The Multilplier Effect of Borrowing and Economic Structure

This was originally part of a larger post, but I decided to edit it down to a single point, and will probably chop the remainder of the post up later. As such, it is not up to date on the latest news, but the news on which it is based I think is not the stuff of 'events', but rather reveals something which is driving current problems in Europe and many other countries are facing.This is from the article that started the post:

“This week the socialist government in France went berserk with austerity and tightening measures. This could put the country’s recovery at serious risk and perhaps President François Hollande may need to re-read the economic page on ‘fiscal multipliers’ – if no book is available the S&P Rating Services offers a sanguine view on page 5. The study proves how the fiscal multiplier in Spain has been closer to 6 to 1, rather than 1 to 0.5% rule which IMF applies. In the case of France we have an economy with low rates, an expensive labour market and now a new marginal tax of 75% - everything being equal will that lead to lower or higher growth?  I think you know the answer, even without 5 years wasted at a university becoming an economist.” Steen Jakobsen, Chief Economist at Saxo

There is a link in the quote to an a report from S&P, which gives a breakdown of fiscal multipliers; 'For instance, in the UK, a fiscal contraction equivalent to about 4% of GDP between 2009 and 2011 had a negative effect on GDP growth about twice as high as the typical fiscal multiplier implies.' (p.5) The reason given in the S&P report for the higher multiplier is that there has been a simultaneous fiscal tightening over the developed world, and that the effects of reflationary policies in countries like China are fading. 

There are two interesting points that emerge from the S&P report. The first point is that they are actually identifying how critical government borrow and spend is in supporting many developed world economies. The ever well-informed but ever more dubious analysis of Ambrose Evans-Pritchard leads to this conclusion being drawn from the report:

Europe's manic determination to tighten further into recession to meet its bureaucratic targets is nothing less than suicidal.

However, the real point that can be understood from the report is that it reveals something of the depth of the economic structure that is being supported by government borrow and spend policy. Regular readers will know that I have often expressed concern about the way in which many countries have structures that have developed to service debt driven consumption. The interesting thing about this report is that it starts to hint at the degree to which economies are now reliant on ongoing government borrowing to maintain current standards of living. In my first ever post, I argued that, for example, the UK is poorer than it thinks, and this is the case in all of the countries that are following the borrow and spend path through the economic crisis.

It is not at all complicated. Current standards of living are to a very large degree contingent on borrowing and consuming. Economies that do so are simply entrenching the structure to service consumption based upon growing debt. As soon, as a government cuts back on debt growth, the structure that is supported by debt growth starts to collapse, and the real wealth generating economy underneath the unsustainable structure becomes exposed. Quite simply, there is no way out of the pain of restructuring, unless there is major economic upturn around the world. The problem is that, as the situation stands, this is not going to happen.

The Keynesians argue that the answer is more fiscal stimulus, and that this will regenerate demand, and all boats will rise with the fiscal stimuli. If only everyone borrowed and spent, all would be well. However, there is a fundamental problem with this idea. The more countries borrow, the more they restructure their economies around the borrowing. If, as they Keynesians had their way, all the countries of Europe were to raise their borrow and spend, this would (assuming that creditors would go along with it; a big assumption) lift Europe out of its current funk. The problem is that the restructuring of all economies to servicing debt based consumption would simply be greater. As country A borrows more, it would not only lift country A, but also countries B and C, which would help service the new demands in country A. The new activity in country B would also lift demand in country A amd B, and so forth.

The problem with this solution is that it is simply spreading the underlying structure of debt based consumption more broadly. Instead of just being reliant on your own borrowing to support your current standard of living, you become reliant upon country A, C, D, E etc. also continuing to borrow and consume. It merely extends the reliance of borrow and spend into an ever more entrenched network. As soon as any country in the network stops borrowing and spending, it impacts upon other countries within the network. Just as the upwards multiplier in the above paragraph lifted all boat, the same can be said of the downwards multiplier. It is this downwards multiplier that the Keynesians fear, and they are right to fear it.

The Keynesian's problem is that they simply do not accept that the more governments borrow and spend, the more entrenched the underlying problem becomes. The greater the coordination in borrow and spend, the greater the network effect of the multiplier, and the greater the negative impact when any single borrower cuts back. In the case of Europe, the fate of each economy is closely entwined with the European economy as a whole due to dense trade links. Any increase in borrowing of any country will improve the economy of its neighbours, and thus make those neighbours more reliant upon continued borrowing. The problem is that borrowing must have a limit. And as each borrow and spend domino falls, the others start to wobble as the effects of the falling domino moves through the network, multiplying the effects beyond the original domino. Coordinated borrow and spend is metaphorically moving the dominoes ever closer together.

The other problem is also distantly related to game theory. If country A tightens whilst all other countries increase borrow and spend, country A will start to restructure its own economy to be less reliant on borrowing. The stimuli from other countries will help it through the adjustment, and it will be left in a position of relatively less debt. It will still be reliant upon the network effect of the debt accumulation of the other countries in the network, which still means further pain at some point in the future, but the pain will be less than those who borrowed most profligately. By contrast, the country that borrows the most will undergo the greatest restructuring to service debt, and will contribute most to the network, at a cost of being in a weaker position in the future. Whilst this debt accumulation will maintain (or even enhance) their own standard of living in the near term, they are also disproportionately contributing to the network at a cost of increasing their debt and greater cost in the medium to long term. In other words, the smart policy now is to restructure whilst encouraging others to borrow and spend; as long as you are not the lender to those borrowing and spending, as these countries are going to have the greatest problems in repaying the debt later.

When looking at the fiscal multipliers, it is possible to see something of quite how large the debt consumption structure actually is for each country, but what is does not show is how those multipliers might effect a dense network. The problem is that we know that individual country multipliers will certainly have network multipliers, but nobody can calculate the network multipliers, which would require understanding of a dense network of interlinking relationships and layer upon layer of feedback between actors in the network. The real complexity in the European network is the different starting points of different countries, and that apparently less debt structured countries have already been lending heavily to those that have been net contributors to the system, not realising how dependent they themselves were becoming upon debt based consumption. Without this, we would see a very different response to the crisis. 

What this finally comes to is that government borrowing to support consumption cannot be sustained. Borrowing must have a limit. Although cut backs in borrowing will result in a downward spiral, and the downward spiral will be large if there is simultaneous cuts in borrowing, this does not alter the fact that, at some point, economies must restructure. Coordinated borrow and spend can only make the problems even larger in the future. Acting as a net contributor in the network is foolhardy. Lending to a net contributor is foolhardy. Notwithstanding the complexity engendered by past lending, it leaves Europe in a position where the only real solution is to accept that the restructuring will lead to a downwards spiral. Better now than later.

Notes on Comments on the Last Post:

Lord Sidcup:  I agree that, in some respects, the dichotomy between real and unreal becomes ever harder to see. I am very sympathetic to the creditism argument, and the original version of this post was going to address what is 'real' to some degree. For the moment, I will just say that what we are seeing is not that there is not a real underlying economic reality, it is just getting harder and harder to see. In some respects, it is a flight of fancy to use the world 'real', but what I mean by this is the idea that economies, in the long run, are comprised of individual actors who buy and consume 'stuff' and create 'stuff'. The global economy still comprises this fundamental structure. The relationships between these actors are the fundamental drivers of economics in the long run.

These actors operate in a global system comprised of the other actors, and there are subsystems in which these actors participate, which is individual country economies, and these operate more or less efficiently. These in turn have economic entities which operate more or less efficiently. Beneath this is the layer of individual actors, who also are more or less efficient. Obscuring this is money and debt (I will not argue about the distinction between these here), which is a layer over the top of a system in which each individual actor is a consumer of resources and/or adding value to resources (not all actors are both consumers and 'value adders') within a system.

The fundamental of 'real' wealth creation is the efficiency with which value is added to any given resource, relative to other actors. If you can take an input and add more value to it than another actor, then in the long run you will be more wealthy. The obscuring layers hide where the real value is being created. I know this is an incomplete answer, but I hope it helps to clarify a little about what I mean by real. However, in some respects I accept what you say about a false dichotomy, as the unreal and the real are ever less separable.

Lemming: An interesting point about throwing the dice on infrastructure:

He doesn't say it as such, but I think there's a suggestion that if we borrow lots of money to build infrastructure and then default, at least we'll have the infrastructure; if we don't do that, we'll still default because we won't be able to grow, and we won't have the infrastructure for the future either.

I did not see Evan Davies, but note your mention of 'investment' in infrastructure for new rail lines. These were no doubt called an investment, but rail requires subsidy. As such, it is an investment almost guaranteed to create a negative return in financial terms. However, it might have a positive return in improving 'quality of life', but that is achieved at a cost that needs to be considered against other priorities for government spending.

However, the problem runs deeper than this example. If it is accepted that government should provide and invest in infratructure such as roads (which is another topic), then it is quite right that investing in infrastructure might be viewed as a positive, provided that there is a real need (and in the case of roads I would think that this is probably the case). However, the problem of the UK is not one caused by investment in infrastructure, but rather that there is overall consumption that exceeds the wealth generating capacity of the country. The question then becomes one in which it is necessary to ask what can be afforded. Provided that there is a real need for x infrastructure project, it absolutely should be at the top of the priorities. The problem is that nobody is willing to really accept that there must be much tougher priorities or the resources available to goverment must be used more efficiently.

In other words, asking for greater investment in infrastructure may be reasonable, but still leaves the problem that the current undertakings of the government cannot be afforded in their current form. The assumption is that the spending on infrastructure must be undertaken on top of the current undertakings. Where does the assumption come from? It is quite possible to cut undertaking x and y, and at the same time put resource into infrastructure. They are not mutually exclusive. And if, and it is a big if, the infrastructure improves the economy, this will allow for greater resource for the government in the future. My real worry in all of this was that, in particular during the build up to the crisis, was that the words spend and investment became interchangeable. However, that again is another topic. The main point here is to point out the problematic assumption. There is no reason that spending on infrastructure should mean incresing borrowing.  It is just a question of priorities.

General Comments: Thanks for the positive feedback. Also, some challenges and interesting contributions. I would love to answer all the comments, but as you can see, this is already a long post with some long answers to a couple of the comments already. Quite simply, I have run out of time.

Final Note: For some reason, the Blogger service keeps changing 'S&P' to gobbledygook - apologies if this takes place when I hit the publish button, but I am unsure how to fix it (and it may happen in this note as well).

A reply to a comment on this post (same day as post, the reply was too many characters for the comments so added here):

Nice to see you commenting again Chaingangcharlie. I agree that the lead up to the crisis was not a very positive picture for the invisible hand but.....  but the sudden dropping of massive surplus of labour into the world economy was not the work of the invisible hand, but very visible hands. China and India kept their workforce out of the global supply, and then 'dropped' their workforce into the supply. The invisible hand was not the cause here. As a regular reader, I am sure that you will know my argument that this labour shock was the underlying cause of the financial crisis (aided by regulation), the boom in credit etc. I cannot detail this here. However, the point is that it is not the visible hand.

As for bankrupt, you are right that printing money is not going bankrupt in the strictest terms. However, if you hold a devalued GBP that has taken a 'haircut' as a result of devaluation, how is this different from taking a haircut more directly from a failure to pay and renegotiation?

In both cases, the value of your bond holding has fallen, and the issuer has failed to pay what they implicitly promised; returning to you x% of greater value that you lent. A country cannot be legally bankrupt, but being unable to pay your debts is, from a pragmatic point of view the same thing. 

As for the market knows best, as I have detailed in other posts, the global economy is no longer about market signals, but about government and central bank actions. Again, there are very visible hands at work, and how is that working out for us? You say we will head into a long period of pain, and suggest this is not the answer. However, we can see what has happened when the other answer has been pursued to a conclusion; Greece and Spain.  When it comes to other borrow and spend countries, they may have a while yet, but......what must finally happen unless they eventually accept that they cannot consume more than they produce....?

You have confidence, it seems in the policy makers who failed to see the crisis coming, who have not resolved the crisis since it became apparent in 2008, and who have in the meantime printed and borrowed to no effect. And despite this policy action, as I have discussed before, people are still getting poorer, and doing so whilst racking up future commitments that will make people even poorer.

In the meantime they have obliterated any functioning of the market, created monetary time-bombs, and borrowed to the point where any prospect of repaying the debt grows ever more dim. In so doing, what have they created; an economic system that is now policy driven. But driving where? Do you see this policy action working on any level at all, except for building and ever less sustainable and distorted structure?

You have faith in policy makers to make things right. I have no faith in them whatsoever, as their record is dismal. They have failed on every level, and even the most casual reading of the news shows that this is the case. Even when the news is positive, the situation always reverses. The overused phrase of 'green shoots' appears, only to see that there were no real green shoots, or that the shoots whither as soon as they emerge. How much failed policy would it take to convince you? What would it take to dissuade you of the necessity to change course?

Unlike those who proposed exansionary austerity, I never bought this idea. I always recognised that you cannot restructure away from debt fuelled and unsustainable consumption without a painful adjustment. And this is why I emphasise that the problems are that economies are structured around debt based consumption. If that is accepted, then more debt just deepens the problem. More countries simultaneously increasing debt just raises the problem to a new level and deepens the structural problems. I understand your concern, but surely leaving the current system in place can only eventually make things worse.

And then what will the final mess look like? I do not like the choice I propose but it is the same point I have made for a long time; pain now or more pain later. I go for pain now. It is not good, it should never have got to this situation etc. etc. but the situation as it stands is still the situation.

Anti-Austerity in Europe

I watched the outcome of the French election with considerable interest. It seems that anti-austerity is becoming a major force in Europe. Even more interesting is the collapse of the will for austerity in Greece.

It is a quite fascinating situation, which is also quite alarming. It is fascinating as the 'Krugmanesque' vision of economics may finally be put to the test. That is, it seems that it may now be the case that the borrow and spend spigots will open for already 'in trouble' economies. As regular readers will know, I do not deny that borrow and spend will indeed create employment. After all, it is not difficult to spend somebody else's wealth on make-work activity or paying for activities that would otherwise not be affordable. I do not deny that this will create more tax revenue. If more people are working, and more are spending, then indeed this will indeed create the activity in the economy that will garner greater tax revenue. Likewise, this increased activity will appear to either slow economic shrinkage, stabilise, or even grow an economy.

The problem is that it is very, very easy to spend the wealth of others in generating activity. The problem is that this borrowed wealth will eventually need to be returned to the lender. This in turn generates the problem that, if people doubt the borrower's ability to repay, then they will not lend. The question then arises as to whom, exactly, these want to be borrowers might actually borrow from. It is all very well for people to march on the streets and demand an end to austerity, but they are demanding that governments spend money that they do not have. However much these marching/protesting individuals and their political leaders demand borrow and spend, they have a problem. The problem is simple. They simply do not, within their own country, create the wealth that they desire. That is why they must borrow.

The wealth that is desired by the protesters and their political leaders only exists external to their own economy. It is not theirs, and short of going to war, they can only access this pool of wealth if the holders of the wealth choose to allow access to it. No amount of protest, political rhetoric, demands, tantrums and so forth, will change this.

Of course, there is always the possibility of raising taxation in a country to pay for all of the government spending. It is always possible to squeeze the pips out of the wealthy. Or at least, as long as the wealthy hang around to be squeezed. However, the term capital flight is not abstract; there comes a point at which people feel that the redistribution of their wealth to others is unacceptable, and they will choose to remove their wealth to a place where such a redistribution will not take place.

Even if accepting that the wealthy can be squeezed, the 'in trouble' economies will have to squeeze very hard  to make up for the loss of borrowed wealth from external sources. And that is the problem; even if increasing taxation for the wealthy, will governments be able to manage without the borrowing of external wealth to pay for all of their reinstated/increased spending programmes? I mean really; can this do the trick? I very much doubt it. 

The plans of the anti-austerity movement are quite remarkable. They are remarkable in that they assume that there is some hidden source of wealth that is the right of their country. They do not have, or produce, this wealth themselves, but are apparently entitled to it. If the anti-austerity movement wins out, we will be able to see whether the Krugman approach actually really works in practice. I read recently that Krugman's view is influencing political leaders in Europe; that his proposed remedies are believed to be the solution.

Of course, there is nothing to say that some of the 'in-trouble' economies might not borrow a bit longer. For a while at least, the Krugman solution may appear to work, and encourage others to speak out/act against austerity.The success of anti-austerity will, if this takes place, be trumpeted as a solution - at least up to the point that the lenders of wealth lose all confidence. As an analogy, think of the Jurassic Park films; there is a sequence in which the lead character says something along the lines of; 'That's how it always starts, with the oohs and aahs, but then the biting and the eating starts'.

So, if the anti-austerity movement wins for a while, those in favour of the movement will sound out their 'oohs and aahs', but when all confidence is lost, the picture will change dramatically. It is quite possible that we are about to witness a real world economic experiment, in which the theories of individuals such as Krugman will finally be tested. They believe that wealth can simply appear by borrow and spend/tax and spend. They believe this will create a virtuous cycle that will fix economies.

I, on the other hand, believe that wealth is, in the end, created by creating a framework in which individual endeavour creates real wealth. This individual endeavour, whether from a bricklayer or a the CEO of a multinational, is the real source of wealth creation. They make products and services that people want, and can pay for the goods and services as a result of their own individual endeavours. The relative success of these individual endeavours, in aggregate, in terms of productivity, and in relation to other countries, determines the real wealth of a country. Not borrowing.

I suspect that we are about to find which vision of economics is correct. I hope I am wrong. If I am not wrong, then the outcome may be very disturbing.

Treasury Yields and Currency

At the moment there is a great deal of talk about the falling prices of treasuries. The explanation for this appears to fall into two camps; one explanation is that there is perception that the worst of the crisis is over (meaning that investors are willing to abandon the 'safe haven' of treasuries), and the other is that markets are being spooked by government deficits and quantitative easing (QE - money printing) of the Federal Reserve. Without being a market insider, it is difficult to judge the relative importance of either factor.

One of the errors on this blog has been to overestimate the collective intelligence of the markets, which means that the former explanation is quite plausible. However, the critical factor in the US treasuries market are the rate of QE and the continued confidence of overseas buyers (in particular China). I will return to this, which is a well worn theme of the blog.

The really curious part in this is that any 'recovery' that might involve a move out of treasuries is quite simply impossible. The US is on course for a deficit of $1.84 trillion, which represents about 13% of GDP, and the 'recovery' therefore must be financed through treasuries. If there is any concerted move out of treasuries into other assets, what will be funding the deficit? During the early part of the crisis there was a 'flight to safety' into treasuries, which has inevitably held yields down on bonds, and allowed the growing deficits to be financed. If at any point this process sees any significant reversal, then funding the deficit will become increasingly difficult.

Quite simply, aside from the fact that a failure to fund the deficit would be catastrophic, what kind of 'recovery' is it, if it is being financed by borrowing 13% of GDP?

A long time ago, I made an analogy with a household to explain the absurdity of this notion. A household has been racking up huge debts due to too much expenditure on the 'good things in life', but continues spending. All the time the family's debt is increasing, and then the bad news comes. The wife's job is under threat, and the husband's working hours are being reduced. Their income is declining, but the cost and size of the debt is increasing. They are in deep financial trouble, and are borrowing more and more money in order to keep their lifestyle and also to make payments on previous debt.

It looks like the household is in crisis, and they will soon go bankrupt if they continue their profligate spending. Fortunately, so it seems to our irresponsible family, a visitor comes to their house from 'Dodgy Loan Corporation' and offers them a further and much bigger new loan. They look at the figures, and it appears that, if they accept the loan, the family will be able to continue to live the same lifestyle as they had before. A massive weight lifts off their shoulders, and they live happily ever after.....

We can all (I hope) see the problem in the happy ending. I have not mentioned the prospects for the family's income increasing in the future, and without a massive increase in income, bankruptcy will just be delayed. Sadly, for the family, there is no identifiable prospect of such a massive increase in income in the future, and they are just hoping that 'something will turn up'.

As such, when there is talk of recovery, it is necessary to ask how much of the 'recovery' is simply the massive amount of new borrowing appearing in economic activity. Whilst the money may allow, for a short while, a perception that all is OK, spending is simply exceeding income on an ever greater scale. The debts are just getting bigger, and the prospects of ever repaying are diminishing.

The underlying problem that arises is that the equivalent of the 'Dodgy Loan Corporation' is China, and China is less and less willing to lend. The problem for China is that they have already lent huge amounts, and bankruptcy will mean a loss on their previous lending. The next problem that China has is that the 'family' refuses to rein in their spending, and is continuing to spend more than they earn. In the event of bankruptcy, they lose it all, but if they continue there is no prospects of repayment of the new debt. They are faced with the problem of whether they too might believe that 'something will turn up', or whether they cut their losses.

I have, for months now, been highlighting the many articles in which China has been sounding warnings to the US about their profligacy, and will not repeat the same points I have made many times before. The important point is that China is losing patience, and certainly does not believe that the US policy is sustainable. The best expression of the doubts about the prospects for the US in China was not from official channels, but through the laughter from Chinese students in response to a speech by Geithner in China. He had proposed that the Chinese $US assets were 'very safe'.

The problem for the US is that China does represent the 'Dodgy Loan Corporation', and without their ongoing financial support, the US is bankrupt.

This returns to the question of the bond markets, and the impossibility of a 'recovery' in which money moves out of treasuries into other assets. The only way any movement of money out of treasuries into other assets might be sustained is if China steps up to the plate as the Dodgy Loan Corporation, and actually makes up for the shortfall that will arise. In other words, if other creditors are withdrawing support (for whatever reason), somebody has to enter the market in their place.

It looks very unlikely that China is going to play this role.

The question then arises as to how this problem might play out. I would like to give a firm answer, but must speculate. The problem is that it is impossible to forecast how markets might shift in a situation of an impossible dilemma. If the markets move out of treasuries into other assets, then increasing doubts about the viability of the US state will arise. At the same time, many other indices will tick up, apparently suggesting that recovery is around the corner. In other words the signals will contradict one another. If recovery is around the corner, then perhaps the US state is viable after all. If recovery occurs, then the state will be able to repay the borrowing.

The problem is that the recovery is not a 'recovery'. It is an upswing that is resultant in further expansion in borrowing.

I have to assume that the collective intelligence of the market is not very high, as indications over the last year suggest that they have a limited ability to adapt to new circumstances. Whilst they must eventually adapt, they are slow to do so. In the end, markets will shift towards acceptance of reality, but the process is delayed by clinging on to old paradigms.

In the interim, it is very likely that there are going to be wild swings in sentiment, and what appear to be contradictory indicators appearing all over the news.

These problems are not restricted to the US.

As many of the readers will be aware, there are significant problems in many of the traditionally rich countries - in the Euro area, the UK and in Japan. Each of these economies has a range of problems, similar solutions such as government stimuli and QE, and varying degrees of underlying economic problems. The key question that many investors will be asking in this situation is not which is the best bet as an investment, but which is least worst. I have recently written an article for TFR, in which I outline the underlying problems for investors - determining which currency might be 'safe'.

In the article, I ask why Sterling rose despite the negative watch on the currency from S&P. I will not repeat the article (you can read it here), but the underlying point is that all of the traditionally wealthy economies are looking 'ugly'. As a result, as has happened recently with Sterling, currencies will shift on any news - whether good or bad (e.g. the decline in Sterling as a result of the troubles of Gordon Brown).

What I am trying to do here is paint a picture of the potential for extreme volatility in the coming months. In particular, there are many contradictory forces within individual economies, and uncertainties about the relative health of the traditionally wealthy economies, when one is compared to another. There is, therefore, going to a period of considerable uncertainty as the underlying economic changes start to work through markets, and as investors flee from one high risk into another high risk.

The certainties in this scenario is that the economic shape will eventually shift to reflect the underlying shift in wealth, which is the shift from the traditionally wealthy countries to the 'emerging' markets, and that the economies of countries like the UK and US will be left in tatters.

It is also increasingly probable, but still not certain, that China is going to emerge as the dominant economic power.

In other words, what we are seeing is the final process of the shift of the world into the new economic shape. The only questions that remain are how the process will actually play out, over what timescale, and the level of drama with which the change happens.

Note 1: I have long been discussing the prospects of the RMB as the new reserve currency. I pointed out long ago that the Chinese government would never openly declare such an intention, but that they would rather use proxies. A recent article in the Telegraph reports a continuation of this process:

Guo Shuqing, the chairman of state-controlled China Construction Bank (CCB), also said he is exploring the possibility of issuing loans to trading companies in yuan, allowing Chinese and foreign companies to settle their bills in yuan rather than in dollars.

Mr Guo said the issuing of yuan bonds in Hong Kong and Shanghai would help to develop the debt markets in China and promote the yuan as a major international currency.

The reality is that Mr. Guo would never say such a thing without approval of the government. However, the government is still in a position where they can deny any such intentions, and deny any plan to make the RMB the reserve currency. In the interim, the IMF has suggested that their SDR might be the new reserve currency, following the line of the head of the Chinese central bank. Perhaps they do not realise that this proposal from China was simply a method of indirectly attacking the $US, as an early step in manouvering the RMB in to position as the replacement?

Note 2: Some replies to comments on the last article:

Lord Sidcup: I would like to reply to your 'bafflement', and might do so in the future. However, that is a complete post rather than a reply to a comment. I hope to answer your question at some stage.

Luke Skywalker: Some interesting ideas, which again need a long answer. I would hope though that I have answered many of them throughout the blog.

Matt: I have previously discussed the land tax idea I believe (following another commentator pointing it out), so I would guess that you can find my thoughts in the archive. If I remember correctly, my main worry was how the tax might be assessed. However, it is a long while ago. Overall I remained unconvinced, and will therefore apologise for not revisiting the subject.

Tiberius: Your quote seems to sum up the nature of the process of accepting reality and is relevant to this post, so I will requote here:

"All truth passes through three stages. First, it is ridiculed. Second, it is violently opposed. Third, it is accepted as being self-evident."
- Arthur Schopenhauer

Lord Keynes: Thank you for your many links, and well researched comments. I have previously read (and commented on, I believe) 'The Roving Cavaliers of Credit', which was linked to by a previous commentator. Like many such articles, it is very clever, but I believe misses the real basics of economics. If you increase the money supply, eventually it must lead to inflation. However you look at it, if you have 100 units of output, and 100 units of money, if you increase the units of money without increasing output, there is more money per unit of output. That, in the end, must lead to inflation. It is just a question of time....whether output can expand faster than the impact of the increase in supply.

Note 3: I am a bit short of time for replies, so apologies for the brevity and not including replies to all the comments. I wanted to take time to highlight a little discussion I had on the Von Mises Institute (Austrian Economics) comments section. I have argued in this blog for a fixed 'fiat' money supply, and posted a brief suggestion to that effect. I was rather surprised by the response. I am not certain that my idea is sound, and am open to positive or negative comments. However, I was a little surprised at the dogmatism of the responses from (presumably) Austrian economists. I have copied one of the replies below:

• Cynicus Economicus,

  "regarding the origin of money, I do not believe this is an issue."

  You vastly underestimate the importance of this issue. Money can only originate in the processes of the market. In other words, the best money is chosen by the market. Moneys that don't originate on the market are not good moneys. So the system you're advocating would entail bad money because it cannot originate in the processes of the market.

  "Electronic money is the obvious answer, not paper money"

  Electronic money cannot originate in the processes of the market. The money commodity must have prior barter value before it can originate on the market. Electronic money doesn't have prior barter value. Furthermore, electronic money does not possess an important characteristic of good money: scarcity.

  To be blunt, the system you suggest has no promise.

This was a bad example, but I did feel that they did not address the points that I made. I am not sure that I was very eloquent, but even so...I seem to recall MattinShanghai identifying the Austrian school as dogmatic, and feel I have to agree. This is a pity, as I do like their arguments against Keynesianism. Am I being unfair to them - was my argument addressed? Or was it just poorly expressed, or completely unsound. Comments welcomed.....