The End of Constraints

As we’ve seen, in pre-fiat currency times the monetary base on which banks built their extended credit superstructure was made up of of gold. Once the credit creation process had first evolved to the point where outstanding loans and deposits were a reasonable multiple of the existing monetary base, further credit and money growth was on quite a tight leash. Gold production did hit occasional purple patches (as during the California gold boom), but more usually it only added to existing reserves by a few percent per year.

The sometimes dramatic ebbs and flows of credit and economic activity during this period were all fluctuations around that relatively fixed point of gold reserves. When, as periodically happens in human affairs, animal spirits ran high, banks would expand credit until the relationship between credit outstanding and the monetary base became too stretched, at which point almost anything could trigger a panic and subsequent retrenchment. For a while, they (and their borrowers) would lick their wounds and the ratio of loans and deposits to reserves and capital would return to more conservative levels. In due course, the cycle would repeat.

When the gold standard was abandoned, this automatic, objective restraint ceased to exist. From that time, the size of the monetary base was entirely at the discretion of the central bank. Each one could produce its currency notes and reserves at will, and at minimal cost.

Faced with one of those periodic booms, central bankers always found themselves in a difficult position. Their job, of course, was to rein in excessive credit growth and optimism while underwriting the banking system and offering both concrete and moral support during downturns. That’s why central banks were created in the first place.

The reality was often different. Central bankers are human too, and no less likely to get caught up in prevailing moods than you or I (consider Greenspan’s embarrassing enthusiasm for the supposed blessings of the new economy). Far too often, therefore, they would accommodate the banking system’s headlong growth by adding reserves, or reducing reserve requirements, or some other palliative, all to avoid having to be the grinch, to rain on society’s parade, to stand apart from their fellows.

It’s easy to be critical (and, Lord knows, central bankers have over the years given us plenty of grounds), but in fairness the whole structure, in terms of human psychology, is fundamentally flawed. Given all-wise and perfectly informed automatons, one can imagine it all working rather well. Right.

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The result really oughtn’t to have been a surprise. Inflation has been a constant and insidious influence, overall prices have multiplied by dozens of times, national currencies have shrunk to a tiny fraction of their starting values, and attitudes toward savings and investment have been profoundly altered.

Along the way, credit (the underlying cause of most of this dislocation) grew relentlessly in relation to GDP (or any other economic measure one cares to choose). The inherent asymmetry of official responses meant that when animal spirits ran strong, they were at best only lightly reined in (and far too often spurred on), while any down periods were quickly met with concerted (or, as now, desperate) efforts to get the credit machinery restarted.

The combination of increasingly relaxed standards in terms of reserves and capital ratios, together with a willingness, where necessary, to add to reserves, made what under the gold standard had been cyclical swings around a fairly stable trend into a one-way, expansionist superhighway. As but one illustration, from December 1983 to December 2008 (in the wake of the financial system deregulation in Australia in the early 1980s) total bank assets there grew from $94.267 billion to $2.675 trillion, a compound annual rate of just over 14.3%.

Given such an extravaganza of credit, is it any wonder asset prices went through the roof? And not only here, of course, but to varying degrees everywhere else where the financial system was allowed, or even encouraged, to run amok in this fashion.

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What did all of this credit actually represent? Was it savings? Recycling loans and deposits in an endless iteration does not, of itself, produce any commensurate growth in resources. Quite to the contrary, in fact, since resources often end up being devoted to activities which are either inherently unproductive, or are otherwise misaligned because of the false and conflicting signals generated by this torrent of credit. Stripped of the often self-serving arcana of the world of finance, wasn’t it more akin in its economic effect to the outright printing of fiat money under an old, primitive, non-credit based financial system?

In less charitable moments, I’ve been struck by the passing resemblance between the workings of a modern, fiat fractional-reserve financial system in full flight, and the almost hallucinogenically wondrous episode of financial madness that took place in Kuwait in the early 1980s. It was called the Souk al-Manakh stock bubble and may well have been the most spectacular bubble of all time.

Believe it or not, at this time traders could “pay” for their share purchases using post-dated checks (apparently, the thought of someone not honouring such a check was unthinkable under local customs). Wikipedia sums up the consequences as follows:

“Share dealings using postdated checks created a huge unregulated expansion of credit. The crash of the unofficial stock market finally came in August 1982, when a dealer presented a postdated check from a young Passport Office employee named Jassim al-Mutawa for payment and it bounced. A house of cards collapsed. By September 1982, the Kuwaiti Ministry of Finance ordered all dubious checks to be turned in for clearance, and shut down the Souk Al-Manakh. The official investigation summed the value of worthless outstanding checks at the equivalent of US$94 billion from about 6,000 investors. Kuwait’s financial sector was badly shaken by the crash, as was the entire economy.

The crash prompted a recession that rippled through society as individual families were disrupted by the investment risks of particular members made on family credit. The debts from the crash left all but one bank in Kuwait technically insolvent, held up only by support from the Central Bank. Only the National Bank of Kuwait, the largest commercial bank, survived the crisis intact. In the end, the government stepped in, devising a complicated set of policies, embodied in the Difficult Credit Facilities Resettlement Program. The implementation of the program was still incomplete in 1990 when the Iraqi invasion changed the entire financial picture.”

Absurd? Undoubtedly. Still, are the underlying economic principles really that different? Their “huge unregulated expansion of credit” was accomplished using post-dated cheques. Ours, a multitude of different kinds of promises to pay. It didn’t in either case represent savings in any meaningful sense, and to the extent it doesn’t, credit is not only valueless, but directly destructive. Prices are distorted, assets progressively shift into weaker and weaker hands, and the structures of consumption and production are misaligned. Resources are scarce, as is the accumulated capital (that is, real wealth) resulting from our efforts and the efforts of those who have gone before; to squander them because a poorly structured financial system is allowed to run amok surely borders on the ludicrous.

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All the embellishments peculiar to our own time, the securitisations, the OTC derivatives, the shadow banking system and so on, together with the belief systems which made them possible, are all vitally important, and deserve careful analysis in their own right. Their greatest importance, however, was that they enabled an already deeply flawed financial system to go into hyperdrive. Our credit boom was unique in its extent, not its kind.

I won’t further examine those embellishments here. The piece is already becoming long enough and there are in any case countless worthy attempts to do so scattered about the internet and elsewhere and more appear each day. Suffice to note they all either distorted risk vs reward incentives and/or further distanced the financial superstructure from the underlying economic reality.

Speaking of which, it’s still a puzzle why so few worried about the extraordinary relative growth of that financial superstructure. At the peak, its earnings in the US made up about 40% of total corporate earnings. How was it that regulators, central bankers (and observers more generally) weren’t deafened by the clamorous ringing of alarm bells? Perhaps the explanation lies in Upton Sinclair’s observation: “It is difficult to get a man to understand something, when his salary depends upon his not understanding it”, but I don’t think that’s the whole story in this case. Perhaps not even much of it. For the most part, I suspect those who should have known better were intellectual captives of the widespread worldview that if the markets were voluntarily doing something, then it was probably just fine.

If nothing else, the fact that such strident alarm bells were not heard, or at least not heeded, suggests some caution might be in order about pinning our hopes on (all too) human regulation.