If you are new to this blog, you are invited to read first “The Largest Heist in History” which was accepted as evidence and published by the British Parliament, House of Commons, Treasury Committee.

"It is typically characterised by strong, compelling, logic. I loosely use the term 'pyramid selling' to describe the activities of the City but you explain in crystal clear terms why this is so." commented Dr Vincent Cable MP to the author.

This blog demonstrates that:

- the financial system was turned into a pyramid scheme in a technical, legal sense (not just proverbial);

- the current crisis was easily predictable (without any benefit of hindsight) by any competent financier, i.e. with rudimentary knowledge of mathematics, hence avoidable.

It is up to readers to draw their own conclusions. Whether this crisis is a result of a conspiracy to defraud taxpayers, or a massive negligence, or it is just a misfortune, or maybe a Swedish count, Axel Oxenstierna, was right when he said to his son in the 17th century: "Do you not know, my son, with how little wisdom the world is governed?".

Friday 1 June 2012

Keynesian approach would not work


Last night on BBC HardTalk Prof Paul Krugman argued that to get out of the current economic depression western countries have to borrow more. "Borrow more to spend their way out of trouble", "solve the problem of excessive debt with more debt" arguments were justified by a classic Keynesian economic approach. They were bolstered by seemingly very convincing examples that the problem is that all the countries are trying to repay their debt at the same time and "my spending is your income, your spending is my income" therefore we devoid each other of income.

Is it convincing? What happens to money that is repaid as debt? If the banking system worked properly debt repaid would end up in the banks' vaults. It would be re-lent as banks do not sit on liquidity. Sitting on liquidity generates no income for them: it is a loss. Repaying public debt does not necessarily reduce overall debt but shifts the debt from the state to private investors who would turn it into viable economic activity. Keynesian approach stimulates the economy largely through consumer spending. Public spending cuts and debt repayment stimulate the economy through private investment. Typically the way out of any recession was through using a combination of both.

However at present banks are famously not lending. The system of money circulation slowed down enormously. This is the key to understand the cause of the current economic depression that politicians, mainstream analysts and policy makers and mainstream media completely fail to grasp. Starting with Keynesian approach, there is a validity in the arguments presented by Prof Krugman. When investors are not confident during downturns, they tend not to borrow and invest. This, in turn, slows down the economy. If the state steps in and spends money it jump starts the economy.

There is an assumption behind this process that Prof Krugman did not mention and it is never mentioned by those who advocate Keynesian approach (e.g. Ed Balls). This assumption is that in the background of the economy there is a healthy banking system that performs money circulation and multiplication function through fractional reserve banking. For example, if the state borrows and spends £10 billion, the money ends up in circulation through the banking system. Normally banks re-lend it and, depending on a loan to deposit ratio, this £10 billion is multiplied up to £60 - 80 or even £100 billion. Then the state has to collect back through taxes this initial £10 billion with some interest, to repay the original debt, but the rest stays in the economy.

Keynesian approach it is not a magic and has its dangers. Ultimately, if the state borrows and spends so much that economy cannot absorb it in a productive way, i.e. above the capacity to collect in taxes that should be at least as much as the costs of borrowed money, this results in inflation growth.

At present the banks are not lending: businesses want to borrow but the banks do not lend. They are not lending not because they do not want to - lending is in banks DNA, this is how normally they make money - but because they cannot. Ever since the banks abandoned the fractional reserve banking and started practicing depleting reserve banking*. at around of the turn of the century, the banks depleted their reserves and replaced them with toxic waste. The scale of this toxic waste phenomenon, which created a liquidity shortage, and the mechanism that keeps generating it through depleting reserve banking is enormous. On conservative estimate around $1 quadrillion figure or around 20 times the world's annual GDP. The problem is not only the scale but that it is self-perpetuating at exponential, run-away pace through depleting reserve banking. Therefore whenever money comes into banks it is kept there as a liquidity reserve and is also used to "redeem" some of this toxic waste into cash. Sometimes central banks are doing this directly by quantitative easing. (Banks need to pay for their rents, salaries, bonuses, etc.) This is often referred to euphemistically that banks are repairing their balance sheets.

Prof Krugman was wrong: Keynesian approach would not work in the current situation because the money spent would simply be sunk into banks and would do nothing to stimulate the economy. It would be another tranche of good taxpayers money thrown after bad. What is the way out then? It involves three steps:

Firstly sorting out the banks by explicitly stopping them practicing depleting reserve banking, i.e. perpetuating at exponential pace the existing and contingent liquidity hole. Incidentally depleting reserve banking is highly illegal at present as it is a classic case of a pyramid scheme. However this is completely ignored by the financial industry and we are seeing the effects of this the last 4 years. Thus far the politicians, mainstream analysts, policy-makers and media pundits staunchly defend what is - from technical and legal perspective - a criminal practice that brought upon the western economies the current crisis and keeps them in this, making things worse.

Secondly this should be accompanied by a systemic reform whereby all those in banking take a direct personal risk (civil and criminal liability) for their actions, banks should be deregulated and made compete in such a way that there would be no bank anywhere close to "too big to fail" situation. Simply reintroducing free markets into the financial industry with particular focus on eliminating moral hazard. Prosecuting under criminal law (for setting up and operating a pyramid scheme) all those who caused the current crisis and confiscating their (and their families') wealth would also act as an effective deterrent to the new "captains" of the financial industry. All of them would then think hard before they come up with any "financial innovation" (or as it was in the case of the current crisis a good old and crude pyramid scheme, incompetently disguised as a toolbox of financial innovations).

Thirdly debt reduction in order to reduce the money multiplier to a healthy level, between six to eight. This can be done through printing money, basically by inflation, or through debt restructuring, i.e. defaults. This is not a hard thing to do: the hard part will be to decide who should be losers and to what extent. But this problem, directly or implicitly, is inevitable so we may be better off resolving it in an orderly manner rather than through crude manoeuvrings like around the Greek debt which is simply a question whether the Greek taxpayer have to lose by being squeezed or the banks that lent to Greece (with full knowledge that Greece would not be able to repay the money in any event).

Only then will we have a luxury to discuss Prof Krugman proposal of stimulating the economy in a Keynesian way, through public spending. Or maybe it would be better if it is done through public spending cuts? If the banking system is healthy both will lead to economic growth. The former through consumer spending that will filter to investment, the latter through investment that will filter to consumers' pockets. And as ever, typically, it will be a proper balance that works.


* - more on fractional reserve banking and depleting reserve banking in "Computational complexity analysis of Credit Creation"


COMMENT: I do not hold a strong position how good (or bad) fractional reserve banking is in general. If practiced with loan to deposit ratio of 50% it looks very safe and stable. If practiced with loan to deposit ratio of 99% it is extremely risky and most likely the system would collapse. So it all depends how fractional reserve banking is managed. However depleting reserve banking is a pyramid, is always unsafe and indeed illegal.

16 comments:

  1. Thank you, you are always just so salient it is refreshing to read your analysis.

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  2. Keynesians seem to have a Black Swan problem, a prblem that they have not seen before, so it cannot exist. The banks are not lending to businesses even though the base rate is near zero. The way Western Banks make the money should be restored to morally acceptable, i.e the interst income and interest income only.

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  3. There is nothing unusal in banks not lending. In the 1930's the famous, "we have nothing to fear but fear itself" was aimed by FDR at the banks. The only person who addressed the issue back then was Dr. Hjalmar Horace Greeley Schacht. He fixed Germany's economy in two years. Most of the present bail-out money is off-shore anyway.

    Krugman is part of the racket.

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  4. Maybe the next tax return should issue every tax payer/voter/household with a £160,000 check to be deposited at a bank of their choice. There is then a real overnight 'Norway traffic light road system' reset of the banks accounts..personal debts (we include mortgages) are set against the new deposit, savings upto 80,000 are valid and then we hit the button. Some millionaires are wiped, some with debts greater than 160,000 are wiped out and no-one ends up with more than 240,000 in their account if they have the 'non-moral hazard' high-ground of no debts. Banking returns to real fractional reserve. Sure there are downsides but not a suck to the top that a population (society) can endure and mortgagees with no equity in their can keep upto an average house if they choose to buy it. Electorate, government and Banks discuss that order.

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  5. we all know what is wrong, but simply talking wont help. it is time for all people to act!

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  6. I'd be careful about saying that Vince Cable approves of any of your views. He is an arch socialist, big state apologist. He is also anti business, anti competition and pro Euro. The kind of guy who would make me reassess my views if he voiced agreement with any of them.

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    1. Hi Wooden Beds

      Vince Cable comment relates to my essay "The largest heist in history" only. So at least he approves of some of my views. (In fact I know that he disagreed with some of my views in the past, but I have no idea about now, not even whether he follows my blog.)

      I think your characteristics of Vince Cable does not look fair to me. Dr Cable is a business insider, he was the Chief Economist of Shell. So I think you should be a bit careful before you ridicule him.

      However it seems to me that you may have raised an interesting point on the current crisis. Many of those who do not reject the idea that the current crisis is a result of pure criminality (a pyramid scheme) tend to depart to socialist, big state arguments. Basically they turn what should be a technical and legal debate, respecting free markets, Adam Smith' concepts and rule of law, how to prosecute the criminals who caused the current crisis, into an ideological debate. Under ideological debate, criminality is argued as a respected but different approach to economy, and those who want to punish the criminals are seen as revolutionaries (and criminals are seen as their potential victims). It looks like a strategy to defend the criminals.

      Best, Greg

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  7. I agree with Greg in that the bankers should be seen as fraudsters and thus criminals and be prosecuted for theft and deception. The hard part is convincing anyone within the current status quo of their criminality, because the entire system has been captured by those who are conducting the theft. As I said several years ago, the bankers and politicians who are running the scam hand-in-hand will not prosecute themselves and this statement has been borne out by the complete lack of prosecutions in what has to be the largest theft of public money in history.

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    1. From technical perspective it is not hard to prove that bankers committed fraud. For example see the discussion comment section below: "Capitalism no longer exists; it's communism for the rich".

      However it will take some big changes, war, revolution, major unrest before we start seeing a meritocratic approach to the problem and some prosecution. Having said that the case of Fred Goodwin losing his "Sir" status shows that unthinkable may actually become a reality. We just have to keep discussion and democratic pressure going.

      Best, Greg

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  8. On a slightly different topic Greg... do you think that QE is just another name for an EU-style bailout? In what ways is it different/the same?

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    1. QE is a form of bailout that it does not show on the government balance sheets (i.e. it is not borrowed money). QE is just printing money and spending on "assets that the market cannot value" (as HM Treasury wrote to me), basically buying financial junk, toxic waste. Hence we will all ultimately pay for it through inflation (rather than taxation and debt repayment). If ECB prints money and buys the banks bonds it will be the same as QE here. Merkel is dead against it.

      Best, Greg

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  9. This comment has been removed by the author.

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  10. I think you are correct that stopping the banks exponential debt (money) creation is something that must be addressed. However, that will be very painful as there would be massive debt deflation.

    The idea from "runaway" above that "the next tax return should issue every tax payer/voter/household with a £160,000 check to be deposited at a bank of their choice" may sound crazy, but once you realise that nothing else will work, it doesn't sound quite so mad. Professor Steve Keen proposes something quite similar.

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    1. Let me put it this way: giving everyone £160,000 would not work provided there is a healthy banking system that will be able to circulate and expand this money from narrow money into broad money. (Of course in a way it was done, say, 20 - 30 years ago.)

      If under the current banking system everyone was give £160,000 this money would end up in banks and would be converted into junk (redeemed for toxic waste). So brief injection with no long lasting effect (a bit like the current QE).

      Best, Greg

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  11. Apologies as off comment - Why has UK press 'suppressed US credit agency downgrade of UK to AA minus from AA yesterday (June 4)? Posts elsewhere in UK press sites removed.

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    1. I do not know. Maybe because it was not one of a big 3 credit rating agencies and it is a Jubilee weekend here (still)? I am quite sure Labour will pick up on that. I cannot imagine Ed Balls missing this opportunity. We will see.

      Best wishes, Greg

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