What the Bank of England is trying to do is restart the money creation process which dropped us into this mess while keeping expectations of inflation low. It’s an extremely dangerous game, one which Hayek explored in his Nobel lecture: it is a policy which cannot create sustainable prosperity but which may create massive inflation, with all its destructive effects.
Having mostly failed to see this crisis coming before failing to predict even the general pattern of events, senior economists now want more of the medicine which already nearly killed the patient. This may look like madness or stupidity to those of us without a high level of formal education in economics. It is neither. Contemporary economists are trapped in an intellectual prison founded on now-old errors of method and epistemology: the knowledge and simplifications necessary to make their mathematical models work are unavailable and invalid respectively.
As a result, economists and central bankers in particular think it is their task to intervene when the choices and actions of tens of millions of people produce aggregate statistics they, and politicians, don’t like. Massive economic disruption and misallocation of resources — ultimately, human suffering — is the result. Unfortunately, it looks like those few who hold the terrible power of monetary policy are determined to test their ideas to destruction.
Following the UK credit rating downgrade, I gave Newsnight an interview. They chose a couple of sentences in which I pointed out the reality that welfare, health, education and debt interest are about 3/4 of spending on 2012 figures and that they will have to be cut eventually if we are serious about the state living within its means. You can find it at 17:00. If I had been given longer, I would have said those things you can find in this interview with RT:
We have been on a merry-go-round of deficit spending, excruciating taxes, heavy borrowing and easy money for most of 40 years. That merry-go-round is now running down and will stop. Attempts to spin it up through monetary policy are extremely dangerous: they will store up worse trouble for later.
If the Government does not act to end expansionist policy in time by a return to balanced budgets, by ending government borrowing from the commercial banks, by stopping quantitative easing and by letting the market determine the height of interest rates, then it will have chosen the German way of 1923.
I received an email the other day from Paul-Martin Foss, Legislative Assistant at the Office of Congressman Ron Paul:
Dear Friends of Dr. Paul,
If you are receiving this email, it is because you are a friend of Dr. Paul, a witness at one of our monetary policy hearings, a contributor to what has become Dr. Paul’s Monetary Policy Anthology, or likely some combination of the three.
To honor and preserve Dr. Paul’s legacy as Chairman of the Subcommittee on Domestic Monetary Policy, we have compiled an anthology containing all of Dr. Paul’s activities as chairman. It contains all of his hearings within the DMP subcommittee, transcripts of our Tea Talk Lecture Series, transcripts of his exchanges with Fed Chairman Bernanke, etc.
As a single document, the anthology as formatted runs to over 5000 pages, so we are splitting it into multiple sections and hosting it on Dr. Paul’s Congressional website. Today is the only day that those files will be available online, because today is the last day of the 112th Congress and our website will likely be taken down by close of business today.
Mr Foss subsequently uploaded the files to Dropbox for posterity. We have also archived them in our Downloads section. Here are the direct links:
Ambrose Evans-Pritchard recently pinned the blame for the financial crisis on “Asia’s `Savings Glut’”. This idea is not new. For readers who may have missed it the first time, we’re republishing this article from September 2009 which argues that monetary policy caused the boom, the bust and the savings glut.
Martin Wolf – Global Imbalances
Distinguished commentator and economist Martin Wolf of the FT holds that the savings glut was the source of the excess liquidity that caused the current crisis in which we all find ourselves.
Wolf’s views are expressed crisply in this PowerPoint presentation. In summary, he tells how the Mercantilist approach of the emerging nations after the Asian crisis of the 90s led to a policy of setting exchange rates to encourage exports and limit imports, supported by the stockpiling of foreign currency (a majority in USD) to fund the whole program. The imbalances can be seen as either a “savings glut” or a “money glut.”
I believe from reading Wolf’s articles in the FT that the suggestion is that the savings glut nations not only have policies of fixing exchange rates to encourage exports over imports but also that the people in those nations have a much greater propensity to save than their Western counterparts. It is argued that this demand for money, certainly in USD, causes the Federal Reserve to embark on an expansionist policy.
From page 15 of Wolf’s presentation:
My own view is that the savings glut caused the money glut, by driving the Federal Reserve to pursue expansionary monetary policies, which then led to the reserve accumulations in the creditor countries
But it is also possible to view the Federal Reserve as the causal agent: the money glut causes the savings glut
Either way, the reserve accumulations and fixed exchange rates played a big role in the story
I interpret Wolf’s remarks to mean that when the massive accumulated USD reserves in the emerging nations were partially spent, a surge in liquidity arrived back at the shores of the USA, causing a housing bubble, subprime lending, less than secure CDO’s etc and the bust we now observe.
Wolf is in good company. It would seem that Federal Reserve Chairman Ben Bernanke has endorsed this view in at least the following two recent speeches.
The world is suffering through the worst financial crisis since the 1930s, a crisis that has precipitated a sharp downturn in the global economy. Its fundamental causes remain in dispute. In my view, however, it is impossible to understand this crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s. In the simplest terms, these imbalances reflected a chronic lack of saving relative to investment in the United States and some other industrial countries, combined with an extraordinary increase in saving relative to investment in many emerging market nations. The increase in excess saving in the emerging world resulted in turn from factors such as rapid economic growth in high-saving East Asian economies accompanied, outside of China, by reduced investment rates; large buildups in foreign exchange reserves in a number of emerging markets; and substantial increases in revenues received by exporters of oil and other commodities. Like water seeking its level, saving flowed from where it was abundant to where it was deficient, with the result that the United States and some other advanced countries experienced large capital inflows for more than a decade, even as real long-term interest rates remained low.
Importantly, in our global financial system, saving need not be generated in the country in which it is put to work but can come from foreign as well as domestic sources. In the past 10 to 15 years, the United States and some other industrial countries have been the recipients of a great deal of foreign saving. Much of this foreign saving came from fast-growing emerging market countries in Asia and other places where consumption has lagged behind rising incomes, as well as from oil-exporting nations that could not profitably invest all their revenue at home and thus looked abroad for investment opportunities. Indeed, the net inflow of foreign saving to the United States, which was about 1-1/2 percent of our national output in 1995, reached about 6 percent of national output in 2006, an amount equal to about $825 billion in today’s Dollars.
Saving inflows from abroad can be beneficial if the country that receives those inflows invests them well. Unfortunately, that was not always the case in the United States and some other countries. Financial institutions reacted to the surplus of available funds by competing aggressively for borrowers, and, in the years leading up to the crisis, credit to both households and businesses became relatively cheap and easy to obtain.
The Error
I submit that these two great economists have made a grave error. The government of the USA has legal tender laws that allow only it, ultimately, to create USD via its sanctioned agent, the US Federal Reserve. As it is in charge of the stock of Dollars and the fractional-reserve banking system, it is (counterfeiting aside) the sole source of all issuances.
As I have pointed out in other articles on this site, we use money to exchage our goods and services that we make/provide for sale for other goods and services. Money is the final good for which all other goods and services exchange. Dollars in the USA are the final good you use to exchange your goods for goods offered by other people. A price of a good exchanged for another good is the amount of money paid for that good.
If the pool of money is getting larger, there will be more Dollars to exchange for goods and services. If the quantity of goods and services offered for sale and the number of Dollars in circulation are growing at the same rate, it is possible to argue, if you are prepared to set aside the problems of relative prices, that the “general price level” will be unaffected. However, any economist would argue that if the supply of money increases faster than the supply of goods and services, prices will rise: like any other good, money is devalued by creating more of it.
Therefore, the cause of the crisis can be found only at the door of the monetary authority that created the money in the first place – i.e. the Federal Reserve and other deficit-nation central banks – and not with the saving glut nations. All they have done is seek to exchange some of their goods and services for some of the goods and services of the USA, expressing a time preference along the way. This transfer of ownership does not in itself “bid up prices” to create an “asset price boom”: it is the creation of new money which devalues it.
If new Dollars are locked away for a time and only return to their original economy in an abrupt fashion, they could well seem to be the cause of a sudden asset price bubble, but the prior cause can only be the creation and supply of the wherewithal to do this in the first place.
A Note on Mercantilism
Wolf mentions in his PowerPoint presentation quite rightly that the modern trade regime we have is “in short, a mercantilist hybrid”. Many of the Classical Economist and Political Philosophers such as Hume, Locke, Smith and in later times David Ricardo, point out in various writings that the bullion (gold and silver) that was invariably money was not wealth as such but that the goods they exchanged against were. So, create more money with no associated increase in productivity and the prices of things will rise. Consequently, the Mercantalist goal of having exports higher than imports and thus more bullion at home would just mean that prices would rise at home and cause a flow of that specie to move away from home. Therefore, if in the analogy you substitute US Dollars for bullion, our saving glut nations will get nowhere fast pursuing this policy.
Gold represented claims on already produced wealth. Thus it makes perfect sense that the more wealthy (industrially-devloped, capitalistic etc) countries had more gold historically. As we do not have a link to gold anymore, the USD acts in its capacity as the World Reserve Currency, like gold of old. Using this analogy, the gold producer / gold miner writ large is the Fed and other Central Banks. Dollars will flow away from the mine in exchange for goods and services and this causes a transfer of ownership of goods and services from people in the USA to people in the saving glut nations but can have nothing to do with asset price bubbles as the money was printed by the Fed and no one else. To argue that the savings glut itself has caused the asset price boom is seemingly to endorse the Mercantalist doctrine that was so clearly discredited many moons ago.
Some other reflections on this concept of a “Savings Glut” disturb me and lead me to question whether it is really a meaningful concept at all.
These saving glut nations still seem to have massive gluts but if spending the glut caused the bubble, you would expect the glut to have fallen as well; seemingly, it has not.
If nations save to create a glut, they must indeed refrain from consumption on domestic goods to boost the supply of export goods. This means cheap goods arrive on the shores of the deficit nations. Can this cause a boom across the economy? I think not.
The deficit nations are largely well-developed. As a 40-year-old entrepreneur with a mature business and a happy family, all well rooted in Hertforsdhire, I often say to my wife, “If I was 18 again, I would be straight out to China to exploit some of those massive developmental opportunities. The whole economy seems to be like Manchester was in the Victorian times.” So why do savings there, which should attract a greater rate of return there, not stay there?
In summary, the Fed has more than doubled its money supply since the mid 90’s as have other leading deficit nations. The savings glut and the boom and bust is only attributable to the lax money creation programs of irresponsbile central bankers around the world. They have a poor understanding of economic history and they make an intellectual mistake in misunderstanding what those Classical thinkers knew: money is not wealth.
He said the FPC would also look out for dangerous linkages in the financial system and identify exotic new instruments that might undermine stability. It would be charged with containing credit booms as well as limiting the damage of “credit busts”.
There can, of course, be little doubt that, at the present time, a deflationary process is going on and that an indefinite continuation of that deflation would do inestimable harm. But this does not, by any means, necessarily mean that the deflation is the original cause of our difficulties or that we could overcome these difficulties by compensating for the deflationary tendencies, at present operative in our economic system, by forcing more money into circulation. There is no reason to assume that the crisis was started by a deliberate deflationary action on the part of the monetary authorities, or that the deflation itself is anything but a secondary phenomenon, a process induced by the maladjustments of industry left over from the boom. If, however, the deflation is not a cause but an effect of the unprofitableness of industry, then it is surely vain to hope that by reversing the deflationary process, we can regain lasting prosperity. Far from following a deflationary policy, central banks, particularly in the efforts than have ever been undertaken before to combat the depression by a policy of credit expansion—with the result that the depression has lasted longer and has become more severe than any preceding one.
After a number of interventions about the futile search for stability and the breach of the rule of law inherent in the proposals, I said,
I very much welcome the Bill, which I hope and believe will prove to be the zenith of contemporary thought on bank reform. With due deference to my right hon. Friend the Member for Hitchin and Harpenden (Mr Lilley), I wish to talk about three potential elephants in the room. First, I wish to make some remarks about accounting, then I wish to discuss the conduct of individuals and liability, and finally I wish to talk about financial stability.
I know that the Minister has heard my views on the international financial reporting standard, but I draw his attention to a letter in yesterday’s Financial Times by Lord Lawson, under the headline “Forget Fred and focus on the real banking scandal”. He stated:
“The auditing of banks’ accounts, however, is fundamentally flawed in itself. The IFRS accounting system itself has proved to be damagingly pro-cyclical, and the ability to pay genuine (and genuinely large) bonuses out of purely paper profits, which are never subsequently realised, is at the heart of both the bonuses that cause such public and political outrage, and the reason why bank management consistently does so well when bank shareholders do so badly.”
Andy Haldane, the executive director for financial stability at the Bank of England, gave a speech in December. I shall not read out all the remarks that I meant to cover, but he concluded by saying that
“if we are to restore investor faith in banking sector balance sheets, nothing less than a radical rethink may be required.”
He was referring, entirely, to accounting standards. I therefore refer the Government to my private Member’s Bill introduced on 13 May 2011, which seeks to introduce parallel prudent accounting for banks. It is a couple of pages long and I hope that it can be added to this Bill.
I also refer the Government to “The Law of Opposites”, a paper produced by the Adam Smith Institute and written by my colleague Gordon Kerr, who has spent 25 years “gaming accounting rules”, as he would perhaps say, in order to make a profit. The banking system is in a far worse state than is generally believed. I do not see how either the Financial Policy Committee or the prudential regulation authority can operate without a true and fair view of the state of financial institutions, and I do not believe for a moment that the international financial reporting standards give that to us.
On the conduct of individuals, we fail too often to think about the pattern of regulation in which we have engaged. It seems that the first thing that legislation does is to damage the incentives and disciplines of the market. Having thereby created moral hazard, regulators come along to try to mitigate the consequences of that moral hazard. A banking licence today is a licence to lend money into existence, at interest, with the risk socialised. When we look at central banking, deposit insurance and limited liability, we find that moral hazard is absolutely rife in the banking industry, even before we consider investment banking. I suggest to the Government that it is time to increase the liability of banks’ directors. There should be strict liability for them, and bonuses should be held in a pool and treated as capital for at least five years. I will introduce a private Member’s Bill to that effect on 29 February.
We have talked about financial stability and the difficulty of defining it. There has been a sense that there is some kind of equilibrium economy—an evenly rotating one—in which there could be a sustainable and stable quantity of credit. Indeed, on pages 14 to 16 of the Joint Committee’s report there is an interesting discussion about the need to regulate credit.
To leave time for my hon. Friend the Member for North East Somerset (Jacob Rees-Mogg), I will just say that if we were talking about any other commodity and were discussing adding to a failed regime of price control a regime of quantity control, we would certainly reject the idea out of hand. In Lord George’s testimony to the Treasury Committee before the crisis, he made it absolutely clear that the Bank of England had created a credit bubble to avoid falling into recession, yet we are going to give the Bank even more powers, more tools, [resulting in] more risk of ruin and more big-player effects and distortions of economic expectations.
I congratulate the Government on introducing the Bill, and I sincerely hope that it represents the absolute zenith of contemporary thinking on interventionist bank reform.
In the following video, my remarks begin at 21:31:
I should think society will learn, in the next few years, some important lessons about the use of arbitrary power by monetary and financial authorities. Hold tight.
Another classic article, brought forward. This is a speech by James Tyler to the Adam Smith Institute Next Generation Group on 6 October 2009. This speech is also available on hedgehedge.com.
I have spent the best part of the last two decades pitting my wits against the market. It’s an unforgiving game: I’ve seen ups and downs, and many of my rivals buried under an avalanche of hubris, passion, illogical thought and unchecked emotion.
I have witnessed the sheer folly of the ERM crisis, the Asian crisis, the failure of the Gods at Long Term Capital Management and the insanity of the tech boom.
I have enjoyed the ‘NICE’ decade (Non-Inflationary Constant Expansion), and scared myself silly during the credit crisis.
I am a trader.
I risk my own money and live or die by my decisions, and face the threat of personal bankruptcy every time I switch my screens on. I get no salary – indeed I turn up at the start of the month with a large office overhead – a ‘negative’ salary. I have no fancy company pension scheme, no lucrative monopoly or franchise.
I eat what I kill.
Mistakes cost me my livelihood, so, above all, my decisions have to be rooted in practical and logical decision making.
Some have called my kind parasitic, but I would have said that I bring order, efficiency, predictability, stability and deep liquidity to a crucial process: a process that makes the whole world keep ticking.
I make money work.
I make the market in interest rate derivatives: a market born out of the neo classical revolution in finance fostered in Chicago during the 1970s. I am a child of Friedman, Fisher Black, Myron Scholes and the modern international financial system.
My analysis was steeped in the neo-classical, efficient markets paradigm.
Friedman’s ideal was working. Enlightened central bankers guided the free market with gentle nudges and short term liquidity infusions, free floating currencies gently adjusted themselves to the constant flow of new information and efficient and rational markets took all in their stride.
Credit flowed, people got wealthier, economies developed and all was well.
In September of last year, I placed this article up on our web site detailing the theoretical errors behind the policy of quantitative easing. Clearly, as the MPC has now been given the green light by our chancellor, we expect this currency debasement to be starting soon. All it will “achieve” is a wealth transfer from those lucky enough to get the newly minted money, from those not luckily enough. I aimed to expose the faulty crank-economics that lies behind such thought processes last year and did not think a Tory government would be so foolish to let this happen under their watch, especially as they condemned it under a Labour government. Sadly, articles like this one need to be reproduced so that a new set of readers can hopefully have influence on the present administration.
The mainstream economists hold that the volume of money in circulation, times its velocity is equal to the prices of all goods and services added up. This is the famous Theory of Exchange, MV=PT, or the mechanistic Quantity Theory of Money, where:
M is the stock of money,
V is the velocity of circulation: the number of times the monetary unit changes hands in a certain time period,
P is the general price level,
and T is the “aggregate” of all quantities of goods and services exchanged in the period.
It is held by the overwhelming majority of all economists, that if the velocity of money falls, the price level will fall and thus it is the duty of government, the monopoly issuer of money, the chief Central Planner of the Money Supply, to create more money to keep the price level where it is and thus preserve the existing spending habits of the nation.
Error One — the stock of money
It is held that if you can count the monetary units in the economy and their velocity, you can say what the price level is. As people find it very difficult to count the money in an economy, they cannot see the statistical relationship showing up mechanistically in the price level as expected: the authorities do not have a measure of the money supply which correlates to economic activity.
Working from a sound theoretical basis, I and my colleague Anthony Evans can show you how to count money exactly and how that measure of the money stock correlates to economic activity:
Note that changes in the mainstream measures — M0 and M4 — are quite different to changes in our measure — MA. However, it is MA which shows the best correlation to economic activity and not the measures used by the Bank of England and HM Treasury:
The monetary authorities do not have an adequate measure of the money supply.
Error Two — the velocity of circulation
Velocity is defined as the average number of times during a period that a monetary unit (I will call this MU) is exchanged for a good or service. It is said that a 5% increase in money does not necessarily show itself up with a 5% increase in the price level. It is argued that this is because the velocity of money changes. The trick is to measure by how much the velocity has declined and then create new money — cross your fingers, pray to the Good Lord, do a rain dance around a fire, and hope that the new money will be spent — to fill in this gap left by the fall in velocity.
When you buy a house, we do not say it “circulates”: money is exchanged against real bricks and mortar. The printer who sold me books would have had to sell printed things (i.e. real goods) and saved (forgone consumption) for the future purchase (act of consumption) of the house. Imagine selling your house backwards and forwards between say you and your wife 10 times: the mainstream would argue that the velocity of circulation had risen!
Yes as daft as it sounds, this is the present state of economics.
Thus, if the velocity has gone up by a factor of 10, the price level has increased by the same factor. Here is the suggested rub: therefore, when the velocity of circulation falls, if you increase the money supply by the same factor that the velocity of circulation has fallen by, the price level will stay the same.
Note, as explained above and in detail here, the mainstream do not actually know what money is. Well, let us be clear: it is the final good for which (all) other goods exchange. All of us who are productive make things for sale or sell services, even if it is only our own labour. We sell goods and services which we produce or offer for other goods and services we need. The most marketable of all commodities, money, is accepted by you and other citizens and facilitates exchange of your goods and services for other goods and services. Note that, at all times, money facilitates the exchange of real goods for other real goods.
Party one and a counterparty exchanging or “selling” the house between one another 10 times causing an “increase in velocity” and thus an increase in the price level as an idea is utter garbage. If one party had sold real goods and saved in anticipation of buying the house — real bricks and mortar via the medium of money — this would facilitate a transaction of something (the party’s saved real goods) for something (the counterparty’s real house). Printing money to make sure the price level stays stable to facilitate the “circulating” house in the first example will facilitate a transfer of nothing (the paper) for something (the house). This is commonly called counterfeiting.
This may be another helpful example of why velocity is utterly meaningless. Consider a dinner party: Guest A has a £1. He lends it to Guest B at dinner, who lends it to Guest C who lends it to Guest D. If Guest D pays it back to Guest C, who pays it back to Guest B pays Guest A, the £1 is said to have done £4’s worth of work. The bookkeeping of this transaction shows that £1 was lent out 4 times and they all cancel each other out! Just to be clear, £1 has done £1’s work and not £4’s work. No real wealth or value is created.
The velocity of circulation makes no economic sense.
Error Three — the general price level
Since the monetary authorities have no means to sum the price and quantity of every individual transaction, they must work instead with the “general price level”, ignoring the vital role of changes in relative prices.
As early as 1912, Ludwig von Mises demonstrated that new money must change the structure of relative prices. As anyone who has lived through the past year could tell you, new money is not distributed equally to everyone in the economy. It is injected over time and in specific locations: new money redistributes income to those who receive it first. This redistribution of income not only alters people’s subjective perception of value, it also alters their weight in the marketplace. These factors can only lead to changes in the structure of relative prices.
Mainstream economists believe that “money is neutral in the long run”. They do not have a theory of the capital structure of production which can account for the effects of time and relative prices. They believe increases in the money supply affect all sectors uniformly and proportionately. This is manifestly untrue: look at changes in the Bank of England’s balance sheet and your bank statement.
Hayek wrote that his chief objection to this theory was that it paid attention only to the general price level and not to the structure of relative prices. He indicated that, in consequence, it disregarded the most harmful effects of increasing the money supply: the misdirection of resources and specifically unemployment. Furthermore, this wilful ignorance of relative prices explains the mainstream’s lack of an adequate theory of business cycles, something Hayek provided.
The general price level aggregates away a vital factor: the relative structure of prices.
Error Four — the aggregate quantities of goods and services sold
Since the sum of price times quantity for every individual transaction is not available, the authorities must use the “aggregate quantity of goods and services sold”. This is nonsense: the quantities to be added together are incompatible. It makes no sense to add a kilogram of potatoes to a kilogram of copper to a litre of petrol to a day’s software consultancy to a 30-second television advert.
The aggregate quantity of goods and services sold is an impossible sum.
Error Five — the equation is no more than a tautology
Consider this, if I buy 10 copies of Adam Smith’s Wealth of Nations from a printing company for 7 monetary units (or MU), an exchange has been made: I gave up 7 MU’s to the printer, and the printer transferred 10 sets of printed works to me. The error that the mainstream make is that “10 sets of printed works have been regarded as equal to 7 MU, and this fact may be expressed thus: 7 MU = 10 printed works multiplied by 0.7 MU per set of printed works.” But equality is not self-evident.
There is never any equality of values on the part of the two participants in exchange. The assumption that an exchange presumes some sort of equality has been a delusion of economic theory for many centuries. We only exchange if each party thinks he is getting something of greater value from the other party than he has already. If there was equality in value, no exchange would happen! Value is subjective and utility is marginal: each party values the other’s goods or services more highly than their own.
Thus, while the mainstream believe that there is a causal link between the “money side” of the equation and the “value of goods and services side”, it is just a tautology from which no economic knowledge can be gained. All we are saying, if the Quantity Theory holds, is that “7 MU’s = 10 sets of printed works X 0.7 MU’s per set of printed works”: in other words, “7 MU = 7 MU”. Thus what is paid is what is received. This is like announcing to the world that you have discovered the fabulous fact that 2=2.
The mechanistic Quantity Theory of Money is not a causal relation but a tautology.
Conclusion
The mechanistic Quantity Theory only provides us with a tautology and every term of “MV = PT” is seriously flawed. Public policy should not rest on the foundation of this bad science.
If the money supply contracts as it has done so spectacularly since late 2008 (see the chart above), you will have less goods and services supporting less economic activity. This for sure is bad. We now have less money and less exchanging of real goods and services for other real goods and services.
The only way to get more goods and services offered for exchange is if entrepreneurs get hold of their factors of production — land, labour and capital — and reorganise them to meet the new demands of the consumers in a more efficient way than before. The only thing that the government can do is to make sure it provides as little regulatory burden as possible and the lightest tax regime that it can run in order to allow entrepreneurs to facilitate this correction.
Certainly in my business of the supply of fish and meat to the food service sector — www.directseafoods.co.uk — I have never witnessed such an abrupt change in consumption patterns as people have traded down from more expensive species and cuts to less expensive ones. Thus I have to reorganise my offer to my customers and potential customers. No amount of fiddling about with the level of newly minted money in the economy will help this reorganisation of my factors of production: they need to be retuned to the new needs and desires of my customers.
Quantitative easing, as I have said before, is firmly based on a belief in the so called “internal truths” held in the Quantity Theory of Money. I hope any reader can see that this belief is based on very faulty logic. Bad logic gives us bad policy. A policy of QE says that because the velocity of circulation has fallen, we can print newly minted money, out of thin air, at the touch of a computer key, and create more demand for the exchange of goods and services.
Money has been historically rooted in gold and silver because these cannot “vanish” overnight as we are seeing under our present state monopoly of money — fiat money, money by decree, i.e. bits of paper we are forced to use as legal tender. Remember, since 1971 when Nixon broke the gold link, money is just bits of paper, notwithstanding a promise to pay the bearer on demand. In the near future, this will no doubt remain the case. Indeed, anyone who dares to mention that the final good, for which all goods exchange, should be a real good that is scarce (hard to manipulate it, hard to destroy it) unlike paper and electronic journal entries (easy to manipulate, easy to destroy) is considered a lunatic!
On a point of history, it is worthwhile remembering that, as we have mentioned here, the 1844 Peel Act did remove the banks’ practice of issuing promissory notes (paper money) over and above their reserves of gold (the most marketable commodity i.e. money) as this was causing bank runs, “panic”, boom and bust. They did not resolve the issues of demand deposits to be drawn by cheque. Both features allow banks to issue new money — i.e. certificates that have no prior production of useful economic activity such as our printer printing books or my selling of meat and fish — while retaining real money — claims to the printing of books and selling of my meat and fish — only to a percentage of the deposited money, i.e. the Reserve Requirement of the bank. In the UK, there is no Reserve Requirement anymore as far as I am aware, hence banks going for massive levels of leverage. It is no surprise that the house of cards has fallen down.
Our proposal for a 100% reserve requirement is offered for discussion as the only sure-fire way of delivering lasting stability. Listening to economists talking about the “velocity of circulation” falling and thus suggesting that we should conduct large scale Quantitative Easing to hold the price level is not economics, but the policy of the Witch Doctor and the Mystic.
It is staggering that so much garbage, posing as sound knowledge, hinges on these grave errors.
In today’s TelegraphAmbrose Evans-Pritchard gives a splendid analysis of the dire fiscal problems facing the developed economies, but a dreadful analysis of their monetary problems.
With the UK debt to GDP ratio racing up towards 100%, there can be no serious question that the UK is approaching a fiscal precipice. The Government is indeed very fortunate to have kept its credit rating – even at the beginning of the year, one big bond investor was warning that UK Government debt was a “must avoid” as it was “resting on a bed of nitroglycerine” – but this cannot last unless the Government provides a credible plan to map the country back towards solvency.
We must also keep in mind that the ‘visible debt’, the debt on the Government’s balance sheets, is just the tip of the iceberg: when one takes into account all the hidden commitments the Government has entered into – PFI, public sector pensions, state pensions, etc. – the situation is far far worse: we are looking at debt to GDP ratios in the range of perhaps 350% to 500%.
The true fiscal situation is, thus, even more dire than Mr. Evans-Pritchard makes out. Nonetheless, he is absolutely right that fiscal expansion is not an option. Instead, the Government is drinking in last-chance saloon and it is a choice between painful spending cuts now and much more more painful cuts later.
However, Mr. Evans-Pritchard also tells us that “ultra-loose monetary is the only option for Europe, the US and Japan”. He suggests that in the US, M3 has fallen at a 10pc pace for much of this year, telling us that this was the “Great Depression rate” and so the economy hit the buffers with the “usual lag” along textbook Quantity Theory lines. The clear implication is that this needs to be reversed to get the US economy going again.
This analysis is nonsense. First off, there is no “usual lag” – Milton Friedman spoke spoke of “long and variable lags”, but most economists interpret this in the region of perhaps 12-24 months – so it is pushing it to blame very recent falls in M3 for the decline in the US economy. But in any case, the Fed discontinued publishing M3 statistics back in 2006 – one suspects, because they painted an embarrassingly expansionary picture about the true stance of US monetary policy in the bubble years.
Instead, we need to take a broader picture and look at how the monetary aggregates over a much longer period. If we do so – and lets look at the official statistics published by the St. Louis Fed on its Federal Reserve Economic Data site – we get a picture of seriously expanding monetary aggregates over a sustained period of time. Even if we look at the most recent year-on-year data we find:
St. Louis adjusted monetary base up by about 15% (though having fallen in recent months a little to $2 trillion, itself up from about $800 billion before the crisis – a big expansion in my book!);
M1 up about 5%;
M2 up about 2%;
MZM (the closest now to M3), down about 2 to 3%.
By contrast, in the early 1930s, US monetary aggregates fell by about a third.
And one should never look at monetary aggregates alone; we also need to look at real interest rates, and in this respect the difference between recent years and the early 1930s is again very pronounced. In recent years, real interest rates have been strongly negative – this of course has been a key problem, repeatedly fuelling boom-bust cycles; by contrast, in the US in the early 1930s, real interest rates were VERY highly positive, sometimes in double digits.
So the overall monetary policy stance in recent years is anything but contractionary, and there is no comparison to the 1930s.
Monetary expansion has merely created an inflation time bomb and fuelled repeated speculative cycles, the latest one being in the banking sector itself, by allowing the banks one last lending binge at negative real interest rates subsidised by the long-suffering taxpayer. Further monetary expansion would merely give the patient more of the poison that is already doing much to kill him.
Fortunately, there are solutions, but one has to think outside the washed up Keynesian macroeconomic toolbox. The reason the economy is doing so badly is because the banking system is still broken, and the economy will continue to do badly until the banking system is properly fixed. Some of us have been hammering on about this for years.
This is, I would suggest, also a matter of some urgency: the Bank of England’s latest Inflation Report suggests that CDS spreads on UK banks are rising very sharply, and are nearly as high now (200 basis points) as they were at the height of the crisis (almost 240 basis points, as opposed to a mere 10 basis points before the crisis hit). The storm clouds are gathering again for everyone to see, and no expansionist ‘solutions’ are going to help.
In their working paper Assessing UK money supply measures in the light of the credit crunch, Toby Baxendale and Anthony J. Evans provide a better measure of the money supply. In this article, Steven Baker explores the background to the paper and indicates some key findings.
This article was originally published in October 2009.
Many people know the Bank of England is creating new money through quantitative easing but if the quantity of money is being increased, how is that quantity being measured? What is counted as money?
When the Bank is concerned about the risks of very low inflation, it cuts Bank Rate – that is, it reduces the price of central bank money. But interest rates cannot fall below zero.
So if they are almost at zero, and there is still a significant risk of very low inflation, the Bank can increase the quantity of money – in other words, inject money directly into the economy. That process is sometimes known as ‘quantitative easing’.
But when I consider quantitative easing, I am concerned with the following problems:
It is not clear that the Bank of England has a useful definition of the money supply. The present measures do not correspond to economic activity — which is what the Bank is trying to increase with new money — and this crisis was famously not foreseen.
As commentators have reported, “the Bank’s Governor, Mervyn King, seemed pretty confident that QE could work. But even he would admit he has no idea how long it will take – or how much money he will have to print to get there.” This uncertainty seems less than ideal given the risk of price inflation.
According to Austrian-School economic scholars including Hayek and Huerta de Soto, injecting new money can create only a harmful illusion of prosperity1.
As my colleagues point out in their working paper, the fact that the monetary authorities have turned to increasing the quantity of money will focus attention on how that quantity is measured. This article provides some background information and indicates Baxendale and Evans’ key findings.
“The continuous injection of additional amounts of money at points of the economic system where it creates a temporary demand which must cease when the increase of the quantity of money stops or slows down, together with the expectation of a continuing rise of prices, draws labour and other resources into employments which can last only so long as the increase of the quantity of money continues at the same rate – or perhaps even only so long as it continues to accelerate at a given rate. What this policy has produced is not so much a level of employment that could not have been brought about in other ways, as a distribution of employment which cannot be indefinitely maintained and which after some time can be maintained only by a rate of inflation which would rapidly lead to a disorganisation of all economic activity.” Hayek, 1974 Nobel Prize Lecture [↩]
Jimmy Stewart plays George Bailey who is cast as the “honest” and trustworthy banker in the classic Hollywood film, “It’s a Wonderful Life.” Kotlikoff’s book laments that in the real world of modern banking, such characters no longer exist.
Kotlikoff himself is a Professor of Economics at Boston. Several Nobel Prize winners have endorsed the book: George Akerlof, Robert Lucas, Robert Fogel, Edward Prescott, and Edmund Phelps. I count 36 endorsements from the great and the good of the academic world on the back cover and front pages. I do not recall ever seeing this in a book.
The book is written for the layman. It is very light on economic theory, but does reference some otherworldly models. It is very good at explaining what on the face of it appear to be complex financial phenomena, but are in fact con tricks that in any other industry would earn you a prison sentence. Kotlikoff shows his readers how the financial system has failed in its fiduciary duty, and presents a very simple and elegant solution for its salvation called Limited Purpose Banking (LPB). He also proposes a reduction of the financial service sector regulators in the USA from its current 115 down to one: the Federal Financial Authority (FFA).
In his opening remarks he discusses the Modigliani-Miller Theorem, written in 1958, showing in elegant maths how in the absence of bankruptcy costs, leverage does not matter. If a company takes on more risk by borrowing more, its owners will offset that risk by borrowing less, leaving total debt in the economy unchanged. Kotlikoff makes no mention of the fact that leverage in itself is not a bad thing if it is made up of people forgoing their consumption today, i.e. saving and committing it to projects that will deliver up goods in the future. This glaring omission does not impede him from telling the story of our financial meltdown and making a solid policy recommendation for this crisis. It does, however, prevent him from seeing the elephant in the room: that the credit creation process itself is the source of the boom and the bust.
The nature of fractional reserve banking is such that if you deposit your cash in a bank, it will lend it out many times over. This means that multiple claims come to exist on the original real money that was deposited. If you deposit £100 in bank A, which lends it to an entrepreneur who deposits it in Bank B, both you and the entrepreneur now have £100! Like magic, we have £200 in the system, with £100 of it created ex novo by the banking system itself! In the UK, with no legal reserve requirement, we have a only £3 on average kept in deposit for every £100 of IOU’s promised by the banking system.
Kotlikoff provides a mainstream justification for fractional reserve banking, citing the Diamond-Dybvig Model, which holds that we value immediate liquidity for emergencies. We do not need that money all the time, so banks can use this and get us a higher return in the meantime. Therefore, governments must do everything to prevent a bank run if more people want their money back than actually exists in the bank vaults.
This is the theoretical understanding we have today and the model is used to justify all sorts of bank bailouts, as we have seen.
Kotlikoff points out that whilst the bailouts have prevented a collapse of the system of fractional reserve banking, the bailouts do not preserve the purchasing power of money. They just guarantee that the money unit will still exist. This is a very good point. All the bailouts are being funded by more claims on the future taxpayer. In the UK, we have a system of money debasement called Quantitative Easing, which will just debase and reduce our purchasing power.
In effect, the bailouts do not do what they say they do on the tin, and daily our purchasing power is getting weaker. It is hard enough to get politicians in the UK to acknowledge the scale of our official national debt, but we owe at least as much again “off balance sheet”, in unfunded pension liabilities and Private Finance Initiative obligations. Debasement will be the most popular way forward for all future governments as they will not want to overtly extract more wealth from us. Dishonesty will be the preferred policy.
Limited purpose banking would be a simple solution to all of this. Banks would be limited to their main purpose of matching savers to borrowers. All financial companies would act as pass though mutual fund companies. They would be middle men, never would they own the financial assets. They could thus never fail in the “run on the bank” sense — i.e. depositors wishing to withdraw money — but only if they were very bad at business. This is thus as near as you will get to risk-free banking. Never again would the economy be held liable to bail out the bankers.
Kotlikoff foresees at least two mutual funds being offered, with custodians holding the assets: one that holds cash and one that holds insurance funds. He does stress that innovation could still happen, with a multiplicity of funds being offered. The Federal Financial Authority (FFA) would regulate the custody element of the safe keeping of the various mutual fund assets. He assumes that regulators will be able to opine, like the current rating agencies, on the soundness of the assets that have been bought by the fund. He would trust the government over the rating agencies. I personally would trust neither! In my industry, selling meat and fish, we have a number of free market created quality assurance bodies such as the British Soil Association for organic certification, the Marine Stewardship Council for fish sustainability that require no government sanction. These have the confidence of both the consumer and producer. I would suggest that this and not a super regulator is the way forward.
Cash funds are nice and easy; they hold cash and are 100% reserved. They can never go up or down in value. These cash mutual funds represent the demand deposits of the new spec banking system. All services such as cheque writing and paying bills is done via this vehicle.
I have written about 100% reserve banking here and Steve Baker has specifically examined the 100% reserve banking proposal of Irving Fisher, to which Kotlikoff refers. He notes that the current economic profession considers these ideas to be “crackpot”; the Diamond-Dybvig model remains dominant. He goes go on to say, “I want to be clear that I am not an advocate of narrow banking in of itself. Narrow banking is a small feature of limited purpose banking and would hardly suffice to deal with today’s multifaceted financial problems.”
He notes that with the many cash mutual funds in place, the money measure in the USA, MI, would correspond exactly with what the government had printed. So to cover all obligations, a massive print up in US dollars would need to take place — many trillions of dollars to truly purge the system. What Kotlikoff misses is De Soto’s insight, based on the work of Fisher, that there will be a unique moment in history when instead of causing debasement, the printed money would cover all unfunded demand deposits, swapping them out for cash. Wipe out or retire these demand deposits and the banking system has no current creditors, only assets. Take out the equivalent amount of assets from the banking system, so the banking system has the same net worth as before, then put these assets into the mutuals and pay off the national debt. This is not inflationary, requires no debasement, and will help deliver up safe banking. This is summarised in our Day of Reckoning article.
Insurance mutuals would have all the other banking instruments such as CDO’s in them and could market these funds to whomever they wished. These are essentially what we would term a hedge fund today, though Kotlikoff proposes that these be closed end. This means you have to sell your shares in the fund to redeem your money. Consequently, long term lending can take place in these funds without the fear of a maturity mismatch. The only money this type of fund can lose is what is invested in it. It could never in itself pull down the banking system.
I sense that the author does not feel comfortable with the 100% reserve label, with its “crackpot” associations. In discussing the transfer of Citigroup he says,
“Here we’d need to swap all of CitiGroup’s debt for equity and prevent it from ever borrowing again to fund risky investments. We can now think of CitiGroup as a huge mutual fund with lots of different assets, one big commercial bank with 100 percent capital requirement, or one LPB with a large number of different mutual funds corresponding to the different Citigroup asset classes.”
He also points out that LPB could not actually be that far away if you take into account all the reserves that have been created already. This is something George Reisman has also pointed out.
Kotlikoff defensively shows how LPB would not reduce liquidity. It would not reduce real credit, i.e. savers forwarding money to borrowers. It would stop credit created out of thin air via the banking system, the prime cause of the crisis, but this is not mentioned in his book. It would lead to an optimal size financial sector. Our cash assets would be safe as you can get. Government could still monetise debt as it could still create cash from nothing. The currency and thus the purchasing power of money could not collapse by the actions of the banking system, but only by the actions of the government.
Kotlikoff concludes,
Limited purpose banking is the answer. This simple and easily-implemented pass-though mutual fund system, with its built in firewalls, would preclude financial crises of the type we’re now experiencing. The system will rely on independent rating by the government, but private rating as well. It would require full disclosure and provide maximum transparency. Most important, it would make clear that risk is ultimately born by people, not companies, and that most people need, and have a right, to know what risks, including fiscal risk, they are facing. Finally, it would make clear what risks are, and are not, diversifiable. It would not pretend to insure the uninsurable or guarantee returns that can’t be guaranteed. In short, the system would be honest, and because of that, it would be safe-safe for ourselves and safe for our children.
Although I think he has failed to identify the state sponsored banking system, with its fractional reserve credit creation point as the cause of booms and busts, his solution has many merits and many similarities with the solution proposed by Fisher, De Soto, and others. He missed what I call the golden opportunity, or unique moment in history, to actually enact a reform that delivers up 100% reserve of LPB and pays off the national debt and other unfunded obligations at the same time. My own solution is the De Soto 100% reserve free banking solution with banks working within the existing commercial law to which all non-bank companies must adhere. However, both systems have the same effects and would do the job needed: to sort out the banking system, provide stability, and let capitalism flourish. Yet another workable solution has been proposed by our very own Paul Birch. Kotlikoff’s contribution to the debate, with all the Nobel endorsements, is timely, and I hope policy makers give due attention to innovative solutions like these.
This has been copied from Money, Bank Credit, and Economic Cycles which can be downloaded here or bought here.
PREFACE TO THE SECOND ENGLISH EDITION
I am happy to present the second English edition of Money, Bank Credit, and Economic Cycles. Its appearance is particularly timely, given that the severe financial crisis and resulting worldwide economic recession I have been forecasting, since the first edition of this book came out ten years ago, are now unleashing their fury.
The policy of artificial credit expansion central banks have permitted and orchestrated over the last fifteen years could not have ended in any other way. The expansionary cycle which has now come to a close began gathering momentum when the American economy emerged from its last recession (fleeting and repressed though it was) in 2001 and the Federal Reserve reembarked on the major artificial expansion of credit and investment initiated in 1992. This credit expansion was not backed by a parallel increase in voluntary household saving. For many years, the money supply in the form of bank notes and deposits has grown at an average rate of over 10 percent per year (which means that every seven years the total volume of money circulating in the world has doubled). The media of exchange originating from this severe fiduciary inflation have been placed on the market by the banking system as newly created loans granted at very low (and even negative in real terms) interest rates. The above fueled a speculative bubble in the shape of a substantial rise in the prices of capital goods, real-estate assets and the securities which represent them, and are exchanged on the stock market, where indexes soared.
Curiously, like in the “roaring” years prior to the Great Depression of 1929, the shock of monetary growth has not significantly influenced the prices of the subset of consumer goods and services (approximately only one third of all goods). The last decade, like the 1920s, has seen a remarkable increase in productivity as a result of the introduction on a massive scale of new technologies and significant entrepreneurial innovations which, were it not for the injection of money and credit, would have given rise to a healthy and sustained reduction in the unit price of consumer goods and services. Moreover, the full incorporation of the economies of China and India into the globalized market has boosted the real productivity of consumer goods and services even further. The absence of a healthy “deflation” in the prices of consumer goods in a stage of such considerable growth in productivity as that of recent years provides the main evidence that the monetary shock has seriously disturbed the economic process. I analyze this phenomenon in detail in chapter 6, section 9.
As I explain in the book, artificial credit expansion and the (fiduciary) inflation of media of exchange offer no short cut to stable and sustained economic development, no way of avoiding the necessary sacrifice and discipline behind all high rates of voluntary saving. (In fact, particularly in the United States, voluntary saving has not only failed to increase in recent years, but at times has even fallen to a negative rate.) Indeed, the artificial expansion of credit and money is never more than a short-term solution, and that at best. In fact, today there is no doubt about the recessionary quality the monetary shock always has in the long run: newly-created loans (of money citizens have not first saved) immediately provide entrepreneurs with purchasing power they use in overly ambitious investment projects (in recent years, especially in the building sector and real estate development). In other words, entrepreneurs act as if citizens had increased their saving, when they have not actually done so. Widespread discoordination in the economic system exerts a harmful effect on the real economy, and sooner or later the process reverses in the form of an economic recession, which marks the beginning of the painful and necessary readjustment. This readjustment invariably requires the reconversion of every real productive structure inflation has distorted. The specific triggers of the end of the euphoric monetary “binge” and the beginning of the recessionary “hangover” are many, and they can vary from one cycle to another. In the current circumstances, the most obvious triggers have been the rise in the price of raw materials, particularly oil, the subprime mortgage crisis in the United States, and finally, the failure of important banking institutions when it became clear in the market that the value of their liabilities exceeded that of their assets (mortgage loans granted).
At present, numerous self-interested voices are demanding further reductions in interest rates and new injections of money which permit those who desire it to complete their investment projects without suffering losses. Nevertheless, this escape forward would only temporarily postpone problems at the cost of making them far more serious later. The crisis has hit because the profits of capital-goods companies (especially in the building sector and in real-estate development) have disappeared due to the entrepreneurial errors provoked by cheap credit, and because the prices of consumer goods have begun to perform relatively less poorly than those of capital goods. At this point, a painful, inevitable readjustment begins, and in addition to a decrease in production and an increase in unemployment, we are now still seeing a harmful rise in the prices of consumer goods (stagflation).
The most rigorous economic analysis and the coolest, most balanced interpretation of recent economic and financial events support the conclusion that central banks (which are true financial central-planning agencies) cannot possibly succeed in finding the most advantageous monetary policy at every moment. This is exactly what became clear in the case of the failed attempts to plan the former Soviet economy from above. To put it another way, the theorem of the economic impossibility of socialism, which the Austrian economists Ludwig von Mises and Friedrich A. Hayek discovered, is fully applicable to central banks in general, and to the Federal Reserve—(at one time) Alan Greenspan and (currently) Ben Bernanke—in particular. According to this theorem, it is impossible to organize society, in terms of economics, based on coercive commands issued by a planning agency, since such a body can never obtain the information it needs to infuse its commands with a coordinating nature. Indeed, nothing is more dangerous than to indulge in the “fatal conceit”—to use Hayek’s useful expression—of believing oneself omniscient or at least wise and powerful enough to be able to keep the most suitable monetary policy fine tuned at all times. Hence, rather than soften the most violent ups and downs of the economic cycle, the Federal Reserve and, to some lesser extent, the European Central Bank, have most likely been their main architects and the culprits in their worsening. Therefore, the dilemma facing Ben Bernanke and his Federal Reserve Board, as well as the other central banks (beginning with the European Central Bank), is not at all comfortable. For years they have shirked their monetary responsibility, and now they find themselves in a blind alley. They can either allow the recessionary process to begin now, and with it the healthy and painful readjustment, or they can escape forward toward a “hair of the dog” cure. With the latter, the chances of even more severe stagflation in the not-too-distant future increase exponentially. (This was precisely the error committed following the stock market crash of 1987, an error which led to the inflation at the end of the 1980s and concluded with the sharp recession of 1990–1992.) Furthermore, the reintroduction of a cheap-credit policy at this stage could only hinder the necessary liquidation of unprofitable investments and company reconversion. It could even wind up prolonging the recession indefinitely, as has occurred in Japan in recent years: though all possible interventions have been tried, the Japanese economy has ceased to respond to any monetarist stimulus involving credit expansion or Keynesian methods. It is in this context of “financial schizophrenia” that we must interpret the latest “shots in the dark” fired by the monetary authorities (who have two totally contradictory responsibilities: both to control inflation and to inject all the liquidity necessary into the financial system to prevent its collapse). Thus, one day the Federal Reserve rescues Bear Stearns, AIG, Fannie Mae, and Freddie Mac or Citigroup, and the next it allows Lehman Brothers to fail, under the amply justified pretext of “teaching a lesson” and refusing to fuel moral hazard. Then, in light of the way events were unfolding, a 700-billion-dollar plan to purchase the euphemistically named “toxic” or “illiquid” (i.e., worthless) assets from the banking system was approved. If the plan is financed by taxes (and not more inflation), it will mean a heavy tax burden on households, precisely when they are least able to bear it. Finally, in view of doubts about whether such a plan could have any effect, the choice was made to inject public money directly into banks, and even to “guarantee” the total amount of their deposits, decreasing interest rates to almost zero percent.
In comparison, the economies of the European Union are in a somewhat less poor state (if we do not consider the expansionary effect of the policy of deliberately depreciating the dollar, and the relatively greater European rigidities, particularly in the labor market, which tend to make recessions in Europe longer and more painful). The expansionary policy of the European Central Bank, though not free of grave errors, has been somewhat less irresponsible than that of the Federal Reserve. Furthermore, fulfillment of the convergence criteria involved at the time a healthy and significant rehabilitation of the chief European economies. Only the countries on the periphery, like Ireland and particularly Spain, were immersed in considerable credit expansion from the time they initiated their processes of convergence. The case of Spain is paradigmatic. The Spanish economy underwent an economic boom which, in part, was due to real causes (liberalizing structural reforms which originated with José María Aznar’s administration in 1996). Nevertheless, the boom was also largely fueled by an artificial expansion of money and credit, which grew at a rate nearly three times that of the corresponding rates in France and Germany. Spanish economic agents essentially interpreted the decrease in interest rates which resulted from the convergence process in the easy-money terms traditional in Spain: a greater availability of easy money and mass requests for loans from Spanish banks (mainly to finance real estate speculation), loans which these banks have granted by creating the money ex nihilo while European central bankers looked on unperturbed. When faced with the rise in prices, the European Central Bank has remained faithful to its mandate and has tried to maintain interest rates as long as possible, despite the difficulties of those members of the Monetary Union which, like Spain, are now discovering that much of their investment in real estate was in error and are heading for a lengthy and painful reorganization of their real economy.
Under these circumstances, the most appropriate policy would be to liberalize the economy at all levels (especially in the labor market) to permit the rapid reallocation of productive factors (particularly labor) to profitable sectors. Likewise, it is essential to reduce public spending and taxes, in order to increase the available income of heavily-indebted economic agents who need to repay their loans as soon as possible. Economic agents in general and companies in particular can only rehabilitate their finances by cutting costs (especially labor costs) and paying off loans. Essential to this aim are a very flexible labor market and a much more austere public sector. These factors are fundamental if the market is to reveal as quickly as possible the real value of the investment goods produced in error and thus lay the foundation for a healthy, sustained economic recovery in a future which, for the good of all, I hope is not long in coming.
We must not forget that a central feature of the recent period of artificial expansion was a gradual corruption, on the American continent as well as in Europe, of the traditional principles of accounting as practiced globally for centuries. To be specific, acceptance of the International Accounting Standards (IAS) and their incorporation into law in different countries (in Spain via the new General Accounting Plan, in effect as of January 1, 2008) have meant the abandonment of the traditional principle of prudence and its replacement by the principle of fair value in the assessment of the value of balance sheet assets, particularly financial assets. In this abandonment of the traditional principle of prudence, a highly influential role has been played by brokerages, investment banks (which are now on their way to extinction), and in general, all parties interested in “inflating” book values in order to bring them closer to supposedly more “objective” stockmarket values, which in the past rose continually in an economic process of financial euphoria. In fact, during the years of the “speculative bubble,” this process was characterized by a feedback loop: rising stock-market values were immediately entered into the books, and then such accounting entries were sought as justification for further artificial increases in the prices of financial assets listed on the stock market.
In this wild race to abandon traditional accounting principles and replace them with others more “in line with the times,” it became common to evaluate companies based on unorthodox suppositions and purely subjective criteria which in the new standards replace the only truly objective criterion (that of historical cost). Now, the collapse of financial markets and economic agents’ widespread loss of faith in banks and their accounting practices have revealed the serious error involved in yielding to the IAS and their abandonment of traditional accounting principles based on prudence, the error of indulging in the vices of creative, fair-value accounting.
It is in this context that we must view the recent measures taken in the United States and the European Union to “soften” (i.e., to partially reverse) the impact of fair-value accounting for financial institutions. This is a step in the right direction, but it falls short and is taken for the wrong reasons. Indeed, those in charge at financial institutions are attempting to “shut the barn door when the horse is bolting”; that is, when the dramatic fall in the value of “toxic” or “illiquid” assets has endangered the solvency of their institutions. However, these people were delighted with the new IAS during the preceding years of “irrational exuberance,” in which increasing and excessive values in the stock and financial markets graced their balance sheets with staggering figures corresponding to their own profits and net worth, figures which in turn encouraged them to run risks (or better, uncertainties) with practically no thought of danger. Hence, we see that the IAS act in a pro-cyclic manner by heightening volatility and erroneously biasing business management: in times of prosperity, they create a false “wealth effect” which prompts people to take disproportionate risks; when, from one day to the next, the errors committed come to light, the loss in the value of assets immediately decapitalizes companies, which are obliged to sell assets and attempt to recapitalize at the worst moment, i.e., when assets are worth the least and financial markets dry up. Clearly, accounting principles which, like those of the IAS, have proven so disturbing must be abandoned as soon as possible, and all of the accounting reforms recently enacted, specifically the Spanish one, which came into effect January 1, 2008, must be reversed. This is so not only because these reforms mean a dead end in a period of financial crisis and recession, but especially because it is vital that in periods of prosperity we stick to the principle of prudence in valuation, a principle which has shaped all accounting systems from the time of Luca Pacioli at the beginning of the fifteenth century to the adoption of the false idol of the IAS.
In short, the greatest error of the accounting reform recently introduced worldwide is that it scraps centuries of accounting experience and business management when it replaces the prudence principle, as the highest ranking among all traditional accounting principles, with the “fair value” principle, which is simply the introduction of the volatile market value for an entire set of assets, particularly financial assets. This Copernican turn is extremely harmful and threatens the very foundations of the market economy for several reasons. First, to violate the traditional principle of prudence and require that accounting entries reflect market values is to provoke, depending upon the conditions of the economic cycle, an inflation of book values with surpluses which have not materialized and which, in many cases, may never materialize. The artificial “wealth effect” this can produce, especially during the boom phase of each economic cycle, leads to the allocation of paper (or merely temporary) profits, the acceptance of disproportionate risks, and in short, the commission of systematic entrepreneurial errors and the consumption of the nation’s capital, to the detriment of its healthy productive structure and its capacity for long-term growth. Second, I must emphasize that the purpose of accounting is not to reflect supposed “real” values (which in any case are subjective and which are determined and vary daily in the corresponding markets) under the pretext of attaining a (poorly understood) “accounting transparency.” Instead, the purpose of accounting is to permit the prudent management of each company and to prevent capital consumption [1], by applying strict standards of accounting conservatism (based on the prudence principle and the recording of either historical cost or market value, whichever is less), standards which ensure at all times that distributable profits come from a safe surplus which can be distributed without in any way endangering the future viability and capitalization of the company. Third, we must bear in mind that in the market there are no equilibrium prices a third party can objectively determine. Quite the opposite is true; market values arise from subjective assessments and fluctuate sharply, and hence their use in accounting eliminates much of the clarity, certainty, and information balance sheets contained in the past. Today, balance sheets have become largely unintelligible and useless to economic agents. Furthermore, the volatility inherent in market values, particularly over the economic cycle, robs accounting based on the “new principles” of much of its potential as a guide for action for company managers and leads them to systematically commit major errors in management, errors which have been on the verge of provoking the severest financial crisis to ravage the world since 1929.
In chapter 9 of this book (pages 789–803), I design a process of transition toward the only world financial order which, being fully compatible with the free-enterprise system, can eliminate the financial crises and economic recessions which cyclically affect the world’s economies. The proposal the book contains for international financial reform has acquired extreme relevance at the present time (November 2008), in which the disconcerted governments of Europe and America have organized a world conference to reform the international monetary system in order to avoid in the future such severe financial and banking crises as the one that currently grips the entire western world. As is explained in detail over the nine chapters of this book, any future reform will fail as miserably as past reforms unless it strikes at the very root of the present problems and rests on the following principles:
the reestablishment of a 100-percent reserve requirement on all bank demand deposits and equivalents;
the elimination of central banks as lenders of last resort (which will be unnecessary if the preceding principle is applied, and harmful if they continue to act as financial central-planning agencies); and
the privatization of the current, monopolistic, and fiduciary state-issued money and its replacement with a classic pure gold standard.
This radical, definitive reform would essentially mark the culmination of the 1989 fall of the Berlin Wall and real socialism, since the reform would mean the application of the same principles of liberalization and private property to the only sphere, that of finance and banking, which has until now remained mired in central planning (by “central” banks), extreme interventionism (the fixing of interest rates, the tangled web of government regulations), and state monopoly (legal tender laws which require the acceptance of the current, state-issued fiduciary money), circumstances with very negative and dramatic consequences, as we have seen.
I should point out that the transition process designed in the last chapter of this book could also permit from the outset the bailing out of the current banking system, thus preventing its rapid collapse, and with it the sudden monetary squeeze which would be inevitable if, in an environment of widespread broken trust among depositors, a significant volume of bank deposits were to disappear. This short-term goal, which at present, western governments are desperately striving for with the most varied plans (the massive purchases of “toxic” bank assets, the ad hominem guarantee of all deposits, or simply the partial or total nationalization of the private banking system), could be reached much faster and more effectively, and in a manner much less harmful to the market economy, if the first step in the proposed reform (pages 791–98) were immediately taken: to back the total amount of current bank deposits (demand deposits and equivalents) with cash, bills to be turned over to banks, which from then on would maintain a 100-percent reserve with respect to deposits. As illustrated in chart IX-2 of chapter 9, which shows the consolidated balance sheet for the banking system following this step, the issuance of these banknotes would in no way be inflationary (since the new money would be “sterilized,” so to speak, by its purpose as backing to satisfy any sudden deposit withdrawals). Furthermore, this step would free up all banking assets (“toxic” or not) which currently appear as backing for demand deposits (and equivalents) on the balance sheets of private banks. On the assumption that the transition to the new financial system would take place under “normal” circumstances, and not in the midst of a financial crisis as acute as the current one, I proposed in chapter 9 that the “freed” assets be transferred to a set of mutual funds created ad hoc and managed by the banking system, and that the shares in these funds be exchanged for outstanding treasury bonds and for the implicit liabilities connected with the public social-security system (pp. 796–97). Nevertheless, in the current climate of severe financial and economic crisis, we have another alternative: apart from canceling “toxic” assets with these funds, we could devote a portion of the rest, if desired, to enabling savers (not depositors, since their deposits would already be backed 100 percent) to recover a large part of the value lost in their investments (particularly in loans to commercial banks, investment banks, and holding companies). These measures would immediately restore confidence and would leave a significant remainder to be exchanged, once and for all and at no cost, for a sizeable portion of the national debt, our initial aim. In any case, an important warning must be given: naturally, and I must never tire of repeating it, the solution proposed is only valid in the context of an irrevocable decision to reestablish a free-banking system subject to a 100-percent reserve requirement on demand deposits. Any of the reforms noted above, if adopted in the absence of a prior, firm conviction and decision to change the international financial and banking system as indicated, would be simply disastrous: a private banking system which continued to operate with a fractional reserve (orchestrated by the corresponding central banks), would generate, in a cascading effect, and based on the cash created to back deposits, an inflationary expansion like none other in history, one which would eventually finish off our entire economic system.
The above considerations are crucially important and reveal how very relevant this treatise has now become in light of the critical state of the international financial system (though I would definitely have preferred to write the preface to this new edition under very different economic circumstances). Nevertheless, while it is tragic that we have arrived at the current situation, it is even more tragic, if possible, that there exists a widespread lack of understanding regarding the causes of the phenomena that plague us, and especially an atmosphere of confusion and uncertainty prevalent among experts, analysts, and most economic theorists. In this area at least, I can hope the successive editions of this book which are being published all over the world [2] may contribute to the theoretical training of readers, to the intellectual rearmament of new generations, and eventually, to the sorely needed institutional redesign of the entire monetary and financial system of current market economies. If this hope is fulfilled, I will not only view the effort made as worthwhile, but will also deem it a great honor to have contributed, even in a very small way, to movement in the right direction.
[1] See especially F. A. Hayek, “The Maintenance of Capital,” Economica 2 (August 1934), reprinted in Profits, Interest and Investment and Other Essays on the Theory of Industrial Fluctuations(Clifton, N.J.: Augustus M. Kelley, 1979; first edition London: George Routledge & Sons, 1939). See especially section 9, “Capital Accounting and Monetary Policy,” pp. 130–32.
[2] Since the appearance of the first English-language edition, the third and
fourth Spanish editions have been published in 2006 and 2009. Moreover,
Tatjana Danilova and Grigory Sapov have completed a Russian translation, which has been published as Dengi, Bankovskiy Kredit i Ekonomicheskie Tsikly (Moscow: Sotsium Publishing House, 2008). Three thousand copies have been printed initially, and I had the satisfaction of presenting the book Octo- ber 30, 2008 at the Higher School of Economics at Moscow State University. In addition, Professor Rosine Létinier has produced the French translation, which is now pending publication. Grzegorz Luczkiewicz has completed the Polish translation, and translation into the following languages is at an advanced stage: German, Czech, Italian, Romanian, Dutch, Chinese, Japan- ese, and Arabic. God willing, may they soon be published.
In their working paper 