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By Steven Baker, on 22 January 10
Today, we publish our brief guide to money and banking.
The Guide comprises:
- Four charts showing how Baxendale and Evans’ measure of the money supply correlates to economic activity whereas the Bank of England’s measures do not,
- How wealth is created,
- What is and is not money,
- What is wrong with the mechanistic Quantity Theory of Money,
- The role of the interest rate in the business cycle,
- How banking has become socialised through legal privilege and taxpayer guarantee,
- The shape of the debate on money and banking.
By James, on 20 January 10
A speech by James Tyler to the Adam Smith Institute Next Generation Group, 6th October 2009. This speech is also available on hedgehedge.com.
I have spent the best part of the last two decades picking my wits against the market. It’s an unforgiving game: I’ve seen ups and downs, and many of my rivals buried under an avalanche of hubris, passion, illogical thought and unchecked emotion.
I have witnessed the sheer folly of the ERM crisis, the Asian crisis, the failure of the Gods at Long Term Capital Management and the insanity of the tech boom.
I have enjoyed the ‘NICE’ decade (None Inflationary Constant Expansion), and scared myself silly during the credit crisis.
I am a trader.
I risk my own money and live or die by my decisions, and face the threat of personal bankruptcy every time I switch my screens on. I get no salary – indeed I turn up at the start of the month with a large office overhead – a ‘negative’ salary. I have no fancy company pension scheme, no lucrative monopoly or franchise.
I eat what I kill.
Mistakes cost me my livelihood, so, above all, my decisions have to be rooted in practical and logical decision making.
Some have called my kind parasitic, but I would have said that I bring order, efficiency, predictability, stability and deep liquidity to crucial process: a process that makes the whole world keep ticking.
I make money work.
I make the market in interest rate derivatives: a market born out of the neo classical revolution in finance fostered in Chicago during the 1970s. I am a child of Freidman, Fisher Black, Myron Scholes and the modern international financial system.
My analysis was steeped in the neo-classical, efficient markets paradigm.
Friedman’s ideal was working. Enlightened central bankers guided the free market with gentle nudges and short term liquidity infusions, free floating currencies gently adjusted themselves to the constant flow of new information and efficient and rational markets took all in their stride.
Credit flowed, people got wealthier, economies developed and all was well.
And then the crisis struck.
Continue reading “My Journey to Austrianism via the City”
By James, on 13 January 10
A speech to the Policy Exchange on 31st March 2009 by Cobden Centre sponsor James Tyler. This article first appeared on hedgehedge.com.
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.
By Steven Baker, on 19 November 09
 Through tomorrow and Saturday, ESCP Europe and The Cobden Centre are hosting a Colloquium on Sound Money. The Colloquium is to be directed by Founding Fellow Dr Anthony J Evans and chaired by Corporate Affairs Director, Steve Baker.
A team of academics, banking professionals, entrepreneurs and politicians will meet to discuss:
- What is Money?
- The Interest Rate and Intertemporal Coordination
- The Gold Standard and the Great Depression
- Deflation and Prosperity
- Free Banking vs 100% Reserves
- Central Banking
- Proposals for Reform
The authors whose work will be under consideration are Carl Menger, Joseph Salerno, Frank Shostak, Ludwig von Mises, Friedrich A Hayek, Joan and Richard James Sweeney, Murray Rothbard, Lawrence Reed, Lawrence H White, George Selgin, Vera Smith, Tim Congdon, Richard Salsman and Jesús Huerta de Soto.
By James, on 18 November 09
Cobden Centre Advisory Board member and Chief Executive of Tyler Capital, James Tyler, sets out the case for 100% reserve banking.
Background
In October 2008 the Federal Reserve briefed a secret congressional committee that the US economy had, at one stage, been only a few hours away from a total meltdown in the financial system.
How did this come to pass, and how can we prevent it again?
The Problem
Fractional Reserve Banking (FRB) is an inherently unstable complex system.
Each and every bubble and crisis has some kind of link to FRB, going back thousands of years.
Even where financial crises are caused by natural disasters (the San Francisco earthquake of 1906 being a prime example), the financial crisis only followed because banks did not have enough reserves to pay out worried depositors – due to fractional reserves.
In a nutshell, depositors wanted what they thought was their property back, only to find it did not exist.
Over 70% of people in the UK believe that money placed in an instant access account remains their property. This is not the case.
Fractional Reserve Banking
- Person ‘A’ deposits £100 of cash into his instant-access bank account.
- At this point, he signs over property rights to the bank – the bank gives him a promise to return on demand
- The bank retains a small reserve (say £3), and lends out £97 to Person ‘B’
- Both ‘A’ and ‘B’ both have a claim to instant access on this money.
- In one move, the bank has turned £100 into £197 of useable money
- ‘B’ buys a Widget from WidgeCo for £97
- WidgeCo deposits the £97 with his bank ‘Z’.
- Bank ‘Z’ now lends out around £94 to person ‘C’ keeping just under £3 as a ‘reserve’
- Person ‘C’ borrows to buy computer, and pays £94 to ‘D’
- Money supply has started its process of mushrooming:
- ‘A’ Has the right to £100
- ‘B’ has spent his claim to £97, and owns a widget
- WidgeCo has a claim to £97
- ‘C’ Has spent £94 and owns a computer
- This process continues until there is no more money to lend
- If any one person with a claim to their money exercises their right, the inverse pyramid collapses.
- If person ‘A’ claims any more than £3 of his money, the inverse pyramid collapses.
In 2007/8 this money pyramid almost collapsed.
Continue reading “How to avoid future encounters with financial meltdown”
By Steven Baker, on 15 October 09
Via The perils of cheap money – Telegraph Blogs, Ambrose Evans-Pritchard explains another danger of low interest rates:
Here’s a little nugget from Germany. The regulator BaFin has woken up to the danger that near-zero interest rates are a major danger for the Germany’s €700bn life insurance industry. They may not be able to meet their premiums. If deflation takes hold, they risk going the way of all those life insurers that went bust in Japan during the 1990s.
BaFin thought it had covered every possible shock – a share price crash, a debt crisis, etc – but nobody ever paid much attention to the long-term actuarial shock of low rates.
By Toby Baxendale, on 4 October 09
Toby Baxendale exposes flaws in the economic thinking of the left, indicates the dangers of deficit spending and points to a better way to fund welfare while stimulating genuine commercial investment.
Published in the FT on Friday the 2nd of October under the title “A cool look at the current deficit hysteria”, we find an article by a respected economist saying that there is nothing to worry about running a deficit at the present and predicted size. Our predicted budget deficit of 12.4% of GDP in the current financial year, gradually declining to 5.5% in 2013-14 is no big deal. Coupled with the public sector debt itself, we see it leveling out at 76% of GDP. Sir Samuel says “Debt ratios of this size are historically far from unprecedented. In the Victorian period the ratio was nearly 200% and almost reached that level again in the early 1920s. In 1956 it was just under 150 per cent.” He goes on to add, “the debt was gradually reduced from the peaks mentioned above without any heroic gestures.” In a classic Keynesian tone, he concludes “The big error of the current discussion is to confuse the budget balance of individuals and companies with the government budget balance, which needs to be in deficit so long as attempted savings exceed perceived investment opportunities. Gordon Brown more or less understands this, and I wish he would use his talents to explain such fundamentals instead of stirring up an outdated class war.”
For our international readers, Gordon Brown’s speech to the Labour Conference 2009 was a class war-laced speech worthy of some of the most envy driven and hating sections of the Left. The full text is available here, if you want to take yourself back to the start of the last century. I presume this is what Brittan refers to in the last quote.
Also deficit spending — living beyond our means — in the language of the left is “investment.” There are 5 references to this type of activity in this speech. I recall a timely quote to remember from Ludwig Von Mises in Human Action (Scholar’s Edition), Page P.737:
At the bottom of the interventionist argument there is always the idea that the government or the state is an entity outside and above the social process of production, that it owns something which is not derived from taxing its subjects, and that it can spend this mythical something for definite purposes. This is the Santa Claus fable raised by Lord Keynes to the dignity of an economic doctrine and enthusiastically endorsed by all those who expect personal advantage from government spending. As against these popular fallacies there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens’ spending and investment to the full extent of its quantity.
How is Wealth Created?
As I have said on this web site before, wealth is created on the factory floors, in the boardrooms and in the offices of people making their factors of production — land, labour and capital — work better for them in satisfying the needs and requirements of their consumers. Invariably, this means those factors need to be brought together in better combinations or made more productive. The latter is the most common way and this almost always needs savings — i.e. forgone consumption — to invest in the newer, more productive processes.
Governments do not create wealth, they can only take it from A and give to B.
What does an Interest Rate do?
As I have said before on this web site:
Simply put, you value more highly present goods of the same quality and quantity than you do future goods. Furthermore, the value of future goods diminishes as the length of time necessary for their completion increases. This sets up a price differential between goods now or goods later. This price differential is called an interest rate.
In reality it is also the rate of profit in the economy, as it is these saved resources that are the only source of future funding for investment and the associated return on that investment. So it is arguable to say that this is the most important metric in the economy.
To underscore this, it is the saved resources of all the economic agents in society that produces the goods and the profits of the future. The return (interest) on the savings can only be the additional component that allows the additional investment in making the production structure — all those activities mentioned above going on in factories and offices — that will produce the new goods and services. The rate of return on these savings must in-fact be the rate of profit of that which is lent to enterprises.
How do we Fund a Deficit?
The Government Bond
If the government has taken less in tax receipts than it gives out in transfer payments i.e. it has deficit, then it will raise the difference on the whole through the selling of government bonds or “Gilts”. These are promises that the UK taxpayer will pay back the bond holder at a date in the future.
It is important to note here that the savings and investment process that ensures that saved resources are put to their most urgent investment needs, as described above, immediately becomes distorted when a government bond soaks up resources to go into the government coffers for spending and not into productive industry. In short, at the very time today when we need our best wealth creators, the owners of all the businesses in this country, to be firing on all cylinders, looking at making themselves more productive and selling goods and services more in tune with the new demands today, in this post-boom world, we have a policy of running a deficit which will starve these wealth creators of the wherewithal to start lifting us out of this mess.
Contrast this with the Corporate Bond
A wealth creator may sell a corporate bond to fund his investment activities. Thus we must also observe that when you work producing wealth, you create a surplus.
You had capital of £X and, by the end of the year, you have capital of £X + £Y. You can give a return — coupon or interest rate — back to your investor. The merry-go-round can start all over again with a greater level of wealth accruing in society.
With the government bond, capital is taken away form the citizen and the interest is extracted via the taxation system to pay the bond holder. There is no wealth created, only at best transferred to another person and at worst totally destroyed.
When the proceeds of the government bond are issued to people on the dole (2.6m) and people on incapacity benefit (2.7m), capital is completely destroyed and the tax payer then pays interest on nothing!
A Note on Welfare Spending and the Future Funding of Welfare Provision
We currently rob Pater to pay Paul: that is, we fund a good portion of our welfare budget via the on-going issuance of public debt, the need for which has arisen as we are not prepared to live within our means as a nation i.e. less tax is taken than is spent by HMG.
The Rt Hon Ian Duncan Smith MP has produced a report here called “Dynamic Benefits: Towards Welfare That Works” that starts the process of simplifying the system for the claimant and the administrator. This is very welcome and long overdue. It also starts the reversal of the process whereby, over the last 12 years of Labour Government, benefits have become so rewarding — in the sense that if you are on welfare and you take employment, your net pay decreases — there is a great incentive never to get off them. All of this is welcome.
However, what you need to do, in the smallest local regions possible, is create an insurance scheme in a mutual or let the old Friendly Societies — see here for a brief account of their great history — take subscriptions from the people in the area to provide welfare to the people who need it when they fall on hard times. This has the effect of forcing the Society to invest in productive business activities to get a return on their investment to pay any welfare claims.
Contrast a bond paying interest on nothing (no capital) like a government bond with a corporate bond generating wealth (paying interest on capital) which the old Friendly Societies used: the latter is beneficial to the economy because investment takes place. Government spending can only ever be a redistribution.
Summary:
As Ludwig Von Mises says in the Scholar’s Edition of Human Action p770/1:
If government spending is financed by taxing the citizens or borrowing from them, the citizens’ power to spend and invest is curtailed to the same extent as that of the public treasury expands. No additional jobs are created.
So the message I am hopefully giving here, with the best clarity that I can, is that deficit spending totally undermines the wealth creation process.
If the government is urged to step in and spend where the private sector sees no opportunity, as Sir Samuel says, this will only lead to more general impoverishment. Does it need saying that only wealth creators create wealth and not wealth re-distributors, that is, the government?
This gives rise to the notion that a public debt is no burden because we owe it to ourselves. Now in fairness to Brittan, he is not saying this, he is just saying that in the absence of enough opportunities for savings to be fully utilized, then the government should spend instead. I hope in the above I have demonstrated that if funded by bonds (the majority way), then this is in fact a set-back to recovery.
By Toby Baxendale, on 22 September 09
 No to Keynes' Circular Flow The essential idea of a Liquidity Trap as expounded by J M Keynes in this “General Theory” is that there is a point in time, when the interest rate has fallen so low, that investment bonds, be they public or private, are returning so little, that the investor then decides to keep all his money as a cash balance. This then snuffs out any further economic activity that may have been brought about by the former investments. There is a general freezing up in the economy and a Recession becomes a Depression.
It is fashionable in all sectors of the media, politicians and economists to say that they think this event is happening right in front of our very own eyes
In the famous circular flow of income that the Keynesians adhere to, one man’s spending is a another man’s income.
Is it possible that a person would not spend anything in a Liquidity Trap? I think not. All people have to buy their day to day food stuffs, pay for heating, pay for shelter and other such basics.
Having an excess cash balance simply means that you are choosing to keep your money as cash for later use. You produced goods and services in exchange for money (cash) which you have kept as money, ready to exchange for other goods and services at a moment of your choosing.
Please reflect on this very salient point: a rise in your personal demand for money held as cash does not effect the production of goods and services because money is only employed to exchange things. If it did effect production, an unlimited rise in the demand for money (IE a Liquidity Trap) would mean that no one was exchanging goods and services for other goods and services. Society would cease to be!
We actually have a situation where we have the balance sheets of Central Banks showing cash reserves increasing to startling percentages since the start of the recession in August 2007 with a massive uplift since the Lehman Brothers crash on September 15th 2008 at 07:58. In the USA there are $760 billion of extra cash reserves that now sit in the USA banking system, some 123% more than the same period a year ago. By July of this year, the BoE had increased its balance sheet by £153 billion or 158% over the same time last year.
It would seem that the Keynesians have a point: there is all this cash in the system, untold amounts of liquidity that we have never seen before, and it is not being spent. Is this not the classic Keynesian circumstance in which a Liquidity Trap emerges? This is when silly Monetarist ideas of sprinkling money “from a helicopter” come into vogue: I recently saw a very nutty idea being put forward in the FT by Wolfgan Manchau saying that we should have some electronic devise inserted into money that makes it expire as legal tender after a period of time so people are forced to spend:
Central banks could deploy policies to discourage cash hoarding. One extreme possibility would be to stamp cash, putting an expiry date on banknotes that would force their holders to pay a fee equivalent to the negative interest rates.
Seemingly, people with these views are so divorced from reality they have forgotten, or perhaps never knew, how real wealth is created. I have explained this within Can the Manipulation of Interest Rates Create Wealth?
I find it useful to point out here that if we all spend our salaries on consumption goods only each month, we would not be able to buy any capital goods such as a house or a car, unless we are paid each month a net equivalent to buy a house or a car. Clearly, only a handful of football players and bankers are in a position to do this. No savings would be made if this policy was ever recommended which, in the medium term, would lead to large scale impoverishment of society. From savings, you have the wellspring of investment to produce the new goods and services of the future.
The massive build up of liquidity has come about as the economy has gone into recession. Governments around the world have reacted by putting newly minted money into the economy.
Why did the boom turn into bust? I would always argue that it was the prior large scale expansion of liquidity that led to excessive credit creation under Gordon Brown’s Chancellorship and indeed his Prime Ministry. From 1997 to today, we have seen an increase in money supply (as measured by M4) from £700 billion to £2 trillion.
The bust happened because the structure of production had become so distorted that the production sector was producing goods that the consumer did not want and/or could not afford to buy. How could this collectively happen? For some help with the answers to this, I turn to Hayek which I summarise. I funded the publication of Prices and Production and Other Works, which prints Hayek’s works written during his time at the LSE.
Capital Theory, the Structure of Production and Boom and Bust
From 1931-50, F A Hayek, the 1974 Nobel Price winner in Economics worked out the following in summary and was awarded the Prize for this work;
- A depression is always a shortening of the capital structure of production. Entrepreneurs have invested in things that people do not want in significant numbers such that when people collectively wake up to this fact, the bubble bursts and a realignment of production to the needs of the consumer takes place.
- This is caused by a concept that at the time was called “forced savings” as opposed to voluntary savings. To understand this further, we must look voluntary savings.
- When there are voluntary savings — in my business, using part of my cuts of meat to keep me sustained so I can invest in making a steel to sharpen my knives to “up” my productive output for any given time period — these can support the elongated structure of production that matches, via the interest rate, the prices and thus the needs of the consumers. This increase in voluntary savings causes a larger demand for producers’ goods in relation to consumers’ goods, so goods in the higher stages, those most removed from the production of consumer goods will see an increase in prices relative to the consumer good prices. The consequent narrowing of the spread or margin between the two furthest ends of the production structure and the consumer good end, or in other words, the lowering of the rate of interest, make possible a prolonged and indeed a permanent new process of production. This is steady capitalistic, very safe and very boring non boom growth.
- A lengthening of the structure of production caused by the opposite of voluntary savings — which Hayek called, in keeping with the time, “forced savings” — happens, simply put, when bank credit becomes more available via the demand deposit money creation multiplier described here or through the process known in modern parlance as “Quantitive Easing”. Both credit expansion and QE give the same signals to entrepreneurs that there is now a very low interest rate. This suggests there are plentiful real savings — money is cheap — therefore we can bring those production plans forward that we held at the margin of our thoughts and start investing. However, the consequent elongation of the structure of production is not sustainable because a reversal in the price spread between the producers’ goods and the consumers’ goods takes place as soon as the increase in the supply of cheap money via the private banking or central banking system slows or stops altogether. This is because the spending habits of the consumer have not actually changed.
- This has been compounded in our case by something else Hayek was hot on, if government expenditure rises , more is extracted from the citizens via either taxation or government-induced inflation. This too will cause a shortening of the process of production and a lengthening of the depression.
- If money were kept inelastic — i.e. a fixed supply in relation to the productive needs of the economy, then this could not happen.
In summary, any change in the money supply, through giving new loans to entrepreneurs or to consumers, first lengthens the production structure, then shortens it as real consumer needs have not changed.
Our problem arises from the prior elongation of the structure of production unbacked by real savings, brought about in particular via the low interest rate policy of Gordon Brown’s Government post 2000. This was enhanced by the massive and unprecedented increase in the money supply under his Chancellorship. That caused more investment in the heavy stages of production: the building of houses, or car factories, or to produce consumer goods that indeed, when push came to shove, not enough people could afford. The correction is now taking place. This is when entrepreneurs rebalance or redirect the factors of production that they have under their command to focus on the actual needs and demands of their customers.
There is no Liquidity Trap (I doubt that this is even a meaningful concept), just a badly misallocated structure of production which, despite the government, is in fact slowly but surely fixing itself.
Further reading
By Toby Baxendale, on 16 September 09
 UK Savings Ratio The Cobden Centre’s Chairman, Toby Baxendale, explores whether cheaper money will make for greater prosperity.
You often hear politicians and economic commentators say that we must have low interest rates to make sure the price of money is as low as possible to allow people to borrow and thus spend. This is very much the common view whatever your political outlook. The thought behind this is the Keynesian notion that one person’s spending is another person’s income. This is the famous circular flow of income. In a further article, I will address the latter notion. The first notion — whether cheaper money will make for greater prosperity — I will address now.
First of all, I would like to recap how we entrepreneurs create wealth.
How is Wealth Created?
I would like you to absent the concept of money and consider a situation of barter. As a butcher, when I kill an animal, I may get for the sake of argument, 10 cuts of meat: this is my production. I only need 2 for my immediate consumption, so with the remaining 8 cuts, I trade with Andrew, a garment manufacturer, for some garments to keep me warm. I consume 2 cuts and I save 8 cuts in order to trade for other goods and services. I need to produce to consume: I need to save/invest to consume.
If I wish to consume more of Andrew’s garments as I have a family to dress and keep warm, 8 cuts of meat may well not be enough to purchase these new needs and requirements of mine. At this point in time, I am faced with a choice, either my production has to increase so I can generate more cuts to exchange for other goods, or I accept my fate and stay where I am. I decide that I can invent a method of cutting up the parts quicker by using a sharper knife, thus I seek to invent the “steel” or knife sharpener that improves my productivity from generating 10 cuts in a day to 15. With these 5 extra cuts, I can get more garments.
The problem is , that in order to get the steel built, I need to spend some of my time that would be making the 10 cuts. Thus, I have to save and forgo some consumption while I have the steel built. I also have to rely on my savings — those stored cuts of meat — that I have not consumed to keep me afloat. This is what an economist may mean when he says adding capital to an economy lengthens the structure of production. The steel in this example adds a stage to the capital structure of society, to make me more productive, so I can consume more things.
To be clear, saving is the only thing that allows this to happen. In this example, my personal capital structure has gone from me with a knife in my hand consuming two cuts a day and exchanging 8 saved portions, to me and a knife and a steel to produce 15 cuts of which I consume 2 and exchange 13 saved cuts. Now Andrew will be doing the same, i.e. lengthening his structure of production to meet my new found desires for more goods. He will also have to save — i.e. forgo consumption — to invest with the sustenance that savings gives him, to become more “capitalistic” or capital intensive in his production structure, to meet my demand.
Money, as we have established elsewhere, like language, never arose by government decree, but by the spontaneity of individual human action to solve the problem of barter. If my cuts of meat were exchanged for 13 monetary units of gold from Andrew as I did not want his garments, I would now have 13 monetary units of gold as this was the final good chosen by most to exchange for other goods and services. Note that the gold in this illustration has been “backed” by my productive activities i.e. the cutting of the cuts in the first place.
Consider now the advent of money by decree or the fiat currency or paper money we have now, that could be just created at the touch of a computer key board as I have written here. In this simple example, enter the bandit into the economy, who I am going to call Gordon Brown, who says to Andrew and me, “from hence forth, you will accept, by pain of imprisonment, my new money paper notes.“ With this new money, he offers me the paper money in exchange for my saved cuts of meat. He has achieved an exchange whereby he gets my meat i.e. real goods and services and I get his bits of paper. There has been a one-off wealth transfer from me to him. Granted that I now have this new purchasing power and can spend on other things, but Gordon has got goods, my meat, for which he has done no prior production. My article on Quantitive Easing here, explains this process further.
What is the Interest Rate?
The Time Preference view of interest says that there is always a difference in value between present goods and future goods of equal quality and quantity.
Simply put, you value more highly present goods of the same quality and quantity than you do future goods. Furthermore, the value of future goods diminishes as the length of time necessary for their completion increases. This sets up a price differential between goods now or goods later. This price differential is called an interest rate. In reality it is also the rate of profit in the economy as it is these saved resources that are the only source of future funding for investment and the associated return on that investment. So it is arguable to say that this is the most important metric in the economy.
In our simple economy of Toby, Andrew and Gordon, we have demonstrated that in order for Toby to gain more of Andrew’s goods, he must save i.e. forgo consumption and invest the saving that is sustaining him. Time and resource to make the steel is required — a lengthening of the structure of production from just knife, to knife and steel that is now more capitalistic — that allows him to sharpen his knife, to be more productive, to produce more to buy more of Andrew’s garments.
Andrew to has to save to invest more in, say, a loom rather than hand stitching to be able to meet Toby’s new demand. How do we get this right? How does entrepreneurial insight work more times than it does not? The price mechanism helps us know what is needed most in society. Thus Andrew noting that Toby will pay more for his garments, “reads” this price signal and chooses to invest in a loom.
For every given structure of production, every allocation of goods through its various stages of production needs a relationship between the final finished goods — the meat and the garments — and the means of production — the labour, the knife, the steel, the stitching the loom. If we are in perfect equilibrium, these two sets of prices must equal the interest rate; at this rate, just enough money is saved from production to facilitate just enough investment to support this capitalistic production structure.
If Toby’s time preference changes and he decides to postpone even more consumption and saves in a bank, he is notifying to the likes of Andrew that he is putting away consumption today and postponing it until a future date. Taken as a whole economy and in the light of what we have said in the above Toby and Andrew example, it is clear that the more savings, the more postponement of extra consumption, so that more investment in more capitalistic methods can be developed, the more production and consumption of goods and services there will be. Disturb this symbiotic relationship and you will get a structure of production in society that does not reflect the needs and desires of its citizens.
It is bizarre in the extreme to hear the mass of politicians and commentators advising us to “spend, spend, spend” without giving any thought to where the future investment / profits of the economy are going to come from. It is bizarre that they always argue for a lower interest rate or “cheaper money” so you can spend more. A quick reflection on your personal circumstances will tell you that if you just spent the entire sum of your monthly salary each month on consumption goods, could you ever save to purchase a large capital item such as a car or a house.
It is a tragedy today that we have governments trying to tell the world, “consume! consume! consume!” when in fact, they need to consume and save as well so they can consume ever more of the things they want later with their saved money. One-sided consumption will only lead to an impoverishment of society.
Very low interest rates not artificially set low would reflect plentiful savings. This would be a postponement of present consumption for future consumption, for entrepreneurs to use this money, via bank intermediaries, to invest in making our processes of production longer or more capitalistic to bring forth more consumer goods to provide for future consumption. Higher rates should indicate the reverse.
It is of no surprise that at the height of the boom period during 2007/08, the savings ratio hit rock bottom. When you have just consumption you can never save to invest in the future. As these savings are the future profits of business, it is no wonder that the whole economy fell off the edge of the cliff.
UK Savings Ratio Interfere with this process and set a rate under or over that natural rate of interest of all economic agents and you will distort the capital structure away from that which people want to serve their needs and requirements. This is boom and bust that we have all become so accustomed to. In my business for sure I have had activity and customers that have only been supported by low interest rates over the 10 years or so.
Now the merry go round has stopped.
The lesson for politicians is let the market rate of interest prevail as this matches investment and profits with future needs of society. Artificially setting a low rate of interest distorts the productive structure through investment to make more goods and services — a boom — than consumers actually can afford or want — the bust.
Further reading
By Sean Corrigan, on 10 September 09
 Lord Timon's Purse In Lord Timon’s Purse, Sean Corrigan explores the causes of the forty US banking failures of 2009 and sets out some of the basics of money and bank credit.
Despite the US seeing its fortieth banking failure of the calendar year – the greatest number in sixteen years ‐ financial markets are managing their usual feat of deluding themselves that a Goldilocks outcome is in prospect.
News articles abound in sighting of what, in the tiresome horticultural parlance, are invariably referred to as ‘green shoots’; a back up in bond yields is rationalized away as a ‘re‐normalization’ from crazily‐depressed levels (a view with which we actually have some sympathy); rising commodity prices are not to be feared, being merely the expression of an understandable eagerness to indulge in ‘recovery’ plays; slack labour markets and the widespread under‐utilization of capacity is seen to allow central banks to maintain their current accommodative stance for many months to come and – mindful of the ‘mistakes’ made in 1937 – when the unwinding process finally arrives, it will be well‐signalled and gentle.
So, ‘Out of the eater came forth meat; out of the strong came forth sweetness’ and out of banking weakness comes forth equity delight – or so the Street desperately hopes.
Away from the sales pitches and book‐talking, opinion is still, as ever, divided over the outlook for prices. The old war of words is being rehashed between those who see a long, gloomy stretch of near‐deflation as the outcome and those beginning to fret over a resurgence of inflation almost as soon as the real economy regains some traction.
Inevitably, this polemic has degenerated into yet another battle pitting Gold Bugs against New Dealers and Dollar Permabears vs. card‐carrying Keynesians – a Prosperian dialogue light on intellectual substance and generally lacking in insight.
Sean revisits some of the basics (emphasis mine):
On such observations as these [on bank lending and bond issuance] rests the case of those Deflationists who do at least possess sufficient sophistication not to regard a mere drop in the CPI index (and one highly influenced by the fall in over‐elevated energy prices, at that) as the Alpha and Omega of the argument. However, these sages then usually make at least one of two further mistakes in their analysis; viz., that they confound Money with Credit and that they then entirely neglect what is fast becoming the primary mechanism by which new money is being introduced to the economy.
In order to dispel the confusion, we must here digress to reprise a few basics.
ʹMoneyʹ‐ for now disregarding the question of its particular composition ‐ is above all the medium of exchange whose other commonly‐cited attributes as a unit of account and a store of value are decidedly derivative, emergent functions, the first of which is not strictly commensurate with current money itself – e.g., SDRs ‐ and the second of which is sadly more often an aspiration rather than a statement of fact.
In order to function as the medium of exchange, money must be widely and unequivocally accepted ‐ indeed, it must be THE most widely accepted ‐ substitute for the specific consumable goods we seek in a typical trade when we surrender a different batch of consumables to our counterparty but have no use for the goods which he, in turn, is offering for sale. The upshot of this is that money is itself a present good, that is, one instantly utilisable in the here and now.
Again, to emphasise the crucial point, money must be thought of as THE present good par excellence (not, incidentally, just a mere representation of such goods) the one for which there is always a ready market: to say otherwise is an existential denial that it is money at all. While this may have been easier to grasp when money actually took the form of a tangible good ‐ whether cowrie shells, cattle, or silver crowns ‐ it is no less the case today when it has largely been robbed of physical expression.
Money, then, is the medium in which we can make final settlement of any transaction, as is recognised by those étatiste legal tender laws which Leviathan wields to force free individuals to use the bastard versions to whose creation it reserves to itself the exclusive right of sanction and from whose creation it thereby intends mischievously to profit.
By contrast, ‘Credit’ is an assignation of the right of command over present goods to another, whether for a fixed or an indeterminate period. Entailed in this alienation is a sacrifice for which we seek recompense by charging a fee ‐ namely, interest.
[NB: contra the mainstream misconception, interest is not the price of money (that can only mean its reciprocal value expressed in the other goods for which it exchanges), but the price of the time which passes while we forego enjoyment of our property]
Read more here.
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