Friday, August 17, 2012
Fact and Fiction on Reserve Requirements
In the system we have now, we do use both a reserve restriction and an asset restriction. But, the modern reserve restriction has changed fundamentally, and has nothing to do with the monetarist understanding of reserve restrictions, except in a purely formal sense.
In the day of specie convertibility, reserve restriction had a definite functionality. It served to limit the amount of money subsitutes put into circulation, because by law and custom all such money substitutes had to be convertible into specie on demand. Therefore, the reserve restriction had to do with specie – at the end of the day, banks had to have a certain percentage of specie holdings – reserves – or they would either be shut down or fail. So there were two kinds of money, and reserve restriction had to do with maintaining some ratio between them.
Central banks arose only in response to this specie convertibility arrangement. Bagehot’s Lombard Street describes the process. Banks began depositing their reserves with other banks, big banks, on Wall Street or, in England, at the Bank of England. The latter bank only hesitatingly and with trepidation accepted the responsibility this entailed. For this developing practice led to a gigantic inverted pyramid of money substitutes. Those banks continued to issue money subsitutes against their reserves; but the Bank of England turned around and used these reserves to engage in similar monetary expansion, so that at the end of the day the total amount of specie left to cover all those money substitutes became rather minuscule. This was the problem Bagehot blew the whistle on.
This arrangement of centralized specie reserves only served to facilitate control of the money supply by private bankers. On the face of it, it served the economy by providing the means to generate an elastic money supply far beyond the actual amount of specie available. In practice, it led to dizzying booms and horrendous busts, depending on how specie holdings were manipulated. It also led to the social question, socialism, communism, and the modern labor movement. But that's another story.
Within that context, one can easily see the rationale of reserve restrictions. They helped keep the generation of money substitutes within some reasonable distance of the original specie of which they were supposed to be the direct representation.
Nowadays, we have no specie convertibility requirement, so reserve restrictions have nothing to do with there being real money on the one hand, and money substitutes on the other. All attempts by monetarists to establish Federal Reserve generated money as in some sense “real” money, in terms of which regular banks issue money “substitutes” like in the old days, are only attempts to maintain the fiction of continuity between this system and that one, and to maintain a centralized control of the money supply like in the days of specie of convertibility. But events have shown that the money supply in the modern banking and monetary system cannot be manipulated like it was in the days of specie convertibility. For this we should be very thankful. In formal terms, the money multiplier is still in effect, but in practice it only serves to set some ultimate limit to lending, a limit that is never reached.
We still have reserve requirements today, and they are useful, but for an entirely different reason than in the days of specie convertibility. In fact, using the same word for today’s reserves and for the reserve banking model of yore, of which our Federal Reserve system is an obsolete example, is an exercise in equivocity. Reserves today have a totally different function than reserves then.
This is because there is no money substitute that has to be kept within some sort of relation to “real” money. The money generated by the banking system is all the same, from the central bank to the bank across the street. Rather, what reserve requirements do is keep banks from running into liquidity problems in making the regular payments to customers and other banks that they need to do to stay in business. A reserve serves as a buffer to absorb losses in the case of loan defaults. With bad loans, a bank is left without payments budgeted to come in, income that was budgeted to cover payments, payments that still have to be made. So reserves help to cover such shortfalls. But the center of gravity in the new system is precisely asset valuation, in order to minimize the negative effects of such defaults. If the collateral base accurately approaches the value of the loan, then a default is not a disaster, for the underlying security is still valuable, and can still be used to cover costs. In the case of the credit crisis, a whole mass of similar assets (foreclosed homes) came on the market at the same time, precipitating a collapse in market value of those assets and thus the book value of securities (mark to market).
In this world, a central bank no longer has any function as a reserve bank. The banking system as a whole can serve as a reserve bank, the one for the other. There is absolutely no need for traditional reserve banking with its money multiplier; the system runs on an entirely different principle. The Federal Reserve could go back to being the government’s banker, which is what public banks usually were before the notion of central banking ever got off the ground. The history of the Bank of England provides the foremost example. Both the first and second Banks of the United States were called into being simply to facilitate the fiscal needs of the federal government. The nascent central banking functionality exercised by Biddle had nothing to do with any “lender of last resort” and any money multiplier function. It was only an attempt to keep banks from overstepping specie reserve requirements – to keep them honest. And they didn’t like it, and got Andrew Jackson to do their dirty work for them. Andrew Jackson was not the champion of the people against the banks, but of the banking interest against Nathan Biddle! But that,too, is another story.
Tuesday, August 14, 2012
Private Issue of Money -- the Root of Our Monetary Problem?
In a comment posted under an article by my friend Jerry Bowyer (Where's the Hyperinflation?), "ps61penn62prin64" writes that "private currency monetary systems... are doomed to fail the interest of American citizens."
Bowyer's article discusses the sizeable increase in the money supply generated by the Fed, and how this has -- or has not -- affected the inflation rate. Bowyer concludes that although inflation has not manifested itself because of Fed action, it will. This is because the Fed has "an almost unlimited capacity to produce syrup [i.e., base money] and pump it at high pressure into the system. And they want to do so. They want more money in circulation, because their Keynesian models tell them that easy money is the answer to our economic stagnation."
This view of our monetary system is based on the notion that we have a fractional-reserve system. Which we do, but only in the most formalistic sense. For all practical purposes, our system is not tied to some base money, manipulated by the Fed, allowing it to stretch and shrink the money supply at will. The Fed does not have this unlimited power -- if it did, we'd have been toast (Weimar Germany, anyone?) long ago. If this were true, how do we explain our current struggle, which is a low-interest-rate, low-inflation environment?
But let's now address the issue raised by ps61penn62prin64, as to whether the private issue of currency is the problem.
Right up front, I will state that the state-sanctioned private issue of money, such as is provided for by the Federal Reserve system, by no means need be a problem. Indeed, it is simply a function of "the common law right to borrow" (as Hammond pointed out in his Pulitzer Prize-winning book, Banks and Politics in America, published in 1957). In such a system, banks take a position front and center, as "experts in futurity" to use John R. Commons' pregnant phrase, converting property into liquidity. This is not banks loaning depositors' state-issued money; this is banks loaning money of their own creation. It is not the Jimmy Stewart, but the James Steuart form of banking.
This being so, the banks are creating representations, symbols, of property holdings, and it is these symbols that form the money supply. These symbols, these representations, only reflect a deeper reality -- the reality of the issuing agents' (i.e., banks') balance sheets.The problems we face are thus not problems of liquidity, but of solvency. Our problems are not that there is not enough liquidity, as in the days of the gold standard, nor that there is too much liquidity. Our problems revolve around solvency: that the assets on the books of banks (and this holds for the "shadow banking system" as well) do not match up with the liabilities.
When this happens, we have a freeze-up of credit, as banks only become concerned with restoring balance sheets rather than engaging in fresh lending. This is why we are dealing not with an inflation problem but rather with a disinflation problem.
Originally the Constitution authorized only Congress to create and manage money, in the form of coinage. Coinage is the preeminent form of state-created money. Coinage had always been the prerogative of the state. But with the shift toward a commodity-based money system during the 18th century, power over coinage and over money had been passing out of the hands of the state and into the hands of the bankers. The regime of coinage was already on its last legs at the time of the Constitution's ratification. My forthcoming book will discuss this transformation in detail.
Hence, the Constitution was outdated already at the time of ratification. It did not address the issue of banks. Hammonds' book details the debate surrounding this issue as it developed during the early Republic, as the pros and cons of banks' private money were discussed. The principle was finally accepted in terms of fractional-reserve -- banks were only creating money substitutes, and were under the obligation to provide real money -- specie -- whenever asked.
We labored under this system for a long time. But when we threw off the gold standard, we threw off fractional reserve banking. Our banking system is now asset-based, not reserve-based. It is a system of state-sanctioned, yet market-driven, money. There is nothing wrong with that, in principle. In practice, it can be problematic. The problems mainly come about because we don't understand it, and act in terms of faulty understanding. Especially when governments get in on the action. Then the liquidity bias, fomented by our faulty understanding, gives government room for its misplaced Keynesianism. And we discover once again that the problem had nothing to do with liquidity, but rather with solvency.
And so we need to look at other things than the Fed's production of "syrup" if we want to understand what is going on with inflation rates, interest rates, and thus the economic fundamentals that determine how are economic lives are to be lived.
We need to go from Jimmy Stewart to James Steuart.
Bowyer's article discusses the sizeable increase in the money supply generated by the Fed, and how this has -- or has not -- affected the inflation rate. Bowyer concludes that although inflation has not manifested itself because of Fed action, it will. This is because the Fed has "an almost unlimited capacity to produce syrup [i.e., base money] and pump it at high pressure into the system. And they want to do so. They want more money in circulation, because their Keynesian models tell them that easy money is the answer to our economic stagnation."
This view of our monetary system is based on the notion that we have a fractional-reserve system. Which we do, but only in the most formalistic sense. For all practical purposes, our system is not tied to some base money, manipulated by the Fed, allowing it to stretch and shrink the money supply at will. The Fed does not have this unlimited power -- if it did, we'd have been toast (Weimar Germany, anyone?) long ago. If this were true, how do we explain our current struggle, which is a low-interest-rate, low-inflation environment?
But let's now address the issue raised by ps61penn62prin64, as to whether the private issue of currency is the problem.
Right up front, I will state that the state-sanctioned private issue of money, such as is provided for by the Federal Reserve system, by no means need be a problem. Indeed, it is simply a function of "the common law right to borrow" (as Hammond pointed out in his Pulitzer Prize-winning book, Banks and Politics in America, published in 1957). In such a system, banks take a position front and center, as "experts in futurity" to use John R. Commons' pregnant phrase, converting property into liquidity. This is not banks loaning depositors' state-issued money; this is banks loaning money of their own creation. It is not the Jimmy Stewart, but the James Steuart form of banking.
This being so, the banks are creating representations, symbols, of property holdings, and it is these symbols that form the money supply. These symbols, these representations, only reflect a deeper reality -- the reality of the issuing agents' (i.e., banks') balance sheets.The problems we face are thus not problems of liquidity, but of solvency. Our problems are not that there is not enough liquidity, as in the days of the gold standard, nor that there is too much liquidity. Our problems revolve around solvency: that the assets on the books of banks (and this holds for the "shadow banking system" as well) do not match up with the liabilities.
When this happens, we have a freeze-up of credit, as banks only become concerned with restoring balance sheets rather than engaging in fresh lending. This is why we are dealing not with an inflation problem but rather with a disinflation problem.
Originally the Constitution authorized only Congress to create and manage money, in the form of coinage. Coinage is the preeminent form of state-created money. Coinage had always been the prerogative of the state. But with the shift toward a commodity-based money system during the 18th century, power over coinage and over money had been passing out of the hands of the state and into the hands of the bankers. The regime of coinage was already on its last legs at the time of the Constitution's ratification. My forthcoming book will discuss this transformation in detail.
Hence, the Constitution was outdated already at the time of ratification. It did not address the issue of banks. Hammonds' book details the debate surrounding this issue as it developed during the early Republic, as the pros and cons of banks' private money were discussed. The principle was finally accepted in terms of fractional-reserve -- banks were only creating money substitutes, and were under the obligation to provide real money -- specie -- whenever asked.
We labored under this system for a long time. But when we threw off the gold standard, we threw off fractional reserve banking. Our banking system is now asset-based, not reserve-based. It is a system of state-sanctioned, yet market-driven, money. There is nothing wrong with that, in principle. In practice, it can be problematic. The problems mainly come about because we don't understand it, and act in terms of faulty understanding. Especially when governments get in on the action. Then the liquidity bias, fomented by our faulty understanding, gives government room for its misplaced Keynesianism. And we discover once again that the problem had nothing to do with liquidity, but rather with solvency.
And so we need to look at other things than the Fed's production of "syrup" if we want to understand what is going on with inflation rates, interest rates, and thus the economic fundamentals that determine how are economic lives are to be lived.
We need to go from Jimmy Stewart to James Steuart.
Why We Do NOT Have a Fractional-Reserve System
This blog entry is for anyone who believes, as John Tamny here puts it, that “Fractional reserve banking quite simple IS.”
Among the many good points Tamny makes in his article, there is the underlying assumption that our system is, in some important sense, a fractional-reserve system. But is this a valid contention?
My contention is that it is misleading to view our system as a fractional-reserve system, that a truly fractional-reserve system functions in a very different way than ours does, and that the focus on reserves obfuscates the true nature of money. If our system is fractional-reserve, then why don’t we have any panics and deflationary contractions the way we did in the 19th century, the heyday of fractional-reserve banking?
The way it worked then was that there was a specie convertibility requirement. Specie – gold or silver – had to be held by banks for them to issue money substitutes, either notes or deposits. The reserve ratio – required by law – was set at 1:3 or 1:5, although in practice banks would often exceed this ratio. What would happen is that there would be drains of specie, for various reasons, out of the banks, to the big banks in New York, or oftentimes out of the country as well. In the case of the Panic of 1837, it was the government that unwittingly set off the panic. The government began requiring specie payments for land purchases in the western territories, leading to demand for specie that outstripped supply, thus drains of specie, runs on banks by depositors afraid that their particular bank would not be able to maintain specie levels, resultant bank failures, business failures, unemployment, etc.
This is quite definitely a problem of liquidity shortage. The banks’ books balanced, assets matched liabilities; the only problem was the specie requirement, a setup that, in James Steuart’s words, was only demanded by custom, as only specie was considered to be real money – Keynes’ “barbarous relic.” It was finally dispensed with, for all practical purposes, during the 1930s.
Fast forward to today. When does anyone talk of reserve requirements the way they did in the 19th century? When does anyone worry that banks don’t have enough reserves, therefore they ought to pull their savings or cash deposits out of the bank, precipitating a bank run? We don’t have “runs on the bank” any more. Why? Why is the Fed's discount window -- the ultimate source of liquidity in need -- hardly ever resorted to?
The problem we have today regarding bank reserves is of an entirely different order. When we worry about a bank’s reserves, we worry about whether it can deal with a balance-sheet problem: assets that have lost their value, as for instance collateral being marked to market. We have solvency problems today, not liquidity problems. There is plenty of liquidity. The problem is, where the assets aren’t available to exchange for liquidity, the provision of liquidity becomes problematic. The solvency problem then becomes a liquidity problem. Interbank lending rates go through the roof. And commercial/business lending, the heart and soul of economic growth, grinds to a halt.
The protagonist of Fed fiat money as base money would say that this base money forms the reserve, is established by law as reserve against which reserve requirements must be met. So that, if the Fed wished, it could precipitate similar deflationary contractions simply by selling off part or all of its holdings, thereby reducing deposits and/or bank notes in circulation, precipitating a reduction in the money supply by the amount dictated by the money multiplier. This doesn’t happen, our protagonist would say, because of political pressure. But it could, theoretically. Let’s suppose that it did. Does anyone think that the banking system really would participate in reducing the money supply to that degree? Not only would it miss out on the profits involved in lending, such a measure would precipitate a depression. It is my view that as soon as banks realized what the Fed was doing, they would stand up to this obvious insanity and refuse to comply with the legal reserve requirement. What would then happen? I don’t think the government could force compliance across the board, perhaps at one bank or a few banks, but not all the banks. Because the reserve requirement is an entirely artificial arrangement and has nothing to do with actual practice, the way it did in the day of specie convertibility. In those days, it was customers, not the government, that enforced compliance. In our day, the banks would simply refuse compliance, not to customers, but to the government.
For this reason, it is permissible to speak of the modern banking system as a fractional-reserve system only in the most formalistic way. Actual practice makes fractional reserve a non-issue. Reserve requirements do not have the importance that they had in the days of specie convertibility. We have made the transformation that James Steuart foreshadowed, when he pointed out that bank money was not money because an extension of specie – a fortiori of “base money” – but because a representation of the assets put up for security. This “Copernican Revolution” has yet to be adequately acknowledged. Theorists like Hyman Minsky work within its framework. They don’t talk of fractional-reserve requirements, they talk about asset bubbles as problematic because leading to balance-sheet mismatches.
Why do we maintain the fiction of the centrality of fractional-reserve? Because the system we now have grew out of a true fractional-reserve system. We removed the base money component, and the Fed has endeavored to maintain the illusion that its money somehow is as important as specie used to be. But Fed action does not produce automatic changes in the money supply the way gold inflows and outflows did in days of yore. Fed action can only indirectly induce changes in the money supply by influencing interest rates, and thus making lending more or less attractive. In our system, the liquidity problem has receded; it is solvency (balance-sheet) problems that we have to worry about.
To make my point crystal clear: our system may be labelled fractional-reserve in the same way that England may be labelled a monarchy. In terms of law, England is a monarchy. But if the queen ever attempted to exercise the power of a monarch, the monarchy would be peremptorily abolished. In the same way, in terms of law we have a fractional-reserve system. But if the Fed ever attempted to exercise the power inherent in such a system, such as absolute reductions of the money supply by virtue of the money multiplier mechanism, it would be peremptorily abolished as well.
Among the many good points Tamny makes in his article, there is the underlying assumption that our system is, in some important sense, a fractional-reserve system. But is this a valid contention?
My contention is that it is misleading to view our system as a fractional-reserve system, that a truly fractional-reserve system functions in a very different way than ours does, and that the focus on reserves obfuscates the true nature of money. If our system is fractional-reserve, then why don’t we have any panics and deflationary contractions the way we did in the 19th century, the heyday of fractional-reserve banking?
The way it worked then was that there was a specie convertibility requirement. Specie – gold or silver – had to be held by banks for them to issue money substitutes, either notes or deposits. The reserve ratio – required by law – was set at 1:3 or 1:5, although in practice banks would often exceed this ratio. What would happen is that there would be drains of specie, for various reasons, out of the banks, to the big banks in New York, or oftentimes out of the country as well. In the case of the Panic of 1837, it was the government that unwittingly set off the panic. The government began requiring specie payments for land purchases in the western territories, leading to demand for specie that outstripped supply, thus drains of specie, runs on banks by depositors afraid that their particular bank would not be able to maintain specie levels, resultant bank failures, business failures, unemployment, etc.
This is quite definitely a problem of liquidity shortage. The banks’ books balanced, assets matched liabilities; the only problem was the specie requirement, a setup that, in James Steuart’s words, was only demanded by custom, as only specie was considered to be real money – Keynes’ “barbarous relic.” It was finally dispensed with, for all practical purposes, during the 1930s.
Fast forward to today. When does anyone talk of reserve requirements the way they did in the 19th century? When does anyone worry that banks don’t have enough reserves, therefore they ought to pull their savings or cash deposits out of the bank, precipitating a bank run? We don’t have “runs on the bank” any more. Why? Why is the Fed's discount window -- the ultimate source of liquidity in need -- hardly ever resorted to?
The problem we have today regarding bank reserves is of an entirely different order. When we worry about a bank’s reserves, we worry about whether it can deal with a balance-sheet problem: assets that have lost their value, as for instance collateral being marked to market. We have solvency problems today, not liquidity problems. There is plenty of liquidity. The problem is, where the assets aren’t available to exchange for liquidity, the provision of liquidity becomes problematic. The solvency problem then becomes a liquidity problem. Interbank lending rates go through the roof. And commercial/business lending, the heart and soul of economic growth, grinds to a halt.
The protagonist of Fed fiat money as base money would say that this base money forms the reserve, is established by law as reserve against which reserve requirements must be met. So that, if the Fed wished, it could precipitate similar deflationary contractions simply by selling off part or all of its holdings, thereby reducing deposits and/or bank notes in circulation, precipitating a reduction in the money supply by the amount dictated by the money multiplier. This doesn’t happen, our protagonist would say, because of political pressure. But it could, theoretically. Let’s suppose that it did. Does anyone think that the banking system really would participate in reducing the money supply to that degree? Not only would it miss out on the profits involved in lending, such a measure would precipitate a depression. It is my view that as soon as banks realized what the Fed was doing, they would stand up to this obvious insanity and refuse to comply with the legal reserve requirement. What would then happen? I don’t think the government could force compliance across the board, perhaps at one bank or a few banks, but not all the banks. Because the reserve requirement is an entirely artificial arrangement and has nothing to do with actual practice, the way it did in the day of specie convertibility. In those days, it was customers, not the government, that enforced compliance. In our day, the banks would simply refuse compliance, not to customers, but to the government.
For this reason, it is permissible to speak of the modern banking system as a fractional-reserve system only in the most formalistic way. Actual practice makes fractional reserve a non-issue. Reserve requirements do not have the importance that they had in the days of specie convertibility. We have made the transformation that James Steuart foreshadowed, when he pointed out that bank money was not money because an extension of specie – a fortiori of “base money” – but because a representation of the assets put up for security. This “Copernican Revolution” has yet to be adequately acknowledged. Theorists like Hyman Minsky work within its framework. They don’t talk of fractional-reserve requirements, they talk about asset bubbles as problematic because leading to balance-sheet mismatches.
Why do we maintain the fiction of the centrality of fractional-reserve? Because the system we now have grew out of a true fractional-reserve system. We removed the base money component, and the Fed has endeavored to maintain the illusion that its money somehow is as important as specie used to be. But Fed action does not produce automatic changes in the money supply the way gold inflows and outflows did in days of yore. Fed action can only indirectly induce changes in the money supply by influencing interest rates, and thus making lending more or less attractive. In our system, the liquidity problem has receded; it is solvency (balance-sheet) problems that we have to worry about.
To make my point crystal clear: our system may be labelled fractional-reserve in the same way that England may be labelled a monarchy. In terms of law, England is a monarchy. But if the queen ever attempted to exercise the power of a monarch, the monarchy would be peremptorily abolished. In the same way, in terms of law we have a fractional-reserve system. But if the Fed ever attempted to exercise the power inherent in such a system, such as absolute reductions of the money supply by virtue of the money multiplier mechanism, it would be peremptorily abolished as well.
Jimmy Stewart Banking versus James Steuart Banking
In his excellent book The New Lombard Street, Perry Mehrling writes of "a world that never was ... Jimmy Stewart banking of blessed memory" (p. 117). This is an obvious reference to one of Jimmy Stewart's most famous roles: George Bailey in the holiday classic movie It's a Wonderful Life. In the movie, Bailey is a small banker forced into near-bankruptcy by the inadvertent misplacement of the bank's holdings, holdings that are the deposits of its customers. When those customers catch wind that the bank's holdings are gone, there comes the prototypical "run on the bank,"which precipitates Bailey's attempted suicide. For the rest of the story, watch the movie. For now, what's important is the model of banking this presents. Merhling summarizes it: "In traditional banking, so nostalgic memory reminds us, banks took deposits from households in their community and made loans to other households in their community. It was a simple business...." And this is the model that many still consider to be what banking is all about, with any deviation being a sign of imminent destruction.
But that is not at all what banking is all about. In fact, Jimmy Stewart banking has been a rarity in history, if in fact it ever really was practiced. This is because bankers have instead practiced fractional-reserve banking, which means that deposits of whatever is considered to be real money are held, not to be lent out, but to serve as a base upon which a circulating medium may be erected. That is to say, money substitutes are put into circulation as if they were real money; the banks manufacture and maintain these money substitutes, either by means of notes, checks, or whatever other medium technology can provide; and society is freed from the restrictions of a scarce money supply. In former days, when specie -- gold and silver -- were the only true forms of money (copper serving for small change only), such an "elastic" money supply was a godsend. But it could just easily be turned into a curse, as we shall see.
I said that Jimmy Stewart banking was a rarity. The best example history provides is the Bank of Amsterdam from the 17th and 18th centuries. It received deposits of specie and held them in its vaults. It did this for a fee. Depositors could conduct transactions on the books with each other, freeing them from the need to safeguard and exchange actual specie holdings. By law, the bank could not allow overdrafts. So this was a strict "warehousing" function that the bank provided, which allowed it to serve as a clearinghouse of monetary transactions for all its depositors. And its depositors were all the great ones of Europe.
There was a problem here, though. What no one knew, was that the bank was surreptitiously lending both to the city of Amsterdam and to the East India Company. In 1794, its demise became a foregone conclusion when it came to light that the bank had been making millions of guilders of loans to these entities. So even here, Jimmy Stewart banking was more a pretense than a reality.
Surreptitious lending of deposits was bad enough. The real problem with this system was the power it gave to any who might gain control -- corner the market -- on whatever served as base money. In the days of bimetallism, when both gold and silver served as base money, such overtures to manipulation were difficult to realize. The combined market for gold and silver was too large. But such manipulation did become feasible when the switch was made to the gold standard. Gold was a very scarce medium, and during the days of the gold standard, holdings of it were centralized, leading to the serious opportunity for manipulation by a coterie of banking families -- J.P. Morgan being the most conspicuous example.
Hence, the days of the gold standard were the heyday of fractional-reserve banking. The only "true" money was gold, and the bankers controlled that market, and thus the availability of true money. Banks generated money substitutes as multiples of their gold holdings; but when markets dictated gold outflows out of the country, the money supply contracted by the same multiple, leading to harrowing busts that make contemporary crises seem walks in the park.
But in the midst of -- or rather, at the start of -- the fractional-reserve era, another form of banking existed, at least in the mind of one man. And as a matter of fact, this form of banking has held sway ever since the collapse of the gold standard in the 1930s. This is not Jimmy Stewart banking, but James Steuart banking.
James Steuart was a Scottish baronet who lived in the 18th century, had once supported Bonnie Prince Charlie's bid for the throne of England, and consequently was forced to live in exile for 18 years. While in exile, he wrote a work the importance of which has yet to receive the recognition it deserves: An Inquiry into the Principles of Political Economy (1767). In that work, he espouses a view of banking derived from practice but without the prejudice towards specie that blinded his contemporaries. Steuart realized that the function of banking did not lie in extending base money into money substitutes; rather, the function of banking was to convert property into money. He used the metaphor of "melting down" property, a reference to the melting down of plate and other forms of precious metal so that it could be converted into coin. For Steuart, property was "melted down" into money -- "symbolical" money, as he put it -- when it was put up as security for a loan. This security represented the true money base, because at the end of the day, should the borrower default on the loan, the loan's real worth was simply the value of the security that had been pledged.
Now then, this symbolical money no longer represented base money, it represented the property put up as security. Therefore, it was this property that served as money base, not specie. Steuart foretold the emancipation from gold and silver that the world would only come to accept after the onerous experiences of a Great Depression and two world wars. And that emancipation was not only from a superstititious view of money, but also from a class of men who, using this money, gained control of the nations.
The money systems of today are based on Steuart's principle, not Stewart's. Nor do we practice fractional-reserve banking in any material sense of the term, although in formal terms our system is a fractional-reserve one. After all, our system of central banks is called the Federal Reserve System. But for all practical purposes, reserve requirements do not determine the money supply, nor do they precipitate bank failures the way they did in the 19th century. Rather, it is the willingness of property-owners to put up marketable assets as security for loans that determines the money supply. And it is the quality of those assets on the balance sheet that determine the solvency, and thus survivability, of a bank.
But that is not at all what banking is all about. In fact, Jimmy Stewart banking has been a rarity in history, if in fact it ever really was practiced. This is because bankers have instead practiced fractional-reserve banking, which means that deposits of whatever is considered to be real money are held, not to be lent out, but to serve as a base upon which a circulating medium may be erected. That is to say, money substitutes are put into circulation as if they were real money; the banks manufacture and maintain these money substitutes, either by means of notes, checks, or whatever other medium technology can provide; and society is freed from the restrictions of a scarce money supply. In former days, when specie -- gold and silver -- were the only true forms of money (copper serving for small change only), such an "elastic" money supply was a godsend. But it could just easily be turned into a curse, as we shall see.
I said that Jimmy Stewart banking was a rarity. The best example history provides is the Bank of Amsterdam from the 17th and 18th centuries. It received deposits of specie and held them in its vaults. It did this for a fee. Depositors could conduct transactions on the books with each other, freeing them from the need to safeguard and exchange actual specie holdings. By law, the bank could not allow overdrafts. So this was a strict "warehousing" function that the bank provided, which allowed it to serve as a clearinghouse of monetary transactions for all its depositors. And its depositors were all the great ones of Europe.
There was a problem here, though. What no one knew, was that the bank was surreptitiously lending both to the city of Amsterdam and to the East India Company. In 1794, its demise became a foregone conclusion when it came to light that the bank had been making millions of guilders of loans to these entities. So even here, Jimmy Stewart banking was more a pretense than a reality.
Surreptitious lending of deposits was bad enough. The real problem with this system was the power it gave to any who might gain control -- corner the market -- on whatever served as base money. In the days of bimetallism, when both gold and silver served as base money, such overtures to manipulation were difficult to realize. The combined market for gold and silver was too large. But such manipulation did become feasible when the switch was made to the gold standard. Gold was a very scarce medium, and during the days of the gold standard, holdings of it were centralized, leading to the serious opportunity for manipulation by a coterie of banking families -- J.P. Morgan being the most conspicuous example.
Hence, the days of the gold standard were the heyday of fractional-reserve banking. The only "true" money was gold, and the bankers controlled that market, and thus the availability of true money. Banks generated money substitutes as multiples of their gold holdings; but when markets dictated gold outflows out of the country, the money supply contracted by the same multiple, leading to harrowing busts that make contemporary crises seem walks in the park.
But in the midst of -- or rather, at the start of -- the fractional-reserve era, another form of banking existed, at least in the mind of one man. And as a matter of fact, this form of banking has held sway ever since the collapse of the gold standard in the 1930s. This is not Jimmy Stewart banking, but James Steuart banking.
James Steuart was a Scottish baronet who lived in the 18th century, had once supported Bonnie Prince Charlie's bid for the throne of England, and consequently was forced to live in exile for 18 years. While in exile, he wrote a work the importance of which has yet to receive the recognition it deserves: An Inquiry into the Principles of Political Economy (1767). In that work, he espouses a view of banking derived from practice but without the prejudice towards specie that blinded his contemporaries. Steuart realized that the function of banking did not lie in extending base money into money substitutes; rather, the function of banking was to convert property into money. He used the metaphor of "melting down" property, a reference to the melting down of plate and other forms of precious metal so that it could be converted into coin. For Steuart, property was "melted down" into money -- "symbolical" money, as he put it -- when it was put up as security for a loan. This security represented the true money base, because at the end of the day, should the borrower default on the loan, the loan's real worth was simply the value of the security that had been pledged.
Now then, this symbolical money no longer represented base money, it represented the property put up as security. Therefore, it was this property that served as money base, not specie. Steuart foretold the emancipation from gold and silver that the world would only come to accept after the onerous experiences of a Great Depression and two world wars. And that emancipation was not only from a superstititious view of money, but also from a class of men who, using this money, gained control of the nations.
The money systems of today are based on Steuart's principle, not Stewart's. Nor do we practice fractional-reserve banking in any material sense of the term, although in formal terms our system is a fractional-reserve one. After all, our system of central banks is called the Federal Reserve System. But for all practical purposes, reserve requirements do not determine the money supply, nor do they precipitate bank failures the way they did in the 19th century. Rather, it is the willingness of property-owners to put up marketable assets as security for loans that determines the money supply. And it is the quality of those assets on the balance sheet that determine the solvency, and thus survivability, of a bank.
Wednesday, December 28, 2011
How to Make the Euro Project Work
The euro seems to be on its last legs, and the vision which inspired its genesis seems to have vanished from the politicians sponsoring it. The recent spat with England and Prime Minister Cameron has only served to highlight the vacuum in vision. Previously, whenever England was scapegoated, English politicians skulked like whipped curs, and Euro-politicians adopted that practiced condescending, look-askance stance toward the wayward one. This time around, the feeling among English politicians and electorate was more relief than abashedness, and the pose of superiority by the likes of Premier Sarkozy could hardly be attempted, let alone maintained. The media did its best to foster the impression, and the attempt failed.
So what now? What of the grand vision of a single currency binding fiscally responsible, growth-oriented economies into a viable, synergistic whole? What we now have is a ramshackle construction inviting the incurrence of debt and inhibiting its repayment, a growth-crippling currency combined with a debt overhang that makes the US dollar seem a safe haven.
But was this ever the end which was envisioned? Was the euro ever simply to have facilitated fiscal responsibility and economic growth? Was there perhaps another goal envisioned by its founders, a goal which perhaps now has been lost sight of by those who were to carry the torch?
In point of fact, the euro is simply one building block in an entire agenda. What is needed to save the euro is to understand that agenda. The euro needs to be set off against other, equally desired, institutions in order to take firm root.
There is a simple calculus that all politicians from Northern to Southern Europe have to make: the euro comes with a price, and that price is for the nothern nations to assume the fiscal burden of the southern nations. That burden consists of, on the one hand, debt, and, on the other, the continued flow of transfer payments. These transfer payments are the key to the entire project. Welfare payments, subsidies, pensions, they all need to be included in a blanket agreement without which a common currency cannot survive.
Of course, the southern countries would be only too happy to establish such an arrangement, and so the northern countries need to make specific that this takeover involves not only liabilities but assets -- specifically, control of the political machinery by which the decisions are made over such transfer payments. The southern countries have to relinquish political control of their citizenries.
In turn, this cannot be done only for the southern countries. Such an arrangement will require the transfer of political responsibility over welfare-state decision-making to the level of the European Union, for the northern as well as the southern countries. Germany, the Netherlands, France, Belgium, will likewise have to yield democratic control to Brussels and Strasbourg.
Can such a system be called democratic? Strictly speaking, yes, because it will still be a one-man, one-vote system. But as it stands here described, the price would be too high for the northern countries to pay. They will not relinquish their national parliaments in favor of the European Parliament without, to use a common-law notion, "consideration."
That consideration must be a form of control. Behind the democratic facade, there must be a predominance of control lodged in the northern countries. How can this best be achieved?
Through control of the central bank, and short-term interest rates. A tight monetary policy favors the more economically powerful areas -- the "core" -- of a currency region, and keeps the weaker areas -- the "periphery" -- more or less in thrall.
Would that be enough? Possibly. A monetary policy geared to the needs of the northern countries would ensure enough prosperity in those countries to shoulder a good deal of the welfare-state burden of the southern countries, without precipitating an inflationary spiral, which is what would take place if monetary policy were geared toward the southern countries. And the southern countries would console themselves with the awareness that their sky-high unemployment rates and exuberant levels of welfare payoffs were covered. The facade of a European Parliament would give the impression of democracy, and, for the rest, all residual conflicts could be worked out on the pitch -- of what use is the UEFA Champions' League if not this?
So what now? What of the grand vision of a single currency binding fiscally responsible, growth-oriented economies into a viable, synergistic whole? What we now have is a ramshackle construction inviting the incurrence of debt and inhibiting its repayment, a growth-crippling currency combined with a debt overhang that makes the US dollar seem a safe haven.
But was this ever the end which was envisioned? Was the euro ever simply to have facilitated fiscal responsibility and economic growth? Was there perhaps another goal envisioned by its founders, a goal which perhaps now has been lost sight of by those who were to carry the torch?
In point of fact, the euro is simply one building block in an entire agenda. What is needed to save the euro is to understand that agenda. The euro needs to be set off against other, equally desired, institutions in order to take firm root.
There is a simple calculus that all politicians from Northern to Southern Europe have to make: the euro comes with a price, and that price is for the nothern nations to assume the fiscal burden of the southern nations. That burden consists of, on the one hand, debt, and, on the other, the continued flow of transfer payments. These transfer payments are the key to the entire project. Welfare payments, subsidies, pensions, they all need to be included in a blanket agreement without which a common currency cannot survive.
Of course, the southern countries would be only too happy to establish such an arrangement, and so the northern countries need to make specific that this takeover involves not only liabilities but assets -- specifically, control of the political machinery by which the decisions are made over such transfer payments. The southern countries have to relinquish political control of their citizenries.
In turn, this cannot be done only for the southern countries. Such an arrangement will require the transfer of political responsibility over welfare-state decision-making to the level of the European Union, for the northern as well as the southern countries. Germany, the Netherlands, France, Belgium, will likewise have to yield democratic control to Brussels and Strasbourg.
Can such a system be called democratic? Strictly speaking, yes, because it will still be a one-man, one-vote system. But as it stands here described, the price would be too high for the northern countries to pay. They will not relinquish their national parliaments in favor of the European Parliament without, to use a common-law notion, "consideration."
That consideration must be a form of control. Behind the democratic facade, there must be a predominance of control lodged in the northern countries. How can this best be achieved?
Through control of the central bank, and short-term interest rates. A tight monetary policy favors the more economically powerful areas -- the "core" -- of a currency region, and keeps the weaker areas -- the "periphery" -- more or less in thrall.
Would that be enough? Possibly. A monetary policy geared to the needs of the northern countries would ensure enough prosperity in those countries to shoulder a good deal of the welfare-state burden of the southern countries, without precipitating an inflationary spiral, which is what would take place if monetary policy were geared toward the southern countries. And the southern countries would console themselves with the awareness that their sky-high unemployment rates and exuberant levels of welfare payoffs were covered. The facade of a European Parliament would give the impression of democracy, and, for the rest, all residual conflicts could be worked out on the pitch -- of what use is the UEFA Champions' League if not this?
Thursday, November 11, 2010
Much Ado About Easing
"Quantitative Easing" is the latest thing to get in a tizzy about these days. Everyone seems to have an opinion on quantative easing, either in favor (deflation-countering inflation is a good thing) or opposed (depreciation is a bad thing).
An investment analyst whose work I recommend, Nicholas Vardy, the "Global Guru," recently jumped on the QE bandwagon. The sentiment among global growth prognosticators has recently turned bullish. The question for Vardy is, "So what really has changed since the end of the summer?" And his answer, "of course, is quantitative easing." What is the effect of quantitative easing? "An extra $600 billion sloshing around global financial markets has two effects. First, it devalues the dollar, sending dollar-denominated commodity prices higher. Second, with interest rates forced down, investors are sent on a desperate chase for yield, driving up the prices of all assets in emerging markets."
The problem with this argument is, so-called quantitative easing does not cause $600 billion to begin sloshing around financial markets. It doesn't slosh around anywhere but the Fed's primary dealers' balance sheets. Now these primary dealers are commercial banks, and the money they have credited to them by the Fed, in exchange for the Treasuries they sell, is money which is added to their balance sheets. Hence, there is $600 billion more sloshing about there, not on the financial markets. For that money to enter financial markets, these banks have to lend. That is the way our two-tier banking system works. Now, the question is, are there market players out there willing to borrow, and put up the necessary collateral, in order to come by that additional $600 billion, in order to drive up securities prices on financial markets? That is the missing link that must be shown to exist in order for fears of depreciation to be grounded.
Vardy's second point, regarding lower interest rates and the "desperate chase for yield," is more to the point. Indeed, this is the primary effect of "quantitative easing," which is to flatten the yield curve from the long end. By doing this, the Fed may well be trying to force banks to lend more because the alternative, profits gained from borrowing at zero interest to buy interest-yielding treasuries, will narrow. I think that is the Fed's end game, not fomenting inflation/depreciation, which depends on a lot more than simple quantitative easing. But the Fed could achieve such a goal more quickly and surely by simply raising interest rates at the short end, thus flattening the yield curve from that side, which would do much to encourage lending. After all, the October 2010 Senior Loan Officer Opinion Survey doesn't show any increased lending activity at all. When such lending activity does increase, that is when we need to start worrying about inflation, depreciation, and cutting back on the Fed balance sheet.
An investment analyst whose work I recommend, Nicholas Vardy, the "Global Guru," recently jumped on the QE bandwagon. The sentiment among global growth prognosticators has recently turned bullish. The question for Vardy is, "So what really has changed since the end of the summer?" And his answer, "of course, is quantitative easing." What is the effect of quantitative easing? "An extra $600 billion sloshing around global financial markets has two effects. First, it devalues the dollar, sending dollar-denominated commodity prices higher. Second, with interest rates forced down, investors are sent on a desperate chase for yield, driving up the prices of all assets in emerging markets."
The problem with this argument is, so-called quantitative easing does not cause $600 billion to begin sloshing around financial markets. It doesn't slosh around anywhere but the Fed's primary dealers' balance sheets. Now these primary dealers are commercial banks, and the money they have credited to them by the Fed, in exchange for the Treasuries they sell, is money which is added to their balance sheets. Hence, there is $600 billion more sloshing about there, not on the financial markets. For that money to enter financial markets, these banks have to lend. That is the way our two-tier banking system works. Now, the question is, are there market players out there willing to borrow, and put up the necessary collateral, in order to come by that additional $600 billion, in order to drive up securities prices on financial markets? That is the missing link that must be shown to exist in order for fears of depreciation to be grounded.
Vardy's second point, regarding lower interest rates and the "desperate chase for yield," is more to the point. Indeed, this is the primary effect of "quantitative easing," which is to flatten the yield curve from the long end. By doing this, the Fed may well be trying to force banks to lend more because the alternative, profits gained from borrowing at zero interest to buy interest-yielding treasuries, will narrow. I think that is the Fed's end game, not fomenting inflation/depreciation, which depends on a lot more than simple quantitative easing. But the Fed could achieve such a goal more quickly and surely by simply raising interest rates at the short end, thus flattening the yield curve from that side, which would do much to encourage lending. After all, the October 2010 Senior Loan Officer Opinion Survey doesn't show any increased lending activity at all. When such lending activity does increase, that is when we need to start worrying about inflation, depreciation, and cutting back on the Fed balance sheet.
Monday, August 30, 2010
Why the Fed Should Boost Interest Rates
If the Fed wants to boost economic activity, it should think about raising the federal funds target rate. Why? Wouldn't that restrict lending? Paradoxically, it would likely increase lending.
This would force banks to engage in more lending in order to make a profit. Currently, banks can make money doing virtually nothing, as they borrow money from the Fed at zero percent interest and use that money to buy government bonds yielding 2-3%. This blog makes the same point. If banks can make a profit without risk -- because government bonds carry no risk -- then why lend at risk? But if the Fed raises its rates, then this margin will shrink and banks will be forced to engage in riskier activity, such as lending to business and consumers. Perhaps then, as the big banks move away from risk aversion, interbank rates would drop, facilitating borrowing across the board.
The argument is that raising rates will plunge the economy into a depression. With bonds trading at yields of less than 2%, bond markets, it is said, are signalling that inflation is dead. But is this not to reverse the actual situation? Are bonds not trading at this low a level because the baseline rate is zero? Raise the rate, and these short-term rates will also rise. This will simply have the effect of flattening the yield curve -- 30-year rates remain stubbornly above 3 1/2%. As long as the yield curve does not invert, is there a problem with that?
St. Louis Fed chairman Thomas Hoenig has been arguing for some time that the federal funds rate needs to be moved out of the zero percent range. His argument makes sense. The Fed can do more to boost economic activity than lower rates.
This would force banks to engage in more lending in order to make a profit. Currently, banks can make money doing virtually nothing, as they borrow money from the Fed at zero percent interest and use that money to buy government bonds yielding 2-3%. This blog makes the same point. If banks can make a profit without risk -- because government bonds carry no risk -- then why lend at risk? But if the Fed raises its rates, then this margin will shrink and banks will be forced to engage in riskier activity, such as lending to business and consumers. Perhaps then, as the big banks move away from risk aversion, interbank rates would drop, facilitating borrowing across the board.
The argument is that raising rates will plunge the economy into a depression. With bonds trading at yields of less than 2%, bond markets, it is said, are signalling that inflation is dead. But is this not to reverse the actual situation? Are bonds not trading at this low a level because the baseline rate is zero? Raise the rate, and these short-term rates will also rise. This will simply have the effect of flattening the yield curve -- 30-year rates remain stubbornly above 3 1/2%. As long as the yield curve does not invert, is there a problem with that?
St. Louis Fed chairman Thomas Hoenig has been arguing for some time that the federal funds rate needs to be moved out of the zero percent range. His argument makes sense. The Fed can do more to boost economic activity than lower rates.
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