Chapter 2 B Adverse effects of excessive money creation

Chapter 2B. The adverse results of excessive money creation.  Originally written in 2006 before the results of the problems described here became obvious. 

It is the need to make money on all deposits which forces banks to seek out a continuously growing number of new borrowers and in the process take on ever more risky loans, which in turn drive up asset prices. 

            Unrestrained credit creation is the force driving the property market bubble which has forced first time buyers out of the housing market and created considerable wealth for those lucky enough to have owned their property for some time. This is a completely unproductive and unfair result. It also raises pressure for inflationary increases in wages as people struggle to afford the cost of putting a roof over their heads.
            Although there is no practical limit to the amount of money that can be created there is a definite finite limit to the quantity of real assets in the world. This accounts for the popularity of British Government Bonds (or Gilts) because they are recognised as secure for interest and repayment. It also accounts for the popularity of our water supply companies and airports with foreign buyers. We are busy selling our real assets such as water companies to foreign buyers who are using Bank money to buy them. It is keeping up the value of the pound and lets us live in some style, but in reality we live in a country without much in the way of visible means of support. This can go on for a very long time, possibly tens of years, but at some point we will have to earn our living by selling as much as we buy, particularly when the oil and gas finally run out.
             Water supply companies should never have been privatised in the form of joint stock companies for a number of reasons. Firstly, they are natural monopolies and would not be run in the public interest if they did not have a government appointed regulator. There is no competition of any sort to ensure value for money.  Southern Water has  been fined £20m for not serving the public interest. Secondly, a joint stock company can start up all sorts of outside activities which may be cross subsidised by the sale of water.  Thirdly, they can and in many cases have been bought out by foreign companies using Bank money, that most ephemeral source of value, while their true value is ever rising in real terms and they produce an ever rising income stream from customers for water.  It is as near to selling our birthright for a mess of pottage as you can get.
            Consider the buy out of a British Company by a foreign private equity company (who now collectively own about 20% of our companies). The money could be raised by borrowing Japanese Yen at very low interest rates and converting these into Pounds. The main risk taken by the purchaser is that the value of the Yen will rise in relation to the Pound, giving an immediate loss on the loan when repaid. But the act of borrowing Yen and converting them into Pounds depresses the value of the Yen in Pounds (and increases the value of the pound). This provides a win-win situation for the private equity companies and they will reckon on re-selling the British Company at a profit before the chickens come home to roost.
            Borrowing in one currency to invest in another carrying a higher interest rate is known as “The Carry Trade”. It is one of the more popular occupations of Hedge Funds. It is probable that borrowing operations such as these account for the remarkable buoyancy of the exchange rate of the pound in the face of continual adverse balance of payment figures. Something like this must explain the change from the late 1970’s when we were forced to borrow from the International Monetary Fund to pay for our imports – Oil revenues are part of the explanation but hard exports of goods are certainly not.
            It is true that there are many beneficial forms of inward investment, if they create new assets. If inward investment is used to build a new car factory it is a good thing, if it is used to buy an existing utility it is not a good thing.
            Another common destination for new loans is to gear up speculative positions in securities. These range from the old fashioned Investment Trusts through the infamous Split Capital Bonds to the latest fashion for Hedge Funds and Private Equity Companies. Little of this “gearing” increases the productive capacity of the Nation but they all muddy the waters of productive investment, and provide large rewards to the participants in what would otherwise be zero sum gambling operations were it not for the immense annual increase in new Bank money. Having your car in the highest gear is fine until you come to a hill.
Thefinancial world is a giant casino where the roulette, black jack and poker are replaced by futures trading; currency trading and new forms of tradable derivates which are continually being created. The gambling chips used are real currencies and the quantity of chips in circulation on the casino floor is being steadily increased at little cost to the players. Players are therefore able to win even if other players and “the house” are not losing. Most of the chips stay on the tables ready to make ever larger and more numerous bets but some are withdrawn to buy real assets and to fund the extravagant life style of the players.  
“When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill done.” J M Keynes, p.533 of his biography by Robert Skidelsky. This book is a brilliant account of the life of a brilliant man and is well worth reading if only for the insight it gives into the history of the first half of the 20th Century and how the official dogma then was willing to sacrifice millions of workers on the cross of gold. The complete reversal in accepted opinion today is equally wrongheaded. No one was more aware of the monetary cause of inflation than Keynes, and had his views prevailed on German reparations after the First World War we would never have had to fight the second.
            For non technical and entertaining accounts of the ways the World Wide Casino is played read: “Liar’s Poker” by Michael Lewis (Hodder 1989) and “Hedge Hogging” by Barton Biggs (Wiley 2006). “Rogue Trader” by Nick Leeson (Little Brown1995) is an interesting account of how Barings Bank was ruined. “Debt and Delusion” by Peter Warburton (Penguin 2000) is an extremely good and prescient account of the ways that the monetary system is being exploited and forecasts the present crisis brought on by ever more complex derivatives.
            The vast increase in the quantity of money each year is the primary source and reason for the remarkable profits made in the financial industry. It can be summed up as borrowing new bank money to buy real assets. The price of an asset bought rises as a result of the purchase which in turn allows a sale at a profit above the original loan. Such operations would yield little or no profit if the supply of new money could not be increased so easily by the private clearing banks. The creation of bank money by banks is essentially legalised forgery since it virtually ranks equally with government printed currency notes when it comes to buying something.  
            The diversion of much of the bank money into the world wide casino explains the fact that general inflation is considerably lower than the rate of increase in money. The other reason is the misleading nature of our inflation indexes, which are described later (Chapter 5). It also explains where the money lost by banks on bad loans has gone.
Volatile Exchange Rates
            Uncontrolled monetary expansion, when associated with currency speculation causes extreme volatility in exchange rates. Exchange rates are no longer controlled by the fundamentals of balance of payments. They are controlled either by direct government intervention as in the case of China or by the enormous sums flowing in speculative exchange markets.  Japan, in particular, is defying the laws of financial gravity. The Yen remains very low and we do not know how many Yen have been borrowed abroad to take advantage of very low interest rates in Japan. When the Yen eventually rises, as rise it must, we may see some very damaging results for those who have borrowed heavily.      
            George Soros made about £1 billion from the British taxpayer by borrowing 6.5 billion of sterling in the lead up to our exit from the ERM on Black Wednesday in September 1992 and switching it into Deutschmarks and French Francs. This is typical of the sort of operation which unrestrained bank lending allows and favours. 
            Highly volatile exchange rates are very bad for international trade, particularly bad for products with long lead times and disastrous for those industries like Airbus which must invest years ahead in plant, equipment and trained work forces. The fate of Airbus is on the line, not only because of technical delays but also because the current Euro/Dollar exchange rate of 1.48 is 61% more unfavourable than it was when design of the present aircraft was on the drawing board. The sterling dollar rate has oscillated between one dollar and over two dollars to the pound. It is simply not possible to take a long view on highly technical projects when exchange rates move so rapidly and by such large amounts.
            One cannot rate too highly the importance of stable exchange rates. In the world as it is today with fierce competition in manufacturing it is vital that we move to the higher levels of technology but this is completely impossible without long term research and design and that depends on being able to predict a fairly narrow range for the value of our currency for several years ahead. It is also true that we need much more effort in technical education and training. It is a grave mistake to think that we can prosper by services alone.
            It is a mistake to take a dogmatic view that protection of home industries is always wrong. China is not only a low cost producer; it also plays to a completely different set of rules, not least of which is control of exchange rates at below market levels. Also it is of doubtful morality, as well as being unwise, to exploit their working practices which have been illegal here for many years. It will not be pleasant when our only way of paying for imports is running bed and breakfast establishments for tourists. 
            The determining factor deciding our policy on foreign trade should be to define how we will earn our living internationally in the future, how we will pay for imports. There seems to be a mood of great optimism that a completely free international market will give us a continually rising standard of living but the reasoning behind this view has yet to be stated clearly and in detail. Our Eastern Suppliers growing trade surplus with us has to be added to our increasing imports of fuel and raw materials; creating an imbalance which is currently being financed by borrowing. Our creditors have learned by experience that investment in our financial instruments can be reduced in value by inflation and by a return of exchange rates to reality; and in order to protect themselves they are setting up “sovereign funds” to buy real assets instead of IOUs in the form of bonds.