Distributed Economics

Poke around in the entrails of history, and a surprising number of revolutions, and coup’s of one form or the other of etat, can be attributed at least in part to some form of underlying monetary breakdown. Typically the form of breakdown that involves at its heart,too much debt being issued, for the available supply of peasants to support payment of. It would be nice to think that the very least a communist government, formed by and on behalf of the workers and peasants of its country could achieve, would be to avoid that one.

There are two very strange things about the news out of China these days. One, is that there have been clear signs of a loan induced housing bubble for some time now. The other is the succession of increases the People’s Bank of China has made in the required reserve rate for its banks in order to constrain that bubble. The latest increase on May 10th to 17%, follows a raise to 16.5% in February 2010,  and a set of increases over the last couple of years.

According  to the existing Economic theory of how the banking system works, each one of these should have triggered a large contraction in the available money and loan supplies, given that the removal of money from  the system triggered by the reserve increases – is a multiple of the reserve change.

Despite this, there is in China today a rapidly increasing CPI, and a raging housing bubble, alongside  a steadily increasing reserve ratio. The situation gets even worse, if the  underlying non-monetary economy is considered, which in China is one of steadily increasing production. Since production increases cause deflation, as the existing money supply is used to trade and purchase more things, this suggests money and loan supply expansion, rather than the contraction that should have been triggered by the reserve changes.

All of which suggests something has gone very badly wrong indeed, in the Chinese banking system.

Monetary statistics are available on the People’s Bank of China’s web site for the period since 1999.  They are unfortunately not at the same level of detail as the USA, or indeed Iceland.  In particular since there is no break out of the M series components, it’s not possible to know how much debt instrument contamination is present in these series. There is a format change in 2005, and since the number’s don’t quite match up for the different series, the chart below is just for the last 5 years.

Chinese Money Supply

The data for the entire period, assuming that measurement has been reasonably consistent, shows that M1 has increased by approximately 4x in 10 years, about twice the quantitative  increase in the the Dollar and the Euro over the same period. It would also appear from the chart that the process has begun to accelerate.

The data shown is certainly consistent with reports of a credit fueled housing bubble, originating from uncontrolled lending within the banking sector, triggering asset inflation and commercial bank expansion of the money supply. What is perhaps most remarkable about the chart above, is the complete absence of any affects from the reserve increases that the Chinese central bank has been imposing to try and throttle the system back. It has been steadily ratcheting the reserve rate up for the last 3 years, it’s now at 17%, but there has been no corresponding contraction in the money supply. It’s probably the case that the expansion would have been even greater had they not increased the reserve requirements. But still. If economic theory was correct, what the chart should be showing is a massive contraction in the money supply – since changes in the reserve requirements theoretically  have a 10x multiplier effect on the money and loan supplies – and it’s plainly not.

Given the reports of a housing bubble, increasingly lowered lending standards, and CPI, it sounds like this is probably the Equity Capital exploit cutting loose again. Whether this  is because the banks are abusing inter-bank lending mechanisms as occurred in Iceland, or have just figured out they can stuff some form of debt into their equity capital holdings is very hard to say – there simply isn’t the kind of publicly available data to properly analyze the Chinese banking system. Given the repeated increases in the reserve ratio, it seems highly unlikely that any part of this is deliberate government policy though.

Which points to another aspect of this entire problem. Both the exploits discussed here, the Equity Capital exploit, and the Asset backed security loophole, are outlined for a system with full reserve requirements. De facto, the European and American banking systems don’t use reserve requirements for central bank control any more, and rely on market operations. Those don’t in fact work, but as China is currently demonstrating, neither do the textbook, central bank control mechanisms via the reserve requirements either.

The other interesting implication of this, particularly if the expansion continues to accelerate, is that if the Yuan were to be allowed to free float, it would probably depreciate against the Euro and the dollar, rather than appreciate as is being called for by American and European economists.

& won’t that be fun.

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Over in the land of the rising Volcano,  the first full report on a banking system collapse has just been released.

Interestingly, even with a report that goes into a fair amount of detail on the extraordinarily contrived web of lending and borrowing between a small circle of Icelandic  businessmen, the main Icelandic banks, and their overseas Creditors, there seems to have been relatively little attention paid to the problems in the underlying monetary mechanics that allowed it to happen. In particular, the  approximately ten times expansion in the money supply that accompanied the businessmen’s sleight of loan practices, appears to have been overlooked.

Money supply figures for Iceland are available from the Icelandic Central Bank. The following analysis is based on the “Monetary Aggregate” (Peningamagn og tengdir liðir) spreadsheet which is the only statistical series that appears to have been updated since the collapse in September 2008. It labels figures since Sept 2008 as ‘provisional’.

This series covers M1, M2 and M3 statistics up until 2009. As previously discussed, the M series monetary statistics are not an entirely pure measure of the total amount of money in any given monetary system, as they can include some forms of debt instruments. In the Icelandic case, two adjustments need to be made to get a quantitative estimate purely of Icelandic Krona: the removal of Money market accounts from M3 which eventually amount to about 10%, and also foreign currency accounts which are included as part of M2. Foreign currency savings accounts incidentally, as a percentage of krona denominated M2, vary between 15-43% of total M2 over this period – which suggests there are other potential stability issues, especially for small currencies, lurking in the background connected to the fractional reserve banking system.  Iceland’s banking and currency system has never been a haven of price stability.

The issue illustrated here is both scientifically fascinating, and utterly appalling in its eventual effects. Iceland deregulated its banking system in 2001. Two of the banks, Kaupthing [nee Búnaðarbanki] and Landesbanki, were sold to private businessmen, who in at least one case used money borrowed from one bank, to purchase shares in the other. Now let’s think about that for a moment, in the context of fractional reserve banking. You borrow money from one bank, and use it to buy control in another. How does that borrowed money get treated? If – and it seems to have been the case – that money is put into Equity Capital holdings at the second bank, then the total amount  the second bank  can lend, and thereby increase the overall money supply by, has just increased. As a result of a debt somewhere else in the banking system. It’s a feedback loop entirely within the commercial banking system, increasing the money and debt supply, independent of any control by the central bank.

The statistics are divided into two series, with considerably less detail available from the earlier period. We can see from the first series below, that quantitatively the currency was relatively stable up until 1997 when M3 began to diverge from the other measures. Unfortunately, there is no detail in the first series to suggest exactly why.

The second series is over a shorter time period, slightly over 6 years. Although the most dramatic behaviour of the currency is in 2007-8, what happens before then shouldn’t be overlooked. Between September and October 2003 for example, M1 and M2 double.

Iceland is a very small country, of approximately 300,000 people, which is why these effects are so obvious. M2 as shown here is the total amount of bank deposits in the country, aside from longer term time deposits which are counted as part of M3. Iceland, as elsewhere, stores its currency electronically – physical notes are printed as needed. But the size of the country, and the electronic nature of its storage, doesn’t change the quantitative nature of what happened in September 2003.

Looking rather closely at those two months, it looks like there was approximately an 100,000 M.Kr. increase in bank deposits. At a guess, and that’s all it is, the proximate cause of the increase was probably the first payments by the Icelandic banks of the money being lent for the Icelandic Power Companies then latest venture into Aluminium production, to the tune of  $20 million in locally sourced loans. This at some level just represents how fractional reserve banking works, and if nothing else, demonstrates the dangers of making big loans within a small currency base. In terms of nuts and bolts economics, the production of things, the support of livelihoods, and general improvements in living standards,  the loan certainly made sense, in increasing total electrical power available to the economy. It’s the monetary side effects, inflation as a result of a loan, and then presumably deflation as it’s repaid -  although it seems that’s an increasingly old fashioned concept these days  -  resulting purely from the mechanics of the underlying system where the loans are created, that don’t.

The money supply continues to increase over the next 3 years. It’s masked to some extent by the rather dramatic increases in 2007, but M1 doubles by the end of 2006, M2 increases by about 1.8 times, and M3 by a factor of 1.6. CPI Inflation rises from 2% in 2004, to 8% in 2006, and this causes other problems. Icelandic krona loans are index linked, something that was introduced to deal with a previous bout of severe inflation – in fact, i’d guarantee that historically Iceland got severe inflation anytime their power company decided to expand their electricity supply, and borrowed money to finance it. Fractional reserve banking is far from problem free even when it’s not being deliberately exploited.  The increase in the last decade though, had another cause.  In the background of the Icelandic economy, a small cabal of Icelandic businessmen had effectively turned their businesses, in conjunction with their relationships with the owner’s of the three main Icelandic banks, into what appears to have been a co-ordinated exploit of the Equity Capital loophole.

As a result of this, the Icelandic money supply measures double again in the year between January 2007 and September 2008, when the collapse of Lehman Brothers intervenes, and turns Iceland into, were anyone paying any attention to the actual systemic issues behind the credit crises of the early 21st century, the canary in the goldmine.

Doubling the money supply in slightly over a year, is by any standards extraordinary. As is having it increase by an order of magnitude in  7 years. It’s not Weimar levels of increase, but neither is it something that should just be occurring without any comment. It also makes any and all economic statistics for that period from Iceland highly suspect. Money is used as an economic measurement. If the quantity of money is changing, and this isn’t corrected for, it’s akin to trying to measure with an elastic band.

Quantitative changes in the ratio’s between currencies don’t necessarily play themselves out in immediate adjustments to currency trading, the relationships themselves seem to be quite sticky with sudden, abrupt changes. The Icelandic Krona’s exchange rate was relatively stable up until the crisis hit in 2008 in an 80-100 band. The high interest rates being paid because of central bank attempts to control the monetary expansion acted to attract foreign investment, and damp down the quantitative impacts of the increase.  In Iceland as elsewhere, a lot of the quantitative increase in the money supply is essentially getting trapped within the monetary system, which limits the impact on general inflation. Iceland did experience a severe housing bubble though, and there as elsewhere, the shells of uncompleted luxury condominium projects litter the countryside.  What is clear today, is that anybody holding Icelandic Krona at the 2008 rate of 90 to the Euro, has lost about half of their purchasing power with the current, capital control protected rate of 172.

The total quantity of Icelandic M1 and M2 in circulation over the 2003-2009 period in fact increased by about 10 times. Measurements of M2 can’t be compared exactly between countries, because they aren’t consistently defined, but driven by similar systemic factors, US M2 doubled in roughly the same time frame, and the Euro increases by about 50%. This would counterbalance the Icelandic increase to some extent, and any increased production would also have had a counterbalancing deflationary effect.  While it’s also certainly not the case that all currency is local, neither is all currency available for foreign currency trading.

Although the Icelandic Central Bank has been heavily and rightly criticised for its role in this, it has a  simple defense on the behaviour of the monetary mechanics. It followed the Economics textbook. It raised interest rates, to try and control the money supply expansion being created by a business culture that had devolved to simply making as many loans as possible, and extricating the proceeds abroad. All this achieved though, was to attract more foreign currency into the economy in pursuit of higher interest rates. Enabling increased expansion, and more loans, rather than the careful control and regulation suggested by Economics theory.  The Economics textbook is wrong at a very basic level, but since its false assumptions are so embedded and central to the discussion itself, it seems impossible to break its hold on the debate.

But perhaps we can start with a simple question.  In Economics’ textbooks, control of the money supply is consistently described as being solely the responsibility of the Central Bank, and for very good reason. Changes in the total supply of money effect everybody, double the money supply, halve the value of people’s savings. Weimar was just the extreme case.  So perhaps somebody could ask the Icelandic Central bank if they deliberately increased their money supply by ten times over the last 7 years?

And if they didn’t, who did?

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