This was another hectic week for financial markets, and nerves were calmed somewhat over the past 24 hours with another liquidity injection from the central banks – this time the provision of dollars from the U.S. Fed channelled through a few other central banks, most importantly the ECB. This is certainly not a solution but again the doctoring of symptoms. Pumping ever more fiat money into the system to avoid – or rather postpone – a much needed recalibration will not solve the underlying malaise. Four years into the crisis the banks still need emergency funding. That is a damning indictment that financial structures are far from sustainable.
Not a European problem
The euro debt crisis is not a specifically European problem but the European version of a global problem. Decades of constantly expanding fiat money have created a highly distorted global economy and a bloated and excessively indebted financial infrastructure. The fundamental problems are now the same the world over: weak banks, too much debt – now increasingly public sector debt – and a severe addiction to cheap credit.
As I explain in detail in my new book Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown, ongoing and persistent expansion of the money supply must disrupt the market process, it must lead to distortions in relative prices, to misallocations of capital and the accumulation of economic imbalances. The majority of observers ignore these effects. They just see the near-term boost to headline growth and the impact on the price level. Higher inflation is the only negative effect from money production that they can fathom. This is a grave intellectual error.
The key flaw in our system of constantly expanding fiat money – which only came into full bloom in 1971 when the last link to gold was severed – is that those in charge of the money franchise are always tempted to avoid liquidation and correction and to spur the system onward with ever more bank reserves, artificially lowered interest rates and more debt. This has been going on for decades but we have now reached the limit.
Default – painful, yes. Needed? – Definitely
A default of Greece now appears very likely. This is a positive development. Positive as it points toward shrinkage – toward smaller debt, toward a smaller Greek state, toward an important lesson for banks: Don’t think that lending to the state is without risk!
The exposure of European banks to European sovereigns is mind-boggling. It is indicative of a severely distorted and corrupt financial system. This has nothing to do with capitalism. This has nothing to do with free markets. This whole charade gives ‘capitalism’ a bad name. The sooner it ends the better.
With the help of ‘lender-of-last-resort’ central banks and under implicit and explicit state protection, banks have been able to engage in fractional-reserve banking, and therefore money and credit creation, on an unprecedented scale – with many of the loans being in turn extended to the banks’ generous state protectors. Lending to sovereign borrowers used to be a low-yielding but supposedly safe business – very lucrative if you conduct it in size. You may give 5 million to an unstable capitalist enterprise and charge it a hefty interest rate, or you can give 5 billion to the state at a lower rate. What can go wrong?
Back to Greece. Default is now likely and that is a good development. I am not taking lightly the pain that this will cause for many individuals. It will involve hardship. But what is the alternative? The situation is simply beyond repair. The Greek state has maneuvered itself into an unsustainable position. And it is not alone – but probably the first in line.
Default is not the end of the world. It involves the acknowledgement of the debtor that he borrowed too much and the acknowledgement of the lender that he lent too much. Both take a hit.
No bailout
A full-fledged bailout by Greece seems no longer an option. The Germans are unwilling to do it – and let’s face it, they don’t have the money for it, contrary to the caricature in parts of the press of Germany as an economic powerhouse with unlimited resources. Of course, the German government could borrow the money at a lower rate than anybody else but this would set a dangerous precedent. Italy and Spain would be next in line.
The biggest risk to the euro is not a Greek default but the markets waking up to the bleak long-term outlook for the solvency of the core, Germany and France. The bizarre willingness with which the markets continue to treat German Bunds (and for that matter, U.S. Treasuries) as absolutely safe assets is one of those aspects of the crisis that feels surreal and unsustainable but that have thus far allowed the system to stagger on. The Germans would do nobody a favour by risking the standing of their bond market as a safe haven – however unfounded that standing may appear on closer inspection. The moment the market thinks the core is in trouble, the euro will be in trouble.
It also appears unlikely that the ECB can save Greece. Full-scale debt monetization – with disastrous consequences for the euro – still seems a very likely endgame. This, to me, is still the biggest risk, namely that a correction of the system’s excesses through default, balance sheet reduction and credit contraction will not be allowed to occur for political reasons as the short term impact on growth and employment would be considered unacceptable. But as the system will – sooner or later – contract, this could trigger a massive monetary expansion by the central banks. But not yet, I think, not for Greece.
A very old and well known story is told in Genesis 11. It is the story of the curse of Babel:
Now the whole world had one language and a common speech. As people moved eastward, they found a plain in Shinar and settled there.
They said to each other, “Come, let’s make bricks and bake them thoroughly.” They used brick instead of stone, and tar for mortar. Then they said, “Come, let us build ourselves a city, with a tower that reaches to the heavens, so that we may make a name for ourselves; otherwise we will be scattered over the face of the whole earth.”
But the LORD came down to see the city and the tower the people were building. The LORD said, “If as one people speaking the same language they have begun to do this, then nothing they plan to do will be impossible for them. Come, let us go down and confuse their language so they will not understand each other.”
So the LORD scattered them from there over all the earth, and they stopped building the city. That is why it was called Babel—because there the LORD confused the language of the whole world. From there the LORD scattered them over the face of the whole earth.
I retell this tale not for the sake of the theology but for the sake of our present debates. In what follows, the names have been omitted in the hope that I may be excused any hint of misrepresentation…
When I first approached a prominent worldwide leader of the Austrian School, in frustration at the pitiful state of economic debate, to ask who were the UK’s best Austrians, with a view to starting a UK-based Austrian-School think tank, things seemed ever so easy. I had mostly read Mises and a touch of Rothbard. I understood the Austrian school and the monetary theory of the trade cycle but I was not broadly read into the scholarly debate over money.
And then I discovered the curse of Babel amongst the monetary scholars of the free-market.
One eminent free-market British academic believes that central banking, fiat money and fractional reserve deposit taking are institutions which have evolved naturally in society and which should be preserved. He believes the Bank of England should be privatised.
Most Monetarists seem to think central banking and fiat money are just fine, together with the Keynesians, some of whom at least think they are free market, but some advocate various forms of full-reserve banking.
Most, perhaps all, Austrians think the central banks are a plain instrument of statism which should be abolished, together with deposit insurance, legal tender laws and various other privileges. They reject fiat money outright, more often than not, as a creature of interventionism and a tool of the enemies of liberty.
But one faction believes that fractional reserve deposit taking is a breach of sound property rights — a thoroughly libertarian concept — and that it emerged out of fraud to be legitimised by the state.
The other faction pay little heed to the theory of property rights in demand deposits, emphasising freedom of contract. They believe fractional reserve deposit taking is a natural and honest phenomenon which enjoys the consent of depositors. They argue that full-reserve deposit taking is only ever a product of the state and deride the full-reservers willingness to restrict freedom.
Amongst all this, the protagonists accuse one another variously of economic or legal ignorance or a misinterpretation of history. All sides have their scholars and their literature. Both factions claim the term “free banking” as a rejection of central banking. Sometimes they claim the support of the same scholars…
It seems once we go beyond money as the means of exchange, universal agreement stops. Truly, when it comes to the institutional arrangements for money, we are under the curse of Babel.
It is a pity then that money is dying.
Right across the western world and perhaps shortly in China, we see state-supplied money running out of control, with all the distortions and maladjustments that implies, across sectors, regions and time. It seems the state’s response to every setback is more borrowing and more debasement. Unable to sensibly measure the money supply and unsure whether circumstances are inflationary or deflationary, the authorities wrestle to prop up a system damned by its own inadvertent design, a design which emerged out of the failure of Bretton Woods, itself a system condemned to a youthful death.
Five years ago, I would have wondered how the monetary authorities of the Weimar Republic could be so stupid…
At The Cobden Centre, we are agreed that honest money is a product of the market subject to the laws of property and contract, not the will of authority. With Richard Cobden, we agree that the very terms of regulating and managing the currency are an absurdity: the currency should regulate itself. Unfortunately and despite endless study, we seem to be able to agree neither what the proper institutions of such a system would be nor how to get there.
We have previously published an admittedly incomplete list of ten plans for reform. Since I agree with Sir Mervyn King (PDF) in that “of all the many ways of organising banking, the worst is the one we have today”, I could happily accept most of them as a step forward. Perhaps Bagus’ “button-pushing” withdrawal of the state would have disruptive consequences beyond our imagination but it seems mere perseverance with our present system is little more predictable, except in as much as it shall fail.
The original curse of Babel was cast, it seems, to prevent a people speaking as one: for speaking as one, nothing they planned to do would be impossible for them. Perhaps we shall not aspire so high, but we must change if we are to rise above the level of The People’s Front of Judea and win a battle which, it seems, must be won in our lifetimes.
Want to know what is the biggest threat to your prosperity? Look no further than the policy statement released last night by the U.S. Federal Open Market Committee (FOMC)– America’s monetary politburo, the nation’s committee for financial central planning staffed with a select group of highly educated bureaucrats and guided by a former economics professor, and continuously engaged in administratively setting interest rates, manipulating asset prices and determining the extent of lending in what is really the pseudo-capitalist economy of the U.S. of A.
I don’t mean the specific wording of the statement that gets the economists on Wall Street so excited – what phrase did they change? Is this more hawkish or more dovish than last month’s statement? – Who cares? What matters is the sheer and utter economic idiocy underlying the Federal Reserve’s ‘mandate’ and at the core of practically every fiat money central bank. What you see in this statement – black on white – is the conceptual lunacy at the heart of our global paper money system, the reason we are in a massive crisis and about to get deeper into it.
The core belief enshrined in this document, and indeed in every Fed policy statement, is this: the central bank can and should, via discretionary changes in the supply of state paper money, affect interest rates in such a way that the economy reaches full employment and enjoys stable prices. What frivolous hubris! In a proper market economy, interest rates would, of course, be set by the market and result from the free interplay of voluntary saving and voluntary investment decisions by independent agents. Alas, not so in our semi-socialist system of state-controlled fiat money with a central planning bank. The committee knows better what interest rates and asset prices the economy needs to reach its full potential. After all, the committee is staffed with really clever people. Such things cannot be left to the public – or the market.
Think about the puerile assumption behind this: good, lasting and competitive jobs, one assumes, not as a result of saving, capital formation and entrepreneurial risk taking but as a result of clever monetary manipulation by the FOMC. And as the committee has ascertained that, presently, the US public is not reaching its full economic potential, Americans need to be cajoled into doing better with continuing super low interest rates that encourage them to go further into debt, and with bond prices delicately manipulated via the Fed’s debt monetisation program. This is such unspeakable rubbish, and such a shameless declaration of administrative arrogance, I can’t believe that many people outside the common-sense-free ivory tower of the MIT economics department and the privileged paper money aristocracy take this seriously. My sense is that fewer and fewer people in the real world do.
This idiotic assumption is the reason the entire world has, over the past forty years, converted from commodity money, or, paper money at least tentatively linked to commodities, to complete fiat money systems in which the supply of money is not only fully elastic and unrestricted by any ‘barbaric’ raw materials – shudder! – but under the full control of the enlightened and well-meaning state bureaucracy. By injecting new money into the economy, full employment can be generated. Fantastic! No really, it is fantastic. I mean fantastic as in imaginary, fanciful, implausible, incredible, insane, ludicrous, mad, irrational, nonsensical, outlandish and preposterous. That type of fantastic.
Make no mistake. This system is not only suboptimal, it is unsustainable. And we have already reached the endgame.
Let us establish some principles first. Central banks do indeed pose a risk to economic stability but not because their monetary policy is constantly too tight but because is it systematically too loose. Inflexible commodity money – such as gold and silver – has everywhere been replaced with state-issued fully flexible paper money under the control of central banks for one reason and one reason only: so that the supply of money can be constantly expanded in accordance with politically defined goals (such as a certain growth rate, a certain inflation rate, a certain unemployment rate….and constantly expanding bank balance sheets). Today’s consensus believes the following: When inflation is low and thus not an imminent threat, the central bank should ‘support’ economic growth via low interest rates and a moderate expansion of the money supply.
Wrong.
This is precisely the dangerous fallacy that made the dramatic events of the past four years ultimately inevitable. Yet, nobody seems willing to learn the lesson.
Constant expansion of the money supply and the persistent lowering of interest rates below the levels that would be justified by available savings – the raison d’etre of paper money and central banking – lead to misallocations of capital. Always. This – and not higher consumer price inflation – is the most immediate negative effect of monetary expansion. Today’s consensus is, sadly, still obsessed with CPI inflation (CPI= consumer price index). As long as monetary expansion doesn’t lead instantly to a higher grocery bill, the mainstream considers it a welcome boost to growth and practically a free lunch. This is a gross misconception, and this misconception is in essence still behind most of the commentary on monetary policy today. And it was again on display in the debate about the ECB’s recent move.
You can read Detlev’s superb article in full here but beware: he believes “that a collapse of the paper money system is practically inevitable”…
Another classic article, brought forward. This is a speech by James Tyler to the Adam Smith Institute Next Generation Group on 6 October 2009. This speech is also available on hedgehedge.com.
I have spent the best part of the last two decades pitting my wits against the market. It’s an unforgiving game: I’ve seen ups and downs, and many of my rivals buried under an avalanche of hubris, passion, illogical thought and unchecked emotion.
I have witnessed the sheer folly of the ERM crisis, the Asian crisis, the failure of the Gods at Long Term Capital Management and the insanity of the tech boom.
I have enjoyed the ‘NICE’ decade (Non-Inflationary Constant Expansion), and scared myself silly during the credit crisis.
I am a trader.
I risk my own money and live or die by my decisions, and face the threat of personal bankruptcy every time I switch my screens on. I get no salary – indeed I turn up at the start of the month with a large office overhead – a ‘negative’ salary. I have no fancy company pension scheme, no lucrative monopoly or franchise.
I eat what I kill.
Mistakes cost me my livelihood, so, above all, my decisions have to be rooted in practical and logical decision making.
Some have called my kind parasitic, but I would have said that I bring order, efficiency, predictability, stability and deep liquidity to a crucial process: a process that makes the whole world keep ticking.
I make money work.
I make the market in interest rate derivatives: a market born out of the neo classical revolution in finance fostered in Chicago during the 1970s. I am a child of Friedman, Fisher Black, Myron Scholes and the modern international financial system.
My analysis was steeped in the neo-classical, efficient markets paradigm.
Friedman’s ideal was working. Enlightened central bankers guided the free market with gentle nudges and short term liquidity infusions, free floating currencies gently adjusted themselves to the constant flow of new information and efficient and rational markets took all in their stride.
Credit flowed, people got wealthier, economies developed and all was well.
A speech to the Policy Exchange on 31st March 2009 by Cobden Centre sponsor James Tyler. This article first appeared on hedgehedge.com but it remains as relevant today.
I want to talk about two things today;
Number 1: Free markets did NOT cause this crisis… Governments did.
Number 2: Inflation targeting has failed. Money has failed. What should we do?
Free markets did not cause this problem.
In theory, markets work by reacting to prices and direct capital towards where it will be most productively used. This is how wealth is created. Usually this works well, but markets are made up of humans, and can be fooled into overshooting by false signals.
Bubbles build up, expanding until people lose confidence. Bubbles then burst. It’s a corrective process that, relatively benignly, irons out imbalances.
The problem only comes when bubbles go on for too long, because once they get too big, the pop can be terrifying. And that’s what we’ve got now – one hell of a big bang.
False signals have caused a spectacular mal-investment in real estate and its derivatives.
But these false signals did not come from the market, but from government.
False signals.
False signals came from Greenspan’s introduction of welfare for markets. Markets were taught that no matter how much risk they took, they would always be saved. 1987, 1994, 1998, 2001. Each bust bigger than the last, and disaster was only staved off with aggressive rate cuts and increased money supply.
Clearly this was not laissez faire. Just think if events had been allowed to take their course. I bet if LTCM had gone bust then a badly burned Wall Street would have learned a lesson and Lehman’s would still be around today.
In 1999 Clinton mandated that Fannie Mae and Freddie Mac reduce lending standards. The poor were encouraged into debt. This intervention triggered a race to the bottom of lending standards as commercial banks were forced to compete against the limitless pockets of Uncle Sam.
False signals came from deposit insurance. Deposit your money in a boring mutual? Why bother when you can lend it to a lump of volcanic rock in the Atlantic at 7% and be guaranteed to get your money back.
The Basle banking accords required banks to replace rock solid reserves with maths.
Government protected and regulated ratings agencies produced negligent ratings duping pension funds, who were obligated to buy high quality paper, into buying junk cleansed by untested mathematical models.
Central banks create boom-bust.
But most damaging of all was the absurdly low interest rates set between 2001 and 2004.
The resultant glut of cheap money fueled an unsustainable boom encouraging more mortgages to be taken out, and pushing property prices ever higher.
The market responded by pushing scarce economic capital towards highly speculative property development.
As prices rose people remortgaged, and borrowed to consume more. This unchecked process tended to be destructive, as scarce economic capital flowed out of our economy and headed to those economies efficiently producing consumer goods, such as China. Rampant asset inflation clouded our ability to see this depletion process in action.
Everyone had a great time whilst the party lasted, not least Governments who were incentivised to let it run, blinded by ever larger tax revenues.
But all parties come to an end, and central banks had to prick the bubble eventually. Interest rates went too high, and sub prime collapsed, and then all property prices plummeted. Trillions of dollars were ripped out of the financial system, and the credit crunch began.
It’s happened before.
But, despite its complexity, there was nothing new or unpredictable about this process. All the great busts of the 20th century were preceded by a Government sanctioned fiat currency booms.
In the 1920’s, the Fed pursued a ‘constant dollar’ policy. This was the era of the innovation, Model T Fords, radios and rapid technological advancement.
Things should have got cheaper for millions of people, but money supply was boosted to try and keep prices constant. All that extra money flowed into the stock market, pushing prices to crazy levels, and we all know how that ended.
In the modern day, targeting price changes has been an utter disaster for us too.
It let the Bank of England pretend they were doing their job, when money supply was growing at a double digit rate. It let the authorities relax whilst an economy threatening credit bubble was building up.
And it gave Gordon Brown the leeway to convince people that boom and bust was over.
Things should have got cheaper.
Inflation targeting made no allowance for globalisation, the rise of India and China, and the benign falls in general prices that should have been triggered. Think about it; if all those cheap goods were to become available, consumer prices should fall. We would have had greater purchasing power, and become wealthier for it.
But, the Bank of England was aiming at a symmetrical plus 2% target. Falling prices in some goods necessitated stimulating rises in others. They unleashed an avalanche of under priced debt and we had our own crazy asset boom.
Inflation targeting was a myopic policy.
Governments make terrible farmers.
When a central bank sets interest rates, they set the price of credit. Inevitably they create distortions.
Consider this; Governments cannot set food prices without causing a glut -or- painful shortages. Now, food is a pretty simple commodity, yet we all understand that central planners simply cannot gather enough information to set the price accurately.
It has to be left to the spontaneous interaction of thousands of buyers and sellers to set the price.
So, why do we think that enlightened bureaucrats can put an exact price on something as vital, yet complicated, as credit?
In a nutshell, if I can’t tell how much my wife will spend on Bond Street this weekend, how can they?
Let’s wake up from this fantasy.
There is a better way.
What’s the cure? Let the invisible hand to do its time honoured job. Leave interest rates to be set by the millions of suppliers and users of capital.
Get the central planners out of the way.
It’s the way it used to happen. The period of fastest economic growth the world has seen was America between the civil war and the end of the 19th century. Money was free and private and the Fed did not exist.
So, how do we get back to freedom in money? Fredrich Hayek – the great Austrian economist – did the best thinking on this. What he proposed was that private firms should be allowed to produce their own currencies, which would then be free to compete against each other. People would only hold currency that maintained its value, firms that over-issued would go bust Producers of ‘sound’ money would prosper.
History gives us plenty of successful examples of private money working well, 18th Century Scotland had competing banks, all with their own bank notes. People weren’t confused. It worked. There are many other examples.
In the modern age, technology makes the prospect of monetary competition even more tantalising. Mobile phones, oyster cards, smart tags, embedded chips, wireless networks. The internet. Prices could flash up in the shopper’s preferred currency.
A proposal.
Here’s an idea of how to kick the process off;
Tesco’s want to get into banking. Why not currencies as well? Tesco would print one million pieces of paper. Let’s call them Tesco pounds. It would be redeemable at any time for £10 or $15. They would then be auctioned, and the price of a Tesco set.
Anyone who owns a Tesco has a hedge against either the £ OR $ devaluing therefore the Tesco has an additional intrinsic value. Maybe they’ll auction at £12.
Tesco would specify a shopping basket of goods that cost £60. It would promise that 5 Tesco Pounds would always buy that weekly shop. The firm would use its assets to adjust the supply of Tesco Pounds so that they kept this stable value.
They would need to otherwise their shelves would be cleaned out!
As central banks inflated the £ and $ away over time, the convertibility into these currencies would matter less. We would be left with a hard currency that meant something.
There would be other competitors and a real choice about which money to hold your wealth in.
McDonalds has a better credit rating than Her Majesties Government, so maybe people would be happy to hold Big Mac tokens? I don’t know – it will be a free choice.
Currencies would sink or swim depending on how well they performed. What’s more, firms issuing the currencies would come up with different ways of maintaining their value. Some would offer Gold. Manufacturers may use notes backed up by steel, copper and oil.
Let’s see what a free market chooses. Somebody might have a brainwave and come up with an idea that nobody has thought of.
That is what free markets are best at.
I can guess the reactions that my proposal might inspire in some. How would the man on the street cope? Well, nobody would outlaw the Government’s money, and people could carry on as before. Through the operation of the market, we would find out what worked best . Step-by step, the economy would be transformed and standards driven up.
In economics, spontaneous orders are always so much more rational and stable than planned ones. Always.
Conclusion.
This is not a crisis caused by free markets. A free and unregulated market in money has not existed for over a century.
This is a Government crisis. A crisis over the monopoly of money.
Inflation targeting seemed so persuasive…. but it was a false God, and we deserve better. Stability and sound money can only come if we put the money supply back where it belongs…
Recent economic data has convinced the Bank of England not to expand its Quantitative Easing program. According to the Office of National Statistics, annual CPI inflation rose from 3.3% in November to 3.7% in December, 2010 and is now currently 4%. The overall expectation is that CPI inflation will peak at 4.4% by the middle of 2011.
This increase in inflation coupled with poor economic data (with GDP contracting 0.5% last quarter) has come as something of a shock to the Bank of England. The Bank was apparently operating under the assumption that printing money was the way to get the economy going. They are surprised that the result has been a significant increase in inflation and a worsening economy.
Rather helpfully, on the Bank’s website there is an explanation of how Quantitative Easing was supposed to improve the economy. Quite clearly, the Bank explains that they purchased British Government bonds (gilts) and high quality (investment grade) bonds from private sector companies (banks, pension funds, insurance companies and non-financial institutions). The Bank’s concern was that there was too little money “circulating” in the economy. Using this method, the Bank was able to inject the much needed money directly into the economy and the companies that needed it. The idea was two-fold; a) asset prices increase, wealth increases and spending increases; b) more money, means more spending, bank reserves increase, meaning more lending, spending and income increases, inflation arrives at the magic 2% rate and we all live happily ever after, growing fat off of the magic wealth creation machine at the Bank. But there is a dark side to this fairy tale and at the risk of sounding clichéd, it is because in this case, more money really does mean more problems.
The problem is that the Bank is operating under the rather naïve assumption that printing money and rising prices mean that they are creating value. If this were true, none of us would need to work. The government could just issue us all with paper, ink and printing presses. Whenever we needed to buy something we could just print off some money and go to the shops and buy what we need. And of course, prices would rise, the shops would make lots of profits and apparent wealth would increase. There is one nagging doubt however. Who would make all the goods that we would buy, if we are all sitting at home printing money? Perhaps we could get the Morlocks to do it. Or maybe specially trained chimps.
Clearly, the Wizards of Oz, currently residing at the Bank of England, do not understand how value is created, how capital grows and how the wealth in society is generated. To create value one must produce something of value, a good that someone can use to improve their wellbeing or allow them to subsist. This good can be sold for money and the money can be used for consumption, held as a cash balance or to improve the tools needed to produce a greater quantity and quality of goods. Ultimately, all money will be spent on either a consumer good (like a loaf of bread or a new pair of shoes) or a capital good (like a baker’s oven or shoe-making machinery). The latter choice would result in an increase in capital (the value of all capital goods) and capital goods, and in the long run, a general increase in wealth. The increase in wealth occurs because an improvement in the quality and quantity of capital goods allows us to create a greater number of better quality consumer goods in a shorter period of time. This increase in the supply of consumer goods means that their price will fall resulting in a reduction in the cost of living for the society at large. We will all be better off. The important concept to take away is that for this increase in wealth to occur, somebody had to sacrifice some of their consumption to instead purchase a capital good (otherwise known as an income producing asset). This increases the price of income producing assets relative to consumer goods. From the perspective of a consumer like you and me, the goods we buy become cheaper and in a healthy economy, the prices of consumer goods fall over time.
The Bank of England does not believe that any sacrifice is needed today for an increase in wealth tomorrow. In the Land of Oz you do not need to sell something of value in order to get money in exchange, you can just print money instead. Obviously, printing up banknotes does not create anything of value. What happens instead is the reverse of the process described above. The increased supply of money, according to the fundamental laws of economics, will reduce its purchasing power, meaning that the relative prices of consumer goods will rise over time. This will increase the cost of living for people in general, meaning their real wages will fall. Because the cost of labour is now comparatively cheaper, rather than invest in an increase in capital goods, companies will invest in labour instead (Jesus Huerta De Soto, 2009). This means there will be a lower quantity and quality of capital goods and a reduction in the future supply of consumer goods. For the average person, this means a lower salary and a smaller selection of more expensive goods to spend it on. Most of us become poorer.
But not all of us will become poorer. By printing this money and handing it over to a favoured few in society (i.e. the banks) this is in one sense, handing them nothing and in another sense, pure and simple counterfeiting. This is because, in the case of Quantitative Easing, the banks will trade this money for real or financial assets, or to their employees in exchange for their services. This increased monetary demand for financial assets or banking services will bid up their prices. The assets can then be sold in the near term at a profit and the banking employees will spend their increased salaries and bonuses on consumer goods before prices start to rise. Bankers will certainly feel wealthier. In fact, this whole process represents a wealth transfer from one group of people in society to the banks and a shadow tax on much of the population. This is because the early recipients of the new money (the bankers and the Government) will get to spend this money before the prices rise significantly. Slowly this new money will be dispersed around the economy but the further you are from the source the less it will be worth when you finally receive it.
The main beneficiaries of Quantitative Easing therefore, are the Government and the banks. The banks buy gilts from the Government and then sell them to the Bank of England (just under £200bn’s worth) at a profit. The Bank of England pays for these gilts with freshly printed money. Thus the Government has a ready buyer for its debt and the banks become more profitable and apparently more stable. Because of their now greater reserves and new found stability, the official rationale behind Quantitative Easing was that banks would then lend out these reserves to businesses and households thus stimulating the economy. Except, in fact the opposite has occurred. The economy has contracted, inflation is continuing to rise, net lending is down and unemployment has risen.
With a firm understanding of the basics of how wealth is created the Bank of England would have known this would happen. Unfortunately, they operate under the Keynesian delusion of how the world works and their main objective would appear to be saving the banks (because we are all doomed without them) rather saving the economy. With inflation getting higher and higher one might wonder why Mervyn King, the Governor of the Bank of England, does not simply raise interest rates or resell the gilts. However, this would set the Bank of England’s plan into reverse, with higher rates leading to lower asset values, weakened balance sheets and an increase in mortgage defaults, leading to more bank losses and bankruptcies.
Clearly, the Bank of England’s plan is doomed to failure and has been from the start. Mervyn King would have greater luck trying to empty the ocean with a bucket. The problem is two-fold; a) the Bank of England views the recovery or liquidation stage of the business cycle as a problem to be solved and; b) it tries to solve this problem by doing more of what caused this problem in the first place. This “solution” has prevented the necessary liquidation of unprofitable projects and write-offs of bad loans, and has continued to subsidise inefficient operations. Quantitative Easing has resulted in a transfer of wealth from society at large to the banks and the Government, and has vastly extended the length of what would have been a short but sharp recession. Quantitative Easing has made us poorer while benefiting a select few in society.
Forty years ago today, Britain moved to decimal currency. A 1971 penny was worth the equivalent of today’s 10p. In recognition of this dramatic debasement, and its devastating effects, 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.
Based heavily upon the brilliant Murray N. Rothbard book, The Mystery of Banking, Robert P. Murphy delivers an excellent lecture on the “theory” (such as it is) underlying the structure of central banking.
“Of all the many ways of organising banking, the worst is the one we have today.”
If by the end of the lecture you think, “Crikey, it can’t really be as mad as that, can it, surely nobody would ever consciously construct and defend such an insane monetary system?”, then welcome to the pleasure dome; I am afraid to say that just like Mervyn King you really have acquired full understanding:
More information about this lecture series available here.
As the bailout of Ireland begins in earnest, many in the media are asking “What went wrong?”, and coming to some dubious answers. The circumstances are well known. Ireland saw a long boom before the financial crisis. That boom was accompanied by a large rise in house prices and a boom in building construction. After the financial crisis and ensuing world-wide recession, many Irish banks were bailed out by the government or nationalised. The Irish government practised austerity policies, increasing taxes and reducing expenditure. But, as the cost of the bailouts increased, so did the budget deficit.
Many commentators are now claiming that Ireland’s membership of the Euro was the underlying problem (for example, Peter Oborne. In this argument many sound economic ideas have been mixed with careless ones.
One argument is that if Ireland had not been part of the Eurozone it would have been able to devalue it’s currency. It’s true, that if Ireland still had the Punt then this would be possible but not as significant as many people believe. In today’s world with floating fiat currencies controlled by central banks there is no clear concept of “devaluation” any more. The economic prospects of the region encompassed by each currency and the policies of the central banks are taken into account by the exchange rate market, and the exchange rate fluctuates minute by minute. This means there are two different arguments. The first, which focuses on the private sector, is that when a country enters recession the value of it’s currency falls allowing a growth in exports. This is a dubious argument, but whatever its merits it could not have seriously improved the financial situation of the Irish banks or the Irish government. The second argument is that in a crisis the state’s central bank may create money and use it to pay debts and finance bailouts.
A modern state can easily create new money without having additional assets. If Ireland had kept the Punt, it’s own fiat currency, then the government could have bailed out the banks using newly created money. But, that would simply be a hidden tax. Inflation would ensue then holders of money and money-substitutes would see the real value of those assets fall. Holders of assets denominated in money such as loans and bonds would see those fall in value in real terms too. The tax would be paid by the people through this loss of purchasing power. Any permanent increase in the stock of money must lead to inflation, though there may be a time lag until it becomes noticeable. A temporary increase could only be achieved by withdrawing money from circulation afterwards, and that could only be done with taxation. That governments can create money to get themselves out of sticky situations is beneficial to governments, but not to the people they’re supposed to serve.
Critics of the Euro also claim that the Eurozone currency area could not have worked. According to this view the ECB must run monetary policy to suit the core Eurozone countries. But interest rates that are a good fit for Germany and France will cause problems in other Eurozone countries. There is some truth in this. In the years before the crisis, the ECB ran low interest rates to stimulate the northern European economies, particularly Germany and France which were struggling with rigid labour markets. A side-effect of that policy was the building booms in Southern Europe and Ireland which weren’t sustainable. Though there is some truth in this view, it’s still confused. The idea that labour market problems can be successfully compensated for by reducing interest rates is from Keynesian economics. The idea that central banks reducing interest rates to excessively low levels causes unsustainable booms is from Austrian economics. These views can’t be mixed because they come from conflicting theoretical starting points. It isn’t possible that Keynesian economists are right in France and Germany but Austrian economists are right in Ireland and Portugal. In my view the ECB’s low interest rates may have been an attempt to stimulate the Northern European economies, but that policy wouldn’t have worked under any circumstances. The ECB’s policy came at a cost to Ireland and the Southern European countries when the property bubbles burst, but that cost doesn’t reflect any benefit to the Northern European countries.
It’s true that a Central Bank faces greater problems if the currency area that it regulates spans many countries with different conditions. But, as we have seen, Central Banks can’t avoid recessions and crises even if they only regulate the currency of a single sovereign nation.
Many countries have found themselves facing the consequences of the bad decisions made by Central Banks. Ireland isn’t unique in that respect. What makes Ireland unique is the extraordinary lengths that the government have taken to support banks and property developers. In September of 2008 the Irish government guaranteed for two years all bank accounts with Irish banks and almost all loans to those banks. This September, when that guarantee was due to expire, it was extended for another three months. The government decided that rather than risk paying out on that guarantee they would bail out banks as and when they needed it. They nationalised the worst-affected bank – Anglo Irish Bank in 2008. So far, through several bailouts Anglo-Irish Bank has cost the Irish government €22.9 and the other banks have cost ~€10.1, though the extent of losses hasn’t been fully recognized and will probably be much greater. It is these debts that have caused Ireland’s budget deficit to rise much more than those of other countries.
There have been many rumours about corruption in the Fianna Fail and in Anglo-Irish bank. The actions of the former board of Anglo-Irish bank are under investigation by financial regulators and the police, the former CEO has been declared bankrupt. There are close links between the ruling Fianna Fail party and many property developers, that was the subject of jokes long before the crisis. The previous Taoiseach Bertie Ahern was investigated for receiving bribes from property developers. I think there’s probably some truth in these allegations of corruption. But the politicians that form the government had many ways they could abuse their power for personal gain. A politician has many ways he can make a little on the side without bankrupting his country.
It’s ideas rather than corruption that have created such a great crisis for Ireland. The government thought that the resources the state could lay claim to were inexhaustible. They believed that if the state guaranteed bank accounts that this guarantee alone would satisfy the markets. The Finance Minister Brian Lenihan once called the guarantee the “cheapest bailout in the world so far”. The government forgot that the power of the state isn’t magical. A government can transfer the liabilities of banks onto the taxpayers, but they can’t abolish them. Back in 2008, the government were worried that the failure of a bank would harm Ireland’s reputation, but in the long run their cure was worse than the illness.
As Phillip Booth wrote, the first step the Irish government, the IMF and the EU should take is to end the guarantees.
