Why debt is a huge problem

Generally accepted wisdom tells us that excessive debt is a serious problem although some people question why government debt to a central bank is problematic. After all what is wrong with one government agency owing money to another?  Why not just let the debt build up?

In this case the generally accepted wisdom is probably correct because debt is an important part of our money supply.   If we were to lose our money supply our economy would be in big trouble.

Money is a complex part of our economy and I suspect few people, including a lot of economists, really understand how it works.  Fractional reserve banking is complex but I have found it relative easy to understand.  I have explained it in the essay  LETS go to market: Dealing with the financial crisis on this weblog and there are numerous explanations that can be found with any search engine.  I encourage you to figure it out.

About 90 per cent of our money supply is based on the debt created in fractional reserve banking. This is a problem for three reasons.

The first is that the money supply needs to be flexible up and down.  The amount of money we need to facilitate the exchange of goods and services must be proportional to the quantity of goods and services we need to exchange.  I know economists like to model the economy on a least squares regression formula which gives an upwards line with a steady slope.  However, the reality is that the economy behaves like a fractal which means there are a series of ups and downs and more ups and downs within each trend. The amount of money needed varies with each up and down but fractional reserve money can only keep on increasing.  This sort of works when there is continuous economic growth but if growth slows or reverses, then there are problems.

The second problem with fractional reserve banking is that interest is charged on the debt created. This adds a purely financial demand for more money in that it is not needed for exchange of goods and services.  If all outstanding debts plus interest had to be repaid at the same time there would not be enough money in the economy. From time to time this feature of fractional reserve banking catches up with us and we call it a financial crisis.

The third problem is that when there is a financial crisis lots of people lose their savings.  The need to save for a rainy day, or retirement, is a part of our psyche and fully exploited by the marketing arm of the financial industry but there are three ways in which we can lose our savings: a financial crises, inflation or a major economic downturn. these are more likely when the economy is not growing or declining. With the current economic climate most of us would probably be better off to live for today and worry about tomorrow when that day comes.  The best way to secure one’s future is probably a market garden.

These are real problems and from time to time they cause havoc in the lives of most of us.  Therefore we are right to worry about excessive debt.  The good news is that there are other ways of creating money and the bad news is that money is such an emotional concept that most people are not prepared to consider other ideas.

One of the other ways of creating money is discussed in my ebook Funny Money: Adapting to a down economy which is available free from the link at the top of this weblog.

We tend to take money for granted so long as the economy is working but it is such an important concept that we would do well to try to understand it and make changes.  I cannot see that happening so in the meantime we should remember the advise of Shakespeare: Neither a lender nor a borrower be.

 

Answering concerns about an income scheme

A discussion forum on the Canadian Broadcasting Corporation website brought out a number of concerns about proposals for a basic income scheme. There were more than 2,000 comments.  Here are answers to some of the concerns.

How do we pay for a basic income scheme?

There are two answers to this question.  The first is that it would replace a range of existing social welfare payments and would make these payments with more efficiency.  Employing fewer people this would increase the need.  Also I believe subsidies should be given to consumers rather than producers so this would release a lot more money for an income scheme.

For the second answer we have to focus on the agricultural surplus, the excess production by each agricultural worker which allows food for people to do other things. Without the agricultural surplus we would not have civilization as we know it.

Until now the agricultural surplus has been distributed via employment but the current level of technology is making this more difficult.  Thus the interest in a universal basic income scheme.  We should note that the agricultural surplus is based largely on petroleum and could be somewhat precarious.

As most of the technology that has gone into the agricultural surplus has been developed over the last 2,000 years and most if not all of us have ancestors who worked on that, we should consider it a part of our inheritance. We are all entitled to a share.  We should have a collective responsibility to ensure everyone has the opportunity for the same standard of living as most other people.  The amount of payments should depend upon the population and the quantity of goods and services we are able to produce.  If this ratio goes up then the payments should go up and if this ratio goes down then the payments will have to go down.

I believe there are some serious problems with the way in which our economy creates money.  As an income scheme involves money this would be a good time to deal with that problem.

How do we stop people from smoking dope all day?

The simple answer to this question is that we do not. We do not need everyone to work all the time to maintain the agricultural surplus.    We no longer need a work ethic.

A basic income scheme would be a tremendous transfer of decision-making power to individuals (from governments and from bankers who create money via the fractional reserve banking system) and we have to allow people to make their own decisions and to take or benefit from the consequences.  The agricultural surplus should give us all the right to decide what to do with our time.

An income scheme would be communist.

This blogger dislikes the isms because they tend to be mostly meaningless.  As I understand communism it involves treating people humanely and government control of the economy.  It seems to appeal to people who wants to tell others how to live their lives.    I believe we should try to treat people humanely and I do not want others telling me how to live my life. As decision making power goes with money an income scheme would be a transfer of power to individuals.  It is difficult to think many communists would want that.

A guaranteed basic income scheme would help with a lot of social and economic problems but such major changes would go against a lot of vested interests.  Even people who would benefit the most are likely to fear the unknown.  Therefore concerns need to be taken seriously.

This blogger has just published an eBook Funny Money: Adapting to a Down Economy which discusses a lot of these issues. The price is only 99 cents.  I encourage you to have a look at it. Until April 19, 2016 you can get a free copy from Smashwords.  Use the link and code at the top of this weblog.

Hiding from the economic crisis

Why are interest rates so low?  It’s a question which has apparently been occupying a couple of North America’s top economists but this blogger sees the discussion as a screen hiding some very important economic issues.such as the root cause of the economic crisis and values which will guide us in trying to  find a solution.

On the surface the answer is simple.  Interest rates are the price of money and are determined by supply and demand.  They are low  because that is where the two balance.  They appear low because we are used to high returns on our investments and are reluctant to give them up.  There is no reason why interest rates could not be zero and maybe they should be.

To understand the root cause of the economic crisis we need to go into a macro economics classroom and watch the lecturer draw his basic diagram on the blackboard.  It is in the shape of an”x” with one side representing the financial side of the economy and the other the real or physical side.   This is important.  As we measure the physical part of the economy in financial terms it is easy to forget the distinction and analyze economic problems only in financial terms.  We need to ask what is happening to the physical side of the economy because it could be that is where the problem is.

This blogger figures the problem is with the resource base.  There are lots of energy and mineral resources left on this planet but we have exploited the most easily accessible.   Those that are left take a lot of time and energy to extract and this is causing a lot of economic problems.  It could even force us into negative growth.  This is a much more serious problem than why interest rates are low.  It is also an extremely difficult problem because it challenges some deeply held beliefs and values.  It’s a lot easier to talk about why interest rates are low.

Some ideas about how to fix the economy are included in the essay “LETS go to market: Dealing with the economic crisis” on this weblog.  A major feature of that essay is a proposal to change the way in which we create  money.

The emotions surrounding money make it a such a difficult subject that few people understand the economics of money and banking. This is unfortunate as money is so essential to how we exchange goods and services.  I encourage you to take a look at the essay.

While I prefer to see low interest rates as a symptom rather than the problem here are  some observations.

Money should be considered a tool to facilitate exchange rather than as a commodity with a value of its own As the quantity of goods and services we want to exchange varies up and down  so does the amount of money supply we need,  If there is too much money there will be inflation and if there is too little money there will be deflation.   Some people believe there should be mild inflation but this reduces the value of savings and should be  considered theft.

Quantitative easing has been an attempt to stimulate economic activity by increasing the money supply.  It has resulted in a rising stock market but has done little for the real economy.  That has to be a sign of a serious problem which has not been identified.

The way in which we create money, known as fractional reserve banking, is a heavy-duty problem because it is based on loans on which interest must be paid.  If all debts had to be repaid at one time there would not be enough money in the economy.  It is a Ponzi scheme on a grand scale and it is no wonder we experience frequent financial crisis.  For more on this topic see these previous posts on this weblog.

I believe we are facing a serious economic problem in that it is not clear there can  be a return to economic growth.  Dealing with this will require some major changes in our way of life.  It is disappointing that two of our most well-known economists are protecting us from having to deal with this with a frivolous argument. It’s as if they are playing in the turkey poo on animal farm and producing gobbledygook.

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The future of money: inflation, deflation or disappearance into thin air

The future of money has been getting a little attention lately.  It could go one of three ways – inflation, deflation or part of it could disappear into thin air.  Concerns about money probably reflect concerns and uncertainty about where the economy is going.  Frequently behind these concerns lurk people who want a fixed money supply such as gold or bit coin.

This blogger figures money should be defined as a tool to facilitate the exchange of goods and services.  I do not like definitions that make it a store of wealth or a measure of value because these give money an intrinsic value which it does or should not have.  Money should only have value as a tool. 

One of the most important features of money should be the amount available  in the economy needs to be flexible.  It should be able go to up or down  with changes in the quantity of goods and services we want to exchange.  If the money supply is not flexible then as we change the quantity of goods and services then either prices must go up or down or the velocity, the rate at which money changes hands will change.  It is dangerous to assume there will be only growth.

Inflation happens when the money supply increases faster than the rate of economic growth and deflation happens when the money supply goes not keep up with the rate of growth.    Inflation is good for borrowers as the can repay their loans with money which has less real value.  This is one reason governments and their agents want to see mild inflation.  Deflation is good for lenders as they will be repaid with money which has more value.  The ideal should be price stability so nobody loses.

Our understanding of inflation and deflation has been distorted by the long period of economic growth we have just experienced. Most inflation has happened along with growth and most deflation has resulted from banking authorities trying to restrict the amount of money available.  This happened in the 1930s and todays central bankers have sworn to never again let that happen.

There is some evidence that our time of economic growth has terminated.  It is unclear how this will affect prices.  Quantitative easing which is an attempt to increase the money supply has not led to high inflation.  Past hyperinflations have occurred when governments have increased to money supply faster than the economy was capable of growing.  It appears the money created by quantitative easing has led to inflation in the financial markets rather than consumer markets.

Economists generally understand how fractional reserve banking works to increase the money supply but I am not aware of anyone who has thought out the opposite process.  Money that can be created out of thin air can just as easily disappear into thin air.

In fractional reserve banking banks are required to keep a portion of their deposits as reserves for protection against runs. The rest is loaned out and redeposited with the new deposits subject to the same fractional reserve.  The result is that a large proportion of our money supply is  somewhat precarious.  This blogger and many other people on the internet have explained the process.  Just search “fractional reserve banking.”

Central banks can add money to the system by purchasing financial instruments or by changing the reserve requirements.  The could also reduce the money supply by selling financial instruments or by changing the money supply although it is unlikely they will do either under current conditions.

Another way the money supply could be reduced is if the banks suffer large losses.  Any loans the banks have to write off will directly decrease their available reserves.  (The technical term is high powered money.)  This means they will have to decrease their outstanding loans with the same multiplier effect as the money supply was increased.  We will hear about it as a contraction of credit.

So if the banks experience unusually large losses there could be a drastic decrease in the money supply which could have dire consequences.  ( I have read that a number of Canadian and British banks are highly exposed to the energy industry with unsecured loans.)

If a large part of the money supply were to disappear into thin air in the short term a lot of economic activity would come to a screeching halt.  People have in the past used playing cards or candies as a substitute for money.  In the long term the level of activity would depend upon the physical resources available.

People who talk up monetary reform often want a return to a gold standard or facsimile (bit coin).  It is not clear that either of these would correct the problems inherent in the fractional reserve way of creating money.  Nor would they provide the flexibility that is needed in the total amount of money available.

We all think we know everything there is to know about money.  That is a part of what our parents teach us. However, it is a complex subject which few people understand and there are a lot of unknowns, especially if we have to deal with an extended period of low or negative growth.

Why we have financial crises

I believe the root cause of financial crises is in the fractional reserve system of creating money.  Therefore the way to avoid future crises is to change how we create money.

Dear Reader,  This post requires you to understand how money is created by the banks.  I’m feeling too lazy to write that up now so if you don’t already know I encourage you to figure it out.  Google “fractional reserve money”  or look at my essay “LETS go to market: Dealing with the financial crisis” or these other posts on this weblog.  It may appear complicated and overwhelming but if you think it out it should be easy to understand.  I think very few people understand this process which is unfortunate because we can not reform something people don’t understand.  There is a lot of emotion when dealing with money.

There are two aspects to the economy – the physical and the financial.  It’s a distinction which is easily forgotten because we measure the physical side in financial terms.    Both of these can cause economic crises and solutions probably require knowing where the problem originates.  A complication is that a physical problem can and usually does trigger a financial problem.  I believe our current economic problems are largely physical in that we have used up the most easily accessible energy and mineral resources.  There are lots of resources left but they are becoming more and more difficult to extract.

The big problem with fractional reserve money is that  interest is charged on the money created by the banks.  But the process does not create money to cover the interest.  So long as the economy and the money supply continues to grow there is no problem.  However, when growth ceases and the money supply contracts there just isn’t enough money in the economy to repay all the loans with interest.  It’s sort of like a Ponzi scheme.

Fractional reserve banking is about increasing the money supply but to the best of my knowledge not much thought has been given to when the process unfolds.  Just as money can be created out of thin air it can just as easily disappear into thin air.  This is a problem because money is essential in our economy for the exchange of goods and services.  Even a small reduction in our money supply can cause severe economic hardship because losses on bank loans come out of the reserves.  Thus losses are high powered money or leverage in reverse.  A run on the bank would also be a loss of reserves if the money is put under some mattresses.  If the money is transferred to another bank then there would be no loss of money supply to the economy although it would take some time for the adjustments to work through the system.

During the crisis of 2008 I figure the losses to the banks reduced the money supply forcing a slowdown in the physical side of the economy.  During the crisis people talked about a shortage of credit and the need for banks to start lending.  As our money supply is based on loans this is the same as saying we didn’t have enough money to facilitate the exchange of goods and services.

The U.S. officials dealing with the crisis were aware of the danger to the economy. They were also aware that a large part of the economy was sound and that the banks had to be saved so as to not have a complete collapse.  They were in a bind because saving the banks appeared to be saving people who did not deserve to be saved.  To have let the banks fail would have hurt all of us.  That is the power of the banks.  They are too important to fail.

The financial intermediation industry is focused on the double  R – risk and rewards.  The great  profits and bonuses of the industry are based on maximizing the rewards and passing the risk on to others.  As a general rule the higher the risks the greater the rewards.  In an ideal world the rewards would go to the people taking the risks but bankers have ways of grabbing the rewards while leaving the risks with the depositors.

The first thing they do is that their  marketing focuses on expected returns.  The risks involved are seldom mentioned so that customers don’t demand the rewards to go with the risk they are taking.  Governments try to protect savers with deposit insurance schemes although the real reason is to prevent runs on the bank.

The second trick is leverage.  If you did your homework you know that banks are required to keep a fraction of deposits on reserve for people who want to withdraw their deposits.  The smaller this reserve requirement the greater the leverage and the more money they can create and the larger the profits.  Regulated banks are told how much they must keep on reserve.  Unregulated financial institutions can get away with greater leverage – until things go wrong and they cannot repay their depositors.

The third profit-making stunt is to finance long-term loans with short-term deposits.  As short-term interest rates are generally lower than long-term interest rates this increases the spread/margin for the banks.  Some people claim this conversion of short-term deposits into long-term loans is a great accomplished of the financial system.  In fact it is a very dangerous practice and through the centuries many bankers have lost their businesses, if not their shirts. (But the profits were great while they lasted.) This is because when there is a crisis people will refuse to roll over their short-term deposits.  With no way to call in their loans the banks become bankrupt even though most of their outstanding loans are good.

If banks were to match the terms of their deposits with the terms of their loans their business would be financial intermediation rather than speculation and the risk would go to depositors  who are carrying the risk in any case.

I hope you can see from these notes that there are serious problems within the financial industry and the fractional reserve way of creating money.  Money is such an emotional issue and the interests of the financial industry are so strong that I believe it will be impossible to make reforms.  

 

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Payday loans, slavery and money creation

What is the marginal cost of making a payday loan? Or any other type of loan?  The answer to this question should help to answer a question about interest rates on loans raised in the Buttonwood column of The Economist, November 30, 2013 issue. What interest rates should lenders be allowed to charge?

Unfortunately loans and credit are complicated beyond simple economics because the making of loans is an instrument of exploitation even to the point of slavery and because credit is involved in how we create money.

Economic theory tells us that so long as there is competition the price of a product should be equal to the marginal cost of producing that product.  Therefore for loans the marginal cost would be the cost to the lender of acquiring the money to loan (i.e. the interest paid to the depositor of for payday lenders to their source of funds) plus the operating costs and the cost of loans written off.  The legitimate interest rate to charge on a loan should be easy to calculate and for banks we can compare the rates they pay on deposits and the rates they charge for loans.

It appears the need for credit is almost universal at least in large-scale economies.  I’m not sure about hunting and gathering groups which practice a sharing economy.  It appears there has always been a need for short-term lending of the type done by payday lenders.

The problem is that the making of loans can be an instrument of exploitation.  One of the quickest ways to get control over a person is to lend them some money.  In peasant societies people borrow to put on funerals and weddings and if they cannot repay they sometimes find themselves in slavery.

In our own society there are probably lots of people with dreams of doing something other than the daily employment but they are unable because of their debt load.  All this consumer debt works as an instrument of social control for the one percent.  So long as we are in debt we work to support their goals and interests rather than for our own.  If a person wants to be truly free one should try to live without  borrowing.

As for payday loans Mr./Mrs./Miss/Ms Buttonwood says:

“Provided the terms of the loan are made clear, then it should be up to borrowers to decide whether to accept the costs involved. An interest rate is simply the price of money.”

Once again this is simple economics without the human factor.  For many people there are times when  it may not be easy “to decide whether to accept the costs involved.”

The other complication with lending is that our money supply is based on fractional reserve loans by financial institutions.  As money is essential for the exchange of goods and services it is also essential that we carry a debt load.  Says Buttonwood

“But businesses and consumers are positively encouraged to borrow. Indeed, when debt growth slows, as it has in recent years, an air of panic develops about how to get it going again.”

There are a number of problems with the fractional reserve method of creating money, most of which have been discussed elsewhere on this weblog and especially in the essay “LETS go to market: Dealing with the economic crisis.”  Basically it is a Ponzi scheme which is urgently in need of reform.

The reform proposed in that essay, a national Local Exchange Trading System (LETS) should also help with the need for short-term credit.  It would be a lot less exploitive as no interest would be charged and control over the money supply would be in the hands of all people.  A national LETS system would transfer a lot of economic decision-making from bankers and governments to individuals.

There are consumer loans and there are business loans.  Loans are a transfer of purchasing power from one person  to another and interest is compensation for the transfer.  A LETS system  should take care of the need for short-term consumer  credit.  The compensation for business loans should come out of the profits in which case they should be considered equity.

Back to the question of caps on interest charged on payday loans.  Is it the role of government to prevent some of its citizens from exploiting others?  If yes, then governments should limit interest  rates  charged (marginal cost is a guideline) or find another way of creating money so that the need for short-term consumer credit is easily satisfied.

If you liked this post your are invited to comment, press the like button and/or click  one of the share buttons. If you disagree you are invited to say why in a comment.  While I like the idea of sharing this platform, my personality is such that I don’t reply to many comments.

The risks of making loans

Crowd funding for unsecured personal loans is interesting in that it spreads the risk and potentially dangerous in that  it may attract investors who ignore the risk factor.  It is also unique in making loans that do not add to the money supply via fractional reserve banking.

An article in this week’s The Economist reports on some American firms that are making crowd sourced loans to individuals usually to consolidate and reduce the cost of credit card borrowing.  This model means borrowers get a cheaper interest rate and depositors get more on their deposits.  This is different from crowd sourced funding for business development although both involve risk.

CCBill_20120401When ever one makes a loan, either directly or though an intermediary (a bank deposit) one is transferring purchasing power to somebody else.  Mostly one hopes to get more purchasing power (interest or dividends) back.  There are three risks in doing this:  a government may decide to give you a haircut, the person may default or you may get caught by inflation.  We can try to protect ourselves from default by purchasing deposit insurance.  I don’t know how to protect ourselves from a haircut or inflation.  Maybe by supporting the Tea Party.  These risks will always be there no matter how bankers try to offload them.

As I understand it the crowd loan companies allow you to put a small amount of money into a number of loans.  Each amount is tied to that loan and your deposit is returned to you if, as and when the borrower repays the loan.  This allows you to spread your risk among a number of borrowers.  This may let lenders think they are reducing their risk but most business and financial models work well when the economy is growing and have problems when growth declines.  There is some probability our economy will continue to decline for some time to come.  Here is the risk statement of one of these companies.

I like that this way of funding loans does not involve fractional reserve banking and thus has a neutral impact on the money supply.

I fear that too many people will see the higher interest rates being paid on deposits and  ignore or not realize the risk involved.  If and when the risk becomes reality, there will be a lot of crying and screaming and possibly a lot of suffering.

It may be that the risk in crowd funding is no greater than with other forms of saving/making loans.  It is just a little more obvious. I still think that given the current economic situation the best investment is a market garden.

Banking – a risky business now and in medieval times

Modern bankers are protected from personal bankruptcy by the concept of “too big to fail.”   This hasn’t always been the case as in medieval times banking was a very risky business with failed bankers losing everything.

I have just finished reading Money, banking and credit in Medieval Bruges by Raymond de Roover who discusses a number of issues about money and banking most of which are still relevant.

His book covers the Italian merchant bankers who used bills of exchange to avoid shipping specie, the Lombards who operated as pawnbrokers to provide licensed usury and retail credit and the money changers who were the forerunners of today’s commercial banks.  It is the latter that I found most interesting.

One of the first things to impress me was de Roover’s use of the term purchasing power to describe money.    When so many people think of money as a commodity with a value in its own right, it is important to be reminded that the main function of money is as purchasing power.  He points out the Italian merchant bankers used bills of exchange to transfer purchasing power from one place to another.  Also the money changers transferred purchasing power when they assisted their customers to transfer funds from one person to another.

Briefcase_Vector_DesignMedieval bankers knew that loans to princes and governments were perilous and should be avoided.  Considering the amount of debt owed by governments today is so great it will never  be repaid this is probably a good rule.  Rolling over debt plus interest is a racket and a lot of people are going to lose a lot of purchasing power.   Some will find their retirement plans disappearing.

De Roover is emphatic that the money changers were creating money through their fractional reserve policies.  They were accepting deposits and making transfers of purchasing power by via entries from one account to another.  As all the money changers were physically close they could do transfers between customers of different bankers.  As most of their transfers were on paper and they kept about 30 per cent in reserve,  much of the money in their strong boxes was available for other uses.  Some was loaned to customers as overdrafts and the rest was invested in commercial ventures.  In either case they were creating fractional reserve money and adding to the money supply.  Modern banks follow a fractional reserve policy and are creating money when they make loans.

Because of usury laws no interest was paid on deposits or charged on overdrafts.  They made their money on exchanging currency and from investments.  This is interesting because I believe interest being charged on fractional reserve money/loans causes us a lot of problems.

By making investments in commercial ventures the money changers were living dangerously because this money was not on hand if requested by depositors.  Financing long-term investments with short-term or demand deposits is a high risk business plan and many money-changers found themselves bankrupt.  De Roover quotes a medieval source as saying that in Venice 96 out of 103 banks came to a bad end.  He figures this may be an exaggeration but in any case banking was a high risk venture and many bankers lost everything.

When we had our banking crisis a few years ago some bankers were financing sub prime mortgages with overnight loans.   This was more dangerous than the medieval money changers because it was on a much larger scale.  This practice was highly profitable because of the high spreads between short- and long-term interest rates.     When it became apparent these mortgages were problems the overnight financing was no longer available and the banks were in serious difficulty.

The difference between the money changers and Wall Street bankers was that the money changers were very small operations.  The concept of too big to fail had not yet been invented.  Even so the payment transfer function was so important that new money changers quickly appeared and eventually a number of medieval cities established civic banks to perform that function.

There are a number of issues discussed in this book many of them still problems even if on a much larger scale.

I have long believed that banking is a risky business and that there is a need to find a way of creating money other than the fractional reserves of banking.  I still do.

 

If you liked this post your are invited to comment, press the like button and/or click  one of the share buttons. If you disagree you are invited to say why in a comment.  While I like the idea of sharing this platform, my personality is such that I don’t reply to many comments.

The basics of banking

Somebody has questioned how it is that banks can/should make their profits on the spread between deposits and loans.  Sometimes, when we are familiar with a subject we ass u me that everyone understands all the basics.

In the jargon of economics banks are financial intermediaries which means they are the facilitator between people who have money to lend and those who want to borrow.  People with money they don’t want to spend immediately can deposit that money in a bank.  The bankers then lends that money to somebody who has an use for it.

Bankers charges interest on the loan.  Some of that money is paid as interest on the deposit and the balance, the difference between the two interest rates, is the spread with which the banker pays his expenses and takes his profit.  It is very similar to the retailer who purchases goods wholesale and marks them up to sell at a retail price.

DooFi_PiggybankThat is the core business of banking.  Boring.  However there are a couple of additional factors which make banking  very important and very risky.

The first is that banks operate under the fractional reserve principle which means they are required to keep a percentage of deposits as cash or in a form which is immediately available.  This is just in case many people want their deposits returned at the same time.  Loans cannot always be called in quickly.  A “run” on the bank has to be most bankers worst nightmare.  I believe all bankers would lie about the financial health of their banks  to try to prevent a run.

I try to avoid dealing with bank loans staff but a couple of times I have asked how it feels to be creating money.  They cannot believe they are creating money in making loans but to those who have studied economics of money and banking that is what they do.  The process is explained  in the essay “LETS got to market: Dealing with the economic crisis.”  I figure the process is a Ponzi scheme and responsible for a lot of economic evils.  It also gives bankers a great deal of power.  Because banks create money it makes them so essential for the economy they cannot be allowed to fail.

The second complication is that making loans is a risky business in that borrowers are not always able to repay their loan.

This can be a problem for the economy as a whole  because if the banks have to write off  a large quantity of their outstanding loans,  the money supply can drop quickly and without money the exchange of goods and services stops.

Risk also  makes it easy for bankers to take for themselves some huge profits.  The general rule is that the longer the term of a loan or deposit the higher the interest rate charged or paid  because the risk is higher.  Prudent banking requires bankers to match the terms of their loans and deposits so that a loan for five  years is matched with a deposit that is committed for five years.  Thus the depositor gets more interest because he/she is carrying more risk.  In an ideal world the spread will be the same for all time periods.

But bankers can make huge profits by financing long-term loans upon which they receive a high interest rate with short-term deposits upon which they pay low-interest rates.  This way they increase the spread and take the rewards of the  higher risk.  This  tactic increases the risk as interest rates can go up above the returns from the loan or depositors may decide to withdraw their money.  I know of a Canadian financial institution that purchased some government bonds (made a loan) at ten percent.  Management expected interest rates to go down so that the interest received would be greater than what they had to pay on deposits – a nice profit,  This was just before interest rates went up to 19 percent and for a while the loses were considerable for the size of the institution.  Just before the financial crisis of 1907/08  at least some of the Wall Street banks were financing long-term sub-prime mortgages with low-cost overnight deposits.  As it became apparent a housing crisis was in the making the depositors stop renewing their deposits.

Of course when risk becomes reality and banks are faced with huge loses they are so important they cannot be allowed to fail and taxpayers end up paying for the risk.

So there you have it.  Prudent banking is simple and boring.  Breaking the basic rules brings in huge profits and ends with a major crisis.

A Chicago plan for reforming banks

This week I came across a couple of articles about the Chicago  Plan for reforming banks and I like it because it proposes changing the way in which we create money and gets rid of the evils of fractional reserve money.

This plan was proposed in the 1930s by some economists from  Chicago and suggests banks be reorganized into two separate identities.  One type of bank would only accept deposits which would be kept 100 per cent with a central bank.  This type of bank would probably have to charge fees for looking after the deposits but they would be safe (except from inflation which would probably be less of a problem – or haircuts.)  No more fear of bank runs.

bankThe second type of bank would be a financial intermediary in that it would make loans based on 100 per cent equity deposits of its customers.  As all deposits would be equity, customers would know there are risks of a loan not being repaid.

As most, if not all,  bankers would see immediately, this would be the end of outrageous Wall Street profits.  Under the current system bankers make huge profits by taking for themselves  the premiums from risky loans but when the risk becomes reality somebody else takes the losses because the money creation feature of banks makes them too important to fail.  People putting money into a loan making business would know the risks and expect the returns to compensate.  The end of fractional reserve money creation would also do away with the leverage which allows bankers the profits from creating money on which they charge interest.

According to the Chicago Plan governments would create the money supply at zero interest.  This would be good in that interest charges would not be built into money creation thereby  reducing the potential for inflation.       My concern is that governments make decisions for political rather than economic reasons.  To me a national LETS (local exchange trading system)  would be preferable way to create money because the amount of money in use would depend upon the collective decisions of individuals.  For the sake of price  stability it is essential that the money supply should be flexible up and down.

When I wrote my essay “LETS go to market: Dealing with the economic crisis” I didn’t put a lot of thought into how to organize banking with a national LETS money system.  I didn’t know it then but the creators of the Chicago plan had already done that.

Banking, risk, greed and a house of cards

When I took the  course on economics of money and banking,  banks were said to be financial intermediaries which means they act as the facilitator between savers and borrowers.

I thought about this a lot as I read House of Cards by William D. Cohan published by Doubleday in 2009.  It is an account of the history and collapse of Bear Stearns & Co. which was the fifth largest investment bank in the United States.

It appears the two big problems in this bank failure were risk and greed.

When a person borrows money there is some risk that he/she will not be able to repay the loan.  The longer the term of the loan the greater the risk. As interest is in part to allow for risk the longer the term the higher will be the interest rate charged.

The question: Who is going to take the risk? The depositor or the banker?  Whoever takes the risk should also get the interest compensation.

It is clear from this book that the bankers took upon themselves the risk although when the risk became reality  their depositors also lost.  The bankers may not have realized, may not have wanted to realize, the risk they were taking.,

What makes this risk attractive is that short-term interest rates are generally much lower than long-term interest rates.  Therefore a banker can make lots of money by taking short-term deposits with which to make long-term loans.  And this is what Bear Stearns was doing.  A large chunk of the mortgages they were holding in a couple of hedge funds were financed with overnight deposits.  Apparently this was/is a common practice on Wall Street.   There are two risks in doing this: short-term interest rates may move against you or your depositors may  withdraw.

So long as the economy was experiencing economic growth it worked and the bankers made obscene fortunes.  But when economic growth slowed down and it became known that these sub-prime mortgages were not as sound as they had been  promoted, the bankers found that their short-term  lenders refused to re lend the money. Disaster. And these guys had the nerve to whine when it became apparent they were going to lose some of their personal fortune.  They also had to be rescued because banks create money and are too important to let fail.  When Bear Stearns went down there was a lot of worry that the whole financial system would collapse.

One has to note this way of working probably under priced the risks of the sub-prime mortgages and that the investment bankers had a vested interest in doing so.  It made it much easier for them to sell their wares.  If the full risk of the sub-prime mortgages had been charged in interest rates most low-income borrowers would not have been able to afford them. (It is interesting that the U.S. government starting with Clinton encouraged this business by asking the banks to finance  housing for low-income people.)

It is probably safe to say most of these investment bankers were con artists.  However, I would suggest that to have a successful con you must have at least two greedy people.  It is hard to con somebody who is not greedy.

So how do we prevent bankers from taking upon themselves excessive risk?

The first answer is to changed the way in which our economy creates money so that banks are excluded from the process.  For more on this please see the essay LETS go to market: dealing with the economic crisis  on this weblog.

The second thing is to require banks to match the terms of their deposits and loans.  They should make their profits out of the spread between the interest rates they pay and charge. The risks and rewards should go to depositors according to the decisions they make.

The third thing us to require them to publish lots of information about their business.

As for greed, governments should probably not try to legislate. Greedy people should be expected to take the consequences. (Lets make a distinction between cons involving two greedy people and exploitation by a person who has superior strength)

Wall Street has rebounded from this  crisis.  One  has to wonder of any lessons have been learned or are investment bankers still financing long-term loans with short-term deposits.  If so there is potential for another crisis.

Money as a reason for revolution

Here’s a quote from Henry Ford which I like as I believe we need some revolutionary changes in the way in which money is created.

It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.

 

And the revolutionaries probably would not be calling for the creation of a trillion-dollar coin .

 

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It takes a crisis to encourage a new way of creating money

Local Exchange Trading Systems have been around for some time but it appears it takes a financial crisis to bring them into their own.

Here are some links to news reports about the TEM currency being used in parts of Greece to replace the Euro. One,   two,   three.

So far as I can see the TEM is a LETS under a different name, maybe because of the different language.

I very much like the concept because it is a different way to create money.  It does not involve banks and loans and interest rates all of which are problems with the way our economy currently creates money.

It is sad that it takes a large-scale crisis to encourage this type of money system.  It is also sad in that the local scale limits it use and restricts the exchange of goods and services to just people in a local district.  To be really useful it needs to be expanded to a national level.

The development of the TEM illustrates that while a financial crisis can cause a lot of human suffering it is not the end of the world.  Recovery is possible.  I wish we could say the same about the other aspect of the current crisis – the depletion of the most easily accessible energy and mineral resources.

 

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Solving the debt crisis with two coins in the bank. Probably not.

Two platinum coins worth $1 trillion each to solve the U.S. debt problem.  This proposal is reported in this article on the Huffington Post.  The coins would be made by the mint and deposited with the federal reserve to meet debt requirements.  Platinum would be used to get around legal requirements.

The good part of this proposal is that it would replace fractional reserve money with fiat money.  Fractional reserve money is created by the banks when they make loans.  Very little economic thought has gone into the effect of interest rates in this money creation.    This new fiat money would not involve interest charges and that is probably very good.

The problem would be what it does to the money supply.  Presumable  the $2 trillion would be used to pay off government debt.  Some of this debt would be held by the central bank and repaying this shouldn’t change the money supply.  The rest would be to repay bondholders and this would increase the money supply.  Further it would be what economists call high-powered money which is subject to a multiplier effect as it worked its way through the banking system.

The result would be the potential for a massive increase in money supply.  This is the opposite to a return to the gold standard which would force a decrease in the money supply.    The result would be deflation and a decrease in economic activity.

There are four variables in the equation that connects the financial system and the physical side of the economy: the amount of money, the quantity of goods and services produced,  the price index and the velocity or speed at which money circulates. The formula is MV=PQ.  If one of these changes at least one of the others has to change.

If we were to have an increase on the money supply then the velocity must decease or either the price index (inflation) will go up and/or the quantity of goods and services will go up(economic growth).

In an attempt to stimulate economic growth central banks have been trying to increase the money supply and called it quantitative easing.  So far there has been little indication of its working.  This leaves either inflation or a decrease in velocity.

There has been little inflation from quantitative easing so probably the velocity has fallen.

So the impact of the two little platinum coins is unclear but they would certainly be disruptive and have the potential for hyperinflation.

For a fuller explanation of fractional reserve money is created and some of its problems please see the essay “LETS go to market: dealing with the economic crisis” on this weblog.

 

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Money, interest rates and purchasing power

This week’s The Economist has a column on the implications of high and low interest rates.
One of the problems with money is that we treat it as a commodity – something which has a value of its own. Every time I use the bank’s ATM I told to let the bank put my money to work for me (and the bank).

We would have fewer macro financial problems if we were to think of money as a tool that facilitates the exchange of goods and services.  It is a concept  which represents purchasing power.

One of the things I like about local exchange trading systems (LETS) is that they create money that only facilitates exchange.  It has no value of itself and there is no interest involved.

This is in contrast to fractional reserve money which is based on debt issued by banks and upon which interest is charged.

In a fractional reserve system when we deposit money in a bank or make a loan to somebody we are transferring purchasing power to somebody else.  We do this expecting a return of even more purchasing power.  But this additional purchasing power is an illusion.  It  comes at the expense of somebody else or it  leads to inflation.

When the economy is growing more goods and services are being produced so there is extra to be purchased and the problem is not so obvious.  When the economy is stagnant there are no extra goods and services to be distributed and this is showing up in the form of low interest rates.

 

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Milton Friedman and Money Mischief

I have just finished reading Money Mischief, Episodes in monetary history by Milton Friedman published about 20 years ago.

Friedman is remembered for his interest in the economics of money and banking. However, I have two concerns about omissions from this book.  The first is that he places too little emphasis on the T or Q in the quantity theory formula and the second is that he has missed the significance of interest in the creation of money.

Any discussion of money in economics has to include the formula MV=PT because this shows how the real and financial sides of the economy are connected.  This formula states that the stock of money times the velocity with which it changes hands is equal to a price index times the total of transactions or the quantity of goods and services exchanged.

Friedman uses this formula to support a claim that inflation is purely a monetary thing.  Prices go up when there is too much money in the economy and governments control the total amount of money.

My concern is that he does not appear to recognize the potential of T (or Q) to disrupt the economy.

In the chapter on money he suggests T could go down because workers are “paying less attention to their work and more to the stock ticker.”  A few pages later he states: “What happens to output depends on real factors: the enterprise, ingenuity and industry of the people; the extent of thrift; the structure of industry and government; the relations among nations; and so on.”

He may be excused on the grounds that throughout recorded economic history downward changes in T have not been an obvious problem.

However, there is some evidence that the resource base is now being depleted, or at least the most easily extractable, of the resources are gone.  This is certainly going to impact on the T in the formula.  Other things which could impact the formula are climate change, natural disasters or disease epidemics.

MY second concern relates to the role of interest in the creation of money.  Friedman didn’t see this and I have not come across any other economist who has recognized it.

During the 20th century there was a change in the nature of money from that based on a commodity (gold or silver) to money based on fractional reserves and credit.  (For a more detailed discussion of fractional reserve money and its problems, please see my essay “LETS go to market.”)

So long as money was based on gold the total supply was limited by the amount of gold and could be increased only as more gold was dug out of the ground.  If you look at the formula it is easily seen that this could cause problems in a growing economy.

With the switch to fractional reserve money the problem became reversed.  Now there is the potential for too much money to be available.

One of the differences between commodity money and fractional reserve money is that with the latter as new money is created the creators (the banks) demand that interest be paid on that new money.  I see this as a  built n force requiring that even more money be created to pay interest.  I see this as a sort of Ponzi scheme which from time to time collapses into a financial crisis.

Friedman provides a different take on why the money supply is increasing.  “Whatever may have been true for money linked to silver and gold, with today’s paper money it is governments and governments alone that can produce excessive monetary growth, and hence inflation.”

I have to take issue with him.  Fractional reserve money is not paper. It is entries in the computers of the banks.  Governments are involved in its creation when their bonds are purchased by central banks.  It might be good for governments to stop issuing bonds but I am not sure it is fair to blame them for inflation.

However we create money, the formula makes it clear that if the goal is price stability the money supply or its velocity must be easily variable.

International banking and money as a commodity

The Economist this week has an article about international banks and the problems of their retreating to their home markets.

The big problem here is that we treat money as a commodity when it really should be an intangible token which represents the goods and services produced by an economy.

Money represents purchasing power and gives its holder command over goods and the services of people.  International financial transactions should then represent and match exchanges of goods and services between different countries.

Historically we have mostly used gold, a commodity with limited usefulness, as the token.

By treating money as a commodity we have given it a value of its own and made transactions that do not match the exchange of goods and services.  This has made the financial system complicated, convoluted and chaotic.  It is no wonder there are lots of problems.

The cashless society

A news report on the Huffington Post tells us Sweden is close to becoming a cashless society.

The desirability of a cashless society depends upon the color of the hat one is wearing.

If I were a chief of police I would not be too keen on it because  it would make a lot of crime difficult and that would reduce my empire.

If I were a tax collector I would like it because all transactions would be recorded and the underground economy would become taxable.

If I were a dictator I would love it. Just think of the potential for social control where every time a person  participated in a transaction their location would be recorded on a computer.

However, I am just a person interested in the economics of money and banking and I see the cashless society as raising the question of just what is money.

I have tried to look at that question in an essay “LETS go to market:: dealing with the economic crisis” which has been posted on this weblog.

On breaking up the large banks

It appears some people would like to break up the large banks.  It might be wise to interpret this to mean increasing competition.

This would be a good thing for consumers.  For there to be perfect competition no player in a market should be large enough to influence prices either by withholding a product or service or by refusing to purchase. So to make the case for breaking up the large banks one should evaluate their effect on pricing in each market in which they operate.

If the case can be made then the thing is to increase competition which means looking at licensing.  Licensing programs are one of the ways in which governments restrict competition.  They way to deal with too large banks would be to allow more players onto the field.

Competition also requires that all players in a market should know everything.   Therefore we should require banks to make more disclosures about their own financial conditions.  This would be difficult because the greatest fear of every bank executive is a run by depositors demanding the withdrawal of their money.  I predict there are very few bank managers who would hesitate to lie to hold off a run on their banks.

In dealing with banks we also need to remember their involvement in money creation.  This gives them a great deal of power because our economy depends upon adequate money and because bankers get to determine whether or not a project goes ahead and who gets to do it.

Breaking up the large banks, or rather increasing competition in their markets, would be good for consumers although it may not be so good for at least some people in the industry. I wonder which group are most effective at lobbying.

Why we can’t let banks fail

One of the concerns with the Greek (and Irish and Spanish and Portuguese and the rest of Europe) debt crisis is that a number of banks will have to take a loss. It is tempting to say “so what, banks are rich and their shareholders can cope with a loss better than anyone else.

But there are some complications. Banks are essential in creating the money supply. When banks make a loan they create money and the total money supply is increased.. When the loan is repaid, the money supply decreases until the money is re-loaned and the supply goes back up.

Thus the money supply is constant – until a central bank purchases government bonds. This is the creation of new money but because of fractional reserve requirements (banks are required to hold a percentage of deposits in reserve against withdrawals) money created by the central bank is called high powered money and the money supply goes up with a multiplier effect.

All this is explained in any textbook on the economics of money and banking. What I have never seen explained is the effect on the money supply when a bank writes off a loan. Probably it has the reverse effect of high powered money – a decreased money supply subject to the same multiplier.

In most cases the writing off of loans will have little effect on the money supply However, if the amounts to be written off are large as was the case with the American housing crisis or is likely to be the case with any sovereign debt write off , the impact on the money supply will be substantial and it we lead to an abrupt decline economic activity.

Banks and their shareholders my be rich, but if they suffer loses on their loans, a lot others will become much poorer and out of jobs.

(Here is a link to the wikipedia article on money creation)

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