In a recent Mises Daily article Mark Thornton has offered an excellent critique of why Krugman’s attack on the Austrian view of money market mutual funds (MMMF) is totally misplaced. I would like to add another angle as to why Krugman’s attack on the Austrian School of Economics is fundamentally flawed. According to Krugman as quoted in Thornton’s article:
How do the Austrians propose dealing with money market funds? I mean, it has always been a peculiarity of that school of thought that it praises markets and opposes government intervention — but that at the same time it demands that the government step in to prevent the free market from providing a certain kind of financial service. As I understand it, the intellectual trick here is to convince oneself that fractional reserve banking, in which banks don’t keep 100 percent of deposits in a vault, is somehow an artificial creation of the government. This is historically wrong, but maybe the actual history of banking is deep enough in the past for that wrongness to get missed.
But consider a more recent innovation: money market funds. Such funds are just a particular type of mutual fund — and surely the Austrians don’t want to ban financial intermediation (or do they?). Yet shares in a MMF are very clearly a form of money — you can even write checks on them — created out of thin air by financial institutions, with very few pieces of green paper behind them.
So are such funds illegitimate?
It seems that Krugman has a problem with the money supply definition. Once the definition is established even Krugman could see that the whole issue of the MMMF is irrelevant as far as the money supply issues are concerned.
The purpose of a definition is to present the essence, the distinguishing characteristic of the subject we are trying to identify. A definition is to tell us what the fundamentals of a particular entity are. To establish the definition of money we have to ascertain how the money economy came about.
Money emerged because barter could not support the market economy. A butcher who wanted to exchange his meat for fruit might not have been able to find a fruit farmer who wanted his meat, while the fruit farmer who wanted to exchange his fruit for shoes might not have been able to find a shoemaker who wanted his fruit.
The distinguishing characteristic of money is that it is the general medium of exchange. It has evolved from the most marketable commodity.
Through an ongoing selection process over thousands of years, people have settled on gold as money. In other words, gold served as the standard money. In today’s monetary system, the core of the money supply is no longer gold but coins and notes issued by the government and the central bank.
Consequently, coins and notes constitute the standard money, known as cash, that is employed in transactions. In other words, goods and services are sold for cash.
At any point in time part of the stock of cash is stored, that is, deposited in banks. Once an individual places his money in a bank’s warehouse he is in fact engaging in a claim transaction.
In depositing his money, he never relinquishes his ownership. No one else is expected to make use of it. When Bob stores his money with a bank, he continues to have an unlimited claim against it and is entitled to take charge of it at any time. Consequently, these deposits, labeled demand deposits, are part of money.
Thus, if in an economy people hold $10,000 in cash, we would say that the money supply of this economy is $10,000. But, if some individuals have stored $2,000 in demand deposits, the total money supply will remain $10,000: $8,000 cash and $2,000 in demand deposits—that is, $2,000 cash is stored in bank warehouses. Finally, if individuals deposit their entire stock of cash, the total money supply will remain $10,000, all of it in demand deposits.
This must be contrasted with a credit transaction, in which the lender of money relinquishes his claim over the money for the duration of the loan. As a result, in a credit transaction, money is transferred from a lender to a borrower.
The distinction between a credit and a claim transaction serves as an important means of identifying the amount of money in an economy.
Following this approach, one could easily note that, notwithstanding popular practice, money invested with money market mutual funds (MMMF) must be excluded from the money supply definition. Investment in a money market mutual fund is in fact an investment in various money-market instruments.
The quantity of money is not altered as a result of this investment; only the ownership of money has temporarily changed. Including investment in MMMFs in the money definition will only lead to a double-counting thereof.
The fact that mutual funds offer their clients cheque facilities has prompted some analysts to suggest that deposits with mutual funds are similar to bank demand deposits.
However, when an individual writes a cheque against his account with the money market fund, he in fact instructs them to sell some of his money market certificates for cash. The buyer of these certificates parts with his money, which is then transferred to the writer of the cheque; money changes hands, but no new money is created.
Furthermore, the fact that MMMF cheques are employed in payments does not mean that they are money. Cheques are a particular way of employing existing money in transactions.
The crux in identifying what must be included in the money supply definition is to adhere to the distinction between a claim transaction and a credit transaction.
Contrary to Krugman, Austrians are in favor of a free market in financial markets. Austrians, however, oppose the creation of money out of “thin air”, which sets in motion the consumption of capital and economic impoverishment. Austrians hold that the key to true free financial markets is to close all the loopholes that enable the creation of money supply out of “thin air”. This means the closure of the Central Bank and passing a law that forbids fractional reserve banking .
In his various speeches and comments the Chairman of the Federal Reserve Ben Bernanke has given the impression that the central bank’s monetary policy remains a very powerful tool to steer the economy away from serious economic slumps.
Equally monetary policy can also be very effective in preventing the economy from entering an “over heating” phase – monetary policy, if set expertly, can keep the economy on a stable growth path with a moderate unemployment rate and a moderate rate of inflation, or so it is held by many economists.
Note again that in this way of thinking by means of suitable monetary policies the US central bank can keep the economy on a stable economic path.
Now if we accept that key economic data such as GDP and industrial production mirror fluctuations in the money supply rate of growth then one can deduce that by stabilizing the money supply rate of growth one can stabilize fluctuations in economic activity.
Indeed Professor Milton Friedman suggested keeping the money supply rate of growth at a given figure in order to stabilize the economy. But is it possible to stabilize the money supply rate of growth given that the Fed all the time reacts to fluctuations in various economic indicators?
On account of a variable time lag between changes in the money supply and changes in various indicators there are going to be various responses by the Fed.
For instance, whilst previous loose monetary policy could start producing upward pressure on prices in general, a more recent tightening in the monetary stance could start to depress the pace of economic activity.
Given that the central bank regards itself as inflation fighter it is likely to tighten its stance thereby exacerbating the economic slump.
As a result lending by banks is likely to slow down and this, on account of a decline in the rate of growth of credit out of “thin air”, is going to put downward pressure on the growth momentum of money supply.
After a time lapse this is going to put downward pressure on various economic indicators and in turn will cause the Fed to ease its stance.
In short, a tighter or a looser monetary stance by the central bank affects the growth momentum of the money supply, which after a time lag affects economic activity.
Once the Fed responds to the changes in various indicators, it sets in motion more fluctuations in the money supply rate of growth and thus creates further fluctuations in economic activity and in turn in the money supply rate of growth.
In this sense the Fed it would appear is chasing it’s ”own tail”.
Now, from 1960 to the present day, the growth momentum of our monetary measure, AMS, has been displaying visible fluctuations, which were followed by the fluctuations in economic activity.
Most economists view these types of fluctuations in economic activity as cyclical in nature and are not related to Fed’s policies as such. (On this way of thinking the source of the so-called cycles are various external and internal shocks).
Whilst the Fed is not the cause behind the cyclical fluctuations, it can move the economy away from a lower cyclical phase by means of a looser stance, so it is held.
This is also the view of the Fed Chairman Ben Bernanke who holds that the current elevated unemployment rate of 8.1% can be lowered by strengthening the pace of economic activity through an aggressively loose monetary stance.
The opponents of this view hold that currently this way of thinking is not valid. They believe that on account of structural issues the rate of unemployment is stacked at a very high level and cannot be lowered by means of monetary pumping. If anything, monetary policy is likely to generate a higher rate of inflation. The opponents are of the view that the so called structural problems can be fixed by means of fiscal rather than monetary policies.
We suggest that the history of the last 60 years tends to support the view of Bernanke, i.e. that loose monetary policy can move the economy away from an economic slump.
Having said that, one needs to acknowledge periods such as the Great Depression, when during the 1930’s monetary pumping was ineffective in moving economic activity away from an economic “black hole”.
After closing at 11% in August 1931, the yearly rate of growth of Fed’s assets jumped to 105% by October 1931. Despite this massive pumping, the yearly rate of growth of AMS fell from minus 6.2% in August 1931 to minus 14.5% by July 1932.
As a result, the yearly rate of growth of industrial production plunged to minus 31% by July 1932. It stood in negative territory until April 1933 when it reached a zero percent rate of growth.
We suggest that on account of a severe depletion of the pool of savings — that is, the pool of sustenance — it took some time before the rate of growth of industrial production moved into positive territory. (Note that a fall in the money supply stopped the diversion of resources away from wealth generators towards non-productive activities, allowing the strengthening in the pool of sustenance and in turn in economic activity).
We suspect that at present the pool of sustenance is also likely to be in trouble. It remains to be seen whether the pool is still growing or stagnant. If it is stagnant then Bernanke’s opponents are likely to be right – monetary policy is going to be ineffective in reviving the economy. (Note that as far as we are concerned loose monetary policy can never revive an economy, it can only create an illusion that it can do so when the pool of sustenance is still expanding).
We suggest that the opponents are wrong that somehow loose fiscal policy could do the trick. In similarity to loose monetary policy, a loose fiscal policy can only create an illusion that it is effective when the pool of sustenance is expanding. When the pool is stagnant or declining this illusion is shattered.
If anything, the more the government tries to “help” the more damage it inflicts upon the pool of the means of sustenance and the worst things become. It is for this reason that the great Austrian economists Ludwig von Mises and Murray Rothbard argued that the best way to revive the economy is for the Fed and the government to do nothing as soon as possible.
Nothing here means that the Fed must stop pumping money while at the same time government outlays must be cut to the bone. All this will release resources to the wealth generators who will set in motion a genuine economic recovery.
Summary and conclusion
In his various speeches the Fed Chairman Ben Bernanke has given the impression that the US central bank has the tools to stabilize the economy. We suggest that this is not possible given the Fed’s responses to the movement of various economic indicators such as unemployment, real GDP and the CPI, responses which have subsequently set in motion various shocks. All this is manifested through the fluctuations in the rate of growth of the money supply, which after a time lag sets in motion fluctuations in economic indicators. Whilst the Fed cannot stabilize the economy it would appear that it can somehow counter cyclical swings. For instance, when the economy falls into a recession the Fed at least historically was able to revive the economic statistics by means of monetary policy. Some commentators contest this way of thinking, arguing that currently various structural issues have made monetary policy ineffective. We hold that the issues are not structural as such, but have emerged on account of past and present reckless policies of the Government and the Fed which have severely weakened the economy’s ability to generate wealth. We hold that the real economy could be fairly quickly revived by drastically reducing government outlays and by stopping the Fed’s monetary pumping.
This post originally appeared on www.stevebaker.info.
I spoke last night in the general debate on the economy, saying*:
As I rise to speak I am reminded of a quotation from an economist who was a fierce critic of Keynes, a chap called Henry Hazlitt, who said:
“Today is already the tomorrow which the bad economist yesterday urged us to ignore.”
We have heard today some moving accounts of individual and collective suffering in different regions of the country and among different sections of the public. We should be asking ourselves why, oh why, have we been delivered into this misery, which looks as if it will extend over years. Much of the conversation we have heard has been along the lines of aggregates, coarse economic aggregates, and has tended to stray away from individual choices and consequences. We have talked about markets in the abstract, and it is a pity that we seem to have forgotten that markets are a social phenomenon, and that they are about people co-operating. When we talk about markets, we tend to imagine overpaid people, high-frequency trading and those who add nothing to society.
I am reminded of something a constituent said to me recently after hearing a Minister’s speech. He asked, “Why is it that everything always seems to get harder for the working man, whoever is in power?” Indeed, in my constituency unemployment is up by 6.3% among the over-50s, up by 9.5% among those aged 25 to 49 and, scandalously, up by 23% among the young. We have heard that child poverty increased by 200,000 under the previous Government and that it is likely to increase by up to 100,000 under this Government. In the 21st century, that should not be our economic position.
Why are we in this debt crisis? I have just checked the M4 money supply figures—I am sorry to return to aggregates, but needs must. When Labour came to power the money supply was about £700 billion and it is now about £2.1 trillion, so it has tripled over the past 14 years. Unfortunately, most economists talk about money flowing into the economy as if it were water poured into a tank that found its own level immediately, but what if it is like treacle or honey? What if it builds up in piles when poured into the economy and takes a while to spread out? What if that money was loaned into existence in response to individual choices led by the excessively low interest rates pushed by the central bank? What if it was loaned into existence in particular sectors, such as the housing sector, where prices have more than doubled over the same period, and what if it was the financial sector that received the benefit of that new money first? Would that not explain why financiers and bankers are so much wealthier than everyone else, and why economic activity and wealth has been reorientated towards the south-east?
Unfortunately, the idea that money takes some time to move around the economy is lost on most economists, which I very much regret. Why did most economists not see the crisis coming? I put it to the House that it is because their theories of credit are mistaken. They make fundamental errors. Unfortunately I do not have time to go into that, but the fundamental point is that credit is a choice to consume more now and less later. It is about the exchange of present goods for future goods, and co-ordinating the economy through time, and I am afraid that the current intellectual mainstream in economics has dropped us into this desperate mess.
Opposition Members criticise the Thatcher and Reagan years. I think that there was much to applaud in those years, but unfortunately their intellectual underpinning was monetarism, which, like Keynesianism, is infected with those dreadful mistakes. People in the Occupy movement, and our constituents, are right to question the justice of our economic processes. The hon. Member for Penistone and Stocksbridge (Angela Smith) said earlier that the system cannot endure, and I am inclined to agree. I agree that the current debt-based and—I am afraid to say—statist system cannot endure. However, if this system is not to endure, which way should it fall? [Humanity] tried the statist direction in the past and it led to misery and murder. I stand for free markets and free co-operation, but I say this to the House: if this is capitalism, I am not a capitalist.
* (I have made a small correction to the quote and a clarification in , both of which I have requested from Hansard)
Related reading can be found here:
- Hazlitt, Economics in One Lesson (buy, PDF), chapters 1, 6 and 23 in particular.
- Mises, Human Action (buy, online), especially chapter 20 “Interest, Credit Expansion, and the Trade Cycle”
- Hulsmann, The Ethics of Money Production (buy, PDF).
The Bank of England’s money supply measure M4, which I referred to, may be found here. I used M4 in this context because it is the conventional mainstream measure, but I prefer Kaleidic Economics’ MA for reasons explained on that site (Notes and Coins is too narrow and M4 too broad). MA tells a clear story of where jobs and growth came from and where they went – money supply growth created the illusion of prosperity, broke the banking system and collapsed, taking the illusion with it:
Year on year change in Kaleidic Economics' MA - click for source
When we updated MA (our Austrian school measure of the money supply) for August, we expected to see signs of the market turbulence that has characterised recent events. Although still in a monetary contraction, MA is falling at a lower rate than previous months. It has been indicating a tightening of credit conditions for several years now, but has not significantly deteriorated.
Via Honesty is best policy | The Jewish Chronicle, I set out MA, the Austrian measure of the money supply developed by Dr Anthony J Evans and Toby Baxendale:
Ask economists how much money there is and you will get many answers. You know money is what you can exchange for real goods and services, but economists often include things like time deposits, which cannot be spent because they have fixed terms. Money is one half of every transaction, so its supply really matters. According to my colleague Dr Anthony J Evans of Kaleidic Economics, the Bank of England’s preferred measures, “Narrow Money” and “Broad Money”, are either too narrow or too broad. From the perspective of the Austrian School of Economics, Anthony, together with entrepreneur Toby Baxendale, chairman of The Cobden Centre, has established and now publishes a different measure which they call “MA”. A chart (see above) of the growth of MA shows a pattern that is not visible in the Bank of England’s measures.
Given a good measure of the money supply, we shouldn’t be surprised that our economic and financial troubles continue.
Please see the full article for more and Kaleidic Economics for the data and explanation.
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.
And then the crisis struck.
Continue reading “My Journey to Austrianism via the City”
Even though the Chinese authorities made no bones about the fact that they had conveniently ‘rebased’ their latest CPI numbers in order to mitigate the rather inconvenient influence thereupon of surging food prices, so eager was the market to hew to its chosen course of Onward and Upward, that this naked manipulation was gratefully taken at full face value, all around the speculative globe.
Perhaps more germane to the preservation of the Herd’s blithe psychology, however, was the additional information that Chinese money supply seems to have decelerated alarmingly to reach its slowest real (and nominal) pace since the great, post LEH‐AIG adrenaline shot was injected directly into the heart of the economy in early 2009.
Moreover, there are numerous reports in the press that the successive increases in bank reserve ratio requirements are starting to bite and that pressure is also being felt in maintaining the prudentially‐mandated loan‐deposit ratios in a system where banks are precluded from competing for deposits by adjusting interest rates and where their customers are becoming tired of seeing the real value of their savings continually eroded.
If this is indeed the case—and, as ever with China, it is foolish to be too categorical about what does or does not make it into the English version of its press—this could truly mark the beginning of the end of the reflationary asset cycle we have all been so happily riding, for much of these past two years.
Certainly, China, is not the whole world, but it has unchallengeably become what is perhaps the nexus of current economic evolution, as well as comprising the most important marginal consumer of many key inputs, whether we consider raw materials, capital goods, or components.
Take two‐way trade flows as an instance. From a base of around 15% of those passing across US borders in the 1990s, China’s ports now deal within excess of 70% of the value handled in the world’s biggest economy and the gap is closing so rapidly that—were the present trends to remain in place for just another 3‐4 years— China would take over the undisputed, global number one spot. Just in case one is tempted to dismiss this as more a tale of secular American decline than of Chinese resurgence, note that, in the same period and in regard to this same measure, China has moved from 50% of Japan to more than 200% and from ~30% of Germany to 140%.
Another little factoid which should give one pause is that, over the past six years, China’s cumulative $920 billion trade surplus with the consumer of first resort—the US— matches, almost dollar for dollar, China’s combined trade deficit with Japan, South Korea, and Taiwan combined, a correspondence reinforced by that fact that the relevant totals for each individual year lie in a range of parity +/‐15%.
For another indication of the key role being played by China and those within its economic ambit, take the case of Germany. Between 2000 and 2010, this, the world’s other great export powerhouse, did almost no new business with the US, its growth being predicated upon sales to (and purchases from) the rest of Europe (whether inside or outside the single currency area) with between a fifth (of incremental exports) and a quarter (imports) also being accounted for by Asia.
To show just how crucial this re‐orientation has been for the German rebound of the past two years, look also at the following plot showing the progression of business revenues through Boom and Bust, and take this in cognisance of VDMA comments about its members’ unprecedented present concentration of orders in Asia, in general, and China, in particular.
Thus, if China’s tightening does continue in earnest—and if it has the same effect as those already being felt in, say, India and Brazil ‐ then we can expect some pretty significant ramifications to ensue.
A speech to the Policy Exchange on 31st March 2009 by Cobden Centre sponsor James Tyler. This article first appeared on hedgehedge.com but it remains as relevant today.
I want to talk about two things today;
Number 1: Free markets did NOT cause this crisis… Governments did.
Number 2: Inflation targeting has failed. Money has failed. What should we do?
Free markets did not cause this problem.
In theory, markets work by reacting to prices and direct capital towards where it will be most productively used. This is how wealth is created. Usually this works well, but markets are made up of humans, and can be fooled into overshooting by false signals.
Bubbles build up, expanding until people lose confidence. Bubbles then burst. It’s a corrective process that, relatively benignly, irons out imbalances.
The problem only comes when bubbles go on for too long, because once they get too big, the pop can be terrifying. And that’s what we’ve got now – one hell of a big bang.
False signals have caused a spectacular mal-investment in real estate and its derivatives.
But these false signals did not come from the market, but from government.
False signals came from Greenspan’s introduction of welfare for markets. Markets were taught that no matter how much risk they took, they would always be saved. 1987, 1994, 1998, 2001. Each bust bigger than the last, and disaster was only staved off with aggressive rate cuts and increased money supply.
Clearly this was not laissez faire. Just think if events had been allowed to take their course. I bet if LTCM had gone bust then a badly burned Wall Street would have learned a lesson and Lehman’s would still be around today.
In 1999 Clinton mandated that Fannie Mae and Freddie Mac reduce lending standards. The poor were encouraged into debt. This intervention triggered a race to the bottom of lending standards as commercial banks were forced to compete against the limitless pockets of Uncle Sam.
False signals came from deposit insurance. Deposit your money in a boring mutual? Why bother when you can lend it to a lump of volcanic rock in the Atlantic at 7% and be guaranteed to get your money back.
The Basle banking accords required banks to replace rock solid reserves with maths.
Government protected and regulated ratings agencies produced negligent ratings duping pension funds, who were obligated to buy high quality paper, into buying junk cleansed by untested mathematical models.
Central banks create boom-bust.
But most damaging of all was the absurdly low interest rates set between 2001 and 2004.
The resultant glut of cheap money fueled an unsustainable boom encouraging more mortgages to be taken out, and pushing property prices ever higher.
The market responded by pushing scarce economic capital towards highly speculative property development.
As prices rose people remortgaged, and borrowed to consume more. This unchecked process tended to be destructive, as scarce economic capital flowed out of our economy and headed to those economies efficiently producing consumer goods, such as China. Rampant asset inflation clouded our ability to see this depletion process in action.
Everyone had a great time whilst the party lasted, not least Governments who were incentivised to let it run, blinded by ever larger tax revenues.
But all parties come to an end, and central banks had to prick the bubble eventually. Interest rates went too high, and sub prime collapsed, and then all property prices plummeted. Trillions of dollars were ripped out of the financial system, and the credit crunch began.
It’s happened before.
But, despite its complexity, there was nothing new or unpredictable about this process. All the great busts of the 20th century were preceded by a Government sanctioned fiat currency booms.
In the 1920’s, the Fed pursued a ‘constant dollar’ policy. This was the era of the innovation, Model T Fords, radios and rapid technological advancement.
Things should have got cheaper for millions of people, but money supply was boosted to try and keep prices constant. All that extra money flowed into the stock market, pushing prices to crazy levels, and we all know how that ended.
In the modern day, targeting price changes has been an utter disaster for us too.
It let the Bank of England pretend they were doing their job, when money supply was growing at a double digit rate. It let the authorities relax whilst an economy threatening credit bubble was building up.
And it gave Gordon Brown the leeway to convince people that boom and bust was over.
Things should have got cheaper.
Inflation targeting made no allowance for globalisation, the rise of India and China, and the benign falls in general prices that should have been triggered. Think about it; if all those cheap goods were to become available, consumer prices should fall. We would have had greater purchasing power, and become wealthier for it.
But, the Bank of England was aiming at a symmetrical plus 2% target. Falling prices in some goods necessitated stimulating rises in others. They unleashed an avalanche of under priced debt and we had our own crazy asset boom.
Inflation targeting was a myopic policy.
Governments make terrible farmers.
When a central bank sets interest rates, they set the price of credit. Inevitably they create distortions.
Consider this; Governments cannot set food prices without causing a glut -or- painful shortages. Now, food is a pretty simple commodity, yet we all understand that central planners simply cannot gather enough information to set the price accurately.
It has to be left to the spontaneous interaction of thousands of buyers and sellers to set the price.
So, why do we think that enlightened bureaucrats can put an exact price on something as vital, yet complicated, as credit?
In a nutshell, if I can’t tell how much my wife will spend on Bond Street this weekend, how can they?
Let’s wake up from this fantasy.
There is a better way.
What’s the cure? Let the invisible hand to do its time honoured job. Leave interest rates to be set by the millions of suppliers and users of capital.
Get the central planners out of the way.
It’s the way it used to happen. The period of fastest economic growth the world has seen was America between the civil war and the end of the 19th century. Money was free and private and the Fed did not exist.
So, how do we get back to freedom in money? Fredrich Hayek – the great Austrian economist – did the best thinking on this. What he proposed was that private firms should be allowed to produce their own currencies, which would then be free to compete against each other. People would only hold currency that maintained its value, firms that over-issued would go bust Producers of ‘sound’ money would prosper.
History gives us plenty of successful examples of private money working well, 18th Century Scotland had competing banks, all with their own bank notes. People weren’t confused. It worked. There are many other examples.
In the modern age, technology makes the prospect of monetary competition even more tantalising. Mobile phones, oyster cards, smart tags, embedded chips, wireless networks. The internet. Prices could flash up in the shopper’s preferred currency.
Here’s an idea of how to kick the process off;
Tesco’s want to get into banking. Why not currencies as well? Tesco would print one million pieces of paper. Let’s call them Tesco pounds. It would be redeemable at any time for £10 or $15. They would then be auctioned, and the price of a Tesco set.
Anyone who owns a Tesco has a hedge against either the £ OR $ devaluing therefore the Tesco has an additional intrinsic value. Maybe they’ll auction at £12.
Tesco would specify a shopping basket of goods that cost £60. It would promise that 5 Tesco Pounds would always buy that weekly shop. The firm would use its assets to adjust the supply of Tesco Pounds so that they kept this stable value.
They would need to otherwise their shelves would be cleaned out!
As central banks inflated the £ and $ away over time, the convertibility into these currencies would matter less. We would be left with a hard currency that meant something.
There would be other competitors and a real choice about which money to hold your wealth in.
McDonalds has a better credit rating than Her Majesties Government, so maybe people would be happy to hold Big Mac tokens? I don’t know – it will be a free choice.
Currencies would sink or swim depending on how well they performed. What’s more, firms issuing the currencies would come up with different ways of maintaining their value. Some would offer Gold. Manufacturers may use notes backed up by steel, copper and oil.
Let’s see what a free market chooses. Somebody might have a brainwave and come up with an idea that nobody has thought of.
That is what free markets are best at.
I can guess the reactions that my proposal might inspire in some. How would the man on the street cope? Well, nobody would outlaw the Government’s money, and people could carry on as before. Through the operation of the market, we would find out what worked best . Step-by step, the economy would be transformed and standards driven up.
In economics, spontaneous orders are always so much more rational and stable than planned ones. Always.
This is not a crisis caused by free markets. A free and unregulated market in money has not existed for over a century.
This is a Government crisis. A crisis over the monopoly of money.
Inflation targeting seemed so persuasive…. but it was a false God, and we deserve better. Stability and sound money can only come if we put the money supply back where it belongs…
Under the control of the free market.
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.
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.
Money growth differential puts pressure on the US$
At the end of September the price of the Euro in US$ terms closed at 1.357 – an increase of 7% from the end of August. The yearly rate of growth of the price of Euro stood at minus 7.3% in September against minus 11.5% in the month before.
The currency rate of exchange seems to be moving in response to so many factors that it makes it almost impossible to ascertain where the rate of exchange is likely to be headed. We suggest that rather than paying attention to the multitude of apparent variables, it is more sensible to focus on the essential variable. As far as currency rate of exchange determination is concerned we suggest that this variable is the relative changes in the purchasing power of various monies. In short, it is the relative purchasing power of various monies that set the underlying rate of exchange.
A price of a basket of goods is the amount of money paid for the basket. We can also say that the amount of money paid for a basket of goods is the purchasing power of money with respect to the basket of goods. If in the US the price of a basket of goods is $1 and in Europe an identical basket of goods is sold for 2 euros then the rate of exchange between the US$ and the euro must be two euros per one dollar.
An important factor in setting the purchasing power of money is the supply of money. If over time the rate of growth in the US money supply exceeds the rate of growth of European money supply, all other things being equal, this will put pressure on the US$. Since a price of a good is the amount of money asked for the good, this now means that the prices of goods in dollar terms will increase faster than prices in euro terms, all other things being equal.
As a result an identical basket of goods is priced now, let us say at $2, as against 2.5 euro. This would imply that the exchange rate between the US$ and the euro will be now 1.25 euros per one dollar. Note the fact that changes in a money supply affect its general purchasing power with a time lag means that changes in relative money supply affect the currency rate of exchange also with a time lag. (When money is injected into the economy it starts with a particular market before it goes to other markets – this is the reason for the lag. When it enters a particular market it pushes the price of a good in this market higher – more money is spent on given goods than before). This in turn means that past and present information about money supply can be employed in ascertaining likely future moves in the currency rate of exchange.
Another important factor in driving the purchasing power of money and the currency rate of exchange is the demand for money. For instance, with an increase in the production of goods the demand for money will follow suit. The demand for the services of the medium of exchange will increase since more goods must now be exchanged. As a result, for a given supply of money, the purchasing power of money will increase. Less money will be chasing more goods now. Various factors, such as the interest rate differential, can cause a deviation of the currency rate of exchange from the level dictated by relative purchasing power. Such deviation, however, will set corrective forces in motion.
Let us say that the Fed raises its policy interest rate while the European central bank keeps its policy rate unchanged. We have seen that if the price of a basket of goods in the US is one dollar and in Europe two euros, then according to the purchasing power framework the currency rate of exchange should be one dollar for two euros. As a result of a widening in the interest rate differential between the US and the Euro-zone an increase in the demand for dollars pushes the exchange rate in the market toward one dollar for three euros. This means that the dollar is now overvalued as depicted by the relative purchasing power of the dollar versus the euro.
In this situation it will pay to sell the basket of goods for dollars then exchange dollars for euros and then buy the basket of goods with euros – thus making a clear arbitrage gain. For example individuals will sell a basket of goods for one dollar, exchange the one dollar for three euros, and then exchange three euros for 1.5 basket, gaining 0.5 a basket of goods. The fact that the holder of dollars will increase his/her demand for euros in order to profit from the arbitrage will make euros more expensive in terms of dollars – pushing the exchange rate in the direction of one dollar for two euros. (We suggest that the arbitrage will always be set in motion if the rate of exchange deviates, for whatever reasons, from the underlying rate of exchange).
Since November 2009 the money growth differential between the US and the Euro-zone has been in a visible increase. After closing at minus 24% in November 2009 the differential jumped to minus 4.2% in August this year. We suggest that the strengthening in the differential is the key reason for the underlying strengthening in the Euro against the US$. Given the relatively more conservative Euro-zone central bank versus the US central bank it is quite likely that the money growth differential will continue to strengthen further – thus providing further support to the Euro.
After closing at minus 3.7% in April the growth differential between US and Euro-zone industrial production climbed to 0.11% in August. We envisage that in the months ahead the differential is likely to stabilize at the August figure. So from this perspective the slight increase in the differential is likely to provide only marginal support to the US$ versus the Euro. The differential between the federal funds rate and the European central bank policy interest rate is likely to stand at minus 0.75% in the months ahead. (The fed funds rate is forecast at 0.25% while the ECB rate at 1%). So from this perspective it is going to have neutral effect on the price of Euro in US dollar terms.
Again we maintain that the strong support for the Euro versus the US$ is on account of a strengthening in the money growth differential since November 2009. (Note again that the effect from changes in money supply and the differential works on the currency rate of exchange determination with a time lag). This means that the US$ is likely to remain under pressure. An increase in the industrial production differential is likely to mitigate the strengthening of the Euro against the US$. On a short-term basis the price of the euro in US dollar terms appears to be just about “right” as far as the valuation versus its 12-month moving average is concerned. The price to its 12-month moving average ratio stood at 1.0 in September versus 0.9 in August. Note that in September last year the ratio stood at 1.08.
Prospects for the Yen against the US dollar
At the end of September the price of the US$ in Yen terms closed at 83.9 – a fall of 0.3% from the end of August. Year-on-year the price of the US$ in Yen terms fell by 6.5% in September after declining by 9.5% in the month before. Observe that the Yen has been strengthening against the US$ since July 2007. The price of the dollar to its 12-month moving average stood at 0.94 in September the same figure as in August. Note that in September last year the ratio stood at 0.946.
Since November 2009 the money growth spread between the US and Japan has been trending up. The differential stood at 2.8% in August against 2.1% in July and minus 13% in November last year. Now after falling to minus 29.1% in February the industrial production growth spread between the US and Japan climbed to minus 9.2% in August. In the months ahead we expect the growth spread to stabilize at around the August figure. The interest rate spread doesn’t have much importance at present given the policy rates in US and Japan are close to nil. We suggest that in the months ahead the money growth differential is likely to dominate the currency rate of exchange scene. This implies that the price of the US$ in yen terms is likely to remain under pressure.
Money growth differential continues to support Aussie dollar against the US dollar
At the end of September the price of the A$ in terms of US$ closed at 0.967 – an increase of 8.5% from the end of August. The growth momentum of the price of the A$ has also strengthened visibly. The yearly rate of growth jumped to 9.4% from 5.4% in August. The ratio of the A$/US$ to its 12-month moving average climbed to 1.076 in September from 0.999 in the month before – this could be interpreted that relatively to its 12- month moving average the price of the A$ in US$ terms is over-stretched.
A major factor behind the strengthening in the A$ against the US$ is a visible strengthening in the money growth differential between the US and Australia. After falling to minus 15% in November last year the differential shot up to 9.1% in June before settling at 7.6% in August. From the demand for Aussie dollars perspective a strong increase in the price of gold provides important support for the Australian currency versus the US dollar. From these two key factors we suggest that for the time being the Aussie dollar is going to be well supported in the months ahead, all other things being equal.