When people start blaming Big Evil Capitalists for the latest SNAFU in the global capital markets – the collapse of many debt products linked to what are called sub-prime mortgages in the US – remember that the problem stems in part from how lenders have been positively encouraged by some states to lend money to risky borrowers and people with a history of debt defaults and late payments (thanks to Glenn Reynolds for the link).
Of course, ultra-low interest rates in many nations, such as Japan, have also fuelled a vast rise in the levels of global monetary growth, which in the near-term encouraged people to invest in any asset class offering a decent return regardless of risk of assets held, like bundles of sub-prime mortgages repackaged into exotica called collateralised debt obligations (please do not ask me to define these, it is too early in the morning and I have only had one coffee). Low interest rates have cut the price that investors typically demand for shouldering risk; now that rates have risen to curb inflation, the price for that risk has gone up.
Milton Friedman and Robert Heinlein may be dead, but the truths they espoused are very much alive. As they said, there is not, and never has been, such thing as a free lunch.
“remember that the problem stems in part from how lenders have been positively encouraged by some states to lend money to risky borrowers and people with a history of debt defaults and late payments.”
I am hoping that the phrase “postively encouraged” is a bit of that world famous English penchant for understatement. In truth, in many instances, the government actually forced this behavior in the name of equality.
And borrowing from risky peoples is also quite risky(Link), as Americans will learn soon.
And will the great lesson be learned that booms and busts are natural in an economy, and all the government can do, when it aims to lengthen the duration (decrease the frequency) is increase the amplitude? In other words, the government just makes the booms bigger with the consequent bigger busts. We call them “bubbles” now, as if they materialize out of nowhere.
Over the last half decade, the US has been pumping money out like there was no tomorrow, and that money has to go somewhere, it can’t just sit idle (there is nothing worse than having a diluting effect of new money with it being put somewhere) so where did go? We shinnied out pretty far on the weakest branches of the tree, and now people are falling off, unfortnately they take out other people, sensibly not so far out on stronger branches, with them on the way down.
Of course the lesson won’t be learned and “capitalism” will be blamed instead of the hybrid, tacitly controlled/centralized economy we really have. It’s the greatest Statist achievement of the 20th Century, having a centralized economy, which is doomed to fail, with enough vestiges of “capitalism” to be blamed when it does. And those who’ve acted most stupidly will be bailed out, and those who acted wisely will be punished.
Quite so one must not “red line” an area as a bad credit risk. And one must not “discriminate” by not lending poor people money.
By the way, before people start saying “rich guy not wanting other people to have a home of their own”, – I am poor (no one should ever lend me money – you will not get it back) and have lived in rented places all my life.
However, citing Milton Friedman was a mistake.
I know that late in his life Milton Friedman turned against monetary expansion – but he supported it for most of his time as a economist.
Governments (via central banks, currency boards, Federal Reserve systems, or whatever) should only be concerned with keeping the “price level” stable (this to be calculated by some price index or other).
However, often (most famously in the late 1920’s) the “price level” can remain stable whilst a vast credit money bubble is being formed.
The older definition of “inflation” (monetary expansion) is better than the modern definition (a rising “price level”).
When one of the powers-that-be says “prices are stable so I am not concerned about the increase in the money supply” (or something like this) it is time to prepare for a crash down the road.
Actually as people find cheaper ways to produce goods and services the “price level” (if people insist on this stupid concept) should gradually (gradually – a sudden drop in general prices means that a bubble has just gone pop) fall over time. If it is not falling then something is wrong (very wrong).
Paul, I must catch up on my reading; I am more of a “Vienna” man than a “Chicago” one.
Friedman did support expansion of the money supply, but surely no faster than the sustainable rate of growth as he saw it. Of course, the issue is whether central banks, even if they are run by clever cookies like Greenspan, Volcker or Bernake, can do this consistently well in the face of economic or other pressures.
My guess is that Greenspan’s period of office will be regarded as mixed.
Johnathan,
A good question to keep in mind when prices are stable and the money supply is increasing is “How does that money enter the money supply?”
I’m not sure if you are familiar with the game of Monopoly™. When I was young we used to play many made-up variations of the rule including auctions and loans. It made it very apparent what that new money was up to. The ‘banker’ who controlled the money supply, ruled.
Another way to ask the question is “Product ‘A’ used to cost me three weeks wages per year. Now it costs me three days, yet the price is the same. Why?” And the answer is that money is worth less and by diluting the money supply and hiding behind the markets accomplishments in lowering the costs, the source of the new money is taxing everybody who holds currency. People who should be able to buy two weeks worth of product ‘A’ with their savings can now only buy three days worth.
Think in terms of purchasing power parity applied across time instead of across currencies. The central banks are emptying out everyone’s piggy banks and pocket books. Even when prices appear stable.
We live in a world where the counterfeiters own the presses that print the ‘legitimate’ currency. And they play a perpetual game of chicken with economic catastrophe. Just imagine letting the player who is the banker in Monopoly dip into the till.
Sheesh. I need sleep or something. I’ll try the last sentence of the“Another way … “ paragraph again.
People who saved three weeks (15 working days) of pay should now be able to buy 5 year’s worth of product ‘A’ with their savings (because the manufacturer is now making it for 3 working days pay), but they can still only buy one year’s worth. The printer of currency has stolen the remaining 4 years worth of value from their currency.
But since the product costs “the same” the money printers sell the illusion that there has been no inflation, you are just making a lot more money.
Did I do any better that time? I hope?
There’s a way to make money out of this bursting bubble. I just have to figure it out.
adaniel forgets the old saying ‘If you owe someone 10,000 your are at his mercy. If you owe someone 10,000,000 he is at your mercy’. If those bonds become worthless China will be hurt far more than the USA.
Increasing the money supply “in line with economic growth” is the problem.
Sorry but Irving Fisher (of Yale) was wrong in the 1920’s – and he is still wrong.
If a central bank (whatever it is called) or some government supported club of private banks (as the was the case in the United States between the National Banking Act of 1861 and the Federal Reserve Act of 1913) start to pump up the credit supply (via various book keeping tricks) then that is a problem.
Loans must be from real savings (i.e. income that people have chosen not to consume – but to lend out instead).
They must not be “based on” real savings. If it is anything less that 100% of all credit (however defined, whatever terms are used) being from real savings (not book keeping tricks called “savings”) then there is a problem.
To give a practical example:
If Mr Smith wants to borrow $100 someone (or more than one person) must either lend him the money – or Mr Smith does not get to borrow $100.
If Mr Jones lends Mr Smith $50 and Mr Wilson lends Mr Smith $50 that means that Mr Smith has now borrowed $100 – but it also means that both Mr Jones and Mr Wilson have $50 LESS (50 + 50 = 100).
When Mr Jones and Mr Wilson lend money to Mr Smith they DO NOT HAVE THE MONEY ANYMORE – AND WILL NOT HAVE IT TILL WHEN AND IF MR SMITH PAYS THEM BACK.
A “bank” (or other financial institution) is (or should be) just a middle man in such transacations (living off the difference between the interest it charges Mr Smith and the interest it pays to Mr Jones and Mr Wilson).
“But we can not have a financial system like this, we want to be able to expand credit for investment”.
Then you will have booms and busts – and every bust will be used as an excuse for more statism.
If people want to know why “finance capital” is hated the events of Thursday and Friday should it explain it to them.
When manufacturing firms were under threat were tens of billions of “liquidity” “injecting into the system” over only a couple of days, in order to save these enterprises? Take a walk round the places where the factories used to be – and you will get your answer.
No wonder the major financial newspaper in the United Kingdom of Great Britain and Northern Ireland is so leftist.
How can one live (indirectly) off vast (and endless) government “loans” (and other such) and deny them to other people?
So the “Financial Times” supports general statism.
People may not know the details of the “financial world” but they know the centuries old line “we just put peoiples savings to work” is a lie.
“It is not a lie”.
O.K. the next time there is a “Long Term Capital Management” meltdown, or a French bank meltdown (or whatever) I look forward to such people saying “the Bank of England, the Federal Reserve Board, and the European Union Central Bank, should do nothing – in fact these institutions should not exist”.
There was no “lender of last resort” or “insurance scheme” for the boot and shoe industry, or for a lot of other industries that used to be large and important in this country.
Z,
I hear that argument floated a lot. Almost like a protective mantra. But its truth depends on how one measures pain. If China crashed the dollar (and they are presently slowly converting forex reserve to domestic and foreign stocks, ‘dumping’ in slow motion), they would hurt, no doubt. But crashing the dollar would drastically take down Japan and some of the most productive EU countries in the process. China has a huge and far more self contained economy than any of the others and would survive quite well. They would come out of it a (or even ‘the’) top world power. And China, both the people and the leaders, have a far greater tolerance for pain than any westernized nation.
It is probably not how much China would hurt that matters. It’s what they would have relative to everyone else after things finished crashing. It’s a close enough call that gambling on that argument you quote is a very bad idea. Especially in light of China’s ongoing restructuring of their exchange reserves. And since they hold the debt, they ‘choose the time and place’ as it were. It’s quite possible they may have decided to retain only enough dollars to have the power to cause a crash at the time of their choosing.
Only time well and time certainly is not on our side.
Without making any comment one way or the other on it, this was a story I once heard in learning basic economics. Many of you will have heard it before, but perhaps some haven’t.
Once upon a time, all the currency was made of Gold. Gold was valuable, so you could exchange goods for Gold, and then exchange Gold for other goods. There was only so much Gold to go round, which was necessary so that it held its value, and that meant everyone could only do so much trade.
But Gold is heavy, and was wearing people’s pockets out. Worse, Mr Rich, who had lots of Gold, had to employ two people to walk around with him everywhere he went in order to hold his trousers up. Gold was inconvenient.
So Mr Banker, who everyone in town trusted, offered to lock the Gold in his big shiny safe, so that people would only need to carry enough for their immediate needs. He gave them little certificates to say how much Gold had been deposited with him.
After a while, people figured that they could just exchange the certificates, and somehow everything still worked out fine. There were as many certificates as there was Gold, the certificates were exactly as valuable as the Gold, they didn’t actually need the Gold itself.
So Mr Banker was sat there with a vault full of Gold, exchanging the odd certificate here and there, but generally not doing anything with it. It just sat there in the vault, getting dusty. There was never any need to touch more than a tiny fraction of it at any one time. So Mr Banker thought of a rather Wizard Wheeze. What if he… ahem… borrowed some of that Gold and lent it to people starting up businesses? So long as he always had enough on hand for day-to-day business, nobody would be the wiser.
He made a profit by demanding more back than he lent. The actual owners of the money made a profit, because he put a slice of his profits into their accounts to stop them asking any awkward questions, and the businessmen made a profit, because they could invest in better equipment, training, technology, and so on as a result of being able to borrow the money up front, which allowed them bigger profits even after deducting Mr Banker’s take, than if they could only borrow money that actually existed.
So soon it was the case that the number of certificates representing Gold amounted to about ten times the amount of real Gold, which was now nearly all in permanent use. Because everybody knew they could exchange any given certificate for the corresponding Gold, the certificates were still worth what they claimed to be, and because most people never did, they never found out that in fact they weren’t.
And everybody was happy, and everybody got richer, and business boomed. Because you see the wealth of nations is not measured in little certificates, or even in Gold, but in the goods and services that a society’s businesses generate. And because expanding the money supply expanded the amount of goods and services that could be produced, the wealth of society was genuinely increased.
Money exists in one of those strange loops of self-referential recursion. People value it because it can be exchanged for goods and services, and it can be exchanged for goods and services because people value it. Truly, it is a fascinating philosophical question to ask what sort of thing ‘the value of money’ is. The ontology is just mindblowing. It is very easy to call it a con-trick, and in some ways it is, but the very fact that it actually works indicates that at some level something about it has to be real. Our belief bends reality into conformity. Economics is a subject built on air.
I’m not saying there’s any point to this little story, except perhaps to say that what happens to the money doesn’t matter so much as what happens to goods and services and people’s lifestyles. Losing illusory money that never really existed in the first place is no great loss. And what damage you get to businesses is not so much an actual negative, but a reduction in the positive benefits of the con-trick. Without the con operating and with only the money you have on hand, the ‘busts’ are how things would be normally. It’s a part of the story as to why the third world is so poor.
No doubt real economists would splutter and scoff at such a simplistic explanation. I usually only tell it (in a talking-to-five-year-olds voice) to wind them up, by making it all sound so ridiculous. Still, I think it’s an entertaining story, and lots of fun.
I agree that what is important (economically) is what goods and services people can get.
However, one does not increase the long term supply of these goods and services by book keeping tricks designed to “expand credit”.
If Mr Smith lends $100 Dollars (gold, silver, paper, whatever) to Mr Jones, Mr Smith can not use that same $100 Dollars to buy himself goods and services. He has to wait till when and IF Mr Jones pays him back.
Mr Smith giving the money to a bank and the bank lending the money to Mr Jones, does not alter this.
Either Mr Smith has the money or Mr Jones has it – they can not both spend the money at the same time.
Efforts to “expand credit” (by allowing lending not 100% financed from real savings – i.e. by other people NOT consuming) do not increase the real supply of goods and services over the long term.
In fact, by creating booms and busts, such book keeping tricks make living standards in the long term LOWER than they otherwise would have been.
And, of course, every bust is used as a excuse for more statism (for example the New Deal) – which makes living standards even lower than they would have been.
As for the events of the last couple of days:
More than One Hundred Billion Dollars (in Euros) from the E.C.B. alone (and money on top of this from the Bank of England and the Federal Reserve Board).
No wonder the “Financial Times” is so statist. One can hardly (at least not decently) support that sort of level of subsidy for one’s own people and oppose “free” health care and other such for everyone else. Whether it is “loans” or whatever.
Or is the line “it is wrong to subsidize people – unless they work in the financial industry”?
Of course the bankers (and other such) are not always the ones at fault.
For example, the goldsmiths of London used to offer to look after people’s savings (to protect them from robbers) and to look after the money of visitors (giving them paper to save wear on their clothing – as Pa Annoyed describes).
The goldsmiths used to put the money in the Treasury (where it would be even safer than in their own strong rooms).
Accept that in 1672 the government of King Charles II stole the money (his people used some fancy words, but stealing is what they did – and their courts said what they did was fine, just as the Supreme Court in 1935 said the theft of privately owned gold, and the voiding of private contracts, in 1933 was fine).
So perhaps bankers (and other such) think “in a world ruled by criminals – why should we not be criminals also, especially as the rules made by the big criminals make our frauds supposedly lawful”.
If people prefer the fancy words.
Investment must be 100% financed by real savings, for if it is not the capital structure will be distorted.
P.A.,
The only problem with your story is the transition from being able to exchange the little certificates for gold (the gold standard), to only being able to exchange the little certificates for little certificates.
Bretton-Woods broke down ~1970. In about 1980 we went on the ‘US government debt’ standard. Now that ‘standard’ is breaking down.
When those ‘little certificates’ aren’t secured by something trusted, even a trustworthy government’s debt, … well, think Weimar Republic or a couple of other cases.
When your gold holding banker started printing certificates for gold that didn’t exist, those certificates started bidding against the certificates for gold that really did exist. At that point the value of the certificates relative to gold goes down, the value of gold relative to certificates goes up. People didn’t start suddenly producing more to sell to those people with the newly printed certificates, they sold less to the people who had the certificates for real gold. It didn’t increase net real production, it merely displaced it to whoever the banker gave the printed money to. Those little certificates can be secured with virtually anything of non-arbitrary quantity and the system can work. There have historically been bi and trimetal mediums-of-exchange mixed in a single economy almost more often than not. But they have to be secured by something that isn’t arbitrary. Those little certificates are only worth what you can exchange them for.
If all you can exchange them for is goods in the market, then every additional certificate is just diluting the purchasing power of the certificates.
A standard based currency is only as good as what is backing it. If those gold depositors in your story had ‘run on the bank’ and asked for their gold so they could move it to another banker, depositors would have been stiffed by the first banker who had, in reality, been trafficking their stolen gold. Certificates secured by government debt are only as strong as their ability to be claimed during a run. If they are not that strong, then the only alternative available to the money supply managers is to monitize during a run, (print more). What currently stops a run on the dollar is that there is no other currency (other bankers in your story) who is not playing the same game to varying extents.
We saw some monitizing on Thursday and Friday. The Fed inserted ~62 billion dollars into the market. What appears to be happening is that big consumer banks are pulling out of the interbank lending market by raising their interbank loan rates out of fear that other banks are in the same or worse shape than they are. They also, through higher interest rates from the Fed and higher (more reasonable) standards of lending, are drying up the retail lending market compared to what the economy is addicted to. This is called ‘money getting tight’ so the Fed pumps some more in (the $62B in two days). But each time they do this they dilute the currency pool which causes a little inflation which compels them to raise interest rates which tightens the market. So the Fed prints more money, which causes inflation, compelling them to raise interest rates … Defaults on mortgages etc remove a natural, non-inflationary way that money would normally gets back into the lending pool. So the Fed has to print money.
There is one unforgivable sin a reserve currency can commit. That is inflation. We are in a loop where serious inflation appears inevitable. If so, holders of dollars, in order to maintain the value of their savings, have to get rid of those dollars. The way they do this is by converting them to ‘stuff’. They crack open their piggy bank and spend it. Then they can sell the stuff they bought for a different, non-inflating currency, or they can hang onto stuff. But either way, they dump dollars. Because a big loss is better than a total loss. If enough dollars are dumped at once, everybody with dollars dumps them at once in a big race to the door. All those many extra dollars are now chasing a pool of stuff that hasn’t had time to expand. Welcome to hyperinflation. What would thousands of dollars per person of extra circulating cash do to prices? I for one think it is a recipe for wholesale dollar dumping. Right now, for each of the 300,000,000 persons of the US, foreign governments hold approximately $10,000 (you’ll have to do some arithmetic). Nothing says they have to hold it except for their own self interest. China’s government alone holds over $4,000 for every single US citizen.
This kind of raises a side question, are the Euro central bank and the Bank of England propping up the dollar, dumping the dollar, or using propping as an opportunity to dump dollars? I don’t know. I suppose it depends on what and how they are doing it.
There is also another big but not much discussed factor at work, and that is the effect of easy and low interest home loans on the retail consumer market. When higher interest rates and more rigorous lending standards reduce discretionary income, retail consumer spending goes down. (That should be a “d’uh” statement but apparently a lot of the ‘encouraging’ numbers we see are ignoring that ‘little’ detail.)
Things will settle down for a while longer, but sooner or later a bump will be too big for us to print our way out. The printing cycle will trigger inflation that will trigger a run that will trigger another printing that will make the run bigger that will … Then dumping starts for real except, they are not dumping the money to lenders, they are buying stuff and competing against borrowers. What money the banks actually still have available for lending is worth less and less in the market place. So, presumably, the Fed ‘helps’ the banks by printing and giving them some more money to lend out. Which causes …
Well, you get the idea.
You can’t increase goods and services directly from credit, (i.e. make up some money and think it corresponds to whatever goods you can buy with it), but it can be used indirectly as part of the process.
Better technology usually requires an initial investment of effort – either to research it, learn it, build the tools and production line for it, or recursively to create the more sophisticated ingredients for it. You need to consume a large pile of resources over a long period without getting any return, before you can start using the new process to generate goods and services more efficiently. (That initial pile of resource is called your capital and the system is called capitalism, of course. But you know all this.)
If Mr Smith loans to Mr Jones, Mr Smith indeed cannot spend the money until Jones repays. That’s how finance worked in medieval times. It was basically rich people (who had got rich by some form of theft, usually) who loaned their own money individually. It worked, but not very well. Most of the risk is on Mr Smith, so finance was limited and expensive, and so most artisans had little or no access to it.
But when Mr Banker loans the money, Mr Smith’s saving’s are still accessible to him – he can call in any day he likes and withdraw it, and the money instead comes from Mr Brown and Miss Scarlet, or if they withdraw their money instead, from Mr Smith and Colonel Mustard. The money comes from a common pool that they share ownership of. Now, through the offices of Mr Banker, they have all in effect loaned far more than they actually have – they have gambled without the ability to back it up – but because Mr Banker has a widely spread portfolio, not every business is going to go bust, so with very high probability the money is safe. Scientists, teachers, tool makers, and sub-contractors are all willing to work for a while to build your capital, and accept your fictitious money, because it is backed by the community. (Incidentally, note that I haven’t once mentioned government in all this.)
This way, finance becomes cheaper and you can generate a bigger pile of resources – gambling on being able to get it back in time from capitalist improvements – which then enables bigger and better improvements. It’s a massive positive feedback effect – the more you do it, the more wealth you have in the next round to do it more. It is the reason the West is so rich.
But positive feedback is unstable – a small drop in confidence translates to a larger drop as it passes through the system translating to an even larger drop. You can’t control it, and the ride is bumpy. Centralised authority has no hope of being able to control it, and their tinkering often make things worse. But for some reason people believe that the economy is a function of government, and they’ll pan a leader if the economy isn’t doing well, so most governments can’t resist the temptation.
The answer is not to ban unbacked finance, but to take the levers of influence out of the hands of politicians, and to not shout at them when things go wrong. Simply shrug if the market takes a dive. It just does that from time to time.
But as for the role of central banks in propping up the economy, whether it is a good idea depends on what’s gone wrong. If it is simply a crisis of confidence – the con trick stops working for a bit – then injecting some fictitious money which you can take out again later is a good idea. It smooths over the bump. If on the other hand something else is going on – the investments have been made at a higher risk than was thought, for example – then you have to correct your course which is going to involve a jump, and you shouldn’t try to fix it with fake money (or accept that if you do, it is at a cost). In essence, you’ve accumulated this loss over a run-up period without realising it, and it is now hitting you all at once.
There’s nothing you can do about it. It’s the way the system works. And shouting at governments and financiers and telling them to change the system only makes things worse. We are no more competent to fix it than they are.
Leave it alone; that’s the best thing.
Whatever.
🙂
Investment financed from credit expansion (rather than real savings) is not a good thing. One must remember (to take from Bastiat) not only “what is seen” but “what is unseen”.
Malinvestment and a distorted capital structure come back to bite us all in the backside – that is a big “whatever” Pa Annoyed.
As for government intervention. The banks (and other financial industry enterprises) act the way they do, in part, because they think the powers-that-be will support this.
If they understood that (for example) in a bank run there would be no help (of whatever kind) from the government and that they would not be able to “stop payments” of whatever commodity they had promised to pay in (whether it was gold of certain purity or silver – or whatever the contract stated) then they would be a lot more careful.
The enterprises that were not careful would go bankrupt – so market evolution would favour the honest enterprises. For example, the bank (or other such) would be a lot clearer about what money they were just looking after for you (for which they might well charge a fee – after all the money is taking up space in the vault) and what money they were lending out (which your contract might say you could NOT just demand at any time – but which they were paying interest on “we are lending this money out, it is not going to be in the vault”).
Also you fail to see that each bust means vast pressure for government intervention. Sure the intervention makes things worse not better – but that will not stop it.
For example, all the careful reasoning in the world could not have prevented the wrong headed policies of first President Herbert “the forgotten Progressive” Hoover and then F.D.R.
Only preventing the credit money boom of the late 1920’s could have prevented the reaction to the bust (to stop the reaction one must prevent the bust, and to prevent the bust one must prevent the boom).
In this case Milton Friedman’s favourate Ben Strong of the New York Federal Reserve should NOT have boosted the money supply in the late 1920’s in order to prop up the exchange rate of the Pound (as his pal M. Norman at the Bank of England wanted – because people here were not prepared to accept that the pre World War One exchange rate was no longer valid because of the greater inflation of the Pound in relation to the Dollar inflation).
And the best way to avoid this. Do not have a Federal Reserve System (or a “Bank of the United States” first and second, or a “National Banking Act” or any of the other dodges by which government tries to induce credit expansion, violating the basic economic rule that investment must be 100% financed from real savings).
This is not a “free market” – this is a series of government inducements and supports (a big “whatever”) and it always ends in tears. The present funny money smoke and mirrors con game will (sooner or later) go the same way as all the other frauds. There will be a lot of distress, but (as you know) the statist reaction to the crash will cause far more distress than the crash will.
Well perhaps it will be different this time, and people will allow prices and wages to adust – we shall have to see (although I doubt they will). I suppose (in opposition to my own words above) people are agents (they are reasoning beings – free will) they do not have to make the same mistakes again and again.
However, the level of knowledge among both the general population and the elite is so low that I have no confidence. It is all very well being an agent (having free will – being a human being) but if one has little knowledge (or lots of false “knowledge”) well then………
As for exchange rates.
Actually both British Pound and European Union Euro money supply expansion has been larger than that of American Dollar (for years) – so people betting on the Pound and the Euro as a safe long term place are mistaken.