Some money is BOTH base AND broad.

Most people who have worked thru a basic introductory economics text book know that a nation’s stock of money can be split into an infinite number of categories. But one common categorisation involves splitting money supply into just two categories: base and broad.

Base money is central bank created money. Other names include “the monetary base” or “high powered money”. In contrast, there is broad money, i.e. commercial bank created money.

However, there is a small portion of the total money supply which is both base AND broad. This arises where a private sector non-bank entity purchases government debt. And this small portion of the money supply seems to give rise to a large amount of confusion: hence this post.

When a non-bank entity buys government debt, the central bank then owes the entity a debt. But non-bank entities cannot deal direct with central banks. So when the above purchase occurs, the arrangement the relevant parties end up with is: central bank owes a commercial bank a debt, and the commercial bank owes the above entity a debt.

Or as the Bank of England puts it, “When assets are purchased from non-banks . . . the banking sector gains both new reserves at the Bank of England and a corresponding increase in customer deposits.”

And in a different document, and in different words, the BoE says, “If the Bank of England purchases an asset from a non-bank company, it pays for the asset via the seller’s bank. It credits the reserve account of the seller’s bank with the funds, and the bank credits the account of the seller with a deposit. (Hat tip to Gillian Swanson for directing me to the above BoE articles.)

Money is of course a form of debt: a creditor / debtor relationship. And the creditor in that relationship can make someone else the creditor (for some or all of the debt). “Making someone else a creditor” is commonly known as “making a payment”.

The actual size of the above tranche of money that is both base and broad is normally insignificant. But it will have risen substantially as a result of QE. As far as I can see from U.S. figures, the size of this tranche is currently about the same as the total amount of physical cash in circulation ($100 bills, coins, etc).

.

Banks are inherently fraudulent institutions.

A bank, by definition, is an institution which undertakes to return $100 to depositors for every $100 deposited. Or to be strictly accurate, it undertakes to return $100 possibly plus some interest and possibly less some expenses. However the two latter are small compared to the capital sum: about 5% of the capital sum per year at most.

In contrast to guaranteeing to return $100 for every $100 deposited, investment and lending are risky activities. If you “invest” in the stock exchange, or in your own business or the business of a friend or relative, you might double your money or lose the lot.

Thus the phrase “investment banking” is blatant self-contradiction: it’s fraudulent. Or rather it’s an attempt to fool depositors: it’s an attempt to persuade them they can be guaranteed to have their $100 back, at the same time as reaping the rewards of engaging in commerce: making an investment that might involve the $100 disappearing. And normal banking or retail banking isn’t much better.

And who pays for the above fraud or charade? Well, it’s the taxpayer.

Unit trusts and mutual funds don’t make the above absurd promise about returning $100 per $100 deposited, so why should banks be allowed to make this promise?


Fooling politicians and everyone else.

The word bank, and in particular the phrase “investment bank”, are also attempts to fool politicians. Those are the folk who are supposedly the guardians of taxpayers’ money, but who in fact are easily fooled into parting with taxpayers’ money.

That is, ever since banks first appeared on planet Earth, bankers have persuaded politicians that the banking system cannot be allowed to fail, thus taxpayers’ money must stand behind banks, including investment banks.


Ban bank lending?

So the logical course of action would seem to be to certainly ban banks from investing, but also to ban them from lending. However there is an apparent problem there, or rather there is an alleged problem which most bankers know perfectly well is not a problem at all. It’s a pseudo problem which politicians can easily be made to fall for. And it’s the alleged fact that if banks don’t lend, that constrains economic activity. Or it constrains growth. And banks are very concerned about growth: you can tell that from the fact that they’ve done about as much for growth over the last five years as was done for the economic growth of Hiroshima and Nagasaki by the atomic weapons dropped there.

Now obviously, all else equal, if banks stop lending, that constrains economic activity. That is, if those with money to spare cannot invest their money via one of those fraudulent institutions we call “banks”, then less investment or lending takes place. (Those with money to spare can still of course invest via other entities: the stock exchange, unit trusts, mutual funds, etc).

But the above assumption that all else needs to be equal is of course total nonsense. That is, the deflationary effect of preventing banks from investing or lending can easily be compensated for by increasing the money supply.


Those Austrians, yawn, yawn.

Now the knee jerk reaction of Austrians and other simpletons to the phrase “increase the money supply” is entirely predictable: they’ll start chanting “Weimar”, “Mugabwe”, “inflation”, etc. However (to repeat the point for the benefit of simpletons) the above money supply increase won’t be inflationary as along as the stimulatory / inflationary effect equals the DEFLATIONARY effect of stopping banks engaging in investing or lending.

Another factor that contributes to the reluctance to constrain, if not ban bank lending is the popular perception that money in a bank somehow represents real wealth; and that failure to invest this money means real wealth lying idle. Most politicians suffer from this delusion, and even those sitting on Britain’s recent investigation into banking, the Vickers commission, suffered from the delusion.

The truth is that money in banks is nothing more than a series of book keeping entries (or if you like, numbers in computers). Money is nothing more than a claim to resources. It is not “resources” as such. It does not equal real investment in the same sense as a house or factory is a real investment.


Back where we started?

Now it might seem that if we ban investment and/or lending by banks and compensate for that by increasing the money supply, that we’re back where we started.

Well we certainly OUGHT to be back where we started in that GDP would be back to where it started. But we wouldn’t be back where we started in a very important sense: taxpayers would no longer be underwriting commercial activity. That is, taxpayers would no longer stand behind investments or loans made by banks.

In fact, if the cross subsidisation of banks and depositors by taxpayers is banned, then GDP ought to RISE, all else equal.


Taxpayers SHOULD stand behind genuine savings accounts.

In contrast to investing, having access to an account which is 100% safe is arguably a basic human right. Possibly this sort of account should be run by the state. Or possibly banks should be allowed to run this type of account, with state backing, but with very strict limits on what can be done with the money.

Even investing in government stock is questionable because such stock can rise or fall in value. Personally I’d allow nothing to be done with the money other than lodging it at the central bank.


Basle plonkers.

Of course an alternative way to ensure bank safety is to ensure adequate bank capital. That supposedly means that when a bank has an unusual run of bad luck or incompetence with its investments or loans, depositors’ money is still safe.
But the problem there is the people framing rules on capital adequacy are manifestly incompetent, plus they are wide open to regulatory capture. According to Mervyn King, the best capitalised bank in the UK according to Basle II rules three months before the collapse of Northern Rock was . . . . have a guess . . . . wait for it . . . Northern Rock.


Conclusion.

The best solution is just to ban institutions which promise to repay $100 for every $100 deposited from investing or lending.


.

Banks aren’t lending to SMEs – boo hoo.

British politicians have over the last year or so been worrying about the reluctance of banks to lend to small and medium size enterprises (SMEs). I criticised politicians for this concern about a year ago here. It’s time to make some additional points on this topic.

In addition to politicians, Positive Money makes much of the fact that banks lend primarily to those purchasing property while failing to fund SMEs and socially desirable stuff like infrastructure. (Incidentally, I support Positive Money, but disagree with them on a few points.)

Investments made primarily or partially because of their social desirability are dead loss from the strictly commercial point of view (at least that’s certainly the case with the National Health Service and state education). Given that banks undertake to repay depositors about £100 for every £100 deposited, it is a BLATANT SELF-CONTRADICTION to expect banks to invest in loss makers. (To be more accurate, banks undertake to repay the original £100 possibly plus interest and possibly less expenses.)

As regards SMEs, much the same point applies: it is a SELF-CONTRADICTION to ask an institution to guarantee to return £100 per £100 deposited AND take significant risks.
In contrast, for those who want to take a risk, there are plenty of options: i) the stock exchange, ii) start your own business, iii) help a friend or relative with their business, iv) bet on a horse.

Banks INEVITABLY go for safe investments, like property. And even property has not proved safe enough over the last five years.

Frances Coppola makes a good job of attacking the “banks must lend more to SMEs” argument.

As pointed out above, it is fundamentally silly to expect an institution which guarantees to return money to depositors to take risks. But of course the way we’ve solved this problem so far is to have government guarantee banks. And for the naïve, that seems to solve the problem: banks can take risks while depositors’ money is safe. Problem is that that just means taxpayers are subsidising commerce. And it’s not the taxpayer’s job to do this.

A vastly more intelligent and logical solution to the above safety / risk conundrum is to make depositors come clean: that is, force them to decide between safety and risk taking. Put another way, depositors need to be prevented from having their cake and eating it (enjoying the rewards of risk without actually taking any risk).

And that can be done via the “two account” system advocated by Positive Money and others in their joint submission to the Vickers commission. (See “Step 1”, p.7, here.)

The two account system enables a depositor to EXPLICITLY allow the depositor’s bank to take a risk with their money. The benefit for the depositor is a better rate of interest. The drawback is that this is COMMERCE, and there is no obligation on taxpayers to rescue those who take commercial risks if everything goes belly up. That is, under the two account system, depositors who explicitly let their bank take a risk with their money do not get their money back, or don’t get all of it back, if everything goes belly up.

That two account system might result in far more money being allocated to SMEs than politicians wittering on about the subject.


Is more alcohol the solution to alcoholism?

Another fundamental absurdity in politicians’ concern about bank lending to SMEs is that we’ve just had a credit crunch caused by excessive and irresponsible borrowing (in case you hadn’t noticed). And the solution adopted by the authorities? Well it’s to cut interest rates so as to encourage more lending and borrowing. You just couldn’t make it up.

In particular, having lent irresponsibly, banks have learned their lesson. They’re more cautious about lending. Politicians, it seems, have not learned any lessons. Politicians think the solution for excessive lending and borrowing is yet more lending (to SMEs in particular).

Presumably politicians think the cure for alcoholism is to supply alcoholics with yet more alcohol. And the cure for someone with a broken leg? Presumably it’s to break the other leg.


Lenders need specialist knowledge.

Lending to an SME ideally involves a detailed knowledge of the particular business the SME is in. And the average British bank manager just does not have that knowledge. Thus loans to, or investments to SMEs will inevitably tend to come from specialist lenders: not bog standard high street banks.

For example, Siemens has set up a bank. Siemens clearly has a detailed knowledge of the business it is in.

As this Financial Times article put it, “Siemens often acts an anchor lender, prompting other banks to participate as they presume that the engineering group is better placed to judge the technological risks of a project.”


Less lending constrains economic growth?

A popular argument put by economic illiterates (aka politicians) is that less lending means less economic growth. This is also an argument put by banks when lobbying for less bank regulation. And politicians fall for the argument every time.

Well is blindingly obvious that less lending means less growth ALL ELSE EQUAL. But of course there is no need for all else to be equal. That is, given less lending, demand and growth can perfectly well be boosted by boosting plain simple old consumer spending and/or increased public spending.

That boosts firms’ order books, and for what it is worth, there is nothing that potential lenders like more than a firm with a full order book.

.

If the market can’t allocate the unemployed to jobs, why not have the bureaucracy do it?

In a perfect market, a surplus of people with a given set of skills and experience (i.e. a particular “type” of labour) would cause a drop in the wage for that type of labour. The market would clear, and all members of that type of labour would find employment. So given a perfect market, there’d be no unemployment.

At least that would be the case assuming there is nothing of a macro-economic nature preventing full employment. E.g. let’s assume the above wage cuts result in instantaneous price cuts, which increases the value of the monetary base and national debt. That in turn means a rise in value of private sector net financial assets, which in turn raises aggregate demand. (That’s the “Pigou” effect.)

So perfect market = full employment. Imperfect market = unemployment. That’s the problem. Now for the solution – well, an improvement on the current situation anyway.


The market and the bureaucracy.

There are two ways of allocating economic resources: allocation by the market and allocation by the bureaucracy. Since the market can’t allocate the unemployed, what system should the bureaucracy adopt in order to do the allocation? How about this.

Assume that given a decline in unemployment, every employer would expand numbers employed in the same proportion. That is a crude assumption. But it’s very roughly correct.

So assuming the objective is to expand numbers employed by each employer in the same proportion, employers need to be told, “You can expand your payroll by X%, and the additional employers will be free. Moreover, this is something you really ought to do because your competitors will probably be doing it, which will cut their unit costs. I.e. if you don’t do likewise, your competitiveness will decline.”

Hey presto: unemployment falls.

Well that’s the theory. Now for the possible problems.


Would the free employees displace regular employees?

Obviously it’s impossible to guarantee that out of the millions of employers in the country there would never be an instance of regular employees being displaced.

But the more important point is to consider the main “overall” or macroeconomic effects. And the important point here is that the above mentioned rise in aggregate demand would mean that OVERALL, there’d be no net displacement. That is, on balance, there’d be a net rise in numbers employed. (Incidentally, in the real world, there’d be no need to rely on the Pigou effect: governments can of course raise aggregate demand whenever they want).

Moreover, there are several measures that can be taken to dissuade employers from using free employees as substitutes for fully viable employees. For example if the time that a given free employee stays with a given employer is limited to a few months, that induces employers to claim the subsidy only in respect of their LEAST PRODUCTIVE employees: no employer wants to lose their MORE PRODUCTIVE employees.


And finally.

And finally, smart readers will have noticed that the above system comes to the same thing as a “Government as Employer of Last Resort” system, of a particular type. It’s an ELR system under which the unemployed are allocated to EXISTING employers, public and private, rather than allocating them to SPECIALLY SET UP EMPLOYERS doing just public sector type work (which is what the WPA and numerous other ELR systems have consisted of).

In other words, the above is a piece of theory which underpins the idea: “allocate ELR employees to existing employers, public and private.”

Obama boasts about having cut government spending during the recession.

I realised long ago that governments are economically illiterate. But it’s worse than that: seems they’re actually economically mad.

According to TPM Livewire, the transcript of one of Obama’s speeches reads, “It’s worth noting, by the way – this is just a little aside – after there was a recession under Ronald Reagan, government employment went way up. It went up after the recessions under the first George Bush and the second George Bush. So each time there was a recession with a Republican president, we compensated by making sure that government didn’t see a drastic reduction in employment. The only time government employment has gone down during a recession has been under me. So I make that point just so you don’t buy into this whole bloated government argument that you’re hearing.”

.

Mervyn King and the economics profession need to study the Tinbergen principle.

Mervyn King said in a recent speech that inflation was well under control prior to the crunch. See paragraph beginning “Let me start…”. That is pretty much correct. It is true that in the early 2000s inflation was definitely below the 2% target, while just before the crunch it was a bit over the target (3% at most). But certainly, King is more or less right: inflation was under control.

But that raises a dilemma. Had the excessive borrowing taking place prior to the crunch been reined in with higher interest rates, that would arguably have brought an unnecessary dose of deflation.

At least for those not acquainted with the ideas put by the economics Nobel laureate, Jan Tinbergen, there seems to be a dilemma.


The Tinbergen principle comes to the rescue.

The Tinbergen principle states that for each policy objective, at least one policy instrument is needed. Personally I don’t like that formulation. I’d re-phrase the Tinbergen principle thus: for each policy objective, there is a policy instrument best suited to meeting each objective.

Anyway, the obvious way to deal with excessive borrowing is to raise the price of borrowing, i.e. raise interest rates. And assuming that is correct, it follows from the Tinbergen principle that the best way of adjusting demand must be SOMETHING ELSE.

And indeed, there is very simple and different way of adjusting demand: have government create new money and spend it (and/or cut taxes). Or conversely, given a need to rein in demand, government can do the opposite: raise taxes and “unprint” the money collected.

Had interest rates been raised prior to the crunch, at the same time as implementing the right amount of “print and spend”, borrowing would have been reduced, while overall demand would have remained constant. That is, demand would have shifted FROM attempts to purchase more and bigger houses TOWARDS other consumer items (and/or increased public spending).

Indeed, under a full reserve banking system where demand is adjusted JUST BY the above “print/unprint” policy, interest rates would rise AUTOMATICALLY given a surge in attempts by households (or anyone else) to borrow more.


Objections.

The reaction of some of those who accept the conventional text book description as to how the banking system works will be to claim that the above “print and spend” policy would raise bank reserves, which in turn would reduce interest rates and ENCOURAGE lending.

The answer to that is that the above conventional text book description is wrong (as is now widely accepted). That is, banks and their lending activities are capital constrained, not reserved constrained.

For some literature on the latter point, Google something like “banks capital constrained reserve”.

I listed a good ten or so reasons here as to why using interest rates to control demand is not a brilliant idea here. The above “dilemma” is yet another reason to add to the list.

Another possible objection to the above “raise rates and print” policy is thus. Central banks cut interest rates by buying government debt. That puts cash or monetary base into the hands of the private sector, which in turn reduces rates. However, the above “raise rates and print” policy WOULD ALSO put cash into the hands of the private sector – which would on the face of it reduce rates.

The answer to that is that there is big difference between putting monetary base into the hands of would be lenders (former Gilt holders), and putting monetary base into the hands of the average household. In the latter instance, a smaller proportion of the new money will be lent.

___________

P.S. (same day). Hat tip: I learned about Mervyn King’s speech from Frances Coppola’s blog. She also comments on his speech.



.

Benjamin Franklin’s arguments for increasing America’s money supply.

In 1729 Benjamin Franklin wrote a 6,500 word article advocating an increase in America’s money supply. I’ve done a 700 word summary below. (I learned about Franklin’s article from Mike Norman’s blog.)


Ultra brief summary.

Basically, Franklin argues that a shortage of money leads to a semi-barter economy, which is inefficient. And he argues for money to be created in the form of bills of exchange with land being the collateral that backs such bills. Interestingly, he is aware of the Real Bills doctrine (or the idea behind it) namely that banks will only issue an amount of money or bills that the rest of the private sector actually wants or needs to do business, etc.


This summary is not 100% accurate.

I don’t guarantee the summary is entirely accurate, particularly as there are some convoluted passages I don’t understand. But hopefully the summary will give a flavour of Franklin’s arguments. In fact Franklin himself pleads for similar indulgence. He says, “As this Essay is wrote and published in Haste, and the Subject in itself intricate, I hope I shall be censured with Candour, if, for want of Time carefully to revise what I have written, in some Places I should appear to have expressed myself too obscurely, and in others am liable to Objections I did not foresee.”


700 word summary.

Franklin starts with four points, after which he lists another four points relating the SORT OF PEOPLE likely to favour and oppose a money supply increase. I’ll take all his points in turn including the above eight. I’ve put MY COMMENTS on Franklin’s ideas in brackets.

First, he claims that a shortage of money results in a high interest rate. And trade is discouraged because those with money will tend to lend it out at interest rather than invest in a business. As distinct from businesses in general, Franklin is particularly concerned about the price of land, and thinks that a high price for land is desirable because it encourages husbandry.

(Strikes me that a shortage of money will result in people paying a high price to borrow MONEY, but I see no reason it would result in a high price (in terms of person hours) to borrow anything else. A country that is short of money is a semi-barter economy. Trade is discouraged in that barter is inefficient, but not because of the “high price” of business assets.)

Second, Franklin claims an increase in the money supply has encouraged ship building.
(I expect he is right: I would expect more money to encourage specialisation, e.g. in shipbuilding.)

Third, a lack of money induces would be immigrants to migrate to countries with more money. This is a problem when those potential immigrants are what Franklin calls “Labouring and Handicrafts Men, which are the chief Strength and Support of a People”.

Fourth, lack of money encourages the consumption of European goods. Plus it encourages employers to pay their employees partially in kind rather than in cash (which is what you’d expect in a semi-barter economy).


The sort of people likely to favour and oppose a money supply increase.

1, Those currently engaged in money lending.
2. Those currently in possession of plenty of money, even if they don’t engage in money lending.
3. “Lawyers, and others concerned in Court Business.” The reason Franklin gives is that the legal business results in people going into debt (presumably to pay fines, etc).
4. Dependents on and friends of the above three.
In contrast, traders and manufacturers will favour a money supply increase.
Franklin then considers whether a money supply increase will debase the value of money, and he starts by pointing out that barter is inefficient. He then points out that gold and silver have often been used as money. But the value of precious metals varies. Franklin claims the value of silver in terms of person-hours shrank to a sixth is former value after large quantities of gold and silver were transported to Europe by Spaniards from mines in central America.

He then considers bills of exchange and points out their convenience.

Then he argues for bills based on land. He says, “For as Bills issued upon Money Security are Money, so Bills issued upon Land, are in Effect Coined Land.” Plus he points out that with America’s population rising, the value of land should continue to rise so there is minimal danger of the value of the collateral declining.

He gets the point that more than one factor gives money its value. He says, “Money as Bullion, or as Land, is valuable by so much Labour as it costs to procure that Bullion or Land. Money, as a Currency, has an Additional Value by so much Time and Labour as it saves in the Exchange of Commodities.”

In the paragraph starting “From these considerations” he doesn’t seem to think that an excess money supply leads to inflation. He does not give any good reasons in this paragraph. The really good reason comes in the next paragraph…..

In the paragraph starting “If it should be objected…” he gets the point that the population will only “coin land” (i.e. demand money) to the extent that money is needed in order to do business. This is essentially the “Real Bills Doctrine”.

.