Saturday, April 25, 2015

My letter to the WSJ re: Austrians understand why there is a commodity glut

Re: Glut of Capital and Labor Challenge Policy Makers

Dear Sirs:
The worldwide commodity glut is not a surprise to Austrian school economists. It is a wonderful example of the adverse consequences of monetary repression to drive the interest rate below the natural rate. Longer term projects, such as expansion of mineral extraction, appear to become profitable. But such is not the case for the simple reason that printing money does not represent an increase in real, saved resources. Eventually it will be clear that capital has been wasted, what Austrian school economists call "malinvested". No amount of further monetary repression can cure this problem, although I am certain that the Keynesian school economists in charge of central banks and governments all over the world will give it a good try. Akin to bleeding the patient until he recovers, we may not survive this Keynesian medicine.

Wednesday, April 22, 2015

Critiquing a Monetary Reform for Iceland

The Prime Minister of Iceland recently commissioned a report by Frosti Sigurjonsson (henceforth referred to as "Mr. S") to recommend a better money and banking system for Iceland. (I'm sorry, but isn't Frosti a great first name for someone from Iceland!) The recently released report recaps Iceland's sorry history of money and banking disasters and lays the majority of the blame for the 2008 collapse on the institution of fractional reserve banking, which caused an out of control increase in the money supply. Mr. S recommends its abolition. For this I applaud Mr. S and hope that the prime minister accepts the report and urges the Icelandic legislature to act upon it.

My endorsement of the report's primary recommendation does not mean that I believe that Mr. S fully understands money and banking from an Austrian perspective. Nevertheless, his recommendation, limited as it is, is a huge step in the right direction. To this extent it is compatible with my recommendations, delivered at the recent Mises Canada's "Prices and Markets" conference, that called for the abolition of fractional reserve banking, the separation of deposit and loan services, and an end to deposit insurance. Mr. S recommends the same for Iceland.

Mr. S is correct that the central bank lost control of the money supply in the years leading up to 2008 as the banks leveraged their excess reserves into new loans, which created new deposit money out of thin air. Sounding very much like Weimar Republic and Zimbabwean central bankers, he states that it was the duty of the Central Bank of Iceland (CBI) to "provide banks with reserves as needed in order to not lose control of interest rates or even trigger a liquidity crisis between banks." He accuses the banks of lending for speculative rather than worthwhile purposes, whereas he has no such concern over government control over this powerful economic lever. He is confident that the central bank would expand and contract the money supply in a fashion that would be beneficial to all society and that government would spend new monies only for purposes that would benefit the nation. Whew!

The resultant monetary regime in Iceland would be very similar to that of America during our Civil War (1861-65), when the North introduced fiat paper money. The Greenbacks--so named due to their color on one side--were pure irredeemable fiat monies issued by the Treasury Department. At that time America had no central bank, thanks to the foresight and courage of President Andrew Jackson, who was able to block the renewal of the charter of the Second Bank of the United States in 1837. When the North won the war, it did eventually buy back the Greenbacks for gold. The lesson here is clear--one of the main reasons that governments debase money is to fight wars. The North found it impossible to finance the war with taxes and honest debt, so it resorted to confiscation via the monetary printing press. Are Iceland's leaders any different? They may not want to fight a war, although they did get into a naval shoving match with Great  Britain in the 1950s through 1970s over fishing rights, the so-called "Cod Wars". So one never knows.

Mr. S believes that government needs the power to introduce new money to meet the needs of an expanding economy and that the central bank and government will do so for the good of the nation as a whole and not for private purposes. At a minimum he believes that the money supply must expand in order for the economy to expand. In this regard he is a full-fledged Friedmanite, who little understands the adverse impact of even a low level of money growth on the structure of production. On the contrary, he sees money growth as necessary for economic growth and has full confidence that government will spend any newly created money only for good. It is obvious that either he's never heard of public choice theory or does not subscribe to its conclusions. Really, who today believes that government, which after all is manned by some of the most fallible humans in society, can (1) be completely altruistic in its spending decisions and (2) would know what is best anyway? I refer Mr. S. to F. A. Hayek's wonderful Nobel speech in which he clearly articulates his theory of the pretence of knowledge.

Mr. S concludes his proposal with a call for what he terms the "sovereign money system". Right away we know that he is not an Austrian when he states "The CBI will create enough money to promote the non-inflationary growth of the economy." He would separate money creation from money allocation. A money creation committee would decide how much money to create and then the parliament would decide how to spend it. New money would serve five purposes--fund new government spending, reduce taxes, pay off the public debt, provide a citizen bonus, and increase lending to business. Money would not be backed by debt, but would be a sovereign asset created at will. The proposal does remove the ability of banks to increase the money supply through the lending process. All to the good so far. But it transfers this power to government. It allows government to spend what it wishes, as long as the money creation committee goes along, by counterfeiting whatever amount is desired. Government would not be required to increase taxes or issue new debt. Halleluja! A counterfeiter's dream! Also a government dream. Somehow I have little confidence that the money creation committee will not go along with whatever spending plans the parliament desires, a sure path to hyperinflation.


Be that as it may, I hope that Iceland implements that aspect of Mr. S's proposal that requires banks to maintain one hundred percent fiat reserves on checking accounts. Then separating deposit banking from loan banking would negate the need for deposit insurance. Perhaps Iceland's central bank and government will exercise their money printing power with discretion long enough for the rest of the world to see the benefits of abolishing fractional reserve banking and moving to a one hundred percent fiat reserve system. After that we can fight the next battle--prohibiting central banks from expanding the fiat money supply and then finally tying money to specie at a legally enforceable ratio. At that point money production can be turned over completely to private hands and the central bank abolished.

Sunday, April 19, 2015

My letter to the WSJ re: One trillion dollars, not $200 billion

Re: China Central Bank Cuts Reserve Requirement

Dear Sirs:
Your statement that the reserve requirement cut to 18.5% by the PBOC will free up $200 billion for new lending probably is understated. Assuming that the $200 billion refers to new excess reserves (admittedly, not made clear), the amount of new lending that can be supported by this action is just over one trillion dollars--the additional reserves divided by the new reserve requirement.

Friday, April 17, 2015

My letter to the NY Times re: Please, make me unemployed!


Dear Sirs:
I find it incredible that anyone, especially the vaunted New York Times, would treat with respect the fallacious concept that pay can be set arbitrarily--and enforced by the police power of the state--at whatever level is desired by workers. Arbitrarily raising the price of anything will reduce its demand. This is economics 101, and it applies to labor just as it applies to any other good or service. These workers may as well be chanting "Please, make me unemployed!".

Thursday, April 2, 2015

What's so great about the new Asian Infrastructure Investment Bank?

Recently a friend sent me the updated Wikipedia link about the newly formed Asian Infrastructure Investment Bank that has been in the news so much, mostly gathering glowing endorsements that this is a great undertaking.

Asian Infrastructure Investment Bank

OK. I may be the only person who is critical of this so-called bank. After all, every nation seems to be jumping on this bandwagon, except the US and Japan. And that's my problem with the bank--that it is funded by governments and not private capital. Now maybe the US and Japan are not "investing" in the new bank for the wrong reasons, such as the fact that they won't be able to make all the decisions. Perhaps that is why so many of the world's governments are funding this new bank--they want to make all the decisions. But that doesn't mean that forming a new bank is a wise decision. I am also critical of the World Bank, IMF, and Asia Development Bank. These so-called banks are funded by governments who get their funds either through coercively obtained taxes or money printing. Investment decisions will be driven by political considerations, because those who make the investment decisions are not putting their own money at risk or that of private investors to whom they are answerable. Governments cannot make rational decisions about investment, because they do not possess a hierarchy of spending preferences that can be formed only from actually owning investment resources personally. So why does anyone believe that another government funded investment bank can guide development better than private individuals? Furthermore, the so-called experts cannot know that Asia "needs" $8 trillion in new and better infrastructure. This is a meaningless statement, because "needs" is a subjective term. (I've been trying to convince my wife that I "need" a new set of golf clubs, but she is rightly skeptical.)

Here's my prediction: the AIIB will turn into just another socialist and crony capitalist boondoggle, enriching political elites and their friends while funding projects that lose money. Can anyone say "Chinese ghost city"?


I would welcome responses that take me to task for being so critical. Maybe I'm missing something.

Sunday, March 29, 2015

How money creation threatens hyperinflation

In order to understand the relationship between money creation and the price level, we first need to get some definitions straight.

To Austrians the terms inflation and deflation refer to money and not prices. There is no doubt that money has experienced unprecedented inflation. In February of 2010 base money was $2.1 trillion. Four years later it was $3.8 trillion. In the same time frame, M1 has increased from $1.7 trillion to $2.9 trillion. M2 has gone from $8.5 trillion to $11.7 trillion. Excess reserves have doubled from $1.2 trillion to $2.4 trillion. (Please keep in mind that prior to 2008 excess reserves seldom were more than a few BILLION dollars, which is effectively zero and represented mostly the aggregate of excess reserve cash in thousands of community bank vaults.)

To Austrians changes to the price level, what the public incorrectly calls inflation and deflation, are the result of changes to the aggregate demand for consumers' goods and the aggregate supply of consumers' goods. Think of a simple ratio with the numerator representing demand and the denominator representing supply. Notice that an increase in supply will cause the price level to fall. Aren't we all happy with this? I am. Or a decrease in demand will cause the price level to fall. There can be many causes of a decrease in demand--a fall in the money supply due to bank failures, a change in subjective time preference to save more, or a rational desire to hold more cash during times of uncertainty. None of these are bad for the economy per se. Whatever the cause, the antidote to a fall in demand is falling prices. The relationship between supply and demand must be re-established.

The point I am trying to make is that it is fruitless to attempt to prop up prices with more money creation, as the unprecedented increase in all categories of money in recent years has shown. In fact, excess reserves represent the potential for a massive increase in the money supply. The ratio of mandatory reserves to M1 is around 3%. The ratio of mandatory reserves to M2 is around 1%. Just do the math to find out the mathematical potential increase in the money supply should the banks eventually be able to convert excess reserves into mandatory reserves via the lending process. Keep in mind that this is exactly what the government WANTS banks to do; i.e., make more loans to supposedly stimulate the economy. An increase in the demand for goods of this magnitude, the numerator of our simple equation, would cause the price level to skyrocket perhaps to hyperinflation levels.

Therefore,digging even deeper into our problem, one finds that legal tolerance for fractional reserve banking is at the heart of the problem. Fractional reserves allow banks to create money out of thin via the lending process. Instead of funding an increase in loans by an increase in real savings, loans are "funded" by...well...nothing. This triggers the Austrian business cycle. Production, the denominator in our simple equation, falls. When supply falls, prices rise. Creating even more money will not help the situation, only exacerbate it.

Hyperinflation is a cancer that lurks in our monetary structure. Time to surgically remove it before it metastasizes.