The quantity theory of money and transforming economists into fairy godmothers

It could be that the quantity theory of money is controversial and often dismissed because it deals with two aspects of economics where we most want to deceive ourselves – money and economic growth.

When I  started to research and think about this post I quickly got so ticked off that I went downstairs to my lathe to transform a piece of firewood into a magic wand for one of my grandchildren.  (Abracadabra.  All economists will become fairy godmothers – in their next reincarnations.)

The theory states that MV=PQ  where M is the money supply, V is the velocity at which the money changes hands,  P is the price level and Q is the quantity of goods and services exchanged.  What gets me ticked off is that this is frequently taken to mean there is a direct, proportional relationship between the money supply and the inflation rate or price level.   Can’t people see there are four variables in this formula?

The value in this formula is in that it explains relationships and shows how the real or physical side of the economy connects to the financial.  It is difficult because there are problems with fractional reserve money and because some people believe (or need to believe) that economic growth will always continue.  I think these are two aspects of economics where some people have psychological problems accepting the truth.    It becomes even more difficult if one tries to use this formula in a computer model as the four variables are difficult if not impossible to measure.

To maintain the equality, if one variable goes up then one or more of the other variables must also change,  For example, if the money supply increases then velocity must go down and/or one or both of the price level or the quantity of goods and services produced must go up.  It could be that during  recent decades the money supply was increasing faster than Q was increasing. We saw the difference as inflation.

The way we create money is a  major problem.

The fractional reserve creation of money works only so long as more and more money is being created.  Bankers create money by making loans. The problem is the interest.  If all loans plus interest had to be repaid at one time there would not be enough money in the system.. This is similar to a Ponze scheme and works only so long as more and more money can be created.

This means there is constant upwards pressure on the M in the formula – until the money creation breaks down and the M goes down suddenly and either prices fall or the quantity of goods and services produced goes down or both.  When the United States was trying to stick to a gold standard there were frequent economic crises because there was not always enough gold to support the amount of economic activity for which there were human and material resources.  The gold discoveries of the 19th century contributed to prosperity because they added to the money supply.

The big problem on the other side of the equation is Q.  A lot of people believe or assume economic growth will continue forever.  I figure Q behaves as a fractal, that is with ups and downs and ups and downs within each up and down – something like the seashore.

Some of the things which drive Q are not likely to be steady.  Discoveries of energy and mineral resources are erratic;  agricultural  production can vary with the weather; and new technology comes in spurts.  I think Q is currently being restrained because we have used up the most easily accessible energy and mineral resources.  We have picked the low-hanging fruit and what is left is going to take a lot of energy to get.

As Q is a fractal its changes in direction are likely to throw the equation out of balance and force one or more of the other variables to adjust.

Prices appear to respond mostly to changes in M or Q.  Sometimes governments decide to try to control inflation with price controls. and this usually causes problems with the balance of the equation.  Inflation is to the advantage of borrowers and deflation is to the advantage of lenders.  To be fair to everyone we need price stability.   As governments are large borrowers it is natural for people concerned with government finances to favor inflation.  Probably the best way to price stability would be to find another way of creating money so that the total is flexible.  Then the money supply rather than prices could respond to changes in the quantity of goods and services produced.

To the best of my knowledge not much is known about velocity.  I understand that in the days of the gold standard people would hoard gold if they were worried about other forms of money.

To call the formula MV+PQ the quantity theory of money is probably a little misleading. It would be better to think of it as the connectivity formula.  As such I believe it is very valuable in understanding what is happening to the economy.

Perhaps if we had more fairy godmothers we would have  a better understanding of what is happening to us.

 

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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.

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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.

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.

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.

 

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.

Bank gambling with long-term loans and short-term deposits

Turning short-term deposits into long-term loans is one of the main reasons banks exist, enabling customers to have the comfort of deposits that can be withdrawn at any time together with the certainty of mortgages that might last for 25 years.

This statement from a columnist in The Economist  contradicts what I always thought was prudent bank policy – that the time term of a loan should be matched by a deposit of an equal time term.  To mismatch these terms is to use other people’s money to gamble on which way interest rates are going to move.

I know of a Canadian financial institution that purchased a pile of government bonds at ten percent expecting interest rates to go down in which case the deal would have been profitable.  This was just before interest rates went up to 19 percent and this business lost a pile of money as it had to pay a lot more on short-term deposits than it received on its long-term bonds.

This was an extreme case but with the current economic instability we should probably be asking banks to publish information about how the time-terms of their deposits and loans are matched.  Banks should make their profits on the spread between deposits and loans.

 

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.

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