Fractional Reserve Banking - More Explanation....

This post is a follow on from many comments on my last post on fractional reserve banking. If this is your first visit to the blog, you may want to look at some of the posts linked to on the left before this post, as this post is a little narrow and more than a little abstract, and attempts to clarify the previous post. If you do want to read on, in order to understand this post, you will need to read my previous post, which is here and may find the comments made by readers helpful in understanding the questions I am trying to address.

Before going on, I will re-emphasise something that some people missed. I am very clear that the central banks do indeed create money (but more of that in a future post). However, this should not be mixed up with the principle of whether Fractional Reserve Banking FRB creates money. My post on FRB seems to very contentious, with one commentator on a forum being very complimentary about the blog overall, but also suggesting that I do not understand FRB. I think the problem prompting such comments is very basic, and is the subject of argument amongst the different schools of economics - the question of what money is.

Returning to the definition of money, in my original post I went to some effort to make clear my definition of money. The argument about whether FRB creates money depends on how you might define money. Perhaps I never made the relationship between FRB and money clear as one person asked why I added this discussion of what money is.

I specifically gave the case of the IOU to make the point of my definition. The IOU is only money in the narrowest sense because it has a limited use in exchange, as it is only meaningful to a very limited number of people who are able to assess the value of the IOU. I would quote the section of the original post here but it is quite long. As such you may wish to return to the post, and you will find it about a third of the way down (using the scrollbar).

As another aside, it might be noted that a fiat currency can be viewed as an IOU, as in a fiat system we just collectively (most of the time) believe in the value of the fiat money. There is no underlying contract that gives value to the money, but simply a belief that is has vale. This is a difficult point to summarise, so you may wish to read my post here as this discusses money in some depth.

The question at the heart of the debate is whether FRB allows the creation of money from nothing. If we go back to how the money creation argument let us look at another example which is as follows:

Depositor A deposits 100 gold coins into Bank A.
Bank A loans 80 gold coins to borrower A for the purchase of a house.
Borrower A writes an IOU for 80 gold coins made out to Bank A.
At this stage we still have a total of 100 gold coins.
The house Seller A accepts the 80 gold coins in exchange for the house.
Seller A then deposits the 80 gold coins into Bank A.
At this point in time, we still have only 100 gold coins in total.
Bank A again has in hand the 80 gold coins.
Bank A lends out 64 of the gold coins to borrower B to purchase a house.
Borrower B writes an IOU for the 64 gold coins.
And so the process might continue....

....But you will notice that on each occasion, the total number of gold coins never changes, and the amount that the bank can lend diminishes on each occasion. Furthermore, there is never an increase in the number of gold coins, just an increase in the IOUs. I have left out interest on this occasion for simplicity and also because (at some point) I would like to deal with this on a post about inflation and deflation. In the end, in the above scenario, the bank will only ever be able to lend a total of 80 gold coins.

The key question in all of this is how money is defined, and this is why I went to some effort to make clear what my definition of money actually is. Under my definition, money only exists in the collective minds of all of us. Whilst some might imagine that the IOUs are money, they are not money, they are IOUs whose value requires specialist knowledge, is highly speculative and they are therefore of limited use as money.

The whole point of a bank run is that, when push comes to shove, these IOUs can not be used as money, because the depositors will not accept a note from the bank that says 'at some point in the future, subject to all kinds of circumstances, we will be able to give you x number of gold coins' - the simple reality is that in a case where gold coins are the universally accepted currency, that is all that counts as money in real terms.

As the situation stands, when people lined up outside Northern Rock, they wanted and accepted £5, £10, £20 and £50 notes, not IOUs. By their definition this is the only money there is, and they collectively are the only people that matter, as they finally determine what money actually is. In other words, the banking system creates what they believe is money on their balance sheets, but the people that really matter (all of us) do not accept the 'money' on their balance sheets as 'money'. It is an entry in a book, and can not be used as a unit of exchange that is accepted by us all.

In the example I have given above, lots of IOUs are created but there are never more than 100 gold coins, and therefore no money has been created. When someone wants their money back, they will not accept the IOUs, but they will accept the gold coins.

I used gold coins on the basis that in everyone's minds eye, it could be seen that no more money is created in the system. In my discussion of the subject I make very clear that the 100 pieces of gold creates a total of 80 pieces of gold lending in a 20% reserve system. Even Ben Bernanke's discussion of FRB agrees with this saying the following regarding a 20% reserve system:

'At this final stage the ratio of reserves to deposits equals the ratio desired by the banks (20%). No further expnasion of loans and deposits can occur after this point because the ratio of reserves to deposits is at its minimum acceptable level.' - Macroeconomics, 4th Edition, Ben Bernanke and Andrew Abel, p525.

In other words, at the end of the system, no more than 80% of the reserves can be lent. However the money shuffles around, the total money 'out in the world' will never be more than 80% of the total deposits. In the case of inter-bank lending, as I pointed out, the amount of those reserves 'out in the world' actually diminishes each time a bank lends to another bank.

At its most basic, an IOU on a bank balance sheet does not constitute money. It does not constitute money because it is not accepted as a unit of exchange. This is why we have bank runs.

I can quite understand why people become so confused about this, as many people would like to imagine that the IOUs do constitute money, in particular many economists. However, the reality is that, when push comes to shove, this does not constitute money, which is why banks hold reserves. However everyone might try to pretend that an IOU is money, the truth that it is not money is revealed when a depositor asks for their money back.

The problem that we have here is made even greater by the fact that fiat money is of itself a form of money based upon nothing more than belief that it is money. However, it is the only medium of exchange that is universally accepted. The idea that IOUs on a bank balance sheet are money is occasionally tested, and whenever the test happens, it is found that it is NOT money. Once again, we can see this in the case of Northern Rock.

As before, comments are welcome. I hope that I can leave this subject and start to look at central banks, but will come back to the subject if anyone can do the following:

1. Show me how the IOUs held by Northern Rock, the numbers in their books, constituted money.
2. How, using gold coins, with no central bank input, a fractional reserve banking system might create more gold coins than depositors have put in (excluding interest payments). For the sake of ease, please try to use 20% reserves.
3. How a bank lending to another bank does not lead to diminishing credit outside of the banking system (again in a flat 20% reserve system)

As I have said, comments welcomed and I hope that I have clarified my point. Like many commentators on my last post, I am occasionally seduced by the idea that money is 'created' when I have read the clever arguments, but keep pulling myself back to the reality of what a depositor accepts as money, and also what I would accept as money. What would you accept as money if you went to get your money from the bank, and they refused to return your £10 as a bank note when you ask for it to be returned as such?

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 more.....re-regulation 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....

The Underlying Value in Currency - Why the £ is Falling

This post started out as a short response to a comment by B33ENN, who is a relatively new commentator on the blog, and who commented on my post on 'UK Government Borrowing - Where is the Money Coming From'. However, as I wrote my response I found that I was reiterating many of the points that I have made throughout the blog. As such, it occurred to me that newer readers of the blog may not have an underlying understanding of the principles of the blog, and that sometimes I make posts with assumptions that they do.

The problem with the way that the blog is structured is that it is a cumulative argument. I therefore strongly recommend that newer readers take a look through the key posts that I have linked to (these can be found to the left of this). In the meantime, I have adapted what was originally going to be a quick comment in the comments section of the UK borrowing post.

The original post discussed how low interest rates were possibly leading to a reluctance of depositors from depositing money in the banking system. I pointed out that under normal circumstances these deposits would be made available for investment, and the government was therefore constraining the supply of capital for investment through such low interest rates.

The first point I would like to address is that two commentators quite rightly identified that I was simplifying the methods by which bank deposits are channeled into the economy. This from B33ENN:

This is not exactly as I understand the mechanism. Yes, the banks do use the reserves as a basis for lending. However, the banks actually use the reserves as margin for leveraged lending. In simpler terms, they create “new money” in the form of new loans by amplifying the reserves according to the fractional reserve lending criteria. So for example, if a bank holds £10 in saved deposits, it then can create a further £90 worth of loans. These loans then become “real money” in the economy flowing out through business and individuals who borrowed and then deposit it into more banks that repeat the exercise until you reach a maximum amount that can be created from that first £10.

Lemming also commented to this effect. They have have both rightly pointed out that I have simplified the method by which deposits are turned into lending. I did not want to go into Fractional Reserve Banking (FRB) as this would distract from the underlying themes of the post, which was the centralisation of the government in the economy and where the government was actually finding the money to lend. In a sense they are right that this is unavoidable as part of the discussion, but I wrongly assumed that it did not need to be detailed. The point here is that deposits create the opportunity for banks to make further lending.

For readers who have never previously heard of FRB, I strongly recommend the (controversial) Wikipedia article here as an introduction, as it also includes the role of central banks (you may also want to read the heated debate that is linked to at the top of the article if you are really interested). If you have never heard of the system, it may come as quite a surprise, or even a shock. Another interrelated point that you may want to consider is the system of 'fiat money' which I discuss here.

The reason why these are important considerations is that they are at the heart of our economic system. In the case of FRB, we have a system which is inherently inflationary, through a continual steady expansion of the money supply by central banks (printing money if you wish), and through fiat money we have a system in which the value of money is almost entirely built upon confidence (which I discuss here- not an easy post, but stick with it) and which allows for unconstrained printing of money. It should be noted that printing money does not require physical printing of bank notes and minting of coins and quantitative easing is a process in which the process of 'printing' money goes into overdrive.

My argument is simple. Flooding money into the market in the manner of quantitative easing to create money for the government to lend to the banks, in order for the banks to lend to the government, business and consumers can only lead to currency collapse and hyper-inflation. Governments/central banks are claiming that they are doing so to avoid deflation, and I will address this question for the UK.

What the government is doing is massively increasing supply of the currency at a point in time when the external demand for the currency is in free fall. A large part of the demand for the £GB has been to buy the £GB in order to then lend it into the UK, and this source of demand is disappearing. Another part of the demand is as a reserve currency, but that status is diminishing with the weakening of the £GB (the two factors are related). On the other hand, there has not been much demand for the £GB as a currency to buy goods or services from the UK, something that can be seen in the balance of trade figures. Essentially, the value of a currency rests in supply and demand, and the confidence in the currency. The confidence element needs some explanation.

Confidence is a very difficult problem as it is possible for individuals and institutions to assign a greater value to a currency than underlying supply and demand would suggest that it should have. The loss of confidence in the £GB is seeing the £GB's value declining through loss of confidence, but that loss of confidence is rooted in the reality that the UK does not produce enough goods or services that people in other countries want to buy. In other words, individuals and institutions have realised that the £GB is not very useful as a currency to exchange for goods and services - there are many pounds in the market but there is little demand for goods and services that are exchanged in pounds. In the end the value of a fiat currency is determined by how many goods and services there are that people want to buy versus how many units of currency there are in circulation.

What has happened over the last couple of decades is that this principle has been forgotten. Demand for the £GB (and the $US - though the $US is a more complex case), has been supported by demand to lend into UK consumption. What has been forgotten by all of these lenders is to ask exactly with what the UK could produce to repay this lending. This error is now being recognised and what you then have is a situation in which investors are 'getting out of'' the £GB, as they recognise that there is simply not enough being produced in the UK to support its value. It is for this reason that the £GB is falling so fast. At the same time as demand for the £GB is falling there is a situation in which government creating more £GB at a time when there are already more £GB than the market wants. This is inherently inflationary.

The inflationary aspect of this is twofold. On the one hand all imported goods are going to become more expensive. In a massive simplification, there is a situation in which the UK currently does not produce enough goods that the Chinese factory worker wants to buy, such that his labour on a plasma TV can not be exchanged for any goods from the UK.

In order for UK consumers to buy that plasma TV, they must produce something with a commensurate value that the Chinese worker wants to buy. If they do not, then there is nothing to exchange for that plasma TV. The only solution to the problem is devaluation of the £GB. What this means is that the UK worker must work x number of hours more in order to be able to offer something in exchange for the plasma TV. In other words, the value of the labour in the UK must be adjusted to a point at which it can produce something that has sufficient value in exchange for the Chinese worker to buy.

What you are seeing in the change in the exchange rate devaluation is the value of labour between the UK and China moving to a new equilibrium. This example, of course, is just for the UK and China but needs to be applied across the global economy which, whilst more complex, does not change the underlying question of relative efficiency in the production of goods and services between economies.

Quite simply, the UK is not efficient enough at producing goods and services to continue to compete in world markets on the current exchange rate. This has simply been hidden through a false confidence that arose out of demand for the £GB to support lending into consumption. The illusion of the £GB was built upon a false confidence in the efficiency of the UK as an economy. It is actually not very efficient.

In light of this, the £GB can only continue falling until it reaches a new equilibrium that reflects the true state of the UK's efficiency in the production of goods and services. This problem can only be compounded by the production of more currency. The underlying value of a currency can be simplified as follows (ignoring investment overseas):

The total of goods and services produced in the country which have value in exchange with other countries divided by the units of currency in circulation.

In a fiat money system, if you increase the units of currency in circulation, without increasing the value of goods and services that you produce, the value of the currency must eventually fall. As such, in printing money, you create inflation on all imported goods and services. If you print with wild abandon, then you create massive inflation in imported goods and services. A simple case in point is oil, which has been falling in price around the world as demand for oil has been reducing. In principle, as a net importer, the UK should be seeing dramatic drops in the price of this input, but the reality is that the reduction of the cost of this commodity is ameliorated by the falling £GB.

Whilst the UK is seeing an absolute fall in the price of oil, it is seeing a relative increase in the price of oil in relation to countries whose currency is appreciating against the £GB. In other words, the UK is becoming poorer relative to those countries, even though it appears that oil is becoming absolutely cheaper. In practical terms, the UK worker must now work x number of hours more than a worker in another country to fill up his car with petrol (gas if you are a US reader). However, the falling price of oil is seen as deflationary by government and the central bank, such that their solution is to incorporate this in overall inflation, and print more money to prevent this deflation.

In doing so, they increase the supply of units of currency, the value of £ goes down further, thereby increasing the cost of oil imports, further impoverishing the individual filling up their car with petrol relative to a person in another country. Although the solution has prevented deflation within the country, it has also done so at the relative impoverishment of the person filling his car up with petrol. In this case the person is poorer as the value of his £GB has been transferred to the newly printed money.

The real question however, is how all of this will balance out. Will the fall in the £GB offset the fall in the price of commodities and counteract the fall in demand for a range of goods and services. I have argued that it is more probable that the plunge of the £GB will actually counteract the deflationary effects of contraction in demand through the increased cost of all imports. However this is not certain, as it depends on where the £GB will eventually settle. This in turn depends, in part, on the government.

However, a fundamental problem in all of this is whether deflation is a bad thing. For example, if the price of a loaf of bread deflates, is this a cause for worry? The answer to questions such as this largely depend on whether you are a saver or borrower. If you are a saver, you see the value of your savings increase in relation to the price of goods and services so you do very well in a deflationary environment. On the other hand, if you are a borrower, you see the value of your debt in relation to goods and services increase. This is very bad news for you. It is also unfortunate that so much has been done to encourage you into borrowing, and discourage you from saving.

If we look at the wider economy, there has been a problem that too many people have been borrowing for consumption, and not enough people have been saving. This is a problem. Deflation creates a situation in which individuals are motivated to pay down debt as fast as possible, and people are encouraged to save. This would represent a dramatic shift in the balance of borrowing and saving, and arguably a shift that would rebalance the economy away from being consumption driven to being driven towards saving and investment.

The counter argument is that this deferral of spending will create a self-reinforcing downward spiral of the economy, where nobody is producing anything due to lack of demand, as everybody is saving or paying down debt. However, if the economy has been balanced to much towards borrowing for consumption, and has therefore become imbalanced (the crux of my argument), then surely this is exactly what is needed. If the only thing supporting large parts of your economy is rooted in unsustainable borrowing, then the only solution is that the parts of the economy that have been artificially supported by that borrowing driven consumption must be allowed to be destroyed. They could not be sustained in any case. Deflation is just a mechanism of rebalancing.

Deflation would also have the effect of creating greater savings. In so doing the capital base of the financial system would effectively be fixed, but painfully so. Those banks that were overstretched would go to the wall, creating a period of further crisis. However, the surviving banks would end up accumulating capital, and would then be able to divert that capital into the process of economic recovery. With the £GB having fallen, and the true efficiency of the UK economy reflected in the realigned £GB, many new potential areas of business would once again become potentially competitive. Such new businesses will need capital in order to grow.

As such, B33ENN was correct when saying that if the government did not act as it is, there would be huge asset liquidations. Where he is wrong is that the government has the capability to save the economy by acting as a guarantor through printing money and borrowing. The fundamental point is that the current crisis is about the fundamental state of the economy, the inability to produce enough goods and services to exchange for our massive levels of importation of goods and services. It is the massive imbalance in the economy that is the problem. The real problem with the deflationary solution is not that it would lead to a rebalancing of the economy away from debt fuelled consumption, which is any case essential, but that it would do so in a very painful way. This is politically unacceptable, but absolutely MUST happen.

We then have to ask ourselves what will happen with the borrowing and money printing solution. As I pointed out in my last post, the banks are now offering interest rates that are a deterrent to saving. As such, the only way to fill the hole in bank capitalisation is through the government providing that capital. However, the government must either print money, causing inflation and further disincentive for saving, or borrowing. How can either of these solutions possibly help in rebalancing the economy away from consumption? On the one hand the money printing will further devalue the £GB, but that would in any case happen with the £GB falling to its natural equilibrium value. It would not really have any impact on the reduction of the value in relation to the equilibrium, it would just be a further devaluation for devaluation's sake. In other words, it will not change the equilibrium which is determined by relative efficiency in creating goods and services for exchange versus the number of units in circulation.

Printing more money just changes the number of units, not the equilibrium point.

In addition we need to remember that, as I have pointed out in many posts, the creation of fiat money in this way is a transfer of value from the existing money supply onto the new money. As such it is a form of taxation. In this situation, the government is both pointlessly devaluing currency and also massively increasing the tax burden in a time of economic crisis. In doing so they are impoverishing every investor, and every saver. The only result of such activity is eventually to kill investment activity, and create capital flight. Available capital and investment is the long term solution to the crisis, and will be needed to restructure the economy.

As for borrowing more money, the problem arises (as I have endlessly pointed out) that borrowing for consumption today (which is what the borrowed money would primarily be used for) means a contraction at some point in the future. In other words, it will delay the contraction now at the cost of a greater contraction in the future.

My argument is that what all of this money creation and borrowing amounts to is an attempt at pretending that the economy is actually still producing enough wealth to support the UK's high standard of living. Whilst the economy was previously built upon consumer borrowing, the government is seeking to replace the position of borrower and spender. One of the comments of B33ENN was the traditional role of central banks is to be the lender of last resort. In this case the government is becoming the borrower of last resort. What it is doing is pretending that we still create value in goods and services for exchange with other countries that we do not in fact do. Borrowing money is just a method to try to bury this reality.

In short, the UK has built an economy around consumption, and that consumption is built upon debt, and without the flood of credit into the UK, nothing is going to allow us to continue the service/consumption economic model. Whatever the government does, somewhere, somehow, there must be sufficient wealth creation to pay for the goods and services that we consume from our trading partners. Our trading partners have (foolishly) been extending credit to us for a long time. That has stopped. No amount of government intervention is going to prevent reality from emerging.

Whatever the government does, the bankruptcy, unemployment MUST happen, as the basic shape of the economy was directed towards unsustainable consumption built upon debt provided by wealth producing economies.

The government can guarantee all kinds of things, but in doing so the government will just transfer the damage from private companies and individuals to the government, making the government ever less solvent. The government can, of course, just keep printing more and more money to address this. However, in doing so they just destroy the value of money, and this MUST lead to hyper inflation. If you doubt this is the case, you may wish to read this article in the Telegraph. Quite simply people are losing their confidence in money, even in the 'mighty' $US. In the case of the article, the rich are moving into having physical holdings of golds - literally buying gold as an 'in the hand' physical asset. The rich have the ability to get sophisticated advice on how to invest their money, and are therefore in the vanguard of the collapse in confidence.

The whole point of this blog is to point out that there is something fundamentally wrong in the UK economy. It is no longer able to generate the wealth to support itself at the current standard of living. As such I was surprised to see B33EN suggesting that the government can somehow turn back economic reality. He is not alone in this. Many clever economists are effectively telling us that you can create something from nothing, but at some point the illusion must disappear. Creating money from thin air does not create value, it transfers value. At some point, somehow, you have to create value, and that means engaging in activity that creates something - wealth creation through selling goods or services that our trading partners want.

We are simply not doing enough of this. How can government guarantees, borrowing money, and printing money change this reality?

B33ENN is falling into the trap that many mainstream economists fall into, by looking at the situation as if it were complex. It is not. It is very simple. A strong economy is one in which you create things that others want exchange with you. Without that, there is nothing.

Government can not make wealth. It can not produce anything, it can only spend the money of those that create wealth, which is those who create something with value in exchange. The only role government can have in wealth creation is to set up an environment in which wealth creators can thrive. Destroying the value of money is not such a situation, and nor is the taxation implicit in money printing. It is simply a way of pretending that the fundamental problems do not exist. If you do not sell enough goods and services that people want, eventually they will not want to sell you anything, as you do not have anything they want in return.

It can not be put more simply than this. All the rest is nonsense. All the rest is window dressing that hides this reality.

It has been a bit of a meandering post (again), but as usual I have simply been writing my thoughts as they occur to me. I hope, however, that this makes sense. I hope that I have illustrated that any illusions of endless government interventions is just (at best) a delaying mechanism. The economy must change, and that change will under all circumstances be painful. I am not sure that I have given the post a good title, but I hope that it is roughly right.

Update to the Post: 14 January 2009

I mention a couple of times in the post that the fundamental problem of the UK economy is that it is just not very good at the creation of goods and services that other countries want to buy. The result is revealed painfully in this Telegraph article:

The trade gap ballooned to £8.3bn from £7.6bn in October, the highest level since records began in 1697, reflecting the fact that Britain is importing more from other countries than it is exporting. Economists had expected the deficit to narrow to £7.5bn because of sterling's sharp slide in the final few months of 2008.

This is a reflection of the underlying problems in the UK economy. Just as poor economic conditions expose the weakness of companies, it is the same with the economic position of countries. Even with a sinking currency, we are still importing more than we are exporting. However, we should also remember that there will be a time lag from currency change to the shift in the balance of trade. As such, whilst these figures probably reflect the exchange rate of the £ a few months ago, rather than now (e.g. in long supply chains, there will be delay before contracts expire, and new contracts sought)

A Note for one of the Regular Commentators, Steve Tierney: Steve, apologies but your post appears to have been lost by the Blogger system. I have had no email notification (I have checked through my inbox), and there is nothing in the system. Please be assured that your comments are seen as a welcome contribution to the blog, and I would not, in any case, not publish just because someone said something that I did not 'like'. As such please accept my apologies.

As a general note to all readers, I publish all comments provided that they are not spam, do not use bad language and...that is pretty well it. I am a follower of the political philosophy of Mill's 'On Liberty' on the issue of free speech, so do not undertake any censorship. Bad language is unacceptable, as it is unnecessary to express a point of view but can be offensive, so this is why this would not be published. Spam is deleted as it is just using the site for advertising for which the writers do not wish to pay, and adds nothing to the site.

I have had a complaint from a person for deleting a post which I believed was spam. I flicked through their very long web pages, and found that they were recruiting individuals into some kind of new form of investment. I read no further, and the person has complained that I did not understand what was written. My answer is simple - any offer of any kind of investment requires the capital of individuals. It is therefore treated as spam.

US Government Guarantees a Crash

Update: 23 Sept. Just a note. It seems that the bailout will be financed through borrowing, which is a relief. Better that than just printing money. However, not bailing out the system is the best option, but at least this is better than the worst case.........

I have had a comment in which one of the regular commentators (Lemming) on the blog has played devil's advocate, and put forward an argument that the bailout is the right thing to do. This is the argument put forward:

'Aside from external debt, does a country's internal debt matter, anyway? If most of the bad debts which are being monetized were as a result of over-inflated house prices it won't matter if they vanish into thin air, will it? It's just good for some people, and bad for others, with a net result of zero. (People spent money on imports with the dollars they raised against their houses, however, but more fool the foreigners who were taken in and who exchanged real goods for worthless paper.)

Is the same true for derivatives 'de-leveraging'? That is, if the debts and 'assets' had never existed nothing material would change?

At the end of the day, if the world's economy was 'reset', we would still have the same level of prosperity we have today, wouldn't we? There would still be the same natural resources, the same number of people with the same talents, and the same infrastructure. The financial system has got itself gummed up, and technically some people have enjoyed a standard of living they did not deserve, (financed by others who were seemingly happy to pay for it) but if the whole world can see that by insisting on following through on every failed loan and transaction, that it drags everybody down into the mud, it might be best to 'start again' and reset the mechanism. Sure, some people in far away lands are owed some money for past productive activity, but even they might see that they must 'let go'?

Is this the logic that has led to the US dollar being artificially propped up by the world for years, i.e. that it is better to keep the mechanism running, even if it results in undeserving people living in luxury, than for the mechanism to grind to a halt. Have we reached the stage where it is impossible to keep the mechanism running whatever we do, so more drastic action is needed?'

The first point to make is that it is now apparent that the 'rescue' of the financial system will be financed through monetisation ('printing' money), not through government borrowing . This approach will have very serious consequences for the US and world economy.

The first problem this presents is that it will destroy confidence. I have discussed the importance of confidence in a fractional reserve banking system elsewehere in the blog. The important aspect of the post is that in a system of fractional reserve banking is that money in such a system has no value whatsoever except what we collectively believe it has. By printing money in this way, the US will certainly destroy confidence, as there appears to be no limit on what the government is willing to print.

The result of this unconstrained printing of money is that the $US will fall. This is very different magnitude of fall compared to that which would occur has the US government decided to finance the bailout through borrowing. In the latter, the bailout would be funded by the US taxpayers, but in the former the pain is shared around the world by all holders of $US assetts. This may appear to be a clever move, as it shifts the burden more widely, and moves some of the pain to the rest of the world. However, the price will be high for printing money (see article here for an example - though the article does not give a picture of the seriousness) .

As I have already mentioned the entire banking system rests on confidence, and this is a fragile base for a financial system. If you destroy confidence, money has no real value whatsoever, and this is the problem of removing a currency from exchange for a tangible asset such as gold. If you give me $1, I will only value it if I believe that the next morning I can still use it to buy the same amount of product as I could today. If I no longer believe in this, and it is just a matter of belief, then I will not accept the $1 that you give me and will want to be paid in some other way. If a government can print money with no constraint, and with nothing to back it, then I will cease to 'believe' in the value of money. The best way to understand this is to take a look at my original post, where I make a comparison between the virtual world of 'Second Life' and the real world. When you see this comparison, I hope that all becomes clear.

This is a very roundabout way of coming to the subject of the foolish foreigners who have exchanged goods for worthless paper. Yes, this is quite right, they have done this. Yes, they have been foolish to do so. However, the system is built on trust (confidence), and those foolish foreigners will learn their lesson. That is, they will no longer trust that they will ever be paid for what they provide, or at least they will lose belief that they will ever be paid in full. This means that the TVs, the toys and all of the other imports that the Western consumer has been able to buy will only be available with a massive risk premium attached to their price, as they will have no confidence that the $US they get in return for their product will be worth the same tomorrow as it is today. I talk about this as if individual firms will take this approach, but in reality it is the collective loss of belief that matters.

What of the idea that if everything is reset, we still have the same amount of resource, the same people and the same infrastructure. This is very true, that nothing has changed 'on the ground', except for confidence. It is here that we return to the massive accumulation of debt in the Western economies. In a situation of loss of confidence, who will keep the lending going? Who will lend into currencies that are devaluing, and at what risk premium?

The trouble is that when the debt ATM is shut down, how much is all of the talent, infrastructure and so forth really able to produce? Can it produce enough wealth for Western consumers to buy the latest shiny plasma TV from a Japaense company manufacturing in China? In other words, are the Western economies producing enough to have sufficient product/services to exchange for the shiny plasma TV? The answer is that most of the Western economies have not been producing enough for a very long time, and that the continued lending was built upon a false belief that they were. Once again we come back to the idea of confidence and belief. I return here to my analogy of the aristocrat who lives beyond his income, with all of his creditors lending on the basis that the aristocrat's family always having been so wealthy for so long that they just can not believe that in reality he is broke.

The reality is that the majority of the Western economies are just not producing enough value to continue to live in the manner to which they have become accustomed. We are, in reality, broke and in debt. No one is going to lend to us, and we now have to adapt to living on the value that we really produce.

Yes, the world has kept the West living in luxury, but it has been no conspiracy. It is, as I have said earlier, that the world has just 'believed' that the West was rich, and always would be. The world is waking up to the reality, that when they lend to the Western economies, that the Western are unable to produce sufficient goods and services to pay back what has been lent or, put another way, the West is unable to produce sufficient goods or services of sufficient value to make trading with them on todays' terms worthwhile. That means that the terms of trading with the Western economies will be more realistic, and that means the value of currencies must fall - and fall by a huge amount. There is no possibility of resetting the mechanism, because the mechanism was never a deliberate policy, but was built upon a collective delusion.

What can be done? What drastic action can fix the problem?

The answer is that nothing can be 'done'. Printing money will only exacerbate the problem, fuelling hyper inflation. For the Western economies, such as the UK and US, they will simply have to adapt to living within their means. The welfare states, the health services, the wasteful use of money by government will all be unsupportable. The massive boom in services, the expensive restaurants, the crystal healers, the retail expansion - all of these will shrink back to a sustainable size to reflect the contraction of the economy as the debt ATM shuts down. The result will be massive unemployment, unemployment on a scale that we have never imagined. The foreign investment will dry up completely, the cost of all the imports will surge, as well as the cost of commodities.

I have previously suggested that inflation would be held back by the rise in unemployment, that costs in the UK would be held down and that this would counter the worse effects of devaluation. I no longer believe that will be the case, as I now believe that the currency collapse will be so severe that massive inflation is the only outcome. I wrote a couple of months ago that it was hard to believe the logic, the inevitability, and the severity of what is coming. I suggested that I had been too conservative in my predictions, that it would be worse even than I had suggested in 'A Funny View of Wealth'. Now, as we stare over the precipice, the distance to the bottom is becoming ever more clear, and it is a very scary thing.

As I sit in my comfortable home, enjoying the comforts of the Western lifestyle, it is hard to imagine that it is coming to an end, but it is. In my case I am hoping that I have taken a course of action that will insulate me from the worst of what is to come (at least for three years), but I worry for those who will be exposed to the full force of this economic hurricane, and wonder how the world will look in two years time.

I suspect that it will not be a pleasant sight.

Note 1: Lemming also posted a link to a very interesting site. I strongly recommend it to all the readers here. It includes articles by Ron Paul, and for readers of this blog in the US I would strongly recommend Ron Paul to you. He appears to be the one potential leader who understands the situation, and knows what to do. Quite simply, you should be begging him to run for president, though sadly it is probably too late. In the UK I see no such potential leaders, and that is a very worrying thing.

Note 2: I have just taken a look at the Sunday editions and found the following:

'After a week of unprecedented financial turmoil, they predict that government borrowing is about to surge as the Treasury’s tax take is slashed by a slump in earnings from the City and the downturn.

Leading forecasters say the government will soon be forced to borrow as much as £100 billion a year, giving Britain easily the biggest budget deficit of any western country'

This is exactly as I have been predicting, though I still believe that this is conservative. It is time for structural reform. The UK can not afford to go on as it is. If you are new to this blog, take a look at the links at the top of the blog, where I outline some solutions. If you like them, recommend the blog to others, as the purpose of this blog is to try to make a small contribution to the realisation that reform is the only way through this. If we do not accept this king of reform, the alternative will be more government 'solutions' and it is the solutions of the government that led us to this crisis.

Yet another note: I have just taken time to look at the Sunday edition of the Telegraph and the coverage of the crisis is becoming ever more gloomy. A good example can be found here (I use the word 'good' very loosely):

'Power has tangibly shifted - away from the United States and the Western world generally, and towards the fast-growing giants of the East. That's been happening for some years now'

The article in question goes on to say:

'How much more can the US taxpayer take? It sounds insane, but the liabilities being taken on by the Fed and the US Treasury are now so enormous that the government itself could default. No?'

and

'But the ultimate financial question - until recently, unthinkable - is now being asked. Yes siree, the mighty US government could default. That's how much the world has changed.'

At the moment it is the US that is take the brunt of the pounding. However, the UK economy is far, far weaker than the US economy. I do not mean in terms of what has been taken in the past to be strength and weakness (see 'A Funny View of Wealth'), but underlying strength. We are more indebted, and lack any clear competitive advantage in most sectors. If we look at the pain of the US now, we need to multiply that pain for the UK.

In another article, it appears that the FSA is trying to find a buyer of B&B. The death roll of several UK banks is starting, but expect an acceleration of the pace, as everyone now examines the state of even the most 'sound' and largest banks.

It seems that we are now entering the final stages of the beginning. In this case, the beginning is the destruction of the economy of the UK. This is the shock of the crash. I am not sure how longer this phase will last, as there may be some more false dawns, but suspect that it will just be one or two months at the most. The time scales are very much in line with myprevious predictions on this blog. As I have repeatedly stressed over the last few months, make sure that you have your liquid assets ready to move at short notice. Ensure your accounts have Internet access and, at the first sign of rumour, move your money to another account. Be careful of using the same bank but with different brands.

After the crash will be the shock. The shock is when we contemplate the financial ruins, and see the bankruptcies multiply accross all of the economy, and unemployment sky-rocket. The outstanding questions will be the final order of the collapse. Will it be national debt default, or banking collapse, or both in conjunction. Both will happen, so it is not clear that one order of disaster is better than the other. It is only to be hoped that it all happens sooner than later, as the longer the delay, the more foolish action will be taken to avert the crisis from government.

I think I mentioned in a recent post that I am shocked at the panic. As I said, I thought others would watch dispassionately as all this occured. On reflection, I can see that it is only that this is no surprise that allows me to see it as an inevitable unfolding of events. I watch as the panic unfolds, and can imagine the late night meetings in the government as they desparately seek a solution that is not there. The momentum is now going to carry the crisis forwards, whatever they do. Instead of panicked meetings, I can only hope that someone is thinking through the aftermath, and asking how to pick up the pieces. I have always had this in mind as I have written this blog.

This is my last note today, as it is all rather depressing to think about.

(all notes written on day of original post)

Isn't all Growth built on Debt?

I have had a comment on the question of debt, and consumer debt in economic growth, from a regular commentator 'Lemming' (whose questions become ever more perceptive and interesting):

'I'm still a bit baffled, and this section seems to fit quite neatly with my question on fractional reserve banking. If money is created only when someone takes out a loan, then by definition isn't all economic growth really a growth in debt? And as the debt is taken on in order to spend the money, isn't that growth going to be driven, in large part, by consumer spending?

I was thinking of this when I asked my earlier question. If I understand the UK's 'FRB' system correctly, it appears that someone, at some point, decided that the best way to regulate the growth of the economy is to base it on the man-in-the-street's judgement, as measured by his requests for loans.'

The poster, for example, describes the irresponsible person buying a plasma TV for every room in his house, relying on debt to fund this purchase. The poster suggested that the growth of such debt was the driver for growth of finance overall, and that this the driver for the economy in the hands of 'stupid people' (ordinary consumers, though I think Lemming means financially illiterate here) .

In order to lend the money to the individual, the bank must first borrow money in order to lend money, with for example central banks providing the initial liquidity. This initial liquidity is then fed through the banking system, and appears to multiply many times over, due to fractional reserve banking (see here for and explanation of this). At the end of the chain is the bank lending money to consumers.

These consumers are then borrowing money, which then flows from the banking system into consumption - in this case a plasma T.V. At each stage of the lending chain, one organisation is guaranteeing, repayment to another, all the way up the lending chain. In other words, each bank is often reliant on many banks all making repayments.

Is the consumer in the driving seat, and driving the economy by driving demand for finance? This is a very interesting question. Is demand for finance creating a debt laden economy?

Of course, the above is massively simplified, as there are often a multiplicity of interdependencies and relationships between different banks, and financial institutions. I do not want to give a more complex explanation than this, as the key question in such a system, is whether all growth is built upon debt. Is it possible to have the capitalist system without growth in debt?

The issue here is what the debt is being used for. If the generation of debt is being used to finance a productive asset, then few people would argue that this will benefit the economy in general and therefore consumers indirectly. On the other hand, if there is a massive expansion in the money supply being fed into credit based consumption, then this creates a situation in which consumers will just be foregoing future wealth. The trouble arising from such a scenario is when the supply of money expands such that there is an oversupply of money, and this money is then allocated poorly (the current situation). In this situation there is a ballooning of debt, which must one day be paid, and finance becomes so cheap/available that it gives consumers incentives/capacity to be 'stupid' (to use Lemming's expression). In so doing the banks fuel what appears to be expansion through consumer led growth, such that the economy appears to be performing well, which in turn maintains an illusion that the consumers will be able to continue paying debt.

So which causes which? Is it growth in the money supply that creates the debt, or is it demand from the consumers which produces debt. It is actually a combination of the two. Without the expansion in the money supply, debt would not be offered to consumers who are relatively high risk, but the consumers still need to take on the debt in order for the money to be allocated to consumer debt. What we have is a feedback loop in which one encourages the other.

The result of such a self-reinforcing system is that the increase in money supply is built on confidence in the economy, on the ability of consumers to continue to service their debt, which is built upon an assumption of continued employment. If the growth in employment is built upon foundations of growth in consumption, then we have the makings of a bubble. Debt pays for consumption, consumption drives employment, and employment drives further lending. One factor reinforces the other. All the time the overall amount of lending and debt is building. Right up to the point where consumption stops, and then the credit bubble bursts, leaving banks and consumers in trouble, and a wreck of an economy.

As an answer then, we can say that, in part, the economy is being driven by 'stupid' consumers. However, we can also say that the economy (in this case) is also being driven by 'stupid' bankers, whose economists have not grasped that consumer credit led growth is a bubble. Had the economists asked where the future repayments of their lending was going to come from, then they might have suggested that their lending was irresponsible. The trouble is that, whilst the economy continued to expand, they ignored the warning signs (increase in values of housing), and chose to imagine that the new 'service' economy was sustainable long term. As such they continued to lend into an already saturated market. At some time, it was inevitable that an increasing number of consumers would be unable to service their debt, leading to a shrinkage in consumption, and a bursting of the credit bubble.

In this case we have the complication of house prices, which enjoyed price rises due (in part) to an increase in the availability of finance on ever more relaxed terms (poor/higher risk allocation of money). This generated a boom in house prices, such that the banks could point to illusory security on their debt, and for consumers to have the illusion of growing wealth in assets to justify their irresponsible borrowing. Without the factor of house price rises, the credit bubble would have burst much sooner. The illusion of security for both parties kept the credit bubble inflating. If you then throw in the unusual factor of migrants coming into an apparently booming economy, increasing the population, and thereby increasing demand for housing, thereby creating further upward leverage on house prices, you have the mess that we are in today.

I am simplifying here and pretending, for the sake of argument, that the UK is a closed economy, ignoring government borrowing etc. The complication in all of this is that external confidence in the UK economy has also been a factor. However, I hope that this goes some way to answering the question. It is not just the consumer that has driven the debt bubble, but also the banks, who have misunderstood the risks inherent in a consumer credit based economy.

A note for Dan, who made a comment on another post.

Dan suggested the idea that he should be able to opt out of certain benefits provided by the government, such as unemployment benefit, with a subsequent reduction in his individual tax rate. This is a perfectly fine idea, as long as he is able to continue in employment. However, if he were to lose employment, what would then happen? Looking at the case of unemployment benefits, there are some problems.

In the case of Dan becoming unemployed it is likely that he would then become completely destitute and would therefore potentially starve to death, or become a beggar (I am assuming that he is not wealthy enough to have a very large amount of savings for the sake of argument). Both outcomes would be unacceptable to society. The only option would be for charity to help out, but would charity be inclined to help in the situation that he actively opted out of the protection of the state in order to benefit from the savings on taxation whilst he was in employment? The answer is probably 'no'.

Modern society does not accept begging or starvation, and therefore society would still (in some way) have to offer some support. As such, an opt out system would not work, on the basis that as a society we would not accept such an extreme level of destitution. Dan's concern is presumably that he feels that taxation is too high. The only option is to either completely abandon, or reform, benefits for everyone to reduce the overall demand on taxation. At some time in the future I hope to look at these questions, and hope that I can propose a solution that would be acceptable to Dan, and to society as a whole.