WHAT'S GOING ON?
IT WAS ALL EXPLAINED IN 1755
CANTILLON EFFECTS OF THE BANK BAILOUT
AND THE 'EXIT' STRATEGY
The enormous expansion of money carried out by the Federal Reserve in the USA, the Bank of England in the UK and other central banks worldwide has been generally proposed and then analysed by economists in terms of stimulating aggregate demand as well as the more immediate aims of providing liquidity into the banking system.
CANTILLON’S ANALYSIS
However, the provision of money via Central Banks into the banking system also raises the question of Cantillon effects. These effects explain both the revival of bank profits and bonuses as well as the lackadaisical approach by politicians to reining in their own expenditure and government expenditure.
These effects were first analysed by Richard Cantillon, the Irish banker living in Paris, in his ‘Essay on the Nature of Commerce in General’ published in 1755, who was one of the few economists referred to by Adam Smith, Keynes, Ludwig von Mises and Schumpeter. His conclusion was that expansion of money was not a question of simply looking at the effects of quantity only, a study of aggregates, but also that expansion led to redistribution of income between different groups in society.
In short, Cantillon and others observed that new money, such as supplied by quantitative easing, but also including other monetary expansion, entered the economy in a specific way and at a specific point (as investible funds) and only gradually spreads through the economy. Those who were the first to receive the new money in effect benefited as they used this new money in an economy where prices were still set by the existing stock of money. Changes in prices produced by such cash injections vary with the nature of the cash injection and, moreover, changes in absolute prices are always associated with alterations in relative prices. In recent times, this cash injection, and the way it was intended by the Central Bank and issued through the banks, explains why the banking sector and the government, as the first recipients, appear insulated from the recession.
Von Mises compared the creation of new money to a situation where a viscous liquid, such as honey, is poured into a vessel, ‘If the stream hits the surface at one point, a little mound will form there from which the additional matter will gradually spread outwards’.
THE HELICOPTER DROP REDISTRIBUTES INCOME
Bob Bernanke, Chairman of the Fed, picked up his various nicknames such as Whirly Ben from a speech he gave on November 21st 2002 entitled ‘Deflation: making sure ‘it’ [deflation] ‘does not happen here’’ and with reference to Milton Friedman’s famous idea of a ‘helicopter drop’ of money to stop deflation.
He said, ‘Indeed, under a fiat money system, a government should always be able to generate increased nominal spending and inflation, even when the short term nominal interest rate is at zero.’
But who benefits depends on who is underneath the ‘helicopter drop’ and who gets the cash, as Richard Cantillon wrote.
Central Banks have often reduced the credit created by the fractional-reserve banking system by open-market operations. What is different in the 2008/9 contraction is that bank credit was contracted by a crisis in the banking system, itself originating in reckless Central Bank money supply.
By the time the Central Banks noticed this contraction, and this delay is inherent in a Central Bank controlled banking system, the effects of the contraction had already taken place in the private economy with drastic falls in economic activity, the prices of assets, commodities, shipping rates, etc. The new policy of quantitative easing has simply thrown all this into reverse and fostered a return to the previous economic activity and price level originally created by excessive bank credit and central bank excess money supply.
In the current crisis, the ‘helicopter drop’ of credit is directly into the pockets of the big banks as well, of course, to help support government activities. They, therefore, benefit in exactly the same way as Cantillon’s example of how the proprietors of a newly discovered gold mine benefit first from the discovery before new gold affects prices in the rest of the economy. Those who are recipients of spending by the big banks and by government benefit next, i.e. their staff and suppliers, while those who receive the new money last are not compensated for their losses while price changes ripple through the economy.
As the Financial Times noted on 4th November 2008, ‘But concerns have grown stronger in recent weeks that the financial institutions participating in the recapitalisation plan will use the funds to pay dividends, make acquisitions, or simply rebuild their balance sheets, rather than deploy them to support the economy.’
It is, therefore, not surprising that the banking sector and the government appear to be least affected by the crisis and there are now numerous criticisms of bankers getting renewed bonuses, legislators being quite oblivious and taking a long time to rein in public spending, etc.
RICHARD CANTILLON’S WARNING
But this is inevitable in such a policy of money creation as Richard Cantillon pointed out in a prophetic warning about quantitative easing.
‘It is then undoubted that a Bank with the complicity of a Minister is able to raise and support the price of public stock and to lower the rate of interest in the State at the pleasure of this Minister when the steps are taken discreetly, and thus payoff the State debt. But these refinements which open the door to making large fortunes are rarely carried out for the sole advantage of the State, and those who take part in them are generally corrupted. The excess banknotes, made and issued on these occasions, do not upset the circulation, because being used for the buying and selling of stock they do not serve for household expenses and are not changed into silver. But if some panic or unforeseen crisis drove the holders to demand silver from the Bank the bomb would burst and it would be seen that these are dangerous operations.’
Of course, at present, much of quantitative easing has meant the funds pumped into the banks have been deposited back to the Central Banks as special reserves and not lent out. The velocity of circulation is, therefore, very low. However, even this increase in bank liquidity is not without effect. It makes banks more confident and engenders a more relaxed deployment of funds than would occur without quantitative easing – exactly as was intended by the policy. It also allows government spending to remain high for a time with no policy to bring the public finances under control.
It would be possible to envisage a ‘helicopter drop’ on a more widespread basis either to existing holders of money, the taxpayers, or to others such as benefit recipients. Of course, any ‘helicopter drop’ will not enhance the productive potential of the economy but would raise the level of prices with alterations in relative prices and consequent effects on distribution of resources. The idea of the ‘helicopter drop’ is, bluntly, that resources would be distributed to those who would spend – whether consumers or investors and away from savers. This creates a temporary consumption boom. The benefits of this are highly questionable when there has already been a previous great expansion of money and credit.
REVERSE CANTILLON EFFECTS
It is also important to consider what happens when the extra credit is withdrawn from the system – a reverse Cantillon effect which the central banks have promised to carry out.
Both Bob Bernanke and Mervyn King have promised to reverse quantitative easing, and also the increase in the monetary base, when conditions are right. But this will have reverse Cantillon effects.
As Bob Bernanke said in London, 13/1/09, ‘As lending programs are scaled back, the size of the Federal Reserve’s balance sheet will decline, implying a reduction in excess reserves and the monetary base.’
Bob Bernanke has laid out his exit strategy quite clearly at an address to the Federal Reserve Board Conference in October 2009 and has attached to his speech a very clear analysis of the liabilities and assets of the Federal Reserve and how he sees those changing. In particular, he had a section entitled ‘Exit Strategy’, ‘At some point, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. Looking at the Federal Reserve’s balance sheet is useful, once again, in helping to understand key elements of the Federal Reserve’s exit strategy from its current policies [slide 7].’ In order to soak up the new money issued, it will be necessary to sell bonds to the financial markets and force the banks to return liquidity to the Central Bank where it will be destroyed. This will also reduce bank reserves, reduce credit and loans.
The withdrawal of this money from an economy is likely to produce severe pain.
One can doubt that all of the monetary stimulation will ever be withdrawn. Frankly, once the extra money gets out from the banks’ special reserves at the Central Banks, historically the quantity of money is never reduced to the pre-existing level. The pain of reducing prices from the new inflation induced level is just too hard for the Central Bank to contemplate.
SECOND REDISTRIBUTION OF INCOME
Reverse Cantillon effects, if effected in the same way in reverse as the cash injection, withdraw money first from those at the periphery who still face prices set by the new money and only later benefit from reduced prices. The Central Bank’s withdrawal is, of course, from the banks and the government but these institutions immediately transmit pressure to the periphery. As money is withdrawn from the periphery to the banks and only then from the banks to the Central Banks, the banks benefit again as they are the last to lose the money and can still use this in an economy with deflating prices.
The reduction of the quantity of money has just as widespread effects as the increase. The absolute price level is reduced but, once again, relative prices are altered.
Von Mises criticised the Fed’s deflation in 1938 just as much as he criticized its inflation in the 1920’s, ‘If a man has been hurt by being run over by an automobile, it is no remedy to let the car go back over him in the opposite direction.’
The provision of credit from Central Banks and its withdrawal will on both occasions result in a redistribution of income to those who are first to receive it and the last to give it up, that is, the government and the major banks and their suppliers, principally their employees and shareholders, who are closest to them.’
Where local government entities are not able to pass costs to taxpayers, they also have had to contract their spending. Thus one can see that, in California, state employees have had to accept a wage cut of 13.8 per cent while federal employees located in California have not suffered any wage cuts.
This may be what current policy intends, that is to transfer resources from others to the banking sector and the government, but it is the reverse of what should be the long term aim, resourcing manufacturing and consumers in the real economy.
Clearly the boom time level of credit, as created by fractional reserve banking, with low cash ratios, must contract substantially, and has done so.
At the same time, the long-term process of reducing government borrowing to zero or below with absolute reductions in wages and personnel throughout government and deflating the consumer debt bubble and repairing the credit markets needs a methodical strategy.
At present there is no plan to transfer some of the pain of recession to government or to entitlement holders in areas such as pensions, health, education, contributions to the EU, etc. A five-year plan should be announced to freeze these now and roll them back dramatically.
In the meantime, both the expansion and then proposed contraction of money transfers resources from the wider economy to those closest to the originating mechanism, that is, the government and the banks.
So, the end result is a shrunken real economy with an oversized government and banking sector.
FUTURUS/19 June 2010
CANTILLON’S ANALYSIS
However, the provision of money via Central Banks into the banking system also raises the question of Cantillon effects. These effects explain both the revival of bank profits and bonuses as well as the lackadaisical approach by politicians to reining in their own expenditure and government expenditure.
These effects were first analysed by Richard Cantillon, the Irish banker living in Paris, in his ‘Essay on the Nature of Commerce in General’ published in 1755, who was one of the few economists referred to by Adam Smith, Keynes, Ludwig von Mises and Schumpeter. His conclusion was that expansion of money was not a question of simply looking at the effects of quantity only, a study of aggregates, but also that expansion led to redistribution of income between different groups in society.
In short, Cantillon and others observed that new money, such as supplied by quantitative easing, but also including other monetary expansion, entered the economy in a specific way and at a specific point (as investible funds) and only gradually spreads through the economy. Those who were the first to receive the new money in effect benefited as they used this new money in an economy where prices were still set by the existing stock of money. Changes in prices produced by such cash injections vary with the nature of the cash injection and, moreover, changes in absolute prices are always associated with alterations in relative prices. In recent times, this cash injection, and the way it was intended by the Central Bank and issued through the banks, explains why the banking sector and the government, as the first recipients, appear insulated from the recession.
Von Mises compared the creation of new money to a situation where a viscous liquid, such as honey, is poured into a vessel, ‘If the stream hits the surface at one point, a little mound will form there from which the additional matter will gradually spread outwards’.
THE HELICOPTER DROP REDISTRIBUTES INCOME
Bob Bernanke, Chairman of the Fed, picked up his various nicknames such as Whirly Ben from a speech he gave on November 21st 2002 entitled ‘Deflation: making sure ‘it’ [deflation] ‘does not happen here’’ and with reference to Milton Friedman’s famous idea of a ‘helicopter drop’ of money to stop deflation.
He said, ‘Indeed, under a fiat money system, a government should always be able to generate increased nominal spending and inflation, even when the short term nominal interest rate is at zero.’
But who benefits depends on who is underneath the ‘helicopter drop’ and who gets the cash, as Richard Cantillon wrote.
Central Banks have often reduced the credit created by the fractional-reserve banking system by open-market operations. What is different in the 2008/9 contraction is that bank credit was contracted by a crisis in the banking system, itself originating in reckless Central Bank money supply.
By the time the Central Banks noticed this contraction, and this delay is inherent in a Central Bank controlled banking system, the effects of the contraction had already taken place in the private economy with drastic falls in economic activity, the prices of assets, commodities, shipping rates, etc. The new policy of quantitative easing has simply thrown all this into reverse and fostered a return to the previous economic activity and price level originally created by excessive bank credit and central bank excess money supply.
In the current crisis, the ‘helicopter drop’ of credit is directly into the pockets of the big banks as well, of course, to help support government activities. They, therefore, benefit in exactly the same way as Cantillon’s example of how the proprietors of a newly discovered gold mine benefit first from the discovery before new gold affects prices in the rest of the economy. Those who are recipients of spending by the big banks and by government benefit next, i.e. their staff and suppliers, while those who receive the new money last are not compensated for their losses while price changes ripple through the economy.
As the Financial Times noted on 4th November 2008, ‘But concerns have grown stronger in recent weeks that the financial institutions participating in the recapitalisation plan will use the funds to pay dividends, make acquisitions, or simply rebuild their balance sheets, rather than deploy them to support the economy.’
It is, therefore, not surprising that the banking sector and the government appear to be least affected by the crisis and there are now numerous criticisms of bankers getting renewed bonuses, legislators being quite oblivious and taking a long time to rein in public spending, etc.
RICHARD CANTILLON’S WARNING
But this is inevitable in such a policy of money creation as Richard Cantillon pointed out in a prophetic warning about quantitative easing.
‘It is then undoubted that a Bank with the complicity of a Minister is able to raise and support the price of public stock and to lower the rate of interest in the State at the pleasure of this Minister when the steps are taken discreetly, and thus payoff the State debt. But these refinements which open the door to making large fortunes are rarely carried out for the sole advantage of the State, and those who take part in them are generally corrupted. The excess banknotes, made and issued on these occasions, do not upset the circulation, because being used for the buying and selling of stock they do not serve for household expenses and are not changed into silver. But if some panic or unforeseen crisis drove the holders to demand silver from the Bank the bomb would burst and it would be seen that these are dangerous operations.’
Of course, at present, much of quantitative easing has meant the funds pumped into the banks have been deposited back to the Central Banks as special reserves and not lent out. The velocity of circulation is, therefore, very low. However, even this increase in bank liquidity is not without effect. It makes banks more confident and engenders a more relaxed deployment of funds than would occur without quantitative easing – exactly as was intended by the policy. It also allows government spending to remain high for a time with no policy to bring the public finances under control.
It would be possible to envisage a ‘helicopter drop’ on a more widespread basis either to existing holders of money, the taxpayers, or to others such as benefit recipients. Of course, any ‘helicopter drop’ will not enhance the productive potential of the economy but would raise the level of prices with alterations in relative prices and consequent effects on distribution of resources. The idea of the ‘helicopter drop’ is, bluntly, that resources would be distributed to those who would spend – whether consumers or investors and away from savers. This creates a temporary consumption boom. The benefits of this are highly questionable when there has already been a previous great expansion of money and credit.
REVERSE CANTILLON EFFECTS
It is also important to consider what happens when the extra credit is withdrawn from the system – a reverse Cantillon effect which the central banks have promised to carry out.
Both Bob Bernanke and Mervyn King have promised to reverse quantitative easing, and also the increase in the monetary base, when conditions are right. But this will have reverse Cantillon effects.
As Bob Bernanke said in London, 13/1/09, ‘As lending programs are scaled back, the size of the Federal Reserve’s balance sheet will decline, implying a reduction in excess reserves and the monetary base.’
Bob Bernanke has laid out his exit strategy quite clearly at an address to the Federal Reserve Board Conference in October 2009 and has attached to his speech a very clear analysis of the liabilities and assets of the Federal Reserve and how he sees those changing. In particular, he had a section entitled ‘Exit Strategy’, ‘At some point, we will need to tighten monetary policy to prevent the emergence of an inflation problem down the road. Looking at the Federal Reserve’s balance sheet is useful, once again, in helping to understand key elements of the Federal Reserve’s exit strategy from its current policies [slide 7].’ In order to soak up the new money issued, it will be necessary to sell bonds to the financial markets and force the banks to return liquidity to the Central Bank where it will be destroyed. This will also reduce bank reserves, reduce credit and loans.
The withdrawal of this money from an economy is likely to produce severe pain.
One can doubt that all of the monetary stimulation will ever be withdrawn. Frankly, once the extra money gets out from the banks’ special reserves at the Central Banks, historically the quantity of money is never reduced to the pre-existing level. The pain of reducing prices from the new inflation induced level is just too hard for the Central Bank to contemplate.
SECOND REDISTRIBUTION OF INCOME
Reverse Cantillon effects, if effected in the same way in reverse as the cash injection, withdraw money first from those at the periphery who still face prices set by the new money and only later benefit from reduced prices. The Central Bank’s withdrawal is, of course, from the banks and the government but these institutions immediately transmit pressure to the periphery. As money is withdrawn from the periphery to the banks and only then from the banks to the Central Banks, the banks benefit again as they are the last to lose the money and can still use this in an economy with deflating prices.
The reduction of the quantity of money has just as widespread effects as the increase. The absolute price level is reduced but, once again, relative prices are altered.
Von Mises criticised the Fed’s deflation in 1938 just as much as he criticized its inflation in the 1920’s, ‘If a man has been hurt by being run over by an automobile, it is no remedy to let the car go back over him in the opposite direction.’
The provision of credit from Central Banks and its withdrawal will on both occasions result in a redistribution of income to those who are first to receive it and the last to give it up, that is, the government and the major banks and their suppliers, principally their employees and shareholders, who are closest to them.’
Where local government entities are not able to pass costs to taxpayers, they also have had to contract their spending. Thus one can see that, in California, state employees have had to accept a wage cut of 13.8 per cent while federal employees located in California have not suffered any wage cuts.
This may be what current policy intends, that is to transfer resources from others to the banking sector and the government, but it is the reverse of what should be the long term aim, resourcing manufacturing and consumers in the real economy.
Clearly the boom time level of credit, as created by fractional reserve banking, with low cash ratios, must contract substantially, and has done so.
At the same time, the long-term process of reducing government borrowing to zero or below with absolute reductions in wages and personnel throughout government and deflating the consumer debt bubble and repairing the credit markets needs a methodical strategy.
At present there is no plan to transfer some of the pain of recession to government or to entitlement holders in areas such as pensions, health, education, contributions to the EU, etc. A five-year plan should be announced to freeze these now and roll them back dramatically.
In the meantime, both the expansion and then proposed contraction of money transfers resources from the wider economy to those closest to the originating mechanism, that is, the government and the banks.
So, the end result is a shrunken real economy with an oversized government and banking sector.
FUTURUS/19 June 2010