Tuesday, February 26, 2013

The Banking System and Economic Growth

There is a strong relationship between the viability of the global banking system and the need for economic growth.  Here is how the banking system relates to the economy. 

1. When a bank customer gets loan from a bank the bank is essentially issuing new currency into circulation.  The new currency is in bank deposit form (rather than paper form).  So, each loan is a new currency being created by the bank.   The money supply (currency supply)  increases when the loan is funded (the act of funding a loan is just a book entry in the bank's ledgers -- nothing more!).

2. When the loan is paid back the currency supply (money supply) goes down because unless the money is re-lended it is out of circulation for use by the public.   Prolonged decreases (due lack of re-lending returned currency/money) in currency supply lead to a severe economic recession and ultimately an economic depression. 

3. If the economy has the capacity to grow then re-lending continues and actually more has to be lent out as time goes on because not only principal has to paid back by previous borrowers but interest also on previous loans.  The currency supply has to constantly increase (by ever more lending) in order to pay back principal and interest.  The banking system cannot operate in backwards (i.e., decreasing currency supply for a prolonged period).

4. This type of banking (constantly increasing money supply by lending and re-lending) is called Fractional Reserve Banking.

5. Most currency (about 90%) is issued (created) by banks and not by the government through the process of Fractional Reserve Lending described above.

6. Economy can ONLY grow if the following is true:

  • cheap source(s) of energy are available to extract and process raw materials (iron ore, copper, lumber, etc.), transport raw materials to a factory, manufacture and send finished goods to the markets. Not to mention "low cost" energy needed to heat and cool homes and transport people and grow food (fertilizer is made from natural  gas, water is pumped out of the ground, pesticides are made from oil ).  Farm machinery runs on oil.  Most electricity generation plants run on fossil fuels.

  • Skilled labor is plentiful (engineering knowledge and management knowledge and medical knowledge).

  • Free/fair markets and entrepreneurship and investment facilitating firms. 


  • A Decent government (peace, security and rule of law).

Growth is not possible anymore because 95% of our energy comes from fossil fuels (coal, natural gas and oil).  We need not only energy but "low cost" energy for economic growth.  Fossil fuels are depleting very fast (the cheap/easy oil is very hard to find).   Peak Oil has been reached (in 1998 crude was $11 a barrel and now it is around $95 per barrel).  Per BLS inflation numbers $11  in 1998 equals $15 in 2013.  Therefore, the price of gasoline has far, far outpaced the inflation rate. 

If we don't have economic growth the banking system WILL collapse as it did during the great depression.

But we cannot get out of a depression by spending money anymore because during 1930's "low cost energy" was available so all the government had to do is print money and have a huge war and get demand going and get currency in the hands of consumers via the war effort jobs.

Our monitary system must be re-designed to be not based on bank-lending created currency.   But this will not happen until a much worst banking collapse to come in the next five years.

Even after the re-designed monetary system (which will cause much, much chaos for lots of reasons:  most bonds will be worthless and stocks will fall by 90%) we will not have much growth ever again unless we find a "cheap" source of energy. Some people are praying for cold fusion technology to be developed soon.

If usury (lending based currency issuance) is NOT abandoned we will have mass global starvation because checks will not clear and supply chains will breakdown.

May God (Allah) protect us, bless us and guide us. We will certainly need his help in the next five years when the economy has to be totally redesigned to use less energy.

Saturday, November 5, 2011

Here is how the banker's game works


Here is how the banker's game works:

1)  Get the government to issue some currency (cash -- paper or reserves at the central bank -- reserves are government issued cash central bank deposits).  Government issued cash is around 5% of the currency (money) supply.  The government issued currency is put into circulation by the government simply spending it.


2)  The rest (95%) of the currency is issued by the private banks.  Each customer loan is a new bank deposit (i.e., new currency) and increases the currency (money) supply of the economy.  Note that this newly created money (currency) is put into circulation by the borrower spending it.  Most currency (about 95% America's currency supply) has been borrowed into existence and when bank customer pays the loan back that amount of currency is removed from circulation.   The banking system cannot go backwards (fewer net loans) as time moves on because fewer net loans means less currency in circulation in the economy.

Accumulation of interest charges on outstanding loans means that the currency supply must constantly increase even if it means giving out lower quality loans.  Think of it like a plane flying it must fly at some minimum speed or else the plane (the banking system) will crash (i.e., banking system collapse).


3) The bankers make dam sure that the common public does not understand how the monetary system works meaning that the private banks issue 95% of the currency. This is whole another topic how they do this.


4) The system works until real economic capacity of the economy grows and debts can be serviced and interest charges paid.  Most of the time the economy oscillates between boom (growth) and bust (recession) because bust is needed to clear debts and start a new lending cycle.


5)  Eventually, one of these cycles goes so deep that currency supply (and demand) falls so low that too many debts become un-serviceable.  The recession becomes a depression now.


6)  The bankers then have to decide how to "reset" the system.  One way to reset the system is to let the depression takes its course.  But of course this path is very chaotic because people lose jobs and may become violent.  Once most debts are cleared lending can start again and the currency supply is replenished.   Wars are a good way to get initial money (currency) into an economy after a depression to get demand going again.  This is the great depression scenario.


7) Another way to "reset" the system is to get the government to print too much money and spend and destroy the currency and blame it on the government.  This justifies issuance of a totally new currency (note that hyperinflation clears debts) and the lending cycle can start again.  For example, the Argentine economic crises with hyperinflation (1999 - 2002).

8) The banking system (as is) is setup to maximize the power and influence of the global bankers and NOT for the maximum general well being of people.  By the way this is a global game.  This is the only system around no matter what country you are in.   The global banking cartel makes sure that no competing systems are allowed to exist (so they might be copied and global bankers will lose power).


9) We need a currency system where money is spent into existence and does not need to be lent into existence so the economy is never starved of currency in circulation.

For more details on this stuff please read the following articles in order listed below:



http://seekingalpha.com/article/209386-modern-monetary-system-there-is-another-way



http://aquinums-razor.blogspot.com/2011/08/what-is-relationship-of-money-to.html



http://aquinums-razor.blogspot.com/2010/07/why-is-deflation-and-depression.html





http://seekingalpha.com/article/210346-should-newly-created-money-be-a-private-or-a-public-asset




http://seekingalpha.com/article/192375-cause-of-today-s-economic-crises-too-much-thrift




http://seekingalpha.com/article/160269-a-radical-solution-for-america-s-insolvent-financial-system




http://seekingalpha.com/article/146658-great-banking-confusion-is-there-a-better-way


Mansoor H. Khan

http://aquinums-razor.blogspot.com/

Sunday, August 7, 2011

What is the relationship of money to the production process (i.e., production of goods and services)?


The real issue in most discussions about money (MMT, debt, high powered money, fractional reserve money, gold standard, etc) is the question that is rarely fully discussed:

What is the relationship of money to the production process (i.e., production of goods and services)?

I believe this question needs to be answered fully and clearly and un-ambiguously by economics before "money" can be fully understood.

I will take a stab at this question here:

Just imagine in your mind entrepreneurs, factories and labor turning raw materials into finished goods (e.g., production of "loaves of bread"). How does currency relate to this picture. I would suggest to you that there are three primary relationships the production process has to currency.


They are:

1. By spending currency consumers generate demand. Demand is basically information (signals) which tells entrepreneurs what to produce and how much to produce (spending generates demand).

2. Currency allows efficient trading of raw materials, labor and finished goods and services between businesses and between businesses and consumers (this is trading).  Trading is exchanging one’s produced output for produced output of another person.

3. Entrepreneurs and labor can and do work and produce real goods and services just for acquiring currency itself with the expectation of purchasing real goods and services later (this is savings).


Item number one above (generation of demand) and two above (efficient trading) are not hard to understand. The last statement (savings) is where the confusion lies. Let us go back to the image of entrepreneurs, factories and labor turning raw materials into finished goods. Now with this image of production in mind what is savings?

Savings is that portion of production (excess "loaves of bread" produced) which is not consumed or traded for other real goods and services immediately. Notice, when it comes to savings the acquirer of currency (the saver) does not care whether it is freshly printed by the government or whether someone who previously saved it is giving it to them in exchange for real goods and services.

If these savings are not "used up" then we will have deflation. In this case deflation is a signal to producers to produce less (and thereby causing the economy to run below capacity).

This is where the philosophical divide exists. Should the government step in and spend money (borrowed or printed) to "use up" the excess productive capacity of the economy for social good?

The reverse is also true. If the economy heats up and private spending causes inflation should the government tax and destroy money and reign in inflation?

It seems to me that we as a society which cherishes private management of economic resources have not settled on the above two questions.

Why is printing money (via the FED) and "spending" it into the economy is a problem if unused capacity of the economy is being "used up" for social good?

In the end what really matters is productive capacity of the economy. Monetary system is an accounting and control system to manage the production system (i.e., the real economy).

Our monetary system is an accounting system in a sense it keeps track of (and limits) who is "allowed" to spend (i.e., "use-up") what portion of the available productive capacity. It is a control system because it can be used to "reign" in spending when spending outpaces production capacity (i.e., inflation ensues) via the FED's open market operations or we may even need to tax and "destroy" money in order to reign in inflation.

Yes. There is a lot of central planning involved in our "fiat" monetary system.

A factory does not care how much national debt exists or what our unfunded liabilities are or even how much private debt exists the factory is perfectly capable of producing "goods and services" no matter what all these accounting entries say.

Long term we have to teach humanity that in a money economy Say’s law is not true (or anywhere near it). What workers get paid and even what business owners make even if completely spent is not sufficient to use-up (liquidate) the production capacity of a modern economy.

That is what banks do they issue credit (new currency) to use-up this slack capacity of the economy. But there is no reason to have banks do this (this is what leads to recessions/depressions) as peak credit causes no more ability to borrow and lowered production of goods and services due to lowered demand (spending).

For centuries banks have propagated this lie. The proper thing to do is to come up with an acceptable way to measure inflation and let the government (not banks) use-up the slack capacity of the economy for social good which could include regular monthly checks to the citizenry.


Sunday, February 13, 2011

Give $500 per month to each U.S. Citizen as a Resolution to Our Economic Problems


In this essay I want to propose that the U.S. Treasury should give every U.S. Citizen $500 per month indefinitely. This view is very similar to the Social Credit ideas proposed by economist C. H. Douglas (1879–1952).

In order for the ideas in this article to make sense please read the following three articles published earlier as background:

Cause of Today's Economic Crises: Too Much Thrift
(http://aquinums-razor.blogspot.com/2010/03/cause-of-todays-economic-crises-too.html)

Modern Monetary System: There Is Another Way
(http://aquinums-razor.blogspot.com/2010/11/modern-monetary-theory-there-is-another.html)

Modern Monetary Theory, Inflation and Idle Resources
(http://aquinums-razor.blogspot.com/2010/11/modern-monetary-theory-inflation-and.html)

The dominant economic theme in the U.S. and the world economy today is: Factory over-capacity and lots of willing, and able labor which goes unemployed. I propose that we use this idle factory and people capacity by stimulating demand. I propose we give $500 per month to every U.S. Citizen indefinitely without regard to their current income or anything else. Rich, poor, young and old would receive this credit (i.e., cash). Even those currently on public assistance would receive this benefit. This rule also simplifies the implementation of this idea. The rich and the well-to-do may not even spend most of the cash given to them which is ok because the middle class, the poor and the unemployed are likely to spend most of the benefit.

The cost of this benefit would be about $1.85 trillion a year (about 12.5% of forecasted 2010 GDP). I am not proposing taxes be raised or other spending be cut. So where will the money come from? The money is already there in the form of idle capacity. This idle capacity consists of world manufacturing capacity running at record low utilization rate and hoards of healthy, willing, able, disciplined and educated labor (i.e., the unemployed).

Of course, the money would have to be newly created (i.e., printed by the FED). Inflation will not result until the world economy bumps up against capacity constraints. Energy prices may rise (especially oil prices and other fossil fuel prices) but we can let them rise to a certain extent. The increased energy prices will spur energy conservation and spur innovation in the development of alternative fuels.

Another valid criticism of this approach to stimulating demand is that much of the new money may end up stimulating demand in China and other exporting countries using “currency pegs” and not so much in the United States. If this occurs this situation will not last too long as “currency pegs” will cause inflation in the exporting countries. Eventually exporters will have to raise prices in dollar terms which will be ok because it will then make manufacturing in the United States more attractive.

The newly printed money will be spent directly by the middle class, the poor and the unemployed thus stimulating employment. This way the public decides how excess capacity (factories and idle labor) is to be used through their money vote (instead of government allocated stimulus spending or the central bank stimulus actions).

If and when inflation ensues the benefit can be reduced and/or taxation increased to balance supply and demand.

The additional income to consumers will stimulate demand and counter deflationary forces currently occurring due to global wage arbitrage. This will also help consumers pay their debts and help stabilize the banking system.

Monday, February 7, 2011

Modern World View and Financial Crises Related Blogs


Since the financial crises started in 2008 I have been reading and analyzing ideas proposed in many financial blogs (and specially the reader comments). The general sentiment in the reader comments is:

Readers are an increasingly jaded audience bored to death with keynes vs hayek, goldbuggery and peak-everything doomerism.

It seems to me that modern Darwinian world view plus our current set of global problems has led many, many westerners (and also many, many non-westerners) to come to the conclusion that:

“we were not the brightest of monkeys!”

But I for one does believe that we can solve our most difficult global problems without annihilating ourselves by using our faculty which distinguishes us the most from the rest of the animal kingdom: The ability to think not only rationally but also very creatively. The message I have for my fellow westerners is the following:

“we are the most blessed of monkeys!”


Here is how the banker's game works:


1)  Get the government to issue some currency (cash -- paper or reserves at the central bank -- reserves are government issued cash central bank deposits).  Government issued cash is around 5% of the currency (money) supply.  The government issued currency is put into circulation by the government simply spending it.


2)  The rest (95%) of the currency is issued by the private banks.  Each customer loan is a new bank deposit (i.e., new currency) and increases the currency (money) supply of the economy.  Note that this newly created money (currency) is put into circulation by the borrower spending it.  Most currency (about 95% America's currency supply) has been borrowed into existence and when bank customer pays the loan back that amount of currency is removed from circulation.   The banking system cannot go backwards (fewer net loans) as time moves on because fewer net loans means fewer currency in circulation in the economy.

Accumulation of interest charges on outstanding loans means that the currency supply must constantly increase even if it means giving out lower quality loans.  Think of it like a plane flying it must fly at some minimum speed or else the plane (the banking system) will crash (i.e., banking system collapse).


3) The bankers make dam sure that the common public does not understand how the monetary system works meaning that the private banks issue 95% of the currency. This is whole another topic how they do this.


4) The system works until real economic capacity of the economy grows and debts can be serviced and interest charges paid.  Most of the time the economy oscillates between boom (growth) and bust (recession) because bust is needed to clear debts and start a new lending cycle.


5)  Eventually, one of these cycles goes so deep that currency supply (and demand) falls so low that too many debts become un-serviceable.  The recession becomes a depression now.


6)  The bankers then have to decide how to "reset" the system.  One way to reset the system is to let the depression takes its course.  But of course this path is very chaotic because people lose jobs and may become violent.  Once most debts are cleared lending can start again and the currency supply is replenished.   Wars are a good way to get initial money (currency) into an economy after a depression to get demand going again.  This is the great depression scenario.


7) Another way to "reset" the system is to get the government to print too much money and spend and destroy the currency and blame it on the government.  This justifies issuance of a totally new currency (note that hyperinflation clears debts) and the lending cycle can start again.


8) The banking system (as is) is setup to maximize the power and influence of the global bankers and NOT for the maximum general well being of people.  By the way this is a global game.  This is the only system around no matter what country you are in.   The global banking cartel makes sure that no competing systems are allowed to exist (so they might be copied and global bankers will lose power).

9) We need a currency system where money is spent into existence and does not need to be lent into existence so the economy is never starved of currency in circulation.

For more details on this stuff please read the following articles in order listed below:


http://seekingalpha.com/article/209386-modern-monetary-system-there-is-another-way



http://aquinums-razor.blogspot.com/2011/08/what-is-relationship-of-money-to.html



http://aquinums-razor.blogspot.com/2010/07/why-is-deflation-and-depression.html





http://seekingalpha.com/article/210346-should-newly-created-money-be-a-private-or-a-public-asset




http://seekingalpha.com/article/192375-cause-of-today-s-economic-crises-too-much-thrift




http://seekingalpha.com/article/160269-a-radical-solution-for-america-s-insolvent-financial-system




http://seekingalpha.com/article/146658-great-banking-confusion-is-there-a-better-way


Mansoor H. Khan

http://aquinums-razor.blogspot.com/



Saturday, November 27, 2010

We Have to Go Spend Money to Keep From Going Bankrupt


“Well, people when I say that look at me and say, ‘What are you talking about? You’re telling me we have to go spend money to keep from going bankrupt?’” Biden said. “The answer is yes, I’m telling you.”

Vice President Joe Biden said this to people attending an AARP town hall meeting on July 16, 2009 at an event in Alexandria, Virginia (CNSNews.com).

This quote at that time was a butt of many jokes. But I actually agree with him. In order to understand why one has to understand what the idea of “Credit Crunch” really means.

A sustained "Credit Crunch" is a death knell for an economy. Credit Crunch implies that "money supply" is decreasing. Our monetary system of Fractional Reserve Banking is such that decrease in money supply for a prolonged period of time means principal and interest payments on existing debts will become more and more difficult to make and eventually lead to widespread defaults and deflation. Money supply is decreasing even as I write this article due to insufficient new bank lending. The net of all borrowings and paying down of debts to commercial banks HAS to be positive (there has to be more money creation as time goes on due to interest charges). If the net money creation is negative for too long (i.e., severe decrease in money supply) the financial system will simply collapse on itself. It cannot continue functioning.
Remember:

1. When money is borrowed from a commercial bank it is actually created (born) and enters circulation at the time of the funding of the loan.

And the following is even more important:

2. When money is paid back to satisfy principal and interest charges to a commercial bank it is actually DESTROYED (dies) and is removed from circulation.

If you understand (#1 and #2 above) then you will see why the credit crunch is very serious issue. Without a sufficient money supply our economy will collapse (as it did during the great depression).

So, why has Japan avoided a great depression for 20 years (Japan's credit crunch occurred in 1990)? Japan has avoided a great depression because Japan has done what America did to escape the great depression. And that is to spend a lot of (i.e., newly printed and/or borrowed) money on public works projects. Of course America spent a lot of (newly printed and/or borrowed) money on the war effort (WWII).

In fact, after WWII there was another serious economic recession (in 1945 – almost 13% decline in GDP) as war related production was ramped down. The GI Bill, the Marshall Plan, the Space Program and later the highway construction program, the Korean War, the Vietnam war, the cold war defense spending and the star wars defense spending kept us out of a depression. By the same token the Y2K spending, the dot com boom and the housing/real estate boom also kept us out of a depression. Note that it does not matter who prints the money (Banks can print and LEND or the government can print and/or borrow and SPEND). Either way, it works. It keeps the economy out of a depression.

If we cannot get sufficient commercial bank lending going again (Japan has been waiting for 20 years) and if the government does not spend to make up for the insufficient bank lending then we will descend into a depression (due to continued contraction of the money supply).

To properly get around this money supply contraction issue (long term) we have to find a way to create and circulate new money into the economy that is not dependent on lending (that really means getting rid of debt based money creation and doing equity based money creation). For more details please see my earlier article posted here:

Modern Monetary Theory: There Is Another Way (http://aquinums-razor.blogspot.com/2010/11/modern-monetary-theory-there-is-another.html)

Modern Monetary Theory: There Is Another Way


Modern monetary theory seems almost too good be true. It seems as if "one is getting something for nothing". Too many people who understand and write about modern monetary systems are very professor-ish and don't really answer the basic question: How can one get something for nothing?

We do get something -- a lot, actually -- for very little effort. How?

All goods and services (i.e., wealth) creation involves not only production (the engineering part) which is easy to see but also exchange (i.e., trading of one’s produced output for produced output of another person). The exchange part is hard to see unless one is involved in barter. Getting money for one’s produced output and buying other people's produced output with that money is just an extremely efficient form of barter. Therefore, going through this thing called "money" makes barter (trading) extremely efficient. So, there you have it. One is getting something (one becomes extremely efficient at barter) by using fiat money that costs very little to produce.

Of course, the producer (the seller) must trust that the money received will retain its value over time to a sufficient degree. This is the main challenge of all currency management by governments or anyone else: Maintain the trust.

Currency failure occurs when this trust is compromised (actual rampant inflation or an expectation of rampant inflation).

But we have major problems with fiat money: Who gets to create it? How much should be created or destroyed and when? And once created how should it be introduced into circulation? And if some money needs to be destroyed, whose money should be destroyed?

Once one realizes that 97% of economic exchanges (trade) is done using bank deposits (yes, bank deposit=modern money) then one will begin to see why banks are so important because they create (and destroy) and distribute (by lending) this very important commodity. It is a common misconception that governments create money (yes, they create some, called base money or cash - coins, paper bills, reserves at the central bank) but most of it is created (or destroyed) by private banks as they are able to leverage (pyramid) up to 10 or more times the government created money or deleverage and destroy money.

It is this private banking industry’s money creation or money destruction that enables booms (more money creation via more lending) or recessions (less money creation via lending less) or deflationary depressions (credit crunch--very little lending). One way to counter a recession or a credit crunch is for the government itself to create money (or borrow) and spend it (fiscal stimulus or even bailouts or purchases of crap assets by the central bank, etc). This is an attempt to counter the money destruction (money is destroyed as loans are paid back by borrowers and new loans don't entirely replace the destroyed money). This is what Japan (since 1990) and U.S. (since 2008) have been doing.

Both governments are waiting for the credit crunch to go away and more normal private (bank) money creation (i.e, lending) to resume. Which many people think will not resume until bad debts are wrung out of the world economy (i.e, take the hit of a worldwide deflationary depression). A worldwide deflationary depression (I think) will lead to much, much chaos and probably wars and extreme poverty.

But I think that there is another way. We need to modify the process of money creation and distribution itself so the real economy (trade) is not so severely impacted (one major reason for extreme booms and depressions is severe changes in money supply that occur due to too much lending or too little lending).

Summary:

1) Money is extremely useful because it greatly facilitates trade.

2) Fiat money can be created very cheaply and there is no problem keeping up with demand for money.

3) Most money creation (by far) is performed by private banks.

4) Decline in the supply of money (electronic scrip=bank deposits) in the economy greatly hampers trade.

Here is my proposal:

a) Remove government bank deposit protection insurance schemes (e.g., FDIC deposit insurance) and allow “Free Banking”. Allow banks to fail. This will greatly reduce the ability of banks to create bank deposit private money.

b) Give the public the option to “store” money electronically risk-free in a government owned bank which can only “store” electronic money and clear checks but not lend it out. 100% reserve credit risk-free money storage for a small fee.

c) Allow new money creation in all forms (coins, paper bills or bank deposits) by the treasury department.

d) The new money should be put into circulation by spending it on legislature approved government expenses and projects and/or the new money can simply be credited to the citizens’ bank accounts and the public itself can decide what to do with it.

e) The object of the government will be no deflation and no inflation (stable purchasing power). I realize purchasing power is hard to measure and the process can be gamed by the government but benefits are so great that this risk should be taken and managed.

f) If inflation ensues the government can tax and destroy some of the money.

g) If deflation ensues then the government can create new money and spend it on legislature approved government expenses and projects and/or the new money can simply be credited to the citizens’ bank accounts.

Monday, November 22, 2010

Modern Monetary Theory, Inflation and Idle Resources

In this essay I would like to discuss Modern Monetary Theory (MMT) and the insights it offers into the relationship of money, money supply, inflation and idle resources. While discussing MMT with others I quickly find that first we need to agree on the definition of money. The most common and generally accepted definition of money is:

a) It is the most common medium of exchange (i.e., trading of one’s produced output for produced output of another person). Therefore, going through this thing called "money" makes barter (trading) extremely efficient.

b) It is the most vendable good.

c) It is the most liquid asset of a civilization.

d) It is a store of value.

e) It is a unit of account

To this definition we should add a few more attributes when modern money (i.e., fiat money) is being discussed:

f) It is a claim or a promise enforced by legal tender laws of the state and the ability of the state to tax. Modern money is a contract. It is a contract between current and future members of a state (i.e., country). The fact that it is a contract is what gives money its store of value.

g) Most fiat money (by far) is issued (i.e., created) by the banking industry by the act of funding a loan and Not by the state.

h) A bank deposit (modern money) is created by creating a booking entry (an accounting ledger entry). It is essentially an accounting entry.

i) In order for savings (a bank deposit) to exist a debtor (a borrower) must exist.

But the best high level generalized definition of money I have come across is:

Money is a social arrangement!

The above definitions encompasses all the other definitions above and more.

It is the last attribute listed above (item i) that is the most troublesome. I have found that most people do not think of modern money this way. Conclusions of MMT are very heavily dependent on understanding and accepting that in order for savings to exist a borrower must exist. All savings is a promise or a claim of some kind. The exception is commodity or convertible to commodity money (e.g., gold, silver or barrels of oil). Since we don’t have commodity money all savings is a promise or a claim.

Once we have this understanding of modern money we can then discuss conclusions of MMT. I realize there are many people who see modern money as “the problem”. I am not going to discuss this here.

Again, the implicit assumption and insight of MMT is that for a saver to exist a debtor must exist. With MMT frame of reference we can see the issues of national debt, unfunded social security liabilities, trade deficit and budget deficit in a very different way.

Here are some conclusions of MMT:

1) In order for the private sector to save (net savings) the government must have deficit spending or we must as a nation have a trade surplus with our trading partners (i.e., our trading partners must run a trade deficit with us on net basis).

2) If we have balanced trade (no trade surplus or no trade deficit) and the government has a balanced budget then no net private sector savings is possible.

3) All private sector income (i.e., production of goods and services) must be consumed by the private sector or invested by the private sector or exported or spent (i.e., consumed) by the government. This is not specifically a MMT conclusion but I want to highlight it here because it clarifies MMT insights.

4) The national debt represents accumulated deficit spending by the government. By the way of MMT it also represents net accumulated private savings (domestic savings or savings by our trading partners).

5) If the savings rate increases and private investment does not increase and the government spending does not increase and our trading partners don’t buy more from us then the economy must slow down (quantity of production of goods and services must decrease).

I will now discuss some common questions in FAQ format which I get when I have explained the above conclusions of MMT to people. These questions are usually from non-economist and non-financial types:

Question: But I can save money without a debtor being on the other side of the transaction. Can I not simply put physical paper cash in a safe deposit box?

The above statement is true. However, only a very small part of the money supply exists in the form of physical paper cash. Even this form of savings is dependent on the existence of the state to enforce legal tender laws and the ability to tax. We would certainly not want to save any significant amount of our society’s money supply in this form. For example, it would be absurd to try to “fund” unfunded social security liabilities by this method.

Question: Can I not save value by storing gold in safe deposit box? No debtor is required.

The above statement is only partially true. The future economic value of gold is highly dependent on market price of gold in terms of the most common medium of exchange at the time of the exchange. Again, it would be an economic disaster to try to “fund” unfunded social security liabilities by this method.

Question: You say that in order for a bank deposit to exist, a borrower must exist. But isn't one of the problems we have right now is that banks are sitting on more deposits than usual, i.e. refusing to lend? Doesn't that mean that at least some of those deposits exist (can at any time be claimed by the depositor) without a borrower existing? Just because one thing is often paired with another doesn't mean that it has to be.

You are only partially (and very partially correct). When banks don't lend the money supply shrinks (total amount of customer deposits shrink, as existing debts are paid off deposits are destroyed!) and banks excess reserves (cash) deposited at the central bank increase. Yes, base money (cash, reserves) does not require a borrower in order to exist. But our banking system does not operate on 100% reserve basis or anywhere near it. Even if did it would not change the substance of my arguments with respect to MMT. As I have explained earlier, even this form of savings (paper cash or reserves at the central bank) is dependent on the existence of the state to enforce legal tender laws and its ability to tax. In this sense even a 100% reserve bank deposit (like physical paper cash) would be a promise or a claim (like a debt obligation) and not that different from a private borrower’s obligation.

But how does MMT relate to prices and inflation?

As a starting point let us consider the equation of exchange by Irving Fisher:

Total Amount of Money supply * Velocity of Money = Price Level * An index of Goods and Services Produced

Total Amount of Money Supply = Total of Coins + Paper Cash + Bank Deposits

Velocity of Money = the average frequency with which a unit of money is spent in an economy in a given period

Price Level = measure of overall prices for some representative set of goods and services, approximated with a price index, a change in the price index is a measure of inflation

An index of Real Production of Goods and Services = index of the amount of goods and services produced in the economy in a given time period

Even though the inputs in the above equation are at an aggregate level or consist of indexes or cannot directly be measured (i.e., velocity of money) the equation is extremely useful as a mental model for seeing the relationship between money supply and inflation. This equation helps us see that:

I) An increase in the money supply will lead to inflation only if velocity is unchanged (or at least does not decrease) and the economy does not expand its production of goods and services because it is running at capacity (i.e., no idle resources or other constraints are present).

II) A decrease in the velocity of money will lead to deflation (a decline in general price level) if the money supply does not increase and the quantity of real production does not decrease.

III) A decrease in bank lending activity (i.e., which determines the money supply) with constant or decreasing velocity will lead to deflation (a decline in general price level) if the quantity of real production of goods and services does not decrease.

Point number I above tells us that governments can increase economic activity by borrowing and spending without introducing inflation if there are idle resources in the economy (i.e., idle labor or idle factory capacity). In my view all idle resources are wasted resources. Many people automatically assume that deficit spending = inefficient spending. With the help of MMT we can see that if deficit spending uses up idle resources for infrastructure spending and/or tax cuts and/or "social credit" then it is not inefficient. In fact, we will be receiving more in goods and services for our investment in physical capital (e.g., idle factory capacity) or people capital (e.g., ready, willing and able idle labor).

I will now discuss some common questions in FAQ format which I get when I have explained the equation of exchange and its implications to people. Again, these questions are usually from non-economist and non-financial types:

Question: So are you telling me that we can spend our way to prosperity?

Yes, the above statement is true if slack (i.e., idle resources exists in the economy). We can increase our standard of living by simply borrowing and spending. Of course, utilization of idle resource will most likely use up more energy resources (like fossil fuels) or other natural resources (like trees and iron ore).

Question: Doesn’t borrowed money have to be paid back with tax revenue?

Yes and no. Let me explain. Borrowed money does have to be paid back or the debt has to be rolled-over as government debt matures. The Government (via the central bank) is a currency issuer and can always borrow more. MMT helps us here too. MMT views taxation as a reduction of purchasing power of the taxpayer and not a “transfer” of money from the taxpayer to the government. At the time of maturing of the debt owed by the government the decision to roll-over or pay off the debt will depend on at least two variables: The price level (i.e., inflation) and policy goals. If inflation is below target then the government can “safely” print new currency units (via the central bank) and pay off the debt. If inflation is above target then it must reduce its spending (reduce its own purchasing power) and/or tax (i.e., reduce private sector’s purchasing power) in order to keep inflation in check.

Question: Won’t interest charges on borrowed money increase taxation ultimately?

Interest charges can be dealt with the same way as any other contemplated government spending. At least three questions must be asked by government officials. What is the price level (i.e., the inflation rate)? Is it below the target price level? What are the policy goals? Based on the answer to these questions:

A) The government can print fresh new currency units (via the central bank) and pay its bills.

B) The government can borrow currency units from the private sector (again via the central bank) and pay its bills. The difference between A and B is that B is little bit like taxation in that it “temporarily” suspends some of the private sector’s purchasing power.

C) Tax and permanently destroy some of private sector’s purchasing power and/or reduce its own spending.

Question: Looks like that you view the economy like a machine which can be fine tuned? Aren’t there too many variables and feedback loops?

Yes and no. The government has to be good and objective at measuring the inflation rate. The measurement will not be perfect but benefits of MMT are huge. The government will be able to put idle resources to work (in deflationary times) by simply increasing its spending.

Question: But the government has an incentive to understate inflation so it can spend more?

Yes we have to trust our government will not lie about inflation. Perhaps the answer is to call for strengthening the independent monitoring of inflation.

Question: Why is deflation such a bad thing? I want prices to go down. My savings buy more.

Yes savings do buy more in deflationary times. There are many reasons why deflation is just as undesirable as inflation and maybe even more so. Deflationary times usually lead to higher unemployment because labor markets don’t clear as well as predicted by neo-classical economics as described by John Maynard Keynes because workers resist pay cuts.

Also, sustained deflation can lead to depressions as described by Irving Fisher in his “debt deflation theory of depressions”.

Question: You say "MMT views taxation as reduction of purchasing power of the taxpayer and not a 'transfer' of money from the taxpayer to the government." Isn't that the kind of statement that only a theoretician could make, essentially a distinction without a difference? From the point of view of the person paying the taxes, it doesn't matter if a man's money is being "transferred" or his "purchasing power" is being reduced, the end result is the same -- he must get by with fewer loaves of bread. Why do you expect him to be happy with less just because some high-sounding economic theory says it's good for him?

I never expected a person to be happy about their purchasing power being reduced. But if we truly accept MMT we would not worry about balancing the budget. We would think of fiscal responsibility in a very different way. We would focus on inflation (and production capacity) and NOT try to maintain or worry about equality of government revenue and government expenditures. Deficits would not be considered "bad" or surpluses considered "good" in themselves. In fact, MMT tells us that if a government ran a surplus that leads to deflation then it would actually be harmful to the economy.

Thursday, July 29, 2010

Why is deflation and depression inevitable in debt based monetary system like ours?


Money is civilization’s most liquid asset. An asset is something of value. Most liquid means that this is the asset most employees want to get paid in and this is the asset most vendors demand for payment. For United States of America most employees demand payment in U.S. dollars and most vendors price their products in U.S. dollars and demand payment in U.S. dollars.

The next point to note is that prices of most products and services (by far) in the United States are determined by:

1) Demand for the product
2) Supply of the product
3) Total Supply of Dollars

The first two items listed above are intuitive the last listed item listed above (#3) is not intuitive. That is correct: the total supply of dollars available in the economy has a very, very strong influence on prices.

Let us continue. Total Supply of Dollars is comprised of:

a) Coins - Coins are created by the U.S. Mint.
b) Paper Bills - Paper Bills (like the Dollar Bill in your wallet). Paper bills are printed by the U.S. office of printing and engraving.
c) Bank Deposits - Bank deposits are created by the banking system. Any money accessible by “writing a check” counts as money.

Coins and Paper bills are put into circulation by the U.S. government by simply spending them. How bank deposits are created is the key to understanding deflation and depressions. Bank deposits believe it or not rule our world because they comprise 95% of the money circulating in the economy. Money rules our world. More precisely, those with the power to be able to create new bank deposits (i.e., bankers) rule the world. Even politicians are easily manipulated by those who hold the power to create money (i.e., bank deposits).

So how are bank deposits created?

A bank deposit is created when a borrower applies for and is approved for a loan. The actual creation of the bank deposit is nothing more than a booking entry to a “checking account”. The act of funding a loan is simply the act of increasing the balance in the checking account of the borrower. This can occur directly (the bank can simply increase the balance in the checking account of the borrower if the borrower’s checking account happens to be in the same bank) or the bank can just “write a check” and give it to the borrower to spend or deposit it in his checking account.

Don’t worry too much about “how the check clears”? This is not important to understand deflation and depressions. Think of the newly created bank deposit (i.e., new money) as the loot and clearing checks between banks is just how the benefits of this loot is shared among the banks.

Think of the banking system as a one “giant bank” in your mind. Think of it as one giant ledger which keeps tracks of who has how much money. As individuals write checks to each other the increases and decreases are just entries to this giant ledger. All new money (bank deposit) creation is simply an adjustment to this huge ledger. Nothing more. Sounds too good to be true. It is true. Banks however cannot just keep increasing the money supply without worrying about inflation. Inflation is the balancing force. The central bank can do various things to reign in bank lending when it is worried about inflation.

Actually, there is another balancing force. Since new money is created when a loan is funded a bank must find credit worthy borrowers in order to increase the money supply (this last point is not 100% correct, I will explain later).
So far so good. So what is the problem? The problem is that most money in the economy is born (i.e., created) when a loan is funded. And the next point is even more important:

Money dies when a loan is paid back by the borrower!

Yes. That is correct. When a borrower uses money (in most cases another bank deposit) to pay interest and principle to the lending institution the bank deposit used as payment “dies”. Under normal circumstances this is not an issue because new borrowings (new bank deposit creation) normally more than offsets the money (bank deposits) destroyed when loan balance and interest charges are paid down.

So do you see that if the net of borrowings (creation of bank deposits) and paying loans back (destruction of bank deposits) is not such that more money is being created than being destroyed then we will have deflation (due to decrease in money supply) and eventually a depression.

Eventually all debt based money creation systems (like ours) reach a point where the private sector refuses to borrow more because it will eventually become too indebted (even at zero percent interest rates) and the banks will get to a point where they will be too hesitant to lend because they will see the onset of deflation coming. Some people call this “Peak Credit”. But it may take a long time to reach “Peak Credit”. Our current cycle of credit expansion started in 1940 (start of WWII) and ended in 2007. Depressions are usually resolved via resets (massive defaults) and can easily lead to wars and chaos.

So why would we ever design a monetary system which has to end in a deflationary collapse? The answer is very simple:

It keeps bankers in power.

Of course, the resolution to this problem is very simple. Bank deposits should be born (created) as equity and not debt just like Coins and Paper Bills.

Mansoor H. Khan

Tuesday, March 9, 2010

Cause of Today's Economic Crisis: Too Much Thrift


In this essay I want to propose that the ultimate of cause of today's economic crisis is that we have too much thrift. This view is very similar to John Maynard Keynes' Paradox of Thrift. What I want to show is that this is not a paradox at all but confusion about what saving money really means and what consequences it has. I want to explain this confusion by way of examples and not using technical economic jargon usually used by economists. But before I can go into why too much savings leads to a disaster in the modern economy I need to clarify what I mean by savings and what money is by way of an example:

A baker produces ten loaves of bread. He consumes one loaf of bread. He barters one loaf of bread with his neighbor, the dairy farmer, for one gallon of milk. He barters three loaves of bread for one bushel of wheat with his other neighbor, the wheat farmer for wheat for next batch of loaves he will produce tomorrow. He gives one loaf of bread to the poor. He is now left with four loaves of bread. Now, he wants to be able save these loaves for his old age. So he goes to the market and sells his excess four loaves of bread for four pieces of gold. He saves the gold in his mattress. He does this because he will need loaves of bread in old age when he is physically unable to work.

Note that I am going to define pieces of gold as money for now. Because it is easier to understand. We will then expand the discussion to include fiat money. The baker saved four loaves of bread. That is his savings. Note that it is more proper to think of savings as the loaves of bread rather than the pieces of gold under his mattress. The baker is not really interested in pieces of gold but he is convinced that he can exchange them for loaves of bread when he retires. Because of this belief the pieces of gold give him psychological comfort and peace of mind that he physically owns the asset which he can exchange for loaves of bread.

Note that when he gets to his old age and goes back to the market and attempts to exchange the pieces of gold for loaves of bread he will get back loaves of bread based on the market price (in terms of pieces of gold) at the time of exchange. By acquiring pieces of gold (which is the most liquid asset in the baker's civilization) he has effectively acquired equity shares in the world economy (at least in his gold based money example economy of the baker). The market price (in terms of pieces of gold) of the loaf of bread at the future time will depend on the balance of equity shares (money) trying to purchase (bid up the price) of loaves of bread and the supply of loaves of bread at that time. Note that it is not the absolute supply of equity shares (pieces of gold) that matters what matters is the number of equity shares trying to chase (purchase) the supply of loaves of bread at that time. Another way to make the same point is this: The price of loaves of bread will not increase even if more equity shares are created and handed out unless receivers of the equity shares actually attempt to spend the newly created equity shares.

Another way our baker could have attempted to save his loaves of bread for the future is by exchanging his four pieces of gold for shares of Google stock. This gives our baker a chance to acquire even more loaves of bread if Google makes good profits in the future. Of course, the baker is taking a risk. Google may not be able to make good profits.

Now apply this situation to all excess producers participating in world markets (by excess producers I mean people like our baker who produce more loaves of bread than they need for current consumption but would like to consume their output in the future). As people become more and more productive there is more and more excess production (if consumption does not increase in tandem with efficiency increases) then this excess production will be directed (by capital markets) to produce more and more assets which can be exchanged ultimately for consumer goods in the future. This is how we get a boom. Bust happens when excess producers realize their assets (like dot com company shares or residential and commercial real estate holdings) will not yield as much return as they expected and may even give a negative return. Rightly, excess producers then rush to safety of the most liquid asset (cash). This causes asset prices to fall and induces managers to reduce investment spending causing unemployment. But this does not mean our ability to produce goods and services has diminished.

If investment slows down and consumption does not increase production must decrease to match the new level of investment. But what usually happens during a period of reduced investment is that consumption slows down as well (unemployed and those fearing unemployment spend less) reducing demand even more and reducing production even more even though our capacity to produce has not diminished during a bust. Slow down of economic activity feeds on itself devastating the economy. In short, too much thrift devastates the economy.

On top of this productivity (output per labor hour) is continually increasing (and has rocketed upwards in the past 100 years). We will have more and more unemployment unless one of following or combination of the following occurs to a sufficient degree to stem the tide of slowdown of investment activity and improving productivity.

1. Increase investment activity. But this won't occur unless #2 below occurs.

2. Increase our consumption. Increase demand for goods and services.

3. Decrease our labor hours. Work less on a per person basis.

4. Do projects which will "use up" excess production capacity.

All the stuff about too much debt (public and private) , falling asset prices and printing money is just accounting entries. We should use accounting to manage the reality around us to improve our lives and not to get confused about what is going on with the production process itself. Bad private debt should simply be liquidated. Falling asset prices does not mean that our ability to produce real goods and services is diminishing. It is in fact steadily increasing and has been for hundreds of years. Federal debt service charges can be paid off with newly printed money. Inflation will only occur if receivers of the new money actually spend it and even then if we run-up against the capacity of the world economy to deliver the demanded output.

Transfer (sale of) of treasury debt to external entities will only become a problem when the United States dollar stops acting like a global currency.

Since the dollar is (at least right now) a defacto global currency it is acting like equity shares in the economic output of the world economy. Of course, United States will not be able to maintain the position of being the sole power to issue equity shares (global money) as productive capacity of other major nations increases. There are several ways to resolve this:

1. Trade less. Yes, this will slow down productivity increases. USA will build up less national debt and there will be less unemployment in the U.S. This option is not a long term resolution.

2. Share the power to issue global equity (global money) with other major nations and/or major emerging nations on some kind of a formula which everybody is comfortable with. This is a long term solution but requires a major shift in thinking.

3. United States can try to maintain USD as the only legal tender in major international transactions by force (as it does for domestic economic transactions via legal tender laws). This is not a long term solution but may be useful in the short term.

Also see another article I have written: Modern Monetary Theory, Inflation and Idle Resources for more explanation of what to do if inflation ensues.

http://aquinums-razor.blogspot.com/2010/11/modern-monetary-theory-inflation-and.html

Tuesday, September 8, 2009

A Radical Solution for America's Insolvent Financial System


The core problem of the U.S. banking system (and maybe the world's banking system) is not liquidity but insolvency. The liabilities of the United States' banking system exceed the value of its assets. The issue is not only the toxic assets (toxic mortgage backed securities, toxic commercial real estate loans, sub-prime mortgages, alt-A loans, adjustable loans likely to go bust, increase in prime mortgage default rates, etc) but also off-balance sheet liabilities (such as expected huge-unaccounted-for future derivatives losses).

This means that bailouts are just beginning and will require bigger and bigger sums of taxpayer money as time goes on. The government will resort to borrowing more and more and eventually to printing money when treasury debt auctions start failing. The end result of this path is a currency collapse and probably total chaos as expected by gold bugs.

One other way to deal with this issue is to stop the bailouts and let the dominoes fall. Defaults and cross-defaults will cause many, many depository institutions (even very large ones) to collapse leading to extreme decrease in money supply as bank deposits are destroyed. Deposits of failed banks cannot be used to pay bills, make purchases and/or service debts.

Which will probably lead to even more defaults as unemployment increases and debtor's are unable to service their debts. This process will probably cause extreme deflation as businesses lower prices in a bid to survive. This will also lead to wage cuts, increased unemployment and a deflation spiral and much chaos. But probably less chaos than a currency collapse.

Is there a better way?

Here is my idea:

1) We essentially need an orderly bankruptcy and liquidation of the United States' financial system.

2) I suggest we create a government owned bank and transfer all deposits of the private commercial banking system to the new government owned bank. This "transfer" is really just new money creation. This new money will be digital cash (electronic version of physical paper cash). Very much like reserves at the FED.

3) Note that the plan will not create net new money since we will be destroying all deposits of the commercial banking system in the process.

4) All assets of the commercial banking system will be transferred to the government and auctioned off in an orderly manner over the next 10 years. The proceeds from the sale would go to the United States treasury and not the commercial banks. The assumption here is that commercial banks deserve nothing since the entire industry would have been most likely destroyed any way. Even good banks would have been destroyed due to bank runs and defaults if the government had allowed the dominoes to fall. Of course bank shareholders, bank bond holders and counter parties of bank derivatives would not receive anything.

5) After the transfer FDIC protection will be removed for any private bank which wishes to remain in business or any new private depository institution or bank. From that point on the government should make it absolutely clear that there will be no more bailouts and no more conversions. This will discourage (but not completely eliminate) fractional reserve deposit banking and private money creation that results from pyramiding of government created money. This will also limit debasement of the currency that results from fractional reserve deposit banking. In fact, we can have "free banking" from that point on and not even have reserve requirements or capital requirements. All depositors who use private banks will be fully at-risk. The industry will have to set the interest rate high enough to attract depositors.

6) The new government bank will act as an electronic "piggy bank" only. All deposits will be 100% reserve and it will not make any loans. Loan making will be left to the private banking system (with no deposit insurance or a possibility of a future bailout). The new government owned bank exists only as a "safe" money storage and a payment clearing system so the public does not have to carry around physical paper cash to make purchases and pay bills.

7) Of course this plan is not without pain or cost. Cost of funds for banks and borrowers will probably rise as bank deposits are a source of very low cost money for the banks. Nothing is free. We are just exchanging higher cost of funds for removal of systemic failure risk. Economically we are recognizing that when money is loaned there is always credit risk.

8) We are just separating the payment and clearing transaction system which is absolutely necessary for day-to-day commerce (no credit risk) from the loan banking and investment system (has credit risk).

Saturday, July 11, 2009

100% Reserve Account Proposal - Update

Yves Smith of Naked Capitalism has pointed out that Irwing Fisher had proposed something similar in his book, 100% Money (Published in 1935).

Here is how my proposal is different:

Irving Fisher in his book 100% Money (1935) proposed that all banks be required to hold 100% reserves for money deposits payable on demand. In other words the government should outlaw fractional reserve banking. Fisher believed that booms and busts are a result of credit created by fractional reserve banking.

I propose that the government require commercial banks to provide 100% reserve account as one of the options. I do NOT propose that the government should outlaw fractional reserve banking.

Summary:

a) The 100% reserve accounts would just be another option that a public would have. I am in no way saying that banks should be forced to offer 100% reserve deposit accounts only just that they must provide it as one of the choices.

b) I also propose that many institutions absolutely necessary to maintain law and order must not take any credit risk with their liquid capital (utility companies, municipalities, states, hospitals, etc). The idea here is that civil law and order should not be disrupted even if several very large financial institutions fail at the same time.

c) I would also remove the protection of FDIC insurance for moral hazard reasons. But I would still have an FDIC like institution to facilitate a quick and smooth transfer of 100% reserve accounts to another bank from the failing bank. The idea here is to keep the payment system running smoothly so day-to-day commerce can continue to function even if a very large deposit taking institution fails.

d) The main objective is to preserve Adam Smith’s invisible hand in disciplining and destroying poorly managed very large financial institutions. I am not proposing that we write a more stringent Glass-Steagall Act or keep anyone from creating complex financials products (securitization, derivatives, etc.) or keep any bank from investing non-100% reserve bank deposits in risky and/or complex financial products. In fact, I would want most banking regulations repealed, as they are unable to protect us from systemic meltdown. Doing this will greatly lower regulatory compliance costs for banks.

e) I strongly believe that if we don’t let very large financial institutions die then they will eventually economically destroy us by mis-allocating huge amounts of capital. There should be no such bank that is too big to fail. But we also don’t want to descend into total chaos after a meltdown and not be able to maintain a basic payment system to conduct day-to-day commerce.

f) In short, our basic electronic ledger based payment system should function even if several very large deposit taking financial institutions fail at the same time without resorting to physical paper cash to conduct day-to-day transactions. Deposits in 100% reserve accounts will provide a basis to build new viable financial institutions if a meltdown occurs.

g) My proposal is a variation on what is sometimes called “Free Banking” with the 100% reserve deposit account as a required option for the public.

Thursday, July 2, 2009

Welcome Market Oracle and Seeking Alpha Readers


Welcome to Aquinum's Razor.

If you are visiting this site as a result of the article published in Market Oracle and Seeking Alpha, thank you for stopping by!

You should know that the article on those websites is a slightly edited version of the first two blog entries here. In the near future on this blog I will be discussing other economic topics and ideas, including: my thoughts on free markets; how banks create money; why money can't be saved; money supply and fractional reserve banking. Check back in a week or so for the next entry.

Meantime, feel free to peruse what's here, leave your thoughts and comments, and let me know if you have any questions. And have a great Fourth of July weekend!

Thursday, May 7, 2009

Not the End of the World, Part II


This is a continuation of my previous blog entry: Not the End of the World.

In part II I would like to elaborate why I think we could avoid future banking crises, such as the one we are now going through, by adopting slight and strategic "tweaks" to our free market principles (as we currently implement them).

Previously I implied that leaving the resolution of the current banking crisis to the market is like allowing nuclear bombs to explode all over the country (and maybe all over the industrialized world) in order to punish bad management in the banking industry. I suggested that defaults and cross-defaults and bank runs would lead to a nuclear fission-like chain reaction, causing massive bankruptcies and a huge, sudden and violent contraction in the money supply, and probably deep, double-digit unemployment (the unemployment rate during the great depression was 25% -- except now it would probably occur at the speed of the internet).  This would be the classic Adam Smith way of punishing bad behavior by the banking industry. In the modern economy, this would involve a tremendous amount of collateral damage.

As background to my proposed alternatives, I would first like to remind readers how banking currently works, and how the public uses the services of a bank. I would also like to talk about the big difference that exists between paper money and bank deposit money.

Great Confusion

The (usually) transparent process of inter-bank lending works so well that most of the time we don't even think about it. This process has largely weaned the public away from physical paper money. Note that most money (about 90%) now exists only as entries on bank ledgers, backed by loans (debt). Possessing physical dollars is like having equity in the economic output of the United States of America, and has no credit risk associated to it. Physical paper money is not anyone's liability.

Bank deposit money, on the other hand, does have credit risk associated to it. That risk consists of the liability of the bank in which the deposit resides. Strangely enough, most of the time the credit risk of bank deposit money is lower than the theft and physical-loss risk of paper money. That is why we use bank deposit money more than physical money. Through this (normally) transparent process of inter-bank lending, the banking system acts like a huge clearinghouse (essentially a giant ledger) which clears payments between its customers without the physical transfer of cash, and keeps track of who has how much money. Most money in the world economy is not physical (paper cash or gold) but logical (ledger entries).

To summarize: physical paper money is equity. Bank deposit money is backed by debt (actually that's not 100% true--reserves at the federal reserve system are also equity, essentially an electronic version of physical paper cash).

That difference -- that paper money = equity in the nation's economy, and that a bank deposit = debt (a bank obligation) causes great confusion.

We have become very comfortable with bank deposit money, without thinking much about the credit risk we are taking. Bank failures, when they happen, create confusion and chaos because the vast majority of businesses and individuals use banks for convenience (they can write checks rather than handling physical paper cash) and they don't really think much about the credit risk that is normally associated with keeping their money (their most liquid capital) in a bank.

Is There a Better Way?

Now back to the banking crisis. Two solutions suggest themselves: a long term solution and a short term solution. For the purposes of this essay, we'll start with the long term solution.

Consider the banking industry's contribution to society. The banking industry provides three major services to the public:

1. It provides a "safe" place to hold the public's most liquid assets (cash).

2. It acts like a giant clearinghouse (settling checks without physical paper cash transfer).

3. It is a source of loan money (they evaluate the credit worthiness of borrowers). Think of "credit worthiness evaluation" as a service to society. If bankers do a poor job at evaluating credit worthiness they end will up mis-allocating economic resources.

What I am asserting that it is possible to have a banking system where a customer would get benefits 1 and 2 described above without taking a credit risk, if banks gave people a choice between a regular account and a special "100% reserve account." These special accounts, which are not available to the public today, would have no credit risk. The money in such accounts would not be lendable. There would still be fraud risk, of course. A bank desperate for cash might be tempted to "dip" into the reserves allocated to their 100% reserve accounts. Of course we would make such "dipping" illegal. These accounts would be the electronic equivalent of storing physical paper bills in a safe deposit box at the bank.

Such accounts would have no credit risk (like physical paper cash) but would have the benefit of being used in electronic transactions and be accessible by personal checks. Of course, a reserve account would not earn interest but would most likely have monthly maintenance fees associated to it (similar to a safe deposit box; it would also be very much like the reserve accounts that banks have with the FED). Such accounts, if widely used, would lessen the impact of bank failures on the economy in terms of a contraction of the money supply, chaos and confusion--but would not completely eliminate them. More on this later.

Avoiding Future Meltdowns

Lending involves business risks (credit risks). If a customer were to choose a non-reserve account then he would be subject to losing his money. This would force the public to do some homework before handing money over to a bank (in essence, customers would need to consider banks' credit ratings). Of course in this type of setup, a non-reserve account would probably have to pay a higher interest rate than the fractional reserve accounts do today. In fact if the public had a choice of 100% reserve accounts, there would be no need to impose legal reserve requirements on non-reserve accounts. There would be a clear separation between accounts that have a credit risk and accounts that don't. The accounts with credit risk would need to set their interest rates high enough to attract depositors.

If our banking system were setup this way, we would avoid huge systemic risks in the future, since a major part of the money supply would likely be sitting in non-lendable accounts. Many enterprises probably should not take any credit risk with their liquid capital (utility companies, municipalities, states, hospitals, etc.). In any insolvency or bankruptcy the reserve accounts would receive priority, and unless the bank was fraudulently “using” these reserves the deposit owners of such accounts would never lose their money. If an electronic deposit account with no credit risk were available, then any individual or business choosing not to use such an account would be subject to losing their at-risk deposit. If such an alternative were available, then the depositor who chose the lendable money account would be warned that he or she could lose money if the bank became insolvent.

I will go a step further and state that the availability of such accounts (non-lendable, 100% reserve accounts) should be mandated by Congress through force of law. Each business and individual should be able to choose whether they want to take a credit risk or not.

Coming Soon...

In my next blog entry, I will propose general principles that I believe our government should follow, in any situation, when deciding whether or not to interfere in the normal workings of the free market in order to avert or minimize damage to society (and such interference should always be the exception, not the norm).

Stay tuned.

Tuesday, April 28, 2009

Not the End of the World


I have been thinking a great deal about money, banking, credit and gold since the near collapse of the world’s financial system during the week of September 15, 2008.
I have scoured the Internet for articles on this subject.  Economics books don’t help much.  I am not satisfied with their explanations.  However, I believe I have nailed the main issue that needs to be understood.  The following are some thoughts and observations.
Paper Money and Loaves of Bread
Gold bugs (by which I mean, people who push gold as a medium of common exchange or money) are only partially right.  They say world civilization will revert to gold and silver as money when paper money and bank deposits become worthless due to rampant hyperinflation, after a worldwide Weimar Republic type scenario.  This assumes that there will be a complete mistrust of governments and the banking industry.
Even if this unlikely scenario (world wide hyper-inflation) occurs, I believe paper money and bank deposit money will not be abandoned.  The benefits of paper money and modern banking are just too great.  Gold and silver based money requires physical possession, storage, safekeeping services, and transport for exchange in economic transactions (i.e., for making purchases or payment of bills).  Note that there have been hundreds of currencies that have failed due to hyper-inflationary money creation (via both the printing of money and bank-deposit money creation), but this has not meant that people have stopped seeing the value of a paper money system and bank-deposit based economy. 
People know from the collective experience of the last few hundred years (remember, the pound sterling is 317 years old), that when managed properly, this type of economic organization is superior to carrying around gold and silver.  If a worldwide Weimar event does come to pass it will not be the end of paper money and bank deposit money.  We will just have a fresh start with a new currency, much like what Germany did after the Weimar hyperinflation. (Sorry gold bugs and survivalists, we won’t all be shooting at each other, and gold will go up but only in terms of hyper-inflated money, not much in terms of loaves of bread).
Money Creation
At this point, the world civilization has sufficient understanding that too much money creation can lead to hyperinflation and make a currency worthless.  Note that in modern economies, most money creation is done by the banking system through the process of fractional reserve banking
Fractional reserve banking is just another way of saying that cash initially created by the government is lent and re-lent many times over (i.e., lent, deposited, re-lent, deposited again, and so on).  So the initial cash created is multiplied by the banking system.  The economy “acts” like there is more cash than what was originally created by the government, because bank deposits can be used to pay for purchases or to pay bills just like paper cash.  The amount of money thus “created” is only limited by the banking industry’s willingness and ability to find credit-worthy borrowers.  
Note that it is NOT the government creating the money most of the time; it is the banking system doing it.   United States Government-issued paper cash is only 3% of the world’s dollar supply, and its electronic equivalent, the central bank dollar reserves at the FED (sometimes also called “base money” or “high-powered money”) are probably not much more, in percentage terms. 
Collateral Damage
So what is the problem?  The problem is that the world is finding out that Adam Smith needs to be updated.  Economists know that Capitalism works well because the punishment of the marketplace is allowed to destroy bad actors (a la Lehman Brothers).  Henry Paulsen and Ben Bernanke tell us that Lehman Bankruptcy started a chain reaction where there was so much mistrust between counter-parties of the major financial institutions that inter-bank lending and other lending “seized up” (almost stopped).  If that had been allowed to continue we probably would have had extreme deflation very fast (at the speed of the internet). 
Deflation will occur if bank deposits are destroyed. Remember--each commercial bank, savings and loan, credit union or even money market mutual fund that fails would have reduced the total bank deposits in the banking system.  Failure of a depository institution means that its deposits cannot be used to make purchases, or pay bills, by depositors of those institutions (i.e., businesses and individuals).  Defaults lead to cross-defaults (party B defaults because its counter-party A has defaulted).  Cross-defaults on a massive scale, where a money center bank like Citibank is involved, would have led to massive bankruptcies and widespread bank runs. 
Therefore, in order to punish bad actors we would have to inflict tremendous amount of collateral damage on innocent bystanders.  The Great Depression of the 1930s comes to mind.  Adam Smith’s invisible hand works, but sometimes the collateral damage is enormously large. 
Is There a Better Way?
World War II was a pivotal event in human history.  It did so much collateral damage that near the end of the war, world powers were convinced that all-out total “hot” war was no longer an option, given the current technology.  Therefore, world powers started fighting more “cold” than “hot” wars (Roman and Persian Empires probably fought more “hot” than “cold”).  The USA and USSR fought mostly “cold,” with some small “hot” proxy wars. 
The rules of all-out war broke down in the face of massive weaponry.  The superpowers adjusted to the new reality.

Newton's laws break down near the speed of light.  Einstein updated them.

Where am I going with all this?  Today's world economy, where most of the world's money supply (i.e., stuff used to pay bills and make purchases) is in the form of bank deposits residing in mega-institutions, can suddenly and violently contract if the invisible hand is allowed to dole out punishment in the traditional way to bad actors (in this case, poorly managed large financial institutions).  So the trillion-dollar question is... how should Adam Smith be updated? 

I will discuss this next time.