On Thursday night I went to the LSE to hear a lecture by ProfessorHuerta De Soto followed by a dinner discussion with interested parties including Douglas Carswell MP and Stephen Baker MP. They have tabled a bill to outlaw fractional reserve banking, the practise that allows banks to lend most of the money they collect in deposits and only keep back a fraction of it to repay depositors on demand.
I agreed with much of the Huerta De Soto analysis of what had gone wrong in the bubble and Credit Crunch. Like him, I have argued that bad Central banking lay at the heart of the crisis. I found it more difficult to agree with his remedies, which envisage a completely different structure of banks dependent on a currency linked to gold.
The conversation included some barbed and interesting exchanges between Austrian school devotees and UK establishment neo Keynsian and neo classical economists. The Austrians worship at the shrine of Hayek and are angry at the way in which conventional economics faculties ignore their great man’s work. Their thinking can take them to the point where they want to abolish fiat money, Central banks and much of the apparatus of the present democratic states. The Establishment economists are happier arguing over relatively minor adjustments within a system which may be collapsing, reluctant to see that their chosen remedies may be washed aside by the huge structural and monetary changes unleashed worldwide.
The Austrian bank reformers want every pound of deposits backed by a pound of cash. This removes the need for a Central Bank acting as lender of last resort, and makes a run on a bank impossible or pointless. It would also mean a big contraction in credit, and more difficulties for the small saver in getting a decent return on his savings. They seem a little light in thinking through how they would accomplish such a huge change without too much economic disruption.
If you link this reform to a restoraiton of the Gold Standard, as Professor Huerta De Soto recommends, you add another layer of complexity and change. You enrich countries like South Afirca which mine the metal, and countries like France and China which have been buying it up. Inflation or recession are then linked to how much gold is mined compared to the natural growth of the world economy. You replace the capricious judgements of governments over how much money to issue with the cycles and business plans of the mining industry.
Banking reform is in the air, and rightly so. I don’t think the UK establishment is about to welcome Mr Carswell’s Bill, nor about to seek the gold standard just a few years after the Uk foolishly sold a lot of its gold reserves. We need to discuss improvements to UK and world banking that can deal with some of the manifest problems of poor Central banking 2005-9 that could take root and be adopted.
November 1, 2010
Each bank is different. The regulators need to be able to look at the risk each bank is taking and intervene as needed if that bank is to benefit from the deposit protection scheme, be entitled to take public deposits and have bank of England assistance when needed.
The regulators need to act like an insurer assessing each balance sheet on an individual, almost daily basis as the economic conditions change. General rules for all will always be too blunt, inflexible and thus damaging to the banking industry.
The problem, as always, will be how to find and motivate good & honest such regulator/insurers who will not become too “close” to the banks they regulate and will act in the public’s interest. Not restricting the banks unless they are taking too many risks.
The price of gold should have no part in the process.
November 1, 2010
“… which envisage a completely different structure of banks dependent on a currency linked to gold.”
They should go further. Currencies should be completely privatised; in this way they can be linked to whatever the market wants them to be linked to. In post war Germany the currency was cigarettes.
As a Tory I would expect you to be advocating the privatisation of money. As a Tory I would expect you to be advocating the disintermediation of banks.
Bear in mind that currency is a common law phenomenon and can be traced to the Case of Mixed Money 1606 (Davis Law Reports) which was an example of economic imperialism by England against Ireland. Now, the economic imperialism is by the state against the poor sap (you and I) who have the currency foisted upon us.
November 1, 2010
‘UK foolishly sold its gold reserves’. Please don’t pull your punches – it was the first crass act of Chancellor Gordon Brown. We have yet got the full measure of what he did to this country, but it our duty to not let that man skulk way in Scotland and think he can escape blame for the results of his folly.
November 1, 2010
The regulation system also needs to ensure that the banks are lending fairly and directly to UK businesses. This both benefits the UK and ensures that these bank assets and easier to monitor for risk and security. This in return for the help given with liquidity and the deposit protection guarantee.
Just getting rid of fractional banking might well make the lack or lending even worse.
November 1, 2010
I’m sympathetic to the objectives of the pure Austrian School, think there is much merit in their critique and I hold gold in my investment portfolio.
However I don’t think a return to the gold standard will work. If memory serves me right even Hayek in his classic “Denationalisation of Money” advocated a basket of commodities to back a currency.
My years in the money markets reinforced my belief that central banks are invariably wrong about the appropriate policy at the appropriate time.
It is good that a discussion has started, I fear perhaps after the trillion-dollar-horse has bolted.
November 1, 2010
If currencies were backed by gold then there would be no inflation and so savers would not require a return on their savings to cover it. The only (legal) return possible would be via investing in wealth creating enterprise directly. A good thing surely?
November 1, 2010
“Their thinking can take them to the point where they want to abolish fiat money, Central banks and much of the apparatus of the present democratic states.”
Ignoring the third, as you can do the first two without doing that, I find it difficult to argue that money should be centrally planned (in the manner of Gosplan, as Professor de Soto said) while recognising that in all other industries this practice is immensely harmful. I’m also not sure about outlawing FRB, but denationalising money seems like a no-brainer: just like how denationalising coal, steel, telecoms, etc. seems so in hindsight, even though the “establish economists” railed against it at the time.
November 1, 2010
I agree with your analysis that any sudden change would lead to a drastic reduction in credit, combined with huge problems for people in rolling over debts.
However, its an irrelevance.
The banking bailout has cost UK taxpayers 20 billion (Losses on nationalisation).
The government debts are 6-7,000 billion.
The interest for one month alone on that debt is the same as the entire banking bailout.
That’s the real issue. How are you as a politicians since you personally are to blame (you blame all bankers so its right to blame all politcians) going to pay off that debt?
Where is the politician tax?
November 1, 2010
There is no point in stopping banking crises at the cost of stopping banking. This would just make the contraction permanent: a cure worse than the disease.
November 1, 2010
Fractional reserve banking is vital for economic growth. It’s invention was key to European and particularly British wealth and progress. If banks were only allowed to lend out exactly what they had in their vaults, then economic growth could only come about through deflation – a very slow and painful process.
By seeking to reduce centralisation by abolishing the central bank but re-imposing it by new intrusive laws on what they can and can’t do, De Soto et al are being inconsistent. Either you are in favour of localism and freedom or your are not.
There is no reason, however, why these banks should all be controlled by the government. In this I am not talking about the recent nationalisations but fiat money and a central bank.
The easiest reform would be to re-privatise the Bank of England (it was nationalised the same year as the railways) and repeal the 1844 Bank Charter Act which gave it a monopoly on issuing money (effectively forcing us all to use a government debt instrument every time we want to buy something). In addition, the FSA should be abolished to allow private banks to set their own rules, regulated by the market. The government’s job would be reduced to ensuring that audits are conducted properly for market transparency. (This last role is something it has ignored in recent years as all the bank scandals have involved, essentially, failures to audit properly, allowing employees to steal from shareholders and customers.)
The main argument against this, is that it would drastically reduce the government’s ability to borrow. Oh, hang on… that’s an advantage.
November 1, 2010
You are right.
The credit crunch was caused by incompetent Central Bankers (notably Greenspan, sadly), who misjudged how to respond to global imbalances (such as China’s contrived surplus).
Carswell is a great MP, but this recent suggestion would lead to an overly restricted money supply and anyway I don’t see how we would get from here to there.
There is some irony in the fact that Greenspan was a great advocate of a gold standard (wasn’t he?) when he worshippped at the feet of Ayn Rand.
November 1, 2010
How sickening it is to have continually lay into the bankers as though he had no role in the disaster! Sure, on paper he was not in charge of regulation, but in former years (when we had a decent governor) it was enough for the governor to raise his eyebrows to bring errant banks into line. He SHOULD have had enough influence, even if he did not have the power!
p.s. and o.t. Is your little red icon meant to say ‘Rw’ : it actually says ‘Rm’ (screen grab and blow it up if you doubt this!) – which seems odd.
November 1, 2010
Apologies! Previous comment carelessly left out key words – and should read :
How sickening it is to have Mervyn King continually lay into the bankers as though he had no role in the disaster! Sure, on paper, he was not in charge of regulation, but in former years (when we had a decent governor) it was enough for the governor to raise his eyebrows to bring errant banks into line. He SHOULD have had enough influence, even if he did not have the power!
p.s. and o.t. Is your little red icon meant to say ‘Rw’ : it actually says ‘Rm’ (screen grab and blow it up if you doubt this!) – which seems odd.
November 1, 2010
No surprise then that a politician would support fiat currency and thus the ability to manipulate money supply in advance of elections.
We need to look no further than the history of political tinkering to the money supply and what it has done to inflation over the past forty years to see the damage they have caused in the name of growth.
Look no further than the hoards of pensioners who have been impoverished at the hands of scheming politicians of all persuasions who are happy to impose inflation, the most insidious tax of all, on the weakest in society, for their own gain.
A gold standard would impose a discipline on politicians to conduct honest politics with sound money so we should hardly expect turkeys to vote for Christmas.
November 1, 2010
Why is my comment on “the European Relationship” still waiting to be published ?
November 1, 2010
According to a website devoted to gold, the total quantity that has been mined to date is 120-140,000 tonnes – enough for say 20 grammes per head, or about 2/3rds of a troy ounce – or a little more than $800 worth in today’s money. Put another way, it is worth less than $6 trillion – which is about the size of just the domestic portion of UK banks’ balance sheets (£4 trillion), never mind the rest of the world. A return to gold based 100% reserve banking is simply not feasible in a world with a population of close to 7 billion.
However, attempts to debase and debauch currencies are leading those who seek to preserve wealth to invest in commodities with limited supplies. Prices for many traded commodities have soared far ahead of official inflation. If the temptation to pursue strategies such as QE persists, the risks of currency collapse increase. Proving the wealth speculators wrong would leave them nursing a diminution of their wealth. More difficult to estimate is to whom that wealth would be transferred – but a chunk would certainly go to banks that provide the service. It’s time to get banks working at writing down their loan books, rather than persisting with mark to fiction accounting.
November 1, 2010
Yes John, you are right about the UK establishment’s attitude to Carswell and Baker’s Bill. However, the provisions outlined by the Bill are exactly what is needed. Britain (and just about everyone else in the Western world) totally lost control of money during the Brown years. But monetary control through interest rates alone is not enough – the fractional nonsense must be brought to full stop.
Linking it all to gold always was the most rational way to do this but, as you say, the Mentalist’s selling off of our gold reserves hardly helps us support what we should support now.
And all this leads me to a question – can anyone explain to me exactly why Gordon Brown is so lauded as a Chancellor? Brown strikes me as the worst Chancellor this country has ever had in all its recorded history.
November 1, 2010
Apparently, in 2009, Central Banks became net buyers of Gold. I find that a bit worrying. These Banks are supposedly holding about 35,000 tonnes of the stuff (1,125,285,000 troy ounces). The other 130,000 tonnes that has ever been mined and refined, is hanging around as jewellery, with a little bit used in manufactured products. The stock only goes up by about 1,600 tonnes a year from Gold mines.
I have read that the 8,135 tonnes the US Treasury / FED holds is still valued at US$42.2 per ounce in balance sheets. Also, a lot of it has been lent for various transactions, with no return date on the paperwork? Interesting link:-
http://www.moneychoices.com.au/blog/whos-got-all-the-gold-and-whos-mining-it-infographic.php
UK gold reserves; 310 tonnes. About 16% of our foreign reserves.
November 1, 2010
Bring back the gold standard??? Have these people not read what happened in the 1920s and understood why we are all no longer staked to gold. In my opinion, it would help if all banks in future were much more transparent about their affairs. Publishing on their web sites for example complete and up to date information about ALL their own investments and liabilities so that potential investors can judge their current state before placing money with them would be a useful first step in my view. Borrowers could also benefit from having sight of their books and behaviour in the face of past loans. Let’s have consumer reviews too of their products just like other retailers.
November 1, 2010
Can’t believe that Austrians would take such a deterministic view with regards to Central Banking. Taking such a view is the opposite of Hayek and the Austrians’ basic point: markets work better because they let a multitude of economic actors make decisions for their own reasons based on the information available to them. Austrians should arguing for the abolition of the legal tender laws to permit economic actors to use whatever means of exchange or store of value they wish.
November 1, 2010
“The Austrian bank reformers want every pound of deposits backed by a pound of cash. This removes the need for a Central Bank acting as lender of last resort, and makes a run on a bank impossible or pointless.”
This is the only way for there to be any trust and stability in the banking system.
November 1, 2010
Austrian economic theory is important and has been undervalued over the last forty years. However, I believe that a fiat currency can work if it is controlled properly. Unfortunately, we have too many Keynesian central bankers who have allowed credit creation to get out of control. That is the crucial problem with a fiat currency and fractional reserve banking. If Paul Volker had been head of the Federal Reserve over the last two decades, he would not have allowed credit creation to explode in the way that it did. We need someone similar in the UK. I would still recommend Stephen Roach.
November 1, 2010
I am not an economist but I have followed the Bill and am familiar with the Austrian theory. My understanding is different.
I understood that Mr Carswell’s Bill would create a two types of account, and consumers would be required to choose and state clearly which type of account they wanted – a storage account or an investment account. My guess is that the confusing name “savings account” would be continue to be applied to the second type of account by most people.
The genius of Carswell’s Bill is that it could so very moderate and gentle. I speculate that, at first, only a tiny fraction of consumers would choose to use storage accounts and the effect would be very slight, but that fraction would rise as the fear of credit-money collapse rose towards the end of the next bubble, this would create a healthy incentive for banks to stabilise their positions.
As I said, I’m not an economist and may have misunderstood, if so I’d like hear the truth of the matter. As it is, I feel the Bill is a step in the right direction.
Reply: I was describing De Soto’s scheme, not Carswell’s Bill.
November 1, 2010
“Inflation or recession are then linked to how much gold is mined compared to the natural growth of the world economy. “ No. That is not the case. Nor would it be the result of implementing Carswell’s modest proposal to clarify who’s money it is when a bank accepts a deposit.
Austrian’s have it – in my view correctly – that inflation is a function of money, not prices. Price rises are the result of inflation, not it’s cause. At the same time they argue, and this cannot be denied as it is all around you, that ‘capitalism’ or human action results automatically in falling prices. Combining freedom, and markets and Austrian money will not link inflation / deflation to gold (or other bullion or commodity).
The fact that France has been prescient in buying up Gold is not a reason for us not to adopt properly sound money. Now.
November 1, 2010
That is a terrifically polite post.
In your place, I would have found it hard not to rant about these clowns who don’t know the difference between fractional reserve ratios and capital adequacy ratios, and who are convinced that (non-central) banks create money.
November 1, 2010
Well done John. Finally someone thoughtfully looking at our monetary and banking systems who is not a crazed gold bug or thinks printing money is the solution to all our problems. We need people willing to take a serious and radical look at this problem who are not just going to suggest ragingly impractical bat-crazy solutions.
November 1, 2010
I’ve never quite understood the need for fractional banking. If banks held all deposits as cash (or at least a high percentage say 90%) then there would be a fall in the amount of money available but if the Bank of England increased the amount of money by the same amount why would this cause any form of depression? In fact wouldn’t this cause interest rates to fall helping investment.
I’m sure I’m missing something otherwise this would have already been done – would you know what it is?
thanks for the interesting post (and previous interesting posts)
November 1, 2010
You don’t appear to be offering your own solution.
On the one hand, we can let governments like Brown’s UK, Obama’s USA or Mugabe’s Zimbabwe just print money for reasons of political expediency. This leaves those with said currency, or businesses with fixed prices in said currency at the mercy of the Government, whilst the public sector, politicos and those without any stake in the Country but just live here off benefits do rather well.
There must be a better solution, and linking the currency to a product with a limited and stable supply increase, such as gold or silver worked rather well for the Romans I believe. Tough luck that Brown sent our gold reserves down the tubes-although when you read the last sentence in my previous para you can understand why he did it.
November 1, 2010
To take seriously into negative account that a return to the gold standard would enrich certain other countries really does beg the question of whether the opponents of gold have a serious case to make and the suggestion that global growth would be aligned to the amount of gold mined is laughable.
The price of Gold would follow the growth of the Global economy provided politicians did not stupidly cause it to have a fixed price and the fact that its price would benefit certain economies is no better and no worse than the supply of oil or rice, for example.
Another argument made is that there is not enough gold in existence to allow for a gold standard, which is a nonsense as a price change would sort that our quickly enough and yet another is that Britain could not go it alone, which as an argument misses the point entirely.
The fact that all these arguments are so puerile is a clear sign that there are no real arguments against, simply a desire by politicians to find one
November 1, 2010
Time to get John Majors dual currency out off the cupboard.
Two legal tenders, one political fiat money, one hard commodity currency, one a national currency, one an international currency.
Competition is what is needed.
November 1, 2010
A very interesting post and congratulations for being one of the first mainstream blogs to mention the Austrian schoool and fiat money. I don’t see how a return to the gold standard would make S Africa any richer ~ gold has a value now. No-one is saying go back to £1 = 1 sovereign. Why would small savers struggle to get a return? Interest rates would be set by the market. He may in fact get better rates as whatever rate he does get will be above whatever inflation remains in the system, unlike now when savers are under water. would credit contract? As perhaps the only gold-backed currency, wouldn’t money in fact be attracted to Sterling?
I am not minimising the difficulties in any reversion, but fiat currencies allow governments to counterfeit, which without exception, they all do. The current system is broken and open to wanton abuse. Just because it would be hard to go back does not mean we should not think about how we could do this.
November 1, 2010
Mr Redwood, you make the mistake that there is NOT a huge re-adjustment neccessary in the economy. We have a arrived at the end-point of the Austrian business cycle of at least 37 years of monetary (credit) inflation leading to malinvestment and now collapse. Essentially since Nixon defaulted on gold in 1971. And this credit boom was historically unprecedented and global, the bust will be at least proportional. This bust will occur now or we can keep attempting to inflate and it will occur later , but with even more fury. So, a gold standard will mark the bubble debt to market immediately and , yes , it will precipitate the unavoidable crash, but with 100% reserve banking and gold as money there cannot be another Austrian business cycle.
We are now on the “let’s hope we can kick the can down the road until we grow our way out of this” economic policy. It will fail. The Interest rate swaps alone have a notional value of $600 Trillion. You can never realistically grow your way out fro under that. There is systemic risk and one counter-party defaults , they all default. The notional becomes actual.
People or countries who hold gold and want to increase their wealth have to invest their gold in enterprises that will be profitable. The profits will flow to them as investors in the business. If they just sit on their gold, and because gold is not a debt to anyone, it pays no interest. So, the gold will tend to flow to those investments that are profitable, or are potentially profitable. As it should be. The amount of gold mined annually is a tiny amount compared to the gold already mined and most all of the gold ever mined is still around. So, countries that produce gold cannot hope to be richer than Croesus from their mined gold only. This is one property that makes gold a good currency, it is demand sensitive, the supply is more of less constant.
Under a gold standard as the economy grows the demand for gold increases and so each unit becomes more valuable and your savings grow. People are encouraged to save. More savings are then available to loan in 100% reserve banking. The more valuable units of gold will spontaneously be divided down and money will spontaneously increase, the total amount of gold remaining the same, the units becoming smaller and smaller. Gold is one of the most malleable substances. With technology it is easy to divide, test, and verify. This way no one cartel owns the money supply, and nobody can inflate it. With our system of debt money the principal is loaned, but the interest is not , so their is NEVER enough money to pay the interest. New debt money HAS to be created to pay interest on old debt money, etc etc. A true Ponzi. It last until the economy becomes debt sodden. Where we are now. Collapse will happen.
I posted this on Mr Carswell’s blog : Gold is a non-inflating money ie the VALUE of gold holds.
The reasons are sound. An economist named Gibson noticed that there is a direct relationship(linear?) between the interest rate and the general price level under a gold standard. Keynes studied over 200 years of history and confirmed this , and said it was one of the most solid empirical relationships in economics. He named this Gibson’s Paradox. Prior to this it was thought prices tracked the inflation rate. They don’t.
Summer’s(Larry of the treasury) and Barskey then produced a paper showing that gold tracks the REAL interest rate(inversely) , which is another way of stating Gibson’s Pardox. In other words the demand for gold (since the supply is basically static, new gold supply compared to old above ground supply is negligible) equals the true non-inflationary demand for money in the real economy. So, while the fiat debt based money inflates, the price of gold moves by the same amount IN A FREE MARKET. There are ongoing and increasingly futile attempts to suppress the price of gold, since a rising price would signal rising inflation. In a default deflation gold is a haven from paper currency dislocation. See John Exter’s inverted pyramid.
November 1, 2010
The very fact that gold is beginning to be discussed by mainstream figures such as yourself, together with the problems inherent in our fractional reserve banking system is in itself, I think, a major development. When the banking crisis hit, I started buying gold and when I stated to friends that I agreed with Ron Paul that we had mismanaged our monitary system I was treated to pityfull stares! There needs to be more discussion on this subject in the mainstream media by yourself and others.
November 1, 2010
I am by no means a Banking expert or financial wizard, but as always the answer is probably somewhere between the two arguments.
Certainly we need to avoid Casino type speculation in the fractional reserve system, which has a risk of excessive losses as well as gains.
Certainly if the Banks had to hold 100% of all savings in reserve then we would have to pay them (cost of their overheads) for holding our money on deposit.
Why not simply split the Banks into two Working sectors with their own rules of engagement, customers can then choose which they want to deal with.
The Governments answer to keep on Taxing the Banks is not thye answer, it just means the cost is passed onto the customers.
November 1, 2010
It’s money originating as a debt that’s the problem. And the same people who control the gold now create money out of nothing and charge us for using it — and charge even our governments who once used to create the money themselves for the public good. You know ’em John, will the (rich bankers) and their related cabals really allow us to get out from under their boot?
November 1, 2010
The problem of bank runs and financial instability is misidentified with fractional reserve banking. The actual evil is maturity transformation, of which fractional reserve banking is only one example. The Austrians are too obsessed by gold to diagnose the problem correctly: you should read the Modern Monetary Theory / Chartalists instead for an insightful and eminently applicable analysis of the current fiat money system
Maturity transformation is an unnatural state of affairs – and is only made possible by gigantic government subsidy, both explicit (deposit insurance) and hidden (too big to fail) – because the natural rate of interest for sums on demand is zero: there are no productive transactions in which capital can engage instantaneously which can generate a significant return. You might charge a little for counter-party risk etc. but essentialy zero.
Overnight interest rates cannot much higher. With a twenty year loan, however, a company can invest in plant and generate an income to service the interest. Long-term financing can generate a real return because it enables real investment.
Maturity transformation artificially suppresses long-term interest rates by paying interest to short-term capital. The interest paid does not compensate for the maturity risk the bank is running by lending long and borrowing short.
The current economic situation of zero overnight rates for and high real interest rates for fixed term loans is pretty close to a world without maturity transformation. We could improve upon it, however:
1) Deposit insurance can be removed if maturity transformation is forbidden. The Too Big To Fail then lose their advantage over other banks.
2) The scarcity of capital that Mr Redwood predicts could be solved by the government ceasing to issue bonds. Bond issues do not fund government spending, they mop it up: money is created electronically by the Bank of England. There is no reason to fund government deficits with bond issues when money can be mopped up with taxation instead. By issuing bonds, governments distort the term structure of interest rates; without a risk-free asset to compete against, capital would have to flow to real-world investments and as a consequence the prices bid by banks to fund could fall and thus loan rates would fall.
3) A land tax should be introduced to deflate land prices; a reduction in land prices would mean that more of any given level of capital that seeks a return would be available for investment in buildings and plant rather than in land.
Gold versus fiat money is an irrelevance. Societies without gold nevertheless managed to have money, because the basis of money is credit: provided everybody accepts the counters we use to track our credits and debits, we have a money, and this acceptance can be cultural or imposed from above by a state through the requirement to settle taxes in a given form of money. Moving to gold merely substitutes the question who mines for who prints.
November 1, 2010
The blogger’s commentary on Austrian economics appears to be based on a partial picture of the School. Hayek is not worshipped but referred to. What of Von Mises, Boehm-Bawerk and others? To object to a gold standard on the basis that it would enrich South Africa is curious. To be enriched, the mines would have to be managed in a profitable manner. this argument also concedes the point that fractional reserver banking enriches the “miners” of fiat money, the bankers and those closely connected to them. Is this OK for bankers but not miners?
There has been inflation with gold and silver particularly as the Spanish colonies produced new streams of the metals in the 17th century. However, with QE £50,000,000,000 can appear in an instant.
To say that a gold standard will enrich some countries with more gold than others is to ignore the fact that over time, trade sill enrich those who produce well, and gold will move with the trade.
As for here being less savings under gold and low interest rates, well the confiscation that is QE and inflation will vanish (barring more mining) so real interest rates may be higher. With a static(-ish) monetary base, prices may fall (- as we still see with electronic goods in terms of price but not quality-) but as long as MARGINS remain, profits can be made and prosperity should flow.
As for disruption, that is what we have now. A recession is the revealing of the underlying reality, the cure for the boom. The faster the adjustment, the quicker truly productive economy can restart.
November 1, 2010
Who sold the gold reserves? No boom or bust Gordon Brown.
November 1, 2010
Fascinating history of liberal economics by de Soto in this interview. So much for Adam Smith being the father of the “Invisible Hand”
http://mises.org/journals/aen/aen17_2_1.asp
November 1, 2010
Tim Yates has overlooked the massive inflation in Spain following its conquest of most of South and Central America.
That is unlikely to be repeated if we reintroduced the gold standard as any expansion in the supply of gold is likely to be a small percentage of the current stock of mined metal. However a much worse risk exists – that of massive deflation if we cut back the amount of fiat currency to a fixed multiple of the stock of gold and silver in the vaults of banks and central banks. World economic growth usually exceeds the ratio of newly-mined gold to the world stock of gold so the only way to maintain the ratio of fiat currency to gold is to steadily reduce the price of goods which implies a reduction in wages in any industry/service that cannot increase productivity per head faster than world economic growth (adjusted by the % increase in the stock of gold).
A steady decrease in monetary wages would involve a massive transfer of wealth from borrowers to lenders – a reversal of that under ever Labour government in my lifetime but nevertheless equally undesirable (except in the case of property speculators)
November 2, 2010
Using gold as the backing for a domestic currency seems bizarre. Apart from anything else, a domestic currency does not need to be backed as such; all that is required of it is that it facilitates the sufficient availability of credit to maintain purposeful economic activity. Using a fiat currency to back international trade also seems bizarre since there is a clear temptation for any country to simply print money to purchase goods for which they will have no resources in the future to make redemption; further they can devalue their debts by a simple stroke of the pen. This is the situation with the Federal Reserve Note issued by the private US FED.
Gold as the basis for international trade has many disadvantages indicated by JR; another is its approximate equivalent specific gravity at normal temperature and pressure to tungsten and there is an unknown quantity of gold-plated tungsten ‘bullion’ currently in circulation which, it has been suggested elsewhere, has emanated from Fort Knox and which may have triggered a certain well-known bullion dealer to withdraw from the market.
A sustainable domestic banking system would be one whose lending policies are closely attuned to sustainiing the economic activity of the community it serves. It would not be a magnet for spivs. It would not base its lending purely on exchanging credit for charges on assets; that is how to create asset bubbles not to create real wealth which can only come from generating added value and that can only be achieved by lending to wealth creators who build busnesses.
Although I believe that a fractional reserve system based upon a publicly-owned central bank can work in theory, it cannot do so by simply setting the discount rate and letting matters rest there. The behaviour of the banks recently in which they had become creators of debt to be financed by the taxpayer was disgraceful and much aggravated by the absurb amounts of our money with which they have been rewarding themselves.
The search for a single principle which of itself would ensure a sound banking system is probably illusionary but if it existed it would probably be that banks of themselves cannot create wealth, they can only cream off the wealth created by others.
November 2, 2010
Why why are you, John the MP for Wokingham? You seem to do bugger all in the town…
Reply: On the contrary, as my contributions to the local debate and my various meetings indicate. I am not, however, a Wokingham Borough Councillor. They have the important planning powers and local service budgets and do not welcome an MP without those powers trying to second guess them on everything.
November 2, 2010
Doesn’t this post and the following comments prove that breaking apart the investment and retail branches of the banks is the way to go.
If done you can make one rule for reserves and guarantees for the remaining retail banks and no rules at all for casino banking so Guido can continue to enjoy his gambling habit.
November 2, 2010
Forthurst
Although the atomic weight of gold and tungsten are the same, other properties that are not the same can be exploited as a test. Eg. a small hand held ultrasound meter can distinguish gold and tungsten. Electric resistance and magnetic conductivity can also be tested. Other tests would surely follow. Each gold coin can be made to have a certain test signature. Testing instruments would become cheaper as the market grew. Buying a portable testing device would be a prudent investment for a cautious saver.
There is another way of creating debt free money backed by gold, without anyone holding a monopoly over the supply. Real Bills cleared for gold. A Real Bill arises spontaneously when there is a transaction between buyer and seller. The Seller raises the Bill , it is a type of invoice that can be used as circulating currency. The big difference is that the bill itself has no debt, and it ALWAYS expires after 90 days if the transaction is not completed, or sooner if the transaction was completed earlier and the correct amount of gold is transferred between buyer and seller. Ie it is non-inflating.
This allows some flexibilty and convenience without having to actually have gold coins in your pocket all the time.
It is of course a compromise and imperfect, but it may make the gold standard slightly more palatable for those who cannot stomach a hard gold(bullion) standard, for whatever reason.
But any system must have gold underpinning it, because by the Calculation Problem , outside of a market , it is impossible to economically calculate any allocation , including rates and the the correct amount of money. Gold in a free market will do that for you better than any substance or algorithm known to man. Gibson, Summers, Barskey , Keynes et al proved it. Disprove it and you will refute >5000 years of history.
November 2, 2010
i might add that any metal monertary system will in practice likely be a bi-metal system with silver being used for the small denominations and gold for the larger.
November 2, 2010
Financial Crisis and Economic Recession
Speaker: Professor Jesús Huerta de Soto
Chair: Professor Tim Besley
This event was recorded on 28 October 2010 in Sheikh Zayed Theatre, New Academic Building
The current financial and economic situation of the world should be analysed from the point of view of the Austrian Business Cycle Theory as developed by Mises and Hayek. Professor Huerta De Soto will present innovative solutions to the banking crisis and credit crunch working within the tradition of the Austrian School masters, Mises and Hayek. He will also unveil his proposal for similar legislative change that the “Peel Act” or Bank Charter Act of 1844 achieved with regards to the over issue of promissory notes to gold, but with respect to the over issue of credit. The consequences of doing this should create a climate of financial stability and an opportunity to totally restructure the national debt (potentially pay it off).
Available as: mp3 (40 MB; approx 82 minutes)
http://www.lse.ac.uk/resources/podcasts/publicLecturesAndEvents.htm
November 2, 2010
I think the emphasis should be on stopping politicians using deficit financing.
This is also part of the Austrian economists’ philosophy.
November 2, 2010
Fantastic , thanks.
November 2, 2010
” The Austrians worship at the shrine of Hayek … The Austrian bank reformers want every pound of deposits backed by a pound of cash.”
***
This would require state legislation to regulate commercial banking and is a direct contradiction of the arguments presented by Hayek in favouring market standards for money.
November 2, 2010
Yes the bust was caused in part by too much money in the system, but saying that means we kill our economy by going back to a gold standard is a bit like saying we should all go back to wearing animal skins just because you’ve got a hole in your trousers.
The problems didn’t start in 1931, when we left the gold standard, but in the early 2000’s. Various things happened then but from a UK perspective, one of the most important was the growth in the customer funding gap (broadly the difference between banks’ loans to and deposits from customers) from roughly zero in 2001 to £750bn in 2007.
That infusion of ~£125bn/year was one of the main drivers of the boom, as exemplified by Northern Rock, and the outflow of ~£300bn since then is one of the main reasons we’re struggling now. The £450bn CFG remains a systemic weakness in our banks, not least because around 60% of it has maturities of <1 year – it's a key route/symptom of the maturity transformation mentioned by rtah100.
If Messrs Carswell and co want to make themselves useful, rather than messing about with gold they'd be much more use working out a plan to eliminate the CFG, with an emphasis on the short-term element. It can't be done immediately, it would kill our economy (albeit not as badly as a move to the gold standard), but we need a 10-or-20-year plan.
We also need to think about the systems that got us here, both the warped incentives that encouraged bankers to rack up a CFG, and the regulatory oversight that will stop it happening again. The CFG is one of the best examples of the failure of Brown's regulatory regime – the IMF was going nuts over our CFG and parts of the BoE likewise, but they couldn't do anything because Brown had given all the power to the FSA, who did nothing thanks to a mixture of political pressure and (mostly) general cluelessness. After all, the banks appeared to be ticking all the boxes on the Brown-mandated checklists, so everything was tickety-boo as far as the FSA could tell.
Splitting up the regulators who understood when something was going wrong in banking from the powers to do something about it was a basic mistake. A secondary problem was that it led to regulation being based on ticking boxes rather than a more flexible and robust system based on regulators who vaguely knew how banking worked.
Part of Brown's hubris was that he couldn't believe there were people who were smarter than him – and many of them were working in the commercial world, particularly in banks. There were huge financial incentives for those people to find ways round the letter of Brown's regulations, so they were always several steps ahead of the creators of boxes to tick. That's why Brown's tick-box regulation was bound to fail.
November 2, 2010
PS South Africa hasn’t been the world’s biggest gold miner for a couple of years now – that title belongs to China, with ~300 tonnes, most of which seems to be going straight to their version of Fort Knox.
After China there’s a cluster of countries on around 200t/year – Australia, SA, USA, Russia and Peru. Total production is around 2,350 tonnes per year, or about US$100bn-worth per year.
Look at it another way, all the gold ever mined is roughly the size of a detached house.
November 2, 2010
GR Steele
” The Austrians worship at the shrine of Hayek … The Austrian bank reformers want every pound of deposits backed by a pound of cash.”
***
This would require state legislation to regulate commercial banking and is a direct contradiction of the arguments presented by Hayek in favouring market standards for money.
—————————————————————————-
If you truly free up markets and abolish the legal tender laws and let people freely choose the currency that they wish to transact in , and let insolvent companies fail, then you will find that people will automatically choose gold, and gamblers will be reluctant to take insane risks.
Why gold ? Because money has some common sense properties and gold matches more of these properties than any other substance known. eg:
portable – you cannot carry land or barrels of oil in your pocket
durable – grains, oil, iron etc degrades
divisible – diamonds and land are not readily divisible
few industrial uses – platinum is almost always used up in industry, none left to save or hoard.
scarce – salt or sea shells are common.
non-counterfeitable – paper money and electronic digits are quite easily counterfeitable, no less by fractional reserve banking.
desireable – emu droppings may be all of the above but nobody wants them !
etc etc
Gold IS money !
November 2, 2010
In reference to a comment above concerning the Great Depression stating that it was the Gold Standard that created it in 1929 – I would have agreed with this a few years ago because I believed the argument that if only the US Government had expanded the money supply, then the Great Depression would have been averted.
“The Great Depression was a consequence of
(a) credit expansion to pay off war debts from WWI during the 1920s,
(b) monetary contraction during the 1930s,
(c) government microeconomic policies which completely curtailed the ability of market forces to adjust to the changing circumstances, and
(d) government policies which eliminated the ability of individuals to realize gains from trade. None of this is about the gold-standard.”
“The gold-standard is a serious check on government debasement of the currency.”
I believe that the argument that we need Central Banks to help inflate the money supply to avoid ecenomic depressions is a false one because, without Central Banks and the garuantee of bail outs for faultering Banks, we wouldn’t get into the position of near financial collapse. The other key issue is that a Central Bank makes it easier for a Government to fund Wars and therefore makes the likelihood of War more probable.
November 2, 2010
I English – but I would just like to wave the Scottish blue and white flag with pride based on the following extract:
“2. FREE BANKING IN SCOTLAND
After the founding of the Bank of England, English banking,
during the eighteenth and first half of the nineteenth centuries,
was riven by inflation, periodic crises and panics, and numerous—and in one case, lengthy—suspensions of specie payment.
In contrast, neighboring Scottish banking, not subject to Bank of
England control and, indeed, living in a regime of free banking,
enjoyed a far more peaceful and crisis-free existence.
Yet the Scottish experience has been curiously neglected by economists and historians.
As the leading student of the Scottish free banking system
concludes:
Scotland, an industrialized nation with highly developed
monetary, credit, and banking institutions, enjoyed remarkable
macroeconomic stability through the eighteenth and
early nineteenth centuries. During this time, Scotland had
no monetary policy, no central bank, and virtually no political
regulation of the banking industry. Entry was completely
free and the right of note-issue universal. If the conjunction
of these facts seems curious by today’s light, it is
because central banking has come to be taken for granted in
this century, while the theory of competitive banking and
note-issue has been neglected.”
November 2, 2010
How did it work? Our Scottish friends had the answer:
“Scotland enjoyed a developing, freely competitive banking
system from 1727 to 1845. During that period, Scottish bank
notes were never legal tender, yet they circulated freely throughout the country. Individual banks were kept from overissue by a flourishing note exchange clearinghouse system. Since each bank was forced to toe the mark by being called upon for redemption, each bank would ordinarily accept each other’s notes.”
“An important evidence of the relative soundness of Scottish banks is that Scottish notes circulated widely in the northern counties of England, while English bank notes never traveled northward across the border. Thus, in 1826, the citizens of the northern English counties of Cumberland and Westmoreland petitioned Parliament against a proposed outlawing of their use of Scottish bank notes.”
November 2, 2010
Scottish Banking 1727-1845 continued …
“The petitioners added that, with one exception, they had never suffered any losses from accepting Scottish notes for the past 50 years, “while in the same period the failures of banks in the north of England have been unfortunately numerous, and have occasioned the most ruinous losses to many who were little able to sustain them.”
The Government’s solution was to make the Scottish Banking system as unstable as the English Banking system – to create a level playing field.
1845:
“Peel’s Act to Regulate the Issue of Bank Notes was imposed on
Scotland in July 1845. No new banks of issue were allowed in
Scotland any longer; and the note issue of each existing bank
could only increase if backed 100 percent by specie in the bank’s
vault. In effect, then, the Scottish banks were prevented from further note issue (though not absolutely so as in the case of England), and they, too, shifted to deposits and were brought under the Bank of England’s note issue suzerainty”
Effectively turning Scotlands Free Market Banking System into a Tax payer loss funded Communist Regime with Private Shareholders exracting huge Profits, because Northern County Banks couldn’t compete with the Scottish Banks.
November 2, 2010
I am afraid that if I had my way, Mervyn King would soon be rubbing shoulders with the newly to be created unemployed at the local Job Centre.
I wonder what Merv would look like in Denim Jeans, a T-Shirt and a Pit Bull dog lead in his hand.
November 2, 2010
A lot of people commenting on this really need to look up what Fractional Reserve Banking actually is.
It does NOT consist of a bank lending out money that has not been deposited with it, or creating money out of thin air and lending it. That would be fraud, and illegal.
There’s a pretty good article on it in Wikipedia.
November 3, 2010
I note we have a fresh contribution to the debate from Fathom Consulting, who appear to consist mainly of former BoE employees, and has ties to de Anne Julius. On the one hand they point up the overvaluation of the housing market and the threat of further increases in the customer funding gap, and call implicitly for house price falls and reductions in the stock of mortgages.
On the other hand, they suggest that a TARP or NAMA stye programme of QE should be adopted. In essence, that amounts to a continuation of the SLS and CGS schemes that the BoE has already implemented, albeit those schemes merely replaced foreign funding that was withdrawn partly on the back of the demise of Lehman and Bear Stearns. It would not actually tackle the underlying problem – merely park it with the BoE more permanently – while the national income accountants would struggle to keep it off the national debt.
There is no need for such histrionics. Mortgage lending could be managed down quite easily from the rate at which tier 1 capital has been accumulating in this world of inflated banking margins based on rigged interest rate markets. All it takes is a move down in house prices and an appropriate response from banks. Banks may make no profits and pay only very limited bonuses, but they could survive.
The key is that (in Austrian fashion) once the bank balance sheets are properly cleansed, they can resume normal healthy economic lending. That is an aim that Fathom suggest which deserves wider attention.
November 3, 2010
Adam Collyer
Either Wiki is wrong or you have misread it. But I can assure you that money is created out of thin air and reserves are fractioned, the FED itself admits as much :
“How Banks Create Money
Banks actually create money when they lend it. Here’s how it works: Most of a bank’s loans are made to its own customers and are deposited in their checking accounts. Because the loan becomes a new deposit, just like a paycheck does, the bank once again holds a small percentage of that new amount in reserve and again lends the remainder to someone else, repeating the money-creation process many times.”
http://www.dallasfed.org/educate/everyday/ev9.html
November 4, 2010
Some elementary maths should tell you that the sum of the infinite series 1+x+x^2…+x^n is 1/(1-x) so long as x<1. Thus if the bank lends out a constant fraction of a deposit, the total money creation is finite. Banks choose x so that they can expect to meet demand for cash withdrawals: if cash withdrawals exceed this you get a run on the bank. A lender of last resort can provide cash to prevent the run – provided that the currency itself is not under threat of collapse because its value is undermined as in Weimar inflation.
November 3, 2010
The number of responses is a sign of the interest in this question. Perhaps you should invite Prof de Soto to do a guest post and respond to your piece and to the comments.
The obvious first result of the introduction of a gold standard would be a huge increase in the price of gold, as the current dollar value of all gold holdings is a small fraction of the value of outstanding currencies, as pointed out above. That would mean a tremendous one-off wealth boost for investors – and countries – holding gold. (In Britain we would again be reminded of the baleful consequences of Gordon Brown’s disasterous chancellorship!) You are surely also right to say there would also be a continuing boost to the economies of those countries which produce gold at the expense of those which do not.
Mr Carswell’s idea to ban fractional reserve banking can only work if there is also a gold standard or equivalent. There’s no point putting your money in a cash-backed storage account unless you can be confident of its purchasing power as well as its prompt return when you take it back.
The real question is: how do we bring about a hard stable currency which preserves its purchasing power – which is surely better for rational investment decisions and price discovery in a free market – without the undoubted disruption and one-off distortions of introducing a gold standard?
Step one is clearly to get rid of tax-borrow-spend politicians such as Brown. But its a question as to what Step 2 is – monetarism alone doesn’t seem to have done the trick.
November 3, 2010
@Mark (03 Nov 2010 at 12:20 am)
You’re mebbe missing the fact that there are two aspects to “cleansing bank balance sheets”. One is reducing their debt (ie reducing the CFG) – but that has to happen over the long term if you’re to avoid tanking the economy. The other is to do with how they’re funding that debt. The first half of the CFG expansion was largely done through the wholesale markets, the second half through securitisation. You can imagine the quality of asset-backed securities created in 2004-7 – there’s still a lot of crud on the balance sheets of the banks, much of which wasn’t eligible for central bank schemes, or whose cruddiness was not yet apparent to the banks back in 2008/9.
As you note, SLS and CGS in effect replaced foreign lenders with the BoE for a large slug of the CFG. However, there’s a good argument for a further cleansing of the way that bank balance sheets are financed, to avoid another BS/Lehmans-style domino collapse. The number of dominos lined up on end, waiting to fall, is a much more urgent problem than the total number of dominos on the table – and that risk is in itself part of the problem, reducing banks’ willingness to lend. “Parking” stuff with the BoE does help reduce that systemic risk, even if it merely puts off the time when that money is finally removed from the economy.
November 4, 2010
If we look at how the CFG was financed, then I think there was some £300bn which was essentially hot money sight deposits by foreigners at the peak. The remainder was essentially securitised. Where those securities were sold abroad to foreign interests the risks have been transferred (except to the extent that the securities themselves offered guarantees from the issuer, as many actually did – such as the Northern Rock Granite vehicles). Of course, many risks are lurking in SIVs and other off balance sheet vehicles that will collapse back on their originators. There are doubtless other common mode risks that remain to be publicly discovered in the manner of AIG’s (role in ) the CDS market as the principal insurer.
To some extent bilateral netting under ISDA type provisions reduces risks, but there can easily be large asymmetries in positions that only show up when intermediary “credit sleeves” are removed from the transaction chains. Thus Wall Street banks could claim a margin on selling CDS or loans to customers while “hedging” with AIG: their customers might imagine buying a CDS was secure until it turned out that everyone depended on AIG (or ultimately the Fed and the taxpayer) for the payout. It now appears in the US that some mortgages were packaged into more than one security – (worrying errors and mistakes or worse ed) Doubtless similar problems will turn up in the UK and elsewhere. Turn over the stones and you will find cockroaches. That’s the lesson of every bubble in history. Regulators have had several years to identify the problems. The evidence suggests that accountants have yet to quantify the solutions.
November 4, 2010
I have a longer comment in moderation (I suspect because it mentions particular counterparties although the information I discuss about them is in the public domain).
I agree that the liabilities side of the balance sheet also needs sorting out. At its simplest, it is hard to see why there should be a CFG at all. It implies a need for overseas borrowing as if we were engaging in a massive development programme, instead of financing a stock of housing that changes only very slowly. With large corporates bypassing the banking system by paying down loans and raising their own bonds and equity finance instead, banks don’t need much in the way of liabilities to match assets in the form of loans to industry. Mortgage securitisation is moribund and it is hard to see how that market can be resurrected in anything like its previous form – or perhaps at all. There will be some hot money flows as bouts of QE drive cash out of depreciating currencies – however, these will tend to favour investment in commodities over cash and gilts.
November 3, 2010
Fractional Reserve Banking does create Money out of Thin Air.
Deposit £100 into a Bank.
Bank Keeps £10 Loans out £90 Total Liability still £100
Therefore: The money out on loan was created out of nothing as it is still legally obliged to provide the £100 on demand to the initial depositor.
Total Money supply:
£100 in Deposit Account + £90 out on loan = £190
(Process continues until additional £900 is created out of thin air).
The first Transaction has increased the money supply by 90% and is only backed by the promise of the borrower to pay it back. When they do, the £90 will be cancelled out (returned to nothing) with only the interest remaining on the Books of the Banks.
November 4, 2010
As a ‘student’ of Austrian economics, I can, at best, only regurgitate what I have read (with the hope that my proficiencies at analysis will grow and become sharper).
However, in you criticism of a return to the gold standard, you write that
you imply (however indirectly) that a static quantity of currency will impede economic growth (setting aside the benefits for those who invest in mining operations for the time being).
Yet as Murray Rothbard wrote in Man, Economy, and State:
Or, as Robert Blumen has summarised, ‘The idea that economic growth requires more money is based on a confusion of the real and the nominal. In fact, economic growth does not depend on the quantity of money at all. Any rate of economic growth can occur with any quantity of money.’
Is this a fair counter-argument to your critique of de Soto?
November 4, 2010
What you describe relates to the use of money as a means of payment (a flow in the opposite direction to the provision of goods and services). It ignores the use of money as a store of value (a stock of wealth). Where the purchasing power of money changes, those who hold a stock of it lose out under inflation – as typically occurs with fiat currency, although the post bubble yen provides a counter example – or they gain under deflation. Since increases in the stock of gold cannot match increases in global population, that implies deflation. It matters not whether a cup of coffee is priced at 2,000 lire or £1 or 10 millligrams Au. What matters is whether the same cup of coffee will cost 75p, £1 or £1.50 (or 1,500, 2,000 or 3,000 lire) in a year’s time. If the answer is £1.50, I will hoard coffee beans, not pounds. If the answer is 75p, I will hoard pounds and not coffee beans. The difference in demand is a real effect on the economy.
November 29, 2010
“more difficulties for the small saver in getting a decent return on his savings.”
Don’t talk crap. Interest rates would depend on the total pool of savings. If a lot of people save more, interest rates drop. If people save less, interest rates rise.
What Stephen MacLean says is fully correct and money as a function of the storage of wealth would benefit which a stable money supply. The whole idea behind a gold-standard is the degree to which it restrains governments from printing money.
Mark is confusing deflation for falling prices. Deflation is a contraction of the money supply. If the population increases, nothing happens with the money supply. Hence, an increased population has no effect whatsoever on the size of the money supply. It’s a non-argument.
Prices of products like a cup of coffee are a function of supply/demand and has nothing to do with inflation nor deflation. They are, however, a market signal to entrepreneurs in which areas to invest.