On June 4, the European Central Bank lowered its overnight deposit rate to -0.1 percent. That’s right, banks depositing their money with the ECB would have to pay for the privilege. The rationale given was a concern at Europe’s “ultra-low inflation rate” of 0.5 percent and a fear of deflation. Similar arguments have been used for several years to justify the massive bond purchases undertaken by the U.S. Federal Reserve and Bank of England.
In “Paper Money Collapse”,1 Detlev Schlichter argues convincingly that these monetary shenanigans are a predictable consequence of the system of fiat monies that since the end of the gold standard in 1971 has become ubiquitous. He describes how governments have used their fiat power to increase the amount of money in circulation, causing distortions to the economic system of which inflation “is not the only and probably not the most sinister.
Schlichter, an economist who worked for nearly 20 years in international finance, begins with a remarkably impartial description of conventional monetary theory, which might be summarized as follows: Well-managed fiat currencies promote stability and economic growth, reducing problems, such as those associated with “sticky prices,” by creating an environment of predictable, low inflation, and ensuring that markets have sufficient liquidity during times of (irrational) credit crunches.
He then launches a no-holds-barred attack on this theory, asserting that “Today’s mainstream view on money is logically incoherent because it is in fundamental conflict with essential aspects of money and money’s role in a market economy.” He goes on to show how, contrary to conventional wisdom, “elastic money” (his term for fiat money, the supply of which is variable) is more unstable than inelastic money (i.e. money that is in fixed supply).
Schlichter draws on insights from the Austrian School of economics, especially the business cycle theory developed by Ludwig von Mises. In this theory, the expansion of the money base initially generates a boom but also results in dislocations of resources. The accumulation of these dislocations eventually necessitates a correction, usually manifesting in a recession – although more dramatic outcomes are possible.
In elaborating this theory, Schlichter contrasts the allegedly benign effects of a hypothetical modest monetary expansion, in which the money base magically and transparently increases without requiring any transmission mechanism, with the reality of actual monetary interventions, which are inherently distortionary, since money can only be transmitted into the economy by certain routes that inevitably create winners and losers. Of a money injection through credit markets, he notes:
“There is an indisputable element of deception involved. Savings have not increased and preferences have not changed, but market signals have become distorted in a way that makes economic agents believe that these changes have indeed occurred. Equally, this process involves a decidedly uneven distribution of the new money. Both effects combine to distort decision makers and to have them engage in processes that have no support from underlying consumer preferences.”
He then goes on to describe how the artificial and distorting money injection forces a shift in consumption patterns, which leads to some consumer preferences being unmet, which raises consumers’ time preference, which translates into higher interest rates, all of which begin “to derail the very process that the money injection had set in motion.”
Schlichter emphasizes that his analysis is largely theoretical – and he is dismissive of accounts of the monetary system that overemphasize description without a sound theoretical base. However, he does offer the U.S. housing boom as one example of the inevitably distortionary ways in which money is actually fed into the economy.
He makes a plausible case that this boom was largely driven by easy money supplied by the Federal Reserve and that when the flow of this easy money stopped, the bubble burst. Some readers will no doubt quibble that there were other factors at play in driving the boom, such as the securitization of over a trillion dollars in sub-prime and Alt A mortgages by Government Sponsored Entities (Fannie Mae, Freddie Mac, Ginnie Mae, et al.), as well as regulatory arbitrage. But Schlichter argues persuasively that the GSEs and other elements of government housing policy served to ensure that the Fed’s funds ended up “channeling considerable resources into non-productive domestic real estate.” The fact that the boom ended swiftly when the Fed raised interest rates suggests that but for the Fed’s cheap money, the boom and bust have been much less severe.
Sadly, the U.S. government’s response to the crisis has in no small part been specifically targeted at re-inflating the housing bubble. For six years, the Federal Reserve has been buying mortgage backed securities and currently holds $1.65 trillion of such paper. Total mortgage debt in the U.S. is currently around $13.5 trillion (up from $6 trillion in 2000 and about $3.5 trillion in 1990), which means that the Fed holds over 10 percent of all U.S. mortgage debt.
Schlichter acknowledges that there have been many criticisms of Austrian business cycle theory (and he singles out one paper in particular by Gordon Tullock). But Schlichter takes this criticism as a point of departure to extend Austrian business cycle theory, which was developed in the context of a gold standard (a form of essentially inelastic money).
In particular, he argues contra some economists and politicians, who have claimed that through a continuous expansion of the money supply it is possible to overcome the business cycle. (Remember Gordon Brown’s speech announcing the end of boom and bust – in 2008?) He observes that “a policy of constant and unlimited monetary expansion, of avoiding, or at any rate shortening, all recessionary corrections and periodic liquidations by the market, must lead to a growing deformation of the economy, to an ever more destabilizing accumulation of imbalances.”
As to the “risk” of deflation, Schlichter notes: “In an economy with an unchanged money supply but rising productivity, meaning a growing supply of goods and services, prices will on trend decline. This is called secular deflation.” As a result, merely holding money generates a return: “An unchanged quantity of money buys more things next year than this year.” Schlichter contrasts this with today’s elastic money, “in which central banks usually aim for a steady depreciation.”
In a world of inelastic money with secular deflation, non-lending (pure depository) banks – if they existed – would likely charge customers for holding their money (essentially a security charge), in which case depositors would effectively face a negative interest rate. But in a world in which money is elastic and all banks lend out money against deposits, a negative interest rate makes no sense.
In practice, however, and in contrast with some proponents of “100 percent backed” currency (and to a degree in contrast with the first edition of “Paper Money Collapse”), Schlichter suggests that even in a world of inelastic money and pure free markets, banks would likely operate with fractional reserves. In support of this proposition, he offers a schematic description of how the original system of fractional reserve banking might have emerged from gold traders initially issuing credit notes gradually transitioning to deposit-taking entities issuing transferable claim notes with interest. And he suggests that under pure free market conditions, fractional reserve banking would likely be dominant and such banks would identify the optimal reserve ratio (i.e the ratio that would maximize returns while avoiding costly bank runs). But he observes that for the past 300 years there has not been a genuine free market in money. Schlichter then outlines what such a free market would look like:
“If banking were entirely ‘free,’ meaning ‘capitalist’ in the true sense of the word; if banks were not protected and regulated by the state; if they did not enjoy the privilege of a ‘lender of last’ resort and, in particular, if that ‘lender of last resort’ could not provide unlimited new reserves to the banks; if individual banks were under full risk of default just as any other true capitalist enterprise; and if the public knew this and acted accordingly, banking would be more limited and most certainly safer.”
Schlichter is, perhaps unsurprisingly, a big fan of bitcoin, at least in principle, since it is by definition an inelastic currency. But bitcoin alone is not the solution to today’s monetary and banking woes. Schlichter points out that governments everywhere are: clamping down on payment mechanisms such as Bitcoin that circumvent monitoring by the state, implementing inflationary monetary policies (in part to monetize the massive government debts created due to enormous fiscal interventions), and imposing capital controls. These policies go in precisely the opposite direction to that which would be necessary to create Schlichter’s envisaged free market.
While governments no doubt have political reasons for favoring expansionary policies, they are also often responsive to vested interests, such as the bankers whose bonuses are vastly inflated by the socialization of risk through government guarantees. Schlichter adds a twist to this, arguing persuasively that the current system of elastic money continues to exist in part because of the arguments made in favor of it by self-interest of economists who “work in sectors that owe their size and importance if not their very existence to the fiat money system and its extensive bureaucracies, like the numerous central banks, the International Monetary Fund, the Bank for International Settlements, the World Bank, and the wider financial industry.” His book thus serves in part as a plea to other economists to reconsider their world view. Schlichter reserves particular scorn for a paper by two IMF economists, Jaromir Benes and Michael Kumhof, who he accuses of rewriting monetary history by blaming the private sector “for all of the monetary disasters in history” in order to advocate the full nationalization of money production and elimination of all debt on bank balance sheets.
As of June 11, 2014, the U.S. Fed held just over $4 trillion in assets, up from about $500 billion in 2008, and the Bank of England held £400 billion. The economist Herbert Stein observed that “if a thing cannot go on forever, it will stop.” That clearly applies to the current monetary expansion. The only questions are: when and how. Schlichter defers to von Mises:
“There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”
1 *Paper Money Collapse: The Folly of Elastic Money, Second Edition, by Detlev Schlichter, Hoboken, NJ: John Wiley and Sons, Inc. The second edition was released on July 28.