Times, Saturday April 5/ Sunday April 6 2014, page 24)
This argument, constantly regurgitated by the cheerleaders of money-printing, is weak. First of all, it is certainly no argument in the present environment of close to zero but still positive inflation. If the ECB plans to fight even very low inflation, as Draghi stated at the ECB press conference, than this argument does nothing to support that policy. Certainly, no one defers any purchases when prices are just stable. However, and more importantly, even in a mildly deflationary environment of let’s say 1 to 2 percent per annum, the argument does appear to be a stretch.
Argument ignores time preference
Consumers only contemplate buying something that they consider an economic good, that is, that they consider useful, that they want because it expends some (subjective) use-value to them. In deferring a purchase they can, in a deflationary environment, save money but at the cost of not enjoying the possession of what they want for some time. By not buying a toaster now you may be able to buy it 1 or 2 percent cheaper in a year’s time, or 2 to 4 percent cheaper in two years’ time (always assuming, of course, that the mild deflation persists that long, which nobody can guarantee), but even these small monetary gains come at the expense of not enjoying ownership of the toaster for two years. The small monetary gain obtained by delaying purchases is not for free, as the argument seems to assume, but comes at the cost of waiting. I suggest that only a very small number of items, and only those for which there is very marginal demand indeed, would be affected.
Time preference is not a concept of psychology, it is a constituting element of human action. It is a priori to human action, which means it exists independent of experience or of personal circumstances as it is already entailed in the very concept of what constitutes an ‘economic good’.
If you experienced no time preference in relation to a specific good you would be indifferent as to whether you enjoyed the possession of that good today or tomorrow. And tomorrow you would be indifferent as to whether you enjoyed it that day or the next, and so forth. Logically, you would be indifferent as to whether you enjoyed possession of it at all, and this means that the good in question is not an economic good for you. You do not care for it.
As George Reisman put is succinctly: To want something means, all else being equal, to want it sooner rather than later.
Be honest, how many purchases over the past 12 months would you not have made had you had a reasonable chance of obtaining the item in question at a 1 or 2 percent discount if you waited a year?
That the prospect of falling prices does not usually deter consumption can be readily seen today in the market for consumer electronics (mobile phones, computers), which has been in deflation – and considerable deflation – for quite some time.
Argument ignores opportunity costs of holding money
The argument also seems to ignore that holding one’s wealth in the form of money involves opportunity costs. Rather than sitting on cash you could enjoy the things you could buy with it. In a deflationary environment, your cash hoard’s purchasing power slowly rises and you can afford ever more nice things with your money, which means the opportunity cost of not spending it constantly goes up. (In a way, while you are waiting four years to buy your toaster at an 8 percent discount to today’s price, buying the toaster is also becoming marginally more attractive to others who are presently holding cash and who may initially not even had an interest in a toaster.)
I think that all that would follow from secular (that is ongoing, systematic but moderate) deflation is that cash would be a more meaningful competitor for other depositories of deferred consumption. Saving by simply holding money makes sense in a deflationary environment, so other vehicles to save with (bonds and shares) would have to offer a return reasonably above the expected deflation rate to attract savings. I think this is not an unreasonably high hurdle.
Furthermore, if what Authers and others describe were true for even marginal deflation, that is, if marginal deflation indeed led to more deflation and a progressively weakening economy, the reverse must logically be true for marginal inflation. Consumers would accelerate their purchases to avoid the 1 or 2 percent loss in purchasing power per annum, and this would quickly drive inflation higher. If two percent deflation led to cash hoarding and a collapse in consumption, would the 2 percent inflation advocated today as ‘price stability’ not lead to a spike in money velocity and an inflationary boom? Either scenario seems highly unrealistic.
Monetary causes versus non-monetary causes
If we use the economic terminology correctly, then inflation and deflation are always monetary phenomena, that is, they always have monetary causes. (As an aside, I here use the now standard definition of inflation as an ongoing, trending rise in the general price level, and deflation as the opposite, rather than the traditional meaning of inflation as an expansion of the money supply and deflation as a contraction.) However, the starting point of the present discussion is simply some low readings on the official inflation statistics in the eurozone. And that those could have non-monetary causes, that they could be the consequence of a crisis-driven drop in real demand in certain industries and certain countries is a realistic assumption and is in fact implied by the arguments of the QE-advocates. Outright deflation is presently being recorded in Greece, Cyprus, and Spain. And John Authers’ short statement on deflation in the FT also starts from the assumption that “prices fall thanks to sluggish economic activity.”
But to the extent that recorded deflation is not due to a general rise in money’s purchasing power (due to a general rise in money demand or an unchanged or falling money supply, to which I come soon) but the result of some producers slashing certain prices in certain industries and regions, and of those price drops not being fully compensated by rising prices somewhere else in eurozone, then this has various implications:
Consumers cannot simply assume that this is a lasting trend. The liquidation of capital misallocations and the discounting of merchandise to get it moving are crisis phenomena and cannot simply be extrapolated into the future the way consumers may have extrapolated the secular deflation of gold standard economies in the 19th century. But the straight extrapolation of very recent price changes into the future is at the core of the argument that even small deflation would be disastrous.
Furthermore, it would seem bizarre to advice merchants to not slash prices when demand drops as that would, according to the logic advanced by Authers et al, only lead to further postponement of consumption and a further drop in demand as consumers would simply expect price declines to continue. Would hiking prices be a better strategy to counter falling demand? Should we reconsider the concept of the “sale” and of “discounting” inventory to encourage buying?
To a considerable degree, the reduction in certain prices for ‘real’ economic reasons could be part of the economic healing process. It is a way for many producers, sectors of the economy, and economic regions, to regain competitiveness. It is true that falling wages in certain industries or regions make it more difficult for workers to repay mortgages and consumer loans but often the lower wage may be the only way to avoid unemployment, which would make repaying debt harder still. Behind the often-quoted headline inflation rate of presently 0.5% per annum lie numerous relative price changes by which the economy re-balances. All discussions about the ‘price index’ ignore these all-important changes in relative prices. It so happens that what goes on with the multitude of individual prices in the economy adds up, according to the techniques of the ECB statisticians, to a 0.5% harmonized inflation rate at the moment, and it may all add up to -0.5% next month or next year, or maybe even – 1 percent. To simply conclude from this one aggregate price number that the economy is getting progressively sicker would be wrong.
There is no escaping the fact that recent economic difficulties are the result of imbalances that accumulated during the credit boom that preceded the 2007/2008 financial crisis, of which the eurozone debt crisis was an after quake. Artificially cheap money created the credit boom and these imbalances. A period of liquidation, contraction, changing relative prices and occasionally falling prices is now necessary, and short-circuiting this process via renewed central bank intervention seems counterproductive and ultimately dangerous.
There is, of course, the possibility that proper monetary causes are behind the eurozone’s low inflation and soon deflation, and that those might persist. Banks still feel constrained in their ability to extend new loans and thus create new money. The growth in bank lending and thus in wider monetary aggregates may fall short of the growth in money demand. But it is an essential feature of money that any demand for it can be fully satisfied with a rise in its price. Demand for money is always demand for readily exercisable purchasing power, and by allowing the market to lift the purchasing power of money, that is, through deflation, that demand can be met. The secular, moderate and largely harmless deflation of 19th century gold standard economies had essentially the same origin. Money production did not keep pace with money demand, so money demand was satisfied via slowly falling prices.
And here the same conclusion applies: a more restrained approach to lending, credit risk, and financial leverage, now adopted by banks and the public at large as a consequence of the crisis, may be a good thing, and for the central bank to mess with this process and to use ‘unconventional’ means to force more bank lending and money creation onto the system, out of some misguided commitment to the arbitrarily chosen statistical goal of ‘2-percent inflation’ seems foolish. If successful in raising the headline inflation rate it may succeed in creating the same imbalances (excessive leverage, misallocations of capital and distorted asset prices) that have created the recent crisis.
One commentator recently said the eurozone could ill afford deflation considering the size of its bloated banking sector. But the question is if it can afford the level of lending to attain 2 percent inflation considering the size of its bloated banking sector.
The fallacy of macroeconomics and macroeconomic policy
Let me be clear: I do not recommend a zero-inflation target or a target of moderate deflation. Moderate deflation in and of itself is a little a solution as moderate inflation in and of itself is a problem. I recommend no target as I reject the entire concept of ‘monetary policy’, of the notion that a state agency could conceivably enhance, through clever manipulation of interest rates and bank reserve policy, the coordinating powers of the market that help people realize their personal economic objectives through free trade.
We should remember that no one participates in the economy and in trade and commerce because his or her goal is that the general price level goes up by 2 percent, or that nominal GDP increases by 5 percent. People have their own personal objectives. The market is simply a powerful tool for voluntary and decentralized plan-coordination among independent individuals and groups of individuals that pursue their own goals. It is best left undisturbed. This entire project of ‘monetary policy’ is absurd in the extreme, regardless of what the target is.
It is the fallacy of macroeconomics that certain statistical aggregates, such as CPI, GDP or nominal GDP, are deemed reliable representatives of what goes on in a complex market economy, and it is dangerous hubris to believe that the state should define ‘targets’ for these statistical aggregates and then use policy intervention to achieve them. This might be an approach intellectually suitable for the ruler of a communist or fascist society. It is fundamentally at odds with free trade and a free market, and it must and will fail. That should have been a clear lesson from the financial crisis.
Instead, the mainstream consensus, deeply influenced by Keynesianism and macroeconomics, continues to embrace policy activism and intervention. I fully expect central banks to continue on their path towards more aggressive meddling and generous fiat money production. It won’t take long for the ECB to take the next step.
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.
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”
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.
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 :
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 must be communicated to the offeror – Entores v Miles Far East Corp .
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  – 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  – 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.
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  – 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.
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.
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.