BIS Report Introduction: the unsustainable has run its course

From page 4:

" What has been happening: a description

Over the last two decades, much seems to have gone right in the global
economy. Inflation has been maintained at very low levels almost everywhere
and, until recently, was showing remarkable stability. At the same time, growth
has generally been high, with that in the last four years being the fastest on
record. Along with these features, economic downturns in the advanced
industrial economies have been so shallow since the early 1980s that they
gave rise to the accolade “the Great Moderation”. Moreover, the fact that the
advanced industrial countries had proven so resilient to recurrent episodes
of stress in financial markets was hailed as a further indicator of better
functioning economies. In particular, the maintenance of low inflation by
credible central banks was seen to have played a crucial stabilising role
throughout most of the industrial world.

Yet the very mention of financial shocks leads on to two less reassuring
questions. The first is why both the frequency and the magnitude of such
episodes of financial stress seem to have risen. And the second, sparked in
particular by the events surrounding the distressed hedge fund LTCM in 1998,
is whether the centre of the global financial system might eventually prove as
vulnerable as the periphery. The events of the past year have demonstrated
that these causes for concern are not misplaced.

The financial turmoil began in the market for US subprime mortgages, and
the markets for structured products based on them. Delinquency rates in the
subprime market had started to rise in early 2005, almost contemporaneously
with outright declines in house prices, but there was no significant market
response to this development until early 2007. Credit spreads on such
products then began to widen, rating downgrades increased, and the process
accelerated sharply in August. The trigger, as already mentioned, was the
decision by a small number of investment funds to freeze redemptions, citing
an inability to value their complex assets. From this small beginning, the
financial disruption then fanned out to virtually every corner of the system."

Any comments from an Austrian Economist's view point, especially the underlined?

Fiat debt-based money has a fundamental structural flaw that guarantees periodic crises.  This is the Compound Interest Paradox.  That isn't technically part of Austrian economics, but closely related.

fsk:

Fiat debt-based money has a fundamental structural flaw that guarantees periodic crises.  This is the Compound Interest Paradox.  That isn't technically part of Austrian economics, but closely related.

There is no compound interest paradox inherent in the system. If we're in an economy of two (you and me) and you have all the money (say $10) and you lend me $5 at $1 interest, I now have $5 but I have to give you back $6. If I give you a haircut and charge you $1 for it then I'll have the $6 that I owe you, and so I can pay you back the $6 that I owe you.

The only prerequisite for the system to be stable is that the bankers have to buy enough goods and services from the economy to cover the interest that they're charging. So effectively those borrowing money pay off their interest in the form of goods and services that they provide to the bankers (which makes sense).

If (and only if) the only money that ever gets injected into the system by the bankers is in the form of credit/loans and they never buy any goods or services  from the rest of the economy then yes, a certain percentage of people will eventually have to go bankrupt. Similarly, if the only money that central banks ever inject into the system as reserves is in the form of credit/loans then the commercial banks are eventually going to hit a mathematical wall and some of them are going to have to go bust - so the central bank must at some stage buy real assets from the economy. However, this is completely within the mandate of the Fed (for example)...

One small caveat in all of this is that gold can still be used as reserves, so even if the central bank doesn't inject hard non debt based reserves into the system, it might be technically possible to scrapt through by digging more gold out of the ground. However, from what I recall, the central bank still keeps all the gold reserves that it holds on it's books at $43 and oz. - which makes it incredibly difficult for the commercial banks to increase their reserves in this way.

The argument "The banker has to pay his expenses" only applies to a gold standard in a free market.  Fiat debt-based money is different.

In the present, the Compound Interest Paradox operates with the full force of law.  Here are some examples of the Compound Interest Paradox in action.

Hm, well I didn't really see anything in those examples that added anything to the argument. It's just a rather detailed explanation of the overall concerns - very well explained, to be sure.

However surely you see that the "banker has to pay his expenses" argument applies equally to the central bank with regards to commercial bank loans as long as the central bank injects enough money into the system in the same way that the "banker paying his expenses does" - which is to say, money that is not injected in the form of a loan (or debt)? And the Federal Reservere in the US has a full legal mandate to do just that, if they choose to do so (they can buy eggs and milk, if they like). So the paradox is only "inherent in the system" to the extent that the Fed refuses to exercise these powers.

In other countries it's a completely different story. In New Zealand, for example, the central bank is not even partially privately owned (as the Fed is) - and "profits" that the central bank makes on interest that it charges get lumped into the government's balance sheets at the end of the year. In such a system, the government can use those profits (i.e. interest payments) to buy stuff in the economy - such as paying the wages of government employees... so every thing balances out just fine.

None the less, the practice of central and fractional reserve banking in general does not contain any inherent paradoxes (although involves a fair amount of redistribution of wealth) and if the US system ever breaks down because the central bank is not willing to inject non-debt based forms of liquidity into the system then that would be a problem with central bank policy, not with current central banking law or any of the "rules of the system".

hsofiak:

Yet the very mention of financial shocks leads on to two less reassuring
questions. The first is why both the frequency and the magnitude of such
episodes of financial stress seem to have risen. And the second, sparked in
particular by the events surrounding the distressed hedge fund LTCM in 1998,
is whether the centre of the global financial system might eventually prove as
vulnerable as the periphery. The events of the past year have demonstrated
that these causes for concern are not misplaced.

My personal POV (for what it's worth) is that if the regularity of these episodes has increased then it is because government and central banking policy over the past two decades has focused on treating symptoms rather than causes. They have not attempted to correct underlying malinvestment, but have tried to "fix" it... usually by doing exactly the wrong thing. Rather than increase interest rates, because they have high inflation, they change the way they calculate inflation. Rather than let the housing crash run it's course, they try to bring in government programs to keep housing prices high or have the government guarantee or subsidize people's mortgages or any number of hair brained schemes all designed to avoid a housing crash (none of which acknowledges the Austrian view that a housing crash is in fact just another way of saying a "correction" in the housing market).

As to the magnitude of the crashes, here again I'd say it's because they're treating symptoms... They try to avoid widescale bankruptcies and defaults by pumping yet more money into the system - but the absence of paper money is not the problem. The whole reason there is an anormal number of bankruptcies and defaults in the pipeline is because the system has become unbalanced (and the ABCT can explain why very adequately). What is required is to remove those forces which are unbalancing the system - i.e. the forces of inflation and credit creation... which is to say, what is required is that they do exactly the opposite of what they are doing currently.

But then, I'm no Rothbard or Mises, so perhaps I'm just not getting something here.

fsk:

Fiat debt-based money has a fundamental structural flaw that guarantees periodic crises.  This is the Compound Interest Paradox.  That isn't technically part of Austrian economics, but closely related.

I seem to recall refuting the Compound Interest Paradox a while back using the basic theories of Austrian economics.

Too lazy to do it again though.

Anonymous Coward:

fsk:

Fiat debt-based money has a fundamental structural flaw that guarantees periodic crises.  This is the Compound Interest Paradox.  That isn't technically part of Austrian economics, but closely related.

I seem to recall refuting the Compound Interest Paradox a while back using the basic theories of Austrian economics.

Too lazy to do it again though.

Then perhaps you can be so kind as to supply a link to said refutation?

Solid_Choke:

Then perhaps you can be so kind as to supply a link to said refutation?

Yeah, too lazy to do that also.

Anonymous Coward:

Solid_Choke:

Then perhaps you can be so kind as to supply a link to said refutation?

Yeah, too lazy to do that also.

I don't see any refutation there.  I see the incoherent babbling of someone who doesn't understand how the US monetary system works.

I'm always amused when people say "I refuted your argument, but I refuse to provide any details."

When the Federal Reserve "monetizes the debt", it only creates the principal and not the interest payments.

Did you address the points I raised in my page of examples?

That's one advantage of having your own blog.  I write articles on the most common subjects, and can provide a link instead of repeating myself in full detail.

fsk:

I don't see any refutation there.  I see the incoherent babbling of someone who doesn't understand how the US monetary system works.

I'm always amused when people say "I refuted your argument, but I refuse to provide any details."

When the Federal Reserve "monetizes the debt", it only creates the principal and not the interest payments.

Did you address the points I raised in my page of examples?

That's one advantage of having your own blog.  I write articles on the most common subjects, and can provide a link instead of repeating myself in full detail.

Oh, that's just nice...It's always a good policy to start off with an ad hominem.

Would've been easier to save yourself some typing and just link to 'There are some propaganda artists on the Internet who say "There's no such thing as the Debt Virus."'

But anyway, I see nothing in your blog that addresses my 'incoherent babble' demonstrating how you assume that the economy is a zero-sum game, or at least I think that was my claim since I don't 'understand how the US monetary system works' so could be claiming anything really.

Please, dear sir, put me in my place for challenging your pet theory with something other than claims to authoritism since you 'have your own blog'. Yes, indeed, I know all the fallacies...

lol. I guess one of the troubles with writing a blog is that you invest a lot of time building complex theories that you get quite emotionally attached to... ways of seeing the world. And if anyone attempts to criticize the arguments or claim there's a mistake in your reasoning somewhere, you tend to get a bit defensive because accepting their point of view would require a full head over heals revision of how you see the world.

fsk, I see what you're saying. But have you understood my criticism of your argument yet? Do you see that the Fed can buy milk and potatos or any assets they like from the market, if they want (with money they create out of thin air) and so there is no paradox inherent in the banking system itself.

I realize full well that in the case of the Fed in particular, 90% of open market operations concern US treasuries, and so in reality the Fed rarely injects non-debt based money into the market. I think their reasoning for doing this is that once the money is out there they can't take it back - debt is more flexible (it can be created and destroyed as required - although one has to note a distinct inclination on the part of the Fed to merely create)... Since the private shareholders of the Fed pull out 6% of the "profits" each year for their personal expenditure (which is money that gets injected back into the system) and the rest goes into the Federal government's budget (to balance some of their debt, which is essentially more money they've pumped into the system) I think you'll find there is no paradox in the system itself.

I think it's complex (even intentionally convoluted, I'd argue) but I can't see any reason that the system is not sustainable in a mathematical sense... Jesus Huerta de Soto would argue that the socialist nature of the central banking system makes it unsusstainable long term for other reasons. Hopefully we'll live to see the day that he proves to be correct.

I have attained the ability to see the world more clearly than most, so I'm now "emotionally attached" to the truth.  If you believe "truth is relative", then the actual truth is just one of many possible viewpoints.

The Compound Interest Paradox is one of my favorite ideas, but it's also true.

Yes, the Federal Reserve may buy any assets they choose.  Whenever the Federal Reserve purchases assets, it's via "repurchase agreements", or agreements to pay $X immediately and receive $Y later (where Y>X).  Such payments are the essence of the Compound Interest Paradox, because $(Y-X) was never created, ever.  No matter how many times you aggregate such transactions, you cannot escape.  You can't add minuses to get a plus.

The Federal Reserve can "take back" money by raising interest rates.  Then, fewer new loans are issued and cash drains out of the economy as more loans are repaid than made.  This is the essential point of the Compound Interest Paradox.  By manipulating interest rates, the Federal Reserve scientifically creates recessions.

The system can survive indefinitely, but it needs continuous inflation in order to survive.  Historically, every fiat monetary system ends in hyperinflation, and the US dollar is nearing its end.  At some point, people will start getting disgusted by excessive inflation and start using sound money instead.

On another website, someone famously said "Some people just don't get pointer arithmetic, no matter how hard they try."  Similarly, some people just don't get the Compound Interest Paradox, no matter how hard they try.  Some people just can't understand "Taxation is theft!" and realize that it's possible to have a stable civilization without a monopolistic government.

When I say "Anonymous Coward is stupid/stubborn/trolling", it's not ad hominem.  It's true.  However, truth is relative, so when I say "Anonymous Coward is wrong", he may claim the moral high ground, becuase most people believe truth is relative and there's no such thing as absolute truth.  All opinions should be respected, including stupid ones.

I don't claim authority because I have my own blog.  I claim authority because my line of reasoning is correct.

I know I'm not going to convince "Anonymous Coward", because he's a professional troll or paid disinformation agent.  I've seen enough of them to recognize the pattern.  If spreading disinformation is your full-time job, it's very easy to create multiple online personalities and make sure sensible discussions degenerate into flamewars.  However, I do hope to convince other people who read this thread.

Anyway, I'm not going to convince "Anonymous Coward" that the Compound Interest Paradox is true and he isn't going to convince me it's false.  I'm confident in my research and analysis.

fsk:

I have attained the ability to see the world more clearly than most, so I'm now "emotionally attached" to the truth.

Oh, my... You should probably add the ability to recognize fallacious arguments to your superior knowledge of the world.

fsk:

I know I'm not going to convince "Anonymous Coward", because he's a professional troll or paid disinformation agent.  I've seen enough of them to recognize the pattern.  If spreading disinformation is your full-time job, it's very easy to create multiple online personalities and make sure sensible discussions degenerate into flamewars.  However, I do hope to convince other people who read this thread.

Don't I wish, probably pay a lot better than the crappy job I'm doing now. I just wish these people who like to claim I'm an astroturfer would give me a pointer to an actual paid position since it appears that I would be pretty good at it.

So instead of addressing the points raised you just claim 'superior knowledge' and make grand statements that we are just incapable of understanding your theory because of lack of intellectual abilities? And you call me a troll?

Well not today at least.

You may have noticed that in my post in the other thread that I openly admitted that I may be wrong and most would take this as an invitation to show me the flaws in my argument. And no, 'incoherent babble' isn't a valid counter argument.

As I have read over (most of) your supporting links and didn't see my concerns addressed in any way I would say that I have posed a valid question. The only thing I can assume from your red herring counter argument is that I'm either correct or that you are incapable of applying the capital/time theory that is the cornerstone of Austrian economics to your 'Debt Virus' theory and as such your line of reasoning is not in fact correct.

Never thought I would be accused of being a troll for spouting off Austrian economic theory on the Mises Instutute forum...

fsk:

Yes, the Federal Reserve may buy any assets they choose.  Whenever the Federal Reserve purchases assets, it's via "repurchase agreements", or agreements to pay $X immediately and receive $Y later (where Y>X).  Such payments are the essence of the Compound Interest Paradox, because $(Y-X) was never created, ever.  No matter how many times you aggregate such transactions, you cannot escape.  You can't add minuses to get a plus.

I think you've failed to see my point yet again. You've given two examples of debt based injections of money into the system. But as I keep repeating, the Fed has a mandate to buy all and any assets it likes from the market. If it wants, it can buy potatos. Buying potatos would not be a loan, credit or debt... it would be a permanent injection of cash into the system that could be used to pay of interest in exactly the same way as a banker might inject money into the commercial markets by getting a haircut (and paying his hairdresser cash, with no requirements to pay interest on that cash).

In reality, the Fed doesn't purchase many potatos. Instead they prefer to inject credit or debt into the system (by buying treasuries or by way of the repurchase agreements that you mentioned etc.). But they are not limited to doing this - it is merely what they decide to do as a matter of choice... The trouble is, if they inject non debt based forms of money the banks tend to multiply it out (by way of FRB) and you get even greater inflation - only in this second instance it's inflation that the Fed is then incapable of reining in.

The other aspect of the system (that I'm not too clear about myself, to be honest) is what happens to the Fed's profits. My understanding is that 6% of these go to the shareholders of the Fed (guys like JP Morgan and Chase Manhattan - i.e. Rothschild) and the rest gets incorporated into the Federal budget... so it's not like the interest payments that must be made go into a vacuum - these get injected back into the system by way of the personal expenditure of the banks that receive the 6% and by way of the public spending of the federal entities that get to lump those funds into their balance sheets.

If it is as I understand it (as explained above) then the only really terrible effect of this whole complicated mess is exactly what you mentioned - inflation... and that's a kiler to be sure - it's plain theft, with the kicker that it unbalances what is produced with respect to what is demanded by effectively subsidising those industries that are the primary recipients of the new cash that's created by way of inflation.

So whilst I agree that inflation is theft and that the central banking system exists primarily to orchestrate and control one giant inflation machine, I'm not sure I agree that there is any paradox with respect to interest payments. All interest can (theoretically) be paid - but you'd still have inflation running in almost direct proportion to the quantity of reserves injected by the central bank.

I don't think a lack of money to pay interest will be the primary problem facing the US economy in the years ahead though. As the US dollar continues to weaken (because of a structurally weak economy) plenty of US bank notes are going to come flooding back into the system from overseas. The problem will be that you won't be able to buy much with those bank notes. I think there are sufficient notes in Zimbabwe for people to pay back the interest on loans from the banks. The trouble is, Zimbabwe as a whole can't print enough notes to pay the rest of the world, because noone wants their notes. Fundamentally what is wrong with the Zimbabwean economy is a lack of production - which was brought about by inflation (distorting normal production processes) and direct destruction of property rights (confiscation etc.). A lack of production, with respect to consumption, is exactly the problem that the US faces today as well and, once again, this cannot be changed by merely printing more notes - that will only excacerbate the problem. It's not an interest paradox which will bring down the system - it's real production and real consumption of physical goods which will bring down the system. Although inflation could certainly have contributed to bringing about such a circumstance in the first place.