At what price?

When we speak of profitability we are talking about a cost benefit analysis. Am I better off sitting on the couch or going to get a slice of pizza from the fridge? That will no doubt depend upon the degree to which I’m either hungry or tired. If I’m more tired than I am hungry then I can best maximise the use of my time by lounging around on the couch. On the other hand, if I’m more hungry than tired then I’m perhaps happy to pay the cost (getting up and walking to the fridge) of obtaining pizza since I consider the benefit of eating pizza to be greater than that cost. When the benefits of doing something outweigh the costs (including opportunity costs) that action is said to be profitable.

Let’s say I’m hungry though and there’s no pizza in the fridge – there’s just an apple in the fridge. Outside in the yard there’s a plum tree and at the top of the plum tree I can see a nice juicy plum and, as it happens, I prefer plums to apples. However, the cost involved in obtaining the plum is significantly higher than the cost involved in obtaining the apple. The apple is right there in front of me for the taking but eating the plum would require I spend 5 minutes clambering around in the yard… If I really like plums way more than apples then maybe I’m willing to go out and clamber around in the yard, but I’d have to really like plums a lot more. Now what if, at the time when hunger strikes, I’m currently dressed in a suit ready to go to work? In that case the cost benefit analysis would change yet again – not only would I have to spend 5 minutes clambering around in the yard but I’d have to change my clothes first (so as not to ruin my suit) and then get dressed again for work afterwards… perhaps under these circumstances I’d no longer be willing to do what was required to have the plum and I’d just take the apple. In any event, through the construction of more and more elaborate (but hardly unrealistic) scenarios you can easily envisage that we will eventually arrive at a point where the additional cost of having that plum (as opposed to the apple) is greater than the perceived additional benefits that this would bring me. Above a certain price, the plum simply isn’t worth having – and the price paid is ultimately my time and effort. Above a certain price I’d rather spend my time eating apples (or doing something else like going to work) than I would jump through the necessary hoops required in order to be able to eat plums.

Now most of the time people think of petrol as coming from Saudi Arabia out of massive pumps which can, like taps, simply be opened or closed to produce more or less petrol as needed. And indeed for the better part of the last 2 decades it appears that tap has been running rather freely with oil and petrol prices during that period being what most people would now, in hindsight, see as a relatively cheap. More recently, from 2000 until around 2004 the price of light crude oil was hovering somewhere around $30 per barrel. However from 2004 until mid 2008 the price exploded from around $35 to approximately $160 per barrel and, at the time of this writing, has now settled down to around $50 a barrel again.

At a certain price, and from a producers point of view, people aren’t willing to do much for oil… they’re willing to “turn on the tap”, so to speak, but they’re certainly not going to be clambering around in the yard for it. However if you pay someone enough then they will go to great lengths in order to obtain oil for you. Indeed, when the price of oil is higher than about US$70 per barrel they’ll be willing to move to some of the most inhospitable places on earth, invest in 400 tonne dump trucks and expend vast amounts of heat, water and (ultimately) effort to process tonnes of tar sand in order to bring you a barrel of oil.

However, as we noted above, those people investing not inconsiderable sums of capital in 400 tonne dump trucks and those people spending their time living in a camper vans next to Canada’s tar sands in order to operate such dump trucks are making an economic choice… they are investing that capital in dump trucks to the exclusion of all other possible uses of that capital and their decision to spend their time mining tar sands necessarily precludes the possibility that they might do something else with that time instead. Quite simply, the mining of the tar sands of Canada (and the additional oil that is produced as a result of this) comes at a cost – a cost we will never know since the alternative possible uses of that capital and labour will never be known but you can be certain that as a result of mining the tar sands of Canada there is something else that was not produced instead.

Had the price of petrol never surpassed $70 a barrel and, in a hypothetical situation, had the price of croissants in Canada skyrocketed to $15 each then perhaps the capital that was invested in dump trucks would instead have been invested in bakeries and, rather than spending their time training to be machine operators perhaps the pool of Canadian labourers would have spent their time instead as apprentice bakers. Would that have been so bad? I don’t know – it’s like asking if it’s better for someone to get pizza or lay on the couch… what is the best (and most profitable) course of action really depends on their personal preferences. However, in the case of the choice between croissants and petrol what we are asking is not the preferences of an individual but the aggregate sum of all the preferences of all the individuals in the economy, which are reflected in the prices that they are willing to pay for both croissants and petrol. If the relative prices of croissants and petrol remained reasonably consistent with the ratios that we’ve seen over the last few years then we probably wouldn’t expect dump trucks to be melted down and turned into pastry ovens any time soon. On the other hand, if the price of croissants shifted significantly against that of petrol then we might well expect to see basic goods such as metal and machine tools reoriented to support the baking industry instead of the petroleum industry. In a free market, if such a shift occurred then it would simply be indicative of a change in consumer’s preferences and the new investments in baking equipment could be applauded by the (soon to be) satisfied consumers in the market place.

The problem is that presently our prices appear to be sending some pretty mixed signals. One day the price of oil is through the roof and the next it’s through the floor… and nor is the price of oil in isolation here. Stocks, housing, commodities, durable goods – pretty much across the board we have yoyo prices. Economists wondering what is causing the volatility in prices are no doubt tempted to try to interpret these in terms of supply and demand (since, as we’ve all been told, that’s where prices come from right). And on a case by case basis, with a bit of imagination, such economists might find semi-plausible explanations for many of the price shifts that we’ve seen lately (in the case of wheat, for example, the issue of government subsidied for biofuels is often raised). However it is not the price of any one good in the market or even any one category of or group of goods that has seen volatility. Practically everything is on the move and the economy looks like it’s walking on sailors legs. The economy looks drunk… the kind of legless drunk that usually comes just before someone throws up all over your trousers and collapses unconscious on the floor.

It is absurd to try explaining the volatility in these prices in terms of fickle and changing consumer preferences. Consumer preferences simply have not changed (both in the upward and downward directions) sufficiently to justify the price swings we’ve seen of late. Nor am I inclined to believe that these price changes are the result of supply shocks. This would be peculiar indeed on such a global scale. The bigger the market the smaller you would expect the shocks to be. The effect on prices, of regional problems with the supply of products, would typically be dampened by the sourcing of alternative products from other countries. But that’s not what we’re seeing – we’re seeing global and massive price shifts. So if we’re not willing to accept changes changes in demand as the cause of our changing prices and we’re not willing to accept changes in supply as sufficient to have caused recent price volatility either then we’re only really left with one other choice… and that’s that the prices are not functioning correctly – which is to say that they do NOT reprepresent a relationship between supply and demand.

More and more, I’m starting to doubt the accuracy with which the prices in our market places reflect supply and demand. Of course the US government handing over hundreds of billions of dollars to subsidise various non profitable industries in the US (notably in the banking sector) certainly doesn’t help. The fact that banks can bid up the prices of goods in certain sectors of the economy without having to make sure their activities are profitable raises serious questions about the relevance of the prices of those goods. If government coercion is used to force money to be spent “recapitalizing” Citibank then is any of the capital that Citibank controls or are any of the goods that Citibank purchases currently priced at levels that reflect the preferences of consumers? The answer, quite obviously, is no. And the more the government interferes with the economy (whether that be by way of propping up ailing banks or by fiddling with interest rates to try to boost share prices and “keep home owners in their homes”) the more we have to admit that prices in the market are not being set by the market but are, in fact, being set by government. As in the socialist commonwealth, we have prices in name only – but those prices are not what you think they are. They don’t express the relative importance of goods to individuals in the economy and they don’t reflect the scarcity or abundance of those goods either. These are not prices that will ensure demand is met by supply and nor will they protect us against shortages (of things like savings) and wasteful gluts (of things like cars and houses). 

Our prices find themselves forced into a rather unnatural ménage les trois – no longer solely the marriage of supply and demand (as is natural). More and more they are the perverted prices that central planners have either explicitly sought to place on these goods or have inadvertently brought about by way of their hubris, incompetence and stupidity. What will be the price we pay for all this government fiddling? Ask the Russians – they know from experience. When you take away prices you take away the freedom of consumers to choose and the rational basis for production. The result is poor people without choices and without economy.

The real cost of poor accounting

I recently wrote about the tangible consequences of the profits and losses that entrepreneurs in the economy make:

“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… 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).”

However it must be remembered that the profits and losses that companies announce are estimated on the basis of the company’s accounts. These accounts will be maintained, and thus the profits and losses expressed, in monetary terms, and the ledger entries in theses accounts will contain monetary valuations of the various assets, liabilities, revenues and expenses relating to the company’s operations. 

In the absence of any significant inflation or deflation of the currency, these valuations will ordinarily be fairly accurate estimates of the relative values of the capital used to operate the company. For, the goods and services that make up the capital, income and expenses of companies will be purchased in markets and the monetary value of these things will be the result of a all of the market participants trying to outbid one another for available resources (such as land, labour, wood and steel). Different companies may pay different things for the same goods and some companies will abstain from purchasing goods that they consider too expensive at a price that is entirely acceptable to other companies that happily purchase at that same price (thus reflecting the fact that these goods have different values for different companies). However if the average price paid for a kilo of oak is higher than the average price paid for a kilo of steel then we can say that oak has a higher relative value, per kilo, than steel to the economic system as a whole. This is perhaps because it is preferred by consumers or perhaps because it is more scarce than steel. Regardless, it will indicate that oak can only economically be put to more important uses whereas steel might be used for purposes that were more mundane.

What if, however, we were to hack into the accounts of all of the companies in the nation and replace the prices that they actually purchased or sold steel for with some other random price? Surely their profit and loss statements at the end of the year would be much less accurate than they were before, would they not? If the price that we substituted into their accounts was lower than the price that they had actually paid then the companies that purchased steel would appear to be more profitable and the companies that sold steel would appear to be less profitable than they actually were. Such an accounting error might force some of the steel producers into liquidation, despite the fact that these companies were in reality entirely beneficial to the economy and producing much needed steel. Similarly, such an accounting error might prevent various companies that buy steel from realising that they were not profitable – with the result that these loss making entities would continue to consume real resources from the economy where it simply was not rational for them to do so, from the point of view of the economic system as a whole.

Even if the switcheroony that we performed with the steel prices didn’t cause any companies to liquidate entirely, it would certainly confuse the price signals in the market place such that steel producers were tricked into believing there was less demand for their product than was the case (thus cutting production) and such that steel consumers were tricked into believing there was more steel available than was the case (causing them to wastefully put steel to uneconomic uses).

The negative consequences of our meddling would therefore be twofold. On the one hand our actions would imbalance supply and demand and, if we were to continue to meddle with the company’s books over a long period of time, would eventually lead to a steel shortage. Secondly however, our actions would undermine the ability of companies (and thus the economy as a whole) to accurately gauge their profitability. Of the two side effects, this later could well be the more serious since it will cause ongoing long term real losses to society and the economy as a whole.

One of the primary costs of most companies, of course, is the cost of borrowing. However interest rates do not currently emerge naturally from a free and competitive market. Indeed, in as much as they concern our present discussion the price paid for savings by borrowers is set by central banks entirely arbitrarily. This is not to say the interest rates are set randomly without any consideration to current market conditions. However the relative preferences of consumers (borrowers) and producers (savers) are entirely ignored by central banks when setting interest rates and even the relative scarcity or abundance of real savings in the market place, it seems, is paid very little heed. Primarily what motivates central banks in setting interest rates today is a peculiar Keynesian notion of full employment and, as though the two were somehow diametrically opposed, a “watchful eye” on inflation to balance this.

The fundamental meaning of the accounting concept of profitability, it seems, does not even enter into the equation. Certainly attention is paid to broad statistics such as the CPI, PPI and the GDP. However the fact that interest rates – one of the primary costs incurred by every entrepreneur in the economy – are not an accurate reflection of the real costs of borrowing both to companies and to the economy as a whole means that the ability of every entrepreneur and every borrower in the economy to gauge their profitability has been severely undermined, in real terms. Hence the ability of central banks to calculate the profitability of the economy as a whole and the relevance of statistics such as the GDP is also undermined (even if these statistics were accurate – which is rather doubtful considering the methods currently used to calculate both inflation and the GDP).

What this means is that the normal mechanisms for ensuring that only profitable activities take place (i.e. liquidation and bankruptcy) and that production remains positive with respect to consumption are not working properly. There are millions (perhaps billions) of entrepreneurs all over the planet making what they believe to be profits when in fact these entrepreneurs are a burden to the societies that they live in – consuming scarce savings of real resources which are, as a consequence, no longer available to be put to truly profitable uses. In wasting those resources, the societies that employ central banks have prevented the existence of countless profitable companies that most certainly otherwise would have existed and which, far from being a burden on our societies, would have enriched them and employed just as many people (if not more) than the unprofitable companies resulting from a misguided Keynesian “full employment” policy.

Fundamentally the fault of central banks is that they do not focus on that which should be the focus of all economics – the satisfaction of human needs. Instead they focus on the much narrower goals of the “need for employment”. And in their pursuit of that narrower goal they disregard entirely whether or not the “employment” that they seek to encourage is profitable or not, and thus whether or not their actions (even should they succeed in realising the desired objective) will be good or bad for the economy.

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.

Wild derivative geese

Derivatives markets, it seems, have become a popular scapegoat for the “financial crisis” recently. This is perhaps partly due to the fact that these markets are far less well understood than the securities market. Joe Sixpack can easily understand the idea of trading an apple for an orange, or money for shares, and can get his head around the idea of interest, dividends and yields without too much difficulty. However, since Joe probably doesn’t take out many derivatives contracts it might require a little more mental warmup on his part in order to get his head around these.

This needn’t be the case though since, although Joe might not trade futures or options, more than likely he has dealt with something that is very similar to a derivatives contract: the common mortgage. When the bank lends you money to buy a house, they’re taking a risk. They mitigates this risk by using the house that you purchase as collatoral against the loan so that if you are ever unable to pay back the mortgage they can take your house and sell it to recover their money. Additionally, since they might not be able to sell the house for the same price you purchased it for, they would typically ask you to provide a certain amount, up front, before they’ll be willing to lend you the rest. If they felt the price of your house could potentially drop by as much as 20% then it would be logical for them to require you to provide at least 20% of the funds required to purchase the house before they would agree to lend you the remaining 80%.

A derivatives contract is much the same as a mortage. Essentially you want to purchase something (let’s say $1000 worth of gold) and you only have $100. As such, you need to borrow the remaining $900 from a trading desk or a bank or someone. Once again, whoever lends you that money is taking a risk since if you’re not able to pay it back and the price of gold drops then they may not be able to recover their $900 by selling the gold you purchased. This is an example of a margin contract and the $100 that you put up initially is what’s called the margin (the equivallent of a down payment on a house). The way the lender deals with this situation (and thus mitigates their risk) is by saying that if the price of gold drops by 10% then this will trigger a margin call – basically you have to cough up more money or they will close the contract that you had (i.e. sell your gold), recover their $900 and call it a day.

Now, what’s interesting is not really the mortgage or the derivatives contracts themselves. These are both, quite simply, loan agreements which serve an invaluable role in the economy. Nor are the measures that lenders take to mitigate their risks very interesting to anyone except the lenders, since it is only the lenders that stand to loose anything. If Air Tahiti and Exxon Mobil both take out a futures contract on petrol, with Air Tahiti borrowing the money required to take out such a contract from Murry Rothbard and Exon borrowing from Ludwig von Mises, in the event that Air Tahiti made massive losses and went bust the effect on the global financial system would be minimal – only Murry Rothbard stands to loose his money here and, even then, only if he did a shoddy job of drafting up or executing the futures contract that he made with Air Tahiti. If the markets shift against Air Tahiti then, under normal conditions, Murry would close their futures position on petrol and the money that Air Tahiti fronted initially should cover any losses.

What’s interesting is what is being referred to in the media as counter party failure… a euphimism if ever I saw one (but then virtually all terminology used in the banking industry is). What counter party failur concerns is the instance where Murry Rothbard goes broke and isn’t to provide the cash necessary to purchase the petrol from Exon Mobil on the date agreed upon in the futures contract. However, this is rather a peculiar event. How could Murry Rothbard loose the money that he had already lent to Air Tahiti? Air Tahiti used that money to purchase a futures contract… so what is Murry Rothbard still doing with it? It appears that Rothbard has pretended to lend the money to Air Tahiti whilst simultaneously spending it on something else (e.g. housing in California).
In this particular case, this is not plausible because Murry Rothbard is not a bank and banks are the only institutions in the world that are allowed, by law, to create false certificates of deposit and lend out the same set of funds multiple times under a system known as Fractional Reserve Banking. So the root cause of the problem is quite simply that the banks maintain anything less than 100% reserves. Had the banks that lent money to derivatives traders (so that these people could take out margins, futures and options contracts) maintained 100% reserves then neither the failure of any one nor of any large group of derivatives traders would have had any serious impact on the tax payers in the US or anywhere else in the world… for if banks held 100% reserves then the money that was leant to Air Tahiti would never go anywhere – it would stay locked into that contract until the contract terminated… only ever to be used for that one thing. It would be almost impossible for either Air Tahiti or Exon Mobil to ever be in a position not to live up to the conditions of the futures contract or for money to “dissapear” from the system.
The problem then is, as always (and neither the banks nor the governments want to admit it even in the very rare instances when one or two of their employees are aware of it) that the creation of false certificates of deposit in the money industry is not called embezzelment as it is called in other industries that deal with fungible goods (such as the grain industry), but instead has been legalised and given a different name: Fractional Reserve Banking (FRB). The underlying leverage which is the true danger to the system comes not from the derivatives contracts but from the FRB system that allows banks to lend out $100 on the back of $3 is deposits (3% being the average amount of reserves that most banks around the world keep). Banks, which most people incredibly think of as safe little deposit institutions, are leveraging your deposits 30 to 1 – some of the highest levels of risk around. For your trouble (and the risk you take) here in Europe a depositor cannot even expect to be paid enough interest to cover inflation – you won’t even earn 3% interest for having implicitly made one of the most risky investments that it is possible to make by the simple act of depositing your money at UBS or Deutch Bank.
FRB has existed pretty much ever since the invention of money and loans but this was usually kept in check by the fear of a bank run. Banks that maintained insufficient reserves were always at risk of a run on their reserves (which historically were held in gold). In particular, banks were vulnerable because their competitors (other banks) knew this fact and could call in on loans in unison if they thought they might be able to get rid of a competitor in the market in doing so. However when all banks started to create false certificates, Bank B was actually placed at some risk by the reckless lending on the part of Bank A because a run on Bank A could provoke a wider lack of faith in the banking institutions and hence a run on Bank B’s deposits as well. If Bank B maintained 100% reserves then this probably wouldn’t bother them and they’d see a run on Bank A as a convenient opportunity to eliminate Bank A from the market. However if Bank B also had less than 100% reserves then Bank As problems became the problems of Bank B…
This “interdependence” of banks led to the formation of various cartels over the ages (such as the Ricci family in Florence in the second half of the sixteenth century) who would coordinate their efforts by agreeing upon “production levels” much as OPEC does with petrol – only the “production levels” for the members of these banking cartels were to determine the rates at which each bank could create false certificates of deposit (i.e. their reserve requirement). All of these cartels inevitably collapsed eventually due to free market forces. Even when banks were able to coordinate their inflation nationally they were at risk because of payments that had to be settled, in specie, internationally.
It was not until the invention of the central bank and the implementation of a “lender of last resort” that implicitly backed the reckless lending practices of banks through the use of tax payer’s money that banks really got free reign to wreak havoc. And even then, for many years the central banks themselves were kept in check once again because international settlements had to be made in gold. Only with the bankruptcy of the United States in the late 1970s and the complete abandonment of any tangible asset to be used as reserves – the abandonment of the gold standard – were the doors opened for banks to make the kind of losses that they are making today by creating money out of thin air with absolutely no constraint on their ability to do so. The existence of the central bank as a lender of last resort only exacerbates the problem since people continue to think of banks (inherently inefficient loss making institutions – even their profits are made primarily by way of inflation) as safe deposit institutions. If the full extent of the risk associated with putting your money in deposit accounts at the local bank was allowed to be felt then people would stop putting their money in banks that used it on investments that were leveraged 30 to 1. They’d start demanding the people that housed their money maintained 80% or 100% reserves (depending on how much “risk” they wanted to take on their deposits) and withing 20 to 30 years the problem would go away once and for all – not due to any miraculous government regulation but, as usual, because the invisible hard of the free market would sort it out.
In short, the derivatives industry is a scape goat. It is not the fundamental cause of the current financial woes and nor is the root cause being addressed in any way (or even so much as discussed) in the mainstream media.

PS: For further information about the history of money and banking see Murry Rothbard’s The Case Against the Fed.

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.

Socialism and central banking

As Mises demonstrated in his brilliant essay “Die Wirtshaftsrechnung im sozialistischen Gemeimwesen” (Economic Calculation in the Socialist Commonwealth), the crucial failing of socialism is the absence of any pricing mechanism with regard to producer goods (which are owned by the state). Although money operates in a socialist state, its uses are confined to the purchase of consumer goods. Producer goods (such as factories etc.) are “publicly owned” and directed by the state, as is their productive output. The result was that it was impossible for any prices to form in the markets for  manufacturing goods because there were no such markets. The socialist administrators could not say whether a new tractor was more urgently needed than a new plane or train… whether 100,000 spanners was more valuable than 500,000 nuts and bolts. They had absolutely no objective means of determining what quantities of the manufacturing goods in their economy (which were owned by the state) were required in order to satisfy people’s present and future needs by producing all of the consumer goods that were demanded. They could perhaps say that people wanted more spanners, but without any objective means of calculating the cost of producing these it was impossible to say whether this was an economic use of scarce resources – whether they should produce these instead of nuts and bolts, if they ever found themselves in a situation where they had enough resources to produce one but not the other (which in a world filled with scarcity they invariably did).

Mises’ argument is quite subtle and better explained by Mises. If you were to pull a basic lesson from the essay though, it would be that prices are essential to a healthy functioning economy. Steer well clear of any inclination to use tariffs, price ceilings, price floors, price targets etc.

The problem with our current banking system is essentially the same as that of the Socialist Commonwealth – namely that it is centrally controlled. There is no competition in the money making industry and nor is there any semblance of market determined pricing. The only institution that can inject further US monetary reserves into the global economy is the Federal Reserve Bank and when they do so they fiddle with a price – that being the price of savings (i.e. interest rates). But, as Mises pointed out, prices can only emerge from a free market when individuals are able to trade freely. There is no way that a central authority can calculate what the price of goods should be in the absense of any free market exchange of those goods. Furthermore, prices serve a pivotal role in the economy. They serve as a communication mechanism between producers and consumers. On the one hand, prices communicate to consumers the relative scarcity or availability of goods and consumers can use this information to make sure that they’re only putting goods to economical uses. On the other hand prices serve as a signal to producers as to the relative importance of goods. If the price of something goes up, producers know they need to up production (and if they don’t then new entrants will come into the market to do so, in a freely competitive market).

In a free market the prices of consumer goods will determine what people use them for. Take the price of grain for example. If grain is relatively expensive then, likely as not, people will continue to eat it but they won’t be feeding it to their livestock. If the price of grain plummets to an all time low (lets say 50 cents a tonne) then people would start doing all sorts of crazy things with it. At that price, it would be cheaper than hay, so they’d feed it to their cows, their goats and their horses. They’d probably even make compost out of it to put on the vegetable garden; they’d feed it to birds at the park and use it to paint jackets on snow men at Christmas time. All of this would be fine if grain was at 50 cents a tonne because there was actually way too much grain around and grain producers literally couldn’t get rid of this stuff. The logical result in such a case would be for the price to fall until inventories could be cleared and probably for a few grain producers to get the hell out of the market. However, if there was actually a grain shortage going on and global grain stocks were falling, and governments decided to react to this shortage and seeming inaccessibility of grain to the poor by capping the price of grain or subsidizing the price of grain, what happens is the following. Firstly, the fact that the price of grain is not allowed to float up prevents a crucial signal from being sent to the producers, letting them know that increased production of grain is required. Secondly, the artificially low prices of grain in the markets trick consumers into thinking that certain uses of grain (for example feeding cattle) are economical even though this is not the case given the current supply of grain. What results in such cases are wide scale shortages. Producers don’t produce enough and what little grain there is can be obtained by some people for unrealistically low prices so that they use it to feed their cattle whilst other people that desperately need it for more important uses (such as eating it) go hungry.

Now, back to the banking industry. The Fed sets an extremely important price. It sets the price at which savers sell their savings to borrowers. 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. This price serves as a crucial signal between savers and borrowers (investors that will be starting companies or building new homes or whatever) as to the quantity of real savings that are available to be borrowed.

If you muck around with that price then what happens is exactly the same thing that you get in any other industry (for example the grain industry). If you cap the price of savings (i.e. interest rates) artificially to levels that are below what they would otherwise be in a free market, you do not in any way magic into existence any additional real savings. What you do is prevent crucial signals being sent to producers (savers in this instance) to indicate that additional savings are required – so people stop saving. Additionally you provide false signals to borrowers such that they are tricked into thinking that the use of these scarce savings towards certain purposes is economical where, in fact, if they knew the true market price for these savings (a price which reflected their actual scarcity) it would be clear that this was not the case. The result is that people borrow money to build homes that it wasn’t economical to build or they borrow money to start dot com companies that sell toilet paper on line or any number of other hair brained schemes that never would have been undertaken if the cost of borrowing was 8% or 12% or whatever market rates would emerge for savings in the absence of the Federal Reserve.

What we see emerging from this system so far is the random allocation of scarce real savings via subsidized interest rates to all manner of uses, some of which are economical and some of which are not (the same phenomenon that was witnessed with regard to producer goods in the former Soviet Union). Some of the people borrowing money have genuinely good and profitable businesses to start with it, but there is no discrimination between these good uses of the money and unprofitable uses. If interest rates were higher then only those businesses which were capable of turning a profit at higher interest rates would continue to borrow – the rest would go out of business fairly quickly and so the unprofitable activities would be culled off. However with artificially low interest rates savings are put to both the economical and uneconomical uses. This is a mistake since there are not enough real savings to see the successful completion of both the genuinely profitable businesses and the uneconomical ones (such as the online toilet paper business). There are only enough savings for some of these enterprises to succeed and by lending money (and real savings) to both you not only ensuring the certain failure of many (or even all) but do not even necessarily ensure that the profitable businesses are the ones that succeed (if any do). At some stage, midway through the various business ventures that are being undertaken, it will be discovered that the quantity of real savings available in the economy was not sufficient to see the successful fruition of all of those projects that were started and then you have an economic crisis. Even though we might try to pretend for a while that savings are less scarce than they actually are (by artificially lowering interest rates) reality comes home to bite eventually when the level of real savings is discovered (typically when they are exhausted). In basic terms, because the price of savings is too low, essentially the little grain you have is being used to feed the cattle while the people go starving.

What needs to be done, and must be done, if we want to avoid ever more serious wide scale shortages of real savings resulting in cyclical failures in the economy (recessions and depressions) is to eliminate the monopoly that the Federal Reserve currently has on the issuing of money. If the issuing of notes was left to the free market and both the banks and the public knew that there was no “lender of last resort”, then people would quickly become aware that putting your money in an interest bearing account at the local bank was not in fact the safest thing that you could do with it, so long as that bank retains any less than 100% reserves (which will be almost unavoidable if they are to pay you interest). People would quickly realize that putting money in banks was implicitly an investment that had risks associated with it (quite serious risks – most banks only maintain 3% reserves so they are basically leveraged 30 to 1 – more risky than most futures or options trades carried out by day traders) and after a couple of banks went under and everyone lost their deposits, no doubt they’d start looking for alternative places to put their money. For example, people might put their money in money warehouses which maintained 100% reserves but charged a fee for storing your money. Perhaps a solution in between a money warehouse and a bank would emerge – for example a bank that maintained say 80% reserves and didn’t charge you a fee but didn’t pay you interest, or any number of other combinations which would certainly result in a genuine free market in banking. In such a free market, the failure of individual banks would not engender a global economic collapse and would be no more serious than the failure of a large supermarket or any other business. It certainly would not require trillions of dollars of tax payer’s money, increased regulation or government intervention.

There is nothing inevitable about the socialist nature of our current banking system. Banking does not have to be centrally controlled any more than baking bread must be centrally controlled, in order to ensure its stability. Flour mills and bakers have been supplying our cities with bread for quite literally hundreds of years without so much as a minor hiccup in supply. There have been no bread crisis, no regular bread cycles or wild fluctuations in the price of bread… they’ve just been stoically pumping out a good quality reliable source of food for billions of people for as far back as anyone can remember. This miracle is achieved by Adam Smith’s famous invisible hand – i.e. by the emergence of free market prices which are so conspicuously absent from our modern banking system.

The collapse of so many societies in history has been accompanied by a debasement of their currency that it would be impossible to count them. We cannot get rich by pretending we live in a fairy tale universe where water, metal and oil are any less scarce than they actually are. All that we can do is decide (as far as possible) the most pressing uses for scarce resources and make sure that as much as possible these are the uses they get assigned to. To date, the only mechanism we have discovered of performing that immensely complex task is the free market pricing system (not, you will note, as mainstream commentators are indicating, increased government regulation or coordinated central banking policies).