Prompted by an FT article on banks’ excess profits arising from quantitative easing, entrepreneur and economist Toby Baxendale explains how QE widens wealth inequality and damages the economy.
Lenders’ returns soar on deals with central bank.
Questions raised over acquisition of securities.
Wall Street banks are reaping outsized profits by trading with the Federal Reserve, raising questions about whether the central bank is driving hard enough bargains in its dealings with private sector counterparties, officials and industry executives say.
The Fed has emerged as one of Wall Street’s biggest customers during the financial crisis, buying massive amounts of securities to help stabilise the markets. In some cases, such as the market for mortgage-backed securities, the Fed buys more bonds than any other party.
“You can make big money trading with the government,” said an executive at one leading investment management firm. “The government is a huge buyer and seller and Wall Street has all the pricing power.”
Larry Fink, chief executive of money manager BlackRock, has described Wall Street’s trading profits as “luxurious”, reflecting the banks’ ability to take advantage of diminished competition.
So said the FT yesterday, on the front page: the article is available here.
The essential thrust of the article is that the United States Government — via the Federal Reserve — has intervened in the securities market to buy various bonds in great quantity and with a level of transparency which enables sellers to “game the system”. Sellers charge excessive prices to which the Fed does not object, because the policy objective is to inject new money. In turn, Wall Street bankers are enjoying a bumper recovery in their profits through charging a clip on all transactions brokered.
Thus, not only have these banks been bailed out by the American taxpayer but, for a large part of their profits, they are on the Welfare State. Indeed the whole apparatus of Wall Street is looking like a giant department of the Welfare State. The bankers are prospering on the Welfare State of Credit.
This should come as no surprise to economists in the tradition of Hayek and Mises. The article makes no reference to the very destructive effects on the economy caused by creating money out of thin air to buy government bonds; it just highlights the fact that the governments’ agents in placing the money into the economy are the banks and bankers themselves. This must always be done at the expense of the general population and in favour of the first recipients of the money, i.e. those on whom the government spends the money and the bankers themselves.
Why? Let us recap some basic economics.
How are Goods and Services Exchanged for One Another?
- A butcher produces 10 steaks with a knife and keeps two for his private consumption. He puts the remaining 8 out on his shop front for sale.
- A baker comes along and exchanges 2 loaves of bread for 6 steaks.
- Note that in the absence of money, both parties are exchanging goods for other goods.
- The candlestick maker comes along but he only has candle sticks that the butcher does not want.
- The three participants in this simple economy agree to create a thing called money. Money is the final good for which all things exchange.
- If we allow money into the economy of the butcher, the baker and the candlestick maker, they can overcome the “double coincidence of wants” problem, exchanging their goods and services for all manner of other things they require.
- It is important to remember that there must be production of something to exchange for something else.
- If a bandit entered the economy and said, “Here is my money with my stamp on it. On pain of imprisonment, I require you to accept it in exchange for all your goods and services”, he could then proceed to give bits of paper that he has created from nothing in exchange for some steaks, some candle sticks and some bread. He would be called a counterfeiter and a bandit quite rightly. He has forced people to exchange real goods for bits of paper that will exchange for other goods and services in the future, but in the mean time, for nothing, he has lined his pockets with your goods and services!
If money is created out of thin air — as done by central banks buying securities — it is by definition not backed by production of real goods.
When the newly minted money comes into the economy — through the banker who has had his bond redeemed for new money or the banker who has taken a percentage of the transaction in a commission — nothing has been produced behind that money. The banker has extra spending power in his pocket without any prior production of a good or a service.
The banker goes out to the wider economy and spends this new money. The next recipient of this money, the shop owner, has extra demand for his goods and services, so prices go up as money that is not backed by production is exchanged for real goods and services backed by production. This means that real goods and services have been consumed by nothing, by thin air.
This effect cascades through the economy, with each recipient of new money enjoying a diminished wealth effect as prices are pushed up, all the way to the last person receiving the wealth effect who just pays a higher price for all goods and services. Sadly, these people last in line for new money tend to be those on fixed incomes, pensioners, un-waged people and generally poor people who spend less and less frequently.
Thus this practice of “Quantitative Easing” — creating money out of thin air — is always a tax on the poor in favour of the richest members of society. It is truly a regressive tax; it works away silently in the background in the name of “stimulating the economy”. It is based on a faulty understanding of economics.
How Can Wealth be Created?
The butcher, realising there is more demand than just the baker and the candle stick maker, invests in a more productive way of producing his steaks. He develops his capital structure, buy using his “savings”. These are his two stakes that he did not consume. He now buys a steel to sharpen his knife and increase his productivity, so he can now produce 15 steaks in the same time, to be exchanged for other goods and services.
The key point is that you need to save to invest. Saving means an abstention from present consumption to invest in better methods of production so that you can produce more for the same input factors of production. This is how productivity is improved.
Creating money out of thin air to stimulate the economy — i.e. trick people into thinking they are more wealthy — only leads to a transfer of wealth from the poorest to the richest members of society as consumption not backed by production is encouraged and enjoyed by those closest to the stream of new money and farthest from real production.