Extreme Bank Runs in REPO Markets

Here is a primer on how repo markets relate to the conventional banking system.

MAKING MONEY - THE "FINANICALIZATION" OF THE ECONOMY

In our financial system, a bank loan creates a bank deposit from "thin air". This deposit sits on the bank's books as a liability. The books are "balanced" by the loan agreement, which is an asset. 

A cashier's cheque drawn on the new bank deposit can buy your groceries in a way that the IOU from the borrower to the bank can not. You could say that the bank deposit has higher "moneyness" than the borrower's promise to repay. 

New money is created this manner as the borrowers promise to pay is "financialized". 

Physical cash has the highest "moneyness" (even more than the bank deposit). It is simply decreed to be money by the government's legal-tender laws.

MARKETABILITY

A broader concept related to "moneyness" is "marketability". If legal tender laws did not exist,  the most marketable commodity would become money. People find it convenient to quote prices in terms of a marketable commodity. Financial transactions (including borrowing and lending) gravitate to using the most marketable commodity as money. 

Anything that is marketable can be used as money - metals, tobacco, salt, cowrie shells, beaver pelts etc have all been used. Historically, gold and silver were eventually adopted as money by the free market. If a shortage of the monetary commodity occurs (e.g. gold), people simply start using the next most convenient commodity as money (e.g. silver). 

Legal-tender laws ensure the marketability of cash - by requiring that taxes and other legal obligations be paid using paper money. However, the government can make any commodity money by "fiat" (decree).

LIMITS OF FINANCIALIZATION

Traditionally, financial regulations & prudential banking limited the amount of credit lent into the economy by a banking system - by tying it to the amount of CAPITAL in the retail banks. 

However, investment banks found a way to get around these limits to "financialization" using securitization. The securitization machinery at investment banks bought loans from retail banks and converted them to securities that were sold to investors. Retail bank capital was thus freed up to re-use lending channel to REPEAT this cycle and increase the credit in the system. The system was thus leveraged to many times the amount that would normally have been permitted by regulations. 

This arrangement may sound innocuous at first but it HYPER-LEVERAGES the investment banks' balance sheets. Every time investment banks securitize a batch of loans into investable tranches, they retained the riskiest portion of these loans on their own balance sheet. A small loss on these loan books had the potent to totally wipe them out. 

To mitigate this risk investment banks purchased CDS insurance on the safer tranches from reinsurers like AIG. However AIG itself underestimated the risk in these loans and was not capitalised sufficiently to write this insurance. 

This entire arrangement created a powder-keg ready to explode. The explosion happened in 2008 taking down Bear Sterns and Lehman brothers. AIG, Morgan Stanley, JP Morgan and Goldman Sachs would have disappeared too had the US taxpayer not massively recapitalized AIG, and twisted its arms to ensure that AIG paid the investment banks every last dollar of insurance due to them.

REPO MARKETS - EXTREME "FINANCIALIZATION"

What is not well understand is that the purchase of a lot of these securitized assets was in fact funded indirectly by the retail banks themselves!! There is a MASSIVE lending market for REPOS between dealers and banks, wherein dealers pledge any asset that is valuable for loans from a bank. 

The newly created credit is lent out by the Prime Brokerage divisions of the investment banks to their customers, who buy risky assets. Depending on the potential volatility and liquidity of the pledged asset, the customers may be lent (say) 90%, or 80% or 70% of the value of the security, thus potentially leveraging their position enormously.

BANK RUNS 

During periods of growth, increased confidence and competition amongst banks would cause creeping over-extension of loans to increasingly marginal borrowers. At some point marginal loans start to go bad. As this becomes known, the fear of bank runs starts to spread and the solvency of affected banks comes into question. 

If a bank's assets lost value (i.e. loans go bad) the books would become unbalanced and bank deposits could lose their "moneyness". Depositors became fearful and would try to to convert their deposits into cash, or transfer them into other banks. 

A distressed bank would attempt to restore confidence in the deposits by trying to raise cash through a combination of the following actions:

(a) Borrow money in the unsecured inter-bank market

(b) Pledge "marketable" assets in the REPO market

(c) Call in loans and pull credit lines, where possible

(d) Liquidate assets that can be sold, even if at a loss 

(e) Raise money in the capital markets through a share, rights or bond issue

The resulting curtailment of lending caused a "credit crunch" and liquidation of assets. This disrupted trade and manufacturing, giving rise to the business cycle. 

Central banks were created to try and "smooth out" the business cycle. They act as a lender-of-last-resort for distressed banks to provide them loans during a credit crunch. Central banks operate using REPO transactions. Banks pledge high-quality (i.e. "marketable") assets in exchange of central bank loans. Only the highest quality assets are usually accepted as "eligible collateral" for central-bank repos, otherwise the central bank may end up stuck with these if the bank becomes insolvent due to loan losses  

Central banks stipulate that banks maintain a minimum capital buffer to cover any loan losses. Accounting rules also mandate that any expected losses must be marked down in the books, curtailing further "risk-taking" (i.e. lending). Unfortunately, over the past couple of decades capital requirements and accounting standards have been watered down in the name of "supporting growth". In practice this means that marginal borrows continue to be funded and their claims on real resources (such as groceries) are not liquidated. 

"EXTREME" BANK RUNS

Now let's examine what happens when loans go bad in the hyper-leveraged REPO  markets. The immediate effect was the 2008 collapse of the investment banks. Central banks and the taxpayers stepped into the breach and shored up these entities through massive lender-of-last-resort loans, recapitalization, and by simply purchasing distressed securities off their books for well above market values.

However, the fundamental problem remains. We are in a world where the financial system contain too many promises to pay, and not enough means to pay them. Bad loans are losing the moneyness all over the world, grinding down the capital on bank balance sheets everywhere. The world economy can not grow while it is weighed down by the the burden of servicing all the accumulated debt during the boom times. 

The repo markets are where the real action is. Banks will not lend against these deteriorating assets - whether they are mortgage loans, European debt, chinese grey market debt, etc. 

Left to itself, the world economy will experience a long deflation to clear out the excesses. However, the policy response of countries like the US and UK is INFLATION of the money supply. The obstruction to this policy are CREDITORS like Germany and China, who do not want to see the value of their loans inflated away. The battle of will between these opposing forces will continue and the outcome is a function of POLITICS. 

Markets up 20% in a month - what just happened?

Those surprised by the financial markets' incredibly positive response to the EFSF expansion to $1.4 TN may find Doug Noland's piece about Money and the European Credit Crisis quite helpful in understanding what just happened.

Writing about the historical "preciousness" of money, Doug explains how our financial system creates money. Using an array of financial innovations it "monetizes" any sound financial claim by lending bank deposits against it. This creates an artificial demand for these credits and ensures that sound financial claims are highly liquid and thus, as good as "Money."

2008: Questioning "Moneyness"
 
The credit bubble leading up to 2008 crisis was fuelled by “monetization” of sub-prime mortgage credits through the securitization machinery. The soundness of the resulting derivatives was underpinned by (questionable) credit ratings. Using cheap CDS insurance from AIG, banks could provide liquidity in the secondary market. 

When the securities were revealed to be unsound, they became highly illiquid and lost their “moneyness”. This threatened to bring down AIG and the banks that depended on the unsound insurance provided by an undercapitalised insurer based on fantasy ratings.

The markets enjoyed an incredible windfall since 2009 as Treasury and Federal Reserve backing has restored "moneyness" to Trillions of suspect financial claims. Massive federal debt issuance and Federal Reserve monetization have reflated asset markets and sustained the maladjusted U.S. economic structure.

A Closer Look at Sovereigns

The end of the credit binge caused a painful slowdown in liquidity-fuelled global growth, exposing fundamentally unsound sovereign credits. Governments such as Dubai - dependent on tax revenues from the bubble economy - were bailout out by rich cousins. Those hopelessly in debt, such as Iceland, simply collapsed. Those that weren't permitted to collapse, such as Ireland, were drip-fed financing and their people condemned to debt slavery.

The 2008 crisis has brought forward the Global Government Finance Bubble by several years.

Essentially, the European crisis is about the escalating risk that the entire region's debt could lose its "moneyness." Ever since the introduction of the euro, the European financial system has had an insatiable appetite for Euro-government credits. Under the Euro system European Banks were incentivised to lie to themselves. Euro governments were believed to be fundamentally sound despite unsustainable deficits, and despite explicit EMU treaty prohibitions against bailouts. Core European governments and the ECB would, the banks told themselves, back all government and banking system obligations. 

Many expected that German politicians to calculate that it will cost less to backstop the region's debt than to risk a collapse of European monetary integration. The Germans, however, appreciate like few other societies the critical role that stable money and Credit play in all things economic and social. So far, they have refused the type of open-ended commitments necessary for the marketplace to again trust the Credit issued by the profligate European borrowers, and have insisted that the incredibly bloated banking system eat the losses on Greek debt.

The Franco-Italian Connection 

Increasingly, the consequences of a loss of "moneyness" at the periphery have weighed heavily upon the European banking system. Greece, Portugal and Ireland are just a side-show. Faltering confidence in Italian debt is the real issue. An Italian default will devastate French banks. At the same time, any meaningful French participation in PIIGS bailouts would see France lose its AAA rating. 

The above French conundrum risked impairing the "moneyness" of French Credit, which is at the core of the European debt structure. This is why the Germans have permitted EFSF leverage up to $1.4 trillion.

The grand plan is to allow IMF/BRIC/Japan/Sovereign Wealth investors to backstop the "moneyness" of European debt, thus providing the bazooka that will ensure market confidence in European Credit generally. For now, the markets are assured that the near-term implosion risk is off the table, which set the stage for a huge short squeeze and destabilizing unwind of hedges across virtually all markets. There may be grand plans and grand designs for a credible "ring-fence," but the critical issue of how to ensure ongoing Italian debt "moneyness" continues to prove elusive.

Haircuts and Inflation

Clearly, the world has too much debt to pay off honestly. Most of it will either be defaulted on, or inflated away. There will be repeated crises of confidence as the soundness of credit after credit is called into question and ultimately "demonetized". 

Inflation, where possible, will steal from savers. It will have to be executed carefully, as any rapid loss of value can lead to capital fright, resulting in a loss of confidence in the inflated currency. Witness the masters of propaganda at the Bank of England employ deflationist scare tactics to cloak the effects of their QE-fuelled inflation, which runs rampant in the UK.

As the crisis inexorably grinds from the periphery to the core of the global financial system, the dominos will fall one by one. US treasury bears will have to be very patient. There is plenty of drama to sit through before the final act - demonetization of US credit - is played out. Meanwhile the dollar devaluation will continue in a volatile downtrend.

The Euro: A Tragedy of the Commons

Imagine that each EMU country possessed a Euro printing press. Each country would accrue benefits (higher income) by printing money, whereas the costs (a lower purchasing power) would be borne by all Euro countries. The country that prints the fastest makes gains at the expense of others. In this (hypothetical) situation we are faced with a "pure" Tragedy of the Commons where there is no limit to the exploitation of the Euro resource. The currency ends in a hyperinflation and a crackup boom, in other words, the destruction of the common resource.

Although hypothetical, the example of several printing presses helps us understand the risk to the Euro. Reality is different - deficit countries run deficits and issue bonds, which is not the same as printing Euros. Banks earned a yield spread by purchasing these bonds and posting them as collateral for cheaper loans from the ECB. The loans were effectively new money from the ECB, which was used to repeat this process.

Similar to the mortgage securitization process by US investment banks, this created a “demand” for Euro government, which politicians were only too happy to supply. The incentive for politicians was redistribution. Early adopters bought electoral favors at low prices. Spending the newly borrowed money increased prices and monetary incomes across the EMU. This forced greater borrowing to finance the same lifestyle. The higher the deficits became and the more governments were forced to borrow.

There were several risks to this arrangement continuing forever.

1. Low yields - Banks needed sovereign bond yields to be higher than the ECB lending rate interest rate for this to be profitable.

2. Default risk - default was considered impossible. It was widely confused with a country leaving the Eurozone. As the euro was seen as an irreversible political project the market assumed there were implied bailout guarantees, even though these are explicitly prohibited by the EMU treaties.

3. Collateral quality - Before the 2008 crisis, the minimum rating required by the ECB was A–. This was reduced to BBB– during 2008 for one year, and then another. Finally, the ECB, in contrast to its stated principles of not applying special rules to a single country, announced it would accept Greek debt even if rated junk.

4. Liquidity risk - Government bonds are of a longer duration than ECB bank loans (1 week to 3 months, now increased to 1 year). The risk was that the ECB might refuse to roll over loans collateralized with downgraded country debt, causing liquidity problems for the borrowing bank.

5. Haircuts -The ECB distinguishes five different categories of collateral, demanding applying different haircuts. Haircuts for government bonds are the smallest, thereby subsidizing their use as collateral vis-à-vis other debt instruments. This supports government borrowing. Downgrades mean that haircuts applied by the ECB on the collateral may not allow for full refinancing.

6. Tightening - The ECB might not accommodate all demands for new loans. If a restrictive monetary policy was applied, the risk was that not every bank offering government bonds as collateral would receive a loan.

However, for political reasons, the ECB did accommodate such demands, especially if some governments were in trouble. Indeed, the ECB started offering unlimited liquidity to markets during the financial crisis. Any demand for a loan was satisfied — provided sufficient collateral was offered. Loans up to 1 year were offered. Collateral quality control was waived.

EMU leaders externalized the costs of government spending in two dimensions: geographically and temporarily. Geographically, some of the costs are borne in the form of higher prices by the whole Eurozone. Temporarily, the problems resulting from higher deficits are possibly borne by other politicians and only in the remote future.

These tragic incentives stem from the unique institutional setup in the EMU: one central bank. These incentives were not unknown when the EMU was planned. The Treaty of Maastricht (Treatise of the Economic Community), in fact, adopted a no-bailout principle (Article 104b) that states that there will be no bailout in case of fiscal crisis of member states. Along with the no-bailout clause came the independence of the ECB. This was to ensure that the central bank would not be used for a bailout.

Political interests and the will to go on with the euro project have proven stronger than the paper on which the no-bailout clause was been written. Moreover, the independence of the ECB does not guarantee that it will not assist a bailout. In fact and as we have seen, the ECB is supporting all governments continuously by accepting their government bonds in its lending operation. It does not matter that it is forbidden for the ECB to buy bonds from governments directly. With the mechanism of accepting bonds as collateral it can finance governments equally well.

There was another attempt to curb the perverse incentives of incurring in excessive deficits. Politicians introduced "managed commons" regulations to reduce the external effects of the tragedy of the commons. The stability and growth pact (SGP) was adopted in 1997 to limit the tragedy in response to German pressure. The pact permits certain "quotas," similar to fishing quotas, for the exploitation of the common central bank. The quota sets limits to the exploitation in that deficits are not allowed to exceed 3 percent of the GDP and total government debt not 60 percent of the GDP.

If these limits had been enforced, the incentive would have been to always be at the maximum of the 3 percent deficit financed indirectly by the ECB. Countries with a 3 percent deficit would partially externalize their costs on countries with lower deficits. However, the regulation of the commons has failed. The SGP is just an agreement of independent states - without credible enforcement.

Inflation and deficit quotas of independent states are difficult to enforce. Automatic sanctions, as initially proposed by the German government, were not included in the SGP. Even though countries violated the limits, warnings were issued, but penalties were never enforced. Politically influential countries such as France and Germany, which could have defended the SGP, violated its provisions by having more than 3 percent deficits from 2003 onward. With a larger number of votes, they and other countries could prevent the imposition of penalties. Consequently, the SGP was a total failure. It could not close the Pandora's Box of a tragedy of the commons which will now follow. Expect more bailouts.

Adapted from http://mises.org/daily/5331, an excerpt of Philippe Bagus’ book The Tragedy of The Euro

Current Macro Thesis

Inflation is one way out of this debt crisis. However, the situation in Europe is complicated by the EMU.

• There is a sizeable (and growing) political constituency in Germany/Finland/Holland and other CREDITOR countries against the bailouts
• The German Constitutional courts have placed severe constraints on the government’s ability to negotiate bailouts without the German parliament’s approval
• Euro treaty rules have strict prohibitions against direct monetization of government debt by the ECB & creating permanent bailout mechanisms
• All current support provided by the ECB to Italy/Spain/Greece is done on a Euro-neutral basis … they have to repo-out assets to repo-in other assets

My current macro thesis is:

• The debt-deflation scenario envisioned by Prechter and others is the 800lb Gorilla on the macro-stage. No question in my mind that without intervention we WILL see all assets (incl. Gold) fall, and a flight to cash
• The powers that be will use whatever they can to prevent a deflationary depression by “dampening” the asset price deflation by (1) providing liquidity, (2) quantitative easing (3) monetization of impaired debt assets
• If they succeed, this will cause inflation in “the things we need” – food, energy, basic commodities, etc as all the liquidity finds its way into the speculative world, while slow deflation in “the things we want” like houses, stocks
• The economy will cycle between periods of growth (unsustainable, liquidity fuelled) and deflation (caused by inflationary shocks) causing massive volatility in global markets
• The “stimulus” process is a tightrope walk between runaway inflation & deflationary depression – either outcome is possible if policy mistakes are made
• In western economies, a decade of stagflation is the most likely outcome – no wage increases, increasing food and energy inflation, persistent deficits & high taxes

A short history of money and banking

In 2008 we found ourselves in the midst of a global financial panic - allegedly caused by irresponsible lending by banks. Amongst the sound and fury generated by the crashing of banks, agencies and insurance companies, the world found itself on the brink of a financing crises that threatened stable companies with good balance sheets. They found that their production process was interrupted because their trading partners' banks would refuse to honor each others' Letter of Credit (LoCs).

To many this was a far scarier development than the market crash. It threatened to bring the production and distribution of goods to a grinding halt - all due to a failure of the Letter of Credit system for trade and production finance.


FINANCING THE INDUSTRIAL REVOLUTION

The curious reader may ask, what is the point of labeling a company "stable" if it is dependent of bank credit to finance production? The answer is that no matter how strong a company's balance sheet is, its purchases of raw materials for confirmed orders are almost always funded by banks.

In fact modern industrial economies have only become possible due to the efficiencies brought about through the financial innovation of LoC systems. I would go so far as to say that the industrial revolution would not have been possible without the financial innovation of LoCs.


To many this may sound as a fairly bold statement. What about the steam engine? Or the renaissance? Key scientific discoveries? Surely these were the real enablers of the industrial revolution, not some boring financial instrument! Yes, all of those were important. Yet, without the LoC the Industrial Revolution could not have taken place. The explanation is a bit involved but let us dive into it nonetheless.

Banks as a warehouse
Depository receipts gain currency

Gold and Silver were used as money for many millennia. People frequently deposited their money with Goldsmiths or in warehouses. In turn they would be issued warehouse receipts for their deposited gold. Gradually these receipts became accepted in lieu of physical coins for payments.

Medival prohibitions on usury in the Islamic and Christian worlds prevented a large increase in credit money throughout the dark ages.
As medieval prohibitions on usury were eased in pockets of Europe, banks started to loan out coins on deposit to generate a source of income for the warehouses. In order to attract deposits the warehouses offered interest on the deposits instead of charging depositors for safekeeping. Slowly they began to resemble today's banks rather than gold warehouses.

If a bank's loans went bad depositors run to the bank to be first in line to receive whatever gold remained the bank could produce from its vaults and by marketing or pledging its assets. Due to the constant threat of bank runs, the early banks were forced to lend money to only the safest and most liquid borrowers - as described in the next section.

Thus market forces made prudential lending a competitive advantage that helped a bank attract more deposits, not a regulatory annoyance imposed by the government. Adequate capitalisation too was a competitive advantage, not a regulatory burden - a well capitalised bank was more likely to weather losses and remain sound.

Most people hold money for short term needs in cash or demand deposits. Any savings were invested in bonds or equity. Longer term bank deposits too existed, and banks were careful to match the maturity profile of their liabilities and assets to avoid a liquidity crunch.

The aggregate term distribution of investments forecast the economy's intention of consumption over investment. Greater short term investments implied a lack of investable capital goods, and greater investment for the longer term implied productive capital surpluses available for longer term investing.

Long Industrial Production Chains

Increased demand for Financing

The main characteristic of the industrial age was the dramatically increased division of labor, with an accompanied increase in specialization in each of the steps resulting in longer chains of production.

In the real world multiple inputs go into creating a finished product. A real production chain can be visualized as a river, with a number of tributaries flowing into the single river, each with their own sub-tributaries. However, to illustrate the effect of the division on labor on the demand for money it is sufficient to consider a linear production chain.

A longer production chain involves a larger number of financial transactions leading to the production of finished goods starting from raw material. Consumers only pay for an items at the point of sale. A retailer only pay for goods on delivery. Factories only pay for industrial inputs they become available, and so on all the way to the production of raw material.

Yet, the retailer cannot pay until the customer pays. The factory cannot pay until the retailer pays. The refiner cannot pay until the factory pays, etc. This has huge implications on the demand for capital.

Imagine a product, such as a factory made towel produced with Egyptian cotton. Let us say for sake for argument that the towel is produced in several steps from growing raw cotton in Egypt to selling it to a housewife in London. In each of the ten steps £1 of value is added to the product, and ultimately it sells for £7.

Without bank finance, to make this possible, the following must be happen for each towel sold:

• The retailer must pay the distributor £6
• before which the distributor pay the towel factory £5
• before which the towel factory must pay the cloth merchant £4
• before which the British cloth merchant must pay the Egyptian loom £3
• before which the Egyptian loom must pay the trader £2
• before which the Egyptian trader must pay the cotton grower £1

The total money at hand that the various parties required to finance this production chain is 6+5+4+3+2+1 = £21. That's a lot of capital to tie-up in the production of one towel worth £7 before the customer will pay for it. A huge £21 worth of consumption/investment is forsaken over the length of the production cycle to finance this production chain.

It is no wonder that sub-division of labor was never possible without some way of making this process more efficient and most manufacturing was a artisan type affair with not more than a couple of steps in the manufacturing process. 

Let us now examine how bank loans made eased this demand for working capital and make longer production chains more capital-efficient.

Traditional Banking 

Financing Industrial Production

An eventual towel-buyer would hold a short-term balance £7 in a bank account in anticipation of buying a towel in the coming season (or his/her employer would in preparation to pay wages).

Knowing that the retailer regularly sells a number of towels every season, a bank can take an IOU worth £6 + interest from the retailer and an issue a £6 promissory note (payable in the 90 days) payable against the delivery of towels from the towel factory. The factory's banker will accept this note and further provide a £5 promissory note to the merchant's banker. His banker in turn writes a promissory note to the loom's banker, and so on.

When the customer pays the retailer, the retailer repays his loan. By this time, the retailer's bank's promissory note also comes due and is repaid with the customer's payment. The same process repeated down the supply chain. This type of credit is SELF LIQUIDATING. As goods in urgent demand are delivered, the payments liquidate the credit.

The promissory notes were very low risk forms of short-term credit. It is easy to see why. Retailers who regularly sell consumer goods in high demand such as food, clothing, toys, shoes, books, electronics, etc will continue to experience a very stable demand for their products. The credit is backed by their expected sales. People will continue to eat, be clothed and buy items of everyday use. Therefore it is safe to extend working credit to stock their inventories.

Consumer spending being the largest and least speculative portion of any economy, it is therefore no surprise that these promissory notes became very liquid and marketable instruments. As the industrial revolution swept the world, they began to circulate as money substitutes. Bank Notes from solid, dependable banks were widely accepted at par with coins, and warehouse receipts for bullion. Notes from lesser known banks would trade at a slight discount.

If a bank experienced excessive depositor demand for physical Gold, it could always sell (or borrow against) these safe assets with other banks in exchange for their bullion. This  interbank lending market developed into the modern repo market.

Bank Notes and the Real Bill Markets
Self-liquidating credit - a sound portfolio for Banks


Every bank note in circulation is a liability of the bank, backed by a corresponding asset on its balance sheet - an IOU from a real business in the real economy drawn against confirmed orders, working to provide for urgently sought after items for be paid for on delivery with existing bank balances. Adam Smith used the term REAL BILLS to describe these IOUs.

Eventually secondary markets developed for these Real Bills. Banks and merchants regularly traded them. In fact a merchant could make more profit by investing in the higher yielding Real Bill of a competitor than to tie up capital in stocking his shelves with marginally profitable items.

We know that the yield levels in bond markets are driven by the PROPENSITY TO SAVE. If investors save more, more capital is available and yields go down.

However, the yields in the Real Bills market (more accurately the discount rate) were driven by the PROPENSITY TO CONSUME. If people expected to spend more money, the quantity of short term balances in banks grew, and this lowered their yield and send a clear demand signal throughout the production supply-chain. If consumers planned to cut back on spending, that drove up the discount rate in the Real Bill Markets and automatically put a brake on marginal production.

In this manner the Real Bill market acted as a wonderful signalling mechanism for the longer production chains, signalling consumer demand through the price of short-term, self-liquidating credit.

The supply of circulating notes smoothly grew with increasing economic activity and contracted without leading to deflationary depressions when demand slowed. There was no need for central banks to measure the money supply, set interest rates or gather data about economic indicators. All of this was effectively managed by the invisible hand of the market.

Of course the whole production chain can break down if one of the links breaks down, akin to a series of interdependent house purchases falling through if one of sales in the chain does not succeed.

Central Banks
Lenders of last resort

Natural or man-made disruptions of this free-market financial system were common. Natural disasters, wars, etc would leave the banks "broken" if production was disrupted and borrowers could not repay in these circumstances.

The development of the insurance industry helped mitigate the risks of long distance trade. This made the financing chain more robust. However, excessive risks taken by banks were a constant threat to the smooth functioning of real bill markets. They often found themselves caught up in speculative manias such as the South Sea Bubble, the Tulip Mania, and many other less famous speculative periods.

Thus, regular economic activity unrelated to the speculation was often disrupted by the contagion. Bankers to cease accepting each others' promissory notes if the soundness of their holdings were called into question. This often fed through to the Real Bill market, causing economic dislocation.

Government set up Central Banks to mitigate this problem. These were lenders of last resort who could provide credit to the creditworthy when no one else would.



A BRAVE NEW WORLD

Credit Money
Crises, World Wars and the Great Depression

Through all this change and the innovation of financing production with liquid deposits one thing remained constant. All these forms of circulating money substitutes were always convertible into the coin of the realm (usually Gold coin or bullion) at the issuing bank.

Except if the governments suspended the convertibility by law.

In the lead up to the first world war many countries (notably France and Germany) suspended the convertibility of circulating notes into coin. This action allowed them to grow the supply of circulating bank notes, through bank loans to the governments.This novel technique allowed governments to invade the pool of capital goods and divert them towards war tear more effectively than would have ever been possible through borrowing, taxation or the debasement of coins. It has been argued that this is what caused the world wars to be longer and more bloody than the wars preceding them. Most wars between technologically equal adversaries end because one side is overwhelmed by the other.

The establishment of the Federal Reserve System also helped a great deal in the inflation of circulating money in the US. Note that the US did not suspend convertibility until after the full force of the debt deflation that caused the Great Depression had hit them.

The efforts of European powers to return to Gold convertibility after WW1 helped pushed the world into a Great Depression, towards Fascism and WW2. Too many bank notes were in circulation compared with the specie in bank vaults. Credit collapsed, and the wave of cascading bank defaults led to the Great Depression. One by one the countries were forced back off the Gold Standard in order to rehabilitate their economies.

After WW2 the industrial base of the warring European powers was decimated and their Gold reserves squandered on war. The US was the only country which maintained international Gold convertibility for Federal Reserve Notes. Domestic ownership was still illegal. The Breton-Woods system was set up to help finance the rebuilding of Europe. The US Dollar was convertible to Gold, and all other currencies were pegged to the US Dollar. In fact the articles of the IMF explicitly forbid member nations to make their currencies convertible to gold.

Post WW2 war spending in Vietnam, etc led to a dangerously large issuance of US currency in international hands, which if it were redeemed for Gold would certainly have drained US Gold reserves. An attempt by France to do convert large US Dollar holdings into Gold triggered the suspension of Dollar convertibility into Gold internationally by the Nixon administration.

As most other countries already held US Dollars as reserve assets and the US Dollar was the international trade currency it became the de-facto reserve currency in the new floating-currency system. At that time the US still had a huge industrial base and was a major creditor nation. For the rest of the world this is more an accident of history than by design.

The use of the dollar for international trade settlements is the key. It creates a demand for dollars. Nations like oil producers, Japan, Germany and China are forced to accumulate dollar reserves as a mathematical function of their trade surpluses, and not necessarily because they consider it a quality store of value, or believe in the “strong dollar policy” propaganda.

Today the US is still the largest manufacturing country in the world but continues to lose its industrial base due to free-trade with low-cost countries, and competitive currency devaluations. No country wants a strong currency as it makes exports uncompetitive. Governments in particular want inflation because it makes servicing of government debt issued to fund populist spending easier.

This is why Central Banks are never permitted tolerate any deflation – even that caused by productivity increases.  Any country with a sound currency is forced to intervene to cap the exchange rates – as seen recently with Japan and Switzerland. This can be done either by a zero interest rate policy (ZIRP – e.g. Japan, Swiss), sterilizing trade surpluses (China/Japan/OPEC), or if all else fails by buying unlimited amounts of foreign currency to store as reserve (e.g. Swiss buying Euros).

I cannot see what will stop this race to the bottom in the era of big populist government spending and deficits, stimulus programs, international trade imbalances and exponentially increasing debt. If the powers that be coordinate a smooth international inflation savers and cash holder will continue to pay for the increase in nominal values of income producing assets like stocks. This will be accompanied by several alternating bubbles in various stock and commodity markets.

Sovereign and Financial debt worries and the sort of discord we see today in Europe will periodically create panics, but the printing presses will step in to try and and do everthing in their power to prevent a Great Depression style debt-deflation (as we saw in 2008/2009).

By manadating government debt (or other currencies backed by government debt) as reserve assets, the entire monetary system is reduced to a pyramid scheme where savers are fleeced to finance unprecedented government deficits that are used to buy votes and influece by those in power. A large chunk of investible productive capital of the entire world has been dissipated on bread, circuses and wars in this manner.

Piling debt upon even more debt is making the overall system more and more unstable. When the sand pile finally collapses, it will take out the existing international power structures and many national regimes with it.

Hopefully the survivors of this fallout will do better than the current breed running our world. And if they do let us hope that the new reserve asset of choice is the the best reserve currency created by nature that is no one’s liability –  Gold.