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By Toby Baxendale, on 21 April 10
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.
By Andy Duncan, on 20 April 10
While Economics in One Lesson is almost the definitive starting point for those new to the Austrian School, after you have finished reading it there still remain many mysterious doors in front of you in a maze of subjective choice, all of them tempting you towards the next port of call in your quest to shake off the nostrums of Keynesian economics.
There are perhaps two major pathways to explore in this maze. The first is to acquire an Austrian-style understanding of what is currently happening in the financial markets and the global economy. To do this, we must first understand how the international central banking system works, which is based upon fractional reserves; So what is fractional reserve banking? When did it start? Why did it start? Who started it? How does it work? And where will it take us?
As Churchill said of the old Soviet Union, fractional reserve banking is a riddle wrapped in a mystery inside an enigma. Therefore, to see inside it we need to be guided into this enigmatic riddle by a man wearing X-Ray glasses. This bespectacled man is Murray Rothbard, and the book in which he makes it all sharply clear as day is The Mystery of Banking (which is freely available as a beautifully produced Scribd book).
But before we head off gleefully down this pathway, you might want to consider tackling the second major pathway instead, which is the road to understanding what has been happening in the financial markets and the global economy for the past several hundred years (or even for the past few thousand years, since financial markets were first created in Sumeria, Egypt, Meso-America, and China, and possibly before even that in the Stone Age).
The first major milepost on this second road is the book Human Action, by Ludwig von Mises, perhaps the outstanding publication of the entire Austrian School, since 1870 onwards.
However, Human Action is a forbidding book which can easily scare off the faint of heart. To warm yourself up for it, you might consider a much lighter book instead, which is Economics for Real People (PDF), by Gene Callahan, who has broken his book down into four major parts, all of which make Human Action much easier to access afterwards:
- The Science of Human Action
- The Market Process
- Interference with the Market
- Social Justice, Rightly Understood
Mr Callahan’s book is a sort of half-way house between Economics in One Lesson and Human Action, and at just over 300 pages is meaty enough to give you something to get your teeth into, but short enough to give you time to breathe in and out while you’re reading it.
In the meantime, before deciding which one of the two parallel pathways to go down first, while completing Economics in One Lesson, you might want to watch a series of videos put together by The Mises Institute, each of them covering a single chapter of Hazlitt’s classic introduction to the Austrian School:
- Video 1: The Lesson
- Video 2: The Broken Window
- Video 3: Public Works Mean Taxes
- Video 4: Credit Diverts Production
- Video 5: The Curse of Machinery
- Video 6: Disbanding Troops and Bureaucrats
- Video 7: Who’s Protected by Tariffs?
- Video 8: “Parity” Prices
- Video 9: How the Price System Works
- Video 10: Minimum Wage Laws
- Video 11: The Function of Profits
- Video 12: The Assault on Saving
These videos are all available via a misesmedia playlist.
See also
Our primer.
By Toby Baxendale, on 13 April 10
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:
- the reestablishment of a 100-percent reserve requirement on all bank demand deposits and equivalents;
- 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
- 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.
By Toby Baxendale, on 12 April 10
The Current Financial Crisis — and After
Mises Daily: Friday, April 09, 2010 by Kevin Dowd
[This talk was first presented at the Paris Freedom Fest, September 13, 2009.]
My main topic this morning is the resolution of the current financial crisis, and what might be done to fix the financial system and help avert another crisis in the future.
If this sounds like good news, it is indeed. But you should beware of economists bearing good news on a beautiful Sunday morning: economics isn’t known as the dismal science for nothing.
There is also the bad news — and then there is the very bad news.
The bad news is that the authorities badly botched it, at massive cost to us all — except to the bankers, of course, who are laughing all the way to what is left of our banks. And we are not out of the woods yet, by any means, and the authorities’ responses to the crisis are already sowing the seeds of a new, probably worse crisis down the road.
That is pretty bad, to be sure, but that’s only a preamble to the very bad news. The really bad news is that, even if we get through our current problems in half-decent shape, there are some disturbing storm clouds on the horizon, and these are much more ominous than the current crisis itself.
Keynesian Economics
The first thing to appreciate is the power of ideas. And one point that this crisis has conclusively demonstrated is the enduring hold of Keynesian economics. People now forget that Keynesianism didn’t work well, even in the 1930s; its short-term focus and its failure to deal with the monetary side of the economy led to inflation and, ultimately, to the miseries of stagflation in the ’70s. Keynesianism’s failure was then manifest, and it was rightly repudiated. Fiscal and monetary extravagance were then reined in, inflation was painfully brought down, and the economy boomed.
And then comes the next big crisis, and Keynesianism is suddenly respectable again —and back with a vengeance. We are now told that Keynesian solutions are the only solutions. And it’s not just Keynesianism, but Keynesianism on a mass (or should I say, crass?) scale: massive fiscal stimulus, regardless of the cost; and loose monetary policy, regardless of the inflationary dangers.
This reminds me of an old joke: Keynes was once giving a lecture and noticed that one of his students had fallen asleep. So Keynes asked him a direct question, which woke him up. The startled student responded: “I’m sorry, Mr. Keynes, I didn’t hear the question. But the answer is that we need more stimulus.”
One size fits all, basically.
We have been here before. Writing in 1940, Friedrich Hayek gave perhaps the most perceptive critique of Keynesian economics ever mounted:
I cannot help regarding the increasing concentration on short-run effects … not only as a serious and dangerous intellectual error, but as a betrayal of the main duty of the economist and a grave menace to our civilisation.…
It is alarming to see that after we have once gone through the process of developing a systematic account of those forces which in the long run determine prices and production, we are now called upon to scrap it, in order to replace it by the short-sighted philosophy of the business man raised to the dignity of a science. Are we not told that, “since in the long run we are all dead,” policy should be guided entirely by short-run considerations? I fear that these believers in the principle of après nous le déluge may get what they have bargained for sooner than they wish.[1]
Then, as now, a spending orgy is not what we need. What is needed is a considered response that addresses the structural problems ailing the economy. The key issue, in essence, is that the economy’s financial engine has broken down, and this engine needs to be repaired before the economy can properly recover.
Resolving the Financial Crisis
So how do we fix the financial engine? The answer is that we need to restructure the balance sheets of the main financial institutions. And, as we all know, these balance sheets are best understood using the medium of — poetry:
A balance sheet has two sides.
A right-hand side and a left-hand side.
On the right, nothing is left.
And on the left, nothing is right.
Believe it or not, this little poem gives us the key to resolving the financial crisis. So let’s have a look at a balance sheet:
The right-hand side shows the bank’s assets, which move up and down in value depending on whether the bank makes profits or losses. The left-hand side shows the claims on those assets, the liabilities. These liabilities consist of the bank’s deposits and its share capital. This share capital is also a buffer that protects the value of the deposits and reassures depositors that their money is safe. So, for example, if the bank takes a loss, the loss is usually borne by the shareholders, but if the buffer is big enough, then the bank can absorb any reasonable loss and still have enough share capital left to be safe. This situation is illustrated in the next slide:
The bank makes a small loss, but can absorb it and still be safe.
However, if the bank takes a very big loss, we get the following situation:
The bank’s loss is now so high that the value of the bank’s assets is not enough to pay off the depositors in full. In this case, the shareholders are wiped out completely, and depositors take a loss too. The bank is now insolvent — it can’t meet its debts.
The problem now is how to get the bank back on its feet and operating again on a solvent, going-concern basis.
The answer is to rebuild the banks’ balance sheets. There are good and bad ways of doing this.
The authorities chose the bad way. They panicked — what else could we have expected? And in their panic they injected massive amounts of taxpayer money into the banks, and in so doing threw our money into a virtually bottomless hole.
A much better way, by contrast, is to rebuild the banks’ balance sheets following the precedents of traditional bankruptcy law. The bank would go into some form of temporary receivership, and three things would happen:
1. Its assets would be marked down in value to reflect the losses.
2. The liabilities would be marked down by the same amount.
3. The liabilities would be reorganized so that the bank would have a decent capital base again. This new share capital would come from the depositors, some of whose deposits would be converted into shares.
We might also wish to ring fence the smaller depositors to protect them — this would make the package easier to sell politically, but this is a detail.
The restructuring is shown in the next slide:
The bank’s balance sheet is now much smaller, but the new capital base is large enough to make the bank safe again. The bank can then return to normal business but on a smaller scale.
There would be no taxpayer bailout, no propping up weak institutions, no too-big-to-fail, no humoring of the banks and their bonus culture, no prolonged period of crippling uncertainty, no fiscal profligacy, no loose money. Instead, we should have a quick, emergency-room operation on the economy’s financial engine followed by a rapid return to normal market conditions. This is rather different from what actually happened.
Of course, I am not suggesting that the operation would be easy. In particular, it is very difficult to work out what the “true” value of the banks’ assets should be — no one really knows what a toxic asset is worth. But fortunately, it is not necessary for the write-downs to be “realistic” or accurate. In fact, it is best if the write-downs are harsh and the valuations biased on the conservative side, and these could be based on formulas reflecting worst-case estimates of what different types of asset might be worth (i.e., zero in some cases). And if those valuations later turn out to be too low, it doesn’t really matter: the banks’ assets can be marked up again later.
The trick in all this is speed. We could close down the banks or limit their operations for a weekend or a few days, but not for months. A prolonged disruption of bank activities would cripple the payments system and the supply of credit to the broader economy, and this would be catastrophic. It is therefore essential that the operation be carried out quickly to minimize the disruption to bank activities — and not for the sake of the banks, but for the sake of everyone else.
Looking forward, we should be looking at a reform package with a number of key elements:
“We should abolish the limited-liability statutes and give the bankers the strongest possible incentives to look after our money properly.”
First, we should consider reforms of bankruptcy and insolvency laws to get the ER treatment “right” in the future: should any bank ever need emergency surgery again, this should be a straightforward, by-the-book process anticipated and thought through in advance, not some battlefield-surgery hatchet job.
Second, the financial-services industry needs serious reform. Hard to believe as it might be, there was once a time when the industry was conservative and respected, when it focused on providing straightforward financial “products” to its customers and did so well. We have got to get back to that. No more financial hydrogen bombs blowing up the financial system.
The key to this is corporate-governance reform. I am talking, not about tinkering with the number of nonexecutive directors or a new Sarbanes-Oxley, but radical reform to make the banks accountable and to rein in the moral hazards that have run rampant. And the key to good corporate governance is to remove limited liability: we should abolish the limited-liability statutes and give the bankers the strongest possible incentives to look after our money properly.
And, of course, there is our old enemy, the state. If I had my way, the state would be rolled back right: no deposit insurance, no capital adequacy rules, no financial regulation, no central bank, no monetary policy — in short, the restoration of a sound monetary standard.
Short- and Medium-Term Economic Prospects
I could easily spend the rest of my talk drooling over these wish-lists. But rather than do that, I would like to spend the rest of my time looking at our economic prospects. And our prospects are not too good. To save time, I will focus on the US, but much of what I say applies to some extent to other countries too.
Let’s start with inflation.
If we look over the period 2006–2008, we see inflation of between 2% and 4% on a year-on-year basis, and the broader monetary aggregates expanding quite rapidly and growing at double-digit rates by the end of 2008. We also see an extraordinary growth in the narrowest aggregate, the monetary base, which grew 100% over 2008, a consequence of the highly dangerous and irresponsible policy of “quantitative easing.”
From early this year, admittedly, we see monetary growth halting and prices falling a little. However, I wouldn’t put too much emphasis in such a short downturn in the monetary growth rates, especially in a period where the demand for money is clearly falling due to the impact of the recession. Instead, we need to look over the broad period and consider the likely impact of the large amount of excess money that is already in the system. So, overall, combined with still-low interest rates, these figures indicate a loose monetary policy and the prospect of resurgent inflation once economic activity returns to normal.
Interest rates are low, due in part to “soft” monetary policy, but also due to a flood of hot money pouring into the allegedly safe US Treasury bond market. Low interest rates mean high bond prices, and there are signs that the T-bill market is undergoing a fair-sized speculative bubble. This bubble would seem to be very vulnerable — even a small rise in inflation could easily trigger a loss of confidence and a massive exit from the market. If that happens, market interest rates could rise sharply. And of course, we shouldn’t forget that the prospect of massive federal deficits for years to come will also put upward pressure on interest rates. So interest rates are set to rise.
“For those of you who want any investment advice, my advice boils down to a choice between two positions: a cash position and a fetal one.”
At the same time, the Fed faces a difficult dilemma: If it continues with its current monetary policy, then inflation will return, and probably with a vengeance. The worst thing that the Fed can then do is to put its foot down even harder on the monetary accelerator. This would push interest rates back down temporarily but lead to higher inflation and higher interest rates down the road — and, in all likelihood, to the return of stagflation and yet another massive boom–bust cycle.
But on the other hand, the best thing that the Fed can do is also the hardest thing for it to do: bite the bullet and put its foot on the monetary brakes. Such a policy would encounter massive political resistance — and risk pricking the bond-market bubble and stalling the nascent economic recovery.
In effect, the Fed now risks being hoist by its own petard, a consequence of its own past profligacy.
So the near-term outlook is not too good: the prospect of renewed inflation, even hyperinflation; higher interests rates; a bond-market crash; an uncertain and possibly stalled economic recovery; and the danger of a dollar crisis.
And for those of you who want any investment advice, my advice boils down to a choice between two positions: a cash position and a fetal one.
Long-Term Prospects: Deficits + Entitlements
But all these shorter-term worries pale compared to the long-term outlook.
Federal deficits will be more than 10% of GDP for years to come — these are extremely high.
But this is only the tip of the iceberg. We also have to take account of the unfunded entitlements to which the federal government has committed itself: Medicare and Medicaid entitlements; and pay-as-you-go funding of Social Security, that is, state pensions paid for through current tax revenue, not funded in advance.
These are set to grow massively due to there being more retirees relative to workers, retirees being set to live longer, and old-age entitlements growing higher.
Let’s look at some figures:
The cost of unfunded Social Security and Medicaid is over $100 trillion — and rising. This is about ten times bigger than the total existing debt of the United States, and it is about $330,000 per man, woman and child in the United States — or about $1.3m for a family of four. And rising.
So your average US family of four is facing a government-imposed bill of $1.3m on top of existing taxes! Change the sign around and they’d all be millionaires! Welcome to the age of the negative millionaire.
It is not surprising, then, that leading experts are now openly asking if the United States is bankrupt, and they are anticipating possible futures in which young, educated Americans flee the country in large numbers to escape crippling taxes — and, of course, in so doing, leave their fellow citizens with even greater per capita burdens to bear. A real case of “last one to leave please switch off the lights.”
To quote one leading authority, the president of the Federal Reserve Bank of Dallas:
I see a frightful storm brewing in the form of untethered government debt.… Unless we take steps to deal with it, the long-term fiscal situation of the federal government will be unimaginably more devastating to our economic prosperity than the subprime debacle and the recent debauching of credit markets. (Richard W. Fisher, 2008)[2]
For those of you who are young, the implications are personal. You have your college debts to pay off. It’s hard to get a job, let alone a well-paying one. You can’t get on the housing ladder because property is too expensive. Taxes are likely to be high and rising throughout your working life.
You won’t have much left to pay for your own personal pension. And yet current projections suggest that you are likely to live well into your 90s or later, and there will be little left in the kitty for your state pension when you retire — assuming that you can retire at all. Pension experts are now talking about the end of retirement, and retirement ages are already starting to rise.
Historically speaking, a good retirement will be seen in the future as a 20th-century luxury, something that people before or since usually didn’t get. And you came too late: whereas earlier generations had it easy, you can look forward to busting your gut all your life and working till you drop.
If you are not thoroughly depressed by now, then I am obviously not getting my message across.
You might object that this nightmare scenario is an unfair rip-off, and you would be quite right. Indeed, it might remind some of you of a Ponzi (or pyramid) scheme. A Ponzi scheme is essentially a scam. Someone sets up an investment scheme and gets other people to put their money into it. These people draw in others, and they in turn draw in more people, and so on. Each new intake imagines that their money is being invested on their behalf, but in reality the money is being creamed off by those already in the system.
“The pensions/social security system is an intergenerational Ponzi scheme, the biggest scam ever invented.”
The process continues for as long as enough new suckers come in, but at some point it becomes clear that the scheme cannot pay out. The supply of suckers then dries up and the scheme collapses. And collapse is inevitable. Those who come in early do well, those who come later do badly — and those who come in last lose everything.
I would suggest that the pensions/social security system — the system of intergenerational transfers in which the young get signed up by their elders, often before they are born — not only resembles but actually is an intergenerational Ponzi scheme, the biggest scam ever invented. And to you young people here, I am sorry to say, if you want to see who the suckers of this Ponzi scheme are, just look in the mirror.
So the system must inevitably collapse. The younger you are, the more you stand to lose. And the longer the scam goes on, the more it will cost you.
To you youngsters, I say: it’s your choice how long you choose to put up with this. I say it’s your choice because — with a bit of luck — those of us who are older will have departed the scene when these particular chickens come home to roost.
It’s your choice.
You can play by the rules your elders would impose on you. You can expect to pay higher and higher taxes, work harder and harder to stand still, and get less and less back in return for yourselves — a life little different from slavery — and then the system will collapse anyway.
Or, alternatively, you can fight back. There is no law of nature that says you have to honor checks that other people write at your expense. You are not slaves — you are slaves only if you choose to submit to slavery. You can repudiate those checks.
I am very aware that we are in unchartered territory here, and the implications of what I am saying are revolutionary and certainly dangerous.
Let’s be blunt about what I am suggesting. I am suggesting that if default is inevitable, and if default is more damaging the longer it is delayed, then it would be a good idea to consider embracing it. We should lance the boil, as it were, and kill off the scam — sooner rather than later.
Do you want a life of toil and slavery, followed by ultimate destitution, or do you want to stand up for yourselves and fight for the chance of a decent life? It’s your choice.
Who was it that once told the workers of the world that they had nothing to lose but their chains?
I would like to end as I started, with the man of the moment, the prophet of the short-term, John Maynard Keynes. In 1930, Keynes wrote a delightful essay, “Economic Possibilities for Our Grandchildren,” in which he peered into his crystal ball and mused about how economic life would be a hundred years hence, in 2030, now only a couple of decades away.[3]
Keynes anticipated the benefits of technological progress taking us gradually toward a state of economic bliss in which the problem of economic necessity would in essence be solved. He anticipated three-hour shifts and fifteen-hour working weeks, worked not so much out of need, but more for the sake of having something to do, and he worried about how people would mentally adjust to having so much spare time on their hands. We would be like the Biblical lilies of the field, who neither toil nor spin.
$29 $21
And, at long last, after millennia of struggle, real life would finally catch up with the traditional charwoman’s epitaph. After a lifetime of unrelenting hard work, she went to her grave looking forward above all else to a very, very long rest:
Don’t mourn for me, friends, don’t weep for me never,
For I’m going to do nothing for ever and ever.
At least Keynes was right about one thing: all that spare leisure time is overrated. Thank you all.
Kevin Dowd is a lifelong libertarian economist whose main work has been on free banking and financial laissez-faire. He has recently retired from the University of Nottingham in England and lives in Sheffield, England, with his wife and their two daughters. His next book (written with Martin Hutchinson), Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System, is due to be published by Wiley in May. See Kevin Dowd’s article archives.
This talk was first presented at the Paris Freedom Fest, September 13, 2009.
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Notes
[1] Friedrich A. Hayek, The Pure Theory of Capital, Chicago University Press, 1941, pp. 409–410.
[2] Richard W. Fisher, “Storms on the Horizon,” Remarks before the Commonwealth Club of California. San Francisco, California, May 28, 2008.
[3] John Maynard Keynes, “Economic Possibilities for our Grandchildren,” reprinted in Essays in Persuasion, W.W. Norton reprint, 1963.
By Toby Baxendale, on 9 April 10
George Reisman is one of the most educated and intelligent men on the planet. He was one of only four people the great master economist , Ludwig von Mises, put though and supervised his PhD program with. He also worked for many years very closely with the novelist and noted philosopher and the founder of Objectivism, Ayn Rand .
I have had a number of very useful and inspiring conversations with George Reisman over the years and would like to introduce him to our readers as he is advocating something very similar to us as a method of sorting out the financial mess we are in. I have included the full talk, but you could join it at this section “The 100-Percent Reserve” if you are comfortable with the way the credit is created and causes boom and bust.
This has been copied from the Mises Institute web site.
Mises Daily: Friday, November 20, 2009 by George Reisman
[This talk was given at Economic Downturn: Cause and Cure (Mises Circle, Sponsored by Louis E. Carabini) Newport Beach, California, November 14, 2009.]
Good afternoon, ladies and gentlemen:
As you all know, we are in a severe economic downturn. The official unemployment rate now exceeds 10 percent and according to many observers is actually substantially higher. Within the last year or so, our financial system has been rocked to its foundations. The collapse of the housing bubble and the numerous defaults and bankruptcies connected with it brought down major financial institutions, such as Bear-Stearns, Lehman Brothers, and Merrill Lynch. It also brought down numerous small and medium-sized banks and threatened to bring down even such banking giants as Citigroup and Bank of America. The Dow Jones stock average fell from a high of 14,000 to about 6,500. Important retailers such as CompUSA, Circuit City, Mervyns, and Linens ‘N Things went under, as did countless small businesses throughout the country. Practically every shopping mall gives testimony to the severity of the downturn in the form of vacant stores.
The collapse of the housing bubble and the massive losses and mounting unemployment that have resulted from it have unleashed a veritable firestorm of hostility against capitalism, in the conviction that it is capitalism and its economic freedom that are responsible. It is now generally taken for granted that any solution for the downturn requires massive new government intervention, to curb, control, or abolish this or that aspect of capitalism and its alleged evil.
Reflecting this view, in an effort to avoid financial collapse, the government’s response was the enactment of an $800 billion “stimulus package” designed to boost spending throughout the economic system, and the pouring of more than $1.1 trillion of new and additional reserves into the banking system, along with the direct investment of capital in the country’s most important banks and in major automobile firms, in order to prevent them from failing.
As a result of its so-called “investments,” the government now owns a majority interest in the common stock of General Motors, once the flagship company of capitalism. There have been important extensions of government control over the economic system in other areas as well. For example, the stimulus package contains substantial funding for new bureaucracies to control healthcare and energy production.
The new and additional bank reserves, moreover, are not only massive, but almost all of them are excess reserves. Excess reserves are the reserves available to the banks for the making of new and additional loans, i.e., for new and additional credit expansion. They are the difference between the reserves the banks actually hold and the reserves they are required to hold by law or government regulation.
To gauge the significance of today’s excess reserves, one should consider that total bank reserves as recently as July of 2008 were on the order of just $45 billion, and excess reserves were less than $2 billion. Those $45 billion of reserves supported a total of checking deposits in one form or another on the order of $6 trillion (a sum that included traditional checking deposits, so-called “sweep accounts,” money-market mutual-fund accounts, and money-market deposit accounts insofar as checks could be written against them). That was a ratio of checking deposits to reserves in excess of 100 to 1, or equivalently, a fractional reserve of less than 1 percent.
Today, of the $1.1 trillion-plus of total reserves, all but approximately $62 billion of required reserves, are excess reserves. As of the week of November 4, excess reserves were $1.06 trillion.
Fortunately, for the time being at least, the banks are afraid to lend very much of this sum, but the potential is clearly there for a massive new credit expansion and corresponding increase in the quantity of money. Recognition of this potential is reflected in the current surge in the price of precious metals. Indeed, since $1.06 trillion of new and additional excess reserves are more than 22 times as large as the $45 billion of reserves that were sufficient not so long ago to support $6 trillion of checking deposits, they might potentially support checking deposits in excess of $132 trillion. In effect, what has happened is that our recent brush with massive deflation has turned out to be an occasion for a massive inflationary fueling period in the effort to avoid that deflation.
Inflation and Deflation: Credit Expansion and Malinvestment
The title of my talk, of course, is “A Pro-Free-Market Program for Economic Recovery.” What this entails changes as the government adds new and additional measures that create new and additional problems. If I were giving this talk a year ago, my discussion would have been weighted somewhat more heavily toward deflation and somewhat less heavily toward inflation than is the case today.
A fundamental fact is that our present monetary system is characterized both by irredeemable paper money, i.e., fiat money, and by credit expansion. There is no limit to the quantity of fiat money that can be created. This is the foundation for potentially limitless inflation and the ultimate destruction of the paper money, when the point is reached that it loses value so fast that no one will accept it any longer.
The fact that our monetary system is also characterized by credit expansion is what creates the potential for massive deflation — for deflation to the point of wiping out the far greater part of the money supply, which in the conditions of the last centuries has been brought into existence through the mechanism of credit expansion.
Credit expansion is what underlay the housing bubble, and before that, the stock market bubble, and before that a long series of other booms and busts, running through the Great Depression of 1929 that followed the stock market boom of the 1920s, through the 19th and 18th Centuries all the way back to the Mississippi Bubble of 1719, and perhaps even further back.
Credit expansion is the lending out of money created virtually out of thin air. It is money manufactured by the banking system, always with at least the implicit sanction of the government, which chooses not to outlaw the practice. Since 1913, credit expansion in this country has proceeded not only with the sanction but also with the approval, and active encouragement of the Federal Reserve System, which, as I’ve shown, is now desperately trying to reignite the process as the means of recovering from the current downturn.
The new and additional money is created by the banking system through the lending out of funds placed on deposit with it by its customers and still held by those customers in the form of checking accounts of one kind or another. The customers can continue to spend those checking deposits themselves, simply by writing checks or using other, similar methods of transferring their balances to others.
But now, at the same time, those to whom the banks have lent in this way also have money. To illustrate the process, imagine that Mr. X deposits $1,000 of currency in his checking account. He retains the ability to spend his $1,000 by means of writing checks. From his point of view, he has not reduced the money he owns any more than if he had exchanged $1,000 in hundred-dollar bills for $1,000 in fifty-dollar bills, or vice versa. He has merely changed the form in which he continues to hold the exact same quantity of money.
But now imagine that Mr. X’s bank takes, say, $900 of the currency that he has deposited and lends it to Mr. Y. Mr. Y now possess $900 of spendable money in addition to the $1,000 that Mr. X continues to possess. In other words, the quantity of money in the economic system has been increased by $900. Mr. Y’s loan has been financed by the creation of new and additional money virtually out of thin air. This is the nature and meaning of credit expansion.
Now, nothing of substance is changed, if instead of lending currency to Mr. Y, Mr. X’s bank creates a new and additional checking deposit for Mr. Y in the amount of $900. (This, in fact, is the way credit expansion usually occurs in present-day conditions.) There will once again be $900 of new and additional money. There will be altogether $1,900 of money resting on a foundation merely of the $1,000 of currency deposited by Mr. X.
The $1,000 of currency that Mr. X’s bank holds is its reserve. If Mr. Y deposits his currency or check in another bank, it is the banking system that now has $1,000 of reserves and $1,900 of checking deposits. On the foundation of these reserves, it can create still more money and use it in the further expansion of credit. Indeed, as we have seen, the process of credit expansion is capable of creating checking deposits more than 100 times as large as the reserves that support them.
Credit expansion makes it possible to understand what caused the housing bubble and its collapse. From January of 2001 to December of 2007, credit expansion took place in excess of $2 trillion. This new and additional money made available in the loan market drove down interest rates, including, very prominently, interest rates on home mortgages. Since the interest rate on a mortgage is a major factor determining the cost of homeownership, lower mortgage interest rates greatly encouraged buying houses.
This artificially increased demand for houses, made possible by credit expansion, soon began to raise the prices of houses, and as the new and additional money kept pouring into the housing market, home prices continued to rise. This went on long enough to convince many people that the mere buying and selling of houses was a way to make a good living. On this basis, the demand for houses increased yet further, and finally a point was reached where the median-priced home was no longer affordable by anyone whose income was not far in excess of the median income, i.e., only by a relatively few percent of families.
In the middle of 2004, the Federal Reserve became alarmed about the situation and its implications for rising prices in general, and over the next two years progressively increased its Federal Funds interest rate from 1 percent to 5.25 percent. This rise in the Federal Funds rate signified a reduction in the flow of new and additional excess reserves into the banking system and thus its ability to make new and additional loans. This served to prick the housing bubble.
But before its end, perhaps as much as a trillion and a half dollars or more of credit expansion and its newly created money had been channeled into the housing market. Once the basis of high and rising home prices had been removed, home prices began to fall, leaving large numbers of borrowers with homes worth less than they had paid for them and with mortgages they could not meet.
The investments in housing represented a classic case of what Mises calls “malinvestment,” i.e., the wasteful investment of capital in inherently uneconomic ventures. The malinvestment in housing was on a scale comparable to the credit expansion that had created it, i.e., about $2 trillion or more. That’s about how much was lost in the housing market. When the money capital created by credit expansion was wiped out, the lending, investment spending, employment, and consumer spending that depended on that capital were also wiped out.
And, particularly important, as vast numbers of home buyers defaulted on their mortgages, the mounting losses on mortgage loans increasingly wiped out the capital of banks and other financial institutions, setting the stage for their failure.
The current plight of the economic system is the result of credit expansion and the malinvestment it engenders. Capital in physical terms is the physical assets of business firms. It is their plant and equipment and inventories and work in progress. As Mises never tired of pointing out, capital goods cannot be created by credit expansion. All that credit expansion can do is change their employment and shift them into lines where their employment results in losses. The empty stores and idle factories around the country are very much the result of the loss of the capital squandered in malinvestment in housing.
Other Consequences of Credit Expansion
The plight of the economic system is also the result of other consequences of credit expansion, namely, the encouragement it gives to high debt and dangerous leverage. This is the result of the fact that while credit expansion drives down market interest rates, the spending of the new and additional funds it represents serves to drive up business sales revenues and what the old classical economists called the rate of profit. This combination makes borrowing appear highly profitable and greatly encourages it. Individuals and business firms take on more and more debt relative to their equity. They expect borrowing to multiply their gains.
In addition, credit expansion is responsible for many business firms operating with lower cash holdings relative to the scale of their economic activity, in many cases, dangerously low cash holdings. Many businessmen develop the attitude, why hold cash when credit expansion makes it possible to borrow easily and profitably? Instead, invest the money.
“Why hold cash when credit expansion makes it possible to borrow easily and profitably? Instead, invest the money.”
Thus, when credit expansion finally gives way to the recognition of vast malinvestments and the accompanying loss of huge sums of capital, the economic system is also mired in debt and deficient in cash. Thus, it is poised to fall like a house of cards, in a vast cascade of failures and bankruptcies, first and foremost, bank failures.
The Road to Recovery
The road to recovery from our economic downturn can be understood only in the light of knowledge of credit expansion and its consequences. The nature of credit expansion and its consequences imply the nature of the cure.
The prevailing — Keynesian — view on how to recover from our downturn totally ignores credit expansion and its effects. It believes that all that counts is “spending,” practically any kind of spending. Just get the spending going and economic activity will follow, the Keynesians believe.
This conception of things, which underlies the support for “stimulus packages” and anything else that will increase consumer spending, is mistaken. It rests on a fundamental misconception. It ignores the fact that the fundamental problem is not insufficient spending, but insufficient capital due to the losses caused by malinvestment. It ignores the further facts that credit expansion has brought about excessive debt and, however counterintuitive this may seem, insufficient cash. Too little capital, too much debt, and not enough cash are the problems that countless business firms are facing today as a result of the credit expansion that generated the housing bubble.
Just as a reminder: the way that credit expansion brings about a situation of too little cash while itself constituting a flood of cash is that it makes it appear profitable to invest every last dollar of cash in the expectation of being able easily and profitably to borrow whatever cash may be needed.
What this discussion implies is that an essential requirement of economic recovery is that the widespread problems in the balance sheets of business firms must be fixed. Business firms need more capital, less debt, and more cash. When they achieve that, business confidence will be restored.
Ironically what could achieve at least less debt and more cash in the hands of business, and thus actually do some significant good is if when people received government “stimulus” money, they did not spend very much of it, or, better still, any of it at all. To the extent that all people did with money coming from the government was pay down debt and hold more cash, they would be engaged in a process of undoing some of the major damage done by credit expansion. They would be reducing their burden of debt and increasing their liquidity, thereby increasing their security against the threat of insolvency. Such behavior, of course, would be regarded by Keynesians as constituting a failure of their policies, because in their eyes, all that counts is consumer spending.
The 100-Percent Reserve
The most important single step on the road to economic recovery is the establishment of a 100-percent reserve system against checking deposits. Ideally, the 100-percent reserve would be in gold. And that’s ultimately what we should aim at, for all of the reasons Rothbard explained. But even a 100-percent reserve in paper would do the job of totally preventing all future credit expansion and, equally important, all declines in the money supply.
(Because the 100-percent gold reserve standard is the long-run ideal of advocates of sound money, I cannot help but feel a sense of great satisfaction in the fact that a major step toward its achievement is what turns out to be urgently needed as a matter of sound current economic policy.)
In the simplest terms, to establish a 100-percent-reserve system in terms of paper, the government would simply print up enough additional paper currency so that when added to the paper currency the banks already have, every last dollar of their checking deposits would be covered by such currency. (Strictly speaking, a significant part, and for some months now the far greater part, of the reserves of the banks are not in actual currency but in checking deposits with the Federal Reserve. For the sake of simplicity, however, we can think of the checking deposits held by the banks with the Federal Reserve as a denomination of currency, since, for the banks, they are fully as interchangeable with currency as $50 bills are with $100 bills and vice versa.)
To illustrate the process of achieving a 100-percent reserve, imagine that total checking deposits are $3 trillion. In that case, the Fed would give the banks new and additional reserves that when added to their existing reserves would bring them up to $3 trillion. Through various programs, such as purchasing bad assets, the Fed has in fact already brought the total reserves of the banks up to over a trillion dollars, but almost all of those reserves, as we’ve seen, are excess reserves, a ready foundation for a massive new credit expansion, since excess reserves can be lent out.
What my example implies is adding to the $1.1 trillion of reserves the banking system now has, a further $1.9 trillion and making all $3 trillion of reserves required reserves. This would mean that the banks could not engage in any lending of these reserves and thus would be unable to finance credit expansion or any increase in the supply of checking deposits on the strength of them. The money supply in the hands of the public and spendable in the economic system would thus not be increased. That would happen only if and to the extent that the 100-percent reserve principle were breached.
Under a 100-percent reserve, checking depositors could simultaneously all demand their full balances in cash and the banks would be able to pay them all. Depositors’ demand for cash would not create a problem and no amount of losses by the banks on their loans and investments would prevent them from honoring their checking deposits immediately and in full. Thus the checking deposit component of the money supply could not fall and nor, of course could its other component, which is the paper money in the hands of the public, usually described as the currency component. Thus, there could simply be no deflation of the money supply. And, as I’ve said, because all reserves would be required reserves, there would simply be no reserves whatever available for lending out, and thus no credit expansion whatever. The expression “killing two birds with one stone” could not have a better application.
“The most important single step on the road to economic recovery is the establishment of a 100-percent reserve system against checking deposits.”
In a addition, a significant byproduct of a 100-percent reserve system would be that the FDIC would no longer serve any purpose and thus could be abolished.
Now an essential prerequisite of the 100-percent reserve is knowing the size of checking deposits, so that it will be known how much the 100-percent reserve needs to cover. At present, when one allows for such things as “sweep accounts,” money-market mutual funds, and money-market deposit accounts, the magnitude to which the 100-percent reserve would apply can plausibly be argued to range from about $1.5 trillion to $8 trillion. It is very solidly $1.5 trillion, but does in fact range up to $8 trillion in that checks can be written on the additional sums involved, at least from time to time and for some large minimum amount.
To clearly establish the magnitude of checking deposits, bank depositors should be asked if their intention is to hold money in the bank, ready for their immediate use and transfer to others, or to lend money to the bank. In the first case, their funds would be in a checking account, against which the bank would have to hold a 100-percent reserve. In the second case, their funds would be in a savings account, against which the bank could hold whatever lesser reserve it considered necessary. In this case, the bank’s customers could not spend the funds they had deposited until they withdrew them from the bank.
As I’ve said, the long-run goal in connection with the 100-percent reserve would be ultimately to convert it to a 100-percent gold reserve system. At that time, following the ideas of Rothbard further, the gold reserve of the Fed would be priced high enough to equal the currency and checking deposits of the country and be physically turned over to the individual citizens and the banks in exchange for all outstanding Federal Reserve money. The Fed would then be abolished. But this is a distinct and much later step in pro-free-market reform.
The 100-Percent Reserve and New Bank Capital
It should be realized that a major consequence of the establishment of a 100-percent-reserve system could be a corresponding enlargement of the capital of the banking system and thus an ability to cover even very great losses and thereby avoid such things as government bank bailouts and takeovers.
Consider the balance sheet of an imaginary bank. It’s got checking deposit liabilities of $100. Initially, it has assets of $105, which implies that on the liabilities side of its balance sheet it has capital of $5 in addition to its checking deposit liabilities of $100.
Now unfortunately, malinvestment has resulted in a loss of $20 in the banks’ assets, in the part of its assets consisting of loans and investments. As a result, its total assets are reduced from $105 to $85 and its capital is completely wiped out and becomes negative in the amount of $15.
However, on its asset side the bank still has some cash reserve, say, $10. If $90 of new and additional reserves were added to these $10, to bring the bank’s reserves up to 100-percent equality with its checking deposits, the bank’s asset total would also be increased by $90. This $90 increase on the bank’s asset side would have to be matched by a $90 increase on its liabilities side, specifically by a $90 increase in its capital. Its capital would go from minus $15 to plus $75.
Applying this to the banking system as a whole in transitioning to a 100-percent reserve, we can see that the creation of such a vast amount of new bank capital would be entailed as easily to overcome whatever losses the banks might have suffered in their loans and investments.
As explained, if checking deposits were $3 trillion, the Fed would give the banks new and additional reserves that when added to their existing reserves would bring them up to $3 trillion. If this had been done in September of 2008, bringing reserves up to $3 trillion would have required adding $2.955 trillion of new and additional reserves to the $45 billion or so of reserves the banks already had. This vast addition on the asset side of the banks’ balance sheets would have implied an equivalent addition to the banks’ capital on the liabilities side. No matter how bad the banks’ assets were, I think it’s virtually certain that an additional sum of this size would have been far more than sufficient to cover all the losses that the banks had incurred in their bad loans and investments. Their capital would have ended up being increased to the extent that the additional reserves exceeded the losses in assets under the head of loans and investments.
The government’s bailout program of stock purchases in the banks would have been avoided, along with all of its subsequent interference in matters of bank management.
Now, as we’ve seen, in fact the Fed has already supplied a vast amount of reserves, about $1.1 trillion, to the banks through various programs, such as purchasing bad assets. If the 100-percent reserve principle were adopted now, many or most of those assets could be taken back, and the programs that created them cancelled.
Thus, what I’ve shown here is how transitioning to a 100-percent reserve would guarantee the prevention both of new credit expansion and of deflation of the money supply. It could also provide additional capital to the banking system on a scale almost certainly far more than sufficient to place it on a financially sound footing. To avoid what would otherwise likely be an excessive windfall to the banks, it would be possible to match a more or less considerable part of the increase in their assets provided by the creation of additional reserves, with the creation of a liability of the banks to their depositors, perhaps in the form of some kind of mutual-fund accounts. Thus, the newly created reserves might provide a financial benefit to the banks’ depositors as well as to the banks.
Toward Gold
Of course, a 100-percent reserve system in which the reserves are fiat money does not address the problem of preventing inflation of the fiat money. It would still be possible for the government to inflate the fiat money without restraint. That is why it is necessary to have gold in the monetary system, serving as a restraint on the amount of currency and reserves.
Thus, an important ancillary measure in connection with the transition to a 100-percent paper-reserve system would be for the government to demonstrate a serious intent to move to a gold standard. Obliging the Federal Reserve to carry out a program of regular and substantial gold bullion purchases might accomplish this. In any event, it would be an essential prerequisite for someday achieving gold reserves sufficient to make possible the establishment of a 100-percent-reserve gold system. Along the way, this measure should lead to the day when purchases of gold bullion were the only source of increases in the supply of currency and reserves.
Establishing the Freedom of Wage Rates to Fall
Along with stabilizing the financial system through the adoption of a 100-pecent reserve, it’s absolutely essential to establish the freedom of wage rates and prices to fall. This is what is required to eliminate mass unemployment. Whatever the level of spending in the economic system may be, it is sufficient to buy as much additional labor and products as is required for everyone to be employed and producing as much as he can.
Nothing could be more obvious if one thinks about it. Assume, as is the case today, that there is 10 percent unemployment, with only 9 workers working for every 10 who are able and willing to work. The same total expenditure of money that today employs only 9 workers would be able to employ 10 workers, if the average wage per worker were 10 percent less. At nine-tenths the wage, the same total amount of wages is sufficient to employ ten-ninths the number of workers. It’s a question of simple arithmetic: 1 divided by 9/10 equals 10/9.
(Obviously, this is an overall, average result. In reality, some wage rates would need to fall by less than 10 percent and others by more than 10 percent.)
Of course, total wage payments are not fixed in stone. They can change. And in response to a fall in wage rates to their equilibrium level, to eliminate mass unemployment, they would increase. This is because prior to their fall, investment expenditures have been postponed, awaiting their fall. Once that fall occurs, those investment expenditures take place.
Finally, with debt levels sufficiently reduced and cash holdings sufficiently high, and thus business confidence restored, there is no reason to believe that a fall in wage rates could abort the process of recovery as the result of already employed workers earning less and thus spending less before new and additional workers were hired. The cash reserves and financial strength of business firms would enable them easily to ride out any such situation. And thus mass unemployment would simply be eliminated.
What stops wage rates from falling, what makes it actually illegal for them to fall, and which thus perpetuates mass unemployment, is the underlying pervasive influence of the Marxian exploitation theory. That doctrine is responsible for the existence of such things as minimum-wage laws and coercive labor unions and their above-market wage scales.
The most important fundamental requirement for achieving a free market in labor is the total refutation of the exploitation theory and its complete discrediting in public opinion. Such a refutation will show that it is not government and labor unions that raise real wages but businessmen and capitalists, and that essentially, all that unions do is cause unemployment and a lower productivity of labor and thus prices that are higher relative to wage rates. This knowledge is what is required to make possible the repeal of minimum-wage and pro-union legislation and thus achieve the fall in wage rates that will eliminate mass unemployment
Summary
In summation, my pro-free-market program for economic recovery is a provisional 100-percent-paper-money-reserve system applied to checking deposits, accompanied by a demonstrable commitment to ultimately achieving a 100-percent-gold reserve system. The 100-percent reserve in paper would put an end to all further credit expansion and at the same time make the money supply incapable of being deflated. Its establishment would also greatly increase the capital of the banking system. It would do so by more than enough to cover all the losses on loans and investments incurred in the aftermath of the collapse of the housing bubble and thus make possible the elimination of government ownership of common stock in banks and its interference in bank management. What it would not do is control the increase in paper currency and paper-currency reserves. That will require a 100-percent gold reserve system.
$95 $80
Finally, the freedom of wage rates and prices to fall must be established through the repeal of pro-union and minimum-wage legislation, and more fundamentally, the education of the public concerning the errors of the Marxian exploitation theory and their replacement with actual knowledge of what determines wages and the general standard of living. To say the least, this will certainly not be an easy agenda to follow, inasmuch as it must begin in the midst of a Marxist occupation of our nation’s capital.
Thank you.
George Reisman, Ph.D., is Pepperdine University Professor Emeritus of Economics and the author of Capitalism: A Treatise on Economics (Ottawa, Illinois: Jameson Books, 1996). His web site is www.capitalism.net. His blog is at www.georgereisman.com/blog/. Send him mail. (A PDF replica of the complete book Capitalism: A Treatise on Economics can be downloaded to the reader’s hard drive simply by clicking on the book’s title, immediately preceding, and then saving the file when it appears on the screen. ) See George Reisman’s article archives.
This talk was given at Economic Downturn: Cause and Cure (Mises Circle, Sponsored by Louis E. Carabini) Newport Beach, California, November 14, 2009.
By Toby Baxendale, on 15 March 10
For new readers to this site who are not aware of the debate that exists within the Austrian School, there are those who are supporters of 100% Reserve Free Banking and those who are for Fractional Reserve Free Banking. The importance of this debate is that the School, whilst being the only School in economics to predict the crash, does not have a uniform policy prescription, or at least one policy prescription to fix our economy and put it on a sound and stable footing going forward.
There are a number of policy recommendations from varying branches of the School. We have given a platform to some of them on this site. To caricature: for the Keynesians, it is a matter of spending more via the government, for the monetarists it is print more and more money until the economy fixes itself. Until the differences are resolved within the Austrian School, there can’t be one coherent message to enable us to get out and engage with the political, academic and journalistic fraternities. This article is an attempt to resolve those differences that lie at the heart of our School, rendering it currently impotent in its forward-looking policy prescriptions.
So far, the only two point I see amounting to total agreement between both sides is that the Central Bank should be abolished. If there was a free choice in currency, people would almost certainly choose a commodity-backed currency, as always existed in history prior to the total move to money set by decree of the State. The flavour of what this would be is hotly debated though.
This article is not written to scholarly Journal standards, indeed it is written on a Saturday afternoon and my working life is entrepreneurship and not academia. I aim to stimulate debate within the wider Austrian academic community and beyond, to thoroughly flesh out some of the research areas I recommend and, hopefully, provide grounds for moving forward on a unified, or as near as damn it unified, basis.
A Quick and Dirty Recap on the Differences
The Fractional Reserve Free Banking School
They say all bank deposits are loans. This is the correct position in law since Carr v Carr 1811 in this country.
Therefore in a free banking world, if bank A issues promissory notes (this is a throw back to when the promissory note was redeemable in gold, but the word credit could just as easily be inserted in the place of promissory notes and is more applicable to our day and age) and if bank A lends to its customers in excess of its inherent worth, then Bank B, a more conservative bank and a competitor, may present Bank A’s notes for redemption (or create rumors in the market place to encourage Bank A’s notes to be redeemed) in the knowledge that it has been over inflating its issue. This will cause a run on their competitor’s bank.
This is a good free-market self correcting mechanism that will make sure all parties behave honestly, as large credit-induced booms that will go bust would not happen under this system. Therefore, by removing the ability of banks to go to a Central Bank to be bailed out over night via the discount window, in a Fractional Reserve Free Banking system with a multiplicity of credit / promissory note issuers, never could an over issuing bank go to the Lender of Last Resort, the Central Bank, and get overnight funds to pay its depositors’ redemption requests. The fear of imminent bankruptcy keeps the over issue of credit / promissory notes in a very stable position.
If we think about what has happened since the “Big Bang” in the mid 80s under Lawson when lots of restrictive practices in the City of London were abolished and the legal reserve ratio was abolished (it is now a voluntary system and sits at around 3%), we saw an explosion of credit that has created at least the late 80s / early 90s boom and bust, the late 90s /early 2000 boom and bust and the mother of all booms and busts in the late 2000s. So the free market has certainly been allowed to work as much as possible. As it over extends and under extends it produces catastrophic and distorting results, as we have seen.
This system is not, in fact, free market capitalism, but corporate capitalism. This is because the whole system is underpinned by the Central bank, which lends overnight to the banking systems so they can match their lending with their redemption demands. On the plus side for the State, they can run this system whereby debt is sold via the banking system i.e. their client banks, as all require some kind of liquidity support at some point in time be it explicit or implicit. They can, more importantly, monetize the debt – or, in modern parlance, do QE, which is nothing more than putting more money into circulation than existed before, thus devaluing the pound in our pocket.
This self correcting mechanism of the market is compatible with liberty and does indeed free money from state control. What is more, if you allow people to choose their own money, then the state becomes totally uninvolved with banking and money, and just as we do not have an apple or jam boom and bust, we shall not have a money or credit boom and bust.
The 100% Reserve Free Banking School
Turning to supporters of 100% reserves, the participants in this debate would agree that there should be no Central Bank and free choice in currency with a strong disposition that people, if left to their own devices, would choose gold or silver or a combination as they have overwhelmingly done in history in most places of the world.
Their problem and, indeed, mine is with the very nature of the demand deposit: the relationship between the bank and its depositing customer. Unlike the Fractional Reserve Free Bankers, the 100% Reserve Free Bankers say that when the vast majority of people deposit money in their bank account, such as their salary and their savings, they think that it is “theirs” and indeed it is safe. Of course we all know that banks own “your money” and indeed they owe you “your” money. A bank statement is the bank saying they owe you want you think is “yours.”
The loan you make to the bank is used by the bank (one loans to the bank in ignorance, I suggest). Indeed, once in the banking system, with its ability to multiply on average in the UK up to 33 times the level of credit, with only 3% of your money ever kept in reserves, it is clear that you only have 3% of “your” money in the banking system at any one point in time. As long as no more than one in 33 people walk into the bank to withdraw that which they think is theirs at the same time, then the claim or “their” money is still safe.
This rapid expansion of credit is the start of the Austrian Theory of the Business Cycle. I struggle to see how anyone can doubt the causes of the Business Cycle and both parts of the Austrian School are united on this. Now, the 100% Reserve advocates say that even under a free banking system with no Central Bank, there will still be boom and bust. This is because as the economy grows and there are more participants in the economy, transacting the sale of more goods and services (it is said by all economists except the 100% Reserve Free Banking advocates) the need for the services of more money grows. A series of fractional reserve free banks can issue extra money in the form of credit or promissory notes and you can thus accommodate the needs of trade.
This will cause a boom and bust, just as the current set up with a Central Bank under pinning the system does. This will be the case as every bit of credit issued not backed by prior real savings will cause a lengthening of the structure of production that will set in motion the capital misallocation of resourses that will look like a boom. But as there are no real savings to support the outcome of this new investment activity backed by bank created credit, that will indeed lead to a bust. If you are not happy with why this will cause boom and bust, I suggest cribbing up on the Austrian Theory of the Business Cycle, in particular Hayek in Prices and Production (PDF).
100% Reserve Free Banking advocates will say that to accommodate the growing population and the needs of trade, we should be happy at the spontaneous increase in our purchasing power of our monetary unit (i.e. falling prices). This is wholly beneficial to us all and is not in any way ever going to cause boom and bust.
Jesus Huerta de Soto in his brilliant book Money, Bank Credit, and Economic Cycles (PDF) in Chapter 9 adds a very seductive and interesting twist to the debate when he outlines a reform program that would lead to the total paying off of the National Debt (a very topical issue now!) and a very sound, solid banking system going forward. I have summarized these thought here: A Day of Reckoning .
A Way Forward, the Balance Sheet and Contract Law Approach to Free Banking
On the Nature of a Bank Deposit
I outlined the start of my case in this article last week: Why All Banks Are Insolvent. It does seem to me that it is critical to decide: should current bank deposit contracts be loans, as they lawfully are, or safe keeping / custodian deposits? If they are loans, the Fractional Reserve Free Bankers have the day, if they are custodian accounts or safe keeping accounts the 100% Reserve Free Bankers have the day.
As mentioned in that article:
I commissioned a survey for the Cobden Centre in Oct 2009 with ICM over 2,000 people. 74% of people think that they are the legal owner of the money in their current account rather than the bank. Paradoxically 61% know that their money is lent out even though 67% want convenient (now) on demand access. The full results of this survey will be published shortly in another paper.
This would overwhelmingly suggest that people want safety, they think their money is theirs, even though it is the banks’. They would also like it lent out as long as they can have it back when they want it. I conclude people want safety and easy access, but really they are confused!
It is worth while understanding how a legally binding contract is determined and pondering the glaring confusion that exists with a bank deposit contract.
Law of Contract
Traditionally the formation of contracts has been analysed in terms of offer, acceptance, consideration (and later, intention to create legal relations).
Meeting of the Minds
Horrocks v Foray [1976]:
In order to establish a contract, whether it be an express contract or a contract implied by law, there has to be shown a meeting of the minds of the parties, with a definition of the contractual terms reasonably clearly made out, with an intention to affect the legal relationship: that is that the agreement that is made is one which is properly to be regarded as being enforced by the court if one or the other fails to comply with it; and it still remains a part of the law of this country, though many people think that it is time that it was changed to some other criterion, that there must be consideration moving in order to establish a contract.
Clearly, the depositor does not think he is making a loan to the bank, and the bank knows it is not safe-keeping but on-lending. There is no “meeting of minds.”
The standard which is adopted in deciding whether or not a contract has been concluded is objective rather than subjective. Smith v Hughes (1871):
If, whatever a man’s real intention may be, he so conducts himself that a reasonable man would believe that he was assenting to the terms proposed by the other party, and that other party upon that belief enters into the contract with him, the man thus conducting himself would be equally bound as if he had intended to agree to the other party’s terms.
It would seem that there is confusion at best about the real intentions of the depositor.
Acceptance
Acceptance must be communicated to the offeror – Entores v Miles Far East Corp [1955].
The general rule is that acceptance of an offer will not be implied from mere silence on the part of the offeree and that an offeror cannot impose a contractual obligation upon the offeree by stating that, unless the latter expressly rejects the offer, he will be held to have accepted it – Felthouse v Bindley (1862) 11 CB (NS) 869.
In Order to Create a Binding Contract, the Contract Must be Certain
Scammell and Nephew Ltd v Ouston [1941] – Viscount Maugham – “in order to constitute a valid contract the parties must so express themselves that their meaning can be determined with a reasonable degree of certainty. It is plain that unless this can be done…consensus ad idem would be a matter of mere conjecture.”
Confusion does not constitute a lawful contract.
Previous Course of Dealing Does not Mean Binding Contract Exists
University of Plymouth v European Language Center Ltd [2009] – one party could not rely on an exchange of e-mails and telephone calls as establishing a binding contract with another party, even though the parties had worked together for some years.
It would be very interesting to test that if over the course of a lifetime of banking you always thought that you were depositing for safekeeping if the law courts would give the above interpretation when there has in the vast majority of cases, never been a meeting of the minds.
Consideration
Tweedle v Atkinson (1861) – consideration must move from the promise.
The classic definition of consideration was expressed in Currie v Misa (1875) LR 10 Ex 153:
a valuable consideration, in the sense of the law, may consist either in some right, interest, profit or benefit accruing to the one party, or some forbearance, detriment, loss or responsibility given, suffered or undertaken by the other.
Your banking in some way shape or form , even your “free” bank account, does invariably have some charge somewhere down the line, they get you somewhere, so I would be happy that there is consideration in the current bank arrangements.
Intention to Create Legal Relations
Meritt v Meritt [1970] – In determining the intention of the parties an objective test is used by asking if reasonable people would regard the agreement as legally binding.
With two parties so at odds, I cannot see how we have any intention to create legal relations in the vast majority of deposit contracts.
I would even go as far to say that the vast majority of deposit contracts are unlawful under the Law of Contract.
A sensible policy prescription should be to align the banks to the account holders’ wishes and make the deposit contract one where the bank holds the depositors’ money as custodian / safe keeper and not as borrower. Make this contract explicit. Charge a fee for custodianship / safe keeping.
When a depositor wants to earn some interest on his money, allow an explicit lending contract to be put in place so that the depositor understands that his money has been loaned out, and that it is his no more. He now has a right to his lent money back some agreed time in the future, with a coupon paid.
This allows banks to go back and do what their time honoured role has been, to mediate between the saver and the borrower and to act as custodian and safe keep money for their clients. This is unashamedly boring, and steady as you go banking.
Should a bank be allowed to offer explicitly a fractional reserve account, when you as the depositor know right from the off that they are going to lend your money out a number of times over so there are many claims to this original money that you have deposited? I would say yes under contract law so long as it was explicit and conformed to all the case law listed above, but fundamentally no as this would require the bank to exist under legal and accounting privilege. I work from the assumption that all state sanctioned privilege is a bad as one party is exploiting another lawfully at the expense of the other party. This is antithetical to liberty. I would also add that there could be a similar type of fractional contract but this would be within the realm of hedge funds which operate under the normal commercial law that we all work under – except banks. This will be explored later.
The Balance Sheet Approach
In an article I wrote last week, I outline what I term the Balance Sheet approach to banking. I compare the balance sheet of the UK’s largest company BP, with that of one of our largest banks, Barclays. In a separate article, I look at the accounting treatment of its record profits for 2009 and some remarkable accounting trickery , all perfectly lawful - except that I would not be able to do and such trickery in my business. The link is here More on Banking and the Barclays 2009 Results. The important thing to note is that BP has current creditors and long term or non current creditors. Barclays has only creditors. Why does BP split out its current creditors from its long term ones?
As far as I am aware, in the UK Under International Financial Reporting Standards and UK Generally Accepted Accounting Principles, you have to report your creditors as current, under one year and over one year. This shows the outside world what your ability is to pay your debts, as and when they fall due. Most companies will always aim to match their current creditors with their current debtors, their less than one year creditors, but over current creditors, with the equivalent matching on the debtors’ side and with the long term debt being matched with long term creditors.
Most companies in this sense in the commercial world, other than banks, would indeed be 100% reserve companies and not companies that only keep a small fraction of money aside to pay their creditors. A very good research project for a graduate would be to map out all the FTSE 100 companies and see what percentage were 100% reserved and what were not. With those that were not, what were above 95% , 90%, 85% etc. In reality, if they are not very highly reserved their auditors will not sign off their accounts and they run the risk of insolvency. There is a grey area between a 99%, 95% reserved company as to if it is solvent and at the extreme end, the banks, where they are 3% reserved to current creditors!
Banks need another set of laws that only apply to themselves to operate. Thus they have a privilege accorded only to them. This allows them, like Barclays, to have creditors and debtors only. So all the current money on demand is lumped in with a catch-all lump of all creditors. This implies to the outside world that they perfectly balance their short term creditor needs, i.e. withdrawals with their long term debtors’ repayment profiles such that they never prejudice the current creditor losing his/her shirt. I do not know what specific accounting laws that the banks are allowed to audit to, but they sure are not GAAP that applies to all other commercial organizations. I do intend to find out when I have time, and again, this could be a rich source of research work for a graduate. Notwithstanding, it is clear there is one law for all commercial companies and one law for banks.
It should be clear that a lending and custodian bank where a deposit contract of either type conforms to the Law of Contract, at all points in time will conform to the normal commercial law.
It is clear that a Fractional Reserve Free Bank violates the law of contract and the normal commercial law for every company, thus they have accounting and legal privilege. A custodian / lending bank, conforming to the law of contract and normal commercial accounting law, could not compete with a fractional reserve free bank as the latter would be able to fully use all of its clients’ deposited money to do whatever it pleases, including the creation, on average, of 33 times more deposits. If we take the example of Barclays with some £300 billion of current creditors, the ability to fully use this would place it at a distinct unfair advantage with all other commercial enterprises. Indeed, under the current law, if would be very difficult indeed for a custody / safe keeping bank to get off the ground, the odds are so stacked in favour of the current arrangement.
The Case for Free Banking Under the Normal Commercial Law
Hence I conclude that the current system of making sure companies disclose and match timed liabilities to keep solvent is good and fair to all parties. The anomaly that is fractional reserve banking, be it in its Central Bank sponsored format or in its hypothetical format with no Central Bank, can only work with this legal and accounting privilege in place. This sets one party (the banks/bankers) at a distinct and unfair advantage to another parties (ie all other people / enterprises).
As the Fractional Reserve Free Banking system ex the central bank can only work with the positive intervention of legal privilege and a setting aside of all the principles of contract law, it would seem the case for it is negligible indeed. Added to the fact that there is still the possibility of business cycle inducing properties as they could automatically grow to the needs of trade, we need to map out an alternative that allows people to keep safe, save, invest and speculate.
In the above, I outlined the two forms of deposit that would accord with the normal commercial law that would exist without legal and accounting privilege, i.e. a straight forward safe keeping or custodian contract and a straight forward loan contract.
I would also propose the possibility of a third, called a “High Risk” deposit. This is a deposit contract that again is explicit, that allows one party to deposit in the full knowledge that the institution may or may not engage an over issue of credit, or even promissory notes that may take the form of money if they can become a generally accepted medium of exchange, provided that like in any other company, they are subject to audit and a market valuation up or down of underlying assets at least once per year. As in a normal company’s balance sheet, each year, your properties or other chattels are re valued up, or impaired down, so you can and should do this with the “High Risk” deposit account. This way, there is no extension or contraction of credit over the audit year that does not have real wealth behind it. The boom and bust implications of functioning this way are that of any normal commercial activity.
Conclusion
Any deposit can be made between freely consenting adults provided it is enforceable under the Law of Contract and does not rely on the grant of a state sanction / privilege under commercial law and accounting standards to operate. This would be supporting something that was antithetical to liberty.
Personally, I would prefer to keep these kind of “High Risk” deposits in Hedge Funds and the like – clearly away from banks so as not to confuse. It would be quite possible for somebody with a higher risk profile to place all his money at the disposal of a hedge fund and the hedge fund to offer normal banking services, such as transacting cheques, direct debits, standing orders, issuing debit cards that the hedge fund would subcontract back to the regular standard custodian / safe keeping lending bank. This would give the appearance in almost every respect of the current fractional reserve banking.
To all intents and purposes the overwhelmingly vast majority of non bank companies are 100% reserve companies i.e. they square up with their creditors as and when they fall due or could fall due, unlike fractional reserve banks who make very little provision and rely on state sanction to exist like this.
The balance sheet and contract law approach to free banking allows a solid safe and traditional approach to banking to be the banking system’s default position, but then allows freely consenting adults all other options to enter into whatever deposit contracts they like so long as they are truly lawful.
If this is accepted, I would think it is clear that the proposal of De Soto mentioned above, concerning banking reform, becomes a real possibility in order to be the key policy solution and recommendation of the Austrian School.
It would be right and proper that the School that was the only School to predict the Great Credit Crunch / Meltdown, could provide a series of solutions for a lasting and sustainable recovery.
Afterthought
I have laid out my case that there is such a discrepancy between what the overwhelming majority think happens with their deposited money that under contract law, I doubt very much that an enforceable contract exists as currently offered by the banking system. I propose a reform that would very clearly demarcate what is a custodian / safe keeping contract and what is a lending contract. I agree that freely consenting adults who do no harm to others should be allowed to do as they please which means contract as they please, but entering into a fractional reserve free banking contract would violate very solid good balance sheet accounting and financial reporting standards that have been developed over many years to make sure trade happens without violation of people’s property rights. After that I propose a third contract that could have similar characteristics to a fractional reserve free bank account, called a High Risk account that would allow more speculative activities. The market would evolve in time, and new ways of doing things would no doubt emerge. As long as these new ways of doing things conform to commercial law and do not exist on privilege, then there would be no reason to get het up about this type of innovation.
Some of the debates existing in the wider free banking school need to be addressed.
What is the Difference Between a Fractional Reserve Contract and a House Insurance Contract?
With my house insurance, I pay, not loan, money to an insurance company in exchange for the right to a policy, my consumable item if you like, with the explicit knowledge that they are hoping to charge me and all the other policy holders more than they would pay out in the eventuality of a disaster that I am trying to insure against. There is a small risk that the insurance company will get its sums wrong and not be able to pay me out in full or at all. The policy tells me this.
With a deposit contract, I think I am depositing for custody and safe keeping and only the enlightened few know they are loaning their forgone purchasing power i.e. money to the bank.
So insurance is paying for a product that you consume by virtue of holding the policy for its life time. You know that there is a small risk that you may not get 100% of what you have bought.
With banking, you loan your purchasing power with the overwhelming people doing this in ignorance of what they have committed to. The vast majority expect to have the quiet and peaceful enjoyment of their purchasing power at their convenience and do not deposit in the knowledge that there may be wholesale default.
If we Accept the Legal Position that a Demand Deposit is a Bank Loan, can you Ever Have a Loan with no Fixed Term i.e. an Indefinite Loan?
This is an impossibility.
The loan under these circumstances should properly be called a gift. Fractional Reserve Free Banking relies on the fact that the legal position says all deposits are loans. In 22 years in business I have never borrowed money without a term implied. Even in the most friendly of loans where I have borrowed from a family member and they have said “pay me back when you can,” there is an implied term, when I can, and that it is not a gift.
You can vary terms then reset the period, re cut it, re dice it , re jig it, re price it, etc, but there are still implied terms. At some point in time, a lender always wants to get paid back, otherwise he/she would not be a lender, but someone giving a gift. Depositors are not giving a gift!
In the three banks that I use, representing a very large chunk of the UK banking business, I see nothing whatsoever in any documentation that leads me to believe that when I deposit I am making a loan. What is more, it does not fit my understanding of what a loan is unless we accept it is a callable loan on demand. If it is on demand, it needs to be provisioned for. Prudent management would dictate 100% reserves against my loan. General accounting principles that apply to all commercial activities bar the banks do not have to.
Everything I have ever seen in banking when I have deposited leads me to believe I am depositing money for custody / safe keeping and not as a loan. The language is always that of custody / safe keeping. Free banking going forward needs to be very explicit in nailing in contract what is custody / safe keeping and what is loaning and what is speculating.
Do Fractional Reserve Banks in a Free Market Environment, i.e. one with no Central Bank, Create Inflation?
I touched upon this point in the main body of the article. The price of money is determined, like all things, by demand and supply. Mises called this the money relation. If there is an increase in both, then there will be no inflation. To be clear, Fractional Reserve Free Banking people who advocate this are correct, there will be no price inflation. However, the number of money units has now gone up, so there has been a money inflation. Do we care? Yes, as Austrians we do. Why? Whoever is in receipt of the new money, in a Fractional Reserve Free Banking world with no Central Bank, the first recipients are the new demanders of money. They will get the wealth effect of having new purchasing power first. Where there should have been an increase in purchasing power (falling prices) for all the existing money holders, there is no increase, thus impoverishing those who are holding the existing monetary unit. Again, this gives special privilege to a certain class of person over another class of person. That is antithetical to liberty. The only way this can be avoided is to have Free Banking that sits within commercial law, accounting rules that apply to everyone, and framed within the time-honoured principles of the law of contract.
Do Grain Store Examples Shed any Useful Light into this Debate?
I am often told by advocates of Fractional Reserve Free Banking that banking is like a grain store. That if ten tons were to be deposited by one man who took a certificate from the store holder explicitly stating that the store will be lending 9 ton of the grain out to bread makers in exchange for the original depositor not having to pay for the storage, or even being paid to store there – what would be wrong with this? Also, it would tell me under what time period my grain would be being used by others, and when I could get my grain back. Well, the answer is nothing at all as the contract is explicit – except that I will never get my grain back at all as it is being consumed by someone else. I will never get it back!
Grain examples should be avoided, for they certainly do not stack up.
By Toby Baxendale, on 11 March 10
Why Even the Best Banks are Insolvent and Inherently Dishonest
We are told that Barclays is a good bank and it did well not to take the taxpayers shilling. We are told that it has recovered and is prospering and this indeed is a sign of the economic recovery.
Part of the mission of the Honest Money Movement is to explore and expose these fallacies.
Banks only exist with entrenched legal and accountancy privilege. Privilege for all sectors of the political spectrum is a bad thing. Trade Union privilege to operate a closed shop cuts back on employment and price gouges the customers who buy the goods that the closed shop workers produce. A group of countries who restrict the price of say oil will push up the price of oil and gouge their customers and so on and so forth. All privilege is bad.
Contrast Normal Commercial Activity…
Any business in this country from the plumber to BP will have current creditors, those people it owes money to such as suppliers and current debtors, those people who owe it money for the goods and services sold. It is a legal offense to not pay your assets and your liabilities as and when they fall due. Indeed as a company director you become personally liable should you trade in this position whilst you are insolvent.
…With That of a Bank
A bank has current creditors: on the whole, these are people like you and me who have our salaries or savings paid or deposited into our accounts on our behalf. We do not actually “own our money” that is deposited in the bank. The bank does.
This may come as a surprise to you. However this is a very well established point of law. Since 1811 in Carr v Carr, this has been the case. So you and I are the current creditors to the bank i.e. we are owed money by the bank. In fact your bank statement is just an IOU from the bank acknowledging that it owes you however much it says on the statement on demand.
The assets of the bank are those people to whom the bank has lent its (formerly your) money to i.e. all the borrowers of loans. As has been so clearly displayed during this crisis, they have lent their money out (formerly yours) over 33 times on average to borrowers. I explain the money credit creation multiplier here for a refresher on understanding this process. So when more than 1 of 33 of us wish to withdraw our money that is on demand, the bank can not pay it back as it does not have it.
I enclose a link to the balance sheet of the UK’s largest company, BP here here. Page 106 has the balance sheet.
| Non-current assets |
£161,854M |
| Current assets |
£66,384M |
| Total Assets |
£228,238M |
| Current liabilities |
£69,793M |
| Non Current liabilities |
£136,129M |
| Net Assets |
£92,109M |
This would suggest that BP has current liabilities marginally greater than their current assets. No doubt the timing of the payment to suppliers is carefully balanced off otherwise their auditors could not sign off the accounts if they thought the company could not pay off its assets as and when they fall due.
Contrast this with the Barclays Bank full year 2009 results shown on this spreadsheet.
See tab 4 where we have the consolidated balance sheet. There are just assets and liabilities and there is not a distinction in their accounts between current liabilities i.e. your and my money that has been deposited that is on demand now and a long term liability such as a mortgage to pay off a loan on some property they may occupy etc over a long period of time. There is £322 billion of money on deposit in current creditors that could be withdrawn “on demand” as that is what the bank tells you that you can do with it. Indeed you only deposit it that way because you need to make sure payments happen on demand. They have no requirement to provide you with the ability to make this happen despite the fact that you may have deposited money there!
So unlike BP and any commercial business from the lowest one man band plumber to the mighty BP, who have to account for keeping payments set aside to cover their current liabilities, a bank is not required to. Indeed, it is specifically allowed not to by accounting law and legal privilege under law. If the deposit base of Barclays wanted what it thought was “its” money back i.e. it wanted the £322 billion redeemed into cash or taken out of the bank and moved to another, then as there is no corresponding current asset to pay for this and only assets that have long term payment implications, it would have to suspend redemptions as North Rock did and hope people would wait until it could try to sell some of its long term assets or collect in its loans. In reality, this would be a run on a bank. Barclays by its very nature is inherently insolvent and can only exist by this accounting / legal privilege that does not apply to any other non bank business in the UK!
One of the first things you will ever learn in a law of contract course is that an agreement is reached between parties and a contract established when an offer is accepted with a mirror image of understanding , from the Latin “pacta sunt servanda” or agreements must be kept. So it would strike me that as the vast majority of people think that they deposit their money and it remains their money in a bank and that the law and accounting standards say otherwise, there is a very good argument that there is not a contract in place between any depositor and bank. Certainly as most depositors also want easy access.
I commissioned a survey for the Cobden Centre in Oct 2009 with ICM over 2,000 people. 74% of people think that they are the legal owner of the money in their current account rather than the bank. Paradoxically 61% know that their money is lent out even though 67% want convenient (now) on demand access. The full results of this survey will be published shortly in another paper.
Now we can understand how the banks have the biggest salaries, the biggest bonuses , the biggest offices, the most plush terms and conditions of employment and so on and so forth. If you do not have to provide for your creditors then you can use their money to do what you like with and this is what happens!
Just to give you an idea what this would mean for me in my company Seafood Holdings Ltd if I was allowed to do what the banks are allowed to do. As of December 2009, I had trade current creditors of £8.276m against trade debtors of £12.275m. If I was a bank, I could pick up the full £8.276m and pay a dividend or bonus and still be lawful. I could build a megalomaniac size corporate head office and stick a gold plated statue with me dressed in a Roman Caesar like uniform to please my demented ego! I could behave like the worst most vulgar of City bankers.
We must always remember their key service other than the safe keeping of our money is to act as an intermediary between saver and borrower. This is “Captain Mannering” style boring banking. Like and estate agent who mediates between buyer and seller of houses, he has a High Street presence like most providing a consumer service. Places like the City of London / Canary Wharf and Wall Street etc can only exist as they do today on this legal privilege and on the welfare state of credit whereby we allow them to exist at the tax payers’ expense.
By Steven Baker MP, on 9 March 10
 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
By Steven Baker MP, on 23 February 10
James M. Buchanan (Nobel Laureate, economics, 1986) on reform of the monetary regime through constitutional 100% reserves:
The market will not work effectively with monetary anarchy. Politicization is not an effective alternative. We must commence meaningful dialogue with acceptance of these elementary verities. Far too much has been said and written in elaboration of the first statement, which too often is taken to be equivalent to the assertion that “capitalism” or “the market” has failed. Admittedly claims for market efficacy without qualifiers can be found. But economists should know that anarchy can only generate disorder rather than its opposite.
Later:
It follows that there is no economic reason why any money system, in an idealized setting, would allow for leverage at any level. No holder of a unit of money, as an entry in a balance sheet, should be authorized to lend more than the face value of this unit, quite independent of probabilistically determined expectations concerning potential redemptions.
Why not? Because to allow separate banks to create short-term liabilities to a multiple of the base money on the asset side of the account removes from the issuing authority some of the control of the aggregate amount of that value treated as money in the economy without offsetting benefits, thereby making the financial structure vulnerable to unpredictable shifts among instruments, which, in turn, generate changes in real values.
The modern dilemma is that we are left with a massive resource-using, financial- banking structure that has a functional purpose quite different from that which is widely accepted. The system in existence emerged from a historical process, the characteristics of which were partially appropriate for a monetary standard defined in terms of some commodity base, but which, ultimately, make no sense under a fiat system.
Finally:
Let us not waste this set of crises by exclusive recourse to jerry-built efforts to patch up the failed monetary anarchy we have witnessed.
Read more: http://www.mps2009.org/files/Buchanan.pdf
By James Tyler, on 22 February 10
I see the panel of economic experts that is the acting industry have latched onto the Tobin tax, now re-branded the ‘Robin Hood Tax’. Never mind that Robin Hood fought against unjust taxes by tyrants: the modern day bogey man is the banker.
Now funny thing is, I do agree with a lot of the sentiment expressed by the morally indignant of Primrose Hill.
Yes, the financial world has grown out of all proportion to the real world
Yes, the rewards for participation in this job seem ludicrously high
Yes, bankers have been bailed out by tax payers and are now furiously spinning the wheels of casino capitalism faster than ever before.
Yes, we should do something about it.
But. Not this.
Firstly, why financial markets are important. The good that these things do is provide a price on the future. They allow us all to insure ourselves against the unknown, whether that be a fixed rate mortgage to buy your house, or a bond issue that allows a company to grow.
Financial markets provide sellers for the shares you want to buy, insurers for risks you want to avoid and lenders when you need to borrow.
Attack the market, and you attack its ability to do this job efficiently. The price will be paid by you.
It is said that the market will absorb the Tobin/Hood/Luvvie tax. Anyone who says this clearly underestimates the ability of a bank to pass on its increased costs. You will either pay directly by higher fees, or indirectly, as the cost of everyday things get more expensive.
And more expensive they will be as the Luvvie tax will infect its way through the whole system. At every stage of production, financial markets are used to quantify and reduce costs. Commodity futures allow manufacturers to fix input costs, freight derivatives allow shippers to control cash flow, forward foreign exchange allows import/export companies to insure against wild market swings, credit insurance allow insurance against default and so on and on.
But surely a tiny transactional tax would pass unnoticed? Well, it may seem tiny, but to many market participants this Luvvie tax will be huge. What people fail to understand is that a regular and competitive price in many instruments come from institutions that are prepared to turn over huge volumes in order to make a net margin often much smaller than the Luvvie tax. In one fell swoop, you make a huge proportion of this trading unprofitable, therefore you take away the ability of the market to provide a price. It’s always the way of ill thought out taxes: unintended consequences. Some arbitrary decision is made, and a myriad of economic activity suddenly becomes futile.
So what? Who needs them? Well, you do. Every time you want to invest in your pension, you will (indirectly) need to buy a bond or some shares. Where do you think the seller comes from? Charity? No, it is the myriad of active traders that act as the buffer between ‘real’ buyers and sellers of these things.
In the end, you will pay by being poorer as a pensioner, by paying more interest on your mortgage and by generally being gouged more by the banks.
And so, we turn to the banks. The true villain of the piece.
The problem with financial markets is that banks are allowed to actively participate in this trading game. It would be less problematic if banks used the markets merely to reduce their risks, but this is not what they do. They see markets as a lucrative opportunity to enhance their profits, and they seize it with both hands.
Why is this bad? Because they punt their customer’s demand deposits. They take the money set aside to pay your gas bill, multiply it up tenfold, then wade onto the casino floor. What allows them to do this with some level of (misplaced) confidence is the myriad of legislative favours, monopoly rights, tax payer protection and political pressure arrayed to support them.
Here at the Cobden Centre, we’ve bleated on time and time again about how fractional reserve banking conjures money out of thin air, but it is worth repeating. You deposit £100 of notes and coin in your current account, and this becomes the property of the bank to do with as they wish. You sign it over to the bank, who lend most of it out. £100 of cash, becomes £197 of purchasing power. Whomever gets £97 loan, deposits it at their bank, and the same happens again and again.
Are you happy that the £100 you think is being safely held aside for your weekly food shopping is being used to fund £1000 of credit default swaps? I thought not.
At the end of the day, what consenting adults do in the privacy of their own bedrooms is of no concern to you. What hedge funds do with their willing clients’ money does not concern anyone but the investor. What pure trading companies do with their retained capital is of no worry to you.
The problem is the banks. An the best way to put a stop to their nefarious influence is not by taxing them and innocent parties. Not by robbing pension funds. Not by forcing you to pay higher fees to manage your financial affairs (as you surely will). No, they way to deal with the problem that banking has become is simple:
Free markets built on the bedrock of honest money.
Further Reading
- Huerta de Soto, Money, Bank Credit and Economic Cycles
- Baxendale, A day of reckoning: how to end the banking crisis now
- What is wrong with banking, part 1: the legal nature of banking contracts
- Frank Whitson Fetter, Development of British Monetary Orthodoxy 1797 – 1875
- F. A. Hayek, Denationalisation of Money: The Argument Refined
- Gordon Kerr, How To Destroy the British Banking System and Bailing out the Banks – Glaring Evidence of Moral Hazard
- James Tyler, My Journey to Austrianism via the City, Money is not working and How to avoid future encounters with financial meltdown
- Irving Fisher, 100% Money, 1935
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