Negative rates on bank reserves acts as a fixed tax on the banking system. The only way for the banking system as a whole to reduce its impact is to expand by lending more, increasing the ratio of (untaxed) ‘bank money’ to (taxed) ‘base money’. Unlike conventional profit or transaction-based taxes, negative rates fall most heavily on the least active banks, those with the highest reserve ratios. Conventional taxes, since they discourage activity (lending), are passed from banks onto wider society in the shape of higher margins on loans and lower rates on deposits. Negative rates, on the other hand, cannot be passed on, since they force lending up – all of these additional loans will need funding, and so deposit-taking cannot be deterred by banks trashing rates to savers. Radical policy would replace conventional taxes on banks with a negative rate on reserves deposited at the central bank.
The severity of the financial crisis is down to savers no longer “knowing”* what saving goods (especially bonds) are worth. While the crisis reflects major underlying problems, its immediate escalation is simply a draining away of liquidity from almost all saving goods. The one exception – so far – is money.
A holder of an Italian or Spanish government bond knows that it is backed by a promise made on behalf of million of taxpayers. Yes, both economies (as with all others in the developed world) are mired in difficulties of some description or other. But this diagnosis is not entirely new. Have Italian and Spanish workers all suddenly become less productive? No. Has the word of their sovereigns become questionable all of a sudden. No.
For all the theory directed towards macroeconomics, what causes a recession to occur after a period of growth is confidence. Factors of production – land, labour and capital – do not undergo sudden changes. Yes there are recurrent supply shocks, such as rising commodity prices, wars and natural disasters. But nobody is arguing that any of these is to blame for the current crisis.
Meanwhile, very many people recognise that confidence is key. Keynes talked of animal spirits, and this concept has recently made a comeback in the English language. Behavioural economics has never been more influential.
Yet this level of understanding among policymakers has not unlocked the present conundrum. The more savvy do realise that the key to de-escalating the Eurozone financial crisis is to furnish savers with a saving good whose worth they “know”*. So far, this has prompted calls for the provision of more money (ie ECB intervention). It is beyond the scope of this note to detail the difficulties of such a proposal – suffice to say there are major political impediments.
But as I argued recently (“Dear Mario: A Plan for Italy”**), formal ECB-driven quantitative easing (QE) is not required. No ECB intervention is needed for eurozone sovereigns to issue an instrument whose worth can never be in doubt. Previously this instrument was a government bond, although in this emergency savers now question whether distressed sovereigns are capable of honouring their promises. So a new instrument must be established.
This instrument is a Tax Credit. What distinguishes this from a conventional bond is that the worth of a Tax Credit (to a taxpayer in the year of exercise) is self-evident. This worth is independent of what other savers think or how they behave; it does not rely on a sovereign being in rude financial health in the future. A Tax Credit resembles money much more than it does a bond.
Whereas formal QE cannot be achieved by Italy or Spain (without abandoning the euro) – and might not even be feasible for the ECB given its political environment – Tax Credits can be issued by any sovereign unilaterally with immediate effect simply by offering to subscribe a sum of government bonds in exchange for another sum of Tax Credits exercisable in the future.
Whereas savers (who cannot know for sure what government bonds are worth) demand very high yields to hold bonds issued by distressed sovereigns, they would not have this concern about Tax Credits. Like money, their liquidity is as assured as taxes being levied. Consequently, the terms of the exchange would reflect a much lower (truly risk-free) rate of return: the opportunity cost of holding a Tax Credit (for the taxpayer) is the liquidity premium (on account of the delay before its exercise, at which date it is a cash equivalent).
The government would announce an auction/exchange date together with the sum of Tax Credits being offered (with different years of exercise). Using a risk-free rate of return to accrue value, a maximum exchange rate would be set. E.g. up to EUR110 of 10Y Tax Credits could be offered for EUR100 of 5Y bonds. (My previous note goes into more detail about pricing; the idea would be to offer Tax Credits whose present value corresponds with the surrendered bond par). Italy is running a primary surplus of around 1% of GDP – which, with debt of say 120% of GDP, suggests that paying average interest of 0.8% would mean the government would only need funding for bond repayment. While a yield of 80 basis points is probably ambitious, issuing Tax Credits holds out hope of reducing interest costs towards this breakeven level.
By staggering supply, the government could allow the price of Tax Credits to be bid higher as bondholders compete to exchange bonds for risk-free instruments. The higher the price of Tax Credits, the greater the saving for the sovereign. But by offering present value up to the bond par, this is achieved without imposing a haircut on bondholders, and without resorting to coercion or default. In this way, the sovereign sends a credible signal that it intends to honour its promises, which should encourage bonds to trade back up towards par. Conventional borrowing (bond issuance) would then fall back to affordable levels. (Returning to conventional bond issuance at some stage is desirable as it imposes greater discipline.)
Even with this level of generosity to bondholders (certainly in comparison to market prices), the sovereign would save itself a potentially considerable amount of interest over coming years – and also has the opportunity of postponing refinancing needs too. These two factors mean government – not bond vigilantes – can set the terms of necessary austerity. Restoring financial and economic health is not a given with such an emergency scheme – but by greatly boosting domestic liquidity and investor confidence while reducing interest costs, at least recovery would be back within governments’ sights.
*I use quotation marks in order to set aside wider questions of value and purchasing power, since these important ideas are not necessary in de-escalating the current crisis.
** Also available in the FT Long Room and at http://wealthoflabour.wordpress.com
The nemesis of any nation’s public finances is the moment investors demand risk premia correspondent with fears of bond default. To go from this inflexion point to an actual credit event can be rapid, a matter of weeks or even days – not least because the shift upwards in perceptions of risk actually heightens risk i.e. excessive fears become self-fulfilling.
In such circumstances it is imperative to identify and deploy a “circuit-breaker” as soon as possible, a task that has proved extraordinarily difficult to achieve for distressed eurozone sovereigns, whose credibility is constrained, after all. In this post I outline just such a circuit-breaker.
So what can be done? Leaving aside the host of official eurozone proposals being bandied about, what options short of default can distressed sovereigns really enact themselves that would relieve the funding pressures arising from unaffordable risk premia?
Unlike other borrowers, sovereigns can raise taxes from their citizens. Of course this power does not exclude sovereigns from being viewed as risky; however, the obligation to pay tax does mean that an instrument created for the express purpose of meeting this obligation would, to the holder at least, bear zero credit risk. In normal circumstances, this instrument is money: in the eurozone, euros. However, eurozone sovereigns cannot issue euros, part of the reason they are hard to come by in certain markets. But eurozone sovereigns are not prohibited from issuing alternative instruments that they will accept in settlement of taxes levied on their populations.
In present circumstances, issuing Tax Credits may be the least worst if not the last available method for weak eurozone countries to manage their debt and access funding – two vital pillars in any austerity programme. Moreover, a Tax Credit being another name for currency, such a scheme would in effect promote much-needed monetary easing, helping to restore the economic activity on which austerity depends, namely investment.
To meet these objectives, distressed sovereigns have to infuse Tax Credits with credibility. Whereas convincing investors to hold its IOUs means Italy has to offer unaffordable rates of interest, convincing them to hold a Tax Credit that can be used to redeem future tax obligations ought not to come at such a heavy price. This is because unlike for the government bond, the value of a Tax Credit does not rely on the government meeting an increasingly unaffordable obligation; it relies on the government continuing to levy taxes, which (along with death) is unlikely to end any time soon.
What should investors be willing to concede to the sovereign in exchange for Italian Tax Credits, I wonder? Judging by the risk premia being charged, one answer is surely Italian government bonds.
The difference between the risk premium charged on new Italian government bonds (currently around 7%) and that on Tax Credits (a truly risk-free rate) represents a net saving for the sovereign extracted without coercion. The circa EUR2 trillion question is how to exploit this saving (but no more) in order to achieve the goals of sound public finances and economic growth. Fine-tuning the terms of the debt exchange should be about alleviating the debt ‘stock’ and funding ‘flow’ pressures on the sovereign, while minimising the fallout for investors, many of whom, after all, are domestic savers (pension funds, retail investors) and financial institutions critical for the nation’s revival. Even foreign investors, many comprising important elements in the eurozone financial system, may go on to provide vital funding in the future, provided they are treated fairly.
So to the details. In the case of Italy, the treasury would, in exchange for cancelling surrendered government bonds due in t years, offer Tax Credits exercisable in year t + n. (Tax Credits exercisable per year would be limited, say to % of current collections, to ensure a minimum cash collection for non-debt service expenditures.) The exchange rate (r) offered by the treasury would represent the future value of the Tax Credit divided by the bond notional.
Subject to its terms, the scheme would boost Italy’s liquidity position i.e. its ability to run a budget surplus over the short term. However, liquidity comes at a cost for investors, who will therefore expect to be compensated at a risk-free rate of interest i over the corresponding term in return. As Tax Credits are not interest-bearing, i is implicit in r. That is, in quantifying the terms of the exchange (it is voluntary), investors will discount the future value of the Tax Credit (realised in t + n years) at a rate of interest i – using as a proxy some other benchmark such as the deposit rate at the central bank or yields on German government bonds with similar maturities – or maybe even domestic inflation.
In the case of Italy, with most of its public sector debt held by its own citizens, there is immediate scope to implement such a scheme (although foreign ownership is by no means incompatible with the basic premise as trading would repatriate most bonds). Italy, keen to preserve its status as a performing debtor rather than join the club of bailed-out states, will (unlike Greece, in a more perilous position) seek to avoid passing on economic loss to bondholders. This would be achieved by sizing r = (1 + i) ^ (t + n) for any bond being surrendered.
In discussion with investors, the treasury would have to select its own risk-free benchmark. If i = 1%, then for bonds surrendered with 5 years remaining Italy would offer Tax Credits exercisable in 5 + n years. With n = 5, the Tax Credits would be worth 110% of par. With a longer lag (say 10 years), r would rise to 116%. Yet despite no haircut, there is considerable saving for Italy owing to the difference in compounded risk premia over the period t + n. For a bond costing Italy 5% p.a., this amounts to a saving roughly of:
(1 + (5% – i)) ^ t during the term of the bond and the present value of (1 + (7% – i)) ^ n pending exercise of the Tax Credit (assuming bond yields stay around 7%).
This scheme could be offered immediately and should attract interest on all but the most short-dated bonds (of which bondholders might reasonably expect full repayment). For investors, counterparty risk is removed and there is no writedown of their investments. For the sovereign, cumulative debt service costs are slashed while some austerity is postponed, freeing up cash flow without undermining credibility.
Dear Mario, with such a scheme, Italy would have a reprieve – and the breathing space to commence on its programme of reforms as well as introducing some targeted growth-driven spending. There is a double saving: just as the break-even rate of growth necessary to restore sustainable debt dynamics would fall in line with funding costs, the prospects of securing this growth would also improve, both from the lightening of the fiscal adjustment and a de facto monetary loosening. Moreover the Italian yield curve would fall as bonds on all maturities trade up towards par, with investors heartened by having a concrete and credible exit in sight – and all without a cent of official support or ECB intervention!
Finally and crucially, the scheme acts as a circuit-breaker – more bullish investors might retain bonds in the hope of improved circumstances, whereas the more bearish would gladly surrender theirs. The composition of its investor base would migrate towards the more committed and away from speculators. Instead of escalating the crisis, periods of weakening investor sentiment (and there will doubtless be bumps along the way!) would give the sovereign more flexibility, not less as experienced presently.
Austerity, vital to reverse the deterioration in public finances, is not achieved by keeping productive resources idle – on the contrary, this is inexcusable waste. The scheme, unique among the raft of proposals for allowing for a controlled pro-growth stimulus within the confines of the single currency union, must be considered urgently if Italy – and indeed others – are to survive socially, politically and economically intact.
From a friend of Italy
What is liquidity and what is it for? The most liquid asset, money, we use to make purchases. Since what we ultimately use it to buy -consumable value- is constrained by available goods and services it may be tempting to construe liquidity as being similarly limited by real economic factors. This is incorrect.
In order to examine what liquidity is, it is necessary first to introduce the concept of purchasing power. This refers to the value a saver believes should be obtainable from or in exchange for an asset. Purchasing power differs from value in one critical way: whereas value is a measure of currently consumable surpluses, purchasing power does not specify the time of consumption. While it is its offspring, purchasing power is not yet constrained by saving; it allows for some projection of future, yet-to-be-produced value too.
So, what value is to consumers, purchasing power is to savers. Consumers demand goods and services on the basis of what value they offer now in relation to their price: value is assessed at purchase before being consumed as utility, both experienced subjectively. It should not matter to one consumer what the experience of another is. Savers, meanwhile, seek instruments on the basis of how much value these ought to return in the future, which is also a subjective determination.
However, actually discovering an asset’s purchasing power typically involves the intermediary step of monetisation, either at maturity (for redeemable assets) or upon sale. Both routes hinge on savers transacting with third parties. A maturing instrument will only pay off if its issuer honours its obligations. In a sale scenario, the views of prospective buyers constrain what price is fetched. In the latter, it is the proximity of one saver’s estimate of purchasing power with those of others that tells us anything about the instrument’s liquidity. This is not something capable of being conveyed in the instrument’s spot price, but only over time as price volatility (and only then to a limited extent). While an instrument’s liquidity may be signalled by the time that elapses between offering it for sale and completing the transaction, this is a function of the degree to which the seller’s (initial) price expectations may exceed those of prospective buyers. [Note 1: For a low-order good, a consumer may come to believe that he overpaid for it, but this will not be because he miscalculated other people's assessments: value is always a subjective matter. In matters of pricing, liquidity is relevant only to purchasing power, since (unlike value) this determination is market-mediated.]
So while goods and services must be produced or performed in order to be consumed and offer real value, financial instruments are neither produced nor consumed; they are virtual and their purchasing power largely depends on sentiment. Durable “saving” goods fall somewhere between these two poles: a house, for instance, will be bought on the basis both of its current and residual utility; any bid reflects not only its usefulness as a dwelling to the bidder (its value), but also the bidder’s expectation of what others may be prepared to bid for it in the future (its purchasing power). A house appeals to an instinct to save inasmuch as it quenches the desire to consume: as with all high-order goods, a home is not consumed at once but over time through a process of gradual depreciation. [2: The phenomenon of rising house prices told us little about the value of the homes, which was depreciating. However, it did reflect the rising price of the land beneath, which accounts for a large part of any purchase price. Since land is in perpetually short supply, it commands rent, the level of which responds positively to both output and population. The rate at which the price of homes (including those in terminal decline) was rising indicates just how much general sentiment towards future economic activity was improving. Nevertheless, where prices have been slow to fall, this is probably not because of continued favourable sentiment, but may simply signal a lack of property transactions: with borrowing costs so low, many homeowners have been able to put off selling in the hope that their homes will fetch more acceptable prices in the future.]
Whereas policy should seek to ease economic constraints on value and financial capacity, the fact that sentiment is not subject to economic constraints has been exploited by policymakers. Neither purchasing power nor liquidity is subject to any fixed gravitational pull. The former should be left well alone by politicians; the latter, meanwhile, should be economised, as I argue below (following on from previous posts). This involves swimming against the tide, since it is easy to purport abundant liquidity as being an unambiguous good. Indeed the practice of modern banking is predicated on allowing all savers to be liquid: much of savers’ assets has been homogenised, eliminating purchasing power dispersion in the process. [3: Increasingly, payments are settled not in physical money (cash) but by transfers of savings held in the form of bank liabilities (deposits). In a given currency bloc, all bank deposits are considered identical in kind, and trade at par with the central bank’s own monetary liabilities. This identity (which ultimately hinges on an implicit or explicit public guarantee) is the basis of the liquidity enjoyed by money: there is nothing to distinguish among any holdings of money except their respective nominal amount.]
If we have demonstrated that liquidity need not be scarce, we are still to identify the problem of insulating savers (prepared to forgo higher returns offered elsewhere) from market risk. The short explanation is that this transfers price volatility from savers into the market for real goods, which affects a broader group and risks introducing into production a systemic, or cyclical, character. If changes in discretionary consumption can be made with impunity, shifts in demand for the products of labour will be registered as fluctuation in the price of goods and services. Not only would consumers be punished indiscriminately by rising prices, the opposite would only tend to reduce production.
Without any offsetting positive effect on interest rates as a result of rising consumption, investment could not be expected to fall in the event prices and production grew. Yet one might well hope that some counter-cyclical weight should bring to bear directly on consumption growth. A rise in the price of goods and services cannot in itself be relied on to reduce consumption demand; indeed, the reverse would happen if acquisitions were brought forward in anticipation of even higher prices to come, a self-fulfilling prophecy capable of entrenching inflationary expectations. The flip side of this coin -a fall in consumption and prices- could lead to a postponement of purchases, dampening production, income and subsequent demand, and prodding society nearer a veritable abyss: deflation. With prices stagnant in much of the West, deflation is currently high on the agenda of economists, who look to Japan’s experience with justifiable dread.
Yet the medicine prescribed so far has been the provision to savers of even more liquidity, administered via quantitative easing (QE) programmes (explored further below). An alternative that I have proposed in previous posts is to do the reverse: to tax, and thus to economise on, liquidity. In this way, only those wishing to transact would wish to hold money, with any excess actively marketed in exchange for non-monetary (and so non-taxed) instruments. For their part, savers not holding money would have to liquidate assets in order to increase discretionary consumption above what is ‘scheduled’ by the term structure of their savings. By doing so, they face possible trading losses, especially at times of high consumption demand when the call on liquidity would rise, and with it, the rate of interest. Conversely, should demand fall, the price of various saving instruments would rise, enticing savers to liquidate their holdings and increase consumption.
Note that changes in the price of redeemable instruments, by virtue of bearing a ‘face value’, would be less prone to positive feedback and path-dependency than in the market for goods and services lacking any nominal value. And even if speculative forces were to emerge -were savers to hold on to assets in the hope of even higher prices; or were holders of money to hold out for lower prices for saving instruments- they would be held in check by the taxation of money and the related urge to economise on liquidity. Taxing money increases its velocity, which, incidentally, is the intended outcome of QE – an outcome being thwarted by the Keynesian ‘liquidity trap’.
* * * * * * * * * *
A desirable consequence of my proposal would be that changes in demand for goods and services would first be signalled within the financial markets: the price of financial instruments would rise and fall inversely with demand for liquidity (required in anticipation of spending). A rise in the price of instruments would signal a fall in the price of money -a decline in the rate of interest- whenever consumer spending peters off; the prospect of profit-taking would prompt some savers to consider consuming instead; also, with rates low, investors could avail themselves of cheaper financing. These responses would stimulate greater demand for goods and services, causing an increase in the rate of interest. Remaining savers would now face steeper discounts on their assets, while prospective investors would find financing more expensive to come by. Here, rising interest rates would temper demand.
In this way, shifts in interest rates would act to flatten spending cycles, cushioning the real economy from swings in saver sentiment and stripping out considerable price volatility from the markets for goods, services, labour, land and capital. In this way, cyclical (systemic) disruption to employment and income would be reduced, largely freeing the allocation of factors of production from monetary influence. As we will see further down, the price of goods and services could still fluctuate, but this would be in response to actual changes in demand consistent with myriad choices as between consumption or saving, not to speculation about the course of future prices.
Thus far I have recommended a transition from an economy addicted to the most liquid savings (money) to one that can allow much more of its productive surpluses to be represented in less liquid forms. Of course our society has already invented various vehicles that savers can hold besides money, such as bonds, pensions, insurance and equity. Whatever methods are adopted, savers’ interests always remain rooted in production: only by investing in capital can saving (not involving outright hoarding) take place.
More will be required than simply to contrast against money some ideal saving instrument: the connection between the proposed method of saving and the processes of investment must also be revealed for this alternative arrangement to be considered credible. After all, in the current banking system the functional co-dependence of saving and investment finds some expression, however warped. Banks satisfy savers’ ‘liquidity preference’ at the same time as providing long term financing to investors, silently performing the task of ‘maturity transformation’ – or better, concealing the state’s ultimate responsibility for this. Yet by supposedly shielding both camps -savers and investors- from liquidity (or market) risk, banks have extracted huge public concessions and lodged themselves firmly into the financial sector – but only by making themselves extremely fragile.
So successfully has its ‘services’ been sold to the public that most savers and investors consider banking indispensable. Not only does the public act as guarantor to savers; not only does the related moral hazard distort the rationing of financing; more than these, banks’ promotion of liquidity provokes widespread and unnecessary misery by transforming the natural ebb and flow of economic life into often violent swings in prices and production, virtually institutionalising cycles of boom and bust. Banking has ensnared savers into a liquidity trap, and ultimately foisted massive fiscal stimulus on society in a perilous bid to stave off deflation.
* * * * * * * * * *
In the proposed model, current banking would be disestablished, with saving funds losing all privileges. Money would face continual taxation and redistribution to all (leaving its global quantity unchanged). Raising the tax rate would increase monetary velocity, and vice versa; this tool would be the principal level of monetary policy (as explored further below). Rent would be entirely confiscated in taxation and then redistributed to all, vesting in each citizen the right to receive an equal stream of rent over one’s lifetime – a natural asset base. [4: The due-dates of taxed rental payments (though not taxes levied on money) would be staggered across the population to smooth the demand for money that would arise for this purpose. The treasury would instantly remit these collections; expediency suggests that remittances should not be uniform, but rather staged such that each individual would have a periodic (say annual) payment.]
These high quality rental assets (secured under social contract and thus free from counterparty risk) could be auctioned by those seeking liquidity (for consumption or investment purposes) to anyone wishing to save. [5: It would be worth exploring whether and how to assure a notional payout on saving instruments. For instance, per capita rental dividends could be floored as an (admittedly arbitrary) percentage of what has been distributed at any time in the past. Equally, as an alternative to private life insurance, this same percentage could be further guaranteed in respect of anyone who dies above the age of 21 until such time that they would otherwise have reached say 60. Therefore any beneficiary of their future rental allowance would be able to rule out mortality risk. With these twin safeguards, a homogeneous class of saving instrument could be constructed to account just for the guaranteed rental dividend, allowing pricing for this to be based exclusively on the opportunity cost of liquidity for various tenors (i.e. the yield curve).]
All financial transactions involving these rental receivables would have to clear through a public exchange to allow for re-registration. Additionally, this would ensure that in spite of being taxed, scarce money would have to be acquired prior to consumption (including as part of investment). [6: In other words, payments could not be settled in non-monetary instruments such as these rental receivables (whose title would be evidenced exclusively in the public registry). Admittedly, at least in theory, some payments could be effected by offering real assets; however, as now such barter operations would impose punitive transaction costs.]
In sizing how much money to accumulate, prospective consumers would take their cue from the prevailing price of capital, goods and services. Investors would supplement this with the prevailing wages and rent charged in order to hire labour and land, and could accommodate scheduled costs by compiling a portfolio of instruments with a range of tenors. As liquidity over time is being economised at each point in time, the price of money -more generally, the rates of interest across various tenors- would regulate demand into the future, ensuring it responds to changes in the supply of goods and services (by which it is always constrained). This helps to prevent sudden swings in prices, with all the associated costs on production and employment.
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As hinted previously, economising on liquidity does not mean that prices in general are unable to rise, although this would require an increase in the velocity of money. If there was involuntary unemployment, then the cost of production could be contained even as consumer prices rise, implying growth in the return to capital (producer profits), which is a condition for greater investment. The increase in productivity associated with more capital should temper price rises (and profits) after the initial surge; savers are not compelled to assume their purchasing power has eroded.
If, instead, the supply of labour were inelastic, implying that any unemployment was voluntary (leisure), then rising prices would tend to push up wages, constraining producer profits and investment. By definition, a uniform rise in general prices is, in static terms, consistent with maintained output. It is true that savers will have passively yielded purchasing power to investors, although this transfer is only known ex post; only if this leads to an expectation of further increases in price will current savers tend to liquidate assets and the propensity to save fall. The resultant increase in interest rates will depress investment. Unless this moderates inflation expectations sufficiently and interest rates ease back down, the lower levels of investment will harm future economic growth.
What can we conclude from all this? If there is involuntary unemployment, then an increase in demand and prices can stimulate expansion, and higher overall welfare. The appropriate policy response to involuntary unemployment would therefore be to increase taxes on liquidity, increasing monetary velocity, stimulating prices, profits and production. (It should be noted that with the proposed reforms, there would arguably be next to no involuntary unemployment.) At full capacity, however, rising demand raises all prices, but leaves profits and investment unchanged. With no increase in production, should the price increase create a general expectation of inflation, and therefore higher rates, the policy response should be to lower taxes on money in order to temper price gains and therefore encourage lower consumption.
At present, this monetary policy instrument has not been used. Rather, in the wake of the banking crisis, and with central bank interest rates hovering above zero, authorities have instead directly expanded the quantity of money in QE operations. In his Prices and Production, Hayek analysed what would happen if demand was ‘artificially’ increased by an injection of new money (to consumers). In his analytical framework, which countenances neither the possibility of involuntary unemployment nor its counterpart, excess liquidity, Hayek reasons that by increasing consumer prices, such ‘forced saving’ will eventually lead to productive power shifting from high-order capital projects to low-order goods, as producers seek to profit from nascent price differentiation.
In due course, as the ratio of the supply of consumer to producer goods increases, this pricing differential is eliminated, removing the initial impetus to so-called ‘less capitalistic’ methods of production (caused in effect by higher interest rates according to Hayek) provoked by monetary expansion. Consequently, as the rate of interest falls to its ‘natural’ rate, the organisation of production also reverts to what actually corresponds to real demand. For Hayek, only relative prices are meaningful, and these cannot be tampered with in the long run by changing the quantity of money – that is, unless it is repeated on an ever-increasing scale. Since this comes with its own inflationary problems, Hayek concluded that monetary policy is rendered ineffective at averting recession (in his case the Great Depression), and if authorities intensify their efforts (as many are currently predicting) this may even worsen any downturn.
What can we make of Hayek’s analysis? In his model, money is neutral and lacks any lasting ability to alter economic equilibria. Yet by ignoring the tendency for savers to hoard money, he dismisses too the evidential phenomena of involuntary unemployment. Scarcity does not guarantee economisation, and may even do the reverse: when in fixed supply, savers can profit simply by hoarding money, adding downwards pressure on prices, and thus increasing their own purchasing power. Monetarism departs from the Austrian tradition (of which Hayek was a proponent) by recognising that money can be a real economic factor. In the early 1970s, monetarist-inspired lawmakers removed the outer limits that gold’s official price had placed around the quantity of money. Banks were given the power to alter the money supply at their commercial discretion, and became hugely more influential over economic life as a result.
With banks now in utter disarray, economists from the Keynesian tradition and those of a monetarist persuasion have entered into a temporary truce, uniting under the banner of QE. Each camp seems undeterred by Japan’s experience of combating deflation in the same way. Even if abundant liquidity is an effective inflationary palliative, in order to support this measure one must either be unaware of the volatility that it unleashes or else view it as an acceptable long term cost. Whether mainstream economists are unfamiliar with the option to tax liquidity, consider it politically unpalatable, or believe it would pose greater economic costs, a debate of its pros and cons is conspicuous only by its absence. The ideal of neutral money, as illuminated by classical economists centuries back, remains a valid goal. What is less well appreciated is that allowing money to act as medium of exchange and unit of account does not require it to serve also as a store of value; it requires holders of liquidity to be charged a premium.
Neoclassical economists contend that the opportunity cost of forgoing non-monetary alternatives will ensure that liquidity comes at a premium, as measured by the excess (risk-adjusted) yield offered over money. According to this, and provided it is high enough, a premium will entice savers to release money, averting a liquidity trap. In practice, when savers’ fears mount, especially at a time of panic, their breakeven premium hikes to such exorbitant levels as to rule out economisation of liquidity. With Knightian uncertainty savers flock back into liquidity (unless unopposed). [7: As opposed to risk, Knightian uncertainty eludes parameterisation i.e. where a lack of data or methods makes it difficult to estimate probability.]
It does not help matters that the mere fear of this outcome makes the likelihood and severity of downturn all the greater. Stockpiling liquidity raises term interest rates, accelerating the journey to economic contraction; QE is an attempt to avoid rates rising on the brink of a recession. However at this juncture more is required than avoiding interest rate rises, because to maintain spending it is necessary for the liquidity premium to increase, not fall. The only way to increase the liquidity premium without also raising interest rates is to tax money. [8: This may arouse opposition on the basis that for it to circulate, money must be in demand. This is correct – though despite what may be believed, this does not mean money should be a store of value (with which taxation would of course be in conflict). Compulsory demand for money is created by general taxation; moreover, as already outlined, under my proposal mandatory use of money would be extended to include any transaction related to rent i.e. not just for payment of taxes, but also for subscription of future rent.]
Assuming it was taxed judiciously, such innovation would neutralise money. When neutral, money provides an absolute, linear scale for value, and is no more subject to artificial interference than weight is for mass. Any linear scale is divided into an arbitrary number of units; the choice of unit makes no difference to the scale, much as different numbers of ounces and grams express the same weight. (It is similarly quaint of mankind to retain duplicate currencies to denote the same amount of money). It should be self-evident that the number of units into which a linear scale is divided makes no difference to the use of that scale. Increasing the quantity of neutral money would simply reduce the coverage of each unit of currency along the value scale in indirect proportion, and vice versa. Since taxing liquidity is a precondition for neutral money, altering this tax rate is preferable to QE as a monetary policy tool, which would allow the quantity of money to be stabilised, and the breach in the link between prices and production to be healed.
Falling consumption is feared more than most other economic phenomena – not without reason, because when measured across society, it is a clear sign of distress. Three responses are possible: consumption will bounce back, goods will be hoarded, or production reduced. For the former to occur without a change in preferences, goods will have to be discounted, which, by reducing margins, encourages producers to scale back production. Physical hoarding may take root for a while, but such an expensive method of saving will not be sustained for long. So out of the three outcomes, a fall in production is the most likely to prevail; as a result, idleness is enforced not by any desire for greater leisure but rather by the ill-effects of unmitigated austerity. This is no fault of savers, whose self-restraint is the well from which all capital is drawn. Nevertheless, as long as its net effect is to inhibit production, frugality is self-defeating, since by contriving to bring about economic contraction, it undermines the position of savers themselves. Incidentally, this is a version of an argument made forcefully by Martin Wolf in several recent FT posts, and after developing these broad macroeconomic themes, I will make some further recommendations.
Unless suitably offset in society (i.e. by investment), the desire of savers to reduce consumption cannot succeed in increasing their combined claim to wealth, a false economy neatly expressed by Keynes’ ‘paradox of thrift’. Keynes believed that all efforts should be taken to avert the spectacle of savers’ self-denial being rendered futile by involuntary unemployment, a miserable state imposed by the failure to offset savings with investment. What impedes entrepreneurs from taking advantage of capital opportunities may be psychological, structural, or political in nature, and while further discussion is merited, it falls outside the scope of this essay (though features in the previous post). Keynesian thinking, meanwhile, has traditionally been applied less to addressing the causes of crisis than to counteracting the effects on aggregate demand. Not surprisingly, in the current crisis, tools designed to boost aggregate demand in the face of dwindling private investment have garnered renewed interest (after decades of neglect). Further below I will pick up the thread of policy-making, especially in the context of deflation.
While sane savers would not want wealth production to decline, the importance of production being maintained if the desire to save is to be satisfied is rarely foremost in their minds. Saving entails deferring making purchases and accumulating purchasing power instead; nothing in this calculus influences whether production will be scaled-back as a result, which depends entirely on how producers respond to being unable to sell their wares. Warehousing unsold goods is deeply unsatisfactory, not only because of the associated rental costs, but also because hoping that goods that cannot be sold today will stand a better chance some time in the future is bordering on the reckless. Meanwhile, diversifying into other consumables leaves producers in the same structural position, assuming falling consumption was not driven by a paucity of sought-after goods, that is. The only viable option for producers is to diversify out of consumer goods entirely, and to produce capital and other high-order goods instead.
Capital formation is made possible by the ‘surplus labour’ produced by saving. Unless producer profits are sufficient in scale, this surplus labour will have to be ‘bought in’ if capital production is to commence. This financing function depends on savers being willing to redenominate income out of real goods and into financial instruments. While these instruments will one day need to be liquidated if savers are eventually to ‘overconsume’ (e.g. in old age), their austerity allows real goods to circulate and satisfy consumption demand exerted elsewhere. And because the demand to consume is to a large extent independent of the manner in which production is organised, a willingness to save facilitates the redeployment of productive forces from consumer into capital goods, from which a compensatory demand for consumables will stem, supporting production.
A process that is characterised figuratively as the channeling of savings into investment has the merit of forming a potentially virtuous circle of saving-stimulated productivity growth, on which savers’ interests ultimately rely. Keynes’ paradox of thrift only applies if frugality is met not with capital investment but instead with risk aversion. A fall in the rate of interest is the classical mechanism by which investor demand should respond positively to decreased consumption demand, although the financial market, dominated by a dysfunctional banking system, is not sufficiently free to allow this mechanism to work. This has traditionally been a matter of greater concern for Austrian School economists than for their Keynesian counterparts, who are prone to treating all investment demand equally. While Austrian School thinkers identify what they term ‘mal-investment’ as a cause of crisis, Keynesians have a tendency to treat any investment as welcome.
As mentioned earlier, physical hoarding (of goods, not scarce resources) cannot persist for too long because it will be suffocated by a consequent reduction in production. However, a milder variant may emerge in the form of ’liquidity preference’. Broadly speaking, ‘liquidity’ measures the ease with which a saver can revert to consuming. Money is defined as the most liquid instrument available, and its promise of consumption-on-demand makes it highly prized among savers, whose interest in non-monetary instruments will only be piqued by a suitable offer of yield. The liquidity of money depends on the form it takes: for some time, physical currency was fixed (e.g. by the supply of gold), which meant that money could be hoarded – indeed more ruthlessly than any depreciating good could be. (This was once considered morally appealing: for the Enlightenment philosopher John Locke, hoarding gold was preferable to hoarding perishable goods, since the latter threatened starvation.)
Hoarding money certainly makes it less useful as a medium of exchange, which is, after all, its primary economic role. Under gold, liquidity preference was uncontrollable, and conspired in a tendency towards falling prices and underproduction that bedevilled society. So the removal of quantitative limits governing money in 1971 represented financial innovation, since if nothing else it meant hoarding money could be defeated. ’Fiat’ money (so-called because its quantity could be determined under fiat i.e. arbitrarily) could now be supplied to meet any level of demand, and in a single stroke, gold ought to have lost its lustre. Yet the promise of abundant liquidity sold by the architects of fiat money, and repeated by their descendants in the banking system -the governor of fiat money- has proved hollow: liquidity is always scarce, no matter how money is constituted. If it is to mean anything at all, liquidity must speak to the ‘quantum’ of consumption that the instrument affords. If the supply of money is growing, its unitary purchasing power becomes volatile, dependent on the timing of purchases in relation to one another. If there is insufficient visibility regarding this, say if the money supply fluctuates (as now) in an unruly manner, the liquidity of money will be severely constrained.
Whether or not savers understand the liquidity limits of their deposits is unclear, though as I argue in earlier posts, the supposition that purely liquid, risk-free assets can earn interest should be evidence enough. Indulging liquidity preference by allowing the money supply to expand more or less on demand not only permits debilitating inflationary pressures to build up in the financial system; it has also failed to prevent a tendency towards deflation and depression from resurging, a deep embarrassment to the financial Establishment. Under the regime of fiat money, monetary policymakers were supposed to monitor general price movements for the risk of inflation, and yet by the early 1990s, arguably the most advanced economy at the time, Japan, had entered the grip of deflation, from which it is still to escape. It took flirtation with deflation some fifteen years later before Western policymakers were finally to be roused from a complacent, self-congratulatory belief in the advent of The Great Moderation.
Many commentators have sought to attribute deflation to falling consumption, which, while being a plausible marker of economic distress, as described above, cannot be regarded as its fundamental cause (except to the extent consumption is held down artificially). Politicians who focus on boosting consumption while stopping short of addressing the underlying problem, chronically weak investment, are guilty of conflating cause with effect - or worse, of populism. Nevertheless, in present circumstances even an agnostic boost to consumption may be part of the solution: where deflation is caused by slow-shifting stock encouraging producers to reduce factory gate prices, it can become endemic as consumers react by further postponing purchases in the widely-held anticipation of lower prices to come. Not only is saving as prompted by the allure of speculative gain unwelcome in and of itself -since it reduces consumption below the level that would otherwise have been targeted-, it serves to entrench even further a motivation for its continuation, i.e. falling prices. It is therefore understandable that authorities have sought to avert falling consumption either by running fiscal deficits or expanding the money supply, all in the hope of preventing deflation from setting in.
However, unless this corresponds with an increase in investment, Keynes’ central message is ignored. The co-conspirator with price discounting in entrenching deflation (and risking depression) is not falling consumption, but actually growing liquidity preference. When prices fall, postponing consumption rewards depositors with a greater claim to wealth, even before any interest accrues on their assets. Such economically sterile behaviour is indulged by our banking system and allowed to run amok in times of crisis. And because consumption is punished relative to holding money, deflation arises while production is discouraged, establishing a vicious cycle already well-rehearsed in the literature and media. What is typically left unexplored is the root cause, casually assumed to be falling consumption or deflation, or both. What’s more, while extended episodes of falling consumption almost always signal distress, deflation cannot be assumed to be symptomatic of stagnation, for it could just as easily accompany rising productivity.
Of course, the problem of deflation for policymakers (besides the difficulty in distinguishing from among possible causes) is that, unless actively resisted, it activates liquidity preference. Not only does retaining surplus liquidity inhibit the clearance of current stock and duly dampen production of consumables, it withholds finance needed for capital production and so snuffs out any remaining embers of growth. Note that the economic bad here is not deflation, but rather rampant liquidity preference, which, alongside deflation, establishes an economically lethal combination that produces Keynes’ “liquidity trap“. Until recently, this did not feature prominently in examinations of recession, with the result that instead of mitigating liquidity preference, money became much more abundant. If this was expected to forestall the prospect of a liquidity trap emerging, this has proved over-optimistic. Deflation cannot be extinguished with monetary expansion as long as agents are allowed (and prepared) to hoard it in ever-greater quantities, in an (ultimately futile) bid to insure themselves against economic crisis.
In previous posts I submitted some ideas as to how to contain liquidity preference within its natural economic borders, set by the desire to consume imminently. As part of this task, I outlined the basic terms of a renewed social contract that would, if enacted, make available to savers an abundance of risk-free alternatives to money offering a sliding scale of liquidity offset by yield. In a single stroke, money would be economised and the natural yield curve revealed. However, what I have not considered so far in my posts is how to neuter the specific effects that deflation could, by resurrecting liquidity preference, have on consumption.
The now-conventional wisdom states that one must always oppose deflation outright, and use monetary expansion as the tool (however discredited this approach appears in the light of recent experience). Implicit in this position is the false assumption that deflation is an economic bad, which fails to recognise that prices might just as well fall in response to benign economic forces. What has not been widely considered is whether instead of seeking to eliminate deflation, liquidity preference could be opposed so as to prevent deflation (whatever its cause) going on to hijack economic growth. A solution to this would be to tax liquidity at the rate of deflation, a version of a proposal made by Silvio Gesell in the early twentieth century, which occasionally resurfaces today, chiefly in the guise of negative deposit rates. With such a reform, demand for money would fall to the level needed for transacting; money would be economised, encouraging its velocity to settle on a stable level as money reverts to its classical role as medium of exchange; in turn, prices would become effective signals of supply and demand for goods, services and finance, a condition for a virtuous circle of growth to form.
Never has so much copy been printed on economic policy in the Western hemisphere, which for decades had fallen below the public radar. Suddenly, controversy is mounting regarding the use of fiscal and monetary policy in the West to counter the effects of the financial crisis, with a particular focus on how quickly to reverse the attendant growth in public indebtedness and base money. In order to make headway on these questions, it is necessary first to set out the purpose of economic policy, and restore its connection with welfare.
Economics has a natural interest in welfare. Correspondingly, it must take account of people’s preferences regarding leisure and consumption, since these are the fonts from which welfare is drawn. Both activities, which compete over people’s allocation of precious time, are only made possible by an output of goods and services. If production falls, consumption will also fall unless otherwise permitted by an erstwhile savings rate; conversely, restoring consumption depends on boosting production, for which people must allocate less time to leisure (or produce more in a given period). In the classical model, agents apportion their time between labour and leisure so as to maximise welfare.
The only constraint on the enjoyment of leisure -assuming basic subsistence needs are met- is time. Although experienced subjectively, time is fully describable in its own terms: the difference between one hour and three hours is always two hours. Owing to this tautology, time is an objective axis along which other variables can be compared. The same is not true for the key constraint placed on consumption, wealth, even though it is a by-product of time. Even if labour productivity (the amount of wealth produced in a given time period) is held constant, wealth is not fully describable in its own terms. That is because wealth comes in limitless forms, comprising goods. No two goods can be objectively compared along a single scale in a way that fully accounts for their difference, and although the invention of money provided a scale, it is far from being objective in any meaningful sense. Demand for one good does not imply demand for any other good.
What does this mean? While more free time for leisure permits greater welfare to be drawn, producing more goods may fail to produce a similar outcome - everything hinges on what exactly is being produced. There is a modern tendency among economists and policymakers to treat production as all of a piece and thus to ignore differences in the form that wealth takes. Nowhere is this more striking than in the corruption of the classical term ’capital’, which once denoted a special kind of producers’ good, but now seems to refer abstractly to savings.
One term which features prominently in economic parlance is ‘aggregate demand’, ostensibly the sum of all demand for goods (and services). This may have some application, but it is yet another example of the general tendency to blend what is variegated: output. One effect is that whenever consumption falls, instead of considering whether welfare preferences may have changed, there is an urge to tailor policy so as to boost aggregate demand. While it may be theoretically tempting to hold preferences constant, demand for different goods and services is always in flux. Moreover, as production evolves, consumption may evolve too, as the existence of a new good spawns demand for something complementary or makes something else obsolete.
All this gives rise to natural ‘imbalances’ between supply and demand, the cause of most economic crises. One pertinent question for policymakers ought to be whether their policies are resolving or exacerbating imbalances. A deep faultline in economics divides those on the one hand who believe government intervention is required to ‘correct’ various market failures -some resulting from a flawed social contract, others from human psychology- from those on the other hand who claim that government intervention is largely responsible for such failures, whether by disturbing prices, undermining ‘monetary neutrality‘, suppressing the ‘natural rate of interest‘, unleashing inflation, crowding out investment, etc.
Whichever camp has it, imbalances most certainly arise. They can originate in production or finance, and manifest themselves across space and time. They always signal some surplus product is going to waste.
- Goods may fail to circulate as a result of people simply hoarding them, a very basic spatial imbalance that is entirely uneconomic. Involuntary hoarding (resulting from barter trade) was eased greatly by the introduction of a circulating medium (money). The urge to hoard remains, however, under the mask of ‘liquidity preference‘, the desire to hold money. As discussed in previous posts, the modern banking system not only indulges it, but functions as it does on account of liquidity preference. While elasticity in the money supply means that liquidity preference cannot amount to outright hoarding, it can nevertheless create economic weakness, by freezing exchange and thus delivering a shock to production; and by masking the growth of enormous financial imbalances, whilst neutering monetary policy. Eradicating liquidity preference depends on an alternative to money emerging as a savings instrument, a problem addressed in previous posts that is discussed below.
- Producing goods that are in low demand is equally uneconomic. Imbalances could be confined to low-order goods (i.e. ones that do not take long to produce) e.g. apples could be overproduced while oranges are in short supply. Such imbalances would not tend to sustain themselves for very long, assuming hoarding does not interfere with correcting price signals. Imbalances that are not confined to low orders of production are more complex, and will tend to be more persistent, owing to longer production cycles and relative slowness of repricing in response to changing demand.
Problem (2) was the cause of much pontification by Hayek, the Austrian School economist. In his theoretical writings, he worked on the basis of speedy repricing by assuming that high-order production was decomposed into successive stages, each one interfaced by merchants-cum-producers purchasing intermediate products before manipulating them into slightly higher-order goods to be sold on. Since in his model changes in the price of goods of one order relative to another were wholly responsible for transmitting variations in the interest rate, it was sufficient for him to argue that any interference in the demand for goods of a given order would disturb the rate of interest from its ‘natural’ level.
Foremost among the sources of such interference, for Hayek, was elasticity in the money supply as administered by bank lending. As new money went into the hands of consumers, say, their ‘forced savings’ would increase the price of consumer goods above their equilibrium level, attracting a higher share of productive forces from higher stages in production, thus compressing the term structure of production. By the same token, lending to producer-consumers would artificially raise the price of higher-order’ goods, although the effects of this would be similar, he asserted. Without elaborating on Prices and Production further, any increase in the money supply would (by establishing ‘forced savings’) eventually lead to an oversupply of consumer goods and a corresponding undersupply of producers’ goods, in either case relative to actual demand for them.
For Hayek, allowing the term structure of production to extend to its supposedly natural level was a precondition for economic advancement, or as he put it, for a more ‘capitalistic’ form of production. Anything that opposed this would lead to retardation i.e. depression. So for Hayek it was imperative to establish a ‘neutral’ money and allow the rate of interest to converge on its ‘natural’ level – which meant holding the money supply constant and avoiding outside intervention.
What could Hayek’s recommendations mean today, in the context of our recent financial crisis followed by government intervention on a scale he had feared in his own time would be counterproductive? What do the old-fashioned concepts of ‘neutral’ money and a ‘natural’ rate of interest hold for policymakers today, confronted as they are with such enormous challenges and weighed under a barrage of criticism?
The engine of economic growth and recovery is always deferral of gratification. This is normally associated with saving, but it is important to distinguish savings of consumer goods (hoarding) from investment in producers’ goods. Since for investment to take place, consumption continues apace, it is correct for policymakers to read into falling consumption signs of economic stagnation. However, to respond to this by seeking to boost consumption is to conflate cause and effect.
Rather, policymakers should focus on any structural reasons why consumption would be held below its desired level. In a financial structure that indulges liquidity preference, the risk of falling prices can become a self-fulfilling prophecy as consumers defer purchases in anticipation of improved terms in the future. Indeed any uncertainty can elicit a similar course of self-insurance. Rather than tackling the origins of this in the banking system, authorities have embarked on quantitative easing (QE), a programme of expansion in the monetary base (largely to mitigate contraction in broad money caused as banks reduced lending). While doses of QE may have allayed fears of deflation, they have also had the effect of reducing monetary velocity, with growing money balances sitting idle. Liquidity preference has soared to new highs; should sentiment change, unless these balances are drained with deft timing they will be free to circulate once again, changing hands and bidding up prices with increased rapidity, thus posing the age-old risk of inflation.
However QE is not too dissimilar to banking, since it describes a reversible change in the supply of money. This raises the question of whether an elastic money supply is reconcilable with ‘neutral’ money, which at heart has the sense that money should be no more than a medium of exchange. As long as its role is restricted to that of a token -no longer used as a savings vehicle- money would cease to be used as a store of value, and would therefore be unable to influence real variables, irrespective of its supply. Hayek’s concerns about an elastic money might be valid with a banking system, but if liquidity preference was successfully rooted out, money would circulate at high velocity regardless of its supply. It is this, not an inelastic currency, that is the condition for ‘neutral’ money.
In earlier posts I made some of my own proposals known, including the abolition of banking in favour of a public clearing house bridging savers with investors. In summary, investors would be able to sell their holdings of risk-free rental assets to savers, thus procuring money (and short-term assets). Rental assets would be guaranteed under a new rehabilitated social contract under which rent accruing on all scarce resources would be confiscated from users and redistributed to all. In this way, this universal contract would secure wealth as private property for its producers.
By making these asset purchases, savers simultaneously satisfy their own desire to defer consumption (until some future remittance of rent) as well as investors’ desire to produce capital goods (by financing the ongoing costs of production). Indeed, savers and investors alike could individually target specific durations: savers would balance the benefit of higher returns offered by longer-term instruments against their greater illiquidity, whereas investors would balance the higher cost of obtaining committed term funding against its added certainty. Such myriad individual calculi would determine the nature of financial transactions which, when writ large, would construct the term structure of finance for society as a whole. Rates of interest over time could thereby settle on a yield curve that harmonises the demand to save and invest over different terms. Such a mechanism would furnish the productive economy with a money cost of funding able to commit productive resources over a duration that helps ensure supply and demand remain in kilter. When allied with neutral money, this natural rate of interest would favour sustainable economic expansion.
Official agreement that the flames of economic crisis were fanned by banking dysfunction has prompted calls for all sorts of changes: for systemic restructuring, for heightened scrutiny and regulation, for curtailment of bank activity, even for the establishment of deposit-funded “narrow” banks forbidden from assuming credit risk. Embedded in any criticism of the sector are assumptions about what banks are supposed to do; yet these remain hidden, unexplored and perhaps unknown. Few critics have gone to the trouble of questioning what banks are for, indeed of asking whether banks should even exist. Below I highlight some functions commonly attributed to banking, and challenge the efficacy of the arrangement.
A) Offer savers risk-free assets
Savers are defined by a desire to consume in the future and a demand for instruments that permit them to do so. Banks are entrusted with satisfying most of this demand by issuing risk-free deposits. An exponent of banking would argue that the risk-free character of deposits is down to insurance obtained by pooling myriad credit exposures together. According to the laws of probability, such diversity reduces portfolio loss severity, allowing a relatively small first loss piece in the form of bank equity to cushion depositors from loan losses that inevitably arise. Although banks do obtain the benefits of insurance, it is not a good that they produce: insurance is a by-product of statistical tendencies exhibited by natural populations. Accordingly, credit insurance can be extracted by any entity with the scale to aggregate together a number and range of loans sufficient for the sample to resemble the population, within a certain confidence interval.
Banks are by no means the only type of entity that could harness this resource. In fact, banks have not even been particularly proficient at risk management, as the scale of the fiscal subsidy to the sector attests. To some extent, banks are brokering a level of implicit public reinsurance; even assuming this was an appropriate service for the state to provide, surely it would be better provided directly. In my last post, I identified a dormant source of risk-free assets with which -under a rehabilitated social contract- everyone would be endowed. This would allow investors to offer their assets to savers in return for liquidity, and thus dispense with bank intermediation.
B) Lift borrowing constraints
Individuals’ ability to borrow is constrained by a number of factors. Such borrowing constraints deter savers from lending money to them. However, savers are willing to make deposits with banks, which, in turn, are prepared to lend on to otherwise constrained borrowers. According to this, the existence of banks extends the availability of credit, and this stimulates economic growth. There is truth to this, and indeed this probably explains the origins of banking. However, banks are not the only creditworthy institution capable of financial intermediation: any conglomerate could benefit from insurance and thus increase its risk appetite above what an individual saver could tolerate. Moreover, as noted above, banks’ creditworthiness has relied greatly on a public guarantee, which is an unfair, and costly, advantage.
As noted above, endowing individuals with their natural entitlement of risk-free assets would immediately remove borrowing constraints, and dispense with any reliance on banking.
C) Promote liquidity
It is sometimes said that banks export liquidity, making themselves less liquid in the process. This characterisation is not entirely accurate, but what is helpful is the sense in which liquidity is scarce i.e. that if someone is to have more of it, then someone else is left with less. Measured across society, liquidity charts the degree to which a given level of output is consumed voluntarily. Liquidity ranges from zero, which describes a state of social collapse plagued by hyperinflation, hoarding and squalor; through to one (unity), which would accord with absolute social trust, with savers holding liquid instruments, allowing goods to circulate to meet the demand to consume. Liquidity can be enhanced along this scale through refinements in the social contract and through insurance. The latter is a service offered by banks, yet nothing banks can do can raise liquidity above unity. All that any monetary operation can achieve, including quantitative easing performed by the central bank, is to help redistribute liquidity from where it is not needed to where it is in demand, in return for the appropriate liquidity premium.
Rather than harvesting liquidity from its natural supplier -savers- banks issue new deposits, whose risk-free status qualifies them as money. Expanding the money supply as the method of redistributing liquidity makes banks more leveraged and fragile and means that bank lending casts a long shadow over public finances. However, this is not allowed to make banks any the less liquid, as is sometimes claimed, because, as should be clear, no illiquid entity can function as a bank. Put differently, money issued by a given bank cannot suffer a nominal write-down without impairing the entire currency. When they make loans it is not banks that lose liquidity, it is money, whose oversupply -being delivered to spenders and savers alike- creates a redundancy, and places it at the mercy of shifts in the demand to save or consume. For some time, behind the illusion of ever-growing liquidity, real surpluses are being gradually replaced by “forced savings”. This is a recipe for price volatility, since demand is able to switch suddenly between saving and consumption. In the worst case this may trigger a collapse in liquidity and hyperinflation as savers fly from financial instruments into real goods.
As noted in previous posts, under the existing social contract, an asset’s liquidity is its only means of being risk-free, which is a costly conflation since banks are all but obliged to offer interest and liquidity in order to compete for business. Yet by failing to charge a premium for liquidity, either the premium is charged from the public or else liquidity is a mirage. Liquidity is scarce and banking an inefficient method of rationing it. After all, savers have no wish to consume right away and should be natural sellers of liquidity to capital investors. Provided an alternative to public insurance is established as the source of risk-free assets -a topic addressed in an earlier post- a simple clearing house can be shown as being far superior to banking as a conduit for liquidity.
D) Handle payments
Since bank claims function as “inside” money, they are used to settle transactions. This creates a role for banks in the payment system. Payment instructions often cross banking divides: if Dave, who banks with National Bank, writes a wage cheque to George, who banks with Credit Bank, then National Bank must redeem Dave’s deposit and pay this to Credit Bank, which must go on to issue a deposit in George’s name. Note that the interbank transaction made on behalf of Dave (that evidences the payment of wages to George) is settled not with “inside” money but with “outside” base money. The quantity of base money is subject to the sole discretion of the central bank, which exposes individual banks to possible shortages in such reserves, even while fulfilling the mundane task of handling payments. While there can never be a systemic shortage of base money provided banks are willing to lend to each other, a nasty feature of banking crises is that banks refuse one another credit, thus freezing the payment system and disrupting all manner of economic activity. Administering payments within a single non-bank clearing system would avoid this risk.
None of the functions above are dependent for their performance on a banking system. Maintaining a banking system at all cost, as we do now, is a hugely expensive luxury, and one offering few benefits. Moreover, it has encouraged a number of harmful practices such as speculation, and suppressed useful forces such as balanced investment, both leading to bubbles. Yet despite the palpable costs imposed on society by banking, not even its sternest critics dare question its existence. Indeed, the all-out political and media assault that banks have sustained does not expose weakness, it underscores the strength of political support for the sector – so much so, in fact, that our sovereign credibility has been pledged in order to preserve the banking system. Is a decrepit and dysfunctional banking system really worth sacrificing our fiscal flexibility and economic health for? The small group of strange companies known as banks owes its existence to the grace of the general public, whose tacit consent for its monopoly privileges should be urgently reconsidered to safeguard our economic wellbeing.
In my last post (below and in FT Alphaville Long Room), I attributed a number of economic ills, including bubbles and sovereign crisis, to a lack of appropriate risk-free assets available to savers. This structural deficit has allowed an outsized banking system to step in and indulge savers’ aversion to risk by creating money far in excess of transactional demand. With money used as an open-ended savings vehicle, instead of just as a medium of exchange, its velocity is prone to violent fluctuation whenever sentiment changes, which threatens its very soundness.
Recall that the demand to save describes a willingness to postpone consumption. Yet rather than concede purchasing power (liquidity), savers have been encouraged to hoard it on deposit. Policymakers have expressed little concern about this luxury for the reason that money can be created ex nihilo in what appears a costless manner. This is an illusion: liquidity comes at a premium, which is currently paid for by the public in a variety of ways, some visible and others less so.
What I did not query was whether savers’ demand for risk-free assets is even compatible with those functions required for capital financing. Maximal risk-aversion by way of hoarding would stifle investment, because for any diversion of productivity from consumers’ goods into capital to take place without depressing levels of consumption, goods must be free to circulate. If savers are not simply to hoard goods, are they not obliged to assume financial risk?
The current arrangement would suggest otherwise. The banking system induces savers to hold money in preference to goods, which correspondingly are able to circulate over the course of capital formation. The “successes” of banking are remarkable: savers earn interest, take no financial risk and concede no liquidity, while borrowers are issued with newly-created money with which to go about their business. Everyone’s a winner, or so it seems. Dig beneath the surface and you find a temporary, fragile truce rather than economic victory; with superabundant bank money callable on demand, variation in the demand to consume that is not accommodated by a change in output will rapidly disturb prices. Volatility in the demand for money driven by shifts in liquidity preference is endemic to a financial system that requires money to be hoarded, which risks no less than the soundness of money as a medium of exchange.
Furthermore, we have only recently glimpsed at how many fiscal degrees of freedom can be lost in patching up the system. The triumvirate of liquidity, interest and zero risk that is offered to savers acts as an unacceptable drag on public finances, and seems to be premised on ignoring that risk is introduced whenever capital is being financed. Policymakers are beginning to understand the weakness of this system, although, perhaps not unreasonably -given their role in the said system- their attention is being drawn towards efforts to bolster banks rather than reform the system.
Calls for tighter limits on bank lending, more prudent solvency regulations and insurance schemes each might have some success in reducing the incidence of bank failure and consequent calls on informal state guarantees. But if the desired outcome is reached through discouragement of enterprise, through deterrence of risk-taking, then it will be a hollow victory. It is true that with the financial capacity of society set in relation to savings, squandering finance into doomed projects is socially very wasteful. Under any circumstance, finance will have to be rationed; the best that can be hoped for is that it is allocated on the basis of productivity.
Although private banks are certainly not as interested as policymakers in maximising national productivity, the practice of charging interest on loans may lead one to expect the bulk of finance to be directed towards those able to invest it most productively. Unfortunately, this is stymied by perversions in banks’ inventives, not least of which being those stemming from the public guarantee. Some risks are liable to grow when insured, especially when such growth is handsomely rewarded. And so it was with the banks, who set about taking on increasingly reckless business for many years. The banking crisis is all the more remarkable for being so poorly predicted, especially given the degree of understanding about the powerful moral hazards at play.
Replacing poor incentives would certainly be a step in the direction of more efficient financial allocation. However, as long as the public guarantee remains intact (if dormant) and limited liability enshrined in commercial law, banks would be fools not to return to recklessness once they are out of the media and political glare. Those that exercise caution will be punished by their shareholders and staff when the going is so palpably good.
Leaving such facts aside, I suppose the most we can expect from these reforms is a redistribution of finance towards where it can be put to better use. Yet even a perfectly operating banking system would represent a major systemic risk if it continued along the lines of today. The liquidity premium would perhaps no longer feature quite so visibly in the national accounts, but it would be paid all the same, and still by the public.
There is always a price for liquidity. Indeed if it fetched no price, there would be no saving, and thence no investment. Presently savers can earn an undeserved return by retaining liquidity, which defeats any willingness on their part to sell it. To tackle this, one must ask what savers should buy and hold in return for liquidity. Naturally, unless they are adequately compensated, savers would be loth to hold anything that injures their ability to consume in the future; they would want an instrument that entitles them to receive money at a given date in the future. In current parlance, and given savers’ risk-aversion, this sounds very much like the trusty government bond. However, as was noted in my previous post, the availability of government bonds is set not by savers’ demand, but by fiscal policy. Moreover, lending to the government passes on to it the problem of financial allocation, unless the state is to undertake all enterprise in its own name.
So if the rightful issuer of savings instruments is neither the government nor the banking system, then it must rest with entrepreneurs themselves. Of course it was doubt about the quality of individual borrowers that fostered the emergence of banks, entities able on the basis of their gilded reputation to borrow savings and subsequently lend. I should say that there is absolutely nothing suspect about the service of credit insurance sold by banks.
It is another feature of banking that interests me here - the risk-mitigation techniques that they pioneered, and in particular the practice of taking security over the assets of borrowers. In most cases, banks will only advance a fraction of the value of such assets, which may lead one to wonder why it is that individuals admitted on the basis of their portfolio of assets would opt to borrow instead of selling. Part of the reason is that the main asset at the disposal of would-be borrowers is future rental streams pertaining to privately-owned plots of land. Our social contract is in many respects asocial because it discriminates among its own citizenry -arbitrarily- as to whether or not they are obliged to pay rent. In short, based on historical accident, there are some who are required to pay rent and there are others, in contrast, who are allowed to use resources freely. This is a matter given the full backing of the law, which of course is what lenders rely on when they accept mortgages as collateral.
Leaving any polemic to one side, this state of affairs has concentrated a large share of natural assets in the hands of a minority of landowners. Control over land and other resources is typically an important facet of productive enterprise, so it is not surprising that borrowing is typically more attractive than asset sale to producers. Unsurprisingly, therefore, landowners enjoy a distinct advantage over the landless in obtaining credit and thence creating capital.
A more civilised social contract would surely insist that everybody compete for the use of scarce resources by paying market rent; the converse logic of this would insist also that everybody would go on to receive an equal share of rent collected. These streams of future rent, taxed and disbursed -and thus secured under universal contract- would constitute assets equally enjoyed by all. The justice of such a proposal is rather obvious, since property rights that attach rightfully to what is actually produced (i.e. wealth) should not extend over what is not produced (land and other scarce resources).
Less obvious is that this would make available to savers a risk-free asset class: future rental receivables. By the same token, all citizens would have the ability to obtain liquidity immediately by marketing a unit of future rent (or whatever fraction thereof that is satisfactory to savers) that is payable at a specified date in the future. A process of discounting, as the supply and demand of receivables of differing maturities are exchanged via a public clearing system, would reveal the prevailing rate of interest over a given term schedule (i.e. the natural yield curve).
This fiscal reform would economise on the use of money, no longer demanded by savers or hoarded in case of emergency, but demanded only by consumers on demand. Since it offers holders no utility in and of itself, any given stock of money could function effectively as a medium of exchange, whatever the volume of commerce. This would make ad hoc and de facto monetary policy that is currently devolved to self-interested banks entirely redundant. Indeed, the banking system would be usurped by libertarian money markets, in which rental receivables are exchangeable for others with differing maturities as well as for money. Gone would be any requirement for public subsidy as well as erratic and arbitrary changes in the supply (and velocity) of broad money.
Currency would become entirely subject to democratic management, including as to how its supply ought to vary with overall output (if at all): either nominal price or income stability could be targeted by additions or subtractions to the quantity of rent disbursed. (For what it is worth, I believe that aiming for stability in the price of a basket of goods is altogether preferable to holding the supply of currency constant, mainly because the former has the advantage of avoiding deflation as the economy grows. However, the issue of how, when and by how much the supply of money should alter remains open to debate, especially given the influence such changes might have on pricing and production.)
This fiscal reform -the taxation and redistribution of rent- would thrust productivity firmly into the driving seat, insofar as higher productivity raises the threshold of capital cost affordability facing potential entrepreneurs – in paying rent (bid to secure use of scarce resources); in paying interest (bid to secure capital finance); and in paying wages (bid to secure labour). Moreover, nobody would any longer be distracted by useless and harmful speculation over the price of scarce resources, removing the prospect of debilitating bubbles hijacking economic policy.
The basic engine of economic growth is thrift, that is, the ability and willingness among people to save. It is important to note what is being saved, since it is customary to consider saving in terms of money. This is misleading, because it was possible to save without the existence of money. Indeed, while they make take the form of some other instrument, savings always refer to wealth i.e. useful things, or goods, that people produce by manipulating scarce resources. Wealth results from the cumulative expenditure of labour power in transforming scarce materials into products that are of use to people. Man makes use of wealth by consuming it, which after all is the raison d’etre of production in the first place.
So if wealth is designed to be consumed, why, you may ask, is saving the engine of growth?
It is instructive to approach this question from the opposite direction from saving. Imagine that all that was produced was immediately consumed instead. Society as a whole would have nothing, besides knowledge, to show for its labour expenditure. People would continually have to reproduce wealth in order to consume, and would find the environment (in terms of the reserves of scarce resources that predated mankind) more or less the same on each occasion. There is nothing “wrong” with this state of affairs, and indeed people may become more and more productive, able to enjoy increasingly lavish rounds of consumption.
While saving is not necessary for economic growth, it is only when some goods are carried over from one period to the next that man can begin to create a special type of good: capital. Imagine a farming community, eating all that they harvest. If one year the soil was especially fruitful, and the community was able to store some grains, the following year some farmers may try to produce some other goods, meanwhile subsisting on the saved grain. These other goods might even be implements and tools that the farmers have realised could aid them in their everyday work i.e. capital. Once made, the farmers become more productive, and produce more grains, allowing for even more savings, and so on.
So we see that the act of saving, of thrift, has opened up new opportunities to produce capital i.e. wealth used by man to produce more wealth. Some have termed these goods “producers’ goods” as opposed to “consumers’ goods”.
Such primitive instances of savings are essentially identical to modern forms. However, we have invented a token that we use to stand in for wealth i.e. money. This instrument allows people to exchange goods for other goods more efficiently, which can be shown if we consider the use made of money in finance, specifically capital finance. When these farmers lived off their own surplus grains while they made tools, they were self-financing the production of capital (using equity). However, it would be a strange coincidence, especially in complex non-uniform societies, if all those with ideas to produce capital were also those with savings of their own. Consequently, there is demand for external sources of finance.
Now, with goods as homogeneous as grains it might be possible for some to borrow the grains they need to live off while they set about their capital enterprises. This describes a basic credit arrangement, with the borrower repaying the loan using grains produced in the future. In the meantime, the borrower’s productivity ought to have risen, owing to the creation of new tools. The lender, having denied himself such an increase in productivity, may demand more grains in return than were initially lent out i.e. interest. This example shows that interest (for the lender) and profits (for the entrepreneur) are both special forms of wages.
When a society diversifies its production from grains into a range of goods, the costs of extending credit become higher. A borrower of grains who is producing capital to be used to produce fruit will have to procure grains in the future in order to repay his lender. This obligation depends on what rate his fruit can be exchanged for someone else’s grains in the future, which is unknown. This risk, the risk that the borrower’s labour is less valuable than the lender’s, is present in all credit transactions. However, what acts as a burden in this moneyless example is that the borrower is forced to exchange his fruit for grains, which assumes that a seller of grains will be interested in fruit, or else in some other goods that the borrower can obtain from a third party in return for his fruit.
These transaction costs are eliminated from societies that have agreed on the use of a token, money, to stand in for goods. Instead, the lender loans money that the borrower uses to purchase what he needs to consume while he produces capital, and recoups money by selling his produce in the future.
Money facilitates additional transactions, namely hiring labour and marketing produce. Offering money instead of goods as wages allows potential workers to appraise the opportunity more readily. Offering goods in exchange for money allows a single notional price to be advertised. Both these mechanisms encourage productivity, since the more productive entrepreneurs will flourish from being able to advertise higher wages and sell their goods at lower prices.
Having introduced money, we find that it will intermediate any transaction of goods, labour or finance. We will note in passing that money offers a distinct advantage in settling rent too. Money allows for more efficient markets, and with it, for a more productive allocation of land, labour and capital finance. The quality that allows money to perform this role is its liquidity, which is a measure of its exchangeability into other goods and services. Money is the most liquid instrument in an economy, by definition, and the liquidity of all other instruments is always relative to money. Of interest in this post is the utility of money in capital finance, for it is in this regard that money has in recent times been found so wanting. An asset bubble is one symptom of this deficit.
Let us return to thrift. At the outset we observed that it is customary to consider saving in terms of money. This is not only misleading, insofar as it mystifies the actual counterpart of saving i.e. goods; it is also highly flawed: when someone saves he is expressing his intent to postpone consumption. That is, by saving he is prepared to concede liquidity to someone else wishing to consume. Savers, therefore, can be distinguished from hoarders, who stockpile goods (or liquidity) as self-insurance. As any student of the subject knows, self-insurance is a highly inefficient method of insurance, both individually and socially. A hoarder postpones consumption for all, and thus snuffs out a spark of capital finance.
A saver on the other hand concedes this utility to someone on the expectation that it will be returned to him in the future. This concession is not made because savers are more charitable than hoarders: it is because by conceding liqudity, savers can earn a premium that ought to be denied from hoarders. Money, the most liquid instrument available, should therefore be of little interest to genuine savers (and indeed holding cash yields no nominal return).
The “liquidity premium” sought by savers compensates them for the welfare opportunity cost incurred by extending finance instead of raising their own productivity. It is observable that the rate of productivity growth associated with capital finance generally increases over the medium term, which implies that the term-dependent liquidity premium (the yield curve) should be upwards-sloping too.
The liquidity premium is the primary impetus to save. There may be additional returns demanded by savers to compensate for welfare risks posed by monetary depreciation (inflation) as well as low or negative returns on equity or the default risk of loans. Earning extra risk-adjusted returns is not a defining trait of the demand to save, however earning a liquidity premium is.
One defect of the modern economy is the scarcity of instruments available to savers seeking a liquidity premium only. Government bonds come closest, but can only be held if the public assumes additional debt; hence their availability is set by fiscal policy, not by the demands of savers. While a range of other bonds successfully masqueraded as risk-free, this has now ended. The only option readily available to risk-averse savers is to hold money on deposit i.e. to retain liquidity. Savers do not hold money on deposit with banks in order to hoard liquidity; they hoard liquidity because it is the readiest means of avoiding risk.
This is a blatently wasteful allocation of liquidity towards a constituency who values it lowly. Liquidity is not available in abundance – it comes at a premium, as discussed. Nevertheless, under the constraints of the existing defective social contract, basic economic law has had to be flouted in order to satisfy savers’ natural aversion to risk, and absurdly, hoarding liquidity is rewarded with a deposit rate of interest.
Liquidity will be squeezed out of any financial system if agents trust each other less, and transaction costs rise. By the same token, liquidity can be restored by reforms that successfully improve trust and bring about greater financial stability. Allowing liquidity to reach its full potential is an important public good – of which more will appear in later posts. However, it would be a grave mistake to think that liquidity can be increased above this potential. Sadly, some economists and policymakers have been duped into believing that liquidity is simply set, much like the monetary base, under fiat.
This fallacy is embedded into the architecture of the banking system, which has placed monetary stability at risk. When banks operating in a fractional-reserve system make loans, they are vesting borrowers with newly-created money for a given period; this deposit, as with any deposit, represents the most liquid instrument available. But as we have discussed, liquidity comes at a premium; assuming its availability is constrained, creating a new deposit acts as a silent transfer of liquidity to this depositor from all other depositors. In other words, the liquidity of money erodes. This effect, already scarcely tangible, is further concealed behind public guarantee (explicit or otherwise) of the exchangeability of deposits (bank money) into base money.
All this serves to produce a false appearance that the banking system can at all times provide agents with liquidity -whether by issuing base money or bank money- without withdrawing it from others. That such an illusion may be necessary to allow liquidity even to aspire towards its potential in the current financial system is an indictment of this system more than it is a defence of promoting an illusion. Yet our monetary system is not even geared towards serving this illusion. Its principal agents, commercial banks, are motivated to lend not by some objective of promoting liquidity or financial stability, but by profit. Now, some will retort that as private companies, the profit motive is entirely reasonable. Avowed free-market critics regularly object to this by pointing out that it is the public guarantee that produces much of the profit, gained illlicitly as seigniorage.
While this objection is sound, a more complete critique would denounce the delegation of monetary policy, on which critical public goods depend, to private interests in the first place. (Apart from the undemocratic nature of this arrangement, it also fosters monetary schizophrenia, with commercial and central banks oftentimes at conflict with each other.) In short, the banking system is rewarded for expanding the money supply -and risking the liquidity of money- with the margin between the loan and the deposit rate. It is true that the demand to borrow, without which banks cannot lend and create new money, is normally driven by the borrower’s demand to transact. But completing a transaction does not imply further transactions will take place, so any money created to facilitate a given transaction -which will remain in existence for the term of the loan (pending securitisation)- might just as well remain idle. When it is hoarded by savers, money is taken out of circulation, which makes the effect of monetary expansion on prices unpredictable, and creates the possibility of violent swings in prices occurring long after any monetary expansion. This places the business of monetary policy at the mercy of disturbances in sentiment.
Although depositors are protected from risk, banks are exposed to loan losses, which constrains monetary expansion to some extent. Banks tend to manage this exposure by demanding collateral from borrowers, largely in the form of mortgages. The quality of mortgage security depends on stability in the price of land (i.e. future rent). Provided the price of land is expected to rise, the risk of mortgage loan loss will be considered low, which will stimulate bank lending; and since the price of land is a positively correlated dependent variable of lending -given so much borrowing is motivated by desire to purchase land- lending and land prices will, for a time, offer mutual support. These are the proximate causes of a classic bubble.
Not all monetary growth will remain idle, especially during bubbles. Between 2003 and 2007, the perception of risk fell dramatically, as did the cost of bank loans. This encouraged growth in capital production, much of it in the developing world. Falling production prices exported deflationary forces to the West, whose central bankers responded with lower short term interest rates. So in spite of fairly stagnant real incomes, rising house prices lulled Western householders into a sense of greater solvency, discouraging saving and debt repayment in favour of consumption. Evidently, a global imbalance gradually emerged, with the term structure of production lengthening (into capital goods) alongside growing consumption. Eventually, this placed a strain on supplies of certain consumables, which fell short of demand quite abruptly, causing sharp inflation across a host of basic goods, some of which doubled or even trebled in price. This was the thin end of the wedge for economic stability.
Base rates were quickly hiked, further constraining household affordability. Sentiment towards asset prices crumbled, leading to bank losses and disruption in the payment system as banks ceased to trust one another. Liquidity tanked, causing a sharp increase in the demand for money among banks and non-banks, with hoarding preferred over spending or lending. Consumption fell, and prices began to fall, precipitating self-fulfilling fears of deflation that, owing to increasing demand for money, autonomous programmes of QE did little to halt for some time. Nominal wage cuts meet stiff psychological resistance whatever the prospects are for real wages, which left producers little option than to contract production and lay off workers. These are the basic ingredients of a deep recession that continues to haunt us today, in spite of the vast efforts of governments to fill the void in private sector borrowing and invest, lend and spend in their own name.
The magnitude of this crisis will become ever more real now that Western sovereigns, faced with default, begin to redeem their indebtedness. If the private sector fails to counteract this drop in demand with investment growth, the recession will be severe, in spite of desperate attempts -most recently by the EU and IMF- to bring down borrowing costs. The end-game of an outright collapse in confidence in various currencies cannot be ruled out unless there is wholesale reform.
The first (but by no means the only) policy question that arises from this discussion is what could and should emerge as a risk-free asset. While this has remained largely outside the periphery of respectable discussions of the causes of financial and external debt crises, I will outline my ideas on this site in subsequent posts.