Phases of the crisis – are we approaching the endgame?

Phase 1: Greenspan, the arch money crank

The Greenspan “put”, and the collective adoption by most central bankers of low interest rates after the dot-com bust and 9/11, caused one of the largest injections of bank credit in history. Since bank credit circulates as money, we can say public policy has created the largest amount of new money in history.

This should never be confused with creating new wealth. That is what entrepreneurs do when they use the existing factors of production — land, labour and capital — in better ways, to make new and better products. The money unit facilitates this exchange.

Now to a money crank.  He will assume that new money will raise prices simultaneously and proportionately, so the net effect of the economy is that all the ships rise with the tide at the same rate. He’ll say that money is neutral and does not have any effect on the workings of the economy.

One of the great insights of the older classical economists, and in particular the Austrian School, is that new money has to enter the economy somewhere.  Injected money causes a rise in the price levels associated with the industry, businesses, or people who are fortunate enough to be in receipt of the new money. Prices change and move relative to other prices. It is often quite easy to see where the new money enters into the economy by observing where the booms are.

Suppose a banker sells government bonds to another part of the government (as has been the case with UK QE policy).  For selling, say, £30bn of government debt to the Bank of England, he gets a staggering, eye-popping bonus. With his newly minted money, he buys a new £10m house in Chelsea, a £5m yacht in Southampton, some diamonds for the wife to keep her happy, and lives a happy and rich life. The estate agent spends his commission on a luxury car, and some more humdrum items that mere mortals buy.  At each point in time, the prices of the goods favoured by the recipients of new money are being bid up relative to what they are not spending on.  Eventually these distortions ripple through the economy, and the people furthest from the injection of new money — those on fixed income, pensioners, welfare recipients — end up paying inflated prices on the basic goods and services they buy. A real transfer of wealth takes place, from the poorest members of society to the richest. You could not make this up. I am no fan of the “progressive” income tax, but I certainly can’t support a regressive wealth transfer from the poor to the rich!

Even when the government was not creating new money itself, it was setting the interest rate, or the costs of loanable funds, well underneath what would naturally be agreed between savers and borrowers.  Bankers are exclusively endowed with the ability to loan money into existence, so they welcome the low rates and happily lend, charging massive fees to enrich themselves in the process.

After the dot-com bubble, it was property prices that went up and up.  Not only do we have the richer first recipients of new money benefiting at the expense of the poor, we have a massive mis-allocation of capital to “boom” industries that can only be sustained so long as we keep the new money creation growing.

Our present monetary system is both unethical and wasteful of scarce resources. We do not let counterfeiters lower our purchasing power, and we should not let governments and bankers do it.

Phase 2: Bush & Brown – private debt nationalised by the Sovereign

This flood of new money brought more marginal lending possibilities onto the horizon of the bankers.

They devised a range of exotic products whose names are now familiar: CDO, MBS, CDO-squared, Synthetic CDO, and many more — all created to get lower quality risk off the issuing bank’s balance sheet, and onto anyone’s but theirs!

In 2007/2008, bankers started to wake up to the fact that everyone’s balance sheets were stuffed with candyfloss money, at which point they suddenly got the jitters and refused to lend to each other.  As we know, bankers are the only people on the planet who do not have to provide for their current creditors; they can lend long and borrow short. Thus, the credit crunch happened when the demand for overnight money to pay short-term creditor obligations ran dry.

Our political masters then decided that we could not let our noble bankers go bust; we had instead to make them the largest welfare state recipients this world has ever known! Not the £60 per week and housing benefit kind for these characters, but billions of full-on state support to bail out their banks. They failed at their jobs and bankrupted many, but they kept their jobs with 6, 7, or 8 figure salaries!

Bush told us that massive state intervention was needed to save the free market. Brown said the same. We were told that there would be no cash in the ATMs and society would most certainly come to an end if heroic action was not taken to “save the world”, as Brown so memorably put it (though he seemed to think he had accomplished this feat singlehandedly). Thank God for Gordon!

Now in Iceland, a country I was trading with at the time, their banks did go bust; no one could bail them out. But within days the Krona had re-floated itself and payments continued; within weeks they had a functioning economy.

Within days the good assets of Lehman Bros had been re-allocated, sold to better capitalists than they.

But with these notable exceptions, socialism was the order of the day. Bank’s inflated balance sheets were assumed by sovereign states. Like lager louts on a late night binge, after a Vindaloo as hot as hell itself, heads of government seemed to care little for the inevitable pain that would follow, as states tried to digest what they had so hastily ingested. Indeed, the failed organs of the nationalised banks survive only on life support, enjoying continuous subsidy through the overnight discount window.

But the sovereign governments, under various political colours, had a history of binging. In our case the Labour Party spent more than it could possibly ever raise off the people in open taxes, and the Tories offer “cuts” which in reality mean that the budgets of some departments will not increase as quickly as they were planned to.

Phase 3: King Canute, sovereign default

Default is the word that can’t be mentioned. In reality, we should embrace default. This debt is never going to be repaid. Never, that is, in purchasing power terms.

S&P ratings agency have hinted at this with the recent US rating downgrade. They know the American government can always mint up what it needs so long as it has a reserve currency. They also know that this is a soft default. In real terms, people seem likely to get back less than they put in.

Hard default should be embraced by the smaller nations like Greece and Ireland, so they can rid themselves of obligations they cant afford to pay. This will be good for taxpayers in the richer countries of Europe, as they will no longer be bailing out those who foolishly lent to these countries. It will be good, too, for the debtor nations, as they can remove themselves from the Euro and devalue until they are competitive again. They will, however, need to learn to live within their means. Honest politicians need to come to the fore to effect this.

Yes, this will be painful and the people who lent these profligate and feckless politicians the money will get burnt.

However, the FT has recently seen prominent advocates for a steady 4%-6% inflation target. This is the debtors’ choice and the creditors’ nightmare, with collateral damage for those on fixed or low incomes, for the reasons mentioned above. Should we let the Philosopher Kings have their way?

“Let all men know how empty and worthless is the power of kings. For there is none worthy of the name but God, whom heaven, earth and sea obey”.

So spoke King Canute the Great, the legend says, as waves lapped round his feet. Canute had learned that his flattering courtiers claimed he was “so great, he could command the tides of the sea to go back”. Now Canute was not only a religious man, but also a clever politician. He knew his limitations – even if his courtiers did not – so he had his throne carried to the seashore and sat on it as the tide came in, commanding the waves to advance no further. When they didn’t, he had made his point: though kings may appear ‘great’ in the minds of men, they are powerless against the fundamental laws of Nature.

King Canute, where are you today? We need honest politicians and brave men to step forward and point out the folly of trying paper over the cracks. Unless banks write off under-performing (or never-to-perform) securities from both the private sector and the public sector, we will progressively impoverish more and more people.

Let better business people buy the good assets of the bust banks, and let them provide essential banking services.

Let the sovereigns that can’t pay their way go bust and not impoverish us any further with on-going bailouts. In all my years in business, your first loss is always your best loss.

Yes, this will be painful. Politicians, fess up to the people: you do not have a magic bullet and you can’t offer sunshine today, tomorrow and forever.

I fear that if we do not do this, we approach the end game: the total destruction of paper money. Since August the 15th 1971, paper money has not been rooted in gold. It is the most extreme derivative product, entirely detatched from its underlying asset. Should the failure of this derivative come to pass, we will have to wait for the market to create something else. Will we be reduced to barter, as the German people were in the 20s?

A process of wipe out for all will be a hell of a lot harder than sensible action now.  It is still not too late.

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28 replies on “Phases of the crisis – are we approaching the endgame?”
  1. says: Paul Marks

    I agree that it is not (formally speaking) too late. However, the establishment (and their house journals such as the Financial Times newspaper and the Economist magazine) just demand even MORE funny money creation and wild government spending (sorry “monetary and fiscal stimulus”).

    They dishonestly pretend that the Western government (who, in reality, have run vast deficits for years) have a “balanced budget fetish” and demand that even the American government spend even more money (Mr Wolfe in the Financial Times explicitly mentioned the United States as a country with room for yet more “fiscal flexibilty”).

    The establishment (such as Samuel B, and Geoge Magnus of UBS) even cite Karl Marx as authority whose ideas about “capitalism” were correct (apart from he did not see that handing out yet more funny money to UBS and co would solve everthing).

    Remember these people are not a few freaks – they are normal as far as the universities, the “mainstream” media, and the poltical class are concerned.

    And they have many friends in the stock markets – who look only to the next “stimulus” fix, like a junkie prepared to do anything to please their supplyer.

    So, in theory, you are correct – we can get out of this.

    But in political practice…….

    1. says: Dan Mosley

      Paul,

      I would recommend studying the 30s Great Depression to see the consequences of a ‘do nothing’ approach with respect to monetary and fiscal policy. Reading a summary of Friedman’s Monetary History would be a good place to start.

  2. says: Dan Mosley

    Toby,

    I agree with some of what you say, I think there are some good arguments for saying that we should have let the banks go bust.

    However, I don’t understand why you are in favour of what you call ‘hard default’ over ‘soft default’? The UK had massive levels of debt following WW2, far higher than the present as a percentage of GDP. The way we were able to pay off that debt was through a ‘soft default’.

    It is fairly obvious, given hindsight, that this was a better way of dealing with that debt than a ‘hard default’.

    And on your point about where new money enters the economy, the point is that this money is now lent out by banks to its customers (at least in business as usual, in the liquidity trap situation we are in much of it just piles up in bank vaults). So I don’t really see the relevance of your point on bankers bonuses in the grand scheme of things.

    1. Morning Dan,

      Bonuses being paid on doing a transaction between yourself and yourself i.e. the Treasury and the Bank of England is daft. Especially as these are in tens of millions of pounds to individuals .

      I say “Hard default should be embraced by the smaller nations like Greece and Ireland, so they can rid themselves of obligations they cant afford to pay. This will be good for taxpayers in the richer countries of Europe, as they will no longer be bailing out those who foolishly lent to these countries. It will be good, too, for the debtor nations, as they can remove themselves from the Euro and devalue until they are competitive again. They will, however, need to learn to live within their means. Honest politicians need to come to the fore to effect this.”

      To try and make these nations pay what they are never going to be able to pay is cruel . The people who have loaned to a unsubstantial borrower should take the pain. The nations such as Ireland , Greece and Portugal can get on with making themselves profitable again . Richer nations will not have to bail them out. If a mans income is always going to be £100 and his costs £110, there is no point beating him to death to try to pay what he is never going to pay. Hard default for these people is the better solution.

      1. says: Dan Mosley

        Toby,

        I agree that hard default would likely be the best option for the likes of Greece and Ireland. But I also think that there is a place for soft default as well, which is the point I made about the UK post WW2. With the debts that the US and UK have built up, soft default may be a less painful option in the long run.

        I don’t agree that a 4% inflation rate would have negative consequences for the less well off. Most pensions are linked to the Retail Prices Index, and obviously wage increases in normal times are linked to inflation. It is a special case at the present time that it is difficult to get a real return on savings, but again this would not be the case when the economy returns to normal and interest rates adjust.

        There are many benefits to a slightly higher inflation target, not least giving central banks more room to cut interest rates before getting stuck at the zero lower bound, which has been one of the defining issues of the current crisis.

        1. says: Rob Thorpe

          I agree that hard default would likely be the best option for the likes of Greece and Ireland. But I also think that there is a place for soft default as well, which is the point I made about the UK post WW2. With the debts that the US and UK have built up, soft default may be a less painful option in the long run.

          The US and UK can easily pay off their debts. They simply can’t do so and maintain the foreign wars and lavish welfare states that they’ve built up.

          I don’t agree that a 4% inflation rate would have negative consequences for the less well off. Most pensions are linked to the Retail Prices Index, and obviously wage increases in normal times are linked to inflation. It is a special case at the present time that it is difficult to get a real return on savings, but again this would not be the case when the economy returns to normal and interest rates adjust.

          What I’m concerned about (and I think Toby would agree with me here) isn’t only that some people may lose due to inflation. Just as importantly economic calculation will be distorted. Many businesses are likely to continue to expect the long-run inflation rate to be similar to what it has been in the past. That will cause misallocation of capital as businesses invest in projects that won’t be worthwhile.

          As far as the less well off go, I think this is the problem… As inflation rises welfare benefits will probably be increased correspondingly, as will wages. But, those who have saved will see a fall in their wealth. That encourages the view that there is no point for poor people to save, and that poverty can never be reduced by saving. That leaves welfare as the only form of amelioration. This is a very bad lesson to teach people.

          There are many benefits to a slightly higher inflation target, not least giving central banks more room to cut interest rates before getting stuck at the zero lower bound, which has been one of the defining issues of the current crisis

          One of the defining issues of the current crisis has been that Paul Krugman and his acolytes have talked about the zero lower bound an awful lot. As you know from our past discussions I don’t agree with what they’re claiming. I have been investing much of my own money in bonds since 2008 and I’ve never got an interest rate less than 3%.

          My view is that there are three reasons for exacerbation of the crisis. Firstly in recent times economic calculation has been made on the assumption of a positive price inflation rate of ~2-4%. I think that assumption is “baked into” how business decisions are made. So, when inflation fell below that rate many investments that would have been profitable were not made. Secondly, I think the bank bailouts in the US left many banks there unable to function properly and make loans normally even though they remained solvent on paper. Thirdly, I think the obvious failure of central banks to predict or prevent the crisis caused a great deal of concern. That caused people to worry about making future loans for fear that inflation targeting would be abandoned, and caused the demand for money to rise.

          I think concentrating on interest-rate issues distracts us from thinking about two things which are more important. It distracts us from thinking about why we’re in this situation and it distracts us from thinking about money supply and demand.

          I think if the Central Banks had made plausible commitments then we wouldn’t have got into the situation of 2010-2011 (though I don’t think it could have helped the PIIGS). Although they have rectified the situation to an extent now, in 2009 they left future expectations about their policy too uncertain.

          Keynesians like Krugman try to paint high demand-for-money as an intractable problem. Krugman wraps the idea up in interest-rates because that distracts from the fact that money-supply is quite separate to interest-rates. That allows the Keynesians to argue for bypassing this problem by fiscal stimulus. But, it isn’t really an intractable problem, the subjective issues that drive the demand for money are all connected to uncertainty and they can be tackled.

          On the “zero lower bound” I thought this was interesting:
          http://monetaryfreedom-billwoolsey.blogspot.com/2011/08/bernankes-reason-for-paying-banks-not.html

          1. says: Dan Mosley

            Rob,

            If a central bank made a credible commitment to raise inflation to 4%, I don’t see why businesses would continue to expect the long run rate to be the same as it was in the past. And on your point about savers seeing a fall in their wealth, I don’t think that is relevant. If the long run inflation rate was 4%, as the economy returned to normal the interest rate would adjust so people would still get a real return on their savings. This is confirmed by the Fisher Effect, empirically demonstrated time and again, which states: “All else equal, a rise in a country’s expected inflation rate will cause an equal rise in the interest rate that deposits of its currency offer”. 

            I know we’ve discussed the zero lower bound issue before, but I would like to better understand your position on it. If you think that zero interest rates are not a special case, what would be your answer to the question “why hasn’t there been high inflation despite massive increases in the monetary base in the UK and US?”

            1. says: Rob Thorpe

              If a central bank made a credible commitment to raise inflation to 4%, I don’t see why businesses would continue to expect the long run rate to be the same as it was in the past.

              Do you think that all businessmen look carefully through the finance pages to find out things like this? I think that more realistically many are much more concerned with running their own businesses. I think many judge price inflation from experience as much as from official announcements. Certainly that’s different in big business and in the financial sector. That’s why the expectations that Central banks create are important.

              But I don’t think expectations are so perfect that can counteract price inflation entirely. For example, think about ordinary workers, do they calculate their salary or wages in real terms? When I meet my friends down the pub it strikes me that they’ve never thought “My salary will probably by £X this year, which is £Y in 2010 prices”. Hell, I’ve never deflated my salary in advance.

              I think many calculations are done in direct money values taking no account of inflation, many more than you think.

              The strange thing about this argument is that Keynesians are coming close to contradicting themselves. To say that a known change in the rate of inflation won’t produce real effects is a ratex argument. Why don’t you also apply that to fiscal stimulus. Why should cutting taxes in the short-run work if agents expect them to rise again? I won’t claim that Austrians are completely consistent on that either, I was just complaining about that today in another forum:
              http://thinkmarkets.wordpress.com/2011/09/01/%e2%80%9ca-divine-miracle%e2%80%9d/#comment-10807

              This is confirmed by the Fisher Effect, empirically demonstrated time and again, which states: “All else equal, a rise in a country’s expected inflation rate will cause an equal rise in the interest rate that deposits of its currency offer”.

              I agree in principle with the Fisher effect. But just as I don’t believe in perfect Ricardian equivalence I don’t believe the Fisher effect operates perfectly either.

              I agree that because of the Fisher effect in the long-run savings rates would adjust. But, there is still a one-off loss when the one-off change occurs. Suppose I have £1000, I earn 2% per year and the price level is stable. I spend that 2% every year. Now, suppose the price level trend changes to ~2% per year. That means that in time the interest rate will rise to ~4%. But it doesn’t mean I get back the initial cost of the change to me, there is still a large one-off cost to savers. In fact, the argument behind the Fisher effect relies on that.

              I know we’ve discussed the zero lower bound issue before, but I would like to better understand your position on it. If you think that zero interest rates are not a special case, what would be your answer to the question “why hasn’t there been high inflation despite massive increases in the monetary base in the UK and US?”

              Mainly, I think the demand for money has risen.

              Of course advocates of the zero-bound would say the same thing. They would point to trade-off between owning a short-term bond and a current account (or savings account). I’d point out that this difference is often close during booms.

              I think what’s more important is that uncertainty is driving people to hold more money. I pointed out some of the sources of that in other posts. In Britain the BoE aren’t really following inflation targeting any more, which is understandable but begs the question: exactly what are they doing? There’s uncertainty over the peripheral Eurozone countries. In the US there’s uncertainty over the effect of healthcare legislation, though I’m not convinced that’s as important as some people claim. Because of the recession many people all over the world are uncertain about their jobs and therefore need to avoid making investments that tie up a lot of their assets.

              Lastly, in Britain, the money supply rose straight after the crisis, but has been declining since.
              http://kaleidic.squarespace.com/data/#KA01

              Notice this isn’t just shown by Anthony’s MA measure, M4 shows it too. That said it isn’t clear that money demand is still abnormally high in Britain.

        2. Dan, let’s say we put all people on some index linked formula that was the basic pay award , so inflation is irrelevant . Let’s say if you were in a boom industry such as housing and finance have formally been. To continue booming, you would need to have more resources ploughed into these sectors bidding away resources from others . Wages get bid up over and above the index link in these sectors . The credit infused boom that has created all of this distorts relative wages . This is what you over look . Even if you underwrite low incomes with an index linked calculation it is the relative incomes , not the aggregates that will be the problem. Inflation always transfers from the poor to the richer .

          You argue that some inflation will be good. I presume you mean as our debts as a nation will be paid back with less in purchasing power terms. Well yes this is true, but in the meantime to achieve the raping of our creditors, we have to embark upon an inflation that will NEVER be nice and uniform and will always create winners and losers . What’s more, the loser class will always be the less nimble, the poorer and fixed income people, even if they are fixed to an index.

          I would urge you to purge these ideas of inflation being a potentially good thing from your mind.

          1. says: Dan Mosley

            Toby, 

            I fail to see why your point relative wages is particular to the inflationary case. If the central bank set inflation at 0%, there would still be boom industries, and wages would still be bid up in these sectors. 

            Looking at the history of inflation since WW2, we have had some degree of inflation for that whole span of time. Mostly low and stable, but sometimes high as in the 1970s. I don’t think that the poor have particularly lost out in relation to everyone else because of this inflation. The opportunities that the poor have, their standard of living and material wealth have continued to improve. 

            I’m not arguing for higher inflation from a debt point of view, I would agree that we can pay off our debt without resorting to this (although I think that in extreme cases, such as the UK post WW2, soft default may be a less painful way out). The main reason I’m for it is that in my view base rate hitting 0% has severely limited the ability of monetary policy to stimulate the economy. If inflation and hence interest rates were higher, central banks would have more room to cut rates without hitting the zero lower bound. It would also be far easier for employers to cut wages in real terms in a crisis, limiting unemployment.

    2. says: Rob Thorpe

      Dan,

      Hard default imposes a loss on a particular group – bondholders.

      Soft default by inflation imposes an unexpected redistribution of wealth on everyone holding assets denominated in money.

      Both of them confound expectations and reduce the reputation of the government of the country involved. However, soft default confounds the expectations of everyone dealing with money prices, it causes miscalculation. Hard default doesn’t and that’s why it’s superior.

      I know that inflationary default appeared to work well after WWII. I don’t think it did, I think complicating factors caused it to appear that way.

      1. says: Dan Mosley

        Rob,

        Hard default does not impose loses on bondholders only. As an example, say that Greece left the Euro and carried out a hard default tomorrow. This would have several undesirable consequences beyond bondholders losing their money. The new currency of Greece, new drachmas or whatever, would plummet like a stone (which confounds the expectations of everyone dealing with money prices). Capital would be withdrawn by foreigners. The government would have reduced access to bond markets which may mean it would have to rely on its central bank and consequent inflation (again, confounding the expectations of everyone dealing with money prices). 

        That’s not to say I don’t think Greece should default, I think that given the situation it may be their best option. But it is certainly not an easy option and would have large costs for society, at least in the short term. Things would have been far easier for Greece if they had their own currency in the first place. 

        As long as inflation is low and stable, and I would say that 4% is still low and stable, then I don’t think that this causes miscalculation. 

        1. says: Rob Thorpe

          As an example, say that Greece left the Euro and carried out a hard default tomorrow. This would have several undesirable consequences beyond bondholders.

          You’re now confusing two different things. I was talking only about default, not leaving the euro. That’s a different kettle of fish altogether. Remember it’s still possible for default to occur within the euro. In fact, Greece has already defaulted it to a limited extent by imposing haircuts on bondholders.

          The government would have reduced access to bond markets

          They would if there is a risk of them doing the same thing again. But, if they have made a plausible commitment to change then the opposite is true. Bondholders will consider their new debt more valuable than other states with large sovereign debts.

          But it is certainly not an easy option and would have large costs for society, at least in the short term.

          Yes, any method of default will. My point is that some are worse than others. There was a study of latin american defaults that showed that hard default was the most successful strategy. I can’t remember who it was by, I’ll see if I can find it.

          Also, I think I remember you being a bit of a leftist. Something to remember is that it’s the poor who are generally most exposed to nominal shocks. Rich people generally own shares and property, whereas poorer people store more of their wealth in forms denominated in money terms. (Krugman talks about “rule be rentiers” in his columns neglecting to mention that the situation now in the US isn’t the norm.)

          1. says: Dan Mosley

            Rob, I don’t think I’m confusing two different things. My point is that hard default causes money issues just as much as a soft default does, by reducing access to bond markets and declining value of the currency in terms of other currencies (both of which can cause high levels of inflation in the short term). This is the case irrespective of whether a country is leaving a currency union.

            You say “But, if they have made a plausible commitment to change then the opposite is true. Bondholders will consider their new debt more valuable than other states with large sovereign debts.” I think there are very few cases of a country defaulting and then being able to borrow at lower rates, as the default itself is a measure of economic incompetence. If Greece defaulted and made a “plausible commitment to change”, would you lend them money?

            On nominal shocks, it all depends on the context of the situation in which the nominal shock takes place. Shares and property haven’t been doing too well recently.

            1. says: Rob Thorpe

              I think there are very few cases of a country defaulting and then being able to borrow at lower rates, as the default itself is a measure of economic incompetence. If Greece defaulted and made a “plausible commitment to change”, would you lend them money?

              Remember we are talking about the difference between hard default and soft default here. If a state uses inflation to pay it’s debts then it has still defaulted. It’s debtors may get more from that deal than from a hard default because some of the cost falls on others. But, a default of sorts has still occurred, and that bodes just as badly for the future as hard default does.

              If a state performs a soft-default that shows they are relatively bondholder friendly, and less friendly towards money-holders and those with other money-denominated assets. It doesn’t show that they are less likely to default in the future. The only positive a bondholder may get from it is that that state may continue to be more bondholder friendly in the future. But in modern democracies this isn’t a reliable idea, the next government may be very different.

              My point is that hard default causes money issues just as much as a soft default does, by reducing access to bond markets and declining value of the currency in terms of other currencies (both of which can cause high levels of inflation in the short term). This is the case irrespective of whether a country is leaving a currency union.

              I agree that both hard and soft default cause price inflation, but I think the degree is quite different.

              If a hard default causes foreign investors to refuse to buy government debt then that could cause the value of that countries currency to fall. That would then cause price inflation. But in most countries the proportion of imports is only a small component of prices. Forex rates have to fall greatly for prices to increase significantly. Also, inflation of this sort doesn’t distort capital prices, “soft default” does.

              To clarify all this… I’m not saying that the UK should default. I think the UK can pay it’s debts by taxation.

  3. Toby, I agree that if new money is to be introduced to the economy, it should not be introduced via any particular small group of people – bankers or whoever. The inventor Thomas Edison expressed more or less this view, but in rather convoluted language – see last four paragraphs here:

    http://www.primeronmoney.com/edisonandford.html

    Re having the currency gold based, the first problem with that is that there is nowhere near enough gold in the world to supply everyone with the gold/money they want in order to do business. In practice, this has meant that gold standard currencies in the past have been supplemented with large volumes of paper currency. Thus the claim that reimposing the gold standard somehow dispenses with paper currency is a bit of a cheat.

    Second, if the price of gold under a gold standard system is its free market price, then its price (and hence the price of EVERYTING ELSE) gyrates all over the place, which is not much use. To get round this, the price of gold in gold standard systems has always been fixed, which is another “cheat” aspect of the gold standard.

    Third, the fact that a currency is not backed by gold, does not mean it is not backed by assets. The majority of our money has been “loaned into existence” by commercial banks, and these loans are normally backed by collateral: property more often than not.

    That is not to say I am in favour of a “loaned into existence” and property backed currency: we can do better than that. I’m just suggesting that a gold backed currency is not vastly superior to a property backed currency.

    1. Morning Ralph,

      The solution is to let the gold price rise until there is sufficient backing , then make paper money gold backed.

      Property you can make vast amounts more of , gold you can’t, so sorry to sound like and old record, I do come back to the unique properties of gold pretty much all the time.

      1. says: Rob Thorpe

        Ralph, Toby,

        The problem with property is that it isn’t fungible, so it can’t be used for redemption.

        Imagine I have £1M to withdraw from my bank account. My bank manager doesn’t like me very much so he gives me three basketball courts in Venezuela, the chimney of an old hotel in Turkey and a square meter of the grand canal. Such a redemption system would be unworkable, and without redemption there is no tie between the value of the backing assets and the liabilities. So it would be fiat money.

    2. says: Dan Mosley

      Ralph, I would be interested to get your views on how new money should enter the economy if not through bankers.

  4. says: John Spiers

    Mr. Musgrave sent us to a 1913 essay on money a few weeks back which demonstrated in history gold as a medium of exchange is in the minority, paling in comparison to vast complex agreements of economic import. Bankers broker the housing development here, the oil wells there, the farm in the country, the fishing fleet, the sweatshop and endless other cross referenced deals, and collect a tidy some, with nothing backed in gold, not even “money” by most definitions, all paper backed by paper. Just so.

    The problem with some of these arguments is simply definitions. Paper backed by oil wells is not money, it is obligations, mere contracts. Why call such paper “money?”

    Why not explain things as they are, which I believe is Mr. Baxendale’s brief. If it is other than medium of exchange, then it is not money. People need to understand what they are getting into when they make a deposit into a bank, with a paycheck from a company, both of dubious provenance.

    Most of these economic transactions are appraised in something we call federal reserve notes, a document that does not have the word “money” on it, a phenomena I suspect is true world-wide for currency. Why do we call it money when the originators do not?

    Is there not a simple solution? Simply ground any contract with a reference to liquidating in gold. End of story. In fact, it was once common. After the federal reserve act in USA, business people, knowing about funny money and inflation, protected their projects with gold clauses. Problem solved.

    http://home.hiwaay.net/~becraft/FayCorp.pdf

    Until the government outlawed business protecting itself.

    http://www.rbs2.com/gold.pdf

    It is a problem of definitions, but also a problem of who gets to make definitions. Job one is to outlaw government making definitions.

    Then we can start to clarify, for example, a gold standard that includes cheats is not a gold standard (the concern of wildly fluctuating prices is not a problem in a free market, merely more information, an early warning system. The problem with paper backing paper economies is the wildly fluctuating prices).

    John Spiers

  5. says: john in cheshire

    As a total ignoramus with regards to economics, I have a question regarding the reasons why countries such as Greece could not be allowed to withdraw from the Eurozone :
    If Greece, for example, withdrew from the Euro and transferred all their Euro liabilities to a new Drachma on a one for one basis and immediately allowed the new Drachma to float against international currencies, why couldn’t this work? The losers would be the very people who are causing the problem and the winners would be everyone else, including Greece.

    1. That could well happen . They will try to resist it as the new Drachma will float down. This will mean that each bank with its loans to the Greek Govt will have to write down making themselves potentially insolvent . THis is what all parties are trying to avoid. It is virtually impossible for this default not to happen.

    2. says: Dan Mosley

      John, in addition to Toby’s point, see my reply to Rob above. The Greek government would find it very difficult to borrow money from the markets – who would lend to a country that has just defaulted? It may then be forced to finance its debt through its central bank (i.e. the central bank buying all the bonds which no one else wants to buy, in exchange for new money) which could potentially cause high levels of inflation and further damage the economy.

      1. Dan, it would be a very good thing for the people of Greece if their govt could not borrow anything anymore as a result of mass default: they would have to live wishing their means.

        1. says: Dan Mosley

          Toby, that may be the case. But cast your mind back to the riots following the various austerity programmes that the Greek government has had to implement. These austerity programmes would be peanuts compared to what would happen if the Greek government had to balance its budget immediately. The people would never accept it, and you would probably end up with huge protests, a vote of no confidence in the government, and some kind of socialist workers party being elected.

          The Greek government would probably rather use their central bank to buy debt and create inflation than risk this scenario.

  6. Rob, I agree that a “property backed currency” is still a fiat currency. But if banks lend only on the basis of solid collateral (usually property), it will be a stable currency, seems to me.

    Dan, Re my suggestion that new money should not enter the economy via banks, I didn’t phrase my point very well. I was trying to make the same point that Thomas Edison made which was that introducing new money should not be a profit making operation for PRIVATE banks. That is, new money should be introduced via some communally owned institution, e.g. the central bank. Reasons are thus.

    The reasons for expanding the money supply are reasons that apply to the economy as a whole, e.g. a growing economy will require a growing money supply. Thus there is no reason for any small privately owned group of institutions to do the “introducing” or to profit from that introduction.

    Second, seignorage is essentially costless. That means the private bank system can in principle create money and lend it out in order to fund projects which produce a ridiculously low return on capital. That tends to artificially reduce interest rates to below the genuine free market rate.

    1. says: Rob Thorpe

      Rob, I agree that a “property backed currency” is still a fiat currency. But if banks lend only on the basis of solid collateral (usually property), it will be a stable currency, seems to me.

      I don’t think you get the problem. If a current is “fiat” currency that means that the state control it’s value through controlling the amount of it and through tax laws and legal tender laws.

      That means “backing” and reserves don’t have the same role they have in commodity money systems. The state may hold some assets which they claim are the assets backing the money in circulation. But, since they control the supply of money by independent means this doesn’t matter much. A government may own 100000 mortgages on 3 bedrooms houses, for example. But that government can issue any amount of fiat money “against” those mortgages. If the nominal value of the mortgages falls below that of the money supply then the government can issue bonds (using taxpayers money to fund the bonds) and put those bonds into the pool of backing assets.

      Now, don’t get me wrong. It is certainly better if the government make some attempt to keep backing assets for money, and treat money like a normal liability. That was the initial attraction in the 17th and 18th century of Central Banks with separate accounts. But governments have no reason to maintain this relationship. Today, if a Central Bank looks like going bust it will be bailed out.

      Second, seignorage is essentially costless. That means the private bank system can in principle create money and lend it out in order to fund projects which produce a ridiculously low return on capital. That tends to artificially reduce interest rates to below the genuine free market rate.

      This is wrong. Like many you seem to forget that the fiduciary media that a commercial bank creates is a liability of that bank.

      If anyone is interested in the subject of whether commercial banks can earn income from seigniorage read the comments thread here:
      https://www.cobdencentre.org/2010/12/positive-money-practical-reform/

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