Savings, Bubbles and Sovereign Crisis

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.

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