Tax Liquidity or Fall into its Trap

April 16, 2010

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.


What Causes Financial Imbalances?

March 17, 2010

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.

  1. 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.
  2. 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.

Should Banks Exist?

February 24, 2010

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.

The Price of Liquidity: Financial and Fiscal Reform

February 7, 2010

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.

Savings, Bubbles and Sovereign Crisis

February 6, 2010

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.