Inflation, Deflation and Money

The post that follows is a slight change of direction. I started one post (see below) and found the question of money was nagging at me. In particular, there were some interesting comments on the subject of money after my last post.

The first point I would like to consider is output and money. The measure of output is a bit of a tricky problem when looking at an economy. In particular, if the measure is made in currency x then, if there is inflation of currency x, it appears that output is actually increasing by this measure.

If we imagine that factory x produces 100 units a day, and there is £100 available to purchase these units, we have 1 unit = £1. If we increase the supply of money without increasing output, then we will have more money chasing the output but still no more output. This is inflation. If we then record output in £, we will measure an increase in output. However, this is not the whole story....

MattinShanghai, a regular commentator, has raised the issue of inflation and money supply as follows:

You've talked a lot about the dangers of hyperinflation resulting from the uncontrolled printing of money by central governments. I have to admit that I'm quite confused about the whole subject, and reading numerous opinions published both by "experts" and amateurs, does not help. On the one hand, there are voices saying that we are on the road to Wiemar-style hyper inflation. Others say that the destruction of paper wealth in real estate and the stock markets, collapse of the markets for securities which underwrote many of issued loans, bankruptcy of financial institutions etc. have "shrunk" the money supply so much, that no amount of central bank money printing can fill the "black hole" and avert deflation.

I suppose that my natural reaction in the face of this is simply to suspend judgment and adopt a "wait and see" position. But I also do seem to have some fundamental problems with supposedly "uncontroversial" aspects (at least in mainstream economics) of money theory. I wonder if you or any of your readers can enlighten me on the subject and point out where I'm wrong.

Matt goes on to offer a critique of mainstream economic formulae, and highlights the absurdity of the fudge factors in the formulae. I find myself in agreement with his critiques.

I have previously discussed at some length the nature of money. In particular, I have argued that money is what 'we' collectively believe it to be. Although Matt has suggested that he disagrees with me on what money might be, I find that he hits the nail on the head in the following point:

But it gets worse. Take the money supply 'M'. What is it? Is it just the sum of notes and coins in circulation? What about money stored in jars buried in gardens? Does this count? How about credit card limits? Savings accounts? Private debts? Cheques "in the post"? Questions and more questions...

What I have argued is that money is 'money' when we believe it to be money. When a shop accepts a credit card, and a person generates a debt on the card, the shop is accepting the payment as real money. They believe that the credit card will provide them with x number of electronic currency units that they will be able to exchange for goods and services in the future.

If I am a worker, and I am short of cash, I might exchange my labour to mow your lawn at some future point in time in exchange for your buying me a beer. I might write an IOU note, promising that I will, within a week, spend an hour mowing your lawn. In turn, you might transfer that IOU to another person in exchange for some cakes that they have baked, and I will have to mow that person's lawn for one hour instead.

The critical part of these two very different transactions is that they must be based upon a belief that the currency in question will be repaid in goods or services in the future. If I am actually lazy and unreliable, and therefore unlikely to meet my promise of lawn mowing, then it is unlikely that my IOU would get very far as a currency for exchange. Quite simply, people will not believe that they will be paid.

I have previously given another example; the famine currency. If we are in a situation of famine, and there is a limited supply of food still available, then the idea of what money is will shift. If I offer my services to you in return for payment, and I am on the point of starvation, I will want to be paid in food. You might offer me piles of gold bullion but, if that gold bullion can not be exchanged for food, then I will reject that as a currency, and only accept the food. Gold can not buy what I need, and therefore ceases to have meaning as a currency. The same might be said of any medium of exchange that might be offered to me, if it ceases to allow me to buy food.

Money is therefore a matter of perception. In a previous example, I have pointed to the lines outside of Northern Rock. The people in those lines wanted bits of paper with the head of the queen printed on them, not IOUs provided by Northern Rock. Northern Rock held large numbers of IOUs, but individuals refused to believe in them. They no longer believed that the IOUs would do the equivalent of purchasing one hour of lawn mowing.

It is when we see money in these simple terms that the arguments about deflation make sense, but it is also possible to see how they do not finally add up.

Banks have been passing on the savings of people (value of their labour) to provide credit in return for IOUs. Those people who have provided the IOUs have promised to apportion part of their future labour in return for the money. The trouble is that there was so much money pouring into countries like the UK from overseas, that prices of assets such as houses rose. As such, there was a boom in the issuance of IOUs which started to exceed the ability to repay the IOUs, or at least impossible without a significant fall in consumption of those issuing the IOUs.

In real terms, a Japanese worker has provided a car to a UK consumer. The UK consumer has promised to repay the labour of the Japanese labour with an equivalent value of labour. For the moment we will leave aside the difficult question of how labour might be valued. In our lawn mowing example it was a beer for an hour of lawn mowing, but it might equally have been an hour of building a shed. The important part is that there is an expectation that the returned labour will have a value that is worthwhile to the recipient.

The problem that has arisen is that the Japanese labour has been exchanging their labour for IOUs, but the labour in receipt of the IOUs is unwilling to return an equivalent value of goods or services. The credit crisis is simply a recognition of this fact.

In other words, huge amount of the IOUs are no longer recognised as money, or at best are seen as debased money.

At first blush, this appears to support the deflationary argument. It appears that the money supply in the countries that were recipients of the labour of countries like Japan, now have less money. After all, individual IOUs have ceased to be an accepted unit of money. There is a lack of belief that the individuals can repay in an appropriate value of goods or services.

However, instead of issuing credit to individuals, the new method is to extend ever more credit to governments. As such, instead of lots of individual IOUs being generated, there is a single huge IOU being developed as a replacement. Just as with the individual IOUs, there is an implicit promise to return the value of the labour at some future date. In other words, even as one form of money is being destroyed, more money is being created as a replacement. Of even greater concern is that the previous money that was supposed to have been destroyed, has not in fact been destroyed. It is being converted into the new form of money - government IOUs (of course, government debt was expanding even before the credit crisis, but I hope that you understand the point).

Now, if we return to the beer and lawn mowing example, one of the key features of the transaction is that I have consumed the beer. Now if we imagine that I am not just issuing the IOU to you, but making similar deals all around the town, I am getting extremely drunk, and having a very good time this week. However, all the time I am drinking, I am in a situation where I am promising greater and greater amounts of labour to people all over the town. In fact, I am promising that next week I will undertake 100 hours of lawn mowing. In other words, for the consumption of this moment in time, I am going to have to have a very tough week next week. In addition, even if I do all 100 hours of mowing, I will have to use all of that labour for repayment, and will not be able to exchange my labour for beer during that week.

I wake up on Monday morning with an almighty hangover, and can not face the job of the mowing. As you would expect, the creditors of my beer drinking binge are none too happy when I fail to show up for work. The problem they face is that the beer has now been consumed, and there is no way to get it back.

Unlike in the analogy that I have provided, there is another important consideration. In the real world, governments are now borrowing more, and promising to repay the debts that were accumulated during the binge. As a result of this, the creditors are willing to continue to extend credit. The important point about government is that they can, through the taxation system, enforce less consumption upon people, and indirectly force them to work more. In other words, they are in a position where they can allow me to drink more beer now, but make me work the necessary 100 hours next week. It is on this basis that creditors continue to lend.

As such, as the situation exists, there is more money flooding into the economy, and ever more IOUs being issued in return. In other words, the money supply continues to increase, and the form of money is IOUs.

Now if we were just to imagine that Japan was the only creditor, then we can see that we have a growing debt of labour to Japan. That debt translates into a future commitment to provide goods and services of 'x' value to Japan. If we then think of this in practical terms, each gilt (for example) that is issued is a call on the output of the UK economy. If we then see no increase in the output of the economy, we can see a greater amount of labour owed per unit of labour. If each unit of labour is producing one unit, but we keep issuing ever more IOUs against that one unit, then it becomes less and less possible for that labour to service the debt. What you have is more and more IOUs making demands on the one unit of output. That is inflation.

In addition to this, we have the confounding factor of what I would call 'traditional' money. This is the units of £GB, and I call this traditional on the basis that this is what the people who lined up at Northern Rock believed to be money.

As regular readers will be aware, the Bank of England is creating more of this traditional money, but is doing so without any commensurate increase in output from the economy. This means that, in addition to more IOU money being issued, there is more traditional money being issued. This is, in effect, a double whammy. Both the issuance of traditional money and the issuance of IOUs represent a commitment of future labour in return for the credit now. They are both being expanded at a time when the output from labour is not expanding.

The one factor I have not included in the example of the real world is time. In the case of the lawn mowing, I specified 'next week'. As many are aware, government debt is issued over a range of time periods, such that in different periods, different quantities of debt are due for repayment. I have not included time, as there is currently no proposed time frame for government to start repaying the overall burden of debt. Rolling over existing debt, whilst accumulating more debt, means that the time frames are moot points.

The only solution to these problems are as follows:

1. There is a massive reduction in consumption, and an expansion in working hours. This would allow an increase in output available for repayment of debt. This is deemed as politically unacceptable.
   
2. The government takes the credit offered, and later repays it with less value than was implicit in the original bargain. This is the process of inflation, in which the government allows ever more issue of money whilst not demanding that labour reduces consumption and increases hours to the necessary level for repayment. Under these circumstances, more money will be chasing the existing output, such that the value of all UK money is debased. Inflation.
3. The government, by magic, engineers a productivity miracle such that output exceeds the increase in the amount of money.

The current policy is item number two, but with number 3 as the excuse for greater borrowing.

If we think of money in the terms that I have discussed, it becomes apparent that the reality of money is contingent on the belief that it will have a future value in goods or services. In issuing IOUs, governments are increasing the money supply, as they are increasing the promise of future goods and services. The problem that arises is that they are being dishonest, as there is no way that they intend to repay the IOUs in full.

They are like me drinking too much beer, refusing to work the 100 hours I have promised, and only accepting that I will do 39 hours of lawn mowing. Not only do I refuse to do the 100 hours, I also insist that many of the 39 hours I undertake is used to purchase more beer. In other words, I am cheating my creditors. My currency of IOUs is debased, and is inflated.

When I have discussed money on previous occasions it has always been highly contentious. I fully expect that there will be further debate on this post, and will try to find time to address any of the points. In the meantime, I would like to just highlight the key points of the arguments.

1. Money is a belief in anything that is seen as a medium of exchange for the future value of labour (i.e. goods and services). Money is only money so long as people believe that it might be exchanged for goods and services that they need/want.
   
2. The value of money is determined by the total supply of money, measured as a division of labour output divided by the units of money in supply, over time in which the money might be utilised. e.g. the timescale of IOUs is a factor in the value of money, as in the case of the lawn mowing. Time and value is contingent on the amount of money calling upon labour output in a given period.
   

The last point is complex, and I hope it makes sense (I had to re-read it myself and I'm still not certain). However, the principles I am outlining are my best explanation of money, and why there must be inflation.

This leaves the timing of inflation in relation to the two points above. The money supply, according to my understanding of money, is increasing. The question that remains is how that increase might eventually translate into demand for the value of labour, at what time. This is a question that is, quite frankly, beyond me. However, I hope that, from this explanation, it is apparent why inflation might be delayed for some time. My suspicion is that inflation will be prompted through a collapse in belief in UK issued money, rather than a progressive increase in inflation as debt falls due.

Of one thing I am certain. More money is being issued than can be supported by output. Short of a miracle in productivity, I see no prospects for anything other than hyper-inflation.

Below is the original article that I was going to write. Somehow, thinking about the points below led me into the discussion of money. The post below may make more sense in light of the discussion of money.

More Green Shoots.....

There has been yet more talk recently of economic recovery in the UK, and the £GB has strengthened as a result. This is a perfect illustration of the point that I made in my recent TFR article - that any good or bad news will see wild swings in markets.

In this case, the good news has been provided by an economic think tank, the National Institute of Economic and Social Research (NIESR). The Telegraph reports their findings:

The NIESR figures were the latest sign that parts of the economy have been staging a modest recovery, and coincided with data from the Office for National Statistics, which showed that UK manufacturing output increased by 0.2pc in March.

It was slightly better than economists expected and represented the second monthly rise in a row after the ONS revised up March's figure from a fall of 0.1pc to an increase of 0.2pc.

There has long been talk of a restocking of inventory, and it is likely that this is the process in action (assuming the figures are accurate). However, there is something faintly absurd in such figures, and this is illustrated in the following quote:

Meanwhile, governments across the world have seen their budget deficits explode as they seek to cushion their economies from the crisis. In the US and the UK, the fiscal deterioration is especially severe - with deficits this year around 12pc of GDP each and no credible medium term plans for balancing their budgets.

What we have here are two figures that simply do not add up to anything. On the one hand we have an explosion of fiscal deficits to around 12pc of GDP, and on the other hand we have a minuscule uptick in a couple of indices. In other words, the situation is so dire that the monstrous pouring of money by the government is still leaving the economy in a situation where it is barely into positive territory on a couple of indicators. The real question here is to ask what this indicators would be showing if the debt spigot were to shut down.

It is at that point that we would start to see the underlying output of wealth creation, in contrast to debt fuelled activity.

It is a long time since I discussed the essential reality of government borrowing, and borrowing in general. For every £1 of borrowing now for consumption there will be £1 less to be spent on consumption in the future. If I have a credit card and I spend £25 on a meal today, next month I will have £25 less (+ interest) to spend on a meal next month. The only way that this may not be the case is if my earnings in the future outstrip the debt, in which case I might still have £25 to spend on a meal, instead of £25 + my increased earnings. Even in this case, my consumption now is restricting my future consumption.

In the case of government, if they borrow to spend money on a nurse this year, there will in the future be the same amount unavailable for spending in the future. In other words, one nurse now, costs one nurse (+interest) in the future. Again, the same provisos apply as with the credit card debt.

The question that then arises is to ask how earnings might increase such that they outstrip borrowing. The only way that this can happen is if there is significant investment in the productive parts of the economy, such that productivity rises. This applies to directly to the example of personal debt, and indirectly to government debt. As a worker, I need to achieve greater increases in my income if I am to be able to continue to spend at the same level as I am now, and these increases can only be sustained through greater output in my area of work. If not, at some point in the future, my spending must decline. In the case of government, it is possible to continue with the same spending only if I tax more from the economy, but this is replacement of private spending with government spending. This is neutral for the economy overall in terms of total consumption.

This discussion does not consider an ongoing increase in borrowing, which appears to be the current solution. In this case, all that is happening is that there is the build-up of a larger future contraction in consumption.

Within this scenario is a deep problem. If the government and individuals continue to borrow for consumption now, then there is less money available for investment into productive output. If the government borrows £40,000 today to pay for a nurse (figure guessed at for illustration), then there is exactly £40,000 less for investment into future increases in output of new wealth (i.e. there is less money available for investment into business). The situation is, of course, complicated by the problem that finance is global, such that an individual economy might have finance for both consumption and investment, but the problem in aggregate remains accross the world economy. Bearing in mind the explosion in government borrowing accross the OECD this presents a problem.

What we are looking at is a situation in which there must be a significant future increase in output per person, a massive growth in productivity, if there is not to be a future contraction. However, there is no prospect or indication of such a productivity miracle on the horizon. Whilst it is impossible to deny that such a miracle is possible, it currently looks improbable. In the meantime, governments are competing for finite capital that might make such a growth in productivity possible, thereby making it less probable.

Returning to the slight uptick in output reported in the Telegraph, what we are seeing is the fruits of debt fuelled consumption, not increases in output that might be sustained in the medium term. This is a best case scenario, but it is just as likely that there will be a tail off in the output once inventories are rebuilt.

At this point I was going to discuss inflation, and at this point I moved to the other article. The point I was trying to explain is that it is quite possible that inflation will offer the illusion of increased output. I suspect that, it is quite possible we will start to see inflationary effects appearing in the economy, and that these might be mistaken for recovery.

As such, I am increasingly concerned that there will be a relaxation of governments as a result of thinking that they have solved the crisis. The problem is that, instead of solving the crisis, they are simply deepening the crisis.



Note 1: The discussion of the Austrian school proved to be very interesting. I am happy to see that I could find some common ground with Lord Keynes on the point that commodity currencies are as subject to debasement by government as fiat currencies.

One of the interesting points in the discussion was the role of ideology in forming views on economics. Regular readers may have noted that I pick 'n mix from various sources, wherever I see a point of interest. As such, I value the Austrian school's critique of Keynesian solutions, but disagree with their approach on many points. I am endlessly impressed with Adam Smith, but still believe that trade can be a zero sum game and so forth. In other words, I do not subscribe to a particular ideology, and am not bound by any particular school of thought.

Whilst having a libertarian streak, in that I mistrust government, I still see a role for government in many areas, such as healthcare, or ensuring legal frameworks operate fairly. I simply believe that power should, as far as possible, not be concentrated. As such, wherever possible government should be minimised and powers dispersed.

However, I would hope that the balance of my personal approach is best expressed in the articles on reform. I am not sure that the ideas would fit neatly into any ideology.

Note 2: A long post, but I hope that it proves to be interesting.

The RMB as the Reserve Currency

I have a very curious sense at the moment of the world moving in slow motion. I had thought that the economic crisis would create dramatic moments, but in some respects it appears to be moving through a gradual shift.

One of the predictions that I have made, on two occasions, is the collapse of the $US and the end of the reserve status of the $US. However, it appears that the end of reserve status is being achieved with little drama, as it is apparent that the RMB is slowly but surely being positioned as a replacement of the $US as the reserve currency. We have this latest news from the China Daily:

Five major trading cities have got the nod from the central government to use the yuan in overseas trade settlement - seen as one more step in China's recent moves to expand the use of its currency globally.

The most interesting thing about the article is that the newspaper is part of the state run media, and therefore is careful to toe the party line. It is the following section that grabbed my attention:

Analysts said the experimental use of the yuan in trade settlement also reflects policymakers' rising concern over the shaky prospects of the US currency, of which China has large reserves from previous trade growth, and their willingness to gradually expand the yuan's use globally.

"The trial is the latest move toward making the yuan an international currency," Huang Weiping, professor of economics at Renmin University of China, said. "The prospect of a weaker US dollar is making the transition more imperative for China."

The method here is typical of the way that the Chinese government works. They use another person to make explicit an implicit policy, and thereby leave the situation open to later government denial. However, the idea is now 'out there', and that is their intention. The article also mentions several of the deals that I have discussed in past posts, and therefore offers a good summary of the progressive establishment of the RMB as a reserve currency to challenge the $US:

The mainland is trying to promote the use of the yuan among trade partners and, in the past four months, has signed 650 billion yuan (US95 billion) worth of swap agreements with Argentina, Indonesia, South Korea, Malaysia, Belarus and the Hong Kong Special Administrative Region. The agreements allow them to use their yuan reserves to directly trade with the Chinese mainland within a set limit in volume.

All the while this is going on, there is still chatter in the mainstream media about IMF Special Drawing Rights (SDR) developing into a new global currency. For example, Edmund Conway of the Telegraph points to a paper from the Governor of the People's Bank of China, in which there is a strong backing for SDRs as a global currency.

In fact, perhaps inadvertently the Geithner, Darling, Brown and Obama initiative has dramatically increased the odds of this happening [SDR as a reserve currency]. It will have increased the appetite of the Chinese, the Russians and the others who would like to depose the dollar as the world's reserve currency. Moreover, it has cemented the likelihood that they push for the deposition by trying to get the SDRs installed as the dollar's replacement. Quite how this would work remains to be seen. There appear to be plenty of obstacles and it is dubious that the SDR could be transposed to become a general unit of exchange.

I strongly recommend a read of the paper from the Chinese central bank governor. However, if you read it carefully, it might also be seen as much as an anti-$US statement, as much as a statement in favour of SDRs.

The problem for many analysts is that they are more likely to take an official paper as policy, rather than an article in the newspaper. However, a reading of Chinese history shows that a newspaper article is often used as a method of floating a new policy, often in contradiction to official policy. For example, the battle lines of the Cultural Revolution were heralded with People's Daily articles on the (apparently) innocuous subject of a Ming dynasty official called Hai Rui. I will not delve into details here, but this seemingly unimportant matter was exactly the opposite, and was later to be the precursor to a massive shift in government policy (for a full discussion of this you can find a good outline in 'The Search for Modern China' by Jonathon Spence, chapter 22 - which is one of the better studies of modern Chinese history).

Although the Hai Rui debate dates back to a different period of Chinese history, the methods of using the press, using proxy spokesman, and many other features of the case, can still be seen in use today. A more recent example that I discussed in a post many months ago was the indirect threat reported in a Telegraph article in which the Chinese obliquely threatened to destroy the $US if the US pressed further on trade disputes. As in this case, the idea was floated in such a way that allowed for later denials of this being an official policy. For those who may doubt that China might operate in such a way, I would suggest a reading of my post in which I discussed Chinese quasi-mercantilist policy in some depth.

In other words, China is now actively positioning itself as (at the least) a major issuer of reserve currency, but is doing so in a way in which - if their attempt were to meet resistance or fail - they can step back and point out that it was never their intention. They can therefore proceed with an official position of support for SDR, whilst acting to develop the RMB as a reserve, whilst never risking losing face. It is a very effective way of operating.

The real question is whether they might succeed in this ambition. Can the RMB become the world reserve currency? As I have pointed out in previous posts, they are already using their financial power to bolster their position and influence in developing countries (e.g. a recent loan to Mauritius). At the same time, despite my predictions of the demise of the $US still not coming to fruition, the actions of the US government, the irresponsible fiscal and monetary policy, continue to erode faith in the $US. However, the real key to reserve status is when trade is more broadly conducted in the RMB, such as move to trading oil in RMB. Perhaps Venezuela will offer such an opportunity? An article here suggests that Venezuela may need to turn to China for financial support, and this may well present an opportunity for China to start this process:

In Latin America, the external funding situation remains relatively stable but in the case of further deterioration of capital flows, the solid economies would be able to tap the IMF or the Inter-American Development Bank (IADB) for non-conditional lines of credit, while the economies with less sound macroeconomic frameworks such as Ecuador, Argentina and Venezuela would most likely only be able to obtain funds through more formal conditionality or by turning to lenders like China.

Returning to the question of whether it is possible, I see no reason to prevent the RMB from taking on this role. There has been talk about the RMB not being 'liquid' enough, the lack of depth of their financial markets. However, I take a fairly simplistic view, which is to ask whether a currency has the underlying strength of being able to be used to purchase goods and services. The answer to this question is, of course, 'yes'.

The remaining question is whether the Chinese government would want to have the RMB as the reserve currency. If it were to become the reserve currency, then it would surely dampen their export led growth, would it not? The RMB would appreciate in value and that would hurt the Chinese economy? There is some logic in this argument. The greater demand for the RMB, the more that it will appreciate - in principle. However, they would be able to hold down the value by expanding supply of the currency, though avoiding the level of expansion that has been the case with the $US. They will have surely learnt the lesson of the $US, which has seen the abuse of reserve status to finance massive deficits in government spending. Provided that they increase supply to provide sufficient to meet demand for the currency for trading usage, they will avoid the problems of the $US.

This point is critical. If a currency expands as a unit of exchange, rather than as a method of financing borrowing, the supply might expand without negative impacts and the value of the currency might remain stable. A currency is, in the end, a unit which promises to be utilised for exchange of goods and services and therefore needs to have the backing of an economy capable of honouring that promise. When a currency becomes a reserve currency, it might exceed that capability from the issuing economy, but still remain a currency in which there is confidence. Provided that confidence remains, there is little likelihood of the promise being called in all at once. In this respect, it mirrors fractional reserve banking in which the assumption is that it is safe to loan depositor money on the basis that not all depositors will want their money at the same time.

In other words, provided the currency continues in circulation, without a sustained call on the promise of the currency to provide goods and services from the issuing economy, it can hold and store value. My prediction of the (not yet arrived?) demise of the $US is that the underlying weakness of the $US is resultant from the abuse of the reserve status to build up a debt mountain, and the use of the reserve status to finance that debt. It can only service that debt through new currency issuance. There is no reason to see why China might follow such a course as a major creditor nation, and this is why it is so well positioned as a reserve currency. They only need to expand the money supply such that they provide sufficient units for exchange, not to finance debt. This is the inherent strength in the RMB, and why it might replace the $US.

I am sure that some will suggest that this is a simplistic approach. There are many other factors that are involved, some of which are psychological, or concerned with 'belief'. Whilst I can acknowledge these factors, indeed have to acknowledge them when viewing the continuing position of the $US, I do not believe that the underlying reality can be avoided for ever. In the end, as the situation becomes increasingly transparent and plain before the eyes of people, the underlying reality will become self-evident. In this case, the RMB as a unit of exchange for real goods and services is solidly backed up with the capacity to service the implicit promise of the currency.

On the other hand, the $US is expanding in volume to finance yet more consumption, the output of the economy is in decline, and the units in circulation are expanding beyond what is needed for exchange - whether for internal use or for use as a medium of exchange outside the US. Where is the underlying ability to service the promise?

The big question in my mind is when belief will end, and when will reality reassert itself?

Note 1: A regular commentator on the blog, Lord Keynes (a pen name) will be contributing an article in the future. Lord Keynes is a critic of many of the ideas in this blog, but I believe in open debate, such that I believe this will be a positive contribution. MattinShanghai - I would welcome an article on CDSs, an area I am aware you have both a strong point of view, and have evidently researched in some depth.

Note 2: I have had another article published in the Trade and Forfaiting Review, and you may wish to read this here. The article discusses the Japanese experience of quantitative easing (printing money).

Note 3: There is an interesting article here that I did not manage to integrate into this post. It is an essay on savings by the Chinese central bank governor, and makes interesting reading.

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?