It isn’t often that a Bank of England Quarterly Bulletin starts “A revolution in how we understand economic policy” but, according to some, that is just what Money creation in the modern economy, a much discussed article in the most recent bulletin, has done.
In the article Michael McLeay, Amar Radia, and Ryland Thomas of the Bank’s Monetary Analysis Directorate seek to debunk the allegedly commonplace, textbook understanding of money creation. These unnamed textbooks, they claim, describe how the central bank conducts monetary policy by varying the amount of narrow or base money (M0). This monetary base is then multiplied out by banks, via loans, in some multiple into broader monetary measures (e.g. M4).
Not so, say the authors. They begin by noting that most of what we think of as money is actually composed of bank deposits. These deposits are created by banks when they make loans. Banks then borrow the amount of narrow or base money they require to support these deposits from the central bank at the base rate, and the quantity of the monetary base is determined that way. In short, the textbook argument that central bank narrow or base money creation leads to broad money creation is the wrong way round; bank broad money creation leads to central bank narrow money creation. The supposedly revolutionary connotations are that monetary policy is useless, even that there is no limit to the amount of money banks can create.
In fact there is much less to this ‘revolution’ than meets the eye. Economists and their textbooks have long believed that broad money is created and destroyed by banks and borrowers(1). None that I am aware of actually thinks that bank lending is solely or even largely based on the savings deposited with it. Likewise, no one thinks the money multiplier is a fixed ratio. It might be of interest as a descriptive datum, but it is of no use as a prescriptive tool of policy. All the Bank of England economists have really done is to describe fractional reserve banking which is the way that, these days, pretty much every bank works everywhere.
But there’s an important point which the Bank’s article misses; banks do not create money, they create money derivatives. The narrow or base money issued by central banks comprises coins, notes, and reserves which the holder can exchange for coins and notes at the central bank. The economist George Reisman calls this standard money; “money that is not a claim to anything beyond itself…which, when received, constitutes payment”.
This is not the case with the broad money created by banks. If a bank makes a loan and creates deposits of £X in the process, it is creating a claim to £X of standard money. If the borrower makes a cheque payment of £Y they are handing over their claim on £Y of reserve money. The economist Ludwig von Mises called this fiduciary media, as Reisman describes it, “transferable claims to standard money, payable by the issuer on demand, and accepted in commerce as the equivalent of standard money, but for which no standard money actually exists”. They are standard money derivatives, in other words.
Banks know that they are highly unlikely to be called upon to redeem all the fiduciary media claims to standard money in a given period so, as the Bank of England economists explain, they expand their issue of fiduciary media by making loans; they leverage. Between May 2006 and March 2009 the ratio of M4 to M0, how many pounds of broad money each pound of narrow money was supporting, stood around 25:1.
But because central banks and banks create different things consumer preferences between the two, standard money or standard money derivatives, can change. In one state of affairs, call it ‘confidence’, economic agents are happy to hold these derivatives as substitutes for standard money. In another state of affairs, call it ‘panic’, those same economic agents want to swap their derivatives for the standard money it represents a claim on. This is what people were doing when they queued up outside Northern Rock. A bank run can be described as a shift in depositors’ preferences from fiduciary media to standard money.
Why should people’s preferences switch? In the case of Northern Rock people came to doubt that they would be able to actually redeem their fiduciary media for the standard money it entitled them to because of the vast over issue of fiduciary media claims relative to the standard money the bank held to honour them. Indeed, when Northern Rock borrowed from the Bank of England in September 2007 to support the commitments under its broad money expansion it increased the monetary base just as the Bank of England economists argue.
But there are limits to this. A bank will need some quantity of standard money to support its fiduciary media issue, either to honour withdrawals by depositors or settle accounts with other banks. If it perceives its reserves to be inadequate it will need to access new reserves. And the price at which it can access those reserves is the Bank of England base rate. If this base rate is relatively high banks will constrain their fiduciary media/broad money issue because the profits earned from making new loans will not cover the potential cost of the standard/narrow money necessary to support it. And if the base rate is relatively low banks will expand their fiduciary media/broad money issue because the standard/narrow money necessary to support it is relatively cheap.
Some commentators need to calm themselves. As the Bank of England paper says, the central bank does influence broader monetary conditions but it does so via its control of base rates rather than the control of the quantity of bank reserves. The reports of the death of monetary policy have been greatly exaggerated.
(1) “Banks create money. Literally. But they don’t do so by printing up more green pieces of paper. Let’s see how it happens. Suppose your application for a loan of $500 from the First National Bank is approved. The lending officer will make out a deposit slip in your name for $500, initial it, and hand it to a teller, who will then credit your checking account with an additional $500. Total demand deposits will immediately increase by $500. The money stock will be larger by that amount. Contrary to what most people believe, the bank does not take the $500 it lends you out of someone else’s account. That person would surely complain if it did! The bank created the $500 it lent you” – The Economic Way of Thinking by Paul Heyne, Peter Boettke, and David Prychitko, 11th ed., 2006, page 403. Perhaps the Bank of England economists need to read a better textbook?
The Bank of England
This article originally appeared in The Telegraph on 5 March 2014. It is reproduced by permission of the author.
Five years ago today, the Bank of England cut interest rates about as low as they can go: 0.5 percent. And there they have remained.
If rates have been rock bottom for five years, our central bankers have been cutting them for even longer. You need to go back almost nine years to find a time when real interest rates last rose. Almost a million mortgage holders have never known a rate rise.
And this is all a Good Thing, according to the orthodoxy in SW1. Sure, low rates might hit savers, who don’t get such good returns, but for home owners and businesses, it’s been a blessing.
Don’t just compare the winners with the losers, say the pundits. Think of the whole economy. Rates were set at rock bottom shortly after banks started to go bust. Slashing the official cost of borrowing saved the day, they say.
I disagree. Low interest rates did not save the UK economy from the financial crisis. Low interest rates helped caused the crisis – and keeping rates low means many of the chronic imbalances remain.
To see why, cast your mind back to 1997 and Gordon Brown’s decision to allow the Bank of England to set interest rates independent of any ministerial oversight.
Why did Chancellor Brown make that move? Fear that populist politicians did not have enough discipline. Desperate to curry favour with the electorate, ministers might show themselves to be mere mortals, slashing rates as an electoral bribe.
The oppostite turned out to be the case. Since independence, those supermen at the central bank set rates far lower than any minister previously dared. And the results of leaving these decisions to supposedly benign technocrats at the central bank has been pretty disastrous.
Setting interest rates low is simply a form of price fixing. Set the price of anything – bread, coffee, rental accommodation – artificially low and first you get a glut, as whatever is available gets bought up.
Then comes the shortage. With less incentive to produce more of those things, the supply dries up. So, too, with credit.
With interest rates low, there is less incentive to save. Since one persons savings mean another’s borrowing, less saving means less real credit in the system. With no real credit, along comes the candyfloss variety, conjured up by the banks – and we know what happened next. See Northern Rock…
When politicians praise low interest rates, yet lament the lack of credit, they demonstrate an extraordinary, almost pre-modern, economic illiteracy.
Too many politicians and central bankers believe cheap credit is a cause of economic success, rather than a consequence of it. We will pay a terrible price for this conceit.
Low interest rates might stimulate the economy in the short term, but not in a way that is good for long-term growth. As I show in my paper on monetary policy, cheap credit encourages over-consumption, explaining why we remain more dependent than ever on consumer- (and credit-) induced growth.
Cheap credit cannot rebalance the economy. By encouraging over-consumption, it leads to further imbalances.
Think of too much cheap credit as cholesterol, clogging up our economic arteries, laying down layer upon layer of so-called “malinvestment”.
“Saved” by low rates, an estimated one in 10 British businesses is now a zombie firm, able to service its debts, but with no chance of ever being able to pay them off.
Undead, these zombie firms can sell to their existing customer base, keeping out new competition. But what they cannot do is move into new markets or restructure and reorganise. Might this help explain Britain’s relatively poor export and productivity performance?
What was supposed to be an emergency measure to get UK plc through the financial storm, has taken on an appearance of permanence. We are addicted to cheap credit. Even a modest 1 per cent rate rise would have serious consequences for many.
Sooner or later, interest rates will have to rise. The extent to which low interest rates have merely delayed the moment of reckoning, preventing us from making the necessary readjustments, will then become painfully evident.
We are going to need a different monetary policy, perhaps rather sooner than we realise.
“Sir, Martin Sandbu writes: “We should not worry about inflation – if we strip out volatile or policy-driven elements, it stands at 1.5%, according to Citigroup”, (“Carney has not yet bent the markets to his will”, August 14.)
“Please arrange for Mr Sandbu to cancel the policies concerned and to prevent the volatile situations encountered. When was the last time inflation was 1.5% ? This comment is as meaningless as my saying: “If savings rates were 5%, then I could afford two more holidays a year.” They aren’t, and I can’t.”
- Letter to the editor of the Financial Times, from Mr Charles Kiddle, Gateshead, UK.
King Cnut The Great, more commonly known as Canute, was a king of Denmark, England, Norway and parts of Sweden (thanks Wikipedia !). He is likely to be known to any English schoolchildren still being educated for two specific things: extracting Danegeld – a form of protection racket – from the citizenry, and for the possibly apocryphal story that once, from the shoreline, he ordered back the sea. Over to Wikipedia:
Henry of Huntingdon, the 12th-century chronicler, tells how Cnut set his throne by the sea shore and commanded the tide to halt and not wet his feet and robes. Yet “continuing to rise as usual [the tide] dashed over his feet and legs without respect to his royal person. Then the king leapt backwards, saying: ‘Let all men know how empty and worthless is the power of kings, for there is none worthy of the name, but He whom heaven, earth, and sea obey by eternal laws.’ He then hung his gold crown on a crucifix and never wore it again “to the honour of God the almighty King”. This incident is usually misrepresented by popular commentators and politicians as an example of Cnut’s arrogance.
This story may be apocryphal. While the contemporary Encomium Emmae has no mention of it, it would seem that so pious a dedication might have been recorded there, since the same source gives an “eye-witness account of his lavish gifts to the monasteries and poor of St Omer when on the way to Rome, and of the tears and breast-beating which accompanied them”. Goscelin, writing later in the 11th century, instead has Cnut place his crown on a crucifix at Winchester one Easter, with no mention of the sea, and “with the explanation that the king of kings was more worthy of it than he”. Nevertheless, there may be a “basis of fact, in a planned act of piety” behind this story, and Henry of Huntingdon cites it as an example of the king’s “nobleness and greatness of mind.” Later historians repeated the story, most of them adjusting it to have Cnut more clearly aware that the tides would not obey him, and staging the scene to rebuke the flattery of his courtiers; and there are earlier Celtic parallels in stories of men who commanded the tides..
The encounter with the waves is said to have taken place at Thorn-eye (Thorn Island), or Southampton in Hampshire. There were and are numerous islands so named, including at Westminster and Bosham in West Sussex, both places closely associated with Cnut. According to the House of Commons Information Office, Cnut set up a royal palace during his reign on Thorney Island (later to become known as Westminster) as the area was sufficiently far away from the busy settlement to the east known as London. It is believed that, on this site, Cnut tried to command the tide of the river to prove to his courtiers that they were fools to think that he could command the waves. Conflictingly, a sign on Southampton city centre’s Canute Road reads, “Near this spot AD 1028 Canute reproved his courtiers”.
Cnut did exist, even if his mythologised battle with Nature was a fabrication. And for anyone who thinks that politicians are capable of learning from disastrous policy failures, the following lesson from history is also instructive. Explicitly linking economic policy and monetary policy rates to unemployment rates is not an innovation of either Ben Bernanke’s Fed or Mark Carney’s Bank of England. As Ferdinand Lips points out in his ‘Gold Wars’ (hat-tip to The Real Asset Company’s Will Bancroft):
With the passage of [the US Employment Act of 1946], the US government officially declared war on unemployment and promised to maintain full employment regardless of cost. Thus, it hoped to eliminate the business cycle and to prevent the country from ever sinking to the economic depths of the 1930s.
In the 1950s and the 1960s a weekly column in Barron’s called “The Trader” was written by a certain Mr. Nelson. Week after week, he untiringly drew readers’ attention to the consequences the Employment Act had on the purchasing power of the currency..
One would have thought that economic central planning would have been somewhat discredited after the Soviet empire collapsed in 1989, in favour of free markets. That message has yet to get to the US Federal Reserve or the Bank of England. But the Soviet experience is doubly instructive, in that it shows just how long a fatally dysfunctional system can last in the face of its obvious, existential, contradictions and absurdities.
Our thesis is that we are perilously close to the disorderly end-stage of a 40 year experiment in money and unfettered credit. That experiment started when US President Nixon took the US dollar off gold in 1971, and in the process created a global unbacked fiat currency system for the first time in world history. The history of paper currencies is instructive, too. Not one has ever lasted. Fast forward 40 years.. Texan fund manager Kyle Bass points out that total credit market debt now stands at some 360% of global GDP. For an individual country to maintain a debt to GDP ratio of 250% is consistent with that country deficit-spending its way through a war – such as was the position for the UK in 1945. For the entire world (read: notably the western world) to be loaded with such an untenable debt burden today suggests that something has gone catastrophically wrong with our banking and credit system.
We don’t know what the future holds but, crucially, our investment process does not explicitly require us to, and we have engineered it such that our process carries a degree of insurance against our own overconfidence as asset management fiduciaries. The market can be directed, coerced, bribed, manipulated, distorted and pummelled, but we don’t believe it can ever be completely destroyed – despite the best efforts of central bankers. There is early evidence that bond market vigilantes have had enough with QE and other desperate policy manoeuvrings, and are voting with their feet. If bond yields continue to rise, think very carefully about your exposure to market risk in all its other forms. We have, and are positioned accordingly.
In the current context, if Cnut did ever order back the tide, whether he did so to instruct his courtiers or to display his arrogance over the forces of nature is somewhat moot. The great physicist Richard Feynman made a similar admonition to NASA after the 1986 space shuttle disaster ending up killing seven crew members. In his infamous warning to a bureaucracy seemingly overtaken by ‘spin’, he said in his conclusion to the Challenger report,
For a successful technology, reality must take precedence over public relations, for Nature cannot be fooled.
For Feynman, and for Cnut, it was Nature. For us, it is the markets. Modern critics of the central banks, like ourselves, would suggest that we now have a modern equivalent of Cnut’s Danegeld, in the form of punitively low interest rates, rates which are being kept artificially low to try and resurrect a borderline insolvent banking system which is still content to pay significant executive bonuses and, in some instances, even dividends (to shareholders foolish enough to own common stock issued by banks whose fundamental value cannot be remotely assessed on any sensible economic basis). The economy, in other words, is being held hostage to cater to narrow and largely unreconstructed banking interests. At the same time, the farce of “forward guidance” – the pledge to keep interest rates unchanged until there is tangible evidence of economic recovery, almost irrespective of the latent inflationary pressure being stoked up – is being revealed as farce by Gilt yields that have risen by over 100 basis points since May (and the same holds for US Treasuries). Despite the king’s orders, in other words, the tide continues to come in.
A version of this article was previously published at The price of everything.
From 2006 the Bank of England’s Annual Report has declared the quantity of gold in its custody, including the UK’s own 310 tonnes. Prior to that date a diminishing quantity of on-balance sheet gold (sight accounts) was recorded in the audited accounts, which then disappeared. This tells us that sight accounts (where the BoE acts as banker and not custodian) were dropped. This is sensible, because the BoE is no longer directly liable to other central banks while gold prices are rising.
Of course, the BoE doesn’t hold just central banks’ gold; it also holds gold on behalf of LBMA members. However, LBMA storage at the BoE is probably a fairly small part of the total, because the bulk of settled transactions are in unallocated accounts where the underlying owner does not own physical metal, and the majority of transactions are closed even before settlement is due. Furthermore LBMA members have their own storage facilities or use independent vaults. So to all intents we can regard the BoE’s custody gold as owned by central banks.
It should be borne in mind London is the most important market for physical delivery, particularly for central banks. For this reason most central banks buy, sell, swap or lease their monetary gold in London. The exceptions are Russia, China and the central Asian states who have been the main buyers of gold – always from their own mine output – and do not ship this gold to London; and having substantial foreign reserves from trade surpluses, they have no requirement to do so.
To add to our analytical difficulties, the custody figures presented are net of gold being leased, because leased gold is delivered out of custody. We know that the BoE encourages its central bank customers to pay for its expensive storage charges by earning leasing income, thanks to an unguarded admission from the Austrian central bank last year that it had defrayed its storage costs this way, and a Bundesbank statement that it withdrew gold from London rather than pay high storage fees. The BoE’s custody total is therefore a net figure, with significant quantities of gold out on lease and not actually in custody. However, we can derive some interesting information given the headline custody numbers and some reasonable assumptions.
We can therefore draw up a tentative table as follows:
The approach is to start with the declared gold in custody and subtract what we reasonably know exists to see what’s left. On reasonable assumptions (described in the notes to the table) we can account for all but 467 tonnes of the gold in the BoE’s custody in March 2006. However, remember this is a composite figure, because the BoE leases custodial gold by agreement with its customers – the majority of which will have been delivered out of custody to the market. We have no way of knowing whose gold is actually leased, but at least we more or less know what should be there.
We also know that the gold owned by the central banks represented in the table above plus that of Russia, China, the central Asian states and the US, totalled 12,361 tonnes in March 2006 according to the IMF/WGC statistics. The remaining central banks which are certain to keep gold in London between them owned 18,377 tonnes. To suggest that they had only 467 tonnes of this at the BoE is only true in the sense that some of their gold is out on lease. We can only speculate how much on the basis of what portion of 18,377 tonnes we would expect to be stored in London, but a figure in excess of 5,000 tonnes seems highly likely.
By March this year, the quantity of gold in custody had mysteriously risen from 3,532 tonnes to 6,284 tonnes, leaving a balance not-accounted-for in our table of 2,888 tonnes. Over the intervening years, western central banks officially sold 1,184 tonnes, most of which will have probably passed through the BoE’s vaults. This gold flow is not reflected in custody figures in the table.
The custody ledger is therefore more complicated than its face value. Gold is being leased and has gone out of the door. Gold is being held and not leased, and yet more gold has been shipped in from other centres to be sold, leased or swapped. The amount disclosed by the BoE is effectively a “float”: a net figure comprised of larger amounts. We can therefore assume that despite the rise in custodial gold, gold from the BoE vault has also been supplied to the market.
It is extraordinary that the BoE on behalf of other central banks has been arranging leasing contracts for gold that seems unlikely to return. The lessees may from time to time have been able to buy back the bullion to deliver to the lessor and re-deposited it back with the BoE; but most of bullion goes to India, China or South East Asia from whence it never returns. This may have been less of a problem before Chinese demand took off, people began buying ETFs, and there was a growing supply of scrap. But this has not been the case for several years now, and the remaining leasing agreements must have to be rolled forward, leaving central bank customers of the BoE semi-permanent creditors of bullion banks.
One can only surmise that the central banking community of North America and Europe see gold as an increasing embarrassment. Nevertheless it is hard to understand why central banks continue to lease gold, particularly after the banking crisis when central banks must have become more aware of systemic risks and the possibility their lessees might go bankrupt. More recently, leasing will have almost certainly been a source of finance for cash-strapped eurozone states, and might help explain how they have survived in recent months. However, this cannot go on for ever.
Since the Cyprus debacle
We now turn to the last column dated June this year. The figure for custodial gold of 4,977 tonnes is “at least 400,000 400-ounce bars” taken from tour-note 2 of the new virtual tour of the gold vaults on the BoE’s website. Tour-note 3 gives us the date the information was collated as June this year. This compares with the figure at February 28 from the BoE’s Annual Report of the equivalent of 505,117 bars. So it appears that at least 100,000 bars have disappeared in about four months.
Is the difference of 100,000 bars a mistake? The wording suggests not. The Bank appears to have thought that if it said in the virtual tour, “over 400,000 bars in custody” it would be sufficiently vague to be without meaning; but it is so much less than the figure in the Annual Report dated only four months earlier that it is unlikely to be a mistake. We must therefore conclude that they meant what they said, and that some 1,300 tonnes has left the vault since 1 March.
We now consider where this gold has gone. Gold demand in Europe began to accelerate after the Cyprus debacle at a time when Chinese and Indian demand was also growing rapidly. Meanwhile mine production was steady and scrap sales in the West were diminishing. This was leading to a crisis in the markets, with the bullion banks caught badly short. Hence the need for the price knock-down in early April.
The price knock-down appears to have been engineered on the US futures market, triggering stop-loss orders and turning a significant portion of ETF holders bearish. However, the lower price of gold spurred unprecedented demand for physical gold from everywhere, considerably in excess of ETF sales. The fact the gold price did not stage a lasting recovery tells us that someone very big must have been supplying the market from mid-April onwards, and therefore keeping the price suppressed.
So now we have the answer. The BoE sold about 1,300 tonnes into the London market, which given the explosion in demand for physical at lower prices looks about right.
This leaves us with two further imponderables. It seems reasonable given the acceleration in global demand that the bulk of the gold supplied by the BoE has gone to the non-bank sector around the world. In which case, the bullion banks in London still have substantial uncovered liabilities on their customers’ unallocated accounts, on top of the leases being rolled. The second is a question: how much of the remaining 1,580 tonnes not-accounted-for last month been sold since June?
Conflating these two imponderables, unless the BoE can ship in some more gold sharpish, there is unlikely to be enough available to supply the market at current prices and bail out the bullion banks in London, so they must still be in trouble. The supply of gold for lease seems to have diminished, because the Gold Forward Rate has gone persistently negative indicating a shortage.
It appears the leasing scheme, whereby central bank gold is supplied into the market, has finally backfired. Prices have risen over the period being considered and leased gold has disappeared into Asia at an accelerating rate never to return. While the bullion banks operating in the US futures market have got themselves broadly covered, the bullion banks in London appear to have passed up on the opportunity to gain protection from rising bullion prices.
The final and fatal mistake was to misjudge the massive demand unleashed as the result of price suppression. This was a schoolboy-error with far-reaching consequences we have yet to fully understand.
This article was previously published at GoldMoney.com.
Via City A.M., Bank official: Bond bubble is the biggest threat to financial stability | City A.M..
OUTSPOKEN Bank of England official Andrew Haldane warned yesterday that the bursting of a bond bubble is the biggest threat to the world’s financial stability.
Haldane, the Bank’s executive director of financial stability, told the Treasury Select Committee that central banks’ massive asset-buying programmes have created significant risks.
“If I were to single out what for me would be the biggest risk to global financial stability right now, it would be a disorderly reversion in government bond yields globally,” Haldane told the MPs.
“We’ve intentionally blown the biggest government bond bubble in history. We need to be vigilant to the consequences of that bubble deflating more quickly than we might otherwise have wanted.”
It’s at once terrifying and wonderful to see the conversation about the economic crisis move in this direction. Terrifying because it looks increasingly like those of us who have been talking about the massive economic disruption caused by central banks are correct. Wonderful because at last the Bank’s most courageous official has made this explicit.
The FT recently reported on its front page, “Some of the smartest money in America is getting out of US government debt.” Unfortunately, big players in markets like central banks cause herding. It therefore remains to be seen whether it is possible for the bond bubble to deflate slowly.
In any event, interest rates will rise unless central banks take yet further action. The medium term consequences for our system of money, the welfare state and society are likely to be profound.
This article was previously published at SteveBaker.info.
Once upon a time the pound sterling ruled the world of finance. Today it has been relegated to a less regal status, displaced by the U.S. dollar over the course of the twentieth century. Not only is very little international trade performed in sterling these days, but there are new doubts that it will remain the exclusive currency on the British mainland.
With the looming vote on Scottish independence comes the threat that an independent Scotland will introduce its own currency.
Once upon a time, English as a language was a little known form of communication, largely isolated to the British Isles. Starting at about the same time as the spread of sterling as the universal money throughout the world, English set off on the route to global dominance. Today there are about 350 million native English speakers, but this number is dwarfed by the masses that use it as a lingua franca - their second or even third language.
Considering their common pedigree, one may ask why the currency is now a second-rate citizen in the world of international finance while the language is going stronger than ever.
Historians commonly attribute the rise of the English language to the rise of Pax Britannica throughout the 19th century. This period did see the English economy rise to great stature and expand its scope to the point where the sun never set on the British Empire. However, other great European economies also flourished and encompassed many foreign lands. The Spanish Empire at its pinnacle included more square miles than the British (though never as many people). Both France and Germany had sizable colonies. Even the Russians, it can be argued, held huge “colonies” in the form of the Soviet Bloc.
Alternatively one could say that the rise of the United States (complete with its dominant media industry) assured the rise of the English language. Yet this too seems to put the cart before the horse. Much of America was settled by non-English speakers (Spaniards in the south-west, French in the South-east and Northern European Germans, Scandinavians and Dutch in the upper mid-west). English was emerging as the linguistic force to be reckoned with before the ascendance of the U.S. as a world super power, which really only happened after World War I.
Instead, the rise of the English language can be largely explained by its decentralized nature. It is true that English grammar is quite simple relative to other languages, especially its Romance and Germanic brethren. Yet if anything this would normally incentivize Romance and German speakers to streamline their own grammatical rules to make adoption easier. In most languages this is not possible due to their extreme form of centralization. French and Spanish, as examples, require linguistic changes to be approved by the centralized governing body (L’Académie Française in France, and the Real Academia Española in Spain). Changes are almost impossible as they must go through the usual bureaucratic approval process as other changes to legislature.
It is no surprise that French and Spanish as languages are slow to adopt to changes, in much the same way as their legal systems are outdated and move only at a snail’s pace. Lacking any centralised authority, anyone was able to use English, but more importantly, they could change it as they saw fit. Changes and new words occurred spontaneously as a response to market demands, not to the pen of a bureaucrat. This form of crowd sourcing allowed the English language to be modified as it spread around the globe and incorporate the intricacies of daily life and the existing languages of its newfound locals.
By contrast, the British pound sterling has suffered from centuries of centralised mismanagement. Since the creation of the Bank of England in 1694, the venerable old lady has done what she can to diminish the pound sterling on an ongoing basis. While the First World War was devastating in many respects for Britain, one of the longest lasting effects was the decoupling of the pound from gold. This shift left the once proud currency open to continual and unabated inflation at the hands of the Bank of England, with the result that it is now worth a fraction of what it was just a century prior.
In international finance people use the language that makes trade easiest, as well as the money that best facilitates its dealings. A decentralized language system has proven an overwhelming success as it is now the standard around the globe. The centralized monetary system has been mismanaged to the point where few outside of the country elect for sterling in their affairs. With the Scottish independence vote approaching it is questionable how many people within the United Kingdom want to continue using it.
If George Osborne stays up at night wondering what the future will be for the pounds his Treasury manages perhaps he would do best to take a lesson from British history. The English language became a world standard without the oversight of Parliament – perhaps it is time to recognise the same can be true for the pound sterling as well.
The following is a transcript of the “Adam Smith Lecture” I gave at a private gathering in London on 19 February.
For a long time governments have been redistributing peoples’ income and wealth in the name of fairness. They provide for the unemployed, the sick, and the elderly. The state provides. You can depend on the state. The result is nearly everyone in all advanced countries now depends on the state.
Unfortunately citizens are running out of accessible wealth. Having run out of our money, Governments are now themselves insolvent. They started printing money in a misguided attempt to manage our affairs for us and now have to print it just to survive. The final and inevitable outcome will be all major paper currencies will become worthless.
To appreciate the scale of these problems, we must understand the errors in economic and monetary policies. I shall start with economics.
Modern economists retreat into two comfort zones: empirical evidence and mathematics. They claim that because something has happened before, it will happen again. The weakness in this approach is to substitute precedence for the vagaries of human nature. We can never be sure of cause and effect. Human action is after all subjective and therefore inherently unpredictable.
The mathematicians like to think that economics is a physical science and is not a slippery social science. Economics is a branch of human psychology. It is plainly nonsensical to apply maths to human psychology.
The result is that much of the good work done by the classical economists like Adam Smith has been destroyed by modern economics. The classical economists explained the benefits of doing away with tariffs and the guilds. This revelation was instrumental to the industrial revolution. Then along came Marx who persuaded people that economics was a class interest, that free market economists were promoting the interests of the bourgeois businessman to the disadvantage of the worker. That became the justification for communism and socialism. Keynes and those that followed him never properly challenged Marxian fallacies. They were never involved in what became known as the socialist calculation debate.
It is not generally appreciated that Keynes was strongly socialistic. In the concluding remarks to his General Theory, Keynes looks forward to the euthanasia of the rentier (or saver) and that the State will eventually supply the resources for capital investment. He wanted the state to control profits.
Keynes was primarily a mathematician. Keynes was no more an economist than Karl Marx, whose beliefs led to the economic destruction of Russia and China; or John Law, who bankrupted France, with similar fallacies to those of Keynes.
The misconceptions of Keynesianism are so many that the great Austrian economist von Mises said that the only true statement to come out of the neo-British Cambridge school was “in the long run we are all dead”.
Let me define economics for you at the simplest level. We divide our labour. Each one of us is a consumer; an entrepreneur whether for wages or profit; and a saver for the future. We invest savings to improve production. Each of us discharges these three functions in the proportions we choose as individuals, we interact with others doing the same thing. We exchange our goods at mutually agreed prices using money to facilitate the exchange. We use money to keep score, and that money has to be sound for our calculations to mean anything. Together we are society itself, each providing things others want and will pay for.
The state has no role in this process. Instead it is a cost to society, because it takes some of our spending and savings to support itself. The more the state takes the greater the burden. It destroys society’s potential wealth. But it has not stopped there. Socialism forces the vast majority of people to give up saving and rely on the state to provide. Governments everywhere are now encumbered with obligations they cannot possibly discharge.
On the money side our mistakes go back to the Bank Charter Act of 1844.
The Bank Charter Act gave the Bank of England a note-issuing monopoly backed by gold and government debt. It failed to stop other banks issuing bank credit. This led to credit-driven business cycles which were socially destabilising, adding fuel to the various brands of communism and socialism that developed in the late nineteenth century.
Gold backing for the Bank of England’s notes was gradually eroded, starting in the late 1890s, with a number of countries, including Britain, abandoning it altogether in the interwar years. A gold-exchange standard was adopted for central banks at Bretton Woods. And finally President Nixon in August 1971 abandoned gold altogether.
Ever since then, the expansion of money supply has been increasing exponentially. Quantitative easing is now required to keep the pace of printing up, lest interest rates begin to rise.
Monetary policy from the 1920s has been used to manage an increasingly unstable global economy. The irony is that this instability has its origins in the expansion of money and credit itself. The growth of money supply and bank credit has as its counterpart debt. Few are the assets not encumbered with this debt. Asset prices need more money and credit to sustain them. It is a finite process that ended with the credit crunch five years ago.
That is the background. Now I shall look at the situation today, five years on from the credit crunch. There are four interlinked problems that cannot be resolved: the economy, the banks, government finances and population demographics.
The advanced economies have been progressively undermined by government intervention and unsound money. They are taxed and regulated to such a degree that laissez-faire hardly exists anymore.
Government spending typically amounts to 50% of GDP in the advanced economies; sometimes more, sometimes less. For productive businesses it is like running a marathon carrying a bureaucrat on your back who tells you how to run.
The misallocation of economic resources which is the result of decades of increasing government intervention cannot go on indefinitely. Businesses have stopped investing, which is why big business’s cash reserves are so high. Money is no longer being invested in production; it is going into asset bubbles. Dot-coms, residential property, and now on the back of zero interest rates government bonds and equities. These booms have hidden the underlying malaise. There can be no economic recovery. Our bureaucrat-carrying marathon runner is finally collapsing under his burden.
The burden of government is now too great to be sustained.
Banks are geared 25 to 30 times, which is fine if you can grow your way out of problems. That is no longer the case. They are vulnerable to existing but unrecognised bad debts, and now a fall in government bond prices. All that’s needed to trigger a collapse in the banks is absence of economic recovery. If we have a downturn it will be quicker. All that’s needed is a rise in interest rates, to reduce collateral values. All that’s needed is a fall in asset prices.
Then there is the shadow banking system, which the Bank for International Settlements reckoned amounts to over $60 trillion, of which $9 trillion is in the UK. If an investment bank goes under, the shadow banking system could make it virtually impossible to ring-fence the others.
Another area of risk is cross-border exposure. Cross border loans in Europe amount to EUR3.5tr. France is 1.2tr. Italy 700bn. Spain 500bn. These are only the obvious risks. Much of this is cross-border within the eurozone, meaning a default in any of those three is certain to wipe out the European banking system, and then everyone else’s.
For this not to happen requires the central banks to make available unlimited funds in the form of credit and raw money. As Mario Draghi said, whatever it takes. His solution is to print enough fiat currency to save the system.
From the time of the banking crisis, government finances have deteriorated sharply, and their debts rocketed. No country, except some in the Eurozone has managed to cut government spending, and only those which did, did so under extreme financial pressure and because they couldn’t print money. The fact is that everywhere government spending is increasingly mandated into pensions, social services and healthcare, which makes spending cuts extremely difficult.
Until recently it was assumed that economic recovery would generate the taxes to balance the books. That has not happened, nor can it happen. In the Eurozone governments are now taking on average over half of every working man’s income and deploying it unproductively. Take France. Government is 57% of GDP. The population is 66m, of which the employed working population is about 25m, 17m in the productive private sector. The taxes collected on 17m pay for the welfare of 66m. The taxes on 17m pay all government’s finances. The private sector is simply over-burdened and is being strangled.
The interest rates at which governments borrow are entirely artificial, made artificial by their own intervention in the debt markets. They are financing themselves by printing money to buy their own debt. The moment this ends, and it will, money will flow out of bonds, equities and even property priced on the back of low interest rates. The pressure for interest rates to rise will have to be met with yet more money printing, because governments cannot afford to pay higher interest rates, nor can they afford to see private sector asset values fall. Price inflation will create a real crisis, perhaps later this year.
Populations in the US, the UK, Japan and Europe are growing older. This is bad news for government finances. When someone retires, he stops paying income taxes and becomes a cost. High unemployment is also costly, because the unemployed are not funding future liabilities. Professor Kotlikoff of Boston University has calculated that in fiscal 2012 the net present value of the US Government’s future liabilities increased $11 trillion to $212tr. The whole US economy is only $15 trillion. Europe is worse, far worse: Europe has more pensioners as a proportion of the working population, high rates of unemployment and a large government relative to the private sector, which funds it all. The UK, taking these factors into account, is slightly worse off than the US. Japan has worse birth rates and longevity. They sell more nappies for the incontinent than they do for new-borns. The solution already is to issue increasing amounts of unsound currency.
The world’s economic problems have been building for a long time. Economic fallacies have been pursued first by Marx and then by Keynes in the 20th century, and monetary policy first took a wrong turn with the Bank Charter Act of 1844. The progressive replacement of sound money by fiat currency has destroyed economic calculation, and has destroyed private sector wealth. These policies were deliberate. We have now run out of accessible wealth to transfer from private individuals to governments. That is our true condition.
Governments will still seek to save themselves at the continuing expense of their citizens, and in the process destroy what wealth is left.
There can only be one outcome: the bankruptcy of governments. This means that their fiat currencies will inevitably lose all their purchasing power.
How soon? I’m afraid sooner than most people think. Japan is already entering the black hole, with her currency beginning its collapse. The UK is on the precipice and cannot afford further falls in sterling without triggering the rise in inflation that will force a rise in interest rates and a spiral into insolvency. Europe could go at any time. The US is probably the best of a very bad bunch, but even her economy is looking bad.
I do not make these statements because I am gloomy. I make them because I approach economics without emotion and without political bias. I make them because I have considered our true economic and monetary position using as far as I am able sound aprioristic theory applied to our current position.
This transcript was previously published at GoldMoney.com.
In light of recent events, we’re bringing forward this proposal from June 2010.
There’s two ways to view the financial meltdown that occurred in 2008. The first is that it was a rare and unfortunate blip that can be remedied with calm and enlightened improvements in the regulatory framework. The second is that it exposed a serious flaw in the entire monetary system, and is likely to be repeated unless a radical transition takes place.
It’s no surprise that politicians, bankers and regulators – the architects of the banking industry – favour the first idea. This is why their response has skirted around the edges instead of dealing with the core. Even supposedly extreme measures such as nationalising banks are in fact attempts to preserve the status quo.
For those of us who favour the second idea, 2008 provided a golden opportunity to join the public debate and present a credible alternative. Perhaps we missed it. But if indeed another crisis is coming, this article attempts to outline a 14-point plan that could be implemented quickly and genuinely reform the institutions that create financial instability.
The key aspects of this proposal have been made previously, notably by economists Kevin Dowd and Richard Salsman. It could be implemented in three phases:
Over 2 days the aim is to ensure that all operating banks are solvent
- Deposit insurance is removed – banks will not be able to rely on government support to gain the public’s confidence
- The Bank of England closes its discount window
- Any company can freely enter the UK banking industry
- Banks will be able to merge and consolidate as desired
- Bankruptcy proceedings will be undertaken on all insolvent banks
- Suspend withdrawals to prevent a run
- Ensure deposits up to £50,000 are ring fenced
- Write down bank’s assets
- Perform a debt-for-equity swap on remaining deposits
- Reopen with an exemption on capital gains tax
Over 2 weeks the aim is to monitor the emergence of free banking
- Permanently freeze the current monetary base
- Allow private banks to issue their own notes (similar to commercial paper)
- Mandate that banks allow depositors to opt into 100% reserve accounts free of charge
- Mandate that banks offering fractional-reserve accounts make public key information (these include: (i) reserve rates; (ii) asset classes being used to back deposits; (iii) compensation offered in the event of a suspension of payment)
- Government sells all gold reserves and allows banks to issue notes backed by gold (or any other commodity)
- Government rescinds all taxes on the use of gold as a medium of exchange
- Repeal legal tender laws so people can choose which currencies to accept as payment
Over 2 months the aim is the end of central banking
- The Bank of England ceases its open-market operations and no longer finances government debt
- The Bank of England is privatised (it may well remain as a central clearing house)
You can download a copy of the plan in pamphlet form here.
An essential central banking policy tool
Stop all the Bloomberg feeds, cut off all the cell phones, prevent the press from thinking with a juicy story about the failed politician’s marriage. Because the new governor of the Bank of England, the extremely well-compensated Mark Carney, has just discovered how to fix Great Britain’s economic woes. Can you guess what it is yet? Yes, you might be ahead of me on this one, but he’s going to ‘rescue’ Britain’s economy by printing more money. Who would have thunk it?
(If you can get through the Financial Times paywall, you can read about this here.)
It seems Mr Carney is going to be granted a Federal-Reserve-style mandate of ‘targeting’ both unemployment and price inflation, as opposed to just price inflation. However, since the Bank of England has failed to hit their price inflation target for quite a number of years now, who was counting anyway? This Keynesian dual-targeting of both unemployment and inflation is hilariously based on the 1958 Phillips Curve, which never really worked as a model even back in 1958 and which was repeatedly smashed on the Procrustean rocks of stagflation in the 1970s, to the point where teenage boys would laugh at economics professors who tried to teach it in the ivy league halls of the United States.
However, Keynesians never let history, lost decades, or indeed logic and the unchanging nature of the human condition, ever get in the way of a good mathematical curve, especially when completely unrelated to reality and where it can be used to justify million dollar salaries for themselves personally (once again proving the unchanging nature of the human condition).
And so, after five years of quibbling with a mere half a trillion dollars of quantitative easing, the Bank of England has finally decided to really ‘rescue’ Great Britain, just as Mr Ben Bernanke has ‘rescued‘ the United States, Mr Shinzo Abe has decided to ‘rescue‘ Japan, and Mr Mario Draghi has decided to ‘rescue‘ Euroland. It seems remarkable that they’ve all hit upon the same solution, which is to print more money. Who knew it was that easy?
So why has the Bank of England waited so long outside the western central banking party before deciding to ‘rescue’ Great Britain by flooding it with quadrillions of paper currency units? Before they drown us in yet more digital scrip, however, perhaps they ought to speak first to Mr Gideon Gono, the governor of the Reserve Bank of Zimbabwe. I’m confident he has an opinion on this crucial central banking tool.
Maybe they decided against this because money printing is the only central banking tool, and if they’re to be denied this wonder drug, they may as well just all sack themselves? Though it does seem amazing to me that you have to pay a man a million dollars a year to tell you that he’s going to swing the only golf club available in the bag. However, I suppose if he wears a suit nicely, sounds vaguely foreign, and looks ‘authoritative’ on financial news programmes, it’s cheaper than hiring Brad Pitt. We must also remember that although money printing has never done any general society any good, it has done one group of really special people lots of good, especially over the last few years, when most of them should have been made bankrupt. These people are of course the closet friends and the shadowy shareholders of the western central banks, the über-wealthy bank-rollers of the western political classes.
For they just love money printing, especially when it is used to bail out the banks they own and operate. And they’re still über wealthy as a result, when many of them should be pushing trolleys around supermarket car parks. Though collecting supermarket trolleys is honest work, and honest work is something the über-wealthy long since gave up on. Why work when printed money can steal the production of others? Just make sure that you control the people who do the printing. You can ask any mafia gang controlling a high-quality basement counterfeiter about that. And if the money you’re printing is such high quality that it is the currency of the realm, then you can laugh all the way to the Bank of England. So long as you possess the collective morals of a cackle of hyenas.
This article was previously published at TheEuroVigilante.com.
The London Bullion Market is the global trading centre for physical gold, and the Bank of England holds gold on behalf of other central banks. There are a number of historical reasons the Bank has this privileged role, but the most important are that the Bank is trusted, and it oversees the largest bullion market by far. Therefore a significant portion of the world’s monetary gold should be stored at the Bank of England.
This does not appear to be the case. First, we must try to get an idea of how much unidentified central bank, or monetary gold, is in London at the Bank of England.
Table 1 shows the derived figures for February 2006 and 2012 (The Bank’s accounting year-end).
Subtracting the known or reasonably estimable quantities listed in the table leaves 2,220 tonnes unidentified in 2006, which rose to 4,691 in 2012. To see how these figures stack up in a global context, we need to compose a second table (Table 2).
China, Russia and the middle-Asian states are taken out on the basis that their gold reserves are mostly from local mine production, and for political reasons they can be deemed unlikely to hold gold in London. The United States is assumed to hold all its gold on its own territory.
Immediately we can see a disparity, with unidentified central bank holdings in Table 2 declining by 464 tonnes, whereas the Bank of England reports an increase of 2,471 tonnes in custody. The explanation – taking the World Gold Council/IMF figures at face value – is that either central banks have been shipping their gold to London, or much more likely, the increase is not monetary gold at all. If the latter is correct, and given that the unidentified gold figures in Table 2 declined over the period, the maximum figure for monetary gold has to be within the 2,220 tonnes recorded in 2006.
This 2006 figure includes an undeclared quantity of gold held on behalf of bullion banks, but comparing the LBMA’s clearing statistics at the two dates suggests little overall variation in LBMA stocks. Logically the balance must be non-monetary gold held on behalf of governments and sovereign wealth funds, on the basis that no one else would be eligible for a bullion account with the Bank. Given the political instability in the Middle East and elsewhere over the last decade, it is very likely that this is the origin of the ownership of much of this custodial bullion. And if that is the case, we can assume that these holdings began to accumulate in the Bank’s custody before 2006.
This being the case, a significant portion of the 2006 figure of 2,220 tonnes must also be non-monetary gold. Therefore, on the basis of reasonable supposition it appears that the total amount of monetary gold at the Bank of England, including that of Germany, Austria and Mexico and the UK’s own stock, cannot be more than 3,320 tonnes, perhaps significantly less. The belief that the world’s central banks store a significant amount of their gold in London is therefore incorrect.
This raises two interesting questions: where is it all, and does it actually exist?
This article was previously published at GoldMoney.com.