A Treatise on Unsound Money: Part 1
Written by Derryl Hermanutz
There are a lot of erroneous statements in this article by Adrian Ash masquerading as ‘facts‘ that ‘everybody knows‘. If what everybody knows is limited to reciting groundless slogans, then sure, lots of people who confuse popular slogans with objective observation and analysis will agree.
Let’s take this one:
“…central banks clearly want to see higher inflation. Because in the Fed’s plan – if not in reality, history or anyone else’s model since the late 1970s – the idea is that this will boost employment.“
High inflation and high employment are not observably linked in economic history? Every credit fueled boom has two effects: it inflates the prices in an asset class like stocks or real estate, and it generates widespread economic prosperity and employment. Does Ash not think 1000s of crews building houses and millions of people producing and selling materials and home furnishings and real estate and mortgages qualifies as “employment“? Inflation, employment and general prosperity happen when lots of people are spending lots of money. Which means other people are earning that spending as their incomes.
Savers save their income money, so the spending that creates prosperity (and creates the incomes that become savings) comes from people who “borrow” and spend. And sustained prosperity is caused by people who spend and invest their incomes back into the economy, where the money again becomes incomes that can be spent and invested, in a virtuous cycle. Saving money removes that money from the spending-income stream, which reduces economic activity. Excessive bank lending to finance public and private “deficit spending” of more than their incomes causes “inflation“, but it also causes high employment and high economic growth and prosperity. So yes, reality, history and theory support the causal relationship between inflation and high employment.
Bank loans create new credit-money. Banks don’t lend out their savers’ deposit balances. When a borrower spends his loan into the economy that money becomes income to its recipients, new money that did not exist until it was borrowed and spent into the economy. Some of that income is spent or invested back into the economy where it is earned by others, but some is saved. Money that is saved by some people “comes from” money that is borrowed and spent by other people.
So spare us the threadbare “sound money” moralizing about the evils of debt and the virtues of savings, as if banks have not ALWAYS created ‘fractional reserve‘ credit-money, which is “debt” to the person who borrows and spends it but which is “income” and “savings” to the person who receives the spending as their earnings. There is a long history of the business cycle describing exactly this relation between increased spending and increased prosperity, and between excessive savings and recession. JS Mill’s discussion of “the capitalist cycle” in his 1848, Principles of Political Economy, Book IV section iv.5 tendency of profits to a minimum…prevented from reaching it by commercial revulsion, is especially illuminating:
“…Such are the effects of a commercial revulsion: and that such revulsions are almost periodical, is a consequence of the very tendency of profits which we are considering. By the time a few years have passed over without a crisis, so much additional capital has been accumulated, that it is no longer possible to invest it at the accustomed profit; all public securities rise to a high price, the rate of interest on the best mercantile security falls very low, and the complaint is general among persons in business that there is no money to be made. Does not this demonstrate how speedily profit would be at the minimum, and the stationary condition of capital would be attained, if these accumulations went on without any counteracting principle? But the diminished scale of all safe gains, inclines persons to give a ready ear to any projects which hold out, though at the risk of loss, the hope of a higher rate of profit; and speculations ensue, which, with the subsequent revulsions, destroy, or transfer to foreigners, a considerable amount of capital, produce a temporary rise of interest and profit, make room for fresh accumulations, and the same round is recommenced.”
Does any of that sound familiar in recent history? Too much of an economy’s money accumulated in too few hands destroys the people’s ability to spend, which destroys the possibility of producing to the capacity of fixed capital and labor, which destroys profitability, until enough savers squander their savings on loser speculations, which redistributes money and income into more diffuse and less concentrated hands, which makes more spending possible, which induces restoration of production and productive employment. This is not new knowledge. This is economic “history“. And Mill is not even considering the addition of debt-spending into this equation even though a significant amount of investment in that “gold standard” era was financed with credit-money provided by banks, as Adam Smith admired 72 years before Mill in his 1776, The Wealth of Nations, Book II, Chapter II, MONEY,
“I have heard it asserted, that the trade of the city of Glasgow, doubled in about fifteen years after the first erection of the banks there; and that the trade of Scotland has more than quadrupled since the first erection of the two public banks at Edinburgh, of which the one, called the Bank of Scotland, was established by act of Parliament in 1695; the other, called The Royal Bank, by royal charter in 1727.”
The Bank of England was instituted as a privately owned “central bank” in 1694, a year before the first Scotch Bank went into business, ushering in the modern era of central bank-backed fractional reserve banking, though the Medicis and other “bond merchants” had been creating credit money and lending it to governments for over 300 years already before the B of E was instituted. The B of E was transferred to public ownership in 1946, after Bretton Woods formally transferred global reserve currency status from the pound sterling to the US dollar. The Fed remains privately owned.
You can take a whirlwind tour through world monetary history by reading Niall Ferguson’s 2008 book, The Ascent of Money. You can take a detailed tour of US monetary history by reading the 2010 edition of Ellen Brown’s Web of Debt. Or do the sound money guys think all the trillions of dollars of savings and capital, of “money“, that exist today have “always” been in existence? Debt creates money which becomes capital and savings. That’s where the $trillions “come from“.
Fractional reserve banks “create money”, in the form of loans of checkable bank deposits and/or printed banknotes (banks no longer print their own banknotes: they use central bank banknotes now). Banks “add” to the money supply when they make loans. This addition of credit money, and its corollary “debt” to the borrowers, introduces a new dynamic into the business cycle equation that Mill did not address in his discussion of the capitalist cycle, but which has been operative in fact since at least 1695.
Indeed, the two great old Scottish banks that Adam Smith praised have recently fallen victim to some of the consequences of this new dynamic: systemic debt default that happens after savers accumulate all the money and starve the economy of spending, which makes it impossible for debtors to earn their money back and repay their bank loans. This renders the banks first illiquid due to a shortage of loan repayments and interest payments flowing in, then insolvent as the collateral assets that they lent against drop in price and the banks cannot meet their monetary obligations by foreclosing and liquidating the assets.
In the monetary systems that are in use today by every nation in the world, commercial banks create the circulating money supply by making loans and by purchasing government securities. Borrowers “spend” the money supply into the economy. Central bank “base money” (banknotes and bank reserves) and government money (coins, which cost almost as much to produce as their face value) have become an almost irrelevant part of the money supply (I addressed the issue of money creation by the shadow banking system in a previous article). The private sector and government borrowers spend their bank loans into the economy where their spending becomes other people’s income and savings. The incomes are deposited in banks as bank deposits. Bank loans “create” the money that becomes bank deposits, which are “the money supply“. The sound money crowd seems to have missed this little detail of the past 600 years of financial history.
Spending creates demand for production which creates demand for businesses and workers to make stuff. Spending creates employment, earnings and profits. Saving money removes that money from the spending-income-spending cycle. Savings do not get recirculated by ‘funding investment‘, as sound money folks imagine. Bank lending of brand new bank credit money funds investment.
Hedge funds are large pools of savings, but hedge funds don’t waste their time funding employment generating investment in the real economy because the big money is to be made speculating in the financial economy, where “insiders” with superior information get rich by taking money from “suckers” with inferior information. Mill describes this in the chapter quoted above, “It is true that a great part of what is lost at such periods is not destroyed but merely transferred, like a gambler’s losses, to more successful speculators.“
But the awareness of casino capitalism and information asymmetry didn’t exist in caveman days when sound money guys developed their eternal truths (and a caveman who got suckered by a sharp operator would gather his tribe to go bash the cheat’s head in, which is a significant downside risk to that type of wealth acquisition strategy, as the French nobility discovered in 1789). So they reason that everybody who gets money “must have” earned it fair and square in a free competitive market where you get money by selling something of value that you produced. Free competitive markets are an article of the faith, not necessarily a feature of reality, so the logical implications, of the principles that are assumed to be true by the faith, are not likely to accurately describe economic realities that fail to conform to the faithful principles.
Some pools of savings (hedge funds, pension funds, insurance funds) are used to buy corporate bonds, which big businesses sell to savers as an alternative to corporate borrowing from banks. But small to medium business (especially startups) create most of the new employment, and small to medium businesses invest their owners’ personal savings and get their financing from banks, borrowing new credit-money and spending it into the economy. So again, savings kept in banks do not finance investments that generate employment. Bank lending of new credit money finances that kind of investment.
Excessive bank lending puts buying power in spender’s hands to bid up the prices of the assets they are buying. Large and systemic bank loans, on the scale that is able to create national inflation, are secured by collateral, real things of real value, like houses ‘whose prices always rise‘, or stocks in ‘sure thing‘ internet businesses. Banks don’t lend large amounts of money for “whatever“. They lend for specific purchases. And the bank holds claim to the title of those purchases until the loan is repaid. So banks decide which assets are going to be financed (and their prices inflated by newly financed demand), and which are not.
Bankers hate Hyman Minsky because he blames herd mentality bankers for inflating asset bubbles. But Minsky’s “instability hypothesis” is essentially just a restatement of the business cycle mechanics that Mill wrote about in 1848: reaching for yield after a period of capital accumulation by investing in speculation in the absence of real profitable enterprises to finance. Minsky just adds the missing debt-financing component to Mill’s discussion. So I suppose bankers should hate the field of macroeconomics in general rather than pour all their wrath onto one guy who spoke the truth.
Bankers like mainstream neoclassical macroeconomics, on the other hand, because it completely leaves banking and money-debt creation out of its models, making banking invisible and absolving bankers from any blame when TSHTF. But this time is different, and everybody isn’t mesmerized by ridiculously naïve mainstream economic models. This time we can “see” that bankers blow bubbles.
The Five Parts of the Treatise on Unsound Money