(This is a longer post, posted in multiple parts.)

Banking Bunkum

Part 1: Monetary theology

By Henry C K Liu, Asia Times: November 6 2002

Central bankers are like librarians who consider a well-run library to be
one in which all the books are safely stacked on the shelves and properly
catalogued. To reduce incidents of late returns or loss, they would proposed
more strict lending rules, ignoring that the measure of a good library lies
in full circulation. Librarians take pride in the size of their collections
rather than the velocity of their circulation.

Central bankers take the same attitude toward money. Central bankers view
their job as preserving the value of money through the restriction of its
circulation, rather than maximizing the beneficial effect of money on the
economy through its circulation. Many central bankers boast about the size
of their foreign reserves the way librarians boast about the size of their
collections, while their governments pile up budget deficits. Paul Volcker,
the US central banker widely credited with ending inflation in the early
1980s by administering wholesale financial blood letting on the US economy,
quipped lightheartedly at a Washington party that "central bankers are
brought up pulling legs off of ants".Central banking insulates monetary policy from national economic policy by
prioritizing the preservation of the value of money over the monetary needs
of a sound national economy. A global finance architecture based on
universal central banking allows an often volatile foreign exchange market
to operate to facilitate the instant cross-border ebb and flow of capital
and debt instruments. The workings of an unregulated global financial market
of both capital and debt forced central banking to prevent the application
of the State Theory of Money (STM) in individual countries to use sovereign
credit to finance domestic development by penalizing, with low exchange
rates for their currencies, governments that run budget deficits.

STM asserts that the acceptance of government-issued legal tender, commonly
known as money, is based on government's authority to levy taxes payable in
money. Thus the government can and should issue as much money in the form of
credit as the economy needs for sustainable growth without fear of
hyperinflation. What monetary economists call the money supply is
essentially the sum total of credit aggregates in the economy, structured
around government credit as bellwether. Sovereign credit is the anchor of a
vibrant domestic credit market so necessary for a dynamic economy.

By making STM inoperative through the tyranny of exchange rates, central
banking in a globalized financial market robs individual governments of
their sovereign credit prerogative and forces sovereign nations to depend on
external capital and debt to finance domestic development. The deteriorating
exchange value of a nation's currency then would lead to a corresponding
drop in foreign direct or indirect investment (capital inflow), and a rise
in interest cost for sovereign and private debts, since central banking
essentially relies on interest policy to maintain the value of money.
Central banking thus relies on domestic economic austerity caused by high
interest rates to achieve its institutional mandate of maintaining price
stability.

Such domestic economic austerity comes in the form of systemic credit
crunches that cause high unemployment, bankruptcies, recessions and even
total economic collapse, as in the case of Britain in 1992, the Asian
financial crisis in 1997 and subsequent crises in Russia, Turkey, Brazil and
Argentina. It is the economic equivalent of a blood-letting cure.

A national bank does not seek independence from the government. The
independence of central banks is a euphemism for a shift from institutional
loyalty to national economic well-being toward institutional loyalty to the
smooth functioning of a global financial architecture. The international
finance architecture at this moment in history is dominated by US dollar
hegemony, which can be simply defined by the dollar's unjustified status as
a global reserve currency. The operation of the current international
finance architecture requires the sacrifice of local economies in a
financial food chain that feeds the issuer of US dollars. It is the monetary
aspect of the predatory effects of globalization.

Historically, the term "central bank" has been interchangeable with the term
"national bank". In fact, the enabling act to establish the first national
bank, the Bank of the United States, referred to the bank interchangeably as
a central and a national bank. However, with the globalization of financial
markets in recent decades, a central bank has become fundamentally different
from a national bank.

The mandate of a national bank is to finance the sustainable development of
the national economy, and its function aims to adjust the value of a
nation's currency at a level best suited for achieving that purpose within
an international regime of exchange control. On the other hand, the mandate
of a modern-day central bank is to safeguard the value of a nation's
currency in a globalized financial market of no or minimal exchange control,
by adjusting the national economy to sustain that narrow objective, through
economic recession and negative growth if necessary.

Central banking tends to define monetary policy within the narrow limits of
price stability. In other words, the best monetary policy in the context of
central banking is a non-discretionary money-supply target set by universal
rules of price stability, unaffected by the economic needs or political
considerations of individual nations.

The Theology of Monetary Economics

Inflation, the all-consuming target of central banking, is popularly thought
of as too much money chasing too few goods, which economists refer to as the
Quantity Theory of Money (QTM). QTM is one of the oldest surviving economic
doctrines. Simply stated, it asserts that changes in the general level of
commodity prices are determined primarily by changes in the quantity of
money in circulation. But the theology of monetary economics has a long and
complex history, an understanding of which is necessary for forming any
informed opinion on the validity and purpose of central banking. Below is a
brief summary of the stuff dinner conversation is made of among the gods of
monetary theory.

Jean Bodin (1530-96), a French social/political philosopher, attributed the
price inflation then raging in Western Europe to the abundance of monetary
metals imported from the newly opened gold and silver mines in the Spanish
colonies in South America. Though he held many aspects of mercantilist
views, Bodin asserted that the rise of prices was a function not merely of
the debasement of the coinage, but also of the amount of currency in
circulation. Bodin's religious tolerance in a period of fanatical religious
wars drew upon him the accusation of being a "freethinker", a label as
damaging as being called a communist sympathizer in the United States in
modern times. In his Les Six Livrers de la republic (1576), Bodin replaced
the concept of a past golden age with the concept of progress. He
foreshadowed Thomas Hobbes (1588-1679: The Leviathan, 1651) by stating the
political necessity of absolute sovereignty, subject only to the laws of God
(morality) and nature (reality). Bodin also anticipated Baron Montesquieu
(1689-1755: De l'esprit des lois, 1748) by highlighting environment as a
determinant of laws, customs, beliefs and the interpretation of events, a
view that influenced the US constitution, a view since rejected by current
US moral imperialism.

John Locke (1632-1704) and David Hume (1711-76) provided considerable
refinement, elaboration and extension to the QTM, allowing it to be
integrated into the mainstream of orthodox monetarist tradition. Locke
developed the right of private property based on the labor theory of value
and the mechanics of political checks and balances that were incorporated in
the US constitution. Locke, in 1661, asserted the proportionality postulate:
that a doubling of the quantity of money (M) will double the level of prices
(P) and half the value of the monetary unit.

Hume, in 1752, introduced the notion of causation by stating that variation
in M (money quantity) will cause proportionate changes in P (price level).
Concurrently with Irish banker Richard Cantillon (1680-1734), Hume applied
to the QTM two crucial distinctions: 1) between static (long-run stationary
equilibrium) and dynamic (short-run movement toward equilibrium); and 2)
between the long-run neutrality and the short-run non-neutrality of money.
Hume and Cantillon provided the first dynamic process analysis of how the
impact of a monetary change spread from one sector of the economy to
another, altering relative price and quantity in the process. They pointed
out that most monetary injection would involve non-neutral distribution
effects. New money would not be distributed among individuals in proportion
to their pre-existing share of money holdings. Those who receive more will
benefit at the expense of those receiving less than their proportionate
share, and they will exert more influence in determining the composition of
new output. Initial distribution effects temporarily alter the pattern of
expenditure and thus the structure of production and the allocation of
resources. Thus it is understandable that conservatives would be sympathetic
to the QTM to maintain the wealth distribution status quo, or if the QTM is
skirted, to ensure that the maldistribution tilts toward those who are more
likely to engage in capital formation, namely the rich. Thus developing
economies in need of capital formation would find logic in first enriching
the financial elite while advanced economies with production overcapacity
would need to increase aggregate demand by restricting income disparity.

Hume describes how different degrees of money illusion among income
recipients, coupled with time delays in the adjustment process, could cause
costs to lag behind prices, thus creating abnormal profits and stimulating
optimistic profit expectations that would spur business expansion and
employment during the transition period. These non-neutral effects are not
denied by the adherents of QTM, who nevertheless assert that they are bound
to dissipate in the long run, often with great damage if the optimism was
unjustified. The latest evidence of the non-neutral effects of money is
observable in expansion of the so-called New Economy from easy money in the
past decade and the recent collapse of its bubble.

The QTM formed the central core of 19th-century classical monetary analysis,
provided the dominant conceptual framework for interpreting contemporary
financial events and formed the intellectual foundation of orthodox policy
prescription designed to preserve the gold standard. The economic structure
in 19th-century Europe led analysts to acknowledge additional non-neutral
effects, such as the lag of money wages behind prices, which temporarily
reduces real wages; the stimulus to output occasioned by inflation-induced
reduction in real debt burdens, which shifts real income from unproductive
creditor-rentiers to productive debtor-entrepreneurs; the so-called "forced
saving" effect occasioned by price-induced redistribution of income among
socio-economic classes having structurally different propensity to save and
invest; and the stimulus to investment imparted by a temporary reduction in
the rate of interest below the anticipated rate of return on new capital.

Yet classical quantity theorists tended persistently to minimize the
importance of non-neutral effects as merely transitional. Whereas Hume
tended to stress lengthy dynamic disequilibrium periods in which money
matters much, classical analysts focused on long-run equilibrium in which
money is merely a veil. David Ricardo (1772-1823), the most influential of
the classical economists, thought such disequilibrium effects ephemeral and
unimportant in long-run equilibrium analysis. Gods, of course, enjoy longer
perspectives than most mortals, as do the rich over the poor. As John
Maynard Keynes famously said: "In the long run, we will all be dead."

As leader of the Bullionists, Ricardo charged that inflation in Britain was
solely the result of the Bank of England's irresponsible overissue of money,
when in 1797, under the stress of the Napoleonic Wars, Britain left the gold
standard for inconvertible paper. At that time, the Bank of England was
still operating as a national bank, not a central bank in the modern sense
of the term. In other words, it operated to improve the English economy
rather than to strengthen the sanctity of international finance. Ricardo, by
focusing on long term-equilibrium, discouraged discussions on the possible
beneficial output and employment effects of monetary injection on the
national level. Like modern-day monetarists, Bullionists laid the source of
inflation, a decidedly evil force in international finance, squarely at the
door of the national bank. As Milton Friedman declared some two centuries
after Richardo: inflation is everywhere a monetary phenomenon. Friedman's
concept of "money matters" is the diametrical opposite of Hume's.

The historical evolution in 18th-century Europe from a predominantly
full-metal money to a mixed metal-paper money forced advances in the
understanding of the monetary transmission mechanism. After gold coins had
given way to banknotes, Hume's direct mechanism of price adjustment was
found lacking in explaining how banknotes are injected into the system.

Henry Thornton (1760-1815), in his classic The Paper Credit of Great Britain
(1802), provided the first description of the indirect mechanism by
observing that new money created by banks enters the financial markets
initially via an expansion of bank loans, through increasing the supply of
lendable funds, temporarily reducing the loan rate of interest below the
rate of return on new capital, thus stimulating additional investment and
loan demand. This in turn pushes prices up, including capital good prices,
drives up loan demands and eventually interest rates, bringing the system
back into equilibrium indirectly.

The central issue of the doctrines of the British classical school that
dominated the first half of the 19th century was focused around the
application of the QTM to government policy, which manifested itself in the
maintenance of external equilibrium and the restoration and defense of the
gold standard. Consequently, the QTM tended to be directed toward the
analysis of international price levels, gold flow, exchange-rate
fluctuations and trade deficits. It formed the foundation of mercantilism,
which underpinned the economic structure of the British Empire via
colonialism, which reached institutional maturity in the same period.

Bullionists developed the idea that the stock of money, or its currency
component, could be effectively regulated by controlling a narrowly defined
monetary base, that the control of "high-power money" (bank reserves) in a
fractional reserve banking regime implies virtual control of the money
supply. High-power money is the totality of bank reserves that would be
multiplied many times through the money-creation power of commercial bank
lending, depending on the velocity of circulation.

In the 1987 crash when the Dow Jones Industrial Average (DJIA) dropped 22.6
percent in one day (October 19) on volume of 608 million shares, six times
the normal volume then (current normal daily volume is about 1.6 trillion
shares), the US Federal Reserve under its newly installed chairman, Alan
Greenspan, created US$12 billion of new bank reserves by buying up
government securities. The $12 billion injection of high-power money in one
day caused the Fed Funds rate to fall by three-quarters of a point and
halted the financial panic. If the government had been running a balanced
budget and there were no government securities to be bought, the economy
would have seized up. This shows that government deficits and debt are part
and parcel of the modern financial architecture.

(This post continues, below.)