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  1. Money Manufacturing How our Fiat Money System Works and Fails Dr David Evans November 2010

  2. 1. Introduction

  3. “Fiat” Money System? • Fiat currency:State-issued money whose value comes only from government fiat (Latin: let it be done) – legal tender laws. • Commodity currency:Money unit is a fixed quantity of some commodity. • The West converted from a commodity currency to a fiat currency in stages from 1914 to 1971. Cute but irrelevant

  4. Where Does Our Money Come From? • There is more money than there used to be. (A million dollars used to be a lot of money.) • So someone is manufacturing it (i.e. literally making money).

  5. Taboo Topic:Money Manufacture • Much of the economic conversation is at kindergarten level because hardly anyone knows how money is manufactured. • Do you know how money is manufactured? (Remember, most money is never cash, but just flows between bank accounts.) • Vaguely referred to by euphemisms in public (e.g. the economy is “overheating”)

  6. Money Manufacture Dominates the Economic Landscape • Interest rates • Bubbles • The GFC • Money is power: its manufacture plays a large role in determining which elites get to run society

  7. What if You Could Manufacture Money? • Would not have to work. • Produce the medium of exchange, instead of goods or services that others want. • Freedom! Material wealth! Buy almost anyone to do almost anything you wanted!

  8. Good News • No one can just legally manufacture money without consequence. • System is not that unfair. • Counterfeiting is illegal. • In legal manufacture, a matching liability is always created. Prevents gross exploitation of the manufacturing power. (nothing) $ -$

  9. Bad News • Some people have founds ways of capturing value from money manufacture, by second order effects. • They are wealthy, without working hard. • Historically, fiat currencies engender corruption and unfairness. • Fiat currencies usually die after one or two generations, 25 – 50 years.

  10. The Silence Is Speaking • Money manufacture is central to our economy, yet is rarely discussed. • Therefore those who manufacture money must: • Obtain advantage from it. (Otherwise why be quiet about it? If it was onerous or disadvantageous, they would complain.) • Be powerful enough to persuade the press, economists, and economics commentators to talk about it in euphemisms, if at all.

  11. Banking Isn’t Secret, But No One Tells You How It Works… • Banking thrives behind a wall of complexity, confusion, and misdirection. • Banking is a little too complicated for most people to grasp without a fair bit of effort. • Most of the time we just can’t be bothered, because the system appears to work well enough (and we are blissfully unaware of how it transfers wealth from producers).

  12. Henry Ford “ It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning.”

  13. 2. History

  14. Early Money • Barter • Inefficient • “Chunky” (no change) • Commodity Money • Gold evolved as the money of choice in most of Asia, Europe, Africa, and Central and South America • Used coins etc directly, until the middle ages • Representations of gold started evolving in Europe from 1300, widespread by 1700.

  15. Fractional Reserve Banking • Goldsmiths took gold deposits, issued receipts. • The receipts circulated as money, more convenient than the metal. • Goldsmiths learned they could issue more “receipts” than they had gold. • Lent out these extra receipts and charged interest on them (to cover risk of non repayment, and profit). • Typically safe to lend out 10 times as many receipts as gold deposits.

  16. Fractional Reserve – Example • Deposits with goldsmith: 200 oz of gold. • Issues receipts for these 200 oz. • Then issues receipts for an extra 1,800 oz. • Charges 5% interest on the extra receipts  income of 90 oz per year! • Goldsmith pays gold to anyone who presents a receipt, then destroys receipt. • Very profitable if everyone repays loans. • Borrowers need to find more gold to pay interest.

  17. Fractional Reserve – Features • Base money = gold • Bank money = receipts (cash, bank notes) • Bank money is created out of nothing, yet can buy stuff the same as gold. • Amplifies the base money by 10. • 90% of “money” is created by banks, by lending. • Depositor’s money is NOT lent out; they have access to their money at all times.

  18. Fractional Reserve – Problems • Creating something out of nothing unearned income, cheating, chicanery. • Fractional reserve banking was outlawed as immoral by many governments in the middle ages. • Private banks may not accept receipts from other banks  many bank “monies”. • Private banks can fail in a bank run. Depositors lose their gold, and the bank money they lent out becomes worthless.

  19. Fractional Reserve – Chicanery • Not enough money for everyone to repay debt with interest, unless money supply increases faster than the interest rate. • Private banks profited big time by manipulating the money supply: • Lend freely by low interest rates  increasing debt, money supply booms, economy booms • Raise interest rates (or cut off lending, e.g. 1894)  money supply busts, debts cannot be repaid, business failures allow banks to acquire or buy assets cheaply

  20. Fractional Reserve – Economic Problems • Money supply fluctuates, depending on amount of lending.  Fluctuating prices and interest rates. • Business cycle. • Unstable economy. • Creating something out of nothing causes economic distortions and misallocation of resources. Too much human effort spent on gaming the system, rather than producing good and services.

  21. The Banker’s “Solution” • A central bank: • Guarantees private banks against bank runs. • Homogenizes receipts into a national currency. • Tames the business cycle. • Gives bankers more power and profits. • Bank of England 1694, finally allowed by government under pressure of war. • US Federal Reserve 1913, 3rd central bank of the USA. Major issue in US history, e.g. Andrew Jackson’s main issue.

  22. Switched From Gold… • Using gold as base money constrains the money supply. • But governments often “need” more money. • Paper money issued by the central bank replaced gold as the base money, in stages from 1914 to 1971: • Gold standard unworkable after too many war bonds were issued in WW1. • Bretton Woods broke after US printed too much money in the 1960’s to fund the burgeoning welfare state and the Vietnam war.

  23. …To Fiat (Paper) • Gold was finally eliminated from the money system altogether in 1971 when President Nixon ended the last avenue of convertibility of paper money to gold. • The base money is now created without constraint by the central bank. • This base money derives its legal status and value from government fiat.

  24. 3. Manufacturing Today

  25. Today’s Money System • The current system is a fractional reserve system amplifying up a fiat base. • Combines two types of something-for-nothing (“cheating”): • Base money, created by the central bank. • Bank money, created by private banks. • Each form is unbacked. • Each form somewhat unstable historically. • What could possibly go wrong?

  26. Modern Base Money • Two forms: • Physical cash – Manufactured by a printing press or coin press. • Money in an account at the central bank – Manufactured by increasing the account balance on a computer. • Manufacture is technically unconstrained. • Moderated in practice by the desire of the central bank not to raise inflationary expectations too far.

  27. Modern Bank Money (1) • One form: • Money in an account at a private bank – Manufactured by increasing the account balance on a computer. • Manufacture subject to many constraints. • The private bank must have sufficient reserves of base money at the central bank at all times to cover its issued bank money  bank money amplifies base money, generally a bit over 10:1. • 90 – 95% of all money is bank money.

  28. Modern Bank Money (2) • New bank money is created by lending: amount of bank debt = amount of bank money • Interest is being paid on all bank money. • When a private bank manufactures bank money, it also effectively creates a matching liability. (nothing) Bank money Matching liability $ -$

  29. Modern Bank Money (3) • If the private bank’s liabilities exceed its assets (mainly performing loans) it must cease business. • When bank money is repaid to the bank as a loan repayment, it is destroyed. Bank money repaid Matching liability $ -$ (nothing)

  30. Bank Money Constraints (1) • Reserves can simply be borrowed. • Main constraints in practice are the Basel capital ratios, especially the Tier 1 ratio. • Tier 1 capital = Equity capital + retained earnings = Losses absorbable without having to cease trading • Assets = Loans, bonds, cash • Tier 1 Capital Ratio = Tier 1 capital / Risk weighted assets > 4% (although investors now demand 10%)

  31. Bank Money Constraints (2) • So a bank can create more bank money if it: • Makes less risky loans. • Raises more equity capital. • Increases depositor’s funds (minor). • Return on new bank equity capital in Australia last year was about 45%: • Raise $1 by issuing new bank shares. • Create $10 of bank money, charge interest of 6%, incur total costs of 1.5%. • Income is 10 * (6% - 1.5%) = 45%

  32. Bank Money Constraints (3) • Private banks do NOT lend out depositor’s funds, which are still available on demand. • Far more borrowers than lenders. • A private bank can also increase its lending simply by borrowing money at low interest rates (e.g. Japan, USA, or for short periods) and lend that same money at a higher interest rate – no money manufacture involved.

  33. Modern Money • Bank money represents base money, exchanged at 1:1. • Base and bank money kept separate within the banking system. • Most transactions just transfer bank money from account to account. • System gives some systematic advantage, which gives incentive to unsustainable build-up of debt and bank money.

  34. Monetization • When central bank buys stuff with newly created base money. • Can monetize anything, but usually bonds. • Modern money “printing”: • Treasury issues bonds. • CB buys them with newly created money. • Government spends that money. • Treasury pays interest to the CB, as per the bond repayment schedule. • QE2 buys government bonds on the open market instead (lowers interest rates).

  35. 4. Financial Bubble 1982 – 201?

  36. Monetary Experiment Starts 1982 • Novel money system started in 1971, with the switch to fiat base money. • 1970s dealt with inflation of 1960s. • Reset in 1980 by 20% interest rates. • New extreme monetary experiment: • Base money, created by the central bank • Bank money, created by private banks. • Both unbacked, created from nothing. • What could possibly go wrong?

  37. The Biggest Bubble, 1982 – 201? • Bubbles are due to excess money. • Prices are ratio of money to goods-and-services. So when there is more money, prices go up. • Operates sector by sector, as banks become willing to lend into that sector. • What happens when the central banks simply keep interest rates low until something breaks? 1929, 2012?

  38. The Debt-To-GDP Ratio • Modern money is (almost all) debt, so… • “Amount of money” = total debt • “Size of economy” = GDP • “Size of bubble” = Debt-To-GDP ratio • This is the financial story of our times…

  39. Housing Bubble Starts Greenspan: “Irrational Exuberance” GFC Tech Crash Clinton Strategy Starts 1987 Crash Bubble Starts Change to Fiat Base Money (Nixon) 235%, 1929 & 1987 crashes Gold peaks at 800 USD/oz Volcker 20% interest rates Karl Denninger,

  40. Gold peaks at 800 USD/oz Volcker 20% interest rates GFC Tech Crash -> Housing Bubble 1987 Crash 235%, 1987 crash 235%, 1929 crash Change to Fiat Base Money (Nixon) Clinton Strategy Starts Bubble Starts The longer view: 1870 – Q3 2009

  41. The Clinton Strategy • Clinton’s Problem: Government spending initiatives constrained by bond market. • Solution:Surreptitiously: • Lower Long Term Interest Rates. • Lower the CPI. • Suppress the Gold Price. • Result: Lower short and long term interest rates  extended a long bubble into the biggest, deepest, longest bubble ever.

  42. Gold peaks at 800 USD/oz Volcker 20% interest rates GFC Tech Crash -> Housing Bubble 1987 Crash 235%, 1929 crash 235%, 1987 crash Change to Fiat Base Money (Nixon) Clinton Strategy Starts Bubble Starts The longer view: 1870 – Q3 2009

  43. The Bubble Is Ending • World is running out of borrowing capacity: • Not enough income to service more debt • Debt = 400% of GDP • Interest rate = 4% • Interest repayments = 16% of GDP • World running low on unencumbered collateral. • Money manufacture by private banks stalled in 2008  Global Financial Crisis (GFC)

  44. Response of the Politicians • Stimulus programs: Public debt growth replacing private debt growth. • Base money manufacture by governments replacing bank money manufacture by private banks. • Politicians and public think the bubble was “normal”, that debt can grow forever. • Attempting to kick start back to “normal” with yet more debt.

  45. Political System is Clueless • Our politicians and economic commentators have little idea of: • Previous graph • How money is manufactured. • Totally surprised by the GFC, still have no idea what caused it. • Cargo cult: Create more debt and stimulus and the good stuff will resume.

  46. Paper Aristocracy in Control • Banking class laughing: • Profited mightily during the bubble (finance industry made 45% of ALL profits in 2006 with 5% of employees). • Bailed out and protected at the end of the bubble. • Know what is coming next: • Already own the next assets to do well. • Will acquire distressed businesses cheaply in the upcoming turmoil.

  47. 5. Next

  48. Essence of Problem • Money is a promise – of similar purchasing power sometime in the future. • Work is motivated by those promises. • Too much debt = Too many promises. • Promises cannot all be kept:not all debts can be repaid in dollars near current value. • Business as usual is not an option. • Like an average family that has run up $200k on credit cards. No way out!

  49. The Dismal Arithmetic • 1994 – 2007: Extra money (debt) added an extra 1 – 2 % to GDP, every year. • So 15 - 25% of growth was borrowed from the future. • To return the debt-to-GDP ratio to normal, must pay back that borrowed GDP growth  15 – 25% fall in GDP • Double depression!!

  50. Politicians Will Be Forced to Pick Speed of GDP Loss • The inevitable fall in GDP can be: • Quick – Two years, sharp deep depression brought on by deflationary deleveraging. • Slow – At rate of natural GDP growth. Stagnation for 10 – 20 years. • Hyperinflationary and messy. • Politicians will choose the route of least short-term pain  2. • But mismanagement could see 1 or 3.