July 02, 2003
From the desk of Jane Galt:Wacky Economics of the Week
Comes from Steven Den Beste, who forwarded an email from someone named Ken that linked to this fellow. It's not totally wrong, mind you, but some of the bits are gloriously weird:
Selected quotes:
On the invention of money
I can set up a bank even in a war-devastated poor country, where there is not yet any existing money or banks. All I need to do is decide what collateral asset I think is valuable, and tell someone "Okay, you got yourself a loan of $10,000 if you pledge Asset X to me." I then create a bank account in the borrower's name and write an entry saying that $10,000 is available to him. I give him a checkbook which he can use to order me to transfer money to anyone else's account. If he needs cash withdrawals, I print out a piece of paper which has some fraud protection coding scheme to detect counterfeiting. In a competitive 'free banking' environment, each bank would print their own notes which, apart from having the total number of 'dollars' (or whatever common word is used for the unit of money), would also have the bank name on it.
Of course, I'm still not sure why someone living in a war-torn country without money or banks would give you a nice, valuable asset in return for a piece of paper you don't even have a word for. . .
On inflation
Milton Friedman said that inflation is always and everywhere a monetary phenomenon. What he misses is that accelerated money supply expansion (also called money supply inflation in classical economics, which causes some confusion in lay people who use the word inflation to mean price inflation) need not cause inflation. If the number of goods and services actually desired by the population and deliverable by entrepreneurs increased, then credit can expand at that rate without inflation. Inflation happens when the expansion of credit is faster than the expansion of entrepreneurial knowledge and consumer demand.
I think -- I'm just guessing here, but I'm pretty sure -- that the founding father of the Monetarist school of economics hasn't "missed" that inflation takes place when money supply expands faster than monetary demand.
But it continues
Friedman's discoveries were valuable though, because it allowed a government-created money system to regulate itself by limiting money supply expansion if inflation seemed to be picking up. But it also hampers the rate of growth potentially possible. The true solution is to use our model of looking at collateral-backed credit that back the deposit liabilities. But instead of using fractional gold reserves, the Internet today allows us to require banks to publish their credit portfolio, including deqlinuency, default, and prepayment data. The notes issued by banks would then be bought and sold in the currency markets based on solid information about the credit portfolio, and Internet-based market data on their market price would be available to every shop keeper and entrepreneur equipped with a Web terminal.
I'm not quite clear what he's getting at here. He seems to be that the banks should be required to put their books online so that we can see exactly how much our money is worth. Because what we all really want is to log onto the internet to check what our dollar's trading at before we go downstairs to buy a cup of coffee.
He might be talking about simple bank solvency and credit creation. But the banks are already required to give that data to regulators who are, though it pains me to say it, much better qualified to assess the state of the banks' portfolios than the average consumer. I also have no idea how this would help us quadruple GDP, as the title of his essay promises. Except that he thinks it will help us expand the money supply without inflation:
Securitization is how banks circumvented the strangling restrictions of governement-run deposit-centric banking. Money supply increased far more in the last two decades, with little or no inflation, than Friedman's theory of inflation predicts. But most of this money supply expansion, credit expansion, has happened through the device of securitization. Note that securitization removes the liquidity mismatch problem that causes bank runs. The investor in a pool of loans, or any pool of future income flows, agrees to take as much money as comes in. If there is a default, the investor takes the loss. A risk-averse investor can simply buy the first rights to any money coming in, and accept a lower or even zero return.
Where are these investors who will accept a zero return? I have some very attractive investment opportunities for them!
Money supply expanded without inflation for a number of reasons, none of which have anything to do with securitization. Securitization certainly enhanced the supply of credit (that's how MBNA gets the money to issue you that credit card you've maxed out, for example), but I know of no reason that it would hold down inflation.
I mean, I think that securitization is a very fine thing. I am second to none in my admiration for securitization. But this chap seems to be arguing that it makes you taller, stronger, and rich! rich! rich! It's a modern version of "Free and unlimited silver at a ratio of 16:1!"
Exactly how are we going to get rich, you may ask? And well you may. The secret is (brace yourself) securitization of your bank account!
As securitization booms along -- it grew by $500 billion in 2001 and will accelerate further in the coming decade -- bank deposits are well on their way to becoming obsolete. Investors will choose the risk portfolio they want their savings to be invested in, and be responsible for the loss if the assets they chose default. Bank runs become obsolete.
Why, yes, they do, because you can't get your money out of the bond. Every time you want a little cash, instead of hitting the ATM, you head on down to the trading floor and sell off a bond for some walking-around money. Around $10K of walking around money. We're all going to be rich!
Instead of having fractional gold reserves, we will now have 100% asset backing on every such bond we buy.
Except for, like, unsecured debt.
The currency used by a country that uses all or largely securitized credit will not be subject to the kind of volatility that countries like Argentina have witnesses. Indeed, by allowing banks to issue bank notes -- or even travellers checks -- that are backed by specific assets that are disclosed on their web site and traded in the market, Argentina can solve its liquidity problem in one fell swoop.
Aha, now I see the genius. We are going to eliminate unsecured debt! Revolving credit lines, begone! Well, that would certainly eliminate a lot of volatility, since it would make it hard to have a functioning business above the level of a lemonade stand. Or finance one with few assets but a lot of future cash flow. Which is probably just as well, as we're going to be spending a lot of time just trading our bonds.
I'll leave off here because the essay inexplicably veers onto the subject of education in Afghanistan. As I say, I like securitization. It does allow banks to pool their risks, cutting the cost of capital by reducing their risk premium. But it's wildly inappropriate for demand deposits, which have a time horizon often measured in weeks. His plan, if it could be put into effect, which it couldn't, would more likely reduce credit than increase it.
Before I go, I do want to share his bio:
The writer is the author of "Zen and the Art of Funk Capitalism: A General Theory of Fallibility." Available on Amazon, Barnes & Noble, and other retailers. He is also Chairman of Tranquilmoney, Inc. a company that provides a software platform to manage securitization and structure finance deals.
We've had the Austrian school, the Chicago School. . . and now, the Funk school.
People have ever been fond of making magical promises for easy credit and the expansion of the money supply. This chap is somewhat unique in that his plan wouldn't actually increase credit, but let's say that it could.
What would happen? Would we all get rich?
No, because the constraint on our economy over the long run isn't the supply of credit. Money is just little green pieces of paper with some very interesting economic characteristics. It has no intrinsic value -- we don't want to hold hundred-dollar bills because we like the little green portrait of Ben Franklin.
We want money to buy stuff. And the limit on our GDP is our capacity to make stuff, on the one hand, and our desire to consume it, on the other. The constraining factors are labor supply and the productivity of labor.
Even if we found a way to let banks lend four times as much money, would that give us four times as many people in the labor force? Four times as much productivity of our resources? We might purchase machines to make us more productive, true, but those machines would be produced at the expense of something else we wanted that didn't get produced. We might use our new credit to hire more workers, but those workers would be taken from another firm that needed them. Expanding credit only works in periods when the economy is below full employment because of some shock -- and even then, it has a stiff price, as the odds are that the easy credit will not be cut off as soon as it is unneeded, but rather will introduce inflation that erodes the value of pensions and savings, thus depressing demand later.
The only way the economy will grow is by people learning how to build a better mousetrap. It's no good just standing in the corner and making extravagent promises to the mouse.
Posted by Jane Galt at July 2, 2003 09:29 AM | TrackBack | Technorati inbound linksSo someone is arguing that there is not enough credit in the economy?
I mean, this may be true for certain groups (the unemployed, people with a history of late payments or defaults), but in general ... what??
Has he heard of the mortgage boom? What about all those gold and platinum credit card offers inundating the mailboxes of suburbia?
For God's sake, there is an entire newsletter called the Credit Bubble Bulletin.
And securitization? According to that same Credit Bubble Bulletin "The global credit derivatives market, which wasn’t even tracked until 1997, has ballooned to $2 trillion based on the so-called notional value of the debts that underlie the contracts, according to Fitch…That market, Fitch predicts, will grow to $4.8 trillion by next year."
From an older issue: "Total Credit Market Debt (financial and non-financial) as a percentage of GDP has surpassed 300%, compared to 240% back in 1990."
And short term interest rates haven't been this low since 1958...
It's hard to believe we have too little credit.
He has an interesting idea on banks (with their own currency) reporting their debt portfolios publicly, and then letting the market determine the value of the bank's currency based on the credit it has given.
If I understand it right, then some of this is happening now: banks that make mortgage loans often securitize and sell that debt. There is a full-blown market focused on pricing this debt, etc. But in our world there's just the one currency for all the banks, the dollar... and it is falling. Which seems to imply an oversupply of credit, if anything.
Posted by: Jim on July 2, 2003 05:23 PM"The only way the economy will grow is by people learning how to build a better mousetrap. It's no good just standing in the corner and making extravagent promises to the mouse."
Those words, if driven home to the right people over the last hundred years (by blunt instrument, if necessary) would have saved many millions of lives and countless years of human misery. Alas that it was not to be.
Posted by: M. Scott Eiland on July 2, 2003 05:52 PMThere are people who seek magic solutions. What they want is some sort of straightforward and relatively effortless change which can be made which will solve some really dramatic problem, all at once, forever.
(And it helps if you're the guy who's selling the magic, as this guy seems to be. He's the classic hammer salesman describing all the nails that need to be pounded; he thinks securitization can solve the world's software, and whaddyeknow he sells computer software that supports securitization.)
Posted by: Steven Den Beste on July 2, 2003 06:04 PMIs what he's peddling much different than the anarcho-capitalist line of thinking that the Federal Reserve is simply a dirgiste institute that causes business cycles to be unnecessarily volatile and inflation to be exacerbated, among other things? I don't necessarily agree with all of that, although I can't say that I'm a fan of the Federal Reserve.
Posted by: D. Citizen on July 2, 2003 06:20 PMJane Galt wrote:
Of course, I'm still not sure why someone living in a war-torn country without money or banks would give you a nice, valuable asset in return for a piece of paper you don't even have a word for. . .
You're aware of the so-called "conflict diamonds," right? At any rate, people in such countries do have a word for money, even if the poor quality of their own currency management system forces them to use other countries' currencies. And diamonds are merely one example of such a nice, valuable asset used as an ersatz currency.
Posted by: Phil Fraering on July 3, 2003 12:41 AMI don’t have anything to contribute, I’m just wondering: did you have to reformat that before you could read it, or is it just me?
Ack . . .
Posted by: Daniel Morris on July 3, 2003 01:30 AMAh, but conflict diamonds have intrinsic value to someone besides the "bank" and the guy who signed over the rights to his assets in exchange for a few pieces of paper. Conflict diamonds are portable assets that can be exchanged for stable currency, anywhere in the world where people are willing to make such an exchange.
Posted by: David Perron on July 3, 2003 10:12 AMThe guy Jane quotes is indeed starting with an anarchic idea: competing currencies, issued by competing banks.
This exists today, of course, in the international system. It would be possible intranationally too but there would certainly be some transaction costs associated with it.
But yes, that appears to be what the man is proposing.
As an anarhco-capitalist sympathizer, I don't see anything wrong with that part of it (like I said, except for transaction costs).
I also think his little story about the invention of money is more or less right. Abstract away from a modern poor country to earlier in world history and his analogy makes a lot more sense.
People do indeed trade valuable assets for money all the time. Originally, that money was "guaranteed" redeemable for gold, which people seemed to value... but you were still putting your faith in the guarantee. Now there's no guarantee.
Yet we do it.
So, his story works as a retelling of the "invention" of money. I cut him some slack there even though I think a "war devastated poor country" is the least likely place for money to develop. People will probably put faith in guarantees when things are going relatively well and the world is stable; not during or right after a war.
But back to my point: his idea does rely on a basically anarchic framework.
And even though I attacked him in my first comment for seeming to argue that what the system needs is more credit ... if you got rid of the Fed and the government-supported mortgage lenders (Fannie and Freddie), there might not be a credit bubble and it might well make sense, in such an anarchic system, to think about how to expand credit.
Hmm. Yeah. So maybe he's not so bad on that point.
And though Jane notes that banks now report their portfolios to regulators and that these bureaucrats are more qualified than laymen to value the banks' loans and judge their quality, she misses a point... which is that you shouldn't compare the regulators to the layman, but to professional traders of bank debt who would emerge in a market system (who exist now, in fact, unless I'm mistaken).
Someone not too different from Mindles might be the free-market alternative to a government regulator. Based on what these guys do, all the layman has to know is the price of a bank's currency -- determined by sophisticated traders buying and selling that bank's loans.
None of which is to say that the guy's idea is the only way an anarchic financial system might look. The particular model he proposes is just one way that things might evolve in an anarchy, and by no means is it clear that his way would develop, or work.
Boy, all this and I haven't even clicked over to read the original piece. ;) Maybe I'll go do that now...
Posted by: Jim on July 3, 2003 06:05 PMBut if you're going to do away with demand deposits, as he seems to be advocating, I don't see how people can avoid being professional traders of bank debt. ;-)
Posted by: Jane Galt on July 3, 2003 11:31 PMHi guys,
I just noticed some hits from here and thought I'd check in to establish my relative sanity ;-). No, I am not advocating the end of demand deposits or revolving lines of credit (hey, I live on them ;-). I am just proposing an ideal type way of looking at money as the liability funding a particular type of credit, which in turn is backed by some asset (sometimes an intangible asset like a person's reputation, or a collectivized asset like recourse to a balance sheet). The purpose is a thought exercise, nothing more. In practice all I recommend is encouragement of securitization, as well as disclosure laws for those who securitize (though the market will demand it anyway).
The main way that I propose "quadrupling World GDP" (which is nothing but a pathetic attempt to be catchy, compared to my relatively academic / theoretical writing in the original book) is by focusing on loans for adult training. When relative values change due to technology or globalization or innovation of any kind, some jobs are no longer productive. This is true for steel workers in the US as well as farmers in the third world. The solution is not to preserve those jobs artificially, but to see if any institutions can be built that would facilitate rapid retraining of the workforce to one more suitable for the changed circumstance.
I suggest that since Fannie Mae etc have produced liquidity in home purchase (ok, that's also government backed, but securitization in auto loans and consumer credit have been responsible for those sectors growing right through the current slow period), a similar insitution for adult training loans would have as many people contacting one for retraining as one has contacting one to take out a mortgage. Sure, I hate telemarketers too, but marketing can serve a purpose a lot of the time. My thinking is that if such liquidity were there and people got used to lifelong learning and relearning, we would have a more productive global economy and one not opposed to constant innovation and change. In response to the person who showed the conflict of interest in that I sell securitization software, I would like to make clear that I have offered the software free around the world for development through adult training loans that are securitized.
Lastly, if you read the book (which is also available in PDF for free on my site), you will find that I am firmly in the Austrian school and quote Hayek extensively and reference Mises. I have many other references there too. Of course, my take is a little bit different, and hence my use of "Funk" which I define in the first line of my book as "the underside of anything, of everything" as a modern poet in Boston once said.
There is no silver bullet, nor do I imply utopia if we ease the path for workers to retrain themselves. Things just will be a little bit better, in my opinion.
Regards,
Karun.
--
Karun Philip
http://www.k-capital.com
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