The Problem of Saving

When Schumpeter writes, “Now to the question: what is a savings account?”,[1] he is not being facetious. There is more to savings than meets the eye. Of course, the bare fact of saving is simple enough to understand. Rather than spend all of our earnings, we take some and put it to one side. What could be more straightforward?

Actually, the problem is not so much understanding what savings, or a savings account, is, but what kind of effect it has. And that is anything but straightforward.

Essentially, what is accomplished with the act of saving is the removal of circulating medium from the cycle which is what an economy is.

An economy is a cycle or a circular flow: this is one of the first lessons of basic economics, encapsulated in the principle originally put forward by Jean-Baptiste Say, “supply creates its own demand.” All this means is that, at the end of the day, the producers are the consumer and the consumers, the producers. It is the same people producing who do the consuming, and vice versa.

At least, this is the basic picture, before things get complicated with things like foreign trade and fiscal policy. And things like savings. For what savings does is remove some of the circulating medium by which this economic cycle does its cycling. There are two aspects to the cycle: the circulation of goods and service, and the accompanying circulating medium by which the goods and services are accounted. When a shortfall of the circulating medium crops up, the result is deflation. And so, saving on the face of it has a deflating effect on wages and prices. And a deflationary environment is noxious to economic growth.

As a result, we have what economists have dubbed the “paradox of thrift” whereby saving, normally thought of as an act of economic virtue, or at least efficiency, actually depresses economic activity. The details as to how this occurs differ depending on the analyst, but the upshot is that saving, far from being the benign, even constructive act that it may well be on the personal level, actually has, or can have, a negative effect on the economy at large.

So which is it? Do we really have a paradox here along the lines of moral man, immoral society? Is personal saving something good for the individual or the household or other economic entity, but bad for the economy at large?

To figure this out, we have to take a look at what actually happens in the act of saving. First, of course, there is the proverbial mattress, or, especially in the days of coinage, the chest. In such a case, we have the circulating medium definitively removed from the economy for however much time the saver desires. (Or for much longer than that, as witness contemporary discoveries of hoards of coins from e.g. Roman times.) We can call this form of saving “hoarding.” It is peripheral to the main discussion.

What happens in the modern world is something different. When we save, our first resort is not the mattress but the bank. And when we do this, our money earns interest. What is interest? Let’s just say that is another of those phenomena that economists have a hard time figuring out. Perhaps we can address that subject in a future article. For now, we mention it in passing with the caveat that in the contemporary zero-interest-rate environment, it is not the incentive for saving that it normally might be.

So we put our money in banks. What happens then? Does it just sit there, like in the mattress? Not in the modern system. Instead, it enters into a second market, which runs independently of the market for goods and services with which we are already acquainted. We speak of the financial market. Banks (and non-bank financial institutions) are the gatekeepers of this market. We include a graphic taken from the accompanying course to indicate the structure of this second market.

Figure 3:  Two Markets, Two Monetary Circulations
Figure 1:  Two Markets, Two Monetary Circulations

Savings, then, go into this market, where they are “put to use” to earn income for the bank or other financial entity. The differential between what these latter entities earn and the interest they pay out is their profit.

What happens on this market? There are several submarkets which determine this. The bond market is where corporate and government borrowers go to get ahold of some of these savings. The stock market is where corporate interests go to sell stock in their companies – the money that goes here is not savings in the strict sense, as is money lodged with banks, but it does fall under the same category of earnings set aside to earn a separate income and to be available for future use, so we include it in our discussion.

“For future use” – this already indicates that the so-called paradox of thrift need not be so paradoxical. The writers on the problem of saving often seem to talk as if the money put into saving will never come back. In fact, the whole point of saving is to put earnings aside for “a rainy day,” or for the later purchase of big-ticket items, or for retirement – at any rate, not to eliminate it but to return it to circulation at some future time. And in a developed economy, over time the money put aside as savings will be counterbalanced by money previously set aside as savings and now returning to circulation. In addition, this money may have been supplemented by earnings on the financial market, which means that more money will be returning to circulation than left it. So on the face of it, this shouldn’t be a problem.

But there is a problem, and it is this. In normal situations this flow of funds back and forth between the ordinary and the financial markets is not problematic. But in the contemporary situation, it is.

One reason is because the ordinary market is being hit from various directions, making it unproductive and therefore unattractive. Firstly there are what Jane Jacobs (see this post for more on her) called “transactions of decline,” in which government removes money from productive activities, precisely because they are productive, and redistributes it to non-productive activities, precisely because they are unproductive. This can have a Keynesian motivation, whereby Say’s Law is turned on its head: demand then creates its own supply, and all government has to do is distribute money around to consumers (breaking the link between production and consumption) to generate productivity. According to Keynesians, this should in and of itself bring about prosperity, but as Jacobs points out, it only undermines productive activity and the human capital that underlies that productive activity, and so becomes a self-generating downward spiral.

Other things government engages in that undermine productivity are excessive taxation and regulation. All of this makes the ordinary market an unproductive affair, in which risks exceed rewards. The upshot is that savers put their money, not in ordinary investment, but in the financial market, which essentially is a zero-sum game, but in which at least the prospect of a decent return beckons.

And so more funds flow into the financial market than flow out, creating a dearth of liquidity in the ordinary market, which manifests itself in low interest rates combined with difficulty in borrowing (despite those low interest rates).

The flip side of the dearth of liquidity in the ordinary market is a glut of liquidity in the financial market. As funds pile into the market, returns there diminish and the quest for “alpha” (market-beating returns) becomes a frenzy. This is what happened during the 2000s in the run-up to the credit crisis. With the excess liquidity in the financial market, funds were available for lending that never would have been lent in a normal risk/reward analysis, often under political duress. An example is the subprime lending that took place. Michael Lewis (see this post for more on him) wrote about this in two of his most important books, The Big Short and Boomerang (the latter in particular gives a dramatic picture of the workings of the liquidity glut).

This was exacerbated by the trillions of dollars kept in the financial market by exporting countries like Japan and China (see this post this post for more on this), in their attempts to hold down the values of their domestic currencies. That in itself added substantially to the glut. But the very fact that what these countries were doing– looked at globally – was further undermining productivity by destroying productive capacity in rich countries while misdirecting investment in their own countries, only meant that another nail was being driven in the coffin of the ordinary market. Such “global value chains,” when established and maintained through currency manipulation and other fiscal and monetary policies designed to create unfair advantage for exporters at everyone else’s expense, only make the ordinary market even less attractive, which is another reason for the flight to financial markets, and even to inert investments like gold and other luxury items such as works of art.

A lot of work has to be done to restore ordinary markets to decent functionality. One of these is a return to an emphasis on the national economy as opposed to the lopsided emphasis on global-value-chain globalism such as obtains today. And within the national economy, a return to emphasizing the production side of the economy. Consumption does not magically engender productive activity; in particular, deficit spending to fund consumption is as pernicious a fiscal policy as can be devised. Various forms of capital are needed for that, various forms of infrastructure, from legal to educational (virtue versus entitlement) to religious. All of this is fodder for new discussions, so we’ll leave it at that for now.

This topic and more are dealt with more fully in the accompanying course.


[1] Treatise on Money, p. 147.

An End to Alchemy?

Michael Lewis, the author of various illuminating accounts of the events and progressions of the great financial crisis of 2008 – one of which became an Oscar-winning Hollywood movie – this time provides us with an illuminating account of someone else’s book – Mervyn King’s newly published The End of Alchemy. The thesis is a familiar one: the banking system is fundamentally flawed, and this is the cause of most if not all of our economic misery.

As befits a governor of the Bank of England (2003-2013), King is of course a veteran of the various banking vicissitudes of the 21st century. It is on the basis of this tenure that he writes this book, analyzing problems and offering remedies. But he does not wish to come across as someone with all the answers. As he writes in the introduction, “Many accounts and memoirs of the crisis have already been published. Their titles are numerous, but they share the same invisible subtitle: ‘How I saved the world.’” King may not want to save the world, but he certainly wishes to subject the banking system to a thorough reworking.

This is because the situation is that bad. What was behind the Great Crash of 2008? “Bad incentives that are still baked into money and banking – and so quite likely to create another, possibly even greater, crisis.” Still baked into: for, despite the (“arguably”) biggest financial crisis in history, nothing that addresses fundamental problems has changed. Shareholder limited liability encourages risk-taking, as shareholders take advantage of that absence of liability; deposit insurance encourages depositors to lodge money with banks, without regard to the riskiness of said banks’ lending policies; too-big-to-fail remains entrenched, encouraging gigantic risks to be run in the knowledge that if they turn sour, a bailout will be forthcoming.

Furthermore, the steps that have been taken ostensibly to mitigate the problem have only served to conceal it. Or, as Lewis puts it, “it’s being used to disguise how little has actually been done to fix that system.” Lewis quotes King: “Much of the complexity reflects pressure from financial firms. By encouraging a culture in which compliance with detailed regulation is a defense against a charge of wrongdoing, bankers and regulators have colluded in a self-defeating spiral of complexity.”

On this score we have a framework that seems designed for failure. There is the problem of moral hazard, which basically refers to the fact that when something is insured for, it is actually fostered or encouraged. Insurance against risk actually encourages risk. This problem is not restricted to the banking sector; it is endemic to any form of insurance. And then there is the web of ineffective regulation that seems to make a mockery of attempts to improve the situation.

King has an alternative. It is to revamp the banking system so as to eliminate risk-taking with other people’s money. “Deposits and short-term loans to banks simply need to be separated from other bank assets. Against all of these boring assets, banks would be required to hold government bonds or reserves at the central bank in cash. That is, there should be zero risk that there won’t be sufficient cash on hand to repay people wanting to flee any bank at a moment’s notice.”

So these deposits would be kept separate from other bank assets. These latter indeed could be used to finance the risky business of trading. These assets would have to be acceptable to the lender of last resort, the central bank, in case of financial crisis. And this acceptability will have been determined beforehand. “The riskier assets from which banks stand most to gain (and lose) would … be vetted by the central bank, in advance of any crisis, to determine what it would be willing to lend against them in a pinch if posted as collateral. Common stocks, mortgage bonds, Australian gold mines, credit default swaps and whatever else.”

The upshot is what Lewis calls “the King Rule.” As Lewis describes it, a bank must have on its balance sheet enough assets to cover withdrawals of its short-term liabilities (deposits plus short-term loans to the bank (one year or less)). But of course, you say, of course it has assets to cover those liabilities – that’s what double-entry bookkeeping is all about: every liability on the balance sheet has a corresponding asset. But here’s the rub: in the process described above, of the central bank vetting collateral, these assets would be given a “haircut” – assigned a discount at which the central bank would be willing to rediscount (buy) the asset, in case of a liquidity shortage. And it is this “haircut” valuation that banks in future would have to respect before putting funds out in quest for returns.

How exactly would this work? In the example Lewis provides from King’s book, a bank has $100 million in assets. Of these, $10 million are reserves deposited with the central bank, $40 million are “relatively liquid securities” and $50 million are “illiquid loans to businesses.” The central bank values these assets at 100%, 90%, and 50% of full value, respectively – these are their “haircuts.” Thus, in the eyes of the central bank, the bank’s assets “in a pinch” are worth $71 million, not $100 million. And therefore it cannot have more than $71 million in short-term liabilities. What other liabilities are there that could fill the $29 million gap? Lewis answers, “a lot more equity and long-term debt” than currently is the case.

With all due respect to both Mr. Lewis and a former governor of the Bank of England, I don’t think this is how banks really work. The suggestion is that banks receive deposits and short-term loans and turn around and invest them, sometimes in riskier material, sometimes less risky. So that banks don’t do anything except play with “other people’s money.” But banking doesn’t work that way. The very fact that they engage in what is referred to as fractional-reserve banking, in which they are allowed to “create” a multiple of amount of reserves they hold at the central bank, belies the notion that they only act as passive receivers of money.

In the case referred to above, the bank with $50 million in “illiquid loans to businesses” has on its asset side these loans; but on the liability side, it has deposits it created when it made the loans. That $50 million was not already in its coffers, waiting to be lent out. Not all of it, at any rate. Much if not all of it wasn’t there at all.

This is not to say that banks do not receive deposits. Of course they do. But these deposits, in turn, had to come from somewhere. Those funds weren’t always “just there.” It was in fact created, in the very process of credit extension. This is what Joseph Schumpeter clearly saw, and integrated it into his theory of economic development.

Unlike the deposits created by the bank to lend to businesses (“illiquid loans”), these deposits do run the risk of being removed and placed with another bank, and for that eventuality the bank has to have a contingency plan, e.g., only use that money in ways that can be quickly recovered. But for the loans to businesses, that money will always be replenished: the businesses will be depositing future income even as they withdraw for expenses, and this will remain in a rough balance. This is not the danger to the banking system, and it is hard to see why, on the face of it, these loans should require such a “haircut” as 50%. They are long-term investments by the bank. They are the beating heart of the capitalist system. They are not the problem. The problem lies elsewhere.

The argument of King’s book, then, is to put an “end” to “alchemy.” But this “alchemy” is already built into the very nature of the system. It cannot be gotten around by mandating certain levels of “safe” asset holdings. The focus on quality of collateral is good, but it needs to be done properly. Banks certainly need to ensure that the collateral they accept is marketable, is liquid. But that is easier said than done: because this is not a function of banks, but of markets. And market dysfunctionality goes far beyond bank policies.

There has been a glut of liquidity on world markets in recent decades. Lewis himself knows this all too well: he himself chronicled it in his excellent book Boomerang. Another excellent chronicler and serious economist to boot, Michael Pettis, in his book The Volatility Machine, shows just how this liquidity deranges markets. We like to think of markets as being driven by economic fundamentals, but Pettis shows how, rather than this, they are liquidity-driven, tossed about by massive flows of funds in pursuit of shrinking returns. And banks, together with the burgeoning shadow banking system, are at the forefront of trying to place these funds, running ever increasing risks in the process. This is the dysfunctionality, not so much “illiquid loans to businesses.”

The effect of liquidity-driven markets is to make market valuations go awry. We get asset bubbles and collapses, gyrating valuations, and therefore gyrating bank balance sheets. The collateral-based banking system is struck in its heart. But this is not the banking system’s fault per se, but an ever-increasing oversupply of liquidity.

Where did this global liquidity glut come from? A good portion of it has been the result of the collusion of transnational corporate interests with governments (and central banks!) of low-wage countries by which exchange rates are pegged to favor export industries. The method by which this is accomplished is sterilization – the practice of preventing foreign-exchange earnings from being converted into domestic currency. This has resulted in trillions of excess dollars. Japan and China have been at the forefront of this. The accompanying graphs tell that tale.

Figure 19: China's Foreign Exchange Holdings, 1997-2016
China’s Foreign Exchange Holdings, 1997-2016
Figure 14:  Japan's Foreign Exchange Holdings, 1975-2016
Japan’s Foreign Exchange Holdings, 1975-2016

For the rest, the very existence of debt overhang that afflicts the global economy also spells excess liquidity. The so-called law of reflux explains why. In a nutshell, when debt is repaid, liquidity is extinguished in the same amount. This is a function of the way our banking system creates money. So then, when debt is left unrepaid and instead is constantly rolled over, that liquidity is not withdrawn from the system. It lingers. Hence, excess liquidity.

To make a long story short: what we need is not so much an end to alchemy but an end to the range of toxic fiscal and monetary policies intended to rig the system in favor of various interests. Debt rollover is one of those, as it is simply a result of the too-big-to-fail approach. All of these interests are conflicting. But they have now coalesced in a globalist order that enriches the few at the expense of both workers and entrepreneurs, in both the developed and the less-developed worlds. That’s where we need to focus our attention.

Isaac Newton and the Alchemy of Finance

Western Christendom experienced a sea change in the late 17th century. On one side of that divide was theological dogmatics, scholastic philosophy, the divine right of kings and priests, and, seemingly in their train, wars of religion; on the other side, there was theological indifference, mechanical philosophy, government by consent of the governed, latitudinarian and sectarian church polity, and the political balance of power. Not that these things came all at once; but the tendencies were clear. The mood and temper of the peoples had swung; religion lost its position of overriding importance, to be replaced by economic and political considerations, reason of state, and the wealth of nations.

A pantheon of figures has been elevated to apostolic status as trailblazers in the transition from the Darkness of the one side of this great divide to the Enlightenment of the other. Hugo Grotius, Rene Descartes, Baruch Spinoza, John Locke, Pierre Bayle, Montesquieu, Voltaire, all figure in enumerations of enlightened progenitors of the new era. Paired with these names was a new theoretical orientation which determined the mindset, the Zeitgeist, the Weltanschauung of this new dawn: a new science putting the categories “nature” and “natural law” on a new footing, providing the essential authoritative basis for the new order.

Thus “nature” was the determining factor. The “imperative of nature” came to dominate all areas of inquiry and practical philosophy. The “state of nature” became the orientating condition; rights in a state of nature came to be the touchstone of all just legal and political order; natural religion, religion in accordance with the dictates of nature, came to be touchstone to judge revelation, or at least to form a stand-alone, autonomous body of knowledge alongside revelation; and a new school of thought, economics, arose from out of the disarray of “mercantilist” controversy, basing itself upon – you guessed it – nature, with the initial iteration provided by Richard Cantillon and François Quesnay, and which issued forth as “physiocracy”: the rule of nature.

Perhaps one figure above all others represented and personified this trend. That would be Isaac Newton, the progenitor of the paradigm that anchored all these areas of thought in terms of a unified theoretical construct. Newton put science on a new plane, providing an integrated theoretical explanation for phenomena that had stumped scientists for generations; and it was upon this foundation that the orders of religion, law, politics, and economics were shunted. Alexander Pope’s well-known “Epitaph on Sir Isaac Newton” was, if anything, an understatement of the sentiment of the age:

Nature and Nature’s Laws lay hid in Night:

God said, “Let Newton be!” and all was light.

Christian theology became wedded to Newtonian physics, which in particular served as a tool of apologetics.[1] The philosophy of law and politics, already argued in terms of the individual and consent, received a powerful support from the notion of an atomistic universe. And this very same Newtonian construct likewise served to buttress the budding school of classical economics with all of its “natural laws” of wealth and poverty centering on the individual and self-interest.

In all of these areas, Newton’s philosophy, the “settled science” of the day, supplied a powerful sanction. But this is not everything there is to know about Newton. Some areas of his labor, to which he devoted at least as much time as his scientific investigations, have come to light of late, after having languished in the obscurity they were left in by hagiographic biographers determined to highlight the rational character of one of the chief developers of the scientific method, while ignoring what they deemed to be irrational. And Newton exhibited this “irrationalism” in spades.

One of these areas was biblical study. Newton devoted a great deal of time and effort to biblical chronology and to deciphering the Temple of Solomon. The latter in particular he held to be an expression of hidden truth to be unraveled by the initiate. This interest in the Bible and in theology, along with Newton’s clear belief in the biblical version of events regarding, e.g., six-day creation and the Flood, were enough to put a serious dent in Newton’s reputation as the objective enlightened scientist. But the most egregious offense in this regard was provided by the realization that Newton dabbled in alchemy. More than that: he spent a major portion of his investigative life, not in scientific experimentation, but in alchemic explorations, pursuing the transmutation of elements.

It was John Maynard Keynes who first lifted the lid on this aspect of Newton’s legacy. “Newton was not the first of the age of reason,” Keynes wrote in his posthumously published and delivered lecture, “Newton the Man.” Rather, “He was the last of the magicians, the last of the Babylonians and Sumerians, the last great mind which looked out on the visible and intellectual world with the same eyes as those who began to build our intellectual inheritance rather less than 10,000 years ago.”

Keynes discovered the “real” Newton while perusing a box of forgotten documents he obtained at an auction in 1936. This led to a radical reevaluation on his part. “In the eighteenth century and since, Newton came to be thought of as the first and greatest of the modern age of scientists, a rationalist, one who taught us to think on the lines of cold and untinctured reason. I do not see him in this light. I do not think that any one who has pored over the contents of that box which he packed up when he finally left Cambridge in 1696 and which, though partly dispersed, have come down to us, can see him like that.”

That box revealed Newton the alchemist. Alchemy is the pursuit of transmutation, and Newton avidly pursued it. What the alchemists were after was gold. What one needed for that was the philosopher’s stone; with that in one’s possession, one might convert base metal into the precious yellow metal.

It goes without saying that Newton never came into the possession of such a stone, nor did he ever successfully transform base metal into gold. But it cannot be said that he was altogether unsuccessful in his manipulations in favor of the yellow metal. And here comes the part of the story that is never told, because insufficiently understood. It is the story of how Newton participated in one of the great transformations of world history: the shift of England’s currency from silver to gold, which precipitated the change from a coinage- to a banking-based monetary system. He did so as Master of the Mint, a position he occupied from 1699 until his death in 1727.

A little background is in order at this point. The 16th century witnessed the development of a new order of trade, or, in Immanuel Wallerstein’s terminology,[2] a world-system integrating far-flung areas of the world into a trading network. At the center of this trade network was the fledgling Dutch Republic. In the face of the mercantilist imperative – policies to maximize the retention of precious metals in order to maintain a viable domestic circulation – the Dutch Republic instituted a novel arrangement with regard to currency, dictated by this trading network.

This arrangement facilitated trade with the East. This was because the West ran a chronic trade deficit with the East. There was nothing new about this; from the early medieval period on, the West basically had nothing to offer the more advanced East than such things as furs and slaves, the latter until the slave supply from the Western countries dried up. But there was great demand in the West for what the East had to offer: for instance, silks and spices. How to finance the importation of these luxury goods? Silver.

The one thing the West had that the East wanted, especially since Spain’s discoveries in the New World, was silver. Silver in the East carried a premium vis-à-vis the West, making it profitable to export: this was what made it effective as a means to settle up the trade deficit.

Thanks to new mining techniques and Christopher Columbus, silver became abundant in the 16th century, precipitating the so-called Price Revolution of that century. But in the 17th century the supply began drying up, one of the factors behind the so-called General Crisis of the 17th century and one of the spurs to the spate of policy proposals and implementations summed up in the term “mercantilism.” For one thing, the mines of New Spain were not producing as much as they once did. For another, the flow of silver to the East, primarily China – that bottomless pit, “the World’s Silver Sink”[3] – was beginning to have its effect.

The Dutch Republic served as the funneling mechanism for this flow. Its counter-mercantilist policy allowing the free import and export of specie, and the demand for silver for export exerted a magnetic attraction from all over Europe, with the resulting abundance of coin even precipitating the Tulip Mania of the 1630s.[4] Much of it simply went to offset the burgeoning import business.

English merchants watched all of this with proverbial Argus eyes. They looked on as the Dutch East India Company established its trading network, helped by its special advantage of readily available specie. They sought ways to get around the royal prohibition on the export of currency, and chafed under the restriction.

The breakthrough came in 1663, with the passage of legislation establishing a regime of free coinage. Del Mar finds the impetus for this legislation in the intrigues of Barbara Palmer, Duchess of Cleveland, Charles II’s mistress.[5] With this opening, the East India Company worked diligently to build its own trading network. The needed silver it obtained, among other places, from the domestic circulation, precipitating a dearth of coin. Together with the wars against Louis XIV conducted by “King Billy,” the Dutch stadhouder become King of England, this precipitated an economic and budgetary crisis.

This decimated the coinage, which suffered from debasement at minting as well as the techniques of clipping and sweating. As a remedy, the wise men of the age recommended a restoration of the coinage to the condition it enjoyed under Queen Elizabeth a century earlier. According to Whig historiography, the great men who recommended this measure, occupants of the Enlightened Pantheon, men like John Locke, here once again displayed their sagacity. Post-Whig reassessment has been less kind.[6]

The attempt to restore the coinage to the silver content of days when silver was abundant had, as its detractors predicted it would, a strongly deflationary effect. And it had the opposite result than hoped, for it simply provided a prime source of silver for export. Full-weight silver coins were simply too juicy to let pass. On these terms, it was quite simply more profitable to export silver than allow it to continue in circulation.

So the result of the so-called Great Recoinage was virtually to establish gold as the currency standard for England.[7] Here is where Newton comes in. As Master of the Mint, Newton ensured the continuation of this trend, maintaining a ratio of silver to gold (15 ½ to 1) that upheld the continued priority of gold over silver. By pricing gold favorably against silver, this ratio ensured that the export of silver in favor of gold would continue to be profitable. Both Newton and Locke indicated the direction that the natural philosophy was going to take with regard to economics: the commodification of money, with all the consequences that this would entail.

But the establishment of gold at the heart of the English currency system had another consequence of a different order: it established fractional-reserve banking in place of coinage as the “money method.” This system of banking had a magical working. It turned paper into gold, or gold into paper, for it multiplied a bank’s specie holdings and circulated a currency “as good as gold” albeit many times the actual amount of gold. This alchemical process actually worked, contrary to Newton’s experiments with the philosopher’s stone. And so Newton stood at the cradle of a new alchemy with far-reaching consequences.

It is one of those curious coincidences of history that Keynes, considered by many to be the modern progenitor of the alchemy of finance, was the first to discover and publicize Newton’s own alchemical wizardries. Keynes’ alchemy consisted in the magical transformation of fiat currency into productivity, growth, and wealth, simply by wielding “effective demand.” Newton’s consisted in the more mundane magic of the multiplication of gold reserves. “Their works follow after them,” for their alchemy lives on. In our day and age, the paradigm of alchemical transmutation has crossed over even into biology and gender. As such, it is the pulsating heartbeat of the age in which we live, all pretensions of scientific rationality notwithstanding.


 

[1] See in particular Margaret C. Jacob, The Newtonians and the English Revolution 1689-1720 (Ithaca, NY: Cornell University Press, 1976).

[2]  Immanuel Wallerstein, The Modern World-System I: Capitalist Agriculture and the Origins of the European World-Economy in the Sixteenth Century, with a New Prologue, vol. 1 (Berkeley, CA: University of California Press, 2011 [1974]).

[3] Dennis O. Flynn and Arturo Giráldez, “Born with a ‘Silver Spoon’: The Origin of World Trade in 1571,” Journal of World History, Vol. 6, No. 2 (Fall, 1995), p. 206.

[4] Doug French, “The Dutch Monetary Environment During Tulipmania,” in The Quarterly Journal of Austrian Economics (Vol. 9, No. 1, Spring 2006), pp. 3-14.

[5] Alexander Del Mar, Barbara Villiers: or, a History of Monetary Crimes (New York: Cambridge Encyclopedia Co, 1899).

[6] For instance: Peter Laslett, “John Locke, the Great Recoinage, and the Origins of the Board of Trade: 1695-1698,” in The William and Mary Quarterly, Vol. 14, No. 3 (July 1957), pp. 370-402.

[7] A recent article making this case is Charles James Larkin, “The Great Recoinage of 1696: Charles Davenant’s Developments in Monetary Theory” (2006), available at https://goo.gl/JtcWCH.

Why We Do NOT Have a Fractional-Reserve System

This blog entry is for anyone who believes, as John Tamny here puts it, that “Fractional reserve banking quite simple IS.”

Among the many good points Tamny makes in his article, there is the underlying assumption that our system is, in some important sense, a fractional-reserve system. But is this a valid contention?

My contention is that it is misleading to view our system as a fractional-reserve system, that a truly fractional-reserve system functions in a very different way than ours does, and that the focus on reserves obfuscates the true nature of money. If our system is fractional-reserve, then why don’t we have any panics and deflationary contractions the way we did in the 19th century, the heyday of fractional-reserve banking?

The way it worked then was that there was a specie convertibility requirement. Specie – gold or silver – had to be held by banks for them to issue money substitutes, either notes or deposits. The reserve ratio – required by law – was set at 1:3 or 1:5, although in practice banks would often exceed this ratio. What would happen is that there would be drains of specie, for various reasons, out of the banks, to the big banks in New York, or oftentimes out of the country as well. In the case of the Panic of 1837, it was the government that unwittingly set off the panic. The government began requiring specie payments for land purchases in the western territories, leading to demand for specie that outstripped supply, thus drains of specie, runs on banks by depositors afraid that their particular bank would not be able to maintain specie levels, resultant bank failures, business failures, unemployment, etc.

This is quite definitely a problem of liquidity shortage. The banks’ books balanced, assets matched liabilities; the only problem was the specie requirement, a setup that, in James Steuart’s words, was only demanded by custom, as only specie was considered to be real money – Keynes’ “barbarous relic.” It was finally dispensed with, for all practical purposes, during the 1930s.

Fast forward to today. When does anyone talk of reserve requirements the way they did in the 19th century? When does anyone worry that banks don’t have enough reserves, therefore they ought to pull their savings or cash deposits out of the bank, precipitating a bank run? We don’t have “runs on the bank” any more. Why? Why is the Fed’s discount window — the ultimate source of liquidity in need — hardly ever resorted to?

The problem we have today regarding bank reserves is of an entirely different order. When we worry about a bank’s reserves, we worry about whether it can deal with a balance-sheet problem: assets that have lost their value, as for instance collateral being marked to market. We have solvency problems today, not liquidity problems. There is plenty of liquidity. The problem is, where the assets aren’t available to exchange for liquidity, the provision of liquidity becomes problematic. The solvency problem then becomes a liquidity problem. Interbank lending rates go through the roof. And commercial/business lending, the heart and soul of economic growth, grinds to a halt.

The protagonist of Fed fiat money as base money would say that this base money forms the reserve, is established by law as reserve against which reserve requirements must be met. So that, if the Fed wished, it could precipitate similar deflationary contractions simply by selling off part or all of its holdings, thereby reducing deposits and/or bank notes in circulation, precipitating a reduction in the money supply by the amount dictated by the money multiplier. This doesn’t happen, our protagonist would say, because of political pressure. But it could, theoretically. Let’s suppose that it did. Does anyone think that the banking system really would participate in reducing the money supply to that degree? Not only would it miss out on the profits involved in lending, such a measure would precipitate a depression. It is my view that as soon as banks realized what the Fed was doing, they would stand up to this obvious insanity and refuse to comply with the legal reserve requirement. What would then happen? I don’t think the government could force compliance across the board, perhaps at one bank or a few banks, but not all the banks. Because the reserve requirement is an entirely artificial arrangement and has nothing to do with actual practice, the way it did in the day of specie convertibility. In those days, it was customers, not the government, that enforced compliance. In our day, the banks would simply refuse compliance, not to customers, but to the government.

For this reason, it is permissible to speak of the modern banking system as a fractional-reserve system only in the most formalistic way. Actual practice makes fractional reserve a non-issue. Reserve requirements do not have the importance that they had in the days of specie convertibility. We have made the transformation that James Steuart foreshadowed, when he pointed out that bank money was not money because an extension of specie – a fortiori of “base money” – but because a representation of the assets put up for security. This “Copernican Revolution” has yet to be adequately acknowledged. Theorists like Hyman Minsky work within its framework. They don’t talk of fractional-reserve requirements, they talk about asset bubbles as problematic because leading to balance-sheet mismatches.

Why do we maintain the fiction of the centrality of fractional-reserve? Because the system we now have grew out of a true fractional-reserve system. We removed the base money component, and the Fed has endeavored to maintain the illusion that its money somehow is as important as specie used to be. But Fed action does not produce automatic changes in the money supply the way gold inflows and outflows did in days of yore. Fed action can only indirectly induce changes in the money supply by influencing interest rates, and thus making lending more or less attractive. In our system, the liquidity problem has receded; it is solvency (balance-sheet) problems that we have to worry about.

To make my point crystal clear: our system may be labelled fractional-reserve in the same way that England may be labelled a monarchy. In terms of law, England is a monarchy. But if the queen ever attempted to exercise the power of a monarch, the monarchy would be peremptorily abolished. In the same way, in terms of law we have a fractional-reserve system. But if the Fed ever attempted to exercise the power inherent in such a system, such as absolute reductions of the money supply by virtue of the money multiplier mechanism, it would be peremptorily abolished as well.

Private Issue of Money — the Root of Our Monetary Problem?

In a comment posted under an article by my friend Jerry Bowyer (Where’s the Hyperinflation?), “ps61penn62prin64” writes that “private currency monetary systems… are doomed to fail the interest of American citizens.”

Bowyer’s article discusses the sizeable increase in the money supply generated by the Fed, and how this has — or has not — affected the inflation rate. Bowyer concludes that although inflation has not manifested itself because of Fed action, it will. This is because the Fed has “an almost unlimited capacity to produce syrup [i.e., base money] and pump it at high pressure into the system. And they want to do so. They want more money in circulation, because their Keynesian models tell them that easy money is the answer to our economic stagnation.”

This view of our monetary system is based on the notion that we have a fractional-reserve system. Which we do, but only in the most formalistic sense. For all practical purposes, our system is not tied to some base money, manipulated by the Fed, allowing it to stretch and shrink the money supply at will. The Fed does not have this unlimited power — if it did, we’d have been toast (Weimar Germany, anyone?) long ago. If this were true, how do we explain our current struggle, which is a low-interest-rate, low-inflation environment?

But let’s now address the issue raised by ps61penn62prin64, as to whether the private issue of currency is the problem.

Right up front, I will state that the state-sanctioned private issue of money, such as is provided for by the Federal Reserve system, by no means need be a problem. Indeed, it is simply a function of “the common law right to borrow” (as Hammond pointed out in his Pulitzer Prize-winning book, Banks and Politics in America, published in 1957). In such a system, banks take a position front and center, as “experts in futurity” to use John R. Commons’ pregnant phrase, converting property into liquidity. This is not banks loaning depositors’ state-issued money; this is banks loaning money of their own creation. It is not the Jimmy Stewart, but the James Steuart form of banking.

This being so, the banks are creating representations, symbols, of property holdings, and it is these symbols that form the money supply. These symbols, these representations, only reflect a deeper reality — the reality of the issuing agents’ (i.e., banks’) balance sheets.The problems we face are thus not problems of liquidity, but of solvency. Our problems are not that there is not enough liquidity, as in the days of the gold standard, nor that there is too much liquidity. Our problems revolve around solvency: that the assets on the books of banks (and this holds for the “shadow banking system” as well) do not match up with the liabilities.

When this happens, we have a freeze-up of credit, as banks only become concerned with restoring balance sheets rather than engaging in fresh lending. This is why we are dealing not with an inflation problem but rather with a disinflation  problem.

Originally the Constitution authorized only Congress to create and manage money, in the form of coinage. Coinage is the preeminent form of state-created money. Coinage had always been the prerogative of the state. But with the shift toward a commodity-based money system during the 18th century, power over coinage and over money had been passing out of the hands of the state and into the hands of the bankers. The regime of coinage was already on its last legs at the time of the Constitution’s ratification. My forthcoming book will discuss this transformation in detail.

Hence, the Constitution was outdated already at the time of ratification. It did not address the issue of banks. Hammonds’ book details the debate surrounding this issue as it developed during the early Republic, as the pros and cons of banks’ private money were discussed. The principle was finally accepted in terms of fractional-reserve — banks were only creating money substitutes, and were under the obligation to provide real money — specie — whenever asked.

We labored under this system for a long time. But when we threw off the gold standard, we threw off fractional reserve banking. Our banking system is now asset-based, not reserve-based. It is a system of state-sanctioned, yet market-driven, money. There is nothing wrong with that, in principle. In practice, it can be problematic. The problems mainly come about because we don’t understand it, and act in terms of faulty understanding. Especially when governments get in on the action. Then the liquidity bias, fomented by our faulty understanding, gives government room for its misplaced Keynesianism. And we discover once again that the problem had nothing to do with liquidity, but rather with solvency.

And so we need to look at other things than the Fed’s production of “syrup” if we want to understand what is going on with inflation rates, interest rates, and thus the economic fundamentals that determine how are economic lives are to be lived.

We need to go from Jimmy Stewart to James Steuart.

Jimmy Stewart Banking versus James Steuart Banking

In his excellent book The New Lombard Street, Perry Mehrling writes of “a world that never was … Jimmy Stewart banking of blessed memory” (p. 117). This is an obvious  reference to one of Jimmy Stewart’s most famous roles: George Bailey in the holiday classic movie It’s a Wonderful Life. In the movie, Bailey is a small banker forced into near-bankruptcy by the inadvertent misplacement of the bank’s holdings, holdings that are the deposits of its customers. When those customers catch wind that the bank’s holdings are gone, there comes the prototypical “run on the bank,”which precipitates Bailey’s attempted suicide. For the rest of the story, watch the movie. For now, what’s important is the model of banking this presents. Merhling summarizes it:  “In traditional banking, so nostalgic memory reminds us, banks took deposits from households in their community and made loans to other households in their community. It was a simple business….” And this is the model that many still consider to be what banking is all about, with any deviation being a sign of imminent destruction.

But that is not at all what banking is all about. In fact, Jimmy Stewart banking has been a rarity in history, if in fact it ever really was practiced. This is because bankers have instead practiced fractional-reserve banking, which means that deposits of whatever is considered to be real money are held, not to be lent out, but to serve as a base upon which a circulating medium may be erected. That is to say, money substitutes are put into circulation as if they were real money; the banks manufacture and maintain these money substitutes, either by means of notes, checks, or whatever other medium technology can provide; and society is freed from the restrictions of a scarce money supply. In former days, when specie — gold and silver — were the only true forms of money (copper serving for small change only), such an “elastic” money supply was a godsend. But it could just easily be turned into a curse, as we shall see.

I said that Jimmy Stewart banking was a rarity. The best example history provides is the Bank of Amsterdam from the 17th and 18th centuries. It received deposits of specie and held them in its vaults. It did this for a fee. Depositors could conduct transactions on the books with each other, freeing them from the need to safeguard and exchange actual specie holdings. By law, the bank could not allow overdrafts. So this was a strict “warehousing” function that the bank provided, which allowed it to serve as a clearinghouse of monetary transactions for all its depositors. And its depositors were all the great ones of Europe.

There was a problem here, though. What no one knew, was that the bank was surreptitiously lending both to the city of Amsterdam and to the East India Company. In 1794, its demise became a foregone conclusion when it came to light that the bank had been making millions of guilders of loans to these entities. So even here, Jimmy Stewart banking was more a pretense than a reality.

Surreptitious lending of deposits was bad enough. The real problem with this system was the power it gave to any who might gain control — corner the market — on whatever served as base money. In the days of bimetallism, when both gold and silver served as base money, such overtures to manipulation were difficult to realize. The combined market for gold and silver was too large. But such manipulation did become feasible when the switch was made to the gold standard. Gold was a very scarce medium, and during the days of the gold standard, holdings of it were centralized, leading to the serious opportunity for manipulation by a coterie of banking families — J.P. Morgan being the most conspicuous example.

Hence, the days of the gold standard were the heyday of fractional-reserve banking. The only “true” money was gold, and the bankers controlled that market, and thus the availability of true money. Banks generated money substitutes as multiples of their gold holdings; but when markets dictated gold outflows out of the country, the money supply contracted by the same multiple, leading to harrowing busts that make contemporary crises seem walks in the park.

But in the midst of — or rather, at the start of — the fractional-reserve era, another form of banking existed, at least in the mind of one man. And as a matter of fact, this form of banking has held sway ever since the collapse of the gold standard in the 1930s. This is not Jimmy Stewart banking, but James Steuart banking.

James Steuart was a Scottish baronet who lived in the 18th century, had once supported Bonnie Prince Charlie’s bid for the throne of England, and consequently was forced to live in exile for 18 years. While in exile, he wrote a work the importance of which has yet to receive the recognition it deserves: An Inquiry into the Principles of Political Economy (1767). In that work, he espouses a view of banking derived from practice but without the prejudice towards specie that blinded his contemporaries. Steuart realized that the function of banking did not lie in extending base money into money substitutes; rather, the function of banking was to convert property into money. He used the metaphor of “melting down” property, a reference to the melting down of plate and other forms of precious metal so that it could be converted into coin. For Steuart, property was “melted down” into money — “symbolical” money, as he put it — when it was put up as security for a loan. This security represented the true money base, because at the end of the day, should the borrower default on the loan, the loan’s real worth was simply the value of the security that had been pledged.

Now then, this symbolical money no longer represented base money, it represented the property put up as security. Therefore, it was this property that served as money base, not specie. Steuart foretold the emancipation from gold and silver that the world would only come to accept after the onerous experiences of a Great Depression and two world wars. And that emancipation was not only from a superstititious view of money, but also from a class of men who, using this money, gained control of the nations.

The money systems of today are based on Steuart’s principle, not Stewart’s. Nor do we practice fractional-reserve banking in any material sense of the term, although in formal terms our system is a fractional-reserve one. After all, our system of central banks is called the Federal Reserve System. But for all practical purposes, reserve requirements do not determine the money supply, nor do they precipitate bank failures the way they did in the 19th century. Rather, it is the willingness of property-owners to put up marketable assets as security for loans that determines the money supply. And it is the quality of those assets on the balance sheet that determine the solvency, and thus survivability, of a bank.