Monday, June 24, 2013

Three Principles of Banking, I: The Situation

A serious problem in the world today is that the people in charge of the world’s central banks have no idea what a central bank is supposed to do.  Their guiding assumption is that central banks were invented to finance government.  They also believe (erroneously) that “money is peculiarly a creation of the State” (Keynes, Treatise on Money).

That being the case (which is demonstrably not the case), the money supply (which they believe is limited to coin, banknotes, demand deposits, and some time deposits, i.e., M2) necessarily consists of bills of credit emitted by the State and used directly as money (e.g., the U.S. “Greenbacks” and Treasury Notes of 1890), or accepted by the central bank and used to back central bank promissory notes (e.g., National Bank Notes and Federal Reserve Bank Notes), which are in turn used to back new demand deposits or banknotes, i.e., “print money.”  The result is an unstable, debt-backed currency.

(N.B., while they are physically indistinguishable from one another, “Federal Reserve Bank Notes” are backed with government debt, while “Federal Reserve Notes” are backed with private sector hard assets.)

What has been happening on the world’s stock markets is that massive quantities of money are being created by the world’s central banks to “stimulate growth.”  All of this money is backed only by government debt.  Very little of it is going to new capital formation, however.  In an economic downturn, banks are reluctant to lend for that purpose.

The demand for new capital is derived from consumer demand — but the demand (“stimulus”) that is being pumped into the global economy in massive quantities is not going to consumers, but to financial institutions.  Seeing little or no return in lending the money for new capital formation, the banks “prudently” put the money into the secondary market where they see good returns from speculating in shares, making money by going both long and short.

This, naturally, drives up the prices of shares, creating a bubble in the stock market — just as was seen in the Mississippi and South Sea Bubbles in the early 18th century, the Panic of 1825, and the Crash of 1929, among others.  In the meantime, the productive capacity continues to decay, and the production of marketable goods and services that provides the tax base that stands behind the government debt and the profits that support the prices of shares declines relative to the amount of money being poured into the economy.  A crash is inevitable, because there is nothing behind either the rise in the price level on the secondary market, or the new money that is causing the rise in the price level — a double whammy.

What this leads to is the subject of tomorrow’s posting.


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