Distributed Economics

Here is a thought experiment. Assume that the money supply is completely constant, there are no loan supply induced fluctuations, the government is behaving itself, and there is simply a fixed quantity of money in the banking system. In a period of steadily rising production, due to technological and social change, what happens to prices?

They go down.

Deflation, to use the technical term, occurs because as more and more things, assets, food, granite kitchen tops, hit the market, there is less and less money available per thing, and the price drops. Or to put it another way, in a world with a constant money supply, if you inflate production, you deflate costs. It doesn’t really have anything to do with the social organisation of production, and it’s  highly debatable if it’s a good or a bad thing in terms of the effect on human behaviour. It’s just  math.

Over the last 20 years, there has been a lot more stuff available, at all levels of society. This is the age of the nail gun. The fully automated factory, and the completely unautomated Indian call centre.  There are more people, producing more things than there have ever been on the face of this planet, so the real question of the age should be, why hasn’t there been massive deflation -  rather than mild inflation, and raging asset inflation.

The simple answer, and the one born out by the central bank statistics is the money supply has been increasing. But that just raises the issue of why? And if we accept the idea that it’s not the central banks, and that is something that is also born out by the statistics, then the question is also who?

Equity capital is at the moment, the only real control on the part of the money supply within the commercial banking sector. To clarify, the chart below shows the difference between the ‘reserve’ of deposits that banks may be required to keep against deposits, and the equity capital that acts as a reserve against loan loss.

Under the Basel treaties, individual banks are required to keep equity capital reserves that are at least 10% of their loans.

Reading the Basel treaties, it’s apparent that their main concern is risk. Basel is all about reducing the risk of any individual bank defaulting, and to achieve that, it mandates equity capital reserve requirements, since it’s the equity capital that gets used when a bank suffers losses to ensure that depositors don’t lose their money. So if the only concern is what happens at individual banks, then it makes sense to  regulate that they have adequate equity capital reserves, and that those reserves are held in safe, secure financial instruments, that also provide the bank with some kind of return to compensate it for the ‘cost’ of maintaining a stack of otherwise useless money. (From the individual bank’s selfish point of view.)

Like mortgage backed securities for example.

41. Loans fully secured by mortgage on occupied residential property have a very low record of loss in most countries. The framework will recognise this by assigning a 50% weight to loans fully secured by mortgage on residential property which is rented or is (or is intended to be) occupied by the borrower.

(Clause 41 of the Basel Capital Accord)

Those were the days. Bet they rewrite that for Basel 3.

In fact, there’s a serious problem with allowing any kind of debt based financial instrument into equity capital, however tempting the associated income stream may be, and that is that as soon as you do, it allows the commercial banks to do the one thing that they’re not supposed to be able to do without central bank involvement – create money.

Consider 2 banks:

Bank A creates a $900 Mortgage Backed Security, and sells $800 of it to the depositor at Bank B for $1000. How much would it really be  worth? I’ve yet to be able to track down how much they sold these things for, but it’s a guaranteed (or at least it was before the loan insurers blew up), financial instrument paying anywhere between 5% and 15% a year for 5-25 years. So $1000 seems like a bit of a bargain. It doesn’t actually matter as long as its more than the underlying loans were made for.

Bank A takes the $100 tranche of the MBS it retained, and uses it to increase its equity capital. It counts it as 50% so it only increases its reserves to $150. It takes the $100 and pays that out as bonuses, which get deposited in its employee’s bank accounts, at its branches. One of the perks of being a bank employee is free banking from your employer, and usually reduced rate loans too.

Assuming the strictest case, i.e. that the deposits at Bank A are being held in net transaction accounts, then Bank A can now lend 90% of its deposits ($990), provided that this doesn’t exceed 10 times its equity capital. The new loan then gets deposited at Bank B.

The end result of all this sleight of loan, is that the total money supply has been increased by $90, and the  total loan supply has been increased by $900 MBS and $90 additional loan capacity in the banking system. This makes for a fairly slow leak as these things go, since it can take months or even years to issue the underlying loans. It’s worth noting that the central bank, who supposedly control the money supply, played  no part at all in any of this. It’s the commercial banking system that is out of control here.

So the money supply is increasing, but this isn’t effecting inflation nearly as much as it should. In fact its masking what would have been some fairly dramatic deflation over the last 20 years due to productivity improvements. Unfortunately however, the total loan supply is increasing much faster.

Which is where the real problem lies.

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