“Popping down to #guardiancoffee later on to order a ‘Toynbee’: short, rich and intensely bitter.”
– Tweet from Robbie Collin (chief film critic, The Telegraph).
We have come a long way since the release of ‘All the President’s Men’. Alan J. Pakula’s 1976 thriller, about the Watergate scandal, may be the first and last film in which the real hero is an institution (The Washington Post, under its principled then executive editor, Ben Bradlee). Or for that matter, not even an institution, so much as an idea: the free press. Robert Redford and Dustin Hoffman may spend their two hours of screentime rushing about having doors slammed in their faces and meeting covert sources in sinister garages, but it’s the idea of the resolute pursuit of truth in the face of administrative obfuscation, peer group indolence, executive greed and a flurry of non-denial denials that lingers long after the titles have rolled. These days, newspapers cut out the middleman and do the bugging themselves.
The concept of a free press has not exactly thrived over subsequent years. Media groups have bulked up into ever more massive, and conflicted, conglomerates. Media channels have proliferated, creating a ‘winner takes most’ competitive environment that has dumbed down everything and crushed audience numbers for anything but the lowest common denominator pap. That catch-all culprit, ‘the Internet’, has facilitated an explosion in the number of amateur content providers that cannot but relentlessly erode the margins of paid-for publishing models. Some of this Schumpeterian creative destruction is to be welcomed. Competition always is. But from an aesthetic and cultural perspective, one is left to wonder whether some industries are better left untouched by those biting digital winds. From the perspective of quality, and in a culture in which time increasingly seems scarcer than money, one sometimes has to ask whether what is free is often far too expensive.
Felix Salmon last week issued an obituary for journalism as usual:
“Labour has almost no leverage over capital any more, which helps explain the rash of “Uber for X” start-ups: they’re nearly all based on the idea that there is a bottomless pool out there of people with smartphones willing to do just about anything (drive a car, go shopping, do laundry, clean an apartment) for $15 an hour. If a company loses one of those workers, it’s no big deal, it just replaces that person with someone else who’s just as good and just as cheap. Now just apply that model to journalists.”
Megan McArdle responded with a less than entirely convincing defence of her own chosen career. Or perhaps she was just expressing Felix Salmon’s concerns from a subtly dissimilar angle:
“..the problem is not competition for eyeballs from new outlets that are writing news in a different, fresher way. The problem is competition for ad dollars from companies that don’t produce news at all. Making news is expensive. It’s hard to compete against companies that don’t bother. Journalism’s biggest threat comes from companies like Google and Facebook that cheaply aggregate our expensive content and sell low-cost, demographically targeted ads in huge numbers. They can kill the whole business.”
Ezra Klein waded in to the debate, and was almost ridiculously upbeat by comparison.
As with so many things, it turns out that Michael Lewis got there before almost everybody:
“As you walk through the front door of the Columbia School of Journalism, the first thing you see is this paragraph, cast on a bronze plaque:
“OUR REPUBLIC AND ITS PRESS WILL RISE OR FALL TOGETHER. AN ABLE, DISINTERESTED, PUBLIC-SPIRITED PRESS, WITH TRAINED INTELLIGENCE TO KNOW THE RIGHT AND COURAGE TO DO IT CAN PRESERVE THAT PUBLIC VIRTUE WITHOUT WHICH POPULAR GOVERNMENT IS A SHAM AND A MOCKERY. A CYNICAL, MERCENARY, DEMAGOGIC PRESS WILL PRODUCE IN TIME A PEOPLE AS BASE AS ITSELF. THE POWER TO MOULD THE FUTURE OF THE REPUBLIC WILL BE IN THE HANDS OF THE JOURNALISTS OF FUTURE GENERATIONS.
“..The first sentence on the bronze plaque that you see when you walk through the front door of the Columbia Journalism School may or may not be true, but it sets a fittingly autocratic, unreflective tone. The second sentence is ungrammatical. The last two sentences offer the sort of grandiose vision of journalism entertained mainly by retired journalists or those assigned to deliver speeches before handing out journalism awards. Highly flattering to all of us, of course, but it would be more true to flip the statement to read: “a cynical, mercenary, demagogic people will produce in time a press as base as itself …”
The problem with journalism isn’t just the competitive environment; the problem with journalism is journalists. But our focus here is more specifically on journalism relating to matters of finance and investment. Such journalism tends to fall into one of four categories:
- The omniscient economics correspondent. Invariably a tortured authoritarian still clinging to the discredited remnants of Keynesian economic theory. “QE does work, we just haven’t done enough of it yet.”
- The anti-business zealot. “Everyone should pay their fair share of taxes – especially everybody else.” These social campaigners often come from inherited wealth, and are employed by a tax-advantaged trust.
- The clueless tipster. Spanish practices among the gutter press have poisoned the communal well and led to a generalised suspicion by the public that wealth management is little more than organised insider dealing.
It is not enough, and it is certainly not accurate, to say that journalists are merely commentators on financial market action. The commentator at a sports match has no ability whatsoever to affect the outcome of the game. But the financial journalist does, depending on the consumer reach of their ‘platform’.
The irony is that most investors might be better served by cutting out the commentary altogether (an irony of which we are, of course, well aware). The psychologist Paul Andreassen showed that people who receive frequent news updates on their investments earn lower returns than those who get no news. The following is from a 2002 Fast Times article:
“The barrage of information and pseudo-information has been magnified by the explosion in financial news over the past decade. In the late 1980s, psychologist Paul B. Andreassen did a series of experiments with business students at MIT that showed that more news does not necessarily translate into better information. Andreassen divided students into two groups. Each group selected a portfolio of stocks and knew enough about each stock to come up with what seemed like a fair price for it. Then Andreassen allowed one group to see only the changes in the prices of its stocks. Students in that group could buy and sell if they wanted, but all they knew was whether the price of a stock had gone up or down. The second group was allowed to see the changes in price and was also given a constant stream of financial news that supposedly explained what was happening with each stock. Surprisingly, the less-informed group did far better than the group that was given all the news.
“The reason, Andreassen suggested, was that news reports tend to overplay the importance of any particular piece of information. When a stock fell, its fall was typically portrayed as a sign that further trouble lay in wait, while a stock that was on the rise seemed to promise nothing but blue skies ahead. As a result, the students who had access to the news overreacted. Because they took each piece of information as excessively meaningful, they bought and sold far more frequently than the people who were just looking at the price.”
The consistently excellent Wall Street Journal columnist Jason Zweig says he was once asked at a journalism conference how he defined his job. His response:
“My job is to write the exact same thing between 50 and 100 times a year in such a way that neither my editors nor my readers will ever think I am repeating myself.”
As Zweig puts it, good advice rarely changes, whereas markets change constantly. “The temptation to pander is almost irresistible. And while people need good advice, what they want is advice that sounds good.”
These are desperate times for investors. Interest rates have been slashed to zero, making a surreal mockery of any sort of savings culture. In some cases they have gone below zero: Bloomberg’s Mark Gilbert points out that negative bond yields are becoming the new normal for many sovereign borrowers, with (clearly terrified) investors willing to pay for the privilege of lending their money to governments. Finland last week auctioned five year notes at minus 0.017%. At least six other countries have five year debt trading at, or below, zero.
At the same time, desperate investors have stampeded into the shares of businesses that seem ostensibly “safe”. In the process, they have bid up the prices of many of those shares to what we consider unsustainable (and probably “unsafe”) levels.
Like us, Zweig sees huge merit in the advice of the legendary value investor, Benjamin Graham:
“The investor’s chief problem – and even his worst enemy – is likely to be himself.”
Another piece of Ben Graham’s advice which we feel is particularly relevant today:
“Investors do not make mistakes, or bad mistakes, in buying good stocks at fair prices. They make their serious mistakes by buying poor stocks, particularly the ones that are pushed for various reasons. And sometimes – in fact very frequently – they make mistakes by buying good stocks in the upper reaches of bull markets.”
That advice could have been written for the market environment of February 2015.
Back to Jason Zweig:
“My role, therefore, is to bet on regression to the mean even as most investors, and financial journalists, are betting against it. I try to talk readers out of chasing whatever is hot and, instead, to think about investing in what is not hot. Instead of pandering to investors’ own worst tendencies, I try to push back. My role is also to remind them constantly that knowing what not to do is much more important than what to do. Approximately 99% of the time, the single most important thing investors should do is absolutely nothing.”
Good luck getting an editor to endorse that message.
There is an intriguing post-script to the Watergate story that touches on the venality of human nature (and therefore, more or less directly, on the biddability of politicians). One of the participants in the decision to break into the offices of the Democratic National Committee was Jeb Stuart Magruder. On hearing that the Watergate burglars had been caught, he responded with a degree of bewilderment consistent with an FT or New York Times economics correspondent:
“How could we have been so stupid ?”
Robert Cialdini points out that the original idea for the break-in came from G. Gordon Liddy, who was in charge of intelligence-gathering for the Committee to Re-elect the President (the appropriately monickered CREEP). His proposal was expensive. It required a budget of $250,000 in untraceable cash, and the involvement of no fewer than ten individuals.
But that wasn’t even his first proposal.
His first plan, proposed two months earlier, involved a $1 million programme, featuring a “chase plane”, break-ins, kidnapping and mugging squads, and a yacht featuring “high-class call girls” to blackmail Democratic politicians. The sort of thing that high-ranking IMF officials wouldn’t necessarily be averse to participating in, when not busy saving the world.
Magruder reports that “no-one was particularly overwhelmed with the project” but “after starting at the grandiose sum of $1 million, we thought that probably $250,000 would be an acceptable figure.. We were reluctant to send him away with nothing.”
You do not need to be a senior Republican activist to master this particular strategy. Any seven-year old girl could proffer a similar negotiating gambit:
“If you want a kitten, ask for a pony.”
So you can choose to trust the newspapers. You can choose to trust the marketing businesses masquerading as asset management firms. You can choose to trust bloggers. But you will probably be well served by shrinking, rather than expanding, your universe of advisory inputs, and focusing on a smaller, more focused network of trusted – and trustworthy – serious and intelligent people. If in doubt, trust no-one.
In 1985, Arnold Schwarzenegger played John Matrix in the action movie, Commando. One line stands out. While dangling a bad guy over the edge of a cliff Matrix said, “Remember, Sully, when I promised to kill you last?” The frantic man replied, and Matrix added, “I lied.” He let Sully go.
Thomas Jordan, Chairman of the Governing Board of the Swiss National Bank (SNB), must be channeling John Matrix. On December 18, 2014 Jordan said, “The SNB remains committed to purchasing unlimited quantities of foreign currency to enforce the minimum exchange rate with the utmost determination.” Last Thursday, not even a month later—he said, “The Swiss National Bank (SNB) has decided to discontinue the minimum exchange rate…”
Schwarzenegger said it better. Besides, Commando was just a work of fiction. Central bankers toy with people’s livelihoods. Several currency brokers have already failed, only one day after this reversal.
When a central bank attempts to peg its currency, it’s usually trying to stave off collapse. The bank must sell its foreign reserves—typically dollars—to buy its own currency. Recently, the Central Bank of Russia tried this with the ruble. It never lasts long. The market can see the dwindling dollar reserves, and pounces when the bank is vulnerable.
The SNB attempted the opposite, selling its own currency to buy euros. It faced no particular limit on how many francs it could sell. Despite that, the market kept testing its willpower. Here is a graph showing the price of the euro in Switzerland. The SNB’s former line in the sand, is drawn in red, a euro price of 1.2 francs.
The price of the euro was falling the whole year. Jordan’s promise caused but a blip. The pressure must have been intense. So he tried one last trick, familiar to any gambler.
Thomas Jordan bluffed.
He said the SNB is committed and tossed around words like unlimited. The market saw his bet, and raised. That forced him to fold.
I wrote about why the SNB pegged the franc. It wasn’t about exporters, but commercial banks. They borrow francs from their depositors, but lend many euros outside Switzerland. This means they have franc liabilities mismatched with euro assets. When the euro falls, they take losses.
The SNB inflicted this same problem on itself with its intervention. It borrowed in francs, creating a franc liability. This borrowing funded its purchase of euros, which are its asset.
As of November, its balance sheet showed 462 billion francs worth of foreign currencies, and it has disclosed that euros represent just under 50% of that. This puts their euro assets around 230B francs (which probably increased after that). The euro has fallen from 1.2 francs to just under 1.0, or 17%.
On Thursday, the SNB lost at least 38B francs, or 6 percent of Swiss GDP.
Why on earth did it choose to take this loss? It threw the commercial banks under the bus, and got tire tracks on its own back too. Without being privy to its internal discussions, we can make an educated guess.
The SNB hit its stop loss.
As traders kept buying francs, the SNB was obliged to keep increasing its bet. Its exposure to euro losses was growing. To continue meant more euro exposure on the same capital base—rising leverage. It chose to realize a big loss now, rather than continue marching towards insolvency.
The market is much bigger than the Swiss National Bank. If the citizens of insolvent states like Greece want to sell their euros for francs to deposit in Swiss banks, and if hedge funds and currency traders want to bet on the franc then the SNB can’t stop that freight train.
Everyone who holds francs is happy, because the franc went up. However, the fallout has just begun. Franc holders will discover that they are creditors. They can’t rejoice for long at their debtors’ pain. Pain will one day morph into defaults. Soon enough the franc will abruptly reverse. Who will bid on a defaulted bond, or a currency backed by it?
The game of floating paper currencies is not zero-sum, but negative-sum. Every move destroys someone’s capital. On Thursday, the SNB admitted it lost 38B francs. How much did commercial banks, pension funds, and other debtors in Switzerland lose in addition?
[Editor’s Note: this piece, by Ivo Mosley, first appeared at http://defendinghistory.com/antisemitism-banking/69351]
A good deal of today’s nationalist and right-wing antisemitism rests upon the fantasy that “the Jews” control the world through finance and banking. Nor is the same fantasy entirely absent from left-wing antisemitism, which currently tends to concentrate itself on criticism of Israel.
The fact that some Jews are very good at banking is, apparently, enough to justify race-hate in the antisemite’s mind. Of course, a number of Jews are also prominent as scientists, civil rights activists, generals, hairdressers, actors, musicians, historians, etcetera, without anyone blaming science, civil rights, theatre, hairdressing, war, music, history, etcetera on “the Jews.” This highlights one of the traditional functions of antisemitism: if something is obviously bad, “the Jews” can be reached for as a scapegoat.
The object of this article is twofold: first, to analyze what is rotten in the world of capitalism and finance; second, to show that while it has nothing to do with “the Jews” as a people or as a tradition, it has everything to do with a tradition that for centuries excluded “the Jews.”
Capitalism and Predatory Capitalism
There are two stories about how capitalism is financed. One is commonly believed and accepted, but not true. The other is true, but hidden under veils of obscurity.
The familiar story is that citizens save up bits of money: banks gather up those bits of money and lend them to capitalists, who put them to good use for the benefit of all. This, however, is not what banks do – nor is it necessarily what capitalists do.
The unfamiliar, but true, story is that banks create money out of nothing when they lend to capitalists, who use the new money to purchase assets and/or labor, from which they expect to make a profit.
The first story needs no elaboration: as well as being untrue, it is simple and widely understood. The second needs to be explained, however, because though it is not so very complicated, it is unfamiliar to most people.
Economists generally avoid mentioning the fact that banks create money, but central bankers are happy to state it and even on occasion to try to explain it. The Bank of England website states simply: “Most money in the modern economy is in the form of bank deposits, which are created by commercial banks themselves.” And again: “The majority of money in the modern economy is created by commercial banks making loans.” The same article explains that this fact is not recognized by most economists: “rather than banks lending out deposits that are placed with them, the act of lending creates deposits — the reverse of the sequence typically described in textbooks.” (Quotes from the Bank of England Quarterly Bulletin, 2014/1.)
The way bankers create money today requires two things: a “magic trick” by which a small quantity of money held by the banker becomes a great deal of money in circulation; and laws which make the “’magic trick” not just legal, but binding on all citizens.
The “Magic Trick” of Banking
“A banker may accommodate his friends without the payment of money merely by writing a brief entry of credit; and can satisfy his own desires for fine furniture and jewels by merely writing two lines in his books,” wrote Tommaso Contarini, Venetian Banker and Senator in 1584.
The Encyclopedia Britannica of 1950 states firmly and definitively, “A bank does not lend money.” So just what does it do, when we think it is lending money? The answer is: it writes two numbers into a ledger, just as Tommaso Contarini did in 1584. Those numbers represent two equal-and-opposite claims, with a time lapse in between. The borrower gets a claim on cash belonging to the bank, which it can exercise immediately. The bank gets a delayed claim against the borrower, which it may exercise when the loan is due for repayment. In the meantime, the bank charges the borrower interest. When both claims have been exercised, the bank’s creation – the loan – disappears.
The claim which the bank creates for the borrower is called “credit.” “Credit” means “believes,” meaning whoever owns the claim believes they can get cash from the bank when they want it. This is where the “magic trick of banking”’ begins. If people believe they can get cash from a claim, they are happy to receive a claim in payment, so long as they too can use the claim to get cash from the bank. Joseph Schumpeter observes: “There is no other case in which a claim to a thing can, within limits to be sure, serve the same purpose as the thing itself: you cannot ride a claim to a horse, but you can pay with a claim to money.”
The second bit of the magic trick is for the banker to create many claims on the same bit of money – or, to put it another way, to create claims on money that isn’t there. Banks, naturally enough, want to maximize their profits, so they create as many claims as they think they can get away with, bearing in mind the regulators and people’s demand for cash. By creating fictitious claims a bank turns a billion, say, of cash into sixty billion, say, of credit.
The magic trick may seem somewhat technical in nature, but it has enabled bankers, with the active connivance of governments and capitalists, to replace money we can own with money we must rent off governments and banks. The effects of this substitution are immense, incalculable, far-reaching, all-pervasive (more on this later).
The Legal Underpinnings and Authority for Bank-Money
For a claim to pass from hand to hand as money, completing the “magic trick of banking,” one more thing is needed: the law must recognize it as a valid claim.
Normally, people are not allowed to create claims on property they don’t have. You can’t, for instance, create a claim on Buckingham Palace – unless you happen to own it. Nor can you mortgage your house sixty times over, and spend the money. Banks alone may do this kind of thing. Only banks (and “other depository institutions”) are authorized in law to create claims on property they do not have.
For centuries, banks operated in a legal grey area. Their activities were restricted to merchants, who understood the risks involved, and to what might be called the “higher criminal class” of rulers and potentates. Lending to princes often carried an interest rate of 100% — but still, most bank-crashes occurred when monarchs defaulted on their debts.
The watershed in banking history came during the decades on either side of 1700, when the English House of Commons, newly-all-powerful and consisting of rich men voted in by other rich men, wanted to exploit the fruits of bank-credit for their own devices of war and profit.
The Lord Chief Justice of the time, Sir John Holt, was supporting the traditional legal position that a claim on property was valid only if the claim was on a specific piece of property. Parliament passed an Act of Parliament (the Promissory Notes Act of 1704) to overrule him. Over the next three centuries, other countries followed the English example and “credit-creation” — creating claims on assets that don’t exist — is now authorized for bankers all across the world.
The Two Traditions: Money-Lending and Banking
Within the European tradition, Jews were long known as money-lenders. The relatively straightforward nature of money-lending, as a freely-negotiated contract between lender and borrower, was complicated by moral and social issues.
Usury (lending money at interest) was deplored in the Judeo-Christian tradition, but Jews were allowed (by their own religious laws and by self-interested Christian monarchs) to lend to non-Jews. A pattern was established: monarchs licensed Jewish money-lenders to lend to their subjects; agents of the monarch helped them collect their debts, then the monarch would rob the money-lenders of much of their profits. Throughout much of Europe, discriminatory laws forbade Jews to earn a living any other way. Although money-lending was a despised and hated occupation, it could make people very rich.
Meanwhile, banking — the creation of credit — was developing in an entirely separate tradition via the activities of merchants, exchange-dealers and civic banks. The tradition was Christian, protective of its own, and often openly antisemitic. When these early bankers “lent” money they were not lending hard cash, they were lending claims written into ledgers.
Failure to distinguish between banking and money-lending, and the superior social status of bankers (who being in close collusion with the State are liable to pick up honors as well as great wealth) have led many writers to claim that Jewish money-lenders were bankers, i.e. creators of credit. This in turn has fed the delusions of antisemitic pseudo-historians. In reaction to this false history, most serious historians of banking have found themselves making statements similar to this from Raymond de Roover: “Unlike the Christian moralists, the rabbis paid little attention to exchange dealings or cambium, because, as Yehiel da Pisa explains, this business was not practiced by Jews. This is further evidence that the latter confined their activities to money-lending on a small scale and that the leading international bankers, such as the Medici or the Fuggers, were all Christians. There is, therefore, nothing to support Sombart’s thesis according to which the Jews were the originators of international finance and the founders of modern capitalism.”
All this, of course, was a long time ago, and nowadays bankers are Anglo-Saxon, Chinese, African, Indian, Jewish, Christian, Islamic or whatever: assorted individuals who have no more consuming interest than to make lots of money.
What is Wrong With Creating Money as Fictitious Credit?
Bank-credit — money created as credit on assets that don’t exist — has many features that may be viewed as negative. It replaces money owned outright with money rented out, and is therefore (in the words of John Taylor of Virginia, 1753-1824) a “machine for transferring property from the people to capitalists.” Along the same lines, it allocates new money to borrowers on the mere promise of profit: as a result, much of it goes to inflating asset prices, again increasing inequality. It enables governments to borrow with little accountability, and to charge interest and repayment to “the people”: these charges make domestic labor more expensive, and therefore less competitive. It is created in large quantities during booms, and disappears during busts as loans are retired or “go bad,” thereby exacerbating business cycles. It encourages the production of arms and war by providing unaccountable finance to both governments and arms manufacturers, at the expense of their peoples. It encourages large concentrations of power in government, corporations, and individual “oligarchs,” reducing independence among citizens. It has an endogenous (inbuilt) insatiability: money drifts to the ownership of capitalists and only economic growth, state hand-outs and war (when governments create new money for working people rather than for banks) can supply consumer-money to the poor. The effects of this insatiability on the environment are literally devastating. It gives vast wealth to an elite who care only for making more money: the tastes of this elite have corrupted human culture. Lastly, because the process is not widely understood and is conducted largely in secret, it makes Western claims to political “democracy” dubious at best.
Given all this, it might be a good idea to contemplate reform, which would have to include (i) the replacement of credit money with digital money owned outright and (ii) withdrawal of the license allowed banks, to create claims on assets they don’t have.
Most people familiar with the reality of bank-credit also profit from it. Reason gives way to self-interest in human affairs, so enlightenment and reform are hardly to be expected from among the powers-that-be. As for antisemitism, mental disease is also resistant to reason, so the targets of criticism in this essay are unlikely to be affected by the contents of this article. However, the majority of humanity have strong reasons to desire both financial reform and less racial hate and I hope this essay has made a small contribution to those ends by shedding light on a topic that is not at present widely understood.
According to the French historian Fernand Braudel, to understand the present we should master the whole of world history. The same may be said for the rate of interest: to grasp its significance we should have a full understanding of the whole of economics. Interest is the most important price of economy, the most pervading, as pointed out by the American economist Irving Fisher. Interest plays a key role in affecting all economic activity: interest and the price level are strictly interconnected, subject to leads and lags, they move in the same direction. A falling interest rate induces falling prices and a rising interest induces rising prices. Capital values are derived from income value: if interest is 5%, a capital amount yielding $100 every year has a value of $2,000. The interest rate translates, as it were, the future into the present bridging capital to its income.
When interest drops from a high down to a low level it raises the capitalized value of equipments, bonds, annuities or any other assets providing a stream of future incomes. The rate of interest reveals the individual’s rate of time preference or their “impatience for money”: the inclination towards current consumption over future consumption and vice versa. For example if the individual is indifferent between €1.04 next year and €1.00 today, his rate of time per preference per annum is four percent.
Interest can therefore be considered the minimum future amount of money required to compensate the consumer for foregoing current consumption. It is as it were, the return on sacrificing consumption towards more future consumption. When time preference falls, savings rise and interest falls. And the lower the time preference the more the supply of income saved and transferred in the form of credit to satisfy investment demand. In the economy there cannot be any real net investment without an equal amount of real net saving. The price balancing the supply of income (from savings) and the demand for it (for spending and investment) was defined by the Scandinavian economist Kurt Wicksell, the “natural rate of interest”.
Its function is to ration out existing scarce savings into productive uses and to induce to sacrifice current consumption to add to the stock of capital. The 18th century French finance minister Anne-Robert-JacquesTurgot put it this way:
The current interest of money is the is the thermometer by which the abundance or scarcity of capitals may be judged; it is the scale on which the extent of a nation’s capacity for enterprises in agriculture, manufactures, and commerce, may be reckoned.. Interest may be looked upon as a kind of like a sea level …… under which all labor, culture, industry, commerce cease to exist». In the contemporary economy interest is a monetary tool by which central banks pretend to regulate the abundance of capital. Unfortunately in doing so they make the economy sink under the sea level. To understand this effect the rate of interest has to be investigated through its relation with money and capital.
Interest and Money
In ordinary language interest is defined either as the cost or the price for borrowing money, but these notions are partly true. If interest is a cost for the borrower is also an income for the lender. On the other hand by defining interest as a “price” we are lead into thinking that it varies inversely to the money quantity. This is what the monetary theory of the interest holds. Despite some appearance of truth it is a fallacious doctrine because being also the interest a quantity of money paid or collected against a loan it varies in direct proportion to the quantity of money. For example, if a loan was $100 earning $5, and the money supply doubled, it will rise to $200 earning $10. Interest must double to make loans equivalent (in fact: 5/100=10/200) although in percentage remains unchanged. If anything, other things being equal, an increase of money supply causes interest to rise, not to fall, for the “price of money” is not interest but money purchasing power. Furthermore the definition of interest as the price for money obscures the fact that what is exchanged in a loan is not money but present money against future money, namely credit. Credit is the temporary transfer of wealth or purchasing power from one person to another upon payment of interest. Since purchasing power is wealth and wealth producing income is capital, the rate of interest is the income paid for the use of capital. But what is used is not “abstract capital” because there is not a generic demand for capital, otherwise there would be no difference between the interest rate and the discount rate, but between the money market and the capital market. When a person asks for a loan for consumption he is not asking for capital but for money as means of payment. Who discounts bills or notes does not need capital he already has in some form or another, he wants to transform it in a more liquid form. Ultimately he needs “liquidity” not to expand his capital or business but to anticipate its monetary form. Because most businesses due to seasonal fluctuations cannot be conducted on a cash basis they need credit or liquidity just to compensate these fluctuations. The price for the temporary use of liquidity is the rate of discount. It doesn’t represent interest on capital but a rent, as it were, measuring the value of the money services namely for specific services: making the flow of the production smooth, keeping solvency or allowing specific profits in money transactions. The whole all transactions involving transfers of liquidity used to increase the marketability of all the forms of wealth as to render them more fluid, form the money market. Here money is invested without losing its form, without turning itself into capital which is the money income employed in production. However, liquidity emerging as cash surpluses to fund cash balances deficits, is always grounded on capital operations and being limited by the use of capital depends on the rate of interest.
Interest and capital
While the rate of discount concerns money or short term credit to anticipate the monetary form of real capital, the rate of interest concern the money or long term credit to extend real capital. So it is a long rate not a discount rate because what is lent is not money but capital (which is wealth employed in view of more future production). Hence the purpose of capital or long credit market is to provide the nexus between savers and borrowers to finance productive investments and expand the economy. Thus interest is the price balancing the supply and demand for money capital. An increased supply competing for borrowers pushes down the interest. An increases demand competing for lenders pushes up interest. The interaction supply/demand establishes the rate of interest at the point where the lenders rate of time preference tends to equal the borrowers rate of profit. This is because the use of capital depends on its marginal utility: in the market it is convenient to borrow till the income earned from the use of capital will exceed the cost of its use coinciding with the rate of time preference. So interest is the price of money capital as determined by the interaction between the least productive use and the savers’ return on sacrificing consumption. In practice it oscillates between an upper limit and a lower limit. The former is the rate of profit, otherwise borrowing would not be convenient, and the latter the rate of time preference which represents for the economy as a whole the cost of capital accumulation. This lower limit cannot be zero otherwise lenders would use income directly giving up sacrificing current consumption.
However because the rate of interest reflects the productivity of capital and it’s convenient to borrow until capital yields a positive income, it is the rate of profit that commands the rate of interest. Hence interest may also be defined as the market price of money capital typified by the rate of profit.
To the extent people are provident and have a low time preference, the capital is abundant, the rate of interest is low and long term capital-intensive projects can be undertaken, the economy expands, technological progress advances and wages productivity rises. Conversely, if the time preference is high, capital is scarce, interest higher and more liquid projects prevail. However according to the monetary theory the market rate of interest is typified by the return or yield per year on riskless long term government bonds which are deemed to typify the benchmark for the rate of profit on capital assets. Yet because governments consume instead of producing the bond yield typifies the shifts of income supply towards consumption uses. In fact the lower the bond yield the higher the government consumption and the lesser the capital available for production. Therefore bond yields reflect propensity to consume, in contrast with interests on capital reflecting propensity to invest.
Because capital it is tied up for long time in production and regain its liquid form after the sale of products, the rate of interest has a different economic nature than the rate of discount: while the latter is subject to money fluctuations, the former is less sensitive to them for it gives up its monetary form for an extended period until the time of loan repayment. Moreover by borrowing liquidity one looks at prospects of immediate gain while by borrowing capital one looks at incomes over a longer period of time. In general, the interest rate is higher than the discount rate because being less liquid commands a premium for liquidity. However when production languishes, profits fall, capital withdraws from production, interest falls while discount rate rises as demand for short-term loans rises to preserve liquidity. Interest rises during periods of economic development when present income is sacrificed and invested in capital. Once capital starts to produce new income, interest falls setting the pace for the boom period when discount rises because the higher volume of spending increases demand for money. So in general they vary independently from one another. Although there is a constellation of rates of interest depending on the loan maturities, all tend to a same level. Money capital moves where it is most needed, runs from less profitable assets to more profitable ones and like water flows to find its level. So by continuous market oscillations any capital tends to provide the same income any difference due to the risk.
It’s worth noting that if the liquidity of capital invested is lost for many years it can be regained at any time in the stock exchange by selling shares. However because shares represent titles on already existing capital, their sale does not adds to capital stock and doesn’t affect the rate of interest, rather it adds to liquidity affecting the discount rate.
Other interest rate determinants
Interest as a market price arising from the interaction between the rate of profit and the time preferences governs the price of capital assets as well as their allocation other things being equal. In fact, because the rate of profit arises in the economic system as a difference between the prices of products and the prices of factors of production to manufacture them, it is affected by these price levels. Fluctuations in these prices cause fluctuations in the rate of profit and as consequence in the rate of interest which is typified by the rate of profit. And because capital assets are determined by discounting their expected returns by interest rates of the same maturities as the life of the capital assets,it follows that all capital allocation in the market is affected by the ratio of demand to supply of both products and factors of production.
However, the value of money is also determined by supply and demand of money. If interest, in essence, depends on real factors such as time preferences, rate of profit and supply and demand, being itself a money sum must logically be dependent on the value of money although indirectly. To explain the emergence of interest the Austrian economist Eugene Bohm Bawerk argued that because present goods due to the time preference worth more than future goods of like kind and quantity, they command a premium over the future goods. In other terms, interest is the discount of future goods as against present goods or the demand price of present goods in term of future goods. However, once goods are priced in term of money, the interest rate becomes a ratio of exchange between present and future money sums and its value may not coincide with the ratio between their physical quantities because of changes occurring in the prices level. If, for example the money supply rises, the value of the expected monetary sum lent falls. Then savers expecting a rise in prices will ask for a higher interest to compensate for the loss in the value of loan capital (this confirms the mistake of monetary theory in claiming that a rise in the money supply lowers interest). Because money affects the value of real capital it’s wrong to assert (as Knut Wicksell did) that a loan might be likened to a temporary transfer of goods repayable in goods rewarded by an interest paid also in goods and determined by the supply and demand of physical goods. Interest cannot be appraised by abstracting from money because as the money value changes so does the value of real factors determining interest, all acting through money. Only if the value of money were constant would the “real” and “monetary” interest coincide.
As Ludwig von Mises pointed out, interest is a category of human action, a primordial phenomenon unlikely to disappear even in the most ideal world. In fact the forces determining interest prevents it from falling permanently to zero or even below. If it were zero saved income could not be exchanged for more future income or to say it differently, the valuation between present and future goods would be at par which may happen only in world where all goods would be free and no capital would be necessary to produce them. If the interest were negative future goods would command a premium on present goods, a reversal of human nature whereby present goods would be valued less than future goods and lenders would have to pay an interest instead of receiving it. The capital would shrink and the economy would regress. Such extreme values which are a little like to the absolute zero in physics, may be only inflicted to interest by exceptional circumstances such as revolutions, seizures, thefts, invasions all situations of great danger when people would prefer to pay a “penal rate” rather than lose their entire capital. Still, in the contemporary economy, similar abnormal situations are artificially created. This is because interest is not commanded by the self generating forces regulating the rate of interest, but by the central banks planned monetary policy closely related to the governments’ fiscal policy.
Central banks set an official or discount rate, a minimum and arbitrary lending rate, the “price for liquidity”, which varies through monetary policy consisting of buying and selling in the open market governments issued bonds against such liquidity. Thus monetary policy acts as a pressure and suction pump alternately decreasing and increasing the quantity of money to push the interest up and down either to keep bonds in the desired relationship with the official rate or to provide a money supply favorable to economic stability and growth. In so doing central banks mimic the natural tendency of interest. For example by expanding money supply during recessions they lower the official rate as this were the after effect of new income streams arising out of foregoing savings required to restore economic growth. The long term rate then changes through expectations towards the official rate: if the latter falls the former is expected to rise and vice versa. However because interests are used to determine the present value of capital assets by discounting their expected income, monetary policy misprices capital assets and misallocate them. This is because the entire interest market structure (the relationship among interest rates influencing prices of income producing assets of different maturity) depends solely on liquidity fluctuations commanded by monetary policy which is completely divorced from the real factors that determine the interest and lay the foundation of liquidity. So not in any sense can the market rate of interest be compared with the one determined by central banks. By ignoring the distinction between money and capital, monetary policy denies the natural function of time preferences and rate of profit confining them to an adaptive role vis-à-vis of their monetary manipulation.
On the other hand because government bonds provide the basis for the money expansion that grows as interest drops, the official rate may be looked upon as a tool of fiscal policy reflecting capital dissipation.This is because central banks pay for these bonds not with income released by foregoing capital operations, but with means of payment they themselves “coin” and lend as they were saved income. This manoeuvre – also known as credit easing – is tantamount to discounting and putting into circulation expected wealth as if it were current wealth, to consume or to use as capital. In other words, central banks by advancing means of payment act as the future were so prosperous as to pledge an ever increasing wealth allowing for their repayment. But the fact is that the most of these means of payment passed off as an existent wealth besides using up, without replacing, the wealth already produced, will never be repaid for they will be misallocated into unproductive uses by a rate of interest not reflecting the existence of money capital but the mere expansion of means of payment that, as already pointed out, should cause interest to rise, not to fall. The paradox is that subsequent rounds of this expansion entail equivalent rounds of waste making capital scarcer and scarcer. Thus economic downturns are just the result of the attempt to create capital on the foundation of monetary policy rather than on the foundation of the real factors determining the rate of interest. Unfortunately, they tend to become permanent to the extent central banks in trying to alleviate them expand money by buying bonds on a huge scale so as to push interest down to zero. But at this level lenders, having no incentive to turn income into capital, will turn capital into income which means they will be living out of their capital until is depleted. As interest vanishes “under the sea level” so does capital till “labour, culture, industry, or commerce will cease to exist” as Turgot predicted long ago.
Via Bank plans to cap risky mortgages – Telegraph:
Mortgage lending would be “capped” to stop borrowers taking out risky loans under radical Bank of England plans to prevent a repeat of the credit crisis, a senior official has disclosed.
But why did borrowers wish to borrow so much, so riskily? And why did lenders wish to lend so much, at such risk?
In the first place, credit has been too cheap for too long. Low interest rates are bound to encourage people to borrow more and save less. Therefore, people saved less and borrowed more. This was the result of the Bank of England’s decisions.
House prices kept rising because people kept borrowing and pumping money into housing. Housing was excluded from the Bank’s measure of inflation, so rates stayed low.
The appearance of inevitable and uninterrupted house price rises gave the impression that we were in a new era within which the old rules did not apply: borrowing caps could be raised to excessively risky levels and borrowers could rely on price increases to deal with the capital.
Lenders used models which fundamentally understated risk. For example, markets do not behave within the Gaussian or “normal” distribution: extreme events happen more often than a normal distribution predicts. Furthermore, the risk of mortgage default correlates across similar mortgages when the economic environment changes. Still, the models said risks were lower than they were, so more credit could be extended.
Since the lenders were neither, on the whole, mutuals or partnerships with open-ended liabilities and since the employees making the decisions shared only in the upside, there was insufficient motivation to manage to the true level of risk.
Moreover, securitisation of mortgage pools and so forth palmed off the risk onto hapless investors who probably trusted the risk models and the market environment created by excessively cheap credit. And, “Hey, look at the returns!” The personal touch was missing from the relationships between borrowers, ultimate lenders and intermediaries, further corrupting the system.
Of course when the pantomime ended, the taxpayer was forced to pick up the bill. And still bonuses were paid in bailed-out banks!
Now, having created the boom with cheap credit and moral hazard, the Bank plans, not to fix the root problems, but to pile intervention upon intervention…
There is much else to be said, for which I recommend The Alchemists of Loss and Money, Bank Credit, and Economic Cycles. However, on the face of it, the Bank’s present proposals merely extend the infantilisation of the financial services sector.
Later this week, I will indicate ten serious plans for financial reform.
By way of nakedcapitalism.com this excellent article from washingtonsblog.com on “Fictional Reserve Banking”:
But whatever you think about fractional reserve banking, whether or not you agree with its critics, the truth is that we no longer have it.
As the above-linked NY Fed article notes:
In practice, the connection between reserve requirements and money creation is not nearly as strong as the exercise above would suggest. Reserve requirements apply only to transaction accounts, which are components of M1, a narrowly defined measure of money. Deposits that are components of M2 and M3 (but not M1), such as savings accounts and time deposits, have no reserve requirements and therefore can expand without regard to reserve levels.
And as Steve Keen notes – citing Table 10 in Yueh-Yun C. OBrien, 2007. “Reserve Requirement Systems in OECD Countries”, Finance and Economics Discussion Series, Divisions of Research & Statistics and Monetary Affairs, Federal Reserve Board, 2007-54, Washington, D.C:
The US Federal Reserve sets a Required Reserve Ratio of 10%, but applies this only to deposits by individuals; banks have no reserve requirement at all for deposits by companies.
So huge swaths of loans are not subject to any reserve requirements.
Welcome to the new financial landscape…
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.
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.
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.
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.
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
Drawing on the work of Nobel Laureates in economics from three traditions, plus numerous other distinguished scholars, Cobden Centre Chairman, economist and successful entrepreneur Toby Baxendale presents an informal introduction to our proposal for honest money and the benefits consequent on the reform. See also our precis of Irving Fisher’s 100% Money.
- The average overhang of credit to money of all banks in the United Kingdom is 34 x to its reserves i.e. its actual money base.
- If more than one person in 34 walks into all banks simultaneously to withdraw their deposits, there will be a system wide bank run and a mass liquidity event with systematic default and insolvency.
- We saw the start of this with Northern Rock in the summer of 2007.
- We attempt to paper over the cracks and restore confidence in the banking system still today – with little success.
Sterling Liquid Assets (BoE FSR, Jun 2009)
A practical, politically-acceptable proposal
Our proposal is, as Irving Fisher wrote, “The opposite of radical”:
- Require 100% cash reserves to be held against all demand deposits; there can never be a crisis if a bank always holds 100% cash against all its demand deposits.
- Parliament can do this with one Act.
A similar Act took place in 1844. The Bank Charter Act or “Peel’s Act” established a 100% reserve requirement for bank notes that were issued claiming to be redeemable in gold. The reality was that there were 23 notes in issue for every one unit of gold at the time, creating instability, “panic” and general economic chaos. Not a too dissimilar situation from today where we have 34 claims on money to one unit of money. Politicians in the 19th century did not see the creation of unbacked credit through accounting entries as a problem, since it was only done on a very small scale. The problem then was rampant note issue (claims to real money) well over and above the monetary base, as this was the preferred method the bankers used at the time.
It is often forgotten but when you place £1m in a savings account (in cash) in say the Royal Bank of Scotland, which has no legal reserve requirement, they then lend £970k (in credit) , keeping on average 3% of cash back in reserves, to an entrepreneur in say HSBC, who then deposits that money in HSBC. We now have one claim to the original £1m and one claim to the £970k. The money supply has moved from £1m to £1.97m – just like magic! This is credit expansion.
The reality is that across all the banks in the United Kingdom licensed by the Bank of England, we have for every £1 of money (in cash), £34 in claims to money (credit)!
Peel’s problem was the over issue of notes to gold: our problem is the over issue of credit to money.
Continue reading “A day of reckoning: how to end the banking crisis now”
Over at Moneyweek, Bill Bonner argues in a subscriber-only article that ersatz money is a flop.
Bonner describes John Law‘s disastrous paper money scheme and the origins of ‘our current experiment with paper’. He identifies the features of the long credit boom, which has come to an end, with reserves of dollars worlwide, over consumption and over production. Bonner argues that Japan blew up first and that the planet-wide bubble burst in 2007. He says we are now all following Law’s example.
Bonner quotes — as emphasised below — Mises in Human Action:
The wavelike movement affecting the economic system, the recurrence of periods of boom which are followed by periods of depression, is the unavoidable outcome of the attempts, repeated again and again, to lower the gross market rate of interest by means of credit expansion. There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.
I recommend the article, which can be read by taking a free trial.