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By Steven Baker MP, on 25 May 10
 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?
As the Bank of England explains:
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.
- As the end of the present round of QE approached, it appeared it was not working.
- According to Austrian-School economic scholars including Hayek and Huerta de Soto, injecting new money can create only a harmful illusion of prosperity.
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.
Continue reading “What is money?”
By Toby Baxendale, on 21 April 10
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.
By Toby Baxendale, on 22 February 10
I went to this event today.
“22/02/2010 – Ideas Space
Quantitative Easing: Friend or Future Foe?
The Bank of England entered unchartered territory in January last year when the Treasury authorised it to begin a radical monetary policy experiment that we now know as “Quantitative Easing”. Given the unprecedented monetary conditions resulting from the liquidity crisis, the Asset Purchase Facility has been welcomed with open arms, and now stands at almost £200bn invested in UK gilts and corporate debt. But has QE had an economic impact to match its political use? Will the cure prove as dangerous as the disease? How and when should the Bank close the lid on this potential Pandora’s Box?”
Several leading economic figures including Roger Bootle, Tim Congdon and Allister Heath, chaired by Policy Exchange’s Chief Economist, Andrew Lilico, will debate and discuss the merits of quantitative easing, the exit strategies for the Bank of England, the main challenges the UK’s economy will face as a result of the program in 2010 and beyond, and how policymakers should face them.”
These are my notes:
Tim Congdon spoke first , this basic message was that unless money supply, primarily bank deposits, is kept very tight and only moderately growing, there will be trouble ahead with boom or bust. QE has kept the economy on the road and the money supply has not fallen. He acknowledges that there were some problems in measuring this.
Roger Bootle second, he opened by accusing one of our columnist, Liam Halligan of being intellectually devoid of any understanding of economics as he viewed Liam’s world to be predicated on massive inflation and a bond strike and this would never happen. He also said that QE could happen an infinitum. I tell no lie, this is what he said. In fact he was of the view that this should go on and on for whatever amount of time until we were out of trouble. People needed to believe that this policy was going to be the policy that would sort out the economy and indeed he agreed with Krugman, that crude of all the crude Keynesians, that Japan had actually done too little to stop the ongoing deflation. The UK’s risk was never going to be inflation but deflation.
Allister Heath opened with saying he reluctantly supported QE as the key thing was to stop a monetary deflation but questioned why we were having a debate in the first place about the merits of QE and should we do more etc when we should be questioning why do we inflation targeting ? As this has given us the biggest boom and bust in living memory should we not dispense with this independent Bank of England , FSA and other so called control bodies and centralise further into one overall controlling body that controls the broad money supply?
I was utterly bemused by all this tosh spoken in the name of economics with glimmers of hope only coming from Allister Heath.
The chairman asked three questions and the audience were asked three questions with one follow up.
I asked “in business I create wealth by making my factors of production work more efficiently to produce more goods and services. I invariably have to lengthen the structure of my production by saving and investing this money in new and more efficient kit to produce more of my goods and services for better prices and service level for my customers. With those goods I can exchange them with other entrepreneurs, shop keepers etc for my basic food, rent for my roof over my head etc via the medium of money. Money is bits of paper in this country and an electronic bank deposit, so having more of the bits of paper and banks deposits to exchange for the same goods and services would only mean my purchasing power had been debased, so no wealth would have been created. I thought this question go to the heart of the matter.
The second was about bond yields – had they or had they not moved up or down.
The third as about what the panel thought about the questioner’s view that we could only get out of this mess via and export related recovery.
Peter Bottomley asked a question that I cannot remember.
The Chairman then had another round of questions.
Mine was relegated to the bottom by the Chairman. Roger Bootle thought it should be answered by Tim Congdon and in the end Allister Heath did give an answer which acknowledged that no wealth could be created by paper alone and that there was a large body of work in Mises and Hayek showing that the creation of credit causes boom and bust . He was reluctant to support QE as it at least kept money supply near static as opposed to imploding, but saw no ability for it to create wealth . I was not allowed time to debate this with Allister , but did mention afterwards that as he said to me, the Austrian School was divided between those who would support a printing of money to offset a fall in V and those who would just advocate a deflation to allow the market to clear at new lower prices. Having to go I should have added, there is a third camp based around the Cobden Centre who would advocate 100% reserves as this would fix the money supply and you can never have a run on the bank with 100% reserves in place. This is explained here http://www.cobdencentre.org/2010/02/a-day-of-reckoning/ .
Allister framed his discussion in the mainstream language of the Quantity Theory of Money, more I suspect to engage with his fellow economists rather than he having any belief in it being more than a tautology. For a refutation of the Quantity Theory see here http://www.cobdencentre.org/2009/09/qe-errors/ . I did point out at the end after the event had finished that if V went down, how could me selling a house to someone, real bricks and mortar exchanging for money and having it sold back to me for the same 10 times create any wealth? Yes we can increase the velocity of the circulation of money by doing daft things like I describe, but Allister accepted nothing like wealth creation will come of it.
The medium of exchange will not create wealth on its own. It is not wealth. If you hold these bits of paper you hold claims to wealth. The retained goods and the savings we have are wealth. The whole capital infrastructure of our companies and private balance sheets are wealth . This infrastructure drives wealth creation via the dynamic entrepreneurial spirit of men of action who mix the factors of production into the most efficient combinations to satisfy the most amounts of needs. No small matter of printing paper that facilitates exchange or adding electronic reserves to banks will make that wealth creation process any easier. The second part of this article explains how wealth is created http://www.cobdencentre.org/2009/09/can-the-manipulation-of-interest-rates-create-wealth/ .
A poor day for economics!
By Toby Baxendale, on 4 February 10
Drawing on the work of Nobel Laureates in economics from three traditions, plus numerous other distinguished scholars, Cobden Centre Chairman, economist and successful entrepreneur Toby Baxendale presents an informal introduction to our proposal for honest money and the benefits consequent on the reform. See also our precis of Irving Fisher’s 100% Money.
Fact
- The average overhang of credit to money of all banks in the United Kingdom is 34 x to its reserves i.e. its actual money base.
- If more than one person in 34 walks into all banks simultaneously to withdraw their deposits, there will be a system wide bank run and a mass liquidity event with systematic default and insolvency.
- We saw the start of this with Northern Rock in the summer of 2007.
- We attempt to paper over the cracks and restore confidence in the banking system still today – with little success.
 Sterling Liquid Assets (BoE FSR, Jun 2009) A practical, politically-acceptable proposal
Our proposal is, as Irving Fisher wrote, “The opposite of radical”:
- Require 100% cash reserves to be held against all demand deposits; there can never be a crisis if a bank always holds 100% cash against all its demand deposits.
- Parliament can do this with one Act.
A similar Act took place in 1844. The Bank Charter Act or “Peel’s Act” established a 100% reserve requirement for bank notes that were issued claiming to be redeemable in gold. The reality was that there were 23 notes in issue for every one unit of gold at the time, creating instability, “panic” and general economic chaos. Not a too dissimilar situation from today where we have 34 claims on money to one unit of money. Politicians in the 19th century did not see the creation of unbacked credit through accounting entries as a problem, since it was only done on a very small scale. The problem then was rampant note issue (claims to real money) well over and above the monetary base, as this was the preferred method the bankers used at the time.
It is often forgotten but when you place £1m in a savings account (in cash) in say the Royal Bank of Scotland, which has no legal reserve requirement, they then lend £970k (in credit) , keeping on average 3% of cash back in reserves, to an entrepreneur in say HSBC, who then deposits that money in HSBC. We now have one claim to the original £1m and one claim to the £970k. The money supply has moved from £1m to £1.97m – just like magic! This is credit expansion.
The reality is that across all the banks in the United Kingdom licensed by the Bank of England, we have for every £1 of money (in cash), £34 in claims to money (credit)!
Peel’s problem was the over issue of notes to gold: our problem is the over issue of credit to money.
Continue reading “A day of reckoning: how to end the banking crisis now”
By Steven Baker MP, on 18 December 09
Via Don’t Blame the Federal Reserve – Stephen Mauzy – Mises Institute:
Banks operate under a fractional-reserve system that allows them to create liabilities and money virtually at will. This system expands money beyond what it would otherwise be and guarantees inflation by pushing the broad money supply far beyond the base money. Money, in essence, is debt, with supply dictated by loan demand.
A full-reserve scheme would prevent banks from lending phantom money. Banks’ primary functions would be bifurcated into money warehousing and deposit lending. As warehouses, banks would collect fees for storing deposits, with the deposited funds always available to the depositor. As deposit lenders, banks would accept time deposits to lend. The depositor would earn interest for the use of his money, while the bank would earn the spread between the rate it paid to depositors and the rate it charged its borrowers.
Insufficient credit is the first and most voluble objection to a full-reserve banking system. This shortage may or may not occur. If it did, no problem — private finance companies would arise to fill the credit void. They wouldn’t accept deposits, instead they would raise funds by issuing equity and debt. These companies would be free to specialize and lend to what their charters dictate.
By Steven Baker MP, on 13 December 09
Via Labour’s dishonesty is leading us down the road to sovereign default, Liam Halligan launches a scathing attack on Alistair Darling, Gordon Brown and British political class:
Over the past 10 years, Labour has turned a budget surplus into a deficit equal to 13pc of GDP – the biggest in our peacetime history.
Government borrowing is at its highest since the Second World War and almost twice the previous post-war peak. And yet, and yet … when he stood up to deliver the PBR on Wednesday, the Chancellor, Alistair Darling, managed to make a ghastly situation even worse.
Read on…
By Steven Baker MP, on 30 November 09
Via The Four of Horsemen of the Apocalypse – Frank Field MP:
For some time now it has been possible to see the four horsemen of the apocalypse on the horizon. Most economic commentators ignore their existence and the potential damage that could be inflicted on our economy if they all swept through at once.
Horse one symbolises the ruinous state of public accounts. [...]
Horse two is the harbinger of inflation. [...]
Horse three warns of a rapidly collapsing tax base. [...]
Horse four sounds a jobless recovery. [...]
The economic and political outcome is too grim to describe if all four horses of the apocalypse swoop down at once.
[...]
Recommended reading.
By Steven Baker MP, on 19 November 09
 Through tomorrow and Saturday, ESCP Europe and The Cobden Centre are hosting a Colloquium on Sound Money. The Colloquium is to be directed by Founding Fellow Dr Anthony J Evans and chaired by Corporate Affairs Director, Steve Baker.
A team of academics, banking professionals, entrepreneurs and politicians will meet to discuss:
- What is Money?
- The Interest Rate and Intertemporal Coordination
- The Gold Standard and the Great Depression
- Deflation and Prosperity
- Free Banking vs 100% Reserves
- Central Banking
- Proposals for Reform
The authors whose work will be under consideration are Carl Menger, Joseph Salerno, Frank Shostak, Ludwig von Mises, Friedrich A Hayek, Joan and Richard James Sweeney, Murray Rothbard, Lawrence Reed, Lawrence H White, George Selgin, Vera Smith, Tim Congdon, Richard Salsman and Jesús Huerta de Soto.
By Toby Baxendale, on 13 November 09
Norma Cohen in the Financial Times of 26 October 2009 wrote:
Britain’s economy cannot recover unless its damaged banking system is restructured, the newest member of the Bank of England’s monetary policy committee warned on Monday night.
For a short moment, I thought we might see the Cobden Centre’s proposal for bank reform discussed intelligently! I publish the usual warnings that when you read it, you will find that the Emperor has no clothes. I will also be showing you that the world is not flat, but it is in fact spherical.
Posen quite rightly contends that we need to “fix” our banking system. This fix seems to be more banks. We have between 8.5 and 13.26 banks per million people in the Group of Seven countries. I do not see the connection with this earth shattering proposal to create more banks and new economic prosperity. It seems to rest on just having more lending channels.
I will stick with the banking proposal mentioned above, which is based on sound legal principle and robust economic theory.
Separately, however, he scotched suggestions that the £175bn devoted so far to quantitative easing in the UK – the vast majority of which involves gilts purchases rather than corporate bonds – could sow the seeds of future inflation, dismissing supporters of such a view as “nutters”.
If the Bank could create inflation easily under such circumstances, and if the majority of market participants and households believed that – not just the nutters – then we would be halfway home,” said Mr Posen.
Posen will certainly deem the Cobden Centre as “nutters” as we have opposed the terrible, unjust effects of QE. The last time I wrote fully on this matter was here.
In simple terms, new money introduced into the economy never enters it evenly. Indeed, it first goes to the bankers who organise to both sell and buy the bond and the bond holder who receives the newly minted money. In possession of this purchasing power, they may pay off a bit of debt which will make lenders think there is more liquidity to lend.
This means projects which were marginal and, more than likely, do not have much hope of survival come into existence. When this happens broadly, it is called a “boom”. This is a distortion of the capital structure and will only sow the seeds of a new bust. Thus Posen has no Theory of Capital. In the second section of this article I explain in more detail why you need to have a good theory of capital and a working understanding of the structure of production.
Conversely, recipients may go out and buy something with this newly-minted purchasing power. This will bid up prices. This will slowly but surely ripple through the economy and at each point in time, the next spender / purchaser down the line pays that little bit more for goods and services. Now, those on fixed incomes, pensioners, people on the dole or low incomes tend to spend less frequently. This means that they will pay, more than likely, the higher prices. Thus, we have a wealth transfer from the poorest in society to the richest in society.
For people interested in social reform as we are at the Cobden Centre, a stealthy transfer of wealth from the poorest to the richest is exactly the wrong thing to be achieving.
Also, when QE hits the banking system, as we have seen from our contributor Gordon Kerr’s brilliant article, the banker will create a credit derivative from this transaction and book up to 30 years’ profit to his P&L for doing so.
This is another reason why banks are now showing record recovery profits and our political masters are allowing this to go ahead.
I always ask readers who doubt what I say regarding QE to ask themselves, “if QE is so good for the economy, why not carry it on and end world poverty now?” Mr Posen is in the infamous company of the likes of Gideon Gono. This is the Reserve Bank of Zimbabwe supremo who in his book “Casino Capitalism” gloriously savours how all the best governments in the World have now followed his lead in printing money (another name for QE) so he must be right!
Much as we all want to come out of this recession as soon as possible, we must take note that it is only by entrepreneurs making things that people want, better and cheaper, creating more wealth than existed before, that we will be able to climb out of this Labour Party induced mess. Lower burdens on the productive class are the only sure policy initiative for doing this.
By Sean Corrigan, on 5 October 09
Sean Corrigan’s Material Evidence: bond yields, new money, state borrowing and the difficulty of making sound business decisions in the present environment.
 Material Evidence 2009-09-23 Read the report here.
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