Why your savings and pensions are at risk

The fractional reserve way of creating money means a lot of people are at risk of losing all or part of their savings and pensions.

If there is too much money supply in the economy then we have inflation and people with savings or pensions lose some of their purchasing power and those who owe money benefit because they repay their loans with less purchasing power.  Now you know why governments and the people who speak on their behalf promote mild inflation.  This is at least unauthorized taxation if not theft.

pexels-photo-2105902If you have deflation, then people who are owed money win because they are repaid with more purchasing power than they loaned.  The borrowers lose because they have to repay with more purchasing power.

To be fair to everyone we need to manage the economy so that just the right amount of money is available at all times.  At a time when the economy is on a down trend, this is very important as too much money puts us in danger of hyperinflation.

Getting this amount right has long been a challenge to central banks although the common sense answer is fairly simple.  The money supply should vary with the quantity of goods and services we want to exchange and it should be flexible up and down.

The wrench in the simplicity is the fractional reserve way of creating money.  When banks make loans they must (or should) keep a fraction of the amount on reserve for when the depositor wants his/her money returned.  As the amount is only a fraction banks are at risk of a “run” if depositors lose faith.  And because of the fractional reserve there is a multiplier effect involved.  Does not this sound like a set up for a crisis?  The mechanics of this process are a little complex although I have always found it easy to understand. To figure it out I suggest you Google “fractional reserve” or look at my free e book Funny Money: Adapting to a Down Economy or look at the essay Going to Market on this weblog.

The other end of the wrench is  that interest is charged on the loans made by the banks.  Mainstream economists have given little or no thought to the consequences of this. Because all of our money is created by the making of loans, if all the outstanding debt were to be paid off at one time there would not be enough money to repay it all because of the interest.  The charging of interest on the debt/money means there is never enough money available to repay all outstanding debt. Inflation is built into the fractional reserve way of creating money.

The system works only so long as the economy and the money supply continues to grow.  An upset in either means crisis of which we have had many.

The relationship between money supply and economic output is expressed in a formula, MV=PQ, some times known as the quantity theory of money.  Money times the velocity at which it circulates in the economy is equal to a price index times the quantity of goods and services produced.

I get ticked off because 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?  Total output is an important part of this formula.  If it should happen to go down something needs to happen to another variable.

Our society has a strong commitment to economic growth and a need to keep it growing so that people will not suffer from unemployment.   Some desperate people are trying to stimulate growth by increasing the money supply. This may increase inflation but it will not lead to growth unless we can find inexpensive energy and mineral resources to support it.  I suspect the new American president has  his eye on parks and reserve lands to encourage more economic activity.  He will probably succeed in the short term to be followed by a major economic collapse.

This blogger thinks we need some major economic reforms, not only in our financial system but in our commitment to economic growth.  We need to minimize our production and exchange of goods and services so we are using fewer energy and mineral resources.

A lot  of people operate on faith in our financial system and ignore suggestions we need reform.  I think the risk is so great that prudent people will at least give some thought to these issues.  It is your savings and your pensions and your future that is at risk.

 

 

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Power of individuals and the universal basic income

Proposals for a universal basic income are bringing out lots of arguments which show a lack of understanding of the UBI and the nature of money. Here is an example in an article from  The Independent.

The author of the article claims a UBI will open the door for increased government control over people’s lives. This blogger figures the opposite will be the case and an income scheme will be a tremendous transfer of power to individuals.

The first and most important thing to say about a UBI is that it needs to be a part of a radical overhaul of the way in which we exchange goods and services and the way in which we create money.  Probably the current economic crisis is the result of our having used up the most easily accessible of energy and mineral resources.  There are lots of these left but they require lots of energy to extract.  The fractional reserve way of creating money also has lots of problems and needs to be reformed.

There are lots of people who want to tell others how to live and those of us who value Independence will always have to be vigilant and assertive.  This is separate from the UBI and will be an issue regardless.

Money represents purchasing power and giving it to people empowers them in that they can make purchasing decisions according to their values. This is different from food stamps in that stamps are for specified products and can hardly be the equivalent of money. A UBI will be a tremendous transfer of power to individuals and one would expect a lot of people to object to this.  Some of those who object will likely be the bankers whose power derives from creating fractional reserve money.

Another UBI issue is dependency.  Some people including the author of the reference article fear it will make us more dependent upon the state. I beg to differ because we should think of the UBI as an inheritance.  We can have it because we have such large agricultural surplus which is based on hundreds of years of agricultural and technological development.  We should all have a right to a share of the agricultural surplus.

The universal basic income will lead to a revolutionary change in the way we exchange goods and services.  Many of the issues are discussed in my book Funny Money: Adapting to Down Economy.  I encourage  you to have a look at it.  Details at the top of this blog.

This columnist from The Economist is encouraging theft

This post is to accuse the Buttonwood columnist in The Economist of encouraging the theft of people’s savings.

In the Nov 30th 2013 issue he/she says “Debt needs to be reduced by default, inflation or financial repression (keeping interest rates as low as possible).”

Lots of others including economists concerned with government policy make similar statements.

The problem is that one person’s debt is another person’s savings.  Therefore when debt is reduced by default or inflation it is going to take away from somebody’s savings.  This might be more visible if loans were made directly from a saver to a borrower without the financial intermediation of banks.

It might also be easier to understand if we were to define money as something representing purchasing power.  Thus a loan is a transfer of purchasing power from the lender to the borrower.  If the loan is not repaid because of default or is reduced by inflation then the lender has lost some of his/her purchasing power.

Some people might say the losses from default are carried by financial institutions.  This is true only if the banks are making excess profits.  If they are not making excess profits and maybe even if they are the losses are most likely to be spread over all their depositors in the form of reduced interest payments.

Of course people who owe lots of money, especially governments, benefit from inflation because they don’t have to repay as much purchasing power.  The ideal should be price stability – zero inflation and zero deflation.

However it happens default or inflation reduces the purchasing power previously owned by savers.  To me this is theft by or on behalf of borrowers.

What caused the financial collapse?

Here are four causes of the financial crisis not based on conventional economic wisdom:  the way in which we our economy creates money, the using up of the most accessible energy and mineral resources, the greed of most of us and imprudent or fraudulent banking practices which allow bankers to make excessive profits.

For a more conventional explanation see this article in The Economist.

We all use money and many people are very good at “making” money but very few understand its function and how it is created.  As gold and other items have traditionally been used as money we treat it as a commodity with some value of its own.  But money is a tool to facilitate the exchange of goods and services.  It is a token of purchasing power.  It is important that we have just the right amount of money to use otherwise we have inflation (too much money for the transactions we want) or deflation (not enough).

The money we use results from fractional reserve banking in which banks are required to keep a percentage of their deposits as reserves.  How this works is explained in the essay “LETS go to market: Dealing with the crisis” on this weblog.  It is complex but I find it  easy to understand.

Our money supply is based on loans made by banks and upon which they charge interest. For this system to work there must be a continuously increasing supply of money which sort of works so long as the economy is growing.  However, even a slowdown can cause problems because we need the right amount of money for the number of economic transactions.   I think this is a Ponzi scheme and therefore it is bound to collapse.  Periodic financial crises are built into the way we create money.  This is one of the causes of the current crisis.  When the U.S. mortgage bubble burst the money supply and the financial system collapsed.

There are two sides to the economic equation.  One side deals with the financial and the other with the physical goods that provide us with food, shelter, clothing. transportation and toys.

Since the industrial revolution we have been living in unprecedented increasing prosperity.  However there is some evidence that since the 1970s the growth of this prosperity has been slowing down and maybe even declining.  My theory to explain this is that we have used up the most easily accessible of the energy and mineral resources and it now takes more energy to recover what is left.  To use jargon, the marginal costs have increased.  This is bound to affect standards of living as more effort must be applied to resource extraction and less to other things.  This is background to the financial crisis.

Wall Street bankers are the kings of greed who got their riches partly be being in the right place at the right time.  They also make good scapegoats.

A scapegoat is somebody you blame for the consequences of your own weaknesses.  Most if not all of us have some greed and this was a factor in the financial crisis.  Before and since the crisis many people wanted the most they could get.  This includes the savers and investors who wanted the greatest returns to the poorer people who wanted housing they couldn’t afford.  Every time I go to the ATM machine or actually enter the bank I am reminded the financial industry is still appealing to the greed of its customers.

The final cause of the financial crisis is that bankers are smart enough to realize they can increase their margins and make huge profits by mismatching the terms of deposits and loans.  At the best this is imprudent.  It could even be fraud.

Bankers are financial intermediaries in that they collect deposits and make them into loans.  The difference in interest rates provide a margin which covers their expenses and provides some profits.  Prudent banking requires that the terms of the deposits and loans match.  Thus if a banker makes a loan for ten years then he should have on hand ten-year term deposits of the same amount.  Breaking this rule can be very dangerous and very profitable.

The reason for breaking the rule is that the longer the loan the greater the risk and therefore the higher the interest rate which will be charged on the loan and which must be paid to get deposits committed for the same time. A banker who finances a long-term loan with short-term deposits can increase his margin.  Prior to the financial crisis the banks were financing long-term mortgage loans with short-term deposits, some of the deposits were committed just for one day at a time.  This worked well when the economy was going well but when it became apparent there were problems the depositors became worried about their money and refused to roll them over.  As banks are required to only keep a fraction of their deposits on hand there was a limited number of depositors who could be refunded.

I think this should be considered fraud against the depositors or in this case the taxpayers who covered the losses.  It was necessary for the government to step in  because we would have lost even more of our money supply and that would have been disastrous.  The question which probably should not be asked: are bankers continuing to mismatch deposits and loans?

So there you have it, my list of four factors which contributed to the crisis.  All of these will be challenging to change.  Some ideas for change are in my essay “LETS go to market: Dealing with the economic crisis.”

 

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 morality of austerity and inflation

Somebody on LinkedIn has asked if austerity is a morality issue.

Of  course austerity is a morality issue but so is inflation.

Austerity is a moral issue because it inflicts unemployment and hardship on some people.  Inflation is a moral issue because it is a form of theft in that it reduces  the purchasing power of savings and pensions.  The opposite to austerity is government stimulus spending but it is not clear we can have stimulus without inflation.

So the challenge is to design a way of exchanging goods and services and a money system to facilitate that exchange such that there is no inflation or deflation.  To do this we will have to first challenge all sorts of motherhood issues with regard to money, work and economics.

 

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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