Economics

The curse of Babel

By Steven Baker MP, on 15 August 11

A very old and well known story is told in Genesis 11. It is the story of the curse of Babel:

Now the whole world had one language and a common speech. As people moved eastward, they found a plain in Shinar and settled there.

They said to each other, “Come, let’s make bricks and bake them thoroughly.” They used brick instead of stone, and tar for mortar. Then they said, “Come, let us build ourselves a city, with a tower that reaches to the heavens, so that we may make a name for ourselves; otherwise we will be scattered over the face of the whole earth.”

But the LORD came down to see the city and the tower the people were building. The LORD said, “If as one people speaking the same language they have begun to do this, then nothing they plan to do will be impossible for them. Come, let us go down and confuse their language so they will not understand each other.”

So the LORD scattered them from there over all the earth, and they stopped building the city. That is why it was called Babel—because there the LORD confused the language of the whole world. From there the LORD scattered them over the face of the whole earth.

I retell this tale not for the sake of the theology but for the sake of our present debates. In what follows, the names have been omitted in the hope that I may be excused any hint of misrepresentation…

When I first approached a prominent worldwide leader of the Austrian School, in frustration at the pitiful state of economic debate, to ask who were the UK’s best Austrians, with a view to starting a UK-based Austrian-School think tank, things seemed ever so easy. I had mostly read Mises and a touch of Rothbard. I understood the Austrian school and the monetary theory of the trade cycle but I was not broadly read into the scholarly debate over money.

And then I discovered the curse of Babel amongst the monetary scholars of the free-market.

One eminent free-market British academic believes that central banking, fiat money and fractional reserve deposit taking are institutions which have evolved naturally in society and which should be preserved. He believes the Bank of England should be privatised.

Most Monetarists seem to think central banking and fiat money are just fine, together with the Keynesians, some of whom at least think they are free market, but some advocate various forms of full-reserve banking.

Most, perhaps all, Austrians think the central banks are a plain instrument of statism which should be abolished, together with deposit insurance, legal tender laws and various other privileges. They reject fiat money outright, more often than not, as a creature of interventionism and a tool of the enemies of liberty.

But one faction believes that fractional reserve deposit taking is a breach of sound property rights — a thoroughly libertarian concept — and that it emerged out of fraud to be legitimised by the state.

The other faction pay little heed to the theory of property rights in demand deposits, emphasising freedom of contract. They believe fractional reserve deposit taking is a natural and honest phenomenon which enjoys the consent of depositors. They argue that full-reserve deposit taking is only ever a product of the state and deride the full-reservers willingness to restrict freedom.

Amongst all this, the protagonists accuse one another variously of economic or legal ignorance or a misinterpretation of history. All sides have their scholars and their literature.  Both factions claim the term “free banking” as a rejection of central banking. Sometimes they claim the support of the same scholars…

It seems once we go beyond money as the means of exchange, universal agreement stops. Truly, when it comes to the institutional arrangements for money, we are under the curse of Babel.

It is a pity then that money is dying.

Right across the western world and perhaps shortly in China, we see state-supplied money running out of control, with all the distortions and maladjustments that implies, across sectors, regions and time. It seems the state’s response to every setback is more borrowing and more debasement. Unable to sensibly measure the money supply and unsure whether circumstances are inflationary or deflationary, the authorities wrestle to prop up a system damned by its own inadvertent design, a design which emerged out of the failure of Bretton Woods, itself a system condemned to a youthful death.

Five years ago, I would have wondered how the monetary authorities of the Weimar Republic could be so stupid…

At The Cobden Centre, we are agreed that honest money is a product of the market subject to the laws of property and contract, not the will of authority. With Richard Cobden, we agree that the very terms of regulating and managing the currency are an absurdity: the currency should regulate itself. Unfortunately and despite endless study, we seem to be able to agree neither what the proper institutions of such a system would be nor how to get there.

We have previously published an admittedly incomplete list of ten plans for reform. Since I agree with Sir Mervyn King (PDF) in that “of all the many ways of organising banking, the worst is the one we have today”, I could happily accept most of them as a step forward. Perhaps Bagus’ “button-pushing” withdrawal of the state would have disruptive consequences beyond our imagination but it seems mere perseverance with our present system is little more predictable, except in as much as it shall fail.

The original curse of Babel was cast, it seems, to prevent a people speaking as one: for speaking as one, nothing they planned to do would be impossible for them. Perhaps we shall not aspire so high, but we must change if we are to rise above the level of The People’s Front of Judea and win a battle which, it seems, must be won in our lifetimes.

Steve Baker is a professional engineer with a background in the Royal Air Force and entrepreneurial software businesses. Among other things, he has worked with major banks and regulators internationally. His personal and political website is at stevebaker.info. Steve is MP for Wycombe. | Contact us
15 August 11 | Tags: , , , , , , , | Category: Economics | 41 comments
Economics

A Note on the Notice of Withdrawal Clause

By Anthony J. Evans, on 31 March 11

Regular readers of this site may be aware of a debate relating to the contractual devices that banks might use to ensure that they are solvent. One of the terms that has been used is a “notice of withdrawal clause”, but what is this?

It might be argued that a notice of withdrawal clause (or a “withdrawal clause”) is merely another term for the more often invoked “option clause”. This has received extensive treatment in the “free banking” literature (for example Dowd (1988), Selgin & White (1994, 1997)), and we can use the following definition:

option clauses… give banks the option of deferring redemption of their notes provided that they later pay compensation to the noteholders whose demands for redemption are deferred” (Dowd, 1998, p.319)

The confusion may stem from the fact that in some instances option clauses and withdrawal clauses are used interchangeably. For example Selgin & White (1997) say:

one possible run-proofing device discussed in the literature is an “option clause” or “notice of withdrawal clause” allowing a bank temporarily to suspend the redeemability of some or all of its liabilities (notes or demand deposits) provided the bank pays a pre-specified (penalty) rate of interest on the suspended liabilities

However, I believe there is stronger textual support for the idea that they are distinct devices. In an earlier article Selgin & White (1994) say the following:

a bank might contractually reserve the option to suspend for a limited time the redeemability of its notes or demand deposits, as Scottish banks did with banknotes before 1765 (when the practice was outlawed) and as banks do today when they include “notices of withdrawal” clauses in deposit contracts

My reading is that they are often used interchangeably (or perhaps as though a withdrawal clause is a type of option clause), because they perform the same economic function. But a detailed reading would reveal them to be different.

In my working paper on the sound money debate I define a withdrawal clause as follows:

In addition to the option clause banks might also offer (and historically did offer) a “notice of withdrawal” clause, specifying that their customers were required to give 























































30 days notice prior to making a redemption claim. The fact that this clause existed (to protect the bank from a legal point of view if it were ever to suffer a liquidity crisis) does not mean it is always invoked, and banks could routinely not enforce this rule and satisfy immediate redemption requests.

Firstly, note that this is presented as a different clause to the option clause. But secondly, we can see that it differs from the option clause in terms of the default nature of the contract.

Recollect that an option clause allows banks – under certain conditions – to convert a demand deposit into a timed deposit (thus giving them time to generate liquidity whilst avoiding firesale losses). This is seen to be good for the banks (obviously!) but also good for the customers (since it’s better to receive the deposit plus interest at some point in the future than to see the bank being wiped out).

However in the case of the withdrawal clause there is a notice period written into the contract – it is technically a timed deposit (where the notice period serves as a minimum term). But if the bank wanted to offer an instant access account it can simply publicise the fact that it does not routinely enforce this notice period and that it satisfies redemptions on demand.

I suspect the reason withdrawal clauses received less explicit attention in the literature is that unlike the option clause they are not a uniquely “free banking” concept. Indeed, notices of withdrawal are routinely used in contemporary banking. Investopedia define it as follows:

A notice given to a bank by a depositor. As its name implies, a notice of withdrawal states the depositor’s intention to withdraw funds from an account. This notice applies to both time-deposit and NOW accounts

In short, the option clause means that a de jure demand deposit can be treated as a de facto timed deposit. The withdrawal clause means that a de jure timed deposit can be treated as a de facto demand deposit. They are two sides of the same coin – both allow instant access fractional reserve accounts, the only difference is the default position.

So perhaps provisions such as option clauses and withdrawal clauses allow banks to offer fractional reserve accounts that aren’t fraudulent or reliant on legal privilege, but does that make the 100% reserve argument wrong? Not necessarily. The withdrawal clause in particular “works” precisely because it changes the de jure status of the account. A counter argument might be “if a withdrawal clause applies to a timed deposit then you are admitting that fractional reserve banking is irreconcilable with demand deposits”. From the view of legal theory (and depending on your definitions), this may well be correct. However the de facto status of this account is instant access and redeemable “on demand”. In terms of the economic function of the account it exists exactly as “free bankers” envisage.

References

Anthony J. Evans is Associate Professor of Economics at ESCP Europe Business School, and Founding Fellow of The Cobden Centre | Contact us
31 March 11 | Tags: , , , | Category: Economics | 5 comments
Economics

Money is not working.

By James Tyler, on 1 March 11

A speech to the Policy Exchange on 31st March 2009 by Cobden Centre sponsor James Tyler. This article first appeared on hedgehedge.com but it remains as relevant today.

I want to talk about two things today;

Number 1: Free markets did NOT cause this crisis… Governments did.

Number 2: Inflation targeting has failed. Money has failed. What should we do?

Free markets did not cause this problem.

In theory, markets work by reacting to prices and direct capital towards where it will be most productively used. This is how wealth is created. Usually this works well, but markets are made up of humans, and can be fooled into overshooting by false signals.

Bubbles build up, expanding until people lose confidence. Bubbles then burst. It’s a corrective process that, relatively benignly, irons out imbalances.

The problem only comes when bubbles go on for too long, because once they get too big, the pop can be terrifying. And that’s what we’ve got now – one hell of a big bang.

False signals have caused a spectacular mal-investment in real estate and its derivatives.

But these false signals did not come from the market, but from government.

False signals.

False signals came from Greenspan’s introduction of welfare for markets. Markets were taught that no matter how much risk they took, they would always be saved. 1987, 1994, 1998, 2001. Each bust bigger than the last, and disaster was only staved off with aggressive rate cuts and increased money supply.

Clearly this was not laissez faire. Just think if events had been allowed to take their course. I bet if LTCM had gone bust then a badly burned Wall Street would have learned a lesson and Lehman’s would still be around today.

In 1999 Clinton mandated that Fannie Mae and Freddie Mac reduce lending standards. The poor were encouraged into debt. This intervention triggered a race to the bottom of lending standards as commercial banks were forced to compete against the limitless pockets of Uncle Sam.

False signals came from deposit insurance. Deposit your money in a boring mutual? Why bother when you can lend it to a lump of volcanic rock in the Atlantic at 7% and be guaranteed to get your money back.

The Basle banking accords required banks to replace rock solid reserves with maths.

Government protected and regulated ratings agencies produced negligent ratings duping pension funds, who were obligated to buy high quality paper, into buying junk cleansed by untested mathematical models.

Central banks create boom-bust.

But most damaging of all was the absurdly low interest rates set between 2001 and 2004.

The resultant glut of cheap money fueled an unsustainable boom encouraging more mortgages to be taken out, and pushing property prices ever higher.

The market responded by pushing scarce economic capital towards highly speculative property development.

As prices rose people remortgaged, and borrowed to consume more. This unchecked process tended to be destructive, as scarce economic capital flowed out of our economy and headed to those economies efficiently producing consumer goods, such as China. Rampant asset inflation clouded our ability to see this depletion process in action.

Everyone had a great time whilst the party lasted, not least Governments who were incentivised to let it run, blinded by ever larger tax revenues.

But all parties come to an end, and central banks had to prick the bubble eventually. Interest rates went too high, and sub prime collapsed, and then all property prices plummeted. Trillions of dollars were ripped out of the financial system, and the credit crunch began.

It’s happened before.

But, despite its complexity, there was nothing new or unpredictable about this process. All the great busts of the 20th century were preceded by a Government sanctioned fiat currency booms.

In the 1920’s, the Fed pursued a ‘constant dollar’ policy. This was the era of the innovation, Model T Fords, radios and rapid technological advancement.

Things should have got cheaper for millions of people, but money supply was boosted to try and keep prices constant. All that extra money flowed into the stock market, pushing prices to crazy levels, and we all know how that ended.

In the modern day, targeting price changes has been an utter disaster for us too.

It let the Bank of England pretend they were doing their job, when money supply was growing at a double digit rate. It let the authorities relax whilst an economy threatening credit bubble was building up.

And it gave Gordon Brown the leeway to convince people that boom and bust was over.

Things should have got cheaper.

Inflation targeting made no allowance for globalisation, the rise of India and China, and the benign falls in general prices that should have been triggered. Think about it; if all those cheap goods were to become available, consumer prices should fall. We would have had greater purchasing power, and become wealthier for it.

But, the Bank of England was aiming at a symmetrical plus 2% target. Falling prices in some goods necessitated stimulating rises in others. They unleashed an avalanche of under priced debt and we had our own crazy asset boom.

Inflation targeting was a myopic policy.

Governments make terrible farmers.

When a central bank sets interest rates, they set the price of credit. Inevitably they create distortions.

Consider this; Governments cannot set food prices without causing a glut -or- painful shortages. Now, food is a pretty simple commodity, yet we all understand that central planners simply cannot gather enough information to set the price accurately.

It has to be left to the spontaneous interaction of thousands of buyers and sellers to set the price.

So, why do we think that enlightened bureaucrats can put an exact price on something as vital, yet complicated, as credit?

In a nutshell, if I can’t tell how much my wife will spend on Bond Street this weekend, how can they?

Let’s wake up from this fantasy.

There is a better way.

What’s the cure? Let the invisible hand to do its time honoured job. Leave interest rates to be set by the millions of suppliers and users of capital.

Get the central planners out of the way.

It’s the way it used to happen. The period of fastest economic growth the world has seen was America between the civil war and the end of the 19th century. Money was free and private and the Fed did not exist.

So, how do we get back to freedom in money? Fredrich Hayek – the great Austrian economist – did the best thinking on this. What he proposed was that private firms should be allowed to produce their own currencies, which would then be free to compete against each other. People would only hold currency that maintained its value, firms that over-issued would go bust Producers of ‘sound’ money would prosper.

History gives us plenty of successful examples of private money working well, 18th Century Scotland had competing banks, all with their own bank notes. People weren’t confused. It worked. There are many other examples.

In the modern age, technology makes the prospect of monetary competition even more tantalising. Mobile phones, oyster cards, smart tags, embedded chips, wireless networks. The internet. Prices could flash up in the shopper’s preferred currency.

A proposal.

Here’s an idea of how to kick the process off;

Tesco’s want to get into banking. Why not currencies as well? Tesco would print one million pieces of paper. Let’s call them Tesco pounds. It would be redeemable at any time for £10 or $15. They would then be auctioned, and the price of a Tesco set.

Anyone who owns a Tesco has a hedge against either the £ OR $ devaluing therefore the Tesco has an additional intrinsic value. Maybe they’ll auction at £12.

Tesco would specify a shopping basket of goods that cost £60. It would promise that 5 Tesco Pounds would always buy that weekly shop. The firm would use its assets to adjust the supply of Tesco Pounds so that they kept this stable value.

They would need to otherwise their shelves would be cleaned out!

As central banks inflated the £ and $ away over time, the convertibility into these currencies would matter less. We would be left with a hard currency that meant something.

There would be other competitors and a real choice about which money to hold your wealth in.

McDonalds has a better credit rating than Her Majesties Government, so maybe people would be happy to hold Big Mac tokens? I don’t know – it will be a free choice.

Currencies would sink or swim depending on how well they performed. What’s more, firms issuing the currencies would come up with different ways of maintaining their value. Some would offer Gold. Manufacturers may use notes backed up by steel, copper and oil.

Let’s see what a free market chooses. Somebody might have a brainwave and come up with an idea that nobody has thought of.

That is what free markets are best at.

I can guess the reactions that my proposal might inspire in some. How would the man on the street cope? Well, nobody would outlaw the Government’s money, and people could carry on as before. Through the operation of the market, we would find out what worked best . Step-by step, the economy would be transformed and standards driven up.

In economics, spontaneous orders are always so much more rational and stable than planned ones. Always.

Conclusion.

This is not a crisis caused by free markets. A free and unregulated market in money has not existed for over a century.

This is a Government crisis. A crisis over the monopoly of money.

Inflation targeting seemed so persuasive…. but it was a false God, and we deserve better. Stability and sound money can only come if we put the money supply back where it belongs…

Under the control of the free market.

James Tyler is Chief Executive of Tyler Capital. | Contact us
1 March 11 | Tags: , , , , , , , , , , , | Category: Economics | 3 comments
Economics

Banking: the shape of the debate

By Steven Baker MP, on 25 January 10

ESCP EuropeShould banks be permitted to operate with a fractional reserve on demand deposits or should 100% reserves be a legal requirement? Should there be a central bank with a monopoly on note issue? What are the consequences of these choices? These were mainstream questions in the 19th century and they demand attention today. Here, following the ESCP Europe/Cobden Centre “Colloquium on Honest Money”, Steve Baker  frames the debate to be had about money and banking.

Today, people are well aware that we have a banking crisis, a “credit crunch“. That is, there is a problem in the financial system, a system which is centrally planned — see Economic Interventionism, Banks and the Crisis – and an approach which necessarily works badly – see Strip the Bank of England of its power. So, what are the features of the present system and what are the alternatives?

The two important features of the present, orthodox system are:

  • The banks are not required to keep money in reserve to the value of demand deposits. That is, they operate with a fractional reserve. As Toby Baxendale has pointed out, today if more than one person in 34 asks their bank for their money back in notes and coins, which is a reasonable, contractually-sound request, we will have a systemic banking crisis — a run on all banks — because there is simply not as much cash as people’s bank statements say there is.
  • There are, across the world, central banks in which committees of experts set “monetary policy” — see The kindness of geniuses – a rate of interest which, through various mechanisms, affects the entire economy.  And the economy is, of course, what people choose to do, since the economy is nothing more or less than the cooperation of thinking, acting individuals and of corporations run by thinking, acting individuals; therefore, manipulating the interest rate necessarily distorts the actions of people and the productive structure. Central banks also act as “lenders of last resort” in the event of a run on a particular bank — which is possible because of their fractional reserve — but in the case of Northern Rock, the Bank of England did not ultimately fulfill that role.

Stepping back from today’s monetary orthodoxy — a fractional reserve and a central bank — the options are plain: we can have a 100% reserve on demand deposits, or not, and separately, we can have central banks with a monopoly on the supply of currency, or not. Hence, Jesús Huerta de Soto models (PDF) the banking debate as follows:

The shape of the banking debate

The shape of the debate (click to enlarge)

As Irving Fisher, one of the founders of Monetarism, pointed out in the sub-title and content of his book 100% Money, there are potential benefits to be gained from moving to another system. For example, Fisher identified the following as the headline benefits of moving to a 100% reserve requirement:

  • keeping chequing banks 100% liquid so that there can be no more runs on banks,
  • preventing inflation and deflation,
  • largely curing or preventing depressions,
  • and wiping out much of the National Debt.

Since we have had a run on a bank, since the money supply has deflated, since attempts to reflate the money supply risk price inflation and distort the economy, since the boom-bust cycle is evidently still in progress and since we are doubling our national debt, it is perhaps worth taking seriously the question of how our system of money and banking is organized.

Furthering that discussion was the purpose of the recent ESCP Europe/Cobden Centre Colloquium on Honest Money directed by Founding Fellow Dr Anthony J. Evans, Chaired by Corporate Affairs Director Steve Baker and attended by Chairman Toby Baxendale amongst 9 other academics and practitioners in the field of money and banking.

We will continue to develop and promote a range of ideas to open up and further the debate on money and banking.

Further Reading

Steve Baker is a professional engineer with a background in the Royal Air Force and entrepreneurial software businesses. Among other things, he has worked with major banks and regulators internationally. His personal and political website is at stevebaker.info. Steve is MP for Wycombe. | Contact us
25 January 10 | Tags: , , , , , , , , , , , , , , | Category: Economics, Law | 4 comments