A reader has sent in his thoughts about the recent proposals to reform the regulatory apparatus of the UK banking system:
Last Friday I had a quick view at the report by HM Treasure on a proposal to reshuffle the institutional setting for financial system regulation and oversight in the UK. The introduction (4 pages) is interesting but sometimes depressing. It openly recognised that UK authorities (Bank of England and FSA) failed to see the problems coming and to react adequately. Good. However, the solution it proposes is not to improve the understanding of the building up of bubbles and imbalances, or to reinvigorate the political will so it can make decisions even if those affect the banking status, or to stop trying to achieve the unachievable (a big apparatus able to foresee everything in the system as a whole), but… just rearranging chairs… (every one else in the world, G20, ECB, FED, is rearranging chairs too, so this reshuffling is quite mainstream). However, maybe in the case of the UK there is a possibility to introduce sound thinking in this new Bank of England-based structure (and stop the endogamic kind of thinking within current monetary authorities), through the external members of the newly created “Financial Policy Committee”. The report says (p. 17) among other things:
2.43 It will be important to ensure that the external members of the FPC are able to provide sufficient levels of expertise and challenge to the Committee’s deliberations – this will not only include experience of banking, but also other financial sectors such as insurance and investment banking and, of course, macroeconomic expertise.
2.44 In addition to the chief executive of the CPMA, the Chancellor will appoint four external members of the FPC using a similar recruitment process to that used for the MPC. The Government will look carefully at the best way to ensure that external members demonstrate ample relevant knowledge and experience and the ability to work constructively in a committee environment, without conflicts of interest that would prevent them participating fully in the work of the Committee.”
My take on this is that the external members of the FPC have to be radically different in make up than the internal members of the current MPC i.e. usually a academic, or some who has come from that background. Entrepreneurs, great business leaders and representatives from the SME sector , all who operate at the coal face would have more of an idea about what is and is not actually going on in the economy, better still, why not think about reforming the whole system anyway so we do not rely of 20 or so central planners to determine the value of our very currency, arguably with language, the foundation of civil , peaceful society.
Above all, if we are only tinkering and not radically reforming, he concluded “please appoint those WHO DID SEE it coming and who have a sound theoretical framework behind it (and kick out those who were clueless…)”
Bravo to that, we can name a number of Austrian School economists and Austrian influenced fund managers and entrepreneurs who could do this job.
A lifelong friend in a senior position at a major UK bank confirmed to me privately that last week’s news that banks were approving 4 out of every 5 loan applications from small businesses was nonsense.
Fortunately our Government has not been so easily duped.
The Daily Telegraph reports today that Vince Cable is considering plans to force banks to lend. It publishes this direct quotation from the Business Secretary:
What we would question is whether banks should be paying out dividends and bonuses when that money could be used to … support small business lending.
The original fuzzy thinking behind the bailout was to protect depositors and prevent a system meltdown and economic chaos. In late 2008 Kaletsky wrote passionately in praise of the bailout, claiming it was the only way to stave off the then threat of mass unemployment and civil unrest.
Even those in favour of the bailout recognise that economic chaos now looms starkly on the horizon given the seizure in both the interbank funding market and in turn the trickle of bank loans finding their way to borrowers. The Government bailout team either didn’t consider this risk at the time or were incapable of designing a bailout contract that would ensure that future loans were made. Therefore Mr. Cable has no choice but to act, or else the very economic chaos that triggered the bailout will ensue anyway.
Doubters of my conclusion that Cable should be praised may question how banks can declare such sizeable profits without making loans. The answer to this is that there are still massive quantities of debt available for purchase at below par prices in the capital markets. Why lend money out in the real economy in an accounting environment where the most you can recognise as a profit in your books, if the borrower performs optimally, is about 2% of the amount loaned every year?
If the alternative is to purchase a bombed out “alphabet soup” structure at say 60 pence in the pound then the annual profit can be enhanced by marking up the price (and adding this unrealised gain to your annual profit statement) since all the other banks are doing the same thing. The annual profit line is also greater since central bank funding comes at the “official” rate that is much lower than the interbank market rate.
In early 2009 the ECB and Bank of England invited banks to fund alphabet soup purchases from a separate pot of taxpayers money called the “Discount Window”. The Discount Window is not part of any market at all, so the banks were delighted to accept all such funding offers. Given the scale of this activity prices of such assets have risen gradually and steadily and so another bubble is inflating but the nature of the accounting regime (the ease with which a profit can be recorded without a transaction occurring) hides this bubble from the eyes of scrutineers.
And so our banks have been very active in the last 18 months, not in the real economy but in the world of alphabet soup bonds.
Therefore I conclude that Cable is brave and correct to design measures that force banks to lend or else banks will continue to operate as state backed hedge funds rather than drivers of the real economy.
But on the other hand, what about moral hazard? The notion of forcing banks to lend has been widely mooted in the press and usually dismissed on three grounds:
How can the Government ever hold banks to account if loans which we taxpayers have forced banks to make go bad?
Forced loans is a concept blatantly at odds with the official position that the government does not control banks, we taxpayers are merely substantial shareholders;
Bankers are skilled market operators and therefore we cannot interfere with their compensation contracts. The more we define their role the more difficult it will be to maintain that senior bankers are not just highly paid civil servants.
All three points are entirely correct and prove that the idea of forcing banks to lend is ridiculous.
And so we have established that Cable’s plans to force banks to lend to small businesses are both commendable and ridiculous in equal measure.
This conclusion says more about the wisdom of bailing out the UK banks than any rant ever could.
Trade and commerce is the lifeblood of wealth creation. Without specialisation and exchange, we would all starve. You have oranges, I have apples. Individually we are bored, together we have a fruit salad.
For specialisation, exchange and commerce to work its magic, firstly we need some common ground: a market. Now, mention that word to a Socialist, and he starts to froth and foam at the mouth. The evil of markets, how the market forces this and exploits that, blah blah.
Unfortunately, they are confused. You see a market is just a bit of space, physical or virtual, where people who want to buy meet those willing to sell. That’s it. It has no power of its own. No influence. No horns and a pointy tail.
However, badly aimed as their invective is, they do have a fair grievance lurking in those passionately beating breasts. What they are trying to say is that they object to those who have power in a market. Who wields the power in a market, and where does it come from? That is a fair question to ask.
I contend that power always comes, ultimately, from Government. They hold the monopoly on power, they set the rules, and their arbitrary decisions can mean life or death for any businessman taking a risk. They get the keys to the gun cabinet.
Markets and traders
Only loons attack commerce between good old wholesome types looking to exchange the hard earned fruits of their labour for other stuff they need: I exchange my apples for your oranges.
Unless, that is, you want pears. The free interaction of people that is the market decided on a clever mechanism to get around this problem. It created an intermediate commodity called money.
Money is just a commodity like any other. The free market chose something that was durable, portable, respected, and consistent. The free market originally chose gold and silver as money, and gold remained money until governments came along and nationalised then destroyed it. Money now is a fraud – the greater fool theory of acceptance only because somebody else will too.
The creation of money was a fantastic innovation – a neat solution to the problem of the double coincidence of wants… or rather what to do when there wasn’t a coincidence.
But what happens if an orange farmer wants to sell next year’s crop now? Maybe there is a great demand for oranges and the farmer has cultivated trees to meet the demand, but does not want to take the risk of a craze for plums depressing the demand for oranges. A consumer of oranges may only want to buy what he can pick up and select. A grocer may not want to tie up his cash in something so far off into the future.
What is needed is someone in the middle. Someone willing to guarantee a price for those oranges now, take them in the future and then sell them on when they are needed. This is where the speculator steps in and provides a vital service.
Ahh… the evil speculator, now there is a ripe target!
How can somebody who produces nothing, does not employ physical labour, and does not reorganise the factors of production, be in any way productive in society? Off with their heads!
Speculator: one who speculates on abstruse or uncertain matters
The key is uncertainty. The future is not known; if it was, then the central planners might stand a better chance. But the future peculiarities of individual desires and wants can never be known, so there are always highly uncertain outcomes inherent in planning for the future. The world is too complicated to simplify into maths or bureaucratic diktats. The risks are too great and the mistakes too expensive. What we need is a mechanism to attempt to put a price on future outcomes. We need to “crowd-source” the answer to the problem of resource allocation. And, that’s what speculation is…
I risk my own shirt to take on risks that others do not want. I’m proud to say I speculate. I speculate that I will be able to find another buyer for those risks at a future point in time, and then I charge a fee for my services.
Some say that this is making money from nothing, but I say I provide a service to the world in smoothing out the jagged pointy edges. If things go wrong, I will have to pay the price personally.
The act of speculation is important in the signals it sends out. If prices rise, it signals a shortage which stimulates extra production to satiate demand. Or if the speculator successfully sells short some shares, the falling price will send out a signal that not all is well with that company.
Let me quickly clear a couple of things up …
Markets are not efficient
This is a stupid, indefensible idea peddled by neo-classicist eggheads. Information is often wrong and therefore people err. Mistakes are made, but I contend that the mistakes made by crowds are much smaller than when Government gets its grubby hands on a ‘problem’.
Markets work in waves and ripples and patterns, not aggregates, averages and efficiencies
Early adopters get rewarded the most; late arrivers are penalised. The crowd sometimes gets carried away, and prices rise too much or fall in an unwarranted way, but by and large, when not unduly influenced by power, markets are a remarkably efficient way of making a myriad mind-numbing decisions that all hang together. Markets are smart in the way a regulator can never be.
Short Sellers
Secondly, I want to sing the praises of those great unsung heroes of stock markets: the short sellers.
Selling short is the process of selling something you do not own, in order to profit from a fall in prices, then buying it back at a lower price.
Short selling is a dangerous game. You are hated by all and sundry. Governments, regulators, corporate bosses, and fat cats. Everyone, it seems. You are always at risk of being targeted for a ’short squeeze’. But short selling is vital for two reasons:
1) Buyers need a seller to buy from.
If you want to buy some shares – who do you think it is that will sell them to you?
It’s not usually an investment fund, or a pensioner, or your mate. It’s the ‘market’, and it is more than likely that the person you bought them from will not own them, but will scrabble around for the rest of the day trying to find them a penny cheaper. Can you be bothered to do that?
The stupidity of banning short selling is that it stops the market working – meaning that movements are likely to be bigger, and the falls greater.
2) Short sellers are the policemen of the markets – a much better (and more fearsome) regulator than the FSA.
Without short sellers, Enron and WorldCom would have got away with their fraud for a lot longer. It is a tragedy that the short sellers of banks were not bigger and better armed during the run up to the sub-prime crisis.
Don’t get me wrong, short sellers were there, playing their lonely game, but they were just too small in face of the great money/banking juggernaut carelessly careening away. Stronger short selling might have seen off the sub-prime fiasco earlier and with less pain.
As a society, we should desperately be encouraging short sellers in situations like this. Big business needs to respect the short seller – it keeps them honest. When prices are rising in a rampant fashion, usually no good comes of this. This is when we need the short seller to tame the wild beast.
Speculators do a much better job of sifting through the morass of conflicting signals to fish out the price for the best allocation of resources in a way that Sir Humphrey, sitting in an ivory tower in Whitehall, could only dream about.
So, traders and speculators are vital for a productive and fully-functioning capitalist economy. In a pure and free economy, they are a force for efficiency and part of the crowd-sourced resource allocation system.
But unfortunately, we do not have free markets
The sub-prime fiasco has shown us that markets, especially financial markets, are anything but pure. Markets are distorted by power, and it’s important to turn your swivel gun onto the source of that power….
The one thing you should always know about busts is that you can’t stop the pain at that point: it’s too late, the damage has already been done. The boom may have felt good at the time, but those tequila slammers at 2am always seem like fun. Remember the feeling in the morning. Trying to alleviate the hangover by more of the same is the action of an alcoholic. It’s the boom when assets are wildly misallocated, and that’s where we should focus.
The sub-prime crisis started with government, was promoted by government agencies, and was taken to the dizzying heights of stupidity by a banking system fuelled with masses of cheap money, produced by central banks that panicked after the previous cheap money bubble went pop in 2001.
The bankers perceived an inexhaustible supply of cash that could be lent at a profit to people who had no chance of paying back. The Mexican strawberry picker given a $750,000 loan to buy a house he could never afford to repay. A cleaner running a buy-to-let portfolio of 4 houses, with zero down payment.
What’s the problem with banks, after all, it’s a free world?
Banks are not run by kindly old bespectacled men, carefully lending money to young families to give them their first break. Remember It’s a Wonderful Life with Jimmy Stewart – the friendly banker looking after good ol’ townsfolk? Scrub it from your mind.
Banks are vast hedge funds, with vast trading floors of speculators, all doing “God’s” work, as some idiot once said.
One UK clearing bank has been described as a huge smart hedge fund, with a mediocre provincial bank bolted onto its underside. That’s probably true for all of them.
A few starters on banks:
1) They are licensed by the government. I cannot start up a bank – neither can you, unless you go through the various hoops, fires, and barriers erected in front of you. You need mountains of capital. They make it difficult to join their club.
2) They operate under a specially loosened set of accounting rules.
Normally, companies are required by accounting rules and law to make sure they provide for their liabilities as they fall due. If you order a load of gear on credit, you have to show that you have the ability to pay for it – and pretty rapidly. Companies are expected to make their creditors ‘whole’
Look at the accounts of Vodafone and in their balance sheet they have to provide for ‘current liabilities’ and ‘long term liabilities’, but not so for a bank. Banks get away with a broad ‘liabilities’ section, with no attempt at sorting near term risks from long terms assets. It doesn’t matter whether they owe money tomorrow and are due to cover it in 5 years time.
3) Banks thrive on red tape, loopholes, fuzzy wording and obfuscation
For instance, 75% of people in this country believe that when they place their hard-earned money in a current account, it remains their money. It most emphatically is not. You hand your money over, and you get a promise. Well, I say promise, but the bank goes to great lengths to hide this fact. You are given a statement, which shows your money proudly sitting there, waiting for you – all safe and sound.
Except it’s not.
It is being lent out to Dubai World! Or passed onto the trading floor, and being pushed into Alphabetti Spaghetti Derivative Hooplas, funnelled into their massive casino operation.
Even though you might spend it tomorrow, the bank will not have your money. If you want it, they have to get it from somebody else’s account, or go onto the money markets and borrow it.
4) A bank is an operation designed to make profits from money that is not their own.
When you put your Tesco’s money into a bank, you are investing in a hedge fund, except you don’t get any of the profits. If it all goes wrong, as it did in 2008, then the taxpayer pays for all the losses.
Even in the good times, the taxpayer insures deposits (explicitly or implicitly), leaving the banks free to gamble away. Does this seem like free market capitalism to you?
What is the problem with this, after all, it’s a free world?
Well, it’s not. As I said before, banks operate with privilege and monopoly rights, with taxpayer backing. And we can add a final potion into the mix: incentive and liability
The sub-prime crisis cost Wall Street and the City trillions, or rather it is costing taxpayers that much. If I lose money, I remortgage my house; otherwise I don’t come back.
When Goldman Sachs put all its eggs in the AIG basket, they should have received a bloody nose – at the very least. Yet uncle Sam paid them out 100c on the $ and Goldman scored a slam dunk. God’s work, eh? A miracle indeed.
A trader called Howie Huber recorded the single biggest loss ever at a bank. He cost Morgan Stanley over 10 billion dollars, but he got to keep the 24 million dollar bonus he earned the year before.
Dick Fuld at Lehmans faced some devastatingly hard questions from some horrible congressmen, but retired a very rich man.
It was the taxpayer who paid the price. Private profits and socialised losses – emphatically NOT what I’d call free market competition.
Now I don’t mean that we should round these guys up and shoot them, or even take their bonuses back – they signed contracts, and we respect the rule of law, and contracts. It’s the basis of our freedom and we risk tyranny if we selectively choose to violate these rights.
We have to recognise that bank traders get a free option. You can bet it all on red or black: win, you get a bonus. Lose, you may lose your job – but then probably use your ‘reputation’ to walk into another one.
The system is wrong, and something must be done about it.
In terms of dealing with the crisis we have to understand that damage is done before we are aware of it. In the sub-prime crisis, it was done in those happy days of 110% mortgages, up front discounted rates, and more freshly printed money than you know what to do with. We were killing our economy with cheap money love.
When gravity asserted itself, and the inevitable bust came we faced a simple choice: take the pain, or hide it.
In 1982, 100 Keynesian economists wrote a letter to the times saying that the government’s economic policies were suicide. It’s a bit of a coincidence, then, that that was the exact moment the real economy started to grow. Time and again, history shows us that if we take our medicine early, we get through the illness quicker.
Or we could take the Japanese/Keynesian approach, and hide it with fiscal aggregate kabalah nonsense. And lose twenty years in the process
But banks.. what should we do with them?
Some suggestions:
1. Firstly, banks should not speculate with your beer money – unless you understand this, and you explicitly sign it off.
2. Banks should be audited as strictly and as thoroughly as normal companies are – no favours.
3. Banks should legally have to provide for liabilities as they fall due – as every other company should.
4. Banks should offer accounts that are 100% reserved. That is where your money is kept safe, not used to speculate – and it remains your property.
5. Speculation should be undertaken by hedge funds and specialist trading groups, not by deposit-taking institutions, or by the likes of Barclays, that can borrow money from the Bank of England at 0.5% and walk over to the craps table.
6. Anybody, or company, that offers fiduciary advice should face 100% liability in case it goes wrong.
And most importantly,
7. Any person paid more than a certain amount by a bank, should be liable when things go wrong.
The contract that Dick Fuld signed should have meant he lost his house when he crashed Lehman’s. Howie Huber should now be serving Big Macs. And Lloyd Blankfein should be a little more circumspect when talking rubbish about doing God’s work.
By kind permission of Paul Birch, we reproduce his essay setting out a proposal for honest money through bearer shares, previously published on this site in October 2009. Paul’s own site may be found here: www.paulbirch.net.
1. Introduction
Nobody understands money, least of all economists. Too sweeping a statement? Perhaps. But every analysis of the workings of monetary systems that I have ever read has been seriously in error at one or more crucial points. This is true not only of the supposedly impartial opuses of academic economics, but also of the writings of Marxists, socialists, Keynesian dirigists, free-marketeers, anarcho-capitalists, libertarians and utopians of every flavour.
On important issues of monetary policy, then, and whether a free market in money is either workable or desirable, the protestations of the experts must be considered unreliable. In particular, the claims of libertarian-leaning economists, such as Ludwig von Mises, that the operation of “free banking” would be both stable and superior to the system of government monopoly called “central banking” need to be treated with scepticism; they have not proved what they think they have proved.
Here I intend to give a description of certain aspects of the creation and use of money free of major error; it is conceivable that I may not entirely succeed. I shall argue that free banking, as it is usually understood, may be liable to gross instabilities and inefficiencies, especially in a free-market environment, and that a centralised fiat currency has definite advantages. However, I shall then describe an alternative form of free-market banking that appears not to suffer from these deficiencies and into which the current system of state control could be metamorphosed. I shall argue that it is the innate honesty or dishonesty of the banking method that most distinguishes good money from bad; and that it is of the greatest importance to ensure that the laws under which banking takes place are able effectively to restrain all dishonest forms of banking, including those in which the dishonesty is most subtle.
2. What is Money?
So what is money? A deceptively easy question, that. Answers from the past include “gold”, “silver and gold”, “a medium of exchange”, “a promise to pay”, “a store of value”, “a measure of demand”, “just another commodity”. Such answers hold a germ of truth, but only lead to controversy, because they miss the essential point. All along we’ve been asking the wrong question. Instead, let us ask a new one:
What is the function of money?
The function of money is to keep track of who owes what to whom. In a world in which there is division of labour and in which we obtain diverse satisfactions by the voluntary exchange of goods and services we have need of an accounting device to permit this exchange to take place at minimal cost and without undue coercion or confusion. This accounting device we call money. Simple barter is not enough, because the goods I want are seldom held by the person to whom I can render service.
Imagine a central register, detailing every transaction entered into by each and every person, and containing a list of all the favours owed by each and every person to each and every other person. That would do it. It would be hideously complicated, but it would work. Fortunately, though, we needn’t go to such lengths, because in a market economy most of that data is redundant. All we really need to know is the current balance to the account of each person — how much the rest of the world owes him or how much he owes the rest of the world — and even that need not be centrally recorded.
In a market economy, then, the function of money is to reduce the transaction costs of honest trade (including gifts and bequests other than those directly in kind) by reliably and efficiently registering the indebtedness resulting from previous transactions. The details of those previous transactions no longer matter; only the present net position counts (except for incomplete transactions, such as when you have bought an item but not yet paid for it).
So, if the function of money is to keep track of honest trade, can we now answer the original question in a more enlightened and constructive way? I think we can.
Advisory Board Member Steve Baker, MP for Wycombe, yesterday made his maiden speech in the House of Commons. The full text may be found here. The articles which most closely inspired the speech are here and here.
The following section of the speech — which we have annotated with links to relevant articles — made some key points about honest money:
As a trustee of a charity for economic education, I would like to give what is perhaps an alternative perspective on the cause of the banking crisis; I hope that Members will indulge me. I should like to put to them a proposition that is uncontroversial: around the world, the system of money is a product of the state. Our monetary system is characterised by private banking, with a fractional reserve controlled by a central bank, which determines monetary policy and has a monopoly on the issue of legal tender. A Monetary Policy Committee sets interest rates.
The banks have the legal privilege of treating depositors’ money as their own. In the words of Irving Fisher,
“our national circulating medium is now at the mercy of loan transactions of banks”.
In the other place, in the Banking Bill debate of 5 February 2009, the Earl of Caithness explained eloquently the base of 19th-century judicial decisions-and yes, our system of money has evolved since then-that enabled that situation to take place. He called it
The Bank Charter Act 1844 ended the practice of banks over-issuing notes, but it left them virtually unmolested in their ability to issue deposit currency to be drawn by cheque. That loophole haunts us today. Unlike the situation in respect of any other commodity, in the case of money, price controls do not drive the product off the market. Artificially lowered interest rates increase the demand for credit, and decrease the supply of savings, but the legal privilege granted to banks means that they can meet demand by extending credit that is unbacked by real savings. There is a good argument to say that that causes the boom-and-bust cycle, the misdirection of resources in the capital structure of production, and over-consumption by consumers. That is the biggest problem that we face today.
We could talk about the moral hazard of having a state-backed lender of last resort and state deposit guarantees, and of the socialisation of the cost of failure; I only wish that I had time to touch on the accounting rules on derivatives. Perhaps that is for another day. My political hero, Richard Cobden, spoke on the subject. He held
“all idea of regulating the currency to be an absurdity”,
but I see that time is short; I shall have to save the rest of the quote for another day.
Today, money is a product of the state. The Bank of England controls the price, quantity and quality of money. Perhaps if we were talking about any other commodity, there would be far less confusion over and questioning of the cause of the crisis. If money is a product of the state, we should ask ourselves, “Is this a good idea?”
In the coalition, we have a Government ideally suited to be conservative to preserve what is good, but radical to change all that is bad. If we are to have a once-in-a-generation, fundamental review of the role of government, let us also examine government’s role in the system of money and bank credit.
In recognition of soaring inflation, and the looming threat that our new government will resort to monetisation of the national debt, we are bringing forward this classic article, originally published in December 2009.
Mr Smith works hard, plans carefully, and saves what he can, putting his money into a building society. He pays his credit card bills off each month, and tries to overpay his mortgage when he can.
Mr Smith got a 3% pay rise last year – inflation was only 2% – so he felt good about that. But… he doesn’t feel any wealthier.
Year after year, the government had said that the economy was growing strongly, but still, things seemed harder for his family and him. Train ticket prices up again. Heating bills rocketed when the price of oil went up, but never seemed to come down. He swears a loaf of bread and a pint of milk were much cheaper in years gone by.
When he changes his cash for Euros, he realises that his holiday in France is now unbearably expensive. His tax rates didn’t go up, but still, after all his bills were paid, he seemed to have less and less spare cash than he remembers a few years ago.
There are Mr Smiths everywhere. Careful folk, who plan, save for a rainy day and have a sense of personal responsibility.
Smith is the target.
It is Mr Smith who is going to pay for the banking crisis.
His saved wealth will pay the national debt.
His prudence will bail out Gordon Brown’s profligacy.
His forgone holiday will pay the banker’s bonuses.
His careful spending will pay for the vast number of quangos.
His financial planning will bail out the failed NHS computer project, over-budget military programs and ID cards.
His sense of responsibility will end up funding the destruction meted out in Iraq and Afghanistan.
It won’t be the politicians or the bankers who pay for global warming – he will.
He knows he pays tax… but what is hard for him to comprehend is that there is another pernicious process draining his wealth and subverting his hard work towards paying for the misjudgement of others. Whether he likes it or not, he naively pays for the decisions made by the political class.
He has no choice. No option. He was never asked to vote for it. And for the most part, the act of theft is so subtle he doesn’t even know it is happening.
Why does he feel poorer?
Why is it that Mr Smith seemed to miss the ‘boom’, yet is hurting more in the bust? Why doesn’t life get easier for him? What is going on?
Inflation.
As technology produces things more cheaply, Mr Smith should have been able to reap the rewards – except that things don’t get cheaper for him. Society cheats him when the government opens the spigot of new money, washing this value away as the torrent of new money chases prices higher beyond his reach.
The winners are always those close to the gusher – the banks, financiers and politicians. These are the ones who get to spend the new money first, thus chase prices up before Mr Smith gets any sniff of what is happening.
To save or to invest?
Think about your personal circumstances. Every time your payslip comes in, you have a choice of how much to spend and how much to save. Every rational person knows that there is a balance to be struck between current enjoyment (consumption) and future enjoyment (savings – or deferred consumption).
This choice is exactly the same for society as a whole. As a country, we must decide how much to consume, and how much to defer consumption in order to allow our children and us to enjoy things in the future.
The choice for us all is simple. Defer consumption and invest for the future, or consume and enjoy now.
What is the process by which we save for the future? There are two ways.
Voluntary saving. If society needs to invest for the future, but people prefer to consume, then the savings rate – the profits paid on investments and/or the interest rate paid on deposits, rises until people choose to defer consumption and invest.
Forced saving. Government policy forces a decrease of the purchasing power of money via inflation of the money supply. The net effect is a transference of wealth from savers and fixed income groups towards net borrowers (itself included). It also creates an artificial pool of liquidity into which the government can sell its IOUs.
The evil of Forced Saving
The natural state of affairs in a free market, with a more consistent supply of money, is that general prices fall as technology advances. The prudent are rewarded, and borrowers have to carefully evaluate and moderate their flights of fancy, only investing borrowed funds carefully in sound projects.
When the value of money declines, savers find that their money buys less, whilst borrowers are happy to find that they can repay their debts with money of a decreased value. It’s like borrowing five books from the library and finding that you are only required to give four back!
By setting a target for rising prices and then pulling levers to increase the supply of money in the economy to achieve it, the government prevents the natural response of general prices to competition, increased efficiency and innovation: they stop prices from falling.
Entrepreneurs, innovators, inventors and new businesses exist because they believe that they can satisfy society’s wants better than they have been served before. They have ideas, innovations and take risks in order to provide goods that are cheaper than they otherwise would be. Businesses operating in a competitive environment always seek to reduce costs, be that one step more efficient and produce a cheaper or better widget. As group of people, entrepreneurs bring efficiency and innovation, and they make stuff cheaper.
The benefit to Mr Smith should be that his income goes further. As time progresses, technological innovation should mean he can buy more with the same cash. But that’s not what happens, as any pensioner knows. Saved money buys far less now than it did at the time it was saved.
Governments achieve rising prices by encouraging the supply of new money. This new money comes from the central bank via its control of the banking system. The first users of this new money are invariably politicians, finance capitalism and big business. These guys get to use the newly minted money first, and thus spend it first. This process bids up prices, leaving everyone else chasing behind, and poor old Mr Smith last in the queue.
What an evil system it is then, when government can control money in such a way as to give it a first user advantage that penalises all those in the general population whose wealth is being rapidly diluted. A process that systematically violates and loots pensions, savings, fixed incomes and the actions of prudent, and rewards the profligate, the speculative borrowers and above all, rewards the biggest borrower of all: Government.
Let’s be clear. The current system is a process that diverts the benefits of innovation and technological advancement that should accrue to the general population, and thrusts it towards the desired spending of the well connected and the political class.
We need to stop this continual violation of the little man. Mr Smith has to start realising what is happening to him.
That’s why I’m proud to support the efforts of the Cobden Centre.
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.
Gordon Kerr’s second address this year at the European Parliament was at a meeting of the European Enterprise Institute. The meeting was chaired by Diego Feio MEP and the meeting organised by Christopher Pichonnier. The platform was shared with Tryggvi Thor Herbertsson (MP, Iceland) and Rok Spruk, a Lithuania based economist. This speech was originally published on 4 March 2010.
1. Introduction
Mr Feio, Mr Pichonnier, ladies and gentlemen, thankyou for inviting me to address you today. We are here to explain and hopefully start to resolve the Icelandic banking collapse.
By way of brief personal introduction I am a banker. In my 29 year career I have experienced several banking crises. In the early 80’s I worked on Paris Club restructurings for Latin American sovereign defaulters.
Later in the 80’s I travelled frequently to the US in connection with the Savings and Loan crisis. In the early 90’s I worked mainly in Stockholm on mortgage backed transactions during the Swedish banking collapse.
A few years later I designed instruments that would in turn play a small but significant role in precipitating the collapse of the Western banking system. These instruments were called synthetic capital structures. They created the appearance of an increase in capital on bank balance sheets when in reality the economic risk and return positions of the banks concerned were essentially the same after the transactions as before.
I am a member of the Advisory Board of a London based banking educational charity – The Cobden Centre, and I work for a small investment banking firm in London.
My message to you today is simple. There is nothing specific about the way the Icelandic authorities managed its economy or its banking system that caused this massive failure. The root of the problem lies within the very essence of the banking system itself. Iceland, as a very small country with an aggressive banking industry, was just at the tipping point when the system itself failed, and has therefore suffered to a disproportionately greater extent than others.
2. Were the Western Governments correct to bail out the banks?
Imagine the feeling of going to see a doctor with a puzzling medical condition, having both legs amputated, and three months later experiencing a recurrence of the symptoms. You are admitted to hospital again, but this time the doctor who greets you post examination is far more sombre.
He explains that you have had a pancreatic tumour all along. Had it been correctly diagnosed on first consultation the tumour would have been annulled, but now it is out of control and certain to kill you.
This, I believe, is a fair parallel with the way in which banks in the UK and many other European countries have been rescued. I believe the bailouts are having the opposite effect to that which was intended. They are not helping to re-stimulate lending to small and medium sized businesses – the engines of these economies.
A smarter observer than I has compared the UK solution to the actions of an alcoholic, accepting with equanimity inevitable long term pain as the consequence of his inability to resist the temptation of one more short term, fuzzy high.
There is a danger that solutions presently proposed could accidentally cut the legs off Iceland and condemn its economy to years of stasis, instead of helping to cure its crippled banking condition.
Let us look now at the banking system itself. The legal rules which allow banks to gamble depositors’ demand funds on long term investments have simply created a liquidity pyramid scheme which, enhanced by various other banking developments, have boosted a variety of assets to unsustainable price levels that cannot be supported by the wealth of the relevant underlying economy. Iceland, being both part of this system and a tiny country with its own currency, simply sits at the pinnacle of this Western banking system crisis.
3. Iceland and the Global Collapse.
I urge you to resist the temptation of embracing the political exculpation of ‘global credit crunch’. Although the crisis was truly global this simple linguistic term seeks if anything to discourage serious analysis of what went wrong.
Many papers and speeches I have read are good quality diarised timelines of events in Iceland, without presenting credible cures or accurate analyses of the cause.
Iceland’s collapse was clearly related to the global failure, but each country does not necessarily need a global solution. Indeed, whenever I hear of a problem that can only be solved by global accord I cannot avoid the conclusion that such a problem is being expressed as intractable. The climate change issue is but one other example of a problem looking for a global solution.
Before addressing Iceland’s unique challenges, may I present some of the “banking developments” to which I referred earlier. I am about to set out just some of the features of permitted banking activity which have combined to create an unsustainable pyramid of asset prices which Western liquidity may struggle to support.
Most of the features I am about to describe do not appear on the radar screen of the press or blissfully ignorant politicians. For brevity I will set out only five such features:
a) The circular effect whereby asset prices are inflated merely by the creation of loans provided by banks to finance the purchase of such assets. I have many times witnessed competitive bidding wars between two purchasers wherein the independent valuer has simply up valued the assets each time one side or the other’s bank has issued a larger loan offer. It is essentially the case that the size of the loan determines the asset price, not the other way around. Therefore it is impossible to divorce the independent valuation of assets from the quantity of debt which banks are willing to issue against the assets.
b) Under EU fractional reserve regulations banks are required to maintain a minimum of say 8% “fraction” of their exposures as capital. Since the bulk of European banks are shareholder owned, market forces virtually compel them to push fractional reserve regulation to the limit. It is very difficult for the CEO of a major bank to keep his job if he is not fully leveraged in supposedly stable market conditions.
c) The absurd accounting regime that encourages banks to transfer as much exposure as possible into derivative format. The derivatives accounting regime presents two important benefits to banks: 1) the front ending of multi year’s hoped for income as Day 1 “profit”, and 2) the ability of a bank to leverage its capital not 12 times (the reciprocal of the 8% basic capital ratio) but up to 200 times (the reciprocal of 1/16 of the basic capital ratio). The 200 times leverage rule has historically been the starting point for calculating the capital to be reserved against derivative exposures, and now, under Basel 2 rules, this higher level of leverage is permitted against any AAA rated assets even in non-derivative format provided the bank concerned is regarded as sufficiently sophisticated).
I have a second confession to make. I was involved in designing the early forms of credit derivatives. I have written articles about this activity on the Cobden Centre website and I am grateful to its founder, Toby Baxendale, for inviting me to write about this. Let me clarify for the record one frequently confused point. The motivation behind the emergence of credit derivatives was not the enabling of banks to distribute loans to non-banks. That activity was operating perfectly well before the advent of credit derivatives via other financial instruments.
The overriding motive behind the emergence of credit derivatives was in the accounting rules. Credit derivatives allow banks to book multi-year profits, subject to supposedly conservative reserves, before they have been realised or earned in a sense that would satisfy an accountant in any industry other than banking.
d) I referred earlier to the liquidity pyramid that results from the legal relationship between banks and depositors. Depositors’ money belongs in law to the bank, not depositors. The EU seems aware of this concern and some proposed new regulations talk about inhibiting banks’ future ability to mismatch the maturities of assets and liabilities. This mismatching has, I believe, been a major contributor to the crisis in a very simple way:
Person ‘A’ deposits £100 of cash into his instant-access bank account and receives a promise to return the cash on demand.
The bank retains a small reserve (say £3), and lends out £97 to Person ‘B’.
Person B purchases £97 worth of goods from person C who in turn redeposits the money in the bank.
Both ‘A’ and ‘C’ both have a claim to instant access on this money.
In three steps, the bank has turned £100 into £197 of useable money.
e) The use of the ECB discount window to finance banks purchase of assets post crisis. There has, in the last 10 months, been a gradual rise in the prices of large volumes of the very type of banking assets that many UK commentators have termed “alphabet soup”. Less kind commentators have termed some of these assets a “Liverpudlian Stew” – a rather unpleasant menu item, even by British culinary standards. It is in essence an attempt to present undigestible left over food as attractively as possible. (On behalf of Liverpool may I thank the EU for ordaining it as European City of Culture in 2008).
These price rises seem inconsistent with present reduced liquidity within the banking system. The only explanation I can reach is that some financial institutions have been able to fund their purchases of such assets via the central bank discounting windows such as the ECB itself. Banks are then, as rational players in a regulated industry, motivated to make money by the monetisation of unrealised future profits by entering into synthetic arrangements on these same assets. If true this effect will dash all our hopes that we may be coming out of the crisis.
4. ICELAND
Let us look at Iceland more specifically. The root of the problem lay not in the failure of Iceland’s specific regulators or its national regulation system per se, but in the simple combination of three factors:
i. Its small size and status as a country;
ii. Its banks seeking aggressive growth;
iii. Its acceptance of the Western bank regulatory regime.
The scale of the problem measured against Iceland’s GDP was simply incredible. The country effectively staked its economic future on international banking, raising capital internationally and lending it out in highly leveraged packages relying on rating agencies and more experienced capital markets arrangers.
The deposit base which lay at the root of the banks’ efforts to prop up the pyramid should have collapsed before the problems became quite so bad, but thanks to Iceland’s status as a sovereign state and international conventions whereby one country’s banks can be “passported” to raise deposits in another, Iceland’s banks succeeded in raising considerable sums of demand deposits from other countries’ savers, in particular the UK and the Netherlands. Those savers looked only to their own national regulators who, under passporting rules, in capital markets parlance simply “wrapped” the Icelandic Central Bank.’’
Ironically the taxpayers of countries such as the UK and Netherlands in effect wrote credit default protection on Iceland, and now, having been called on this protection, seek to exercise rights of subrogation against the Icelandic taxpaying citizenry. But if the Icelandic people did not understand what was going on, are these actions not akin to luring the demented old lady next door into leaving you her house in her will and thereby disinheriting her children?
Icelanders who had saved in its major banks, supervised by its national regulators, were effectively performing the function of a junior mezzanine investor (ie just above the shareholders) in the capital structure of a typical “alphabet soup” investment whose fragility was almost impossible for the ordinary taxpayer to understand.
And so, the pyramid inflated further until September 29 2008. On that date Glitnir, on seeing its credit lines withdrawn following the collapse of Lehman, knew it was unable to raise funds to satisfy a €750 million payment due on October 15th and approached the Central Bank of Iceland for an emergency loan. The loan request was turned down and instead Glitnir was forced to accept €600m from the central bank in return for a 75% stake. Its shareholders were practically wiped out[i].
Iceland therefore suffered like no other country, and at a rapacious rate. At less than 6% of GDP, government debt was tiny at the beginning of 2008. Under an FRB system that mirrored that of all major European countries its banking system was quickly destroyed and its people burdened with unimaginable levels of debt.
5. What Should Iceland Do?
We have just heard from Dr. Tryggvi Thor Herbertsson MP that there is great doubt as to whether it will join the Euro. Even if the Eurozone states can fund the PIGS and other bailouts presently planned, should Iceland ask for an EU bailout?
The short term appeal is obvious, is the longer term outlook as rosy? What of the concerns of abandonment of control over fiscal and monetary policy? Are these measures consistent with the Icelandic character and way of doing things?
Let us consider Greece very briefly. The calm 2 weeks ago when the Greek bailout was announced has been replaced by concern. The austerity measures the EU would impose will be as unpopular in Iceland as they are in Greece.
There is clearly a gulf between the positions of the bailor and the bailee. As I prepare this speech I read in February 25th Daily Telegraph the following report by Ambrose Evans Pritchard:
“Hans-Werner Sinn, head of Germany’s IFO economic institute, said Athens was holding Euroland to ransom, threatening to set off mayhem if there is no bail-out. “Greece should never have entered the euro zone because they did not qualify and they are now blackmailing other European countries via the euro. It’s not for the EU to help Greece. We have an institution that is very experienced in bailing-out activities: the IMF,” he said.
Otmar Issing, former doyen of the European Central Bank, echoed this view in Germany’s Bundestag last Wednesday, warning that a Greek rescue would “open the floodgates” for serial bail-outs and destroy EMU discipline. “The crisis is made in Greece. It is the result of bad policy, not outside forces like an earthquake.” “
Does this rhetoric imply that life under the EU will be much better for Icelanders? That is clearly a decision for Iceland’s Government and people.
If Iceland joins the EU then I would urge the EU to reform its own regulatory regime fundamentally to protect Iceland from further catastrophe. Relying on rating agencies as the basis of regulation, rather than markets, makes little sense.
It is not impossible to devise a fractional reserve regulatory system that will work if its practitioners are expert bankers and fully appraised of everything that its banks are engaged in post reform. But this is fraught with risks.
A far easier solution for Iceland is to make one simple law change. Grant depositors title to their deposits, stipulate that the state and taxpayers will never again bail out the banks, and allow free market forces to create a safe and transparent banking system. A ban on the maturity mismatching of assets, combined with a clear policy of NOT bailing out the banks in future, will enable free markets to flourish.
Do not blame the bankers, they were merely acting like rational capitalist players in a wrongly regulated system. If we are to allocate blame then look to yourselves right here in the Brussels Parliament. It is you rulemakers who have made the mistakes. You should have worked this out.
6. Conclusion
The way forward for Iceland should be to look to itself. Tryggvi, your people have a powerful sense of identity. You have a wonderful natural economy, a well educated population and a well documented strength of character. You can fix your problems yourselves, but maybe with a little help from my firm! The detail of implementation needs to be set in the context of modern banking. A restructured banking system as proposed today would ensure:
1) Depositors could NEVER AGAIN lose their money;
2) Credit would resume flowing from savers to entrepreneurs;
3) The reopening of the international capital markets to Iceland
Without these measures I fear it will be back to the operating theatre in a year or two, with little prospect of a speedy recovery.
Mr Feio, Mr Pichonnier, ladies and gentlemen, thank you for your time.
END
Gordon Kerr – March 2nd 2010
EU Parliament, Brussels
[i] What the Icelandic Collapse has Taught Us, February 2009, Tryggvi Thor Herbertsson
The M3 money supply in the United States is contracting at an accelerating rate that now matches the average decline seen from 1929 to 1933, despite near zero interest rates and the biggest fiscal blitz in history.
But this begs the question, “Why is the money supply dependent on interest rates and government spending?”
It turns out the great economist Irving Fisher told us back in the 1930s: banks create and destroy credit money by granting and calling loans. As Fisher wrote:
Thus our national circulating medium is now at the mercy of loan transactions of banks; and our thousands of checking banks are, in effect, so many irresponsible private mints.
He went on (emphasis mine):
As the system of checking accounts, or check-book money, based chiefly on loans, spreads from the few countries now using it to the whole world, all of its dangers will grow greater. As a consequence, future booms and depressions threaten to be worse than those of the past, unless the system is changed.
Fisher set out the problem in the 1930s and a solution, one which offered the possibility of paying off the national debt and largely ending economic cycles: 100% reserves on demand deposits. We face the same problem today and we have the same tantalising possibilities.
The Banking Bill fails to address the fault which has led to every major banking and currency crisis during the past 200 years, including this one. It merely, lazily and weakly, papers over the cracks. Like Lilliputians, we are trying to tie down Gulliver with ever more strands of rope. It did not work then; it has not worked since 1811; and it will not work now.
This is why colleagues and I established The Cobden Centre: we need honest money now to end the crisis and set us on a firm foundation for a sustainable and healthy future economy.
In their working paper Assessing UK money supply measures in the light of the credit crunch, Toby Baxendale and Anthony J. Evans provide a better measure of the money supply. In this article, Steven Baker explores the background to the paper and indicates some key findings.
This article was originally published in October 2009.
Many people know the Bank of England is creating new money through quantitative easing but if the quantity of money is being increased, how is that quantity being measured? What is counted as money?
When the Bank is concerned about the risks of very low inflation, it cuts Bank Rate – that is, it reduces the price of central bank money. But interest rates cannot fall below zero.
So if they are almost at zero, and there is still a significant risk of very low inflation, the Bank can increase the quantity of money – in other words, inject money directly into the economy. That process is sometimes known as ‘quantitative easing’.
But when I consider quantitative easing, I am concerned with the following problems:
It is not clear that the Bank of England has a useful definition of the money supply. The present measures do not correspond to economic activity — which is what the Bank is trying to increase with new money — and this crisis was famously not foreseen.
As commentators have reported, “the Bank’s Governor, Mervyn King, seemed pretty confident that QE could work. But even he would admit he has no idea how long it will take – or how much money he will have to print to get there.” This uncertainty seems less than ideal given the risk of price inflation.
According to Austrian-School economic scholars including Hayek and Huerta de Soto, injecting new money can create only a harmful illusion of prosperity1.
As my colleagues point out in their working paper, the fact that the monetary authorities have turned to increasing the quantity of money will focus attention on how that quantity is measured. This article provides some background information and indicates Baxendale and Evans’ key findings.
“The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate – or perhaps even only so long as it continues to accelerate at a given rate. What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained and which after some time can be maintained only by a rate of inflation which would rapidly lead to a disorganisation of all economic activity.” Hayek, 1974 Nobel Prize Lecture [↩]
In their working paper