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Bank of England - UnPlugged

by ChrisCook Fri Nov 2nd, 2007 at 08:05:09 AM EST

There has been much discussion on ET re Northern Rock and this

Northern Rock as Tax payers goldmine

appeared on the FT website and in the FT today.

Now, this article blows wide open the current deficit-based charade of a system we have, and the strange role of Central Banks within it.

The article deals with the Bank of England's role in the Northern Rock fiasco and asks

Is there a serious threat to Britain's public finances? Is a large sum of public money at risk?

and then analyses exactly why this is in fact a "nice little earner" for the BoE, if not for the Northern Rock shareholders.


The answer - paradoxically - is: there is no damage at all. On the contrary, the £30bn rescue of Northern Rock will boost the central bank's profits and reduce - yes, reduce - the budget deficit by £2bn.

and the explanation

The explanation is that the Bank of England can create money "by a stroke of the pen". Parliament has made it the UK's only issuer of legal-tender notes, and it can expand the note issue or credit a balance convertible into notes at virtually nil cost.

Because of these special powers, the Bank does not need to borrow in the interbank market at a positive interest rate.

Instead the interest cost on its £21bn loan (and indeed its £30bn loan if it reaches that level) is zero. So the Bank's profit on the operation in the circumstances discussed would amount to about £2bn (that is, 6¾ per cent on £30bn).

Congdon then goes on to explain why it is that the Bank of England cannot do this for everyone who wants interest-free credit.

Like me. And the answer is of course that I might not pay it back.

Cost of Credit?

The actual function of Banks as credit intermediaries is in fact to guarantee the credit of the borrower. The cost of that guarantee is a combination of system cost and default costs.

This cost bears no relation to the arbitrary interest rates set by Central Banks, and we have recently seen the relationship between the rate set by Central Banks and that charged by clearing banks diverge.

In fact banks have been accustomed for some time now to "outsource" to investors their guarantee risk. The credit derivatives that they use are essentially guarantees of finite duration.

There is a crucial qualitative distinction between unsecured credit - which is backed only by future earning power of individuals and corporations - and "asset-backed" secured credit.

This is that productive assets such as Land (which backs Northern Rock's loan portfolio) actually underpins more than two thirds of UK money in existence.

It is the stream of "use value" units of land and property - let's call them "Square Metre/ Years" which has the "Value" in exchange for which we are accustomed to exchange other forms of "Value" eg our time value through the medium of money.

Now, the actual "cost" of such "Capital" (albeit Land has been essentially defined out of existence by conventional Economics) is a matter of supply and demand.

Cost of Capital?

But what actually is the true Cost of Capital (as opposed to the arbitrary Cost of credit and hence the financial capital consisting of "Money as Debt")?

Gregory Clark The Industrial Revolution Unplugged: and Interview with Gregory Clark had interesting data here, but drew the wrong conclusions.

It turns out we have very clear evidence of changes in peoples preferences over this long pre-industrial interval. The example the book gives is that people were becoming more patient as the Industrial Revolution approached. The measure of patience in these pre-industrial societies is the interest rates?

Because the interest rate tells you much you have to reward people to own land or own houses. How much do you have to pay them not to consume immediately, but instead own that asset and wait for future consumption? If you go back to ancient Babylon they had mortgage markets but the interest rates were typically twenty to twenty-five percent.

If you go to medieval Europe their interest rates were ten to twelve percent for things like land. By the eve of the Industrial Revolution the return on land in England dropped to about four percent. So in the pre-industrial world interest rates seem to indicate the amount of patience people are exhibiting.

Clark wrongly assumed that people are getting more patient (and less greedy?) because he assumed that a return on capital has always been based upon the "Cost of Credit".

It has nothing to do with peoples' preferences and everything to do with a market price for Capital.

The supply of productive not financial Capital has been growing over the ages so that the world in awash in it, and hence the price is now very low in real terms.

Medieval England had absolute price stability. It had almost no government debt. It had very strong security of property. People who invested in land in local villages, who needed a ten percent return in order to make that investment, had absolute property security.

It was because there was no deficit-based money that there was no inflation.

What I am getting to is not that Treasuries or Central Banks should issue credit interest-free (although they could, as the Social Credit movement advocated) but that we should look at new ways at which "Value Units" such as Land Rental Units and   Energy could be created using "Equity" or "Asset-based" solutions.

In the dis-intermediated "Clearing Union" model I advocate, Banks become service providers, and Central Banks like the Bank of England  -currently bailing out Northern Rock - are entirely redundant.

I got lost in the middle of the diary, but I thought the Congdon article was a fairy tale.  

He insists that NR´s fundamentals have not changed!  If that were true, they wouldn´t need to borrow from BoE, so the underlying values have changed and it has become ´unsustainable´.  When BoE lends to an ´unstable´ bank, on an emergency basis, repayment and (L2 billion) interest income cannot be presumed in the best of cases.

That an FT writer (and NR stock investor) denies the reality of the subprime/derivative global problem does not apply to NR is too absurd, but the FT has no shame.

Now, I wish we could know how many central banks are covering how many other cases.

Our knowledge has surpassed our wisdom. -Charu Saxena.

by metavision on Fri Nov 2nd, 2007 at 07:31:48 PM EST
Well I sort of got carried away and did two Diaries in one....sorry about that.

From my days in the UK's Insolvency Service I learnt that there are two "insolvency tests". One is the "Assets vs Liabilities" test. The other is the "Paying debts when due" test, and this is the one that NR fails of course.

The US situation is very different to the one in the UK, I think, because of the restricted supply of land here. Property in the US has become over priced due to the irresponsible "sub-prime" lending that drove prices to unsustainable levels.

The reality of US defaults is about to hit big time - all we are seeing at the moment, is the expectation of defaults.

But don't forget that even in a default situation property will never - absent complete fraud - go to zero value, and so even when a bank gets hit by defaults it may in practice not actually lose that much if it can only hang on and keep paying its depositors while it repossesses and sells off the property, and probably takes a loss on it.

So even if the Fed did start printing gazillions of "interest-free" dollars (greenbacks), and buying up all the defaulting sub-prime loans with them, it then essentially has the option of becoming a bloody great landlord, and all of the rentals paid by the hapless sub-prime borrowers could go to the tax payer via the Fed.

In fact this - quasi-nationalisation - would be the perfect solution.

Surely there would be inflation? Well actually no, the Fed's credits simply cancel out the existing bank-created loans, and no money actually enters circulation.

The trouble is that it is difficult to get your head around the reality of our system.

As Galbraith said

The process by which banks create money is so simple that the mind is repelled

"The future is already here -- it's just not very evenly distributed" William Gibson
by ChrisCook (cojockathotmaildotcom) on Fri Nov 2nd, 2007 at 08:11:11 PM EST
[ Parent ]
an interesting diary on a subject that is well outside of my experience. thank you for the insight.

keep to the Fen Causeway
by Helen (lareinagal at yahoo dot co dot uk) on Sat Nov 3rd, 2007 at 11:32:09 AM EST

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