Monday, 30 July 2012

Laurence Kotlikoff's latest book.

This book is a scathing indictment of the U.K.’s Vickers commission report on banking, and with good reason. The opening sentence of the Executive Summary reads:

“The Independent British Banking Commission, the Vickers Commission was charged with keeping the British economy safe from another major failure of its banking system – a failure from which the UK economy is still reeling. Unfortunately, it’s done nothing of the kind.”

And later in the summary, Kotlikoff says,

“Instead of fixing the real problems with banking - opacity and leverage – the Vickers Commission Report pretends to fix banking by re-arranging the deck chairs.”

The book is short: roughly 25,000 words. But quality is more important than quantity.

The Vickers commission proposes splitting banking into two categories (in a similar way to Glass-Steagall). There are “High Street / retail” banks (or bank subsidiaries), and in contrast “casino / investment” banks (or bank subsidiaries), and the two are allegedly separated by a “ring-fence”.

Some basic points made by Kotlikoff are as follows.

1. Vickers HINTS that it would let investment banks go bust. But as is obvious from the demise of Lehmans, it is very doubtful as to whether that was a good idea. The consequences were disastrous. So would Vickers let investments banks go bust? They aren’t clear on that one.

2. Vickers proposals would not have saved Lehmans.

3. Several crucial decisions as to what needs to be done to effect the much vaunted ring fence are just not taken by Vickers. That is, the Vickers report leaves those decisions to “the regulators”. (That’s the folk with a proven inability to regulate banks.) As Kotlikoff says in his conclusion, “The Commission’s proposals are a full employment act for regulators.”

Incidentally, Kotlikoff missed a trick here. One of decisions you might think Vickers would have taken in relation to it’s “ring-fence” is the decision as to whether ring-fenced banks can lend to large corporations. But they shy away from that decision (top of p.12 of the Vickers report).

4. Vickers fails to deal with the central problem with banking in its present form. This is that banks can promise to return £X to depositors for every £X deposited at the same time as investing or lending on that money in ways that are nowhere near 100% safe. And as soon as those investments / loans turn out to be worth significantly less than their face value, the bank is bust. How many European banks are currently bust in all but name? We don’t know.

The solution is to bar banks from taking the above risk: that is, it’s depositors who have to take the risk. Under Kotlikoff’s “narrow banking” proposals, a depositor can let their bank do anything they like with their money. If a depositor wants their money invested in for example the chemical industry, the money goes into a chemical industry mutual fund (unit trust in the UK). And the value of those funds / trusts rises and falls in line with the performance of the underlying assets.

As to depositors who want instant access to their money and 100% safety, they put their money into cash mutual funds. I.e. the money in effect is not invested or loaned on at all.

That way, depositors can certainly lose out on their fund/trust investments (cash funds apart), but it’s almost impossible for the bank to go bust.

5. As to Vicker’s reaction to narrow banking, it is obvious they just didn’t understand the concept. Vickers deals with narrow banking in paragraphs 3.20 to 3.24. And this section has the bizarre heading “Should credit provision to individuals and SMEs be prohibited?”: the implication being that narrow banks don’t lend to individuals and SMEs (Small and Medium Size Enterprises). The suggestion is of course complete nonsense. Narrow banks would offer, for example, mortgages to households just as banks currently do. It’s just that the lending is done (under the Kotlikoff model) via mutual funds.

There is actually plenty of nonsense in this section NOT DEALT WITH by Kotlikoff, which I’ll deal with here in a week or two.

6. Another curiosity to which Kotlikoff draws attention (Ch.5) is the way in which British establishment figures have on the face of it changed their minds on narrow banking. Both Martin Wolf and Mervyn King expressed approval of the idea a few years ago, but now disown the idea, and for reasons which are not clear. Possibly knighthoods and lordships have been offered by David Cameron to those concerned as long as they don’t interfere with the Tory Party’s source of funds: the criminals and fraudsters who run banks.

Or possibly the British establishment when they are in disarray (e.g. haven’t a clue as to how to organise banks) cling together under some very conventional and conservative set of ideas.

7. Kotlikoff rightly draws attention to another basic point that Vickers & Co didn’t understand, which is thus. Vickers was much concerned about restrictions to liquidity that might flow from restricting bank activities. The answer, as Kotlikoff rightly points out (Ch.5, p.61) is that the government / central bank machine can supply any amount of liquidity any time (inflation permitting) simply by printing money and spending it into the economy.

Put another way, do we want the nation’s money supplied to us by spivs, criminals and fraudsters or by government?


Sunday, 29 July 2012

Full reserve degenerates to fractional reserve, absent regulations to stop it.

I’ll illustrate how by reference to some hypothetical economies.

Assume an economy with a full reserve banking system, i.e. private banks don’t create money or credit. Let’s say money consists of gold coins, and citizens can deposit surplus coins at banks for safe-keeping. Plus banks issue cheque books and debit cards to customers. The advantage of the latter two is of course that it obviates carrying gold coins around, which might get stolen. Plus for large transactions, wheel barrows loaded with good coins are obviously impractical.

The total stock of gold coins is enough to induce the private sector to spend at a rate that brings full employment.

The rate of interest for safe loans is X% with spreads over X% for riskier loans.

Private banks in that scenario would soon discover that they can make loans at less than X%. After all, lending such money into existence costs banks nothing, administration costs apart: it’s not as costly as digging up gold. And as long as decent collateral is offered to back the loans (e.g. houses), the banks cannot lose. And that is exactly what the goldsmiths of London did in the 1600s and 1700s.

In our hypothetical economy, the result of the latter activity is an increase in demand, which in turn means inflation (given the above full employment assumption). However, while TEMPORARY bouts of inflation are possible under the gold standard, longer term or permanent inflation is not possible, assuming the cost of digging gold out of the ground stays constant.

And wouldn’t you know it: in Britain in the 1800s (when Britain was on the gold standard) the cost of bread at the end of the 1800s was much same as at the beginning. Actually it was a bit LOWER in 1912 than in 1798. Scroll half way down to the table here.

Having said that allowing private banks to lend money into existence is inflationary, THERE IS an alternative, which is for government to raise taxes, withdraw gold coins from circulation and just store them – perhaps in the central bank vaults. But notice what is going on here: the CONFISCATION of purchasing power from citizens at large in order to enable privately produced money to be spent. Put another way, the monetary base is being replaced with privately produced money.

Fiat money.

Now suppose that our hypothetical economy has a fiat currency instead of using gold. A fiat currency is much like a game of Monopoly. In Monopoly, the money initially distributed is of value, because players are agreed that it shall be of value, and because the money is needed to play the game / engage in “economic” activity. Likewise, in our hypothetical economy, ANYTHING which is declared by some authoritative body like government to be money is likely to BECOME money and to RETAIN its function as money, simply because SOME FORM OF MONEY is useful.

Another popular explanation for why fiat money has value is that government demands such money for taxes due. So let’s say our hypothetical economy has a government that collects tax.

Now in a fiat money system, gold is not there to stop long term inflation.

Thus when private banks start “lending money into existence” as the saying goes, inflation ensues, but that inflation does not need to be reversed by periodic severe recessions, as occurs under the gold standard.

Moreover, banks and those they lend to are not greatly concerned about the inflation. Reason is that in making a loan, BOTH bank and borrower become creditor AND debtor. I.e the agreement (at least initially) is: 1. The borrower owes the bank £Y till the loan is repaid, and 2, the bank owes the borrower £Y, which obligation the bank undertakes to transfer to anyone that the borrower chooses – using his/her cheque book. Initially, to repeat, both bank and borrower are both debtor and creditor, so neither are bothered by inflation.

In contrast, once the borrower has spent the money allotted to them by the bank, the situation is SLIGHTLY different – thought the new situation is still one where banker and borrower are not bothered about inflation.

That is, once the borrower spends the money borrowed, i.e. transfers the money to entity Z, the bank then owes entity Z, and has to pay entity Z (or entity Z’s bank). However, assuming all commercial banks expand their loan books at about the same rate, the amount of money created out of thin air by entity Z’s bank which is deposited at our original bank will approximately equal the amount of money flowing the other way. Thus to all intents and purposes, the above “initial” set up does not change: neither bank nor borrower are bothered about inflation.

There is no free lunch.

Now there is no such thing as a free lunch. If bank and borrower gain, then someone has to lose, and of course it’s the person paid by the borrower. That person or entity is left holding a permanently depreciating asset (which in most cases they will pass on to other entities).

Apart from not being bothered by inflation, the bank of course, gets some interest. So the net effect, to repeat, is that bank and borrower steal purchasing power from the rest of the population. Nice work if you can get it.

In addition, the rate of interest is reduced to an artificially low level. That is, in a genuine free market, the rate of interest is determined by borrowers and GENUINE SAVERS: that’s people who abstain from consumption in order to enable those they lend to to engage in consumption.

In contrast, private banks can create savings from thin air, i.e. at no cost (administration costs apart).


Tuesday, 24 July 2012

Daniel Gros is clueless on deficits and debts.

Daniel Gros is Director of the Centre for European Policy Studies in Brussels. He argues for austerity in this VoxEu article on the grounds that the present rate of increase in national debts is “unsustainable” (see his last paragraph).

Incidentally, a country in a common currency area like the Eurozone faces a VERY DIFFERENT set of problems to a “monetarily sovereign” country: that is one which issues its own currency. To deal with both types in a short article like Daniel’s is risky if not absurd: something I won’t do here. I’ll keep it simple, and concentrate on monetarily sovereign countries.

The fashionable word: “sustainable”.

You can nearly always identify people who can’t think by their excessive use of fashionable phraseology. Daniel is an example.

The acceleration of a car from 5mph to 10mph is not “sustainable” in that if it carries on accelerating, it will ultimately exceed the speed limit, or its speed will become dangerous. Or its engine power will ultimately place a limit on further acceleration.

Is that an argument for not exceeding 10mph in your car?

Running the taps on your bath is not “sustainable” in that the bath will ultimately over-flow. Now that’s a brilliant argument for having just one inch of water in your bath, isn’t it?

The number of half-witted “sustainability” arguments of the above sort is almost limitless.

And of course, Gros is right in the sense that the size of a national debt relative to GDP cannot carry on increasing FOR EVER. But the latter point is just plain daft.

A more intelligent question is: what’s the OPTIMUM level of debt? (Incidentally, advocates of Modern Monetary Theory probably don’t need to read further, as they’ll already know the answer.)

Likewise, the intelligent question in relation to car speed is: what’s the best speed in any given scenario?

The optimum level of debt is the level that induces the private sector to spend at a rate that brings full employment.

Government debt is an ASSET as viewed by owners of that debt, and those owners are of course sundry private sector entities. And the more of such debt the latter entities hold, the more they are likely to say “I’ve got enough of these assets now”. I.e. the more they are likely to try to divest themselves of said assets.

But government debt and cash are very similar in nature. I.e. the more of such debt the private sector holds, the more the private sector is likely to SPEND. And spending is the solution to the recession.

So what’s the optimum level of debt children? Well it’s the level at which the private sector spends at a rate that brings full employment. And since we are currently nowhere near full employment, there is plenty of scope for letting the debt continue to rise for the moment.

Put another way, the private sector will tend to hoard cash (or near cash equivalents, like government debt) if the private sector thinks it has an inadequate stock of such assets. And that act of saving or hoarding equals Keynes’s paradox of thrift: which leads to excess unemployment.

What if interest rate rise?

The next non-problem that gives the Daniel Groses of this world sleepless nights is: what happens if lenders become reluctant to lend to a heavily indebted country and the rate of interest the country has to pay rises significantly?

No problem!! The solution is to cease borrowing. Doh!

Assuming the relevant economy still has excess unemployment, i.e. excess spare capacity, the relevant government and central bank just need to print and spend money into the economy (and/or cut taxes). As long as there really is spare capacity, no significant inflation will ensue.

Indeed, that leads nicely to the next mistake made by Daniel.

Deficits do not necessarily mean increased debt.

Daniel, like many of the incompetents that make up Europe and America’s elite, thinks that deficits necessarily lead to increased debt.

As Keynes, Milton Friedman and many others pointed out, a deficit can accumulate by expanding the monetary base rather than expanding the debt.

Indeed, this is PRETTY MUCH WHAT HAPPENED in the U.S. in 2011!!!! To be more exact, 77% of the increased debt was QEd in the US in 2011. Daniel seems to have no idea what is going on.

Of course you could argue that “QEd debt” is still there: in the hands of the central bank.

But this debt is simply a debt owed by one part of the “government / central bank machine” to another. Those debts might as well be torn up.

It could also be argued that the resulting increased monetary base will one day prove inflationary. Well OK it might. But if that happens, the relevant central bank just needs to reverse the QE operation. (Or government and central bank between them need to implement some other deflationary measure.)

And if those debts in the hands of the central bank HAVE BEEN torn up, no problem. I.e. if the central bank holds NO GOVERNMENT DEBT, there is nothing to stop the bank wading into the market and offering to borrow at above the going rate.

And if the legislation in the relevant country prevents the central bank doing that, then the legislation needs changing.

And finally, it should be said in Daniel’s favour that at least his incompetence is not as bad as that of the buffoons on Capitol Hill. These people (and this is scarcely believable) have over the last three decades have actually implemented PRO-CYCLICAL fiscal policies: i.e. run surpluses in recessions and deficits during booms. At least that’s the case according to this article by Jeffrey Frankel.

Monday, 23 July 2012

British planning restrictions boost the cost of the average house by about £40,000.

At least that is the case if my back of the envelope calculations below are right.

Looks like about half the rise in British house prices over the last 20 years is attributable to inflation, with the rise in the cost of residential land or “planning permission” land accounting for a smaller but significant portion of the rest.

The price of the average house rose from £52k in 1992 to £165k in 2012 according to this Nationwide site.

As to inflation, according to this Bank of England calculator, goods costing £1 in 1991 would cost £1.76 in 2011.

So if house prices had risen just in line with inflation, the average house would have risen to £92k (1.76 x 52).

Residential land prices.

According to this site, the average cost of residential land, or land with planning permission rose from £174k per hectare to £1.6m twenty years later (that’s around 1986 to 2006).

The same site cites research by the Halifax bank which more or less ties up the above figures. It claims residential land prices rose nine fold between 1983 and 2003.

As to the number of houses per acre, this site says new housing was being put up at rate of 16 per acre in 2005 in Britain.

There are about two acres per hectare. So taking the above £1.6m, that means £800,000 per acre. And that at 16 houses per acre means about £50,000 land cost per house.

That ties up quite nicely with a figure given by a Policy Exchange work: £45,000 per dwelling (in 2009-10).

As to the average cost of land WITHOUT planning permission (agricultural land) in 2011, this is given as £6,156 here and £8,500 here. So let’s take a rough average: say £7,000.

There is obviously a “mark-up” when planning permission is obtained for land on which to build. This mark-up for an average size house was between £43k (£50k less £7k) and £38k (£45k less £7k), a year or two ago. Hence the £40k figure given in the title of this article.

The rise in the cost of getting planning permission.

As distinct from the ABSOLUTE portion of house prices attributable to the cost of residential land, there is the INCREASE in that portion over the last 20 years.

As noted above, the cost of land with planning permission has risen from £174k to £1.6m over the last 20 years. So the cost of land with planning permission for one house would have been £4.3k (£40k x (174/1600)) twenty years ago. £4.3k adjusted for inflation is £7.6k (£4.3k x 1.76). So the portion of the RISE in the cost of the average house over twenty years attributable to the increased cost of getting planning permission is about £32.5k (£40k less £7.6k).


Local authorities have been too stingy in granting planning permission.


Sunday, 22 July 2012

The multiplier is irrelevant.

The amount of employment created per million pounds spent varies with HOW the money is spent. For example, if the money is channelled towards groups of the population that save more than normal, relatively little employment is created. That is, the so called “multiplier” is low. And this leads some na├»ve folk to deduce that stimulus money should be channelled towards economic activities with as high a multiplier as possible.

The idea is invoked by the author of this “Touchstone” article and the authors of this recent IMF report on the UK. But then as Bill Mitchell has pointed out ad nausiam, the IMF gets just about everything wrong.

The basic flaw in the multiplier argument is that creating money with a view to spending it costs a monetarily sovereign country NOTHING. Money can be created at the press of a computer mouse.

So let’s assume there is a choice between employing people to perform economic activity A and activity B. Also suppose that the multiplier under A is poor because those concerned save a high proportion of the increased income that is caused by implementing A.

Also suppose that REAL OUTPUT per head is higher under A than B. Which should we go for: A or B?

The answer is A, because economics is all about maximising REAL GDP per head (within environmental constraints). The fact that those involved in A choose to store a large proportion of their increased income under their mattresses (to put it figuratively) is irrelevant. It does not cost anything to print more £20 notes for people to sleep on, if that’s what they want to do.

Weimar, Mugabwe, bla bla bla.

Of course a significant portion of the population, if not a majority, start chanting “Weimar” or “Mugabwe” as soon as they hear the phrase “create money” or similar.

They need to read David Hume’s essay “On Money” written over 250 years ago. As Hume correctly pointed out in relation to money supply increases, “If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.” Quite right. And stuffing money under mattresses has exactly the same “non-effect”.


Another problem with skewing the economy towards SPECIFIC areas of economic activity, is that those areas are likely to run into skills shortages and capital equipment shortages before the rest of the economy reaches capacity. I.e. inflation is likely to rear its ugly head before full employment is reached.

Of course people can possibly be re-trained to deal with those skill shortages, but what’s the point? When the recession is over and the above “skewing” is unwound, those newly acquired skills become redundant and those concerned have to return to using the skills they had in the first place.


Another possible reason for multiplier differences as between different forms of economic activity (mentioned by the IMF report) derives from the different extent to which imports are sucked in. But that is not a reason to concentrate on non-import dependent activities: activities which as a result have a high multiplier. Reasons are as follows.

First, the policy is a form of “beggar my neighbour”: creating jobs in one country at the expense of another. That policy might be justified where JUST ONE country is in recession. But that is not the case: a significant proportion of countries worldwide are in recession. Thus if every country ignores the IMF’s daft “concentrate on non-import dependent sectors” idea, that WILL SUCK IN more imports to any given country than if that country were to ignore the IMF’s advice. But if every country does the same, then its swings and roundabouts: the deterioration in one country’s balance of trade as a result of ignoring the IMF will be nullified by GAINS TO its balance of trade deriving from the fact that other countries are adopting the same policy.

Second, unless market failure can be demonstrated, we can only assume that for any given country, market forces result in an amount of international trade relative to GDP that is about optimum. Moreover, that ratio is not going to change significantly as between recessionary and non-recessionary times (at least, certainly not if other countries are in recession at the same time).

Thus distorting the economy towards non-import dependent activities, as per IMF advice, just results in a misallocation of resources. That is, it reduces GDP and living standards.

And even if the above “international trade to GDP” ratio DOES change when a country is in recession, then again, unless market failure can be demonstrated, the assumption must be that the market has got the “international trade to GDP” ratio about right (recession or no recession).


Friday, 20 July 2012

In 2010 Martin Wolf supported limited purpose banking.

He said, “I like this idea. In essence, it says that you cannot gamble with other people’s money, because, if you lose enough, the state will be forced to pay up. So, instead of having thinly capitalised entities taking risks on the lending side of the balance sheet while promising to redeem fixed obligations, financial institutions would become mutual funds. Risk would then be clearly and explicitly born by households, who own all the equity anyway. In this world, financial intermediaries would not pretend to be able to meet obligations, that, in many states of the world, they simply cannot.”

Hat tip to Lawrence Kotlikoff.


Wednesday, 18 July 2012

Tim Worstall does not understand money or banking.

Tim Worstall is normally clued up on economics. But not, so it seems, on the subject of money and banks. He says, “No, banks do not create money. The banking system as a whole creates credit. But individual banks do not create money. They just don’t.”

He needs to look up the definition of the word money in a dictionary. It is defined as something like, “Anything widely accepted in payment for goods or serves or in settlement of a debt.”

Now the fact of the matter is that when someone gets a loan from a private bank, the latter does not need to get the relevant money from anywhere: it can just credit the borrower’s account with a book keeping entry – or if you like, it can credit the borrower’s account with money ex nihilo.

And when the borrower draws a cheque on that account or does a credit or debit card transaction based on the account, the cheque or card transaction will be “widely accepted” in payment for goods and services. Ergo the bank has created money.

Here are some quotes on the subject.

"Banks create money. That is what they are for. . . . The manufacturing process to make money consists of making an entry in a book. That is all. . . . Each and every time a Bank makes a loan . . . new Bank credit is created -- brand new money." - Graham Towers, Governor of the Bank of Canada from 1935 to 1955.

"When a bank makes a loan, it simply adds to the borrower's deposit account in the bank by the amount of the loan. The money is not taken from anyone else's deposit; it was not previously paid in to the bank by anyone. It's new money, created by the bank for the use of the borrower."

- Robert B. Anderson, Secretary of the Treasury under Eisenhower, in an interview reported in the August 31, 1959 issue of U.S. News and World Report

Northern Rock.

Worstall then claims that if private banks can create money “then Northern Rock would not have gone bust, would it?”

The answer to that is that there are an infinite number of grades or types of money: in particular, “Northern Rock money” is not as good as central bank money.

Indeed it was common in the 1800s and before for WEALTHY INDIVIDUALS AND FIRMS to issue a form of money: bills of exchange. The latter were simply I.O.U.s or promises to pay a certain sum on a particular future date. And they were passed from hand to hand in settlement of debts or in payment for goods and services. Ergo bills of exchange were a form of money. And issuers of bills of exchange who conducted their affairs in a competent manner had no problems, while the incompetents ended up doing a “Northern Rock”: going bust.

To summarise, private banks cannot issue a form of money which is as good as gold. They cannot produce a form of money which is as good as central bank money. But they can nevertheless issue a form of money.

Wholesale borrowing.

In the paragraph starting “What Rock actually did…” Worstall claims that Northern Rock funded itself via the wholesale money market: i.e. borrowing from other banks or other institutions.

True: to a large extent it did. But that does not prove that Northern Rock did not in addition create money. In fact for those of us who understand banks, it is obvious that a bank which DOES NOT expand faster than other banks will NOT NEED to borrow from the wholesale markets. While banks that ARE EXPANDING faster than others WILL NEED to borrow. Reason is thus.

When a bank “lends money into existence” as the saying goes, most of that money will be deposited at other banks. And the latter will want central bank money from the former bank in exchange for the former bank’s “funny money”: that’s done at the end of each working day in the books of the central bank. Now if a bank is expanding faster than other banks, it will need to borrow to cover what it owes other banks.

However, if every other bank is expanding at the same rate, the amount of money deposited at the first bank will be about equal to the amount of the first bank’s money deposited at OTHER BANKS. I.e. it all nets out, roughly speaking.

Conclusion: the fact that Northern Rock was borrowing significant amounts wholesale does not prove (a la Worstall) that Northern Rock was not creating money. It is just evidence that that Northern Rock was expanding faster than other banks, which indeed it was.


Tuesday, 17 July 2012

What proportion of the money supply is created by private banks?

Positive Money and the New Economics Foundation say about 97%, and on the grounds that about 3% of money consists of physical cash (£20 notes, etc). Therefor the rest must be privately created.

Frances Coppola says the figure is significantly less than 97% because the above reasoning leaves out commercial bank reserves at the central bank – an argument I’ve been putting for some time. But that's not the end of the argument.

Central bank money or “monetary base” comes into existence when government makes any sort of payment (e.g. a tax rebate or social security payment). Each recipient of those payments will deposit most of the money in a commercial bank. And the commercial bank will have its account at the central bank credited.

Assuming government pays out more than it receives during some period, that means the initial effect is to boost private banks’ stock of reserves by some given amount. And the latter amount of money has clearly been created by government – or if you like, the central bank.

Thus it seems reasonable to say that reserves are central bank created money. Moreover, such money is in effect in circulation: that is the above non-bank recipients (recipients of tax rebates or social security payments) can do what they want with the money. But that does not mean we can get at the total amount of money in circulation that is central bank created by adding up physical cash and bank reserves.

Reason is that as soon as private banks think they have more reserves than they need, they use the surplus to invest in something with a better yield (reserves normally pay no interest).

Thus to get at the proportion of money created by central bank it strikes me we need take physical cash add total deposits and subtract total loans.

This site gives the deposit to loan ratio of U.S. FDIC insured banks as 79%. (loans are $7.28 trillion while total deposits are $9.22 trillion).

From that I deduce that about 20% of money in the U.S. is central bank created. But I’m bound to have gone wrong somewhere.

Any ideas?


Saturday, 14 July 2012

“Funding for Lending.”

“Funding for Lending” is the British government’s latest attempt at stimulus (or pretence that they’re going for stimulus). It consists of lending money to banks if the latter show they’ve lent some minimum amount to businesses and mortgagors. (To be strictly correct, the Bank of England will lend eligible private banks government debt. But the latter is as good as cash.)

The obvious problem here is that banks do not lend central bank money or “reserves”. Private banks just don’t need central bank money in order to lend. Put another way, private banks can create money out of thin air and lend it out whenever they see a viable lending opportunity.

An INDIVIDUAL private bank’s lending is constrained in that it cannot expand much faster than other banks by simply creating its own money. So any private bank in that situation will be helped by the scheme. On the other hand, Funding for Lending will only last 18 months. Now what bank is going to go out on a limb so to speak on the basis of a source of funds that will only last 18 months? Didn’t the rapidly expanding Northern Rock go bust because it relied on short term sources of funds which then dried up?

As distinct from an INDIVIDUAL bank “going out on a limb” or expanding its lending faster than other banks, i.e. to the extent that all private banks expand at the same rate, “Funding for Lending” is useless for reasons given above: private banks don’t need central bank money in order to lend.

Conclusion: “Funding for Lending" smells like a gimmick designed primarily to make it looks as though government and central bank are doing something.


Friday, 13 July 2012

Martin Wolf criticises Lawrence Kotlikoff.

Martin Wolf in today’s Financial Times puts seven suggestions for improving the banking system. The fourth involves criticising Lawrence Kotlikoff’s 100% reserve banking ideas. In reference to banks, Wolf says “I accept that leverage of 33 to one, as now officially proposed is frighteningly high. But I cannot see why the right answer should be no leverage at all. An intermediary that can never fail is surely also far too safe.”

There are several mistakes in those two sentences, as follows.

1. If an ultra-high level of safety COSTS SOMETHING, then that could easily be an argument for sacrificing some safety in exchange for reduced costs. But if Wolf thinks such costs exist, he needs to tell us what they are.

The Vickers commission (of which Martin Wolf was a member) CLAIMED such costs were involved. They claimed that 100% safety would supress bank lending, which in turn would supress economic growth. As I’ve pointed out before on this blog, that suppression of economic growth would certainly take place ALL ELSE EQUAL. But all else needn’t be equal. That is, the government / central bank machine can easily expand the money supply to make up for the more conservative way in which money is used under a full reserve or 100% safe regime.

And producing new money costs NOTHING in real terms: money is just book-keeping entries, or if you like, numbers in computers.

2. Where does Martin Wolf think the money came from to boost house prices prior to the crunch? It came from money creation by private banks, not central banks or governments. That is, the money supply expanded thanks to the fractional reserve system. In other words booms and slumps would be ameliorated if we reduce the 33:1 leverage. But as long as there are no costs involved in reducing the leverage to 1:1, why don’t we go for the maximum amount of amelioration possible: i.e. just abandon fractional reserve?

In other words it can well be argued that the real costs – costs of CATASTROPHIC proportions – derive from fractional reserve, not from full reserve.

3. As argued by Huber & Robertson (amongst others) the freedom that private banks have to create “savings” out of thin air and lend them out results in artificially low interest rates. If H&R are right, then that is an argument for a total ban on money creation by private banks: i.e. it’s an argument for 100% reserve.

Personally, I would cite another argument in addition to H&R’s, which is that when a private bank boosts demand by creating and lending out money, demand must be supressed elsewhere in the economy (assuming the economy is already at capacity). And in practice, that suppression of demand takes place in a pretty random fashion, e.g. government might cut spending on education, roads or health care – you name it.

A more efficient allocation of resources would be involved where when one entity wants to borrow more, the concomitant reduction in current consumption is born by whoever is least concerned about abstaining from consumption. And that objective would be attained where when one entity borrows more, interest rates rise. And that increase in rates would occur automatically under full reserve.

Wednesday, 11 July 2012

Bank of England tries to explain QE.

Just in case you thought central banks know what they are doing, this Bank of England (BoE) article will disabuse you.

The article claims quantitative easing was implemented primarily to keep inflation up to the 2% target: a strange objective (see 2nd para of “Introduction”, p.200).

Personally I think that maximising GDP within environmental constraints and providing jobs for those who want them is a more fundamental and important economic objective.

Their reasoning becomes SLIGHTLY clearer a few paragraphs later in a sentence that is not 100% clear: it says that a below target rate “could have led to inflation expectations, which would have pushed up on real interest rates, even with nominal rates kept at very low levels and reduced spending in the economy”. Presumably they meant “pushed up” rather than “pushed up on”. Also they don’t actually mention NEGATIVE rates of inflation, but I assume they had that in mind.

Now this reasoning is bizarre. The only circumstance in which inflation is likely to drop to zero or below is where there is a serious collapse in demand and unemployment reaches the worst levels experienced in the 1930s. AND THAT’S THE REAL PROBLEM: the collapse in demand and the unemployment.

That a zero or negative rate of inflation adds to the problem because it causes a rise in REAL interest rates is a possible CONTRIBUTORY FACTOR – that’s all. It’s a bit of a technicality.

Might, can, could and may.

Anyway, moving on . . . on page 201 they say “there are a number of potential channels through which asset purchases might affect spending and inflation..”.

“Might”? That fills me with confidence about the whole QE idea.

A couple of sentences later they say, “Asset purchases may also have a stimulatory impact through their broader effects on expectations..”

“may also have”? My confidence that the BoE knows what it is doing grows by the minute.

Still on page 201 and under the heading “Portfolio balance effects”, they say, “Unless money is a perfect substitute for the assets sold, the sellers may attempt to rebalance their portfolios by buying other assets that are better substitutes…”

“may”? I’m even more convinced.

Next, (p.202) under the heading “Liquidity Premia Effects” they say, “When financial markets are dysfunctional, central bank asset purchases can improve market functioning by increasing liquidity through actively encouraging trading. Asset prices may therefore increase through lower premia for illiquidity.”

There’s a “can” AND A “may” in that passage. Two uncertainties for the price of one!

Next, under the heading “Confidence effects”, they say, “Asset purchases may have broader confidence effects..”

“may have”? Now this is getting silly.

Then under the heading “Bank Lending Effects” they say “A higher level of liquid assets could then encourage banks to extend more new loans..”

“Could”!! Well that makes a change from “may” and “might”. No – it’s worse than that: the idea that banks lend out reserves or that they are encouraged to lend when reserves are boosted is an idea that has attracted widespread criticism. E.g. see about one minute into this video clip:

We plebs and peasants always knew QE wouldn’t work.

I pointed out on this blog when QE was first mooted about two years ago that it wouldn’t have much effect. And for a more professional demolition of the whole idea, see here.

So what does work?

Well fantastic as it might seem, if consumers are given more money, guess what they do with it? Yep: they spend a significant proportion of it!!!!

Amazing that, isn’t it? The average mentally retarded six year old probably knows that. But there seem to be no end of academic economists and central bankers who can’t work that one out.

To be more exact, when the average consumer comes by an increase in income or a windfall, they spend anything between about a third and two thirds of it within about six months, plus they save between about a third and two thirds (depending on the exact nature of the windfall).

That’s what the empirical evidence shows. See here, here, here, or here.

No “maybes”, “mights”, “coulds” etc. The empirical evidence is quite clear.
But as I pointed out here, many academic economists are not too interested in reality.

And finally, I owe a hat tip to Neil Wilson for drawing my attention to the above BoE article.


Tuesday, 10 July 2012

U.K. banks spent £92m last year on lobbying politicians.

And employed 800 people to do the lobbying. See here and here.

Just when you thought banks’s depraved behaviour couldn’t get any worse.

Though on second thoughts you can't really blame banks: they recognise a sucker when they see one.


Monday, 9 July 2012

Reduce working hours as Germany has done?

Dean Baker recently advocated reduced working hours in The Guardian, and praised Germany for doing so.

I normally agree with Dean Baker, but not this time. The basic flaw in the hours reduction idea is thus.

The ultimate constraint on raising employment is the inflation that arises when unemployment drops to some level or other (which you could call “the economy being at capacity”, but I’ll call it NAIRU). That is, as employment rises, it becomes increasingly difficult for employers to find the labour they want from the ranks of the unemployed, so they resort to outbidding each other for “already employed” labour. And that means inflation.

That constraint probably does not apply at the moment in most countries. That is, employment at the moment in those countries could probably be increased by a straight rise in demand. So even if the NAIRU constraint does NOT APPLY, hours reduction is STILL NOT the best cure for the problem.

But assuming the NAIRU constraint DOES APPLY, a compulsory reduction in hours has NO EFFECT WHATEVER on the number or variety or quality of people making up the unemployed. There is thus NO INDUCEMENT WHATEVER for employers to abstain from bidding up the price of already employed labour or giving in more readily to union demands at that “capacity” or NAIRU employment level.

Thus hours reduction WOULD MAKE SENSE just at the moment for almost every country in the Eurozone APART FROM Germany. That is because those countries are stuck (thanks to the EZ) in a situation where they cannot raise demand.

But Germany, in contrast, CAN RAISE demand to the level where excess inflation becomes a serious possibility. Indeed, many have argued it should go even further and deliberately engineer a few years of excess inflation because, so the argument runs, that would help periphery countries (though I’ve got doubts there).

Ergo hours reduction for Germany makes no sense. It makes no sense for the U.S., U.K. or any other monetarily sovereign country. But it would make sense, to repeat, for most EZ countries other than Germany.


Wednesday, 4 July 2012

Full reserve and the Kotlikoff / Werner system.

Summary. Assume a pure fractional reserve banking system. Also assume the simplest and most extreme case of banking collapse: all banks go bust. In this scenario the money supply vanishes: not too clever.

In contrast, under FULL RESERVE, where deposits are taxpayer guaranteed that encourages the misuse of depositors’ money. Plus when all banks go bust, and assuming government reimburses all depositors, the money supply initially doubles which is liable to be inflationary, until that supply is withdrawn via tax. Also not too clever.

The best system is full reserve plus the “Kotlikoff / Werner” condition that where depositors let their bank use their money in a commercial fashion, and it all goes belly up, depositors lose their money.


Fractional reserve.

Take the simplest possible pure fractional reserve system. There is just one private bank with no assets or liabilities. It creates $P out of thin air and lends it to X to enable X to build a house. X pays the money to Y to build the house. The house turns out to be worthless. The words “Spain” and “Ireland" should spring to mind. That means X is bust. The bank is also bust, and Y’s money vanishes into thin air.

As Irving Fisher put it in his paper “100% Money and the Public Debt” (1936), “The most outstanding fact of the last depression is the destruction of eight billion dollars - over a third – of our “check-book money” - demand deposits.”

Full reserve plus taxpayer backing for deposits.

Take a second scenario: full reserve with taxpayer guarantees for depositors regardless of what use banks make of depositors’ money.

Initially the central bank / government spends $P into the economy, and that money ends up in the hands of A,B & C, and they deposit the money in the private bank, and the private bank in turn deposits that money at the central bank (private banks always keep their monetary base at the central bank).

As in the above fractional reserve example, X applies for a $P loan from the bank, and pays Y to build a house. The house again turns out to be worthless. And as in the above illustration, the private bank is bust. Or to be more accurate, the bank has $P at the central bank, but it owes $P to A,B & C, plus it owes $P to Y (i.e. the bank owes a total of £2P).

However, deposits are taxpayer guaranteed, so the government / central bank machine graciously gives $P to the private bank.

But that means the money supply has doubled.

Notice how we’ve had a ballooning of monetary base / reserves over the last three years?

Alternatively, government does NOT FULLY reimburse private banks: but that just leaves banks in a precarious position – ring any bells?

Full reserve with no taxpayer backing for all deposits.

Lawrence Kotlikoff and Richard Werner advocate banking systems which have in common the characteristic that depositors must decide how much of their money they want to be 100% safe, and how much they want their bank to use in a commercial fashion: that is lend on to businesses and mortgagors.

Incidentally, citing the above two individuals here should not be taken to imply their agreement with this post.

Anyway, forcing depositors to make that choice means that depositors will put money they are likely to need in the coming months into their safe accounts. While money which they think they won’t need and/or which they are prepared to risk will go into “risky” or “investment” accounts (under a Werner system), or into “non cash mutual funds” to use Kotlikoff terminology.

Let’s assume everything is the same as the illustration just above (except of course that there is no taxpayer backing for depositors’ money in investment accounts). I.e. the private bank lends to X, who pays Y with the house turning out to be worthless.

In this scenario, the private bank does not go bust: it is depositors, i.e. A, B & C who lose out.

There is not too much of a deflationary effect because A, B & C still have the money they intended spending in the near future (in their safe accounts).

There is no need to double the money supply.

It is true that something has disappeared: the investments made by A, B & C. However, the disappearance of an investment does not have anywhere near the same deflationary effect as the disappearance of the same amount of money: a fall in the value of the Dow Jones or FTSE does not influence the weekly spending habits of the wealthy by all that much.


I vote for the third option. That’s the full reserve plus making depositors decide how much of their money they want to be, 1, instant access, 100% safe, but not earning any / much interest, and 2, how much of their money they want to earn a significant amount of interest, while not being instant access and not 100% safe.

Tuesday, 3 July 2012

Lawrence Kotlikoff ridicules Vickers.

Quite right. See here.

The U.K.’s “Independent Commission on Banking” (often called the Vickers commission after the surname of its chairman) advocated a partial separation of High Street or retail banking from casino or investment banking.

As has been pointed about five hundred times by as many different individuals, that sort of separation, even if complete (a la Glass-Steagall) would not have stopped the credit crunch. Reason is that even if banks cannot use the money in grandma’s account for INVESTING, there are still plenty of silly things banks can do.

Look at Ireland and Spain. Banks there basically LENT TO property ventures, rather than actually invest or buy shares in property businesses. So Vickers would not have prevented the banking fiasco in Spain or Ireland.

In fact Vickers specifically allows banks to lend to any business (bar financial business) in Europe.


Sunday, 1 July 2012

Tim Worstall’s hopeless criticism of Krugman and Layard.

I’m much heartened by the response so far to the Krugman / Layard manifesto. That is, I’m heartened by the low quality of the criticism aimed at it.

First, there is a hopeless article by Tim Worstall in the Telegraph. Worstall is normally clued up on economics (and witty and sarcastic, which I like). But he went right of the rails in the Telegraph article.

He makes a very common mistake, namely claiming that deficits during recessions have to be matched by surpluses at other times. He argues further that since it is difficult to cut public spending or increase taxes (with a view to implementing surpluses), Keynsianism is fatally flawed.

Deficits never have matched surpluses!!!

As to the idea that deficits need to be matched by surpluses at other times, the first whapping great flaw in this idea is that deficits over the last century or so JUST HAVEN’T matched surpluses. I.e. it’s been a case of more or less constant deficits. For some figures, see here or here. It’s a sea of red ink!

And there is a simple and perfectly acceptable reason for this more or less constant deficit, which stems from the fact that we aim (I think rightly) for inflation of around 2%.

First, assume national debt (ND) and monetary base (MB) are to remain constant relative to GDP (which over the very long term is the actuality). For example UK national debt relative to GDP in 1900 was much the same as a century later: a bit under 50% of GDP.

Assume also that inflation is running at the target 2% rate. That means ND and MB will decline at 2% p.a. in real terms unless they are constantly topped up. And that topping up can only come from a deficit.

Moreover, there is economic growth in real terms to consider. If that’s running at say 2%, and assuming again that ND and MB are to remain constant relative to GDP, than requires even more “topping up”. Now that’s a fair amount of “topping up induced deficit” in total.

That explains why deficits during the last half century or so just haven’t matched surpluses at other times. It’s been a case of more or less constant deficits.

Bread and circuses.

As Worstall’s final point, namely that the plebs are always demanding more bread and circuses, i.e. more free goodies supplied by the state, while objecting to the increased taxes inevitably required to pay for the goodies, well that’s ALWAYS a problem. But the fact that the average citizen or voter lives to some extent in Alice in Wonderland is not a valid criticism of Keynes.

Moreover, Keynsian style deficits DO NOT NECESSARILY require increased public spending. A Keynsian deficit can perfectly well consist of reducing taxes rather than increasing public spending: a further nail in the Worstall coffin.

Josef Joffe

Another silly attack on Krugman and Layard appeared in a letter in the Financial Times from the editor of Die Zeit. (I thought Germans had brains!!).

Joffe employs about three hundred words to tell us he doesn’t understand where the money for the KL manifesto will come from. Well I’ve got news for Joffe.

The entire world now operates a fiat money system!!!! That’s a system under which banks, both central and private, can create money out of thin air.

Of course, as the massed ranks of economic illiterates never tire of reminding us, that ability to create money out of thin air has inflationary risks. But the historical reality is that for 95% of the time, responsible countries manage to keep inflation under reasonable control.

Keynsianism does have an inflationary bias. Keynsians are well aware of that. I’m not sure exactly what the alternative to Keynsianism is, but let’s call it a “gold standard / Austrian / do nothing” policy. And the problem with the latter is that it has a DEFLATIONARY bias: i.e. it gives us 1930s style decade long mass unemployment and human misery.

I prefer Keynsianism warts and all.