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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, on 24 December 09
Via Thrifty families accused of prolonging the recession – Times Online, yet more crass Keynesianism:
Anxious families are repaying debts instead of spending in the shops, amid concern over the uncertain economic outlook. The share of income saved in banks and building societies has risen to its highest level in more than a decade, heightening fears that faltering consumer demand could prolong the recession.
But see also Correction, Mr. Bernanke:
It is real savings that fund economic activity. The increase in the pool of real savings is the key behind sustained real economic growth.
These two authors make fundamentally different diagnoses and policy prescriptions because economics is not a positive applied science comparable to, say, physics. There are at least four schools of economic thinking, as Jeffey Tucker explains, but only one school predicted the bust.
This conflict over whether saving promotes recovery really matters: if the wrong side win and policy makers take heed, the recession will be deeper and longer than necessary.
Further reading
By Toby Baxendale, on 4 October 09
Toby Baxendale exposes flaws in the economic thinking of the left, indicates the dangers of deficit spending and points to a better way to fund welfare while stimulating genuine commercial investment.
Published in the FT on Friday the 2nd of October under the title “A cool look at the current deficit hysteria”, we find an article by a respected economist saying that there is nothing to worry about running a deficit at the present and predicted size. Our predicted budget deficit of 12.4% of GDP in the current financial year, gradually declining to 5.5% in 2013-14 is no big deal. Coupled with the public sector debt itself, we see it leveling out at 76% of GDP. Sir Samuel says “Debt ratios of this size are historically far from unprecedented. In the Victorian period the ratio was nearly 200% and almost reached that level again in the early 1920s. In 1956 it was just under 150 per cent.” He goes on to add, “the debt was gradually reduced from the peaks mentioned above without any heroic gestures.” In a classic Keynesian tone, he concludes “The big error of the current discussion is to confuse the budget balance of individuals and companies with the government budget balance, which needs to be in deficit so long as attempted savings exceed perceived investment opportunities. Gordon Brown more or less understands this, and I wish he would use his talents to explain such fundamentals instead of stirring up an outdated class war.”
For our international readers, Gordon Brown’s speech to the Labour Conference 2009 was a class war-laced speech worthy of some of the most envy driven and hating sections of the Left. The full text is available here, if you want to take yourself back to the start of the last century. I presume this is what Brittan refers to in the last quote.
Also deficit spending — living beyond our means — in the language of the left is “investment.” There are 5 references to this type of activity in this speech. I recall a timely quote to remember from Ludwig Von Mises in Human Action (Scholar’s Edition), Page P.737:
At the bottom of the interventionist argument there is always the idea that the government or the state is an entity outside and above the social process of production, that it owns something which is not derived from taxing its subjects, and that it can spend this mythical something for definite purposes. This is the Santa Claus fable raised by Lord Keynes to the dignity of an economic doctrine and enthusiastically endorsed by all those who expect personal advantage from government spending. As against these popular fallacies there is need to emphasize the truism that a government can spend or invest only what it takes away from its citizens and that its additional spending and investment curtails the citizens’ spending and investment to the full extent of its quantity.
How is Wealth Created?
As I have said on this web site before, wealth is created on the factory floors, in the boardrooms and in the offices of people making their factors of production — land, labour and capital — work better for them in satisfying the needs and requirements of their consumers. Invariably, this means those factors need to be brought together in better combinations or made more productive. The latter is the most common way and this almost always needs savings — i.e. forgone consumption — to invest in the newer, more productive processes.
Governments do not create wealth, they can only take it from A and give to B.
What does an Interest Rate do?
As I have said before on this web site:
Simply put, you value more highly present goods of the same quality and quantity than you do future goods. Furthermore, the value of future goods diminishes as the length of time necessary for their completion increases. This sets up a price differential between goods now or goods later. This price differential is called an interest rate.
In reality it is also the rate of profit in the economy, as it is these saved resources that are the only source of future funding for investment and the associated return on that investment. So it is arguable to say that this is the most important metric in the economy.
To underscore this, it is the saved resources of all the economic agents in society that produces the goods and the profits of the future. The return (interest) on the savings can only be the additional component that allows the additional investment in making the production structure — all those activities mentioned above going on in factories and offices — that will produce the new goods and services. The rate of return on these savings must in-fact be the rate of profit of that which is lent to enterprises.
How do we Fund a Deficit?
The Government Bond
If the government has taken less in tax receipts than it gives out in transfer payments i.e. it has deficit, then it will raise the difference on the whole through the selling of government bonds or “Gilts”. These are promises that the UK taxpayer will pay back the bond holder at a date in the future.
It is important to note here that the savings and investment process that ensures that saved resources are put to their most urgent investment needs, as described above, immediately becomes distorted when a government bond soaks up resources to go into the government coffers for spending and not into productive industry. In short, at the very time today when we need our best wealth creators, the owners of all the businesses in this country, to be firing on all cylinders, looking at making themselves more productive and selling goods and services more in tune with the new demands today, in this post-boom world, we have a policy of running a deficit which will starve these wealth creators of the wherewithal to start lifting us out of this mess.
Contrast this with the Corporate Bond
A wealth creator may sell a corporate bond to fund his investment activities. Thus we must also observe that when you work producing wealth, you create a surplus.
You had capital of £X and, by the end of the year, you have capital of £X + £Y. You can give a return — coupon or interest rate — back to your investor. The merry-go-round can start all over again with a greater level of wealth accruing in society.
With the government bond, capital is taken away form the citizen and the interest is extracted via the taxation system to pay the bond holder. There is no wealth created, only at best transferred to another person and at worst totally destroyed.
When the proceeds of the government bond are issued to people on the dole (2.6m) and people on incapacity benefit (2.7m), capital is completely destroyed and the tax payer then pays interest on nothing!
A Note on Welfare Spending and the Future Funding of Welfare Provision
We currently rob Pater to pay Paul: that is, we fund a good portion of our welfare budget via the on-going issuance of public debt, the need for which has arisen as we are not prepared to live within our means as a nation i.e. less tax is taken than is spent by HMG.
The Rt Hon Ian Duncan Smith MP has produced a report here called “Dynamic Benefits: Towards Welfare That Works” that starts the process of simplifying the system for the claimant and the administrator. This is very welcome and long overdue. It also starts the reversal of the process whereby, over the last 12 years of Labour Government, benefits have become so rewarding — in the sense that if you are on welfare and you take employment, your net pay decreases — there is a great incentive never to get off them. All of this is welcome.
However, what you need to do, in the smallest local regions possible, is create an insurance scheme in a mutual or let the old Friendly Societies — see here for a brief account of their great history — take subscriptions from the people in the area to provide welfare to the people who need it when they fall on hard times. This has the effect of forcing the Society to invest in productive business activities to get a return on their investment to pay any welfare claims.
Contrast a bond paying interest on nothing (no capital) like a government bond with a corporate bond generating wealth (paying interest on capital) which the old Friendly Societies used: the latter is beneficial to the economy because investment takes place. Government spending can only ever be a redistribution.
Summary:
As Ludwig Von Mises says in the Scholar’s Edition of Human Action p770/1:
If government spending is financed by taxing the citizens or borrowing from them, the citizens’ power to spend and invest is curtailed to the same extent as that of the public treasury expands. No additional jobs are created.
So the message I am hopefully giving here, with the best clarity that I can, is that deficit spending totally undermines the wealth creation process.
If the government is urged to step in and spend where the private sector sees no opportunity, as Sir Samuel says, this will only lead to more general impoverishment. Does it need saying that only wealth creators create wealth and not wealth re-distributors, that is, the government?
This gives rise to the notion that a public debt is no burden because we owe it to ourselves. Now in fairness to Brittan, he is not saying this, he is just saying that in the absence of enough opportunities for savings to be fully utilized, then the government should spend instead. I hope in the above I have demonstrated that if funded by bonds (the majority way), then this is in fact a set-back to recovery.
By Toby Baxendale, on 22 September 09
 No to Keynes' Circular Flow The essential idea of a Liquidity Trap as expounded by J M Keynes in this “General Theory” is that there is a point in time, when the interest rate has fallen so low, that investment bonds, be they public or private, are returning so little, that the investor then decides to keep all his money as a cash balance. This then snuffs out any further economic activity that may have been brought about by the former investments. There is a general freezing up in the economy and a Recession becomes a Depression.
It is fashionable in all sectors of the media, politicians and economists to say that they think this event is happening right in front of our very own eyes
In the famous circular flow of income that the Keynesians adhere to, one man’s spending is a another man’s income.
Is it possible that a person would not spend anything in a Liquidity Trap? I think not. All people have to buy their day to day food stuffs, pay for heating, pay for shelter and other such basics.
Having an excess cash balance simply means that you are choosing to keep your money as cash for later use. You produced goods and services in exchange for money (cash) which you have kept as money, ready to exchange for other goods and services at a moment of your choosing.
Please reflect on this very salient point: a rise in your personal demand for money held as cash does not effect the production of goods and services because money is only employed to exchange things. If it did effect production, an unlimited rise in the demand for money (IE a Liquidity Trap) would mean that no one was exchanging goods and services for other goods and services. Society would cease to be!
We actually have a situation where we have the balance sheets of Central Banks showing cash reserves increasing to startling percentages since the start of the recession in August 2007 with a massive uplift since the Lehman Brothers crash on September 15th 2008 at 07:58. In the USA there are $760 billion of extra cash reserves that now sit in the USA banking system, some 123% more than the same period a year ago. By July of this year, the BoE had increased its balance sheet by £153 billion or 158% over the same time last year.
It would seem that the Keynesians have a point: there is all this cash in the system, untold amounts of liquidity that we have never seen before, and it is not being spent. Is this not the classic Keynesian circumstance in which a Liquidity Trap emerges? This is when silly Monetarist ideas of sprinkling money “from a helicopter” come into vogue: I recently saw a very nutty idea being put forward in the FT by Wolfgan Manchau saying that we should have some electronic devise inserted into money that makes it expire as legal tender after a period of time so people are forced to spend:
Central banks could deploy policies to discourage cash hoarding. One extreme possibility would be to stamp cash, putting an expiry date on banknotes that would force their holders to pay a fee equivalent to the negative interest rates.
Seemingly, people with these views are so divorced from reality they have forgotten, or perhaps never knew, how real wealth is created. I have explained this within Can the Manipulation of Interest Rates Create Wealth?
I find it useful to point out here that if we all spend our salaries on consumption goods only each month, we would not be able to buy any capital goods such as a house or a car, unless we are paid each month a net equivalent to buy a house or a car. Clearly, only a handful of football players and bankers are in a position to do this. No savings would be made if this policy was ever recommended which, in the medium term, would lead to large scale impoverishment of society. From savings, you have the wellspring of investment to produce the new goods and services of the future.
The massive build up of liquidity has come about as the economy has gone into recession. Governments around the world have reacted by putting newly minted money into the economy.
Why did the boom turn into bust? I would always argue that it was the prior large scale expansion of liquidity that led to excessive credit creation under Gordon Brown’s Chancellorship and indeed his Prime Ministry. From 1997 to today, we have seen an increase in money supply (as measured by M4) from £700 billion to £2 trillion.
The bust happened because the structure of production had become so distorted that the production sector was producing goods that the consumer did not want and/or could not afford to buy. How could this collectively happen? For some help with the answers to this, I turn to Hayek which I summarise. I funded the publication of Prices and Production and Other Works, which prints Hayek’s works written during his time at the LSE.
Capital Theory, the Structure of Production and Boom and Bust
From 1931-50, F A Hayek, the 1974 Nobel Price winner in Economics worked out the following in summary and was awarded the Prize for this work;
- A depression is always a shortening of the capital structure of production. Entrepreneurs have invested in things that people do not want in significant numbers such that when people collectively wake up to this fact, the bubble bursts and a realignment of production to the needs of the consumer takes place.
- This is caused by a concept that at the time was called “forced savings” as opposed to voluntary savings. To understand this further, we must look voluntary savings.
- When there are voluntary savings — in my business, using part of my cuts of meat to keep me sustained so I can invest in making a steel to sharpen my knives to “up” my productive output for any given time period — these can support the elongated structure of production that matches, via the interest rate, the prices and thus the needs of the consumers. This increase in voluntary savings causes a larger demand for producers’ goods in relation to consumers’ goods, so goods in the higher stages, those most removed from the production of consumer goods will see an increase in prices relative to the consumer good prices. The consequent narrowing of the spread or margin between the two furthest ends of the production structure and the consumer good end, or in other words, the lowering of the rate of interest, make possible a prolonged and indeed a permanent new process of production. This is steady capitalistic, very safe and very boring non boom growth.
- A lengthening of the structure of production caused by the opposite of voluntary savings — which Hayek called, in keeping with the time, “forced savings” — happens, simply put, when bank credit becomes more available via the demand deposit money creation multiplier described here or through the process known in modern parlance as “Quantitive Easing”. Both credit expansion and QE give the same signals to entrepreneurs that there is now a very low interest rate. This suggests there are plentiful real savings — money is cheap — therefore we can bring those production plans forward that we held at the margin of our thoughts and start investing. However, the consequent elongation of the structure of production is not sustainable because a reversal in the price spread between the producers’ goods and the consumers’ goods takes place as soon as the increase in the supply of cheap money via the private banking or central banking system slows or stops altogether. This is because the spending habits of the consumer have not actually changed.
- This has been compounded in our case by something else Hayek was hot on, if government expenditure rises , more is extracted from the citizens via either taxation or government-induced inflation. This too will cause a shortening of the process of production and a lengthening of the depression.
- If money were kept inelastic — i.e. a fixed supply in relation to the productive needs of the economy, then this could not happen.
In summary, any change in the money supply, through giving new loans to entrepreneurs or to consumers, first lengthens the production structure, then shortens it as real consumer needs have not changed.
Our problem arises from the prior elongation of the structure of production unbacked by real savings, brought about in particular via the low interest rate policy of Gordon Brown’s Government post 2000. This was enhanced by the massive and unprecedented increase in the money supply under his Chancellorship. That caused more investment in the heavy stages of production: the building of houses, or car factories, or to produce consumer goods that indeed, when push came to shove, not enough people could afford. The correction is now taking place. This is when entrepreneurs rebalance or redirect the factors of production that they have under their command to focus on the actual needs and demands of their customers.
There is no Liquidity Trap (I doubt that this is even a meaningful concept), just a badly misallocated structure of production which, despite the government, is in fact slowly but surely fixing itself.
Further reading
By Sean Corrigan, on 17 September 09
 Superhighway to Serfdom By kind permission of Sean Corrigan, we make available the September edition of his Resource Ruminations “Superhighway to Serfdom”:
“The danger of modern liberty is that, absorbed in the enjoyment of our private independence, and in the pursuit of our particular interests, we should surrender our right to share in political power too easily. The holders of authority are only too anxious to encourage us to do so. They are so ready to spare us all sort of troubles, except those of obeying and paying! They will say to us: what, in the end, is the aim of your efforts, the motive of your labours, the object of all your hopes? Is it not happiness? Well, leave this happiness to us and we shall give it to you. No, Sirs, we must not leave it to them. No matter how touching such a tender commitment may be, let us ask the authorities to keep within their limits. Let them confine themselves to being just. We shall assume the responsibility of being happy for ourselves”
Benjamin Constant, ‘The Liberty of Ancients Compared with that of Moderns’, 1816
…
Imagine, if you will, that we stand today at a cross-roads and that we see to our right a minor road which branches away to climb rapidly upward in an ultra- (even a hyper-) inflationary surge to ruin. On our left, we find a trackway which twists downward, descending rapidly into a Slough of Despond after threading its way past the rusting ironwork, boarded windows, and unfinished building work of a renewed financial crisis and after jolting its users horribly about in the ruts and potholes of further, poor political decision-making as they motor to their doom.
In all likelihood, however, our state-employed bus driver will avoid these two offshoots and will rather stick steadfastly to the busy highway along which we are currently speeding, a broad Road of Good Intentions along whose dreary verges we see an army of labourers sweating over the construction of an ever more ramshackle confusion of governmental props, buttresses, and scaffolding as they try manfully to shore up the crumbling Babel of bad debt and faltering businesses to be found there, at least beyond the next election date.
Read the full report.
By Steven Baker, on 28 July 09
Via FT.com / UK – Darling threatens banks over loans.
Ministers have warned Britain’s banks to increase the supply of affordable loans to businesses or face the threat of a competition probe if evidence of market failure emerges.
Alistair Darling, chancellor, has ordered ministers to hold a series of one-to-one meetings with bank chiefs through August to establish whether margins and fees have risen excessively on loans to small and medium-sized companies.
The bosses of seven major banks were told on Monday that ministers would leave “no stone unturned” and could present their research to the Office of Fair Trading if there was a suspicion that competition was not working effectively.
By Steven Baker, on 27 July 09
Via No need to panic about GDP | Anthony Evans | Comment is free | guardian.co.uk :
GDP doesn’t tell us how economic activity affects living standards. It fails to distinguish between a bubble and sustainable growth. It doesn’t forewarn about inflation. And perhaps most importantly – it doesn’t help the average person on the street know whether they’re more likely to become unemployed. After all, declining incomes actually increase the demand for many types of goods and services, which is why plenty of workers are prospering in the downturn. As the old saying goes, statistics are like bikinis – what they reveal is interesting, but what they conceal is critical. And macroeconomic aggregates are more of a full Victorian bathing suit.
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The industry built around forecasting gives economics an aura of scientism that is destined to disappoint. A narrow focus on statistical releases can blind us to the bigger picture. The crisis isn’t just a failure of monetary policy, but a failure of the monetary regime.
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