It’s not just the economy, stupid.
It’s everything, stupid.

My Cobden Centre colleague and Chief Executive of Tyler Capital, James Tyler, explains how we came close to financial collapse and what to do about it:

Fractional Reserve Banking (FRB) is an inherently unstable complex system.

Each and every bubble and crisis has some kind of link to FRB, going back thousands of years.

Even where financial crises are caused by natural disasters (the San Francisco earthquake of 1906 being a prime example), the financial crisis only followed because banks did not have enough reserves to pay out worried depositors – due to fractional reserves.

In a nutshell, depositors wanted what they thought was their property back, only to find it did not exist.

Over 70% of people in the UK believe that money placed in an instant access account remains their property.  This is not the case.

Read more: How to avoid future encounters with financial meltdown » The Cobden Centre.

Over at The Cobden Centre, my friend and colleague, financial engineer Gordon Kerr, explains how to destroy the British banking system through the use of derivatives which take advantage of the regulatory system, then sets out four measures to solve the problem:

Nine years ago I worked as a structuring engineer in a three-man team within the investment banking unit of a major British bank. One of us was very bright. He stunned me one day with an idea as to how we could:

Produce immediate (but illusory) substantial profits for our bank, thus ensuring that we would enjoy generous personal remuneration;

Generate ‘virtual’ share capital to boost our bank’s capital reserves;

Leave the actual investment risk exposure and profit expectation of our bank almost exactly the same after the transaction as before it.

Was this idea the kind of rocket science derivative engineering that justifies master of the universe labels for the three of us who designed and implemented it? No: it was extremely simple. Here’s how it worked. We transmuted some loan assets into a derivative transaction for regulatory purposes, whilst leaving the actual loan arrangements unaltered.

An article by my Cobden Centre colleague, Toby Baxendale, exploring whether manipulating the interest rate can create real wealth:

You often hear politicians and economic commentators say that we must have low interest rates to make sure the price of money is as low as possible to allow people to borrow and thus spend. This is very much the common view whatever your political outlook. The thought behind this is the Keynesian notion that one person’s spending is another person’s income. This is the famous circular flow of income. In a further article, I will address the latter notion. The first notion — whether cheaper money will make for greater prosperity — I will address now.

First of all, I would like to recap how we entrepreneurs create wealth.

Of course, those in debt want low interest rates and those saving want them high, but that is not the question before the country… read more here.

Perhaps cold comfort to those of us who live out of the city:

It is often pointed out that if Martin Luther King’s most famous speech had declared: “I have a nightmare”, he would not have persuaded anyone.

He might not have sold very many books, either. There is only so much gloom the average reader can take, and today’s publishing climate is not receptive to Old Testament prophecies of imminent destruction.

…

Expensive petrol, he suggests, will bring all sorts of benefits, from lower road deaths and less obesity to tastier, locally grown food. It could also mean the downfall of Wal-Mart and the “carnival of excess” that is Las Vegas: deaths that Mr Steiner does not seem inclined to mourn.

via FT.com / Books / Non-Fiction – The brighter side of expensive oil.

Via FT.com / UK / Politics & policy – Call for more intervention on energy:

An “interventionist” approach by the government will be needed if security of energy supply is to be guaranteed, a report commissioned by the prime minister will conclude on Wednesday.

Malcolm Wicks, the former energy minister appointed by Gordon Brown as his special representative for international energy issues, will say that “the time for market innocence is over” and that the government needs to do more to safeguard electricity and gas supplies.

…

“The era of heavy reliance on companies, competition and liberalisation must be re-assessed,” he said. “We must still rely on companies for exploration, delivery and supply but the state must become more active: interventionist, where necessary.”

Oh dear. At this point it is worth indicating more or less any part of my reading list, but consider, for example, this from Mises in Economic Freedom and Interventionism:

The Middle Way

Many politicians and authors believe that they could avoid the necessity of choosing between capitalism (laissez faire) and socialism (communism, planning). They recommend a third solution which, as they say, is as far from capitalism as it is from socialism. In imperial Germany this third system was called Sozialpolitik; in the United States it is known as the New Deal. Economists prefer the term used by the French, interventionism. The idea is that private ownership of the means of production should not be entirely abolished; but the government should “improve” and correct the operation of the market by interfering with the operations of the capitalists and entrepreneurs by means of orders and prohibitions, taxes, and subsidies.

But interventionism cannot work as a permanent system of society’s economic organization. The various measures recommended must necessarily bring about results which, from the point of view of their own advocates and the governments resorting to them, are more unsatisfactory than the previous state of affairs which they were designed to alter. If the government neither acquiesces in this outcome nor derives from it the conclusion that it is advisable to abstain from all such measures, it is forced to supplement its first steps by more and more interference until it has abolished private control of the means of production entirely and thus established socialism. The conduct of economic affairs, i.e. the determination of the purposes for which the factors of production should be employed, can ultimately be directed either by buying and abstention from buying on the part of consumers, or by government decrees. There is no middle way. Control is indivisible.

It is interventionism that produces all those evils for which a misguided public opinion indicts laissez-faire capitalism. As has been pointed out above, the endeavors to lower the rate of interest by means of credit expansion generate the recurrence of depression. Attempts to raise wage rates above the height they would attain in an unhampered market result in prolonged mass unemployment. “Soak-the-rich” taxation results in capital consumption. The joint outcome of all interventionist measures is general impoverishment. It is a misnomer to call the interventionist state the welfare state. What it ultimately achieves is not improving but lowering the common man’s welfare, his standard of living. The unprecedented economic development of the United States and the high standard of living of its population were achievements of the free enterprise system.

But nevertheless, here we go…

Writing for The Cobden Centre, I ask “What is money?“:

In their working paper “Assessing UK money supply measures in the light of the credit crunch”, Toby Baxendale and Anthony J. Evans provide a better measure of the money supply. In this article, Steven Baker explores the background to the paper and indicates some key findings.

Many people know the Bank of England is creating new money through quantitative easing but if the quantity of money is being increased, how is that quantity being measured? What is counted as money?

Via FTSE 100: stock market has best month in more than six years – Telegraph:

The stock market has enjoyed its best month in more than six years, boosting the savings of millions of investors and bringing hope that the worst of the recession may be over.

The FTSE 100 index of leading shares climbed 8.5 per cent in July, adding £134 billion to the value of the stock market, its best monthly performance since the fall of Baghdad during the second Gulf war in April, 2003.

The rise in share prices followed a series of strong profit figures from Britain’s biggest companies, with many proving to investors that they are coping well in the recession by cutting costs.

However, according to Austrian-School Theorists¹:

[U]ninterrupted stock market growth never indicates favorable economic conditions. Quite the contrary: all such growth provides the most unmistakable sign of credit expansion unbacked by real savings, expansion which feeds an artificial boom that will invariably culminate in a severe stock market crisis.

In other words, and most unfortunately, the present stock market conditions are an illusion produced by quantitative easing that will not last. And:

The crash will take place as soon as economic agents begin to doubt the continuance of the expansionary process, observe a slowdown or halt in credit expansion and in short, become convinced that a crisis and recession will appear in the near future. At that point the fate of the stock market is sealed.

1. De Soto, “Money Bank Credit and Economic Cycles”, p462 [↩]

Via British banks highly vulnerable to future shocks, Bank of England warns – Telegraph:

Britain’s banks remain over-indebted, highly vulnerable and harbour growing funding gaps which leave them susceptible to future shocks, the Bank of England has said.

…

In a sign of the strain facing nations’ public finances – including the UK’s – the report also revealed that the threat of a sovereign debt default has become one of the biggest concerns for investors. A survey put together for the report identified sovereign risk as a financial stability concern for the first time.

The report also laid out a number of key criteria banks will have to fulfil in the future – reforms which could transform the structure of the financial system. Among its recommendations were that in future banks should “face a credible threat of closure or wind down”, should have a “risk-based, pre-funded deposit insurance system”, should increase their levels of capital and liquidity, depending on their size, and should provide a “will” which explains how to dismantle them in the event of insolvency.

The Bank of England’s Financial Stability Report is available here. The summary is quite accessible.

However, to answer the underlying “why?” one must look elsewhere. It may also be worth considering this speech by the Earl of Caithness:

The Banking Bill which we are currently discussing in the House is very complex and detailed, but it does nothing to resolve the current banking crisis, which lies at the heart of our economic problems. … the fault that really needs correcting is our whole banking system.

The debate which must be reopened and made contemporary is that between the Banking and Currency Schools of the nineteenth century. At the time of the 1844 Bank Charter Act, the Currency School committed three errors which haunt us today. More to follow at The Cobden Centre.

This post has been brought forward for those people who asked me today about money, bank credit and economic cycles while I was telling for the EU and local elections.

As the Austrian Theory of the Trade Cycle gains interest for its coherent explanation of our present predicatment, it also gains opponents. Here, Robert Murphy answers Australian economist John Quiggin:

The Mises-Hayek theory of the business cycle — and of our recent housing bubble in particular — is gaining more and more adherents in the “real world.” To give anecdotal evidence: Five years ago, when I’d write a Mises Daily article, the fan mail would pour in from college students. But now, I get questions from hedge-fund managers and others working in the financial sector. Austrian economics is no longer a hobby; this is serious stuff.

…

I am not here to tell you the Mises-Hayek theory of the business cycle is a work of art that has no flaws. If I said that, then I would be living up to Quiggin’s caricature. What I will say is that the Austrian explanation of the boom-bust cycle makes more sense than any other explanation I’ve seen. In particular, most rival schools of thought say that the way to fix an economy plagued by overconsumption and reckless lending is to have the government borrow obscene amounts of money and to have politicians take over financial accounting. And it’s the Austrians who allegedly cling to dogma in the face of overwhelming counterevidence?

via Correcting Quiggin on Austrian Business-Cycle Theory – Robert P. Murphy – Mises Institute .

Why should we care? Because we are all in this economic mess together: understanding how we came to be here is the beginning of our route out.

See also The Importance of Capital Theory:

Once we understand how our present problems are due to a Fed-induced distortion in the capital structure, it becomes clear that the worst recommendation is for the Fed to cut interest rates and pump in ever more “liquidity.” It was artificially cheap credit that fueled the housing boom in the first place. Greenspan brought the federal funds target rate down to a ridiculous 1 percent — meaning the interest rate was actually negative, once we adjust for price inflation — and held it there for a year. He did this in order to (apparently) obviate the need for a harsh recession in the “real economy” after the dot-com crash. But in fact he sowed the seeds for our present crisis. If Bernanke continues shoveling in hundreds of billions to needy bankers, five years from now Americans (and the rest of the world) may look back fondly on the present the way the 2001 downturn now seems like a minor inconvenience.

It is worth remembering that Alan Greenspan once blamed the Great Depression on the actions of the Federal Reserve in that it pumped excess credit, “triggering a fantastic speculative boom”.

There are issues here that we should all strive to understand. That understanding is not out of reach: Rethinking economics — primer.

A couple of quotes from De Soto, pp 456-474.

From “Effects the business cycle exerts on the banking sector”:

Hence we can conclude that an inherent trend in the privileged exercise of fractional-reserve banking leads to bank consolidation and encourages bankers to develop and maintain close relations with the central bank as the only institution capable of guaranteeing banks’ survival in moments of crisis, situations banks themselves create regularly. Furthermore the central bank directs, orchestrates, and organizes credit expansion, making sure that banks expand more or less in unison and that none stray far from the established pace.

Eerily familiar… and for fun, from “Marx, Hayek and the view that economic crises are intrinsic to market economies”:

To contend that an economy of real socialism offers the advantage of eliminating economic crises is tantamount to affirming that the advantage of being dead is immunity to disease.

De Soto goes on to provide a clear and detailed solution which he claims could provide stable and gently growing constant prosperity.