The imaginary economy?

Speaking at the Asia-Europe summit Chinese Premier Wen Jiabao recently said, “The biggest responsibility is to stabilise the financial order as soon as possible. We need to use all available tools to prevent the crisis from harming real economies.” The Premier’s comment is hardly in isolation. Take, for example, an article recently published in the Times under the heading Banking crisis infects the real economy, or one from The Economist on Oct 9th titled The banking crisis overflows into the real economy. You will note the continued use of the phrase “real economy” in all of these articles – as though Wall Street and the banking sector could somehow be considered in isolation from that other place where people are born, work, eat, sleep and die.  

I even met a student of economics (studying at the University of Vienna) who told me that the entire banking crisis was ridiculous and that the problem was simply mass hysteria… a psychological problem. Her belief was that if everyone simply believed in the system that it would be fine. The problem, in her view, was a lack of faith. Once again, I was surprised by the hidden implication that losses in the money markets were somehow unrelated to daily affairs – as though the bankers and stock brokers of the world were busying themselves by day playing an elaborate game of monopoly which bore no relation to the homes we live in or the food we eat.

However only those leading the meanest of subsistence lifestyles, completely divorced from any kind of trade, could be somehow immune to events of the markets. In the era of specialization we are all bound to the market. Firstly it is the place in which we sell our products and services (which are far too specific and specialized to be useful in such abundance to us as individuals) and secondly they are where we source all those things which we do not make ourselves – which for most of us is virtually everything.

And in the market place it invariably occurs that one individual might need the services of another, without having any services that the other person might want in exchange. The lawyer who wants a haircut, for example, can probably offer very little to the hairdresser in terms of legal advice, in exchange for the haircut. Instead the lawyer must find (and offer) the hair dresser something that the hairdresser does want. And even the hairdresser cannot necessarily offer the baker haircuts every day or every week in exchange for bread. Perhaps the baker is bald. So the hairdresser too needs something of value to offer the baker, the dentist and the plumber in exchange for their services (especially if all these later happen to be bald). Naturally people seek out products which are readily tradable to fulfil this purpose – a commodity which others will readily accept for their services – and this becomes money. Money is a readily tradable commodity which emerges from the economy – a medium of exchange to help resolve the problem that all of the various business people above have – the double coincidence of wants.

However, although this function (a medium of exchange) is important and can hardly be overstated – perhaps money’s most important role is much less obvious. For money, as Carl Menger pointed out, having emerged from the economy initially as a medium of exchange then starts to serve a very different purpose. Once money has emerged and one can readily trade goods for money and money for goods, it becomes possible to compare the prices that people pay for goods in the economy in terms of that common reference. Of course, people will pay different things for even the same goods. One person might pay $1.10 for a loaf of bread where another pays $1.20, but in sufficiently large markets where competition is present someone who happened to have a few hundred loaves of bread would probably be able to gauge with a fair degree of accuracy how much he or she might be likely to sell that bread for based on the recent sales of similar products in the market. And so one might be able to estimate the potential monetary value of, for example, a few hundred loaves of bread or a box of beer or a house or a swimming pool.

The monetary value that we attribute to things (based on recent prices that they fetched in the market place) then makes it possible to compare the relative exchange values of different products and services in the economy and makes possible the otherwise impossible task of accounting. With a common unit of estimated value that can be attributed to each of the assets that a person holds, as well as a unit by which they might measure their revenues and expenses, it is possible to gauge the profitability of one’s activities. And when seen as an aggregate, the sum of the activities of all of the businesses in a particular region might be tallied to gauge whether their activities have been profitable or not.

What exactly does profitable mean in this case though? Certainly, in the absence of inflation or deflation, someone running a profitable business will end up either with more money and/or controlling more capital at the end of the year than they had at the start. This will no doubt be the primary incentive for individuals to own and maintain profitable companies. For the economic system as a whole though, the most important characteristic of profitable companies has very little to do with money. What is important for the economic system is that when companies are profitable they consume less than they produce. By contrast, when companies consume more than they produce they are said to make a loss. Of course, the consumption, production, profits and losses are all expressed in monetary terms but that does not mean the companies are actually consuming money (it doesn’t “disappear” when they use it – it is merely transferred). What they consume is resources, such as steel, iron, health insurance, mathematical modelling services etc. And what they produce is some similar form of real, tangible good (maybe computers or apple pies). 

So although the profits of companies are expressed in monetary terms, the real benefit that profit making enterprises bring to the economic system is much more important than money. What profitable companies provide to the economy is goods and services of a higher exchange value than that of the goods/services that they consume. Perhaps these enterprises produce a greater quantity of goods than they consume (as might be the case of an Orchardist who borrows a bin of apples, uses the seeds to plant trees and then gives back a few tonnes of apples a year a little further down the line – essentially taking 50 apples and turning them into 50,000 apples), or more likely they transform things that are liked less into things that are liked more. They take wood and turn it into houses, steel and turn it into cars. You give them rags and they give you back lavish gowns. In short, they make people wealthy.

When companies make a loss then, what goes missing from the economy is not money either… indeed, if under our present banking system this happens from time to time this is entirely incidental. More importantly, for human concerns, is the fact that loss making companies consume many more resources than they give back to the economy. Those companies in our economy which make losses cost us (normally shareholders – but in the present day the government has taken it upon themselves to spread the pain far and wide, to be borne by any productive citizen that they can get their paws on) and the cost is not merely monetary. The loss is not fictive or imaginary – it is not some wild hysteria or a lack of faith in the system – it is the loss of those real resources that the company consumes (steel, iron, health insurance and mathematical modelling services).

The creation of new money cannot fill the void that loss making companies (or banks) leave in their wake. Indeed, the losses that companies make are made on the basis of historical records and time, as we all know, only moves in one direction. There is no way, short of a time machine, to undo the losses that those companies make. The only thing that can be done is to try to prevent such companies from making losses again in the future, which is best achieved quite simply by dissolving the companies in question – freeing the resources that they consumed (including labour) to be used by the remaining companies in the economy that are profitable.

Borrowing things that don’t exist

In my previous post I spoke about the role of interest rates in balancing the supply of real savings (from depositors) and demand for those savings on the part of borrowers (investors):

What’s difficult to grasp here is that savings are not just abstract dollar notes. When I save, I am implicitly producing something of value (e.g. I bake some bread) and providing it to the economy whilst simultaneously not consuming anything (I don’t take anything back from the economy). As the baker, I might save a couple of hundred dollars a week. What I’m actually saving though is not dollars, but loaves of bread – I’m creating a surplus of a few thousand loaves of bread in the economy which have been created, but not consumed, and are available to be “invested” by a borrower who can eat that bread for a while, during which he will not be baking any bread (e.g. while he’s building a garage in his back yard). All around the economy there are millions of people in all walks of life that are saving in this manner. Some of them are saving flour, some are saving metal, some are saving wooden planks – yet others are saving accounting services and computer programming services and yet others again are saving health insurance or health care. All of these things are very real physical resources – resources that will be required by investors that need to “borrow” from the economy to start new companies or buy tractors for their farms etc. and the interest rates that savers negotiate with borrowers is the “price” of savings.

However in the absence of a sound monetary system, loans in our current economy are able to be made irrespective of whether any real savings are present or not. What then happens when this occurs?

To understand the consequences of lending in the absence of savings, imagine an economy where Mom and Pop go to work each day in an orchard. They work hard and each week they take their fruits to market and make just enough money to get by… no more and no less. They have sufficient money to maintain the orchard and their equipment and they have sufficient money to pay for phone, TV, good steak, nice wine – to live to the standard to which they’ve become accustomed. Their standard of living need not necessarily be a poor standard of living, but they are none the less consuming 100% of the fruits of their labour (excuse the pun) each week and at the end of the year they have no cash savings whatsoever – their account balances at the local bank are exactly the same as they were at the start of the year.

Now imagine that all of the entrepreneurs all over the country are in exactly the same situation as Mom and Pop – which is to say that everyone is consuming the totality of their production and there are no real savings made by anyone.

Finally imagine that, despite the complete absence of any additional deposits or savings, the banks decide to make new loans in this economy to a bunch of people. In creating these loans the banks are issuing new credit which will be used as a medium of exchange and are therefore expanding the effective money supply. The result is, rather predictably, that the new money that has been lent by the banks bids for resources in the economy (metal, wood etc.) in addition to the money that was already being used to bid for these resources and the price of goods goes up – in particular the price of those goods demanded by the people who received this new credit goes up as does the price of anything the bankers are buying (since the bankers will now be earning additional money by way of interest)… which is a classic inflationary scenario. The immediate effect of this is that Mom and Pop won’t be able to buy good steak – they have to buy hamburger meat instead because steak costs too much. Left to their own devices Mom and Pop would rather consume all the fruits of their labour immediately and would rather eat steak than eat hamburger meat and save, but they have now been forced to reduce their standard of living so that the bankers can issue new loans.

What is even more nefarious in all of this is that had Mom and Pop decided to save then they would have been paid interest on their savings – which is to say they would have received some long term benefits from delaying immediate consumption and satisfaction of their needs. If the interest rates were high enough to entice them to do this then Mom and Pop would even have been better off for having done so. However, since the banks didn’t want to pay them sufficient interest to entice them to save (and make available the real savings that were required for the new businesses to start) and found it more expedient to simply force them into slave savings mode – essentially confiscating a portion of their wealth that had previously been used to maintain the standard of living that they aspired to – Mom and Pop will get nothing for their trouble aside from the pleasure of eating hamburger meat rather than good quality steak. If they’re lucky, the bank manager might give them a good poke in the eye next time he sees them – at least then they’ll know who stole their steak.

Eventually the new money in the system will push up the prices of the fruit that Mom and Pop sell and they will regain the standard of living that they had before. However, in the short term Mom and Pop have unwittingly been forced to lower their standard of living to pay for the new investments that the bank decided to “fund”. The banks will recover interest on the money they lent to investors so they’re more than happy to extend these loans. The bankers basically get to take a bit of Mom and Pop’s wealth, lend it out, make a tidy profit and chuckle smugly to themselves over champagne on their yachts.

However, the above is not an accurate portrayal of what is currently taking place in the economy. For, the above is merely what happened in the past 8, 15 or 100 years (depending on how far you want to trace back inflation, which has been more or less unchecked since the invention of central banking in Britain). What is happening now is rather different. For, the banks have already issued the credit and already expanded the money supply. What is becoming apparent presently is that many of those who took advantage of the lines of credit that were offered are perhaps no longer (or never were) in a position to pay the money back. Since modern banks do not maintain 100% reserves, when someone defaults on a loan the implication is that money actually disappears from the banking system entirely (just as quickly as it appeared in the system upon the creation of the loan in the first place).

What are the consequences for Mom and Pop in this case? In the absence of additional money injected into the system what we could expect is less people bidding for an unchanged quantity of goods, services and basic resources in society and thus price deflation. So we’d expect to see more or less the opposite of what we saw during price inflation. And just as the initial inflationary period was bad for Mom and Pop (because other actors in the economy saw the new money resulting from inflation before them and were able to outbid Mom and Pop for resources) we might expect the deflationary period to be a bit of a boon for Mom and Pop. Where price increases hit other goods before they hit fruit and veggies before, we’d expect the price decreases accompanying deflation to come to the fruit and veggie sector of the economy later than it hits other sectors of the economy… So initially perhaps Mom and Pop will be able to buy a bit more than they were able to buy before, with the same quantity of money. Those who will initially be struggling during the deflationary period are those who defaulted on their loans (naturally) and those who extended credit to these people (typically the banks). Eventually price deflation would hit the fruit and veggie sector as well, and Mom and Pop’s standard of living will go back to where it was before.

The above is something of an oversimplification since strict labour laws typically prevent companies from lowering people’s salaries and so the only way they have of cutting costs during a deflationary period is by laying off staff – resulting in rising unemployment. Adjustments to the structure of capital in the economy accompanying such a “bust” following an inflationary boom will also necessitate re-skilling and likely temporary unemployment in order to heal past wounds. However a full discussion about the structure of capital is beyond the scope of this post. More importantly for this post, the above description of a deflationary recession simply isn’t what’s currently occurring anyway. What is currently occurring is that the banks and governments around the world are frantically injecting money into the system to make up for the trillions (literally) of dollars that they pulled out of thin air over the past 8 years and which are currently evaporating as individuals and companies default on their debts. Deflation, it is held by those in the seats of power, is the worst evil known to man and must be avoided at all costs since deflation apparently causes unemployment (to be clear, not a theory I agree with but this is the common thinking anyway). For banks that make their money by inflating, the pain associated with deflation is clear to see. Furthermore, they have a trump card – the banks never lent their own money – they lent yours. They pretended to be deposit institutions that would hold their depositor’s money safely in locked vaults. In reality banks are not deposit institutions at all but highly leveraged investment institutions. They keep only the tiniest fraction of the money that depositors give them. On the back of 30 million dollars in deposits a typical bank will lend almost one trillion dollars out, and therefore when but 3% of their loans go bad most banks will have no reserves whatsoever remaining. They can loose all of the money that has ever been deposited with them if they are not able to recover a mere 3% of their loans. The fact that banks lose other people’s money (depositor’s money to be exact) is the Achilles’ heel of the general public.

In effect, the banks have a hostage: people’s deposits. Were it not for their deposits, Mom and Pop would probably say, “What do I care if prices go down? Let the banks sink – f#$% em, they’re rich pricks anyway!” And given that the banks essentially got rich by stealing Mom and Pop’s wealth, you’d have to have some sympathy with Mom and Pop for holding such a view. However even Mom and Pop (who don’t have any savings) have at least a little money deposited with the bank – they keep sufficient funds in their current account to ensure that they’re able to conduct their day to day affairs with respect to the orchard they own and the management of their household. Mom and Pop don’t want to loose that money. Furthermore, although on aggregate the rate of savings in the United States may currently be low, there will always be some people that save and others that don’t. Those people that have been squirreling away money for years to save up for their wedding or their children’s education certainly don’t feel very comfortable about the idea that those hard earned savings might just evaporate overnight because the bank that they held those savings in happened to be, in actual fact, a highly leveraged investment vehicle and not the trustworthy deposit institution that they had presumed it was (because of the big “BANK” sign over the door).

As such, the idea of moral hazard (which most people haven’t even heard of) was all too easy to sweep aside in the mass media. What was focused on instead was the frightening possibility that people might loose their deposits. A short term cure for that particular problem has thus been sought without any regard to the long term consequences of the actions taken to bring about such a quick fix.

Long term, the problem will only raise its ugly head again because banks do not lend their own money – they lend yours! The system of fractional reserve banking with a lender of last resort means that banks get to earn interest on the loan of fictive money while times are good (interest that they pay their staff salaries and healthy bonuses from) and then when it all turns to custard they really don’t care, because government and the lender of last resort are both more than willing to cover up their crime by picking up the tab (and I use the word crime here in the most literal sense, since the use of false certificates of deposit which is characteristic of fractional reserve banking is recognised as a crime and known as embezzlement in all other industries). No amount of government regulation can counter-balance this. We know (as do the banks) that the government is willing to make use of force to ensure the payment of any loans that banks make and which go bad (i.e. government makes tax payers pay back the loan). For this reason, after the dust has settled in the current crisis people will continue to deposit money in banks such as Fortis and UBS, treating these institutions as the safe deposit institutions that they always treated them as despite the fact that their actions have betrayed them as being anything but, time and time again… and it will be business as usual.

The band aid which will be put on the open gash left in our economies will be completely ineffective regulation (it has to be ineffective since it does not address the root cause of the problem) and commentators in 2014 or 2016 will be taking about how the free market has failed them yet again and brought about yet another unavoidable crisis. The reality, of course, will be that the free market had nothing to do with it – the free market hasn’t been seen anywhere near the banking sector for well over 100 years.