John Tomlinson

A Challenge to Banking

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SECTION ONE - Dishonest Money

Piecemeal Solutions

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 stockbrokers.

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 counter-productive.

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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Attempted cures

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 of money.

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 money.


The Hourglass Is Emptying
"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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