The Explanation: Collusion

Finally I found some explanation provided in The Mystery of Banking by Murry N. Rothbard, an economist of the Austrian School and member of the Ludwig von Mises Institute.

"The Institution (of Central Banking) began in late seventeenth century in England, as a crooked deal between a near-bankrupt government an a corrupt clique of financial promoters." Rothbard describes how at the end of the 17th century the British government found itself in a position short of options. After half a century of civil war and a bad credit standing, it seemed impossible to issue new government bonds. Higher taxes were no option, as those wars had been fought over the king's attempt to extend taxing.

Because of distrust, British government had no direct access to borrowing or to printing money not backed by gold. So they chartered the Bank of England, which would 'issue new notes', used to buy government bonds. Funded by a private financial group and fueled with an aura of prestige created in the public, this institution created notes it would have to redeem in Gold. While the British Parliament did not make these notes legal tender - meaning they would have to be accepted as money by everyone - they made the new Bank holder of all government deposits in addition to the right to issue new notes to buy government debt.

So maybe we did find one answer to the questions why governments are in debt and do not print the money they need (want to spend) in excess to the revenues (taxes) they get: It would be too obvious that this would be inflationary, devaluing the money base. Everybody could and would understand that printing would make paper worthless over time. And nobody would trust governments enough to allow them to do so.

Instead, a complicated scheme was invented. Non-governmental, independent institutions are the only ones to create money. Government has to borrow as you and I do. And those institutions have the task to ensure sound money, to fight inflation and deflation, to ensure the stability of our financial system, as politicians and governments cannot be and are not trusted. But in the end the central banking system with fractional reserves is even more inflationary then the government blatantly printing money.
And once the scheme started, governments and banks become interdependent. Taking the right to create money away from the banks would let the pyramid of debt we collected crumble. We would hit the banks, depriving them from a huge source of income. But the GDP would contract and no politician could stand this pressure.

Oh boy: where is the person telling me this is not true. Please help!

Additional (supporting) sources on the topic:
Nouriel Roubini and David Backus - Lectures in Macroeconomics
Milton Freedman - A Monetary and Fiscal Framework for Economic Stability

Who's behind the FED?

In summer 2010 I took a tour at the Fed of New York, the most important of the 12 Reserve Banks constitution the Federal Reserve System. The nice thing about many US institutions is that they care a lot about public relations. Tours are free and end with a visit of the gold vault 50 feet below sea level storing 7.000 tons of gold (much of it belonging to foreign countries such as Germany). Visitors are not only provided with USD 1,000 (unfortunately cut to pieces) but also with extensive information material. Even more can be found on the Web-Page, including Annual Reports. Let us take a closer look:

• In 2010 the Fed of New York had an income prior to distribution of USD 40 bn (USD 39,789 mn - just to make sure Europeans and others take away the same picture). This was mostly coming from interest income and is net of operating expenses of USD 1.8 bn.
  
• Most of the interest income comes from US Treasury securities and federal agency and government-sponsored enterprise mortgage-backed securities (read: interest on US debt and on papers bought by the FED in the aftermath of the financial crisis 2008/09.
  
• USD 30.1 of this income prior to distributions is paid to the US Treasury, and a minor portion of 0.5 bn is paid to member banks.
  

At least now we can dismiss some of the horror stories on the internet: Yes, the FED is privately owned, as it consists of private member banks who have to provide capital (the bigger the bank, the more capital they have to provide). Yes, they get a 6 % interest (dividend) on this capital, but it is not the major share of the FEDs income. And yes, while the treasury pays interest to the FED, it gets this money back by dividend payments. But no, it does not seem to be a system set up by bankers to rob the people blatantly.

Still we have that strange circle of money flows: the FED buys government debt (in many cases by 'creating' the money it needs to do so), gets interest on it coming from the Treasury and pays back this interest as dividends to the US Treasury. And still the Treasury seems to be at a disadvantage: not all of its debt is held by the FED so not all the interest comes back; in addition it has to worry about debt to GDP, ratings, ... Why not just print the US dollars needed all by themselves and avoid all that hazzle?

The search in explaining that mystery continues ...

Two questions still open

In my last post I addressed two questions:

1) What does it take to become a bank, being allowed to create money and thus gain interest on this new money?
2) Why do governments not create money into existence by spending it, but rather lend it from central banks and pay interest on in?

Today I am 230 pages further down the road thanks to a great reading suggestion by Ulrich:

Bernstein provides us with a great piece of education and I think for the first time I really understand the Fractional Reserve System. On page 36 he comes close to question 2: "But our Government is legally and morally prohibited from financing its expenditures by printing the money to do it. The Government is in the same boat as the rest of us - it has to has to finance its expenditures by obtaining money from somebody else. This it normally does by levying taxation on us or by borrowing the money from us. But the important point is that the Government cannot spend money indefinitely without replenishing its bank account. [...] Where then can we look for the source of money? Indeed, to the banks themselves!"

Bernstein describes the monetary system of the USA very well. While reading his booklet, written in the 60ies but not outdated at all, you will learn a lot about the FED, its members, money creation, the gold standard, exchange rates. Being written in the 60ies, some eye-openers might surprise you, as the perspective is of course different then ours.
Gold is traded at 35 bucks an ounce, a USD is worth 4 Deutsch Marks or 5 French Francs. This is 45 years in the past - hopefully we will live another 45 years. What will be the exchange factors by then? Thought provoking ....

Still my questions did remain open. Why is a limited number of banks allowed to profit from creating money? Why does the government not keep this rights to itself? Or at least, shouldn't we all have the same rights?
I showed some own initiative. Knowing that the banks create the money, I took a look at the FED of New York, one of the 12 members of the Federal Reserve System of the US. (to be continued ...)

Printing money, why are governments in debt?

[email dated 04/12/2011]

Given the stormy (but still too warm) afternoons of the recent weekend I stumbled over the following piece of documentation on YouTube:

It was quite thought provoking. Even given my financial education I cannot answer the questions that did arise for me. Main one being: Why is it the USA carries debt anyway? Why is money created the way it is done?

As far as I understand, money creation follows two ways (and I use the USA as example as I must admit - shame on me - I do know even less about the European institutions):

1) Either the FED issues money, creates, prints it, mostly in digital form these days. Eg. it buys some troubled assets like Asset Backed Securities (ABS) from some banks, uses fresh money to do so and thus creates new dollars. Or - as lender of last resort - it buys US treasury bills as nobody else wants them and thus helps the state to finance its deficit. Especially in the later case, these means the US government (read: the tax payer) has to pay interest on the money created.

2) Other banks are allowed by regulation to create new credits based on the assets they have. Take the case where the FED bought some illiquid ABS from some banks. The money the banks got they can lend out to business and private persons - but not only the money they got but a multiple of this, as they are allowed to leverage up to a certain degree. The leverage allowed is calculated in complicated formulas I am not educated enough to go into detail. But whenever you raise equity or you hold less risky assets (like less risky loans given out, cash instead of ABS, ...) you can hand out additional loans 5x, 10x, 25x that value. Its called fractional banking system.

What 1) creates is: Unlimited profit ratios, as you create money out of thin air and loan it out to get interest or you get (maybe depreciated but not worthless) assets for free.
What 2) creates is easy profits. For 1000 bucks I deposit at a bank they might pay me 20 interest a year. Leveraging my 1000 bucks 10 times they (the whole banking system) can hand out 10.000 bucks and get maybe 500 interest a year.

Immediately 2 questions arise - number one of course 'what does it take to become a bank'. Cause the leverage model is so clever, I would love to do it on my own. Okay - i get no bank license and maybe there are reasons why - this would be illegal. I cannot create money.

Question 2 and here I stumble: Why are governments all over the world that stupid and allow such a process of money creation? The easy way would be to print the money just for themselves, never issue any debt obligations, never pay interest, never be on the verge of default (or close to). Just distribute the currency to teachers you have to pay, build roads, and so on and so on. Banks could still exist but would not be allowed to leverage up or create money .

The only issue governments would have is devaluation of their currency when they overdo it and the paper they print gets worthless (which can also happen under the current system).
It opens a whole lot of questions, also on ethics and social fairness. Why shall a small group have the right to profit on money creation. And no: the FED is no governmental institution distributing its profits to the USA.

Any insights appreciated! I must admit I did not learn all too much at the university about this and would appreciate a good reading list on 'Money Creation'.

ETFs and what they really do

[email dated 04/12/2011]

ETFs (Exchange Traded Funds) are one of the instruments still in favor of investors today. Cheaper than Funds, they allow to follow the performance of an index, short an index or can be an easy way to participate in the ups and downs of things you can hardly trade as a private person other-ways, like Gold or Wheat.

After heavy reading this weekend I am even more cautious on what ETF to buy. I did know, that ETFs, eg a DAX30 ETF, can be synthesized, meaning they do not hold stocks only, but options, derivatives, etc. - mainly from the mother company of the firm issuing the ETF. So what you have really got buying them is the promise of a big bank (like Commerzbank, SocGen, ...) to pay the ETF-issuing company (comstage, Lyxor, ... ) enough so that they can pay the ETF-Holder according to the development of the DAX30.

What I did not know is that even for non-synthezised ETFs - those actually holding the shares of the DAX30 in the same composition as the index - counter-intuitive things take place. Additional value for the issuer of those ETFs is often created by lending the stocks of the ETF to short-sellers. This is done up to 90 % of the portfolio. It is a crazy idea that by buying a long ETF you actually help the folks on the other side of the trade by lending them shares. This instrument is dead for me ...

Coming that far, do you know whether the stocks in your portfolio at which bank whatsoever you hold them, can be lended-out to short-sellers? I will investigate into this for my banks now and asking customer support for clarification.

What a difference a day makes

[email dated 30/11/2011]

Global markets surge after world's central banks increase liquidity and make money cheaper. Stocks surge. EUR is up. GLD and SLV are up, too.

What a difference a day makes.

Big break-down limits have been avoided (S&P500: 1125; DAX: 5000). Money flows in. FED, EZB, BoJapan, BoEngland, BoCanada and the Swiss guys take part in the action.
You know my bias - I guess you assume my reaction would be: see - inflation is coming. Central banks are flooding the markets. Move to gold and silver - and platinum. Raise your debt level - buy real estate.

I tell you, what worries me is: all those banks took action together now. Their thought was that the situation is serious enough to do it now. Or let me restate this: all of them thought the situation is serious enough, so that they could agree on a common action, have been forced to agree on common action now. They did see no alternative to this action ... Did try to surprise the markets today. They must really be scared.

But did that fix any problems?

Do you trust Greece more today than yesterday?
Portugal? Spain? Italy?
France?
The US?
Germany?

This is all about trust - and if there is no trust, there is no limit on how bad things can go. In the end, even Germany can not put enough austerity measures on to compensate for the lack of taxes in a crumbling economy. You cannot safe your way out of a situation where nobody lends you anything anymore. No country in the world can.

Today central bankers showed that they lost trust. They showed that they think coordinated action is necessary --- otherwise serious things would go bad.
In the short run, the money was put into action and did what it should do. Prices move up. But tomorrow folks will start to think: why did they do it?

I do not take this as a positive signal at all.

More than ever I see dangers ahead: either massive inflation - or deflation by debt contraction.

The question remaining open: which force is the more powerfull? Can trust contract faster than countries print money? Or can central banks print money faster than credit contracts because of lack of trust?

Have a good one.

And do not forget the open question: What performs well in hyper-inflation and deflation by debt contraction?

How this blog started ...

Late 2011, in the midst of the debt crisis in Europe, I started to share thoughts and questions on money, finance and related topics with a few friends, colleagues, and loved ones. Writing late night emails to a list of BCC recipients, I got personal email response, entered into lengthy discussions via telephone, or found an occasional book on my office desk related to the topics of last night.
The process started to become inefficient. Apart form some technical issues like sending emails to company accounts with clearly non-work-related content, there was one major issue: all the feedback I got was only visible to me.
I want to change this, hopefully leading to a forum allowing comments from different sides without compromising the identity of people participating active or passive. I encourage people to contribute with comments but also to invite others, who might have the passion to read and comment on topics discussed her, thus increasing the community.

To get the whole thing started I will post some of my last emails (slightly altered) over the weekend.
As this is my first blog, I guess I will pay dearly in learning what can and cannot be done here and how to do it best. Hopefully you will pardon inconveniences caused by this.

I hope the blog will become a provoking place to visit: thought provoking and action provoking. As the Chinese proverb says: we are living in interesting times. Given the day-in-day-out hazzle of our lives we might not dedicate sufficient time resources to the high volatility and insecurity of our times - and might loose big on this. Let us try to avoid that.