The golden calf

In my post "The Nature of Money" I noted that money's use as a store of value is secondary to its function as a medium of exchange, and commented that long-term savings should not be held as "money" but rather as hard assets or investments in productive activities. I made it clear that my personal belief is that the latter is far preferable, because it benefits not only the holder but the rest of society too.

This attracted the attention of a number of people who appear to have an almost religious belief in the virtue of gold as a store of value. The result was a bruising three days of intense debate on twitter, which was only ended when I blocked several of these people and warned off the rest. I was frankly shocked by the fervour of their belief: the more convinced they were that eventually I would "see the light" the less I wanted to have anything to do with them. I felt much as an agnostic must feel when subjected to the attempts of religious cultists to convert them to their religion. How can an inert metal be the object of such faith?

Since that encounter I have spent some time reading the writings of their guru, an anonymous blogger known as FOFOA (which apparently means Friend of Friend of Another). I'm going to summarise here what I have drawn from these writings.

• In these people's world, gold does not rise in price as people invest in it, unlike any other commodity. They invert the charts that show the rising gold price and use them to demonstrate instead that the dollar is collapsing.   
• They then go on to suggest that because the dollar is the international reserve currency, when it collapses against gold everything else will collapse too and there will be worldwide hyperinflation (I've noted before that hyperinflation is currency collapse, not price increases per se). They call this a "phase transition" into a new financial world where gold will be the international reserve and all savings will be in physical gold, not in money or in any forms of asset-backed paper. They believe that once the gold price reaches a certain level this transition becomes inevitable, and therefore they are pushing for the gold price to rise (or rather, for the dollar to fall against gold, as they see it).
• They believe the reason for the dollar's collapse is the unsustainable level of US public debt, which is driven at least in part by its trade deficit arising from the dollar's status as international reserve currency. They call this status an "exorbitant privilege" and claim that it has been used to enable the US to borrow higher amounts, at lower interest rates, than any other country. Although there is currently a large and liquid market for USTs - and even a shortage of them - they believe that the world will eventually reject US debt as a safe asset, which will trigger unstoppable flight to hard assets (gold) and hyperinflation of the dollar against gold as noted above.
• They encourage all the "enlightened" to buy physical gold to protect their wealth against the coming hyperinflation, which will also see collapse of the value of all assets except physical gold and other "hard" assets. 
• They note that central banks have been buying gold. They seem to think this means the central banks are preparing for the phase transition, in which they expect the financial system to be recapitalised with gold.
• Their aim is to create a system of paper currencies unlinked to gold (they do not propose return to the gold standard) whose function is only as a medium of exchange, coupled with physical gold both as an international reserve and a store of value for all savers. There would no longer be any means of saving in currency or in any form of asset-backed paper. At-risk investment for a return would still be possible, but the current arrangement where by ALL savings are reinvested in productive activities would end. In this respect their theories are similar to those of other "full reserve banking" enthusiasts, except that they do not accept public or private debt as appropriate backing for savings: to them, all savings should be in physical gold. 
• They identify the Euro as the future currency of international trade, because in their view it has broken the link both with national governments and with gold: they regard the gold reserves held by the ECB as a pure store of value unconnected with the currency. The fact that the Euro is the national currency of 17 countries is of no importance to them, and they dismiss out of hand the possibility that the Euro may prove unsustainable because of the deep structural imbalances between its member countries. 

These theories together create a looking-glass world: everything is the wrong way round. In particular, the reversal of the gold price chart makes it impossible to have a normal conversation about "flight to safety" behaviour and the pricing of commodities. Duncan Weldon noted in his recent post that the reasons people give for low gilt yields resemble a Necker cube: whether the cube faces inwards or outwards depends on your perspective. The reversal of the gold price chart is similar. The rest of humanity regards gold as priced in dollars, so when lots of people are buying gold its dollar price rises: in that it behaves like any other commodity. But not to these people. Gold, to them, is not a commodity, so its price is not moveable: if the amount of dollars required to buy an ounce of gold increases, that is because the value of the dollar has fallen, not because the price of gold has risen. To these people, gold is the ultimate, original, perfect store of value, which has been deprived of its true status by the use of paper (including gold-backed paper) as a store of value. They describe the "freeing" of gold from its present use as a fixed asset backing paper investments, and from any present or future monetary use, as Freegold.  

I must emphasise that this is my understanding. One of the features of my conversations with the Freegolders people was their insistence that I did not understand, and that when I did I would convert to their belief. The FOFOA blog itself says something similar about people who criticise its writing. For me this is uncomfortably close to the concept of "gnosis" - the idea that there is hidden or special knowledge that is acquired only through spiritual enlightenment.  And when you partner this "gnosis" with their belief in a financial Armageddon from which only those who subscribe to their teachings will be saved, we seem to have something akin to a doomsday cult.

However, although I am uncomfortable with the quasi-religious presentation of this set of theories, if they made sense economically I would subscribe to them. But as far as I can see they don't - at least not in any vision of the world that I recognise. My real objections to their proposals are far more fundamental. 

Firstly, these people do not like or trust government. I've noted before that when people don't trust government they reject it: they may physically leave the country, or they may take their assets out of the country or place them (as they think) beyond reach of the grasping hands of public servants, or they may seek to overthrow it and replace it with something more to their liking. These people think that by putting their wealth in physical gold they can prevent it being eroded by government mismanagement (inflation) or expropriation (taxation). And their belief in financial Armageddon and phase transition to a new gold-based financial order (which they are working to bring about by encouraging people to move their savings to physical gold) amounts to seeking to overthrow the existing system and replace it with something more to their liking. 

Personally, I think government is necessary. Yes, all governments have their faults: some are corrupt, some are incompetent, some are unlucky. But they do provide the basics in society: protection of boundaries, rule of law, and - increasingly - social safety nets. This latter is the most controversial, and there are plenty of people who think it is far too large and protects people who don't really need protection. Personally I think that social safety nets are a good thing: there will always be people who exploit them, but they are nonetheless one of the things that raise us beyond mere "survival of the fittest". The desire and ability to care for those who are not able to care for themselves is part of what distinguishes us as a species: it is, to some extent, what makes us human. Government is responsible for redistributing resources from those who have more than they need to those who have less than they need: philanthropic giving also achieves this but on a more patchy and less consistent basis. It is not surprising that those who have more than they need, and who selfishly wish to hang on to their surplus, resent government seeking to take it from them. That selfish desire to hang on to wealth is I believe the main motivation of the Freegold supporters. And that brings me to my second objection. The unproductive hoarding of wealth runs counter to everything I believe - both economically and as a Christian.

Economically, I think large-scale hoarding of wealth is bonkers. Our economies don't grow by themselves: businesses need capital in order to produce, and the creation of that capital requires investment. Investment comes from the excess production of other businesses and individuals, recycled back into the economy through lending to, and equity investment in, productive activities. There is nothing productive about sitting on a hoard of gold, and the only beneficiaries of the trade in physical gold that would ensue from forcing all savings into gold would be the buyers and sellers of gold. That is not to say that the present situation, whereby debt and equity assets are "churned" on secondary markets, is much better: but at least the initial investment goes into productive activities, even though subsequent trading of the assets is largely unproductive. If the initial investment is in gold or other hard assets, NO-ONE benefits. And if enough people invest in hard assets instead of putting their wealth to productive use, the economy will be starved of the investment it needs to grow. Far from encouraging people to buy gold, personally I would impose punitive taxation on large holdings of unproductive assets. It's economically disastrous. 

The argument used by those who have surpluses is that they have gained them through their own hard work and should not have to use them to benefit others. This frankly is the law of the jungle. If everyone thought like that society would be a very unpleasant place: those with wealth would hoard it, and those without wealth - including those who are unable to care for themselves - would starve. In my post on the benefits of a debt money system I pointed out that lending is one of the ways in which we recycle the resources of the rich to benefit the poor: the other mechanisms by which we do that are taxation and philanthropic giving. These people reject both lending and taxation, never mention philanthropic giving at all, and promote hoarding. And this is where both my understanding of economics and my Christian beliefs force me to reject everything they propose.

When production is insufficient to meet the needs of all, surpluses deprive others of their needs. The only justification for holding a surplus would be if production is falling, when meeting one's own future needs at the expense of the immediate needs of others is at least understandable (though from a Christian perspective clearly wrong). But if production is NOT falling, then hoarding surpluses is both economically and morally wrong. Economically, because it deprives the economy of the investment it needs to increase production to a level where everyone's needs can be met - which surely must be the goal of any civilised society. And morally, because hoarding a surplus when there is no reason to assume that it will be needed in the future, is sheer greed, and refusing to use that surplus for the benefit of others is sheer selfishness. So when people put their savings into unproductive assets, they are guilty of both greed (because they have taken more than they need) and selfishness (because they have deprived others of what they need). I'm sorry to use emotive terms, but we are no longer in the realms of simple economics. We are dealing with the morality of hoarding.

The entire moral argument for Freegold therefore hangs on belief in financial Armageddon. Without that, I doubt if many people would buy it. No wonder the guru promotes the "coming disaster" story.

So, is this financial Armageddon likely? Are we really facing global hyperinflation, currency collapse and economic meltdown? I don't think so, because the whole argument comes from an inverted view of the world: even if the dollar crashed against gold, it still would not be experiencing hyperinflation if its value held up against other measures. But if we were, I wouldn't be hoarding gold, personally. Tinned food, candles and matches would be far more useful. The Freegolders seem to think that their "phase transition" would only take a few months, and they reckon they have enough food stored to keep them going during that time. But economic and social chaos on the scale they envisage wouldn't take a few months to resolve. It would take years. And I stand by what I have already said. I do not believe that protecting my wealth, while leaving others to suffer what would be appalling hardship during such a change, is compatible with my Christian beliefs. If this ship is sinking, I will share my last sea biscuits with my fellow crew members and go down with the ship, rather than save my life at others' expense.

But what if the guru is completely wrong? What if financial Armageddon doesn't happen? What if - as Izabella Kaminska has suggested in her recent series of posts, "Beyond Scarcity" - we are entering an era not of insufficient production to meet everyone's needs, but an era of OVER-production? If there is actually more than enough production to meet everyone's needs, then hoarding is pointless and surpluses are worthless. The value of a surplus is determined by the extent to which it is needed, regardless of the medium in which it is stored. Surpluses by definition are not "needed" now, at least by the holder - though as I noted above they may be needed by others. But if they are not needed in the future either, they have no value.

Without financial Armageddon, Freegolders - and other hoarders - would be forced to confront this conundrum: if a surplus has value and is not used in a way that benefits others, it is immoral, because it deprives others of their needs: if it has no value, either now or in the future, it is pointless.

So why do they do it? I don't know, but I am reminded of the story of Moses on Mount Sinai (Exodus chapter 32). He spent rather longer up the mountain than the Israelites were expecting. They became fearful that he wasn't coming back, and that (more importantly) God had abandoned them. So they turned to another god. They melted down all their gold jewellery and created a golden calf, and they bowed down and worshipped it.......

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The necessary arrogance of elites

Throughout history, there has been a tendency of elites – moneyed elites, intellectual elites, dynastic elites, religious elites – to regard themselves as fundamentally different from the rest of humanity. All fields of human endeavour develop elites, which are the brightest and best in those fields: so, for example, Olympic athletes are “elite” physical sportsmen and women, whose sporting prowess far exceeds the capability of ordinary mortals. But in many fields, once elites have developed they have a vested interest in maintaining themselves, whether or not they still have genuine excellence. And they create barriers to admission of people who are not “one of them” but who possess genuine ability. They use special language that is not known to ordinary people. They require particular social connections: in the most extreme form elite membership is restricted to members of the same family (dynastic elitism), but more commonly it is restricted to people who move in particular social circles (class-based elitism: the “old boys’ network”). In this last form, “who you know” defines whether or not you are part of an elite, not “what can you do”: this skews human endeavour away from developing excellence towards developing connections, and therefore further dilutes the actual ability of the elite, which forces them to become even more protective of their privilege.  They may also prevent people who are the wrong sex, the wrong colour or who lack particular physical attributes which are not actually required for excellence in that field from becoming part of the elite. All of these are ways of defending their privileges.

So far, I haven’t said anything extraordinary. Elitism is a well-understood phenomenon and one which makes a lot of people very angry. But there is a necessity to the arrogance of elites, and it is not simply self-preservation. Individual members of the elite may lack genuine ability – they may simply have gained membership through their connections. But the body of knowledge and understanding that the elite AS A WHOLE has, however divorced it may seem to be from the understanding of ordinary people, nevertheless contributes to the development of human culture. And the defences that they put in place to protect their privileges enable them to maintain and develop unpopular and even apparently worthless practices that may in the future bring real value to humanity.

This will not be obvious to many people, so I will use a musical example. In the 20^th century, so-called “serious” music went down what appeared to be blind alleys. It departed from any attempt to appeal to ordinary people, and became the province of musical academics, who enjoyed it for its structural challenge rather than its appeal to human emotion. You could say that it became completely divorced from reality. Milton Babbitt, in his famous essay “Who cares if you listen?” argued that ordinary people couldn’t really be expected to understand serious music, any more than they could understand theoretical physics, and so it didn’t matter if ordinary people didn’t want to listen to it. The fact that many talented and skilled musicians didn’t really enjoy listening to it either appears to have been lost on him. He even seems rather proud of the fact that music that no-one wants to listen to is commercially dead: but despite his claim that "serious" composers were self-funding, in reality he could only reject popular appeal because state and philanthropic funding of “serious” music made commercial viability unnecessary. “Serious” musicians at this period were rent-seekers, relying on their connections with the rich and powerful to secure the funding they needed to produce music of little popular appeal or commercial value.

Perhaps the darkest of the blind alleys was the mathematical approach of the post-Schoenberg serialist school. The most famous exponent of extreme serialism, Pierre Boulez, was severely criticised by fellow composers for his “dry, ascetic” approach and eventually dropped it in favour of something slightly less rigorous. In the end, music cannot simply be a mathematical system – it must appeal to human emotions or it loses its purpose.

Meanwhile, ordinary people with ability – barred from the elite, or even rejecting it outright - were developing new forms of music. The major musical developments of the 20^th century were in popular music culture, starting with jazz and blues and moving on into the rediscovery of simple theatrical music in the American musical, the creation of rock&roll in the 1950s and 60s, and the development of contemporary popular music from indigenous musical forms. Deprived of state and, often, philanthropic funding, popular music forms and develops through the free market: music that is not popular with at least a significant proportion of people does not survive. Because of this, some forms of popular music have become “tribal” in nature: they are associated with particular groups of, especially, young people for whom the music they listen to is a part of their group identity, and its quality as music is of secondary importance. Anyone watching the reality TV shows will be aware that participants often seem to inhabit particular cultural silos, and their followers are the people who self-identify with that silo: the winner may not be the person with the most musical talent, but the one whose cultural silo is the most dominant. In popular music, “survival of the fittest” is the name of the game, but “fittest” doesn’t necessarily mean musical excellence.  

It would be all too easy to conclude that the “serious” music of the 20^th century was simply the death rattle of an obsolete art form. But that would be far from the truth. As serious music became ever more divorced from commercial reality, becoming the province of academics and no longer requiring mass popularity for its survival, it became more experimental. It was in serious music that the possibilities of electronics for creating different musical forms and textures were first explored, and it was also in serious music that the sounds of nature were appreciated as music in their own right and incorporated into musical creations. And it was in serious music that forgotten parts of Western musical culture were rediscovered and transformed into contemporary musical forms. Yes, many – perhaps most – of these experimental musical creations will not survive the test of time. But their value lies in the groundwork they provide for contemporary musical developments. Today we are seeing the important developments in popular music coalescing with the equally important developments in serious music to create new, vibrant, exciting and challenging music for the 21^st century. Had “serious” music not been protected as it was, and enabled to flourish in its academic hothouse, it would probably have died – and we would be the poorer for it. The arrogance of the musical elite, and its connections to those with financial power, enabled this tender plant to survive the turbulence of the 20^th century musical melting pot.

I would argue that the same is true in economics. In fact if anything, economics has become even more “hothouse”, and even more divorced from reality, than “serious” music. Economics has become dependent on elegant mathematical models whose relationship to the real world is questionable: it is a standing joke that in economics, if the evidence doesn’t agree with the findings of the model, you change the evidence. In some cases – notably in models of the financial system, which are the foundation of monetarist economics - the models are founded on a wrong understanding of how the world actually works. When the foundation is wrong, so is everything built upon it: but the arrogance of the economic elite makes them unwilling to accept that they may have got some things wrong, so they silence people who point this out and put up academic barriers preventing funded research into anything that questions the foundations on which they have built their models of the world.

And as with “serious” music, when economics becomes so divorced from reality that it fails adequately to explain the real world in which people live, people reject it. People rightly ask why academic economists failed either to predict or adequately explain the financial crisis, whereas heterodox economists working in the real economy – many of them untrained in formal economics – not only predicted it but correctly identified the causes. There is a real danger that the anger people feel over what they see as the failure of mainstream economics leads to rejection of mainstream economics in its entirety and, importantly, withdrawal of funding for academic economic research. This, I feel, would be a mistake.

We may not see the relevance of dynamic stochastic general equilibrium models in a world which manifestly is not in equilibrium. But that doesn’t mean that these, and other mathematical models, have nothing to contribute. The redefinition of the foundations of economics that is currently being done by heterodox economists will inevitably result in many of the models beloved of academic economists becoming obsolete: as with much of the experimental serious” music of the 20^th century, they will not survive the test of time. But there will be models that remain relevant, and there will be others that appear obsolete but that will in due course be redeveloped and find new life in the new economic paradigm. If we allow them to disappear, our economic understanding in the future will be poorer.

The academic economic elite is fiercely protective of its privileges, which is a matter of some annoyance to those who understand that it is dependent on state and philanthropic support (and is therefore arguably rent-seeking). The defensiveness of academic economists is a double-edged sword. On the one hand, as I argued above, the protection they seek to maintain will ensure the survival of unpopular and even apparently worthless economic models so that they can in due course find their place in the future economic paradigm. But on the other hand, if the academic elite’s defence of its privileges extends to refusing even to admit that some of their foundations are wrong, they may find that the rich and powerful are no longer willing to support them. Yes, “serious” musicians got away with dismissing developments in popular music as unimportant, but their work did not impinge on people’s lives in the same way as economists’ work does: people can ignore music they don’t like (though they may complain about use of their taxes to fund it), but they can’t ignore wrongly-founded economic thinking when it contributes to a major financial disaster. Economists should fear the popular vote: they may not be commercially dependent on popularity themselves, but the politicians who support them are, and when funds are tight (as they are at the moment) supporting an apparently useless economic elite may be more than the popular vote is prepared to accept. Elite arrogance is necessary, but if it goes too far it can destroy the very thing it aims to preserve.

The nature of money

This rather rambling post is sparked by recent discussions with, among others, Positive Money and assorted goldbugs,  FTAlphaville's fascinating posts about e-money in Kenya, and the World Bank's wide-ranging investigation into forms of money used by those who don't have bank accounts - which (unbelievably) is more than half the world's population.

People seem very confused about money. We have Positive Money saying that banks create money when they lend, but that in order to make payments they have to be supplied with money by the central bank. Then we have Tim Worstall insisting that banks don't create money when they lend - despite the fact that loan accounting involves the creation ex nihilo of a real deposit which can be spent like any other sort of deposit. Yes, the spending of that deposit has to be funded - but that brings us back to Positive Money and central bank money creation for payments.......

As is usual when people have a major argument about a particular point, and neither side will give way, both are missing the point. They both define "money" far too narrowly, and therefore end up with definitions of money that not only differ from each other, but also exclude many of the forms of money used in our society. 

So first, let me define what I mean by money. Actually this is not just my definition - it is the standard economic definition. Money is a medium of exchange in transactions. Any good which is widely accepted as payment for goods and services is, by definition, money.

Once you accept this definition of "money", it becomes evident that we have more than one type of money circulating in our society. What we normally think of as "money" is actually currency, which is not the only type of money around - as I shall demonstrate. And even currency comes as more than one type of money. 

Currency is one of the factors that determines national identity and ensures self-determination, and it is therefore at least partly a political construct. The ability to define and control currency is an essential function of a sovereign state. When a country voluntarily or involuntarily adopts a foreign currency as its national currency, it loses a degree of sovereignty: it is no longer able to control the value of what is usually the main form of money in that country, and that affects its ability to manage its own economic affairs. 

In modern nations, currency comes in more than one form. Cash is made up of banknotes and coins, which in most nations are produced by the central bank and/or by authorised banks on behalf of the government. Controlling the amount of physical cash in circulation is a central bank function, and compared with other forms of money very easy to do. In developing countries, physical cash is still the primary means of settling transactions in national currency, as many people don't have bank accounts. 

But in Western countries these days, most of the currency in circulation doesn't exist in the form of physical money - it exists in the form of currency-denominated balances in bank accounts. In these days of internet banking, point-of-sale electronic payment and internet sales, bank account balances are as widely accepted as cash. They ARE money, regardless of how they were created - as are debit and credit cards. And many of those balances are created, or at least topped up, by bank lending. Bank lending DOES create money.

The situation in developing countries is somewhat different. Bank lending is much less important there as a means of money creation, and bank balances are not the main form of money as they are in the West. Cash is still king, but e-credit on mobile phones is fast becoming an equally important means of settling transactions.  E-credit can be regarded as an alternative to the national currency: it is exchangeable with national currency at a rate of exchange which is currently determined by the credit provider. Countries where e-credit is widely used, such as Kenya, can be regarded as having more than one currency in circulation. 

There are other types of money that are not convertible with national currencies. Many of these have restricted usage, but within those parameters they still meet the definition of "money" as a medium of exchange. Lewes pounds, for example, are widely accepted in Lewes in payment for goods & services, but they are not accepted anywhere else and are not convertible into sterling. Tesco clubcard points can be collected (saved) and used to pay for a wide range of goods at Tesco stores and from their online shop, but they cannot be exchanged for cash and are not accepted outside Tesco. Perhaps the most widely used form of non-currency money in the UK is Air Miles, which started life as a way of saving up for expensive air tickets and has "morphed" into a way of acquiring non-currency credits that can be accepted in payment for a wide range of goods and services. 

There are also true international e-currencies. Bitcoin is gradually becoming more accepted - despite recent security breaches. Paypal accounts have their own credits and are now available on mobile phones.

There are types of money that have specialised restricted use - that we don't normally think of as money. Some people find it helpful to think of central bank reserves as a different form of money that is created only by central banks and used only for transactions between banks. It is denominated in national currency and exchangeable one-for-one with bank credit, which is also denominated in national currency. Banks can - and do - place excess deposits in reserve accounts at central banks for safe keeping, usually for a few basis points in interest. These deposits become liabilities of the central bank, and therefore "morph" into central bank money ("reserves") while they are held on deposit there. When they are withdrawn they become private bank money again. Confusion arises because the central bank has to ensure there is enough money the system to enable all banks to keep zero or positive balances in reserve accounts overnight: when the throughput of payments increases and/or some banks choose to keep higher reserve balances, therefore, it has to create more money. This is entirely separate from the money creation that private banks do, and therefore some people prefer to think of these as completely different types of money even though they are both denominated in national currency. Personally I don't find it helpful to think of central bank reserves as a restricted form of money. I find it more useful to think of the central bank payments mechanism as a pump, and reserves as the oil that lubricates its operation: adding more reserves, up to a point, enables the pump to run faster, which increases the throughput of payments and should improve the velocity of money in the economy. It does not necessarily encourage more lending, though.

Another type of money that has a restricted use is government debt. I've noted before that currency and government debt are simply two versions of the same thing - currency is perpetual zero-coupon debt securities. Here I note the same thing the other way round - government debt is time-limited interest-bearing currency. And it acts very like money in the financial markets: the shorter the maturity, the more like money it behaves. High-quality government debt is a primary source of the collateral that lubricates money transmission in the shadow banking system.

The proliferation of types of money means that our measures of money are deeply flawed. In the UK we have "narrow money", which is notes & coins in circulation plus central bank reserve deposits. We have "broad money" (M4), which is notes & coins plus private sector deposit balances (including commercial paper). But those are not the sum total of money in circulation. They don't include Government debt apart from currency. They don't include Paypal credits, Tesco Clubcard and Nectar points, Air Miles or local currencies such as the Lewes pound. They don't include mobile phone credits (a pay-as-you-go phone is in effect a pre-loaded cash card): admittedly, in the UK mobile money is not yet widespread, mainly I think because so many people have bank accounts that it is just as easy to use the existing payment systems. But the breakdown of trust in banks means that this may change, and as it does so we will find our measures of money departing further and further from economic reality.

So if we aren't even measuring the supply of money accurately, what hope is there of controlling it? And do we really want to, anyway?  Positive Money, among others, would like to restrict all money creation to the central bank. Are they therefore proposing that the Bank of England should control Paypal credits, Tesco & Sainsbury loyalty cards, Air Miles? Hardly. They are only talking about ending bank credit creation - and personally, as I have said elsewhere, I think this is misguided. But they don't even recognise the existence of other forms of money: they believe that notes & coins, central bank reserves and private bank credit are the only forms of money in circulation. Because of this their primary aim, which is state control of the money supply as the main monetary policy tool, is fundamentally flawed.

National control of electronic money that is not denominated in national currency is simply impossible.  Paypal, Bitcoin, Air Miles, e-credit - all of these are actually or potentially international. And that I believe is the way that money will go. Countries will continue to have their national currencies, but there will also be international e-currencies which will have fixed or even variable exchange relationships with national currencies. At the moment e-Safaricom credits in Kenya are exchangeable with the Kenyan shilling. But it wouldn't be difficult to make those credits additionally exchangeable with, say, the US dollar, would it? And once exchangeable with the US dollar, they would be exchangeable with all other traded currencies too.

If the future lies with international e-currencies competing freely with national currencies, it is questionable what role if any there could be for a central bank money supply policy. More radically, it is also questionable whether interest rate management, which has been the central plank of monetary policy in Western economies for the last thirty years, would be the best way of managing national economies in a world of international currencies. Most e-currencies are not interest bearing, so it seems likely that interest rate changes would only affect them through their exchange rate with the national currency. But why would an international e-currency operating in the UK necessarily be anchored to sterling? Even if it accepted sterling credits, it could well convert them to e-credit via the US dollar. Perhaps it is time to reconsider the monetary orthodoxy that influences both money supply and exchange rates by means of domestic interest rate changes?  I would venture to suggest that when national fiat currencies exist in parallel with international e-currencies, exchange rate management may become more important than interest rate management: these currencies would be likely to act as international currency anchors rather as gold did in the Gold Standard era, and there may need to be international co-operation in the management of national exchange rates to e-currencies. Perhaps it is time for a new (virtual) Bretton Woods?

Whatever form of money people choose to use, they need to have confidence in it. When confidence in a form of money breaks down, people stop using it. Bitcoin and Paypal have both had security breaches that have affected confidence, and both have seen a significant decline in usage as a consequence. When people lose faith in a national currency, they turn to a foreign currency that they trust, often the US dollar - so we have "dollarization" in the unofficial economy, often coupled with strict exchange rate control in the official sector. This was the situation in the Soviet Union prior to the fall of the Berlin Wall in 1989. When I went there in 1982, the existence of the "dollar market" was evident. People would buy consumer goods from tourists that they could exchange for dollars: I remember being asked if I would sell my watch. Some tourists deliberately brought in goods that they could sell. Selling consumer goods for roubles meant that you got a much better exchange rate (from a tourist's perspective) than if you exchanged sterling or dollars at the official rate: we all knew that the locals would then sell those goods on the black market for dollars, which would enable them to buy things that were either unavailable or ridiculously expensive in roubles. When the population rejects a national currency and there is no exchange rate control, the currency becomes worthless and the result may be hyperinflation.

Some people confuse money (medium of exchange) with a store of value. These are the people, generally, who want money to be intrinsically valuable in its own right - gold, for example. This is nonsense. Money does act as a store of value in the sense that it creates a means of valuing goods that otherwise would be difficult to compare. But it cannot have intrinsic value in itself.  No good is "intrinsically" valuable: the value of a good is ALWAYS determined by its usefulness to the holder. If I am starving, gold is worthless to me unless I can exchange it for food - and if everyone is starving, a loaf of bread may be far more valuable than a gold ingot.  

Stores of value generally are things that don't decay and whose value tends to appreciate over time - property, art, wine, precious metals, debt securities, stocks & shares. To be actually valuable, stores of value have to be realisable in terms of some kind of money. Therefore it is not surprising that some people loosely describe "money" as a "store of value". But that is an incorrect definition of money. For example, gold is currently a store of value. But as the entire world is currently operating paper currencies, it is not currently a medium of exchange, however much some people might like it to be. It simply is not widely acceptable as payment for goods and services. Therefore gold at present is NOT "money", though it often has been in the past.  It is, however, an excellent store of value. 

It is the people who confuse money with a store of value who tend to be most scared of inflation. This is understandable, because if you believe that your personal worth is determined by the value of the money that you hold, depreciation of that money is disastrous. Paper money (what we call "fiat" currency) is not a good store of value: inflation is a feature of fiat currency systems and over time nearly all fiat currencies will depreciate to a greater or lesser extent. But that is not a good reason for adopting commodity money, such as a gold standard. Nor is it a reason to defend the international value of a currency at the price of domestic economic devastation. Rather, it is a good reason not to keep your long-term savings in the form of fiat currency!

I believe that the safest and most effective store of value is not any sort of non-perishable "good". It is investment in productive activity and engagement with society to promote economic growth and gain a return from that growth. Hoarding doesn't help anyone: if everyone hoards, money ceases to circulate, productive activity collapses, and hoarded goods become worthless as loaves of bread become more valuable than gold.....  



Related posts:

The shoebox swindle
The shoebox shortage
Do we really care who creates money?

The shoebox shortage: part II of the Britham series

In the little village of Britham, all is not well.

It seems that a group of youths with more money than sense - and a liking for kite-flying - borrowed large quantities of shoeboxes from the bank, promising to make lots of money with them. What they actually did was cut them into pieces and attach them in orderly sequences to the tails of their kites. They then went up to the top of the hill overlooking the village to fly their kites. But on one particularly windy day, lots of the kites slipped from their owners' grasp and sailed up into the sky, never to be seen again.

Now the local bank is short of shoeboxes, and the local paper reports that they are turning down people who want loans. The town is up in arms. Business is grinding to a halt and people are losing their jobs because of the lack of shoeboxes. The local mayor decides to do something. 

Next to Britham's Printers is an equally stately-looking building with a sign outside saying "Britham's Boxes". The mayor sends his deputy to ask them if they produce shoeboxes.

He goes into the shop. Lounging at the counter is the manager of Britham's Printers, whose printing presses had rescued the bank when it ran out of money.

"Is this your place too?" asks the deputy mayor.

"Yes", says the print shop manager. "I run both businesses. My name's Merlin, by the way. What can I do for you?"

"The bank has run out of shoeboxes. Those pesky youths have lost lots of them. Can you provide some more?"

"Hmm. I'd rather not provide the bank with shoeboxes directly - even printing money for them upsets people. But there is something I can do."

He takes the deputy mayor through the door at the back of the shop. Behind the shop is a HUGE warehouse. In one corner is an enormous pile of card. Next to it is a large number of tubes of glue. And in the opposite corner is a small pile of pretty silk purses of various colours, each with a golden clasp. The print shop manager points at them.

"I need more of those. But the shop that sells them has a policy of only selling to little old ladies, and the little old ladies - well, I don't know what they do with them, but I reckon they stuff them under their mattresses. So I'm struggling to get them.  Now, if I could provide those old ladies with card and glue in return for their silk purses, they could make shoeboxes and you could pay them to borrow their shoeboxes."

"That sounds complicated," says the deputy mayor doubtfully, wondering why on earth a print shop and box manufacturer would want silk purses.

"Honest, trust me, it'll work. My best people have worked this out", replies Merlin.

The following day, every little old lady in Britham is offered card and glue to make shoeboxes for the bank, in return for parting with their silk purses. The takeup is surprisingly good and before long there is a queue of little old ladies with shoeboxes waiting outside the bank. The box manufacturer's pile of silk purses is already halfway to the ceiling.

But the people of Britham still can't get shoeboxes from the bank. The "pesky youths" experience has made the bank manager extremely wary of lending shoeboxes to anyone under the age of 60 - at least that's what the local newspaper says. Although there don't seem to be many people going into the bank these days, except little old ladies with shoeboxes.....

The deputy mayor visits the bank manager to impress on him that he MUST lend his shoeboxes to local businesses. The bank manager promises to do his best, though he complains that they don't seem to want to borrow. He sends out flyers to all the local businesses offering loans. But nothing much improves. The supply of shoeboxes remains restricted, fewer and fewer goods are sold and people take to growing their own food. Meanwhile the pile of silk purses grows ever bigger, as does the pile of shoeboxes at the bank.

Mystified by the lack of lending, the deputy mayor decides to visit some local businesses to find out more. Some of them moan that banks charge too much. But others simply say "we don't want to", without offering an explanation. Just as the deputy mayor is leaving one of them, the door to the warehouse opens and he catches a glimpse of the contents. It is stacked from floor to ceiling with shoeboxes. And he remembers seeing a similar stack of shoeboxes in his uncle's shed yesterday when he went round for tea. He didn't think anything of it at the time, but.... the thought hits him that maybe everyone is hoarding shoeboxes, and that's why there seems to be a shortage of shoeboxes.....in which case making more shoeboxes only gives people more shoeboxes to hoard, doesn't it? 

The next day, outside the bank there is an angry man with a placard reading "END THE SHOEBOX SWINDLE! STOP BANKS CREATING SHOEBOXES!" On the other side of the street there is another angry man with a placard reading "END THE SHOEBOX SWINDLE! FILL SHOEBOXES WITH GOLD!"  And there is an article in the local newspaper arguing that the current shortage of shoeboxes is all because the only way people can get shoeboxes is if banks lend them, and banks aren't lending. It suggests that Britham's Boxes should create shoeboxes itself and give them directly to people and businesses to "get the economy moving".  That evening, a scholarly gentleman gives a talk to the Chamber of Commerce in which he argues that the problem is actually that far too many shoeboxes have been produced by the banks, and the solution is for all shoeboxes to be created only by Britham's Boxes. 

The Salvation Army opens a soup kitchen at the local working men's club - which is full of disgruntled people who are unable to find work. The churches hold jumble sales to raise the money to pay their ministers. The high street looks like a ghost town as more and more shops and businesses close. People dig up their flowerbeds and lawns to grow vegetables, and turn rabbit hutches into hen coops. The streets are clogged with bicycles and pedestrians as people stop using cars.

And all the while the shoeboxes stack up in the banks, the businesses and the garden sheds of Britham.


Related posts:

The shoebox swindle
Do we really care who creates money?
The paradox of thrift

The shoebox swindle

It's morning in the charming little village of Britham. A man - let's call him John - goes into his local bank.

"I want to borrow £1000", he says.

"Let's see what we can do", says the bank manager.

After close inspection of John's payslips and a few phone calls to local shops and tradesmen to check that John has always paid his bills and paid for his goods, the bank manager agrees to give him the loan.

"l'll just sort that out for you now", he says.

He disappears through the door into the back office. Once in the office, he gets out a shoebox. Into the shoebox he puts.....well, we'll find out later what bank managers put in shoeboxes. Then he seals the box and stamps it with an official bank stamp saying "£1000". He takes the box back out to where John is waiting.

"Here you are", he says. "Here's your loan".  He and John shake hands, and John leaves, carrying his shoebox.

John takes his shoebox to the bike shop to buy his son a bike for his birthday. The bike he wants is on sale at £500. John hands the shoebox to Fred, the bike shop owner. "There's one thousand pounds," he says. "Can you give me change?"

Fred doesn't have £500 cash in the till, but he has another shoebox with an official bank stamp saying "£500" that someone gave him earlier. So the two swap shoeboxes.

John takes the new shoebox to the grocer, where he buys his week's shopping and hands the shoebox over in payment. Muttering beneath his breath "people seem to think I'm a b***y bank!", Bob the grocer gives him three shoeboxes. each marked "£100", plus £80 in cash. Bob then takes the £500 shoebox to the bank. "Can you look after this for me, please?" he says.

Armed with the shoebox that John gave him, Fred goes to the wholesaler to replenish his bike stocks.  Outside the wholesaler's warehouse is a large sign saying "CASH ONLY - NO SHOEBOXES". Fred is slightly puzzled by this, but doesn't think anything of it. After all, the shoebox contains £1000, so all he has to do is open the box.....

Opening the box takes him a while, because whoever sealed it used industrial-strength glue. And all the while the wholesaler watches pityingly. He's seen people do this before.

Eventually Fred manages to get the box open. And inside is - nothing.

"I'VE BEEN SWINDLED!" he shouts. John is nowhere to be seen, but the bank that issued the shoebox is still open. He runs in. "This box is empty. Where's the money?" he cries.

"I'm really sorry, sir", says Joe the cashier. "Our back office must have forgotten to put in the money. If you will take a seat, I'll go and get it for you."

Slightly relieved, Fred sits down. Joe runs through to the back office.

"Someone's opened their box!" he cries. Everyone stops whatever they were doing. The manager turns ashen.

"How much?" he asks.

"One thousand pounds", says Joe.

"Crikey", mutters Stacey the clerk. "We'll never raise that much from a whipround!"

She is indeed correct. The amount they manage to raise by emptying their pockets is £100, mainly in used £10 notes.

Joe rings round the banks in the nearby villages to see if he can borrow the £1000, but none of them want to know. Apparently a bank in Pondland ran out of money and went bust, and now none of the banks will lend money to other banks in case those banks also go bust and they lose their money.

"I've got a better idea," says the manager. "Give me one of those £10 notes".

He runs out to the street. Opposite is a stately-looking shop called "Britham's Printers". Its owner sees him coming.

"How much is it this time?" he says.

"A hundred of these, and I need them quickly!" He hands over the £10 note.

The printer goes out to the back of his shop, where there is a printing press. He runs off one hundred £10 notes.

"Here you are," he says. "I need it back tomorrow, though, and I'm keeping your £10 as payment. Oh, and I need some security. How about that gold watch you're wearing?"

The bank manager gives him his gold watch and walks back to the bank carrying the new banknotes. He goes in by the side door so Fred doesn't see him, and he gives the notes to Joe. Joe carries the bundle of notes through to the front office where Fred is waiting.

"Here's your money, sir," he says. "I'm so sorry about that". He picks up the shoebox, carries it through to the back office and puts it on the shelf.

Fred walks home a happy man. The bank manager is not so happy, though. He has to raise one thousand pounds by the end of next day or he loses his gold watch. And the printer doesn't accept shoeboxes - after all, he knows what is in them.

The next day, Fred takes his £1000 in new £10 notes to the bike wholesaler and hands it over in return for a consignment of bikes. The wholesaler takes the £1000 to the bank and hands it in in return for a shoebox stamped "£1000". After all, shoeboxes you get directly from the bank must be ok. It's only shoeboxes from customers that could be dodgy. Can't be too careful these days! Mind you, that shoebox is a bit battered - looks as if it's been opened before, maybe?

The bank manager takes the £1000 cash to the printer and hands it over. The printer returns his gold watch to him.

"See you tomorrow", he says.

But next day, the headline on the local newspaper reads, "LOCAL BANK RUNS OUT OF MONEY - HAS TO GET EMERGENCY FUNDING". It seems that when she got home, Stacey told her husband about the emergency printing yesterday, and her husband went to the pub that evening.....anyway, somehow the story got out and now it is all over the local papers. Bob the grocer sees this and thinks, "Oh heck, I put £500 into that bank yesterday! I'd better get it out!"

Outside the bank is a VERY long queue......



Related posts:
The shoebox shortage - part 2 of the Britham saga

Do we really care who creates money?

According to Positive Money, 97% of the money in circulation in the UK is created by private banks when they lend. Only 3% is money created by the central bank on behalf of the Government. Shock, horror!

Actually, that sounded a bit high to me, so I looked into the origin of this interesting statistic. About 3% of the total money supply in the UK (sterling M4) is indeed notes and coins in circulation. But Positive Money aren't correct to claim that the rest is entirely held by banks. They've ignored the little matter of central bank reserves.....This is actually rather more important than it sounds, since the effect of QE and a generally risk-off environment has been to encourage banks to keep more money in reserve accounts at the Bank of England rather than lending it to each other. So the true figure is probably more like 90%.

Well, ok, that's still a lot, isn't it?

No, it isn't. You see, nearly 90% of the UK population has at least one bank account. And guess what they keep in those accounts? Yup, you got it. Money. In fact most of the money in our society washes around the banking system. Some of it gets diverted into central bank reserve accounts (7%), and some of it gets withdrawn from ATMs (3%). The rest circulates as paper (cheques) and electronic transfers from one bank to another corresponding to the payment and spending activity by households and businesses.

Fifty years ago the proportion of notes & coins in circulation to money held in commercial banks was much higher. That is because far fewer people had bank accounts and the majority of working-class people were paid in cash. Even for those who did have bank accounts, making payments directly from bank accounts was not a simple matter. Regular payments could be set up as standing orders, but all other direct payments from bank accounts involved considerable delay. Most people preferred to use cash for their daily expenditure.

That was the world that I grew up in. Cash was king, cheques took two weeks to clear and credit and debit cards didn't exist.

It's still like that in large parts of the world. Even in the UK, over 10% of people still work on a cash-only basis because they do not have bank accounts or because for some reason they cannot use their bank accounts (for example because of high debts - if someone is over their overdraft limit, any money they put into their account "disappears" and is not available for essential personal expenditure such as food, so they don't put money in the bank at all). They are the very poorest of our society.

In poorer parts of the world such as Africa, where high proportions of the population don't have bank accounts, payments are increasingly being made electronically in ways that bypass banks. Mobile phones, rather than bank accounts, are the preferred means of funds transfer. Various agencies are energetically trying to improve access to banking facilities, but not so that payments can be made - on the contrary, they are encouraging further development of non-bank payment platforms. They are more interested in encouraging people to use banks for STORAGE. You see, these very poor people don't trust banks. They like to have money they can touch. And they don't borrow - even if they could, many of them have a horror of owing money. They save instead. Cash, under the bed or the carpet. But people who stuff their mattresses with cash are at risk of losing their precious money through fire, flood, mice, beetles and above all through theft, often violent. Compared to those risks, banks in poor countries are safe places. They are also rare - which is much of the problem. No-one really wants to put their cash in the bank if the nearest branch is 60 miles away and the only way of getting there is walking. So reducing the number of the "unbanked" is an uphill struggle, both in terms of provision of basic banking services AND in terms of their takeup.

It's interesting, isn't it, that much of the debate that rages around bank reform in the UK is concerned with making banks safer places to put money and reducing our dependence on debt. It's almost as if we want to be back where we were fifty years ago - where much of the world still is. We look back on that time through rose-tinted glasses. We perceive it as a "golden age" of financial responsibility, when bankers were pillars of the community rather than the hated pariahs they have now become. But we were also materially poorer then. I come from a firmly middle-class family, but we did not have a fridge until I was seven, we did not have a washing machine, we only had partial central heating, we did not run a car and we didn't have a television. We did not have overseas holidays, we walked everywhere and we borrowed books from the local library instead of buying paperbacks. When clothes developed holes, we mended them. There was a stigma around debt and few people borrowed, except for mortgages - and even those were not as common as they are now, as that was the heyday of post-WWII social housing. And people saved, because saving was regarded as "good". Even if it meant that they struggled to provide food for their families, they saved. Many of those elderly people who saved so much then are now among the richest in our society: not only have their savings appreciated, but those who owned their own houses have also benefited from significant inflation in property prices.

I have no desire to return to that way of life. It doesn't look like a "golden age" to me. So many things we take for granted simply weren't there then. Yes, for many people debt has got out of control. Yes, banks have behaved badly and destroyed much of our trust in them. But does that mean we throw away all we have gained?

The fact is that our credit money system has allowed many of us to borrow from our futures and become materially richer in consequence. As a society our standard of living is very much higher than it was fifty years ago: we live longer, we are healthier and we have more material goods. I don't know that we are necessarily happier because of this, and there is no doubt that inequality within our society has risen - there are still pockets of serious poverty, and the rich have benefited disproportionately. There is much to be done to redress that. But I can't see why discovering that 90% of our national currency is created by bank lending is so awful that we need to completely dismantle our financial system. I really don't care how my money is created, as long as I receive it on time and can spend it on things I need. Whether commercial banks or central banks should create money is not important to those whose problem is that they don't have enough money.

It seems to me that we are spending an awful lot of time and energy arguing about who should own the production of the means of exchange in our society, when we could perhaps use that energy more productively in finding ways of redistributing that means of exchange so that everyone has enough of it......

LIBOR-rigging and double standards

This afternoon, Paul Tucker, Deputy Governor of the Bank of England, appears before the Treasury Select Committee (TSC) to explain the Bank of England's role in the LIBOR-rigging scandal.

And boy does he have some explaining to do. As Tim Worstall pointed out the other day, the Bank of England must have known that LIBOR submissions from HBOS and RBS both before and after the failure of Lehman in September 2008 were far lower than the rates they would realistically pay if they were to attempt to borrow in the interbank market. Both were shut out of the markets at the time and dependent on Emergency Liquidity Assistance (ELA) from the Bank of England.  This crisis funding was not declared to the public, and it seems that in order to keep it quiet, the Bank of England accepted much lower LIBOR submissions so that HBOS and RBS gave the impression of being solvent when they were actually at death's door.

Of course, HBOS and RBS actually had no way of establishing what a realistic interbank borrowing rate would have been for them - "infinite" is the closest we can get, since no-one would lend them money at any price. And there were other panel banks in the same sort of mess, such as WestLB and UBS. So there was no way that LIBOR could be allowed to represent the reality in the marketplace: the consequences for the billions of loan and derivative contracts priced off LIBOR would have been horrific. Therefore the actions of the regulators in accepting, and maybe even encouraging, unrealistic LIBOR submissions at this time were reasonable and may have prevented a bad situation from becoming much worse.

Barclays' LIBOR submissions were higher than other banks' throughout this time despite the fact that other banks were clearly in much worse shape: even after the famous Tucker/Diamond phone call, when Barclays admits it reduced its submissions, they were STILL higher than other banks, because it seems other banks reduced theirs further. Barclays says it repeatedly pointed out this discrepancy to regulators on both sides of the Atlantic, but regulators did nothing - which supports the argument that regulators knew perfectly well the rate was being manipulated.

The picture that is emerging is collusion among regulators and panel banks to maintain LIBOR at a sensible rate at a time of market turmoil. So far so good. I don't, personally, have a problem with this as an emergency strategy. What I do have an issue with is the fact that Barclays has now been fined for manipulating its LIBOR submissions at this time. Admittedly that is not the only reason for its fine, as I noted in a previous post. But it is a significant part of the FSA's censure.

To me it is unacceptable that the FSA fined Barclays for behaviour that the Bank of England condoned, and may have encouraged, in other banks at the same time. This is the worst kind of double standards. I am struggling to understand the FSA's motives in exposing the Bank of England, and possibly the Treasury, in this way. The cynical part of me remembers that the FSA is about to be disbanded and its bank regulatory functions transferred to the Bank of England. Surely this isn't the FSA lashing out at its rival?

Whatever the reason, it leaves a problem. If the FSA's censure of Barclays for LIBOR manipulation during the financial crisis is allowed to stand, then the Bank of England's behaviour in allowing other banks to manipulate their submissions must be criticised - along with the BBA, the Treasury and even the NY Fed. The alternative is that the real drivers of LIBOR manipulation during this time declare their hand, which would allow the FSA to recant without losing face. But if this second course of action is followed, then the world must accept that LIBOR is not, and never will be, a market-determined rate. It is open to political manipulation when circumstances dictate.

The Treasury Select Committee is currently responsible for getting to the bottom of this unholy mess. I do hope that at least one member is on the ball. Their performance in Diamond's interrogation doesn't fill me with hope, frankly. And I am astounded that the Government thinks a parliamentary inquiry will be sufficient. Unless the TSC does very much better today than it did last week, there will be far too many questions left unanswered. The case for an independent judicial inquiry is becoming overwhelming.

I am a bank

I am a bank.

Honest, I really am. This is not a joke.

You see, I lend people money. Or, more accurately, I allow them to run lines of credit, which I create for them out of thin air.

Let me explain. My day job is teaching singing, much of it to teenagers in secondary schools. These teenagers' lessons are paid for by their parents. I invoice them for 10 lessons at a time and they are supposed to pay for the whole series of lessons before the series starts.

In practice, hardly anyone does. About half will have paid by the 5th lesson and the remainder have to be chased. The vast majority do pay by the end of the series of lessons, but there are a small minority who have to be cajoled, threatened or even sued. Some negotiate with me for payment in instalments and then forget to make those payments.

No doubt because of their own financial difficulties, the proportion of people who pay late is rising, as is the proportion of people who don't pay at all. In the last year I have sued two people at the County Court for non-payment of fees, one of whom didn't reply and has had default judgement served against them - but I still haven't been paid. The other has offered to pay off the fees and associated charges at £20 per month, which is all she reckons she can afford.....but if that is true then she couldn't afford the lessons in the first place, because the fees for 10 lessons between January and March were £135. In effect she is expecting me to extend her an interest-free loan.

But she is not the only one. In fact every single one of the parents who pays late is effectively expecting me to lend them the money to pay my fees.

Which is why I say I am a bank. But unlike a normal bank, I am expected to lend to them interest-free - parents get very angry if I start imposing interest on late payments, although the law does allow me to do this and even recommends a rate. If I upset parents, they may take their business elsewhere - and student numbers are falling at the moment because poorer parents are finding it difficult to maintain their childrens' musical activities at the moment. So I could end up even worse off if I insist that parents have to pay up front.

I am by no means alone in this. Most small businesses are forced to extend lines of credit interest-free to customers, particularly large and rich ones who have the leverage to squeeze them out of business if they complain. Most small businesses, therefore, are unofficially acting as banks.

And they do it at considerable cost. Like most micro businesses, I rely on the fees from my singing lessons to meet my personal living expenses. Because parents routinely breach my terms and conditions that clearly state that payment must be made in full within 14 days of the invoice, which is sent at the start of term, I have no idea when I will be paid - but my own bills still have to be paid. Unlike parents, I have no access to interest-free credit: I can only borrow from the bank, and if I go over my overdraft limit that funding is at a penalty rate. And as I said above, it is difficult for me to pass these costs on to my customers.

There has been considerable discussion recently about trust in banking. People are understandably angry that banks have betrayed their trust and behaved disgracefully. I have no doubt that the parents who fail to pay my bills on time (or at all) are among those who are angry at the fraudulent behaviour of banks. What a pity they can't see that their own behaviour is just as bad.

Businesses like mine depend absolutely on trust - trust from the parents, that their child will be properly taught: and trust from me, that parents will pay in accordance with agreed terms and conditions. If one side fails to abide by their obligations, that trust is broken. I already feel as if I should, for my family's sake, seek employment with a steady income, but I resist that pressure because I love the work I do and believe that I deliver real value to my students. But if the present trend - increasing volumes of late and failed payments - continues it will not be possible for me to continue.

Now, instead of being negative about this, I could treat it as a business opportunity. Currently my business  overdraft rate is 6%, and the rate that I can charge on bad debts that are going to the County Court is 8%. It may be that the reason parents get cross if I charge them interest is that they don't realise that I'm lending them money. Suppose I were to make it explicit in my terms and conditions? I could say "A credit account will be opened for you when you book your first course of lessons. To avoid interest charges, you must pay the account in full by ..... date. After that interest will be charged at 8%". I would need to send out statements of account, of course, and I would still have bad debts. But I would be making money on the credit I extend to my customers. I would be borrowing short (overdraft) at 6% and lending long (3-month credit line) at 8%.  This is credit intermediation and maturity transformation.

And note that credit creation is involved. I only have to borrow when I have a bill to pay, which may be some time after I've extended lines of credit to my customers. The line of credit is a stream of future payments plus interest and I would borrow on the strength of those future cash flows. But my customers in effect have borrowed money from me to pay my bill, even though I don't actually have that money until I borrow from the bank to meet my expenses (money that I wouldn't have had to borrow if they ACTUALLY paid upfront - I hope that is clear). In this way I have effectively created money. 

Effectively, I would be an unregulated and unlicensed bank - a "shadow bank", making money on the spread between borrowing and lending. And you will note that I would be borrowing from real banks - which are supported by the taxpayer - to fund my shadow banking activity. If I went bust, the real bank would lose money and the taxpayer would be on the hook. I am hopeful that those taxpayers would include the parents whose failure to pay caused my business to fail - but if they cheated me, perhaps they cheat the government too?

The thing is, though, I don't want to run a bank. I don't want to make money by borrowing short and lending long. I want to teach singing and be fairly paid, on time, for what I do. Is that too much to ask?


A shorter version of this article is cross-posted at singingiseasy.blogspot.co.uk.

So whose fault IS it, then?

Following Bob Diamond's resignation this morning - forced, according to the BBC, by an unholy alliance of the Bank of England's Mervyn King and the FSA's Lord Turner - Barclays is fighting back. It has produced this statement in advance of Diamond's meeting with the Treasury Select Committee.

The impression this statement gives is that Barclays feels it has been hung out to dry for manipulating a rate when they believed they were doing so under instruction from the Bank of England. And Barclays insists that other banks were submitting lower rates and that Barclays repeatedly complained to the British Bankers' Association (BBA), the Bank of England, the FSA and the Federal Reserve about this to no avail. If it's true that Barclays warned regulators that other banks were manipulating their submissions and regulators ignored the warnings, it doesn't exactly show the regulators in a good light. That's bad enough.

But scroll down through the statement and the charts in the appendices, and right at the very end there is a file note recording the main points in a telephone conversation between Paul Tucker of the Bank of England and Bob Diamond at the height of the financial crisis in 2008. Here it is in full:

It would appear that someone 'senior' in Whitehall didn't want Barclays out of line with other banks. Wonder who that was?

I'm not the only person who noticed this, by the way. Joseph Cotterill at FTAlphaville did too.

On the demonisation of derivatives

Ever since the financial crisis of 2007, there has been a prevalent belief that derivative financial products - swaps, options and the like - are a) useless and b) harmful. So, for example, in today's Guardian, Will Hutton castigates derivatives:

Derivatives should rather be seen as economically purposeless constructs whose ease of manipulation in opaque markets makes the investment banks rich – while the rest of us take our chances.

This is simply wrong. Derivatives, like all financial products, have real-world uses that benefit ordinary people and businesses. It is when they are MISUSED that the problems arise. And I would be the first to admit that in the last decade, misuse of derivatives has enriched a small minority beyond their wildest dreams and caused misery for millions.

The latest scandal concerns a form of derivative use that is close to my heart. Retail customers - small and medium-size businesses (SMEs) - have been sold derivatives ostensibly to help them manage their interest rate risk. Use of options and swaps to reduce the exposure of retail customers to movements in interest rates and exchange rates was the subject of my MBA project, and I worked in partnership with two people from the insurance industry to create what our supervisors thought would be an important new financial product. Although we did not proceed further with this ourselves, clearly the large banks have done so - or at least, they have sold derivative products to retail customers, though not quite as we intended, as I shall explain. And I am, personally, bitterly disappointed that instead of selling derivatives in the best interests of their customers, they have done so purely to make money for themselves at the expense of their customers.

I'm going to summarise here the findings of my project. It is twenty years since I completed it, and there have been many changes in banking and financial markets since then - not least the development of credit derivatives - but the salient points are still as they were then.

The main premise is that derivatives such as options (including caps and floors) and swaps have a legitimate use as INSURANCE for businesses borrowing money for investment, and, particularly, for trade. We particularly considered the need for elimination of currency risk in cross-border trade finance, for which currency swaps are useful because they combine currency and interest rate risk management (there is a relationship between exchange rates and interest rates that these swaps exploit). We also thought that currency options should be available as standalone products for businesses self-financing cross-border trade. None of this is rocket science - it is simply a case of "locking in" the future cost of financing trade flows to countries whose currencies "float" against the business's "native" currency.

For businesses financing investment by means of borrowing, there may be a need to manage interest rate risk. Business loans are often floating-rate, which means that the business's interest cost can rise considerably when interest rates rise, as historically they have done at periods of economic stress and particularly when inflation is rising. Conversely, when interest rates fall the business's interest costs also fall, which benefits them. So with floating-rate loans there is an upside and a downside interest rate risk - variable-rate mortgage holders will also be familiar with this.

Businesses that expect interest rates to rise may choose to "lock in" their interest cost by swapping their floating-rate payments for fixed rate. The product that enables this is an interest rate swap. The problem, of course, is that if interest rates then fall, the business does not benefit from the reduced interest cost. It is possible to sell on interest rate swaps that are no longer required, but when floating interest rates on lending are well below the fixed rate, the sale price will be astronomical - after all, who wants a swap that is going to make them pay MORE than they are at the moment? It is also possible to cancel them, but again that will be expensive, because the fixed rate then rebounds to the holder of the other side of the swap - who at the moment is benefiting hugely from the very low interest rates.

An alternative approach to managing interest rate risk is to cap the interest rate. This is done by purchasing a series of options that are exercised when the interest rate rises above the set limit ("strike price" of the option). The payments the buyer receives from the exercised options cover the excess interest over the agreed rate limit, effectively reducing the interest cost. I hope this makes sense (no-one ever said derivatives were easy to understand!). Interest rate caps have the advantage that they limit the risk of interest rate rises while still allowing the buyer to benefit from interest rate falls. The downside is that, just like insurance, the option premium has to be paid whether or not the options are ever exercised.

Because of their large size and diversity, multinationals are able to manage their interest rate exposure much better than SMEs. They have access to capital markets for funding and can use exchange-traded derivative products. They also are likely to have in-house expertise in financial management. But for SMEs there is no liquid market, and there may be no in-house understanding of financial management either. Most of them are reliant on bank borrowing for finance, and if they use derivatives they can only obtain them over-the-counter, because the size of the loans they are insuring is too small for exchange-traded products. Over-the-counter products are less transparent and generally more expensive - it is like the difference between bespoke tailoring and mass-market fashion. Yet for SME's, bespoke is all that is available. And they are often critically dependent on banks and accountants for financial advice - as the Breedon report noted.

My MBA project concluded that there was a clear opportunity for large banks to provide a useful service to SMEs. They could create cheap and effective insurance products to help businesses manage their interest rate and currency risk. SME lending is a mass-market product: the risks can be pooled and hedged against in aggregate. Securitisation of the loans themselves would not be necessary, because banks could hedge the lending on their own balance sheets and charge fees to the clients that were sufficient to cover the hedging costs with a reasonable margin. And we thought that banks should develop a service to advise businesses how best to use these products to control interest costs and meet foreign currency requirements.

This is very far removed from what banks have actually done. Instead of using their balance sheets and their market access to develop cheap and effective interest and exchange rate management products for SMEs, they have sold individual SMEs inappropriate over-the-counter products which they did not understand and from which they were unable to exit. Furthermore, they have made buying those products a condition of lending, and they have abjectly failed to provide the advisory service that my partners and I wanted to see. The findings of the FSA are damning:

We have found a range of poor sales practices including:

·    Poor disclosure of exit costs;

·    Failure to ascertain the customers' understanding of risk;

·    Non advised sales straying into advice;

·    "Over-hedging" (i.e. where the amounts and/or duration did not match the underlying loans); and

·    Rewards and incentives being a driver of these practices.

The four largest UK banks have been censured by the FSA for mis-selling, and have agreed to compensate those businesses which were sold inappropriate products (notably the notorious "structured collar", which actually increases interest cost when interest rates fall below an agreed "floor"). That's all well and good. But what worries me is that the adverse publicity around this episode, as with other episodes of derivatives abuse, will prevent the legitimate use of simple derivatives to insure against business risks. Banks won't feel able to offer them, and SME's will be too scared to accept them. This is not progress.

Many people on reading this will respond with, "Well, yes, we can see the point of simple derivatives for insurance purposes. But all this speculative trading in derivatives - that has to end. It serves no useful purpose".  But they would be wrong.

You see, it is not possible to eliminate risk, only to move it. When a business eliminates the risk of adverse interest rate movements by swapping floating rate for fixed rate, someone else has to accept the risk. That "someone else" is typically a speculative trader or investor who is seeking to make a return. Similarly, with options: the writer of an option accepts the risk of adverse movement in return for a payment, in just the same way as an insurance company does - the payment is even called a "premium". But options writers are looking to make a return from accepting that risk. They are, again, speculative traders.

The job of speculative traders and investors is to make money by accepting and managing risk. If they get it wrong they can lose a LOT of money. They can even bring down a bank. But that doesn't mean that what they do is useless. On the contrary, their work is essential if ordinary businesses are to eliminate risks that don't belong to their businesses.

So let's have no more demonisation of derivatives and the people who trade them. Derivatives are useful to businesses, and the people who trade them provide a necessary service which is of value to society. It is important that this activity is properly regulated, so it remains essentially a service and doesn't become an end in itself. We should treat derivatives as what they are - insurance products - and regulate their use and their trading in exactly the same way as we do insurance.

Despite everything that has happened, and the awful reputation that derivatives (and banks) now have, I still live in hope that eventually someone, somewhere, will offer SME's the sort of cheap and effective financial risk management products and advisory service that I and my MBA partners imagined, twenty years ago.



(I apologise to Izabella Kaminska of FTAlphaville for plagiarising the title of this post. I recommend a read of her original, by the way - On the Demonisation of Debt)