Taking Stick of Money Today
When last I posted, I ended our short history of money noting, among other things, that money is no longer backed by precious metals as once it "was" (I hope to make the scare quotes more salient later). Even before Pres. Nixon removed the US from the gold standard in 1971, wild swings in our money supply drove the country into a Great Depression that few theorists foresaw. Few theorists today foresaw the current crisis, and that should be easily explained. We have, essentially, unlearned the lessons of the Great Depression, removing the legal speed governors and safety interlocks that prevented our economy from revving too out of control from 1934 to about 1980, pulling the final bit of monetary prudence away from the system in 1999.
For that reason, it is illustrative to go back to the heady days of 1929 and see the policies that brought down the economy . . . you know, the policies we have today . . . and maybe answer brucenstein's initial question about the weirdness of money. I don't know if I'm up to the task, but I'll give it the old college try.
First and foremost, let's remember where money comes from: In the US and most Western nations, money is created when lenders borrow from depository banks, which are legally entitled to govern and create our money supply.
In his attempt to get to the bottom of the Great Depression's cause, Ferdinand Pecora interviewed the giants of banking and finance in office at the time to see what how they would describe their actions. One of the most interesting reads in the subsequent Pecora Commission Report comes from the testimony of a one Albert_H._Wiggin, former president of Chase National Bank. Mr. Wiggin, apparently engaged in all sorts of financial shenanigans, including at one point shorting the stock of Chase National Bank . . . while he was president of Chase National Bank! Reading the excerpted testimony was a joy, sometimes vivid enough to picture the guy squirming in his chair. At one point, we find this exchange:
MR. PECORA. That was a speculative operation, wasn't it, which was contemplated in behalf of the syndicate at that time, as distinguished from an investment operation?
MR. WIGGIN. Possibly. I think speculation is a very difficult term to describe. I think whether it is a speculation or not is dependent upon the wealth or capital of the person doing it, whether they can afford to stay with it. There are a great many things that enter into the definition of speculation.
(Stock Exchange Practices. Hearings before the Committee on Banking and Currency Pursuant to S.Res. 84 and S.Res. 56 and S.Res. 97, aka the Pecora Commission Report, p. 176. Note: Links to a PDF file; also, page numbers in PDF are different than those of the report. I use the page number here found in the report.)
In fact, his successor at Chase National after the Crash, Winthrop W. Aldrich, says quite clearly that (with the events of the Crash now on his mind) Mr. Wiggin is wrong:
This experience as a bank official, coupled with the testimony which was presented to your committee . . . had convinced me that many of the abuses in the banking situation had arisen from failure to discern that commercial banking and investment banking are two fields of activity essentially different in nature. I came to believe that while it was essential that there should be coordination between these two types of banking, such coordination could best be protected from abuse and thus enhanced in usefulness through absolute separation of interest between the two fields.
(Aldrich, quoted in the Pecora Commission Report, p. 155.)
Mr. Wiggin, as president of a commercial bank, engaged in speculation, the realm of the investment bank. At times, credits extended from his commercial bank were used in investment, which is contrary, according to Mr. Aldrich, to the role of either bank in the economy. To understand why this is, we need to meet a man prominent in those times but all but forgotten today.
When you are a mathematical genius, people can listen to you. When you apply that genius to the economy, and, more importantly, use your theories to guide investments, people really listen. But when you lose all of that money in the Great Depression, people stop listening, even if what you say later proves very, very important.
Irving Fisher was just such a man. From the Wiki we learn:
Fisher made important contributions to utility theory and general equilibrium. His work on the quantity theory of money inaugurated the school of economic thought known as "monetarism." Both Milton Friedman and James Tobin called Fisher "the greatest economist the United States has ever produced." Some concepts named after Fisher include the Fisher equation, the Fisher hypothesis, the international Fisher effect, and the Fisher separation theorem.
Ah, but then Fisher speculated on margin (meaning he borrowed the amount of his investment based upon a promise to resell the investment at a profit and retire the loan) and lost everything, a fortune worth about $100 million in today's dollars. Afterward, few listened to him.
This was a great pity, because in the depths of the Great Depression, he developed an explanation of how financial speculation could lead to economic collapse. However, this new theory - which rejected many of the assumptions of his previous model of finance - was ignored. Instead, Fisher's pre-Great Depression theory of finance continued as the economic theory of how asset prices are determined.
(Steve Keen, Debunking Economics: The Naked Emperor Dethroned?, Palgrave Macmillan, 2011, p. 272, emphasis mine.)
So, to recap, Mr. Fisher makes a name for himself creating and elaborating upon economic theories which, once he applies them with his own money and a bit more he borrows, prove disastrously wrong. He then develops new theories based upon the empirical evidence of what actually happened in the Crash . . . which are all but ignored. A footnote in Keen's book proves most illustrious about the fate of Fisher's theories (and theories in general): "Almost 90 percent of the over 1,200 citations of Fisher in academic journals from 1956 were references to his pre-Great Depression works." (Ibid, p. 281.)
"Pre-Great Depression works." You know, the ones that were proved wrong.
So, let's see what differences lie between Fisher's two approaches. In his first, general equilibrium, all exchanges of stuff are kinda like bartering. You have stuff I want, I have stuff you want, and we use money as a way to evaluate what each thing is worth. The greater the gap between the demand for an item and its supply, the greater its price will be. After each purchase - each trade, if you will - we take a snapshot of the market and call the last prices the new equilibrium point, the new balance between supply/demand. This theory of Fisher's - remember, still widely held today - assumes two important caveats:
(A) The market must be cleared-and cleared with respect to every interval of time.
(B) The debts must be paid. (Fisher 1930, p.495)
In this theory, money is only a marker of value, a passive entity similar to an engine's lubricant. If it is ever removed from the engine, there is trouble, to be sure; but why would that happen? When it happened, Fisher came up with the debt deflation model, which completely abandoned equilibrium of any kind.
Under his newer (and more discounted) theory, Fisher "rejected equilibrium, and noted that in fact debts might not be paid, but instead defaulted on:"
It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will "stay put," in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.
(Fisher 1933, p. 339)
With this observation, Fisher echoes John Maynard Keynes, who earlier famously challenged Fisher's long-run view that an economy can be reduced to static snapshots of cleared markets: "But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again." (Keynes 1971 [1923], quoted in Keen, ibid, p. 187.)
As both Keynes and a post-Crash Fisher knew, mariners need to know when the storms are likely coming. And, more importantly, why.
Finally, let me get to the meat of the competing theories and hopefully shed light on what makes financial storms.
When I and The Wife™ borrowed to purchase our house, the money for that loan was created by our lending bank. If we had had to produce the money in whole, or to borrow it from what neo-classical economists call "patient consumers," or people who are willing to forgo a bit of their financial assets in return for a bit of interest, there would be by definition less money in the economy. When there is less money circulating, the price for any given asset will be lower.
I'm not sure that our home purchase actually should have been made this way. After all, as Winthrop W. Aldrich noted:
The commercial bank's credit function is very definitely governed by its responsibility to meet its deposit liabilities on demand. . . . Its primary credit function is performed by lending money for short periods to finance self-liquidating commercial transactions, largely in the movement of goods and crops through the various stages of production and distribution; and in the making of short-term loans against good collateral.
(Pecora Report, p. 155.)
Strikes against our loan and points for follow. Strike One: A thirty-year mortgage is hardly a "short period." Point One: Our loan is "self-liquidating," in that it lasts only 30 years (or fewer). Strike Two: It was borrowed to purchase an existing and quite finished house, not by definition a good or crop moving "through the various stages of production and distribution." Unknown at this time whether it's a hit or a strike: And as long as the house maintained its value, the collateral was good.
As long as the house maintained its value. We now all know in retrospect that the housing bubble deformed the dollar value of all houses. Our house value is holding (knock wood), but whole banks had to get bailed out because a lot of those recent home values sank like boats anchored in a storm of rising debt.
Fisher's entire 9-step scenario can be found at the debt deflation Wiki page. Fisher, though, got a bit of it wrong, I believe probably because he didn't understand first hand the role of commercial banks in creating money. He says, "Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both." Note the emboldened phrase. Now go back to how money is actually created, and substitute "this will lead to defaults," where a "default" means that the money created by any given loan literally disappears from the economy.
Understanding that missing piece from Fisher's theory fell to Hyman Minsky and his Financial Instability Hypothesis. The Wiki sums it up nicely.
Minsky argued that a key mechanism that pushes an economy towards a crisis is the accumulation of debt by the non-government sector. He identified three types of borrowers that contribute to the accumulation of insolvent debt: hedge borrowers, speculative borrowers, and Ponzi borrowers.
The "hedge borrower" can make debt payments (covering interest and principal) from current cash flows from investments. For the "speculative borrower", the cash flow from investments can service the debt, i.e., cover the interest due, but the borrower must regularly roll over, or re-borrow, the principal. The "Ponzi borrower" (named for Charles Ponzi, see also Ponzi scheme) borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat.
If the use of Ponzi finance is general enough in the financial system, then the inevitable disillusionment of the Ponzi borrower can cause the system to seize up: when the bubble pops, i.e., when the asset prices stop increasing, the speculative borrower can no longer refinance (roll over) the principal even if able to cover interest payments. As with a line of dominoes, collapse of the speculative borrowers can then bring down even hedge borrowers, who are unable to find loans despite the apparent soundness of the underlying investments.
And here, finally, we get back to Mr. Wiggin and his difficulty describing "speculation," something he never did with the clarity of Mr. Minsky (at least not while under oath!). When commercial banks engage in speculation in Minsky's varying degrees of egregiousness, bubbles inflate. The will inevitably deflate. We can see evidence of this.
Financial assets are supposed to be backed by physical assets, but more and more they are not.
Worst, this process might be inevitable. Steve Keen has amassed evidence that bank lending not only inflates beyond prudence, but that this process, once started, is inevitable and further inextricably linked to the health of the economy. Remove lending and you remove not the engine's lubrication, but its fuel. From his website, Debt Watch:
Historic US debt to GDP ratios.
As the money supply grows, the competitive pressure for banks to find borrowers with both a good investment idea and the means to pay the loan decreases, leading to a gradual loosening of lending standards. Debt increases, but more importantly, it must increase, simply because if it did not, the country would falter into recession, threatening existing and outstanding loans. Sometimes our governments incur debt to stabilize during a downturn (as in WWII war spending, clear on the chart) and sometimes not. Our economy is endogenously a positive feedback mechanism. The more money we have, the more debt we have; the more money we need tomorrow, the more debt we need tomorrow.
(If you want a really speculative thought experiment on how banks may have escalated this debt situation in a wild west kinda way that explains much I left out of this post, here's the link. I haven't proven any of it. I haven't found convincing disproof, though, either. If nothing else, you may find it entertaining.)
I know, I know, I still haven't addressed this issue of issuing my own money and what effect that would have on the economy. I felt the need, though, to provide background I could at least refer to in the coming controversy I feel is all but inevitable. Besides, remember what H. L. Menken said: "For every subtle and complicated question, there is a perfectly simple and straightforward answer, which is wrong."
Alternatively, we can take heart in Tolstoy:
The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.
Leo Tolstoy, 1897
X-posted to talk_politics.
For that reason, it is illustrative to go back to the heady days of 1929 and see the policies that brought down the economy . . . you know, the policies we have today . . . and maybe answer brucenstein's initial question about the weirdness of money. I don't know if I'm up to the task, but I'll give it the old college try.
First and foremost, let's remember where money comes from: In the US and most Western nations, money is created when lenders borrow from depository banks, which are legally entitled to govern and create our money supply.
In his attempt to get to the bottom of the Great Depression's cause, Ferdinand Pecora interviewed the giants of banking and finance in office at the time to see what how they would describe their actions. One of the most interesting reads in the subsequent Pecora Commission Report comes from the testimony of a one Albert_H._Wiggin, former president of Chase National Bank. Mr. Wiggin, apparently engaged in all sorts of financial shenanigans, including at one point shorting the stock of Chase National Bank . . . while he was president of Chase National Bank! Reading the excerpted testimony was a joy, sometimes vivid enough to picture the guy squirming in his chair. At one point, we find this exchange:
MR. PECORA. That was a speculative operation, wasn't it, which was contemplated in behalf of the syndicate at that time, as distinguished from an investment operation?
MR. WIGGIN. Possibly. I think speculation is a very difficult term to describe. I think whether it is a speculation or not is dependent upon the wealth or capital of the person doing it, whether they can afford to stay with it. There are a great many things that enter into the definition of speculation.
(Stock Exchange Practices. Hearings before the Committee on Banking and Currency Pursuant to S.Res. 84 and S.Res. 56 and S.Res. 97, aka the Pecora Commission Report, p. 176. Note: Links to a PDF file; also, page numbers in PDF are different than those of the report. I use the page number here found in the report.)
In fact, his successor at Chase National after the Crash, Winthrop W. Aldrich, says quite clearly that (with the events of the Crash now on his mind) Mr. Wiggin is wrong:
This experience as a bank official, coupled with the testimony which was presented to your committee . . . had convinced me that many of the abuses in the banking situation had arisen from failure to discern that commercial banking and investment banking are two fields of activity essentially different in nature. I came to believe that while it was essential that there should be coordination between these two types of banking, such coordination could best be protected from abuse and thus enhanced in usefulness through absolute separation of interest between the two fields.
(Aldrich, quoted in the Pecora Commission Report, p. 155.)
Mr. Wiggin, as president of a commercial bank, engaged in speculation, the realm of the investment bank. At times, credits extended from his commercial bank were used in investment, which is contrary, according to Mr. Aldrich, to the role of either bank in the economy. To understand why this is, we need to meet a man prominent in those times but all but forgotten today.
When you are a mathematical genius, people can listen to you. When you apply that genius to the economy, and, more importantly, use your theories to guide investments, people really listen. But when you lose all of that money in the Great Depression, people stop listening, even if what you say later proves very, very important.
Irving Fisher was just such a man. From the Wiki we learn:
Fisher made important contributions to utility theory and general equilibrium. His work on the quantity theory of money inaugurated the school of economic thought known as "monetarism." Both Milton Friedman and James Tobin called Fisher "the greatest economist the United States has ever produced." Some concepts named after Fisher include the Fisher equation, the Fisher hypothesis, the international Fisher effect, and the Fisher separation theorem.
Ah, but then Fisher speculated on margin (meaning he borrowed the amount of his investment based upon a promise to resell the investment at a profit and retire the loan) and lost everything, a fortune worth about $100 million in today's dollars. Afterward, few listened to him.
This was a great pity, because in the depths of the Great Depression, he developed an explanation of how financial speculation could lead to economic collapse. However, this new theory - which rejected many of the assumptions of his previous model of finance - was ignored. Instead, Fisher's pre-Great Depression theory of finance continued as the economic theory of how asset prices are determined.
(Steve Keen, Debunking Economics: The Naked Emperor Dethroned?, Palgrave Macmillan, 2011, p. 272, emphasis mine.)
So, to recap, Mr. Fisher makes a name for himself creating and elaborating upon economic theories which, once he applies them with his own money and a bit more he borrows, prove disastrously wrong. He then develops new theories based upon the empirical evidence of what actually happened in the Crash . . . which are all but ignored. A footnote in Keen's book proves most illustrious about the fate of Fisher's theories (and theories in general): "Almost 90 percent of the over 1,200 citations of Fisher in academic journals from 1956 were references to his pre-Great Depression works." (Ibid, p. 281.)
"Pre-Great Depression works." You know, the ones that were proved wrong.
So, let's see what differences lie between Fisher's two approaches. In his first, general equilibrium, all exchanges of stuff are kinda like bartering. You have stuff I want, I have stuff you want, and we use money as a way to evaluate what each thing is worth. The greater the gap between the demand for an item and its supply, the greater its price will be. After each purchase - each trade, if you will - we take a snapshot of the market and call the last prices the new equilibrium point, the new balance between supply/demand. This theory of Fisher's - remember, still widely held today - assumes two important caveats:
(A) The market must be cleared-and cleared with respect to every interval of time.
(B) The debts must be paid. (Fisher 1930, p.495)
In this theory, money is only a marker of value, a passive entity similar to an engine's lubricant. If it is ever removed from the engine, there is trouble, to be sure; but why would that happen? When it happened, Fisher came up with the debt deflation model, which completely abandoned equilibrium of any kind.
Under his newer (and more discounted) theory, Fisher "rejected equilibrium, and noted that in fact debts might not be paid, but instead defaulted on:"
It is as absurd to assume that, for any long period of time, the variables in the economic organization, or any part of them, will "stay put," in perfect equilibrium, as to assume that the Atlantic Ocean can ever be without a wave.
(Fisher 1933, p. 339)
With this observation, Fisher echoes John Maynard Keynes, who earlier famously challenged Fisher's long-run view that an economy can be reduced to static snapshots of cleared markets: "But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again." (Keynes 1971 [1923], quoted in Keen, ibid, p. 187.)
As both Keynes and a post-Crash Fisher knew, mariners need to know when the storms are likely coming. And, more importantly, why.
Finally, let me get to the meat of the competing theories and hopefully shed light on what makes financial storms.
When I and The Wife™ borrowed to purchase our house, the money for that loan was created by our lending bank. If we had had to produce the money in whole, or to borrow it from what neo-classical economists call "patient consumers," or people who are willing to forgo a bit of their financial assets in return for a bit of interest, there would be by definition less money in the economy. When there is less money circulating, the price for any given asset will be lower.
I'm not sure that our home purchase actually should have been made this way. After all, as Winthrop W. Aldrich noted:
The commercial bank's credit function is very definitely governed by its responsibility to meet its deposit liabilities on demand. . . . Its primary credit function is performed by lending money for short periods to finance self-liquidating commercial transactions, largely in the movement of goods and crops through the various stages of production and distribution; and in the making of short-term loans against good collateral.
(Pecora Report, p. 155.)
Strikes against our loan and points for follow. Strike One: A thirty-year mortgage is hardly a "short period." Point One: Our loan is "self-liquidating," in that it lasts only 30 years (or fewer). Strike Two: It was borrowed to purchase an existing and quite finished house, not by definition a good or crop moving "through the various stages of production and distribution." Unknown at this time whether it's a hit or a strike: And as long as the house maintained its value, the collateral was good.
As long as the house maintained its value. We now all know in retrospect that the housing bubble deformed the dollar value of all houses. Our house value is holding (knock wood), but whole banks had to get bailed out because a lot of those recent home values sank like boats anchored in a storm of rising debt.
Fisher's entire 9-step scenario can be found at the debt deflation Wiki page. Fisher, though, got a bit of it wrong, I believe probably because he didn't understand first hand the role of commercial banks in creating money. He says, "Assuming, accordingly, that, at some point of time, a state of over-indebtedness exists, this will tend to lead to liquidation, through the alarm either of debtors or creditors or both." Note the emboldened phrase. Now go back to how money is actually created, and substitute "this will lead to defaults," where a "default" means that the money created by any given loan literally disappears from the economy.
Understanding that missing piece from Fisher's theory fell to Hyman Minsky and his Financial Instability Hypothesis. The Wiki sums it up nicely.
Minsky argued that a key mechanism that pushes an economy towards a crisis is the accumulation of debt by the non-government sector. He identified three types of borrowers that contribute to the accumulation of insolvent debt: hedge borrowers, speculative borrowers, and Ponzi borrowers.
The "hedge borrower" can make debt payments (covering interest and principal) from current cash flows from investments. For the "speculative borrower", the cash flow from investments can service the debt, i.e., cover the interest due, but the borrower must regularly roll over, or re-borrow, the principal. The "Ponzi borrower" (named for Charles Ponzi, see also Ponzi scheme) borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat.
If the use of Ponzi finance is general enough in the financial system, then the inevitable disillusionment of the Ponzi borrower can cause the system to seize up: when the bubble pops, i.e., when the asset prices stop increasing, the speculative borrower can no longer refinance (roll over) the principal even if able to cover interest payments. As with a line of dominoes, collapse of the speculative borrowers can then bring down even hedge borrowers, who are unable to find loans despite the apparent soundness of the underlying investments.
And here, finally, we get back to Mr. Wiggin and his difficulty describing "speculation," something he never did with the clarity of Mr. Minsky (at least not while under oath!). When commercial banks engage in speculation in Minsky's varying degrees of egregiousness, bubbles inflate. The will inevitably deflate. We can see evidence of this.
Financial assets are supposed to be backed by physical assets, but more and more they are not.
Worst, this process might be inevitable. Steve Keen has amassed evidence that bank lending not only inflates beyond prudence, but that this process, once started, is inevitable and further inextricably linked to the health of the economy. Remove lending and you remove not the engine's lubrication, but its fuel. From his website, Debt Watch:
Historic US debt to GDP ratios.
As the money supply grows, the competitive pressure for banks to find borrowers with both a good investment idea and the means to pay the loan decreases, leading to a gradual loosening of lending standards. Debt increases, but more importantly, it must increase, simply because if it did not, the country would falter into recession, threatening existing and outstanding loans. Sometimes our governments incur debt to stabilize during a downturn (as in WWII war spending, clear on the chart) and sometimes not. Our economy is endogenously a positive feedback mechanism. The more money we have, the more debt we have; the more money we need tomorrow, the more debt we need tomorrow.
(If you want a really speculative thought experiment on how banks may have escalated this debt situation in a wild west kinda way that explains much I left out of this post, here's the link. I haven't proven any of it. I haven't found convincing disproof, though, either. If nothing else, you may find it entertaining.)
I know, I know, I still haven't addressed this issue of issuing my own money and what effect that would have on the economy. I felt the need, though, to provide background I could at least refer to in the coming controversy I feel is all but inevitable. Besides, remember what H. L. Menken said: "For every subtle and complicated question, there is a perfectly simple and straightforward answer, which is wrong."
Alternatively, we can take heart in Tolstoy:
The most difficult subjects can be explained to the most slow-witted man if he has not formed any idea of them already; but the simplest thing cannot be made clear to the most intelligent man if he is firmly persuaded that he knows already, without a shadow of doubt, what is laid before him.
Leo Tolstoy, 1897
X-posted to talk_politics.