How fractional reserve banking leads to boom and bust

New favourite lecture

For a long time I considered Peter Schiff's lecture:
Why the Meltdown Should Have Surprised No One to be the most insightful lecture on the state of our economy you can find on the internet. I've now changed my mind. I'd say it has been topped by Michael Hudson's lecture at the American Monetary Institute in October 2010. To see it go to this page on Steve Keen's blog and scroll down to where it says "Hudson Talk". The viewer is expected to already know about fractional reserve banking and I don't think the lecture will make much sense without that.

Biflation

I've said this before, but I'd just like to say it again in another way...

Since the crash and for several years to come, as the leverage unwinding progresses. The things purchased with borrowed money will fall in price relative to the price of things bought with saved money.

Things bought with borrowed money include:

Housing (I'm talking about the price of the house, not the size of the mortgage payments).
Shares (trading on margin).

Things bought without borrowing money include:
Food
Utilities (water, gas,electricity)
Services

Note that in many countries the standard inflation measures (like CPI in the UK) tend not to include (or give much weighting to) things purchased with borrowed money.

Now whether the absolute numerical price of these things rises or falls depends on the rate at which governments pump up their monetary bases. If they pump very fast they may get rising prices in both classes of good. If they pump up slowly there may be falls in both classes. However there is a wide range in between where the price of shares and housing can fall while the price of food and services will rise.

How can savings fail?

A concept I have discussed before on this blog is that it is impossible for everyone (or even just a large fraction of the population) to save at the same time. If there is an attempt to do so then the savings will perform less well than people may expect. I have come up with a story to illustrate the point. Imagine a very simple society with only two types of good, Apples and Jewels. These choices are actually surrogates for "Essential, perishable, goods" and "Non essential, non-perishable goods". There is no money, only barter. People normally only ever swap apples for jewels if they have plenty of apples spare and want the jewels simply to wear, look good and show off their status".

Let us say that the apples are grown year round. There are no fridges, so apples can only be stored for a few days before rotting.

One day the newspapers publish an (accurate) prediction that the apple crops will take a marked downturn in a few months time because of an expected weather event, perhaps el-nino or some such. Everyone will now want to "save" so that they don't go hungry. They can not store up apples because they will rot, so instead they all want to buy jewels so they can "sell" (exchange) them for apples at a later date. The jewel/apple exchange rate will rise dramatically. People will see the high jewel/apple ratio and assume that they have lots of savings. Later on the harvest fails and there is a shortage of apples. People will now be forced to start selling their jewels for apples. The jewel/apple exchange rate will plummet. The amount of apples people can buy with their jewels will be disappointing.

Here is a diagram of the situation (click on it to show full size):

Now in the real world the jewels may be a variety of savings vehicles, shares/bonds/money. Unfortunately things are complicated by the fact that the amount of money in the system is variable (due to the magic of fractional reserve banking) but one way or another, in the real world, our current savings are liable to disappoint. Either through defaults, monetary inflation or even both.

Bank of England seem confused about inflation.

Yet again the CPI inflation figures are above target. This seems to be confusing the Bank of England who are sure that inflation should be falling because the money supply is falling. Maybe they should have read this blog entry from last year.

UK jobs - let's do the math

The chief secretary to the treasury has just announced that they plan to reduce government spending by 38 billion pounds per year, by 2014. Let's assume that each government job corresponds to a spend of £35,000 (admittedly a bit of a wild guess). Now 38,000,000,000 divided by 35,000 is 1,085,714 or approximately one million. That's one heck of a lot of jobs to be found elsewhere in the economy!

Mickanomics, the book!

Just in case you were wondering why I've been so quiet recently. The answer is that I've decided to compile my thoughts about economics in to a book. I have decided that perhaps a blog is not really the right format for my ideas. The problem with a blog is that people only ever want to read the most recent entries and I don't think my later posts make a lot of sense unless you start reading form the beginning. Also I think that the discipline of writing a book is a good way to check that my ideas are consistent.

If anyone would like to check out the chapters I have written so far and give me some feedback on errors/style/clarity etc. please just drop me an email to reissgo(at)gmail.com