Monday, November 9, 2015

Power is Money

Since bank lending creates the vast majority of the money supply, bank lending controls the vast majority of resource allocation in our economy. That’s why it is extremely important that policymakers fully understand the banking system, and why it’s so tragic that they don’t.

From a political perspective, realizing how much of the money supply, and therefore allocation and distribution of real resources is controlled by bankers, is very difficult. It is not easy to acknowledge that most economic activity is dictated not by our democratically-elected government issuing money as it spends, but by profit-chasing bankers living it up as overpaid bureaucrats. The vast majority of what we call money is not created by government spending, but by private bank lending. This realization forces one to rethink their approach to all public policy issues, since public policy always involves resource allocation in some form or another.

Every individual and every industry in this country relies on the banking system in some way, so it’s important for all of us to understand how it actually works. The first step in this process is to throw out any preconceived notions about how you thing banking works, because they are almost certainly outdated at best, and totally wrong at worst.

Recognizing banks as credit allocation utilities, and not intermediaries of preexisting savings, changes everything. All economic models get blow up once the reality of money as a measurement tool, and not a quantity the price of which is determined by supply and demand, is realized. Therefore, since most economic models treat interest rates as a reflection of the supply/demand for money, these models become useless. All the efforts by economists to derive meaning from interest rates (what is “natural”, what is the “equilibrium rate”, Taylor Rule, etc) are a complete waste of time, and distract from the necessary focus on what is happening in the real economy.  

Fiat currency is a unit of measure and a medium of exchange, and it works great in those roles. Savings of fiat should be a completely separate activity from the day to day transactions in the formal monetary economy, not artificially linked to the medium of exchange in some kind of metal commodity. Fiat costs nothing to produce, and is unlimited in supply. Its value is ultimately derived by the fact that it is the only thing that the US government will accept for tax payments, which it imposes to the tune of $3 trillion a year. You can’t pay your taxes with gold coins.

When the banking system lends money into existence, it only does so for the purposes of yielding a positive financial return. This can be a very useful incentive to drive many different types of commerce that an economy needs to thrive. But no sensible person could argue that all money creation should be directed only towards profitable enterprises. There are many things beneficial to human society that cannot be achieved under a profit motive. Public infrastructure, retirement security, education, healthcare, defense; these are all things that we acknowledge in some form need to be managed by the governmental sector, since they are both necessary to our lives, yet not always feasible when run for a profit. There is no line in our Constitution, or precedent in human history, that says that society should be solely, or even largely organized around markets.

One main example is the incorrect economic argument that government borrowing raises interest rates by “crowding out” funds that would otherwise be available for nongovernmental use. However once one realizes that the money supply is not fixed, and in fact largely influenced by bank lending, this point becomes moot. Government “borrowing” could not possibly increase the cost of bank lending, since there is nothing than the banks would otherwise use that is being “crowded out.” As previously described in this blog, bank lending is merely the creation of a new account balance for the borrower. This occurs through the simple process of a loan officer typing a number into a keyboard. Nothing pre-existing is “used” to create the loan balance; the money is simply typed into a computer, much like any email or spreadsheet, and created from nothing.

This leads us to the peculiarity of modern day discussions about political economy, both among regular Joes and the policymaking elite around the world. For some reason, public money creation is given far more attention than is necessary, while private money creation, in addition to being a much larger force that can quickly become unsustainable, is mostly ignored. The massive housing bubble in the run-up to the financial crisis was ignored by almost all the economics profession, while the public money expansion in the years after, caused by necessary increases in government debt around the world, was given disproportionate attention by the chattering classes. 

In neither period was the difference between public and private money creation ever discussed in a significant way. When he looked back at the last 30 years of economics, the UK’s Lord Adair Turner expressed his dismay that the economics profession had obsessed over fiscal policy and levels of public debt, while entirely ignoring the levels of private debt which ultimately caused the financial crisis.

The power to create money is one of the greatest powers in the world, second only to use of physical, military force. It could be argued that money creation is even more powerful, because it occurs all day, every day, in manner so mundane as to attract nearly no attention. If the US government, for example, sent Marines to point guns at bankers, mortgage brokers, builders, contractors, and construction workers, and ordered them to build 1000 new houses, the American public would rightly be horrified. But when the quasi-governmental banking system lends money into existence for mortgages (FDIC insured banks), the government insures billions of dollars of mortgages from failure (FHA/VA/FCA), then packages mortgages into securities (Fannie/Freddie), and then buys these securities (Federal Reserve), all of which has roughly the same effect as the previously described militaristic scenario, no controversy is stirred. The same public purpose was achieved, but with totally different means.

So instead of provisioning Americans with housing with use of physical force, the government supports the current monetary system in all its complex machinations. From a purely macro point of view, if power is defined as the ability to deploy real resources for a desired purpose, then both physical force and money issuance are forms of power.

Of course, I don’t mean to suggest that the government should use physical coercion to deploy the nation’s resources. Our current financial arrangements have the capability of doing this peacefully and somewhat efficiently, although improvements obviously need to be made. The first, and biggest step toward making these improvements is educating the public about how the nature of modern money and how the banking system accurately works, so voters can make informed decisions about the policy decisions that their elected officials make in this space. 


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