Friday, May 29, 2009


Zeitgeist Addendum

Recently my cousin contacted me out of the blue (I hadn't spoken with him in several years) and said that he had stumbled upon Austrian economics and was now voraciously consuming all kinds of material. We discussed the apathy of the average American--maybe I'll start writing columns about AAA--and how frustrating/depressing/infuriating it was that so much freedom was vanishing with so little fuss.

My cousin asked me to check out Zeitgeist Addendum, since it had some pretty bold claims and he wanted my opinion. (Here it is on Google Videos.) My general reaction is that it was typical of a high-quality leftist critique of modern society: It accurately noted the suffering and injustice of the world--especially endured by the poor--and it understood the depravity of governments, including our own. But unfortunately, it incorrectly generalized and blamed "free trade" and "capitalism" for the evils it correctly linked with the World Bank, IMF, and "right wing" governments.

Before I delve into more specifics, let me offer the following clip that comes in the beginning of the movie. I think it is a perfect summary of what Zeitgeist has to offer:

Money = Debt?

The opening chapter is the movie's strongest. They go through the mechanics of the Federal Reserve System, and they really do a great job showing how insane and evil it is. Despite my serious misgivings with the rest of the movie, this piece on the Fed might make it on net a positive contribution, since I think it will wake up a lot of leftists on just how corrupt our financial system is.

In particular, I finally understood why so many people harp on the notion that with our system, "money is debt," and that the system is thus inherently biased towards more inflation, because the Fed needs to print more money in order for borrowers to pay off the last injection (plus interest). Several times on Free Advice (e.g. here) I have borderline ridiculed such a claim, since it overlooked the fact that even with a fixed money supply in gold coins, you can easily have positive interest rates because the money can change hands during the course of the year. (All that really happens is that you perform a flow of services and work off your debt that way.)

Another problem I have with people calling our current money "debt" is that, if anything, it's the opposite! Under the gold standard, the green pieces of paper issued by the Treasury really were liabilities--they had printed right on them a promise to deliver a certain amount of gold when the bearer turned in the Treasury note:

But under a fiat system, those green pieces of paper mean nothing. As Bill Barnett humorously observed to me on the phone one time, "Bob, on the Fed's books currency is listed as a liability. But if I turn a $100 bill over to the Fed, what do they owe me in return?" I thought for a second before answering, "Umm, a $100 bill?"

Now Zeitgeist did go too far, in my view, by basically saying that interest on loans was per se a bad thing, since it was "obviously" impossible for people collectively to pay back more than they had borrowed in the first place. The movie featured quotes from people suggesting that this way a very efficient way to enslave people, that it was the source of mortgage defaults, etc.

Yet even though I think the movie (or more accurately, documentary, but I don't want to keep typing out that high-falutin' term) painted with too broad a stroke, it did jolt me out of my cynicism to see their point: The way our monetary and banking system is set up right now, when the Fed increases bank reserves through open market operations, the commercial banking system then pyramids much more money creation on top of this through the creation of loans. In other words, in our system, most new money enters not through running the printing press, but rather through private banks deciding to lend money to people that the banks create out of thin air.

It's odd that it took Zeitgeist to get me to focus on this point, since I "knew" it all along. Yet for some reason--perhaps my rejection of the Fed and all its works--I always focused on the central bank's "creating money out of thin air," rather than the much more significant (in terms of the total increase in monetary aggregates like M1) acts of commercial banks doing the same thing.

Creating Money Out of Thin Air

Let me walk through this to make sure we get the point; it's very subtle and, like I said above, even though I "knew" it and had taught it to undergrads, it never really hit me until my cousin told me about this movie.

When a private corporation, let's say IBM, buys a financial asset, it writes a check drawn on its bank account. Let's say IBM buys $1 million in government bonds from the Acme Bond Dealer. So IBM writes a check drawn on its bank, let's say Chase, and gives it to Acme. IBM's balance sheet is unchanged in total size: Its liabilities (and shareholder equity) remain the same, while on the asset side, its checking account goes down by $1 million, while the value of its Treasury bonds go up by $1 million. The opposite happens to Acme's asset-side of the balance sheet.

Of special importance however is that this purchase doesn't affect the total quantity of money held by the public, and so it is neither inflationary nor deflationary per se. In the most obvious case, suppose Acme is also a customer of Chase Bank. Then when the check hits the bank, Chase simply reduces IBM's checking account by $1 million, and increases Acme's by $1 million. Total demand deposits are the same as before the transaction; money has just been swapped for bonds, nothing more.

OK now what happens instead if the Fed decides to buy $1 million in bonds from Acme? Well the Fed writes a check on itself and acquires the bonds. Its balance sheet goes up by $1 million (remember that IBM's didn't budge). Rather than one asset going up, while another going down, what happens to the Fed is that its assets go up by $1 million (the market value of the bonds it bought). There is no finite "checking account" balance that the Fed needs to debit; it can write an infinite amount of checks on itself.

In terms of the accounting, the balance sheet still balances, because on the liabilities side, the Fed adds $1 million to the reserves under the account of Chase. This is because when Acme gets the check from the Fed, it deposits it in its own checking account (Chase Bank), who then clears it with the Fed. So from Chase's point of view, they increase the checking balance of its client, Acme, by $1 million (just as in the IBM scenario), but now, instead of reducing some other client's account by $1 million, instead Chase increases its own "checking account balance" with the Fed by $1 million.

Thus, even at this stage the economy now has $1 million more in money "held by the public"; Acme has $1 million more in its checking account, and no other private person or company has a smaller amount of currency or checking balance.

But we're not done. At any given time, a bank must satisfy reserve requirements, meaning that it must have a certain fraction (let's say 10%) of its outstanding demand deposits, backed up in the form of vault cash or reserves on deposit with the Fed. For example, if Chase's customers added up all of their checking account balances and the grand total were $50 billion (I have no idea what a realistic number would be for this), then Chase would need to hold (let's say) $5 billion as reserves, either in the form of actual currency--green pieces of paper--in the vault, or as part of Chase's own checking account with the Fed itself.

Sooo, now that Chase's reserve balance at the Fed has instantly jumped up by $1 million, it means that Chase is holding "excess reserves," and can increase the total amount of checking account balances held by its customers, by $900,000. (This part always stumped me in the past--why couldn't Chase make new loans of up to $10 million right off the bat? After all, $1 million in reserves can support up to $10 million in expanded checking balances, right? The answer is that when its customers get these new loans, presumably they are going to write checks for much of the principal, which means other banks will "call in" a lot more of this new influx of reserves, than would be true on average for the original situation before the Fed open market operation. In other words, if Chase tried to expand the money supply to the fullest extent in the first step, it would end up being way below its reserve requirements.)

Don't worry, I'm not going to follow it through the next steps, when each subsequent deposit leads to further and further expansions because of new loans by other banks. I just want to point out that Chase bank officials are here creating new money, in a very real sense, and they are doing it by creating the amount of debt owed by the public. What happens to Chase's balance sheet at this stage is similar to, but not the same as, what the Fed does when it creates money out of thin air.

Let's say that Chase exploits its excess reserves by granting a loan to a homebuilder for $900,000, at a 5% annual interest rate. So now on Chase's balance sheet, its liabilities have increased $900,000--it just bumped up the homebuilder's checking account by that amount. The homebuilder can now start paying workers, buying lumber, and buying real estate, writing checks up to $900,000 on this account.

On the asset side, Chase has acquired a "bond" issued by the homebuilder. In other words, in order to get the loan from Chase, the homebuilder has promised a stream of $45,000 annual payments, with the principal to be repaid in x years. (I'm translating the homebuilder's "bond" into something comparable to the Treasury bonds that the Fed buys; you get the idea I hope.)

Now it's crucial to understand the mechanics (and any experts out there, please correct me if I botched the accounting above), but it's also important--once you've mastered what the heck is actually happening--to step back and see the big picture: Just as the Fed writes checks on itself--"creating money out of thin air"--in order to buy debt, so too private commercial banks can write checks on themselves, and thereby create money out of thin air, in order to buy debt. And in practice, the amount of this being performed by the commercial banks is several multiples of what the Fed itself does.

And here's the best part: Ever since that "savior of capitalism," FDR, instituted FDIC, if this house of cards ever collapses, then taxpayers are on the hook to bail out the bankers who mismanaged their portfolios and somehow managed to get wiped out, even though they have the ability to create money out of thin air and lend it on whatever terms they deem safe.

That is breathtaking, when you really comprehend it. Thanks for opening my eyes, Zeitgeist Addendum.

Economic Hitmen, and Then a Bunch of Bunk

The interview with the Confessions of an Economic Hitman guy is also very sobering. I am not bothering to cross-reference his tales with any other "normal" sources, but he tells a very plausible account of how the CIA, IMF, and World Bank muscle financially strapped Third World countries into signing away their lucrative natural resources to multinational companies. When two populist rulers say Go Home Yankee, they coincidentally go down in separate plane crashes.

After those scenes, however, the movie descends into anti-capitalist and anti-religious bunk. I'm not going to bother critiquing it, but let me just give some examples of how silly it is: At one point, the narrator "explains" that Jamaica (I think?) got destroyed by the evil multinational bringing in food that was so cheap it put the locals out of business. Now on the face of it, that's pretty funny: A leftist complaining that the capitalist nations aren't charging poor people higher prices for food.

But beyond the absurdity of it, this charge contradicts the claim made later in the movie, when it says that capitalism is based on scarcity, not abundance. In other words, it's not in the capitalist system's interest to increase production, because then prices (and "hence" profits) go down. So then, what was the story with the evil free trade and Jamaica?

Just promise us that you wont list it under "Movies they don't want you to see," in your next PIG book.
Wait a second here, let's put out a scenario and see what you think about the idea that capitalism is based on scarcity.

Let's say at any given moment we could put a number as to how many apples (this is just a place setter, use any commodity) we have in the economy, as that number goes up and down the price will go up and down. If we have less apples and the demand doesn't change the price of apples will go up, if we have more apples and the same demand the price will go down. It's in the best interest of people making money to buy up the entire supply of apples and slowly release them into the economy (although apples decay so mainly these people stay out of food, however recently they've taken aim to buying up factory farms to control the prices of food), you'd be able to charge more for them. The problem with our system today is the insane amounts of money people (and hedgefund/investment places) have, they regularly buy up all of something and slowly release it back into the economy just to see a small increase in price (though overall making billions). Those with money game the system to increase prices even as production skyrockets (thanks machines).

Here's my take on this, we have enough apples for everyone to have as many as they can fit into their mouth in an entire day. We're not running out of apples so why should they cost anything? I understand that some resources are scarce and that maybe, for instance, not everyone can have a boat load of gold (which is pretty much a useless resource anyway), but the idea that we need an income just to survive is a dated one and it's causing all this crime. If you had to choose between breaking into someone's house to eat or going to sleep hungry on the streets what would you choose? For how many days would you choose to sleep on the street before you broke down and did whatever it takes to get some food? Would you simply die of hunger or would you compromise your morals in order to continue living (even if your answer is to die overwhelmingly the choice of everyday people is to live, so even if you feel like you'd die before you stole food you're not in the majority)? It's for this reason I question capitalism, or at least whatever the hell you'd call what we're living in here in America, because whatever it is it's broken and it needs to be fixed, I don't care what it takes but putting someone behind bars who's only crime was trying to survive is counter-productive.
Watchout5, I guess I can't prove to you waht would happen in a truly free market, but for what it's worth, it is the US government that ordered farmers to literally destroy crops, kills piglets, etc. during the 1930s.

Your analysis is leaving out competition. Yes, if someone could buy all the apples on the market and then sell only 1/10 of them, he might make a bunch of money.

But at that (much much) higher apple price, somebody else who was previously growing something else would switch to apples. Or, people who hadn't previously bothered harvesting the apples would start doing so. Etc.
Watchout5, your claim, that, "It's in the best interest of people making money to buy up the entire supply of apples and slowly release them into the economy" is simply false.

In some circumstances it can be beneficial to stockpile a product in order to sell it later. That's not necessarily a bad thing for consumers, either. But regardless, that's not how producers make money.

If you are an apple grower, to use your own example, you can't really make money by not selling apples. It doesn't make any sense. You are in the business of producing apples and selling them. As long as selling those apples nets you more money than the cost of producing them, you'll likely continue to produce more apples.

Producing and selling less apples might increase the price of individual apples, but it would also decrease your total income because now you're obviously selling fewer apples in the first place. And as Bob pointed out above, when the price of apples begins to rise, it incentivizes other farmers to grow more apples of their own.

But apple farmers aren't the only people who are incentivized to sell more apples when the price goes up. The very people who you criticize--those who hoard products just to sell them at higher prices--are equally incentivized to sell when the price goes up.

When supply drops, for whatever reason, the rising prices encourage producers to produce more, and hoarders to sell their stock. The moderating effect of this natural system is not inconsiderable. It doesn't thrive on scarcity at all.
How does it compare to 'Money as debt'?

Commercial banks do not create money per se. It's a little more subtle. They create claims on money which, in turn, increase the money supply.

Abstract from money. I own a fleet of 10 cars. I "deposit" them at a local garage. The garage owner hands me 10 slips of paper that I can redeem for each of my cars.

The garage owner now has 10 cars on his lot. The rules say he must hold 1/10 in reserve at the city lot. So, he "deposits" one of my cars there, and loans out my 9 remaining cars.

The garage owner cannot directly loan out 90 cars -- he doesn't have that many.

Of course, the system of garages can loan out 45 cars (car is a unit that cannot be subdivided, so partial "cars" cannot be loaned out), creating 55 claims to 10 physical cars.

The same holds for the banking system. A banker cannot loan out that which he does not possess.

Just as only a car manufactureer can create a car, only the fed can create money. The garages and banks create claims to cars and money (fidudiary media), which, in the market, function the same as money.
Reality is based on scarcity. Capitalism merely deals with this fact.
In one sense you are right, banks can't create base money, they can only create claims to Federal Reserve Notes(FRN). However, when the claims to FRNs are exchanged instead of FRNs, which is what happens every time a credit card or check transaction is made, then the claims to FRNs are de facto money.
This is the same principle that brought about paper money in the first place. Paper notes were not money at first, they were a claim to real (gold/silver) money. But when the paper eventually became so wide spread that "real" money never came into the picture, then the paper itself was, in fact the money. That is why it was so easy for FDR to close the domestic gold window--people already accepted paper as money.

Bob, do you think the personal use of a check book is a good analogue to the creation of money (credit) by banks? When I write a check for $100 and give it to Walmart, then Walmart has a claim to $100, so they are effectively $100 richer. But, until Walmart cashes the check, my account has not decreased. Now since checks are usually cashed rather quickly, it is not usually a good idea to create more claims (checks) than the money I actually have in my account. So just like a bank can create money out of thin air, I can create money out of thin air, by signing a check I turn a worthless piece of paper into "money."
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Last try.


I am missing the "However ..." Seems we agree.

I wrote: They create claims on money which, in turn, increase the money supply.And: The garages and banks create claims to cars and money (fidudiary media), which, in the market, function the same as money.According to Mises Made Easier:Fiduciary media. Money-substitutes freely accepted at face value which consist in claims to payment on demand of specified sums of money in excess of the monetary reserves held for their redemption. Fiduciary money includes token money, bank or treasury notes and demand deposits (deposit currency or checkbook money) which exceed the amount of cash reserves immediately available for their conversion into money proper. Fiduciary media are money-substitutes (q.v.) and "Money in the broader senses (q.v.) but not "money in the narrower sense" (q.v.).
My entry looks correct when I type and preview it. After I submit, it bunches up. Oh, well. Three tries ie enough.
You're right Jim, I must have skipped you last sentence.
In the JAMAICA example the price doesnt stay low.It was lowered below the capacity for the native farmers to make a living then their land was purchased and prices hardly a gift to the people of Jamaica who had their agri buis stripped out from under them.
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