It was always a mistake to think that the demise of UK mortgage lender Northern Rock, entailing a massive bailout of the bank by the UK taxpayer, would be the only major example of a financial institution getting into dire trouble. Investors have woken up this morning to the news that JP Morgan, the blue-blooded US bank, has bought US bank Bear Stearns for less than a tenth of what Bear was worth, based on its share price, late on Friday. Wow. Bear Stearns, which has been building a fancy new European HQ in London’s Canary Wharf (that is a often a bad sign), was one of the earliest victims of the credit crunch. Two of its hedge funds were smashed last year by heavy losses linked to US mortgage-backed debt that has turned out to be worthless. The Fed has stepped into the JPMorgan/Bear Stearns deal with a £30 billion (don’t you just love these big round numbers?) funding facility. The dollar is in free-fall, which might be great for US exporters, not so marvellous for Germany, France or other countries. There is a whiff of panic in the air.
One of the more thoughtful, if sobering, analyses comes from The Times (of London) columnist William Rees-Mogg. He points out that once again, the late Milton Friedman has been proven correct: we have been through a period, since the 1990s, of rapid monetary growth. The inflationary impact of that growth had been temporarily masked in the High Street and the labour market by the deflationary effect of cheap goods from China and elsewhere. But for those who wanted to look hard enough, the warning signals were plenty: asset price bubbles in property, gold, antiques, fine wine, equities, as well as the frenzy of mergers and takeovers, much of which was funded by cheap debt, as well of course as the heavy lending to sub-prime borrowers in the US, Britain and elsewhere.
The trouble, however, is whether central banks have, or ever had, the weapons to control runaway lending. Consider this: for much of the 1990s and “Noughties”, Japan, the world’s second-largest economy, operated a zero-interest rate policy. Its official interest rate today is 0.5%. Let me repeat: 0.5%. As a result, speculators have borrowed vast amounts of money from Japan and reinvested the proceeds in places like Britain, where rates have been over 5%, or the US, or Switzerland, or Australia, New Zealand, and the euro zone. This is what is called the “carry trade”. These carry trades mean that to all intents and purposes, low-rate nations set the prevailing value of borrowing money.
Of course, old-style mercantilists might argue that this proves the need for exchange controls, capital controls and the like. I disagree, but I can understand the reactions. We live in a globalised market for money and credit, but without some sort of international “anchor” mechanism like the old gold standard, there is a dangerous vacumn in the system. Yes, I know all the arguments against tying currencies to gold (which is above $1,000 per ounce), but surely the finest minds of our economics profession need to figure out one of the key challenges of our time: how to ensure that the price of money is handled intelligently in today’s global market place.
Update: Megan McArdle has thoughts.
I assume that the last sentence was sarcastic ,right?
It isn’t pleasant, but the strong Euro is shielding us from inflation to some extent. We are expeiencing less of it than the US and the UK.
As to rapid monetary growth: The Fed under Bernanke is slashing short-term interest rates, which will lead to even more monetary growth. Unfortunately, this is going to drive up long-term interest rates, as a kind of inflation premium that investors demand.
A case in point:
Central banks should follow one and only one goal, and that is to keep inflation under control. By making money even cheaper than before, Bernanke even might help create some new bubbles, to follow the burst housing bubble.
Perceptions of increased inflation provide a solution to the current problems, because the greater threat is the deflationary impact of a prolonged economic slump. Furthermore the recent rise in US Treasury yields brings the yield curve into positve territory after being negative for many years. The persistent negative yield curve bears much of the blame for our current financial woes because it negated the core profitability of banks (“borrow short, lend long”) and drove them to ever riskier businesses in order to generate decent returns, with the consequences that we now suffer.
With the curve now positive, banks can generate profits with much lower risks, enabling them to rebuild their capital bases. Higher bond yields should also stem the weakness of the dollar in due course.
Letting the bond market do the work should also appeal to libertarian principles as this is a free market solution, keeping governement intervention to the minimum.
Just to add to my post above and to reply to the question posed in the original post, let the bond market do the work and keep the finest economic minds out of it.
It should be kepy in mind that the Federal Reserve Banks are PRIVATELY OWNED.
They are owned by the member banks of their respective districts.
Those banks are, in turn, owned by private shareholders.
The structure as created provided a vehicle to be licensed by the Federal Government to issue credit instruments that have the legal status of Legal Tender (a common law concept of contract law), which serves as currency.
The U.S. does not issue any significant amounts of circulating “money” (coinage). It receives part of the profits made by the FRS from issuing its credits, as consideration for the exclusive (protected by a 100% tax on bank notes issued otherwise) license.
Renewal of access to hard assets ( e.g., gold) outside the currency system and availability of credit instruments from outside the perimeter (Euro, Yen, Reals, etc.) have blunted the forces available to the FRS to buttress the banking system by a “control” of credits that serve as “money.”
We are not observing “Government” interventions via monetary increases and decreases; though its debt issuances do affect the monetary increases of the Federal System (usually adversely).
Yes, RRS,
but the Federal Reserve sets the discount rate as well as the fed funds rate, and those do have infleunce on inflation levels.
Well sort of. They would probably be called QUANGOs in the UK.
Wrong. I am a fan of the idea of ending central banking fiat money I think the idea of commodity-based currencies and genuine private banking, or some such, is an idea that needs to be explored in greater detail, hence the final sentence of my article. I was absolutely not calling for some sort of international set of regulations to “fix” these issues or some reheated version of Bretton Woods. Give me at least some credit.
“Wrong. I am a fan of the idea of ending central banking fiat money”
I think you will find the alternatives have been explored in detail in previous eras and found wanting. See Adam Smith’s the Wealth of Nations for further detail.
I’d heard that Colonial Scrip worked quite well and that Guernsey does not use debt money. What’s the story there? Anyone care to comment?
You mean, unlike modern fiat money central banking systems, which have worked just marvellously (sarcasm alert). The Great Depression, for instance, was in part caused by massive mistakes made by the Fed in pumping up the US economy and then cutting off the spigots.
I am not, by the way, suggesting that a move to genuine private banking systems gets us away from the normal vagaries of the business cycle, in case anyone asks.
Fiat money cannot ensure monetary policy will always be properly suited to the prevailing needs of the economy but non-fiat money ensures that it never will be.
Here’s a couple of guys who make the point better than me. It is Mundell’s work that is definitive in establishing, both empirically and theoretically, the inefficacy of non-fiat money.
http://www.irpp.org/po/archive/may01/friedman.pdf
“Never?”. That is a pretty big claim to make, Adrian. And given the clusterfuck now hitting global financial markets, the stagflation of the 70s, the boom-bust of the 80s-early0=-90s, the Great Depression….I could go on, but you should get the point that fiat money has had a pretty spotty history in delivering any form of stability. Yes, there were nasty episodes in the 19th Century – the railway boom-bust of 1840s – but nothing on the scale of the Great Depression, arguably the worst and most sustained crisis ever to have hit the financial world, made worse, let us not forget, by protectionism.
….for less than a tenth of what Bear was worth…
I seriously doubt that. Bear was leveraged to the hilt, that’s how they generated outsized returns.
Any market will have this. The quality of perception will degrade without market knowing with time until the level of negative information is such that there is a reckoning. This isnt necessarely connected to fiat money or any other standard despite the fact that it can influence. If anyone wants a regulation safety just say anyone cant lend at below 3% rate or whatever value. Of course that makes less economical growth, since high risk speculative technologies and ideas will not have funding.
If anyone wants safety maybe
we should ban firms since 70-80% of them fail in first 3 years and turn Communist. I bet House subprime has better rates.
“Never?”
The underlying basis of non-fiat money is to tie its issue to some material item, such as a commodity or basket of them, whose demand is meant to perfectly track real demand in the economy. It should not be necessary to point out to a libertarian the problems with determining what that item should be, or who should decide upon it. For that reason, whenever non-fiat money has been used it, of itself, created vicious boom-bust cycles because the pricing mechanism is distorted and harms the efficient allocation of resources. That is what Mundell’s research established.
So, yes, I stand by “never”.
With respect to the current problems, in my opinion the cause is perverse incentives in financial risk-taking caused by governmental intervention in capital adequacy rules, especially Basel 2. Bankers stopped thinking about their risk some years ago and concentrated on gaming the rules to maximise their leverage. That interpretation fits your libertarian bent better, a near-perfect example of unintended consequences. I think you’re rather missing the point with your focus on monetary policy, for which your proposed solution is surreptitiously statist.
Finally, it was the excessive adherence to the gold standard that screwed up monetary policy in the Great Depression, hardly an argument for non-fiat money.
Advocating money that is not backed by some worthless promise by a state-monopoly central bank is “surreptitiously statist? WTF?
Nope; the Fed during the 1920s operated a loose monetary policy, increasingly so right up to the Wall Street Crash. I am not aware that the adherence to the Gold Standard was a factor.
Like I said, the gold standard cannot be revived and I am not aware that it could or should be; I am not a gold bug chasing after some cure-all for the mistakes we get from the Greenspans et al; but really, to imagine that the vast torrents of monetary liquidity that have boosted asset prices these past few years is a great advert for the virtues of the current system is naive, and at worst, disengenous.
The Basel 2 system has only just been implemented and it took a long and drawn out period to do just that. Arguably, the development of a vast market in insuring debt – credit derivatives – and the securitisation of credit payments has had a significant impact in quickly transmitting the impact of cheap money through the entire financial system.
To be fair, Adrian, I read the Mundell piece you linked to and I find it quite persuasive. I am not convinced, though, that monopoly currencies that have become accepted wisdom since the 20th century are
OK, “surreptitiously statist” was unnecessarily provocative. I was embellishing the point that somebody has to make arbitrary decisions even with non-fiat money.
On the impact of Basel 2, I have to disclose my profession as an investment banker and merely say that I do know at first hand what has been going on. “How do we get this off balance sheet?” is the first and pretty much the only question that has been driving bank transactions for years, ever since the sovereign credit crisis of the 1980s. Basel 1, and after that Basel 2, gave official sanction to this practice. Credit derivatives have merely provided an efficient mechanism for moving the credit risk to where it attracts the least regulatory capital. The problem has not been cheap money, it has been mispriced credit risk.
Regarding your mention of the Yen carry trade, same point. The trade works if you are are incentivized to under-price your market risk, in this case in FX. The problem is not in cheap rates in Japan but in the willingness of private market participants to take a mighty punt on the Yen/$ rate.
In theory, debt-backed currency is as good as, or better than, asset-backed currency. But it relies on a truly independent central bank, and I’m not sure such a beast actually exists. If not for political influence, I doubt the Fed would have allowed the Ponzi scheme debt explosion we’ve seen in the last couple decades here in the US.
But the 19th century is riddled with severe boom-bust cycles. I’d rather have somewhat lower growth over the long run than a cycle with 30% unemployment every generation or so – remember, that’s what provided the impetus for the great “isms” of the 20th century. If the Fed can leaven out the cycle, then I’m all for it. I guess it will be some time before we know where the bottom is in this one.
Also, I’m not sure how we would transition to an asset-backed currency. Going to debt currency from asset seems straightforward, but my intuition says going back the other way will require the state to acquire a lot of assets it doesn’t currently posess.
RSS, I don’t normally comment on formatting, but too “much” quoting of “ordinary” words makes your “posts” very “hard” to read.
I’ve only skimmed the discussion because it’s late, but here’s my tuppence for what it’s worth.
Suppose we let the current rotten banking system stand, but just break all its ties with the government, then allow competing currencies based on anything people like, the price of gold or biscuits or fiat. Would the most stable currencies would win out in the marketplace, while the inflationary ones would disappear up their own fundaments?
Is the fundamental problem that we do everything to avoid banks failing, thus propping up fundamentally bad businesses, which we don’t do in other economic sectors?
Also, there’s the fractional reserve thing; high street banks are running two businesses conflated- firstly, a safe place to store money, secondly a loan brokering business, which uses money that naive depositors think is used safely to generate interest.
If those two businesses were visibly separeted (even if operated under the same roof) then depositors would be clearer about the fact that of their money that is “in the bank” most of it isn’t in the bank at all, it’s been loaned out and thus may be lost. After a few bank failures people would get the idea and make a wiser choice of how much of their money to store and how much to risk in return for a profit from interest. You may (statistly) need some regulation requiring banks be audited for their stored assets to ensure they’re not sneakily loaning it out against customers’ wishes, perhaps.
I know that fractional reserve is no secret, I’m not accusing the banks of being fradulent or anything. But most people aren’t aware of it, since they don’t need to be because we have this system of using the state and its organs to prop up banks regardless of how twatty they are in their business practices. Any business sector that is told it can be as stupid in the search for extreme profit as it likes and somebody else will always bail them out isn’t likely to be very responsible, is it?
The problem has not been cheap money, it has been mispriced credit risk.
A distinction without a difference. For sure, the drive to get stuff “off balance sheet” with special purpose vehicles and the like has fuelled a lot of this, but the wheels have been greased by cheap credit, no mistake. The credit derivative market, by the way, is on the whole a good thing, I think, since it makes it easier for people to buy and sell the risk in otherwise hard-to-get corporate bonds, most of which are not easily tradable in the cash market.
I also know a bit about this topic; I spent more hours than I care to remember listening to the likes of Eddie George, the International Swaps and Derivatives Association, Moody’s and lord knows who else opine on it.
“Milton Friedman has been proved correct”
For most of his life (although not, I admit, for the last years of it) Milton Friedman argued that the supply of money should be increased to keep the “price level” index stable.
For example, Ben Strong of the New York Federal Reserve (the man responsible for the credit money boom of the late 1920’s) was a hero to Milton Friedman.
True even to people who define “inflation” as movements in the “price level” index (rather than an increase in the supply of money) the actions of Alan Greenspan and the mini me versions of him in the Bank of England and some other organizations have been too much.
But only mildly so – after all Alan Greenspan could point to a fairly low upward movement in the price level index (which ever index people liked to look at) till near the very end of his time.
Does this mean that the real credit-money inflation has been mild or only recent?
No.
It has been VAST and it goes back quite some years.
Say Ludwig Von Mises (Theory of Money and Credit 1912) has been proved correct, or say F.A. Hayek has been proved correct, or any other of the Austrian school has been proved correct.
But this is nothing to do with Milton Friedman and the Chicago school.
And to say “nothing to do with” is actually being rather kind.
Please do not talk of “tying currencies to gold”.
Either gold (or some other commodity) is the money – or it is not.
“Gold standards” and other such, are just a load of double talk that misleads people.
After all the United States was “on the gold standard” during the late 1920’s credit money expansion.
“But it broke the rules of the Gold Standard”.
These rules are vague and subject to interpretation.
“Money is gold of X per cent purity” is not.
Ditto silver or any other commodity.
Here (much though I attack him on many other issues) Murry Rothbard was quite correct.
In case someone brings up F.H. Hayek’s idea of index money……
Firstly such an index would be subject to political interpretation (there is no “scientifically objective” price index) and it would also be absurd in practical terms.
One would go to the bank with one’s note and get….. well get what?
X per cent of one product, and Y per cent of another product (and on and on over vast number of products).
The idea of index money was the most absurd idea Hayek ever had.
Yes there can be competing currencies.
But a contract must clearly state what currency (i.e. what commodity) it is to be paid in.
And the same is true for governments and their taxes.
President Martin Van Buren was right.
One needs to strip away all the clever stuff (whether it is a “national bank” or various pet State banks) and simply take the gold (or whatever the currency is) into the Treasury and pay it out of the Treasury as it is spent – pay-as-you-go.
No credit bubble at either Federal or State level. And no corporate welfare (open or hidden) for banks or other politically connected enterprises.
And no “let us pretend” as regards notes.
If a bank issues a note and does not have the commodity it says it does – then the Board of Directors go to prison.
After all they could always have said “we are a fractional reserve bank – do not automatically expect gold if you turn up with one of our notes, we may or may not have some”.
That would be fine from a legal point of view.
“But then we can not lend money”.
Yes you can – you can lend REAL SAVINGS.
Borrowing (whether for consumption or for investment) should be from real savings (i.e. other people choosing not to consume) and from this source alone.
Not from credit/money bubbles.
Eh? I thought he said the stock of money should rise to match economic growth. Very crudely, if an economy rises by 3% per annum, and monetary growth is 10%, you will end up with inflation of 7%, etc.
J.P.
The two things are the same.
If one is aiming at keeping the price index stable and economic growth is 3% then (according to Milton Friedman for most of his life, although, I admit, not for the last years of it) one should increase the growth of the money supply by 3%.
Leaving aside the problems of the “price index” and “price level” and the measure of economic growth (and so on and so on) there is still a vast problem with the above.
It is not an inflation rate of 0.
It is an inflation rate of 3%.
Because inflation is not the rise in the “general price level” it is the increase in the credit-money supply – i.e. (in practical terms) the effort to produce more money (on top of real savings) to lend.
No great rise in the general “price level” can hide very real and very damaging inflation.
For example the activities of Ben Strong of the New York Federal Reserve in the late 1920s.