Computer-based market trading 'beneficial' - BS!

This report claiming that high frequency trading did no harm made me angry. Its a bit like a report into the effects of placing sharp metal spikes on the outside of cars concluding that "there is no increased risks to the passengers"!!...

Well of course there isn't - but its the people outside the cars I'm worried about! The scope of the report was too narrow to be of any value.

Tweet

How the BBC is misleading the public about the financial crisis.

More than 99% of the general public think that money works as a system of tokens (real or electronic) that get passed from person to person as trade is carried out. They assume that the total amount of it would remain constant were it not for occasional money printing by government. Money could indeed work this way had governments chosen such a system, but in reality it works completely differently. Bear this in mind as when you read the following.

Here I present two tables, the first contains things the BBC say that are either false or misleading, and the second is a table of important things they don't say but should.

What the BBC say	How the public perceive this information	Why this is wrong
There is a “credit crunch”	There is a problem specifically for those people who want to borrow money. There is no impact on the money supply.	Because “credit” is money (technically “broad money”). When you buy something with a debit card, what you are spending is (97%) “credit” even if you personally have not borrowed any money. A "credit crunch" is in fact a money crunch. See here for more info.
Contagion is due to “interconnectedness”.	Some kind of financial disaster may happen because of “interconnectedness”.	The contagion effect has very little to do with “interconnectedness” and everything to with our highly leveraged monetary system. See here.
QE is “printing money”	The money supply must therefore be going up.	Without QE the money supply would be falling fast. QE is being done to slow down its rate of fall. In all the years of this crisis I have only heard this on the BBC once.The money supply, even after QE, is falling. See Mervyn King confirm what I’m saying here.
QE is “printing money”	More money is created, and that’s the end of the story.	Because it is compulsory that the money created through QE is extracted from the economy in the future. This will be painful. It is “kicking the can down the road”.
QE is “printing money”	QE is “printing money”	Money printing is in fact against EU regulations.
Let’s listen to esteemed mainstream economist X	This economist understands the crisis.	Mainstream economics spectacularly failed to foresee the crisis. Economist X doesn’t have a clue why its happening. If this was football, this economist has just been relegated to the Vauxhall conference league and yet the BBC will talk to him/her with reverence and won’t even ask them to explain why they missed the crisis.
Let’s listen to a non-mainstream “controversial” economist Steve Keen.	Lets not take him too seriously.	If this was football, this guy has just won the premiership. Yet the BBC didn’t have him on until years after the crisis began.
“Only the Bank of England can create money in the UK.” See here.	“Only the Bank of England can create money in the UK.”	This is flat out wrong. Private banks create almost all of the money supply, the BOE only create a tiny proportion.

What the BBC don’t say	Why they should
The money supply can shrink	More than 99% of the population are unaware that it is even possible for the money supply to shrink. They have no idea that this possibility has anything to do with the financial crisis, yet this phenomena is at the heart of it. No wonder the population at large do not understand the crisis. See here for more info.
Anything about Irving Fisher	During the great depression in the 30’s… famous economist Irving Fisher developed an alternative monetary system known as Full Reserve Banking (in which the money supply can not shrink). The plan was endorsed by hundreds of academic economists and was probably the most significant economic idea to arise from the depression. Sadly the (tiny number of) people in government that had the power to implement the plan at the time, didn’t have the courage to do so. Then the war broke out and the plan was mothballed.This financial crisis is an almost exact repeat of the depression of the 30’s and yet there is no discussion of him or his plan on the BBC.
Banks behaving better shrinks money supply. And makes banks go bust or need more bailouts.	This is a tragedy not mentioned on the BBC. See here for details.
People taking economics at university are either not taught about the monetary system at all, or are taught an oversimplified and FALSE model of it.	For proof of this, look no further than this quote from Professor Charles Goodhart, who describes standard university teaching of our monetary system as “…such an incomplete way of describing the process of the determination of the stock of money that it amounts to misinstruction”. So anyone reading this who has a degree in economics - please note that your understanding of the way our monetary system works is probably wrong.
Over 90% of bank lending in the past years has been for the purchase of non-productive assets.	The BBC are constantly referring to investing in “risky assets”. But the public has little idea of what this term means. They may think that it means investing in businesses that make products that may or may not sell. But it actually means non-productive assets. Not “businesses” of any kind.Sadly the suppression of this kind of lending shrinks the money supply for the rest of us - so it would be a disaster to suppress it so long as we keep our current "fractional reserve" monetary system.

Banks behaving better shrinks the money supply!

The population at large are demanding that banks behave better. In turn, this is encouraging some politicians to demand that banks behave better. So presumably a raft of strict new rules and regulations will swiftly be put in to place to control the banks… won’t they? Well not as long as we keep hold of our crazy fractional reserve system.

You may have noticed that the new rules and regulations to control bank excesses appear to be both rather timid and slow to be applied. For example the recommendations put forward by the much trumpeted Independent Commission on Banking were rather weak to start with, have since been watered down, and even then are not due to come into force until 2019!

Most people are assuming that the reason for all this timidity is that the politicians are in the pockets of the banks. The political parties receive significant bribes, oops sorry, I mean campaign contributions from the banks and so are reluctant to do anything that may upset them. But there is a second, more significant reason that is scarcely mentioned in the media or known about by the public. Namely that in a fractional reserve system, banks behaving better shrinks the money supply.

Much of the bad behaviour of the banks involves the lending of money for non-productive purposes, like the purchasing of houses or the purchasing “on margin” of shares on the secondary market or derivatives. But as we know, lending creates money and repaying loans destroys money. So any curtailing of lending, even bad landing, simultaneously shrinks the money supply. What’s more, a smaller amount of money creation for purchasing assets reduces the value of those assets. If banks are holding these in order to comply with capital adequacy regulations then this will result either in banks going bust, or banks having to receive even more bailouts than they have already.

Now you can see that the idea of making banks behave better has a double-whammy of resistance.

As I have said many times before, if we instead had a system of full reserve banking, then none of this nonsense would be going on. The money supply could be held constant… Maybe I should make this my catchphrase?

Tweet

Why money disappears when loans are repaid.

Much to my frustration, 99% of the discussion of, and public information about, fractional reserve banking concerns the money creation process. Videos on the subject will often have scary music accompanying animated graphs of the money supply growing exponentially. The viewers will often be led to the conclusion that fractional reserve banking is a one way process in which the money supply can only ever increase, and the only problem with it, is inflation.

In this article I hope to correct this imbalance by talking about the other side of fractional reserve banking - the disappearance of money. It is perfectly true that when banks make loans, they create fresh new money that never existed before out of nothing. It is also true that when loans are repaid (or more specifically when the principal is repaid) that money disappears back out of existence. In a fractional reserve system, there can be periods where the net money supply shrinks. If there is a period in which banks are reluctant to make loans then the rate of money destruction through the repayment of existing loans can exceed the rate of money creation from making new loans. This is what happened in the great depression in the 30's. The money supply in the US fell by around a third. A falling money supply is every bit as problematic for an economy as high inflation.

In the current climate (since 2007) banks are reluctant to make new loans. The money supply is currently falling. It would be falling even faster right now were it not for quantitative easing. The entire crisis now is one of a falling money supply. The "Armageddon" scenario that we need to be worried about, is one of a sudden additional shrinkage of the money supply- an *implosion*.

Now lets look at the technicalities of why money disappears when loans are repaid. The first step is to consider what money is.

Money is anything which is widely accepted in exchange for goods and services. Or to put it another way - does it pass the "Tesco test". The test is to ask - can you walk in to Tescos and exchange that thing for a basket of food. If you can, then its money - if you can't then its not money.

Armed with this definition we now need to consider whether an I.O.U. is, or is not money. If I, Michael Reiss, gave "Fred" a piece of paper with the words "I.O.U. £10" and my signature written on it, Fred may be happy to take it if he knew me well enough. And indeed he could exchange that for £10 of conventional money from me at some point in the future. So the I.O.U. is worth something to Fred, but not to anyone else. That piece of paper would certainly fail the Tesco test. It is not money. To summarise:

IOU's from non-"establishment" sources are not money (but they may be valuable to certain individuals)

But now consider the following scenario. Lets say I go to a bank and ask for a loan of £100. The bank would ask me to promise to pay it back, i.e. they would ask me to write them an I.O.U. for £100 (I'll ignore the interest payment for simplicity). The bank could then give me a cheque book and tell me that I can use it to buy things up to a value of £100. But what they are giving me is effectively an I.O.U. for £100. The entire process can be considered as an exchange of I.O.U.s. The bank receives an I.O.U. from me, which according to the previous summary, is not money, though is valuable to the bank. In exchange I received an I.O.U. from the bank in the form of a cheque book. The I.O.U. from the bank DOES pass the Tesco test. I can indeed buy a basket of food with it. Notice that the bank's "I.O.U. £100" never existed before I went in to ask for the loan. The bank just created it out of nothing. The money supply increased by £100 in the process.

To summarise:

IOU's from "establishment" sources are money.
or to put it another way
Getting a loan from a bank is an I.O.U. swapping arrangement.

Now consider what happens when I pay back the loan. This can get a little tricky - so first lets consider a rather unlikely scenario which simplifies the analysis. Imagine that I used the bank I.O.U. to buy a second hand lawnmower from my neighbor. The neighbor, readily accepts a cheque for £100 in full and final payment. One week later my neighbor offers to buy my bicycle for £100. I take back my original cheque for £100 in settlement. Then I could go back to the bank and pay back my loan with that same cheque. The cheque ends the loan arrangement. The bank can tear up and throw away my I.O.U that I had given them, and at the same time I will no longer have the ability to spend their I.O.U. The money supply has now shrunk back down buy £100 in the process.

Obviously a scenario in which I pay back the loan with exactly the same cheque that the bank originally gave me is highly improbable to say the least, but it does illustrate the idea. In reality it is more likely that I will pay back the loan with *somebody else's* I.O.U. from another bank. But despite the I.O.U. exchanges that may happen between a loan and a repayment, the idea remains the same: A loan repayment corresponds to the cancellation of an I.O.U. swapping arrangement. Canceling I.O.U. swapping arrangements is one and the same thing as making the money disappear back out of existence or shrinking the money supply.

As I have said many times before, if we instead had a system of full reserve banking, then none of this nonsense would be going on. The money supply could be held constant.

Tweet

Q.E. not so bad after all?

When people first heard about QE they were nervous. Many economists said that it would cause high inflation. QE got a bad press. Well now years have gone by, we’ve had huge amounts of QE in many countries and there has not been much in the way of inflation. Indeed the price of many items has been steadily falling. Houses for example. So does this mean that QE isn’t so bad after all? Is it just a technical process with no bad side effects?

Misrepresented in the media…

The first thing to say is that Q.E. has been appallingly misrepresented in the media. You will see it described as “money printing” again and again. This is very misleading. Money printing is a one step process; you print the money and that’s the end of it. There’s nothing more to be done. Plain old money printing is in fact, against EU regulations, and is also illegal in both the US and Japan. Q.E. is much more accurately described as borrowing money into existence; with a resulting obligation to make even more money (the original amount plus interest) disappear back out of existence. This obligation places a burden on our economies in the future. It’s more “kicking the can down the road”.

I was so infuriated by the media repeatedly describing Q.E. as money printing, that just as an experiment, I’d make a complaint to the BBC. Their reply was that, according to a financial dictionary, Q.E. is a term described as “a monetary policy in which the central bank engages in open market transactions aimed at increasing money supply in the economy. Easing could also involve direct money creation (printing).” … I have since replied with a letter telling them to note the word “could” in the definition. I.e. it could involve direct money printing, but only in another country or at another time in our history when it wasn’t against regulations. But in the UK, today, it is not allowed! I am currently waiting to see what they say next - stay tuned.

So what happened to the inflation?

A naive view of money is that there is a pool of money out there that can never disappear, and that the amount only ever increases by virtue of governments creating more of it. If this were true, then such large amounts of Q.E. would indeed cause an immediate surge in inflation. However, modern (digital) money does not work like this at all. Instead money is in a continuous state of being created and destroyed. It is created when private banks make loans, and is destroyed when people pay the loans back. So the total amount of money that exists can be considered as analogous to physical system of water being poured into a leaking bucket. Imagine the water coming in corresponds to new loans being made and the water pouring through the leak corresponds to loans being paid back. The amount of water in the bucket at any one time is therefore highly dependent on the two rates of flow. In the economic climate since 2007, the rate of new loans being made by the private sector has slowed markedly, whilst all those previously existing mortgages and other long-term loans are still being paid back. This means the total money supply should be falling - leading to deflation. The huge amounts of Q.E. are not so much adding to the money supply, but rather is attempting to stop the money supply falling.

Strangely, the financial media never present Q.E. in terms of preventing a fall in the money supply. In all the time I have been listening to various financial pundits, I have not once heard it being described as such. Indeed I have scarcely even heard the concept of a falling money supply ever mentioned in any context. I was beginning to feel like I was the only person who was aware of what Q.E. was all about until at long last I heard Mervyn King himself being questioned by MP’s saying:

"What we were doing was injecting money into the economy and what the banking system has been doing is destroying money".
"What we were doing was to partially offset what would otherwise been an even bigger contraction."

There is a video of his statement here:
http://www.bbc.co.uk/news/business-15446545

Why Q.E. is a burden for the future.

When bank-issued loans are paid back the money disappears. When the coupon and principal on bonds is paid back, that money does not disappear - except that is, when those bonds are held by the central bank.

Armed with this information, lets consider the consequences of a central bank owning large amounts of government bonds (as compared to the more usual scenario of the private sector owning all those bonds).

In order for the government to pay back loans, it has to gather more in tax revenues than it pays out for all its regular functions. An unusual concept I know, but it has to be done occasionally! If it’s the private sector that owns all of the government bonds, then as the government pays back, the money supply does not change. The people receiving the money can then circulate it into the rest of the economy and it can be taxed again and again. If however it’s the central bank that owns the bonds then the process of the government paying off its debts destroys the money. The money will not go on to circulate in the rest of the economy. Thus the money supply will shrink and it will become ever harder to repay the debts as the repayment process progresses. Indeed a shrinking money supply normally brings on recessions. Thus the process of unwinding Q.E. will be an ever more painful process as it goes along. At some point the system will no doubt break.

Of course none of this nonsense would be going on if we had a sensible monetary system like full reserve banking.

Tweet

Momentum trading…

I am forever seeking more and more condensed explanations for phenomena in economics. Rather like the process of developing unifying theories in physics. Just recently I figured out a new one. A way of expressing what is wrong with textbook economics (or at least a major component of what’s wrong) in just one sentence:

One of the biggest flaws in textbook economics is ignoring “momentum trading”.

Many of those reading this may now be thinking to themselves - how could this obscure technical sounding term have much of an impact on the whole economy? Let me explain. First of all I shall explain what momentum trading is, then I shall explain why it affects the entire economy.

Momentum trading is purchasing investment vehicles (like shares for example) purely (or largely) on the basis that their price appears to be steadily rising. The idea is that, even if you have little idea of why it is rising, you know from life’s experience that pretty much any phenomena that you observe carrying on in a certain way for a sustained period, tends to carry on behaving in that same way. If you are right, then you will be able to sell that investment vehicle at a higher price at a later time. Momentum trading may be an obscure term used by certain types of technical investors, but in the real world, many more people than just traders are practising it. Indeed the practice could be described as ubiquitous. Just look at the phrase “property ladder”. This is a two word phrase meaning “buy a house now because prices can only ever go up. It will be a good investment”. Its the personification of momentum trading!

The equilibrium models of textbook economics fall apart if lots of momentum trading is going on. They rely on the idea that rising prices discourage purchasing and falling prices encourage it. This may be true for most goods that are purchased in order to be consumed, but clearly is not true for goods (and I’m including shares and houses here) purchased wholly or partly as investment vehicles.

Economists from the Austrian school are equally guilty of this denial.

Tweet

Keen vs Krugman

Go Steve!