wall st crisis
14 Oct 2008
Why Are We Captive To Wall Street?
The way banks work means their problems become ours too. But does it have to be this way? Geoff Davies thinks not
The other day a colleague told me that his chooks are still laying eggs. They don't care about the financial markets, they just get on with chook business as usual.
There's a key question hiding in this remark that ordinary people with average levels of financial understanding are asking themselves. Why can't we just get on with our daily business as usual? Why are the stupidities of some Wall Street cowboys threatening to bring the world's routine daily business to a halt?
Certainly the answer involves greed, some naughty CEOs, a lot of stupid people who bought impenetrable junk mortgage packages, deregulation, people who gambled with lots of other people's money, irrational exuberance, fear, panic and all the rest of the diagnoses being tossed around. But those factors still don't explain why the whole innocently bystanding world is suddenly threatened with a depression.
Hardly anybody is talking about the big magnifying destabiliser at the core of our economic system. Whatever trend is happening, it will magnify it. Worse, it will ensure that trends in so-called investment markets will spill over into daily business, so if the investment markets crash, Main Street burns too.
The magnifier is called fractional reserve banking. Banks must have in their "reserve" funds at least, say, 10 per cent of the amount that they have loaned out. That's to cover the needs of people who want to withdraw their deposits in the course of normal business. That sounds sensible, but the flip side of it is that banks can loan out ten times as much money as they have.
How can banks loan out more money than they have? By creating new money out of nothing. That's right, Virginia, out of nothing. That's where most of our money comes from.
When times are good the fractional reserve magnifier can cause the amount of money in circulation to keep expanding under its own impetus. For example, loans to buy houses can generate more deposits, more loans and more money to bid up the price of houses, and you get a housing-price bubble. Sound familiar?
The big danger in the fractional reserve system is that if a bank's loans go bad it may have to dip into its reserves to cover losses, and that means trouble. For every dollar of reserves it uses, it has to reduce its loans by $10. That's the magnifier at work. It means other borrowers may suffer. It also means there will be a sudden drop in the amount of money in circulation, and that's the part that may hurt you and me.
If levels of debt have outrun the ability of the real, productive economy to generate wealth, then any bad loan may trigger a chain reaction. The failure of a big loan may cascade into the failure of many more. If enough loans go bad a bank may fail. Because banks rely on huge loans from each other to stay solvent, if one bank fails, other banks are put at risk. The conflagration spreads.
In the Great Depression the financial markets collapsed, the money supply shrank and prices fell (that's deflation - if you want to really scare an economist, sneak up behind him or her and whisper "Deflation.."). As prices fell, anyone who had money hoarded it, so even less was in circulation and the plunge steepened. Confidence collapsed, businesses failed, all the other destabilisers in our pathological economic system switched into reverse and brought everything crashing down with them.
A sensible economic system would have mechanisms that acted against fear, stupidity and bad luck. In other words the system would be designed to be stable in presence of our human foibles, instead of magnifying their effects.
I suspect most economists don't understand this concept. Engineers and physicists understand that dynamical systems are destabilised by positive feedbacks and stabilised by negative feedbacks, but the neoclassical theory is about equilibrium. It cultivates a static view of the world. Economists don't seem to have such dynamical concepts in their mental armoury.
In 1932 a small town in Austria issued a different kind of money. You had to put a four-cent stamp on each dollar every month for it to keep its value. In effect its value steadily shrank. Sounds crazy, but it circulated 12 times faster than the national currency because of course no-one wanted to be holding much at the end of the month. People even paid their local taxes ahead of schedule.
Because it circulated rapidly, the shrinking money facilitated a lot of exchange, and that was what people desperately needed in the depth of the Depression. Worldwide, there was plenty of work to be done, and plenty of people wanting to do the work. What they lacked was enough reliable currency to facilitate the exchanges involved. After a year the town lifted itself out of depression and was attracting a lot of attention, until the Austrian central bank outlawed the shrinking money.
For some reason economists regard this as a very disreputable subject. They don't want to hear about it, they don't want to look at it, they don't want to be seen anywhere near it. It's true there were some rabble-rousing campaigners for monetary reform in the 1930s, but I suspect economists are just afraid of what they might see if they look. They might find some of their most cherished beliefs challenged.
A great virtue of such shrinking money is that its supply is stable and independent of the investment process. It doesn't depend on the fractional reserve multiplier to supply money, nor risk the collapse of the money supply if investments fail.
You might be thinking investment would not be possible in such a system because no-one would ever save. But saving can be achieved by buying things of real present value. When you want to invest you can convert those things back into money as you need it to build your factory or whatever.
In its mythical form, capitalism is supposed to invest surplus wealth in new wealth-generating enterprises, but our present system doesn't run on savings, it runs on borrowings. Increasingly the borrowings are not from other peoples' savings, but from the future, because that's what you're doing when you create new money. That's why we're drowning in debt.
Instead of saving from the past and giving a gift to the future (that's us and our children), we borrow from the future, incur great risks, and threaten our children with ruin. A savings-based system avoids the instability of borrowing from the future. Funds that are used at present to pay off debt would flow into savings instead.
Under such a system you could still borrow from the future (as you do when you use unsecured credit with your credit card), but such borrowing should be tightly controlled, restricted to situations where it's really needed (such as poor countries) and carefully insured by asset-rich insurance companies.
Perhaps the chooks aren't so stupid. They get on with the business of producing real wealth (eggs) instead of playing clever and deceitful games with pieces of paper and blips in computers.
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I’m sorry why does everyone on the left of economists completely forget about the money supply and inflation problems of the 70s? No it wasn’t just the oil shock either.
Markets are, and will always be the best way to control money supply.
If you want to talk regulation. lets talk regulation.
Laws about minimum bank and company capitalisation would be a good way to start. Laws to limit the trade of assets whose value are not easily determinable would also be useful, like OTC derivatives. Limit short selling. Limit hedge funds. Ban 100% capital loans.
I’d like to see a tax break for small investers who attend and/or vote in AGMs. Something simple to reduce capitalism without democracy, governance and responsibility.
But seriously, can the left stop getting excited about a return to heavy government control of money supply or price/wage fixing. It’s not gonna happen and nor should it.
Luke, I am not a socialist, I said nothing about wage/price fixing, I did mention regulation and so did you, so it would be helpful to leave out the irrelevancies. Nor am I "everyone" to your "left".
Yes, inflation needs to be watched. The alternative system I mentioned makes it much easier to control inflation because the money supply can be much more directly managed. And it’s still a market-based system.
One of the great ironies of modern so-called free-market economies is that their money supplies are (very poorly) centrally managed by a tiny handful of men.
What about the recent huge inflation of house prices, which is not counted in official inflation figures but which we punters know has eroded our purchasing power? In the seventies there was another blowout of the money supply - see Steve Keen’s website.
There is no basis, in theory or practice, to expect that free markets will necessarily regulate anything (see my book), as is currently being spectacularly demonstrated. Sorry to demolish 130 years of neoclassicism. Open up to some wider possibilities, beyond the stale old false dichotomy of socialism versus same-old capitalism. By being a bit smarter about it we could get markets to behave more like they’re claimed to, but clearly don’t.
"After a year the town lifted itself out of depression and was attracting a lot of attention, until the Austrian central bank outlawed the shrinking money." - indeed, whether it is the cost of money, the quantity or even the velocity of money, Central Bankers, like Casino bosses, jealously guard their apparent Holy right to dictate all things monetary.
"Banks" and more importantly our "Central Banking system" will outlaw anything which threatens their existence and what more appropriate time than right now to examine why we permit Central Bankers such power and authority over our lives that even Popes and Emperors never wielded?
Could it be that people are really not aware how powerful these bankers really are? How powerful must you be to dictate to an entire planet what they may or may not use as "money" and to outlaw all trade, enterprise or employment outside of their paper system?
I put it to you that an entire platoon of Popes and Emperors would not have dared.
And yet here we are again, Great Depression II and the score is 2-0 to the bankers - again.
Geoff Davies, your reference to velocity is interesting but have you read Prof Aantal Fekete’s alternative take that the causes of this credit crisis have been misdiagnosed such that the remedies being applied results in a prognosis which differs entirely from most of what we are hearing from the "mainstream" today?
Fekete refers to "liquidation value of debt" which he claims rises as rates of interest fall. This rising "liquidation value" during periods of falling interest rates destroys bank capital which he claims has gone unnoticed until now when there is suddenly no further capital left to dissipate.
Well worth reading as an alternative point of view.
Great article, thanks Geoff!
GV
I’m all for saving, like saving one’s virginity for marriage, saving for a rainy day. Saving pennies and letting the pounds look after themselves?
Just one question?
How does one ever own their own home, or own business or even first car? Unless you inherit them.
Obviously when there are only 4 banks, the same money is being lent over and over again, and it circulates around and around.
A bit like when you have a prang in your car and the other party is with the same insurance co, who cares then whose at fault?
It’s obvious the money does’nt actually change hands.
The thicker and weightier contracts from banks have taken over from the paper money. In fact they are rivalling the gold bricks that are buried in vaults somewhere and remain entombed for posterity. The deeds are more and more complicated.
Say I buy your house, and we’re both with the commonwealth bank, then the money comes out of my CBA cyberspace account and goes into your cba cyberspace account. What has actually changed from the bank’s viewpoint…nothing.
So the future fund now is going to bail out the filthy rich.
Meanwhile we are still going to get screwed with little more than a blessing from the acountant to remember to wear our rubbers.
The banks will do their over due, due dilligence, over-dilligantly , and guess how many ways we get to pay for it.
Ah, A loan from the bank, the penalty you pay and pay and pay…and………………..
God help us all,
Oli
Geoff, sorry, the previous post went through before I could edit and I wanted to ask whether your example of "cancelling" currency as it circulates alludes to the various systems being proposed these days where currency is brought into existence with the introduction of certain commodities such as oil or carbon credits and where they "cancel" or "extinguish" once the commodity is consumed?
GV
Geoff,
how is mandating that a currency depreciate not a price control/fix?
I don’t see the current crises as a failure of markets, I see it as a demonstration that completely unregulated markets will lead to intolerable social fallout. The market mechanism in itself has done it’s job in my opinion. It’s just that we, and me included would prefer that ‘doing it’s job’ doesn’t have such dire consequences.
so, we should regulate. But not mess with supply and demand, especially for money. ( I don’t believe you can compare your idea Geoff, to say, a rule on minimum capitalisation and lending standards. They aren’t the same thing)
Of course markets aren’t going to self regulate if regulate equals preventing market failure and upholding any social values - that is inevitable, no need to convince me there Geoff - What they will do is efficiently move money to productive assets most of the time.
The risk accrued whilst doing so and the sectors from which we decide no failure is acceptable and therefore fix prices and supply (education, health, social safety net etc), can all be managed by us as a society through regulation, and to some extent, more citizen awareness in their economic actions.
I certainly don’t think the market can EVER deliver the above paragraph on its own. That’s economic rationalism, and I hope this crises sees the end of it.
This process of using free supply and demand will sometimes fail, but the definition of that ‘failure’ can be completely tolerable in my opinion as long as the failure only extends to those aspects of life of which to do without, or do harder, is socially tolerable.
The reward is greater prosperity over the long run.
"Why are we all captive to Wall Street?"
Why indeed. Sure, we can be "captives of" Wall St and "captivated by" Wall St, but to be "captive to" something… now that’s got me asking a more existential set of questions.
But let’s just put basic sentence structure to the side for one minute. We can hardly expect such a timely article to be proof read. And timely it is.
Mr Davies, not surprisingly a scholar of depression era Austrian history, has kindly offered us another "engineering-based" final solution - this time he’s offered to exercise our financial demon: the dreaded fractional reserve lending system.
Apparently the existing system has a logical flaw in that economists cannot grasp. Mr Davies informs that economists "don’t understand" feedback loops and their paranoia about deflation makes them blind to advocating counter cyclical policies. I wonder if Mr Davies is familiar with the "mental armoury" of one J.M.Keynes? If memory serves me correctly (readers should note that I did read Keynes as an undergraduate a long, long time ago in a university far, far away) Mr Keynes seemed quite concerned with government being the instigator counter-cyclical policy in order to stabilise the naturally unstable economy.
This crisis has nothing to do with the logic of the fractional reserve system. It is the result of the logical flaw associated with the ‘credit default swap.’ The CDS has been the bedrock of a fraud committed by what can only be described as a global ponzi finance scheme. A fraud predicated on dodgy asset valuations that are themselves the result of a systemic and absolutist government philosophy of minimal oversight.
“Money is to be the servant of man, and I protest all theories that enthrone money and debase mankind.” - J M Keynes
This crisis has everything to do with the fractional reserve system, after all, a CDS and a banknote printed by a Central Bank are identical financial instruments in every respect save one, which is that the state guarantees the banknote and AIG guarantees the CDS.
Both are frauds in that both are ponzi schemes and we do not need additional regulation to prevent what would amount to fraud if any citizen or taxpayer were to participate in such schemes in the absence of a monopoly granted by the state to commit these frauds unhindered by fear of prosecution.
The "mental armoury" of Keynes? Which armour, Keyenesian theories stand naked before this spotlight which is the global credit crisis and modern Keynesian views on this crisis are identical to the kind of fallacy-driven central planning which turned the downturn of 1929 into the Great Depression.
Are we really in the process of repeating those same foolish mistakes a mere 80 years later?
Bob Karmin, just to be clear, my criticism is of neoclassical economics and its derivatives - economic rationalism, market fundamentalism, neoliberalism, it goes by various names. I agree Keynes understood something about feedback (and the policies that carry his name are now suddenly back in fashion). However I also think we explore new options.
Rogerio, loosen up. Management of markets does not imply Stalinist central planning. There are many levels at which markets can be managed. As I said to Luke, we can move beyond the stale old socialist/capitalist false dichotomy.
Luke, at present the interest rate is dictated centrally. The depreciation rate on shrinking money is analogous, though its dynamical effect in markets plays out differently.
All: The assumptions on which the neoclassical prediction of a general equilibrium is based are absurdly unrealistic, and if you change them you predict complex self-organisation, a very different kind of behaviour. Evidence for disequilibrium is everywhere - turn on you radio and you’ll hear more coming in by the hour. Those who just want to proclaim the infallibility of unfettered markets need to do some homework.
I don’t see anything wrong with borrowing from the future, per se.
This crisis has arisen because people have been unwilling to borrow from the future. What do you think a credit default swap is supposed to give you? It’s supposed to give you a insurance policy against things turning sour, presumably ‘in the future’. Banks have written loans with the understanding that they are not borrowing from the future.
Borrowing from the future is inherently risky. You can’t get rid of that risk through the prohibition of the fractional reserve system. Just like the financial wizard of Wall Street couldn’t get rid of the risk by ‘spreading it around.’
The only thing that can go someway to mitigating excessive risk taking by lenders (and therein lies the problem) is more transparency, more oversight and a an onus on reflexivity in regulation.
Well I am "loose" enough to admit that I am comfortable with the "stale old socialist/capitalist false dichotomy". In fact I am so "loose" I would happily settle for either, just so long as nobody tries to overdose me with one or the other. I’m easy, really, I honestly am.
I did challenge Bob Karmin’s claim that this crisis has nothing to do with "the logic of the fractional reserve system" though, but if that is going to get everyone all huffy I’ll gladly withdraw my comment and quietly take to wondering whether anarchy is not perhaps the answer to it all.
In fact, I won’t even question Bob’s peculiar urge to borrow from the future.
Why all this talk about stuffy old dead men like Keynes anyway, what is wrong with exciting young economists like Jörg Guido Hülsmann or rabbi Israel Kirzner?
Geoff,
I think you and I probably see a lot more eye to eye than is apparent.
I guess it’s just my opinion that regulation which targets social risk in the inevitable disequilibrium of markets is preferable attempting to completely change the functioning of that market and somehow eliminate the disequilibrium.
I believe this because:
- disequilibrium can be made socially tolerable and is worth ‘tolerating’ because of the immense dynamic efficiency of those times when the market is functioning.
- Models which try to supplant disequilibrium are usually flawed in that they do not have any empirical evidence of the behavioral/psychological element..where as what they are disproving, general equilibrium, is happening right in front of us, so we don’t have to theorize as much.
In the final analysis, the current stock of theoretical and quantitative thought found popular in the west has become so rigidly institutionalised that new tools and concepts for economic analysis are avoided even when it remains glaringly obvious that existing ones are clearly inadequate.
Nowhere has this been more evident than in the cultist popularity granted to the ideas of Keynes throughout the last century.
Transitional economics requires a flexibility and a maturity which the western world, and in particular the Anglo nations of the Western world, no longer possesses.
Evidence of this is obvious from any comparative study of modern economic development and thought in China, in eastern Europe and the former Soviet Union where the process of economic reform is being done in careful steps.
It is noteworthy how western nations fail to recognise that their economic institutions, and in particular their monetary institutions, have become too rigid and inarticulate to deal with the needs of the 21st century as we deliver to the global economy yet another financial crisis of disastrous proportions but which China and Russia may ironically survive with little damage.
During a visit to China about a year or two ago Fed Chairman Bernanke and Secretary Paulson concluded an unsuccessful series of meetings with Chinese officials by attending a banquet where both Bernanke and Paulson conveyed the grave concerns of their US Congress over China’s weak currency and monetary policy and both relied on their office and reputations to offer advice on monetary policy to the Chinese officials hosting the event.
In response a young junior official from the Chinese Central Bank concluded the evening by thanking Bernanke and Paulson for travelling to China to present their advice on monetary policy but she thought it opportune to remind these distinguished guests, on behalf of the Chinese people, that China had invented both paper and paper currency, and that China was confident in it’s ability to progress into the 21st century unassisted by any of us.
I am afraid this planet has run out of natives to colonise and civilise and I see some reverse osmosis in economic thought beginning to develop as our western civilisation slowly bankrupts itself morally and economically and as it tragically clings to nostalgic memories of economists from times long past and whose ideas do not belong in this 21st century.
"I am afraid this planet has run out of natives to colonise and civilise"
Defeatist.
But Pobjie, it was a gloat, not a whinge.
Oh, OK, a sort of supervillain thing.
Ah, Goldfinger… (trilled "R" in smoothed Jock accent)
Luke, I also suspect we’re not too far apart. I don’t think disequilibrium can be completely eliminated - life is always unpredictable to some degree. However I think we can eliminate some of the feedbacks that greatly exacerbate disequilibrium - for example by having no fractional reserves, and by having transaction taxes that take the profit out of market speculation but don’t unduly burden investment in real wealth production (a Tobin tax). We should get creative in looking for such deft adjustments. The markets could be much less unstable than they are, and they would interfere less with real wealth creation as well as being fairer.
Rogerio, sorry I didn’t mean to offend. It’s just that such discussions often go quickly to wild extremes, when there are actually useful debates to be had.
Bob, blame NM for the headline :-). When we issue new money we borrow from the future. The money is an implicit promise to provide goods or services of equal value to the market in the future. When we spend money we’ve earned, we are collecting on someone else’s promise. So money itself involves debt, and therefore risk. The beauty of shrinking money is that it keeps the level of such debt small.
A separate question is how to handle investment. At present we have extreme amounts of new money flooding the world, thanks to the Wall Street cowboys. Given the destruction of other peoples’ wealth that’s currently under way, and the extortion that’s been going on for a long time, I think we ought to look at shifting the balance of investment back to savings.
Rockjaw, sorry I missed your query about "cancelling" currency. No, I’m not referring to commodity-backed currency (necessarily). As I noted above, if I issue new money into circulation, I’m promising to supply real value to the market in future. If, later, I supply that real value and earn money in return, then I can pay it back to the bank I got it from and the money is effectively extinguished. That applies to token money (such as a $10 note) as well as to commodity-backed money.
I’m not familiar with Aantal Fekete, Jörg Guido Hülsmann or rabbi Israel Kirzner. I’ll check them out when I get a chance.
Ben, let’s go after the Martians or somebody. There’s got to be somebody out there to feed our ever-expanding frontier, right?
Serious point - this unfettered market disease is worst in the Anglo countries, the ones whose frontiers expanded the most, until they came to think they could go on expanding forever.
All: this is the least adversarial, most constructive blog discussion I’ve ever had. Thank you.
More like Blackbeard…
"Argh.. I’ve buried mi gold on a deserted island, so them scurvy dogs in the establishment can’t touch it… Argh"
Thanks Bob, it was on the tip of my tongue…and there was also some difficulty looking up the spelling for the word "stablishment".
Aye and you can all laugh you lubbers, but I’m not the one going down with this ship!
Geoff, thank you, the example of the Austrian town in your piece is understood, I think, but I will ask you to please satisfy my curiosity further by assisting me with additional reference material so that I can alleviate my confusion and my curiosity as to how your proposal would work in practice.
Google has been no help whatsoever. I already understand the "commodity destruction/cancellation" form of currencies being proposed by a number of other people, but yours is not commodity based and so it is quite novel to me.
Help!
Rogerio, I have just finished reading that link you posted on Ben Eltham’s piece here:-
http://www.canada.com/story.html?id=851901&p=1
Great link - thanks
Economics Nobel Laureate Reuben Brenner, is definitely somebody I will be reading much more of.
The reason Rogerio’s link to Brenner’s piece is relevant to Geoff’s article, I think, is because the article is current and in it Brenner makes specific reference to different forms of "money". He prophetically speaks of an "inevitability of change" to what we regard as money today.
Unlike Geoff, Brenner’s approach is more from a "government failure theory of market action" approach, but without the typical "government hater" view which usually accompanies such opinions.
It is peculiar that economists do not share a universal definition of money or the form which it should take, but I think it is also a problem to which, perhaps, the answer is dynamic. One day we happily use seashells and the next day it’s plastic while tomorrow "money" itself becomes obsolete to a new society, who knows?
Instinctively I know that it is the journey we should be enjoying, and not the destination. Right now I am happy to travel in the gold carriage and if Geoff wants me to extinguish my ticket every few miles or so, I will object most strongly untill I am given a REALLY good reason/motivation for the inconvenience.
George Vickers
I looked at Brenner’s article, but I don’t think he’s on the right track. You can have a meter standard because lengths of things don’t change. You can’t have a value standard because nothing in this world has a fixed, unchanging value. (The value of gold is highly subjective, and culture-dependent.)
He also overlooks the extreme volatility of currency markets caused by speculation. Currency trading goes 50-100 times faster than is sensibly needed to reflect slowly changing economies, which means 98-99% of currency trading is speculation. The extreme volume of trading and the disconnection from values in the real, productive economy generate wild fluctuations in exchange rates. I think that’s the source of most of the mayhem he talks about. You could fix it with a small transaction tax (0.1%?) that takes the profit out of speculation.
My book Economia has more on all of this, but it’s a bit hard to get now. I’m working on a new short one. If anyone asks nicely, I could send them the relevant chapter.
One of the better commentaries I’ve seen lately is by Charles Eisenstein, Money and the Crisis of Civilisation:
http://www.realitysandwich.com/money_and_crisis_civilization#tabs-mediaf…
Doesn’t cover everything, and makes a bit much of interest, but otherwise some deep insight.
Thanks Geoff. The local library says your book is available and so I might receive a copy soon.
By "speculation" on the currency markets I hope you do not include the practice of "covering forward".
At the risk of sounding argumentative, speculators were recently blamed for the sudden rise in the price of oil, for example, but the airline industry is a perfect example of how, without the ability to purchase on the futures market, their industry would have been in shambles today.
Looking forward to the book, thanks Geoff, and thanks for the link.
GV
LukeMR
The small investor might get a little glow of righteousness when attending an AGM but he will always be outgunned overwhelmingly by the big funds whose boards overlap - more or less coincide - with the boards of the companies they invest in and whose aims and ambitions coincide as well. All the executives have the same agenda - increase executive rewards as much as possible. If bonuses depend on the share price today and pumping up of the price of shares requires the sacking of experienced workers and the selling-off of divisions that have vast potential but no immediate gratification then so be it. None of the funds who own most of the shares give a toss about tomorrow. They care only about today, and they only care about themselves. The small shareholders have no power, and will always have no power.
Tim Flannery’s book on North America goes into the "no more natives left to colonise" story, and is very interesting on the subject of the US and its relationship with the rest of the world. From my point of view the great capitalist pyramid scheme requires ever-more customers and ever-more raw materials. You start with what you’ve got at home then when they run out or run low you start gazing enviously at someone else’s. I think we’ve scarcely seen the beginning of US aggression, let alone the end.
"From my point of view the great capitalist pyramid scheme requires ever-more customers and ever-more raw materials." - yes, but only if you combine it with the great socialist scheme of reaping and consuming where you have not sown.