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I predict a riot

It is with no feelings of joy that we republish this article, first posted on 8 February 2010

Guest contributor Anita Acavalos, daughter of Advisory Board member Andreas Acavalos, explains the political and economic predicament in Greece.

In recent years, Greece has found itself at the centre of international news and public debate, albeit for reasons that are hardly worth bragging about. Soaring budget deficits coupled with the unreliable statistics provided by the government mean there is no financial newspaper out there without at least one piece on Greece’s fiscal profligacy.

Although at first glance the situation Greece faces may seem as simply the result of gross incompetence on behalf of the government, a closer assessment of the country’s social structure and people’s deep-rooted political beliefs will show that this outcome could not have been avoided even if more skill was involved in the country’s economic and financial management.

The population has a deep-rooted suspicion of and disrespect for business and private initiative and there is a widespread belief that “big money” is earned by exploitation of the poor or underhand dealings and reflects no display of virtue or merit. Thus people feel that they are entitled to manipulate the system in a way that enables them to use the wealth of others as it is a widely held belief that there is nothing immoral about milking the rich. In fact, the money the rich seem to have access to is the cause of much discontent among people of all social backgrounds, from farmers to students. The reason for this is that the government for decades has run continuous campaigns promising people that it has not only the will but also the ABILITY to solve their problems and has established a system of patronages and hand-outs to this end.

Anything can be done in Greece provided someone has political connections, from securing a job to navigating the complexities of the Greek bureaucracy. The government routinely promises handouts to farmers after harsh winters and free education to all; every time there is a display of discontent they rush to appease the people by offering them more “solutions.” What they neglect to say is that these solutions cost money. Now that the money has run out, nobody can reason with an angry mob.

A closer examination of Greek universities can be used as a good illustration of why and HOW the government has driven itself to a crossroad where running the country into even deeper debt is the only politically feasible path to follow. University education is free. However, classroom attendance is appalling and there are students in their late twenties that still have not passed classes they attended in their first year. Moreover, these universities are almost entirely run by party-political youth groups which, like the country’s politicians, claim to have solutions to all problems affecting students. To make matters worse, these groups often include a minority of opportunists who are not interested in academia at all but are simply there to use universities as political platforms, usually ones promoting views against the wealthy and the capitalist system as a whole even though they have no intellectual background or understanding of the capitalist structure.

This problem is exacerbated by the fact that there is no genuine free market opposition. In Greece, right wing political parties also favour statist solutions but theirs are criticised as favouring big business. The mere idea that the government should be reduced in size and not try to have its hand in everything is completely inconceivable for Greek politicians of all parties. The government promises their people a better life in exchange for votes so when it fails to deliver, the people naturally think they have the right or even the obligation to start riots to ‘punish’ them for failing to do what they have promised.

Moreover, looking at election results it is not hard to observe that certain regions are “green” supporting PASOK and others “blue” supporting Nea Dimokratia. Those regions consistently support certain political parties in every election due to the widespread system of patronages that has been created. By supporting PASOK in years where Nea Dimokratia wins you can collect on your support when inevitably after a few election periods PASOK will be elected and vice versa. Not only are there widely established regional patronage networks but there are strong political families that use their clout to promise support and benefits to friends in exchange for their support in election years.

Moreover, in line with conventional political theory on patronage networks, in regions that are liable to sway either way politicians have a built in incentive to promise the constituents more than everyone else. The result is almost like a race for the person able to promise more, and thus the system seems by its very nature to weed out politicians that tell people the honest and unpalatable truth or disapprove of handouts. This has led people to think that if they are in a miserable situation it is because the government is not trying hard enough to satisfy their needs or is favouring someone else instead of them. When the farmers protest it is not just because they want more money, it is because they are convinced (sometimes even rightly so) that the reason why they are being denied handouts is that they have been given to someone else instead. It is the combination, therefore, of endless government pandering and patronages that has led to the population’s irresponsible attitude towards money and public finance. They believe that the government having the power to legislate need not be prudent, and when the government says it needs to cut back, they point to the rich and expect the government to tax them more heavily or blame the capitalist system for their woes.

After a meeting in Brussels, current Prime Minister George Papandreou said:

Salaried workers will not pay for this situation: we will not proceed with wage freezes or cuts. We did not come to power to tear down the social state.

It is not out of the kindness of his heart that he initially did not want to impose a pay freeze. It was because doing so would mean that the country may never escape the ensuing state of chaos and anarchy that would inevitably occur. Eventually he did come to the realisation that in the absence of pay freezes he would have to plunge the country into even further debt and increase taxes and had to impose it anyway causing much discontent. Does it not seem silly that he is still trying to persuade the people that they will not pay for this situation when the enormous debts that will inevitably ensue will mean that taxes will have to increase in perpetuity until even our children’s children will be paying for this? This minor glitch does not matter, though, because nobody can reason with a mob that is fighting for handouts they believe are rightfully theirs.

Greece is the perfect example of a country where the government attempted to create a utopia in which it serves as the all-providing overlord offering people amazing job prospects, free health care and education, personal security and public order, and has failed miserably to provide on any of these. In the place of this promised utopian mansion lies a small shack built at an exorbitant cost to the taxpayer, leaking from every nook and cranny due to insufficient funds, which demands ever higher maintenance costs just to keep it from collapsing altogether. The architects of this shack, in a desperate attempt to repair what is left are borrowing all the money they can from their neighbours, even at exorbitant costs promising that this time they will be prudent. All that is left for the people living inside this leaking shack is to protest for all the promises that the government failed to fulfil; but, sadly for the government, promises will neither pay its debts nor appease the angry mob any longer. Greece has lost any credibility it had within the EU as it has achieved notoriety for the way government accountants seem to be cooking up numbers they present to EU officials.

Dismal as the situation may appear, there still is hope. The Greeks many times have shown that it is in the face of dire need that they tend to bond together as a society and rise to the occasion. Family ties and social cohesion are still strong and have cushioned people from the problems caused by government profligacy. For years, the appalling situation in schools has led families to make huge sacrifices in order to raise money for their children’s private tuition or send them to universities abroad whenever possible. This is why foreign universities, especially in the UK, are full of very prominent and hard working Greek students. Moreover, private (as opposed to public) levels of indebtedness, although on the rise, are still lower than many other European countries.

However, although societal bonding and private prudence will help people deal with the consequences of the current crisis, its resolution will only come about if Greek people learn to listen to the ugly truths that sometimes have to be said. They need to be able to listen to statesmen that are being honest with them instead of politicians trying to appease them in a desperate plea to get votes. The time for radical, painful, wrenching reform is NOW.

There are no magic wands, no bail-outs, no quick and easy fixes. The choice is between doing what it takes to put our house in order ourselves, or watching it collapse around us. This can only come about if Prime Minister George Papandreou uses the guts he has displayed in the past when his political stature and authority had been challenged and channels them towards making the changes the country so desperately needs. Only if he emerges as a truly inspired statesman who will choose the difficult as opposed to the populist solution will Greece be up again and on a path towards prosperity. He needs to display a willingness to clean up the mess made after years of bad government and get society to a point where they are willing to accept hard economic truths. One can only hope…

Further reading

Economics

My Journey to Austrianism via the City


Another classic article, brought forward. This is a speech by James Tyler to the Adam Smith Institute Next Generation Group on 6 October 2009. This speech is also available on hedgehedge.com.

I have spent the best part of the last two decades pitting my wits against the market. It’s an unforgiving game: I’ve seen ups and downs, and many of my rivals buried under an avalanche of hubris, passion, illogical thought and unchecked emotion.

I have witnessed the sheer folly of the ERM crisis, the Asian crisis, the failure of the Gods at Long Term Capital Management and the insanity of the tech boom.

I have enjoyed the ‘NICE’ decade (Non-Inflationary Constant Expansion), and scared myself silly during the credit crisis.

I am a trader.

I risk my own money and live or die by my decisions, and face the threat of personal bankruptcy every time I switch my screens on. I get no salary – indeed I turn up at the start of the month with a large office overhead – a ‘negative’ salary. I have no fancy company pension scheme, no lucrative monopoly or franchise.

I eat what I kill.

Mistakes cost me my livelihood, so, above all, my decisions have to be rooted in practical and logical decision making.

Some have called my kind parasitic, but I would have said that I bring order, efficiency, predictability, stability and deep liquidity to a crucial process: a process that makes the whole world keep ticking.

I make money work.

I make the market in interest rate derivatives: a market born out of the neo classical revolution in finance fostered in Chicago during the 1970s. I am a child of Friedman, Fisher Black, Myron Scholes and the modern international financial system.

My analysis was steeped in the neo-classical, efficient markets paradigm.

Friedman’s ideal was working. Enlightened central bankers guided the free market with gentle nudges and short term liquidity infusions, free floating currencies gently adjusted themselves to the constant flow of new information and efficient and rational markets took all in their stride.

Credit flowed, people got wealthier, economies developed and all was well.

And then the crisis struck.
Continue reading “My Journey to Austrianism via the City”

Economics

The Staggering Economic Errors Behind The Policy of Quantitative Easing

In September of last year, I placed this article up on our web site detailing the theoretical errors behind the policy of quantitative easing. Clearly, as the MPC has now been given the green light by our chancellor, we expect this currency debasement to be starting soon. All it will “achieve” is a wealth transfer from those lucky enough to get the newly minted money, from those not luckily enough. I aimed to expose the faulty crank-economics that lies behind such thought processes last year and did not think a Tory government would be so foolish to let this happen under their watch, especially as they condemned it under a Labour government. Sadly, articles like this one need to be reproduced so that a new set of readers can hopefully have influence on the present administration.

The mainstream economists hold that the volume of money in circulation, times its velocity is equal to the prices of all goods and services added up. This is the famous Theory of Exchange, MV=PT, or the mechanistic Quantity Theory of Money, where:

  • M is the stock of money,
  • V is the velocity of circulation: the number of times the monetary unit changes hands in a certain time period,
  • P is the general price level,
  • and T is the “aggregate” of all quantities of goods and services exchanged in the period.

It is held by the overwhelming majority of all economists, that if the velocity of money falls, the price level will fall and thus it is the duty of government, the monopoly issuer of money, the chief Central Planner of the Money Supply, to create more money to keep the price level where it is and thus preserve the existing spending habits of the nation.

Error One — the stock of money

It is held that if you can count the monetary units in the economy and their velocity, you can say what the price level is. As people find it very difficult to count the money in an economy, they cannot see the statistical relationship showing up mechanistically in the price level as expected: the authorities do not have a measure of the money supply which correlates to economic activity.

Working from a sound theoretical basis, I and my colleague Anthony Evans can show you how to count money exactly and how that measure of the money stock correlates to economic activity:

Measures of the UK money stock

Note that changes in the mainstream measures — M0 and M4 — are quite different to changes in our measure — MA. However, it is MA which shows the best correlation to economic activity and not the measures used by the Bank of England and HM Treasury:

MA vs GDP, 12 month lag
MA vs Retail Sales, 12 month lag

The monetary authorities do not have an adequate measure of the money supply.

Error Two — the velocity of circulation

Velocity is defined as the average number of times during a period that a monetary unit (I will call this MU) is exchanged for a good or service. It is said that a 5% increase in money does not necessarily show itself up with a 5% increase in the price level. It is argued that this is because the velocity of money changes. The trick is to measure by how much the velocity has declined and then create new money — cross your fingers, pray to the Good Lord, do a rain dance around a fire, and hope that the new money will be spent — to fill in this gap left by the fall in velocity.

When you buy a house, we do not say it “circulates”: money is exchanged against real bricks and mortar. The printer who sold me books would have had to sell printed things (i.e. real goods) and saved (forgone consumption) for the future purchase (act of consumption) of the house.  Imagine selling your house backwards and forwards between say you and your wife 10 times: the mainstream would argue that the velocity of circulation had risen!

Yes as daft as it sounds, this is the present state of economics.

Thus, if the velocity has gone up by a factor of 10, the price level has increased by the same factor. Here is the suggested rub: therefore, when the velocity of circulation falls, if you increase the money supply by the same factor that the velocity of circulation has fallen by, the price level will stay the same.

Note, as explained above and in detail here, the mainstream do not actually know what money is. Well, let us be clear: it is the final good for which (all) other goods exchange. All of us who are productive make things for sale or sell services, even if it is only our own labour. We sell goods and services which we produce or offer for other goods and services we need. The most marketable of all commodities, money, is accepted by you and other citizens and facilitates exchange of your goods and services for other goods and services. Note that, at all times, money facilitates the exchange of real goods for other real goods.

Party one and a counterparty exchanging or “selling” the house between one another 10 times causing an “increase in velocity” and thus an increase in the price level as an idea is utter garbage. If one party had sold real goods and saved in anticipation of buying the house — real bricks and mortar via the medium of money — this would facilitate a transaction of something (the party’s saved real goods) for something (the counterparty’s real house). Printing money to make sure the price level stays stable to facilitate the “circulating” house in the first example will facilitate a transfer of nothing (the paper) for something (the house). This is commonly called counterfeiting.

This may be another helpful example of why velocity is utterly meaningless. Consider a dinner party: Guest A has a £1. He lends it to Guest B at dinner, who lends it to Guest C who lends it to Guest D. If Guest D pays it back to Guest C, who pays it back to Guest B pays Guest A, the £1 is said to have done £4’s worth of work. The bookkeeping of this transaction shows that £1 was lent out 4 times and they all cancel each other out! Just to be clear, £1 has done £1’s work and not £4’s work. No real wealth or value is created.

The velocity of circulation makes no economic sense.

Error Three — the general price level

Since the monetary authorities have no means to sum the price and quantity of every individual transaction, they must work instead with the “general price level”, ignoring the vital role of changes in relative prices.

As early as 1912, Ludwig von Mises demonstrated that new money must change the structure of relative prices. As anyone who has lived through the past year could tell you, new money is not distributed equally to everyone in the economy. It is injected over time and in specific locations: new money redistributes income to those who receive it first.  This redistribution of income not only alters people’s subjective perception of value, it also alters their weight in the marketplace. These factors can only lead to changes in the structure of relative prices.

Mainstream economists believe that “money is neutral in the long run”. They do not have a theory of the capital structure of production which can account for the effects of time and relative prices. They believe increases in the money supply affect all sectors uniformly and proportionately. This is manifestly untrue: look at changes in the Bank of England’s balance sheet and your bank statement.

Hayek wrote that his chief objection to this theory was that it paid attention only to the general price level and not to the structure of relative prices. He indicated that, in consequence, it disregarded the most harmful effects of increasing the money supply: the misdirection of resources and specifically unemployment. Furthermore, this wilful ignorance of relative prices explains the mainstream’s lack of an adequate theory of business cycles, something Hayek provided.

The general price level aggregates away a vital factor: the relative structure of prices.

Error Four — the aggregate quantities of goods and services sold

Since the sum of price times quantity for every individual transaction is not available, the authorities must use the “aggregate quantity of goods and services sold”. This is nonsense: the quantities to be added together are incompatible. It makes no sense to add a kilogram of potatoes to a kilogram of copper to a litre of petrol to a day’s software consultancy to a 30-second television advert.

The aggregate quantity of goods and services sold is an impossible sum.

Error Five — the equation is no more than a tautology

Consider this, if I  buy 10 copies of Adam Smith’s Wealth of Nations from a printing company for 7 monetary units (or MU), an exchange has been made: I gave up 7 MU’s to the printer, and the printer transferred 10 sets of printed works to me. The error that the mainstream make is that “10 sets of printed works have been regarded as equal to 7 MU, and this fact may be expressed thus: 7 MU  = 10 printed works multiplied by 0.7 MU per set of printed works.”  But equality is not self-evident.

There is never any equality of values on the part of the two participants in exchange. The assumption that an exchange presumes some sort of equality has been a delusion of economic theory for many centuries. We only exchange if each party thinks he is getting something of greater value from the other party than he has already.  If there was equality in value, no exchange would happen! Value is subjective and utility is marginal: each party values the other’s goods or services more highly than their own.

Thus, while the mainstream believe that there is a causal link between the “money side” of the equation and the “value of goods and services side”, it is just a tautology from which no economic knowledge can be gained.  All we are saying, if the Quantity Theory holds, is that “7 MU’s = 10 sets of printed works X 0.7 MU’s per set of printed works”: in other words, “7 MU = 7 MU”. Thus what is paid is what is received. This is like announcing to the world that you have discovered the fabulous fact that 2=2.

The mechanistic Quantity Theory of Money is not a causal relation but a tautology.

Conclusion

The mechanistic Quantity Theory only provides us with a tautology and every term of “MV = PT” is seriously flawed. Public policy should not rest on the foundation of this bad science.

If the money supply contracts as it has done so spectacularly since late 2008 (see the chart above), you will have less goods and services supporting less economic activity. This for sure is bad. We now have less money and less exchanging of real goods and services for other real goods and services.

The only way to get more goods and services offered for exchange is if entrepreneurs get hold of their factors of production — land, labour and capital — and reorganise them to meet the new demands of the consumers in a more efficient way than before. The only thing that the government can do is to make sure it provides as little regulatory burden as possible and the lightest tax regime that it can run in order  to allow entrepreneurs to facilitate this correction.

Certainly in my business of the supply of fish and meat to the food service sector — www.directseafoods.co.uk — I have never witnessed such an abrupt change in consumption patterns as people have traded down from more expensive species and cuts to less expensive ones. Thus I have to reorganise my offer to my customers and potential customers. No amount of fiddling about with the level of newly minted money in the economy will help this reorganisation of my factors of production: they need to be retuned to the new needs and desires of my customers.

Quantitative easing, as I have said before, is firmly based on a belief in the so called “internal truths” held in the Quantity Theory of Money. I hope any reader can see that this belief is based on very faulty logic.  Bad logic gives us bad policy. A policy of QE says that because the velocity of circulation has fallen, we can print newly minted money, out of thin air, at the touch of a computer key, and create more demand for the exchange of goods and services.

Money has been historically rooted in gold and silver because these cannot “vanish” overnight as we are seeing under our present state monopoly of money — fiat money, money by decree, i.e. bits of paper we are forced to use as legal tender. Remember, since 1971 when Nixon broke the gold link, money is just bits of paper, notwithstanding a promise to pay the bearer on demand. In the near future, this will no doubt remain the case. Indeed, anyone who dares to mention that the final good, for which all goods exchange, should be a real good that is scarce (hard to manipulate it, hard to destroy it) unlike paper and electronic journal entries (easy to manipulate, easy to destroy) is considered a lunatic!

On a point of history, it is worthwhile remembering that, as we have mentioned here, the 1844 Peel Act did remove the banks’ practice of issuing promissory notes (paper money) over and above their reserves of gold (the most marketable commodity i.e. money) as this was causing bank runs, “panic”, boom and bust. They did not resolve the issues of demand deposits to be drawn by cheque. Both features allow banks to issue new money — i.e. certificates that have no prior production of useful economic activity such as our printer printing books or my selling of meat and fish — while retaining real money — claims to the printing of books and selling of my meat and fish — only to a percentage of the deposited money, i.e. the Reserve Requirement of the bank. In the UK, there is no Reserve Requirement anymore as far as I am aware, hence banks going for massive levels of leverage. It is no surprise that the house of cards has fallen down.

Our proposal for a 100% reserve requirement is offered for discussion as the only sure-fire way of delivering lasting stability.  Listening to economists talking about the “velocity of circulation” falling and thus suggesting that we should conduct large scale Quantitative Easing to hold the price level is not economics, but the policy of the Witch Doctor and the Mystic.

It is staggering that so much garbage, posing as sound knowledge, hinges on these grave errors.

Further reading

Economics

HM Treasury’s Press Release on Reforms to Financial Regulation

A reader has sent in his thoughts about the recent proposals to reform the regulatory apparatus of the UK banking system:

Last Friday I had a quick view at the report by HM Treasure on a proposal to reshuffle the institutional setting for financial system regulation and oversight in the UK. The introduction (4 pages) is interesting but sometimes depressing. It openly recognised that UK authorities (Bank of England and FSA) failed to see the problems coming and to react adequately. Good. However, the solution it proposes is not to improve the understanding of the building up of bubbles and imbalances, or to reinvigorate the political will so it can make decisions even if those affect the banking status, or to stop trying to achieve the unachievable (a big apparatus able to foresee everything in the system as a whole), but… just rearranging chairs… (every one else in the world, G20, ECB, FED, is rearranging chairs too, so this reshuffling is quite mainstream). However, maybe in the case of the UK there is a possibility to introduce sound thinking in this new Bank of England-based structure (and stop the endogamic kind of thinking within current monetary authorities), through the external members of the newly created “Financial Policy Committee”. The report says (p. 17) among other things:

2.43 It will be important to ensure that the external members of the FPC are able to provide sufficient levels of expertise and challenge to the Committee’s deliberations – this will not only include experience of banking, but also other financial sectors such as insurance and investment banking and, of course, macroeconomic expertise.

2.44 In addition to the chief executive of the CPMA, the Chancellor will appoint four external members of the FPC using a similar recruitment process to that used for the MPC. The Government will look carefully at the best way to ensure that external members demonstrate ample relevant knowledge and experience and the ability to work constructively in a committee environment, without conflicts of interest that would prevent them participating fully in the work of the Committee.”

My take on this is that the external members of the FPC have to be radically different in make up than the internal members of the current MPC i.e. usually a academic, or some who has come from that background. Entrepreneurs, great business leaders and representatives from the SME sector , all who operate at the coal face would have more of an idea about what is and is not actually going on in the economy, better still, why not think about reforming the whole system anyway so we do not rely of 20 or so central planners to determine the value of our very currency, arguably with language, the foundation of civil , peaceful society.

Above all, if we are only tinkering and not radically reforming, he concluded “please appoint those WHO DID SEE it coming and who have a sound theoretical framework behind it (and kick out those who were clueless…)”

Bravo to that, we can name a number of Austrian School economists and Austrian influenced fund managers and entrepreneurs who could do this job.

Economics

Laurence Kotlikoff’s “Jimmy Stewart is Dead”

Jimmy Stewart plays George Bailey who is cast as the “honest” and trustworthy banker in the classic Hollywood film, “It’s a Wonderful Life.” Kotlikoff’s book laments that in the real world of modern banking, such characters no longer exist.

Kotlikoff himself is a Professor of Economics at Boston. Several Nobel Prize winners have endorsed the book: George Akerlof, Robert Lucas, Robert Fogel, Edward Prescott, and Edmund Phelps. I count 36 endorsements from the great and the good of the academic world on the back cover and front pages. I do not recall ever seeing this in a book.

The book is written for the layman. It is very light on economic theory, but does reference some otherworldly models. It is very good at explaining what on the face of it appear to be complex financial phenomena, but are in fact con tricks that in any other industry would earn you a prison sentence. Kotlikoff shows his readers how the financial system has failed in its fiduciary duty, and presents a very simple and elegant solution for its salvation called Limited Purpose Banking (LPB). He also proposes a reduction of the financial service sector regulators in the USA from its current 115 down to one: the Federal Financial Authority (FFA).

In his opening remarks he discusses the Modigliani-Miller Theorem, written in 1958, showing in elegant maths how in the absence of bankruptcy costs, leverage does not matter. If a company takes on more risk by borrowing more, its owners will offset that risk by borrowing less, leaving total debt in the economy unchanged.  Kotlikoff makes no mention of the fact that leverage in itself is not a bad thing if it is made up of people forgoing their consumption today, i.e. saving and committing it to projects that will deliver up goods in the future.   This glaring omission does not impede him from telling the story of our financial meltdown and making a solid policy recommendation for this crisis. It does, however, prevent him from seeing the elephant in the room: that the credit creation process itself is the source of the boom and the bust.

The nature of fractional reserve banking is such that if you deposit your cash in a bank, it will lend it out many times over. This means that multiple claims come to exist on the original real money that was deposited. If you deposit £100 in bank A, which lends it to an entrepreneur who deposits it in Bank B, both you and the entrepreneur now have £100! Like magic, we have £200 in the system, with £100 of it created ex novo by the banking system itself! In the UK, with no legal reserve requirement, we have a only £3 on average kept in deposit for every £100 of IOU’s promised by the banking system.

Kotlikoff provides a mainstream justification for fractional reserve banking, citing the Diamond-Dybvig Model, which holds that we value immediate liquidity for emergencies. We do not need that money all the time, so banks can use this and get us a higher return in the meantime. Therefore, governments must do everything to prevent a bank run if more people want their money back than actually exists in the bank vaults.

This is the theoretical understanding we have today and the model is used to justify all sorts of bank bailouts, as we have seen.

Kotlikoff points out that whilst the bailouts have prevented a collapse of the system of fractional reserve banking, the bailouts do not preserve the purchasing power of money. They just guarantee that the money unit will still exist. This is a very good point. All the bailouts are being funded by more claims on the future taxpayer.  In the UK, we have a system of money debasement called Quantitative Easing, which will just debase and reduce our purchasing power.

In effect, the bailouts do not do what they say they do on the tin, and daily our purchasing power is getting weaker. It is hard enough to get politicians in the UK to acknowledge the scale of our official national debt, but we owe at least as much again “off balance sheet”, in unfunded pension liabilities and Private Finance Initiative obligations.  Debasement will be the most popular way forward for all future governments as they will not want to overtly extract more wealth from us. Dishonesty will be the preferred policy.

Limited purpose banking would be a simple solution to all of this. Banks would be limited to their main purpose of matching savers to borrowers.  All financial companies would act as pass though mutual fund companies. They would be middle men, never would they own the financial assets. They could thus never fail in the “run on the bank” sense — i.e. depositors wishing to withdraw money — but only if they were very bad at business.  This is thus as near as you will get to risk-free banking. Never again would the economy be held liable to bail out the bankers.

Kotlikoff foresees at least two mutual funds being offered, with custodians holding the assets: one that holds cash and one that holds insurance funds. He does stress that innovation could still happen, with a multiplicity of funds being offered.  The Federal Financial Authority (FFA) would regulate the custody element of the safe keeping of the various mutual fund assets. He assumes that regulators will be able to opine, like the current rating agencies, on the soundness of the assets that have been bought by the fund. He would trust the government over the rating agencies. I personally would trust neither! In my industry, selling meat and fish, we have a number of free market created quality assurance bodies such as the British Soil Association for organic certification, the Marine Stewardship Council for fish sustainability that require no government sanction.  These have the confidence of both the consumer and producer. I would suggest that this and not a super regulator is the way forward.

Cash funds are nice and easy; they hold cash and are 100% reserved. They can never go up or down in value. These cash mutual funds represent the demand deposits of the new spec banking system.  All services such as cheque writing and paying bills is done via this vehicle.

I have written about 100% reserve banking here and Steve Baker has specifically examined the 100% reserve banking proposal of Irving Fisher, to which Kotlikoff refers.  He notes that the current economic profession considers these ideas to be “crackpot”; the Diamond-Dybvig model remains dominant.  He goes go on to say, “I want to be clear that I am not an advocate of narrow banking in of itself. Narrow banking is a small feature of limited purpose banking and would hardly suffice to deal with today’s multifaceted financial problems.”

He notes that with the many cash mutual funds in place, the money measure in the USA, MI, would correspond exactly with what the government had printed. So to cover all obligations, a massive print up in US dollars would need to take place — many trillions of dollars to truly purge the system. What Kotlikoff misses is De Soto’s insight, based on the work of Fisher, that there will be a unique moment in history when instead of causing debasement, the printed money would cover all unfunded demand deposits, swapping them out for cash. Wipe out or retire these demand deposits and the banking system has no current creditors, only assets. Take out the equivalent amount of assets from the banking system, so the banking system has the same net worth as before, then put these assets into the mutuals and pay off the national debt. This is not inflationary, requires no debasement, and will help deliver up safe banking.  This is summarised in our Day of Reckoning article.

Insurance mutuals would have all the other banking instruments such as CDO’s in them and could market these funds to whomever they wished. These are essentially what we would term a hedge fund today, though Kotlikoff proposes that these be closed end. This means you have to sell your shares in the fund to redeem your money. Consequently, long term lending can take place in these funds without the fear of a maturity mismatch. The only money this type of fund can lose is what is invested in it. It could never in itself pull down the banking system.

I sense that the author does not feel comfortable with the 100% reserve label, with its “crackpot” associations. In discussing the transfer of Citigroup he says,

“Here we’d need to swap all of CitiGroup’s debt for equity and prevent it from ever borrowing again to fund risky investments. We can now think of CitiGroup as a huge mutual fund with lots of different assets, one big commercial bank with 100 percent capital requirement, or one LPB with a large number of different mutual funds corresponding to the different Citigroup asset classes.”

He also points out that LPB could not actually be that far away if you take into account all the reserves that have been created already. This is something George Reisman has also pointed out.

Kotlikoff defensively shows how LPB would not reduce liquidity. It would not reduce real credit, i.e. savers forwarding money to borrowers. It would stop credit created out of thin air via the banking system, the prime cause of the crisis, but this is not mentioned in his book. It would lead to an optimal size financial sector. Our cash assets would be safe as you can get. Government could still monetise debt as it could still create cash from nothing. The currency and thus the purchasing power of money could not collapse by the actions of the banking system, but only by the actions of the government.

Kotlikoff concludes,

Limited purpose banking is the answer. This simple and easily-implemented pass-though mutual fund system, with its built in firewalls, would preclude financial crises of the type we’re now experiencing. The system will rely on independent rating by the government, but private rating as well. It would require full disclosure and provide maximum transparency. Most important, it would make clear that risk is ultimately born by people, not companies, and that most people need, and have a right, to know what risks, including fiscal risk, they are facing. Finally, it would make clear what risks are, and are not, diversifiable. It would not pretend to insure the uninsurable or guarantee returns that can’t be guaranteed. In short, the system would be honest, and because of that, it would be safe-safe for ourselves and safe for our children.

Although I think he has failed to identify the state sponsored banking system, with its fractional reserve credit creation point as the cause of booms and busts, his solution has many merits and many similarities with the solution proposed by Fisher, De Soto, and others. He missed what I call the golden opportunity, or unique moment in history, to actually enact a reform that delivers up 100% reserve of LPB and pays off the national debt and other unfunded obligations at the same time. My own solution is the De Soto 100% reserve free banking solution with banks working within the existing commercial law to which all non-bank companies must adhere. However, both systems have the same effects and would do the job needed: to sort out the banking system, provide stability, and let capitalism flourish. Yet another workable solution has been proposed by our very own Paul Birch. Kotlikoff’s contribution to the debate, with all the Nobel endorsements, is timely, and I hope policy makers give due attention to innovative solutions like these.

Economics

De Soto and the Relevance of his Banking Reform Proposal Today

This has been copied from Money, Bank Credit, and Economic Cycles which can be downloaded here or bought here.

PREFACE TO THE SECOND ENGLISH EDITION

I am happy to present the second English edition of Money, Bank Credit, and Economic Cycles. Its appearance is particularly timely, given that the severe financial crisis and resulting worldwide economic recession I have been forecasting, since the first edition of this book came out ten years ago, are now unleashing their fury.

The policy of artificial credit expansion central banks have permitted and orchestrated over the last fifteen years could not have ended in any other way. The expansionary cycle which has now come to a close began gathering momentum when the American economy emerged from its last recession (fleeting and repressed though it was) in 2001 and the Federal Reserve reembarked on the major artificial expansion of credit and investment initiated in 1992. This credit expansion was not backed by a parallel increase in voluntary household saving. For many years, the money supply in the form of bank notes and deposits has grown at an average rate of over 10 percent per year (which means that every seven years the total volume of money circulating in the world has doubled). The media of exchange originating from this severe fiduciary inflation have been placed on the market by the banking system as newly created loans granted at very low (and even negative in real terms) interest rates. The above fueled a speculative bubble in the shape of a substantial rise in the prices of capital goods, real-estate assets and the securities which represent them, and are exchanged on the stock market, where indexes soared.

Curiously, like in the “roaring” years prior to the Great Depression of 1929, the shock of monetary growth has not significantly influenced the prices of the subset of consumer goods and services (approximately only one third of all goods). The last decade, like the 1920s, has seen a remarkable increase in productivity as a result of the introduction on a massive scale of new technologies and significant entrepreneurial innovations which, were it not for the injection of money and credit, would have given rise to a healthy and sustained reduction in the unit price of consumer goods and services. Moreover, the full incorporation of the economies of China and India into the globalized market has boosted the real productivity of consumer goods and services even further. The absence of a healthy “deflation” in the prices of consumer goods in a stage of such considerable growth in productivity as that of recent years provides the main evidence that the monetary shock has seriously disturbed the economic process. I analyze this phenomenon in detail in chapter 6, section 9.

As I explain in the book, artificial credit expansion and the (fiduciary) inflation of media of exchange offer no short cut to stable and sustained economic development, no way of avoiding the necessary sacrifice and discipline behind all high rates of voluntary saving. (In fact, particularly in the United States, voluntary saving has not only failed to increase in recent years, but at times has even fallen to a negative rate.) Indeed, the artificial expansion of credit and money is never more than a short-term solution, and that at best. In fact, today there is no doubt about the recessionary quality the monetary shock always has in the long run: newly-created loans (of money citizens have not first saved) immediately provide entrepreneurs with purchasing power they use in overly ambitious investment projects (in recent years, especially in the building sector and real estate development). In other words, entrepreneurs act as if citizens had increased their saving, when they have not actually done so. Widespread discoordination in the economic system exerts a harmful effect on the real economy, and sooner or later the process reverses in the form of an economic recession, which marks the beginning of the painful and necessary readjustment. This readjustment invariably requires the reconversion of every real productive structure inflation has distorted. The specific triggers of the end of the euphoric monetary “binge” and the beginning of the recessionary “hangover” are many, and they can vary from one cycle to another. In the current circumstances, the most obvious triggers have been the rise in the price of raw materials, particularly oil, the subprime mortgage crisis in the United States, and finally, the failure of important banking institutions when it became clear in the market that the value of their liabilities exceeded that of their assets (mortgage loans granted).

At present, numerous self-interested voices are demanding further reductions in interest rates and new injections of money which permit those who desire it to complete their investment projects without suffering losses. Nevertheless, this escape forward would only temporarily postpone problems at the cost of making them far more serious later. The crisis has hit because the profits of capital-goods companies (especially in the building sector and in real-estate development) have disappeared due to the entrepreneurial errors provoked by cheap credit, and because the prices of consumer goods have begun to perform relatively less poorly than those of capital goods. At this point, a painful, inevitable readjustment begins, and in addition to a decrease in production and an increase in unemployment, we are now still seeing a harmful rise in the prices of consumer goods (stagflation).

The most rigorous economic analysis and the coolest, most balanced interpretation of recent economic and financial events support the conclusion that central banks (which are true financial central-planning agencies) cannot possibly succeed in finding the most advantageous monetary policy at every moment. This is exactly what became clear in the case of the failed attempts to plan the former Soviet economy from above. To put it another way, the theorem of the economic impossibility of socialism, which the Austrian economists Ludwig von Mises and Friedrich A. Hayek discovered, is fully applicable to central banks in general, and to the Federal Reserve—(at one time) Alan Greenspan and (currently) Ben Bernanke—in particular. According to this theorem, it is impossible to organize society, in terms of economics, based on coercive commands issued by a planning agency, since such a body can never obtain the information it needs to infuse its commands with a coordinating nature. Indeed, nothing is more dangerous than to indulge in the “fatal conceit”—to use Hayek’s useful expression—of believing oneself omniscient or at least wise and powerful enough to be able to keep the most suitable monetary policy fine tuned at all times. Hence, rather than soften the most violent ups and downs of the economic cycle, the Federal Reserve and, to some lesser extent, the European Central Bank, have most likely been their main architects and the culprits in their worsening. Therefore, the dilemma facing Ben Bernanke and his Federal Reserve Board, as well as the other central banks (beginning with the European Central Bank), is not at all comfortable. For years they have shirked their monetary responsibility, and now they find themselves in a blind alley. They can either allow the recessionary process to begin now, and with it the healthy and painful readjustment, or they can escape forward toward a “hair of the dog” cure. With the latter, the chances of even more severe stagflation in the not-too-distant future increase exponentially. (This was precisely the error committed following the stock market crash of 1987, an error which led to the inflation at the end of the 1980s and concluded with the sharp recession of 1990–1992.) Furthermore, the reintroduction of a cheap-credit policy at this stage could only hinder the necessary liquidation of unprofitable investments and company reconversion. It could even wind up prolonging the recession indefinitely, as has occurred in Japan in recent years: though all possible interventions have been tried, the Japanese economy has ceased to respond to any monetarist stimulus involving credit expansion or Keynesian methods. It is in this context of “financial schizophrenia” that we must interpret the latest “shots in the dark” fired by the monetary authorities (who have two totally contradictory responsibilities: both to control inflation and to inject all the liquidity necessary into the financial system to prevent its collapse). Thus, one day the Federal Reserve rescues Bear Stearns, AIG, Fannie Mae, and Freddie Mac or Citigroup, and the next it allows Lehman Brothers to fail, under the amply justified pretext of “teaching a lesson” and refusing to fuel moral hazard. Then, in light of the way events were unfolding, a 700-billion-dollar plan to purchase the euphemistically named “toxic” or “illiquid” (i.e., worthless) assets from the banking system was approved. If the plan is financed by taxes (and not more inflation), it will mean a heavy tax burden on households, precisely when they are least able to bear it. Finally, in view of doubts about whether such a plan could have any effect, the choice was made to inject public money directly into banks, and even to “guarantee” the total amount of their deposits, decreasing interest rates to almost zero percent.

In comparison, the economies of the European Union are in a somewhat less poor state (if we do not consider the expansionary effect of the policy of deliberately depreciating the dollar, and the relatively greater European rigidities, particularly in the labor market, which tend to make recessions in Europe longer and more painful). The expansionary policy of the European Central Bank, though not free of grave errors, has been somewhat less irresponsible than that of the Federal Reserve. Furthermore, fulfillment of the convergence criteria involved at the time a healthy and significant rehabilitation of the chief European economies. Only the countries on the periphery, like Ireland and particularly Spain, were immersed in considerable credit expansion from the time they initiated their processes of convergence. The case of Spain is paradigmatic. The Spanish economy underwent an economic boom which, in part, was due to real causes (liberalizing structural reforms which originated with José María Aznar’s administration in 1996). Nevertheless, the boom was also largely fueled by an artificial expansion of money and credit, which grew at a rate nearly three times that of the corresponding rates in France and Germany. Spanish economic agents essentially interpreted the decrease in interest rates which resulted from the convergence process in the easy-money terms traditional in Spain: a greater availability of easy money and mass requests for loans from Spanish banks (mainly to finance real estate speculation), loans which these banks have granted by creating the money ex nihilo while European central bankers looked on unperturbed. When faced with the rise in prices, the European Central Bank has remained faithful to its mandate and has tried to maintain interest rates as long as possible, despite the difficulties of those members of the Monetary Union which, like Spain, are now discovering that much of their investment in real estate was in error and are heading for a lengthy and painful reorganization of their real economy.

Under these circumstances, the most appropriate policy would be to liberalize the economy at all levels (especially in the labor market) to permit the rapid reallocation of productive factors (particularly labor) to profitable sectors. Likewise, it is essential to reduce public spending and taxes, in order to increase the available income of heavily-indebted economic agents who need to repay their loans as soon as possible. Economic agents in general and companies in particular can only rehabilitate their finances by cutting costs (especially labor costs) and paying off loans. Essential to this aim are a very flexible labor market and a much more austere public sector. These factors are fundamental if the market is to reveal as quickly as possible the real value of the investment goods produced in error and thus lay the foundation for a healthy, sustained economic recovery in a future which, for the good of all, I hope is not long in coming.

We must not forget that a central feature of the recent period of artificial expansion was a gradual corruption, on the American continent as well as in Europe, of the traditional principles of accounting as practiced globally for centuries. To be specific, acceptance of the International Accounting Standards (IAS) and their incorporation into law in different countries (in Spain via the new General Accounting Plan, in effect as of January 1, 2008) have meant the abandonment of the traditional principle of prudence and its replacement by the principle of fair value in the assessment of the value of balance sheet assets, particularly financial assets. In this abandonment of the traditional principle of prudence, a highly influential role has been played by brokerages, investment banks (which are now on their way to extinction), and in general, all parties interested in “inflating” book values in order to bring them closer to supposedly more “objective” stockmarket values, which in the past rose continually in an economic process of financial euphoria. In fact, during the years of the “speculative bubble,” this process was characterized by a feedback loop: rising stock-market values were immediately entered into the books, and then such accounting entries were sought as justification for further artificial increases in the prices of financial assets listed on the stock market.

In this wild race to abandon traditional accounting principles and replace them with others more “in line with the times,” it became common to evaluate companies based on unorthodox suppositions and purely subjective criteria which in the new standards replace the only truly objective criterion (that of historical cost). Now, the collapse of financial markets and economic agents’ widespread loss of faith in banks and their accounting practices have revealed the serious error involved in yielding to the IAS and their abandonment of traditional accounting principles based on prudence, the error of indulging in the vices of creative, fair-value accounting.

It is in this context that we must view the recent measures taken in the United States and the European Union to “soften” (i.e., to partially reverse) the impact of fair-value accounting for financial institutions. This is a step in the right direction, but it falls short and is taken for the wrong reasons. Indeed, those in charge at financial institutions are attempting to “shut the barn door when the horse is bolting”; that is, when the dramatic fall in the value of “toxic” or “illiquid” assets has endangered the solvency of their institutions. However, these people were delighted with the new IAS during the preceding years of “irrational exuberance,” in which increasing and excessive values in the stock and financial markets graced their balance sheets with staggering figures corresponding to their own profits and net worth, figures which in turn encouraged them to run risks (or better, uncertainties) with practically no thought of danger. Hence, we see that the IAS act in a pro-cyclic manner by heightening volatility and erroneously biasing business management: in times of prosperity, they create a false “wealth effect” which prompts people to take disproportionate risks; when, from one day to the next, the errors committed come to light, the loss in the value of assets immediately decapitalizes companies, which are obliged to sell assets and attempt to recapitalize at the worst moment, i.e., when assets are worth the least and financial markets dry up. Clearly, accounting principles which, like those of the IAS, have proven so disturbing must be abandoned as soon as possible, and all of the accounting reforms recently enacted, specifically the Spanish one, which came into effect January 1, 2008, must be reversed. This is so not only because these reforms mean a dead end in a period of financial crisis and recession, but especially because it is vital that in periods of prosperity we stick to the principle of prudence in valuation, a principle which has shaped all accounting systems from the time of Luca Pacioli at the beginning of the fifteenth century to the adoption of the false idol of the IAS.

In short, the greatest error of the accounting reform recently introduced worldwide is that it scraps centuries of accounting experience and business management when it replaces the prudence principle, as the highest ranking among all traditional accounting principles, with the “fair value” principle, which is simply the introduction of the volatile market value for an entire set of assets, particularly financial assets. This Copernican turn is extremely harmful and threatens the very foundations of the market economy for several reasons. First, to violate the traditional principle of prudence and require that accounting entries reflect market values is to provoke, depending upon the conditions of the economic cycle, an inflation of book values with surpluses which have not materialized and which, in many cases, may never materialize. The artificial “wealth effect” this can produce, especially during the boom phase of each economic cycle, leads to the allocation of paper (or merely temporary) profits, the acceptance of disproportionate risks, and in short, the commission of systematic entrepreneurial errors and the consumption of the nation’s capital, to the detriment of its healthy productive structure and its capacity for long-term growth. Second, I must emphasize that the purpose of accounting is not to reflect supposed “real” values (which in any case are subjective and which are determined and vary daily in the corresponding markets) under the pretext of attaining a (poorly understood) “accounting transparency.” Instead, the purpose of accounting is to permit the prudent management of each company and to prevent capital consumption [1], by applying strict standards of accounting conservatism (based on the prudence principle and the recording of either historical cost or market value, whichever is less), standards which ensure at all times that distributable profits come from a safe surplus which can be distributed without in any way endangering the future viability and capitalization of the company. Third, we must bear in mind that in the market there are no equilibrium prices a third party can objectively determine. Quite the opposite is true; market values arise from subjective assessments and fluctuate sharply, and hence their use in accounting eliminates much of the clarity, certainty, and information balance sheets contained in the past. Today, balance sheets have become largely unintelligible and useless to economic agents. Furthermore, the volatility inherent in market values, particularly over the economic cycle, robs accounting based on the “new principles” of much of its potential as a guide for action for company managers and leads them to systematically commit major errors in management, errors which have been on the verge of provoking the severest financial crisis to ravage the world since 1929.

In chapter 9 of this book (pages 789–803), I design a process of transition toward the only world financial order which, being fully compatible with the free-enterprise system, can eliminate the financial crises and economic recessions which cyclically affect the world’s economies. The proposal the book contains for international financial reform has acquired extreme relevance at the present time (November 2008), in which the disconcerted governments of Europe and America have organized a world conference to reform the international monetary system in order to avoid in the future such severe financial and banking crises as the one that currently grips the entire western world. As is explained in detail over the nine chapters of this book, any future reform will fail as miserably as past reforms unless it strikes at the very root of the present problems and rests on the following principles:

  1. the reestablishment of a 100-percent reserve requirement on all bank demand deposits and equivalents;
  2. the elimination of central banks as lenders of last resort (which will be unnecessary if the preceding principle is applied, and harmful if they continue to act as financial central-planning agencies); and
  3. the privatization of the current, monopolistic, and fiduciary state-issued money and its replacement with a classic pure gold standard.

This radical, definitive reform would essentially mark the culmination of the 1989 fall of the Berlin Wall and real socialism, since the reform would mean the application of the same principles of liberalization and private property to the only sphere, that of finance and banking, which has until now remained mired in central planning (by “central” banks), extreme interventionism (the fixing of interest rates, the tangled web of government regulations), and state monopoly (legal tender laws which require the acceptance of the current, state-issued fiduciary money), circumstances with very negative and dramatic consequences, as we have seen.

I should point out that the transition process designed in the last chapter of this book could also permit from the outset the bailing out of the current banking system, thus preventing its rapid collapse, and with it the sudden monetary squeeze which would be inevitable if, in an environment of widespread broken trust among depositors, a significant volume of bank deposits were to disappear. This short-term goal, which at present, western governments are desperately striving for with the most varied plans (the massive purchases of “toxic” bank assets, the ad hominem guarantee of all deposits, or simply the partial or total nationalization of the private banking system), could be reached much faster and more effectively, and in a manner much less harmful to the market economy, if the first step in the proposed reform (pages 791–98) were immediately taken: to back the total amount of current bank deposits (demand deposits and equivalents) with cash, bills to be turned over to banks, which from then on would maintain a 100-percent reserve with respect to deposits. As illustrated in chart IX-2 of chapter 9, which shows the consolidated balance sheet for the banking system following this step, the issuance of these banknotes would in no way be inflationary (since the new money would be “sterilized,” so to speak, by its purpose as backing to satisfy any sudden deposit withdrawals). Furthermore, this step would free up all banking assets (“toxic” or not) which currently appear as backing for demand deposits (and equivalents) on the balance sheets of private banks. On the assumption that the transition to the new financial system would take place under “normal” circumstances, and not in the midst of a financial crisis as acute as the current one, I proposed in chapter 9 that the “freed” assets be transferred to a set of mutual funds created ad hoc and managed by the banking system, and that the shares in these funds be exchanged for outstanding treasury bonds and for the implicit liabilities connected with the public social-security system (pp. 796–97). Nevertheless, in the current climate of severe financial and economic crisis, we have another alternative: apart from canceling “toxic” assets with these funds, we could devote a portion of the rest, if desired, to enabling savers (not depositors, since their deposits would already be backed 100 percent) to recover a large part of the value lost in their investments (particularly in loans to commercial banks, investment banks, and holding companies). These measures would immediately restore confidence and would leave a significant remainder to be exchanged, once and for all and at no cost, for a sizeable portion of the national debt, our initial aim. In any case, an important warning must be given: naturally, and I must never tire of repeating it, the solution proposed is only valid in the context of an irrevocable decision to reestablish a free-banking system subject to a 100-percent reserve requirement on demand deposits. Any of the reforms noted above, if adopted in the absence of a prior, firm conviction and decision to change the international financial and banking system as indicated, would be simply disastrous: a private banking system which continued to operate with a fractional reserve (orchestrated by the corresponding central banks), would generate, in a cascading effect, and based on the cash created to back deposits, an inflationary expansion like none other in history, one which would eventually finish off our entire economic system.

The above considerations are crucially important and reveal how very relevant this treatise has now become in light of the critical state of the international financial system (though I would definitely have preferred to write the preface to this new edition under very different economic circumstances). Nevertheless, while it is tragic that we have arrived at the current situation, it is even more tragic, if possible, that there exists a widespread lack of understanding regarding the causes of the phenomena that plague us, and especially an atmosphere of confusion and uncertainty prevalent among experts, analysts, and most economic theorists. In this area at least, I can hope the successive editions of this book which are being published all over the world [2] may contribute to the theoretical training of readers, to the intellectual rearmament of new generations, and eventually, to the sorely needed institutional redesign of the entire monetary and financial system of current market economies. If this hope is fulfilled, I will not only view the effort made as worthwhile, but will also deem it a great honor to have contributed, even in a very small way, to movement in the right direction.

Jesús Huerta de Soto
Madrid
November 13, 2008

_________________________________________________________

[1] See especially F. A. Hayek, “The Maintenance of Capital,” Economica 2 (August 1934), reprinted in Profits, Interest and Investment and Other Essays on the Theory of Industrial Fluctuations(Clifton, N.J.: Augustus M. Kelley, 1979; first edition London: George Routledge & Sons, 1939). See especially section 9, “Capital Accounting and Monetary Policy,” pp. 130–32.

[2] Since the appearance of the first English-language edition, the third and
fourth Spanish editions have been published in 2006 and 2009. Moreover,
Tatjana Danilova and Grigory Sapov have completed a Russian translation, which has been published as Dengi, Bankovskiy Kredit i Ekonomicheskie Tsikly (Moscow: Sotsium Publishing House, 2008). Three thousand copies have been printed initially, and I had the satisfaction of presenting the book Octo- ber 30, 2008 at the Higher School of Economics at Moscow State University. In addition, Professor Rosine Létinier has produced the French translation, which is now pending publication. Grzegorz Luczkiewicz has completed the Polish translation, and translation into the following languages is at an advanced stage: German, Czech, Italian, Romanian, Dutch, Chinese, Japan- ese, and Arabic. God willing, may they soon be published.

Economics

Greg Mankiw Ponders Greenspan’s Paper the Crisis and Considers 100% Reserves

We are grateful to Robert Arbon for pointing out this article on Greg Mankiw’s Blog:

I just returned from the spring meeting of the Brookings Papers on Economic Activity, where I was a discussant for Alan Greenspan’s new paper on “The Crisis,” which has gotten a bit of media attention. I thought blog readers might enjoy reading my comments on the paper. Here they are:

This is a great paper. It presents one of the best comprehensive narratives about what went wrong over the past several years that I have read. If you want to assign your students only one paper to read about the recent financial crisis, this would be a good choice.

There are, however, particular pieces of the analysis about which I am skeptical. But before I get to that, let me begin by emphasizing several important points of agreement.

To begin with, Alan refers to recent events in the housing market as a “classic euphoric bubble.” He is certainly right that asset markets can depart from apparent fundamentals in ways that are often hard to understand. This has happened before, and it will happen again. When the bubble bursts, the aftershocks are never pleasant.

Read more.

Economics

The Crack-up Boom

This post is excerpted from Mises’ “The Causes of the Economic Crisis and Other Essays Before and After the Great Depression” which is available to buy here and download here. Both Andreas Acavalos and Toby Baxendale supported the production of this book.

Emphasis mine.

On covering government deficits by creating new money (pp 2-3):

If the practice persists of covering government deficits with the issue of notes, then the day will come without fail, sooner or later, when the monetary systems of those nations pursuing this course will break down completely. The purchasing power of the monetary unit will decline more and more, until finally it disappears completely. To be sure, one could conceive of the possibility that the process of monetary depreciation could go on forever. The purchasing power of the monetary unit could become increasingly smaller without ever disappearing entirely. Prices would then rise more and more. It would still continue to be possible to exchange notes for commodities. Finally, the situation would reach such a state that people would be operating with billions and trillions and then even higher sums for small transactions. The monetary system would still continue to function. However, this prospect scarcely resembles reality.

On credit expansion by banks, its effects on the economy and the ensuing crisis (pp 113-115):

The crisis breaks out only when the banks alter their conduct to the extent that they discontinue issuing any more new fiduciary media and stop undercutting the “natural interest rate.” They may even take steps to restrict circulation credit. When they actually do this, and why, is still to be examined. First of all, however, we must ask ourselves whether it is possible for the banks to stay on the course upon which they have embarked, permitting new quantities of fiduciary media to flow into circulation continuously and proceeding always to make loans below the rate of interest which would prevail on the market in the absence of their interference with newly created fiduciary media.

If the banks could proceed in this manner, with businesses improving continually, could they then provide for lasting good times? Would they then be able to make the boom eternal?

They cannot do this. The reason they cannot is that inflationism carried on ad infinitum is not a workable policy. If the issue of fiduciary media is expanded continuously, prices rise ever higher and at the same time the positive price premium also rises. (We shall disregard the fact that consideration for (1) the continually declining monetary reserves relative to fiduciary media and (2) the banks’ operating costs must sooner or later compel them to discontinue the further expansion of circulation credit.) It is precisely because, and only because, no end to the prolonged “flood” of expanding fiduciary media is foreseen, that it leads to still sharper price increases and, finally, to a panic in which prices and the loan rate move erratically upward.

Suppose the banks still did not want to give up the race? Suppose, in order to depress the loan rate, they wanted to satisfy the continuously expanding desire for credit by issuing still more circulation credit? Then they would only hasten the end, the collapse of the entire system of fiduciary media. The inflation can continue only so long as the conviction persists that it will one day cease. Once people are persuaded that the inflation will not stop, they turn from the use of this money. They flee then to “real values,” foreign money, the precious metals, and barter.

Sooner or later, the crisis must inevitably break out as the result of a change in the conduct of the banks. The later the crack-up comes, the longer the period in which the calculation of the entrepreneurs is misguided by the issue of additional fiduciary media. The greater this additional quantity of fiduciary money, the more factors of production have been firmly committed in the form of investments which appeared profitable only because of the artificially reduced interest rate and which prove to be unprofitable now that the interest rate has again been raised.

Great losses are sustained as a result of misdirected capital investments. Many new structures remain unfinished. Others, already completed, close down operations. Still others are carried on because, after writing off losses which represent a waste of capital, operation of the existing structure pays at least something.

The crisis, with its unique characteristics, is followed by stagnation. The misguided enterprises and businesses of the boom period are already liquidated. Bankruptcy and adjustment have cleared up the situation. The banks have become cautious. They fight shy of expanding circulation credit. They are not inclined to give an ear to credit applications from schemers and promoters. Not only is the artificial stimulus to business, through the expansion of circulation credit, lacking, but even businesses which would be feasible, considering the capital goods available, are not attempted because the general feeling of discouragement makes every innovation appear doubtful. Prevailing “money interest rates” fall below the “natural interest rates.”

When the crisis breaks out, loan rates bound sharply upward because threatened enterprises offer extremely high interest rates for the funds to acquire the resources, with the help of which they hope to save themselves. Later, as the panic subsides, a situation develops, as a result of the restriction of circulation credit and attempts to dispose of large inventories, causing prices [and the “money interest rate”] to fall steadily and leading to the appearance of a negative price premium. This reduced rate of loan interest is adhered to for some time, even after the decline in prices comes to a standstill, when a negative price premium no longer corresponds to conditions. Thus, it comes about that the “money interest rate” is lower than the “natural rate.” Yet, because the unfortunate experiences of the recent crisis have made everyone uneasy, the incentive to business activity is not as strong as circumstances would otherwise warrant. Quite a time passes before capital funds, increased once again by savings accumulated in the meantime, exert sufficient pressure on the loan interest rate for an expansion of entrepreneurial activity to resume. With this development, the low point is passed and the new boom begins.

Further reading

Economics

Banksters on the Welfare State of Credit

Our Corporate Affairs Director Steve Baker has posed this question to some of his fellow board members, “Would be great to nail this phenomenon on the system of money – that is to demonstrate clearly that it is credit expansion which redistributes wealth to the wealthy:

In other words, the trickle-down effect that is meant to spring from wealth accumulation has not worked as it should have. Flexible labour markets have delivered big time for bankers and shareholders, but failed to improve the lot of ordinary workers in the same way. In Britain, growth in consumption was funded not by real economic advancement, but by the fool’s paradise of ever-increasing debt.

 http://www.telegraph.co.uk/finance/comment/jeremy-warner/7105004/Capitalism-has-forgotten-to-share-the-wealth.html

 The essence of a credit expansion starts with the policy of the Treasury / Bank of England aka “the State”. The aim is to make money cheaper so that more money / credit is granted to borrowers, more economic activity is then meant to take place.

How is this done?

 If you wanted to make jam cheaper, you would need to produce more of it for the same level of demand. The only way the jam market would clear is for the jam to sell at that demand for a lower price.

 The State has the monopoly issue of money under its control. If the whole history of man was displayed in the form of a 12 hour clock, with today being the 12th hour, the State has only had this monopoly of the production of money since the end of the Gold Standard at the outbreak of the 1st World War. Attempts to get back on the Standard took place in the 20’s but were abandoned in the 30’s. Post World War II until 1971 there was a weak form of Gold Standard under the Bretton Woods system. Since that date, there has only been paper standards in different countries. So from the dawn of civilization until about the 11th hour and the 59th minute of human existence, Gold was money. It was a commodity for which all things exchanged for, it was produced by private individuals and no one person controlled the production of gold. Like language, it was a spontaneous invention of human beings to facilitate working together. It is thus one of the greatest inventions of man.

 If the the State, as the monopoly issuer of paper money decided that the economy needs more liquidity (we have done this with our £200bn QE program), the bank will buy its governments outstanding debt obligations , or IOU’s, commonly called Gilts or Bonds, with newly minted money (to monetize). Thus the new money, like the new jam, or the jam over supply illustrated in the above example , enters the economy via the recipients of the new money.

 Dear reader, I would like you to pause for a minute and ask yourself how comfortable would you feel about the government setting the price of jam and issuing all of its supply? Is this not what they tried to do in the Soviet Union? Absenting the price mechanism, that coordinates the choices of many millions of people, to allow suppliers of jam to know how much to produce to satisfy the demand for jam, and we have shortages for jam leaving shops empty for sometimes many months on end. Why do we trust the State to do this?

 We seem to accept that the government, in its wisdom, that must be greater than that of all its citizens , can plan the production and supply of money as the old Soviet system did for a whole host of goods and services, for its subjects.

 Experience will tell us, that like the Soviet production of jam, our State production of money will cause shortages and surpluses of varying degrees. Worst still, constructivist policy activism by the State via its agents at the Bank of England attempt each time they set the interest rate, to produce just enough money to keep the economy on an even keel. The evidence that they get this wrong is called “Boom and Bust.”

 If you got jam production wrong, your surplus jam goes to waste or you can not feed your demand.

 An over supply of money is called a “boom.” An undersupply is called “bust.” Every single boom from the Soutth Sea Bubble onwards can be traced back to some artificial expansion of money / credit not brought about by the free interplay of market forces determining the production of money. As money permeates every aspect of the economy, an over or under supply of it has far more consequences than an over or under supply of money. In this current “bust” I would submit that virtually all people in the world wide system of capitalistic production have been effected in their personal lives to some degree of negativity as they have had to adjust to the new world order.

The effects of this over supply are so little understood, it is worth while explaining once more by looking Richard Cantillon in his Essai sur la Nature du Commerce en Général (1755). This showed us that if money supply doubled, prices do not necessarily double. Money is not neutral in terms of consumption and production. Money goes into the system when created by the government to the bond holders whose bonds are redeemed. With this new money they have the first wealth effect of this new money. Like a counterfeiter he exchanges his new bits of paper for real goods and services, bidding up the prices of these goods and services. The producers of these initial goods and services then do the same with the goods and services that they buy and so on and so forth until the prices for the last people, those who spend less in the economy, the poor, those on fixed income (pensioners, the thrifty saver) etc, spend on goods and services that now have  a higher money price. Thus, the insidious effect is a transfer of wealth away from the poorest in society to the richest in society: those banksters who buy / sell the bonds and the bond holders who have received the newly minted money.

We must remember, the bankster in all of this is often the agent of the State when he sells and buys the government debt either creating over supply or under supply of money. He takes his commission right at the well spring or the fountain of this money making process. He gets the first ability to benefit from the wealth effect as he can spend his money on goods and services at the same time as the bond investor. He is a direct recipient of the first order of the wealth transferred from the poorest to the richest members of society. The bankster is on the welfare state of credit. The government is totally in control of this process yet does not seem to realize it.

This is why Jeremy Warner in his well argued Telegraph article wonders how so much wealth has been created for so few and why his the trickle down did not have a positive effect on the poorest members of our society. I hope I have demonstrated that as the production of paper money in itself does not create wealth , as if it did, world poverty could be ended tomorrow, like a counterfeiter, new money allows its first recipients to exchange nothing (bits of paper) for real things such as Mayfair town houses etc. The sad salient point, is as the “wealth effect” works its way through society bidding up prices, the poorest people pay more for their goods and services. They have what little wealth they have confiscated to the benefit of the likes of the banksters who are knee deep on the welfare state of credit. Real wealth creation happens when entrepreneurs start coming up with better methods of production to make better goods and services more efficiently then before. There has been too much of the former providing the illusion of wealth and too little of the latter.