In the meantime, the debasement of paper money continues

Incredible confusions

Part 1: ‘Positive Money’ and the fallacy of the need for a state money producer

I am usually inclined to encourage the inquiry of the fundamental aspects of money and banking. This is because I tend to believe that only by going back to first principles is it possible to cut through the thicket of widely accepted but deeply flawed theories that dominate the current debate in mainstream media, politics and the financial industry. From my own experience in financial markets I can appreciate how convenient and tempting it is in a business context, where quick and easy communication is of the essence, to adopt a certain, widely shared set of paradigms, regardless of how flimsy their theoretical foundations. Fund managers, traders and financial journalists live in the immediate present, preoccupied as they are with what makes headlines today, and they work in intensely collaborative enterprises. They have neither the time nor inclination to question the body of theories – often no longer even perceived as ‘theories’ but considered accepted common wisdom – that shapes the way they view and talk about the outside world. Thus, erroneous concepts and even outright fallacies often remain unquestioned and, by virtue of constant repetition, live comfortably in the bloodstream of policy debates, economic analysis, and financial market reportage.

This goes a long way in explaining the undeserved survival of a number of persistent modern myths: deflation is the gravest economic danger we face; Japan has been crippled by deflation for years and would grow again if it only managed to create some inflation; lack of ‘aggregate demand’ explains recessions and must be countered with easy monetary policy; and money-printing, as long as it does not lead to higher inflation, is a free lunch, i.e. we can only expect good from it. None of these statements stand up to scrutiny. In fact, they are all utterly absurd. Yet, we can barely open a newspaper and not have this nonsense stare us in the face, if not quite as bluntly as stated above, than at least as the intellectual soil from which the analysis or commentary presented has sprung. Deep-rooted misconceptions can only be dismantled through dissection of their building blocs and a discussion of basic concepts.

The dangers of going back to basics

However, going back to basics and to first principles, analyzing critically the fundamental aspects of our financial system, is not free of danger. Here, too, lies a minefield of potentially grave intellectual error, and when things go wrong here, at the basic level, the results and policy recommendations derived from such analysis are bound to be nonsensical too, if not even more nonsensical than what the mainstream believes. In this and the following essays I am going to address some of the erroneous notions at the fundamental level of money and banking that seem to have gained currency in the public debate of late.

I get periodically confronted with these confusions through readers’ comments on my website. Some of the questions and suggestions expressed there reveal the same, or very similar, errors and misunderstandings, and these often seem to have their origin in other publications circulating elsewhere on the web. Among them are the following fallacies, in no particular order:

·         The idea that the charging of interest, or in particular the charging of interest on money, is a fundamental problem in our financial system.

·         The notion that there must be a systematic shortage of money in the economy because banks, through fractional-reserve banking, bring into circulation only amounts of money equivalent to the principal of the loans they create but not the necessary amount to pay the interest on these loans.

·         The notion that it is a problem that money-creation is tied to debt-creation (again, as a consequence of fractional-reserve banking) and that it would be possible and advantageous to have the state issue money directly (debt-free) rather than have the banks do it. 

·         The idea that schemes are feasible that allow the painless shrinkage or even disappearance of the national debt.

 All these ideas are nonsensical, based on bad economics and fundamental logical flaws, and to the extent that they entail policy proposals, these policies, if enacted, would not only not give us a stable and more prosperous economy but would surely lead to new instabilities or even outright chaos.

None of these misconceptions originate, or even resonate, as far as I can tell, with the ‘mainstream’. The mainstream– the financial market professionals, the central bankers, financial regulators, and the media – remain resolutely uninterested in dealing with fundamental questions of money and banking for the reasons given above. Here, the discussion continues to centre on how the economy can be ‘stimulated’ more, what ‘unconventional’ policies the central banks may still have up their sleeves, and if the central banks need new targets or better central bankers. Icebergs or no icebergs, these deckchairs need re-arranging.

But, outside the mainstream, among certain think tanks, ‘activists’, bloggers and some economists, even those at the IMF, the appetite for fundamental analysis has grown. In many cases this has led to utter confusion, as I will show in this set of essays.

I should declare a personal interest here. I feel the need to make my disagreements with these ideas and the resulting policy proposals as clear as I can as, on more than one occasion, casual readers of my website seemed to have assumed some sympathy on my part with the erroneous ideas put forward by others. The mere fact that somebody else also focuses his or her attention on the system’s same fault-lines, such as, for example, the instabilities created by fractional-reserve banking, has led them to believe that we must share considerable intellectual ground and arrive at similar conclusions and policy recommendations. Sometimes this confusion may be the result of a lack of familiarity with my work, sometimes with a lack of knowledge of or attention to the precise concepts articulated by others. In any case, this confusion needs to be cleared, partly because I do not want to be associated with what I consider economic nonsense, and partly because articulating the differences – and highlighting what, in my view, are the mistakes of the other side – should further clarify the issues and improve the debate. As I already said, the mix-up is usually greatest when the topic is fractional-reserve banking. So let me start right here:

Fallacy 1: As fractional-reserve banking is a source of economic instability, it would be better to force the banks to become fully-reserved banks with no ability to create money, and have the state create all money directly and inject it – wisely – into the economy. This would allow us to enjoy the benefits of more money without suffering the disadvantage of more debt. We may even use this process to reduce or eliminate existing debt.

This is the position of UK ‘think tank’ – or pressure group? – Positive Money, which has proposed legislative changes in the UK based on its analyses. Positive Money enjoys the support of the UK’s left-leaning ‘new economics foundation (nef)’ (so egalitarian and new age is nef that it doesn’t allow any capital letters undue dominance in the writing of its name) and of the Centre for Banking, Finance and Sustainable Development at the University of Southampton. Together these organizations have submitted a policy proposal to the Independent Commission on Banking.

The starting point of ‘Positive Money’s’ thesis – namely, that fractional-reserve banking is a source of economic instability – is essentially correct. But – as I will show in this essay – their analysis of fractional-reserve banking is incomplete, and their view lacks entirely any deeper understanding of money demand and of how changes in money demand are being met naturally in a market economy. Moreover, Positive Money has no perception of the necessary – and necessarily disruptive – effects of money-injections into the economy, regardless of who injects the money, and seems completely blind to the obvious disadvantages of channeling all new and free money through the state bureaucracy. Having shown – a bit flimsily and without resorting to any theories of capital or business cycles – that fractional-reserve banking is problematic Positive Money seems to have exhausted its critical faculties and jumps hastily to the conclusion that the privilege of money-creation should be given to a wise, independent and benevolent state agency. The arguments of Positive Money are economically unsound and politically naïve and dangerous.

If these resolutely anti-banking and pro-government proposals sound familiar to readers of this website, it is because they resemble the ones put forward by economists Benes and Kumhof in their widely quoted, less widely read and apparently even less understood IMF working paper 12/202, which I attempted to dissect here. In the following I will not repeat my criticism of Benes/Kumhof. Neither Benes/Kumhof nor Positive Money provide a single economic argument to support the claim that the state is a superior guardian of the privilege of money creation. This is not surprising because there is no such argument. Yet, we have to be grateful to Positive Money for at least not resorting to the bizarre line of reasoning that Benes and Kumhof came up with, namely that in order to improve upon our modern monetary order we have to first discover the ‘true nature of money’, which is apparently not open to the theoretical investigation of economists but can only be unlocked by anthropologists who tell us how money came about in primitive society thousands of years ago, and by certain monetary historians who re-interpret the historical record to tell us that the privilege of money creation has always been safe – and thus, in a logical jump of breathtaking audacity, is assumed to always be safe in the future – in the hands of government. Such mysticism is an insult to any true historian and to any proper economist. Sometimes it may be better to have no explanation at all than to put forward such rubbish. So thank you, Positive Money, for sparing us this nonsense.

Some thoughts on fractional-reserve banking

Let us start by briefly sketching the key problems with fractional-reserve banking.

Most of what we use as ‘money’ today is deposit-money and thus an item on a balance sheet of a bank. This form of money has come into existence through the banking system’s lending activities, i.e. through fractional-reserve banking.

Banks, for as long as they have been around, have never only just channeled saved funds into investments, such as fund management companies do today. Banks have always also been in the business of creating money derivatives (or fiduciary media), that is, financial instruments that are treated as money proper by the public (usually because they were issued with a promise of instant redemption in money proper), and thus circulate in the economy next to money proper. This process allows banks to fund a portion (and potentially a large one) of their lending through their own issuance of money derivatives, although today hardly anybody even distinguishes any longer between money proper and bank-created money derivatives. In a way, it can be said that the banks extend loans by drawing cheques on themselves and having these cheques circulate in the economy as money (and in the hope that they won’t be cashed!). These ‘cheques’ used to be the banknotes of the olden days, when banks were still allowed to print them, today there are deposit money, items on a bank balance sheet, like your current account balance.

This form of banking has made a considerable expansion of money in the economy possible. Fractional-reserve banking has been conducted in some shape or form for 300 years, and its effects on the economy have been the focus of the attention of economists for about as long (Cantillon, Ricardo, Mises – to name just some of the most outstanding social scientists dealing with it). Economists have long suspected, and over time have become ever more successful in demonstrating, that this activity is the source of economic instability. Fractional-reserve banking – and the elasticity of the supply of money that it creates – helps explain business cycles.

In my book Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown – I explain in some detail why elastic money is so undesirable, making use of the seminal work of Ludwig von Mises, in particular. In order to understand the full range of problems with fractional-reserve banking in a modern economy we need some knowledge of the origin and role of interest rates, of the nature of what is called ‘money demand’, of investment and saving, and thus the rudimentary elements of a theory of capital. I cannot provide this in a blog post and I am not going to try. Let it suffice to say that the extra money created by banks lowers interest rates on credit markets and expands the supply of investible funds beyond the volume of available true savings. Thus, investment and saving get out of line, misallocations of capital ensue, and what appears like a solid economic expansion for a while is ultimately revealed as an artificial and unsustainable credit boom that will end in a recession. Sustainable growth requires investment funded by proper saving, i.e. by the voluntary reallocation of real resources from present consumption to future consumption (that is saving). Bank credit expansion creates a dangerous and fleeting illusion of the availability of more savings, which means more resources for investment projects that are in fact not there.

Should fractional-reserve banking be banned?

Do I have some sympathy for the proposal to ban fractional-reserve banking? Well, I do agree that an inelastic monetary system, for example a 100% gold standard, would be the most stable (least disruptive) monetary system. (Interestingly, this is not what Positive Money suggests, but more about that later.) But I do not believe that fractional-reserve banking should be and can realistically be banned. Not only because it has been around for so long but also because the exact definition of what is being used as money by the public in a dynamic monetary economy at any moment in time must remain fluid. Financial intermediaries will always succeed in periodically bringing ‘near-monies’ into circulation and thus become de facto money producers, at least for a while.

Furthermore, there is no legal case for banning fractional-reserve banking. It is, in my view, not fraudulent (as some modern Austrian School writers maintain) and there is no basis for banning it on standard property rights considerations. Moreover, there is also little need to ban it as we can, in my view, rely on market forces and the superior regulators of capitalism – profit and loss – to ultimately keep it in check. (Some economists dispute this but here is not the place to discuss this point in detail. I will argue my case below. However, it is not even essential for a critique of the ideas of Positive Money.)

I think that the most straightforward and most obvious solution to these problems is that we remove the extensive framework – erected and maintained by the state – to actively support and systematically subsidize fractional-reserve banking. This means removing the institutions – implemented through acts of politics and maintained through acts of politics- of unlimited fiat money, which means unlimited bank reserves, and of lender-of-last-resort central banks that have the power to issue such unlimited bank reserves. Unlimited state fiat money and central banks are today the indispensable backstops for large-scale fractional-reserve banking activities of the nominally ‘private’ banks.

If fractional-reserve banking is disruptive – and I agree with Positive Money that it is – should we not – as a first step and before we even consider such authoritarian measures as universal bans – take away the state-run support system for fractional-reserve banking by which the banks and their clients are systematically shielded from the consequences of their activities, and through which the true costs of fractional-reserve banking are persistently being socialized?

Fractional-reserve banking and the state

What the folks at Positive Money fail to appreciate is that in a free market the ability of banks to create money is severely restricted. A deposit at bank X is only considered ‘money’ by the public to the extent that this deposit can be used for transactions with potentially everybody else in the economy, that is, not just with other customers of bank X but also any non-customers of bank X, and this is only the case if the deposit remains instantly redeemable in money proper (let’s say, gold or, in today’s world, state paper money) or can be transferred to any other bank. Thus, bank X runs the constant risk that its customers demand redemption of the type of money it CAN create (the deposit that sits on its own balance sheet) in a form of money that it CANNOT create: gold, state paper money or deposits at the central bank that are required for transfers to other banks. (Hint: these are the ‘reserves’ from which fractional-reserve banking gets its name!)

In an entirely free market, in which the state does not interfere in the economy and in which there is no central bank and no fiat money but in which money proper is necessarily a commodity chosen by the market, one the supply of which is outside political control or anybody else’s control for that matter, such as is the case with gold, in such a system fractional-reserve banking is an inherently risky enterprise. The constant fear of requests for large redemptions will severely restrict the ability of private banks to lower their reserve ratios and fund large parts of their lending by issuing ever more money derivatives. Each additional bank deposit that is created out of thin air will increase the risk of a bank run, which, in a world without central banks, bailouts and state deposit insurance, must lead to the failure of the bank.

Sure, banks may still be tempted to issue more deposit money but it requires a somewhat strange view of human nature to expect that even after a number of bank runs, in which bank shareholders and most depositors were wiped out, financially speaking, fractional-reserve banking would merrily continue and could in total be conducted at anywhere near the scale it is today, when banks do not have to content themselves with strictly limited reserves and do not have to operate under the constant risk of business failure but can safely rely – or, at least rely to a much larger degree than in a free market and a hard currency system -  on an unlimited and constantly expanding pool of fiat reserves provided by lender-of-last resort central banks, and where depositors need to pay no attention to the soundness of the various deposit-taking institutions as they simply rely on the blanket cover provided by the state.

Positive Money’s account of fractional-reserve banking makes it appear as if the state and its agencies were simply innocent and powerless bystanders in the business of money creation, rather than active promoters of and eager and indeed indispensable accomplices in the exercise. Positive Money creates the impression that bloated bank balance sheets, real estate bubbles and excessive debt levels had all been created by scheming and out-of-control private banks, entirely on their own accord and behind the back of an unwitting and clueless state, rather than constitute the inevitable consequences of an institutional framework built on the widespread belief that constant bank credit expansion is a boon to the economy.

The truth is that the state, beholden to the generally accepted fallacy that cheap money – and even artificially cheapened money- is a source of prosperity and that we should never allow credit contraction or deflation, has actively supported the gigantic money creation of recent decades. Without an essentially unlimited and ever cheaper supply of bank reserves from the state central banks, private banks could never have expanded their balance sheets so aggressively and issued such vast amounts of deposit money.

Or, to put this differently, had the state wanted to stop or restrict the creation of deposit money by the banks at any point, the state – in form of the central bank – could have done this at the drop of a hat. Restricting the availability of new bank reserves and/or making bank reserves more expensive would have instantly put the brakes on fractional-reserve banking. Not only did the state not choose to do this (at least not for the past few decades), to the contrary, whenever the banks had maneuvered themselves into a position where they thought it themselves prudent to stop or at least slow down their balance sheet expansion for a while in order to protect limited capital or their limited reserves, the central banks invariably cheapened bank reserves further, specifically to encourage further deposit money creation.

In the present context, any criticism of fractional-reserve banking must include, in order to be consistent and complete, a rebuttal of the false beliefs in the benefits of cheap money and criticism of the state’s systematic support for this activity. Positive Money evidently fails to appreciate the role of state institutions and government policy in the present process of money creation or it would argue much more simply and straightforwardly for the voluntary restriction or abandonment of these policies first, and it would be less eager to hand full control over monetary affairs to the state.

Money injections must result in resource reallocations and mis-allocations

Furthermore, a proper understanding of fractional-reserve banking, one that is based on monetary economics and that does not stop at the most apparent symptoms of bank credit expansion, reveals that its core problem is its disruption of the pricing process that would normally co-ordinate economic activity smoothly (in this case, the co-ordination through market interest rates of voluntary saving with investment activity). The problem with fractional-reserve banking is precisely that it leads to persistent misallocation of resources. Would it not be sensible to ask if money injections through the state bureaucracy would also result in very similar or maybe even larger misallocations of resources or misdirection of economic activity?

This seems indeed very likely. We all know that whenever the market is replaced with administrative decisions by a bureaucracy, the results will be suboptimal as the bureaucrat has to make his decisions without the help of market prices, for if he would allow market prices to guide resource use and economic activity there would be no reason for his intervention in the first place. He might then as well leave everything to the market. It is precisely the political decision that the market should not be allowed to allocate resources through market prices and the profit and loss calculations of private enterprises that is the excuse for state involvement in the economy. According to the proposal by Positive Money, a state agency would determine centrally how much money the economy needs and then give this money to other departments of the state, which would spend it according to how it sees fit.

Positive Money does not provide any mechanism for how the state agency might determine who in the economy experiences a higher demand for money, and how the money would get to where it is needed. This is not surprising because there can be no such process, as I will explain shortly. According to Positive Money, the state agency would simply make a macro-level decision as to the amount of new money supposedly needed and hand the necessary amount over to other departments of the state (without the standard process of double-entry bookkeeping that is used today, I might add, by money-creating central banks. According to Positive Money’s proposal, the money is simply created and handed over to the state bureaucracy as a gift.) By putting this money into the economy the state will, of course, exert a tremendous influence on the pricing and the allocation of resources and the direction of economic activity. This does not bother Positive Money. It is simply assumed that this must be better than having private banks do this via the credit market.

It is clear that Positive Money has not fully understood why fractional-reserve banking is harmful. For a functioning economy an uninhibited pricing process for all resources is required in order to direct the use of these scarce resources in accordance with the preferences and demands of consumers. Fractional-reserve banking systematically distorts the pricing process (it corrupts the coordinating properties of interest-rates) but Positive Money suggests to replace it with a process that does away with market prices altogether, and that consists of the arbitrary and politically motivated allocation of resources through a state bureaucracy (even if the central bank is, as Positive Money naively assumes, ‘politically independent’ the departments of the state that are the first recipients of the new money and that decide how the money gets injected into the economy are certainly not).

Apart from the well-established and justified reasons to be suspicious of substantial state control over any part of the economy, there are other reasons to reject this proposal. As I have shown in Paper Money Collapse, EVERY injection of new money into the economy, regardless by whom, has to occur at a specific point from where the new money will disperse through a number of transactions. This process must always – from the point of view of a smoothly functioning, uninhibited market economy – lead to disruptions. It can never be neutral and it can certainly never enhance the functioning of the economy, or lead to a better plan-coordination between economic actors. Money injections always lead to arbitrary changes in relative prices, reallocations of resources and redistribution of wealth and income, without ever enhancing the wealth-generating properties of the economy overall. Money injections never benefit everyone, they always create winners and losers. It does not matter who injects the money.

Is a money producer needed at all?

Given all these problems, is it really necessary that anybody in the economy has the privilege of creating and allocating new money? Once fractional-reserve banking has been banned and money-creation by the banks has ceased (or, in my scenario, once the support for fractional-reserve banking has stopped and money-creation by banks has been much reduced), why not leave the economy to operate with a given and stable quantity of money?

Positive Money:

“But that doesn’t necessarily mean that the economy will run smoothly on a fixed amount of money – we may still need to increase the amount of money in the economy in line with rises in population, productivity or other fundamental changes in the economy.”

Positive Money does not explain why this should be the case, simply because there is no reason why this should be the case. The quote above reflects another widespread fallacy about money, namely that a growing economy somehow needs a growing supply of money. Many people will find intuitively that this makes sense. Yet, on further reflection anybody who thinks for a minute about the purpose of money and about how we all use money every day can see quickly that this statement is without any basis in fact and lacks any economic logic.

A growing economy does not need a growing supply of money and therefore does not need a money producer. On the basis of a stable and given supply of widely accepted money the public can satisfy ANY demand for money it may have.

How?

The person who has demand for money never has demand for a specificquantity of money. Nobody who demands money has demand for a specific number of paper notes or a specific weight in gold coins or a certain quantity of bits on a computer hard drive (or whatever is used as money). We have demand for a certain quantity of money because of what we can buy with it, and this depends not on the quantity of the monetary asset as such but on its exchange ratio versus non-money goods. We always have demand for money’s exchange value, for what we can buy with it, for its REAL purchasing power. The value that money has for us, it has because of its purchasing power in trade. Money does not have direct use value, such as any other good or service.

Whether a certain quantity of cash is sufficient for me to carry with me for a good night out in London, depends on what that quantity of money can buy, that is, its real purchasing power. My demand for money is always a function of its exchange value, but money’s exchange value is necessarily subject to constant change as a result of the constant buying and selling of money versus non-money goods by the trading public.

If the public at large has an additional demand for money (i.e. an additional demand for purchasing power in the form of money) what will the public do? – Answer: the public will do what every individual does who wants to increase his or her holding of money, the public will reduce its present ongoing money-outlays on non-money goods (i.e. spend less and accumulate cash) and/or sell non-money goods for money (i.e. liquidate assets). This process will immediately exert a downward pressure on the money-prices of non-money goods and an upward pressure on the purchasing power of the monetary asset (the result is deflation, if you like, but in contrast to all the excited scaremongering about deflation in the media this is a normal market process and nothing to be scared of). By raising the exchange value of each unit of money this process will satisfy the additional demand for money naturally and automatically. The same physical amount of money is circulating in the economy but now this same amount can satisfy a larger demand for money.

Of course, the reverse will happen if the public lowers its demand for money. The purchasing power of money will drop (inflation) and the same amount of (physical) money will still be held but now at a lower exchange value per unit reflecting the lower demand for money.

These processes do not work for other goods or services. If the public has a higher demand for cars, somebody has to produce more cars. This is because the demand for cars is demand for the use-value that cars provide. Additional demand for cars cannot be satisfied simply by raising the prices of cars. But money is demanded for its exchange value, and additional demand for money can be satisfied (and is in fact satisfied) by a higher exchange value of money, i.e. lower money-prices of non-money goods.

Importantly, the processes described here would not just commence once we converted to a system of inelastic money. These processes are by necessity at work all the time – even now in our economy of constantly expanding fiat money and excessive fractional-reserve banking where they are, of course, usually overshadowed by the inflation from constant monetary expansion.

Money qua money has two characteristics: it is the most fungible good in the economy and it is demanded exclusively for its exchange value. From this follows that every individual can hold exactly the desired portion of his or her wealth in the form of money at any moment in time, and it equally follows that the public at large can hold exactly the desired portion of its wealth in the form of money at any time.

If more economic transactions are to occur in a given period of time money can circulate faster, and in fact, money then IS GOING TO circulate faster. If the demand for money holdings rises, this demand can be satisfied automatically and naturally by a rise in the purchasing power of the monetary unit, and in fact, the purchasing power of the monetary unit IS THEN GOING TO rise.

Via the constant buying and selling of money versus non-money goods the public automatically adjusts the velocity of money and the exchange value of the monetary unit, and thus the public is always in possession of precisely the amount of money purchasing power it needs. It is in the very nature of a medium of exchange that any quantity of it – within reasonable limits – is sufficient (and indeed optimal) to satisfy ANY demand for money.

There is no need to fear that this process would lead to undue volatility in money’s purchasing power, to constant fluctuations between inflation and deflation. If some people have a higher demand for money and start selling non-money goods for money, and this is beginning to lift the purchasing power of the monetary unit, then those who have an unchanged demand for money will readily sell some of their money for non-money goods in order to merely maintain the same real purchasing power in the form of money that they had before. Nobody can say that this process will lead to complete stability of money’s purchasing power. Such stability is unachievable in human affairs. But dramatic swings in money’s purchasing power can reasonably be expected to be rare.

Be that as it may, there is certainly no process available by which even the most dedicated, smartest and impartial monopolist money producer could anticipate the discretionary changes in the public’s desire for money balances and neutralize the resulting changes in money’s purchasing power through pre-emptive money injections or withdrawals. Once the changing demand for money has articulated itself in any statistical variables (and, in particular, in rising or falling prices) the public will already have satisfied its changed money demand through the processes described above. The whole idea of superior monetary stability through a central state monopolist is entirely absurd.

Equally absurd is the idea – this one not being advocated by Positive Money, I shall add – that fractional-reserve banks could play a role in satisfying the public’s demand for money. This is, I fear, another widespread fallacy, and it has its origin in a confusion of demand for loans with demand for money. Banks are not in the business of meeting their customer’s money demand (which they could not do even if they tried) but in the business of meeting their clients’ loan demand. Banks conduct fractional-reserve banking in order to extend more loans (on which they collect interest!), not in order to bring more money into circulation. The deposit money that is also created in the process (the ‘cheques’ the banks write to fund the loans) is simply a by-product of their expanded lending business (and this money is absorbed by the public through inflation).

By the same token, nobody (or at least hardly anybody) who has a higher demand for money will go to a bank, take out a loan and pay interest just to hold a higher money balance. Demand for money is not demand for loans. The people who take out loans do not have a high demand for money. To the contrary, they have a high demand for the goods and services that they quickly spend the borrowed money on. That is why they are willing to incur the extra expense of interest. As explained above, people who have a high demand for money cut back on spending or sell assets.

Conclusion

Positive Money starts with a correct observation, namely that today’s large-scale fractional-reserve banking is unnecessary and destabilizing for the economy. However, their suggestion of a ban on fractional-reserve banking strikes me as overly authoritarian, unnecessary and probably unpractical and unrealistic. Simply removing the state-run support infrastructure for fractional-reserve banking would be sufficient, in my view. Where the ideas of Positive Money become bizarre and dangerous is when they propose to install the state as an all-powerful central money creator. There is absolutely no justification whatsoever for such a function in a market economy. It is entirely unnecessary and would probably entail the same, if not worse, misallocations of capital that we suffer now. We would be guaranteed to stumble from one dysfunctional system into another dysfunctional one. The lessons from a proper understanding of fractional-reserve banking and of money demand are very different from what Positive Money suggests.

Part 2: Of interest and the dangerous habit of suppressing it

The idea that the charging of interest is unethical and should be banned has a long tradition in the history of human civilisation. It seems to have played a role at some point in all the major religions, certainly in Christianity, Judaism and Islam, and it is today promoted most strongly by advocates of Islamic banking.

As an economist I cannot (and should not) comment on matters of religion. Religion and economics deal with completely different aspects of human existence. Religion is about ‘ultimate ends’ and ‘personal values’. Economics does not deal with ends but with means. Economics does not tell anybody what his or her values should be. Contrary to what is frequently claimed – usually by those who do not understand economics – economics does not tell you that you should strive for more material goods and more services at your disposal.

But it so happens that we live in a world in which most people have personal aims or goals that involve having at least a certain material wealth, and in which most people prefer the possession of more material goods to less material goods; and the science of economics – for economics is a science, and in fact an objective, wertfreie (value-free) science – can then explain why people have a better chance of achieving these (material) aims if they use such social institutions as the division of labor, private property, trade, money, and many others. Additionally, the science of economics can show how these social institutions work, demonstrate the laws and regularities inherent in them, and can develop rules for their most appropriate use. Economics is purely about the means of social cooperation for the attainment of material goals. It never concerns itself with ultimate ends.

If most of the population became Buddhist monks tomorrow and would lose any interest in accumulating material wealth, would happily withdraw into monasteries and dedicate themselves to meditation, none of the principles and laws of economics would have suddenly become less true or invalid. The law of comparative advantage as articulated by David Ricardo would be as true on that day as on any other. The laws of economics would still apply just as the laws of gravity would. Of course, the interest in economic studies would probably diminish rapidly but that is all. Or, not quite all: Society would also be rapidly impoverished in material terms – even to the point of mass starvation –, and this the economist can ascertain with certainty, although nothing can be said about any compensating gains in spiritual wealth, of course.

If you believe that your God demands that if you lend money you should not charge interest, than there is nothing that I, as an economist, can say to you – other than, maybe, give me a call whenever you have some extra cash. The point at which I can – and should – comment is when you were to claim in addition that the observance of this rule would lead to a more stable and better functioning economy, that the non-charging of interest would not diminish society’s wealth but even increase it, or that the resulting economic structure would at least conform better to some generally accepted notion of fairness. Here we have reached a point where debate has become possible, not because I, as an economist, have intruded onto the religious ground of values and ultimate ends but because the advocate of religion has intruded onto the economists’ ground of the study of the laws for wealth creation.

I am not saying that all advocates of the non-charging of interest for religious reasons also claim that this would fix the economy. I assume that in the case of most religious rules the goal is spiritual not material, meaning the objective is to make the follower a better person, not better off. But in the wake of the financial crisis interest in fundamental aspects of our economy has increased, and within the ensuing debate it has certainly been argued by some that non-interest models of finance and banking could address fundamental problems of our present system, or even provide a functioning alternative to present arrangements. I have also encountered skepticism to the charging of interest, or, as it is often put, ‘interest on money’, by apparently non-religious commentators to my website.

Usury and the mainstream

To many readers this debate may at first appear as a bit of a sideshow. It does not appear to be one of the main areas of debate between economists, policy makers and financial market participants right now, at least outside Islamic finance. However, I fear that the representatives of today’s economic and political mainstream have much more in common with those who want to reintroduce usury laws than might at first appear. The vast majority may not ask for the banning of interest per se. However, it is today certainly the view of the vast majority that interest can and should be depressed to low levels in order to squeeze more growth out of the economy. It is today generally believed that, as long as inflation is not a major problem, policy makers may manipulate interest rates to lower levels with impunity. In fact, almost our entire financial infrastructure is designed for the utmost flexibility in the production of money under the guidance of the central bank, and this is done almost for the sole purpose of being able to ‘guide’ interest rates to the benefit of economic growth, which almost always means guiding them downwards. That is why the inelastic monetary base that once formed the foundation of finance and banking and that consisted of gold or silver, was replaced with the fully elastic base of limitless fiat money as the new bank reserves; and why in every economic downturn it is now the unquestioned obligation of monetary authorities to lower interest rates and to keep them low.

The advocates of the banning of interest (a minority in the present debate) argue that no interest makes for a better economy; the advocates of the periodic but frequently long-lasting artificial depressing of interest rates (an overwhelming majority in the present debate) argue that low interest makes for a better economy.

Both are wrong.

The answer from the economist should be this: Interest rates are market prices and they express, like all market prices do, the subjective valuations and preferences of market participants. In order for economic processes to be guided ultimately by the valuations and preferences of the public, prices need to remain completely uninhibited in their formation and in whatever impact they may exert on the employment of resources, including labor.

The financial crisis is not the result of the habit of charging interest but the inevitable consequence of the systematic distortion of interest rates– usually to the downside – through our fiat money arrangements and our monetary policy of making credit artificially ‘cheap’ in the mistaken belief that this aids economic performance.

Time preference

Interest is not confined to a monetary economy and not exclusive to the lending of money. Even in a society that does not know and use money, we could observe the phenomenon of interest. At its most basic level, interest is the difference between the present price of a good that is available today and the present price of a good of the same kind that is only available later. An apple today is worth more than an apple next week or next month. The ratio between these two prices is interest and it is an expression of time preference.

Time preference is not a psychological phenomenon in the sense that some people may have it and others do not. If you want something – and ‘wanting something’ is in fact the precondition for considering this something to be a ‘good’ – then you will value you it higher at a nearer date than at a date further in the future. As George Reisman put it so well: “All else being equal, to want something means to want it sooner rather than later.”

Let us assume you claimed to have no time preference in respect to a specific good. That would mean that you were indifferent as to whether you could obtain that good today or tomorrow; and tomorrow you would be indifferent as to whether you could have it that day or the next. Logically, this means you would be indifferent as to whether you obtained it at all, which means you wouldn’t really want it and it was therefore not a ‘good’ to you. (Quod erat demonstrandum.)

This would also mean you would never feel the urge to act to obtain it. Economics deals with action and action requires ‘wanting’ and ‘wanting’ logically entails time preference and time preference is the core element of interest.

There is nothing mysterious, suspicious, sinister or wicked about the phenomenon of interest.

If you lend a consumption good or a small amount of money to a close friend or a close relative, you may not ask to be compensated for not having this good at your disposal for some time, or for departing with some of your purchasing power for a while, but in the more extended network of human cooperation among otherwise unconnected individuals that makes for the modern society you would probably expect most people to ask for some compensation when lending to others, and for their counterparts to grant them some compensation, and none of this would appear irrational, unjust or forced.

The height of time preference is subjective and will be different from person to person, and different for the same person at different moments in time. Time preference and therefore interest is always an expression of personal, subjective valuation.

Market interest rates

The interest rates we observe daily in markets contain, of course, certain other elements in addition to time preference, although time preference remains the core ingredient. These other elements are usually a risk premium for the risk that the borrower cannot repay (credit risk) and a premium that money will have lost some of its purchasing power by the time the loan gets repaid (inflation risk). Thus, when lending to entities with non-negligible risk of default (most private entities) and in a currency that has a tendency to inflate (most paper monies), market interest rates will be higher than would be justified by time preference alone.

Under certain circumstances, these ‘premiums’ may actually turn into ‘discounts’. If the period for which the loan is agreed is expected to be a period of general deflation, than the nominal loan rate could actually be lower than justified by time preference, as the expected rise in the purchasing power of money during the life of the loan already constitutes a form of compensation. Under a strict gold standard the monetary unit could reasonably be expected to gradually gain in purchasing power over time (secular deflation, which means money has an inherent real rate of return), and loans to borrowers with relatively low default risk would be extended at very low nominal rates of interest.

Negative interest rates

Certain interest rates are presently very low, zero or even negative. To the extent that they are policy rates we have no trouble explaining them. They are not market rates and not even ‘prices’ in the strict economic definition. They are administrative decrees, determined by central bank bureaucrats, and not the outcome of the voluntary interaction of market participants. For what it is worth, I expect some of these rates to be lowered again, probably from near-zero into negative territory. But this is entirely a political phenomenon.

However, certain government securities, usually in the so-called safe-haven markets and usually those with shorter maturities, have also been trading at zero interest rates or even at negative interest rates (yields) lately. Very low administrative rates (policy rates) may have helped here but on their own they cannot cause this phenomenon. How can we explain it?

Deflation could be one explanation but I do not think it is the main driver, as other indicators of inflation expectations often still point to ongoing declines in money’s purchasing power. I think that in these instances the ‘credit risk premium’ has actually been turned into a ‘credit risk discount’.

Government bonds, in particular those with shorter maturities, are often held not for their return but their liquidity and safety. In these instances, they do not compete directly with equities or corporate bonds or real estate but with money. In the present environment there is, I believe, a strong demand for money holdings. Holding cash or cash equivalents allows investors to remain on the sidelines, to keep their firepower dry and wait how things pan out. But for many institutional investors holding large sums of money inevitably means holding sizable bank deposits and thus incurring considerable counterparty risk in respect to the fragile banking sector. Government bonds are expected to be (almost) as liquid as money proper or deposits, and to have lower counterparty risk than bank deposits. The demand for them is so considerable that investors even accept a negative yield, which means they are willing to pay a fee rather than collect a return for the privilege of ‘parking’ funds with the state.

A personal comment here: I think that these investors are sitting on a powder keg as I expect inflation to rise and concerns over sovereign solvency to intensify. But I have no problem understanding why certain market rates can become negative under certain conditions. It has to be stressed, however, that none of this means that the public’s time preference has disappeared or has even become negative. Time preference is always positive.

‘Interest on money’

Money – or at any rate, money proper – does not earn interest or any other income. Money is a medium of exchange. It has no direct use-value, only exchange value. Gold used to be money and gold does not pay interest (other than its inherent real rate of return in the case of deflation). Today, otherwise worthless pieces of paper are used as money and these paper tickets do not pay interest, either.

Already, the Romans knew that pecunia pecuniam parere non potest, money doesn’t beget money. You have to invest money to make a return, that is, you have to spend it.

If you pay money into a bank, ownership of that money passes on to the banker. You no longer own money proper but you now own a claim against the banker for the payment of money proper. You own a monetary derivative. For obvious reasons, the public today considers these derivatives as good as money proper (at least most of the time) but they are certainly not the same thing. If you hold money proper (cash) you hold a form of money that is not somebody else’s liability. Also, your bank deposit does not constitute a contract for safekeeping, as in that case you would have to pay the banker a fee rather than the banker paying you interest.

There is no such thing as interest income from holding money.

The manipulation of interest rates

There can be no doubt that a lot of the blame for the deterioration in the quality of economic debate can safely be put at the feet of Keynesianism’s half century of intellectual domination. Today, many people still seem to perceive the main economic problem to be one of a lack of overall activity, so the government should boost that aggregate by adding its own activity (through deficit spending) or by providing an extra dose of caffeine for the private sector in the form of low interest rates. Any activity seems to be better than too little activity, although nobody can explain how activity came to be so insufficient all of a sudden.

The key challenge for any economy, however, is not the aggregate level of activity but the coordination of the activities of diverse and usually unconnected individuals with different ideas, values, plans and objectives. Nobody participates in the economy for the sake of a higher GDP but only for the fulfilment of personal plans. A well-functioning economy is not one that delivers a certain aggregate of activity but that allows its individual participants to achieve their own individual objectives in the best possible way. (Remember the Buddhist monks.) For that we need uninhibited markets with unobstructed price-formation.

One of the important challenges of coordination for any economy is this one: To what extent should society’s available pool of resources be employed for the satisfaction of immediate consumption needs, and to what extent can resources be used to meet consumption needs in the more distant future, that is, to what extent can they become capital goods in the meantime? Evidently, this should be determined by the public’s time preference, and this is communicated to all actors in the economy via interest rates.

If the public has a high time preference it means it values present goods particular highly relative to future goods; it has a strong urge for present consumption; it has a low tendency to save; and market interest rates will tend to be relatively high. Every one of these sentences is simply a different way of describing the same phenomenon: the public has a high time preference.

Low savings availability on capital markets and high interest rates mean that entrepreneurs can only realize investment projects with the highest prospective returns. This changes naturally if the public lowers its time preference, increases savings, which lowers interest rates and encourages extra investment. Real resources are being shifted from present consumption to investment and allow for future consumption.

Saving and investing are the key inter-temporal decisions in an economy, and they are being coordinated by interest rates. Low interest rates are not necessarily good or bad. What matters is that they correctly reflect the preferences of the public.

The temptation to artificially lower interest rates is understandable. Investment increases the capital stock, and raising the amount of capital per worker is one of only two means we know of, of how to increase overall prosperity (the other being the division of labour). But a proper capital stock requires real resources, and those can only be made available through acts of real saving from real income. Printing more money and lowering interest rates on loan markets artificially creates the illusion of savings and it must lead to the dis-coordination between real saving and real investment, and thus to economic imbalances. Those are the true cause of financial crises and economic recessions.

Interest is an essential component of human action and the charging of interest rates an integral component of human cooperation on markets. Abolishing interest rates or depressing them through policy intervention will never make markets work better, will never make financial markets more stable, and will never make society more prosperous.

In the meantime, the debasement of paper money continues.