Wednesday, January 28, 2009

Fractional Reserve Banking - A Problem?

As promised, a post on fractional reserve banking (FRB). It is rather an odd subject, and some might think a little too much a matter of detail. However, I would encourage you to read on, as this is something that is useful to discuss in understanding the economy. It is, after all, a central part of our banking system, and also the subject of lots of debate, not to mention a favourite subject of conspiracy theorists.

I will confess that I have had to come back to this introduction, as it has turned into a very long post. However, at the end, you will see why there are some problems with what you are hearing regarding failure of regulation, and also some problems in what is being understood about the state of bank lending and the money supply. I believe that this is important, and that it is important that we all understand FRB.

I had hoped to discuss central banking, but that will have to be left for another time - which means that there is a hole in this discussion. It is a hole I will fill at a later date.

I mentioned when I discussed FRB in a recent post that I had some nagging doubts about the subject. At the time I had read several discussions of the impacts and operations, and had also seen lots of references to the subject from various conspiracy theorists. However, there seemed many interpretations so the subject remained opaque. I thought I had a good understanding, but was not sure. As such, I thought I would look a little deeper, and see if I could grasp why the different interpretations cause so much confusion, and offer my own understanding of the subject.

As what I am presenting is my own interpretation, I have put a list of some of the reading I have undertaken below, as you may want to take a look at the different arguments first hand.

A good starting point in understanding the subject is to understand where FRB came from, as this is very revealing. It actually originates with medieval money changers, whose role was assuring the quality of gold, holding gold securely and facilitation of transactions between merchants. If you believe the conspiracy theorists, they propose that these 'wicked' people would take gold deposits, then secretly and sneakily lend the deposits to other people. In doing so they profited from the money of others, and only kept a fraction of the gold deposited with them. This is, according to some thinking, a fraud in which the depositors are duped by the money changers. They claim that today such wickedness continues (see note 1).

Regardless of the conspiracy theorists, in this situation we can see the essential points of FRB. A depositor deposits gold with an intermediary, the intermediary lends out a proportion of the deposit, and keeps only a fraction of the total deposits. To this we should add that one of the key parts of the system was that, if a depositor wanted their gold, it had to be repaid on demand. As such, we have a situation where, if all the depositors ask for the return of their deposits at the same time, then the gold changer goes bust. They do not have all the gold that has been deposited....

Having heard the conspirator view, an alternative point of view is that there are some good reasons why the gold changers lent the gold deposits. I have given these as a summary below:
  • The law in the medieval period was immature, such that there were cases of gold changers running off with deposits (it still happens today - of course). If only having a fraction of the deposits available, there was less that the gold changer could steal at any one moment. It was a reassurance.
  • For the same reason (that only a fraction of the gold is available) it was more difficult for monarchs/princes to expropriate it. This was common during the medieval period, in particular during times of war.
  • Depositors are also potential borrowers. If you have a person who is a depositor, you will get to know their business. If you know their business, you are more likely to lend to them, as they are less of a credit risk. In addition, lending to them encourages them to keep their deposits with the money-changer. A merchant would want to deposit with a gold changer who also lent, as such a person was most likely to provide credit when it was needed
A more commonsense argument against the idea of the money changers 'cheating' the depositors is that a medieval city was a place of limited size, with trade dominated by merchant guilds, and this makes it highly improbable that the gold changers could secretly lend their depositor money on a regular basis without people noticing. I simply can not imagine that it would be possible to cheat a narrow group of merchants in this way.

Another interesting point from history is that gold changer (from now on I will call them bankers) were sometimes regulated. In one Italian city, the bankers placed collateral with the city in order to be allowed to have a cloth with a shield on their trading table. This was an assurance to the people who deposited with the banker that he had collateral, but others could still act as a banker without such collateral. In other cases a city would have a system of limited licenses, which allowed them to only have a few bankers to monitor. This oligopoly regulation had an advantage for the 'regulators', which was that the city would be able to demand preferential credit terms for the city government as part of giving access to the city banking market.

It is interesting how absolutely clear the situation of FRB is when we look at it in the historical context. In particular, when we see the picture of the depositors giving the gold coins to the banker, and the banker then lending out those same coins to the borrower, we can see that the discussion of banks 'creating' money looks rather odd. I will quote my last discussion, to express how the money 'creation' argument is expressed.
However, the system gets a little bit weird when we think of a bank using my £100 deposit to invest it/deposit it with another bank. That bank then has an £80 deposit from the original bank, but only needs to keep £16 in reserve, leaving £64 which they can then lend. If we think about this, my deposit has allowed lending of £80 + £64, which means that they are lending more than I have deposited (£80 is lent from the original bank, and £64 from the second bank). If we add up the two sums of money available for lending, then we appear to have created money. This is the standard picture of FRB, that money is created from nothing, but I will illustrate further.
However, I went on to say the following (think of it as gold coins not £):
When I enter into bank A and deposit £100, the bank effectively writes me an IOU for the £100. The bank then takes my money and lends £80 to bank B, who writes an IOU to bank A for £80. That bank then lends £64 to a consumer, who writes an IOU to bank B. Whilst it may appear if we look at it in some respects that we are creating money, as more money has been lent than deposited, I think that this is an exaggeration of what is actually happening. In the end, the amount of credit that reaches the end user of the credit has not expanded in the way that those who are anti-FRB seem to imply. Whilst each bank appears to be creating money, the reality is that the more banks that touch the money, the less money there is available to be lent into the economy outside of the banking system.
If we think of it as pieces of gold coming out of one banker's strong box, being placed into another banker's strong box, then being lent to a final borrower, it is very clear that no money is actually 'created'. It is just pieces of gold being moved from one bank to another, but each time the gold moves, there is a note on the balance sheet. The point here is that recording money does not mean the creation of money. I am genuinely puzzled that so many economists seem to have fail to see it this way. A quick reading of the history of FRB makes this obvious, but I thought it was self-evident before this.

Now, having established that FRB does not 'create' money, there are some complications that I will come to later.

Before I deal with anything else, what of the issue of us all being 'dupes'. This is the idea that somehow we are all unaware that the banks are going out lending our money without our knowledge. In the modern world, because of deposit guarantees by governments, we have come to a point where we do not (normally) worry about such issues. However, what if we took the guarantees away? Would we all be 'duped' into depositing at such risk?

The reality is that, even without government guarantees, it is difficult to make the case that depositors are being duped. If this was the case then, in the time when there were no guarantees (e.g. pre-1930s USA), what would have stopped a person from publicising that everyone is being duped and offering a 100% reserve bank. If we all wanted 100% reserves, then someone would have offered a fee based 100% reserve deposit system. In effect, they would corner the banking market. The reality is that, before government guarantees, all depositors would know that the banks lent money, or why else would the banks be in business?

There still remains the idea that it is somehow 'wrong' that a bank can take £100, promise to return the money on demand, and yet still lend £90 of that money. The idea is that this is a fraud. They do not have the right to lend that money, as it must be available for immediate return. This is a common idea amongst Austrian economists, and the link takes you to the relevant section. The interesting point here is that there is a mixing of the role of central banks, and the role of FRB in general. More of that another time....

In the meantime, to answer the question of whether it is wrong to lend the deposits, I will return to discussion in my post on banking regulation (I did not realise it was so long until I looked again today). I discussed an example of an individual with £10,000 to invest. He could put the money in a bank, he could buy shares in the company that he works for, or he could invest the money in his sister's business. In all cases, ignoring government guarantees, he would be in a situation where the capital has gone out of his hands and where he might at some point not be able to withdraw his money. In the case of the bank, there is the possibility of a bank run, in the case of the shares his company share price might be volatile and fall, and in the case of his sisters business (a restaurant) the money might be tied up in equipment.

In all cases he has risked his money, and in all case he is in a position where he might not have immediate access to all of his money. In this example, I would like to highlight the case of his investing in his sister's business. Would we say that his sister is acting fraudulently by taking his money and not being able to return it on demand? I think few would say such a thing.

However, when it comes to banks, they do make this promise. This is the problem, not the FRB system. It is the promise that is the only problem, but there is also an element of self-delusion. If we invest money, then we are surely living a delusion if we think that it is not at risk. When we deposit money with a bank, they will invest that money, and will therefore risk the money. It is no different to our investing with our brother/sister/uncle, who may lose all of our money if their business fails. The only difference is that we choose to allow another fallible individual to invest the money rather than us. If you really want to understand this, I can only suggest that you go through my post on bank reform and money.

Quite simply, the idea that a bank can be regulated such that it will not lose your money is delusional. I address how to manage this in the bank post, so will not repeat it here.

At this point, it might be worth recapping with some key points:
  1. FRB does not 'create' money, however attractive and clever the arguments to the contrary. Think of the strong-boxes and gold as you read the arguments
  2. There is nothing wrong with lending depositors money, provided that you are explicit that there is some kind of risk to their deposit
  3. It is not possible to invest and gain a return on money without risk
For the moment, I would like to return to the example of the person investing £10,000 in his sister's restaurant. Having made the investment, let's imagine that a year later he needs his money back. He goes to his sister, but she does not have the cash available in the business, as she has used her revenue to expand the business. However, she calls her accountant, and asks the accountant to value her business, and provide her brother with the report. Her brother owns a share in the business, and this is given as having a value of £15,000. The brother takes the report to a bank, and asks to borrow £9,000 and offers his share of the business as security. The bank agrees to the loan, and the brother draws down and spends the money in the form of bank notes. The brother writes an IOU.

Have we created money here? The business has £15,000 of equity that he has borrowed against, and the bank has given £9,000 as money in the form of credit. Yesterday the money in the business did not exist, today it does not exist, but there is an entry in an accountants book of £15,000, and an actual £9,000 in physical banknotes circulating in the wider economy. The £15,000 in a book is only notional money, 'perhaps' money, but £9,000 in bank notes has appeared because of it. The money supply measured in the economy appears to have increased. Where has it come from?

In this case, the money is coming from a depositor somewhere. For the sake of simplicity, we will imagine the bank only has one depositor However, the money has been committed to the loan. On the one hand, a person who is a depositor has put £10,000 in their account and the money remains in that account. Nothing is debited from that account. On the other hand, the bank gives the brother £9000, and records that the brother now owes the bank £9000. If you look at the bank it appears that the £9000 has never left it, as it is recorded as still being in the account of the depositor. It looks like there is £10,000 in the bank, and an additional £9000 in the economy. The money supply appears to have increased.

The reality is that it is loaned out, in this case with the notional security of a share in the business. This is the 'fraud'. The bank just hopes that the depositor does not ask for more than £1000 before the payment is made.

If the depositor was to ask for £2000, then the bank would be insolvent, even though it has a very good prospect of returning the full £10,000 to the depositor in the long term. If the depositor asks for £2000, this is a bank run.

As another thought, what happens if the bank refuses to loan the brother the £9000? They do not think the restaurant business is a good business at the moment, and therefore do not accept the accountants figures. In this case, the deposit in the bank sits unused. In this case, there is still £10,000 in the depositor's account, but no £9000 in the wider economy. The money supply has not increased.

All of this looks very reasonable, right up to the point where you think about the movement of the gold coins. When we think about this, we can see that, outside of the banks books, the amount of money has not changed. There is no more money, even though it is recorded that there is. The reality is that, money is not appearing and disappearing, it is just a question of whether the money is utilised or not utilised for lending, and the rest is just book keeping entries.

What is the key difference to the wider economy in these situations? If you believe some pictures, there has been a contraction in the money supply in the second case, and an expansion in the first. However, in both cases the real amount of money available in the economy is the same. It appears that this causes some confusion. People are mixing up book keeping with the actual money. We know that there is no more money, or the bank would be able to lend the money and be able to return the depositor's money.

I will give another example, which is about what counts as money.

In this case, I am going to lend money to my friend Fred. He needs to borrow £10. I give him the money in return for an IOU (I would obviously not ask for an IOU in real life). The same day another friend, David, comes to me also asking to borrow £10. However, I have no money left. The friend has a problem that he pays petrol money to George for a lift in his car to work, and the George will not trust that he will pay later.

I then offer Fred the IOU and sign at the bottom that I am giving the IOU to him. David takes this to George, and presents it to him as payment. George knows me and knows I fulfill my promises, and knows Fred (who wrote the IOU), and trusts that he will pay me. He accepts the IOU and gives David his lift into work.

Have we just created money? Have we just added £10 to the money supply, or even £20? After all, George has just accepted the IOU as payment for a service. I have accepted the IOU as a future payment. The IOU looks and performs exactly as money does. Even more odd is, what happens when Fred pays me, and I pay off the IOU? George rips up the IOU. Have we destroyed money?

How about if, in a different scenario, George knows Fred and also knows that he works in the building industry. George also knows that the building industry is in a slump, so doubts that Fred will be able to pay. He therefore does not accept the IOU. How does this fit with money creation? Have we just shrunk the economy? Does the non-creation of money mean that the money supply has shrunk, or not grown?

The point that I am hoping that I am making here is that the notion of what counts as money is very flexible. This is important in the consideration of FRB, as one of the big questions that is important in the consideration of FRB is what actually counts as a reserve. Furthermore, at what point does something become money? In the case of the IOU for example, does it only become money when it is accepted by George, or is it money anyway? Is it money when it is in my hand, before Fred returns the £10?

This is not an abstract debate, but is at the heart of why there is disagreement over whether FRB is a good or bad thing - a key part of the debate is the definition of what money is....

On the one hand the 'Austrian School' says that it is 'a present good' not a form of credit and therefore a bank becomes like a warehouse, whereas the Keynesians define it as a 'future good'. I am not sure that either perspective is actually very useful, and they also do not account for how ordinary people view money. In my post on banking reform, I offered this definition of money, which I hope will make sense:
In other words, money is a contract for the provision of x amounts of goods and/or services. It allows us not to have to go through life making lots of impossibly complex contracts, between all of the specialisms in which we participate, which would be quite impossible and inefficient to manage. Quite simply, it is better that we use an intermediary that offers the same contractual commitment. In order for this to work, the contract implicitly must have the same value tomorrow as it does today.
You may want to read the full explanation here, if this does not make sense to you. Under this definition, the IOU is money, as there is an underlying contract and it can be used as a unit of exchange. However, it is not very useful as it can only be exchanged in the future, and it is necessary to know that Fred is a builder and that he works in the building industry before we accept or do not accept the value of the contract.

This is important, as what is held as a reserve in a fractional banking system depends on how we look at money. For example, a government bond looks remarkably like an IOU type of money. We need to know a lot of detail about the state of the government in order to know whether the government is likely to be able to honour the underlying contract. The same goes for many financial instruments...they are all IOUs that are money, but with a necessity that we have an understanding of the underlying condition of the issuer of the IOU. In this respect, for all but specialists (and they also struggle with understanding the value of the underlying contract), such money is not much use to ordinary people.

It should be mentioned here that the perception of ordinary people is important in defining money. All money is a collective belief that x will provide y, and any money that does not provide such a belief may be money, but is money of little use. As in the case of the IOU, it only becomes useful if we think Fred will actually get work to support the value of the IOU.

On the other hand, if the money is backed by a fixed specie of a commodity, such as gold, then we know that, whatever happens, we can exchange our money for x amount of something. The contract is explicit and clear to everyone. What this means is not that we have produced price stability, or come to a formula for perfect economics, but rather that we have given money a point of reference that we can all understand. You do not need to be an expert to understand that, if you really want, you can swap x units of currency for x units of gold. Again, you should read my full discussion if you have outstanding questions.

It is here that we come to one of the problems of modern FRB. The problem is that new banking regulations have seen playing around with what can be effectively counted as a reserve. In particular the Basel Committee, which was formed by central bank governors from the G10 countries, established two regulatory frameworks for banks, called Basel I and Basel II. Basel I was drafted in 1988, and has been widely implemented such that it is the key regulation that has been in place in recent years, and Basel II was drafted in 2004 and has therefore been adopted as the de facto modern regulatory standard for OECD banks.

The first accord is one in which they introduced miniminum reserve requirement of 8%, and then delineated these reserves into two different types (tier 1 and tier 2) with 4% required from each tier. For example, in tier 1 we do have the familiar and comforting cash reserves, which means actual money on hand to pay to depositors and capital paid for by the sale of bank equity. However, in tier 2 we start to move further away from our familiar notions of money, and start to include items such as subordinated debt, which is a kind of debt issued by the banks where the debt is at the bottom of the heap in payout (meaning the lender comes at the bottom of any claims in the event of bankruptcy). Already, we are starting to move away from our gold into the strong box, and gold out of the strong box model, as we are doing the something similar to replacing the gold with silver.

On top of this, we also have a problem in the way that the reserve requirements are calculated. Instead of the flat rate of 8% being applied evenly, meaning for every loan, there must be an 8% reserve, Basel I added a system of weighting to different types of lending, such that only certain kinds of loans required the full 8%. This makes the 8% figure entirely notional.

Examples of the weightings can be found below:
  • Sovereign debt held in domestic currency, all OECD debt, and all claims on OECD governments - 0%
  • Bank debt created by banks within the OECD, loans guaranteed by OECD governments, Short term non-OECD bank debt - 20%
  • Residential mortgages - 50%
  • Most other loans - 100%
What we have here is a situation in which the amount that needs to be held in reserve has changed to a variable amount, and that does mean a change in the money supply. In particular, as banks alter the shape of their portfolio, it is possible that the amount of money that is really available outside of the banking system will actually change. Furthermore, under these rules, we have a system in which it is possible to lend to governments with no need to hold reserves. They are given no risk whatsover. If we think back to the history of banking, going back to the medieval period, we had a situation in which governments would grant banking privelages in exchange for preferential terms. It all looks painfully familiar.....

Above all else, it is possible for banks to lend to government with no reserves whatsoever. This means that, in principle, a bank can loan to their government without any deposits whatsoever. This is blatant encouragement to lend to the government and it might be considered that it is no coincidence that the debt of many OECD governments continue to grow at a shocking pace. You may be unsuprised to find that the provision of this facility was not changed in Basel II, though the mechanism has changed...

Another interesting aspect of this new method of reserve calculation was that it saw OECD banks as being nearly risk free, and mortgages as relatively low risk. This is very interesting, as what we have is a group of experts who think that they know what future risks are. We can now see how completely wrong the regulators actually were, as many OECD banks are effectively bankrupt, and I would argue that the same applies to some governments (though this has yet to be proved unlike the banks). The most disturbing part of this is that the regulators implemented the rules to create a stable banking system, but it has resulted in the current chronic instability.

However, this miscalculation of risk was not the only damaging part of this new framework. The framework also led to the development of many of the instruments of the destruction of the banking system that we see today. I have detailed in the post on banking reform how the Bank of England accepts that Basel I led to the development of securitisation, and it is also detailed in a paper by Balin (2008).

Securitisation was a very handy way of being able to keep a low risk weighting whilst actually holding relatively risky debt. Another result of Basel I was that banks 'hid' their risks through 'off balance sheet' entities such as subsidiaries, which allowed them to maintain an appearance of having a low risk status whilst taking significant risks. As such, I will repeat this, just so everyone is clear on this. Basel I led directly to the boom in securitisation and off-balance sheet vehicles that has since destroyed the banking system.

Now we come to Basel II which attempted to rectify the faults of Basel I, and we will see that many of the changes encouraged the current crisis. A positive point was that they sought to stop the off-balance sheet chicanery. However, they also set up a system in which 'approved' ratings agencies would determine the risk weighting of the different kinds of loans.

Welcome to the world of AAA- rated CDOs carrying a 0% risk weighting, meaning that no reserves were needed whatsover for the risk in these instruments! I will not go into all of the details of the various weighting methods for different type of debts, as I am sure that you can grasp the idea that an AAA- CDO having a 0% risk weighting might well have been an incentive for the creation and expansion of such instruments of destruction, and that any system that allows this is problematic. Essentially, the problem is that the ratings agencies had no incentive to rate the risk accurately, as the people issuing the instruments paid, and they also were often incapable of understanding what they were rating.

However, this is not the only problem that was built into Basel II. They also devised a way of monitoring credit risk that encouraged the banks to measure their own credit risks. With the approval of regulators they were encouraged to model the risk on their own loan books, which is where another instrument of destruction was born - the 'rocket scientist' risk models. These were the risks models that predicted that the financial crisis could not happen. These gave them the confidence that all was well, and have rightly been subjected to lots of justified criticism ever since.

In addition to credit risk, we can add calculations for market risk (the now infamous Value at Risk models) and operational risk. I will not detail these as they the problems again were rooted in how the risks were modelled. What we are left with is a new method of calculation of reserves which still retains the 8% starting point, but equally turns this into a notional figure. The calculation is below:

Reserves = 0.08 * risk weighted assets + operational risk reserves + market risk reserves

There were other elements to Basel II such as a widening of the scope for regulatory oversight and other measures but, as in the case of the oversight, it seems that the basic problem is that the regulators were as clueless as the banks themselves in calculating and seeing risk. Their poor performance was no more than a reflection of the poor performance of the ratings agencies.

From this brief discussion, there are several key points that need to be made. The first of these is that FRB does not, of itself, lead to money creation. A change in the actual structure of reserves that are held can, however, change the money supply. If the portfolio of a bank includes lending to government, for example, they are left with more cash to lend to other sectors. In addition, if we think of the strong box of gold, the money supply can be altered by a decision not to lend the money. The money is still there, but not playing an 'active' role in the economy. However, this does not happen in practice.

The theory goes that, as banks become worried, they will stop lending and money will become 'inactive' in the economy. However, the reality is that the money does not become inactive, but instead will go into government bonds, or other 'safe' instruments. What happens is that the government gets yet more finance, and the banks still appear to have lending capacity because the lending makes no impact on their reserves. Remember, loans to AAA rated governments have 0% weighting as they are 'risk free', and therefore make no impact on reserve requirements. It therefore appears that banks are lending less as the lending to government makes no impact on their reserves.

We therefore have a situation at the moment where the banks are apparently 'hoarding' money. However, the more borrowing that governments undertake, the more the banks will lend. All the while, their reserve position is unchanged, giving the impression that they are not lending. Meanwhile the government suggests that the banks are hoarding, and they should therefore increase the money supply to encourage them to lend. The reality is that the money is pouring into government coffers, but that does not mean that the money supply is being reduced. As I have discussed in other posts, the government is merely a buffer to getting the new money into the 'real world' money supply. The government provides capital to the banks, then the banks lend to the government.

The government can not spend immediately, as it takes a while to allocate the money to projects. However, the created money has added to the money supply. It is just that it will take time before it appears in the wider economy. The key point here is that banks never leave money sitting on deposit doing nothing, except in the very, very short term. At present they are not lending into the wider economy as before, such that their reserve position suggests that they are reducing the amount of money in the economy by 'sitting' on deposits. However, they are not sitting on the deposits but moving money into government debt.

In addition to this, money is flowing out of the countries to return money according to demands of depositors overseas. Again, money is not disappearing but ending up in overseas reserves. This money might be 'inactive', but I can not be sure. Are the overseas depositors 'sitting' on the money? Again, I am not sure. However, I am sure that these demands for returns of deposits will represent an outflow of money from many economies, in particular the UK economy. In the case of the US, for the moment, the deposits are still flowing into funding of government debt. How long that can last is the big question....

Since I have been writing this blog I have relied on my sense of logic and rationality as a guide to what I write. I will freely confess that fractional reserve banking has been a great challenge. The challenge was that the explanations just did not make sense, clever as they may have appeared. In particular, it is a subject which many economists have given considerable thought to - but I can not help thinking that they have missed the point, in particular with the view of 'money creation'. I have offered a point of view that suggestst that they have misunderstood what they are seeing, and that they have mixed up balance sheet entries with money that actually reaches the economy. This is a long way from conventional economic theory.

(As such, keeping in mind the strong box holding gold, I recommend reading the references that I have provided, so that you can make up your own minds)

There is no doubt that the regulation of the banking system has made a situation in which the money available in the economy has changed, but this is about regulation, not FRB. The ability for the regulatory system to work has been built in government guarantees of the banking system, which has allowed us, as individuals, to pretend that the banks do not risk our money. After all....if all goes wrong the government will step in and save the banks....

We are now in the process of doing this - stepping in and saving the banks. The trouble is that, it is not the government saving the banks, it is us. This is the lie that governments keep telling us - that they are saving the banks and the financial system. I describe why this is a lie in detail in my last post.

The regulators - who are bankers, economists and politicians - have set up a system in which our banks were supposed to be free of risk, but instead created a system of systemic risk. We are all now paying the price of the wisdom of the regulators and 'experts'. It is all of us that are paying for the misguided regulation, but still there are calls that the same regulators that made the mess do is the mantra, but this call is driven by the same people that have taken our economies to destruction....

Even now, in the midst of the crisis, how many people understand how the reserve requirements actually work, and how these encouraged the problems? I would suggest - very, very few. In such circumstances it is easy to redirect blame on the banks, on 'greedy bankers', but they have just foolishly responded to the incentives and limitations imposed by regulation. We hear considerable chatter about deregulation as the cause of the crisis, but it was actually the regulation, and the distortions of behaviour resultant from the regulation, that caused the crisis.

We can add in to this mix, that many economists have failed to connect the real world with banking balance sheets. FRB appears to be a perfect example, where economists look at balance sheets, rather than the money that flows to real people and business in the economy.

My intention when starting this post was also to discuss the role of central banks in FRB, but I am afraid that this will have to be delayed for the moment, as this post is already far longer than I intended. In particular, the central banks do create money, and also have some significant impacts on the role of FRB. Their role in the economy, as I will discuss at another time, is entirely negative. In a later post I will discuss the central banks, and will refute the conspiracy theorists, whilst pointing out the problems with central banks.

Note 1: Apologies for a long post, but there was no way to get the message over without some kind of detail. As always, comments are welcome. In particular, as I am contradicting so much economic theory I welcome economists to comment (no equations, please, just clear explanations).

Samples of Reading...

Balin, J (2008), Basel I Basel II, and Emerging Markets: A Nontechnical Analysis

Block, W & Garschina, KM 1996, 'Hayek, business cycles and fractional reserve banking: Continuing the de-homogenization process', The Review of Austrian Economics, vol. 9, no. 1, pp. 77-94

Bordo, MD 1990, 'The Lender of Last Resort: Alternative Views and Historical Experience', Economic Review, vol. 47, no. 2, pp. 18–29.

Bordo, MD & Redish, A, 'Why Did the Bank of Canada Emerge in 1935?'

Carlos, DA 1985, 'GOOD-BYE FINANCIAL REPRESSION, HELLO FINANCIAL CRASH', Journal of Development Economics, vol. 19, pp. 1-24.

Cochran, JP, Call, ST & Glahe, FR 1999, 'Credit creation or financial intermediation?: Fractional-reserve banking in a growing economy', Quarterly Journal of Austrian Economics, vol. 2, no. 3, pp. 53-64.

de Soto, JH 1995, 'A critical analysis of central banks and fractional-reserve free banking from the Austrian school perspective', The Review of Austrian Economics, vol. 8, no. 2, pp. 25-38.

de Soto, JH 1998, 'A critical note on fractional-reserve free banking', Quarterly Journal of Austrian Economics, vol. 1, no. 4, pp. 25-49.

Klein, B 1974, 'The Competitive Supply of Money', Journal of Money, Credit and Banking, vol. 6, no. 4, pp. 423-53.

Phillips, RJ & Jerome Levy Economics, I 1995, Narrow Banking Reconsidered: The Functional Approach to Financial Reform, Bard College, Jerome Levy Economics Institute.

Rajan, RG, Center for Research in Security, P & University of, C 1998, 'The Past and Future of Commercial Banking Viewed through an Incomplete Contract Lens', Journal of Money, Credit & Banking, vol. 30, no. 3.

Selgin, G 1994, 'On Ensuring the Acceptability of a New Fiat Money', JOURNAL OF MONEY CREDIT AND BANKING, vol. 26, pp. 808-.

Selgin, G 2000, 'Should We Let Banks Create Money?' INDEPENDENT REVIEW-OAKLAND-, vol. 5, no. 1, pp. 93-100.

Selgin, GA & White, LH 1987, 'THE EVOLUTION OF A FREE BANKING SYSTEM', Economic Inquiry, vol. 25, no. 3, pp. 439-57.

Tobin, J 1964, 'Commercial Banks as Creators of" money"'.

There are plenty more references. I have also skipped the conspiracy theorist references, as you can find these easily online. Some references are also a little incomplete, which I will admit is resultant from being a little tired (a poor excuse). However, you should be able to find them.

Note 1: I have never seen any anti-semitism explicitly expressed in any of the conspiracy theories, but there does sometimes appear to be a sub-text running underneath. I have no reason for sensitivity to such issues, approached the conspiracy theory with an open mind, but could not help but notice this. Still, nothing is explicit, so it could be that there is no such intention and I have imagined this. I am not sure why I would though....

Monday, January 26, 2009

Reflections on the Banking Bailouts

I have been giving some thought to the massive banking bailouts, and I am increasingly concerned about what it going on, and the justifications for the bailouts - the idea that we must 'save the financial system'. The more I think about this, the more curious the expression becomes. In fact, the more I think about it, the more I find the expression to be disturbing. It is being thrown around like confetti by politicians and being repeated by the media. My problem is this. Which financial system are we discussing?

If we actually think about financial systems, the requirements of a 'financial system' are surprisingly simple. Here is what is needed:
  1. A unit of exchange which holds its value, and which is widely accepted and trusted (money)
  2. Institutions where any surplus of money acquired can be safely stored (security of money)
  3. An institutional structure that allows for individuals to use their surplus of money to fund the activities of others, thereby risking their surplus for a greater amount of money in return at some time/times in the future (investment).
Much more could be said on point 3, which is purposefully simplistic. I have kept it that simple, because, however we actually look at the situation, this is pretty well a summary of what is required in a capitalist financial system. If anyone can see any other purpose for the financial system, I would welcome their thoughts.

Returning to the bailouts of the banks, this activity is apparently 'saving the financial system'. My puzzle is this; what is actually being rescued?

Now, before I go any further, I must confess to a very serious error in many of my previous posts. Like many others I have been saying that the government is bailing out the banks, and this is completely wrong. The government is not bailing out the banks, YOU are. I would like to be 100% clear on this. I must emphasise this point because every newspaper article, every columnist, every commentator keeps on talking about the government bailing out the banks, and I have also been guilty of expressing this fallacy.

The reality is that the government only has the value resultant from the efforts of individuals in wealth creation activities as a means to fund the bailouts of the banks. In literal terms, when you go into work today, a considerable part of the value of your labour and efforts are being transferred to the banks. As such, part of the value of your labour is literally being given to the banks. The banks are returning absolutely nothing to you for the value of your labour, and this is why it is a gift. For example, the banks are giving the government shares, but shares in something that is insolvent is giving nothing (see note 2). The government is expropriating a percentage of the value of your labour to give to the banks.

In addition to a part of the value of your labour and efforts today being transferred to the banks, a considerable amount of your future labour is being given to the banks. With every day that passes, the government is literally giving larger and larger amounts of the value of your future labour away, by using that promise of future value to give more money to the banks. This means that, in the future, the value of your labour is no longer all your own, but has been given to others in a binding legal contract. Such has always been the way of government (to expropriate a part of the value of your labour) but now it is doing so in order to give it to the banks.

This is, of itself, a rather disturbing idea. However, as we are now in the business (in the US and UK) of 'quantitative easing' the situation is even more disturbing. For regular readers, apologies for repeating this again, but quantitative easing is unconstrained increases in the supply of money, or money printing. When new money is created, it has no value of itself, but transfers the value from the existing money supply onto the new money, and the new money goes towards government uses. For every newly printed unit of currency, there is a removal of value from every other existing unit of currency. This is a form of taxation and it is a tax on every asset, and every unit of currency held by every individual and organisation. These savings and assets represent the stored value of your past labour. This money is going to be used to support the banks, and will effectively be given to the banks.

What we have is a situation in which part of the value of YOUR labour from the past, present, and future labour is being given to the banks. The banks are offering absolutely nothing in return for the value of your labour that is being transferred to them.

I am hoping that this is now completely clear in your thoughts. The government is not bailing out the banks, your labour - past, present and future - is being given to the banks with absolutely no exchange in return. You are all currently presenting a gift to the banks. The government is telling us all that gifting ever greater parts of the value of your labour is good for us all, and that we should be appreciative of the governments efforts to force us to present these ever increasing gifts to the banks. In this point of view, giving money to the banks is 'good', because we will all benefit from 'saving the financial system'.

It is to be hoped that they have a very, very good reason to be doing this.

At this point we can return to the question of what, exactly, the government might be 'saving', when they say that they are saving the financial system with the value of your labour. It is here that the situation becomes very opaque indeed. If we go back to the first bailouts, the nationalisation of Northern Rock in the UK for example, we were told that it was nationalised to prevent a run on the bank. Later bailouts were being made for exactly the same reasons. In amongst all of the chatter, talks of CDOs, and all of the other complex products that constitute finance, there is a very simple point at the heart of the crisis.

Banks have taken the money from depositors and have 'lost' that money such that they are unable to return either the original deposit or any interest. I will clarify this point, as it is very important. When I say that the banks have lost the money, it conjures up an idea of the money just vanishing.

The money has not vanished, it has been transferred. Money does not vanish, it is transferred from place to place, person to person. It is necessary to remember that the only way that money can be destroyed is by central banks, and the central banks have over the last few years been creating money, not destroying money. There is, of course, the possibility of the destruction of physical bank notes, but I do not think anyone is suggesting that people in Citibank were taking $US and putting a fire under them (though they might as well have done so). As such, the money is not being destroyed, is not vanishing, but is being transferred.

The question is this; where is it being transferred to?

If we think about, for example, the Royal Bank of Scotland (RBS) - it has apparently 'lost' a large amount of money and is therefore insolvent without ongoing gifts from you. It has taken large amounts of deposits from individuals and businesses, and has put that money to work in a very bad way, such that it has lost that money. This means that they have transferred the deposits to others in the expectation of that money being returned with interest, but the person they have transferred it to is unable to return it. This is a loss to the bank, and therefore a loss to the depositors, but we must remember that someone, somewhere was in receipt of that depositor money. It was not destroyed, did not vanish, but was instead transferred.

Let's imagine that the money was used for a person to buy a house. When the individual purchased their new home, RBS provided the finance in the form of a mortgage. When RBS provided the finance, they are transferring some of the money of their depositors to the seller of the house. As such, the money has not vanished, it has been transferred. The former seller now has the money, and will according to their own personal circumstances utilise this money in some way. If we fast forward into the future on this transaction, we can imagine a situation in which the borrower loses his job and stops paying the mortgage, such that RBS is forced to repossess (foreclose for US readers), and sell the property. When they sell the property, after all of their expenses, they do not recover the full value of their original loan, making this a bad investment by RBS. It has just 'lost' some of the depositor's money.

However, as we can see from the above, it has not literally 'lost' the money, it has been transferred. The money is still there, but it is in the hands of the original house owner (assuming he has not spent the money). The money is still there, but the depositors no longer have any claim on the money.

In the case of RBS, it has not only been taking deposits from ordinary people and companies to make investments but has been borrowing on its own account to make investments. We need to careful here, as this borrowing is still based in deposits somewhere. When a bank borrows on the wholesale market, it is borrowing from another bank's depositors, even if indirectly, or through complex instruments. It does not matter how it gets into the hands of RBS, the origin of the money is from the stored value of the labour of individuals, otherwise known as savings.

It is here that we come to the big problem. We know that, one way or another, RBS has taken large sums of money either directly or indirectly from lots of depositors. It has then invested that money very poorly. The money, at every stage, is not literally lost, but it being transferred to somewhere. RBS has committed that it will return money to depositors at a certain rate of interest. They promised to return to the depositors more money than they were given, but no longer even have the full amount of the original deposits which have been transferred somewhere else. When depositors are asking for the return of their money, RBS simply does not have enough money to repay their depositors. This is in part because some of the depositors money is tied up in investments which, if they were sold now, would not return the original sum paid for them, some of the money is tied up in investments that are not immediately accessible, and so forth.

Above all else, their investments have been losing money - but remember that this is not a case of the money vanishing or being destroyed. Someone, somewhere actually has possession of that money.

Here is the important point. None of the money has been destroyed, it has all at some stage been transferred. The question is; where to?

For the moment, I would like to leave this question to one side, and return to what is happening to the money that is being gifted to banks like RBS. We know for a fact that as fast as we are gifting the money to these banks, it is being used for something - such that they are constantly asking the government to arrange that we gift them ever more of the value of our labour. We know where some of that gifting goes. For example, when a person who has deposited their money in RBS goes to a cash machine (ATM), and withdraws £50, that money is available to the depositor because of our gift to the bank. If a UK company writes a cheque for office supplies, then the money will be transferred from RBS to another bank using the gifted money.

However, as we are all aware, ever greater amounts of the value of our labour is being gifted to various banks. When we consider the massive scale of the bailouts, this amount of money is more than can possibly be used for these kinds of day-to-day claims on money deposited with the bank. We are looking at sums of money that are way, way beyond these requirements. However, as fast as we are gifting money, it is disappearing, meaning it is being transferred to somewhere.

The question here is again; where to?

Here is where the situation becomes very disturbing. We now know that, across the Western world (see note 1), that broadly speaking the banks are in a very similar situation. They nearly all seem to require that we gift them lots of the value of our labour. If we are all doing this across the Western world, then we know that we are not transferring the money between Western banks, or at least some of the banks would suddenly become very solvent and have lots of money. This is not happening.

As such, the only answer is that the transfers must be going to non-Western depositors, however that might be indirectly achieved. The question then becomes who, and where?

Whatever has happened, none of the money has been lost, it has been transferred. We are seeing ever greater amounts of the value of our labour being gifted to the banks, but we are not seeing that gift appear within the Western banking system. It is being transferred somewhere else. It is being transferred to our creditors, such as the oil states and China. It is being transferred to repay their lending to us.

It is here that we can start to see the central problem. At this moment in time, our governments are transferring ever larger amounts of money taken from the value of our labour, suggesting that they are doing so in order to protect the 'financial system'. It is at this point that we have to ask which part of the financial system they are actually protecting.

The stereotypical picture that we are offered to justify the protection of the banks is the picture of lines of people outside of the banks trying to gain access to their deposits. We can almost hear the cries of outrage at the idea of the 85 year old lady who loses her life savings in a banking collapse. This is supposed to be the financial system that we are protecting, helping to ensure that the little old lady does not lose her savings.

However, in order to protect that little old ladies' savings (or the deposits of companies or whatever variation of this theme), why has it been necessary for so much to be gifted to the banks? Surely, if there were a bank run, the value of the assets of the bank could have been sold, and the government could then have had the option of using its expropriation of the value of our labour to compensate those who lost deposits. It is here that we can see that something is very wrong in the picture. We know that many of the depositors must be from non-Western countries or the money pouring into the banks would appear somewhere in the Western banking system. They are not just protecting depositors in the country, but all overseas depositors too.

In other words, the value of our labour that is being expropriated by the government and being gifted to the banks is largely being used to pay overseas depositors - the Asian countries, the oil states, not depositors within our own countries. Money is pouring out of the Western world. This is why, when so much money is being dropped into the banks it seems to disappear as fast as it is dropped in. When the banks are announcing losses, they are not actually 'losing' the money, they are transferring the money to a new place. That place is not within the Western world - or someone somewhere would be recovering from the crisis.

The problem is this. What we are actually witnessing is our own insolvency. We are having to service the debts that we owe to all of the creditor countries, and we just do not have the means to service these obligations. As fast as we are gifting the value of our labour to the banks, the banks are then using that gift to repay our external creditors, but it is just not enough. The government is having to expropriate ever greater value of our labour to keep the repayments going.

The next big question in this is to ask whether the value of our labour is actually enough to repay what we collectively owe. We have seen ever greater transfers of money out of our countries, as we now know that that is where the money has been transferred to. Each unit of money transferred out is a promise that we will make a repayment equivalent to x units of our labour value in the future. Money is a means of exchange for goods and services, and provision of goods and services are resultant from labour.

Much of the money that is now being repaid was used to fund consumption. This has come in many forms, consumption by individuals and consumption by government. I have many times repeated that borrowing for consumption now means a future contraction. It has been one of the themes in this blog. The simple fact is that we have been borrowing for consumption, and we are now actually at the point where that consumption is being paid for. With interest. However, as fast as we transfer the money that we owe back to the creditor countries, we are making promises to provide ever more labour, as that is what the money we give promises. The money is a future contract on our labour (even a commodity requires labour for extraction and movement etc.).

The reason why governments are expropriating our labour in such quantity is not to protect domestic depositors, but to protect overseas depositors. The financial system that they are trying to save is a system in which we can maintain our borrowing for consumption, which is not actually the purpose of the financial system at all. Only through the expropriation of ever greater value of our labour can they continue to service the debt, and it is only if they continue to service the debt that we can still continue the system of borrowing to consume. Overall, we are still in the position of borrowing ever more money, and we are now borrowing it in ever greater quantity.

The trouble is that this is just taking us ever deeper into insolvency. We are, with every day that goes by, simply consuming more than we can produce, and the longer this consumption continues, the worse the situation is becoming. I have long argued that we must finally accept that we tighten our belts, and deal with the fact that we are much poorer than we think.

The really terrible part of this is that large sections of the media have actually accepted that the government is bailing out the banks. This is simply not true. What the government is actually doing is very, very rapidly impoverishing us so that we can continue to consume -for a short while longer- more than we can produce. They are doing so by promising and expropriating ever greater amounts of the value of our present, past and future labour.

As I sit here writing this, I can not but help but wonder about whether any of those responsible for these ongoing bailouts have any idea whatsoever of what they are actually doing. They stride around bombastically proclaiming that they are 'saving us', saving the financial system, when the reality is that they are deluding themselves, and every single one of us.

In practical terms, this is what this means; you will be working to pay back the investment made by, for example, a Chinese individual who has deposited their savings in a Chinese bank. Deposits like this is what is currently funding much of the economy. This funding of current spending will, in the end, need to be returned to that depositor with interest. If we take away the cumulative deposits of all of these overseas savers, we are left with a much smaller and poorer economy. The stored value of their labour is quite literally being used by us so that we can consume more than we produce. This is the answer to the cigarette lighter problem I wrote about a long time ago.

How long can we and our governments sustain this process of, on the one hand, spending ever more borrowed money on consumption, and on the other committing ever more of your value of labour into supporting the borrowing and consumption? We are just digging our own hole ever deeper because, unless there is a miracle on the horizon, there is simply no way that we are ever going to produce more than we are consuming. If we keep on borrowing to consume the future contraction will just get ever larger, and ever more devastating.

Yes, if governments can keep on propping up the banks with ever more borrowing to pay off the previous borrowing, this process might, just might, go on a little longer. However, in doing so they just wreak more havoc with the future.

The reality is that our creditors are seeing that this can not be sustained. They are seeing us for what we are. We are like the individual using a credit card to pay off our bank loan and mortgage, and all the while selling our furniture to try to make ends meet. All the while we are doing this, we are still shopping and spending more than we earn. It is madness.......

I have read so much justification for the bailouts. I see it everywhere, in the newspapers, and even in the latest edition of the Economist. They all make it sound so plausible, that the banking system must be saved. What none of them are talking about is that you are gifting your future, present and past wealth so that we can continue to consume that we can pretend that we are the kings of the world for that little bit longer...I very rarely put things so bluntly, but it is pathetic. They are 'saving' the banks in an effort to keep the credit lines open, to convince our creditors that we are not bust.

My answer to the question of what part of the financial system we are saving is quite clear. The financial system that is being saved is the financial system that allows us to consume more than we produce at an ever increasing cost to the future. It is a very different financial system to the one which I detailed at the start of the post. A financial system is not there for us to collectively impoverish ourselves, but that is the financial system we are trying to save.

My answer to the crisis is very simple - better now than later. Let the financial system collapse. It is in any case worthless.

Note 1: I use the Western world very loosely here, and it also includes surplus countries such as Germany. I am therefore being a little too simplistic, but hope I will be forgiven for a compromise to aid the overall clarity.

Note 2: I am a business which is losing money, with greater liabilities than assets. I come to you and say that I will give you a share in my business if you give me a large sum of money. You look at my books, and find that I have assets worth £1000, and liabilities of £2000. I lose £100 a week on operations and my losses are increasing fast. There is no significant forthcoming circumstance I can point to which might indicate a change of this situation. If I give the shares to you, are they actually worth anything? In such a case, the only reason someone might give the sum of money would be if they were mad, or as an act of charity - a gift.

Note 3: I think this post might sound a little odd. I hope it makes sense.

Note 4: I think that I will have to deal with the issue of Fractional Reserve Banking (FRB), which I wanted to avoid for this post. I have already had a comment on the subject, so I think now is the time to deal with it.

I will explain the principle in brief. If lots of people deposit lots of money into a bank, they make an assumption that not everybody will want their money returned at the same time. As such, they are happy to lend out a portion of the money that they get. This means that, if I deposit £100, they feel comfortable to lend a proportion of that money (e.g. keep 20% and lend 80%) in the belief that they can service all of the demands for return of deposits that will actually occur. As such if I deposit £100 they will only keep, for example, £20 available for cash and will then invest the rest. In simple terms, the level of the reserve is set to give a safe margin against an expectation of the maximum demand for return of deposits over x period of time.

A bank run is when everyone starts asking for a return of their deposit at the same time and, because the bank only holds a fraction of the deposits as immediately available to return as cash, they can not return all of the deposits.

However, the system gets a little bit weird when we think of a bank using my £100 deposit to invest it/deposit it with another bank. That bank then has an £80 deposit from the original bank, but only needs to keep £16 in reserve, leaving £64 which they can then lend. If we think about this, my deposit has allowed lending of £80 + £64, which means that they are lending more than I have deposited (£80 is lent from the original bank, and £64 from the second bank). If we add up the two sums of money available for lending, then we appear to have created money. This is the standard picture of FRB, that money is created from nothing, but I will illustrate further.

When I enter into bank A and deposit £100, the bank effectively writes me an IOU for the £100. The bank then takes my money and lends £80 to bank B, who writes an IOU to bank A for £80. That bank then lends £64 to a consumer, who writes an IOU to bank B. Whilst it may appear if we look at it in some respects that we are creating money, as more money has been lent than deposited, I think that this is an exaggeration of what is actually happening. In the end, the amount of credit that reaches the end user of the credit has not expanded in the way that those who are anti-FRB seem to imply. Whilst each bank appears to be creating money, the reality is that the more banks that touch the money, the less money there is available to be lent into the economy outside of the banking system.

If you look at the table such as the one shown in Wikipedia, it is accurate but it is deceptive as each transfer from bank to bank actually diminishes the amount of credit available to end users outside of the banking system. Each time a bank touches the money, the availability of credit outside of the banking system actually reduces. In other words you can increase the money supply within the banking system itself, but the more that my deposit is used for intra-bank loans, the less of my original deposit is available outside of the system.

If we look at my £100 deposit, as soon as Bank A lends it to Bank B, only £64 is available to lend outside of the banking system. On the other hand, if Bank A lends the money directly to a consumer or business, they have £80 to lend.

Now I will freely confess that this appears to go against much of the thinking about FRB, and that there are many very clever people who theorise about this. However, as hard as I look, I can only find a situation in which the more that my deposit is loaned within the banking system, the less money that is available in the economy outside of the banking system. As such, if you take the example given in Wikipedia, it appears that money is being created, but the reality is that available credit outside of the banking system is destroyed.

In this situation, it appears to me that if banks stop lending to each other, then the deposits that are held by the banks will make available more credit external to the banking system. I am more than happy to have somebody correct me on this, as this is just the result of my own thinking on the subject, and maybe I am missing something/ or misunderstanding something. It is one of the few areas in my own thoughts about economics where I have nagging doubts. I only have doubts on the basis that so many people seem to imply that FRB creates money available in the wider economy, but I find that this is not the case. In fact, I find that the more money that is created in the banking system the less the availability of money in the economy.

Perhaps I just have it wrong? Comments welcomed (please note that I am not talking about central banks lending into the banking system here which has a different starting point altogether, and where money and credit can both be created).

Saturday, January 24, 2009

The Myth of the Eternal Status of the $US as 'the' Reserve Currency

There appears to be a mantra that is said in response to the idea of the collapse of the $US, which is to repeat the words '...but it is the world's reserve currency...'

Wherever I look, including occasional comments on the blog, I keep seeing this as a justification for why the $US will not fall. I feel it is time to address this point of view directly. I have, in part, answered some of the points in a recent post in the notes sections. However, I would guess that not everybody will get as far as the notes and, in any case, the points that I made could do with a little more elaboration and explanation. It is quite a lengthy post, but it must cover quite a bit of ground before it all pulls together at the end.

Before going further it might be useful to think about what a reserve currency actually is. First and foremost it is a way in which governments/central banks can store value, and it will be a currency that is the basis for comparison and execution in trade transactions. This is currently the function of the $US, which is the major reserve currency, with the Euro taking second place and the £GB third place (or perhaps it has slipped from this position of late?). However, in order for it to be the currency of transaction comparison, it must have a strong position in its own right in the world trading system.

At the moment there is no question at all that the $US is important as a reserve currency, and to deny this role would be fatuous. A large amount of trade is transacted in the currency as well as being the primary currency for government/central bank reserves.

However, that this is the current situation does not imply that this will be the situation into eternity. It is worth remembering that the £GB was once the reserve currency, but economic weakness saw it overtaken by the $US. In other words, reserve status is not a magical and unalterable fact. In many cases I sense that the argument against the collapse of the $US is actually a belief that a world in which the $US is not the reserve currency is an impossibility. This is not an argument, but an act of faith - a reserve currency does not exist by magic. The $US became the reserve currency due to the underlying economic strength and weight of the US in the world economy.

Before starting to look at the US role in the world economy, let's first of all be very clear about a particular point. Unlike the UK, the US is still a manufacturing heavyweight, and output of manufacturing has remained strong (the link takes you to an article that proposes that the service economy is supportable but it provides a useful chart), despite the decline of numbers of people employed in manufacturing.

In addition (again unlike the UK) added value from manufacturing in the US has been increasing. However, the same can be said of many competitors of the US, such as China. I found it very hard to find good data for this but did find this rather useful table (I suggest you pause and take a look at the link and the added value columns, taking particular note of the US and China).

As you will see in the table, the relative growth rates in added value between for example China and US are not very encouraging for the US on balance, and the data only goes to 2001. We should remember that China's growth rate has been accelerating. This is not to take away from the real gains in the US, but to emphasise that the position is relative slipping in comparison to China. I think we can safely assume that China's growth in added value will have seen very significant improvements since 2001, and we might speculate that the US may have gone into decline. At the very least, it is unlikely to have seen much growth (if anyone has better and more up to date figures, please feel free to post the link, as I do not like to make assumptions).

What we have here so far is not too bad a picture. The US appears to be doing well, but others are catching up fast.

However, this is not the whole story as, for example, the last point in time at which there was a US merchandise trade surplus was 1975. What this means is that the US consumes more than it produces in merchandise. Set against this, it might be argued, strength does not just lie in manufacturing but also as income from investments and export of services, intellectual property and so forth. The problem here is that the US has been running a continual current account deficit for a very long time. In other words, the US as a whole is running, in very crude terms, at an ongoing operational loss.

What we have here is a mixed bag of statistics and information, but no clear sense of what this actually means.

In order to understand what this actually means, there is a very curious and rather apt analogy that we can make with the US economy and the troubles of the US car industry. We might think of the US as General Motors (GM), and China as being like Toyota (we could add in Europe as Ford, and so forth, but for simplicity we will just look at the two). There are many parallels that we can make between the US auto market, and the world economy. An obvious parallel is the increase in market share of Toyota at the expense of GM, the ongoing losses at GM and the ongoing (until now) profits at Toyota. In both the US car market and global economy, there has been growth, but in both cases there has been a building of overcapacity (with resultant tough competition).

Added to this we have a contraction of demand in both the world economy, and a (more) dramatic contraction in the US automotive market. This contraction is cruelly exposing the weaknesses that were not so apparent in the 'good times'. This resemblance is most helpful to illustrate the bad state of the US economy, in particular if we think of the bailout of GM by the US government.

In the case of the GM bailout, the US government quite reasonably pointed out that GM had been having difficulties for a long time, and that the problems were evident during the good times. GM were already loaded up with mountains of debt, were saddled with huge structural legacy costs, their workers were paid far more than the workers in the Toyota factories, but with no advantage to explain this differential. They had been increasingly bleeding money. Whilst GM were still producing volume, they were simply not turning that volume into an overall profit. This might be a description of the US economy as a whole in comparison with China, although in an exaggerated form.

As a result of the fact that the problems were long standing, key conditions of the bailout were that GM management addressed the problems of both their legacy costs, as well as the wage differential between their workers and the Toyota workers. This was the minimum that was required. The government was willing to tide GM over for a short period, but only on the basis that they would have a breathing space to deal with these issues, and come back with a plan on how to move from making a loss to eventual profitability. This latter point will be the basis for any further assistance.

Few would argue that these demands are not reasonable, as the government wants to know that it is not going to be pouring money into a black hole (though, this is of course a political process, so whether the politicians will ever actually look at the eventual plan in a realistic and hard headed way is questionable). Few would also dispute that the declining market share of GM in relation to Toyota, the ongoing losses, are a big worry, and that the government is right to demand a plan from GM to show the way to profitability. Quite simply, the government does not want to throw money into a company that has no clear route to ever returning to profit.

It is at this point we need to ask the question about whether the US government is treating its own plans for the US economy in the way that it has treated the GM bailout. The US is still producing volume, but is operating at a loss. It is losing market share to a rival, which has been growing steadily and doing so profitably. Whilst both are suffering in the current market conditions, one has a large surplus with which to tide itself over, and the other is saddled with large debts. One is relatively loaded with legacy costs and the other is relatively free of such costs. In the past, GM and the US had a strong technological advantage, but even that advantage is eroding rapidly. In the case of the automotive industry, companies like Toyota appear to have surpassed GM in development, but this is not the case for the US economy and China. However, the differential is fast eroding, with China rapidly climbing the technological value chain.

If we look at the financial position of GM and the US at the moment, in very broad terms, they are aslo in a similar position. They share the problem that, even as debt is increasing, revenues are rapidly decreasing. This means that the debt is growing in both absolute terms, and in relation to revenue. This means that there is ever less income with which to service the existing debt, let alone any new debt.

I will not pretend that the US economy are the same, but the comparison/analogy does illustrate an important point when we consider the bailouts.

Whilst the bailout of GM is contingent (in principle) on a clearly defined route out of trouble, including a reduction in structural costs of the business, no such clearly defined route to reverse the deficits is being outlined for the US economy. It is just believed that, somehow, it will all come right in the end. For example, the GM autoworkers are being told that they will have to accept a cut in their pay and benefits package to narrow the gap with the Japanese transplant factories. As yet, no solid proposals for such plans have been forthcoming for the US economy. Various commentators are suggesting that there will be proposals to control the spending on welfare programmes for example, but nobody is saying that spending will be reduced.

In the case of Irwin Stelzer, his interpretation appears to be that the 'control' of expenditure will happen at some undisclosed notional better economic time in the future. In other words, everything will carry on as before, with any hardship delayed to some notional point in the future. Such a proposal from GM would rightly be regarded as a completely unrealistic denial of their underlying situation. Apparently, for the US economy, the same principles do not apply. If the stimulus/US bailout plan were subjected to the same basic consideration as the GM plan, it would be thrown out without any hesitation. It does not address the basic problems of the US economy at all.

As an aside, in one other respect, we have another curious comparison. One of the conditions of the bailout of GM appears to be that it must invest in electric cars. There is no proven market for these cars, no reason to believe that they will be a success, but a significant slice of their investment programme will be devoted to this cause. In much the same way, the US government is pouring 'stimulus' money into various green programmes. In both cases, there is a situation of significant financial problems, and in both cases precious capital will be sunk into activities with dubious prospects of positive returns. In both cases, economic pragmatism is bowing to the interests of politics. As I mentioned, an aside.

Overall, what we have is a situation in which the US government is seeking to rescue the economy in a way that would not pass their own criteria for the bailout of GM. The US government would not award a bailout to itself if it asked the same questions of itself as it did GM. It seems the basic questions that apply to GM do not, for no apparent reason, apply to the US economy. Overseas creditors will be taking note of the lack of a clear plan for return to surplus. They are not fools.

This should be a worry....but the $US is a reserve currency, so its ok. The US can just keep creating money, and all will be well. As I have mentioned, the US government is not an automotive manufacturer - we should remember that the US is a sovereign country, not a company able to turn to its own government as lender of last resort. In the case of the US government it has the central bank, and more of that later...

If the US wishes to borrow (aside from the central bank), it has two avenues for borrowing. On the one hand, it can use the deposits of US savers who, through the banking system, can buy government bonds. However, as we are all aware, the government is having to lend large amounts of money to the banks in order to prevent their bankruptcy, as they are insolvent and have lost much of their depositor's capital. The fact that the banks are also then lending this government money back to the government does not help in terms of clarity, but a money-go-round does not actually increase the finance available to the government through borrowing, and more of that later....

The bottom line is that the only way that the US government can really continue borrowing in normal ways is by raising money in international markets, and that means gaining finance from the surplus countries such as the oil producers and the big exporters like China and Japan. There is also potential for funding from countries like the UK where there is increasing nervousness about holding the £GB, and where the $US is still seen as a safe haven. The trouble is that, at this moment in time, all across the OECD governments are all on simultaneous borrowing binge, meaning that there is significant competition for available capital.

So far, the US has done very well out of this, as there has been a 'flight to safety', with the $US seen as a safe haven. This is the advantage of being the main reserve currency. It is the natural place to go when the markets are spooked. As a result, the $US has managed to defy gravity, and has remained relatively steady.

However, I will now quote a note from my previous post, regarding one of the major creditors to the US (again I am discussing China but the principle will apply to other holders of $US reserves):
However, a good way of looking at this is to think of yourself in the position of Hu Jintao. He is seeing that his exporters are collapsing, and that the growth necessary for stability is dropping away. Set against this, he has huge piles of foreign currency, a strong position to spend to support his economy. However, he has a difficult problem.

All the while his economy has been growing, it has accumulated massive reserves of foreign currency. In order to enact a stimulus, he really needs to utilise some of these reserves in order to prop up his economy. However, in order to utilise those reserves, they need to be sold into the market place to buy, for example, the commodities that will be required in support of infrastructure projects. If China starts trying to sell those reserves, he is in a position where there will be a flood of the currencies onto the markets. That flood of currency will depreciate the currency, as there are not enough goods to be purchased in the currency, and likely little demand at this time to use the currency as a reserve. During the downturn, others will equally want to use their reserves to finance their way through the trouble, rather than accumulating greater reserves.

If we look at the $US, if this is sold into the market, and sees the resultant depreciation, then there will be further troubles for exporters. Although the RMB is not a free floating currency, if the $US depreciates, and the RMB does not appreciate, the US will (quite reasonably) howl with rage, and will take protectionist measures. If that is the case, China can say goodbye to one of the major export markets.

In other words, what China has done is accumulate currency that it dare not use as, if it uses the currency, it will destroy the currency. The only solution available will be to try to discreetly sell as much of the currency as it can without 'spooking' the markets.

The trouble is that, with so many countries holding these $US reserves, most of whom have their own economic problems, it is likely that everyone is having the same thoughts, and confronting similar problems. What you have is a situation in which there is something like a Mexican stand-off. As soon as one starts selling, then everybody must start selling. They are all, at the same time, terrified of selling, because in doing so, they destroy the value of what they are selling. It is a time bomb just waiting to go off.
What I am pointing to here is a big contradiction. The $US is the reserve currency by tradition, but it is now clear that there is a fundamental problem with the currency. It is close to being completely unusable. This is not a reserve currency in that it is not a store of value.

The problem is more serious than I have suggested in the above quote. Mr. Hu is facing an even sharper dilemma. He has all of these $US reserves, a currency that he dare not use, but he will become increasingly in need of something to prop up his own economy. However, as we are all aware, the US is now on the path of quantitative easing, or printing money without constraint. At present, this has not yet fed into inflation but, as I explained in a previous post, the government is acting as a buffer soaking up the newly minted money before it actually reaches the market. A large part of the new money goes through the money-go-round creating a buffer, and the newly created money must go through the government before reaching the open market, and the government thereby also acts as a buffer on the money reaching the market. However, as the governments plans are enacted, this new money will eventually appear in the market place.

In a previous note on a post, I had the following to say regarding the UK, but it applies to the US:
If, for example, the banks use money to finance borrowing of overseas governments, this is a net outflow of currency, which will further weaken the £GB. If the money remains in the UK, it will eventually reach the economy in the form of loan guarantees, and various other government stimuli measures. In all cases, the money does eventually reach the market. The important point in all of this is that there is a significant buffer in all of this, which is the ability of the government to actually utilise the money such that it reaches both businesses and consumers in the UK.
I believe that in the case of the US, the freshly printed money is going straight to the banks, then is being lent to the US government, with very little going outside the US. As such there is going to be an increase in the money supply in the US in the near future, and that money will have nowhere to go except to chase a limited number of goods and services. The reason for this is quite difficult to explain, but I will try my best.

The first consideration is the supply of $US over time. There is a chart here which shows the massive amount of $US reserves that are now held by governments around the world. You will note the amazing rate of growth. One of the reasons that has been cited for the growth in reserves was the experience of the Asian crisis, but I will leave that to one side for the moment. The important point is that, as fast as the US could create money, it has been soaked up as increases in reserves around the world.

At the same time as this has happened, there have been several asset bubbles in the US, including the housing bubble. These have also soaked up the increase in money.

The problem here is that the US central bank has been pumping out huge amounts of money out with no apparent inflation. Like many central banker fixations, they have obsessed about inflation. Inflation happens when there is too much money chasing a limited number of goods or services. However, what has been happening is that the huge amount of printed money has been soaked up by central banks for reserves, and soaked up in asset price inflation, such that it has not been chasing goods and services. Furthermore the supply of goods has been increasing with the growing productive muscle of the emerging economies. As such, there has been a combination of very serious inflation in the money supply in the US without a corresponding increase in measured inflation.

Now the expression measured is very important, because asset price inflation did not count in official inflation. In particular, as fast as new money was produced, asset prices such as houses inflated. Greenspan, in his wisdom, allowed one bubble after another to soak up the expansion in money. However, we have now gone one bubble too far, and there is no new bubble on the horizon to soak up the money being dropped into the market (which would in any case just be a delay, not something that would be a 'good' thing). As such, one of the sources of money absorption has been bubbles in assets, which stopped the prices of other goods going up. Mainstream economists seem to think inflation was conquered, but it was just displaced into something that was not measured.

The other absorber of $US I mentioned was the steady accumulation of $US reserves by central banks. To understand this we have to once again imagine Mr. Hu in his Beijing office. Mr. Hu has a series of dilemmas with which he must wrestle.

On the one hand, he has more reserves than he can possibly do anything with. If he uses them, he destroys them. However, he needs to save his own economy. One way of doing that is to keep the exports flowing to the US. However, if he does that, he will simply accumulate even more reserves which he can do nothing with. Furthermore, if he is looking at the US plans with any kind of critical evaluation (which he has hinted at) then he will not see great prospects for the future value of the $US reserves.

In addition, without the exports to the US, Mr. Hu will see further contraction in his own economy, and possibly social unrest. In order for the exports to save him, he must accept the continuation of a system in which China exchanges pieces of paper with nice pictures on them in exchange for goods. In other words he must finance US consumption with massively subsidised Chinese production.

The problem is that Mr. Hu is not alone. There are many people sitting on $US as reserves but with very little that they can do with them. The trouble is that the money was issued without a corresponding growth in the output of value in the US economy. Instead of real growth in value, there was an apparent growth due to debt fuelled consumption. As such, there has been a significant growth in the supply of money without a significant growth in real output of value. As I have pointed out in many posts, GDP is a sham figure that is meaningless unless the source of the activity is included. Debt driven consumption produces significant activity now, but at the cost of future activity. It does not signify that an economy is creating more value or wealth, just more activity. In the case of debt fuelled growth, it is a mirage.

As such, what we have is a situation in which there has been a massive expansion in the money supply, but no commensurate sustainable expansion in the products or services that the money supply can purchase. As such supply of $US has outstripped the supply of US produced goods and services, and by a very large amount.

If we return to Mr. Hu, and those in a similar position, the only way out for them is to continue to soak up ever more $US. This is because there is now no assset bubble within the US to soak up the newly created money coming off the printing presses. There is no place for the newly created money to go into the US economy as it does not produce enough goods and services to soak up the money. This means that the only place it can go is overseas, meaning yet further $US accumulating in reserves overseas.

The trouble is that they already have more $US than they can do anything with. The fact that the $US is a 'reserve currency' is what has allowed for the destruction of the currency. As long as the $US was the reserve currency, it was possible for more and more to be issued for other central banks to accumulate, and this situation was not a problem - right up until now when all of the holders of the reserves need to actually utilise them. It is now that their real status as a reserve currency is being tested - that test is their worth as a store of value. It is failing that test.

In such a situation, the mantra that the $US will be saved because it is the 'reserve currency' starts to look increasingly weak. Here are the fundamental questions:

Why would anyone want more $US when the reserves that they have are already beyond any utility? For example, why would China wish to continue to pay for US consumption with their labour and savings? Why would any country wish to do this, as many other countries are in the same position of holding large $US reserves? As such, I would ask those who argue that the $US will not fall 'because it is a reserve currency' the following question:

'Under what circumstance do you think that a currency might lose its status as a reserve currency?'

In other words, how much money does the US need to pump into the market before every country, every individual, and every organisation calls 'enough'? How completely useless must the currency be before it collapses. Quite literally, there is $US trillion + out there, which no one can find any use for. If they use their reserves in any quantity, they risk destruction of their reserves.

Do the defenders of the $US as a reserve currency think that the creditors have not noticed that they are sitting on piles of paper they can not use? Do they think they are not analysing the US stimulus plan and not going through every detail looking for the time when they will be repaid for their loans? They are sitting on their reserves, and probably wondering if they will ever be of any use, of any value. With more money being pumped out, they will be getting very agitated. When they look at the stimulus plans, all they will see is ongoing deficits, and no plan for return to a surplus. Ever.

I must emphasise this point. At no point has anyone in the US government to my knowledge offered any plan that has not involved ongoing increase in debt, increase in the money supply, and there has been no plan whatsoever to return to surplus.

Under the current circumstances the $US is not a store of value, but a destroyer of value. I can almost visualise the meetings in governments around the world, as brows furrow over the central problem of the $US. What will be causing those brows to furrow is that, if the $US goes down, the world economy will follow it on down. On the other hand, if everyone holds on to the $US, the only way they can save it is through absorbing an ever increasing supply of $US, which means an ongoing financing of US profligacy in return for a currency of ever faster decreasing value.

Furthermore, the massive increase in supply of $US that comes with quantitative easing is just going to make the value of their existing $US more questionable, even without the prospect of adding more junk to the pile. The greater the supply of $US that are printed, the more that everyone is subsidising the US at the expense of their own economies and their own populations.

There is even worse than this for the $US reserve holders. Either they absorb those excess $US that are being created or that money will sit in the US chasing the limited stock of goods and services that are available from the US economy itself, thereby creating hyper-inflation within the US, and thereby also destroying the value of the $US. Either they subsidise exports and absorb the new money, or the value of their reserves is destroyed.

They must finance the US deficit and trade imbalances, or the $US is junk, and the world economy becomes junk with it. As I said, a Mexican standoff. Someone is going to blink, start selling the $US, and everyone will follow. The dollars will pour into the market.

I suspect that the US government and central banks around the world are in regular discussion on this issue, though less directly than I have put it here. It will be dressed up in nice language, and will all be terribly civilised and discussed in technical evasions of the reality. However - there will be a subtext - on the one side the US will be pointing to an apocalypse if the $US falls, and on the other side there will be the furrowed brows.

It is a very fragile situation, and it just needs a small push.....

Note 1: This has been a very challenging post to pull together, so I am worried that I may have missed points, or not been as clear as I should be. As such, any comments will be very welcome, in particular if there are any inconsistencies in the post.

Note 2: In a table earlier, you may also note that the UK has seen growth in manufacturing output, but this brings me to an interesting point. I will quote my first essay for the blog as follows:
'According to an EMEA report, gross added value from manufacturing in the UK saw a rise in the mid-nineties, followed by a decline in the early 2000 period, a decline that led to the added value falling back in 2005 to where it had been in 1999[20]. '
I have put this in as an aside, in case the figures in the table encourage a false sense of confidence in the UK economy. Also, you will see from another table I linked to a similar picture.

Note 3: This is a very long post, and I apologise for not responding to comments this time. However, many thanks for the comments and the many very useful and interesting links.

Note 4: I am aware I am focusing on China but, as I have mentioned in many posts, China is increasingly in the driving seat for what happens next. Of course, it is only one player amongst many, but it is an increasingly important player with potential to effect significant change. For example, if China were to bite the bullet and continue to finance US deficits....then the day of reckoning for the $US might be delayed for a while yet (though will still happen eventually).