14:   Whence the Tsunami of Capital Deluging the World

William Krehm

One of the most unspeakable and unspoken secrets of economics is the creation of money, what it is, how it falls from heaven or spurts up from hell, and how from a scarcity it can change into a plethora. But since much of that subject has been muffled in secrecy, some of the key parts are a tale rarely told, and when told it is so incredible, that the experts in the counting house will not quite believe it.

Thus The Wall Street Journal (3/11, "Huge Flood of Capital to Invest Spurs World-Wide Risk Taking" by Greg Ip and Mark Whitehouse): "It’s a sign of a major global investment phenomenon: There’s an unprecedented wave of capital flowing around the world with all of its owners anxiously searching for a better return. World pension, insurance and mutual funds have $46 trillion at their disposal, up almost a third from 2000. In the same period global central-bank reserves have doubled to $4 trillion, and other gauges of available capital have risen as well. Meanwhile, world central banks have kept short-term interest rates low, even after the Federal Reserve’s latest quarter-point boost. That means investors who put their cash in safe money-market paper can net only a modest margin above inflation."

Let’s take a break here, to ask what is this "inflation" concept that for at least two decades drove the return on money to dizzy heights. Ask economists and 999 out of 1000 will tell you that it is rising prices that are a sure sign that "too much demand is chasing too little supply." But pause to recall that one of the most common blunders in logic is at the bottom of this supposed basic truth – the assumption that because a given statement is true, you can flip it around like a pancake. It ain’t so. And what wins economists Nobel prizes for Economics, will flunk students in a freshman course in logic. Example: If a loaded gun pointed at a man’s temple is fired, that man falls dead. Unquestionably true. Turn it around: If a man falls dead, it means that a loaded gun has been fired at his temple. Not true. But the model of a self-balancing market that rules the world of economic theory and without which few universities will bestow a PhD on an earnest scholar, and still fewer will grant him tenure if by some accident he managed to get on the teaching staff. And note that it is in the interest of money lenders and bankers to argue that inflation is the greatest peril for society and must be repressed by higher interest rates, which happen to be banker’s basic revenue and the battering ram for the conquest of the entire economy.

Likewise: if too many dollars are chasing too few goods, prices will go up. Dead on. Turn it around – as orthodox economists do, and timid doubters don’t dare pursue their doubts to their conclusions – and it is not necessarily true. Prices can go up because our governments have bailed out our deregulated banks from their gambling losses, and to plug the hole that has left in the government budget a Goods and Services Tax has been imposed on consumers, and can be seen on any invoice, as raising prices; or because the population for the past two generations has flocked from the countryside and small towns to million-headed cities that need costly public transport, educational institutions that will train producers and even consumers to familiarize themselves with the use of computers. And a thousand other services that farmers of our grandparent’s lifespan didn’t need or command. No matter how bright the Bill Gates’s of the world may be, they need costly public infrastructures to permit mega-cities to build their mammoth corporations based on new technologies. And these costs create an ever deeper layer of price. That I identified and called the "social lien" almost 35 years ago.

The recognition of this structural, non-inflationary element in our price rise since WWII, would have recognized the new power alliance that took over as a result of the Bank Act of 1935 brought in under Roosevelt, which in essence put the bankers of the US in the doghouse. They were obliged to stick to banking. They were strictly forbidden to take over corporations or functions of the other financial pillars – the stock market, insurance, and mortgages. For these have their own pools of liquid capital to serve their own businesses. Allow the banks access to these and they will use them – as they did before the 1929 crash – as legal tender base to which they can apply the banking multiplier that allows the banking system to create a multiple of this money base in the hope that with the little cash ("lazy money" in their eyes because it earns no interest) they keep they will have enough to meet the claims of depositors for their deposits. That is why the system is known as the "fractional reserve system," because the banks keep in cash only a fraction of what they lend out at interest. The fraction of reserves to the loans supported by it at the end of the war when the 1935 Bank Act in the US was not only in force, but served as a model for most countries in the Western world. Moreover, banks were severely controlled in the interest they could pay for what they borrowed and what they could charge their borrowers. For years the ceiling was 6%. Today the only limit on the interest that can be charged on loans by anyone in Canada is 60% under criminal law. There is no limit under civil law.

The Roosevelt legislation – copied in Canada – also provided two main alternate ways in which the central bank could rein in inflation – mistakenly identified with rise in the price index. It could either raise the benchmark interest set by it, that one bank could charge another for overnight accommodation. Or it could raise the proportion of the deposits taken in by the banks from the public into chequing and other short-term accounts. That lowered the effective banking multiple – the credit that the bank could create by lending out several times as much cash that it actually kept in its vaults or with the central bank. On these "statutory reserves" the central bank paid no interest – that is true for all deposits with the central banks. The central bank was thus able to cool an overheated economy by reducing the amount of credit a bank could lend out on a given backing of "fractional reserves." In essence the banks raised the fraction of the reserves needed to back a given volume of loans, thus reducing the amount of the lending.

Canada’s central bank, the Bank of Canada, opened its doors as a private institution, mimicking both the Bank of England and the Federal Reserve which were privately owned, but it was nationalized in 1938, when its 12,000 shareholders were bought out at a good profit. The result: when the government of Canada, its one shareholder borrows from the central bank, the interest it pays on the loan returns to it, less a minor handling charge, in the form of a dividend cheque. It is thus a near interest-free loan. Much of the WWII costs were financed through the Bank of Canada – against victory bonds that the public subscribed to, borrowing the money from their banks (that like the bond purchaser also had little money – the war broke out after almost a decade of depression). The victory bond was then deposited with the Bank of Canada by the banks until the buyer had paid all the installments due to retrieve the bond that had served as collateral. What interest was paid the BoC until the bond was redeemed, ended up with the Government in the form of a dividend, and that kept the amount of money created by the process to a minimum.

Government borrowing from their own central bank created money by spending it into creation. Private banks when they employ the fraction reserve system lend it into creation. The higher interest rates are, even if it is supposed to stabilize the economy, the greater the profits of the banks and this – all subject to multiplication by the fractional reserve system – creates a plethora of money creation. During the 1970s and 1980s the banks were allowed to breach the principle of the Rooseveltian Bank Act that prevented banks from taking over stock market brokerages, insurance companies, and mortgage lenders – the so-called other "financial pillars." Applying the "fractional reserve system to each of these in turn, the banks were able to compound the loans created. Higher interest rates intended to force prices to remain flat, when not only was the population multiplying by a huge immigration, but natives were moving from the countryside and small towns into huge cities, and created a vast new infrastructure. Far more education was required even for consumers let alone producers in this new mixed economy.

Until 1999 all such capital expenditures of all levels of government were treated as current expenses to be paid off in a single year, so that in year 2 of the existence of say a bridge a new building or a highway would appear on the government books at a token value of $1, while the debt incurred for its construction would appear as a debit. This had an endless stream of consequences of which the plethora of investment money that seems to be flooding the world is only one. Let us trace a few of these. If a building is written off in the year of its completion, then to pay off the debt incurred you would have to raise taxation beyond all rime or reason to prevent the apparent budgetary deficit created by such bad bookkeeping from getting out of hand. So taxes would be raised more than were really necessary. A greater government deficit, is assessed by the bond-rating agencies and their lower rating of government credit drives up the interest it must pay on its borrowing from the general public or even the what it borrows from the private banks. That has nothing to do with too much demand chasing too little supply. There may be tens of thousand workers in the building trade eager to find work, but the higher interest rate will frighten builders from starting new projects – even though there might be a great need for them. The figures at the higher interest rates due to the government’s bad bookkeeping also frighten investors – including the government – away. More unemployment means more call on the government for social services.

But buildings carried on the government balance sheet at a token one dollar are an open invitation to selling them off at a ridiculously low price to private investors, who organize a company to list them on the stock market at their real value, and charge the taxpayers user fees what they have already paid for as taxpayers. Meanwhile the profits made from such bargains add to the amounts of capital seeking further profitable investments, especially of a speculative sort that can pay off in spades for well-connected buyers.

The earnings of such speculative investors exceed ever more vastly the rewards of those contributing to actual production. The problem is to provide a constant supply of such financial opportunities. That is reflected in the increasing number of students drawn to business colleges as compared with those enrolling in engineering or science courses in our universities. Corporations that actually produce something useful have increasingly tended to become the gambling dice of speculative finance. They are bought and sold for capital gains, or for their temporary effect in goosing the market price sufficiently and soon enough to make it possible for high executives in these corporations to convert their stock options into shares before they expire. That can provide the motive for the expansion of firms, their sale or acquisition as much or even more than the actual needs of society or the market.

Money has a peculiar trait. If great profits have been earned in highly speculative ways, those profits are unlikely to be deposited in saving accounts or under a mattress. The owner, led to consider himself a financial genius by his winnings, is likely to seek out the next speculation so that he can continue adding to his fortune and his self-esteem at least at the same impressive rates. So it happens that more and more of our brightest young people will choose financial courses at university, and the sheer bulk of the good fortune already achieved clamours for escalating encores. That increasingly shapes the format of our institutions – dependent as they are on electoral and other contributions to political parties and to our universities.

The only thing that could be more tempting than gambling with your own past winnings providing the prancing steed to ride to further victories is to gamble with other people’s money. For life is short and frail, and immense leverage made possible by docile shareholders offers shortcuts to glory. The is how the art of the derivatives arose. It is a distinguished offspring of the futures markets for such plebeian items as pork bellies or corn. But rather than betting on an entire actually existing security, it gambles on an abstracted feature of that security. Instead of dealing in entire bonds you can swap the changes in the exchange in which a given security is denominated for the exchange of a quite different security. In many instances a cash balance is paid up front to the counterparty, who is tempted to face a future commitment in exchange for some immediate up front payment that he has need of to float another interesting wager. What is notable is that neither party needs to actually own the security to bet on the future of the security in which it is denominated. It is like betting on horse races without owning a horse, or coming to the race track. The principal is the money that will change hand as a result of the horse race, and the exposure has to with money and the reliability that the counterparty to the bet will show up to settle your winnings.

Hedge funds collects large and presumably savvy investors who get together to back a reputedly successful organizer of such investments. Banks for their part run derivative boutiques that actually design derivative operations that will keep the operation off the company books, and thus beyond the knowledge of the tax collectors. Hedge funds used to be a sort of walled reserve of the very rich accessible only to those with at least a hundred million or so dollars to play with, but the lower limit for participants to put up is now a mere million or two. This is one of the few remaining traces of the democratization of our society that is said to come with ever more decontrolled markets – along with the omnipresence of credit cards, of course.

W. Krehm

– from Economic Reform, December 2005