How QE works

Various commentators are saying that Europe’s QE won’t work, or QE in general doesn’t work because it just boosts the value of assets. Increasing the reserves of banks, critics say, doesn’t cause banks to lend money to the real economy.

That’s irrelevant. QE is not supposed to make banks lend more money. Banks don’t need reserves to lend money, or rather it works the other way. Banks lend money if there’s demand for loans, and then ask for reserves which are always given.

What QE does is indeed to boost asset prices. Central banks buy bonds, people who sold the bonds buy stocks, stocks go up in value. Or people who sold the bonds spend money, money ends up in company profits, stocks go up in value.

And this how QE works. What happens when stocks go up in value? Companies expand and hire more people. What happens when stocks fall in value? They cut costs and lay off people. When stocks rise in value pension funds are wealthy. When they fall, poor.

In our imperfect system QE is a blunt instrument that makes rich people richer while boosting the economy. The problem, though, is with concentration of financial wealth, not with QE.

On Bitcoin

My thoughts on Bitcoin, originally a comment here: http://rwer.wordpress.com/2014/03/22/bitcoins/

Bitcoins are virtual gold, or maybe palladium. The have low use value, high scarcity, can’t be forged, and aren’t controlled by any government. They’re clearly designed to facilitate payments and store value. People aren’t obliged to accept them, but they do so voluntarily. Very few real-world vendors accept Bitcoins, making their use value low and uncertain, but the speculation is that acceptance will grow making them valuable. Currently they’re like an obscure precious metal, say palladium. Proponents hope they’ll become mainstream like gold, silver, money.

So are they money? They’re clearly an attempt at commodity money, like gold. Let’s assume the proponents/speculators are correct and they achieve broader acceptance. What are the implications?

The three faces of capitalism

There are three activities that a capitalist firm does. Every firm engages in all three at different times, but the balance and the timing bring about radically different outcomes: Financially, in immediate human welfare, for development, and morally. I therefore call these the three faces of capitalism.

• Capital formation:In capital formation the firm consumes financial assets (usually cash) and builds real assets that it will later use for production or extraction. Capital formation thus takes two forms:
  • Productive capital formation, such as technical innovation, the building of customer relationships and goodwill, channels to market, facilities or machinery, organizational and human capital.
  • Extractive capital formation, such as the acquisition of monopoly licenses or exclusivities, financial muscle, commodity stocks, control over suppliers or distributors, land, and all IP assets.
• Production: Production is what an industrial, agricultural, or service firm does. Resources come in, labor and and devices are applied, and goods or services come out. The goal of production is to sell the goods or services at a profit, while minimising the share paid to suppliers and labor, and the running cost of devices.
• Extraction: Extraction is what a landlord, bank, media company, utility, mining company, or retailer does. These firms have a productive function, but their dominant mode of business is to extract rents from assets that they own, while rationing those assets so as to command the maximum price.

The companies that people admire, Google, Apple, the great electrical and electronic firms, the venerable auto and aviation firms, the computer companies, the large and small software houses, big infrastructure, big science, universities, and medicine are all admired because of their productive capital formation: R&D, innovation, bright ideas, making what previously didn’t exist or wasn’t possible. Productive capital is seen as a beacon of hope and progress for humanity, and great store is set by it wittingly or unwittingly.

The need to reform money

I’m not happy with this post. I tried to mix some rather speculative economic thinking with an attempt to explain to a wide audience, and it doesn’t work. I’ll rewrite it as geeky economic article.

The asset bubble that started in the late 1990s and exploded in 2007 as the financial crisis was caused, in my opinion, by our monetary system. In particular, the following cycle took place:

1. The general public in western, mainly Anglo-Saxon, economies started using real estate as hard money, profiting from its parasitic appreciation linked to GDP growth. The real economy deflated against housing.
2. Banks issued new money backed by the rising real estate. This broke monetary policy by expanding the money supply first as intended but then beyond, as banks used securitized debt to evade regulation and recycle their license to create money and use it as their capital.
3. A positive feedback loop developed, where appreciating houses led to banks issuing more money, which led to inflation of money against housing. The market responded by raising house prices further, until both housing and housing-backed money crashed.

The system of money used by western economies, although no secret, is not widely understood by the public. I’ll explain how our monetary system works, how it caused the crisis, and how it ought to be reformed in principle. Obviously I have no tried and tested new system to propose, but I’ll try to articulate what new conditions it should meet.

Hard money and its parasitic appreciation on GDP

The traditional conception of money is as a fixed quantity, such as a ton of gold. It changes hands, and some people hoard it, but it doesn’t grow or shrink. That way the value of goods can settle against gold through the market. This “hard money” concept served well for most of history because the size of the real economy didn’t change much either. In a static economy, a gold coin buys a sack of wheat, say, now or in a hundred years. Using gold does nothing to erode inequality, but doesn’t amplify it either. Sitting on gold yields zero return, so any productive investment whose risk-adjusted real return is above zero beats that, and will probably get funded.

The three-phase crisis cycle

We’re in the third phase of the financial crisis that peaked in 2008. The events of 2007-2009, which are generally called “The Crisis”, were only phase two. The three phases are:

• Phase One: The bubble. Creation of false assets by financial capital, mostly banks and smaller players in the property market. These assets have a nominal value way in excess of their real earnings potential, and that gap in value is hidden.
• Phase Two: The stall. Transfer of the deficit of those assets to state balance sheets under emergency conditions. Private insolvency becomes state liability, while the gap between nominal and real wealth remains outstanding and is now visible.
• Phase Three: The payback. Closing of the gap by a transfer of funds from the public to states. This may be achieved by means such as austerity, taxation, write-off, default, or inflation. These different options hurt or benefit different groups.

We’re in phase three, and the reason we have austerity in most of the west is that austerity is the method capital wants to see used to resolve the gap. Using austerity in the payback phase serves to consolidate the gains that capital made in phase one, such that the whole cycle is a transfer of real funds from the general public to capital. Austerity is the “hard money” way to close the cycle. It’s the only way to close it that refuses to accept nominal losses.

Using inflation (by printing money), taxation of capital gains, debt write-off, or controlled default would allow the valuation gap to close by eroding rather than consolidating the nominal gains made in the bubble phase. These options wouldn’t be clean but they would be fairer and less destructive of the real economy. These options are very unfriendly to capital, so they’re absent from politics. The US Fed is using a small amount of inflation, presumably to reduce damage to the real economy, while the fabulously independent European Central Bank insists on a hard Euro and austerity. The ECB is working as intended, since the whole point of an independent central bank is to avoid taxation of capital in situations like this. On the whole, present monetary policy is strongly in favor of wealth and capital and against social cohesion or development.