Middle Earth Economics

After so much gloom, I had to pass on this link as follows:

http://worthwhile.typepad.com/worthwhile_canadian_initi/2012/12/the-macroeco.html


Enjoy!

An Agenda for Gold?

For those familiar with this blog, they will know that I am not overly supportive of a gold standard currency, but that I think that it is better than the current fiat money system (see here for my alternative). As things stand, we can now see the dangers in the current fiat system, which is the ongoing debasement of many currencies through money printing (QE- Quantitative Easing).

It never does any harm to emphasise the point that so-called QE is absolutely no different from running a physical printing press, even though there are occasional commentators who try to suggest it is different. Creating money by electronically crediting a bank with previously non-existent money is no different from running a printing press and shipping the newly printed money into the bank's vault. In both cases, money is created and an asset is purchased. It is just that the former does so without the bothersome necessity of running a physical printing press. I suspect that, if the central banks were to be undertaking the old-fashioned printing press method, there would be greater outcry against the policy of QE. Trucks filled with newly printed money arriving at banks would focus minds and attention on what is taking place. As it is, the modern method of money printing is just abstract enough to obscure the reality of what is taking place.

However, it seems that commentators are now starting to see that there is something wrong with the new policy of printing our way out of troubles, and the gold standard is moving up the agenda. This from Forbes:

There is nowhere left to hide. America’s governing elites begin to internalize the magnitude of their failure to generate jobs. CBO now predicts worse than 8% unemployment until 2014. America begins to engage, seriously, with the implications of the faltering dollar and reconsider the appeal of the gold standard. From The New Yorker to The National Interest to The Washington Monthly to The Nixon Foundation, thoughts turn to gold.

The linkage between returning to a gold standard and the urge to print money is obviously related. Once again, there is talk of printing money in the US, or QE3:

As Wall Street parses the message the Federal Reserve chairman sent in his speech Friday from Jackson Hole, the narrative that has taken hold includes, on one level or another, more action to help boost the markets and the economy.

That was supported Monday with key endorsements from Fed presidents Charles Evans and Narayana Kocherlokota, who both said they either would support further monetary measures or a continuation of the ones already in place.

Whether future moves come in the form of traditional quantitative easing or something else is what Bernanke and other Fed officials must decide between now and the next Open Markets Committee meeting on Sept. 20. The expectation for easing was heightened when Bernanke said the meeting would be extended from one to two days, indicating that serious consideration would be given to additional monetary measures.

The UK is also flirting with another round of money printing, with this from the Guardian:

Hopes of a fresh round of quantitative easing in the UK increased on Thursday after Martin Weale, of the Bank of England's monetary policy committee (MPC), used a speech in Doncaster to say there is "undoubtedly scope" for the radical recession-busting policy to be extended.

Weale, who was one of two hawks advocating an increase in interest rates until he changed his vote at this month's meeting, said the Bank could restart quantitative easing if oil prices continue to fall and the sovereign debt crisis in the eurozone worsens.

Warning that events on the continent are a greater threat to the UK economy than the slowdown in America, Weale said: "There is undoubtedly scope for further asset purchases to trigger further reductions in yields on government debt should the need arise."

The European Central Bank (ECB) is more constrained, with an inbuilt philosophical opposition to printing money:

New York professor Nouriel Roubini called on the ECB to reverse monetary tightening immediately given the darkening global picture. "It should reduce rates to zero, and make big purchases of government bonds," he said.

Frankfurt is unlikely to heed the advice. The bank's president Jean-Claude Trichet, last week stuck to his anti-inflation script and said "we do not do QE".

The ECB began buying Spanish and Italian bonds for the first time yesterday, causing 10-year yields to plunge by 90 basis points. However, an ECB statement over the weekend came with too many strings to satisfy investors. The bank is likely to be tested over coming weeks.

David Marsh, co-chairman of OMFIF, said the statement was "half-hearted" and suggested that dissenting German hawks were imposing limits. "The ECB is clearly not going in with all guns blazing," he said.

Notwithstanding the growing discussion of a gold standard, one of the great curiosities about QE is how it has now entered into mainstream commentary as if it were a perfectly reasonable thing to do. There are all sorts of justifications given for the policy, but the lack of any remit for central banks to undertake the policy is quietly ignored or forgotten. The most obvious case of this is the Bank of England, which is supposed to use monetary policy to target inflation. Despite several years of overshooting the inflation target, as can be seen from the earlier quote, QE is back on the agenda in the UK. How is it that the Bank of England's remit is forgotten by so many commentators?

It seems that there is a growing divide in mainstream commentary on the policy of printing money, with some expressing fear about the consequence of the policy and moving back to the idea of a gold standard, and others supporting the policy as a magic bullet for the economic woes that are assailing so many economies. At the heart of the debate is the question of inflation, with those who are anti-QE arguing that it is inflationary, and those in favour suggesting that the lack of massive inflation following early QE demonstrates that the fears of inflation are exaggerated. A good explanation comes from Liam Halligan:

The reality is QE has already done an awful lot of damage. America has expanded its base money supply three-fold in two and a half years – from 6pc to 18pc of national income. But even this jaw-dropping measure hasn't led to much of an expansion in monetary measures, such as M2 that include bank lending, precisely because the banks, for all the propaganda to the contrary, are still determined not to lend. They can make more money simply channelling QE money into stocks and other investments.

Crucially, the banks also remain petrified of counter-party risk in the inter-bank market. Many of them, disgracefully, are still concealing vast sub-prime losses in off-balance-sheet vehicles. So they assume other banks are doing the same. Such mistrust between the banks – "we're lying, so they must be lying" – gums up the wheels of finance and starves even creditworthy firms of the funds needed to invest and create jobs.

That's why M2 has remained flat, despite a massive expansion of base money. The way to break the deadlock, though, isn't to do more QE, but to end inter-bank torpor by forcing "full disclosure" of bank losses. Such disclosure is barely happening, on either side of the Atlantic. The UK's monetary base has also tripled, while producing – for the same non-disclosure reasons as in the US – only minimal growth in M2.

Liam Halligan has captured one element of the reason for the lack of inflation, and another is the exporting of inflation through the 'carry trade', as the Wall Street Journal reports:

For much of the past two years global investors borrowed dollars and Japanese yen at the rock-bottom interest rates set by the U.S. Federal Reserve and the Bank of Japan and then poured that cheap money into currencies like the Australian dollar and Mexican peso to earn much higher interest rates.

Now, those popular "carry trades," which profited from a difference in interest rates as high as 12 percentage points in Brazil's case, are starting to unwind as investors lose faith in the outlook for global growth and fret over financial turmoil. If it continues, it will bring an end to a rally in emerging market and commodity-based currencies that began shortly after the Fed slashed rates to near zero at the end of 2008 and it could drive up borrowing costs for banks, companies and even households in those countries.

That unwinding could be cut short if the Fed's announcement Tuesday that it would keep its target interest rates at "exceptionally low" levels "at least through mid-2013" makes carry trades attractive again. But the problem with the strategy is that it is only profitable if currencies are either stable or if the funding currency is falling against the investing currency. And if the past week's bout of global financial turmoil persists and puts emerging market and commodity currencies under more pressure, many investors will be forced to throw in the towel and buy back dollars.

The problems of the carry trade for the recipients has led to reactions to try to prevent the inflows of 'cheap' money, such as Brazil establishing capital controls:

Brazil has been vocal on one of the themes put on the table by France as G-20 chair: how to better police capital flows globally. Several emerging countries, including Brazil, have been faced with buoyant capital flows in search of higher yields, which have put upward pressure on their currencies and hurt their exports.

Countries have reacted by imposing capital controls or intervening on their currency in a unilateral way. This has prompted the G-20 to try and coordinate capital controls better, so as to avoid adverse impact on growth from disorderly moves.

This is what I had to say in TFR magazine in December 2009:

But there is also another factor, there is increasing talk of a US dollar ‘carry trade’, as a result of dramatically increased liquidity combined with near zero interest rates.

The idea is simply that a good return on investment can be made by borrowing at a low interest rate in one country, and investing in another that has a higher interest rate. In doing so, the inflationary effects of printing money are exported to the country that is the destination for the carry trade.

This was what happened when Japan resorted to quantitative easing, with the printed money going west in the yen carry trade, acting as one of the sources of excess liquidity for the credit bubbles that burst in 2007 and 2008. There is less talk of a sterling carry trade, but it’s fair to assume that, with monetary circumstances similar to the US, something similar may be taking place there (albeit on a much smaller scale).

The interesting point here is that, as a result of the carry trade, Japan itself did not experience the inflationary effects of printing money. The case of Japan is cited as the reason why inflation will not take place in the UK and US. However, there is a fundamental difference between the UK, the US and Japan.

During the period of the carry trade, Japan was generating a large current account surplus, so the flood of yen onto the market did not result in significant currency weakness. By contrast, both the UK and US have been (and continue) to run large current account deficits. In both cases the currency is already sitting on weak foundations and, therefore, export of the dollar and sterling into the carry trade will simply put more pressure on the value of those currencies. They are flooding the market with currencies for which there is already a potential over-supply.

What we can see is a problem looming on the horizon. Output in both the UK and US has fallen (and is still falling in the UK), which means that some of the effects of the reduction in credit are already ‘eaten up’.

Furthermore, the governments of both countries are stepping in to fill the void of private credit contraction with government borrowing. If the money sitting in central banks were to enter into the economy, there would be a real increase in the money supply and this would cause rapid inflation. On the other hand, if the money exits the economy via the carry trade, it will severely weaken both nations’ currencies and re-enter the economy through the back door of import-price inflation.

At the moment, the increase in money has not entered into the real economy, but it will do at some point. I suspect that it will be through the back door of the carry trade.

What we can see in Liam Halligan's analysis and my own explanation is the reason why it is that we do not currently see massive (or hyper) inflation in the money printing economies. However, what we can also see is the potential for inflation to start a rapid upwards climb in the QE economies. The only way that the money supply might be reduced is to reverse the QE, which would mean selling the government bonds that have already been purchased and destroying the proceeds of the sale. Could markets absorb such a sale when government debt is already flooding the markets? It seems improbable.

For the proponents of QE, the lack of massive inflation is used as a justification for continuation of the policy. For those who are arguing for a return to gold, they can see that somehow, at some point in time, the massive expansion of the monetary base in QE countries must eventually see a rise in inflation. For the latter, they are not always clear in their understanding/explanation of why massive inflation has not taken place. However, their instinct that QE must eventually have a price is correct. Furthermore, the price is already being paid around the world as easy money has flooded into other economies. That in turn is creating distortions in markets, and those distortions will ripple back towards the countries that caused the problem in the first place. Again in TFR, this is what I had to say about 'extreme policy' in the context of the 'carry trade':

From enactment to (unpredictable) result, there is a period during which the effects of the policy build and interact with the results of other policies and the markets, both domestic and international.

It can therefore often take a long time before the full effects become apparent. As they do become apparent, the other actors respond with their own policy provision, and the effects of that policy will again take time to impact.

Among all of the major economies, the responses to the economic crisis have been extreme policy making. We are only now seeing the full impacts of those policies, and the reactions to those policies are building. The underlying problem is that, the more extreme the policy of one actor, the more likely that the response of another actor will be extreme. The world economy is a dynamic system, and the actions of each policy will, in the end, lead to a response from other actors in the world economy.

As such, when actor ‘A’ pulls on policy lever ‘X’, they really cannot see the outcome of their own actions. The larger the actor, and the more extreme the policy, the greater the chance that the reaction of other actors will also be extreme. The greater the reaction of these actors, the greater the reaction that will be forthcoming in response.

And so it continues, creating an ever more unstable system; the more the levers are pulled, and the harder that they pull on them, the greater the potential for the policy intentions to be confounded, and the greater the general instability.

We can see this instability taking place. We see, for example, the Swiss taking ever more radical measures to try to lower the value of their currency in the face of the 'safe haven' purchases of their currency. We can see the instability in the surge in the gold price. We can see the instability in the on-off panics in markets. Every day we see more examples of the instability.

One way or another, the effects of extreme policies such as QE ripple out into the global economy, only to eventually wash back in unpredictable forms. The great conceit of the policymakers is that they think that they know what they are doing. In the end, the call for a return to a gold standard is really a call for the policymakers to take their hands off the levers of monetary policy, as they do not really understand what happens when they pull on the levers.

A ramble towards a conclusion

Spiegel Online is one of those rare media outlets that is intelligent, and also gives due space to explain the stories that are covered. I may not agree with their analysis, but it is certainly one of the more worthwhile sources. I was therefore interested to see their headline that asks whether the world is going bankrupt. I will quote from their conclusions:

It has become evident that debt-to-GDP ratios of 80, 90 or 100 percent will sooner or later cast doubt on a country's creditworthiness. Even supposed paragons of fiscal virtue such as Germany must be careful. The German debt ratio of 83 percent is too high, given the ageing population. Who is supposed to pay down that debt in the future?

I am not entirely convinced that the story supports their headline, but it is nevertheless interesting to see recognition that the current situation cannot continue. Perhaps even more startling is Edmund Conway in the Telegraph. Regular readers will remember that I was extremely critical of his stance on quantitative easing (money printing) by the Bank of England, but he seems to have completely reversed his previous support for this dangerous policy. In a surprising article, he traces the roots of today's crisis to the abandonment by Nixon of the gold standard. This is an example of his analysis:

Over the past 40 years, in the absence of a coherent international monetary system and under the veil of floating currencies, countries which would otherwise have been penalised for doing so were allowed to borrow enormous amounts (eg. The US and UK, or Greece). Other countries (eg. China or Germany) indulged them by lending enormous amounts. In the meantime, investors convinced themselves that the apparent economic growth fuelled by this debt was genuine rather than an artificial product of a binge.

The 2008 crisis represented the first recognition that those increases in asset prices and economic growth were chimerical. The recent relapse represents a recognition that the losses have merely been transferred on to sovereigns' balance sheets.

Even more interesting is the growing view that the $US is looking ever more fragile as the world's reserve currency. For example, the New York Times is taking a moderate position, where they posit that the $US has a long while to go yet as the reserve currency, but nevertheless see the writing on the wall:

Still, recent actions have clearly hurt the dollar more. And it is the bleeding from a thousand cuts, both inevitable and self-inflicted, that will eventually cost the dollar its dominance.

Even more interesting is commentary from Peter Hartcher of the Sydney Morning Herald. He commences his story with a comparison between US defence cuts and China's first aircraft carrier being completed. His story is rooted in the shift in power between East and West, and he sees the $US decline as a key element in the shift:

It's not just that the creeping shift of power from West to East has become a rush. We've known about that for years. There is something else going on, too. You can see it in the price of gold. An ounce of gold traded for about $300 a decade ago. This week it hit an all-time high of $US1800. Why?

Some investors have lost faith in the US dollar. It was the official global reserve currency for the first 25 years after the Second World War and the de facto reserve currency after that. Even the governments of the G-20 nations are actively discussing the idea of spreading the risk, creating a new reserve system comprising the currencies of multiple countries. This was unthinkable just a couple of years ago.

But while confidence in the US might be sinking, there is no corresponding rise in confidence in China. "You can see it in the price of gold," observes one of Australia's leading investors, Kerr Neilson, the head of Platinum Asset Management. "There is a system change under way."

Apparently, according to this commentator we have all known about the shift for years, but of course this is not true. Certainly when I was writing about the end of the $US as a reserve currency, and the great shift in wealth, when starting this blog, it was a radical position. It is now moving into the mainstream. Certainly the rise of China was widely discussed, but it was not posited that this would be at the cost of the fall of the West. China was supposed to rise up to meet the West; it was not supposed to happen that China would rise and the West would fall, only for both China and the West to meet somewhere in the middle. However, if you look at one of the key themes of this blog, the limits on resource growth and increases in the world labour force, it was the only possible outcome.

The DNA of the current panic is the recognition of the simple fact; the West is getting poorer right before our eyes. The allocation of limited resources in the world is shifting to the East, and that means that there is less to support the lifestyle of the West. Sure, commodity output is increasing, but just not enough for China (and the East more broadly) to rise up without seeing a fall in the West. I forget where read it, but a recent article discussed the shift of interest in US companies from serving the domestic market to an ever greater focus on the emerging markets. It has been going on for many years, but the article noted that this was a change in degree. Somewhat surprisingly, the Governor of the Bank of England has explicitly stated that the standard of living in the UK is in decline. All around us, we can see the shift in wealth, and it appears to be accelerating.

I put emphasis on the word appears. It has long been the contention of this blog that the shift has just been hidden with debt. For example, when (or rather if) governments adopt genuine austerity measures and stop borrowing from overseas, and consumer borrowing funded through overseas lending stops, the true level of real wealth will be revealed. Instead of thinking of this lending in abstract terms of money, I have always viewed it as the borrowing of resources and labour. It may be counted in money, but in reality it is always the lending of resource and labour. The complication in this system is that the resource is measured in units of money where the units might be changed to cheat the lenders. However, in all events, when the borrowing stops, there is going to be a change in the standard of living experienced by the borrowers.

It is becoming obvious that, faced with declining standards of living in the West, the solution to the problems is seen as defaulting on debt through currency devaluation, which a recent article in the Financial Times heralds as currency wars:

Yet with Tuesday’s announcement the Fed committed to easy money for the foreseeable future and signalled it was ready to loosen further. Thus the conditions are dangerously propitious for the currency wars to break out again.

A currency panic, with destabilising moves in exchange rates reinforcing collapsing asset markets, is one of the few problems from which the global economy has mercifully been spared throughout the global financial crisis. Even in the extraordinary movements of this week, there are few signs that leading currency markets have become disorderly. The falls in the dollar against the yen and Swiss franc have been accompanied by a rally rather than a sell-off in the prices of Treasuries, even at longer maturities. Investors appear to be responding to (justified) fears about the underlying strength of US growth rather than betting on market meltdown or sharing Standard & Poor’s views on US fiscal solvency.

Yet, although it is hard to imagine that the world’s leading economies are having much good fortune, their governments are riding their luck as far as currencies are concerned. If there is a re-emergence of serious political tension over exchange rates – perhaps a flight out of the euro pushing the dollar higher – the global economic order still does not have a credible means of co-ordinating currency management.

As this article recognises, the game is out in the open. It is also a rather apt way of describing the situation. Was it Bismark who said something about war being diplomacy by other means? In this case, what we are seeing is war by other means. It cannot end well. More to the point, it does nothing to address the real problem, which is access to resources. The only real solution to the overall problem is expansion of resource availability overall, and I am not sure what the solution to this might be. There are some bright spots, such as the emergence of technology to access shale gas. This might allow for greater supplies of one of the key inputs into the world economy, which is energy.

However, on the other side of the equation, there is still a pool of labour that is not fully integrated into the world economy, but is nevertheless entering into the world economy. The entry of this labour will be resource intensive, continuing the trend of the last 10-20 years, with the necessity of building resource hungry infrastructure. And then there is the nature of this new labour. It is comprised of individuals who have very little, whose resource use is just somewhere above that required for survival of themselves and their families. Any improvement to their resource makes a huge difference to their lives, and they will grab any opportunity to raise themselves up. Visit the countryside in China or India, and you will see what I mean. And who can blame them for wanting a better life?

And then there is the West. We have the infrastructure. We have opportunities and systems that have allowed us to have lifestyles that this emerging labour could only dream about. However, it was not enough for us. We wanted more, and more and more. We voted in governments that told us that we could have more and who borrowed in our names, and we borrowed to support our lifestyles, all the time thinking that it was our 'right' to enjoy our huge share of the world's resources. Well, it is time for the West to wake up, and accept that the game has changed. What excuse was there for countries with fully developed infrastructure to borrow money, or why did so many individuals borrow so much when their wages might allow for a reasonably good life? It was borrowed because we wanted to consume more than we can produce. We came to a point where we thought that we deserved to enjoy such a high standard of living as a right.

We have done so much in the recent past to support our idea of wealth as a right. The trouble is that it is not a right that is exclusive to us. The peasant on a Chinese or Indian farm is perfectly entitled to compete with a worker in the West for a greater share of resource. People talk of sweat shops, and unfair competition resultant from poor wages. However, as I once expressed in a previous post, I would not want to be the person that turns a young Chinese girl back to her village, when she seeks a better life in the city. Standing on the road to the village, and telling her that she is going to be exploited for working for so little will not convince her not to leave. For her, it is a better life than that which she has now. She deserves the better opportunity.

So we come to the underlying problem. How can we insist that we should have the disproportionate share of resources as our right? What is it that makes us somehow so different? On what basis do we found our belief that we will always be so much more wealthy? I have yet to see any argument that can explain this.

The situation is now one in which the world has already changed. We are just seeing the consequences, but we are failing to adapt. We must change to meet our new circumstances. That means that we can no longer take for granted that we will have all that we had before. That means that we must think hard on what we think are the priorities for where we allocate our diminishing resource. For example, is it health care, or is it education? How can we make our systems work with less resource, and what are our priorities within each area?

What we now see is that the attempts to solve the so-called financial crisis were simply delaying mechanisms. It was never a financial crisis, but an economic crisis. All around us we can see the chaos as the fundamental change in the world economy forces itself firmly back into view. Sure, the central bankers and policymakers squeezed the problems from view for a while. But still the economic crisis forces itself back into view. However much we may not like it, we are all variants of Greece. But when we are confronted with reality, who is there left to bail us out? In a recent Economist article, the discussion was one of how France, if it extends itself much further on bailing out others, will teeter towards its own crisis. It is the absurdity that the massively indebted are saving the even more massively indebted. Their credit is, for the moment, just a bit better than the bailee....

This is a somewhat rambling approach to a post. It was not my intention to go down this particular route, but it seems that, wherever I look at in the news, the footprints lead me back to the same place. This post is a reflection that the surface symptoms all lead to the same underlying causation. If we look at the surface, we can not deal with the problem, or rather we can not confront the problem. The comments and quotes that started the post are starting to reflect the explanation of the economic crisis that emerged when I started this blog. The trouble is that the shifting understanding of the commentators, the move towards the position of this blog, have not gone far enough yet. They are starting to 'get it', but they still have not confronted the hard reality of the new shape of the world economy. They still do not fully accept the hyper-competition of the new world economy. It is brutal, but there is no way to avoid confronting it.

Note: I had a comment on my last post in which a regular reader accused me of taking an ideological position for tracing the roots of the crisis back to the final impacts of communism/socialism. If my fundamental premise that the economic crisis is a result of the shock entry of so much labour into the world economy is accepted, this is not an ideological position. The governments in countries like India and China rejected the global capitalist economy, and developed systems in which most of their labour force were utilised in a way that was barely above subsistence. When they abandoned this path, and sought to connect their labour into the capitalist world economy, the flood of new labour can only be explained as being resultant from the previous policy.

Sure, there are very significant problems in the way that the capitalist system met the change that this entry caused, but that does not take away the fact that the problem started somewhere. Perhaps a more appropriate point would have been to comment on my use of 'capitalist' as a broad brush characterisation, as there are elements of different economies that might suggest that this term is being misapplied. However, for the sake of ease, it seems a good shorthand for the contrast between, for example, the Chinese system pre-Deng reforms and the system joined post-Deng reform. Also, socialist for India might be described as misnomer. However, post-Independence India followed the lead of the Soviet Union in economic policy, albeit with Indian characteristics (to adapt an expression used for communism in China).

I was a little disappointed with the tone of the comment. However, as the comment came from a longstanding follower of the blog, I nevertheless thought I would respond.

When will the Money Printing Stop?

Having already posted today, this is more of a note than a full post. I have noted recently that the UK inflation figures yet again defied Bank of England expectations of deflation. Whilst their recent inflation report was full of caveats on inflation vs. deflation, the original justification for quantitative easing (QE-Money Printing) was a deflation scare. As I have pointed out in many posts, the target inflation rate has barely been missed throughout the entire period of QE, and the predictions of deflation have never come to pass. The requirement for the Bank of England to write a letter of explanation to the chancellor is if the Bank of England misses the inflation target by 1%.

Yet again, inflation is still sitting stubbornly close to the target, such that no letter is required. This from the Telegraph:

The Consumer Prices Index (CPI), which is the Government's preferred measure of inflation, dropped to 1.6pc from 1.8pc in July - the lowest level since January 2005 according to data from the Office for National Statistics (ONS). It was the third month in a row that CPI was below the 2pc target.

As it is, the main cause of the fall in the rate of inflation is lower gas and electricity prices, which have fallen by considerable amounts. If we turn our minds back, it is apparent that the high prices with which these price falls are compared were extremely high prices resultant from the spike in prices of oil, which I predicted would fall back.

It is also noteworthy that the reason for continuing inflation is the higher prices of imports, which was my suggested reason for continued inflation when considering inflation versus deflation. The weakness of the £GB was always going to have a counterveiling impact to the shrinking of the economy. This point is of particular note for the US, now that the $US is sliding. In the case of the UK, I pointed out that currency weakness would take a while to show up in import inflation, as prices and contracts will take a while to adjust (e.g. when a contract is signed, it takes often takes a long while before the contracted goods are actually delivered at the pre-inflation price). The same will apply for the US, with time lags in inflationary pressures.

Returning to QE, it is interesting to see that the media have been distracted from the original purpose of QE, now that the predicted deflation has not taken place. This is from the FT:

Although six months is a comparatively short time to judge QE, Mr King can already point to some signs of success, but these are balanced against other more negative indicators.

On the positive side, government and corporate bond yields have fallen, boosting company borrowing in the capital markets. Indeed, sterling corporate bond issuance has surged to an annual record, with three months still remaining of the year.

Ten-year gilt yields are only 3 basis points lower, at 3.61 per cent, than the day before QE - but Charles Bean, the Bank's deputy governor, insists that they would have been 50bp higher without QE.

Investment grade sterling bond yields are 2 percentage points lower, at 6 per cent, than in early March, although euro-denominated corporate bond yields have fallen just as sharply with the help of the European Central Bank's injections of liquidity into the money markets.

QE has also boosted the equity markets, although it is difficult to quantify how much money investors have switched into shares from their gilt sales. The FTSE 100 has risen 38 per cent since the launch of QE, but a lot of the gains were due to an improving world economy and resilient corporate profits.

Like so many commentators, the deflation scare that was the justification for QE is quietly being forgotten. It is not clear why the memory of so many journalists and commentators are so short. With the notable exception of Liam Halligan in the Telegraph, it seems that the origins of QE are of no importance.

Throughout the policy of QE the Bank of England has sought to generate confusion over the role of deflation and inflation as their justification for QE. This is an excerpt from a previous post, where I highlight the kind of methods being used:

If we remember, the bank targets CPI, not RPI. However, in the Bank of England inflation report from February, it might be noted that the RPI is discussed in the report, even though the CPI is the target for inflation. You will note how the measures are blurred in this passage.

Deflation is sometimes used to describe any fall in the general level of prices (as measured in the United Kingdom by the CPI, RPI or the GDP deflator), however short-lived. A more economically significant phenomenon, however, would be a sustained period of negative inflation.

The RPI is likely to fall temporarily over the coming months (Section 4.1). This period of negative retail price inflation would be unusual (Chart A) and predominantly reflects the much lower contribution from mortgage interest payments, following the recent large falls in Bank Rate. The MPC’s central projection is for its target measure, annual CPI inflation, to remain above zero throughout the forecast horizon. (p33)

Whilst there is no direct statement of targeting of RPI, the way in which the whole passage is put is somewhat grey. The same section of the report then goes on to warn of the dangers of deflation......it appears that the Bank of England is subtly conflating the two measures, and they even use a chart which is designated as the 'ONS composite index'. (p33) One of the interesting points is that an argument for printing money directly follows this discussion of RPI and deflation:

Periods of low inflation, associated with weak demand, may limit a central bank’s ability to use conventional monetary policy to stabilise the economy. But if reductions in official interest rates do not prove sufficient to meet the inflation target, policymakers still have other options available to them to stimulate the economy, if necessary (see the box on pages 44–45 in this Report). (p33)

In a previous post, I have explained exactly why there is no element of QE that might justify the policy. This is beyond either a summary or quote, so I would recommend those that have not already read the post, to read it now.

Yet again, despite no indication of serious deflation, there is no indications of any halt to quantitative easing. Why is this? More to the point, why is it that so many in the media are sitting back and watching the monetization of government debt continue with so little concern? At this point, the press should be filled with outrage. Instead, they appear to accept this policy as if it were perfectly normal. Have they not noticed that the policy justification has failed to materialise?

Exactly how or when QE might stop, and under what circumstances, continues to be opaque. It seems that nobody seems willing to give the answers, and the press does not appear to be concerned. In the interim, the government continues to spend money still wet from the printing press.....to say that this is a bad situation is an understatement.....

Reforming Money - Fixed Fiat Currency

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.