My occasional email friend got one into yesterday's FT:
Sir, There is a defect in Martin Wolf’s thoughts on the effects of low interest rates, namely that he does not ask what the optimum rate of interest is (Comment, December 9).
I suggest the optimum is the rate at which the benefit of borrowing for borrowers equals the cost of forgone consumption for lenders. This optimum is only attained where for every borrower who wants to borrow £X for Y years there are lenders who knowingly forgo £X of consumption for Y years.
Unfortunately fractional reserve banking and maturity transformation stymie this optimisation, and bring artificially low rates of interest.
To illustrate, where a bank creates money out of thin air for someone who wants to fund a home extension, that new money forces a reduction in consumption somewhere in the economy (assuming the economy is at capacity). For example, less must be spent on schools, beer, etc.
A “forced reduction in consumption” is not the same as “knowingly forgoing £X of consumption”.
Ralph Musgrave, Durham, UK
I don't think this is the final word on the matter, but it's heading in the right direction - in times of a house price/credit bubble, it is in fact the borrower who is suffering from a forced reduction in consumption, as he's paying twice as much in mortgage repayments as he would otherwise be doing etc.
The vendor who suddenly has a load of money in the bank is not forgoing consumption at all, he is gambling that the future consumption that he can buy with the money is of greater value than the future consumption value of the house. If the vendor happens to be a farmer who's been given planning permission over some fields, well for him it really is money out of thin air.
Wednesday, 15 December 2010
Reader's Letter Of The Day
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35 comments:
Er... banks do not loan money. They create it a zero cost and charge rent for that, nominally called interest.
Neither do they loan capital. And money creators do not lend their capital (buildings, F1 teams, Footy teams, yachts, etc) Interest proper is the return to the use of capital.
So there is no way to determine the optimum rate of interest here.
Is he really asking to determine the optimum rate of rent?
Defining terms is essential as always before you can proceed with certainty. What does he mean by interest?
If we do not define that thing first then all the intellect in the world will just appear as twisted logic.
RS, please read the second half of the letter and my comments below, all will become clear. And we know perfectly well what 'interest' is in this context.
Unfortunately fractional reserve banking and maturity transformation stymie this optimisation, and bring artificially low rates of interest.
Oops, forgot the comment on that - "got it in one".
JH, your comment was perfectly clear.
The gimmick is, FRB is nowhere near as inherently bad as people make out (all it means is that banks can lend out your deposit thus earning interest, most of which is passed back to you, the depositor).
Where is gets poisonous is FRB in conjunction with an asset price bubble, which 9 times out of 10 is a land price bubble.
In theory, you could still have land price bubbles without FRB, i.e. instead of vendors putting their money on deposit, they would have to subscribe as share capital.
But it's the combination of land price bubbles together with FRB (the traditional Home-Owner-Ist way of running/ruining the economy and people's lives) that is toxic.
MW: I wont be doing any further reading until we are all agreed on terms. I don't see that here yet. Apologies.
AC1: I don't believe in FRB being a reality any more than you do. I'm simply asking for all of us to agree on terms before delving into confusing logic. Why would we not want to do that I wonder!!!
Steve Keen, who I do not fully support because he ignores rent, has a good handle on the FRB myth. He is worth a quick read. The money reformers cannot yet answer his evidence which is quite funny. FRB is an effect of money creation, not a cause apparently.
RS: " I wont be doing any further reading until we are all agreed on terms. I don't see that here yet."
We (i.e. everybody who is not you) are all agreed, and we use words in their ordinary or every day meaning, which is sometimes different in different contexts. It's you who says that words mean different things to how everybody else understands them.
Oh, and I'll close your rudeness tag for you, you seem to have forgotten.
*/rudeness*
MW
OK. So please define the meaning of "interest" WE are all supposed to have agreed on? I await with "interest"
Huh! Where was I being rude? Also AC1 was being rude to me (do I care?) in your terms but you did nothing. Rules for one, not the other? Did I hit the spot or something here?
RS, in the context of Ralph's reader's letter* 'interest' means if you borrow e.g. £100 from the bank for one year at 5% interest, after a year you have to repay £105. That is how the bank makes a profit.
* 'Interest' can have other meanings in different contexts, such as "I await with interest".
MW
You just told the world we are all agreed on the meaning of the term interest.
I asked you to clarify what we have agreed on exactly if so.
You respond by telling me something someone else has defined unilaterally.
That's obfuscation isn't it? And is not clarifying what we have apparently agreed on at all. This is not pedantry. It is essential.
So back to my point: unless we are agreed we cannot proceed with certainty in the dialogue until we have.
Evidently we have not yet got to that point, so any discussions will be nonsense.
Circles... going round in? That's not me creating a circular argument.
To make matters worse,I don't follow the original letter.If money is being created out of thin air ,how is consumption going down elsewhere in the economy?Does he mean if the economy is working at full capacity nothing more can be produced so consumption cannot go up? Search me.
BTW the orthodox idea of money being created out of thin air is generally verboten on this site.
DBC, the original letter merely sets off a train of thought. I explained how credit bubbles shift 'consumption opportunities' from buyer/borrower to vendor/depositor.
"the orthodox idea of money being created out of thin air is generally verboten on this site."
?? As Onus Probandy put it, what banks do is to 'split the zero' into a loan and a deposit. In credit bubbles, they are indeed created out of thin air. But you cannot create a positive without creating a negative, it's basic physics.
The bank does not become richer by 'splitting the zero', it becomes richer by charging more interest on the loan that it pays on the deposit etc.
To give you a folksy example, if two blokes have a £1 million bet on the outcome of a sporting event, afterwards, the winner has a bit of paper saying "IOU £1m" signed by the loser (the winner is unlikely to collect in full); and the loser has a corresponding debt (which will drive him into bankruptcy). But taking the two together, they are slightly worse off than they were beforehand. This is what banks like to do.
"it becomes richer by charging more interest on the loan that it pays on the deposit"
That only works if people repay the loans, otherwise it becomes poorer, and poorer until it goes bust.
Now they just get richer because Mr Bernanke stuffs them full of freshly printed dollars.
They probably spent your deposits on yachts, Ferraris and bribes (or tax as they like to call it) ages ago.
SL, the loan generally has some form of collateral. So even if it isn't repaid by the borrower, it can generally be repaid by selling the collateral. Of course this can go wrong if the collateral suffers a capital loss between the loan being agreed and the loan defaulting. But even then the amount of interest paid during the non-default period plus the reduced value of the collateral may leave the bank with a profit. It all depends upon how far through its lifetime the loan defaults.
SL: "Now they just get richer because Mr Bernanke stuffs them full of freshly printed dollars."
Or the IMF, the ECB, HM Treasury etc etc.
D: "the loan generally has some form of collateral"
Ultimately, the only collateral is the borrower's willingness and ability to pay. The value of 'land' (security in 99% of cases) is merely a function of all potential borrowers' willingness and ability to pay to 'own' it.
"As Onus Probandy put it, what banks do is to 'split the zero' into a loan and a deposit."
Ok, so they started with nothing and created a deposit and a loan. The loan goes to the borrower, but where does the "deposit" come from if no-one wants to lend the bank any money?
B: "where does the "deposit" come from if no-one wants to lend the bank any money?"
That's the clever bit! The borrower takes out a mortgage, buys a house, the vendor takes the cheque for the sales proceeds and puts it straight back in the bank!!
The traditional view that banks patiently wait for deposits to accumulate and then make loans is not correct - banks creates loans out of thin air and the deposits follow on from that.
I suppose this is some kind of advance over the old line on this site that banks are middlemen simply taking money from savers and loaning it on to borrowers with the banker as honest broker making money from the different rates of interest charged.
Banks don't just make money out of thin air (ex nihilo) during credit bubbles though and not just to stoke land inflation.Thin air money was supplied to ramp up shares before the 1929 crash .
Robin Smith got it right in one when leading off this exchange and got shot up when angered by the pro-bank rhetoric.
DBC, while it is fair to say that I have always described (derided?) banks as middlemen, it is incorrect to say that I subsribe to the old line that they "take money from savers and lend it to borrowers".
I have never said anything other than "they lend money to borrowers, who spend it, i.e. give it to somebody else, who promptly deposits the 'money' back into the banking system".
This is neither pro- nor anti-bank, I am just saying how it is. I could describe how a bullet kills a human being but that does not mean that I am pro-murder, does it?
PS, the late 1920s share bubble was merely the follow on bubble from a mid-1920s land price bubble. It is just that the latter was air brushed out of history.
As for bubbles, agreed, but it does make my case that the hose of out-of-thin-air money can be connected to any incipient bubble: dot-com shares ; real estate; gold etc that comes along.You are right that the post WW1 land market turmoil has been stricken from the conventional historical record.
As for your protestations that you never said what you did say about the banks as "middlemen": in the spirit of Christmas "Oh yes you did!"
DBC, I refer you to my previous comment. If you can track down a single post where I said otherwise then we can discuss further.
Interestingly, the dot.com bubble was not credit fuelled, the banks weren't that stupid. This was real little old ladies being conned out of their life savings - the interest rate cuts to fuel the noughties land price bubble came after the dot.com bubble had *popped*.
You were supposed to say "Oh No I did n't!"
See MW 23 Nov 2008
"..banks are just middlemen,the don't actually create any new money"
MW Comment on Alice Cook's blog Oct 2008 (Lehman's crash middle of Sept;subsequent G7 action under discussion)"There will always be some people with spare money that they want to invest,there will always be people who need to borrow.The bankers are just middlemen (and serve a useful purpose in this respect,I have no grudge against banks)".
I rest my case.Now lets move to sentencing.
DBC, well done Your Honour, you have me bang to rights, but I've moved on a bit since two years ago.
I plead youthful exuberance and the state of limitations, plus a reduction in sentence for time served.
That's the clever bit! The borrower takes out a mortgage, buys a house, the vendor takes the cheque for the sales proceeds and puts it straight back in the bank!!
Well, usually the vendor spends the money on another house and so on until we get to someone retiring and downsizing in which case some of the money is spent on an annuity, but all along the way little bits are taken out and spent on other things, like solicitors' fees and tax and a new car etc. I really can't see much of the loan being returned as a deposit. Why would anyone want to deposit money in a bank when they get bugger all interest?
Glad to hear that you've "seen the light" in the last two years, MW. Anyone who still holds to the old money multiplier/fractional reserve ideas (or even worse the "if it's not gold it's not real money" view) would be well advised to read Steve Keen's "The Roving Cavaliers of Credit" article for a lesson in how banks really work. It's actually even worse than the FRB critics think! Savers are not only unimportant; they're unnecessary!
Follow that up with a look at Chartalist ideas on what gives fiat money its value -- Wikipedia has a reasonable article -- and you should be pretty well set to understand how modern government tokens (aka money) work in relation to goods, interest, taxes, savings, inflation, deflation, etc., etc.
B, we've done this before. The vendor withdraws the money and gives it to shopkeeper who puts the money in the bank. Then shopkeeper withdraws the money and gives it to employee. The total amount of money in the bank is the same, the mortgage of the purchaser is the same.
Then maybe employee takes some of that money and repays his mortgage, in which case the positive and the negative collapse into non-existence again etc.
D, Chartalists are maybe half right. There is in fact no need for government deficit spending, and there are plenty of perfectly well run economies to prove it.
What??!!I can't believe this.After literally years of argument you have turned round and changed your mind??!! I feel a bit at a loss like Dennis Weaver at the end of Duel after the tanker's gone over the cliff.
DBC, I looked at all this banking stuff in more depth a couple of years ago and came to the conclusion that loans create deposits rather than the other way round. Big deal. Quite when my epiphanal moment was is by the by. That's not exactly 'changing my mind', it's 'going along with what everybody else says until you realise they are talking bollocks'.
Had you asked me six years ago what I thought of LVT I would have stared at you blankly.
I agree that the Chartalists are maybe half right. But some of their ideas are excellent. Such as the theory that fiat money's value lies in its ability to pay the taxes of the issuing government. And even with the ideas that aren't so hot, such as the idea that the government can control the value of fiat money via deficit spending, it's good mental exercise to work out why it won't work (Hint: it's to do with the banks).
D: "even with the ideas that aren't so hot... it's good mental exercise to work out why it won't work."
Which brings us neatly back to the reader's letter in question!
So it does! As to the reader's letter, Mr Musgrave made a very good point. I hadn't thought of bank creation of money as "forced reduction in consumption” for everyone other than the borrower before but he's absolutely right.
Your point about the vendor is also true but only after the sale has been made.
D: "Your point about the vendor is also true but only after the sale has been made."
There is a gap of a few seconds or minutes between Bank A handing over the money to purchaser's solicitor; the purchaser's solicitor handing it over to vendor's solicitor; and the vendor's solicitor paying it back into Bank B, but hey.
UK banks are effectively a closed system, so it doesn't really matter - in olden times, the gap may have been hours or days, it still worked in exactly the same way.
Before we have any more shocks : you do still believe that QE is" a paper -shuffling exercise..not in itself printing money "MW 4 Feb 2010.There have to be some constants in a changing world.
DBC, I am an old fashioned bookkkeeping kind of guy, yes, QE is pure paper shuffling as I have explained dozens of times.
When the govt runs deficits, that is 'printing money', not when it swaps longer terms liabilities ("gilts" A) for short term liabilities ("commercial bank deposits at Bank of England" B).
QE is tantamount to commercial banks surrendering a £5 note to the Bank of England and being issued with 501 pence in coins by the Royal Mint. (so yes, there is a small profit margin for the banks). Seeing as neither notes nor coins have inherent value, and they come out of and go straight back into the banks' vaults, this has barely any effect on the outside world outside the closed loop of the banking system.
Seeing as the amount of A sold = increase in B, I think we need look no further than that.
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