Krugman advises repeat of blunders of the 1920's and '30's

Re:  Those Depressing Germans, by Paul Krugman

Dear Sirs:
Paul Krugman's Keynesian view of the world has caused him to champion two of the most damaging economic policies of the 1920's and '30's--monetary stimulus and national autarchy.  His incessant call for stimulating what he sees as inadequate demand perpetuates the very economic doldrums that he wishes to end.  Central bank money printing has caused the financial dislocations that have resulted in the the euro-debt crisis.  Calling Germany's production of highly sought and attractively priced goods as "beggar thy neighbor" policy would have been applauded by those giants of economic autarchy, Mr. Smoot and Mr. Hawley of worldwide trade destroying fame.  Rather than the cause of the continuing economic crisis in Europe, Germany is its biggest victim.  As Mr. Krugman accurately stated, German capital initially financed large deficits in southern Europe, meaning that it paid the Greeks, etc. to buy German goods.  What a deal!  And now it is shipping the fruits of its industry to these same nations and being paid in ever depreciating euros.  Its TARGET2 balance at the European Central Bank offsets huge unfunded deficits by those same southern Europeans.  Germany is importing inflation; it is not beggaring its neighbors.

Why Basel III will fail and isn't necessary anyway

Last week I "attended" an online webinar about Basel III's proposed new liquidity requirements for banks.  My goal in attending the webinar was to get a general idea of how difficult it would be for banks to understand the new regulations and comply with them.  Plus, I wanted to assess the likely impact Basel III would have on bank operational costs and earnings.

Let's cut right to the chase.  These regulations are extremely complicated, to my mind almost incomprehensibly so.  The narrated presentation of forty-five very busy slides contained many caveats that certain provisions were unclear and/or still unresolved and were awaiting industry comments before final publication.

This webinar focused not on capital requirements, which were addressed at Basel I in 1988 and again at Basel II in 2004, but on liquidity requirements.  Whereas bank capital is viewed as the ultimate guarantee of final payment of a bank's liabilities, should its assets deteriorate, liquidity addresses the ability of a bank to quickly meet the demands of depositors for immediate redemption of their deposits.  Yes, folks, what if there is an old-fashioned run on the bank and everyone wants his money right now?  Can the bank honor its obligations...not tomorrow, or next week, or next month...but today?  Basel III attempts to create a framework for banks to evaluate the quick liquidity of their short term assets in relation to their short term liabilities and set minimum liquidity ratios .  When viewed in this context, an Austrian economist immediately sees that Basel III is trying to compensate for the inevitable weakness of fractional reserve banking and the mixing of deposit banking with loan banking.

Fractional reserve banking allows banks to create money out of thin air through the lending process.  When a bank obtains new reserves, for example from a new deposit, its reserve account at the Fed is credited for the full amount of the deposit.  However, under fractional reserve banking, the bank need maintain only a fraction of the deposit as reserves at the Fed.  Let us assume that the reserve ratio is ten percent and the bank receives a new deposit of ten thousand dollars. The bank need keep only one thousand dollars as reserves against this ten thousand dollar deposit.  Although the bank of first deposit can safely lend only nine thousand of this new ten thousand deposit, the banking system as a whole can lend out one hundred thousand, the reciprocal of the reserve ratio multiplied against the new reserve.  (1 / 10% reserve rate X $10,000 in new reserves = $100,000 total increase in fiat money)

Today's "effective" reserve ratio is not ten percent but just over one percent!  (Required reserves of $120 billion support $10.819 trillion of M2, the broadest measure of money.)  Although before 2008 excess reserves in the banking system were very minimal--seldom more than two billion dollars--as a result of the Fed's quantitative easing programs the banking system currently holds $2.214 trillion in excess reserves.  These excess reserves represent a potentially massive increase in the money supply, for as banks seek to maximize their profits via increased lending, they turn excess reserves into required reserves.  This process may take awhile, but there is no reason for the banking system to keep excess reserves.

This pyramiding of new money on top of a small ratio of reserves causes disequilibrium  in the time structure of production.  The lower interest rate required to increase lending makes previously unsound investments appear to be sound.  Most of these are long term investments for which the cost of money is a major factor.  Since these long term investments are not funded by a real increase in saving, there are no real resources freed for their completion.  Eventually they will be liquidated.  At that point the entire pyramid of new money collapses upon the banks in the form of loan losses.  The banks now have "illiquid" assets with which to honor their deposit liabilities.

Notice that Basel III does not address this core problem.  Capital has been destroyed by fiat money creation by sending it to stages of the structure of production that will never become profitable.  This capital, on the banks' books in the form of long term bank loans, cannot be used to meet Basel III's onerous liquidity rules because it no longer exists.  Basel III regulations attack the symptom and not the cause of the disease--fiat money expansion.  However, we can be assured that the politicians and the bureaucrats will host Basel IV and give it a good try!

The only protection against money pyramids and their subsequent collapse is sound money, money back one hundred percent by reserves. This requirement would apply to bank notes, token coins, and bank book entry (checking) deposits.  What we today call banking is a mixture of the melding of deposit banking and loan/investment banking.  Murray N. Rothbard described such a system decades ago in The Mystery of Banking.  Deposit banking is the safekeeping of reserves and the production of efficient money transfer systems--checks, automated clearing house payments, paper notes, token coins, etc.  None of these systems are money per se; they are fiduciary media, representing reserves held in safekeeping at the bank.  The deposit side of the bank maintains one hundred percent reserves against its notes and checking accounts.  Deposit customers pay fees for safekeeping and money transfer services.  Real reserves cannot be destroyed, so real money cannot be destroyed.  Thusly, real money cannot cause money pyramids which must collapse.  Under a sound money regime, the only liquidity regulation required is that the bank always maintain one hundred percent reserves to back its fiduciary media.  This is the job of an audit firm, not the job of a sophisticated bank consulting company.

For those banking customers who desire to employ their excess funds to earn an interest return, the loan/investment side of the bank serves as an intermediary; i.e., the depositor lends his excess funds to the banker who relends it at a high enough interest rate to pay for the cost of his services, the interest cost to the depositor, and a provision for possible loan losses.  The bank's deposit customer, who now is an investor in the bank, has no guarantee of the return of his funds aside from the size of the banker's capital account and his reputation for making good loans.  The loan banker need practice simple asset/liability management, ensuring that his loans mature according to the same schedule as his deposits.  The loan bank's customers cannot withdraw their money before the end of the agreed upon term, unless the banker offers to do so at a substantially penalty to the depositor.

The important point is that when money is transferred from the deposit bank account to the loan bank account and subsequently to the loan customer no new money has been created.  The supply of money has remained the same throughout; the only thing that changed is who has temporary ownership of it.  There is no need for Basel III.  There is no need for special bank regulations and, thusly, no need for regulators.  Banking becomes simply another business that is subject to normal, everyday commercial law.  If auditors find that the deposit banker has failed to maintain one hundred percent reserves, the banker is subject to prosecution for criminal fraud and the confiscation of his personal assets to honor his deposit obligations.  There can be no guarantee of the full return of the depositor's money from the loan side of the bank, just as no one can guarantee that a bond or stock will retain its value.

Sound Rothbardian banking eliminates monetary inflation and the boom/bust business cycle along with the imbedded expense to pay for a great deal of unneeded regulatory compliance.  Loan interest rates would fall as a result of falling bank operating expenses and loan losses.  Sound money would reduce the inflationary premium currently built into bank loans to compensate them for being repaid in debased money.  Bankers could concentrate on their core business of finding and nurturing good borrowing customers, rather than satisfying the needs of regulators always fighting the last war.

Influential columnist perpetuates dangerous economic fallacy

Re: Southern Europe is on a precipice, by Ambrose Evans-Pritchard

The London Telegraph's influential economics columnist Ambrose Evans-Pritchard (AEP) perpetuates one of the greatest and most dangerous economic fallacies in the world today--that a country can improve its economic performance by debasing its currency. No country can force another, against its will or against its complicity, to subsidizing its economy. Yet that is exactly what AEP and almost all mainstream economists believe.

Here are selected quotes from AEP's latest muddle thinking:

"...China is exporting excess manufacturing capacity to Europe, or, in plain talk, exporting unemployment."

"...the euro has long been too strong for its own good."

 AEP bemoans falling prices:

"It (the euro) is pushing Europe’s crisis states into Thirties-style deflation, making it almost impossible for Italy, Spain and Portugal to dig their way out of debt."

In other words, AEP wants the deficit countries to be able to cheat their bondholders by paying off their bonds in depreciated money.

"They are one shock away from outright deflation."

Oh, the horrors to the common man of falling prices, which allow him to enjoy a higher standard of living!

"François Heisbourg, French head of the International Institute for Strategic Studies, is calling for the euro to be “put to sleep” in order to save the European project."

Put to sleep? Must we destroy the euro in order to save it?

Rather than export unemployment, cheapening one's currency imports inflation. Any increase in exports is fully paid by those already holding the currency. For example, by holding its yuan cheap against other currencies, China's non-exporting sectors subsidize its exporting sectors. This is simply an internal transfer of wealth. AEP and others see only the increase in the export side and ignore or have difficulty envisioning the cost to the rest of China's economy.

For a more detailed explanation of how cheapening one's currency works to a country's detriment, read my article titled Value in Devaluation?.

Oh, No! Falling Prices!

Re: Europe moves nearer Japan-style deflation trap, by Ambrose Evans-Pritchard

What a bunch of nonsense! If Japan had not initiated its famous bubble in the first place, it would not have to fear deflation and it would not still be experiencing zero growth from it incessant money printing to combat the bursting of the bubble. In any event, why does anyone, other than debtors, desire inflation? The world's biggest debtors are governments, who naturally wish to pay off their debts with debased money. The rest of us want honest money, which means falling not rising prices as productivity and the expansion of trade bring cheaper and cheaper goods to the real economy where we great unwashed must live. Now the ECB will interpret the reduced inflation (note that the EU still experiences some inflation, just not as high as the governments desire) as an excuse to continue to print money. Poor Ambrose...will he ever get it right? I doubt it.

Permanent Currency Swaps Will Make Matters Worse

Re: Central Banks Make Swaps Permanent as Crisis Backstop

Rather than backstop and mitigate a crisis, these currency swaps will cause the crisis to spread. This is a typical socialist solution, perpetrated by today's preeminent socialist institutions--central banks. Permanent currency swaps will cause a crisis to spread rather than mitigate its underlying causes. Dumping one currency for another is simply an indication of rational self-interest by those who understand reality.

Why the Fed will NEVER end Quantitative Easing

Re: Fed likely to delay taper after disappointing US jobs data

The Fed will NEVER end its Quantitative Easing program much less "taper" it slightly. The Fed's QE policy itself causes malinvestment in the structure of production, which leads to higher unemployment, among other evils. But the Fed believes that the very evils it causes require even more credit expansion, so it continues to pump reserves into a banking system already awash with excess reserves of $2.3 trillion (as of Oct 16, 2013, obtained from its own reports). So the Fed's justification for continuing QE is the result of its own QE policy! The American economy is right back in a bubble similar to that of ten years ago, only this time the economic data is worse, because the economy has had even more credit expansion poison. The longer the Fed continues QE the worse the malinvestment and the worse will be the inevitable and necessary recession/depression to cleanse the system. The real economy is getting further and further away from its sustainable structure of production, which only can be attained by the investment of real savings and capital accumulation in an economy with honest and not phony money.

Germany's Merkel wants the EU to control national budgets

From today's Open Europe news summary:

Spiegel: Merkel demands EU Treaty change to give Commission control over national budgets
Der Spiegel reports that, in a meeting with EU Council President Herman Van Rompuy last week, German Chancellor Angela Merkel set out her proposals for giving the EU greater powers over eurozone members’ national budgets, a move which would require EU Treaty change. Merkel will reportedly insist on legally enforceable contracts between the Commission and individual member states, setting out their obligations for maintaining budgetary discipline and improved competitiveness. In return, Germany could agree to a eurozone budget which would amount to tens of billions. Finally, the President of the Eurogroup would become a “Euro Finance Minister”.

Spiegel Online cites Axel Schäfer, deputy-chair of the SPD’s parliamentary group as saying that “the SPD will not support any settlements if Merkel conducts parallel negotiations with Britain’s David Cameron over the transfer of EU competences back to member states.” Schäfer also warns that the SPD will not support an EU Treaty changes that trigger referenda in individual member states.
Open Europe research: What to expect after the German elections Spiegel Spiegel 2 DWN Irish Times

What national government would ever agree to such a contract or honor it if it did? Merkel has shown the true colors of the euro-federalists; i.e., that the nation state must subordinate itself to an unelected supranational body, in effect a dictatorship of foreigners. As long as the EU exists the national governments will continue to raid the EU treasury, and they will NOT accept orders from Brussels and most certainly not from Berlin. Merkel should mind her own business, set a good example (which Germany HAS been doing!), and leave the rest of Europe alone. Germany should get out of the EU, open its borders to free trade, and reinstate the deutschmark. THIS is the way to lead!