Phases Of The Crisis – Are We Approaching The Endgame?

Phase 1: Greenspan, the arch money crank

The Greenspan “put”, and the collective adoption by most central bankers of low interest rates after the dot-com bust and 9/11, caused one of the largest injections of bank credit in history. Since bank credit circulates as money, we can say public policy has created the largest amount of new money in history. This should never be confused with creating new wealth. That is what entrepreneurs do when they use the existing factors of production — land, labour and capital — in better ways, to make new and better products. The money unit facilitates this exchange. Now to a money crank.  He will assume that new money will raise prices simultaneously and proportionately, so the net effect of the economy is that all the ships rise with the tide at the same rate. He’ll say that money is neutral and does not have any effect on the workings of the economy. One of the great insights of the older classical economists, and in particular the Austrian School, is that new money has to enter the economy somewhere.  Injected money causes a rise in the price levels associated with the industry, businesses, or people who are fortunate enough to be in receipt of the new money. Prices change and move relative to other prices. It is often quite easy to see where the new money enters into the economy by observing where the booms are. Suppose a banker sells government bonds to another part of the government (as has been the case with UK QE policy).  For selling, say, £30bn of government debt to the Bank of England, he gets a staggering, eye-popping bonus. With his newly minted money, he buys a new £10m house in Chelsea, a £5m yacht in Southampton, some diamonds for the wife to keep her happy, and lives a happy and rich life. The estate agent spends his commission on a luxury car, and some more humdrum items that mere mortals buy.  At each point in time, the prices of the goods favoured by the recipients of new money are being bid up relative to what they are not spending on.  Eventually these distortions ripple through the economy, and the people furthest from the injection of new money — those on fixed income, pensioners, welfare recipients — end up paying inflated prices on the basic goods and services they buy. A real transfer of wealth takes place, from the poorest members of society to the richest. You could not make this up. I am no fan of the “progressive” income tax, but I certainly can’t support a regressive wealth transfer from the poor to the rich! Even when the government was not creating new money itself, it was setting the interest rate, or the costs of loanable funds, well underneath what would naturally be agreed between savers and borrowers.  Bankers are exclusively endowed with the ability to loan money into existence, so they welcome the low rates and happily lend, charging massive fees to enrich themselves in the process. After the dot-com bubble, it was property prices that went up and up.  Not only do we have the richer first recipients of new money benefiting at the expense of the poor, we have a massive mis-allocation of capital to “boom” industries that can only be sustained so long as we keep the new money creation growing. Our present monetary system is both unethical and wasteful of scarce resources. We do not let counterfeiters lower our purchasing power, and we should not let governments and bankers do it.

Phase 2: Bush & Brown – private debt nationalised by the Sovereign

This flood of new money brought more marginal lending possibilities onto the horizon of the bankers. They devised a range of exotic products whose names are now familiar: CDO, MBS, CDO-squared, Synthetic CDO, and many more — all created to get lower quality risk off the issuing bank’s balance sheet, and onto anyone’s but theirs! In 2007/2008, bankers started to wake up to the fact that everyone’s balance sheets were stuffed with candyfloss money, at which point they suddenly got the jitters and refused to lend to each other.  As we know, bankers are the only people on the planet who do not have to provide for their current creditors; they can lend long and borrow short. Thus, the credit crunch happened when the demand for overnight money to pay short-term creditor obligations ran dry. Our political masters then decided that we could not let our noble bankers go bust; we had instead to make them the largest welfare state recipients this world has ever known! Not the £60 per week and housing benefit kind for these characters, but billions of full-on state support to bail out their banks. They failed at their jobs and bankrupted many, but they kept their jobs with 6, 7, or 8 figure salaries! Bush told us that massive state intervention was needed to save the free market. Brown said the same. We were told that there would be no cash in the ATMs and society would most certainly come to an end if heroic action was not taken to “save the world”, as Brown so memorably put it (though he seemed to think he had accomplished this feat singlehandedly). Thank God for Gordon! Now in Iceland, a country I was trading with at the time, their banks did go bust; no one could bail them out. But within days the Krona had re-floated itself and payments continued; within weeks they had a functioning economy. Within days the good assets of Lehman Bros had been re-allocated, sold to better capitalists than they. But with these notable exceptions, socialism was the order of the day. Bank’s inflated balance sheets were assumed by sovereign states. Like lager louts on a late night binge, after a Vindaloo as hot as hell itself, heads of government seemed to care little for the inevitable pain that would follow, as states tried to digest what they had so hastily ingested. Indeed, the failed organs of the nationalised banks survive only on life support, enjoying continuous subsidy through the overnight discount window. But the sovereign governments, under various political colours, had a history of binging. In our case the Labour Party spent more than it could possibly ever raise off the people in open taxes, and the Tories offer “cuts” which in reality mean that the budgets of some departments will not increase as quickly as they were planned to.

Phase 3: King Canute, sovereign default

Default is the word that can’t be mentioned. In reality, we should embrace default. This debt is never going to be repaid. Never, that is, in purchasing power terms. S&P ratings agency have hinted at this with the recent US rating downgrade. They know the American government can always mint up what it needs so long as it has a reserve currency. They also know that this is a soft default. In real terms, people seem likely to get back less than they put in. Hard default should be embraced by the smaller nations like Greece and Ireland, so they can rid themselves of obligations they cant afford to pay. This will be good for taxpayers in the richer countries of Europe, as they will no longer be bailing out those who foolishly lent to these countries. It will be good, too, for the debtor nations, as they can remove themselves from the Euro and devalue until they are competitive again. They will, however, need to learn to live within their means. Honest politicians need to come to the fore to effect this. Yes, this will be painful and the people who lent these profligate and feckless politicians the money will get burnt. However, the FT has recently seen prominent advocates for a steady 4%-6% inflation target. This is the debtors’ choice and the creditors’ nightmare, with collateral damage for those on fixed or low incomes, for the reasons mentioned above. Should we let the Philosopher Kings have their way?

“Let all men know how empty and worthless is the power of kings. For there is none worthy of the name but God, whom heaven, earth and sea obey”.

So spoke King Canute the Great, the legend says, as waves lapped round his feet. Canute had learned that his flattering courtiers claimed he was “so great, he could command the tides of the sea to go back”. Now Canute was not only a religious man, but also a clever politician. He knew his limitations – even if his courtiers did not – so he had his throne carried to the seashore and sat on it as the tide came in, commanding the waves to advance no further. When they didn’t, he had made his point: though kings may appear ‘great’ in the minds of men, they are powerless against the fundamental laws of Nature. King Canute, where are you today? We need honest politicians and brave men to step forward and point out the folly of trying paper over the cracks. Unless banks write off under-performing (or never-to-perform) securities from both the private sector and the public sector, we will progressively impoverish more and more people. Let better business people buy the good assets of the bust banks, and let them provide essential banking services. Let the sovereigns that can’t pay their way go bust and not impoverish us any further with on-going bailouts. In all my years in business, your first loss is always your best loss. Yes, this will be painful. Politicians, fess up to the people: you do not have a magic bullet and you can’t offer sunshine today, tomorrow and forever. I fear that if we do not do this, we approach the end game: the total destruction of paper money. Since August the 15th 1971, paper money has not been rooted in gold. It is the most extreme derivative product, entirely detatched from its underlying asset. Should the failure of this derivative come to pass, we will have to wait for the market to create something else. Will we be reduced to barter, as the German people were in the 20s? A process of wipe out for all will be a hell of a lot harder than sensible action now.  It is still not too late.

Charles Moore reviews Keynes vs Hayek

I was pleased to see the LSE’s recent Hayek vs Keynes debate picked up by Charles Moore atThe Telegraph:

The Hayekians, led by Professor George Selgin, argued that Keynes failed to see the way busts are the natural result of booms – the “malinvestment hangover” from the party that went on too late the night before. In the rap, by the way, Keynes is depicted as the life and soul of the party, getting all the girls (not quite what happened in his real private life), but then throwing up after too much whisky. Prof Selgin pointed out that, since the current crisis began in 2007/8, absolutely tons of public money has been poured into all the banks that went wrong, and they have only gone wronger.

Moore sums things up nicely:

Hayek’s ideas … appeal to anyone who inclines to believe that people are more likely than governments to act in their best interests. Reality is the best counsellor: “There is no painless recovery from an unsustainable boom”, and if something is unsustainable, it makes no sense to try to sustain it. Keynes appeals to our longing for a clever piece of magic which can rescue us from our follies. Hayek appeals to our more common-sense understanding that only our own best efforts can save us. Being highly suspicious of prestidigitation by governments, I lean to the side of Hayek.

Very encouraging times to be an Austrian!

What Type Of Free Banking Do We Want?

The article below represents the intellectual endeavours of two of the young stars of the Austrian School to address some of what they describe as “quibbles” with one of the more senior members of the School, Professor George Selgin and to some extent Prof Horwitz and our own Founding Fellow, Prof Anthony Evans. I have taken great inspiration from all of the people mentioned above, some more than others, but I fall on the side of the 100%FB for some of the reasons advocated by the two writers. Debates get heated and we get hot under the collar, but one thing is for sure: with an eye on practical politics, we must remember that the true enemy is the monetary socialism that we have today. We may have currency failure in Europe soon. In the USA we may have a final realisation that, as in the UK at the dawn of the First World War, the baton of economic leadership has moved on. These are the most uncertain of times. If we in the free market movement are to have any hope of getting anywhere, we must be able provide positive policy solutions. I would urge all mentioned here to turn attention to just that going forward, if no further understandings can be made between FRFB and 100%FB. I know for sure, I would bite your hand off today if any one of those systems was offered in exchange for an end to state supported FR banking! There is even a small chance that as this Great Recession rolls out, that is all the powers that be may be left with as policy solutions. We must be ready to provide solutions to our political masters.

Unanswered Quibbles with Fractional Reserve Free Banking

Abstract: In this article we reply to George Selgin’s counterarguments to our article “Fractional Reserve Free Banking: Some Quibbles”. Selgin regards holding cash as saving while we focus on the real savings necessary to maintain investment projects. Real savings are unconsumed real income. Variations in real savings are not necessarily equal to variations in cash holdings. We show that a coordinated credit expansion in a fractional reserve free banking (FRFB) system is possible and that precautionary reserves consequently do not pose a necessary limit. We discuss various instances in which a FRFB system may expand credit without a prior increase in real savings. These facets all demonstrate why a fractional reserve banking system – even a free banking one – is inherently unstable, and incentivized to impose a stabilizing central bank. We find that at the root of our disagreements with Selgin lies a different approach to monetary theory. Selgin subscribes to the aggregative equation of exchange, which impedes him from seeing the microeconomic problems that the stabilization of “MV” by a FRFB system causes.

Read the whole article (PDF).

Related articles:

AEP: Return Of The Gold Standard As World Order Unravels

Cobden Centre readers may find it heartening that Ambrose Evans-Pritchard is now showing an interest in hard money:

On one side of the Atlantic, the eurozone debt crisis has spread to the countries that may be too big to save – Spain and Italy – though RBS thinks a €3.5 trillion rescue fund would ensure survival of Europe’s currency union. On the other side, the recovery has sputtered out and the printing presses are being oiled again. Brinkmanship between the Congress and the White House over the US debt ceiling has compelled Moody’s to warn of a “very small but rising risk” that the world’s paramount power may default within two weeks. “The unthinkable is now thinkable,” said Ross Norman, director of … Step by step, the world is edging towards a revived Gold Standard as it becomes clearer that Japan and the West have reached debt saturation. World Bank chief Robert Zoellick said it was time to “consider employing gold as an international reference point.” The Swiss parliament is to hold hearings on a parallel “Gold Franc”. Utah has recognised gold as legal tender for tax payments.

The bad news?

A new Gold Standard would probably be based on a variant of the ‘Bancor’ proposed by Keynes in the late 1940s. This was a basket of 30 commodities intended to be less deflationary than pure gold, which had compounded in the Great Depression. The idea was revived by China’s central bank chief Zhou Xiaochuan two years ago as a way of curbing the “credit-based” excess.

But, amusingly, Ambrose closes with a quote from our favourite Fed chairman:

Mr Bernanke himself was grilled by Congress this week on the role of gold. Why do people by gold? “As protection against of what we call tail risks: really, really bad outcomes,” he replied. Indeed.

Homo Oeconomicus And The Monetary Basis For A Big Society

Jesse Norman’s book on the Big Society, which I reviewed recently, caused me to reflect once again on Homo Oeconomicus, that totally un-human being, that rationally calculating bundle of circuits, which mechanically responds to events to maximise its utility. We know utility is a thoroughly personal, subjective measure that is taken by the economics profession to be objective, and capable in society of being maximised.  Norman rightly ridicules this concept, calling it delightfully “rigor mortis economics”. Thus he is on the side of all economics pre-Keynes and post-Keynes, and particularly in line with the Austrian view. Norman shows that the credit induced boom of the Labour years did not create real and lasting wealth.  He shows that savings are the essential ingredient in any capital formation, and that capital formation is the wellspring of good fortune in our society. A demand-led (consumption-led) society will only end up cannibalising itself if saving, and thus capital formation, is not prioritised. However, at no point in the book do we see a discussion that we have on this website all the time: how the agent of all this credit creation is the state itself, with the monopoly central bank being able to manipulate the reserves of the private sector bank to fulfil an interest rate policy set by the politicians. ALL responsibility for the Great Recession rests in the hands of politicians around the world. Thus, a weakness in the book is that with no money reform agenda to run in parallel with a reformist Big Society agenda, the connected society may well be doomed from the outset. This is my worry with this work: that its vision does not yet sit on solid foundations of honest money. If the two were inextricably linked, then I think we’d have an economic and political agenda that is very credible, and which and would set the country on a path of peaceful and stable growth.  When people can plan for their own future, without fear of their wealth being confiscated by currency debasement, or destroyed by recurring recessions, they are in a much better position to help others. The Big Society agenda is very much in tune with the Manchester School social reformers who have inspired the creation of this web site. We wish Cameron well in his practical application of this very British tradition. Norman gives this current form of politics its intellectual muscle and brain power. I hope both will underscore their work with an honest money agenda, otherwise we will keep on having to revisit these problems every generation.

Global Warming: The New Malthusian scare

I was kindly sent a copy of Lord Lawson’s book “An Appeal to Reason: A Cool Look at Global Warming”. When I was 16, I was given a small pamphlet by the Heritage Foundation called “Our Moral Heritage” by F A Hayek which was lecture 24 of the Heritage Lectures 1983 with a splendid introduction by our very own Dr Eamonn Butler.  What struck me and has stayed in my mind 26 years later is this passage that has great relevance to the current global warming debate:

Private property, of course, was never “invented” in the sense that people foresaw what its benefits would be. Its main benefit turned out to be the division of labour, which it brought about. That in turn increased the possibility of maintaining a large number of people because it generated an increase in productivity by enabling the use of a much greater variety of information than could ever be possessed by any single agent. But even more than that, it meant that an increase in the population did not become, as Malthus predicted, a process where the increase of humanity led to decreasing returns, and therefore to a decrease of personal incomes. On the contrary, it was found that, insofar as it made possible and increase of human numbers that was due to increasing differentiation, the increase of population was not subject to the law of decreasing returns. In fact, the increase of the density of the population increasingly helped improve productivity. Malthus’s application of the law of decreasing returns to increasing humanity was based on the assumption that human labour is uniform. But the great development made possible by property was that human labour and human capacities became highly specialised. And so the increase of population became an increase in variety. It made possible the institution of what Adam Smith was the first to recognise as the division of labour. Smith taught (but his successors did not understand) that the division of labour was a direct function of the extent of the market. And the extent of the market, of course, is a consequence of the increase of population. The increase of the population, far from reducing productivity, and far from leading to impoverishment, is in fact that source of the increase in our productivity and the increase in our capacity to keep alive ever increasing numbers of men.

Property is man’s command over something.  It allows the universal division of labour. Jesus Huerta De Soto has extended this concept in a very Hayekian manner to the universal division of knowledge. The savings of man grow the capital structure, add to productivity, and allow the planet to support more and more of us. This is a truly wonderful thing. Today, environmental groups call for a reduction in carbon on scales that would require a gigantic decline in our population numbers: we are told we must self-sacrifice and surrender our standard of living for the general good of a much lower population.  The most extreme voices would send us spinning back to the dark ages and the more moderate would see us stagnating in development. As a primary school child in the 70’s , I was told that we were descending into a global ice age. I was shown pictures of how 10,000 years ago, the glaciers reached 70 miles north of London. I thought to myself, thank god, I will be just OK! This was of course set in the back drop of being told that in any given 3 minutes, I may have to run for cover as the Russians would nuke us! We were shown films of what a nuclear holocaust could be like. I concluded that it would be better off being evaporated in a nanosecond, becoming a shadow of vaporised dust on a wall, than to survive. In the 80’s, as a teenager, I was taught that all the oil in the world would run out by 1988! I thought to myself, “I might get one year of being able to drive in a car, and then that is it, game over”! Accordingly, I am very wary of any claims of Armageddon by scientists and politicians. In fact, I struggle to give the environmental arguments the time of day as my instinct tells me it is another gigantic scare by people grappling with only a part of the complete, complex picture of what is really going on. Lawson embarks on a logical and unemotional inquiry into the so-called science behind global warming, and in particular the works of the Stern Review and the IPCC: the UN’s Intergovernmental Panel on Climate Change.  He points out that on the worst case forecasting scenario, we will have a global warming of 3 degrees Celsius or 0.03% per year for 100 years. I ponder how my local cathedral City of St Albans was a great wine growing centre up until the Reformation. Maybe in 2100, it might be the same again. The ebb and flow of temperatures over many centuries allows man time to adapt.  As Lawson says

In any case, average world temperature is simply a statistical artefact. The actual experienced temperature varies not only between day and night and between summer and winter. It also varies enormously in different parts of the globe; and man, whose greatest quality is his adaptability, has successfully colonised most of it. Two countries at different ends of the earth, both of which are generally considered to be economic success stories, are Finland and Singapore. The average annual temperature in Helsinki is less than 5 degrees Celsius. That of Singapore is in excess of 27 degrees Celsius. If man can successfully cope with that, it is not immediately apparent why he should not be able to adapt to a change of 3 degrees  Celsius when he is given a hundred years in which to do so.

The adaptive capacity of man as witnessed throughout our whole history should not be underestimated. Concerning the unreliability of the science, I particularly love this quote from the book

In the light of the evidence it is scarcely surprising that the worst the IPCC report can come up with, so far as the polar ice sheets are concerned, is the conclusion that “There is medium confidence that at least the partial deglaciation of the Greenland ice sheet, and possible the West Antarctic ice sheet, would occur over a period of time ranging from centuries to millennia for a global average temperature increase of 1-4 degrees Celsius.” The idea that anything sensible can be said about the likely state of the world a thousand years ahead, still less that we can take rational policy decisions on this basis, is mind-boggling.

I could not agree more. Lawson points out that our political masters have gone down the socialist planning route in an attempt to address the perceived problem. As a sop to capitalism, your centrally-planned ration of carbon emissions can be traded. On this point Lawson says:

For one thing, it is in no sense the “market” solution that it purports to be. It is essentially a government controlled, administrative rationing system, in which the rations can be subsequently traded. It is rather as if, instead of seeking to cut back on smoking by taxing it, we were to allocate Soviet–style production permits to the cigarette manufacturers, which they were then permitted to buy and sell among themselves. Of course, for the market-makers and other middlemen who trade in the CO 2 emissions permits, it is indeed a market, and one which they will not hear a word said against; for them it permits a lucrative and – they hope – growing business opportunity.

Nothing short of a scam. Despite this, Lawson believes one should tread in this area with caution and he advocates a tax on carbon to encourage more conservation in our carbon consumption and thus emission, rebated back pound for pound to the people it is taken from, across the board to see how their behaviour is changed by higher energy prices. I am not in the business of advocating any tax at all, so I can’t support Lawson on this matter. The only solution I can see is private property rights, and as Hayek comments in the opening quote, this discovery of man has generated an immense explosion of or numbers and our well-being. I am minded to think of advocates in my old industry of fishing, where the new coalition government want  to deploy rights-based solutions to the management of our fish stocks which involve some quota setting, and rights to fish this out by certain fishermen with certain boat sizes etc.  But it will be no better than setting rations or taxing behaviour. What is best is the full denationalisation of the oceans. This is of course what man has done on land. Some genius ancestor of ours, whose name is lost to history, invented a “fence”: a strange contraption kept out his marauding Neanderthal cousin who wanted to eat his crops and livestock. As the great migrations of biomass ebb and flow in our ocean currents, ocean stewardship by the fishing community themselves needs to take place. If they pay a small fortune for the rights to fish these wild biomasses, they will want to do that sustainably, year in, year out, so they generate a return of the money spent. A latter-day fence-making genius will design systems that can protect his biomass from encroachment by other hunters as we have so successfully done on land. This is the future of sustainable fishing. What is the future of sustainable global temperature? So far as it is a problem (and I am not convinced it is), if the carbon pumping industries and consumers of the world start causing global wealth to decline, will that not cause claims of restitution against polluters that will then enforce change? Is this not a matter of private property rights enforcement, just as a polluting chemical plant can be sued by the water authority whose river is polluted to make restitution and enforce a change in behaviour? Will not our acute sense of self interest, rather than self-sacrifice, and our belief in private property rights and enforcement thereof be the solution to any problem that may or may not exist? Lord Lawson is a radical thinker and on the whole I fully endorse the book with only the reservation mentioned above about taxes. The Global Warming Policy Foundation continues to to great work in appealing to reason.

James Turk interviews James Grant

Grant is the owner of Grant’s Interest Rate Observer. He is one of the greatest financial commentators and you have probably never heard of him. Our friends at the Mises Interview interviewed him in 1996, . His book the Trouble with Prosperity predicted the Dot Com crash, it is a very Austrian orientated work. His publications have been pretty spot on warning of booms and bust in general. His investment advice is also not that shabby. This talk is very informative. If you can afford to subscribe to his publications, I urge you to. His statement to Ron Paul’s Domestic Monetary Policy & Technology Subcommittee is also well worth watching.

The Untouchable Case for Indian Capitalism

An excellent article from B. Chandrasekaran for the Wall Street Journal:

The plight of the Dalits, those whom the Hindu caste system considers outcastes and hence Untouchables, was a rallying cry of Hindu reformers and Indian leftists for half a century. But today these victims of the caste system are finding that free markets and development bring advancement faster than government programs.

Continue reading

Telegraph: Banks Buy Bulk Of £39.8bn Of New Gilts

The Telegraph reports:

Banks bought 91pc of the £39.8bn of net issuance of new gilts with purchases totalling £36.1bn, compared to the £11.4bn of UK debt bought in the preceding six months. The scale of the buying of UK Government debt was revealed in figures published on Wednesday by the Bank of England, which show the increased dependency of the gilt market purchases by the country’s major banks.

Shocking. Sounds a lot like monetization of the debt! (Hat tip to Sean Corrigan)

Some More Quibbles with Free Banking

If you are interested in monetary theory and what the Austrian School has to say about this debate, the paper that Anthony linked to last week is well worth reading. It addresses some common misunderstandings about Monetary Equilibrium Theory (MET). This theory is controversial and is much critiqued in Austrian circles. It is but one branch of two very clear conceptions of money developed by Austrian School theorists past and present.  Both concern the Theory of Free Banking, with MET supporters favouring Fractional Reserve Free Banking and the rest of the Austrians favouring Full Reserve Banking. It may seem a mystery why people so philosophically aligned come up with very different final policy conclusions.  Both support the absence of the State in the banking architecture, preferring a free market for banks, but due to differences in definitions and monetary theory, they disagree about the ground rules for the market. S Horwitz is a key developer of the MET School and A Evans (H&E) is clearly sympathetic. P Bagus and D Howden (B&H) are for the Full Reserve policy solution.  As a side note, Selgin and White from my reading are the intellectual “daddies” of H&E with respect to money and banking. I see little of MET mentioned in their works (especially their latter writing) and more of disequilibrium. This subtle use of language is important, as any Austrian will tell you; human action is dynamic and thus ever changing. Perhaps you can be less in disequilibrium but never in equilibrium. I mention this as H&E stress the importance of getting definitions right.

Definitional Issues – Savings

H&E say,

Unlike inflation, we believe that Bagus and Howden are defining savings in the same way as Free Bankers – meaning the act of abstaining from consumption.

So far so good. They then clarify an important point:

Bagus and Howden (p. 39) write: “Horwitz suggests that the creation of deposits increases the supply of savings, as depositors are lenders of real loanable funds. In other words, the mere creation of credit and the corresponding new deposits constitute an increase in real savings.” We reject this interpretation because they misrepresent the causality. Bagus and Howden claim that Horwitz is saying that creating deposits increases the supply of savings, which suggests that the causality runs from money creation to savings. However, the Horwitz quote in question clearly says the reverse:

Savers supply real loanable funds based on their endowments and intertemporal preferences. Banks serve as intermediaries to redirect savings to investors via money creation. Depositors give banks custody of their funds, and banks create loans based on these deposits.” (1992, p.135)

The order is that savers provide funds to banks by increasing their deposits, and then those new deposits, which banks receive as reserves, serve as the basis for loans to the bank’s borrowers. Those loans are credited to the borrower’s deposit account. So it is not the case that the “creation of deposits increases the supply of savings” but precisely the opposite: increases in the supply of savings (“real loanable funds”) enable banks to create new loans and additional supplies of money. In other words, savings in the form of holding larger bank balances makes possible the funds for investment that are created through the lending process.

Further clarity is given with this helpful quote:

To see what free bankers actually argue, consider Selgin and White (1996 p.102),

“an increased demand to hold claims on intermediaries, including claims in the form of banknotes and demand deposits, at the expense of holding additional consumer goods, is equivalent to an increase in desired saving”

Note that they do not say that an increase in the demand to hold bank liabilities constitute an increase in savings, they say that an increase at the expense of holding additional consumer goods does. If the increase in demand to hold bank liabilities is facilitated by a substitution from other forms of saving (e.g. from capital goods), then there has only been a change in the composition of savings.

However, I have to conclude that still after years of debate and lots of reading and writing, debating and hair pulling, the eminent Professors, possibly all six mentioned thus far, do not quite have an adequate concept of savings. Granted, I am a mere layman, but the experience of life and a joyful self education in reading great and not so great economists leads me to conclude that yes savings is a matter of abstaining from consumption, but with respect to what you hold as a money balance in the form of a bank IOU, you may well be abstaining from consumption, but that does not mean you are putting forward your savings for loanable funds. In a conversation with a noted eminent Free Banker, we labelled this “inadvertent savings.” This is a very important distinction to be made and I would define savings as “an act of abstaining from consumption and willingly offering for loanable funds.” The mere fact of just having a bank IOU, i.e. a demand deposit, does not mean you wish that your purchasing power be lent to someone else! With this in mind, we can observe that if there is a large change in demand for money to the extent that noticeably fewer goods and services are being transacted for money in the economy, i.e. we are in a depression as we are today, then an accommodation by a fractionally reserved free banking system will funnel all those new loanable funds (the depositors’ higher money balances) to individuals and business who in turn demand it to support their weaker activities. This may well be not what the depositor base wants. The depositor base in times like we have today probably want their money balances kept safe as a precaution. Indeed, in my example, having sold my business, I keep enough money balance on deposit (I am loath to say savings now!) for the express purpose of sustaining me and my family, i.e. for ongoing consumption and for “rainy day purposes,” the latter due to the massive uncertainty that exists in the economy today. This means, ALL my cash is NOT set aside for money to be mediated to the loanable funds markets as far as I am concerned. This is exactly what I do not want happening to my deposits. In a mature fractional reserve free banking system, this will happen despite my wishes unless I want to deposit under my mattress or shoe box etc. The Holy Grail of economics is that the savings of today provide the investment money to the companies and entrepreneurs to make the products, the goods and services that the savers will eventually want to buy with their returned savings. How can this happen when a banking system will mediate money away from precautionary balances that have been “inadvertently saved” back out into loans? This explains a theoretical weak point in MET and the Theory of Free Banking (the two are slightly different, as noted above), but it might actually make the fractional reserve free banking position more robust if they addressed this issue of precautionary deposits or inadvertent savings. H&E do not want to be drawn into legal or ethical issues concerning this debate and wish to keep it to the economics. I say they can never be separated and via the door I have just opened to strengthen up their theory, I would say that if depositors were asked to clarify their intentions then only money set aside for savings would go to savings, while money kept as a precautionary balance or for current on-going consumption would not be lent out. This was the objective behind the Carswell-Baker Bill presented to Parliament last year. It is interesting to speculate, as speculation only it is, but all the panics in the halcyon days of fractional reserve free banking in Scotland (1770, 1772, 1778, 1793, 1797, 1802–1803, 1809–1810,1810–1811, 1818–1819, 1825–1826, 1836–1837, 1839, and 1845–1847; see Checkland,Scottish Banking: A History, 16951973, Glasgow: Collins, 1975), may well have been averted or substantially mitigated had people been able to distinguish how they wanted to have their on-demand money balances treated. I would suggest that some empirical research needs to be done and maybe one of the eminent professors might like to get a graduate student to do this as part of their research. Empirically find out what element of cash balances held as on demand deposits are in fact precautionary and not intended to be lent to other people and enterprises. Find out how much of depositors’ current accounts, that are currently lent out by the banking system, are really intended for investment (with acceptance of risk). My hunch (and a hunch only), is that at times of panic / depression, when money demand does change, most savers want their money kept safe. Moreover, in these depressing times, as people refrain from consumption, they do not want the goods and services produced in the quantities and formats that were offered up before the change in demand.  Depositors’ reduced appetite for investment would send an important signal. I am a sceptic as to the merits of fractional reserve free banking for many reasons, both legal and moral, but greater awareness on the part of depositors, with an explicit choice between safe-keeping and investment, would tighten up the monetary theory aspects of its approach. By the way, Selgin’s Theory of Free Banking is very worthwhile to read in full. B&H are right to single this book out.  It presents a new theory that will be debated for many years to come. To conclude, with H&E’s clarification of what they do and do not mean by savings and the holding of bank liabilities, I submit the debate would be enriched if this potentially large element of precautionary and current or near-current consumption element of a bank IOU is dealt with. Much more could be said on this debate. I hope my “observer” contribution is valuable to the professionals. Although H&E value the academic approach over internet-based economics, I have no intention of writing this up in academic language and or providing footnotes citing references. Aristotle never did, and if it is good enough for that giant polymath, it is good enough for a speck on the body of knowledge like me! I hope some find this constructive and useful.