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How the GDP Framework Creates the Illusion That By Means of Money Pumping the Central Bank Can Grow an Economy

HOW THE GDP FRAMEWORK CREATES THE ILLUSION THAT BY MEANS OF MONEY PUMPING THE CENTRAL BANK CAN GROW AN ECONOMY

In response to a weakening in the yearly growth rate of key economic indicators such as industrial production and real gross domestic product (GDP) some commentators have raised the alarm of the possibility of a recession emerging.

Some other commentators are dismissive of this arguing that the likelihood of a recession ahead is not very high given that other important indicators such as consumer outlays as depicted by the annual growth rate of retail sales and the state of employment appear to be in good shape (see charts).

Most experts tend to assess the strength of an economy in terms of real gross domestic product (GDP), which supposedly mirrors the total amount of final goods and services produced.

To calculate a total, several things must be added together. In order to add things together, they must have some unit in common. It is not possible however to add refrigerators to cars and shirts to obtain the total amount of final goods.

Since total real output cannot be defined in a meaningful way, obviously it cannot be quantified. To overcome this problem economists employ total monetary expenditure on goods, which they divide by an average price of goods. However, is the calculation of an average price possible?

Suppose two transactions are conducted. In the first transaction, one TV set is exchanged for $1,000. In the second transaction, one shirt is exchanged for $40. The price or the rate of exchange in the first transaction is $1000/1TV set. The price in the second transaction is $40/1shirt. In order to calculate the average price, we must add these two ratios and divide them by 2. However, $1000/1TV set cannot be added to $40/1shirt, implying that it is not possible to establish an average price.

 …click on the above link to read the rest of the article…

Do Banks Require Savings to Accommodate Demand for Lending?

DO BANKS REQUIRE SAVINGS TO ACCOMMODATE DEMAND FOR LENDING?

There is an emerging view held by many commentators that it is banks and not the central bank that are key for the expansion of money. This way of thinking is promoted these days by the followers of the post Keynesian school of economics (PK).[1] In a research paper by the Bank of England’s Zoltan Jakab and Michael Kurnhof, they suggest that

In the intermediation of loanable funds model of banking, banks accept deposits of pre-existing real resources from savers and then lend them to borrowers. In the real world, banks provide financing through money creation. That is they create deposits of new money through lending, and in doing so are mainly constrained by profitability and solvency considerations.[2]

It seems that for the researchers at the Bank of England and PK followers the key for money creation is demand for loans, which is accommodated by banks increasing lending. In this framework, banks do not have to be concerned with the means of lending, all that is necessary here that there is a demand for loans, which banks are going to accommodate i.e. demand creates supply.

According to the Bank of England researchers,

In the real world, the key function of banks is the provision of financing, or the creation of new monetary purchasing power through loans, for a single agent that is both borrower and depositor. The bank therefore creates its own funding, deposits, in the act of lending, in a transaction that involves no intermediation whatsoever. Third parties are only involved in that the borrower/depositor needs to be sure that others will accept his new deposit in payment for goods, services or assets. This is never in question, because bank deposits are any modern economy’s dominant medium of exchange.[3]

 …click on the above link to read the rest of the article…

The Ghost of Failed Banks Returns

THE GHOST OF FAILED BANKS RETURNS

Last week’s failure in the US repo market might have had something to do with Deutsche Bank’s disposal of its prime brokerage to BNP, bringing an unwelcome spotlight to the troubled bank and other foreign banks with prime brokerages in America. There are also worrying similarities between Germany’s Deutsche Bank today and Austria’s Credit-Anstalt in 1931, only the scale is far larger and additionally includes derivatives with a gross value of $50 trillion.

If the repo problem spreads, it could also raise questions over the synthetic ETF industry, whose cash and deposits may face escalating counterparty risks in some of the large banks and their prime brokerages. Managers of synthetic ETFs should be urgently re-evaluating their contractual relationships.

Whoever the repo failure involved, it is likely to prove a watershed moment, causing US bankers to more widely consider their exposure to counterparty risk and risky loans, particularly leveraged loans and their collateralised form in CLOs. The deterioration in global trade prospects, as well as the US economic outlook and the likelihood that reducing dollar interest rates to the zero bound will prove insufficient to reverse a decline, will take on a new relevance to their decisions.

Problems under the surface

Last week, something unusual happened: instead of the more normal reverse repurchase agreements, the Fed escalated its repurchase agreements (repos). For the avoidance of doubt, a reverse repo by the Fed involves the Fed borrowing money from commercial banks, secured by collateral held on its balance sheet, typically US Treasury bills. Reverse repos withdraw liquidity from the banking system. With a repo, the opposite happens: the Fed takes in collateral from the banking system and lends money against the collateral, injecting liquidity into the system. The use of reverse repos can be regarded as the Fed’s principal liquidity management tool when the banks have substantial reserves parked with the Fed, which is the case today.

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How Fractional Reserve Banking Contributes to Increases in Money Supply

HOW FRACTIONAL RESERVE BANKING CONTRIBUTES TO INCREASES IN MONEY SUPPLY

Some commentators consider fractional reserve banking as a major vehicle for the expansion in the money supply growth rate. What is the nature of this vehicle?

We suggest that fractional reserve banking arises because banks legally are permitted to use money placed with them in demand deposits. Banks treat this type of money as if it was loaned to them.  However, is this really the case?

When John places $100 in a safe deposit box with Bank One he does not relinquish his claim over the $100. He has an unlimited claim against his money. Likewise, when he places $100 in a demand deposit at Bank One he also does not relinquish his claim over the deposited $100. Also in this case John has an unlimited claim against his $100.

Now let’s assume that Bank One takes $50 out of John’s demand deposit without getting any consent from John in this regard and lends this to Mike. By lending Mike $50, the bank creates a deposit for $50 that Mike can now use.

Remember that John still has an unlimited claim against the $100 while Mike has now a claim against $50. What we have here that the Bank One has generated an extra spendable power to the tune of $50. We can also say that Bank One has $150 deposits that are Bank’s One liabilities, which are supported by $100 cash, which are Bank’s One reserves. Note that the reserves comprise 66.7% of Bank’s One deposit liabilities. This example indicates that Bank One is practicing fractional reserve banking.

Although the law allows for this type of practice, from an economic point of view, this results in money out of “thin air” which leads to consumption that is not supported by production, i.e., to the dilution of the pool of real wealth.

 …click on the above link to read the rest of the article…

Inflationary Financing and GDP

INFLATIONARY FINANCING AND GDP

This article demonstrates that only government borrowing in the US and UK drives GDP growth. This surprising conclusion is confirmed by long-run statistics. GDP does not represent economic progress, nor does it include the expansion of activity in the non-financial private sector, because that marries up with larger trade deficits, which are excluded from GDP. These findings have important implications for how the global downturn will be reflected in national statistics for the US and UK and the eventual prospects for the dollar and sterling.

Introduction

We tend to think of a nation’s accounts as being split between government and the private sector. It is for this reason that key tests of a nation’s economic sustainability and prospects for the currency are measures such as a government’s share of a nation’s economic output, and the level of government debt relative to gross domestic product.

While there is value in statistics of this sort, it is principally to give a quick overview in comparisons with other nations. For a more valuable analysis it is always worthwhile following different analytical approaches in assessing the prospective evolution of a currency’s future purchasing power.

Bald comparisons between government and non-government activity are a bad indicator of the true position. A more practical approach would admit that government finances are inextricably linked with the private sector. As Robert Louis Stevenson might have put it, a public servant is a Mr Hyde, who is a non-productive cost on productive society, while being a Doctor Jekyll spending his salary into the private sector as a consumer and contributing to a nation’s production in a demand role. The source of Mr Hyde’s income is the production of others, and increasingly his pay is made up by the debasement of everyone’s currency. Governments also spend money acquiring private sector goods and services, further distorting the overall picture. It all takes some untangling, a long way beyond a simplistic or conventional approach.

 …click on the above link to read the rest of the article…

The Bank’s ‘Stress’ Tests

THE BANK’S ‘STRESS’ TESTS

MY REPORT ON THE BANK OF ENGLAND’S LATEST (NOVEMBER 2018) STRESS TESTS WAS PUBLISHED BY THE ADAM SMITH INSTITUTE ON AUGUST 3RD.

The purpose of the stress tests is, in essence, to persuade us that the banking system is in good shape on the basis of a make-believe exercise which purports to show what might happen in the event of a supposed severe stress scenario as modelled by a central bank with a dodgy model and a vested interest in showing that the banking system is in great shape thanks to its own wise policies.

We are expected to believe that the central bank has managed to rebuild the banking system despite enormous pressure placed on it by the institutions it regulates, whose principal objective is to run down their capital ratios (or equivalently, maximise their leverage) in order to boost their returns on equity and resulting short-term profits, and never mind the systemic risks and associated costs imposed on everyone else or the damage their high leverage did in the Global Financial Crisis.

These latest Bank of England’s stress tests were published in the Bank’s November 2018 Financial Stability Report, the core message of which was that the UK banking system was doing just great, but that a No-Deal Brexit would be a disaster. Wrong on both counts.

I will focus here on the first issue, the state of the banking system.

In essence, the Bank paints a reassuring picture of bank resilience. The message is that the UK banking system is now so strong that it could sail through another crisis that is more severe than the last one and still be in good shape. How do we know this? Because the stress tests tell us, claims the Bank. However, the truth is that the Bank’s stress tests are useless at detecting bank fragility.

 …click on the above link to read the rest of the article…

Low Yield, No Yield, Negative Yield–Buy Now But Don’t Forget to Sell

LOW YIELD, NO YIELD, NEGATIVE YIELD – BUY NOW BUT DON’T FORGET TO SELL

  • The amount of negative yielding fixed securities has hit a new record
  • The Federal Reserve and the ECB are expected to resume easing of interest rates
  • Secondary market liquidity for many fixed income securities is dying
  • Outstanding debt is setting all-time highs

To many onlookers, since the great financial crisis, the world of fixed income securities has become an alien landscape. Yields on government bonds have fallen steadily across all developed markets. As the chart below reveals, there is now a record US$13trln+ of negative yielding fixed income paper, most of it issued by the governments’ of Switzerland, Japan and the Eurozone: –

Bloomberg - Negative Yield - 21st June 2019

Source: Bloomberg  

The percentage of Eurozone government bonds with negative yields is now well above 50% (Eur4.3trln) and more than 35% trades with yields which are more negative than the ECB deposit rate (-0,40%). If one adds in investment grade corporates the total amount of negative yielding bonds rises to Eur5.3trln. Earlier this month, German 10yr Bund yields dipped below the deposit rate for the first time, amid expectations that the ECB will cut rates by another 10 basis points, perhaps as early as September.

The idea that one should make a long-term investment in an asset which will, cumulatively, return less at the end of the investment period, seems nonsensical, except in a deflationary environment. With most central banks committed to an inflation target of around 2%, the Chinese proverb, ‘we live in interesting times,’ springs to mind, yet, negative yielding government bonds are now ‘normal times’ whilst, to the normal fixed income investor, they are anything but interesting. As Keynes famously observed, ‘Markets can remain irrational longer than I can remain solvent.’ Do not fight this trend, yields will probably turn more negative, especially if the ECB cuts rates and a global recession arrives regardless.

 …click on the above link to read the rest of the article…

For Those Who Don’t Understand Inflation

FOR THOSE WHO DON’T UNDERSTAND INFLATION

This article is a wake-up call for those who do not understand the true purpose of monetary inflation, and do not realise they are the suckers being robbed by monetary policy. With the world facing a deepening recession, monetary inflation will accelerate again. It is time for everyone to recognise the consequences.

Introduction

All this year I have been warning in a series of Goldmoney Insight articles that the turn of the credit cycle and the rise of American protectionism was the same combination that led to the Wall Street crash in 1929-32 and the depression that both accompanied and followed it. Those who follow statistics are now seeing the depressing evidence that history is rhyming, though they have yet to connect the dots. Understandably, their own experience is more relevant to them than the empirical evidence in history books.

They would benefit hugely from a study of the destructive power of the Smoot-Hawley Tariff Act combining with the end of the 1920s credit expansion. The devastating synergy between the two is what crippled the American and global economy. And as we slide into a renewed economic torpor, contemporary experience tells us the Fed and all the other central banks will coordinate their efforts to restore economic growth, cutting interest rates while accelerating the expansion of money and credit. The current generation of investors argues that this policy has always worked in the past (at least in the past they have experienced) so the valuation-basis for financial assets and property should stabilise and improve.

This brief summary of current thinking in financial markets ignores the fact that a catastrophic tariff-cum-credit-cycle mixture is baking in the economic cake. Crashing government bond yields, reflecting a flight to relative safety, are only the start of it.

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Debt, Deficits and the Cost of Free Lunches

DEBT, DEFICITS AND THE COST OF FREE LUNCHES

It seems that every generation or two, fundamental economic ideas are questioned and challenged. The reasonable and important idea that governments should balance their budgets on an annual basis was challenged in the 1930s by the rise of Keynesian Economics and the counter-argument that deficit spending was desirable, if it was used to maintain full employment. Now it seems that any defense or desire for fiscal restraint and less government spending and borrowing are entirely out the window. Fiscal folly is the watchword of the day.

It is not surprising that politicians care little about annual budget deficits and growing debt, since spending money is their way of buying votes from interest groups wanting to eat at the government trough. In America today, it is all a political game by which Democrats and Republicans pander to their respective voting blocs, especially in an upcoming presidential and congressional election year like 2020.

On the one hand, the danger of a looming political crisis is warned about in the media when they point to the coming budgetary circus that will most likely start playing out toward the end of the summer of 2019, when Congress comes back into full session and the new federal budget year that begins on October 1, 2019, will have to be handled in some way.

Budgetary Brinkmanship and Political Plunder

Will the country be facing another federal government shutdown threat like the one in late 2018 and early 2019? Will the national debt limit be raised to permit the spending of the huge sums of money needed to fulfill all the demands for other people’s money above actual taxes collected through the syphoning off of private sector resources by continued government borrowing in the financial markets?

 …click on the above link to read the rest of the article…

Should the Fed Tamper With the Quantity of Money?

SHOULD THE FED TAMPER WITH THE QUANTITY OF MONEY?

Most economists are of the view that a growing economy requires a growing money stock, because economic growth gives rise to a greater demand for money, which must be accommodated.

Failing to do so, it is maintained, will lead to a decline in the prices of goods and services, which in turn will destabilize the economy and lead to an economic recession or, even worse, depression.

For most economists and commentators the main role of the Fed is to keep the supply and the demand for money in equilibrium. Whenever an increase in the demand for money occurs, to maintain the state of equilibrium the accommodation of the demand for money by the Fed is considered a necessary action to keep the economy on a path of economic and price stability.

As long as the growth rate of money supply does not exceed the growth rate of the demand for money, then the accommodation of the increase in the demand for money is not considered as money printing and therefore harmful to the economy.

Note that on this way of thinking the growth rate in the demand for money absorbs the growth rate of the supply of money hence no effective increase in the supply of money occurs. So from this perspective, no harm is inflicted on the economy.

Historically, many different goods have been used as money. On this, Mises observed that, over time,

. . . there would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money[1].

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In Praise of Hayek’s Masterwork

IN PRAISE OF HAYEK’S MASTERWORK

Friedrich von Hayek first published The Road to Serfdom in 1944. His book was subsequently popularised by a condensed version in The Reader’s Digest. This article re-examines Hayek’s theme in the context of today’s economics and politics to see what lessons we can learn from it, and whether personal freedom can survive.

Why personal freedom is important and the treat to it

Destroy personal freedom, and ultimately the state destroys itself. No state succeeds in the long run by taking away freedom from individuals, other than those strictly necessary for guaranteeing individualism. And unless the state recognises this established fact its destruction will be both certain and brutal. Alternatively, a state that steps back from the edge of collectivism and reinstates individual freedoms will survive. This is the theoretical advantage offered by democracy, when the people can peacefully rebel against the state, compared with dictatorships when they cannot.

Nevertheless, democracies are rarely free from the drift into collectivism. They socialise our efforts by taxing profits excessively and limiting free market competition, which is the driving force behind the creation and accumulation of personal wealth and the advancement of the human condition. At least democracies periodically offer the electorate an opportunity to throw out a government sliding into socialism. A Reagan or Thatcher can then materialise to save the nation by reversing or at least stemming the tide of collectivism.

Dictatorships are different, often ending in revolution, the condition in which chaos thrives. If the governed are lucky, out of chaos emerges freedom; much more likely they face more intense suppression and even civil war. We remember dictatorships through a figurehead, a Hitler or Mussolini. But these are just the leaders in a party of like-minded statists.

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Debasing the Baseless–Modern Monetary Theory

DEBASING THE BASELESS – MODERN MONETARY THEORY

  • Populist politicians are turning to Modern Monetary Theory
  • Fiscal stimulus has not led to significant inflation during the last decade
  • MMT is too radical to be adopted in full but the allure of fiscal expansion is great
  • Asset markets will benefit over the medium-term

A recent post from the Peterson Institute – Further Thinking on the Costs and Benefits of Deficits – follows on from the Presidential Lecture given by Olivier Blanchard at the annual gathering of the American Economic Association (AEA) Public Debt and Low Interest Rates. The article discusses a number of issues which are linked to Blanchard’s speech: –

  1. Is the political system so biased towards deficit increases that economists have a responsibility to overemphasize the cost of deficits?
  2. Do the changing economics of deficits mean that anything goes and we do not need to pay attention to fiscal constraints, as some have inferred from modern monetary theory (MMT)?
  3. You advocate doing no harm, but is that enough to stabilize the debt at a reasonable level?
  4. Isn’t action on the deficit urgent in order to reduce the risk of a fiscal crisis?
  5. Do you think anything about fiscal policy is urgent?

Their answers are 1. Sometimes, although they question whether it is the role of economists to lean against the political wind. 2. No, which is a relief to those of a more puritanical disposition towards debt. The authors’ argument, however, omits any discussion of the function of interest rates in an unfettered market, to act as a signal about the merit of an investment. When interest rates are manipulated, malinvestment flourishes. They propose: –

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Chapter 8: Negotiable Debt, A Bit of History

CHAPTER 8: NEGOTIABLE DEBT, A BIT OF HISTORY

This chapter is a quick summary and clarification of what happens when debt becomes negotiable. The focus is on money, but other aspects are referred to, highlighting the general undesirability of making debt negotiable. There will be some repetition of material previously covered, for the sake of assembling it all in one place.

We all know what money is: a special, universal kind of property whose purpose is to be exchanged for things that are up for sale. Because money can buy almost anything, hijacking the money supply is an obvious objective for any person or class that wishes to become massively wealthy and/or powerful.

Thousands of years ago, when money was valuable metal, a simple way of doing this emerged. Having accumulated a quantity of the metal, a person or institution could issue promises-to pay, and these promises-to-pay could circulate as money. While their promises circulated, nothing needed to be paid out: the promises themselves acted as money. And because the promises were valuable, they could be lent at interest.

The promises were, of course, a form of debt. The issuer owed (in theory) the amount written on the note, or represented by numbers in an account, to anyone owning a ‘promise’.

Debt lent at interest! It’s an idea that still seems strange and unfamiliar, even though it has dominated the world of wealth and power on and off for thousands of years.

This strange hybrid of debt and money is known today as ‘credit’. We are all familiar with ‘credit’; when we have money at the bank, we are ‘in credit’. Legally, the bank owes us money. The bank’s debt circulates as money, so it is best referred to as ‘circulating credit’.

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Chapter 7: Secrets, Ignorance and Lies: Money, Credit and Debt

CHAPTER 7: SECRETS, IGNORANCE AND LIES: MONEY, CREDIT AND DEBT.

“The tyranny of fraud is not less oppressive than that of force.” John Taylor of Caroline, Virginia (1814).

Our money system relies on people not understanding it. If people understood it, they would demand reform.[1]

The most outrageous falsehoods are propagated daily about money and banking. Here are one or two examples:

‘A commercial bank is fundamentally nothing more than a middleman to put these two groups of people (investors and entrepreneurs) together in an efficient way’.[2]

This untruth is repeated regularly in education and the media, and most people believe it. The ‘middleman’ story is denied repeatedly and explicitly by authorities who know about the system, and are honest.

Here are some authoritative denials of the ‘middleman’ narrative:

The Bank of England: “One common misconception is that banks act simply as intermediaries, lending out the deposits that savers place with them…[this] ignores the fact that, in reality in the modern economy, commercial banks are the creators of deposit money. …Rather than banks lending out deposits that are placed with them, the act of lending creates deposits – the reverse of the sequence typically described in textbooks.”[3]

Abbott Payson Usher (20th century banking historian): ‘The essential function of a banking system is the creation of credit, whether in the form of the current accounts of depositors, or in the form of notes. The form of credit is less important than the fact of credit creation.’[4]

Joseph Schumpeter (economist): ‘It is much more realistic to say that the banks ‘create credit’, that is, that they create deposits in their act of lending, than to say they lend the deposits that have been entrusted to them.’[5]

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How Asset Inflation Will End–This Time

HOW ASSET INFLATION WILL END — THIS TIME

Life after death for asset inflation: this is what happens when “speculative fever” remains high even after monetary inflation has paused. This may well have been the situation in global markets during 2019 so far. But history and principle suggest that life after death in this monetary sense is short.

Readers may find it odd to be talking about a pause in monetary inflation at a time when the Fed has cancelled programmed rate rises and the ECB has embarked (March 7) on yet further “radical” policy moves. Moreover, the “core” US inflation rate (as measured by PCE) is still at virtually 2 per cent year-on-year.

Yet we know from past cycles that in the early stages of recession many market participants — and, crucially, central banks — mistakenly view a stall in rate rises or actual rate cuts as stimulatory. Later with the benefit of hindsight these policy moves turn out to be insufficient to prevent a tightening of monetary conditions already in process but unrecognized.

Even had monetary conditions been easing rather than tightening, it is highly dubious whether this difference would have meant the powerful momentum behind the business cycle moving into its recession phase would have lessened substantially.

(As a footnote here: under a gold standard regime there is no claim that monetary conditions will evolve perfectly in line with contracyclical fine-tuning. Both in principle and fact monetary conditions could tighten there at first as recessionary forces gathered. Under sound money, however, contracyclical forces would emerge strongly into the recession as directed by the invisible hand.)

Under a fiat money regime, monetary tightening can occur in the transition of a business cycle into recession, despite the opposite intention of the central bank policy-makers, due to endogenous factors such as an undetected increase in demand for money or a fall in the underlying “money multipliers.”

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Olduvai IV: Courage
In progress...

Olduvai II: Exodus
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