Stealth Tax and the Money Tree

[This is a previously unpublished essay written by Sarel Oberholster in November 2004 but the subject matter of Basle accords and capital coefficients were considered not digestible fare for the readers of finance and investment essays. Perhaps this essay deserved to be published as it deals with the very reality that we are facing today. The content of this essay is even more relevant now in October 2008.]

Fractional Banking, the Money Multiplier and money creation by banks are economic concepts that need updating. Failing to do so will expose you to almost limitless taxation by stealth. Nothing is safe, not your income, or your wealth; even your pension is there for the taking.

Fractional banking is a derivative of the money multiplier theory, which works like this. A bank receives a deposit, which can then be recycled and multiplied throughout the banking sector subject to the “fraction” that a bank will or are obliged to retain as a “reserve” against withdrawals. Say the reserve is $10 out of $100, then the 1st deposit-receiving bank can lend out $90, the money recycles in the economy and ends up as a $90 deposit with the next bank who in turn will “reserve” $9 and lend out $81, ad infinitum until the fractions simply gets to small to matter. Not a complicated theory at all, only starting at the wrong place. The very 1st $100 is the only “money” the rest is simply an assumption about credit distribution. The multiplication may or may not happen. Of more importance is that the existence of “reserving” will act as a natural brake on the extent of credit distribution in any economy. This is the first area where updating is required.

The advent of a standardised worldwide approach towards bank supervision as new monetary policy embodied in the Basel Accords (Basel I – the 1988 Capital Accord and Basel II - 2001) have effectively superseded “reserving” as part of monetary policy. You can read up and find these accords at the BANK FOR INTERNATIONAL SETTLEMENTS, Basel Committee on Banking Supervision by following this link http://www.bis.org/bcbs/ . Implementation guidelines for the Basel II accord can be found at this link http://www.bis.org/publ/bcbs109.pdf .

These accords changed the focus of credit creation by banks as managed by central banks. All forms of credit and banking risks are graded (“risk weightings”) and banks are required to hold a prescribed percentage of capital against each class of risk. These are called capital co-efficients and banks must then comply with “Capital Adequacy Ratios”. It follows that capital adequacy ratios have taken over from fractional reserving as the limiting variable in credit creation by banks. The size of the reserving “fraction” has become so small such as to all but eliminate it as a brake on credit creation.

The new overarching credit creating policy variables are the Capital Adequacy Ratio from Central Bank Supervision over banks and Liquidity Accommodation to banks. First let’s look at Capital Adequacy.

The Capital Adequacy Ratio for banks under Basel II is generally targeted at 12% by 2005. This simply means that a bank’s capital must equal 12% of the sum of its risk exposures. A simplified example would be that a bank’s Capital Requirement would be $12 if it has advances of $100. It gets a bit more complicated with different “tiers” of capital and the fact that the $12 may also be lent out, but the fundamental principle of the example holds true irrespective. Risk weightings make up the sum of the risk exposures.

The risk weighting for standardised credit risks is 100% (the vast majority of all Bank lending other than residential mortgage lending, lending to government and public sector entities, and lending to other banks). This only means that the full 100% of the $12 shown in the above example will apply.

Special rules of “risk mitigation” apply to certain classes of loans made by banks. Residential mortgage advances of high quality can get risk weighted as low as at 35%. Again a simple process. $100 of these mortgages will get only 35% of the normal $12 Capital Requirement i.e. $4.20, which translates to almost 3 times as much Residential mortgage lending at the original $12 capital. Lending to governments can be as low a risk weighting as zero but normally would not exceed 10% as a risk weighting. That means banks can lend to government 10 times more than to anybody else, as a worst case scenario, but at a zero rating, banks can lend to government an unlimited amount. Hang on to this principle for it is part of a simple circular process to create unlimited government funding via the banking sector, for the Fed will supply the banks with all the “money” they need to advance to borrowers to complete the circle.

Armed with understanding the basics of Capital Adequacy, Risk Weightings and risk mitigation, facilitates understanding of the processes in place to distribute unlimited credit, or better known as unlimited debt. Banks are very capable in managing their capital needs to satisfy the capital adequacy requirements.

Banks do not actually create money. They distribute credit. Their ability to distribute credit used to be a function of the amount of deposits that they could attract. That was the next problem that stood in the way of limitless credit. This problem was solved through central bank “accommodation”, even before the advent of Basel I.

Banks are credit shops; they buy and sell credit. Banks operate on the basic principle of selling all qualifying credit on any given day and then try to balance the books at the end of the day. This they do by attracting deposits. They sell the excess, when deposits exceed their sales of credit, in the inter-bank market. Those banks experiencing a shortfall after exhausting all sources of deposits will access the inter-bank market for deposits. Obtaining a deposit from the central bank makes up a shortfall after exhausting the inter-bank market.

The process involved in obtaining such a deposit is normally described in complex technical language, but it remains just a deposit by the central bank at the bank with a shortfall. It is a structural given in the modern economy, that there will always be a daily shortage of available deposits. The shortage is made up by the central bank in terms of its liquidity policies towards the banks. The central banks would also penalise banks when they make use of this accommodation. Such penalties, hawkish or dovish, would be a function of prevailing monetary policy and will be expressed as an interest rate. Here, however, is the link in the chain; banks would normally need government securities as collateral to obtain accommodation, so banks will tend to hold fair volumes of government debt as “liquidity reserves”.

Think about it. Banks have no idea of exactly how much credit they will grant on any given day or what the level of withdrawals will be. So, a bank will not say, “lets see what deposits amount to for the day?” and then grant loans until the deposits have been used up. Any luckless, would be borrowers, would then have to wait until the next day to know if the bank managed to obtain enough deposits to grant them a loan. It just does not work that way. Banks sell credit first and then balance the books thereafter; there is no other way!

The economic and logical trap that creates the mirage of banks as money alchemists can be found in misinterpreting bank credit and fiat money as the same thing. They’re not. Every bank must balance its books every day. Credit sold must equal the sum of deposits taken, capital and central bank accommodation. It is no more complicated than that from a global perspective. The only money creation in this exercise is the accommodation by the Central Bank.

Here’s a sample from the Bank of Japan accommodation policy, where an “unlimited accommodation” policy has been in place for a long time. Available on the Home Page of the BOJ, by following this link, http://www.boj.or.jp/en/seisaku/04/pb/k041029_f.htm [this link has since been deactivated].

“[Monetary Policy Meetings]

October 29, 2004
Bank of Japan
(For immediate release)
________________________________________
At the Monetary Policy Meeting held today, the Bank of Japan decided, by unanimous vote, to set the following guideline for money market operations for the intermeeting period:
The Bank of Japan will conduct money market operations, aiming at the outstanding balance of current accounts held at the Bank at around 30 to 35 trillion yen.
Should there be a risk of financial market instability, such as a surge in liquidity demand, the Bank will provide more liquidity irrespective of the above target.”

The Central Bank is the only entity that can show a deposit to a bank on one side of its balance sheet and a “money” liability on the other side of its balance sheet. It is of no relevance for money creation how many debits or credits are created in the books of all the banks in the world on any given day. That is simply the turnover of banks. The end of day “accommodation” where central banks balance the books of banks is where the money creation happens. The existence of providers of credit beyond banks, such as Mortgage Lenders Freddie Mac and Fannie Mae, Corporate Finance entities such as used by GM and other “in-house banks” and large scale direct investments in securities from junk bonds to high quality mortgage securitisations have made the measurement of “money supply” in M2 and M3 susceptible to gross understatement of the actual “money creation” taking place. Credit derivatives, collateralised debt obligations and other exotic financial instruments, actively used by banks and other financial entities will not even appear on the radar. In the end it is better to follow trends in debt rather than the traditional money supply variables.

Large-scale stimulation of the economy through budget deficits (fiscal stimulation) and quantitative easing (monetary stimulation) would be expected to show up on the balance sheets of commercial banks as an increase in holdings of Government Securities. More so if overnight interest rates for banks are much lower than yields on Government Securities and the Fed promises lower rates for longer (the “carry trade”). It is therefore interesting to observe how holdings of U.S. Government Securities at all Commercial Banks [1] increased since the 1st quarter of 2001 with the recorded growth rate at 5.52% in Feb 2004 the highest growth rate in this series from its inception in Jan 1947. Observing this increase against the advent of the downturn in equities and subsequent recovery is most illuminating. The down trends in both Commercial Bank holdings of Government Securities and the DJIA may just be a very ominous signal. Note also a similar down tendency early in the first bear phase of the DJIA.





The explosive growth in purchases by banks of Government Securities is consistent with similar increases in the budget deficit, the trade deficit, mortgage debt, in fact almost all types of debt, all of which manifested in an equally stimulated aggregate demand, creating an illusion of a healthy growing economy.

The money tree belongs to the Central Banks and only them. They guard this power jealously. Banks cannot create money; they can only function as the conduit for the Central Bank’s credit stimulation policies, which in turn is derived from monetary policy as expressed by government. Ultimately all other financial intermediaries’ actions will be captured in the central bank accommodation provided to the banks. Knowing also that central banks can actually provide unlimited accommodation and banks just need to ensure capital adequacy, leads to understanding how an economy can be stimulated with unrelenting quantitative easing at any level of interest rates. Add to this the arrival of all new forms of electronic banking and internet banking, facilitating the distribution of credit in almost real time and you will get an idea of how efficient and dangerous debt stimulation has become. Finally add the fact that the Basel accords are being implemented right now all over the world, duplicating the quantitative easing/liquidity accommodation circle like an internet virus in every nook and canny of the world and then decide for yourself how concerned you should be.

Stealth tax is the name of every turn of the circle between quantitative easing and liquidity accommodation, stealth tax on your assets, stealth tax on your future income and even stealth tax on your children’s income and their children’s income. The “debt ceiling” of $7.4 trillion must be raised urgently, a couple more turns of the circle and US Congress will be asked to raise it again, and again, and again …

Sarel Oberholster
BCom (Cum Laude), CAIB (SA).
8 November 2004
E-mail – ccpt@iafrica.com

[1] Series USGSEC. Source: Board of Governors of the Federal Reserve System.

Economic Accounting

I often write about monetary policy because its abuse is behind the current woes of the world economy. It may create an impression that I recognise no fiscal implication so it is perhaps overdue to take a look at some economic accounting. We’ll keep it simple.

How does the “bailout with money from thin air” work?

In five simple steps:
1. Central Government raises a debt in the form of a government security (a bond, Treasury bill, etc.)
2. The Central Bank (FED) buys the security from the Central Government.
3. The Central Bank (FED) pays for the Central Government security with money that it does not have.
4. The Central Bank raises a monetary debt as a liability against the economy. (To be repaid with interest from taxes to be collected by Government.)
5. Central government uses the cash for “bailout” purposes.


Here is the accounting:

A) Central Government: - Credit bank account (Asset), debit loans (Liability).
B) Central Bank: - Credit Government Securities (Asset), debit money stock (Liability).


Here is a graphic representation:





The graphic representation shows the interaction between monetary policy and fiscal policy. The newly created “cash” is menacingly not neutral for the economy. It most certainly is not a reshuffling of resources or a redistribution of existing resources. It is an outright new FISCAL DEBT in the hands of Central Government to be repaid by taxpayers or future generations of taxpayers. It is a monetary dilution of economic value (pure monetary inflation) in the hands of the Monetary Authorities until it has been repaid from taxpayers’ money and then neutralised form monetarised debt. Meantime the Monetary Authorities can swap the new Government Securities for toxic banking assets.

The summarised logic behind the bailout is that the Stock Exchange losses of the Great Depression of 1929 resulted in a loss of money supply and to prevent the depression the Monetary Authorities have to “create cash out of thin air” to replace the loss of money from the system. The problem with this theory is that it ignores the pre-existence of a Babelian Tower of Debt built on reckless debt expansion supported by loose monetary policy. The pre-existence and collapse of the Babelian Tower of Debt is the true problem not the fact that the collapse of the Babelian Tower had left a gaping bad debt hole behind. How can the solution be to fill the hole with Government debt to be repaid by taxpayers, most of whom are already overextended in debt? The world had mercy on geese being force fed to produce enlarged livers, perhaps some mercy for debt force fed taxpayers would also be in order.

The solution to the debt problem cannot be found in adding Fiscal irresponsibility to Monetary irresponsibility. Nor is it wise to doom future generations to debt enslavement or endemic inflation in an irrational effort to sustain a collapsing Babelian Tower of Debt.

The expectation that “some inflation” will be good and will prevent a downturn is a fallacy. The very foundation for a depression is built upon the bailout activities. It spreads an ill in the financial sector, via irresponsible Government borrowing aimed at replacing a market proven unsustainable private debt load, to the healthy sectors of the economy. The banking bailout method even surpasses the debt enslavement of Keynesian infrastructure spending. At least the Keynesian method buys infrastructure with the debt and leaves future generations with the inherent infrastructural capital. The banking bailouts only buys bad debts, bad securities, loss making entities, exit strategies for stock exchange speculators, exit strategies for reckless executives and many more similarly dubious assets. What kind of a legacy does this leave behind for future generations who must repay the debt?

The markets must be allowed to clear and rebalance. Intervention should be restricted to policies that will allow the process of clearing and rebalancing to proceed in an orderly manner. Authorities should not reach for oppressive regulation to sustain the Babelian Tower of Debt nor should they be tempted to discount the labour of our children and grandchildren to save the reckless of yesterday.

Beware the danger should the “bailout cash from thin air” escape from the financial economy into the “real” economy. Why would it not, as there are no actual barriers between the “financial” economy and the “real” economy? The competing new money created from thin air will usurp the production surplus of the economy and drive us into depression. (1.)

Sarel Oberholster
BCom (Cum Laude), CAIB (SA)
October 2008



Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .

Please feel free to comment on this blog but let's be polite.


ooooOOOoooo



1. From “bailout” to Depression.


I have previously explained the process whereby the production surplus is removed through monetary excess from the economy in my essay “Praxeology of Commodity Pricing” published at this link http://sareloberholster.blogspot.com/2008_08_01_archive.html .


I reproduce an extract hereunder explaining the process whereby competitive new money skims the production surplus from the economy. Use the “bailout cash” as an input of competitive new money in Exhibit 3 to see how such an escape into the “real” economy could result in a depression where the participants to the “real” economy literally starve.



© Sarel Oberholster

Here is a simple static construct of a ten unit economy with ten units of money available to buy the oil. Thus one unit of money will buy one barrel of oil (price formation). The next step is to introduce motion into the static construct.

Farmer buys the ten barrels of oil, adds his labour and produces 20 units of grain. Farmer use 10 units of grain to feed himself and his family and sells 10 units of grain to Oil producer for 10 units money. Oil producer feeds himself and his family and uses his labour to produce another 10 barrels of Oil. This is now a perpetual and stable economic construct.


© Sarel Oberholster

Next we introduce a State as another economic participant. We do not give State the power to tax but we grant the power to create money. State uses this power and openly creates ten more units of money. State enters the economy with the new money and competes with the old money for the available ten barrels of oil.

The entry of State as an economic participant with new money has very significant consequences for the stable economic construct. First look at what happens to the static construct of Exhibit 1. We add the new money and observe the effect. We also make the assumption that State consumes the Oil for its own purposes (for example to make war or consuming it as a source of energy). The result is shown in Exhibit 3 [and Exhibit 4].


© Sarel Oberholster

The equilibrium in the economy has been disturbed. The presence of twenty units of money competing for the same ten barrels of oil has the effect of changing the price of oil from 1 unit of money to two units of money (100% inflation). State now receives 5 barrels of Oil for its 10 units of money while Farmer receives the other 5 units of Oil.

Who has won and who has lost? State has gained 5 barrels of Oil and walks away an outright winner. Oil producer still received all the money in the economy so perhaps Oil producer is no worse off, but we shall see. Farmer has clearly lost 5 barrels of Oil as Farmer held all the money when half the purchasing power of the total money in the economy was transferred to State through its action of creating 10 units of money. It is only when we assess the impact of State's money creation behaviour on the dynamic but stable economic construct that we see the extent of damage done to this very simple economy. State has managed to acquire the total production surplus in the economic construct through its money creation action.

The construct must remain constant but for the behaviour of State and the consequences thereof. State has created money and vested half the economic product on itself. The new money had competed on an equal footing with the existing money in the economy and has reduced the purchasing power of Farmer by half. Farmer can now only purchase half the production inputs (5 barrels of Oil) needed for his farming production. Farmer can only produce half the grain on half the production inputs. However, Farmer uses this half of his farm product to feed himself and his family and no longer has a surplus product (sellable grain) to sell to Oil producer. Pity Oil producer, holding all the money in the economy yet cannot buy any food. Oil producer will starve. Yet Farmer earns no money to purchase any Oil (production inputs) from Oil producer for the next production cycle and will therefore starve when the next production cycle arrives. See Exhibit 4 hereunder.


© Sarel Oberholster

Two Rules

The sport of kings they call it. Horseracing. Perhaps not so well known is the two rules that form the foundation for this industry.

o Thou shall not race with any horse other than a stud horse; and
o Thou shall not bred stud racing horses with artificial insemination.

Consider the consequences of these two rules. Nobody but the owners of stud horses may race their horses, means that the supply of eligible horses is monopolised within a small group. Thus the price of a thoroughbred racing horse would be vastly more that the price a “farm” horse which may in fact be faster that the racing horse. Clearly the speed of the “racing horse” is not the first priority as one would have expected in a sport which race horses. Note how these two rules are Siamese twins. The one is useless without the other.

Limiting the supply of stud animals by banning artificial insemination further enforces the monopoly. Normal scientific livestock management would require that the quality of the herd be maximised and the gene pool be managed. Artificial insemination plays a pivotal role in managing the quality of the herd. Again the rule against artificial insemination has an objective which is diametrically opposed to breeding the fastest race horse.

It is clear that these rules are designed to sustain an artificial market and an artificial industry. Fundamental to the two rules are price control and as with all price control rules, quantity control. The consequences are limited in its impact as few are the economically active participants in this industry relative to the total world economy.

Much more menacing are the two rules for money.

o The government shall decide the interest rate, the price of money; and
o The government shall decide the supply of money.

Would you dare to consider the consequences of these two rules? The normal practice in all markets is to discover the price of anything through the process of negotiation between willing buyers and willing sellers. Note the plural. This is a collective process, more collective, inclusive and honest than any collectivism proposed by interventionists. How is it that a few persons around a table can decide what the rate of interest should be? Totally ignoring the process of price discovery. As with the racing industry, ignoring the fundamental purpose of interest rates. Why is it at all a surprise that a credit bubble is fermented and a credit collapse is achieved. What happened to the principle that the interest rate is a reflection of the credit risk? All gone in total artificiality. I need to repeat this; all interest rates derived from a government decided “Target Rate” is fake.

The next rule is even scarier. The sole right to print money. How easy it has become for politicians to propose a “plan”, any plan, which requires money without having to discuss where the “money” would come from. When government has an emergency, real or perceived, and it has no money to pay for it, this is the answer. Create the money. This is an option only available to government. It is not without consequences but I have often written about those. Underlying everything is the total disconnect with reality inherent to these two rules. Again they are Siamese twins. The one without the other is ineffective as the economic consequences are direct and decisive when only one is deployed.

Together these two rules can build a massive artificial economy. The economic particle accelerator stuffed with abuse of these two rules produce a credit explosion. The credit explosion touches every part of the economy and spread the artificiality like a plague through the whole system. The uncontained structural distortion achieves the unthinkable result of systemic failure.

The only solution to preventing a perpetual cycle of systemic failures is the removal from the power of government of at least one of these two rules. Accelerating the abuse of these two rules will not fix the systemic failure. It will only make it worse.

Sarel Oberholster
BCom (Cum Laude), CAIB(SA).
October 2008

Please email me at ccpt@iafrica.com with any comments. More links and essays can be found on my blog at http://sareloberholster.blogspot.com/ .


© Sarel Oberholster