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!

Khan acadamy explains full reserve banking

A video describing full reserve banking (rare as hen's teeth!).

Exchange rates… How does that work?

In this first section I will explain how the system should work - but doesn’t. The second section will explain what needs to be included to make the model work.

The brokers...

In any exchange you have brokers. These are people who match up buyers and sellers, taking a small percentage from both. They may also have a small float of the commodities being traded. These people continuously monitor the enthusiasm for trade in each direction and adjust the prices up or down to keep the two sides in balance. If the broker failed to do this then not all buyers could be matched with sellers and the broker would miss out on opportunities to earn commission.

The situation can be summed up in the picture below, with the enthusiasm for exchange in balance.
Now let us consider how changes in the balance between buyers and sellers can occur. Assuming that they are currently in balance at 100 yen per dollar. Then over the coming months Japan has a spurt of good economic development. New highly automated factories come on line, producing new products more efficiently than ever before. Meanwhile in America, there are many strikes and factory output makes no progress. In the shops the Japanese goods have their prices lowered and more of them are purchased relative to the American goods.

In order for Americans to buy the, now higher, proportion of Japanese goods, they will have to convert additional dollars into yen. Quite the opposite will be going on in Japan. The proportion of American goods that appear good value relative to Japanese goods will diminish. There will correspondingly be a reduction of Japanese in the queue to convert their yen into dollars in order to buy American goods. The only way the foreign exchange brokers can equalise the size of the two queues is to offer less yen per dollar.
If the exchange rate mechanism worked as described so far then we would not end up with American shops full of cheap Japanese goods that trounced American goods on value. Instead the mechanism should ensure that the dollar yen exchange rate was constantly adjusted so that the Japanese goods appeared roughly constant in value compared to the American ones. The container ships travelling back and forth between the two countries would contain equal amounts of goods in both directions. If the Japanese were now far more efficient and productive than the Americans then the ships would be equally full of goods, but imbalanced in terms of the man-hours required to make the contents. It may be that the boat full of Japanese goods sailing to America contained 1million Japanese man-hours of produce, whereas the equally full boat travelling in the opposite direction would contain 2million American man-hours of goods.

You may notice that in the real world the theoretical events just described do not appear to have transpired. The container ships sailing between Japan and America are not equally full of goods. There must be something missing from the model…

Savings...

In this section we will consider the effect of savings on the exchange rate. Consider what would happen if there was a greater enthusiasm for saving in Japan than in the US. One possible mechanism for the Japanese to save is to purchase US government bonds. In order to do this the Japanese must exchange some yen into dollars. The result is that there are now two kinds of Japanese people in the queue wishing to exchange yen for dollars, one set wishing to get dollars to buy American goods the other wishing to get dollars to buy American bonds. If there was a steady growth in the total quantity of US bonds purchased by the Japanese then the exchange rate could be maintained at a lop-sided value throughout.

As you can see, from the point of view of the broker, he has perfectly balanced the supply and demand between dollars and yen even though the flow of goods will be unequal.

Can this lop-sided state of affairs continue indefinitely?

Nobody saves forever for no reason. The whole point of savings is that they can be dipped into in hard times. The hard times could be due do myriad random reasons, but one almost guaranteed one is simply demographics. Many countries around the world having ageing populations with diminishing numbers of active workers. At a certain point in this process, a tipping point is reached the number of people retiring and cashing in their savings becomes greater then the number of people attempting to save for the future. The result would be that the Japanese on aggregate have no desire to buy additional American bonds, indeed they will want to cash in their bonds and convert the released dollars into yen. I.e. they will join the queue on the left hand side of the above picture. At this point the only way the brokers can get the queues back into balance is to insist on more dollars per yen. The value of the dollar will then plummet and the Japanese will be very disappointed in their investments.

Tweet