The Mystery of Banking and Capital in the 21st Century

18 months between posts might seem excessive, but I have been reading books by some impressive economists - Murray Rothbard - The Mystery of Banking, and Thomas Piketty - Capital in the Twenty-First Century. Both authors come from Europe - Rothbard from Austria and Switzerland, and Piketty from France, and their european perspectives are enlightening.

Rothbard's focus is on how money and money supply works, and how the demand for loans led to the concept of Central Banking, and how this has become organisations ( Reserve Bank, Federal Reserve, etc. ) with their own commercial and political agendas that run counter to the aims and needs of the wider community and societies that they supposedly serve.

Piketty has collated and analyzed the records on property ownership, tax payments, deaths duties, and company shareholdings, from 20 countries, the oldest data from the 1700s in France and England, to build a model of how capital builds over time, and how it is used and distributed.

Piketty's key finding is that capital always tends to create returns in excess of the rate of economic growth, and that only in the immediate post WW2 period, did technology allow wage earners to match the earnings of capital ( itself temporarily reduced by the costs and damages of WW2 ).

Piketty expands his argument to include financial inequality ( income and wealth ) as a key factor in social unrest, and rebellion.  Critics have been quick to point to capitalism as the source of equality of opportunity, and of improved health, education and social equality, especially in developing countries.

However, Piketty has already pointed out that we are just leaving the "abnormal" post WW2 period, and that he is warning about returning to the long term trend line, where capital creates capital ( or wealth ), faster than wages can create capital.  And he notes that there is no clear correlation between increased capital and increased social equality, except in situations where improvement of the skills and health of the workforce generate productivity increases and so raises the return on the capital.

The key point that I take from these two books is the realisation that the actions of the expanded central banking system has both increased the growth in returns from capital, and through fractional reserve banking, decreased the ability for wage earners ( and governments that rely on them for tax revenue ) to build up capital.

This might not be a serious problem if the form of capital, and the uses made of it to generate returns, where similar that of the 1700-1900s.

Over this period, labour was a key component in the sources of returns on capital invested.
In the cases of using capital to invest in colonial trade and industries, the labour component was small, slavery was often part of the "capital" owned, and wages were tiny. But in most developed economies the return relied on skilled labour, whether in agricultural, industry, or mineral or timber extractions. So wages were a necessary "cost" and proportional to the nett return.

However, the last 60 years have seen a shift towards money being a commodity in its on right, rather than just the mechanism of exchange, or temporary store of value - the "oil in the cogs of the economy", or the "catalyst in the process of production".

The percentage that financial services contribute to the economy is also growing at around 5% per year - from a current 9% ( 2013/14 ABS ) - and half our overseas "trade" is transfers of money to related companies ( globalisation ).

The nett effect is that money is increasingly a form of capital ( rather than a measure of capital ), and one that can generate a return on itself with very little labour required.

Combine this with fractional reserve banking, and you have a system that shifts wealth to the more wealthy by diluting the existing wealth of the less wealthy, and reducing the capital creation ability of wage earners - an efficient source of the inequality that Thomas Piketty is concerned by.

Mr. Soddy’s Ecological Economy

Frederick Soddy, born in 1877 in England, was a chemist with Ernest Rutherford when they jointly determined that radioactivity was atom decay and transformation. Back in Scotland, he described and named the concept of an isotope, and determined the changes in atomic number brought about by radioactivity. He received the 1921 Nobel laureate in Chemistry for his work on radioactive decay, and foresaw the energy potential of atomic fission.

He turned to economics, revolted by the mass chemical deaths of World War I, published four books from 1921 to 1934, and campaigned for a radical restructuring of global monetary relationships, but was dismissed as a crank.

He saw economics as a physical machine that must draw energy from outside itself.
The first and second laws of thermodynamics forbid perpetual motion - systems that create energy out of nothing or recycle it forever. He criticized the prevailing belief of the economy capable of generating infinite wealth.

Current economists model the economy as a living system. drawing from its environment valuable (or “low entropy”) matter and energy, ores, the raw materials provided by plants and animals. And like all life, an economy emits a high-entropy wake — it spews degraded matter and energy: waste heat, waste gases, toxic byproducts, apple cores, the molecules of iron lost to rust and abrasion. High entropy emissions include trash and pollution in all their forms, including yesterday’s newspaper, last year’s sneakers, last decade’s rusted automobile.

Matter taken up into the economy can be recycled, using energy; but energy, used once, is forever unavailable to us at that level again. The law of entropy commands a one-way flow downward from more to less useful forms. An animal can’t live perpetually on its own excreta. Neither can you fill the tank of your car by pushing it backwards. Thus, Georgescu-Roegen, paraphrasing the economist Alfred Marshall, said: “Biology, not mechanics, is our Mecca.”

Following Soddy, Georgescu-Roegen and other ecological economists argue that wealth is real and physical. It’s the stock of cars and computers and clothing, of furniture and French fries, that we buy with our dollars.

The dollars aren’t real wealth, but only symbols that represent the bearer’s claim on an economy’s ability to generate wealth.

Debt, for its part, is a claim on the economy’s ability to generate wealth in the future.

Soddy said that the ruling passion of the age, is to convert wealth into debt — to exchange a thing with present-day real value (a thing that could be stolen, or broken, or rust or rot before you can manage to use it) for something immutable and unchanging, a claim on wealth that has yet to be made.

Problems arise when wealth and debt are not kept in proper relation.

The amount of wealth that an economy can create is limited by the amount of low-entropy energy that it can sustainably suck from its environment — and by the amount of high-entropy effluent from an economy that the environment can sustainably absorb. Debt, being imaginary, has no such natural limit. It can grow infinitely, compounding at any rate we decide to accept.
Whenever an economy allows debt to grow faster than wealth can be created, that economy has a need for debt repudiation. Inflation can do the job, decreasing debt gradually by eroding the purchasing power, the claim on future wealth, that each of your saved dollars represents. But when there is no inflation, an economy with overgrown claims on future wealth will experience regular crises of debt repudiation — stock market crashes, bankruptcies and foreclosures, defaults on bonds or loans or pension promises, the disappearance of paper assets.

It’s like musical chairs — in the wake of some shock (say, the run-up of the price of gas to $4 a gallon), holders of abstract debt suddenly want to hold money or real wealth instead.

But not all of them can. One person’s loss causes another’s, and the whole system cascades into crisis. Each and every one of the crises that has beset the American economy in recent years has been, at heart, a crisis of debt repudiation. And we are unlikely to avoid more of them until we stop allowing claims on income to grow faster than income.

The problem isn’t simply greed, or ignorance, or a failure of regulatory diligence, but a systemic flaw in how our economy finances itself.  As long as growth in claims on wealth outstrips the economy’s capacity to increase its wealth, market capitalism creates a niche for entrepreneurs who are willing to invent instruments of debt that will someday need to be repudiated.

Soddy suggested five policy prescriptions - taken at the time as evidence that his theories were unworkable. And yet these four are now conventional practice:
abandon the gold standard,
let international exchange rates float,
use federal surpluses and deficits as macroeconomic policy tools that could counter cyclical trends, and
establish bureaus of economic statistics (including a consumer price index) in order to facilitate this effort.

Soddy’s fifth proposal, was to stop banks from creating money (and debt) out of nothing.

Banks do this by lending out more than they physically hold of their depositors’ money at interest — creating debt ( a claim on real wealth in the future ) and creating apparent debit balances in the borrower’s demand deposit (checking) account, where it can be lent out again to create more debt and demand deposits, and so on, almost ad infinitum.

Herman Daly, an ecological economist, and many others have proposed a gradual, legislated move to 100-percent reserve requirement on demand deposits.

Banks could still support themselves by charging fees for safekeeping, check clearing and all the other legitimate financial services they provide. They could still make loans and still be able to lend at interest, but based on the real money of real depositors.  This would re-establish a one-to-one correspondence between the real wealth of the community and the claims on that real wealth.

The immediate response to this economic theory and its fifth proposal, is horror at the impact it would have on GDP, the share market, and economic activity.

But real debts do exist. These are mainly the real world matter and energy high entropy emissions and environmental impacts. The currently, un-costed, costs of removing CO2 from the atmosphere and oceans; of repairing degraded land and water supplies; of neutralising the toxins and organochlorides; and of redressing social inequity and poverty caused by the debt process.

And the problem is that these real debts have to be paid from current wealth generation.
They are not a claim on future real wealth. And they have physical priority over the interest created and charged from debt creation.

We are at a stage where real debts are increasing eroding our current wealth creation, making us all a little poorer each year, and throwing into doubt our ability to create wealth in the future, and so seriously weakening the claims by debt to that wealth.

This is both creating social and personal dissatisfaction and tension, and bringing forward the likelihood of financial crisis and collapse - debt repudiation.

It is increasingly likely that Soddy’s fifth proposal will also become conventional practice.

What is Money?

I was going to write on redefining the financial institutions and the financial products they produce, but realised that you need to start with an understanding of money first.

So what is money?  The problem here is that the one word - money - is used for quite different things.
They are all real things, but they are not the same, and they all have different functions.

Economists talk of three functions - as a store of value;  as a standard or unit of exchange; and as a medium of exchange.

Money started as a gift between people. It could be a gold object, or a pig, or pottery, or shells, but each was a symbol of good will. Over time this changed. As societies grew, the pathway between the doer of, and the receiver of, any service or action got longer, and with new surpluses in agricultural products, these, like corn in Egypt, became the form of money - (this is called commodity money)

Farmers in Egypt could deposit their crops in government run warehouses, in exchange for receipts that showed the amount, quality and date. The farmers could then write a transfer for some of this grain to some-one else in exchange for goods or to pay rent. The various warehouses balanced these transfers and moved grain from one warehouse to another if needed. Other crops were also used in this way, like tobacco in the USA. These were efficient systems. The crops held their value, it was easy to understand and record, and the transfer dockets allowed small and large transfers to happen. It was also efficient in that the grains would deteriorate with time, and could be eaten, so there was an incentive to use it, to circulate the value through the society. Strangely this was like earlier times. Money was only useful as a "gift" to other people. If you did not spend it, it would disappear.

Things changed a bit with the invention of coins ( though the first coins were little metal toy tools, shells, and animals to mimic the exchange of the real things ). At first the coins were issued in parcels that made up the receipts as before, and the individual coins could be used for the smaller exchanges and transfers.

 As trade between kingdoms and peoples developed, these coins became useful as they extended the range of valid exchanges. They also helped cities manage the industrial revolution. As people specialised in the work they did, they also narrowed the range of goods they produced and so found direct barter harder to achieve. A neutral store of value was very handy.

The first coins were made and issued by the government of the region ( king, duke, war-lord ) They were usually made in gold, silver or bronze - metals both soft enough to mint, and relatively rare.
They were also issued in proportion to the underlying commodities. However, that soon changed.

Governments found that they could mint and issue a little more than what was supported by the commodities they held, so long as they were powerful enough to convince people the coins had value, though in part, the amount of gold and silver in the coins influenced this value ( because the coins could be melted and re-minted in the name of the receiving government ).

As the supply of coins increased, the problem of safely storing them arose. The government goldsmiths started to offer to store the coins, in exchange for letters of credit. This evolved into paper money, official documents that state that the person holding the letter, or note, has that amount of money. People had to trust that these notes had value - this is fiat money.

Now it got sneaky - the goldsmiths and the governments realised that the chance of all the people with letters of credit asking for their gold or grain at the same time was very slim. So they could issue many more paper money notes than they held reserves, and they could do this as loans to people without the reserves, and charge interest on those loans.

At the same time - merchants were using Bills Of Exchange or Promissory Notes - the merchant's promise to make payment for goods supplied at some specified future date. Provided that the merchant was reputable or the bill was endorsed by a credible guarantor, the supplier could then present the bill to a merchant banker and redeem it in money at a discounted value before it actually became due - an early form of credit – a medium of exchange and a medium for storage of value.

Kings and Dukes used similar bills to both record current taxes paid and taxes due to be paid. They then found that they could exchange these Bills, or Tallys, for gold or coin or services or supplies in advance of the actual tax collection, and then, of course, realised that they could create bills against assumed or estimated, future tax collections.

This acceptance of symbolic forms of money - coins, and paper money - meant money could represent something of value - a reserve -  that was available in physical storage somewhere else in space, such as grain in the warehouse. As a bill or promissory note it could also be used to represent something of value that would be available later in time, a document ordering someone to pay a certain sum of money to another on a specific date or when certain conditions have been fulfilled.

##[  http://en.wikipedia.org/wiki/History_of_money ]

This was the first divide between real money ( RM - money used as daily exchange and based on current real reserves ) and money that only became real in the future, and required trust that the future would be as described in the bill or note.

Essentially, both the paper money issued in excess of the actual reserves held, and the bills and promissory notes issued based on future creation of reserves meant that those people who accepted this form of money ( model money MM ) locked in their future to fit the model described by the issuer of that money. ## [ TD ]

For example, most of the money offered when you apply for a mortgage is model money - only a fraction is based on real money that matches cash reserves at the bank.  But the moment you sign the agreement, this model money becomes real money to be extracted from your future reserves - you sign your future over to the issuer of the loan.

This can be hard to see, but it means that your future becomes something that can be bought, sold and exchanged - this model money - now real money - becomes a commodity itself.

And as profits can be made trading commodities, what was earlier a bit of a fiddle issuing paper money and bills based on a near and likely future, has now become an industry as big as the real money world it overshadows. And why the financial industry can have such a large impact on ordinary lives and businesses.

Global Warming & Wealth

If you accept that wealth is embodied energy, then Global Warming is the crisis we have to have. Our problems are twofold.

One is that the source of this energy is currently limited. We are using up the fossils fuels and minerals. We are reaching the limits in farming and forestry. And we are not seriously value adding energy in wind, solar, tide or thermal. In short, the sources of energy is peaking and, with growing populations, our wealth will decline.

Our second problem is that along side the energy based wealth system, we have a huge corporate & financial wealth system that feeds off the energy based system.

This system already understands that it will need to forge new links into any new energy sources to survive, and it will fight hard to maintain the existing links and preserve the wealth flow it enjoys from the old fossil fuel and agribusiness energy sources now under threat

So back to Global Warming. There is little doubt that the climate is changing. The questions are whether human activity is responsible and whether we can do anything about it. It doesn’t matter. Unless we develop renewal energy sources, limit the use of fossil fuels, and conserve and rebuild the agricultural sources of energy, we are going to get less wealthy.

Government and corporations understand this. The extended debates over climate change and the small scale reponses in reducing fossil fuel use conceal a more serious issue. How to refocus our actitivies onto renewable energy based wealth creation without exposing the corporate and financial wealth system.

We need to be wary of two things. Global Warming will be pushed as a crisis requiring a personal moral response – tighten our belts, take your share of the punishment, it’s not governments fault, this is bigger than all or us!!! – while not much happens.

Worse still, Global Warming could be pushed as a crisis requiring draconian reponses, the partial suspension of democratic rights, the imposition of economic change, hugely costly projects which favour the corporate and financial wealth system.

There is no need for any of us to become less wealthy. But we must understand where real wealth comes from and invest in those sources, and reject the crisis politics that will try to insulation the non-energy based wealth processes from change.