What’s Wrong with the World

Well articulated and well argued, Paul. Your effort is a rare exercise in political and economic wisdom -- spot on throughout.

One quibble, and then a further comment:

It is incontrovertible that deposit insurance is not going away, as also that it should not go away, inasmuch as informational asymmetries will always leave smaller depositors at the mercy of bank principals and larger depositors; it is, quite simply, unjust that the little people should bear the brunt of the failures of the great. That said, I do not perceive that deposit insurance entails Too Big To Fail; pushes the financial system in that direction, certainly, but entails it? - No, this I doubt. Some Senator, whose name escapes me presently, proposed an amendment to the FinReg bill lately passed, which amendment was touted by Simon Johnson, and would have imposed a cap upon the size of our banks. Desposit insurance could very easily result in larger banks gobbling up smaller ones, as these latter become imperiled; an effectively enforced cap on the size of financial institutions - an anti-trust regime for banks - could cap this process of aggregation.

Will it happen? Well, no. It will happen around the same time that quantitative traders admit that they cannot possess all of the information necessarily presupposed by their formulae. But it is theoretically possible, as well as practicable; it is simply unattainable given the balances of politico-economic forces.

Meanwhile, small business confidence is plumbing new depths, and not irrationally, but because the business climate really is that dire. Small businessmen with whom I've spoken routinely cite a 30% (or thereabouts) decline in business during the Great Recession, and no relief is in prospect. On top of the worsening climate in the real economy, insane commodity speculation, the new field of the yield-hunters, threatens destabilizing price runs/swings, at a time of financial distress in the real economy. Once more, the demands of financiers, speculators, and investors (or do I repeat myself), coupled to their mathematical models and abstractions - where the demands and the models themselves reflect the modern disease of abbreviation - take precedence over the needs of reality, of real people trying to put food on the table.

I don't believe that we're confronting the prospect of a Lost Decade; we're confronting the prospect of a two-track economy, with grinding austerity for the masses and fevered profiteering by the financiers and industrialists of a globalized economy. Like Latin American political economy? We're getting it.

Maximos,

To Paul you wrote that "it is, quite simply, unjust that the little people should bear the brunt of the failures of the great". Are you equally opposed to the "little people" sharing in the benefits of the wisdom and success of the "great"?

Now of course not, but the whole of political economy revolves around the question of how that happens. Responsibility in these matters is, of course, asymmetrical, unless we are pagans.

All,

Green shoots, people, green shoots:

http://esi.dowjones.com/

If the Republicans can take the House in the Fall and roll back some of the worse anti-business excess of the Democrats, the American economy will start growing again.

If the Republicans can take the House in the Fall and roll back some of the worse anti-business excess of the Democrats

When will the silliness end?

The banking system itself isn't too bad. The shadow banking system is still too large. I'm afraid the wealthy are doing too well for us to have a lost decade. I agree with Maximos that South America is seeming to be a better model. Whether we speak of a lost decade or South America, I remain on the wrong side of the pole alas. My greater concern at this point is that the wealthy aren't near as concerned with maintaining our police state as it is presently constituted. I'm sure a vast reduction in our police forces and reductions in our prison populations will all end well. (A tinge of sarcasm was included there.) Admittedly, I am an advocate for both, but not in an indiscriminate manner. Thankfully we've refined the youths weapons and tactics: http://rawstory.com/rs/2010/0718/afghan-iraq-wars-teaching-gang-gangs-combat/ .

I agree with Maximos that South America is seeming to be a better model. Whether we speak of a lost decade or South America, I remain on the wrong side of the pole alas.

I wouldn't say that it is a better model, merely that it is the logical terminus of our political economy. I'm not sure that a political economy with Carlos Slim, on the one pole, and millions of peasants seeking to emigrate, on the other, is either sustainable or just. Assuredly, the juntas that periodically enforce such politico-economic arrangements, whenever the little people get too uppity, are not. Perhaps, though, I misunderstand you.

If the Republicans can take the House in the Fall and roll back some of the worse anti-business excess of the Democrats, the American economy will start growing again.

You're assuming, in the face of clear evidence to the contrary, that they are fiscal conservatives.

In my view, the heart of the issue is not deposit insurance, Too Big to Fail or globalization but whether it is even possible for paper money, or electrons standing in for paper money, to be the basis for a functioning national or global economy. As usual, Professor Antal Fekete has thoughts on this (apologies for the lengthy excerpt):

3. The Redistribution of Losses

The gold bond is essential to the theory of interest presented in this essay. The formation of the rate of interest under a regime where interest is payable in irredeemable currency is an entirely different matter. The central bank's attempt to keep a lid on the rate of interest is doomed, as this effort incorporates the contradictory aims of monetary policy and interest-rate policy. Open market operations in bonds can indeed be used to lower the interest rates that are high due to currency depreciation.

The central bank goes into the open market and buys government bonds. As a result bond prices go up or, what is the same, interest rates go down. But the flipside of this is that now there is even more irredeemable currency in circulation. This cannot help but make the pace of currency depreciation increase. Yet it was the fast depreciation of the currency that was responsible for the high interest-rate structure in the first place. In other words, while the central bank is fighting a side-effect of the disease, it only makes the root cause more entrenched.

Furthermore, under the regime of irredeemable currency malevolent bond speculation overwhelms and strangles benign bond arbitrage. Recall that under the gold standard there was no bond speculation -- none whatever. There was only arbitrage between different maturities, keeping the yield curve in good shape.

The price of bonds, and with it the rate of interest, was remarkably stable, precluding profitable speculation. But when governments left the path of monetary and fiscal rectitude and started passing retroactive laws, declaring fraudulent bankruptcy, devaluing the currency under false pretenses, reneging on gold clauses enshrined in their bond obligations, and embracing the policy of debt abatement -- they threw the value of their outstanding bonds to the winds. The arbitrageurs responsible for maintaining stability in the bond market are gradually forced to vacate the field. Their place is being taken over by speculators who thrive in volatile markets. The entire character of the bond market and bond trading has changed beyond recognition.

The rational basis upon which bond values rest was overthrown when gold-redeemability of the currency was abolished. The fanatic denial of this fact is central to mainstream economic orthodoxy. Nevertheless, the disappearance of predictable arbitrage and the advent of unpredictable speculation make for violent and increasing fluctuations in the rate of interest, throwing the capital markets into a turmoil.

No longer does the propensity to save regulate the availability of long-term credit through the mechanism of the interest-rate structure. The regime of irredeemable currency is characterized by a chronic paucity of savings -- regardless how high the rate of interest may go. Savers are not blind to the fact that their savings, denominated as they must be in a depreciating currency, are continually and systematically plundered. Their protector against plunder, the gold coin, has been ousted from the system.

But the savers are not entirely defenseless, and they can fight back. They could consume their savings before further depreciation takes its toll. More ominously, they can extend their consumption beyond the limits set by existing savings, if they plunge into debt in an effort to turn a bad situation, created by the depreciating currency, to advantage. It can hardly be doubted that a lot of this is occurring in the world today.

Crossing the wires at the traffic light

The regime of irredeemable currency creates a disharmony between individual and society, where harmony has reigned before. Through a false incentive system, this regime inhibits capital accumulation and, ultimately, it promotes capital consumption. The need to convert income into wealth is overtaken by the need to protect oneself against plunder.

The propensity to save is corrupted by the false view that savings can be substituted by debt. While there are natural limits to debt-creation under a gold standard, all such limits have been thrown to the winds under the regime of irredeemable currency. The volume of total debt increases exponentially as interest paid on the old debt is immediately converted into new debt. The mechanism to liquidate debt has been dismantled. Debt can no longer be liquidated, and at maturity it is dumped into the lap of the government.

As for the government, there is simply no way to retire its debt. Redeeming a government bond in irredeemable currency merely replaces interest-bearing debt by non-interest bearing debt (that is, by a less desirable form of debt, making the debt-pyramid even more unstable). In the meantime total debt is increasing exponentially, following the law of compound interest. The inordinate growth of the Debt Behemoth and the ongoing capital destruction inevitably lead to a credit collapse.

The forcible removal of gold from the heart of the credit system in 1971 was ill-advised.
It brought about a radical change in the character of the bond market. It drove out the arbitrageur, and invited in the bond speculator. The regime of irredeemable currency crosses the wires at the traffic light. It sends the red signal to producers when the green signal is intended. High interest rates beget even higher interest rates, as speculators keep betting on lower currency and bond values.

Threatened by ever higher interest rates, producers are confronted with endless capital losses. This is a regime of hot money jumping around nervously from place to place, seeing no safety anywhere, but going from places that seem unsafe to places that, for the moment, seem less unsafe. This is a regime under which men are afraid to make long term plans, or to grant long-term commitments. This is a regime that encourages farmers
to eat the seed corn, the dairy-man to slaughter the milk-cow for the meat, and the orchard owner to cut down his fruit trees for firewood. This is a regime of junk bonds.

The degeneration of the bond market into a casino where gamblers run riot pronounces a most devastating verdict on the regime of irredeemable currency. Previously all owners of capital, including the speculators, were subjected to the same discipline, and were constrained in their activities by a market process making them servants of the general public.

If they correctly anticipated changes caused by the uncertain future, speculators would reap profits. But if they failed to do this, then they would suffer losses and, unless they mended their ways in time, they would lose their capital to others who were better at serving the public. Now, under a new dispensation granted by the regime of irredeemable currency, speculators can be self-serving without the obligation to promote the general welfare. They grow fat on the sweat and blood of the public. All they need to do in order to make a killing is to out-guess government bureaucrats whose job it is to manipulate currency and bond values.

http://www.professorfekete.com/articles%5CAEFWhitherGold.pdf

Paul,

This may be of interest to you. It's Karl Denninger's take on the way that colleges have repeatedly scammed the feds and students.

What I find to be a sad state of affairs and a sign of how unlikely things are to change is the way that non-profits and others that claim to act for "higher purposes" than profit are even now largely flying under the radar viz a viz corruption. Just slap the ol' "common good" label on it and it gets a free pass until the corruption stinks more than a land fill.

I don't know where MZ is getting his bourbon, but I want some.

Andrew E. -- what is your view on the finance barbarism, the absolute wild West lawlessness, of the early Republic's purely private banking? Banks just issued their own paper, left and right, everywhere. Think about the machinations of Burr and Gen. Wilkinson on the Ohio and Mississippi. Their treachery and fraud probably exceeds by some magnitude the fiat currency shenanigans of recent decades.

Their treachery and fraud probably exceeds by some magnitude the fiat currency shenanigans of recent decades.

I don't know enough about it to say if that's true, but I have a hunch that granting that, their treachery and fraud had far, far less far-reaching effects than the effects of fiat currency combined with high deficits, especially in a political and judicial climate where government is not otherwise constitutionally limited. The perception that things are free and that the government can just go on expanding if only we have good will and want to do good with the "money" created is, has been, and will be incredibly poisonous to the entire republic, and it is enabled to no small extent by fiat currency.

Lydia -- I don't know. It's an unknowable. Had Burr effected his Spanish satrapy on the lower Mississippi, I suspect our subsequent history would have been markedly less tranquil. Was this a close-run thing? No, not really. But what about the Rhode Island bank; should it be perfectly legal to loan out half a million in paper with an $8 cash backing? Yes, cash in that day was precious metal specie; so just remove the reserve system and we're better off?

It's an unknowable.

I don't think that what is happening _now_ is unknowable, though. And it's obviously happening on an unimaginably vaster scale than anything that even could have happened in those years. If we can see that the government's ability to run up unlimited debt and to create money, to all appearances ex nihilo, to cover never-limited spending is having incredibly dire consequences right now and will have even more dire consequences in the future, that's got to be relevant to our recommendations, it would seem to me.

"Their treachery and fraud probably exceeds by some magnitude the fiat currency shenanigans of recent decades."

And so it goes: The conservative rails against this public/private "monstrosity" called the Fed (or is the bullseye on fiat currency? Or fractional reserve banking? These things get conflated), but what of those Wild West days of "free market" banking? They don't look so good, either. So if the laissez faire option doesn't work, where's a conservative to turn? A statist solution? More government and political control of the money supply? Impossible. We come full circle. Maybe the current system is the worst except for all the others?

It's not as if a hard currency peg suddenly confers fiscal responsibility on politicians, after all...

Yeah, sorry. I was trying to answer the implicit question of whether Burr and Wilkinson threatened the Republic with the gravity you equate to fiat currency. That's hard to answer. I would say that we tend to discount how fragile that early Republic was.

It's not as if a hard currency peg suddenly confers fiscal responsibility on politicians, after all..

Let's substitute a credit card here. Not giving a teenager uncontrolled access to your credit card doesn't "automatically confer" fiscal responsibility on him, but _giving_ him that uncontrolled access, especially if he has a past record of fiscal irresponsibility, is highly likely to make matters a lot worse.

Giving politicians the idea that they can just engage in deficit spending for whatever "good" they want to do, whatever gigantic, power-hungry, monstrous projects they want to set up, is...well...insane. It pretty much guarantees irresponsible behavior on their part, especially when we have people in charge who want to increase the government's role, power, and projects without apparent upper bound.

Lydia -- what about "giving [bankers] the idea that the just engage in deficit spending for whatever '[profit]' they want"?

I mean, General Electric in essence prints money every day. It's called commercial paper. It fills up the overnight coffers of money market funds, endowment funds, pension fund, etc. There is a hell of a lot more of it in (digital) circulation every day than there are actual dollar bills, much less physical gold.

I see no evidence to think that an economy based on hard currency would be (a) more stable or (b) less subject to the whim of politicians and activists.

Paul,

My understanding of early American banking comes primarily from Murray Rothbard's History of Money and Banking in the United States. The first wave of banking expansion in the US was driven primarily by state-chartered banks following on the heels of the First Bank of the United States. Not until the War of 1812 did the needs of war finance spur the growth of private banks throughout the Republic. The federal government needed to sell war bonds to fight Britain but the New England states were not very supportive of the war and the banks in those areas refused to finance it. The federal government then encouraged the formation of inflationary banks in the South and West to whom it could sell all the bonds it needed to and take the paper money and buy war goods in New England. When this inflationary bubble burst in 1814, as a result of the New England banks beginning to demand specie for their inflated currency, the federal government set an important precedent by allowing the banks a "holiday" in which they could refuse specie redemption but continue collecting on debts owed them. It was then in 1815, after this new dispensation by the federal government, that virtually all the private banks came into existence. And to varying degrees over the subsequent decades, banking institutions were granted holidays from time to time when thought necessary and were generally treated very differently by government than other businesses. Yet despite it all the value of the dollar was still higher at the end of the 19th century than at the beginning. This is not something that can be said about the 20th century.

I, however, am not primarily interested in establishing a system of purely private banking. My concern is to do away with irredeemable currency and all it brings with it such as exponential growth in debt and the concomitant financial economy and paper fortunes, capital destruction and de-industrialization. We wouldn't have to dismantle the Federal Reserve, we could simply open the mint to gold and silver, repeal the legal tender laws and outlaw open market operations ensuring that federal reserve notes are backed by either gold or real bills rather than federal debt.

An important aspect of monetary reconstruction would be to restore the international market in real bills (in the 19th century, bills of exchange drawn on London) which acts as the clearing system of the gold standard and gives gold the flexibility to function properly in a complex international economy. The advent of legal tender laws in the early 20th century (to make financing WWI possible) paved the way for central banks to back their notes with government debt and eventually killed off the real bills market making the gold standard unworkable as was discovered after WWI and leading into the Great Depression.

At the moment I was just thinking of the federal deficit, of deficit spending at the federal level, and of things like Obamacare,etc., which will increase the deficit, but nobody on the Democrat side really cares. It seems to me that something would be improved if they had a lot more trouble doing that.

I see no evidence to think that an economy based on hard currency would be (a) more stable or (b) less subject to the whim of politicians and activists

Recall, at present when the Federal Reserve increases the money supply it does so by issuing federal reserve notes which stand as liabilities on its balance sheet. The Fed uses the notes to buy up treasury debt which stand as assets on its balance sheet and serve as backing to its note (or reserve) liabilities. However, the treasury debt matures into federal reserve notes, which are backed by treasury debt. Is it not obvious that this is, as Antal Fekete describes it, a check-kiting scheme? The federal government is issuing obligations it has neither the ability nor the intention to honor. Debt can never be extinguished because maturing treasury bonds require federal reserve notes for retirement which in turn require more treasury debt to come into existence. It's patently fraudulent. And inherently unstable as the exponential growth in the debt and derivatives markets since 1971 demonstrates.

Under such a regime the Fed can never afford to reverse the process because to sell its assets (bonds) for cash, which it then retires, just means that more federal reserve notes will need to be issued if the outstanding treasury debt is ever to be paid off, which isn't possible anyway. The end result is always increasing amounts of debt and never decreasing amounts.

Contrast this with the gold bond. The amount of debt that can be issued is limited by the government's ability to pay it down in gold, collected from its citizens as payment for taxes. When the government retires its bonds with gold the debt is extinguished. The gold now in possession of the former bondholder is not simultaneously a liability on the balance sheet of the Fed as is the case with federal reserve notes under a fiat regime. A further implication of this, as Fekete notes, is that interest rates are stable which prevents bond speculation and the wasteful and damaging growth of the derivatives markets which are used to manage and leverage artificial risks created by a volatile interest rate structure.

Look, all systems of currency in the end depend on human psychology. The stability of a gold standard presupposes the subjective human judgment gold's value. Nor is the supply of gold strictly limited. More gold is pulled out of the earth every year. It so happens that today China is the world's leader in gold production.

The gold standard was a system with a lot to recommend to it. If there were a real chance of returning to it, I would evaluate its merits. But I would certainly not consider one of its merits that it profoundly restrains the adventurism of politicians. European monarchs were perennially cash-strapped in a hard currency environment, but still managed to wage wars of conquest constantly.

Right now our system of currency replaces gold with expectations of revenue from the most reliable revenue-generator on earth: the American taxpayer. It is this that backs both the Reserve notes in my wallet (which are, I guess, zero coupon infinite duration bonds) and the Treasury bonds that form the structure of world finance. The basic fear with fiat currency is inflation, while the basic fear with commodity-backed currency is deflation. I'm not dead-set against commodity-back currency, but neither am I inclined to expect a great restoration of healthy politics upon a return to the gold standard.

Look, all systems of currency in the end depend on human psychology.

Agreed.

The stability of a gold standard presupposes the subjective human judgment gold's value. Nor is the supply of gold strictly limited. More gold is pulled out of the earth every year.

As I mentioned in another thread recently, the evidence for this value is in gold's stocks-to-flows ratio which is approx. 50 to 80. It takes 50 to 80 years of annual gold production to equal the existing gold stock held above ground. New gold supplies have little or no effect on the value of existing gold stocks accumulated over millenia. This is what gives gold money its inherent stability.

It so happens that today China is the world's leader in gold production.

Perhaps they know something we don't.

The gold standard was a system with a lot to recommend to it.

I don't know that I would call gold money just another system. I mean, wasn't it simply "the way things were done" for thousands of years? Don't we traditionalist conservatives appeal to this kind of tradition in all manner of other contexts when debating liberal policies?

If there were a real chance of returning to it, I would evaluate its merits.

Am I wrong in saying that if traditionalist conservatives only discussed those conservative ideas that look to have a real chance of happening then we wouldn't have much to talk about? It seems we discuss all manner of things that look like pipe dreams at present.

But I would certainly not consider one of its merits that it profoundly restrains the adventurism of politicians.

I would ask, does democratic republicanism, monarchy, dictatorship? Can't all these forms of government be corrupted, taken over or ended by those who have power? Yet we discuss them and arrive at conclusions about them based on their inherent tendencies and logic.

European monarchs were perennially cash-strapped in a hard currency environment, but still managed to wage wars of conquest constantly.

There will always be war. But was there always the total war of WWI or WWII? Were the wars of European monarchs in some sense limited by their war chests and their plunder? I don't know.

Right now our system of currency replaces gold with expectations of revenue from the most reliable revenue-generator on earth: the American taxpayer. It is this that backs both the Reserve notes in my wallet (which are, I guess, zero coupon infinite duration bonds) and the Treasury bonds that form the structure of world finance.

Well I would say that under a gold standard the currency system also relies on the ability of government to collect taxes in the form of gold. I think the main difference here is that our current system has no final extinguisher of debt. Debt simply cannot be paid down, even if the American nation were transformed overnight into an austere people singularly focused to making good on its obligations. Our current mechanism of money creation, check-kiting, doesn't allow it. Surely that's worth discussing.

Debt simply cannot be paid down, even if the American nation were transformed overnight into an austere people singularly focused to making good on its obligations. Our current mechanism of money creation, check-kiting, doesn't allow it. Surely that's worth discussing.

Sure, let's discuss it. Because I simply don't understand what you mean "cannot be paid down." The Treasury notes can be paid off, and you could have no new notes issued (the Treasury stopped selling 30-year bonds in 2001 for a 5 year period).

What is more problematic, perhaps, is the "current mechanism of money creation". But I am not positive that simply writing new dollar bills is, indeed, the problem that everyone claims. This year, each dollar in existence represents a specific share of the total wealth owned in the US. US entities will create new wealth during the year, to the tune of 1.5% or 2%, maybe 2.5% if we are lucky. That means that next year, the same dollar bill will either be the same percentage of the overall number of dollar bills, and therefore represent a greater amount of wealth than this year, or we need to print new dollars to represent the proportionate amount of new wealth created. There isn't, in principle, a necessary determinant to prefer one method over the other. The problem with the second approach comes in with putting those new dollar bills into the system: cannot be done without a local disturbance of the valuation of goods, whether that locale be Wall St. or Main St.

The problem with the gold standard is that there is simply nothing which makes the change in the gold supply or demand comparable to the change in overall wealth. And there are all sorts of possible changes in culture that can significantly change the desirability of gold without changing the overall wealth (such as finding a superlative industrial use for it, or replacing an existing industrial or decorative use with a much cheaper alternative - like what happened with copper phone wires). When that happens, the change in value of someone's gold holdings is quick and is not a reasonable reflection of how the overall wealth has changed.

Even if you used a currency that was hinged on a whole plethora of metals - a little of this and a little of that - you don't escape the dilemma: much, much greater wealth in Western society is found in non-metal items now than was true some 50 years ago, what with plastic and other alternatives. And much, much more wealth is tied up in intangibles anyway: software is not even a material good, but it is a huge deposit of wealth. Information in general is a non-material form of wealth. The idea of a currency is a bedrock value setter that isn't susceptible to easy change.

Federal reserve notes (FRNs) are backed by treasury debt purchased in open market operations. Treasury debt is typically issued at or near par implying that there are FRNs sufficient to cover the principal. But treasury debt pays interest and FRNs do not. In order to make the necessary interest payments on treasury debt more FRNs need to be created, and with the new FRNs comes more interest bearing debt requiring yet more newly created FRNs. Treasury debt is thus perpetually rolled over and increases in amount as interest compounds. Even if there were enough FRNs to cover both principal and interest, which there isn't, the debt would still never go away. It is just transferred to the balance sheet of the Federal Reserve as FRN liabilities, which are unredeemable and can't be extinguished in any way that makes financial sense. Under a gold standard, the FRNs are backed by gold and real bills. The FRNs can be removed from the balance sheet of the Federal Reserve System by redeeming them for gold coin or bullion.

Gold, unlike all other commodities, has constant marginal utility or declining marginal utility that declines slower than any other commodity. This is demonstrated by gold's high stock-to-flows ratio of 50 to 80 (all other commodities, save silver, have a ratio around 1/3). New supplies of gold have little effect on the massive stores of above ground gold; mine output (because again gold has constant marginal utility) is quickly absorbed into existing stores. Gold, as money, is the numeraire so I don't think it makes sense to say that gold's value fluctuates over time. It is the value of all other commodities, goods and services which fluctuate in value versus one another as expressed through their gold prices. The actual quantity of gold in existence is irrelevant.