Friday 27 November 2009

Ascent or Descent of Money

Murray Rothbard once said, "Historians don't understand economics and economists are useless historians". As an avid reader of history, it's a common issue that I fully appreciate. One historian who is held in high esteem regarding economics is Niall Ferguson. After reading his recent book, 'The Ascent of Money', I beg to disagree. He may be on TV, he may have a fancy academic post, he may in fact be a highly intelligent person, but clever people can be as fallible as any other person. In Contrast with his other works, 'The Pity of War' or 'Empire: How Britain Made the Modern World', his recent book felt rushed, an attempt to cash in on the unfolding economic events at the time of publication. It was after all published a full year after the credit crunch.

Money, Regulation, Gold Standards, Bubbles and Greenspan are typical topics discussed, but in many of the above, confusion is the only common theme. Professor Ferguson tries to piece together various areas without the pre-requisite economic knowledge. The Achilles heel of historians is once again on display for all to see.

Money. The books title has the word. It dramatically begins with a list of aliases, however the book falls woefully short of explaining what money is, what its context is, how important it is. A passing mention regarding our sovereign monopoly of money doesn't connect the dots. If the required homework had been carried out, Ferguson would have realised that this was the key. Why do we live in seemingly free markets but they periodically crash, overproduce, mal-invest? Its our governments incompetence over money that causes this. There is no mention that money originated from the free market to overcome barter, that kings took over money for personal gain, that inflation has always been a common phenomenon under this type of arrangement. This admission sets the pace for the rest of the book - for non-critical minds a satisfying read, for others, frustrating.

Stating 'Anything can serve as money, clay, silver, paper', it is true many things have served as money but it doesn't mean they have lasted throughout the ages. Metals have generally been used as the de-facto monetary standard. On the other hand, paper, has continuously ended in runaway inflation as there is no limit to expand the supply. Unfortunately this part of history is omitted leading Ferguson to the conclusion that its 'different this time', they can suck out the liquidity, but as Winston Churchill would argue 'All fiat money has ended in inflationary disaster'. Gold Standards are rendered as inflexible, inelastic, incompatible to increase the money supply under times of extreme contraction, however only half the story is told. It is the first part, the initial unwarranted monetary expansion during the boom that causes the bust, not the lack of expansion in money after the crisis. Classic examples such as John Law in France, which lead to hyperinflation because he tried to fix the economic bust by printing more money seems to allude our academic friend. Despite coming to the conclusion that it ended in disaster and no good came from printing more money, Ferguson still believes it to be a good idea. As the quote at the top of this blog states, you either keep expanding indefinitely destroying the currency or you take the medicine.

Despite mentioning the recent great economic powers, Germany, United Kingdom, America, Holland did he ask the question what did all of these have in common during their height? Sound Money. The United Kingdom exported sound money around the world, gold, silver or bimetallic standards, to keep a check on government abuse. All the nations listed went into decline as soon as they abandoned these principles. The Bank of Amsterdam abandoned 100% reserves, Britain abandoned its gold standard in the thirties, Nixon's closing of the Gold Window in '71 in which we have since seen a relative decline in Americas Global dominance.

One pressing issue isn't even mentioned, fractional reserve banking. Its one of the most important issues in banking and one of the reasons finance makes a disproportionate income compared with all other sectors of a modern economy. Despite what is conventional told, you don't need fractional reserve banking to run a successful economy. 100% reserve banking, where the banks can not create money out of thin air would not only give greater stability, but would be fairer for all. Savers are rewarded, peoples purchasing power would increase, all sections of society would gain equally from such a system. One of the reasons society is plagued with great income inequality is that when you inflate the currency based on no supply and demand dynamic, this excess liquidity will inevitably end up in assets such as houses, stocks and so forth. The rich in general posses more assets and when they increase in value caused by the monetary expansion their wealth increases disproportionately. For example, if houses went up 100%, then a person with the previously valued £100,000 house would gain £100,000, however the asset rich person with a £1,000,000 would gain £1,000,000 - ten times the gain, or to put it another way a 1000% more! The rich get richer while the poor get poorer. People with no assets have no such luck.

Fractional reserve banking is an immoral system. It allows the banking community to leverage, i.e. create money at will and profit from something that they can create out of thin air. Can you imagine a factory that could make products out of thin air? A civil engineer making invisible bridges and getting paid for them? This is finance, the rules the government lay down. Allowing our banks to inflate the money supply based on governments targeting their inflation metrics. The better the free market does its job, by lowering the cost of goods and services, the greater the rewards for the banking community as expansive monetary policy is the solution for falling prices. Alas this topic isn't even covered in the book.

Bubbles and Regulation are narrated upon, nevertheless critical analysis is lacking. Ferguson outlines bubbles along with expansive monetary policy but the vital connection is not made. Instead human psychology is used to explain the 'irrationality' of markets, the conventional scapegoat. If our money was sound there wouldn't be the excess money to inflate bubbles and prolong their expansion misleading people to mistake these false price signals. The liquidity would not be available to inflate bubbles as other sectors of the economy would require capital. I recently saw Ferguson interviewed after his book in which he remarks that behind bubbles you will almost always find a central banker, from John Law to Alan Greenspan. It's a shame the book misses this point.

Regulation. We need more regulation? We need to set up a regulatory committee to stop people from poking themselves in the eye, or do we? People are rational to the extent that they make informed decisions. When banks get reckless they get reckless based on the premise that they get bailed out. One of the most heavily regulated industries is banking. I work in the computer software sector and from what I know we don't have any regulation. We don't have codes of conduct in how to make software. Good software companies survive using good business processes and sound coding techniques. They don't need some bureaucrat who visits every so often to inspect the software. The market, that is people, decide what is good or bad quality and cost effective. It should be the same with banks. If a bank is unsound it fails like any other business. When banks used to be allowed to go bust, they took pride in their long history. This in turn attracted people to bank with them as they continually survived during economic crisis. All of this occurred with little or no regulation, people came to that decision on their own accord.

Take for example electronics companies who for example make Computers. Should we have a regulation that states a certain quality of hard drive should be used in order to minimise computer failures, or should we allow people to decide if they wish to pay more for a PC with greater reliability. Of course the market drives up quality. When the Japanese companies started destroying the Western electronics giants they did so not from government regulations but because of market forces, people individually making rational decisions based on build quality and innovation. The books passing comments in relation to regulators maintaining financial stability contradicts the recent economic crisis we are living through.

Described as the best historian of his generation, what premise do I a software developer, have to disagree? Was it not the clerk in a patent office who challenged classical Newtonian mechanics and set off a whole generation of physicists who questioned authority and conventional wisdom? Just because a person has an academic post or a prestigious award doesn't mean he has mastered a particular subject matter. Just as Einstein was brilliant, he was as fallible as us all. Later in his life he couldn't accept quantum mechanics and a host of other new theories, stuck in the past he slipped into insignificance despite being one of the most recognised scientist in modern history. In my opinion one of the greatest economists, Ludwig Von Mises, couldn't even get a paid academic post whilst residing in America.

Critical thinking is rarely conventional wisdom, something Professor Ferguson has forgot. His earlier books such as 'Empire: How Britain Changed the Modern World' challenged the conventional viewpoint that the British empire was inherently bad for the world, on the contrary Ferguson argues well that it was beneficial and ahead of its time. 'The Pity of War' argues that the first world war was not inevitable, people were more apprehensive than conventional wisdom makes belief. It wasn't as black and white with the infamous Archduke assassination that set off a series of chain reaction events that is narrated by many historical texts. Britain held the key, indeed she was the prime cause of the war due to unusual diplomatic moves and indecisiveness.

Ferguson states that finance is the key to modern society. Finance is vitally important but its no more important than the doctors, the engineers, the scientists, the factory workers; everyone plays a key role in society enabling living standards to rise. Finance is the heart of the economy, not the brain. It pumps credit around the economy to the sectors that require it, the brain is the scientists, innovators, entrepreneurs and inventors. These people decide how to do things better and how best to satisfy individuals desires.

Whilst reading the book the title always troubled me. Have we witnessed the 'Ascent of Money'? If that were the case would the story of money not read that people first experimented with common objects such as, shells, clay, beads then we moved to using metals. This became cumbersome so we transitioned onto a more convenient medium which behind it lay the backing of a finite metal such as gold or silver. Then people threw away the governments monopoly and allowed the market to choose what money was. Instead we witnessed the first three steps, but have now instead moved to fiat money, backwards in time to the exception, not the rule. History warns us that fiat systems have always self imploded and we are no more wiser than any previous civilisation that tried to manage paper money. The 'Descent of Money' I feel would have been a more fitting title.

Saturday 7 November 2009

Central Banks are changing their Tune

This week the IMF began sales of their Gold reserves. I have mentioned previously that the IMF have been looking to do this, however how wrong was I regarding what may happen to Golds price! Two hundred tons came onto the market and rather than the price possibly dropping, the price instead soared. The Central Bank of India gobbled it all up in a single transaction. Many articles have already been published in relation to the event, and with good reason. The shiny stuff has risen in price for the past decade, despite european central banks selling huge quantities, the most infamous being my countries sale of half our reserves known appropriately as 'Browns Bottom'. The worlds central banks are suddenly looking at Gold from a different viewpoint. The move by India shocked everyone. The next sale could see multiple buyers apply, China, Russia, Brazil and other emerging nations will be feeling anxious - "How do we get out of our paper reserves"? One day there will be a rush for the exits, a dash for the ultimate form of cash. Meanwhile Geithner and Obama parade around the globe, reassuring foreigners of their strong dollar policy, their words contradicting their actions. A sound currency does not exist with zero percent interest rates, deficits as far as the eye can see along with printing more of the stuff. You don't need to be an 'A' grade economist to see the anomaly.

It's important to remember that you can't grow gold. Gold can't be produced in a factory, or planted as a tree. There has always been a finite supply throughout history and when there's no where for investors to turn, they head to safety, historically that has been precious metals. The limited supply can be seen with the recent "Sell your Gold" adverts, dealers buying the public's jewelry, melting it down, and selling it to institutional investors. While the recession continues to force the public to liquidate their hard assets for paper cash, the paper cash investors are diversifying into such assets. One only has to look at the events last autumn, bullion dealers ran out of stock which caused the adverts you now see. Hoarding along with limited ground supply has led the dealers to impell the public to sell.

One thing you have to understand is that China is sitting on 2 Trillion Dollars of paper promises. They currently have around 1,000 tonnes of gold. $2 Trillion could buy them an awful lot more, if they can find willing sellers. The recent IMF sale was $6.7 Billion for two hundred tonnes, I'm sure you can do the maths to see China's buying potential. Compared with nations in the West, many other emerging economies still have woefully imbalanced Gold reserves as the table details (original table taken from following article).



There are many countries who have plenty more cash to convert into Gold, histories ultimate form of payment. Germany, Italy and France hold approximately 70% of their nations reserves in Gold. Compared to China, India and Russia with 1.9%, 6.2% and 4.3% respectively, if I was a betting man I would say the latters percentages will inevitably increase.

For too long the West had a monopoly of talent and capital, corrupt regimes around the world ensured this. Battles between the far left and right in South America, Asia's experiment with Communism, Eastern Europe held back by the Iron Curtain, Middle Eastern states squandering the oil bonanza of the seventies and of course Africa's various despotic rulers. For too long during the 20th Century statism looked like the solution to peoples problems, when in fact it was the cause. Many talented individuals migrated to the West in search of a better life for their families. The collapse of Communism along with the revolution in telecommunications saw to it that many emerging nations began to realise their potential. Why emigrate to the West when they now have the same intellectually challenging jobs at home? Many Western countries still have one trump card - longevity in respect to human rights. No matter how bad my government messes up I always know I will be able to say what I want. I always know that the right path will eventually be trodden. I always know that Britain was the first nation to overthrow a monarchy on the continent during its Civil war, thus beginning the process towards the present inherently stable democratic system that has endured for centuries. The above may not seem much, but its amazing how we can all take this for granted. It won't stop the shift of power from West to East. Gold, it seems, is also moving in the same direction.