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| Issue 67 26 July 2004 |
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Savings and Investment, Keynes and Bernanke Labels, as Thomas Sowell demonstrates in The Vision of the Anointed: Self-Congratulation As a Basis for Social Policy (Basic Books, 1996, ISBN: 046508995X), are both necessary and dangerous things. Carefully and dispassionately used, vocabulary helps to transmit ideas accurately and efficiently. Employed carelessly, however, terminology creates vagueness, ambiguity and misunderstanding; and utilised recklessly, concepts can obstruct reasoning, obscure evidence and generate misjudgments. This risk applies particularly forcefully to contemporary mainstream economists and people who pay attention to them (such as many participants in financial markets). Intermediaries between academic economists and markets participants, namely “market economists,” can amplify misconceptions and thereby magnify miscalculations. Since the Second World War, economists have used ever more advanced mathematics and econometrics to describe and analyse their subject matter. During these years they have also become more and more specialised. As a result, today’s typical economist does not (because pressures of time mean that he cannot) read much economics outside his narrowing field of specialisation; and the vast bulk of today’s university-based economics is well beyond the average layman’s comprehension. Considered as a group, today’s economists are a curious kind of priesthood. Increasingly unable to communicate with other priests and lacking much incentive to talk to the laity, members of each specialisation speak primarily to one another. Much of their discussion – namely, how to specify their mathematical and econometric models – is a modern variant of how many angels can dance on the head of a pin. In sharp contrast, economists are relatively indifferent to the definition and clarification of the concepts – including some of the most fundamental concepts of economics – that underlie their models. Hence an irony: the typical economist obsesses about numerical precision, but when one disentangles key words from dense thickets of mathematics one often finds that the concepts’ definitions are superficial and their interrelations slipshod (for an overview, see Deirdre McCloskey, The Vices of Economists – The Virtues of the Bourgeoisie, Amsterdam University Press, 1996, ISBN: 9053562443; Robert H. Nelson, Economics As Religion: From Samuelson to Chicago and Beyond, Pennsylvania State University Press, 2001, ISBN: 0271020954; and Mark Skousen, Economics on Trial: Lies, Myths and Realities, Irwin, 1991, ISBN: 1556233728). As with so much that is wrong with contemporary mainstream economics, this problem owes much to the malignant influence of John Maynard Keynes. Keynes seemed to be utterly indifferent about the use to which he put words. In his erratic hand, a particular concept, X, sometimes meant a, sometimes it meant b and other times c (where a, b and c are mutually incompatible). A critical concept to investors, saving, provides a good example. On p. 62 of The General Theory of Employment, Interest and Money (1936), perhaps the twentieth century’s most damaging book about economics, Keynes says “having now defined both income and consumption, the definition of saving, which is the excess of income over consumption, follows” (italics in the original). So far, not so bad; but not quite so fast: “[by current investment we mean] the current addition to the value of the capital equipment which has resulted from the productive activity of the period. This is, clearly, equal to what we have just defined as saving. For it is that part of the income of the period which has not passed into consumption.” So is savings equal to investment or to current investment? Over the next dozen pages, Keynes not only defines investment so that in the real world it is always equal to savings; he also defines it so that these two things are conceptually identical. But he waits until p. 74 to say so explicitly: “in the previous chapter Saving and Investment have been so defined that they are necessarily equal in amount, being, for the community as a whole, merely different aspects of the same thing.” Further, “whilst, therefore, the amount of saving is an outcome of the collective behaviour of individual consumers and the amount of investment of the collective behaviour of individual entrepreneurs, these two amounts are necessarily equal, since each of them is equal to the excess of income over consumption . . . Provided it is agreed that income is equal to the value of current output, that current investment is equal to the value of that part of current output which is not consumed, and that saving is equal to the excess of income over consumption . . . the equality of saving and investment necessarily follows.” To Keynes, then, the actual quantities of savings and investment (as opposed, apparently, to current investment) are in practice not just always equal – in principle, they are “merely different aspects of the same thing.” Except when they are not: in A Treatise on Money (1922) Keynes explains his Credit Cycle (he used the upper case) “in terms of savings running ahead of investment or vice versa . . . On my theory, it is a large volume of saving which does not lead to a correspondingly large volume of investment (not one which does) which is the root of the trouble” (I, pp. 178-179; italics in the original). And on p. 84 of The General Theory he informs us it is “impossible for all individuals simultaneously to save any given sums. Every such attempt to save more by reducing consumption will so affect incomes that the attempt necessarily defeats itself.” Should the reader thereby infer that it is impossible for all individuals simultaneously to invest any given sums? It is hard to say: “it is not surprising that Saving and Investment should often fail to keep step. In the first place – as we have mentioned already – decisions which determine Saving and Investment respectively are taken by two sets of people influenced by different sets of motives, each not paying much attention to the other . . . There is, indeed, no possibility of intelligent foresight designed to equate savings and investment unless it is exercised by the banking system” (A Treatise on Money, I, p. 279). Keynes’s many followers have attempted to rescue their Great Leader from his many inconsistencies and logical absurdities. His books are littered with scores and perhaps hundreds of them, and it is a wonder that anybody regards this body of work as anything other than a vast muddle written by a prolific crank (see in particular Henry Hazlitt, The Failure of the “New Economics” – An Analysis of the Keynesian Fallacies, Foundation for Economic Education, 1959, 1994, ISBN: 157246016). These followers’ help also creates additional confusion. Alvin Hansen, for example, in his Guide to Keynes (McGraw-Hill, 1953, p.59), heaps some of the blame upon Keynes’s detractors: “one source of confusion arose from the failure of [Keynes’s] critics to realise that while investment and saving are always equal, they are not always in equilibrium. All this could have been avoided had Keynes made it clear from the outset that the equality of saving and investment does not mean that they are necessarily in equilibrium” (italics in the original). Hanson tries to set Keynes’s readers straight by suggesting that saving and investment can be equal but not in equilibrium if over time there is a “lag” or “lagged adjustment” of the one to the other. But if the one “lags” the other, then surely it is obvious that they are not always equal? Although saving and investment are conceptually equivalent and empirically identical (or perhaps not, depending upon what page of which book and what interpretation by which supporter you are reading), Keynes is resolutely consistent about their moral status. He devotes much space – not just in The General Theory but also in his Treatise on Money and The Economic Consequences of the Peace (1920)–to the praise of investment and the denigration of savings. Investment is good because it increases employment: “employment can only increase . . . with an increase in investment . . .” (The General Theory, p. 98) and saving is bad because it decreases employment (pp. 111, 235-242). Keynes’s definition and use of these two critical concepts is thus – to put it bluntly – blatantly and absurdly contradictory. The dispassionate reader must suspend the rules of logic in order to conclude that whilst saving and investment are “necessarily equal” and “merely different aspects of the same thing,” saving reduces employment and investment increases employment. Got that?
Prof Bernanke Delivers Another Speech Fortunately, these days not every economist regards himself as a Keynesian. Indeed, some hotly reject the title. Yet most of today’s economists are Keynes’s heirs in the sense that they use the gerund “saving” and the noun “saving(s)” haphazardly. Further, they either denigrate or take for granted individuals’ willingness to sacrifice current for future consumption (to save), convert the proceeds saved into capital goods or titles thereto (to invest), accept the risk that inheres in any investment operation and thereby (if the investment bears its expected fruit) consume more in the future. From this verbal carelessness and complacency spring many misjudgments. One of the most significant – because it initially benefits a privileged few and eventually harms so many people – is lax and occasionally reckless monetary policy by central banks and lending policy by commercial banks. The Remarks by Governor Ben S. Bernanke to the Virginia Association of Economics on 10 March 2005, entitled “ The Global Saving Glut and the U.S. Current Account Deficit,” provide a recent example (see also U.S. Current Account Deficit: Causes and Consequences by Roger Ferguson). Your and my thoughts about saving and its essential role in commerce and industry ultimately do not much matter because we are not and will not become market-moving bureaucrats. But Prof Bernanke, a former head of the Department of Economics at Princeton University, member of the Federal Open Markets Committee and now the head of the President’s Council of Economic Advisers, is a market-moving bureaucrat. What he does can reverberate around the world. Accordingly, what he thinks and says often prompts me to take a stiff drink and a good lie down (see in particular Deflation: Making Sure “It” Doesn't Happen Here). In his Remarks (the remarks of market-movers are important enough to merit the upper case), Prof Bernanke correctly emphasises one critically important point. “That inadequate U.S. national saving is the source of the current account deficit must be true at some level; indeed, the statement is almost a tautology. However, linking current-account developments to the decline in saving begs the question of why U.S. saving has declined.” Alas, apart from that point he utterly drops the ball. Most importantly, the possibility that profligate monetary policy – the very policy of the Fed of which until recently he was a prominent member – might have anything to do with America’s abysmal rate of savings utterly escapes him (see also Stephen Roach’s What Global Saving Glut?). But we mustn’t smirk: in this respect, as in many others, Australian policymakers offend almost as badly as Americans. Prof Bernanke not only overlooks the Fed’s complicity in this epochal degeneration of American thrift: he also disputes “the common view that the recent deterioration in the U.S. current account primarily reflects economic policies and other economic developments within the United States itself.” The implication is that this decline is to a significant extent foreigners’ fault. And then comes the real howler: over the past decade or so, a diverse combination of forces “has created a significant increase in the global supply of saving – a global saving glut – which helps to explain both the increase in the U.S. current account deficit and the relatively low level of long-term real interest rates in the world today.” By definition, the views of market-moving academic economists influence “market economists” – who, by publicising bad ideas, compound the damage these ideas wreak. Accordingly, The Financial Times (13 June), The Australian Financial Review (30 June), The Australian (6 July) and Business Week (11 July), among others, have parroted Prof Bernanke’s contention that there is a global saving glut. It is important, when analysing others’ statements and arguments, to remain charitable. We learn most from intelligent and influential people with whom we disagree. But it is difficult to avoid the conclusion that anybody who speaks of a “glut” of savings, i.e., to use a pejorative term to describe the only means that can finance the accumulation of capital and hence the maintenance and increase of living standards, may not properly understand the essential role that savings play in a market economy. Nobody, after all, ever talks about a “glut” of take-home pay or consumer spending. Prof Bernanke, it seems to me, conflates three distinct things:
Debt can be and should be – but, alas, need not be – backed by savings. Accordingly, one can finance debt out of savings, inflation or some combination of the two. Bernanke collapses these critical distinctions when he states “if a country’s saving is less than the amount required to finance domestic investment, the country can close the gap by borrowing from abroad. In the United States, national saving is currently quite low and falls considerably short of U.S. capital investment. Of necessity, this shortfall is made up by net foreign borrowing – essentially, by making use of foreigners’ saving to finance part of domestic investment.” But as Robert Blumen reminds us, the world’s $US-buying bloc, whose most important members are the central banks of major Asian trading nations, is unable to harness enough savings to purchase all the $US-denominated debt it wants (see in particular Richard Duncan, The Dollar Crisis: Causes, Consequences and Cures, John Wiley & Sons, 2003, ISBN: 0470821027 and Nouriel Roubini’s and Brad Setser’s Will the Bretton Woods 2 Regime Unravel Soon? The Risk of a Hard Landing in 2005-2006). There are not enough domestic savings in these countries to finance their central banks’ voracious appetite for debt denominated in $US. Accordingly, their central banks resort to inflation in order to purchase the remainder. The result is a massive boom of debt not backed by savings. This boom affects not just the buyers of the debt (primarily in Asian and certain developing countries), but also its sellers (primarily people in English-speaking countries). Theoretically and historically, and among both buyers and sellers of debt, this type of boom has a nasty habit of turning into a bust (see Blumen’s blogs of 10 January, 17 March and 14 May; and Stefan Carlsson’s blog of 10 April).
Kudos for Traditional Loan Banking Let us demonstrate these points from first principles. Following the logic of Murray Rothbard (The Case Against the Fed, Ludwig von Mises Institute, 1994, ISBN: 094546617X and What Has the Government Done To Our Money?, LVMI, 1963, 2005, ISBN: 0945466102), suppose that I have saved $10,000 and decide to establish a loan business (call it the Acme Loan Co. Ltd or ALC for short). After I do so, its balance sheet looks like this:
ALC lends money to borrowers and charges interest on these loans. If it lends intelligently, such that it lends to credit-worthy borrowers who honour their obligations, and if it manages its operations prudently, such that interest income exceeds its expenses (including any provision for doubtful loans), then it lends profitably. Let us say that ALC lends $9,000 to another business (call it X Ltd) and retains $1,000 as a reserve. In exactly one year, X undertakes to repay the $9,000 and also pay $900 of interest. X thus receives $9,000 from ALC and in return ALC receives an IOU and interest from X. Reflecting this transaction, and for simplicity ignoring expenses and taxes, ALC’s balance sheet becomes:
As a result of this transaction ALC’s assets and shareholder’s equity have increased. Assume that in a year’s time, and as agreed, X repays the loan and the interest. ALC’s balance sheet thus becomes:
From ALC’s point of view, the loan is repaid and it is (and so, as its sole owner I am) $900 richer. From X’s point of view, in order to repay the principal and interest, it had to employ the $9,000 such that it generated at least $9,900. Perhaps X used the principal to buy consumer goods from a wholesaler and then sold them to retail customers. If, for example, its gross margin was 25% (it was, in other words, able to sell for $11,250 the goods it bought for $9,000) and if its distribution, marketing, occupancy and administrative expenses (“overheads”) were 10% of sales, then from the $11,250 it would be able to repay overhead expenses of $1,125, the $9,000 of principal and $900 of interest. Like almost every business (we will shortly explore a glaring exception to this rule), X must satisfy the claims of its various creditors – including ALC. If it cannot, then its creditors will play a considerably more influential role in its affairs and it may become bankrupt. What remains after all these claims have been settled ($11,250 – $1,125 – $9,000 – $900 = $225 or 2% of the revenue from its sales) is X’s net profit from this transaction. Both ALC and X, then, benefit from their borrower-and-lender relationship. Notice that in order to repay ACL what it was owed, X saved $900 from its gross profit. In economic terms, the three transactions (my investment, ALC’s lending and X’s repayment of the loan) can be summarised thus: I have channelled by savings of $10,000 into ALC; ALC, in turn, has channelled these savings into a loan; the loan’s recipient, X, has put my savings – repackaged as a loan – to a profitable purpose; and X has saved some of the proceeds of its sales in order to the repay the loan. My savings, profitably invested through an intermediary, thus return to me as even greater savings. And these savings also enable another entity to generate savings. In this fundamental respect, loan banking is a legitimate (and, if conducted profitably, mutually productive) practice. Most importantly for our purposes, loan banking financed completely from savings is non-inflationary in the sense that none of these transactions affect the overall supply of money. I have saved some of my money (i.e., refrained from spending it) and then, through an intermediary, lent it to somebody who does spend it. This conclusion applies even if ALC lends in order to finance consumption rather than investment. Assume that it lends to an individual, Fred, who will use the proceeds to buy a car. Perhaps Fred anticipates that next year he will earn a higher income (or incur lower expenditures) that will enable him to repay the principal and interest. In this instance, Fred uses the principal not to invest and attempt to earn a profit, but rather to rearrange the timing of his consumption. He pays a premium for the use of the money today and thus avoids the inconvenience of waiting longer to buy the car. But the essentials remain unchanged: I have saved money and invested it in ALC; ALC has packaged my savings into a loan; and its recipient must save in order to repay it. Whether used for investment or consumption, loan banking benefits both the lender and the borrower; and credit completely backed by savings does not inflates the money supply. The same point holds in much more complex settings. Assume that a consortium of well-to-do individuals invests large amounts of their savings in ALC (i.e., become shareholders); as a result, its assets and shareholders’ equity increase by equal amounts. Let us also say that ALC floats bonds and various term deposits, and that people exchange their savings for these securities; as a result, ALC’s assets and liabilities increase by equal amounts. By increasing its base of assets, these transactions increase ALC’s capacity to package others’ savings into productive loans that generate interest income. If it pays 7.5% on its liabilities, earns 10% on its assets and its expenses and provisions are equivalent to 0.5% of its assets, then its profit is equal to 2% of its total assets. ALC aggregates others’ savings, in the form of equity, bonds or certificates of deposit; and it channels these savings into productive and profitable lending. ALC is, in effect, a broker or intermediary between one set of people who wish to lend their savings and another who wish to borrow others’ savings; and in exchange for these services (namely finding willing lenders and matching them to creditworthy borrowers), ALC earns a profit. It possesses two basic skills: first, it locates and aggregates savings; and second, it ascertains which individuals and businesses are worthy temporary recipients of these savings. Importantly, ALC is no different from any other business: if it miscalculates – if, for example, it pays too much for its liabilities and receives too little for its assets – then its shareholders and creditors will suffer losses. And if these losses are sufficiently severe such that it cannot meet its creditors’ claims, then it will become bankrupt. But no matter how complicated the source and destination of its funds becomes, and regardless of its ability to channel savings into productive loans and profitable investments, one critical fact does not change: traditional loan banking (which, from the lender’s point of view, is the issue of credit/ownership of debt financed by savings, and from the borrower’s point of view is the issue of debt/receipt of credit financed from savings) does not increase the money supply and thus provides no fillip towards inflation.
Applause for Traditional Deposit Banking The logic of deposit banking and loan banking are very different. It is therefore quite unfortunate that the same term, “banking,” has long been applied to both. Loan banking arose as a means of harnessing and redirecting savings; in sharp contrast, deposit banking arose as a safe and convenient means of storing savings. Centuries ago, owners of money (that is, real and market-based money, namely gold and silver, as opposed to the counterfeit stuff printed by today’s governments) did not often wish to store it at home or at the office. The risk of theft prompted them to seek a safe place of storage. Further, large amounts of these metals are heavy and thus difficult and costly to lug from place to place. Far better, then, to deposit money in a secure “money warehouse” and in return to receive a ticket or receipt stating that the bearer can redeem the stated amount of money upon presentation of the ticket at the warehouse. Centuries ago, deposit banks offered much the same service to owners of gold or silver as modern banks offer to owners of important papers or valuable jewellery: safe-deposit boxes. Originally, in order to spend his gold, the depositor (call him A) went to the warehouse, claimed his deposit, took his gold and presented it to the other party (call him B) to the transaction. Over the decades and centuries, several deposit banks earned a reputation for honesty. Their “warehouse receipts” thus began to circulate from one individual to another as a surrogate for gold, which thereby remained in the warehouse. To finance his transaction, A simply transferred the ownership of his warehouse receipt (“gold certificate”) to B. How did deposit banks earn their keep? Exactly as modern storage firms – or, indeed, contemporary bank safe-deposit box services – do: they charged a fee in proportion to the length of time that the deposit is stored, and according to the weight, volume, value, etc., of what is stored, on their premises. To generate a profit from this service, deposit banks had accurately to estimate the cost of storage (including the depreciation of the vaults and buildings and the risk of theft). What are the monetary consequences of traditional deposit banking? It changes the form but not the quantity of the money supply. Assume that the total supply of money is 1,000,000 ounces of gold and that a dollar is by definition a certain weight of gold. For simplicity’s sake, assume that a dollar is an ounce of gold. Further, suppose that 750,000 ounces are deposited in money warehouses and therefore that $750,000 of warehouse receipts (“gold certificates”) circulate among the population. (The remaining 250,000 ounces circulate as coin and bullion). In this case, the money supply remains at $1,000,000 and 1,000,000 ounces; the only change caused by traditional deposit banking is that the money in circulation is 250,000 ounces and $750,000 of gold certificates, and that the certificates serve as substitutes for the 750,000 ounces deposited into vaults. Under these conditions, traditional loan banking proceeds exactly as previously described. Hence traditional deposit banking, when these banks function as genuine money warehouses, is as legitimate and non-inflationary as loan banking. Where should these warehouse receipt transactions appear on a deposit bank’s balance sheet? Nowhere! These days, when I contract with Standard Warehouse Ltd to store a family heirloom that I reckon is worth $5,000, neither the heirloom nor that amount appear as an asset and a matching liability on Standard’s balance sheet. The proceeds from the storage do so (i.e., the fee that I pay to Standard); but the item stored does not. Why? Because the warehouse does not own the heirloom, it cannot appear on the “assets” side of its balance sheet; and because I have not lent it to the warehouse (note that the warehouse isn’t paying me interest – quite the contrary, I am paying it a fee for storage), it cannot appear on the “liabilities” side of the balance sheet. The heirloom is mine and remains mine: for safety, convenience or other reasons I have simply contracted with the warehouse to store it there. Further, depending upon the contract’s fine print I can collect it any time I choose (say, during business hours). Legally, my transaction with Standard is neither an investment nor a loan: rather, it is a bailment (i.e., the employment of somebody to store or guard something).
Brickbats for Modern Deposit Banking All men are occasionally tempted, if only fleetingly and usually only in a relatively minor way, to commit unethical acts. And whatever their moral fibre, some men are positioned more advantageously (if that is the word) than others to commit such acts. And some good men can, without their consent or even knowledge, be parties to unethical systems, transactions and incentives. Prominent among these men are modern bankers. As an individual, the typical banker is as honest and ethical as anybody. He is a good spouse, civil neighbour and loyal friend. And yet contemporary banking – the structure of law and incentive within which the typical banker works – is in moral terms fraudulent and in economic terms damaging. Modern banking, in short, is a shell game and Ponzi scheme. (If so, then the inclusion of banks in “ethical” or “socially responsible” portfolios is a telltale sign that the portfolio manager has little grasp of either modern banking or traditional ethics.) Why? Three preliminary points are important to make in this regard. The first relates Stuart tyranny to the development of English (and, by extension, modern) deposit banking. There were no deposit banks in the Old Country before the middle of the seventeenth century. Instead, merchants often stored surplus gold in the King’s Mint. As every schoolboy once knew, during the reign of Charles I relations – particularly financial relations – between the King and Parliament deteriorated. Things came to a boil in 1638. Unable to obtain sufficient funds from Parliament, Charles confiscated a large sum of gold from merchants who had deposited their gold in his mint. This theft was eventually repaid; fatefully and very confusingly, however, Charles called his confiscation a “loan.” A second point is the subsequent and very unfortunate tendency to entrench this Jacobite confusion into English banking and common law. In sharp contrast to developments in grain and other warehousing law, deposits in banks came to be regarded as debts rather than bailments. The consequences were and remain momentous. According to law, an employee of a non-money warehouse (say, an art auctioneer or a grain handler) who temporarily “borrows” stored valuables without the depositor’s knowledge, uses them to contract with third parties and attempts to return them before anyone is the wiser is an embezzler, i.e., somebody who fraudulently expropriates the property of others entrusted to his care. And an embezzler is subject to imprisonment. But a money warehouse and its employees enjoy a fundamentally different legal position. According to a landmark decision (Foley v. Hill et al., 1848), “the money placed in the custody of a banker is, to all intents and purposes, the money of the banker, to do with it as he pleases; he is guilty of no breach of trust in employing it; he is not answerable to the principal if he puts it in jeopardy, [or] if he engages in hazardous speculation.” The deposit banker who cannot meet his contractual obligation to a depositor, in other words, is not an embezzler: he is simply an insolvent. As such, he is possibly subject to civil but not (unless he undertakes actions above and beyond the embezzlement-that-dare-not-speak-its-name) criminal prosecution. A third point is that, unlike a family heirloom, gold and silver bullion are fungible goods (so too are coins, unless they have a numismatic value). The family heirloom that I store in the warehouse is unique: accordingly, if one day I arrive at the warehouse to claim it, and find that the warehouse manager has sold it and substituted in its place a “very similar” heirloom, I am unlikely to be favourably impressed: quite the contrary, I will be likely to protest vigorously and perhaps launch legal proceedings. In sharp contrast, the ounce of gold (or bushel of grain, etc.) that I store is indistinguishable from and hence effectively identical to any other ounce or bushel or such-and-such a grade. Accordingly, the contract with the warehouse is likely to state that my deposit will be mixed with other ounces of gold or bushels of grain, and that my warehouse receipt entitles me to an ounce of gold of pre-agreed degree of purity (or a bushel of grain of a given grade, etc.)–but not the same ounce or bushel that I originally deposited. Hence if I arrive at the warehouse to claim my ounce, and find that the warehouse manager has substituted in its place another ounce of equivalent purity, I am unlikely know; even if I do notice, I am unlikely to care; and even if I am miffed, the terms of my contract with the warehouse give me no legal recourse. From these three points emerge powerful (dis)incentives. The employee of a non-money warehouse that stores my grain or family heirloom has little incentive – quite the contrary, he has some strong disincentives – to speculate with my grain or Queen Anne chaise. Sooner or later, the depositor will demand his heirloom and grain, and so the probability of detection is relatively high. Moreover, legal precedents provide a credible threat of prosecution. The employee of the money warehouse with a reputation for honesty and probity, on the other hand, has every incentive to speculate with my gold and silver. He has every inducement to depart from what I have called loan banking financed completely from savings and to undertake fractional reserve banking. The employee of the money warehouse, in other words, has every incentive to issue counterfeit warehouse receipts and speculate with the proceeds. Depositors are likely to exchange warehouse receipts rather than physical metal, and are thus unlikely to detect this speculation; the higher the bank’s reputation for honesty, the less likely it is that they will even suspect mischief; and even if they do and even if the speculator loses their deposit, the structure of the law give the hapless depositor few or no credible means of redress through the courts. The baleful economic consequence of Jacobite deposit banking is that any money deposited in the bank’s vaults must be recorded on the bank’s balance sheet. For the duration of its deposit, gold or silver becomes the property of the bank, and in that respect it appears as an asset on the balance sheet. But a balance sheet must balance: because the deposit is redeemable at the depositor’s request, it is also recorded in the balance sheet’s liability column. Let us assume that, reflecting these legal developments, Acme Loan Co. Ltd decides to accept deposits of gold. (For simplicity and as before, assume that by definition one dollar is one ounce of gold). If it accepts 50,000 ounces from depositors, its balance sheet becomes:
Depositors have deposited 50,000 ounces of gold, i.e., $50,000, and in return they have received warehouse receipts for $50,000. These receipts can circulate from one person or business to another as a surrogate of the gold. Although a first step has been taken towards mischief and inflation, no actual transgression against sound banking has yet occurred. ALC is still backing all of its warehouse receipts either with gold or cash, and the supply of money is unaffected. A deposit now appears on ALC’s balance sheet, but otherwise nothing has happened. The amount of cash or gold in ALC’s vaults that is ready for instant redemption is its reserves. Not only has ALC kept all of its warehouse receipts backed fully by gold bullion or coin: it is “over-reserved.” Its reserves, expressed as a percentage of its warehouse receipts, is $60,900/$50,000 = 122%. No matter how much gold is deposited, the total money supply remains unchanged as long as ALC’s (and, by extension, all other banks’) reserves are at least 100% of its warehouse receipts.
As it implies, fractional reserve banking is the practice of managing a bank’s operations – in effect, its lending operations – such that its cash and gold falls below the 100% threshold. How does this occur? Not because the bank’s employees steal from the bank. (Yes, it occurs once in a blue moon, but when it does its magnitude as a percentage of the bank’s assets is usually insignificant.) Instead, the bank will either lend the gold or – far more likely – issue fake warehouse receipts for gold and then lend them to borrowers. If it does so, then the traditional deposit bank becomes a modern loan bank. And that provokes a hornet’s nest of moral and economic problems. Why is fractional reserve banking not just bad but also destructive? Because the bank is no longer an intermediary between one individual’s savings and another’s credit (where the amount of savings equals the amount of credit less some amount the bank keeps as a reserve). Instead, it is now taking money from a depositor – money that the depositor can redeem any time he pleases – and simultaneously (or shortly thereafter) lending a greater amount of money – part of which is funny money – to a third party. The bank is thereby increasing the amount of credit it extends to borrowers above the amount of available savings. It is doing so by issuing fake warehouse receipts (i.e., receipts not backed by gold coins or bullion) and lending them to borrowers as if they were genuine receipts. As a result, the depositor erroneously thinks that his warehouse receipts can be redeemed on demand for cash or gold – but they cannot because his cash or gold has been lent to (and thus also claimed by) the borrower. A look at ALC’s balance sheet illustrates this fundamental point. Let us say that ALC, having accepted the $50,000 of deposits, now issues $80,000 of additional warehouse receipts and lends them to Y Ltd for one year at a 10% rate of interest. In exchange for these receipts it receives an IOU and interest receivable from Y.
ALC has thereby issued $69,100 of counterfeit warehouse receipts. Of the total quantity of receipts it has issued ($130,000), $10,900 is backed by gold coin and $50,000 is financed with gold bullion. This total of “backed” receipts, $60,900, falls $69,100 short of the total quantity of warehouse receipts. ALC’s reserves, expressed as a percentage of warehouse receipts, have thus fallen from 122% to 47%. Each $1 of warehouse receipts is backed by only $0.47 of gold coin and bullion. Equivalently, atop each $1 of reserves the bank “pyramids” $2.13 of warehouse receipts. $80,000 of these receipts is lent to Y Ltd, which in turn uses the receipts to buy goods and services. Accordingly, ALC has increased the supply of money by $69,100 – that is, by exactly the quantity of fake warehouse receipts. Whence did this new money come? Out of thin air and the clear blue sky. The supply of money has increased by the exact amount of warehouse receipts not backed by gold coins or bullion – that is, not backed by savings. As a result, the supply of money has been contaminated by credit not financed with savings. Another way of looking at this invidious practice is to recall an axiom of sound financial management – one that every business except a bank must obey. The time structure of a firm’s assets must be no longer (and preferably shorter) than the time structure of its liabilities. If, for example, Z Ltd must repay $1,000 to a lender on 1 January and $5,000 the following 30 June, then it must manage its assets such that it has at least $1,000 of unencumbered liquid assets (gold coins of bullion) shortly before 1 January and at least $5,000 of such assets shortly before the following 30 June. If it does not, then it is in big trouble. But notice that modern deposit banks that undertake fractional reserve banking do not – because by definition they cannot – observe this rule. ALC’s $130,000 of liabilities (warehouse receipts) is due on demand, that is, potentially instantly; but its liquid assets amount to only $60,900. Its remaining assets, the IOU and interest receivable, can be converted into liquid assets only in a year’s time. ALC’s assets, like any and every fractional reserve bank’s assets, necessarily have a longer time structure than its liabilities. In this sense, it is potentially – because it is inherently – bankrupt. For decades, even centuries, this criticism has received a typical response. Rarely do all of a bank’s depositors seek to redeem all of their warehouse receipts; accordingly, this objection to modern loan bank and fractional reserve banking is at best abstract and theoretical and rarely if ever concrete and applicable to the real world. This objection, of course, misses the point. In the real world, ALC has created money and thereby generated inflation. It has lent counterfeit warehouse receipts to Y Ltd, which in turn has spent them. Just as in the case of outright counterfeiting, the fake money does not shower equally upon everyone. The new money is injected into some specific economic or geographic point of the structure of production. In George Orwell’s Animal Farm, some animals are more equal than others; similarly, inflation benefits some today and punishes everybody (but some more than others) tomorrow. ALC issues the bogus money – and benefits because in return it receives interest income. ALC lends this money to Y Ltd– which benefits because it can use the receipts to buy goods and services at the lower prices prevailing under the previous (i.e., smaller) supply of money. And so on for the people or firms who sell goods and services to Y. But as the bogus money ripples outward, demand for particular goods and services are (artificially) increased and their prices rise. The sellers of these goods and services benefit, but their buyers do not. The more extensively banks produce credit not backed by savings, the more pronounced the eventual rise of the prices of those goods and services bought and sold by the recipients of the new money. Clearly, however (again, the parallel with outright counterfeiting is exact), the early recipients of the bogus money benefit at the expense of the late recipients – and both benefit at the expense of those people who never receive the new money at all. Fractional reserve banking is fraudulent, inflationary and aids some at the expense of others. But the problems do not end there. Unlike credit backed by gold, credit not financed by savings is subject to contraction as well as expansion (see, for example, Part III of the circular to shareholders entitled “Rethinking the Great Depression: Implications for Value Investors”). What goes up can come down. The creation of credit not financed by savings renders banks vulnerable and exposes them and their borrowers to a contraction of credit. If Y cannot repay its IOU, for example, then ALC’s assets decline. But its liabilities are rock solid – it must redeem its fake warehouse receipts, which remain on the liabilities side of its balance sheet. As a result, its shareholders’ equity may fall, cease to exist or even become negative. It is primarily for this reason, but also others, that during the late-19th and early 20th centuries commercial banks in English-speaking countries warmed to the idea of government policies and institutions that would rescue them from the consequences of their recklessness. At the centre of this welfare state of credit sit central banks. As an example of the contraction of credit, let us say that a year has passed and that Y’s loan has come due. Let us also assume that the warehouse receipts that Y used to finance the purchase of various goods and services have circulated through the structure of production and have returned to Y. Various firms, in other words, have purchased goods and services from Y and have used the fake warehouse receipts to finance these purchases. Y, in turn, uses gold coins to finance its interest payment and the fake warehouse receipts to repay its loan from ALC. If so, then the effect upon ALC’s balance sheet (for simplicity, assume that during the year it has undertaken no other transactions) is:
The repayment of the loan means that the $80,000 of warehouse receipts ($10,900 genuine and $69,100 fake) have been cancelled, and the money supply has contracted by $69,100. But if the money supply contracts, then there is deflationary pressure upon prices. There will be a ripple effect – but this time it will be the mirror image of the “beneficial” inflationary ripple. Clearly, however, neither ALC nor any other fractional reserve bank will sit idly and allow its loan book to contract. To do so is to extinguish a major source of its interest income. Equally clearly, however, such banks are in constant danger of the weakening of the quality of credit that inheres in their policy of inflation. Whether suddenly or gradually, if fractional reserve banks contract their balance sheets – or even greatly reduce the rate at which they lend fake receipts – they also put pressure upon borrowers. If it is sufficiently severe, the deflationary pressure – the successor to the inflationary boom – will provoke the downward leg of the business cycle, i.e., a recession or bust. To undertake modern banking operations is thus to navigate a hazardous course between the creation of credit not backed by savings (which generates interest income that bolsters their return on shareholders’ equity) and the steady decline in credit quality that accompanies the creation of such credit (which threatens their shareholders’ equity). It is for this reason that, these days in all Western countries, banks are among the most protected – indeed, featherbedded – institutions. From the government’s point of view, the owner of a small business who exhausts his credit can go to Hell. But major banks are “too big to fail” and their executives know it. Give human nature and putting yourself in a banker’s shoes, why not spin the roulette wheel and lend recklessly? After all, the effect of government policy is to indemnify your speculative losses. The consequence of this “welfare state of credit,” as James Grant has called it, is thus the promotion of bull markets – that is, excessive risk-taking in lending markets and on financial markets. Borrowers borrow big and then have a wild night on stock, bond and real estate markets. The welfare state of labour feeds the very disease – human idleness – it supposedly tries to cure. Similarly, the welfare state of credit feeds speculative frenzies whilst simultaneously trying to abolish the losses that inevitably follow excessive risk taking. It creates the boom that causes the bust – but, through the central bank’s monetary policy, tries vainly to abolish the bust. Its long-run consequence is to produce commercial and financial instability (“imbalances”) below the calm surface. Accordingly, that Australia has not experienced a bracing and restorative bear market and recession since the late 1980s is not evidence of successful monetary policy and sound commercial banking. Quite the contrary: like the “green” policies that accumulate combustible matter on the forest floor, it is evidence of the moral hazard that accumulates bigger imbalances – and thus more painful reckonings – for another day. Note the diametric contrast between a fractional reserve monetary standard and a pure gold standard. Gold is physically a very durable commodity. Under a 100% gold standard, under which all borrowings are financed exclusively with savings, there is virtually no way that the supply of money can decline. In diametric contrast, credit not backed by savings is an abstract notion. Gold sits objectively in a vault but credit exists subjectively in the mind. When not backed by gold, credit is instead supported by “confidence” – most notably, confidence in the government that monopolises and manipulates the underlying fiat currency. Accordingly, the expansion of credit by fractional reserve banks must necessarily prove to be unstable: the more extensive the inflation, the more credit standards fall and the more likely it is that credit will eventually suffer from a want of confidence and perhaps an outright contraction. Hence the dim outlines of the modern business cycle that has plagued the Western world since the mid-to-late eighteenth century – not coincidentally, from almost exactly the moment that banks began to create credit not backed by savings.
A Glut of Savings or a Tsunami of Credit? This analysis has three implications. First, we can rescue Keynes from his absurd contortions. Even under a régime of hard money, whereby credit is financed completely by savings, and assuming for simplicity that savings are deposited in banks and then lent to borrowers, not all borrowers will be investors. Not all borrowers, in other words, use their loans to buy capital goods (recall Fred and his car). Under a hard gold standard, investment will not exceed savings; critically, however, bank credit will tend towards savings in banks less bank reserves. But when fractional reserve banking is the norm, as it has been for roughly the past century, then the amount of credit will exceed savings; and the lower the fraction of bank’s assets that is backed by savings, the more egregious the imbalance by which credit will exceed savings. Clearly, savings presently finances some percentage of lending around the world. The average bank’s reserve ratio, in other words, is greater than zero. Equally clearly, however, is it considerably less than 100% (a crude rule of thumb is 5%-15%, and avert your eyes from Chinese banks). Roughly five years ago, enthusiasts of The Great Bubble asked “Do Profits Matter?” Their arrogance belied their confidence that they did not. The laws of human action demonstrate that profits do matter, and the victims of the mania suffered the consequences of their ignorance. Today, enthusiasts of government intervention ask, implicitly but stridently, “Do Savings Matter?” (see in particular the amazing collection of fallacies propounded by The Economist in The Shift Away from Thrift). The laws of human action show us that they do. The trouble is that is it not central bankers but the general public who will suffer the consequence of élites’ ignorance. True enough, credit and investment are much more superficially plentiful under contemporary arrangements than they would be under a gold standard. The core myth of fractional reserve banking is that conjuring ever more fiat money – and investment and consumption – out of thin air creates more workers, mines, office space, manufacturing plants, houses, holidays and Holdens. It does no such thing: it simply enables funny money to rearrange and redistribute the existing structure of mines, offices, factories, McMansions and cars. Eventually, the price of inflation must be paid: it puts a fire under the prices of consumer as well as capital goods, and “investments” reveal themselves as unviable malinvestments which must be liquidated. If credit not backed by savings were really able to finance production, then why should anybody save anything? Why not expand the quantity of credit infinitely? Thanks to contemporary banking practice and today’s mainstream economists (who, consumed by the obscurantism of their mathematical models, do not appear to understand the economic consequences of modern banking), the general public has no inkling that investment can expand – and living standards be maintained and increased – only to the extent that people forego current consumption, convert the proceeds into investments and accept the risk that inheres in any investment operation. If and only if an investment bears its expected fruit, then its owner will be able to consume more in the future. Our second implication, then, is that savings matter. They matter much more than the mainstream realises, and they matter precisely because investment – the basis of steady and improving standards of living – presupposes savings. If so, then our third melancholy implication is that the world is presently awash not in a glut of savings, but rather in a tsunami of credit not backed by savings. Most people know that in Australia, Britain and the U.S., rates of savings are now lower than at any time since the Great Depression (in Oz and America, the rate may well be less than 0.0%). In contrast, few people seem to realise that savings have also been falling in other rich countries. Although the present rate remains higher in Japan than in the U.S., savings have been declining even faster in Japan than in America. People in Asian countries other than China are also showing signs that they have begun to abandon the frugal ways that have underwritten their prosperity. It is true, as Prof Bernanke stated in his recent Remarks, that savers in one country can finance investors in another. The trouble is that these days nothing of the sort is happening. Instead, the dwindling band of savers in Asia is financing the ever more gluttonous coterie of consumers in Anglo-American countries. As a result, savings around the world are being consumed rather than invested. A glut of savings? My eye: savings are in short supply. And that – no thanks to Humpty Dumpty, John Maynard Keynes and the economists and finance journalists they have inspired – ultimately bodes ill for everybody. Chris Leithner
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