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.
I attended a lecture recently given by Dr. John Thanassoulis from Oxford University. His objective in this lecture was to explore the question of whether there is a case for financial regulation which intervenes in bankers’ pay. To cut a long story short, Thanassoulis’s conclusion was that, yes, effectively the Government should intervene in bankers’ pay and cap it at an appropriate level to lower the overall risk of the banking industry. Leaving aside who decides what “an appropriate level” to pay bankers is, in my view there are a host of problems with Thanassoulis’s analysis and conclusions.
Before getting into the problems I will describe Thanassoulis’s argument. Fundamentally, he believes that the level of remuneration at banks is a legitimate source of concern because the higher the remuneration the greater the following:
a) Restriction of bank lending
b) Increased risk incentive for the banker
c) Increased risk taking by banks in general.
Thanassoulis characterises these aspects as an externality (in other words a cost that others have to pay rather than the banks themselves) thus requiring intervention. Interestingly, he views competition in the banking industry as a problem, because in order to compete for the best banking employees banks must pay higher remuneration thus increasing risk. In his view, competition in a free market can sometimes be a problem.
Thanassoulis’s analysis results in him drawing other bizarre conclusions. Because he is concerned that that banking executives are overly concerned with the short-term (unlike say government regulators) and because bankers discount deferred pay, banks should be forced to defer pay to force bankers to focus on the long-term. Secondly, remuneration should be capped to a proportion of assets under management or profits, nominally to lower risk but also to refocus banking towards lending. Banks exist to lend money but apparently this is not sufficient motivation for them to actually lend money. It is also not clear who is qualified to actually decide what the cap should be or who can define the long-term versus the short-term. Is the long-term 20 years or three? Is the short-term three months or one year? How far into the future can one accurately divine? That is a question for mystics perhaps or maybe left for analysis after the fact.
Oftentimes, when you find yourself making conclusions that on their face are absurd it is wise to go back and revisit your premises. In this case, Thanassoulis’s basic premise is that for whatever reason bankers took excessive risks. Fundamentally, he believes that bankers took excessive risks because they were incentivised to do so by their compensation package. And furthermore, he seems to lump “bankers” into one homogeneous group when in fact, there are many types of bankers who perform various different functions. Essentially, when many people think of bankers, they often seem to have in mind equity traders, a group I could imagine would fit the public image of an aggressive, all caution to the wind, testosterone charged bankers. Indeed, Thanassoulis appears to refer interchangeably between traders and bankers without defining either. The reality of course is far more complex.
Certainly commercial bankers (such as RBS, HBOS, Lloyds, who needed varying amounts of bail-outs) tend to be a much more genteel group than might be suggested by their public image. The approach taken by such bankers to lending is consideration of the borrower’s ability to pay them back, whether this is over three years or twenty (long term?). Simply put, banks will not lend if they do not believe there is a reasonable chance of regaining their principal. It is true that during boom times a lot of loans were made that ex post have proven to be unwise, but the risks weren’t fully appreciated at the time. Bankers, like many individuals, conducted themselves as though the good times would continue to roll. The issue here, therefore, is not excessive risk-taking but a misspecification of risk. Commercial lenders base their specification of risk on actuarial models which unfortunately, can be biased based on recent events. Furthermore, these models cannot account accurately for the business cycle, thus risk estimates are biased downwards. As such, bankers are making loans based on a belief that the risk is lower than it really is.
Furthermore, the very nature of banks allows them to have more funds available for these improperly specified loans than they otherwise would. This is for two reasons. First, modern commercial banks hold fractional reserves. At the height of the boom period banks were holding perhaps 1% of deposits on reserve and lending the rest out. Secondly, where necessary, the central bank would provide additional liquidity (i.e. print money to support banks’ lending).
And so not only was the risk estimate of lending understated, the amount of money available to lend was too high. If banks have money to be lent it will be lent. This is the modern function of banks. The pressure on banks to lend will increase over time as profits that are made on earlier successful projects need to be reinvested. This results in the banks increasing in size (due to increased asset values, new employees required to manage the multiplying projects etc.) necessitating further lending in a crowded loan market. Furthermore the increasing esteem of banks provides further pressure to become involved in prestigious new projects. These developments will also cause banking pay to rise and increase competition in the market to hire bankers.
Additionally, with a lowered perception of risk the interest rate charged to borrowers will be lower than it otherwise would be. This in turn encourages companies and individuals to borrow money and invest in projects or spend on frivolities. Indeed, borrowers will also have a lowered perception of risk, essentially for the same reason as bankers. And so while the cross-hairs of blame are centred on bankers, the same mistakes were made by all market participants. HMV and Woolworths are two such casualties that borrowed money for investment in projects that ultimately proved to be wasteful.
Fiddling around with bankers pay, capping it, deferring it, re-portioning it is a complete waste of time, trying to solve a problem that does not exist. Bankers’ pay, its composition or amount, has nothing to do the causes of the recent economic bust, other than that it is merely another symptom of the business cycle. Bankers are well paid because the economy is set up to reward them in this manner. The majority of the financial resources in the economy are funnelled through the banking system and bankers take their cut. This is because of the legal and economic structure in which banks operate. That is, the central bank fractional reserve system. Thus, in good times and bad, banks disproportionately benefit.
In any event, the compensation of banking employees is not a major source of risk in banking. The major risk factors in banking include (but are not limited to) the risk of the project itself, market risk (i.e. movement in variables such as interest rates) and the gap between short-term borrowing and long-term lending. If well paid banking executives steer the bank towards high yield projects it is because they have the appearance of being relatively low risk, not because they are anxious to take on high risk, high yield projects. Unfortunately, they are unaware that the benefits from such projects are an illusion created by the very business cycle that banks perpetuate.
The obvious solution is to abolish every aspect of fractional reserve banking, including central banking and fiat currency. This will not happen any time soon as it benefits the government to have this system in place. The government has access to a hidden tax through inflation and a willing scapegoat when things go wrong. The villagers will go armed with pitchforks and torches trying to kill the wrong monster.
Indeed, while complaining that banks are not lending, (after criticising them for lending too much!) the government assures that banks will not lend in any great amount by making it impossible to do so. The low interest rate environment, created by that agency of the government, the Bank of England, has made it impossible for banks to exit many of their positions for many years. But we should recognise here that the primary objective of the government is to ensure the survival of their colleagues at banks around the country (and by extension the world) and not either a quick end to the depression or lending to businesses that may or may not need the funds.
As such, John Thanassoulis’s conclusions are quite invalid and will not solve any particular economic problem. Instead, he has fallen prey to the smoke screen promoted by the Government which has focused the causes of the depression on trivial issues like bankers’ pay. Indeed, in this manner the Government takes advantage of feelings of envy amongst the population at large to focus their rage away from government policy and the fundamental causes of the depression. This is slightly analogous to a similar method used with petrol prices. When prices are too high, it’s not because of the approximately 150% tax on petrol but because of greedy oil companies and price-gouging petrol station owners.
UK Chancellor George Osborne and Bank of England Governor Mervin King last week announced another round of fiscal and monetary stimulus measures, including steps to ease the funding for banks and allow them to extend more loans.
If these measures were hoped to instil confidence they must be classified as a failure. We have lived through quite a few years of unprecedented and fairly persistent monetary accommodation and occasional rounds of QE by now, and I doubt that yet another dose of the same medicine will cause great excitement. Furthermore, observers must get confused as to what our most pressing problems really are. Have we not had a real banking crisis in the UK in 2008 because banks were over-extended and in desperate need of balance sheet repair? Is a period of deleveraging and a rebuilding of capital ratios not urgently required and unavoidable? Let’s not forget that the government is still a majority-owner of RBS and holds a large chunk of Lloyds-TSB. If banks are still on life-support from the taxpayer and the central bank, is it wise to already prod them to expand their balance sheets again and create more credit to ‘stimulate’ growth?
The same confusion exists on fiscal policy. Is the Greece crisis not a stark warning to all other sovereign borrowers out there, which are equally and without exception on a slippery slope toward fiscal Armageddon, that it is high time for drastic reduction in spending and fundamental fiscal reform? If the Bank of England or the government assume any of the risk of the latest additional credit measures, then the taxpayer is on the hook.
None of this will instil confidence, not in the economy and not in the banks, and certainly not in politics. UK newspaper ‘The Independent’ headlined: “King pushes the panic button”, which I consider a pretty apt description.
Banks are parastatal dinosaurs
One thing is now clear to even the most casual observer: banks are not capitalist businesses. In their present incarnation they have little to do with the free market and no place in it. They are constantly oscillating between two positions: One moment, they are a state protectorate, in desperate need of support from the state printing press or unlimited taxpayer funds, as, in the absence of such support, we are supposedly faced with the dreaded social fallout of complete financial collapse; the next moment they are a convenient tool for state policy, simply to be fed with ample bank reserves and enticed with low interest rates to create yet more cheap credit and help manufacture some artificial growth spurt. Either the banks are the permanent welfare queens of the fiat money systems, or convenient policy levers for the macro-economic central planners. In any case, capitalist businesses look different.
Central banks and modern fiat money banks are quite simply a blot on the capitalist system. In order for capitalism to operate smoothly they will ultimately have to be removed. I believe that the underlying logic of capitalism will work in that direction. Personally, I believe that trying to ‘reform’ the present system is a waste of time and energy. It is particularly unbecoming for libertarians as they run the risk of getting infected with the strains of statism that run through the system. Let’s replace this system with something better. With a market-based monetary system.
When and how exactly the present system will end, nobody can say. I believe we are in the final inning. Around the world, all major central banks have now established zero or near-zero interest rates and are using their own balance sheets in a desperate attempt to avoid their highly geared banking systems from contracting or potentially collapsing. If you think that this is all just temporary and that it will be smoothly unwound when the economy finally ‘recovers’, then you are probably on some strong medication, or have been listening for too long to the mainstream economists who are, in the majority, happy to function as apologists for the present system.
I still believe that chances are we will, at some point, get the full throttle, foot-on-the pedal monetary overkill, the ultimate uber-QE that will push the system over the edge. This will be the moment when central bankers discover – and discover the hard way – that their ability to print their fiat money may well be unlimited but that the public’s confidence in this fiat money certainly is not. The whole system will blow up in some hyperinflationary fireball, which has been the end of most previous experiments with complete fiat money systems, all others having ended with a voluntary return to commodity money before the public had lost complete faith in the system. And the prospect for a voluntary and official return to a gold standard seems slim at present. However, this is not the topic of this essay.
The future of money
I am often asked what will come next after the present system collapsed? Will we have to go back to barter? – No. Obviously, a modern capitalist economy needs a functioning monetary system. My hope is that from the ashes of the current system a new monetary system arises that is entirely private and not run by states – and that does not have the unholy state-bank alliance at its core, an alliance that exists in opposition to everything that the free market stands for. Nobody can say what this new system will look like precisely. Its shape and features will ultimately be decided by the market. In this field, as in others, there are few limits to human inventiveness and ingenuity. But we can already make a few conceptual points about such a system, and we should contemplate working on such a system now while the old system is in its death throes.
A private gold ‘standard’…
Free market monetary systems, in which the supply of money is outside political control, are likely to be systems in which money proper is a commodity of limited and fairly inelastic supply. It seems improbable that a completely free market would grant any private entity the right to produce (paper or electronic) money at will and without limit. The present system is unusual in this respect and it is evidently not a free market solution. Neither is it sustainable.
The obvious candidates are gold and silver, which have functioned as money for thousands of years. We could envision a modern system at whose centre are private companies that offer gold and silver storage, probably in a variety of jurisdictions (Zurich, London, Hong Kong, Vancouver). Around this core of stored monetary metal a financial system is built that uses the latest information and payment technology to facilitate the easy, secure and cheap transfer of ownership in this base money between whoever chooses to participate in this system (Yes, there would be credit cards and wire transfers, and internet or mobile phone payments. There would, however, be no FOMC meetings, no Bank of England governor writing letters to the Chancellor, and no monetary policy!).
Are these gold and silver storage companies banks? — Well, they could become banks. In fact, this is how our present banking system started out. But there are important differences about which I will say a few things later. In any case this would be hard, international, private and apolitical money. This would be capitalist money.
Another solution would be private virtual money, such as Bitcoin.
Bitcoin is immaterial money, internet money. It is software.
Bitcoin can be thought of as a cryptographic commodity. Individual Bitcoins can be created through a process that is called ‘mining’. It involves considerable computing power, and the complex algorithm at the core of Bitcoin makes the creation of additional Bitcons more difficult (and thus more expensive) the more Bitcoins are already in existence. The overall supply of Bitcoins is limited to 21 million units. Again, this is fixed by the algorithm at the core of it, which cannot be altered.
Thus, creating Bitcoin money is entirely private but not costless and not unlimited. Most people will, of course, never ‘mine’ Bitcoins, just as under the gold standard most people didn’t mine gold. People will acquire Bitcoins through trade, by exchanging goods and services for Bitcoins, then using the Bitcoins for other transactions.
Bitcoin is hard money. Its supply is inelastic and not under the control of any issuing authority. It is international and truly capitalist ‘money’ – of course this assumes that the public is willing to use it as money.
There are naturally a number of questions surrounding Bitcoin that cannot be covered in this essay: is it safe? Can the algorithm be changed or corrupted and Bitcoins thus be counterfeited? Are the virtual “wallets” in which the Bitcoins are stored safe? – These are questions for the computer security expert or cryptographer, and I am neither. My argument is conceptual. My goal is not to analyze Bitcoin as such but to speculate on the consequences of a virtual commodity currency, which I consider feasible in principle, and I simply assume – for the sake of the argument – that Bitcoin is already the solution. Whether that is indeed the case, I cannot say. And it is – again – for the market to decide.
There is one question for the economist, however: could Bitcoin become widely accepted as money? Would this not contradict Mises’ regression theorem, which states that no form of money can come into existence as a ready medium of exchange; that whatever the monetary substance (or non-substance), it must have had some other commodity-use prior to its first use as money. My counterargument here is the following: the analogy is to the banknote, which started life not as a commodity but as a payment device, i.e. a claim on money proper which was gold or silver at the time. Banknotes were initially used as a more convenient way to transfer ownership in gold or silver. Once banknotes circulated widely and were generally accepted as media of exchange in trade, the gold-backing could be dropped and banknotes still circulated as money. They had become money in their own right.
Similarly, Bitcoin can be thought of, initially, as payment technology, as a cheap and convenient device to transfer ownership in state paper money. (Bitcoins can presently be exchanged for paper money at various exchanges.) But as the supply of Bitcoins is restricted while the supply of state paper money constantly expands, the exchange-value of Bitcoins is bound to go up. And at some stage, Bitcoin could begin to trade as money proper.
A monetary system built on hard, international and apolitical money, whether in the form of a private gold system or Bitcoin, would be a truly capitalist system, a system that facilitates the free and voluntary exchange between private individuals and corporations within and across borders, a system that is stable and outside of political control. It would have many advantages for the money user but there would be little role for present-day banks, which goes to show to what extent banks have become a creature of the present state-fiat money system and all its inconsistencies.
Banks profit from money creation
Banks conduct fractional-reserve banking (FRB), which means they take deposits that are supposed to be safe and liquid and therefore pay the depositor little interest, and use them to fund loans that are illiquid and risky and thus pay the bank high interest. Through the process of fractional-reserve banking, banks expand the supply of money in the economy; they become money producers, which is, of course, profitable. Many mainstream economists welcome FRB as a way to expand money and credit and ‘stimulate’ extra growth but as the Currency School in Britain in the 19th century and in particular the Austrian School under Mises and Hayek in the early 20th century have argued convincingly (and as I explain in detail in Paper Money Collapse) this process is not only risky for the individual banks, it is destabilizing for the overall economy. It must cause boom-bust cycles.
It cannot be excluded that banks could conduct FRB even on the basis of a private system of gold-money or Bitcoin. However, in the absence of a backstop by way of a central bank that functions as a lender-of-last resort, the scope for FRB would be very limited indeed. It would be too dangerous for banks to lower their reserve ratios (at least to fairly low levels) as that would increase the risk of a bank-run.
I am sometimes told that I am too critical of the central banks and the state, and that I should direct my ire toward the ‘greedy’ ‘private’ banks, for it is the ‘private’ banks that create all the money out there through FRB. Of course they do. But FRB is only possible on the scale it has been conducted over recent decades because the banks are supported – and even actively encouraged – in their FRB activities by a lender-of-last resort central bank, in particular as the central bank today has full and unlimited control over fiat money bank reserves. Under a system of hard money (gold or Bitcoin), even if the banks themselves started their own lender-of-last resort central bank, that entity could not create more gold reserves or Bitcoin reserves and thus provide unlimited support to the banks.
FRB is particularly unlikely to develop in a Bitcoin economy, as there is no need for a depository, for safe-keeping and storage services, and for any services that involve the transfer of the monetary system’s raw material (be it gold or state paper tickets) into other, more convenient forms of media of exchange, such as electronic money that can facilitate transactions over great distances. The owner of Bitcoin has an account that is similar to his email account. He manages it himself and he stores his Bitcoin himself. And Bitcoin is money that is already readily usable for any transaction, anywhere in the world, simply via the internet. The bank as intermediary is being bypassed. The Bitcoin user takes direct control of his money. He can access his Bitcoins everywhere, simply via the SIM card in his smartphone.
The tremendous growth in FRB was made possible by the difficulty of transacting securely over long distances with physical gold or physical paper tickets. This created a powerful incentive to place the physical money with banks, and once the physical money was in the banks it became ‘reserves’ to be used for the creation of additional monetary assets.
Channelling true savings into investment is very important, but remember that FRB is something entirely different. It involves the creation of money and credit without any real, voluntary saving to back it. FRB is not only not needed, it is destabilizing for the overall economy. Under gold standard conditions, it created business cycles. Under the system of unlimited fiat money and lender-of-last-resort central banks, it created the super-cycle, which is now in its painful endgame.
Banks make money from payment systems
When I recently made arrangements for a trip to Africa I dealt directly with local tour operators there, which, today, can be done easily and cheaply with the help of email, websites, and Skype. Yet, when it came to paying the African tour operators I had to go through a process that has not changed much from the 1950s. Not only were British and African banks involved, but also correspondence banks in New York. This took time and, of course, cost money in form of additional fees.
Imagine if we could have used gold or Bitcoin! The payment would have been as easy and fast as all the email-communication that preceded it. There would have been no exchange rates and little fees (maybe in the case of gold) or no fees (in the case of Bitcoin).
Another example: Last year I gave a webinar at the Ludwig von Mises Institute (LvMI). The LvMI is located in Auburn, Alabama, I did the seminar from my home in London, the LvMI’s technology officer sat in Taiwan, and the seminar attendants were spread all over the world. All of this is now possible – cheaply, quickly and conveniently – thanks to technology. Yet, when the LvMI paid me a fee it had to go through a few banks – again, correspondence banks in New York – it took quite some time and it incurred additional costs. And the fee from LvMI was paid in a currency that I cannot use directly in my home country.
Banks make money from monetary nationalism
Future economic historians will pity us for having worked under a strange and inefficient global patchwork of local paper currencies – and for having naively believed that this represented the pinnacle of modern capitalism. Today, every government wants to have its own local paper money and its own local central bank, and run its own monetary policy (of course, on the basis of perfectly elastic local fiat money). This is naturally a great impediment to international trade and the free flow of capital.
If I want to spend the money I got from the LvMI where I live (in Britain), I have to exchange the LvMI’s dollars for pounds. I can only do that if I find someone who is willing to take the opposite side of that transaction, someone who is willing to sell pounds for dollars. The existence of numerous monies necessarily re-introduces an element of partial barter into money-based commerce. Sure, the 24-hour, multi-trillion-dollar a day fx market can accommodate me, and do so quickly and cheaply, but this market is only a second-best solution, a highly developed make-shift to cope as best as possible with the inefficiencies of monetary nationalism. The better, most efficient and capitalist solution would be to use the same medium of exchange around the world. The gold standard was a much superior monetary system in this respect. Moving from the international gold standard to a system of a multitude of state-managed paper currencies meant economic regression, not progress.
One hundred years ago, you could take the train from London to Moscow and use the same gold coins all along the way for payment. There was no need to change your money even once. (Incidentally, neither did you need a passport!)
The notion of the ‘national economy’ that needs a ‘national currency’ was always a fiction. So was the idea that economies work better if money, interest rates and exchange rates are carefully manipulated by local bureaucrats. (This fiction is still spread by many economists who make a living off this system.) The biggest problem with monetary policy is that there is such a thing as monetary policy. But in today’s increasingly globalized world, these fictions are entirely untenable. Capitalism transcends borders, and what it needs to flourish is simply hard, apolitical and thus international money. Money that is a proper tool for voluntary human interaction and cooperation and not a tool for politics.
Banks benefit from the present monetary segregation. They profit from constantly exchanging one paper money for another and from foreign exchange trading. Non-financial companies that operate internationally are inevitably forced to speculate in currency markets or to pay for expensive hedging strategies (again paying the banks for providing them).
Banks make money from speculation
There is, of course, nothing wrong with speculation in a free market. However, in a truly free market there would be few opportunities for speculation. Today the heavy involvement of the state in financial markets, the existence of numerous paper currencies, all managed for domestic political purposes, and the constant volatility that is generated by monetary and fiscal policy create outsized opportunities for speculation. Additionally, the easy money that central banks provide so generously to prop up their over-extended FRB-industry is used by many banks to speculate in financial assets themselves, often by anticipating and front-running the next move of the monetary authorities with which these banks have such close relationships. And to a considerable degree, banks pass the cheap money from the central banks on to their hedge fund clients.
Remember that immediately after the Lehman collapse, investment banks Goldman Sachs and Morgan Stanley, which previously had shunned deposit and retail banking but have always been heavily involved in securities trading, quickly obtained banking licenses in order to benefit from the safety-net the state provides its own fiat-money-deposit banks.
Banks channel savings into investment
Yes, to some degree they still do this, and this is indeed an important function of financial intermediaries. However, asset managers can do the same thing, and they do it without mixing this services with FRB and money-creation. In general, the asset management industry is much more transparent about how it allocates its clients’ assets, it has a clear fiduciary responsibility for these assets, and it cannot use them as ‘reserves’. In the gold or Bitcoin economy of the future, you will, of course, be free to allocate some of your money to asset managers who mange investments for you.
Have I been too harsh on the banks? – Maybe. The bankers, in their defence, will say that they are not the source of all these inefficiencies, that they simply help their clients deal with the inefficiencies of a state-designed and politicized monetary system – and that they reap legitimate rewards for the help they provide. – Fair enough. To some degree that may be true. But it is very clear that the size, the business models, the sources of profitability, and the problems of modern banks are uniquely and intimately linked to the present, fully elastic paper money system. As I tried to show, even if the paper money system was meant to last – and it certainly is not – the forces of capitalism, the constant search for better, more efficient and durable solutions, coupled with technological progress, would put enormous market pressures on the present banking industry in the years to come. But given that our present system is not the outcome of market forces to begin with, that a system of fully elastic, local state monies is not necessary, that it is suboptimal, inefficient, unstable, and unsustainable, and that it is already in its endgame, I have little doubt that modern banks will go the way of the dodo. They are to the next few decades what the steel and coal industries were to the decades from 1960 to 1990. They are parastatal dinosaurs, joined at the hip with the bureaucracy and politics, bloated and dependent on cheap money and state subsidy for survival. They are ripe for the taking.
The demise of the paper money system will offer great opportunities for a new breed of money entrepreneurs. In that role, I could see gold storage companies, payment technology companies, Bitcoin service providers and asset management companies. If some of these join forces, the opportunities should be great. The world is ready for an alternative monetary system, and when the present system collapses under the weight of its own inconsistencies, there would be something there to take its place.
The present fiat money economy is ripe for some Schumpeterian ‘creative destruction’.
In the meantime, the debasement of paper money continues.
This article was previously published at Paper Money Collapse.
Under cover of its multiplicity of fabricated wars on drugs, terror, tax evasion, and organized crime, the US government has long been waging a hidden war on cash. One symptom of the war is that the largest denomination of US currency is the $100 note, whose ever-eroding purchasing power is far below the purchasing power of the €500 note. US currency used to be issued in denominations running up to $10,000 (including also $500; $1,000; $5,000 notes). There was even a $100,000 note issued for transactions among Federal Reserve banks. The United States stopped printing large denomination notes in 1945 and officially discontinued their issuance in 1969, when the Fed began removing them from circulation. Since then the largest currency note available to the general public has a face value of $100. But since 1969, the inflationary monetary policy of the Fed has caused the US dollar to depreciate by over 80 percent, so that a $100 note in 2010 possessed a purchasing power of only $16.83 in 1969 dollars. That is less purchasing power than a $20 bill in 1969!
Despite this enormous depreciation, the Federal Reserve has steadfastly refused to issue notes of larger denomination. This has made large cash transactions extremely inconvenient and has forced the American public to make much greater use than is optimal of electronic-payment methods. Of course, this is precisely the intent of the US government. The purpose of its ongoing breach of long-established laws regarding financial privacy is to make it easier to monitor the economic affairs and abrogate the financial privacy of its citizens, ostensibly to secure their safety from Colombian drug lords, Al Qaeda operatives, and tax cheats and other nefarious white-collar criminals
Now the war on cash has begun to spread to other countries. As reported a few months ago, Italy lowered the legal maximum on cash transactions from €2,500 to €1,000. The Italian government would have preferred to set a €500 or even €300 maximum limit but reasoned that it should permit Italians time to adjust to the new limit. The rationale for this limit on the size of cash transactions is the fact that the profligate Italian government is trying to reduce its €1.9 trillion debt and views its anticash measures as a means of cracking down on tax evasion, which “costs” the government an estimated €150 billion annually.
The profligacy of the Italian ruling class is in sharp contrast to ordinary Italians who are the least indebted consumers in the eurozone and among its biggest savers. They use their credit cards very infrequently compared to citizens of other eurozone nations. So deeply ingrained is cash in the Italian culture that over 7.5 million Italians do not even have checking accounts. Now most of these “bankless” Italians will be dragooned into the banking system so that the notoriously corrupt Italian government can more easily spy on them and invade their financial privacy. Of course Italian banks, which charge 2 percent on credit-card transactions and assess fees on current accounts, stand to earn an enormous windfall from this law. As controversial former prime minister Berlusconi noted, “There’s a real danger of crossing over into a fiscal police state.” Indeed, one only need look at the United States today to see what lies in store for Italian citizens.
Meanwhile the war on cash in Sweden is accelerating, although the involvement of the state is less overt. In Swedish cities, cash is no longer acceptable on public buses; tickets must be purchased in advance or via a cell-phone text message. Many small businesses refuse cash, and some bank facilities have completely stopped handling cash. Indeed in some Swedish towns it is no longer possible to use cash in a bank at all. Even churches have begun to facilitate electronic donations from their congregations by installing electronic card readers. Cash transactions represent only 3 percent of the Swedish economy, while they account for 9 percent of the eurozone and 7 percent of the US economies.
A leading proponent of the anticash movement is none other than Bjorn Ulvaeus, former member of the pop group ABBA. The dotty pop star, whose son has been robbed three times, believes that a cashless world means greater security for the public! Others, more perceptive than Ulvaeus, point to another alleged advantage of electronic transactions: they leave a digital trail that can be readily followed by the state. Thus, unlike countries with a strong “cash culture” like Greece and Italy, Sweden has a much lower incidence of graft. As one “expert” on underground economies instructs us, “If people use more cards, they are less involved in shadowy economy activities,” in other words, secreting their hard-earned income in places where it cannot be plundered by the state.
The deputy governor of the Swedish central bank, Lars Nyberg, gloated before his retirement last year that cash will survive “like the crocodile, even though it may be forced to see its habitat gradually cut back.” But not everyone in Sweden is celebrating the dethronement of cash. The chairman of Sweden’s National Pensioners’ Organization argues that elderly people in rural areas either do not have credit or debit cards or do not know how to use them to withdraw cash. Oscar Swartz, the founder of Sweden’s first Internet provider, a supporter of the phasing out of cash, argues that without the adoption of anonymous payment methods, people who send money and make donations to various organizations can be “traced every time.” But, of course, what the artless Mr. Swartz does not see is that this is the whole point of a cashless economy — to make even the most intimate economic affairs of private citizens transparent to the state and its fiscal and monetary apparatchiks, who themselves hate and fear transparency like vampires do sunlight. And then there are the benefits that accrue to the government-privileged banking system from the demise of cash. One Swedish small businessman shrewdly noted the connection. While he gets charged 5 kronor (80¢) for every credit-card transaction, he is prevented by law from passing this on to his customers. In his words, “For them (the banks), this is a very good way to earn a lot of money, that’s what it’s all about. They make huge profits.”
Fortunately, the free market provides the prospect of an escape from the fiscal police state that seeks to stamp out the use of cash through either depreciation of central-bank-issued currency combined with unchanged currency denominations or direct legal limitation on the size of cash transactions. As Carl Menger, the founder of the Austrian School of economics, explained over 140 years ago, money emerges not by government decree but through a market process driven by the actions of individuals who are continually seeking a means to accomplish their goals through exchange most efficiently. Every so often history offers up another example that illustrates Menger’s point. The use of sheep, bottled water, and cigarettes as media of exchange in Iraqi rural villages after the US invasion and collapse of the dinar is one recent example. Another example was Argentina after the collapse of the peso, when grain contracts (for wheat, soybeans, corn, and sorghum) priced in dollars were regularly exchanged for big-ticket items like automobiles, trucks, and farm equipment. In fact Argentine farmers began hoarding grain in silos to substitute for holding cash balances in the form of depreciating pesos.
As has been widely reported recently, an unlikely crime wave has rapidly spread throughout the United States and has taken local law-enforcement officials by surprise. The theft of Tide liquid laundry detergent is pandemic throughout cities in the United States. One individual alone stole $25,000 worth of Tide detergent during a 15-month crime spree, and large retailers are taking special security measures to protect their inventories of Tide. For example, CVS is locking down Tide alongside commonly stolen items like flu medications. Liquid Tide retails for $10–$20 per bottle and sells on the black market for $5–$10. Individual bottles of Tide bear no serial numbers, making them impossible to track. So some enterprising thieves operate as arbitrageurs buying at the black-market price and reselling to the stores, presumably at the wholesale price. Even more puzzling is the fact that no other brand of detergent has been targeted.
What gives here? This is just another confirmation of Menger’s insight that the market responds to the absence of sound money by monetizing highly salable commodities. It is clear that Tide has emerged as a subsidiary local currency for black-market, especially drug, transactions — but for legal transactions in low-income areas as well. Indeed police report that Tide is being exchanged for heroin and methamphetamine and that drug dealers possess inventories of the commodity that they are also willing to sell. But why is laundry detergent being employed as money, and why Tide in particular?
Menger identified the qualities that a commodity must possess in order to evolve into a medium of exchange. Tide possesses most of these qualities in ample measure. For a commodity to emerge as money out of barter, it must be widely used, readily recognizable, and durable. It must also have a relatively high value-to-weight ratio so that it can be easily transported. Tide is the most popular brand of laundry detergent and is widely used by all socioeconomic groups. Tide also is easily recognized because of its Day-Glo orange logo. Laundry detergent can also be stored for long periods without loss of potency or quality. It is true that Tide is somewhat bulky and inconvenient to transport by hand in large quantities. But enough can be carried by hand or shopping cart for smaller transactions while large quantities can easily be transported and transferred using automobiles.
Just like the highly publicized war on drugs that the US government has been waging — and losing — for decades, it is doomed to lose its surreptitious war on cash, because the free market can and will respond to the demand of ordinary citizens for a reliable and convenient money.
This article was previously published at Mises.org.
Two days ago, Greg Smith, a Goldman Sachs executive director, resigned in sensational fashion, writing a column in the New York Times. In the article, he laid out the reasons for his resignation, citing the change in culture at the firm over the ten years he worked there. He wrote,
It might sound surprising to a skeptical public, but culture was always a vital part of Goldman Sachs’s success. It revolved around teamwork, integrity, a spirit of humility, and always doing right by our clients. The culture was the secret sauce that made this place great and allowed us to earn our clients’ trust for 143 years. It wasn’t just about making money; this alone will not sustain a firm for so long. It had something to do with pride and belief in the organization.
In particular, he attacked what he sees as the 3 ways to get ahead at Goldman Sachs:
- “persuading your clients to invest in the stocks or other products that we are trying to get rid of because they are not seen as having a lot of potential profit.”;
- “get your clients — some of whom are sophisticated, and some of whom aren’t — to trade whatever will bring the biggest profit to Goldman”; and
- “Find yourself sitting in a seat where your job is to trade any illiquid, opaque product with a three-letter acronym”
While the article might have been dismissed as one disillusioned ex-employee’s rant, it will ring all too true across the financial sector. The Motley Fool reports Goldman Isn’t Alone in the Delicate Art of Ripping Off People. After quoting some illustrative returns, fees and rewards in the industry, the author writes:
The clients that Goldman and the rest of Wall Street rip off are skilled at ripping off their own clients, thank you very much. Each is part of the same game of inflating expectations and overcharging fees — a system summarized best by the title of Fred Schwed’s classic book, Where Are the Customers’ Yachts?
And then he points out that the losers, the client’s clients, are people like you and me: savers, pension fund beneficiaries and retired schoolteachers. The article finishes by asserting that Goldman is just one example of “putting personal interests before clients.”
How did all this come to pass?
In 1999, just over ten years ago, Goldman Sachs went through a public listing. It had previously operated as a partnership but now it is majority owned by institutional investors.
Over on Forbes, an article explains the difference in incentives between a bank run as a partnership and one run as a traded corporation: the switch in incentives is from long-term success to short-term results. The author gives some persuasive arguments for the partnership model and says investment banks should be required to return to it. He finishes,
Real banking reform isn’t about lashing out, but about restoring the connection between bankers’ profits and the economy they serve.
Which is why, as part of my work on injustice in the financial system, I introduced my Financial Institutions (Reform) Bill. The Bill would minimise moral hazard within the financial system by ensuring that those who take risks are held personally liable for the consequences. It would realign bankers’ rewards, their risks and their actions in the real economy. I said,
Hard-working families and individuals paying tax out of typically modest incomes must never again suffer the injustice of carrying the risks, and consequences of risks, taken in the pursuit of often enormous private returns. Risks must fall to those who take them. Instead of vicarious liability of taxpayers, there must be responsibility in the banking system. The Bill represents an opportunity to free the banking sector and the public from regulatory capture and lobbying. It could raise standards from the bottom up, through the preservation and extension of commercial freedom and the development of professional, personal and mutual responsibility.
At the time, I had no idea that yesterday I would meet David Fishwick, founder of a savings and loans firm in Burnley, who is delivering just that. It began when he found people could not buy from his van business for want of credit, so he started making loans himself. He’s an entrepreneur, a self-made multi-millionaire from ordinary beginnings.
Channel 4 are now making a documentary about Dave’s attempts to start a decent bank which serves both savers and businesses. The Lancashire Telegraph reports,
“My bank may be tiny but it will be better than a high street bank. I want to show how banking can be socially responsible and not greedy and reckless and I’m going to do what the high street banks just can’t bring themselves to do, give away any profits to charity.”
The venture will see him guarantee and underwrite all the banking activity from his personal fortune.
It’s quite a rebuff to all those who told me no-one would run a bank if they had to put their own assets at risk. As I pointed out, some of history’s greatest bankers bore their own risks without limit. Now, Dave Fishwick is demonstrating that the basic business of banking — intermediating savings to entrepreneurs through productive loans — is an enterprise which individuals will back with their own wealth.
Dave’s banking business is small. The FSA essentially won’t meet him and no wonder: they make their money from fees levied on those they regulate. Dave’s business is presumably too small to cover the FSA’s costs. So he doesn’t have a banking licence, accepting savings and making loans on a different legal basis. His business, as he tells it, is based on his personal guarantee, trust and entrepreneurship. In the terms Hazlitt explained, credit is something people bring to Dave, through running profitable businesses, and that’s what enables him to make loans out of people’s precious savings, personally underwritten by him.
Dave Fishwick may yet fail. His business may be crushed out of existence by a dull and clumsy state. But I have said time and again that we need a new generation of local financial institutions which reconnect savers and productive businesses. It seems Dave is redeveloping the teamwork, integrity, spirit of humility and sense of “always doing right by our clients” which used to engender pride and belief amongst Goldman Sachs’ staff. There will always be a place for large, sophisticated firms but, together with ideas like Funding Circle, Dave’s enterprise may indicate that a new, more responsible and productive financial system is emerging spontaneously in society.
I look forward to watching the documentary in the next couple of months.
This article was previously published at stevebaker.info.
Earlier today Conservative Steve Baker MP put forward a Private Member’s Bill, the Financial Institutions (Reform) Bill, which outlines a programme of radical reforms to the banking system and calls for an end to state meddling in banking. Steve is co-founder of the Cobden Centre, and has been MP for Wycombe since May 2010.
The underlying principle of his Bill is to minimize moral hazards within banking, by making those who make or preside over risk-taking as liable as possible for the consequences of that risk-taking. Since financial institutions often circumvent rules, the Bill also includes mutually reinforcing measures that minimize scope for evasion.
Within this framework, bankers would be free to do as they wished, but they would bear the consequences of their own actions.
Thus, Steve’s Bill addresses the rampant moral hazard problems within the modern banking system, and this is the central issue in putting the banking system back on its feet and restoring its integrity. Indeed, his proposals provide nothing less than a free-market solution to the current banking crisis
I would therefore ask all supporters of free markets to promote this Bill and to push for similar measures in other countries.
One key provision of the Bill is to make bank directors strictly liable for bank losses and require them to post personal bonds as additional bank capital. These measures reaffirm unlimited personal liability for bank directors, and will rule out all-too-familiar “It wasn’t my fault” excuses on their part.
The Bill also calls for bonus payments to be deferred for five years, and for the bonus pool to be first in line to cover any reported bank losses. Any reported losses would be covered first out of the bonus pool and then out of directors’ personal bonds before hitting shareholders.
These measures would provide strong incentives for key bank decision-makers to ensure responsible risk-taking, as their own wealth would now be very much at risk.
Amongst other measures, the Bill:
- Proposes a tough bank solvency standard, and would require any insolvent bank to be automatically put into receivership;
- Calls for the Government to propose a fast-track receivership regime for insolvent banks and to produce a plan and associated timetable to end all state involvement in the banking system;
- Calls for accounts to be prepared using the old UK GAAP governed by Companies Act legislation, as proposed in Steve’s previous (2011) Private Member’s Bill, the Financial Services (Regulation of Derivatives) Bill. This would put an end to the various accounting shenanigans associated with IFRS accounting standards; and
- Calls for the establishment of a Financial Crimes Investigation Unit to investigate possible crimes committed by senior bankers: this Unit would investigate all banks that have failed or received public assistance since 2007 and would replace the Financial Services Authority, which has proven to be utterly useless.
Further details of the Bill can be found on Steve’s website:
I am an artist and serial entrepreneur, and I, like many, have been pillaged and plundered by the United States government. Heckle Sketch is my latest means of satirically venting frustration while communicating important messages about freedom and free market capitalism that are lost to the majority. The majority includes a government which was founded on such principles.
I have been involved in creating successful, innovative businesses for the past 16 years. I have lofty, but also realistic, visions for the advancement of mankind through biotechnology, space colonization, energy efficiency, etc. I have believed I can make a contribution toward these advancements through free market business creation and relevant investment. I am now realizing that I have been duped.
My latest venture, Tangerine Wellness, is a free market solution to rising health care costs, which the U.S. government cannot successfully address. The solution offers financial incentives to employees of large corporations for weight-loss and maintenance – lose weight, earn money is the motto. It is a solution that makes people healthier and has decreased healthcare costs for our clients.
Tangerine is solving the healthcare cost problem, yet we are being hindered from continuing to do so. In addition to the mountains of bureaucracy added to prospective clients’ operations because of massive healthcare reform, the changes have instilled uncertainty about their approach to employee wellness and about offering healthcare coverage at all. Prospective clients are not making market-driven decisions about the health of their employees, nor their healthcare coverage. They are basing their decisions on government coercion, which will result in continued rising healthcare costs.
When you spend over seven years putting your energy, heart and soul into a profitable endeavour that actually solves a major problem only to have the concept dismissed on government whim, you begin to question whether continuing to innovate is worth it. It is one thing to deal with natural free market forces; it is another to deal with free market forces as a secondary factor to unpredictable government intervention. Tangerine continues to be profitable and is wisely shifting toward a consumer-direct approach, but that is no cause for excitement when around the corner could be any new bulldozing regulation.
My nutshell story of Tangerine cuts to the point I am trying to make while leaving out many other similar painful, government-related experiences both in this and past endeavours. Driven by a need to understand the nature of the beast that threatens my survival, I have dug deeply into the landscape of economic theories and schools of thought. I see clearly why government is harming my businesses and others, why it is the core cause of our massive economic crisis, why it is stifling innovation and the advancement of mankind, and why it is so hopeless to expect the system to repair itself.
So, what does one do when one’s dreams are shattered by government injustice and there is no hope to fix the root causes through the current system? Well, if you’re also an artist with a sense of humour, you make fun of the injustice through art while trying to make it a form of education toward a brighter future. “Ben and the Fat Cat Banksters” is my first painting to do this by humorously exposing the harm the Fed produces through fiat money printing and bailouts. Do not be fooled – so long as I can put a brush to a canvas, or commission others to do so, every perpetrator of freedom and free market capitalism that exists will be…HECKLE SKETCHED!
Following his recent paper The law of opposites: Illusory profits in the financial sector, TCC Advisory Board member and founder of Cobden Partners Gordon Kerr appeared on Bloomberg. The video is here.
Click for video
Gordon dealt with the flaws in IFRS, the reasons for the debt crisis, the case for hardening money, the need for international money in support of trade and more.
Later in the day, I said in the Commons that the Government’s response to the ICB report seemed to take accounting for granted, asking the Chancellor to consider the issue seriously in the forthcoming white paper.
I was asked recently why it is that market forces do not push down the wages of the top earners in financial services. The answer, it would seem to me, is that the profitability of the financial services sector is based on privilege, rather than normal economic activity, and it is this that drives hiring behaviour.
In a normal industry, where there is a profitable project, a number of different entrepreneurs have the ability to invest in this area. The act of investing produces a good that a consumer buys. The more of these goods produced, the lower the price that consumers will pay such that the profit making opportunity diminishes and the ability to pay higher wages/expand the business diminishes. This process is good for society since it provides more goods demanded by the public at lower prices. The entrepreneurs are motivated to hire additional people in order to invest in these areas increases profits to themselves. A beautiful system, I’m sure you’ll agree.
However, the profits of the financial service industry are far in excess of where they would be in a true market economy without fractional reserve banking/fiat currency/central banks. Profits within the industry are essentially a product of the net interest margin (difference between interest rates at the short and long end of the curve) and the outstanding liabilities (more credit lent means more profit).
The central bank’s action keeps the net interest margin wide since it buys government debt at the short end of the curve and has an inflationary bias. In addition, the ability of the central bank to continue to bail out the industry should it get into “liquidity” trouble encourages more risky behaviour – both in taking on additional leverage and taking additional duration risk. Hence the product of net interest margin and liabilities is artificially kept high by central bank action. These excess profits are paid for by the rest of society through higher inflation.
Given that the vast majority of the banking sector’s profitability is dependent on privilege, it makes no sense for a firm to hire additional people in order to exploit profit making opportunities – there are no opportunities. The rational response is to hire no one at all, except in the case where hiring defends and extends this privilege. This explains the army of remuneration consultants, the bank-funded pro-central bank economists, the lobbyists, the symbiotic relationship between government and banks particularly evident in the higher echelons of the US government where officials seem to pass between top positions in government and on Wall Street so easily.
Some hiring of people of course is inevitable in order that administrative work is done, and this is also beneficial in defending privilege since the industry can argue to the government, from whence its privilege comes, that it is an importnant provider of jobs. However, the insiders with the top positions are very reluctant to hire additional people since this would not increase their wealth though providing additional goods with demand, but rather dilute their privilege through more heads.
Reproduced by kind permission of Jacob Wolinsky at ValueWalk.com
Can you tell us a little bit about your background?
I studied economics in my home country, Germany, and joined J.P. Morgan as a trader in Frankfurt in 1990. By 1996 I had become a portfolio manager in J.P. Morgan’s asset management division and moved to London, which I still call my home. I specialized in European and global bond portfolios. From 1998 to 2001 I worked at Merrill Lynch Investment Managers, which has since become part of BlackRock, and in 2001 I joined Western Asset Management, the Pasadena-based bond specialist. For Western I oversaw their London-based investment team and was lead portfolio-manager for all their global strategies. When I left Western in 2009 my team there oversaw roughly $65 billion in assets under management for institutional clients from around the world. I look back on my years in the business with many fond memories. I worked with some interesting people and had some fascinating clients. But by 2009 I had become very pessimistic on our financial system as a result of my study of Austrian School economics and my own experience after almost two decades in the business. The two perspectives combined to form a rather unpleasant outlook. I wanted to step outside the industry, think things through, and write a book about it.
What investing style do you subscribe to?
I am not sure I subscribe to any identifiable style, or that I even consider it particularly desirable to do so. Let me explain. I spent almost 20 years in the institutional asset management business. There is very limited room to develop your own style to begin with. These companies are asset-gathering companies. They need to constantly grow and attract new clients. In order to do that they not only try to establish a decent track record but also a specific house style and a clear and distinguishable process that they can market. They try to create a brand. As a portfolio manager you have to play along and do things in a way that fits the process. Incidentally, that was something I was actually quite good at. Now it so happens that certain styles work for some time and then stop working. Markets constantly change. In the industry, however, whenever somebody has good numbers for a while and a good story about how those numbers have been generated, he is usually in a sweet spot. New clients come rushing in. But I have become very cynical in this regard. That is usually the moment you should sell these firms or money mangers. I accept that my take on the style-question is unusual. But that is how I see it.
The truth is I tried many different things over the years. Only now, that I am out on my own, outside the mainstream industry, can I look at things with an entirely open mind, which is refreshing. I like Doug Casey’s distinction between traders, investors and speculators. Many people call themselves investors when what they really do is trading. This is certainly true of many ‘investors’ in the asset management industry. I would now call myself a speculator. Most of the time you do nothing. Until you spot a major dislocation, or a major event or an opportunity, something that you have a completely different view on from most other people. That’s when you go in and take risk. Example: I am convinced this crisis is misunderstood by most. We are witnessing the failure of our fiat money system. This will get much worse. I try to position myself for it.
What attracted you to the Austrian school of thought?
I came across some writings by F.A. Hayek by chance more than twenty years ago. I can honestly say that I felt immediately that I was reading something special, something that made sense, that was true. I found it exceptionally convincing, and it made a huge impression on me. For the next four years I read everything Hayek wrote. Then, I discovered the other Austrians, Mises, Rothbard, Menger. To sum it up, I would say that it is the methodology that makes the Austrian School so special. Ludwig von Mises, for me, is the unsurpassed master of the Austrian School. He understood better than anybody what economics is about, what it can do and what it cannot do, and how it should go about it. Austrian School Economics starts with the individual actor. Purposeful individual action and human cooperation on markets is the driving force behind all economic phenomena. From the starting point of the individual, the Austrians reconstruct and explain all institutions of the market – from the bottom up, so to speak. By contrast, most modern economists approach economics as if it was a natural science, where we must collect observations, statistical data, and look for patterns. This is the right approach for natural sciences because in nature we can’t perceive of purposeful action. But we do understand the actions of humans in the economy. The approach can be and has to be different. Furthermore, macroeconomists implicitly assume that the statistical aggregates and the large wholes that they work with in their models (consumption, investment, retail spending, aggregate demand, and so forth) are what really interact with one another in the real world. This is a tremendous intellectual error. The economy is ultimately driven by countless individual decision-makers. The Austrians do not lose sight of that.
It is no surprise to me that the Austrian School has such a strong appeal for real-life entrepreneurs and risk-takers. No other school of thought understands entrepreneurship, risk-taking, capital accumulation and capital maintenance, relative prices and the real-life elements of time and error, like the Austrian School does. Of course, politicians, central bankers and state bureaucrats are, by contrast, drawn towards mainstream macroeconomics. It gives them the illusion that the economy can be planned and manipulated from the top down.
What inspired you to write a book?
When you begin to understand Austrian monetary theory you realize that our financial system is built on quicksand – elastic, constantly expanding fiat money to be produced without limit and at full discretion by the central banks. I realized that the growing instabilities and dislocations that I observed in my work-life as a portfolio manager over the past two decades were the inevitable consequence of our monetary infrastructure. What amazed me was that nobody around me saw it that way. Whenever a credit boom threatened to turn into a credit bust – as it sooner or later must – everybody was calling for a monetary stimulus, for lower rates and for policy accommodation to extend the credit boom further. Such a policy may indeed prevent a correction now, but only at the cost of making an even bigger correction necessary in the future. But everybody in financial markets is so indoctrinated with a specific and narrow subset of modern macroeconomics – I would say the most toxic aspects of Keynesianism and Monetarism – that everybody believes any policy to be a good one if it only creates some near-term GDP boost. There is no perception of long-term dislocations and market imbalances, of what the consequences of such a policy of artificially cheap credit must ultimately be. I think a gigantic intellectual bubble exists in which most financial market participants operate. That bubble will probably only get pricked by real events, i.e. the massive crisis that is now unfolding. But I wanted to try and give people a different perspective, to debunk some of the erroneous common wisdom that is readily accepted by so many people in the business.
Can you explain to people what your definition of money is?
Money is the medium of exchange. It is the most fungible good in the economy and therefore most readily facilitates exchange of property. It is neither a consumption good nor an investment good. We hold it not to satisfy any of our consumption needs, nor to generate a return. We have demand for it because it gives us flexibility. To hold money balances means to hold purchasing power in its most readily tradable form.
Capitalism developed on the basis of inelastic, inflexible and apolitical commodity money, such as gold and silver – inelastic in its supply and outside political control. Today we live in a world of entirely elastic paper money under discretion of the state, and for the first time in history, such a system spans the entire globe. Remember also, that today’s fiat money system only came into full bloom on August 15, 1971.
Today, most mainstream economists maintain that the perfect elasticity of the money supply is a plus. My book argues that this is wrong. The relative inelasticity of gold makes gold a superior form of money. Elastic money systems must ultimately collapse. Throughout history they always have.
Can you tell us about the US system pre-Fed era?
I should stress first that I am not a monetary historian, although there is a short chapter on the history of paper money systems in my book – all of these systems collapsed by the way. Understanding monetary systems requires theory. History can illuminate concepts or raise new questions. Only theory can explain.
Prior to the founding of a central bank, the Federal Reserve, in 1913 and the subsequent abandonment of a gold anchor in 1933 (domestically) and 1971 (internationally), the US used, for the most part, commodity money. I say ‘for the most part’ as America conducted some interesting experiments with paper money as well, all of them complete disasters. In fact, one of the first historic examples of a paper money system outside Medieval China, was Massachusetts, which, in 1690 when still a British colony, issued paper money to fund military excursions into French Quebec. Then there were the famous continentals, a paper money issued by the Continental Congress in 1775 to fund the Revolutionary War. These early experiments with paper money ended like they always do – with worthless paper tickets. Then in the early part of the 19th century the dollar was defined as a specific amount of gold. This was proper commodity money, a gold standard. There was no central bank. Gold was money. Commercial banks had to redeem their banknotes in specie, which set tight limits on bank credit creation. But the government couldn’t stop interfering, in particular whenever it needed cheap credit, usually to fund wars. Requirements to redeem in physical gold were lifted on a couple of occasions, so in the wake of the War of 1812, when the US was fighting Britain again, and most famously during the Civil War, when the greenbacks were issued and soon inflated into worthlessness. In 1879, the US joined Britain, and in fact most of the then industrialized world, in what became known as the Classical Gold Standard. After the inflation of the greenback era, a corrective deflation was allowed to unfold (but strong economic growth continued nevertheless), and from 1879 to 1914 there was no meaningful deflation or inflation in the system at all. This was a time of hard, inflexible and stable money. This was a period– in the US and globally – of solid economic growth, rising living standards and growing international trade, and of harmonious economic relationships between countries. The Classical Gold Standard was not perfect but probably the best monetary system we have had so far.
Many people have proposed going back to the gold standard? We had many depressions and recessions while on the gold standard, do you think it would be a good idea?
Yes, we should definitely return to a gold standard — not one that is “managed” by the government, but a proper gold standard with no involvement of the state. I wouldn’t hold my breath, however. As we have seen, governments love fiat money. It gives them control over the economy. We will eventually return to some form of gold standard but only after the complete collapse of the present system in a major crisis.
The elasticity of money – which means periods of money expansion and credit booms followed by periods of monetary stagnation or contraction – is the main cause of business cycles. How did this occur under a gold standard? Answer: the spread of deposit banking and fractional-reserve banking, in particular in the late 19th century. These banking practices introduced an element of elasticity into the money supply. They can be profitable for the banks but they are risky and are destabilizing for the broader economy, even under gold standard conditions. That is why many Austrians argue for a 100-percent gold standard, for 100 percent reserve banking. I am not in that camp. I think fractional-reserve banking should not be banned, cannot be banned, and ultimately does not need to be banned. Many of these issues can be solved in a free market. We may have the occasional recession but the system can cope with that.
However, the Fed was founded in a joined effort by politicians and bankers in order not to restrict and contain fractional-reserve banking but, to the contrary, in order to encourage and subsidize it. Money has since not become less elastic but much more elastic. Of course, credit cycles still occur. They now only get much, much bigger. We had a thirty-year credit boom. We will now get a major credit bust. Compared to what we are facing now, the recessions of the gold standard era will look like a walk in the park.
Why do most policy makers seem to be in the Keynesian school and not the Austrian school of thought?
Please remember my answer to the question above about the appeal of the Austrian School. The methodology of the Austrians is superior, but the methodology of mainstream macroeconomics, and Keynesianism in particular, is appealing to politicians. These schools perceive the economy as an organism that sometimes performs below potential, which then provides a convenient excuse for the politicians to get involved. Keynesianism has popularized the concept of ‘aggregate demand’. A recession is now seen simply as a lack of aggregate demand. So politicians have a pseudo-scientific excuse to run deficits and spend money they don’t have. Strangely, the fact that “lack of aggregate demand” can at best be a symptom but hardly an explanation of the recession does not appear to bother too many people.
Truth is, the recession is the result of imbalances that the economy accumulated during the previous artificial credit boom. Once these dislocations (such as excessive levels of debt, overextended banks and inflated asset markets) exist, the cleansing of a recession is needed and unavoidable. That is not a popular message among politicians.
Greece was forced to implement austerity and the budget deficit as % of GDP went up and unemployment skyrocketed. What are your thoughts on the reason why this occurred?
That is not surprising at all. You have to remember that in today’s world GDP is a very poor measure of economic health. In the EU, 50 percent of recorded economic activity is conducted by the public sector. In my adopted home country, the UK, it is 53 percent. The public sector spends more money than all private individuals and corporations put together. This is more socialism than capitalism.
We don’t have to assume that everything the state does is pure waste. For some of these things there would be a proper demand even in a state-less free market. However, we – and in fact the state bureaucrats as well – have no means of telling what is truly demanded by the buying public and what is of marginal or of no productivity, and what is thus complete waste, because the public sector operates outside of market prices and without the guidance of profit and loss. But whatever the state does enters the GDP statistic just the same.
So whenever the state is being cut back – which hardly ever happens, only in cases of default, which is why I am a big advocate of government defaults – a lot of things drop out of the GDP statistics and unemployment goes up because public sector employees are laid off. This drop in GDP is not a lasting problem. We know that a lot of state activity was at least suboptimal to begin with. Now resources (including labor) are being redirected to the private sector, where they will eventually be employed again, and this will enhance wealth and prosperity in the long run. In my view, Greece should stop paying anything to her creditors, declare full default, and shrink the state drastically. For a short while, the statistics would look dreadful. Then Greece would have a massive and lasting recovery. With no debt, a small state and a free economy it could, after some time, outperform everybody else in Europe.
Taxes went up in the Clinton era and the economy still boomed, do you think slightly increasing taxes will be detrimental to the economy?
I object to taxes for moral and ethical reasons (which are subjective) and economic considerations (which are objective). Taxes are always detrimental to the economy. They were so, too, under Clinton. It so happened that other things outweighed their negative impact. Remember, the mega credit boom that started in the early 80s was still in full swing, the Greenspan put was still operable, the NASDAQ bubble was still being inflated. Some of the growth of those years was genuine, that is, based on entrepreneurship, capital creation and innovation, but a lot of it was also the result of easy money. Under these circumstances the tax hikes were not felt that much, that is all.
Today’s environment is very different. The credit boom has ended, and has ended for good. The state and the financial sector have benefitted most from decades of cheap credit and are now severely overstretched. The economy overall is much weaker. Higher taxes would be detrimental. Also, the idea that the gigantic government deficits could be closed with higher taxes is idiotic. To the US I would give the same advice as I just gave to Greece: default, shrink the state massively, go back to hard money. Alas, they won’t do it.
I am curious what you think about the major currencies; Dollar, Euro, Yen, some of the emerging countries?
They are all locked in a deadly race to the bottom. All these currency-areas face the same problems, which are the typical problems of a fiat money system reaching its endgame: massive public debt, uncontrollable deficits, weak banks, addiction to cheap credit and constant asset price inflation. None of these governments want to face up to the reality that they are broke and that what the economy needs is for the market to be allowed to liquidate unsustainable levels of debt and other economic imbalances. As that is deemed politically unacceptable, they will continue to try and buy time by producing ever more currency units and injecting them into financial markets. Inflation and currency destruction will be the endgame. I would stay away from paper money as much as I can. Buy gold and silver instead, and certain other real assets. To guess which of these paper currencies will hit the bottom first is a mug’s game, in my view.
Is inflation or deflation a bigger threat right now?
Inflation and deflation are both unpleasant but it is wrong to call them both an equal threat right now. Allowing deflation now would have a clear advantage, namely it would bring the economy back to a state of balance and toward more proportionate and sustainable structures. A deflationary correction that would allow the liquidation of market dislocations would be painful but it would ultimately restore the economy to health.
If all market interventions, including cheap money from the Fed, would cease now, we would indeed face a sharp economic contraction and most likely a period of deflation. But this is ultimately unavoidable anyway. Current economic structures are simply unsustainable, and the market has a way of dealing with what is unsustainable: liquidate it. The market is craving a cleansing recession, including drops in certain prices. As I said before, this is deemed politically unacceptable. That is why we will get ever more aggressive monetary policy and ever more money printing. This will not solve our problems but it will lead to inflation and most likely complete currency collapse. My outlook for the coming years is inflation, much higher inflation, not deflation. The reason for that is policy.
Hopefully you won’t consider the following analogy tasteless but to ask what is the bigger threat, inflation or deflation, is a bit like asking a cancer patient what is the bigger threat, death or chemotherapy. Nobody will readily embrace either. But it appears to me that in constantly telling us that we need to avoid deflation at all cost, today’s policy establishment is telling us that we should avoid chemotherapy and accept death by hyperinflation.
What are your opinions on Gold?
Gold is the essential self-defense asset. Whenever fiat money systems enter their endgame and are about to collapse, gold comes back. It is the eternal form of money. As Greenspan once said (and he said it when he was already the head the world’s foremost paper money central bank): In extremis, nobody accepts paper money. Gold will always be accepted.
At its current price of $1,720 an ounce I still consider it cheap. Much more fiat money will be created in coming months and years. You want to own something that is not simultaneously somebody else’s liability (such “money in the bank” on your deposit or savings account) and that cannot be created for political purposes at will and without limit, such as paper dollars.
Don’t trade gold, accumulate it.
QEII, Operation Twist, thoughts?
These operations get ever more extreme. It is just part of the logic of the system. We are in a mess because of the trillions that were created out of thin air in the past. To keep the system going a bit longer, the central banks now have to produce ever more money ever faster. Will it stimulate the economy? Yeah, right.
Like a little hamster in his wheel, Bernanke will have to run ever faster to keep the printing press humming and keep the system from correcting. We will get QE 3 and QE 4, no question. By the way, Operation Twist could already be QE3 in disguise. On the face of it, the Fed is just selling short duration Treasuries and buying long duration Treasuries. But the Fed also promised to keep interbank rates near zero for a long time (meaning: forever), and to achieve that they may be buying back short-term Treasuries pretty soon. Listen, there are no exit strategies. The Fed’s balance sheet will continue to grow. It is already bigger than M1. We will get more and more money……
Flashback to September 2008, what do you think the Government should have done?
Nothing. I like Jim Grant’s term: “constructive inaction”. If you believe that the Fed and the government saved us from another Great Depression with all their bailouts and quantitative easing, think again. All they did was postpone the depression – and to make the final disaster worse. All these imbalances are still with us, many of them are larger and have been moved to the state’s balance sheet. Nothing is fixed.
But if you think that this advice – do nothing – is unrealistic and that the government, after having actively supported the build-up of this credit edifice for decades, cannot simply walk away from it once the house of cards finally unravels, then I would suggest the following: Any actions by the government should have been directed toward sustaining the payment infrastructure and maybe to minimize the fallout for bank depositors, who for a long time have actively be lured into entrusting their savings to an increasingly leveraged, government-supported banking system, which has now checkmated itself. I am not suggesting a debt-funded bailout of the deposit base. But the US government allegedly sits on 260 million ounces of gold, some of it confiscated from its own population. Current market value: $450 billion. That could have been handed back to the banks as a backstop against their deposits. This could have been the first step towards abolishing the Fed and returning the country to a gold standard.
If you were Ben Bernanke what would you do now?
Abdicate. His mandate is contradictory and impossible. He is supposed to provide a stable medium of exchange for the American public, and at the same time provide an unlimited backstop for Wall Street and Washington. Well, it is one or the other. We already know which one he chose.
Same question, Barack Obama?
Abdicate is again a good option.
I am not an American so I am looking at this from a distance. It strikes me that the presidencies of George W. Bush and Barrack Obama were both unmitigated disasters for their country. I don’t even think the two as men are necessarily bad or evil. As individuals they may be decent and have good intentions. But the politics are just shockingly bad. The growth of the state, of government involvement in the economy and in all walks of life, the budget deficits, the ever-growing debt pile, the aggressive monetization of debt and the dependency on cheap credit and ongoing market manipulation – this is a complete shipwreck by any standard but, if I may say so, particularly shameful for a country that for freedom-loving people around the world was once a beacon of liberty, opportunity and capitalism. As a generally pro-American libertarian, I can’t tell you how much it hurts to see this once great country go to bits like this.
What needs to be done? Stop printing money, return the country to a gold standard, default on the debt (it will never be repaid anyway!), shrink the state aggressively, stop all foreign wars – the military is the government’s biggest single expenditure item at close to $1 trillion a year.
If you think this is unrealistic then let me tell you that I think all of this will ultimately happen – but not by choice but by necessity, as a result of a massive crisis.
If you were Angela Merkel or Jean-Claude Trichet?
I think that what I said about Bernanke and Obama broadly applies to Merkel and Trichet as well. At the core, the problems are the same. Europe’s problem is not that many different countries share the same currency. Many more and much more different countries did the same between 1879 and 1914 under the gold standard, and it worked very well. The problem is precisely that they do not share an international, apolitical and inelastic commodity money, but a fully elastic and politicized fiat money that comes with built-in expectations of government and bank bailouts. Stop printing money, return to hard and de-politicized money, preferably a gold standard, and shrink the state – the advice is the same.
Who are you endorsing for US President? Ron Paul?
I think the entire political process, not only in the US, but in all modern mass democracies, has become a most degrading and dispiriting spectacle. I agree with P.J. O’Rourke: Don’t vote. It only encourages the bastards. Politics needs to be thoroughly delegitimized as a problem-solving device. It creates more problems than it solves. So I am not endorsing anybody.
Having said this, Ron Paul is, of course, by far the best choice from my point of view. I don’t think that this will surprise you considering what I said above. He is right about ending the wars, abolishing the Fed, returning to a gold standard, shrinking the state. But I fear that he doesn’t have a snowball’s chance in hell to win the presidency. So the crisis will continue. Don’t bet on politics. Trust your own reason. Be prepared.