Saturday, January 24, 2009

Solutions For A Paradigm Shift

I often take flak from readers in the comments section of my blog or in personal e-mails about being unfair in my criticism of modern day monetary policy and of policy makers in general. Often, the critics suggest that if I feel what is being done is so idiotic, perhaps I should put forth my own solutions. Kind of like a heckled baseball player suggesting the fans try and hit that pitcher's four-seam.

Well, no. Not really. That's a bad analogy. Bad, because the game I'm playing is different from those currently making decisions. I don't believe government can conceivably "fix" the economy because I don't believe in centrally planned economies. I don't believe a government can actually "create" anything - it can only displace "creation" from somewhere else or borrow it from the future.

Therein lies the problem. The entire structure of our economy was unsustainable. It was based on a belief that we could borrow infinitely from the future, yet not expect to one day bear the consequences. Yet thus far, all proposed solutions offer nothing that rejects this most unrealistic paradigm, and attempts to replace it with something else. All proposed solutions offer only the "hope" that we can return to this unrealistic paradigm. Separate from my belief that a return to this paradigm is undesirable, is my belief that it is unobtainable. Unobtainable because of the irreparable damage done to the collective psychologies of those involved in carrying it out. Also unobtainable because of a demographic situation in offending economies that will be seeing a smaller generation (Millenials) needing to take over from the productivity of a much larger generation (Boomers).

If a resuscitation of this old paradigm were to occur, two things would need to happen: a) younger generations would need to be re-convinced of the merits of going into debt (ie. a materialist "gotta have it now" mentality); and b) they would need to take on an even higher proportion of debt than their parents as a function of their smaller size.

Neither of those things are even remotely possible.

A legitimate solution needs to address the inconvenient truth that the old paradigm is not coming back. For the 97% (or thereabouts) of people who have been left with the short end of the stick throughout this giant experiment, this should bring no anguish. However, most people's major source of information (mass media, corporate advertising, politicians) happen to be among the 3% that benefited greatly from the common person's plight. Hence, any notions that the old paradigm be replaced are met with the fiercest of fear-mongering propaganda one could imagine. I suppose if I had a way of legally stealing from others, I would defend it also. But alas, I don't.

For starters, these proposals are to be considered global in nature. However, as the US still enjoys the benefit of issuing the world's reserve currency, I am sure that if they were to be pro-active, others would soon follow.

1. Address the way banks do business. The current system of lending money into existence is a broken one. If depositors cannot trust their bank to look after their deposit, the banking system will always be dysfunctional, and the economy will be prone to periodic panics of confidence. Instead, banks should be required by law to keep 100% reserve ratios at all times on any demand deposit and it's equivalents. Doing this would eliminate the need for government deposit insurance and it's resultant moral hazard implications. Banks would go back to making money the way they used to: lending money at a slightly higher rate than they pay in interest on deposits and through service charges. The need for tight regulatory control would be non-existent. Of course, banks would protest this vehemently because it would take away their oligopolistic control. Nearly anyone with a fair amount of savings would be able to set up a neighborhood bank and operate it at a legitimate profit.

2. Repeal all laws granting government a monopoly over determining and issuing currency. The logical offshoot of this is that the market would naturally return to a gold standard as it has countless times throughout history. But that should not exclude other assets from being exchangeable as well. In fact, with today's technological advancements, there should be nothing stopping a multiple currency system of banking. Land banks, grain banks, metal banks, and others would inevitably pop up. People could just as easily pay for a new suit with bushels of wheat as they do with paper money, because everything is done electronically. Employers and employees could agree on payment by any number of "currencies." The reason a barter economy was always considered inefficient was because it was impractical for the farmer to bring 20 bushels of wheat to the tailor as payment for his suit. We now have the technology to make that practical. If the tailor doesn't want wheat, but instead wants gold, he can immediately make that conversion on the open market. Either that or the buyer can do so prior to the transaction. As long as it is ensured by law that banks keep 100% reserves of whatever currency they say they have, such a system would be more resilient to panics than the world has ever experienced. It also need not hinder the advantages of an efficient division of labour.

3. The implementation of the prior two ideas would render the need for a "lender of last resort" as redundant. The current justification of a Central Bank is twofold: to prevent banking panics by providing weak banks with access to capital if depositors were to stage a "run" on the bank in question, and to also "smooth" the business cycle by manipulating the rate of interest. I don't agree with either. As we can see, increased banking stability nor a smoothing of the business cycle has been achieved. In fact, I argue that the moral hazard implications of banks knowing they will be backstopped actually create what they try to prevent. And I argue that manipulating the rate of interest creates malinvestment, which serves to accentuate the business cycle rather than suppress it. With the central banks out of the way, the market would be left to determine the appropriate rate of interest based on it's perception of risk in lending to businesses or individuals. Because banking will have returned to it's rightful role as a small, local operation, the rate of interest can adjust to the fluctuations of the local economy. Gone will be the problem of trying to find a flat rate of interest for an economy as large and as diverse as the US or Canada. Individual lenders and individual borrowers will set a rate of interest on their own. The way it was always meant to be.

A common theme to the above suggestions is a discriminatory reduction in the role of government in the economy. Government's role as the "stabilizer" of an unruly free-market has been proven as fallacious. No amount of regulatory control or monopolistic decree has has had any such stabilizing effect. In fact, the current crisis shows us that it has done the exact opposite.

Above is a graph of US government expenditures as a percentage of GDP over the last two centuries. Can anyone tell me what this massive increase has achieved? Other than a debt that can never be paid, a mountain of still unfunded promises in the form of social security/health care, and a legion of aggravated foreigners? The same can be said about most other major economies. The overall size of government has been shrinking in Canada, yet the starting point was much higher.

Did the lack of big government in 19th century US hinder an increase in the standard of living? Quite the opposite. Going back to that traditional role will not have the disastrous consequences trumpeted by the few who benefit from this current paradigm.

In addition to the above suggestions and the subsequent reduction in the size of government, a number of other positive consequences would naturally result:

4. The elimination of the federal income tax. The role of this tax varies greatly depending on each individual country. But to be sure, it's implementation in the United States (1916) and Canada (1917) were originally considered temporary as a means to pay for the Great War. They were never repealed, and as can be seen from the chart above, they fueled an enormous expansion of government. This is not to say all taxes can be eliminated. But a large chunk of the most punitive ones can be either drastically reduced or repealed entirely. Government would still be able to fund it's defense obligations (assuming a non-interventionist foreign policy), basic emergency services, and implementation of justice via it's other various income streams. The benefits of a lower income tax are obvious. Increased incentives to work, thereby boosting productivity. Combining this with an open competitive currency system, people would have the incentive to work longer hours or multiple jobs, but as a result of their increased productivity they would likely be able to obtain a higher quality of life by working less.

5. A new social morality. A new precedent would be set by the implementation of the above. Confiscation of one person's property would be seen as immoral no matter who does it. If government cannot get away with counterfeiting currency (currently done under the guise of "monetary policy"), even less justification can be found for private citizens to attempt the same. "Trust" will be restored to society. Instead of the suspicion that is bred by having someone's hand constantly in your pocket, we will be more inclined to "love thy neighbor." This new social conscience is a far cry from the paradigm we have lived through recently. Government's rampant inflationary policies have been the lifeblood of society's greed and materialism. The knowledge that your purchasing power will become greatly reduced naturally disincentivizes people from responsible social behavior and encourages debt accumulation and a gambling mentality. Disagree? I've got evidence: Exhibit A. Exhibit B. I rest my case.

Admittedly, on the surface, much of the above seems quite far-fetched. Paying for your clothes with electronic grains? No income taxes? No Central Bank? No more obnoxious music videos? But think about it. If you tried to explain our current system to people 120 years ago, they would laugh with incredulity.

The remaining task is to determine a logistical way to fairly implement this shift. In my opinion, it is not a matter of if we experience a paradigm shift. The question is how it will happen. Through chaos or through order. The old paradigm is not revivable, as discussed earlier. By not addressing the inconvenient truth that we are bankrupt as a western civilization, we risk the possibility of an eventual sudden breakdown. Iceland experienced this last year. California is experiencing this as of this writing. And other large states or nations are lining themselves up for a similar fate. Ireland, Spain, Mexico, Pakistan and the Baltic states. Russia and the UK are not far behind.

Doubtless, anytime there is a paradigm shift of this magnitude (think collapse of Soviet Russia, fall of Habsburg dynasty, French Revolution, etc) there are winners and there are losers. Questions we need to ask ourselves include: shall the average person pay the price for mistakes made by others? To what extent will we extort money from the innocent to pay for the guilty? If they can no longer pay, lest they starve, do they become the criminals?

Those are all rhetorical questions. We know the answers, even if they mean tough decisions. But like the bank robber finally caught 20 years after the crime - who has turned his life around and has a family. He still needs to be punished (and give the money back, of course). So too must the holders of fiduciary media (a paper claim of future payment, ie. government debt) be the casualties of this shift. Many of these holders are undeserving of this treatment, but at least they made a conscious decision to take the investment risk. The alternative is to make the average person pay for other's misperception of risk. And that payment will be endless. The amount of inflated paper claims that no longer have any value (derivatives, mortgage securities, government debt) dwarf the actual economy. Most of it is hiding in off balance sheet vehicles. This is precisely where the TARP money has been going, and why nobody can see where it went. Banks have been using it to write down the asset values of their Level 2 & 3 assets. Citigroup's Level 3 assets total over 800 Billion alone. That gives credence to the enormity of the problem. Obama's stimulus package would be enough to bail out one bank.

Bad debt needs to be liquidated. This means many banks will go bankrupt. Many companies will go bankrupt. Prices of everything will fall. Unemployment will rise. The danger is that this occurs over a long period of time. If it is permitted to occur fairly rapidly, savers will soon return to buy up assets and the middle stages of production (those requiring labour) can occur sooner. This is the only course of action that gives justice to the average person. Congressman Paul recently argued for a similar solution in a statement before the house.

To that end, I offer the following immediate actions that should be taken:

1) Move to back all demand deposits and their equivalents with 100% physical reserves, thus keeping depositor's money safe
2) Legislate mark-to-market accounting for every institution
3) Allow the "fire-sale" of securities to which there is a claim for a tangible asset
4) Repeal laws outlawing the use of non-government issued currency
5) Eliminate securities that are of no claim to anything tangible, including government debt

There would be pain involved, but the economy that emerges from the rubble would be one based on legitimate production and accumulated wealth. Much of the rest would take care of itself. People will find a way to get through the tough time in between. They'll grow gardens in their backyard. They'll knit their own clothes. The lower prices of everything will assist people in getting by. History is rife with examples of societies displaying incredible ingenuity in times of stress. I hardly doubt this time would be any different.

You wanted my solution? Now you have it.


Anonymous said...

A very interesting post.

I have read about competing currencies and competing currencies seem to hinder trade. I think it is a good thing that EU adopted the Euro.

I personally think that a quad-metal (gold, silver, platinum, palladium) standard might be a good idea. This will allow the central bank to expand the monetary supply at a reasonable pace to accommodate economic growth. Fiat money supply are often increased at a crazy rate of 10% to 20% annually. There is no way that most economies can grow around 10% to 20% a year. As a result, inflation and bubbles appear.

RRB said...


I suspect that rather than requiring banks to have 100% reserves, if instead all the government did was repeal legal tender laws, we'd be all set.

The likely effects of this repeal would be:

1. People would still be able to use dollars for transactions - alternately, they could use any of the private currencies that pop up as well. The transition would be smooth, and existing systems need not be turned upside down overnight.

2. Banks will be denied the Fed's money magic, so their unfair advantage (i.e. their ability to offer cheap loans by effectively growing the money supply themselves) would vanish.
It may well be that 100% reserve banks are the victors in this new system - or maybe they would just be a component. There may be other banks that disclose a lower reserve ration, say 50%, and offer depositers a higher interest rate on deposits to compensate them for the higher risk. Either way, the market would decide the outcome, not politicians.

3. With the threat of competition from hard asset-backed currencies, the govt would automatically be much more disciplined about growing the dollar-based money supply, which in turn would automatically limit the growth of govt.

In a nutshell, mandating 100% reserves is not a laissez faire solution - it is simply a different regulation. Ideally, the market would figure out what the ideal reserve ratio is. The repeal of legal tender laws would make that market mechanism infinitely more efficient than it is at present.

Look forward to your thoughts.

Matt Stiles said...


There is a little bit of method to my madness in laying out how I think this could be done. Although, they are all extremely loose ideas and presume I'll be convinced of better ways to do them.

The reason I had moving to back reserves 100% as priority number one was not because I thought it was necessarily the best way for a bank to do business (no, government should not be in charge of determining this). However, if mark-to-market accounting were to be restored (#2), I would guess that nearly every bank in the western world would be immediately insolvent.

If people cannot be confident of having their money stored safely or at least accessible so they can store it themselves, there is risk for total social breakdown. Rioting, martial law, food shortages, you get the picture.

I'm trying to outline a conceivable strategy to progress from the old paradigm to the new without massive loss of life or chaos. I think if legal tender laws were suddenly repealed, there would be a similar rush out of anything dollar denominated, thus causing shortages in many goods and again, chaos.

I could be wrong on that.

VancityAllie said...

I just wanted to say I really enjoyed your comment on the most recent condohype post, about capitalism.

Well done!


mannfm11 said...

Matt, not everyone that has something stole it. In fact, many people that have something have it because they stayed out of the shopping malls with their credit cards. Most Americans with no net worth deserve nothing, as they have blown every dime they ever saw, regardless of whether they worked for the minimum or made six figure incomes. The system is already set up where those that have are going to be the ones that pay, as no one else can.

As far as the 100% reserves? How can you have accounts and loans too? The first loan breaks the reserve and the whole concept is nonsense. I have thought this over myself and the only real matter would be for the government to run the banks and loan the money into existance with a lawful order to maintain the money supply and run the banking system. All lending outside the bank could be done at risk, which means that you loan it, you are probably going to lose it. You can't violate the property standard of taking the assets gained by saving people in the form of government bonds and then pledge to be for the idea of government not taking private property. The entire basis of the 5th amendment is the basis for freedom in the US, yet it lays there unenforced and unrecognized. The taxing of one group for the support of another is the taking of property for public use without compensation. Debts can be paid off if put on a different basis than the fractional reserve basis we are on now. Getting back to the bank, all one needs a bank for is to clear funds. Let all other financial transactions take place under the idea of investor beware. There are plenty of prisons in the US to hold all the fraud artists.

Matt Stiles said...


First off, none of these ideas are set in stone. I fully expect to revise this radically upon learning of better ways to do things.

On the issue of 100% bank reserves. They are for demand deposits and their equivalents. Banks can attract loans for higher interest accounts and use those proceeds to make loans. Depositors would know that they're on the hook for any losses, so they would ensure that the money is lent wisely (and they would be able to, because the bank is a small, local operation) and also, they would be the ones determining the cost of mortgage rates. Not some guy in a corner office 3000 kms away.

And I think you misunderstood my point about debt holders. My point is they would simply be put on a rung below physical asset holders in the liquidation of the financial system. Governments are bankrupt. They need to declare bankruptcy and go through liquidation like any other poorly run business. The holders of their debts would be in the same position as a corporate bond holder in the event of bankruptcy. Their payment would be subject to the liquidation.

In my opinion, that is the only moral way to do it. But as I said, I'm likely missing something here.

What I do know is that younger generations will not accept being on the hook for previous generations' carelessness. Government bankruptcy can either occur now in a calm and orderly process, or it can be put off until the rule of law can no longer be funded and we plunge into chaos.

Matt Stiles said...

I'm not the only one calling for 100% reserves. Jesus Huerta de Sota, professor of economics at the Complutense University of Madrid, has been calling for this in his book Money, Bank Credit and Economic Cycles and highlighted it in a recent article:

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