Insurance you can’t use

At the moment I am reading a book called “Gold – The once and future Money“. Published in 2007 it is written by Nathan Lewis. Given that Nathan is a long standing advocate of the gold standard and given that he eminates from the same economic school of thought as me (supply-side) he is preaching to the choir in many ways. Yet the book is still surprising to me. More than just another tomb about the superior nature of the gold standard and free market money the book is more an account of monetary history and the numereous times since antiquity that we have used floating currencies (soft currencies) and redemable currencies (hard currencies), central banks and other monetary tools of trade. Thus far I have encountered a lot of history about liquidity crisis and solvency crisis back to antiquity. For instance it has an interesting account of a Roman liquidity crisis the year Jesus Christ was executed as well as the mechanism by which it was resolved. It contains a wealth of other examples through history with an account of how the problems were ultimately resolved in each instance (sometimes neatly, sometimes quite poorly). I had naively believed that central banking had been invented in the last couple of centuries but examples can be found thousands of years ago. The book is in many ways a book about statesmanship as it applies to monetary affairs and well worth the read.

One of the points that the book brings home, and which is very relevant in the current global financial context is the difference between a bank solvency crisis and a bank liquidity crisis. The former can cause the latter but the two are quite distinct problems and the remedy is quite different. What the world is witnessing at the moment is primarily a solvency crisis in part of the banking sector and liquidity issues are a secondary effects driven by uncertainty. The remedy for a solvency crisis is bankruptcy. Nationalisation of the insolvent banks can be a workable proxy for normal bankruptcy processes however nationalisation cuts against my libertarian instincts (I worry that unlike bankruptcy proceedings government nationalisation will lead to governments holding onto the banks at the end of the process). Understanding the solution to a liquidity crisis entails a little more work and I don’t care to use up too much space on the details here.  

However on the issue of liquidity crisis the book makes a good point via an anecdote from history that I thought worthy of sharing. For a long time US law has mandated that banks hold reserves of a prescribed amount. Currently the amount is 10% of demand deposits. Prudence would dictate that banks hold reserves as a form of insurance against a liquidity crisis even in the absence of any law but the law has a strange effect. The law creates a form of insurance that can’t be readily used. In the event of a liquidity crisis banks can’t reduce their reserve below the legislated level. At the precise time when solvent banks need to fascilitate a transfer of short term credit (from the insolvent to the solvent) the legal system effectively bars them from doing so. In attempting to guard against the bad times the law prevents the flexibility needed to deal with the bad times. One example given in the book is a liquidity crisis in the USA in 1907. The crisis was averted because J.P.Morgan used his personal influence amoungst bankers (some might call this cartel behaviour) to collectively break the law and reduce their reserves.  Reserve ratio laws are like insisting that everybody has a basement full of food for the difficult times, and yet it insists that you never eat the food, even in bad times. It is in effect insurance that you can’t use.

In Australia we don’t have reserve requirements proscribed by law. Yet.

35 thoughts on “Insurance you can’t use

  1. I wouls say the two most important things for financial market stability are:

    1. Flexibility, and

    2. The depth of the market.

    That’s basically why Australia is relatively trouble free and J P Morgan could do what he did.

    The lesson of the story is that the biggest, most unregulated market is the most stable. This isn’t just libertarian mantra. Ask yourself: how do capital controls and reducing lines of credit help anyone?

    Essentially, allowing banks to tap reserves in a crisis is a market alternative to printing more money.

    As for books, you might want to chase this up – I’ve been after it for a while:

    History of Interest Rates, 2000 BC to the Present, by Sidney Homer

  2. Good story TP. I thought about the solution before I got to the Morgan story. After all, who will sensibly complain about the use of reserves. The law would lead to an absurd result and so would not be interpreted in that way. It used to be called the golden rule of statutory interpretation, don’t know what they call it in law school now. Anyway, the law is presumed to not be an ass.

  3. The analysis is all wrong. Because there are no solvent banks with reserves under 10%. And there is no chance of these guys lending money to the other banks under those conditions even if they were allowed to. This fellow is dreaming.

    The JP Morgan agreement wasn’t that solvent banks with low reserves would bail out insolvent banks with low reserves. It was rather that they return to some level of minimal mutual lending and build their reserves very slowly while foisting the recession onto the public.

  4. Surely the law makers didn’t overlook this gigantic flaw in the theory of having a mandated reserve. I would expect that there are some well defined contexts under which banks are allowed – even expected – to dip into their reserves.

    It should be plainly obvious to anyone who’s thought about it for more than two minutes, especially those charged with making laws on the issue, that without such a trigger built in, the legislation is less than useless.

  5. It gold, it’s shines and you dig it out of the round, but it is not magic.

    Gold is an acceptable storage of wealth ( though it is behaving more and more like any other commodity). As a means of payment it long ago lost it’s value, there is just not enough of it.

  6. Charles – I have never advocated gold as a primary medium of payment. As you say there is not enough of it. However this is irrelevant in deciding if a gold standard is a good idea or not. A gold standard entails using gold as the national unit of account, not as a day to day medium of exchange. I advocate an elastic money supply with the value fixed to gold. As the Bank of England demonstrated in the 1800s it takes bugg3r all gold to do that.

  7. But Fleeced. They aren’t going to stop digging it out of the ground merely on account of it not being used for money?

    The same gold pretty-much is going to be dug out right?

  8. TerjeP

    If money can be converted into gold then the money supply is limited to the amount of gold required to meet the needs of all concurrent chickens.

    I would have thought that cleaning up the current mess would have made it clear why a limit on the money supply is not a good idea.

    On the one hand we have private investors scared of their own shadows, as a result we pretty much have the government sector doing all the lending. We currently have two lots of money out, a bunch being horded ( or more correctly invested in treasuries) and the stuff the government is lending to keep the real economy up and running.

    The fact that the private sector has funked really isn’t a long term issue, they are hording something the government can create and destroy as it sees fit.

    If the money supply was limited by a gold standard the scared capitalists could horde all the money convert it to gold and really screw things up.

    Gold is now a commodity; it has no magic properties.

  9. “If the money supply was limited by a gold standard the scared capitalists could horde all the money convert it to gold and really screw things up.”

    Now, that happened in _ _ _ _ when the gold standard was widely used?

  10. Depression 1930 ( the countries that abandoned the gold standard recovered first, part of the problem was England deflating to try and recover the gold standard).

    The US government ( never one to worry to much about rights) passed a law making it illegal to horde gold.

    Panic of 1893

    The lack of gold standard is why I believe the current mess will be recovered from quickly. Only a complete fool would want a repeat of the depression, a repeat of the misery created by the slavish belief in limiting money supply to the luck one has in digging up a piece of yellow metal.

  11. A gold standard only works if economic activity involving gold (supply and demand for industrial uses) mirrors the economic activity in the rest of the economy. This may hold for some economies, but it means that a gold standard is not universally applicable.

  12. Oh, and the more leverage you have, the worse the distortion. It might work if you hold most of the gold that is dug up in a vault – but is that necessarily an efficient idea?

  13. Charles – what is happening at the moment in the world is primarily a bank solvency crisis not a liquidity problem. There is a good case to be made that the solvency crisis was primed by too much liquidity in the first place and a distortion in the price of credit, and hence risk.

    A gold standard does not limit the amount of capital that can be lent. It merely stands as a safeguard against devaluation. A liquidity crisis is primarily a shortage of short term working capital. In other words a shortage of lenders.

    Under Brenton Woods there was a gold standard and a lender of last resort. There was never once a liquidy crisis. Likewise in the period when Britain was on the gold standard and the Bank of England stood as the lender of last resort and did the job of lender of last resort.

    Devaluation does not solve a liquidity crisis. It merely cheats one class of person (lenders) to satisfy another (borrowers). It creates the illusion of liquidity and nothing more. It is a bit like suggesting that you can solve a blackout by turning the lights off.

  14. It would be very politically difficult to go onto a gold standard in the current world environment. However that is what ultimatly needs to happen if we are to return to sanity. Otherwise capitalism will be forever plagued with accusations that it is an unstable system.

  15. TerjeP

    No gold doesn’t limit the amount of capital that can be lent, however having a gold standard does limit the options available when hoarding overtakes lending.

    And if there was never a liquidity crises under Brenton Woods why did Brenton Wood come to an end?

    Capitalism is unstable and was unstable when the gold standard was in place. Are you under some illusion that 1930 and 1893 didn’t happen? And like it or not the gold standard had to be abandoned to get out of the 1930 depression.

    On the flip side, a lot of things get built when the party is on, this is the cost of capitalism, I think it is a small cost to pay, but them I set myself up for the failure. 2007 looked to much like 1929 for my liking, and no I didn’t buy gold, I held resources in cash. Haven’t you noticed, the value of cash rises because the cost of asset falls, and you want to talk about gold, like every other commodity it’s price has fallen as demand has fallen.

    The reason I have confidence that this round will end shortly and not plunge us into a depression is the complete lack of any artificial constraint on the money supply.

    Hoarding will effect the dynamics of the system but it will not destroy it. Adding liquidity to the system does not devalue the currency, competent central banks are adding liquidity to the system in a manner that allows it to be removed when the hoarders get over themselves. Central bankers are trying to stabilize the system they are not trying to take it over.

    Hoarders don’t chase goods and services so the currency is not being devalued, bet you inflation is down in 2009. As to the relative exchange rate, why in the short term is the US dollar so strong?

    As there is no gold standard the hoarders are buying government paper, well more correctly entries in a central banks database record.

    It is the lack of a gold standard that allows the central banks to do this, the hoarders have nothing more than a entry on a hard drive somewhere, the central banks don’t even need to ramp up the printing presses to sort out the mess.

  16. Brenton Woods ended because the US leadership believed inflation would cause an economic boom. They failed.

    A liquidity crisis is a lack of cash not a lack of gold. It is when banks (or governments under a fiat system) are not providing as much cash as people need.

    A solvency crisis is when people don’t think their bank (or government) will be able or willing to honour their commitments. That is when they come knocking and asking for gold.

  17. “The lack of gold standard is why I believe the current mess will be recovered from quickly. Only a complete fool would want a repeat of the depression, a repeat of the misery created by the slavish belief in limiting money supply to the luck one has in digging up a piece of yellow metal.”

    Only a complete and utter idiot would believe this nonsense you are spruiking, charles.

    Is this where you are learning economics from?

    “Let’s look at Stiglitzian prescriptions for helping a distressed emerging market debtor, the ideas you put forth as superior to existing practice. Governments typically come to the IMF for financial assistance when they are having trouble finding buyers for their debt and when the value of their money is falling. The Stiglitzian prescription is to raise the profile of fiscal deficits, that is, to issue more debt and to print more money. You seem to believe that if a distressed government issues more currency, its citizens will suddenly think it more valuable. You seem to believe that when investors are no longer willing to hold a government’s debt, all that needs to be done is to increase the supply and it will sell like hot cakes. We at the IMF—no, make that we on the Planet Earth—have considerable experience suggesting otherwise. We earthlings have found that when a country in fiscal distress tries to escape by printing more money, inflation rises, often uncontrollably. Uncontrolled inflation strangles growth, hurting the entire populace but, especially the indigent. The laws of economics may be different in your part of the gamma quadrant, but around here we find that when an almost bankrupt government fails to credibly constrain the time profile of its fiscal deficits, things generally get worse instead of better.”

  18. You seem to miss one small point Mark, the key is to put money in, in a manner that allows you to take money out. That is why central banks lend, and it happens to be what central banks are doing. Perhaps you should try and understand the why behind what they are doing instead of trying to sell the failed solutions of past centuries.

    Inflation only occurs when the money starts chasing goods and services, and yes before the market collapsed that was what was happening. The biggest risk at the moment is deflation, haven’t you noticed the price of all commodities including your magic metal gold is falling. It’s not goods and services that the hot money is chasing at the moment, today’s target is safe havens, and gold is not one of them.

    Anyone silly enough to put money into gold in 2007 has lost about 30%, they have to take the loss if they want to take advantage of the bargains being offered in 2008. The bargains are brought with cash.

    I know it very hard to come to grips with dynamic systems, you seem bright, try it.

  19. TerjeP

    Brenton Woods failed when France and England asked for payment in gold and Nixon ended the charade. In other words they where not willing to shrink the money supply. While modern economies exist the gold standard will not return.

  20. Piffle. Modern economies are much the same as ancient economies except they are not in the past.

    And so what if gold is falling at the moment. What do recent gold investments that may or may not be loosing money have to do with a gold standard? I suspect that you simply have no clue what you are talking about. Your criticism is of what you imagine a gold standard to be and not what a gold standard actually is.

  21. If you say so TerjeP.

    I suggest you look at the inflation rate over the last 400 years, while we had a gold standard there was two cases of serious inflation and many example of economic instability. One inflation period occurred when Spain rapped and pillaged the new world ( an over supply of the stuff), the other when a large percentage of the consumers died ( the black death). No gold is not a magic metal, it is about supply and demand and connecting your money supply to a variable unrelated to the amount of money needed to support the current state of the economy, an act of stupidity that economists now understand.

  22. Let’s say your correct charles. (Economists don’t have anything against gold being dug up, but anyway). So why do you want to print more money when we already have 5% inflation?

  23. Also something else to consider- quite a few gold mines have re-opened recently, as owners dug deeper to get at gold that is now worth the costs of more expensive mining. I think the world has enough gold for our purposes- we just need a better system.

  24. Here is my censored & updated comment reposted, ALS gremlins,


    Your posts lately have been nothing but uninformed gibberish and prescribe truly insane economic policies in the face of the available data. Pointing out that economies are dynamic is no excuse for your ideas to create unsustainable inflation and sow the seeds of a new credit cycle.

    Why put money in? The problem with your dopey idea charles is that the Japanese have tried it for over a decade and all they got was like reverse stagflation – no growth, falling prices. That’s the point of the letter Rogoff wrote. I think Ken Rogoff understands economies are dynamic systems. You need to stop this condescending schtick to well qualified experts. What are you? An unqualified goon? A liquidity trap is not something to be trifled with.

    We don’t need more money now charles. Inflation was 5% before the last rate cut, talk of “deflation lead depressions” is simply piffle.

    It’s a dynamic system – that doesn’t mean sweet FA charles. What matters is monetary policy takes 18 months for the full effect to be made. How do we deal with massive inflation 18 months down the track?

    You purport to be the “master” of “dynamic systems”, please explain why this leads to a different conclusion. You obviously have know idea as to how economists come to their conclusions. Why don’t you read up on what the Treasury, RBA or Econ Tech actually do before posting inane drivel?

  25. Mark

    1) The Japanese do not have the reserve currency.
    2) They tried to recover using fiscal policy, they didn’t recapitalize there banks.

    Re treasury and RBA
    How much money has the US treasuring injected into the banking system in the last three months? I could be wrong but to my knowledge the only country to increase interest rates in the last couple of months is Finland, feel free to correct me if I have missed another. Bet you didn’t bother to check out past periods of inflation.

    Want to make a bet on the inflation rate in 6 months time?

  26. The Japs sure did recap their banks, Charles. they took out the crap from their balance sheets.

    You’re winging this aren’t you charles?

    And what does reserve currency status have to do with anything when they were also the largest creditor nation in the world during the 90’s?

  27. Charles – yes the inflation caused by the Spanish plundering the new world was extreme. It almost hit 4% per annum at some points. That was extreme in those days.

    And yes the black plague did also cause some prices to rises in Europe, however those same price rises caused an outflow of gold and and in flow of scarce goods as was appropriate. You can’t kill off large sections of the population without some economic disruption. If the extreme levels of taxation that typified the feudal era had not pervaded then recovery would have been even quicker.

    However I don’t expect any continents to be discovered any time soon or any massive plagues so it is now pretty safe to go back to a gold standard.

  28. “the key is to put money in, in a manner that allows you to take money out”

    Monetary planning is useless to society in the long run, just in a less damaging way then directly planning land, labor & capital.
    Prices are real, have a time sensitive context and do not just reflect short run discrete physiological states. Prices have (or should have if not politically mangled) relevant information on what should be done, but only for each and every entity in the markets, not for one entity (Central bank) to attempt to arbitrarily coerce every other entity to move in one prescribed direction (spend, save etc) based on reacting to old data, wishful thinking, dodgy theories, political expediency etc.

  29. “1) The Japanese do not have the reserve currency.”

    So bloody what?

    “2) They tried to recover using fiscal policy, they didn’t recapitalize there banks.”

    They had 0% cash rates and negative real interest rates. They recapitalised their banks by implicitly slugging everyone with an inflation tax. You are off the planet if you argue otherwise.

    Yes they may have had expansionary fiscal policy as well. This doesn’t help your argument that we need inflationary pressures and to crowd out private investment and increase the cost of capital.

    “Want to make a bet on the inflation rate in 6 months time?”

    Do you?

    My guess it will be the difference between money growth and growth in national income. It always is.

  30. Damian…well said.

    Introduce yourself and please post or comment regularly. Please think about ALS and LDP membership if you haven’t done so yet.

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