A Challenge to Banking
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SECTION ONE - Dishonest Money
The Aswan dam, when it was planned and first constructed,
was hailed as the solution to Egypt's irrigation and flooding
problems. Yet viewed from hindsight, the problems that such
a magnificent feat of engineering caused are mammoth. The
fishing industry, which used to rely on sardines from the
Nile delta for a substantial proportion of its income, saw
its annual catch of 18,000 tonnes drop to little over 500
now that there was no longer a flow of alluvial silt to provide
feeding grounds for the sardines. In addition the snails which
carry the bilharzia-producing liver fluke no longer died in
the winter months in the empty irrigation canals, so the disease
spread, bringing with it widespread disability.
When the decision was made sixty-odd years ago at Bretton
Woods to stop the convertability by anyone other than governments
of paper money to gold, governments and financiers alike believed
that the problems of the Western monetary system were solved.
It was hailed as an economic achievement of enormous magnitude,
perhaps as great as that later attributed to the engineering
achievement of the Aswan dam.
With hindsight we can now see that it, too, brought with it
a new league of problems: ones to which, as yet, there have
been no permanent solutions. The question which we must now
ask: Can any of the currently attempted solutions be developed
to provide a durable correction?
The most simplistic theorists would say that the market should
solve its own problems: that the banking system should be
self-correcting. Others would say that there are sufficient
natural constraints on money-lending to avert crisis. The
reality is somewhat different.
The system does, of course, have some natural constraints;
it would otherwise have collapsed by now. There are two natural
limitations which have helped to contain the inflationary
explosion. The first is the time lag between a deposit and
a withdrawal. Bankers need to maintain sufficient money on
the shelf to meet withdrawals. Although norms are established,
market conditions can lead to large increases in the volume
of withdrawals without apparent prior notice. Prudent bankers
therefore have tended to maintain reasonably large excess
reserves in order to meet these should they occur.
The second is the existing net asset value against which bankers
are willing to lend. All of the assets which bankers are willing
to accept as collateral have a measurable exchange value at
any given point in time. Bankers are willing to lend only
a portion of that exchange value against each asset. The sum
total of all of those portions tends to provide a practical
ceiling limitation upon the total volume of money which banks
do create. Bankers themselves are unwilling to create more
once these portions have been fully loaned.
Even this ceiling is not absolute. The actions of bankers
themselves force a rapid elevation of it. This occurs because
of the "bidding power" which lenders provide. Potential
purchasers of a specific asset can obtain from their banks
a commitment to provide an agreed portion of the eventual
purchase price of that asset. Each potential purchaser can
then gear his "bid" according to his other available
money and his expectations from that asset.
For example, if you and I were each seeking to buy the same
house, we would first obtain from our respective mortgage
lenders the proportion of the sale price which they would
provide. Suppose each agreed to provide 90 per cent. If the
asking price was $100,000, we would each need about $10,000
to make a successful bid or offer. Suppose you had $10,000
in savings and offered the owners their asking price. If I
had $12,000 in savings, I could offer them up to $120,000
and outbid you. If they accepted my offer, the market value
of the house would have increased. "Bidding power"
would have led to the increase.
Where there are a number of assets, and a number of bidders,
the assets can change hands quite often. This can produce
the effect of a continuing increase in the sale price of each
asset. The upward spiral of increasing prices can continue
to grow until it becomes obviously unsustainable: lenders
will then withdraw further "bidding power" or potential
bidders will withdraw from the market; or both will occur
simultaneously, triggering a fall in the price of the assets.
If the rate of price increase has been sufficiently disproportionate
and rapid, the level of exchange value of these assets can
then collapse to their former levels or less.
This is what occurred on Wall Street in the late 1920's where
publicly listed shares were the assets against which "bidding
power" was provided and lenders were willing to finance
90 per cent of the price. When potential purchasers of shares
began to question whether the rises in share prices could
be sustained and many declined to buy, prices began to fall.
They had to fall only 10.1 per cent before their price was
less than the amount which had been borrowed to purchase them.
Before that point was reached, however, the borrower would
have been called upon to put up more money to reduce the loan
to a level of 90 per cent of the new value of the shares.
When borrowers could not provide the money required by these
"margin calls", the shares were sold - which drove
prices down even further. As a result of these forced sales
in which often both the borrower and the lender lost money,
share prices were driven further and further downward. The
losses were on such a scale that many who had borrowed to
purchase shares were forced into bankruptcy. So, too, were
many of the stockbrokers which had provided the loans to the
buyers and many of the banks which had provided loans to the
It was this same "bidding power" which caused the
price of property to rise so spectacularly and then to collapse
so catastrophically in London in both the early 1970's and
late 1980's. In both of these "boom and bust" cycles
property, not shares, was the collateral for the loans. In
the "bidding" process, each purchase was funded
by new loans. Net new loans produced new units of money. The
end result was a continuing increase in the supply of money
in each market-place.
In the United States, following the Wall Street collapse in
1929, as a result of the inability of either failed share
purchasers or failed stockbrokers to repay their loans, many
banks also collapsed. Their depositors thus lost their deposits.
This had the opposite effect. It reduced the money supply.
Thus, much of the inflation produced in America by the "bidding"
process in the 1920's did not survive.
In the latter cases, however, in London in the 1970's and
the 1980's, systems were in place to protect deposits and
there was no widespread bank collapse. Deposits were not lost.
The money supply did not shrink and the inflation produced
by the "bidding power" remained. With respect to
inflation, Central Banks and depositor protection have been
Nor can we find much comfort in attempts to cure inflation.
Economists and governments, in devising methods for curing
inflation, have placed emphasis on the effects and not on
the causes. As a result, the solutions which have been attempted
have treated the symptoms rather than the illness.
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Consider, for instance, the wage and price policies which
have been tried. Returning to our earlier "Big Ben"
time analogy, these policies can be compared with attempts
to limit one or other section of the community to but one
verification per year of the watches of its members against
Big Ben. The lack of synchronisation with the remaining sections
of the community would produce similar effects to those in
the time analogy.
The two people who agreed to meet for lunch but didn't check
their watches against Big Ben would actually meet for dinner
according to official time and, therefore, would have had
to squeeze all the things they had planned to do after lunch
into their schedule for the following day. The days would
also keep getting shorter and more and more missed programmes
would have to get squeezed into these shorter and shorter
days. Time would continually be being lost.
Restricting the income of some will mean that those who have
been restricted will continually be losing purchasing power
and they will have to put off some purchases until another
day as they feel the effects of this lost purchasing power.
The continued application of such a policy will erode first
the net disposable income and then the financial safety margins
of both individuals and businesses. This can so damage an
economy that any consideration of these policies as a solution
to anything is unacceptable and has proven so wherever tried.
The level of prices or wages has to do with the distribution
of units of money which already exist. The level of wages
has to do with the distribution of the units of money received
by a business or an industry. The level of prices has to do
with the distribution of units of money which enter the market-place.
An increase or a decrease in either level can only change
the location of existing units of money. Neither can create
one new unit of money.
Inflation, however, is a result of the production of new units
of money. It has nothing to do with the distribution of existing
ones. Solutions cannot be found in controlling the distribution
of units of money. Price or wage controls, therefore, will
not stop or even reduce inflation. They will, however, disadvantage
the section of the community affected by the controls.
The level of government borrowing is another "red herring"
which has been blamed for causing inflation. The level of
borrowing, either government or private sector, has to do
with the distribution of units of money available for investment.
Increases or decreases in this level cannot create one single
new unit of money. Changing investment distribution from the
public to the private sector accomplishes nothing in the fight
against inflation. The attack must be waged against the lender
whose actions actually produce inflation. The attack must
not be waged against the borrower.
If the lender lends what already exists, against which no
previous claims are outstanding, and if it is his own and
he recognises that he will be without its use until it has
been repaid, then the market will not be misled and there
will be no inflationary effect. It is only when the lender
lends that against which prior claims have been issued, or
creates new claims against exchange value for which prior
claims have already been issued, that existing claims are
debased and inflation rears its ugly head.
Nevertheless, in utter frustration, even indexing has been
attempted. In our "time analogy" example, this can
be compared to connecting every church bell in the United
Kingdom to Big Ben, so that those within earshot can re-set
their clocks and watches every hour on the hour as the nation's
bells peal. Although this, too, appears to be a reasonable
solution, its absurdity becomes apparent when one observes
the relationship between "official" Big Ben time
and natural time. In the second month, for instance, it will
be dark at official noon and light at official midnight. In
due course, two "official" days would fit into one
natural day. It is a nonsense.
The time analogy is useful in that it shows us exactly how
a mechanical fault can lead to an ever increasing rate of
change. The time analogy also helps us to see why some of
the accepted programmes have failed to cure inflation.
One of the most commonly used methods for controlling inflation
is to increase interest rates. Although interest rates were
dealt with earlier in this book, it is worth restating the
arguments. Interest payments are also about the distribution
of money that already exists. They transfer units of money
from the borrower to the lender. The transfer of units of
money from one to another does not create one single new unit
Increases in interest rates are also counter-productive. They
entice lenders to lend more. Worse, they squeeze businesses
at both ends. They increase costs. This reduces the amount
a business has for other expenses. So, sales decline while
costs increase. This drains the economy. It leads to increased
unemployment and increased personal and business bankruptcy.
Yet, increasing interest rates remains the preferred tool
used throughout the Western world in the fight against inflation
and reductions in interest rates remain one of the principal
tools used to encourage economic activity. While lower interest
rates do serve a useful purpose in that they reduce the running
costs of existing borrowers, that is not the real purpose
for the reductions. Interest rates are reduced in order to
encourage more people and businesses to borrow and spend and,
thereby, to increase the levels of both production and employment.
When looked upon dispassionately, this latter use of the interest
rate tool is perverse. Lowering interest rates encourages
more people and businesses into debt in the name of building
a healthier economy. It claims that the economy is less healthy
than it could be because either not enough people and businesses
are in debt or because those that are in debt are not yet
deep enough in debt. Yet it is debt that destroys individuals,
businesses and, ultimately, economies. The use of interest
rates as a tool for manipulation or control of economic activity
ought to be immediately abandoned.
Monetarists have recognised that it is increases in the money
supply which create inflation. To this extent they are correct.
Their solutions, however, deal with the distribution of existing
units of money. Their solutions are misguided. If we are to
stop inflation we must stop the production of new units of
"Without change the future of the Western
monetary and banking system looks very bleak indeed."
As we reach the borrowing capacity of the population
the banking system will be unable to produce the new
units of money necessary to meet withdrawals and maintain
customer confidence. Without continuing expansion the
current banking system cannot survive.
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