Economic Medicine and Poison, part 1

The most helpful thing we could possibly do for the economic corpus is to create a sound currency that is linked to a stable banking system.

Right now we have neither, and so we have risks to the economy that are simply unknown. A risk that you don't know is always worse than one you can understand. Will your bank be around tomorrow? This is no longer an idle question.

Creating a stable currency would not be hard. It's a simple matter of pricing, and there is nothing that markets do better than pricing, when they are allowed to function without interference. Take an item of real value, one that cannot be produced by the printing press. Let's say, I don't know, how about the gold standard of money?

Gold has been used as money for 5000 years or more. Let's say we go back to using gold as money. You want to sell something. OK, how many grams of gold would you accept to part with it? You want to buy something. How many grams would you give up to obtain it?

The thing is, we're used to using dollars as our standard. We think, "how many dollars is that worth?", not "how many grams?" Like visitors in another country, we'll be running the numbers through our heads, converting to dollars. At least for a while. Pretty soon we'll get the hang of it.

If we get rid of the risky fractional reserve system (perhaps following this great plan by Kotlikoff and Leamer), then we have the absolute best basis for economic prosperity. Systematic inflation becomes impossible. And deflation has no power to wreak economic havoc. Deflation becomes your friend, because deflation is simply falling prices. We only associate deflation with the end of the world because deflation has typically occurred only at the end of a credit bubble, as the harbinger of deep recession, bringing with it financial panic and high unemployment.

The problem is how the stable currency would interact with the dollar. The dollar decays like a radioactive isotope. A stable currency operating in parallel with the dollar would instantly reveal what a poor currency the dollar really is. Fewer assets would be held in dollars, and fewer transactions would be made in dollars. Both would cause a reduction in the demand for dollars, and a depreciation in the value of the dollar. Perhaps that would be viewed as an "attack" on the dollar. It's not an attack to remove lipstick from a pig. (My apologies to Mrs. Palin.)

The dollar is worth about what the paper it's printed on is worth, and to put it next to a commodity with real value simply reveals that truth.

Bernanke on Financial Innovation

While there are legitimate financial innovations, e.g. the stock market, options, shorting stocks - many financial innovations are merely more sophisticated ways to gamble or rip someone off.

Fed chair Ben Bernanke offers an interesting argument about three financial innovations that he considers worthwhile and important. These are: credit cards, mortgages, and bank overdrafts.

There is a certain wolf-in-sheep's-clothing aspect to Bernanke's speech.

He says, in effect, gosh, some of these financial innovations haven't gone all that well. It's very challenging for regulators, because on the one hand, we don't want to stifle innovation, because that makes all our lives better. On the other hand, sometimes things get out of hand, we ought to consider how these innovations will react when they are "stressed", and recognize that regulation may be needed. Who could argue with these mild-mannered banalities?

Yet if we step back and ask the question, why should the Fed have a role to play in preventing people from getting fleeced? That doesn't seem like the Fed's role. People get ripped off all the time. It seems to me that a better defense against that than the Fed could ever be is this device called the internet. It sure seems like a great way to spread information to other consumers not to do things that end up being a huge rip-off.

And why would the Fed place restrictions on financial activity at all? We already have laws against fraud. What else is needed?

We have to recognize that the Fed has an impossible task: to prevent a house of cards from collapsing. The fractional reserve system is fundamentally insolvent. This is what creates a danger to financial stability in the first place. The reason that somebody not paying their mortgage may mean I lose my job is because banks are running the biggest fraud in history, an epic pyramid scheme that makes Bernie Madoff seem insignificant. And the job of the Fed is to oversee this fraud, to make sure that we keep it up, to continue to shovel an ever-increasing share of society's surplus value into the coffers of the banks. This is why it strikes me as rather disingenuous for Ben Bernanke to worry that complex mortgage products may not ultimately help the consumer. Talk about dodging the real issue.

Ron Paul Grills Bernanke

Here's a good video of Ron Paul giving Fed chair Ben Bernanke the business.

Much has been said about how Ron Paul sounds crazy, conspiratorial, etc., but at least he's up there questioning the economic guru of the day.

Ben Bernanke firmly believes that the reason the Great Depression happened was that the Fed did not act aggressively enough, and allowed monetary policy to tighten, worsening the Depression. In fact, the Fed was quite aggressive. Consider that the Fed flooded the banking system with liquidity, raising the money supply by 10% in a single week. However, this was counteracted by the contraction in bank lending, because banks were in the process of deleveraging.

If that doesn't sound familiar, it ought to.

The very same thing happened in the Fall of 2008. The money supply actually tightened, despite the Fed creating massive amounts of money and injecting it into the system. This is because the money supply is not controlled directly by the Fed, but rather it's a product of the fractional reserve system. If banks lend less, the money supply falls, perhaps as much as $10 for every $1 fall in lending. That's the magic of the fractional reserve system. Banks create and destroy money, and the process is not under the direct control of the Fed.

Did the Oil Boom Cause the Recession?

There are several recent papers which make the argument that without the oil price boom of 2007-08, there wouldn't have been a recession. James Hamilton says "I don't quite believe the conclusion myself."

These papers make some interesting points, and there certainly is a connection between rising expenditures on gas and falling consumer spending. That said, I don't find it persuasive that rising oil prices "caused" the recession. The primary cause of the recession is the bursting of the artificially induced credit bubble. What caused that bubble was the rapid expansion of the money supply, which is always the ultimate cause of bubbles. There is only one way that stocks can outpace overall productivity growth over a long period, there's only one way that any asset can become outrageously overvalued without coming under pressure from short sellers and that is money creation.

Great New Proposal by Kotlikoff and Leamer

Professors Kotlikoff and Leamer offer a bold yet simple way to reform the banking sector in their article in Forbes entitled A Banking System We Can Trust.

This is the most important proposal I have yet seen in the mainstream press to reform the financial system. Unlike the other plans I've seen, it would actually work, for it would end the fractional reserve banking system, while preserving the function of banks, which is to serve as a conduit for savings to flow to investment. Kotlikoff and Leamer call it "Limited Purpose Banking".

Everyone who is concerned about the financial crisis should read this article. I hope that policymakers and my fellow economists take heed.

There is one further step I'd suggest to protect the financial stability of the banking sector: tie the value of the dollar to a commodity. In an earlier post, I outlined a plan to do this. A commodity basis is necessary for the dollar to serve its function in the long term, which is to provide a stable store of value to facilitate trade and investment. Because the Federal government seems to run on deficit spending, it has tended to escape the discipline that commodity money imposes. But an escape from that discipline is only found in inflating the money supply, which cannot work in the long term.

Karl Case on Real Estate (and Banking)

On 3/31/09, me and a few dozen of my economics professor colleagues tuned in to a webcast by Karl Case, co-creator of the Case-Shiller Home Price Index. He told an interesting story of how the housing market came to be constructed, how home prices became collateral for all kinds of other assets, and how the smartest statisticians on earth could have been wrong about default rates on subprime mortgages, since they were deceived by a 30-year long real estate boom. I liked his story of the real estate bubble, though I think he missed the primary cause, the only logical reason why housing could become hideously overvalued: money creation.

I questioned him on the connection between fractional reserve banking and the housing bubble. His response showed how little he had thought about banking. "There's no need to destroy the entire credit system and bring lending to a halt," he replied.

I understand that response, for I thought much the same a few years ago, before I began to research the issue. Banks are a major conduit through which savings become investment. It is an economic necessity that such a conduit exists, but it is far from the only one. When corporations issue stocks or bonds, for example, savings become investment. (Assuming the corporation uses the money it raises for investment and not some other purpose.)

If we insist that banks are honest and do not permit them to engage in fraud, it does not mean that there will be no credit system and no lending. It simply means that lending will be done on a basis that is absolutely solid and does not involve the fraud and instability of the fractional reserve system.

The great American economist Irving Fisher showed this quite clearly in his 1935 book 100% Money. Murray Rothbard argues for the same thing in his article The Case for the 100% Gold Dollar. A full reserve system would not destroy banking, nor would it end credit. Banks would be restricted to lending only from bonds they would issue specifically for the purpose of investment. People who bought such bonds would know that they are taking a risk, sacrificing liquidity for a return. No lending from demand deposits (checking and savings accounts) would take place.

Full reserve banking would not end credit, it would simply make the credit system rational, functional, and morally sound.

Inflation Coming Soon

Wow. Greg Mankiw has written an unusually provocative argument in favor of inflation, even outright monetary destruction. Addressing the problem that the Fed can only push rates to zero, (and if that doesn't stimulate lending, what will?) he writes:

Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.

That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.

I am shocked by how reckless his proposal is. Unbelievable. The way out of the financial collapse is to basically render useless one-tenth our money. (As Mankiw no doubt realizes, in practical terms this wouldn't work, since the overwhelming portion of the money supply is not attached to paper notes. Only about $800 bil of the money supply is paper currency, while M3, the broad measure of the money supply, is nearly $15 tril)

Imagine if stimulating the economy were as easy as Mankiw suggests. If destroying 10% of our money is this good, why not destroy 50%? Why not simply build immense fires and burn all our paper Federal Reserve notes that we call money? What a fantastic stimulus that would be.

Destroying money through inflation will not cause a stimulus of any kind, it will cause chaos. Inflation introduces distortions into the economy. Businesses cannot easily calculate future returns; inflation transfers money from worker to employer, from saver to borrower, from the poor who tend to be far away from the money-generating mechanism, to the wealthy and well-connected, who tend to be nearer to the source, and hence can spend their income before prices rise.

Because Greg Mankiw is a towering figure in the economics establishment (professor at Harvard, chair of the Council of Economic Advisors under Bush, influential blogger and textbook author), and because this interesting article appears in the NY Times, (where it is immediately heralded by Paul Krugman) I suggest that Mankiw is striking a chord that will resonate with the central banking and political establishment, which no doubt sees the logic of inflation.

Though the CPI indicates that deflation has been our recent history, that will not last under a determined attempt to produce inflation. Remember, the Fed can print money and drop it from Helicopters. The Fed can write the US government a check for a trillion dollars. (The Fed can even write me a check for a trillion dollars, but I'm afraid I will not stop blogging.) If the Fed wants inflation, the Fed will get inflation. Mankiw simply says what needs to be said to ease the way toward that inflation.

By the way, it is completely wrong to say that inflation will stimulate bank lending. Banks are extremely reluctant to lend under inflationary conditions, unless interest rates are fully flexible, indexed to inflation and all other relevant conditions. Does that sound familiar? That is what an adjustable rate mortgage is all about. But even if rates are fully adjustable, there are two additional problems:

1) what if raising the rate high enough to cover the bank and ensure that the loan is profitable destroys the borrower?

2) how many borrowers are willing to borrow with such uncertain costs of borrowing?

If inflation was such a reliable way to stimulate bank lending, Zimbabwe would've become the world's banker, instead of the world's most recent example of the failure of central banking.

Within a year, we'll see double-digit inflation rates.

FASB Suspends Mark-to-market Accounting Rules

And the market loves it! The Dow is up 270 points as I write this. (Here's a link to a WSJ article on this development.)

Well, we should have known that with the steady drumbeat of analysis (examples here, here, and here) blaming the financial crisis on mark-to-market accounting that this would eventually happen.

Unbelievable. It is absolutely absurd to blame the financial crisis on mark-to-market accounting. What causes banks to suddenly realize that they have solvency problems is that they are insolvent every single day of every year; it's only that a dip in asset prices causes them to worry about it for the first time. Modern banks run on the fractional reserve system. During a credit boom, market competition pushes banks to decrease their reserve ratios, for this is key to higher profits. The Fed tends to look the other way as banks move assets around to avoid mandatory reserve requirements (either 10% or 3% depending on the size of the bank.) According to Fed data, aggregate bank reserves fell to 0.74% of bank deposits, showing that banks are adept at getting around mandated reserve ratios. (Reserves have exploded since the fall of 2008, showing the fear that has struck the banks.)

Allowing corporations more flexibility to value their assets (i.e. facilitating wishful thinking or outright deception) will not make this crisis go away, it will prolong it. The crisis will be over when markets clear. That requires accurate information, not opacity.