Introduction
I have long promised a discussion of a system of fixed fiat currency, and the discussion that follows is my first attempt at this। It is a very long discussion, and I hope that you will have the patience to plough through such volume (I guess that many will not). However, I do hope that it will prove to be an interesting potential system that might help prevent a repeat of the current economic crisis.
The fixed fiat currency system proposed here will not please any school of economics, as within the proposed system is something to cause consternation within each school. The discipline of macroeconomics is currently going through a period of turmoil as a result of the economic crisis that is engulfing the world. Leading economists such as Krugman are calling into question many of the foundations of macroeconomic theory, and debate is commencing on both the causes and solutions to the current economic crisis. The fixed fiat currency proposed here is an addition to that debate.
In order to understand the fixed fiat currency system there is a necessity to return to the basic question of what money actually is. Furthermore, once the nature of money is explained, it is apparent that any system of money must also include non-traditional forms of money, and that will mean that the proposed system must also take into account the financial system.
The proposed system is not perfect. It will not remove booms, it will not provide for social justice or any other ‘magic’ solution to the economic ills of the world. However, it offers greater stability, transparency and above all honesty and fairness. The latter notions are curiously absent from most macroeconomic discussion, which is puzzling as economics has a foundation in human endeavour.
The article is sparsely referenced, but includes ideas such as the value of labour which is rooted in the work of Karl Marx, critiques of fiat money which owe a debt to the many articles on the von Mises Institute website, and the overall theory and work of Adam Smith in the Wealth of Nations is an important overall inspiration.
There have, of course, been other sources, but none of these are specific such that they might be referenced. Overall, the majority of the considerations are the result of personal analysis and thought arrived at independently. This does not preclude the possibility of others already having come to similar conclusions or ideas, and I will apologise in advance if these ideas have been proposed by others.
Due to the relatively independent way in which this has been considered, robust but polite critiques are welcomed. It is, after all, the musings of an individual barely schooled in any economic theory.
The Nature of Money
The first point to make is that all economic activity is rooted in the value of labour. A commodity such as gold only has value once labour has dug it from the ground, and labour has moved it to the surface. Once it arrives at the surface it will be some form of labour that is utilised to move it to where it is next utilised.
For example, if a commodity is moved by truck, the truck represents a store of the value of labour of others, with the truck being a representation of a long chain of economic activity rooted in labour. From the commodities dug from the ground and being processed, the transportation, sale and processing of the commodities, the purchase by component manufacturers of the commodities and the final assembly of the truck, each step of the manufacture of components is rooted in the labour of individuals.
At the heart of all economic activity is human labour, and economics is the process of exchange of value of labour between individuals, organisations and other economic units.
Within this system of exchange of value of labour, the underlying purpose of money is very clear. It should only act as a medium through which the value of labour might be accounted, and is always representative of a store of value of labour, with an underlying contract that it might, at some future point in time, be exchanged for the value of labour of others.
Any system of money should seek to represent the value of labour in a way that is both fair and stable, such that the underlying contract is met regardless of elapsed time. Such a system implies that the value of money should be a neutral token to be used in the exchange of value of labour, such that it offers a fair exchange as determined by how individuals and organisations value the labour of each other. The purpose here is not to discuss the rights and wrongs of how one person’s labour might be valued against another, which is a debate about social justice, but rather to identify that all economic activity is the exchange of value of labour.
If we view what might constitute money as it is defined here, it is possible to see that there are two forms of money that operate within an economy. The first form of money is the issuance by government of fiat currency, which might be called ‘traditional money’ for the sake of ease of expression. This is the money that is currently created by central banks in the form of banknotes and coins, as well as by entries in the balance sheets of banks. At present, the issuance of such money is controlled by central banks according to their understanding of the underlying state of the economy, and historically has seen a progressive and continual expansion of the money supply wherever the system has been enacted.
The other form of money is IOU money. To illustrate the principle of IOU money, a simple illustration might serve to explain how it is created, and from where the value in IOU money is derived. This will also aid in understanding of the value of traditional money, as the two types of money interact throughout an economy, and traditional money is just a particular form of IOU money.
If we think of an individual (we will call him Fred) in a small town who is short of traditional money, he might visit his local pub and talk with his associates in the pub about exchanging his labour in return for pints of beer. In return for the pints of beer, Fred might promise the individuals who are buying the beer for him that he will mow their lawns which will take one hour of his labour in their garden. This means that one pint of beer = one mowed lawn, which represents one hour of labour for each pint of beer that has been purchased for him. As he is drinking beer, he is worried he will forget to whom he has offered his services, and will therefore provide a slip of paper offering one mowed lawn to be undertaken next week.
Fred, being a heavy drinker, starts to issue many IOUs and Henry has exchanged pints of beer for two IOUs. However, on reflection, Henry decides that he only needs one mowing of his lawn next week, and wonders what he might do with the IOU. He then sees a friend with a sandwich and offers the IOU to the friend, in exchange for half the sandwich. The friend accepts the IOU and provides half a sandwich.
What we are seeing is the creation of money. Fred, in offering a future commitment of his labour, is creating IOU money. It serves as money, as the IOU notes have become a recognised unit of exchange. When the person exchanged the sandwich for the IOU, he was exchanging the sandwich on the basis that the value of labour stored in the sandwich would be exchanged in the future for the value of Fred’s labour. In so doing an exchange of labour has taken place, and an underlying contract has been created. The IOU also acts as a measure/account of value of labour, as we are starting to see that one hour of labour in a garden = one pint or half a sandwich.
At the moment, Fred’s IOU money is ‘good’ money. Everybody in the pub accepts Fred’s IOUs as money, and Fred continues to drink beer in exchange for the IOU money. At the end of the first day, rather drunk, he staggers out of the pub having exchanged 15 IOUs for pints. He returns to the pub the next day and, being a heavy drinker, does the same thing. On the third day that he returns to the pub, he tries once again to make the exchange of IOUs for beer. However, as he enters the pub, he meets a cold reception.
Fred now owes 30 hours of gardening for next week. An individual in the pub has pointed out that Fred is already employed by a gardening firm, and that his ordinary working hours are 40 hours per week. This will mean that next week, Fred will need to undertake 70 hours of labour. There are doubts in the pub that he is this hard working and, just before he came into the pub, one of his IOUs was therefore hurriedly exchanged for a packet of peanuts, which are half the price of half a sandwich in traditional money. Confidence in the money being issued by Fred has fallen. The currency has devalued due to lack of confidence in Fred meeting the contract in his IOUs.
Fred is thirsty and alarmed at the lack of confidence in his IOUs. He therefore decides to take measures to restore the value of his IOU money. He explains to everyone in the pub that, if he does not meet his gardening commitments, he will instead provide the holders of the IOUs with some of his gardening tools. Whilst many people do not want the gardening tools, having the IOUs backed by the tools means that, at least, if all else fails, they might sell the tools in lieu of the labour owed. Fred’s IOU money is now backed by assets, and Fred is now able to continue exchanging IOUs for beer.
Within this scenario, it is possible to see how the value of money is created and maintained. In all cases the money is backed by, or representative of, the value of labour. Even when Fred backs his IOU money with his tools, the tools represent a store of value of labour of others. In all cases, the money is an IOU of value of labour, and the value of money is determined by the confidence in Fred’s ability to deliver that value next week.
In the case of traditional money, the same thing occurs. It is accepted on the basis that it will, at a future point in time, represent a contract for the exchange of labour. It is identical to what Fred has done, but is different in that it represents a wider pool of labour, and is abstracted away from being a single variant of value of labour. Whilst Fred’s money uses units of one hour of gardening as the base unit of measure, traditional money has no single base unit to measure against. This is different to, for example, a gold standard currency, in which the commodity becomes the base unit of measure.
We can also see in the case of Fred how money holds value when supported by an asset. If we look at a commodity standard, or the issuance of asset backed securities, we can see that asset backed money simply offers a substitute of stored value of labour in place of the future commitment of labour.
However, there is a problem with asset backed money. If we imagine that Fred is very lazy, and fails to meet his future commitment of the value of his labour, he will have to offer a large number of his tools in lieu of his labour. Many of the recipients of the tools will want to sell them, and the result will be a flood of tools being offered for sale in the local classified section of the local newspaper. However, there is no reason why there might be a sudden demand for so many tools within the town, and therefore many of the tools cannot be sold. The holders of the tools are faced with holding on to the tools in hope of later demand for the tools, or selling them at a steep discount. They believed that the tools were a substitute for the hour of gardening labour, but find out that they are not.
This point is the underlying problem with any asset backed form of money. Whilst, in the case of Fred, he has offered an assurance over and above his promise to deliver, the value of that underlying assurance does not necessarily represent the actual value of labour that is contracted in the money that he is issuing. The same point may be made for any money secured by an asset, such as gold backed currency. The value of the underlying asset is subject to fluctuation, such that it may advantage or disadvantage the holder of the money, with no reference to any labour undertaken by the holder. The same might be said for any commodity currency, such as gold coins or silver, which might be subject to variations such that each unit changes value in relation to the value of labour.
What is apparent from the example of Fred’s money is that the only real value of money resides in the meeting of the underlying contract of provision of value of labour. In other words, the only way to achieve the full value of Fred’s IOU money is for Fred to actually do the hour of gardening work promised in the IOU, which means one mowed lawn. In practical terms, therefore, any good money system should not be based in assets but in firm commitments for the fair exchange of the value of labour at a future point in time.
Current Fiat Currency Systems
In the current fiat currency system, it is apparent that the currency is neither fixed against an asset, and is not fixed against any value of labour in the economy. The issuance of the money is not referenced to the potential output of value of labour in the economy, and the supply of money is continually inflated. It is like Fred offering ever more IOUs regardless of whether he might meet the contract for each unit offered. The issue of each unit of currency does not represent the actual value of labour in the economy, and is issued independently of this.
An interesting comparison with current fiat systems is the issuance of currency in the online world of Second Life. It is a currency issued by the owners of the Second Life world, is utilised for exchange within the world and can be converted into $US through a currency exchange. Both currencies are as arbitrary as one another, as neither currency is rooted in anything. People are now earning a living in Second Life, and use the currency exchange to allow them to convert their online value of labour into ‘real world’ money.
As an example of the problem of un-rooted currency, if we were to imagine the economy has a total daily output of 100 units of labour, and Joe provides one unit of that labour, the value of Joe’s labour is worth 1% of the total value of labour in the economy. If today we have 100 units of money in circulation, Joe will be given 1 unit of money as a result of his labour, and Joe would hope to be able to exchange his money for 1% of the total value of labour the next day. However, if the units of money are increased by ten units the next day, then Joe’s 1 unit can no longer be used in exchange for the 1% of the total value of labour.
The problem arises as to where that value of Joe’s labour has gone? He undertook the labour, stored his labour in the unit of money, and some of it has now disappeared. He might reasonably think that this is unfair and unjust. He might reasonably ask where that value has gone.
The value has, of course, been transferred to the newly issued money। They have, in effect, taken some of the value of Joe’s labour from him. Whoever issued the money, they are now in a position to utilise that value of labour that has taken from Joe to exchange with the value of labour of others. In so doing, they have expropriated some of the value of Joe’s labour. Any such system is inherently unfair and unjust. The new holders of the value of Joe’s labour have not actually done anything which might justify their expropriation of his labour. If Joe’s labour was building a brick wall, and his payment was made for this task, it is not clear how someone who made no efforts or contribution to the building of the brick wall might have a portion of the value of that labour of building the brick wall.
An interesting point to note is that, once a central bank creates money, as is pointed out by the Austrian economists, the first recipients of the newly created money are banks. The earlier the money is utilised, the greater the value of the money that is retained, as it takes a while before the newly created money creates inflation in the economy. The issuance of new currency is therefore beneficial to the banks that receive it.
The problems extend beyond this. Such a system also undermines the utility of the money as a neutral account of the value of labour. If the supply of money is variable, it is not possible to calculate the relative value of labour now with the value of labour in the future with the money. How is it possible to exchange the money today at ‘x’ units of value of labour, if we do not know that we will, in the future have ‘x’ units returned to us. It makes the value of money arbitrary, and inherently unstable.
Furthermore, in the current world trading system, it is apparent that it is possible to manipulate currency issuance in order to pursue quasi-mercantilist policies. It is also possible for governments to impoverish sections of their society in order to meet state goals, and to hide fiscal imprudence through the manipulation of currency. These points will be discussed later.
Fixed Fiat Currency System
The only way that a system of money might offer both stability and fairness is to instigate a system of money that represents each individual’s actual input of value of labour into the wider economy that is utilising the money. The only way to do this is to fix the currency against the actual value of labour in the economy. This means that each unit of money becomes a token that represents ‘x’ percent of the total value of labour in the economy. In order that the token always represents such a percentage, the number of tokens must be invariant.
There are several advantages in such a system, which will be addressed later, as follows:
1. A fairer system of money, that allows more individual freedom of choice
2. Greater stability of the financial system, with a tendency towards consistent and steady price deflation
3. A system in which asset and other bubbles might be more evident, providing an early warning of the formation of bubbles
4. A more transparent world trading system that has self-balancing characteristics, and which will provide a fiscal discipline upon government
5. Allowance for a more transparent banking regulation system, and the removal of most current banking regulation.
The Problem of Currency Units
One of the potential arguments that might be provided against a fixed fiat system is that it provides for a system that will trend towards deflation (discussed later). In a situation of continual deflation, there is a potential problem with the utility of currency units. This is best illustrated with an extreme example. If we were to imagine that the Normans has instigated a fixed fiat currency in England in 1066, and there were 100,000 units of currency, each unit today would hold a value of labour that would make such units impractical for day to day usage.
As such, it would be necessary to break such units up into smaller units, to allow for the multitude of small exchanges that are necessary within an economy. The way that this might be accomplished without the inflation of the money supply is to view each unit of currency as if it were, for example, a loaf of bread. If the loaf is cut into smaller slices to share it out, the loaf of bread remains but in the form of many slices. It is still just one loaf of bread that is being shared out.
In the same way, as each individual currency unit becomes less useful, the currency would then be subdivided into smaller units, with the subdivision meaning that there is no actual change in the overall value of the original unit, just that the value is split amongst the new units. In practical terms, if we issue 100 pence in coins, we must destroy the £1 note that was divided.
Steady Deflation
One of the great advantages of a fixed fiat currency system is that it provides for a system which will achieve steady and consistent inflation. The assertion that this is advantageous might horrify many economists, and therefore requires some explanation. In particular, there appears to be a widespread belief that deflation is a ‘bad thing’. There is no evidence that this is the case, but rather there is plenty of evidence that a change in the rate of inflation or deflation, or a move from inflation to deflation is damaging.
However, before moving to the effects of change, it is worthwhile destroying some myths about deflation. The first myth is that deflation prevents individuals from making purchases, whilst they wait for better prices. In the following examples, it will be shown that the reality is that people do not delay purchases in the expectation of lower prices.
Example 1 – Fast Moving Consumer Goods
If a shampoo manufacturers were to improve their output by 5% through a manufacturing innovation each year, their output of shampoo would increase, and this would reflect in a decrease in the price of shampoo. In other words, there will be a steady and continued deflation in the price of shampoo. According to the idea that consumers will delay purchases in an environment of deflation, in such a situation, consumers would choose to walk around with greasy hair, never buying shampoo in the expectation of further price decreases. Such a proposition is fatuous.
Example 2 – Hedonic Goods
Over the last few years countries such as the UK have seen the emergence of many discount airlines, such as Easyjet. The emergence of these kinds of airlines, and the increase in competition within the sector, has seen the price of air travel deflating. Much of the utilisation of these airlines has been by consumers using the discount airlines to have cheap foreign holidays, and this can be described as a hedonic good. It is an entirely discretionary expenditure as there is no necessity to go on holiday to another country. Despite the continual deflation, there have been many years of continual expansion in the discount air travel market. The deflation has not prevented consumers from taking flights to go on holiday, but rather has had the opposite effect.
Example 3 – Computers
Personal computers (PCs) are an interesting case, as they have year on year improved performance and year on year seen deflation of actual prices. It is also an example that includes both business purchases and consumer purchases. Despite the ongoing deflation in the prices, the market for PCs has had a long period of explosive growth throughout this deflationary period. It seems that the steady deflation in prices has had no impact through the postponement of purchases.
Example 4 – Special Cases
Remaining with the example of PCs, it is possible to construct a hypothetical example of how consumers might indeed delay their purchase in expectation of deflation. If one of the large computer manufacturers were to announce that they would be introducing a new type of computer in the coming year, and that the computer was to offer twice the performance at half the cost, it is quite likely, assuming their claim were credible, that consumers might delay their purchase of computers in expectation of this future deflation.
If the thinking of those who argue against deflation is considered, such a deflation is a ‘bad thing’ as consumers withhold their money in expectation of lower prices. If this logic is followed, then the new and more effective design of computer is not a good thing for the economy, as it has created a deflation in the price of computers, and has caused a delay in the purchasing of computers. However, once the computer is introduced, it will make more computing power available to more people. How this might be a ‘bad thing’ is not entirely clear. Everyone who purchases a computer sees their wealth increase, as they are able to enjoy relatively more computing power in relation to their income. They are quite literally wealthier.
Debt and Deflation
There is an argument that suggests that deflation causes problems with the servicing of debt, as the value of the debt sees relative increases through the deflation. This is a scenario that appears to be very plausible, and can be backed by some solid calculations and formulae. However, what is missed in such arguments is that it is not deflation that is problematic, but the move from inflation to deflation. It is not the change in the value of money that is problematic, but the change in inflation/deflation from the original inflation/deflation position from the time of the issuance of the loan.
A good example of this can be seen in private mortgages on housing. If a loan is taken out in a high inflation environment, the interest rate will be relatively high. The targeted central bank interest rate will be high, and the lenders will seek to account for the high inflation by charging a rate of interest that will overcome the devaluation of the money that they are lending, such that they can achieve a positive return. If the interest rate is fixed over a period of, for example, five years and at year four the rate of inflation has fallen by a half, the holder of the debt is effectively seeing the value of their debt inflating. The earlier rate of inflation was eroding the value of their overall debt, and this was accounted for in the interest rate. However, with inflation falling, their debt value is no longer declining at the same high rate, but they are still servicing the debt as if this were the case. Their payments in relation to the actual value of the debt have increased.
If we think of this example and think of a change in the rate of inflation from 5% to 2%, and compare this with a change from 2% inflation to deflation of 1%, we can see that there is the same process taking place. In both cases we are seeing the relative burden of debt in relation to income moving in exactly the same way. In the inflation and deflation environment, interest rates will move to reflect the underlying changes in the value of money, and debt burdens will be locked into repayments that are based upon an out of date criterion.
In other words, it is not inflation or deflation that is problematic, but rather it is the change in inflation/deflation that alters the burden of the debt. As such, any monetary system should aim to achieve either stable inflation or stable deflation.
Fixed Fiat and Deflation
A fixed fiat system does not guarantee stability of deflation, but does have features which will inherently stabilise the rate of deflation. If it remembered that a fixed fiat currency is tied to the total value of labour in the economy that is issuing the currency, it is apparent why this is the case.
If output of value of labour in an economy increases, the value of labour per unit of currency will also see a commensurate increase. This is the deflationary effect of a fixed fiat currency. However, there is no guarantee of an increase in output of value of labour. For example, if there were no technological or process improvements over a period of time (unlikely), then there would be no inflation or deflation. Equally, if for example there were a natural disaster that destroyed infrastructure, then the output from the economy would fall, creating inflation.
External inflation such as an increase in commodity prices might also create inflation, though these inputs might reasonably be isolated from the overall measure of inflation/deflation in the economy. These are factors that can not be changed from within an economy, as they are resultant from both internal factors and external factors that are beyond any action in any individual country. For example, if there is a poor worldwide harvest of wheat, this might see food price inflation across the world.
No monetary policy or manipulation of the money supply will alter the amount of available wheat in the world. As such, any shift in prices of commodities might cause a temporary shift in inflation/deflation, but there is no monetary policy that might influence this. The only thing to do with such changes is monitor their effects, and try to strip out their effects from the trend of inflation and deflation.
In most cases, deflation will follow the gradual and progressive level of increased efficiency resultant from step-by-step innovations in process and technologies. However, if there were a major innovation, such as the introduction of new highly efficient technology, there might be a resultant period of relatively high deflation, as output increases rapidly such that the value of each unit of currency rapidly increases.
Real cases in history that might cause rapid deflation in a fixed fiat system would be the introduction of electricity into manufacturing, or the introduction of railways. In both cases, the introduction of the technologies resulted in higher output per unit of labour, such that there was a widespread overall increase in the value of labour across the economy. This is a positive form of deflation, as the overall output of value of labour has increased without an increase in the volume of available labour. The economy has simply become wealthier. This is best represented in the earlier argument about the introduction of a far better PC. We should wish for this kind of dramatic deflation.
Hoarding of Money in Deflation
It is possible to read in accounts of deflation the use of the word ‘hoarding’. Before discussing why people might invest in a deflationary environment, it is worth addressing the word ‘hoarding’. It is a word with particular connotations, such as the idea of a dragon hoarding gold. Within such connotations it is possible to perceive that there is an emotive meaning in that the word implies selfishness and greed. The use of such an emotive word should therefore start to ring alarm bells, as it is a rhetorical device rather than a reasoned argument.
However, there is an underlying concern that, in an environment of deflation, people will simply use cash as their method of saving, rather than using their money to invest in new productive activities. This appears to be a plausible argument.
Nevertheless, it is not as plausible as it seems. The underlying argument is that, if there is deflation, the value of cash is in any case going to increase over time, so why would an individual risk making an investment if they can just ‘sit on’ their cash and see a positive return.
The problem with this argument is that it does not account for the variable levels of risk that individuals are willing to take in order to see a return on their money. For example, in the environment pre-economic crisis, there were a range of investment opportunities, each with a relatively different level of risk. An individual in the UK might have placed their money in government bonds at a low rate of return but with very low perceived risk, or they might have invested their money in a perceived high risk and potential high reward emerging market tracker fund. We know that people invested their money in both of these investments, and this clearly demonstrates that different individuals at different points in their lives will be willing to take varying risks with their accumulated store of the value of their labour.
In a situation of steady deflation, the behaviour of individuals will not change. Some individuals will ‘sit on’ their money, and others will seek to gain a return on their money that is greater than the return provided by the deflation. The key difference in the system is that the necessity of investment is taken away, such that no individual is forced to risk their capital. If we think of an individual approaching retirement, due to continual inflation, they must risk the value of their labour stored throughout their life, if they are to retain the full value of the store. In doing so, they also risk the loss of that capital with the result that they might live through an impoverished retirement. There seems to be no reasonable justification to force such a risk on any individual.
Within a fixed fiat system of steady deflation, it is apparent that some individuals will utilise their store of labour value to invest in order to gain a return, and others will enjoy the benefits of retaining the value of their store in relative security. Whilst there are no guarantees that sitting on cash will preserve the purchasing power of that cash (e.g. the natural disaster example), the holder of the cash has the assurance that he/she will remain as wealthy relative to others under all circumstances.
Interest Rates and Investment in a Fixed Fiat System
In a period of steady deflation, how will investment actually work? It is an interesting question that is far simpler than it might first appear. If we were to imagine a steady rate of deflation of 2%, how might interest rates be determined?
As has been outlined, it is possible to ‘sit on’ cash, and that cash will then yield an annual return of 2%. In order to persuade an individual to invest, it is necessary to offer a higher yield relative to the perceived risk in the investment. In looking at the problem this way, it is apparent that investment decisions are no different to the choice that was outlined in the example of an inflationary environment. If inflation is running at a rate of 3%, an individual might seek a real return on their investment of 5%. As such, they will direct their investment to an area where they will expect a total return on their investment of 8%. If the rate of deflation is 2% they will, using the same calculation, seek an investment with a return of 3%. In both cases they are aiming for the same real return, and will make the same risk/reward calculation. There is absolutely no difference except that the individual has a choice on whether they might invest their money at all.
What if the rate of deflation was very high? The first point to understand is that a high rate of deflation means that the economy is actually very successful. It simply means that the output of the overall value of labour has seen a significant increase. In real terms, the economy is wealthier overall.
However, should the deflation reach a very high level, for example an extreme deflation of 10%, there will be a problem in presenting investments that might attract individuals to take risks. The rate of return on the investment would have to be very high, as few people would be willing to take risks when they can earn a 10% return by ‘sitting on’ their cash. The result would be that the flow of money for investment would diminish, and the speed of the growth in the output of the economy would be constrained. The question here is whether this might be a good or a bad outcome.
If the output of the economy is expanding at such a rapid rate, it is quite possible that there will be a period in which there will be ‘irrational exuberance’. The history of the many examples of how individuals might become carried away with a particular class of investment needs no retelling, from the South Sea bubble, to the more recent housing bubble.
However, there have also been other bubbles which have been resultant from the introductions of new technologies, such as the telecoms or Internet bubbles. In both cases, there were significant innovations which had potential to increase output in the economy, and in both cases early investment yielded strong returns. However, in both cases the early returns led to manias, and those manias saw significant overinvestment in the sectors, so that overinvestment took place with a resultant misallocation of resources.
In a fixed fiat currency system, the deflation that would result from the expansion in the economy would present a natural stabiliser on investment during technological innovation. It might be argued that the high deflation would ‘starve’ the new technology of capital for expansion, but the opposite view is that each innovation might be ‘digested’ before any manias developed. This is not to say that a fixed fiat system would guarantee no manias, as people will always have the potential for ‘irrational exuberance’ under any system. However, if an innovation creates dramatic deflation, the deflation might cause far greater caution in further investments, and therefore act as an automatic stabiliser.
As the drop in investment takes place, the growth in the output of the economy will start to moderate, and the economy should stabilise back towards a steadier rate of deflation. Whilst giving the extreme example of 10%, it is unlikely that there might be such extremes, as the stabilising effect is progressive and self correcting. One of the underlying strengths of the fixed fiat system is the inherent self-stabilising effect, such that investment and borrowing should be taking place in a steady rate of deflation, thereby ensuring that lending and borrowing do not see volatility such as the alterations in the costs of servicing debt burdens.
Stability of the Financial System
At the start of the discussion, it was identified that there are two types of money in an economy, broadly characterised as traditional money and IOU money. Up to this point IOU money has not been discussed, despite the important part that it plays in the system of money overall.
Whilst the fixed fiat money system might create a steady deflationary tendency, it does not account for the rise and fall in the supply of IOU money. This raises the question of how IOU money might be regulated such that there are no booms or busts due to overexpansion or contraction of this money supply. As has already been identified, there is a natural stabiliser which should ameliorate bubble forming investments and activities, but this does not fully account for expansion of IOU money. For example, if deflation is very high, it might be that one company will less willing to extend credit to another company. This is a natural circuit breaker on the economy in which fast expansion will see a commensurate contraction in credit.
However, one of the main sources of IOU money is the banking and financial system, and any stability in the monetary system must therefore ensure some stability in the creation of IOU money in the banking system. The temptation here is to introduce a system of complex regulation, and enforce various measures upon the banks. However, the use of a fixed fiat system, alongside provision of particular information, offers a simpler and more effective method of managing the banking system.
The first point is that the fixed fiat system allows individuals to hold cash at very low risk to their stored value of labour. This extremely low risk allows for the creation of what might be called ‘deposit banks’. These are banks which literally, for a small fee, will store the money of an individual, with the entire holdings of deposited money always available for return. This is so essential to the system that, if no private institution were established to offer this service, the government would need to offer such a service. The function of the deposit banks is simply to store the money, facilitate transfers and transactions, and a fee would be needed to pay for the services.
The reason for the necessity of these banks is that each individual must have a clear and available choice of a bank which does not does not risk their stored value of labour. In having this choice, individuals have real choice in the way that they risk their money.
The second element of the financial system is ‘speculative banks’, which are any banks or financial institutions which might not, on any given day, be able to return all of the deposits that they have taken. These are any financial institution that takes depositors money and uses it for any kind of investment. In all such banks, at least proportions of the deposits that are held are at risk of loss, and can not be returned on demand. The name of this type of bank is explicitly given to remind any depositors of money into the bank that they are speculating, and the banks would be regulated such that they would need to include the name speculative bank in their name.
However, the most important element of the regulation of these banks is not their name, but something more fundamental. It is essential that depositors into the speculative banks are aware of how much of their deposit is subject to risk at any particular period in time. For the sake of pragmatism, this information should be available on a daily basis, and would need to be published daily in all branches of the bank, and on the bank’s website homepage (in a specified format). In particular, each bank would need to give an exact percentage of their deposits available for withdrawal as cash on the previous day, as well as a rolling trend for the percentage. This information will ensure that every depositor is fully aware of the amount of their deposited money that is at risk. The penalties for the provision of false information would need to be severe.
The third element of the system is the provision of information about the nature of the risks being taken by the speculative banks. At present, there is no regulation that prevents the banks from paying for external assessment of their level of risk. The conflict of interest in such a system is apparent, and has been made more apparent as a result of the financial crisis. One of the problems in assessment of risk is considered to be the asymmetry of information, and it therefore necessary to ensure a system where there is well financed external assessment of the risks in individual banks. The only way of ensuring this is to regulate the usage of the information provided by external assessment agencies to ensure that each individual who uses the services of the agency is restricted to using the information for their own personal use. For example, newspapers could not report the assessment of agency ‘x’ of bank ‘y’ without the explicit permission of the agency.
The regulation would ensure that there was the available finance for an effective system of external and independent assessment of the banking system, and individual banks within the system. Even within such an independent system, errors will still be made, and any assessment would need to make a statutory declaration in a regulated format advising the recipient of this fact.
The purpose of the provision of information about the banks, and the development of deposit banks, is to provide individuals with the information about the risks that they are taking, and to make informed choices as to whether they take risk. No form of regulation can remove the risk taken in any form of investment, and the only solution to this problem is to make risk a choice, and make the nature of the risk as transparent as possible. When individuals are presented with information and choice, any guarantee of the deposits by the government no longer becomes necessary, and the financial system can be largely left to operate as the market demands.
The last element of the regulation relates to the one remaining problem that might arise in the banking system. This is the notion of the ‘too big to fail’ bank. It is apparent that, if institutions become large enough, their collapse might lead to severe problems in the economy. The existence of banks of this size is therefore a danger to the stability of the economy. It goes beyond the scope of this discussion to go into detail of how banks might be broken up and regulated in order to remove this risk, but regulation of size of banks would be a necessity.
So far, a radical system of regulation and deregulation has been presented. It is apparent that a fixed fiat system is necessary to allow the deposit banks to play their role in the system. However, this does not explain how stability in the provision of IOU money might be achieved.
In order to understand this, it is necessary to think of individuals making choice according to their own circumstance and their individual appetite for risk at various points in their life. Pension and life insurance markets give a clue to how these decisions are presented and made, and it is apparent that in aggregate the total level of risk individuals will take will remain relatively stable over time. Under the current system, any deposit into the banking system is undertaken without any heed to the levels of risk in an individual bank (excepting during the recent bank runs). The assurance of government guarantees of the banking system, and deposit guarantee schemes, means that banks are able to operate with levels of risk of which the depositors are unaware.
In the system proposed, in which levels of risk are more transparent, individuals will be confronted with clear information about the levels of risk that they are undertaking. If there is an aggregate steady level of acceptance of risk, the banking system will adapt to the informed choices of individuals, and will provide a range of options that will meet the aggregate demand for risk. As that aggregate demand will normally not see abrupt changes, any change in issuance of IOU money by the banks will be dampened to reflect the aggregate risk demand in the market. Once again, there is nothing in the system to prevent manias, although the deflationary nature of the system will ameliorate the manias. As a result, in normal time, the issuance of IOU money from financial institutions should remain relatively stable and constant.
This entire system can only be achieved in a system of a fixed fiat currency, which provides the foundation of the reformed system of banking and finance.
Government Issue of IOU Money
Another potential source of issuance of IOU money is government, typically in the form of government bonds. The purchase of these bonds can be broadly divided into domestic and overseas purchases, and each has a different impact and considerations in the consideration of financial stability.
A government issued bond, as with any form of money, is a promise to return a value of labour in the future. The key difference between a government bond and other forms of IOU money is that the government can utilise the law and tax system to force individuals to provide a proportion of their value of labour in servicing the obligations of the bond. It makes them a relatively sound form of money, as they can in principle make (within some boundaries) large claims on the value of labour in an economy.
The starting point in the consideration of the issue of bonds is the purchase of the instruments by overseas buyers. This has most curious effects on the economy that receives the bonds, and upon the perception of the state of the recipient economy. Before going on to these points, it is worth reiterating that the bonds that are issued are no different from the IOUs for gardening provided by Fred in the explanation of money, with the exception that the bonds might force Fred to work the necessary hours for repayment. Just as Fred uses the bond to allow him to consume beer, a stored value of labour, a UK bond purchased by a Japanese investor allows the UK government to consume the stored value of labour of Japanese workers.
A good way of thinking about this is to imagine that the purchase of the bond by a Japanese investor is being used to build a hospital. For the sake of simplicity, we will imagine that the bond is for the building of the hospital alone, and is only purchased by Japanese institutions. As part of the purchase, Japanese currency will arrive in the UK, and that might be used to exchange for other currencies to purchase material, services and equipment, or purchase these directly from Japan. In addition to this, some of the money will be used to pay UK contractors and suppliers. In all cases the payment is being made from the stored value of labour of Japan.
If we imagine the purchase of a piece of medical equipment from Japan, at some point in the future, the promise of the bond is that value labour of a good or service slightly greater than that purchased will be returned to Japan or whoever holds the bond. When the device is shipped to the UK from Japan, it will also generate significant activity in the economy, with an importer handling the import, a logistics company moving it to the hospital, and the contractors who install it into the hospital. At each stage of the process, the value of labour being utilised is a consumption of the Japanese value of labour that was provided in the currency exchanged for the bond. However, the impact upon the economy extends beyond these discrete actions.
For example, each of the individuals or organisations that have been paid through the issue of the bond will go on to spend the IOU money provided by the bond in the wider economy. For example, a contractor may save enough money to purchase a UK built car with cash, thereby increasing output of cars in the UK economy by one car. However, whilst he is paying for the car in what appears to traditional money, he is in fact spending the IOU money from the bond. If we think of the myriad of ways in which the bond IOU money will increase output in the economy, it is apparent that the IOU money has an effect on output far greater than the headline figure. The money from the bond becomes tied up with the traditional money in the economy, and separation of the IOU money from traditional money becomes impossible.
The issue of bonds then needs to be placed in a wider context, if we are to understand the implications and effects of the bond. If an economy is running a current account deficit, then the economy overall is being provided with goods and services over and above the output of the economy. If governments are issuing bonds and these are purchased by overseas investors, the money that then flows into the economy represents an aggregate consumption of the value of labour of the creditor country. The problem that then arises is how we might actually measure the output of the economy. As has been illustrated in the case of the hospital bond, the value of Japanese labour entering the economy becomes inextricably entwined with the economic output as a whole. It generates considerable activity throughout the economy.
If we then consider that GDP measures are a consideration of the activity within an economy, it is possible to see that the GDP figure is measuring the output of Japanese value of labour output as if it were UK value of labour output. Furthermore, the greater the issuance of bonds, the greater the activity in the economy, and the higher apparent GDP will be. Issuance of IOU money in the form of bonds will increase activity in the economy, giving an illusion of growth in the economy. This becomes particularly problematic if the sustainability of bond issuance is being measured as a percentage of GDP, as that figure will include the impact of previous bond issuance, and is not representative of the output of the UK, but is representative of the output of the UK economy and the imported value of labour of Japan (to return to the earlier example).
The GDP measure of the economy does not actually represent the output of the economy, but the measure of debt to GDP allows government to continue the issuance of more IOU money than might be sustainable.
It is here that we come to the question of how a fixed fiat system might prevent such problems. The first point is to say that a fixed fiat system will not be able to prevent governments from the issue of bonds, which is of itself a dubious practice in ordinary circumstances (though the reason for this will be left aside for this discussion). However, if a country is running an overall current account deficit, under the fixed fiat system, the country will find that money is flowing out of the country, and that there is a process of deflation taking place. This deflation will make the purchasing power of the currency increase, and will therefore make the goods and services of the country more attractive, as the currency will provide more goods and services per unit. This will mean that a current account imbalance, as soon as it appears, will start to correct itself.
However, if a government is issuing IOU money to overseas investors during a period of a current account deficit, it is immediately apparent that the government is seeking to artificially maintain the current account deficit. They are seeking to prop up consumption within the economy, and in doing so are building an unsustainable economic structure. In so doing, they are issuing money against a level of output that is already unable to service the current exchanges in value of labour between the bond issuing country and its trading partners. Without the endless confusions being caused in targeting variable interest rates, different volumes of money, such reckless behaviour will be very apparent.
In other words governments will not be able to hide irresponsible policy behind a wall of monetary policy. The current account balance between countries will become main the determinant of the relationship between their currencies. In terms of exchange rates, they will become transparent, and will alter according to trading relations, not with monetary policy. Our Japanese investor will see clearly that fiscal expansion during a current account deficit is a policy that can not be sustained, and the future repayment of the bonds must see a devaluation of the currency. No overseas investor would invest into such a poor currency.
A fixed fiat system prevents governments from borrowing more money than might be supported by the actual output of value of labour in the economy. It creates transparency and clarity about the state of the economy in relation to trading partners.
With regards to the issuance of IOU money, where the purchase is made by individuals or organisations from within the issuing economy, this is more problematic. However, there is an indicative measure of whether the government is indulging in fiscal irresponsibility which is that, within a fixed fiat system, inflation should only take place in few limited circumstances, and those circumstances can be reasonably isolated from the general trend within the economy.
Barring the impact of these circumstances, in the event of inflation, it is apparent that the government is issuing more IOU money than can be supported by the output of value of labour within the economy. Any inflation within the economy can be seen as a warning sign, and it is then a matter for the electorate to discipline the government for causing the inflation. This moves beyond economics, and is the question of how a mature democracy might function, and is therefore beyond the remit of this discussion. How or when a government might be disciplined is firmly within the realm of the relationship between governance and the democratic system.
Overall, the fixed fiat system provides clarity about the actual state of the economy, and also provides some mechanism of stabilisation of trade between countries. It is a system which should, in most situations, offer considerable stability and ensure that an economy grows in a sustainable way.
The Problem with a Fixed Fiat System
There is a problem with a fixed fiat system in a world in which the current fiat system holds sway. In particular, there is the problem that a fixed fiat currency would be very attractive to investors who have their domestic currency operating in a conventional fiat system. In particular, they will know that the value of the currency will never be eroded through the issuance of greater volume of the currency. As such, over the long term, it will appear to be a stable and secure form of money into which a person’s value of labour might be stored.
The problem that this stability represents is that it will encourage a situation in which the stability of the fixed fiat currency will be undermined by the apparent stability of the currency. It is a contradiction that requires some explanation.
If, for example, the UK switched to a fixed fiat currency, and Japan remained on a standard fiat system, then Japanese individuals would likely want to place their stored value of labour in the UK. The result of this would be to see lots of Japanese investors seeking places to put their money in the UK. For example, government bonds would appear to be attractive, offering considerable security. However, as has been detailed, the issuance of government bonds is in fact the issuance of money. As such, if the government, or other recipients, of Japanese investments accept the flood of Japanese money, the money supply will have increased, which is inflationary.
The problems that this might cause are best illustrated with the carry trade from Japan. The carry trade was resultant from the policy of quantitative easing in Japan in conjunction with low interest rates in Japan. The result of the policy was that, as fast as new traditional money was added to the Japanese money supply, money flooded out of Japan seeking higher interest rates in other countries. In so doing, the increase in the money supply helped create the asset and credit bubbles in countries such as the UK. Furthermore, the money that was being created was earning a rate of interest that helped counteract any loss of value of the Yen that should have resulted from the increased issuance. The investment of the money flowing out of Japan contributed to the positive current account balance of Japan, thereby strengthening the Yen.
In other words the targeting of interest rates and quantitative easing was a contributory factor in the development of imbalances in the world economy. It illustrates the danger in conventional fiat money systems, and these kinds of imbalances would appear in any economy with a fixed fiat system.
The only solution to this problem is that all currencies should move to a fixed fiat system. Under such a system, there would be no targeting of interest rates, as the money supply could not be manipulated, and also there would be no possibility of quantitative easing. In a world built around a fixed fiat system, the world economy would look very different. For example, if we imagine our Japanese investor, his choices will look very different.
In determining where to place his money, he will no longer be looking at the relative prospects for any individual currency in terms of monetary policy of the country, but will be looking at the fiscal policy of the country, and the output of the value of labour in the country. The interest rate in the country will no longer be set by the control of issuance of money, but by the conditions of the market in the country.
The only way such a system might be enacted would be through international agreement. For example, if the G20 were to agree to the system, and made trade with any country conditional on implementation of the system, then it would become the world currency system. The problem that arises is that the system would run counter to the quasi-mercantilist currency policies undertaken by countries like China. It would also present a constraint on governments borrowing from overseas sources, and this would force them to have to confront the underlying economic difficulties within their countries. Whether there could be any agreement in these circumstances is questionable.
Conclusion
So what is the key, the underlying principle behind the fixed fiat currency system? With a little reflection, it is apparent that the underlying driver behind the many benefits is the shift to something that becomes a representation of the actuality of the economy. It creates transparency, and thereby creates systems that are inherently stable. It removes power from the regulators, the central banks, the government and the financial system, and transfers and distributes that power into the wider economy. It is essentially a democratic reform.
Even if this reform of money were to found to be a sound and coherent approach to the management of money in the economy, it is unlikely that it would ever be enacted. It hurts too many interests, and those interests would fight any implementation of the system. However, if the system is workable, this paper is written and published on the basis that it is better to have an alternative system ‘out there’ in the world, rather than locked away in the thoughts of one individual.
I therefore conclude the article with two points. The first is that I am profoundly pessimistic about the prospects of any change which might remove the privilege and power of the banks, and even more pessimistic about the prospects of government accepting such reform. The second point is to reiterate the point at the start of the article. This is the musing of an individual without any schooling in economic theory. As such, thoughts, comments and critiques (hopefully polite) will be welcomed.
Notes:
Note 1: I am not sure how many might reach the end of the article, but I hope at least a few will find it worth the effort. For those who do get this far, I would like to thank you for your patience.
Note 2: I use Japan as an example on several occasions for illustration and examples. This is not to single out Japan as a particular source of problems, but rather the country is used for ease and consistency.
Note 3: A couple of the examples I have used for the deflation argument have been used elsewhere (I forget where), but I also used these examples in an article a long while ago, so I have not referenced the article.
Note 4: The Austrians will object to the fixed fiat system, as they believe all currency should originate in the 'market'. I see no reason for this, and would be happy to see a commodity currency compete with the fixed fiat. I am confident about which might win over as the chosen currency used by most people. It is also noteworthy that in reality, for a commodity currency, they are actually discussing gold and silver, both of which have considerable variation in value over time. This is an inherently unstable currency. I also had a brief debate on the subject of a fixed fiat currency system on the von Mises website. They suggested any fiat currency would be subject to debasement. My pointing out that commodity currencies have been debased throughout history fell on deaf ears.
Note 5: Suggestions and further ideas are welcomed. This is, after all, the first attempt to outline this system.
Showing posts with label gold standard. Show all posts
Showing posts with label gold standard. Show all posts
Saturday, July 25, 2009
Friday, December 26, 2008
Banking Regulation - Buyer Beware
This post on bank and financial regulation has been under consideration for a long time. The reason why it has taken so long is that I was allowing myself to become confused, in much the same way most people become confused over these issues. The cause of this confusion is that we all seem to forget what the financial and banking system is, and what it does.
The reason I am now able to write this post is that I have had a very good comment posted on 'Financial Crisis - A Brief Review', in which the author offers an argument that deregulation caused the current financial crisis. The argument that was presented helped me to focus in on what matters, which is to ask what banks are for, and how the financial system operates. In particular, the argument that the Financial Services Modernization Act of 199, in conjunction with a fiat money system, was fingered as the guilty party (I am simplifying, so I suggest reading the original comment). The comment also pointed me to the Ludwig von Mises Institute for an article in support of the argument. The reason why the comment and this article allowed me to finally write this post was that I was preparing all kinds of complex counter arguments, including a long discussion on the Basel Accords, when I realised that I too was missing the point. Whilst I cover these issues, I am now not so concerned with these details, but more concerned with basic principles.
I was forgetting what the banking system was for, and what money is for. It is only if we remember this that we can start to think of how the system can operate effectively. If we keep these basics in mind, it will become apparent that much of the banking regulation is trying to achieve the impossible, the removal of risk. It also becomes apparent that the system of money is built on foundations of sand.
The logical starting point for reform would be the issue of what money actually is. It is not some magic substance that has a picture of a famous dead person on it, or the picture of the queen, but something which has a purpose in the exchange of goods. Lets imagine, for example, that a sofa shop owner is in need of milk for his family, and that the milk requirement is one cows worth of milk production per day. He believes that one cow's worth of milk production for the lifespan of the cow is worth one sofa in his shop.
Now, in the real world, it may be the case that I do not have a cow to provide the milk to the sofa shop owner, or a farm, or anything else which the sofa shop owner wants. However, for the sake of ease, we will say that I am in the business of providing consultancy to farmers, advising them on best practice in milking. As such, I can sell my advice for milk. My own milk requirements are very small, so I do not need all of the milk that the farmer provides in return for my advice. When I want to buy the sofa, I could therefore write a contract that, instead of providing one cow lifespan worth of milk to me in return for my services, the farmer instead directs that same milk to the sofa shop owner. As such, I am now in the position to make an exchange for the sofa, and can take it home.
As such, money is an intermediary, which allows us to not have to go through this complex process to make an exchange for a sofa. In order for money to operate in this role, so that I do not have to set up lots of contracts, the person in the shop must believe that the intermediary that I provide (money) = one cow's worth of milk over the lifespan of the cow. In other words, the shop owner would expect that the money I provide will be able to purchase milk in the quantity of one cow's production (a) over the number of days the cow will live (b). When I enter the shop without a cow or a cast iron milk supply contract, I must provide the shop owner with something which guarantees that I will provide the shop owner with a x b worth of milk, over a period of several years. In effect, that is what I am exchanging for the sofa.
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. When I hand over money for in exchange for the sofa, the sofa shop owner is going to get a bad deal if, in three years time, he finds that he is only able to purchase three quarters of a cow's milk production. It is for this reason that inflation is bad. It is, in effect, a breach of a contract. Whenever inflation occurs, we lose some element of our belief in money to honour the contracts between one another. I have chosen the milk production example to illustrate this point, as it is very important in the consideration of money.
To illustrate this point, I recently had a comment on a post regarding hyper-inflation and whether it is a good time to buy a house at such a time. My answer was as follows:
If we take the value of gold, it might be that the demand for gold drops, due to a change in society where gold becomes associated with 'bling', thereby reducing the demand for gold for personal decorative use. In such a situation, there will be an oversupply of gold relative to the demand for gold, and the value in exchange of gold will drop relative to other items. The problem that I am illustrating is that nothing has a fixed and enduring value in exchange relative to other things.
Now we come to the situation of money today. As many readers will be aware, the gold standard was abandoned many years ago. The gold standard was a situation in which each unit of currency could, in principle, be exchanged for a fixed amount of gold. Today, there is no such backing, such that money has no contractual guarantee. I would therefore like to return to my milk and sofa example.
When I enter the sofa shop, bearing a fistful of bank notes, I am offering the sofa shop owner something that he believes to be a contract, but which actually is not a contract at all. If we say that there is a situation of high inflation, or hyper inflation, then there is no recourse for our sofa shop owner. I might give him £2000 which today looks like it will pay for a cow's lifetime supply of milk, but which will in three years time not be able to be used to purchase even one day's supply of milk. There is no contractual commitment in what I had handed him. None whatsoever.
How does the situation differ under the gold standard? I have already pointed out that the value in exchange of gold varies relative to other goods and services. As such, I could go into the shop and purchase the £2000 sofa in exchange for money which can be converted into x amount of gold. If there is a massive expansion in gold production, or gold was less desirable for the 'bling' factor, then it may also be the case that the gold in three years time would be insufficient to buy the milk that was required by the sofa shop owner.
In such a situation, it becomes apparent that money, in all forms, is a fundamentally flawed concept. I will commit the sin here of quoting Wikipedia, but they offer an excellent summary of what money is supposed to be:
We are therefore in the tricky position of having to make some choices. On the one hand, we could abandon the concept of money altogether, which would mean endless complexity in arranging reciprocal contracts between endless numbers of individuals. On the other hand we have to use something as an intermediary in exchange whose value is subject to change. The former option is simply impractical, and the latter is unsatisfactory. However, the options are just these.
From this perspective, it is apparent that there is a necessity for money, but that money needs to still retain a contractual value. Under the present system of fiat money, there is quite literally no contract whatsoever, and the value of money in exchange rests in its entirety on the delusion that there is an underlying contract. Such a system has huge risk, because if ever there comes a point where individuals demand that the contract they believe to be there is fulfilled, they will find that there is nothing there at all. It is the current situation in the Western world that there is a huge amount of money issued, that this money has been used to purchase goods and services from other countries, but there is very little that the money can actually be exchanged for. This is seen in the imbalance in trade between the East and the West (ignoring cases like Germany).
In other words, if the countries that have provided the goods and services try to exchange the money issued in the West for goods and services, they will find insufficient goods and services available for the money to purchase. We have, for example, used the money issued to buy plasma TVs from China and can not offer any good or service in return for those purchases. We have used an item in the exchange which is not actually backed up with any contractual commitment to reciprocate with anything. We are in a situation where, if the perception of the underlying contract is tested, it will be found that it does not exist. At that point, the belief in the value of money will quite literally disappear. This is the risk that has been taken.
It is at this point that we return to the very imperfect gold standard. If all currency issued is backed by gold, then there is an explicit contract. If you do not wish to use the money in exchange for any goods or services, then you have the option of exchanging the currency for a fixed amount of a commodity. Whilst there is a risk that the value of that commodity might fall in relation to its value in exchange with other commodities, goods or services, it will always have some value in exchange. It guarantees that money will always have some value. Gold is used because it has, throughout history, has a relatively high value in relation to many other commodities. However, any commodity has the same function and the question of which commodity just becomes a question of relative historical value stability, and practical questions of how it can be stored/used/transferred etc.
In short, money must have an underlying contractual commitment, or it becomes subject to losing its meaning. Whether that contract is an exchange for gold, or any other commodity, the important point is that the contract is fixed. In this way our sofa shop owner knows that, whatever happens, he will always be able to buy at least some milk with his money, even if he is unable to buy as much milk as he originally expected. It is very imperfect, but it is better than the option of being able to buy no milk at all, which is possible under a system of fiat money.
It is at this point we now need to turn to the broader issue of banking and financial regulation. Although I have not expressed any preference for which commodity might be used as a backing for money, I will stick with the gold standard as being the method of contractual commitment.
The first question that is raised is who might issue money. My answer is very simple. Anyone at all. That means you, or I, or the person next door can issue money. It is, in any case, what we do all the time. If we remember that money is an intermediary in exchange, we start to see that, for example, when we offer to do something for another person in exchange for something else, we are effectively issuing money, in some cases the unit of currency is a verbal promise, in others a contract written to say that we will do something. In both the case of the contract and the promise, they are both units of exchange.
For the purposes of the wider economy, in ensuring that exchange is efficient and effective, it is important that there are monetary units that are widely accepted. It is only in ensuring that this objective is achieved that there should be any regulation of money. Whilst anyone can issue money (though I suspect few would accept notes backed by nothing where there is a gold standard alternative), there is a regulatory role in ensuring that there is available a particular form of money that is contractually tied to gold. As such there is a regulatory role in the issuing of this money. That role is to fix the rate of exchange, ensure that it is never changed, and to ensure that money that is so fixed can be identified as such.
As such, any individual, or institution, can issue gold backed money, provided that they can demonstrate that they have the gold available to meet the standard, and that the gold is secured against sale. The role of government in such a system is to monitor the institutions that are issuing the money to ensure that they have sufficient gold, and the printing of the money in a consistent format with the issuing institution's name printed on the money. The government might also issue currency, but only if it is also backed with sufficient gold to meet the standard. The institutions that can issue money according to the gold standard would have a special designation as deposit banks. All money within these banks would be contractually guaranteed to be able to be converted into gold (or at least nearly all of it, as an allowance would be needed to allow the banks to acquire the gold as deposits rise). As these banks would not be investing money, they would need to charge a fee for the deposits.
In addition to deposit banks, there would also be an alternative, and relatively unregulated banking system, where the banks would be designated as 'speculative' banks. It is here that we come to the difficult subject of regulation. Before we continue, it is worth reviewing the two basic purposes of banks.
The first purpose of banks is as a place to store money in a relatively safe place. The deposit banks serve this purpose, and therefore there must always be deposit banks available to individuals and businesses, even if the government must step in and offer this service (the least preferable option). The second role of banks is as a conduit for investment. This is best explained by thinking of an individual who has £10,000 saved from their salary. They have several options of what to do with this money. On the one hand, they might put it into a deposit bank, which will only guarantee that, at any time in the future, that money will be able to be exchanged for a fixed amount of gold. Alternatively, they may wish to use that money for speculative investment.
The investor has several choices on how to invest that money. On the one hand, the investor has a sister who is planning to open a restaurant. She is looking within the family for investment capital. Being her brother, he knows her well, she has explained her plans, and he must therefore make a judgement on whether this is a good investment. On the other hand, he might invest the money in the company which he works for, as the company is offering shares in the company to employees in order to raise money for the development of a new product. He knows the company well, he knows the details of the plans for the new product, and can therefore reasonably judge whether it is a good investment. His final option is to outsource the investment decision to an institution specialising in investments - a speculative bank.
In all three cases there is a common factor. In all three cases he must risk some, or all, of the value of his money. In all cases, the money will be invested in projects where, if he wants the money to be returned, there is no guarantee that it will be immediately available, or whether it will ever be returned at all. All three cases are identical in this respect, and no amount of regulation will ever change this basic reality. It is here that we come to the fundamental problem of modern regulation. It is aimed at removing the risk from investment, the risk that money will not be returned to investors. It is really very simple, as soon as a person/institution wishes to gain interest on their capital, they take a risk with that capital. The only way for interest to be accrued is through investment, and all investment is speculative and inherently risky. To try to regulate risk away is therefore an impossibility, but this is the purpose behind much of the regulation.
Regulation of risk is not possible, but regulation of provision of information about risk can be regulated. If we take a look at the Basel banking accords, they do not seek to regulate information but are seeking to regulate risk. A very good discussion of the Basel accords can be found here at the Bank of England website, and I will use it as the basis of discussion. In particular, the date of the paper is 2001, and the paper therefore details the thinking of regulatory institutions pre-credit crisis. The introduction to the piece starts as follows:
The answer to this perceived problem, was Basel I. This is described in the BoE paper as follows:
So here we have the essential problem. A bunch of very smart people got together and said that they were able to determine levels of risk. Their conclusions have been shown to be wrong. In particular, OECD banks have demonstrably been shown to be, in a very large number of cases, unsound. I will reiterate this point once again - they were wrong.
Another point in the Basel I accord was that it creates a perverse incentive to lend to governments. Investing in government debt means that money is not being invested into potentially wealth creating investments in the private sector. It also virtually guarantees that government will have access to credit, regardless of whether the governments are acting responsibly or irresponsibly. Such guaranteed provision will almost certainly have been a factor in the growth in Western government / OECD debt. However, it would be impossible to prove one way or another.
So now we come to the Basel II accord. Once again, I will quote from the BoE paper. It makes interesting reading.
Another interesting feature of Basel II is that the accord put the credit rating agencies centre stage in the assessment of risk:
I started the post mentioning a commentator's very good and interesting argument that deregulation caused the problems. It is a good basis to discuss the idea that deregulation was the problem. One of the points made was as follows:
The author of the comment, in a second comment, quotes the following:
They were wrong, but conferred a false sense of security/legitimacy in the activities of the banks, much as the SEC did in the example given above.
What of the Financial Services Modernization Act, the Commodity Futures Modernization Act of 2000? These are fingered as the guilty in the cause of the financial crisis. However, I would suggest that, for example, the legal structure of financial institutions is not an issue of concern. The structure of financial instruments is not an issue of concern. As you may be gathering, the real issue of concern is the nature of the oversight of the activities of the institutions.
As the BoE suggests, there is an asymmetry of information. When I gave the example of the person investing the £10,000 I pointed to two examples in which the investor had good knowledge about the potential investments (his sister and his company). In these cases information was not a problem, but even with good information the risk remained. The problem of information arose with the speculative bank. How can an investor make an assessment of an institution as complex as a bank in the assessment of risk. How can he know what an SIV or CDO actually are. It is here that we have the assymetry of information.
Before continuing, a quick question. Should the investment of our investor's money in his sister's restaurant be subject to regulation? Just as putting money in a speculative bank risks the life savings of our investor, so does investment in his sister's new business. Regulation is there to protect the investments of depositors, but why would that protection not apply to investment in his sister's new business. In both cases, if the investment of that money goes wrong, then he loses his savings. For some reason, when the word 'bank' is mentioned, confusion arises. We MUST protect the savings of individuals invested in banks, but not if an individual invests in other ways. Why? In both cases the individual might lose all their money, so investing in his sister's business should be regulated, if regulation is to be meaningful and consistent.
For example, if the government guarantees money invested through a bank, why would it not do the same if the business of the sister of our investor goes bankrupt. In both cases the money was used for investment, in both cases our investor lost his savings. Where is the difference? As I said, mention of the word 'bank' seems to change everything, but I can see no rational explanation of why this should be the case. An investment is an investment, whatever the conduit.
The classic picture conjured up in defence of the regulation is that of a little old lady losing her life savings. My answer to this is the deposit banks. If, however, the little old lady wishes to venture outside the relative safety of a deposit bank, then she must accept that she moves into risk, including risk to all of her capital. However, the problem is just the same for all investors, and conjuring up images of little old ladies is just an emotive argument. A 30 year old man with a family to support will also be hurt badly if he loses all of his savings.
So how can this problem be overcome, the problem that when we invest money, we are subject to great risks? The answer is that the problem can never be overcome, but can be mitigated with information. In particular, the nature and source of the information needs to be regulated.
As such, the most important piece of regulation would be to actually make it illegal for banks, or any other financial institution, to pay for any kind of rating on their overall financial status, or the status of any of their products. It is obvious really, but the users of the ratings need to pay for the ratings if their interests are to be represented. As long as the banks pay for their own ratings, their is a fundamental conflict of interest.
The other regulation is even more straightforward. All of the speculative banks need to call themselves by this title, as a constant reminder of their nature. Whenever an account is opened, a standard form will state that they make no guarantee of the return of any cash deposited in their care, and that the person opening the account must declare that they accept the conditions. In addition, on a daily basis, they would be regulated to publish their daily (gold standard) cash reserves available for immediate withdrawl as % of deposits, as well as a monthly rolling statement of % change upwards and downwards. These would be audited on a random basis, with massive fines for any attempt to massage/distort the figures. The figures would be published on their websites and, where a bank has branches, published in the all of the branches in a predetermined format.
The aim of such a measure is to remove the complacent belief that any investment is safe. It is to remind individuals and business that they should take care over where they place their money. It is a climate of fear, and one which will encourage people to pay for services which critically scrutinise the state of the banks. A climate of fear sounds unpleasant, but it is the only discipline that will ensure that investors and depositors have a care for the use of their money. In addition, there is the security of the deposit banks, which will always be an option if the fear of the unregulated sector is too great for any individual. The deposit banks offer greater security than the existing banking system. In addition, other banks will take intermediate risk positions, maintaining relatively high cash reserves, but at the cost of smaller returns on money invested. This is the nature of all investment - the trade off between risks and returns. In a deposit bank, almost no risk and no returns.
At the heart of this argument, I keep on returning to risk, and the impossibility of the removal of risk. Even a deposit bank, backed by gold has risk. Any regulation that suggests that it removes risk is a delusion, and this has been demonstrated in this financial crisis. What was safe is now unsafe, and the regulators have been found to be wrong.
As such, my proposed reform does nothing to remove risk, or to attempt to mitigate risk. The aim of the system is simply to make the nature of the risk more transparent. Despite this, little old ladies, and 30 year old family men, will lose their savings. However, if that little old lady were to lose her money through investing in her grand daughter's business, no one would call for regulation of the granddaughter's business or ask that she not be allowed to ask her grandmother for investment.
As I said at the start, banks just serve two purposes. A relatively safe place to leave your money, or as a conduit for the risky business of investment. I have proposed a return to the gold standard, not because I believe that it is risk free, but because it provides for an alternative that offers people a certain contractual guarantee, albeit a guarantee with a limitation that the value of that guarantee is variable. It allows for deposit banks to offer a fairly low risk, but nevertheless a risk. It also supports the value of money, through offering an explicit contract. The value of that contract may vary, but the contract remains regardless of any change of circumstance.
I am not sure that I have done this subject full justice, but hope that, at least, it presents a challenge to the belief that banks must be regulated. There is a lot more detail that I would like to discuss, but time is (as ever) too short and I have other comitments that I need to attend to. I am also sure that there will be faults in my thinking, so I look forward to the astute readers of this blog pointing out the problems.
Note 1: I have not responded to the many posts over the last few days, as this has been a bit of a long and demanding post. As ever, I will try to catch up, though the backlog seems to get bigger by the day.
Note 2: I have reread the post, and apologies that it is a bit clunky in places. I hope that it is clear enough.
The reason I am now able to write this post is that I have had a very good comment posted on 'Financial Crisis - A Brief Review', in which the author offers an argument that deregulation caused the current financial crisis. The argument that was presented helped me to focus in on what matters, which is to ask what banks are for, and how the financial system operates. In particular, the argument that the Financial Services Modernization Act of 199, in conjunction with a fiat money system, was fingered as the guilty party (I am simplifying, so I suggest reading the original comment). The comment also pointed me to the Ludwig von Mises Institute for an article in support of the argument. The reason why the comment and this article allowed me to finally write this post was that I was preparing all kinds of complex counter arguments, including a long discussion on the Basel Accords, when I realised that I too was missing the point. Whilst I cover these issues, I am now not so concerned with these details, but more concerned with basic principles.
I was forgetting what the banking system was for, and what money is for. It is only if we remember this that we can start to think of how the system can operate effectively. If we keep these basics in mind, it will become apparent that much of the banking regulation is trying to achieve the impossible, the removal of risk. It also becomes apparent that the system of money is built on foundations of sand.
The logical starting point for reform would be the issue of what money actually is. It is not some magic substance that has a picture of a famous dead person on it, or the picture of the queen, but something which has a purpose in the exchange of goods. Lets imagine, for example, that a sofa shop owner is in need of milk for his family, and that the milk requirement is one cows worth of milk production per day. He believes that one cow's worth of milk production for the lifespan of the cow is worth one sofa in his shop.
Now, in the real world, it may be the case that I do not have a cow to provide the milk to the sofa shop owner, or a farm, or anything else which the sofa shop owner wants. However, for the sake of ease, we will say that I am in the business of providing consultancy to farmers, advising them on best practice in milking. As such, I can sell my advice for milk. My own milk requirements are very small, so I do not need all of the milk that the farmer provides in return for my advice. When I want to buy the sofa, I could therefore write a contract that, instead of providing one cow lifespan worth of milk to me in return for my services, the farmer instead directs that same milk to the sofa shop owner. As such, I am now in the position to make an exchange for the sofa, and can take it home.
As such, money is an intermediary, which allows us to not have to go through this complex process to make an exchange for a sofa. In order for money to operate in this role, so that I do not have to set up lots of contracts, the person in the shop must believe that the intermediary that I provide (money) = one cow's worth of milk over the lifespan of the cow. In other words, the shop owner would expect that the money I provide will be able to purchase milk in the quantity of one cow's production (a) over the number of days the cow will live (b). When I enter the shop without a cow or a cast iron milk supply contract, I must provide the shop owner with something which guarantees that I will provide the shop owner with a x b worth of milk, over a period of several years. In effect, that is what I am exchanging for the sofa.
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. When I hand over money for in exchange for the sofa, the sofa shop owner is going to get a bad deal if, in three years time, he finds that he is only able to purchase three quarters of a cow's milk production. It is for this reason that inflation is bad. It is, in effect, a breach of a contract. Whenever inflation occurs, we lose some element of our belief in money to honour the contracts between one another. I have chosen the milk production example to illustrate this point, as it is very important in the consideration of money.
To illustrate this point, I recently had a comment on a post regarding hyper-inflation and whether it is a good time to buy a house at such a time. My answer was as follows:
I have read about hyper-inflation in principle, but here is a good question of the process in practice. The first thing is that, during hyper inflation, the value of cash is destroyed. At the same time the cash price of assets rise, although their real value may not change. At its most basic, what I am trying to say is that, if a pint of milk has the same value as a loaf of bread, whilst the cash value of these may change, the relationship of the value, one to another, does not necessarily change. So it is with housing. If a house is worth 100,000 pints of milk today, all other things being equal, it will be worth 100,000 bottles of milk tomorrow. However, the value of housing was over-inflated, such that all things are not equal. As such, whilst the cash price of a house may rise, the value of that asset will presumably continue to decline relative to other assets.Within this reply, we have a problem when we think about money. Within this scenario we have a situation where the value of one thing versus another is unstable. In the case of of the house, today it might be worth 1oo,ooo pints of milk but the next day it may only be worth 99,000. Alternatively, if there is a sudden expansion in the dairy industry, it may be that the house will be worth 110,000 the next day, as there is an oversupply of milk into the market, thereby reducing the value of milk relative to other items. This can happen to any particular product, commodity or service - and that includes gold.
If we take the value of gold, it might be that the demand for gold drops, due to a change in society where gold becomes associated with 'bling', thereby reducing the demand for gold for personal decorative use. In such a situation, there will be an oversupply of gold relative to the demand for gold, and the value in exchange of gold will drop relative to other items. The problem that I am illustrating is that nothing has a fixed and enduring value in exchange relative to other things.
Now we come to the situation of money today. As many readers will be aware, the gold standard was abandoned many years ago. The gold standard was a situation in which each unit of currency could, in principle, be exchanged for a fixed amount of gold. Today, there is no such backing, such that money has no contractual guarantee. I would therefore like to return to my milk and sofa example.
When I enter the sofa shop, bearing a fistful of bank notes, I am offering the sofa shop owner something that he believes to be a contract, but which actually is not a contract at all. If we say that there is a situation of high inflation, or hyper inflation, then there is no recourse for our sofa shop owner. I might give him £2000 which today looks like it will pay for a cow's lifetime supply of milk, but which will in three years time not be able to be used to purchase even one day's supply of milk. There is no contractual commitment in what I had handed him. None whatsoever.
How does the situation differ under the gold standard? I have already pointed out that the value in exchange of gold varies relative to other goods and services. As such, I could go into the shop and purchase the £2000 sofa in exchange for money which can be converted into x amount of gold. If there is a massive expansion in gold production, or gold was less desirable for the 'bling' factor, then it may also be the case that the gold in three years time would be insufficient to buy the milk that was required by the sofa shop owner.
In such a situation, it becomes apparent that money, in all forms, is a fundamentally flawed concept. I will commit the sin here of quoting Wikipedia, but they offer an excellent summary of what money is supposed to be:
"Money is a matter of functions four, a medium, a measure, a standard, a store."In all cases it is very easy to achieve the first three, but the last point is the one that causes the problem. In all cases it is impossible to guarantee the last item, even with gold. If it is a store, it must be accepted that it is potentially a leaky one. In other words, whatever is used as the standard unit of exchange, it carries with it risk that the value in exchange today and tomorrow might not be the same.
We are therefore in the tricky position of having to make some choices. On the one hand, we could abandon the concept of money altogether, which would mean endless complexity in arranging reciprocal contracts between endless numbers of individuals. On the other hand we have to use something as an intermediary in exchange whose value is subject to change. The former option is simply impractical, and the latter is unsatisfactory. However, the options are just these.
From this perspective, it is apparent that there is a necessity for money, but that money needs to still retain a contractual value. Under the present system of fiat money, there is quite literally no contract whatsoever, and the value of money in exchange rests in its entirety on the delusion that there is an underlying contract. Such a system has huge risk, because if ever there comes a point where individuals demand that the contract they believe to be there is fulfilled, they will find that there is nothing there at all. It is the current situation in the Western world that there is a huge amount of money issued, that this money has been used to purchase goods and services from other countries, but there is very little that the money can actually be exchanged for. This is seen in the imbalance in trade between the East and the West (ignoring cases like Germany).
In other words, if the countries that have provided the goods and services try to exchange the money issued in the West for goods and services, they will find insufficient goods and services available for the money to purchase. We have, for example, used the money issued to buy plasma TVs from China and can not offer any good or service in return for those purchases. We have used an item in the exchange which is not actually backed up with any contractual commitment to reciprocate with anything. We are in a situation where, if the perception of the underlying contract is tested, it will be found that it does not exist. At that point, the belief in the value of money will quite literally disappear. This is the risk that has been taken.
It is at this point that we return to the very imperfect gold standard. If all currency issued is backed by gold, then there is an explicit contract. If you do not wish to use the money in exchange for any goods or services, then you have the option of exchanging the currency for a fixed amount of a commodity. Whilst there is a risk that the value of that commodity might fall in relation to its value in exchange with other commodities, goods or services, it will always have some value in exchange. It guarantees that money will always have some value. Gold is used because it has, throughout history, has a relatively high value in relation to many other commodities. However, any commodity has the same function and the question of which commodity just becomes a question of relative historical value stability, and practical questions of how it can be stored/used/transferred etc.
In short, money must have an underlying contractual commitment, or it becomes subject to losing its meaning. Whether that contract is an exchange for gold, or any other commodity, the important point is that the contract is fixed. In this way our sofa shop owner knows that, whatever happens, he will always be able to buy at least some milk with his money, even if he is unable to buy as much milk as he originally expected. It is very imperfect, but it is better than the option of being able to buy no milk at all, which is possible under a system of fiat money.
It is at this point we now need to turn to the broader issue of banking and financial regulation. Although I have not expressed any preference for which commodity might be used as a backing for money, I will stick with the gold standard as being the method of contractual commitment.
The first question that is raised is who might issue money. My answer is very simple. Anyone at all. That means you, or I, or the person next door can issue money. It is, in any case, what we do all the time. If we remember that money is an intermediary in exchange, we start to see that, for example, when we offer to do something for another person in exchange for something else, we are effectively issuing money, in some cases the unit of currency is a verbal promise, in others a contract written to say that we will do something. In both the case of the contract and the promise, they are both units of exchange.
For the purposes of the wider economy, in ensuring that exchange is efficient and effective, it is important that there are monetary units that are widely accepted. It is only in ensuring that this objective is achieved that there should be any regulation of money. Whilst anyone can issue money (though I suspect few would accept notes backed by nothing where there is a gold standard alternative), there is a regulatory role in ensuring that there is available a particular form of money that is contractually tied to gold. As such there is a regulatory role in the issuing of this money. That role is to fix the rate of exchange, ensure that it is never changed, and to ensure that money that is so fixed can be identified as such.
As such, any individual, or institution, can issue gold backed money, provided that they can demonstrate that they have the gold available to meet the standard, and that the gold is secured against sale. The role of government in such a system is to monitor the institutions that are issuing the money to ensure that they have sufficient gold, and the printing of the money in a consistent format with the issuing institution's name printed on the money. The government might also issue currency, but only if it is also backed with sufficient gold to meet the standard. The institutions that can issue money according to the gold standard would have a special designation as deposit banks. All money within these banks would be contractually guaranteed to be able to be converted into gold (or at least nearly all of it, as an allowance would be needed to allow the banks to acquire the gold as deposits rise). As these banks would not be investing money, they would need to charge a fee for the deposits.
In addition to deposit banks, there would also be an alternative, and relatively unregulated banking system, where the banks would be designated as 'speculative' banks. It is here that we come to the difficult subject of regulation. Before we continue, it is worth reviewing the two basic purposes of banks.
The first purpose of banks is as a place to store money in a relatively safe place. The deposit banks serve this purpose, and therefore there must always be deposit banks available to individuals and businesses, even if the government must step in and offer this service (the least preferable option). The second role of banks is as a conduit for investment. This is best explained by thinking of an individual who has £10,000 saved from their salary. They have several options of what to do with this money. On the one hand, they might put it into a deposit bank, which will only guarantee that, at any time in the future, that money will be able to be exchanged for a fixed amount of gold. Alternatively, they may wish to use that money for speculative investment.
The investor has several choices on how to invest that money. On the one hand, the investor has a sister who is planning to open a restaurant. She is looking within the family for investment capital. Being her brother, he knows her well, she has explained her plans, and he must therefore make a judgement on whether this is a good investment. On the other hand, he might invest the money in the company which he works for, as the company is offering shares in the company to employees in order to raise money for the development of a new product. He knows the company well, he knows the details of the plans for the new product, and can therefore reasonably judge whether it is a good investment. His final option is to outsource the investment decision to an institution specialising in investments - a speculative bank.
In all three cases there is a common factor. In all three cases he must risk some, or all, of the value of his money. In all cases, the money will be invested in projects where, if he wants the money to be returned, there is no guarantee that it will be immediately available, or whether it will ever be returned at all. All three cases are identical in this respect, and no amount of regulation will ever change this basic reality. It is here that we come to the fundamental problem of modern regulation. It is aimed at removing the risk from investment, the risk that money will not be returned to investors. It is really very simple, as soon as a person/institution wishes to gain interest on their capital, they take a risk with that capital. The only way for interest to be accrued is through investment, and all investment is speculative and inherently risky. To try to regulate risk away is therefore an impossibility, but this is the purpose behind much of the regulation.
Regulation of risk is not possible, but regulation of provision of information about risk can be regulated. If we take a look at the Basel banking accords, they do not seek to regulate information but are seeking to regulate risk. A very good discussion of the Basel accords can be found here at the Bank of England website, and I will use it as the basis of discussion. In particular, the date of the paper is 2001, and the paper therefore details the thinking of regulatory institutions pre-credit crisis. The introduction to the piece starts as follows:
The 1988 Basel Accord was a major milestone in the history of bank regulation, setting capital standards for most significant banks worldwide—it has now been adopted by more than 100 countries. After two years of deliberation, the Basel Committee on Banking Supervision has set out far-reaching proposals for revising the original Accord to align the minimum capital requirements more closely with the actual risks faced by banks.The important point in this paragraph comes in the last sentence. This is the problem that is inherent in all regulation, that there is an objective standard of assessment of risk that can be discovered and codified. The thinking behind regulation is best summarised again in the BoE paper:
One issue when deciding on the capital requirements forSo here we have expressed very clearly. Bank regulation is to protect depositors. What the statement does not do is explicitly state is protect them from what. What they mean when they say protect depositors is that the intention is to protect depositors from losing their money. Such an objective is impossible, as all investment carries risk, including complete loss of all capital. The only way to protect depositors is through the provision of a deposit bank (as detailed before) and even that carries the risk that the value of gold might be subject to change. The other problem highlighted is information asymmetry between depositors and the banks. Rather than address this problem, regulation seeks to address the impossible - the elimination of risk for depositors.
each probability-of-default band is the appropriate
solvency standard that regulators should be targeting for
minimum capital.(5) This needs to balance prudence
with efficiency. Banks are regulated to protect
depositors (because of information asymmetries and the
social consequences of loss of savings) but just as
importantly to protect the financial system. This reflects
their central role in the economy. Because of their
position in the payments system and lending to small
and medium-sized businesses and retail customers, the
cost of banking crises can be very high. Bank of
England research,(6) which examines 43 crises worldwide
over the last 25 years, indicates that economic activity
forgone during the length of a banking crisis can
amount to between 15% and 20% of annual GDP.
The answer to this perceived problem, was Basel I. This is described in the BoE paper as follows:
The 1988 Accord represented a revolutionary approachSo here we have a determination of risk which assumes that, for example, OECD based banks are safe. We now see that this is not the case, and many of the banks in the OECD would, without government support, now be bankrupt. We also see that lending into government securities is also 'safe' but, as I have argued elsewhere in this blog, countries such as the UK are extremely unsafe at present.
to setting bank capital—an agreement among the
Basel Committee member countries that their
internationally active banks would at a minimum carry
capital equivalent to 8% of risk-weighted assets (with
the Committee setting broad classes of risk weights).
The agreement was made against a background of
concerns about a decline in capital held by banks,
exacerbated by the expansion of off balance sheet
activity, and worries that banks from some jurisdictions
were seeking a short-term competitive advantage in
some markets by maintaining too low a level of
capital.
The introduction of the Accord seems to have led to
some rebuilding of capital by the banks in the G10, but
over time the broad nature of the risk categories created
strains.(2) The Accord differentiates between exposures
using general categories based on the type of loan—
exposures to sovereigns (split into OECD and
non-OECD), exposures to banks (split into OECD and
non-OECD, with the latter split into less than one year
and more than one year), retail mortgages, and other
private sector exposures. Little allowance is made for
collateral beyond cash, government securities and bank
guarantees.
So here we have the essential problem. A bunch of very smart people got together and said that they were able to determine levels of risk. Their conclusions have been shown to be wrong. In particular, OECD banks have demonstrably been shown to be, in a very large number of cases, unsound. I will reiterate this point once again - they were wrong.
Another point in the Basel I accord was that it creates a perverse incentive to lend to governments. Investing in government debt means that money is not being invested into potentially wealth creating investments in the private sector. It also virtually guarantees that government will have access to credit, regardless of whether the governments are acting responsibly or irresponsibly. Such guaranteed provision will almost certainly have been a factor in the growth in Western government / OECD debt. However, it would be impossible to prove one way or another.
So now we come to the Basel II accord. Once again, I will quote from the BoE paper. It makes interesting reading.
The broad categories reflected the stateI have highlighted two sections with italics, which stand as two examples which will illustrate contradictory points. In the first section, the securitisation boom is seen to be as a result of Basel I. This was to lead to many of the problems we have seen today. The second point was actually a positive point for Basel 1, which was that it was limiting the growth of credit derivatives, which are creating ongoing problems for the banking system today, but this was seen as a negative by the BoE. Basel II sought to rectify this 'failing'. In both cases, the regulation had distorting effects on the structure of markets, and in one case a positive outcome is seen as a negative. The regulators simply can not make accurate assesment of risk.
of systems in banks at that time. But during the
1990s, banks started to develop more sophisticated
systems to differentiate between the riskiness of various
parts of the portfolio to improve pricing and the
allocation of economic capital. These systems
highlighted the discrepancy between required capital
and economic capital for some exposures, creating an
incentive to sell some loans. The chart below sets out a
risk measure, the value at risk (VaR) over a one-year period,(1)
for portfolios of exposures in each rating
category, and shows that for loans to all borrowers down
to BBB the Basel minimum requirements of 8% capital
(of which 4% is equity) would probably be higher than
the equity capital that a bank would chose to hold.
This disincentive for banks to hold prime-quality loans
was probably one of the factors behind the securitisation
boom in the United States. By March 1998, outstanding
non-mortgage securitisations by the ten largest US bank
holding companies amounted to around $200 billion
(more than 25% of these banks’ loans).(2) Banks outside
the United States were also increasingly turning to
securitisation to adjust their portfolios. The ability of
banks to choose how much risk they wished to carry
against a particular quantum of regulatory capital
threatened to undermine the objective of an
international capital floor. Another concern about the
Accord was that the limited recognition of risk reduction
through collateral or credit derivatives would discourage
banks from taking advantage of these techniques and
more generally impair the development of markets.
Another interesting feature of Basel II is that the accord put the credit rating agencies centre stage in the assessment of risk:
Under the standardised approach banks will slotThe BoE paper acknowledges that the rating agencies may be no better than the banks at assessing risk, but fails to acknowledge that there is a central conflict of interest - that the ratings agencies are paid for conducting the rating by the banks themselves. The importance of the poor preformance of these ratings in the current financial crisis can not be overstated. However, they were critical to the entire Basel II system:
assets into weighting bands according to ratings from
eligible rating agencies (ie recognised by national
supervisors in accordance with specified criteria).
Exposures to borrowers without a credit rating will beAt the heart of all of this regulation is an unfounded belief that, somehow, there are a bunch of people with sufficient wisdom to determine risk, and therefore create a system in which risk of failure is abolished. Such a point view can only do one thing - create complacency. It creates a situation where, provided you meet the rules, you must be sound. However, the institutions then game the rules, and seek ways to best exploit the rules. The only solution to this is ever more rules, and ever more complexity, and within that complexity the institutions will just find new ways to subvert the rules. Above all else, however, is the simple fact that it is not possible to remove risk from investments, and that risk must be an accepted part of any system, including risk of bankruptcy.
placed in an unrated band that will carry a 100%
weight (ie 8% capital charge), but regulators are
requested to review the default experience of the
particular market (and individual bank) to decide
whether this is sufficient. Undrawn facilities to
corporates of less than one year, which currently
carry a zero weight, will be weighted at 20%.
I started the post mentioning a commentator's very good and interesting argument that deregulation caused the problems. It is a good basis to discuss the idea that deregulation was the problem. One of the points made was as follows:
But, at any rate, since Basel II was not even published until June 2004, and not implemented in the US until the years after 2005 (well after the housing bubble began), how could it be a major cause of the current crisis?I would not suggest that Basel 1 caused the problem by itself, but rather was a contributory factor, and this can be seen in the BoE paper. The reason for the housing bubble was actually the result of a flood of capital into western markets (resultant from the shift in the world economy) with insufficient good investment opportunities to soak up the capital. Once the sound investments were gone, then there was little choice but to invest in ever more risky investments. This was compounded by the state entities of Freddie Mac and Fannie Mae having an unfair advantage in the provision of lending into prime mortgages, leaving less investment opportunities for the genuinely commercial banks. As for Basel II, it may not have caused the problems, but it certainly exacerbated the problems. In particular, putting the ratings agencies centre stage was problematic, as well as the structure for internal risk assessment.
Of course, Basel I (which was published in 1988 and implemented in most Western countries in 1992) could have played a role. But in the absence of the three factors discussed above (the Financial Services Modernization Act, the Commodity Futures Modernization Act of 2000, and the real estate bubble), how could Basel I have caused this on its own?
The author of the comment, in a second comment, quotes the following:
Paulson convinced the SEC Commissioners to exempt the investment banks from maintaining reserves to cover losses on investments. The exemption granted by the SEC allowed the investment banks to leverage financial instruments beyond any bounds of prudence. In place of time-proven standards of prudence, computer models engineered by hot shots determined acceptable risk. As one result Bear Stearns, for example, pushed its leverage ratio to 33 to 1. For every one dollar in equity, the investment bank had $33 of debt!”I would argue that this is just an example of the problem of regulation. The SEC legitimised all of this. Without such legitimacy, without the approval of a regulatory body, would this kind of practice have been so readily accepted? It is at the very heart of my argument - regulation and regulators encourage complacency. The commentator also mentioned the role of regulatory arbitrage, with the UK offering a laxer regulatory regime as a way of attracting more banking business to the UK. It is yet another example of how regulation can create distortions in the market place. The UK claimed that its 'soft touch' regulation was both sound and more efficient but, as with the US system, it was neither sound or efficient. It is possible to therefore suggest that every regulatory regime should meet the same standards of regulation, but we then encounter the Basel approach, where the risk assessment regime of both of the accords have now been shown to be wrong.
They were wrong, but conferred a false sense of security/legitimacy in the activities of the banks, much as the SEC did in the example given above.
What of the Financial Services Modernization Act, the Commodity Futures Modernization Act of 2000? These are fingered as the guilty in the cause of the financial crisis. However, I would suggest that, for example, the legal structure of financial institutions is not an issue of concern. The structure of financial instruments is not an issue of concern. As you may be gathering, the real issue of concern is the nature of the oversight of the activities of the institutions.
As the BoE suggests, there is an asymmetry of information. When I gave the example of the person investing the £10,000 I pointed to two examples in which the investor had good knowledge about the potential investments (his sister and his company). In these cases information was not a problem, but even with good information the risk remained. The problem of information arose with the speculative bank. How can an investor make an assessment of an institution as complex as a bank in the assessment of risk. How can he know what an SIV or CDO actually are. It is here that we have the assymetry of information.
Before continuing, a quick question. Should the investment of our investor's money in his sister's restaurant be subject to regulation? Just as putting money in a speculative bank risks the life savings of our investor, so does investment in his sister's new business. Regulation is there to protect the investments of depositors, but why would that protection not apply to investment in his sister's new business. In both cases, if the investment of that money goes wrong, then he loses his savings. For some reason, when the word 'bank' is mentioned, confusion arises. We MUST protect the savings of individuals invested in banks, but not if an individual invests in other ways. Why? In both cases the individual might lose all their money, so investing in his sister's business should be regulated, if regulation is to be meaningful and consistent.
For example, if the government guarantees money invested through a bank, why would it not do the same if the business of the sister of our investor goes bankrupt. In both cases the money was used for investment, in both cases our investor lost his savings. Where is the difference? As I said, mention of the word 'bank' seems to change everything, but I can see no rational explanation of why this should be the case. An investment is an investment, whatever the conduit.
The classic picture conjured up in defence of the regulation is that of a little old lady losing her life savings. My answer to this is the deposit banks. If, however, the little old lady wishes to venture outside the relative safety of a deposit bank, then she must accept that she moves into risk, including risk to all of her capital. However, the problem is just the same for all investors, and conjuring up images of little old ladies is just an emotive argument. A 30 year old man with a family to support will also be hurt badly if he loses all of his savings.
So how can this problem be overcome, the problem that when we invest money, we are subject to great risks? The answer is that the problem can never be overcome, but can be mitigated with information. In particular, the nature and source of the information needs to be regulated.
As such, the most important piece of regulation would be to actually make it illegal for banks, or any other financial institution, to pay for any kind of rating on their overall financial status, or the status of any of their products. It is obvious really, but the users of the ratings need to pay for the ratings if their interests are to be represented. As long as the banks pay for their own ratings, their is a fundamental conflict of interest.
The other regulation is even more straightforward. All of the speculative banks need to call themselves by this title, as a constant reminder of their nature. Whenever an account is opened, a standard form will state that they make no guarantee of the return of any cash deposited in their care, and that the person opening the account must declare that they accept the conditions. In addition, on a daily basis, they would be regulated to publish their daily (gold standard) cash reserves available for immediate withdrawl as % of deposits, as well as a monthly rolling statement of % change upwards and downwards. These would be audited on a random basis, with massive fines for any attempt to massage/distort the figures. The figures would be published on their websites and, where a bank has branches, published in the all of the branches in a predetermined format.
The aim of such a measure is to remove the complacent belief that any investment is safe. It is to remind individuals and business that they should take care over where they place their money. It is a climate of fear, and one which will encourage people to pay for services which critically scrutinise the state of the banks. A climate of fear sounds unpleasant, but it is the only discipline that will ensure that investors and depositors have a care for the use of their money. In addition, there is the security of the deposit banks, which will always be an option if the fear of the unregulated sector is too great for any individual. The deposit banks offer greater security than the existing banking system. In addition, other banks will take intermediate risk positions, maintaining relatively high cash reserves, but at the cost of smaller returns on money invested. This is the nature of all investment - the trade off between risks and returns. In a deposit bank, almost no risk and no returns.
At the heart of this argument, I keep on returning to risk, and the impossibility of the removal of risk. Even a deposit bank, backed by gold has risk. Any regulation that suggests that it removes risk is a delusion, and this has been demonstrated in this financial crisis. What was safe is now unsafe, and the regulators have been found to be wrong.
As such, my proposed reform does nothing to remove risk, or to attempt to mitigate risk. The aim of the system is simply to make the nature of the risk more transparent. Despite this, little old ladies, and 30 year old family men, will lose their savings. However, if that little old lady were to lose her money through investing in her grand daughter's business, no one would call for regulation of the granddaughter's business or ask that she not be allowed to ask her grandmother for investment.
As I said at the start, banks just serve two purposes. A relatively safe place to leave your money, or as a conduit for the risky business of investment. I have proposed a return to the gold standard, not because I believe that it is risk free, but because it provides for an alternative that offers people a certain contractual guarantee, albeit a guarantee with a limitation that the value of that guarantee is variable. It allows for deposit banks to offer a fairly low risk, but nevertheless a risk. It also supports the value of money, through offering an explicit contract. The value of that contract may vary, but the contract remains regardless of any change of circumstance.
I am not sure that I have done this subject full justice, but hope that, at least, it presents a challenge to the belief that banks must be regulated. There is a lot more detail that I would like to discuss, but time is (as ever) too short and I have other comitments that I need to attend to. I am also sure that there will be faults in my thinking, so I look forward to the astute readers of this blog pointing out the problems.
Note 1: I have not responded to the many posts over the last few days, as this has been a bit of a long and demanding post. As ever, I will try to catch up, though the backlog seems to get bigger by the day.
Note 2: I have reread the post, and apologies that it is a bit clunky in places. I hope that it is clear enough.
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