Gavekal: When money becomes vouchers
The very essence of money is changing before our eyes in the euro area, and to a lesser extent in the United States.
I’m not smart enough to understand the full implications of this transformation, but I’m sure it will be important, and now is the time to prepare.
To make my point, I will first describe the monetary system that has operated in Europe for at least 200 years. Simply put, it was based on a bottom-up credit creation process. Next, I will describe the new monetary system, which is based on a top-down process of creating money and credit.
In the past, money creation started with a request for credit by an economic agent, usually an individual, a company or a public body. In the case of an individual, it would offer assets as security for an advance; a business can indicate the profits it expected to derive from a given investment to justify the loan; a public body would offer its capacity to tax the population.
This economic “agent” then went to a bank, or a consortium of banks, to raise funds, which revealed new money – or a loan – in his account. So, at the start of this money creation process, there was always a demand from an economic agent to get money from a lender against a promise to repay in the future. This led to the concept of money having a time value.
From there, the banking system kicked in. The loan made by one bank appeared as a deposit in another bank, which then lent this new money, and so on. The limit of this fractional reserve system resided in banks’ own funds since the reserve requirement applied to each loan by the system regulator stopped the growth of the money supply ad infinitum.
Once the limit of 100% of the adjusted capital of all banks was reached, the growth of the money supply naturally stopped. The closer we got to that limit, the larger the spread between the interest rates on risky loans and three-month government bonds. Indeed, a widening of this gap was a sure sign that the business cycle was maturing. The system therefore had built-in credit quality control to complement the work performed by commercial bankers.
Walter Bagehot, and all that
The return offered by risk-free assets (the interest rate on government bonds) was dictated by the central bank, which also oversaw commercial banks to maintain liquidity in the loan market.
Among other things, the central bank had to verify that commercial banks did not all lend to the same sectors and companies. If a bank had to face a liquidity problem to refinance its loans, the convention was for the central bank to offer financing, but at a penalty rate.
Regarding the anchor interest rate, no credit risk and no time risk, the role of the central bank was to set the rate at which the government would borrow for the next three months. Historically, there have been two schools of thought about where this rate should be set by the central bank:
- It should be close to the marginal return on invested capital (ROIC) earned by companies. This means that borrowers must achieve a ROIC high enough to service their debt, a discipline that tends to ensure financial stability. In this scenario, the central bank tries to set short rates at a level where saving equals investment. This is what happened in the United States from 1980 to 2000 – “the great moderation” – and in Germany from 1970 to 2000.
- It must be defined below the ROIC. The result is a lot of financial engineering, because if the marginal ROIC is 4% and short rates are 0%, it pays to borrow and buy assets that earn 3%, 2%, or even 1%. . In this case, the activity focuses on existing assets rather than new investments. As a result, economic growth declines and the end of the game is a financial crisis which, of course, forces the central bank to cut interest rates even further. We have seen this in the United States in the 1970s, and in the United States and the euro area since 2000. The risk is that such a cycle ends in what Irving Fisher called debt deflation. .
To summarize the old system:
- A bottom-up process that saw an economic agent apply for a loan, thus making the demand-induced increase in money supply
- The loan was intermediated by a competitive banking system
- The cost of borrowing reflected the assessment of the project by the lender, and therefore the premium charged against a risk-free rate
- The risk-free rate was set by a central bank who understood that setting it near the marginal ROIC made financial engineering more difficult
- The role of the central bank was to be both a regulator (setting reserve requirements, etc.) and an auditor of the commercial banking system to avoid bad capital allocations occurring in the event of a panic.
In terms of asking for loans or asking for money, it was a market-based system; the price of that money was set by a combination of the private and public sectors, with regulatory functions typically performed by a country’s central bank.
So why has this system stopped working in the euro area and is it likely to do so in the United States?
- In the euro area, the risk resulting from the passage of time cannot be mitigated by using the financial markets because nominal interest rates are negative – a logical nonsense which implies that the future is more certain than the present.
- By applying negative nominal rates, the European Central Bank (ECB) has become the system-wide time risk reinsurer.
- The ECB also appears determined to be the sole reinsurer of all country and credit risks. As a result, the interest charged by a lender has no relation to the fundamentals of a particular borrower.
- Governments are now financed by deposits in commercial banks in the euro area, with institutions being forced to buy sovereign bonds. These instruments are effectively subsidized by the ECB, which allows banks to generate profits.
- National governments that are funded by the banks that buy their bonds now lend directly to the private sector, even though companies have not requested it. Therefore, proper due diligence is no longer performed on many loans.
- Another “innovation” is that the shared debt is issued by the European Commission, with the revenues going to national and regional governments.
If this analysis is even partly correct, it means that the creation of credit in the euro zone is now a top-down affair, with the currency no longer being issued according to the “bottom-up” demands of individual entities.
The starting point is that funding must first meet the needs of governments, ensuring that the money always flows down. This means that a majority of the loans will not be reimbursed by the underlying investment but by taxes levied, ultimately, on all or part of the populations who have benefited from the investment.
The old monetary system was based on money created by the private sector through loans, the ultimate repayment of which would guarantee the withdrawal of that money.
It was then, because the new system involves the issuance of “spending vouchers” which are distributed to the population according to political criteria.
Unlike the old currency, these coupons will never be withdrawn, and I suspect their number will increase exponentially over time, as the assignats did during the French Revolution of 1789.
In the old system, money was created by the private sector for the private sector, and those who could not service the debt disappeared through the process of creative destruction, their assets being handed over to new risk takers. . Therefore, at the heart of the process was a risk taker who could lose everything.
In the new system, growth comes from spending created by the treasury of the merged central bank Leviathan, which allows governments to distribute spending coupons that will never be reimbursed and do not meet the criteria of being a unit of account or a store of value, as no assessment can be made on time or credit risks.
So, at the base of the capitalist system, we now have governments spending money that they don’t really have on people who haven’t asked for it.
Milton Friedman once said that when it comes to spending money, there are only four possibilities:
- You spend the money you have earned, and it is usually well spent;
- You are spending the money you have earned on someone else. The results can be surprising;
- Someone else who made the money spends it on you. The disappointing results are visible most Christmas mornings;
- Someone who hasn’t earned the money spends it on someone they don’t know. The results are always horrible.
It seems to me that the first monetary system falls under the first point and the new monetary system falls under the last.
We’ll see the final results, but I’ll admit a sense of apprehension.
This piece was originally published by Gavekal and is republished with permission.
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