Joe Cobb

by Joe Cobb

The concept of “money illusion” was identified by John Maynard Keynes in his masterly book on the Economic Consequences of the Peace (1919), and the brilliant American economist, Irving Fisher, also wrote a book with that title (1928). Economists have used the term to describe the tendency for people to think of money in terms of its face value. Money, of course, does not have any fixed value since what money can buy depends on what prices producers and sellers ask for real things. [ See this discussion from Wikipedia for a general introduction to the ideas of economists on money illusion. ]

Money illusion was famously described by Thomas Mann in a story about a friend in Germany, after the first World War, who had borrowed 10,000 marks from the famous author before the war. After the great German inflation of the 1920s had begun, Mann’s friend gave him a nearly worthless 10,000 mark note. That the paper money could not possibly repay the debt he owed he failed even to understand.

John Maynard Keynes seriously proposed using inflation as a way to reduce unemployment in his General Theory of Employment, Interest and Money (1936) because he believed workers would be too stupid to figure out that nominal wages, even after pay increases, could be lower in real terms if the pay increases did not keep up with inflation. Cutting the wages of labor is one prescription for reducing unemployment, since with lower wages employers can find it economical to hire more workers or to forego layoffs.

Keynes knew a major cause of the massive unemployment in Britain in the 1920s was due to the deflationary collapse of the money supply, which also happened in the United States in the 1930s. The purchasing power of a U.K. pound and the American dollar skyrocketed. The U.S. consumer price index in 1929 was 53.1 but by 1933 it had deflated to 38.8 and didn’t return to its pre-Depression level until 1943. Anyone who had money could buy a lot more with it in 1933.

Since there was a national effort under presidents Hoover and Roosevelt not to reduce wages paid, it is no surprise unemployment skyrocketed in that decade. A worker receiving $1.00 per hour in 1929 enjoyed a 37 percent real wage increase, if he still had his job in 1933 at the same $1.00 per hour. Keynes understood if you double the prices a worker has to pay for food and rent, it is a real pay cut. Cutting wages by inflation could get the unemployed back to work. Keynes was not a friend of the working class. Karl Marx, by contrast, supported the gold standard as did other famous socialists like George Bernard Shaw.

A Different Form of Money Illusion

Yet a more serious form of money illusion has seldom been noticed by economists due to one of the most useful things about money itself: You can add it up. Money (and credit) have a mathematical property that apples and oranges do not have. You cannot add up apples and oranges. If an accountant combines the dimes and quarters in a bag of coins with the Federal Reserve notes in his wallet, he can calculate his money supply. Adding apples and oranges does not create a “fruit supply.” Accountants will disregard the differences between the coins and paper money, although it might be impossible to spend the coins to buy many things in the market. Some things require different forms of payment.

When a market system operates smoothly and many people are willing to trade different forms of money at zero or minimal expense it is easy to disregard this essential difference between the forms of money. But consider the example of someone offering to sell a bag of pre-1964 silver dimes and quarters. Most people would immediately recognize the greater value of the old coins, but it took more than a decade after 1964 for people no longer to receive old silver coins in change as most retail cashiers failed to understand the difference between copper clad quarters and old silver quarters.

One of the primary services banks provide in a modern economic system is to provide what seems to be a par value payments system. Indeed, one of the primary requirements of the National Banking Act of 1863 was to establish a uniform currency, issued by private banks. Other national banks had to accept deposits of the “national currency” at face value. Prior to the Civil War, it was common for money issued by private banks to be discounted when it was used in trade or deposited in banks a few miles away.

It is of course very useful not to have to worry about different forms of money circulating in a “floating exchange rate” system, but since 1971 this is exactly what has changed in the world economy. Under the broken Bretton Woods Agreement, national governments were supposed to keep their money units fixed for international trade and finance, just as the National Banking Act did for trade between different cities and states in America.

Today it might seem to be more complicated to make international payments, exchanging between yen and euro and dollar (often requiring derivative contracts to hedge against exchange risk) but the system is also more transparent now. When a currency grows weaker, buyers and sellers immediately see the change in the market. Sellers of the weak currency have to pay more to buy stronger valued money.

The attempted ideal of a par value payments system is the source of this more subtle form of money illusion. Under par value payments, weakness of a currency is only seen – after a delay – in rising retail and wholesale prices. The delay is eliminated by arbitrage in basic commodities, as prices of gold and oil in different currencies reflect the strengths and weakness of currencies themselves under flexible exchange rates.

The Changing Role of Banks

The popular idea of a bank is symbolized by the bank vault. Children are taught you deposit your money in a bank and it will be there when you want to take it out. Banks have always solved the problem of robbery or forgery by offering people a more secure way to save their money. But savings is not the most important service the banks perform. Only a child would believe a bank will take his deposit and keep the money in its vault, like a toy chest, and give it back when the child demands it.

The banker does not operate a warehouse for money.

Bankers are “community bookkeepers” who make it easier for people to make payments to each other and to keep track of how much different parties owe each other (measured in terms of accounting units).

Bankers fundamentally perform accounting as a free public service, while managing investments for their own account – like an insurance company.

A bank customer comes to do business not by “depositing” but by “purchasing” from his banker a line of credit. A customer may not know the difference when he pays $100 cash in exchange for a $100 line of credit, but the difference between what bankers do for the economic system and what government coins and paper money do are very different. A bank offers its credibility as a payor, and it will pay your bills when you ask – if you buy its line of credit.

One of the truly misleading ideas from the British Neo-Classical School of economics, which dominates economic journalism and universities worldwide today, is the idea that bank credit, coins, and government money can be added up like “the fruit supply” to measure M-1, M-2, etc. In the past 30 years, this idea has proven less and less useful in making economic forecasts. In the United States today, even our understanding of what causes price index inflation is seemingly disconnected from “money supply,” mostly because credit has entirely displaced money and the “supply” of credit defies measurement.

By servicing the payments activity of millions of customers, bankers perform one of the essential roles in our modern economy. A banker is always the largest debtor in town, because he owes every one of his customers the nominal value of their bank balance. He does not owe them “money”; he maintains for them lines of credit, which they can switch among themselves in the market for goods and services. When you buy gasoline with your debit card, the banker switches some amount he formerly owed to you and now he owes it to the oil company. Nothing changes hands, except a bookkeeping entry is switched in the bank’s ledgers.

These bank services are not free, of course. Even though bank customers may enjoy fixed exchange rates between different bank services, the bankers are covering their costs in different ways. For merchants, accepting your debit card will mean paying a fee to the bank for the transaction. Logically the bank could charge you, the spender/buyer, for the service, but Congress has passed laws since the 1960s to make the use of cards, checks, and electronic payments look like free services to most bank customers. The banking industry requested these legal restrictions in the early days because introducing credit cards was difficult in the 1960s when store keepers wanted to charge the bank fee to the customer, like a sales tax, on top of the prices marked on goods. Even today one can sometimes see a sign at a cash register that says “Discount for Cash” but it is against the law to say openly your price will be higher for payment by credit card.

The Banker as an Investment Manager

The modern banker operates like a money market mutual fund. Banks own specific assets with less than perfect liquidity and perform “community bookkeeping” for customers with abstract units of credit providing superior liquidity. Liquidity can be understood as the narrow degree of the bid/ask price spread for an asset.

It is a common misconception to say that “banks create money when the make loans.” The standard illustration in economics textbooks will have a bank accept a deposit for, say, $100 and with the magic of the “money multiplier” turn around and expand that amount to $1,000 by making loans to other customers.

If you model the business of a bank like an insurance company, you can understand this model of a bank, but it doesn’t fit today’s banking system.

What banks do is to invest in less-than-perfectly liquid assets and create more-nearly-perfectly liquid liabilities for others to use as assets in payments.

An insurance company is an example of a fractional reserve institution. It takes your deposits and promises to pay you back under certain conditions, like an accident or your death. The insurance company knows all its customers will not have accidents or die on the same day, so it keeps reserves on hand for daily payments and invests the rest.

A banker keeps enough cash in his vault to make daily payments and invests the rest. To the extent that a government requires a certain level of reserves, it might appear to make the bank safer, but actually when reserves are sterilized, they are no longer available to make daily payments. Bankers used to invest only with borrowers, who pledged mortgages or inventories, but the communications revolution has built financial markets that make it possible for banks to invest in any asset of value. Arrangements among banks permit efficient operations with nearly zero reserves for daily cash payments. When governments enforce central banking monopolies they substitute regulations for private agreements, and expose the system to “crony capitalism.”

Under the Bretton Woods system of fixed exchange rates, governments enforced controls on international capital payments to try to hold back pressures to devalue or revalue, which nevertheless happened frequently. Following the abandonment of the Bretton Woods Agreement in 1971, the newly freed international financial markets allowed much more fluid movement of capital among different economies around the world. Flexible exchange rates unmasked and destroyed protection from competition that had profited bankers for centuries.

Under the guise of safety and consumer protection, interest rates and bank costs had been regulated to restrict competition. During the 1970s, however, regulated interest rates were not able to keep up with the rapid depreciation of government money. The non-bank investment community was less severely regulated.

Mutual funds had operated for a century by pooling small investors and buying a portfolio of assets. A mutual fund would issue and redeem its own shares and manage its assets for profit. Wall Street entrepreneurs discovered the trick of investing in high grade, liquid government bonds and issuing shares for a fixed price of $1.00 each. As their bonds went up in value, the mutual funds would issue new “stock dividends” at $1.00 face value.

This looked exactly like what banks called “paying interest on savings,” and indeed the only difference was how each type of company was regulated. There was no economic difference. The regulated bankers begged for deregulation so they could compete, and government changed the rules.

The Payments System

In fewer than 30 years, the banks have been transformed from conservative community bookkeepers who made nearly risk free investments within their own local regions, like credit unions, to an international assets trading system. The old “legal tender” idea that money comes from governments is misleading.

Today you have to ask what is “money”?

Although there are many ongoing regulations imposed by governments regarding banks and what people can use to pay taxes, the old idea that governments “print money” is simply not true today. Governments print bonds. And banks turn them into liquidity.

The crisis in Europe over the debt of Portugal, Italy, Greece, and Spain highlight the fallacy that governments can leverage their power to tax and issue risk free bonds. It was an international government regulation, the Basel III Accord, that set the stage for the current Eurozone crisis. The Basel agreement designated all government bonds as risk free and encouraged banks to buy them. Now it is clear the PIGS bonds will probably default, and the banking system is threatened with collapse. Unfortunately the important role the banks play, as agents in the payments system, is also jeopardized.

Modern society cannot survive a disintegration of the payments system, since prices are the information data that makes worldwide division of labor possible. What is occuring in the Eurozone is a crisis threatening the payments system because too many banks hold questionable government bonds.

The governments that operate central banks, like the Federal Reserve, could impose a drastic reform that would stabilize and preserve the payments system, but even to describe it shows why it is not desirable: The government could take over every bank and make it a branch office of the Federal Reserve. Like the old postal savings system, so popular in Europe and even in Japan today, it could function with checking accounts and debit cards effortlessly. Private banks would still work as mutual funds or investment managers, but they would no longer be connected with the payments system – and bailing out banks from bad investments would not be a public policy issue.

Of course, to make the government the monopoly for payments would open the door for the Treasury printing press to cover the Federal deficit, and the next question in everyone’s mind would be a situation like Thomas Mann’s story in 1923 Germany. Before that, the French Revolutionary government had also tried to finance itself by establishing a payments system based on seized church land (assignats), and it failed with a massive inflation.

Some people who want to abolish the Federal Reserve think replacing Fed chairman Ben Bernanke with Treasury secretary Timothy Geither would be an improvement. [see H.R. 6550] They don’t see there is no example of monopoly government banking, even with legal tender laws, that has succeeded in providing a stable payments system.

The solution for monetary and economic stability has to be found in the other direction, more deregulation and freedom for banks to transform assets into liquid payments media.

Escaping the Money Illusion

The money illusion that dominates the world financial crisis is the mistake that money issued by governments – the government accounting system itself – provides a stable basis for private accounting systems. The illusion is sustained by the legal institutions of a par value payments system within countries, even though such a system does not exist between countries.

The crisis in Europe is rooted in the mistake of attempting to manage a single unit of accounting for both payments and investments, as well as for each government’s tax and accounting system. In the early days of the European Union, discussions of how to coordinate currency exchange rates were set upon the idea of creating a common currency.

The British Treasury, which wisely kept the U.K. out of the Eurozone, proposed an alternative. John Major, head of the Treasury under Margaret Thatcher, proposed a parallel currency in which the Euro would serve as a transnational unit for financial assets but not as a unit for local and consumer transactions. The legal tender status of the Franc, Mark, Lira, Peseta, and Drachma would have remained unchanged. In retrospect, it is a sad result the proposal didn’t command wider respect among European finance ministers.

Consider again the example of apples and oranges. An asset is something of value and it can have a market price. A financial asset is denominated in accounting units, but financial assets often do not sell at their nominal face value. Many financial assets do not have a face value. Since many financial assets in today’s market are worth less than their value at maturity – and their value at maturity is uncertain due to flexible exchange rates in currency markets – the concern about what information is actually conveyed by bank balance sheets is quite well placed. Government regulations don’t help to give clear information, and bank and bond rating agencies are growing more important in the role of economic policemen.

The Eurozone crisis is based on the uncertainty about the value of government bonds, which used to seem like nuggets of gold in portfolios of rising and falling private equity values. Private promissory notes and bonds were always at some risk, and their nominal yields reflected the risk, as well as discounts in the market from their face value. But now more than ever, it is clear that financial assets are more like apples and oranges and government bonds are more like Ponzi or Madoff investments.

The more distrust the common man can come to accept in his view of the payments system, the healthier the system will become.

Free Banking as a Model for the Future

Conventional wisdom changes slowly, and the system of central banks, national currencies, par value payments, and fixed exchange rates is still very recent in historical and social memory – only a few hundred years old. Flexible exchange rates are new.

The world as a whole does not have a central bank or a single currency. Par value payments and fixed asset values are impossible to create by governments, even by international regulations.

There is a reasonable case to make about preventing fraud and deception in financial markets, but looking at the Eurozone today it is clear that governments cannot be the source of those reasonable expectations against deception and fraud.

In a banking system that is not organized as a cartel, not based on a government central bank with a government monetary unit to defend, the model of free banking described in Adam Smith’s Wealth of Nations (1776) offers more stability. If all banks were private investment institutions, trading assets in a global market and offering “community bookkeeping services” in more than one legal tender unit of accounting, ordinary people as well as larger players would be able to look critically at what the exchange rates in the market are telling them about economic values and the risk of assets.

The private payments system has already developed the technological network, with the debit and credit card. A single card can make payments in any currency a merchant might want, and a bank customer could still keep his line of credit denominated in something else, or even multiple units of accounting.

Some card issuers hold liquid non-monetary assets instead of government money for customers, which might be how we escape from the curse of government bonds. Scottrade manages my assets and I can spend from my account using a Visa card or checkbook – in any and every monetary unit currency on earth, wherever I travel. “What’s in Your Wallet?”

The key to a more stable payments system is more information. Government regulation and government accounting are sources of disinformation. Protestors may stage publicity stunts decrying “crony capitalism,” but the real problem is the centuries-old relationship between bankers and the government, with its power to offer favors for funds. The story Adam Smith tells about the original charter of the Bank of England in 1694 is an illustration of what has evolved in 300 years (the bankers gave King William a deal in exchange for a monopoly charter).

Worldwide competition in the financial markets has the power to restore the stability of dynamic equilibrium to financial markets, but only if a transition away from government accounting and fictional financial assets (such as PIGS bonds) is allowed to evolve.

Any government guarantee of purity should be the signal of secret toxic ingredients.

This entry was posted on Friday, November 25th, 2011 at 6:15 pm and is filed under Economics, Editorial Page. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.